* EU eyes system of transferring ownership of bonds, shares
* Draft law aims to open up settlement to competition
* Euroclear Bank, Clearstream could face costly revamp
By John O'Donnell and Huw Jones
BRUSSELS/LONDON, March 7 The settlement of share and bond trades in the European Union will be thrown open to competition and close scrutiny under a draft EU law published on Wednesday.
Settling trades, the final step in any deal where ownership of a bond or share is transferred to the buyer, relies on a multi-trillion euro system to swap legal title to a security in return for payment.
The system stood up well during the financial crisis and none of the 30 central securities depositories (CSDs) in the EU needed support.
But the European Union's financial services chief Michel Barnier wants to turn this fragmented landscape into a more efficient, better regulated system to cut cross-border trading costs for investors.
"Settlement is a crucial process for the securities markets and the financing of our economy," Barnier said in a statement.
Before the market for trading shares and bonds became electronic, investors depended on a paper certificate as proof of ownership. With new technology, this was reduced to an electronic tag, held in a CSD such as Euroclear.
When trades take place, sellers instruct the depository to deliver ownership of the share, bond or other security, switching the name on the electronic record once payment is received.
Many exchange operators earn handsome profits from CSDs. Deutsche Boerse, for example, owns Clearstream Frankfurt and Clearstream Luxembourg, where it directs most trades from its exchanges.
Reuters reported last week that banks like Bank of New York Mellon are already considering how to compete with settlement houses like Euroclear and Deutsche Boerse's Clearstream.
The draft law will set the parameters for competition and accelerate fundamental changes already under way in the sector.
The European Central Bank will launch a basic Europe-wide settlement service for stocks and bonds in 2015, forcing CSDs to find new "value-added" business, like managing collateral.
The draft law will for the first time give authorised CSDs a pan-EU "passport" operate across the 27-nation bloc - as long as they are adequately capitalised and comply with safety rules.
It also allows a bank or broker trading in one EU state to use a CSD in any other member state and prohibits a CSD from discriminating against a customer.
Settlement is the last of three main market infrastructure sectors to be opened up to competition. The EU has already opened up trading and clearing to new entrants.
"It's an arcane bit of the plumbing, but it's absolutely vital," said Graham Bishop, a member of a European Commission expert group which made recommendations to improve the working of this market roughly a decade ago.
"We identified many problems in this market more than 10 years ago," he said. "But many of the players, whether it be banks or exchanges, resist bitterly because new laws often mean losing a chunk of profit."
The draft law bans a CSD from carrying out many banking services, a move, which if approved, would force Euroclear Bank and Clearstream's Frankfurt and Luxembourg operations to separate out basic CSD operations from banking services. CSDs in Austria and Hungary would also be affected.
The European Commission said CSDs that provide banking services as well are exposed to more risks and a greater likelihood of suffering a default - an argument Euroclear and Clearstream have vigorously opposed.
If a national regulator thinks a CSD that also offers banking services is safe it can make a "reasoned request" to the European Commission for exemption from the rule.
Questions over the ownership of securities are central to the smooth working of a market. Lehman Brothers had offered bonds and shares that its clients owned to others as security, which led to the panic that broke out after the bank's collapse.
The patchwork of national regulations makes the marketplace highly complex, because laws differ across countries. One of the aims of the draft legislation is to harmonise settlement times to a maximum of two days following the trading day.
There would also be penalties on banks and brokers that fail to settle trades on time and fully "dematerialise" securities - recording their ownership electronically rather than with paper certificates - by 2020.
The European Parliament and EU states have the final say on the draft law and changes are often made during the approval process.