Consolidation in the European securities infrastructure - what is needed?
Sirkka Hämäläinen, Launch of the ECB-CFS research network on "Capital markets and financial integration in Europe", Frankfurt am Main, 30 April 2002
I am delighted to speak today before such a distinguished audience of economists interested in the role of capital markets in the European integration process. I will be talking about an issue that has only recently started to attract the level interest it deserves from senior economists and analysts: namely, securities market infrastructure. The previous speaker, Alberto Giovannini, is one of the most prominent analysts in this area. The work and results of his group concerning the barriers to integration in the area of clearing and settlement arrangements have already generated a long list of topics for research. I shall comment on the same topic and present some of the principles and needs that the Eurosystem is supporting and promoting in this area.
1. The starting-point
By eliminating currency segmentation, the introduction of the euro has naturally been a major factor in the integration of European financial markets in general.
From the outset of the single currency, the large-value payment systems of the euro area have been connected through the TARGET system and a euro area- wide money market, necessary for single monetary policy, has been created. The need for collateral in money market transactions provides a special incentive to the cross-border use of securities in the euro area.
The consolidation process triggered by the single currency has been supported by other factors. The implementation of the Investment Services Directive has introduced a "single passport" policy for market participants in trading. This allows each market participant in a regulated or organised domestic market to be recognised in the regulated or organised markets of other EU countries. Advances in technology have allowed stock exchanges and settlement systems to overcome the obstacle of location, and remote access can now be offered to financial intermediaries anywhere in Europe .
These factors have naturally altered the competitive position of national securities service providers, such as stock exchanges and securities settlement systems, transforming them from locally protected institutions to competitors in a cross- border context. Under market pressures, an overly fragmented industry is now engaged in an important consolidation process.
Despite all these developments, the securities infrastructure in the euro area today remains highly fragmented, with a large number of stock exchanges, derivative exchanges, regional exchanges and various regulated trading systems as well as several national clearing and settlement institutions. No other currency area has ever had to cope with such a highly fragmented securities infrastructure.
This fragmentation, the natural inheritance of the infrastructures of its member countries, is both a challenge and an opportunity. It is a challenge because a cumbersome process of reshaping the current state of the infrastructure is inevitable. But it is an opportunity because it allows the euro area to create a new infrastructure of the highest standard in terms of efficiency and safety.
2. How will the domestic infrastructure for the euro develop?
There is increasing co-operation and competition among service providers pointing towards the integration of the securities infrastructure in Europe . Different models of integration can be identified in the market. One approach is the establishment of branches, with local partners using a common technology to access regional markets. This is the strategy that is promoted by NASDAQ, for example. Another approach consists of mergers between service providers; here Euronext and Euroclear are prominent examples. Furthermore, a strategy of hostile take-overs could be attempted, along the same lines as the Swedish OM Group's attempt to take over the London Stock Exchange. Finally, some benefits of consolidation can still be realised through softer forms of co-operation such as the interconnection of service providers through a common electronic interface.
Although these factors seem to suggest that the securities infrastructure will start to look something like a "domestic" infrastructure for the euro, there is the question of whether the consolidation process will proceed without some form of public involvement - in addition to the national harmonisation in the fragmented legislation which is the self-evident responsibility of the public authorities. In a competitive environment, market forces in principle push for the most efficient solution. But how competitive is the European securities infrastructure? Is there any evidence to suggest that some market players are abusing their dominant positions? Are there any market failures to support the argument for public action? And, in particular, will market pressures be sufficient to overcome existing national interests?
An analysis of the business environment for securities trading, clearing and settlement indicate the existence of several sources of insufficient competition. I will not attempt to provide any extensive analysis in this regard, but would just like to touch upon some questions illustrating why there could be a need for public intervention in order to achieve consolidation.
(i) The recent report of the Giovannini Group identified a number of barriers to efficient cross-border clearing and settlement in the EU which reduce or even eliminate competition. Alberto Giovannini and his group have continued, and are continuing - as we know - the analysis of public policy aspects.
(ii) There are service providers, for example custodian banks, who may actually benefit from fragmentation. They specialise in providing services for market participants who are active in several markets, acting as a single access point to many different systems in many different markets. If these service providers are at the same time the owners of the fragmented settlement systems, they naturally have little interest in pursuing a consolidation policy which would eventually jeopardise their own business. Similarly, conflicting shareholder interests or the protection of perceived national interests may hamper the co-ordinated consolidation process.
In general terms, the markets have difficulties in allocating the overall benefits that can be reaped from the shift to a consolidated infrastructure. Those who would bear the costs of integration are not necessarily the same players who would derive the most benefits from it. In addition, there is a timing difference which produces conflicts between short-term and long-term gains.
Obviously, the complexity of the different interests at stake has an impact on the competitive environment of the securities service industry.
(iii) One important aspect of consolidation concerns the role of the banks and their competitive position in providing securities services. Some banks have been expanding their trading, clearing and settlement capacity by investing heavily in their own in-house systems. They trade, clear, settle and deposit transactions in-house rather than forwarding them to the clearing and settlement systems. Some are also setting up separate legal entities, which provide these services to other financial intermediaries, like fund managers, brokers/dealers and the smaller banks. This development is based on the fact that the costs of a transaction are in some cases lower within a single bank than in the market, and custodian banks therefore opt for "insourcing" or internalisation.
Here we are faced with the question of the implications of this insourcing on the consolidation process as such. Important open questions also arise with regard to the regulatory framework. When different kinds of market players offer the same services, they should be subject to the same regulatory requirements regardless of whether they are qualified as banks or not. The question is typical of financial conglomerates. What kind of regulatory reform is needed in the area of oversight and prudential supervision policy to ensure a regulatory level playing field for all market players?
(iv) There are interesting historical examples demonstrating that the current infrastructures in many countries are partly the result of some form of public intervention. In the United States , the Securities and Exchange Commission took a leading role in the mergers of different institutions when restructuring the national securities infrastructure in 1976. In Italy , Banca d'Italia played a major role in establishing a new settlement system in the late 1980s. In France , some 20 years ago, the "Rapport Perouse" launched a substantial restructuring and consolidation of the French trading industry. And the so-called Big Bang in the United Kingdom in 1986, among other things, also involved the introduction of electronic trading and a new settlement system; after the failure of the project, the Bank of England established a Task Force on securities settlement in 1993, which led to the establishment of the central securities depository in the United Kingdom three years later.
These historical examples are all very different but they have two points in common. First, they all involved some form of public intervention either by the legislator, the securities regulator, or the central bank in order to effect changes in the national securities infrastructure. Second, the interventions all sought to improve the efficiency and competitiveness of the domestic securities industries. Given the current degree of fragmentation of the securities infrastructure for the euro, it is natural to study whether similar action might be useful or necessary today at the euro-area level.
I would like briefly to outline the Eurosystem's views in this area.
3. The ECB's views on efficient infrastructure and the role of the public sector
It is clear that in order to reap the benefits of the single currency in the financial markets, the securities industry needs a "domestic" infrastructure for the euro area as a whole. The Eurosystem takes the position that the infrastructure for the euro should be located in the euro area, as is the case for the core infrastructures of any monetary area.
It is naturally in central banks' interests to have the infrastructure for their currency located within their area of jurisdiction. This enables them to address regulatory concerns efficiently and means that they can address any liquidity problems that may be triggered by payment, clearing and settlement systems. For these reasons, too, existing and possible future international agreements between central banks and securities regulators (for instance, the CPSS/IOSCO Recommendations) give a prominent role to "home" authorities.
I would like to add at this juncture that the existence of a domestic infrastructure does not preclude the emergence of "global" infrastructures, such as the Continuous Linked Settlement (CLS) Bank in the field of payment systems, or the International Central Securities Depositories in the field of securities settlement. Key concepts for the Eurosystem in this respect are legal feasibility and interoperability, which means agreeing upon common processes, methods, protocols and networks to enable co-operation between different infrastructures.
An interesting issue from the central bank's point of view is the degree of concentration. Network externalities and economies of scale suggest a high degree of concentration, possibly even a natural monopoly, but fully consolidated networks also present certain negative features. A high degree of consolidation implies that any failure of the network will have high systemic and contagion risks and costs. In addition, in a monopoly situation, service providers do not necessarily have adequate incentives to innovate and enhance their product or service. This can be reflected in excessive prices for the users or unjustified barriers to entry for potential new providers.
While the Eurosystem clearly supports the view expressed among others by the Lamfalussy Committee of Wise Men that the consolidation process should in general be driven by market forces, there are reasons why the public authorities in general and the Eurosystem in particular should be interested and involved in the process. First, efficient and safe securities clearing and settlement systems are a necessary condition for integrated capital markets, the sound execution of monetary policy, the smooth functioning of payment systems and the preservation of financial stability. Second, the complexity of the consolidation process and the different interests at stake requires fair conditions for competition and coordination between competitors, as well as co-operation between market participants and the public authorities and, possibly, policy decisions.
The role of the public authorities is important in two main fields: removing obstacles to consolidation and ensuring an integrated regulatory and oversight framework.
There is no need to repeat the activities recommended by the Committee of Wise Men or the Giovannini Group or the activities included in the Financial Services Action Plan. The ECB supports the work of the European Commission in this area and welcomes in particular the extension of the Investment Services Directive to include clearing and settlement systems. The Eurosystem's contribution to removing obstacles to consolidation mainly focuses on acting as a catalyst for improvement by encouraging discussions among the relevant players, and, last but not least, on harmonising central bank procedures and operations.
Because of the potential systemic implications, securities clearing and settlement systems are a critical financial market component. That is why ensuring an integrated regulatory and oversight framework is of the utmost importance to the authorities. Such issues fall under the competence of both central banks and securities or banking supervisors and thus need joint consideration.
It is essential that co-operation with all the relevant authorities establishes effective risk management standards for the clearing and settlement systems. Securities regulators and central banks have already initiated a discussion of these issues. At G10 level, for example, the CPSS-IOSCO Joint Task Force has established standards for securities settlement systems. The fruitful experience gained here has encouraged similar work to be undertaken at EU level. For this purpose, the ESCB has established a framework for co-operation with the Committee of European Securities Regulators, primarily aimed at assessing how the G10 recommendations should be adopted and implemented throughout Europe .
4. Conclusions and suggestions for further research
I would like to conclude my overview by summarising four very closely inter linked areas where we at the ECB would like experts to focus their attention.
First, even if the process of consolidation were to remain in the hands of the private sector in general, there can be circumstances under which policy decisions might be needed. It is important for us to analyse under which circumstances, from an economic point of view, there is an argument for public involvement in the consolidation process itself.
Second, optimal organisation of the securities industry and in particular the optimum degree of concentration is an open and interesting question. What kind of trade-off between scale effects and competition best guarantees efficient services, low costs to clients and safe systems from the point of view of financial stability?
Third, it is well worth examining the precise impact that the "insourcing" of the securities services by banks has for both the consolidation of the industry and the oversight, supervision and financial stability functions.
Fourth, it would be interesting to have an objective study of the preferences, expectations and needs of the various securities market players, as well as their complaints and frustrations with regard to the different practices and procedures of the ECB and the National Central Banks. Is there anything in the Eurosystem which is hampering the consolidation of euro area-wide domestic systems?
Last but not least, I am delighted to see the considerable interest that all the participants in this workshop show in financial market issues. I am convinced that your input and co-operation will greatly promote the understanding of developments and problems in financial market integration, along with the understanding of the remedies needed.