Custody initiative: Euroclear

Euroclear became the first and only non-US national agent offering instant US dollar settlement of transactions in central bank money outside of the US in October 2018. The launch was undertaken by Euroclear UK & Ireland (EUI) via a complex arrangement – which includes a backstop whereby the Bank of England (BoE) acts as a custodian of a trust fund – that ultimately reduces risk of custodians and settlement banks related to international US dollar transactions.

The system also reassures the US Federal Reserve System that participants settle their mutual obligations linked to an increasing flow of dollar transactions taking place beyond its jurisdiction in a structured way. And the Euroclear solution may represent a template for other major financial marketplaces, such as Hong Kong.

“Our concept of delivery versus payment is the simultaneous and irrevocable, outright transfer of title of the asset with payment in central bank money,” says Ian Dowglass, head of innovation and business transformation at EUI. “The two cannot occur separately. They have to happen together or they don’t happen at all. Those core principles are absolutely crucial in the models that we have developed for sterling, euro and dollars.”

The central securities depository (CSD) first secured central bank money settlement in sterling and euros. In both cases, it required engagement with the central bank overseeing the payment platforms of both currencies and legal arrangements to secure finality on those central bank cash platforms. Both the BoE and the European Central Bank have core accounting entries in their core ledger to support cash settlement taking place in Crest, the BoE’s securities settlement system, and Target 2, the similar system run by the European Central Bank.

EUI settles sterling in central bank money via a direct connection with the BoE and euros previously through the Central Bank of Ireland. But because of Brexit, euro transactions settlement could no longer take place through the Irish central bank. “So we switched our euro connection from the Central Bank of Ireland to the ECB, which is allowed to have accounts for non-European Economic Area entities, and we got a special dispensation to enable us to do that,” says John Trundle, EUI chief executive until mid-2019. “But for the dollar service, we didn’t have a direct solution.”

This presented the company with a challenge. The 2014 European CSD regulation requires domestic CSDs to provide settlement in central bank money if they lack a banking licence. This meant that, as a multicurrency provider, EUI needed to upgrade its dollar offering to settlement in central bank money. To overcome this hurdle, the company started negotiations with the Federal Reserve System.

Institutional co-operation

“The Fed could see the financial stability arguments for dollar settlements being done in central bank money. If we didn’t offer this service, the transactions would largely still take place in the UK market,” says Trundle. “That would be an uncontrolled process by which participants would settle their mutual obligations in an unstructured, uncontrolled way, which ultimately would be reflected in the US system.”

As a multicurrency provider, EUI needed to upgrade its dollar offering to settlement in central bank money. To overcome this hurdle, the company started negotiations with the Federal Reserve System

Nonetheless, Euroclear faced a new technical challenge: it wanted the same concept of settlement finality it enjoyed with sterling and the euro, so transactions could not be unwound. However, in the Fed’s case, Euroclear lacked access to the accounting structures working in the BoE and the ECB. To overcome this issue, the company developed a system operating over its clients’ accounts at the Fed. Through this, it can issue an instruction to direct debit the banks that are paying in and instructions to pay the banks that are receiving funds.

“EUI submits one file per day with the transactions that have been netted down. The company nets several transactions, and it really streamlines the process to simple credits and debits to the Federal Reserve Bank’s customers’ master accounts that they have at the Fed,” says a person with direct knowledge of the process. It is a similar system to the Federal Reserve Bank of New York Fedwire Funds Service. Once the file arrives, the credit is processed at one of the depository institutions – settlement providers that have accounts at the Federal Reserve Bank of New York. It is irrevocable, which reduces settlement risk.

The solution is part of the National Settlement Service the New York Fed offers to private-sector operators. It only does this on behalf of its settlers that are depository institutions. They authorise the New York Fed to debit or credit their account, and they also authorise EUI to act as their agent.

Additionally, Euroclear set up a contingency fund in central bank money at the BoE that is only to be used in the most extreme event scenarios.

“The nature of our access to the Federal Reserve Bank’s National Settlement Service to achieve dollar central bank finality resulted in a slightly different method to that used for sterling and euro,” says Dowglass. “So it was in that area that we worked collaboratively with both the Federal Reserve Bank and the Bank of England to realise our objectives. Central bank money finality ensures there is no risk of not being paid, providing both confidence and certainty to markets.”

Rising trading capacity

The new system is already reducing settlement risks. One of the most common dollar-denominated transaction types handled by EUI is related to mergers and acquisitions of international companies listed on the London Stock Exchange.

On January 8, 2019, Japanese pharmaceutical group Takeda acquired London-listed Shire for $62 billion. That day, the dollar values on the Euroclear system spiked up by $30 billion, but settlement continued to take place with central bank money finality. The custodians involved in the operations received their payments at minimum risk.

The Central Banking Awards were written by Christopher Jeffery, Daniel Hinge, Dan Hardie, Rachael King, Victor Mendez-Barreira, Alice Shen and William Towning