Clearing and settlement – from goats to derivatives

Why, asks Stewart Fleming, did the EU not update its financial plumbing before the introduction of the euro?

Anyone who spends their leisure hours leafing idly through the pages of the 1989 report of the Committee for the Study of Economic and Monetary Union - the Delors Report which was the blueprint for the single currency - will look in vain for any discussion of clearing and settlement.

Indeed, as Peter Norman makes plain in this book, it was not until the euro was launched that the real work began on trying to develop the deeper cross-border financial market infrastructure needed to underpin the single currency.

Norman, sometime Brussels bureau chief for the Financial Times, has produced a history of EU clearing and settlement systems, albeit with an emphasis on Brussels-based Euroclear.

To explain in simple terms the function of the ‘plumbing’ through which cash flows in return for ownership of stocks, bonds and other financial securities, Norman quotes the Italian banker and public servant, Alberto Giovannini, who was chairman of an influential group of experts, set up by the Commission in 2000 to study the EU’s complex and largely nation state-based clearing and settlement systems. Giovannini compares them to a medieval market square where people can bring their goods to exchange for cash and "one guy can take the goat away and the other guy takes the money away".

While Norman explains the formidable complexity that is now built in to the systems for exchanging stocks and shares, bonds, futures and options contracts for cash, it is good to keep the goats in mind. Like a credit-card transaction, clearing and settlement is less mysterious than it might seem.

In a world of state-based central securities depositories, Germans bought shares in German companies, Italians bought shares in Italian companies, and, as with cross-border cash transactions, they had to pay through their noses to their banks if they wanted their money to cross borders and currencies.

Norman traces the development of International Central Securities Depositories, such as the Brussels-based Euroclear and its rival Cedel, in facilitating the growth of the international ‘offshore’ Eurobond market (initially US dollar-based) in the 1960s. He explains how growing dissatisfaction with price-gouging by some of those involved in the cross-border trading of bonds and shares was reinforced by concerns that fragmented financial markets are bad for the single currency and the EU economy. Belatedly financial market policymakers were drawn into efforts to force the pace of deeper EU-wide financial integration. Norman implies that events are now moving swiftly enough. Perhaps this is too optimistic.

This history reveals just how difficult it is to bring about far-reaching changes within the EU if there is no committed, top-level, political leadership. Experts such as Alexandre Lamfalussy, who must be counted among Norman’s "visionaries", knew full well, long before the 1990s, that payments systems, including clearing and settlement, were vital for financial stability. That lesson was taught by the collapse of the small German bank, Bankhaus I.D. Herstatt, in 1974.

But the single currency was still launched without a policy aimed at deepening euro financial market integration. Why? Prime ministers and their finance ministers found this nitty-gritty stuff too technical. They were too busy defending their national interests and their plans to build up Paris, Frankfurt or London as national champion financial centres to want to focus on the integration of EU financial markets.

Ambitious companies, notably Deutsche Börse, the German stock market, and its boss Werner Seifert, capitalised on this coincidence of national and corporate self- interest to try to become the leader of EU integration - on their terms. And London, emerging as a world (not a mere European) financial market was doing very nicely on its own, thank you.

London’s dominant American investment banking community was only too happy to reinforce a Eurosceptic-driven ‘hands off’ prejudice, that financial markets, would do the job better without political intervention.

So where has this lack of pro-active, top-level, political involvement in the development of Europe’s financial markets got us? We know that, partly because of inadequate regulation, at least three European banks (one in Britain) have had to be rescued from collapse in the past eight months. Another, France’s giant Société Générale, has been flirting with disaster. So too has the perennially troubled German behemoth, Westdeutsche Landesbank. Do not underestimate how close we have come to economic catastrophe.

Norman ends by suggesting that EU visionaries should fix their gaze on what he calls "a new global paradigm", not the petty regional focus which, he implies, is what the decision of the European Central Bank (ECB) to develop T2S - a narrowly based but central-bank run, settlement engine - amounts to. This reviewer begs to differ: the active involvement by the ECB can help to strengthen settlement infrastructure from top to bottom - no bad thing, current history suggests.

One lesson of the last six months is that what the EU needs most, in both the market infrastructure and the market regulatory fields, is stronger political leadership. The ECB needs to play a bigger role in both fields. Its active involvement may just help to move these technical issues up the political agenda, resist short-sighted populist interventions and put pressure on other policymakers, especially finance ministers, to pay more long-term attention to the financial services industry which is now such a big (in the UK’s case too big) factor behind our economic successes - and failures.

* Plumbers and Visionaries: Securities Settlement and Europe’s Financial Market by Peter Norman.

Published by John Wiley and Sons. 352 pages. £45

• Stewart Fleming is a former US editor of the Financial Times.

Why, asks Stewart Fleming, did the EU not update its financial plumbing before the introduction of the euro?