With competition increasing, central securities depositories are facing a conundrum: They are meant to provide security and stability, but to survive they need to move into new market areas, which means taking on new risks.

As custodians move away from clearing individual transactions to batch netting, CSDs face a challenge to their traditional revenues. With batch netting, thousands of transactions are cleared together at less cost to the client and less revenue to the CSD.

“To increase their customer base and create new revenue streams, a lot of CSDs are expanding to serve multiple asset classes and more complex corporate actions,” says James Martin, an Advisor with OMX Professional Services. Some are also beginning to more actively offer direct clearing to larger institutions — either through direct membership or a service bureau arrangement, Martin says. This bypasses custodians, which saves institutions money and preserves CSD revenues.

“By expanding into unfamiliar markets and products, CSDs can expose themselves to the very risk they’re trying to mitigate,” he says. So while in many cases CSDs need to rethink their operating model, they must move cautiously, carefully evaluating the potential benefits and pitfalls of their choices and crafting a risk mitigation strategy.

CSDs in emerging markets often face different problems from those in more established markets. The former, says Martin, often operate in regulatory environments that are not as strict or advanced as those in more developed markets. This can lead to a lack of market confidence in the stability of a CSD, as well as low liquidity. At the same time, CSDs in these countries often work hand in hand with their governments to attract international investment to their country. To meet that goal, it is imperative that the CSD provide a stable infrastructure that is reliable and meets international standards.

In addition, many of these CSDs run on systems developed in-house, most of which cannot clear more complicated asset trades. “They’re now realizing that they have to come up to speed,” Martin says. CSDs in more established markets generally do not face this problem, he says, although traditionally they tend to be conservative and resistant to change. “Due to slow implementation time frames, they need to plan well in advance how to meet their future revenue challenges and quickly move new products to market,” he says.

So what are CSDs to do? They need to think carefully about their function and status in the financial infrastructure, the requirements of their customers and their own needs. That’s particularly important because, Martin says, “CSDs can’t just change their operating model every other year.” Regulators would not allow that, and it would contribute to the very volatility CSDs are supposed to prevent.

Martin stresses the importance of securing market buy-in to any proposed changes. “We see the process of interviewing market participants as vital to helping CSDs make decisions and to ensure that the CSD continues to meet market needs,” he says. Other focus areas include operational modeling, risk evaluation and mitigation, the importance of understanding new products before launching them, and the regulatory environment.

“Now is an ideal time for CSDs to review their internal workings, as G30 and Giovannini deadlines are coming into play,” he says.

But regardless of new regulations and products, Martin says, in the future the primary role of the CSD will continue to be the same as in the past: to ensure market stability and orderly transaction processing.

By Ariane Sains Illustration Måns Adolfsson

MarketView 2005:3