Q2 2015 If it’s out there, it’s in here · PDF fileIf it’s out there, it’s in here Q2 2015 Marc Bayle on T2S ... T2S With the live launch of TARGET2-Securities (T2S) .......

If it’s out there, it’s in hereQ2 2015

Marc Bayle on T2Spage 4

Mobilising collateral page 8

Cash in a Cloud?page 17

Securities Services

The greater the challenge, the more important your partner.

With the increasing velocity of change, the difference between who succeeds – and who merely survives – will be defi ned by clear thinking, quick decisions and rapid refl exes. This is where SIX Securities Services comes in.

As one of Europe’s few truly international post-trade service providers, we have learned to adapt to rapidly changing land-scapes, carve out our own innovative path and deliver indus-try-recognised performance. The result is satisfi ed customers who enjoy having us to help steer them to success. Solutions for the future. Now.

3

Radar · May 2015

4 Before and after With the live launch of TARGET2-Securities

(T2S) only a few months away, Radar spoke to Marc Bayle, chairperson of the T2S Board, about the concrete benefits of the project.

8 T2S and harmonisation Post-trade harmonisation is a central objective

of T2S. In mid-April, the ECB’s T2S Advisory Group released its Fifth T2S Harmonisation Progress Report.

10 Mobilising collateral: Up and running

New collateral solutions are tackling old prob-lems, but providers will only prove themselves once market participants overcome some chal-lenges of their own.

14 Sensitive skin How radically do existing CCP risk models and

default fund arrangements need to change?

19 Mirror, mirror in the Cloud Can the technologies of virtualisation be applied

to restructure the cash component of interna-tional securities transactions?

Every now and then, driven by some new external factor, the financial services industry gets it into its collective head that it has undergone a ‘paradigm shift’. Industry veterans will often tell you that this is more a question of inexperience or memory loss than anything else and that there is nothing new under the sun.

I am reminded of this by responses to the financial crisis that advocate a hard-nosed review of operational scope, calling into question what functions really need to be retained in-house and what can be offloaded to a third party to release internal pressure on resources.

Far from being an attractive solution to a new set of challenges, however, third-party sourcing should be seen from a longer-term perspective, applicable in good times as well as lean. A decade ago, for example, when financial exuberance was widespread, the BIS released a report examining trends in outsourcing in the financial sector. “Outsourcing in Financial Services” spelled out the potential risks that outsourcing activities could pose to financial sector firms, while recognising its substan-tial potential benefits. It also set out the principles that should be taken into account to deal with these risks.

The report was the work of the Joint Forum, established in 1996 under the aegis of the Basel Committee on Banking Supervision, IOSCO and the IAIS to deal with issues common to the banking, securities and insurance sectors. It noted that, “Increasingly more complex ar-rangements are developing whereby related entities per-form some activities, while unrelated service providers perform others. In each case the service provider may or may not be a regulated entity. The Joint Forum principles are designed to apply whether or not the service provider is a regulated entity.”

Put simply, the case for drawing on expert third-party providers for particular functionality is well rehearsed as are the potential risks and how to address them. Third-party sourcing (out-sourcing or insourcing) should not be seen as a response to new circum-stances, but, handled appropriately, as both a prudent and profitable business practice.

Avi Ghosh | Editor

radar controlsRadar is produced by Asset International in London on behalf of the publisher, SIX Securities Services in Zurich.Brandschenkestrasse 47, 8021 Zurich, Switzerland

Editor: Avi Ghosh · [email protected]

Graphic Design: Philip K. Schneevoigt

Although SIX Securities Services makes every effort to ensure the accuracy of this publication, neither it nor any contributor can accept any legal responsibility whatsoever for consequences that may arise from errors or omissions or any opinions and advice given. This publication is not a substitute for professional advice on a specific transaction. No reproduction without prior permission.

Securities Services

The greater the challenge, the more important your partner.

With the increasing velocity of change, the difference between who succeeds – and who merely survives – will be defi ned by clear thinking, quick decisions and rapid refl exes. This is where SIX Securities Services comes in.

As one of Europe’s few truly international post-trade service providers, we have learned to adapt to rapidly changing land-scapes, carve out our own innovative path and deliver indus-try-recognised performance. The result is satisfi ed customers who enjoy having us to help steer them to success. Solutions for the future. Now.

nothing new under the sun? Contents

4

Radar · May 2015

T2S

With the live launch of TARGET2-Securities (T2S) only a few months away, Radar spoke to Marc Bayle, chair-person of the T2S Board, about the concrete benefits of the project.

and afterBefore

5

Radar · May 2015

T2S

”For Wave 1, the initial

benefit will derive from

the fact that they will

have a state of the art

platform with modern

services enabling a

more integrated and

effective approach to

securities settlement

and collateral

management.”Marc Bayle, ECB

Marc Bayle | ECB

T2S has been described as a game changer by intermediaries, but what about investors and issuers? How quickly do you expect change to be-come evident to them?

We have just published our 5th harmoni-sation progress report, which shows that T2S will bring benefits much beyond pure settlement and even before it has been implemented (See box).

Unless you’re a market infrastructure professional, it might not be obvious how far reaching this type of project can be and how far it can challenge the current organisation of the market. We also need to

bear in mind that the word ‘quickly’ prob-ably means something different in a market infrastructure environment than it might in, for example, a trading context. Neverthe-less, I would suggest that change is al-ready evident. Our work on harmonisation is one very concrete example. In October last year, almost all markets involved in T2S moved to a T+2 settlement cycle. This has had an impact on the functioning of the securities market generally and is an achievement on its own, but was only pos-sible because of T2S.

As far as issuers and investors are con-cerned, I would expect the full value of T2S to become visible in 2017, when the migra-

6

Radar · May 2015

T2S

tion process is complete. As you know, we’re taking a phased approach with the first wave of migration – including SIX Securities Services – later this year. Over four waves, all the markets in Europe will join the platform, but we will already have a critical mass of activity on the platform be-fore the end of 2016, by which time most of the high-volume markets will have joined. A much more integrated access to Euro-pean financial markets should be visible to investors and issuers by then.

T2S gives issuers the opportunity to achieve the equivalent of domestic issu-ance at a multi-country level, which is not possible today without additional cost. The primary markets will be able to settle instantly in all the countries that are on the

platform. Similarly for investors, it will lower the barriers for access to what we call today cross-border activity. All this is very concrete and will gradually become more evident as more markets join.

What then can clients of first-wave institutions expect?

For Wave 1, the initial benefit will derive from the fact that they will have a state of the art platform with modern ser-

vices enabling a more integrated and effective approach to securities settle-ment and collateral management. The auto- collateralisation and optimisation processes in T2S will have a positive impact on their liquidity and this will be-come increasingly beneficial as the plat-form brings on more and more markets. [There is a 3 minute YouTube video that shows this very simply.]

To what extent is T2S a stand-alone catalyst for change or is its impact dependent on broader regulatory enablers, such as CSDR?

Both. On 17 September 2014 the CSDR entered into force, but we are still waiting for the regulatory technical standards that

are being developed to know exactly how CSDR will be implemented. The ability to get agreement on CSDR was partly due to the pressure of T2S. This new piece of EU legislation complements the operational in-tegration provided by T2S and for example puts an appropriate settlement regime in place across Europe.

Do you expect the governance frame-work of T2S to change once the user base has grown?

“T2S gives issuers the opportunity to

achieve the equivalent of domestic issuance

at a multi-country level, which is not

possible today without additional cost.”Marc Bayle, ECB

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Radar · May 2015

T2S

We will maintain user involvement in governance. In 2017, once migration is complete, we will take a step back and see what worked well and what didn’t up to that point. One thing we can already say was good – and a key factor in the suc-cess of the project so far – is the fact that it involves private/public sector coopera-tion. Transparency in communication has also helped to resolve problems. When you consider the complexity deriving from the number of institutions involved, I would describe the governance of T2S as lean, strong and very effective so far.

Looking specifically at non-EU-based investors and issuers, is there a mes-sage for them?

Yes, definitely. Our mission in the Govern-ing Council of the ECB as the owner of this project is to make Europe a more inte-grated economy, to bring greater benefit to Europe. This is also good for non-EU based investors who can invest more ef-ficiently in Europe as well as for companies looking to develop their activities in Eu-rope who will be able to issue bonds and equities into a bigger market. We are in fact taking part in an increasing number of events outside of Europe to explain what is happening with T2S. We have been going to SWIFT’s annual Sibos event regularly and will do so again this year in Singapore.

There is also an interesting development in which the ECB is involved in the context of the Financial Stability Board, which is trying to make markets more efficient at a global level. In increasing the capacity to interconnect, T2S will help markets re-spond to this challenge.

One important element of T2S is the fact that we have adopted international stand-ards in the way we set up data and com-municate. This involves the ISO 20022 format, which is now being adopted globally. It will make it easier to interact

with other markets outside Europe. In fact, T2S has been developed from the start on ISO 20022. TARGET2 will be adopting ISO 20022 in 2017 and the SEPA direct debit and credit transfer schemes are also based on ISO 20022. This will allow for potential economies of scale.

Can the T2S ecosystem be replicated elsewhere? Do you see T2S as a model for other regions?

There’s no easy answer to that question. In theory, yes, it could be. An opportunity to license the T2S software could be enticing as it would help to further reduce unit costs for our own users, but the complexity of a market infrastructure project needs to be taken into account. I’m not sure it would be easy to implement. On the other hand, the idea of reusing some of the concepts and strategies we have adopted to bring a group of countries with their own political agendas closer together would be much more feasible. If you look at the reasons for the success of T2S I see two main ones: (1) the broader context where Europe seeks to build a single market with a single currency for many of the countries involved; and (2) an active and committed central bank, the ECB, steering the project with a really strong governing body. You also need con-vergence on legislation among participat-ing countries. There are a lot of elements involved in reaching where we are today.

Nevertheless there is a lot that can be done in terms of cooperation between a set of countries that want to work together. Technological barriers have been reduced and common standards can be more easily agreed, but I think at a minimum you need to have a political impulse for a group of countries to collaborate on a common project. It’s complex and you need to have a sustained commitment. Our approach to integration and harmonisation is perhaps more exportable in the short term than a pure export of the T2S software. •

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Radar · May 2015

T2S

Participants in the T2S project have been working on a single rulebook for post-trade processes, including messaging protocols, operating hours, regulatory and legal rules, across the 21 European markets and 24

CSDs that will be connecting to T2S. In mid-April, two months before the live launch of T2S with the five first-wave CSDs – SIX- SIS (Switzerland), Monte Titoli (Italy), Depozitarul Central (Romania) Malta Stock

T2S and harmonisationPost-trade harmonisation is both a central objective of T2S and a key contributor to the integration of financial markets in Europe.

9

Radar · May 2015

T2S

Exchange (Malta), and BOGs (Greece) – the ECB’s T2S Advisory Group has released its Fifth T2S Harmonisation Progress Report.

The report identifies significant advances over the past year in compliance with T2S harmonisation standards.

In the table above, Priority 1 activities are necessary to ensure efficient and safe cross-CSD settlement in T2S. All markets should be ready to operate in compliance with the standards by the time they migrate to T2S. Priority 2 activities are also impor-tant for the enhancement of the competitive environment and the efficiency of T2S, but work will continue after launch.

In the definition column, green indicates that the process is complete (a standard/rule is endorsed at the T2S or EU level). At the other end of the spectrum, red means that obstacles still exist. In the Monitor column, green shows that a monitoring and reporting framework has been implemented and results are regularly reported. Blue in the compliance column indicates that no further action is required in any of the T2S markets, while green shows that implemen-tation is on track overall. Yellow points to some technical and regulatory barriers still to be addressed in certain national mar-kets. Red meanwhile indicates significant barriers to full implementation of the stand-ard in some markets..•

Table 1: Status dashboard of T2S harmonisation activities (as at 23/03/2015)Activities – priority 1 Definition Monitor Compliance

1

T2S Messages

T2S ISO 20022 messages G G G

2 T2S mandatory matching fields G G G

3 Interaction for registration G G G

4 Interaction for tax info G G G

5 Schedule for the settlement day G G G

6 T2S Corporate actions standards G G R

7

Legal harmonisation

Settlement finality I (moment of entry) G X X

8 Settlement finality 2 (irrevocability of transfer order) G G G

9 Settlement finality 3 (irrevocability of transfers) G G G

10 Outsourcing IT services G G B

11 Settlement discipline regime Y X X

12 Settlement cycles G G B

13CSD Account structures

Availability of omnibus accounts G G B

14 Restrictions on omnibus accounts G G G

15T2S Accounts Numbering

Securities accounts numbering G G G

16 Dedicated cash accounts numbering G G G

Activities – priority 2 Definition Monitor Compliance17 Legal harmonisation Location of securities account/conflicts of law R X X

18 Corporate actions market standards CA market (CAJWG) standards G G Y

19 Place of issuance Y X X

20 Tax procedures Withholding tax procedures R X X

21 Shareholder transparency – registration R X X

22 Market access Y X X

23 Securities amount data G G G

24 Portfolio transfer Y X X

Radar · May 2015

New collateral solutions are tackling old problems, but providers will only prove themselves once market participants overcome some challenges of their own.

Collateral

11

Radar · May 2015

Collateral

Barriers to the cross-border movement of assets for collateral management purposes used to be a grudgingly accepted part of the securities market landscape. But further impediments to collateral velocity imposed by post-crisis regulation mean existing road-blocks are less easily tolerated.

Basel III’s capital requirements and the migra-tion of OTC derivatives to central clearing both increase demand for and act as a drag on the movement of high-quality liquid assets. Custo-dians, central securities depositories (CSDs) and tri-party agents are now innovating and collaborating, aware that collateral transfers will be weighed down further as regulatory deadlines roll out over the next five years.

InteroperabilityMuch can be achieved by pooling assets and improving interoperability between service providers. This requires firms to overcome commercial sensitivities and draft painstaking legal agreements. But an increasing number of deals are being struck to allow assets held in custody to cover a new collateral exposure without leaving their custody location, for example.

At SIX Securities Services, CEO Thomas Zeeb sees growing regulatory concerns over concentration risk as leading to ever deeper levels of cooperation between service providers, notably custodians and international CSDs. SIX is developing a col-lateral management programme that stands apart from custody systems, but which draws information from accounts at multiple CSDs and custodians globally. “There is no reason in principle why for example, a large insurance company, pension fund or asset manager could not hold an account direct with a CSD, which a designated custodian bank could then operate on their behalf, providing the ancillary services that a CSD typically does not,” says Zeeb.

In other approaches, Euroclear has inked deals with a number of custodians to smooth collateral flows for mutual clients, and has set up a joint venture with US post-trade facility Depository Trust and Clearing Corporation to offer combined collateral management services. Germany’s Clearstream has forged a ‘Liquidity Alliance’ with other CSDs to share data across a common platform to support clients’ collat-eral and liquidity management needs.

“There is no reason in principle

why, for example, a large

insurance company, pension fund

or asset manager could not hold

an account direct with a CSD,

which a designated custodian bank

could then operate on their behalf.”Thomas Zeeb, SIX Securities Services

Thomas Zeeb | SIX Securities Services

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Radar · May 2015

Collateral

In this new era, collaboration sits along-side competition, with new offerings aiming to differentiate providers from rivals. For example, CME Clearing Europe’s announce-ment last year of segregated accounts that provide choice of location – supported by SIX Securities Services and BNP Paribas Securities Services – is designed to offer clients more protection and preferential capital treatment compared with other clear-ing houses bidding for new central-cleared OTC derivatives volumes.

Mind the gapsThe future of collateral could be one of evolving ‘co-opetition’, with no one provider dominating, in part due to the concentra-tion risks flagged by Zeeb. The end-user’s choice of collateral partners may be based on geographic and asset class coverage rather than the intrinsic superiority of one service over another.

Philippe Ruault, head of clearing and cus-tody solutions at BNP Paribas Securities Services, says custodians are building gate-ways with multiple CSDs to support collateral mobilisation, but admits gaps persist. “The

sell-side can leverage their assets under custody already, but this capability needs to be extended to the buy-side, where firms are typically not members of CSDs, but will increasingly need access to repo markets for collateral optimisation purposes,” he observes. “Specialisation of certain service providers in particular asset classes can also be a barrier and may take time to erode.”

Familiar grit in the wheels of collateral mobilisation – from inconsistent documenta-

tion to message protocols and from insol-vency rules to rehypothecation restrictions – are being gradually worn down, but newglitches arise. Ruault cites requirements forEuropean CCPs to keep client collateral insecurities settlement systems and UCITSdue diligence rules as recent constraints,while Olivier de Schaetzen, head of productsolutions for global markets at Euroclear,points to capital concerns. “National regu-lators are increasingly keen to ensure thatbanks retain sufficient assets in-country tosupport their domestic operations,” he says.

More positively, the advent of TARGET2-

“The sell-side can leverage their

assets under custody already,

but this capability needs to be

extended to the buy-side, where

firms are typically not members

of CSDs, but will increasingly

need access to repo markets for

collateral optimisation purposes.”Philippe Ruault, BNP Paribas Securities Services

Philippe Ruault | BNP Paribas Securities Services

13

Radar · May 2015

Securities (T2S), the European Central Bank’s single settlement platform for euro-denominated securities transactions has the potential to smooth cross-border asset flows considerably. BNP Paribas’ Ruault sees T2S – scheduled to go live in June 2015 – as a “great plus” in terms of settlement efficiency, while others say much will depend on its ability to achieve critical mass.

Delays and distractionsVirginie O’Shea, senior analyst at Aite Group, says it may be 2017 before we know whether T2S is a ‘game-changer’ in terms of collateral mobilisation, and predicts only a gradual uptick in demand for real-time collateral opti-misation services as firms while get their own house in order. “We may not see a massive increase in the amount of collateral move-

ment. Before you can start thinking about collateral mobility, you need to identify the available collateral pool,” she says.

The buy-side spectrum encompasses fax users at one end and automated margin calculation and allocation at the other, while even the most sophisticated sell-side firms still have gaps in their enterprise-wide inven-tory and collateral management efforts.

“Obtaining a holistic view of collateral was never previously a priority for the buy-side but now it’s becoming a nirvana. A large asset manager might have hundreds or thousands of CSAs; modelling all those to

understand one’s collateral position is a ma-jor challenge,” says Andrew Howat, head of business development at Calypso Technol-ogy. But while it may make sense to central-ise collateral inventory and operations in a single system, Howat suggests it would be a mistake to isolate the activity. “You can’t consider collateral on its own, separate from your cash and liquidity positions.”

One reason for slow demand for collateral mobilisation solutions on the buy-side is the continuing delays in the onset of cen-tral clearing in Europe. “For the moment, asset managers are more focused on more immediate – e.g. operational and counter-party risk – implications of the introduction of central clearing,“ acknowledges Barry Hadingham, head of derivatives and coun-terparty risk at Aviva Investors. The focus on

establishing clearing arrangements pushes collateral down the priority list not just for us-ers but providers, with clearing houses not necessarily ready to offer the margin offsets that might help collateral-hungry clients.

For Euroclear’s de Schaetzen the collabora-tion and innovation being used to mobilise collateral is an ongoing campaign, fought on many fronts, and one in which the mundane as well as the eye-catching must be ad-dressed. “The industry is achieving higher STP levels. But missing information can still cause costs to escalate, so it’s important that messages can travel seamlessly across the value chain,” he says.•

“National regulators are increasingly keen to

ensure that banks retain sufficient assets

in-country to support their domestic operations.” Olivier de Schaetzen, Euroclear

Collateral

14

Radar · May 2015

Central clearing

How robust does a central counterparty (CCP) need to be? This question has become core to the future stability of the

global financial markets. The pre-crisis world was highly reliant on banks, especially in the lightly regulated, OTC derivatives markets.

How radically do existing CCP risk models and default fund arrangements need to change?

skinSensitive

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Radar · May 2015

Central clearing

But safely migrating counterparty risk onto CCPs – as required by the Group of 20 – is easier said than done.

Concentration of risk in CCPs as a result of the G-20 reforms presents a major chal-lenge to their operation and regulation. “Risk management, particularly the management of counterparty and credit risks, is essential to avoid the possible failure of a CCP, which could present a serious threat to financial sta-bility”, according to the International Organi-sation of Securities Commissions (IOSCO), which is framing new standards for CCPs and other financial market infrastructures (FMIs) in partnership with the Committee of Payment Market Infrastructures (CPMI).

Risk transferThe ability of CCPs to adjust their risk man-agement and business models is becoming an urgent matter. Few jurisdictions have actually mandated central clearing. But over half (56%) of interest rate derivatives for which central clearing facilities exist were voluntarily cleared at end-September 20141. Even though most existing positions remain bilateral, many new transactions are being centrally cleared (75% of US single-currency OTC interest rate derivatives and 86% of credit derivative indices2); while client clear-ing is also on the increase.

With each new centrally-cleared transaction, risk is transferring from banks to CCPs, but

“Over the last 18 months, we have

made a number of changes to our

risk management processes to take

greater account of liquidity and

concentration risks. Overall, our

models have become more flexible

and pro-cyclical.”Tomas Kindler, SIX x-clear

Tomas Kindler | SIX x-clear

1. based on reports by 16 large dealers to the Depository Trust and Clearing Corporation

2. US Commodity Futures Trading Commission

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Radar · May 2015

Central clearing

are they ready? Much has changed already. In compliance with Swiss law, SIX x-clear has compiled a recovery and resolution plan that includes early warnings on capital or liquidity issues, detailed risk mitigation measures and an orderly wind down. SIX x-clear is also compliant with the European Market Infrastructure Regulation (EMIR), but awaits European Commission confirmation of Swiss regulatory equivalence.

“Over the last 18 months, we have made a number of changes to our risk manage-ment processes to take greater account of liquidity and concentration risks. Overall, our models have become more flexible and pro-cyclical. Although the vast major-ity of our volume is securities, we do see derivatives clearing as a potential growth area and have borne this in mind when implementing changes,” says head of clearing Tomas Kindler.

A new ball gameFor the migration of counterparty risk to succeed, the Financial Stability Board (FSB) specified four guiding principles: fair and open access to central clearing; cooperative oversight by regulators; a global resolution and recovery framework; and appropriate liquidity arrangements. In parallel, CPMI-IOSCO’s April 2012 Principles for Financial Market Infrastructures (PFMI) proposed best practice on operations, risk management and governance, specifying that CCPs must be able to withstand the collapse of their two largest members.

In October 2014, CPMI-IOSCO issued guidelines for FMI resolution and recovery regimes to further steer operators, stake-holders and regulators, in line with the FSB’s ‘Key attributes of effective resolution for financial institutions’. CCP recovery plans must include use of a range of tools to al-

locate uncovered losses caused by mem-ber default, to address uncovered liquidity shortfalls, to replenish financial resources, to re-establish a matched book and allocate losses not related to member default. The tools should create “appropriate” incentives for owners, participants and other stakehold-ers to control the risks they “bring to or incur in the system, monitor the FMI’s risk-taking and risk-management activities, and assist in the FMI’s default management process (DMP)”.

To this end, guidelines have also been issued on the quantitative and qualitative information CCPs must publish to facilitate greater transparency on risk management, leading some to object to the sharing of commercially sensitive information. Antici-pating the issues arising from new default, loss allocation and recovery mechanisms, CPMI-IOSCO recommended FMIs draw up “clear processes” for managing conflicts of interests with stakeholders. FMIs must also have measures in place for an orderly wind-down, in case their recovery plan fails, and should be able to enter resolution as and when supervisors dictate.

Shared responsibilitiesThe challenges of allocating losses and liquidity shortfalls are recognised in CPMI-IOSCO’s recovery guidance. Distributing losses far and wide – e.g. to indirect partici-pants – minimises the amount each entity would have to bear, but may not reflect ability or willingness to manage or absorb losses. Allocation of default losses to CCP shareholders – an existing feature of default waterfalls – could be extended to recovery, to incentivise robust risk management, it says.

Many support compulsorily inserting more shareholder funds between those of de-

17

Radar · May 2015

Central clearing

faulting and non-defaulting members in the waterfall of funded assets drawn upon in the event of default. Under EMIR, 25% of CCP capital must be used to absorb losses ahead of member funds. US regulators have not ruled on the issue, leading to different approaches by the CME Group and its rival derivatives exchange and clearing house Intercontinental Exchange (ICE), which recently announced a voluntary increase in the capital it contributes to the default funds of its European, Asian, Canadian and US options CCPs, citing the benefits to mem-bers’ regulatory capital costs. CME insists it can withstand the failure of its two biggest members using existing risk management techniques and resources, while analysts have pondered investor support for more ‘skin in the game’.

While potentially benefiting from lower capital charges, clearing members such as JP Morgan have called for CCPs to put more of their capital at risk to counteract competitive forces which would otherwise tend to lower risk standards. As well as proposing CCPs match 10% of overall member default fund contributions or that of the largest single member, the US bank proposes a separate recapitalisation fund, the size of which would be based on standardised stress-tests. JP Morgan argues that the chaos caused by a CCP failure is such that, should default funds not save it from collapse after a member failure, liquidation should be avoided via resolution resources, tapped in advance from all stakeholders and held by a gov-ernment agency.

“The starting point for any assessment of

the size or nature of a CCP’s default fund has

to be the instruments it clears, i.e. how are

they valued and how liquid are they? For the

moment, the vast majority of instruments

migrating to central clearing are IRS, which

overall are highly liquid and so relatively

easy to value.”Niki Beattie, Market Structure Partners

Niki Beattie | Market Structure Partners

18

Radar · May 2015

Central clearing

Speaking up for end-investors newly ex-posed to CCPs, a BlackRock paper agrees on the need for greater transparency of clearing-house risk management processes and increased contributions and certainty over the default waterfall. But if pre-agreed funds are insufficient, the global fund management giant favours an immediate tear-up of the matched book and auction of defaulter’s positions to facilitate a swift return of margin to minimise end-investor losses.

The International Swaps and Derivatives Association (ISDA) steers a middle path, arguing that clearly-defined and transparent recovery mechanisms should be pursued while the DMP is deemed effective. Only once it has failed and efforts to re-establish a matched book are “ineffective, unfeasible or create systemic instability” should closure be effected. In addition to loss-absorbing resources, DMP should include auction of defaulted member positions; limited cash calls to solvent members; and loss-alloca-tion tools including “pro-rata reduction in unpaid payment obligations”.

Although ISDA proposes further analysis on the ideal level of CCP ‘skin in the game’, the association calls for the CCP’s contribution to the default waterfall to be divided into two tranches to better incentivise overall risk management practices.

Variation at the marginBelow global guidelines and generic pro-posals, there is a need to take account of disparate factors including market, size, infrastructure ownership and asset class mix. “The starting point for any assessment of the size or nature of a CCP’s default fund has to be the instruments it clears, i.e. how are they valued and how liquid are they? For the moment, the vast majority

of instruments migrating to central clear-ing are IRS, which overall are highly liquid and so relatively easy to value,” says Niki Beattie, managing director of Market Struc-ture Partners, who recently benchmarked Australia’s monopolistic clearing regime against international best practice. “It’s far easier to contemplate failure if the CCP isn’t the pivot for the entire national market,” she observes. “For markets too small to support clearing competition, the focus will be on devising a process to prevent failure and mutualisation of risk becomes more impor-tant.” Another distinction, points out Beattie, is that certain CCPs, such as Germany’s Eurex Clearing and Switzerland’s SIX x-clear, are licenced banks and as such their default funds might be viewed differently from UK-based CCPs.

The variations between CCPs only seem to strengthen the case for a more common approach to stress-testing. Moreover, the needs of clearing members to calibrate their own risk methodologies and assumptions to those of the CCPs they clear through require greater transparency and benchmarking of stress-tests and related processes. In response to these needs, CPMI-IOSCO is currently reviewing the stress-testing arrangements of CCPs in order to as-sess whether more granular guidance is required. “Stress-testing, which is an es-sential component of risk management by CCPs, is an area where CPMI-IOSCO is considering whether additional guidance is needed. CCPs, clearing participants and other relevant stakeholders will be consulted in the course of this review,” according to the organisation.

With central clearing of IRS due to start in Europe for clearing members in Q1 2016, the focus on the stability and transparency of CCPs will only intensify over the course of this year. •

19

Radar · May 2015

A recent thought piece by Thomas Zeeb, CEO, SIX Securities Services for Post Trade Views (www.post-tradeviews.com)

has drawn attention to the potential for re-engineering the cash side of international securities transactions. Zeeb suggested

Mirror, mirrorFinancial cloud

Cloudin the

Can the technologies of virtualisation be applied to restructure the cash side of international securities transactions?

20

Radar · May 2015

that the way cash is transferred around the globe is an inhibitor of greater expan-sion in global securities market activity.

“The securities involved in a transaction are rarely a problem. They are usually held in dematerialised form in a depository in the jurisdiction where you want to deliver them, regardless of where their beneficial owner or instructing broker is located,” Zeeb points out. Swiss securities, for

example, are generally held at SIX SIS Ltd in Switzerland, making delivery or receipt of the assets traded a simple book entry. “If, however, you are a US investor want-ing to buy securities in the Swiss market, you have to get the cash there for your purchase in time for settlement,” he notes. Zeeb suggests that there could potentially be a way of speeding up the cash side of a securities transaction by ‘virtualising’ it.

Both central banks and other supervisory authorities have also begun to explore possibilities in this regard.

In late April, the European Securities and

Markets Authority (ESMA) issued a Call for Evidence on investment using virtual currency or distributed ledger technology. The document contains a succint analysis of the possible uses of decentralised ledg-ers. Meanwhile, in Q3 2014, the Bank of England (BoE) published a detailed analy-sis of innovations in payment technologies and the emergence of digital currencies ‘Innovations in payment technologies and the emergence of digital currencies’1,

A distinction between virtual currencies such as Bitcoin and their associated infra-structure lies at the heart of mainstream interest in what might otherwise be viewed as ‘fringe’ or ‘alternative’ developments.

In the case of the BoE paper, money and payment systems, while intrinsically linked, are not necessarily inseparable. “For any system other than the exchange of physical banknotes or coins, a means of recording the values stored is also needed – a ledger,” says the paper. “The key innovation of digital currencies is the ‘distributed ledger’, which allows a payment system to operate in an entirely

“While strides are being made in systems

that allow for broader collateral aggregation,

the stresses caused by impediments to

collateral mobility are real.”Thomas Zeeb, SIX Securities Services

Financial cloud

1. Innovations in payment technologies and the emergence of digital currencies’,

Robleh Ali, Financial Market Infrastructure Directorate, John Barrdear. Monetary Assessment and

Strategy Division, and Roger Clews and James Southgate, Markets Directorate, Bank of England.

Radar · May 2015

21

decentralised way, without intermediaries such as banks. …Distributed ledger tech-nology represents a fundamental change in how payment systems could work.”

The Bank of England paper argues that, while Bitcoin introduced a new currency and a new payment technology together, “the distributed ledger technology could, in theory, be used without the creation of a new currency. It would technically be possible for an existing central bank to issue digital-only liabilities in a distributed- ledger payment system equivalent to those deployed by recent digital currencies.”

Zeeb too makes a clear distinction between virtual currencies and the technology supporting them. “I am not advocating the mass adoption of Bitcoin or other crypto-currencies that are, in many cases, underpinned by little more than hope,” he stresses. Nor is he necessarily advocating the adoption of block chain processes in cross-border payment clearing and

settlement. “What might be possible with the maturing of cloud technologies,” he suggests, “is the virtualisation of existing good currencies.”

Despite the use of computerised ledgers, the underlying process – where a payment is made by reducing the balance in a customer’s account and increasing the balance in the recipient’s account by an equivalent amount – has, as the BoE paper puts it, not changed since the 16th century.

Technology has speeded things up and addressed certain risk issues, but the central ledger remains at the heart of the settlement process with balances recorded both in the ledger at the respective central bank and reflected in the participant bank’s internal ledger. “The approach used in the modern banking system, which emerged as a computerised replication of earlier paper-based records, is for specialised entities (usually banks) to maintain master ledgers that act as the definitive record of

Financial cloud

Block chain explainedFor Bitcoin, perhaps the best-known virtual currency, the distributed ledger takes the form of a ‘block chain’. As ESMA explains, a block chain is a public register containing all transactions in the virtual currency. It keeps track of who owns how much of the currency.

In a nutshell, whenever a transaction in a virtual currency is completed, it is logged in a block. This contains an identifier of the previous block so that blocks are linked in a chronological order. “Every time a block gets com-pleted a new block is automatically generated. The information contained

in a block differs from virtual currency to virtual currency but most seem to contain the following information items: a block number, a time stamp, an identi-fier of the previous block as a reference, the block’s own identifier, at least one transaction, information about the fees/rewards contained in the block and in the case of bitcoins: the merkle root (a data structure summarising all the transactions in the block) and a difficulty statement.” The use of the term ‘crypto-currencies’ as a classification reflects the use of techniques from the field of cryptography in the authentication process.

22

Radar · May 2015

Financial cloud

each individual’s money holdings,” the BoE paper explains. “In turn, they hold accounts recorded in the ledger of one central body (typically the central bank). Those holding the ledgers have the ability to prevent any transaction they deem to be invalid…Any electronic payment system must have a reliable method of recording transactions that all participants can agree is accurate.”

“It is too early to be definitive, but a cloud structure could be envisaged where both commercial and central banks would hold mirror accounts,” says Zeeb. An inves-tor would sell securities in, for example, the US market, be credited at the Fed and have that credit mirrored in the cloud account. “With that credit visible, the

funds could be immediately used to pay for a purchase elsewhere. There would be no need to wait for the transfer to arrive or draw down on a credit line,” says Zeeb.

As he points out, this would not displace existing foreign exchange clearing mecha-nisms, but the underlying transfers would be a simple back-office function after the event. Nor would such a structure need to be an all-or-nothing facility. “If the Fed, the ECB, Bank of England and SNB were connected to it, they would already

enable a significant percentage of global cross-border transactions,” he points out.

Collateral managementApart from its operational benefits, such a system could eventually have a beneficial impact on collateral management. Increasingly, collateral must be deployed for regulatory compliance purposes. “While strides are being made in systems that allow for broader collateral aggrega-tion, the stresses caused by impediments to collateral mobility are real,” says Zeeb (see page 8). For a firm seeking to optimise its collateral across the globe and reduce collateral overhang by aggregating individual markets, the logical thing to

do would be to put all its collateral with one manager. The ensuing concentra-tion risk is, however, unlikely to sit easily with regulators. “One potential answer to this conundrum is to develop a collateral and management control system that operates at a ‘meta’ level without the need for physical transfer between accounts,” he suggests. The ability to virtualise existing currencies with the support of central banks, would, however, lighten the burden that such a system would have to support. •

“The key innovation of digital currencies

is the ‘distributed ledger’, which allows a

payment system to operate in an entirely

decentralised way.”Bank of England

Unlocking the potential.Securities Services

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