Highlights from The Network Forum – Annual Meeting 2023

Some of the main discussion points from the two-day event, included digitalization and tokenization, the future of centralized clearing, and shorter settlement cycles.
So, what were the key takeaways to emerge from TNF? 

Digitalization cannot be avoided, and those who ignore it risk being left behind.

Although digital asset trading is still in its infancy, the investor appetite is certainly there for it. Many expect that flows into digital asset classes, such as security tokens, will increase exponentially over the next 5+ years.

Forward-thinking providers, including SIX, are developing the infrastructure to help investors trade digital assets.

“Most of the industry agrees that securities will eventually be digitalized and traded on distributed ledger technology (DLT). There is also broad consensus that there will not be a big bang, with everyone suddenly replacing traditional securities with DLT-enabled digital assets,” said Jesús Benito, Head Domestic Custody & TR Operations at SIX, speaking at TNF.
He added: “There will be a number of years whereby both traditional and digital assets co-exist with each other.”

To complement its traditional exchange business, SIX launched the SIX Digital Exchange (SDX), a wholly digital exchange which supports the issuance, trading, custody, and settlement of digital assets.
“Both the traditional exchange and SDX will co-exist with each other for a long time, but I expect they will eventually converge as we move from the old ecosystem to the new one,” said Benito.

Today, the exchange operator is trying to bridge the gap between the traditional and digital asset ecosystems.

But how is it doing this?

Benito said SIX, the Swiss central securities depository (CSD), has direct access to SDX’s CSD, which will make natively digital CHF-denominated bonds more accessible to the wider market.  This operational link will enable investors to purchase digital bonds issued on the SDX CSD, but they can then be held and settled at the Swiss CSD.  

Benito noted that SIX is also developing digital asset capabilities in Spain. In 2022, the company – along with BBVA and the Inter-American Development Bank (IDB) - unveiled the first bond issuance in Spain listed on a regulated market and registered using blockchain technology.

Smart contracts were used for the execution of the distribution, purchase and sale, settlement, and corporate events processes, using electronic money tokenized by BBVA for the management of cash throughout the term of the issuance.

By developing solutions that support both traditional and digital assets, service providers will put themselves on a strong footing to attract business as the investment process evolves. 

The future of CCP (Central Counterparty Clearing House) interoperability across cash equity and repo markets - along with the potential for more asset classes to be centrally cleared - were among some of the issues tackled during TNF.

Interoperability is an arrangement whereby two or more CCPs establish a link that enables cross-CCP execution of transactions, meaning that market participants can trade freely in the same trading book without having to share the same CCP.

In addition to offering users more choice, interoperability can generate efficiencies as firms can reduce the number of CCPs they work with, and simultaneously benefit from netting opportunities across venues. As CCP competition has increased due to interoperability, fees have also fallen dramatically.

Despite its purported benefits, Laura Bayley, Head Clearing Services, SIX, said interoperability appears to be stagnating and is limited to multilateral trading facilities and a handful of stock exchanges, including SIX.  

This comes amid growing competition from the so-called preferred clearing model, whereby both counterparties to a transaction must select their preferred CCP.

“Notwithstanding our conviction that interoperability is the model that brings members the most advantages and has brought down prices for clearing, we are trying to encourage competition by applying as a preferred CCP in markets, where interoperability is not available,” said Bayley.

On regulation, revisions to EMIR (European Market Infrastructure Regulation) are ongoing.

One of the most significant proposals contained within the so-called EMIR 3.0 will require market participants to clear certain derivatives transactions (i.e., euro/Polish zloty denominated interest rate swaps, euro denominated credit default swaps and euro denominated short-term interest rate derivatives) on active accounts with EU CCPs.

“On the topic of active accounts, we believe that the prospect of clearing fragmentation in Europe poses significant risks from a counterparty risk perspective. Despite pushback from much of the European derivatives industry, the European Commission is committed to shifting some of the volumes of Euro-denominated interest rate swaps from London into the EU,” according to Bayley.

Bayley stressed CCPs in the EU are currently working to develop the capacity to handle any increase in clearing volumes. “In the case of SIX, we are fostering our existing interest rate swap clearing service in Spain to provide an attractive and competitive alternative choice for euro denominated interest rate swaps,” Bayley added.

As digital assets become more widely traded, CCPs have identified a commercial opportunity.

Bayley said there is growing demand from investors for CCPs to clear digital assets. “CCPs directly mitigate broader market volatility in financial markets by stepping into the risk and ensuring greater settlement efficiency through their netting capabilities. This can make us particularly attractive to provide clearing services to new, more volatile assets in the crypto markets,” said Bayley.

The topic of shorter settlement cycles has been covered extensively at TNF ever since India moved this year to T+1 and the US and Canada each announced that they would adopt it in 2024.

Although T+1 offers a number of risk benefits and capital efficiencies relative to the incumbent T+2 model, its adoption could create problems for investors and intermediaries. For investors in certain time zones, T+1 could require them to pre-fund their FX trades, potentially resulting in liquidity issues.

Furthermore, trade fails, or late settlements could spike following T+1’s implementation, leading to financial institutions being slapped with penalties or higher fees, warned Bayley.

To avoid this, automation will be critical. “The focus on automation is expected to increase for all stakeholders and especially for those active in different time-zones as they have less time to resolve issues,” continued Bayley.

Even though most firms are still in the planning stages for T+1, experts at TNF are already talking about T+0 (i.e., end-of-day settlement) and atomic settlement (i.e., instant settlement) as being the next logical steps once T+1’s rollout is fully implemented.

While proponents argue atomic settlement will eliminate settlement risk, Bayley said it could create problems elsewhere.

“Atomic settlement does not provide the netting efficiencies which are currently offered by today’s post-trade infrastructures.  For instance, at SIX our settlement efficiency ratio is at 98.6%. This means that only 1.4% of gross trades in terms of volume is actually physically settled. The remaining 98.6% is settled virtually at the CCP by netting opposite trades within the same account. This also enables market makers and liquidity providers to fund activities that would otherwise be much more expensive to fund. These advantages cannot be overlooked when discussing instant settlement,” said Bayley.

However, she added: “Even so, I believe there are opportunities for clearing in an instant settlement world. Any system will have risks, and we as a CCP can use our capabilities and expertise to help manage that risk.”

Post-trade is going through a period of significant change, sparked by digitalization but also market reforms and regulation. This will force providers, including FMIs, to adapt.
Those that embrace this transformation will likely end up being the market leaders.