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ECONS528: FINANCIAL MARKETS, GOVERNANCE AND REGULATION

CHAPTER VII: THE SECURITIES AND DERIVATIVES MARKETS

Pierre Francotte2013-14

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Reading

• Harris, Larry (2010), « The Economics of Trading and of Regulated Exchanges » in « Regulated Exchanges: Dynamic Agents of Economic Growth », Oxford University Press, New York.

• Cantillon, Estelle & Yin, Pai-Ling (2010), « Competition between Exchanges: A Research Agenda », in International Journal of Industrial Organization, 29(3), May 2011, 329-336.

• CEPS (2011), MiFID 2.0, Casting New Lights on Europe’s Capital Markets, Brussels.

• CPSS-IOSCO (2001), « Recommendations for Securities Settlement Systems », CPSS Publ. N° 46 (November).

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Reading • CPSS-IOSCO (2011), « Principles for Financial Market

Infrastructures », consultative report (March).• CPSS-IOSCO (2004), « Recommendations for Central

Counterparties », CPSS Publ. N° 64 (November).• Gorham, Michael (2010), « The Long Promising Evolution of

Screen-based Trading », in « Regulated Exchanges: Dynamic Agents of Economic Growth », Oxford University Press, New York.

• Harris, Larry, editor, « Regulated Exchanges: Dynamic Agents of Economic Growth », Oxford University Press, New York.

• Schwartz, Robert.A & Francioni, Reto (2004), Equity Markets in Action, Wiley, Hoboken, New Jersey.

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CONTENTS

IntroductionI. Holding and TransferII. InfrastructuresIII. Regulation of Securities and Derivative

Markets

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INTRODUCTION

• Different holding and trading structures for securities and derivatives:– Trading is done through separate channels (OTC and exchanges)

• some exchanges offer both securities and derivatives trading, but through separate channels/platforms

– Netting done through separate CCPs• some CCPs offer netting for both assets, but again through separate

channels/platforms

– Settlement only for securities, not for derivatives:• settlement for securities in CSDs• settlement of derivative contracts typically through cash payment or

delivery of goods• trade warehouses for derivatives, but only databases, not records of

ownership (unlike CSDs).

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I. HOLDING AND TRANSFER

A. Holding and transfer of securitiesB. Holding and transfer of derivatives

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A. Holding of securities

• Securities holding through a « multi-tier » chain of intermediaries connecting ultimately:– end investors – to the issuer of the securities.

• Ownership rights over securities preserved if proper segregation from intermediaries’ own assets at each level of holding.– precise rights and conditions for ownership preservation

depend on applicable legal system,– greater complexity when chain of intermediaries in different

countries (because different legal systems and need to ascertain which court would apply which law).

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Transfer of securities

• Transfers are:– agreed through trading– effected through settlement– often, but not always, after netting.

• What is clearing?– process –after trading- of calculation of the respective

obligations to pay and deliver the securities• it is often confused with netting or settlement (e.g., « clearing

houses »), but• separate step needed prior to netting or settlement, normally

effected by the netting or settlement institution.

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Securities trading chain

SETTLEMENTCSDs CUSTODIAN BANKS

NETTING (NOT ALWAYS)

CCP

TRADING

EXCHANGES OTC

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Trading

• Trading is the agreement between the parties to make a transaction (sale, pledge, etc).

• It requires agreement on all key elements:– object: which (ISIN #) and how many securities– price– time: delivery date

• Key elements must be « matched » (confirmation).

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Netting

• Netting consists in transforming multiple obligations between several parties in a single debt or claim by party.

• Debts to counterparty are « novated » to become new debts to CCP (new contracts replacing old one).

• The debts to pay for/receive securities must be:– certain (not subject to conditions)– already due and payable (not with different future time

schedules)– in same currency/ for same securities (ISIN #).

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Examples of netting

• Example of bilateral netting through CCP:– A owes 100 to B and B owes 300 to A– Netting:

• B owes 200 to CCP, and • CCP owes 200 to A

• Example of multilateral netting through CCP:– A owes 100 to B, B owes 300 to C, C owes 500 to A– Netting:

• A has claim of 400 on CCP• B owes 200 to CCP• C owes 200 to CCP

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Netting vs trading/settlement

• Trading and settlement are required steps for every transaction, whether on exchange or OTC.

• Netting is not required, but:– in last two decades, most equity markets have set

up CCPs (exception: Spain, but coming)– bond transactions, including for government bonds,

and repos also netted in practice– authorities are pushing for more transactions

(especially derivatives) to go through CCPs.

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Settlement

• Settlement is the transfer of securities and, where relevant, cash, to execute the trade obligations.

• Physical settlement extremely rare – done by credits/debits in accounts with CSD or intermediary.

• Practice in most markets is settlement 3 days after trading (T+3):– Germany is T+2,– EU pressing for shift to T+2 across EU to reduce market risk

and residual counterparty risk,– some emerging markets are still on T+ 20 or 30 for some

securities.

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Against payment or free of payment

• Most transactions involve the transfer of securities in exchange for cash: – examples: sales, securities lending, repos, pledges– called « against payment » (A/P)

• Settlement of some transactions involves only the transfer of securities with no cash involved:– example: realignement from one account to another,– called « free of payment » (FOP).

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Delivery versus payment (DVP)

• A/P transactions typically link the finality of transfers of securities and transfers of cash (DvP):– party gets final receipt of the securities only if the other

party gets final receipt of the cash and vice versa.– removes credit risk (counterparty risk):

• buyer gets the securities and seller gets the cash, as intended, or• at worst, buyer keeps its money and seller keeps its securities,

but neither party is ever without both cash and securities.

• DVP is cornerstone of risk-controlled settlement: – disconnected transfers of cash and securities highly

frowned upon by regulators and now very rare.

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DVP vs transfer of ownership

• DVP (finality of transfers) is determined by rules of CSD or intermediary settling transactions– finality means the CSD/intermediary will not reverse

credits, even in case of default/bankruptcy.• But transfer of ownership of securities is separate

matter and is determined by law:– in some countries: ownership transferred at time of

agreement (trading)– in other countries: ownership transferred at time of

execution of contract (settlement).

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B. Holding of derivatives

• Derivatives are contracts, not negotiable instruments:– not held through chain of intermediaries– copies of contracts and contract details kept by

each party.

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Contract terms

• Derivatives contractual terms are generally a combination of:– a master agreement (e.g., ISDA master agreement) which

set the generic rules for all contracts concluded pursuant to it,• must be signed by both parties

– the specific terms of individual derivative transactions (e.g., amount, price, etc):• agreed over the phone or electronic platforms (for OTC

contracts) or through exchanges (on-exchange trading),• must be later confirmed in writing (normally within a few days).

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Backlogs

• In practice, transactions are sometimes conducted before master agreement is signed and confirmation of contract specifics often missing for several weeks or months.

• Backlog has represented a significant exposure for individual banks and globally,– led regulators, especially in US, to threaten to prevent

further activity by dealers that did not tackle backlog quickly,– prompted emergence of new services of data warehouse

(trade repository) and matching support to help dealers reduce backlog on time.

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Trade warehouses

• Databases offered by a third party:– records major elements of contracts – allows parties to identify and resolve mismatches.

• Main trade warehouses are DTCC (« DerivServe »), but so far mainly for CDS contracts, and Tri-Optima for interest rates

• other provider: Euroclear• competing solutions being developed by derivatives exchanges

because of strategic and financial value of data (e.g., CME).• EU would like development of a European solution (concern

about the exclusive US regulatory oversight).

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Trading and netting of derivatives

• Derivatives can be traded OTC or on exchange:– 95% of derivatives outstandings are OTC,– on exchange trading requires standardisation of

derivatives contracts.• Netting of derivatives can be done through

CCP:– same legal novation mechanism as for securities– limited netting so far – also requires

standardisation.

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Close-out netting

• Key clause in master agreements is close-out netting – key to reduce counterparty risk:– in case of default under a given contract by a

counterparty, allows party to accelerate and net out payments under all other derivative contracts with defaulting counterparty,

– but effectiveness requires that contract has been signed and be legally enforceable in relevant jurisdiction.

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II. THE SECURITIES AND DERIVATIVES INFRASTRUCTURE

1. Exchanges2. Central Counterparties (CCPs)3. Central Security Depositories (CSDs)4. International CSDs (ICSDs)

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1. Exchanges

A. What is an exchange?B. Main characteristics of exchangesC. ServicesD. Annexes

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A. What is an exchange?

• An exchange is a « market »: a place where goods are sold and bought:– based on multilateral arrangements – governed by non-discretionary rules (cf MiFID).

• Goods can be:– securities: stock and bonds exchanges– derivatives: derivatives exchanges– commodities: commodities markets, etc.

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Regulated exchanges

• « Regulated markets » (or regulated exchanges): authorised as operators of markets, as opposed to:– OTC, and also– variety of bilateral or multilateral facilities that

are extensions of internalisation by broker-dealers and that are subject to some, but not all, the regulations applicable to regulated markets:• in EU: MTFs, Systematic Internalisers, etc

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B. Services

• Historically core services:– listing of new stocks (IPOs)– trading (for securities and for derivatives)– clearing (for derivatives)

• But have added a number of other services over time, due to:– pressure on trading revenues, and– pressure to meet for-profit objectives following

demutualisation.

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Additional services

• Additional services include (varies per exchange):– sale of data and information, including data analytics– transaction reporting for clients to regulators – services to issuers, e.g.:

• help create visibility for company• help company communicate electronically with (potential)

investors in market-ready format,

– technology services:• outsourcing of IT platforms to other exchanges• leverage of exchange’s IT by banks• co-location of computers with clients’ computers.

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Expansion into post-trading

• Several exchanges own CCPs and/or CSDs:– most derivative exchanges have their own integrated

clearing and netting (CCP) services:• CME• ICE• Deutsche Börse (Eurex)• NYSE-ENX (LIFFE)

– several stock exchanges control CCPs and/or CSDs:• Deutsche Börse: German CCP+CSD, ICSD (Clearstream),• Nasdaq-OM: Nordic CCP, CSDs in Baltics and Iceland,• LSE: Italian CCP+CSD and LCH.Clearnet• in contrast, NYSE-ENX owns no equity CCP and no CSD.

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Diversification of revenues

• Multi-service exchanges generate substantial part of revenues from ancillary services Year: Q3,2011(exc LSE: 2010)/Source: SE’s sites.

40.00%

2.50%

22.00%

33.00%

LSE

50%32%

17%

NYSE-ENX

12%

41%35%

11%

DBörse

Equities trading & listingDerivatives tradingPost tradingIT & Data

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C. Main characteristics of exchanges

• Objectives• Liquidity• Market models

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Objectives of exchanges• Several objectives of different nature, as per Schwartz-Francioni

approach (equity markets):– macroeconomic: capital allocation through secondary market– microstructure: fair and orderly price discovery– legal: investor protection through

• laws and regulations• self regulatory role of exchange

– operational: reliability• systems availability and data integrity• scalability (volumes) and response time (loop)• speed (latency)

– social: equal treatment in terms of • availability of public information from exchange• access by individual members.

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Liquidity

• Defined as « ability to quickly trade substantial size at low cost when wants to trade »– Low cost: width of market (cost for a given quantity)– Size: depth of market (ability to trade quantity at given

price)– Quickly: immediacy (time required to arrange a trade of

given size at given price)• Liquidity is a major factor of attractiveness of an

exchange, as it reduces bid/offer spreads (costs).– exchanges’ market models and algorithms are designed to

increase liquidity of market.

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Market models

• Market models of exchanges designed to achieve these various objectives and to make the exchange efficient (including by maximising liquidity)

• Different types of market models:– Continuous or call auction markets, and– Order-driven or quote driven markets.

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Continous vs call auction

• Continuous market: – orders to buy/sell matched on a continuous basis.

• Auction/call market: – orders to buy/sell batched at a given time of day and

matched only then.• Trade-off is between flexibility and liquidity.• Many exchanges combine both models:– auction to start the day and sometimes later in the day

at pre-determined times, and– continuous the rest of the day.

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Order-driven market

• Market prices set by the balance of supply and demand with price set so that the largest volume of financial instruments can be traded.

• Main advantages:– transparency– certainty for investors that trade takes place in

accordance with order• Main disadvantage:– potential lack of liquidity.

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Quote-driven market

• Registered “market makers” are required to display bid and offer prices, and in some cases the maximum ticket size to which these prices relate.

• Main advantage:– Liquidity: market makers are required to meet orders for

which they provide quotes.• Main disadvantage:

– lack of transparency: unlike an order-driven market it does not show the flow of individual orders.

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D. Annexes

1. Competitive environment2. Major exchanges and other trading venues3. Main current issues

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Annex 1. Competitive environment

• Exchange environment deeply transformed in last 25 years, triggered in particular by:– regulatory steps, including:• removal of fixed commissions• incentives for competition (Reg NMS in US and MiFID

in Europe)

– technology innovation and in particular screen based trading, and

– demutualisation.

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Regulatory easing

• Originally exchanges were largely « clubs » with protective rules, such as:– fixed commissions (imposed on transactions with non-

members and commission unrelated to size of order)– exclusionary membership rules and exclusive access to trading

for members– prohibition for members to be incorporated or quoted

companies– obligation for members to bring all their business.

• No real competition between trading venues (e.g., between NYSE and Nasdaq).

• Costs passed on to members’ clients (in particular retail).

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Regulatory easing – Cont’d

• Regulators took actions to reform securities and exchange activities in 1970s-1990s:– US: mid-1970s to 1990s

• main objective: reduce costs for consumers and avoid excessive fragmentation.

– EU: various directives (starting with ISD 1993)• main objective: European integration

– UK: Big Bang 1986; Japan: Big Bang 1997.• Dented protectionism for members and exchanges:

– reduced costs for consumers– reduced margins of privileged members– increased competition.

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Reg NMS and MiFID

• Reg NMS (US) and MiFID (EU) implemented in 2007.

• Many rules, but some specifically to create more competition between exchanges and from alternative trading venues.

• Effectively impose that orders be directed to trading venues offering best execution – Reg NMS: rule of « order protection » (forces routing

to lowest price venue)– MiFID: rule of « best execution » (not just price).

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Screen based trading

• Screen based trading has replaced almost entirely open-outcry (voice) trading since mid-1980s.

• Originally resisted by users of established exchanges (especially stock exchanges), slowing down the SEs’ ability to adapt to competition.

• Had massive impact on market, including on:– competitive landscape– costs– risks

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Impact – competitive landscape

– allowed exchanges that adopted it to gain market share from laggard exchanges:• DTB went from 30% to 100% of market share of bund

futures market from LIFFE over 1995-98• CME jumped from 50% to 97% market share of US

futures over 2004-08 by acquiring NYMEX and CBOT leveraging its screen-based edge.

– facilitated the development of alternative trading and matching venues that compete with SEs:• Alternative Trading Systems (ATS)• Multilateral Trading Facilities (MTFs).

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Impact – competitive landscape - Cont’d

– allowed development of algorithmic and high frequency trading:• manual trading took minutes, • screen-based trading takes milliseconds

– prompted new services (and fees) by exchanges:• co-location of computers of client and exchange• outsourcing of IT platforms (facilitating future

alliances or mergers).

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Impact - cost

– increased volumes massively, allowing to reduce cost:• reduced bid/ask spreads (by over 90% vs 1990s)• lower broker-dealer trading fees (by 90-95% vs 1980s)• lower price of data for traders• lower exchange fees, but not as much (as exchanges

had become for profit, they looked to benefit from growing volumes).

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Impact - risk

– facilitated direct access to exchange by underlying customers (e.g., hedge funds), although still under responsibility of broker,

– reduced manual errors and risk of manipulation after the trade,

– but created new types of risk, with potentially bigger financial impact:• manual mistake in using screens (« fat finger»),• programming bugs or design mistakes in softwares,• domino impact of algo trading programs• manipulation through HFT (e.g., cancelling of orders).

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Demutualisation

• From 1700s to 1990s, exchanges were:– de facto monopolies (often de jure as from 1980s),– not-for-profit mutuals (owned by users),– largely self-regulated.

• Demutualisation:– starting in 1993 (with Sweden) - now almost all,– caused by opportunities (growth of cross-border

business), but also conflicts of interests within boards,– transformation into publicly-quoted, for-profit firms,– typically self-listing.

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Impact - demutualisation

• Triggered fundamental changes:– in business approach:

• forced much greater discipline (quoted companies)• gave strategic and financial means to invest • gave acquisition currency (listed shares), fuelling M&A activity.

– in relationship with clients (no longer shareholders)• less cosy/consensual • competition with users• spurred IBs’ backing for MTFs (Turquoise, Chi-X, etc)

– in relationship with regulators• no longer seen as quasi-arm of governments/regulators• reduced regulatory/market surveillance role in most countries• self-regulation no longer acceptable• prompted adoption of Reg NMS and MiFID.

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Consolidation

• Consolidation:– first within countries

• NYSE and Nasdaq acquired local exchanges within US,• CME acquired CBOT and NYMEX• domestic consolidation in European domestic markets and now Asia (e.g.,

Tokyo-Osaka stock exchange mergers - 2011).

– then within regions• Euronext , OMX, LSE-Borsa, Euronext-LIFFE• DBörse: strong vertical model, but no SE acquisition• limited M&A (other than domestic) in Asia

– cross-Atlantic mergers before regional completion:• NYSE-Euronext• Nasdaq - OMX• NYSE-ENX – DBörse?

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Vertical integration

• Expansion to CCP services:– Derivatives exchanges have their own CCP

• in US: CME, ICE, etc– DTCC historically not a CCP for derivatives – now partnership

with NYSE

• in Europe: DBörse (Eurex clearing), Euronext-LIFFE– LSE has limited derivative activity

– Stock exchanges historically relied on independent CCPs for equity transactions:• Euronext, LSE: LCH.Clearnet• but DBörse built its own CCP for German shares.

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Vertical integration – Cont’d

• Exchanges generate flows to CCPs and CSDs and have been looking to own and control the entire chain:– produces some vertical cost synergies (rather limited),– gives greater strategic agility

• faster roll out of products and services• facilitates M&A expansion to similar vertical silos

– makes clients more « captive » (vertical « silos »)• constrains external competition • allows price packaging across levels (cross-subsidies?)• prompted Code of Conduct, forthcoming free access rules • key issue in DG Competition review of DB-NYSE/ENX merger.

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Annex 2. Major exchanges and other trading venues

• Competition for derivatives exchanges is OTC market:– pure bilateral OTC, or– inter-dealer platforms, using request-for-quote model (RFQ)

• Competition for stock exchanges strongly encouraged by regulators in US (Reg NMS) and EU (MiFID) as from 2007: – by broker-dealers under bilateral trading services (internalisation-

dark pools, systematic internalisers),– by alternative trading systems with multilateral trading services

(multilateral trading facilities – MTFs under MiFID),– by OTC markets.

• Partial reversal by regulators now as focus shifts to transparency (e.g., proposed MiFID II - 2011).

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SEs vs ATS

• Alternative trading venues have gained significant market share from traditional stock exchanges, especially for blue chips:– US: NYSE and Nasdaq have less than 50% market

share together– UK: LSE has about 55%

• BATS has become largest trading venue in Europe.– has captured 23% of equity trading in Europe.

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Trading volumes by trading venues

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Major regulated stock exchangesCapitalisation Turnover

NYSE-Euronext (US) 13,791 NYSE-Euronext (US) 8,731

Nasdaq OM (US) 4,068 Nasdaq OM (US) 6,008

LSE group 3,849 Shanghai 2,219

Tokyo 3,655 Tokyo 2,202

NYSE-Euronext (Eur) 3,248 Shenzen 1,551

Shanghai 2,804 LSE group 1,531

Hong Kong 2,712 NYSE-Euronext (Eur) 1,129

TMX 2,231 Korea 1,014

Deutsche Börse 1,622 Deutsche Börse 898

BM/Bovespa 1,553 TMX 825Source: WFE 06/2011 Turnover: electronic order book

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2. Central Counterparties

A. What is a CCP?B. Annex

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A. What is a CCP?

• Entity that interposes itself, in one or more markets, between the counterparties to the contracts traded, – becoming the buyer to every seller and the seller to every

buyer and – thereby guaranteeing the performance of open contracts.

• Shifts counterparty risk to CCP• Scope:

– securities and/or derivatives trades– applies to trades between CCP members (benefit of

concentration).

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CCPs and risk

• Impact of CCPs on counterparty risk:– reduce risk massively through netting, but – also concentrate risk on themselves by becoming

counterparty to every trade.• CCPs could be source of systemic risk if failed:– need to reduce residual risk (close-out netting)– should not « overuse » CCPs (e.g., for illiquid assets or

non-standardised assets)– need strong protection measures, in addition to CCP’s

capital (which is often small in relation to risk).

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CCPs protection against risk

• Five mechanisms:– criteria for admission as member of CCP– initial margins

• typically cash or highly liquid securities• purpose is to protect CCP during transition after default and prior

to close out netting and sale of collateral

– variation margins (daily)• cash• covers for valuation changes of collateral (cf repos)

– other collateral• default funds from members, third party guarantees, etc

– CCP own capital.

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C. Annex - CCP

• Risk Management – CCPs• Major CCPs• Major current issues

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Risk management: CCPs• Year:2011/Source: BIS

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Major CCPs – securities CCP - United States Ownership ActivityDTCC – US Users and exchanges All securities

CCP - Europe Ownership Activity

LCH.Clearnet - • Users (83%) and exchanges (17%)• LSE controlled

• Bonds and repos• Equities: LSE• Equities: Euronext• Equities: MTFs

Domestic CCPs Domestic exchange • Equities - Eurex Clearing (DBörse)- Germany + Ireland - Cassa di Comp (LSE) - Italy - Etc

EMCF ABN-AMRO (78%) + Nasdaq OM (22%)

• Equities: several MTFs

Euro-CCP DTCC • Equities: several MTFs + Nasdaq OMX

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Major CCPs – derivatives CCP – United States Ownership Activity

Exchange-linked CCP• CME• ICE• Nasdaq OM• NYSE-ENX

Individual exchange Trades on exchange (interest rate, commodities, energy, fixed income and equity derivatives, etc).

NY Portfolio Clearing DTCC (50%) + NYSE (50%) • Fixed income derivatives

CCP - Europe Ownership Activity

LCH-Clearnet • Users and exchanges• LSE controlled

Full range (incl. interest rates on SwapsClear)

Eurex Clearing Deutche Börse Full range

ICE Clear Ltd ICE Energy + CDS

NYSE Clear LIFFE NYSE-ENX – soon acquired by ICE

Full range

CME Clearing Europe CME Commodities

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Consolidation

• ICE is acquiring NYSE-ENX, including NYSE Clear LIFFE

• Euro-CCP and EMCF are merging– To be owned (each for 25%) by:• Nasdaq OMX• ABN AMRO (Clearing Bank) • DTCC• BATS-Chi-X

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Major current issues

• CCPs part of vertical silos• Regulatory push for CCP clearing for OTC

derivatives• Concerns about CCPs being single points of

failure – need to strengthen resilience.• ECB location requirements for clearing of

EUR-denominated trades.– UK lawsuit against European Commission

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Vertical silos

• Neutrality of CCPs that are part of vertical silos– Deutsche Börse/Eurex CCP for German equities– Acquisition of LCH.Clearnet by LSE (51%)– Regulatory focus:

• Part of 2007 voluntary Code of Conduct sponsored by the Commission, but failure to change behaviours

• Possible issue in context of DG Competition’s approval of NYSE-ENX /DB merger,

• Possible EU regulation/directive on open access by CCPs (EMIR).

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Clearing of OTC trades

• Regulatory push for OTC derivatives to be cleared and netted through CCPs.

• Concerns:– most derivative contracts: bilateral and OTC• backlogs and legal documentation weaknesses• often inadequately collateralised

– Bear Stearns, Lehman failures:• lack of clarity about bilateral positions and even more

overall cross-dealers positions, and• risk of contagion (systemic risk).

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Clearing of OTC trades – Cont’d

• G-20 response to the financial crisis calls for all standardised OTC derivatives to go through CCPs by end 2012, with in 2011 only:– 50% of IRS contracts, – 20-30% commodity derivatives, – less than 10% CDS

• Expected impact:– force greater and systematic collateralisation, and– give fuller cross-dealers picture.

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EUR trade clearing location

• ECB wants all CCPs that have large EUR activity to be located in a Eurozone country:– officially driven by lender of last resort

considerations– would force a CCP like LCH.Clearnet to shift from

London to continent• UK government has begun legal action against the

ECB/EU before Court of Justice• UK concerned about attempts to weaken London as

financial centre.

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3. Central Securities Depositories

A. What is a CSD?B. ServicesC. Risk profileD. Annex

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A. What is a CSD?

• Institution that is the ultimate holder, and often register, of the securities of a market on behalf of investors and is closest to the issuer in the securities holding chain.

• CSDs have two main functions:– safekeep the securities of the market through

immobilisation of the stock of securities, and– effect transfers of the securities through accounting

movements in accounts of investors/intermediaries in its own books (securities settlement system).• No physical movement of securities for transfers.

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Reduce risks and inefficiencies

• CSDs were created primarily to reduce risks and increase efficiency for the investor community, because immobilisation of securities and book-entry transfers:– reduces risk of losses or thefts (safekeeping in

vaults), and– allows immediate and secure transfers and re-

transfers without the need to wait for actual delivery of certificates.

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From immobilisation to dematerialisation

• Immobilisation implies that physical certificates are warehoused.

• Dematerialisation means that there is no physical certificate and that legal ownership is represented by a book entry.

• Progressive move towards dematerialisation:– France started in Europe (1984), followed by other markets:

Belgium, UK, NL, etc– simplifies legal framework– has political connotations (« wealth register » used for wealth

tax, makes fraud by investors more difficult for bearer bonds).

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Status of CSDs

• CSDs are part of the securities market infrastructure and have a special status:– specific regulatory framework (more demanding

rules and some special treatment) designed to minimise risk-taking and protect investors

– assets of investors are not on balance sheet of CSDs,– CSDs are typically not bank, with some exceptions:

• Germany’s CSD (Clearstream Banking Frankfurt)• ICSDs

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B. Services

• CSDs offer two main services:– holding of assets: notary function for issuers and

safekeeping of domestic assets for investors,– settlement of transactions in central bank money (cash

transfers in accounts with the central bank).• Have developed range of additional services, such as:

– basic corporate action and tax services– collateral management– securities lending (for some CSDs)– proxy voting for investors– shareholder-related services for issuers.

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Monopolies?

• CSDs have a monopolistic position only for the notary/safekeeping service.

• For other services, they compete with local custodians and ICSDs, including settlement: – in some markets local custodians effect more than half

of settlement transactions in their own books.– Target 2 Securities (ECB platform for settlement in

central bank money) not meant to be a competitor, but outsourcing solution for CSDs:• but it will erode settlement profit margin of CSDs like

competition would.

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Governance – two models

• Historically, CSDs were set up and owned:– by market participants (mutuals), or– by stock exchange (which was itself a mutual).

• Major objective of market was not to maximise profit, but to ensure low risk, low cost services to market.

• Most CSDs remain mutuals, including– CSDs that are part of Euroclear: UK, France, Belgium, NL,

Ireland, Sweden, Finland.– DTCC in US,– most CSDs in Asia.

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For-profit model

• In last 10-15 years, as exchanges have demutualised, the CSDs they owned have become more « profit-oriented »:– Germany (Deutsche Börse), – Italy (Borsa Italiana), – Spain (BME), – Hungary (Keller), – Norway (VPS).

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Central banks as CSDs

• Central banks used to be the CSD for their government debt in many countries:– most have transferred responsibility to the local CSD

(e.g., UK, France, Spain, NL) over the last decades,– some central banks remain CSDs: US (Fed), Belgium,

Greece, Hong Kong,– ECB is taking back settlement responsibility with T2S.

• Raises questions of rules applicable to a public sector entity carrying out commercial activities while acting as regulator.

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New CSDs

• Global custodians entering the market and setting up own CSDs:– Bank of New York Mellon– JP Morgan with LSE

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Major domestic CSDs

Depot in trillion of $0

5

10

15

20

25

30

35

4036

16

5

DTCCEuroclear CSDsClearstream CSDs

Turnover in trillion of $ 0

200

400

600

800

1000

1200

1400

1600

1800 1700

428

92

Year: 2010 Sources: DTCC, ECB

84

C. Risk profile

• Limited credit and market risk• Operational risk• Risk containment

85

Limited credit and market risk

• CSDs are designed to take limited risks:– no credit risk • CSDs do not provide credit to facilitate settlement as

settlement is generally done with central bank money (except CSDs-banks for foreign securities, e.g., Germany)• some CSDs take some limited credit risk on domestic

securities (through advance of interest and dividend payments and through ex post fee charging),

– minimal market risk (only on own assets, e.g., capital assets).

86

Major risk is operational risk

• The main risk for CSDs is operational risk:– computer systems failures– software design failures– manual mistakes– thefts or losses in vaults, fraud, etc

• Consequences for market efficiency could be large:– inability to make reliable transfers would affect

functioning of the market and have spill over effect on trading and lending more generally as posting of securities collateral could be affected

– could trigger questions on ownership rights.

87

Risk containment

• Therefore, CSDs:– are expected by their market (clients, issuers)

and by the regulators to take extraordinary measures to mitigate operational risks:• computer back-ups, with regular testing• automation of tasks (reduced risk of manual errors)• special testing of software changes with market

participants before launch,

– limit their liability in case of problems (mutualising risk among market participants).

88

Limited capital requirements

• Non-bank CSDs have generally limited capital requirements because of the nature and limited magnitude of risks:– so far determined by each domestic regulator (no

pan-European regulation), although forthcoming CSD directive will likely specify a requirement,

– regulators often set capital requirement in terms of cost base (e.g., 6 months cost base) to allow for an orderly unwind in case of failure.

89

D. Annex - CSDs

• Size• CSDs by region• Major current issues

90

Size

• By definition, CSDs have effectively all of the domestic securities of the country in their books,– even if securities are held by intermediaries, they are sub-

deposit in CSD,– with some limited exceptions:

• some physical securities may remain « under the mattress »• private companies’ shares may remain in companies’ books.

• In contrast, settlement of transactions can be internalised in books of intermediaries (e.g., custodian banks), in which case no settlement in CSD:– in some markets, estimates that about 50% of settlement takes

place in custodian banks’ books.

91

Assets on deposit • Total assets on deposit:

– in EU CSDs: €31.2 trillion, with over half in Euroclear group,– in US: $36.5 trillion (DTCC).

52.00%

15.00%

13.00%

9.00%

11.00%

EU CSDs depot end 2010 Source: ECB

Euroclear CSDsClearstream CSDsItalySpainAll other CSDs

92

Turnover • US settled about $1.7 quadrillion per year• EU CSDs settled in 2010 about €510 trillion, of which half in Euroclear

CSDs.

55%

12%

13%

15%

5%

EU CSD turnover in trillion of € Year: 2010 Source: ECB

Euroclear CSDs

Clearstream CSDs

Italy

Spain

All other CSDs

93

CSDs by region

• Europe• US and Asia

94

Europe: new competitive environment

• Historically, CSDs have offered a limited range of services at low risk and moderate cost:– safekeeping of securities and record-keeping,– book entry settlement in central bank money (i.e., cash

movements in accounts of the central bank, not of the CSD or of banks),

– basic corporate action service (collect and pass on to clients interest and dividend payments from issuers, management of standardised/automated corporate actions, etc)

– sometimes, standardised collateral management services (France, UK), services to issuers, such as proxy voting (UK), information about shareholders (France, Belgium), etc.

95

Need to adapt under competitive pressures

• CSDs had historically limited competition:– mostly from own clients, which internalised part of the settlement

activity in their own books for transfers between two clients of the bank,

– from ICSDs for securities that were traded offshore (e.g., German bunds).

• But competition has broadened in Europe, especially after the launch of the EUR, which prompted an increase in cross-border trading and settlement:– greater competition from banks and ICSDs,– new competition from other CSDs, and– new competition from issuer-servicing providers (e.g.,

Computershare).

96

Exacerbated by T2S and clearing

• Core profitability of European CSDs has been weakened by competitive pressures, and, in addition:– most large markets have introduced CCPs to

reduce counterparty risk and post-trading costs:• CCP netting can reduce settlement activity by > 90%;

– ECB has decided to offer pan-European settlement in central bank money, which would wipe out CSD margins on settlement services.

97

Moving up the value chain

• To survive, European CSDs are seeking to move up the value chain:– more sophisticated services on domestic securities

(corporate actions, issuer services, information services, securities lending, collateral management, etc)

– new services on foreign securities, competing directly with other CSDs, ICSDs and custodian banks (which are also their clients and sometimes their shareholders),

– with uncertain prospects of success.

98

Impact on role and risk profile of CSDs

• Competitive approach will change risk profile:– several CSDs will seek to become banks (necessary

to offer attractive service on foreign securities)• only if forthcoming EU rules allow it

– better service often means more customised approach and therefore greater operational risk,

– time to market requirement and low cost in a competitive market will test safety standards, and

– limited liability approach will be under pressure.

99

Strategic partnerships

• European CSDs will struggle to survive on a stand alone basis:– T2S impact,– the largest CSDs are already part of a broader group:

• Euroclear CSDs part of Euroclear group with seven markets (over 50% of European market) and with a largest ICSD in the world,

• German CSD part of Deutsche Börse group (vertical structure) and the second largest ICSD in the world (Clearstream),

• Italian CSD part of London Stock Exchange group.

– competition and regulatory costs will increase.• Will likely force other CSDs to secure their local anchor (e.g.,

with stock exchange or government) and/or join another group.

100

US and Asian CSDs

• Two CSDs in US:– Federal Reserve for government securities– DTCC for all other securities:

• is also a CCP and a derivatives data warehouse,• seeks to expand geographically by leveraging its scale

and US financial actors’ presence abroad.

• Asian CSDs still very domestically oriented:– generally mutuals,– their future likely to be determined by evolution of

their country’s stock exchange.

101

Major current issues

• New regulation to be applied to European CSDs:– unrelated to the crisis,– driven by Commission’s desire to codify framework

and ensure resilience of CSDs,• Combined impact of T2S, stock exchange

consolidation, and new regulation on European CSD landscape:– core profitability under threat,– potential increase in risk profile (see above).

102

4. International CSDs

A. What is a ICSD?B. SizeC. ServicesD. Annex

103

A. What is a ICSD?

• Hybrid organisations:– CSDs for « international securities », such as Eurobonds,– custodian bank-type providers for domestic securities.

• Result of historical factors:– started as pure CSDs for Eurobonds in late 1960s/early

1970s– progressively added new products and services, starting

in the 1970s, • to leverage economies of scale and scope • with support of their clients/shareholders (mutuals).

104

Two main ICSDs

• There are two large ICSDs, both in Europe:– Euroclear (HQ in Brussels)– Clearstream (HQ in Luxembourg)– other hybrid CSDs:• SIS: extension of the Swiss CSD (ICSD for Swiss banks),• Clearstream Frankfurt: German CSD (ICSD for German

clients),• most domestic European CSDs ambition to become

ICSD as strategic positioning (cf above),• DTCC is also ambitioning a role as « investor CSD ».

105

B. ICSDs’ size

10.3

5.1

Depot in € trillion (ECB-2010)

EuroclearClearstream

277

63

Turnover in € trillion

106

C. Services

• ICSDs offer a much broader range of services than CSDs.

• ICSDs are: – like CSDs for Eurobonds• Compete with one another and with some CSDs (DTCC

in US)

– like local custodians for other products (shares, domestic bonds, funds, etc)• Compete with pone another and with local custodians

across the world.

107

Operating in a competitive environment

• Euroclear and Clearstream compete with one another, but are not a duopoly:– for international securities, competition with DTCC for issuance

business:• for international securities issued in USD, DTCC has larger market share

than the two ICSDs.

– for domestic securities, ICSDs act as custodian bank-type providers and compete with custodian banks (half a dozen multi-market custodians and about 20-30 domestic custodians across Europe).• ICSDs have larger market shares in bonds• custodian banks have larger market shares in equities (where local

market intimacy is critical and the liquidity is in local market).

108

Service range

• Offer all the services of CSDs, but with greater customisation and proactivity for clients and with more sophisticated tools:– safekeeping of securities (use sub-custodians),– settlement of transactions in multi-currency (>40 currencies)– corporate action servicing– collateral management services– securities lending (to avoid settlement fails)– investment fund routing and servicing – issuer services (as CSDs for international securities)– and… credit (ICSDs are banks) to facilitate settlement.

109

Single purpose banks

• Both ICSDs are banks for the single purpose of facilitating settlement and related services.

• Reflected in their balance sheet and capital structure:– relatively small balance sheet – high capital ratios– very low credit risk:

• intra-day credit, • uncommitted lines of credit• collateralised (in EB: 99% secured) with assets deposited in

the ICSD.

110

Credit needed for settlement efficiency

• Securities settlement effected on a delivery-versus-payment (DVP) basis– requires that buyer have cash or (collateralised) credit line with

ICSD at time of transfer (otherwise securities not transferred),– otherwise settlement « fails » and neither cash, nor securities

are transferred,– cost of settlement fails very large (cost of borrowing cash for at

least one day):• 1% fails of settlement in Euroclear Bank alone costs clients € 730

million/year (based on 5% interest rate).• cost of fail, even for only 1 day, is often a multiple of the profits on the

trade for client.

111

Short term, collateralised, credit

• ICSDs provide mainly very short term credit (intra-day or overnight for one day):– generally use whole stock of own securities in ICSD as collateral, – credit reimbursed with proceeds of immediate resale or onward

transfer of securities to underlying client.

• Credit is oil in the system and was « island of stability » during 2007 liquidity crisis:– while inter-bank lending (especially overnight) froze completely late

2007, ICSDs did not have problems getting liquidity and continued to provide settlement-related credit to clients,

– without it, financial markets would have suffered much greater strains, as trades would have failed.

112

D. Annex - ICSDs

• Comparison with CSDs and global custodians.

113

ICSDs vs CSDsService CSDs ICSDs

Safekeeping Yes Through sub-custodians or through CSDs

Settlement Central bank money settlementMostly mono-currency

Commercial bank moneyMulticurrency

Corporate actions Standardised Broader and more proactive

Collateral Mgt Only a few, generally limited Highly developed, including triparty

Securities lending Only a few Yes, for fail-curing Funds A few Yes, highly developedIssuer services Yes Yes, for EurobondsCredit As a rule no (some exceptions) Yes – for settlement

related activitiesFees Very low/standardised Low/standardised

114

ICSDs vs global custodiansServices ICSDs Global Custodians

Safekeeping Use CSDs/subcustodians Use ICSDs/subcustodians

Settlement Yes Use ICSDs/subcustodians

Corporate actions Yes Enriched from ICSDs/subcustodiansHighly proactive

Collateral Mgt Yes Some, mostly use agents/ICSDs

Securities lending Fail curing only Street lending (proactive)

Funds admin & accounting

No Yes

Credit Intra-day,collateralised settlt related activities

Extensive, for range of activities

Insourcing of back offices

No Yes

Risk analysis/advice No Yes

Fees Low/standardised High/customised