Why Financial Market Infrastructures Matter
By Luis Carlos Nino, Thomas Murray
Originally published on TABB Forum
For now, the post-trade clearing and settlement infrastructure in Europe is humming along. But the unintended consequences of regulatory change could increase systemic risk rather than reduce it.
In the world of capital markets, the public spotlight has predominantly fallen on pre-trade and trade analysis. The media focuses its attention on the price of shares, the movement of currencies, the possibility of changes to interest rates and the fundamentals of markets, as well as corporate news.
These aspects matter for those making decisions to buy or sell securities and other instruments. In addition, these elements are visible and are perhaps more easily understood by the general public. In any case, it is important to note that public attention has not shifted to the financial market infrastructures (FMIs), because these have been working well, even during times of crisis. They are also less visible and somewhat less exciting to the press and public imagination.
In the mid-term, the post-trade sector will garner more of the spotlight, as it should. This is because, following the 2009 Pittsburgh G20 Summit, the tectonic plates of capital market infrastructures started to shift across the world. On the back of this summit, a series of complex and controversial new pieces of legislation were passed in the United States, the European Union (EU) and elsewhere. As a result, the landscape of the financial industry has been changing dramatically and will continue to evolve over the coming years.
These changes to the financial environment are aimed at making financial markets less risky and more efficient. With the ostensible goal of minimizing risk and following the G-20 mandate, standardized over-the-counter (OTC) derivatives contracts have to clear through a central counterparty (CCP). In addition, CCPs in the EU must meet specific criteria to ensure they have robust risk management frameworks.
Similarly, and also with the same goal, EU regulators have set specific criteria that central securities depositories (CSDs) must meet. These criteria are aimed at standardizing key elements of settlement and safekeeping. In addition, EU lawmakers have established that both investors and issuers will be free to choose any infrastructure within the EU, as long as it meets EU requirements. This will open the field of competition, driving FMIs to be more efficient. Ultimately, this may benefit investors and issuers.
At least in theory.
There are, in these regulatory changes, some side effects that must be analyzed and monitored.
First, having CCPs clear OTC derivatives substantially increases the degree of risk concentration in the market. This means CCPs will be more vulnerable and the repercussions to the market in the case of failure would be very serious and difficult to contain.
Secondly, by making CSDs compete with one another, there will be a consolidation process among them. Those CSDs that are expensive or have significant weaknesses in terms of asset servicing capabilities and asset safety, are likely to be absorbed by large groups that can generate economies of scale and are able to provide high quality services to both investors and issuers. Ultimately, this means more commercial concentration, as Europe will go from having more than 20 CSDs, to having just a handful.
All of these elements will be sufficient in diverting the media spotlight towards FMIs. But there is one more element that makes these regulatory changes even more important for investors and financial intermediaries.
Recently enacted EU regulations have imposed a high degree of legal liability on depository banks in terms of monitoring and advising their end clients of the different risks associated with the infrastructures they use. This implies that financial intermediaries should have a thorough understanding of FMIs and be in a position to monitor developments.
These potential changes are of international significance.
The result is that there will be more risk concentration at CSDs and CCPs. Admittedly, there will be opportunities for investors and issuers, if they feel they can benefit from engaging with a different CSD or CCP. For some financial intermediaries, there are new responsibilities to their end clients.
What do these elements have in common? They need to continuously monitor, over the next few years, the evolution of the post-trade space in Europe.
A final thought: As Europe’s infrastructures evolve, they will be doing so in the context of ongoing regulatory and commercial changes in the global financial system. This means a lot of moving parts.