Bringing it all back home

By netting more of their transactions internally, the world’s largest banks are transforming customer relationships and process capability into competitiveness and profits. They may take business from exchanges and clearers and it is possible that they are embarking on a course that could reshape Europe’s securities trading infrastructure.

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Giulio Di Cerbo

When recently asked what the biggest challenge to his business was, a senior executive in the custody division of a newly merged European bank delivered an unexpected answer: Euroclear.
He could have cited one of a handful of competitors providing global securities services or even a regional upstart at work in local markets. But Euroclear is an international central securities depository (ICSD), an entity enabling broker and dealers to handle trades for clients outside the country where they are domiciled. That speaks volumes about the changing role of larger banks in the continental securities trading landscape.
Merger-driven titans such as Citigroup and Deutsche Bank are internalizing transactions flows, netting off the natural matches and conducting and settling transactions on their own. They are using straight-through processing technology that allows them to take in and execute orders and to book the trades directly into client accounts. They are acting like exchanges and clearing houses, as well as broker dealers.
"The focus is on consolidation, at the trade level, at clearing level, at settlement level, at custody level," says Jos Schmitt, a partner at Capco, a global financial services and technology solutions provider. "Unless it's mandated, there will be no need any more to go to central organizations, so the larger banks can accomplish everything internally."

A bonus is that the savings in both exchange and settlement fees are resulting in lower per-unit costs, offering greater pricing flexibility.
Banks that have taken the lead are already capable of internalizing about a third of their transaction volumes. Connectivity and consolidation among market participants seeking to control more of the customer transaction chain should push levels still higher.
"We're new and proceeding cautiously, so we may be slightly behind the curve," says Chris Hipkins, the Paris-based global head of cash equity trading at BNP Paribas, created by a merger 16 months ago. "The merger has given us strong clearing and custody capability. Now that we have that link in the chain, we are making every effort to control and internalize flows."
Others with significant potential to internalize include JPMorgan Chase. And there are growing links between Merrill Lynch and HSBC. Banks that can combine broker/dealer and capital markets functions with custody and settlement remain few in number. Even so internalization will have an impact far beyond the organizations directly implementing it.
Falling prices from low-cost/high-volume producers should squeeze middle-level players out of the businesses. As a result the transactions that pass through market infrastructure mechanisms such as exchanges and clearing houses may decline in both number and value.
The benefits of huge market share
"The future will see custodian banks - which stand between the depositories and the central counterparties - moving up the chain and providing multi-country horizontal integration on settlements," remarks Giulio Di Cerbo, head of global sales at Citibank's Worldwide Securities Services division. "Netting or internalization today takes place at many levels of the transaction chain going from trading to settlements. Internalization means that you effectively control both sides of the trade and we are able to pass on the economic benefit to customers."







Chris Hipkins

Indeed, some market participants foresee that as larger banks come to market with fewer transactions, the economic viability of more narrowly focused mechanisms in Europe's fragmented and costly to use market infrastructure will be threatened. Sceptics say however that the levels of internalization, while significant, are not yet enough to enable banks to compete seriously with existing providers. In addition, the regulatory implications must also be addressed - especially in areas such as the delivery of best execution by a single securities trading infrastructure.
"It is certainly a trend in the market and one that banks have been thinking about for a long time," says Martine Dinne, executive director and head of the commercial division at Euroclear in Brussels. "But they still have a lot of work to do before they can match the economies of scale we possess and that enable us to keep basic costs as low as they are."
That the world's largest banks are seeking to leverage the portions of the transaction chain that they control is a natural by-product of the mergers and acquisitions that created them. A handful of large banks now possess the broker/dealer and investment banking functions that enable them to source trade flows, as well as the custody and accounts management capabilities necessary for the safekeeping of securities. And they do so across a range of markets.
By linking their varied business activities, these banks are producing the kind of one-stop shops that can process a transaction from request for execution through to issuing a report to an expanded roster of customers.
"Banks are creating their own central counterparty mechanisms, allowing them to match order flows internally," says a director at one European stock exchange. "Essentially, they are replicating the order book. But they are doing so without any kind of price discovery mechanism. So in that respect, they still need exchanges."
Nevertheless, the internalization push means that trade flows to execution venues and post-trade infrastructures will decline. That is because banks are managing their liquidity more efficiently, dipping into markets only when they need to source or sell securities they do not already possess in the natural flows of securities transactions they process.
Underpinning the efficiency drive is technology. Gains in systems integration software and the demands for straight-through processing from both customers and market-led initiatives for speedier settlement mean that banks are investing to upgrade and integrate their operations. Now they want payback.
"Banks had to change their offering and legacy systems to satisfy clients and contend with new economy entrants as they attacked every link in their customer value chains," says Capco's Schmitt. "Those threats are gone. But consolidation among market participants that took place to deal with it left large banks with a union of skills, financial strength and expanded market share."
One result is a lower cost per transaction because the banks that internalize flows pay proportionally less both for back-office processing and for trade and post-trade services. The corresponding increase in the width of margins is boosting profits now, but also providing banks with room for manoeuvre.
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