Exchanges, Clearing & Settlement and TARGET2 Securities Richard Derksen

1. De Nederlandsche Bank Exchanges, Clearing & Settlement and TARGET2 Securities Richard Derksen 2nd Conference of Macedonian Financial Sector on Payments and Securities Settlement Systems Ohrid 30 June 2009

2. Agenda • The world of securities and exchanges • Risks in clearing and settlement of securities • What´s going on in Europe? • Code of Conduct clearing & settlement • Markets in Financial Instruments Directive (MiFID) • Consequences for central banks • TARGET2 Securities

3. Securities chain Agreement to exchange securities for funds trading Calculation of obligations clearing Delivery of securities and payment of funds settlement

4. Clearing & settlement infrastructure Exchanges CCP National Central Bank Issuer CSD custodian custodian Agent bank Agent bank Agent bank Agent bank Agent bank Agent bank Investor Investor Investor Investor Investor Investor Investor

5. Entities in securities Issue/hold securities Issuer/Investor Central securities depositories: storehouses for securities and domestic settlement services providers CSDs International central securities depositories: international settlement services providers, CSDs for Eurobonds ICSDs National and international settlement services providers, typically banks Custodians platform for trade in securities Exchanges Central counterparties: central providers for clearing services CCPs Executes transactions for customers Agent Bank National Central Bank; provides settlement services, oversight NCB

6. Life cycle of securities transactions • Transactions (by a telephone call or system) • Entry in a system (buy or sell) • Validation • Authentication & authorisation • Matching & confirmation • Clearing • Money settlement (usually t+3) • Securities settlement (usually t+3) • Custody (corporate actions)

7. Exchanges, CCPs and CSDs - basic model Buyer/ Seller EURONEXT Trading Member Trading Clearing Members LCH.Clearnet SA Clearing EUROCLEAR Nederland Securities settlement ENL DNB / T2 Admitted Depository Cash settlmn. Institution

8. Clearing / CCP Clearing Member Clearing Member Clearing House Role: • Trade confirmation • Netting • CCP = central counterparty Issues: • Counterparty credit risk concentrates at CCP. Default CCP might affect the whole financial system (so… Oversight)

9. Central counterparty CCP = central counterparty • Interposes itself between buyer and seller of a security • Guarantees clearing and settlement towards market participant • Takes over exposure counterparty credit risk • Novation: contract between buyer and seller replaced by contract between buyer and CCP and seller and CCP Pro: • Decrease counterparty credit risk; • CCP risk management for clearing member • Cost reduction • Trade benefits

10. CSD: settlement EUROCLEAR Nederland Depository DNB / TARGET2 ENL Settlement (ESES) Securities account A Securities account B Cash account A Cash account B Cash account A Cash account B DVP • Role: • Recording of changes in legal titles resulting from securities transactions • Exchange trades settle on T+3 • Issues: • DVP: delivery versus payment to limit principal risk (Herstatt risk) • SFD: Finality offers protection against unwinding

11. CSD: Depository Aangesloten Aangesloten Instellingen Aangesloten Euroclear Nederland Instellingen Aangesloten Instellingen Central Securities Depository (CSD) Aangesloten Instellingen Admitted Instellingen Institution • Role: • Maintenance of securities accounts • Facilitating reconciliation with any official register • Facilitating the exercise of securities holders’ rights and corporate actions • Issues: • Immobilisation and demateralisation • Operational risk

12. Role of central banks • Services in central bank money • Cash settlement in TARGET2: DVP model 2 (with ESES DVP model 1) • Collateral management for CCPs • And in the future… TARGET2Securities (Pan- European platform for settlement of trades, 2013) • Oversight • Financial stability – limit systemic risk • Limit losses of participants • Limit contagion to other markets • Enhance confidence in payment systems

13. European developments • Lisbon agenda 2010: European economy has to become stronger to compete with the USA and Japan/China • National markets in Europe have remained isolated, cross border transactions too complex, too costly: there is no integrated European financial market • Importance of clearing and settlement of those trades for smooth functioning of the financial system: inefficiencies have serious consequences • European Union has identified 15 barriers for integration (Giovannini 2001) • Technical, market practices (10) • Legal and fiscal barriers (5)

14. What is the status of integration… Too high settlement costs - EU domestic costs range from 0.35 to 3.43 €; - … and are higher than US (+ 0.10 to 2.90 €); - Cross-bordercosts higher than domestic ones (19.5 to 35.0 €). Source: Oxera, LSE, CEPS

15. Integration & consolidation Financial integration for all market participants: • Equal access • Uniformal set of rules • Treatment in an equal way Consolidation means a less number of service providers

16. Vertical integration Deutsche Börse Eurex Clearing Clearstream Integration models in Europe Horizontal integration Euroclear (ICSD) CIK (BE) Euroclear (FR) Euroclear (NL) Crest (UK) CBISSO (IE) Euroclear

17. Dynamics in the securities market • Market integration, level playing field and harmonisation • Consolidation of exchanges and SSSs in the market goes full speed on • Markets in Financial Instruments Directive • Code of Conduct for Clearing and Settlement • CESAME Group to lift technical, market practices Giovannini barriers • Internalisation: huge banks settle transactions internally

18. Post trade market in Europe • No central system as in the US, but still very fragmented • Different models: horizontal, vertical, user-owned, demutualised… • High cross border tariffs, (semi) monopolies, low competition • No EU Directive for clearing and settlement … so no European passport for cross-border services

19. Trading NYSE NASDAQ NSCC FICC Clearing DTC FED Settlement securities FEDERAL RESERVE Settlement cash Post trading infrastructures US

20. Trading Euronext Amsterdam + Brussels + Lisbon + Paris Euronext Amsterdam + Brussels + Lisbon + Paris London Stock Exchange Borsa Italia na Deut sche Borse Luxembourg Stock Ex change Oslo Bors OM Nasdaq HEX Bolsa y Merc. Esp. GPW LCH.Clearnet Group ltd Clearnet SA LCH CC&G Eurex Clea ring Clearing Euroclear Nederland CIK Euroclear France Crest Co Monte Titoli Clearstream BF ClearstreamBL VPS Nordic CSD Iber clear KDPW CRBS Settlement securities DNB NBB BdF BOE Banca d´ Italia Bundesbank BCL Nordic central banks Banca d´ Espana Bk of Poland Settlement cash TARGET2 Post trading infrastructures EU

21. EU initiatives for more efficient securities markets in Europe 1. Code of Conduct The solution from EU commissioner McCreevy (2006) • Selfregulation: Code of Conduct • Signed by 60 EU exchanges, CCPs and CSDs in November 2006 • Objective: stimulate competition and decrease cross-border cost • 3 parts • Price transparancy – 1 January 2007 • Interoperability – 1 July 2007 (Guideline) • Unbundling & account separation – 1 January 2008

22. EU initiatives for more efficient securities markets in Europe – 2. MiFID ´Markets in Financial Instruments Directive´, 1 November 2007 • MTF: alternative trading platforms next to regulated markets • Best execution moves trading to markets that offer the best price • Art 34 and 46: • the right of a market participant to access remotely a foreign CCP and/or CSD • The right of a regulated market/MTF to choose a particular CCP/ CSD • No double regulation

23. Results until now… Code of Conduct – around 2 years MiFID – nearly 1 year Guideline on Interoperability – 1 year Results: • New MTFs and in their slipstream… • New CCPs • Around 90 requests for interoperability (links between CCPs and CSDs)

24. Results till now… Negative: • Increased fragmentation and complexity • No European passport, so a regulatory mess • Not 1 link realised Positive: + Increased competition + Breaking down monopolies + Significant reduction in tariffs (in the Netherlands clearing cost from 0.65 eurocent to 0.05 eurocent per trade)

25. Trading Euronext Amsterdam + Brussels + Lisbon + Paris Euronext Amsterdam + Brussels + Lisbon + Paris London Stock Exchange Borsa Italia na Deut sche Borse Luxembourg Stock Ex change Oslo Bors OM Nasdaq HEX Bolsa y Merc. Esp. GPW LCH.Clearnet Group ltd Clearnet SA LCH CC&G Eurex Clea ring Clearing Euro clear Nederland CIK Euroclear France Crest Co Monte Titoli Clearstream BF Clearstream BL VPS Nordic CSD Iber clear KDPW CRBS Settlement securities DNB NBB Banq. de France Bank of Englnd Banca d´ Italia Bundesbank BCL Nordic central banks Banca d´ Espana Bk ofPoland Settlement cash TARGET2 Complexity European market increases EU market = Incumbent trading, clearing and settlement + …

26. Trading: MTFs Turquoise Smartpool Bluenext Equiduct Chi-X Nasdaq OMX BATS Clearing: New and existing CCPs EuroCCP LCH.Clearnet SA EMCF Settlement agents Citibank Fortis Bank Nederland Euroclear Nederland CIK Euro clear France Crest Co Monte Titoli Clearstream BF Clearstream BL VPS Nordic CSD Iber clear KDPW Settlement securities DNB NBB Banq. de France Bank of Englnd Banca d´ Italia Bundesbank BCL Nordic central banks Banca d´ Espana Bk of Poland Settlement cash TARGET2 Complexity European market increases … MTFs and new CCPs

27. Consequences for central banks • Services in central bank money • Cash settlement also for MTFs and new CCPs – national silo´s disappear • Collateral management for new CCPs • Oversight • What stability risks come with • New CCPs and their settlement agents • Increased complexity • Interoperabiliteit • Rely on foreign regulators, supervisors and overseers (MiFID art 34 and 46)

28. Risks in clearing and settlement of securities liquidity risk • credit risk: • replacement cost risk • principal risk custody risk Risks legal risk operational risk risk of settlement bank failure systemic risk

29. Risks Credit risk: The risk of loss from default by a participant, as a consequence of its insolvency Replacement cost risk Principal risk

30. Risks Principal risk • Risk that full value of securities or funds will be lost when either the seller or buyer fails to settle • Can be eliminated by Delivery versus Payment

31. Securitiescash 2 ^2 CSD NCB A B A B ^3 3 ^ 1 1 Bank A Bank B Sell Order Buy Order Delivery versus Payment (DvP) DvP

32. DvP in practice • Sell/buy transaction • The CSD blocks the securities in the account of the seller, followed by sending a payment instruction to the NCB • The central bank transfers the funds from the buyer’s to the seller’s account and sends a confirmation to the CSD • The CSD move the securities from the seller’s to the buyer’s account

33. Risks Replacement cost risk • Risk of loss of unrealised gains • Due to price changes between trade and settlement • Exposure depends on price validility and time gap between trade settlement (i. e. t+3)

34. Risks Risk of failure of a settlement bank • Failure of bank providing cash accounts for payments • Impact particularly severe if all CSDs use the same • Approaches to control: use of the central bank money, limited purpose bank

35. Risks Systemic risk • Failure of one institution could cause other institutions to fail • Liquidity and credit problems may disrupt financial markets • Liquidity is dependent on confidence in reliability of SSS • Oversight function central bank

36. Risks Liquidity risk • Risk that counterparty will not settle an obligation when due • Costs depend on degree of liquidity • Potential to create systemic problems

37. Risks Custody risk • Risks that securities are not adequately protected by the custodians • Either full loss or temporary inability to transfer securities • Segregation of accounts

38. Risks Operational risk • Due to deficiencies in systems and controls, human error or management failure Legal risk • Due to uncertain legal rules (unenforceability of contracts, bankruptcy laws, delay in recovering funds or securities)

39. What is T2S? • An integrated settlement platform of the Eurosystem for the DVP settlement of securities transactions in central bank money within the euro area : - All securities which have to be transferred- Cash needed for settlement • Supports the integration of the securities settlement market infrastructure • Making cross-border transactions domestic ones in the Eurozone • The extension to other currencies will also be possible

40. Why (1)? The current initiatives: Deutsch Börse Gruppe T2S: a workable solution for DVP cross-border settlement of securities within central bank money Euroclear Group APK Euroclear NL NTMA Euroclear BE Clearstream FFM NBB Clearing Clearstream Lux OeKB Euroclear FR Monte Titoli SCL Bilbao BOGS SCL Barcelona Interbolsa Iberclear CSD SA Siteme SCL Valencia

41. Why T2S (2)? • The model can offer advantages in terms of efficiency and cost-cutting • provided that a critical mass of CSDs actually join and the system can be developed at reasonable costs • Commitment CSDs • Cost estimations to be further investigated • It will benefit financial stability (enabling cross border securities settlement in Central Bank Money)

42. CSD Custodian bank or ICSD central bank money Investor Investor bank Background: Essential concepts T2S concerns only settlement in central bank money commercial bank money

43. EXCHANGE LISTING TRADING CCP CLEARING CLEARING HOUSE CENTRAL BANK CSD SETTLEMENT CASH CLEARING INVESTOR ISSUER CSD INVESTOR CSD BANK & BROKER ISSUER Traditional roles in securities market

44. EXCHANGE LISTING TRADING CCP CLEARING CLEARING HOUSE CENTRAL BANK T2S SETTLEMENT CASH SETTLEMENT SECURITIES ACCOUNTS INVESTOR BANK & BROKER CSD ISSUER CSD INVESTOR CSD ISSUER Securities accounts at the centre

45. How? • CSDs outsource the administration of securities accounts to T2S • Credit institutions transfer cash to T2S, real time DVP is now possible • During or at the end of the day the securities return to the CSDs and the money goes back into the TARGET2 payment system • CSDs retain the remaining functions such as custody and notary functions

46. Euroclear (BE, FR, NL) Euroclear (BE, FR, NL) Siteme Siteme Securities accounts Securities accounts Securities accounts Securities accounts TARGET2 – Securities outside of operating hours Euroclear (BE, FR, NL) Siteme BOGS Securities accounts Securities accounts Securities accounts OeKB Securities accounts Clearstream Securities accounts TARGET2 - Securities NBB Clearing Securities accounts Monte Titoli Securities accounts TARGET2 NTMA Cashaccounts Iberclear Securities accounts Securities accounts Other CSD’s APK OeNB, NBB, BBK, BdE, BoF, BdF,BoG, CBFSAI, BdI, BcL, DNB, BdP Securities accounts Securities accounts

47. TARGET2 – Securities during the operating hours Euroclear (BE, FR, NL) Siteme BOGS OeKB Clearstream TARGET2 - Securities NBB Clearing Sub-cashaccounts Securities accounts Monte Titoli TARGET2 NTMA Cashaccounts Iberclear Other CSD’s OeNB, NBB, BBK, BdE, BoF, BdF,BoG, CBFSAI, BdI, BcL, DNB, BdP APK

48. What is T2S? Where are the benefits coming from • 3 sources of cost savings • fee savings: • economics of scale • elimination of the cross-border aspect • collateral savings (single pool of collateral) • back-office savings (one or few technical interfaces) • Non-quantifiable benefits • driver for harmonisation • enhanced competition in market infrastructure • market liquidity (dynamic effect)

49. Uncertainties • Success of T2S depends on the decision of the CSDs to participate (voluntary) • Concentration of risk, monopolisation of settlement • Prerequisite of the project: harmonisation of legal structures and operating rules • Removal Giovannini barriers, especially • Barriers 4, 6 and 7: T2S may ensure common operating hours and finality rules for domestic and cross border transactions

50. The T2S User Requirements • Scope of assets • All types of securities which CSD’s are settling today (debt instruments, equities, investment funds, warrants) • Scope of services • Whole life cycle of a transaction: receiving settlement instructions, providing matching facilities, verifying availablity of securities and CeBM etc • T2S • Four central banks develops the platform: Deutsche Bundesbank, Banco de Espana, Banque de France, Banca d’Italia