The processing infrastructure of securities will face major changes during the coming years due to regulatory, technology and customer requirement developments. The industry is likely to move to the next level of processing technology and considerably increased efficiency. The technology will shift into immediate real-time trading and delivery in a truly global 24/7 network environment, which is completely integrated within a fully automated straight-through processing (STP) design. The industry market set-up can:
- Consolidate into global oligopolies/monopolies.
- Move towards a flat and open network of interoperable competing service providers.
Current processing patterns are inherited from the paper and batch age, while achieving the benefits of modern technology and moving to next generation systems will require complete process restructuring in line with what has been done in other data processing-based industries. Electronic efficiency requires clear addresses and common international identifiers, for example for custody accounts (ICAN) and taxation identifiers (ITID).
The move to the next generation infrastructure would result in improved services at a lower cost level to end-users, issuers and investors. The current infrastructure operates far below the currently achievable level of efficiency. A high proportion of the current legacy service providers will find their current operations, margins and investments threatened by modern developments, which is likely to induce a strong resistance to change.
The regulators can affect the new market structures (consolidation or openness), the speed towards the new generation (acceleration or deceleration), the efficiency of the process of change and the extent of benefits reaching the end-users. An efficient regulatory support for reaching the next generation infrastructure will require a common vision of next generation design to be implemented via a common regulatory policy. It will also require firm support for the change process itself. A prolonged use of the outdated technology and market and regulatory set-up will postpone the benefits and maintain current risk levels.
Current Situation: Unsatisfactory
Most of the EU authorities in this field seem to share the views that the current infrastructural set-up:
- Is too expensive and inefficient for end-users (issuers and investors).
- Has a lack of competition in the market due, for example, to monopolies in the form of non-interoperable siloed structures and the infrastructure seems to be consolidating further.
- Means cross-border payments processing is inefficient, hindering the emergence of a truly common internal market.
- Is outdated due to its legacy overload from the paper and batch era, whereas technology developments have been rapid in other industries.
- Systems currently operating with both higher operative and stability risks than necessary.
However, improving the situation has proven to be a major undertaking. There are many interdependencies and legacy business processes that make it difficult to employ a step-by-step approach, as most steps would require other simultaneous steps. There is a need for deeper analysis on what kind of securities infrastructure will benefit the consumer, issuers and investors, before starting to change the infrastructures via regulatory interventions.
Major Development Trends
There are currently several ‘mega-trends’ affecting the capital markets and society in general:
- Global network openness, with freely moving capital, data, labour, taxpayers and processing resources. The idea of a permanent home country/location are disappearing, to be replaced by a ‘suitable temporary location’ for given activities based on individual choices. A growing volume of activities are conducted just somewhere in the network, at a physically and geographically difficult-to-locate web-address.
- Borderless business consolidation with multinational business structures, which are difficult to oversee, supervise and control by individual local authorities regarding overall risks and abuse of market powers. Most multinational entities are just too big for individual governments and their geographically limited mandates.
- Increasing stability concerns due growing institutional dependencies, highly critical parts in operational networks/hierarchies and risk containing conventions, such as short-selling.
- Integrated immediate information and communication technology providing global end-to-end STP in real time. All necessary data is available in the network and there is no practical limitation on data volumes. The most efficient processing convention is immediate transaction-based processing.
- Global network externalities driving towards global monopolies/oligopolies or open competitive service provision among competing network-based service providers.
- Emergence and growth of flat service provision structures with end-customers and original service providers trading directly with each other, i.e. abolition of middle men and expensive service provider hierarchies.
- Defensive actions of legacy systems to preserve their privileges, as long the old structures remain, current high profit margins can be maintained without new investment needs. It is very difficult for new entrants to gain volume in monopoly or near-monopoly markets.
The main customers in the securities industry, issuers and investors, would gain from developments towards increased efficiency and competition, particularly when authorities ensure sufficient stability. Authorities need to review their policies and actions in order to support increased efficiency and sufficient stability in this rapidly changing environment.
Modern infrastructures are characterised by complete automation, organisational ‘flatness’ (reduction of multi-level organisational service hierarchies into direct end-user services) and functionally-focused efficient entities. The processing in modern infrastructures is split into base functions, which are combined into transaction-based service processes operating seamlessly from end-to-end in a common network surrounding. STP operates from sending to receiving customer automatically and immediately, with each participant in the chain carrying out the assigned functions. In order to achieve efficient leanness, the current processing patterns need to be restructured using modern ICT solutions.
Source: Bank of Finland
Efficiency and leanness require simplification and restructuring of the current infrastructure based on the essential processes in a real-time environment. Tiered and hierarchical structures need to be replaced by equal and interoperable entities providing the required base functions. Each group of operative entities are assigned specific tasks to be performed according to common standards. Figure 1 contains the most obvious structure for a future flat and lean model, in which competitive central securities depositories (CSDs) provide issuer services, and custodians in competition provide investor services and automated trading and settlement platforms facilitate trading, including immediate settlement of successful trades. This hierarchical simplicity will support efficiency and competition. The functions of each entity is described in more detail below.
CSDs would, in a lean set-up, provide purely the basic issuing functions, increasing and decreasing the amount of issued securities on the market, distributing interest and dividends, as well as providing corporate action services based on issuers’ requests. The CSD focus is on issuing services including keeping records of where the issued securities are kept in custody. This will ensuring that the overall balance of each security in custody is the same as the total issued (i.e. the sum of all custodians’ omnibus accounts at the CSD continuously equals total issued securities). In a flat set-up, CSDs would operate in an interoperable network, facilitating the portability of issued securities. Issuers could easily move their business to another competing CSD. This requires that all CSDs operate using standardised links in all directions, towards issuers and custodians supported by an ISIN portability mechanism/register. When an issuer moves to another CSD, the sending (old) CSD will need to send its custodian link and omnibus account information to the receiving (new) CSD where the issuer services have moved.
ISIN portability mechanism/register keeps a record of all issued securities and the current CSD in charge of the specific securities (International Securities Identification Number (ISIN)). This is necessary in a CSD network with portable securities. It needs to be operationally efficient so that it can be used on a daily basis. This register could be operated within a specific institutional entity, but it could also be a virtual function within the CSD network.
In a lean environment customers’ security book-entry accounts would be kept by custodians operating in a non-hierarchical network. The main task of custodians would be to keep records of the ownership of securities by its customers. In a flat model there would be no sub-custodians as all custodians would be on the same level and would have direct links to all CSDs. As each CSD would operate strictly standardised custodian links, maintaining parallel CSD-links would just be copying single link information to different CSD addresses. If an issuer changes CSD, the corresponding custodian link needs to move automatically to the new CSD based on the information received from the portability mechanism/register. In the same way, if an investor changes custodian, the sending (old) custodian needs to transfer the necessary security account information to the receiving (new) custodian.
When the investor transfers several types of securities these transactions could involve several CSDs, where the custodian omnibus accounts need to be updated. Each custodian should be in a position to provide custody services for all ISIN codes in the system using direct links. Keeping investors’ book-entry accounts in this kind of structure resembles keeping bank customers’ currency accounts. From technical point of view, each ISIN-code just represents a different currency. In order to promote competition and portability, custodians would need to use standardised customer interfaces for the core custody services (investors would have difficulty changing custodian if they need to update their basic interfaces every time by adjusting to different custodians’ technical languages).
Settling trading platforms
The largest efficiency gain that modern technology and a flat infrastructure will bring is the possibility for immediate settlement on highly efficient trading platforms. Trading will move to automated trading platforms, often called multilateral trading facilities (MTFs), electronic communication networks (ECNs) or alternative trading systems (ATS), which are just geared to matching trading transactions in a continuous 24/7 environment. Trading will, for all book-entry securities, become a computer-to-computer STP service, the growth of which we have already witnessed for some time in the form of algorithmic trading. However, the current platforms are just matching trade transactions and have left settlement to be done sometime later after the actual trade. With the available technology, it would already now be more efficient to settle the trade immediately as part of the trading process.
In a real-time environment, it is in fact more costly to postpone settlement. Investors would receive the results of the trade immediately after the trade match, which require them to present the funds/securities immediately before the trade. Immediately after any trade, investors get title to the asset and could resell immediately. The settling trading platforms will need to block the traded assets for the split second of trade to initiate the delivery versus payment (DVP) settlement dialogue, between the custodians involved. End-to-end STP will require the use of common standardised transactions between all trading platforms, custodians and CSDs.
Listing and rating agencies
Securities listings have been important parts of the functions of exchanges. However, they are not an essential part of core securities processing and trading. The rating or listing status has no impact on the technical processing of securities. The settling trading platforms will process any book-entry ISIN code exactly the same way. Listing and rating agencies provide information services to the investors completely outside the scope of asset transactions. In a standardised environment, trading platforms could specialise in trade with a given set of ISINs or provide general services for any ISIN including the trade price information. The automated exchanges just process transactions. These information agencies perform an important task for the investors by analysing the issued assets according to given requirements and assuring in that way a given quality of the assets, but they have will have no processing functions.
Next week, read part 2 of the article, which will look at regulatory, tax and practical implementation issues affecting securities processing.
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