How Can Banks Prepare for Migration to TARGET2?

The Eurosystem has decided to implement the second generation of its large-value payment system, TARGET, in order to bring further harmonisation and additional services to users. The launch of the new system, called TARGET2, is planned for November 2007. TARGET2 will mark a significant change in the processing of large-value payments in euros, as it will be based on a single shared platform (SSP), whereas the current organisation relies on the interlinking of 17 national real-time gross settlement (RTGS) systems. Potentially 10,000 participants will be affected. In addition to the technical changes needed to connect to the future system, they will face structural evolution in their organisations. In order to ensure the success of such a complex and large migration, what do banks and central banks need to do?

The Scope of Migration

Current TARGET system

TARGET came into being with economic and monetary union (EMU). Two main objectives were assigned to the system when it began operations on 1 January 1999:

1. To act as a ‘channel’ for the transmission of the Eurosystem’s single monetary policy. For money market rates on the various euro area financial markets to level out, it was in fact necessary to have a tool that would make it possible to settle market operations in real time over the euro area as a whole.
2. To contribute to strengthening the security of large-value settlements thanks to RTGS, i.e., payments settled individually with immediate finality.

TARGET has fully attained these two objectives and is now the ‘backbone’ of euro area market infrastructures. With average daily transactions amounting to a value of €2,100bn, TARGET is one of the three largest payment systems in the world, along with the FEDWIRE system and CLS.

Why TARGET2?

TARGET was created on the basis of the national RTGS systems of the European Union Member States, which were linked (‘interlinking’) via the SWIFT network. This approach was motivated at the time by the imperative need for TARGET to be operational as from the first day of EMU. However, the counter side of this is that TARGET is based on a concept of minimum harmonisation, which limits the system’s ability to contribute to European financial integration.

TARGET2 will mark a significant change in the processing of large-value euro payments. It will be based on a SSP, which is being developed and will be operated by a group of three central banks (3CB), namely the Banque de France, the Deutsche Bundesbank and the Banca d’Italia.

Main characteristics

With TARGET2, the Eurosystem will contribute to European financial integration while keeping business relationships between national central banks and users decentralised. Its development has been driven by four principles:

1. Harmonisation: TARGET2 is harmonised both technically and functionally and is expected to bring about further harmonisation of business practices in large-value payments processing in the euro area. In technical terms, there is a single user interface and standardised payments message formats, with SWIFT as the network service provider. In functional terms, TARGET2 offers a comprehensive, standardised set of features. TARGET2 is also harmonised in terms of pricing and the principle ‘same service, same price’ is applied for all participants of the system, irrespective of their location.
2. Consolidation: The technical consolidation of TARGET2 is most notable, as it moves from the former ‘system of systems’ architecture to a single platform, which is jointly used by all participating central banks. The technical consolidation of TARGET2, its features and the harmonisation of interfaces and services will, in turn, enable the banks to consolidate the organisation of their large-value payments business and to integrate their euro liquidity management better at a European level.
3. Robustness: The SSP must satisfy demanding requirements in terms of robustness and business continuity measures. It is based on the most advanced technology and on a two regions/four sites concept. The payments and accounting processing services can run in either of the two regions, and each region has two identical sites available for immediate failover. Hence, in an emergency, an intra-region or inter-region failover can take place to restore full processing capacity within a short timeframe. In addition, TARGET2 will offer contingency procedures to process (very) critical payments under all circumstances in a timely manner.
4. Efficiency: TARGET2 improves cost efficiency, which benefits both users and central banks. The consolidation of the technical infrastructure considerably reduces the overall TARGET2 costs. In addition, it offers liquidity-saving mechanisms (e.g. payment prioritisation, reservation of liquidity for different payment priorities, bilateral and multilateral sender limits), intraday pooling of liquidity within groups of accounts, consolidated real-time information on account balances and queues as well as harmonised procedures for the settlement of ancillary systems.

Foreseen impact on industry

The SSP, on which TARGET2 is based, will enable real-time, integrated monitoring of the liquidity position in all RTGS accounts of a credit institution, or even a banking group, across Europe. Thus, multi-country banks will be able to manage the activity of their branches and subsidiaries from a single point and to centralise their cash management, which will include liquidity involved in the settlement of ancillary systems – as settlement of these systems will be performed over RTGS accounts after a transition period (maximum four years after TARGET2 goes live). They will be able to optimise their internal organisation for payments in euro, for example by centralising payment flows and liquidity management under a unique access platform and a common ‘group of accounts’.

It is expected that TARGET2 will contribute to the harmonisation of the business practices of its users and can therefore be seen as a stimulus for further consolidation. Indeed, TARGET2 is expected to help concentrate internal processes (such as treasury and back-office functions) and promote the harmonisation of ancillary systems interfaces throughout Europe.

Among other comparable high-value payment systems, TARGET2 will be the one that offers the most comprehensive and efficient optimisation and liquidity management tools. Nevertheless, a participant will benefit fully from these mechanisms only if it relies primarily on TARGET2 for the processing of its operations and for optimising its intraday liquidity, by issuing its operations as soon as they are ready to be submitted, without retaining them on its participant platform because waiting for the needed liquidity to become available.

The Way to Migrate

Several country groups windows

Twenty European countries will be using TARGET2 from the outset, which means that about 10,000 participants (1,000 direct and 9,000 indirect) will use TARGET2 to initiate payments on their own or on their customer’s behalf, and close to 53,000 entities worldwide could be addressed via TARGET2. Consequently, the change from 17 national RTGS systems to one centralised platform is a real challenge.

The idea of a European ‘big bang’ has been discussed and discarded, as the overall risk is considered to be too great. On the contrary, the migration to TARGET2 will be carried out by ‘country groups’ (see figure 1 below), allowing TARGET users to migrate to TARGET2 in different waves and on different predefined dates.

Each wave will consist of a group of central banks and their respective national banking communities. The number of migration groups will be limited to four. TARGET users will only be allocated to the first three groups, while the fourth one will be reserved for contingency purposes.

A central bank and its whole community will migrate simultaneously. Two main migration models have been identified, with obvious business implications in opting for one or the other model:

1. The ‘migrate all at once’ model, where all current systems will be dismantled at the moment the central bank migrates to the SSP. All transactions would be included in the SSP from day 1, meaning that all migration actors would have to be prepared to settle directly in the SSP from day one.
2. The ‘no compulsion, no prohibition’ model, where some pieces of the current infrastructure will coexist with the SSP for some time, in order to cater for internal needs. Only part of the transactions will be settling in the SSP from day one, the rest of the business being gradually moved, hence reducing the impact on other systems/participants.

For example, as Banque de France has decided to allow the French banking community to reap all the TARGET2 benefits as soon as possible, it will dismantle all its current systems at the time of the changeover, which means that its migration to TARGET2 requires all participants’ readiness to join the SSP at once.

In contrast, in Portugal, where the current RTGS system will be kept largely untouched, and all changes required to migrate to the SSP are at the central bank’s level, participants’ readiness should not be a critical issue.

The need to define roles and responsibilities clearly

From the outset of the project, the Eurosystem has clearly defined all the stakeholders and assigned to them roles and responsibilities, being highly transparent on the governance of the project:

• Level 1 of governance, which is the Governing Council of the ECB, is the ultimate decision-making body for TARGET2.
• Level 2 of governance covers the participating central banks, and is responsible for the overall migration to TARGET2. The Level 2 Central Banks are responsible for adjusting their internal systems and interfaces to the SSP specifications. Each has set up its own migration project plan and has to make sure that itself, its customers and the national banking community can migrate the payment processes to the SSP.
• Level 3 of governance (3CB) builds and operates the SSP service on the basis of the General Functional Specifications and the User Detailed Functional Specifications for the benefit of the participating CBs. The 3CB are responsible for the provision of all technical tools, procedures and resources necessary to provide the SSP services. On demand and to a reasonable extent, they provide technical support to the participating CBs with regard to their migration activities.
• SWIFT, vendors and other service providers are responsible for the preparation of the respective deliverables.
• Groups of users/forums are responsible for providing input and alleviating communication and coordination among their members.
• All TARGET users are responsible for their own readiness and migration.

Identification of critical players

Within each national banking community, there are some players without whom the migration to TARGET2 could not be envisaged, owing to the systemic risk this would entail or to the negative impact it would have on the smooth functioning of TARGET. These players can be central banks, credit institutions, ancillary systems or even third-party providers. Consequently, the readiness of such critical players should be one of the main criteria for the final decision of a national community to migrate. This is particularly true for countries that have adopted the so-called ‘migrate all at once’ model.

As a first step, central banks identify their critical players, based on the ‘migration model’ chosen. Once this identification has been done, the second step consists in involving them more actively in the migration project, to monitor their preparations more closely and possibly to envisage fallback arrangements to settle their transactions once their central bank has joined the SSP.

A well-organised user test campaign is essential

After a phase of acceptance testing, during which the participating central banks will check that what has been developed by the 3CB complies with the initial requirements, the Eurosystem will launch a user testing phase of several months (six months for the first window, 11 for the third window). To meet the objective of a smooth transition to the new TARGET2 system and environment, it will aim to verify that all involved parties:

• have designed and developed TARGET2-related software (access platform) compliant with the agreed specifications.
• have installed sufficiently robust and safe infrastructures meeting the throughput requirements.
• are ready from a business, operational and procedural view point for the ‘go-live’ of TARGET2 operations.

In order to do so and to contribute to an efficient and effective testing organisation, the testing strategy defined by the Eurosystem will:

1. Comply with the defined requirements: Deliverables in terms of testing will always be validated against agreed requirements known and defined in advance. Detailed testing scenarios have to be agreed by the responsible parties in advance and should not leave room for different interpretation.
2. Set clear and effective procedures: All detailed test scenarios will be finalised and formally approved before the actual tests are performed (including clear entry and exit criteria and detailed time schedules for all activities and checks to be performed).

After each testing phase, a test report summarising the outcome of that phase will be prepared by the involved central bank(s). Each test will have to be assessed against the pre-defined criteria as ‘successful’, ‘partially successful’ or ‘not successful’. For each test with the results ‘unsuccessful’ or ‘partially successful’, this report will indicate its level of criticality, the proposed workaround (if any) and the proposed action plan in view of its resolution. The general objective of the user tests is to give sufficient confidence to level 2 that TARGET users are able to make use of the application in the production environment and that the whole system is sufficiently reliable, that the procedural framework is operationally stable and that central banks’ staff is sufficiently trained.

A national banking community will be ready to migrate if, and only if, the following conditions are met:

• Firstly, all critical players should have successfully completed all mandatory tests.
• Secondly, special attention will be brought to the group of non-critical players that failed the tests and for which there is no other alternative way to settle once their central bank has joined the SSP. Appropriate measures should be in place to ensure that this group would not create a systemic risk or have a negative impact on the smooth functioning of TARGET2.

Four user testing phases

Four user testing phases are foreseen as illustrated in Figure 1.

1. Connectivity testing: This testing phase aims to verify the ability of each TARGET user to connect technically to the SSP via SWIFTNet, hence detecting as early as possible any showstoppers, which might hinder or delay the start of consecutive user test phases.
2. Interoperability testing: This phase aims to verify that each user is ready to operate on the functional level according to the specifications and does not affect the system by, for example, sending invalid messages/requests. It also enables the TARGET users to test in free testing mode, hence allowing them to run any other test activity that they would deem appropriate.
3. Country testing: Country tests aim to demonstrate the ability of the national TARGET2 user community to make use of the application from a technical and procedural/operational viewpoint. This will also include testing of specific procedures in force at the national level and the training of operational staff in TARGET2 procedures including the changeover from TARGET1 to TARGET2.
4. Business day testing: The character of business day testing can be best described as ‘dress rehearsal’ and aims to test what has not been covered in earlier steps (mostly procedures having cross-border dimensions), since it involves all the countries migrating in the same window. In particular, the changeover from TARGET1 to TARGET2 is rehearsed during this phase.

A specific tool has been developed by the Eurosystem to support the user testing phase: the TARGET2 Test Related Information System (T2TRIS) is a web-based application designed to facilitate coordination and communication between all stakeholders. The T2TRIS is available to all TARGET2 users via the ECB’s TARGET2 website, and provides them with all information relevant to the preparation, planning, actual performance of and reporting on TARGET2 user testing activities.

Banks must be well prepared

For 9,000 of the 10,000 TARGET users in Europe, internal preparation should be rather light, as they will be indirect participants and will rely on their direct participant. However, for the remaining 1,000, the migration to TARGET2 is not a simple enhancement or a new release to an existing system. It will have a deep impact on organisations. They need to address strategic choices, business decisions and operational issues as well as technical problems. This is particularly true for banks with multi-country presence.

For a multi-country bank group, TARGET2 can deeply affect the group’s organisation, as it calls for a reassessment of the number of central bank accounts in euro, the model for the minimum reserves constitution, the repartition between direct and indirect participation within the group, the potential use of alternative payment systems, the commercial relationships with other banks, and access to and participation in the numerous ancillary systems (cash, securities and foreign exchange) which will settle in TARGET2. TARGET2 will be at the centre of the euro payments world; that is why preparation of these multi-country players needs to be timely, comprehensive and thorough, supported by rigorous testing.

The French Case

A ‘migrate all at once’ model

Given that TARGET2 will replace France’s two large-value payment systems (Transferts Banque de France (TBF) and Paris Net Settlement (PNS)), the French banking community worked intensively, even before the end of 2002 public consultation on TARGET2, on defining its requirements with regard to the future system.

This enabled it, in addition, to play a very active role right from the start of European banks’ work on TARGET2. The French community’s migration to TARGET 2 represents a strategic risk: it is a collective and complex operation which is similar to a national big-bang. The migration concerns a large number of players, and its schedule does not allow for any delay: the user tests began in May 2007, and changeover to TARGET2 is in February 2008.

In addition, other major changes will be implemented at the same time in the field of payments, securities settlement and collateral management. In fact, the French securities settlement system, RGV2, will migrate to the new Euroclear platform ESES in November 2007, whereas the unique French Retail Payment System, SIT, will be replaced by a totally redesigned system, CORE, towards the end of 2007. Meanwhile, Banque de France, answering a demand from the French banking community, is taking advantage of TARGET2 as well as a new French legal framework for financial collateral arrangements, to change its guarantee management mechanism. Therefore, the ‘collective’ and ‘big bang’ aspects of this operation require strong coordination, which is achieved via well-defined project structures and plan.

Project structures

At the strategic level, the TARGET2 project is regularly monitored by the highest representatives of the French Banking Federation. The monitoring was based on work carried out by a special task force led by the Centrale des reglements interbancaires (CRI), which liaises with the European banks’ TARGET Working Group.

At the operational level, the French financial community’s work on migration to TARGET2 is led by Banque de France and based on a ‘migration’ committee, assisted by a technical group, which liaises with the Eurosystem’s working parties on TARGET2.

Project plan

The project plan aims to set the rules of the coordination; it defines mainly the following:

• Project team membership and responsibility: the project team is led by Banque de France and is composed of the 17 French critical players.
• Identification of the project tasks: the project is composed of 14 tasks. Each task consists of identifying the corresponding prerequisites, the covered activities, the produced deliverables and the acceptance criteria for these deliverables.
• Definition of the macro planning mentioning time constraints and expected dates for the deliverables. The expected dates for deliverables provide common reference planning for the whole French community.
• Definition of the deliverable matrix including a complete list of all deliverables together with all the relevant information, notably, expected delivery date (or delivery frequency), author, distribution information etc. In a nutshell, the project plan states what is to be done, by whom and at what time. Banque de France closely monitors the progress of each critical player by:
• Obtaining accurate individual information from the critical players, through regular questionnaires and meetings.
• Analysing and summarising this information in a monitoring sheet that is communicated to the critical player project management. Information collected from the critical players is compiled, consolidated and reported to the Migration Committee as well as the Eurosystem, without identifying the individual players.

Complete and timely information

In addition to the coordination of the work stream, Banque de France makes sure to circulate the information that allows all financial market players to lay the groundwork for their migration to the new system. This information is disseminated mainly via the Banque de France website (www.banque-france.fr, ‘Payment and securities settlement systems’ bookmark, under TARGET2), but also via regular functional workshops, publication of an information letter on TARGET2, and e-mail exchanges for ad hoc queries.

Conclusion

Migrating to TARGET2 is at the same time an opportunity and a challenge. This is an opportunity for banks and central banks to rationalise their organisation of euro liquidity management, which will allow financial benefit only if they consider the migration to TARGET2 as a real reorganisation project and allocate sufficient resources to it. This is also a challenge for them, as the deadline for the launch of TARGET2 has to be met by all, whatever the workload needed to reach it. Consequently, the migration process from TARGET to TARGET2 has to be carefully planned and coordinated at all levels – Eurosystem, central banks and participants – and a thorough and comprehensive user testing campaign will take place for more than six months. Good cooperation between the owners of TARGET2 and the participants all along the project will be a critical factor in the successful launch of the system and its acceptance by users.

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