As the dust settles on the Deutsche Börse and Clearstream merger, the European clearing and settlement picture is no clearer. High costs and inefficient market practices still dominate and many institutions – particularly investment management firms – are struggling to implement straight-through processing (STP) solutions.
Put simply, STP is a way of managing information effectively to eliminate as much manual intervention in the trading chain as possible. It is considered essential as markets move to shorter settlement regimes, such as T+1, which is scheduled for 2005 in the US markets. It is also crucial to reducing costs (through dramatically reduced head counts) and avoiding operational risks.
Comparisons are often made between the US clearing and settlement landscape which is operated by a single entity, the Depository Trust Co, and that of Europe, which supports 15 separate settlement systems. Because of this fragmentation, post-trade costs are higher in Europe than in the US. Despite initiatives aimed at rationalising the number of exchanges and clearing houses in Europe and the implementation of STP technologies, the underlying settlement methodology has remained virtually unchanged.
Financial institutions now operate in a global environment and face competition on a global scale while margins are continuing to shrink. Settlement has been identified as a cost centre and efforts are under way to reduce costs significantly. In such a fragmented market, institutions have to make significant capital outlays on their back office systems in order to deal with several central securities depositories (CSDs) and other participants with varying technical and legal requirements.
Euroclear, for example, estimates that 60% of total cross-border settlement costs are eaten up by the back office, with the use of local agents’ accounts consuming 35% and the cost of using a CSD or international CSD (ICSD) a mere 4%. Rival ICSD Clearstream estimates that 30% of settlement costs are linked to depositories, with the remaining 70% channelled into intermediaries’ costs and back office requirements.
The fragmentation of clearing and settlement in Europe makes it virtually impossible to define and compare a single standard fee for settlement. Each clearing infrastructure has developed its own complex tariff structure that takes into account the kind of transaction, its volume, and the size and nature of the client as well as the particular package of services required by the client. The issue becomes even more complex, and expensive, in the cross-border arena, where participants are obliged to open accounts with local CSDs or use costly intermediaries. In addition to the cost of using intermediaries, the end-user has to expand its back office and invest in multiple interfaces and systems in order to be able to deal with the complexity of the settlement.
The merger of Deutsche Börse and Clearstream has created a ‘vertical silo’ that integrates trading, clearing and settlement infrastructures. The move was highly controversial, with critics claiming that as a listed company Deutsche Börse would be under pressure to make money out of clearing and settlement rather than trying to reduce costs. JP Morgan and UBS promptly moved their business to Euroclear.
The preferred industry solution was a merger of the two international central securities depositories, Clearstream and Euroclear. Such a ‘horizontal model’ would separate the trading entity from that of the clearing and settlement body. Yet the shareholders in Clearstream – many of whom were vocal in their support of a merger of the two ICSDs – could not resist the windfall on offer and voted to approve the Deutsche Börse and Clearstream deal.
Ina Hanisch, managing director of financial trading software developer GL Trade Frankfurt, believes the Deutsche Börse acquisition of Clearstream is a “much-needed step to improve the clearing and settlement landscape in Europe. While many see the merger as a negative outcome, I believe it is a positive one and it is now incumbent on Deutsche Börse to prove the critics wrong.
“Discussions about what to do to rectify the clearing and settlement situation in Europe had gone on for far too long. That is why Deutsche Börse’s step is so positive and without it, the European Central Bank may well have imposed a solution on Europe to integrate the capital markets – a decision was long overdue.”
Deutsche Börse argues that it can deliver cost synergies, improve efficiencies and provide better co-ordination between the trading and settlement sides of the business. In announcing the merger it stated: “The company will provide services and products throughout the securities industry beginning with trading and information products all the way through clearing and settlement. Increasing the level of integration will result in new product and service offerings at a faster rate, thus creating value for customers and shareholders alike. The combined entity will introduce a system of straight-through processing and interoperability standards to European capital markets, open at each stage of the processing chain.”
While the European markets have been fixated by costs of settlement, across the Atlantic, the US securities industry has focused in on settlement timeframes. T+1, which has become a moveable feast, is now scheduled for 2005, which has given more time for voices of dissent to be heard. Andrew Tinney, global head of investment banking at consultancy Andersen, has been particularly vocal.
In his paper, ‘T+1 – time to reconsider’, Tinney challenges the validity of adopting the proposed T+1 reduced settlement standard at a time when the industry has already undergone substantial upheaval, not only post-11 September, but also in preparation for the euro and moving ahead to the demands of complying with Basel II.
“The arguments for T+1 are not as strong as those parties with a large vested interest in promoting it would have us believe,” says Tinney. “After huge spending in the industry on Y2K and the euro, another major round of non-discretionary spending is unhelpful. Our suggested phased approach would serve as much more comfortable mid-way point in achieving the ultimate goal of same-day settlement (T+0), allowing companies to become efficient in the most rational way.”
Tinney’s phased approach would involve an interim move to T+2 as a midway point before the industry moved to same day settlement. A move to T+2 combined with the mandating of same day trade confirmation and the introduction of central clearing counterparties. Such an approach, he says, will reduce credit risks without a major increase in operational risk.
At the Securities Industry Association’s STP/T+1 conference at New York in April, delegates were polled on their T+1 strategies. According to the SIA’s findings, while the vast majority of firms had come “out of the starting gate”, advancement beyond the planning stage had stagnated since the same conference the year before. Fifty per cent of firms had not started or were only in the assessment phase of T+1 and STP projects.
Preparation for T+1 in the US will require vast capital outlay. A survey by US analysts TowerGroup in January estimated that firms would spend around $2.5bn (e2.7bn) over the next three years, rising to almost $5bn as the deadline approaches.
A key component of T+1 and other STP projects is the automation of trade matching. The virtual matching utility (VMU) model enables multilateral interconnectivity for securities trade enrichment and matching. As settlement deadlines shrink the use of fax machines by asset managers to send confirmations and instructions to counterparties needs to be eliminated, so enter the VMU.
However, this is yet another area of confusion, created by the existence of more than one VMU. The two main protagonists – GSTP, which was established by the industry body, Global Straight Through Processing Association, and Omgeo, a joint venture of Thomson Electronic Settlements Group and the Depository Trust and Clearing Co – are not the best of friends. Other VMU suppliers are likely to emerge, with SunGard being the first to throw its hat into the ring. The Securities and Exchange Commission has mandated interoperability between the two main protagonists and talks are under way.
A fund management conference in London in late November 2001 pointed up fund managers’ concerns. The failure to put flesh on the bones of interoperability means that some asset managers are turning their attentions to more pressing problems. Nigel Thomas, vice-president of State Street Investment Manager Solutions Europe, says the technology investment playing field has changed in the past six to eight months. “There are a lot of other issues for fund managers that are more pressing than the need to reconfigure systems and processing streams for a VMU,” he says.
Foremost among these is the switchover to the ISO15022 standard in November, when the current securities industry message standard ISO 7775 will be replaced.
There is little doubt that STP is a worthy undertaking as it will deliver cost savings, improve operational risk profiles and lead to greater efficiencies. Yet bear markets and greater competition mean that the levels of technology investment required are simply not there.

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