T2S: Moving Toward a Capital Markets Union

In his 1996 book The Clash of Civilizations and the Remaking of World Order, political scientist Samuel P. Huntington describes how globalization transformed the socio-political and economic life of the world in the 20th century. While Huntington’s theory has been challenged since then, nations seemed unable to bear the burden of an interconnected world individually, forced to form alliances or unions. 

The obvious example, of course, is Europe. The European Union has been working toward a political and economic unification since its formation in the 1950s. The recent financial crisis paved the way for an even more ambitious idea: the capital markets union. That is where the Target2-Securities (T2S) platform comes in.

Juggling Markets

Approximately 10 years ago, the European Central Bank (ECB) conceived the idea of a platform where central securities depositories (CSDs) from across Europe would be put together, making cross-border settlement easy and effective. While the idea sounded attractive, it wasn’t until the onset of the global crisis that things moved a bit faster, with the ECB realizing that such an enormous project had to be strategically designed. 

“Detailed planning and extensive preparation were among the key prerequisites for turning our vision of a pan-European securities settlement platform into reality,” says Mehdi Manaa, T2S program manager at the ECB. “When you undertake large projects like this, flexibility and adaptability to different events that could occur during the project lifecycle are key factors of success.”  

“We are looking at around a 15 percent increase of our total cost, whereas T2S has been announced as a chance to lower post-trade costs in the market. Indeed, there is a small decrease on the settlement fees, but this is offset by an increase in the safekeeping fees.” Hugh Palmer, Societe Generale

It is true that the ECB had to juggle many balls during the platform’s establishment, which cost more than €1.2 billion ($1.3 billion) during the first five years alone. “We are talking about changing the settlement environment for over 20 markets in Europe,” says Phil Brown, co-CEO of Clearstream Banking Luxemburg. “In a pre-T2S world, even within the same market, you partially had different standards, rules and laws. It’s not as if you had homogeneity and then all you had to do was place everyone on the platform. Standards and practices across Europe had to be harmonized.”

According to Brown, the project had to adapt to the new reality of the global meltdown, which brought sweeping changes to the market. “You had a multitude of changes on how banks are regulated, changes in the banks’ strategies and approaches to collateral, the lack of liquidity and funding in banks, to name but a few,” he says.

Rough Start

Split into five waves, the program was launched in June 2015, when the first set of CSDs from Switzerland, Greece, Malta, Romania and Italy tried to migrate onto the platform. However, at that time, it seemed that everything went awry, as Italy had to postpone its migration and delay until the second wave, facing major technical problems. Unfortunately, this was only the beginning.

A few months later, it emerged that Euroclear Belgium, Euroclear France and Euroclear Nederland (ESES) were facing internal testing difficulties, and, after long negotiations with the ECB and the other participants, announced a six-month delay of their migration. “This required a total reshuffling of the migration waves and a detailed revision of the project plan in a very limited timeframe,” says Manaa. “Due to higher dependencies between the ESES markets and other CSDs, combined with limited time between the waves, finding an appropriate solution was much more challenging than the postponed migration of the Italian market.”   

Philip Van Hassel, Euroclear’s T2S program director, says the delay was agreed to secure that there would be a smooth transition avoiding a negative impact on the market. “It is a huge project from an infrastructure perspective—we had to make sure that our software platforms were ready and that the interaction with the respective players was ready,” says Van Hassel. “It was not only our own legacy platform that needed to be adjusted, but also the pipes and the communications with the T2S platform itself, to the Swift network. We all felt that at that moment, we were just not ready.” 

The cost of this delay was a major concern to the market, which the ECB acknowledged. As Manaa says, the revision of the migration program is estimated to result in both a revenue loss and a cost increase. There are two theories the ECB considers most probable as to how this delay will be monitored. The first is to see whether an increase of the volumes will allow compensation, or, secondly, whether an adjustment on the price of settlement, which is now at 15 cents, will be required from 2019 on. 

Doubts 

On the other hand, Hugh Palmer, T2S product manager, financial institutions and brokers at Societe Generale Securities Services (SGSS), says the delay raised doubts in the markets as to the success of future migrations, which has affected the number of custodians’ clients on joining or remaining with the wait-and-see camp. “We should also bear in mind that it had a knock-on effect on other projects ongoing in the markets, most notably in what’s called H2D/HDR,” Palmer says. “That is delayed until the first quarter of 2018, and is a project that involves the full harmonization with the T2S corporate actions standard group (CASG) and corporate actions joint working group (CAJWG) standards for income and corporate actions management.”

Ray of Light

The first breath of fresh air came on September 12 this year, when the third migration wave concluded without major issues, including the previously delayed Euroclear CSDs. It was the largest migration to date, with France being at the center of attention.

“It was a success,” says Stephen Burton, director of post-trade at the Association for Financial Markets in Europe (AFME). “It seems both the buy and the sell side have learned their lessons.” 

The T2S community has unanimously declared that the third wave is a milestone for this convoluted process, as all market participants praised the professionalism of the CSDs involved as well as the role of the ECB and the four national banks of France, Italy, Spain and Germany that are in charge of the platform’s development and operation. “The need to overcome the psychological impact of the delay, the additional workload and tight deadlines were very challenging for everyone,” says Manaa.

Reaching the 50%

Wave three has not only helped ease the sentiments of all the participating parties, but also addressed the concerns of the European market on the platform’s scalability. Euroclear France has been the largest CSD to migrate to date, and regardless of the numerous tests and rehearsals months before its migration, the market was holding its breath to see if the platform would be able to cope with such large numbers of instructions and securities.

“The migration started on Friday and up to Sunday morning we were able to confirm to the ECB and to the other CSDs that we had reached the point of no return,” says Van Hassel. The numbers are indicative of the size of Euroclear’s migration and demonstrate the significance behind its success. 

According to Euroclear, more than 340,000 balances and 120,000 pending instructions migrated to the T2S platform, while the number of rejected instructions was limited. “All the holdings, all the position balances that customers were maintaining as of Friday evening had to migrate to the T2S platform,” says Van Hassel. “Then, all the pending instructions that were not yet settled, because the settlement had not reached yet, had to be moved to the new platform. On Sunday afternoon, customers sent 25,000 new instructions for future settlement.”

Officially, the capacity reached 50 percent of the overall transaction volume expected by the time all participating CSDs connect to the platform. The transition proved that in technical terms, it was stable and able to accommodate the settlements of a large number of transactions. “This platform can take many more times the number of transactions than are already on it. The next wave will be another big wave, but there is no indication that it will be a problem for T2S,” says Burton. 

Clearstream, the largest CSD so far, is set for migration during the fourth wave in February 2017, and since day one it has tried to eliminate any problems that might emerge from the platform’s capacity to host its settlement volumes. “We work closely with the Eurosystem on this question, because with each successive wave, the volumes get bigger,” says Brown.  “Part of the project planning has been the scaling system. And that’s why we’ve been doing migration weekend rehearsals, to make sure we are okay with the volume.” 

Indeed, with that conclusion, the transaction volume will reach almost 90 percent and the ECB has been preparing for this by releasing new software in the production environment to increase the stability of the platform before the migration. “We have to continuously monitor and update the volumetric assumption and adapt the capacity of the platform to make sure we can handle the volume increase without disturbance,” says the ECB’s Manaa.

Crossing Borders

At the stage when half of the CSDs are already on the T2S platform, one could expect that the cross-border instructions, one of the key reasons for which the platform was originally designed, would have kicked off. Unfortunately, however, this is yet to be observed. “The judgement call will be when Clearstream moves onto the platform,” says Burton. “Then, there is a possibility that securities can be moved between major CSDs. So probably next year we will be able to see more cross-border movement.” 

Clearstream is waiting for its turn to move things in the right direction. “Not everyone has the organizational culture or the technical ability to provide cross-border services, so there is only a small group of CSDs that will be involved in this business,” says Brown. “But cross-border traffic will open up great opportunities. What makes the real difference is when a client, say, from Italy, can send a cross-border instruction to their domestic CSD. And that capability only becomes valid after we have joined T2S.”

While there was no controversy around the use of the platform, there have been concerns about the overall cost of the T2S use, as well as the cost of settlement. The ECB has set a pre-fixed cost of €0.15 per transaction until the end of 2018. The question is what happens next? As previously stated, the ECB is considering raising that cost to compensate for the six-month delay on the migration waves. But no one is sure whether the settlement cost will continue to be cheap and if migrating to a unified platform will be worth the trouble. 

The cost of T2S itself, however, is the major reason skepticism around the initiative has risen. As SocGen’s Palmer explains, the final price for participating in the T2S is distinctively higher than expected. 

“Our offices in Milan have done a simulation of our total annual costs, integrating the announced fee schedule,” says Palmer. “We are looking at around a 15 percent increase of our total cost, whereas T2S has been announced as a chance to lower post-trade costs in the market. Indeed, there is a small decrease on the settlement fees, but this is offset by an increase in the safekeeping fees.” 

Why T2S Matters 

A survey conducted by BNP Paribas Securities Services, published in May 2016, showed that an overwhelming majority of industry players—close to 90 percent—believe that the new settlement platform will transform post-trade processes in Europe after its full implementation. In addition, 39 percent of respondents said that harmonization and efficiency are the main advantages, while 25 percent chose collateral and liquidity. “The biggest benefit is the ongoing harmonization across the various markets,” says AFME’s Burton. “This means that members that are acting in more than one market have to build a particular type of functionality once, rather than multiple times.” 

Also, as Brown points out, liquidity and funding are the two key areas where the industry will have to focus to make the most out of the new settlement platform. “If you only have to fund in a single place through your central bank money account, you will definitely have to commit less of your capital to fund your trading activity,” Brown says. 

As far as the collateral is concerned, the prediction is that there will be an enormous demand for it. “What T2S will do is make it much easier to get collateral from where it is to where it needs to be,” says Brown. “It will make a big difference not only for the dealers but also for the buy side.” 

The Road Ahead

The Target2-Securities platform was developed as a place where Europe would come together and form an alliance to face the challenges of an ever-changing global market landscape. It is often considered as the precedent or the first step toward a capital markets union. 

If all issues are addressed and the initiative turns out to be successful, there is no doubt that this will be a milestone on the EU’s capability to strategically move in the global economic arena. After all, as Clearstream’s Brown says, right now more so than ever, a capital markets union is what Europe needs to grow its entire economy. 

Salient Points

• European CSDs are migrating to the Target2-Securities platform in five waves. Three have finished, reaching the 50 percent of the total volume of securities expected after the conclusion of the final wave in September 2017. 
• Delays during the first two waves have caused concerns in the market, but the success of the third wave indicated that the problems might have been addressed. 
• For most participants, the benefits that T2S will bring outweigh the overall cost of participating in the platform.
• T2S is considered by many as the first step toward a capital markets union in Europe, which will benefit it entire economy.