The processes by which companies innovate and diversify are the most talked-about and least understood of any in business. Mathias Papenfuss, head of regulatory implementation at Clearstream and chairman of ECSDA, draws on his experience of the mutating European industry of the last 20 years to portray change at CSDs as the outcome of complex and protracted interactions between competition, technology, regulation and culture.
“The world does not stand still,” says Mathias Papenfuss, head of regulatory implementation at Clearstream and chairman of the European Central Securities Depositories Association (ECSDA). “Even the core central securities depository (CSD) functions of safekeeping and settlement are moving. In this environment, any CSD that does not subscribe to the need to innovate is systematically choosing to fall behind. You can always become more efficient and effective even if you provide a fully commoditised service and have the most advanced set-up and the most sophisticated procedures available to deliver it.”
Even commoditised services face demands for an innovative approach
It is hard to disagree. In the European Union (EU), for example, all CSDs switched in 2015 to settlement on a common timetable of trade date plus two days (T+2). True, it was a necessary step, enforced by a legal requirement in the Central Securities Depositories Regulation (CSDR), to accommodate the subsequent transition to the TARGET2-Securities (T2S) pan-European settlement platform operated by the European Central Bank (ECB). Nevertheless, it was still a commoditised service – securities transaction settlement – that had to be changed.
The pressure to innovate does not have to come from law or regulation. A commoditised function such as settlement is also subject to technological obsolescence, necessitating investment in faster, better and cheaper systems. Papenfuss goes further, arguing that it is precisely because a core function is commoditised that CSDs have an obligation to innovate around and on top of it. “It is better to extend the range of activities by leveraging our core competencies,” he says. “As we have seen, some of the activities that use that leverage are far removed from the traditional activities of a CSD.”
CSDs can use their core competence to diversify into areas far removed from securities markets
Papenfuss points out that CSDs are already exploring new opportunities created by the digitisation of official business, such as safekeeping and validation of university degree certificates and the maintenance of land registries. “In these cases, CSDs are becoming data repositories,” he explains. “Whether you store the entitlements of beneficial owners, or university degree certificates, you can still use the same technology. In any case where information is becoming digitised, CSDs have relevant services to offer. They can range far beyond the securities industry.”
An obvious opportunity for CSDs, and especially those running beneficial owner accounts, is the creation and protection of individual documentation and digital identities. A Know Your Client (KYC) process dependent on validated copies of a passport or a driving licence and a utility bill, for example, could be replaced by on-line accounts which enable individual account-holders to release digitally fingerprinted and cryptographically protected documentation to employers offering work or banks offering mortgages or unsecured loans or governments issuing passports.
The constraints on diversification by CSDs include culture as well as competition
There are of course constraints on the ability of CSDs to diversify and innovate in these sorts of ways. Their customers tend not to be enthusiastic about CSDs competing for the business of their clients. Regulators discourage CSDs from entering businesses which might imperil the stability of systemically important institutions. The ownership and governance structures of a CSD, and especially the limits they place on financial resources, are also not always conducive to diversification.
But there is also a less obvious cultural constraint at work. “CSDs are under just as much financial pressure as any other business entity, but their starting point does put them at a disadvantage,” says Papenfuss. “Traditionally, they have enjoyed a protected status in their national markets. Consequently, the need for the management to employ strategic thinking was definitely reduced. CSDs had less need to look forward and move ahead. However, that has changed since some time as a result of technological developments.”
Technology is disrupting the traditional business of the CSDs
Certainly, new and powerful digital technologies have potentially revolutionary implications for institutions which in the normal course of business accumulate and manage large quantities of data and operate at the centre of highly structured hub-and-spokes networks. Blockchain is the obvious instance, but artificial intelligence (AI), machine learning and robotic process automation are also rich in potential threats to the traditional business of CSDs.
The new technologies create opportunities too. They can lower the costs of conducting existing business – marginal cost, in fact, can be lowered effectively to zero – and extend their reach to more distant customers. They can also open up entirely new lines of business for CSDs. “Technology is a transformational force because it is not limited to national boundaries,” says Papenfuss. “Technology allows much more competition beyond the domestic borders of a CSD. It is one of the game-changers we see when we look into the traditional business of a CSD.”
He likens the present circumstances to the Dot Com era of the 1990s, when the leadership of the CSDs first passed to executives with a technology background. Now, armed with superior technology, their successors are thinking in terms of extending the reach even of their most commoditised services across borders and into wholly new markets. They also know that potential competitors can do the same to them. In Europe, no leader of a CSD will have failed to notice the speed at which a European regulator granted a CSDR-compliant licence to the new, blockchain-based CSD ID2S.
European CSDs have embarked on a slow but far-reaching process of change
ID2S is not the only factor to put European CSDs on alert. Papenfuss has noticed an increased appetite from potential competitors to national CSDs both inside and outside the EU to form links with investor CSDs in domestic markets in order to give their clients access to European securities or European investors. The structures created by certain global custodian banks, which have appointed a single CSD to settle transactions in T2S and a single sub-custodian network to service client assets throughout Europe, are a case in point.
“Linking and partnering is something that all European CSDs are exploring seriously,” says Papenfuss. He thinks every incumbent CSD in Europe is engaged in a strategic review. They are nevertheless applying for authorisation under CSDR on an unchanged basis. This reflects the fact that, burdened by technological legacies of the kind ID2S lacks, they do not want to waste time on the authorisation process when there are new business opportunities to explore and exploit. “Most CSDs are applying in their `as is’ rather than `to be’ situation,” says Papenfuss.
The likeliest long-term victims of this exploratory process are the sub-custodian banks of Europe, which currently survive because T2S offers settlement only, and the asset-servicing functions of the national CSDs are often patchy and inadequate. “It is not a change that will happen overnight,” says Papenfuss. “The CSDs have to do more than ramp up their capabilities. It requires a change of mentality too. They have to become more service-oriented. It will take years to get there.”
Innovators need reasons to do things differently not orders to change
Another reason a more dynamic and innovative marketplace will take time to emerge in Europe is that there is no single European capital market. The CSDs of Europe continue to service markets which remain rooted in domestic securities laws and regulations, notably in fields such as corporate actions and withholding tax. “Harmonisation is taking place at a European level but reaching the ultimate objective of fully harmonised and standardised processes even within the eurozone is still to come,” says Papenfuss. “In the securities markets we still have areas that need to be tackled. We need trigger points to effect the necessary change, like the introduction of T2S led to the harmonisation of settlement on T+2.”
This European experience has persuaded Papenfuss that global harmonisation of post-trade standards will proceed even more slowly, as regional initiatives have to be pursued first. He also thinks a drive towards harmonisation is an ineffective agent of change in its own right and needs an accompanying infrastructural investment (such as T2S) to catalyse movement. An earlier prospect, says Papenfuss, is global agreement on best practices. Even if these are not always applied, they do at least provide a benchmark to which CSDs can aspire.
Papenfuss is not a supporter of accelerating the process of change through direct regulatory measures, because these can have unintended consequences. He points out that the settlement discipline provisions of CSDR, for example, threaten to impose costs and distortions on securities settlement in Europe, and put the CSDs of Europe in an invidious position in relation to their users, because what appealed most to regulators (incentivising counterparts to avoid trade failure) is hard to implement in practice.
“In order to operationalise a regulation, you still need private sector engagement,” explains Papenfuss. “As we have found with the CSDR settlement discipline rules, devising requirements to make the regulation work soon pushes you back into the discussion about harmonisation and standardisation you were trying to avoid by regulation in the first place.” In other words, innovation cannot be ordained from above. It needs to bubble up from below as well.
Thursday 11 April 2019
11.15 am-13.00 pm
Innovation and diversification
Moderator: Mathias Papenfuss, Head of regulatory implementation, Clearstream Group and Chairman, ECSDA
John Trundle, CEO, Euroclear UK and Ireland
Hossein Fahimi, CEO and Board Member, Central Securities Depository of Iran
Joydeep Dutta, Executive Director, CDSL, India
Thomas Zeeb, Head of securities and exchanges, SIX Group AG, Switzerland
Paolo Caniccio, CTO, LSEG and CTO, Post-trade, Monte Titoli