There was a time when it was all much simpler in Europe in equity investing. People stuck to their domestic markets largely and those who ventured abroad paid for the privilege. Now with arrival of the euro, investors increasingly expect to be able to trade equities across border, certainly within the Euro-zone, if not the EU, as if they are in a single market. Currently, just 60% of equity trading is reckoned to be domestic.
Of course, it is never as simple as that with matters European and the securities settlement industry is under immense pressure to deliver a single market here. A number of top level EU reports and initiatives are in play , coming from Lamfalussy’s wise men, the Giovaninni Group and more recently MEP Generoso Andria at the European Parliament. But so far most of the action has been at market level, where the moves towards greater harmonisation do not necessarily mean greater harmony among the players.
For investors the most glaring way the lack of a single market reveals itself is in the cost of an equity cross-border transaction compared to a domestic one. This has been borne out by analyses of overall costs of cross border trading, such as that by the Centre for European Policy Studies (CEPS) and by the Giovanni Group, both in 2001.
Brussels-based International Central Securities Depositary (ICSD) Euroclear, agreeing with these findings, says that the costs to a customer are much higher for a cross border transaction than for an ‘internal’ one where the ICSD is on both sides. “This is true where one CSD has a direct link to another and still more when an agent bank is involved and has an impact on both transaction charges and custody fees,” its says in its 2002 report ‘Delivering a domestic market for Europe’.
As an example, Euroclear says a CSD’s internal transaction tariff might be E1, while for cross border delivery the cost might be E15 to E30. In addition there could be the customers own back office charges for processing cross-border deals, which have been put as high again as the CSD costs.
But a number of other studies rejects such high costs, Deutsche Boerse comments in its report ‘Cross-border equity trading, clearing and settlement in Europe’, that cross-border wholesale trades of say E200,000 cost an average of 30% more and retail 150% more than domestic trades. Agent bank and custodian BNP Paribas in its study ‘Clearing and settlement in the EU’ quotes a survey by French custody bank association AFTI that the cost of an European equity trade is not 10 times a domestic one but 2.5 to 4 times, and a further survey by JP Morgan and McKinsey reckons a wholesale cross-border trade is 1.3 times that of a domestic one.
But it is not just a question of the level of the costs, their nature also matters. The CEPS study’s cost breakdown attributed 65% to the back-office end, 35% to the agent banks, who currently control 90% of the cross-border equity trades, with just 2.5% each at CDS and ICSD level.
Giving its breakdown, DB comments that only 20% of these costs can be influenced by “intermediaries, exchanges, clearing houses and central securities depositaries (CSDs) through measures like harmonisation of market practices, as well as industry consolidation.” Some 40% is due to different laws, taxes rules for corporate actions and such like and another 40% to different languages, market practices and local investor behaviour.
Then there is the question of what all these costs come to at Europe-wide level – what it costs the investment community in total. Euroclear puts it at around E5bn, and DB is not too far from that, at E4.3bn, consisting of about E2.3bn in higher commissions, E1bn in cross-border settlement fees and E1bn in higher custody fees.
That said, in the marketplace consolidation between a number of players at the market level have taken place. The Euroclear group has brought together the central securities depositaries of France, Ireland, the Netherlands, the UK, and soon Belgium, with the cross border business of of Euroclear Bank, the international CSD(ICSD). It has strong connections with the Euronext grouping of four exchanges, which owns 80% of the Clearnet central counterparty, while Euroclear owns 20%”. This arrangement is seen more of a horizontal bringing together of the bodies that make up Europe’s settlement systems, while the Deutsche Boerse has taken the ‘vertical’ approach with its 50/50 ownership of the Eurex central counterparty with the Swiss Exchange, its 100% ownership of Clearstream Bank International, the other ICSD, and Clearstream Bank the German CSD. This control of the different layers is referred to as a ‘vertical silo’.
Such moves have ruffled the feathers of the agents banks, of which there are some 50 in Europe currently, with BNP Paribas claims a leading position in international trading in equities, says it processed 22.4m transactions in 2001, mainly equities, which was equal to the total international transactions of the two ICSDs combined, which were mainly bonds. It has formed the ‘Fair and Clear’ group comprising number of other banks, notably Citibank, as a pressure group.
In its study, part of submission to the EC and European Parliament, BNP Paribas has reacted strongly to the consolidation, stressing “the importance of the current EU consolidation process taking place according to well defined principles and leading to a healthy competitive environment, where activities and tasks are carried out by different entities, carrying different risks, are strictly segregated”.
But both Euroclear and DB believe that they are bringing more competitive markets. In particular, Euroclear has put in hand an initiative due to bear first fruits in 2005, which could reduce the costs of cross border equity transactions by 90%.
Mark Kirby, head of the equities division at the bank in Brussels puts it: “If we reached our Nirvana of realising all our ambitions, resolving the differences in national market practices and having one way of processing rights issues or settling repo transactions, then we will have achieved a lot in terms of delivering a domestic market for Europe.” At least as far as it is in the power of Euroclear to do so.
By having a single platform on which all the different Euroclear-eligible securities transactions are processed, instead of five different systems as at present, the cross border movements become simpler, cheaper, less risky and easier to manage, Kirby maintains. “Simply by executing all domestic and cross-border transactions on a ‘book entry form basis’, we will be able to process our clients’ trades in one place.”
This work the group is tackling in a number of ways, one of the most ambitious of the projects is the single settlement engine(SSE). “The idea here is that we take what goes on in each of the five platforms, and transfer that settlement activity on to a single platform. Irrespective of the transaction being between two counterparties in the same market or with a counterparty in any other Euroclear group entities, they will all result in a simple debit and credit in the client’s account.” The aim is to strip out the need to debit and credit securities and cash in accounts processed on five different platforms and replace them with one settlement engine. “We will perform exactly the same function, but in one place and for all securities covered by Euroclear group,” says Kirby.
“The real advantage is that Irish, UK and Dutch securities, for example, are processed on the same platform and any customer anywhere can access the complete range of Euroclear eligible securities – at the moment they can only access the securities of their own domestic market.” One of the difficulties with the current arrangement, with different systems in each country involved in the settlement process, is that a cross border transaction can be expensive, depending on how many intermediaries are involved, and take hours whereas it will soon take nano-seconds, as he puts it.
While Euroclear cannot say what will emerge as the tariff for such cross-border settlements, Kirby reckons costs will come “crashing down”. “It will be much closer to what a domestic tariff looks like now.”
The other element in the cross border equation is the harmonisation and standardization process. “A major part of back-office costs comes from needing to cope with significant differences in market practices, as well as the different systems and services in different CSDs,” he points out. Euroclear believes it is in a strong position to harmonise procedures within the different CSDs it now owns and will contribute to the pan-European harmonisation efforts arising out of the recent Giovanni group recommendations.
The benefits of all this will not be felt directly by the investor, as few pension funds are directly linked into the settlement systems. He reckons it will be through a combination of cost reductions and increased liquidity on a pan-European level that will ultimately provide benefits for investors.
So even if there is no further consolidation at exchange level, the different markets in Europe could compete head-on in exchange services, with the investors being able to choose where to settle their business.
Such a competitive cost-driven scenario also emanates from Frankfurt where the Eurex combination of Deutsche Boerse and its grouping of services, in a 50/50 joint venture basis with the Swiss Exchange. It has opted for integrating the three layers of trading, clearing and settlement. Through its Clearstream operation it does settlement and custody. At the clearing layer is Eurex Clearing, which now acts for the Eurex derivatives exchange, bonds and repos, as well as the equity cash market from March this year providing an equity central counterparty for the German market.
“Our portfolio of products and services in trading comprises equities, bonds, repos, derivatives and commodities both in the cash and futures market traded on and off exchange,” says Walter Allwicher of DB.
But what distinguishes Frankfurt from Euronext and Euroclear is the degree of vertical integration of the different layers. “We believe we deliver superior value for our customers, by straight-through processing through all levels of the chain.” This means, for example, products can come to market in a shorter time. “So if we introduce a new product or service, we can adjust and fine tune all elements of the processing chain from trading over clearing and settlement all the way to custody. This makes us the best transaction engine in the world.”
Its tie up with the Swiss exchange and the merger of Deutsche Boerse Clearing and Cedel which formed Clearstream, means that it has also looked at the horizontal route. “We are not dogmatic about either the vertical or horizontal approach as long as it creates customer and shareholder value,” he says. “We are now the largest exchange organisation in the world by revenue and we do have the strongest financial power.”
It is from this standpoint that it regards what is going on in Europe and elsewhere. In its view only 20% of the inefficiencies in cross border trading, clearing and settlement are related to the exchange-controlled part. “Some 80% of incremental cost cannot be influenced by intermediaries, exchanges, clearing houses, or CSDs. These costs result from different laws, taxes and regulatory environments are from different currencies, he says. “These barriers need to be removed to increase the efficiency of European capital markets.”
DB sees the challenge ahead is to increase efficiencies from STP, where there are still huge benefits to be gained. “We want to see the lowest possible capital cost for issuers and the perfect investment opportunity for investors,” he agrees. Lowest trading costs and spreads are part of this. “Xetra is the market that offers the lowest spread across the board.”
As to how DB sees the game play out at European level, he says that the issue of further consolidation is not an end in itself, it’s a matter of what benefits it would provide its shareholders and customers. “ Our group is trying to streamline then existing diversity on the Europeans markets within the framework of a free market economy. It wants to create value for shareholders and can only do so by serving its customers to the very best. We are convinced that this approach benefits all capital market participants best,” says Allwicher.
In the submission to the EC and Parliament, BNP Paribas argues that the ICSDs’ lack of the success in the equity field is due the fact they have currently high processing costs and the domestic nature of equity markets.
The bank is clearly deeply suspicious about the nature of the two ICSDs, which it seems to regard as sheep in wolves clothing being one-time agent banks who jumped to CSD status and are now using their ‘mutualist’ role to advance their commercial aims. They act partly as an agent bank in clearing and settlement of securities, but as CCPs and CSDs “play a central role for the clearing and settlement of trade orders – the equivalent for securities as central banks are for cash”. So BNP Paribas has been lobbying hard, particularly at parliamentary level through the Fair and Clear Group to highlight the perceived dangers of integration of stock exchanges and clearing and settlement systems in Europe. “It is clear indeed that, given the fact that both CCPs and CSDs constitute ‘bottleneck’ facilities, the vertical integration of all trade-related activities in a ‘vertical silo’ would prove very cost attractive to its owner. But it would give it strong market power vis-à-vis its customers and an incentive to abuse this power cannot be ignored.”
The group seems to have found some resonance at the Parliament, with resolution emanating from there providing for the sort of separation between services that should be commercial and those that should not. MEP Andria suggests a single CSD for Europe on the lines of the DTCC in the US, with maybe three regional CSDs on the road there, thus perhaps dismantling what Euroclear and DB have put into place.
As to how it sees lower costs of equity trading being delivered to the marketplace, BNP Paribas says rather blandly: “Market forces will eventually lead to the creation of efficient European processing platforms for clearing and settlement services.” How long this process may take, the bank does not say. But in the meantime, Europe’s investors will be gamely stumping up E4 to 5bn a year in additional costs to handle their international equity trades as a result of market inefficiencies.

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