The current European system of securities’ clearing and settlement is still rather fragmented along national boundaries, thereby making cross border operations costly and less efficient. As a response to this, the European Central Bank («ECB») is launching the project of a centralized public securities’ settlement platform, called «Target 2 Securities» («T2S»), which would entitle each participant to settle, through a single Target2 account, any securities’ transaction performed through a Central Securities Depository that provides for settlement in central bank money in Euro. The legal basis of T2S is to be found in Article 105 (2) of the EC Treaty and, more specifically, in Articles 17, 18, 22 and 23 of the ECB Statute. This paper is structured as follows. The first part briefly describes the background of T2S. Part two addresses the policy reasons supporting the ECB initiative. Part three discusses the legal basis for T2S. Part four discusses the trade-off between market-driven integration and public consolidation of securities’ clearing and settlement in the Eurosystem, also in the light of the «open market» and «free competition» principles set out in Article 105 of the Treaty. Part five briefly examines similar initiatives elsewhere, also looking at those promoted and managed by other Central Banks. Part six concludes with a few initial remarks on the extension of the legal framework of Target to T2S.

SOMMARIO:

1. Introduction - 2. Policy reasons for T2S - 3. Questions on the legal basis - 4. Market-driven integration or public direct intervention? - 5. A brief comparative overview - 6. The extension of the legal framework of Target to T2S - NOTE

1. Introduction

By now Central Securities Depositories (hereinafter, «CSDs») operating in Europe settle the central bank money leg of any securities’ transaction denominated in Euro through the local real-time gross settlement component of the Target system. To this purpose, all (direct or indirect) participants in a CSD must also participate (directly or indirectly) in the national real-time gross settlement system of the country where the CSD is located. This makes the settlement procedure particularly costly and less effective when cross border transactions are processed (it has been calculated, indeed, that cross-border securities’ settlement in the EU is up to six times more expensive than domestic settlement). The fragmentation of clearing and settlement along national boundaries, moreover, frustrates the possibility to profit from the economies of scale made available in principle by a single currency and by current market integration. With the introduction of Target2 (hereinafter «T2») (which will open on November 2007) it will be possible, according to the European Central Bank (hereinafter, «ECB»), for each participant in T2 to settle, through a single T2 account, any securities’ transaction performed through a CSD that provides for settlement in central bank money in Euro. Cash and securities might be settled, therefore, on the same IT platform along the lines of an integrated model at the Eurosystem level (such a platform is referred to as Target2 Securities, hereinafter «T2S»), with estimated efficiency gains and costs’ savings which, even if the system were not compulsorily mandated (a point which seems still open to discussion), should compel de facto existing national CSDs to outsource their user accounts to the T2S platform. As recently pointed out by Mr. Godeffroy, Director General of the Payment Systems and Market Infrastructure at the ECB [1]   «users consider that the most efficient model [for securities settlement] is the integrated model, where cash and securities are settled in the same platform. Consequently [to achieve this model] there were two options: outsourcing the management of central bank accounts to the CSDs, as in the system which Euroclear will open soon, or outsourcing the CSD accounts to a central bank platform. The conundrum is simple. Outsourcing cash accounts to the CSDs means fragmentation of liquidity. Outsourcing securities [continua ..]

2. Policy reasons for T2S

From a European regulatory perspective, the project of a «Euro-common venue» for cash and securities settlement is clearly conceived on the assumption that, in addition to improving market efficiency through a prompter achievement of economies of scale and reducing liquidity risks in the Euro-area – thereby safeguarding and, if possible, enhancing financial stability – it will also lift existing barriers in the cross border trading of securities denominated in Euro, thus creating a level playing field for securities settlement in Euro to all Eurosystem counterparties. In doing so, the ECB intends to respond to a perceived market failure in the regional integration, as it is deemed to be the current persistent fragmentation, along national boundaries, of the existing securities settlement providers. In fact, over the last decade, also in the wake of the CPSS and IOSCO recommendations for securities settlement systems [2], there have been several attempts to tackle fragmentation and inefficiencies in the European securities settlement market [3] and an elaborated action plan was put forward by the Giovannini Group [4] and by the European Commission [5]. Indeed, it is widely recognized that European public authorities have some scope for intervention in this field [6]. When trading, clearing and settlement are too costly or complex as a result of insufficient integration, financial transactions are discouraged, and this has a negative effect on the allocation of capital, risk sharing across agents and economic growth within the integrated area [7]. It is therefore common wisdom that a greater degree of integration in the Eurosystem – promoted or realized, as the case may be, by public intervention – is needed, in order to fully exploit the advantages of having a single currency. However, different models of integration are available (from vertical integration to horizontal integration to a single clearing and settlement system) [8] and the basic question in the current regulatory agenda rests on what instrument is best suited to the purpose of market integration and consolidation. The question, in particular, is whether such integration of clearing and settlement systems should be market-driven and therefore left in the hands of market participants or should be the result of direct public intervention. The ECB project is a clear regulatory response in this latter sense, [continua ..]

3. Questions on the legal basis

The legal basis for the ECB proposal for T2S rests, in general terms, on Article 105 (2) of the Treaty (according to which the ESCB must promote the smooth operation of payment systems) and, more specifically, on the ESCB Statute (hereinafter, the «Statute»). Although the Statute includes no specific reference to T2S, it contains nevertheless several provisions, which, upon a functional and systematic interpretation, appear relevant in this respect. They confirm, in my opinion, that the ECB has, in principle, the legal authority to carry out the functions it proposes. And namely: a) A provision often referred to as setting out a proper legal basis to the ECB project is Article 18 of the Statute, which reads as follows:   In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may: – operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals; – conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.   As it results from the plain reading of the provision, Article 18 includes buying and selling «marketable instruments» and conducting credit operations. Albeit the wording of this Article does not explicitly mention securities settlement operations (the T2S proposal was not foreseen at the time the Statute was drafted, and thus Article 18 contains no explicit mandate to carry out settlement operations of securities), it seems, nonetheless, to cover (also) the basic functions displayed by a securities settlement system, especially when a central counter party is put in place. b) In addition to Article 18, further (and, in my view, clearer and, perhaps, more convincing) legal basis for the T2S initiative can be found inArticles 22 and 23 of the Statute.Article 22, titled «Clearing and Payment Systems», sets forth that the ECB and national central banks may provide facilities, and that the ECB may make [continua ..]

4. Market-driven integration or public direct intervention?

It might be questioned, however, whether the creation of T2S as a common and public venue for securities’ clearing and settlement promoted and managed by the ECB does or does not harm competition. Article 2 of the Statute sets out, indeed, that:   In accordance with Article 105(1) of the Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2 of the Treaty. The ESCB shall act in accordance with the principles of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4 of this Treaty.   In devising the new system, specific consideration must be paid, therefore, to the reasons of an open market economy and of free competition. It should be considered, in this respect, that in discussing the EU clearing and settlement system, the Lamfalussy report [11] was clear in concluding that any integration process should be largely in the hands of the private sector, although it warned that any failure of the private sector to make sufficient progress in integration would justify public-sector intervention. A similar approach was taken also by the Giovannini Group, which, in its Second Report [12] sponsored a market-driven integration and consolidation, although it added that «the financial industry is the quintessential regulated industry and therefore it is difficult to conceive of reforms that affect the very architecture of financial services which do not involve public authorities. Thus it would be naïve to assume that the integration of the EU clearing and settlement environment could be left to private market participants alone. On the contrary, the public sector can be expected to play a major role – both in co-ordinating private sector actions and re-regulating clearing and settlement on a pan-EU basis». It should be duly assessed, therefore, if, as it seems, despite recent market moves apparently responding to the ECB T2S project as the European Code of Conduct for Clearing and Settlement [13], the disappointing results achieved so far by market-driven integration after seven years from the launch of the Euro do show the occurrence of that [continua ..]

5. A brief comparative overview

Also elsewhere it is, and has been, not uncommon for central banks to provide for securities clearing and settlement services. Outside the Euro area, the most cited examples are those of the Federal Reserve in the US and of the Bank of Japan. The latter provides, in fact, centralised securities settlement services for Japanese government bonds and bills. In the US the SEC published a seminal study on clearing and settlement already in 1975, advocating the establishment of a single clearing house in lieu of the then existing multiple integrated silos and anticipating that this would have made possible a decrease of the post trading costs of about 65% (a percentage of savings which seems to be confirmed by subsequent practice). At that time, the US system was still experiencing a serious «paperwork crisis», with the country’s major Stock Exchanges closing one day a week to process the paperwork accumulated. The National Securities Clearing Corporation (hereinafter «NSCC») was eventually founded in 1976 and at about the same time the Depository Trust Company (hereinafter «DTC») started centralising settlement and depository services: operations which, in the US, are traditionally devised as utility services. NSCC and DTC eventually merged in 1999, establishing the Depository Trust & Clearing Corporation (hereinafter «DTCC») – a holding company that controls by now the two entities. The DTCC is, however, a private and mutualized company, owned by its users (major banks, broker/dealers, mutual funds, and other companies operating in the financial market, including the National Association of Securities Dealers and the New York Stock Exchange). The DTCC, through its subsidiaries, provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities and over-the-counter credit derivatives. DTCC’s depository unit also provides custody and asset servicing for more than two million securities issues from the United States and 100 other countries and territories. It is reported to be the most cost-effective settlement system operating so far [16]. Fedwire, run by the Federal Reserve, provides similar services for Government bonds. The Fedwire Securities Service processes securities’ transfers either on an individual or gross basis in real time. The Fedwire Securities Service [continua ..]

6. The extension of the legal framework of Target to T2S

Once conceded that the ECB would have proper legal basis for finalizing its T2S project upon showing the case of efficiency gains and the uncertainty and higher costs, delays and risks associated with a market-driven consolidation, it remains to be clarified to what extent it should be possible to expand the existing Target legal framework also to T2S. This question is, however, premature and shall be properly addressed only after completion of the feasibility study launched by the ECB. For the time being, it might be worth simply recalling that the existing legal framework for Target is laid down in the ECB Guideline of 30 December 2005 (ECB/2005/16) [18] as amended on 3 August 2006 [19]. The Guideline covers both technical and substantive issues relating to the operation, governance and management of the Target platform. Despite the very fact that the existing Target and T2S platforms would share some common features, key differences between them are very likely to require either a separate legal framework for T2S or a suitable complement to the existing Guideline devoted to T2S. Indeed, should the ECB, after completion of the feasibility study currently under way, decide to proceed further with the project, the T2S guidelines shall specifically address all features concerning securities’ settlement. In this respect, there are a number of specific issues on which the ECB did not anticipate its final position, some of which are currently under consultation [20]. As such, there is room and time for further consideration, in due course, of the legal rules, which will govern in detail the functioning of such a new venue and service.

NOTE