The Bank of England could kill T2S

In fact, it is now in principle boring enough to survive the collapse of the euro. Which means the interesting question is not whether T2S can survive the euro but whether it can survive its own pretensions, for the apparent solidity of T2S is exactly that – apparent, not real. Only its own intrinsic boringness keeps the project going, by diverting attention from its financial and strategic vulnerabilities.

In theory, T2S can survive the collapse or radical restructuring of the euro because it is being built as a multi-currency system. This means that the retreat of fringe members of the euro back into the drachma or the escudo, or even the lire or the peseta, cannot halt the project. But the multi-currency functionality is not about being communautaire. It is about being commercial, for T2S is not a budget piece of infrastructure. The ECB puts the cost of the development at €346.5 million down to launch in September 2014, plus an average of another €60.2 million per annum for the subsequent eight years between September 2014 and September 2022 to cover migration and operating costs.

That is a total of €828.1 million. Throw in cost over-runs, and the burden imposed on the industry by changing securities settlement and payments links from national CSDs and RTGS systems to T2S and TARGET 2, and the total cost to the securities industry might easily hit €1 billion.

There is larger problem. The principal purpose of T2S is to cut the costs of cross-border settlement, and it is self-evident that it cannot achieve this goal without at least reducing the number of CSDs. De-commissioning CSDs will cost money, yet it is not obvious that they can be decommissioned completely. They perform crucial roles for both issuers and investors in their domestic markets, and these roles cannot be assumed by T2S, or continue to be subsidised from settlement revenues aggrandised by T2S.

But even if the ECB financial projections for T2S turn out to be exactly on the money, it is going to take an awful lot of settlement business to recoup the initial investment and migration costs – and T2S is being built, and will operate, on a full cost recovery principle. Having committed itself to a price of no more than €0.15 per settlement instruction from launch in September 2014 to December 2018, T2S is going to need around 4 billion transactions just to cover the costs of the project plus the migration incidentals of the first four years.

In January this year, according to World Federation of Exchanges (WFE) data, the principal stock exchanges of Europe hosted around 65 million equity trades that month. As a monthly average volume (an heroic assumption) that would translate into about €116 million a year at 15 cents a trade, or about 25 per cent short of what T2S needs to stay on course to recover its investment and migration costs in the first four years. The sheer size of that shortfall is a graphic reminder that T2S was also a project conceived at the height of the bull market, when equity transaction volumes were running at record levels, and before the mania for netting through central counterparties (CCPs) threatened to cut those volumes dramatically.

For T2S, volume projections a decade into the future are a far from academic exercise. At the moment, the costs of T2S are being borne by the four central banks - the Deutsche Bundesbank, the Banca d’Italia, the Banque de France and the Banco de España - and the ECB itself, and they are expecting to recover their investment in full by no later than 2022. They expect fully 75 per cent of the costs to be recouped through settlement charges, and 25 per cent from sales of data. This pressure explains why the ECB is desperate for the larger non-euro markets – Sweden, Switzerland and especially the United Kingdom - to join the T2S project by agreeing that Swedish Krona, Swiss Franc and Pound Sterling transactions can be settled in central bank money via T2S.

The United Kingdom is easily the most important outsider. WFE data suggests the London Stock Exchange Group accounts for 30 per cent of equity trades in Europe. The architects of T2S know the long term financial viability of the project depends on servicing those volumes. In fact, the 15 cent transaction charge is conditional not only T2S coming within at least 10 per cent of its transaction volume targets overall, but on non-euro currencies (of which the pound sterling is the largest) adding 20 per cent to transaction volumes. If it misses the targets, T2S can do nothing about it until December 2018, when its commitment to fixing the delivery-versus-payment charge at €0.15 expires. Even then, the Governing Council of the ECB has promised that T2S fees will not increase by more than 10 per cent a year between 2019 and September 2022, when the projected cost recovery period ends.

This means that, if the cost of the project is contained to €828.1 million and equity volumes remain static, the central banks will have fully recovered their costs at some point in 2021. But if the costs of the project rise by, say, a quarter, or equity volumes dip by 10 or 15 per cent, recovery will be postponed. If volumes fall by 25 per cent, the costs will not be recovered by 2022 in spite of transaction prices going up by 10 per cent a year. And even these projections depend upon the 30 per cent share of equity volumes hosted by the London Stock Exchange (LSE) being serviced by T2S. The inclusion of the sterling component of those transaction volumes, despite the recent decision by the LSE to put Monte Titoli into the first wave of migrations on to T2S, is far from certain.

The United Kingdom has a well-deserved reputation for being in the rearguard of any European initiative and, having abjured membership of the euro, the Bank of England is not hurrying to join T2S either. It is noteworthy that the only real enthusiasts for T2S in London are the global custodian and global investment banks, whose American leaderships see T2S as a European equivalent of the DTCC that will enable them to get rid of their expensive sub-custody and local clearing agents throughout the continent. HSBC, the largest indigenous custodian bank, is nominally supportive but under no serious commercial pressure to be overtly committed, because its continental European interests are so small.

The retail stock brokers and wealth managers of the United Kingdom, on the other hand, are committed to opposition. This owes something to the chauvinism of the English provinces, whose inhabitants derive some pleasure from opposing any and every initiative from Europe, but their hostility to this particular infrastructural investment is based in commercial realities. Retail brokers conduct little business outside the United Kingdom, and see T2S as likely to add to their costs rather than subtract from them. After all, CSDs - including the CSD for the United Kingdom, Euroclear UK and Ireland (EUI) - will have to charge for the services they provide on top of settlement in T2S. It is not certain that these charges plus €0.15 per instruction will be lower than what is charged today.

Today, EUI charges €0.40 on average to settle a trade, so it is fairly obvious that the CSD will have to cut its charges if T2S is not to simply add €0.15 to every euro-versus-sterling trade, yet its incentive to do so is limited if T2S starts to devour the settlement revenues of the Euroclear group. Most of the services provided by EUI – such as registration and corporate action processing - will not be affected either way by T2S, so the basis of a price cut is not immediately apparent. Yet some costs are almost certain to go up. Functionality to assess stamp duty on UK transactions (currently calculated by EUI) will have to be added to T2S. The addition of an overnight settlement cycle in T2S will also force settlement banks to charge for overnight credit advanced to brokers, who will also in all likelihood incur the costs of collateralising commercial bank money, thanks to capital relief on collateralized exposures.

There are other reasons to expect costs to go up for UK domestic users. It may be that that some UK securities could settle in euro in T2S, while the vast majority of domestic trades continue to settle in sterling in EUI. But that would lumber users with the cost of maintaining a separate infrastructure in the UK, plus the construction and operation of suitable connectivity to facilitate liquidity between the two systems. In theory, Euroclear could even mobilise its ESES platform to settle UK securities in euro without the need to put sterling into T2S, but that would only add a further layer of cost and complexity in the shape of matching custody accounts in T2S and ESES and building communications links between the two platforms.

It is increasingly obvious that there is no cost-effective compromise available for sterling. When it comes to T2S, the United Kingdom must decide whether it is in or it is out, and pay the price accordingly. This decision is imminent. In fact, to join the early participants – so far, only BOGS, the CSD for Greek government securities, Monte Titoli and the Romanian CSD, Depozitarul Central, have definitely agreed to join the first migration to T2S in September 2014 – a decision to participate must be made within a matter of months, if not weeks. Yet the Bank of England (which must agree to make sterling available as a settlement currency in T2S) does not seem eager to decide quickly.

For the Bank of England, the attractions of agreeing to settle trades in sterling in T2S are not obvious. The central bank is not being offered shares in a new legal entity, plus a seat on the board of directors, but a contractual agreement with a Eurosystem dominated by France and Germany and (as long as they remain inside the euro) Italy and Spain. While T2S is currently owned and run by the Eurosystem, with banks and CSDs merely being consulted, two contracts - a “Framework Agreement” between the Eurosystem and euro area CSDs and a Currency Participation Agreement between the Eurosystem and non-euro central banks willing to settle trades in their currencies in T2S - are now circulating. Their terms govern the timing of membership of T2S, and the interaction between T2S and the national CSDS and central banks during the next phase of the project.

Both agreements are meant to be signed this summer. Neither has been. For the Bank of England, the proposed arrangements mean it might easily lose control of access to central bank money if the Eurosystem can decide who can have an account at T2S, or what forms of collateral are acceptable. The Bank has already asked the ECB for assurances that non-euro central banks be allowed to form their own group within the system, and have a right of appeal against decisions by the Governing Council.

EUI, which is responsible for making UK securities available for settlement in T2S, on the other hand, faces a more complicated choice. T2S threatens its business model, but also creates opportunities for it. After all, EUI is owned by one of the organizations that expect to emerge as a winner from the process of consolidation of the national CSDs of Europe that is bound to follow the launch of the T2S service. Unsurprisingly, EUI committed at an early stage to join T2S for the purposes of euro settlement. The Bank of England, by contrast, has yet to match this decision by making sterling available as a settlement currency in T2S.

It may be that the ECB prefers the continuing procrastination to the alternative. After all, a negative decision from London would call into question the viability of its €0.15 transaction charge, by denying the new system the value of UK transaction volumes. As long as the issue is undecided, the momentum behind T2S can continue to gather force, till the red ink reaches the Macbeth point at which “returning were as tedious as go o’er.” For a central bank already weighed down with Greek government bonds, and answerable to a political caste notorious for its pork-barrel politics and prepared to pay any price to maintain the structure and institutions of the European Union, it should not be too hard to lose the price of T2S somewhere in the accounts.

It may have to do that. The financial projections for T2S are dependent on non-euro transaction volumes. Far from being depressed at present, European equity volumes may even be artificially inflated by the post-MiFID surge in high frequency trading and the still limited impact of CCPs. It is of course possible that transaction volumes will boom, solving the potential financial problem before it becomes real. T2S might even make a contribution to that boom by cutting transaction costs and facilitating access to vast pools of euro-denominated collateral, though the concomitant hostility of certain interests within the European Union to both hedge funds and short selling - to say nothing of the long planned assault on “shadow banking” - is likely to mute even the usefulness of that.

It is far more likely that the euro will collapse, or at least partially collapse, than European equity volumes will boom. If the Spanish and the Italian central banks found themselves perforce outside a “core” euro system, it is hard to see how the present sources of funding of T2S could continue. With T2S on the margins of financial viability even under present conditions, the depressive effects on cross-border trading and investment activity of a major financial crisis accompanied by a reversion to national currencies would make nonsense of its finances.

A project established to cut settlement costs in Europe, not just once but into the foreseeable future, might well end up increasing them. So it should not take the leadership of the Bank of England long to work out that the risks of making sterling available as a settlement currency in T2S outweigh the potential benefits. Indeed, the transaction volumes at the command of the United Kingdom are so large and so important that, merely by refusing to participate, the Bank of England might well vindicate its own decision almost immediately. It could save the many users of settlement systems in the United Kingdom in particular, and in Europe as a whole, a great deal of money in covering the costs of this grandiose project down to 2022. The Bank of England is in an unusually powerful position. Unfortunately, its leadership has of late shown a remarkable talent for getting the big decisions wrong.

Tags: ECBT2SCSDBank of England