Select Committee on Treasury Written Evidence

Memorandum submitted by Citigroup

Citigroup welcomes the inquiry by the Treasury Committee (the Committee) into EU financial services regulation with a particular focus on the proposed framework Directive on Clearing and Settlement (the Directive).

  As part of this submission, we have commented on the Directive as outlined in the "Communication on Clearing and Settlement—the way forward" (the Communication) dated April 2004. In relation to the issues that we understand will be considered in the inquiry, you may find it useful to refer to sections 3.2 (The Need for a Directive), 3.3 (Principles to underpin the New Directive), 3.4 (Scope of the Directive as Proposed) and 4 (Conclusions) and Appendix 7 (Minimum Regulatory Standards) of the Citigroup response to the Communication dated July 2004 (enclosed—not printed).

  If it may be of assistance, Citigroup would welcome the opportunity to meet with the Committee and discuss this submission or issues relating to the EU clearing and settlement in general.


  1.1  It is widely recognised that the European Commission should only legislate in the EU financial services sector: (i) where there are demonstrated risks which are currently unregulated or under-regulated; (ii) where neither the market nor national laws can solve the problem; and (iii) where the benefits outweigh the costs.

  1.2  Citigroup considers that these criteria are satisfied in the EU clearing and settlement sector.

  1.3  The Directive should establish minimum standards that state principles rather than prescribing implementation methods, following the four-level approach embodied in the Lamfalussy procedure. The standards should be left to national authorities to implement, and cross-border implementation should occur through mutual recognition.

  1.4  All terminology should be defined to avoid confusion and in a way which will not limit the market's ability to innovate.


  2.1  Citigroup considers that the Directive should pursue the following policy objectives:

    2.1.1  Avoid regulation where need is not proven, and where market forces should be able to deliver a solution;

    2.1.2  Adopt risk-based functional regulation, and protect investors, market participants, and intermediaries from undue risks;

    2.1.3  Foster competition that will result in cost savings and innovation for the benefit of users.

Undue and double regulation should be avoided

  2.2  The Directive should not cover issues which the market can resolve. Regulatory requirements should not be imposed where risks are not shown to exist, or where an adequate regulatory response is already in place.

  2.3  Safekeeping, asset transfer and banking activities should be supervised to the minimum standards imposed on banks, regardless of the nature of the institution carrying out such activities, but should not impose additional regulation where the institution is already supervised by existing regulation to the minimum standard in such areas.

Appropriate risk-based functional regulation

  2.4  An appropriate approach to risk-based functional regulation should be adopted. The risks associated with different firms undertaking the same activities should be appropriately assessed, managed and minimized. The Directive should not follow an inappropriate form of functional regulation which requires that the same activities be subject to the same treatment, regardless of the institutions that perform them. Such an approach will not deliver the objectives of safety, efficiency, or a level playing field.

Minimum standards of risk management

  2.5  There should be minimum standards of risk management practices for market infrastructure, such as central counterparties (CCPs), central registers and central settlement institutions, that deliver an acceptable level of safety and soundness demanded by market participants and investors. In particular, in the absence of minimum safety standards, operational and credit risk management could be compromised in order to reduce costs and increase revenue because of the systemic risks introduced by centralized functions.

Minimum standards of supervision

  2.6  There should be minimum standards of supervision of CCPs and central settlement institutions by the home state competent authority. The rationale for such standards is to combat systemic risk, which is inherent in centralised functions, such as clearing and settlement, which in practice are provided by dominant firms in each EU Member State, including the UK. Investors are exposed to risk if the central register or settlement functions are not subject to minimum supervisory standards. If a CCP or central settlement institution carries out banking activities, systemic risk and investor protection issues are potentially compounded.

Mutual recognition

  2.7  CCPs and central settlement institutions should be given mutual recognition ("passport") rights to do business in other Member States, provided they are adequately supervised in their home state. The Directive does not need, however, to establish a uniform pattern of such rights. Mutual recognition through an "EU passport" is the best model since it introduces a degree of competition, is non-prescriptive, and is a familiar model in the financial services field.

Non-discriminatory access

  2.8  Conditions of access to CCPs and central settlement institutions should be non-discriminatory, risk-based, and transparent for all members. This principle is a vital underpinning to the "passport": an institution should not only have the right to go out to operate in other EU Member States, but should not apply discriminatory practices to would-be members who wish to come in to use it from outside the institution's home state.

Issuers' choice of access

  2.9  EU Member States should repeal laws and exchange rules which deny issuers freedom of choice of central registers and central settlement institutions. The grant of a "passport" to central settlement institutions will not of itself be sufficient to achieve this goal, as many of the obstacles are inherent in exchange rules. If issuers have no choice, central registers and central settlement institutions will not face effective pressure to improve the efficiency of specific services needed by issuers.

Coherence with existing regulations

  2.10  Coherence with existing EU legislation, such as the Settlement Finality Directive and the Financial Collateral Directive, is essential. It is of major importance that the definitions used in the Directive are consistent with those used in existing EU legislation and any imminent legislative measures. In this context, Citigroup welcomes the delay in the adoption of any ECB/CESR Standards which appear to be difficult to reconcile wholly with the European Commission's simultaneous initiatives.


  2.11  CCPs and central settlement institutions should, through governance standards, be subject to sufficiently robust separation of any monopoly business from services where they compete with others. CCPs and central settlement institutions are in dominant market positions, and may therefore undertake anti-competitive or abusive behaviour which cannot be addressed adequately, or promptly enough, by competitive forces or ex-post enforcement by competition authorities. Governance measures, including accounting separation and unbundling, are required if the risk of exploitative practices by dominant providers is to be contained effectively.


  3.1  In the Communication, the European Commission set out three key elements of the Directive, namely:

    3.1.1  rights of access and choice;

    3.1.2  a common regulatory/supervisory framework; and

    3.1.3  appropriate governance arrangements.

Rights of access and choice

  3.2  The provision of rights of access is pro-competitive and, if realised, would be likely to enhance competition in the EU clearing and settlement sector. However, in this context, there are several important risks outlined below which need to be noted:

    3.2.1  Ensuring issuers also have choice—If the provision of central register and settlement functions are not effectively unbundled, competition is restricted at both levels. In particular, in those jurisdictions where there is no choice, the lack of choice on the part of issuers to choose which central register they wish to use endorses and maintains the dominant position of that central registers. Alternatively, in those EU Member States where the central settlement institution is also the central register, it means that this central settlement institution faces little or no competition. No other central settlement institution will be able to compete to provide settlement services and have direct access to the central register without going through the existing national settlement system. Unless such links are unbundled (which is not necessarily the same as being divested), competition between central settlement institutions will be restricted.

    3.2.2  Inclusion of non-financial institutions—The current access model of clearing and settlement, where mainly investment firms and banks have direct access to clearing and settlement institutions, is implicitly supported in the Communication. While this appears to be the most efficient practice at present, it may be that in the future an alternative and more efficient model for clearing and settlement is built which is predicated on allowing free and direct access by other types of market participants to clearing and settlement institutions.

    3.2.3  Focus on implementation—Notwithstanding the pro-competitive intent of the Communication, the political process for finalising and implementing the Directive may mean that these rights of access are not in practice realised. This is most likely to happen either because onerous requirements are placed on firms wanting cross-border access to clearing and settlement institutions, or because exceptions are established which allow CCPs and central settlement institutions the right not to grant access to specified firms.

Common regulatory/supervisory framework

  3.3  The European Commission's proposal to establish a common set of high-level principles for the authorisation, regulation and supervision of EU clearing and settlement systems creates the following concerns:

    3.3.1  Regulation only where needed—Notwithstanding the stated intention only to impose regulatory requirements where the risks associated with a particular function might adversely affect prudential and investor protection goals, excessive regulation may in fact be imposed. There appears, for example, to be little evidence to date that matching or confirmation, which both appears to be covered by the Proposals in the communication, warrant EU regulation.

    3.3.2  Appropriate application of "functional regulation"—Functional regulation is only useful if it is applied in a risk-based manner. It should not mean, as the Communication stated, that "the same activities . . . [should be] subject to the same treatment . . . regardless of the institutions that perform them". Such an approach will not lead to the minimization of systemic risk and investor protection concerns.

  3.4  Risk-based functional regulation involves the assessment of the risks arising from a particular institution undertaking a particular activity. Any regulatory framework established should ensure that specific relevant concerns about systemic risk and investor protection are managed in a manner, where the benefits outweigh the costs of doing so. If, and only if, the same risks are faced by different institutions, does a risk-based functional approach require that the same regulation be imposed on different institutions.

Governance arrangements

  3.5  Citigroup has a number of concerns relating to the effectiveness of the provisions relating to governance in the Communication:

    3.5.1  Establishing appropriate level of requirements—Any additional governance requirement imposed need to be proportionate to the risks they are seeking to mitigate. Governance constraints should only be imposed: (i) to restrict anti-competitive or abusive behaviour; (ii) to promote systemic stability and investor protection; and (iii) where the benefits of doing so outweigh the costs.

    3.5.2  Where the possibility of anti-competitive or abusive behaviour is low, namely where a provider does not have a dominant position, and where existing regulation is sufficient to promote systemic stability and investor protection, the need for additional governance constraints is low and they should not be imposed.

    3.5.3  Enforcing unbundling—If the European Commission's proposals concerning unbundling are reflected in the final version of the Directive, which Citigroup considers is essential, they may be unenforceable. Evaluating whether an accounting separation is appropriate and fair is a complex and ongoing activity, and the European Commission will need to have the means of assessing firms' compliance with these requirements. The policy of unbundling is likely to be ineffective unless the Directive prescribes a common, industry-sensitive methodology on cost allocation, imposes the requirement that dominant providers provide standardised accounts in relation to both their dominant and competitive activities, and requires that such accounts be subject to regular external audits. In this respect, please refer to section 3.4.3 of the Citigroup response to the Communication for further information.

    3.5.4  Enabling effective competition in all relevant banking services—The European Commission's proposal in relation to what type of money should be used for settlement purposes has a major weakness. The judgment of whether a settlement system should use central bank money or commercial bank money constitutes a judgment on best practices in risk management, and is beyond the scope of this paper. However, if a dominant settlement system uses commercial bank money, requiring it to offer simply its users the alternative of settling in central bank money will not be sufficient to ensure that competition prevails in relation to the full range of relevant banking services (such as credit provision, securities borrowing and triparty repo services). Simply requiring central settlement institutions to provide an alternative offering will enable it to maintain de facto exclusive rights to offer all relevant banking services to the detriment of users, who would gain from competitive offerings from other commercial banks.


  4.1  As mentioned above, Citigroup considers that the Directive should include minimum standards of supervision of CCPs and central settlement institutions by the home state competent authority. Such standards are intended to combat systemic risk and provide investor protection and should include the following:

      4.1.1  The entity provides settlement arrangements which are legally, operationally and otherwise effective in all relevant jurisdictions;

      4.1.2  The entity's rules contain adequate provisions relating to insolvency and/or default, and the respective consequences;

      4.1.3  The entity has adequate arrangements and resources for effective monitoring and enforcement of its rules;

      4.1.4  The entity is prudently managed, in particular with internal systems and controls which are adequate for that purpose;

      4.1.5  The entity's activities are carried out with integrity and appropriate professional skills;

      4.1.6  The entity has financial resources in a form appropriate to and of an amount commensurate with the nature and scale of its operations and the risks to which it is or is likely to be exposed and which are sufficient for the proper performance of its functions;

      4.1.7  The assets of the entity are such as to provide it with liquid resources sufficient for the proper operation of its settlement arrangements and otherwise for the proper performance of its functions;

      4.1.8  The ownership structure of the entity does not result in any unacceptable conflicts of interest and is not in any other way a potential source of weakness;

      4.1.9  The entity has obtained and continues to maintain all authorisations, licences and consents necessary for the conduct of its activities in all relevant jurisdictions;

    4.1.10  The structure, organisation and procedures of the entity are such as to make possible the effective supervision of the entity;

    4.1.11  The entity is able and willing to co-operate, by the sharing of information or otherwise, with specified regulatory bodies; and

    4.1.12  The entity is required to notify the competent authority on the occurrence of specified events (including changes of control, member default, and failure by the entity to comply with any of these requirements)

8 December 2005

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