Paul Tucker from the Bank of England said that the failure of clearinghouses could be more devastating than if major banks were to fail. Do you agree?
I absolutely agree with him. Most of the clearinghouses out there are not capitalised well enough and aren’t always applying standardised risk modelling techniques. There is a significant question mark in my mind on the quality of collateral that they accept. In some cases, even the solvency of such entities has to be called into question.
Over the past few years, we have seen some of the most aggressive clearinghouses running up multi-million pound losses. Business models like this are simply not sustainable. So I agree, in principle, with Tucker’s implication that some clearinghouses may be at risk.
The idea that we can reduce risk in the system by putting more flows through a central counterparty (CCP) pre-supposes that the CCP itself is solvent, is well capitalised, is managing risks and exposures prudently, and only accepts good collateral.
What are your feelings on the ‘collateral shortfall’?
We conducted a micro survey at Sibos 2012. At that time—October—most Sibos delegates believed that there was enough collateral for now, though they added “but ask me again in six months’ as a caveat.
Considering that trading volumes are down anywhere between 25 and 40 percent, it doesn’t surprise me that at today’s levels, there is a reasonable amount of collateral out there. It is of course skewed towards those institutions that actually don’t need that much collateral because they are big, solvent, and well capitalised. It’s the small clients that tend to experience a shortage.
There is certainly enough collateral out there of sufficient quality that will support today’s volumes. But in the future I think there will be a shortfall, and it will be a drag on volume increases.
As a result, business models will have to evolve to accept the constraints of insufficient collateral, and the effect that that will have on trading. Having said this, new sources of collateral will need to be found.
One of the panellists at Sibos—who also runs a CCP—made the statement that a collateral shortfall will not become an issue, because the market will “be creative” in finding new collateral instruments.
To my mind—and now I am speaking as the head of a CCP that is well-capitalised, solvent, profitable and AA-rated as a bank—I have some serious concerns about this statement.
The market must not manufacture collateral, and there should be no room for ‘creativity’. Have we learned nothing from the past four years?
The fact that you create a structured product ultimately makes its evaluation more difficult. If evaluation is more difficult, it raises the question of whether it is suitable collateral for clearing.
As soon as you repackage a product using multiple layers of other products, you call into question the real value of the product and what dynamics may change its value. I would much rather have a bond as collateral—I know its price, it’s liquid, I can sell it anytime I want, and I know what my net exposure is. If I have some sort of structured product with all sorts of baskets of securities, equities, bonds, maybe a few fund units, what is it worth? Who do I sell it to? In a worst-case scenario, if I had to realise the collateral because my counterparty defaulted, what am I going get out of it?
To my mind, creating structured products is absolutely the wrong way to resolve a collateral constraint issue. Collateral must be simple, it must be easily valued, it has to be liquid, and it most certainly has to be high quality.
We have to be very clear—CCPs must not compete on the quality of collateral that they accept. If CCPs start doing that, then the danger of systemically-relevant CCPs initiating the next crisis isn’t all that unrealistic. It is a very real danger.
When it comes to collateral, I am a fan of keeping it simple. Know what it’s worth, value it in real-time and have the legal certainty that you can enforce your claim on it. Otherwise we are going to get ourselves into trouble again.
Can you explain your connection LinkUp Markets?
LinkUp Markets was originally set up to realise many of the functional advantages that Target2Securities (T2S) will bring in the future. However, LinkUp Markets (LUM) leverages infrastructures that are already in place, rather than creating a centralised structure such as T2S. When we started LUM, there were seven central securities depositories. This has now grown to 11.
The initiative got these different CSDs to build bilateral links with each other with a translator in the middle. If an instruction comes from Spain, that will settle in German—the translator will do that—or turn it into Swiss-German so you can settle it in Switzerland. And this goes across all 11 CSDs.
That generates much of the benefit that we will get from T2S because you have central bank money settlement in each of the CSDs, through a single interface, using an existing infrastructure , which is already paid for.
Now with T2S on the horizon, all CSDs have the same challenge: how we are going to build that link to T2S?
In our decision to work with SWIFT, we were able to negotiate a good package it terms of how we will get that link in the future. And SWIFT will do the development work and operate the platform on our behalf. So it’s a logical extension of what LUM was originally designed to do.
The 11 CSDs are not all European. Strate is South African and we also have MCDR—an Egyptian CSD. Both are members of LUM. Whether they will avail themselves to the link to T2S in the early stages, I don’t know. That’s for every CSD to decide for themselves. I suspect the value to them of doing that is relatively questionable—the likelihood is that they haven’t got the volumes to make it worthwhile.
But for example, Strate, which is a member of LUM and therefore has built the interfaces, can easily go through any of the other LUM CSDs to piggyback on their direct connection to T2S. Strate would have direct access through a switching station, if you will. At some point, they may want to build their own direct links—the flexibility is built-in.
How do you ensure that the momentum on T2S is not lost?
I hope the European Central Bank (ECB) will ensure that, but the timeline is fairly clear now for T2S implementation. SIX Securities Services is committed to be a part of the first wave. So we will be testing sometime around the middle of 2014, to go-live in 2015.
The testing will be going on throughout 2013 within ECB on 4CB, the four central banks that initiated it, and all of that is on track. If there are further change requests, then there is enough buffer in the testing process that it won’t delay the second and third wave.
As for T2S’s momentum, the biggest challenge that we have at the moment is general market volume. It’s down. So that will have implications on the business case of T2S. It will have implications for the investment capability of each of the CSDs, which have to spend a lot of money building the links. And it will have implications for end users and customers who will also have to put up a lot of money to test with their CSDs and to change their reconciliation processes, matching processes and everything else to settle in T2S.
But the political will is there to implement T2S. It’s going to come, and I don’t think there is anything that’s going stop it.
SIX Securities Services is outside the EU and outside the eurozone. As a result, we face different challenges to eurozone CSDs. From my point of view, we are one of three CSDs in Europe that can carry out cross-border business. The other two are Clearstream and Euroclear. Currently, about 30 percent of my business is non-Swiss, with the biggest chunk being in Europe and therefore in the eurozone. Our customers in Switzerland obviously want access to the German market, the French market, and so on. The question is how we best connect to T2S, given that the Swiss National Bank has already decided not to take the Swiss franc into T2S.
The way we see it, we have two options: one is a direct connection from our CSD in Switzerland to the ECB. And the second is to establish a new entity in the eurozone itself that would be a regulated CSD, and will play the role of our regional custodian.
Both options are currently being finalised for our board.
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MYRIAD Group Technologies
Simon Shepherd
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