Cablegate: Securities Exchanges, Clearing and Settlement:

Published: Tue 26 Aug 2003 01:01 PM
This record is a partial extract of the original cable. The full text of the original cable is not available.
E.O. 12958: N/A
SUBJECT: Securities Exchanges, Clearing and Settlement:
Alliances Made and Broken; Poker or Chess?
This cable is sensitive but unclassified. Not/not for
Internet distribution.
1. (SBU) Introduction: The European world of clearing
and settlement is not as boring as these dreary back-office
chores imply. Intense rivalry in the market place has
become even more so - spreading beyond the continent, across
the channel and across the Atlantic. Deutsche Borse lost
its bid for the London Stock Exchange three years ago and is
ending its joint venture with the Chicago Board of Trade
(CBOT) only to find the French-based Euronext team striking
up alliances with the British and the CBOT.
2. (SBU) Policy wonks have also been busy. The European
System of Central Banks (ESCB) and the Committee of European
Securities Regulators (CESR) issued a consultation paper
proposing standards for clearing and settlement. Among the
interesting features of these proposals is the notion that
clearing and settlement systems should be open to investment
firms, but such firms from third countries could be denied
access if their home market supervision was not considered
"adequate." The European Parliament adopted a report to hem
in competition between custodians and clearing and
settlement organizations. In April the Giovannini Group
presented a critical pathway for liberalization of Europe's
clearing and settlement structure. Lots of good ideas and
3. (SBU) Enter the European Commission. . This fall
the Commission is scheduled to release a second
communication and, depending on reactions, might issue draft
legislative proposals in December. To date, Commission
officials assert that they are content to let the market
sort itself out before taking legislative action. Observed
one specialist, market pressures are generating solutions
that the Commission could never legislate - so best leave
the sector alone.
4. (SBU) The rough and tumble world of clearing and
settlement is more like poker than chess - bluffs, calls and
raising the stakes. The Commission, congenitally condemned
to initiate but not enact legislation, must confine its game
to chess. End Summary.
Setting the Scene: The Players and the Pot
5. (SBU) The European players in the clearing and
settlement game are very different from those in the United
States. Herein lie a strength and a weakness. The strength
is that the largest European players are part of an
"exchange complex," that combines clearing and settlement
activities with cash listing and trading (equities) (the so-
called "vertical silo" approach) and derivatives trading.
This allows revenues to be generated from different business
lines generally resulting in resilience in the bottom line
when one business line experiences weakness, e.g. lower
equities trading as is the case at present.
6. (SBU) The largest of these complexes in Europe are
the Euronext group and Deutsche Borse. Smaller, but
similarly structured complexes, exist in Italy, Spain and
Sweden. According to the MSMOW study published in June 2003,
Deutsche Borse received 15% of its revenues from cash
listing and trading, 23% from derivates trading and
clearing, 43% from clearing and settlement, and 19% from
information products and systems. Euronext was similarly
diversified: 26% from cash listing and trading, 34% from
derivatives trading, 20% from clearing and settlement, and
17% from information products. Why is this interesting?
One German expert explained that since many of its
activities are similar, investing one time in software
development can generate uses across its product line;
increasing the load on those systems drives down marginal
costs, increasing profitability.
7. (SBU) Compare this diversity with that of the London
Stock Exchange, New York Stock Exchange and Nasdaq, all with
the bulk of their revenues coming from cash listing and
trading (LSE 55%; NYSE, 74%, Nasdaq 71%). This "horizontal"
approach allows investors to move from different systems for
each aspect of securities execution, i.e. trading, clearing
and settling. As these exchanges are heavily dependent on
one or two business lines, in present market conditions,
lower listing and trading activities mean a lower total
bottom line.
8. (SBU) The weakness in Europe is that there is no one
institution that clears and settles - implying heavy
investments by the clearing and settlement industry and
potential risks to investors. In the US the Depository
Trust Clearing Corporation clears and settles all equity
securities in the US. The Options Clearing Corporation does
so for equity options. Futures are somewhat different,
being able to be cleared and settled in the system where
they are traded.
9. (SBU) What is the competition in Europe about? The
MSMOW study estimates that European exchange complexes took
in revenues of euro 5.2 billion in 2002. Profit margins
were roughly 26%. Worth a good scuffle for a part of that
10. (SBU) Competition, however, should be viewed on a
broader scale, that is, by considering the larger pot of
where the investor "spends" money in capital markets
transactions in Europe. The MSMOW study estimates that
total to be euro 40 billion. Of that amount, exchanges and
centralized depositories (institutions holding securities
that enables securities transactions to be processed by book
entries) took in euro 3.5 billion, custodians (entities that
safe keep securities for customers) euro 4.5 billion, data
system providers 2.5 billion, and a hefty euro 29.5 billion
went to commissions and spreads. Now that is a value chain
worthy of an all out fight - exchanges want to cut out the
middle man, custodians want to restrain exchanges, and
middle men want to keep business in house (internalize
transactions) or at least away from an order book open to
all on an electronic exchange (hear the mouse click away
their revenues?).
Action: Market Players
11. (SBU) Three years ago Deutsche Borse was going for
the "golden ring." A merger with the London Stock Exchange
was rumored in the press and its "vertical" processing of
trading, clearing and settlement (straight through
processing) was envied, copied, and attacked as
anticompetitive. Deutsche Borse struck up a joint venture
in the derivatives market with the CBOT in the United
States. Life seemed beautiful; but it still was life. The
merger didn't happen, other exchange complexes have
developed or are planning their own straight through
processing systems, Commission competition authorities have
opened an investigation, and the joint venture with the CBOT
will be dissolved at the end of 2003.
12. (SBU) Instead of Deutsche Borse domination, there
seems to have been a shift to what one analyst terms the
"ABW Strategy," or an "anybody but Werner strategy,"
referring to the head of Deutsche Borse who has been
referred to as "visionary," "opinionated," or "abrasive.".
Highlights include:
- Merger of CrestCo with Euroclear (the settlement
operations for the London Stock Exchange and Euronext,
- Proposed merger of the London Clearing House and
Clearnet (the clearing operations for the LSE and Euronex
- The CBOT replacing its trading platform under license
from Eurex, the Deutsche Borse derivatives operation, wit
new contract with LIFFE Connect, designed and built by
Euronext.liffe (over a year ago Euronext had purchased th
London International Financial Futures Exchange)
- Nasdaq Europe has announced it will close down its
exchange in Brussels at the beginning of 2004 and will cl
Nasdaq Germany by the end of August.
13. (SBU) Deutsche Borse, however, has managed a few
surprises of its own. DB has introduced a system to help
brokers/dealers to internalize transactions (if they can't
beat'em, join'em - or at least made some money out of the
deal) and has announced that it will:
- seek to establish its own licensed exchange in the US
to compete in the derivatives market;
- open its system to investors from other systems,
forsaking the "silo approach" if others (read Euronext) d
the same;
- implement an automated daytime bridge between
Clearstream International (its settlement bank) and
Euroclear Bank to allow same-day bridge transactions;
- attract Dutch brokers and dealers displeased with their
Euronext association (fees went up this year for the firs
time) (the LSE also seeking to pick up some of the busine
from the disgruntled Dutch traders).
Kinda leaves you breathless, waiting for the next move.
Action: Policy Wonks
14. (SBU) European policy officials also have ventured
into the clearing and settlement terrain.
- The European Commission is collecting comments on its
May 2002 Communication on clearing and settlement and is
expected to publish another communication in September;
- The European Commission's November 2002 proposal for
the revision of the Investment Services Directive would
require member states to ensure investment firms from oth
member states have access to central counter party and
clearing and settlement systems in their territory and th
stock exchanges allow participants to designate the syste
for the settlement of transactions;
- European Parliament adopted a report in December 2002
on clearing and settlement proposing that core settlement
services should be managed as a user-owned service govern
by rule of a non-profit entity and that central securitie
depositories perform only settlement services and not "va
added" services;
- European Commission competition authorities opened an
infringement proceeding in March against Deutsche Borse's
Clearstream Banking AG for refusing Euroclear Bank's acce
to the settlement platform for more than two years and fo
charging higher transaction prices to Euroclear than to
other national central securities depositories outside
- Giovaninni Group's Second Report on Clearing and
Settlement issued in April presented a program and schedu
for removing barriers to clearing and settlement within t
- ESCB/CESR's Consultative Report on Standards for
Securities and Clearing Settlements in the European Union
issued at the end of July proposed standards to sustain
integration in the EU by having one single set of standar
for a regulatory framework.
The ESCB/CESR work deserves special mention.
ESCB/CESR: Softer than a Law but Harder than a
--------------------------------------------- --
15. (SBU) The ESCB/CESR Consultative Paper was prepared
by a ESCB-CESR Working Group comprised of representatives of
15 national banks of the EU and representatives of CESR.
The Working Group has proposed 19 standards for clearing and
settlement systems covering such topics as legal framework,
settlement cycles, central counter parties, central
securities depositories, delivery versus payment, risk
controls, operational reliability, governance, access,
transparency, and regulation, supervision and oversight, and
risks in cross-system links. Comments on the paper are due
by October 31. A public hearing will be held on October 2
in Paris.
16. (SBU) The paper reflects the Giovaninni Group's
Second Report, the Group of Thirty's 20 recommendations on
clearing and settlement systems released in January, and the
Recommendations for Securities and Settlements Systems
issued by the Committee on Payment and Settlement Systems
(CPSS) and the Technical Committee of the International
Organization of Securities Commissions (IOSCO) in November
17. (SBU) The standards aim to provide a consistent basis
for regulation, supervision and oversight of securities
clearing and settlement systems, enhance the safety,
soundness and efficiency of such systems, protect investors,
promote competitive EU markets, and avoid systemic risks.
18. (SBU) These standards are unique in several aspects.
The first, is that they are "standards." They are not
recommendations to take or leave. Neither are they
mandatory since they would not have Community law status.
Rather, the ECB/CESR Group believes that standards will be
of a more binding nature than recommendations and that
regulators will implement them on a "best-endeavor" basis.
This has worked for the ECB in its standards for securities
settlement systems in credit operations in the ESCB.
However, the ESCB/CESR proposed standards on clearing and
settlement go well beyond ESCB activities.
19. (SBU) A second interesting feature is the proposal to
apply many of the standards to major custodians, including
custodian banks, some of which clear and settle in-house
rather than going to local clearing and settlement systems.
Some of these banks have significant operations and would be
considered "systemically important custodians." The
ECB/CESR has proposed four criteria to identify such
institutions: (1) magnitude of activities (e.g. 5% of EU
market or 25% of a domestic market); (2) number of systems;
(3) nature and number of clients; and (4) the possibility of
being replaced in the event of failure. Banks that have a
large presence in the custodian business in Europe include
BNP Paribas and Citigroup.
20. (SBU) Finally, the standards go well beyond the
competence of national banks and securities supervisors to
cover tax, accounting and other legal issues. To ensure
consistent implementation and compliance, the Group notes
the importance of cooperation and information exchange among
competent authorities. To ensure such cooperation is done
in a regular and structured manner, the Group volunteers to
take on a monitoring role to organize and co-ordinate
assessments of implementation.
Some Observations: Connecting the Dots
21. (SBU) Actions by market participants and policy wonks
have been, to some degree, symbiotic. Here are some
(a) Cross-Border Activities: Increased cross-border
activities in clearing and settlement presaged by the
Crestco and Euroclear merger or anticipated merger be
LCH and Clearnet suggests that standardization of rul
not only needed to integrate the EU market, but to en
that integration at the company level works at the
operations level, bringing promised efficiencies to
investors while protecting them from increased risks
cross-border transactions. Thus, the ESCB/CESR stand
have some urgency from a supervisory point of view.
is some time, however. According to a London-based e
not much has changed in the actual operations of Cres
Euroclear, for example, so the continental and UK sys
still run separately.
(b) Access: Deutsche Borse's willingness to open its
system to investors that trade on other platforms ref
the pressure from the ISD proposal, the Commission's
competition policy investigation, and, to some extent
ESCB/CESR standard on access. Access is not to be ab
The ESCB/CESR standard would require objective and pu
disclosed criteria that permit "fair and open access"
still being able to control risk. Access could be de
a clearing and settlement system if it posed risks th
could not be effectively controlled. What about acce
investment firms from other countries? Access could
denied, according to ESCB/CESR if there is a lack of
"adequate supervision" and doubts about the enforceab
of the legal powers of the service provider in the ho
(c) Governance: The ESCB/CESR standard on governance c
for arrangements designed to fulfill public interest
requirements and to promote the objectives of owners
users. This reflects, in part, the views in the Euro
Parliament report proposing to require settlement sys
be managed as a user-owned non-profit organization.
European Parliament's view is also supported by a gro
called "Fair and Clear," composed of large custodian
including such big players as BNP Paribas and Citigro
(d) Value Added Services: The ESCB/CESR proposed stand
on risk controls implies that clearing and settlement
systems could extend credits, thus competing with ban
The ESCB/CESR proposed standard states that operators
systemically important systems should not run credit
but where they extend credit they should fully collat
such exposures. Should such systems extend credits t
support the orderly functioning of the market, they c
offer uncollateralized credit but only to institution
high credit standing. The European Parliament report
proposed that settlement systems not be permitted to
such credits, a view shared by "Fair and Clear." Her
concerns coincide: concerns about risks to settlement
systems from credit lending and concerns about compet
to custodian banks from settlement systems offering c
services to their clients. A German expert points ou
is a false issue, in that settlement systems are lice
banks anyway. Moreover, investment firms enjoy the
competition afforded by several players in the
settlement/custodian business, keeping costs lower an
service better than otherwise might be the case.
Where will Competition Drive the Market?
22. (SBU) Allowing the market to find "solutions" to
efficient trading, clearing and settlement systems sounds
nice. But what does it mean? Where will the market take
the trading and post-trading infrastructure? Not being
experts ourselves, we listen to what our betters have to
23. (SBU) The MSMOW study presents there views on how
several key areas may develop:
(1) Silo versus horizontal approach: The vertical
"silo" structure of exchange complexes that offer
clearing and settling and straight through proces
been criticized as anti-competitive. A horizontal
allows investors access to the trading, or cleari
settling systems. The study suggests that this d
burn out as market participants and regulators lo
expensive costs and adopt pragmatic solutions. V
structures will become "interoperable" over time
exchange complexes will be able to fulfill their
providing market infrastructure and making a prof
provided they continue to deliver lower all-in tr
costs. So far, this seems to be the trend.
(2) Separation of Depository from Banking Services:
Settlement systems will have a tough time competi
banks by offering value added services, in the MS
view. Settlement banks, while banks, don't offer
range of banking services. When the market picks
study expect exchanges will stick to their core b
(3) Centralized clearing systems: The study "stron
believes" that centralized clearing will receive
from Basle II. Central counter party mechanisms
manage risk and reduce systemic risks. Banks wil
such mechanisms to reduce risks and corresponding
charges. The ESCB/CESR standard on central count
goes in the same direction. It states that where
benefits of using a central counter party outweig
costs, market participants should either use the
an existing one or establish one of their own.
(4) Internalization versus on Exchange Trading: Th
suggests that continental exchanges that use elec
trading and a central order book for equity tradi
continue to capture a large market share - betwee
trading. In the UK, where two-thirds of trades a
"facilitated" rather than placed directly on an o
book, the study expects little change. In its op
customers and the size of orders will dictate the
exchange trading and internalization in each mark
provided regulation doesn't favor one or the othe
Policy: The Wild Card
24. (SBU) The dynamics of the market place are like a
game of poker: increasing investment stakes in high tech
infrastructure, improving the hand by striking up more
alliances or products, and bluffing about the strategy for
improved business. Needs a strong constitution. But the
winner's take could be considerable.
25. (SBU) Enter the European Commission. To date, the
Commission officials assert that they have been content in
allowing market forces to drive changes in the clearing and
settlement market. Moreover, others are trying to do some
spadework to prepare the terrain. The Giovannini Report and
now the ESCB/CESR standards point to the need for member
states to take action to bring down legal, regulatory and
tax barriers. The ESCB/CESR use of "standards" puts more
pressure on supervisors to take action. This is still short
of legislation. Nonetheless, it could be a not so subtle
threat that if the market doesn't move itself, momentum
could build for some type of legislative action.
Parliament's report favors legislation, as does the "Fair
and Clear" group and others, such as the London Stock
Exchange, that believe that clearing or clearing and
settlement, should be regulated as a public utility.
26. (SBU) The role for specific legislation is not clear.
With so many pieces of legislation pending under the
Financial Services Action Plan (FSAP) that will have a
significant impact on the financial market place
(implementation of the prospectuses, market abuse and
financial conglomerates directives and the accounting
regulation; potential passage of the transparency and
investment services directives) the Commission will be
forgiven if not blessed, for letting these and related
market-driven changes in clearing and settlement systems run
their course. Implementing enacted FSAP legislation as well
as the ESCB/CESR standards should be a priority before
assessing what, if anything needs to be done through
Community law.
27. (SBU) Such an approach is not at all certain. The
MSMOW study regards regulation as a "wildcard." It observes
that "one should never underestimate the unpredictable
nature of lawmaking in Brussels or nationally and potential
unintended consequences of legislation." Amen to that.
While the market is playing poker, the Commission must and
should be thinking chess.
28. (SBU) The report was coordinated with Embassies
Berlin and London and USEU Brussels.
(U) POC: James Wallar, Treasury Representative, e-mail; tel. 49-(69)-7535-2431, fax 49-
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