Upcoming regulatory projects in the European Union aiming to facilitate the development of a single market for financial services will have a major impact on the rest of the world over the next several years.
The example of European codes on unit trusts - Ucits - is useful. The EU updated its standards for allowing Europe-wide marketing of mutual funds. Asian governments have been forced to accommodate these changes - and when individual European governments indicated they would insist on following the new version of Ucits as early as mid-2005, it left Asian regulators scrambling to keep pace.
Now Asian regulators and industry practitioners need to keep an eye on several new moves that Brussels is pursuing that may fundamentally change functions such as custody, trade processing and clearance and settlement, says Tony Freeman, London-based director of industry relations at Omgeo.
"Just as American regulation usually becomes global regulation, increasingly so does European regulation," Freeman says. And as Brussels changes the rules for custodians - an industry dominated by American firms - players will prefer to incorporate these changes worldwide, rather than perform separate operations for Europe.
European regulators are trying to figure out how to make their markets more competitive. There are today some 20 central securities depositories and clearing corporations across the EU. While most markets are extremely efficient in domestic processing, when it comes to cross-border work, they are costly. Moreover, regulators feel pressure from global securities brokers and fund managers, which want a single clearing and processing hub to deal with. And as the volume of trading in cash products, derivatives and other asset classes grows, the inefficiencies become glaring.
For example, according to Omgeo, investment banks find Europe three times more expensive than the United States to clear and settle trades; Europe consumes 75% of global expenditure on clearing and settlement; and that this excess cost tops $1 billion a year.
There are also tensions within the European context. Broker/dealers want to see consolidation among depositories and clearing companies. Agent banks and custodians, meanwhile, want effective competition rules in the wake of central securities depositories' growing businesses in offering bank and custody services. And the European Commission wants lower costs and a unified market, and it wants to do so by making depositories compete across national lines.
This will be tricky, because Europe's financial markets remain steadfastly national. For example, if a resident of one member country wants to transfer a portfolio from her bank to a bank in another country, the transaction costs are prohibitive - it's cheaper to simply sell the portfolio and move cash. There is virtually no cross-border purchasing of insurance or investment products by consumers; even when barriers such as language are overcome, hidden transaction costs swell.
The EU is therefore becoming more interventionist. It is preparing a draft EU directive, to be issued in the fourth quarter, to try to force market-based competition across the entire field of trade processing. Its goals are free competition, free access and interoperability, and it is likely to have a big impact on depositories and custodians - an impact that will spread beyond Europe's borders.
The idea behind this draft is expected to find ways to make national depositories compete on a cross-border basis. These are, however, natural monopolies, and because global broker/dealers want to only deal with a single interface, such as the DTCC in the US, it is unclear how this will play out. Brussels could, for example, force depositories to charge identical fees for domestic and cross-border business - as it did for bank's fees. The regulators seem to hope that market forces will lead the way toward M&A and consolidation, but because these are natural monopolies, that may not happen.
This could create the possibility that the EU will regulate depositories out of existence. Getting such regulation right is difficult. Or the EU could even, at taxpayer expense, decide to build a new, European-wide clearing and settlement utility. Europe's journey toward achieving something like the DTCC, with its high standards of user governance and reasonable costs, could prove arduous.
The regulators are also expected to interfere with the blurring functionality among custodians and depositories. More central securities depositories in Europe (unlike the DTCC) are acting like banks and extending loans. Many custodians are so big that they are clearing and settling cross-border trades internally (and sometimes still charging customers for the same service ostensibly done at a depository).
The EU is uncomfortable with this, because its regulations for depositories are not the same as they are for banks. Therefore it may bar depositories from bank-like activity, and similarly prohibit custodians from settling trades on their own books. Defining these functions, however, can be extremely complicated, for both regulators and market participants.
Freeman predicts that as core custody in Europe becomes priced like a commodity, banks will surrender custody to the depositories in favour of high-value processing and outsourcing services.
Although the EU expects implementing its final directive will take over five years, the example of Ucits demonstrates that changes can sometimes occur faster than expected. Asian regulators and market players will have to keep an eye on Europe.
Besides, there is more than just EU directives. The EU also assembled a "Giovannini Group" of advisors that submitted its first report in 2001. The Giovannini group's goal is to identify and remove barriers to financial services within the EU. In 2003 it identified the first barrier to attack: IT standards. It then appointed Swift to come up with a solution. Swift's answer: define a message protocol that would become mandatory and may extend beyond just messaging and reach into business protocols. Players like Omgeo believe this will allow Swift to expand its own role by using EU goals to assert its control over standards development.
Again, this will have a global impact, because there are European countries such as Switzerland that are not in the EU; there are no regional standards or protocols anywhere in the world - just national or global ones; and it is impossible to carve out Europe as a discrete location, particularly when most securities business in Europe is traded or processed by American firms. This means that Swift users and non-Swift users alike are going to have to accommodate European regulatory changes.
