The globalization of securities markets, the spectacular advance of information technology, demutualization of stock exchanges, and the rise of alternative trading systems are just a few of the issues at the forefront of people’s minds when they consider the evolution of the global financial system.
While many people consider the impact on financial markets of more visible trends of the moment, such as online trading, what goes on with the infrastructure behind the scenes doesn’t receive as much attention. Clearing, settling and depositary services, however, will have just as much impact on the kind of markets we trade 10 years from now.
This is one of the wild cards in how financial markets will develop, according to William E. Irving, global head of capital markets consulting at PricewaterhouseCoopers. “How does clearance, settlement and depositaries work with these exchanges and trading systems?” he asks. “You don’t have to have them all owned by the same entity, but you do have to have them very tightly linked in a process that goes from execution to clearance, with perhaps a central counterparty and then also a strong depositary on the other side,” he says.
Given the need for this tight integration and the cost of setting up such technology, even when a group of dealers or a company tries to set up a trading system on their own, they would still be forced to come back to the optimal clearing and depositary provider.
“Many people in the industry feel that the real future of the industry is with an inverted model. More exchanges, more ECNs, more fragmented liquidity, but countering that we would see intelligent order routing across exchanges, across pools of liquidity, together with very centralized clearance and settlement activity in the back end,” says Irving.
Having many fragmented pools of liquidity, while not ideal from many people’s perspective, could be tolerated provided there was transparency and optimized execution price and a system that allowed straight-through processing (STP) and low-cost, fast clearance and settlement.
Until now, the internationalization of market transactions has not been complemented with a similar internationalization in the clearing and settlement of trades. This has been in part due to the large number of bodies handling clearing, settlement and depositary services. But consolidation is underway.
The US has seen some recent significant developments in this area. The Depositary Trust Company, the industry depositary, acquired the major clearing entity for equities – National Stock Clearing Corporation. That combined for the first time clearing, settlement and depositary in one nationwide entity, providing an opportunity for increased efficiency on a number of fronts.
“From a straight-through processing standpoint you know exactly who you have to connect to, you can set standards, you can minimize the number of interfaces – all the things that make STP possible,” says Irving. “What they’ve done now is gone to the next step and committed to incorporating all the other clearing entities, mortgage-backed securities clearing, government securities clearing, emerging markets securities clearing.”
As competition among exchanges leads to specialization in niche areas, PricewaterhouseCoopers sees the potential for a model in the US with a listing exchange, an OTC exchange, some regional exchanges and ECNs, but with a central clearing counterparty and a central depositary.
In Europe, too, there is much discussion about how far the M&A trend will go in this area. Recent activity has resulted in a few large transnational entities, the largest being Euroclear and Clearstream, and there is the potential for even further consolidation.
The benefits touted by proponents of larger regional securities settlement agencies are much reduced costs of cross-border equity trading, and some reduction of trading costs within a country afforded by economies of scale at the central agencies. The consolidation in the US is not yet taking place across borders, but the idea of a central clearing body to increase the efficiency of the world’s largest markets has pleased institutional investors.
In Asia this kind of consolidation has only been seen within national borders, and everyone agrees that this is as far as it’s likely to go in the short term. Benefits can still be wrought out of information technology that can exchange information, even in relatively complicated areas, between multiple systems in different countries, but that would still necessitate a certain degree of cross-border cooperation.
“One of the major things that’s happened in Hong Kong from the merger of the futures exchange and the stock exchange is actually the merger of the clearing houses that supported the two exchanges,” says Chia Tek Yew, partner and East Asia leader of financial services at PricewaterhouseCoopers.
This has resulted in all futures and stock trades going to one common clearing house, but this isn’t the end point as far as the quest for efficiency goes. “Part of the overall Hong Kong vision was to link that to the Hong Kong Monetary Authority payment gateways and see if you can derive some more efficiencies out of that,” says Chia. “So your clearing and bank settlement services can link. It’s not common knowledge and people don’t talk about it much. It’s just infrastructure.”
There are a number of hurdles in the way of improving cross-border integration of settlement systems, chief among them being sovereignty and foreign currency risk. A big driver of current pan-European capital market trends is actually the EU and the euro, but Asia is much less homogenous in terms of government and financial policy. “I’m not really sure that Singapore and Hong Kong would want to trade on the same basis as the Indonesian rupiah,” says Chia. “Until you have an Asian currency, which is unlikely in my lifetime, this probably won’t come about.”
“The reason it works pretty well in Europe is that the regulatory bodies are all in synch,” says Geoffrey Flynn, CEO of Instinet Asia. “Sweden’s very happy for us to be regulated by the SFA in London, whereas can you imagine the Korean exchange, or regulators, being happy with someone sending order flow into their exchange, but being regulated by somebody elsewhere in Asia?” This problem isn’t confined to agency brokers and applies just as much to securities settlement agencies.
“Those who are equal are fierce competitors. Those who are unequal won’t work with each other,” says Chia. “That is the Asian dilemma.”
