From: Rohit Khare (Rohit@KnowNow.com)
Date: Sun Jul 02 2000 - 14:35:24 PDT
At 3:22 PM -0400 7/2/00, MSDW spake:
>I mention the Napster model because it is not that different from an online
>buttonwood tree market place: the pool of liquidity, for music tracks, is
>the global pool of everyone who is connected to the market and once a
>selection has been made, the transaction is near-instantaneous. Add in a
>payment system and, hey presto, we could have a stock market with
>person-to-person transactions - investors dealing directly with other
>investors using some simple price discovery/auction software in the middle.
OPSummit 2000 - 28 June 2000
How will the evolving pan-European settlement systems impact the efficiency
and effectiveness of Operations?
Executive Director, European Equity Infrastructure,
Morgan Stanley Dean Witter
We have heard three excellent proposals from three excellent speakers, each
of whom is a true enthusiast for their organisation. It is easy to come
away from conferences like this thinking that nirvana is just around the
corner, but then back at the office the real world complexity brings you
back to earth. Progress in reducing our risk exposure and the associated
costs is still very slow but we are starting now to see some real progress.
The accelerating pace of change in equity markets, the enhanced
transparency, the lower barriers to entry, and increased competition are
fast changing the cost structure of this business.
This change in the business model is forcing market participants like us to
look very closely at our operational infrastructure, both external and
internal. And there is a growing appetite on the part of the market for
simple workable solutions that are quick to introduce. There is much less
enthusiasm for grand, expensive, industry wide, supplier led projects that
just might deliver savings sometime in some distant future. As a result of
that impatience, market participants are much more engaged in the debate
about the future development of clearing and settlement in Europe. The
establishment of the European Securities Forum is one manifestation of this
I will expand on each of these points, with examples. First, let me sketch
out the ground I'd like to cover.
I'll start by taking a step back from the day to day complexity of
settlement and try to take a long term view of how we got where we are and
where I think we are going.
Next I will try to draw some lessons from that long term view and apply
those lessons to some of the technology initiatives we are seeing today.
Finally I will look at the current debate around European clearing and
settlement and set out what MSDW sees as its agenda.
A long term view
One of the most striking things about having responsibility for clearing
and settlement of European Equities is the lack of standardisation across
what is supposed to be a single market. This diversity is very expensive
In fact, this would be a good point to state that as a bank, we have no
intrinsic interest in clearing and settlement. We would like to get rid of
it. I don't mean subcontract it. I mean that I would like there to be no
settlement risk and no settlement cost. And I believe we can get to
minimal settlement risk and cost, though it will take a little bit of time
to get there.
I often lose sight of this, but I think that an objective of something
approaching zero settlement risk and cost is very important and that we
shouldn't forget it in the debate around remediation our existing models.
Under the buttonwood tree
I think we can draw important lessons from the past so I want to go back in
time to the early stock markets. It doesn't really matter which one, but
Wall Street is as good as any. Towards the end of the 18th century,
investors would sit under the buttonwood tree on Wall Street and gossip
about the market. When it came to trading, when a price was agreed,
trading, clearing and settlement all took place in one seamless, costless
transaction. I would hand you a bearer certificate and you would hand me
cash. And although fraud was possible, reputation was at stake and
participants knew that if they cheated, then their reputation would be
damned and they wouldn't meet under the tree again.
That is what settlement should be - real time, person-to-person and largely
free of transaction costs.
What went wrong? It all began to change when Samuel Morse perfected the
telegraph in the mid-nineteenth century. Investors became enthusiastic
adopters of the new technology, the Victorian internet, and used it to
trade from afar on the most liquid market, Wall Street. Suddenly those
quaint cheap instant and secure bearer transactions were open to delay,
clearing and settlement risk, repudiation, dispute and simple fraud. The
market's solution was to create an independent third party. So we
established a rule-based clearing house and a legal system to combat fraud.
And we saw this system replicated around the world, but each market
developing its own legal and regulatory system.
Internet on everything
Let's return to the present day. It should be obvious to everyone by now
that the internet is a very significant technological innovation. It is
one of only many networking protocols and until very recently many
organisations believed that it would be possible for a number of networking
protocols to survive in parallel. I doubt if that is still the case. The
internet protocol, or IP, has emerged as the dominant infrastructure of our
age. Because of that, because of its scale, because of the pace of
development and improvement, there really is no point in anyone trying to
direct any investment into any proprietary network unless it is for some
really specialist niche application. For the global financial markets, the
internet is where it is at.
So in looking towards a future for clearing and settlement, if anything is
being proposed that is not ultimately going to run over the internet then I
can say now, it is going to be unnecessarily expensive. As the slogan of
Internet Society of the US says, IP, or internet protocol, on EVERYTHING.
A second technological innovation is very significant for financial
markets. This is a branch of mathematics called cryptography or, in this
case, financial cryptography. I don't need to explain it in detail but
what we can now do is encrypt information in such a way that it can only be
read or decrypted by the person to whom it was addressed, over the internet.
There are quite a few companies out there proposing ways of using these
techniques to handle real cash payments over the internet. There are also
well documented techniques or protocols for exchanging cryptographic tokens
or secure messages over the net in real time, or at least in milliseconds.
I can check the validity of your token and you can check mine and we can
affect a simultaneous transfer of value over the net.
I only mention this because it means that we now have the technical means
to go back to the style of trading under the buttonwood tree ie
person-to-person cash for 'certificate' transactions in real time without
the need for a clearing house, without the need for a central counterparty,
without the risk of repudiation or fraud and all achievable in a seamless,
frictionless and costless way.
Of course, this is a simplification. This model makes no mention of a
mechanism for maintaining a register, which would be a requirement under
company law, and we would need some way of tracking holdings for corporate
event purposes. We also heard mention this morning of the procedures and
potential hierarchies required around repudiation, authentication and
fraud. But these barriers are being tackled now.
But it is hard to envisage the new world against the world we sit in now, I
hear you say. I'd like, therefore, to give you an example of where
something similar has already happened in a non-financial market. It is a
object lesson in how a business model can be turned on its head.
I don't know how many of you are familiar with the MP3 music format: it is
used for sending CD quality music files over the internet, storing and
playing them on your PC or on a portable MP3 player, like a Walkman. In
January this year a Berkeley Ca. student called Shawn Fanning launched a
company called Napster that allowed anyone logging into the Napster serve
to share their MP3 files with each other: I could look at and download your
MP3 files, you could download mine. Napster claims that it does not
condone any breach of copyright. Because it hold no files on its servers,
and only connects people and enables them to swap files, it can claim it is
not in copyright breach itself.
Not surprising, Napster has proved popular. It now has more than 20 million
registered users and has spawned more than a dozen competitors.
I am not in support of copyright theft. I cite Napster only as an example
of how the business model of the music industry has been overturned in a
matter of months by an unstoppable take-up of a simple internet application
devised by a 19-year old student. Interestingly it does look as though the
music industry might be able to use Napster to generate new music sales.
I mention the Napster model because it is not that different from an online
buttonwood tree market place: the pool of liquidity, for music tracks, is
the global pool of everyone who is connected to the market and once a
selection has been made, the transaction is near-instantaneous. Add in a
payment system and, hey presto, we could have a stock market with
person-to-person transactions - investors dealing directly with other
investors using some simple price discovery/auction software in the middle.
That sounds a lot simpler, a lot less costly and a lot less risky that
anything we have today.
Conclusion to part 1
So my conclusion to Part 1, is that over the long term technology will
allow us to move back to real time transactions that are person-to-person
and which involve us in minimal settlement risk.
But as I can't predict when that will happen, I'd like to pull my comments
back towards the real world in which we operate today and try to sketch a
The future of settlement
It should be clear from my earlier comments that from our bank's point of
view, the ideal settlement system is one that is indistinguishable from
trading - trading clearing and settlement as one single frictionless
operation. So how do we get there?
There is currently a big debate in progress about the future of settlement.
The debate is very involved but some questions stand out.
1) Does the market want consolidation or interconnectivity?
2) If we want further consolidation - how far do we want to go? Do we want
a monopoly or competitive provision?
3) Should these providers operate as utilities (and the DTC/NSCC is held up
by Europeans as a paragon of cheapness) or should there commercial
4) Is there a hybrid solution which says that core settlement should be a
utility with commercial provision around 'value added' services such as
As of now, we are a members of a number of exchanges (either as direct or
remote members) and five clearing houses. We work through 24 central
depositories and in some cases have multiple memberships across different
MSDW entities. We operate a network of 24 agents in Europe. These
memberships and the infrastructure required to support them, tie up a
significant amount of capital.
Our stance on the current debate is driven by three key objectives :
… Reliability, integrity and scalability
In Europe, we have had a number of failures in the clearing and settlements
process over the last couple of years, where an agent, CSD or clearing
system has had a major outage. We have seen huge and persistent spikes in
volume over the last four years and expect this to continue. We need a
zero fault, 24x7 environment. In the words of Jack Welch, 99.99% is not
… A reduction in running and investment costs
Average settlement costs in Europe are still very high particularly
compared with the US. The figures being bandied about compare operating
costs of USD 450 million in the US with USD 1.2 billion in Europe and many
put that number higher, especially if you take participants' internal
operating costs into account. Ways of reducing cost would include:
- consolidation amongst ICSD's and CSD's - why pay for duplicate technology
and overhead? We calculate that competing investments by established
agencies to provide scalable capability for the whole market in Europe,
could involve duplicative spend of some $500 million or more cumulatively
over the next 2-3 years.
- A single central counterparty and netting - if we cannot lower agent
costs then we need to reduce the number of trades flowing into the system
- Consolidation across product lines - we should be able to treat equities,
listed derivatives and fixed income securities in the same way.
… Risk reduction
The fractured clearing and settlement process, and the large number of
intermediaries involved in the process, leads to unnecessary levels of
operational risk. So fewer participants and a more standard process would
have a major impact on risk.
How to achieve those objectives? What if we just stepped back and allowed
market forces to operate? One could imagine the following:
- More ECN's and pan Europeans exchange entrants join the fray. We already
have Jiway and Virt-X, we will certainly see competition from other ECN's .
- These new exchanges nominate a single provider or settle internally.
Although both Virt-X and Jiway have set settlement cycles currently in line
with the market, it is not hard to imagine an ECN or exchange offering real
time settlement as a source of competitive advantage. Remember that both
these models assume netting.
- As business migrates to these new exchanges as a result of their
convenience and superior pricing (one assumes), flow starts to shift from
regional to pan european exchanges. And as more trades are netted or
crossed within the pan-european exchange, the number of trades flowing to
the regional CSD starts to decline.
- As local clearing houses see volumes decrease, it makes economic sense
for them to merge or interconnect. We would start to see greater
competition for settlement services and as a consequence, simpler and
Although this scenario is imaginable, I can see it taking some years to
reach fruition. And as I said at the beginning, market participants are
getting more impatient.
We have seen some progress:
… We are starting to see some consolidation around the
Euroclear/Sicovam/Euronext linkages. There is debate about further linkages
involving Clearstream and CREST.
… We are seeing some progress towards a central counterparty and netting
for Europe in the form of the Clearnet/LCH joint venture.
… We have collaborative agreements between CSD's to clear each others'
securities eg CREST and SIS, CREST and Euroclear.
… We have seen cost reduction announcements by CREST, Clearstream and
… We are seeing some very low fees for retail investors. Jiway has
announced a trading and settlement fee of Eur 7.
… We are seeing steady convergence of settlement cycles. By February next
year, the bulk of European markets will have a settlement cycle of T+3.
The issue for the market is how long will it take and what must we do in
the interim to minimise our risk and reduce costs? Let's go back to the
four questions I posed at the beginning of this section around
consolidation & co-operation, utilities v commercial offerings.
- We want to see greater consolidation amongst the ICSD's and CSD's on the
grounds that as shareholders we want to reduce cost duplication and
overhead wherever we can. For that reason also, we want to see
consolidating CSD's adopt best of breed from existing technology rather
than build an equity clearing and settlement system from scratch.
- But if CSD's can agree cheaper and efficient connectivity agreements with
other CSD's then that too is worth encouraging given that consolidation to
a single entity may take some considerable time. Interconnectivity is also
critical to our environment as it stands today. A large part of settlement
activity today takes place in the local market so we want ICSD/CSD
realignments to be as cheap as possible.
- We are actively encouraging moves to establish a single central
counterparty. If existing bodies cannot work towards consolidation for
themselves then an alternative approach would be for a number of major
firms to create a NEWCO which would design its own business model and then
invite service providers to tender for its business.
- If we do end up with a single central counterparty then we would want it
to be a utility owned by the industry. My personal view is that competition
is always better for the market and the debate we are having currently
around consolidation v interconnectivity is partially driven by the fact
that we are shareholders in ICSD's and partly by the fact that as
broker-dealers we settle according to client preference. So although in
theory we could stand back from the debate in Europe and choose the lowest
cost or most efficient provider, in practice the ICSD cost base is of great
interest to us. Longer term one can envisage a world where we do not have
to be owners - I do not need to own Morgan Stanley's caterers in order to
guarantee the cost and quality of our restaurant. But while we are still in
a world of monopoly CSD provision, we need ownership to prevent monopoly
capture. I think in the case of netting, there would also be arguments in
favour of a single utility to maximise its benefits. I don't think the same
arguments necessarily apply in the case of settlement.
I think it is also worth reminding ourselves that clearing and settlement
is only a small part of the larger transaction process. We still have
enormous inefficiencies in the pre settlement process. Despite the
introduction of FIX, orders are still often given by telephone; allocations
are instructed via fax; confirmations need to be sent by fax or telex;
pre-settlement matching is achieved through endless phone calls between
counterparties. The consolidation we have just been discussing won't make
much impact on these costs (though netting certainly will). Initiatives
such as GSTPA and the Thompson/DTCC move contribute to greater market
efficiency but their penetration of the market is still comparatively low
and it has taken an awful long time to get to where we are now.
But this will clearly change eventually as pressure from retail clients
force intermediaries to address their costs. If I have the choice between
an all in Eur 7 per trade and £25.00 per trade, it is easy to see which
broker I will use.
One of the major barriers to a more consolidated or connected market is the
regulatory framework. Despite all the EU harmonisation directives there is
no single market. We have a complex web of regulations in every European
country covering not just financial services but also more general consumer
Some of these regulations may well provide a degree of consumer protection
but they can often also act as a very significant barrier to new entrants
into the financial service marketplace.
As I argued earlier, we created a regulatory regime, way back, because it
was good for business. Allowing distant investors access to the most
liquid markets conferred advantages that made it financially worthwhile to
pay the cost of regulation.
Turning back the legal and regulatory clock is always hard, if not
impossible. I think the way to make significant change in this area is for
us to agree common standards for a new regulatory model to meet the new
requirements of a pan-European and indeed global market. As our chairman
Sir David Walker pointed out to another conference last week, areas where
we could look useful for harmonisation would include listing requirements,
trade and transaction reporting and ongoing issuer obligations. We need
to simplify and standardise the implementation of regulation, working
within the diverse range of local insolvency and company law, which may
take many years to harmonise.
Part III Conclusions
I started off by painting a future that, on the surface, is very simple.
Investors, whether they are retail or institutional, need quick,
transparent and cheap trades. The endgame has to be real time gross
I then painted the more complex and constrained world we live in today.
But it is very clear from the experience in the US that the status quo
cannot be protected and that players will need to adapt fast of their own
accord or they will be forced to do so. The market will sort this out and
business will migrate, over the net, to the more efficient markets. And as
practitioners we will be working through the ESF, and other forums, to
speed up that process.
This archive was generated by hypermail 2b29 : Sun Jul 02 2000 - 14:39:15 PDT