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### Viewing cable 03FRANKFURT7038, Securities Exchanges, Clearing and Settlement:

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
03FRANKFURT7038 | 2003-08-26 13:01 | 2011-08-24 01:00 | UNCLASSIFIED | Consulate Frankfurt

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    This record is a partial extract of the original cable. The full text of the original cable is not available.

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    UNCLAS SECTION 01 OF 07 FRANKFURT 007038

    SIPDIS

    STATE FOR EUR PDAS RIES, EB BAY, EUR/AGS, AND EUR/ERA
    STATE PASS FEDERAL RESERVE BOARD
    STATE PASS NSC FOR CLOUD
    TREASURY FOR DAS SOBEL
    TREASURY ALSO FOR IMI HARLOW, AUSTIN
    PARIS ALSO FOR OECD
    TREASURY FOR OCC RUTLEDGE, MCMAHON

    E.O. 12958: N/A
    TAGS: ECON EFIN EUN
    SUBJECT: Securities Exchanges, Clearing and Settlement:
    Alliances Made and Broken; Poker or Chess?
    T-IA-F-03-0042

    This cable is sensitive but unclassified.  Not/not for
    Internet distribution.

      ¶1.     (SBU) Introduction:  The European world of clearing
         and settlement is not as boring as these dreary back-office
         chores imply.  Intense rivalry in the market place has
         become even more so - spreading beyond the continent, across
         the channel and across the Atlantic.    Deutsche Borse lost
         its bid for the London Stock Exchange three years ago and is
         ending its joint venture with the Chicago Board of Trade
         (CBOT) only to find the French-based Euronext team striking
         up alliances with the British and the CBOT.

      ¶2.     (SBU) Policy wonks have also been busy.  The European
         System of Central Banks (ESCB) and the Committee of European
         Securities Regulators (CESR) issued a consultation paper
         proposing standards for clearing and settlement. Among the
         interesting features of these proposals is the notion that
         clearing and settlement systems should be open to investment
         firms, but such firms from third countries could be denied
         access if their home market supervision was not considered
         "adequate."  The European Parliament adopted a report to hem
         in competition between custodians and clearing and
         settlement organizations.  In April the Giovannini Group
         presented a critical pathway for liberalization of Europe's
         clearing and settlement structure.  Lots of good ideas and
         intentions.

      ¶3.     (SBU) Enter the European Commission.  .  This fall
         the Commission is scheduled to release a second
         communication and, depending on reactions, might issue draft
         legislative proposals in December.  To date, Commission
         officials assert that they are content to let the market
         sort itself out before taking legislative action.  Observed
         one specialist, market pressures are generating solutions
         that the Commission could never legislate - so best leave
         the sector alone.
      ¶4.     (SBU) The rough and tumble world of clearing and
         settlement is more like poker than chess - bluffs, calls and
         raising the stakes.   The Commission, congenitally condemned
         to initiate but not enact legislation, must confine its game
         to chess.  End Summary.

      Setting the Scene: The Players and the Pot
      ------------------------------------------

      ¶5.     (SBU) The European players in the clearing and
         settlement game are very different from those in the United
         States.  Herein lie a strength and a weakness.  The strength
         is that the largest European players are part of an
         "exchange complex," that combines clearing and settlement
         activities with cash listing and trading (equities) (the so-
         called "vertical silo" approach) and derivatives trading.
         This allows revenues to be generated from different business
         lines generally resulting in resilience in the bottom line
         when one business line experiences weakness, e.g. lower
         equities trading as is the case at present.

      ¶6.     (SBU) The largest of these complexes in Europe are
         the Euronext group and Deutsche Borse.  Smaller, but
         similarly structured complexes, exist in Italy, Spain and
         Sweden. According to the MSMOW study published in June 2003,
         Deutsche Borse received 15% of its revenues from cash
         listing and trading, 23% from derivates trading and
         clearing, 43% from clearing and settlement, and 19% from
         information products and systems.  Euronext was similarly
         diversified: 26% from cash listing and trading, 34% from
         derivatives trading, 20% from clearing and settlement, and
         17% from information products.  Why is this interesting?
         One German expert explained that since many of its
         activities are similar, investing one time in software
         development can generate uses across its product line;
         increasing the load on those systems drives down marginal
         costs, increasing profitability.

      ¶7.     (SBU) Compare this diversity with that of the London
         Stock Exchange, New York Stock Exchange and Nasdaq, all with
         the bulk of their revenues coming from cash listing and
         trading (LSE 55%; NYSE, 74%, Nasdaq 71%). This "horizontal"
         approach allows investors to move from different systems for
         each aspect of securities execution, i.e. trading, clearing
         and settling.  As these exchanges are heavily dependent on
         one or two business lines, in present market conditions,
         lower listing and trading activities mean a lower total
         bottom line.

      ¶8.     (SBU) The weakness in Europe is that there is no one
         institution that clears and settles - implying heavy
         investments by the clearing and settlement industry and
         potential risks to investors.  In the US the Depository
         Trust Clearing Corporation clears and settles all equity
         securities in the US.  The Options Clearing Corporation does
         so for equity options.  Futures are somewhat different,
         being able to be cleared and settled in the system where
         they are traded.

      ¶9.     (SBU) What is the competition in Europe about?  The
         MSMOW study estimates that European exchange complexes took
         in revenues of euro 5.2 billion in 2002.  Profit margins
         were roughly 26%. Worth a good scuffle for a part of that
         pie.

      ¶10.  (SBU) Competition, however, should be viewed on a
         broader scale, that is, by considering the larger pot of
         where the investor "spends" money in capital markets
         transactions in Europe.  The MSMOW study estimates that
         total to be euro 40 billion.  Of that amount, exchanges and
         centralized depositories (institutions holding securities
         that enables securities transactions to be processed by book
         entries) took in euro 3.5 billion, custodians (entities that
         safe keep securities for customers) euro 4.5 billion, data
         system providers 2.5 billion, and a hefty euro 29.5 billion
         went to commissions and spreads.  Now that is a value chain
         worthy of an all out fight - exchanges want to cut out the
         middle man, custodians want to restrain exchanges, and
         middle men want to keep business in house (internalize
         transactions) or at least away from an order book open to
         all on an electronic exchange (hear the mouse click away
         their revenues?).

      Action:  Market Players
      -----------------------

      ¶11.    (SBU) Three years ago Deutsche Borse was going for
         the "golden ring."  A merger with the London Stock Exchange
         was rumored in the press and its "vertical" processing of
         trading, clearing and settlement (straight through
         processing) was envied, copied, and attacked as
         anticompetitive.  Deutsche Borse struck up a joint venture
         in the derivatives market with the CBOT in the United
         States. Life seemed beautiful; but it still was life.  The
         merger didn't happen, other exchange complexes have
         developed or are planning their own straight through
         processing systems, Commission competition authorities have
         opened an investigation, and the joint venture with the CBOT
         will be dissolved at the end of 2003.

      ¶12.    (SBU) Instead of Deutsche Borse domination, there
         seems to have been a shift to what one analyst terms the
         "ABW Strategy," or an "anybody but Werner strategy,"
         referring to the head of Deutsche Borse who has been
         referred to as "visionary," "opinionated," or "abrasive.".
         Highlights include:

           -    Merger of CrestCo with Euroclear (the settlement
                operations for the London Stock Exchange and Euronext,
                respectively);
           -    Proposed merger of the London Clearing House and
                Clearnet (the clearing operations for the LSE and Euronex
                respectively)
           -    The CBOT replacing its trading platform under license
                from Eurex, the Deutsche Borse derivatives operation, wit
                new contract with LIFFE Connect, designed and built by
                Euronext.liffe (over a year ago Euronext had purchased th
                London International Financial Futures Exchange)
           -    Nasdaq Europe has announced it will close down its
                exchange in Brussels at the beginning of 2004 and will cl
                Nasdaq Germany by the end of August.
      ¶13.    (SBU) Deutsche Borse, however, has managed a few
         surprises of its own.  DB has introduced a system to help
         brokers/dealers to internalize transactions (if they can't
         beat'em, join'em - or at least made some money out of the
         deal) and has announced that it will:

           -    seek to establish its own licensed exchange in the US
                to compete in the derivatives market;
           -    open its system to investors from other systems,
                forsaking the "silo approach" if others (read Euronext) d
                the same;
           -    implement an automated daytime bridge between
                Clearstream International (its settlement bank) and
                Euroclear Bank to allow same-day bridge transactions;
           -    attract Dutch brokers and dealers displeased with their
                Euronext association (fees went up this year for the firs
                time) (the LSE also seeking to pick up some of the busine
                from the disgruntled Dutch traders).
         Kinda leaves you breathless, waiting for the next move.

      Action: Policy Wonks
      --------------------

      ¶14.    (SBU) European policy officials also have ventured
         into the clearing and settlement terrain.

           -    The European Commission is collecting comments on its
                May 2002 Communication on clearing and settlement and is
                expected to publish another communication in September;
           -    The European Commission's November 2002 proposal for
                the revision of the Investment Services Directive would
                require member states to ensure investment firms from oth
                member states have access to central counter party and
                clearing and settlement systems in their territory and th
                stock exchanges allow participants to designate the syste
                for the settlement of transactions;
           -    European Parliament adopted a report in December 2002
                on clearing and settlement proposing that core settlement
                services should be managed as a user-owned service govern
                by rule of a non-profit entity and that central securitie
                depositories perform only settlement services and not "va
                added" services;
           -    European Commission competition authorities opened an
                infringement proceeding in March against Deutsche Borse's
                Clearstream Banking AG for refusing Euroclear Bank's acce
                to the settlement platform for more than two years and fo
                charging higher transaction prices to Euroclear than to
                other national central securities depositories outside
                Germany.
           -    Giovaninni Group's Second Report on Clearing and
                Settlement issued in April presented a program and schedu
                for removing barriers to clearing and settlement within t
                EU.
           -    ESCB/CESR's Consultative Report on Standards for
                Securities and Clearing Settlements in the European Union
                issued at the end of July proposed standards to sustain
                integration in the EU by having one single set of standar
                for a regulatory framework.
         The ESCB/CESR work deserves special mention.

      ESCB/CESR: Softer than a Law but Harder than a
      Recommendation
      --------------------------------------------- --

      ¶15.    (SBU) The ESCB/CESR Consultative Paper was prepared
         by a ESCB-CESR Working Group comprised of representatives of
         15 national banks of the EU and representatives of CESR.
         The Working Group has proposed 19 standards for clearing and
         settlement systems covering such topics as legal framework,
         settlement cycles, central counter parties, central
         securities depositories, delivery versus payment, risk
         controls, operational reliability, governance, access,
         transparency, and regulation, supervision and oversight, and
         risks in cross-system links.  Comments on the paper are due
         by October 31.  A public hearing will be held on October 2
         in Paris.

      ¶16.    (SBU) The paper reflects the Giovaninni Group's
         Second Report, the Group of Thirty's 20 recommendations on
         clearing and settlement systems released in January, and the
         Recommendations for Securities and Settlements Systems
         issued by the Committee on Payment and Settlement Systems
         (CPSS) and the Technical Committee of the International
         Organization of Securities Commissions (IOSCO) in November
         ¶2001.

      ¶17.    (SBU) The standards aim to provide a consistent basis
         for regulation, supervision and oversight of securities
         clearing and settlement systems, enhance the safety,
         soundness and efficiency of such systems, protect investors,
         promote competitive EU markets, and avoid systemic risks.

      ¶18.    (SBU) These standards are unique in several aspects.
         The first, is that they are "standards."  They are not
         recommendations to take or leave.  Neither are they
         mandatory since they would not have Community law status.
         Rather, the ECB/CESR Group believes that standards will be
         of a more binding nature than recommendations and that
         regulators will implement them on a "best-endeavor" basis.
         This has worked for the ECB in its standards for securities
         settlement systems in credit operations in the ESCB.
         However, the ESCB/CESR proposed standards on clearing and
         settlement go well beyond ESCB activities.

      ¶19.    (SBU) A second interesting feature is the proposal to
         apply many of the standards to major custodians, including
         custodian banks, some of which clear and settle in-house
         rather than going to local clearing and settlement systems.
         Some of these banks have significant operations and would be
         considered "systemically important custodians."  The
         ECB/CESR has proposed four criteria to identify such
         institutions: (1) magnitude of activities (e.g. 5% of EU
         market or 25% of a domestic market); (2) number of systems;
         (3) nature and number of clients; and (4) the possibility of
         being replaced in the event of failure.  Banks that have a
         large presence in the custodian business in Europe include
         BNP Paribas and Citigroup.

      ¶20.    (SBU) Finally, the standards go well beyond the
         competence of national banks and securities supervisors to
         cover tax, accounting and other legal issues.  To ensure
         consistent implementation and compliance, the Group notes
         the importance of cooperation and information exchange among
         competent authorities.  To ensure such cooperation is done
         in a regular and structured manner, the Group volunteers to
         take on a monitoring role to organize and co-ordinate
         assessments of implementation.

      Some Observations: Connecting the Dots
      --------------------------------------

      ¶21.    (SBU) Actions by market participants and policy wonks
         have been, to some degree, symbiotic.  Here are some
         examples.

                 (a)  Cross-Border Activities: Increased cross-border
                    activities in clearing and settlement presaged by the
                    Crestco and Euroclear merger or anticipated merger be
                    LCH and Clearnet suggests that standardization of rul
                    not only needed to integrate the EU market, but to en
                    that integration at the company level works at the
                    operations level, bringing promised efficiencies to
                    investors while protecting them from increased risks
                    cross-border transactions.  Thus, the ESCB/CESR stand
                    have some urgency from a supervisory point of view.
                    is some time, however.  According to a London-based e
                    not much has changed in the actual operations of Cres
                    Euroclear, for example, so the continental and UK sys
                    still run separately.

                 (b)  Access:  Deutsche Borse's willingness to open its
                    system to investors that trade on other platforms ref
                    the pressure from the ISD proposal, the Commission's
                    competition policy investigation, and, to some extent
                    ESCB/CESR standard on access.  Access is not to be ab
                    The ESCB/CESR standard would require objective and pu
                    disclosed criteria that permit "fair and open access"
                    still being able to control risk.  Access could be de
                    a clearing and settlement system if it posed risks th
                    could not be effectively controlled.  What about acce
                    investment firms from other countries?  Access could
                    denied, according to ESCB/CESR if there is a lack of
                    "adequate supervision" and doubts about the enforceab
                    of the legal powers of the service provider in the ho
                    country.
                 (c)  Governance:  The ESCB/CESR standard on governance c
                    for arrangements designed to fulfill public interest
                    requirements and to promote the objectives of owners
                    users.  This reflects, in part, the views in the Euro
                    Parliament report proposing to require settlement sys
                    be managed as a user-owned non-profit organization.
                    European Parliament's view is also supported by a gro
                    called "Fair and Clear," composed of large custodian
                    including such big players as BNP Paribas and Citigro

                 (d)  Value Added Services:  The ESCB/CESR proposed stand
                    on risk controls implies that clearing and settlement
                    systems could extend credits, thus competing with ban
                    The ESCB/CESR proposed standard states that operators
                    systemically important systems should not run credit
                    but where they extend credit they should fully collat
                    such exposures.  Should such systems extend credits t
                    support the orderly functioning of the market, they c
                    offer uncollateralized credit but only to institution
                    high credit standing.  The European Parliament report
                    proposed that settlement systems not be permitted to
                    such credits, a view shared by "Fair and Clear."  Her
                    concerns coincide: concerns about risks to settlement
                    systems from credit lending and concerns about compet
                    to custodian banks from settlement systems offering c
                    services to their clients.  A German expert points ou
                    is a false issue, in that settlement systems are lice
                    banks anyway.  Moreover, investment firms enjoy the
                    competition afforded by several players in the
                    settlement/custodian business, keeping costs lower an
                    service better than otherwise might be the case.

      Where will Competition Drive the Market?
      ----------------------------------------

      ¶22.    (SBU) Allowing the market to find "solutions" to
         efficient trading, clearing and settlement systems sounds
         nice.  But what does it mean?  Where will the market take
         the trading and post-trading infrastructure?  Not being
         experts ourselves, we listen to what our betters have to
         say.

      ¶23.    (SBU) The MSMOW study presents there views on how
         several key areas may develop:

                     (1)  Silo versus horizontal approach:  The vertical
                        "silo" structure of exchange complexes that offer
                        clearing and settling and straight through proces
                        been criticized as anti-competitive. A horizontal
                        allows investors access to the trading, or cleari
                        settling systems.  The study suggests that this d
                        burn out as market participants and regulators lo
                        expensive costs and adopt pragmatic solutions.  V
                        structures will become "interoperable" over time
                        exchange complexes will be able to fulfill their
                        providing market infrastructure and making a prof
                        provided they continue to deliver lower all-in tr
                        costs.  So far, this seems to be the trend.

                     (2)  Separation of Depository from Banking Services:
                        Settlement systems will have a tough time competi
                        banks by offering value added services, in the MS
                        view.  Settlement banks, while banks, don't offer
                        range of banking services.  When the market picks
                        study expect exchanges will stick to their core b

                     (3)  Centralized clearing systems:  The study "stron
                        believes" that centralized clearing will receive
                        from Basle II.  Central counter party mechanisms
                        manage risk and reduce systemic risks.  Banks wil
                        such mechanisms to reduce risks and corresponding
                        charges.  The ESCB/CESR standard on central count
                        goes in the same direction.  It states that where
                        benefits of using a central counter party outweig
                        costs, market participants should either use the
                        an existing one or establish one of their own.

                     (4)  Internalization versus on Exchange Trading:  Th
                        suggests that continental exchanges that use elec
                        trading and a central order book for equity tradi
                        continue to capture a large market share - betwee
                        trading.  In the UK, where two-thirds of trades a
                        "facilitated" rather than placed directly on an o
                        book, the study expects little change.  In its op
                        customers and the size of orders will dictate the
                        exchange trading and internalization in each mark
                        provided regulation doesn't favor one or the othe

      Policy: The Wild Card
      ---------------------

      ¶24.    (SBU) The dynamics of the market place are like a
         game of poker: increasing investment stakes in high tech
         infrastructure, improving the hand by striking up more
         alliances or products, and bluffing about the strategy for
         improved business.  Needs a strong constitution.  But the
         winner's take could be considerable.

      ¶25.    (SBU) Enter the European Commission.  To date, the
         Commission officials assert that they have been content in
         allowing market forces to drive changes in the clearing and
         settlement market.  Moreover, others are trying to do some
         spadework to prepare the terrain.  The Giovannini Report and
         now the ESCB/CESR standards point to the need for member
         states to take action to bring down legal, regulatory and
         tax barriers.  The ESCB/CESR use of "standards" puts more
         pressure on supervisors to take action.  This is still short
         of legislation.  Nonetheless, it could be a not so subtle
         threat that if the market doesn't move itself, momentum
         could build for some type of legislative action.
         Parliament's report favors legislation, as does the "Fair
         and Clear" group and others, such as the London Stock
         Exchange, that believe that clearing or clearing and
         settlement, should be regulated as a public utility.

      ¶26.    (SBU) The role for specific legislation is not clear.
         With so many pieces of legislation pending under the
         Financial Services Action Plan (FSAP) that will have a
         significant impact on the financial market place
         (implementation of the prospectuses, market abuse and
         financial conglomerates directives and the accounting
         regulation; potential passage of the transparency and
         investment services directives) the Commission will be
         forgiven if not blessed, for letting these and related
         market-driven changes in clearing and settlement systems run
         their course.  Implementing enacted FSAP legislation as well
         as the ESCB/CESR standards should be a priority before
         assessing what, if anything needs to be done through
         Community law.

      ¶27.    (SBU) Such an approach is not at all certain.  The
         MSMOW study regards regulation as a "wildcard."  It observes
         that "one should never underestimate the unpredictable
         nature of lawmaking in Brussels or nationally and potential
         unintended consequences of legislation."  Amen to that.
         While the market is playing poker, the Commission must and
         should be thinking chess.

      ¶28.    (SBU) The report was coordinated with Embassies
         Berlin and London and USEU Brussels.

    (U)  POC: James Wallar, Treasury Representative, e-mail
         wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-
         (69)-7535-2238.

    Bodde

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