How will Target2-Securities (T2S) change things for your clients?
T2S is a massive structural change to European financial markets that fundamentally increases stability and efficiency for settlements in central bank money by harmonising the process in all markets. Firms across the industry in Europe will automatically benefit from this advance. But T2S also comes with features, for example enhanced liquidity management, that we as a local custodian can help clients access and make the most of.
Before T2S, when an Italian client, for example, wanted to deposit a German bond in exchange for a cash payment, the process was supported by a connection between two central securities depositories (CSDs).
This meant that delivery was not typically versus-payment – it was free-of-payment with the cash settlement coming separately. Using a single external settlement engine for cross-border settlement in T2S means that all transactions will be delivery-versus-payment and the process of exchange will become much more efficient.
What are the implications for domestic asset servicing?
The T2S platform, which supports settlement, is operated by the ECB but asset servicing at the local level remains entirely in the domain of domestic custodians. This means that custodians such as BNP Paribas play an essential role operating accounts within local infrastructures to deliver asset servicing, tax and corporate actions support to clients.
Early in the evolution of T2S there was concern that the efficiency of these functions would be threatened by the need to migrate onto an alternate system and the result would be increased costs. In response, the large CSDs have worked to ensure the process of decommissioning legacy systems and replacing them has not meant increased costs for end-users.
What are the implications of T2S-compliant solutions for liquidity?
The new T2S solutions enable a whole range of liquidity management options. T2S includes features such as auto-collateralisation that helps participants access liquidity in central bank money based on the assets that they are buying. For example, to finance the purchase of a fixed income instrument, T2S creates an intraday repo with the central bank generating the cash required for settlement, with the bond acting as the collateral. This process is supported not only in the client’s domestic market but also for trades that cross European borders.
Consider the case of an Italian client with a large portfolio of French securities that is purchasing Italian bonds. Assuming the client has signalled to us that it would like to take advantage of this feature, the system can select the collateral required either from the French portfolio or from the Italian bond purchase.
The benefits of this become apparent when you consider that, for certain transactions or at certain CSDs, the Italian bonds may attract a punitive haircut with the need to collateralise other assets to fulfil the settlement obligation.
Does it increase the number of netting opportunities?
Yes, better netting is another benefit. Because everything settles through T2S, the diverse spread of CSDs can all be viewed as a single netting resource.
Clients can benefit from positions across all European CSDs, which are supported by the same custodian, being shared from a netting point of view. And because a sale in the French market, for example, could be netted off with a purchase in the Spanish market, the client needs ultimately to make less liquidity available to settle trades in the cash account.
Banks or brokers that are direct participants must not only finance their own connectivity to multiple infrastructures but can also draw only on the liquidity in their portfolio. By using a custodian, the firm in question will have the option to have trades netted off with the shared liquidity pool that sits in the custodian’s omnibus account.
The larger the custodian and the bigger the asset pool comprised in the omnibus account, the greater the netting benefits.
The more clients a custodian has, and the more diverse the clients are, from the buy and sell side, the more likely it is to have two clients that are trading in opposite directions on a given position, allowing netting benefits by offsetting trades that are passing in different directions. By getting access to the liquidity that this larger asset pool provides, clients end up saving money.
Hence through custodian intermediation, liquidity requirements are considerably lower, resulting in little or no costs for the client. This is a big benefit for clients that want to know how they can best manage the liquidity requirements for their cash account.
Are there any other benefits?
Another benefit of new T2S-enabled settlement process is that it provides more functionality related to settlement. Onesuch benefit is “hold and release”, where clients can specify when a given trade should settle. Ensuring that the client has the stock in question before we release it into the system, for example, provides additional credit or securities protection. The transaction linkage facility in T2S is also a great add-on.
Where two transactions occur at similar times, the new process can ensure simultaneous delivery and receipt, removing the market risk that is created by the client being out of a position for the time that it takes a security to be delivered.
Where do you foresee geographic growth for your local custody operation?
For custodians, growing a footprint in emerging markets means a more diversified revenue stream, which makes for a more robust business. But more importantly it is about supporting clients. European clients, in particular, have been looking to diversify their investment exposure by increasing allocations to emerging markets.
The increase in regulation in recent years, and the greater emphasis on asset safety, has meant that the ability to provide local custody services in emerging markets as well as global custody is very valuable. Because sub-custody is in our DNA we have had a lot of support from our management to expand this part of our offering.
Under the AIFM directive and Ucits rules, the emphasis on global custodians’ ability to guarantee the local custody network has increased. Having a domestic presence in all key markets means that we hold an average of 90% of client assets within our own network. We can maintain the full level of segregation of assets from the global all the way through to local, safekeeping in every case.
A second benefit of a local custody presence is the synchronisation of global and local processes. In cases where we act locally the local custody operation runs on the same framework as the global custody operation, which has benefits for both local and global custody clients. This has been a considerable operational challenge but brings three major benefits for clients.
The first is access to local knowledge. This operational model means that a client can speak to their unique account manager at the global custody level, who covers the 100-odd markets we serve with a bird’s eye view. And when they need local colour on a specific position they have a local manager on the ground there who can answer questions, for example, in Columbia about a specific corporate event.
When we set up a local branch we bring product and sales staff who can work closely with domestic clients. So in Hong Kong where were we have deployed our core local settlement and custody facility, for example, we have been able to very quickly implement value-added features to support execution and clearing for the Shanghai-Hong Kong Stock Connect initiative. We are one of the first global custodians to support an integrated model such as this.
The second is harmonisation across the sub-custody network for all corporate actions. This means harmonising the messages, including filed options, supported by a translation mechanism so that the global system can absorb all messages coming from the local network before broadcasting them out to global custody clients.
The third – which is very important – is the ability to roll out a single tax system, where tax can be managed the same regardless of whether the service is global or local custody and there is ready access for the client to all local tax documents. This is where much of our investment has focused – harnessing the processes by which local markets will communicate a specific tax rule, translating this and hosting it to the online platform.
Two results flow from all this. Firstly, clients end up with more accurate and timely information, fully leveraging our domestic presence. Secondly, they are able to control their local account structure through the global system. This means the client can opt for a flexible account structure and support model, either local or global or a combination, while benefiting from the same service standards.
Which developed markets are you focusing on?
We have seen a lot of growth recently in our offering of local custody in the US. Our experience has been that, while this is a developed market, many of the clients are keen to see a newcomer. Our fresh approach and new systems are being welcomed.
For European clients working in the US, meanwhile, our Lisbon operating centre means that they get servicing on the US market in a European time zone. So we get this reverse effect from the European franchise that delivers new clients and additional assets through the functionality we are offering in the US.
This principle of reciprocal client benefits also applies to emerging markets. Clients that have used us for local custody in Europe will be familiar with our functionality, expertise and service levels. This makes them confident that they can expect the same level of service in the various emerging markets that they are adding to their funds, in search of returns and value for investors. One example is Colombia, which we were among the first custodians to enter.
A second is Turkey, where we can offer clients the benefit of a specific account structure – which enables them to employ a wider range of assets on their books as collateral – while complying with the local regulatory requirement that all assets be segregated.