Underwhelmed fund managers must be more patient in order to realise the potential benefits of T2S, hears Nicholas Pratt.
Target2Securities, the European Central Bank’s (ECB) ambitious attempt to harmonise settlement in Europe’s capital markets, is in danger of losing the support of fund managers before it even gets off the ground.
The ECB has promised to reduce the cost and complexity of securities settlement by providing a single platform that will cap fees at 15% a transaction and make settling cross-border transactions as easy as doing so domestically. Cross-border transactions can be 10 times as expensive.
T2S is initially for securities settled by central banks in the Eurozone. Once the platform proves viable by attracting enough liquidity, it is likely to be extended to other instruments (including funds), countries and even other parts of the transaction lifecycle.
Should this happen, market participants including fund managers will have to make some changes to their settlement processes and will likely face requests to settle via T2S from investors and distributors. Firms will then have to decide what option to take to connect to T2S – whether to seek direct access, which is an option for bank-based asset managers, or appoint a third-party bank as its T2S agent.
T2S has been live since 2015, albeit partially, and it is nine years since the idea was first announced. The response from fund managers has been underwhelming. According to buy-side figure and former Schroders chief operating officer Markus Ruetimann, T2S has been a project full of “promises, compromises and explanations as to why a number of targets were missed”.
FIVE CONCERNS
Ruetimann highlights five concerns that have led him to this conclusion. The first is the most salient – that of settlement cost. The ECB’s headline in its marketing of T2S has been the promise of reduced fees and it has repeatedly stated that the platform will charge 15% a transaction.
However, despite the cheap fee for using the T2S platform, the overall settlement process has not yet become materially cheaper for fund managers, says Ruetimann. “There is no evidence of any significant settlement cost savings so far – unless they haven’t been passed on by the relevant global custodians yet.”
The ECB also promised a more efficient settlement landscape with not just a single settlement platform but a consolidated network of CSDs. Instead, though, there have been more CSDs launched in the wake of T2S.
Collateral management was another advertised benefit of T2S, with central banks launching their own collateral management projects. However, as Ruetimann notes, “with two of these projects failing, it is difficult to gauge if yet another central bank collateral management will be launched and whether it will be successful this time”.
Ruetimann also has concerns about whether the current market structure and regulatory approach will work against T2S and its stated objectives. “On the regulatory side, T2S is primarily an omnibus account solution, whereas many new EU regulatory initiatives propagate account segregation – even at the CSD [central securities depositary] level, to some extent.”
And in terms of market structure, Ruetimann is not convinced that the originally envisioned cross-border settlement efficiency can ever be realised under the current market structure where fund managers employ a network of sub-custodians to deal with the rules and practices of the different regions they operate in.
“T2S necessitates local CSDs to become ‘investor-CSDs’ that will be able to deal with non-domestic securities, not just in terms of settlement, but above all in terms of asset servicing. However, the traditional sub-custody model tends to survive.”
MITIGATING CIRCUMSTANCES
The global custodians, while accepting that the buy-side have made some fair observations, have urged them to look at the full picture and to take into account some of the mitigating circumstances, not least the continual postponements that have dogged the project’s progress – the original timeline was four years and this has since stretched to ten years and counting.
“T2S is a huge project and its implementation has been delayed, so the bigger benefits are slightly further away than they should be,” says Tom Casteleyn, head of product management for custody, cash and FX at BNY Mellon.
At this stage, only 10% of the market has converted to T2S.
There are five stages to the migration plans for the participating CSDs. The first went live between June and August 2015, bringing in minor markets such as Greece, Malta and the euro-denominated activity of Romania and Switzerland and Italy. The full migration will not be completed until the end of 2017, assuming no further delays.
There were also some significant investments made in system changes which need recouping, says Casteleyn at BNY Mellon. Even the direct participants of T2S may not see cost savings for some time because the CSDs have raised their fees in order to recoup the losses they face in settlement fees as a result of T2S.
“For us, T2S is a positive story – it is just the cost of system changes that we have to recoup,” says Casteleyn. “But for others there will be lost revenue that they will look to recoup somehow. The cost savings will come but it may take some time.”
The likelihood of project delays would have been anticipated by most of the market, as would the possibility that the promised cost savings would not be evident straight away. But the proliferation of CSDs that have come in the wake of T2S is not what most people expected, says Casteleyn.
“I thought that there would be more consolidation because I did not expect all CSDs to make the investment for T2S. The consolidation may still come but it will take time because now they have made the investment, they will want to see that out before reconsidering their options.”
The debate about the relative merits of omnibus accounts versus segregated accounts is one that has always been there but has gathered traction of late due to the transparency demands of regulations like know-your-customer rules.
“The global custodian industry is built on the omnibus model but I don’t think it’s a case of one or the other,” says Casteleyn. “It is equally important that the industry can assure the regulators that while it is an omnibus structure, we still know and can track every layer in that chain. The industry would be better focused on that data aspect rather than throwing out the whole omnibus structure.”
While the funds industry has been underwhelmed by T2S so far, this may change once funds are directly included – an initiative the ECB has called ‘T2S for Funds’. Not only should any potential savings be more obvious to fund managers and their investors, it may also add some much-needed volume to the platform.
Funds are already included in the T2S plans of some countries, such as France, and ‘T2S for Funds’ can work, says Casteleyn, provided there is greater standardisation across the industry.
“Standard industry practice will be a pre-requisite for funds to be included in T2S and it is far from an ideal model at present but ‘T2S for Funds’ is not a panacea. Let’s harmonise the way we redeem and subscribe to and distribute funds before we look at a single settlement platform.”
Another issue that will affect the success of T2S is the relative fortunes of different service providers and the battle for certain intermediaries to stay involved in the settlement process – from CSDs to asset servicers.
Fund managers will hope that this battle will eventually lead to reduced settlement fees from intermediaries competing for their T2S business. The fear for fund managers is that they will have to endure the lengthy battle between service providers and operational upheaval without any material benefit.
Above all though, Casteleyn says fund managers and other buy-side firms will have to be patient. “We have to allow T2S to play out. It is a large step that the policymakers have made and it has to be taken step by step. Being hugely critical of the project is not beneficial to anyone. We are at a point of no return and we have to make a fair assessment and then see what other steps can be taken to increase the benefits.”
©2016 funds europe
