ID2S plans to transform the European money markets
Paris is not the obvious launch pad for a young and ambitious CSD that wants to help the European Central Bank (ECB) fulfil its vision of a single euro money market capable of competing with the United States. But the largest commercial paper market in Europe is a solid foundation on which to build a blockchain-based technology platform that offers issuers, investors and their agents a fully integrated, pan-European issuance, trading and settlement platform for a new class of genuinely international financial instruments. It may become extremely lively as economies emerge from the Pandemic, and access to credit becomes crucial for businesses of all sizes and types
The Central Securities Depositories Regulation (CSDR) could have much the same effect on central securities depositories (CSDs) in Europe as the first iteration of the Markets in Financial Instruments Directive (MIFID I) had on securities trading platforms at the turn of the century. That is to say, with markets opened to regulated competition, CSDs might proliferate. So far, however, Paris-based ID2S is the only newcomer.
The case for a new CSD for Europe
Andrea Tranquillini is the CEO. “Did we need a new CSD?” he asks. “Yes, I think we did. We did from the perspective of meeting the objective of the Capital Market Union (CMU) of the European Union (EU) to create a single capital market. But we also needed it from the perspective of modernizing the financial market infrastructures of Europe. Most CSDs are based on legacy systems that are 20 or 30 years old now, which carry significant operating costs that have to be passed on to the users.”
ID2S was initially focused on the French commercial paper market. But Tranquillini says this was only the start, in terms of both asset classes and geography. “The fact that we are incorporated in France does not mean we are limiting our ambitions to the French eco-system,” he explains. “On the contrary, our objective is to become a pan-European CSD, servicing short term paper initially, but later supporting a number of other asset classes that are not harmonized at the European level.”
The initial objective of this expansive strategy is to aggregate liquidity in short-term paper throughout the EU, to create a single European money market, supported by a single European trading platform for short term paper backed by a single CSD. In this vision, short term paper throughout Europe will be traded on the commercial paper platform provided by ID2S sister company Now CP, while being settled and custodied at ID2S. The market will be open to issuers and investors throughout the EU.
The size of the opportunity
The plan is to create a commercial paper market in the EU of comparable size to that of the United States. It does not lack ambition. The Federal Reserve Bank of New York reported total outstanding issuance in the United States commercial paper market of US$978 billion in October.
The stateless European commercial paper market (Euro CP) market – the money market equivalent of the Eurobond market, in which foreign issuers borrow from European investors, and trades are settled at Clearstream and Euroclear – is currently worth rather less than that, at only €600 billion. However, the total amounts outstanding in the various domestic commercial paper markets of the euro area, measured by the European Central Bank (ECB) as Short Term European Paper (STEP), was around €410 billion in October 2020.
That €410 billion is ahead of its 14-year average of €385 billion, ad not that far adrift of its all-time high in March 2015 of €456.8 billion. More importantly, the sum of the two segments of the European commercial paper market – Euro CP plus domestic market CP – reaches around €1 trillion, which is rathe larger than its American rival. So, if the EU has some integration work to do before it can truly rival the American market, there are solid foundations on which to build.
Why it makes sense to launch the CSD from Paris
And the choice of France as the starting point for fulfilling this vision is far from accidental. Stateless Euro Commercial Paper (Euro CP) may be traded in London and settled at the two international central securities depositories (ICSDs), but France hosts the largest domestic commercial paper market in Europe, with €301 billion in outstanding issuance at end-September 2020, three quarters of all domestic issuance in the EU.
This leadership position is one France has enjoyed since commercial paper first came to the continent in the 1980s as a route around restrictions on the growth of bank credit. Originally known as the market in titres de créances négociables (TCN), the first French commercial paper was issued in late 1985. It followed pioneering efforts to copy the vast American commercial paper market – which was by 1985 surging on the back of investment flows from the then-booming but later notorious money market funds – in Spain (1982), Sweden (1983) and Finland (1984).
By 1987 the French commercial paper market had overtaken Spain as the largest in Europe, and it has retained its lead ever since. It has proved an enduringly popular form of short-term financing for industrial and commercial companies as well as financial institutions, though its reliance on banks in particular as the principal source of new commercial paper programmes proved its undoing.
By 2016, the TCN market was in steep decline, with outstanding issuance having shrunk from €600 billion in 2009 to just €300 billion. The reason was obvious: the excess liquidity created by extraordinary monetary policies had obviated the need for banks to borrow in the short-term financing market. So there was little reason to resist when the French regulatory authorities subsumed the commercial paper market into their plans to turn Paris into a major European financial centre.
The French regulators have backed a new infrastructure for commercial paper
In 2016 the Banque de France initiated a project designed to make the TCN market attractive not only to a wider range of domestic issuers but to international issuers as well. The list of eligible rating agencies and accounting regimes was lengthened, and the documentation of commercial paper programmes was standardised. It became possible for TCN trades to settle in the domestic CSD (Euroclear France) in central bank money.
TCNs were even re-branded as Negotiable EUropean Commercial Paper (NEU CP), to emphasize the cross-border ambitions of the reforms from the outset. And in April 2019 five institutions active on both sides of the TCN market (Amundi, BNP Paribas, Crédit Agricole Corporate and Investment Bank, Natixis S.A. and OFI Asset Management) embarked with Orange, the originator of the IDF2S project, in the launch of an electronic platform on which NEU CP could be issued and traded. That was the birth of NowCP.
By 2019, the founders of NowCP had worked out that they could attract more business if they offered investors and issuers a one-stop-shop in which they could settle as well trade NEU CP. Instead of issuers instructing their issuer and paying agents (IPAs), and investors instructing their custodians, and trades settling by a largely manual and bi-lateral process – which often resulted in late settlement – settlement instructions could be created and sent directly to IPAs and custodians.
DvP in central bank money comes to European commercial paper
That was the origin of ID2S, which was authorized as an issuer CSD under CSDR in 2018. Under the new dispensation, matched instructions flow seamlessly through an automated interface between Now CP and ID2S. The “native efficient single flow,” as Tranquillini calls it, enables new issues traded on NowCP to be settled by ID2S in a matter of minutes on trade date (T+0) and in central bank money through the TARGET2-Securities (T2S) securities settlement system operated by the European Central Bank (ECB). Same day delivery versus payment (DvP) is now available until 16.00 Central European Time (CET): the T2S closing deadline.
“The advantage is the absence of legacy,” explains Tranquillini. “When Orange first conceived the business model, it was based on a study of the needs of the issuers and investors and on an analysis of the various weaknesses in the process, of which post-trade settlement on T+2 was one, with settlement frequently failing to occur on time at all. It was very frustrating for bank and corporate treasurers to be obliged to trade on the basis that they might get the money after two days, if settlement occurred on time, rather than in real-time. The settlement process did not match the treasury needs. There was an inefficiency which we have completely eliminated. We have built a process in which only minutes now elapse between the moment of trading and the moment of settlement. And on that basis we are considering extending these efficiencies to other asset classes.”
Since it went live at the beginning of this year, ID2S has actually been capable of settling transactions instantaneously. It is only the persistence of manual processing by certain custodians and IPAs that extends settlement to minutes and up to as long as an hour in some cases. “We do not want to push the market towards a disruptive model,” says Tranquillini. “But, potentially, asset managers could become direct clients of ID2S with the infrastructure we have created. It is therefore in the interest of the intermediaries to be as efficient as possible.”
Blockchain technology is working seamlessly with conventional technologies
The ability to achieve instantaneous settlement rests on an unusual combination of technologies built by SETL, a London-based blockchain vendor now led by Philippe Morel, a former Boston Consulting Group senior partner. Users can access ID2S via a GUI, or by SWIFT messaging or via data exchanges through Application Programme Interfaces (APIs). This means that participant accounts are accessed by conventional means, and not yet operated as “nodes” on a classic blockchain network.
Tranquillini dismisses the notion that a more ambitious approach would see IPAs and custodians operating nodes on a single blockchain network, enabling ID2S to knock out network intermediaries such as SWIFT and the API service providers. “We are far from this scenario,” he says. Blockchain “nodes” are, on the other hand, used by ID2S to capture and store the data about transactions. There are six of them in all, and their contents are synchronized every five seconds.
This has pleasing effects on the operational resilience of ID2S. Three nodes are in active use by participants at any one time and can call on any of the three spare nodes if one fails. In fact, ID2S can run with any of one of the six nodes operational at any one time. Tranquillini says this provides participants with a high degree of reassurance about the safety and security of their data. “To disrupt ID2S, a hacker would have to succeed in disabling six separate nodes within five seconds,” he says.
But Tranquillini does not deny the long-term potential. “The blockchain is deployed today in a limited part of our infrastructure but the evolutionary potential of the blockchain component is obviously enormous,” he explains. “It may go from where it is today to handling tokenized securities and servicing them via smart contracts and encompass collateral management and securities lending as well. But we have been cautious deliberately and are using a revolutionary tool in an evolutionary way. I am very conscious that we are still a start-up.”
As it happens, ID2S does not own the blockchain technology it uses anyway. Instead, it is leased from SETL. This reflects the heritage of the original 60:40 arrangement between founders Orange and SETL, before SETL got into financial difficulties by combining the role of software vendor with the riskier one of being a venture capital company. The arrival of Philippe Morel at the head of the company resolved this dilemma and SETL is now working as a conventional technology vendor with some the largest financial houses in the City of London.
Expansion into other markets in Europe has begun
The ownership of ID2S is equally stable. Orange owns 94 per cent and Citi the remaining 6 per cent. As minority shareholder, Citi has encouraged ID2S to extend its offering beyond France. Certainly, ID2S has now saturated its home market. “A large number of issuers have joined Now CP, including many members of the CAC 40, which is the index of the most liquid companies in France,” says Tranquillini. “At the investor level, Amundi alone covers 40 per cent of the market, and a number of other asset managers are on-boarding, including BNP Paribas Asset Management, OFI Asset Management, and Ostrum.”
In total, six financial institutions, including BNP Paribas and CACEIS, have now opened IPA and custodian accounts to service issuers and investors via ID2S. “In principle, once all the shareholders of Now CP are on-boarded, ID2S will cover 80 per cent of French custodial capacity,” says Tranquillini. “Importantly, the creation of such a community will create what is missing today, a proper liquidity and a secondary market for instruments held today only on a buy-and-hold basis.”
But geographical expansion as well as a liquid secondary market is necessary if ID2S is to continue to grow. A commercial unit has been opened in Dublin to support expansion across borders. ID2S has also requested passporting rights to offer services in other EU jurisdictions under Article 23 of CSDR. But CSDR does not eliminate local regulatory constraints on the ability of ID2S to operate, so the new CSD does not intend to open in every commercial paper market in Europe. “We will go where the demand is, where the clients are looking for innovation and are in need of efficient funding,” says Tranquillini.
European Central Bank policies will boost the ID2S strategy
To fulfil their declared role of running a pan-European commercial paper ecosystem, the Now CP and ID2S offering has to attack the Euro CP market as well as the domestic franchises of the various member-states of the euro area, and compete with Clearstream and Euroclear for the business. They are planning to do so by providing a standardised euro commercial paper offering, operating to a single set of rules that promises to blend the best of the existing Euro CP market with the new rules set by CSDR plus settlement in central bank money.
NEU CP is already eligible at the ECB, and ID2S is a recognized securities settlement system (SSS) under European regulations, which means assets can be placed as collateral and with all the central banks that make up the Eurosystem. The programme launched by the ECB to standardize collateral management rules and processes throughout the euro-area, and its provision of a single collateral management engine designed to allow market participants to pledge assets in any CSD to any central bank within the Euro-system of central banks, cannot but be helpful to an organization wanting to operate a pan-European CSD in an ECB-eligible asset class.
Opportunities are clearly there. The combination of trading on Now CP and straight-through settlement at ID2S could “aggregate” the European commercial paper markets, though it will take time. “Our objective is to aggregate the markets at the European level,” explains Tranquillini. “We want to create a single pool of liquidity, where today there is significant fragmentation. We are open to long term partnerships with those who are willing to re-engineer their business in a more modern, efficient, risk-free and cost-efficient way.”
Covid 19 has proved an accelerator as well as a brake
At the beginning of this year, transactions were picking up so energetically that ID2S was no longer the smallest CSD in Europe. The global Pandemic put a brake on that momentum, but Tranquillini says economic recovery measures are proving helpful. “The effects of the COVID-19 virus on the global economy have caused a first disruption of the markets and, as we all know, the short-term markets in Europe suffered a temporary lock-down,” he explains. “It is an exceptional but equally temporary situation, and the Pandemic European Purchasing Programme (PEPP) is a stimulus for the commercial paper market,” he says. “It should regain the centrality it had before the crisis, and in particular for corporates that do not have access to the Targeted Longer-Term Refinancing Operations (TLTRO) of the ECB.”
ID2S spent the summer of 2020 working on its geographic expansion plans precisely because it believes there will be strong corporate demand for short term credit as European economies climb out of the downturn inflicted by Covid 19. Internationally distributed Euro CP will continue to be issued in London, but the pan-European positioning of ID2S will enable it to tap into issuance activity in multiple markets.
“We believe that we can play a central role in helping corporates get to access to credit,” concludes Tranquillini. “The combination of the joint services of NowCP and ID2S, together with the current situation of interest rates and the safety offered by settlement in euro in central bank money via the Eurosystem of central banks, offer an extremely helpful infrastructure through which to borrow money to recover or to finance new projects. Access to credit through the business model we have created is extremely easy and efficient and the current market circumstances make our business model even more attractive as it facilitates access to credit in line with the CMU expectations. In fact, this will be the foundation on which we will build services in other international asset classes.”
- Banque de France, Monthly Review of the commercial paper and medium-term notes market at 31 January 2020.
- Bank for International Settlements (BIS) Economic Papers No.37, April 1993, Commercial Paper Markets: A Survey by J.S Alworth and C.E.V Borio.
- European Central Bank, Euro money market study 2018.
Written by Dominic Hobson – Co-Founder of Future of Finance
27th November 2020