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Cablegate: Drama in Eu Clearing and Settlement Heightens: Us

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





E.O. 12958: N/A
SUBJECT: Drama in EU Clearing and Settlement Heightens: US
Threat Catalyst for Unification?


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

1. (SBU) Summary: European securities infrastructure
industry of stock exchanges, clearing and settlement
activities is among the most dynamic in the financial
industry, undergoing substantial change in the last decade.
As the European Commission (EC) prepares to decide whether
to propose EU legislation for clearing and settlement
systems, drama over the future shape of the industry is
heightening. Taking a cue from the City of London, EC
Commissioner McCreevy suggested that a pan-European
clearinghouse would be an "interesting prospect." Indeed, it
could cut costs of cross border transactions and satisfy
supervisory, competition policy and users' interests.

2. (SBU) Shareholders in privately owned LCH.Clearnet and
Eurex might not have been expected to be enthused. As if on
cue, a week after the McCreevy statement shareholders of
Euronext suggested that Euronext merge with Deutsche Borse
for exchange trading, possibly spinning off the clearing
operations of both. Filling the stage, the Italian
competition authorities have opened their own inquiry
regarding Borsa Italiana's operation of a clearing system.
Maybe the creation of a pan-EU clearinghouse would produce a
happy ending, but it would still leave nettlesome tax and
legal obstacles to integration. Maneuverings in Europe need
to be appreciated with one eye on the US. Failure to
consolidate more quickly in Europe could leave European
exchanges vulnerable to a takeover from the US - an issue
that gets the continental blood pumping. The drama may be
notching up. End Summary

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To Legislate nor Not Legislate, that is the Question
--------------------------------------------- --------

3. (SBU) A major obstacle to a more integrated, efficient
EU securities market is separate national clearing and
settlement systems. Clearing means validation of trades and
preparation for settlement (e.g. information on securities
transaction codes, settlement date, settlement venue, etc.).
Settlement is the transfer of the ownership of the
securities and corresponding transfer of cash. A group of
private experts led by Mr. Alberto Giovannini, Chairman of
Unifortune Asset Management, has produced two reports
detailing the obstacles to a more efficient European cross-
border clearing and settlement.

4. (SBU) Over a year ago the EC floated the notion of a
EU directive to create uniform regulatory and governance
rules, including requirement for trades on any exchange to
have access to the clearing system of their choice. The
idea is that common rules would facilitate cross-border
consolidation, helping to drive down cross-border processing
costs that run six times that of domestic transactions. The
EC is preparing an economic impact study that will show that
a fully integrated EU clearing and settlement operation
would, in fact, reduce costs. The question they have not
yet answered is whether legislation is necessary and capable
of achieving that objective. EC officials intend to take a
decision on whether to proceed with legislation will be made
around the end of the first quarter of 2006.

5. (SBU) The ECB has been outspoken in favor of a
framework directive to enhance stability of EU payments
systems. The ECB and the Committee of European Securities
Regulators (CESR) were so keen on rules that they drafted
clearing and settlement "standards" without waiting for
legislation or, in the case of CESR, a mandate from the EC.
This procedural end run has been sharply criticized, most
recently at the September 13 hearing of the Economic and
Monetary Affairs Committee that put CESR's Chairman in the
dock. The draft standards have attracted considerable
criticism for both the process by which they have been drawn
up and their content. Rather than finalizing them a year
ago, ECB and CESR have been refining the text and will
release a new discussion draft in October, with a view to
completing it by the spring. Some observers speculate that
the timing aims to coincide with the EC's possible proposal
for a directive, allowing the EC to regain its rightful lead
in drafting EU legislation.

City of London Goes Continental: A Case of Role Reversal
--------------------------------------------- -----------

6. (SBU) Regulation is favored in another quarter, namely
by the Chairman of the London Stock Exchange (LSE). In July
he called on the EC to lead a rigorous debate about the
"structure of post-trading services," as well as their
"ownership." The LSE has favored clearing operations to be
regulated as a public utility. The logic is that since all
trades have to be "cleared," and that only one clearing
system can efficiently exist for a specific financial
instrument in a domestic market, it should be regulated as a
public utility, like a telecom network, since all traders
have to use it.

7. (SBU) A curiosity is that the traditionally market-
oriented City of London is championing a government-directed
approach. In this case it is understandable. The LSE is
the only major European exchange that does not own or have
financial interest in post-trading operations. Thus, it is
easy for them to propose measures that affect only their

8. (SBU) In a bit of role reversal, the continental
exchanges and clearing and settlement operators have favored
a market-oriented solution, not government intervention. No
surprise again. Deutsche Borse's Eurex and LCH.Clearnet, in
which Euronext, the conglomeration of four of Europe's stock
exchanges, has a major stake, are privately owned, publicly
traded institutions.

Commission: Market Solution or Government Lead Market
--------------------------------------------- --------

9. (SBU) EC Commissioner McCreevy has sought to stir the
pot with a September 13 speech in which he mused that the
creation of a pan-EU clearinghouse is an "interesting
prospect." One EC official reported that McCreevy wanted to
provoke a reaction from industry. Another said that
industry talks and talks, but has not developed a clear
approach for the EU clearing industry. The speech was a
"wake up call" to get their act together in the next six
months and develop concrete ideas.

10. (SBU) The EC has been sympathetic to market-lead
consolidation. Indeed, consolidation in trading, clearing
and settlement has "proceeded at an unprecedented pace in
the last few years," according to a study prepared for DG
Competition finalized in July. Eurex clearing is the product
of the merger of seven regional central securities
depositories in Germany. Clearnet provides clearing
services for Euronext changes, i.e. Paris, Brussels,
Amsterdam and Portugal. The most significant consolidation
was the 2003 merger between Clearnet, which was 80% owned by
Euronext, with the London Clearing House, which provided
clearing services for the LSE, into a new entity,

Consolidation: Vertical In Practice, But Not Ownership
--------------------------------------------- ---------

11. (SBU) Market-driven consolidation sounds good in
principle, but UK regulatory authorities and investment
bankers take a different view when it comes to trading
linked to clearing operations. In July the UK Competition
Commission's provisional findings in its inquiry regarding
the possible acquisition of the LSE, states that both
suitors of the LSE - Deutsche Borse and Euronext -- would
either have to divest themselves of their clearing
operations or follow strict governance rules to ensure
clearing operations would not be influenced by the trading
interests of the exchange. The logic of the Competition
Commission was that "vertical integration" in which an
exchange also owns a clearing operation, could result in the
clearing operation rising fees or even denying access to
"captive traders" on the exchange, increasing costs or
barriers to entry. This, in the Competition Commission's
view, may give rise to a "substantial lessening of
competition" for the provision of exchange trading.

12. (SBU) The London Investment Banking Association (LIBA)
wholeheartedly endorsed this logic. In an extraordinary
presentation last February, LIBA asserted that vertically
integrated structures present "risks of price discrimination
and unfair access terms." Clearing and settlement
operations should have "hard wire" governance rules that
give users' interest "top priority" and ensure effective
separation from the operation of the exchange. Better yet,
in LIBA's view, the clearing operations should be separate
entities owned by users.

13. (SBU) Here is another curiosity. LIBA's members tout
the attributes of shareholder value for their clients, but,
in this case, don't seem to care about the shareholders of
Deutsche Borse and Euronext. Not so long ago, investment
banks owned one of the major cross-border central securities
depositories, CEDEL, but sold it to Deutsche Borse. London
City financial experts dismiss these points as irrelevant to
today's market. The market provides its share of irony.

14. (SBU) The report on European clearing and settlement
systems prepared for DG Competition took a more detached
view on "vertical integration." It pointed out that all
countries have vertical systems either through ownership
(like Germany, Italy and Spain) or through exchange laws or
membership rules (even on the LSE) that require trades on
the exchange be cleared and settled through a designated
entity. One exchange expert points out the obvious fact
that have one clearing entity for an exchange is efficient
for all concerned. Thus, the issue is not the link between
an exchange and clearing operation in practice, but rather
the ownership of both that could lead to abusive behavior.

Shaping of the Market to Come

15. (SBU) There is little doubt that unification of EU
post-services operations would help integrate EU securities
markets and reduce transaction costs. A July 2005 study by
the ECB staff has suggested that most research supports the
notion that EU costs in cross-border clearing and settlement
are significantly higher that those in the US. The study
also notes that vertical integration has positive features
and that market-driven solutions are generally the best at
allocating resources to create an efficient securities

16. (SBU) ECB experts' outlook was cautious, declaring
that it would appear premature to "draw up any final
conclusions regarding policy and optimal form of
consolidation." Important elements to any solution would be
proper governance to protect from conflicts of interest and
to ensure rigorous competition.

17. (SBU) Based on these conclusions, one clearing entity
at the EU level could make sense, provided it was fashioned
by the market, not imposed from above. Again, on what
appears to me another cue in the drama, a week after the
McCreevy speech, shareholders of Euronext reportedly
suggested that the firm target a merger with Deutsche Borse
rather than LSE. The clearing operations of both - Eurex
clearing and LCH.Clearnet would be spun off and sold to
users, a prospect that LCH.Clearnet has raise, but one that
Deutsche Borse officials reject. Filling the stage, on
September 20 Italian competition authorities announced an
inquiry into Borsa Italiana's ownership of clearing
operations for the exchange it operates in Milan. This is
getting to be like a chorus in a Greek drama.

18. (SBU) The market solution of major EU clearing
operations merging would appear to give competition
authorities and users what they want: a clearing institution
independent of exchanges and responsive to users' needs. EC
officials confess to being intrigued with the US DTCC that
is such the single clearing entity in the US for equity

19. (SBU) A pan-EU clearinghouse would not mean full
integration of the EU market. The Giovannini expert group
identified technical, tax and legal obstacles to EU
integration in clearing and settlement. The above merger
would address technical aspects, but not the more difficult
legal and tax issues. Indeed, the Giovannini group warned
that if only technical issues were solved, e.g. inter-
operability of systems, risks would actually increase with
trading volume as the legal and tax problems would grow
commensurately. The EC has established working groups to
tackle all three obstacles, but the ones on legal and fiscal
cannot produce quick fixes, as they would require changes in
national legislation.

Defi American, Encore: Unifying Force and a Plus for the
--------------------------------------------- ------------

20. (SBU) A subplot in the European drama on the
consolidation of the securities infrastructure industry is
the role of US industry. There is a concern that the New
York Stock Exchange might be interested in taking over the
LSE. The US DTCC has expressed its interest in opening
clearing operations in London. This specter adds some
urgency to Euronext and Deutsche Borse's strategies -
possibly joining them in common cause.

21. (SBU) Well before the recent suggestion of Euronext
shareholders, German market observers suggested a merger
between Deutsche Borse and Euronext if both failed to
takeover the LSE, in light of UK market and official
resistance (recall the UK Financial Service Authority's open
letter to the press clarifying that whoever owned the LSE,
the LSE would be supervised by the FSA - a point underscored
in the UK Competition Commission's provisional findings). A
former Deutsche Borse official recalls they were close to
such a merger three years ago. While competition issues
might have to be considered, they may not be as onerous as
some expect. The UK Competition Commission's provisional
findings indicate that the "relevant market" to gauge
competition in securities trading is not the UK or even
Europe, but Europe and the US.

22. (SBU) A unified continental exchange would appear not
to be a threat to competition and could provide the EC a
policy bonus. It would allow the EC to recapture the policy
debate now being driven by UK supervisory and competition
authorities and mark a major step toward integrating EU
securities markets. A bold initiative on clearing and
settlement could be a centerpiece for the EC's economic
agenda that, one can kindly say, has lacked pep. Nothing
like a rival from the other side of the Atlantic to get the
continental blood boiling.

23. (U) This report coordinated with Embassies Berlin,
London and Rome and USEU

24. (U) POC: James Wallar, Treasury Representative, e-mail; tel. 49-(69)-7535-2431, fax 49-(69)-


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