By Peter Norman
The world’s securities markets have been enjoying a golden age. Impersonal, unsentimental and transmitted as bits and bytes by the latest information technology, footloose funds flash round the world at the speed of light seeking the best possible return. At the centre of the markets are mighty commercial and investment banks with financial power that dwarfs many a nation’s economy. We all depend on these markets: the businessman seeking finance to expand; the pensioner looking for a better return on meagre savings; the young family wanting to move to a new house and the government that borrows to cover its budget deficit.
Securities will change hands many times to fit the needs of these very different customers. The security might be an equity share in a company, a bond issued by a government or corporation or a share in a collective investment, such as a unit trust or mutual fund. It may be transformed, diced and sliced into a completely different financial instrument - a derivative - to redistribute risk or boost yield. The place where the security is traded may be a registered securities exchange, such as the stock exchanges located in London, Paris and Frankfurt, an ‘over the counter’ market such as that for international bonds where dealers trade using telephones or trading screens, or the trading book of a big investment bank.
Central to any securities market is the transfer of ownership of the security from seller to buyer in return for payment. That is where the idea of an exchange comes from. But if language followed logic, the world’s securities exchanges would no longer glory in that name. Securities are listed on exchanges, they may be traded on exchanges. But the actual exchange of the securities is handled by the various specialised ‘post-trade’ services which are commonly lumped together under the heading of clearing and settlement.
Companies like Euroclear provide the ‘settlement’ and related services that follow the trade of a security and enable the markets to work. Clearing and settlement are often regarded as the ‘plumbing’ of securities markets: a series of electronic ‘pipes’ linking customers with electronic ‘storage tanks’ which keep customers’ securities accounts. Although this end of the securities business is unglamorous and unheeded unless things go wrong, it is of existential importance for the markets.
No matter how sophisticated or speedy the platform on which securities are traded, the market in question cannot serve its purpose without an apparatus that actually completes the transfer of securities from seller to buyer and ensures payment flows in the other direction from buyer to seller. All trading venues have a vital interest in a settlement infrastructure that is fast, efficient and as cost effective as possible and that can meet demands for additional services that can enhance the profitability of those companies that use them.
Just as exchanges and the instruments that they trade have grown more technologically advanced and complex over the past half century, so too have the companies that handle post-trade arrangements.
A securities transaction passes through a number of stages once the trade, the binding agreement between two counterparties to exchange securities and cash at a future date, has been completed.
The first is verification, which is the process of comparing and, if necessary, reconciling discrepancies in the transaction or settlement details. There is some dispute whether verification – which covers issues such as price, quantity and settlement date of the trade - should properly be described as a post-trade activity because it is commonly handled at or close to the point of trade. It is preliminary to rather than part of clearing and settlement.
Clearing comes next. Clearing [has been] defined in [a European] Commission document as ‘the process of establishing settlement positions, possibly including the calculation of net positions, and the process of checking that securities, cash or both are available.’ Clearing, according to this definition, ensures that all the prerequisites for settlement are in place. It focuses on establishing the respective obligations of the buyer and the seller.
In recent years, however, clearing has come to have other meanings of greater importance than the calculation of who owes what to whom following a trade. Clearing in the modern sense refers to the activity of ‘central counterparty clearing’ or CCP clearing, which is provided by a central counterparty or CCP, a specialised financial institution that is placed between the buyers and sellers of securities.
In this process, the CCP assumes the credit risk of the participants in the trade, possibly by guaranteeing a transaction.
The CCP not only assumes the rights and obligations of the counterparties, it also acts ‘as the direct or indirect buyer to every seller and the direct or indirect seller to every buyer’.
Central counterparty clearing activities of CCPs are an increasingly important part of financial market infrastructure. By being placed in the middle of a vast number of transactions, a CCP is able to net the gross obligations it incurs. In other words, the CCP offsets the amounts it owes and is owed by market participants and reduces its obligations to (usually small) residual amounts that become single debits or credits between itself and each of its members.
Central counterparty clearing began to appear in securities markets in Europe in the late 1990s, providing many benefits. CCP clearing simplifies the management of counterparty risks by supplying a single counterparty instead of several. It increases liquidity through netting and cuts settlement costs by reducing the number and value of transactions that have to be settled. It also enables counterparties to remain anonymous to one another.
CCPs assume the risk of default of the counterparties to trades and therefore need to have adequate capital and sophisticated risk management techniques in place. On the other hand, once up and running, they are well placed to exploit economies of scale and scope.
Clearing, as conducted by a CCP, is a separate business to settlement. Although there are some cases – the Deutsche Börse group being one – where clearing forms part of a value chain from trading, through clearing to settlement in what is known as a ‘silo’, it is a functionally different activity. There is no necessity for clearing to be included with other functions of the securities business in the same business entity.
Unless suitable corporate governance arrangements are in place, a case can be made from a competition policy viewpoint for keeping the CCP separate from both trading and settlement. The CCP acts as a funnel by netting all transactions after the trading level and can be in a dominant position to decide where the netted trades will be settled. At the end of the clearing process, the instructions for the transfer of the securities and the funds to pay for them are transmitted to the settlement organisation.
Unlike central counterparty clearing, the settlement of securities transactions has been necessary for the functioning of bond and equity markets for as long as these markets have existed. Securities markets are unthinkable without settlement systems because the transfer of equities and bonds from seller to buyer is only final when delivery and payment have been completed.
There are three types of providers of settlement services: the Central Securities Depository or CSD; International Central Securities Depositories or ICSDs and intermediaries – a catch-all term that covers other commercial organisations engaged in settlement activity. These are usually banks, acting as agent banks and/or global custodians.
The CSD is the basic building block of a modern settlement infrastructure. It is a special financial institution created to remove the need to shift securities in physical form from one investor to another.
CSDs have several functions. In some countries, they are the public notaries for securities because the names of the account holders on their electronic systems are the definitive record of title. They often provide the simple (non CCP) clearing services. The CSD is the institution responsible for immobilising securities in its depository so that the buying and selling of securities can be settled on its books by adjusting investors’ securities and cash accounts. In some cases, CSDs carry out extra services such as corporate action services.
It is difficult to generalise about CSDs because they are national institutions with differing rules and competences. This reflects the national structure of the securities business in Europe and the way that domestic securities have traditionally been settled on a national basis. Companies that list their shares on a country’s stock exchange place their shares in the national CSD. Because each CSD is governed by different national legal requirements covering activities such as corporate actions, they tend to function as monopolies for some services. It is difficult, for example, for a company that has issued shares in one country to move its share to the CSD of another country.
Post-trade services are not a competition-free zone, however. There is some competition among CCPs, between CSDs and CCPs and among CSDs.
When buying or selling securities, the investor interacts with the CSD through an intermediary, such as a bank or stock broker, which is a member of the CSD.
[T]he International Central Securities Depositories or ICSDs were set up by banks in the late 1960s to be the CSDs of the stateless Eurobond market, which is now more usually known as the international bond market. Euroclear and Cedel (later Clearstream) have pursued an intense rivalry ever since. The ICSDs diversified into settling domestic bonds and equities from the 1980s onwards and have formed groups with CSDs since the beginning of the 21st century. Euroclear took over the CSDs of France, the UK, Ireland, the Netherlands and Belgium. Cedel first merged with the German settlement company owned by Deutsche Börse and was eventually fully taken over by Deutsche Börse. In Switzerland, SIS SegaInterSettle combines functions of a CSD and ICSD.
By holding securities in the form of electronic information, CSDs and ICSDs hold a stock of financial assets that the securities’ owners can allow to be lent and borrowed and used as collateral by market participants. Once this attribute of securities in a CSD or ICSD was linked to the power of modern computers and a sophisticated banking infrastructure, there was a huge increase the use of securities as collateral, powering a securities repurchase or ‘Repo’ market worth billions of euros a year.
The two big ICSDs and SIS differ from most CSDs in one important respect: they are banks. For example, Euroclear Bank, the ICSD of the Euroclear group, has a banking license which allows it to extend credit and make profits from banking activities, although these are strictly linked to securities settlement.
The provision of such value added services creates dilemmas for the settlement business. Is it, or should it be, comprised of utilities serving the market, or a profit making activity, or both? What competitive forces or competition rules should exist to ensure no single settlement provider is ripping off other participants in the securities industry value chain? Are there generally accepted rules of corporate governance that can ensure the business generates enough money to invest but not so much as to act as a tax on the capital markets?
Issues of payment have proved to be neuralgic throughout the history of the securities settlement business because, in aggregate, transactions involve huge sums of money. The fear that failure could put at risk the financial system of a nation or group of nations is never far from the thoughts of supervisors.
The quest for delivery versus (simultaneous) payment in order to mitigate risk became a preoccupation of the industry’s executives and policy makers for a decade after the world-wide stock market crash of October 1987. More recently, the sensitivity of some national central banks in the eurozone about the outsourcing of the cash leg of settlement transactions in central bank money to CSDs has prompted the European Central Bank to embark on a project, dubbed Target-2 Securities, to build a settlement platform of its own to serve the euro area. Instead of outsourcing, T2S, as it is called, would ‘insource’ the core securities settlement function of the eurozone CSDs to a platform operated by the ECB.
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