trading around the clock background paper

Trading Around the Clock: GlobalSecurities Markets and Information

Technology

July 1990

OTA-BP-CIT-66NTIS order #PB90-254087

Recommended Citation:

U.S. Congress, Office of Technology Assessment, Trading Around the Clock: GlobalSecurities Markets and Information Technology--Background Paper, OTA-BP-W-66(Washington, DC: U.S. Government Printing Office, July 1990).

For sale by the Superintendent of DocumentsU.S. Government Printing Office, Washington, DC 20402-9325

(order form can be found in the back of this report)

Foreword

The world’s stock exchanges evolved from centuries-old markets of money lenders,currency traders, and commodity dealers. La Bourse, the Paris stock exchange, dates back to1183. Amsterdam’s Effectenbeurs was formed around the trading of shares in the Dutch EastIndia Company in 1602. The London Stock Exchange was organized in the 17th century.

Stock exchanges in the United States, while latecomers, have a unique and colorfulhistory of their own, characteristic of our young nation. Wall Street, a narrow thoroughfare inlower New York City, has become the symbol of U.S. enterprise, initiative, and prosperity. . .but also of greed and chicanery. It was there that securities were first traded about 1725, alongwith the auction of commodities such as tobacco, wheat, and even slaves. The New York StockExchange, the first established in the United States, was chartered in 1792. Modern computerand information technologies now support market-makers and brokers, and runners and tickertapes have given way to computer screens.

International telecommunications systems now link markets around the world withinstantaneous communications. Technology is rapidly turning the stock exchanges into aseamless global market, open 24 hours a day. This situation presents both opportunities forthe Nation and problems that Congress needs to understand.

This background paper assesses the effects of information technology on securitiesmarkets and the current status of global securities trading. It compares securities markets andclearing and settlement mechanisms in Japan, the United Kingdom, and the rest of Europe withthose in the United States. Finally it identities emerging questions about international marketsand national regulatory regimes.

Trading Around the Clock precedes the forthcoming OTA report on domestic securitiesmarkets and information technology, Electronic Bulls and Bears, both requested by theCommittee on Energy and Commerce and the Committee on Government Operations of theHouse of Representatives.

OTA gratefully acknowledges the help of many people who have contributed to thisstudy as advisory panel members, workshop participants, contractors, and reviewers. As withall OTA reports, however, the content is solely the responsibility of OTA and does notnecessarily constitute the consensus or endorsement of the advisory panel, workshopparticipants, or the Technology Assessment Board.

u D i r e c t o r

iii

John Bachman

Securities Markets and Information TechnologiesAdvisory Panel

Managing PartnerEdward D. Jones& Co.

John C. BaldwinDirectorUtah Department of Business Regulation

Paul F. Glaser, ChairmanPresident, Quotron Systems, Inc.

Allan BretzerVice PresidentMidwest Stock Exchange

William BrodskyPresident and Chief Executive OfficerChicago Mercantile Exchange

Eric ClemensProfessorWharton SchoolUniversity of Pennsylvania

James B. CloonanPresidentAmerican Association of Individual Investors

Jack A. Conlon, Jr.Executive Vice PresidentNIKKO Securities Co., Inc.

Janine CraaneFinancial ConsultantMerrill Lynch, Pierce, Fenner & Smith, Inc.

Gene L. FinnChief Economist and Vice PresidentNational Association of Securities Dealers

Richard GrassoPresident and Chief Operating OfficerNew York Stock Exchange

William HarafVice PresidentCiticorp

Robert E. LitanSenior Fellow and Director of Center for EconomicProgress and EmploymentBrookings Institution

James MartinExecutive Vice PresidentTeachers Insurance Annuity AssociationCollege Retirement Equities Fund

Martin MayerJournalist

Robert McEwenPresidentConference of Consumer Organizations

Charles McQuadePresidentSecurities Industry Automation Corp.

Susan PhillipsVice PresidentUniversity of Iowa

Peter SchwartzPresidentGlobal Business Network

Howard ShermanDepartment of EconomicsUniversity of California, Riverside

Robert ShillerCowles FoundationYale University

Hans R. StollDirectorFinancial Markets Research CenterOwen Graduate School of ManagementVanderbilt University

Alan StrudlerResearch ScholarInstitute for Philosophy and Public PolicyUniversity of Maryland, College Park

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the advisory panel members.The panel does not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full responsibitity for thereport and the accuracy of its contents.

iv

Trading Around the Clock: Global Securities Markets andInformation Technology

OTA Project Staff

John Andelin, Assistant Director, OTAScience, Information, and Natural Resources Division

James W. Curlin, Program ManagerCommunication and Information Technologies Program

Project Staff

Vary T. Coates, Project Director

Charles K. Wilk, Senior Analyst

Danamichele Brennen, Inhouse Contractor

Steven Spear, Research Assistant

Mark Anstine, Research Assistant

Administrative Staff

Liz Emanuel, Office Administrator

Karolyn St. Clair, Secretary

JoAnne Price, Secretary

Workshop Participants

Clearing & SettlementAndrea CorcoranCommodities Futures Trading Commission

Dennis DuttererChicago Board of Trade Clearing Corp.

Dennis EarleBankers Trust Co.

Roberta GreenFederal Reserve Bank of New York

John HiattOptions Clearing Corp.

Jonathon KalmanSecurities and Exchange Commission

Gerard P. LynchMorgan Stanley Co., Inc.

John W. McPartlandChicago Mercantile Exchange

Junius PeakeThe Peake/Ryerson Consulting Group, Inc.

Michael ReddyMerrill Lynch World

Robert WoldowNational Securities Clearing Corp.

Technology in Securities MarketsRichard BreunichMerrill Lynch & Co., Inc.

Ron DaleMidwest Stock Exchange

Patricia HillmanBank of Boston

George KenneyAmerican Stock Exchange

Robert M. MarkManufacturers Hanover Trust Co.

Harold McIntyreCitibank Financial Institutions Group

John ParadyPacific Stock Exchange


Joe RhyneQuotron Systems, Inc.

Donald D. SerpicoChicago Mercantile Exchange

Casimir SkrzypczakNYNEX Corp.

Donald SolodarNew York Stock Exchange

Shyam SunderCarnegie-Mellon University

Richard Van SlykePolytechnic University, New York

R.T. WilliamsR. Shriver Associates, Inc.

Scenarios on InternationalSecurities TradingPeter BennettInternational Stock Exchange

Eric ClemensUniversity of Pennsylvania

James CochraneNew York Stock Exchange


David HaleKemper Financial Services

Martin MayerJournalist

Todd PetzelChicago Mercantile Exchange

Peter SchwartzGlobal Business Network

Michael Wailer-BridgeInternational Stock Exchange

Manning Warren IIIUniversity of Alabama School of Law

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the workshop participants.The workshop participants do not, however, necessarily approve, disapprove, or endorse this report. OTA assumes fullresponsibility for the report and the accuracy of its contents.

w’

Reviewers and Contributors

Alden AdkinsSecurities and Exchange Commission

Anthony AinSecurities and Exchange Commission

David AylwoodNational Strategies, Inc.

(for Reuters, International)

Brandon BeckerSecurities and Exchange Commission

John BehofFederal Reserve Bank of Chicago

Peter BennettInternational Stock Exchange

Mary Ann CallahanInternational Securities Clearing Corp.

James CochraneNew York Stock Exchange

Andrea CorcoranCommodity Futures Trading

Commission

Richard J. CowlesConsultant

John P. Davidson IIIChicago Mercantile Exchange

Harry DayNew York Stock Exchange

Dennis A. DuttererChicago Board of Trade Clearing Corp.


Susan ErvinCommodity Futures Trading

Commission

Giulia FitzpatrickBankers Trust Co.

Jane F. FriedBankers Trust Co.

Gary GinterChicago Research & Trading Group,

Ltd.


John HiattOptions Clearing Corp.

Dan HochvertNYNEX Corp.

Brian HunterAmerican Bankers Association

Jonathan KalmanSecurities and Exchange Commission

Peter KarpenFirst Boston Corp.

Richard KetchumSecurities and Exchange Commission

Thomas KetchumEuroClear, Brussels

Olaf E. KraulisThe Toronto Stock Exchange

Wayne LutheringshausenOptions Clearing Corp.

Gerard P. LynchMorgan Stanley & Co., Inc.

Robert M. MarkManufacturers Hanover Trust Co.

Harold McIntyreCitibank Financial Institutions Group

John W. McPartlandChicago Mercantile Exchange

Morris MendelsonUniversity of Pennsylvania

Thierry NoyelleColumbia University

G.W. PalmerAT&T Bell Laboratories

Junius PeakeThe Peake/Ryerson Consulting

Group, Inc.

Joseph RosenRosen, Kupperman Associates

Thomas RussoCadwalader, Taft, Wickersham

Anthony SaundersNew York University

Martha ScanlanFederal ReserveBoard of Governors

Jeffrey M. SchaeferSecurities Industry Association

Robert SchwartzNew York University

Joel SeligmanUniversity of MichiganSchool of Law

Donald D. SerpicoChicago Mercantile Exchange

Yuji ShibuyaNomura Research Institute

Roxanne TaylorQuotron Systems, Inc.

Paula TossiniFutures Industry Institute

Christian TrudeauMontreal Exchange

Richard Van SlykeNew York Polytechnic University

Manning Warren IIIUniversity of Alabama School of Law

Robert WoldowNational Securities Clearing Corp.

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the reviewers and contributors.The reviewers and contributors do not, however, necessarily approve, disapprove, or endorse this report. OTA assumes fullresponsibility for the report and the accuracy of its contents.

vi”

Contractors

Robert G. AngelDigital Equipment Corp.

Eric ClemensUniversity of Pennsylvania

Robert de ContrerasInternational Business Machines Corp.


Frances GraceEditor

Peter KarpenFirst Boston Corp.

Don McNeesPeat Marwick, Main& Co.


Monica RomanTrading Technology, Inc.

Peter SchwartzGlobal Business Network

Charles M. Seeger IIIChicago Mercantile Exchange

Marming G. Warren IIIUniversity of Alabama School of Law

NOTE: ~Aa~=h*mdk~@Mfortivduable=sk~ce andthoughtfulcritiquesprovidedbythecontractors.~e contractorsdo not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full responsibility for the report andthe accuracy of its contents.

viii

Contents

PageChapter 1. The Evolution of a Global Securities Market ●

INFORMATION TECHNOLOGY FOR GLOBAL MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .THE MEANING OF GLOBALIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .COMPETITORS IN WORLD SECURITIES TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .CLEARING AND SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .*COMPETITION AND REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .THREE SCENARIOS FOR GLOBALIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Scenario l: A Cooperative Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Scenario 2: An International Regulatory Regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Scenario 3: Conflict and Disintegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

IMPLICATIONS OF THE SCENARIOS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chapter 2. Information Technology for Global Markets . . . . . . . . . . .THE EMERGING GLOBAL DATA COMMUNICATIONS INFRASTRUCTURE... . . . . . . . . . . .

Public and Private Global Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Systems for the Transmissionof Financial News and Market Data . . . . . . . . . . . . . . . . . ● . . . . . . . . .Electronic Trading Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TECHNOLOGICAL BARRIERS To 24-HOUR TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . ....*..*THE PROBLEM OF STANDARDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● ...*... .

Chapter 3. The Extent of International Securities Trading . . . . . . . . . . . . . . . . . . .... . . . . . .TRENDS DRIVING GLOBALIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .*..*... . . . .

Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Interdependence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. ● . . . . . . . . ●

Capital Imbalances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Financing National Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Institutional Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Regulation and Deregulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● . . . . . . .Privatization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

OBSTACLES TO INTERNATIONAL SECURITIES TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .HOW "GLOBALIZED" ARE SECURITIES MARKETS? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cross-listing of Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .International Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Opening National Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Passing the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Product Links Between Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Multinational Initial Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .International Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....,.. . . . . . . . . . . . . . . .

RISKS INHERENT IN GLOBALIZATION OF SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . .

Chapter 4. Americans Competitors in Global Securities Trading . . . . . . . . . ......... .... ●

JAPAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Recent Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .How the Market Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .,..,... . . . . . . . . . . . .Derivative Products Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Over-the-Counter Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Clearing and Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Market Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Tokyo as a World Center for Securities Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE UNITED KINGDOM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .How the Market Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Clearing and Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .Market Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .The London International Financial Futures Exchange(LIFFE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .London as a World Center for Securities Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE EUROPEAN COMMUNITY MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .The EC’s 1992 Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● . . . . . . . . . . . . . . . . . . . . . . . .

11223457888

11111213161919

23252626262727282828292930323234343535

3737383840414242434344474747484849

PageChapter 5 Internationa1 Clearing and Settlement: What Happens After the Trade . . . . . . . . . . . . 55

THE GOALS OF CLEARING AND SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55HOW CLEARING AND SETTLEMENT WORKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56RISKS FROM DIFFERENCES IN CLEARING AND SETTLEMENT MECHANISMS . . . . . . . . . 57EFFORTS TO REDUCE THE DIFFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59UNRESOLVED PROBLEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64POLICY ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Risks Associated With Default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65Risks Associated With the Payment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66Information Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66Inadequate Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67Standardization and Harmonization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67Shortening the Time to Settlement and Providing Same-DayFunds . . . . . . . . . . . . . . . . . . . . . . . . . . 68

IS AN INTERNATIONAL REGULATORY BODY NEEDED?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Chapter 6. The Regulation of Global Securities Trading ... . . . . . . . . . . 71COMPETITION AND REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71TWO KINDS OF REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72BANKING AND SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73REGULATORY INSTITUTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74ENFORCEMENT OF SECURITIES REGULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74HARMONIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75AMERICAN LEADERSHIP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

Appendix. Clearing and Settlement in Major Market Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Acronyms and Glossary ● .. . . . . . . . . . ● ......... ....,.. ...0..0. 100

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . ● ..*. 105

BoxesBox Page3-A. Exogenous Events and U.S. Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314-A. EC Securities Law Directives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 516-A. International Organizations Related to Coordination of Securities Regulation . . . . . . . . . . . . . . . . . . . 77

FiguresFigure Page2-1. Overview of International Trading Through NASD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203-1. Evidence of the World’s Markets on Oct. 13,1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243-2. Market Capitalization of World’s Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253-3. Foreign Holdings of U.S. Financial Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273-4.TradingAroundtheWorldandNearlyAroundtheClock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335-1. Interfaces Among Clearing Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 575-2. Settlement Date:T+? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

TablesTable Page3-1. Comparison of Major Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303-2. Total Cross-National Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315-1. Group of Thirty: Current Status of International Settlement Recommendations-Equities . . . . . . . . . . 615-2. Recommendations From Major International Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

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Chapter 1

The Evolution of a Global Securities Market

As national economies are linked together bythe exchange of goods and services and bypublic and private communications networks,global securities markets develop. Americansecurities markets, among the world’s best inliquidity, efficiency, and fairness, should standout in this expanded arena, provided they do notfall behind in technological and financial inno-vation. But securities trading on a global scalebrings with it new risks, as well as beckoningopportunities. American investors and Ameri-can regulators and policymakers are seeking tounderstand these risks and appraise the demandsthat they will place on markets, market partici-pants, and their regulators.

This background paper describes the forcesencouraging the development of internationalsecurities markets, the obstacles that must beovercome, and the major sources of unnecessaryrisk. It provides some estimates of the presentextent of cross-border trading, and describes thelargest and most active organized markets-ourcompetitors in providing securities-related serv-ices—in Japan, the United Kingdom, and therest of the European Community. It also de-scribes the important clearing, settlement, andpayment mechanisms that support major mar-kets. Finally, it outlines the questions to be facedas the span of securities trading stretches beyondthe scope of national regulatory regimes.

This background paper prepares the way fora forthcoming OTA report, Electronic Bulls andBears: Securities Markets and Information Tech-nology, which will probe policy issues arisingfrom the impacts of communications and com-puter technology on traditional market struc-tures and practices, and their ability to meet thedemands implied by global securities trading.

INFORMATION TECHNOLOGY FORGLOBAL MARKETS

Global telecommunications shrink distancesand time differences, tie together national econ-

omies, and thus encourage the growth of securi-ties trading across national boundaries. Therapidly increasing capacity and declining cost ofcommunications and computer systems makethese trends sure to continue. The emergence ofmultinational corporations with presence through-out the world is also hastening the globalizationof securities markets. The needs of large institu-tional investors for cross-national investmentsto diversify or to hedge their portfolios isanother strong driver.

The technology for global trading is basicallyin place, in the form of public and privatecommunications networks, the specialized computer-communications systems used for market datadissemination, and—just poised for take-off—automated systems for ‘round-the-globe, ‘round-the-clock trading. The integration of the worldeconomy means that multinational enterprisesand their products and services become knownto investors throughout the world, reducing theinformation barriers that have in the past inhib-ited international securities trading. Significantobstacles remain, because international stan-dards and effective international regulatoryprotections are not yet developed.

The growth in demand for internationalmarket news and market data (quotations, lastsale prices, volume), together with the effects ofthe digitizing of data, has led to brisk competi-tion among information services vendors, and toa turbulent restructuring of that industry. Elec-tronic trading systems being developed both byinformation vendors and by forward-lookingexchanges could become the international ex-changes of the future. At present, they areessentially unregulated. These changes are forc-ing two issues into new prominence:

. Who owns digitized data at various stagesof its processing and dissemination, whocan enforce ownership rights, what consti-tutes ‘‘value added, ” and how shoulddigitized data be priced?

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2 ● Trading Around the Clock: Global securities Markets and Information Technology

● Should proprietary trading systems be reg-ulated as organized markets (like exchanges),and if so, by whom?

It is by no means certain that U.S. marketswill remain in the forefront of the movementtoward ‘round-the-clock global securities trad-ing. While U.S. futures exchanges and ourover-the-counter market are acting aggressivelyto put worldwide electronic networks in place,the U.S. stock exchanges have been slower toact. Meanwhile, securities exchanges in manycountries are moving toward highly automatedmarkets.

The lack of international standards will beincreasingly important; for example, standardsthat apply to international financial services,especially securities trading, need attentionurgently. Government involvement in standards-setting appears to be essential if new sources ofoperational risk are to be minimized.

THE MEANING OFGLOBALIZATION

Foreign currency exchange and markets forgovernment debt securities have long beeninternational. To the extent that there is stillargument about the future of global securitiestrading, it focuses on how quickly 24-hourtrading will emerge, and to what degree it willextend to corporate equities. A two-tier marketsystem could develop, with international elec-tronic trading of the shares of 500 to 1,000multinational corporations, and domestic (coun-try of domicile) trading on traditional exchangesand over-the-counter markets of most othercorporate securities. Or—although this is lesslikely—traditional exchange-based, face-to-face markets could lose out entirely to thecompetition of electronic systems.

There is growing evidence, especially sincethe October 1987 market break and the October1989 break, that securities markets around theworld are linked. They tend to move in parallelin response to economic and financial news, andto react sharply to stress in other markets.Although there has been relatively little re-

sponse in other markets to sharp declines inTokyo Stock Exchange prices in early 1990, theanxious attention of market observers aroundthe world attests to the general recognition thatthis stability may be precarious.

“Globalization of equity securities trading”is a term that covers a variety of related growthtrends. It includes the cross-listing of securitiesin several countries, cross-national portfoliodiversification and hedging, holding member-ship (generally through affiliates) in anothercountry’s exchanges, legal or contractual tiesbetween exchanges, electronic systems for 24-hour trading, “passing the book,” the develop-ment of cross-national stock index derivativeproducts, and related phenomena such as multi-national primary offerings of stock and interna-tional mutual funds. All of these are nowgrowing, although at different rates.

There are nevertheless major obstacles, suchas legal, regulatory, and cultural differencesbetween nations and markets. Some of thesedifferences impose serious risks on investors,market organizations, and other financial insti-tutions. These new or aggravated risks are oftenpoorly understood by individual investors andperhaps by professional investment managers.

In the worst case, the failure of major marketparticipants (e.g., securities firms or banks) withheavy commitments in several countries couldhave gravely detrimental results for nationalfinancial and payment systems and possibly forentire economies.

COMPETITORS IN WORLDSECURITIES TRADING

Our rivals as centers of international securi-ties trading today are Japan and the UnitedKingdom. The potential integration of a Euro-pean securities market, with the EuropeanCommunity’s 1992 Initiative, will bean impor-tant factor in future competition. Other nationsare or may become niche competitors.

The Tokyo Stock Exchange (TSE) vies withthe United States as the world’s largest securi-

—.

Chapter l—The Evolution of a Global Securities Market ● 3

ties market in terms of capitalization and tradingvolume. It has the advantage of a strongeconomy with many multinational corporations,a concentration of capital that may exceeddomestic investment opportunities, a large retailcustomer base, and supportive government pol-icy. It is not as ‘‘international’ as London’smarkets nor as accessible to foreign investors aseither London or New York, because of regula-tory, institutional, linguistic, and cultural barri-ers. Transaction costs and listing costs arerelatively high.

London’s International Stock Exchange (ISE)is also among the four or five largest markets(usually following the TSE, the New York StockExchange, the Osaka Stock Exchange, andNASDAQ, the U.S. over-the-counter market);and it is the most international major market,with nearly a quarter of its listings and a quarterof its transactions involving foreign issues.However, in the aftermath of deregulation andautomation—the ‘Big Bang’ of 1986-and themarket crash in 1987, the ISE has seriousproblems, including the growth of off-markettrading that threatens to cause market fragmen-tation. Spreads and commissions, two compo-nents of transaction costs, are very low; butsettlement costs are disproportionately high.Strenuous efforts are underway to solve theseproblems.

Other European markets, especially the Ger-man exchanges, the Paris bourse, and the Swissexchanges, are making vigorous efforts toincrease their volume, automate their activities,and modernize their regulatory regimes. TheEuropean Community intends to achieve regula-tory harmonization and an integrated, strong“European trading arena” in services by 1992,including eventually an integrated Europeansecurities market. This is a goal rather than anachievement, and there are many obstacles, butsubstantial progress has already been made.

CLEARING AND SETTLEMENTThe most critical problems for international

securities trading, but also the most concerted

efforts at problem resolution, are in the area ofclearing and settlement. Clearing and settlementsystems for financial instruments differ greatlywithin and across countries, in procedures, intiming of settlement, in the institutions in-volved, and in the degree, nature, and locus ofrisks. These differences in countries’ systemsare important because: 1) systems traditionallyused for domestic trading are now being calledupon to accommodate international participants;2) the integrity and efficiency of a nation’sclearing, settlement, and payment system areimportant to its internal financial and economicstability and its ability to compete with othernations; 3) the failure of a foreign clearing entitycould affect a U.S. clearinghouse through thefinancial failure of a common clearing member;and 4) the growing number of U.S. investors inforeign markets may be unaware that risk levelsin some foreign markets can be much higherthan those in our domestic markets.

To improve efficiency and reduce risks, theworld’s clearing and settlement systems must becoordinated with each other in a number ofways. Both the private sector and regulators inthe United States and other countries have begunto take, or are considering, actions to accomplishthe needed improvements. A number of interna-tional studies are in general agreement on thetypes of improvements needed. These studieshave been done by the European EconomicCommission, the Federation International desBourses de Valeurs (FIVB), the Group ofThirty, the International Society of SecuritiesAdministrators, and Bankers Trust Co. (the lastas contractor to OTA). One of the sharedconclusions of these studies is that the world’smajor clearing and settlement systems should be“harmonized” in selected ways in order tostrengthen them and prepare for the emergingglobal trading environment.

The private sector in the United States, withencouragement from regulators, is making im-pressive progress in paving the way for neededimprovements, but many are complex, time-consuming, and costly. In some areas legislationis likely to be needed, e.g., to make it possible

4 . Trading Around the Clock: Global Securities Markets and Information Technology

to eliminate all, or most, physical certificates forsecurities and to align holidays observed bybanks and financial markets. In other cases, U.S.regulators will need to take action.

In many cases, U.S. and foreign governmentcooperation will be needed to effect change. Sixmajor concerns need to be addressed: risksassociated with default; risks associated with thepayment process; information sharing; progressin technology development; standardization;and shortening the time to settlement usingsame-day funds. The attention to date by variousorganizations to international clearing, settle-ment, and payment systems has been helpful,but these efforts are unlikely to provide neededcontinuity, and have not addressed all financialproducts, such as derivative products (e.g.,stock-index futures and options). Because of thediversity, complexity, and universality of issueslikely to continue to arise over the next decade,a single international body should be consideredto facilitate world cooperation in addressingthese issues.

COMPETITION ANDREGULATION

Many complex problems and unnecessaryrisks arise from differences between nations inregulations and in regulatory objectives, andfrom the lack of international machinery formonitoring, surveillance, and governing of globalmarkets. Significant risks associated with inter-national securities markets are related to sub-stantial differences among nations and marketsin:

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prudential regulation (i.e., investor protec-tion rules, such as disclosure requirementsor safeguards against market manipulationor fraud);capital requirements, accounting practices,and other factors relating to the financialintegrity of market professionals and inter-mediaries, brokers, dealers, and traders;andmargining systems, clearing and settlementmechanisms, and payment systems, espe-

cially important because they may involvesystemic risks to financial institutions thatare involved in the markets of severalcountries.

There are also important differences in theactivities permitted to certain market partici-pants (e.g., separation between banking andsecurities activities, or separation of broker/dealer functions).

Differences among nations in regulation ofsecurities markets are a factor both in risks andin competition among markets. There are sharpdisagreements about the effects of market regu-lation on competition among markets for cus-tomers. Some market participants stress thatregulatory costs add to transaction costs, andoppose most regulation on the grounds that itcould drive securities trading (both domesticand international) to overseas, less regulatedmarkets. This concern could lead to ‘regulatoryarbitrage, ’ or a movement to reduce regulatorysupervision of markets to the level of that in theleast regulated competitive market.

However, there are two broad categories ofmarket regulation: access regulation, and pru-dential regulation. In most countries, there hasbeen a movement toward access deregulation inthe last few years; i.e., reducing the barriers tobroad participation (including foreign participa-tion) in organized markets or exchanges, andthis has encouraged internationalization. Insome countries, there has at the same time beena movement toward strengthening prudentialregulation, or rules aimed at protecting investorsagainst unrecognized risk or against marketfraud, abuse, and manipulation. This is some-times called "re-regulation, " and it is also oftendone for the purpose of attracting investors,especially international investors. (Neither move-ment has been obvious in the United States,which already had better investor protectionlaws than many countries, and few if anybarriers to foreign participation.)

The problems of enforcing national regula-tions are complicated by the difficulty ofinvestigating and correcting abuses that origi-

Chapter l—The Evolution of a Global Securities Market ● 5

nate overseas or involve participants outside ofthe country’s borders. In the United States,legislation is being considered that strengthensthe powers of U.S. regulatory agencies tocooperate with foreign regulators. Cooperativeefforts are complicated by laws in some coun-tries that restrict the disclosure of financial data,i.e., privacy and secrecy laws.

Free market proponents argue that regulatorydifferences between nations are best resolved byderegulation in all nations, letting market forcesand competition decide which risks are accepta-ble to investors. But in most markets and in mostcountries, there is a movement toward seeking“harmonization” of regulations and coopera-tive enforcement of standards of fairness andhonesty. Many industry groups and interna-tional associations in the private sector, as wellas regulatory authorities in the major marketcountries, are participating in these efforts.

However, at the policy setting level and at thenegotiating level there are substantial disagree-ments about what “harmonization” shouldmean. Even among regulatory agencies in theUnited States, there appear to be significantdifferences in the approach to harmonization ofregulations. There are several different ap-proaches loosely designated as ‘commonality’(universal regulations); “comparability” (ac-ceptance of substantially equivalent rules); “na-tional treatment” (each country subjecting do-mestic and foreign institutions to the same ruleswithin its borders); and ‘‘mutual recognition”(a country allows foreign institutions to operatewithin its borders under the rules of theircountries of origin). The last two of theseapproaches actually do not require, or constitute,harmonization.

There are several movements underway in-volving either governmental bodies or privatesector associations, or both, to achieve greaterharmonization. Stronger initiatives by U.S.governmental agencies may be needed to en-courage such efforts, or to assert U.S. leadershipon behalf of such efforts, in order both to protectU.S. investors and institutions and to enhance

our competitive position vis-a-vis global securi-ties trading.

THREE SCENARIOS FORGLOBALIZATION

These trends suggest several scenarios forpossible regulatory responses to the globaliza-tion of securities markets. The scenarios out-lined below are intended merely to focusdiscussion on the implications of internationalsecurities trading, and are not suggested as fullydeveloped strategies or policies.

The present political, economic, and regula-tory environment for international securitiestrading consists largely of informal or contrac-tual institutional arrangements and bilateralagreements between national regulatory author-ities. The future regulatory framework for worldmarkets could be a continuation and extensionof these evolutionary developments; or strik-ingly different frameworks might develop. Theycould come about as a result of severe marketbreaks and disruptive economic and politicalevents, or as a result of initiatives shared byprivate and public financial institutions andregulatory authorities around the world.

Many forces, acting together at many levels,could influence such developments. At the levelof the global economy, the process of continuingeconomic development is driven by such forcesas the impacts of major economic imbalances,national economic and finance policies, tradepatterns, inflation rates and interest rates. It willalso be shaped by political events-e. g., changein Eastern Europe, the unification of Germany,and the European Community’s 1992 Initiative.At another level, the evolution of financialmarkets will be shaped by the course oftechnological and product innovation and thebehavior patterns of key players—multinationaland translational business enterprises, securi-ties underwriters, institutional investors, securi-ties firms, exchanges, banks, clearing organiza-tions, information services vendors, and na-tional regulatory authorities.

6 ● Trading Around the Clock: Global Securities Markets and Information Technology

The pattern of technological innovation is animportant factor in the behavior of securitiesmarkets. Innovation in technology and in finan-cial instruments could contribute to sustainedliquidity and expansion; but it is also possiblethat innovation could outpace the capability ofmarket participants to comprehend and controlits effects, or could merely be a drain onresources and attention without contributing toeconomic utility. Accelerating obsolescence ofinformation technology could diminish the re-turn on investment, eventually discouraginginnovation. Financial product innovation candraw new investment into securities markets ordrive out some traditional investors. Somefinancial innovations (e.g., stock-index futures)have certainly dramatically increased the link-ages between different kinds of capital markets,with secondary impacts that are not yet well-understood and are the subject of much contro-versy, especially in the United States and Japan.[These forces are discussed in a forthcomingOTA report, Electronic Bulls and Bears: Securi-ties Markets and Information Technology.]

Peter Schwartz, of Global Business Network,ties together the economic, political, and marketpossibilities into five models of internationalsecurities trading: These are:

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Fragmenting Markets-Conflicts of in-terest, political friction, and protectionisminhibit the process of integration of finan-cial markets. Costly and unreliable tech-nology adds to the burdens on marketparticipants. Key players see no value increating an international framework forregulation of securities trading.Regional Markets-Integration occurs atthe regional level as part of a protectionistworld of trading blocs, with diminishedinterbloc trading, and possibly with newcapital controls.Integrating Markets-Multinational trad-ing blocs develop, but are not an impedi-ment to global integration. They provideuseful models for complex multilateraleconomic regimes. Agreements on generalprinciples are a step along the path toward

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broader multilateral regulatory regimes.The OECD is the model of a regionalorganization in which the political capabil-ity for agreeing on very complex issues canbe developed.Stratified Markets—A two-tiered marketdevelops, with the off-market, large blocinstitutional investors constituting a globalmarketplace and an array of smaller do-mestic retail markets.Global Markets-New technology, theglobal economy, and the commercial strat-egies of financial companies and theircustomers and suppliers, drive the evolu-tion of global financial markets. Theydevelop within a regime of bilateral coop-erative agreements, but the world is mov-ing toward a 24-hour trading day operatingmainly in commercial networks outside ofrecognized markets and their regulators.This is, like the Eurobond market today, anarena for professionals.

Although many others could be fashioned byvarying one’s assumptions, three possible sce-narios for international securities regulation areoutlined below. The first assumes a gradual andorderly transition from the present. If interna-tional securities trading expands through grad-ual evolution and there are no major economicor political disruptions or global market crashes,this is a highly likely scenario; it appears to bethe probable one for global securities markets.But reason and goodwill can be defeated by“accidents of history. ” Disruptions have oftenbeen the triggers of change, sometimes un-desirable change and sometimes change for thebetter.

The second and third scenarios acknowledgethe possibility of drastic disruption and disconti-nuity. Either of these scenarios could develop ifchanges in the marketplace outrun the market’sability to adjust, regulate, or even comprehendits implications. Either might result from amajor market disruption, as large or larger thanthe break of October 1987. Such a disruptionmight be set off, for example, by a sharp declinein the Japanese market, the after-effects of the

Chapter 1—The Evolution of a Global Securities Market ● 7

bankruptcy of one or two major U.S. securitiesfins, or changes in currency value related tounification of Germany or other events inEastern Europe or the Soviet Union, or theJapanese real estate market. While a marketbreak might begin as an internally caused‘‘accident, it is more likely to result from aneconomic environment of weak profits and pricevolatility. Continuing economic imbalances,widening recession, and the inflationary boomthat would likely follow could set the stage forone or the other of these scenarios.

Scenario 1: A Cooperative Framework

A series of efforts, already underway in 1990,leads to the slow development of an effectiveinternational regulatory structure.

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There continues to be a stable, “fairlyprosperous economy. The industrializedworld enjoys slow but steady and unbrokengrowth, low inflation, and unemploymentof less than 6 percent. Interest rates followa somewhat higher path trailing the slowdecline in the U.S. fiscal deficit. Interna-tional imbalances slowly unwind, currencyvolatility diminishes as a result, and thereare no major shocks or disruptions.As capital investment in new technologyincreases, and productivity improves, thestage is set for higher growth and accelerat-ing investment, placing great demand oninternational capital markets. A continuingbull market supports a climate of sustainedfinancial innovation. Today’s multi-domestic markets with limited interna-tional activity move toward ever moreinternational flows.The true global marketplace begins todevelop in the off-market trading arenaused by large institutional investor/professionals. As the structure of marketsgradually becomes ever more stratified,

and the systemic risks associated with thembecome more apparent, the pressure forsome regulatory response mounts.Economic integration begins at a regionallevel and moves toward the global level inthe first decade of the new century. Coop-eration is embodied in the development ofthe international information systems andthe regulatory agreements required to fos-ter increasing integration. Emerging re-gional blocs are the vehicles for greaterglobal cooperation rather than sources ofconflict.The integration of the European Commu-nity leads to a closely linked EuropeanMarket centered in London. Many of theissues resolved in that process became thebasis for wider international agreements(e.g., prospectus standards).A major step in the process is the continu-ing development, following the path earliertaken by the Cooke Committee,l of theInternational Organization of SecuritiesCommissions (IOSCO) technical commit-tee as an effective, permanent organ forsetting the agenda for agreements andpreparatory steps. The Group of Thirtyprovides continuing encouragement andsupport. A high degree of collaborationensues between private-sector financialleaders and regulatory authorities in themajor market countries.During the 1990s a new regulatory frame-work gradually emerges out of the slowaccumulation of bilateral agreements, orMemoranda of Understanding (MOUs).This is a very modest regulatory regime,with limited overt organization.Through the collaborative actions of theseseveral bodies a schedule of agreementsemerges focusing initially on the risksassociated with settlement and common

lb the lg70~ ~ ~ge ~mr of foreiw m~~tio~ ba~ si~ted ~ ~ndon s~~ ,sw~~ serious concerns: over disparities h WCOU.Uthgstandards, over who would act as lender of last xesort if one of these branches failed, etc. The Bank of England proposed the establishment of aninternational Standing Committee of regulators, established in 1974 [now called the Cooke Committee after its chairmam Peter Cooke]. The StandingCommittee developed the Basle Concor&G a set of international principles for handling a banking crisis. The concept here is that the technical committeeof IOSCO (already established and working) or a similar permanent committee of another intermtional organization might quasi-formally assume manyof the coordinating functions of an international regulatory body.


conditions for capital adequacy. The issuesof futures markets and questions of multi-ple listings and multinational share offer-ings are slowly resolved. Common ac-counting standards take even longer.

Scenario 2: An InternationalRegulatory Regime

The average growth rate might be slightlylower or slightly higher than in the cooper-ative framework scenario, but economicvariables swing widely. Exchange rates,interest rates, and inflation rates interact ina period of flux driven by unmanagedimbalances and cascading shocks.Some event—a severe earthquake in NewYork or Tokyo, a financial scandal inLondon’s Eurobond market-triggers ageneral crisis in already stressed securitiesmarkets.The major market disruption creates thepolitical will to establish an institutionalregulatory regime at the international level,although none of today’s internationalfinancial institutions, such as the WorldBank, the IMF, or the Bank of InternationalSettlements, or IOSCO, provide a com-pletely adequate model.Galvanized by necessity, nations act rap-idly and effectively to set up a newinstitution and enforce its decisions. U.S.Government and private sector representa-tives play a leading role in the negotiations.The U.S. Congress articulates a forcefulpolicy of support for the new institution; atits instructions, the regulatory agency be-gins a rigorous assessment of markets-related laws, regulations, procedures, andpolicies to identify necessary changes andadaptations.The economic volatility does not inhibittechnology-based investment, but actuallyaccelerates change as the downswingsfacilitate the write-off of obsolete capitaland the upswings support new investment—Schumpeter’s model of “creative destruc-tion.’ A volatile early 1990s leads to

higher growth and increasing integration ofthe global marketplace.

Scenario 3: Conflict and Disintegration

A break occurs, as a result of a fundamentalcurrency reevaluation crisis, that is severeenough to seriously erode confidence.Market discontinuity and economic down-turn lead to increasing friction rather thancooperation. Slower recovery and a bearmarket result as there are vicious cycles ofmounting damage.Market growth slows dramatically or re-verses, and becomes more volatile. Thereis widespread loss of confidence. Lack ofresources and motivation are almost insur-mountable barriers to innovation.Efforts for international regulatory cooper-ation wither quickly.

IMPLICATIONS OF THESCENARIOS

Effective response to a major securities mar-ket break will in the future require internationalas well as domestic actions. The central issuemay be how to prevent a liquidity crisis frombecoming a solvency crisis. This requires abetter understanding than we have now of howlarge a market break could occur, how and whyit might happen, and how to restore confidenceafterward. In some markets, there may also beunexamined risks of overstraining key systems(e.g., clearing and settlement) in a roaring bullmarket. These uncertainties are probably aspoorly understood as the risk of a major marketbreak.

International securities markets may be mov-ing toward a structure that is efficient, stable,and adequately well-regulated. This outcome islikely if there are no cataclysmic changes fromtoday’s situation, either generated internally (bybehavior of the participants, or by failure ofbasic market structures) or generated by macro-economic events outside of the markets. Asinternationalization continues, it will be impor-tant to deal with the perils of “regulatoryarbitrage’ if competition tempts participants to

Chapter I—The Evolution of a Global Securities Market ● 9

move trades to the cheapest, least regulatedmarkets.

It is increasingly likely that there will be astratified or two-tier market structure. Thiscould mean a divergence of interests betweenthe large, wholesale, institutional, global trans-action market and the domestic, retail market.What have been considered off-market activities(nonorganized, negotiated trading on proprie-tary systems, perhaps unregulated) may come todominate global equity markets for the securi-ties of at least 500 to 1,000 translational orglobal companies in the future.

The central problem will become one ofsystemic risk. Will there be a lender of lastresort? Will the real risks devolve onto commer-cial banking systems, and national paymentsystems? How can volatility in the globalmarket be kept from cascading onto domesticmarkets, where the consequences might begreater? How can the global economy beprotected from excessive risk from the unregu-lated international securities market?

It is clear that the U.S. Congress will neces-sarily have a critical role to play with regard tothe globalization of securities trading. At a

,

minimum, Congress will be called on foroversight and guidance of U.S. regulatory bod-ies and executive agencies—the Securities andExchange Commission, the Commodity FuturesTrading Commission, the Federal Reserve BankBoard of Governors, and the Department of theTreasury, all of whom will be involved inframing the position of the United States in theevolution of an oversight, supervisory, or regu-latory regime for international securities trad-ing. It is not clear that these authorities now holda common view of the interests of the UnitedStates with regard to either: a) the kinds ofaggressive actions and innovation needed tocompete in offering services and products toinvestors around the world, or b) the degree ofrisk inherent in international trading and thedesirability of working with other nations todevelop a stronger regulatory regime to reducethese risks.

In this critical situation, it may be necessaryfor the U.S. Congress to articulate a clearstatement of the national interest for the guid-ance of regulators, as it did in 1934 with theSecurities Exchange Act, and in 1975, with theSecurities Exchange Act Amendments.

Chapter 2

Information Technology for Global Markets

Four forces have caused international securitiestrading to increase:

advances in information technology-telecom-munications and computers;the development of a global economy withmultinational corporations needing both inter-national communications and international sourcesof capital;the emergence of huge institutional investmentfunds needing cross-national diversification;regulatory changes, especially access deregula-tion that opened stock exchanges to foreignmembership in many countries.

The technology for international securities trad-ing is in place, and its capabilities will continue toincrease. The emerging global communicationsinfrastructure has evolved at three levels: 1) publicand private communication networks using cable,microwave, and satellite transmission; 2) communi-cations technology used by providers of marketinformation services; and 3) specialized electronicsecurities trading systems.

THE EMERGING GLOBAL DATACOMMUNICATIONSINFRASTRUCTURE

International securities trading requires a systemfor efficient, rapid, and secure transmission ofmarket data, transactions messages, and paymentinstructions. The infrastructure to do this has devel-oped rapidly over the last 25 years and is continuingits turbulent development. Four technological trendscontributed to this development:

. expanding computer capability and decliningcosts;

● digitization of data, and the resulting conver-gence of computer and telecommunicationstechnologies;

. satellite communications development; and● fiber optics development.

Improved computer performance and decliningcosts have resulted from improvements in basiccomputer technology, very large-scale integration(VLSI) technology, materials (e.g., use of galliumarsenide in production of chips), and computerarchitectures and software.3 In 1960, it cost about$75 to do 1 million computer operations; in 1980 itcost 0.1 cent. By 1997 computer costs are expectedto decrease still further. Computers make it possibleto use telephone systems to transmit, store, anddistribute electronically encoded information; theyalso control the switches that route informationthrough a network.

“Digitizing’ is the translation of informationfrom traditional analog forms such as pictures,speech, or written/printed characters, into discretebinary-coded electronic signals for processing, stor-age, or transmittal. This makes possible the fusion oftelecommunication and information-processing tech-nologies. It allows man-to-machine communicationnot possible with a conventional telephone, and hasprompted the carriers to build multi-media commu-nications systems by combining facsimile, data, andvideo with voice transmittal capability.4 Since the1970s, AT&T, MCI, Sprint, and other communica-tions carriers around the world have been upgradingtheir existing networks to high-capacity digital lines.

Fiber-optics Provides broad bandwidths that allowthe transmission of high-speed video images as wellas the capacity to move large volumes of data.Development of broadband integrated services digi-tal networks (B-ISDN) can eventually provideefficient broadband interconnection for all commu-nication services-transmitting voice, data, video,and text. ISDN is still in the early commercializationstage.

l’rhis ~tion tiWS l.KXWiIy on an CZ@SI OTA repo~ U.S COngreSS, Office of Technology Assessment critical connections: CO?t??WnicUZiOnfOrthe Future, O’E4-CIT-407 (Washington DC: U.S. Government Printing Office, January 1990), especially ch. 3, “New Technologies and Chan@ngInterdependencies in the Communication Infrastructure.”

WL.SIkllows the placement of over 100 logical oprmtions on a single integrated circuit chip, a capaMMy that has been doubling about every 18 montbs.%J.S. Congress, OTA, op. cit., footnote 1, p. 46.4u.s. Cowess, OTA op. cit., footnote 1. See also, Tosh.io Kosuge, “Telemmmunications,” in Peter Robinso~ Karl P. SauvanC and Vishwas P.

Govitrikar (eds.), Electronic Highways for WorZd Trudk (Boulder, CO: Westview Press, 1990), pp. 223-238.

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These developments shape all parts of the com-munications infrastructure: 1) switching or network-ing technology; 2) transmission technology; and 3)terminal technology.s Switching technology con-sists of computer hardware and software for routingmessages and establishing a communication chan-nel, and thus provides the “intelligent” part of thenetwork. Manual switches and electronic analogswitches are being replaced with digital switches.Some superfast packet switches6 can now transmithundreds of thousands of packets per second; by thelate 1990s, with optical switching, even greaterspeeds will be practical. Software development willdetermine the rate of further improvements incost/performance ratios.

With more powerful microprocessors, faster com-puting speeds, and larger memories it is nowpossible to put control functions for the network notonly in the central switch, but also at. nodesthroughout the system. This software-driven andsoftware-defined communication infrastructure--“the intelligent network’ ’encourages the intro-duction of new value-added services using modularsoftware.

Keeping pace with advances in switching technol-ogy are advances in transmission technologies:optical fiber or coaxial cable and radio or broadcasttechnology, which includes satellite, microwave,and for local use, cellular broadcast communica-tions. Customers usually do not know or care howthe message was transmitted, but differences in thesetechnologies result in major differences in the typeof electronic signals that can be transmitted, thequality of transmission, the range of frequencies thatcan be used, the speed of transmission, the confiden-tiality and security of the transmission, and the cost.7

Terminal equipment is that found at the customerend of the network, usually telephones or computerterminals. Many of these terminals now containinformation-processing capability.

Advances in global communications infrastruc-ture technologies will probably accelerate. Never-

theless, there is some danger that network interde-pendence may slow innovation, because once usershave invested in equipment conforming to a particu-lar standard, they will be reluctant to purchaseequipment that is incompatible even if it is otherwisesuperior. 8

Public and Private Global Networks

Telecommunication services are provided in manycountries by state-owned monopolies, that typicallyuse INTELSAT and regional satellite and cablefacilities to transmit international communications.In the United States, telecommunications havetraditionally been provided by government-regulated private-sector fins. The United King-dom, Japan, Hong Kong, and other countries aremoving toward private or private-government sys-tems.9 A user in one country who wants to connectwith an online database in another country mostoften does so with a modem (a device that allowsdigital signals from a computer to be transmittedover analog telephone lines), through a long-distance telephone connection. Telephone compa-nies in different countries pass calls along throughinterconnections across different technologies-amessage often travels through microwave, satellite,and cable transmission facilities.

Public telephone systems have encouraged thedevelopment of computer networks. A computernetwork is a collection of computers-whetherminicomputers, mainframes, or supercomputers—that communicate with each other using commonprotocols, over transmission links that can be cable,satellite, or ordinary telephone lines. The networksmay be local area networks (LANs) or long-distancenetworks (wide area networks, or WANs). Theyallow any computer in the network to access and usecomputer programs or data stored on any othernetwork computer.

In the United States, the unbundling of somecommunication services and the divestiture of AT&Thave encouraged business users to assemble theirown networks. Deregulatory changes encourage the

5Komge, op. Cit., footno~ 4“

6p~&e~.~fitc~~y~tem dividc~s~~nl~~gesinto~y Shortblocks orpackcts tit c~~rollted independently throughnummus geographicallydistributed switching nodes.

7GR~ Feketekuty, *’International Network Competition in Telecommunications, “ in Robinson et al., op. cit., footnote 4, pp. 257-287.

W.S. Congress, O’IA, op. cit., footnote 1, p. 43.%. Brian Woodrow, “Trade in Telecommunications and Data Services: A ‘Constitutional’ Analysis,” “m Robinson et al., op. cit., footnote 4, pp.

15-42.

Chapter 2--Information Technology for Global Markets ● 13

unbundling of services by allowing users to sepa-rately purchase communication services or functionsthat were formerly available only as a single unit (thekind of end-to-end service once offered by theAT&T Bell System). Unbundling has encouragedthe development of value-added services, and maybe carried further by the development of “opennetwork architecture” (ONA), which allows serviceproviders to buy elemental network functions andreconfigure them to meet their particular needs. TrueONA requires further advances in software develop-ment, and it may in the end not be acceptable to allusers because it transfers to them the problems ofnetwork planning and management.10

A striking feature of modern global telecommuni-cations is the development of private networks toserve the needs of individual translational enter-prises. Once data are digital, corporate networksallow translational corporations to perform corpo-rate functions in any country. Many large financialinstitutions like Citibank, American Express, Salo-mon Brothers, major stock exchanges, and otherkinds of multinational corporations such as IBM,Digital Equipment Corp., Unisys, General Motors,and Britain’s Imperial Chemical Industries, havedeveloped their own networks, using satellite capac-ity and transmission lines leased from communica-tion companies. IBM, for example, has “a globalcommunications network that ties together its instal-lations in 145 countries. There are also privatelyowned data networks that serve many corporations,such as Telenet Communications.

Digital data and the declining costs of telecommu-nications have resulted in a proliferation of informa-tion services providers, and in the development ofclosed user-group networks—i.e., SWIFT,ll andReuters Limited, the international news service.

Global networks are “making previously untrada-ble services tradable.” In the past, vendors couldoffer such services in the foreign market onlythrough foreign affiliates.12 Data services, whichmake use of international telecommunication cir-cuits, are offered in many countries on a competitiveand unregulated basis. International data services

have normally used established monopoly transmis-sion arrangements, but alternative distribution pos-sibilities are opening up; for example, domesticsatellite providers in one country may sell cross-border capacity or specialized services in borderingcountries.

These developments are strongly resisted by thegovernment-controlled public telephone and tele-graph authorities (PTTs) in European and ThirdWorld countries. In some countries there are restric-tive laws governing the use of communicationstechnologies and systems to protect the state monop-oly. Such legal, regulatory, and political barriers willbe serious problems for some time, although thereare strong indications that these barriers are breakingdown because communication is essential to compe-tition in today’s world economy. Foreign competi-tion tempts corporations to move their activities toother countries, where business conditions are morefavorable.

Systems for the Transmission of FinancialNews and Market Data13

Communications between exchanges, over-the-counter markets, and clearing organizations indifferent countries, as well as communicationsbetween investors and their brokers in one countryand markets in other countries, are for the most parthandled through the same communication modesused by other business enterprises-i.e., leasedtransmission lines. A portion of these communica-tions are handled by specialized information serv-ices vendors. The rapid, broad dissemination ofmarket data is an essential element in makingsecurities markets both efficient and fair. It is largelyaccomplished today by information services ven-dors using a variety of public communicationmodes.

Advances in technology and restructuring of itscosts are having a profound effect on the structure ofthe information services industry. They may inducevendors to move into more specialized, value-addedservices. It is possible that systems being developedby the vendors for their own competitive reasons

lm.s. Congress, OTA, op. cit., footnote 1.lls~ s~d~ for Swiew for Worldtide ~ter~nk Ffinc~ Telecommunications; it is a system ~OW@ bx and other fmnc~ kLStihltiOllS,

including brokerage fins, to exchange payment instruction or clearing messages.12-1 p. sauva~ ~~semices and Dab Semi@s: ~troduction, “ in Robinson et al., op. cit., footnote 4, pp. 3-15.13~s sation &aws on a ~n~actor repo~ prepa~ for OTA by MoniM Ro~ “F~c~ ~o~tion semic~ Vendors,” August 1989.


could become the real international exchanges oftomorrow, as markets become more global, andcomputer-based trading and telecommunicationsbecome strategic advantages. Vendors are ahead ofexchanges in preparing to field global electronictrading systems. However, vendors will have towork out interfaces with clearing and settlement andother systems (see ch. 5).

As early as 1850 there was a market for interna-tional financial information services; Paul JuliusReuter began using carrier pigeons to fly stockmarket quotations between Brussels and Aachen,Germany. The opening of the first underwatertelegraph cable in 1851, connecting Dover andCalais, allowed Reuter to start delivering marketdata and financial news from London to ContinentalEurope. Because of high start-up and low marginalcosts, vendors could be more efficient than userfirms in information gathering (as is still true today,for the most part). The company Reuter founded,Reuters Holdings PLC, is now one of five companiesthat dominate the market for securities and futuresmarket data (prices and quotations). The other fourare Quotron Systems Inc., Automatic Data Process-ing Inc. (ADP), Telerate Inc., and Knight-RidderInc.14 These five companies have approximately400,000 terminals worldwide.15

The market for financial information can bedivided into three broad categories: 1) generalfinancial news,2) quotes and sale prices for exchange-traded instruments, and 3) quotes and prices forover-the-counter instruments. (The latter two aredifferent markets because the sources of data aredifferent, and because of differences in tradingpractices and trading technology.) Financial infor-mation vendors either gather general financial newsthemselves or select and carry reports from leadingnews organizations. Quotes (bids and offers), last-sale prices, and volume information-includingthose for most stocks, all commodity and financialfutures, and all options-are generated by marketsand sold to vendors. In foreign exchange (forex) andfixed-income (bond) markets, where there are nocentralized marketplaces, price information is con-tributed by banks and securities firms to vendors.

Dow Jones & Co., Inc., is the leading provider offinancial news in the United States, but Reuters hasan edge over Dow Jones in financial news thataffects forex and freed-income prices because ofReuters’ vast international communications net-work. Other providers of on-line financial newsinclude Knight-Ridder, Associated Press, McGraw-Hill Inc., Financial News Network, and MarketNews Service.

Quotron Systems has long dominated the marketfor U.S. stock market data, but ADP is a strongcompetitor. Outside the United States, the leader isReuters (based in the United Kingdom), whichrecently entered the U.S. market for stock prices. Inthe past, Reuters supplied market data and news forforeign exchange, money market instruments andcommodities in the United States, but not forequities. The internationalization of the securitiesmarkets has prompted foreign vendors such asReuters and Telekurs of Switzerland to enter theU.S. market. The relative ease of acquiring anddistributing price information for exchange-tradedinstruments has also attracted new competitors,including PC Quote Inc., and ILX Systems, a newventure backed by International Thomson Organiza-tion.

At the same time, U.S. companies such asQuotron and ADP have been expanding theiroperations overseas. The growing interrelationshipamong the equities, futures, freed-income, andforeign exchange markets has also led to diversifica-tion among vendors who traditionally specialized inone market. Telerate Inc., which holds a nearmonopoly in the market for U.S. Governmentsecurities prices, has entered the equities marketthrough its recent acquisition of CMQ Communica-tions Inc., the leading provider of stock quotes inCanada.

The relative ease with which any vendor canobtain data from the leading North American stockmarkets and many of their foreign counterparts haschanged the market for centralized market trade datainto a commodity market, in the sense of relativelyundifferentiated bulk goods, competing in terms ofprice. It has increased the competition amongvendors so much that in order to maintain their profit

14@o&on is now ~m~ by Citimw; Tel~@ is now o~~ by ~W Jones & CO., hc., Iong Tel~mte’s majority shrth)ld~.15~ ~~ly 1989, 42G,~ were ~~po~ ~~o~ding to MC ~o ~d K~eth Ng, Reuters Holdings pm (New York NY: (hlb~ saChS & CO,,

February 1989), p. 5. There maybe some double counting here due to screens displaying more than one vendor’s data, and there has probably been somecontraction due to securities f- reducing their labor force.


margins and to generate as much revenue perterminal as possible, vendors are trying to add valueto the product through new technology or somespecial feature. Third-party suppliers are now en-couraged to offer historical information, research,analytics, and tailored news services through the

rminals of financial information vendors such asteQuotron, Reuters, and Bridge. The vendors typicallykeep for themselves 30 to 40 percent of the revenuegenerated by third-party products.l6

The commodity or bulk nature of equities tradedata has no parallel in the fried income and foreignexchange markets, which depend on data contrib-uted by dealers, banks or other organizations. Butthe largest securities firms have announced plans (atthe end of April 1990) for a joint venture to distributegovernment bond data 24 hours a day. This networkwould include all 844 primary bond dealers and fourmajor interbroker dealers, who execute trades for alldealers,

Reuters created the market for real-time foreignexchange data in 1973, when it first put computerterminals on the desks of banks’ traders and per-suaded them to enter their rates into the system.Reuters does not pay banks for contributing theirquotes to the service, but charges subscribers a flatmonthly fee. While Reuters is the strongest in theforex market, Telerate is a competitive alternateservice. This benefits forex traders by providing aback-up quotation system and by assuring competi-tion for Reuters. It was difficult for Telerate to gaina place in forex until Reuters agreed to permit itssubscribers to install “binco boxes" —bank in-house computers—that let them simultaneouslyupdate their rates on Reuters and Telerate. Withoutthe binco boxes, Telerate’s forex market coveragewas often slightly behind because dealers postedtheir rates on Reuters first.17

The financial information business is still grow-ing, and continues to attract aggressive competitors.This may eventually bring down prices for informa-tion services. In the meantime, both the integrationof markets and technological change are creatingupheaval and uncertainty among financial informa-

tion vendors. As recently as 5 years ago, a dealer’sdesk would typically hold a Reuters terminal andperhaps one from Telerate. Because markets did notgreatly affect one another, there was no need formost traders in one market to be watching othermarkets .18 The technology generally used was adumb terminal connected to a vendor’s host com-puter by dedicated telephone circuits. But as anumber of niche services sprung up, traders ended upwith more and more dedicated terminals on theirdesks. Many of these were later replaced withpersonal computers, to allow local storage andmanipulation of price information. The video switcheliminated the clutter of terminals on traders’ desksby allowing several screens to be controlled by asingle keyboard, and became an important part oftrading rooms in many countries.

Several other technological advances in the earlyand mid- 1980s also irrevocably changed the deliv-ery of financial information. In addition to usingdedicated telephone lines, vendors began exploringother alternatives, such as broadcasting data by FMsideband and satellite. In the United States, com-modity market data vendors began in 1981 to usesmall, low-cost, receive-only satellite dishes whichwere particularly effective for one-way broadcastcommunications such as financial quotations. Theyare now used by vendors such as ADP, Dow Jones,Knight-Ridder, PC Quote, Reuters, and Telerate.Although dedicated interactive networks remain theprimary delivery mechanism of financial informa-tion vendors, financial data accounts for about 63percent of the approximately 114,000 data broad-casting satellite receiving sites in operation in1989.19

It is often cheaper for securities firms to buyhardware off the shelf than it is for them to leaseequipment from vendors. In addition, the securitiesfirms want to be able to choose whether to use adumb terminal, a PC, or a UNIX-based workstation,and they would like industry-standard hardware thatcan be integrated with the fins’s other systems. Inrecognition of this, Reuters recently stopped manu-facturing terminals and Quotron plans to sell off-the-

16Roq op. cit., footnote 13.170~m-~jor mom for Tel~atess ~Wss fi ~e~afig tie forei~ exc~nge ~ket we s~d tO include two foreign exchange brokers ~ging

for Telerate to carry their quotes, the availability of AP-Dow Jones foreign exchange news on Telerate, and the need for U.S. Merest rate data.18Howwer, fie&~ome ~ders~ways~ven~~ to follow tie fore@ exc~WeWkets since currency pric~ ad intemstrates ~cIosdyhlkd.

19wate~ Info*on StXViCeS, “DataBroadcasting Marketplace,” New Yorlq NY, 1989.


shelf equipment. ADP is also moving to industry-standard hardware.

Vendors have begun to offer their data in digital,as well as analog form, to satisfy the demand foranalytical tools. Receiving a stream of digital data(rather than a pictorial image on screen) gives usersmore flexibility in viewing, analyzing, and usingdata--e.g., the ability to create customized compos-ite pages. This has created a dilemma for financialinformation vendors because neither exchanges orvendors are sure how best to price digital informa-tion.

This has become a highly controversial issue: whoowns the data, who has access rights to it, who canreformat and resell it, and when does reformattingconstitute value-added service? The fees paid bycustomers have in the past been based on the numberof terminals or display devices authorized to receiveinformation in analog form. Resolving the data-pricing issue will become more complicated andmore difficult as international data services becomeeven more fiercely competitive.

Electronic Trading Systems

The commodity nature of data and the diminishedrole of information vendors as systems providers arecausing vendors to move toward offering transac-tional services, using automated execution systems,Citicorp and McGraw-Hill failed with the GEMCOelectronic commodity trading system a few yearsago. The World Energy Exchange and the Interna-tional Futures Exchange of Bermuda (INTEX) bothfailed to convert open outcry traders to screen-basedtrading in the futures market. But these and otherfailed ventures in automated trading have notdeterred Reuters, which in 1987 bought InstinctCorp., a registered broker/dealer offering an elec-tronic securities trading system that began in the1970s. Instinct is now executing trades of an averageof 13 million shares a day (including both NYSE-listed and over-the-counter stocks), a volume stilltiny by comparison with the approximately 273million shares traded by the New York StockExchange and NASDAQ together on an averageday. Reuters hopes, however, that exchanges willbegin using Instinct or another Reuters-developedsystem during the hours when their trading floors areclosed.

Reuters launched the Monitor Dealing Service in1981 to allow forex traders to negotiate transactionsover their terminals instead of telephones. Thissystem has been successful, perhaps in part becauseof its built-in audit trail. In 1989, between 30 and 40percent of the $640 billion traded each day in theinterbank foreign exchange market took place on theMonitor Dealing Service.20

Telerate did not until recently offer forex dealersa transactional system such as Reuters’ MonitorDealing Service, but it has now launched a conversa-tional, or on-line, dealing system through a jointventure with AT&T, known as The Trading Service.This service allows dealers to have multiple “con-versations, ” that is, talk to several dealers at once,unlike the Monitor Dealing Service.

Reuters is taking another step forward in auto-mated trading with an enhanced version of theMonitor Dealing Service and a centralized orderdatabase facility. While the original Dealing Servicefacilitates one-on-one negotiation between two trad-ers, Dealing 2000 will emulate an auction marketwhere bids and offers from multiple parties areexposed. This is designed to replace ‘‘blind”brokers, who act as middlemen in foreign exchangetrading. The system will display the aggregate sizeof all bids and offers at each price, but will notdisclose the identities of the dealers participating.

Quotron has not moved as rapidly as Reuters, butreportedly has electronic execution facilities indevelopment for both foreign exchange and fixed-income markets. It has been aggressively marketingCurrency Trader, which allows corporate customersof Citicorp to automatically execute foreign ex-change trades of $500,000 or less.

Whether the foreign exchange market will acceptthe automated trading Reuters is offering throughDealing 2000 is still uncertain, but the technologyused in that system was adapted for GLOBEX, afutures trading system being jointly developed bythe Chicago Mercantile Exchange (CME) and Reu-ters.

CME is one of two Chicago futures exchangestrying to develop systems for ‘ ‘24-hour trading,’ orthe execution of transactions at a geographicaldistance or outside of trading hours of local markets,CME and the Chicago Board of Trade (CBOT) first

~ank of International Settlement’s statistics.


separately and now jointly, are taking the calculatedrisk that their own automated system--if successful--may eventually put out of business their traditionalform of market, the “open outcry” or pit auctionsystem. They may recognize the likelihood thatinternational markets will eventually be fully auto-mated and free of the constraints of time anddistance, and know that if they do not take the lead,others outside the industry will do so.

This has come about because foreign futuresexchanges began to compete directly with U.S.futures exchanges. There are financial centers inAuckland, London, Paris, Frankfurt, Zurich, HongKong, Tokyo, Singapore, and Sydney which nowoperate futures and options exchanges as well asstock exchanges. Because they began to offer theirown local versions of U.S. contracts, investmentfirms were able to offer these products to customerswithout regard to trading hours in the United States.This trend drove the threatened exchanges to con-sider accommodating 24-hour trading.2l

The first attempts to meet this competition tookthe form of mutual offset agreements. such as theone between The Chicago Mercantile Exchange(CME) and the Singapore International MonetaryExchange (SIMEX) for Eurodollar and foreigncurrency contracts. ‘‘Offset’ (in this context) meansthat one can open a position in one country and closeit in another, and pay only one brokerage fee.CME/SIMEX was for a time one of the mostsuccessful of the many offset agreements attemptedby exchanges, although only marginally so.

Another response was to lengthen trading hours;for example, CBOT began both an earlier opening(7:20 a.m.) and an evening session,

In September of 1987, the CME announced that itwould develop-together with Reuters-an elec-tronic futures and futures-options trading network,the Post (Pre) Market Trade System, later renamedGLOBEX for “global exchange. ” CME membersaccepted the idea, with the assurance that GLOBEXwas strictly an off-hours system, and in return forreceiving a portion of the revenues generated by

GLOBEX. 22 On June 20, 1988 in London, England.the CME and Reuters Holdings PLC reached anagreement to adapt the new Dealing 2000 transac-tion system for the purpose. The network willoperate only after normal CME hours of trading andwill link investors in North America, Asia andEurope.

GLOBEX, when it opens in mid-1990, will be aninteractive data communications network linkingindividual user terminals with a central computer atReuters. For entry of orders, trader terminals consist-ing of keyboard, monitor. and printer will be locatedin the offices clearing members and individualmembers (including overseas members) who arequalified and backed by a clearing member. (See ch.5 for an explanation of the responsibility of clearingmembers.) Administrative terminals, in the officesof clearing members only. would also receiveconfirmations of all trades resulting from ordersentered into associated trader terminals. The termi-nals will display the 10 best bid and 10 best offerprices, along with the quantity bid or offered; the lastsale price, and other data.

Reuters will provide the computer hardware andsoftware and also make available other Reutersservices (e.g., news and cash market quotations)through GLOBEX terminals. The exchange willdetermine the instruments. and the rules and proce-dures for trading, and will provide clearing facilities.auditing, compliance, and market surveillance, De-spite Reuters being a British company. the jointeffort is largely seen as a globally strategic move forthe preservation and enlargement of the U.S. posi-tion in commodities and financial futures trading, Itmay also be a harbinger of global ● ● floor-less* ●

trading in the future. It is significant, however. thatReuters has recognized the value of partnership withan organized and regulated marketplace, the futuresexchange.

MATIF (the French financial futures exchange)has already agreed to use GLOBEX for after-hourstrading, and exchanges in other countries are also

‘lKaren Fierog, “How Technology Is Tackling 24-hour Global Markets,’” Furures, June 1989, p. 68.‘The rights conferred by membership in CME, or “a sea~” are to be divided into access to pit trading and access to hd.ng through GLOBE.X.

Members will have the right to “lease” one of these rights; e.g., a pit trader can lease to someone else, presumably overseas. his access to GLOBE.Xthus generating additional income. If GLOBEX (or other electronic trading s>xtems) comes to domina te futures trading, the increase in value of theiraccess to it will pre sumably compensate the pit members for this competition.


expected to participate, when various regulatoryissues are worked out.23

In 1989 the CBOT unveiled plans for anotheroff-hours global system, “AURORA.” While theGLOBEX system is an automatic order matchingsystem, AURORA attempts to emulate the traders inthe pit with icons (symbols) that allow traders toselect the counterparts to their trade. The CBOTclaimed that AURORA will capture ‘‘all of theeconomic advantages of the auction market com-bined with the advantage of the ability to conducttrading from any location in the world."24 Oneinteresting feature of both AURORA and GLOBEXis that they adjust the timing of all bids and offers toequalize for distance; i.e., the speed with which theyare posted depends on the transmission time for themost distant trader active at that time.

AURORA also tabulates bids and offers bycontract month, reports who traded how much withwhom, and keeps a running tabulation of hispositions for the trader. It automatically sendsmatched trades through for clearing by the Board ofTrade Clearing Corp. The system uses Tandemmainframe computers, Texas Instrument artificialintelligence components, and Apple computer graph-ics.

There were complaints from the financial futurescommunity about the need to install two terminals,and in May 1990, immediately after the JapaneseMinistry of Finance announced that it would permitJapanese firms to subscribe to GLOBEX, CME andCBOT announced they would merge the GLOBEXand AURORA development efforts. The details ofthis agreement are not yet negotiated. AURORAmay survive as an optional user interface. Theoperation of GLOBEX may be delayed until mid-1991.

The London International Financial Futures Ex-change developed an electronic trading system,Automated Pit Trading System or AFT, which likethe AURORA system, emulates open-outcry trad-ing. APT is now trading about 4,000 orders a day,

but is growing, and LIFFE may soon list thinlytraded contracts only on APTS. The system is usednow to extend trading hours to cover the Europeantrading day, but it is not a 24-hour system and willnot be available outside the United Kingdom. LIFFEsays that the cost of high-speed communicationslinks for worldwide trading is prohibitively high.25

However, this could change if the LIFFE systemproves popular.

There are also automated trading systems at theIrish Futures and Options Exchange, the LondonFutures and Options Exchange, the New ZealandFutures and Options Exchange, the Sydney FuturesExchange, the Tokyo Grain Exchange, and theTokyo International Financial Futures Exchange.These trading systems, like those in stock markets,were not designed for 24-hour trading, but possiblycould be adapted. Some of them were specificallydesigned for trading after exchange-hours.

Reuters’ success in recruiting exchanges to use itsautomated trading facilities is not limited to thefutures market. The Chicago Board Options Ex-change and the Cincinnati Stock Exchange haveagreed to form a joint venture with Reuters andInstinct to create a worldwide system for entering,routing, and executing options listed on the CBOEand equities traded by the Cincinnati Stock Ex-change, the only fully automated securities ex-change in the United States.

The New York Stock Exchange recently an-nounced its intention to study the feasibility ofoff-board 24-hour trading systems. The over-the-counter dealers represented by the National Associa-tion of Securities Dealers (NASD), plan to extendtheir automated quotation system, NASDAQ, to theUnited Kingdom, allowing NASD members both inthe United Kingdom and in the United States tomake markets in several hundred issues duringnormal U.K. trading hours, and to use NASDAQservices during the-se hours. If approvedSecurities and Exchange Commission, thewill be open from 4 a.m. to 4 p.m. eastern

by thesystemtime (9

~Atonepoi.ng it was thought that the Sydney Futures Exchange and the ImndonInternational Financial Futures fichange -) M tidy si~~agreements or were ready to do so. ‘fhe agreements with LIFFE were reported to have broken down because of a demand by CME for “exclusivity,”i.e., that LIFFE not join other systems and not list contracts that would compete witi CME products. David BurtoQ Chairman of LIFFE, as quoted in“Unraveling a Technology ‘lhngle,” Fuzures adoptions, special supplement to Euronwney, July 1, 1989.

~t,A~O~—EOS,J~ ~omotio~ literature distributed by ~OT.

~“Europe Forges Ahead in the Technology Race,” Fufures adoptions, Special Supplement to Eummoney, July 1, 1989, p. 2.


a.m. to 9 p.m. London time).26 NASD dealers willhave a choice, on a security-by-security basis, ofbeing a U.S. market-maker, a European market-maker, or an international market-maker, and theirworkstation capability will be defined accordingly.All NASDAQ market services except for its auto-mated small order execution system (SOES) will beavailable internationally. NASDAQ already sharesquotes with both the London and Singapore stockexchanges, for 700 and 35 cross-listed securities,respectively. Automatic intercontinental executionand trade confirmation will now be possible over thelink.

NASD will also introduce, in 1990, an electronicsystem for global trading of unregistered (privatelyissued) foreign and domestic debt and equity securi-ties. The PORTAL27 system will allow users to dialup a special NASD host computer for both primaryand secondary market trading; participants will alsobe able to use their NASDAQ workstation forsecondary trading. All sales will be negotiated(investors will get quotations, last-sale price, andvolume details on screen, in major currencies butwill work with a dealer). PORTAL will lock intransactions and allow settlement by electronic bookentry through the International Securities ClearingCorp. [See figure 2-l.]

TECHNOLOGICAL BARRIERS TO24-HOUR TRADING

Technology risks, such as communications out-ages, are an important factor in 24-hour trading. Lineoutage and other contingency plans must be coordi-nated over several countries, different languages,staggered time zones and varying numbers oftelephone companies. For example, to maintain adedicated circuit from New York to Tokyo caninvolve from five to seven telecommunicationscompanies. This makes contingency plans difficultto formulate. Global operations require competent

and experienced management at all levels around theclock.

Although technology costs are declining relativeto capabilities and services offered, at the same timedevelopment costs, operational costs, and mainte-nance costs of automation have risen. Automatedsystems rapidly become obsolete as new technolo-gies develop; they require sophisticated manage-ment information systems and technical infrastruc-tures, with high re-engineering costs. Regulatoryrules often influence or even dictate technologiesthat must be used. These rules in many cases havehad a positive impact on the industry. For example,The New York Stock Exchange’s rule number 387requires all member firms to confirm their tradeswith institutional clients through the DepositoryTrust Co.’s automated Institutional Delivery systemor its equivalent to be eligible for the delivery v.payment function--i.e., to pay for securities onlywhen actually received (by book entry) and notbefore. But other regulatory, legislative, and politi-cal processes inhibit automation, including disputesover regulatory jurisdiction and foreign legislationprohibiting dissemination of some data. Resistanceto change, respect for tradition, and social customs—which may reflect deeply rooted institutional rela-tionships, strong economic interests, or cherishedvalues-also significantly impede automation insome foreign countries.

THE PROBLEM OF STANDARDSElectronic 24-hour/global trading has several

problems yet to be solved. One is the issue ofinternational regulation to control global market andcredit risk and to coordinate post-trade procedures.Another is the lack of global data standards.28 Twolevels of standards are important, those that affectcommunication of data in general, and those thatparticularly affect securities trading. The needs for

%ere will be two new kinds of market-makers on NASDAQ after this system opens-lhrqxan-ody market-makers from 4 a.m. to noon easterntime and international market-mdcers from 4 a.m. to 4 p.rm, in addition to existing U. S.-or.dy market-makers. Market-makers will make the choice ona security-by-security and ~-w-~1 “ 1 basis. NMD Executive Digest, Jtie 1989.

~~R~ s-s for ~v~e OHeringS, Resales, ~d TIWQ through Auto~ted L*ges.nsmdsmgem~m~els, Speciticationsor criteriafortechnolog, designed to allow technologicdapplicationa coming ffomdiffe=tproduc~

to be ihteroperable. Interoperability allows users to mix and match components of, for example, communication systems and also makes it easier forthem to migrate to a new syst~ phasing out older equipment gradually. Standards may be set by custom or general consent, by market forces, or moreformally by authority. In the United States, standar~whenthey exist-are set by industry, often through professional associations. Standards-settingin the United States is becoming more politiciz@ especially in communications standards, simx the Bell System no longer sets standards de facto. SeeU.S. Congress, OTA, op. cit., footnote 1, pp. 297-299.

Figure 2-1--Overview of International Trading Through NASD

DepositoriesCustodial Banks

II ●

l t

P International

mJ l

‘EFARE@ENSYSTEM

Price Information andInternational Order Flow

I

Local Firms

International Firms “Passing the Book” International Firms “Passing the Book” International FirmsUs. Europe Far East

SOURCE: National Association of Securities Dealers.


global standards range from technical standards andcommon languages to bank holidays.29

International standards are becoming increasinglyimportant for 24-hour trading; these problems arenot new to the general demands of internationalcommerce. The need for standards has arisen inmany other fields, from railroad and air transporta-tion to early telegraph, telephone, and most recently,computer-to-computer, facsimile, and digital voicecommunications. In each of these cases, countriesdeveloped their own systems, often independently ofone another, often with little concern for futureinternational standardization or harmonization withother countries’ systems.

As needs for international commerce emerged,countries typically moved to develop a set ofcompatible international standards. This often led toestablishing an international organization to facili-tate or coordinate worldwide standards-making.Some of these, like the International Organizationfor Standards (ISO), became permanent. The samepattern of evolution is happening today in thefinancial securities field. A half dozen internationalbodies are currently studying some aspect of standards-setting for international trading or regulation ofthese markets.

Standards that affect the financial trading indus-try, including markets, clearinghouses, brokerageand banking industries, information service indus-try, etc., are established in many different forums.The U.S. subgroup of ISO and the AmericanNational Standards Institute set industrial standardsfor information processing and other technicalsubjects. The principal international bodies includeISO, which is the most influential; the ComiteConsultatif International Telegraphique et Telephon(CCITT); and recently several new internationalbodies, composed of representatives of the privatesector and governments, have also been formed.Standards developed by these organizations areformulated by consensus (75 percent of the IS0

body must approve a proposed standard prior toacceptance and promulgation). After a standard isformulated, its adoption by member firms is stillvoluntary.

Technology standards are critical in terms of “theweakest link. ’ That is, if the technical performanceor capacity of a market participant, or clearingmember, is below those of the market or clearing-house, then the benefit of the market’s or clearing-house’s technology is compromised. There is nominimum standard required today for the technologya broker or futures commission merchant must have,either internationally or domestically, in order tooffer its clients the best access to price informationor to clearing services.

Developing compatible standards for trading fi-nancial instruments is as important to internationalcommerce as having the same gauge railroad tracksin neighboring countries. The standards now beingfocused on by national and international bodieseventually will provide the infrastructure for large-scale global trading. Until then, obstacles, risks, andinefficiencies will remain in international trading.

Two types of standards30 are important for bothdomestic and international trading of securities, andparticularly for clearing, settlement, and paymentssystems. The first type is technical standards, thesecond includes standards governing details of theprocess by which trading takes place and theinfrastructure that supports trading.

Technical standards would include those thatapply to international communications in general—e.g., international digital network standards forworldwide voice, data, and graphics services. His-torically, there have generally been two sets ofcommunications standards, the CCITT standards ofthe International Telecommunications Union fol-lowed in most of the world, and U.S. standards thatevolved more or less de facto through the dominanceof the Bell System in the United States.31 U.S.

%M&ringbankholidays is a serious problem; &cause, whenb~ are CIOSed securities transactions cannot be settled, and more importantly creditcannot be provided for market participants, to assure continued liquidity. Consider the consequences if the October 1987 market crash had occurred 1week earlier, on Columbus Day. U.S. exchanges were open but U.S. banks were closed, and critically important credit would not have been availableto bolster market liquidity.

~AMOU@ only tSVO Utegofies of standards are used here, other treatments might use four categories: process, risk assessment, tiastic-, ~dprocedures. Some of the examples cited in this section do not lend themselves to the adoption of uniform standards, but rather needed improvementscan be adected through harmonimtion. In some countries, for example, it is illegal to disclose or transmi t overseas information concerning a person’sfinancial position. As another example, them are also problems in assessing risks that stem from different accounting practices in various countries.

slIthie~de SolapOOl, “Competition and Universal SeIViCe,” “mHany Shooshan (cd.), Disconnecting Bell, The Zmpact of the AT& TDivestiture (NewYOIIG NY: Pergamon Press, 1984), p. 119.


equipment suppliers have increasingly had to adoptstandards set internationally, in order to compete inworld markets.32 Two major sets of standards, forISDN and for open systems interconnection, arecurrently being debated in various internationalmeetings and consultations. With the planned inte-gration of the European Community (EC) market in1992 (ch. 4) there are even stronger reasons for U.S.industry to coordinate its standards with those of therest of the world. The EC established a EuropeanTelecommunications Standards Institute in 1988 forstandards development.33 A continuing industry-wide effort is needed to coordinate U.S. standardswith evolving global standards.

Some basic technical standards are essential forfinancial communications. One example is a univer-sal standard for international communications mes-sage formats that facilitates instantaneous identifica-tion of the exact details of a trading., the nationand firm originating the trade, the number of sharesor contracts being traded, the price, and the identityof the transactors.34 Other examples include techni-cal details of how screen-based trading should occurglobally and the minimum level of technology to beused by all participants.

Procedural standards are even more important.They apply to operational aspects of trading, clear-ing, and settlement; e.g., such as the method for tradematching, number of days to settle a trade, use of adepository for holding equities, use of a recognizednumbering system for identifying financial instru-ments and transactions, formats for data transmis-sion, the method of payment, etc. Infrastructurestandards refer to the method of regulation, mecha-nisms to protect the clearinghouse against thefinancial failure of a clearing member, existence of

funds to protect customers of a failing broker orfutures commission merchant, bankruptcy laws toadjudicate the disposition of customer assets if abroker fails, credit processes at banks, clearinghouseguarantees, etc.

These standards govern the specific dimensionsof investor-protection regulation and fiscal responsi-bility. Prospectus standards (disclosure of informa-tion about a new issue), accounting standards, andownership standards35 are especially important ininternational trading.

Neither technical standardization nor harmoniza-tion of regulations will come easily, cheaply, orswiftly. Some markets will have to make costlychanges, while others will need more modest changes.Even modest changes can prove very difficult andtime-consumin g to implement because of the com-plexity of effecting change in established proce-dures, and because any change can challenge vestedinterests.36 Some changes may be implemented bythe private sector alone, but others will requiregovernment assistance, in the form of changes toregulation or legislation.

Government involvement in standards-setting, inthe United States, is controversial. There is a longhistory of resistance to it from within the govern-ment as well as by industry. But business firms havelittle experience, and in many cases little interest, inprotracted international negotiations. At a mini-mum, encouragement, facilitation, and leadershipfrom government will be needed. More activegovernment participation in developing interna-tional standards related to securities trading willprobably be critical, because other governments aredeeply involved in the standards-making process.

3W.S. Congress, OTA, op. cit., footnote 1, pp. 295-300. For example, computer vendors andtelecommunication carriers had to adopt tie c~x.mstandard for electronic mail. Also, the Federsl Communications Commission has tried to speed up the U.S. standards-setting process for high definitiontelevision because standards are being developed and adopted in other countries.

qqThis institute is f~nced by all of the European PTTs and major tekcommu.nications suppliers.34T@y, ~ch com~ ~ i~ o~ syst~ for iden- trade dati informatio~ so there is little compatibility among tiese syst~ ~te~o~Y.

Recommendations have beenmade by the Group of Thirty to adoptISO standard 6166, which provides a uniform structure for the International SecuritiesIdentification Number, and standard 7775, which deals with the uniform structure of securities messages, i.e., the message types. However, no countryhas to date implemented either standard. Additional inter-depository/clearing system message standards are being developed.

sscom~es tier as to tie de~tion of a “share” and what rights are i.ncluded+.g., shareholder vo~g @@ts.36~s ~ &n &e e=rieme of tie U.S. ~ Force of tie ~oup of ~, attemp~g to b@ about ch~e h cl- and settlement plVCeSXS,

as discussed inch. 5, according to OTA staff discussions with Gerard Lync& a Managing Director at Morgan Stanley, Inc. and head of the U.S. WorkingGroup of the Group of Thhty, December 1989.

Chapter 3

The Extent of International Securities Trading

Global trading of securities is rapidly develop-ing.l The foreign exchange (currency) and govern-ment bond markets are already thoroughly interna-tionalized. Most international securities trading nowinvolves debt securities rather than equities. To whatextent this globalization will also apply to corporateequities, and how quickly, is somewhat uncertain,but by most measures it is well underway. There isalready growing cross-border trade in the shares ofmany giant multinational companies. Most ex-changes have opened their membership to foreign-ers. Some exchanges are already offering derivativeproducts (e.g., stock-index futures contracts) basedon stocks that are listed and traded in the markets ofa different nation.

Securities markets are already globally linked instill another sense. Because of the growing interde-pendence of national economies around the world,their securities markets tend to move in parallel,especially in times of stress.2 This parallel move-ment was illustrated in the crash of October 19-20,1987, and again on October 13, 1989, when marketsaround the world saw a sharp decline (figure 3-l). Inthe first 3 months of 1990, when the Japanese NikkeiIndex lost about 25 percent of its value in a series ofspasmodic declines, it was widely feared that othermarkets would also drop. This did not happen,apparently because there were specific domesticreasons for the Japanese market’s behavior, but therewere definite ripple effects in U.S. and European

markets, and it is not yet certain that their relativeimmunity to Japan’s problems will last.

The globalization of securities markets raises animportant question for U.S. policymakers: Whatactions need be taken to assure the position of theUnited States as a world center for securities tradingand other financial services? The claim is often madethat U.S. markets are the best in the world in termsof liquidity, efficiency, and fairness, but they haveincreasingly strong competition. In 1980 the UnitedStates accounted for 55 percent of world stockmarket capitalization, but that stood at 35 percent in1990, having dropped for a time to a low of 32percent 3 (see figure 3-2). The Tokyo Stock Ex-change was the world’s largest from 1987 to 1989,but then fell back to 34 percent in 1990 as a result oflarge declines in market prices. Japan’s first rank in1987 to 1989 raised fears in some quarters that theUnited States is falling behind in global securitiestrading. Market capitalization alone is not a goodmeasure of market strength, or of trading perform-ance; it is affected by many other economic condi-tions. 4 But rightly or wrongly, the performance andvigor of securities markets is often taken as anindicator of the health of an economy, and thus hassignificant political implications.

Additional risk to U.S. investors is also a publicpolicy concern. As the globalization of securitiesmarkets continues, Congress will need to addressseveral questions:

lm chapter draws on amend OTA contractor reports, including: tic K. Clemens, Principal Investigator, witi St.epk p. BroW ~vi%nkateswaran, and Bruce W. Weber, “Globalization of Securities Markets” (Philadelph@ PA: Wharton School, University of Peansylvar@ July1989); Peter Schwar@ “Scenarios for Regulation of International Securities Trading” (San Francisco, CA: Global Business Network Nov. 3, 1990);Manning Gilbert Warren III, “Securities Regulation in the European Communities” (Tuscaloo~ AL: University of Alabama Law Schoo~ August1989); KPMG Peat hfarwic~ “The Competitive Position of Commercial B-in the Global Securities Markets: An International Study,” 1989.

~or example, in most markets equity prices rose from August 1982 until September 1987. During the 6-day trading period from the end of Oct. 9through Oct. 19,1987 (Oct. 20 for Japan), the Dow Jones Industrial Average declined by 30 perce@ the NASDAQ Composite Index by 18 perce@ theISE Financial Times 100 Index by 13 percent and the l’b~o Stock Exchange Nikkei 225 Index by 17 percent. NASD Special Committee of theRegulatory Review ‘I&&Force, “Quality of Markets,” p. 17. See also, Federal Reserve Bank of New YoI& “The International l%msnus“ sionof Stock”GeorgeM. vonFurstenberg and Bang NamJeo~ “International Stock Price Movements: Links and M~gw,’’BrootingsPapers onEconom”cActivity,No. 1 (Wash@to@ DC: Brookings IrIstitutiom 1989), p. 165; and “Price Disruption in October 1987,” and “InternationalLink ages Among EquitiesMarkets,” QuurterZy Review, vol. 13, No. 2, Summer 1988.

%tal world capitalization was about $9.4 trillion. Japanese share of world capitalimtiodrose from 17 percent in 1980 to 45 percent in 1989. Datasuppli&l to OTA by International Finance Corp. and the New York Stock Exchange. Figures for the end of 1988 were even more striking: world totalcapitalhtion was $9 trillion, United States 30 perccn~ Japan 42 percent. The 1990 figure for Japan is from the Finuna”al Times, March 1990, p. 40.

%the 1980s the United States had arecessio~ and the value of the currency few which affected the rate of capitalization. Japanese markets expandedbecause of the success of Japanese industry, Japan’s capital surplus, its high savings rate, and the Japanese Government’s use of the stock market as aninstrument of economic policy in privatizing government-owned industry and restructuring financial services. Three national companies have beenprivatized: Japan Tbbacco, Japan National Railways, Nippon Telephone& Telegraph.

–23-


Figure 3-l—Evidence of the World’s Markets on Oct. 13,1989

Bangkok: down 6%

Hong Kong: down 6.5%

Taipei: down 3.3%

I IllSeoul: down 0.7%

Tokyo: down 1.8%I

Toronto: up 1.46%

New York: up 3.43%

London: down 3.2%

Paris: down 5.4%

Oslo: down 11.3%

Frankfurt: down 12.8%

I

I IWellington: down 8.5%

Sydney: down 8%

Manila: down 5.92%

Singapore: down 10%

Kuala Lumpur: down 11.5%

SOURCE: Washington Post, Oct.17, 1989.

What additional risks to U.S. financial systemsmight result? How can unacceptable risks beavoided?Will U.S. investors be adequately protected inglobal investing?How can the United States encourage thedevelopment of worldwide cooperative or reg-ulatory mechanisms for trading in internationalsecurities?

Alan Greenspan, Chairman of the Board ofGovernors of the Federal Reserve System, recentlytold a congressional committee that the delays anduncertainties of trade execution, clearing, and settle-

11 I Athens: down 10.05%

I Zurich: down 10.2%

Madrid: down 5.3%

Lisbon: down 7.6%

ment across national boundaries are serious prob-lems: “It is the float that creates systemic risk.”5 Hecalled for harmonization of national regulations andstandards to eliminate artificial reasons to favor onemarket over others.

These risks may grow worse as globalizationcontinues. Grant L. Reuben, an international bank-ing expert, warns, ‘‘. . the enormous volume andspeed of transactions and the cross-border integra-tion and interdependence of institutions and marketshave magnified both the impact and speed that aproblem in one national market has on others.”6

5 0 A te~~ony on J~= 14, 1989, ~ H~g~ on ~te~tio@~tion of sec~ties ~~, before tie Subcommittee on kld.kS, SCMte

Committee on Banking, Housing, and Urban Affairs. Systemic risk is a condition that threatens the stability of the national fmcial system or paymentssysterrq for example, the catastrophic failure of a major f~cial institution accompanied by cascading failures as the institutions on the opposite sideof that institution’s transactions in turn are unable to meet their obligations, causing their own creditors to be unable to pay still others, etc.

%mnt L. Reubeu Deputy Chairma n of the Bank of Montreal, ‘‘Implications of Globalization for Regulation and Safety,’ remarks at the FinancialGlobalization Conference, Chicago, IL, Nov. 2, 1989.

Chapter 3-The Extent of International Securities Trading ● 25

Figure 3-2—Market Capitalization of World’s Stock Markets

Market value of total shares (billion U.S.$)8000

1 A~ Switzerland~ F r a n c eA--- Canada*

5000

4000

3000

i

1000

0

$A

A

West Germany

United Kingdom

Japan**

United States***

1978 1980 1982 1984 1986 1988

Toronto Stock Exchange● TSE only● **NYSE

SOURCE: Internationalization of the Securities Markets 1988. Federation of German Stock Exchanges Annual Report, 1988.

TRENDS DRIVING ●

GLOBALIZATION●

Institutional investors, and to a lesser degreeindividual investors, trade in the markets of morethan one country in order to find higher rates of ●

return at acceptable risk, to diversify their portfolios,or to take advantage of other hedging techniques.The forces encouraging the rapid expansion ofinternational securities trading are: ●

. the declining costs of international communica-tions;

increasing world trade and interdependenceamong national economies;

concentration of capital in countries with rela-tively limited opportunities for domestic in-vestment, especially Japan;

the necessity in some countries, especially theUnited States, of financing government debt(this led the United States, for example, toencourage foreign trade in Treasury bonds);

the growth of large institutional funds such asmutual funds and private and governmentpension plans, with a need to diversify theirinvestments and hedge their risks;


the changes in regulation of financial servicesin many countries, opening their markets toforeign participants; andthe increase in international public offerings,especially as a result of privatization of government-owned industries in several countries.

Communications

The growing availability of telecommunicationsand computers reinforces the effects of these trends.Not only is information technology necessary forglobal trading of securities; it stimulates all kinds oftrade among nations, familiarizingg potential inves-tors with many translational corporations and theirproducts and services. This reduces one historicalbarrier to trading of corporate securities outside oftheir home market-the lack of knowledge aboutunderlying values on the part of foreign investors.

Telecommunications brings increased access toeconomic, industrial, political, and social informa-tion, both through the public media and throughspecialized information services. This is not anunmixed benefit. The speed with which informationis transmitted between markets can have an adverseeffect, if it forces decisionmaking at apace too rapidfor the exercise of discretion. Communication oftrade data is, moreover, not sufficient for disclosureof risk in securities trading. Basic data on manyEuropean, Asian, and South American corporationsare not available, and there is little trans-borderfinancial research and analysis available to investors.

In the early morning of October 19, 1987, hoursbefore the New York markets opened, U.S. portfoliomanagers who anticipated a sharp drop in value ofequities tier the previous week’s slide, beganselling shares in London. One mutual fund was saidto have unloaded $95 million of equities,7 illustrat-ing the ease with which both information and capitalcan flow across national boundaries.

Interdependence

World trade patterns in goods and servicesencourage world trade in securities. Not only domultinational corporations become familiar in many

countries, but they need to raise capital in the localcurrency for plant, property, equipment, and dailyoperating expenses. International trading of corpo-rate securities grew sharply in the 1970s and 1980s.After the 1987 market crash, there was a temporaryreduction in international trading. Most agree thatinternational trading incorporate equities is likely tobe limited to stocks of “world class” corporations.There are already at least 500 corporations whoseissues trade internationally.

It is possible that a two-tier market will develop,with trading in these securities conducted in one tothree world markets, with participants passing theirtrading books from London to New York to Tokyo,while other securities are traded only in their localmarket or time zone. The implications of such atwo-tier market are uncertain. Already Europeansecurities market planners and developers are debat-ing whether there should be different systems,different procedures, and different rules for retailcustomers and international/professional traders.8 Inthe United States, the Securities and ExchangeCommission (SEC) has approved a new rule (144a,Apr. 19, 1990) that will allow institutional investorsgreater freedom in trading private placement securi-ties by exempting many such securities from regis-tration requirements if they are not available toindividual investors.

Capital Imbalances

Another force driving the globalization of securi-ties trading is that some countries have accumulated‘‘excess capital’ not matched by productive domes-tic investment opportunities. That money is availa-ble for investment through the securities markets ofother countries. One example is Japan, with its highvolume of exports. European investors also find thattheir domestic markets cannot meet their investmentdemands. 9

International imbalances lead to a flow of capitalacross national boundaries that some economistsview with concern. In the United States, the growingFederal deficit has been financed to a significantdegree by foreign purchases of Treasury bonds.

bMelam~ “ThePainful Tru@” The InternationalEconomy, July/August 1988, p. 59. Melamed is “Chamnan of the Executive COmmittee ofthe Chicago Mercantile Exchange, This figure was put at $90 million in the Report of the Presidential Thak Force on Market Mechanisms (The BradyCommission), January 1988, p. 30. Some O’lA informants and advisors believe it was much larger.

%YIX disc~sions with oflkials of the International Stock Exchange in IxmdoQ March 1990.%oy C. Smi@ “International Stock Market Transactions,” New York’ sFinanciuZiUarkets: The Chdenge of Globalization, Thierry Noyelle (cd.)

(Boulder, CO: Westview Ikess, 1989), p. 8.

Chapter 3--The Extent of International Securities Trading ● 27

There is concern that we have become dependent onan inflow of foreign capital that could be cut off, orcould undergo sharp price increases (see figure 3-3).But U.S. policy with regard to international securi-ties trading has been that the unimpeded flow ofcapital funds across national boundaries is basicallyadvantageous both to countries requiring additionalcapital funds and those seeking markets for surpluscapital funds.10 Consequently the United States hasplaced few restrictions on foreign portfolio invest-ment, and those are chiefly for information-gathering. 11 SEC disclosure rules, for example,

apply to foreign as well as domestic issuers, and thisis a problem for some companies whose homecountries do not have similar requirements.

Figure 3-3-Foreign Holdings of U.S. Financial Assets

Billions of dollars1400

1213.91200

i 1074.9

1000

800

600

400

200

01980 1981 1982 1983 1984 1985 1986 1987 1988

SOURCE: Goldman Sachs Portfolio Strategies, December 1988.

Financing National Debt

Foreign investment in the United States wasessential to economic development in our firsthundred years. In the middle of the 19th centuryforeigners held about half of Federal and State debtand a quarter of municipal debt. During the next sixdecades foreigners invested heavily in such bur-geoning American industries as steel and railroads.Only during World War I did the United States ceasebeing a debtor nation for a few decades as Europeannations liquidated U.S. holdings to raise money forthe war.12

Further growth of the U.S. deficit and uncertaintyabout the stability of the dollar could inhibit foreigninvestment. It has probably caused some shift inJapanese equity investments from the United Statesto Canada, Europe, and Australia.13 In 1980, 41

percent of foreign activity in U.S. securities was incorporate equities, but this has fallen steadily, to 9percent in the first half of 1989, as U.S. Governmentdebt became the focus of foreign investment; theproportion of foreign activity in Treasury bonds rosefrom 53 to 87 percent.14

Institutional Investors

The growth of institutional investment funds suchas pension funds and insurance funds, especially inthe United States, is a major force encouraginginternational securities trading.15 Public and privatepension plans represent large concentrations offunds that must be invested, and’ many institutionalinvestment managers want to diversify fund hold-ings outside of their own country to protect against

loJ~u5w.Allem “CapitdNWket Changes inthe United Kingdo~ JSPSXL West ~, and Singapore, A Brief Survey,” Congressional ResearchService Report 88-49-E, Jan. 14, 1988, p. 2.

ll~eme some limitations on direct foreign investment in specific industries such as energy, maritime, _ COm.m~~tiOnS, @b_. ~International Investment Survey Act of 1976 (22 U.S.C. 3101 et seq.) mandated a study of the extent of foreign investment to be performed every 5years, and the Domestic and Foreign Investment Improved Disclosure Act (part of the Foreign Corrupt Practices Act of 1977, Public Law 95-213)~ed ~Yone a~uirins 5 percent of the equity securities of an SEC-registered company to disclose ci”tuxmship and residence. Michael Seitzinger,Foreign Investment in the United States: iUajor Fe&ral Restrictions, Congressional Research Service Report 88-164 A, Feb. 23, 1988.

l?l’bid. rn 1988, total foreign direct investment inU.S, plants and machinery was $326.9 billiou compared to U.S. d~t ov~ investment of $308billion. But the U.S. investment is oldeq its current value is probably much higher. Some experts say tbat the returns on foreign investment here aresignificantly lower than returns on U.S. investment overseas. See, for example, Stephen Kindel, “Return of the Native,” Finana”aZ WorZd, Jan. 9, 1990,p. 20.

13111E U.S. share of these Japanese institutional invesbrmts droppedfkom 55 percent in 1986 to 51 percent in 1987, according to Yasuhko“ u-“Japanese Imumnce Companies: Our Strategy for Irtvesting in Ameriw” The International Economy, July/August 1988, pp. 64-65. Mr. Ueyama ispresident of Sumitomo Life Insurance Co. These figures were confiied by the International Securities Clearing Corp. in 1990, but more recent figuresare not available.

14s~tia ~m~ A5m~tioQ C’Foreign ~tivi~ Repofi$’ JSIL 25, 1989, p. 5 and update by telephone, Novembes 1989. Foreign activi~ incorporate bnds dropped fkom 5.3 to 2.6 percent during the period 1980-88.

ls~dominanceof institutional traders differs to someextentbycountry. InEurope, thelargestholders of equities srebiginstitutiona, andlsrgebanksusually handle investments for individual investors in a discretionary mode. InJap~ 69 percent of equities are held by corporations or institutions, butthese tend not to be traded. Individuals do about 42 percent of the securities trading.


both potentially adverse currency fluctuations anddomestic economic recessions.

16 The value of cross-border portfolio investments by U.S. private-sectorpension plans grew from $21 billion in 1980 to $225billion by the end of 1988.17

Some doubts about the value of this diversifica-tion as a kind of transnational hedging have emergedbecause of the way markets behaved in October1987. As described in The Economist:

. . . the world’s 23 largest stock markets fell togetherduring the October crash; and . . . most of themtracked each other closely for months. The correla-tions between stock markets during and after thecrash were uncanny and unprecedented.18

This lessens the protection against risk to beachieved by international diversification. The corre-lation in market behavior is to some extent inevita-ble, given the interactions between interest rates andcurrencies, although precipitous drops in Tokyostock prices in the first quarter of 1990 had onlyslight immediate effect on other markets. Because ofthe swift flow of information and the ease of shiftinginvestments from one market to another, a precipi-tous decline in one marketplace could at any timealarm investors in other marketplaces and causethem to react. But international diversification alsohas other benefits, and is likely to remain attractiveto institutional investors.

Regulation and Deregulation

Deregulation in the United Kingdom, Japan, andFrance has also encouraged international trading byincreasing the access of foreigners to those nationalmarkets and their securities firms. This kind ofderegulation may be called “access deregulation.”There has been a general worldwide trend towardaccess deregulation, and at the same time a world-wide trend toward increased prudential regulation

(sometimes misleadingly called “re-regulation”),aimed at stronger investor protection. London’sdramatic access deregulation in 1986, called “BigBang,’ stimulated other European exchanges toimprove their quotation and settlement systems,broaden exchange membership, and lengthen trad-ing days.

Privatization

Another force encouraging the cross-nationalholding of equities has been the privatization in theUnited Kingdom and Japan of-very large industriesthat had been owned by the state. More stock had tobe offered for sale than could be absorbed byinvestors in a single country, so there have beenmany stock issues that are offered in severalcountries at the same time, with each country’sallotment, or “tranche,” consisting of millions ofshares.

OBSTACLES TO INTERNATIONALSECURITIES TRADING

Although there are strong forces encouragingglobalization, there are also many obstacles:19

lack of liquidity in smaller markets;government policies or regulations designed toexclude foreign participants from national mar-kets;other legal barriers such as exchange controls,discriminatory taxes, and deposit requirements;differences at the interface of banking andsecurities activities;difference in clearing, settlement, and paymentsystems;nongovernmental but officially condoned prac-tices (in effect, non-tariff trade barriers) whichexclude foreign interests, such as restrictionson membership in exchanges;

IGFrom 1985 to 1987, U.S. Wmion plans increased their foreign equity holdings by $19 billio~ while their holdings of U.S. Witks d-m~ by$47 billion. SmitlL op. cit., footnote 9. At the end of 1988, U.S. private-sector pension funds had $52,5 billion in foreign investment. United Kingdomprivate pension plan investment overseas was $69 billion at the end of 1988, Japanese private pension plan investment overseas was $33 billion. Foreignprivate-sector pension plans hadapproximately $62.4 billion in portfolio investments intheUnited States at the end of 1988, and this hadgrownto $67.7billion by June 1989. (Information provided by Intemec Research Corp., November 1989.)

ITFi~s for 1980 ~d 1987 ~m SEC SW Report to U.S. Semte comrnitt~ on B-g, Housing, and Urbm A.ffti Ud U.S. HOW OfRepresentatives Committee on Energy and Commerce, “Internationalization of Securities Markets,” 1987, p. 88; 1988 figure provided by IntemecResearch Corp. to OTA, November 1989.

lsBy~ne set of me-ements, the ~~e~tion~W~nthe23 biggest stoc~kets, whichw~ ().222 for more ti5 ye~ before ti Cr~ W= ().’755at the time of the-crash and has since then remained about 50 percent higher than the pre-crash figure. “Why Stockmarkets Move Together,” TheEconomist, Mar. 11, 1989, p. 77.

lgf$~~~o~ T~de in Services: fkXllrkies,” summary of a report by the OECD Committee on Financial Markets, in OECD, Finuncia2 MarketTrenak, May 1987, pp. 15-43.

Chapter 3—The Extent of International Securities Trading ● 29

● differences as to accounting practices, regula-tory structures, capital adequacy requirements,and investor protection standards;

. differences in corporate organization; and

. other social, cultural, or behavioral barriers.

The risks imposed by these difficulties, andparticularly by the lack of standardized or harmo-nized methods of trading, clearing, settling, andmaking payment are serious. Many internationaltrades fail to settle on time, often because as manyas 12 financial institutions maybe intermediaries toa single securities transaction.20 (See ch. 5.)

Laws and regulations in some countries forbidvarious kinds of participation in securities marketsby foreigners. Tax laws may also inhibit foreignactivities or reduce their profitability. Activities thatare permissible in one country are illegal in others.

Less formal but pervasive social and culturaldifferences are also important. Outsiders may not beable to operate efficiently because of ignorance oflanguage or culture or lack of necessary professionalcontacts. They may find it hard to recruit andmanage indigenous staff. Access to bank loans maybe difficult. In Japan, for example, long-established,interlocking, and stable relationships between do-mestic companies and banks put foreign firms at acompetitive disadvantage.

One important difference between national secu-rities markets is the extent to which banks areallowed to participate. In the United States, theGlass-Steagall Act of 1933 separated banking andsecurities-related activities. Japan’s Article 65 ismodeled after the Glass-Steagall Act. Until recently,Canada also placed legal barriers between banks andmost securities markets activities. Most other coun-tries have ‘universal banking,” meaning that bankscan do underwriting and otherwise participate fullyin securities markets, and banks are often thedominant participants in those markets. The generalinternational trend has been toward more homogene-ous regulatory treatment of financial institutionswithin countries.21 This is true even in the UnitedStates, as Federal regulatory authorities--the Comp-troller-General (Department of the Treasury) and the

Federal Reserve Board-have gradually relaxed theinterpretation of the Glass-Steagall Act to allowbanks and bank-holding companies to edge intosome securities-related activities.

HOW “GLOBALIZED” ARESECURITIES MARKETS?

Several kinds of activities are subsumed in‘‘market globalization,’ a term that is often looselyused. They are:

●

●

●

●

●

●

●

●

A

cross-listing stocks and bonds issued in Coun-try A on the exchanges of Country B;investors of one country buying and sellingforeign stocks in foreign markets, throughforeign brokers;opening a country’s stock markets to foreignbrokers and dealers who serve both foreignersand nationals;legal or contractual ties between exchanges indifferent countries;“passing the book” or 24-hour trading, i.e.,shifting the control of trading to colleagues inother countries and time zones;multinational offerings of stock;international mutual funds; andcross-national stock index derivative instru-ments.

Cross-listing of Stock

simple form of internationalization of marketsis listing stocks issued in Country A on exchanges inCountry B. The value of cross-border offerings ofbonds, including foreign and Eurobonds, grew from$38 billion in 1980 to $238 billion in 1988. Thevalue of cross-border offerings of equity-relatedsecurities grew from $200 million in 1983 to $20.3billion in 1987.22

London’s International Stock Exchange (ISE) isthe most “internationalized” of the world’s bigexchanges, with 23 percent of the companies whosestock is listed on the ISE being foreign companies.The Tokyo and New York Stock Exchanges, whichare larger markets, have far fewer foreign companieslisted (table 3-l); in 1989, the NYSE listed 82

~Jllni~W.P~e, “ACasefor StandardS inIntemational Financial Markets-Jan. 1, 2000,” a discussion paperpmp~edfor tie~~~ Mee@of the International Organization of Securities Commissions, Sept. 1-4, 1987, Rio de Janeiro, Brazil.

21~MG pa -C. ~~~ Coqetitive ~Sition of c~erc~ B* ~ tie Glo~ S-ties -J@s: AII kte~tio~ S~dy,” COXItrtiCtOrreport prepared for the Office of Technology Assessment January 1990.

~s~ op. cit., footnote 14, PP. 58-59.


Table 3-l-Comparison of Major Markets

Tokyo Stock New York London StockExchange Stock Exchange NASDAQ Exchange (lSE)

Annual average trading volume[$ billion] . . . . . . . . . . . . . . . . . . . . . $2,234 &1 ,356 $ 347 $ 361

No. of listed companies, 1988 1,683 1,681 4,451 2,580—Domestic . . . . . . . . . . . . . . . . . . 1,571 1,604 4,179 1,993—Foreign . . . . . . . . . . . . . . . . . . . . 112 77 272 587% Foreign . . . . . . . . . . . . . . . . . . . . 6.7% 4.6% 6.1% 22.7%

SOURCE: Office of Technology Assessment, 1990.

foreign stocks or ADRs23--3.7 percent of its list-ings. In the frost quarter of 1990, this rose to 93listings, and their trading accounted for 5.8 percentof total share volume.24 NASDAQ includes 196foreign issues and 96 ADRs, 5.7 percent of listings.

Several smaller markets, particularly in Europe,are more “international” Of stocks listed on theThe Netherlands exchange, 56 percent are non--domestic; Germany, 49 percent; Switzerland, 42percent; and France, 32 percent.

Most stocks are still traded only in their countryof origin. But London’s SEAQ International regu-larly quotes 750 foreign equities, with continuousquotes in about 350 of them, resulting in tradesvalued at about £ 1 billion daily, compared to £ 1.4billion in domestic equity trades and £ 10 billion inbonds. 25 In Tokyo about 120 foreign issues aretraded, generally less than 2 percent of total volume,but recently this has risen to about 7 percent.Euromoney magazine reported in mid-1988 thatthere were 487 stocks with an active and liquidmarket in at least one trading center outside of itshome Country.26 The home country, for 60 percent ofthese stocks, was either the United States, Japan, theUnited Kingdom, Australia, or Canada.

Obtaining a listing on the Tokyo Stock Exchange(TSE) has become an important element in theglobal strategy of many export-oriented U.S. compa-

nies. Corporations are attracted by the large amountof capital available for investment and by the beliefthat Japanese investors are more interested inlong-term growth and less concerned with veryshort-term performance than are U.S. investors.Some multinational corporations also reason thatlisting in Japan improves their corporate image inthat country, helping them to attract a Japanese workforce. Obtaining a listing on the TSE is, however,complicated and costly.

In the United States, foreign firms who want to listtheir securities on a U.S. exchange or NASDAQ mayregister them with the Securities and ExchangeCommission (SEC), thereby subjecting themselvesto our reporting provisions.27 The SEC has, as noted,recently approved a rule exempting from reportingrequirements companies offering private issues onlyto large institutional investors.28

International Portfolios

Another measure of internationalization is cross-national portfolio investment, the degree to whichCountry A’s investors buy stocks issued in CountryB. For all countries, investment in non-domesticsecurities was $250 billion in 1984 and $1,281billion in 1987, a fivefold increase in 3 years (table3-2). This strong growth in cross-national invest-ment inequities was reversed temporarily in 1988 asan aftermath of the 1987 crash. New foreign

~Non.u,s. corporations Wishg to bve their equities securities traded in the United States can choose to hWe them lmkd w acti~ Sws or mAmericanDepository Reeeipts (ADRs). AnADR is a receipt issued by aU.S. b@ conversable into a specified number of shares deposited in the issuingeoqmration’s country of domicile. An ADR may be freely traded in the ADR marke~ related to but distinct from the market in the actual shares. Shoulda U.S. holder wish to obtain the shares, the ADR is presented to the U.S. depository bank for cancellation and reregistration before the original sharesean be delivered to the holder. Price information on an ADR is in U.S. dollam and maybe easier to get than the price of underlying shares; purchasemof ADRs pay domestic rather tban foreign trading commissions.

~~o~on supplied by the NYSE Washington office, Apr. 2, 1990.nS~Q kte~tio~ statistics.

~Euro~n~, Iv@ 19*8.~But not t. some o~r ties, such ~ ~= gove~g ~eholder proxy votes. Regist~g is optio~ ~ess me foreign issuer @ mOre dUll 3~

record shareholders in the United States, more than $3 million in total assets, and is engaged in business affecting interstate commerce.~R~e 144A, approved Apr. 19, 1990.


Table 3-2—Total Cross-National Investment

TotalYear (billions of dollars) Change

1984 . . . . . . . . . . . . . . . . . . . . . . . $250 –1985 . . . . . . . . . . . . . . . . . . . . . . . $ 4 0 0 +60%1986 . . . . . . . . . . . . . . . . . . . . . . . $ 7 5 0 +88%1987 . . . . . . . . . . . . . . . . . . . . . . . $1281 +71%1988 . . . . . . . . . . . . . . . . . . . . . . . $1031 -19.5%SOURCE: Securities Industries Association. Global Equity Analysis Re-

ports.

investment in Japanese, American, British, Cana-dian, and West German equities in 1988 droppedmuch more than did domestic trading in thosestocks.29 In the highly internationalized Londonmarket, foreign trading in U.K. equities droppednearly 30 percent, while all trading in U.K. equitiesdropped less than 5 percent.30 Only Japanese inves-tors made more overseas equity trades in 1988 thanin 1987. Although reduced, the 1988 cross-borderequities trading was still above that of 1986 and overthree times the amount in 1984.

In 1950, foreign investors held a little more than2 percent of U.S. securities; in mid-1988 it wasnearly 12 percent.31 Foreign investors hold nearly 22percent of U.S. Treasuries (however, the holdings ofcorporate bonds increased faster than holdings ofTreasuries). Foreign investors held about 6 percentof U.S. equities in mid-1988.

The large growth of foreign portfolio investmentin the United States could be risky in a way thatdirect investment is not. Multinational firms monitortheir currency exposure and stand ready to makemassive shifts in response to changing conditions.Factories or farmlands will not be moved outside ofthe country, but foreign capital can be withdrawn ina matter of minutes or hours.32 This could amplify amarket decline, turning it into a rout. [See box 3-A.]In February 1990, as the Tokyo Stock Market wentinto a several-day decline for the frost time in years,this concern was voiced by a number of financialexperts.

Box 3-A—Exogenous Events andU.S. Markets

U.S. markets could be thoroughly shaken byseemingly unrelated events in far-away places.Noting that some seismologists are predictingpossibly devastating earthquakes in the vicinity ofTokyo, Tokai Bank generated the following sce-nario:

. . . Tokai Bank has estimated the damage thatwould be caused to financial markets if there werea repeat of the 1923 earthquake, a 7.8 on the Richterscale, that reduced Tokyo to rubble and left 142,000people dead. The bank’s conclusion is that Amer-ica’s stock and bond markets would be reduced torubble too.

. . . (W)ith one-third of Tokyo’s reclaimed landliquefying into mud, reconstruction would costY119 trillion ($847 billion). Japanese institutionswould have to sell investments in America, sendingstock and bond prices tumbling and interest ratessoaring worldwide. Side-effects would be globalstagflation and a worsening of the Third-World debtproblem.

The hypothetical earthquake that the bank sentrumbling through its computer model knocked 4.8percent off Japan’s gross national product for thecurrent calendar year, causing the world economy toshrink 0.3 percentage points in 1989. The economiceffects would go on reverberating for years . . . .

SOURCE: The Economist, July 15,1989, p. 7. (Condensed)

On the other hand, a strong case can be made thatforeign capital, especially Japanese capital,. hasacted effectively to stabilize American financialmarkets in recent years. David Hale, an internationaleconomist, says,

In 1987 and 1988, the Bank of Japan purchasedover $55 billion of U.S. securities in order tostabilize the dollar. The Ministry of Finance oftenused moral jawboning to prevent Japanese institu-

=oreign individuals and institutions made purchases and sales of $288.3 billion iu all U.S. securities msrkets in the firat 9 months of 1988, whichwas doti 19.8 percent from the firat 9 months of 1987. AU transactions in foreign equities made on U.S. markets were also down in the same three-s by 24.3 percenti to $107.3 billion.

~S~ties~d~~es ~=i~oQ G[o~[E~’~A~ly~sRepo~, vol. ~, Noe 5, J~y 7, 1$)8$). Japanese illVtXtOIS’ nOtpllNhSSSS Of fOre@l Securitk?in 1980 was $4 billiou in 1988 it was $87 billio~ and in the fust 7 months of 1989 it was already $55.3 billion.

31Jefi~ ~. &.~efm ~ David G. Strom “my ~ the ~s About Fore@ ~ves~@” C)@/enge, ~y-Jme 1989, pp. 31-35. F- S1’ebaaed on Federal Reserve Flow of Funds, U.S. ‘Ihsury.

WnecommentatorW eges thatJapanesefund managers “triggeredthecrash” (~ 198’7) @[email protected]. ~“es 5 days earlier, causing a collapsein bond prices and a resulting rise in interest rates that led to widespread selling of equities. R._ Murphey, “Power Without Purpow: ~ ~~of Japan’s Global Financial Dominance,” Harvard Business Review, March-April 1989. But this report is not widely accepted.


tional investors, from dumping dollar securitiesduring periods of exchange rate uncertainty.33

Richard Koo of the Nomura Research Institute toldthe Joint Economic Committee of Congress,

During 1986 and 1987 . . . when the dollar andfinancial markets around the world came precari-ously close to total collapse, Japanese authoritiestried to keep investors in dollars by telling them howmuch good the U.S. had done for Japan after the war,and how important it was for Japan to stay with thedollar to prevent the total collapse of the worldfinancial system.34

Opening National Exchanges

Cross-country exchange membership and broker-age is another form of internationalization. Manycountries have opened their exchanges for member-ship by foreign firms within the last 5 years, or haveallowed foreign firms to buy or buy into theirdomestic securities houses for the first time. Forexample, the first 6 foreign members were allowedto join the Tokyo Stock Exchange in February 1986,and in 1988 16 more seats were made available tonon-Japanese firms.35 Other foreign firms probablywant seats, even though membership costs are high.There are at least 47 foreign securities houses withbranches in Japan; most were reported to be losingmoney in 1988-89. Four large Japanese firms tradeoverseas (Nomura, Daiwa, Nikko, and Yamaichi),and are reported to have invested $350 million inbuilding up their American businesses. These arevery large fins, so their international businessaccounted for only 1 percent of their pre-tax profitsin 1987-88, down from 5 percent the previous year.36

Many American stockbrokers sought to operate inLondon’s markets after the 1986 deregulation.Merrill Lynch, the first U.S. firm with an affiliate onthe London Exchange and among the frost to applyfor a primary dealership in government bonds, spentmany millions of dollars in London on computers,

staff, and anew headquarters. Merrill Lynch becamethe second largest Eurobond underwriter, and by1987 it had a staff of 1,600 in London.37 Other majorU.S. securities firms and banks also made majorefforts to build business in London. But after theOctober 1987 crash, they sharply reduced theirLondon staff. All foreign brokerage houses inLondon were reported to be losing money in 1988and 1989. The unprofitability of such foreignventures causes some observers to doubt that inter-national securities trading will grow as much, or asrapidly, as enthusiasts had predicted. But a morelikely outcome is that as international trade in-creases, a few very large securities firms willeventually dominate the field.

Passing the Book

Twenty-four-hour trading is what many think ofas “globalization.” This occurs when a firm hasfacilities in locations around the world, and passesits “book” (i.e., control of its active trading)between those locations across time zones, in orderto trade some instrument such as U.S. Treasurybonds around the clock.38 (See figure 3-4.) Most24-hour trading now is in foreign exchange andbullion, not equities.

There is some skepticism as to how prevalent24-hour trading in equities will become. One studycalled 24-hour trading a myth, and said,

Many of those who profess to trade for 24-hoursacknowledge that they do so to maintain a “global”profile, not because 24-hour trading is a prime goalin itself.39

Other skeptics, attuned to the traditional, face-to-face form of trading prevalent in New York andChicago, say that trading is an intensely personalactivity and traders will neither be able to stay awake24 hours or to let someone else trade for them. This

33David D. H~e, “The J~~ese h4inistry of Finance and Dollar Diplomacy During the Late 1980’ s,” July 1989 manuscript, provided to OTA bythe author, who is a senior vice president of Kemper Financial Services, Inc.

~Testimony on Oct. 17, 1988.35s~ went t. ~efica~, 4 t. British ~, ~d 2 ~ch to Fr@ch, W=t ~~~ ~d Swiss f-. Motohiro IIca, “Foreign SCZWM= Fhms,”

The Japan Economic Journal, Summer 1988, p. 39.36~s is an~om~ jomst~s es~te; .s= ‘fc~Japan7s Saties F~ Keep theFlag Fl@g?” The Econo~”st, Dec. 3,1988, pp. 85-86. OTA

was unable to obtain this information from the Japanese firms.37Cr~g Fo- “Merrill ScaleS Down Imndon ~itbm,” The Wall Street Journal, June 15, 1988, p. 20.38Forei~ exc@e ~s 1oW ken a ~how _ket. About $350 bil~on ~ fo~i~ c~ncy tr~sactiom tie pla@ ev~ @, colllp~~ tO d)ollt $5

billion daily on the NYSE. S. HanSell, “The Computer That Ate Chicago, “ Institutional Investor, February 1989, pp. 181-188.sgGzo&z capital Mar~et~, ~ ~MG rqo~ (~ter~: KPMG ~t~tio~ ~lce, peat -ck McL,titock Publications, 1988), p. 16.


Figure 3-4-Trading Around the World and Nearly Around the Clock

Keyed to eastern daylight time/local hours shown adjacent to each sessionI I I I I I I I I I I 1 I I I I I I I I I

9 Midnight 3 6 9 Noon 3

1Tokyo

Hong Kong

London

New York

I I IClosed\ I 9 to 11 a.m.; 1 to 3 p.m. I I

T+’+Closed

9 a.m. to 5 p.m.

SOURCE: Office of Technology Assessment.

10 a.m. to 12:30 p.m.; 2:30 to 3:30 p.m.

—

—

will probably not be a major barrier if 24-hour The most extensive, vigorous, and competitivetrading turns out to be profitable.

Richard D. Ketchum, Director of the SEC’sDivision of Market Regulation, claims that for mostequities there will not be sufficient 24-hour orderflow to encourage profitable risk-taking by marketmakers. This is different, he points out, from foreigncurrency and government bond markets ‘‘whereownership of the underlying assets have truly spreadworldwide and relevant news regarding those mar-kets occurs around the clock and around the globe."40

This projection too depends on continuation ofpresent conditions of ownership and informationflow that tend to concentrate liquidity primarily inone home market. These conditions may already bechanging.

U.S. broker-dealers may be likely to try 24-hourtrading because they already have a large investmentin information technology. Salomon Brothers openeda 24-hour desk in New York when the ChicagoBoard of Trade began evening trading in May 1988.Their business in futures and options is covered fromNew York during the hours that the U.S. or Tokyomarkets are open, and from London when theLondon International Financial Futures Exchange(LIFFE) is open.

24-hour trading (except for currency) may eventu-ally be in futures contracts.41 The Nikkei index istraded on the SIMEX exchange in Singapore, as wellas Osaka, and is approved for trading on the ChicagoMercantile Exchange (CME). LIFFE trades Japan’sgovernment bond futures and the Chicago Board ofTrade (CBOT) announced (Nov. 21, 1988) that theywould also do so. When CBOT expected that TSEwas about to begin trading a T-bond futures contractin competition with CBOT’s contract, the Chicagoexchange responded by beginning to trade duringevening hours, 6 to 9:30 p.m. c.s.t., Sunday throughThursday. Four months later, the Philadelphia Ex-change began operating from 7 to 11 p.m. e.s.t.,Sunday through Thursday and from 4:30 to 8 a.m.e.s.t., Monday through Friday, to accommodatetraders in London and Tokyo. Thus, competitionamong exchanges, or the fear of it, is stimulating24-hour trading.

The New York Stock Exchange may find itdifficult to extend its trading hours because of itslabor-intensive trading system.42 It will be hard tofind a second shift of specialists, at least until24-hour trading has become a highly developedactivity-and then it would probably be too late to

~S@tement by Richard G. Ketchum, “Challenges Facing the StZdkX Musq,” at a meeting June 16, 1989, sponsored by Business Week andSecurities Week, manuscript provided to OTA by the author. The statement represents the personal views of the author, not a statement of SEC policy.

41~fiu~N~@wachi, ”Financial Futures: Round-the-Clock Trading Expected to Spread in Tokyo,” Tokyo FinancialMarkets, a Special Surveyof The Japan Econonu”c Journal, Summer 1988.

42The NYSE us a ~fis~ or desi~t~ mmket.~er, system ~d hades must go ~ugh he sp$cfit post (with some (XCeptiOnS) when thefloor is open for trading. Floor trading is supported by automated order routing systems and other forms of automation. See OTA’s forthcoming reporton information technology and domestic securities markets.


capture this market. Under the pressure of rapiddevelopment of international trading, however, theNYSE has recently announced “plans to exploreoff-hours trading.” According to James Cochrane,the Exchange chief economist:

By working with industry participants and ex-change customers to assess current off-hours activ-ity, trading procedures, and market needs, the NYSEis developing a strategic approach to emergingglobal markets. What roles extended hours, availabletechnologies, and key market participants will playin these strategies have not yet been announced bythe Exchange.43

Product Links Between Markets

Non-American exchanges are copying innovativeinstruments developed by the U.S. exchanges. Thechairman of CBOT has complained that “[CBOT]contracts are being Xeroxed overseas. ”44 There aremany new derivative products (futures and options)markets in Europe, Scandinavia, and Japan, at least36 in all outside the United States. Chicago marketsdid more than three-quarters of the world’s futurestrading only 5 years ago. This was down to 60percent in mid-1989, and the TSE’s yen governmentbond futures contract is now the world’s mostheavily traded. The rapid spread of derivativeproducts markets in competition with U.S. futuresand options markets has stimulated a greater willing-ness at the CME and the CBOT to try technology asa way to compete in the international arena.

The French MATIF, opened in 1986, is now thethird largest futures exchange in the world. Thefourth largest is the London International FinancialFutures Exchange (LIFFE), which is trading, amongother non-sterling products, a futures contract on10-year German Government bonds. A contract onthe same German lo-year bonds will be traded by theWest German Deutsche Terminborse, which openedin January 1990 as a fully computerized exchange,operating through monitor screens connected to acentral computer.45

The European Options Exchange in Amsterdamwas the first in Europe, and has many internationallinks. MONEP is the French options exchange. The

London Traded Options Market (LTOM) tradesoptions on equities and a stock index. There areothers in Stockholm, Zurich, and Denmark; optionsmarkets are planned in Finland, Norway, andIreland. Trading in options began in Japan in June,1989, at the Osaka Stock Exchange, with a contractbased on the Nikkei 225 index, but there was alreadya large volume of off-market (private) optionstrading.

The U.S. Commodity Futures Trading Commis-sion (CFTC) and the SEC have both approved theCME’s plan to trade a futures contract based onMorgan Stanley Capital International’s index, repre-senting a basket of 1011 stocks issued in 18countries. The Coffee, Sugar & Cocoa Exchange isnow trading a futures contract based on its Interna-tional Market Index (50 foreign stocks primarilyavailable only outside the United States), andAMEX is trading an options contract also based onthat index.

Whether these index futures or option contractswill succeed remains to be seen. There may not beenough buyers and sellers to assure liquidity. On theother hand, institutional investors may use them toprovide “an international component” to hedgeportfolios, or for other trading strategies such asasset allocation. Some institutions are prevented bylocal law or by their charters from investing abroad,but would be able to use these U.S. futures contracts.

Multinational Initial Offerings

Initial stock offerings on a multinational basisalso encourage international trading. Many coun-tries do not have enough depth in their capitalmarkets to accommodate large new equity offerings.France, for example, was faced in 1986 withprivatizing companies worth about $30 billion, at atime when the total value of listings on the Parisbourse was only about $80 billion.% Very largeissues of stocks may be underwritten in severalcountries at the same time. Multinational offerings

as different tranches withare often underwrittenseparate underwriters. They are increasing as corpo-rations seek to diversify their stockholder base, toincrease the recognition of their products and

As~ner t. OTA Aug. 14, 1989.~Ja_ti ~=, “fitures and Optiom, “ Financial World, Aug. 23, 1988, pp. 27-29.4S~o~on ~ovid~ ~ OTA ~ Me~gese~c~ COrp., New York NY, NOV. 23, 1989.

%roup of Thirty, “Symposium Background Paper: The Globalization of Equity Markets,” Imndo% Sept. 15-16,1986.

Chapter 3-The Extent of International Securities Trading ● 35

services in a broader market, to fund foreignemployee benefits schemes, to facilitate foreignacquisitions, or to defend against take-overs.

International Mutual Funds

These are an alternative to active portfolio tradingand let investors hedge against changes in onecountry’s economic conditions without the disad-vantages of trading in a foreign country withinsufficient information. Some European countries,especially Luxembourg, have tried to get Americaninvestment companies to offer U.S. mutual funds inEurope, but legal and tax differences make itdifficult for U.S. mutual funds to operate in Eu-rope.47

International mutual funds managed by U.S.investment companies for American investors be-came popular in the early 1980s as the dollarweakened (as foreign currencies appreciated againstthe dollar, the net asset value of funds denominatedin those foreign currencies increased). While returnsfor many international mutual funds have beensuperior to most U.S. funds over the last 5 years,some investors in international mutual funds were,however, reported to be disappointed as it becameclear that diversification does not necessarily avoidcyclical risk (for example, the recession of 1982 andthe crash of 1987 were worldwide).48 The funds arealso highly vulnerable to currency fluctuations.Third World country funds are relatively thinlytraded; large infusions of money, from a pensionfund, for example, can swing the market violently,and under stress it can be difficult to get out of themarket because there are too few potential buyers.

The number of international mutual funds never-theless continues to grow. The Investment CompanyInstitute says there are 75 international funds (two-thirds of their portfolio from outside the UnitedStates) and 80 global funds (some U.S. securities).

RISKS INHERENT INGLOBALIZATION OF

SECURITIES MARKETSIf all of the legal, regulatory, and social barriers to

globalization of securities trading are overcome,important systemic risks remain. In times of crisis,the failure of major intermediaries could “imposeunacceptable external costs on the entire financialand payments system and ultimately on the entireeconomy. ’ ’49 There is a strong trend toward concen-tration and consolidation of securities firms, so thatthe failure of any major intermediary will be likelyto have wider consequences than in the past,especially when such intermediaries deal in manymarkets or in many nations. There was no cascade offailures when Drexel Burnham Lambert went bank-rupt, but this is little assurance that it could nothappen in the future.

Several kinds of risks are inherent in securitiestrading and are likely to be affected by an increasein translational securities activities. They includecredit risks, position risks, transaction risks, andsystemic risks.50

Credit risk (also called counterpart risk) is thepossibility that one party to a transaction may notdeliver, or that a borrower may not repay a loan, orthat an intermediary in a transaction (e.g., a paymentbank or a clearinghouse) may fail. This risk is muchthe same in domestic and international trades, but itmay be made worse by internationalization becauseit is harder to make judgments about the reliabilityof counterparties, the quality of assets, or the degreeof protection afforded by disclosure rules. Creditrisk is increased as participants trade in severaldomestic and foreign markets, where regulatorystandards and safeguards may vary widely. (See ch.4.) On the other hand, greater opportunities todivers@ activities may help to reduce total creditrisk. Many countries are now acting to improve theirclearing, settlement, and payment mechanisms, andin some cases the sharing of information (see ch. 5),and this should moderate the increased credit risk.

dT_tiomofmu~= ~mmew~t~mn~ a,sarerequirernents foraccounting procedures and for disclosures, andfort.hetimes whm~itigains must be paid out.

4sKenne& J@wU ~d Jeff ~d~ “IIItemtiorMI Funds: What Factors A.ff=t Thd Returna,” AMA JownaZ, my 1988, p. g.4g&_tion for ~n~c ~o~on ~ ~elopmen~ ‘$~wemnts for the R-bon ~ Sup-ision of Securities ~hts in OECD

Countries,” Financial Market Trends 41, Novembex 1988, p. 36.SOS- remarks made by Grant L. Reu@ ~Uty ~ mancial Globalization Conference in Chicago, Nov. 2,of the Bank of Montreal, at a F“

1989; the address was entitled “Implications of Globalization for Regulation.”


Position risk is that which threatens entire institu-tions with sudden failure: insufficient assets to meetthe demands of depositors, borrowers, investors, orcreditors. This could be associated with: 1) a dryingup of liquidity (when assets exist but cannot bereclaimed and redirected), 2) significant change inthe value of securities being held for trading or otheruses, or 3) adverse changes in foreign exchange ratesor interest rates. International trading can reduceposition risk by offering a greater choice of markets,more opportunities to hedge, and a greater variety oftrading strategies. On the other hand, globalizationof markets tempts traders to trade in environmentswhere they do not understand all of the dangers andmay lack buffers such as back-up lines of credit.

Operational risk is the danger that comes frombreakdowns in telecommunications, computer sys-tems, established institutional procedures and struc-tures (including market-making mechanisms), andother “mechanical” aspects of securities trading.Technology provides powerful capabilities for get-ting things done, and for guarding against the humanrisks of error, inattention, incompetence, misfea-sance, and malfeasance. But technology entails itsown risks of breakdown and misuse, which almostcertainly increase with internationalization. Techno-logically sophisticated systems have failed in allcountries, including the United States, for example,telephone networks, electric power distribution sys-tems, and air traffic control systems. The ability ’todevelop and maintain technological systems is notthe same in all countries. Technological backupsmay be inadequate or untested, or may fail for thesame reasons that the primary system fails. In late1989 and early 1990, for example, a severe droughtin the Philippines caused a shortage of hydroelectric

power, causing blackouts and making it impossibleto depend on electric systems in the financialSector. 51

In addition, dependency on technological systemsincreases the vulnerability when the system fails,because manual skills, interpersonal relationships,and alternative means of operating have often beenforgotten or lost. In global trading, some of thesealternative and backup procedures have never beendeveloped. At the same time, expectations of speedand efficiency have increased because of technol-ogy, and so the impact of breakdown maybe greater.

There is a further risk of unknown dimensions thatcomes with internationalization--sy stemic risk. Thatis the extent to which securities market credit,position, or transaction risk could threaten the basicfinancial industries, the payment system, or theeconomic performance of nations. On this questionthere are many opinions but little useful evidence.There are two complementary approaches to reduc-ing risk: 1) private sector efforts to improve andstrengthen both technological systems and institu-tional interfaces, and 2) governmental efforts toimprove and harmonize regulatory safeguards. Manycountries are now revising their regulatory frame-works. According to the Organization of EconomicCooperative Development:

There is increasing awareness that securitiesmarket activities involve risks that are comparable tothe systemic risks inherent in banking, and thataccordingly, the basic question arises as to whatextent existing regulatory and supervisory arrange-ments are adequate to deal with current marketrealities. 52

These efforts are discussed in chapter 6 of this report.

Sl~rd@ to w ~ m- Vice President for International Development International S=tities ~- COT., MY lm.

%3EcD, op. cit., footnote 49, p. 31.

Chapter 4

America% Competitors in Global Securities Trading

In the competition for leadership in global securi-ties trading, America’s chief competitors at presentare Japan and the United Kingdom.1 The EuropeanCommunity is making a strong effort to integrateand strengthen the securities markets of its membernations (which include the United Kingdom) into atrading arena that can compete on equal terms withthe United States and Japan. There is much skepti-cism, even among proponents, that this can beachieved in the near future, but the EC countries, aswell as other nations such as Canada, Australia,Singapore, and Hong Kong are, or could become,niche competitors.

Institutional investors have the incentive, theinformation access, and the technological infrastruc-ture to trade across national boundaries. In makingthe decision to do so, they balance several factors:price, liquidity, cost (including regulatory costs),and safety (i.e., transparency and fairness). Somemarkets with high investment returns are limited orrisky.

The conventional wisdom about market liquidityhas been that the trading for a specific security willalways concentrate in one marketplace. With tech-nology making possible nearly instantaneous com-parison and arbitrage of prices (eventually on a24-hour basis), that rule may not forever hold true.There could be more than one liquid market, or theactive market for a stock may migrate from onecountry to another or from one time zone to another.

The serious constraints on international trading atpresent are the lack of essential protective regula-tions or enforcement in some countries (see chs. 3and 6), and clearing and settlement risks (see ch. 5).As these barriers are reduced, competition to serveinternational investors will increase. In this competi-tive arena, the United States’ position may dependultimately on the advantages it can get from

information technology and from prudential regula-tion that assures transparency and fairness.

JAPANThe Tokyo Stock Exchange (TSE) was the

world’s largest market in value of investments from1987 to early 1990. It had been a bull market for 7years, growing from $370 billion in 1980 to $2,803billion in 1987, interrupted only briefly by theOctober 1987 crash. In February 1990, its pricesbegan a steep, spasmodic decline. This had littleimmediate effect on other major markets, but someexperts worry that if the Japanese market shouldreally crash, its investors might be forced to pulltheir money out of other markets to cover the losses,causing the crash to spread around the world.

The TSE traces its institutional history back to1878, but it was organized in its present form duringthe United States occupation of Japan, and stocktrading began in April 1949. There are severalexchanges in Japan, but the TSE handles about 86percent of transactions by volume and by value. TheOsaka Exchange accounts for roughly 10 percent,the Nagoya for about 4 percent, and others less than1 percent together.2 The TSE is described in its ownliterature as a quasi-government organization, and‘‘a place for domestic and foreign investors to investtheir assets . . . [and] by making it easy for enter-prises or the nation to raise capital, it also makes animportant contribution to economic development. ”

Traditionally Japanese corporations dependedheavily on debt financing (typically less than 20percent of corporate capital has been equity); andmost of that came from banks rather than fromsecurities markets.3 But large Japanese firms nowraise over 60 percent of their funds in the capitalmarket.4

1~ ~~pt= &aw~ on ~v~ o~ ~on~ctm ~fis, including: ~c K. Clemom, princip~ hvestigator, with Stephen P. Broad, Rav’i%dcateswara~ and Bruce W. Weber, “Globalization of Securities Markets” (Philadelpl@ PA: Wharton School, University of Pennsylvan@ July1989); Peter Schwar@ “Scenarios for Regulation of International Securities Trading” (San Francisco, CA: Global Business Network NOV. 3, 1990;Manning Gilbert Warren III, “Securities Regulation in the European Communities” (lhscalooa AL: University of Alabama Law Schoo~ August1989).

~okyo Stock Exchange, 1989 Fucf Book, p. 17.sThe GT GuUe to World Equity Markets J988 (lmndon: Euromony publications, 1988).ds~t~ent by ~~o Kadoti, of~e ~s~ of F~ce, ~ tie 14~ ~USI Conference of IOSCO, in Venice, Sept. 18-21, 1989.

–37–

38 ● Trading Around the Clock: Global Securities Markets and Information Technology—

Recent Trends

TSE began trading foreign stocks in December1973, with six listed foreign stocks.5 In 1985 thenumber began to rise dramatically, and reached 120by early 1990.6 The average daily turnover offoreign stocks is about 790,000 shares compared toover 1 billion total daily volume.7

Japan’s primary market for government bondswas virtually closed to foreigners until 1986. Whenthere was a new government bond issue, Japanesebanks, securities firms, and life insurance companieswould form an underwriting syndicate and divide upthe issue among themselves for distribution.8 For-eign banks and securities firms were not members ofthe syndicate but were occasionally allotted a smallpart of the issue. In 1989, Japan moved to a partialauction system for selling 10-year bonds.

The number of foreign member-firms on the TSEhas increased slowly, to 22 in 1989. After the stockmarket crash in 1987, the 45 foreign securities firmsin Tokyo began to reduce their staffs. In the yearending September, 1988, 39 of the 45 foreign firmsin Tokyo had net losses, but during the next year,they were by most accounts doing well.9 Theyaccount for only about 5 to 7 percent of tradingvolume, possibly because they lack good retailchannels (the active sector of the market is tradingby individual investors).

The TSE still has fixed commissions (except forlarge trades, for which commissions have recentlybeen unregulated). Traders try to turn over as manyshares as possible, as often as possible, to capturegains, because the ratio of dividends to prices is verylow.10 Both domestic and foreign traders concentrate

on the relatively few Japanese institutional investorsseeking short-term profits. This usually meansbuying and selling Japanese securities, becauseinformation about them is most quickly available.Foreign investors for the last 5 years have been netsellers, and their share of trading has fallen from 10to 2 percent.

How the Market Works

Trading at the TSE takes place as a continuousorder-driven market, where buy and sell ordersinteract directly. There are no official market-makers, no specialists, and no affirmative obligationto make markets. All securities must be tradedthrough an authorized securities dealer. The BigFour securities houses: Nomura, Daiwa, Nikko, andYamaichi, together account for about 40 percent ofthe trading, for their own accounts and for customers(in 1960, the same four firms accounted for 70Percent) .11

In Japan, institutions and corporations hold themajority of stocks, but tend not to trade them.Individuals do most of the trading. Ownership ofshares of companies listed on the eight exchanges inJapan in 1988 was as follows:12

PercentBanks and other financial institutions . ..........44.6Business corporations . . . . . . . . . . . . . . . . . . . . . .. .24.9Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23.6Foreigners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.6Securities firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5Investment trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4Government/local government . . . . . . . . . . . . . . . . . 0.8

There are two kinds of exchange members-regular and Saitori. Regular securities company

%lb&o Stock Exchange, 1989 Fact Book, p. 19.6Da~ ~ppfi~ by ~+ Yuji Shibuya of the Nom= Re-h ~ti~te, Tokyo, F= 81.2.277.~98, NOV. 15, 1989, updated co-sy Of the

International Securities Clearing Corp., May 1990.7~@o f$t~k Exchange, 1989 Fact Book.KO Sakai, “GovernmentBondM arket: More Liberalizadon Measures Urged ’Ib Raise Foreign Share,” TheJapanEcononu”cJournal, Summe r 1988,

p. 28.Whe Wall Street Journal, reported on Aug. 16, 1989, that Salomon Brothers, Merrill LyncQ Goldman Sachs, and Morgan Stanley Japan Ltd. are

doing well in Jap~ but “on the whole, foreign losers vastly outnumber the winnerS. (Marcus W. Brauchli, “U.S. Brokerage Firms Operating in JapanHave Mixed Results,” p. 1. See also “Gaij@ Gaij@ Gone,” The Economist, Jan. 14,1989, p. 69. In 1990, most new reports say that Anerican securitiesfirms in Tbkyo”are making money. (Financial Tz”mes Special Section on Japanese Markets, III-ix, Mar. 15, 1990.)

~oshuo N~@_ ~~~~~e of the~nt si~tion and the ~blems of ~vestorRo~tion in Jap~,” present~ at the NASAA Conferencein Washingto~ DC, Apr. 26, 1990.

llR~Bro~ *+M~m.S~~FirmS prO~~u@~irB_ L*,” Fi~nciaJTj~s, s~i~ Sect.iononJapanese Markets, @. 15,1990,HI-vi. “

12These fiWes ~ from ~ TSEJ’act Book J989, p. 92, which d~s not expl~ why they add to lo2.Apercent. It is likely tit “investment h’llsts,2.4 percent” overlaps with the figures for banks and other financial institutions, Foreign ownership peaked in 1984, at 6.3 percent.

Chapter 4--America’s Competitors in Global Securities Trading ● 39

members, like broker/dealers in the United States,receive orders from customers or trade for their ownaccount. They execute trades through four Saitorimembers, who match buyers and sellers. Saitorimembers are not analogous to U.S. market-makerssince they can neither trade for their own account noraccept orders from public investors. They record amatch of buy and sell orders but do not become acounterpart to a trade.

In executing large block orders (300,000 shares ormore), a regular member can act as both seller andbuyer. However, in active stocks the proportion ofblock trades was only 6.5 percent in 1988,13 becauseinstitutions tend not to trade as much as individuals.

TSE trades only listed securities, and a decisionby the Exchange to list a security must be approvedby the Minister of Finance. Listed foreign stocks andbonds may be denominated in either yen or foreigncurrency but exchange settlement is chiefly denomi-nated in yen. Japanese stocks often trade at muchhigher price-earnings ratios than American stocks,averaging 65: 1 as compared to 12: 1 at the New YorkStock Exchange (NYSE), in part because earningsare not consolidated due to corporate cross-listingand in part because of differences in accountingpractices.

Most of the stocks are traded only on theComputer-Assisted Order Routing and ExecutionSystem (CORES). Exchange member companieshave on-line terminals in their main offices to sendin orders and receive verification. In the TSEComputer-Assisted Trading Room Saitori clerksmonitor the computers, which automatically matchorders on their “Book Display Device” or displayscreens. When a transaction is completed, the noticeis sent to a Trade Report Output Device in the officeof the firm that placed the orders, and recorded on theSaitori members’ Trade Report Printers.

There are three kinds of stocks:

. First Section issues, the most actively tradedstocks (1,169 in 1989), of which only the 150most “blue-chip’ trade on the stock exchangefloor, while the rest trade on CORES;

Photo credit: Courtesy of Tokyo Stock Exchanges

Tokyo Stock Exchange computer-assisted trading room

. Second Section stocks (434 listed), all trade onCORES; and

● Foreign Division listings (120),also trade on CORES.

Of the 1,723 listed issues in 1989,1,573 are tradedonly electronically. However the other 150 issues,which trade on the floor, represent about 78 percentof all trading volume by shares.14 Stock Price displayboards immediately display the price information.The layout of the Exchange floor is much like that ofthe NYSE, but the hand signals used by the tradersare more like those used at the Chicago futuresexchange.

Only First Section stocks can be traded on margin.The customer deposits guarantee money at a pre-scribed rate with the securities company, and canalso use securities as collateral (they are given aspecial “loan value”). The customer pays interestuntil he returns the money borrowed from thesecurities company. For individual investors, about39 percent of transactions were margined in 1988, an8 percent increase in that year. The use of marginshad been declining since 1982, although the value ofmargined transactions had continued to rise (asmuch as 39 percent in 1988).15

A market information system conveys quote andprice information to the offices of the securities

ls~~o siti ficha~e, Fact Book 1989, p. 16.14~~e f@e~ ~em ~ppli~ by NOm~~ R~~h ~ti~te, NW Yom ~, J~~ 1990+ ~C TSE Fact B~~k 1989 tists comparable fi~ fOr

1988: of 1,8(X2 listed stock (1,690 domestic, 112 foreign), 1,652 am traded on CORES and 150 on the floor.15T@o Stock Exchange, Fact Book 1989, p. ~.


Photo credit: Courtesy of Tokyo Stock Exchanges

Tokyo Stock Exchange stock trading floor

companies, the media, and information vendors aswell as to the stock price display boards on thetrading floor. However, no vendor is permitted toprovide real-time digital price or quote streams toinvestors away from the floor.

The bond trading floor is much like the stocktrading floor. Member companies place orders bytelephone directly to Saitori members in a specialgovernment bond block trading room. However,most bond trading is over the counter, includinglarge block trading in government bonds and yen-denominated foreign bonds.

Since there are no market-makers or specialists inthe TSE, the function of keeping an orderly market

16 When there is a majoris handled in other ways.order imbalance in a listed stock, the Exchange postsa “special bid quote” or a “special asked quote”that is better than the last sale price. This can berenewed or modified every 5 minutes until it elicitsenough orders to reestablish some equilibrium.Another way of controlling ups and downs is thedaily price limit (which is imposed on the basis notof a percentage change in price but an absolute yenlimit). Listed stocks cannot be traded at a price thatexceeds the limit of price fluctuation from theclosing price of the previous day (the permittedfluctuation is proportional to the price level, i.e., ahigh-priced stock can fluctuate more than one

selling at a much lower price.) Finally, there aretemporary trading halts when the market becomestoo volatile.

Derivative Products Markets

In 1985 the Tokyo Exchange started anew marketfor long-term Japanese government bond futures.Trading is conducted largely by computer. In 3years, this has become one of the major financialfutures markets of the world. Access to futurestrading is open not only to regular member firms, butalso to non-member securities companies and banks.

In June 1987, the Osaka Securities Exchangebegan trading on stock average futures, using abundle of 50 blue-chip stocks traded in Osaka.Trading in cash-settled TOPIX futures at the TokyoExchange and the Nikkei 225 futures at the Osakaboth began on September 3, 1988.17 This wasdescribed as an opportunity “to offset generalmarket risk, gain financial protection, maintainprofitability, invest in the market as a whole, andarbitrage between futures and cash markets. ’ Arepresentative of the Ministry of Finance, SadaakiHirasawa, said that government policy would en-courage the development of futures markets with“high priority for protecting the position of inves-tors and other market participants.”18

1%id., p. 12.IT~e Nikkei AverWe Share Wce ~dex is simih to the Dow Jones, and is built on the prices of 225 First Section stOckS. The prinCipd d~culty

with tbis index is that it is not weighted and the Tokyo stock price index (TOPIX) was developed in 1969 to remedy this-it is the weighted averageof all First Seetion stocks.

~ssa- fimaw% “Catc@ UpFaS~” Look Japan, July 1988, p. 10.


But on December 8,1988, the Nikkei 225 first fellnearly 200 points in the first 15 minutes of TSEtrading and then jumped 300 points in the final 30minutes. Program trading led by U.S. firms wasblamed. On the day before, there was an unprece-dented volume of trading in stocks, as traders tookadvantage of price differences between stocks andstock-index futures on the first contract expirationdate for contracts.

A month later (Jan. 13, 1989) the president of theexchange said publicly that the exchange mightmove to restrict arbitrage trading between stocks andstock-index futures because arbitrage by foreignersmight induce “excessive volatility and confusion.’ ’19

Before Japan’s second witching hour, March 7,1989, there was worry that a sell-off could drop theNikkei by as many as 1,000 points. Accordingly, theexchange followed the example of the ChicagoMercantile Exchange and changed the rules so thatthe settlement price for TOPIX futures is based onthe opening stock prices the day after expiration. TheExchange also changed stock margins from 30 to 40percent.20In December 1989, two New York firms—Salomon Brothers and Morgan Stanley-who hadpublicly announced that they would cease programtrading in the United States, were reported to beactively program trading in Tokyo, arbitragingbetween the two stock indexes, the Nikkei andTOPIX.21 The vice-chairman of Salomon Brothers,Stanley Shopkorn, was quoted22 as saying,

The Japanese have an ability to monitor and makesure the market works in a more orderly fashion.They don’t have the fears that U.S. investors haveregarding index arbitrage.

But on February 26, 1990, after the Tokyo marketdropped by 11.5 percent in a week, program trading

was again blamed for the break. The Tokyo StockExchange imposed restrictions on computerizedprogram trading between the futures and cashmarkets, and the Ministry of Finance was reported tohave called in large institutional investors andleading brokers to discuss the market situation.23

After further declines in the market, U.S. firms wereasked in early March to restrict their programtrading.24

It is thought that program trading in Japan ismostly done by U.S. fins. To do program trading,brokers need to sell huge blocks of stocks, whichmay depress the prices of those stocks. In Japan,companies may identify which broker was sellingthe stock and punish them by withholding under-writing or other business from that company. TheU.S. firms say, however, that much of their programtrading is on behalf of large Japanese insurancecompanies and trust banks.25 In the midst of therenewed controversy about program trading, inMarch 1990, Nomura Securities Co. (the largestsecurities firm in the world) announced that it wouldbegin program trading, and had hired an experiencedAmerican securities expert to oversee their newactivity .26

Futures and options trading, nevertheless, isgrowing rapidly.27 Three index options contractsbegan trading in mid-1989. The volume of trading inthe most popular of these, the option on theNikkei-225, has grown to about 65,000 contracts perday.

Over-the-Counter Market

About 250 companies are listed on Japan’sover-the-counter market; to be listed requires that anaverage 2,000 shares are sold per month.28This

19@o~d h C’~@o &change my Act To Curb Arbitrage Trades,’ Wall Street Journal, Jan. 13, 1989p. C 14,m,4By BeU, Book, and Cmdle, “ The Economist, Mar. 4, 1989.Z1-CU.S. Fi.rms Using Rogram Trading Make Tokyo Stock Market JumF,” Wall Street Journal, Dec. 9, 1989, p. C 1.22SW B@ett, “~@ fibi~ge for U.S. Finns, ” New York Times, Dec. 19, 1989, p. D 5.23~c.yo N_o~ and st~anwags~l, “~~o Curbs Arbi@age “f’rading,” Financial Times, Feb. 27, 1990, p. 1.

~WCUS Brauchli and Masayoshi Kanabayasbi, “U.S. Brokers Asked in Japan lb Curb Program Trading, Wall Street Journal, Mar. 9, 1990.

~Ibid.~~c~el R. Sesit and Craig l’brres, “Nomura To Plunge Into Program Trading on Global Scale, Challenging U.S. Lead,” The Asian Wall Street

Journal Weekly, Mar. 19, 1990, p. 27.27Tr~ding fi the N&k&225 ~d TopJ’x fi~~ contracts, added togeth~, is now higher ~ trading in the U.S. Stintid & poor 500 index flltur~

(according to Andrew Freemam “Japanese Contracts Could Overtake U.S. Equivalents, “ in the special section of Japanese markets, Financial Times,Mar. 9, 1990) but such comparison can be misleading. Because of differences in U.S. and Japanese margining systems, it is customary to sell andrepurchase more frequently, to capture profits.

~Assetznternational, NOV. 20, 1989, P. 9.


market grew at a rate much slower than expecteduntil mid-1989, but thereafter became more active.The Japan Securities Dealers Association has devel-oped anew electronic quotations system modeled onthe NASDAQ (National Associates of SecuritiesDealers Automated Quotation) system in the UnitedStates; it will be called JASDAQ.

The over-the-counter market was the locus of the“Recruit-Cosmos” influence-peddling scandal, inwhich senior government officials, including thefinance minister, made large profits by buying acompany’s stock just before, and selling it just after,it was approved for over-the-counter sale. The JapanSecurities Dealers Association, which is the self-regulatory organization for the over-the-countermarket, has now proposed new, tighter, regulation toprevent this kind of insider trading.

Clearing and Settlement

All clearing and settlement for stocks is handledby the Japan Securities Clearing Corp. (JSCC), asubsidiary of the TSE, and is usually done on thethird business day after the trade. The failed-traderate is less than 1 percent. Recently, high volumes oftrading are pushing this system to its limits, and a“back office” (after-the-trade paperwork) crisis isthreatened. (See Appendix A: Clearing and Settle-ment, for a detailed description.)

There is a book-entry clearing system; however,JSCC is technically required to return the depositedshare certificates to the owners once a year andwhenever a shareholder requests it. This is a majorburden on the institutions and the market. Discus-sions on how to improve the system have gone on formany years. A Central Depository and Clearing ofSecurities Law was enacted in 1984, but the newDepository Center that it sought to create is not yetoperating; it may begin in late 1991. Settlementcosts in Japan are very high compared to othermarkets.

For foreign stocks, clearing and settlement isthrough full book-entry transfer at the JSCC, whichhas cooperative agreements with overseas public

clearing organizations, securities depositories, andcommercial banks that keep the underlying foreignshares in the home country.

Market Regulation29

The TSE is a non-profit corporation, self-regulating but under the close supervision of theMinistry of Finance. Many changes have been madein the regulatory and tax structure since 1987.Exchange members themselves proposed new rulesto curb stock manipulation, to make initial publicofferings more competitive, and to dismantle proce-dures that allow stock to be transferred to selectedpeople at advantageous prices (as in the recentRecruit-Cosmos scandal).

TSE publications prominently emphasize a deter-mination to guarantee the public interest and protectinvestors, and they tie this to “the principle ofauction,’ which is defined as time and pricepriority. 30 Rules say that financial statements andany other company news that may influence theprices of securities must be “disclosed accurately,promptly, and impartially, at the appropriate mo-ment without delay. ” Nevertheless the Japanesemarkets are far from transparent. The Ministry ofFinance announced in January 1989 that it wouldtighten stock-ownership disclosure rules, makingthem similar to U.S. and British regulations.31

Although insider trading has always been againstthe rules, neither violations nor reprimands weremade public, and most market participants report-edly did not consider them a serious violation ofeither law or ethics. In early 1989 Japan for the firsttime provided criminal penalties for insider trading.Japan’s Securities Exchange Act of 1948 has manyinvestor protection clauses patterned after those inU.S. laws, but according to a leading Japanese criticof the markets, the laws ‘‘have not been satisfacto-rily enforced.”32 Shuzo Nakashima, of the Hiji-ribashi Law Firm, identifies two reasons for this: 1)because of cross-holding of shares among corpora-tions, the interests of other shareholders can be“ignored and neglected most of the time’ and 2)

~SOmS: “Regulations of the Tc@o Stock Exchange,” 1986; “Constitution of the TolqIo Stock Exchange,” 1986; “Listing Regulations of the‘Ibkyo Stock Exchange,” 1984; “A Listing Guide for Foreign Companies,”no date; all supplied by the ‘lbkyo Stock Exchange.-t is, the lowest-priced offer and the highest-priced bid has fnt priority, and if two are placed at the same price, priority is given to that received

first.qltis W. Bmuchl~ “Jap~~e Regulators Seeking lb Tighten Rules orMtock-Ownership Disclosure, “Asian Wall StreetJournal, Jan. 23,1989,

p. 18,32N~ op. cit., footnote 10.


enforcement is neglected because the regulatingauthority (the Securities Bureau of the Ministry ofFinance) is chiefly concerned with the growth of theJapan securities industry and its brokerage firms.Mr. Nakashima lists as major problems insidertrading, price manipulations, churning, and fraud bysecurities advisers.

Japan, like the United States, legally separatesbanking from securities markets, the Glass-SteagallAct having been the model for Japan’s Article 65,adopted during the American Occupation. As in theUnited States, this separation has been made lesseffective by a combination of deregulation andtechnology. The largest banks are demanding uni-versal banking (i.e., permission for banks to engagein all kinds of financial activity, including securitiestrading) while the securities firms want to preservethe separation. The Ministry of Finance is reportedto be considering a compromise in which bankscould set up brokerage subsidiaries and securitiesfirms could open bank subsidiaries.33

This issue has been complicated by the impendingintroduction of GLOBEX (discussed in ch. 2), theelectronic trading system being introduced by theChicago Mercantile Exchange and Reuters. Japa-nese banks began planning to put GLOBEX termi-nals in their offices for trading interest rates andcurrency futures, and later stock index futures andoptions. But the banks were for a time discouragedby the Ministry of Finance; but on May 21,1990, theMinistry of Finance approved the use of GLOBEXterminals.

Tokyo as a World Center forSecurities Trading

Japan is often mentioned as America’s top com-petitor in securities trading, primarily because theTokyo Stock Exchange rivals the NYSE as theworld’s largest market. It is not, however, asintimationalized as London, nor as accessible toforeign traders or investors as either New York orLondon. Language, culture, and high startup costsare all significant barriers.

Most of Tokyo’s trading is concentrated in a fewmajor issues; the 30 most active stocks account forabout 46 percent of volume by transactions and 39percent by value. No one is allowed to deliverreal-time digital price data by electronic systems toinvestors. Frequent trading halts may alarm someforeign investors who are not accustomed to circuit-breakers. There is a trading tax in Japan, of 0.30percent of the value of the transaction. Commis-sions, particularly for retail customers, are highcompared to other markets, and the paper-basedsettlement system, which does not centralize settle-ment between brokers and custodians, is expensivefor institutional traders. Investor protection is weak.So long as Japan’s economy is strong, however, itssecurities markets will continue to be strong compe-tition for those in the United States.

THE UNITED KINGDOMLondon is the other major competitor to New

York stock markets and Chicago futures markets inworld trading. The International Stock Exchange ofthe United Kingdom and the Republic of Ireland(ISE, or informally, the London Stock Exchange)%

is the most “internationalized’ of the major mar-kets, with 1,987 domestic and 707 foreign listings(23 percent). It trades listed bonds and equities,unlisted securities, and options.35 The ISE is nowstruggling to adjust to changes brought about byderegulation, automation, and the crash of 1987, butit has many advantages as a center for global trading.Foreign shares account for about a quarter of alltransactions at the ISE.

The ISE is among the world’s largest stockmarkets by capitalization, but usually ranks afterTokyo, New York, NASDAQ, and Osaka. Theaverage number of ‘‘bargains’ (trades) per dayincreased by 42 percent from 1983 to 1988, but theaverage number of shares traded increased by 192percent (to 408.5 million), reflecting an increase inthe number of large blocks.

London is also the home of the 7-year-old LondonInternational Financial Futures Exchange (LIFFE)

SS,’Jap_@eF~cti Deotiow ~~ the ~lz,” The Econo~”st, my 20, 1989, P. 87.

~Sep~ti exc~%es in ei~t citie~bndo~ Be~@ B~ Btitol Dubl@ Glascow, Liverpoo4 and Manchester-were merged in 1973.The London Stock Exchange was renamed the International Stock Exchange in 1986. Spicer & Oppenheimer, Stock Markets Around the Worki (NewYoa NY: Job Wiley& Sons, 1988); pp. 207 ff.

3S~Ufis~ s~~ties ~ket~dles ismes of ~mp~es @t~nOt&ted~~ethey wish tOASe SIAk sums of money thanlistingrequires,wish to release a smaller percentage of total equities, or have too short a trading reeord. There is an over-th~counter market for equity and corporatebonds.


and the center of the Eurobond market, althoughneither is part of the ISE.36 The Eurobond market isan over-the-counter market operated by banks andstockbrokers. Its investors are principally institu-tions, and Japanese firms have come to dominateEurobond underwriting.

Most major American and Japanese securitiesfirms are members of the ISE, but none hassucceeded in capturing a significant market share inU.K. securities. American firms have done well inmarketing advisory services, banking services, andin mergers and acquisitions.

In October 1986, the British Government deregu-lated the securities market, an event known as “BigBang.” Fixed minimum commission rates wereabolished. Mandated separation of brokering anddealing functions (“single capacity”) was alsoabolished; firms could now operate as both brokersand dealers, trading for customers and for them-selves. Big Bang opened up the markets. Britishbanks were allowed for the first time to becomefull-service financial institutions; they can under-write securities and can own brokerage houses.Restrictions on foreign membership ended. Foreignbanks can now own up to 100 percent of Britishbrokerage fins. Most of the leading firms in the ISEare now corporations, many owned by internationalbanks and finance houses. Before deregulation, theywere all partnerships and the London Stock Ex-change was much like a gentlemen’s club.

The change in market structure was profound; theCouncil of the International Stock Exchange says:

Indeed it was thought that these changes inworking practice were so great that it would not bepossible to implement them in a staged manner butthey would all have to be implemented in a “bigbang. ”37

The ISE Planning Committee “had been worriedthat insufficient market-making capacity would

come forward,’ but instead ‘the degree of oversub-scription was awesome. ”38 The rigorous competi-tion among them contributed to serious adjustmentproblems. Nevertheless, business volumes increasedsignificantly after Big Bang, by some 85 percent forcustomer business and an equal proportion through‘‘inter-market-maker dealings.

How the Market Works

ISE modeled its new electronic trading supportsystem-Stock Exchange Automated Quotations(SEAQ)--after the National Association of Secu-rities Dealers Automated Quotations system(NASDAQ) in the United States, deliberately reject-ing the specialist system in favor of competingmarket-makers. Quotations are displayed on thecomputer network, and transactions can take placeeither by telephone or on the floor. In fact, the floorwas quickly abandoned,39 and all trading takes placeby telephone. The distinction between exchange andover-the-counter trading effectively disappeared.The ISE’s competing market-makers are required totry to make continuous markets in the stocks inwhich they deal from 9 a.m. to 5 p.m., but they do nothave the affirmative obligation to trade their inven-tory that NYSE specialists have.

After deregulation, commissions paid by institu-tional investors dropped to about 0.2 percent oftransaction value, or moved to a “net price, free ofcommission” basis.40 In spite of the halving ofcommissions, The Financial Times reported inOctober 1987 that London stock exchange firms hadearned much higher income over the year ‘‘as aresult of the upsurge in turnover during the past year,particularly from small investors. ”41

Immediately after Big Bang, market-maker firmsspent millions on computer systems. Big Bang led torapid expansion (the number of market-makers onISE grew from 5 to 31). Competition was intense.After the 1987 crash, the drop in trading volume put

—36Sc~aent ad ~u~t~y for Emobonds we dir~t~ by tie Association of ~ternatio~ Bond ~ers (-D) and proc~s~ either by Ewoclear, in

Brussels, or Cedel in Luxembourg.37~~ReviW of the c~~al Market in U.K. Equities,’ A Comtdtative D ocument from the Council of the International Stock Exchange ~ereaftercited

as “Council of the ISE”], May 1989.%bid,, p. 6.3~tis ~p~mostof the~e. ob~~ersmport~ton~t. 19.20,1987, wh~~eNewYorkexc@ef loor and Chicago pitS were bedlam, the bndon

floor was eerily empty. All action was “upstairs” in the members’ offices and trading rooms.‘%l’’here is a value-added tax of 15 percent on commissions, a transfer stamp of 0.5 percent on purchases, and a levy of fO.80 on trades of over flOCKl

to funce the regulatory fkamework. It was announced in March 1990, that the transfer stamp duty will be eliminated when a new computerizedregistration Systeu described later in this chapter, is completed.

dlcfive Wo- ‘<SE Firms Stock Up on Earnings,” Finuncial Times, OCt. 27, 1988, p. 14.


the London securities industry into a period ofsevere cost-cutting and budget-tightening. By March1989, it was reported that British brokerage houseshad lost $2 billion since Big Bang, and hadeliminated thousands of jobs.42

There have been continuing problems for ISE. Ayear after the crash, there was evidence that anincreasing amount of business was being doneoff-exchange using market prices available on SEAQ.The Council of the ISE concluded that ‘the threat offragmentation was very real.”43 SEAQ requiredtraders to post on its computer display their bids andoffers and the quantity of shares for which they areprepared to deal at that price. For this “transpar-ency” big market-makers paid a price. Smaller,competing market-makers could “dump” stocks onthem or raid their inventories, thus convenientlyclosing out their own positions at the end of eachtrading day.44 When two large market-maker firmsannounced that they were reducing the size of dealsthat they would guarantee to transact at theirSEAQ-quoted prices, the ISE dropped its “inter-market-maker obligation,” the requirement that market-making firms deal with one another at the quotedprices.45 A second change in the roles allowedreporting of large trades to be delayed until thefollowing day, so that traders can buy and sell largeblocks of securities without immediately moving themarket price.

The rationale for these “temporary” changes wasthat they would lead to market-makers displayingmore realistic sizes on SEAQ. While there might bean immediate reduction in inter-market-maker busi-ness and large block trades, it was hoped that somefirms would provide more competitive prices inlarge trades in the knowledge that they could sell offlarge blocks through retail outlets and their positionswould not be jeopardized by having to deal withtheir competitors at these favorable prices.

Subsequent analysis of response to the changesindicates that there has been an increase in the

proportion of deals done “at the touch” (i.e., at thebest bid/offer on SEAQ) and no significant declinein intra-market liquidity, but also no immediateincrease in large trades on the exchange--the trendto off-market trading had not reversed.

The rule changes made the market less “transpar-ent,’ and decreased the flow of information. Last-trade prices for large blocks are not at once available.This made it difficult to provide efficient indexes forpurposes of pricing derivative products.46 It tendedto create a ‘‘two-tier’ market by encouragingmarket-makers to reserve their best prices for largeclients, buying or selling large size blocks atnegotiated prices. SEAQ was therefore less reliableat reflecting true market prices. In fact, howeverinstitutions often continued to deal among them-selves and stay away from the exchange altogether.

Although some critics blame the “automation” ofthe market (meaning the demise of its trading flooractivity) for its problems, others appear to fault theexchange for poorly conceived, poorly planned, andpoorly integrated systems. For example, a recenteditorial in The Economist said,

Punished by the inertia brought on by internaldissent, the exchange has never truly found its placein the decartelized world that followed the City ofLondon’s Big Bang in October 1986. . . . Memberfirms have lost hundreds of millions of pounds in thefierce competition to trade British equities. Theefficiency of this screen-driven money-loser hashighlighted, in turn, the awful inefficiency of Lon-don’s paper-pushing settlement system-as well asthe mish-mash of technical systems that makeup themarket’s creaky infrastructure.47

The editorial identified two problems with the ISErelated to technology: a) the difficulty of using thesame system to serve both small private clients andlarge institutional investors, and b) the separation ofdomestic and international markets with separaterules and trading systems.

42Most American Banks had bought British firms lost money, Chase Manhattan bank ended its equity operation in London in January 1989 witha $40 million loss. Security Pacific Corp. and Citicorp also lost money.

43Council of ISE, op. cit., footnote 38, p. 7.44In the United States, NASD found it desirableble to prohibit the use of NASDAQ’ small-order execution system by professional traders, who would

“pick off’ market-makers’ displayed quotes before the market-makers could react to news or rumors affecting the value of stock.45Under the older market-makers had to trade with clients, agency brokers, and others market-makers at the price they had listed on SEAQ. Under

the new rule market-makers must trade at that price with clients and agency brokers, but not with other market-makers.46The index usually used to indicate the performance of the ISE, is the Financial Times/Stock Exchange 100 Share Index, or FTSE.47"Tower or Indecision," The Economist, Feb. 24, 1990.


An editorial in the Financial Times, on the otherhand, suggested that the exchange’s central divi-sions and services should be “unbundled’ andbroken apart, made to “stand on their own feet.”48

The editorial said,

Nor, given the exchange’s current maze of elec-tronic services, many of them in urgent need ofoverhaul, is it clear why member firms should wantto be tied to the exchange by the sort of electronicumbilical cord envisaged by the Elwes group [an ISEpolicy committee that is described below].

In other words, there appears to be a generaldisquiet and dissatisfaction with the ISE, but littleconsensus on the nature, the causes, or the treatmentof the problem. There is a continuing debate aboutthe structure of the exchange. Some members advisebetter integration of ISE’s domestic and interna-tional trading (now handled by separate divisions atthe exchange). Others take an opposite approach,arguing that there should be different procedures,different technology, and different rules for professional/international trades and for retail/domestic trades,possibly even a return to the trading floor for thelatter—an institutionalized two-tier market. A thirdschool believes that ISE’s major problem is simpler—cut-throat competition among its now 25 market-makers-and can be solved only when some of themare shaken out.

By early 1990, the exchange was consideringreverting to its old rules, restoring the obligations ofmarket-makers for firm bids and offers, dealing withall customers at displayed quotes, and reportinglarge trades’ prices immediately. These changeswere recommended by an internal policy subcom-mittee called the Elwes group. The Elwes Reportasserted its conclusion that:

. . .within the developing European and Internationalenvironment, whilst SEAQ and the CompetingMarket Maker System, with telephone negotiation,will remain pre-eminent as a means of transactinglarge securities business, there will be a growingacceptance of automatic execution systems for smallbusiness as well as greater demand for efficient limit

minding and execution facilities especially for theless liquid securities.49

The report said the role of the exchange was shrinking, as trading migrated away from the ex-change to off-board trading, creating the danger offragmentation of the central market. The committeeemphasized the importance of encouraging retailclients, and its continued belief that a quote-drivensystem, rather than an order-driven system50

‘‘should be the mechanism for trading EK equities.’There were four primary recommendations:

●

●

●

●

the introduction of a central limit order facility;mandatory preferencing of orders, requiringbrokers to direct their orders over telephone orproprietary dealing systems to market-makersdisplaying the best price (rather than one notdisplaying the best price, but willing to trade atthe best price);an “order exposure” rule for agency crossesand matching principals, requiring their ordersto be exposed to a market-maker and takeaccount of existing limit orders,requiring market-makers to meet a minimumquote size, with larger trades published as tosize immediately and as to price 90 minuteslater.

The preferencing recommendation was aimed atthe problem that unless a market-maker is assured ofa reward (increased order flow) for making the bestbid/offer, there is no incentive to make competitiveprices and narrow the price spread, especially if byso doing he allows his competitors to “hit” him atthat price. The price-discovery function of themarket is threatened, and the central market maybecome irrelevant. The report recommended that theold rules obligating market-makers to make firmprices in size for brokers dealing as principals bereinstated. The committee also called for efforts toimprove cost-effectiveness (especially improvementof the settlement system).

Following the release of the Elwes Report, the ISEbegan restructuring, by eliminating 80 percent of itscommittees and eliminating 350 jobs, with further

48"Future of the Stock Market" [Lead editiorial], London’s Financial Times, Mar. 2, 1990, p. 18.49Its chairman was Nigel Elwes of Warburg Securities. The Report of the Special Committee on Market Development “Review of the Central Market

in UK Equities,” March 1990.50 In the United States, the National Association of Securities Dealers’ Automated Quotation system (NASDAQ), used by over-the-counter dealers,

is a quote-driven system. The New York Stock Exchange uses “order-driven” systems, meaning that the customer bids and offers, rather than dealers’quotes, are the basis of matching buyers and sellers to determine a going price.


reductions expected. The exchange was to bereorganized into three divisions, each of which willhave its own managing director, management board,and responsibility for its own computer systems andrule-making. The three divisions will be: 1) aprimary markets division to carry out regulatoryresponsibilities and provide services for corporateissuers, 2) a trading markets division to managesecondary trading, and 3) a settlements division. Theexchange said that the restructuring was to ‘‘bringfocus to its disparate operations and introduce amore commercial environment for its managers. ’ ’51

The chief executive of the exchange emphasized ininterviews that an immediate task would be the“rationalizing” and “re-engineering” of the manylarge computer systems serving the various tradingmarkets.

In spite of its problems, SEAQ was given creditfor strong performance on October 16, 1989, whenEuropean markets fell sharply following the 7percent drop in the U.S. stock market the previousFriday.52 The ISE index value dropped 9 percent butregained most of that before the end of the day.SEAQ continued to quote real-time prices through-out the slide and thereby drew trades from the Frenchbourse, which closed, and Frankfort, where themarket fell 13 percent.

Clearing and Settlement

Equities and corporate bonds are traded in 2-week“account periods.” All trades done in a givenaccount period are scheduled for settlement on thesixth business day after the end of the accountperiod. Thus settlement may be as late as 16 businessdays or 21 calendar days after the trade. Clearing andsettlement costs are high. (See AppendixA: Clearingand Settlement, for a detailed description.)

Settlement between brokers and market-makers isthrough a central clearing service, TALISMAN,owned by the ISE and linked to company registrars.

Individual investors, but not institutions, must settlewith their broker whether or not the broker hassatisfied his part of the settlement. For governmentsecurities, there is a computerized book-entry trans-fer system, operated by the Bank of England, andsettlement is normally on the next business day.

Market Regulation

The Financial Services Act of 1986 is now thebasis of Britain’s securities markets regulation. TheISE is a registered investment exchange, whosemembers must belong to a self-regulatory organiza-tion such as The Securities Association (TSA),which also oversees the Eurobond market andcorporate finance activities. Both the ISE and TSAcome under The Securities and Investment Board,which authorizes exchanges and self-regulatoryorganizations, and is itself overseen by the BritishGovernment Department of Trade and Industry. TheISE and TSA share responsibilities for investorprotection.

Big Bang represented access deregulation, but notprudential deregulation. The United Kingdom hasmore investor protection and related regulation thanother European countries.53 Because of the Euro-pean Community’s 1992 Directives, aimed at har-monization of regulation, there may be pressure torelax these regulations. The British securities indus-try reportedly shares a consensus that the 1986Financial Services Act and the resulting level ofprudential regulation is too burdensome and coulddetract from London’s competitiveness.54

The London International Financial FuturesExchange (LIFFE)

LIFFE is not part of the ISE,55 but its presenceadds strength to London’s position in securitiestrading, as does the presence of the EurobondMarket. LIFFE was organized in 1982. It tradesfutures contracts on interest rates, currency rates,

51 As reported by Richard Waters, "London SE Sharke-up Cuts 350 Jobs, Most Committees,” in the Financial Times, Mar. 22, p. 1.

52During and after the 1987 crash there were criticisms of ISE performance as there were of other national exchanges. The Exchange rejected proposalsbreakers be instituted. There were complaints that some market-makers did not answer their telephones to avoid having to deal; but later

evaluation indicated that much of this could be blamed on lack of telephone line capacity. The Council of ISE reports that: “Institutions in generalacknowledged they had been able to divest in some lines of stock with market makerswhose motivation in entering into bargains could only have beenloyalty to their customers and their duty under the rules of the exchange.. . [T]he market makers were net buyers of securities to the value of L.250million . . .“ Council of ISE, op. cit., footnote 38, p. 7.

53Sir David Scholey, "Deregulated Competition or Competitive Deregulation?” Institutional Investor, April 1989, PP. 12-13.54Based on interviews conducted by E. Clemens and others for OTA, op. cit., footnote 1.55On Apr. 4, 1990 there was an announcement in London that LIFFE and the London Traded Option Market which is part of ISE, would merge;

the form of this merger is not yet clear.


and on the stock index. It also trades American-styleoptions contracts.56

In its promotional literature, LIFFE stresses theadvantages of its position between the Far East andNorth America, when “. . the gap between the endof trading in the Far East and the start of trading inChicago can be as much as six hours.”57 LIFFE isdeveloping an electronic trading system, AutomatedPit Trading System or APT, that emulates open-outcry trading, and is similar to the AURORAsystem developed by the Chicago Board of Trade(see ch. 2). APT is intended to extend trading hoursto cover the European trading day, but it will not bea 24-hour system and will not be available outsidethe United Kingdom (LIFFE says that the cost ofhigh-speed communications links is prohibitivelyhigh) .58

London as a World Center forSecurities Trading

London has a long tradition as an internationalfinancial center, and is now the most international-ized of the major securities markets. The liquidityand depth on the ISE are generally good. Very largepositions are routinely moved at the ‘touch price,”or the best buy or sell quote on SEAQ. Until rulechanges in February 1989 (allowing traders to delayreporting deals over £ 100,000) transparency wasconsidered to be excellent (market-makers hadargued that there was too much transparency). It isnow less transparent, but the 1989 rule changes maybe reversed. Market surveillance is considered to begood.

Spreads and commissions have been driven downby competition and are now very low; however,settlement costs are disproportionately high. For 8years there have been plans to end the use of sharecertificates by developing a computerized shareregister— ‘‘Transfer and Automated Registration ofUncertified Stock,’ or TAURUS. It was delayed by“Big Bang” and the post-1987 decline, and theISE’s efforts to complete the design have been

criticized as too costly by registrars and banks (manyof whom have vested interests in the paper-basedsystem, since it provides them with fees).

Since the introduction of SEAQ International, asmuch as 25 percent of the total turnover in Frenchand German stocks on a given day has involved atleast one counterpart in London. After Sweden, in1986, imposed a trading tax of 1 percent on bothsides of a trade, trading volume in shares of 10Swedish companies rose temporarily in London, to5 times the volume on the Stockholm bourse.59 Now15 firms make market in the& Swedish shares onSEAQ International.

Nevertheless, the ISE has serious problems. Thecompetition between London’s markets and thoseon the continent is strong. How this competition willdevelop in the context of the European Commu-nity’s 1992 initiative is uncertain.

THE EUROPEAN COMMUNITYMARKETS

Europe has 39 stock exchanges, as well as someuncentralized or over-the-counter markets and infor-mal, off-exchange trading networks. European stockmarkets, apart from London’s, are not now strongcompetitors to the major market countries. However,one of the major objectives of the Commission of theEuropean Community (EC) is to create and strengthena European securities trading arena. Significantprogress has been made in harmonizing securitieslaws and regulations--i.e., making them similar andmore compatible with the goal of achieving effectiveharmonization by 1992.

There are proposals to establish a Europeanequities exchange network on which a “SingleEuropean List” of shares of 300 large European andforeign corporations would be traded, through anintermarket trading system, like the IntermarketTrading System (ITS) in the United States. On theother hand, Andrew Hugh Smith, chairman of theISE, has proposed that SEAQ-International be the

56 There are two kinds of opions. Conventional or “traditional” options, sometimes cdkxi European-style options, Can be titten on ~Y list~securily, are for a period of 3 months, are traded over the counter, are not transferable, and must be exercised on a specific &y. “Traded options” orAmerican-style options am available on speciilc securities, for 3,6, and 9 months, and may be cashed by sale. Both kinds of options can be written inboth the United States and Europe. LIFFE options are American-style options and include options on futures. See LZFFE: An Zmroduction, publishedby LIFFE.

5T~id0

5S*CEWOP Forges Ahead in the Technology Race,” Furures and Options, Special Supplement to Euromoney, July 1, 1989, p. 24.5g’’Taking Stock Home,” The Economist, May 28,1988, p. 102.


international marketplace, under a‘ ‘joint initiative’of the ISE and the German Federation of StockExchanges, based in Frankfort. The Federation ofEuropean Community Stock Exchanges is planning“le PIPE,” a network to distribute market data fromand among 12 EC member countries. This could, intime, develop into a trading system.

The EC has a consumer potential that is 1.5 timesthat of the United States and 3 times that of Japan,but the EC countries do not have a strong traditionof individual investment in securities. Their ex-changes are, however, already ‘‘international. ” Anumber of them have recently been deregulated togive broadened access to their markets, and somehave begun ambitious programs of automation. TheEC must therefore be considered a potential compet-itor in global securities trading.

Of the 12 EC countries, the United Kingdom,already discussed, has about 35 percent of totalmarket capitalization, West Germany has about 13percent, and France nearly 12 percent. West Ger-many began, in 1989, a screen-based system (IBIS)for displaying market data on major stocks at eightWest German exchanges. The Paris bourse ismaking significant investments in technology in aneffort to strengthen and expand its market share.60 Ithas, in the past 6 years, created four new markets,for: 1) issues of small companies (the SecondMarche), 2) futures contracts (MATIF), 3) options(MONEP), and 4) money market funds (Inter-SVT).France has also restructured the stock exchange forbroader capitalization, re-privatized its government-controlled banking system, and lifted all foreignexchange controls.

Other European markets are also being strength-ened and are undergoing technological and regula-tory changes. Individual ownership of securities isnot widespread in Europe.61 Even in the UnitedKingdom, which has the most well-developed secu-

rities markets, less than 3 percent of householdsowned corporate shares in 1980 compared to about19 percent the United States,62 although this in-creased in the 1980s because of privatization ofsome British nationalized industries. Probably forthis reason, there were no strong customer protectionregulations in Europe; most European countries didnot mandate full disclosure, prohibit insider trading,or have securities regulatory agencies. With theprivatization of state-owned enterprises in severalcountries, bringing with it national policies forencouraging stock ownership, prudential securitiesregulation began to emerge. No comprehensivenational securities laws were enacted until recently,under prodding by the Commission of the EC andfollowing several widely reported stock marketabuses.

The EC’S 1992 Initiative

The Commission of the EC recognized from itsbeginning in 1957 that there should be specialbenefits from the integration of financial servicesmarkets, due to the “unique pivotal role played byfinancial services in catalyzing the economy as awhole." 63 But there was little progress for nearly 30years. In 1985 the Commission of the EC issued aWhite Paper, “Completing the Internal Market,”64

an ambitious legislative proposal to achieve a singlemarket by the end of 1992. The White Paperproposed 300 directives aimed at regulatory har-monization among the member states.65 In 1986,279White Paper proposals (and a Dec. 31, 1992,deadline for implementation) were incorporated inan Amendment to the Treaty of Rome, entitled theSingle European Act. This strengthened the legalframework for development of a common market.

In these directives the EC did not seek to establishidentical regulatory regimes, but instead prescribedbasic essential principles with a requirement of

%iscussion with Paris bourse officials, Apr. 2, 1990.61B. de Cties, GT Gui& to World Equ@ Markets 1988, 101; Euromoney Public, 1988, p. 113.62’’Into the Provinces,” The Economist, Nov. 12, 1988, p. 131; also SEC, “Internationalization of Securities Markets,” Staff Report to U.S. Senate

Committee on Banking, Housing, and Urban Affairs and House of Representatives Committee on Energy and Commerce, 1987.Gsceccti, The European chllenge 1992: The Benefits of a Single Market, 1988, P. 37.

~CoWZeting the ~nterna/ Market: white paper from the Commission to the European COunCil, COM (85) 310 m, June 14.1985.~Und~ the Treaty of Rome, “directives” proposed by the 17-person Commission (2 representatives each from the 5 largest countries and 1

representative each fmm 7 smaller member states) and unanimously accepted by the EC Council of Members, must be implemented by mtionallegislation within each member state within a prescribed period of time. The directives are binding in terms of mult but national legislatures have somediscretion as to ‘‘choice of forma and methds.” l%ieffky, Van Door% and Lowe, “The Single European Market: APractitioner’s Guide to 1992,” 12B.C. Znt’2 & Comp. L. Rev., 1989, pp. 357, 360. The Single European Act of 1986 amended the Treaty to substitute a “qualifled majority” for therequirement of unanimity in approval of directives by the Council.


mutual recognition. This appears to have madeacceptance of the proposed directives much easier.About half of the 279 directives issued have beenapproved by the EC Council of Ministers, meaningthat they are now mandatory. Some of thesedirectives directly create supranational securitieslaw; others are company law directives that providethe foundation and complement the securities regu-lations. Directives adopted or proposed in the fieldof securities regulation include the Stock ExchangeDirectives enacted prior to the Single European Actof 1986, and more diverse proposals dealing withmutual funds, prospectuses, investment services,and insider trading (box 4-A.) The last three reflecta change in the EC’s approach from seekingcommonality to seeking reciprocity. All of thesedirectives rest on the foundation of full disclosureand equivalent protection built by the company lawdirectives.

EC’s company law and securities law directivesseek to create a global common market for securitiestrading by establishing regulatory harmony and ahigher level of prudential regulation to make Euro-pean exchanges more attractive to foreign anddomestic investors. Regulatory harmony shouldprovide European investors with greater opportuni-ties for portfolio diversification. Increased pruden-tial regulation-safeguards against investor abuseand more comprehensive disclosure obligations—should promote public confidence in both primaryand secondary securities markets and should alsoresult in development of a European database onpublicly held corporations. This will facilitate widerknowledge of European companies among inves-tors, analysts, and advisers around the world, andcould result in stronger demand for EC companysecurities. 66 It is also hoped that greater liquidity inthe securities markets will promote the use ofsecurities to fired acquisitions of other businesses;and that this will result in economies of scale.Finally, increased prudential regulation should makeit easier for EC corporate issues to satisfy theregulations of stricter national authorities (e.g., theUnited States) and thus expand the opportunities for

EC companies to raise capital outside of Europe,reducing the cost of capital.

There may also be substantial benefits for non-ECfins, including those from the United States. Theywill be confronted with stronger competition fromEuropean firms expanding to pan-European opera-tions, but the directives should also result in a morelevel playing field for U.S. firms, because theEuropean companies will be subjected to morestringent prudential regulations (and thus some coststhey have not incurred in the past). U.S. firms,having met more stringent U.S. regulations, willhave no serious difficulties or additional costs incomplying with EC requirements.

It appeared for a time that the benefits of the newlyintegrated single market would be denied to non-ECfins. Under Article 58 of the Treaty of Rome,67 allfirms organized within an EC state are considered“nationals” and accorded regulatory parity, pre-sumably without regard to the origin of their capital.This would apply to EC-incorporated subsidiaries ofU.S. firms (although not to branches of U.S. firms).However, the reciprocity and mutual recognitionprovisions of some of the EC securities law direc-tives, especially the proposed Investment ServicesDirective (see box 4-A), seemed to contradictArticle 50’s ban on discrimination. The EC ‘‘WhitePaper” also reflected a Commission policy thatconcessions should be extracted from non-memberstates in exchange for the benefits,68 and this wasreiterated in the Cecchini Report, which said:

In return, EC governments will have the right toexpect appropriate responses from the community’seconomic partners abroad, notably the U.S. andJapan. If the fruits of the European home market areto be shared internationally, there must also be a fairshare-out of the burdens of global economic respon-sibility, with market opening measures extendedinternationally on a firm basis of reciprocity.69

This caused non-EC firms to fear that they wouldnot have access to the “single market” and would beat a disadvantage relative to EC firms. The proposedInvestment Services Directive, for example, could

66CCCCW op. cit., foomote 64, p.%.67’’ Coqa~es or f- fom~ ~ accor~m with the law of a member state and having their registered offke, ~td aas~tio% or @ciPle

place of business within the Community shall.. . be treated in the same way as national persons who am nationals of member states.”6sCo@eting thelnternal Mar~t, White p~perfiom the co~”~~on to theE~opean co~il, COM (85) 310 m; pm. 19, the Ody ~CrCXICC tO

non-member states, says: “Moreover, the commercial identity of the community must be considered so that our trading partners WW not be given thebenefit of a wider market without themselves making similar concessions.”

@cecch@ op. cit., footnote 64, pp. XIX-XX.


Box 4-A—EC Securities Law Directives

The Admission Directive (No. 79/279), adopted in 1979, is intended to facilitate greater interpenetration ofmember states’ securities markets, thereby contributing to establishment of a European Capital market. Togetherwith two other directivesl, it is intended “to establish. . . a coordinated information policy on securities.” Thedirective assumes agreements with non-member states to recognize listing particulars, but the non-memberstates’ laws must give equivalent protection to investors, and the non-member state must also provide reciprocityto the EC member-states. For the United States (and Canada) which have significantly more comprehensivedisclosure requirements, it is unlikely that reciprocal accords can be negotiated in the foreseeable future.

The directive provides minimum requirements for listing, to construct a regulatory floor for equivalentprotection for investors throughout Europe. It contemplates a “subsequent closer alignment of rules,” whichmight be accomplished either by further directives strengthening the requirements, or by requiring mutualrecognition which would effectively lower them (any exchange, as a political and economic matter, would beunable to impose stricter requirements on domestic firms than on firms from other member states).

The Listing Particulars Directive (No. 80/390), adopted in 1980 and sometimes called the InformationDirective, requires extensive disclosure to the general public (some member states had required disclosure onlyto regulatory or self-regulatory bodies). It requires an information sheet with common disclosure standards anda prescribed format, so that for the first time investors and analysts can make comparisons easily on amultinational basis. This directive influenced the SEC in its development of U.S. disclosure forms for foreignissuers. 2

In 1987, the EC Council of Ministers amended the Listing Particulars Directive to include a mutualrecognition directive (once approved in a member state, listing particulars must be recognized by other memberstates, and no additional information may be required). This means that a state with more stringent disclosurerequirements is in the position of imposing more disclosure and greater costs on its domestic issuers than foreignissuers must meet. Almost surely this will mean lowering disclosure requirements to the existing lowest commondenominator.

The Interim Reports Directive (Mp... 82/121) adopted in 1982, requires issuers of equity securities listed onmember-state exchanges to publish certain financial reports at six month intervals. It is intended for investorprotection.

The Public Offer Prospectus Directive (No.89/298), adopted in 1989 after 10 years of controversy, protectsinvestors by requiring risk-related information from corporations in the form of a prospectus. There are regimesfor both listed and unlisted securities but because the directive was adopted after lengthy negotiations it is riddledwith exemptions that reduce its scope: exemptions for private placements, certain small offerings, minimumpurchase offerings, exchange offers, employee offerings, eurobonds, and euroequities. Eurosecurities wereexempted because the industry repeatedly threatened to trade elsewhere. The disclosure requirements are not asstrict as those in the United States. The directive does however embody the principle that investors throughoutthe EC should be protected, and should be provided equivalent protection.

The directive does not require member states to give mutual recognition to issuers from non-member stateseven if they comply with its disclosure requirements. It authorizes negotiations based on reciprocity (mutualrecognition and substantial equivalence of regulatory regimes). Since companies in the United States and Canadawill have met higher domestic requirements, they would like to be allowed merely to file a notice of their homecountry prospectuses, but reciprocity for EC members with lower disclosure requirements will be a stickingpoint.

The Mutual Funds Directive (No. 85/611), adopted in 1985 but amended in 1988, is intended to establishequivalent protection for investors in collective investment funds throughout the EC and to promote thecirculation of these securities throughout the Community on “a level playing field. ” The provisions relate toauthorization, supervision, structure, activities, and”disclosure obligations. Once a mutual fired is authorized by

1~~~ w-, D&&e No. 80/390, and Interim Reports, Dtitive No. smzl.2SEC ~l_Noo 3+1635 1 (Nov. 29, 1979); R. H-, “~Re-onof ~ Is~ eand Trading of Securities inthe United States

and-b European Economic Community: A Compariso~” 3 J. Cwnp. Corp. L. & Sec. Reg. 129, 132-22 (1981).

Continued on next page


Box 4-A—EC Securities Law Directives--Continuedone member state under these provisions it may be marketed in all other member states with the home stategenerally responsible for supervision and control.

The directive does not apply to the closed-end type funds. The fund must offer collective investment intransferable securities, of capital raised from the public, operating on the principle of risk spreading; and its unitsmust be repurchased or redeemed at the holder’s request out of the fund’s assets, directly or indirectly. Accordingto industry spokesmen in the United States, this directive could serve as the basis for international agreementsbeyond [EC] boundaries,” facilitating the internationalization of mutual funds.3

The Proposed Investment Services Directive, newly proposed by the Commission in 1988, would establishmutual recognition of member states’ authorization and supervision of investment firms. This would mean asingle license for investment firms acting as brokerage agent, dealer, market-maker, portfolio managers,underwriter, or investment advisor anywhere in the EC. [Because banks and other credit institutions in the ECalso provide investment services, a proposed Second Banking Directive contains similar provisions.] The homestate must determine, before authorization, that the firm has sufficient financial resources to conduct the servicesthat are to be provided; that the managers are of good reputation and experience; that the controlling shareholdersof the firm are suitable; and that the firm submits a suitable business plan.

The directive requires member states each to promulgate prudential rules requiring investment firms tomaintain sound administrative and accounting procedures and internal controls; to segregate investors’ assetsfrom the firm’s own accounts; to participate in a general compensation fund to protect investors against the firm'sdefault or bankruptcy; to provide regular information to the home state supervisory authority; to maintainadequate records; and to be organized in a way that minimizes conflicts of interest among the firm and its clients.Under the directive as it now stands, investment firms will continue to be regulated under the capital requirementsand general business rules of the home member state, although EC directives in these two areas maybe developedlater. A state’s authority to regulate local activities of investment firms from other member states is largelyremoved by this directive,4 but cooperation between home state and host state in preventing abusive practicesis required by the directive.

Again, the most controversial aspect of this proposed directive is the issue of reciprocity. Investment firms(and their subsidiaries) from non-member states cannot enjoy the benefits of the directive’s “single license”unless the fro’s home state provides reciprocal treatment to all EC investment firms. However, there is agrandfather clause, and foreign firms may rush to incorporate as EC subsidiaries before the adoption and effectivedate of the directive. The related proposal for a Second Banking Directive modified the strict reciprocityrequirement to require only “national treatment” (regulatory parity with domestic firms), and it is possible thatthis proposed Investment Services directive will also be so amended.

The Insider Trading Directive. First proposed in 1987, revised in 1988, and adopted by the Council ofMinisters on June 19, 1989 (ratification not yet complete), this directive seeks to provide equivalent protectionagainst insider trading for all EC investors. When it was first proposed in 1987 only three member states(Denmark, France, United Kingdom) had criminal penalties for insider trading. In the United States, securitiesregulators have not rigorously or officially defined insider information,5 but this directive defines it as:

. . . information which is unknown to the public of a specific nature and relating to one or more issuers of transferablesecurities, or to one or more transferable securities, which, if it were published, would be likely to have a materialeffect on the price of the transferable security or transferable securities in question,6

This directive is almost certain to be approved7; at present only Belgium, Ireland, Italy, and West Germanyhave yet to enact insider trading legislation. However, some observers fear that judges may still treat insidertrading as “a gentlemanly misunderstanding rather than a crime."8

3( ‘EC D~~tive on Mum F~ds May Serve as Basis for Global Agreement, 1~ SaYs,’ 20 Sec. Reg. &L. Rep. (BNA) 1922 (Dec.2, 1988).

4Each s~te rem limited power to restrict investment fii’ conduct when necessary for “the public goo~” a concept based onArticles 36 and 56 of the Treaty of Rome.

Ssee sympo~um: Defining Insider Trading, 39 Ala. L. Rev. 337-558 (1988).

6COM (88) 549, 0~. Eur,Comm. (No.C 277) 13 (Oct.27, 1988).7Nelsom ~~EC M~ms NW /@oral in unit~ p@” Wa/ZSt. Jour~l, June 19, 1989, p. C g.

8~~~i@ Tr~ing in EwOp: A D~t IX@” The Economist, My 20, 1989, p. 86.


deny a single EC license to EC-incorporated subsid-iaries of U.S. fins; they would not be entitled tohome-country control, i.e., authorization and super-vision by the member-state in which they areincorporated unless equivalent treatment is grantedby the United States. Because of differences in thescope and structure of the U.S. regulatory system,this equivalent recognition is politically unlikely.After strong protests, an amendment to the directiveis being considered which would use the principle ofnational treatment rather than reciprocity.

It is less likely that the same change will be madein the reciprocity and mutual recognition provisionsof other directives, including those dealing withAdmission, Listing Particulars, and Public OfferProspectuses (see box 4-A). The U.S. requirementsregarding stock exchange listings and public offer-ings, administered by the SEC, are significantlystricter than EC requirements. They are not inter-changeable with EC requirements and cannot bewaived by the SEC to accommodate EC issuers,even though SEC has considerable regulatory flexi-bility, and has stated that it would favor recognitionof the disclosure documents of foreign issuers if theirhome state provided reciprocal treatment and thedisclosures were based on substantially equivalentstandards. 70

The basic problem is that the regulatory regimeenvisioned in EC securities laws directives, adoptedand proposed, provides less protection for investorsthan is mandated in the United States. They includemany exceptions and exclusions which greatlyreduce the scope and effectiveness of the directives.

For example, the Eurosecurities market-the largestEuropean securities market-is exempted from thePublic Offer Prospectus, although a number ofproblems have arisen with regard to interest andcurrency swaps, distribution methods, and disclo-sure. 71 In some areas there are as yet no ECdirectives. Among the number of regulatory areasnot yet addressed are: rules of fair practice oressential standards to govern the conduct of ECinvestment firms; real-time publication of quota-tions, prices, and trading volume to assure markettransparency. Participants in European securitiesmarkets will continue to be confronted by 12 sets ofconflicting laws (or absence of law) dealing withessential areas of regulation in areas not covered byEC directives.

As yet, EC has no institutional mechanism forcoordination and enforcement of the new regulatorysystem it is creating. Little has been done toharmonize enforcement. The directives provide forcooperation among authorities, but is likely that insome member states there is strong enforcement andin others, almost none.

There are two striking points to note about the EC1992 initiatives in securities trading. First, EC hasmanaged both to improve prudential regulation andto increase regulatory harmony-two goals thatmight have been assumed to be contradictory.Second, it may demonstrate that regulatory harmonycan be achieved at least on a regional level. Thissuggests that harmony could also be achievedamong the other OECD states, if the United Statesplays a strong role in promoting this goal.

70ifSEC policy s~tment on Re@tion of ~t~mtio~ Securities Markets, ” SEC Rel. No. 33-6807, NOV. 14* 1988.71seepo Stob, Gzo~z ~toc~ ~arkefR@om, 1988, pp. 126-147. me mpid gIO~ of sw~s ~d options hM Id to less review of credit risk and

failure to obtain collateral and a number of defaults have resulted. Prof. Manning Warre@ III, op. cit., footnote 1, makes the point that despite assertionsto the contrary the Eurosecurities market is to a large extent a retail market, and Euroequity offerings especially have large potential for abuse becauseof “gaping hopes in member state regulations, ’ unregulated sales pitches and timing pressures.

Chapter 5

International Clearing and Settlement:What Happens After the Trade

“Clearing and settlement” is the processing oftransactions on stock, futures, and options markets.1

It is what happens after the trade. “Clearing”confirms the identity and quantity of the financialinstrument or contract being bought and sold, thetransaction price and date, and the identity of thebuyer and seller. It also sometimes includes thenetting of trades, or the offsetting of buy orders andsell orders. “Settlement” is the fulfillment, by theparties to the transaction, of the obligations of thetrade; in equities and bond trades, “settlement”means payment to the seller and delivery of the stockcertificate or transferring its ownership to the buyer.Settlement in futures and options takes on differentmeanings according to the type of contract.

Trades are processed differently depending on thetype of financial instrument being traded, the marketor exchange on which it is traded, and the institu-tions involved in the processing of the trade (i.e., anexchange, a clearinghouse, a depository, or somecombination). 2 The clearing and settlement mecha-nisms and institutions in the United States, theUnited Kingdom, and Japan are described in theappendix. The differences in countries’ clearing andsettlement are important because clearing and settle-ment systems used for domestic trading are nowbeing called onto accommodate international partic-ipants. The integrity and efficiency of a nation’sclearing and settlement systems are important toboth its internal financial and economic stability andits ability to compete with other nations.

Many markets have ‘clearinghouses’ that handleboth the clearing process and some of the settlementprocess. This is the most common system in theUnited States for exchange-traded financial prod-ucts. Many markets, including the U.S. markets,have “depositories,” that hold stocks and bonds forsafekeeping on behalf of their owners.

Where clearinghouses do not exist (e.g., in someEuropean markets), depositories may take on func-tions of clearinghouses. Depositories may transferownership of stocks and bonds by ‘‘book entry” (acomputer entry in the depository’s record books)instead of physical delivery of certificates to thebuyer,3 which saves time and money. There are alsomarkets in which exchanges perform some of theclearing and settlement functions (e.g., London’sInternational Stock Exchange), and markets inwhich neither clearinghouses nor depositories exist(e.g., until very recently, foreign exchange, or“forex,” markets).

THE GOALS OF CLEARINGAND SETTLEMENT

Differences in the clearing and settlement processamong countries are often linked to historical,economic, and cultural factors in their laws andcustoms. These differences can expose internationalinvestors to extra risk in some instances. Perceptionsof the purposes of the clearing and settlementprocess vary widely among countries. In the UnitedStates and Canada, where public policy supportsbroad public access to the markets, the reduction ofrisk, through the clearinghouse as an intermediary,is a major goal of clearing and settlement. Thesepolicies are reflected in a hierarchy of protections forthe clearinghouse, including minimum capital re-quirements for clearinghouse members.

In many other counties, risk reduction is imposedbefore trading takes place, by controls on who isallowed to participate, or by the participants ‘know-ing their trading partners,’ and, in equities, byreducing the time allowed to settle a transition. Inthese markets, clearinghouse guarantee funds are

lb ~rw~ ~~ c~ptm, Om hm mli~ hmvily on a contractor report by Bankers T~t CO.! “Study of International Clearing and Sett.lemenC”vols. I-V, Octobex 1989, to which scores of institutions and individuals around the world contributed expert papers and/or served on the Bankers Trustadvisory panel. This report is hereafter referred to as “Bankers Trust report.” OTA has also used the discussions of an expert workshop held at OTAon Aug. 22, 1989.

% the United States, equities markets clearinghouses reduce risks by netting payments, among their other precautions to reduce cleiuinghouse risk.These precautions are disparate among nations. Futures markets worldwide are becoming more similar in terms of guarantees for trades.

qD~v~ve instnunents such as futures and options also change ownership or contractual rights Vk book m~.

–55–


generally small or nonexistent,4 and settlement isseen merely as a delivery function, rather than as amechanism for risk reduction.

These different views of the purpose of clearingand settlement have become significant as moreinvestors begin trading in markets other than theirdomestic markets. U.S. investors, accustomed todomestic markets where safeguards are in place,may assume that the clearing and settlement of theirtrades in a foreign market has risks comparable tothose in the United States, where there are guaran-tees provided by clearing and settlement organiza-tions.

The chief aims of clearing and settlement in theUnited States and some other countries are effi-ciency and safety. The faster and more accurately atrade can be processed, the sooner the same capitalcan be reinvested, and at less cost and risk toinvestors. Therefore, as markets become global, onecould expect that investment capital will flowtoward markets that are most attractive on a risk-return basis, and that also have efficient and reliableclearing and settlement systems.

The soundness of clearing and settlement systemsin one nation can also impact other nations. Thefailure of a clearing member at a foreign clearing-house could affect a U.S. clearinghouse through theimpact on a common clearing member. To reducethe risk of such an occurrence, different countries’clearing and settlement systems must be coordinatedwith each other, for example, by sharing riskinformation and harmonizing trade settlement dates.Both the private sector and Federal regulators havebegun to take steps in this direction. It is doubtfulthat the private sector can achieve the neededchanges without national governments taking aprominent and concerted role.

HOW CLEARING ANDSETTLEMENT WORKS

Many kinds of organizations are involved inclearing and settlement. Their functions vary frommarket to market, and not all of these organizationsexist in every country. For instance, clearinghouses

play a key role in the United States and some Asianmarkets; but in many European markets, deposito-ries are more important.

A key role of a clearinghouse is to assist in thecomparison of trades and sometimes, as in theUnited States, also to remove counterpart risk fromthe settlement process. Clearinghouses can providethe buyer with a guarantee that he will receive thesecurities--or other interest-he purchased, andprovide the seller with a guarantee that the paymentwill be received.s

In the United States, the clearinghouse has anumber of working relationships, or interfaces, withother institutions (figure 5-l). A trade in the UnitedStates (as well as in Japan, Canada, and some othercountries) cannot settle through the central systemsuntil it has been matched, i.e., buyers’ and sellers’records of the trade are compared and reconciled. Aclearinghouse has an interface with a market inwhich trades are executed and from which theclearinghouse receives information on the trades.6

The clearinghouse may receive previously “locked-in’ ‘ trades (trades which have already beenmatched), or it may match the trades itself.

A second interface is with its clearing members,i.e., the member firms of an exchange or market. Aclearing member delivers trade information to theclearinghouse and may hold positions both for itself(proprietary positions) and on behalf of its custom-ers. Other traders in a market, who are not clearingmembers, must clear their trades through a memberof a clearinghouse for that market. A clearinghousecontrols the risks of the clearing and settlementprocess through its relationships with its clearingmembers. For example, it may have minimumcapital requirements for clearing members, usemargins or mark-to-market procedures, and requirethat its clearing members place collateral in aguarantee fund as protection against default by otherclearing members. In the event of the failure of aclearing member, the clearinghouse may also havethe ability to assess all other clearing members. Itmay also provide its clearing members with atrade-matching service and notify members aboutthe way a trade is to be settled (the settlement date,

4B~eA ~St s~dy, op. cit., footnote 1, P. 142.

SForty.one ~ment of the ~spondents to a Westion in an international survey conducted tis pm of the Btiers T~st s~dy s~ted tit the risk tita counterpart to a trade may default, i.e., not pay for or deliver securities, is one of the three most signiilcant risks in settlement domestically. BankersTrust study, op. cit., footnote 1, vol. 1, p. 239. Despite such fears, such defaults seldom occur.

%e clearing entity could alternatively receive information about a trade directly from two market participants.

Chapter 5--International Clearing and Settlement: What Happens After the Trade ● 57

Figure 5-1-interfaces Among Clearing Participants

Retail Instltutionalcustomer customer

an accounting system for immobilized or demateri-alized instruments, and/or as a central vault for thephysical instruments themselves, interfaces with thebanks as custodian. It may also, as custodian, havean interface with the banks for payment.7

SOURCE: Office of Technology Assessment, 1990.

and the way payment and delivery or transfer ofownership will be accomplished).

A third interface is with clearing and credit banks.The clearinghouse and the banks work together inthe payment and collection process, since clearing-houses today do not have direct access to thepayment system, e.g., FedWire in the United States.The banks also provide credit to clearing members.

In the securities markets-but not typically infutures and options markets-there is often a fourthinterface with the depository. The depository re-cords and arranges the legal transfer of ownership ofsecurities, and holds securities for safekeeping. Theclearinghouse instructs the depository on how thetransaction is to be settled. The depository may actas an agent, on behalf of the clearinghouse, toreceive funds to settle the transaction.

In addition to the relationships between clearing-houses, markets, depositories, and banks, theseorganizations also have relationships with eachother. Clearing members of a designated market dealwith the banks to settle with the clearinghouse andto obtain credit. There is an important relationshipbetween the banks and the depository. When a bankacts in a custodial role, e.g., delivering securities andreceiving payments in behalf of its customers,instructions on payment and title transfer are sent tothe bank by the customer. The depository, in turn, as

RISKS FROM DIFFERENCES INCLEARING AND SETTLEMENT

MECHANISMSThese differences-the use of guarantee funds,

the time allowed to settle a trade, etc.—in countries’clearing and settlement systems are a major con-straint on global trading and may impose risks ontraders and investors. Defaults in a national clearingand settlement process can propagate through othernational systems, since multinational financial insti-tutions may be active in several national markets.Collapse of a major settlement system could endan-ger financial systems in both its own and othercountries.

Even in day-to-day operations, differences inclearing and settlement systems and in their per-formances constrain some kinds of trading. Forexample, in Japan, settlement in equities and bondsis normally on the third day after a trade (T+3) andin the United States it is normally on the fifth day(T+5). An investor trading General Motors (GM)stock on both the New York Stock Exchange(NYSE) and the Tokyo Stock Exchange (TSE)would have trouble perfectly arbitraging his hold-ings. If the investor were to buy GM shares on theNYSE and simultaneously sell them on the TSE,because the U.S. settlement period is 2 days longer,the GM shares would be delayed by 2 business daysfor the Japanese settlement. If the investor were tobuy GM stock on the TSE and sell GM stock thatsame day on the NYSE, the shares could be availablefor the NYSE settlement because that is 2 days laterthan Tokyo’s. The Japan Securities Clearing Corp.(JSCC)--through its link with International Securi-ties Clearing Corp. (ISCC) in the United States—holds the U.S. shares at The Depository Trust Co.(DTC); therefore instead of physical movement ofcertificates there simply would be a book entrydelivery at DTC. The average number of days forsettlement of various financial instruments in differ-ent countries differs widely (figure 5-2). The number

~our depositories in the United States now have links to the Federal Reserve System. These are The Depository Trust Co., the Midwest SecuritiesTrust Co., the Participants Trust Co, and the Philadelphia Depository Trust Co.


Figure 5-2-Settlement Date: T+?

Average number of days8.0

7.0

6.0

5.0

4,0

3.0

2,0

1.00 , 0

Equities Sovereign Corporate Futures Options Other Physicalobligations obligations derivatives commodities

- North America = E u r o p e ~ N.E. Asia/ Australia

- Middle East = South America

SOURCE: Bankers Trust Co., “Study of International Clearing and Settle-ment,” OTA contractor report, October 1989,

of days for settlement varies widely among countriesin each geographical region. As a result, harmonizedclearing and settlement is needed.

Trading in European markets, unlike in the UnitedStates, mostly does not rely only on stock ex-changes. 8 In Japan, there is as yet no centraldepository, but there is a clearing and custodysystem at TSE. Many European countries havedepositories, but their functions vary from country tocountry, and are often different from U.S. deposito-ries.

There are three principal models for clearing andsettlement in the world’s major stock markets. Thefirst model has no centralized depository or inde-pendent clearinghouse beyond the stock exchange.The exchanges usually perform as many of theclearing and settlement functions as are feasible.These include trade matching, confirmation, andsome type of settlement facility-usually a centrallocation where market participants can deliver andreceive securities and payments. The equities marketin the United Kingdom is an example.

The second model of clearing and settlement isone in which there is a central depository structure,

with trade matching and confirmation servicesprovided by the exchanges. Once trades have beenmatched and confirmed, the trade data are sent to thedepository for settlement. There are variations onthis model with differing degrees of settlementservices provided by the depository. The depositorymay offer book-entry transfer of ownership ofimmobilized securities, with limited provisions forvarying payment methods. Or the depository mayprovide book-entry transfer of dematerialized secu-rities and the ability, through direct links to localpayment systems, to simultaneously and irrevocablytransfer funds for each settlement. An example isWest Germany and its Deutscher Kassenverein(KV) depository system.9

The third model has not only a stock market anda central depository, but also a clearinghouse thatstands between the stock market and depository toreduce risk. The stock market, along with theclearinghouse, provides trade matching and confir-mation services. A trade is confirmed by the marketparticipants and is then passed to the clearinghouse,which substitutes itself as the counterpart to eachtrade. This gives a degree of financial assurance tothe markets since the clearinghouse will honor theobligations of a clearing member if necessary. Theclearinghouse then passes the trade information tothe depository for delivery versus payment10 on thesettlement date. An example is the United Statesequities market.

In most European equities markets,ll there are nocentral clearing organizations that assume the role ofcounterpart to every trade or provide other kinds ofmechanisms to ensure the financial integrity of allmarket participants in the clearing and settlementphase. Where there is no third-party guaranteemechanism for trade settlement, market participantsare forced to choose their counterparties based ontheir own credit assessment.

But when a market ceases to be a closed structurewith only a select group of participants who know

% most cases, the majority of trades are among banks, and occur off the exchange. In these off-exchange tmdes, bankers or brokers interface withthe depository, bypassing tie exchange, except possibly for reporting trades,

%ms-Joachim Hoessrich and Heinz-Klaus Ruetzel, “Clearance and Settlement in Germany,” expert paper contributed to OTA contractor reportby Bankers Trust Co., op. cit., footnote 1.

lo~~~~vewv~s paWent*~ (DVP) ~d “=eive Verw paym~t” are te~ which mean that the buyer and the seller =ch sa@ their ~~ementobligations (to pay and deliver) on the same day. A closely related term is “true DVP,” which means that the buyer and the seller simultaneously makegood on their settlement obligations. An example of true DVP would be a trade settled through a depository, in which the depository simultaneouslytransferred the funds and the ownership of the traded f~cial instrument.

Ilwith the excqtion of the Paris Bourse.


each other, the market must implement some stand-ardized processes which can offer a guarantee offinancial integrity. When a national market encour-ages international participation, it must try to ensurethe continuing financial integrity of the market. Thecurrent focus in Europe on the standardization orharmonization of clearing, settlement, and deposi-tory systems is in preparation for the commonmarket in 1992. (See ch. 4.) The movement towardincreased coordination of clearing and settlementsystems is, however, worldwide, stemming fromrecognition of the increasing internationalization ofsecurities trading.

EFFORTS TO REDUCE THEDIFFERENCES

Improvement of clearing and settlement for globalor cross-border trading in equities is being addressedby the Group of Thirty, an independent, non-profitorganization of businesspersons, bankers, and repre-sentatives of financial institutions from 30 devel-oped nations. The Group of Thirty addresses multi-national financial and economic issues, includingThird World debt. The Group’s recommendationsfor the world’s securities markets are aimed at‘‘maxhizin g the efficiency and reducing the cost ofclearance and settlement,” and thereby reducingrisk. They set target timetables of 1990 for someobjectives and 1992 for others. In a report releasedin 1989,12 the Group concluded that:

While the development of a single global clearingfacility was not practical, agreement on a set ofpractices and standards that could be embraced byeach of the many markets that makeup the world’ssecurities system was highly desirable, . . . and(reached) agreement that the present standards werenot acceptable.

Their recommendations are:

1.

2.

3.

4.

5.

6.

7.

8.

By 1990, all comparisons of trades betweendirect market participants (i.e., brokers, deal-ers, and other exchange members) should becompared within 1 day after a trade is exe-cuted, or “T+l.” 13

Indirect market participants-institutional in-vestors, or any trading counterparties whichare not broker/dealers-should be members ofa trade comparison system which achievespositive affirmation of trade details.

Each country should have an effective andfully developed central securities depository,organized and managed to encourage thebroadest possible industry participation.14

Each country should study its market volumesand participation to determine whether a tradenetting system would be beneficial in terms ofreducing risk and promoting efficiency.Delivery versus payment should be the methodfor settling all securities transactions.

Payments associated with the settlement ofsecurities transactions and the servicing ofsecurities portfolios should be made consistentacross all instruments and markets by adoptingthe “same day” convention.15 (No date hasbeen set for achieving this objective.)A “rolling settlement” system16 should beadopted by all markets. Final settlementshould occur on T+3 by 1992. As an interimtarget, final settlement should occur on T+5 by1990 at the latest, except where it hinders theachievement of T+3 by 1992.

Securities lending and borrowing should beencouraged as a method of expediting the

Wroup of Thirty, Clearance and Settlement Systems in the World’s Securities Markets (New York & bndom -h 1989), P. 1.% the United statos, where there is increasing use of automated trading systems in the stock exchanges and OTC markets, @ _ for

comparison and automatic submission to the clearing system is automatically recorded, Such systems now process two-thirds of NYSE transactionvolume; a large proportion of AMEX volume; and one-third of OTC equity volume. These transactions are pre-matched and reported directly to theclearing sys~ and have been reported on T+l since the mid-1980s. Both the NYSE and AMEX have on-line trade correction facilities. The rules ofthe National Securities Clearing Corp. require that all trade data not already locked in by the automated trading systems must be reported by both tradingcounterparties by 2 a.m. on T+l.

1dThe pfi~p~ function of a Cmti securities depository is to immobilize or dematerialize securities. This function permits the processing oftransactions in “book entry” form, which is the basis for achieving efficient and low risk settlement of transactions by transferring ownership from oneaccount to another by a simple debit or credit on the booka of the depository.

15 Some W~ts use ~~medayt~ ~ds (the PaPent k f~ on ~ sme &y), while others u “next~y” funds for setiement. Adoption of a singlemethod will improve the eftlcieney of the accounting and payment systems, set the stage for subsequent full automatio~ and facilitate otherimprovements such as finality of payment, irrevocability, and bank guarantees.

16~ a ro~~ setflaat ~sta, @ades ~~e on w busin~s &ys of tie w~ which limits the number of ou~~ding (unsettled) trades d redU@Smarket exposure to risk. The goal for the long team is same-day settlement.


9.

settlement of securities transactions.17 Exist-ing regulatory and taxation barriers that inhibitthe practice of lending securities should beremoved in 1990.Each country should adopt the technical stand-ard for securities messages developed by theInternational organization for Standardization(ISO Standards 7775 and 6166).18

Table 5-1 compares nine of the Group of Thirtyrecommendations with the present status of clearingand settlement procedures in 21 countries, includingthe United States. Major changes will be required bymany countries in order to meet these recommenda-tions by 1992.19 In the United States, which iswell-positioned relative to other countries, auto-mated systems will facilitate trade matching on thetrade date and settlement of all trades within 3 days.But, in the United States, there are non-technologicalbarriers to fully achieving the accelerated trade andsettlement objectives, some of which have beenacted on recently. For example:

●

●

●

More stocks must be immobilized in book entryform; this means that retail customers may haveto abandon their pattern of receiving certifi-cates of ownership for their stock shares.The pattern of mailing personal checks to payfor stock purchases will have to change to amore rapid payment method such as electronicbank-to-bank transfer of guaranteed funds.The Federal Reserve System’s Regulation T,which addresses margin-regulations for broker/dealers, has just been modified. Since themaximum allowable time for clearing andsettlement of trades in the United States isdifferent from those of many other countries,

●

some flexibility is needed in tying the cus-tomer’s time period for payment to the foreignsettlement date. In March 1990, Regulation Twas modified to allow the maximum time forpayment to agree with the foreign settlementperiod, provided that period does not exceedthe current U.S. 35-day maximum allowableperiod for settling cash (delivery against pay-ment) transactions.20

Changes also have been made in the marginingof foreign securities in U.S. accounts- withforeign currency-denominated cash and securi-ties.21

Implementation plans for the Group’s recommen-dations were initiated or considered by its members’governments beginning in the spring of 1989. TheU.S. Working Committee of the Group of Thirty metin May 1989 with representatives from exchanges,the National Association of Securities Dealers(NASD), clearing corporations, transfer and deposi-tory firms, banks, regulators, and others, to begindiscussing the recommendations. The U.S. Advi-sory, Steering, and Working Committees recon-vened a meeting on March 1, 1990 to discussprogress on the recommendations on same-dayfunds and shortening the time to settlement. Theseand other issues are being accommodated by theFederal Reserve Board (FRB). David Ruder, thenSEC Chairman, noted at the 1989 meeting that theGroup’s recommendations are consistent with pub-lished policy objectives of the Securities and Ex-change Commission.22 He also listed other areas thatrequire attention, such as capital adequacy standardsfor market participants, information sharing amongclearing entities, and the interaction of derivative

ITS~ties lending ~d borm~ has become an effective tool wed by market participants to satisfy their obligations to deliver or pay a _counterpart. In its absence, a failure to deliver can have the consequence of creating a series of additional failed transactions as one party’s failure toreceive becomes the cause of its failure to deliver on its obligations.

1s’l”he 1S0 is a worldwide standards-making body. ISO standard 7775 applies to Securities Message ~s; standard 6166 appfies to rn~tio~Securities IdentificationNumbex. Currently, no worldwide securities numbaing system is in use. Countries each use their own unique numbering systemfor identiiicatio~ rendering them impractical for cross-border transactions.

~% OIOUP of ~ met in ~ndon in mi&Marck 1990, to discuss worldwide progress toward implemmting its nine recommendations. Seeaearance and Settlement Systems Status Reports: Spring 1990, Group of Thirty, New York and Umdou which covers the progress of 17 countries.While the obstacles facing each nation and the efforts required of each to comply with the recommen&tions are disparate, there was general acceptanceof the recommendations.

%ee 55 Fed. Reg. 11158, Mar. 27, 1990. This 35-day period is separate from the 5-day and 3-day settlement periods discussed e~where. It mf~to the maximum allowable time period for settlement in the event of unavoi&ble delay, e.g., a payment lost in the m@ and it does not apply to reasonssuch as a customer being unable or unwiUing to make payment or deliver securities.

zl~id:22poEV s~aent of tie U.S. s~~tiw ~d fic~e Commission “Re@ation of the ~te~tio~ s~urities ~ets,” November 1988 @

Release No. 33-6807, Nov. 14, 1988; Fed. Reg. 46963, Nov. 21, 1988.


Table 5-l--Group of Thirty: Current Status of International Settlement Recommendations-Equities

Recommendation No. 1 2 3 4 5 6 7 8 9Institutional Central RollingComparison Comparison Securities Securities Settlement Same-Day Securities

Country on T+1 System Depository Netting DVP on T+5 Funds ISO/lSIM Lending

Australia ... . . . . . , , . YesAustria . . . . . . . . . . . . YesBelgium . . . . . . . . . . . NoCanada . . . . . . . . . . . . YesDenmark . . . . . . . . . . YesFinland . . . . . . . . . . . . YesFrance . . . . . . . . . . . . YesGermany . . . . . . . . . . YesHong Kong . . . . . . . . . YesItaly ,...,,.., . . . . . YesJapan . . . . . . . . . . . . . YesKorea . . . . . . . . . . . . . NoNetherlands . . . . . . . . YesNorway . . . . . . . . . . . YesSingapore . . . . . . . . . YesSpain . . . . . . . . . . . . . YesSweden . . . . . . . . . . . YesSwitzerland . . . . . . . . YesThailand . . . . . . . . . . . YesUnited Kingdom . . . . . YesUnited States . . . . . . . Yes

NoNoNoYesNoNoNoNoNoNoNoNoNoNoNoNoNoNoNoYesYes

NoYesYesYesNoNoYesYesNoYesNoYesYesNoNoNoYesYesYesNoYes

NoNoNoYesNoNoNoNoNoNoYesNoYesNoNoNoNoNoYesYesYes

YesNoYesYesYesYesNoYesYesYesYesYesYesYesYesNoYesYesYesNoYes

OpenWeekly

FortnightlyT+5T+3T+5

MonthlyT+2T+1

MonthlyT+3T+2T+5T+6T+5

WeeklyT+5T+3T+4

FortnightiyT+5

NoYesYesYesYesNoYesYesNoYesNoNoNoYesNoNoNoYesYesNoNo

NoNoNoNoNoNoNoNoNoNoNoNoNoNoNoNoNoNoNoNoNo

YesNoYesYesYesNoYesNo

LimitedLimited

YesNoYesNoYes

LimitedYesYesNo

LimitedYes

SOURCE: Updated from A Comparative View: The Group of Thirty’s Recommendations and the Current U.S. National Clearance and Settlement System,(New York City,NY:MorganStanley& Co.,June 1989),

markets.23 Officials of U.S. regulatory agencies aresupportive of the U.S. Committee’s efforts.24

The Group of Thirty is not alone in exploringmany of these issues; other international groupshave attempted to develop consensus on some of theissues in clearing, settlement, and payment systems.These organizations include the Federation Interna-tionale des Bourses de Valeurs (FIBV),25 the Bankfor International Settlement (BIS),26 the Interna-tional Society of Securities Administrators (ISSA),27

the European Community (EC),28 and the Interna-tional Organization of Securities Commissioners

(IOSCO).29 Their activities reflect a growing inter-national concern for making the world’s marketsmore stable and compatible, and for reducingavoidable risk.

The FIBV Task Force includes representativesfrom the Tokyo Stock Exchange, the InternationalStock Exchange, the VP (Denmark’s depositorysystem), the Amsterdam Stock Exchange, the ISCCin the United States, Euroclear, CEDEL, the Groupof Thirty, SICOVAM, ISSA, and IOSCO. The FIBVTask Force met in December 1989 to discuss howcountries might proceed, and again in March 1990 to

23Davids. Ruder, 4cI&M&s on the (MmIp of Thirty Report on International Clearance and Settlement,” May 15, 1989.

~Commenta by G. Corrig~ President of the Federal Reserve Bank of New York and Commissioner Mary Shapiro, SEC, at tie *h 19N meetingof the U.S. Committee.

~~e FIBV smdy “Improving hte~tioti Settkmen~’ June 1989, focused on the settlement of cross-national border trading. This report endorsesthe recommendations of the EEC and Group of Thirty reports and also makes additional recommendations.

~n BIS’S GIOUp of Experts on payment Systems, Committee on Interbank Netting Systems is working on a study of multilateral netting schem=~For infoMutio~ see ISSA Handbook on Clearing and Settlement in the world’s markets, updated regulmly. An edition covering 28 cowtries and

the Euromarkets was published in May 1990.~~e EEC’s “study onhnprovements in the settlement of Cross-Border Securities Transactions in the European Community,’ fOCUSd on tie need

for eentmlized depositones.~Gern~ de -z @em, ~~cl- ~d Setdmen6° rqo~ to the 14th Annual Conference of IOSCO, Venice, September 1989; tie adoption of

a resolution in 1986 that promotes investor protection through surveillance and mutual enfomement assistance; and the establishment of a tecbnicalcommittee to review rnajorproblems in international securities transactions and working groups to address specitlc topics, such as offerrings of securitieson an international basis and multiple listings, the problems with existing memoranda of understanding among markets, and international clearing andsettlement. IOSCO has been studying issues related to capital adequacy for non-bank securities fii and is exploring ideas for risk-based capital~~U21CY standards.


continue its efforts. The FIBV Task Force30 hasagreed to the following steps:

promote the development of links betweennational markets;assist one another by exchanging plans andprocedures for implementation (a Practice whichhas already begun);standardize communications message formats,terminology, and legal agreements;3l andassist each other in understanding the ramifica-tions of their individual decisions on interna-tional trading.32

The Commission of the EC commissioned areport 33 with recommendations that to date have notgained wide support among EC countries. It isunlikely that the EC will adopt the report’s recom-mendations soon, but will await the results of otherinternational efforts. The report’s recommendationsfocused on the need for central depositories inEurope, not on clearinghouses; therefore, many ofthe recommendations do not apply to the UnitedStates.

ISSA, whose officers are directors of six majorinternational banks, produces handbooks on clearingand settlement in world markets to promote progressin securities administration. Key issues in clearingand settlement were identified in an ISSA confer-ence in 1989.34

Among other efforts to improve elements of theclearing and settlement process are:

. The Committee on Banking Regulations andSupervisory Practices of the Bank for Interna-

●

tional Settlements has designated a workinggroup on traded securities, which is currentlyexploring issues including the risk-based capi-tal standard and explicit treatment of positionrisk for banks.The SEC and U.K. regulators have entered intoa bilateral agreement under which the U.K.regulators will waive their capital adequacyrequirements with respect to particular U.S.broker/dealers that have branches in the UnitedKingdom, if the SEC provides certain informa-tion to their U.K. counterparts.35 The SEC isexploring bilateral agreements on the subject ofsharing information for enforcement purposesand, through IOSCO, is looking into thefeasibility of multilateral agreements towardthis end.

Although several of these groups have somemembers in common, each of the efforts is proceed-ing independently,36 and there are several points ofagreement among the most prominent groups (table5-2). These proposals and efforts are a starting pointfor improvement, but some of these will requireaction by the national governments. 37

The reforms suggested by the Group of Thirty andother organizations are being taken seriously in theUnited States. Several recent reforms have beenmade in the U.S. equities markets, many of whichpredate the recommendations of the Group of Thirty.These include:38

. Trade Processing—The NYSE in 1988, began developing an

on-line trade reconciliation system which

~ormation on the FIBV Task Force is based on a December 1989, interview with Mary Ann CaUahruq ISCC, who attended the last Task Fomemeeting.

31A5 in many Other areas where international harmonization or sm~“ tion is in its infancy, there area surprisingly large number of specializedterms used in different ways for comparable functions by various countries, a situation which hinders cross-national border trading.

3ZAS an e~ple of the latter, the Hong Kong Stock Exchange has already decided to implement a 2-day settlement period. Such a short period ~pose problems for settlement of cross-national border trades.

ssJorg-Rol~d Kessler, ‘Study on Improvements in the Settlement of Cross-Border Securities Transactions inthe Euro~~onomic COIUIXIMtY,’1989.

MISSA Sppsi- 4‘Glob~ %xrities Investments: Processing Issues and Solutions, ’ SwitzerlancL my 1989.Ssundm ~ ag=mm~ tie SEC wi~ now u~+ re@ators if it becomes awme that a pfic~~ broker-d~er’s fincid or opellitioti CC)Il&tkXl

is impaired, and U.K. regulators will provide reciprocal services.~~e fact that some of the same people, including regulators, participate in a number of these groups protides a m~ of coordination

internationally,sTSee, for ex~ple, GOUP of ~, “u.S. Working tioup Report on Compressing the Settlement PeriocL” NOV. 22 1989; md B*em Tmst CO.+

op. cit., footnote 1, p. 206.38For ~ ev~ution of Progess on fiplemenfig tie r~mm&tiom of tie president’s worm Group on F~ci~ Mkets rek~ to c1*

and settlemen~ see U.S. Congress, General Accounting Offke, Clearance and Settlement Reform: The Stock, Options, and Futures Markets Are Stillat Risk, GAO/GGD-90-33 (Gaithersburg, MD: April 1990).

Chapter International Clearing and Settlement: What Happens After the Trade ● 63

Table 5-2—Recommendations From MajorInternational Studies

Report

Aspect of operation ISSA EEC G-30 FIBV

Two-sided trade matching . . . . . . . . . —One-sided trade comparison . . . . . . . —National central securities

depository a . . . . . . . . . . . . . . . . . . . YesEvaluate securities netting . . . . . . . . . Yesb

Delivery versus payment . . . . . . . . . . YesRolling settlement . . . . . . . . . . . . . . . YesSame-day funds . . . . . . . . . . . . . . . . . Yesd

Use of ISO standards for messageformatting . . . . . . . . . . . . . . . . . . . . Yes

Lending for settlement . . . . . . . . . . . . Yesf

Cross-border Central SecuritiesDepositories should be linked . . . . Yes

Securities should be immobilized incountry of issuer . . . . . . . . . . . . . . . Yes

——

YesYesc

YesYesYese

YesYes

Yes

Yes

YesYes

YesYesYesYesYes

YesYes

—

—

YesYes

YesYesYesYesYes

YesYes

Yes

YesaDepositories for securities are already widely used in the United StateS.blncluded as part of the risk reduction/resolution recommendation in the

report.clncluded as part of the risk reduction/resolution recommendation in this

dincluded as a subset of the dellvery versus payment recommendation ofthis report.

elncluded as part of the currency accounting recommendation of this report.flncluded as part of the risk reduction/resolution recommendation in thisreport.

SOURCE: Bankers Trust Co. adapted from Federation International desBourses de Valeurs (FIBV) document.

has evolved into its current Overnight Com-parison System.

—The National Securities Clearing Corp. (NSCC)implemented earlier input and output timeframes to facilitate trade matching on the dayafter the trade (T+l).

—The NSCC is participating as part of theGroup of Thirty, U.S. Working Committee,in the evaluation of ways to shorten thetimetable for settling equities trades to T+3(from the current T+5).

—The NASD has implemented a Trade Accep-tance Reconciliation System (TARS) forsame day or next day automated reconcilia-tion of unmatched trades and is currentlyphasing in its Automated Confirmation Trans-action (ACT) system for same day compari-son of all trades not already locked inthrough automated execution systems.

● Risk Management

—Information sharing of the financial posi-tions of participants’ who are active inmultiple markets is being worked on by theSecurities Clearing Group (SCG), whichrepresents U.S. clearing organizations serv-ing equity and equity options markets. Thisgroup is working to develop a system forsharing settlement, margin, and clearingfired at-risk exposure information about jointmembers. 39 An earlier, continuing effort inthe futures industry (the BOTCC’s system)to share pay-collect information is beingexpanded to include options issued by theOptions Clearing Corp. (OCC). (There is stillsome concern by the OCC about the confidenti-ality and perishability of data, and uninten-tional competitive advantage.) In the UnitedStates, the trend is toward interfacing exist-ing centralized risk information systems forderivative markets with the emerging cen-tralized risk information system for equitiesmarkets.

—The NSCC has proposed to the SEC changesin its criteria for assessing risk-based contribu-tions to guarantee funds from clearinghousemembers, and to make earlier calls foradditional contributions. Due to a recentchange, now only 70 percent of an NSCCclearing member’s collateral may be in theform of letters of credit. In addition, theNSCC’s Board of Directors has approved,and NSCC has obtained, a bank line of creditof $200 million.40

—The SEC proposed an increase in capitaladequacy requirements of full-service broker/dealers from the present $100,000 to $250,000to be phased-in by January 1994.41

—The OCC initiated an intra-day margin callprocedure directly to the clearing member’sclearing bank, in contrast with the earlierprocedure of contacting the member andallowing 1 hour for payment.

—The OCC has increased the initial net capitalrequirement upon application for clearingmember status from $150,000 to $1 million.

4oData from Robert Woldow, Executive Vice President and General Counse~ NSCC, March 1990.41 SEC Rel~e No. 3~2724g, “MpOsed Rukmakhg on Broker-Dealer Net Capital Requirements,” S28-89, Sept. 15, 1989.


UNRESOLVED PROBLEMSIn futures markets differences exist both domesti-

cally and internationally. There is some commonal-ity, however, for financial safeguards in U.S. domes-tic futures markets. These safeguards include: origi-nal margins for clearing members based on tradescarried for their customers and their proprietaryaccounts; daily and intra-day marking-to-market andcalling of variation margins; initial and maintenancemargins for customers; clearinghouses serving asguarantors of trades; posting deposits by clearingmembers, which are callable by the clearinghouse;systems for monitoring the risk positions of bothclearing members and customers; and large traderreporting.

Clearinghouses have tended to structure them-selves as fortresses, able to contain significantdamage to their systems from internal causes with ahierarchy of safeguards or “firebreaks.” Assump-tions underlying the adequacy of firebreaks areincreasingly less valid because of the growinglinkages between futures, equities, and optionsmarkets; these linkages have become international.42

Exogenous forces could prove overwhelming,e.g., either a general crisis in the financial markets,or a failure of one or more large banks or broker/dealers for reasons unrelated to the financial marketsthemselves. In such a case the ability of a clearing-house to assess its members, after it exhausted all ofits margin and guarantee funds, would be ineffec-tive.43

Some key questions for market regulators are:

. whether the financial standards at individualmarkets and clearinghouses within their juris-

dictions are satisfactory;what improvements are needed, in cooperationwith other regulators, to strengthen the contri-bution of their markets toward improving theoverall financial integrity of the national finan-cial system; andwhat improvements are needed, in cooperationwith authorities in other countries, to strengthenthe financial integrity of futures, options, andequities markets internationally, and to contrib-ute to an overall strengthening of the interna-tional financial system.

There is also the question of how to supervisegroups that invest in a variety of financial instru-ments and markets internationally. Current systemsare not able to achieve this, although they makesome efforts to provide a picture of the overallfinancial risk of such participants.

Concerns about whether or not futures marginslevels in the United States are set appropriately havebeen addressed by the President’s Working Groupon Financial Markets, which concluded that they areset in a prudential manner and recommended nochanges in margin-setting systems.44 45 Neverthe-less, Federal Reserve Board Chairman Alan Green-span noted his concern that futures margins that areset too low tend to be raised during periods of marketturmoil, reducing liquidity when it is most needed.%

Shortening the interval between trade executionand the collection of margins could be a benefit, byreducing the exposure of clearing members beforethe clearinghouse’s payment guarantee is effected,and the exposure of the clearinghouse in the intervalbetween the provision of the guarantee and collec-tion of margin payment.

42~c~el H+tt, s~Or Adv&r, F~ce ~d ~dus~ Departmen$ B@ of ~l~d, “F~ci~ ~tegrity of Futures Markets,” pleSented at theFutures and Options Market Regulators Symposium in Burgenstoc~ Switzerland, September 1989.

A3Rog~ Rum, ~ef ~ative offl~er, BOT’CC, be~eves tit in a g~~~ f=~ ~ket ~sis sce~o, here cotid & a complete WOnOdCcollapse, ortheFRB, aslenderof Iastresort and provider of liquidity to the financial syst~ will act to stabilize market conditions. In the second scenario,the FRB would probably rescue a large bank and the government might have no choice but to do the same for a large non-bank brokerdealer. Expertpaper contributed to OTA contractor study by Bankers Trust Co, op. cit., footnote 1.

Although the recent experience in the liquidation of Drexel, B- Lambert casts doubt on the concept of afmbeing too large for thegovexnrnentto allow to fr@ and provides credibility to some alternative criteria for a government rescue actio~ such as the broader impact of such a failure.

~~terim Report of the President’s Work@ Group on FiIEUE id A&rkets, May 1988, p. 5: “.. current minimum margin requirements provide anadequate level of protection to the fmcial system. . .“ More recently, however, the Administration appears to have taken a different view, namely,tbatfhturesmargins areset too low, and that a single Federal agency should have day-to-day oversight “toharmonizemargins between futures and stocksto protect the public.” Testimony of Robert R. Glauber, UnderSecretary of the Treasury for P“mance, before the Senate Committee on Agriculture,Nutritio~,and Fores~, May 8, 1990.

*There is* the view that bightZ illitiill _ with less frequent reviews might be safer than today’s lower margins and more fkequent reviews.Hewitt, op. cit., footnote 41.

46~ testimony of Alan Greensp~ ~Federal Reserve Board, before the Senate Committee on Banking, Housing and Urban AHairs, Mar.29, 1990. He said: “I was shocked” about the margin setting behavior in the futures markets in October 1989.


There are advantages for firms that are membersof several exchanges in having their positions ateach exchange confirmed, registered, and guaran-teed at the same time. Simultaneous transfers offunds could be made by their settlement banks inpayment of margins. The advantages would be fargreater (but achievement more difficult), ,if settle-ments were synchronized between financial futuresand options markets. The synchronization of settle-ment timetables across time zones is theoreticallypossible once settlement periods of less than a fullday are achieved.

Is a member-owned clearinghouse that is backedby the assets of its owners safer than an independentclearinghouse, such as London’s International Com-modities Clearing House, that is owned and backedby strongly financed shareholders, i.e., banks? Thisdepends on whether the guarantee is more robust ifbacked by a special reserve fund, the assets of itsmember-owners, external credit lines, guarantees orinsurance arrangements, or by a combination ofthese.47 This also depends on the liquidity of theassets involved.

Large risk exposures to single customers havebeen a source of financial problems in futuresmarkets in some countries (but not in the UnitedStates). In the United States, the Commodity FuturesTrading Commission (CFTC) has had a large-traderreporting process since before the October 1987market break. Similar information-sharing proce-dures are needed to monitor exposure in interna-tional futures markets.

POLICY ISSUESSix areas of major concerns need to be addressed:

● risks associated with default;. risks associated with the payment process;. information sharing;

. technology;

. standardization and harmonization;● shortening the time to settlement and providing

same-day funds.

Risks Associated With Default

Investors need to be made aware of the differencesin the amount of protection provided by variousforeign markets. For example, there are no interna-tional standards for guarantees (by clearing organi-zations, banks, and others)--either for the protectionof investors or to prevent the collapse of financialinstitutions.

In the United States, the Securities InvestorProtection Corp. (SIPC)48 provides a level of protec-tion to market users in equities, bonds, and equity-related options markets. The protections afforded byexchanges and clearinghouses in futures markets tomarket users vary and are extended mainly toclearing members of the exchange’s clearinghouse.49

Insurance can never completely cover all losses.Some failures in securities markets are resolved inthe United States through bankruptcy proceedingsunder the Federal Bankruptcy Code. The Bank-ruptcy Code relies largely on State laws to determinerights to property. These may include State commer-cial law that often relies on the Uniform CommercialCode (UCC).50 The UCC is being reexamined toreflect the realities of today’s marketplace, espe-cially where it applies to third-parties holdingsecurities. Laws dealing with bank liquidation alsoneed to be updated and made more consistent withother bankruptcy laws.51 In nonregulated markets,such as foreign exchange, there is little investorprotection.

The SIPC in the United States, the CanadianNational Contingency Fund, or the United King-dom’s Securities Investment Board contingencyfund are possible models for international markets

gT~ the United Stites, ~~r the 1987 crash the size of guarantee funds was increased and greater cash deposits were rtX@Xi in place of tink lettersof credit, and the size of letters of credit outstanding with futures clearinghouses ffom any single bank was limited.

4SSIPC insmes an investor’s acco~ts Up to $xI0,000 for securities and cash against certain types of loss, e.g., the default of a broker. ‘l’’his includ~a maximum of $100,000 in cash per account. Securities Investor Protection Act, 1970.

g~t Shouldh noted that customers’ losses stemming from Futures Coremission Merchants’ insolvencies have been rare. Insolvency losses horn 1938to 1985 amounted to less than $lOmillion. Nationzd Futures Association study CwtowrkcountProrection, Nov. 20, 1986, p. 13. The basic protectionis the statutory requirement that 100 percent of customer funds be segregated. Commodities Exchange Act, sec. 4d(2). Also, customers have first priorityin commodity brokers insolvencies under the Federal Bankruptcy Code and CFTC bankruptcy regulations.

50’l”he UCC is accepted on a State-by-State basis and amendments to it would still leave open the possibility of non-uniform treatment by the variousStates. The American Bar Association has a current project that is seeking improvements to this area.

51~ ~fia ties, Cmtomem were inched t. keep ~ss=sion of their s~~ties ~rtificat~. Mom r~ntiy, my buyers of securities tend to kivetheir certMcates on deposit with third-parties, e.g., banks, brokers, depositories.


which do not now have any protection for investors.Canada uses private insurance, while the UnitedStates and the United Kingdom use governmentguarantees. These are topics that warrant the atten-tion of governments and the private sector.

Risks Associated With the Payment Process

There have been recent innovations in the waypayments are made for transactions. Increased vol-ume of trading has heightened the stress on pay-ments systems. Issues that have arisen concerningpayment risk include: delayed or inadequate bankcredit, timetables for finality of settlement, andnetting procedures. Problems may arise with 24-hour trading systems, for example, margin callswhen banks are closed.

Bank officials need to be more familiar with theprocesses and risks of clearing and settlement tomake better and more expedient credit decisions,particularly in times of severe market volatility. Atsuch times, the lack of adequate information onwhich to base credit decisions may force some banksto restrict credit earlier than necessary.52 This couldexacerbate a downward market spiral. Knowledgeabout the riskiness of various financial instrumentsand trading techniques are important for lenders.Educational efforts of this kind are receiving someattention by the private sector, but more is probablyneeded.

The timetable for finality of settlement is aproblem. Some payment systems, such as the FRB’sFedWire, offer immediate finality of settlement;other payment systems offer “end of the day”finality of settlement,53 and others are on latertimetables. 54 The shorter the time to finality of

payment, the less is the clearinghouse risk. Time-tables for finality of payment of settlement varywithin the United States and internationally.55 Theprivate sector and the regulators must harmonizedisparate systems, at a minimum to provide same-day finality of payment.

Netting of payments reduces the stress on pay-ment systems by requiring market participants topay (and receive) only the difference between theamounts each owes and is owed by others. Thisincreases liquidity for market participants and re-duces the risk that a market participant will defaulton either payment or delivery of securities. There isconsensus among experts that legally binding net-ting should be expanded, for payments and forsecurities delivery obligations. This issue must beaddressed internationally by the private sector andregulatory authorities.

Information Sharing

In most kinds of financial transactions, a lender(e.g., a bank) will have access to information aboutthe past creditworthiness and the current financialrisks of a potential borrower. However, there is nocentral source of risk information for financialmarkets participants in spite of the large amounts ofmoney often involved. Some organizations in theclearing and settlement industry have arrangementsamong themselves for sharing risk informationabout market participants either formally or infor-mally. Such arrangements are limited in scope, andcreditors are at a disadvantage because increasinglymarket participants trade on more than one ex-change, in more than one market, and in the marketsof more than one country.56 57

sz~e Clearing Orgtitiom and Banking Roundtable is addressing methods to assure that clearing mernbcm have adequate credit dtig ties ofmarket turmoil. Them are currently concerns for the privacy and contldentiality of clearing members tbat hinder the attractiveness of the concept of asingle center for complete information on all members’ positions in all markets. This organization was started by the CME and BOTCC to begin a dialogamong futures and equity-related clearing organizations, their Federal regulators, and clearing banks.

ss~e~~fii~of settl~entis avai~bleonly in the United States (through FedWire) andin Switzerland. The CHIPS system in theunittd Smta,the CHAPS system in the United Kingdom and the SAGI’ITAIRE system in France are examples of payment systems which offer end-of-day finalityof settlement.

~s~ B~ms Trust repo~ op. cit., footnote 1, vol. 1, p. 149.SsResWndmts t. a smey conducted by B~~s Trust Co. iden~~ the use of “~~&y ~ds” ~d ‘ ‘using el~troflic fids Emfa inst~d Of

checks” as the major improvements that they would like to see in the way that payment systems work in clearing and settlement. In answer to anotherquesfionon what changes or improvements respondents would like to see in the clearing and/or settlement process, the two most frequent responses were“standardization of settlement times internationally” and “centralized depositories in other countries. ”

56About 39 ~rcat of tie North ~eric~ respondents to tie s~~ conduct~ by B~ers Tmst stat~ tit they trade in markets k mOl_e dWl Onecountry. Bankers Trust study, op. cit., footnote 1, vol. 1, p. 235.

57while u-se cl~@ouses oWrate ~ sfigle ~kets, 20 ~rcmt of their me~r ~ tie in mo~ tin one market. General ACCOllI@ offiCe,op. cit., footnote 37, p. 4.

Chapter5--International Clearing and Settlement: What Happens After the Trade ● 67

There is a general consensus that risk informationshould be shared,58 but there is fear that riskinformation might give an advantage to potentialcompetitors. Increased automation could facilitateinformation sharing. This could lead to the develop-ment of a common format for reporting and distrib-uting risk information, and standards for the timelydelivery of risk information. Standards also areneeded for evaluation of different risks in differentmarkets: for example, a given dollar amount offinancial obligations in one market may not equalthe risk of a like financial obligation in anothermarket.

Bilateral links for sharing information have beendeveloping among clearinghouses, depositories, andregulators in various countries; these have set thestage for more global sharing of risk information.However, there are often legal restrictions on theflow of information across national borders.59 It is anissue that requires government and private sectorattention if it is to be resolved satisfactorily.

Inadequate Technology60

Technology may or may not have a significantimpact on clearing and settlement at low tradingvolume; but during high volume, technology is oftena key to efficient clearing and settlement. Most of theU.S. clearing and settlement system is technologi-cally advanced, although there are some areasneeding improvement. However, the clearing andsettlement industry worldwide (including manybrokerage firms and banks) are operating at aninadequate level of technology to meet the increas-ing demands of the markets.

Cultural, legal, regulatory and economic factorssometimes work as barriers to increasing the level ofautomation. For example, some countries prohibit

the transfer of equity ownership through electronicbook entries. Others restrict the importation ofautomation and communication equipment and re-quire domestic sources. These are areas where it willbe necessary for governments as well as the privatesector to make decisions about appropriate actions.

While clearinghouses have made significantstrides in upgrading technological levels, the bene-fits of these upgrades can be diluted if all clearingmembers are not sufficiently advanced technologi-cally to respond to new requirements of the clearing-house for which the technology was intended. Insome cases, the weakest technological link maylimit the responsiveness of the system duringoperational stress, particularly under high-volumeconditions. These are areas where, inmost countries,the private sector will have to take the initiative tobring about needed changes.

Standardization and Harmonization

Uniform codes of operation, or standards, for boththe process61 and the infrastructure62 of clearing andsettlement would make it easier to link the world’sclearinghouses and depositories. There is strongmotivation by regulators, the Self-Regulatory Or-ganizations (SROs), and the private sector, forstandardization to meet the demands resulting fromglobalization of world markets. But progress in thisarea is likely to be slow because of the complexityof effecting change. The United States (with respectto equities and options markets) and a few othercountries have standardized their domestic systemsboth in the process and the infrastructure, althoughthere are notable differences among them.

Operating hours and daily schedules for banks andfinancial markets are not uniform, either domesti-cally nor internationally. Banks, including the cen-

5S~e B~rs Trust -~y of fit~tio~ cleouses ~d exc~ges r~ived 18 out of 20 respo~s favo~ the shar@ of risk pOSitiOninformation “as useful or absolutely essential” among clearing and settlement organizations for the purpose of reducing clearing members’ exposurerislm Bankers Trust study, op. cit., footnote 1, vol. 1, p. 231.

5!)As ~-lw, Bel@~ ~d swi~~d ~ve s~ct privacy ~~s which ~trict the m of a client’s ~o~tio~ Such as trade details, witb thirdparties. IBu “Study of Clearance and Settlement for the U.S. Congress-OT&” Aug. 1, 1989, pp. 7, 39. This report is incorporated in the O’E4contractor report, Bankers Trust Co., op. cit, footnote 1.

@This section is based on “IBM Study of Clearance and Settlement for the U.S. Congress-01%’ Aug. 1, 1989, Ibid. The IBM study is based’onopinions of participating experts from the world’s major exchanges and clearing organizations.

Gltt~Wess$* ~fm t. owmtio~ ~tiom filu~ ~de ~tc~, the number of days to clear a tmde, number of days to setfle a ~de~ ‘e ‘eof a depository for holding equities and keeping records of ownership, the use of a recognized numbering system for identifying financial instruments,fo~ta for data ~missio~ and the method of payment.

Gzt{-ticwe,t ~fem t. ~ of ~ ~ny nonor~o~ f-es n=- to -e ~ cl- ~d ~~eme~ proc~s work b a COllsiStent dstable manner. These include the method of regulatio% mechanisms to protect the clearinghouse against the financial failure of a clearing member, areserve of funda to protect customers of a failing broker or futures commission mercmt, banlmptcy laws to adjudicate the disposition of customer assetsif a broker fails, credit processes at banks, clearinghouse trade guarantees, capital adequacy guidelines, and bilateral tax treaties among nations.


tral bank, maybe closed even if financial markets areopen.63 This disparity becomes increasingly impor-tant as market participants invest in more than onecountry. The FRB, SEC, CFTC, and the TreasuryDepartment must first face this issue in the UnitedStates.

Many investors in the world’s equity markets dealwith global custodians for clearing and settlement.64

Therefore, no matter how significant the improve-ments in the clearing and settlement process, thegains in efficiency can be diluted unless parallelimprovements are made by global custodians.65

Currently, there are no standards that define a globalcustodian, 66 yet these are important to achievingsmooth-working global markets. This needs to beaddressed at the international level by both privatesector and government regulators.

Markets around the world compete to be agentsfor capital transfer, and have made innovations toimprove their competitive positions. Before andafter the October 1987 crash, the private and publicsector have taken steps to reduce systemic marketrisks. These risk-reduction efforts include increasedco-operation among the world’s regulatory bodies.But efforts to improve clearing and settlementsystems-domestically and particularly in someforeign countries-likely will fall short unlesschange occurs in: 1) process, and 2) the infrastruc-ture. Many gaps in the infrastructure (methods ofregulation, taxation, customer protection) exist, buthave not yet received adequate attention.

Effective reforms in clearing and settlement willhave to be undertaken on an international scale. Theprivate and public sectors in the United States canact as leaders in the evolution of improvements inthe domestic clearing and settlement industry, butthey face serious constraints in achieving worldwideimprovements unless their efforts coincide withthose of other countries. Both private sector andgovernment actions are required.

Shortening the Time to Settlement andProviding Same-Day Funds

The need for standardization, or harmonization, ofclearing and settlement is manifest by the variousinternational standards-setting efforts already under-way.67 One example of the need for standardizationis shown by the differences among countries in thenumber of days to settle a trade for different financialinstruments. This is a case in which the private sectorlikely will require the support of national govern-ments to establish minimum standards for harmoniz-ing international clearing and settlement. The UnitedStates, for example, must shorten the settlementperiod for equities. This most likely would requireimmobilization of securities in a depository, and thepublic would also benefit from a change to same-dayfunds.68

The elimination of physical delivery of certifi-cates is the key to automating the clearance andsettlement systems. This has been achieved legisla-tively in France, where certificates are dematerial-ized (i.e., paper certificates are eliminated andcomputer-based records are substituted), and inGermany, Switzerland, Euroclear, and CEDEL (theinternational clearing and settlement firm) by usingnominee custodians to centrally transfer ownershipby book-entry. The United Kingdom has establisheda depository nominee (SEPON) for the book-entrytransfer of ownership between market-makers. Thesystem will be extended to other exchange membersand some institutional investors,’ and the UnitedKingdom has plans to implement a book-entrytransfer approach for all transactions. Japan andHong Kong have enacted legislation that requiresautomated book-entry clearance and settlement sys-tems.

The U.S. Working Committee of the Group ofThirty concluded that the greatest deterrent toachieving shorter settlement at the retail level, or the‘‘customer-side, ‘‘ is the physical delivery of certifi-

63~~ isme, fm ~ u~~ s~te~, _ fi~ ~ ~ Feb. 8, 1~ meting of the B- ~d CIXOUW Round@ble, wherc members _ tohold further discussions. The problem is far more complicated internationally and far from being resolved.

64A ~lob~ ~~~ is a * tit holds s~ties ~ oh financial instruments in multiple markets on bdlidf of in~~tio~ investo~.

fiFor mm on this Subjech see Bankers Tmst Co., op. cit., footnote 1, vO1. 1, p. 174.

% International Society of Securities Administrators may begin to develop standards for global custodians in 1990.67B~=TW6 fiits -Cy of cl- ~ ~~=entp~~pmts worldwide, *MI tie qu~tio~ Which Critical c1- W settlement probl~

should theU.S. Congress address, if any... ? The three most ffequent responses forattentionby Congress were: support stmhdmtioneffurta for globaltrading; support immobilization of securities; support increasing the standardization of theckaring and settlement process. It should be pointed out thata significant number of U.S. respondents did not want increased congressional involvement in issues aHecting the clearing and settlement industry.

~lBM study, op. cit., footnote 58, PP. 20,22.


cates (which some retail investors insist on) andreliance on the postal system to accomplish this.@

The retail customer must pay his broker on or beforethe settlement date. Each side requires the deliveryto the broker of either “good funds” or certificatesin a timely fashion. There is no easy way toaccomplish these “deliveries” today, without sub-stantial changes for the retail investor or addedexpense for investors who wish to hold a certificate.

The Group of Thirty’s recommendation for achange from next-day funds to same-day funds(SDF) for the settlement of securities transactionshas no deadline for implementation, but some expectit to be in place in the United States during the1990s.70 The adoption of SDF should contribute torisk reduction and would add uniformity and sim-plicity across all instruments and markets.

However, the U.S. Working Committee, whilerecommending the eventual adoption of same-dayfunds for the United States, recognizes the need forassessing a number of complex issues associatedwith its adoption. There are substantive technicalissues and the requirement for significant behavioralchanges that warrant study before the changeover.Today’s automated payment systems, for example,are considered to be not yet sufficiently developed or‘‘user-tiendly’ to be viable alternatives to thepostal system.

A second issue is that although most major futuresclearing corporations in the United States settle insame-day funds, there are important exceptions, e.g.,NSCC and the six regional equities clearing corpora-tions and depositories. Further work is needed toexamine how these systems would have to be alteredto accommodate an SDF environment.71

A third issue concerns implementing guidelinesissued by the Federal Reserve System to mitigatesystemic risk that could be caused by a failure of a

private payment system (i.e., a clearing agency)participant to settle its obligations.72 The guidelinesare seen as difficult to apply within NSCC and DTCfor the clearing of corporate securities and municipalbonds, and therefore will require additional study .73

Ongoing efforts by the U.S. private sector havebeen laudable. Yet, some of the issues raised byshortening the time to settlement and same-dayfunds, among others, will require continued assis-tance from regulatory bodies and, in some cases, theU.S. Congress, since they are not within the ability ofthe private sector to resolve.

IS AN INTERNATIONALREGULATORY BODY NEEDED?Although the private sector is already dealing

with many issues, government assistance is likely tobe needed, for example, to effect changes in laws,such as those needed for the immobilization ofsecurities certificates.74 The several private sectorstudies do not fully address all financial instruments,e.g., derivative products, that must also be addressedto accommodate the linked markets of today, nor dothese studies address all of the process and infra-structure areas that must be examined. The privatesector alone cannot implement the recommendedchanges fully since consensus will be requiredamong market participants, regulators, and nationalgovernments.75

Some of the organizations’ efforts aimed atharmonization have been peripheral to their primarymissions, or one-time activities. The efforts of U.S.regulatory agencies, that seek incremental improve-ments through bilateral agreements, although sus-tained, are slow. Pressures for harmonization aregrowing, and piecemeal efforts to address theseglobal needs may be inadequate. In other fields ofinternational interaction, such as telecommunica-

@~oup of ~, op. cit., footnote 36.~Mmo~dum from The DTC to the Group of Thirty, U.S. Working COmmitt% J~. 4, 19W.71~id.

T~ede~~~~e system Docket No. R-(X565, “Policy Statement on Private Delivery-Against-Payment SyStemS,” RIN 7100-~76, June 16, 1989.73~oup of ~, U.S. Wo~ Comm.ittW Report on Same Day Funds Convention, Fe- IWO.

VASW, GIOUP of ‘III@, op. cit., footnote 36, pp. 6-10.75The ~oup of ~~ found ~tb~d~co~~~ es~nti~ to -gpro~ss~~oni~ inte~tio~ @s@ smtids and procedures

both in the United States and in other countries. Yet there are indications that important issues, such as the dematerkdization of securities certificates,may be difilcult to change in the United States in the near term. Some Americans also fear that the recommended reforms, if adopted internationally,could make other markets more competitive with U.S. markets, weakening our competitive advantage. In spite of such concerns, the Group of Thirtyis making considerable progress, as of late 1989, according to Oerard Lynch Managing Director, Morgan Stanley, who has played a leading role indeveloping consensus among U.S. participants. Discussions with OTA staff, December 1989.


tions and air and sea transportation, internationaldecisionmaking and standardization, or harmoniza-tion, have long been recognized as essential. Interna-tional consensus and standardization are critical tomaking global trading practices uniformly accepta-ble. This suggests to some people a need for aninternational body to facilitate the process.

Others argue against such action, because othercountries may resent the United States trying tochange their markets, and fear that this resentmentwould generate resistance to U.S. proposals. Nationshave different objectives for clearing and settlementand contrasting views on the best approaches toaccomplishing them; some view the protection ofinvestors as paramount (as a number of countries,including the United States, have historically done),while other nations have as their primary objectivegreater market share. Some people suggest that theUnited States might be disadvantaged if it were tofocus too narrowly on issues such as safety andsoundness while other countries focus on gainingmarket share.

Perhaps one of the greatest problems in achievinga safer global clearing, settlement, and paymentsystem is parochialism.76

The alternative to developing or adapting aninternational standing body to focus on major issuesis continued reliance on informal or bilateral agree-ments—the present approach. These approacheswarrant close examination by the U.S. Congress.

At any rate, since the financial markets are privatemarkets which involve the public interest, the role ofthe Federal Government will have to be played outin concert with suitable private-sector institutions toachieve public policy goals. Many issues needinternational attention, including:

●

●

●

●

●

●

●

●

●

legal issues in cross-border trading,

information sharing across markets and acrossnational borders,

the minimum level of technology to be used byvarious participants with regard to clearing andsettlement,

international regulation of markets,

the critical interface between international mar-kets and banks,

means of protecting clearinghouses from exter-nally caused major disruptions,

minimum financial standards for clearinghouses(i.e., capital and guarantees),

standards for global custodians, and

surveillance and enforcement.

The ability of the United States to unilaterallydevelop new standards and procedures for interna-tional clearing and settlement is limited. As the needto develop a broad consensus on these issues ininternational forums increases, U.S. regulators mustbecome more knowledgeable about other countries’regulations, practices, customs, and laws, and moreproactive in seeking accommodations. Federal regu-lators will need a shared, consistent view of theminimum standards for clearing, settlement, andpayment systems on an international basis.

This subject is discussed in a forthcoming OTAreport, Electronic Bulls and Bears; Securities Mar-kets and Information Technology, along with com-plications associated with U.S. regulatory responsi-bilities divided among the Securities and ExchangeCommission, the Commodity Futures Trading Com-mission, the Treasury Department, and the FederalReserve System.

76A oneob~~erputit: “ . . that unckrthe guise of safeguarding the system and making it more effective and efllcient, the evolution of theregulatmysystem internationally will continue to be distorted in order to advance narrow nationalistic and protectionist puxposes. ‘lb the extent tbat this occurs,less progress will be made in advancing the primary objectives of regulatio~safety and soundness, competitio~ integrity and consistency. In additio~theinternational system will fallshortofitspotentialto facilitate economic growthanddevelopment.>’ @anti.,.Reuba~Deputy “C2@rman of the Bankof Monlreal, “Implications of Globalization for Regulation and Safety,” a talk at the November 1989, Financial Globalization Confenmce in Chicago.

Chapter 6

The Regulation of Global Securities Trading

Global trading in securities runs into complexproblems and unnecessary risks because of thedifferences among national regulatory policies andstructures. There is no international mechanism forregulating transborder activities, nor any way for anation to enforce its own regulations beyond itssovereign reach, except insofar as there are coopera-tive agreements between nations.1 The risks, dis-cussed in chapters 3 and 5, include both unrecog-nized risk for investors who make decisions basedon unrealistic expectations of fairness or institu-tional integrity, and wider systemic risks that mightresult, for example, from the failure of a major firmwith heavy commitments in several countries. Atbest, there are many complex problems that resultmerely from differences among nations in marketstructures and procedures, in the relationships be-tween securities markets and the banking system,and especially in the regulations that govern theseactivities.

COMPETITION ANDREGULATION

Many market participants in many countries arguethat these differences in regulatory regimes are bestresolved through deregulation in those countrieswith the more regulated markets. Advocates of ‘freemarkets,” generally opposed to regulation, use thethreat of international competition to counter anyconsideration of regulatory action. They are quick toargue that additional U.S. regulation or taxation, oreven the maintenance of existing levels of regula-tion, will “drive the markets overseas.” Thisargument may or may not be correct, but it is initiallysuspect because for many of those who make it, it isobviously self-serving. The argument should there-fore be closely examined.

Free market advocates assume that trading willinexorably shift to the least regulated market be-cause it is the least expensive to use, or the “mostefficient.” Regulation can significantly add to thecost of doing business. Mandated costs appear to

have caused trading to shift at some times in the past.For example, the Eurobond market developed inLondon after a U.S. “interest equalization” tax in1964 discouraged the issuance of debt in the UnitedStates by foreign borrowers. A significant amount oftrading in German government bonds is said to havemoved to London to avoid tax in Germany. How-ever, many examples of movement off-shore offeredby free market advocates cannot confidently beattributed to a single simple cause.

The concept of the pull of less regulated marketsis probably too simple for several reasons. First,active markets have some natural protections. Thereis a strong tendency for securities to trade in the mostliquid market, nearly always in the country of origin.Attempts by a second exchange to compete forvolume trading in an existing heavily traded productnearly always fail. As noted several times in thisreport, this situation may change, especially whenthe product is offered in a different time zone. But fortrading to shift to another place, the attracting marketwould have to begin with ample depth, i.e., enoughparticipants at all times to provide liquidity to thosewishing to trade.

The more dubious assumption is that the leastregulated market is necessarily the most efficientmarket, or the most attractive market to investors. Itseems likely that some degree of regulation isdesired or even demanded by participants for theirown protection. Beyond this is the question of howmuch systemic risk modern industrial nations areprepared to assume as the price of participation inworld financial markets. Policy concerning financialinstitutions and markets has been, in nearly allcountries and at all times, “protectionist,” becauseof the concern of national governments aboutmonetary control, savings, capital formation, andfinancial systems. The policy issues related toglobalization of securities trading center on howmuch less or how much more protectionist financialregulatory policy should be in response to techno-

IGA~ ~ ~ he Pwt cov~ gwds, not s~ms, SemiW industries ~ included for tie f~t time in tie most current round of GA~ negotiations,but once a general agreement is reached on trade practices in the international services sector, it will still have to be translated into specflc agreementsfor different types of services.

–71–


logical change and the increasing global mobility ofcapital.2

TWO KINDS OF REGULATION

It is important to recognize that there are two quitedifferent kinds of securities markets regulation.3 Thefirst, which can be called access regulation, is aimedat protecting domestic markets and their participantsfrom outsiders; i.e., restricting access to the marketto maintain the privileges and benefits of “member-ship in the club.” In recent years major marketnations have reduced these barriers; this has been aprimary thrust of deregulation in the United King-dom and France, for example, and even in Japangreater access has been opened for foreigners,although more slowly.4

The second kind of regulation may be called“prudential regulation” and is aimed at assuringinvestors of fair and equal treatment, by regulatingtrading practices, abolishing fixed commissions,making sure that investors are informed about risks,and requiring the availability of information aboutprices, fees, commissions, and factors influencingprices. Most governments consider it in the publicinterest to maintain markets that are fair and have theconfidence of the public. However, some countriesput much greater emphasis than others do, onassuring investors of fair and equal treatment. In theUnited States, broad participation in securitiesmarkets and stock ownership has been valued as away of democratizing the economy, and investorprotection is emphasized. In some countries, therehave never been many “small investors” or house-hold investors, and most market participants are

large institutions, assumed to be able to look afterthemselves.

The exposure of stock market fraud over the last3 years in several countries-the United States,Japan, France, West Germany, and Canada-hasgiven rise to demands for new or more seriouslyenforced prudential regulation or deregulation.5 WestGermany, Belgium, Spain, Italy, and Ireland havepassed or are considering new laws forbiddinginsider trading or providing stiffer penalties. InJapan, insider training was against the law, but untilrecently it was not considered a serious offense.When detected, offenders might be reprimanded, butusually not publicly.6 A stricter law has been passedsince the scandals last year, but enforcement is weak.

In the United States, some people who favorderegulation have suggested that investor protec-tions should now be relaxed because institutionalinvestors, guided by professional money managers,need less protection than the traditional smallinvestor. On the other side, some say that moreregulation may be needed to protect the growingnumber of participants in mutual and pension fundsagainst abuse and mismanagement by fiduciaryagents; and some suggest that deregulation in theUnited States has begun to threaten essential inves-tor protections, by subtly shifting to emphasize notthe “small investor” but the “informed investor,”implying a philosophy of “caveat emptor,” or letthe buyer beware.7

Prudential regulation of markets still differswidely from country to country.8 Regulatory agen-cies in some countries approve nearly any newtrading products, such as index futures contracts,that are proposed by the financial community; other

?llds formulation borrows from a formulation by David D. Hale, Kemper Financial Services Inc., in “How European Economic Integration andJapanese Capital Power Will Produce Managed Trade in American Financial Services During the 1990’ s,” an ad&ess to the Athens College AlumniAssociation Fourth International Economic Conference, 1989. However, Mr. Hale is not responsible for the permutations of his question used in thischapter.

sMuchof t.hema~in this section~wsonm Gilbert Warren~ “SecuritiesRegulation in the European Communities,’ acontractorx’eportto the OftIce of Technology Assessment, Aug. 1, 1989.4- are no barriers to foreign membemh“p onU.S. exchanges other tban the requirement tbat members have anoffke in the United States. In 1977

the NYSE further broadened access to trading by providing for (in addition to the traditional purchase of a “seat”) leasing of seats, electronic accessmembershl“ps, andafewphysical access memberships with limited participation on the trading floor without other attributes of membership. The NationalAssociation of Securities Dealers has never had barriers to foreign membership. Information provided by the NYSE and NASD.

SFor a brief summary of insider trading rules prior to recent changes see An&ew N. GWS, Jr., “Internationalization of the Securities TradingMarkets,” Houston Journal ofZnternationalbw, vol. 9, No. 1, Autumn 1986, pp. 44-49.

6_We~ermd~WdK@4 “The Stock Market in Japam An@emiewand_ysk, “ Congressional ResearchService ReportforCongress,Mar. 15, 1988.

70’IA workshop on “The Small Investor,” IWiy 1, 1990.SW -on ~ws ~vily on ~~z~nts for tie R-don ~d Supervision of Securities ~kets ~ OECD Countries,” in OJ3CD: Finuna”uZ

Market Trendk 41, November 1988. Most of the summary statements below apply therefore to OECD countries, which includes all major markets.

Chapter 6--The Regulation of Global Securities Trading ● 73

countries are more restrictive, on the grounds thatsome forms of trading are basically speculative andmay lead to excessive volatility or undermineconfidence in the financial system. Some majormarket countries heavily regulate securities under-writers and investment advisers; others require onlythat there be disclosure of basic information..

Countries also differ in the degree to whichcompetition among financial institutions is restricted--e.g., whether banks can engage in securities under-writing and related activities. Several countries haverecently removed regulatory barriers that formerlyseparated banks, thrifts, securities houses, and otherfinancial companies. In other countries, chiefly theUnited States and Japan, there are still some legalrestrictions that may affect the participation of banksin international securities activities.

These differences result in part from historicalcircumstance-the way in which national bankingand payment systems evolved, and when and underwhat conditions the existence and importance ofsecurities markets were first recognized. In part, theyresult from differing perspectives on the distinctionbetween private and public sectors (i.e., how capital-istic or how socialistic an economy is). A third factoris the constitutional structure of the government: infederal systems regulatory responsibility may be-long either to provincial or central government, or bedispersed.

BANKING AND SECURITIESMARKETS 9

In most countries, banks are major participants insecurities markets and securities-related activities.In the United States and Japan, the policy has beento protect the banking system from security marketrisks. Banking and securities activities are separated.People making bank deposits are assumed to betrying to safeguard their assets, and are thus givenmore protection; their deposits are guaranteed up toa certain limit by government insurance, and the

types of liabilities that banks may incur are limited.Those investing in securities knowingly and bychoice assume risks, in return for the opportunity toprofit; they are nevertheless protected to the extentof seriously enforced laws against fraud and manipu-lation, requirements that the investors’ risk bedisclosed to them, and insurance protection againstthe failure of a securities firm. Separation of bankingand securities activities tends to result in largeindependent securities houses such as those in theUnited States, Canada, and Japan. OECD analystsconclude that in such systems there may be greateracceptance of innovative products than there is inuniversal banking countries.10

A universal bank system is more common;countries with universal banking (which includeAustria, Denmark, Finland, West Germany, Luxem-bourg, The Netherlands, Norway, Sweden, andSwitzerland) allow banks to engage in the full rangeof financial activities.

11 These countries assume thatthe risk of financial failure in any one activity isreduced by the bank engaging in a broad range ofactivities-a form of diversification.

A third system allows either banks or brokers toreceive customer orders for securities transactions,but requires the trading to take place throughindependent intermediaries. The activity of dealingfor a proprietary account is separated from theactivity of trading as an agent for customers. Thismay constrain the range of services that stockbrokersoffer. This system is used in Belgium, France,Greece, Ireland, Italy, Portugal, and Spain.

These differences in the securities-related powersof banks result at the international level in the issueof national treatment v. reciprocity .12 “Nationaltreatment’ means that a country applies the same setof requirements and regulations to both domesticinstitutions and foreign institutions operating withinits boundaries. In most regards this should providea ‘‘level playing field’ and promote competition.But in the United States, where national laws

%laterial in this section is drawn in part from OECD, op. cit., footnote 8. See also OECD, “International Trade in Services: Securities,” FinunciaZMarket Trends 37, May 1987; and OECD, ZnternationalTrade in Sem’ces:Banking (I%@ 1988); Bank for International Settlements, RecentInnovationsin International Banking, April 1986; and Banking and Payment Services, materials for an International Symposium sponsored by the Board ofGovernors of the Federal Reserve Systeu Washington DC, May 1989.

lOOECD, op. cit., footnote 8, pp. 19-20.ll~west&rrnany and Austria anyone engaging insecurities trading must obtain a banking license. In the other countries, some fmcial fm which

do not accept deposits maybe licensed to engage in securities activities without banking licenses.12See OE~, ]nterMtioMl Tr~e in Sewices: Banking, pp. IS-ZO, se ~o An&w T. Hook and M. AIxrto Alvarez, “COXLIpditiOn From Foreign

Banks,” Chapter 10 of Federal Resave Bank of New York NY, Recent Trends in Commercial Bank Profitability, A Staff Study, September 1986.


separate banking and securities activities, the banksof universal-banking countries are prevented fromengaging insecurities-related activities because theyare officially banks. European countries whosebanks are officially excluded in this way could intheory demand “reciprocity,” or access to U.S.markets as a condition for allowing U.S. institutionsto participate in their markets. The official U.S.position13 is that:

The United States considers reciprocity in finan-cial services to be inconsistent with the internation-ally accepted principles of national treatment andnon-discrimination . . . The national treatment ap-proach used by the U.S. Government in financialservices seeks to ensure that foreign firms in theUnited States and U.S. firms in foreign countries aregiven “equality of competitive opportunity” withdomestic firms.

The European Community has as one goal of its“1992 initiative” the establishment of a singleEuropean market in banking and securities activi-ties. The 1992 Initiative originally included a policyof reciprocity, which has recently been modified.

REGULATORY INSTITUTIONS14

The institutional structures for regulating securi-ties markets differ widely. In universal bankingcountries, one regulatory or supervisory agency maycover all financial activities15; in the United States,securities markets, futures markets, bond markets,and banks have different regulators. In some coun-tries, primary supervision over securities trading isgenerally carried out by self-regulatory bodies, suchas stock exchanges, under the oversight of aregulatory agency. This is the case in the UnitedStates, and it is also the case in Finland, WestGermany, and Switzerland, where securities andbanking supervisory functions are not separated. Incountries with a federal structure, primary responsi-bility for supervising markets may be assigned eitherto the national government, as it is in the UnitedStates, or to provincial or state governments, as it isin Australia, Canada, and West Germany. In theUnited States and the United Kingdom, any entityoffering securities or investment services to thepublic is regulated, but in some countries such as

Italy and Switzerland, some parties-e. g., over-the-counter dealers-are not covered.

Other differences relate to collective investmentssuch as mutual funds; there are different prudentialrequirements about corporate structure, fees, andmanagement compensation. The United States hasrigorous prudential requirements; many Europeancountries are just beginning to develop tougherrequirements after major losses by investors. Therehave been some efforts to harmonize standards. TheEuropean Community has just adopted commonstandards for mutual funds its member countries.

The differences in accounting practices and stan-dards, and in capital adequacy requirements forvarious kinds of financial institutions and marketparticipants are very important and very difficult toresolve. Some of these differences were discussed inchapter 5, on clearing and settlement.

ENFORCEMENT OF SECURITIESREGULATIONS

As securities trading is further globalized, regula-tors responsible for investor protection face thedifficulty of supervising activities that flow throughelectronic systems and networks across nationalboundaries. Currently, the U.S. market regulatoryagencies (the SEC and the CFTC) have limitedauthority to assist foreign authorities with investiga-tions of violations of foreign laws from a U.S.location. When a foreign government needs U.S.assistance with market investigations, it must ask fora court order to compel testimony or evidence. Butit is often undesirable to have a public hearing whilean undercover investigation is in progress. A billnow before Congress, the International SecuritiesEnforcement Act (H.R. 1396), would strengthenSEC authority for cooperative enforcement byincreasing its ability to punish brokers, dealers, andinvestment advisors for overseas violations, givingthe agency greater discretion over the release ofinformation, and allowing the agency to acceptreimbursement from foreign securities authoritiesfor costs of investigations that SEC would conductfor them.

13h ~sue pap~fiom tie TJ.S. Dep~ent of the Treasury entitled “EC Single Market: Banking and Securities” provided by the ~temational TradeAdministratio~ U.S. Department of Commerce, Aug. 1, 1989.

IAMuch of tie materi~ in this sectiom not otherwise cited, is drawn from OECD, op. cit., footnote 8.15This includes: Austria, Belgium, Denmar IG Finland, West Germany, Luxembourg, Norway, Portugal, Swedeq and Switzerland.


In cases where U.S. markets are abused ormanipulated from overseas, the SEC’s investigativepower is limited when the evidence is locatedelsewhere. When the SEC seeks help from a foreigngovernment, it must make a formal request under theterms of the Hague Convention or exert pressure onU.S. branches of overseas financial institutions. TheSEC has been required to go through long negotia-tions or court proceedings to obtain informationabout transactions through foreign banks or securi-ties houses. As Charles Cox, a former SEC commis-sioner, explained:

All nations with securities markets may face thedilemma of deciding whether to protect their marketsfrom foreign-based fraud, or to live with marketswhere some participants can defraud others withimpunity. . . . The acceptable alternative is to de-velop ways of sharing surveillance and investigativeinformation, and to formalize these arrangements inbilateral or multilateral understandings.16

Formal agreements have not been completelyeffective. In spite of the Hague Evidence Conven-tion some nations refuse to disclose information, andthe legal mechanism of letters rogatory have beeninadequate for gathering evidence for litigation.17

While the United States accepts the idea of govern-ment access to financial data for the purpose ofenforcing securities laws, some nations view this asa violation of confidentiality and may have secrecyor blocking statutes that forbid the release of suchinformation.18 Secrecy laws recognize confidential-ity as a fundamental right and forbid any disclosureof a customer’s financial information, includingbusiness records and accounts, without personalpermission. Blocking laws protect national ratherthan individual interests, and are intended to preventthe disclosure of information by citizens as parties toforeign litigation, or to prevent any foreign govern-ment from conducting investigations and imposingits policies within their borders, as an invasion ofsovereignty.19

In 1985, the SEC proposed the idea of “a waiverby conduct,” meaning that anyone who traded inU.S. markets would be held legally to have waivedthe right to prevent the SEC from investigating. Butthe concept was widely viewed as politically unac-ceptable because it infringed on the sovereignty offoreign governments and created tension with friendlynations.

To encourage cooperation from other nations, theSEC is seeking legislation to authorize it to issuesubpoenas and take dispositions in this country onbehalf of foreign securities regulators or law enforc-ers.20 It also wants the power to bar from U.S.securities markets people who have been convictedin foreign courts of certain financial abuses. This,however, raises questions of legal rights or justice,because foreign governments may lack safeguardswhich are considered essential in the United Statesfor those accused of crimes, or may have verydifferent standards of proof.

HARMONIZATIONMany people argue that a worldwide securities

regulatory body is needed, but others believe that abroadly multinational institution with strong author-ity is not feasible, at least at present. They look to aless drastic solution: “harmonizing” regulation byreducing the differences (or the effect of differences)in national regulatory regimes.

Harmonization is the process of reducing regula-tory disparities among mutually accessible markets,through the development of common or mutuallycompatible regulatory regimes, standards, and prac-tices.21 Advocates hope that harmonization wouldlessen the threat of “regulatory arbitrage,” orallowing competition among national securitiesmarkets to force prudential regulation down to thelowest common denominator. Critics fear that har-monization could raise the threat of “regulatoryimperialism” in which less regulated markets are

Iwles COX, “Transactions: Blocking the Success of Market Links,” Maryland Journal ofInternational Labor and Trade, vol. 11, 1987, p. 215.l~id., p. 217.lsB~onBecker~Tho~ Etter(Securities and ExchangeCommis sion), “JnternationalClearanc eand Settlemen6° 16 BrookZynJ. 271,292-293,

1988.WA SEC ~v=tig~on of ~spiciow ties o~x ~ fom~ cow~es indica~ tit some U.S. ad foreign investors avoid SEC surveillance

by executing transactions through financial institutions in countries with secrecy and blocking laws. “Problems With the SEC’s Enforcement of U.S.Securities Laws in Cases Involving Suspicious Trades Originating Abroz@” House Report 100-1065, Oct. 6, 1988.

20H.R. 13%, The International Securities Enforcement Act, now before the Senate.21W-mop. cit., footnok 3. S* W ~er, “Re@@S F

inancial Services in the Unite dKingdom-AnAmerican Perspective,” 44 Buw”ness Luw323, 1989; and Bernard, “The United Kingdom Financial Services M 1985: A New Regulatory Framework” 21 InternationaZLuw 3431987.


forced to become more regulated. Pessimists fearthat the effort to achieve harmonization may itselfbecome a form of regulatory arbitrage.

The term “harmonization” itself has in this waybecome controversial, and because it is controversialit has become difficult to define. Different stake-holders, or interest groups, tend to define the term inways that imply different objectives as well asdifferent approaches. It is necessary to recognize, atleast, that harmonization allows for two approaches.The first, “commonality,” means the developmentof uniform international rules, such as uniformdisclosure requirements, enforced in all countries.The second, sometimes called “reciprocity” or“comparability,’ calls only for substantially equiv-alent minimum standards.

The North American Securities AdministratorsAssociation (NASAA) recently urged the creation ofglobal minimum standards of investor protection;this is a commonality approach to harmonization.The International Organization of Securities Com-missions (IOSCO)22 is attempting to develop disclo-sure requirements for multi-jurisdictional securitiesofferings. IOSCO is also working with the Interna-tional Accounting Standards Committee to developcommon accounting rules and standards. Otherinternational securities organizations working to-ward commonality, or universal standards, are listedin box 6-A.

The SEC and Canadian provincial regulatoryauthorities have proposed reciprocal recognition ofprospectuses in connection with certain types ofofferings from specific kinds of issuers; the require-ments for these perspectuses, although not identicalin the several jurisdictions, show ‘substantial equiv-alence.” This is the comparability approach. Theapproach of the European Community, in attemptingto harmonize securities market regulation among itsmembers, has shifted pragmatically from common-ality to comparability.

“Substantially equivalent rules” could be soughton a global basis either gradually through a multina-tional forum or program, or through a series ofinformal arrangements. Informal arrangements in

the past have not been very effective. The Interna-tional Association of Securities Commissions has anorganized program for exchange of information, butthe meetings have had little impact.23 Bilateralagreements through non-binding memoranda ofunderstanding (MOUs) have been somewhat moresuccessful. They provide flexibility for regulators towork out techniques of securities enforcement in areamer consistent with domestic law, taking ac-count of differing legal systems and culture ratherthan demanding complete uniformity. They mayreduce the need for case-by-case negotiation that candeplete regulatory resources and cause nearly end-less delays, but they are a clumsy solution; eachcountry could find itself with many MOUs that aredifferent from one another. The SEC has MOUs withCanada, the United Kingdom, and Switzerland. TheCFTC is party to MOUs with the United Kingdomand has arrangements with Australia, Canada, andSingapore for sharing information from monitoringand surveillance activities.

The risk with a policy of reciprocity with substan-tial equivalence is that countries with the moststringent regulations will be led to interpret “sub-stantial equivalence’ too broadly. They may beginto interpret their own rules more loosely and enforcethem more slackly, in order to attract or retainforeign investment in the face of competition fromcountries with less prudential regulation. Thendomestic firms will demand regulatory parity inorder to compete with foreign fins, and thisbecomes a form of prudential deregulation throughleveling downward--i.e., another form of regulatoryarbitrage.

Many market participants and many regulators,although eager to engage in international trading ofsecurities and derivative products, are critical of theobjective of harmonization. For example, in theUnited States, CommissionerAlbrecht, of the CFTC,recently told a public meeting that:24

Unfortunately, harmonization is a word that thoseof us at the Commodity Futures Trading Commis-sion, as well as many in the futures industry, havecome to view with a great deal of suspicion. . . . At

~OSCO includes securities regulators from more than 40 countries.~B~ker and Etter, op. cit., footnote 18; - Note (N., eedham), “Insidex Trading Liability,” 16 Brooklyn J. 357,381-385, 1988.MWMXUP. ~br~ht, “mo-htamtio~ Re@tion of Futures and Options Ivlmketa,” a Speech to the Conference on Futures nd @tiom

Markets in the 1990’s-Innovatio~ Regulation and Jurisdictio~ co-sponsoredby the Commodity Futures Trading Commission and the Futures IndustryInstitute, Washington DC, May 2, 1990$

...—— - —


Box 6-A--International Organizations Related to Coordination of Securities Regulation

The International Organization of Securities Commissions (IOSCO)Membership: Securities Regulators from about 40 countries. (SEC is the principle U.S. representative with CFTC

as an associate member.)Aims: Coordination, exchange of information, mutual assistance related to standards and surveillance.Mechanism: Technical committee and working groups on multinational equity offerings, accounting and auditing

standards, capital requirements and financial ’data, enforcement information exchange, off-market trading, clearingand settlement, futures markets.

Federation Internationale Des Bourses de Valeurs (FIBV)Membership: 33 stock exchanges.Aims: To facilitate exchange of information. Recently concentrating on clearing and settlement, disclosure

requirements, listing procedures.Mechanism: voluntary information exchange.

Group of ThirtyAlso called The Consultative Group on Economic and Monetary Affairs.

Membership: 30 individuals from world-class banks, multinational corporations, government agencies, andacademia.

Aims: To increase policymakers understanding of international economic and financial issues and explore theinternational effects of public and private decisions.

Mechanism: Ad hoc committees.

Organization for Economic Cooperation and Development (OECD)Membership: 24 developed nations. Representation by ambassadors and at selected meetings by cabinet-level

officials.Aims: Encouragement of economic growth, expansion of world trade. Looks at securities coordination in terms

of international flow of travel.Mechanism: Permanent research staff, participation of ministers with authority over securities and other financial

institutions.

International Councils of Securities Dealers and Self-Regulatory AssociationsMembership: Formed in 1988, membership includes four SROs (Canada, Japan, the United Kingdom, the United

States) and three Securities Dealers Associations (Canada, Japan, the United States).Aims: To aid and encourage the sound growth of the international securities markets by promoting and

encouraging harmonization in the procedures and effective regulation of those markets, thereby facilitatinginternational securities transactions and by promoting mutual understanding and the sharing of information amongthe members.

the international level, some calls for harmonization tions of foreign firms as they would those carried outshould also be viewed with suspicion. by domestic firms; mutual recognition means that a

country would allow foreign entities to operateCommissioner Albrecht called on governments to within its jurisdiction as long as they complied with. .

recognize the importance of relying on market the regulations of their country of origin and “asforces, saying “Competition is the best harmonizer, long as the rules of the firm’s country of origin arethe best regulator of market forces.” Commissioner comparable to our own. ’ However, the CFTCAlbrecht said that with regard to cross-national participates in international discussions and negotia-trading, “the CFTC favors a policy combining tions related to harmonization.national treatment with mutual recognition,’ and hedefined the two terms as follows: national treatment The SEC has indicated a somewhat differentrequires authorities in each country to treat opera- approach, saying that an effective regulatory struc-


ture for an international securities market mustinclude:

●

●

●

efficient structures for quotation, price, andvolume information dissemination, order rout-ing, order execution, clearance, settlement, andpayment, as well as strong capital adequacystandards;sound disclosure systems, including account-ing principles, auditing standards, etc.; andfair and honest markets, through investor pro-tection legislation, surveillance, and enforce-ment cooperation.=

At the end of 1989, the SEC signaled its intentionof encouraging international cooperation in regula-tory affairs by creating an Office of InternationalAffairs that will report directly to the chairman of theCommission. The office is to set up information-sharing agreements with other countries and directcooperative enforcement efforts. The CFTC alsoactively participates in many international regula-tory cooperative activities.

Many countries are now reviewing their regula-tory frameworks in response to the internationaliza-tion of markets. According to OECD:

There is increasing awareness that securitiesmarket activities involve risks that are comparable tothe systemic risks inherent in banking, and that,accordingly, the basic question arises as to whatextent existing regulatory and supervisory arrange-ments are adequate to deal with current marketrealities. 27

The EC’s 1992 initiative (see ch. 4) provides anexample of how harmonization could be achievedamong major market nations, given sufficient incen-tive and leadership. If successful, the EC initiativemay stimulate further action toward broad multina-tional cooperation. The 1992 directives are aims, notyet achievements, but enough has been done towardintegrating European markets to make it likely thatthe EC will become a significant factor in interna-tional securities trading.

AMERICAN LEADERSHIPIt seems reasonable to conclude that the United

States now has, in the aggregate, the largest and most

liquid securities market and futures market in theworld, and possibly the most efficient, innovative,and fair markets in the world—although there arecertainly challenges on several of these fronts.Assuming that Congress believes that it is in thepublic interest to maintain this position, what mustbe done to assure our competitive position, whilesafeguarding the interests of U.S. investors, finan-cial institutions, and most importantly, the public atlarge?

A number of international cooperative efforts areunderway to achieve harmonization of regulation.The problem for policymakers is how to be sure thatthe United States encourages this movement andprovides leadership for it, without becoming avictim of “regulatory arbitrage” in which countrieswith much lower levels of prudential regulation setthe norms. This calls for coherent and consistentpolicy positions that American negotiators canpresent and defend.

One need is to prevent the erosion of theframework of prudential regulation that Congresshas erected since 1934, as an unintended byproductof the effort to achieve harmonization. The secondneed is to clarify and reassert congressional guid-ance over the evolutionary development of securi-ties markets as they face the challenge of globaltrading. There may be differences between the twoU.S. regulatory agencies in their approaches tointernational regulatory harmonization that couldconfuse and hamper American leadership in defin-ing a desirable regime for global securities trading.A statement of policy similar to that underlying theSecurities Act Amendments of 1975 maybe needed.

This implies something of a dilemma for U.S.policymakers. A general trend toward deregulationand non-intervention has been apparent in theUnited States as well as in other countries, during the1980s. On the other hand, the United States seesmany of the advantages of its chief competitor,Japan, as resting on the close relationship betweenfinancial institutions, industry, and government, sothat Japanese investment banks operate in a marketguided and insured by the government. There islegitimate concern that unnecessary regulation mightinterfere with the ability of exchanges, over-the-

~C~R@ation of~~rmtio~ s~~ti~ ~kets, ” Policy Statement of the United States Securities and fictinge CO* sion, Washington DC,November 1988.

~OECD, Op. cit., footnote 8, p. 31.


counter markets, and financial information systemsdevelopers to experiment and innovate. There is fearthat excessive regulation might make markets lessefficient and drive trading to overseas exchanges.There are also encouraging signs that some U.S.markets are prepared to take a lead in developing thetechnology and institutional mechanisms for globaltrading; in this regard the futures markets are farahead of the stock exchanges.

Large institutional investors want greater transac-tion speed, mobility, and opportunities for diversifi-cation, and there are already strong indications that

they will seek more freedom from the clock than thetraditional exchange trading hours and floor mecha-nisms can accommodate. U.S. stock exchanges areso far slow to show any interest in adoptingautomated trading systems that bypass or competewith traditional dealer intermediaries or that operatearound the clock.28 U.S. regulators may need toactively encourage market officials to take a long-term view of market development, and U.S. regula-tors themselves may have to be encouraged to do soby the U.S. Congress.

~A forthcoming OTA report, Electronic Bulls and Beardecun”ties Markets andhtfonnation Technology, ~cusses tiese issu~.

Appendix

Clearing and Settlement in Major Market Countriesl

Clearing and Settlement in the United States

Three clearinghouses and three depositories serve theNation’s 7 stock exchanges, NASDAQ, and other over-the-counter dealers; 9 clearinghouses serve the 14 futuresexchanges; and 1 clearinghouse serves all the equitiesoptions markets.2 The major clearing members, who alsoclear for non-clearing members of a clearinghouse, tendto be highly automated for lower costs and greateroperating efficiency. For safety purposes, U.S. clearing-houses also tend to be financially structured such that afailing clearing member can be isolated quickly and itsproblems resolved without a ripple effect.

While arrangements between clearinghouses and theirclearing firms vary, the general goal is that the clearing-house maintain adequate resources and commitments toassure settlement if a clearing firm or its non-clearing firmcustomer defaults. These include capital requirements formembers, claims on items in process, if any, as well asclaims on the defaulting member’s remaining assets ondeposit with the clearinghouse (e.g., cash, letters of credit,Treasuries, or securities posted as collateral for margin).The clearinghouse also has claims on other assets of thefailed clearing member. The clearinghouse’s guaranteefired is another resource. Finally, the clearinghouse canmake assessments against other clearing member firms.This succession of fallbacks is a buffer against shocksranging from sudden large drops in the prices of securitiesand futures to defaults by members. As a result, there havebeen few cases of a failure of a clearing member in theUnited States, and no instances of a failure of aclearinghouse. 3

Equities Clearing Organizations

The National Securities Clearing Corp.--NSCC proc-esses 95 percent of all equities trades in the United States.It is jointly owned by the principal equities markets: theNew York Stock Exchange (NYSE), American StockExchange (AMEX), and National Association of Securi-ties Dealers (NASD). It serves 1,800 brokers, dealers,

banks, and other financial institutions, through about 400direct participants.

NSCCsS clearance and settlement process normallyrequires five business days. Trade information is receivedeither in the form of locked-in trades already matched bythe computer systems of the exchange or market; or, asbuy and sell data reported by market participants. Thelatter still must be compared and buy and sell ordersmatched. Locked-in trades are entered directly in theNSCC computer system on the same day as the trade. Thissharply reduces the need for the matching of buy and sellorders at the clearinghouse level. On a typical day, about75 percent of the trades on the NYSE are locked-in (asmaller proportion by dollar value).4 Figures A-1 and A-2illustrate the steps in the NSCC's clearing and settlementof retail and institutional customers’ trades, respectively.

Securities which are held for NSCC members by TheDepository Trust Co. (DTC), and whose ownership cantherefore be transferred within DTC via its computerbook-entry system, are also eligible for settlementthrough the Continuous Net Settlement (CNS) computersystem. This includes the preponderance of trades settledthrough the NSCC. NSCC becomes the counterpart toeach trade; it guarantees that the settlement obligations ofthe trade will be met—both the obligation to deliversecurities and the obligation to make payment. Forlocked-in trades, NSCC’s guarantee takes effect atmidnight on the day (T+l) that the counterparties to thetrade have been notified that the trades matched.

Trades that do not match begin a reconciliation processthat is being shortened and by the end of 1990 will occuron the day following the trade (T+l). Those that remainunmatched by T+3 are returned to their originatingmarketplace for face-to-face negotiation. With the in-creasing number of trades locked-in at the marketplaces,and with the availability of on-line reconciliation systemsat these marketplaces, the need for this process is beingeliminated.

l~pmp~ ~ apP~ OTA b refi~ heavily on a contractor report by B@era Trust CO., “Study of International Clearing and Settlement”vols. I-V, contractorreportprepaxed for the Offkeof Technology Assessmen~ October 1989, to whichmanydozens of institutions and individuals aroundthe world contributed expert papers and/or served on the Bankers Trust advisory panel. OTA has also used the discussions of an expert worbhop heldat OTA on Aug. 22, 1989.

*or information on the clearing and settlement of U.S. Treasury and government agency securities, mortgagdacked securities, and municipalsecurities, see Bankers Trust Repo~ op. cit., footnote 1.

3@e ~~not= ~tthe o~y si~ationhe cmen~sion inwhichthe the Natio~ Securities Clxcorp. (whichcl~ the vut majority of Wuitbtrades ~ the United States) could fai~ would require a major external triggering event, such as the collapse of one or more major U.S. banks causingthe failure of one or more NSCC clearing banks or major clearing members. (Robert Woldow, NSCC, at a meeting of experta on clearing and settlemen~OTA, Aug. 22, 1989.) The events of October 1987 in the United States-when the payment system began to become clogged-were perceived aspotentially disastrous.

4S~ce Auust 1989, the NSCC &gm c~p~ ~des tit ~ not locked-in during the ~ly morning hours C)f T+l.

-81–


Figure A-l-Clearance and Settlement of Retail Customer Trades

[ STEP I. TRADE DATE (T)

MARKETPLACES

Order (I) Execute (2)S E L L I N G + SELLING +

Retail 1 Broker I

I Customer 1 IA I

I Execute (2) Order (1)1 + BUYING ] 4- 1 BUYING ]

I—

I t i I , r ~ - lA

-- L.----J + I

Confirm (3) Trade TradeDetails (4) Details

1~ CLEARINGI CORPORATION

I

STEP 2. TRADE DATE + 1 ( T + 1 )]

[ SELLING

LRetailCustomer

A

SELLING(

BrokerA I

I

L - _ - - - J - l B

Confirm (3)(4)

Results I I I I Results

of

w

( 5 ) + CLEARING

k

+ ( 5 ) of

Comparison CORPORATION Comparison

I (Trade Comparison) I]STEP 3. TRADE DATE +4 ( T + 4 )

rSELLINGRetail

Customer ‘ : : : : ’ b m : ~ ~ r

1 CLEARINGCORPORATION

(Trade Netting and Issuance ofReceive/Deliver Obligations)

(6)

1 1 B J

(1) Retail Customers give orders to buy and sell stock to their respective Brokers,(2) Brokers execute Retail Customers orders in the Marketplaces.(3) Brokers confirm back to their respective Retail Customers that the trades were executed.(4) Brokers submit details of trades executed in the Marketplaces to the Clearing Corporation.(5) Clearing Corporation generates reports back to the Brokers indicating the results of comparison.(6) Clearing Corporation nets the trades.(7) Clearing Corporation issues projection reports indicating net

SOURCE: NSCC, 1990.

receive/deliver obligations to the buying and selling Brokers,

Appendix--Clearing and Settlement in Major Market Countries . 83

Figure A-l-Clearance and Settlement of Retail Customer Trades-Continued

[STEP 4. TRADE DATE + 5 (T+ 5 } ]

(8)SELLING Shares SELLING

(13)BUYING

1Shares BUYING

Broker RetailB Customer

(9) (12)

Shares CLEARING Shares

CORPORATION

it

Instructions + (lOa) (1 la)

SELLING BUYINGBroker A Acct CLEARING CORPORATION ACCOUNT Broker B Acct

Ishares (10b)! shares + [ 1 1 b ) \ shares I

I D E P O S I T O R Y I

(16)SELLING Money SELLING

Retail Broker

L . Y I . - IAw(14)

BUYING Money BUYINGBroker Retail

Money Money

(Money Settlement)

(8) Selling Retail Customer A gives shares to selling Broker A to satisfy delivery obligation.(9) Selling Broker A deposits selling Customer A’s shares in its account at the Depository.(lOa) Clearing Corporation instructs Depository to debit selling Broker A’s account and credit Clearing Corporation’s account with the shares;(lOb) Depository debits selling Broker A’s account with the shares and credits Clearing Corporation’s account.(1 la) Clearing Corporation instructs Depository to debit Clearing Corporation’s account and credit buying Broker B’s account with the shares;(1 lb) Depository debits the Clearing Corporation’s account with the shares and credits buying Broker B’s account.(12) Buying Broker B requests withdrawal of shares from its account at the Depository In order to deliver to Retail Customer B,(13) Buying Broker B delivers the shares to its buying Retail Customer B.(14) Buying Retail Customer B pays buying Broker B for shares received.(15a) Clearing Corporation advises buying Broker B of net pay amount for shares received;

Buying Broker B delivers a check to Clearing Corporation for the requested amount,(15b) Clearing Corporation advises selling Broker A of net collect amount for shares delivered;

Clearing Corporation issues check to selling Broker A for the specified amount.(16) Selling Broker A pays selling Retail Customer A for shares delivered.

SOURCE: NSCC, 1990.


Figure A-2-Clearance and Settlement of Institutional Customer Trades

STEP 1 ––—–TRADE DATE ( T )“-’

MARKETPLACES— –T–

Execufe (2) I IExecute(2)

+ — – — – . L + -[ S E L L I N G { Order I SELLING–

Instltut!onal

J

BrokerCustomer -1 ~

A L- ——.—J

BUYING 4 {

Order BUYING -

Institutional(1) Customer

B

Broker0

Trade 1 TradeD e t a i l s ( 3 ) I Details (3)

~ ’ – — - lCLEARING

CORPORATION

. . ———————- _. .-. . ,STEP 2 – – TRADE DATE + 1 ( T + 1 ) ,

(6)‘SELLING - I ID SELLING ]

(6)1 -

- BUYING j ID BUYINGInstitutionalCustomer

B

Broker ConfirmationB +

Institutlonal I ConfirmationC u s t o m e r I ~ ‘ -

A [

Broker IA ,

-.J

‘+(4)

I Results of CLEARINGComparison CORPORATION

(Trade Comparison)

I Results of I {Comparison

, ~ IDIDConfirmation

(5) ‘ + +Confirmation

(s)

SELLING I

Broker B I Bank BAccount ( Account

I

Broker AA c c o u n tAccount I

1

D E P O S I T O R Y

ISTEP 3. TRADE DATE + 3 ( T + 3 ) OR TRADE DATE + 4 ( T + 4 ) —~— —

. . — —(7b)

SELLING Institutional:= ID Affirm;:.~ —Customer +

A I

(8b)~-.%–BUYING ID r - B U Y I N G

Broker Broker Affirm

+ “ [ - - -

InstitutionalA B Customer

. - ; – _ .

CLEARINGCORPORATION

(7a)

[ IDi Affirm

[8a)

IDAffirm I

I

\ CUSTODIAN I SELLING I CLEARING CORPORATION ACCOUNT BUYING CUSTODIAN ]

~ - Bank A Account I BrokerA Broker B Bank B

F

+ J] Account Account Account

F-”-””- L - L–-.—_ . . . ..— : : : - : - - ” - 5D E P O S I T O R Y

Instltutlonal Customers give orders to buy and sell stock to their respective BrokersBrokers execute Instltutlonal Customers orders In the MarketplacesBrokers submit details of trades executed m the Marketplaces to the Clearing CorporationClearing Corporation generates reports back to the Brokers indicatlng the results of comparisonBrokers send ID confirmation to the Custodian Banks of their CustomersBrokers send ID confirmation to their respective Institutional Customers

Selling Instltutlonal Customer A sends ID affirmation to Custodian Bank A to deliver securities on settlement day (T+5) to Its’ Broker (A)Selling Instltutlonal Customer A sends 1D affirmatlon to selling Broker A indicating that Custodian Bank A WIII deliverthe securities to it on settlement day

(1)(2)(3)(4)(5)(6)(7a)(7b)

(8a) Buying Instltutional Customer B sends ID affirmation to Custodian Bank B, notifylng it to receive securities on settlement day from its’ Broker (B)(8b) Buying Institutional Customer B sends ID affirmation to Broker B, instructing it to deliver securities to its’ Custodian Bank (B)

on settlement day

SOURCE: NSCC, 1990.


Figure A-2-Clearance and Settlement of Institutional Customer Trades-Continued

ISTEP 4. TRADE DATE + 4 ( T + 4)]

Selling Instit. Customer

r S E L L I N G

B r o k e r A I A II 1 — ~

‘STEP 5. TRADE DATE + 5 ( T + 5 ) J

S E L L I N G - SELLINGInstitutional I Broker

Customer AA d

I CUSTODIAN I SELLING

I Bank A I Broker AAccount I Account

I s h a r e s I s h a r e s -I ( 1 1 ) (12b)

CLEARINGCORPORATION

(Trade Netting and Issuance ofReceive/Deliver Obligations)

(9)

+ BUYING 1 BUYING

CLEARINGCORPORATION

—

(12a) (13a)Instructions ~+

I

CLEARING CORPORATION ACCOUNT

I BUYINGBroker

B II

— .I BUYING –

IInstitutlonal

Customer IB ’.

(13b)

D E P O S I T O R Y

lSTEP 6. TRADE DATE+ 5 (T+5) 1

e~D•Œ ‘b’’gat’ie !

I CORPORATION~

1’ I (Money Settlement) I ‘ 1

I

I CUSTODIAN II

SELLING CLEARING CORPORATION ACCOUNT BUYING I CUSTODIAN I

- I J : : E 2(9) CIearlng Corporation nets the trades(10) Clearing Corporation issues projection reports Indlcatlng net receive/delwer obligations to the buying and selling Brokers.(11) Custodian Bank A instructs Depository to transfer shares from its account to selling Broker A’s account,

Depository debits Custodian Bank A’s account and credits selling Broker A’s account with the shares(1 2a) Clearing Corporation Instructs Depository 10 debit selling Broker A’s account and credit its’ account,(12b) Depository debits selling Broker A’s account and credits Clearing Corporation’s account with the shares(13a) clearing corporation instructs Depository to debit Shares from its account and credit shares to buying Broker B’s account,(13b) Depository debits Clearing Corporation’s account with the shares and credits buying Broker B’s account(14) Buying Broker B instructs Depository to transfer shares from its account to Custodian Bank B’s account,

Depository debits Broker B’s account and credits Custodian Bank B’s account with the shares(15) Custodian Bank B pays buying Broker B for shares received(16) Monies from Custodian Bank B to Broker B are used by Broker B to meet Its settlement obligation to the Clearlng Corporation(17) Clearlng Corporation receives rnonies from Broker B and pays to Broker A(18) Monies from Clearlng Corporation to Broker A are used by Broker A to meet Its payment obligatlon to Custodian Bank A

SOURCE: NSCC, 1990.

ElBUYINGInstitutionalCustomer

B


Using the CNS system, the NSCC calculates each daya net long or short securities position for each CNS-eligible security that was traded by the clearing memberon that day. The number of settlement transactions and thegross amount of the clearing member’s obligation eitherto deliver securities or to make payment is adjusted by theamount of any securities or payments that it would receiveas a result of other trades of the same security. This typeof calculation process is known as netting. It reduces thetotal number of securities to be delivered or received, andthe number and size of aggregate cash payments. As aresult of this process of offsetting obligations, the NSCCestimates that movement of about five-sixths of the totaldaily transactional volume of owed securities and cashpayments otherwise required on the settlement date iseliminated. Netting may indirectly increase market liquid-ity by reducing the gross amount of funds necessary tomeet settlement obligations. After netting through CNS,the NSCC then informs the DTC of the net amount thateach counterpart owes in securities on the settlementdate, T+5. The DTC, using its book entry system, recordsthe transfer of ownership by debiting the securitiesaccount of the delivering counterpart and crediting theaccount of the receiving counterparty.6 Payment on thesettlement date is in the form of a certified check, payableto the NSCC. When settlement cannot be made on ‘thesettlement date-e. g., when the securities are not availa-ble in the participant’s DTC account-these obligationsremain in the CNS system and are carried forward andnetted with the next day’s obligations.

Securities that are not eligible for the CNS system maybe settled either through balance order accounting or ona trade-for-trade basis. These other forms of settlementcomprise a very small percentage of trades settled throughNSCC.

In 1989, the fail rate-the percentage of trades whichdo not settle on the settlement date-in trades clearedthrough CNS was 8.13 percent of the total net dollar valueof cash and securities due on the settlement date. Since theNSCC takes the counterpart position and guarantees thesettlement of all CNS-matched trades, NSCC is exposedto various credit, market, and non-market risks.7 The waysin which clearinghouses protect themselves against suchrisks are critically important.

NSCC protects against credit risk, first of all, byretaining a lien over securities which the receivingparticipant has not paid for. For trades not settled by T+5,NSCC uses a mark-to-market procedure to limit itsmarket risk until settlement does occur. Market risk iskept to l-day’s market movement by adjusting members’settlement obligations to current market prices. Memberspay or are paid at settlement based on the current value oftheir open positions on and after T+5, rather than theirvalue when they made the trade. In the interim, until theposition settles, members pay or receive the net differencein market price movement. NSCC’s guarantee fund forCNS takes account of potentially adverse movements ontrades which have not settled before T+5. It is based on thetotal size of all positions open. These include thosepending (before settlement); trades settling on T+5; andtrades for which T+5 has passed and settlement has notoccurred. In addition, a percentage of the market value ofsecurities for next-day (T+l) delivery must be depositedin order to protect the NSCC in the event the memberdefaults. This calculation is done daily for all membersand can be collected more frequently than the monthlynorm. All NSCC clearing members are required tocontribute to the guarantee fund. NSCC’s total funds ondeposit, not including lines of credit, totaled over $400million in 1989 and 1990.

The NSCC also maintains a full compliance-monitoring system to ensure its continuing ability tojudge the creditworthiness of its participants.8 It sharesrisk information with other SEC-registered clearing-houses, both through the SEC’s Monitoring CoordinationGroup and the Securities Clearing Group. NSCC and anumber of futures clearinghouses are now discussingproposals for increasing the sharing of risk information;e.g., data on market participants’ holdings on variousexchanges.

The NSCC is linked to its clearing members by meansof the Securities Industry Automation Corp. (SIAC),which operates NSCC’s technology base. Most partici-pants now have direct computer links; only about 1percent of the full-service members continue to reporttrades via computer tape.

All payments to NSCC are on a net basis; i.e., theNSCC calculates each clearing member’s total credit and

5This appendix tiscusses interdealer and institutional (street-side) settlement only. Concerning depository functions, a broker cm make *1’f.lementwith his institutional customer through DTC’S ID program. A description of customer (retail) settlement is provided by the Securities and ExchangeCommission in vol. II of the OTA contractor report: Bankers Trust, op. cit., footnote 1.

GStock held by DTC is in nominee name and appears on the books of the transfer agent of the issuing company. h a typical -reaction, the -=agent would not be involvedin the change of ownership. The change in ownership between the parties to the transaction would occur solely on the booksof DTC. If, however, a broker or his customer wishes to have the shares registered in his own name, he instructs DTC to send the appropriate quantitiesof stock currently in street name, to the transfer agen~ who would then send the reregistered shares directly to the broker.

7C~t risk refers to the possibility that a p@cipz@ might not pay for or deliver securities. Market risk reftXS to tie priCe Cqes of the -v.Non-market risks include loss of dq human error, systems failure, or any breakdown caused by any factor other than creditor market factors.

8NSCCJS STARS system monitom project~ settkrnent exposures from the time trades are matched until they are titimately setfl~. NSCC alsoemploys a series of exception reporting mechanisms to detect security concentratio~ settlement pattern changes, and security price changes.

Appendix--Clearing and Settlement in Major Market Countries ● 87

debit positions and nets to a single figure that is eitherowed to NSCC or is owed by NSCC. Payment to NSCCis by certified check. Funds are concentrated in onecentral clearing bank. If a certified check is not receivedon the settlement date, then payment via FedWire isrequired the next morning. NSCC pays selling memberswith regular bank checks, but intends to move towards theincreased use of electronic payments as one way toimprove the settlement process.

The International Securities Clearing Corp.—ISCCis a subsidiary of the NSCC and is an SEC-registeredclearinghouse. It was founded in 1985 to assist in clearingand settlement and to provide custody services forsecurities traded among American brokers and banks andtheir counterparties across national borders. It has linkswith clearinghouses and depositories in foreign markets,9

including:

●

●

●

●

the International Stock Exchange (ISE), in London;the Centrale de Livraison de Valeurs Mobilieres(CEDEL), in Luxembourg;20 depositories and custodians in Europe and Asia,indirectly linked by means of a conduit provided byCEDEL;the Japan Securities Clearing Corp. (JSCC), theTokyo Stock Exchange’s clearing and custodyorganization;the Central Depository subsidiary of the StockExchange of Singapore; andthe Canadian Depository for Securities (CDS), inToronto, linked through NSCC.

ISCC also serves as the clearing system for the NASD’sPORTAL market for foreign private placements exemptfrom SEC registration by virtue of Rule 144A. (See ch. 3.)

Futures Clearing Organizations10

The Board of Trade Clearing Corp.—The ChicagoBoard of Trade (CBOT), which handles the greatestvolume of futures contracts trades in the United States,has its own separately incorporated clearinghouse, theBoard of Trade Clearing Corp. (BOTCC). With approxi-mately 139 clearing members, the BOTCC is by far thelargest clearing organization serving the futures markets.

The Chicago Mercantile Exchange (CME) is the largestU.S. futures exchange when measured by another yard-stick, the average total value of open futures and options

on futures contracts. CME has a Clearinghouse Division.This system and other U.S. futures clearinghouses, aresimilar (although not identical) to that at the BOTCC.ll

BOTCC has an on-line trade entry/trade capture systemthat allows it to receive over 75 percent of its tradeinformation through on-line terminals (with the userkeying in data). The remaining 25 percent of tradeinformation is reported by means of computer-to-computer transmissions. In addition, members of theBOTCC that are also members of the CME may use theBOTCC’s on-line trade entry/trade capture technology tosend trade information to the CME. About 20 percent ofthe CME’s trade information arrives at the CME clearing-house through the BOTCC trade entry/trade capturetechnology.

Once a trade has been captured, BOTCC employs atwo-sided matching system in which both the buy and sellsides of a trade are submitted to the trade comparisonsystem for matching. This capability provides the benefitsof comparisons on the day of the trade, and a match bybroker and by counterbroker as well as a match within theclearinghouse. This is the standard for futures markets inthe United States, except for the New York MercantileExchange (NYMEX), which uses a one-sided tradematching system, in which ‘‘sell’ information is put intothe system and the clearing member with the “buy”information must confirm the data at a later time.

BOTCC’s guarantee to clearing members that thesettlement obligations of the trade will be met begins atthe moment a trade has been matched and registered. Atthat time, typically about 1 hour after the final tradesubmission, the clearinghouse becomes counterpart andguarantor to every trade.

In all U.S. futures markets, both buyer and seller makea good faith deposit to the clearing member firm; this is‘‘original margin. "12 The amount required per contract isdetermined by the exchange, and is due from both partiesto the trade on the morning of the day after the trade (T+l).Most clearing members maintain substantial excessoriginal margin deposits in their clearing account at theBOTCC. The amount of margin a clearing member owesis calculated by the clearinghouse based on the value ofhis open contracts and an assessment of the amount of riskthose contracts involve. The BOTCC uses its riskassessment computer system SAFE [Simulated Analysis

9The ISCC is also discussing the possibility of setting up another 1- with the Societe Interprofessiormelle pour la Compensation des ValeursMobilieres (SICOVAM), the French central depository, and with Societe des Bourses Francais, the broker clearing system at the Paris Bourse.

lohluchof tie information in this swtion is based on Roger D. Rutz, ‘Clearance, Paymen~ and Settlement Systems, in the Futures, optiOnS, and StockMarkets,” Feb. 24, 1989, a contributed paper in the OTA contractor report: Bankers Trust, op. cit., foomote 1.

llFor de~~ on tie cle~g ad se~ement processes at tie o~er U,S. fi~es cle~houses, see OTA contractor report by Bankers ‘h@ Op. Cit.,foomote 1.

~ZT’Ilis @@MI m~gin deposit is a perfo~nce bond to protect the fwciai integrity of the clearinghouse in the event that the cl-g f~ is ~bleto meet a margin call or to make or take delivery. Original margin refers to deposit of funds in the form of cask government securities, or letters of credit.There are two levels of margin: the fwst is from the customer to the f~ the second is from the fm to the clearinghouse.


of Financial Exposure] to evaluate clearing memberfirms’ credit, and uses the CME’s SPAN to determine theamount of margin owed.13

There are two methods of calculating original margin:gross margining and net margining. Gross marginingrequires a clearing member to post original margin on allthe long and short positions in these accounts; they cannotbe used to offset each other in case of a deficiency. Bycontrast, with net margining the margin owed by eachclearing member is calculated on the difference betweenall the long and short positions, calculated separately forproprietary accounts and customer accounts. The BOTCCfigures original margin on a net basis, as do most U.S.futures clearinghouses; the exceptions are the CMEClearinghouse Division and NYMEX, which figureoriginal margin on a gross basis.

The BOTCC’s trade-matching process, from the timeit guarantees settlement obligations to the posting oforiginal margin by clearing members, may take 7 hours.14

During this timelag, the BOTCC carries the full risk.Clearing members demand that trades become guaranteedas quickly as possible, since this is the point at whichcounterpart risk should be eliminated.

Besides original margin, futures clearinghouses alsocalculate and collect variation margin.15 The amountreflects the changes in the value of a clearing member’sopen contracts. Variation margin may be collected daily,or more often. The BOTCC routinely issues one morningcall and supplemental intra-day variation margin calls(usually around 2 p.m. c.s.t.).16 One purpose of routineintra-day variation margin calls (and payments to clearingmembers with profitable trades) is to reduce the magni-tude of the following morning margin call, which isalways made at 6:40 a.m. c.s.t. on the day following thetrade date (’I’+ 1). As a result of this system, the BOTCCtypically collects (and pays out) by about 2:30 p.m. c.s.t.on the date of the trade between 60 and 95 percent of thefinal settlement calls that would otherwise have beenmade at 6:40 a.m. c.s.t. on the following day. This reducesthe clearinghouse’s risk because the shorter the period oftime between trade execution and settlement, the morecertain it is that a clearing member will be able to meet itsobligations. In general, the more frequently a clearing-house settles (marks to market) trades each day, and

requires its clearing members to post margin, the greateris the financial integrity of the clearing system.

Lines of Defense—In the futures markets, the maxi-mum potential default liability represents at most onlyone business day’s market movement. This is the first lineof defense for the clearinghouse. The BOTCC segregatesand nets proprietary and customer open positions of eachclearing member across commodity futures and optionscontracts to calculate the amount of both the original andvariation margin of each clearing member. The BOTCC’sSAFE system calculates each clearing firm’s potentialexposure to an adverse move in prices.

Margin deposits are the second most important line ofdefense in protecting the clearinghouse from a default bya clearing firm which could affect other clearing mem-bers. The Commodity Futures Trading Commission(CFTC) requires that all clearing members maintain twobank accounts for settlement and two safekeeping ac-counts for original margin. One set of bank and safekeep-ing accounts is for original and variation margin forcustomer positions, while the other set is for original andvariation margin for proprietary and non-customer (affili-ated firm) positions.17

Another line of defense for the clearinghouse is its netcapital requirements for clearing members. In addition, allU.S. futures clearinghouses share certain types of “riskinformation’’--data on amounts paid and collected byclearing members in the form of both original andvariation margin, reflecting their overall exposure, andamounts paid by clearinghouses to clearing members,representing reductions in the amount of risk faced by aclearing member.

Still another line of defense in protecting the clearing-house from default by a clearing firm is its authority toissue a‘ ‘super’ margin call if the BOTCC determines thata customer or proprietary position represents a clear andimmediate danger (i.e., a particular market conditioncould cause a substantial amount of a clearing firm’scapital to be depleted because of customer defaults). Theclearing member would then be required to deposit theadditional “super” margin (in the form of cash, U.S.Treasury securities, or letters of credit) within one hour ofreceiving the call. Finally, the segregation of customerfunds, clearing member net capital requirements, and

13~e CME biw its OWQ risk management computer system-SPAN (Standard Portfolio Analysis of Risk)--for detm the amount of margin.The fatures industry (with the exception of the Intermarket Clearing Corp. (ICC), which uses the system known as TIMS) is moving towards adoptingSPN as the standard for calculating margin.

ld~went of ~g~ mWt be ~ ~e+y tids+.g., those provided by the Federal Reseme’s Fed* el@~Qic PaY’meQt sYs~em.

15V~tion~@ me the cash flow required to mark positions to market. They flow through the cl-g organization to the clearing member onthe other side of the trade,

160f~e U.S. fi~es Clemouses, the cm C1e@o~ Divisio~ the Comx cl~g~socfitio~ and the Coffee, Sugm~d @cOa Cl-Corp. ah issue routine daily intraday variation margin calls. The others have the capability of doing soon an as-needed basis; e.g., in times of severemarket volatility.

IT’r’he segregation of customer and proprietary funds is a requirement of Section 4d(2) the COQUQOd@ Exc@e ~t.


ongoing financial surveillance, each contribute to bolster-ing the integrity of these markets.

If, despite margin calls, a clearing member neverthelessdefaults on the settlement obligations of the trade, theclearinghouse has several protections against liability forthe default. The clearinghouse may liquidate the clearingmember’s positions and original margin, sell his ex-change membership, use his contributions to the clearing-house guarantee fired, use the clearinghouse guaranteefund and its committed lines of credit, assess all clearingmembers, where permissible, and finally, use the clear-inghouse’s capital.

All U.S. futures clearinghouses have funds available toprotect themselves against default by their members;these are primarily made up of mandatory contributionsfrom clearing members.18 They fluctuate in size. MostU.S. futures clearinghouses, but not the BOTCC19 orKansas City Board of Trade Clearing Corp., also have thepower to assess their members, if the amount of a clearingmember default cannot be covered by capital funds andthe guarantee fund.

The BOTCC uses four settlement banks, all based inChicago. The BOTCC’s morning payment process (6:40a.m. c.s.t.) precedes the opening of the FedWire systemand hence requires the settlement bank to extend credit onbehalf of some clearing members. At times, this creditextension may not be fully collateralized, and thus is a riskfor those settlement banks.

Clearing members must maintain accounts at settle-ment banks for the payment of original and variationmargin, including final settlement payment. When theclearinghouse determines the amount of margin owed, theclearinghouse notifies the clearing member’s bank of thisamount. The bank then examines the clearing member’sassets (cash, government securities, lines of credit),gathers incoming payments from the clearing member(via FedWire, if it is available at the time the bank ismaking the decision), and makes a commitment to theclearinghouse as to whether it will honor the margin callby forwarding the funds to the clearinghouse.

If the clearing member does not have sufficient assetsto meet its margin obligations, the bank’s decision iswhether to extend credit to the clearing member. When a

settlement bank decides that it cannot meet the financialobligations of a market participant, the participant will askhis credit banks for credit. This process generally workswell, but it depends on two assumptions: first, that themarket participant will be able to reach the accountofficers at the credit banks within the permitted time; andsecond, that the credit banks (which do not alwayscoordinate a market participant’s various lines of credit)will not extend more credit than a clearing member isworth. Generally, these assumptions are sound, as firmsusually have a predetermined credit line. But, if a firm ishaving difficulty, if the firm’s needs come during a periodof market stress, a settlement bank may decide not tohonor a margin call, and this could result in theclearinghouse liquidating the clearing member’s cus-tomer positions, after attempting to transfer these posi-tions to another clearing member.20

Clearinghouses, in respect to intra-day margin pay-ments batch process trades rather than processing eachtrade as it is executed. Thus, a clearinghouse may not beable to eliminate their risk instantaneously by shifting itto clearing members. One reason the clearinghouses areforced to do batch processing is that the banking systemmoves too slowly to accommodate any other method. Forinstance, Chicago banks generally use paper-based proc-esses to move money among clearing members.

The working interface between the clearinghouses andthe banks survived with difficulty under immense strainin October 1987.21 In further improving this interface,there are cost-benefit trade-offs. The existence of aClearing Organization and Banking Roundtable thatprovides settlement bankers, clearing organizations, andregulators with a forum for regular discussion of thesetradeoff issues, is some evidence that the system ismoving towards a more secure, less volatile, but stillcompetitive, state.

Options Clearing Organizations

The Options Clearing Corp,--OCC is the commonentity serving all securities options exchanges in theUnited States22 The OCC clears and settles options tradesfor the Chicago Board Options Exchange (CBOE); theAmerican Stock Exchange (AMEX); the PhiladelphiaStock Exchange (PHLX); the New York Stock Exchange

lsne BOTCC does not bve a guarantee, or clearing fund, but does require clearing members to purchase its capital stock when fieY me fitt~to membership, which is similar to a guarantee or clearing fund. The relative number of shares of stock that a BOTCC clearing member must pumhaseis adjusted semi-annually to reilect its open positions and trading volume. Other futures clearinghouses have guarantee funds based on capital, tradingvolume, or open positions. Rutz, op. cit., footnote 10, pp. 23-27.

1% mid-lg8g, the BOTCC estit~ as $325 million the total value of its available trust fpnd, lines of cred.i$ and ckXu@ghOuse @Pi~.~oradditionalinfonnation, see AndreaM. Corcoranand SusanC. Erv~ “Maintenance of Market Strategies in Futures Broker Insolvencies: Futures

Position Transfers From Troubled Firms,” Was~ingfm und Lee Z.uw Review 44:849, 1987, pp. 849-915.zl~m is di==mment ~o~ p~cip~ts ~emselves aS to whether these systems “survived with diffkU.lty,” “~ely ~~ed,” or Perfofi

otherwise. Nevertheless, many improvements have bee~ and are, being implemented to strengthen the clearing and settlement process.22~ WC clws ~ exc~~~ad~ s=fities Optiom, For de~s oncl- ~d se~ement of optiom on fu~es con~cts, see Bankers Trust CO.,

op. cit., footnote 1.


(NYSE); the Pacific ‘Stock Exchange (PSE); and theNational Association of Securities Dealers (NASD).

Unlike the clearinghouses already discussed, the OCCdoes not do trade comparison, since it receives locked-indata on compared trades from each of the exchanges. Theexchanges have chosen to keep their own trade-matchingsystems as a means of competitive differentiation. Thedata on matched trades is sent to the OCC by computer onthe day of the trade. The OCC then must calculate theamounts of money that are owed and due the next day(T+l) by the buyer and the seller. In the case of the buyer,the entire amount of money owed to the OCC is called the“premium obligation,” or “premium,” and is paid incash. The premium, while paid to the OCC, is passed onto the writer of the option. To the buyer of the option, thepremium is the amount he pays to lock in the possibilityof an advantageous movement in the price of theunderlying security. To the writer of the option, thepremium is the maximum amount of profit he can expect.If the market moves against the writer, the premiummight, at best, offset only a small portion of the optionwriter’s losses.

The writer of the option always owes margin to theOCC each day that the option contract is in effect but hasnot been exercised by the holder. This margin23 is similarto the margin owed by the buyer or seller of a futurescontract, essentially ‘good faith’ money which serves asan assurance to the OCC that the writer of the option hasthe financial ability to meet the potential obligations of theoption that he has sold. The amount of margin owedreflects changes in the market price of the option as wellas a portion of the total amount that he would have to payif the option were exercised.

On the day after the trade (T+l), the OCC notifies thebuyer of the amount of cash premium which is owed; atthe same time, the writer of the option is notified by theOCC of the amount of margin that is owed Both amountsare due on T+l. On the next day (T+2), and each daythereafter until expiration, exercise, or closeout24 of theoption contract, the OCC calculates and then collectsmargin from the writer of the option.

Margin thus reflects the adjusted daily value of theoption writer’s open positions (the total amount of moneywhich he could be forced to pay if the options he sold wereto be exercised by the holders). The OCC marks to market(determines the adjusted value and liability of each

member’s open positions) at the end of each tradingsession. If the options contract loses value, the OCCreduces the amount of margin required. When the holderof an option contract decides to exercise it and actuallybuy or sell the underlying product of the option, theperson who originally sold the option is not necessarilythe same person that OCC will require to fulfill its terms.Instead, the OCC randomly assigns a clearing member tohonor the delivery or purchase obligations of the option,from the pool of all clearing members who sold optionswith identical contract terms.

For example, when an IBM option is exercised, theOCC assigns a clearing member with a short position andthen sends delivery instructions to an equities clearing-house such as the NSCC, which incorporates instructionsto deliver or receive into its Continuous Net Settlement(CNS) system. Any obligations not netted out throughnormal CNS procedures are settled by instructions to adepository (e.g., the DTC). Delivery of the IBM stock isthen made by transferring it from the seller’s account intothe buyer’s account at the depository, subject to the CNSsystem.25

When a foreign currency option is exercised, theforeign currency underlying the option contract is deliv-ered to the OCC’s cash account at a designated overseasbank, and then transferred to the account of the marketparticipant who is buying the foreign currency. Thedesignated foreign exchange delivery bank may be anybank designated by the parties involved in the transaction,not necessarily one of the OCC’s settlement banks.

The OCC provides its clearing members with aguarantee on the morning of the day following the trade(T+l), after the buyer of the option has paid the premiumobligation, 26 The OCC guarantee protects the holder of anoption against the possibility that the option writer mightdefault on the payment or delivery obligations of theoption.

Lines of Defense—The OCC’s first line of defenseagainst the potential for clearing member default is itscontinuing monitoring of the creditworthiness of itsclearing members. The options exchanges have limits onthe aggregate amount of open positions that any onemarket participant may carry at any one time. These arenet limits-i. e., the market participant’s short positionsare offset by his long positions. The clearing members’

zsFOrmarginpaymen@ the (XX accepts cash and collateral including: bank letters of credi$ U.S. Tnasury obligations, the actiqitim ~d@Y@particular option contracts, and various other stocks. Additionally, margin obligations can be reduced through corresponding long positions in othexoptions which have the effect of reducing net exposure.

~The “clos~ut” is when a writer or holder of an option contract enters into another option COntraCti -w ~ OffSet@g Positiom~~aNSCC ~comomtes delivew ~~ctiom ~to i~ ~S ~stem, NSCC rather tin ocC ass~es responsibility for, ~d guarantees, deliveries

and payments.2~~ fd~a~ec~e~th~e SEC, cmenflyvn~g approv~, Whichwouldprovide WC clefigme~rswith~ UncOnditiO@_@

on the morning of T+l.


positions are monitored daily by the exchanges in respectto these position limits.

The Securities and Exchange Commission (SEC), theexchanges, and the OCC also monitor market participantsin respect to capital adequacy and other financial require-ments. The OCC is a part of the information-sharingarrangement among all seven SEC-registered clearingentities, as well as a participant in the pay-collect riskinformation system operated by BOTCC.27 The OCC usesa monitoring system to quantify the potential risk of eachclearing member under different market scenarios, in-cluding large price movements. The system evaluates therisk in participant’s stock, options, and futures positions.

The OCC’s second line of defense against clearingmember default is the margin that the clearing membershave on deposit. If this is insufficient to cover the default,the OCC can turn to its guarantee fund, made up of cashand government securities.28 In the event of a default bya clearing member, after closing out the defaultingclearing member’s positions, the OCC follows five stepsto cover any residual liability from a default:

●

●

●

●

●

First, any margin that the defaulting clearing mem-ber has on deposit with the OCC is applied towardsthe liability of the default.Second, if that amount is insufficient, the OCC takesthe defaulting clearing member’s contribution to theguarantee fund and applies it towards the liability ofthe default.Third, if that amount is still insufficient, the OCCmay use its guarantee fund to cover-whatever portionof the liability is outstanding.29

Fourth, if that still isn’t enough to cover the fullliability, the OCC has the right to assess its membersfor the remaining amount of the liability.30

Finally, the OCC, like the NSCC and futures clearingorganizations, may also take legal action as a creditorto recover any sums that are owed by the defaultingclearing member. The amount that can be recoveredin this way is limited by bankruptcy law.

At the end of each trading day, the OCC has anovernight processing cycle during which it calculates thenet amount which each member either owes or is owed.

The net figure reflects, among other things: a) the cashpremium obligation due on each new long position; andb) the margin due for each new short position. The OCCthen sends payment instructions to the settlement bankThe netting is done on a multilateral basis; i.e., the statusof all of a clearing member’s holdings in the optionsmarket is taken into consideration in arriving at the dailynet payment obligation to the OCC.

The OCC has two different methods for calculatingmargin-one for options on equities and another for allother types of options (foreign currency, governmentsecurities, or stock indexes). In both cases, the marginrequired from the writer of an option is equal to the currentmarket price of the option, plus a cushion to cover the riskof a change in the current market price. But for allnon-equity options, as well as all options and futurescontracts cleared by the Intermarket Clearing Corp., theOCC uses the Theoretical Intermarket Margin System(TIMS). TIMS evaluates each clearing member’s overallrisk profile and then sets the total margin owed. The OCCwas the first clearing organization in derivative marketsto change from a fixed or flat rate of margining (percontract) to highly sophisticated computational methods.Rules have been submitted to the SEC to expand the useof TIMS to include setting the margin on equity options.

The CFTC and the SEC have approved applicationsfrom the OCC and the CME to allow cross-margining ofstock index options, futures, and options on futures forproprietary trading accounts of clearing members. Cross-margining between the CME and OCC started in October1989.31 OCC also offers cross-margining through anagreement with its affiliate, the Intermarket ClearingCorp. (ICC). The ICC clears trades for the New YorkFutures Exchange, the Philadelphia Board of Trade,Amex Commodities Corp., and the Pacific FuturesExchange; therefore, OCC members can use their hold-ings on those exchanges to offset the status of their openpositions at the OCC.

The extent to which OCC and ICC offer cross-margining is however limited. The CFTC, concernedabout safety, market stability, and liquidity, has not

zTRob~ Woldow, “~earan ce and Settlement in the U.S. Securities Markets,” February 1989, expert paper contributed to O’JX’S contractor repomBankers Trust Co. report, op. cit., footnote 1.

zWhe total amount required in the guaranteed fund is recalculated mont.hly. As of December 1989, the guarantee, or clearing fund, PIUS a 1~ p~ent. .

muumal additional assessment for which OCC clearing members are unconditionally liable, was about $450 million. The amount of the fund varies inproportion to the amount of clearing members’ liability. It is always equal to 7 percent of the average daily aggregate rnarginrequirements of all clearingmembers in the previous month. Each clearing member must contribute an amount equal to his pro-rata share of outstanding contracts in the previousmonth.

z~e OCC has r~enfly amended its rules to include using its own retained eh gs at the discretion of its Board of Directors.%Iot all U.S. clearinghouses, however, have these assessment powers. See Bankers Trust Co., op. cit., footnote 1, vol. 1, p. 137.Slsee John~att and James M. Kus~sch ctC1~ance and Settlement of D~vative FinancW ~s~ents,” April 1989; and John P. Behof, “Issue

Summary: Intermarket Cross-Margins, for Futures and Options,” The Federal Reserve Bank of Chicago, May 1989. Both are expert papers included inthe OTA contractor report by Bankers Trust Co., op. cit., footnote 1.


approved expansion of cross-margining beyond proprie-tary accounts of major market-makers.32

The OCC has approximately 190 clearing members.The clearing member brokerage firms transact businessfor their proprietary accounts, other brokers who are notclearing members, and institutional and retail customers.The link between OCC and its clearing members isautomated: OCC requires that all members submitpost-trade information through OCC’s on-line ClearingManagement and Control System (C/MACS).33

The OCC allows its members to choose from aselection of designated settlement banks. There arecurrently 16, but the OCC is flexible and may designatea member’s primary banking institution (concentrationbank) as an approved settlement bank. The OCC main-tains accounts at each of these settlement banks, andinstructs the banks on each trading day as to the debits andcredits that are to be made to the OCC’s accounts andthose of the clearing members.

There are controversial proposals to institute futures-style margining for options, which seem to have supportrecently. These are discussed in a forthcoming OTAreport on domestic securities markets.

Clearing and Settlement in theUnited Kingdom34

The International Stock Exchange

The International Stock Exchange of the UnitedKingdom and the Republic of Ireland Limited (ISE) inLondon, also operates exchanges in Belfast, Birmingham,Dublin, Glasgow, and Manchester/Leeds. It trades U.K.equities, gilt-edged securities,35 and other fixed-incomeinstruments, international equities, and options. Theaverage daily trading volume from January to September1988 was 31,213 trades. (See ch. 3 for a detaileddescription.)

The ISE settlement system is undergoing a transition.Today it is still primarily paper-based, but there are plansfor an electronic depository to eliminate the need for

certificates by permitting paperless transfer of title. Thissystem, TAURUS, is scheduled to be introduced in phasesbeginning in 1991 and to be fully operational in 1993.

The clearing and settlement process is managed by theISE for all of its member firms. It is a two-part processconsisting of a trade-matching system (called the Check-ing System) and a computerized settlement system,TALISMAN (Transfer Accounting and Lodgement forInvestors, Stock Management for Principals), introducedin 1979. TALISMAN settles securities trades betweenISE members, including centralized routing of the securi-ties to the registrars for transfer of title.

Trade settlement in the U.K. equities market usually isscheduled for the sixth business day after the end of each2-week dealing/trading period (also known as the accountperiod); all trades done during the 2-week account periodare scheduled to settle on the same day. Trading firmshave the option of settling their trades on a schedule otherthan the account period, if this is agreed upon by thetrading parties. This can occur any time after the secondday following the trade (T+2), but this is rare.

At the end of the trading day, member firms enter theday’s trade data into the ISE’s Checking System eitherdirectly through a PC data transmission to the Exchange’scomputer, or by delivering a computer magnetic tape tothe nearest Stock Exchange Centre. The Stock Exchangecomputer validates and compares all trades. Unmatchedtrades then have to be resolved, amended or canceled. ForTALISMAN eligible securities,36 the selling broker mustobtain from its customer, or its own inventory, the actua1share certificates and a signed TALISMAN Sold Transfer(TST) form, which authorizes the transfer of the securitytitle from the current beneficial owner to SEPON (theISE’s nominee name) .37 The paperwork which includesthe certificate, the TST, and a control document called theSale Docket, after being properly signed, is then depositedat the nearest ISE TAMS MAN Centre.

ISE staff verify the documents and record the depositon the computer. The security certificates and otherdocuments must then be sent to the company registrar to

3~~ on ~tmiew by ow Sm with senior CITC ofllcials, Octobm 1989.33~tt md Kustuscb op. cit., footnote 31.~Muchof thernaterial in this section is based on an expestpaperwrittenby the ISEfor the OTAcontractorreport: Bankers Trust CO., op. cit., foo~ote

1.sSGilt.~g~ ~~ties ~ debt ~~ents ism~ by the U.K. ~ve~ent. The= st~ks pay a fm@ variable or tidex-w~ rate Of hl@lXt, ~d

are co~idered risldree since their interest and capital are guaranteed by the government.36Some Othm, non-~ISm se~emmts can ~ occw at tie ISE through physic~ defiv~ and pa~nt, Stice the ma- Systim Op~t~

independently from ‘I14LISMAN, ewm securities which am not Z4LISMAN-eligible can be validated and matched by the Checking System. But aftersecurities trades are matched, the ISE offers a central physical delivery area that allows such settlement among brokers to occur in one central place.The Stock Exchange’s Central Stock Payment Department takes in securities from sellers and delivers them to the buyers. At the same time, it takesthe paynient from the buyer and gives it to the sellm. This is a man~ labor-intensive process.

qvAnofieeis apnorcompny~whose _eWfitiesm~ldor@~ onbehalfof ~oth~~mn orcompanywhois thetrueowner. SEPONstands for Stock Exchange Pool Nominee. This is the ISE’S limited liability nominee company in whose name TALIS W-eligible securities are heldprior to settlement.


transfer the share registration from the customer’s nameinto the name of SEPON. The ISE’s broker/dealers andmarket-makers who maintain trading accounts withinTALISMAN can, through this SEPON-nominee account,legally hold stock in uncertificated form. The recordinginto SEPON must occur before any stock exchangeTALISMAN settlement can take place.

When broker/dealers and market-makers trade for theirown accounts, or act as principals, TALISMAN effects asimple book-entry transfer of title without any need fortransfer forms or certificates, Approximately 7,000 secu-rities issues can be settled through TALISMAN, most ofthe securities registered in the United Kingdom andIreland.

This clearing and settlement process does not apply toall of the financial instruments traded on the ISE. Optionsare cleared and matched by ISE, but are settled throughthe International Commodities Clearing House in Lon-don. U.K. Government gilt-edged stocks, also traded onthe exchange, are validated and matched through theISE’s checking system, but settled through the CentralGilts Office.38 Foreign equity trades are matched throughan on-line comparison system called SEQUAL,39 thensettled by the broker independently of the ISE, in thesecurity’s home market.

The ISE does not take counterpart positions to trades.Market participants are not given a guarantee that thetrade will settle, only that if securities are delivered, theneither payment will follow, or the securities will bereturned. The ISE’s services traditionally have facilitatedthe post-trading processes for its members only. How-ever, through the recent development of Institutional NetSettlement (INS), the ISE has begun to coordinateinstitutional customer settlements as well.

Payment on the settlement date may be throughTALISMAN, outside TALISMAN, through cash settle-ment, or through the Central Gilts Office, depending onthe type of security and the preference of the TALISMANparticipants. “Through TALISMAN” means that the

TALISMAN computer system keeps track of eachmember’s payment obligations. These payments arenetted each day so that each member need only make orreceive one payment a day at the nearest TALISMANCenter. “Outside TALISMAN” means that tradingparties maintain their own payment records and eitherpaythe counterpart directly or deliver a check to the StockExchange’s Central Stock Payment Department, to bepassed on to the selling party. Cash settlement occurswhen the trading parties agree to settle their trade on adifferent schedule from the official account period, theday after the trade for Gilts and on the second day after thetrade for equities.

Generally, payments for stock exchange trades aremade by check in British pounds, Irish pounds, or U.S.dollars. Approximately half of the brokers make sterlingpayments through CHAPS, London’s interbank elec-tronic payment system. The rest use London’s TownClearing bank checks.

The ISE still has a fragmented and largely paper-basedsettlement system. TALISMAN capability alone is inade-quate to support a major financial center. There are plansto establish a paperless settlement system, called TAU-RUS, an electronic depository service, to enable membersto keep their securities in dematerialized40 form withbook-entry transfer of title on settlement.4142 The ISEalso plans to move towards a rolling settlement cycle toreplace the existing 2-week trading account period with afurther 6-day settlement period.43 One issue that remainsunder discussion is how the ISE would be able to assurelisted companies that they would still be able to quicklyidentify and communicate with their shareholders.

The International CommoditiesClearing House (ICCH)

ICCH44 is an independent clearinghouse which pro-vides matching, clearing, settlement, delivery management,and trade guarantee services for five futures and options

ss~e Centi mts Office is a service jotitiy developed and funded by the Bank of England and the ISE for the settlement of U.K. Governmentobligations.

39- provid~ by the ISE, but different fhm tie ~~ syst~

@Delnateri@ed Cetilcates of ownership are those that no longer have paper certificates and exist only as computer entries.AlmURUS will, h its titi~ stiges, COV~U.rC. equities. The Centnd ~ts offke already in operation is a fully dematerialized el=~otic depositow

for U.K. Government Issues or Gilts.A~mn~on is p~m~ @ ~ ism~ by s~~~r 1990 specifying TAURUS requirements, ~d *K P~ciP~ts to ~gin ~eir

implementation work for the introduction of TAURUS. “The ISE Announces Detailed Plans for the Future of Settlement in the United Kingdo~” ISENews Release, Mar. 9, 1990. These plans are described in “A Prospectus for Settlement in the 1990s,” ISE, March 1990, and project a date of March1991 for the completion of the infrastructure, which includes: the use of the Institutional Net Settlement service, and the phased replacement of magnetictape and paper transfer systems; the phase-in of book entry transfer, i.e., dematerialization of certificates, between October 1991 and December 1993;and the introduction of an initial 5-day rolling settlement (to be shortened to 3 days later) and a full delivery v. payment system by October 1992. ‘Ihesesteps are projected to save over f200 over a I@year period and sre consistent with the Group of Thirty’s recomxntmdations.

43~e tem ~~m~ ~~aent~~ mm ~ tie ~~aent &te is ~ways tie -de &te plus a sp~ific number of &ys. For example: T+3.

%umnary of expert paper by the ICCH for the Bankers Trust Repo@ “Study of International Clearing and Settlement” op. cit., footnote 1.


exchanges in London. 45 The ICCH also provides clearingand settlement services to exchanges in New Zealand,Australia, Hong Kong, Kuala Lumpur, and Paris. Itprovides electronic screen trading systems for threeexchanges; the New Zealand Futures Exchange, the IrishFutures and Options Exchange, and the London FOX.

ICCH is organized into two divisions: the RecognizedClearing House, which handles the London-based opera-tions; and the ICCH International Financial Markets,which is responsible for international operations andcomputer systems. The clearinghouse is owned by agroup of six shareholder banks,46who are the ultimateguarantors of the clearinghouse’s obligations. Ownershipstatus has implications primarily in the case of default bya clearing member. In a clearinghouse owned andoperated by one exchange, all of the clearing members areultimately liable for the obligations of a member who failsto perform. In the case of an independent clearinghouse,such as ICCH, the ultimate liability of meeting a failedmember’s obligations rests with the shareholders, notwith the clearing members. This raises the question ofpotential conflict of interest among shareholders, clearingmembers, and customers of clearing members.47

ICCH has approximately 200 clearing members inLondon who trade at the five exchanges. These membersact as clearing agents for their own in-house trades,customers’ transactions and non-clearing memberstrades. While trading is primarily by means of open outcryon exchange floors, once a trade is struck, both the buyingand the selling party are required by the exchanges toenter the trade data into the exchange’s computermatching system within a specified time. The exchangesystem matches the trade data and makes the matchesavailable on-line to the floor brokers for confirmation. Amatched and confirmed order is sent immediately by datatransmission feeds to the ICCH’s system for settlement.48

Trade data is processed by the clearinghouse on acontinuous basis rather than in a batch cycle at the end ofthe day. Members can monitor their settlement positionsthrough the management information system at any timeduring the day. At the end of a trading day, members canlook at a terminal to see what their initial and variationmargin calls will be on the following morning.

ICCH becomes the counterpart to every trade. ICCHfurther decreases risks to clearing members because itperforms this function across multiple exchanges, nettingmembers’ positions out into a single margin and settle-ment figure. This process is called multilateral netting bynovation. Usually the clearinghouse makes one margincall every day before the start of the day’s trading, but inperiods of high market volatility, it reserves the right tomake more frequent intra-day variation margin calls. Forexample, on October 19, 1987, ICCH made four intra-daymargin calls.

ICCH accepts approximately 30 banks as settlementbanks, including some foreign banks’ branches within theCity of London. Each clearing member typically has atleast two sterling-denominated accounts at his settlementbank; one for segregated funds (e.g., those of individualinvestors) and one for non-segregated funds (in-house,non-clearin g members, and non-segregated customerfunds). In addition, each member may hold foreigncurrency denominated accounts at the settlement bank tocover margin and settlement payments in Deutschemarks, yen and U.S. dollars. The clearinghouse also keepsaccounts at each settlement bank, multiple accounts ifdifferent currencies are involved.

Every morning at 8 a.m., messengers deliver printoutsto each clearing member’s settlement bank detailing dailymargin payments and credits. The banks have until 10a.m. to credit or to debit the accounts of members. Thebanks use ICCH’s “Protected Payment System,” whichfunctions in the same way as third party debit authority inthe United States.49 If a bank has any problems in meetinga margin call for a member, the bank must notify theclearing house by 10 a.m. One of the risks of the marginsettlement is that banks do not have to commit paymentsto the clearinghouse on behalf of a member until aftertrading begins in the morning. The opening hours vary ateach exchange, but the London International FinancialFutures Exchange for instance, starts trading at 8:15 am.This could result in a member accumulating adversetrading positions before yesterday’s margins have beencommitted to by the settlement banks. It could become aproblem during periods of high-market volatility.

Asney Ue the Baltic Futures Exchange (which trades contracts for cattle, pigs, soybean meal, potatoes, and freight ~dexes); the ~t~tio~Petroleum Exchange (which trades contracts for gas oil, crude oil, heavy fuel oil, and leaded gasoline); the London Futures and Options Exchange (FOX)(which trades contracts in coffee, cocoa, and sugar); the Imndon International Financial Futures Exchange (IJFFE) (which trades a range of contractsincluding currencies, interest rates, bonds and indexes); and the I.xmdon Metal Exchange (which trades contracts for aluminw lead, copper, nicke~ zincand silver).

AGNatio~ Wes-ter, Barclqrs BarIQ Lloyds Ba@ Midland B@ Royal Bank Of !lcotkmd, ad s~~ ~e~

47~ 1989, a cl- me-r defa~t ~-~ on the NW Z-rid Futures fic~ge. cmtom~ of the other clearing members wme subjected tOan invoicing-back procedure which in some instances, created losses for them.

48Wi~ tie exception of the a~c~~ exc~g~ (the B~tic Futures Exc~nge and FO~, ~ch of the exc~~ operates its own llWChiIlg iUldconfhmation systems. The agricultural exchanges depend on ICCH for both trade matching and confiition.

4~e Cle-ouse cm tell tie set~aentba~ to move money from amember’s ac~~tatthe b~ to the cle~ghouse’s account at the Setdmentbank without a new authorization from the member.


Since ICCH is a net margin clearinghouse, eachmorning it submits one number to the appropriatesettlement bank for either payment or credit of non-segregated accounts and segregated accounts. Collateral,such as a letter of credit, can be pledged to theclearinghouse as a guarantee against trading on multipleexchanges. If the ICCH did not net margin requirementsacross these exchanges, this practice would increasesettlement risk. As it is, the member has the benefit ofincurring reduced payment risk and cost. ICCH acceptsletters of credit (also known as bank guarantees), cash andU.K. Treasuries as collateral for margin payments. It ismoving towards accepting U.K. Gilts and U.S. TreasuryNotes as collateral but there are some legal issues thatmust be worked out; both of these instruments are held indecertified form in depositories and can therefore not bephysically delivered as collateral to the clearinghouse.The possibility of pledging these securities on behalf ofthe clearing house is being investigated.

Clearing and Settlement in Japan

In many ways securities markets in Japan and theUnited States are similar, in other ways they are verydifferent. Both countries have multiple equity exchanges,and in both, one or two of these exchanges handle mostof the total trading volume in securities. In Japan, this isthe Tokyo Stock Exchange.

50 However, Japan’s over-the-

counter market is minuscule compared to that in theUnited States. In contrast with the well-establishednational depository system in the United States, there isno national, central depository in Japan, but one is nowbeing established.

In Japan, as in the United States, the clearing andsettlement process varies according to the type offinancial instrument traded (i.e., futures, equities, op-tions). 51 To a greater extent in Japan, different financialinstruments are traded on the same exchanges, and theclearing of both securities and derivative products are

handled by the same organization, but the differentinstruments are cleared separately. In the United States,by contrast, equities, futures and options generally aretraded on separate exchanges as well as processed bydifferent clearinghouses.

The Japanese futures market adheres to the mark-to-market principle in requiring payment of margin, butpayment is not due until the third day after the trade. Japanand the United States differ in the types of collateralwhich are acceptable as margin payments; Japaneseclearing houses do not accept bank letters of credit ascollateral, but they do accept listed securities. The reverseis true in the United States.52

In Japan, there are many unwritten rules or protocolsthat must be followed in the clearing and settlementprocess. 53 The Japanese Government, especially theMinistry of Finance (MOF), has a much stronger influ-ence on the day-to-day management of the brokeragebusiness than do regulatory agencies in the United States.But more importantly, the Japanese cultural emphasis onthe importance of honor and conformity, concepts whichrelate to the reputation and behavior of companies andtheir employees, help to explain the punctual settlementpractices in Japan. Trades do not fail in Japan, generallyspeaking, because it is dishonorable not to meet one’sobligations. Further, those who do not meet their obliga-tions risk being put out of business.54

Although there is not a widespread concern in Japan asto the possible volume-induced stress on the clearing andsettlement system, Japan’s financial services industrywould like to see some improvements in it. Issues whichare currently under discussion include:

. The reduction of physical movement of securities: inaddition to Japan’s setting up a central depository forsecurities, the Bank of Japan is creating an on-linedepository for Japanese government bonds.55

~&x ch. 4 for detailed description of the Tokyo Stock &change.sl~e OptioIIS ~ket in Japan had until recently been a private, off-exchange, large volume market. In June 1989, options m tie Nikkei 225 ~d=

began trading on the Osaka Stock Exchange.52~ tie Ufitd Stites, however, fi~es ~le~@ome5 ~ve be~ to view letters of credit u a less d~irable fo~ of cowter~. Securities (with the

exception of U.S. Treasury obligations) are not accepted as collateral byU.S. futures clearinghouses. They are, however, accepted by the Options ClearingCorp., which handles the clearing for all exchange-traded options in the United States.

53For e~ple, protocol dictates that delivering an institutional trade and collection of payment be done by pr-~ement o~Y.54”If shares are not available for delivery in Tokyo, a broker issues a letter of guaranty, essentially a promise to deliver later, to its clients. The client

then pays the broker, with the knowledge that they own the stock and it will be delivered shortly. A safekeeping receipt is delivered on trade &te, withthe shares following when available. The Japanese allow the use of letters of gusranty with domestic counterpardes, but acceptance for foreignparticipants varies from one custodian to the next.” Quoted from Daiwa Securities AxnencaInc., “Viewpoint: Perception and Opinions of a Non-UnitedStates Parented Firm Doing Business in the United States and World Securities Markets, ” Summer 1989, p. 4, contributed paper in OTA contmctorreport, Bankers Trust Co., op. cit., footnote 1.

55Nomura Securities, “The Securities clearing and Settlement System in Japaq” Februq 1989, contributed paper in OTA contractor report byBankers Trust Co., op. cit., footnote 1; Toshitsugu Shimizu, “settlement System of ‘Ibkyo Stock Exchange,” Oct. 5, 1988, ibid.; interviews withMasayoshi Hamam and Toshitsuqu Shimizu of the Tolqo Stock Exchange, Mar. 8, 1989, Bankers Trust Co., op. cit. footnote 1; and IBM, “Study ofClearance and Settlement for the U.S. Congress-OTA,” Aug. 1, 1989, also part of the OTA contractor report by Bankers Trust Co., op. cit., footnote1.


. Same-day funds: except for Japanese governmentbonds, the settlement of all stock exchange trades inJapan is through checks, which do not clear until thenext day. Some risk could be removed from thesettlement process if payment were to be made insame day funds, via an electronic funds transfersystem. 56

The Japanese securities industry is also discussingways to facilitate cross-national border trading for bothJapanese investors and foreign investors. Some possibleimprovements include:

●

●

●

Immobilization of securities in their home market:the Japanese securities industry supports this, as wellas the creation of bilateral and possibly multilaterallinkages among depositories and clearinghouses.57

Elimination of Depository Receipts (DRs): the TokyoStock Exchange advocates this as part of immobiliz-ing securities.58

International harmonization of settlement times; asnoted, equity settlement in Japan takes 3 days, and inthe United States 5 days.

The Tokyo Stock Exchange (TSE)

Japan Securities Clearing Corp. (JSCC)—The TSEhas a division known as the Clearing AdministrationDepartment, which is the planning and rule-making bodyfor all matters concerning clearing and settlement.59 Itsupervises the overall process, but the bulk of theday-to-day clearing and settlement process is entrusted tothe Japan Securities Clearing Corp. (JSCC), a whollyowned subsidiary of the TSE. All of the approximately120 members of the TSE are regular members of JSCC,so there are no exchange members who are not alsoclearing members. All must maintain a clearing office inTokyo and a banking relationship with each of the 13approved clearing banks.60

JSCC settles cash-market equity trades (both domesticand foreign), a variety of bond trades, and futurescontracts (TOPIX)61 and U.S. government bonds tradedon the TSE. For equities trades, cash settlement and thetransfer of shares from seller to buyer occurs on the same

day (3 days after the trade date), but the payment andsecurities delivery processes are separate. JSCC is notinvolved in the payment process, which is handled by theTSE’s Clearing Administration Department; JSCC takescare of the securities delivery. The transfer of title tosecurities is handled through JSCC’s computer BookEntry Clearing System and through physical delivery ofpaper securities certificates.

Neither JSCC nor the Clearing Administration Depart-ment take the counterpart position to trades. Nor are anyother formal guarantees made by either organization toassure that the payment and securities delivery obliga-tions of settlement will be met.62

All equities are processed by JSCC’s computerizedBook Entry Clearing System and are settled in one of fourways:

1.

2.

3.

4.

“Regular way settlement”: normally, on the 3rdday following the date of the trade; 99 percent of theTSE’s stock transactions are settled in this way.Cash transactions: settlement is on the day of thetrade (T+O); however, if both parties agree, settle-ment can be on the day after the trade.Special agreement: settlement is scheduled at theseller’s option, for a specified day within 15 days ofthe trade date. This method is primarily used whenthe counterparties to the trade are geographicallyseparated from each other by a considerable dis-tance.When issued: this method of settlement is used forpurchases of securities which either have not yetbeen issued, or, for some other reason are not yetavailable for delivery to the buyer. Contracts forthese types of securities trades are settled on the 4thbusiness day after the trade. After the shares havebeen issued the stock exchange determines a dateafter which “when issued” transactions may nolonger be performed.

Less than 1 percent of the transactions at the TSE endin a failure to deliver shares on settlement day. If,however, there is a default on either payment or delivery

S6SW IBM Aug. 1, 1989, op. cit., footnote 55.sT~ Japm s~ties CIWUI@ COrp. (JSCC), which clears transactions for the Tc@o Stock Exchange @sE), c~entiy maintains linkages with

depositories and/or clearing houses in nine countries. See interview with Masayoshi Hamana and paper by T@hitsugu Shimuzu, op. cit., footnote 55.SsDqository R~eip@ me domestic rweipts for the shares of a foreign-based corporation which are on deposit inabankvaulc or ac~tidmsitory,

in that corporation’s domestic market. A DR for a foreign stock can be purchased in a domestic market which does not list the underlying stock itself.Ibid.

59stw~ on~ To@o [email protected]&c~e MC traded by ~o ~~entmc~odso ‘rhe 150 most active stocks me trad~~~y on the -c@ f100r. The

TSE recently announced that it is developing an electronic order book for these 150 issues which may be in use in late 1990. All other domestic andforeign stocks are traded through CORES, the Computer-Asisted Order Routing and Execution System. See Ch. 4: Americans Compefitorsin SecuritiesTrd”ng. AISb see Harnana and Shimimq op. cit., footnote 55; and IBM repo~ op. cit., footnote 55.

me TSE rotates among these banks on a month-to-month cycle.61~~T0p~~J me ~~o Stwk price~dexfi~es con~cts, Jap~’s equivalent of the Standard and Poor’s 500 index futures contracts onus. stocks.bz~e TSE does provide for interest and peualties on those OCCaSiOXld MM tit f~.


of securities, the TSE requires that the trade be cleared orcanceled within four additional business days.63

For “regular way” settlement, procedures differ ac-cording to whether the trade was done on the floor orthrough the CORES (automated execution) system. Forfloor trades, specifics of the transaction are written ontrade slips which are transmitted via optical characterreader and computer terminals to the member firms whichare counterpart to the trade. As for electronic trades, thetrade data is automatically transmitted to the counterpar-ties. Trade data is compiled overnight by computer andtransmitted to the JSCC before the exchange re-opens thenext morning. If either counterpart finds an error,corrections must be made by contacting the TSE by theafternoon of T+l.

Settlement is always on a net basis, in respect to boththe payment and securities. Accordingly, by the morningT+2, JSCC advises the counterparties on their netsettlement obligations. By 4 p.m. on T+2, each net sellerfirm advises JSCC as to how it intends to provide sharesfor settlement (i.e., book entry or physical delivery), andeach buyer firm advises JSCC as to how it wants toreceive the shares due to it. The seller delivers securitiesby means of either the JSCC’s computer book entrysystem or through the physical delivery of certificates bymid-day on the third day following the trade. Payment isalso made on T+3, but is by bank check (next day funds)rather than electronic funds transfer.

Since finality of settlement is thus delayed on thepayment side, this settlement cannot be said to offer truedelivery versus payment (simultaneous settlement of thedelivery and payment obligations of a trade). On themorning of the fourth day following the trade, thepayment obligation for settlement is netted into a single

.

Most TSE transactions do not involve physical deliveryof certificates. In only 15 percent of all TSE transactionsdo both buyer and seller request that the actual certificatesbe part of the settlement. In 41 percent of TSE trades, bothcounterparties request settlement through JSCC’s bookentry system. The result is that book entry is used for

either receipt or delivery of securities in about four-fifthsof all transactions.64

Depository Functions-Although currently clearingand settlement is done in Japan without a centraldepository, this is expected to change in October 1991, inrespect to domestic stocks. The central depository to beset up by financial services industry and the governmentregulatory agencies is to be called the Japan SecuritiesDepository Center (JASDEC).65 All the details have notyet been worked out, but the plan is for JASDEC’srelationship with the JSCC to be similar to that betweenthe National Securities Clearing Corp. (NSCC) and theDepository Trust Co. (DTC) in the United States.Alternative ways to streamline the custodial and deposi-tory aspects of clearing and settlement for foreign stocksare being discussed. JSCC has recommended that itincrease the number of its linkages with foreign clearinghouses and depositories.

Currently, JSCC’s book entry clearing system transfersTSE-listed stocks directly between accounts, but a majorproblem is that this is done on the basis of stock exchangerules, not on the basis of law. In order for re-registrationto occur before each record date, JSCC returns thedeposited share certificates to the shareholders (it will alsodo so at any time its members request it). JASDEC’sCentral Securities Depository System will immobilizephysical certificates, providing for book entry sharetransfer facilities, and tracking real ownership.66 Thesecurities that will be eligible for such processing arelisted share certificates, OTC share certificates of theJapan Securities Dealers Association (which is develop-ing a new electronic market, JASDAQ, modeled onNASDAQ), and warrants listed on stock exchanges.Participants in the central depository will be required toobtain written permission from their clients in order toimmobilize share certificates, and then will be responsiblefor opening and maintaining deposit accounts for theclient. Share certificates will be transferred to the name ofthe central depository and kept in joint custody. EveryJapanese exchange and clearing house will open a shareaccount at JASDEC. JASDEC will also handle book-entry deliveries of over-the-counter securities.

63rf ~~ is ~ defa~t on the securities delivery, the seller may issue a “due bill” to the TSE (an IOU, actually a bank check for the money amountof the failed trade). The due bill is deposited with the TSE until the seller’s obligation has been met. If the seller should default on the delivery, the TSEwill turn the due bill over to the buyer. The due bill is a contractual agreement between the seller and the TSE, and is covered by exchange rules andregulations and defaulting sellers are subject to TSE penalties.

isasti op. cit., footnote 56.6S~ $$~w CO~g Central Depository and Book-Entry Deliveries for Share Certificates and Other Securities” which authorized the creation

of JASDEC was passed in May 19S4. Development work on JASDEC began in December 1984; the target date for implementation is October 1991,66~thiswy, the services provid~ at JASDEc will be similar to those provided by the XMJRUS @nmsferand Auto~t~Re@t@ion of unc~~

Stock)”book-entry computer system used by the International Stock Exchange in Ixmdon.


The Osaka Securities Exchange (OSE)67

OSE has 94 exchange members and an additional fournon-member special participants, admitted in order totrade in futures contracts. Unlike the TSE, the OSE tradesoptions as well as securities and futures. The options arebased on the Nikkei 225 index; trading began in June,1989.

Clearing and settlement of options contracts is handledby the OSE’s own clearing department. All members ofthe OSE are also clearing members. The process at theOSE is similar to that at the TSE, with a few notabledifferences. First, all trade data comes in via trade slipsand optical character recognition (OCR) reader the OSEdoes not yet have electronic trading, although it will beginsometime in 1990. Secondly, all equities are settledthrough physical delivery instead of by book-entrytransfer of title. The OSE does, however, plan to make useof the JASDEC depository and custodial capabilities,when it opens, but will retain its own clearing department.

Special Features of Japan’s Markets

Japanese Banks and Settlement-Japan does not nowoffer “delivery versus payment” service, because stockexchange payment is generally made through checkswhich do not clear until the next day. This poses a risk forthe seller, since there is always the possibility that a checkmay bounce.

The exchanges decide which banks are clearing banks(TSE has 13 clearing banks, OSE has 8). Clearingmembers must maintain an account with each of thosebanks, but do not give their banks third-party debitauthority (i.e., blanket authorization to debit a clearingmember’s account at the instruction of the clearinghouse).The exchanges receive payments from members anddeposit them into an exchange account at one of theapproved banks,68 collecting all monies owed to it for thatday before disbursing money from the same bank accountto members who are net sellers. Both the TSE and the OSEset and annually review individual payment limits foreach of their members; within these limits the membermay present uncertified checks for settlement obligations.

Futures Contracts69--TOPIX and Japan and U.S.government bond futures contracts are traded on theTokyo Stock Exchange. Osaka Securities Exchange StockFutures (OSF50)70 and Nikkei 225 futures contracts are

traded on the Osaka exchange. Eurodollars, yen, andEuro-yen contracts are traded on the newly created TokyoInternational Financial Futures Exchange (TIFFE). Trad-ing for both the latter contracts has been computerizedsince it began, in October 1988. TOPIX futures contractsare traded through the TSE’s CORES-F system.

Whereas open positions in the Nikkei 225 StockAverage are settled in cash on the last trading day of thecontract, open positions on the last trading day of theOSF50 contracts are settled by physical delivery of sharesof the 50 underlying stocks. The OSE’s clearing depart-ment requires both the buyer and the seller of an OSF50or Nikkei 225 futures contract to deposit as initial margina minimum of 9 percent71 of the sales/contract value (witha minimum of 6 million yen). One third of the initialmargin payment must be paid in cash. After the first dayof the contract, additional margin is owed depending onprice fluctuations in the market, after daily marking tomarket. Additional margin is due when a loss due toadverse market price fluctuations exceeds 3 percent of thesales or total contract value.

TOPIX futures are settled in the months of March,June, September, and December. Customer margin re-quirements are similar to those at the OSE for OSF50contracts, an initial margin of either 9 percent of the valueof the transaction or 6 million yen. Members must alsopay margin of 6 percent or more of the price of thecontract.

Government bond futures are settled on the 20th ofMarch, June, September and December. Banks andnon-TSE member securities companies may use accountsat JSCC to clear Japanese Government futures contracts.

The TSE and the OSE accept as collateral to meetmargin requirements for futures any of the following:cash, any securities listed on any Japanese exchange,stocks registered with the Japan Securities DealersAssociation, or beneficiary certificates of the securitiesinvestment trusts. Bank letters of credit are not acceptedas collateral. Payments are due from clearing members forthe netted position of each type of futures contract. TheOsaka Securities Exchange maintains a Settlement Fundand a Default Compensation Reserve Fund System whichcover participants against the default of other exchangemembers. These funds are for the trading of all instru-ments on the Exchange, including futures contracts. TheTSE also has a guarantee fund, which totals 5 billion yen.

GTrnfomtion in this section is based on the IBM repo~ op. cit., footnote 56, on the response to questions posed to Mr. Y05hioh of the O* StoolExchange by OTA contractor, Bankers Trust Co., op. cit., footnote 1, and an interview by OTA contractor, Bankers Trust Co., with Messrs. YoshibzuuOritani, Eiji Hirano, and Iwao Kuroda, Bank of Japan, March 1989.

GsTheexc~ges~~ acco~ts at eachof the clearing banks, although only one is used at any one time. The exchanges mtatewh.ichof me cIXbanks they use according to a defined schedule (i.e., the OSE rotates every 10 days; the TSE, once each month).

Gwo~tion supplied by the TSE and the OSE, in OTA contractor report by Bankers Trust Co., op. cit., foO~Ote 1.T~e OSFSO is almost a dormant market.TIU.S. fi~es margins are generally 3 to 5 percent.


International Trading72—The TSE currently lists 120foreign stocks. JSCC advocates building and maintainingcustodian relationships in the country where these securi-ties were issued. Clearing and settlement communicationscan then be handled through business linkages (i.e.,dedicated communication lines) between depositories andclearing houses. Trades in foreign securities listed on theTSE are cleared through JSCC’s book entry system. Theyare held by JSCC in the issuer’s home country, eitherthrough a link to that country’s depository, or in a custodyaccount through a bank in that home country. JSCC haslinkages for this purpose with Australia, Canada, theNetherlands, Germany, France, Spain, Sweden, Switzer-land, the United Kingdom, and the United States.

Both the TSE and the JSCC feel that there aresignificant advantages to the book entry approach,combined with overseas custody linkages, because theefficiency of equity clearing is based on the ability ofinvestors to fulfill the delivery obligation by eitherbook-entry receive or delivery on the settlement date(T+3). Settlement of transactions on behalf of non-residents is usually more complicated than settlement for

domestic clients, because information must pass througha series of intermediaries. So, at least with linkages, it iseasier for the nonresident to deposit securities locally inthe home country, where most custody is. This eliminatesa risk for the TSE-member broker, who remains obligatedto settle on T+3, and otherwise might have difficultyreceiving the physical shares from clients in time forsettlement.

U.S. securities comprise 70 percent of the foreignsecurities traded on the TSE. The TSE has a specialarrangement with the International Securities ClearingCorp. (ISCC) in the United States, through which U.S.shares traded in Japan are kept for JSCC by ISSC ondeposit at The Depository Trust Co. (DTC) in New YorkCity. In the same way, JSCC acts as a custodian forJapanese securities which are being traded on someexchanges outside Japan. Currently, it provides thisservice to depositories in the Netherlands and France andis discussing with ISCC the possibility of acting as adepository for Japanese stocks being traded by ISCCparticipants in the United States.

Tz~o~tion in tb,is s~tion is based on a paper by Nomura Securities, in the OTA contractor report by Bankers Trust CO., op. cit., footnote 1.

Acronyms and Glossary

ACT

ADPADRAMExBISBOTCCCBOECBOTCCITT

CEDEL

CFTC

CMECNsDTCDVPECFIBv

FRsG-30GAOGMICCICCH

IOSCO

ISCCISE

IS0ISSA

ITS

JASDECJSCC

Acronyms

—Automated Confirmation Transaction[System] (NASD)

—Automatic Data Processing, Inc.—American Depository Receipt—American Stock Exchange—Bank for International Settlement—Board of Trade Clearing Corp.-Chicago Board Options Exchange—Chicago Board of Trade-Comite Consultatif International

Telegraphique et Telephon (InternationalTelecommunications Union)

—Commodity Exchange Act—Centrale de Livraison de Valeurs

Mobilieres—Commodity Futures Trading Commission

(U.S.)-Chicago Mercantile Exchange-Continuous Net Settlement—Depository Trust Corp.-delivery-versus-payment—European [Economic] Community—Federation International des Bourses de

Valeurs—Federal Reserve Board (U.S.)—Federal Reserve System-Group of Thirty-General Accounting Office-General Motors—Intermarket Clearing Corp.—International Commodities Clearing House

(U.K.)—International Futures Exchange of

Bermuda—International Organization of Securities

Commissions—International Securities Clearing Corp.—International Stock Exchange of the

United Kingdom and the Republic ofIreland (in London)

-Organization for International Standards—International Society of Securities

Administrators—Intermarket Trading System—International Telecommunications Union—Japan Securities Depository Center (Japan)—Japan Securities Clearing Corp.

KCBTCC —Kansas City Board of Trade ClearingCorp.

KV —Deutscher Kassenverein

LIFFE —London International Financial FuturesExchange

MATIF —Financial Futures Market (France)MOF —Ministry of Finance (Japan)MONEP —Paris Options Market (France)MOU —Memoranda of UnderstandingMSE —Midwest Stock ExchangeNASD —National Association of Securities DealersNASDAQ —NASD Automated Quotation systemNikkei 225 —Nikkei 225 futures contracts (Japan)NSCC —National Stock Clearing Corp.NYMEX —New York Mercantile ExchangeNYSE —New York Stock ExchangeOCC -Options Clearing Corp. (U.S.)OECD -Organization for Economic Cooperation

and DevelopmentONA -Open network architecture (of computer

systems)OSE -Osaka Stock Exchange (Japan)OSF50 -Osaka Securities Exchange Stock Futures

(Japan)OTC -Over-the-counterPHLX —Philadelphia Stock ExchangePSE —Pacific Stock Exchange

—Postal, Telegraph, & Telephone[Authority]

S&P 500 —Standard & Poor 500 Stock IndexSCG —Securities Clearing GroupSDF —Same-Day FundsSEAQ -Stock Exchange Automated Quotation

system (London)SEC —Securities and Exchange Commission (U.S.)SEPON —The Stock Exchange POol Nominee (U.K.)SIAC -Securities Industry Automation Corp.SICOVAM -Societe Interprofessionnelle pour la

Compensation des Valeurs MobilieresSIMEX -Singapore International Monetary

ExchangeSIPA -Securities Investor Protection ActSIPC -Securities Investor Protection Corp. (U. S.)SPAN -Standard Portfolio Analysis of RiskSRO —Self-Regulatory OrganizationT+l —Trade Date Plus One DayTALISMAN —Transfer Accounting and Lodgement for

Investors, Stock Management forPrincipals (U.K.)

TARS —Trade Acceptance Reconciliation System(NASD)

TAURUS —Transfer and Automated Registration ofUncertified Stock (U.K.)

-1oo-

Acronyms and Glossary .101

TIFFE —Tokyo International Financial FuturesExchange

TIMS —Theoretical Intermarket Margin SystemTOPIX —Tokyo Stock Price Index FuturesTIMS —Theoretical Intermarket Margin SystemTOPIX —Tokyo Stock Price Index Futures

Contracts (Japan)TSE —Tokyo Stock ExchangeUCC —Uniform Commercial Code (U. S.)

GlossaryAccess Deregulation: Changes in national laws or

regulations that open the counties markets, especiallymembership on exchanges, to foreign participation.

American Depository Receipt (ADR): A receipt signify-ing ownership of shares in a foreign corporation.Transactions are made in the ADR in lieu of transac-tions in the security, which is usually held by a trustee.The ADR is usually issued by a foreign branch of anAmerican bank.

American-Style Option: A put or call option that can beexercised at any time before expiration; all listedoptions are of this kind, including those on Europeanexchanges. See “Option” and “European-Style Op-tion. ”

Amex: American Stock Exchange, in New York, thesecond largest U.S. stock exchange.

Analog Signals: Resemblance or correspondence; used todescribe traditional forms of electronic informationsuch as pictures, speech, or written and printedcharacters, as opposed to digitized information.

Arbitrage: The simultaneous or closely related purchaseand sale of the same product or related products inorder to take advantage of price differences betweenthem (which are presumed to be unrealistic andtemporary). Arbitrage often involves stock and eitherfutures or options; it may involve a basket of stock anda stock-index futures contract.

AURORA: An electronic system for the internationaltrading of futures contracts being developed by theChicago Board of Trade; it is now to be merged withthe GLOBEX system (see GLOBEX) but details havenot been worked out.

Bear Market: A market with generally declining prices.See “Bull Market.”

Block: A large number of shares of a single stock; usuallydefined as 10,000 shares or shares whose value is atleast $200,000.

Bond: A debt security; a long-term promissory noteevidencing corporate or government debt, which paysinterest to the holder.

Book-Entry: An item in a depository’s computer recordsthat identifies, or is used to transfer, ownership ofstocks or bonds.

Broker: A securities firm or individual that representscustomers in transactions (i.e., trades as an agent). See“Dealer.”

Bull Market: A rising market; that is, a market withgenerally rising prices. See “Bear Market.”

Call: See “Option.”Capital Markets: Markets where debt and equity securi-

ties are traded. Includes private placement as well asorganized markets and exchanges.

Capitalization (of an exchange): The total value of listedsecurities.

Cash Market: The market in which transactions arecompleted immediately and assets will be delivered inreturn for payment; as contrasted with a futures market.Cash markets include organized, self-regulated ex-changes and over-the-counter markets for stock andcommodities.

Churning: Excessive trading of securities or otherproducts by a broker or floor trader, usually in order togenerate commissions. A form of market abuse.

Clearing or Clearance: The processing of transactions instock, futures, or options markets, in which the buyer’sand seller’s records of a transaction are matched, inpreparation for settlement. Clearing includes confirm-ing the identity and quantity of the security or contractbeing bought and sold, the transaction price, date, andidentity of the buyer and seller. In some clearingorganizations, it also includes the netting of trades.

Clearing Member: A securities firm that is a member ofboth an exchange and its clearing organization; aclearing member handles (for a fee) the clearing oftransactions of other members of the exchange who arenot clearing members, as well as its own clearances.

Clearing Organization: An organization that handlesclearing and (sometimes) settlement; clearing organiza-tions do not exist in some countries.

Closing a Position: Eliminating an investment fromone’s portfolio, either by selling it or (in futures andoptions trading) making an offsetting transaction—e.g., a purchase of a futures contract offsets the sale ofa futures contract.

Counterparty: Either party (buyer or seller) to a transac-tion.

Custodian: A bank or other financial institution thatkeeps stock certificates and other assets for a customer(an individual, corporation, mutual fund, or pensionfund).

Dealer: A securities firm or individual acting as principal(trading for a proprietary account) rather than as agent(trading on behalf of a customer). If a firm acts as


principal in some transactions and as agent in others,it is called a broker/dealer.

Debt Security: An instrument representing money bor-rowed, such as a bond, a bill, a note, or commercialpaper. It specifies a fixed amount of money, a date ordates of maturity (repayment), and usually a fixed rateof interest or discount on the original purchase price.

Delivery v. Payment: A settlement term, meaning thatdelivery of a security requires payment at the sametime; in effect, a cash-on-delivery transaction.

Dematerialized: Existing only in the form of electronicrecords, in lieu of a paper certificate (e.g., a dematerial-ized security).

Depository: Organizations that hold stocks and bonds forsafekeeping, on behalf of their owners.

Derivative Products: Tradable futures and options con-tracts for which the pricing depends on (i.e., isderivative of) the price of a specified asset, such as astock, a commodity, or the basket of stock representedin a stock index such as the Standard& Poor 500.

Digitization of data: The translation of data fromtraditional (analog) forms such as pictures or printedfigures and text to binary-coded electronic signals.

Dow Jones, or Dow Jones Averages: Market indicators,issued by the Dow Jones & Co., to indicate changes inprice of groups of stocks: for example, industrial,transportation, utility, and composite groups of stocks.

Efficient Market: A market in which the prices ofsecurities immediately reflect all available informa-ion; for "free market” advocates, a market in whichprices are relatively unloaded or “distorted” bytransaction costs, taxes, regulatory costs, or otheradditions to fundamental stock value.

Equity Security: An instrument representing and con-veying ownership interest in a corporation, i.e., stock.

Eurobond: A bond sold in a country other than the onein whose currency the bond is denominated; forexample, a U.S. bond sold overseas.

Eurodollar: A U.S. dollar on deposit in a foreign bank;usually a European bank, possibly a foreign branch ofa U.S. bank.

European-Style Option: An option that can be exercisedonly on its expiration date, rather than before that date.See “Option” and “American-Style Option.”

Foreign Exchange: Foreign currency market; foreigncurrency is bought and sold for immediate or futuredelivery.

Forex: The informal market for foreign currency.Fourth Market: Securities transactions made directly

between institutions, without the intermediation ofbrokers or dealers.

Futures Contract: An agreement to buy or sell acommodity (including financial instruments) for deliv-

ery in the future, at a specified price. Each party to thecontract is obligated either to fulfill the terms of thecontract or to offset the contract by entering into anopposite transaction. The latter (the most commonlychosen alternative) can be done because the clearingorganization becomes one counterpart to all transac-tions.

GLOBEX: An electronic system for international tradingof futures contracts, developed by Reuters and theChicago Mercantile Exchange, scheduled to becomeoperational in 1990-91.

Group of Thirty: An independent, non-profit associationof business persons, bankers,- and representatives ofother financial institutions from 30 developed nations,who address major global financial topics at policylevels.

Hedge: Protecting one position by taking an offsettingposition. Typically, one takes a position in a futuresmarket opposite to a position in a cash market (acommodity or stock market) in order to minimize therisk of loss from an adverse price change. Aninstitutional investor may use stock-index futures tohedge an indexed stock portfolio. Other means ofhedging include selling short, buying a put option, orselling a call option.

Index: A market indicator that represents the averageprice of a specific basket or portfolio of stock.

Index arbitrage: The simultaneous purchase/sale of thebasket of stock represented in an index (such as theStandard & Poor 500) and of the stock-index futurescontract for that index in order to profit from temporarydifferences in their price.

Insider Trading: Trading a security on the basis ofconfidential or privileged information, to which onehas access as an “insider” (e.g., as an officer, director,or attorney) of the corporation issuing the security.This is illegal in many countries, because it disadvan-tages other investors.

Instinct: A proprietary electronic securities trading sys-tem, owned by Reuters, that does about 13 milliontrades per day.

Institutional Investor: An institution with a largeportfolio, such as a mutual fund, a public or privatepension fund, a labor union, or an insurance company;the trading is usually the responsibility of a profes-sional money manager.

Intermarket Trading System: An electronic networklinking stock exchanges in the United States, allowingorders to be routed from one exchange to anotherexchange offering a better price.

Investment Banker: A firm that underwrites stock,advises other firms on how to raise capital, arrangesacquisitions, etc. See “Underwriting.”

Acronyms and Glossary .103

Liquidity: The characteristic of a market (or of a listedsecurity) with enough potential buyers and sellers toallow large transactions without a substantial changein the prevailing price.

Listed Security (also listed option, listed future): Onethat has been accepted for trading by an organized andregulated securities exchange. Unlisted securities aretraded in the over-the-counter market.

Locked-In Trades: Transactions that are matched andconfirmed by computer, usually at the place of thetrade, before being sent to a clearing organization.

Long Position: Shares (or other instruments) owned byan investor or dealer.

Maintenance Margin Call: A call for additional funds tobe put into a margin account because of an adversemarket movement.

Margin: In securities markets, the amount that must bedeposited with a broker by one buying securities-thebroker extends credit for the remainder of the purchase.In the United States, minimum margin requirementsare set by the Federal Reserve Board of Governors. InU.S. futures markets, both buyers and sellers put downinitial margins, which are defined as performancebonds or good-faith deposits to assure that the traderwill fulfil the contract. The minimum margin require-ment is set by the clearing entity of the futuresexchange. If the futures price moves adversely, theinvestor will be called on (daily or more often) to putup more money or collateral.

Marked-to-Market The daily or intra-daily adjustmentof settlement obligations (in futures and optionsmarkets) to reflect current market prices. Marking-to-market determines the amount of margin that must beheld, and is done by clearing organizations to limittheir risk to one day’s market movement.

Market-Maker: A dealer who makes firm bids and offersat which he will trade. In some markets (e.g., the U.S.over-the-counter market and the International StockExchange) there are competing market-makers; inothers (e.g., the New York Stock Exchange) there isone designated market-maker for each stock, called aspecialist.

Mutual Fund: A fund operated by an investmentcompany that raises money from the public (by sellingshares) and invests it in stocks, bonds, options,commodities, or money market securities.

Netting: The determination of the difference betweenone’s total credit and total debt positions, which resultsin a single amount that a market participant either owesor is owed.

Offset: (1) In futures markets: to close out or cancel aposition by taking an equal, opposite position-for

example, one offsets purchase of a futures contract byselling a futures contract of the same kind. (2) Ininternational trading, to open a position in one countryand close it in another, under an agreement between thetwo exchanges.

Open Outcry: The method of trading on commodities(and futures) exchanges, where traders shout out theirbuy and sell offers.

Option: A contract conferring the right to buy (call) or tosell (put) a security at a designated price during aspecified period.

Over-the-Counter: A market where stock transactionstake place through dealers, but not on or through anexchange or centralized market.

Passing the Book: Transferring the responsibility forportfolio trading from one location to another in adifferent time zone, in order to trade for more hours ofthe day-the ultimate is “24 hour trading. ”

Pit: The floor of a futures exchange, surrounded by tieredplatforms on which traders stand to shout their bids andoffers (see ‘Open Outcry”).

Position: An investor’s or dealer’s stake in a security orin a market. A long position equals the number ofshares owned. A short position equals the number ofshares owed.

Price-Earnings Ratio: The current market price of astock divided by its earnings per share.

Private Placement: The distribution of securities, notlisted on an exchange or organized over-the-countermarket, to a small number of usually institutionalinvestors. Such placements are exempt from manySEC and state registration requirements.

Program Trading: The simultaneous purchase (or sale)of a large, diversified portfolio of stocks, ordinarilyusing a computer to handle the complex order routing.

Prospectus: A description, e.g., of an issue of stock,giving essential information about the stock for thebenefit of potential buyers; (in the United States) asummary of the registration statement filed with theSEC.

Prudential Regulation: Regulation aimed at assuring thefairness of a market, and protecting the investor fromfraud, manipulation, or unrecognized risk.

Put: See “Option.”Rolling Settlement: An arrangement whereby trades can

be settled on any business day, as opposed to one ormore designated days for each trading period.

Same-Day Funds: Payment is final on the same day it ismade (checks do not represent same-day funds,because it may take them several days to clear, duringwhich the receiver of the check does not have accessto the money).


SEAQ International: The automated trading supportsystem used to facilitate translational trades at Lon-don’s International Stock Exchange.

Seat: Membership on an exchange.Secondary Market: The market in which stocks are

traded after their initial issuance and placement. Theexchanges and other markets discussed in this reportare all secondary markets.

Security: An investment contract conveying participationin a common enterprise, in which there is expectationof profit resulting from the efforts of others; thisincludes stocks, bonds, and options, but not futurescontracts.

Settlement: Payment to the seller and delivery of stockcertificates (or other means of transferring ownership)for the buyer.

Short Position: The number of shares (or other instru-ments) owed by an investor or dealer; see ‘short sale.

Short Sale: The sale of a security which is settled bydelivery of borrowed securities (rather than securitiesowned by the seller). Generally, the seller expects tobuy securities later, at a lower price, to cover the shortsale.

Specialist: An exchange member who acts as designatedmarket-maker on an exchange for one or more stocks;the specialist’s functions are: 1) to assist othermembers on the floor find buyers or sellers with whomto trade, 2) to hold and execute limit orders (orders to

buy or sell when the market reaches a certain price) forother brokers, 3) to buy for or sell from his owninventory when necessary to provide liquidity and tomoderate or smooth out price jumps, and 4) throughthese and related means to maintain a fair and orderlymarket.

Standards: A criterion established by authority, custom,or general consent as a model or a measure of quality,quantity, form, size or some other parameter. Ininformation technology, for example, general confor-mance to a standard makes possible interoperability orinterconnectivity of systems.

Third Market: Trading exchange-listed securities over-thecounter rather than on the exchange.

Treasuries: Bills, bonds, and notes issued by the U.S.Treasury.

Underwriting: The act of buying new issues of securitiesfrom issuing corporations, and reselling them. This isone of the activities of investment bankers, but it isusually carried out through the formation of an ad-hocsyndicate.

Universal Banking: The most common bank regulatoryarrangement, whereby banks can engage in mostfinancial activities, including securities underwritingand trading. In the United States and Japan, in contrast,banks are restricted from engaging in many securities-related activities, including underwriting.

Index

access deregulation 4, 11,28,47American-Style Option 48Amsterdam Stock Exchange 61Arbitrage 4,9,37,40-41Article 65 (Japan) 29,43Associated Press 14Auckland 17AURORA 18,48Automatic Data Processing, Inc. (ADP) 14,15, 16

Bank for International Settlement 61,62Bankruptcy Code (U.S.) 65banks 2, 4-5, 14, 22, 29, 32, 37-38,4043, 48, 57, 62,

64-67,70,73-75,78Big Bang 3,28,4445,4748bond dealers 15bond markets 23,33,74book entry 19,55,58,60

Canada 14,27,29-30,37,55-56, 66,72,74, ’76capital imbalance 26capitalization of stock markets 23CEDEL 61,68Chicago Board of Trade 16,33-34,48Chicago Board Options Exchange 18Chicago Mercantile Exchange 16-17, 33-34, 41, 43Cincinnati Stock Exchange 18Citicorp 16clearing and settlement 3-4, 8,37,42,55-70,74

goals of 3,55-56interfaces 14models of 3

Comite Consultatif International Telegraphique et Tele-phon 21

Commodity Futures Trading Commission (U.S.) 9, 34,65,70,76

crash of October 19872,6,28, 32cross-listing of stocks 29cross-national diversification 11,28-30custodian 43, 57,67-68,70

default 4,56-57,65-66Denmark DV 34,61,73depositories 42,55-58,62,67,69deregulation 3-5,11,28,32,43-44,47, 71-72,76,78Deutscher Kassenverein 58digital data 13,16Dow Jones & Co., Inc. 14-15

enforcement 5,37,43,53,62,70,74, 76,78Eurobonds 29Euroclear 61,68Eurodollar 17European Community 1-3,5,7,21,37,47,61, 74,76

Federal Reserve System 24,60,69-70Federation Intemationale des Bourses de Valeurs FIBV 3,

61finality of payment 66Financial News Network 14firebreaks 64foreign membership in exchanges 11, 14-17, 19,44foreign portfolio investment 27,31forex 14-16,55Frankfort 42fraud, abuse 4,43,49-50,72-73,75futures 2,4,6,8-9,14,16-18, 21-22,23,33-34,39-41,43,

47,49,55,57,63-65,69-70, 72,74,76,78-79futures exchanges:

Chicago Board of Trade 16-18,33-34Chicago Mercantile Exchange 16-17,33-34LIFFE (London) 18,33MATIF (Paris) 17,34,49

GEMCO 16Glass-Steagall Act 29,43global custodians 68,70GLOBEX 16-18,43Greenspan, Alan 24,64Group of Thirty 37,59-63,68-69

recommendations of 62U.S. working committees of 60,63,68-69

harmonization 3-4,21-22,24,47-49,59, 65,67-70Hong Kong 12, 17,37,68

ILX Systems 14individual investors 2,25-26,39,42information services vendors 1,5, 13information sharing 4,60,63,65-67,70information technology (computers, telecommunications)

1,6,11,26,32-33,36,37, 39initial offerings 34Instinct 16institutional investors 1,5-6,25-28,30-31,34, 37-38,41,

44,46,59,68,72,79International Futures Exchange 16International Organization for Standards 21,76International Society of Securities Administrators 3,61International Telecommunications Union 21International Thomson Organization 14Irish Futures and Options Exchange 18

Japan (see stock exchanges, clearing organizations) 1-2,6,12,23,25-34,37-38, 4044,50,55-58,60,72-73,78

Japan Securities Clearing Corp. 57

Knight-Ridder 14-15

–l05-


large block trades 45London (also see stock exchanges) 3,7-8,14,16-18,26,

28-30,32-34,43-45,47-48, 55,65,71London Futures and Options Exchange 18

margins 15,39,41,56,63-65Market News Service 14Memoranda of Understanding (MOU) 7,76Merrill Lynch 32Monitor Dealing Service 16mutual funds 2, 26,29, 35,50

NASD, NASDAQ 3,16,18-19,30,4244,60,63national debt 27National Securities Clearing Corp. 57,63national treatment 5,53,73-74,77networks (communications) 1-2,6, 11-12, 15, 36,48, 74New Zealand Futures and Options Exchange 18Nikkei 23,33-34

obstacles to international trading 1,3-4,8, 13, 19,28-29,37,46,60,67

options 4, 14, 17-18,23,34,41,43,48-49, 55,57,63-65,67

Paris 17Paris bourse 3,34,49Portal 19portfolio diversification 2,50President’s Working Group on Financial Markets (U. S.)

64privatization 26,28,49

Quotron 14-16

reciprocity 6,73-74,76regulation 4-6, 8, 19, 21-22, 24, 26, 28-29, 32-33, 37,

4244,47-50,53,60,62, 68,70,71-72,74,76-78access regulation 4, 72prudential regulation 4,28,37,47,50,53,72, 75-76,

78regulatory arbitrage 4, 8,75-76, 78

Reuters 13-18,43risk management 63

risks 1-5,7-9, 19,21,23-26,28,31,33, 35-36,37,55-59,61-70,71-73,78

rolling settlement 58

Salomon Brothers 13,33same-day funds 4, 60, 65-69scenarios 5-8SEAQ International 30,44-49Securities and Exchange Commission (U.S.) 21,26,30,

59Securities Investor Protection Corp. 65SICOVAM 61Singapore 17, 19,33Singapore International Monetary Exchange (SIMEX)

17,33standards 1-2,5,7-8, 19,21-22,24,28,33,35, 53,59-60,

64-65,67-68,70,74-76, 78stock exchanges:

International Stock Exchange (United Kingdom) 3,29,4344,55,61

New York Stock Exchange 3,16,18-19,29,33,38,57Tokyo Stock Exchange (Japan) 2,23,30,32,37,41,43,

57,61Sydney 17, 18Sydney Futures Exchange 18

24-hour trading 33,55technological innovation 6technology 1, 11, 13-16,19,21-22,26,33-34, 36,37,43,

4546,49,65,67,70Telerate, Inc. 14-16Tokyo Grain Exchange 18Tokyo International Financial Futures Exchange 18Trade Acceptance Reconciliation System (NASD) 18trading systems (automated) 1-2, 11, 14, 16, 18,46,70transaction costs 3-4trends driving globalization of markets 25-26two-tier market 26,46

Uniform Commercial Code 55universal banking 43, 73-74

Zurich 17,34