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

UNCLAS SECTION 01 OF 04 FRANKFURT 007207 
 
SIPDIS 
 
SENSATIVE 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS LEE 
TREASURY ALSO FOR ICN COX, HULL 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: Drama in EU Clearing and Settlement Heightens: US 
Threat Catalyst for Unification? 
 
 
T-IA-F-05-033 
 
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 
 
  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 
     competitors. 
 
  ¶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 
  Solution? 
  --------------------------------------------- -------- 
 
  ¶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, 
     LCH.Clearnet. 
 
  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 
     infrastructure. 
 
  ¶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 
     securities. 
 
  ¶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 
  EC? 
  --------------------------------------------- ------------ 
 
  ¶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 
     wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
     7535-2238 
 
Bodde