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* Banks eye move into settlement as collateral becomes king
* Euroclear says welcomes fair competition
* Draft EU settlement law may split up some operators
By Huw Jones
LONDON, Feb 28 (Reuters) - Banks are looking to break into the last bastion of Europe's securities market, the settling of trades, to meet growing pressure from regulators for safer trading backed with collateral.
Bank of New York Mellon and other lenders may bypass Euroclear and Clearstream to build their own settlement houses, several industry officials said. Settlement is whereby legal ownership of a security is swapped for cash.
"We are aware they are one of several banks that may be thinking of setting up a central securities depository (CSD). In Europe, it would be the first time," said Paul Symons, director and head of public affairs at Euroclear.
"Euroclear Bank already operates in a highly competitive environment. We welcome additional competition, provided it is done on a level regulatory playing field," Symons said.
Other industry sources say BNY Mellon may be looking at operating a CSD out of Ireland and may not wait until a new EU law has been approved. The bank had no comment after repeated requests.
Banks want to exploit two developments: a new EU law that will tear down cross-border barriers by giving a Europe-wide "passport" for CSDs; and the European Central Bank's Target 2 Securities (T2S) platform for settlement of stock and bond trades across the 17-country euro zone from 2015.
Some banks hope for first mover advantage by creating a CSD even before T2S or the EU law are in place and industry officials say the central aim is not so much the "plain vanilla" settlement of trades as T2S would handle that.
Banks with their own CSD could plug into T2S - only CSDs can have direct access - to offer EU-wide collateral services as regulators want trades backed by cash or top quality assets to limit fallout if things go wrong.
The European Commission said its draft law aims to promote competition and make the system safer. Barriers being targeted include requirements for issuers to issue in their national CSDs or for market participants to settle in their national CSDs.
A copy of the draft obtained by Reuters said settlement houses would also have the right to link up with rivals and have access to trading feeds from any clearing house.
The EU has already opened up trading to competition and is approving laws to make it easier for clearing houses to compete too. The draft EU law on CSDs would open up the final leg of a transaction to competition.
The draft law says the lack of competition helps to keep transaction fees high and inhibit trading and investor choice. The draft law could be published as early as next month.
"CSDs play a crucial role for the collateral market especially for monetary policy purposes," a draft said.
"For instance, almost all of the eligible collateral for central bank monetary policy operations in the EU, especially in the euro area, flows through securities settlement systems operated by CSDs," the draft added.
Diana Chan, chief executive of EuroCCP clearing house, said a more efficient collateral management service is something banks want to get into.
"The ability to transform and move around collateral will be key. The combination of the new central securities depository regulation and T2S will radically alter the landscape and make it easier to shift collateral around," Chan said.
There are over 30 CSDs in the EU that settled 920 trillion euros of trades in 2010, the EU draft says. Due to T2S many will have to look at other ways to generate revenue, with Spain's Iberclear for example setting up a derivatives trade repository.
The draft has been repeatedly delayed because it contains a contentious proposal to stop CSDs from holding licences to carry out banking activities which regulators see as risky.
There is still a debate inside the Commission over whether to include this in the final proposal. Even if it stays intact, it would still likely face resistance as EU states and the European Parliament have the final say.
Five settlement houses, Euroclear Bank, Deutsche Boerse's Clearstream in Frankfurt and Luxembourg, Keler of Hungary and OeKB in Austria would have to split banking activities from core CSD operations, Euroclear's Symons said.
This would create a dangerous, inefficient and untested model, Symons said.
"We don't know of any regulator or central bank that has called for such an interventionist approach. Given the large amount of government debt business we handle, we think this could have a significant negative effect on financial stability if you seek to split up the market infrastructure that is already working effectively," Symons added.
Clearstream had no immediate comment on the draft law.
The draft seeks to harmonise the period between a trade and settlement to two days. CSDs would have to hold capital, retained earnings and reserves to cover at least six months of operating expenses.