Europe’s CSDs are facing a regulatory squeeze warns Nasdaq

Bergström: CSDs will need to adapt their business models

European banks and CSDs will be forced to change their business models under relentless pressure from Basel III, CSDR and T2S. That may involve consolidating services, as well as considering opportunities for collaboration, according to Henri Bergström, head of product management for CSD technology, Nasdaq’s Market Technology business.

“Many of the small and medium CSDs in Europe are fighting for survival, in part because of the heavy cost of T2S and CSDR,” he said. “They are being forced to invest a lot without increasing their revenue – in fact, they will have to outsource their settlement under T2S to the ECB, which will add cost and likely decrease their revenue. There will have to be an adjustment and CSDs are looking to use the regulatory change to create new services.”

Basel III requires banks to set aside more collateral, among other measures. T2S is the European Central Bank project to harmonise settlement across Europe. CSDR aims to harmonise settlement cycles and provide common rules for CSDs across Europe. Each of these sets of rules places obligations on post-trade businesses. According to Bergström, national CSDs may be replaced by broader regional businesses.

Part of the ongoing change to post-trade services in Europe was the adoption of T+2 settlement in all European markets last year (except Spain, where major changes to domestic post-trade infrastructure mean that the switch to T+2 will take place next year). The move to T+2 has increased liquidity across much of Europe, but T2S and CSDR will have positive and negative effects on established business. Custodian banks and asset managers will be able to concentrate their assets with a single provider such as Clearstream or Euroclear, leading to increased collateral efficiencies. That is good news for pension funds, but bad news for some CSDs, which will inevitably lose out on fees as business consolidates in the hands of fewer, bigger players.

On the positive side, Bergström adds that issuers will be increasingly free to choose how they issue securities. Previously, they mostly chose their local CSD. But improved competition will help to drive down costs. CSDs will be able to outsource their settlement to the ECB and focus purely on asset servicing. Custodians and CSDs will then face increased pressure either to continue competing, or alternatively to collaborate. Some market players have upped the stakes by creating their own CSDs – notably BNY Mellon in Belgium and the LSE in Luxemburg.

Nasdaq itself is affected, as the company operates five CSDs and one CCP. Of its CSDs, three are located in the Baltic. According to Bergström, that means big choices will have to be made.

“We have to to consider what we will do and how to handle the regulation,” he said. “We have three CSDs in the Baltic alone and there is a re-authorisation process mandated by the rules. Will we re-authorise all three? That is a hugely expensive process. Maybe we can save some costs and consolidate the service. We have invested a lot of effort in offering multi-currency and multi asset-class clearing to our members, including portfolio margining to make collateral management and liquidity as efficient as possible.”

Beyond the question of how CSDs and custodians will be able to compete in the new regulatory environment, there are also questions to be resolved over the level of risk in the market, the resilience of the system in the face of shocks and the availability of high-grade collateral. For some years, market participants have raised concerns over a possible collateral shortfall arising from Basel III. While plenty of industry initiatives, such as the global Liquidity Alliance, have attempted to address the issue, Bergström is still concerned that it could be a problem and that it might impact on trading.

“It’s not just individual EMIR though, it’s the differing regulation in the US and Europe – regulations that look similar but have differences,” he added. “How should a US bank trade with Europe? Which rules apply? We also have Basel III, which is global. That means that banks will either need to place extra margin on bi-laterally traded OTC trades or use a CCP. That will add to the need for collateral. Furthermore, Dodd-Frank and EMIR have focused so far on fixed income derivatives, but other asset classes will be added. So T2S will make the collateral market more efficient by facilitating barrier-free movement and ECB auto-collateral service. However, Basel III will increase the need for collateral not only in Europe but globally. It’s hard to predict what the exact outcome will be.”