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STUDY of INTERNATIONAL CLEARING AND SE'ITLEMENT ADMINISTERED BY BANKERS TRUST COMPANY UNDER CONTRACT TO OFFICE OF TECHNOLOGY ASSESSMENT CONGRESS OF THE UNITED STATES VOLUME I This contractor document was prepared for the OTA Background Paper Trading Around the Clock: Global Securities Markets and Information Technology. July 1990, and the OTA report Electronic Bulls and Bears: U.S. Securities Markets and Information Technology. September 1990. This document does not necessarily reflect the analytical finds of OTA, its Advisory Panel, or its Technology Assessment Board.
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STUDY of INTERNATIONAL CLEARING A.ND SETILE~m AD~ BY BANKERS TRUST COMPANY UNDER CONTRACT TO oma: OP TECHNOLOGY ASSESSMENT CCNGlU:SS OF"nm UNITED STATES VOLUME I
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PREFACE This study of International Clcariug and Settlement was performed by the Bankers Trust Company Strategic Planning Department, Global Operating and Information Services, under contract L.3-0950.2 of the Office of Technology Assessment of the Congress of the United States (OTA). All errors contained herein are the sole respoDS1bility of the contractor, and not that of any of the experts who participated in this study. In 1988 the Strategic Planning Department, Global Operating and Information Services, responded to an outstanding request from the Office of Technology Asses.went ior bids to perform this study. Bankers Trust Company's compensation is nominal and all experts involved in this study, without exception, are participating pro bono. All costs will be home by Bankers Trust Company, as contractor of the study. We gratefully acknowledge the assistance of those individuals and corporations who gave so generously of their time and information as part of this study of international clearing and settlement. In particular, we thank the experts who wrote the papers for this study that we have used as the basis for our summary. Without their contnoutions, there would be no report. We are indebted to IBM, for its comprehensive research and report on technology in the clearing and settlement industry. Next, we thank the members of our advisory board for their willingness to provide us with assistance on the ~ues and problems which arose during the course of our work. Furthermore, we thank all of the clearing houses, depositories, exchanges, market participants, and custodians who participated in the survey we conducted as part of our research. Their survey answers helped us to identify the prevailing practices in the clearing and settlement industry, as well as the risks and problems which the industry faces in the world's major markets. We also thank all of the people who worked so hard to organize the tremendous amount of information we received for this report and to assemble it into the study that we now present to you. F'mally, we thank Frances Grace, our editor, without whom this report would have no chance of being read by any literate human being. Dennis M. Earle Giulia F. Fitzpatrick Jane F. Fried Bankers Trust Company October 1989 Page i
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Banken Tnlst Company Board of Advison/Obseners OTA Study of International Cleariq and Settlement Mr. Gerard Lynch Managing Oirector Morgan Stanley 1 Pierpont Plaza Brooklyn, NY 11201 Mrs. Andrea M. Corcoran Diredor Division of Trading and Markets Commodity Futures Trading Cornminaon 2033 K Street N.W. Room640 Washington, DC. 20581 Mr. Kurt Meuche Senior Vice President U Dion Bank of Switzerland Bahnhofstnwe 45 8021 Zurich, Switzerland Mr. Jonathan Kallman As-sistant Director Division Of Market Regulation U.S. Securities and Exchange Commission 450 5th Street N.W. Washington, DC Hon. Y osu.ke Kawakami Chief, Planning Section Ministry of F'mancc Securities Bureau Secondary Market Division 3-1-1 Kasurnigaseki Chiyoda-Ku, Tokyo TlOO Japan Professor Morris Mendelson The Wharton School University of Penasylvania Philadelphia, PA 19104 Profwor Hugh Patrick Columbia U Diversity School of BusinCM 522 Uris Hall 5th Floor 116th & Broadway New York, NY 10027 Mr. Gary Ginter Executive Vice President Chicago Research and Trading Group 440 South LaSalle St. Chicago, IL 60605-1092 Ms. Roberta J. Green Senior Vice President Loans and Credits Payment System Studies Federal Reserve Bank of New York New York, N. Y. 10045 IT IS TO BE CLEARLY NOTED TIIAT THE ABSENCE OF NEGATIVE COMMENT FROM EITHER ADVISORS OR OBSERVERS SHOULD NOT BE IMPLIED TO CONSTITIJTE APPROVAL OF THIS mJDY AS A WHOLE OR THE INDMDUAL PARTS mEREOF. Papii
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CONTRIBUTING EXPERTS PAR11CIPATING AFFILIATION COUNTRY TITLE OF PAPER EXPERT Ameriaua Baaken American Bankers U.S. Letter in re: Global Custody Assodatloa ~abOD Job P. Behof Federal Reserve Bank U.S. "wue Sum.maey: lntermarket of Chicago Cross-Margining For Futures And Options" William Bria,, Stock Clearing Corp. of U.S. "Stock Clearing Co~. of Philadel hia, Philadcphia And Philadelphia Philadel;hia Depository Depository Trust Co." Trust Company Mary Ana Callahan International Securities U.S. "Clearance And Settlement In The Cearing Corp. Intcrnatioaal Securities Markets: An Overview Of The Role Of The lntcrnatioaal Securities Clearing Corp." CFTC Supplied Commodity Futures U.S. 1. FISMOU agreement Doc:amenu Trading Commission 2. "Commodity Account Protection A Study By The Division Of Trading And Markets" James W. Chamberlain International Clearing U.S. "Netting Of Foreign EYcbangc Systeois, Inc. Trades And Other Obligations: An IDusttation Of The Use Of On-line, Real-time Clearance And Settlement Systems For The Quantification Alld Control Of Risk In F'mancial Markets" K. w. Chaa The Stock Excbange of Hong Kong In~ Hong Kong Ltd. Alger B. Chapman Chicago Board Options U.S. "International Securities Regulation Excbange In A Global Electronic Environment" Andrea M. Con:oraa & Commodity Futures U.S. "Maintenance Of Market Strategies SusanC.Enta Trading Comrnis.sion In Futures Broker Insolvencies: Futures Position Transfers From Troubled F'ums" E. Gerald Corripa Federal Reserve Bank U.S. "Remarks Before The Federal of New York Reserve Bank Of Richmond Payment System Symposium" Daiwa Securities Daiwa Securities U.S. "Viewpoint: Perception And America lac. America Inc. Opinions Of A Non-United States Parented F'um Doing Business In The United States And World Scc:uritics Markets" Euro-Clear Euro-Clear Euro Market -rhe Euro-Clear System" Federal Resene Bank of Federal Reserve Bank U.S. L "The Federal Reserve W"tre NewYork of New York Transfer Network 2 "Securities Lending" Page iii
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PARTICIPATING AFFILIATION COUNTRY TinEOFPAPER EXPERT Theodore H. Focht Securities Investor U.S. "The Securities Investor Protection Protection Corporation Act: An Overview" J.E. Gall National Australia Australia "The Australian Securities Market" Bank Limited D.J.L Glennie Hong Kong Shanghai Hong Kong "The Stock Evbange of Hong Bank Kong" Fred Hampton Depository Trust U.S. "D~tory Trust Company: ShortCompany An Long-Term Issues" John C. Hiatt & James The Options Clearing U.S. "Clearance And Settlement Of M. Kustusch Corporation Derivative F'mancial Instruments" Haas-Joaddm Hoessrich The Deutscher West "Clearance And Settlement In & Heinz.Klaus Ruetzel Auslandskassen.vere~ Germany Germany" AG Les Hosking Sydney Futures Exchange Australia Interview Philip Hubbard. Peter Chi~ Research & U.S. "Issues, Risks And Opportunities In Reed & Beth Shapiro Trading Group, Ltd. Clearing And Settlement" Kopin IBM IBM U.S. "IBM Study of Clearance and Settlement" ICCH ICCH United "ICCH: The Independent U nilled Kingdom Clearing House" The lnternadonal Stock The International Stock United "The International Stock Exchange Excbanp London Evbangc London Kingdom London: A Perspective Of Clearing And Settlement" Robert Kay Morgan Stanley Trust Company U.S. "Global Custody Issues" Joseph L Kolb Security Pacific National Trust U.S. "A Comparative Overview Of Current Clearing And Depository Company Systems", & "Reflections On The Work Of The Group Of Thirty, And Observations And Perceptions On The Important Issues Relating To The Global Marketplace" Margaret L Koontz National Securities U.S. "Clearance And Settlement In The Clearing Corporation Municipal Bond Market In The U.S.; An Overview Of NSCC's National System For Municipal Bond Processing" Messrs. Kuroda, Hlraao Bank of Japan Japan Intaview reflecting personal opinion & Oritaai of the experts John McPartland & Kim Chicago Mercantile U.S. "The Challenges Of The 24-Hour Taylor Exchange F'mancial Marketplace" KurtMeuche Union Bank of Switzerland Letter in re: Sharing of Risk Switzerland Information Page iv
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PARTICIPATING AFFILIATION COUNTRY Tin.E OF PAPER EXPERT Mwudpal Securities Municipal Securities U.S. "Automatr.d Clearance and Rvemaktn1 Board Rulemaking Board Settlement in the Municipal Securities Market: A Report to the Securities and Excbange Collllllis.gon", 1987. Charles W. Mooney, Jr. U Diversity of U.S. "Beyond Nef otiability: A New Penmylvania Model For ransfer And PledJce Of Interests In Securities Contro ed By Intermediaries" GeorpMuiler CEDEL Euro Market "CEDEL's Principal Activities In International Securities Clearing And Settlement" Nadoaal Futufts National Futures U.S. "Customer Account Protection Assodadoa Association Study" The Nomun Securities The Nomura Securities Japan "The Securities Clearing And Co., Ltd. Co., Ltd. Settlement System In Japan" Organization ror Organization for Multi-national "Arrangements For The Re~ation Economic Coopendoa Economic Cooperation And Supervision Of Securities and Dr..~opment and Development Markets In OECD Countries" Pac:iflc: Stock Excbanp, Pacific Stock Exchange, U.S. "Extended Hour Trading And Inc. Inc. Clearing And Settlement Issues" Randall J. Pozdena Federal Reserve Bank U.S. "24-Hour Fcdwire: Some of San Francisco Observations" Robert N. Reiss National Association of U.S. "Charaderistics Of The Securities Dealers, Inc. International Stock Market Of The Future" Angus Richards The Australian Stock Australia Interview Exchange Raymond J. RIiey & The Securities Transfer U.S. "Securities Transfer" Michael J. Foley Association, Inc. Thomas A. Russo Cadwalader, U.S. "Clearing Issues", presented at Wickersham & Taft ALI/ ABA Broker-Dealer Regulation Conference Jan. 13,1989 Roger D. Rutz Board of Trade U.S. "Clearance, Payment, And Clearing Corporation Settlement Systems In The Futures, Options And Stock Markets" SEC Supplied Securities and U.S. 1. Release No. 34-27044 Documents Evhaoge ColllJDiMion 2. Policy Statement: "Regulation Of International Securities Markets'' 3. Release No. 20221 4. Release No. 34-26626 Ian Shepherd & Llnda McKinsey & Company Australia "Towards A Framework For A Tullberg F'mancial Markct.c Infrastructure" Toshitsugu Shimizq Tokyo Stock Excbange Japan "Settlement System Of Tdcyo Stock Exchange" Pagev
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PARTICIPATING AFFILIATION COUNTRY TITLE OF PAPER EXPERT SICOVAA1 SICOVAM France "Key Recent Developments in France: The RELIT Settlement Reform Man: V. Slmoa11 & Keith Price Waterhouse U.S. "Globd Custody Issues" J. Fulmer Robert Tundermaa Canadian Depository Canada "Canadian Cearing And For Securities Ltd. Settlement Keitla Ussher Austraclcar Australia "Austraclear" Hajime Yoshioka The Osaka Securities Japan Written answcn to fr:.icific questions Exchange posed by Banken rust Robert W. Woldow National Sccuritics U.S. "Clearance And Settlement In The Corporation, U.S. Securities Markets: An International Securities Ow:rview Of The Role Of The Ce_arjng Corporation, National Securities Clearing and Government Co~ration In Equities Trading", Securities Clearing & learancc And Settlement In Corporation The Markets For Government Securities: An Overview Of The Role Of The Government Securities Oearing Corporation" Pap vi
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RESPONDENTS TO SURVEY OF INTERNATIONAL CLEARING AND SETIU:MENT CLEARING HOUSES AND EXCHANGES! A Terme Internationale de France Amsterdam Stock Exchangt:/Effcctenclearing Austraclear Limited Australian Stock ExcbanF Board of Trade Clearing Corporation Bolsa de Valores Montevideo Bolsa de V alores de Rio Janeiro Bolsa de V alores de Sao Paulo Bourse de Luxembourg Capital Market Authority Chambre de Compensabon du Marche A Terme International Coffee, Sugar & Cocoa Clearing Corporation Frankfurter Ka.s.,enverein AG Hong Kong Securities Clearing Co., Ltd. Madrid Stock Exchange Manila Stock ETchaage Midwest Securities Trust Co. Minneapolis Grain EYcbaage New Zealand Stock E,:cbaage Osaka Securities Evbaag~ Schweizerische Effekten-Giro AG Securities Oearing Automated Network Services, SON. BH. Stock Oearing Co~ration of Philadelphia/Philadelphia Depository Trust Company Stock Excbaage of Singapore, Ltd. Taiwan Stock Excbaa~e Corp. The Board of Trade o Kansas City The Canadian Depository for Securities The Chicago Board Options ETCbaag~ The ~o Mercantile E1:cbange The Pacific Stock Exchange The Tel Aviv Stock );Yt:Wx~ Ltd. The Tokyo Commodity r ange The Tokyo Grain Exchange Tokyo Stock E.1:cbanv, Trans-Canada Options Inc. V ancouvcr Stock Exchange V oerdipa~ccntralen Zurich Stock Exchange 1 One respondent requatcd anonymity. France Netherlands Australia Australia United States U~y Brazil Brazil Grand Duchy of Luxembourg Egypt France United States West. Germany HoqKong s Phillii,ines U nitcd States United States New Zealand Japan Switterland Malaysia U nitcd States Singapore Ret>ublic of China Umted States Canada United States United States United States Israel Japan Japan Japan Canada Canada Denmark Switzerland P:ige vii
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RESPONDENTS TO SURVEY OF INTERNATIONAL CLgARING AND SE1TLEMENT MARKET PARTICIP~ ABN Capital Markets Corp. Ace Koe1a Coey Ltd. Adams, Block & Coe Securities, Inc. American Pacific Securities Corp. Anderson & Bysma. Inc. Associated Planners Securities Corp. Australian Mutual Provident Society Banco Po~lare Commercio & Industria Bank of Italy Banque de Neuflizc, Schlumberger, Mallet (NSM) Banque Paribas Barclays de Zocte Wedd Gov. Securities Bateman Eichler, Hill Richards, Inc. Berkshire Ca~ Co Berliner HanacJs-un1 Frankfurter Bank Bielfcldt & Co1Dpany Block-Kelly Company. Boston Institutional Services, Inc. Brown & Groover, Inc. Brown Brothers Harriman & Company Bryan, Worley & Company, Inc. Cawe Centrale des Banques Populaires Cawe des Dq,ots et CoDsifJDations Ca Securities, Inc. r~!'!n d. -&'I& Investors Semccs, Lt Carret Securities, Inc. Cartwright & Goodwin, Inc. Century Investors of America, Inc. Charter ln\atment Group, Inc. Chemical Bank Fixed Income Churchill Securities, Inc. CL-Alexanders Rouse ~e), Ltd. Coastal rmancial Secunties Corp. Commercial Investment Alternatives, Inc. Cooper Investments, Inc. Coughlin and Company, Inc. County NatWest Securities Corp., U.S.A. Crandall Vickery & Company, Inc. Credit Commercial de France CRT Services, Inc. Cuna Brokerage Services, Inc. D. F. Green & Company D. G. Bank D. R. Dwyer Company Daiwa Securities America, Inc. Derby Securities, Inc. Diamant Investment Corp. Dimn Bretscher Noonan, Inc. Dominick & Dominick Futures, Inc. Dresdner Bank AG Dr=:! Burnham Lambert, Inc. Orem Burnham Lambert Holding, Ltd. Orem Burnham Lambert (Asia), Ltd. 2 26 respoadaus requested anonymity. United States Japan United States United States United States United States Australia Italy Italy France France United States United States United States West. Germany United States United States United States United States United States United States France France United States United Kingdom United States United States U Diced States United States United States United States S!nflporc Umted States United States United States U Diced States U Diced States U Diced States France U Diced States U Diced States United States West Germany United States United States U Diced States United States United States United States West Germany U Diced States United Kingdom Japan
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Dupree & Company, Inc. East/Wea Securities Company Edward D. Jones & Company Emanuel & Company E:rccution Services, Inc. FBS Capital Markets finaac:w Clearing & Services Corp. Fmscr Imestmcnts Company Fmt Albany Corp. Fust Canada Securities International, Ltd. Fust Chicaao IJM:Stmems Services, Ioc. rtl'St Marathon Securities, Ltd. Frank Ruuell Company G. X. Clarke & Company Garvey Commodities Corp. Geisel Grain Company Gill&. Assoc., Inc. Harold Dance Broke~ Harris Tnm and Saving., Bank Herbert B. White &. Company Hori7.on Securities, Inc. Integrated R~urces Equity Corp. Investment Account Services Corp. Inve.1ton Northwest. Inc. J. M. Saaoon & Company (PTE), Ltd. J. P. Morgan Securities, Inc. Jett Inwstment Co. Jordan Sandman Were, Ltd. Julius Baer Securities, Inc. Keefe, Bruyette &. Woods, Inc. Klcinwort Benson Government Securities, Inc. Lakeside Bank Langill & Company Lewco Securities Corp. Liquidity Fund Investment Corp. Mark Securities, Inc. Martin Nelson & Company Maxus Securities Company Maxwell Noll, Inc. McCaulhan Dyson Futures, Ltd. Mcinnes &. Company, Inc. Meeschaert-Ro1melle, Soc. de Bourse Merrill Lynch Midland Doherty, Ltd. ML &. Company Mo113;D Keegan &. Company Mumcipal In~ors Service, Inc. Municipal Securities, Inc. Murphy Favre, Inc. National Australia Bank National Nominees, Ltd. New England Discount Brokerage, Inc. Newbridge Securities, Inc. Nomura Securities Company, Ltd. Nomma Securities Northwest wvcstment Services, Inc. Ocean Securities Corp. Owen Reeder Pembroke Cearing Corp. Prudential Bache Securities United States United States United States United States United States U aited States U aited States United States Uaitt.d States Canada United States Canada United States United States United States U nitcd States United States U nitcd States United States U aited States U nitcd States United States United States United States S!zipporc U mted States United States New Zeafa11d United States United States United States United States U nitcd States United States United States United States United States United States United States Australia United States France United States Canada U Diced States United States United States United States Uuited States Australia Australia United States United States United States Japan United States United States U nitcd States U nitcd States United States Page LX
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R. B. C. Dominion Securities, Inc. R. G. Knox Corp. Richard J. Altobelli &. Company Robertson, Colman &. StepJiens S-S-T Clearing Company, Inc. S. G. Warburg &. Company, Inc. S. J. Wolfe&. Company Sage Rutty &. Company, Inc. Seattle-Northwest Securities Securities Corporation of Iowa Seidler Amdcc Securities, Inc. SLS Securities Company Spellman Capital Corp. Stone &. Youngberg Sullivan &. Cromwell Talley McNeil&. Tormey, Inc. The Bank of Tokyo, Ltd. The Chicqo Corporation Traub &. Com1any, Inc. Union Bank o Switzerland Union Planters Investment Bankers Group Wagner Stott Clearing Corp. Wheat Fust Securities, Inc. William R. Hough &. Company Pagex Canada United States United States United States United States United States United States United States United States United States United States United States United States United States United States United States Japan United States United States Switzerland United States United States United States United States
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TABLE OF CONTENTS Section 1 Introduction 1.1 Primer on Clearing and Settlement 1.2 The Clearing and Settlement Proce.u 2 The Clearing and Settlement Process in Major World Markets 2.1 The Clearing and Settlement in North America 2.1.l Clearing and Settlement in the United States 21.1.l Group One: Equities 2.1.l.l.A The National Securities Clearing Corporation (NSCC) The NSCCs Interface with the Stock Evbangr,s The NSCC Proccu Including the Interface with the Depository Trust Company Risk and Risk-Reduction at NSCC NSCC's Interface with its Clearing Members NSCC's Interface with the Banks 2.1.Ll.B The Stock Clearing Corporation of Philadelphia SCCP's Interface with the Philadelphia Stock Excbaoge The SCCP Proccu SCCP's Interface with Clearing Members SCCP's Interface with the Banks 2.1.Ll.C The International Securities Clearing Corporation (ISCC) The ISCC Process 1 21 23 26 31 34 34 34 34 34 36 3i 3i 37 38 38 39 39 .io 41 Pngcxi
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TABLE OF CONTENTS (CONTINUED) Sec;tion Page xii Depository Links Cearing House Links Custodial Links Services Offered by ISCC Only for U.S. Investors The ISCC's Interface with its Clearing Members The ISCC's Interface with the Ban.ks 2.1.Ll.D Equities: Buying on Margin 2.Ll.2 Group Two: Futures 2.1.1.2.A The Board of Trade Cearing Corporation (BOTCC) The Interface between the Chicago Board of Trade (CBOT) and the BOTCC The BOTCC Proc:eM Interfaces with Depositories BOTCC's Interface with the Banks 2.1.1.2.B Other Futures Clearing Houses The Clearing and Settlement Process Risk and Risk Reduction Interface to Banking System 2.1.1.3 Group Three: Options 2.Ll.3A Equity-Related Options-The Option1 Clearing Corporation (OCC) Introduction The OCC's Interface with the Exchanges The ace Process Risk and Risk-Reduction at the OCC Netting, Margin Requirements, and Cross-Margining The OCC's Interface with its Clearing Members 41 42 42 43 44 44 44 45 45 45 46 48 48 48 49 51 52 53 53 53 53 53 55 57 57
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Section TABLE OF CONTENTS (CONTINUED) The OCC's Interface with the Banking System The OCC's lnterfaQ with Depositories 2.1.l..3.B Options on Futures Contracts 2.1.1.4 Group Four: "Govies" United States Treasury and Agency Securities Introduction 2.1.1.4.A The Federal Reserve Bank and the FedW'll'e System 2.1.1.4.B The Government Securities Clearing Corporation ( GSCC) 2.1.1.S Group Fi\le: Mortgage-Backed Securities The Cleam'lg and Settlement Proceu The PTC's Interface with the Banking System 2.1.1.6 Group Six: Municipal Securities The Clearing and Settlement Process for Municipal Securities "Hot Issues" in the Cearing and Settlement of Municipal Securities 2.1.2 Clearing and Settlement in Canada 2.1.21 Equities: The Canadian Depository for Securities ( CDS) The Clearing and Settlement Proceu The Interface between CDS and its Participants The Interface between CDS and the Banking System The Canadian National Contingency Fund 2.2 The Oearing and Settlement Process in Europe 2.21 lotroductioa 2.22 Oearing and Settlement ofEurobonds The CEDEL and Euro-clear Systems 2.22.1 The Centrale de Livraison de V aleurs Mobillieres ( CED EL) 58 58 58 61 61 61 63 64 66 67 67 68 69 70 70 70 71 72 72 73 75 n n rage xiii
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TABLE OF CONTENTS (CONTINUED) Section Introduction n CEDEL's Interface with its Clearing Members 78 The Clearing and Settlement PrOCCM at CEDEL 79 CEDEL's Interface with the Banking System 80 2.2.2.2 The Euro-clear System 81 Introduction 81 The Interface between Euro-clear and its Participants 82 The Clearing and Settlement at the Euro-clear System 83 The Interface between the Euro-dear System and the Banks 84 2.2.3 Clearing and Settlement in France Societe lnterprofessionnelle pour la Compensation 84 des Valcurs Mobiliercs (SICOVAM) Introduction 84 The Clearing and Settlement Process 36 SICOV AM's Interface to the Banking System 86 SICOV AM's Interface with its Members 36 Future Trends 87 22.4 Clearing and Settlement in the United Kingdom 87 2.2.4.1 Equities: International Stock ETcban~ (ISE) 87 Introduction 87 The Clearing and Settlement Process for the ISE 88 ISE: the Payments Process 90 Future Trends at the ISE 90 2.2.4.2 Futures: International Commodities Clearing House, Ltd. (ICCH) 91 Introduction 91 ICCH's Interface to the Eu:banges 92 The Clearing and Settlement Process 92 Papxiv
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TABLE OF CONTENTS (CONTINUED) Section Interface to J3aDb 2.2.S Clearing and Settlement in West Germany: Kassenvereine (the KV's) and the Deutscher Auslandskasseuverein, AG (the AKV) Introduction The Interface between the DWZ and the Exc:baoF-1 The Settlement Proces.1 International Trading; Settlement of Trades Aaoss National Borders The Interface between the KV's and the Banks The Interface between the KV's and their Members General Observations 23 The Clearing and Settlement Process in Northeast Asia and Australia 23.1 Introduction 2.3.2 Clearing and Settlement in Australia 23.2.1 Clearing and Settlement in the Equities Markets The Interface between the Australian Stock &cbange and its Clearing House The Clearing and Settlement Proc:es.1 The Interface between the ASX Clearing House and the Banking System 23.22 Clearing and Settlement in the Futures Market The Clearing and Settlement Proc:es.1 ~ace between the ICCH and the Banking System 23.2.3 Clearing and Settlement in the Options Markets 23.2.4 Clearing and Settlement of Money Market Securities Austraclear's Pr~ and Interface with the Banking System 92 94 94 95 95 97 97 98 98 99 101 103 104 104 105 105 106 106 106 107 107 107 Page xv
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TABLE OF CONTENTS (CONTINUED) Section 2.3.3 Clearing and Settlement in Hong Kong: The Hong Kong Securities Clearing Company, 108 Ltd. (HKSCC) Introduction 108 The Clearing and Settlement Process of the soon-to-be Old System 108 The Role of the Banks and the Role of Registrars in the Settlement Process 109 Some Problems with the Current Proc:eu 110 The Clearing and Settlement Process of the Proposed New System 110 23.4 Ccaring and Settlement in Japan 111 2.3.4.1 Introduction 111 2.3.4.2 Clearing and Setde~ent in the Equities Markets 114 The Tokyo Stock EYcbange (TSE) 114 The Interface between the Tokyo Stock Pvbange (TSE) and the Japan Securities 114 Ocaring Corporation (JSCC) The Clearing and Settlement Process for the Tokyo Stock Exchange (TSE) 115 JSCC's Interface with Depositories 118 The Osaka Securities Exchange 110 The Clearing and Settlement Process for the Osaka Securities Exchange ( OSE) 120 The Inti.mace between the Osaka Securities E.vbange's Clearing Department and 121 Depositories The Interface with the Banking System, in the Clearing of Equities Transactions for the 121 both the TSE and the OSE 2.3.4.3 Clearing and Settlement of Bonds 12:? Overview 122 Settlement 122 Book-Entry Capability 122 2.3.4.4 Clearing and Settlement of Futures Contracts 122 Ovcrvi~ m Pagem
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TABLE OF CONTENTS (CONTINUED) Section The Ocaring Houc Pr~ 123 Futures Contracts: The Interface between the Ocaring Houses and the Banking System 124 2.3.4.S Ocaring and Settlement of Options Contracts 124 2.3.4.6 Ocaring and Settlement of Money Market Securities 124 2.3.4. 7 International Trading 124 3 Risk Facton in the Ocaring and Settlement Process 127 3.1 Error Risk 129 3.2 Failures in the Settlement Process (Both in Receipt and Delivery) 130 3.3 Risk Auociatcd with Foreign Evbaoge 130 3.4 The Risk that a Counterparty in a Trade Might Declare Bankruptcy Before the Settlement 135 Date, or, Might Otherwise Default on Payment or Delivery 3.4.1 How Ccaring Entities Protect Themselves from Defaults on Trades ( and Clearing 136 Members) 3.4.2 Default on Trades Not Processed by Clearing Houses, and Trades in Unregulated 139 Markets 3.4.3 The Risk to Individual Investors Due to the Failure of a Brokerage rum in the Equities 139 Markets 3.4.4 Clearing Entities Abroad and the Extent to Which They Offer Protection Against 142 Default 3.5 The Risk of a Oearing Entity Collapse 143 3.6 Risks Associated with the Banking System 145 3.6.1 Risks Associated with the Failure of a Bank 145 3.6.2 Risks Associated with Payments Systems: Delays and Differences in F"mality of 146 Settlement 3.6.3 Risks Associated with the Credit Proceu 150 3.6.4 Risks Associated with International :Ranking, and Other Issues 152 Page mi
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TABLE OF CONTENTS (CONTINUED) Section 3. 7 The Risks of the Failure of Collateral 154 3.8 Risks Associated with Increased Trading Volume 158 Oearing Houses and other Oearing Entities 158 Depositories and Banks 160 3.9 Risks Associated with Transfer Agents 161 3.10 Risks Associated with Technology and Computer Security 163 3.11 Differences in Clearing and Settlement Practices: Worldwide Variations Between Markets 167 3.12 Availability and Reliability of Information In International and Domestic Trading 1 iO 3.13 Risks Associated with Tax Withholding and Tax Reclamation 172 3.14 Risks As.wc:iatcd with Global Custodians 1 i-+ 4 Trends: Emerging Trends and Their Potential Implications for the Clearing and Settlement 179 Process 4.1 Extended Hour Trading 181 4.2 Increased Globalization 184 4.3 Linkages of &cbanges, Clearing Houses, and Depositories 186 4.3.1 Domestic Linkages 186 4.3.2 International Linkages 18i 4.4 Regulation of the Clearing and Settlement Process 190 4..5 Cross-Margining 194 4.6 Netting 196 4.7 Automation of the Clearing and Settlement Process: Organizations Automating for the 198 F'"U"St Tune, or Increasing the Degree to which Their Operations are Automated 4.8 The Immobilization and Dematerialization of Securities Certificates 200 4.9 The Sharing of Risk Information Between Markets, Exchanges and Clearing Houses 203 Page xviii
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TABLE OF CONTENTS (CONTINUED) SecUon 4.10 Standardization of Clearing and Settlement Procedures (Including Reduced Settlement Tunes) 5 Foreign Perspectives: Clearing and Settlement in the U.S., as Seen by Foreign Investors The View From Canada The View From Japan 6 Survey Results 6.1 Results of the Qearing House and ETcbanv, Survey 6.2 Itc:sults of the Market Participant Survey 7 Market Break Reports: Review of the 'g'l Market Break Reports as They Relate to Clearing and Settlement 8 Technology in Clearing and Settlement Index 204 209 211 212 213 219 233 24i 257 261 Page xix
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STUDY OF INTERNATIONAL CLEARING AND SE'ITLEMENT EXECUTIVE SUMMARY Pagel
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TABLE OF CONTENTS Section Pagel
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Study of International Oearing and Settlement Executive Summary EXECJJTIYE SUMMARY The EJeCUtive Summary is meant to serve as a short review of the finding., of this study. It should be read with further reference to the other sections of this report and to the expert papers which were submitted for this study. What Js CJe1dn1 and Settlement? And Why Is It Im11ortant? The words "clearing and settlement" are far from catchy. And they arc unlikely to turn heads in an elevator, as a phrase overheard. Nonethcl~ "clearing and settlement" is a vital area which affects the health of the United States economyand every other nation1s domestic markets as well as the orderly, succ~ful functioning of the global economy. "Clearing and settlement refers to the processing aspect of tradmg on the world's stock, 1 futures, 2 and ~3 exchanges, as well as the processing of trades which are done outside of any organized evbangc_ 4 Generally speaking. "clearing and settlement" is what happens after the trade everything from double-clicclring and confirming the terms of the transaction to paying for and delivering the traded financial instrument. 5 "Clearing"6 is the process of confirming and matching (after the trade) the terms of the deal: how much is being bought and sold, at what price, on what date, from which s;eller, to which buyer. "Settlement" is the fulfillment-by each party to the trade-of the obligations of the trade. For example, in the equities markets, to the buyer, "settlement" means payment; to the seller, "settlement" means delivering the traded financial instrument ( or transferring ownership) to the !buyer. The way that trades are proces.,ed varies greatly accordmg to the type of financial instrument which is being traded; accordmg to the exchange (if there is one) on which it is beuig traded; according to the institutions which are involved in the processing of the trade (for instance, a clearing house, a depository, or both), and according to the country in which it is being traded. 7 1 2 3 4 5 7 Banon'sDictioaaryof P'mancc and lmabnentTerms (1987) def ma stoct" as ownenhipof a corporation represented by sbua tbac are a claim on the corporatioa's caminp and aacts. "Pucurea contnc11 are agrecmcatl to buy or sell a specific amount of a product (for example, com or gold), currency (for~ dollan or ,en), or rmuc:ial illltlWIICIIC (for example, iDdael on suxa or bonds) at a given price on a specific dale ill die future. "01xionl caatnct1 ue coatnct1 whicll give the hokier of the coatnct the rigbt but noc tbc obliption to buy or scU a specific quantity of a giYeD ptoduct or (UIIIICW inltnment, up to or at a giYeD time period 1n the future, at a specified price. Ia the U.S.. OYer-tbe-Counter stocks are one p>d example of financial illlb'Uments which are not traded through a stocteshaage. 8anon'1 Dictionaly of Finance and lnvatmcnt Tenn1 (1987) defines a financw iJWnamcnt as a tepl document in which some contnctuai relationlbip is giw1I fomw expreaion or bywhicb some rigbt is granted for example, notes. contnletl, apecmcntL Stocki, bonds. futures contradl, opciona conb'ICU, and treuury notes are ail financial illllnamentL 1be tenm c1eanng-and scttJemcnt take on diffcringmcaainp depending on the cype of financial instrument involved (eqwticl, opdonl or futura). The defiaitiom UMd bcte are meant to acquaint tbc reader, unfamiliar with clearing and sctticmeat. wim die aencm DOCioa o1 wnaa tbe procaa ilM>IYeL T~ ia aJlo extremely dependent on the type of illlmment ilM>hed. Por eumple, the tcnn margm is often Uled ,a equines to mean a dawn payment oa a purctme of a saoct. while ia opdonl and futures it refers to paymea11 to imun: the performance o( tJic coatnct. Yet even futures and opcionl expens UN the term differently to reflect the fact that the rnupna are not cak:u!ated or Uled in the same way ia their respective markets. Similarly thae an: natioaaJ differences m tmninololY wbicb aced to be recognized: for example, trade marchingin the U.S. ii often referred to cbcctinS-in tbc U.lC Page 3
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Study of lntemational Ceariag and ScttJemcnt Executive Summary Many markets haw institutions known as "clearing houses," which most simply put handle both the clearing and some aspects of the settlement proccMCS This is the most common system in the U.S., although it does not apply to trade., of all types of financial instruments. Many markets, including the U.S., have institutions known as "depositories," which hold stocks and bonds for safekeeping on behalf of their owners. The depositories allow stocks and bonds to change ownership by "book-entry" (that is, arecord keeping entry) rather than through the physical exchanging of the securities. In markets where clearing houses do not exist (for exampl~ in many European markets), depositories may handle functions which might otherwise be handled by clearing houses. There are also markets in which neither clearing houses nor depositories exist: foreign currency trading is a good example. There are many reasons for the dil'ferences in the. way that trades are processed; internationally, variations in the clearing and settlement process can often be traced to historical, economic, and c:u1tura1 differences. Some of these differences add up to extra risk for the investor; other differences in the way that trades are processed arc merely that ditl'erenccs, which do not in themselves carry any additional risk for investors. Domestically, from a U.S. perspective the clearing and settlement industry is a healthy one a good news story in the U.S. economic landscape. But, as in any business, unless the industry continues to change in reflection and anticipation of changing business conditions -it could f?Jl behind. The need to keep pace with the times is just as aitical in the domestic markets of other nations and because of the inaeascd interrelationship of the world's markets the progress of each nation in meeting these challenges is important to all other nations. Ways to Improve the c1eadn1 and Settlement Process; an Ovemew or Eu,erts' Major Observations and Issues Reqpidn1 Action The stability of the world economy the trillions of dollars of capital which is invested in the world's market.s depends upon the success of the clearing and settlement process. The experts who contnbutcd to this study identified many issues which are currently under debate in the clearing and settlement industry. Given the diversity of experts who contnouted to this study, it should come as no surprise that there was not always agreement on the best way to approach each wue. Some of these issues are of a policy nature which could benefit from action on a national and/ or international scale others might best be addres.1Cd by the private sedor, working independently or in conjunction with governments. In keeping with the purpose of this study the identification of issues which might benefit from Congresuonal action we have clasmied each recommendation according to the type of action which our experts have indicated might be appropriate. Issues which could be addressed by the U.S. Congr'CS.' on a domestic level have been classified as DOMESTIC; issues clasmied as INTERNATIONAL arc those which could be addressed on an international seal~ by more than one government; issues marked as PRIVATE SECTOR arc those which could be addres.,cd by the industry it.~ although government action might still be appropriate. There arc five basic areas in which our expe~u have identified issues needing resolution. They arc: Risks Associated With Default; Risks Associated with the Payment Process; Information Sharing; Technology; and Standardization. In presenting each group of issues, we have first provided a short d.isc:u.won of the background information necessary to understand our experts' views .Page 4
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Study of International Cearing and Settlement Emcutiw Summary 'DJe Blsks oC the CJeadu1 and Settlement Process In the business world, as in all other areas of human enterprise, there is no process which is risk free. Nonethclca, especially in respect to financial affairs, there is a natural tendency to try to seek the optimal combination of risk and return. What are the risks of participating in the financial markets? Brought down to its simplest levei they are similar to those of any other commercial enterprise. The chief risks would be either a change in the value of the product (for example, the decline of a stock price) or the chance that one party to the transaction will either be unable to, or will refuse to, honor his contractual obligations. In other words, the buyer could be caught having paid for whatever he purchased but the seller might default and not deliver whatever it was that the buyer purcbas.cd. The reverse could also be true: the seller could deliver, and be left holding the bag if the buyer defaulted and failed to make payment In every market that we studied, the clearing and settlement process did act to reduce the risk of default and other risks to participants in the financial markets. The degree to which the clearing and settlement p~ reduces risk varies from market to market, and country to country, depending on the way the clearing and settlement process is set up in a given market, and upon the nature of risk in that markeL Internationally, there are significant differences in the actual degree of risk that is present in the clearing and settlement proceu; in the perception of the amount of risk which is present in the clearing and settlement process; and in the amount of risk which is considered to be acceptable in any given markeL Qearing houses, depositories, regulatory agencies, and other organizations involved in the clearing and settlement proc:c:u have a variety of techniques to protect market participants against the risk of default and other risks (such as the failure to honor contract obligations in a timely manner, human and technological error, and problems ~ed with high volume trading). 8 In many major markets, including the U.S., protections against default frequently include the monitoring of the financial health of market participants and the maintenance of guarantee funds.9 According to many experts, while it seems reasonably certain that a U.S. clearing house or depository could not be caused to fail as a result of any one particular risk, this is not true in all other countries. In a world in which market participation is increasingly global, it is possible that the failure of a foreign clearing.entity could impact a U.S. clearing house through the financial effects on a common clearing member.lo It is again reasonably clear m the mind of most experts that the U.S. clearing and depository bodies would be able to absorb the impact of such domino effects. This is not to imply that there are not events which could overwhelm the financial system as a whole and in turn acate a situation beyond I The amount of procection vuia pady, apia depending upon the orpnizations im,otved. the markets involved, the country, die rep&aton, etc. Mally deuinl bOUla maintain paraatce fuada-moaeywmdl ia kcpc in raciw ia the ewnt tJlat it ii needed to cowr tbe fmancial obliplionl of a defawan1 daring member (a ruarut participant wno iaa member of the clearing house). 11 Not all martct ~II are memben of a clearing orpnizatioa. A clearing member is a mamt panicipant who, puticiput ma daring organization. dean and settles oa bia OW11 bcbalf and pernapa for thOle market participants wbo are ctearin1 memben. A common ctearing member would be a institution registered as a clearing member at bodl clearing houla, in tbia cae in separate countric&. If the customer of a clearing member were to fail, the first line of dcfemc bccoma the rmanciat integrity of the clearing member icself. PagcS
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-Study of llltemadoaal Ceariq 111d Settlement F.m:udve Summuy the ability of all clearing houses and depositories to cope.11 It is for this reason as well as to improve the maaagemc:nt of day to day risks that the experts in this study have identified the mues which need to be addressed to coatiaue to upgrade the level of safetyofboth the domestic U.S. and the international clearing and settlement systems. Issues Regpido1 Action To Reduce lbe Risks oc Default In the U.S., the Securities Investor Protection Corporation (SIPC) provides protection to investors in the equities (stocks), bonds, and equity-related options markets. In the futures markets, the protections afforded to investors varies by excbaaF and is typically extended to cleariag members of that en:baage's clearing house. In non-regulated markets, such as foreign exc:baage, investor protection has not been implemented. There is no universal agreement on the appropriate level of investor protection in all markets. [DOMESTIC, PRIVATE SECTOR] Recognizing that no form of insurance can ever completely cover all l0S.1CS in all cases, inevitably some failures arc resolved through bankruptcy proceeding., under the Uniform Commercial Code (UCC). The UCC should be, and is being, 12 re-t'Vrniar,d to reflect the realities of today's marketplace, especially where it relates to the third party holding of securities.13 Laws dealing with bank liquidation also need to be modernized, upgraded, and made more consistent with other bankruptcy laws. [DOMESnC] International standards, particularly applying to guarantees (by clearing entities, banks, etc. both for the direct protection of investors and to keep a financial institution from collapsing) and otherprotedioas against default (iacludiag bankruptcy laws) have yet to be developed.14 Investors need to be made aware of the tremendous range that exists in the amount of protection afforded investors in various foreign markets. Investors should also be made aware that while guarantee funds serve a useful purpose, they can never be a free pass for protection against low grade investments. [INTERNATIONAL] The SIPC in the U.S., the Canadian National Contingency Fund, or the United Kingdom's Securities Investment Board contingency fund might be seen as models for the types of protection that might be developed in those international markets which do not now have any protection for their investors: The Canadian model is interesting in that its protections are offered through an orgaaization set up by the financial services industry rather than by the government, as is the case in the United States and the United Kingdom. [INTERNATIONAL, PRIVATE SECTOR) ll Ill tbeorJ, thae couid indude a major dilruplioa of the world's banking systems or collapae o( a major markeL In all caaa tblS problem would be orden of magnitude more severe than the failure of Ulc ctearing house icsclf and would wanut tblS attenlioa of aadoaal audloriua. 12 America Bar Alloc:iatioa project. 1be UCC ii accepced oa a state by saace bail and amcndmen11 to it would still lave open the pollibility of non-wworm treatment. 13 111 previoul yan when tbo marut exhibited a ,,uy and hokl mctbodology, cuatomcn wae inclined to hold their securitia. At, muteta move to a ,,uy, scil, buy, scU mode, C1IIIOmCn tend to leave their securities on depolit with tJlild-putia (banb, broken. depolitoria) to speed up the delivay of scaaritia. 14 At, put of tllil study Bankcn Tnat surve,ed major market puticipull and cJcarin1 houaa on a global buis to supplement the wort of ourputic:ipating experts. Sectioa 6 of tbil ,Ndy retlecu the quantitative basil for the sta1ement about iafl'IICnlCNraA differenca. Page6
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Study of International Cearing and Settlement Executive Summary Jsmes Requirin1Ac;tton To Reduce De Risks Associated With the Pmuent Process As tbe markets both nationally and internationally have expanded, there have been innovations and improvements in the way that market participants pay for their transactions. There has also been increased stress on payment systems, lS because of the increased volume and other demands posed by market partic:ipaats who are trading on an increasingly global basis. Our experts indicate that the.,e pressures are likely to inc:rea.,e with the arrival of 24-hour trading (which we discuss in the section of the Executive Summary entitled: "Future Trends and the Nature of Change"). Here are some of the issues which our experts have identified as areas for further study or action: Bank executives involved in making decisions about whether to extend aedit need to become more familiar with the mks and processes of clearing and settlement. In times of severe market volatility (such as the October "Kl market break), the lack of adequate information on which to base credit decisions could force some banks to restrict credit earlier than might be necessary. Such a restriction could aggravate a downward market spiral. Education of decision-makers in the banking indu.ury is an ongoing effort ( many changes have already been made to reflect les.was learned during the market break) and its inclusion here should not be presumed to imply that no action is being taken. The issue of education will always be one which requires constant vigilance. [PRIVATE SECTOR) As market participants inaeasiogly seek to undertake many transactions, quickly, a constraint can be the timetable which is available for "finality of settlement." "F"mality of settlement" is the point in time at which a payment becomes final and irrevocable. It can be compared to the time period between the moment a person writes a check and the moment that the check officially clears; until the check 006 clear, however, the writer of the check still has the ability to stop payment. Some payment systems, such as the U.S. Federal Reserve Bank's FcdWire electronic payment system, offer immediate" finality of settlement. This means that the moment the payment is made, it becomes irrevocable. Other payment systems offer "end of the day" finality of settlement meaning that the transaction is in-evocable after the close of busin~ of the day that the payment entered the funds transfer system. Other payment systems are on still other timetables in respect to finality of settlement In addition to the obvious convenience of avoiding delays in settling transactions, the timetable for finality of settlement is aJso significant in that the shorter the timetable, the 1~ the risk that something could happen (for instance, the bank could become insolvent) during the time period before the transfer of funds became irrevocable. The timetables for finality of settlement vary both within the U.S. (as FedWirc is not used to settle all transactions in all U.S. markets) and intemationally.16 [DOMESTIC, INTERNATIONAL, PRIVATE SECTOR) 15 1'aymea1s,aema ila fiDaDc:ia1 term Nferrin1 to tbe payment scrvica provided by banksnamely, checks and electr0nic ruodltnmfer. 1, Immedfare flnalit,y of settlement ii available ia the U.S. (througb PedWiN) and in Switzerland. The CHIPS payment = in the U.S.. the OIAPS payment system in the United Kingdom, and the SAGmAIRE payment system in ruce ue c:xamplel of payment systems wnidl offer end of day finality of settlement. Page 7
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Study of International Cearin1 and SettJement Elecudw Summuy One way to reduce the stress on payment systems is the "netting' of payments. "Netting' means that market participants are required to pay (and receive) only the net amount of their financial obligadoas (that is. amounts owed by a market ~cipant are reduced by the amounts of money that are owed to that same market participant).17 There arc SCMral types of netria~ "bilateral netting (in which the payment obligations, plus and minus, are balanced out between two trading parties who may have made a series of trades between each other); "multilateral netting (in which payment obligations are netted out betwe~n more than two trading parties, through a third party. such u a clearing house); and (in the futures and equity related options markets) cross-margining (in which a market participant's initial margin requirements are netted out aaoss the markets).18 There appears to be a consenaus among many of our experts that netting should be expanded, both for payment and securities dc1iwry obligations. Netting. in addition to relieving stress on payment systems, aJso increases liquidity for market participants and reduces the risk that a market participant will default on either payment or securities delivery. [DOMESTIC, INTERNATIONAL, PRIVATE SECTOR) Qaanizations Involved in the Oearin1 and Settlement Process; To What Extent Do Da: Reduce Their Risks By Sharin1 Infonnation About Market Participants? Most transactions in the financial markets involve aedit to some extent; therefore, the organization extending credit (for eDmple, a clearing house or bank) to a market participant must have access to information about the financial risks facing that market participant. Outside of the financial markets, for example, when an individual seeks a loan from a bank, much of the aedit information that the bank will use to evaluate the loan request will come from a central source such as the TRW aedit reporting service. The type of information provided by TRW could be called "risk information, as it details the amounts of money the loan applicant owes, as well as the loan applicant's pattcm of paying or not paying his bills. In the financial markets, although typically the amounts of money involved in credit decisions are much larger, there is no single source of risk information paralleling those available to lenders in the consumer credit market. Experts participating in this study have indicated that some organiz.ations in the clearing and settlement proces., (for instance, excbaag,--S and clearing houses). and some regulators, do have arrangements between themselves for the purpose of sharing risk information about market participants. The risk information sharing arrangements which do exist, however, arc limited in their scope in that they do not neccs.wily include all of a market participant's holding., and financial obligations. This 17 Nettiq can allO be UMd to determine the amount of securities or other financiaJ iastnaments which are owed the seller, or to tbe bu)'er. Not ail clearing boulCI or dcpOlitoria offer the netting of either payment or sccuriria dchvery oblipciom. 11 Croa,.margining ii a relatively new development. Its ~roponents argue tbac it should be expanded in the U.S. and aplored internationally. Othen argue mat the benefits reduction in the size of the payments owed by market paniciputs will be minimaJ. Page8
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Study of Intemational Cearing and Settlement Em:utive Summary caa place credit providers at a because increasinalv, many market participants are UM>1w:d in more than one market, 19 or more than one exc:bang,a..,~ and increasingly in the markets of more than one country.21 This fad bas led to a fairly global view tbat the sharing of risk information (information about a market participant's ezposure to risk througb his portfolio and bank loans, as well as information about tbat participant's creditworthiness) betv.un o,gaaizadoas involved in the clearing and settlement should be encouraged. There is no consensus, however, about how to inaeasc the sharing of risk information. Possibly because of the debate over HOW to accomplish this go8.4 some in the industry do not advocate an increase in the sharing of risk information. Jsmes Reqpido1 Action To Jmame the Sh1do1 o( Risk Intonnation Among those in the industry who do advocate that the sharing of risk information should be inaease~ there are a number of concerns about HOW to accomplish these goals. Each of these concerns arc issues which could be addressed on a DOMESTIC level (by the government of one nation), on an INTERNA110NAL level (by more than one government), by the PRIVATE SECTOR, or on all three levels: Because the data which constitutes risk information can convey a competitive advantage, there is coacem about who should obtain the risk information, where it should be kept, who should distribute it, and under what circumstances (i.e., should the information be continuously available? distributed on a periodic basis? available only upon request? available only at times of unusual volatility in the financial markets?). [DOMESTI~ INTERNATIONAL, PRIVATE SECTOR] Information sharing arrangements could benefit from increased automation, the development of a common format for the reporting and distribution of risk information, as well as the development of standards for the timeliness of risk information. Standards also need to be developed for the evaluation of different risks in different markets: for instance, the same dollar amount of financial obligation in one market may not carry the same a.mount of risk as the exact same dollar amount of financial obligation in another market [DOMESTIC, INTERNATIONAL, PRIVATE SECTOR) Information sharing has been developing internationally between regulators for some time. And bilateral links between clearing houses and depositories in various countries seem to have set the stage for more global sharing of risk information. One chief obstacle to increased information sharing on an international scale is the fact that there are often restrictions on the Oow of information aaoss national borders. Such restrictions, where they exist, need to be cased. These include unintentional restrictions ( such as differing accounting systems and differing technology levels), and intentional restrictions (such as limits on the aou-border transmittal of information about bank accounts and 1' Por aample equitica and opcioal, or optionl and fucura. 21 Par aunple. witbi.a tbc futures markers, a market partiapant migbt be a member of botb the Chicago Mercantile f!mange and die Clicago 8oud of Trade. 21 Por example, a major participant in tbe equities (stock) markets may well be inwlwd in the U.S., European and Japlaaeadlanpa. Page 9
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Study of International Cearin1 and Scttlemeat Emcudve Summary protectioaist .. motivated legislation OD what types of technology can be used in a given country). There are restrictions OD both the kinds of information that can be transmitted, and the manner in which it can be transmitted. [INTERNATIONAL] Iechnoloa In the C1earin1 and Settie,nent Jndusta22 In times of low volume, the sophistication ( or lack of sophistication) of technology may not have a significant impact on the clearing and settlement process, in terms of the risk of delays or errors. But in times of high trading volume, technology often is one of the factors which determines whether the clearing and settlement process will be able to adhere to the deadlines which keep the system operating in a normal manner. This di.cnssi"ll is only beginning to evolve and thoughts OD how to address it are cmemely preliminary. Most parts of the U.S. clearing and settlement system are technologically advanced, although there are some areas where improvements would be helpful. On an international scale, it is important to note that with the growth of investment aaoss national borders., assescrncnts OD risks and strengths associated with technology can be made only by examining both the technology base of the investor's home country and that of the countries he invests in. Here are some of the areas that, according to our experts, would benefit from further study and attention: Although the 21st century is now a stone's throw away, many organizations in the clearing and settlement industry worldwide (including many brokerage rums and banks) are operating at a level of technology that is insufficient to meet the inacasing demands of the marketplace. This lack of uniformity in the use of automation aeates obstacles both within many domestic markets, and in trading aaou national borders. Cultural and economic differences can make the task of increasing the level of automation a difficult hurdle to surmount. [PRIVATE SECTOR] Upgrades in sophistication at one organization (for instance, a clearing house) will not make for much improvement if its interfacing organizari,.,ns (for instance, brokerage firms) are noc at the same technological level While clearing houses have made significant strides in upgrading technology levels, the technological level of the clearing house's working relationship with its clearing members (the market participants it serves) cannot be any higher than the technological level of each clearing member. In other words, the technology is only as sophisticated as its least sophisticated link. In times of high volume this could become a problem. [PRJV ATE SECTOR] 22 Sued on of puticipating experts a1 well a1 the IBM contribution to our study entitled: "Ttchno/og'J in airr,,,aana s..,,,. . Page 10
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Study of International Ccaring and Settlement Executive Summary Standgmizatiog aC the Oeada1 and Settlement Pmeess Standardizadon refers to the creation of uniform codes of operation for both the "process"23 and the infrastructure of clearing and settlement. A strong impetus for standardization comes from the inaeasing globali7.ation of the world's markets and the associated trend to link clearing houses and depositories of many countries. In the absence of standardmtion these linkages can take inordinate amounts of time to develop. Among the world's major markets, the U.S. already enjoys a high degree of internal standardization of both the proc:es., and the infrastructure. Many other major financial markets are similarly homogeneous internally. When compared to each other, however, they appear significantly different. To gain some appreciation of the degree of international diversity, consider just one category by which markets are typically compared. namely the number of days that it takes to settle a trade. We asked market participants and clearing houses around the world to tell us the number of days required to settle trades of various financial instruments in their markets. The following chart shows the average of these responses by instrua.aent and by ~_phic region: North America, Europe, Asia and Australia, the Middle East, cmd South America.25 25 Proc:aa rcfen to such opentioaal upcc11 11 tbc method for trade maldling, tbc number of days to clear a trade, number of days to settle a trade, use of a depolitmy for holdin1 equities, use of a recognized numbering system for identifiyia1 fiaw:w UIIU'Umellu, fonnau for daca tnmmiaion. tJle method of paymenr.and odlc1'I. "tnfrutructurc rcfen to tbe mctbod of regu1adoa, mcdMnWDI to protect tbe clearing apimt the financial failunofactcaringmcmber,c:mtcnceoffuadltoprocectCUICOlllenofafailingb10kerorfunanscoaunillion merchant, bumaptcJ law to adjudicate the dilpOlitioa of CUIICOIDer me .. if a blOkl:r faill, credit pre c 11n at banks, clearing lacMIIO trade puaatca, capiw adequacy guidelincll. 11 well to bilateral tu tratia between nanona. Al put of tbil study, Bankers Trua Company surwyed major market pamcipanu, clearing bOUICI and ~torics forcommen11oavuioua upccts of tbe dcaring ud settlement procesa. The summuyof this suiwy appean as Section 6 of tbia study. Page 11
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Study of International Cearing aad Settlement &ecutM Summary SETTLEMENT DA TE: T+? A. VERA.GE # OF DAYS 8.0 .,_ ___________________________ 7.0 6.0 5.0 4-.0 3.0 2.0 1.0 0.0 EQ~ !ill] !Offl !IIIICl ... .... ... ... -------------~::: ... ... .... ... .... ... ... .... .... SOV. OBLIG. CORP. OBLIG. FUTURF.S OPTIONS OTHER DERIV. PHY. COMM. I EUROPE I 11 w/ !UfflALl! mJDll wr [I]) soUTB AiDICA As the preceding chart demonstrates, the amount of time that it takes on average to settle a trade varies widely anywhere from less than a day to more than a week. While there are specific factors influencing and determining these differences (i.e., the type of instrument traded, the market in which it was traded, technology levels in the various organizarions involved in processing the trade, and cultural fadors in the country where the trade occurred), it can be argued that it could still be possible to narrow the gaps in a move towards more uniform timetables for settlement, at least for similar financial instruments. Not all differences need to be eliminated for a system to be considered standardized. But elimination of some of the key differences could remove some existing stumbling-blocks to aoss-national border trading. It goes without saying that most major financial centers are as concerned about standardization in respect to efficiency and risk as is the U.S. financial community. There is strong international participation in the many significant efforts which are already underway with the aim of standardizing the clearing and settlement process for the equities markets. 26 Bwn ill effons already underway, government assistance can l'IO\'e uacfw if noc necessary. The Group of Thirty clearly n:copizcd tbat sccunties sbouJd be held at a depolitory (sudl aa Depolitory Tnast Company in the U.S.), rather than in die bands of individual investors, for pater ef(aciency. Al noted aboYe sucb efficiencies can prove m01t imponant in rime1 of market turmoiL Efforts to insure tbat sccunties are held only at depositories might well benefit from the action of individual governments, since issues of ownership and control are iDYOtved. Page 12
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Study of International Ceuing and Settlement Executive Summary The world's options and futures markets are already fairly standard in their procasiog However, in terms of the infrastructure of the clearing and settlement system there are major differences in the world's markets of which investon need to be aware. Issues Reqpirinz Action To Further Standardization With respect to the equities (stock) markets, concerns involving standardization have been addrcued by the Group of Thirty, the Emopean Economic Community, the Federation Internationale des Boursc de Valeurs, and the International Society of Securities Administrators. The nm step may be the approach which is suggested in the Mc:Kinsey expert paper done for this study-namely, the convening of an international conference to develop formal standards for the clearing and settlement industry. [INTERNATIONAL, PRIVATE SECTOR] Vtth respect to taxation, there needs to be an inaeased awareneu of the degree to which investon in certain foreign markets are put at a disadvantage. This is because when it comes to the withholding of dividends and interest, reciprocal treatment bet111een nations in most cases exists only in theory and not in practice. Even when tax treaties pertaining to the withholding of dividends and interest do em, our experts have indicated that they are sometimes flaunted. [INTERNATIONAL) The times and the days that banks and financial markets are open are not standardized either within the United States or internationally. Banks including the central bank of any given country, today may be closed even if the financial markets are open. By the same token the rmancial markets today may be open even if the banks are closed. This ~ue becomes more important now that market participants are investing in more than one country; with the arrival of 24-hour trading, globalization of investments is likely to increase along with the need for systems for timely payment. [OOMESTJC, INTERNATIONAL) Regulation in various countries runs the gamut from none to lots. This aeatcs great differences between markets with regard to risk. Among investors, there is a lack of awareness of not only the wide variety in rules and laws (including, in some markets, their absence), but also of the fact that there is a wide range in the degree to which th* rules are enforced. [INTERNATIONAL] Global Custodians: many investors in the world's equities markets ~riencc the clearing and settlement process only through their dealinp with the global custodian. r1 Therefore, no matter how great the improvements in the actual "process," their impact would be significantly blunted unless parallel improvements are made among global custodians. This is partially due to the fact that clearing and settlement pr~ are not standardized OD a global basis. Standards do not exist as to what constitutes a global custodian.28 Investors need to be aware of the lack of uniformity among global custodians (banks who bold securities and other rmancial instruments OD behalf of customers in foreign markets, and handle certain investment decisions and pt'OCCSsing on behalf of the customers). [PRIVATE SECTOR] rt The entity wbidl bolds securities ia multiple mamas on behalf of incellUltionaJ imacon. 21 'The lncemacional Society of Securities Adminisrnton may begin to undertake the tut of defining standards for global MNFfOdWM iJI 1990. Page 13
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Study of lntemationai Cearing and Settlement Executive Summary Future Trends and The Nature aC Chana Due to improvements in communications and technology, among other tbings,29 there is a developing global perspective on the part of investors. For many classes of investors, such as U.S. pension funds, it is no longer posstble to refer to their investment strategy as domestic. This trend toward globalization bas been accompanied by the introduction of new types of financial products (for instance, "baskets" groups of stocks, bonds, or currencies sold together as a unit), as well as the trading of financial instruments outside their home markets (for example, Japanese Government Bond futures contracts have been proposed by the Chicago Board of Trade, and the Chicago Mercantile E,:cbanr, has proposed to begin trading ~akkei stock market index futures contracts). Additionally, there is a move under-way to extend the trading hours of the world's major exchanges. In some~ evbaages are considering simply staying open longer hours. In other cases, exchanges are preparing to be part of 24-hour computerized international trading systems, some of which are c:urrendy in the final stages of development. Each of these trends poses new challenges for the clearing and settlement industry. Some of these developments encourage aoss-aational border linkages between clearing houses and depositories, 30 while others impact the myriad of institutions involved in clearing and settlement (such as transfer agents, global custodians, and banks acting as payment and credit agents).31 As the markets around the world realized that they were in competition with each other for the global investor's capital rnmy ot them have made innovations to improve their competitive position. Improvements of this variety, taking place at various speeds in different countries, includes the estab&hment of depositories32 in markets where there are none.33 In addition, pre-dating the October '87 market break, there has been an ongoing private and public sector effort to reduce systemic risk in the markets in general. These efforts include the "netting" of financial obligations aaoss a broad spectrum of financial obligations as well as increased co-operation among the regulatory bodies of the world's major financial markets.34 2' 31 31 32 33 34 It ii no-common to fmd computer syaema which dilptay the price infonnatioa of many major marlcets at the same time and. via bip speed nctworb, ue able to dclMr that information to a multitude of i11Yaton around the world almOlt imtucaneouatJ. Computer syacma of this type indudc: NASDAQ, Nikkci, Reuters. and Telcratc. Por CDlll1)lc, in tbc U.S. the role of the lntemationa! Securities Ocaring Corporation ii to create and operate linkages between the major U.S. equitiaclearingcntitics( sucb a the National Securities OearingCorporation) and dcp01icories (sudl a the Depmitory Tl'\111 Company) with their foreign counterpans. la basic tcrms, Tramfer Agents act to record the owncnhip of corporate securities. Global Custodians are usually banlrll acting u the repmirory for securities in many countries for a panicular cJient. Dcpmitories, which hold siocb and bonds for safetecpinr, improve efficiency and reduce the risk of default by elimiaatin1 the need for the phylic:a& dctivery of securities at the time of a trade. The depmitory instead holds securities ill "book enuy form. transferring ownennip via a "book entry' ia a computer accounting system. The owner of a stock hdd ill book entry form will not. then. poae11 a paper stock cenificate. If a certificate exists. it is immobilized dim ii, held at tbe dcpolitory. Ail othersecuritia beinS bcJcl at a depalirory ue known a c1ematerialized meaning that tJlcJ no loapr have paper stock c:effif'acata and am onJy a computer book entrica. impovemcnts ill international martcts indudc: the setting up of aa automated securities dcpolitory in Japan; the dcWIOpmcnt of a new clearing and sctttcmcnc system for equicia in Hong Kong: and tbe exploracion in Wac Germany of the idea of allowing market panicipanta to borrow securities to meet me securities deli,,eryobliption of settling tndel (an amngement that ii aheady permitted in the U.S. and some other major markets). Both the Securities And Exchange Commillion and the Commodity Fururea Trading Commillion have been active and sua:eand in these effons. Page 14
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Study of lntemational Cearing and Settlement Executive Summary It is important to note that efforts to improve clearing and settlement systems, both domestically and internationally, will be ineffective unless they are on two levels: changes in the process and changes in the infrastructure. The increased globali7.ation of the marketplace furthermore mandates that any true reform of the clearing and settlement process will have to be on an international scale. In that light, while the private and public sectors of the United States can undertake to act as a leader in the evolution of the clearing and settlement industry, they cannot in the long term act alone. It is our hope that the ISSUCS identified through the research for this study will serve as a guide for discnssioa, action, and where appropriate -a launching point for further investigation. Just as important, it is our hope that this study will help to inaease both national and international awareness of the very real cballenge., which the industry must face if it is to take advantages of the opportunities presented by globalization and the advent of 24-bour trading. Page 15
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Study of International Cearing and Settlement Bm:utive Summary APPENDIX IQ EXECJJTIYE SUMMARY; Cmss Ketemim on Where To Get More Information on Each Group or Qhseaations and Issues A wide range of industry experts worldwide contnbutcd their knowledge and experience to this effort. Every paper bas significant value in its own right and addreues some or all of the issues referenced above. In order to provide the reader interested in the policy aspect of clearing and settlement a guide to these expert papers, we have identified those which are seminal to the issues being discussed as well as those which should be read to learn more about the background surrounding each particular issue. Risks AsSoCiated With Default To learn about the protections the Securities Investor Protection Corporation provides for investors in equities and equity-related options, please refer to the expert paper by Focht. Much research has been done on the question of continuing the futures contracts of investors in case of the failure of a futures cornrnisuon merchant. Please refer to the papers by the National Futures Association (NF A) and by the staff of the Commodity Futures Trading Cornmission (CFI'C) and the paper by Corcoran and Ervin. To learn more about the Uniform Commercial Code, its role in the failure of a financial services firm, and suggested improvements, please consult the paper by Mooney. .. Risks Associated With De Pam,ent Proc:ess For background reading on payment systems in the U.S. and other major markets, please refer to the Bank for International Settlements' study Paymmt Systems in Eleven Developed Countries" ( this volume is not indudedinour study). For an overview of policy issues relative to international payments please refer to the paper by Corrigan and the paper by McPartland and Taylor. To understand more about the impact of the trend toward 24-bour trading and its impact on the banking system please consult the paper by McPartland and Taylor, page 26 and following. A view of the complexity of this issue comprises the entire paper by Pozdena. The most comprehensive disamion on the netting of foreign e.xcbange transactions is the report by the Bank for International Settlements: Report on Netting Schema, February 1989 (the text of the BIS report is not included in our study). The reader may also wish to refer to the paper by Chamberlain (included in our study), which provides a comprehensive view of how one properly constructed foreign e.vbanp netting service was built. cross-margining" is covered by a number of expert papers: Recommending crasrm~ Hiatt and Kustusch Hubbard, Reed and Shapiro Questioning the value of cross-m~ Rutz Page 16 page 22 and following page 3 and following page 40 and following
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Study of International Cearing and Settlement Executiw Summary Recommending a"margining while suggesting that a more system-wide approach called futures-style margining" be studied: Behof entire paper Foreign views OD the utility of a-cm-margining differ even from those in the U.S. who oppose it. For more OD this, please refer to the correspondence from Kurt Meuche (included in this study). De Shanna of Risk Intonnation For more OD the status of information sharing in the U.S. today, as well as on many of the issues associated with the process, please refer to the following papers: Woldow ~ginning OD page 20 Hiatt and Kustusch 1,,!ginning on page 16 Rutz cliscumons begin on page 20 and page 44 Chapman beginning OD page 12 Brigp l,,!ginning on page 13 Additional information can also be obtained from the report of the President's Task Force on Market Mecbaaisms (Brady Cornmiufon) and the Working Group Recommendations Regarding Clearing and Settlement which are not included in this study. An eJamplc of regulator-to-regulator of risk information can be found in the paper submitted by the Commodity Futures Trading Commiqfon. For more on the efforts of organizations which have been working on issues involving international coordination, including those related to sharing of risk information, please refer to Exhibit II ia the paper by Chapman. This paper also provides valuable insight into the complexity of this issue on an international scale. The issue of differing national perceptions of risk is a very complex subject. The paper submitted by Corrigan and the paper by Shepherd and Tullberg both provide a good overview of the macro level risks ia the international arena. Almost every paper contributed by an international participant has addressed efforts underway in each market to improve efficiency and reduce risk. The key concept which must be understood is that there arc legitimate international penpectives on what constitutes efficiency and what is "risk". It must also be understood that foreign entities do not always see the U.S. process in the same light as U.S. market participants do. For additional reading on this please sec the following: Daiwa entire paper Meuche conespondencc Yoshioka page 8 Tunderman page 13 Nomura Securities page 15 Page 17
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Study ol Iatemational Caring and Settlement Execucive Summary Iecbu0Jou The IBM study of the use of technology in clearing and settlement provides a very comprehensive view of the background and issues auociatcd with technology. Information on specific technology in use in international markets can be found i the papers of participating international experts. Stmdardization; Yiewed rmm a Domestic; cu.s,} Perspective The U.S. clearing and settlement systems enjoys a high degree of standardization in both processing andinfrastructure. To lcammore about the U.S. system, please refer to the following papers describing both the clearing and settlement proceu and its associated infrastructure: Discnssion of equities: Woldow Brig, Discussion of futures: Rutz Discussion of depositories: Hampton SEC entire paper entire paper entire paper entire paper entire paper entire paper Standardization; Yiewed From An Intemational Perspective For the reader wishing to learn more about the international diversity of clearing and settlement there is no shortcut to reading the papers contnl>uted by experts in each country. Several contributors to this study have e.vrnined efforts aimed at strengthening the infrastructure of clearing and settlement. For more on this, please refer to the papers by Corrigan, Chapm~ Kolb, Pacific Stock Evbange, Rew, Shepherd and Tullberg, Nomura Securities, as well as Simons and Fulmer in their discussion of international tax treaties. For more information on global custody and its related issues please refer to the expert paper by Kay as well as that by Simons and Fulmer. Additional wues relating to transfer agents can also be found in the paper by Riley and Foley. An excellent prospective on the status of international regulation can be obtained by the OECD report included in this study. Additional perspectives on the ~ues auoc:iated with international regulation can be found in the paper by Chapman. The policy statement of the Securities and Exchange C"mrnission in regard to "harmonization of international regulation is also included. Pagc18
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Study of International Oearing and Settlement Executive Summary International efforts aimed at standardizing the process of clearing and settlement are numerous and include the following (none of which are a part of our study, although the conclusions are taken into account in our report): the study by the Group of Thirty: C1ranu and Sdlemoat Systmu in dw World's Securities M"""'3", March 1989, about the standardization of the clearing and settlement process for equities, the study by the Federation Internationale des BoW'SC de V alucrs: Improving Intemationai S~, 1989~ discuuing aoss-national border linkages between clearing and settlement o,gaaizati'>ns, the study by the European Economic Community: stut.ty on improvanents in the settlement of ams-bordu securitia tnuuaction.r in the European Community", Dr. Joerg-Ronald Kessler, July 1988, regarding the use of depositories in Europe. Futun Trends And The Nature oc Chan&e To learn more about extended-hour trading. and 24-hour trading, please refer to the papers submitted by the Pacific Stock E,:cbanv, and by McPartland and Taylor. Page 19
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STUDY OF INTERNATIONAL CLEARING AND SETTLEMENT 1. INTRODUCTION Page 21
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Sectfop 1 latroduction 1.1 Primer on Oaring and Settlement 1.2 1bc Oearin1 and Settlement Pmcesa Page 22 TABLE OF CONTENTS 21 23 26
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L INTRODUCTIONTOTHESTUDYOF INTERNATIONAL CLEARING AND SE'ITLEMENT 1.1 PRIMER ON CLEARING AND SET11..EMENT Study of International Ccaring and Settlement Introduction This rudimentary introduction is intended to give a person unfamiliar with the clearing and settlement process enough background information to be able to read this report. It is not intended as a substitute for an in-depth eumiuarion of the expert views which are included in this study. Nor is it intended to serve as a substitute for our synopsis of those expert papers. Some may find the question and answerapproach primitive. Our belief, however, is that if this report is ever to serve in asssring Congres.,ional hcarinp, it must begin with the assumption that the proccs.1 known as clearing and settlement' is poorly understood outside the industry itself. We beg the reader's indulgence for what may, at times, appear to be an overly simplistic treatment of the subject. For a more detailed analysis, please refer to later sections of this study. Q: What is clearing"? A: Trades are made between buyers and sellers, either. at some type of meeting place known as an CJ'Cbangc, or off the cvbangc, directly between two parties. At the completion of a trading day, or some portion thereof, the buys and sells are matched. (That is, each buy order is matched with each sell order. If there is no discrepancy between the two, the buy and sell orders are then officially classified as a matched trade.) The matched trades are cleared for and moved along for settlement. Unmatched trades arc then researched and ultimately resolved. Q: What is settlement? A: In the trading of stocks and bond., settlement is the process of taking matched trades, and ftd6JJing tJie obligation to either deliver or pay for the traded securities. This means that on the settlement date, the seller delivers the securities and the buyer makes good on the money owed for his purchase. Although in stocks and bonds, settlement is the end of a proccu, in the futures markets it is the ~nning of a process. "Settlement, in futures markets, refers to the payment of initial margin as a good faith deposit, as well as the payment of daily variation margin ( which reflects the cbangfog value of the conttad). "Settlement, in the options markets, refers to the delivery or receipt of an asset ( cash or otherwise) to meet an obligation. Settlement obligations arc: the option buyer's obligation to pay a premium to the seller; the option seller's obligation to pay margin; and the obligation to pay or deliver upon the exercise and aignrnent of an options contract. Q: Why are clearing and settlement referred to as if they were one? A= Because together they comprise what is the trade processing aspect, or "back office," of all stock (equity), futures and financial instruments, and commodities trading. Page 23
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-Study of International Cearin1 and Settlement Introduction Q: A: Q: A: Q: A: Pap24 How would you compare the process of clearing and settlement to that of the trading process? As opposed to the spontaneous nature of the trading act itself, clearing and settlement is a more regimented proecs&. While both trading and clearing are governed by rules, regulations, practices, and other formal and structured means of doing b11siaess, clearing and settlement is a very technical businra in which the knowledge of the process is essential. While it is different &om the art of trading. clearing and settlement is no less important or sophisticated in its own right. Why do we know so little about clearing and settlement, if it is so important? Because, despite the turmoil of recent market problems, the clearing and settlement process has remained effective: it is a system that works. In spite of from market pressures, mraordiDarily heavy ti'ading volume, and various other risks in clearing and settlement, imMwatioa, and competition, the clearing and settlement ia.dustry performs remarkably well. Most of the knowledge about clearing and settlement is confined to the financial services industly and does not extend to the public at large. Why is it important to distinguish between the clearing and settlement process for equities, futures contracts and options? Because they are not the same. Each category of financial instrument is different, and these differences are mirrored in the differences in the clearing and settlement processes for each type of financial instrument. ~ refers to stock: financial instruments which give the owner a share of ownership in a company or corporation. One difference between equities and other financial instruments, in respect to the clearing and settlement proceu, is the use of the term margin. In the equities markets, margul refers to "buying OD margin the arrangement in which a broker's retail customer finances a securities purchase in part by means of a loan from the broker. "Futures contracts" arc contracts to buy or sell a specific quantity of a stock index, foreign currency, or other commodity at a given price, OD a given date in the future. In the futures markets, clearing houses require a good faith deposit., expressed as a percentage of the purchase price of the trade, payable on the day after the tracit-, this is called initial or original margin). "Variation margin (paid on the day after the trade) is also required; this is an amount of money (figured daily by the clearing house) which reflects the price change in the value of the futures contract. options" arc contracts which give the holder the right, but not the obligation, to buy or sell a specific quantity of a specific security, foreign currency, or commodity at a specific price within a given time period. Purchased options are fully paid for on the day after the trade. The seller of an option must post mar~ Margin in this case is a performance bond reflecting the option sellers ability to fu1.till the terms of the option contrad.
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Study of lntemational Cearing and Settlement Introduction Q: Didn'ttbe Pres.idcnt's Comrreissionon the 1987Market Break (The Brady Report) recommend a "unified clearing system? (That is, having a single clcaringmecbaaiw liandle all transactions for futures and equitie.,.) How do you acbiC\'e that if futures and equities arc different? A:. While tbe Brady Q\mmissioa used the term unify", the rrmmmendation of the Brady Report was NOT to cbaage the clearing and settlement processes for futures and equities so as to make them identical Instead, the recommeadadon of the Brady Report was to reduce market risk by consolidating information about the status of the holdings of market participants in various excbanges. Q: Is credit a key part of the clearing and settlement pr~? A:. Credit fuels the actual payments needed to make the settlement proc:c:u work. Credit is typically supplied in oae of two forms: a line of credit, or a letter of credit A line of credit is when a bank extends credit to a customer, allowing him to borrow up to a pre-determined amount. A letter of credit is an extension of credit by a bank to a customer, allowing for payment up to a specified limit, to a third party. Q: Don't all clearing houses operate in a basically similar manner? A:. In an abstract sense, yes. But in practical terms, the policies and procedures vary widely within the U.S. and abroad. Q: Why do we need to care about what happens outside the U.S.? A:. Because investment monies generally travel to what the investors consider to be the market or product providing the highest return. For example, take a look at the growth of U.S. pension funds uwesting abroad. Since U.S. investors are involved, we have a more than pawDg interest in the safety and efficiency of the foreign markets. Similarly, we have seen a continued growth in foreign investment in the U.S. markets. These foreign investors have meaningful interests, and rights, in the way we operate and in the way that relates to clearing and settlement in their country of origin. Q: Is the clearing and settlement process regulated? A: In the United States, the Scc:urities and E,:cbaag,: Commiwon (SEC) regulates the clearing house., which do busineu oa behalf of SEC-regulated markets. The Commodity Futures Trading CommiS-VQll (CFI'C) regulates clearing houses within its jurisdiction. The Federal Rcsene Board and the Comptroller of the Currency regulate the banking industry. Clearing and settlement is also regulated abroad. In international trading, regulation is by the government in the country of origin for the equity or other financial instrument being traded. The degree of regulation varies greatly. For example, in Japan. the Ministry ofrinance (MOP) has a strong de~ of regulation; in the United Kingdom, the Securities and Investments Board exercises a more remote role of supervision. This contrasts to the situation in respect to international instruments such as Eurobonds, which are cleared by Cedel and Euroc:lcar, a pr~ which is not regulated by any governmental authority. Page :ZS
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Study of lntcmatioaal Ocaring and Senlemeftt IDb'OductioD Q: Aside &om the clearing houses and the evbaages, who are the other players in the clearing and settlement process? A: The clearing and settlement proce&1 involves every company and every person who invests in a market, as well as their brokers. Here are some of the key players in the clearing and settlement industry: Banks, foreign and domestic, provide credit and settle payments. Custociiaos hold sccurities for customers. Depositories sene several functions. In markets where depositories exist, securities may be either immobilized (that is, the actual paper securities are held in the depository) or dematerializ.ed (that is, there are no actual paper securities certificates, just records of ownership). In either case, the depository maintains ownership records and, if its securities are dematerialized, it also handles the legal transfer of title. Transfer agents (when actual paper securities certificates are involved) change the name on the tide of a security after it cbanges band., in a purchase or sale. Registrars maintain records on who owns stocks and bond., and keep track of the wuance of stocks and bonds. (Note: there is some overlap between the functions of transfer agents and registrars.) 1.2 THE CLEARING AND SETit.EMENT PROCESS Clearing and settlement is the process in which the terms of the trade are confirmed ( agreed to), accounted for, and fnlfilled. This pr~ varies by type of financial instrument, by clearing house, by depository and by country. Oearing and settlement both domestically in the United States, and in other countries -is a heterogeneous process with no current degree of uniformity. There are many types of organizations involved in the clearing and settlement process some exist in one market but not another. For instance clearing houses play a key role in the United States and some Asian markets; in contrast, in many European markets., the focus tends to be more on depositories. The functions of clearing houses and depositories also can vary from market to market. For the purposes of this introduction to the clearing and settlement process, our discussion will focus on clearing houses rather than depositories. l Clearing houses, especially those set up along the U.S. model, tend to concentrate many different aspects of the proce.u within a single organization, while interacting with the other institutions involved in the procesL Our focus on clearing houses, therefore, gives the reader a view of clearing and settlement from the vantage point of the center of the process. 2 1 Theme of dcpOlit.oria ildilcuacd ill me ~Ec:oaomic Commllllityrepon: sllldyon i,nprot,an,.na in IJwmtimlffll of Cl'OS:l-bordlr scuntia transaaiolu in 1/w EuirJ,,ln &o,,o,,,ic C"""""11iq. Other SIUdics containing useful research oa tbil subiect include tbe Group of Thiny's 1-repon: ClaJrana aad S-.lmfe11 S,-,,,s in 1/w World'.r SuritiG Mllllral9 and the F~11 I~ dG Bouna M Va/an' 1989 repon: fmp,ov;ng IIIUfflOlional SetlloMnL 2 ID our SNdy we focua 011 what ii more c:ommon1y Iman a street-tide scttlcmat (settlement between brokers or between futuracommillioll merclwu1). While we dilCUllsome islua reprdingcuaomer-lide settlement (the settlement betweca a brobr and CIIICOmer), we did nocwritc this report from tbe CIIIIOIDCr's perspective. Pora discussion of customer (retail) scttlcment ('lcuc refer to the infonnatioa 011 OTC provided by tbe Securities and Exchange Commission in Volume D. In addiuon, the Group of Thirty's Working Group iD Nonb America will publish a repon later ia 1989 which deus with specific iSIIICS aaociated witb cuaomer-Gdc settlement. Page26
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Study of lntemational Cearing and Settlement Introduction Another reason clearing houses serve as a useful focus for our cliscnssion is the fact that they often act to remove risk &om the settlement process. They remove risk by providing both the seller and the buyer with a guarantee that each will l'eccm: eitbcr the payment due, or the delivery of the traded fiaaaciaJ instruments. In the U.S., the institution known as a clearing 1iouse has a number of important relationships which must be understood in order to determine its role in the financial services process. The newcomer to this subject may find it helpful to examine t.he diagram below, which illustrates the way that these relationships affect the clearing and settlement process. EXCHANGES CLEARING MEMBERS CLEARING HOUSE DEPOSITOR IE BANKING INSTITUTIONS A clearing house basically has four interfaces, or working relationships, with the outside world. The first interface is with a futures, equities, or other financial instrument c,Tcbange, from which the clearing house receives information on trades which are executed on that cxchange.3 Whether the clearing house is receiving previously locked-in trades (trades which have already been fully matched -that is, each buy order has been irrevocably paired with a corresponding sell order, with no price or quantity discrepancies), or whether it is doing the matching proccs.1 itself, the catalyst in clearing house operations is generally the interface with the excbaage. The second interface is with the clearing members of a clearinghouse. 4 A clearing member is someone who is allowed to clear trades directly through a designated clearing house. Other individuals or cntitie., trading on an evbaav-, who are not clearing members, must clear their trades through a brokerage or futures firm which is a member of a clearing house for that cxcbange. Through its relationships with its clearing members, a clearing house controls the risks of the clearing and settlement process. 3 The adlan~ lloM=ver, does nor ncceaarily have to be aa orpnizcd exdwlge. Por iastance. lbe clearing entity could be receiving information from a trade wtudl. wu done directly between two market panicipants. 111 some caa, clearing members, even if the trade wu done at an C2dlanp. haw the responsibility of reporting trade information to the clearing houlc (this ii true at the Board of Trade Ccanng CorporationBOTCC ror example) Page 27 ..
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Study of International Cearing and Settlement labOduaioa Every trade reported to a clearing house must either be directly for a clearing member, or, indirectly, for someone who is being repre.,cntcd by a clearing member. As such, the interface with the clearing members may indude a clearing house requirement that its members place monies in a guarantee fund as a protectioo agaiasr clearing member default. The cleariaghouse may also provide its members with a trade rccoaciliation process and advice on the settlement obligations of the members in the areas of both delivery and payment. The third interface is with the banks. The clearing house and the banks work together in the payment process. The banks aJso provide aedit to the clearing members. The fourth interface is with the depository. The depository records and arranges the legal transfer of ownership of securities, and holds securities for safekeeping. The clearing house sends instructions to the depository on bow the traasactioa is to be settled. The depository may act as an agent to reCCffe, on behalf of the clearing house, funds to settle the traasadion. Depositories do not exist in all markets. It should be noted that at least three of the components which the clearing house deals with also have relationships among themselves. Obviously, the evbauge bas arclationsbip with the clearing member; and the clearing members are usually members of the designat,..d excbaage. In turn, clearing members have rcladoasbips with the banks: in the sense that a clearing member must maintain an account at a bank in order to effect settlement with a clearing house. This circuitous arrangement is necessitated by the fact that the clearing houses themselves do not have direct ac:c:eM to the payment system. In addition, clearing members may maintain relationships with banks in order to obtain acdit. A third major relationship is between the banks and a depository. A bank may be acting in a custodial r~le, in which it is the trustee for a given instrument. When a bank is acting as custodian, instructions on payment and title transfer may be sent to the bank by the depository, and vice versa. F"mally, the depository, as a residence for immobilized or dematerialized instruments.. or physical instruments themselves, has an interface with the banks as custodian. It may also, in some cases, have an interface with the banks -for payment. Relative to the latter, it should be noted that at least three depositories in the United States bave, or are seeking permission to set up direct links to the Federal Rcscrve Bank. (These depositories are: the Depository Trust Company, the Midwest Depository Trust Company, and the Participants Trust Company.) Having examined at the most general level the question of what clearing and settlement is, we will now take a closer look at the proces.1 which the clearing houses and depositories are asked to undertake. The following sections of this paper will evrniae the clearing and settlement processes, systems, both current and proposed in: North America. Europe, and Northeast Asia/ Australia.
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STUDY OF INTERNATIONAL CLEARING AND SETILEMENT 2. THE CLEARING AND SETTLEMENT PROCESS IN l\1AJOR WORLD MARKETS Page 29
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Pap30
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STUDY OF INTERNATIONAL CLEARING AND SE'I*l'LEMENT 2.1 THE CLEARING AND SETTLEMENT PROCESS IN NORTH AMERICA PagcJl
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TABLE OF CONTENTS Sec;tfog 2.1 The Carin& and Scttlemeat Proc:aa in Nortll America 2.Ll Qearina ud Settlement in tbe United States 2.LU Group One: Equida 2.LLLA Tbe Nadoall Secmida Oearing Corporatioa (NSCC) The NSCCs Interface with tbe Stock Excbaaps TIie NSCC Procea IDduding tbe lllcerfacc wiell Cbe Depmicory Trust Company Ri1k and Rilt-Rcductioa at NSCC NSCC'a llltemce wida ill Qearina Memben NSCC'a llltaface wida tile Baab 2.1.1.1.B Tbe Stack Cearins Corporaeioa ol Pbiladclphia SCCP's lncaface wida tbe Philadelphia Stoct B.xmange TbeSCC-P!OCal SCCP's lnlafacc wida Oaring Memben SCCP'I Interface wida tile Banks 2.LLLC TIie International Securities Ccariq Corporation (JSCC) TbeJSCCPracell Depmi&my Liab Carias HoU1e Liab CUIIDdiall.iab Sefficel Offered by ISCC Only for U.S. lnYaton Tbe ISCC's lnterfac:c wiCII its Caring Memben The ISCC's lntmfac:c wiCII the 8ana 2.1.Ll.D Bquitia: Buying on Margin 2.Ll.2 Group Two: Punua 2.1.1.2.A '111c Baud ol Trade Caring Corporation (BOTCC) Tbe laaerface becween tbc Clicago Boud olTnde (CBOT) and the BOTCC TbeBOTCCPIOCCII lntelfaca witll Depmitoria BarCC's lntaface with the Banks 2.Ll.2.B Otber Futures Cearing Housa Tbe Cearins 111d Settlement Process Rilk and Rilk Reduction lllterface to Butia1 System 2.Ll.3 Group Three: Opriom 2.1.1.3.A Bquitr,,Related Opciom-Tbe Opriona Caring Corporation (OCC) IDbOductioa The OCC's Iaccrfac:c wiCII the Exdlanps TbeOCCPIOCCII RIK 111c1 Ru-Reduction ac ,11e ace Neuiag, Maraia Raquiremcnca, and Ct011-Margining Tbe OCC's Iaccrflce witll its Ccariftg Mcmben The OCC's lacafac:c wiCII tbc Banking System Tbe OCC's Interface wiCII Depmicoria 2.1.1.3.B Opriom on Puhll'CI Coatnc11 2.1.1.4 Group Pour. Oovia United Staca Treuury and Agency Securities latroduelioa 2.LU.A Tbe Pedcni Raerw Sant and tbc PedW"tre System 2.LU.B Tbe Oovemmem Sccuriria Carine Corpontioa (GSCC) 2.1.1.S Group P'MC Mo,.._Bldmd Securities Tbe Cearia1111d Senlcmeal Procal The PTC's laterfllce wida tbe Baaking Sysccm 2.LL6 Group Sue Municipal Secuitial Tbe Ocaring 111d SettlcmeDt Procaa for Municipal Securities 9Hoc ......-in die Ceuinc and Settlement of Municipal Sc:aarities 2.1.2 Ccarin1 and Settlement in Canada Pap32 2.1.2.1 P.quitia: The C2necti1a Depmitory for Securities (CDS) 1be Caring aad SettJcmenc Procea The latafac:e between CDS aad i11 Participant; The lnlelface between CDS aad the Banking System The C-edwa Natioaal Contingency Pund 31 34 34 34 34 34 36 37 37 37 38 38 39 39 40 41 41 42 42 43 44 44 44 4S 4S 4S 46 48 48 48 49 51 52 53 53 53 53 53 55 57 57 58 58 58 61 61 61 63 64 66 67 67 68 69 70 70 70 71 72 72
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Study of International Cearing and Settlement 1bc Ccaring and Settlement Proc~ In North America 2 THE CLEARING AND SETTLEMENT PROCESS IN MAJOR WORLD MARKETS 2.1 CLEARING AND SETl'LEMENT IN NORTH AMERICA The clearing and settlement process for NorthAmerica (United States and Canada) is a heterogeneous one. In the United States alone, there are nine clearing houses serving the 14 Futures Exchanges; one clearing house serves the five Options Evbaages and the National Association of Securities Dealers (NASD); seven clearing houses and depositories serw eight Stock Excbaages and the NASO; one clearing house for government securities, as well as a depository for mortgage-backed securities; and one clcariag house for international securides tracling.1 The clcariag and settlement proces.1 UM>hes many different clearing houses, depositories, and excbanps, and also occurs on many levels simultaneously. One level is at the clearing house; another is that of the clearing members (the firms which are members of clearing houses and are directly serviced by them); yet another level is that of the Fully-Disclosed Brokers (FOB's),2 non-clearing Futures Commjion Merchants (FCM's), and other market participants (including retail customers) who mmt be represented by others in the clearing and settlement procea. For the purposes of our djsc11ssion, we will first enmia,: the U.S. markets in detail in terms of the way the clearing and settlement proa:M varies according to the type of financial instrument which is being traded. In this way, the reader who might not be familiar with the nuances of the financial markets has an opportunity to learn some of the basic principles before turning his attention to analysis of practices in foreign markets. Our eumiaatfon of the U.S. markets is split into six groups: Group One: Equities (stock); Group Two: Futures; Group Three: Options; Group Four: U.S. Treasury and Agency Securities; Group Fm:: Mortgage-Backed Sec:urities; and Group Sa: Municipal Securities. In ca.,es where there is more than one clearing house serving a given market, we have profiled either the clearing house which is the largest in that market, or one which is representative of a category (for instance, the Philadelphia Stock Clearing Corporation was chosen for our summary as an example of a regional equities clearing house). The Canadian system for clearing and settlement is also diverse. There are two clearing entities serving Canada's four stock evbanges and two clearing houses serving ~c futures and options markets. 1 Par I lia of tbo clearing boUla and em1111gea. plcalo refer to page 3 ia the expcn paper submitted for this study by Ropr Rldz. 2 Pun,-Dildmed Broten do not belong to clearing houses themlc!Ya and mua instead rely on other brokers to represent tbcm at daring boulCS to complete tbe clearing and scttJement proc:aL Page 33
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Study of Internalioaal CCUUII and Sculcmcnt The 0euin& ud Settlement Procell In Nortla America In both the U.S. and Canada, there arc two trends which seem to be evident. The first is the product diversification of clearing houses which arc moving into new businesses in support of the market places in which their members participate. The second major trend deals with the clearing houses moving towards a continuous type of clearing capability, in support of 24-hour ( continuous, round-the-dock) trading. Underlying both trends arc significam changes in the way that clearing houses interface with the banking system. In the section which follows, we attempt to lay out the mechanisms and ~ues related to clearing and settlement in North America. We also attempt to identify for the reader specific., which correspond to tbe trends outlined in the prr.ceciing paragraph. 2.1.1 CLEARING AND SETrLEMENT IN THE UNITED STATES 2.1.1.1 GROUP ONE: EQUITIES THE NATIONAL SE~ CLEARING CORPORATION (NSCC) (S11mmf1 of the expert paper submitted by Robert Woldow for this study) In the clearing of equities (stocks and bonds) in the United States, the NSCC plays a unique role, in that it processes 95% of all equities trades in the U.S. Jointly owned by the principal equity markets that it scnes (the New York Stock En:banr NYSE; the National Association of Securities Dealers -NASD; and the American Stock Exchaoge-AMEX), this organi7.ation serves 1,800 brokers, dealers, banks, and other financial institutions. The NSCC's Interface witb the Stock Excbeaps The NSCC's clearing and settlement proccu normally requires five businw days. Trade information comes into the NSCC either in the form oflocked-in trades &om the computer systems of the exchange or market, or, buy and sell data reported by market par.ticipants. Data reported directly by market participants still needs to be compared and buy and sell orders must be matched. Locked-in trades are those in which the buy and sell orders have already been matched via computer trades which arc declared inevocable at the time the computer determined there was no disaepancy between the price or quantity in both the buy and sell order. Locked-in trades are directly entered into the NSCC computer system on the same day as the trade. The availability of locked-in trades sharply reduces the need for comparison (matching of buy and sell orders) at the clearing house level On a typical day, some 75 percent of the NYSE's trades are locked-in. Trades which have not been locked-in currently flow into the NSCC for comparison on the afternoon of the day following the trade (T + 1). Following the Odober 1987 market break, the NSCC decided to cbange the time of comparison to the early morning hours of the day following the trade (T + 1 ). This change is now being implemented. The NSCC Process lndudlq the Interface with the Depository Trust Company Trades at the NSCC arc settled in one of three ways: Continuous Net Settlement (CNS); balance order accounting; and trade-for-trade, depending upon the nature of the traded securities and the nature of the transaction.
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Coadaaoa Net Setdemeat Study of International Cearing and Settlement The Ca.ring and Settlement Pl'0CCS.' In Nordl America Securitica which are being bdd by the Depository Trust Company (DTC) in New York, whose oncrsbip can be cbangr.d via the DTC's computer book-entry system, are considered to be eligible for settlement through the NSCC's CoatiDIIO'll Net Settlement (CNS) computer system. The vast majority of trades settled through the NSCC are settled through CNS. For those trades, the NSCC provides a trade guarantee. This means that the NSCC becomes the counterparty to each trade, and guarantees that the settlement obligaaions of the trade both the obligation to deliver securities and the obligaaion to make payment will be met. The NSCC's guarantee takes effect at midnigbt following the time that the collllterpartica to the trade have been notified by NSCC that the trades ba\'e beeJP cfasaified as matcbcd, or compared. Most trades arriving at NSCC do L~atcb. Trades which do not match begin a reconciliation process on the second day following the trade (T + 2). Those remaining unmatched by T + 3 are returned to their originaring marketplace for face to face negotiation. With the increasing availability of on-line rccoaciliatioa systems this process is cbanging Using the CNS system, the NSCC calculates each day a net long or short securities position for each CNs-eligible security which wu traded by the clearing member on that day. This means that for each security traded, the gross amount of the clearing member's settlement obligation to either deliver securities or make payment is reduced by the amount of any securities or payments which he may be eligible to receive as a result of other trades of the same security. This type of calculation process is known generically as netting. The purpose of netting is to reduce both the total number of securities to be delivered or received, and the total number of payments due and owed, and the overall si7.e of those payments. Netting therefore increases market liquidity ( the total volume of securities available for trading at any given time), by reducing intermediary parties to the trade and correspondingly the grou amount of funds necessary to meet settlement obligations. NSCC's netting process is comprehensive. As a result of this offsetting pr<>e:CM, roughly five-sixths of the total daily volume of owed securities and owed cam payments is eliminated as obligations which otherwise would have been due on the settlement date. After Ddring through CNS, the NSCC then informs the Depository Trust Company (OTC) of the net amouat that each couaterparty owes in securities on the settlement date. The settlement date is the fifth msine.u day after the trade (T + S). Settlement of trades processed by CNS is electronic. The OTC, using its book-entry system, records the transfer of ownership of the purchased security by debiting the OTC securities account of the selling coum:erparty, and aediting the DTC account of the buying counterparty. Payment on the settlement date is in the form of a certified check, payable to the NSCC. When settlement cannot be effected on the settlement date, as in the case in which the securities were not available in the participant's OTC account, these obligations remain in the CNS system and are carried forward and netted with the nm: day's obligations. Securities which are not eligible for settlement through the CNS system may be settled either through balant= order accounting or on a trade-for-trade basis. through special order accounting. 3 J Tba number of tnda wbicb an not settled througta OlS, however, repracnca a very small percentage of the trades seflJed throup NSCC. Pap JS
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Study of Jaternatioaai Ceariq and Settlement The Carin& ad Settlement Procal IA North America BeJnce Order Accoandaa Trades settled through hsdaace order accounting. ewn thougb they do involve the physical delivery of scc:urities ( as opposed to computer book-entry transfer of title at the DTC), are still settled on a net basis. Therefore, at the end of the trading day, the NSCC compares the long and short balances for each CNS-ineligil,le security which was traded. The result of this DCttiag process is a series of figures which represent the cleariag member's net obligations to both pay for and deliver traded securities. The NSCC then iuues a "balance order" specifically stating what the couaterparties' obligations on settlement day will be, in respect to both payment and the physical delivery of securities certificates. The settlement date, as in trade., settled througb CNS, is T + S. NSCC guarantees completion of these trades also, but only through the close of \,1wacsa on T + S. This contrasts to the CNS settlement method, in that ttades settled through CNS never involve the physical delivery of 'securities certificates. This is because CNS-eligible securities do not leave the depository; their ownership is recorded and transferred solely through the DTC book-entry computer system. Trade ror Trade The third method of settlement at NSCC is called "trade-for-trade, which is accomplished through "special order accounting. What this means is that, for a variety of reasons, the counterparties to a trade may decide to settle a trade in a different manner and/ or on a timetable which is different from the T + S settlement date that is usual for NSCC trades settled through either CNS or balance order accounting. By example, if settlement is to be on a trade-for-trade basis, the counterpartics to the trade at the time of submisuon will indicate that the trade is not to be netted. Trade-for-trade items are not netted and are not guaranteed. The securities delivery might be electronic, through book entry transfer of ownership at the DTC; or, it might be accomplished through physical delivery of actual securities certificates. Risk and Rlsk-Reducdoa at NSCC The fail rate at NSCC (that is, the percentage of trades which do not settle on the settlement date) is low. 1989 NSCC statistics indicate that for trades cleared through CNS, the fail rate was 8.13 percent of the total net dollar value ( that is, the total net value of cash and securities due on the settlement date). Nevertheless, since the NSCC takes the counterparty position ( assumes the role of buyer in dealings with the seller, and seller in dealings with the buyer) and guarantees the settlement of all matched trades settled through CNS -NSCC is exposed to various risks. These risks, in broad terms, are: aedit, market, and non-market related risk factors. Credit risk relates to the powoility that a participant might not pay for securities delivered to him. Market risk relates to the potential for insolvency, prior to settlement, on the part of a participant with an obligation to deliver or r,:ccive. Non-market risks include loss of data, human error, systems failure, or any other error or breakdown caused by any fador other than aedit or market risk factors. Pap36
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Study ol lnccmational Ocarina and Settlement The Ocarina aad Settlement Process Ill Nonb America For the NSCC, credit and market risks are offset by its mark-to-market program, paying/receiving members hued on open positioaaafterT + S acompared to tbccurrent market price, and the existence of its clearing house guarantee fund, wbidl caa be used to recoup tbe losses that NSCC would suffer in the event of a default by a clearing member. NSCC's CNS clearing fund for CNS fadors in market movement on pending trades (i.e., before T + S); total me of all positions open; and, total amount of securities which can be allotted the nm day. This calculation is done daily for all members and variances outside parameters can be collected more &equendy than the monthly norm. All NSCC settling members are required to contribute to the guarantee fund. The NSCC also 11.1~ntaius a full compliance monitoring system to ensure its ongoing ability to judge the creditworthiness of its participants. la addidoa, the NSCC excbaoges risk information with other SEC-registered c1cariag houses, both througla tbc Secmides and Evbange Commission's Monitoring Coordination Group and the Securities Oearing Group. Evidence of the NSCC's ability to acc:uratcly monitor its clients' positions is reflected in the fad that in 13 years of operation, the NSCC has suffered losses in excess of a clearing member's available collateral only three times. The sum total of the unreaMred loues in thme three cases amounts to just $448,000. And only one of those loucs can be attributed to the Odober 1987 market break. NSCC and a number of futures clearing houses are holding discus.uons in respect to proposals directed at inc:rcasing the sharing of risk information. This would include information such as data on market participants' holding., on various c.vbang,i.s. NSCC's Interlace witb its Cleafflll Members The NSCC is linked to its clearing members by means of the Securities Industry Automation Corporation (SIAC}, which operates NSCC's technology base. Like most technology bases, this has evolved to the point where most participants have direct computer links, with only about 1 percent of the full service members continuing to report trades via computer tape. Access through multiple telecommunications networks and PC technology has also become more widespread in recent years. NSCC's Interface witb tbe Banks All payments to NSCC are on a net basis: that is, the NSCC calc:ulates each clearing member's total credit and debit positions and comes up with a single net figure that is either owed to NSCC or is owed by NSCC to a clearing member. Payment to NSCC is effected by certified check. Funds are concentrated in one central clearing bank. When a check is not received, Fed Funds (through electronic funds transfer) are required the next day. NSCC pays sellers with regular bank checks. If an adjustment is required in the amount due the seller, NSCC will send it by Fed Funds. NSCC has indicated a desire to move towards the increased use of cled:ronic payments, as opposed to checks, as one way to improve the settlement process. 2.1.l..1.B THE STOCK CLEARING CORPORATION OF PHIL\DELPHIA (Summl'J of espert paper submitted by William Bria,, ror this study) One of the six non-NSCC clearing and settlement entities for the equities market is the combination of the Stock Oearing Corporation of Philadelphia (SCCP) and the Philadelphia Depository Trust Company (PHD.ADEP). Through these entities, participants can record, clear, and settle trades, and receive all post-settlement security services, rcgardlCM of where the trades were actually executed. Page 'J7
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Study ol lnternalional Cariq and Sealemcnc The Ceariq ad Scttlemenc Procell In Nortb America SCCPs l.aterfac:e witla the Phlledelplda Stoct Ezdenp SCCP's function is somewhat similar to that of the NSCC. That is to sayit settles each of its clearing memben' accounts with stocks the c1earing members baw traded and with the cash the clearing members either received or paid to other clearing house members. Similarly to the NSCC, the clearing member is the point of contact for settlement; fully disclosed brokers, who arc not clearing members must be represented by a clearing member in tbe c:1earing and settlement proccsL A member of the Philadelphia Stock Evbanp cm clear trades at SCCP or at another equities clearing house. Similarly, a member of the Philadelphia Stock Excbange who also esec:utes trades on another excbange can direct that those cxecunOIII be settled at SCCP. Trades executed at the Philadelphia Stock Evbange are first matched by the brokers and then entered into SCC7s Purchase and Sale system (P & S), either automaricaJly or manually. An audit trail for distribution to members is distributed on T + L Each members' transactions are recorded by SCCP on pieces of paper known as "blotters. Blotters are distnl>uted to both bu~ and selling members in order to check the information and to make corrections. The P &. S system usc=s a one-sided entry method in which only one entry need be submitted for recording each cvbaagc trade. Trade corrections are manually entered. For
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Study of Internacional Ccarina and Settlement Tba Carini and Settlement Process la North America A Specialist Margin Armmd: is used exdUSMly by specialists malrjng markets in securities, with the margin set at 25 percent of the combiDccl Jong aad short politioas. 4 Margins arc reviewed daily, with aetring permitted cwerall tbe margin accomdl held by a member, to reduce the need to actually move funds. Margin calls must be sarisficd t.be same day that they are made. The Regional Interface Operation (RIO) ia the national system for routing trades to members' preferred clearing corporarioas. SCCP, NSCC, and tbe Midwest Clearing Corporation (MCC) are members. RIO trades are recorded ill the P & S system in the same manner as all other trade transadiom. They are tnasmined to the designrect clearing COl'pOl'3bOII on the following day. RIO accounts are used to settle these trades. Philadelphia Depositol'y (PHILADEP)-ctigiblc sccmirica are cleared by book entry movement between PHJL.\DEP and SCCP in a manner similar to that used in tnasac:tions between the NSCC and the OTC. Securities which are not PHILADEP-eligable must be cleared by physical delivery or rcccip(. PHllADEP accepts for deposit all a:rtifica1es meeting its eligibility requirements, including equity securities. corporate bonds, warrants, American Depository Receipts (ADR's), registered municipal bonds, and bearer bonds. Deposits accepted between 8:30 a.m. EST and 11:00 a.m. EST receive same-day aedit. As would be expected, PHILADEP also bandies dividends, interest, and reorganizations. PHILJ\D EP is also a participant in the DTC's National Institutional Delivery System (ID). (For a view of SCCP and PIDLADEP's assessment of risks in clearing and settlement, please refer to pages 13 and 14 in the expert paper submitted to this study by William Brigg.,.) SCCPs Iaterrace witla Cleariq Members While enjoying the advantage of on-line technology which can interface with the exchange, PHILADEP, and the DTC's ID System, a large amount of the clearing member interface seems to be paper-based. Trade corrections and member transactions are manually entered. SCCP issues four types of color-coded tickets to differentiate between trade cancels, non-CcntramartS Philadelphia Stock Excbangc (PHLX) trades, trade corrections, and bond trades. While the actual processing of the CNS system is teclmologically current, the fact that so much of the overall system still relies on paperwork prevents us &om being able to discuss the extent to which automation is a part of the interaction between the clearing house and its members. SCCPs Iaterface witla the Banks All cash transactions for settlement obligations mmt be satisfied daily with clearing house funds. Members have as many as two separate money settlements each day: one with SCCP, for CNS tnnsactions, and one with PHILADEP, for book entry receives and/ or delivery versus payments (DVP) transactions. Accepted forms for satisfying settlement obligations include: drafts or cashier's cbccks, c1ectronic funds transfer (EFT), and transfers among margin accounts. 4 Por more dcalil oa tbil plcalc refer to tbc c:xpen paper by William Brigp. 5 Tbe Pbiladc1pbia Stod: Emange's computer tndiag system. Pap39
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Study of International Carias anc1 Senlemeac The CeuiDs aad Settlement Pnxea la Nortla America 2.1.1.1.C THE INTERNATIONAL SECUIUTIES CLEARING CORPORATION (ISCC) (SPWINP'J ol Espert Paper by Mu, Alla CalJeben) The lntcrnatioaal Securities C1cariDg Corporation (ISCC), located in New York City, is a subsidiary of the National Securities Clearing Corporatioa (NSCC). It was founded in 1985 to as.mt in clearing and settling trades of stocks and bonds aaosa aatioaa1 borders. ID order to asmt U.S. market participants in trades of foreign stocks and bonds and in order to as.mt foreign market participants trading in the U.S. -the ISCC has a number of links between iuelf and clearinghouses and depositories in foreign markets. The orgaamtions which have clearing. settlement, or custodial links with the ISCC are: the lnternadoaal Stock Excbange (ISE), in London. the Ccntrale de Livraison de Valeurs Mobillieres (CEDEL}, in Luxembourg. the 20 depositories and custodians in Europe and Asia which are indirectly linked to the ISCC by means of a conduit provided by CEDEL the Japan Securities C1cariDg Corporation (JSCC), in Tokyo. the Central Depository subsidiary of the Stock Exchange of Singapore. the Canadian Depository for Securities (CDS), in Toronto, which is linked to ISCC through ISCC's parent company, NSCC. The ISCC is also discussing tJic possibility of setting up another link -with the Societe lnterprofessioDDelle pour la Compensation des Valeurs Mobilieres (SICOVAM), in Paris. Some of the ISCC's links arc one way, that is they service investors seeking to purchase in one foreign market but do not service investors in that foreign market seeking to buy securities in the first market. 6 Other ISCC links are two-way serving investors at both ends of the link. An example of a two-way ISCC link is its arrangement with the International Stock EYcbaugc (ISE) in London. The ISCC provides U.S. market participants with a service whereby the reporting of data from trades in foreign markets can be done by the U.S. market participant in a standard format supplied by ISCC. The ISCC then takes this data and transforms it into a format which is appropriate for the foreign entity or entities which will be clearing and settling the trade. For foreign market participants trading in the U.S., the ISCC serves as a point of aCCCM to the U.S. clearing and settlement process. The ISCC "sponsors foreign clcariJi_g and depository organizatfons at the National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC). This means that the ISCC sets up accounts at the NSCC and the OTC which it then as.dgns to specific (foreign) ISCC-linkcd clearing houses, depositories, or custodians. Where J)OWblc ( depending upon the level of technology and other factors), the ISCC turns over the actual handling of these accounts to the--ISCC-linkcd foreign clearing house, depository, or custodian to which the accounts have been assigned. ISCC nota tbat ic continua to punuc opponunitica to mue these oae way link& into two way links. Pap:40
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TIie ISCC Process Study of lnternationaJ Ocaring and Settlement Tbe Ocarina and Settlement P~ ID North America Because the ISCC services its members througb links between itself and foreign clearing houses and depositories, its clearing and settlement process varies according to the particular link which is being used to process any given trade. The ISCC does not do trade comparison ( comparing the buy and sell orders from the trade, to determine if there are any discrepancies). Thia service is provided but it is done either by clearing house., wbichmaintain links with the ISCC, or, by excbangcs (which then provide the trade information to depositories maintaining links with the ISCC). The ISCC docs, in some CJla, 7 provide a guarantee for the counterparties to the trade in that it is liable for the settlement obligations of its members, in the event of a default by an ISCC member. In our dim1ssron of the ISCC process we will examine three types of links: a one-way link with a depository; a two-way link with a clearing house; and a link for the purpose of custody (holding securities for safekeeping. on behalf of the owners of the SCl.1Jrities). Depoaltor, IJab We will first examine the ISCC process u seen through a link to a depository. the Auslandskassenvercin (AKV), which is indirectly linked to the ISCC through the conduit provided by CEDEL The AXV link is one-way: that is, it services U.S. investors seeking to trade in West Germany but, as of this time, it does not asmt West German investors seeking to trade in the United States.8 Mary Ann CalJaban, in her expert paper submitted for this study, outlines the services provided by the link between the ISCC and the AK.V: "ISCC partidpants are able to clear thN tradu in German securities with aJl German and non-German manben of CEDEL, as 'Mll as with all members of the AKY, including those which are not dinct memlJaY of.CEDEL Th~ s~ is tnu of each market linked with CEDEL" Trades settled for ISCC members through the link to the AKV arc processed using the AKV's usual timetable and all other specific aspecrs of the AXV settlement proceu.9 This is because at the ISCC, specific clearing and settlement procedures are always determined by the organization which is doing the actual pr~ssing of the trade (in the home market of the traded security). 7 The~ will. orwill not, provide a trade guarantee depending on its contracturaJ arrangement with the particular linking orpaization tbac is imolved in tbc clearing utd/or scnling of a transaction. Each link with the ISCC is different: some inctude trade guuantca, some do not. I ISCC bal, hoM=Yer, expreacd interest in developing similar scrvica to auist West. Gcnnaa investors in the future. 9 Por more information on the A.KY, plcuc refer to Section 2.2.5: ~iJring and SfflU!mfflt in War Germany in our summary, and to the cxpcn paper submitted by Hau-Joachim Hocurich and Heinz-KJa111 Ruetzcl. Page 41
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Study of lalallaaonal Carina and Settlemeat The Carin& and SeUlcmcnt Pnrm la NortJa America Clearbla Boue Lbw Although tbc actual process for a trade processed through a link to a clearing house differs from that for a trade processed through a link to a depolitory, the manner in which tbc ISCC provides access to the foreign clearing and settlement proccsa is tbc same. That is, the specific clearing and settlement procedures will always be determined by the O'poizarioa which is doing the actual procewDg of the transaction, in the home market of the traded security. A good example of the ISCC proceu as experienced through a link to a clearing house is the way that trades involving ISCC participants in the U.S. are cleared and settled by the International Stock Fxcbaov, (ISE) in London. This is a ~way link, serving inwstors in the U.S. who wish to trade in ISE-listed securities, as well as imestors in tbe United Kingdom who wish to trade in U.S. securities. Mary Ann Callahan, in her paper, outlines tbe scnices prOYided through the link to the ISE and the ISE's TAIJSMAN trade settlement computer system: "Establi.slwt in Octoba' 1986, tM ISCC-ISE link allows U.S. brolc8r-dealen to compare and set* transacdons in any /SE-I~ U.K. equity with any member of the ISE. ISCC mmabm panidpatingin thll linlchaw access to ISE systmu fortrtuMJ comparison ( clucking, in British securitiu jargon), settummt (through TALISMAN), institutional settlement, and to its custodial services. The IS CC-ISE lin/cage is direct, meanin! thal U.S. broker-<.Uaien' trada in U.K. securitiu may ckared according to /SE rulu." 0 The ISE also provides custodial services (for the safekeeping of traded securities) which make it possible to settle international trades without the delays, added costs, and uncertainties of settlement through the physical delivery of securities. Custodial Links The ISCC has a number of links with orgaoizati'lns solely for the purpose of custody of securities. Custodial links are vital in P-limioating delays in ~-national border trades, because the practice of holding securities oa deposit with a custodian (in the home country of the traded security) avoids the need for physical delivery of securities to the buyer aa~ national boundaries oa the settlement date. Some of the ISCC's custodial links are one way (for the benefit of investors on only one side of the linkage); others arc two way links. A good example of a custody link is ISCC's link with the Japan Securities Ccaring Corporation (JSCC). Currently, this is a one way link. ISCC bas opened an account for JSCC at the Depository Trust Company (DTC); through this account, shares of the 70 American stocks which are listed on the Tokyo Stock Excbangr. are held in custody on behalf of Japanese investors. Efforts arc now underway to expand the ISCC/JSCC arrangement into a two-way link, in which the JSCC would hold the Japanese securities, which are being traded by U.S. investors, in its vaults.11 11 Pormme oa the ISi!, plcale refer to Scctioa 2.2.4.1 [IUl!malionaJ SI/Xk Exdlang,,t9 in our summary, and to the expen paper submitted by the ISE for this study. 11 Por more on JSCC. please refer to Section 2.3.4: Japan, aa well u to the expert papers on Japan included in our study. Page 42
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Americ:all DeposllOl'J Recelpta (ADR's) Study of ln1ema1ional Ccariq ud Se1t1ement 1be Ocarin1 and Settlement Process 111 North America American Depository Receipts (ADR's) provide U.S. market participants with another way of purcbasiag (oreign securities, other than trading ia the actual home market of the traded security. ADR's are receipts which represent owncrsbip of shares in a foreign-based corporation, the actual shares of which are on deposit in a bank vault in the home country of the is.,ucr of the securities. ADR's are traded in the U.S., rather than in the home market of the foreign company whose shares they represent. The advantage, for the U.S. UM.1tor, is that not only the trading, but also the clearing and settlement process, can be handled by U.S. clearing and settlement o,gaoizations. ADR's for foreign securities are cleared and settled tbrougb the NSCC and the OTC, in the same IIUlllDel' as U.S. securities. U.S. ilnators puw:basing ADR's, therefore, would not use the ISCC as part of the clearing and settlement procesa. For foreign market participants trading foreign securities in the U.S. in ADR form, the ISCC serves as t1ie 1ink to the U.S. clearing and settlement process: namely, the NSCC and the OTC. MumalFuds For foreign brokers -ISCC also serves as the gateway to the United States' clearing and settlement process for purchases of 30 international and global mutual funds. "International mutual funds are those in which the securities are invested completely in foreign sec:uritics. Global mutual funds are those which maintain a combination of domestic and foreign investments. In both cues, the ISCC links the foreign market participant to the NSCC, which handles the actual trade confirmation, settlement, and the registration of investors' purchases aod redemptions. Semas Oll'ered by ISCC oaly for U.S. Investors The ISCC now has one service which is only for U.S. investors: netting. But it is planning to add another domestic-only service: a clearing system for PORTAL ISCC's Foreign Securities Comparison and Netting Service began in 1988. This service is solely for trades which involve only U.S. market participants trading foreign securities. Through this service, U.S. UM.1tors who are participanl$' in ISCC may settle in foreign markets on a net basis. PORTAL (Private Offering Resales and Trading through Automated Linkages) is a trading syst~m that will be operated by the National Auociation of Securities Dealers (NASO). Mary Ann Callahan, in her paper, describes PORTAL's plaoncd operations: "PORT.AL will p~ri:!e .: !!"~::..-!! of supporting trading of certain private placements and intemalionaJly tl'alUd fomgn equities (which will not be registend with the SEC). The fl1ll1ket is
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Study of latemational Clearin1 and Seulcmcnt The Cearina and Settlement Procaa la North America The ISCC's IDterface witla Its C1earin1 Memllen The ISCC's clearing members, or participants, are brokerage firms.12 The interface between the ISCC and its participants is automated, for the most part. Using the ISCC's Global Compass on-line computer syst~ ISCC participants input and l'ecewe trade data in a standard format. This data is then tnasJatr.d into the appropriate format for use in the market where the transaction is being settled. Information is processed in batches, rather than as each trade is made. This means that at the end of the day, each broker sends the ISCC infonaarioa on that day's trades; the ISCC converts them into the proper format for the foreign orpaizarioa which will process the trades; and the data is then sent out again in a batch to the appropriate ISCC-liaked foreign clearing house, depository, or custodian. All of the e:msring ISCC links with clearing houses and depositories arc computer-to-computer links. The ISCC's IDterface witla tbe Baab The nature of the ISCC's interface with the banking system depends entirely upon the particular clearing house or depository link which is being used to process a given trade. Therefore, the transacri'ln wouid be settled by means of whichever banks are approved or designated by the clearing house or depository which is handling the tnnsaction for the ISCC on behalf of the ISCC member( s ). 2.1.1.1.D EQ~: BUYING ON MARGIN (Sued oa aa article la tbe Federal Resene Bank of New York Quarterly Review, Summer 1988.) The term !D3l'li.a, when applied to the equities markets, usually refers to the practice of Buying on Margin. 13 "Buying on Margin" is, in effect. a loan to facilitate a purchase of stocks or bonds.14 The Federal Reserve Board and the SEC are involved in regulating the purchase of securities on margin. The Federal Reserve Board determines which stocks may be used to "buy on margin" and which may not.15 Marginable stocks consist of all U.S. e'tcbanv,-tradcd stocks and some, but not all, over-the-counter (OTC) stocks. Broker/dealers are not allowed to accept non-marginablc stock as collateral in making loam. By way of contrast, banks and other lenders may lend any amount they wish against t.he deposit of non-margin.able stock u collateral. Public customers wishing to borrow from a broker/ dealer to buy stock on margin must open a margin account with the broker/ dealer. The account is debited by the face value of the margin loan and it is aedited with the market value of the stock. The market value of the stock, minus the face value of the loan, is the net equity of the account. The Federal Reserve Board requires that the net equity level be no less than 50 percent of the value of the stock which is being purchased. 12 13 14 15 Thia couJd cbaage. ISCC is ptanning to offer U.S. bana the U1C of its CUIIOdiaA aa:ouncs in foreign countries. Anotbcr type of margin in equities ii that applied to short saJa. A short saJc ii the sale of a security which is not owned by _the seller ac the time of the sue. A margin short saJe ii one when tbe bU)V bol"l'OM the security he is selling. intending to purcbale the same security at a later dace to repay the loan. This requires margin in the sense that aaeta mlll& be kepi in the seller's aa:ou.at to protect apinst a default on his loan (i.e. botrOWed securities). The tcnn mugi.11. when referring to tbe futures and options rnartecs, carries a different meaning. Margin in those ma.mu ref en to payments made by the market panicipant to prove their ability to meet the obligations of a f uturcs or optiona contract. Federal R.aerw Board regulation u detennines wtlich stocks may be used as collateral for buying on margin. Page 44
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Study of lncemational Ceuin1 and Scctlcment 'The Ocarina ad Scttlcmeac Process In North America New York Stock Excbange rules also require that a minimum net equity of $2,000 be maintained in the account at all times. Tbc amOllllt of margin that is required, and tbe types of collateral that can be used as margin, both vary depending 1)11 the partic:ular security being traded wl the individuals involved in the trade. Often, f~ a given security and ilnestor, the amount of margin that is required will also depend on the status of tbc investor's holdinp in various markets. Dilferences in margin requirements go be),>ad simple variations in margin levels: there arc also differences in the way margin is c:aJnJlared, the length of the posting peri~ the form tliat margin can take, and the timing of its collection. 2.1.1.2 GROUP 'IWO: FtmJRES 2.l J 2,A 11IE BOARD 01' TRADE CLEARING CORPORATION (BOTCC) (SYmPMrJ of expert paper submiUed by Ropr Rutz for this study) FuturescoDIJ'ae:tS arc agreements to buy or sell a given amount of a commodity or financial instrument, at a given price. on a given date in the future. The buyer of a futures contract may be seeking to lock in a desirable price for a product that he will need in the future; he may be hedging another investment, by buying a futures contract whlch would become profitable if bis first investment were to become unprofitable; or he may be simply speculating that the market price for the underlying product will mcwe in his favor. The Chicago Board of Trade (CBOT) handles the greatest volume of futures contracts trades in the United States.16 The CBOT has its own separate clearing house -the Board of Trading Clearing Corporation (BOTCC). The BOTCC'sclcaring and settlement pr~ are indicative operationally of most U.S. futures clearing houses. We have therefore chosen to present an examination of the BOTCC as our introduction to the clearing and settlement of futures contracts in the U .s.17 The IDterface betwwl the Chicago Board of Trade (CBOT) and tbe BOTCC BOTCC has an on-line trade emry /trade capture technology which allows it to receive over 75 percent of its trade information through on-line te"Dinais, with the remaining 25 percent of trade information being reported by means of computer tnuwisvoas. In addition. members of the BOTCC who are also members of the CME may use the BOT CC' s on-line trade entry /trade capture tedmologyto send trade information to the CME. About 20 percent of the Chicago Mercantile Evbangt:'s trade information arrives at the CME clearing house through the BOTCC trade entry /trade capture technology. 16 Tho CBOTs volume may soon iacn:uc, l'aowewr. it ia actively pursuing the expanded oppornanitia represented bJ 24-hour. round the doct ending. The CB01' ia now dcYelopin1 a 24-hour compucer trading system whicb is called Aurora. 17 The Clic:ago Mercantile Exchange ii the largest U.S. futures exchange when measured by another yardscick -the avenp tocal vmuc of open fucures and options oa fucurcs coacncu. Page 45
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Study of lntcmatioaaJ Cearins aad Settlement The Ceuiq and Settlement Prcxaa ID Noltll America The BO'rCC Process Once a trade has been captured, BOTCC employs a two-sided matching system in which both the buy and sell sides of a trade are submitted to the trade comparison system for matching. (By and large, this is the standard for futures markets in the United States.) Abroad, a number of other cxcbaages also use a variation of this method. Thia rather sophisticated capability allows for multiple intra-day comparisons, a trade date comparison deadJine in which tbe deadline is T =-trade date, and a match by '>rokcr and by Ooor trader as well as a match within the clearing house.18 If clearing processing" is defined as the system which combines mm:ched trades with existing open positions held by eacb clearing member in order to calndate the new number of open positions. then "trade registration can be defined aa the system which interposes the clearing house as the counterparty to eacb clearing member's open poaitioa. BOTCC's guarantee begins at the moment a specific trade has been matched and registered. At this time, the clearing house becomes the opposite party to every trade at the clearing house: substituting itself as the buyer to every clearing member seller, and substituting itself as the seller to every clearing member buyer. Typically, this occurs about one hour after the final trade submwion. As a practical matter, there is very little difference between the final time that trades are matched and the time that clearing members arc notified that their trades have been registered. Both the buyer and tbe seller make a good faith deposit to the clearing house which is called initial margin". The amount of initial margin is determined by the clearing house, and is due from both counterparties to the trade OD the morning of the day after the trade (T + 1). Most clearing members maintain substantial excess initial margin deposits in their clearing account at the BOTCC in anticipation of these margin requirements. There may be as mucb as a seven-hour delay, however, between the timing of the guarantee and the collection of the initial margin. Therefore the BOTCC is carrying the full risk of the open contract until the time that the counterparties post initial margin. The minimi,:ation of this delay between guarantee and posting of initial margin, however, is not the primary objective of all participants in the clearing and settlement process. Clearing members want to know, as far in advance as possible, upon notification by the clearing house, that particular trades have been matched and are at that moment guaranteed by the clearing house. The BOTCC also issues routine daily intra-day variation margin calls, (usually around 2 p.m. CST), whicb are an advance payment on the final ~ttlcment due the nm morning. One purpose of routine intra-day variation margin calls ( and payments to clearing members with profitable trades) is to reduce the magnitude of the final settlement call, which is always made at 6:40 a.m. CST on the day following the trade date (T+ 1). As a result of this system (depending upon the volatility of the market), the BOTCC typically collects ( and pays out) by about 2:30 p.m. CST on the date of the trade (T + 0) anywhere &om 60 to 95 percent of the final settlement calls that would have been made at 6:40 a.m. CST OD the following day. 11 Sued oa information from the paper submitted by Roger Rutt for this study. P1easc refer to Table II. in the Rutt expert paper, for an interesting comparison of a wide variety of U.S. c:learing mechanisms. Page46
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Study of International Cearina and Settlement The Cearina and Settlement Process Ill North America This reduces the clearing house's risk because the shorter the period of time between trade execution and settlement, the more likely it is that a clearing member will be able to meet its obligations. In general, the more frequently a clearing house settles (marks to market) trades each day, and requires its c1caring members to post margin, the greater is the financial integrity of the c1caring system. In the futures markets, clearing houses do not permit loues to accumulate; all losses are settled with the c1caring house no later than the morning immediately following the trading day. As a result, the maximum potential default liability represents only one busin~ day's market movement. With approximately 139 clearing members, by far the largest number for any futures exchange, the BOTCC uses the position of. each clearing member as the buis for determining the amount of both the initial and variation margin of each clearing member. The initial margin deposit is a performance bond to protect the 6oaocia1 integrity of the futures c1caring house in the event that a clearing firm is unable to meet margin calls or other financial obligations to the clearing house, such as making or taking delivery. The method used for calculating initial margin requirements is called Simulation Analysu of Fmancial Exposure (SAFE). Margin deposits at clearing houses are the first and most important line of defense in protecting the clearing house &om a default by a clearing firm which could affect other clearing members. The Commodity Futures Trading Commiwon (CFrC) requires that all clearing members maintain two bank accounts for settlement and two safekeeping accoUDts for initial margin. One set of bank and safekeeping accounts is for variation and ioitia1 margin for customer positions, while the other set is for "8liation and initial margin for proprietary and non-customer ( affiliated firm) positions.19 The second line of defense consists of position limits, the limit to the total amount of open contracts in a particular conttad that an investor may own or controL20 No person, including partnerships and corporations, may own or control more than the position limit established for each contract. Brokers may apply to the excbaugc for permission to exceed particular limits based on whether the position is for hedging, or other activities appropriate to a commercial enterprise. The CBOT and BOTCC have set their predetermined position limits, which are approved by the CFTC. As a result of position limits, it is not surprising that on the morning of Odober 20, 1987, the CBOT had extensive surveillance information pertaining to all of the trades that were executed on the preceding day. The third line of defense in protecting the clearing house &om default by a clearing firm is its authority to ism: a super" margin call. If the BOTCC determines that a customer or proprietary position represents a clear and immediate potential for an exposure, Le., the risk that a particular market condition could cause a substantial amount of a clearing firm's capital to be depleted because of customer or fum defaults, the BOTCC may iMue a "super" margin call. The clearing member would then be required to deposit the additional "super" margin (in the form of cash, U.S. Treasury securities, or letters of aedit) within one hour of receiving the call. 1' Tbe segregation of proprietary funds from c:uaomer funds ii a Rquiremcnt of the Commodity Exchange Act. (Please refer to tbc paper induded in tbia snady by ADdlea Corconn and Susan Ervin: Maintenance of Market Strategies in Puhala Broker lmolYencics: Futures POlitionl Tramfers Prom Troubled Firms. for additional in{onnation.) 21 Additional defenses include net capita! Rquirements and on-going financial surwillance. Pap: 47
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Study of lntemational Cearing and Settlement The Cearing and Settlement Process In North America Interfaces with Depositories Futures e'tcbaugr.s do not interface with depositories, whose purpose is to bold stocks and bonds for safekeeping and to handle the legal transfer of title on traded stocks and bonds. BOl'CC's Interface with the Baab The BOTCC has four banks, all based in Cb,icago. The BOTCC's morning payment process (6:40 a.m. CST) precedes the opening of the FedWire system and hence often requires the settlement bank to extend credit on behalf of some clearing members. This aedit extension is usually not backed up by collateral. 2.1.J..2.B OTHER roroRES CLEARING HOUSES (S11mmary of Expert ~per by Roger Rutz) Besides the Chicago Board of Trade (CB011, there are 13 other futures exchanges in the United States. Of these, the largest is the Chicago Mercantile EYcbangr, (CME), which exceeds even the CBOT when measured by the yardstick of the average total value of open futures and options on futures contracts. 21 In discussing the trading of futures contracts -it is also worth noting that the CME has taken a leadership role in the effort to begin 24-hour, round-the-clock, round-the-world trading. In coajunctioa with Reuters, the CME is now developing the GLOBEX 24-hour trading facility, which it expects to have oa line in mid-1990. 22 The CME's clearing house is a division of the e::rcban!V, the CME Clearing House Division. There arc seven other clearing houses serving the futures industry ( aside from the Board of Trade Clearing Corporation BOTCC): the Coffee, Sugar and Cocoa Clearing Corporation (CSCCC), serving the Coffee, Sugar and Cocoa &cbangr. ( CSCE) the COMEX Clearing Association (CCA), serving the Commodity Excbangr. Inc. (COME<) the Commodity Clearing Corporation ( CCC), serving the New York Cotton Exchange (NYCE) the lntermarket Clearing Corporation (ICC: serving the Amee Commodities Corporation (ACC), the New York Futures Exchange (NYFE), the Pacific Futures Exchange (PFE), and the Philadelphia Board of Trade (PBOT) the Kansas City Board of Trade Clearing Corporation (KCBOTCC), serving the Kansas City Board of Trade (KCBOT) the Minneapolis Grain Excbange Clearing House Division (MGE), serving the Minneapolis Grain EYcbang., (MGE) "' the New York Mercantile Evbange Clearing House Division (NYMEX), serving the New York Mercantile Eu:bangc (NYMEX) 21 The CBOT ii tbe largest U.S. futures exchange in tenns of trading volume. 22 The CBOT is also developing a 24-hour computer trading system, which is called Aurora. Pap48
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Study of lntemationaJ Caring and Settlement 1be Cearing and Settlement Process In North America The BOTCC, beside., clearing for the CBOT, also clears transactioaa for the Chicago Rice & Cotton Ev:bange (CRCE) and the MidAmerica Commodity Excbangc (MidAm). Trade entry (the reporting to the clearing home of the initial agreemcnl on the trade) is done through a variety of systems. Some clearing houses have their own computerized trade entry systems; KCBOTCC and NYMEX fit into this category.23 Others receive trade entry information from the e.xcbanv,s; the CCA, CCC, and the CSCCC 6t into this category. Still other clearing houses rely on computcmed trade entry systems provided by other orpnizarions (for instance, the ICC relics on SIAC the Securities Industry Automatioa Corporation in New York City for two of its exchanges: ACC and NYFE). Roger Rutz, in the expert paper submitted for this study, explains the arrangement set up to facilitate trade entry at the CME: "77ul BOTCC and CME~ an agreetMltt that pamits CME manbaJ to use tJu BOTCC's on-liM tmninab for trad4 enay to the CME. TM BOTCC simply receivu the infonnalion and transmits it to CME's data centD' for p,ocasing. About 20 percent of the CME's tnMM information anivu through this link. Altematiwly, clearing memben may transmit all CBOT and CME tradu to tither BOTCC or CME, which will then transmit the trade information to tM other dearing house. 11we arrangemmts established to improve speed and efficiency in capturing [ reporting) traM inf onnation." Trade matching. which is also called trade comparison, is done on the day of the trade (T +0). Trade matching is the process of comparing the data from the buyer and the seller, to make sure there are no discrepancies as to price, quantity, etc. Among the eight futures clearing houses which we are disaming in this section only the CME, KCBOTCC, and NYMEX do trade matching. All of the others rely on the e,:cbangr.s for this servicc.24 All the futures evbanges except NYMEX use the two-sided trade matching system we have already described that is, both buy and sell orders arc submitted to a trade comparison system for matching. At~ a one-sided trade matching system is used. This means that the "sell" information is input into the comparison system and the clearing member with the "buy" information must confirm the data at a later time. As a result NYMEX is not able to offer its clearing members the service of providing multiple intra-day trade comparisons -that is, trade matching done at more than one time per day. As for the other clearinghousesmultiple intra-day trade comparison is offered by CME, CCA CCC, and KCBOTCC, but is unavailable at CSCCC. 23 The system Uled by NYMEX ii provided by the Commodity Exchange Center, which is jointly owned by the New York fu&ura acbanga. 24 The CME and NYMEX daring houscs are.. however, divisions of tbe exchanges that they SCrYe as opposed to the KCBOTCC, wtlic:b ii separately incorporated and independent from the exchange. AdditionaUy, the BOTCC. as dilcuacd earlier, ailo doca trade matching and ii separately incorporated and independent from the exchange. Page 49
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Study of International Cearing and Settlement The Caring and Settlement Procell In North America All futures clearing houses do provide a trade guarantee, a guarantee to both counterpartics that the settlement obligations will be met. In providing this guarantee, the clearing house takes the countcrparty positio11 and becomes seller to the buyer and buyer to the seller. The trade guarantee becomes effective on the day of the trade (T +0) when the members arc notified that the trade had been match~ with a few exceptions. 25 "Settlement," in the futures markets, refers to the payment of "initial margin" as a good faith deposit, as well as the payment of daily "variation margin" ( which reflects the changing value of the contract). Both types of margin serve as an assurance to the clearing house that the counterpartics will be able to meet the financial obligations of the futures contract. Initial margin is always due on the morning of the day after the trade (T + 1 }, although the exact time of day varies from clearing house to clearing house. At the CME, 26 initial margin payments are due at 6:40 a..m.; at other clearing houses, the payment ;s due either just before, a~ or just after 9 a.m. Variation marginthe amount a clearing member may owe if the financial obligations and/or risk of his open contracts inaeascs -is calculated at the time of the next mark to market after the payment of initial margin. Variation margin will continue to be calculated each day until the obligations of a clearing member's futures contracts have been met. In additio~ three clearing houses the CME, the CCA, and the CSCCC issue routine intra-day margin calls, which enable the clearing houses to more quickly cover the increased liability of any market losses the clearing member may have suffered on open contracts (futures contracts whose full obligations have not yet been fulfilled by the counterparties ). All clearing houses do, however, have the capability of issuing intra-day margin calls on an as-needed basis (for instance, in times of market volatility). In all cases, the payment of margin must be in same day funds such as arc provided by the Federal Reserve's FedWire electronic payment system. The amount of margin a clearing member owes is calculated by the clearing house based upon the value of his open contracts and an cWCSSment of the amount of risk those contracts may involve. The CME has its own risk management computer system SP AN (Standard Portfolio Analysis of Risk) -for detcnnining the amount of margin. The futures industry (with the exception of the BOTCC, which has another risk asscssm,:nt computer system SAFE, and ofICC which uses TIMS) is moving towards adopting SP AN as the standard for calculating margin. Over and above the ~ue of the type of computer system used to assess the degree of risk is the matter of what type of margining system is used. There are two methods of calculating initial margin: 27 groa margining, and net margining. The CME and NYMEX are gross-margining clearing houses; all the other futures clearing houses figure margin on a net basis. Grog margining is the practice of requiring a clearing member to post original margin on all the long and short positions in all accounts, even if they are offsetting. This contrasts with net margining in which the margin is calculated on the difference between all the long and short positions by product in all accounts. 25 P1eue refer to page 10 of the Roger Rutz expert paper, included in our study, for a chart on some of the variations on the timing of the trade guarantee at the various futures exchanges. In addition to the BOTCC described earlier. All futures dearing organizationa collect and pay variation margin on a net basis. Page.SO
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Study of lntemationai Cearin1 and Settlement The Cearing and Settlement Procesi In North America As Roger Rutz points out in his expert paper, clearing members by U.S. law are required to maintain separate bank accounts for the payment of margin on customer accounts and the payment of margin on proprietary accounts (trading the clearing member is doing on his own behalf). Clearing members are required to collect from their customers margin amounting to at least the amount that the clearing member must pay the clearing house. A clearing member can, however, require that its customers pay a larger amount in order to reduce the sac of the final settlement paymenL Risk and Risk Reduc:tioa For the clearing members, risk is averted by the clearing house's guarantee of the settlement obligations of the trade, by their own colh:cr:im of margin payments from customers, and by the measures that the clearing house takes to procect itself from the effects of a potential default. The clearing house's first defense against the liability of cleving member default is the margin that the clearing member has on deposit. Beyond that, the clearing house also protects itself through position limits -limits on the total amount of any one type of futures contrad that can be owned or controlled by any one clearing member. As Roger Rutz explains in his expert paper, the Commodity Futures Trading Commwion approves position limits for all futures contracts, but there can be exceptions to those rules: "All futures arhangu have proceduru approved by the OTC that permit customen to apply to CM arhange to ~eed a conlraet's position limit. Individual customers may apply to exchange to a&eed a contract's position limit Individual customers may apply to CM arhange to exceed particular limits based on whether the position is for hedging or other activitiu appropriaU to a cornmercilU enurprise. The customer must provi~ financial infonnation to demOflS'tT'tlU that it has sufficient capital to maintain the level of positions il has applied for." Rutz notes that the New York futures clearing houses establish their own position limits for clearing members, based on the clearing member's total capital According to Rutz: nese clearing houses thus attempt to limit their exposure from def aull by limiting the positions thal clearing members may cany. Position limits arc monitored. All futures clearing houses also share pay and collect information ( amounts paid by clearing members in the form of margin, reflecting their overall exposure, and amounts paid by clearing houses to clearing members, representing reductions in the amount of risk faced by a clearing member). If -despite margin requirements and position limits -a clearing member nonetheless does go into default and the amount of the margin on deposit docs not cover the liability of the default the cl~IJ'ing house may liquidate the clearing member's positions, sell its evbange membership, and then turn to the clearing member's firm capita!, its guarantee contributions, clearing house capital, coawuttcd lines of acdit, and guarantee funds. All of the futures clearing houses have guarantee funds; most also have the power to assess their members, if the amount of the default cannot be covered by capital funds and the guarantee fund. The KCBOTCC and NYMEX arc the exceptions to this, in that they have the right only to a limited as-ces-srn~nt of their clearing members for any liability remaining after turning to capital funds and the guarantee fund. Page 51
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Study of lntcmalioaal Carine and Scttlemaat The Ceariq and Scttlcmcnt Procaa la Nortb America Interface to Ranking System Clearing members must maintain accounts at settlement banks for the payment of initial mar~ variation margin, and the final settlement payment on futures contracts. When the clearing house determines the amount of margin that the clearing member owes, the clearing house notifies the clearing member's bank of the amount that is owed by the clearing member. The bank then CDJDines the clearing member's currently available assets ( cam, government securities, lines of acdit ), gathers incoming payments from the clearing member (via FedWire, if it is available at the time the bank is making the dccisioa), and makes a commitment to the clearing house oa whether it will or will not hoaor the margin call (forward the funds to tbe clearing house). The decision by a bank oa whether to boaOI" a margin call oa behalf of a market participant is often a credit decisionthat is, a decision by the bank oa wbetbcr to mend aedit to the clearing member. In cases ia which a settlement bank decides that it cannot stretch itself to meet the financial obligations of a market participant, the bank will tell the market participant to coatad his acdit banks, to sec if one of those banks will agree to stand behind him in the aedit prOCCSL This process works well and is based upon two assumptions: first, that the market participant will be able to reach the account officers at the acdit banks within the permitted time frame; and second, that the credit banks (which do not always coordinate a market participant's various lines of credit) will not extend more acdit to a clearing member than a clearing member is actually worth. Uudcr normal cirn,rnswices, there arc no problems with either of these underlying assumptions. In times of market stress, however, some banks tend to become acdit averse, as a result of not knowing wh~re a market participant stands financially across the scope of his markets and positions. This uncertainty may tend to str~ settlement ban.ks and force them to ma.kc the final decision on honoring a margin call If the margin call is not honored, this may result in the clearing house's liquidation of the clearing member's customer positions after attempting to transfer these positions to another clearing mcmbcr.28 Settlement ban.ks understand full well that margin calls which are not honored may, and usually do, result in the liquidation of a clearing member's positions. Clearing houses, in rcsped to margin payments, arc limited to proceMiog trades only in batches as opposed to as each trade is executed. This limitation on the clearing house's ability to quickly process trades also limits the clearing house's ability to remove risk from the markets and transfer it to the banking system. One reason the clearing houses arc forced to prOCCM trades in batches is the structure of the banking system, which still moves too slowly to accommodate any other method. For instance, the widespread use of paper-based processes by banks for moving money makes it difficult for ban.ks to respond to the needs of a clearing system which settles each trade as it occurrs. The interface between the clearing houses and the ban.ks is a system that wor~ and in October 1987, the system worked well under immense strain. Still, in ~s.sing r.his interface, there are tradeoffs to be C'!Vmioed in terms of inacascd financial protection, as opposed to the costs and benefits of that protection. The existence of the Clearing House and Banking Roundtablc, which provides settlement bankers, clearing organizations and regulators with a forum for regular discussion of these tradeoff issues, provides reasons to believe that the system is moving towards a secure, less volatile, but still competitive, state. 21 Por additionaJ information please refer to the paper t,y Andrea Corcoran and Susan Ervin. PageSl
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2.J..1.3 GROUP THREE: OfflONS 2.J..1.3.A EQUITY-RELATED OfflONS-THE OfflONS CLEARING CORPORATION (OCC) Study of Intcmationai Ccaring and Settlement Tbc Cearin1 and Settlement Process In North America (Summary of Espert Paper by Jou H1aU wl James M. Kustusch) lntroducdOII The neJt major entity we will evmiae in tlii.1 study is The Options Oearing Corporation (OCC). Unlike futures evbanF', which tend to have their own clearing entities (either a clearing house division of the e,:cbang,-.,, or an affiJiatr:d corporation), the ace is the centralized common entity serving all sccuritie., options cm:banges in tbe United States. Options are similar to futures coatrads in that they are instruments to purchase a given product at a set price in the future. Options differ &om futures contracts in that they represent only an omoN to buy or sell, rather than an OBLIGATION to buy or sell (unlike a futures contract, which obligates the holder of the contract to buy or sell its underlying product at the end of the term of the contract). There are two types of options: "put" options, carrying the right to sell something at a given price within a given time period; and "call" options, carrying the right to buy something at a given price within a given time period. The OCC's Interface witb tb~ Eubanges The OCC clears and settle., options trades for: the Chicago Board Options Exchange (CBOE); the American Stock E.xcbang,: (AMEX); the Philadelphia Stock Evbange (PHUC); the New York Stock E:rcbange (NYSE); the Pacific Stock Evban~ (PSE); and the National Aswciation of Securities Dealers (NASO). Unlike many clearing houses which process trades of other types of financial instruments in the United States, the ace docs not do trade comparison (the matching of information from both buyer and seller to make sure, in advance of settlement, that both sides are agreed on the terms of the trade). Instead, the ace receives trade comparison data from each of the individual exchanges for which it clears and settles. ace operates as a common clearing entity for six exchanges. These exchanges have opted to utilize their own trade matching systems as one means of competitive differentiation. The ace Process Step-by-Step: From the trading floor to the exercise, or failure to exercise, of an options contract Once the trade has been matched, the data is sent to the ace -via computer. This occurs on the day of the trade (T + 0). The ace then must calculate the amounts of money that arc owed the next day by the buyer and the seller. In the cue of the buyc!, the amount of money owed initially to the ace is called the "premium obligation, or "premium. The premium, while paid to the OCC, is actually passed on to the writer of the option (that is, the seller of the option). The premium, to the buyer of the option, is the amount of money he must pay to lock in the possibly advantageous price offered in the option. To the writer of the option, the premium is the maximum Page 53
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Study of lntematJonaJ Ceariag and Settlement The Ccarin1 and Settlement Proccsa In Nortll America amoUD.t of profit he can expect to make on the deal. Of course, there is no guarantee that the writer of the option will make money on the deal: if the market moves against the writer, the premium might end up, at best, as a sum offsetting only a small portion of the option writer's losses. Regardless of the type of option that is involved in the trade, the writer of the option will always owe margin to the OCC due each day that the option contract is in effect but bas not been exercised by the holder of the option. The margin29 owed by the writer of the option is, similar to the margin owed by the buyer of a futures contract, essentially "good faith" money which serves u an auurance to the ace that the writer of the option has the financial ability to meet the potential obligations of the option that he has sold. The amount of margin owed rcflccts a portion of the total amount that he would have to pay if the option were exercised. On the day after the trade (T + 1), the OCC notifies the buyer of the amount of premium obligation which is owed; at the same time, the writer of the option is notified by the ace of the amount of margin that is owed. Both amounts are also due on T + L On the nm day (T + 2), and each day thereafter until the expiration, or closeout30 of the option contract, the ace caJcu.lates and then collects margin from the writer of the option. Margin is essentially an amount which reflects the adjusted daily value of the option writers open positions (the total amount of money which he could be forced to pay if the options he sold were to be exercised by the holders of the options). The ace marks to market (determines the adjusted value and liability of each member's open positions) at the end of each trading session. If the market moves against the writer of the option, he will owe additional margin. If, on the other hand, the market moves in favor of the writer of the option -the ace gives the broker who wrote the option a acdit for the amount of previously pledged margin which is now in excess of minim um margin rcquiremcnts.31 At this point in our discuwon, it is worth restating the fact that there is no certainty that the writer of the option in fad, be required to fulfill the terms of the option. The holder of the option that is, the buyer of the option -is the one who decides whether to exercise the option and requires that the writer of the option to make good on the offer made in the option contract. In fact, depending ~n price fluctuations in the market, the holder of the option may decide that the market price of the underlying cWCt of the option is no longer favorable enough to warrant the exercise of the option. If this happens, the writer of the option is left with the premium obligation that was paid on T + 1; this is the total amount of money that the writer will receive. Therefore it can be said that the writer of the option assumes the bulk of the price and market risk of an options trade. If the market moves against the writer of the option ( for instance, the price of the security underlying the option goes up, beyond the price offered in the option contract), he stands to lose if (as is likely) the holder of the option exercises the option. 2' Por margin paymcncs. the OCC aa:epu cub and coUatera! induding: bank letters of credit. U.S. Treasury obligations. tbe Ktlla! equiric:s underlying I paniaalar option contract. and various ocher stocks. Additionally, margin obligations caa be reduced throup corresponding long poaitiona in odlcr optiou wnicb have tbe effect ot reducing net Cxpolli&&re. 31 The dolcou&" ol I contract ii when writer or holder of an option contract encers inco anocber option contract which produces an offsetting pmition. J1 When tbe option contract expires. the OCC simply refunds the margin to the selling broker. PageS4
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Study of International Cearing and Settlement 1be Cearing and Settlement Process Ill North America If the market moves in favor of the option write1, his potential for profit is still limited to the premium. On the other hand, if the market move., against the option writer, his potential loss is unlimited. In contrast, consider the situation of the bolder of the option. Becausc be is not obligated to exercise the option, his total potential loss is limited to the si7.e of the premium that was paid to the option writer oa T + L What happens when the bolder of an 9ption contract decides to exercise it and actually buy or sell the underlying product of the option? The ace, as the clearing bomc, is the countcrparty to all trades: that is, to buyers, it acts as the seller; to sellers, it acts as the buyer. The person who originally sold the option is not necessarily the same person that ace will require to fulfill the terms of the option. This is because the OCC, upon being notified that the bolder of an option wishes to exercise the option, randomly assigns a clearing member to honor the deliYery or purchase obligations of the option. The clearing member who must fulfill the obligations of the option is chosen from the. pool of all clearing members who sold options with identical contract terms options which have the same underlying product, and the same price for that underlying product and the same maturity date. As for the actual deliveryin equity-related options (for example, an option to buy IBM stock), the ace sends delivery instructions to an equities clearing house (for example, the National Securities Oearing Corporation), which then sends instructions to a depository (for example, the Depository Trust Company). Delivery of the actual securities underlying the option contract is then made by transferring the securities from the seller's account into the buyer's accoun~ through accounts at the depository. When a foreign currency option is exercised -the foreign currency underlying the option contract is delivered to the aCC's cash account at a designated bank, and then transferred to the account of the market participant who is buying the foreign currency. The bank may be any bank designated by the parties involved in the deal -it need not be one of the 0CC's settlement banks. Risk and Risk Reducdoa at the OCC The ace also provides its clearing members with a guarantee, which is effective on the morning of the day following the trade (T + 1), after the buyer of the option has paid the premium obligation. The ace guarantee protects the bolder of an option against the powbility that the writer of the option might default on a request to honor either the payment or delivery obligations of the option. The aCC's first line of defense against the potential for clearing member default is the ongoing monitoring of the creditworthiness of its clearing members. The SEC and the various options excbaugr.s which arc served by the ace have limits on the total amount of open positions that any one market participant may carry at any one time. The aCC's clearing members arc monitored on a daily basis by the exchanges, in respect to whether these position limits arc being adhered to. The position limits arc net limits that the market participant's short positions arc offset by his long positions. Page 55
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Study of Intematioam Carin& Uld Settlement The Carini and Settlement Proceu In Noltll America The SEC, the evbang,a..s, and the ace also monitor market participants in respect to whether they arc continuing to meet capital adequacy and other financial requirements. The ace as an SEC-registered clearing agency, is a part of the information-sharing arrangement among all seven SEC-registered clearing entities. ThroURb this arrangement, the ace shares credit and other risk information pertaining to its members.32" The acC's second line of defense against t.bcs potential for clearing member default is the margin that its clearing members have on deposit with the OCC. If there is a default, and the amount of the margin on deposit is insufficient to cover the amount of the default, the ace can cover the default, by turning to its guarantee fund. The ace guarantee fund is made up of caah and government securities. As of this writing, the guarantee fund totals 190 to 200 million dollars. The fund is not med in size. This is an advantage in terms of protection for the ace and its membe~ because the amount of protection varies in proportion to the amount of liability that exists. The size of the guarantee fund varies according to the total value of the contracts being traded by the clearing members each month. Its siz.e is always equal to seven percent of the average daily aggregate margin requirements of all clearing members in the previous month. Each clearing member must conttibute an amount equal to his pro-rata share of outstanding contracts in the previous month. What happens in the event of a default by a clearing member? After closing out the defaulting clearing member's positions-where pos.gble the ace has five steps that arc followed to cover any residual liability &om a default: r~ any margin that the defaulting clearing member has OD deposit with the OCe is applied towards the liability of the default. Second, if that amount is insufficient, the ace takes the defaulting clearing member's contn"bution to the guarantee fund and applies it towards the liability of the default. Third, if that amount is still insufficient, the ace may use its guarantee fund to cover whatever portion of the liability is outstanding. Fourth, if that still isn't enough to cover the full liability, the ace has the right to assess its members for the remaining amount of the liability.33 rtftb, the amount that was taken out of the guarantee fund is replaced -by asscMing all ace clearing members, on a pro-rata basis. After going through this process, the ace may also take legal action as a acditor -to recover any sums that are owed by the defaulting clearing member. The amount that the ace can recover in this way is limited by bankruptcy law. 32 Por more on this information sharing arnngemcnt. plcac refer to the expen paper by Rohen Woldow, included in our study. 33 Not all U.S. clearing houses. however. haw these auessment powers. For more on thil. please see table 6 in the cxpen paper by Roger Rua. included in our study Pap56
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Netda& Marpa Requirements, ud Crou-~ Study of lntemational Cearing and Settlement The Cearing and Settlement Process In Nonb America Payments to and from the ace and its members are OD a net basis. At the end of each trading day, the ace has an overnight procegjng cyde in which it calculates the net amount which each member either owes or is owed. The net figure reflec:ts: a) the premium obligation due on each new long position; and b) the margin due for each new short position. The ace then sends payment instructions to the settlement bank. The OCC's netting proceM is done on a multilateral basis: that is, the status of all of a clearing member's holding., in the options market is taken into consideration in arriving at the daily net total which represents the clearing member's daily payment obligation to the acc. The ace has two different methods for calculating margin. -one for options on equities and another for all other types of options (for instance, foreign exbange, gcwernment sccuriti~ or stock indexes). In both cases, the margin required from the writer of an option is equal to the current market price of the option, plus a cushion to cover the risk of a chaagc in the current market price. In the derivative markets, the ace was the first to evolve from a fixed or flat rate of margining (per contract) to highly sophisticated computational methods. For all non-equity options, as well as all options and futures contracts cleared by the Intermarkct Clearing Corporation, the ace uses the Theoretical Intermarket Margin System (TIMS). TIMS evaluates each clearing member's overall risk profile and then sets the total margin owed. OCC plans, in the near future, to expand the use of TIMS to include setting the margin on equity options. The CFI'C and the SEC have approved applications from the OCC and the Chicago Mercantile E-icbangc (CME) to allow the aoss-margining of stock index options, futures, and options on futures. Crcm-margining between the CME and ace started in October, 1989. For more OD this, please refer to the expert paper submitted for this study by John Hiatt and James M. Kustusch, and the expert paper submitted for this study by John Behof. Also see Section 4.5 of our study: Cross-Margining.,. The ace also offers cross-margining through an agreement with its affiliate, the Intermarket Clearing Corporation (ICC). The ICC clears trades for the New York Futures Exchange, the Philadelphia Board of Trade, Amcx Commodities Corporation, and the Pacific Futures Exchange; therefore, OCC members have the capability of using their holding., on those exchanges to offset the status of their open positions at the acc. The extent to which ace and ICC offer crOM-margining is limited. This is because the Commodity Futures Trading Commission (CFrC) has not approved expansion of cross-margining beyond proprietary accounts to the accounts of major market makers. Nonetheless, according to the OCC, reductions in overall margin requirements have been quite significant. The OCC's Interface with Its Clearing Members The ace has approximately 190 clearing members. All of the clearing members arc brokerage firms who are members of one or more of the evbanges that the ace serves. The brokers, in their transactions with the ace, are representing themselves, brokers who are not clearing members, and customers both institutional and retail. The link between ace and its clearing members is automated, as is noted by John Hiatt and James M. Kustusch, in their expert paper: Page 57
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Study of llltemational Ocarina uc1 Settlement The Ccaring and Settlement Procca Ill Nortll America "OCC ha.r mandawJ. that all rnenben submit post-lrrlM information either in machine readab/4 formal or through OCC's on-liM Clearing Management and Control System (C/MACS)." The OCC's laterfacewitb die Baakta1 System The OCC, unlike futures clearing bouses,34 allows its members to choose from a selection of designated settlement banks. There are currently 16 such settlement banks, but the ace is flexible in accommodating the needs of its members and may designat~ a members primary banking institution ( concentration bank) as an apprcwed settlement bank. The OCC maintains accounts at each of these settlement banks, and imtructs the banks on each trading day as to the debits and aedits that are to be made to the OCC's accounts and those of the clearing members. The OCC's Iaterface witb Depositories Options arc not held in certificate form and are therefore not stored in depositories. As a result, there is no direct interface between the ace and depositories, for the purpose of settlement. There are direct links between the ace and depositories, for the purpose of the "reporting" of collateral "Reporting" of collateral is the process of a depository confirming that it does have on deposit a stock that a clearing member has posted as collateral for margin. 2.1.1.3.B OPnONS ON FUTURES CONTRACTS (Based oa Informadoa Provided By the Chicago Men:antile Exchange Cleariag House Dlvisioa) In the previous section (21.1.3.A: "Equity-Related Options .. The Options QearingCorporation ( OCC) "), we provided an introduction to the way the options markets arc structured, the way that options are traded, and the two basic types of options that exist ("put and "call" options). Our discussion was, however, generally limited to options on equities (stock) and equity-related instruments. We will now tum our attention to the clearing and settlement of put and call options on futures contracts. 35 Options are distinct from futures contracts in that options carry the righ~ but not the obligation, to buy or sell a given commodity at a given price within a given time period. Futures contracts, on the other hand, are binding. An option on a futures contract, therefore, provides the holder of the option the opportunity to lock in a potentially favorable price without having to make an immediate decision on whether to follow through on the terms of the underlying futures contract. 36 35 Pucurea clcuins houaa require their deuing mcmben to use one of several specific designated settlement banks. HOM:Yet, at tb11 tun~ SCYeta& futures clearing houses are considering switching to this more flexible system for settJcment bankL In addition to equity-related options and options on futures. tbcre are two ocher kinds of options: currency options and Treuury security ~tiona. Both currency and Treasury security options are cleared and settled through the Options Cearing Corpontion (OCC); plcuc refer to Section 2.1.1.J.A for more information about the OCC. Por more information on futures conrnc:u. please refer to Section 2.1.1.2.B: Otltt!, FUIUl'f:S Ckanng Hausa. Page S8
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Study of International Cearing and Settlement The Cearing and Settlement Process In North America Options on futures contracts are traded on numerous excbangr,s. In the U.S., options on futures are traded on: the Chicago Board of Trade (CBOT); Chicago Mercantile bcbaogr. (CME); the Coffee Sugar and Cocoa E,:cbange (CSCE); the Commodity Excbangc Incorporated (COMEX); the Kansas City Board of Trade (KCBOT); the MidAmerica Commodity Evbaogc (MIDAM); the Minneapolis Grain EvbanF (MGE); the New York Cotton Excbangc (NYCE); the New York Futures Exchange (NYFE); and the New York Mercantile Evbang,: (NYMEX). Some examples of c.vban~ outside the U.S. which trade options on futures contracts arc: the Baltic Futures Evbaoge (BFE): the Intcrnatioaal Petroleum Evbaog~ of London (IPE); the Marche A Tcrme Des Instrument rwancicrs (MA TIF); the London Futures and Options E1'cbaogr. (FOX); the London International rmancial Futures E:rcbaogc (LIFFE); the London Metal Evbange (LME); the Sydoe:t, Futures Excbangc (SFE); and the Singapore International Monetary Exchange (SIMEX). Put aad Call Opdoas Just as is the case in equity-related options, a "put option on a futures contrad gives the buyer of the option the right to "put ( sell) the underlying instrument to the writer of the option ( the seller of the option), at a set price which is called the "strike" price. Similarly, a "call option gives the buyer of the option the right to "call (b~) the underlying instrument from the writer of the option (the seller of the option), at the strike price. The buyer of the option, regardless of whether it is a put or call option, must pay the seller a sum which is known as the "premium." The option buyer's potential for profit is unlimited; his potential for 1cm is limited to the size of the premium that is paid. The seller of the option (the writer of the option) is in the opposite situation: his potential for profit is limited to the size of the premium paid by the buyer; but his potential for loss depending on the market movement -is unlimited. Sellers of options therefore may be viewed as selling (writing) insurance against price movement. Put option writers are selling insurance protecting the buyer against price decreases, while call option writers arc selling insurance protecting the buyer against price increases. The Clearina and Settlement Process The clearing and settlement process for options on futures contracts is very similar to that used for equity-related options, in terms of trade matching ( checking the original trade information to make sure there is no discrepancy between buyer and seller in respect to price, quanuty, etc.), margining, and the exercise of options ( the decision by the buyer of an option to buy or sell the option's underlying product). Following the trade, the clearing firm representing the buyer of the option pays the premium in cash to the clearing firm representing the seller through the clearing house. 37 This lilt provides only a sampler of excbanges trading options on t'utura contracts; it is not meant to be inclusive. The lilt ii taken from u-Hour Trading: TM Global NfflWJrlc of FutunS and Options Mar1cets (New Yorlc John Wiley & Sona, 1989), pap 163-290 (Contraet SpifklJlions l1y CoUlllrf and Exchan~). Page 59
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Study of International Cearing and Settlement The Ceariq and Settlement Proccsa In Nortb America The selling clearing firm must then deposit a sum which is called risk premium, or "good faith margin. The amount of risk premium or margin reflects the mark to the market value of the option price plus an additional risk component which reflects the estimated potential one day price change in the option. After paying the premium on the option, the buyer of the option has no further financial obligation, unless he chooses to exercise the option. The writer of the option, however, is responsible for margin payments which are adjusted daily according to the price Ouctuatlons of the product underlying the option contract ( and with more sophisticated margining systems, volatility, time to expiration, interest rates, and other factors affecting option premium levels). This obligation to post margin is ongoing until the option contract expires, is offset by the writer through the purchase of the same strike price, maturity and type of (put or call) option that bad been written ( sold), or is liquidated by the clearing house because the writer of the option bas failed to meet a margin call. If the buyer of the option does decide to exercise the option he notifies his clea~ firm, which in tum notifies the clearing house. The clearing house mmt be no,med in advance of the time that the option contract is to ~ire. The purpose of this advance notice is to give the clearing house, during its overnight processing cycle, time to randomly awgD mi option writer ( cho.,cn from the pool of clearing house members who have written options on futures conttacts for the same underlying produd, at the same strike price, and the same option type (put or call), with the same expiration date) who must fulfill the terms of the option contract. On the business day following the exercise of the option, the clearing house's computer book-entry accounting system removes that option contract from what is known as the eubangc's "open interest" and simultaneously acates a futures contract at the strike price. The buyer of the exercised option and the awgDed writer of that option are now the counterparties of the newly acated futures contract. Accordingly, both countcrpartics now owe margin to the clearing house to demonstrate their ability to make good on the payment and delivery obligations of the futures contract. The first day's payment is calculated by the clearing house and consists of original margin and settlement variation. The clearing house uses the risk margin deposited by the writer of the option towards the amount that the option writer now owes as original margin on the futures contrad.38 Any excess margin on deposit is released to the writer of the option simultaneously with his cash payment of the "settlement variation: an amount reflecting the difference between the price ( strike price) in the newly created futures contract and the current futures settlement price for the underlying product of the contract. ll Thia aaumcs an 'in-the-money' exercise, where, in tbc case of a call, the strike price of the option is beneath the current tunares settlement price, or in the case of a put, the strike price is above the futul"C$ settlement price. Page 60
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2.J..1.4 GROUP FOUR: ooVJES Study of International Cearing and Settlement The Cearing and Settlement Process Ill North America UNITED STATES TREASURY AND AGENCY SECURITIES lntroclucdoa Governments (local, state, federal, and foreign) issue securities for the same reasons as corporations do: to raise money to fund projects and operations. The U.S. Federal Government issues two types of securities Treasuries and Agencies. Together they arc known as Governments ( or Govies ). There are four kinds of Treasuries: Trcuury bonds, Treasury bills, Treasury notes, and Savings 3onds. Agencies, on the other hand, are issued by federal agencies such as the Federal National Mortgage ~on, the Farm Credit System, the Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks and Student Loan Marketing Associatfon. The major difference between tl\ese two types of Govies is that Treasuries are directly backed by the full faith and credit of the federal government, unlike Agencies, which are not. This means that to repay the interest and principal of Treasuries, the federal government pledges its full taxing and borrowing power, including revenue other than taxes. This same pledge docs not apply to marshalling the funds to repay the interest and principal of Agencies. The market for both types of Govies is large, strong and has experienced significant growth in recent years. Between 1978 and 1988, the size of the market for U.S. Treasuries inacased by more than 300 percent rising from $550 billion to $1.8 trillion.39 Moaey managers around the world, as well as other governments, are participating in these markets more than ever before. An important and active market such as this one requires an extremely quick and reliable clearing and settlement prOCCM. This need is met by several institutions: the Federal Reserve Bank; the Government Sec.uitics Oearing Corporation (GSCC); the Mortgage-Backed Securities Clearing Corporation (MBSCC); and the Participants Trust Company (PTC). The question of which institutions take part in the clearing and settlement process depends upon the type of Govie that is being traded. The banking system (i.e., the Federal Reserve Banks and depository institutions holding securities accounts with the Federal Reserve Banks) handles the settlement process for all Treasuries and some Agencies (see Section 2.1.1.4A). As for the clearing process -it may also be done by the banking system ( which handles Treasuries and book-entry eligible Agencies); or it may be done by GSCC (which handles certain Treasuries and those book-entry eligible Agencies which are not mortgage-backed securities, sec Section 2.1.1.4.B); or MBSCC (which handles only mortgage-backed securities including GNMA's, 40 and are discussed in Section 2.1.1.5 of this summary.) 2.1.1.4.A TIIE FEDERAL RESERVE BANK AND THE FEDWIRE SYSTEM (Summary of reprint provided by tbe Federal Reserve Bank or New York) The FedWire system, operated by the Federal Reserve Bank System, is an electronic wire transfer system. It is used both for the transfer of funds and for the book-entry transfer of government Agency and Treasury securities, between banking institutions on behalf of themselves and their customers. lt See tbc paper contributed to this study by Robert Woldow, Attachment P, page 1. 41 ONMA's securities issued by the Qovemment r:farional Monpge ~ation. Page 61
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Study of International Cearing and Settlement The Caring and Settlement Procell In Nardi America AD.y depository institution ( all domestic commercial banks, foreign banks with branches or agencies in the United States, trust companies, saving., banks, savings and Jou associations, and FDIC-eligible credit unions) may maintain both book-entry securities accounts and cash accounts with the Federal Resene. Currently, 3619 participants maintain book-entry securities accounts. Depository institutions hold cash and securities for themselves and on behalf of their customers, including correspondent banks, governments, corporations, institutional investors, individual investors, and financial institutions. When a customer instructs his bank to move his assets to his countcrparty's account (i.e. to pay" someone, or to deliver securitics for settlement), this is accomplished by simultaneous book-entry of the cash and securitics accounts which each bank maintains at the Fed, and corresponding entries in the accounting system which each bank uses to keep track of all of its obligations to its cmtomers. If the two counterparties use the same bank, the transaction is effected by debiting and crediting the bank's internal accounting system, and the bank's account at Federal Rescnc is unaffected. Govics trades arc usually settled on a .:next day" buis (that is, on the day after the trade (T + 1)) although a number of trades arc settled same day. The book-entry delivery (transfer of ownership) of securities and simultaneous payment of cash for those securities are performed via the FedWire. It can therefore be said that the FedWtrc provides the Govics market with a "true" delivery vs. payment settlement capability.4 1 98% of all marketable U.S. Treasuries arc settled via book-entry.42 Similarly, a high percentage of Government Agency Securities arc settled via book-cntry.43 On the day after the trade (T + 1), the countcrparties instruct their banks to move the money and securities required for settlement of the obligations of the trade. The bank may only move securities if those securities are present in its book-entry account at the time the transaction is processed. However, funds overdrafts, to an extent, are allowed. Therefore, the settlement of a Govies trade may result in an overdraft in the receiving bank's cash account with the Fed. 44 An interesting aspect of the Federal Rcscrvc's book-entry system is that some of the trades c:ntering the FedWtre system have not yet been compared or matched (that is, checked for discrepancies in the trade data submitted by both the buyer and the seller). Even so, all trades which enter the FedWire 41 "True' dctiYeryvs. paymenc (DVP) is a term meaning we tbe buyer and the seller's scnlemcnt obligations arc fulfilled simuJtaneoualy. In addition to DVP, securities may aJio be dcli"Yen:d free. wnb the offsctung movement of funds ocaamng acroa tbe FedWire f undl sysrem. The remaining 2% represenc securities which are iaucd in physic:aJ r onn onJy. AJl.hougtl the Treasuries aa:ount for rnoa o( tbe doUarvaJuc o( GoYia eligible for book~ntry on the FcderaJ Rescrvc's syaem. 95% of the aauaJ imaa are Agency Sccuritic:L (Statistics pl'OYldcd by the FederaJ Reserve Bank of ~ew York in the paper submitted to. and induded in. thia Shady.) have atways been a conc:em of tJle Peden& Rcscm: Bank. whicb actiYely monitors this aspect of systemic rist. The P~ Raem: ia currently considering a propou! to runtier linuc overdrafts oa the Fed Wire. The PedcraJ Raem: notes, hoM:ver, thac overdrafts in cwa accouna caused by the scnlemenr of U.S. goyemment securities tranactiom differ Crom overdrafts raw ting from trade related paymcnc activity. This is because a) CM:rdrafts rcsuJtiq hom securities scnJemenc are coacencnted amoag very few ~-pmicory instinuiona (75% of all overdrafts are aa:ouated for by four New Yort uty bub), tb111 cbaagsng tbc nacure o( tbe risk to be monitored (i.e. it IS more of an inltihlhOIHpCCUic risk); and b) tbe vaJuc ot tbe securities bcld by the receiving insticution ( ac tbe Fed) is equivalent to tJle amount of tbe overdraft. This offcn the Federal R.cscr-..e Bank the pouibilicy of establishing a claim against these securities if ncccsary. Por more on risu auoci.ated with payment system&. the reader ia referred to Section 3.6.1 of thlS summary, and to the Peden& R.cscm: Banko( New Yort paper entitled: 71w F~ R.aaw Wff Transfa-Nnworlc. ThlS paper. which WM reprinted for our study, diKuslcs the management of overdrafts. Pag.:62
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Study of lntemational Ccaring and Settlement The Ccaring and Settlement Process In North America for settlement are immediately executed. 45 As a result, it is possible that a trade executed by the FcdW'ue might later tum out to have contained some discrepancy in the terms of the trade. If this happens, the trade can be reversed-during the "reversal period", right before the FedWtre closes for the day. This aspect of the FcdW'trC system is one of the reasons that the Government Securities Clearing Corporation (GSCC) was created -to do trade matching in advance of the time that the trade enters the FcdW'tre system for settlement. 2.1.1.4.11 THE GOVERNMENT SECURITIES CLEARING CORPORATION ~GSCC) (S11mma'7 of apert paper by Robert Woldow) The Government Securities Clearing Corporation (GSCC) is an affiliate of the National Securities Ocaring Corporation (NSCC). GSCC began its companion operations in August, 1988, in response to the market demand for automated trade matching and netting of Govies trades. GSCC has 61 participants, which together submit approximately 24,000 counterparty positions per day, reflecting 12,000 trades. These participants include almost all of the primary dealers in government securities, as well as the inter-dealer brokers and major clearing agent banks. 46 The participants MC represented by a user-dominated Board of Directors, which sets policies and directions for the clearing corporation. GSCC is regulated by the Securities and E"fcbanv, Commwi()n. At the same time, GSCC maintains relationships with the regulators of the Govies market and its participants the Federal Reserve Bank Syst~ the National ~on of Securities Dealers, Inc:. (NASO), and the United States Treasury Department. GSCC provides two services for its particit'ants: trade comparison/matching and netting. Trade Comparison/Matching GSCC currently does trade matching for trades of Treasury bills, bonds, notes, STRIPS47, and non-mortgage-backed Government Agency Securities. Participants submit their trade informatio~ and GSCC matches the delivery and receive obligations of the original counterparties to the trade. All matched trades arc reported to the participants; inter-dealer paper confirmations arc unnecessary. Nettina In July, 1989, GSCC began offering netting as a service to its participants. "Netting" allows market participants to pay or receive only the net amount of funds or securities that would result from two or more trades. This improves market liquidity and reduces the risk of default, because it reduces both the number and the overall si7.e of the payments and securities deliveries that must be made. Netting at GSCC is done for matched trades. on the day after the trade (T + l) .U Provided tbc sccuritia are in tbc accouac and the bank's FED cap (i.e. overdraft limit on cuh) has not been reached. 46 Thole bub wt1icb cJear Govia directly lhrougb tbc PcderaJ Rescr.ie. 41 ~te Iradinl of Rcg:iltered Interest and er,incipa! o( ~ritics -are zctO
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Study of International Cearing and Settlement The Cearing and Settlement Proccsa In North America GSCC nets trades through a method known as multilateral netting by novation. This means that a new contract is drawn up with each GSCC participant, reflecting his net settlement obligations from one or more trades. The counterparty to each of these novated contracts is the GSCC, rather than the countcrparty (or counterparties) to the original trades. In this way, GSCC acts as the buyer to the seller, and the seller to the buyer. GSCC provides its participants with a guarantee that the obligations of settlement (i.e., payment and securities delivery) will be met. As the number of participants in GSCC's multilateral netting program increases, the number of deliveries and receives in the entire Govies market (i.e., those handled by GSCC and those which are not) as a whole will deaease. This is because the more participants in the system, the smaller the number of unnetted trad.es. Notification of Settlement Obligations In order to net and novatc the trades of a particular security, GSCC sets a uniform current market price for each security. GSCC then notifies each participant as to the amount of each security to be delivered and the amount of cash to be paid in order to satisfy all netted obligations. There is often a difference between the uniform current market price for a security ( calculated by GSCC) and the price established at the time of the original trade. Therefore, GSCC also calculates the adjustment payment .necessary to ensure that all netting participants meet the obligations of their original trade agreements. This adjustment is called the Transaction Adjustment Payment (TAP). GSCC notifies each participant of its net securities obligation, its net payment obligation and its net TAP obligation. The three net obligations are then settled through the ban.king system. 48 All payments and deliveries are made to GSCC's securities and cash accounts at its settlement/ clearing banks. Movements of funds between these settlement/ clearing banks occurs through FedWire. Future Trends at GSCC GSCC plans to implement automated interfaces with its participants, creating a fully on-line trade matching system. These automated interfaces may eventually be used to capture trade information at the point of executio~ send confirmations to the counterparties, and route matched trades directly to the netting system. 2.1.1.5 GROUP FIVE: MORTGAGE-BACKED SECURITIES (This Section provided by the Management of the Participants Trust Company) Mortgage-backed securities are financial instruments representing pools of individual mortgages. Investors in these securities receive monthly payments derived from interest and principal paid by borrowers of the mortgages to their holders. In the U.S., mortgage-backed securities are issued by government authorized corporations including the Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association and the Government National Mortgage Association. In our discu.s&on of mortgage-backed securities, we will focus on the securities issued and guaranteed by the Government National Mortgage Association which are commonly know as GNMAs. 41 For more on the FedWirc, please refer to Section 2.1.1.4.A. Page 64
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Study of International Oearing and Settlement The Oearing and Settlement Process In North America GNMAs are backed by pools of government insured or guaranteed mortgages. These mortgages are insured by the Department of Housing and Urban Development (FRA) or the Farmer's Home Administration (FMHA ), or guaranteed by the Veterans Administration (VA). GNMA guarantees, with the full faith and credit of the U.S. Government, the timely payment of principal and interest to holders of the securities. This guarantee assures the investor of receiving all scheduled monthly payments, as well as prepayments and early recoveries of principal, in a timely manner. These payments are assured even if homeowners who have the underlying mortgages do not make their payments on time or default on their mortgages. The pace at which investors will be paid the full principal and interest on GNMAs is not predictable. A homeowner with a mortgage represented by a GNMA may sell his home. Furthermore, when interest rates are declining, such homeowners are apt to pay off the loan prematurely and refmance to take advantage of the newly available lower interest rates. Conversely, in a climate of rising rates, homeowners are likely to hold onto their mortgages longer than might otherwise be expected. GNMAs inaease the overall supply of mortgage credit available for housing by channeling funds from the securities markets to the mortgage market. Investors likewise benefit from the government-guaranteed monthly payment which GNMAs provide. Currently more than $500 billion GNMAs have been issued a11,d arc being traded. Most GNMA transactions arc cleared by the MBS Clearing Corporation (MBSCC) and settled through the Participants Trust Company (PTC). The Participants Trust Company (PTC) Located in New York City, PTC is approved and authorized by the Federal Reserve System, the Securities and Exchange Commission (SEC), and the Banking Department of New York State to settle transactions in GNMAs. PTC is owned by 13 banks and 13 brokerage firms. Most of these financial institutions are members of the Public Securities As.5ociation (PSA), a group of such institutions which underwrite and trade municipal and federal debt securities. PTC was formed in March 1989 after acquiring the assets and business of the Depository Division of MBSCC. MBSCC continues to be involved in processing GNMAs in that it compares and nets such trades. PTC provides four basic electronic services, namely: 1. It holds mortgage-backed securities in book-entry form on the behalf of the actual owners of the certificates. PTC contracts a bank to be the custodian of the physical securities. 2. It disburses to its Participants principal and interest payments from issuers of mortgages which underly the GNMAs held in book-entry form. 3. It provides settlement services for these securities: accepting payment from the buyer and forwarding the funds to the seller, and simultaneously transferring ownership to the buyer. 4. It offers financing services to its Participants by providing facilities which use GNMAs as collateral Page 65
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Study of International Oearing and Settlement The Cearing and Settlement Process In North America Cunently, 38 financial institutions (including the 26 owners) are Participants in PTC. Although PTC, at this time, settles only GNMAs, its charter permits expansion into processing other securities. PTC was approved as a limited-purpose trust company by the Federal Reserve System in March 1989. It began processing GNMA transactions directly thereafter. It is anticipated that all GNMAs will be eliglole for settlement through PTC in the first quarter of 1990. In September 1989, the value of transactions settled through PTC exceeded $13.5 billion dollars and principal and interest disbursements nearly totaled Sl.2 billion. These amounts are likely to double by year-end 1990. The Clearing and Settlement Process GNMAs are traded over-the-counter through specific arrangements between counterparties, most of whom use the clearing house, MBSCC. Virtually all transactions are cleared through, and netted byMBSCC. MBSCC compares the trade data which have been reported by the buyer and seller. After the buyer and seller individually verify that it is a matched trade, MBSCC determines the settlement obligations of each of the counterparties. The settlement obligations take one of two forms: trade-for-trade or netted. Netting requires agreement by all relevant counterpal'ties that debits for payment and/ or delivery may be offset by credits for payment and/ or delivery. Apprmi:imately 90% of GNMA trades cleared through MBSCC are netted in respect to settlement obligations. Trade-for-trade settlement obligations are established by specific agreements between the counterparties of each individual trade. MBSCC informs the counterparties of their obligations 48 hours before the settlement date. The 48-hour notification holds for both cash and forward transactions. The latter are settled through PTC each month on one of three days set by PSA The type of GNMA determines the specific settlement day. PTC settles all transactions through book-entry transfer of ownership at the depository. (There are no individual cenilicates for GNMAs. For each pool, a jumbo certificate represents all beneficial owners of that pool.) The net buyers (Participants with net debit balances) pay PTC vi.a FedWire and PTC pays the net sellers (Participants with net credit balances), again using FedWire at the close of business each day. In this manner, PTC provides delivery-versus-payment services: delivery of securities is effectuated simultaneously with payment. PTC guarantees its Participants that all their settlement obligations will be satisfied, that is, payments will be. made and securities will be delivered. If one or more Participants were to default by failure to satisfy net debit balances(s), PTC can nevertheless assure settlement. PTC minimizes risk and assures settlement by: L limiting membership to creditworthy applications; 2. enforcing strict credit constraints on all transactions; 3. maintaining extensive committed lines of credit; and 4. specifying rules governing the allocation of losses were any-to occur. Page 66
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Study of International Ocaring and Settlement The Ocaring and Settlement Process In Nonh America Applicants must satisfy rigorous financial and operating standards, and Participants are monitored periodically to ensure that these standards arc maintained. Participants are also required to establish Participants Funds between one and ten million dollars, consisting of cash and government securities. A transaction is pr<>CC:Med only if each party to it has sufficient equity and liquidity. The adequacy of securities providing equity is achieved by discounting or "haircutting" them enough to ensure their market value. Adequate liquidity is realized for a Participant by utilizing its fmancial status to limit its debit obligation, which may in no circumstance exceed PTC's committed lines of credit with banks. In the unlikely event that a Participant defaults, PTC would exercise its previously established lines of aedit, obtaining the funds necessary to aMure settlement by pledging the defaulter's securities. PrC'S Interface with the Banking System Currently, PTC gains a~ to the FedWirc electronic payment system though another bank. However, it proposes to change this arrangement and to establish a" direct link" to the Federal Reserve Bank of New York (FRBNY). The "direct link" would give PTC its own cash and securities accounts at the FRBNY and eliminate the need for an intermediary. 2.1.1.6 GROUP SIX: MUNICIPAL SECURITI~ (Summary of information provided by the Municipal Securities Rulemaking Board) In this section, we will discuss the clearing and settlement of municipal securities. These securities arc usually traded over-the-counter (OTC) 4 9 through individual arrangements between countcrparties. The trading of municipal securities is done acwrding to rules laid out by the Municipal Securities Rulemaking Board (MSRB), which consists of persons representing securities firms, banks dealing in municipal securities, and the public. The MSRB operates under the oversight of the Securities and Fvbange Commission (SEC); that is, the MSRB's rules are subject to the approval of the SEC. These rules are enforced by the NASO, the Comptroller of the Currency, the Federal Reserve Board and the Federal Deposit Insurance Corporation (FDIC). The Clearing and Settlement Process ror MunicipaJ Securities The clearing and settlement process for municipal securities is usually handled by registered securities clearing agencies such as the National Securities Clearing Corporation (NSCC) and The Depository Trust Company (DTC).50 The trade might, however, first go through a regional clearing house (such as the Midwest Clearing Corporation or the Stock Clearing Corporation of Philadelphia). In the following discussion, we will describe the process as it occurs at NSCC and OTC. 49 ~be-counter" (OTC) refers to securities wh..ich are not listed or traded on organized exchanges. Instead, trading ii conducted through telephone and computer nerwom connecting dca!ers in stocks and bonds. 51 Not ail municipal securities an: eligible for deposit at the OTC. OTC-ineligible securities are settled through physic.a! delivery of securities; the payment ponion of the settlement obligation is worked out between the counte~n1cs on a trade-for-trade basis. OTC.ineligible securities may still, however, be ctcarcd through the NSCC. Page 67
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Study of IntemationaJ Ocaring and Settlement The Oearing and Settlement Process In North America For intcrdcaler trades,51 NSCC does the trade match.iJig (comparison of data from the buy and sell orders, to make sure that there arc no disacpancies).52 Historically, the transaction is then settled on a trade-for-trade basis: according to specific agreement between the counterparties for that particular trade. However, the NSCC has a pilot program by which some transactions in OTC-eligible municipal securities are netted through the NSCC's Continuous Net Settlement (CNS) System. In this case, the NSCC takes the counterparty position ( acts as the buyer to the seller, and acts as the seller to the buyer) and guarantees to each counterparty that the obligations of settlement will be met. The NSCCs guarantee for municipal securities is effective beginning on the day before the settlement date. The settlement date for municipal securities is normally five days after the trade date (T + 5) for regular transactions. Cash transactions settle on the day of the trade. Cash transactions are typically done only for short term municipal securities which settle via FedWire. Another exception to the T + 5 settlement date timetable is the settlement of trades for when issued securities ( those which have not yet been iMued). Herc, the settlement date will be determined by agreement between the counterparties to the trade. The obligation to deliver securities on the settlement date is satisfied either through computer book entry transfer of ownership at the OTC, or, through the physical delivery of securities. Municipal securities being held at the OTC may be in certificate form eunmobilizcd" securities) or they may be dematerialized ( no longer existing. in certificate form, existing instead only as entries in com put er accounting systems recording the ownership of securities).53 The obligation to pay for netted securities on the settlement date is satisfied when the buyer delivers a certified check, payable to the NSCC. The check is delivered to the OTC, which acts as an agent for the NSCC in the settlement process. The NSCC then pays the seller, via regular bank check. "Hot Issues in the Clearing and Settlement o( Municipal Securities The MSRB, in its March 1988 report to the SEC "Automated Clearance And Settlement In T71e Municipal Securities Market, identifies an area in which there is room for improvement in the clearing and settlement proces.\. According to the MSRB report: "Many [ municipal securities J dealers, including a number of dealers that are strong supponen of automaJed clearance, still havt not made the intemaJ technicai changes, training and supervisory commitments necessary to use automated systems efficiently and to comply with the automated clearance rules." The MSRB points out two problems which are a result of the need for increased automation and the need for changes within brokerage firms and banks in order to use automation more efficiently: 51 "lnterdealer tra
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Study of International Ocaring and Settlement The Oearing and Settlement Process In Nonh Arnenca On the day after the trade (T + 1), in the clearing of when issued" inter-dealer trades, only 43% of the trades are matched trades. On T + l, the percentage of secondary market54 inter-dealer trades which have been matched is 75%.55 These percentages arc in contrast to the almost 100% trade matching rate that is seen on T + 1 in the clearing of corporate securities. On T + l, the rate of customer affirmation of OTC-eligible municipal securities56 is 64 percent; the rate of customer affirmation for OTC-ineligible municipal securities is 25 percent. These two. percentages compare to the 90 percent customer affirmation rate which is seen on T + 1 in the clearing of trades of corporate securities. Three other areas of concern relating to municipal securities emerged from the responses of the market participants who answered the questions in the survey done for our study.57 They are: Municipal securities settlement obligations historically have not been netted through the NSCC. A pilot program for netting municipal securities, however, is now underway. Sometimes trades are settled through physical delivery when actually they were eligible for book-entry settlement at a depository. This happens in cases involving older bearer bonds which at first may not have been eligible for book entry settlemenL One of the counterparties may request that the OTC make the traded security eligible for book-entry settlement; once this status has been adjusted, the other counterparty to the trade may not realize that physical delivery of the securities is no longer necessary or desirable. Discus.Yous are underway within the industry over the best way to resolve these issues: both those identified by the MSRB in its report, and those identified by our survey respondents. The MSRB in particular notes that Congressional action might be helpful in some areas. 2.1.2 CLEARING AND SETI'LEMENT IN CANADA (Summary of Expert Paper by Robert Tunderman) There are five exchanges in Canada: the Toronto Stock Exchange, the Montreal Stock Exchange, the Vancouver Stock Exchange, the Alberta Stock Exchange, and the Toronto Futures Exchange. The Toronto Stock Exchange handles over 80 percent of all equities trades in Canada and is by far the largest of the Canadian equities exchanges. In terms of trading volume, the Toronto Stock Exchange is, furthermore, the fifth largest stock exchange in North America. Trades in the Canadian equities markets are cleared and settled by the Canadian Depository for Securities, Limited (CDS), in Toronto and the Vancouver Stock Exchange Service Corporation. CDS clears and settles trades for both the Toronto Stock Exchange and the Montreal Stock Exchange. As for the Vancouver Stock Exchange Service Corporation it clears and settles for the Vancouver Stock Exchange, and it provides settlement services for the Alberta Stock Exchange ( which clears its own trades). 54 Secondary martet: securities which are being re-&0k1, as opp0Kd to securities 1n the pnmary market. which are being soki for tbe rll"St time at issuance. 55 Thia statiltic. aJon,with the others excerpted here from the MSRB rcpo~ is from data on the clearing and settlement of trades of mwiictpaA securities i.n the month of February, 1988. 5' cuacomer affirmation: a cusiorner ia required to report beck to the broker or dealer that the trade data is accurate. Unlesa this ia done. a trade cannoc be COIISldered a matched trade. Cuatomer affirmation is done through the N'auonai IulitutionaJ OeaJer System (NIOS). 57 The results from our survey ,e S~ of llll6nalionaJ Ckaring and Steakmau: Marien Parricipa,us, arc included in Section 6 o( this study. Page 69
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Study of International Oearing and Settlement The Qcaring and Settlement Process In North America Trades in the derivative markets are cleared and settled through two clearing houses: Trans Canada Options Incorporated and the International Options Clearing Corporation. Both serve the Vancouver Stock Excbange Options Trading. Trans Canada also processes trades on the Toronto Futures Exchange and options trades on the Toronto Stock Evbaogc. 2.1.2.1 EQUITIES: THE CANADIAN DEPOSITORY FOR SECURJTIES (CDS) In our discuwon of clearing and settlement in Canada, we will focus on the Canadian Depository for Securities, since it processes the largest volume of trades in Canada. The Oearing and Settlement Process Depending upon the type of securities which are being traded, CDS may act either as a clearing house or as a depository, or, it may serve both functions. As is the case at the National Securities Clearing Corporation in the United States, CDS offers a Continuous Net Settlement service (CNS) for securities which are depository eligible and can be transferred from one account holder to another via a book-entry method. CDS also provides its participants58 with services for settlement of trades involving the physical delivery of securities. This type of settlement occurs outside of CNS. If a security is eligible for proces.sing through the CNS system, CDS takes the counterparty position in the trade and guarantees settlement. This guarantee is effective following the completion of the trade matching process ( comparing the original buy and sell orders to make sure there are no discrepancies in either price or quantity). On the other hand -if the trade cannot be processed through CNS -CDS does not provide the counterparties with any guarantees. In these cases, acrording to CDS: "CDS processes troding information received from participants in order to determine net secwities and funds positions facilitating the most economical and efficient settlement procedures for participants involved. CDS does not guarantee that trades reported to its facililies will invanab/y settle regardless of counterparry default." CDS provides five basic services to its participants who trade both on the primary markets as well as the secondary oncs:59 (1) trade reporting; (2) confirmations; (3) settlements; ( 4) new stock issues distribution; and ( 5) other support services such as securities lending facilities. For participants ia the Toronto Stock Exchange, Montreal Exchange and the over-the-counter markets, CDS provides a trade reporting service. This includes reports for all stock and bond transactions. CDS allows participants, once a trade has been reported, to proactively or reactively confirm their trades. In a reactive confirmation, CDS automatically confirms a trade if, after a designated time 51 CDS clearing members are caHcd participants. 59 Securities being sold in the primary markets refers to SCC\lntics that are being sold for the first time to the public. Investors at thLS point actuaJly trade with the company issumg the sccuntics. Securities being sold in the "secondary markets refers to all SCCllritics which are not being sold for the first time. Page 70
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Study of lntemat1011al Ocanng and Settlement The Ocanng and Settlement Process In Nonh Amenca period, neither counterparty has objected to the terms of the trade ( as stated by the CDS trade reporting service). A proactive confirmation, on the other hand, requires that the trades of direct participants' customers be explicitly confirmed. CDS can settle trades either through book-entry transfer of title in its depository, or through the physical delivery of securities. A book-entry transaction is processed through the continuous net settlement system, while a physical delivery occurs on a trade by trade basis. Electronic delivery is also an option for newly issued securities, providing they arc settled before the issuance closing date. Whether or not a security is CNS eligible -CDS sets the settlement date for T + 5. In addition to the basic clearing and settlement services, CDS offers other services such as secwities lending. 60 ~en the need arises, CDS acts as an intermediary between lenders and borrowers of securities. If, while a security has been lent, a dividend distribution is made for the lent security, CDS will assist borrowers in making a claim against those dividends. Furthermore, CDS will automatically net a participant's dividend proceeds against other potential payments he may have. Since it is a depository, CDS is the nominee company for stock it holds. According to Robert Tunderman, in his expert paper submitted for this study: "Participants transfer their securities into CDS's nominee name for credit in the CDS ledger system. CDS, as nominee. becomes the shareholder of ail secunties in its custody. Participants, who maintain effective ownership of their deposited securities, are then able to use their ledger positions with CDS to effect a variety of seNices. In addition to the aforementioned clearing and settlement services, CDS provides: custodial functions; ledger management facilities allowing members, among other things, to pledge ledger balances as loan collateral; processing of entitlements such as dividends and interest payments on bonds; and, le(%cr reconcilement and balance reporting services. The Interface between CDS and its Participants Members of either the Toronto or Montreal stock exchanges, ban.ks, and trust companies may be CDS participants. The participants communicate on-line with CDS. There are no paper instructions traveling back and forth between CDS and its participants. The Interface between CDS and the Banking System The Canadian Payments As.sociation provides the mechanism through wn.ich payments are made for securities settlement. The settlement proces.s for payments in the banking system begins ac 8:30 a.m. EST. If the payment instructions were received by the bank before midnight~ the participants' preliminary nee gain or loss information will be made available at 9:30 a.m. EST. 60 -SCCUritics lending: shon-term loans o( sccuntics. U$u.aUy for the purpo&C of meeung the secuntics delivery obligation of scnlemenL Page 71
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Study of InternationaJ Cea.ring and Settlement The Ocaring and Settlement Process 1n North America Since data comes from different regions of Cana~ the risk exists that a payment instruction might miss that midnight deadline. Ally payment instructions received after midnight will be processed by T + 2. This adds an additional payment system risk to the settlement system. In either case, final settlement, including adjustments and any central bank advances, does not take place until 4:00 p.m. EST on the day after a payment instruction is recognized as received by the payment system. The Canadian NatiooaJ Contingency Fund All interesting point worth noting is the Canadian markets' use of a contingency fund. Similar to the UnitcdStat~61Canadaoffersa'nationalcontingencyfund'tocovera_rctailorinstitutionalcustomer's potential losses as a result of a broker's financial failurc.62 Unlike the U.S., however, the Canadian contingency fund is a private sector effort that is sponsored by the Alberta, Montre~ Toronto, and V ancouvcr Stock Excbangr.s, and the Canadian Investment Dealers Aswciation. 63 61 U.S. iavestors, o( course. are protected by the SIPC. For more on this. please sec Section 3.4.J: ~ Ri.sJc to lndivuiuai /lfWSI/JtS Dw to lM F(l,UJ,,lff of a Brolc6a~ Finn in Equines Markets, and the expert pa per by Theodore Focht, included in our study. 62 Thia appfica onJy to equities and casb transactions. 63 Very few countries, however. ofCerinveston protection from the effects of the bankruptcy of a brokerage firm. Besides tbc U.S. and Canada, the United Kingdom also offers such protection. In the United Kingdom, investors arc protected by tbe Securities Investments Board contingency fund. Page 72
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STUDY OF INTERNATIONAL CLEARING AL~ SEITLEI\'IENT 2.2 THE CLEARING Ai~D SETTLE~IENT PROCESS l:\T EUROPE Page 73
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TABLE OF CONTENTS Section 2.2 The Oearing and Settlement Process in Europe lll Introduction 2.2.2 Oearing and Settlement of Eurobonds. The CED EL and Euro-dear Systems 2.2.2.1 The Centrale de Uvraison de VaJeurs Mobillieres (CEDEL) Introduction CEDEL's Interface with its Ocaring Members The Oearing and Settlement Process at CED EL CEDEL's Interface with the Ban.king System 2.2.2.2 The Euro-dear System Introduction The Interface betM:cn Euro-dear and its Participants The Oearing and Settlement at the Euro-clear System The Interface between the Euro-dear System and tbc Banks 2..2..3 Ccaring and Settlement in Prance Societe lnterprofes&ionnellc pour la Compensation des VaJeurs Mobilieres (SICOV AM) Introduction 1bc Oearing and Settlement Proccs& SICOV AM's Interface to the Banking System SICOV AM's Interface with its Members Future Trends 2.24 Oearing and Settlement in the Unucd Kingdom 2.2.4.l Equ1ucs: IntemationaJ Stock Exchange (ISE) Introduction The Oearing and Settlement Procesa for the ISE ISE: the Payments Process Future Trends at the ISE 2.2.4.2 Futures: IntemationaJ Commodit1c. Ocanng House, Ltd. (ICD-1) Introduction ICCJ-l's Interface to the Exchanges The Oearing and Settlement Process lnterf acc to Banks 2.2..5 Oearing and Settlement in West Germany: K.usenvcrcine ( the KV's) and the Deutscher A,asJandskavcnverein, AG (the AKY) Page 74 Introduction The Interface between the DWZ and the Exchanges The Settlement Process International Trading: Settlement of Trades AC?"065 ~auonal Borders The Interface between the KV's and the Banks The Interface between the KV's and their Members GcneraJ Observauon& i.3 75 i1 n n 78 79 80 81 81 32 83 84 84 84 86 86 86 87 37 37 37 38 90 )O 91 'JI )2 12 1l
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Study of International Qearing and Settlement The Qearing and Settlement Process In Europe 2.2 CLEARING AND SETI'LE1\1ENT IN EUROPE 2.2.1 INTRODUCTION In this section on clearing and settlement in Europe, we seek to give the reader an understanding of post-trade processing in the more prominent European fmancial markets: the United Kingdom, France and West Germany. We also include a discussion of Eurobond clearing and settlement. We will make some general observations about the state of clearing and settlement in Europe and construct a theoretical framework desaibing the clearing and settlement process in terms of developmental stages. In looking at the European markets, we note that we have concentrated more on stocks and bonds than we have on the trading of futures and options contracts. This is in part because the futures and options markets arc a relatively recent phenomenon in most European countries. One notable exception to this, of course, is the International Commodities Clearing House (ICCH) in the U .K. We have included a section on the ICCH, both as a unique example of a unified clearing and settlement system and as a means of comparison to the U.S. derivative markets. One thing which becomes immediately evident when examining the European equities markets, is that each country has a different clearing and settlement system, each of which differs from the U.S. system. The European markets, unlike those in the U.S., do not rely on clearing houses. Many European countries do have depositories, but their function is often different from U.S. depositories. The role that depositories play in Europe also varies from country to country. Generally speaking, we found that there are three principal types of approaches to the clearing and settlement industry in the world's major markets which arc important to understand. Therefore, for the purposes of this discussion, we will exarnint: three models of markets, each showing a different approach to clearing and settlement. The first model would be one in which there is no centralized depository structure or independent clearing house to effect the post-trade process. In such a market, the exchanges usually perform J.s many of the clearing and settlement functions as is feasible. These include trade matchin~ confirmatio~ and providing some type of settlement facility-usually a central location where market participants can deliver and receive securities and payments. An example of a market set up along these lines is the equities market in the United Kingdom. The second model of clearing and settlement is one where a central depository structure exists, and trade matching and confirmation services are provided by the exchanges. Once trades have been matched and confirmed, the trade data is sent to the depository for settlement. There arc sub levels within this model which represent differing degrees of settlement services provided by the depository. At one levc4 the depository will offer book-entry transfer of ownership of immobilized securities, with limited provisions for varying payment methods. At a higher level the depository provides book-entry transfer of dematerialized securities and has the ability, through dire ct links to local payment systems, to effect simultaneo~ irrevocable funds transfer for each settlement. An example of a market with a model two type system of clearing and settlement is West Germany and its Kasscnvereine depository system. Page 75
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Study of IntemarionaJ Qc.aring and Settlement The Ccaring and SeuJement Proccu In Europe The third model is one that has not only a stock evbaoge, and a central depository, but also a clearing house -which stands in between the stock cxcban~ and depository and acts as a risk amelioration mec:baoism In this type of market the stock cxcbangr-, in conjunction with the clearing house, provides trade matching and confirmation services. Once a trade is confirmed by the market participants, it is p.wed to the clearing house where the clearing house substitutes itself as the counterparty to each trade. This act gives a degree of financial assurance to the markets since the clearing house will, as a last resort, honor the obligations of a clearing member. The clearing house then passes the trade information to the depository for payment versus delivery on the settlement date. An example of this type of market is the United States equities market. In European equities markets, there are no central clearing organizations which assume the role of counterparty to every trade or provide other kinds of mecbaoisrns to ensure the financial integrity of all market participants in the clearing and settlement phase. Indeed, there are arguments for and against the concept of a risk-taking clearing organization. An argument again.st a clearing house is that, just as excbaogr..s only provide the facilities to make trading p<>S.\lDle and do not guarantee what actually happens on the exchange, clearing and settlement agents should not offer guarantees to participants other than the flawless performance of the clearing and settlement operations. Another argument again.st the need for clearing houses states that if there is no third-party guarantef! mecbauism for trade settlement, market participants are then forced to choose their counterpartie s with more care. Free market allocation of resources would thus make riskier counterparties inci Lr higher a cost of doing business. A counter-argument to the above is that when a market ceases to be a closed structure with only a select group of participants who know each other, the market must implement some standardized pr~ which can offer a guarantee of financial integrity. A case in point is when a local market experiences an increase in trading volumes as a result of more local and international participation. The choice then for the market is either to stay the way it is and not allow for growth, or, to implement systems in the market which can ensure the financial safety of the market while at the same time accommodating growth. In closing. we must stress that the European markets arc undergoing fundamental changes. The current focus in Europe is on the standardization or harmonization of clearing. settlement and depository S}'Stems in preparation for the common market in 1992 and the deregulation of the financial markets ( e.g., free capital movements, etc.). In reviewing the papers submitted by the experts who participated in our ~tudy, it is evident that a number oflocal European markets are planning to upgrade the clearing and settlement facilities available to the participants.1 1 Pora comprebemive di&a.aaion o( tbe specific scttJemenc LS5\ICS facing the European Communicy, we refer the reader to the reccntJycompleced studycommis&ioncd by the EEC sau:Jyon /~ ua w Smianau of Cross-border Suntia Transtions in rJw Euro{'ftJII Econom,c Comnu.uur,, for the Commi.Siion o( the European Communuics. Directoratc-GcneraJ XV, Financia! Institur.ions and Company Law, Dr. Joerg-Ronald Kessler, July 1988. Page 76
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2.2.2 CLEARING AND SETl'LEMENT OF EUROBONDS THE CEDEL AND EURO-CLEAR SYSTEMS Study of International Qearing and Settlement The Oearing and Settlement Process In Europe There arc two global orgaoizatfons which clear and settle internationally traded instruments indudiog Eurobonds (bonds issued in currencies other than that of the home country of the issuer) and Euro-equities (stocks issued in currencies other than that of the home country of the issuer). They are: the Centrale De Livraison De Valeun Mobillieres (CEDEL) and the Euro-clear System. THE CENTRALE DE LIVRAISON DE VALEURS MOBILLIERS (CEDEL) (S11mm11r1 ol Expert Paper by George Muller) lntrodacdoa CEDEL was founded in 1970 by a consortium of market participants as a response to the difficulties that were being experienced in clearing and settling Eurobond trades. The Eurobond market, which began in the 19(,0's, is a t.ruly international market in which fixed income securities are issued and traded aaoss national borders. CED EL was set up as an international and independent clearing and settlement organization. Based in Luxembourg, CEDEL operates under Luxembourg law. CEDEL is owned by 108 shareholders: banks and other financial institutions.. To protect the independent and neuttal status of CEDEL, no single shareholder may own more than 5 percent of CEDEL's total amount of shares. The following chart2 is intended to give the reader a better understanding of CEDEL's size: both according to the number of brokerage firms which use CEDEL, and according to the total annual volume of clearing and settlement transactions processed by CED EL: 2 This chart ia bucd on a table on page 7 in the March. 1989, PederaJ Reserve Bank of New York publication cuaring and Sealing tlw Euro-sUritia Market: Ewo-cktzr and CEDEL Page n
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Study of Intemational Cearing and Settlement The Cearing and Settlement Procea In .Europe Dollar V aluc of Transactions Processed by CEDEL (in billions of USS) Total Value of Securities Cleared and Settled by CEDEL Being Held at Various National Depositories (in billions of USS) Actual Number of Transactions Processed (in millions) Total number of CED EL clearing members 1988 1717.00 279.00 4.0 2251 1987 1986 1971 1600.00 1200.00 2.60 208,00 156.00 0.60 4.3 3.4 n/a 1997 li64 292 CEDEL provides a wide range of services as a clearing and settlement agent. Unlike U.S.-style clearing houses, but similar to many clearing entities in foreign markets, CEDEL does not assume the risk of the settlement process and docs not provide its market participants with a guarantee of either payment or delivery. This means that CEDEL does not put itself in the counterparty position (the practice of acting as the buyer of the traded security when clearing for a seller, and acting as the seller of the traded security when clearing a transaction for a buyer) in trades. Therefore, if a trade ends in a default by either buyer or selle!', the defaulting trading party remains liable and must make other arrangements with the counterparty of the trade to fulfill his obligation (to cithe1 pay or deliver). This could take the form of a credit agreement with the counterparty in the trade, or a credit agreement with another financial institution. CEDEL's Interface witb its Clearing Members The majority of CEDEL's active particirants receive daily reports, detailing the status of pending securities transactions; any securities in inventory; securities which have been affected by corporate actions such as a dividend payow; and a statements on cash movements and balances. In addition to these reports, participants can obtain many other reports which provide a comprehensive overview of their market activities and holdings. CED EL interacts with its clearing members in a number of ways: telex; mail; computer-to-computer links; or via CEDCOM (CEDEL's computer system). CEDCOM allows for the automatic input of trade data into CEDEL's computer systems and, in turn, input of data into the computer systems of CEDEL's clearing members. The majority of the transactions at CEDEL arc processed via CEDC0M. Page 78
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Tbe Cleari111 and Settlement Process at CEDEL CEDEL provides six primary services to its users: Safekeeping of securities certificates; Study of International Oearing and Settlement The Oearing and Settlement Process In Europe Matching of Eurobond trade information from counterpartics; Settlement of the securities obligation in trades (that is, the obligation of the seller to deliver and/or transfer tide to the buyer on the settlement date); Settlement of the payment obligation in trades ( that is, the obligation of the buyer to make payment to the seller); Links to other systems and markets; and Short-term loans of securities, to ful6ll settlement obligations. In the Eurobond markets, the trade matching portion of the clearing process OCC'-!l'S on the day after the trade (T + 1). On the day of the trade (T +0), the counterparties in the tzade send the trade information (bow many bonds, at what price) to CEDEL, by means of either computerized or non-computeriz.ed processes. CEDEL, in its daily procc&i;ing cycle, then attempts to match ( confirm that all trade details reported by the buyer and the seller arc the same) the trades and set a settlement date. The matching, or comparison, pr~ is done by means of the ACE Trade Matching and Confirmation System (ACE being the ~on of International Bond Dealers, CEDEL, and Euro-clear). The ACE computer system allows clearing members to perform trade confirmation directly with CED EL ( that is, through computer linkages) rather than having to resort to the more time-consuming paper-based me~hod of Telex communication. CEDEL has two methods that it uses in a~ as a depository for securities certificates. The first way is keeping securities in fungible form.3 What this means in terms of CED EL storing fungible securities is that the securities accepted at the CEDEL facility do not have to be stored with specific identification numbers referenced to specific clearing members. CED EL also stores securities in non-fungible form. This means that securities with specific certificate identification numbers cannot be substituted by CED EL to satisfy the obligations of a clearing member on the settlement date, for other securities certificates which are for the same company and same number of shares. At CEDEL, the settlem,:ut of securities that is, the transfer of tide occurs through book entry. That 111cans that instead of the actual paper securities certificates being delivered on the settlement date, the tide is transferred by means of CEDEL's computerized book entry accounting system. It is possiole, however, to arrange for the physical delivery of securitiesalthough this is a rare O<"';urrence among the market participants who use CEDEL Through this book entry syste~ CEDEL also has the capability of effecting settlement on the same day of the trade. Another CEDEL service, which is especially convenient for international market participants, is CEDEL's capability of clearing and settling in either a single currency or more than one currency (within a single transaction). CEDEL clears and settles transactions in 27 different currencies. 3 "Punpble means interchangeablCt a good example being cash. Wben you go to the bank and deposit three fifty dollar bills, and retum next week to mue a 1150 withdrawal, you do noc demand that the exact same bills be returned to you ail you want ii tbe money, and one fifty dollar bill is fully interchangeable with the next. Page 79
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Study of International Oearin1 and Settlement The Ceari.ng and Settlement Procca In EuJope CEDEL also has links to national depositories in 16 different countries 4 and it uses 50 different banks around the world as depository institutions. These links arc used to facilitate the settlement of trades of securities oa deposit in their home countries. CED EL also maintains electronic link, or "bridge, to Euro-clear. The electronic bridge fac:ilitatcs the settlement of Eurobond trades between market participants who may be members of either CEDEL or Euro-clear (or both). CEDEL's Interlace witb the Bankfog System There arc three basic ways that CEDEL interfaces with ban.ks: interactions with banks acting as depositories for securities (in the country of origin of each instrument) being traded by CEDEL clearing members; interactions with banks in their role as vehicles for market participants to make payments for trades being cleared and settled by CEDEL; and interactions with banks in their role as providers of credit to assist market participants in meeting the settlement obligations of trades being cleared and settled by CED EL The expert paper submitted by CEDEL for this study identifies the long list of banking relationships that the institution maintains on behalf of CED EL users. In order to avoid some of the complications which would otherwise occur, CED EL has ( as previously stated) approximately 50 different depository banks around the worl~ and each security in the depository system is assigned to the custody of a specific depository bank ( as opposed to all of the ban.ks accepting all of the depository-eligible securities). As for CEDEL's interface with banks in respect to both the payment and the credit process CED EL interacts with approximately 40 different correspondent banks around the world. These banking relationships give CED EL the flexibility and breadth of coverage that it needs in order to offer CED EL users a wide variety of services. CEDEL and its correspondent banks arc able to communicate with each other by means of the computer-to-computer links of the SWIFT network.5 CEDEL is therefore able to offer delivery versus payment service ( delivery of securities and payment for securities is made at the same time), by simultaneously debiting and crediting the cash and securities accounts of market participants. In the event that a party to the trade needs a~ to credit to effect settlement, CED EL offers a variety of options. A clearing member may obtain acdit directly from CEDEL. Another possibility is that the clearing member may obtain credit through CED EL as part of a tripartite aedit agreement. 6 Small scale market participants, on the other hand, may turn to their parent companies or other third parties, to provide CEDEL with a guaiantee of payment. These credit facilities serve as liquidity or 'grease' in the settlement cycle. 4 Pora lilt of CEDEL's links to nationaJ depositories. plcuc refer to page 5 of the expert paper submitted for this study byCEDEL 5 SWIFT, or the Society for Worldwide Interl>ank finanaal Ielecommunication, is a mutually-owned organization founded in 1973 by a group o{ 250 Ewopca.a and North American banks. 6 ... tripan;,. cndia 1ft berMWn w kndlr and llw bon'otwr with CEDEL acting as agent for dnmnuung w auquaq of cQ/JQuiraJ and ~g tlw laul6's UUffl!Sl in thal col/aJmJL CEDEL dOt!S""' bear any~ aposun in such crediz. , ClaJring and $ading w Euro-suritia Marica: Ewo-c~ar and CEDEL, Federal Resezve Bank of New York. March 1989, p. 18. Page 80
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Study of International Oearing and Settlement The Oearing and Settlement Process In Europe In addition to these aedit arrangements, CEDEL clearing members can arrange short-term loans of securities ( this type of loan is often used by members who do not have the securities that they are required to deliver on the settlement date). These short-term securities loans are guaranteed against default by a Guarantor Syndicate of eight banb headed up by Citibank. This means that the banks are ass~ all of the risk of the securities lending and part of the risk of the clearing and settlement process. 7 The result, for securities loans, is that lenders and borrowers of securities interact with, and arc responsible to, the banking syndicate rather than with and to each other. This system has two advantages for market participants. FU'St, the risk of default is now a risk being home by the banks instead of the securities lender. Secondly, the fact that loans arc arranged through the syndicate, rather than directly throughthc countcrparties, provides the counterpartics in securities loan/borrow arrangements with a degree of confidentiality. THE EURO-CLEAR SYSTEM (Summa.,, olExpert Paper by The Euro-dear System) latroducdoa The Emo-clear System, which is located in BruMCls, Bclgi~ was founded in 1968 by the Morgan Guaranty Trust Company of New York. The Euro-dear System, the larger of the two international clearing and settlement systems, clears and settles internationally traded instruments including Eurobonds, international equities, domestic government debt securities, and domestic equities issues. In 1972, Morgan Guaranty sold Euro-dear to the Euro-clear Clearance System Public Limited Company (ECSplc). ECSplc retained Morgan Guaranty as the operator of the Euro-clear System. ECSplc is owned by 124 Euro-dear Participants: banks, brokers and investment institutions. To prevent any one participant from gaining control over ECSplc, no panicipant may own more than 3.25% of the shares of the company. In 1987, the Euro-clear Clearance System Societe Cooperative was formed in order to give the Euro-clears more than2,000 participants the opportunity to participate in the decision-makm.g process through ownership in the Cooperative. The Cooperative is 88.5% owned by ECSplc and 11.5% owned bythc participants directly. The Cooperative maintains the agreement with Morgan Guaranty Brussels to operate the Euro-clear System. Through its Board of Directors, the cooperative establishes matters 1Jf policy relating to the Euro-dear System including such matters as the approval of new participants, establishment of fees and determination of the securities to be included in the System. Euro-dear" accepts over 27,000 diff enmt securities, covering a broad range of intemationaily-traded fixed and floating rate debt instruments, convertibles, warrants and equities. Included are domestic government debt instnunents from 10 countries and~ than 24()() equity securities from fifteen countries .. g Today, the Euro-clear System has close to 2500 participants worldwide, all of which are banks, broker-dealers, and other institutions which issue, trade, hold or make markets in Euro-clear eligible securities.. The following chart gives the reader a good understanding of Euro-clear's size: 7 Por more on tbil, plcalc refer to page 3 of the Peden.I Resene Bank of New York Maren. 1989, report creanng and Saling tJw Euro-Surilia Mark: Emo-clear and CEDEL. I ED:apted from page 1 of 7M Euro-
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Study of International Oearing and Settlement The Oearing and Settlement Process In Europe Dollar Value of Transactions Processed by Euro-clear (in billions of USS) Value of Securities Held for Participants (in billions of USS) Number of Transactions Settled (in millions) Number of Euro-clear Participants 1988 290').5 610.0 6.7 2456 1987 1986 1985 3081.9 2336.3 1457.2 SZ12 4020 274.0 13 5.8 4.4 2248 2053 1811 The Euro-clear System offers four basic services to its participants through one central point at the Euro-clear Operations Center in Brussels: securities clearing, securities lending and borrowing, custody, and money transfer. The Euro-clear System, like CEDEL, does not interpose itself as the counterparty to trades and thus docs not provide the counterparties to trades with a guarantee that the obligations of settlement (i.e., payment and securities delivery) will be met. The Interface Between Euro-dear and Its Participants Euro-clear's Participants send their trade instructions to the Euro-clear Operations Centre either by telex or by means of Euro-cleat's EUCLID, a proprietary telecommunications system. EUCLID, introduced in 1979, allows participants to electronically send information globally through local data entry by utilizing time-sharing systems. This reduces the costs and increases the efficiency of sending trade information around the world. Euro-clear Participants can obtain reports showing the status of their transactions four times a day starting on trade date. Participants automatically receive detailed daily statements of their cash and securities movements and positions. In addition, to these reports, Participants can obtain many other reports which provide a comprehensive overview of their market activities and holdings. As we previously mentioned in Section 2.22.1, Euro-clear and CED EL maintain an electronic bridge between one another. This bridge facilitates the settlement of trades between market participants who may be members of either CEDEL or the Euro-clear System (or both). Page 82
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1be Cleari111 and Settlement Process at tbe Euro-dear System Study of International Ocaring and Settlement The Ocaring and Settlement Process In Europe Eurobond trades arc generally settled seven days after the trade date (T + 7), in accordance with custom in the Euro-markets and the rules of the Associari'ln of International Bond Dealers (AIBD ). Other securities settled through the Euro-dear System, such as certain domestic equities and Euro-commercial paper, have settlement times which vary to as little as two days. In any case, the following dcsaiption of the Euro-clear clearing and settlement process represents the typical post-trade transaction flow. On the day of the trade (T + 0), each of the counterparrics to the trade sends the trade data, along with the appropriate settlement instructions, to the Euro-clear Operations Center (EOC). On the same day, EOC validates the trade information and attempt& to match each instruction with a corresponding counterparty's trade. Invalid instructions -for example, trade information that is incomplete or incorrect in some way are rejected immediately for correction by the sending party. Instructions which are unmatched, but vaJid,9 arc kept in an inventory of unmatched instructions and put through the matching process until they are matched or cancelled. Trades are confirmed and matched on the day of the trade (T +0) through the ACE system, a trade confirmation and matching service, which was developed in cooperation with CEDEL, with the support of the AIBD. ACE gives participants a fas4 easy and secure mechanism for confirming and matching trades. After the matching and confirmation process is complete, the matched instructions for a given settlement date arc pa.w:d along for settlement, along with any previously unsettled transactions. The Euro-clear securities settlement prOCCM takes place the night prior to each settlement date.10 For trades between two Euro-clear Participants, settlement occurs on a simultaneous delivery versus payment basis, if the counterpartics to the trade have sufficient securities and adequate cash or credic in their respective accounts. Transfer of securities to and from domestic markets are also a delivery versus payment basis where local conditions permit. If the balance of a Euro-clear Participant's account is insufficient to cover his settlement obligations, the Participant may "pre-advise" funds to his account. This means that the Participant will inform Euro-clear of the specific amount of money which is in the process of being transferred to the Euro-clear account at Morgan from another of the Partici"lant's banks. This pre-advisement of funds is sufliccnt to allow Euro-clear to settle the trade during the night, even though the funds will not actually reach Morgan Guaranty Bnwels until the daytime hours of the settlement date. For this reason, the practice of pre-advising funds can be viewed as a form of credic available in the overnight settlement processing cycle, subject to appropriate credit controls by Morgan Guaranty. "Unmatched, but valid" trades are tb01e wtlich do noc contain any technical em:,rs as to the details o( the trade but haw nor yet been paired with the counterpany to the trade (for instance, EOC might have the data from the seller. but doa not yet have the data Crom the buyer). 11 Thia contn&U with the settlement process at CEDEL, wtlich occurs during the daytime hours of the settlement date. Page 83
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Study ol lnternationaJ Ccaring and Settlement The Ccaring and Settlement Procesl In Ewope Participants who do not have the securities nccc~ry to cover their settlement obligations have the option of borrowing the securities. The Euro-dear System provides full securities lending services, through Morgan Guaranty. A Participant who fails on a scttlementll may borrow securities on settlement day through an automatic ( or standing) order, or through a specific instruction to the Euro-clear Operations Centre. The borrowed~ are then counted as part of the Participant's holding., during the next settlement cycle. Similarly, Participants wishing to inacasc the returns on their portfolio of securities holdings may be automatic or opportunity lenders through the Euro-clear System's lending and borrowing program. Morgan Guaranty Brussels acts as the guarantor in securities lending transactions. In this capacity, Morgan guarantees the return of the borrowed securities ( or the cash equivalent) to the lender in the event that the borrower fails to return the securities. The Interlace Between the Euro-dear System and the Banks In order to support their securities settlements, Euro-clear Participants maintain cash and securities accounts at Morgan Guaranty Bank in Bnwels. (These accounts arc separate and distinct from any other accounts a Participant may have with the Morgan Guaranty Bank, since they exist for the primary purpose of securities settlement through the Euro-clear System.) Participants can agree to settle their trades in any one of26 currencies. A Participant's cash account with Morgan Guaranty Brussels is divided into 26 sub-accounts, one for each currency. Securities arc kept by the Euro-clear System on behalf of participants at depositories, national clearing systems and central banks around the world. The Euro-clear System maintains a network of depository institutions in over 20 countries to provide Participants with extensive custody-related services. These services include: safekeeping of securities, administration of dividends, bond coupons, and bond redemption payments, and securities-related tax scrvices.12 In order to make the securities settlement prOCCM as efficient and effective as possible, securities, once deposited into the Euro-clear' s System, are held on a fungible basis. This contrasts with CED EL' s system, where Participants can eled to have their securities held in non-fungible form. 2.2-l CLEARING AND SETIU:MENT IN FRANCE SOCIETE INTERPROFESSIONNELLE POUR LA COMPENSATION DE:S VALEURS MOBILIERES (SICOVAM) (S11mmary based oa information provided by SICOV AM) Introduction There are seven stock exchanges in France. The Paris Bomse is the largest and is the main stock CYcbangr. for the country. The other exchanges arc located in Lyon, Marseille, Nancy, Lille, Bordeaux, and Nantes. 11 EuJ'O-dc:ar, on tbe moming of the settlement date, notifies the counterpartics whether the trade has settled or whether it bu failed (i.e., one of the counterpa11ic:s baa not met hil settlement obligations). 12 Ketchum, on pa~ 11 of the expert paper written (or this study, also notes that Morgan Guaranty maintains a number of insurance policies with respect to securities hetd in the Euro-dear System. Page 84
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Study of International Oearing and Settlement The Oearing and Settlement Process In Europe Over the past five years, the financial markets iu France have experienced a major transformation. The excbanges, the market participants, and the clearing and settlement systems arc undergoing dramatic changes which are intended to modernize the French markets, including computerizing many c,:cbange activities at the Paris Boursc. The third quarter of 1990 is the target date for thi--transformation, well in advance of the target date of 1992 that was set by the Group of Thirty for many of its recommendations OD streamlining and otherwise improving the clearing and settlement prOCCSL France has already made two major changes, with the opening in 1986 of two new markets. They are the F"mancial Futures Market (MATIF) and the Paris Options Market (MONEP). One area in which France is already ahead of a number of other countries is in having dematerialized sccuritics, in a centralized securities depository: Societe lnterprofcsuonclle pour la Compensation des Valcurs Mobilicrcs (SICOV AM). SICOV AM was aeatcd in 1949, as a volwitary book-entry system for the transfer of title on traded securities. Over the past five years, however, SICOVAM's role has changed significantlyas a result of a law mandating the dcmaterializatioD ( eliminatfon of actual paper securities certificates, switching imtead to computerized records of share ownership) of virtually all French securit..id. The law, which was enacted in 1981, went into effect in 1984. It mandates that: "All movabk assets, whether registertd or beam; may only be rq,resented by entry in an account, in the name of the owner, with either the issuing company or a financiai intermedialy... Owner.ship is transfemd by debiting and aediting the accounts concerned." 13 Only those securities which have not been dcmaterializ.cd arc physically held at SICOV AM or by banks and brokers. All other securities are held in banks and brokers' accounts in book-entry form at SICOV AM. One major result of the dematerialization law has been a marked increase in the number of trades which are settled through SICOV AM. SICOV AM's functions include the settlement of equities, corporate and government bonds, and certain mutual fund (SICA V, FCP and FCC) transactions OD behaH of its members. SICOV AM also acts in the traditional role of registrar for registered securities:14 keeping track of the names of shareholders and any dividends, etc. which are owed to shareholders. To help its members trade international securities and to awst international investors in the trading of domestic French securities, SICOV AM has, over the years, built linkages with 13 different clearing and depository organizations in Europe, the United States and Japan. Through these linkages, SICO V AM provides book-entry transfer services for foreign securities listed on the Paris Exchange. These securities are kept by SICOV AM at linked depositories in the home country of the issuer. At the end of September 1988, SICOV AM was settling trades in over 6,000 listed securities, including 295 foreign securities. It held approximately 600,000 securities accounts OD behalf of its members, with a value of Ffr 3.6 trillion. Volume averaged 40,000 book-entry transfers a day. 13 International Society of Securities Administrators Handbook. December 1987, France, page 8. 14' The majority of French securities an: in bearer fonn. Page 85
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Study of lntemationaJ Ocaring and Settlement The Cearing and Settlement Process In Europe The Clearing and Settlement Process In France there have traditionally been several ways to settle securities transactions. These are: a monthly clearing system which today accounts for two-thirds of transaction volume, even though it is only used for a small number of equity issues; a fortnightly clearing system ( which will soon change to T + 5); and a system without clearing. In our discussion, we will concentrate on settlement throu~ SICOVAM. After a trade has been arranged between brokers at the Paris Bourse (stock exchange), the trade data is cleared by an organization called the Societe des Bourses Francaises (SBF), which acts as the cxchange's clearing house, to mov~ trades along to settlement at SICOVAM. SBF nets the confirmed trades for each stock exchange broker. This data is subsequently transferred (by means of computer magnetic tape) to SICOV AM and also to the Banque de France for settlement. On settlement day, SICOVAM will acdit and debit members' securities accounts, and Banque de France will proccM the related payments, with the results reported on the next day. SICOV AM's Interface to th Banking System All brokers and banks in France must maintain accounts at the Banque de France, the French central bank, for the purpose of cash settlement of securities transactions. The SBF sends the magnetic computer tape both to SICOV AM and the Banque de France on settlement day. The cash and securities obligations of settlement are handled separately. After .. receiving the cash settlement instruction from SBF on settlement date, the central bank credits or debits the brokers' bank accounts in accordance with the received settlement instructions. Since SICOV AM does not maintain cash accounts for its members, nor docs it settle the payments side of a trade, the current system is not coo.si"~red to be a real delivery versus payment system. However, as noted later in our discussion of fu.ture trends at SICOV AM, this is one of the issues being addressed in the plan for the new settlement system. SICOV AM's Interface with its Members In France, only brokers can trade bonds and shares on the official market -the stock exchanges. However, according to estimates, 80% of all securities orders come from customers through banks. SICOV AM's members arc banks and brokerage firms. As of December 1988, SICOV AM had 765 members; 532 banks and public-sector securities issuers, 62 brokerage firms, and 170 securities issuers ( also known, in the U.S., as underwriters or investment banks ) and SBF, which interposes itself between the net settling brokers. Even though SICOV AM receives transactions from SBF via computer tape, the direct interaction with its members has been primarily paper-based. According to SICOV AM, over 50% of their transactions arrive in paper form from SICOVAM's members, although this is going to change dramatically in the coming year, through introduction of an industry-wide network caJled S.I.T. Page 86
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htareTrmds Study o( International Ceari11g and Settlement The Cearing and Settlement Process In Europe The fail rates in France have often been quite high; for a period in 1988 there were 1 million outstanding trades in the system. This number was subsequently reduced to CJ00,000 later in the yearlS. These high fail rates give added weight to arguments supporting the introduction of the sweeping changes which are planned for the French clearing and settlement systems. In 1990, SICOV AM will introduce a true delivery versus payment service, through a new coordinated guarantee system with Banque de France, the central bank. In addition, the settlement period in France will move from the current fortnightly cycle to a rolling T + 5 settlement time for most securities, similar to that in the United States. The monthly settlement system will also remain in effect. These new plans are part of the RELIT system, which will deacase the overall costs of securities transactions while inacasing the security and reliability of securities settlement. SICOV AM is also evaluating two other proposals which would enhance the services offered to its members. One would establish a regulated securities lend/borrow arrangement system, which would allow short-term loans of securities to meet the obligations of settlement ( conceivably, this could reduce fail rates). The other proposal is for SICOVAM to move towards the c"tpability of being able to settle trades in more than one currency. Initially, RELIT will introduce the ECU as a possible settlement currency, along with French francs. 2.2.4 CLEARING AND SEITLEMENT IN TIIE UNITED KINGDOM 2.2.4.1 EQUITIES: INTERNATIONAL STOCK EXCHANGE (ISE) (Snmmary of tbe expert paper by tbe ISE) lntroducdoa The International Stcx.k Excbange (ISE), in London is one of the three most important financial markets in the world. The ISE consists of the International Stock Evbange of the United Kingdom and the Republic of Ireland Limited, and operates exchanges in Belfast, Birmingham, Dublin, Glasgow, London and Manchester /Leeds. ISE members include broker-dealers and market makers.16 The instruments traded on the ISE include: U .K. equities, gilt-edged stocksl 7 and other fixed income instruments, international equities, and options. The average daily trading volume from January to September 1988 was 31,213 trades (also known as 'bargains' in the U.K.), at an estimated value of 3,248.5 million Stg. U 'Pari.J goa for spdi6 SffllaMnl, financial Tunes, July 5, 1988, page 25. 16 Broker-dealers, according to the International Society of Securit:ca Administtaton (ISSA) handbook. are Agems buyi,tf aNJ selling suritia 011 bdtalf of clir.ta, for wlru:h S6Vic~ ,1wv will c/tas'p a commission. '1'hl'j may also act as p,v,apab aNJ build up posilioM in suritio and sdl tJwm to their-cJ/ena. 'Martct Maiten, a1lo from the handbook. are: '/JtoM,-dltl/6J who "'1w wizh w SIIJCk &change in rapt of*'-sUrida in whit:h lJwy will maJ a co"""""' zwo-way pri&e. . 1'IW'j may dmJ dirt wilJa invemng diltna, quoting net pril:a.. 17 Gilt-edpd stocks are loan stocks issued by the U.K. G
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Stlldy of lntemational Oearin1 and Settlement The Ccarin1 and Settlement Procca In Europe The ISE is undergoing a period uf transition with respect to its settlement system. The current, primarily paper-based, settlement system is still in place, but plans are being developed to introduce an electronic depository that will allow participants to hold sccuritics in fully dematerialw:d form and thus permit paperless transfer of securities title. This system, TAURUS, is scheduled to start operatfons in 1990. In this section we will evrnioe the current clearing and settlement system and also take a look at the changes which will be implemented in conjunction with the TAURUS system. The Clearing and Settlement Process ror tbe ISE The clearing and settlement proccs.1 in the U.K. is managed by the Stock Evbange for all of its member firms. It is a two-part process consisting of: A Chcckingl8 System which validates trades and matches them with a corresponding buy or sell order; and A settlement system, TALISMAN.19 TALISMAN, introduced in 1979, is the ISE's computer-based settlement system. TALISMAN transfers securities' tides between ISE member firms and helps them keep track of their securities positions. The settlement period in the UK equities market is during the six business days after each two week dealing/trading period (also known as the account period).20 Trading firms have the option to settle trades on a cash settlement basis before the account periQd is over. This type of settlement, if agreed upon by the trading parties, can occur any time after the second day following the trade (T + 1). The typical clearing and settlement prOCCM at the ISE looks Sl'mething like this: at the end of the trading day, member firms enter the day's trade data into the ISE's Checking System. Member firms can send trade detail to the Checking System either directly through a PC-com put er data transmission to the Evbaogc's computer using Stock Evbaog~ software and a British Telecom link, or by delivering a computer magnetic tape to the nearest Stock Evbang,: Centre. The computer tape may be the firm's own or one produced by a computer bureau. The Stock EYcbangc computer validates and compares all of the trades and produces reports on matched and unmatched trades. U nmatchcd trades then have to be resolved and amended or si.tnply cancelled. Matched trades arc passed on to T AUSMAN for settlement To settle, the selling broker must obtain from its customer the actual share cenificates and a signed TALISMAN Transfer Form. This form authom.es the transfer of the security title from the customer into the ISE's21 nominee company name. The paperwork, after being properly signed, is then deposited at the nearest TALISMAN Centre. TALISMAN verifies the documents and enters the transfer information into the computer system. The security must then be sent to the company registrar so that the share registration is transferred from the customer's name into the name of SEPON. 11 Checking" ia the term used in the United Kingdom to refer to trade marching. 1' :IramCer Accounting and Lodgement for Investors. ,Stock ~agement for Principals. 20 According to the ISE, in tbe United Kingdom mamt time is noc o( tbe CS1Cnce and trades can settle after the sectJemcnt period. 21 A nominee is a person or company in whose name securities are held or traded, on behalf of another pe~n or company, who remains the true owner. Page 88
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Study of International Oearing and Settlement The Oearing and Settlement Process In Europe SEPON22 is the Stock Excbangr.'s limited liability, uncertilicated, nominee company, in whose name TALISMAN-eligil>le securities are held in safe custody. The ISE's broker-dealers and market makers maintain trading accounts with SEPON. Through this account they can legally bold stock in unc:ertificated form. The re-registration procesa uaually occurs before the actual 'account' or settlement date. On the settlement date, the title of the security is transferred by book-eDlry method from the trading account of the selling broker to the account of the buying broker. At the same time, the two brokers' payments accounts at TALISMAN are a-edited and debited accordingly. TALISMAN then issues to the buying broker a stock 4ote as proof of his new stock ownership. The share transfer form (generated by the computer and authorizing the transfer) must be sent to the registrar to have the stock re-registered from the nominee name (SEPON) to the name of the new owner or the owner's nominee company (for example, a custodian bank). Then a new share is iued in the new owner's name; usually, it will be deposited into a custodian account. When broker-dealers and market makers trade for their own accounts, or act as principals, TALISMAN effects a simple book-entry transfer of title without any need for transfer forms or certificates. Allin all, approximately7,000sccurities are settled through TALISMAN. This includes most securities registered in the United Kingdom and the Republic of Ireland. The clearing and settlement proceM explained above does not apply to all of the financial instruments which arc tNded on the ISE. Options, for example, arc cleared and matched by ISE, but ultimately are settled through the International Commodities Oearing House in London. U.K. Government gilt-edged stocks, also traded on the e-rcbaoge, arc validated and matched through the IS E's checking system, but settlement occurs through the Central Gilts Office. 23 International equities, on the other band, arc matched tlirough an on-line comparison system called SEQUAL24 The trades arc then settled through settlement facilities in the home market of the security. In some cases, such as retail trades, settlement occurs through physical delivery and payment. The ISE bas a central physical delivery system that allows such settlement to occur in one central place. The Stock ETCbaoge's Central Stock Payment Department takes in securities from sellers and delivers them to the buyers. At the same time, it takes the payment from buyer and gives it to the seller. Since the Checking System operates independently from TALISMAN, even securities which arc not TALISMAN-eligible can be validated and matched by the Checking System. In examining the ISE's checking and settlement systems, it is important to note that at no time does the ISE take counter-party positions to trades. (That is, market participants are at no time provided with a guarantee that the trade will settle.) The services that the Stock Exchange provides serve only to facilitate the post-trading processes for its members. Therefore the market participants themselves must -WUJDe any counterparty and/or market risks. zz The Stoct exchange mo& tiofflinec 23 The Central Gilts Office ii a sclVice jointJydc:Yeloped and funded by the Bank of England and the ISE for the settlement ot U.K. Oovemment oblipriona. 24 A1lo pn,vidcd by the ISE. but different from the Oecking system. Page 89
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Study ol lntemationaA Oearin1 and Settlement The Ccarin1 and Settlement Procca In Europe ISE: the Payments Process Payment on the settlement date may be through TAL SMAN, outside TALISMAN, through cash settlement, or through the Central Gilts Office. 'Through TALISMAN' simply means that the TALISMAN computer system keeps track of each member's payment obligations each day. These payments are netted eacli day so that each member need only make or receive one payment a day at the nearest T AUSMAN Center. 'Outside TALISMAN', as it implies, means that trading parties maintain their own payment records and either pay the coUDterparty dirccdy or deliver a check to the Stock Excbang~' s Central Stock Payment Department, where it is on to the selling party. 'Cash settlement' occurs when the trading parties agree to settle their trade before the official account period. In such a case, the trade is usually settled and paid for in cash the day after the trade (T + 1) for Gilts and on the second day after the trade (T + 2) for equities. Generally, payments for stock excbange trades arc made by check; the participants will, on se~tlement day, deliver or receive a check at the stock CYCbangr:. Payments by check can be made in British pounds, Irish pounds or U.S. dollars. In addition, approximately 50% of the brokers make sterling payments :hrough CHAPS, London's interbank electronic payment system. Future Trends at the ISE As can be seen from the preceding cliscu.won, the ISE still has a largely paper-based settlement system. While TALISMAN provides a central facility for ISE members to effect settlement, this capability alone is inadequate to support a major financial center such as the ISE. This recognition has resulted in plans to establish a paperless settlement system. TAURUS,25 as the new system is called, will be an electronic depository service. This means that members will be able to keep their securities in dematerialised form and thus achieve real book~entry transfer of title on settlement. 26 In addition, after TAURUS is implemented, the ISE is considering moving towards a rolling settlement cycle to replace the current fixed two week trading period followed by a 6 day settlement period. The term "rolling settlement" means that the settlement date is always the trade date plus a specific number of days. For example: T+3. Even though many features of TAURUS have already been identifie~ TAURUS is still under development. Some concerns are still being addressed. One ~uc in particular which remains under discussion is how the ISE, under the new system, would be able to assure listed com panics that they would still be able to quickly identify and communicate with their shareholders. 25 Iramter and Al.ltomated Registration of 1.lncenificated Stock. 2' TAURUS will. in its initial stages, cover U.K. equities. The Central Gilts oCficc already in operation is a fully dematerialized eJectronic depository for U.K. Govemment lslues or Gilts. Pap90
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FU11JRES: Study of International Ccaring and Settlement The Cearin1 and Settlement Process In Europe INTERNATIONAL COMMODITIES CLEARING HOUSE, LTD. (ICCH) (Summa'7 of tbe apert paper by tlae ICCH) lntroducdoa The International Commodities Clearing House, Ltd., (ICCH) is an independent clearing house that provides matching. clearing, settlement, delivery management, and trade guarantee services for five cxcbaogr.s in London: Exbaage Futures and Options Traded Baltic Futures Excbaogc Cattle, Pip, Soybean Meal, Potatoes, Freight Index International Petroleum Evbange Gas Oil, Crude Oil, Heavy Fuel Oil and Leaded Gasoline London Futures and Options E'tcbange Coffee, Cocoa, Sugar (FOX) London International Fmancial Futures Range of 20 contracts including Currencies, Excbaogc (LIFFE) Interest Rates, Bonds and Indexes London Metal Excbange Aluminum, Lead, Copper, Nickel, Zinc and Silver In addition to servicing the London derivative and agricultural exchanges, ICCH provides clearing and settlement services separately to exchanges in New Zealand,Australia, Hong Kong, Kuala Lumpur and Paris. ICCH also provides electronic saecn trading systems (the Automated Trading Systems I and II) for three eTcbaoges; the New Zealand Futures Eu:bangc, the Irish Futures and Options E"tcbaagr,, and the London FOX for the white sugar futures contract. ICCH is organized into two divisions; the Recogni7.cd Clearing House, which handles the Loudon-based operations, and the ICCH International Financial Markets, which is responsible for international operations and computer systems. For the purposes of this study we will concentrate primarily on ICCH's London-based clearing and settlement operations. The clearing house is owned by a group of 6 shareholder banks. The banks National Westminster, Barclays Bank, Lloyds Bank, Midland Bank, Royal Bank of Scotland and Standard Chartered Bank act as the ultimate guarantors of the clearing house's obligations. Ownership status has implications primarily in the case of default by a clearing member. In a clearing house owned and operated by one en:baogr., all of the clearing members are ultimately liable for the obligations of a member who fails to perform. The clearing house will first follow a series of steps to meet the member's obligations; liquidating the member's open positions, using any margin on deposit, selling the member's clearing membership, putting a lien on the security deposit, and approaching the member's parent company for collection. If there arc any outstanding liabilities left after the clearing house has taken the af orementioocdstcps, the other members arc asked to contribute the difference. The amount that each member must contribute is calculated based on overall member trading activity and capitalization. Page 91
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Study of latemational Cearing and Settlement The Oaring and Settlement Procea In Europe In the case of an independent clearing house, such as ICCH, the ultimate liability of meeting a failed member's obligations rests with the shareholders, not with the clearing members. ICCH's lnterrace to the Excbaops ICCH has approximately 200 clearing members in London who trade at the five exchanges. These members in tum act as clearing agents for their in-house trades, customers' transactions and non-clearing members trades. While trading is primarily by means of open outay on eu:bange floors, matching, confirmation, and settlement occurs electronically. Once a trade is struck, both the buying and the 5;elling party are required by the cu:bangr.s to enter the trade data into the e.,:cbang~'s computer matching system within a specified time frame. These systems match the trade data and make matched trades available to the tloor brokers for confirmation on a real-time and on-line basis. Once a matched order is confirmed it is sent via real-time data transrniMion feeds to the ICCH's system for settlement. All except the agricultural exchanges (Baltic Futures Evbange and FOX) operate the matching and confirmation systems intemally. ICCH runs these systems on behalf of the agricultural exchanges. The Ceariag and Settlement Process Trade data sent to ICCH is pr~d by the clearing house on a continuous basis throughout the day rather tban in a batch cycle at the end of the day. Members can monitor their settlement positions real-time through the clearing house's management information system any time during the day. At the end of a trading day, me~bers can look at a terminal to sec what their margin calls will be on t1e following morning. The settlement data appears on the terminal saeens as two numbers; one for initial margin and one for variation margin. U the clearing member keeps segregated customer accounts, he will also see two separate numbers for the customer's margin calls. As a clearing house, ICCH legally takes on the counterparty position to every trade. This transfers and redu~ the risk of failure to perform from the trading parties to the clearing house. ICCH further dcacascs risks since it performs this function aa" multiple exchanges. It nets members' multiple positions out into a single margin and settlement figure that represents a member's obligations over a number of markets. The proccu by which ICCH docs this is caUed multilateral netting by novation. 27 Usually the clearing house makes one margin call every day before the start of that day's trading. In periods of high market volatility, the clearing house reserves the right to make more frequent intra-day variation margin calls. For example, on Odober 19, 1987, ICCH made four intra-day margin calls. Interface to Banks Settlement banks ICCH accepts approximately 30 banks as settlement banks. All of these ban.ks are located within the City of London and the list includes foreign banks with branches in the United Kingdom. MuJtilateraJ netting by novation means thac a new contract is drawn up with each member which reflects his net settlement obliption tor one or more trades. Page 92
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Study of Intemational Cearing and Settlement The Cearing and Settlement Process In Europe Each cJearing member typically has at least two sterling-denominated accounts at his settlement bank; one for segregated funds ( such as those of individual investors) and one for non-segregated funds (in-house, non-clearing members, and non-segregated customer funds). In addition, each clearing member has the option of holding foreign c:urrency denominated accounts at the settlement bank to cover margr~ and settlement payments in Deutsche Marks, Yen and U.S. dollars. If there are segregated funds, the clearing members must set up two accounts for each currency. To effect margin settlements the clearing house also keeps accounts at each settlement bank, in some cases multiple accounts if different currencies are involved. Every morning at 8 a.m., messengers delMr printouts to each clearing member's settlement bank detailing daily margin payments and credits. The banks ha~ imtil 10 a.m. to acdit the accounts of members who are owed funds or to debit the accounts of members who owe money. The banks use ICCH's "Protected P_ayment System, which functions in the same way as third party debit authority in the United Statcs.28 If a bank has any problems on meeting a margin call for a member, the bank must notify the clearing house by 10 a.m. One of the risks of the actual margin settlement is that banks do not have to commit payments to the clearing house on behalf of a member until after trading begins in the morning. The opening hours vary at each e.vbange, but the London International Financial Futures E'tcbang,: for instance, starts trading at 8:15 a.m. This could result in a situation where a member accumulates adverse trading positions before yesterday's margins have been committed to by the settlement banks. While the fact that banks do not have to commit payments before the eYCbanges open may not pose a problem on average trading days, it could become a problem during periods of high market volatility. ICCH is a net margin clearing house. That is, it computes members' marginboth initial and variation amounts based on a sum total of overall open contract positions. In addition, for margin payment purposes, the clearing house takes members' variation and initial margins across exchanges and instruments and nets out one figure for both. So the next morning the clearing house submits one number to the appropriate settlement bank for either payment or aedit of non-segregated accounts and segregated accounts. This contrasts with the U.S. derivative clearing houses, where the variation margin and initial margin calls to the settlement banks arc usually two separate figures. Collateral ICCH accepts the following instruments as collateral for margin payments: letters of aedit ( also known as bank guarantees), cash and U .K. Treasuries. Treasuries arc accepted as physical instruments delivered directly to the clearing house. (Letters of aedit arc also delivered to the clearing house.) The clearing house is moving towards accepting U.K. Gilts and U.S. Treasury Notes as collateral. However, there are some legal issues that must be worked out before these instruments can be accepted. One of the obstacles is that both of these instruments are held in decertified form in depositories and can therefore not be physically delivered as collateral to the clearing house. The possibility of pledging these securities on behalf of the clearing house is now under investigation. 21 1be dealing house CUI tell the settlement bank to move money from a member's account at the bank to the clearing boulc's account at the settlement bank. without a new authorization Crom the member. Page 93
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Study of latemational Cearing and Settlement The Ceuing and Settlement Proccsa la Europe At ICOI, collateral, such as a letter of a~ can be pledged to the clearing house as a guarantee against trading on multiple evbaages. If the ICCH did not net margin requirements aaoM these e.Tcbaugr.s, it would seem that such a practice would inaease settlement risk. However, since ICCH docs net the margin requirements for all of these excbaages, there is no added settlement risk to having collateral pledged against trading oa multiple e.TCban~ and the member has the benefit of incurring reduced payment risk and cost. 2.2.5 CLEARING AND SETI'LEMENT IN WEST GERMANY: KASSENVEREINE (THE KV'S) AHD THE DEUTSCHER AUSL\NDSKASSENVEREIN, A.Ci (THE AKV) (SumQUlry of~ Paper by Haas-Joecbim Roessricb and Heinz-Klaus Ruetzel) lntroductloa In West Germany, the clearing and settlement system is an interconneded, three-tiered structure. It consists of exchanges, central depositories, and an electronic data pr~g center, which provides all operational and computer support. There are a tota.1 of eight evbauges in West Germany: Frankfurt, Berlin, Bremen. Ducsseldorf, Hamburg. 'i:..J1over, Munich and Stuttgart. The settlement for these exchanges is done by six depositories, which are called Kassenvercine" or "Wertpapiersammelbanken. The Ka.ssenvcreine (KVs) are linked together through mutual accounts and thus form the central depository system for the Ge: man markets. The KV's themselves are owned by the banks the registered shareholders for cad, KV lxing banks in the particular region serviced by each KV. All of West Germany's C.Tcbang,a.s and KV's (depositories) are serviced by the Deutsche Wertpapierdaten-Zentrale GmbH (DWZ), a centralized data processing center. In servicing the e.Tcbaogr.s, the DWZ handles clearing functions including trade entry (the recording of the original data from a trade) and trade matching. In servicing the KV's, the DWZ handles the settlement process: payment for and delivery of securities, as well as transfer of title. Another key organization in the clearing and settlement process is the Deutscher Auslandskasscnvercin, AG (AKV). The AKV, which was established in 1970, is }~intly owned by the KV's. Its purpose is to assist domestic investors in the settlement of croM-nationaJ border trades. A ssisring in the settlement process the AKV acts as an intermediary between its custodians in foreign markets and its member ban.ks in West Germany. The AKV also functions as a gateway for foreign clearing organiz.atioos and depositories to enter West Germany's KV system. Page 94
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The Interface between the DWZ and ti..-Excbenps Study of International Oearing and Settlement The Cearing and Settlement Process In Europe West Germany's eight regional evbanges rely on the DWZ for trade matching ( comparing the information on the pair of buy and sell orders which make up a trade, to make sure that there are no differences in price, amount, etc.}, reconciliation of trades which at first cannot be matched, contract reporting (the issuing of contracts reflecting the terms of matched trades), trade confirmation (notifying the countcrpartics of a trade that the terms of the trade have been confirmed), and trade accounting processing c;ervices. 29 In West Germany, the buying and selling of securities is done by ban.ks. Anyone who wishes to buy or sell securities must give his order to the bank at which he maintains an account. The bank's dealer will then instruct a MikJer30 at t.he stock excbange to find a counterparty for the trade or, handle the trade directly, by means of telephone communications with another bank. The securities themselves arc held by the ban.ks, in the accounts of the KV's, in trust for the investors. After two banks on a c'tcbanv, have agreed to a trade, the relevant data is entered at on-line terminals and transmitted directly to the DWZ for trade comparison and trade contract reporting. The DWZ then compares the trade data and once the trade has been matched, contract notes arc issued to the counterpartics, who have a fixed time limit within which they may object to or confirm the terms of the contract notes. Contract notes arc issued and delivered continuously throughout the day while the stock e'tcbaogc is open. Counterpartics confirm the information in the contract notes through theDWZ. After the terms of the trade have been confirmed, the DWZ sends the trade information to the KV s for settlement processing The KV's themselves have no operational links with the exchanges. The Settlement Process West Germany is one of the few countries in which the settlement of trades is scheduled to occur on the second business day after the day of the trade (T + 2). It may be that this comparatively short time period for the settlement of trades was one of the motivating factors which spurred West Germany into developing a highly automated settlement system. Functions such as handling payments for purchased securities, legal transfer of title on traded securities, safekeeping of securities, payment of dividends and recording of corporate actions arc all done electronically at the KV' s. In the morning of the day after the trade (T + 1), the DWZ sends each bank a list of the transactions that have to settle. In the afternoon of the day after the trade (T+ l)-1 each bank sends instructions to the KV's on how to settle the day's trades. These instructions are sent either by computer or manually, on paper. Securities settlement occurs electronically by means of computer book-entry transfer of title at each KV. This principle also applies when the selling and buying banks belong to different KV' s. Such a system is pos.gble because the KV's have immobilized all securities in their vaults and because the KV's use the system of 'collective safe custody': 2' Par a detailed breakdown on the services provided by the DWZ. please refer to the IBM repon submitted for, and induded in. this study as volume IV. 31 A 'Maida' ii a floor broker. Page 95
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-Study of International Oearing and Settlement 1be Ccaring and Settlement Process In Europe "Within 1M system of colkctive safe custody the individual certificates an no longer kept apart, under their respective ownen' names, but an held colkctively instead. 1ne aggregate amount of all the securitia of the OM and sanw category such as, for instance, all the ordinary shares of the VollawaA'fflWOX Mid in custody by the KassenvereiM, constitutes what is known as the colkctive holding in that particular security." "The moment an account-hold6 deposits securitiu in the collective holding of a Kassenverein, he ( or his security-deposiag customu) loses his former title to ownership of specific securitiu as was evidenced in the serial numbm of the items -whilst at the same tbM acquiring a co-ownership fraction, pafectly equivalent in vailu!, of the relevant collective holding, which is p,opo,tionate to his deposit_ and caJculaled on the basis of the total amount obtaiMd once his items hmw beoa adud."31 On the day that the trade is to be settled, the KV handling the transaction proceeds with the delivery versus payment32 operation by transferring the title of the securities electronically through book-entry instructions. At the same time, the KV instructs its bank to effect a credit or debit to the appropriate member's bank account.33 Unsettled Trades Trades which fail to settle on T + 2 are carried forward by the KV on a list of unsettled or open items. When the seller makes delivery of stock and the buyer pays, the record of the trade is taken off of the open items list. Approximately 40% of the daily trades executed on the stock exchanges settle after T + 2 34 In West Germany, as is typical of other markets with sizeable fail rates ( that is, the rate at which buyers or sellers fail to make good on their obligations on the day of settlement), the cost of failed trades is built into the overall cost of doing business. Market participants in West Germany cannot yet avail themselves of one arrangement that is often used in other parts of the world in order to meet the securities delivery obligation of settlement. Securities loan/borrow arrangements short-term loans of securities for the purposes of meeting the obligations of settlement arc not allowed by West German law. There is, however, a movement underway by industry participants to lay the legal groundwork that would permit securities lending. Given that the KV's (unlike U.S.-style clearing houses) do not take the counterparty position and guarantee the settlement of trades, the absence of securities loan/borrow arrangements adds ( comparatively speaking) an extra element of risk for the counterparties in the settlement process. 31 Prom the c:xpen paper submitted to this study by Hau-Joachim Hoesaricb and Heinz-Klaus Ruetzel, page 1. 32 "t>eliYeryvenua payment is a senn meaning that in the settlement of a trade. payment and delivery of securities are doae ac tbc same time. The term true delivery versus payment is also used; thas means that payment and delivery are simwtaneoUL Because of their electronic settlement system, the KV's are able to offer uuc delivery vemas payment sclYic:e. 33 We will discUla the ICV's payment proces1 more completely in the section about the interface between the KV's and tbebankl. 34 We are not able, at this time, to ascertain the causes for this rate of unsettled trades. Page 96
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Study of International Oearing and Settlement The Oearing and Settlement Process In Europe lnternadoaal Trading: Settlement or Trades Across National Borders The AKV asmts its members and the KV's and their members in the settlement of foreign securities transactions. The AKV, which is a depository, has direct links with other clearing and settlement agents abroad, namely the Centrale de Livraison de V aleurs Mobillieres (CED EL) in Luxembourg, Euro-clear in Bnwels, and the Japan Securities Clearing Corporation (JSCC) in Tokyo, as well as links with commercial custodians in international markets such as New York. By setting up accounts at the AKV, foreign depositories and clearing organiz.ations -who are not allowed to be KV account holders gain access to the clearing and settlement process for West German securities. When a bank in West Germany buys or sells securities abroad, it sends instructions to the AKV on how to settle the trade on its behalf. On settlement day in the foreign country, the AKV will settle the transaction through an account it has at a depository in that foreign markeL The AKV then credits or debits the AKV member's account.35 In addition, the AKV acts as a depository for foreign wucs that are listed or admitted for trading on West German stock eu-baoges. That is, the AKV will: "hold the original certificates in safe custody in the country of issue, under its own name, and isslU a global bearer catificau (in short: GBC) for this cover holding. The GBC is then deposited as a share cemjicau with one of the German central depositories, and a collective holding of securities that an good delivery in West Germany is thus provided. ,,36 In this way, the KV's, through the AK.V, can transfer title of foreign securities listed in Germany by means of the efficient book-entry method. Due to recent law changes, the domestic KV' s can in certain cases use specified foreign depositories as third party custodians for KV members. This means that the KV's may substitute for the AK.V in the settlement of certain international trades those in which the KV has a direct account relationship with a depository in the country of origin for the foreign security. In order for the KV's to settle trades directly through direct accounts with a foreign depository, the depository must meet stringent legal requirements. For a desaiptive diagram on the KV's and AKV' s international linkages, we refer the reader to Exhibit 4 in the expert paper by Hans-Joachim Hoessrich and Heinz-Klaus Ruet7.eL The lnterf'ace between the KV's and the Banks The KV's have direct working relationships with the Landeszentralbanken (LZB), the regional branches of West Germany's central bank, the Bundesbank. Cash settlement of trades can only occur through LZB bank accounts. To effect cash settlement, both the KV's and their members have cash accounts at the LZB. On settlement day, the KV' s send instructions to their respective regional LZB to debit or credit the member's bank account according to the specific amount involved in the trade. 35 P1eue see Section 2.1.1.1.C [1116naliDnaJ Sutitia Ckaring Co,poralion (/SCC)9 for more infonnation on linkages of this type. 3' Prom the expert paper submitted to this study by Hans-Joachim Hocssrich and Heinz-Klaus Ruetzel. page 1. Pagc'
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Study of International Cearing and Settlement 1be Ccarin& and Settlement Procea lnEuzope The KV's have third-party debit authority over their members' bank accounts at the LZB. This means that the KV member has agreed in advance to give the LZB the authority to honor all KV instructions to debit or aedit his accounts. Therefore, the bank does not need the permission of the account holder each time it receives, and carries out, instructions &om the KV to debit or acdit the KV member's accounts. Third-party debit authority is common practice in markets which use electronic funds transfer rather than paper-hued payment methods for settlement. The settlement process through the KV's is thus fully automated. The KV's, OD settlement day, provide true delivery versus payment service by simultaneously debiting or crediting both their members' securities accounts at the KV's and their cash accounts at the Landeszentralbanken. 1be Interface betwaa the KV's ud their Members The members of the KV's are the banks which trade OD West Germany's exchanges. The linkages between the KV and its members may be through computer terminals or computer tape, or may be paper-based. The preferred mode of interaction between the KV's and their members is electronic. This is consistent with West Germany's focus on taking advantage of technological solutions to make the clearing and settlement process very efficient. General Obsem!doas It is noteworthy that the West German system works well without a traditional clearing house structure. That is, there is no o,gaoization which acts as a central trade clearing service and which takes the countcrparty position to every trade. The system, as it exists, provides highly efficient operational services without any apparent trade guarantee functions. How do the KV's protect themselves against the possibility that a KV member might be unable to meet its payment or securities delivery settlement obligations? The KV's have a strict delivery versus payment policy: that is, no securities will be delivered unless they are paid for. If the buyer's cash balance at the LZB is insufficient, the transactic>D will not be carried out. Similarly, no delivery instructions will be executed uni~ sufficient sec:uritics are available in the seller's account. Any claims resulting from the bankruptcy of a counterparty to a trade may be lodged with a special Deposit Insurance Fund. It can be argued that the risk of KV member insolvency is remote, since only established West German banks and a finite set of approved brokers are involved in the trading and the clearing and settlement processes. Page 98
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STUDY OF INTERNATIONAL CLEARING AND SETTLEMENT 2.3 THE CLEARING AND SETTLEMENT PROCESS IN NORTHEAST ASIA AND AUSTRALIA Page 99
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TABLE OF CONTENTS Sedfon 2.3 The Oearing and Settlement Process in Northcut Asia and Austtalia 2.3.1 Introduction 2.3.2 Ccaring and Settlement in Australia 2.3.2.1 Ocaring and Settlement in the Equities Markets The Interface between tbc Austnlian Stock Exchange and its Oearing House The Cearing and Settlemat Process The Interface between the ASX Oearing HOUie and the Banking System 2.3.2.2 Caring and Settlement in the Futures Market The Cearing and Settlement Proc:esa Interface between the ICCI and the Banting System 2.3.2.3 Cearing and Settlement in the Options Markets 2.3.2.4 Cearing and Settlement of Money Market Securities Allltndcar's Procaa and Interface witb the Banting System 2.3.3 Cearing and Settlcment in Hon1 JCons The Hong Kong Securities Cearing Company, Ltd. (HKSCC) lntroductioa Tbe Ccaring and Settlement Procaa ol the~ Old System The Role of tbc Bulb and the Role of RA:giltran in the Settlement Process Some P!oblcma witb the Current Proc:eu The Cearing and Settlement Process of tbc Propolcd New System 2.3.4 Cearing and Settlement in Japan Page 100 2.3.4.1 Introduction 2.3.4.2 Cearing and Settlement in the Equities Markets The Tok,o Stock Exchange (TSE) The Interface between tbc Tok),> Stock .Exchange (TSE) and the Japan Securities Oearing Corporation (JSCC) The Oearing and Settlement Process (or the Tok)o Stock Exchange (I'SE) JSCC's Interface with Dcpolitorics The 0Ata Securities P.xcbange The Oaring and Settlement Pnxesa (or the Osaka Securities Exchange (OSE) The Interface between the Osaka Securities E.xchange's Oearing Depanment and Depositories The Interface witb the Banking System. in the Oearing of Equities Transactions for the both the TSE and theOSB 2.3.4.3 Oe.tring and Settlement of Bondi Ovem:w Settlement Book-Enny Capability 2.3.4.4 Cearing and Settlement of Futures ContractS Ovem:w The Caring House Process Futures Contracts: The Interface between the Oearing Houses and the Banking System 2.3.4.5 Cearing and Settlement of Option1 ContractS 2.3.4.6 Oe.tring and Settlement of Money Market Securities 2.3.4. 7 International Trading 99 101 103 104 104 lOS lOS 106 106 106 107 107 107 108 108 108 109 110 110 111 111 114 114 114 11.S 118 120 120 121 l:?l 122 122 122 122 122 122 123 124 124 124 124
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2.3 CLEARING AND SETILEMENT: IN NORTHEAST ASIA AND AUSTRALIA 2.3.1 INTRODUCTION Study of International Cearing and Settlement The Cearing and Settlement Process Nonbeut Asia / Australia Our discumon of Northeast Asia and Australia consists of summaries of the clearing and settlement processes of various markets in Australia, Hong Kong and Japan. This information was supplied to us by several experts in each of these countries, either through the submission of a paper for this study, or through an interview. In this introduction, we will highlight the differences between these markets and the markets of the United States, as well as the trends occurring in the region. Comparison Although each market has its own peculiarities, the major differences and similarities worth noting in the Australian, Hong Kong and Japanese markets relate to: where instruments are traded, cleared and settled; settlement periods for equity trades; and regulatory influence. Where instruments are .traded, cleared, and settled In Australia and Japan, as in the United States, the clearing and settlement process varies, according to the type of financial instrument traded (i.e. futures, equities, options, etc..). In Japan, stocks, bonds, futures and options are all traded on the same eu:banges. But the clearing and settlement process for each type of financial instrument is handled separately. Conversely, in Australia, the Australian Stock Excbauge (Melbourne) trades both stocks and futures contracts. The evbang~ clears and settles equity trades itself. But it uses the International Commodities Clearing House (ICCH) in Australia to clear and settle futures contracts transactions. Settlement Periods In terms of settlement times, an interesting observation arises from the comparison of the settlement periods for equities traded in Australia, Japan and Hong Kong. That is, that there is probably some limit as to the shortest pos.wle time period for settlement of transactions in equity markets, given the tendency for shareholders to have their shares on deposit with custodians outside the country where the stock was issued. Consider, for example, the current period for settlement of equities in Hong Kong: T + 1. This next day settlement schedule is difficult for most foreign investors to achieve, since they cannot move their securities quickly enough to meet that deadline. Similarly, in Japan foreign investors trading on the Tokyo Stock Fu:baogc may also not be able to meet the T + 3 settlement date if they use foreign depositories for their Japanese securities. In Australia the timetable for settlement of equities trades is on demand at the disaetion of the seller: H, however, the seller has not set a settlement date by T + 10, the buyer has the option of taking recourse against the seller. In practice, buyers typically delay exercising recomse against sellers until a muC:. longer period bas elapsed. Therefore, a significant number of transactions settle after T+lO. Page 101
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Study of IntemationaJ Cearing and Settlement The Cearing and Settlement Process Nortbcut Asia / Australia Both domestic and foreign investors trading in the Australian markets cite the necessity of moving to a true T + 10 settlement timetable. Many observers also claim that it is difficult to meet the T + 10 goal. One difficulty cited is the intensive paper-pushing pr~ surrounding the transfer of title on a security (including the physical delivery of securities). Reguladon In terms of the regulation of the clearing and settlement pr<>CCM, it appears that in both Japan and Australia there is relatively little regulation and a comparatively greater degree of trust in counterparties than is seen in the United States. At one extreme, Austraclear, the -,electronic scoreboard for money market-securities, has no involvement in the settlement process. Each counterparty to an Austraclear trade must evaluate the other counterparty and feel comfortable that the trading partner will not default on his obligations. Australian market participants are relatively comfortable with this arrangement, one which contrasts sharply to clearing and settlement prOCCMCS in the U.S. ( where all trades processed by clearing houses are provided with guarantees against default). The comparative lack of concern with third party guarantees in Australia may be a result of the fad that the Australian market is relatively small and the market participants know each other well. Given this type of environment, Australia has a much looser re~ory influence on the market. The regulators arc viewed as a source to help the industry work out its problems. They do, however, have the power to disallow rules proposed by the industry .. Conversely, in Japan, the government ministries have a great deal of influence over the markets and the clearing and settlement process. Furthermore, the clearing and settlement process in Japan, is greatly influenced by moral suasion. In Japan, trades do not fail -it is a manner of honor. In the United States, on the other hand, trades do not fail because it costs too much. Trends The most cited trends revolve around developing new clearing systems and ways to immobilize and demateriafu:e securities, especially through the establishment of depositories. Clearing Systems The Sydney Futures Exchange plans to set up its own clearing house, replacing the service which ICCH curreody provides to it. F'mal decisions have not been made as to how this will be accomplished. The Hong Kong Stock Exchange is also implementing a new clearing system. It provides for central clearing, delivery versus payment, and netting, as well as a depository function. The commingling of depository and clearing functions is not unique to this new system. In Japan, JSCC currently performs both clearing and depository funwons, although this will change in the near future. Depositories The immobilization of securities is a top priority in the equities markets in each of these countries. In Japan, work has begun on JASDEC (Japan Securities 12.cpository Center), which will further immobilize physical certificates, provide for increased book-entry share tl'ansfer and will track real ownership of securities. Page 102
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-Study of International Oearing and Settlement The O~DI and Settlement Process Nonbeut Asia / Australia Currently, 6070% of the transactions on the Tokyo Stock ETcbanF are settled via book entry of securities ( at the discretion of the buyer and seller) through the Japan Securities Clearing Corporation (JSCC). At the Osaka Stock Excbange book-entry settlement is not available and all transactions are settled through the physical delivery of securities certificates. The Australian equities market is currently searching for its own solution to the need to immobilize securities certificates. Stock issuers have been demanding that when shares are immobilized, the depository should be required to maintain records on real ownership of shares ( as opposed to holding shares solely in the name of brokers or custodian banks). This procedure, however, would be quite costly, so efforts have focused instead on the development of the FAST (Bexible Accelerated. Security Iramfcr) computer system, which at shareholders' discretion only -allows the decertification ( elimination) of shares (paper securities certificates). The Australian Stock Excbangr-considers FAST a first step to achieving a book entry settlement capability. FAST was implemented, on a pilot basis, in July, 1989. Hong Kong's new clearing and settlement system, currently under development, will provide for the dernaterialization of securities and for book entry transfer. This is in contrast to the current practice of physical delivery, where re-registration of a security certificate takes three weeks, and in effect, prevents that certificate from being traded with.in that time period. Over and above the processing headaches, delays of this magnitude tend to deaease market liquidity, since fewer shares are available for trading at any given point in time. 2.3.2 CLEARING AND SETIU:MENT IN AUSTRALIA Bankers Trust Company extends its thanks to the Melbourne office of McKinsey & Company for its generosity, hospitality and as.gstance in making our trip to Australia so very enjoyable and worthwhile. Through its as.gstance, representatives from the following companies have contnouted greatly to our understanding of the Australian market: AMP Society ANZ-McCaughan Austraclear Australian Stock Excbaag,: BZW-Mcares Macquarie Bank McKinsey & Company NAB-AC. Goode National Mutual National Companies and Securities Commission (NCSC) Reserve Bank of Australia Sydney Futures EYcbang,: Westpac-Ord Minnett We are grateful to the representatives of these companies who spoke with us during our visit. In general, the clearing and settlement systems in Australia are poised for significant change. Various indu.my groups within Australia, as well as international and foreign organizations, arc exerting pressure for major reforms to be intrQduccd to the Australian system of clearing and settlement of traded instruments. Page 103
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Study of International Ceaiag and Semement The Ceuinc and Settlement Procal Nortbalt Alia / AIIICl'aila Industry players want the right solutions implemented, and this implies debates on proper functionality, cost-effectiveness, o .-gauiv,tioaal structure, and regulation. However, as in most situations where major change is needed, there are always those entities which profit from the inefficiencies of the system aa well as those who would have to bear the financial and/or procedural burdens of the proposed changes. It has been said by many in Australia that a contnouting factor to the delay in consensus for solution is the threat of a loss of franchise and/or control of information. It has also been said by many that there is no distinct leadership force directing change. However, this is not to say that cbauge, uc not underway. For certain traded instruments this progress is rapid, for others the debate continues and interim solutions are suggested. In any case, we found the industry players in Australia to be very open in diCOJwug their views on what should be done to make the Australian market more efficient, and therefore more attractive to foreign investors. The current hot issues" in clearing and settlement in Australia are: The need to establish a depository to replace the paper movement in securities transfer and settlement. The various proposals for the clearing house now in the process of being set up by the Sydney Futures Exc.bangc. The risks, if any, associated with Austraclear'~ nonor settlement system. The movement from checks to electronic payments systems. wues related to establishing the Australian market as an international market. 2.3.2.1 CLEARING AND SETTLEMENT IN THE EQUITIES MARKETS (Summary of espert papers by Angus Richards and John Gall) The Australian Stock Excbange (ASX) was formed in 1987 through the amalgamation of the six local and independent state stock evbanges (i.e., Sydney, Melbourne, Perth, Adelaide, Brisbane and Hobart). Each state excbauv is now a subsidiary of ASX. Ettbauge hours in each state are set by the evbange division operating in that state. 2500 high volume stocks traded on the floors of the six ASX subsidiaries account for SO percent of ASX volume. The rest of ASX's trading volume consists of 1550 stocks which are traded via an automated trading system called SEA TS. The Interface betften the Australian Stock Excbanp. aad its Clearing House Locked-in trades originate from either the ASX floor or the SE.A TS system and are entered into the ASX Data Service System. Since the trades are locked-in, there is no trade matching or trade comparison performed. Less than 1 % of the transactions are disputed. The ASX Distnoution System feeds information to JECNETl and other information distribution services aa well as to the ASX Broker-to-Broker Settlement System (BBS), which maintains records of open trades. 1 JEOIET i.1 the ASX retail martct infonnation computer network. The system captures price informa~ion from the individual sublidiary stock exchanges of the ASX and from the national screen trading system. SEA TS, and distributes it to ASX mcmben and. for a fee, to other martct information vendon such u Reuten and MoneyWatcb. Pap 104
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The Clearing and Settlement Process Study of International Cearing and Settlement 'The Ccaring and Settlement Process Northcut Alia / Austnlia Domestic and foreign participants complain about the lack of a fixed period settlement discipline in Australia's securities markets. It is generally stated that transactions on the ASX must be settled by T + 10, although there is no strict adherence to this time frame. A large portion of ASX trades are settled within T + S; trades settling within this time period account for 60 percent of the value of all ASX trades. At the same time, many ASX trades take longer than T + 10 to settle. The Australian Stock Excbaoge docs provide a guarantee of completion of the trade; this guarantee is underwritten by the Australian National Guarantee Fund. Security settlement is paper-based, and it is the logistics behind this paper movement process which impede the market from adopting a fixed settlement period. The ASX has pushed for the dematcrialization of securities. But its proposal for a c:cntral dcpoutory, CENSAS (~tralized Saip and Accounting Systems) was abandoned in 1986. CENSAS was dropped as a result of opposition from issuers, who contend that the use of a depository with stock registered under one large nominee would impair disclosure of beneficial ownershir and furthermore aeatc problems in shareholder communications. As debate continued over the perceived need for a central depository, issuers suggested that they would accept immobilization of securities if certain modifications were made to address these conccms. The key modification of the counter proposal is the development of STARS (Settlement Iramfer and Registration System). This is a book entry transfer, name-on-register computer system, similar to the International Stock Excbange's original TAURUS (Iraosfer and Alltomated Registration of llnccrtificatcd Stock) system proposal. However, the STARS alternative was shelved in early 1988 due to the high estimates for initial implementation (AS40m). Instead, work has begun on FAST (Elexil>le Accelerated Security Iransfcr) system, which will support decertificated shares at the discretion of the shareholders. The FAST pilot will be implemented for a small number of companies, and will last 12 months. However, since FAST is not compulsory, paper transfers are still part of the system. FAST is therefore considered by the ASX to be a small step towards a completely book entry transfer process. At the same time, it is considered to be compatible with the evolution to either a name on register system or a depository system. Austradear, the money market electronic scoreboard. is investigatiog whether it can contribute all or part of a solution for securities transfer. Austradear itself is discussed in another part of this summary. The Interface betftell the ASX Clearing House and the Banking System At the ASX, money settlement and saip ( securities) movement are separate. On the funding side, the ASX takes the counterparty position for each transaction. First, brokers submit to the BBS system notifications of the deliveries that are being made that day to counterparty brokers. On the basis of that notification, BBS computes net money settlement obligation of each broker on that day. The 2 The benc(ICial owner is tbe individual or ~mtioll that bll lepJ rigbt to the benefits accruing to tbe security, that is the diYidcndl, capical pin. voa.ns rights. etc. The beneficw owner can cboole to regilier the shares in his own name, or iD die name of a designated nominee. The nominee company hu power to authorize tnnsfen and respond to corporate ICtiom on beb.aif of tbc bcne(ICiaA owner. Nominee compuia an: used for a range o( reuons. the mmt common being for sbua mana~ by a custodian and for inwstmcnts ex corpontionL Under securities law in Australia. a nominee compaay mua disdolc tbe beneficial ownen of shares when requested by tbe issucn. Page 105
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Study of Iaaematioaai Ccaring 111d Settlement TIie CeuiDs and Settlement PIOCal NordlallAlia/AUICnlia ASX then requires the broker to deliver a check payable to the clearing house around 2:30 pm, which is cleared overnight by the hanking system. This introduces an overnight risk to the clearing house as it waits for finality of payment. Brokers who are unable to meet net settlement obligations are subject to immediate suspension. The transactioasare unwound, and the procea is backed by a Guarantee fund, administered by the National Securities Evhanges Guarantee Corporation. 2.3.2.2 CLEARING AND SETl1.EMENT IN THE nmJRES MARKET (Summery ol tbe apert paper submitted by Les Hosking) Futures are traded OD the Sydney Futurel En:bange md the Australian rmancial Futures Market (AFFMa division of the Melbourne Stock Evbangc ). TheAFFM trades futures contracts on 10,000 share parcels of 4 Australian securities which are settled by the International Commodities Clearing House, Ltd. (ICCH) in London. The Sydney Futures Excbange (SFE) has 29 local members and supports volume of 51,000 contracts per day, which is expected to be supplemented when off-hours trading is instituted. The SFE has developed SYCOM (S!dney ~omputer Qvemigbt Market), an extended hour trading system for the local members, and has agreed in principle to join the GLOBE< system (a Chicago Mercantile Excbange/Reuters joint venture). Tbe CJearb1c aad Settlement Process The SFE is planning to set up its own clearing house, replacing the service which ICCH currently provides. Fmal decisions have not yet been made on many of the details concerning the way this new clearinghouse will be set up. However, as part of the current proposal, the SFE clearing house function will indude a ASlOOm guarantee fund (formed by contributions from the SFE and each of its clearing members, u well as an insurance policy). One of the reasons for bringing the clearing house function in house related to the current situation in which the ICCH administers the clearing house guarantee fund. The ICCH is owned by 6 British banks, and maintains a fund of 150 million pounds Stg to cover settlement problems for broker default. The problem is that this fund is accessed chronologically. Many Australian market participants fear that a crisis could occur sometime after Australian busin~ hours, depicting the guarantee fund during Australia's night, leaving the Australian market in the unacceptable position of having no guarantee fund to draw upon when it opens in the morning. Interface between the ICCH and tbe Baakin1 System Currently, as with the ASx. all payments arc made by check to the ICCH. (The operation of ICCH is described in detail inScction22.4.2 of this study) The SFE hopes that the payment system supporting clearing and settlement in the markets will move towards electronic payments. The SFE also recogni1.es the need for the banking system to be able to meet margin calls during the hours that payment systems arc traditionally closed. Pap 106
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Study of International Caring and Settlement The Oearing and Settlement Process Nortbem Alia / AumaJia CLEARING AND SE't"TW....EMENT IN THE OPTIONS MARKETS The Australian Options Market is operated by the ASX in Sydney. Call and put options based on underlying equity securities are traded for some 2S issues. Options are settled on T + 1 by the Options Clearing House, which is owned and operated by ASX. CLEARING AND SETltEMENT or MONEY MARKET SECURmES (S0mmarr of tbe apert paper submitted by Keith Usslaer) Austr-4Ciear has two purposes: a) it is an cJectroaic scoreboard upon whi~ daily ~ctivity is logged, and b) it provides for the immobilizadon of :noney market securities. The electronic scoreboard records deals/ttadcs on: Bank Accepted Bills of Evbanp Bank Endorsed Bills of Evbange Bank Certificates of Deposit Promissory Notes Non-Bank Bills of Evbange Federal Government Treasury N<>'-es Semi-Government Securities Forward Deliverable Bill Agreements Forward Interest Rate Agreements Austradear has 130 members, comprised of banks, life offices (that is, life insurance companies), trustee companies, and other leading industrial and financial corporations (that is, Austraclear is a wholesale market only). It records transactions which are elec:tronically agreed upon by both parties, and tallies the money settlement obligation owed by each member throughout the day for end of day payment. The transaction size on Austraclear is large, the average transaction being approximately ASSm. Austradear's Process aad Interface with the Bankina System Austraclear neither a.uumes the counterparty position on each trade, nor does it authorize deposits and withdrawal against bank accounts to effect settlement. Austraclcar is a p~ive communications intermediary, and it does not make margin calls for trades, nor does it monitor open positions. The players are honor-bound to meet settlement obligations, and the counterparty risk remains between the buyer and the seller on each trade. An Austraclear member may authorize banks to automatically meet its ( that is, the member's) daily obligation, but this is an arrangement made between the member and its bank, without the interference or influence of Austraclear. Therefore, delivery is on a transaction by transaction basis, whereas money movement is on a net basis. However, immediate payment, as opposed to end of day payment, may be obtained for any given transaction directly through the banking system, if requested. In the settlement of any given trade, Austraclear may handle both the transfer of tide on the securities and the buyer's payment to the seller. Austraclear might, however, handle only the transfer of title leaving the buyer and seller to make their own separate arrangement on payment. Austraclear D"aiotaius depositories in each of the mainland state capitals, and uses its national communications network for the recording. settling and transfer of ownership of securities. In addition, members can borrow funds through the system by pledging securities to lenders. Pap 107
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Studt of llltcmatioaal Ccaring and Settlement The Oearing and ScttJemcnt Praccss Nortbalt Alia / Allltnlia 2.3.3 CLEARING AND SETnEMENT IN HONG KONG: THE HONG KONG SECURITIES CLL\RING COMPA1'iY, LTD. (HKSCC) (SPWDW'7 of apert papen by K. w. Chu wl D.J.L Gleaale) Bankers Trust Company mends its thanks to Mr. K.W. Chan from the Stock Exchange of Hong Kong. Ltd. and the representatives &om the Hongkong and Shanghai Banking Corporation, who generously gave their time and assistance to this project. IDtroducdoa In Hong Kong. the clearing and settlement proce.,s is in a period of transition. The current, system is primarily paper-b.ed: a buyer de1M:rs a bank check in e,cbaog,: for the seller's physical share certificates. While such a system may work well in markets of low daily share transactions and little international activity, it create ::.iefficiencies and backlogs in an international market with high trading volume. In fact, Hoag Kong recogni7.ed this when, after the October 1987 market aash, the stock cxcbanr, had to close for four days, in part because of the large volume of unsettled trades. In response to these events, the Hong Kong Stock E'tcbangr. proposed, in conjunction with the major Hong Kong banks, the establishment of a new automated clearing and settlement process for Hong Kong based on the book-entry transfer of title. The result was the recent aeation of the Hong Kong Securities Clearing Company, Ltd. For this report we will look first at the~ paper-based system and then list some of the important proposed features of the new clearing and settlement syste~ which is scheduled to be fully implemented by the second quarter of 1991. The Hong Kong Stock E"
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Study of International Oearing and Settlement The Ocaring and Settlement Proces.1 Nonheut Alia / Australia Settlement in Hoag Kong is scheduled to occur before 1 pm on T + L At that time, the buying broker delivers a check to the selling broker and the selling broker delivers the share certificates. (Currently, in Hoag Kong. there are no electronic fund.1 transfers settlements of trades.) For share ccrtific:ates to be considered good or negotiable, the selling party or transferor (which may be either the broker itself or a client oa whose behalf tbe broker is acting) must be the registered shareholder and must sign the stamped transfer deed which matches the share certificates. The broker then endorses the transfer deed to validate that the ad valorem duties or taxes for the transaction have been paid. Next, the buying party or the transferee mmt sign the transfer deed to effect the change of tide. Then: "Ona tJw transfer ea has bn sipd by tM transfeiu, dw shales are no longagood (delivery) and must be lodged, togetJw, with tM dads, with tM company rqistrar for rrgistrotion in tM transf~~'s 1111m& Registration procedwu take approximately three ,.,.Ja and during this time it is not pouible to sdl tM shares ( oxept by ~ciaJ arrangement or a.r daaytd MHvay) since n certijkata arr available for livay. ,,3 As a result of this lengthy transfer-of-title period during which shares arc not available for trading (or at least for on-time delivery), it is common practice to leave share certificates in 'street name' or negotiable form after the transferor bas signed it. Only when shares must actually be transferred will they then be re-registered. Another point worth noting in examining t.he current Hoag Kong clearing and settlement system is the fact that there is no netting of trades for the day. The result is that each trade has to be settled individually. For example, assume broker A sells 100 XYZ shares to broker B and broker B then sells 75 of the same securities back to broker A later in the day. Under the existing system the two brokers cannot net the trades. Instead of broker A owing broker B only 25 shares, broker A has to settle the 100 shares and broker B, in tum, settle the 75 shares. This procedure adds time and cost to the settlement process. The Role of Banks and the Role of Registran la tbe Settlement Process Banks play various roles in this market; they provide securities purchase and sales services, check clearing functions, and custodian services which include the settlement of trades. Banks, in their role as custodians, act as nominees for investors whose shares arc held in accounts at the bank. In Hong Kong over SO% of the registered shares arc in the names of bank nominee companies accounts. In Hong Kong, the transfer of title on securities is handled by registrars, whose function is to keep track of the identity of shareholders of listed companies. Registrars process transfer of title actions and any dividend declarations or other stock actions on behalf of the iMuing companies. As noted above, the registration process is a paper-based pr~ and therefore time-consuming. Since many shares arc kept in street name, shares tend to be registered by the street name traders twice a year when dividends are paid out. J Stot:Jc of Hong Kong Limiud9, Mr. DJ.L Glennie. Hongkong and Shanghai Banking Corporation, May 1989,papS. Page 109
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Study ol lntemadoaal CcariDI and Settlement The Ceuiaa 111d Scttlemeat Procaa Nortbalt Alia/ Auanlia Settlement in Hoag Kong is technically not a true delivery versus payment process, even though the buyer is required to both pn:sent a check to the seller and pick up his shares on settlement date. There is still the chance that the buyer's check might not be honored by the drawee's bank and be returned for insufficient funds. The seller would then be left without the shares and the payment of the trades. ID a true delivery versm payment system, such a case could not happen. Since the proceu of clearing and settlement, particularly the latter, is so paper intensive, meeting the T + 1 deadline is not always possible. Mr. Glennie, in his paper submitted for this study, observes that this is particularly the cue when foreign ilneston trade in the market: "butiladonal invuton in Eumpc or U.s.A. fin" it almoft impossible to get delivery instnu:tioM to thdr custoduRu tM following dlly and tJunfo,e settloamt in Hong Kong is ,.,,_d r,un as a cas~ of 'wha OM c1111' rathe than abitiing by a spific period." Fails ( default in the payment for or delivery of securities on the settlement date) as we know them, arc common, though they are not regarded as fails in Hong Kong. A trade that settles on T + 3 is usually considered good. The Cleariac and Settlement Process of tbe Proposed New System The new, automated clearing and settlement system being developed by the Hong Kong Securities Clearing Company, Ltd. (HKSCC) will address and solve many of the deficiencies of the existing paper intensive prOCCSL The major <&tinguishing features of the new system arc: a single, central clearing operation run by the HKSCC; true delivery versm payment; the gradual dematerialization of securities certificates, or saipts; tramfcr of tide on securities by means of computer book-entry, electronic payments for settlement; netting of transactions; provision for the clearing house to take the counterparty position, guaranteeing the settlement of~ trade; and, the settlement date will be changed from T + 1 to either T + 2 or T + 3. The operating plan for the new clearing house calls for all stock C'!Vbangc members to become clearing members. This will include brokers as well as cmtodians. There will be no other way to clear and settle trades in Hong Kong. The clearing house will, after each trade is matched, assume the counterparty position to each trade and thereby provide a reasonable degree of finality of settlement. This centralization of the clearing and settlement process will maxirni-m efficiency and reduce the risks inherent in the current system. On the settlement date HKSCC will debit and aedit both the counterparties' cash bank accounts and their securities accounts at custodian banks. This will provide true delivery versus payment service. that is, simultaneous payment for and delivery of securities on the settlement date. Individual investors who prefer delivery of actual securities certificates will still be able to do so, if they so request. At this point, however, it is not anticipated that there will be a big demand for this service. Page 110
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Study of International Cearing and Settlement The Ccarin1 and Settlement Proceu Northcut Asia / Australia For more information please refer to the HKSCC chart in the Far &st section of the IBM report submitted for and induded in this study. Also please refer to our interview with Mr. K. W. Chan, the Project Director for the creation and start-up of the HKSCC. 2.3.4 CLEARING AND SETl1iMENT IN JAPAN Bankers Trust Company extends its thanks to all of the Japanese companies and institutions which gave so generously of their time and information. We would also like to thank the Financial Attache's Office at the United States Embassyin Tokyo for it, assistance in making our trip to Japan so successful. latruductloa Before beginning our specific disc:usuon of dearing and settlement in Japan, we will first take a moment to compare the markets in Japan and the United States. The markets in both countries, induding their clearing and settlement processes, are in some ways very similar and in other ways, very differenL This is true of exchanges, clearing houses, and depositories. E:rcbar Both countries have multiple equity e'1'cbang,:s. Also, in both Japan and in the U.S., one or two of theR evbang,a-s handle most of the total trading volume for each country's overall equities (stocks and bonds) markeL Both countries also have an active over-the-a>untcr (OTC) market. One difference between the countries is that in Japan, derivatives (futures and options) contracts are traded on the same stock evbang,-,s which handle equities, while in the U.S., different types of financial instruments (i.e., equities, futures, and options) arc generally traded on separate exchanges. ClearfnaHoases Since the trading of equities and derivatives in Japan occurs on the same stock exchanges, the clearing process for both types of trading is handled by the same organizations, although the two types of clearing are handled separately within those organizatiQDS. This contrasts with the situation in the U.S., where equities, futures and options are traded on separate exchanges and each transaction is processed by a clearing house a.uociated with the particular excbange where the trade occurred. The futures markets in both countries adhere to the mark-to-market4 principle in requiring payment of margin. Japan and the U.S. differ in the types of collateral which arc acceptable as margin payments. Japanese clearing houses do not accept bank letters of aedit as collateral, but they do accept listed securities. In the United States, the reverse is tru~ although futures clearing houses have begun to view letters of aedit as a 1~ desirable form of collateraL Securities (with the exception of U.S. Treasury obligations) are not accepted as collateral by U.S. futures clearing houses. They are, however, accepted by the Options Clearing Corporation, which handles the clearing for all options trades in the U.S. 4 "Mutc-to-mami-ii the clearing house practice of adjusdng tbe value of eadl ctearing member's holdings and the size of tbe potential ~re to liability pOICd by his open positions ( trades agreed on. but not ~t ctO&ed out). The clearing house uses this figure to adjua tbc amount of variation rnargiJl the clearing member mu.st then pay to assure his ability to meet the obliptions of tbe futures contract. Page 111
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Study ol lntcmatioaal Ccarin1 and Settlement 1bc Ccaling and Settlement Procal NortballAlia / Allltnlia De,-itories There is no depository now functioning in Japan, although JSCC performs some depository functions. Japan, however, is now in the process of establishing a depository. The plans for the new Japanese depository call for it to have a relatiomhip with Japanese c.lcaring organizations similar to the U.S. arrangement between the Depository Trust Company (DTC) and the National Securities Clearing Corporation (NSCC).5 The new Japanese depository will also have the ability to maintain records OD the beneficial ownership of securities, a feature which is currently not offered by the OTC. The Slrllctlln of Japuese Markets There are eight securities excbanr-s in Japan, located in Tokyo, Osaka, Nago~ Kyoto, Hiroshima, Fukuoka, N'aigata and Sapporo. The Tokyo Stock E'tcbange (TSE) is by far the largest securities evbange in Japan, representing 80-90% of Japan's total equity trading volume. In volume it ranks as second in the world, following the New York Stock Evbange. 6 The Osaka Securities &c:bange (OSE) is the second largest evbange in Japan, and its volume is considerably lea than that of the TSE. The OSE, however, is actively trying to inacase its market share by providing different services from those offered by the TSE. Currently, the OSE is the leader in futures trading in Japan. ~d it is the only evbange in Japan which trades options. The OSE also has another unique feature called the New Second Section. The Second Section makes it possible to trade an increased number of stocks on the OSE, by means of special listing aitcria intended to facilitate the participation of small and medi~ si7.e companies. Equities, corporate bonds, Japanese government bonds and yen-denominated foreign bonds are all traded OD both cvbanv.s, as well as in the OTC markeL Shares are primarily traded on the exchanges, while most bonds are traded OTC. In addition, both evbanges trade foreign bonds denominated in foreign currencies. The settlement for these bonds, however, is in yen. Futures contracts are traded on the TSE, the OSE, and the Fmancial TIFFE (Tokyo International Fmancial Futures Evbange ). Rot" Issues la the Clearull and Settlement Industry It is important to note that in Japan, the clearing and settlement process operates considerably more on trust than is the case in the United States. There are basically two reasons for this. First, the Japanese government, compared to U.S. regulatory agencies, plays a much stronger role in the day-to-day business of a Japanese brokerage firm. The second reason for this trust-related process is the Japanese cultural emphasis on the importance of honor -a concept which goes beyond individual honor and includes the reputation of companies and their employees. As an example of this business environment consider the response of the Osaka Securities Exchange to our question asking about the risks of clearing and settlement in Japan. The OSE, talking about risk, says: 5 Por mons details oa tbe U.S. system. please refer to Section 2.1: ClaJring and Settlanou in North America, and the expel! papen wbidl ue mcntior-ed in that section. Prom rnsiMJapan's Fllllllldal M~ by Alon Viner, The Japan Tunes, 1987 (originally published by the Economist Publicatiolll Umitcd). Page 112
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Study of International Oearing and Settlement The Oearing and Settlement Process Nonheast Asia / Australia "mmlbersurities companiu are licensed by the Mmisterof rmance, and an doing business under the Mlllistry's administrative guidance and individual e:tdumges' supervision. From this viewpoint, we do not believe that an1 serious risks might be raised associated with the clearing and settlement bu.sinus in Japan. ,,7 Trades do not fail in Japan, generally speaking, because it is dishonorable not to meet one's obligations. Entities which do not meet their obligations are soon out of busin~ 8 Although there is not a widespread concem in Japan as to the p<>Wble failure of the clearing and settlement system, Japan's financial services industry would certainly like to see some improvements in their process implemented. Here are some of the mues which are currently under discussion in Japu, relating to clearing and settlement for the domestic market:9 The Reduction of Physical Movement of Securities Japan is in the proces.1 of setting up a central depository for securities, which will be called the Japan Securities Depository Center (JASDEC). In additio, the Bank of Japan is aeating an on-line depository for Japanese government bonds. (Hamana/Shimizu) Same Day Funds Except for Japanese government bonds, the settlement of all trades in Japan is through checks, which do not clear until the next day. It has been suggested that a certain degree of risk could be removed from the settlement process if payment were to be made in same day funds, via an electronic funds transfer system. (Please see the section on TSE and JSCC in the IBM Report included.) The Japanese securities industry is also diccussing a number of other wucs, relating to facilitating aoss-oational border trading both for Japanese investors and foreign investors. s~,tne of these concerns include: 7 8 11 Immobili7.ation of Securities in Their Home Market The Japanese securities industry supports the immobili7.ation of securities in their (i.e. the securities') own market. Japan supports the aeation of bilateral ( and pos.gbly multilateral) linkages among depositories and clearing houses. The Japan Securities Clearing Corporation ( JSCC), which clears transactions for the Tokyo Stock Evbange (TSE), currently maintains linkages with depositories and/ or clearing houses in nine countries. (Hamana/Shimizu) EJirnination of Depository Receipts (DR's) In accordance with the philosophy of immobilizing securities, the TSE advocates the elimination of Depository Reccipts.10 (Hamana/Shimizu) Pteaae refer to Quesaon 13 in tbe expert paper indudcd ill our report by Hajime Y o&bioka. [f shala l1ff no, availal* forddiwl1 in Toit)to, a broka iSSUG a lau:r of~ es,mli,aJJy a promise to
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Study ol llltcrnatioaal Cearing ad Settlement The Ocariag 111d Settlement Procr:a Nortbalt Alia/ AUlb'aJia Coordination of Settlement Dates Several institutions in Japan would like to sec more staadardi7.ed settlement periods. Currently, equity settlement in Japan is on T + 3, while equity settlement in the U.S. is on T+5. (Hamaaa/Shimim) The differences in these settlement time periods impose limits on international trading. For example, an ilffl:stor trading General Motors stock oa both. the NYSE and the TSE would not be able to arbitrage bis holding.,. If the UM:Stor were to buy GM shares on the NYSE and simultaneously sell them on the TSE, the fact that the U.S. settlemcmt period is two days longer would result in the_ GM share c:ertifi~ not being available in Japan for settlement. Conversely, if the investor were to buy GM on the TSE and sell GM that same day on the NYSE, it would take more than three days for the share ccrtificatcs to be transferred from Tok),, to New York, since this security is not kept on deposit in the security's country of origin. (Noman Securities) We will discuss crou-national border trading in further detail in the last section of this summary on the Japanese markets. 2.3.4.2 CLEAR.ING AND SETit.EMENT IN mE EQUITla MARKETS (Syatllesia of tbe Expert Papen f.roal Noman Securities; Masayoshi Hamaaa and Toahitsup Sbimiza; Hajlme Yosbloka; ud parts of tbe IBM Report: "Technology or Cleanace ud Settlement' submitted ror this study) In this section, we will focus on the clearing and settlement me-cbaaisrns .u the Tokyo Stock Excbaoge and the Osaka Securities &cbaage. Except for the payment pr~ we will evrnine separately the various aspects of trading. clearing and settlement at the two exchanges. The payment process, being essenrialJythe same at the two exchaages, is discussed in our section "The Interface with the Banking System, later in this summary on Japan. THE TOKYO STOCK EXCHANGE (TSE) (Syatbesis of tbe Expert Papen from Nomura Securities; Masayosbi Hamaaa and Toshitsugu Sbimim ud parts of tbe IBM Report: 9Tecbaoloa ol Clearance and Settlement submitted ror this study) Stocks on the TSE arc traded by two different methods. The 150 most active stocks are traded manually on the trading floor. All other domestic and foreign stocks (approximately 1400 issues) are traded through CORES, the Computer-Assisted Order Routing and Execution System. nae hat.erface betwftD tbe Tokyo Stoa Excbange (TSE) and tbe Japan Securities Clearing CorporadOII (JSCC) The Tokyo Stock Fxrbanr has a division known as the Clearing Administratbn Department, which is the piaaniag md rule-making body for all matters conceming the clearing and settlement process for tbe TSE. The Clearing Administration Department supervises the overall proceM, but the bulk of tbe day-to-day clearing and settlement proccs.1 is entrusted to the Japan Securities Clearing Corporation (JSCC). JSCC, a wholly-owned subsidiary of the TSE, was established in its present form in May, 1971, in response to increased trading volume on the TSE. Pqe114
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Study of IAtemational Ccaring and Settlement Tbe Oearing and Settlement Process Northcut Alia / Australia All 114 members of the TSE uc regular mm,~ of JSCC, that is, there arc no evbangc members who are not also clearing members. All clearing members are required to maintain a clearing office ia Tokyo, and a baakiag relatioaabip with one of 13 approved clearing banks (for more OD this, please refer to our section oD "Tlw lnllllfaa to tlw Bankings,-,,.). TIie CJeariDa and Setdemeat Proc:eu for die Tokyo Slack Exdvtn (TSE) JSCC settles cash-market equity trades {bodl domestic and foreign), a variety of bond trades, and TOPDCll and ~= bond futures traded on the TSE. In the settlement of equities trades cash settlement and the transfer of shares &om seller to buyer occurs on the same day (3 days after tbe trade date: T + 3), but the payment and securidca dclift:ry processes are separate. JSCC ia not imohed in the payment process, which is bandJed by the TSE's Clearing Administration Department. JSCC meanwhile takes care of the securities delivery portion of the settlement process. The transfer of title on shares of securities is handled through JSCC's computer Book Entry Clearing Syatcm aad through actual physical delivery of paper securities certificates. Neither JSCC nor the OcaringAdministratioa Department takes the counterparty position to trades. Nor are any other formal guarantees made by either organization to auure that the payment and securities delivery obligations of settlement will be meL All equities traded on the TSE arc processed by JSCC's computerized Book Entry Clearing System and arc scu1ed in one of four ways: L The Regular Way: Settlement is on the 3rd day following the date of the trade (T+3). 99 percent of the TSE's stock traasactions are settled in this way. 2. CuJa Transacdoas: Settlement is on the day of the trade (T + 0). If both parties agree, settlement by means of this method might instead be on the day after the trade (T + 1 ). 3. Special Agreement: Settlement is scheduled. at the seller's option, for a specified day within 15 days of the trade date. This method is primarily used when the counterpartics to the trade arc separated &om each other, geographically, by a considerable distance. 4. WIim Issued: This method of settlement is used for pur~ of securities which either have not yet been issued, or, for some other reason are not yet available for delivery to the buyer. Contracts for these types of securities trades are settled on the 4th business day after the trade (T+4). The stock evbaav, determines the date after the shares have been iMued that "when issued transactions may no longer be performed. 11 -rt>PIX: Tok),> Stock Price Inda futures contnct1. similar to me Standard and Poor's 500 index futures contracts wbicb ue tndcd ill the U.S. Por mon: information oa TOPOC. plcalc refer to the Tokyo Stock E.xchange's own book.lee oa tbe subject: 70P/X FUIIIIG OwliM of To)G Slll Priu Inda F111111a. Pap115
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Study of lntematioaal Oearins ... Settlement Tbe Ceuiq ad Settlement PIOCCII Nordlcal&Alia / Allltnlia Lesa than one percent of the transactions at the TSE end in a failure to deliver shares OD settlement day. In the event that a trade does fail ( ends in default oa either payment or delivery of securities), the TSE requires that the trade be rcsolvecl that is, cleared or cancelled within four additional busineu days. If there is a default on the securities deliw=ry portion of settlement obligations the seller may issue a "due biJI to the buyer, which is an IOU for the scc:urities owed. A due bill is actually a bank check issued by the seller, to the buyer, for the money amoUDl of the failed trade. A due bill is placed on deposit with the TSE, which holds the due bill until the seller's obligation to deliver scc:uritics has been met. If the seller does not meet his contractual obligations, the TSE will tum the due bill over to the buyer. Althougb the due bill is a coatractual agreement between the buyer and the seller, it is covered by exbanp ruk:s and regulations. The defaulting seller may therefore be subject to TSE-imposed penalties and/or sanctions. Since settlement by the Regular Way is the most common method of settling equities trades OD the TSE, v.,s will now e.vmini, that method step by step, ~ginning with the actual trade: T + 0: Trade, Trade Comparison If the trade was done manually on the Ooor of the TSE, specifics of the transaction are written down on trade slips which are then transmitted (by means of Optical Character Reader (OCR) computer terminals) to the offices of the member firms which arc the counterparties to the trade. If the trade was done electronically, through the CORES computer trading system, the trade data is electronically transmitted to the offices of the counterparties to the trade. In either case ( manual or electronic), the counterparties to the trade, upon receiving the trade data, must compare it to their own records on the trade (i.e., price, quantity). Tosho Computer Systems (TCS) which provides the computer services for the TSE compiles data on the trade. This pr~ is done overnight after the exchange closes, and is completed (that is, the data is transmitted to the JSCC) before the C.Tcbangr. re-opens the next morning. T + 1: Error Correction On the day after the trade, TCS c.listnoutes hard copy printouts of the details of the trade (i.e., price and quantity) to JSCC. If either counterparty finds an error in the trade information, corrections must be made by contacting the TSE by the afternoon of the day following the trade. T + 2: Settlement Instruction wued Settlement is always on a net basis, in respect to both the si7.e of the payment due and the amoUDl of securities which arc owed on settlement day. Accordingly, by the morning of the second day after the trade (T + 2), JSCC advises the counterparties on their net settlement obligatioas.12 By 4PM on T + 2, each net seller firm pre-advises JSCC as to how it intends to provide shares for settlement (i.e., book entry or physical delivery), and each buyer firm advises JSCC as to how it wants to receive the shares due to it. 12 1bia netted figure on settlement obliptions is ca1cuJatcd by tbe Cearing Administration Department of the TSE. Page 116 ..
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T + 3: Settlement Study of International Oaring and Settlement The Oaring and Settlement Process Northcut Alia / Austtalia The selling counterparty makes good oa his obligarion to de1iwr securities by means of either transfer of title through the JSCC's com~ Book Entry System, or through the physical delnery of scc:urities certificates. Shares arc transferred from seller to buyer at mid-day on the third day folloy;ing the trade (T + 3). Payment is also made OD T + 3, but is by bank cbcck (next day funds) rather than cledroaic funds transfer (which might provide same day funds). Since finality of settlemait (tbe time at which a 6aaacia1 transac:tion becomes irrevocable) is thus delayed OD the payment side, this settlement cannot be said to offer true delivery versus payment (simultaaeom settlemait of tbe dcliwry and payment obligations of a trade). T +4: Update for C1eariag Members On the morning of the fourth day following the trade ~uniing that the trade has settled the JSCC provides the couaterparties with statements reflecting the settlement debit or aedit of their clearing member share accounts at JSCC. The payment streams arc separate for 1) the cash market for equities and bonds and 2) the cash market for the block trading of government bonds. In each stream, the payment obligation for settlement is netted into a single figure. The settlement for various futures contracts also occurs in separate streams. In addition to its head office at the Tokyo Stock Evbange JSCC has satellite offices at the 7 regional en:baages. These branch offices a5.UU in the physical delivery of securities which may be in the custody of TSE members in remote locations. Most TSE transactions, however, do not involve the physical delivery of actual paper securities certificates. Only 15 percent of all TSE transactions involve trades in which both the buyer and the seller request that the actual securities certificates be made a part of the settlement process. In 41 percent of TSE trades, both counterpartics requested that the transfer of title be handled through JSCC's book entry system. The result, as we can sec in the following chart, is that book entry is used to satisfy the securities delivery obligation of about four fifths of all transactions at the TSE: 13 the seller delivers: physical shares shares via book-entry Total the buyer receives: physical shares 15.3% 25.2% 40.5% account acdit 18.3% 41.2% 59.5% Total 33a. 66.49; 100.0% 13 Por more 011 tbil subject, plcuc refer to the expert paper by Toahitaugu Shimizu. submitted for this study. Page 117
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Study of llltcrnatioaal Cearing ad Scttlemeat 1he Cearing IDd Settlement PIOCCII Noltbalt Alia / Alllbalia JSCC's Interface witb Depoeltories (Sum1DB'1 ol Expert Papen by Nomura Secaridel; Mua,-bl Hamav ud Toshitsugu Shimizu; aad pordoaa ol the IBM Report submitted for tlala Study) Oftnlew JSCC clears and settles all equities trades on the TSE both those involving domestic securities and those molviag foreign securities. Currently, this clearing and settlement process is done without a central depository. Thissitualion is about to cbanp ill respect to tbe proce,singof trades of domestic stocks. The financial services industry and the various gownment ,gcnries wich regulate the industry have agreed to set up a central depository to improve the depository and custodial clements of JSCC's clearing and settlement process. The new depository will be called the Japan Securities Depository Center (JASDEC). All the details of the new depository's operation have not yet been worked out. But the plan is for JASDEC to establish a relationship with the JSCC which would be similar to that between the National Securities Clearing Corporation (NSCC) and the Depository Trust Company (DTC) in the U .s.14 As of this writing, it was still undecided what the division of labor will be between the JSCC and JASDEC, once JASDEC is on line. That is, it's not certain which organization will perform which functions of the book entry and custodian prOCCSL It has been determined that there will be no duplication of effort between the two institutions. There bas also been disc:wwon of ways to streamline the custodial and depository aspects of the clearing and settlement process for foreign stocks. JSCC's recommendation, in this case, is to increase the number of linkages that it has with clearing houses and depositories in foreign countries. Depositories aad tbe Processing or Domestic Securities Currently, JSCC's Book Entry Clearing System (established in July 1971) transfers domestic stocks dirccdy between accoUDts, instead of requiring physical delivery of share.,. JSCC has a major shortcoming. however, in that share transfers arc carried out on the basis of a contrad between JSCC and its participants, as opposed to being on the basis of law. Therefore, JSCC must return the deposited share certificates to the shareholders at the close of each accounting period of the issuing companies to reflect changes in ownership, or any time a shareholder exercises rights. The law (Law Concerning Central Dtposito,y and Boolc-Ent,y Dtliveriu for Share Certificates and Other Suritia) which authorized the creation of JASDEC was paMCd in May, 1984. Development work onJASDEC began in December of 1984; the target date for implementation is Odober, 1991. JASDEC's Central Securities Depository System will stteamline the safekeeping and delivery of share certificates and other securities by immobilizing physical certificates, providing for book entry share 14 Por more 011 the NSCC and the OTC, pleac refer to Sectioa 2.1 Cwr;ng a,Jd Sffllemetu in Non/I Amm&a which specifically dilcula tbe opcntioal of each orpnmtioa. Pql118
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Study of International Clearing and Settlement The Ccaring and Settlement Process Nonbcue Alia / Australia transfer facilities, and tracking real ownersbip.15 The securities which will be eligible for processing throup tbc Central Securidea Depoaitory Syucm arc listed share certificates, OTC share certificates of the Japan Securities Dealers .Assoriarioa, aad warrants listed on a stock excbanv,. Participants in the central.depository will be required to obtain written permmion from their clients in order to deposit (that is, immobilim) share ccrtilicatca in the depository. The participants are responsible for opening deposit accounts for the client and for keeping the books on those accounts. Share certificates held in the central depository are transferred to the name of the central depository and are kept in joint custody. Depository participants and their customers may request account to account delivery of share ccrtificatea. Thia will be performed through book-entry. Every Japanese excbaage 111d clearing bow will open a share account at JASDEC. Deliveries of over-the-counter sec:mities will also be done by JASDEC, by means of book entry transfer of title. Depoeitoriea and tbe Proca1iq of Foreip Securities (Suwnw'7 of Expen Paper Submitted by Noaaun Secaritles) The TSE c:urrently lists 112 foreign stocks. JSCC advocates building and maintaining custodian relationships in the country where the security was issued. Clearing and settlement communications can then be handled through buines.1 linkages between depositories and clearing houses. Both the TSE and the JSCC fccl that there are significant advantages to the linkage approach, because the efficiency of the equity clearing system is based upon the ability of investors to present physical share certificates, or an authorized substitute thereof ( such as book entry shares) to fulfill the securities delivery obligation on the settlement date (T + 3). It is difficult for a non-resident seller to produce the physical ccrtiticates to JSCC when they arc stored outside Japan (in a custodian account, foreign depository, or elsewhere). Because of geographical distance, the settlement of transactions on behalf of non-resident clients is usually complicated, compared to the settlement of transactions for domestic clients. In settling transactions for r orcign clients -information must pass through a series of intermediaries and this often results in delays in the physical delivery of securities certificates. This situation represents a risk for the TSE-member broker, because he is obligated to settle on T+3, even though he still may not ha"' received the shares from his clienL Securities arc cleared through JSCC's book entry system. The actual securities that is, if they exist and have not been dematerialized in a depository are held in a custody account on behalf of JSCC in the home country of the security. JSCC has linkages r or this purpose with Australia, Canada, the Netherlands, Germany, Spain, Sweden, Swiaerlaod, the United Kingdom, and the United States. U.S. securities comprise 70 percent of the volume of all foreign securities traded on the TSE. Because of this large volume, the TSE has a special arrangement with the International Securities Clearing Corporation (ISCC) in the U.S. Through this linkage, all U.S. shares traded in Japan are kept on deposit at the Depository Trust Company (OTC) in New York City. 15 In tbil way, tbe SC1'Yicca provided at JASDEC will be similar to th01e provided by the TAURUS (Transfer and Automated Regiaradoa of Uncertified Stock) book entry computer system used by the International Stock Exchange in Loadoa. Pap 119
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Study of latematioaal Cearina ad Settlement Tbe Ceuiaa aad Settlement Procal Noltbalt Alia/ Auatratia In the same way, JSCC acts as a custorfiao for Japaoc.1C securities which are being traded on exchanges outside Japan. Currently, JSCC pnJYidea this service to the Nominee Amsterdam Stock Pxcbange in the Netherlands and to SICOV AM in Prance. JSCC is also dicn1mng with ISCC the pos&bility of acting as a depository for Japanese stocks being traded on U.S. excbanges to simplify the clearing and settlement process for those croa-aariooal border trades. THE OSAKA SECUlllTla EXCHANGE (Summer, of tbe Ezpert Paper bJ llaJlae Yolldoka cl pordw of tbe IBM Report submitted for tlaia Slady) The Osaka Securities Pxcbaogc (OSE) baa 94 cn:baagc members, 70 of which maintain offices in Osaka. The other 24 arc out-of-town members. There arc an additional four non-members who are special participants, admitted to the OSE in order to trade in futures contracts. The Cleariag aad SeUJemmt Process ror tbe Osaka Securities Excbaaae (OSE) The OSE 111aintainc its own clearing house department. As is the case al the TSE, all members of the OSE are also clearing members. Unlike the TSE, the transfer of shares from trades on the OSE is always done through the physical delivery of securities certificates. As at the TSE, trades arc settled in one of four ways (i.e., Regular Way, Cash Transactions, Special Agreement, When Issued). Again, as at the TSE, mmt transactions arc settled by means of the Regular Way. The settlement procedures and time frames arc as follows: T +0: Trade, Trade Comparison Trades on the OSE arc initiated on the floor with hand signals Trade slips arc read by an OCR reader, and the data is entered into the computer system al the OSE. The trade data is then made available to the counterparties through terminals on the floor of the evbange. The OSE c.vbaage computers generate printouts at the end of the day. T +0, T + 1: Error Correction Members submit cbaage, to the floor broker, on paper, which is again read by the OCR reader and entered into the excbanv computer system. On the day after the trade, the cxcbaoge computer sends the clearing department a computer tape record of all trades entered into on the previou day. This list already reflects any corrections that may have been made by the counterparties after their initial review of the trade data. Based on the computer tape record from the excbangr.., the clearing house then nets the traasactioas. For each clearing member, the clearing department calculates a net figure, for each security traded, that reflcds the total number of shares which are being sold and the total number of shares which arc being purcbased. The payment obligations of settlement arc also netted (amounts owed are reduced by amounts due to the clearing member). T + 2: Notification of Settlement Obligations On the second day after the trade, clearing members receive hard-copy notification, from the clearing department, of their net payment or securities obligations for settlement. T + 3: Settlement Settlement is done manually, through the physical delivery of securities certificates and checks.
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Study of International Oeariag and Settlement 11L Ccaring and Settlcmcnt Process Nortbcul Asia / Australia The OSE plans to introduce computerized trading for equities sometime in 1990. TIie lllterface Betweea tbe Osaka SermideP Evbe'I Cearma Department aad Depositories M previouly mentioned, tbe OSE uti1i7.cs physical deli\U)' cxclusiwly. The OSE's clearing department has aewr needed to provide a book-entry facility for delivery similar to that which JSCC pnwides the TSE, because en:bange volume baa not warranted it. However, companies listed on the OSE do use JSCC for book-entry of subsc:ripbon rights, aa do those companies listed on the TSE and oa the Nagoya Stock &c:bange. Tbe OSE is planning to make use of tbcJASDEC depository and custodial capabilities, when JASDEC is implemented (target date: October, 1991). At the same time, however, the OSE plans to retain its OWll clearing department. The laterface wltll tlw Banking System, la the Clearing of Equities Traaw:tioas for boda die TSE ud tbe OSE (SPwme117 of tbe Espert Paper submitted by Masayosbl HaPMna and Toshitsugu Shimizu). Japan at this time does not offer delivctf versus payment service on the settlement date. This is because payment on settlement day is m:.tde through checks which do not clear until the next day. This poses a risk for the seller, since there is always the possibility that a check may not clear the next day. The en:banges approve which banks arc clearing banks (TSE h.1S .i..; clearing banks, OSE has dcsignat.--d 8 city banks), and the members must maintain an accouuL with those banks. Clearing members do not give their banks third-party debit authority a blanket ( as opposed to case by case) authori7.ation to debit a clearing member's account at the instruction of the clearing house (instead of the clearing member) to honor the clearing member's financial obligations. The cm:banges receive payments from members and deposits the checks into a TSE bank account at one of the apprmed banks. Th" excbanp collects all monies owed to it for that day, for each instrument type, before disbursing money to members who are net sellers from the same bank account. The excbanges maintain accounts at each of the clearing banks, although only one is used at any one time. The cscbaogcs rotate which of the clearing banks they use according to a defined schedule (i.e. the OSE rotates~ 10 days). Each year, both the TSE and the OSE review the payment limits they have set for each of their members limits within which the member may present uncertified checks as payment for settlement obligations. Certified checks are required for sums exceeding these limits.16 Same day funds transfer would alleviate the risk introduced to the system by the use of checks. This is important not only for payments between the ~'tcbange members and the TSE, but also for source funding from clients to the members. 16 Catified dleca ia Japan are similar to thme ia the United Stares. l_n tbe U.S.. tbc bank mam the cuaomer's check certified.and ;i ia tha1 same dlect whidl is presented for paymenL By contrut. ia Japan. the bank kecp1 the CU1101Del1 achllJ cbcct aad writes its own dleck. wbidl it giws to the cusiomer. The cuscomer then presents the bank's dlect to tbe pcnoa or company to whom he owa tbe money. Pap 121
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Study of lntcrnatiomd Carias 111d Settlement The Carias IDcl Settlement Proc.'CII Nortbeat Alia/ AUICnlia 2.3.4.3 CLEARING AND SETl'LEMENT 01' BONDS Ovavlew (~ummf1 of Espert Coaartblldw submlf1ed by lwao Kuroda and Nomun Securities) Bond trading on the TSE is accomplisbed through floor trading. Settlement of small transactions is armmplisbed on T + 3; the settlement date for large block transactions is set by agreement between the buyer and tbc seller. Bonda traded OTC are settled citbcr directly through securities companies and imestors, or by banks which are licensed to deal in bonds. Convertible bonds traded on the TSE are basically cleared in the same manner as are stocks that is, tbrougb JSCC. Settlement Government bonds are cleared through the Bank of Japan. Payments are made cith~.
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Study ol lntcrnational Ccarin1 and Settlement Tbe Cearin1 and Settlement Process Nortbeaa Asia / Australia The Osaka Securities Exc:bange designed the OSFSO CODlract to closely parallel the Nikkci 225 Stock Awnge (which is the most widely known stock price inda: in Japan). Trading for both contracts has been computerized since October 1988. Whereas open positions in the Nikkci 225 Stock Average are settled in cash on the last trading day of the contract, open positions on the Jut trading day of the OSFSO contracts arc settled by physical delivery of shares of the SO underlying stocks. Both types of futures contracts have a life of 15 months. 'l1le C1eariJ11 House Process The Osaka Securities Exc:bange's clearing department requires both the buyer and the seller of an OSFSO or Nikkci 225 futures contract to deposit as initial margin a minimum of 9% of the sales/contract value (with a minimum of 6 million yen). One third of the initial margin payment must be paid in cash. After the first day of the contract, additional margin is owed depending upon price fluctuations in the market. The Osaka Securities Excbange marks to market ( evaluates the adjusted value of a market participants' holdinp and open positions) daily. Additional margin is due when a loss due to market price ftuctuation exeeds three percent of the sales or total contract value. As for TOPIX futures contracts they are traded through the TSE's CORES-F system. TOPIX contracts are settled in the months of March, June, September and December, on the third business day foDowing the second Friday of the month. The margin requirements for buyers and sellers of TO PIX contracts arc similar to those at the OSE for OSFSO coatrac:ts. TOPIX buyers and sellers must pay an initial margin of either 9 percent of the value of the transaction, or, 6 million yen whichever is larger. Members must furthermore pay, at the bqpnning of each contract month, 6 percent or more of the price of the contract on the first trading day of that contract month. GmernmCDl bond futures arc settled on the 20th of March, June, September and December. Ban.ks and non-TSE member securities companies may use ( as special participants/ associate members) accounts at JSCC to clear Japanese Government futures contracts. The TSE and the Osaka Securities Excbange accept the following collateral to meet margin requirements for futures contract trading from their members: Cash Listed scc:uritics on any Japanese excbange, including stocks, corporate bonds, government bonds and convemblc bonds. Stocks registered with the Japan Securities Dealers ~on Beneficiary certificates of the securities investment trusts Bank-issued letters of aedit are not acc:cpted as collateral by either evbaage. In addition, the Osaka Securities E,-cbange maintains~ Settlement Fund and a Default Compensation Resene Fund System which cover participants against the default of other c1'cbaagr. members. These funds are in effect for the trading of all instruments on the Excbangr.., including futures contracts. The TSE also has a guarantee fund, which totals 5 billion yen. Page 123
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Study of latematioaal Cearill& ad Settlement Tbe Cearill& and Setdcmcnt Procal Nortbealt Alia / Alllb'lllia The OSE is investigating participating in GLOBEX, the automated after-hours futures and options trading system which is currcndy under dadopment by Reuters and the Chicago Mercantile Evbange. Fumns Coatncts: Tbe laterface ..... tbe CJeariaa Boues aad tbe Bankio1 System As discussed in the equities section, the TSE has separate streams (separate clearing and settlement processes) for different types of financial instruments. Thia ia also true of the clearing and settlement processes for the different types of futures contracts. For future.,, the settlement streams are as follows: G~cnt Bond Futures (Margin and Mark-to-market) Government Bond Futures (Settlement of Contracts) TOPIX Futures (Margin, Mark-to-market, Settlement of Contracts) Payments are due from clearing members for the netted position of each type of futures contrad. 2.3.4.5 CLEARING AND SETJU:MENT OF omONS CONTRACTS The trading of options contracts began in Japan in June, 1989, at the Osaka Stock Excbangr.. The OSE is trading options contracts based on the ~tkkei 225 index. The trading of options contracts will become computem.cd in the fall of 1989. .. Clearing and settlement of options contracts is handled by the OSE's clearing department. 2.3.4.6 CLEARING AND SETILEMENT OF MONEY MARKET SECURITIES (Summary of coatributloa to this study from lwao Kuroda) There is neither a central depository, nor a formal arrangement for clearing other money market instruments (for instance, certificates of deposit, promissory notes, etc.) in Japan. Settlement of trades of money market securities is usually done through electronic funds transfer, specifically through BOJ-Net. 2.3.4.7 Given the level of interest that Japanese securities firms have in investing in U.S. markets, and the interest of U.S. securities firms investing in the J apanesc markets, it is worthwhile to discuss briefly here some of the differences the investor abroad experiences when trading in the domestic markets in each of the two coUDtrics. There has been an increase in the level of foreign investment in the J apancse markets in recent years. Foreign investors are rcstrided from purcbasing shares of companies belonging to several industry groups, including communications, broadcacting and transportation. Foreign investors cannot purchase equities on margin in Japan, except for the.purpose of hedge-selling, and then only in certain cirrnmstances.18 There are no restrictions against foreign investors in the futures markets. 11 Por more on this subject. please refer to page 14 oC die Nomura Securities expen paper submitted ror our snady.
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Study of International Ccarin1 and Settlement 'Ihe Caring and Sctdemcnt PtoeeSI Nonbeac Alia / Australia Comersely, Japanese investors in the U.S. markets are required to submit a number of documents wbich are different from those required in Japan. Many Japanese investors feel that the U.S. should adopt more ftcxible rules in this area and allow Japanr.sc investon to substitute alternative documents for tbc papers now required by the U.S. ruJe-makiag bodies. Pap12.S
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.. STUDY OF INTERNATIONAL CLEARING AND SETTLEMENT 3. RISK FACTORS IN THE CLEARING AND SETTLEMENT PROCESS Page 127
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TABLE OF CONTENTS Sectfog 3 Rist PICIOII in tbe Ceuial and Scttlcment Procea 3.1 ErrorRilk 3.2 Pailura in tbe Settlement PIOCal (Bodi in Ra:eipc and Delivery) 3.3 RilkAllociated widl Ponrip En:twap 3.4 The Rist tbla a CoaterputJ ill a Trade Mipt Dedue Ban.lauptcy Before the Settlement Date. or, Might Otberwile Default oa Paymeat or DetivaJ 3.4.1 HOIF Carias P.nlidea Pramct 1bemlelva fzam Defaults oa Trades (and Ccariag Mcmben) 3.4.2 Default oa Trades Not PM c 11 e II bJ Cearins Houw, and Trades in UarepJatcd Markell 3.4.3 The Kilt to Individual lavatorl Due to tbe Failure of a Brotenge P'um in the Equities Markets l.4.4 Cearins Bntitia Abroad and tbe Bzceat to Wbicb They Offer Protection ApiDst Default 3.5 Tbe Rilt of Ceuina Bnlity CoUapa 3.6 Rim Aaociated witb tbe 8111mg 5,-m 3.6.1 Rillm Aaociated widl tbe Pail1m: of a Bank 3.6.2 Rillm Aaociated widl Paymeata S,.em: Delays and Diffcrenca in finality of Settlement 3.6.3 Rila Allociated witll tbe Credit Procea W Rillm Alloci1ted widl latanadoaal BaaJdnr, and Other laua 17 TN Kilb of tbe Pailme of Collatcnl 3.8 Rim Alloci1ted witb mere sccl Trading Volume Carias HOUIII and otbcr Carias Entities Depositoriea and 8anlrl 3.9 Rim Allocilted witb Trulfer Agents 3.10 Risa Alloci1tec111fttb Technology and Computer Security 3.11 Diffcrew in Ccariag and Sculemeat Pnaica: Wortclwidc Variations Between Markets 3.12 Availlbility ud R&lilbility of llllormatioa la lntcmatioaai and Domeaic Trading 3.13 Rilb Alloci1ted 11fttb Tu Withbolding and Tu Rcdamalioa 3.14 RilbAlloci1ted 'itb Global CUIIDdiam 127 129 130 130 135 136 139 139 142 143 14S 14S 146 150 1S2 154 158 158 160 161 163 167 1'70 172 174
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3 RISK FACTORS IN TIIE CLEARING AND SETl'LEMENT PROCESS 3.1 ERROR RISK Study of International Oearing and Settlement Rist Factors Studies of processing mdustries, such as clearing and settlement, usually focus on the procedural nature of the business and therefore conclude that "human" and computer" error are the greatest potential sources of risk. In theory, dac two aspects of all operations always provide the opportunity for error of any dimension. A great deal of what has been written in the academic and trade journals about clearing and settlement has focmed on the potentially damaging resu1rs of such human and technological failure. We believe the best source for assessing risk, and its actnaliurii,n, is the market participants, who would have to bear the brunt of any error-based failure. The responses to our survey of market participantsl do not support the popularly held belief that error-related problems are the greatest source of ri$k in clearing and settlemenL 10 percent of the respondents to our suney cited human error as a risk in their domestic clearing systems; 10 percent said that computer problems pose a risk to their domestic clearing systems. Narrowing our focus to the responses of market participants trading in more than i country -less than 8 percent said that technology or human error was one of the 3 most important risks in either their domestic clearing or domestic settlement systems. This may be compared to the fact that 20% of the respondents cited that the possibility that a counterparty to a trade might not pay for or deliver securities is a risk in domestic clearing processes. 20% of the respondents also said the possibility that unmatched trades might not be resolved in a timely manner is a significant clearing risk in domestic markets. Similarly, when uked what their most significant problems are in clearing domestically, 7% of the respondents said human error, as compared to approximately 16% who said that unmatched trades not resolved in a timely manner arc a problem. In each question wbcrc we gaw respondents the opportunity to list their risks and problems in both domestic and international clearing and settlement, human error risk and computer error risk were cited half as much, or less, than were process and policy-oriented issues such as mismatched trades, foreign exchange risk, counterparty risk and the lack of infrastructure to support clearing and scttlemenL However, the very fact that human error and computer error were not the most often cited risks by the respondents to our survey in domestic or international markets, does not neccMarily mean that they are not important ~ues for discus.uon. While 10% of the respondents to our survey thought computer error was an important problem in their day-to-day clearing processes, the same percentage of respondents recommended inaeased automation of the clearingproccu, especially so as to include a greater variety of financial instruments. l TIie results of tbc 511rwy1 Banken Trua administered for this siudy are incJuded u Section 6 o( this synopsis. Page 129
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Study of llltematioaal Oearia1 and Settlement RilkPactom 3.2 FAILURES IN THE SETrLEMENT PRoas8 (BOTH IN RECEIPI' AND DELIVERY) This section encompaues both the risks in terms of failure to receive or deliver a cash instrument, and the failure to make or receive payment for a cash instrument. On the securities side of the proccu, we have included the following risk groups ( as identified by our survey participants): refusing delivery of securities on the grounds that they lack good papers; delays in delivery; mismatches between trades and physical dcJivery;outright failures to honor trades; possession and control issues related to the absence of a depository in a given market; and incorrect custodian action. On the payment side of the proceu, our suney participants identified the following risks: delays between the authorization of payment and the actual transmittal; alack of standards for the turnaround of payment on delivered certificates; central banks dosing before payment could be effeded; credit and outright failure to perform financially; foreiglt excbanv (F /X) fluctuations; and risks in the bank money transfer prOCCSL The following chart summarizes our survey results on how market participants view these risks. This analysis was done by evmining :ul of the responses to the survey, and breaking down the answers according to the type of firm which was surveyed. ,&of %of %0( Rapoadcata R,:spondenu Respondents "' %of Identifying Identifying Identifying R,:spondenta Rapoadcnta Ri&kol Counterpany Counccrpany Identifying Rilk of ldentifyin1 Couacerpany Default on Default on Couaterpu!J Couacerpany Defawt on Payment Payment Defaultoa Default on Securities u an uan (Including F /X) Securities Payment a a lntematiorw lnrcmationa! uan TYPl!OPPIRM Domeaic Domatic Problem Problem International Problem Problem Problem F'1111111doin1 6% 10% 3% 9% 10% blllinal oaJy ill oae couaay F'111111 doiq 109& 17'o 6% 15% 17% bllliDalillmore thaa ODe COUDb'J All surver 7" 13,r, 4% 11% 12% n:spoadcata Reviewing the preceding chart, the most obvious conclusion is that multinational firms are more likely to perceive a counterparty risk in the settlement of securities, or payment thereof, as a risk. 3.3 RISK ASSOCIATED WITH FOREIGN EXCHANGE (Summary of Expert Paper Submitted for tbJs Study by James Chamberlain) Foreip excbanv (the trading of one currency for another) is an unregulated market. While typically the province of the banks and firms which are large enough to support their own foreign exchange (F /X) operations units, foreign excbangc is essential for anyone conducting business on an Pap: 130
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Study of International Cearing and Settlement Risk Factors intcrnatioaa1 scale. To understand the issues which foreign excbange interjects into the clearing and settJement process for equities, futures and options, the reader must first become familiar with the operations and procedures of the F /X markcta. As James Chamberlain observes in ma espert paper submitted for this study, there arc no reliable statistics on the met current volume of foreip e:rcbaap activity worldwide. He goes on to say that: "tlul 11ffd to hedg, cummcy risJ; pbu ban/a' saong emphasis on 0/f-balanc.1 shelf income Juwe contribuwl to an ~, fom,a ext:lumge market. Sophisticated communicationl systems and atmsiw /amt,, ext:lumge broker activity have permitted a ,owing~ of institution.s to obtain worldwi"'1 aaas which, in tum, has acc,Jerated 1M developmsat of IIIOUnd-lM-dot:k tnu.ling l'IUldrm in a 1Ull1UH!r of currencies." According to Chamberlain: "Rent new, agou:y estimata put the global daily fomgn at:hange turnover at between $350 billion (U.S.) and $400 billion (U.S.) wilh London, New York, and Tokyo {being the primary trading} COiien. TM most actively t1'tlMd curm,ciu are: the United Stales dollar, the lapanae yen, the British pound, and the We.st Gamon mark. A second, less actively t1rlMd, tier of cunou:ia consists of: the Swiss franc, the Canadian dollar, the Italian lira, the Dutch guiJdlrr, Frent:h franc, the Spanish peseta, and the European Cwmu:y Unit "2 There are no central clearing entities serving the international or the domestic interbank markets for foreignexcbangr.. Chamberlain notes that the market players in F /X, besides ban.ks, include non-bank 6aaacia1 institutions and multinational corporations. Foreign excbaaF contracts may be settled in one market, at the agreement of the counterparties. Or, they may be settled dually in each of the home markets of each of the currencies which are being traded, when settlement is dual it does not necessarily have to be simultaneous. As for the settlement proccs., itsc~ Chamberlain gives this breakdown: "Grou paymmt instnu:tions are communicaud among participants and agent banks using variou.r systmu such a.r SWIFT, telex, inlanal communications, and other vthkles. Sdlenuma tn jinaJiud through the central bank or other payment systems in each country of origin, pursuant to spialiud a,eemenu bdween tmdingpaltia. Suda systems are not uniform in operation; they range from eltronic funds transfer systems sud& as the U.S. FedWw, providing immedial4 jinaJity of paynumt, to payment systems still based on OW!fflight processing of paper docummts and batch-mode accounting, and systems which by local law delay finality of payment until a spified later timL" F /X, as an instrument, can be bought as a spot transaction (typically, with a 2 day settlement period) or as a forward transaction (that is, buying currency at a negotiated fixed rate for delivery sometime in the future). It is very difficult, however, to price forward conttacts beyond one year in the future. The risk in F /X spot transactions is that a couaterparty might fail to deliver the currency of his side of the transaction at the stated place and time. A default of this type places the non-defaulting countcrparty at risk in two ways. F'U'St, he may have already paid out the funds to his counterparty which he must now rccover.3 Furthermore, the funds arc not available to finance an F /X trade with another seller of the desired currency. 2 The European Currency Unit (ECU) ii a nnancial illltnament which repn:senrs a i,utcec of 12 European currencies. 3 Thia ii known as a ioa problem. Page 131
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Secondly, even if the non-defaulting counterparty still has the funds that were to finance the purchase he does not haw the foreign currency the deal was to provide. 4 This could pose a problem if, for instance, the foreign currency was to finance a time scnsit:M, b11sines.1 transaction. The risks in F /X forwards are more complicated. At settlement date minus two, they become spot transactioas-with the associated risks of spot transacdoas. The longer the intervening period between the origination of the contract and the day on which it becomes a spot transaction, the greater the potential replacement cost of the contract in the event of a counterparty failure. Since this is an unregulated auction-type market, an F /X contract is obtained by contacting a number of major providers of the service, obtaining prices, and then cxec:nring the trade at the best offer. Rates on F /X contracts vary by the amount of money that is moved: smaller amounts incur higher rate.,. Not all currencies in the world haw liquid markets: that is, some currencies will be hard to get no matter what the rate. For a still smaller group of currencies, national regulations prohibit the transfer of funds and prohibit all F /X trading (South Africa is a good example of this situation). Special care must be given to the time of day after which a given currency cannot be obtained in a spot transaction. For major currencies, in most time zones, these currency trading deadlines are often in the morning. Any player in the international markets who wishes to trade ( and settle) outside his home country must either contract through a local broker in the market he seeks to access, or, open up a branch office in the local market himself. In either case, replcuishm~nt of funds in those targeted markets, or redemption of profits, is done through F fX. T'unely replenishment of F /X becomes a problem when dealing in the derivative markets, for example, where margin requirements must be met daily -sometimes intra-day. The responses we received as a part of our survey results indicate that among fum.s which do business internationally, 25% cited F /X as a major risk factor in the settlement of trades. Among those firms which do busincs.1 only in their domestic markets -13% of respondents cited F /X as a major risk factor. The nature and extent of risk in F /X is currently the subject of extensive discussion and analysis. Various arrangements designed to reduce risk have either been inttoduced or arc under industry and regulatory consideration. Generally speaking, there are two major developments in the F /X markets which are intended to reduce risk. They arc: a) the inttoduction of netting; and b) efforts to set up F /X clearing houses which would take the counterparty position in trades and thus offer the counterparties a guarantee of each counterparty's settlement obligations. "Netting, in F /X. refers to the practice of reducing the overall flow of cash and the total number of cam payment obligations without c:uttiag down on the amount of trading. Periodically either at the end of a trading session or trade by trade, depending upon the particular arrangements -the participant's currency obligations relative to all netting participants, plus and minus, arc balanced out. The participant then owes ( or is owed) only a single amount per currency, no matter how many trades he may have made in that particular currency for that settlement date with any counterparty. This type of P /X netting is known as multilateral. Netting can also be "bilateral:" that is, the practice of balancing out the payment and delivery obligations of two counterpartics. 4 Thia is known u a uquidity' problem.
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Study of International Ccaria& and Settlement Rist factors Netting. whether multilateral or bilateral. can be achic'Ved through a number of methods, including what is known as netting through DOYatioa. "NOYatioa refers to the practice of creating a new contract to rctlcc:t the obligations of one or more old contracts, with the new contract replacing the previous contract( s). A ncwated contract may haw: been drawn up in order to substitute one counterparty for another for example, a clearing house taking the counterparty position to a trade would be substituted for the original buyer in a novatcd contract with the seller. Another type of novated contract doea not imohe a clearing house: a contract between two counterparties substituting for a series of old coatracta-tbe new contract being strictly for the purpose of Ddring 'lut the obligations of cadl counterparty, O\a' a series of trades between the two parties. Bilatcral netting is now offered by FXNET, through a group of London-based banks, and by Intemadonal Clearing Systems. Inc. (ICSI), which is a subsidiary of the Options Clearing Corporation (OCC), in Chicago. ICSI also offers multilateral netting. ICSI was established in 1987 to design, develop, and operate clearing services for the foreign exchange markets. ICSI has fulfilled this mandate in that it bas developed a clearing house model for F /X and, in the U.S., an F /X clearing house is now in the development stages in consultation with ICSI. ICSI furthermore w developed systems for F /X clearing: systems for trade confirmation, risk management, and ( as previously stated) both bilateral and multilateral netting. In respect to netting, a recent study by the Bank for International Settlement (BIS) of netting and its associated risks is the best reference on the subject currendy available. Netting will clearly reduce the number of payments, the actual movement of funds. and in doing so, it will reduce payment system risk. But the netting proc:esa, depending upon how it is done, may impose other new, as yet unknown, risb: &om a legal and a procedural point of view. In terms of risk, there are two basic wucs which are under discussion in the F /X markets in respect to netting. The first is whether a netting agrcem~nt would be enforceable in the event of a bankruptcy proceeding involving a defaulting countcrparty of an F /X contract. The second is whether the termination and closeout provisions of a netting agreement would be subject to a stay or other interference in the event of a counterparty bankruptcy. It is true that some netting agreements can be structured in ways that invite legal challenge.5 But it is ju.,t as true that netting arrangements can be structured effectively, legally speaking. The legal requirements for contract formation in the Gaited States arc well understood. And, in respect to novation -the futures and options markets have used the principles of novation and third party substitution as central clements in their net contract formation processes for many years since 1891 in the case of futures clearing houses. There is some uncertainty about bow a novated foreign e.vbangr. contract would be affected in the event of a counterparty bankruptcy. How well would the novated contract hold up in cowt in a liquidation or bankruptcy proceeding? 5 For example, in the cue of British Eagle Airlioca venua Compagnie Nationalc Air France. the Engtish House of Lords ruled that only tbCIC net obliptionl (for inter-airline ticket paymcnt1) wtlidl had been nOYated were to be honored. Page 133
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Study ol latcmaaoaal Cariq ad Settlement RiltPICIDII Thia uncertainty is rooted in several factors: a) the fact that the defaulting counterparty could be a bank, and laws governing bank liquidations arc antiquated, compared to the bankruptcy code which governs non-bank liquidations; b) there is a relative lack of legal precedent in respect to bank liquidations; and c) the Federal Deposit Insuranc:c Corporation's (FDIC) policies and practices are not made public. Further complicating the situation is the fact that bank liquidations are subject to state laws, which differ from state to state, aa well as the provisions of the national banking act. ICSI, however, believes that, for several tt.aSOm, clearing houses operating under the model which it bas designed would be able to handle in a reasonably predictable fashion a situation in which a bank failure affected a novatcd F /X contract. ICSI points out that the clearing house would be the counterparty in all novatcd contracts, and the clearing house would be treated as a secured aeditor ( entitled to preferential treatment, compared to other creditors) in the event of a liquidation by a bank which was a counterparty to a CODttad. As a secured aeditor, the clearing house also would have a lien on the collateral (government securities, cash, or contract rights) which would have been posted by the now failing bank. Its lien on contract rights would greatly enhance its ability to promptly close out contracts in the event of a default. ICSI cites two other factors which it says suggest that the novatcd contract that ICSI has developed would hold up in the event that a bank counterparty went into liquidation proccc~. ICSI points out that although in 1978 changes were made in the bankruptcy code limiting the rights of creditors in bankruptcy proceedings involving exccutory contracts, 6 no such changes were made in the laws which relate to bank liquidations. Therefore, a clearing house operating under the model designed by IC:SI would be in a better position to exercise its right to terminate or close out the contracts of the failing bank countcrparty. The other factor cited by ICSI as one which suggests that a novatcd contract would hold up in the event of a default is a legal opinion from the legal staff of the FD IC. The legal staff of the FDIC, in an interpretive letter, states that they consider it unlikely that a court would uphold any effort by the FDIC to delay or prevent the liquidation of the collateral (which in this case includes the contract rights of the failing bank) posted by the now defaulting bank. It is interesting to note the degree to which financial services firms who arc exposed to F /X risk are well-informed when it comes to understanding the potential impad of netting. To determine this, we asked a question in our survey about whether or not F /X netting will inaeasc, deacase, or keep constant the risk levels in F fX. We deliberately posed this question towards the end of the survey, far removed from the earlier questions about the risks of settlement. 12% of the multinational firms which had previously identified F /X as a settlement risk answered this new question by saying that they believe netting will either inacase or deaeasc F /X risks. Among the domestic firms who identified F /X as a settlement risk, 2% said that netting is likely to change the nature of F /X risk. This would seem to indicate that financial services firms need to become more aware of developments in netting as exemplified by the Bank for International Settlements study. Aa encutory coatl'ICt ii any contract which requires funber puugc of time and additionaJ c:wnts in order to be fulfilled. Page 134
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3.4 THE RISK THAT A COUNTERPARTY IN A TRADE MIGHT DECLARE BANDUPrCY BEFORE THE SETl'LEMENT DATE, Shady ol Iotcrnational Carini and Settlement Kilt Factors OR, MIGHT OTHERWISE DEFAULT ON PAYMENT OR DELIVERY There are three basic levels of coumerparty risk. One occurs when the defaulting countcrparty is a clearing member; another occurs when the defaulting counterparty is a non-clearing member a Fully-Disclosed Broker (FOB) or Futures Commwioa Merchant (FCM); and finally, when the defaulting counterparty is an individual customer of a broker. The following analysis does not distinguish between the three l~ls of counterparty default riH, although in most cases our discussion does focus OD the risk of default by clearing members. In counterparty default, there are further ramifications other than the immediate effects of a default OD the settlement of an individual trade. There is tbe compounded risk that the defaulting party outside of the now-failed trade might :.-., a portfolio of heavily margined equities holdings. As a result, the clearing member or bank which extended the margin aedit to the now-defaulted customer or brokerage firm could wind up with a bad loan OD its books never to be repaid. What about the bankruptcy laws? What happens when a counterparty files for bankruptcy after the time he agreed OD an equities trade but BEFORE that trade was settled? In the U.S., the laws known as the Uniform Commercial Code (UCC) protect the ownership interests of counterparties to securities transactions by giving a broker a lcgai claim to a trade before it actually settles. The provisions of the UCC, however, vary from state to state and according to other factors. Marc Simons and Keith Fulmer, in their expert paper fort.bis study, comment on bankruptcy laws as viewed through the experience of the global custodian (banks representing their customers in a variety of foreign markets): "Within an intunational contat, tM applicabilily of tM UCC will lUpend on the location of tM pa,tia and tM surities, the place where tM transaction occurs, and the parties choice of law (UCC-105)." They continue: "FUltluJnnore, und6 rquJations proposed by tM United Stata Department of Treasury, the ri,m of pa,tia in U.S. government transactions would be detmnined under f ede.'UJ law rrllha' than the UCC and w~ securitiu tn handled through an account with a non-U.S. custodian, tM laws of the custodian's jutisdiction would apply." When cli.vussing bankruptcy risks it is important to consider investor protection laws, which are de.1igned to protect individual investors in the event of a broker defaulL In many countries the investor's sole protection against a defaulting broker usually lies with the local bankruptcy laws.7 The importance of this topic is funher underscored by Coopers and Lybrand, in its recent study opporauuty and Risk in the Global 24-Hour Marketplace. Coopers and Lybrand conducted a survey of 45 commercial banks, investment bankers, brokerage firms, money management firms, and insurance companies. Asked to what extent investor protection laws cause distortions in competition in the worldwide financial marketplace, 20 percent of the survey respondents answered "to a great extent. 33 percent said somewhat; 38 percent said "very much," and only 2 percent said not at all." 7% said they were not sure whether investor protection laws arc a problem. 7 Some countries.~. sucb aa the U.~ Cmada. and tbe U.K.. do have contingency funds to protea investors agains, tbc effccu of a broker's bankrupccy. Page 13.S
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At this time, in the U.S., an American Bar ,4ssnciarion advisory committee is studying the UCC with au eye towards improving the protection it can provide for participants in the securities markets. Given the broad-based nature of our study, we will not prOYide here the in-depth examination of internatioaal law wbicb the imator in intenwioaal markets might hope to see at this point in our di.-cmsioa. For our purposes, it suffices to say that there are significant ,:oacerns regardiag investors' rights in tbe ew:at of coualerparty default in a foreign market. Aad, at least in this country, efforts are underway to address the mues rmed by that situation. 3.4.1 BOWCLEARING ENTITIES PROTECTTIIEMSELVl:S FROM DEFAULTS ON TIW>ES (AND CLEARING MEMBERS) Many clearing houses, to protect thcmae1ves &om collapse in the event of default by clearing members, maintain dcaring house guarantee funds, wbic:h are primarily made up of mandatory contnbutions &om clearing members. A clearing house guarantee fund, in the U .S~ may include cash, letters of credit, and trcuury bills. In addition to guarantee funds many clearing houses have their own capital aad committed lines of credit. These clearing houses before turning to their guarantee funds to cover the liability of a default -could first use these capital funds and lines of aedit. Most clearing houses also have a further source of funds to tum to in the event of clearing member default: that is, the power to collect assem,:nts from other members of the clearing house. Roger Rutz, in the expert paper submitted for this study, found that most of the clearing houses he studied in the U.S. do have asseswent powers, which are also called murualizarion of risk." He says: "Through arluzngr or ckaring house ruJa and regulations, these assasment powers enable a clearing house to call [ ~) each ckaring mtmber for a s-pific "1n0Ullt of funds, based on Wl1U1IU fomwlas typicaJJy related to a ckaling menbers past trading volume and/or open positions, to cover the monetary loss to the ckating house resulting from a clearing rnembet'defauit." The following chart, which is based on data from the expert papers by Roger Rutz, Thomas Russo, Robert Woldow, aad William Briggs, provides an overview of 11 U.S. clearing houses aad the amount of capital, guarantee funds, aad lines of acdit available to each in the event of a default: Pap 136
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Study o( International Cearing and Settlement !Usk Factors 0ftmew ol U.S. CJearbaa Houes' Protectioa Apiast Default& Toal value of tbe c:leariq Docs tbc daring boulc have boule'I capital, panatce IDd aa mnt powers? (i.~ tnllt fuda, and liDa of cu tbcy require their credit. daring members to put up more money after a ( in Smillioaa ) default?) aarcc 184 No CME 200 Yea CCA .,, Yea9 CCC 25 Yea csccc 25 Yea ICC 8 Yea KCBOTCC 11 No MCC 11 Yea NSCC 3iO Yea NYMEX 98 YealO ace 194 Yea There is an economic trade-off between the cost of doing business in a given market (i.e., the size of a clearing member's required contnbution to a clearing house guarantee fund) and the question of whether the guarantee fund will be sufficient to cover a worst-case type of default. It would appear that the key to mitigating the economic trade-off and financial integrity of clearing houses is the prevention of clearing member default ( as opposed to wessments of clearing members after the fad). Clearing houses protect their own interests by working to anticipate and prevent default and by setting up an adequate guarantee fund. Unfortunately, it is virtually impowble to use historical data to predict future failures; so there is no sure way to absolutely determine what constitutes an "adequate" size for a clearing house guarantee fund. As for the derivative markets Rutz presents a convincing case that the risk management reporting systems of the derivative clearing houses are adequate to reasonably deted potential failures before they escalate to the point where there is an outright failure by a clearing member. Rutz makes a case that this is true for the clearing houses serving both the futures and options markets. I These statistics are for Pebnauy, 1989. The BOTCC, however, notes that its total has significantly increased since tben. Aa of tllil writing, S325 million ii the correct figure for the BOTCC. The CME and OCC aJso provide an updated figure: $376 million and $300 million. n:spectM:ty. 9 Information on CC\ messment powers wu obtained from SS 9.4(9)(iv) of Comex Oearing Association, courtesy of the crrc. 11 Information on NYMEX Aaeslmcnt pc:,wetS wu obtained from NYMEX rule 9.23(c), courtesy of the CFTC. Page 137
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Study of International Oearing ud Settlement Riltfacton The expert papers by Robert Woldow and William Brig, outline the situation for clearing houses serving the equities markets. Woldow notes that after the October 1987 market break, the seven SEC-registered clearing agencies entered into a formal contract to share internal information on clearing members with potential problems. Similar processes were also in place in the futures markets with the CME/BOTCC agreement as well as most futures clearing entities having signed up for the BOTCC Risk Information Sharing System prior to the October 1987 market break. As for internal early warning signals oa the risk of failure -Woldow notes that the National Securities Clearing Corporation produces a daily report tracking the holding., of clearing members. The report projects the continuous net settlement ( CNS) position for a three-day period in each CNS-eligible security which represents 10 percent or more of the member's total CNS positions.11 It also lists any clearing member position in which there is a price fluctuation of more than $15,000. And it includes a two-day price projection of the risk exposure of a clcariag member's open positions. The Stock Clearing Corporation of Philadelphia also monitors, from the day after the trade to the day of settlement, the status of clearing member holdinp. As noted by Brigg.,, the SCCP daily computes the variance (marks to market) between contract price and current market price. These daily recalculations allow the SCCP to clmcly monitor clearing members' positions. As noted in previous sections, margin requirements for futures and options as well as clearing house guarantee funds arc some of the defenses clearing houses in the derivative markets have in countering clearing member defaults. Equities clearing houses in the U.S. arc fairly standarda.ed in their methods of as.sessing risk and colltttiug payments and collateral from clearing members to defray that risk. In the futures markets, there is the pos.goility that the risk assessment algorithm SP AN (Standard for Portfolio Analysis of Risk, the successor to the CME's Dollars at Risk -DAR margining systcm)12 could be adopted by futures clearing houses as the industry standard. In the options markets, margin is calculated through the risk asscs,wcnt algorithm TIMS (Theoretical Intermarket Margin Systcm).13 There is some disagreement within the clearing industry on the comparative merits of the systems that are used by the equities and derivatives markets to detect the potential of clearing member failure before that failure actually occurs. However, since October 1987, clearing houses serving both markets have taken steps to firm up their detection procedures which have resulted in improvements and will continue to do so. The ultimate goal, of course, is to remove risk from the clearing and settlement process to the extent that a clearing house will never be forced to use its capital, guarantee fund (if indeed one exists) or lines of acdit. U For aa aplaaacioa of the Coati.nuoua Net ScttJcmcnt syaem at tbe National Securities Ccaring Corporation (NSCC), the reader ia refem:d to the section of our study CJearing and Settlmwnt ill Non/I Afflo'ica, and to the cxpen paper br Robert Woklow, included i.a mis study. 12 Eortfolio al!iafysia of risk (SP AN) performs two functions. Pint. it analyzes tbc ~tions (holdings) of a marut puticipa!lt ia order to detenninc the dcpe of risk which is present in thOIC posuions. Then, using that i.aformaiioa. SP AN sets or adjusts the margin payment which ia o.d by the market panicipant to the clearing house. 13 Plcue refer to Section 2.1.1.3 for a more complete discuuioa of this subject. Page 138
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Study of lntemacional Curing and Settlement Risk factors 3.4.2 DEFAULT ON TRAD~ Nor PR~ED BY CLEARING HOUSES, AND TRADES IN UNREGULATED MARKETS Risk is also present m trades which arc not processed by clearing houses. In the U.S., the trades which do not go through clearing houses arc either one of the unregulated markets or some trades in the ewer-the-counter market (OTC). Many OTC trades haudled by the National ~tion of Securities Dealers (NASO) are processed by the NSCC. But for those OTC trades which do not go through clearing houses, counterparty risk is directly absorbed by the trading partner. Trades arc effected and settled directly. Foreign Evbauge (F /X) is an unregulated market and as such, there is no requirement that a clearing entity be involved in trades. When an F /X transaction is handled without a clearing house, the risk of default is borne directly by the counterparties. The question of whether a clearing entity will be brought in on an OTC or F /X trade depends on the particular transaction and the needs of the counterparties. In foreign cxcbaugc, an exception to the rule of clearing houses generally not being involved in F /X trades would be a case in which F /X traders interpose a clearing house between themselves. This might be done for the purpose of netting out a day's trading obligations, through multilateral netting, bilateral netting or netting by novation.14 An example of this would be the F /X multilateral netting system proposed by the International Clearing Systems, Inc. (ICSI). In trades which do not involve clearing houses, it is common practice among trading firms to maintain position limits with countcrparties, which reduce potential counterparty risk. The adequacy of these procedures most probably varies from excellent to completely inadequate, but this is a subject which is beyond the scope of this study. In these markets, failure due to default or bankruptcy of a trading partner will be completely absorbed by the affected counterparty in the trade. 3.4.3 TIIE RISK TO INDMDUAL INVF.STORS DUE TO THE FAILURE OF A BROKERAGE FIRM IN THE EQUITIES MARKETS (Smnma!')' of Expert Papen by Theodore Focht and ':hades Mooney) If a U.S. brokerage firm itself fails, its customers arc protected, within limits, by the federal Securities Investors Protection Corporation (SIPC). If a brokerage firm files for bankruptcy AFTER an investor has paid for a security but BEFORE that security bas been delivered to the investor, the SIPC guarantees a refund to the investor. In the reverse situation in which an investor has turned over securities to the broker to be sold, but hasn't been paid yet the SIPC guarantees a refund of either the securities or a cash equivalent. (Both refund guarantees however, have limits imposed by SIPC.) The SIPC's guarantees apply only to 1~ suffered by customers of failing brokerage firms. The SIPC's guarantees do not apply to lossc., which might be suffered by clearing houses or the brokerage firms themselves (trading for their own house accounts). Theodore Focht, in his expert paper submitted for this study, provicb a history of the SIPC as well as a discussfon of how it works. According to Focht, prior to 1938 customers of brokerage firms filing for bankruptcy were treated as general acditors of the failing firm -a status which made it exceedingly unlikely that they would recover the full value of their holding.,. 14 for more on P /X netting. pleuc refer to Section 3.3 RisJa ~iated wilJI Fomgn E:#hange, in our summary. Page 139
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In 1939, Congress enacted Section fJOe of the Bankruptcy Act,15 which added specific language to guide the bankruptcy courts on the c:icumstaaces in which customers of brokerage firms would be allowed to reclaim their property (cash and securities certificates). While this was an improvement, it still did not prevent customer tosses.16 Therefore, when the rate of stockbroker failures rose in 1969 and 1970, Congress took action and approved the Securities Investor Protection Act.(SIPA), the law which created today's SIPC. Focht quotes &om a Senate report written at that time, one which stated that the mandate of SIPC would be: "to p,ott individual invuttn from finandal hardship; to~ IM economy from the di.rtuption whit:h can follow tM fllilluw of llllljor jinandal iArtitutions; and to achieve a gounlupgrodingoffinant:ialrapo,uibilityrequimnmaofbtOkenanadakn toeliminau, to t1w nummum atent pouibk, tJw ru1a wlaida wld to outonw 1oa. Focht gives us an understanding of SJPC: "SIPC is a non-profit membenhip co,poralion whose memben include most interstate b~. Membmhip in SIPC is lllllomatic upon registralion as a broker or dealer with tM Securities and E.xchangw Commission. .. [The Securities Investor Protection Act SIP A requires the] SIPC to establish a [guarantee) fund via assessments upon its members. If SIPC's funds should borM inadequate, SIPA au.lhorizl!S a borrowing against tM U.S. Treasu,y of up to OM billion dollan. These resources are available for the satisfacdon of tM claims of customn 1111d bro/ce-dealen .. Focht also goes into considerable detail in the way that the SIP A established procedures for the liquidation of financially troubled broker-dealers who arc members of SIPC. He notes: (liquidation] proceedingunder SIP A is a bankruptcy proceeding/or all practical purposes . 1n4 SIP A proceeding looks not only to the disposition of claims of customers, but aiso to clainu of bro~akn and general crediton." Focht goes on to say that there are, nonethel~ some fundamental differences between an ordinary bankruptcy proceeding and an SIP A liquidation: "Bllwe [the 'customer' status given investors by SIPAJ is a preferred status giving the cu.stome1' priority OW!r other creduon in the distribution of assets manhaikd by the [SIP A] trustee, the customvs burden of proof under SIPA diffm from that of ordinary general ~dilon in banlauptcy proceedin&J." He explains: "SIPA requires that a daJtor's [the failing brokerage firm) obligations to its customers be 'ascatainabk from the books and rteords of the debtor or 'otherwise established to the satisfaction of the trustee. 1 FurthermortJ, the satisfaction of a claim 'may be conditioned upon the trustee requiring claimanu to eucute, in a form to be detumined by the trustee, appropriate receipts, supporting affidavits, releases and assignments." LS Section 60e of the Ban.lauptcy Act wu ultimately repealed. in 1979. 16 Por complete details please refer to Theodore Pocht's expert paper induded in this study. Page 140
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Study of llm:mational Ocarina and Settlement Risk Factors There are, however, limits to the protectioaa that the SIPC offers customers of failing stock brokerage firms. Focht says that to satisfy net equity claima of customers, the SIPC is authoriu,d to advance to the trustee: "not nun than ~000 per cwtonc,; 11114 in no ftlent more than $100,000 for that portion of a dllim which is for cash. T1uu of tJw audl of tM ftlikd jinn, tads customer with a valid claim is amued of sod.rfoaion within tJw limitr indic.aud." What about broker-dcalcrs who were represented by tbe failing brokerage firm? Focht says "clo,eout Iossa ina,nwJ by broken dllalinr with tM debtor [failing brokerage firm] shouid be prolUd by tu1van&a from SIPC if and only if tM brolcer 1WU acting for one of its CIUtOmen and 1M tnlnSaCtion MIi 'wholly aa:utory' on tM [banlauptcy} filing dau. No SIPC funds can be used whae tM b"""1n Mn JIUICNISUII or sdling seauilia for their own benefit.,, The SIPC also provides protection for investors who are either lenders or borrowers in short-term loans of securities (loans often made for the purpose of satisfying the securities delivery portion of settlement obligations). A court order is uually mucd enjoining holders of such securities loan/borrow contracts from liquidating the contracts for a period of 21 days, without the written permission of both the SIPC and the tru.uce [representing the invcstorJ.17 What if the amount owed a customer by a failing broker exceeds the SIPC limits? Focht explains that t1u1 availability of SIPC's funds does not ltssen tM burden of customer's claims on the general all* or its general cretJiton. Focht notes that sIPC's funds do not insure customers against all loss in their suritia accounu. Since SIPC does not cover all the losses of a failed broker-dealer's customers there are cases in which c:mtomers have had to tum to the bankruptcy courts to recover whatever losses might be outstanding Bankruptcy proceedin&' rely OD article 8 of the Uniform Commercial Code (UCC). As is pointed out by Charles Mooney in the expert paper written for this study-the UCC laws were written in a time when investors tended to hold securities in their own pc)SSCS.Uon, in certificate form. In today's market, however, there is a growing tendency for securities to be held by third parties brokers, banks, or dcpositorie.s. The securities furthermore arc often held in a form known as fungib1cl8 bulk" meaning that records are kept OD the exad number of shares that an investor owns in a particular company but no particular individual share of stock is owned by any one investor. Mooney suggests that given the trend towards holding securities in fungible form -it is now appropriate to revamp article 8 of the UCC. He advocates modifying the laws in order to give investors more rights as a-editors, in the event that the securities they own become the subject of a bankruptcy proceeding. Please refer to Mooney's report, included elsewhere in our study, for a complete discussion of this subjec:t. 17 Pormorc detaill oa thil, aad other upccu of tbe SIPC, tbc reader is referred to FoclH's expert paper. which is included ia ias enlirety ellcwnere in this study. 11 9Puagibtc meam interchangeable, a good e:rample being cash. When you go to the bank and deposit three fifty dollar bills, and return the next week to make a Sl.SO witbdrawaJ. you do nor demand thac the exact same bills be returned to you ail you want ii the money, and one fifty dollar bill ii fully interchangeable with the next. Page 141
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Study of latematioaal Ocarina and SctdemCDt RilkPICIDIS 3.4.4 CLEARING ENTITIES ABROAD AND 'nlE EXTENT TO WHICH THEY OFFER PROTECrlON AGAINsr DEFAULT We will now examine the ment to which clearing entities in non-U.S. markets have guarantee funds which can be med in the event of a default. This was ome of the questions that our survey addressed.19 Outside the U.S., there is no umcrsal acceptance of the concept that a clearing entity should be able to provide some degree of protection from the effects of default. In most cases, clearing entities which do not provide such protection will unwind (that is, cancel) the trades of a failing member and in addition will haw a first lien on the member's excbangc seat. In analyzing the confidential responses to our survey we found no correlation between the so-called sopbistication of a given market and the presence or absence of a guarantee fund in that same market. We did, however, find similarities between clearing entities within certain geographical areas apparently refieding tJic existence of national values on what constitutes an acceptable level of risk. Herc is the breakdown on the responses of non-U.S. clearing houses to our survey question about whether they maintain clearing and settlement guarantee funds: 64 percent said that they do not maintain guarantee funds. 12 perCC1U said that they rely on a national guarantee fund, which is a fixed amount of coverage provided by the government on behalf of all clearing entities in a given country. 12 percent said that they do maintain their own guarantee fund and that it varies in size according to the total value of the trading volume of the clearing members, who are required to contnbute to the guarantee fund. 6 percent said that they rely on standby line of aedit commitments from one or more banks with commitments to loan a fixed amount of funds. 6 percent said that they would be protected by a guarantee fund maintained by the exchange for which they clear and settle -but the fund would protect them only if the entire exchange were to default. Evrniuing the preceding survey results, it is evident that there are great differences between markets in the amount of protection which exists for both clearing entities and their members. Furthermore, in markets where guarantee funds do~ their structure varies greatly. The degree to which a guarantee fund actually docs provide protection is a function of its size in relationship to the sac of the open positions ( open interest) of its clearing members. Since the exposure &om clearing members' open positions varies over time, the guarantee fund must either be large enough to cover a worst case scenario or it must be variable: able to expand according to ongoing computations of risk. It is impossil>le to determine exactly bow large a fixed amount guarantee fund would have to be in order to be large enough. For some clearing entities this question becomes even more complicate~ because a single guarantee fund can cover markets in different time zones, and it is possible that a large-scale default in one time zone could wipe out the guarantee fund before the market in the later 1f Some of the organizations we surveyed are clearing houses; hOM:Yer, some are noL This is because in foreign markets. clearing and settlement is often handled by orpnizatiom other than clearing houses ( for instance, depositories). The raultl of this sun,:y are iocluded in this siudy u Section 6. Page 142
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Study of lntemational Oearing and Settlement Risk Factors time zone opened for basiac-a An example of this type of exposure to risk is the 150 million pound sterling guarantee fund of the hltemarioaal Commodities Clearing House (ICCH) in London, which also covers trading on the Sydney Futures ExcbaaF in Australia. It is interesting to note that of all the foreign markets we surveyed, only half of the clearing entities which maintain guarantee funds have guarantee funds of the type which VarJ in me according to the amOUlll of exposure to risk. When international trading is only on a small scale in any given market, differences in the amount of protection provided against default are of only national consequence. But as globaliz.ation of the markets increases, the uneveDDCSS of guarantees against default may slow the growth of markets forcing participants in crou-aational border trading to make increasingly complicated calculations on risk versus return on capital 3.5 THE RISK OF A CLEARING ENTITY COLLAPSE What are the circ11rnstances which could trigger a clearing house failure? Roger Rutz answers this question in his expert paper OD U.S. derivative markets: "For" OM day marled~ to CIIIUI a cktll'ing house filibw, that one day market would have to dqkte: (1) a customer's mare initial margin deposit at the daring jinn; (2) tM customer's entire capital base; (3) the entire capital of the carrying ckanngmanberand in smM instances tM entire net worth of tM 'parmlfirm' and individual stockholdas that own the clearing monber, ( 4) the entire initial margin deposit held at a daring house, which could only occurif tM ckalinghowe had permitted a clearing member to cony such a large concentrated posidon; and (5) the entin resources (clearing funds) available to tM clearing howe. It is an extremely infiniwimai probability of occurrence that all of those events will happen." Robert Woldow, in his expert paper done for our study, also suggests that the possibility of clearing house collapse is remote.. He argues that the powbility is remote for several reasons: clearing houses employ a pervasive scheme of devices to protect themselves against the effects of a default by a clearing member clearing houses have many financial resources upon which they can draw, in the event of a default by a clearing member even if a clearing member docs go into bankruptcy, clearing houses have a preferred status in the U.S. Bankruptcy Code, compared to other aeditors of the failing clearing member Writing specifically about the bankruptcy code and the ways that the National Securities Clearing Corporation (which pr~ the majority of equities trades in the U.S.) protects itself against collapse, Woldow says: "A.r" clearing agency, [NSCq ... possessa a pref~d status under the Bankruptcy Code for tM close-out [liquidation] of outstanding obligations of a failed member. It also maintains the right to set~ff losses against profits in liquidations." Similarly, in his expert paper, William Briggs details the recourse that the Stock Clearing Corporation of Philadelphia (SCCP) has in cases of default by a clearing member. To mitigate the effects of Page 143
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Study ol lllternatioaal Ceariq and Settlement Rist Pacron default, the SCCP may, in certain circumstances, cancel pending trades. It may aJso move to perfect its security interest ( that is, C(\Dfiscate and liquidate) in assets (securities) which have not been paid for. In U.S. futures markets, clearing o.-paizarioas have the authority to liquidate trades in case of clearing member default. In most foreign markets, judging &om our survey results, there are generally fewer safeguards to prevent a a>mplete financial collapse by a clearing entity.20 One factor which contributes to risk in the derivatives markets is the fact that not all noa-U .S. derivatives cvbaages require margin payments, which serve as an ~urancc that a clearing member will be able to meet his obligations on the settlemem date. Another risk factor, which we have already discuwd, is the amount of guarantee fund protection which might or might not be available. A third risk factor, which we will not discuss in detail, is the fact that bankruptcy and other laws affecting scc:urities vary from counuy to counuy. This affects a clearing entity's ability to confiscate securities involved in failed trades. For instance, the securities involved in a trade may be in the custody of a depository in a foreign country, as a result of an arrangement between financial institutions in more than one counuy. In the event of default, interpreting the laws on the disposition of the securities would be difficult at best. Moreover, an added level of complexity exists since there is no international conflict of laws provision. Although clearing members in many countries have defaulted, which in turn affeded many clearing entities, the laws surrounding the complete failure of a clearing entity a failure affecting market participants in more than one counuy have not been tested. Instead of r-ngaging in conjecture on what would happen if there were to be a collapse of a clearing entity, it is more instructive to examine the ability of clearing entities to detect advancing problems and deal with them well before the soundness of the clearing house itself is put at risk. We will begin with the observation, from our survey, that not all clearing entities believe either that they are at risk or that they need protection from the pos.ubillty of clearing member default Our survey found that among those clearing organizations who do not believe protection from the effects of default is neccsw-y the surveillance of ongoing practices is generally less automated than is the case at U.S. clearing houses. The amount of regulation and the amount of risk which is considered acceptable is without question the prerogative of the public and private entities who control a given market. However, it is also true that the failure of a clearing entity and its affected capital markets would have international repcr~ons even if there were no foreign trading on the affeded cxcbaoge. (For example, U.S. investors have holding., in foreign stock, stock which could lose value in the event of a U.S. clearing orgaoizatfon or excbauv failure.) Joseph Kolb, in his expert paper, gets right to the point in his recommendation on the situation: Clearing Corporation guarantees should be consistent across the capital markets of the world. According to the Securities Industry Association, the volume of international cr0S.Yaational border trading in 21 Not ail foreign clearing entities proYidc a guarantee of contract perfonnance. In the absence of such a guarantee. the clearing house risk ii non-existent, but the impact of a clearing member dcf ault would be borne by its trading partners. Page 144
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Study of Intemational Cearin1 and Settlement Risk Factors 1986 grew to 750 billion U.S. dollars, an 80 percent increase from the previous year. Given this large trading volume, and the tremendous growth rate in international trading. it may be that the idea of a strictly domestic" market is obsolete. Clearly it would be advantageous if international standards were to be developed for the amount of protection that a clearing entity should provide against default, including minimum standards for audit systems. However, if thCK standards are to be developed, the cost of this protection and the needs of emerging or growth markets must also be considered. There is, as yet, no consensus on the methods that ought to be used to asse.u the safety and soundness of individual clearing entities ( unlike banks, for which an international agreement on capital adequacy requirements is in place). In addition, as clearing houses begin to get involved in the settlement of non-indigenous financial instruments, the potential impact of clearing house failure begins to have international implications (beyond th~ involving the clearing members who would be directly affected by the failure). 3.6 RISKS ASSOCIATED WITH THE BANKING SYSTEM In the U .S"7 settlement banks are typically an established, specific group for each exchange or clearing house. In Japan, the cvbangr.s rotate the settlement bank they use according to a defined schedule (i.e., the Osaka Securities Evbange rotates every ten days). Whether a bank is serving the derivative markets or serving the equities markets, it plays two important roles. FU'St it serves as a vehicle for payments to and from the clearing house or depository. Second, the bank may provide the credit which fuels market liquidity. (Market liquidity: ready availability of buyer and sellers in a market.) Banks serving the derivative markets do have special needs in that they must help clearing members meet a short timetable for payment of initial and original margin (T + 1) as well as variation margin. 3.6.1 RISKS ASSOCIATED WITH THE FAILURE OF A BANK There are several ways that problems in the banking system affect the clearing and settlement industry. These are the failure of a banking institution, payment systems delays and differences, and issues sunounding acdit. When a settlement bank fails, there are two powblc scenarios. The first possibility is that of an outright financial collapse, followed by the dissolution of the bank. The second possibility is that the bank could fail and its a.uets could be transferred to another institution. When a bank fails, its assets and liabilities (including customer assets, cash, and government securities) are frozen. While one would expect the ccnttal bank in that country to act quicldy to intervene, there is no certainty that the bank will ultimately be preserved as an institution. That is a policy decision which is separate from the issue of how ( or if) insurance will cover the failure. 21 Regardless of whether or not the inst1t11tion is ultimately preserved, the fact remains that a bank failure will cause an immediate disruption of bank services. There is also the possibility that not all deposits may be redeemable. 21 Thia point wu noted by Carter H. Golembe, in tbe paper be presented at the Federal Reserve Bank of Kansas City sympmium in 1987. Page 145
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Study of International Cearing 111d Settlement RilkPldOn The fewer the number of settlement banks used by a given clearing entity, the greater is the potential impact of a settlement bank failure. The Bank for International Settlements comments on this on page 203 of its 1986 study R.ent Innovations in lnlemational Banking. According to the B.I.S.: 'TM financial spte,n can H vulMrabk if there tn large concentrations of the normal marled and credit risk.r whidt arise in credit transadions." This is especially true of those derivative clearing houses which issue margin calls and require bank guarantees before the banks and other payment systems arc open. A clearing member is typically a,goc;iated with only one settlement bank per clearing house, and each settlement bank interacts with the other settlement banks for that clearing house, to pay and collect funds due and owed for all of the clearing members. Because of this interdependence of the settlement banks, the failure of a bank could conceivably interrupt a whole community of clearing members, their customers and clearing houses. In the U.S., since the establishment of the Federal Deposit Insurance Corporation (FDIC), we have not experienced such a major disruption of bank services, altho~ in theory the existence of an insurance program docs not preclude such a disruption in the future. Changes in the banking industry in recent years have significantly altered both the nature of risk in banking and the capability of regulators to assess and manage risk in banking systems. For a look at this subject please refer to the BJ.S. study Recent IMovations in IntemadonaJ Bankmg." 3.6.2 RISKS ASSOCIATED WITH PAYMENT SYSTEMS: DELAYS AND DIFFERENC!:S IN FINALl'IY OF SETILEMENT Aside from the question of a bank collapse there is another related issue which we must examine. This is the question of risks asM>Ciated with payment systems, including the risk of default on a payment obligatioa, and the risks incurred by the failure of a payment system to perform in a timely manner. There are three types of payment system risks: reliability, private direct credit, and systemic. Reliability" risks can be defined as those asM>Ciated with the degree to which a payment system exhibits a consistent and effective performance of its function in transferring funds. Even the most sophisticated electronic funds transfer systems, such as the U.S. Federal Rcscrve's FedWire, can wind up at the receiving end of complaints about reliability. This issue was addr~d by SRI International, in its survey for the Federal Reserve cntided Electronic Payments Savka for the FUlll/'e. In a di.scusgon of survey participants' comments about FedWire service, the report concludes: "Almost thrte-quartm of money center banks contend they have had problems as a result of intmupdons in FedWw service. Respondents assert that the critical nature of the funds application danands tM higMSt reliability. Improved contingency and backup arrangements an also neeMd. ,.23 22 Por emnplc, when tbc Continental Dlinoia Bank failed in 1984, tbc amount of insurance coverage that the FDIC was committed to provide wu 3.S billion U.S. dollars. Thia amount wu insufficient to ConcincncaJ's liabilicies, but tbe bank,... nevenbclcSI because of tbe Pedenl ReseM:'s pofic:y decision that aJ.lowing ConrincncaJ to fold would noc be in the best iateresu of t~c national economy. 23 Currently, the Pedcra! Resem: hM a formal requca out for propouJI on establishing a Fed Wire II system to add~ some of tbeae conccrm. Por more information oa i.slucs conceming PedWire, the reader is referred to the cxpen paper by Randall Pozdena (included in our study) aad Section 4.1 of our summary: &tentud Houn Trading. Page 146
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"Private direct aedit risk, as defined by the Federal Reserve, is Study of International Cearing and Settlement Risk Factors "tM potDltUII lou to a dqosilOly instilulion owu.ting daylight cmJil to another participant on a~ [ electronic funds transfer] networlc who might unabk to cover its net debit position on that MtWodc at tM tmw of settkment." "Private direct aedit risk, while defined as affecting the users of an electronic funds transfer network, obYiou.vy ultimately affects the parties at all other levels of a defaulting transaction. This is also true for the third type of payment system risk, systemic risk. The Federal Reserve def mes this as: "lM potential loss to a saia of cndilor instuutions arising from tM inability of one of them to cover its intra-day debit position on a privau [ electronic funds transfer) networlc al the end of the day." EvrniuariQn of all three types of payment systems risk is focused on a single wue fmality of settlement which has been put under even greater scrutiny in recent months in light of the Group of Thirty's recommendations. One of the key recommendations of the Group of Thirty was for world markets to move (where this has not already been achieved) toward using same day funds to achieve delivery versus payment service for settlement of trades, rather than next day funds, as is common with most payments by check and with some electronic funds traasf er systems. Delivery versus Payment means that, usually through electronic systems, payment and delivery of securitim are simultaneous on the date that a trade is settled. This is obviously desirable because of the amount of risk it removes from the system. An additional level of risk may be removed from the system with delivery versus payment where the movement of funds is through a funds transfer system with immediate finality of settlement. In order for this type of delivery versus payment to occur, the payment system used by the market ( country) must provide for immediate finality of settlement and the clearing houses and the ban.ks must work out procedures and interfaces to utilize the facility. Just because a payment is Leing made by means of an electronic funds transfer system, does not automatically mean that there is immediate finality of settlement. (Finality of settlement is the point at which a financial transaction is recorded on the books of the central bank of the country. This means that all debits and acdits arc posted into the participant's account with the central bank and therefore cannot be reversed.) FcdW'ire is an example of an electronic funds transfer system with immediate finality. Some electronic funds transfer systems provide same day availability, with finality at the end of the day, when the transactions are sent through the central bank. The Clearing House Interbank Payments System (CHIPS) in New York is an example of an electronic funds transfer system with end of day finality. Electronic funds transfer systems without immediate finality of settlement have the risk that a trade could unwind (be sent back to the originator) because of a bank failure after the time the payment entered the system and before finality of settlement. However, through legal provisions, some of these systems can provide immediate irrcvocability of payments, that is, the transactions cannot be unwound after they are made. CHIPS is currently working with its members to establish immediate irrevocability of payments on its network through the use of collateral, and is asking the U.S. Congress Page 147
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Study of International Ccariag and Settlement RilkPICtOn to ensure that netted payments will remain netted cw:n in bankruptcy. F'mality of settlement will still occur at the end of the day, when each CHIPS participant moves money over FedWire to meet CHIPS obligations. The following chart lists some electronic funds transfer systems in various major countries and shows when a payment made through that system is final, and when it is irrevocable. The source of the information for the chart was the Bank for International Settlements 1989 edition of Payment Systems in Elevoa ~lo~d Counlria. Page 148
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PaymcntSyaem Cowltry ( and Operator /Owner) Bdgium Cearing Center for tbc Belgium F'tlWICial Syaem (CEC, owned by tbc ballkiDg inltitutioal) Canada Automated Ccariq Settlement System (A~ owned by tbc Canedian paymenaa aaociatioa) Prance SAOrITAIRE (managed by tbe Bank of Pruce) Italy lntcJbank Electronic PWKII Trulier semce (SETIP, maapd by tbc Interbank Society for Automatioll) Japan BOJ-Nct ( maaapd by the Bank of Japan) .. Oaitame-yen ( opentcd by the Bank of Japan) Zenginsystcm ( opentcd by tbe Tok)'o Ban.ken Aaociatioa) Netherlands Nedcrlandlchc Bank circuit (manapd by the Nc:dcrlandlcbe Bank) Bank Giro Center circuit (owned by tbe banks) Sweden Bank Giro (owned by banks) Switzerland Swia Interban.k Ccaring System (SIC, managed by Tclekun. AO, oa betwf of tbe Swis& Narionai Bank) United Kingdom Ccuing House Automated Payments System (CHAPS. managed by APACS) U nitcd States PedW"tre (operated by Federal Raene Dana) Cea.ring HOUie Interbank Payments System (OUPS, manapd by tbe New Yorlc Cearing House) We.t. Germany Bundc:lbut (maaag"Cr of payment system currentJy still paper-based. Electronic pilot expected Fail 1989) P'mality ol Payment or Settlement BycJcle ofbusiaca OD payment date Cluoaologically by dCIC of businell ol payment date plus 1. Howewr, tbe payment system retlOldively boob settlement OIi paymcat date By dole of buainca 011 payment date By clme of bulinca 011 payment date Immediate By d01e of businea on payment date Next day By clme of businea on payment date By cJme of bu.sines& on payment date By doae of bUlioca on payment date Same day or sometime on following 10 (ten) business days By cl01e o( business on payment date Immediate By ct01e of business on payment date By dOIC of busincsa on paym~nt date Study of International Ocaring and Settlement Risk Factors TllDC Before Settlement When a Payment is Considered Irrevocable Not applicable Not applicable Irrevocable at settlement Noc applicable Immediate Immediate Immediate Not applicable Not applicable Not applicable Immediate Immediate Immediate Irrevocable at settlement Im:voc:ablc at settlement Page 149
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Study of International Ocarina ud Settlement RiltPacton As the preceding chart demonstrates, there is variation among these different systems in terms of irrevocability and finality of settlement. F'mality and irrevocability arc not the only issues related to payment systems that affect the clearing and settlement proces&. Banks which use FcdWire, for example, arc nonetheiess confronted by daylight overdraft limits which constrict the amount of funds that can be transmitted over the FcdWire without having corresponding credits in incoming funds. Delays in collecting and disbursing funds through payment systems pose risks of some magnitude in the derivative markets, since settlement banks supporting the trading of futures and options are operating with a greater need for timely payment (compared to the equities markets). An example of this kind of problem comes &om the Chicago Mercantile EYcbangr.. It reports that on October 20th, 1987 its clearing house experienced some delays in receiving confirmation of payments of original margin. In addition to electronic payments systems, much of the world still operates by means of paper payments that is, checks. While this was not identified as a major concern by the clearing entities which participated in our survey, unpaid checks were cited by some as a payments system risk. Additionally, settlement times for checks vary enormously internationally. This contrasts to the situation in the U.S., where checks to clearing houses24 must be nett-day funds. As we have just stated, the U.S. Federal Reserve Bank does offer immediate finality of settlement. But it is fairly unique, among central banks, in doing so. Most often, internationally, finality is offered as of the end of the trading day. The result is a combination of private payment system and central bank delays in finality of settlemenL 3.6.3 RISKS ASSOCIATED WITH THE CREDIT PROCESS Another major role for banks in the clearing and settlement process is the provision of credit either for the purchase of equities or for the payment of original and variation margin on futures contracts. There arc three aspects of the credit process which need to be examined in our disawion of bank-related risk fadors in the clearing and settlement process. The first aspect of the aedit prOCCM that we will eYarninc is the types of collateral which banks ac:ccpt from borrowers to secure acdit. Just as there is a wide diversity in the types of collateral which is acceptable to clearing houses, there is a correspondingly wide range of collateral acceptable to banks. F'mancial innovations have expanded the types of accepted collateral to include hard to value instruments such as options. Banks may fmd it more difficult to provide credit against the value of the new types of collateral due to uncertainties associated with this collateral. On the plus side, these aew types of collateral may provide market participants with the opportunity to use unrealized profits on one investment as collateral for further trading. This would enhance overall market liquidity (i.c:aease the total dollar value of financial instruments that buyers and sellers arc able to trade). 24 SomesecuriticsclearinghoUiCSstill use checks. Options and futures clearing organizations use electronic funds transfer exdusiYely. Page 1.50
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Study of International Cearing gel Settlement Ria Factors The down side of the new types of collateral is obvious. If the market were to go into a rapid downward spiral, a borrower's collateral could suddenly depreciate, constraining his available credit at a time when liquidity (the ability to continue trading in the market) would be at a premium.25 The second aspect of the credit procc.,s that must be examined is the types of collateral which clearing members present to clearing houses on behalf of themselves and their customers. Besides equities and government securities, clearing members may also present ( as collateral) standby bank letters of aedit. These are written comminn.-.ms by banks26 in which the holder of the letter (in this case, the clearing member) is pre-approved to borrow up to a set amount of money, the timing and the amount of the loan (aside from the upper limit) being left entirely up to the clearing home as beneficiary. Letters of credit may pose some issues of conccm to regulators clearing houses, banks and clearing members. A letter of aedit is typically drawn down (that is, cashed in) in different economic circurnstanc:cs than existed when the bank first made the standby commitment for the loan. This creates two types of risk: first, that the holder of the letter of acdit may not be as creditworthy as he was when the bank first made its aedit dccision;Z7 and second, that the markets ( for instance, interest rates) may have changed in such a way as to affect the cost of the loan. There are three basic concerns in respect to letters of acdit: There is uncertainty about what would happen if a bank (for reasons of material adverse change) refused to honor a letter of aedit and was subsequently sued by the beneficiary of the letter of aedit (in this case, the clearing house).28 In such a situation, even if the courts later held the bank to be liable for the funds that were to have been provided by the letter of credi~ the clearing house in the interim would have to borrow funds to cover the shortfall of funds. In the U.S., the Uniform Commercial Code (UCC) allows banks as long as two days (after it is presented the required documents requesting payment) to actually transfer the funds to the beneficiary of the letter of credit. Therefore, letters of credit cannot be considered to be timely instruments. 29 Another issue relating to letters of credit has generated considerable discussion in the fmancial community and will only be discuMed in general here. The issue is whether banks should change their current practice of not fadoring letters of aedit into their balance sheet calculations ( not until they have been drawn down, or cashed in, that is). 25 The American Bu Aaoc:iatioa ia cu~ntty performing a study which COYers thia subject, and we will postpone any funber dilcuuioa of tbia topic until thac Shady ia completed. The banb from which lenen of credit are acceptable are specified by the clearing house. Thia situatioa ia known aa maceriaJ adverse change. Por additioaaJ information please sec t.cner of Credit, May/June 1988, published by Executive Enterpnses Publications. Also please refer to the following scminaJ cases: In re Twist Cap, I~ 1 B.R. 284 (Bankr. D. Fla. 1979); Two OiL Inc. v. Tamp~cx, Inc., 58 B.R. 966 (Ba.nu. S.D. Tex.. 1986) and In re Air Conditioning. Inc. of Stuart, 72 B.R. 657 (S.D. AL 1987). Some ctcaring houses have contractual arrangements with the banks to waive this two-day period. Page 151
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Study of International Cearing and Settlement RiskFacton It has been suggested that ban.ks should consider including letters of acdit (provided to financial services firms and clearing houses) OD their balance sheets, in much the same way that loans are carried OD the balance sheet. The rationale for this suggestion is that the bank's commitment to loan the money even if only potential in nature is binding. It is furthermore argued that aeclit CDendcd by means of letters of aedit is even rukier for the lender than an ordinary loan., because the letter of aedit might be used when the borrower is in I~ solid financial condition. The third aspect of the acdit process which we will examine is the ability of banks to keep the aedit pipeline open in times of market turmoil Oearing members often turn to more than one bank for loans both short term and long term and each acdit bank may have only a partial view of the exposure that clearing member has in terms of ms holding., and obligations both domestically and internationally. That is, a aedit bank may not be aware of loans or letters of acdit that another bank may have given the clearing member. The Securities and E,:cbanF Cornmission, in its report on the Odober 1987 market break, commented on the problem of banks being forced to make decisions based upon only partial information about clearing members' overall market positions. According to the SEC: "On several occasions during tM week, [Options Clearing Corporation] members had ~quau funds in their clearing bank to satisfy OCC debit instructions. At the same timty lM clearing banks unable to establish whether OCC clearing members could imnudiately transfer the necessary funds to the bank. ,,30 The banks were able to continue lending, without the information that they needed, only because of the intervention of the Federal Reserve Bank. Stepping in, the Federal Reserve "consistent with its responsibilities as the nation's central bank, affirmed [on October 20th, 1987] its readiness to serve as a source of liquidity to support the financial and economic system. ,,31 There continues to be cliscu.won within the industry on inacasing the sharing of risk information between the various participants in the clearing and settlement prOCCM. But there are numerous obstacles to be overcome before this can be achieved; this subjed is discus.sed later in this summary (Section 3.12: Availability and Reliability of Information in both International and Domestic Trading) and in the expert papers which were submitted for and are included in this study. 3.6.4 RISKS ASSOCIATED WITH INTERNATIONAL BANKING, AND OTHER ISSUES As banks (inacasingly) continue to lend internationally in support of busin~ relationships developed with various market players, the impact of a failure of a given credit bank can easily travel aaoss national borders. For example, letters of credit held as collateral by foreign clearing entities would have to be replaced; funds that had been "due from" the now-failing bank might be suspended; an unwillingn~ might exist to pay funds "due to" the failing bank; and so on. JI The subject ia discussed rwty oa page 10-41 in the SEC mart.ct btea.k repon. 31 Excerpted from the Wail Street JoumaJ article "Afta CM Crash On tJw Spot: Suxk Maricn's Frmzy Pua Fed's G~mspan in a Cru&ial Posiaon, by AJa.n Murray, on October 21st. 1987. Page 152
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Study of International Cearing and Settlement Risk Factors International banking has become more of a conccm as aoss-national border trading has increased, with settlement of trades being effected in the home market of the traded instrument. There are great variations between international markets in finality of payment and the degree of regulation and oversight. It also would appear that there are great differences in international credit availability and pricing.32 These differences give rise to other related concerns, such as the legal recourse that would be available to an investor in a foreign market if the settlement bank in that market were to fail A related risk muc, for both banks and foreign investors, is the practice known as "haircutting." This refers to the practice of clearing houses or regulators discounting, for risk reasons ( for instance, currency fluctuations, problems with liquidity, or problems between governments), the value of bank accounts in foreign currencies.33 Both the Chicago Mercantile Evbaoge (CME) and the Chicago Board of Trade ( CBOT) have had contracts approved by the CFI'C which would be priced and settled in the currency of the underlying contract. 34 If a foreign settlement bank is used, CFrC rules require that the foreign currencies be accepted only at devalued rates, i&. subject to the "haircuts" required by CFTC Rule L17 (c) (5).35 We were unable to identify an outside expert to further develop the ~uc of whether the world banking system is adequate to support the increased globalization of the markets. Since the Office of Technology Ascessrnent contract with Bankers Trust prohibits the use of any internal Bankers Trust studies as source material for our study, this subject must be left to other researchers. There is also a need for further study and awareness of the way the banking system functions in respect to clearing and settlement. Our even cursory analysis of the 1987 market break reports reveals that banks and clearing entities are to a great extent unaware of each other's needs and operational concerns. By this we mean that bank expertise in clearing and settlement is usually confmed to their fiduciary services groups, except in the universal ban.ks in Europe. 36 The payment and credit divisions of the bank tend to be ICM aware of clearing house operational characteristics and risks. Indeed, banks acting as aedit ban.ks may not even be aware of how their services are being used to facilitate clearing and scttlcmenL 32 33 35 3' Por more on intemationaJ credit. please refer to Recffll Trmds in ComtMrrial BanJc Profuabiiily. a staff study by the Federal Rcsem: Bank of New York. September 1986, Olapter 10. This subject was also discussed in some detail by Jama McConnick and Jonathan Moynihan of tbe First Manhattan Corporation, in their presentation Blueprint for BanJc Shardtoll:/6 Vmue å tlw Odds in Profilabilily and M~, at the Morpn Staniey, Janua,y 1988 Merge rs and Acquilitiona Conference. "Haircutting" can aJ.lo refer to tbe practice of devaJuing, compared to face or current market vaiue, the vaiuc of other allCII, such aa suxk:I or government securities. Sec Section 3.7, '77w Rim of tlw Failun of Collaurar, for more on this subject. 1be CFrC baa approved a futures contract on tbe Nillii Stock Average at the om and the following futures contracts at the CBOT: futures oa Yen Bondi. Gilts and tbe TOPIX index. None of these approved c:onrracu have been listed ror trading ( u of September 8, 1989). CFTC RuJc 1.17(c)(5)(vili)(1988) addreaa tbc dcpmit of aaets other than casb to margin an account and vaJucs the aaet at the lesser of the vaJuc attributable to tbe aaet pursuant to the margin rules of the applicable board of trade or the market value of the aaet after application of the percentage deductions specified in Rule 1.17 (c) (S) (i&u for rixecS price commitments 20 pcn:ent hain:ut). Note that the SEC woutd appty a 6% hairc:uL A wuversaj bw is a bank which pcrfonm the traditional functions of a commerciat bank and an investment bank. Page LS3
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Study of lntemationaJ Oearing and Settlement RiltFacton A final note on our discussion of banking and payment system risk fadors in clearing and settlement: it hu been difficult to attribute various parts of this section to specific authors ( as we have tried to do in all the other sections of the summary of our study). This is because although we did discuss the ismes with a variety of experts in both the private sector and at regulatory authorities, little has been written on the subject. Our conversations on bank-related risks to clearing and settlement wer~ of two varieties: those with banks who wanted to know more about clearing and settlemen~ and those with clearing houses who wanted to know more about banks. We believe the preceding disc1.J.won to be an accurate representation of the concems and recommendations that were voiced. But there is a need for a much more exhaustive exarniuarion of the interaction between banking and clearing and settlement, both dornestically and internationally. 3.7 THE RISKS OF THE FAILURE OF COLLATERAL We have already taken a preliminary look at the types of collateral which arc presented to ban.ks and clearing houscs.37 We will now attempt to assess the amount of risk which could accrue from the failure of collateral held by a clearing house. In order to do we will first examine the requirements for the types of collateral which are required by clearing entities -both for the posting of margin, and for mandatory contributions to the clearing house ( or other clearing entity) guarantee fund. In our survey, we asked clearing entities to detail the types of collateral which arc accepted for posting margin, as well as the types of collateral which arc accepted for clearing house guarantee funds. Judging by the responses to our survey, it appears that compared to the types of assets which can be used to post margin, clearing houses are much stricter in their requirements for the types of assets which arc accepted for the clearing house's guarantee fund. The following chart bring., out that point, while it also shows the types of collateral which are considered to be acceptable:
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Sovereign Obligations Cash Bank Guarantees or Lines of Credit Equities Percentage of Cleariaa Houes tbat Accept Various Flneadal lnstrumellts Into tbelr Guarantee Funds or u Margla Collateral Study of International Cearing and Settlement Risk Factors In Guarantee Fund As Margin Collateral 0 1 0 20 30 40 50 60 70 80 90 1 00 of clearing houses accepting instrument .. The clearing entities we surveyed did not give us a percentage breakdown on the types of collateral that tend to be used by clearing members ( for instance, what percentage of all collateral posted as margin in a given year was government securities?). We did, however, discuss this question with a number of clearing houses and it seems that the percentage breakdown, in terms of which financial instruments are most used, varies greatly from one clearing entity to the next. Of the different types of collateral which are accepted, cashthe currency of the home market of the clearing entity -is viewed as being the most secure. The next most secure type of collateral appears to be sovereign obligations ( notes, such as U.S. Treasury securities, backed by the full faith and credit of a federal government). In the country in which they originate ( for example, U.S. Treasury securities might be used as collateral for a transaction being cleared by the National Securities Clearing Corporation), short-term sovereign obligations tend to be accepted at market value, but long-term obligations tend to be "haircut" or discounted (reduced in value). Clearing entity policies vary on the amount of haircut that is applied to the long-term sovereign obligation and the government securities of foreign governments. There are several fadors which determine the assessment of the degree of risk ( and the haircut which results). F'U'St the clearing house must make a determination on the volatility of the market and the depth of the market (How many potential buyers arc there for the collateral? How difficult would it be to sell the collateral?). Second, the clearing house must consider the fact that the financial instrument is denominated in its own home currency, and thus, there is the risk of currency fluctuations affecting the value of the instrument before it can be liquidated. Page 155
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Study of lntemational Cearing and Settlement Rist Pacton F'mally m respect to sovereign obligations ( debt securities issued by governments) of foreign governments, consideration must be given to the question of whether the foreign government will be both willing and able to fulfill the obligations of the securities (sovereign risk). Yet another consideration in determining the degree of risk in a sovereign obligation which is being used as collateral is the matter of its maturation date. Being debt instruments, sovereign obligations have fixed maturation dates on which they rcw=rt to cash. One problem with this is that the maturation date may be too soon ( making it unlikely that there would be buyers for the note, leaving the clearing house with collateral which in the event of a default -would be difficult to quickly convert into cash to cover the clearing entity's losses). Letters of aedit from banks, as collateral, pose two type., of risk. In the cue of the bank being located in the home country of the clearing entity, there is the risk that the bank might: a) fail to honor its guarantee to provide funds to the holder of the letter in a timely manner; orb) completely fail to honor its guarantee. If, on the other hand, the bank is located in a foreign country there are the additional risks ~ted with the economic and political climate of that particular country. Many guarantee funds also accept government agency securities as collateral (for instance, U.S. Federal Home Loan Mortgage bonds, or Japan~ Housing Corporation bonds). The face value of these securities, when they are posted as collateral, is often discounted since they arc not backed by the full faith and credit of a national government Similarly, in evaluating the risk factors of equities (stocks) posted as collateral, there are several aspects that must be considered. F'trSt, and most obviously, there is always the possibility of a severe downward spiral in the market. To guard again~ ordinary price fluctuations, equities as collateral arc ordinarily "haircut (valued at a reduced rate) by as much as 50 percent. A deep slide of the market, however, could pull the value of the stock down even lower than 50 percent of its original value. Two other types of risk aMC>ciated with equities as collateral are market depth risk ( that is, how big is the market -how many potential buyers are there for this stock?) and price discovery risk. Price discovery risk is the danger that, in the event of extremely heavy trading vo!ume, there might be significant delays in the availability of trading information the information which forms the basis for the pricing of the equity. This could leave the holder of the collateral more or less in the dark as to the appropriate value to assign to the equity in question. The specific exposures of equities to risk arc reflected in the fact that none of the clearing entities we surveyed accept equities as collateral for their guarantee funds. What happens if there is a failure of collateral that is, if an instrument or letter of credit posted as collateral loses a significant amount or all of its value? The failure of collateral can be analyzed on two levels, each level having its own ripple effects upon market participants. If the collateral failure is at the clearing house level this would put the clearing house itself ( an~ in tum, its members) at risk -until the time that new collateral has been posted to make up for the value of the failed collateral. 38 31 There ia no intc:mational standard for auc:s.ang the: compara1ive safety of markets based on the risk factors of the types of colla1eraJ aa:cpted by clearing entities. Since the failure of a clearing entity would directly impact upon a market. the absence of such an intemationaJ standard pmes a risk in intemationaJ trading. Pap 1.56
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Study of International Cearing and Settlement Risk Factors The failure of collateral could aJso be at the levd of the clearing house member, who might be holding the collateral against the financial obligations of non-clearing member Futures Commission Merchants (FCM's), Fully-Disclosed Brokers (FDB's), or retail customers. Exposure to the risk of failure of collateral is sometimes greater at this level, because brokers may be more lenient than clearing homes in the types of collateral that they accept. The clearing member docs oot have a guarantee fund, as does a clearing house, to immediately cover the effects of the failure of collateral. Another difference is that the failure of the collateral would oot change the fact that the clearing member's financial obligation to the clearing house, in respect to settlement of the trade, remains despite the failure of collateraL Given this situation, brokers who arc ~Olding cquiti~ as collateral might be f orc.cd to liquidate the holdinp that were pure.based oo margin. This would oot be necessary, of course, if the investor who posted the now-failing collateral were able to provide additional collateral against his obligations. However, the ability .to come up with new collateral might very well depend upon the willingness of other financial institutions -especially, banks to provide additional infusions of credit But aedit is difficult to obtain in times of market turmoil the very situation which could provoke a failure of collateral One reason for this is that banks typically do not have access to information about a customer's positions on all e,:cbanges, and low levels of automation at some organizations can outdate the information which IS available about a potential borrower's ~ts and liabilities. Summarizing the results of our survey on collateralthe only true constant hctween markets is variety. The standards oo types, quality, and amounts of collateral vary according to: the country that is involved; the requirements of regulatory agencies; the specific clearing entity processing the transaction; and the requirements of the aedit provider, be it a clearing member, a bank, or a broker who is extending margin to a customer. An example of the kind of situation these collateral differences create would be a market player who, in all the markets in which he trades, posts only cash and government securities as collateral. Even though his own collateral is relatively unlikely to fail, he may still be at risk in those markets because other market players may have posted less reliable collateral. In the event of a failure of that collateral, the market player who posted the strong collateral could wind up being assessed by the clearing house, to help it make up for the loss. In an even worse case scenario, the entire market could be affected -if the clearing entity were to collapse as a result of the failure of the collateral. The absence of an international standard for asses.gag the credit-worthiness of collateral ( and, in turn, the financial integrity of clearing entities according to the quality of collateral) poses a risk in international trading, since the failure of a clearing entity would directly impact upon a market. Even so, little attention has been paid to the question of leve~ out the risk playing field in terms of the types, quality, and amounts of collateral that arc required. '39 In addition to the fact that there is no international standard for asses.sing the value of collateral, there is also no uniformity in the regulations in various countries pertaining to collateral. 40 The combined effect is the aeation of a risk factor which is of greater magnitude than an analysis of either situation alone would reveal. 39 Al, an examp~ maay incemational clearing orpnizations accept Jetten of credit for capita!, margin, variation margin II well M guarantee funds. 41 Por more on the: regulacory diffcrencea between martets. please refer to Section 4.4 of this study: Reguiazion of the Ckaring Proust, and to the expert papen wh.icb are mentioned in that section of this summary. Page 157
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Study of laternational Ccaring and Settlement Risk Factors A more in-depth study of this issue, for mmplc, might evrnine the various aspects of the relationship of these two risk factors. For instance it might be useful to compare the risk fadors of, OD the one hand, a transaction involving strong collateral in a heavily regulated market, and, OD the other hand, a transaction involving weak collateral in a self-regulated market. Besides being an muc which merits study, this is an muc which is beyond the scope of the private sector but can be addressed by regulators. Just as an investor feels rclativcly secure in a situation in which the Options Clearing Corporation might place a 50 percent ( devaluing) haircut OD equities collateral in a market subject to the watchful eye of the Securities and Excbangr. Commission, there is also a degree of discomfort in seeing the same type of collateral being given a good deal more weight in mother market which might have little or no regulation. 3.1 RISKS ASSOCIATED wrrB INCREASED TRADING VOLUME Clearing Houses and other Clearing Entities The risks associated with inaeascd trading volume fall into two categories: those a.s.sociated with predominantly manual (paper-based) clearing and settlement processes; and those associated with clearing and ~ttlement systems which arc heavily dependent upon technology. This is not to imply that within a given market, the presence ( or absence) of a high level of technology automatically reduces risk in and of itself. For example, in Australia, the Austraclear electronic scoreboard system is technologically sophisticated. But unlike a U .S.-style clearing house ( which might actually be ICM technologically sophisticated), Austraclcar employs only good faith settlement practices (that is, it does not take the couoterparty position in trades -it only keeps track of who is trading what). The two categories of risk must be evrniocd separately, to analyze the different risks they bring into the clearing and settlement process. To begin with, let us evrnioe the Japan Securities Clearing Corporation (JSCC), which clears trades for the Tokyo Stock EYcbaogr. (TSE). This is a good example of a clearing and settlement process which is primarily paper-based. The trade matching process here is still done through visual comparison of hard-a>py printouts of trade information. How effective is this syste~ in terms of risk? The pl'OCCM worked remarkably well during the October 1987 market break. One reason for this may have been the fad that it is against Japanese cultural standards to allow fails, or defaults on trades. Nevertheless it is still true that, a window of vulnerability remains, however small it may be. (For more on this, please refer to the ciiscus&on of the Japan Securities Clearing Corporation, in the IBM report submitted for and included in this study.) Oearing and settlement systems, however, should be as automated as possible given a market's indigenous culture and technological capabilities. One good example of problems in phasing in automation is provided in the IBM report, submitted for this study. The IBM report discusses concerns which have been voiced about SEGA's (Schwcizcrische Effekten-Giro AG -a Swiss clearing house and depository) need for a staff with an adequate technological skill level The automation level of the clearing house is only as good as that of the level of automation in its interface with the other organizations involved in the clearing and settlement process. For instance, there is a potential bottleneck if the interface between a clearing entity and the banks is largely manual, rather than automated. The IBM report also touches on this, in its discussion of the interface between Nomura Securities and the ban.king system.
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Study of International Cearing and Settlement Risk Factors The survey of clearing houses and other clearing entities done for our study shows that many of these institutions arc not even well on the way to automation. Manual clearing. manual delivery, and hand delivery of checks arc not uncommon: sometimes e\a in markets which otherwise display a comparatively high degree of automation. This poses a risk because manual operadooa arc very sensitive to large inaeascs in volume, which in tum increases the exposure to the risk of human error. ID the United States, the impetus for automation at clearing houses originated in the desire to put an end to the back office (trade processing paperwork} paper logjams acatcd by heavy volume trading. As markets continue to expand clearing houses with low levels of automation may repeat the same unpleaaat experiences of the past, in terms of backlog., caused by an inability to keep pace with trading volume. The advent of 24-hour trading cxacerba1es this risk, because of the added trading wlumc and added types of tramactioaa (for instance, accesa to a considerably larger number of international markets) that 24-hour trading is cxpcctcd to involve. Now let us examine the types of high trading volume risks which arc involved in automation. Automation replaces manual related risk with technology risk. As is noted in the IBM report ~ion of the International Securities Clearing Corporation (ISCC), automation in many cases -tends to lower overall risk. But experience has shown that comp~cr systems arc NOT infinitely expandable. In some cases, the upper limit of a computer system's capacity may be im~d by the hardware (for instance: disk space, central prOCCMing unit (CPU) cycles, communication line speeds, etc.). In other cases, the upper limit of a computer system's capacity may be imposed by the software which is being used by the clearing house (for instance: data base file allocation sizes, queue lengths, inefficient enqueueing/dequeucing of aitical resources, etc.). Most clearing entities with any significant degree of automation have already stress-tested their computer systems and are aware of the upper limits of the capacity of those com put er systems. 0 f course, the degree to which a strcs.1 test mimics the conditions that might be experienced on a day of unusually heavy volume depends upon the conditions under which the test was run. There is one risk factor which is cpmmoo to both manual and highly automated clearing and settlement systems. That is the risk of a catastrophic failure, such as an earthquake in Tokyo, or a massive blackout in New York. Many evbangr.s and clearing houses have taken precautions against such disasters. These precautions could take the form of making sure that key buildings are earthquake-resistant (as bas been done in Tokyo). Or it could take the form of developing standby alternative processing and computer centers (as is being done in New York). These procedures might be adequate, in general, to protect the workplace and technology of the clearing and settlement pr~ While a catastrophic failure could occur on any day, if it were to occur on a day of especially heavy trading volume, the quality of the standby systems could have :i significant impact on an already volatile marketplace. At this time, there arc no uniform standard~ for the procedures or quality of standby systems for clearing and settlement. This lack of unifonmty holds true both in comparing various clearing entities within a given country, and in comparing the standby systems present in different countries. For more on th.is subj~ please refer to the IBM rcpo~ which gives some specific examples. Page 1.59
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Study of International Cearm1 ud Settlement Risk Pacton Depositories and Banka The operations of depositories and banks arc also sensitive to large inaeases in trading volume. In his expert paper on the Depository Trust Company, Fred Hampton reports that the "DTC cauliously obsavu the potentially unfavorab~ impact of physical deposit and wilhdrawal activity at high (volunu! J SIIStlliMd for an exterlMd period, such as several wee.la. Transfer agent badcJO&f, t!l1'fHU!OW rejects, and missed transfen could develop, and are more ~ly to occur with [transfer} agents that have not fully automated their depository function.,, This type of risk could be even greater at dep<>fitories whi~ compared to the OTC, have a higher ratio of physical delivery of securities ( as opposed to book-entry-only transfer of tide) in the transfer of title proceu. Like depositories, banks also have a custodial function in holding securities for safekeeping, although the types of things they can do with the securities are not the same. It seems reasonable to say that some banks arc better equipped than others to deal with sudden inacases in trading volume, the variation most likely being a function of the individual sophistication and level of automation of the bank. Br.ginning on page 17 of their expert paper on Global Custody Issues, Marc Simons and Keith Fulmer provide an excellent picture of the ways in which banks acting as global custodians ( serving a variety of international markets) and banks acting as sub-custodians (serving one local market only) are vwncrable at times of especially heavy volume. Robert Kay, in his expert paper on Global Custody Issues, also presents a useful assesc;rn~nt of the risks and challenges for custodians. Reading both papers (included in their entirety in tlm study), it is clear that volume risks as.wciated with depositories and other custodians vary greatly depending upon the capabilities of the custodian in question. Another type of volume risk a.w>ciatcd with cmtodians relates to the capacity of securities loan/borrow systems to keep up with offering., and borrowing., in times of high market activity. csecurities loan/bon-ovt' is the practice of custodians making short-term loans of stocks and bonds on behalf of their customers. 4 1 The borrower uses the securities to meet his obligations for settlement of a trade either because he sold short, or because the shares he owns are tied up for some reason, such as a geographic delay that cannot be surmounted before the settlement date.) Securities loan/borrow arrangements require the short-term transfer of title on the stocks or bonds which arc being held by the lender, according to the terms of a contract between borrower and lender. This contrad is administered by the depository, which also handles the change of title, or the registration of the change (in the evcl)t that a transfer agent and actual paper stock certificates are also involved). If the depository and for example, a bank as custodian, were to become backed up in processing of loan/borrow arrangements, this could result in default on trades for which the seller was counting on a short-term loan of the traded security. Due to the broad scope of this study, this is a question which we did not enrnine in det~ so we cannot fully evaluate the degree to which the pressures of high volume on securities loan/borrow systems arc a significant risk factor for market participants. -41 These shon-tenn loana can. of course, a1:D be arranged directly berween two market participants. Page 160
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Study of International Ocaring and Settlement Risk Factors Another area of concern in considering the risks of high volume~ the ability of banks to sustain high performance levels for an extended period of time -performance both in terms of providing credit and in terms of maintaining a timely payment system. Outside of the banking industry, it is popularly believed that banks arc highly automated operations. Quite the opposite is often true. A bank may have an on-line computerized interface to vther fmancial institutions and orgaoizati"ns involved in the clearing and settlement process. But the presence of this on-line interface does not in itself mean that the bank's internal processing is conducted in a highly automated manner. 42 The fad is that the level of technology, and the capability to sustain a high level of payments, is not uniform among settlement banks, clearing house banks, and general purpose payment banks. These differences can stress a bank1s ability to perform, as a payment system, in a timely manner. Other strcs.,cs on timely payment (in the U.S.) include: limits on daylight overdrafts, bilateral limits within clearing houses (for example, as at the Qearing House Interbank Payment System CHIPS), and limits OD the how-s that the FcdW1te is in operation. In their role as providers of credit, banks operate almost entirely in a non-automated manner, especially when it comes to decisions OD customer aedit limits. This means that for the customer, there arc two points of uncertainty, and therefore, risk. The first is that the bank might decide against providing any further credit. The second is that because of operating pressures OD aedit officers caused by high volume, the bank might delay its decision on whether to grant aedit. (For some empirical evidence on this subject, please refer to both the Securities and E1:cbangc Comrnis.sion and the Commodities and Futures Trade Commission reports OD the 1987 market break.) Summing up our discussion of the risks of high volume trading, it seems fair to say that even if international standards were to be adopted for the settlement pro...css, that change would bring only a false sense of consistency and security. This is because there arc no international standards for protection against volume sensitivity and other risks which have a potential impact on the clearing process. 3.9 RISKS ASSOCIATED WITH TRANSFER AGENTS (Summary olExpert Paper Submitted by the Securities Transfer Association) In a securities trade, the legal transfer of title is generally handled in one of two ways. If the securities are dematerialized that is, there are no actual paper securities certificates the change of title is often handled through ~k entry: a change in a depository's computerized recorc! system tracking ownership of securities. If the company which issued the securities docs not have a direct relationship with the depository, or if the traded securities arc in the form of paper securities certificates, transfer of title is handled by transfer agents. 43 42 For more on the differing levels of automation at banks, please ref er to the 1987 Salomon BrothcIS report T echnolcgy in Banking: A Palh to Compffiriw Advantage. 43 This is the case in the U.S.; however, in some foreign markets the lcgaJ transfer of tide on securities is instead handled by registran, who also track the ownership of securities. Our discus5ion of transfer agents is limited to practices in tJ .s. market&. Page 161
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Study of IntemationaJ Cearing and Settlement Risk Pactor1 In the U.S., there are approximately 600 transfer agents; some of them are major corporations which act as transfer agents for their own transactions. Many banks act as transfer agents; non-bank financial institutions such as brokers may also act as transfer agents. A transfer agent, working with either a depository, a bank or broker, or an individual customer, examines the endorsements on the securities certificate: checking the seller's signature and other verifying information. If there are no problems, the transfer agent then cancels the certificate and makes up a new negotiable securities certificate -to be presented to the buyer. The transfer agent then notes the change of ownership OD records maintained by the transfer agent on behalf of the company which ~ucd the securities. Transfer agents also have a number of ancillary functions: Since they maintain records OD the ownership of stock, 44 transfer age~ts are in a position to asmt corporations in communications with their shareholders. In that capacity, transfer agents may handle all shareholder communications (proxies, annual reports, etc.). Stock issuers may also choose to have them handle the disbursement of dividend and interest payments. In this capacity, the transfer agent would give the issuer's bank instructions on the payment of dividends and interest. They may also act as custodians for either domestic or foreign securiti~ which may be in American Depository Receipt Form. 45 Transfer agents could hold securities in their own vaults. The securities could also be held in a depository, in an account in the name of the transfer agent. 46 This latter arrangement allows an automated transfer of title process to occur at the depository, without having to physically move the securities. A good example of this type of arrangement is the Depository Trust Company's (OTC) Fast Automated Securities Transfer (FAST) system, which links OTC and the bookkeeping systems for the various transfer agents' custodial accounts. The Securities and E'tcbangc Commission (SEC) requires that the transfer of title be completed within three business days of the time that the transfer agent receives (from a broker-dealer) instructions on the title that is to be transferred. Transfer agents are regulated by the Federal Reserve Board, the Comptroller of the Cw-rency, and the Federal Deposit Insurance Corporation, in addition to the SEC. The transfer agent process has a low degree of automation. The risks associated with the transfer agent process are therefore those associated with manual processes. According to Raymond Riley and Michael Foley of the Securities Transfer Association: "[The] processing of transfer instructions outside the depository ( or otherwise outside automaled, standardized programs) cnates a risk of delay, confusion, and error. To the atent any broker-dealer or other custodian processes a significant volume of instructions in that fashion, the risks increase." Maayorpnmtions which acr as transfer agents also act as registrars ( the responsibility of the registrar being to account for the ownership of all the securities issued by one or more companies). In the U.S., fcderaJ law requires that if an organization acts as both a transfer agent and a registrar-those functions must be handled by separate departments. with separate records, and separate management. Pteue refer to Section 2.1.1.1.C The IntemationaJ Securities Oearing Corporation, for a discus.&ion of American Depolitory Receipts (AD R's). ADR's are notes representing the ownership of foreign securities; gcneraHy AD R's are traded in the U.S., rather than in the market of the company which is5ued the stock. In a CU5U>diaJ arrangement of this type, the transfer agent is known aa the nominee and the actual owner of the security is known as the "beneficiaJ owner. Page 162
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Study ol I.ntemationai Oearing and Settlement Risk Factors In recognition of this fact the Securities Transfer As.cociation has two recommendations: Broker-dealers with any suh.d:aurial certificate transfer volume should be required to process depository-eligible securities through a depository, or some other suitable automated facility which is connected to transfer agents. All registered securities depositories should be required to develop standardized automated transfer proces.c;iug systems. While these recommendations specifically refer to the U.S. markets the Securities Transfer AMOciatfon notes that similar initiatives, undertaken internationally, would greatly enhance the infrastructure of world markets. 3.10 RISKS ASSOCIATED WITH TECHNOLOGY AND COMPUTER SECURITY Many of the risks of technology are obvious. What is not so obvious is the extent to which each risk poses a threat to the integrity of the clearing and settlement process. Herc is a list of some of the risks, due to technology, facing market participants: 1. Simple programming error 2 Intentional programming error by knowledgeable personnel 3. Simple operational error, through a "hole" in the system created by a condition no~ anticipated by programming personnel 4. Intentional operational error by knowledgeable personnel, through a "hole" in the system created by a condition not anticipated by programming personnel 5. Error by computer operations personnel 6. The potential that transactions might be lost during the process of error recovery ( i.e., fixing a mistake) 7. The amount of "down" time that might result from a necessary switch to new hardware or off-site backup facilities, in the event of serious problems with the original computer 8. Potential damage as a result of sensitivity to the ICM of electrical power at computer or user locations The preceding list includes only a fraction of the possible problems to which any user of technology (clearing house, depository, custodian, bank, central bank, trading firm) is exposed. While the probability of each type of problem actually occurring is relatively low, the degree of risk and the actual potential for damage varies from one organization to the next. Of greater concern to the trading community at large is "Computer Security:" the need to protect an organization's information assets from an unauthorized intrusion by an outsider. Issues which fall into this area of concern include: enayption and authentication of communication lines into a computer system; protecting the system from incoming computer 'viruses' and hackers; protecting intra-firm communications capabilities (land lines, satellite, line-of-sight microwave, local area networks -1.AN's); and in some cases, encryption of data stored in the computer itself. As might be imagined, computer security is not a subject which can be adequately discussed in a broad-based study such as this one. This is, however, a matter which can be addressed by regulators internationally -in terms of whether computer users are complying with reasonable standards of protection. Page 163
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Study of Intcmational Cearing and Settlement Rilt Pacton In the area of technology-related risk there is another concern which in many cases is closely related to the wue of computer security. This is the risk posed by the fact that many countries have significant restrictions on the types of information that can be transmitted aa~ national borders, and limits on the manner in which information can be transmitted. As the number of transactions which must be cleared aCZ"OU national borders inacases, so does the concern over restrictions on the a~-bordcr transmittal of information. Cross-border transactions sin,nltaocously bring into play a number of financial institutions, in a number of countries. Given their need for timely and full information to speed the clearing and settlement of transactions obstacles in transmitting information can pose a risk for market participants. Some countries put restrictions on the sharing of information with a broad range of third parties ( for example, as is done in Belgium) while in other countries, there are few government-imposed restrictions. These two examples serve to illustrate the tremendous range in the amount of restrictions that may, or may not, exist in a given country. At the broadest level, we can divide TDF (trans-border data flow) restrictions into two categories. The first are "dired" TDFs, which include: technological restrictions, regulatory restrictions, and restrictions imposed by laws. This category of restrictions curtails the flow of information by directly preventing certain types of transactions. The second category is "ind.ired" TD F restrictions. These include: di.ff erences in accounting practices, restrictions motivated by concerns about security, cultural differences and differences in technological sophistication, and the general unwillingness of some market participants and financial institutions to expose their financial information to third parties (for instance, exposure through an information network such as that which is provided by Reuters). This category of restrictions inhibits the flow of information through the imposition of inefficiencies, rather than by directly preventing the transmittal of specific types of data. There are a number of restrictions which specifically aff ed the operations of banks in the clearing and settlement process. They arc: Restrictions on the types of data that can be shipped: for instance, limits on the transmission of both customer data (bank balances, notification of transfer or payment of fun~ the status of securities being held by the bank as a custodian, etc.) and limits on the sharing of risk information. Restrictions on the manner in which the data may be transmitted: for instance, technological restrictions, and regulations on encryption of data. Differing regulations on encryption of data can pose special problems: one country may require transmittal of data in a specific code, while another country involved in the same transaction may require that data be sent and rCCC?ivcd only in another code, and a third country may require that data nut be encrypted. Technological restrictions include those imposed by telecommunications carriers and those which are rooted in the culture and technological sophistication of a given country. There are also TDF restrictions which apply to the movement of information about the securities themselves ( rather than just the information affecting the payment process, as we have just discussed). For example, Japanese law prohibits the timely export (transmission across national borders) of real-time market information. (This restriction, and other interesting TD F restrictions affecting securities are discussed in the IBM report.) Page 164
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Study of International Ocaring and Settlement Risk Factors In respect to confidentiality a number of countries closely proted: access to the electronic flow of personal data. They include: Austria, Denmark, France, Germany, Luxembourg. Norway, and Sweden. In addition, Austria, Dcmnar~ Luxembourg, and Norway have all adopted legislation that would provide privacy protection to persons acting as corporations. In the countries where such laws have been adopted, privacy protection for persons acting as corporations includes restrictions on the collection, proai-.s-,,ing. storage, and transmission of personal data. Licenses may be required to establish and maintain data bases of information concerning the financial activities of a person, company, or other organizati'ln. There are also laws restricting the transrnis.sion of information to countries which do not have strict privacy laws. Some governments view financial information as vital to their national security. West Germany and Swiaerland both have ~cularly strong laws which, motivated by national security considerations, restrict the transfer of data. Most nations, with the notable exception of the United States, still have nationally-supported telecommunications monopolies PTI"s (Postal Telephone and Telegraph companies).47 PTT's may charge CXCCS.Uvc international rates, as tariffs to subsidize low domestic rates. Government regulations may also give local communications firms preferential rates compared to those charged foreign competitors. An example of this type of situation is the extra charge levied on users of electronic data transmission services in West Germany. As is noted in the Institutional Investor (October 1986, page 280): this extra charge in West Germany subsidizes "the local postal system to the tune of DM 2 billion to DM 3 billion annuaily ... PTr's arc also in the position of regulating equipment that can be attached to their communications systems. In West Germany, for instance, the PTr restricts the type of equipment which can be conned:cd to its communications systems. This restriction gives the inside track to domestic equipment vendors. This type of protectionism, while designed to su.pport the domestic communications industry, impinges on efforts of the securities industry to achieve international standardization. While technology offers a wide variety of ways to transmit information, the types of equipment that are in place to receive information vary even more between countries, and between various organizations within a given country. (Please refer to the IBM report, included in this study, for details on the diversity of technology for the receipt of information.) The point here is that even though numerous sophisticated information retrieval systems have been developed their existence is meaningless unless the systems are used. Many markets, and many companies., still have a relatively low level of technology. Charles C. Cox, in his paper presented at the XI Annual Conference of the International Association of Securities Commissions ( on July 16th, 1986), commented on cultural differences as obstacles in cross-national border transactions. According to Cox: "In addition to direct obstacles to the free flow of capital such as taxes, exchange controls, and investment controls, perhaps ~aler obstacles result from cultural and historic 47 -Natiooaily.upportcd in the sense of nationwide monopolies which arc either substantially protected by the goyemment, subsidized by the pemmcnt, or both. Page 16.5
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Study of International Qearing and Settlement Risk Pacton mf/emu:es in various national app,oadaa to capital formation. Disclosun!., auditing and accounting principles, trade processing, t1'ad4 and quotadon dissemination, market nuwiJlance, and enforcanen1 are all affected by such mf/emu:es." The following chart presents a sample of some of the restrictions that specific countries impose on the flow of information aaOM national borders: RULES AND LAWS ON TRANS-BORDER DATA TRANSMISSION Austria: said rules protecting confidentiality of personal electronic data Brazil: must use domestic labor and hardware for data proces.$ing requirements Canada: all basic financial records must be pr~d and maintained in Canada (but may be maintained elsewhere as well) Denmark: strid rules protecting confidentiality of personal electronic data France: customer-related information cannot be transmitted across the border Liechtenstein: seaecy rules prohibit banks from revealing names of customers Luxembourg: strict rules protecting confidentiality of personal electronic data Mexico: equipment used in transmitting and proces.sing data must be manufactured within the country Norway: strict rules protecting confidentiality of personal electronic data Panama: seaecy laws prohibit banks from revealing names of clients Switzerland: strict rules regulating data transmission across their borders United Kingdom: None for personal electronic information. "Official Secrets" blocking exists. United States: rmancial Privacy Law West Germany: processing of data must take place within the country, prior to international transmission over leased private lines. Postal Telephone and Telegraph companies (P'ITs) restrict hardware and favor local vendors, although there is no monopoly on modems per se. West Germany has strict rules on confidentiality of personal electronic data. The significance of the restrictions highlighted in the previous chart is most easily brought out by considering the simple act of two or more organizations trying to share risk information about market participants during a time of market turmoil. While a number of countries, such as Japan and the U .K., have reached agreement with the Securities and Exchange Commission on the sharing of information, the laws of other nations continue to make it difficult to share risk information. 48 Given the need to keep the credit pipeline open in times of trouble, restrictions on the cross-national border traosmis.sfon of data definitely add to bank and market uncertainty. 48 Foran example of the mechanisms used to circumvent these obstacles. pleue refer to the CFfCs FISMOU agreement included ia this study. Page 166
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Study of International Oearing and Sculemen, Rlsk Factors 3.11 DIFFERENCES IN CLEARING AND SETIUMENT PRACTICES: WORLDWIDE VARIATIONS Bi:IWEEN MARKETS There are many differences between markets when it comes to the procedures used in clearing and settlement. But not all of these contribute to risk. For example, there arc many differences between the clearing and settlement procedures used in the equities markets on the one hand, and the derivative markets on the other hand. It can be argued that these differences (which include margining practices, the time period for settlement of obligations, and the types of collateral which is acceptable) may not contribute to risk, because the practices employed by these markets arc appropriate for their needs. It could furthermore be argued that an attempt to modify clearing and settlement practices in markets (for example, along the lines of the Brady recommendation for unified clearing: the creation of a link between all clearing houses handling tramaction.s in all U.S. markets) could impinge upon the tendency of some markets to evolve with investor needs. Indeed, in an environment of unified clearing, an innovation such as today's swaps"49 market might never have developed.SO Differences in clearing and settlement practices between like markets ( that is, markets trading in the same type of financial instrument) arc seen most often when one looks at international trading. Such differences in clearing and settlement procedures for similar types of financial instruments may inacasc market inefficiency and the cost of doing business in a given market. But the differences, in and of themselves, do not necessarily inaeasc risk. Reviewing the expert papers submitted for this study, it appears that among international markets, there is an often implicit, and at times explici~ standard for the procedures involved in clearing and settlement and the amount of risk which is acceptable in that process. There is also some agreement on improvements which should be made in order to reduce the amount of risk in trading across national borders. The following list highlights some of these concerns: L There is a need for an international institutional securities delivery (ID) system, to help reduce the fail rate on international securities tr:tnsactions. (For more on this, please refer to the expert paper by Fred Hampton, included in this study.) 2. There is a need to develop standards for clearing house guarantee funds: whether they should be required, how large they should be, and what their composition should be. (For more on this, please refer to the expert paper by Joseph Kolb, included in this study.) 3. Many clearing and settlement systems, and many banking systems, need to improve their ability to respond to times of especially heavy trading volume. (Again, please refer to the expert paper by Joseph Kolb.) ff ~ arc trades of a panic:ularty complex nature. Instead o( the practice of one person making an ordinary cash pu.rcnuc of securities or other financial IA5U\lments held by a seller, the two panics UM>tved agree to an exchange of specific aaeu held by each individual These as&ets could be cash, securities. futures contracts. or any other type of nnancia1 imrrument. la addition. the two parties may agree to a schedule of payments, instead of paytng the entire amount on the senJement date. Thia point wu brought out in the course of a March 1989 interv,cw (done for lh1s study) of Profes10r Morris Mendefson o( the Whanon School of Business and Profes&0r Charles Mooney of the U DMnity of Penmytvmia Law School 51 Por more on the pc:aible impact of unified clearing on the smaller stcxk exchanges.. please refer ,o the expert paper by Philip Hubbaro, Beth Shapiro Kopin, and Peter Recd. in Appendix A of lhia report. Page 167
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Study ol lJltcmarionaJ Ccaring and SettJcmcnt Risk Pacton All of the expert papers contained in this study include similar references to implicit standards of performance in clearing and settling international trades. It would, however, require research beyond the scope of this study to accurately cWCSS the differences between markets in clearing and settlement standards. For example, from the viewpoint of many cultures, regulation of the process by moral suasion" alone that is, no significant degree of official government oversight would appear to provide market participants with inadequate protection. However, it may be that in some marke~ because of the culture of that country, the effectiveness of moral suasion could exceed the value of government regulalion in another country which ( comparatively speaking) docs not place a high cultural value on honor or moral suasion as a part of cvcryday life. As noted in the Mc.Kinsey expert paper submitted for this report, it may be possible to construct an international framework for the transformation of implicit' guidelines into explicit" standards for clearing and settlement. The emergence of such an international consensus on standards for clearing and settlement would enable the industry to develop a meaningful analysis of differences between markets. That is, it would be poSS1ole to distinguish between those differences between markets which represent significant risks, and those which do not. Efforts by the Group of Thirty, the Federation Internationale de Bourse dJJ Vaieurs (FIBV), tbe European Economic Community (EEC), and others have tried to move the clearing and settlement pr~ in the direction of international standardization, in varying degrees. Each of these organizations, from its own well-defined focus and viewpoin~ has outlined a series of recommended steps to move towards increased international standardization. An international conference, such as that proposed in the Mc.Kinsey paper, could build on existing efforts such as the recommendations of the Group of Thirty. The result could be a formal international agreement on standards for the clearing and settlement proccs.s.. Reviewing the expert papers submitted for this study, it appears that the potential does exist for the development of a formal international consensus defining performance and acceptable risk standards for the industry. Once that definition is in force, it will then be po~ble to determine which markets have true diff ercnces" in clearing and scttlemenL "Differences" in the sense that there is a significance in a particular market's divergence from international norms, as opposed to a technical difference (for instance, a minor difference in operating procedure) which may have no real impact. In the following chart, we examine the extent to which there arc internationally perceived ~.tandards for various aspects of the clearing and settlement process. For each perceived standard on the way things ought to be done in the clearing and settlement process, we will also examine which countries conform to that perceived standard: Page 168
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Study of lolcmalional Cl~ring and Sculcmcnl Ruk Paclon. The Outlook for tbe loleruaaUooal Staodardlzatloo of Cleari111110d Settlement: A compantJve look at 21 countrla la reaped to tbe queitlon of whether their eq11ltJe111 maarktu already baave the apMbllltla which arc recommended la ftve key Group of Thirty propoial1. Does country Perform trade Perform book-entry Allow the short-term Provide true delivery Make the payment already have companson settlement of trades loans of secwities to vs payment through an capability to: (matching of trade by immobilizing or fulfill the delivery settlement of trades c!cctronic funds information) demalerialinng obligations of (payment and system with same on T + 11 securities in a settlement 1 delivery of securities day finality of deposilory? are simuhaneous)1 payment? Australia yes DO yes yes DO Austria yes yes no DO yes Bdgium DO yes yes yes yes Canada no yes yes yes yes Denmark yes DO yes yes yes Finland yes DO no yes DO France yes j'eS yes DO yes Hong Kong yes DO limited yes no Italy yes yes limiled yes yes Japan yes DO yes yes yes Korea no yes no yes no Netherlands yes yes yes no DO Norway yes DO DO yes yes Singapore yes no yes yes no Spain yes no limited no DO Sweden yes yes yes yes no Swilzerland yes yes yes yes yes Thailand yes yes no yes yes United Kingdom yes limited yes yes limilcd Uniled States no51 yes yes yes no West Germany yes yes no yes yes 51 'lbc U.S. market, have commlllcd lo change 10 T t I by J 'J'JO. Today over 90"...t of hl>lcd ilnd NASDAQ trade, arc compared by T t I. Page lti9
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Study of International Cearing ud Settlement RiskFacton Most of this information was taken from a chart included in A Comprehensiw: View: The Group of Thirty's &commendations and tM CU11ffll U.S. Nalionai Clearance and Settlement System-, Morgan Stanley & Co~ NYC, June 1989. The exccptioa is the information on the United Kingdom, which was provided by the International Stock F:rcbanfV in London. In addition to the standards for equities markets demonstrated by the preceding implicit international standards are also evident in various aspca.s of the clearing and settlement procedures for futures, options, custodians, transfer agents, tuation, bank payments, and so forth. To dace, however, only the Group of Thirty has been able to traosiarc any subset of implicit standards into anything resembling an explicit set of industry standards. If there "WCre to be a formal effort to define and document international standards, hopefully this could lead to a broad
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Study o( International Cearing and Settlement Rilk Factors 7. There is no easy way for a market participant to compare the risks of various clearing entities. This is in marked contrast to other types of publicly available risk information. (The Reuters data base COUNTRY RISK, for instance, evaluates markets aa:ording to political and economic risk, other data bases evaluate banks aa:ording to the risks involved in their indigenous markct.s.) The prcccding list of informational risks ( each problem, by the way, is cli.scuMCd in more detail in other sections of this study) is not meant to be comprehensive. Nor is it meant to imply that all market participants experience all of these risb. Indeed, some market participants may not experience a single one of these problems. For example, there might be no informational risk at all for an individual investor trading through a fully disclosed broker on the NYSE, clearing the trade through the NSCC, with the securities certificates being held immobili7.Cd at the DTC. But in the international trading of equities and derivatives, these risks may be experienced more often and may have a multiplicative effect. These informational risks, which compound each other, arc: not knowing a clearing member's balance across a variety of bank accounts; not knowing the status of the securities being held at depositories or with custodians; and not knowing the position risk (the dc(lree to which a market participant could be affected by price fluctuations) of the parties involved in any given trade. Proposals to increase the sharing of risk information in general have not always met with agreement. and for good cause. A number of concerns have been identified Would the; various participants in networks for increased sharing of information know what to do with the newly available data? Wtii.le clearing houses would be able to ma.kc appropriate use of risk information affecting their own members, how would they use information on the balances of accounts in branches of international banks? And what about the banks? Is their understanding of the clearing and settlement process. out.side of the part which dircaly affects the~ adequate to enable them to use the newly available data to keep the credit pipeline open in times of market turmoil? These issues become even more complicated in cross-national-border trading. Page 6 of the Pacific Stock Evbaogc expert paper (included in this study) provides a useful discussion of this subject. Both that paper and the expert paper submitted by McKinscy (also included in our study), stress the need for international cooperation at the private and/ or public levels. In a review of the expert papers submitted for our study, it is apparent that there arc two areas in which productive action can now be taken. First, proposals to inaea.sc the sharing of risk information should be actively promoted Before this can be done, however, a consensus must be developed on the best way to share risk information. Secondly, market participants ( especially those outside the clearing and settlement process) should be educated on how to use the new data which would become available with the expansion of risk information sharing. It should furthermore be noted that unless the risk information about a market participant is complete (that is, it includes all of his open positions and credit exposures) the data could be misleading. Therefore, the sharing of INCOMPLETE risk information could act to increase risk, rather than reducing risk factors, which is the goal of risk information sharing arrangements. In an effort to reduce overall systemic risk, clearing houses have long been at the forefront of the trend towards sharing information with each other. However, many other potential users of this data (who arc outsi
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Study of International Oearing and Settlement RistFacton 3.13 RISKS ASSOCIATED WITH TAX WITHHOLDING AND TAX RECLAMATION Marc Simons and Keith Fulmer, in their expert paper submitted for this study, discuss the tax situation which international investors face: "Most fomgn counlriu impose an tax on dividends and inlerest payments paid by companiu whose suritia are issiud within their borden. These payments are received by U.S. investor! net of applicabk withholding taus. The amount of ta% withheld varies by country, asset~ and inW!Star tax status. &ciprocal tla treaties between the United States and most foreign govmunents allow U.S. investon to reclaim a portion of the tar withheld by fomgn govemnumts. TM dijfD'f!IICe ~m tM amount of. ua withheld and the reclaimabk portion is recogniud as a direct f omgn tar expense." Simons and Fulmer go on to give examples of how the status quo works in a less than efficient manner, a-eating risk for players in the global marketplace: "The timeliness in receiving the reclaimable portion of the withholding tax varies significantly by cowury. Certam countries, notably Italy and the United Kingdom, have been historically slow in remitting the reclaimable tax back to the U.S. investor. This has forced some U.S. invuton to reclassify this reclaim as reserves ( e.g. write off) instead of income." The chart on the next page, provided by Simons and Fulmer, based on one in the 1988 Price Waterhouse guide Corpo,au Taur A Worldwu:u Summary, desaibes the situation on tax treaties which affect investors in a number of major markets: Page 172
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Study of rntemationaJ Ccaring and Settlement Risk Factors Tu Treaties BetMen tbe U.S. and Foreign Countries and the Degree to Which Tua Paid by U.S. Investors are Refunded by Foreip Governments Pem:atap olbond Percentage Percentage Interest Percentage of Dividend& ofBoad thatsholakl ol Stock tbat should Interest be Withheld Intcrea be Withheld Number whichil accordillgto which ii According to of Country Withheld Tu Treaties Withheld Tu Treaties Treaties Arpntina 15.759& NA 17.,SK, NA 8 Austratia 10.009& NA 30.00% 15.00% 21 Allltria 0.009& NA 1.0.00% 10.00% 40 Belgium 25.009& 15.009& 25.00% 15.00% 41 Brazil 25.009& NA 25.00% NA 16 Canada 25.009& 10.00 or 15.00% 25.00% 15.00 or 0.00% 37 Denmark 0.009& NA 30.00% 15.00 or 5.00% 42 P'IDWld 30.00% NA 25.00% 15.00 or S.00% 46 Prucc 45.009& NA 25.00% S.00, 10.00 or 70 15.00% Hoag.Kong 17.009& NA 0.00% NA 0 lta!y 12.50, 15.00 or 12.SO or 15.00% 30.00% S.00, 10.00 or .JO 30.009& 15.00% Japan 20.00% 10.00% 20.00% 15.00% 38 Korea :S.00% 12.00% 25.00% 10.00 or 15.00% 26 Luxembourg 0.00% NA 15.00% 7.50% LS Mexico 21.00% NA 50.00% NA 0 Netherlands 0.00% NA 25.00% 15.00% 40 NewZeaJaad 15.00% 10.00% 30.00% 15.00% 21 Norway 0.00% NA 25.00% 15.00% 47 Siuppore 33.009& NA NA NA 0 South Africa 10.00% NA 15.00% NA 25 Spain 20.00% NA 20.00% NA 19 Sweden 0.00% NA 30.00% 15.00% 24 Switzerland 35.00% S.00% JS.00% 15.00% 22 Taiwan 20.009& NA JS.00% NA 0 Tbailand 10.00 or 25.00% NA 20.00% NA 20 United 27.009& 0.00% NA NA 83 Kingdom United 30.00% NA 30.00% NA 40 States West Ocrmuy NA NA 25.00% 15.00% so Reprinted from the expert paper submitted by Marc Simons and Keith Fulmer, page 8. Page 173
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Study of International Ccarin1 and Settlement Rist Factors According to Simons and Fulmer, the difference between the country withholding rate and the U.S. Treaty rate is that portion of the withheld amount which should be reclaimed by the U.S. investor. Theoretically a market participant can reclaim the taxes which he paid but did not owe, in the case of the most recalcitrant foreign government. But the judgement may be made that it is not worth the trouble. Robert Kay, in his expert paper submitted for this study, gets right to the point in his asses.crnient of the situation: procedurts for effecting a reclaim are count,y specific, but can be generally characterized a.r comp/a, manuaJly intensivf!, time consuming and in many cases only marginally productive." 3.14 RISKS ASSOCIATED wrra GLOBAL CUSTODIANS To the reader who is outside the financial services profession., the term "global custodian" may not carry much meaning Before disc:uwng the problc~-; aMOCiated with banks acting as "global custodians," we will first present two definitions of the term. Marc Simons and Keith Fulmer, in their expert paper submitted for this study, offer this definition of a bank which is serving as a "global custodian:" "TM role of the global custodian is to provide saf elaeping and income collection services for invaton inf oreign securities. As part of their saf elaeping responsibilities, the custodian oveneu tM settlement process ( exchange of cash for securities), provide. foreign exchange and wile transfer services, recei~ or delivers securities (in either book-entry or physicai certificate fonn ), and maintains proper records of customer transactions and securities held in ovmeas depositoriup bu:ome collection services inclut,k, collecting dividend and interest payments, notification of proxy or capital change information, and filing tax reclamation node es to f ortign tar authorities for rebates of taus withheld on income e.amed." Robert Kay, in his expert paper submitted for this study, defines the four specific roles of a global custodian: "a) ensuring its clients have a standardized interface for transaction information irrespective of the type of securities being bought or sold or the country of issue of the securities, b) ensuring its clients have a standardized f onnat for reporting and valuation of securities Juul in custody, c) em,uing its sub-custodians in each country receive standardized information conceming transactions irrespective of the client or fund manager involved, d) providing essentially an insurance protection to its clients that their interests, in tenns of physical safekeeping, protection of rights and entitlements, will be appropriately safeguarded." Page 174
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Study of International Cearing and Settlement Risk Factors The primary U.S. investors in international securities who use global custodians are U.S. pension funds. They held approximately S<,O billion in foreign auets in 1988 and arc forecast to grow to over $1 trillion invested m i.otemational markets by the year 2000. 52 U.S. retail investors are also entering the international market place via international and global mutual funds: $6 billion in international funds, $11 billion in global equity funds and S3 billion in global bond funds in 1988. 53 In servicing the international securities needs of investors, global custodians play an important fiduciary role. Like many other aspects of the clearing and settlement process, however, there are no international standards on global custodians: how many markets docs a custodian have to serve in order to call itself a "g.\obal custodian? how wide should the scope of services offered by a global custodian be? what yardstick should be to measure the effective performance of a global custodian? The tremendous variations that cmt between 0"83oizatioas calling themselves "global custodians" leave the investor to determine for himself whether or not a particular custodian's services are adequate. This can inject an clement of risk for the market participanL Kay, in his paper, comments on the problems faced by global custodians themselves. He indicates that custodians often arc put into a position in which events are beyond their control: 'TM fint problem faced by tM global custodian, is that the period between trade dale and settlmtml dau is not unifonn varying from 1 day to 6 weeks. In addition, efficiency of the local settlement system, whether involving physical movement of securities or book entry may depend heavily on the timellness of instructions received by the sub-custodian and local a.ecuting broker, as ~u as w consistency of such instnv:tions." He continues: "Thus the first issue faced by tM global custodian is that, through no f auJl of its own, it may be unabk to ensure settkment of a transaction, and not even abk to confirm it has passed accurau instmctions into the local settlement system, prior to contractual settlement dale. Secondly and related to the first issiu, is the /act that many local settlement systems involve no matdiing of transactions between parties prior to settlement dale, and none, except the Eurobond market, involve an aulomtlled matching process. The global custodian therefore has only /imiud opportunity to know in advance of settlement dale, that a trade is going to fail" Global custodians, and their customers, face a number of problems a.swciated with this lack of advance warning on potential defaults of payment or delivery. Problems which fall into this category include: foreign exchange transactions which may have been executed in order to be ready for settlement of the now-defaulting trade; the lack of market mccbauisrns to protect institutional investors or global custodians from the effects of bankruptcy of a countcrparty prior to settlement; and -in markets where fails arc the norm in settling physically dclivered securities the tendency of depositories and clearing house to wait several days before notifying a custodian that a trade has failed. 52 Plcuc see the expert paper submitted to this study by Marc Simons and Keith Fulmer, page 1. 5J Data on the intemational positions o( invat0n in other countries is not as readily available, and thus is not included in thil summary. Page 17S
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Study of lftternationaJ Ccaring and Settlement Risk Pacton There are a number of undesirable consequences which result from these problems. In his expert paper, Kay lists some of them: unanticipated counwparty risk, inability to provuu adequau mums on unanticipated idk cash balances, unpredictable ~ls of 'failed' trades, accidental acceptance of frrzuduknt securities." The Group of Thirty's recommcndatiom should produce considerable progress in reducing some of the risk fadors noted in the preceding list. There are, however, many other risk fadors associated with the global custody prOCCSL The following list of excerpts from the Simons and Fulmer paper highlights some of the additional risk fadors: Risks Associated with the Global Custody Process Risk Associated with Agent Banks and Networks54 Regulation Investment Knowledge and Services Busin~ Considerations Processing Standards "'IM lade of uniform regulation goveming the use of depositories and book-entry securities have raised a host of rtgUlatory and legal issues confronting investors inf oreign securitia." "Accounting and recordkeeping procedures vary widely among agent banks [sub-custodians~ Most sub-custodians were unp,q,ared to handle the vo~ of security transactions or the demands of periodic reporting required by U.S. investon." "The variability of intemalional bank regulations and local practices places a greater emphasis on the global custodian to ensure unif onnity of business practices among its agent banks." "Unfortunately, the investment opportunities presented in international markets have uncovered an array of disparate settlement regulalions aggravated by intensely manual recordkeeping practices. Risk Associated with Income and Collection of Interest Timely Collections "There is frequently a delay by agent banks in promptly crediting tM custodian's account on a timely basis, thereby raising the probability of interest being earned on the float [by the sub-custodian)." 54 Banks, acting as custodians, representing gtobal custodians in specific local markets. Page 176
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Customer Accounts Study of International Cearing and Settlement IUsk Factors unusua1 tnlding volumu, high inc~ collection periods or problems encounlertd in the recondlialion process can impact tM timing of income payment remiltancu to customers. Consi.rtmt iMJay$ in ~eiving inc~ paymmts has been a chronic problem to U.S. based investon. Risk Associated with Valuadoa ol Securities aad Nodllcadoa or Corporate Actioa Reliance On Agent Banks LacJc of tllllomllled sourcu and~ in procedures med IICIOU sub-autoduzns requin the global custodian to atablula Septllflle inlemaJ departmmts to vaify the accuracy and compktenas of information re~d by its sub-custodians . Risk Auodated with lnformadoa Technology Trade Capture Referring to the basically manual approach to this step: Information Services u! risks inhemat in this paper based approach are many; ( 1) lost tekcopia, (2) dala enlly errors and ( 3) inconsistencies b~m telex infonnation and corresponding secun'ties accountilrg data. ae lade of readily available securities information, such as security prices, corporau action notices and fundamentai data on compania, places an additionai burden on the custodian to provitl4 a more inf ormadonal based service." It is important to remember that even as action is taken towards increased international standardization of the clearing and settlement process, these improvements will be diluted in their impact unless there is also an effort to addrCM some of the concerns that now face global custodians. The clearing and settlement process, for many investors, is experienced only through their dealings with the global custodian and therefore the performance level of the process can only be as good as the performance of the custodian. Given that fact, the financial community -in enmining ways to streamline and improve clearing and settlement should take the broadest possible view of what constitutes the clearing and settlement proces.,. This means that the definition of organizations involved in the process should be wide enough to include those organizations which serve as the market participant's looking glass for access to the process. Kay, in his paper, also supplies a list of additional issues, issues which are at an even more technical level His summary of the state of global custody puts into perspective the manner in which investors in international securities may continue to see the clearing and settlement process: "Global custody is not for the 1aintMarted' or the naivt. It is a costly business involving control of massive and complex.flows of information, extensive technological investment and the use of e:xtemaJ resources disposed across the globe." Page 177
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Study of Intemational Oearing and Settlement Risk Pacton What would it take to achieve standardization in global custody operations? Unfortunately, as we can conclude &om the preceding di-.cu,uion, there arc many obstacles standing in the way of any degree of international uniformity in global custody operations. To achieve this goal, some of the changes which would have to be a part of the process would include: standardization of international tax treaties and compliance with those treaties; improved efficiency in informing custodians about corporate actions; and a movement away &om manual (paper-based) procedures and towards both increasc:d automation and more uniform levels of technology, from one market to the next. Those individual investors who seek to D'laiotaio physical certificates as proof of ownership will remain at special risk: since they would not reap the benefits of book-entry settlement systems (implementation of which the Group of Thirty has recommended be done by the year 1992). Investors imisriog on the use of actual physical certificates seem likely to continue to cause global custodians one of their most significant problems: namely, insuring succes.uul physical delivery of securities certificates to meet the obligations of settlement. Outside the United States, experience has shown that problems related to physical delivery of securities can result in a fail ( default) rate of as much as 40 percent on the securities settlement portion of trades. Pap 178
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STUDY OF INTERNATIONAL CLEARING Ai~D SETTLEMENT 4. TRENDS Page 179
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TABLE OF CONTENTS Section 4 Trends: Emerging Trends and Their Potential lmpUcations ror tbe Qearing and Settlement Proccss 4.1 Extended Hour Trading 4.2 lncreucd Globalization 4.3 Linkages o( Exchanges. Cearing Houses, and ~tories 4.3.1 Domestic Linkages 4.3.2 International Linkages 4.4 Regulation o( the Cearing and Settlement Procea 4.5 Crea-Margining 4.6 Netting 4.7 Automation o( the Cearing and Settlement Proccsl: Organizations Automating for the First Tame. or Increasing the Degree to which Their Operations are Automated 4.8 The Immobilization and Dematerialization o( Securities Certificates 4.9 The Sharing o( Risk Information Between Markets, Exchanges and Oearing Houses 4.10 Staadardi7Jltion o( Cearing and Settlement Procedures (Including Reduced Settlement Tames) Page 180 179 181 184 186 186 187 190 194 196 198 200 203 204
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Study of Intcmational Cearing and Settlement Trenus 4. EMERGING TRENDS AND TIIEIR POTENTIAL IMPLICATIONS FOR TIIE CLEARING AND SE'ITLEMENT PROCESS 4.1 EXTENDED HOUR TRADING (S11mmary ol Expert Papen by John McPartland and Kim Taylor, the Pacific Stock E:rcbanp and Randall Pozdena) Extended hour trading, whether it be through GLOBEX (the international trading computer system which is now under joint development by Reuters and the Chicago Mercantile Exchange), AURORA (the computer system which is being developed by the Chicago Board of Trade), or through the simple extension of trading hours of a given exchange, poses a number of challenges for clearing and settlement. In the United States, the clearing and settlement process operates by means of having the clearing home take the counterparty pogtion (that is, to the buyer, the clearing house represents the seller, and vice versa) at the earliest possible point in time after the trade is executed. The clearing houses then move the transaction along towards settlement. One of the steps in this pr~ is the conversion of clearing house risk into bank risk, by means of the payment pr~ in equities trades, or, in trades of derivatives, by means of the margin process. To accomplish this goal of transferring risk from the clearing house to the banks, clearing houses collect trade data from an exchange and process it over some fixed period of time. Simply put, clearing and settlement is a batch process acting in real time to an exchange with fixed, li.m.ited operational hours. ff trading on an exchange is extended either through the addition of several more trading hours, or a complete move to 24-hour-a-day trading, there is the possibility (in the first case) and the certainty (in the second case) that the c'tcban!v.'s trading hours would overlap the hours that the clearing house must use for the proccwng of trades. As a result, trades made during the extended hours would miss the current day collection process of the clearing house. Those trades would then have to be processed the next day. This processing delay could have the effect of inacasing risk for clearing houses because it would represent a lengthening of the period of time that a clearing entity would have to carry risk before transforming it to bank risk.l Several wucs will have to be addr~d in order to facilitate the implementation of 24-hour trading, especially if it expands to include equities. The Pacific Stock Exchange, in its expert paper included in this study identified several of these issues: The need for a system to monitor the as.sets of market players to ensure compliance with capital adequacy requirements. The need to improve the extent that various clearing houses and other clearing entities share information about market players who arc trading on more than one exchange. 1 Since 24-hour trading also allOWI on-going adjustment of positions. it also offers the potential of reducing risk. The CME and BOTCC, in their propoled 24-hour trading systems. will attempt to reduce the risk of overnight trades through the introduction of an additional intra-day margin call. Page 181
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Study :,( International Oearing and Settlement Trends The need for an increased awarencs., of circuit-breakcrs2: which markets have them, how they work, and their potential impad on 24-hour trading. The need for an expansion of the number of stocks which are eligible for netting through the Continuous Net Settlement, CNS, system. The need to develop guidelines for corporate actions such as cash and stock dividends, stock splits, stock listing., and delisting., which become effective on the following day. The need for improved aCCCM to information on the extent to which there is a market (i.e., interested buyers) for any given security or financial instrumenL Enmioiog t.he preceding list, one can see that there are fewer obstacles to 24-hour trading in the derivative markets, since some of the above concerns which relate to equities do not apply to the derivative markets. For instance, the derivative markets (except for equity-related options) do not have to conccm themselves with matters such as stock splits, dividends, aod listing.,. Therefore the derivative markets have become the first to begin extended hours trading. John McPartland and Kim Taylor, in their c:cpcrt paper submitted for this study, point out the chief problem that derivatives clearing houses would face in the ever-continuous world of 24-hour trading: By far CM main problem, from a clearing organization's perspective, is the absence of a 24-hour payment system: He goes on to explain that as trading continued round the clock, the financial risk to clearing entities would inaease. This is because, although a clearing entity during the night hours would be theoretically able to exposure and make a margin call, there would be no way to collect that margin payment during the hours that the banks are closed. Addressing this point, McPartland says: '7M a:tension of trading houn without a corresponding e:xtension in the hours during which funds can be transf emd with finality increases the clearing organization's exposure . We estimau that within two yean the clearing and settlement systems of the major 24-hour adtangu and the risk management andaccowuing systems of the major market pamcipants will the operational capacity to rmiove price risk from the clearance and settlement systems on a near reaJ-time basis and will have to sit idly by, as the clearing organization, guarantor of all trades, watches this price risk accumulate until the indigenous banking system opens the next busiMss day." In evrnining the need for a 24-hour payment system, we must also discuss a number of issues relating to the services provided by the Federal Reserve Bank, especially the FedWire for transfer of funds. The Federal Reserve understands that its method of operation does not meet market needs. Cu.rrently, dollar payments which must be made during the hours that the FedWire is closed are accomplished through such contractual conventions as time-dated transfers and provisional transfers. However, various FcdWire reform proposals are circulating both in the market and within the Federal Reserve to addrCM this distorted payment activity. 2 The term c:ircuit-breaken refen to limits on volume or price movement. For exampl~ a futures exchange may halt trading on a particular commodity whO&e price fluctuation has reached the circuit-breaker limiL On a larger scale. a stock exchange which is experiencing extremely heavy volume may shut down completely because of circuit-breaker limiCL Page 182
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Study of International Cearing and Settlement Trends In his expert paper submitted for this study, Randall Pozdena comments on three such proposals, each with several variations:3 (1) the provision of a 24-hour FcdWll'e nocration for the settlement of dollar payments; (2) the maintenance of an overnight settlement facility distinct frow the current FedWire system; and (3) the encouragement of foreign entities ( such as other central hanks) operating during the Federal Rcscrvc's nighttime to prO\lldc dollar settlement facilities. Pozdcna acknowledges that there arc numerous trade-offs to consider when evaluating the practicality and desirability of these alternatives. In any case, he not;;.5 that the Fed must weigh the benefits of an CJtendcd howdollar payment system against the disadvantages that could be involved in such a change. The disadvantages of estending FcdWll'e service could include: the cost of providing extended service; the potential risk for individual reserve banks; and the potential impact on the stability of payment systems and, in turn, the banking ~ystem. 4 There are several ways that both payment and banking systems could experience increased stress as a result of extending FedWll'e servicc:5 Currently, members of the FedWll'e system are allowed to go into an overdraft position during the day, but they must meet certain reserve requirements at the end of the afternoon ( which is when FcdWll'c service currently shuts down for the day). If an extended FedWU'e were to include nighttime overdraft privileges, banks could suddenly have a 24-hour period in which they could be in an overdraft position, a lengthy time period which would inaease the risk that they might fail to meet the requirements of the next FedWire bank reserves deadline. This conccm is based OD the idea that FedWll'e service could be expanded WITHOUT the addition of a second daily time deadline for banks to bring their accounts out of the overdraft position. If (instead of simply expanding the hours of operation of the current FedWll'c service) a separate nighttime FedWU'e system were to be established, it might also include a requirement for participating banks to maintain additional nighttime reserves.. This would impose new operating costs OD the participating banks. Since no interest is charged OD the intra-day aedit the Federal Reserve provides by virtue of allowing daytime overdrafts., there is no real market now for intra-day lending. 6 Currently, there is a market at night, because that is when the Federal Reserve's member banks frequently borrow overnight funm to meet the end of day reserves requirements. It remains to be seen what the impact on the lending market would be if the Federal Reserve were also to allow nighttime overdrafts. 3 These variations mainly pertain to different ways of treatil,~ the nricing of overdr.dt credit, and proposed changes in bank rescne requirements. 4 Pozdaa also dilcuaes certain upeas of the current daytime-onJy FedWire payment system which increase risk. risk whicb could be lessened through cbanges in tbc Fed's current procedures. Pozdena raises two issues: the way that pl'OYiding immediate finality of settlement througb the ccntraJ bank's account reduces the iucentive of the receiving Ulltitutioa to monitor tbc creditwont,incsa of the sending irwitution; and tbe way that the Fed's policy of not charging for intra-day credit reduces the incentive for member banks to net ~ymenrs, resuiling in unnecessarily large gt'06I credit cxpOIUl'CI. 5 For a more complete discuaioa of this subject, please refer to the expert paper by Randall Pozdena. submitted for and i.ncbaded in this snady. 6 W~ are aware of the Fed's current proposal to charge member banks for intra-day overdrafts. However, we will not consider this in our study. Page 183
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Study ol latcmationaJ Cc:aring and Settlement Trendll The Federal Reserve has indicated that there may be a systemic advantage in not providing an extended dollar payment system facility, in that the time in which the FedW-tre is closed can serve as a natural citcuit-breaker" in times of market turmoil. The argument here is that in the event of a problem, the 'down time' of the overnight hours provides Federal RcscrYC policy makers with some breathing roo~ time to analY7-C the situation and decide on what action, if any, might be taken when the markets reopen in the morning. In~ this circuit-breaker" philosophy has its parallel in the operation of the individual eu:baoges, which currently a1so close for a suhctaarial part of the night ( although this will change with the implementation of GLOBEX and other extended hour trading systems which will operate for most, if not all, of the nighttime hours). The excbanges, also have their own internal circuit-breakers, in the form of price fluctuation limits for the trading of any given stock or contrad within a given trading day. Clearing and settlement organizations arc, of course, just one of the many groups using the payments system in any country. The regulators who control the payments systems arc facing issues which are larger than those which affcd: only the clearing and settlement industry. Therefore, it is unlikely that any early solution will be found to the problem of developing a payment system which could reduce risk by keeping up with the continuous activity of 24-hour trading. What seems to emerge from this analysis is that a number of events will have to occur in order for a broad-based 24-hour trading market to evolve. 7 Even in the derivative markets, where there are fewer obstacles to the development of a 24-hour system, a switch to round-the-clock trading would still bring that market up against a PQWCrful stumbling block: the lack of a 24-hour-a-day payment system offering finality of settlement. 8 4.2 INCREASED GLOBALIZATION The phrase globalization of the markets means the activity of investing outside a firm's home market. While markets such as the foreign c,Tcbang~ markets arc by definition global, the markets for equities, financial futures, and options havebecome global only within the past decade. 9 A summary of a number of studies on the inacasc of globalization of the markets is included at the b--ginaing of John McPartland and Kim Taylor's expert paper. Similar data is also presented in the expert paper by Joseph Kolb. (Both expert papers have been included in their entirety elsewhere in our study.) Regardless of the extent to which globalization has already occurred, it seems reasonable to say that globalization is inacasing. Inaeascd globalization has imposed some additional pressures on the clearing and settlement process. Two of the most obvious results arc: a) the need for clearing systems to have a multi-currency capability to service not only domestic but also foreign market participants; and b) the need to develop standards on settlement of aoss-national border trades, including the question of in which currency trades should be settled, and the way in which the securities delivery obligation should be fulfilled. 7 Por a detailed disc:uaion o( this subject. please refer to the expert paper on the Pacific Stock Exchange, submitted for and indudcd in this study. 8 Por more 011 this subject, please refer to tbc expert paper by John McPanland and Kim Taytor, submitted for and indudcd in this study. For an example of an existing 24-hour market, please refer to tbe discussion of Foreign Exchange in Scctioa 3.3 of this study. 9 Por global physical commodities {gold, coffee, supr) the OTC began the process of iaternacionaJ regulation in 1975. Page 184
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Study of lotemational Ccaring and Settlement Trends Here is a list of some of the other concerns which have emerged as a result of the prCMurcs of inaeased globalization: 10 L A need for an increased ability to handle the additional volume camed by aoss-national border trading. (Kolb) 2. A need to improve operational cfliciency in various clearing entities, to reduce the fail rate OD trades. (Kolb) 3. A need to develop a standardized trade confirmation and trade matching system for the international trading of sccuritics. (Kolb) 4. A need to standardi7.c the time periods for the settlement of equities trades. (Group of Thirty; Daiwa) S. A need to immobili7.e securities by having the certificates held by depositories. (Kolb; Reiss; and the Group of Thirty) 6. A need, in equities trading. to shorten both the time between trade execution and trade confirmation and the time period between trade confirmation and the trade settlement date. (Group of Thirty) 7. A need to change the regulations in a number of countries in order to allow the practice of stock loan/borrow (that is, short-term loans of securities, usually held by custodians, to fulfill settlement obligations). (Group of Thirty; Hoewich/Ruetzcl) 8. A need for financial intermediaries to have access to SWIFT, an international bank-owned institution which provides an information network to its members. Banks, various exchanges and financial services firms use SWIFr to send each other mes.\agcs, including payment instructions. (Kolb) 9. A need to standardi7.c international law concerning the taxation of securities transactions. (Kolb; Kay; Simons/Fulmer) 10. A need for uniform listing requirements ( requirements for issuers of securities to disclose information pertaining to a company's financial status and operations). (Chapman; Nomura Securities) lL A need for common accounting and auditing standards to determine the capital adequacy of market participants. (Chapman) 12 A need to standardi7.e risk management (both risk management computer systems and other systems for evaluating risk). (Chapman) 13. A need to standardize the times at which clearing house guarantees become effective. (Kolb; Reiss) 14. A need for margin guidelines for the Over-The-Counter currency options markets. (Hubbard/Recd/Shapiro) 18 All of tbcse illuca, except taxation, are discuacd elsewhere in our summary of this study, as well as in the expen papen which are a put of this study. Por mere information. the reader is referred to the specific expert papen which are sugated in parentheses following most items on this lisL Pap l&S
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Study of IoternationaJ Cearing and Settlement Trends 15. A need to identify the steps needed to wure the finality of payments. This is necessary to ensure that settlement obligatiom will be me: in cases in which there are potentially different banking regulations, dilf erent payment prac:!iccs, different bankruptcy provisions, as well as the ever-present evbangc rate risk. (Hiatt/Kustusch; Reiss) 16. A need to provide proxy information in a timely and meaningful manner. (Kay) 17. A need for the definition of an official closing price on international securities. (Kay) 18. A need for uniform numbering of scc:urities, for identification purposes. (Simons/Fulmer; Daiwa) 19. A need to standardiz.c du. rules for calcui&ring the lost interest charges which parties defaulting on delivery must pay. (Nomura Securities) 20. A need lO inacase the me of technology to achieve on-line acccu to a broad spectrum of functions. (Hocs.vich/Ruet7.el) This list is far &om exhaustive and docs not include all of the recommendations from the experts who participated in our survey. The recommendations that we have chosen to highlight nonetheless reflect a broad spectrum of wues. Remembering that in our study, we have opted for a broad definition of the process to include the relevant aspects of banks serving as movers of funds, custodians, depositories, etc., it is not surprising that there are so many concerns about globalization. This list, and others like it, should not be construed to imply that glo~~aGzation will not inacase if these conditions are not corrected. Lists of this sort do, however, serve lw inacase awarenCM of the fact that the risks of doing business globally are very real and any attempt at reducing these risks will have to be multifaceted. 4.3 LINKAGES OF EXCHANGES, CLEARING HOUSES, AND DEPOSITORIES 4.3.1 DOMESTIC LINKAGES Evbangr.s arc already linked, informally, by the fact that many market players tend to trade on more than one cvban~ for the purpose of hedging and arbitrage. For example, an investor may hold in one market a futures contract on the Standard & Poors 500 index, while on another exchange, he may hold the actual stocks which comprise the index. Recngnizing this fact, and other investor needs, a number of formal links between exchanges, clearing homes, and depositories have developed. Evbanges themselves often enter into aoss-market agreements to off er offset trading. In addition, in the U.S., the CME and NYSE have entered into an arrangement to synchronize circuit-brcakcrsll in the event of rapid and significant market fluctuations. The purpose of these interactions are many. They range from perceived competitive advantage to better control over the markets (as in the case of CME and NYSE). A number of other linkages exw (for instance, the Chicago Board Options Evhange owns the Cincinnati Stock Exchange), and were instituted for a wide variety of purposes. 11 ID the equities markets. cin:uit-breaten refer to aucoma,ic limits on price nuctuacion. When price nuctuation reaches tbc level which trigen the circuit-breaker, trading will be halted: trading of one stock (if that is the circuit-breaker limit wrucb wu chaJJenpd), or trading on the entire en:hange (if the circuit-breaken for the entire exchange were cballcnpd). Pap 186
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Study of International Cearing and Settlement Trends Existing Unkages between clearing and settlement organizations in the U.S. include: the link between the Midwest Securities Trust Company (MSTC) and the Depository Trust Company (DTC), for the purpose of book-entry transfer of tide on securities. the link between the Midwest CcaringCorporation (MCC) and the National Securities Oearing Corporation (NSCC), for the purpose of trade matching. the link between the OCC and both the MSTC and the MCC, for the pledging of securities as collateral for options contracts and the settlement of exercised options conttacts. the link between all U.S. securities (including options) clearing houses The Securities Clearing Group for the sharing of risk information. the link between the BOTCC's lntcrmarket Information System and all U.S. futures clearing houses,. for the purpose of providing these other futures clearing houses with information on the status of individual clearing member payments. In addition, all U.S. clearing houses, on an informal basis, share risk information on clearing members who may be on the verge of default. 4.3.2 INTERNAnONAL LINKAGES This section discusses linkages between various organiv,tions in the clearing and settlement industry with the sole focus being the question of whether these linkages inaeasc, or reduce, risk. There is a worldwide market for an inacasing number of financial instruments which are traded on an ever-growing number of evhangr.s in various countries. Some of this trading is done through agreements linking various stock or derivatives excbaoges.12 Evhange linkages, however, have their limitations, and the complexities of exchange linkages can introduce difficulties in the clearing and settlement prOCCM. For example, McPartland and Taylor describe the delivery of currency conttacts traded through the SIMEX/CME mutual offset linkage as a complicated prOCCSL There arc two basic rea.wns for excbange linkages. rU'St, linkages between exchanges in different time zones automatically provide an extension of the how-s in which trading is possible. Second, linkages between exchanges provide a geographic expansion of the market for the product which is being traded. The number of linkages between CYchanges appears to be growing, despite the seemingly inherent operational limits of such ventures ( as already experienced by organizations such as the CME and the NASD with their linkage partners).13 Because of the complex arrangements that are typical of such linkages, they may inaeasc the overall systemic risk depending on the structure of the arrangement. Linkages between clearing houses, on the other hand, have been aeated to reduce overall risk. Similarly, linkages between depositories, where they exist, offer another level of risk reduction for the equities markets. 12 Exdlange linkages are dilcuacd botb by John McPutJand and Kim Taylor and by Robert Rcisl in the expert papers they submitted for tbil study. ll Pteuc refer to the expert papen by Robert Rc:isl and by John McPartland and Kim Taytor included in our study. Pap: 187
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Study of InternationaJ Oearing and Settlement Trcndl Linkages between clearing houses (such as those between the International Securities Clearing Corporation and a variety of clearing cntitie., outside the U.S.) are often established to simplify the clearing and settlement process for international trading. Arrangements such as those made by the ISCC therefore act to reduce risk in the clearing and settlement procesL Linkages, of course, also exist at a more primary level: within a given country. These arrangements between clearing houses, again, are set up for a variety of reasons, all related to risk reduction. Linkages also exist between a number of depositories. Internationally, the concept of linking depositorie., recently received a boost &om the European Economic Community .. Study on Imp,ovonents in the Settlemmt of Crou-Border Suritia Transactions in the EEC, by Dr. Joerg-Ronald Kessler. Kewer concludes (beginning on page 54 of his .report) that the linking of depositories in various EEC countries would tend to a,itigat.-: the costs and risks of trading aaoss national borders. The following chart lists some of the formal links between markets ( excbaogr.s, clearing houses, and depositories) and the reasons for those linkagcs.14 EXAMPLES OF LINKAGES DEPOSITORY LINKAGES MSrC for cuatody, book entry mOYCment o( U.S. issues; and SICOV AM (Prance) Ccantdian Depolitory for Securities (CDS) for settlement and delMry of equity and bond aacl exemacs; West Canada Oearing Corpontioa AXV for German securities kept in safe custody in Germany and on behalf of foreign account holders; O!DEL {Luxembourg), Euro-Oear (Bruaell), ClK (Brussell), JSCC (Tokyo) Vancc~r Stock Exchange to allow memben to move positions between West aacl Canada and CDS OD a book: entry basis; CDS VUCOUYet' Stock Exrbange for book entty mcwement of U.S. stock issues; and Midwest Securities Trust (tJ .S.) PKV (Germany) NECIGEP, OEKB and SICOV AM act as third-pany and custodians ia respect to securities which are deposited NECGEP (Amsterdam), OEJCB (Austria) and SICOV AM with FKV; (Paris) AXV (Germany) AXV provides lcpi accesa to FKV for CEDEL. and Euro-clear, CIX and JSCC; PICV (Germany) 14 Thil dwc is baled OD publidy available infonnation. This study, and this ctwt. do not discuss linkages which at this point baYe merely been proi,osed. Thia study and chart. similarly do noc discus& thole linkages which are not in the public domain at thil time. Therefore, this list of linkages is not comprehensm:. Page 188
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Study of International Ccaring and Settlement Trends CLEARING HOUSE LINKAGES MSI'C/MCC for campariloa, deuiDg and settlement of USA and IDd C.nediea equities; VIIICOIM:I' Stock Exr:haage SaYice Corporation MSTC/MCC for campari1oa, dearing and settlement of U.S. and IDd UJC. equities; lntemationa& Suxt EIICbaage. Loadoa JSCC (Toqo) aa:aa to foreip man.et securities clearing for Japanese and aa:ouat holden; CDS (Canada), Arv (Ocrmaay), ISE (Loadoa), Madrid Stock E=ange. NASE (Amstmlam), SICOV AM (Puia) EXCHANGE LINKAGES NASO and Stock Exdlaage of Singapore a.m and SIMEX (Sinppore) Trana Cuada Oprionl and occ link for quotation of selected NASO stcxks in Sinppore; for offset trading; OTHERLINKAGES for facilities management of ace Canadian office. We have established that there arc presently many linkages. It is not clear whether these linkages have actually removed or introduced risk and to what extent. None of the experts who participated in our study recommended either an increase or a dcaease in the number of c.'tcbangr, linkages. Another point, however, was brought out by those of our experts who did discuss cvbangr, linkages in their papers. They suggest that the implementation of a true 24-hour trading system would eclipse the significance of these linkages. This is because the 24-hour trading systems now being developed would provide brokers with the ability to make trades directly on many excbanges, without having to go through a formal cvbanv, linkage (the current system for such trades). Almost without exception, all of our experts identified strong arguments in favor of further linkages between clearing houses. (There are disagreements, however, over the best way to accomplish this goaL) Only the U.S. experts participating in our study di.sawed the question of linking depositories. This may be because the U.S., compared to other markets, has a relatively large number of securities immobili7.ed in depositories. But the conclusions of the EEC report make it clear that the advantages of depository linkages are well understood in foreign markets and an increase in the number of those linkages is probable. Page 189
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Study of International Oearing and Settlement Trends 4.4 REGULATION OF TIIE CLEARING AND SETrLEMENT PROCESS There is a significant amount of regulation of the clearing and settlement process in most countries, except in those which rely solely upon moral suasion. An in-between case is those clearing entities which are supervised by means of rule reviews, in the absence of inspections. In some cases, regulation is done at the national level (for example, as in Japan), while in other cases, the regulation is handled at a local level within a country (for example, as in Vancouver, Canada). In still other cases (for example, as in New aafauti), an CTcbaugrmay be regulated by more than one government agency.15 Even within a single country, regulation of clearing and settlement operations can vary substantially from one market to another. In particular, variations can exist in the ways in which (and the degree to which) governmental agencies share regulatory authority with self-regulatory organiz.ations (excbaug,-.s, the clearing agencies themselves, or both). Variations can also exist in the extent to which governmental regulation is clearing and settlement specific" (i.e., the extent to which regulatory objectives arc clearly defmcd with reference to stated clearing and settlement activities and policy goals). In the United States, the Securities and Etcbauge Cornrni&sion (SEC) has authority over all equities and equity-related options. The Commodity Futures trading Commission (CFTC) has authority over all futures contracts (both financial futures and commodity futures). The CFTC also has authority over options on futures traded on the futures e,Tcbauges. The Federal Reserve Board and the Comptroller of the Currency regulate the banking industry. The following chart outlines the aspects of the clearing and settlement process which are regulated, both in equities and equity-related options, and in the futures markets: 16 15 The compuatiw: effectm:ncsa of either locaJ or split responsibility regulation cannot be inferred from this snady. 1, In futures contnct markets clearing o~nizations are considered part of the contract market. In this respect the CEA. u law, differs from tbc SF.A which speaficaJly references ciearing orpniDtions. The CFrC's authority over clearing Orpnmtiona bu been upheld by the courts in the case of BO'fCC VIL CFJ'C. Page 190
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Aspect of Regulation Ocarins and settlement entities rqu&atcd witbin a compn:bclllive national SJIICIII. stana~ Ceuing and scttlemeat ldiYities regulated pursuant to defilw=d, dearing-oriented staada:rdl md objcctiva. Study of International Oearing and Settlement Trends Regulatory Proanma ror CJearma and Settlementl7 Regulatory Propama of the Seauitiea Ocarins Apndel (iadudin1 optioaa, aduding tralUria) Sections 3(a)(23), J(a)(2S) and 17A of tbe Securities E.xdwlge Act of 1934 rsEA1 Rqulatory Propama of the Commodity Futures/Futures Ocuing Orpnizatioaa No comparable statutory pl'OYision.18 Secriom 17(b) and 17A(b) of No companble statutory provilioa.19 the SEA. Rqulatioll of self-regulatory Sectiolll 17, 17A(b) and 19(d), Section Sa(8) of the Commodity Exchange Act (CEA) actioaa (member dilcipliDc; 19(h) of tbc 51:A (applicable (contnct nwtets, not dcaring organiDtions per se, SRO performance) to bodl achaaga and required to enforce rules).20 ctcarin1 agencies). Review and Sectioaa 19(b) and 17A(b) of Section Sa(12) of the ceA (approval and disapproval) approval/dilapploval procesa the SEA. and CFrC Regulation 1.41 (defining contract market to for deamg apncy ru1eL illdude dcaring orpnizationa for purposes of rule review procea); Section 8a(7) (alteration or supplementation).21 Pnmiutioa of dearin1 recordl and facilitia. Sectiolll 17(b) and 17A(d)(3) Scctiona 6(b) and 8 of the CEA. and Scctioa 19 of tbe SEA. As for the regulation of acm-national border trading, that is an entirely different matter. U.S. regulators have taken the position that trades executed abroad on behalf of U.S. clients should be afforded some degree of regulatory oversight by U.S. regulators ( an example of this is the regulatory arrangement for trades in the United Kingdom). How successful this approach will be remains to be seen. Equally interesting will be the evolving control sought, or not sought, by non-U .S. regulators over transactions executed on U.S. exchanges (for example, through the GLOBEX 24-hour computer trading system now being developed by Reuters and the CME) by non-U.S. customers. 17 Cwt provided by the Options Oearing Corporation. 11 The CFTC requires contract mutcts to pl'OYidc a clearing ability. (CP'rC Interp. Letter No. 82-S, June 15, 1982.) The arrc hu authority to ~uire clearing o~tiona to submit ndcs to the CFTC. ~g!j~~e~= vs. 19"-1980 Comm. Put. L Report (CCH) para. 20,534 (D.D.C. January 11. 1978L u:raie Cearipg Corp. vs, CfIC, No. 78-1263 (D.C. err. Mardi 29, 1979). Based on information provided by the CFrC. 1' HOMM:r, tbe CFl'C spccuica IWldarda in rula and rule enfon:ement reviews. Based on information provided by the arc. 21 The marbt's obliption exicndl to enforcement ot clearing orpnization rules. Baled on information provided by the CPTC. 21 Sectiona Sa(12) and 8a(7) both exclude from CFrC jurisdiction rules relating to the setting of levels of margin, not indudinl optioDL Page 191
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Study of International Cearing and Settlement Trendl The following chart highlights a sample of 23 major clearing entities located in 15 national legal principalities: CLEARING AND/OR SErrLEMENT COUNTRY INS'ITlUl'ION REGUIATOR METHOD Allltnlia Australiu Stock Exchange National Companies and RuJe reviews. moral suasion Securities Commission Allltrlldear Limited None directly Buic:aily self-regulated Brazil Bola de Valores (Rio de ComiluodeValorea Rule reviews, inspection, moral Janeiro) Mobil.iarioca (securities suuion commiaion) Canada Tram Canada Optioal 10 provincial securities Rule review at provincial level commis&iona VaDCOUYer Stock Exchange Office of the Superintendent of Inspection at provincial level Finaoc:iaJ Institutions of the Province of British Columbia Denmark Vocrdipapircentralen Danish Banking. Insurance and Rule reviews, inspection Securities Supervisory Authority Hong Kong Hong Kong Securities Ceariag Securities and Putun:s Buically self regulating Company, Ltd. Commillion Japan Tokyo Stock Miniauy Of finance Rule reviews. inspection Malaysia Kuala Lumpur Stock Exchange Securities Cearing Automated Rule reviews Network Services Luxembourg Baune de Luxembourg GoYemment Commillioner Inspection NewZea1and New ZeaJand Stock Eichange Justice Dept.. New Zealand Rule reviews by Justice Dept., Securities Commission ActiYe co-operation with Com.mission Sinppore Securities Oearing and Stock Exchange of Singapore Rule rev;ews, inspection Computer Services (Pte) Ltd. Ltd. and The Monetary Authority of Sinppore Switzerland Zuric:b Stock Exchange Canton of Zurich. Stock Inspection Exchange Commilll.riat UK ICCH Securities lawstments Board Rule reviews. inspection Uruguay Bola de VaJorea (Montevideo) SRO (Self Regulated Mora! suasion by Central Bank Orpnization); Central Bank of Uruguay Page 192
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CLEARING AND/OR SE'ITLEMENT Study of International Cearing and Settlement Trends COUNTRY INS1TIUl10N REGUL\TOR METHOD USA Doud of Trade Oearin1 Corp. Commodity Futures Trading Rule reviews, inspection Commillioa KCBOTCC Commodity Futures Trading Ruic reviews, inspection Commilliioa Midwea Securities Trust Securities and &change Rul~ reviews, inspection Company CM,miflioal. Pedcnt Raene Bond, State of IlliDoil Dept. of Baking NSCC Securities and &change Rule reviews, inspection Commiaion DTC Securities and P.xcbange Ruic reviews, inspection Commi11ioa. Pedcnt Raerw Bank Qicago Mercantile Exdwlp Commodity Futures Tl'ldiq lluJe reviews, impectioa (Ocaring Houa Division) Commiaion occ Securities and P.idlanp Ruic reviews, impection Commillioa West. Germany Frankfurter KaacnYerein AG Buadaaulsichtaamt fur das Inspection Kreditwesen. Bertin -Based on the preceding sampler of regulation affecting trans-national border trades, the following conclusions can be drawn: 1. Regulation of clearing and settlement entities, at the national level, is not uniform around the world: there are great diff crences in the manner and degree of regulation. 2 Within a country, regulation may be performed at the national level, at a local level, by a single agency, by more than one agency, or by the clearing and settlement agency itself ( that is, a self-regulated organiz.ation, or SRO). 3. One should bear in mind that where rule reviews arc present, the rules themselves may not be at the same level of protection between one country and another. Differences in national practice and expectations can aeate additional risks (for example, the closing of the Hong Kong Stock Evbange in Odober 1987). 4. Cr~national border trading may be difficult in an environment in which there arc not only international differences in operational procedures, but also differences in the degree of surety provided by regulation. It is not powblc, at this level of analysis, to gauge the effectiveness of each regulator within the confines of a study such as this one. It is p0Wblc, however, to form some conclusions about the difficulty of doing aoss-bordcr trades: simply as a result of the vast number of regulatory agencies involved, particularly in dealing with evbangcs where rule reviews and inspections are not performed. Page 193
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Study of International Ccaring and Settlement Trendl Clearing houses also act as SRO's in a very broad sense: they have the right and obligation to police their own members. Policing may take the form of requiring additional collateral, or, a suspension of a member's clearing rights. The degree of uniformity in these practices is of some concern and cannot be adequately userted to be uniform, either within a given country, or internationally.22 As noted in our introduction, clearing and settlement is not a uniform industry, especially internationally. Compounding differences in ~nal procedures, the differences in regulatory approaches may add additional degrees of risk.23 These risks may be further compounded if the effectiveness of a given regulator is deemed wanting. It is important to understand that the risks imposed here arc related to investing in international instruments: a customer of one country buying a 6aanrial instrument in another market. The risks come from the fact that the settlement will always be in the home market of the traded instrument. Certain home markets, due to differences in reg11lario11 and other factors, will tend to produce greater delays in settlement, aeating greater risks for collection and disbursement. 4~ CROSS-MARGINING Cnm-marginingis the practice of reducing the total initial payment obligations of a market participant by allowing clearing members who trade on more than one e.'tcbang~ to reap the offsetting benefits of their open positions (i.e., a loss on one CTCbanr, offset against a gain on another evbangc ). This type of offsetting is done when complementary financial instruments are involved: for instance, derivatives which arc commonly purchased together for the purpose ofaeating a hedged investment strategy. An investment strategy of this type could find the investor owning an option on the Standard and Poor's 500 index, on the one side, and a futures contract, on the other side, which is tied to the Standard and Poors 500 index. Addres.mlg the subject of a~-margining. Hiatt and K~ in their expert paper, state: "OCCbelieW!s that properly structured cross-margin agreements (whereby either one clearing organization or two clearing organizations working in tandem maintain a security interest in all of tM intermarlcet positions of a clearing member) will greally enhance the financial integrity of du marlcetplace, while at du same time providing du necessary margin relief for market paltidpant.r.,, Exhi"bit A in the Hiatt and Kustusch paper lays out some fairly dramatic potential benefits of a~margining, based upon data &om the OCC and the CME on the aoM-margining of financial instruments which naturally tend to hedge each other.24 Roger Rutz, in his expert paper on the Board of Trade Clearing Corporation, offers a contrary view. He suggests that acm-margining (between the BOTCC and the CME) would NOT greatly reduce the size of the payments owed by BOTCC clearing members, and in tum the size of the overall cash flow at the BOTCC. Rutz states: -22 Owr and be)'ond the quaaioa of variations in the degree to whidl daring bousa are willing to police their members is tbe matter of vuiabOal in technology. Thae allo cu affect a daring bouae's ability to both recognize risk and identify potential policy iaua. 23 Tbe Orpniutioa for Economic Co-operation and Devdopmcnt plOYides a comprehensM di.scuaion of regulatory diffetenca in its November, 1988. Financial Manet Trends report Amin~ for tJw Rqularioll and Supawion of Sunlia Mllllcs in OECD COWlll'ia. 24 Por more oa tllia subject. please refer aJlo to the Securities and Exchange Commission report on the Marltet Break: Chapter 10, paps 57 and 58. Page 194
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Study of International Cearing and Settlement Trends ". only 7.0 percent of the total dollar value of settlements could have been avoided where tJw dollar~ of settlentena aueded $5 million." This conclusion, and other analyses in the Rutz paper, arc based upon data from the CME/BOTCC reftectlg total cam payments to the clearing houses. Regulators haw: approved applications from the CME and the ace to aoss margin stock index options, futures, and Ol)bODS Oil futures. John Behof, in his expert paper submitted for our study, provides an outline of the essence of the CME/OCC aoss-margining plan. According to Behof, participation in aoss-margining will be initially limited ~o clearing members trading for their own accounts ( as opposed to those of their customers). Participants would be allowed to plcdgc option positions to banks as collatcr~ and, there would be a standardization of the financial UISb'Ulllenm which both CME and ace accept in payment of margin computed according to the cross-margining method. Payment of margin and ~ums will be through joint bank accounts held by the CME and the acc. Behof makes an interesting observation about the CME/ace aou-m~ plan, in discussing the fact that it will exclude most CBOE market-makers (floor tradcrs)2S, CME locals (floor traders), and other non-clearing member 'professional' traders. Bchof notes that it may be difficult to interpret the data from this aou-margining plan (once it is underway) in respcd to the question of whether the cash freed up by ~margining would be then made available to fuel a greater volume of market transactions. The reuon i. litial data may not answer this question is because it would pertain only to clearing members, and whatever credit policies banks demonstrate towards clearing members may not be the same as those shown towards the non-clearing members who will not be a part of the initial pilot program. Bchof also bring., up another interesting subject, in his c:liscuwoo of the suggestion that the equities markets should move towards the system of margining which is used in the futures markets (initial margin plus variation margin payments for every day that position risk inaeases). According to Behof: "Some p,oponmts of more m,olutionary systma-widt: ~asuru than crou-marginingwould "II" that aoss-margining ... is~ but of fairly low impact in ~lieving liquidity isnus in a crisis. but solution for liquidity prob/mu, they claim, would be to convert the dif/emtt settlement systems for stocks and options to a daily settlement system." He contin~ "17ais 'futura-styk' margining system would mark-to-market [ calculate the daily change in the value of a market participant's holding.,], pay out gains, and collect losses on a daily basis for aJl stocks, options, and futuru positions . Proponents of this system say that 'futura-styk' margining would not only solw cash-flow problems of intermarlcet spreads ffor aampk, a large margin paymmt is owed in OM market, but money is owed to the pa,ticipant in anothtr market J but would also improve the integrity of the overall financial marled '~' by limiting the tinw ~en trade execution and settlement." 25 Bodi tbe CME and OCC, however, are committed to eventually including profeuionaJ traden in crca-margining. Page 19S
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Study of International Cearing and Settlement Trends Bchof seems to indicate that ~margining with bank financing26 might be a more feasiole solution for cash flow problems in the equities markets: 'TM implanentation of a 'pay u you go' margining system in stocJc.r and options may or may not be tM right way to go, but would intlOlw! a major rutructuring of the way equities and options ar, tratJed Ooa-margining with bank finandn& on the other hand, can be implelnenud within tM cummt market structure without any major changes in the way these di/femat markm operat& Thu evolutionary approach can In implemenud quiddy and be in plaa whik tM tMbau continua u to WMther morr major structural changes such as 'futwu-styk' margining tW Me/WL" Behof also sugcsts that crou-margining. had it been in place, would have been helpful in reducing some of the pr~ures which many market participants experienced during the October, 1987, market break. In advancing this theory, he Qplains that because of the market break, many clearing houses tripled their margin requirements, aeating additional demand for financing at a time when the banks were also tightening up and aedit was significantly I~ available. Behof suggests that aoss-margining could have cut down on the amount of margin that was required and, as a result, the overall demand for acdit from the banks.r, 4.6 NEIIING We have already discussed the practice of netting, and the ways in which it is used in the foreign excbauge markets (see Section 3.3: ms1cs .Associated with Fo~ign Exchange", of this study). We will now discuss two other aspects of netting: the netting of offsetting securities holding., (positions) and the netting of futures margin obligations. Among the world's major equity markets, very few allow the netting of securities holding.,. Some of the markets which do offer securities netting arc: Canada, Japan, and the United States. The netting of securities is a practice which reflects the fact that many market participants engage in trading which consists of multiple trades (both buys and sells) of the same security within a single trading day. The movement towards allowing the netting of securities (offsetting the amount of securities owed to and owed by a market participant) is also a reflection of the growing institutiooalizatiiJn of the markets and the atrophy of the traditional equities market philosophy of "buy and hold.,. In this evolving market environment, it is apparent that a firm's obligation to deliver or receive securities, and receive or make payment, is really a function of the net of the trading firm's position at any given point in time. In equities trading, just as would be the case in the foreign exchange markets, the absence of netting can only serve to inaeasc risk. This is because without netting. the trading firm is obligated to effect settlement on every transaction: a practice which inaeases overall transactional costs and at the same time inacases the possibility that the trading firm will be unable to meet its settlement obligations. 2' "with bank financill( This ii a reference to market participants being allowed to pledge (to banks, as collateral) option paatiorw mataincd m a croa-margi.a aa:ounL rt During tbc October 13 and 16, 1989 market volatility, the OCC/CME c:roa-margiDing program resulted in reduced DIUJUI payment by $164 millioa for the two fU'IIII participating in tbe pilot. (Prom the statement of the Honorable Richard C. Breeden, Cwnnan. SEC, before the Subcommictee on Telecommunications and Finance of the House Committee 011 Energy and Commerce, October 25, 1989.) Page 196
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The Group of Thirty addrCSM:S this point in its report: Study of International Cearing and Settlement Trends "For high-volume markets with a high concentnztion of transactions among participants, some form of netting of transactions and clearanc~ of tradu between and among market participants can minimiu risk and costs." To what extent is netting available in international markets? And what kinds of differences exist in netting methods: on the one hand between countries, and on the other hand, between various clearing entities within a given country? In a survey done for this study, 32 clearing entities in a total of 17 countries responded to our questions on these issues. The following chart highlight~ their responses: Cowatry Australia Brail c.anada Denmark Egypt Ocrmaay HonglCoog llracl Japan MaJa),lia Lunmbourg NcwZeaJand Singapore Switzerland United States Uruguay Numbcrof lmdtutiona laYoMd in Ccuing and Settlement Who Rapondcd to our Suniey 2 2 3 .1 1 1 1 1 4 1 1 1 1 1 s 1 Are trade poaitioas netted each day? dependl oa eadl dearing house ya IIIOldy yes, it depends on each clearing house no ya no no ya IIIOldy yes, it dependl on each clearing house not daily, but weekly not daily, but thn:e times a week DO ya no moltlyya no As the preceding chart demonstrates, there is a remarkable degree of diversity in the availability of netting. In some countries the netting of securities IS available: but only on a periodic ( once a week, for instance), rather than continuous, basis. In other countries, such as Canada, netting is permitted for securities trading but it is not allowed at all in the futures markets. Because of the suc:ccs.uu1 precedent of netting aaoss national borders in the foreign exchange markets, we know that the potential exists for netting aaou national borders in the trading of equities and other financial instruments. The advent of 24-bour trading, through the GLOBE< or AURORA computer trading systems now under development, could aeate the opportunity to continuously net or aou-margin global positions. This is not poMible now, because continuous netting of global positions would depend upon constant access to price discovery and trading information. Page 197
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Study of lntemational Ccaring and Settlement Trends 4.7 AUTOMATION OF THE CLEARING AND SE'ITLEMENT PROCESS: ORGANIZATIONS AUTOMATING FOR TIIE FIRST TIME, OR INCREASING THE DEGREE TO WHICH TIIEIR OPERATIONS ARE AUTOMATED In this section, we will discuss the trend towards the use of additional technology in clearing and settlement. (Please refer to Section 4.8: "Tiu Immobilization and Dematerialization of Securities Certifkatu", of this study for a discussion of depositories and the immobilization and dematerialization of securities certificates, a topic which is closely related to the wues wc will cover in the next few pap.) For the purposes of this study, wc surveyed clearing and settlement entities in a variety of countries and asked them to assess the extent to which the clearing and settlement prOCCM is automated. Each was asked to judge whether the clearing and settlement processes in their home market are primarily electronic, primarily paper-based, or a mixture of both. The following chart outlines the responses of our survey participants: Are the interfaces between the clearing member firms and the clearing and settlement systems in the Are local clearing systems Are I~ settlement systems country primarily electronic, primarily electlODic, primarily electronic, paper-based or a Countly paper-bucd or a paper-bucdora combination? combination? combination? Allltl'l.lia clectJoaic combination combination Brazil electroaic combination electronic Canada combination combination combination Denmart elcctrmic: elcctroaic electronic Egypt paper paper paper France combination combination NA Hong Kong paper paper paper Isncl elecm>aic electronic combination Japan combination combination combination Malaysia combination combination paper Luxembourg paper paper paper Netbertands electronic electronic combination New Zealand electn>nic electronic electronic Philippines combination combination paper Sinppore paper paper combination Spain combination combination NA Switzerland electronic elcctroaic electronic Taiwan elccm>aic paper combination United Staaca combination combination combination Unaguay NA paper NA West.Germany elc:ctJonic electronic combination NA question not amwered by any respondent Page 198
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Study of International Oeariag and Settlement Trends Despite the fact that data from a number of European clearing and settlement entities was not available, the preceding chart does serve to highlight the degree to which the worldwide clearing and settlement process is based on non-automated procedures. Especially notable is the degree to which, outside of the U.S., the interface with market participants is through non-technological means. Joseph Kolb comments on this in the expert paper he submitted to this study: "Whik settling trades in the major capital markets l110U1ld th~ glmH, market participants in many cases are highly ~ndent on local institutions to function as ckarance and settlement agents. While some of thae institutions tn adept at electronic communications, many still function through manual telex inst1uction and inf,tquently maikd statements. In addition to impeding efficient settlement of cross-bordB' transactions, the lade of timely communications of instructions, cash, and surity positions rtduca a mar/cet participant's ability to control his assets." Further automation of the settlement pr~ would, hopefully, provide improved protectioa against the effects of sudden surges in trading volume, but this improvement would only exist to the extent to which the ENTIRE clearing and settlement pr~ (including all its interfaces) is automated. To begin with, let us examine the potential impact of introducing a U .S.-style Clearing and Settlement system into a country which has a comparatively less well-developed technological base. The introduction of such a technologically sophisticated system into a market which docs not have the personnel or training to cope with its operation and maintenance might all~viate existing risks, but new, more significant risks would be imposed as a result. Kolb makes this point in his expert paper: "To fit New Yorlc-bas~d systems (SIAC/DTC)28 into another count,y is tantamount to pultinganAmerican combin~ usedforhawutingwheal in the Midwest, intolapanforrice hantuting." The caveat here is that the introduction of new technology will have to be handled with great care. Next, let us examine the question of inacasing the amount of automation in the interface between clearing houses and depositories, and their members. As our survey results indicate, this proccM will be even more complicated, requiring changes in the operations of both the clearing houses and those of the clearing members. This presents a challenge even greater than that of merely inaeasing the automation level of the clearing house itself. The Coopers and Lybrand report "Opportunity and Risk in the 24-hour Global Marketplace" takes a look at this question from a larger view than the focus of our study ( our focus is limited to the clearing and settlement pr~): "Substantial minoritiu now use technology for monitoring of risk e:xpon.w by counterpany, counay, industly, or cumncy, communicating around the world so that ail [their) offices l110U1ld the world know the organization's positions in aJl instruments, 'what if decision support, and calcuJating and monitoring capital risk on a global, jinn-wide basis." 21 SIAC ii the comeuter operations of the New York Stock Exchange, the National Securities Ocaring Corporation, the American Stock Exchange, and the Depository Trust Company. Page 199
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Study of International Ceariq and Settlement T.radl There is additional risk in the level of automation that exists at the trading firm itself. The IBM report submitted for our study notes that there are great differences in the degree to which trading firms are automated. It is aucia1, in times of market volatility, for a firm to be able to quickly translate its trading blotter into settlement requirements and, in tum, spccilic payment and delivery obligations. Automation, if properly used, can reduce the risk associated with this process at trading firms. As for automation in the banking industry, the international differences in payment systems arc the focus of a separate Office of Tccbnology Assessm~.nt study. For the purposes of this report, suffice it to say that there are major international differences in banking procedures ( check clearing times, finality of scttlcment, etc..). Added on top of this is the huge range in the extent to which automation is, or is not, praent. Many banking procedures are still completely manual These differences in the extent of automation elist both intra-country and inter-country. More than anything else, they arc the result of the r.ecnological sopbisticari'ln of an individual bank. In their expert paper OD global custody, submitted for this study, Marc Simons and Keith Fulmer comment OD the problem of unequal automation between interfacing orgauinrions: "TM slllt4 of O\lf!l'Seas [ noD-U .S.] automation is~ and ineffective when compared against a highly sophisticated and capital intmsive domestic [U.S.] technology standard." Similarly, in bis expert paper, Robert Kay writes: "Tunelbum of what is an international communications flow requirts aJl parties t<> have a reaonabk ~oft~ sophistication which is not always available." Etforts are underway OD the one level to improve the clearing and settlement pr~ of clearing houses and depositories, internationally, through new and improved technology. But these efforts raise two concerns: Will the clearing houses and depositories be able to cope adequately with the new technology? How significant is the impnwement of the technology of clearing and settlement entities if the tcclmology level of its interfaces (i.~ members and banks) is not similarly improved? While there is a trend to elevate the automation of the clearing and settlement process, a number of questions remain about the long term effec:tivcnes.1 of these efforts. 4.1 THE IMMOBILIZATION AND DEMATERIALIZATION or SEC~ CERTIFICATES "lmmobila.ation" refers to the practice of storing securities certificates in a central depository to facilitate the legal transfer of tide and eliminat,: the securities movement risk of the settlement process (through book-entry). oematerialization" refers to the elimination of actual paper securities certificates and instead switching to a system (book entry) in which computers track and record the ownership of securities. Both practices addr~ the growing belief in the marketplace that the orderly operation of securities trading is best effected when securities arc held in a central location, that is, in a depository institution. The desirability of having a depository to service any given securities market is addressed by the European Economic Community, in its July, 1988, report Improvements in the Settlement of Croa-BorderSecuritiu Transactions in the EEC." According to the report: central dq,osilory has a key rok to play in ensuring high quality in the settlement of surida transactions in the individual countries." Pap200
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Earlier in the same report, it is also noted: Study of International Caring and Settlement Trends "Refenmu should be maM to 1M principle that settlement of tM pun:hase and sala of se:urida mu.rt Ula plau pll1i ptmU, i.&, tM st!OU'itia mwt be deliwrrd against final paynu,nt, whiUI paynwnt mwt be 11111M only against simultaneous, final deliwty of tlN set:Ulitia." Similarly, the Group of Thirty notes in its recoau,tendadons that: central suritia dqository:1 prindpal function is to immobiliu or demalerialize slJCUlitia, thereby auuring that tlul bulk of s:Ulitia transactioM tn processed in 'book entry' form. The depository p,ovida tM ba.ri.r for achieving ef1ident and low-risk transaction tdtlonenL,, Fred Hampton of the Depository Trust Company, writing about dematcriali7.ation, observes: 'TM promotion of boolc~ 111 a way to issw and hold securida .. wiU bt a continuing ,aponsibilily for tM deposito,y in future yean. Sevaal avenuu will bt pur.rued: TM inamringlycompla w securuiu beingdevtloped are ideal candidates for issuance of ltOdc in boolc~ (BEO) form; Al DTC apa,ub it1 savica to new s:Ulily twu, it will promote tMir issuance in BEO form; DTC continua to prornt* the isSUIIIICe of debt suritiu in BEO fonn; An unknown is the extDat to which BEO III an issuance method can applied to equity s:Ul'idu. It seems clur that the perpetual life of the equity security will make an effort to diminau stodc cettijicatu vay difficult withouts~ fonn of legislati~ action." This last comment by Hampton refers to the ability to dematerialize (i.e., eliminate) actual paper securities certificates. There are no current legal obstacles to the immobilization. of securities certificates in a single location, in this case, a depository. An example of the use of book-entry-only in aos.,-national border transfer of securities is provided in the expert paper submitted for this study by Hans-Joachim Hoessrich and Heinz-Klaus Ruetzel of West Germany's Deutscher Auslandskas-senvcrein AG (AKV): "Sinu the anwntlment of the Securuiu Dq,osil law in tM ~ar 1986, German central securida dqo.ritoriu have been allowed to maintain direct-account relationships with fomgn suritia dqosiloria, and to~ certain eligibk securitiu Mid in saft custody at thae institutions. A proequi.sitl!, however, is that under CM legal rtgUlations in those countria p,ottction of the investors co-ownmhip status is also guaranteed." In their paper, Hoemich and Ruetzel go on to desaibe the way the book-cntry-proccu works in these foreign depository relationships: "Thee institution., act as third-party custodians in ~ct of securities which art deposited with FKY and thus clJtltinlu to constuule good ~livt,y in Germany. Conveneiy, FKV may kup German securitie, in colltiw safe custody in Frankfurt [FKV], on behalf of foreign suntia dqositoria." Thus cross-national border trades arc settled without the physical delivery of securities. 29 1' Pormore oa tbe relatioalhip between the AXV and tbe FKV, pleue refer to our sunmwy on West Germany, in Section 2.2.5: a.n,r and Setlli!mol ia West Gmrtany, of thil study. Pase 201
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Study of lntcrnadonal Ccariq 111d Settlement Trencll In assessag the degree to which dcmaterialii.ation or immobilaatioo can occur, it is useful to look at the degree to which depositories, a necessary prerequisite, exist. Because of the tremendous differences between countries, it is not yet pnwl>le at this time to achieve the dcmaterialization of securities certificates, or even the immobilil.atioo of securities certificates, on a truly international scale. The Group of Thirty, commenting on this situation, recommends in its report that: "Eada country should an efftiw and fully develo~d central s~curities posito,y, o,gani:z,d and manag,d to encourage tM blOlldat possibk industry pattidpation ( directly and indirtly ), in pl, by 1992." While immobilization may be easily achievable, dematerialii.ation presents another hurdle, as is noted by the Group of Thirty: "While dematmalizadon off en paniauaradvantagu with regard to efficiency and flex,1,ility, law, and practices of some countriu and their mar/cm do not pmnit ~aiization." Even when immobiliwion is achieved, it will be done using the securities numbering/identification scheme of the local markets. In their report, Simons and Fulmer observe that: "Evm among tM various Europtan depositoriu there is no consensus on how to identify securitiausinga common numbering/u:Jentijication schernL This lade of uniformity makes it particuJllrly difficult for global custodians and !Mir agent banks to commonly identify suritia aams international marlcds." 30 This amounts to immobili2.ation being a useful supplement to the existing international framework to achieve book-entry-only settlement among the players in a given market. But until an international standard for identifying securities has been developed, immobilization may have less of an impact on those market participants who arc involved in aoss-national border trading. They continue to say that "Although /SIN is gaining support from SW'I.FT[Societyfor Worldwide Interbank F"mancial Telecommunications], NSCC (National Securities Clearing Corporation], ISCC (International Securities Ccaring Corporatioo],Mulwm Securities Clearing Corporalion, Euro-Ckar, and CEDEL [Centralc de Livraisoo de Valeurs Mobilicrcs], it is not widely usetJ.31 SEDOL (Stock F.:rchange Daily OfjiciaJList), the standard used by the International (London) Stock F.:rchange, i.r used primarily by money managers and global custodians in the United States." The Group of Thirty concludes that: "In pa,tu:uJar, countriu should adopt fJie /SIN numbering system for securities issues as dejiMd in tM ISO (International Standards Organisation] Standard 6166, at least for cross-border transactions." JI In tbe United Stata, tbe CUSIP ~nee oa Uniform ccuritica ldcfltifacation frocedure) number is the accepted form of identifying securities. 1D other C011Dtria. other securities numbering systems are used. According to Simons and Fulmer, there haw been efforts to create a universal identifier, such aa the International Securities Identification Number (lSIN), but so far, a c:omcuua among the world's major nuuteta baa yet to develop. 31 Euro-Ocar and CEDEL, however, are already committed to adopting the ISIN identification numbering system. Pap202
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Study of International Ccarin1 and Settlement Trends As we can see from the precedingcliCC11 ssioa, there does seem to be some linkage between the question of the immobilization and dematcriali7.at of certificate., and the proposal for international standarda.ation in the way that securities are numbered for identification purposes. It may be that these scemiagly separate iaues are more inter-related (m terms of achieviaginternatioaal settlement) than is immediately apparent. 4.9 THE SHARING OF RISK INFORMATION BE'IWEEN MARKETS, EXCHANGES AND CLEARING HOUSES Since the October 1987 market break, there has been much progress among clearing houses in increasing the sbariag of risk information about the status of the holdings (positions") of clearing members.32 But much remains to be done. Knowledge of a clearing member's risks across the whole range of imtruments and excbangc,, he is iawlw:d with is DttCSsary for a clearing house to accurately measure a clearing member's ability to meet the obligations of settlement. The individual clearing.member is likely to take the broad view of his holding.,: his position, plus and minus, in all of the market.I in which he has investments. This contrasts with the tendency among clearing houses themselves to view the clearing member, and his creditworthinm, purely from a standpoint of Im positions at the clearing house which is making the risk assessment decision about the clearing member. Factored into that decision may be whatever information the clearing house may have acquired from information sbariag arrangements with other clearing houses. Banks are even further outside this information loop in that they generally have no access to information about the status of any investments a customer may have in the various markets ( other than any information which might be supplied by the customer). The banks are furthermore in the dark as to what that customer's position might be, in terms of credit exposure at a customer's other banks. Even if the banks DID have this information, clearing houses at this time have no computer system or procedures to interface with banks for the purpose of sharing risk information. As noted elsewhere in this report, there arc a number of obstacles standing in the path of increased sbariag of risk information: L The need to protect confidentiality of client data at all levels of the system; 2. Laws in various countries imposing restrictions on the flow of information aaoss national borders (also known as TDF, trans-bqrdcr data flow); 3. The lack of a uniform international standard for the identification of securities certificates and other financial instruments; 4. The lack of accepted international standards for electronic communications systems; 5. The uneven technical capability to receive or send data quickly enough for the data to still be up to date and useful; 6. Uneven knowledge about how to use additional risk information (i.c~ about the status of market participant positions and bank accounts), if it were to be made available as has been proposed. 32 Por more on this subj~ please see Section 7 ol thia study: R,vww of dw Rqo,u on 11w Oaaber 1987 Market Brtak. Page 203
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Study ol Iatematioaal Ceuins and Settlement Tienda As noted in Section 3: "77N Cllting tllld Setllt!nwnt Procas: Risk Factors, of this report, there is some doubt about whether orgaaizad'lna besides rJearing houses and trading firms would be ready to make appropriate use of any new risk infonuanoa which might be acquired through increased information sharing. For example, would access to such information ha~ cbangcd the banks' l'Caction to the market break of m Would they haw: used tbe information in such a way as to keep the acdit pipeline open for market participants whose credit was cut off then as a general market precaution (rather than because the participants' own market and credit positions were judged to be too risky)? Ocarly, additional research into this area could prove fruitful in identifying mecbaaisrns that would allow for the sharing of risk information in a prodlldiw manner. In remarks on May 15th, 1989, Securities a.I Excbange Cornrnis.cfon chairman David Ruder stated the case for the sharing of risk information in intcmatioD?l markets: impo,tant compoMnt of sound """'"' linka,a i.r tM ~anent by ckaring a,au:ia to monitor information about tM jinancial and opmmonal condition of paltidpanu in multipk marlceu and to sluw that information with clearing entitiu in thos~ other ntatlcdS." Similar sentiments but with more of a domestic U.S. orientation can be found in the expert papers by Robert Woldow and Roger Rutz, both included in this study 4.10 STANDARDIZAnON OF CLEARING AND SETrLEMENT PROCEDURES (INCLUDING REDUCED SETl'LEMENT TIMES) In the area of standardizing clearing and settlement pr~ for the global securities market, the lead has been taken by the Group of Thirty which has produced a set of recommendations which are being actively pursued. The Group of Thirty's recommendations are as follows: L By 1990, all comparisons [ matching of buy and sell orders) of trades between direct market participants (i.e., brokers, broker/ dealers and other excbangc members) should be accomplished by T + L 2 Indirect market participants ( such as institutional investors, or any trading counterparties who are not broker/dealers) should, by 1992, be members of a trade comparison system which ac:hicves positive affirmation of trade details. ("Positive affirmation" means that the trade is confirmed only after both counterparties confirm the terms of the trade, as contrasted to the system in common use 41: many clearing entities, in which the trade is confirmed if there are no objections after both parties have received initial notifications of the terms of the trade.) 3. Each country should have an effective and fully developed central securities depository, ~aized and managed to encourage the broadest possible industry participation ( directly and indirectly), in place by 1992. 4. Each country should study its market volumes and participation to determine whether a trade netting system would be beneficial in terms of reducing risk and promoting efficiency. If a netting system would be appropriate, it should be implemented by 1992. Page 204
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Study of International Cearin1 and Settlement Trends S. DeliYery versus payment (DVP) sbould be employed as the method for settling all securities tramactioas. A DVP system should be in place by 1992. ["Delivery versus payment" means that in the settlement of a trade, the delivery of sccuritic., is done at the same time that the buyer makes his payment.) 6. Payments usociatr-d with the settlement of sccuritic., transactions and the servicing of securities portfolios should be made consistent acroa all instruments and markets by adopting the "same day' funm comentiom. 7. A "Rolling Settlement'33 system should be adopted by all markets. F"mal settlement should occur on T + 3 by 1992. Aa an interim target, 6na1 settlement should occur on T + 5 by 1990 at the latest, saw only where it hinders the ac:bie\,:ment of T + 3 by 1992. 8. Securities lending and borrowing should be encouraged aa a method of expediting the settlement of securities r-ansar:tions. Existing regulatory and tuation barriers that inhibit the practice of lending securities should be removed by 1990. 9. Each country should adopt the standard for secu. ies m~es developed by the Intcmadoaal Standards Organisation (ISO Standard mS). [This is the recommendation that messages about securities haw standardm:d formats, in order to speed and clarify communications between nations.] In partic:ular, countries should adopt the ISIN [identification) numbering system for securities as defined in the ISO Standard 6166, at least for cross border transactions. These standards should be universally applied by 1992. The focus of the Group of Thirty was on the trading of securities rather than the trading of derivative instruments. Another effort along the lines of the Group of Thirty was recently undertaken by the European Economic Community. The "Study on Improvanents in the Settlenent of Cross-Border Securitia Transactions in tM European Economic Community" focused OD the need for centralized depositories. In that cont~ the EEC study's recommendations are similar to those in the Group of Thirty report. Another recent study OD the settlement of aoss-oational border trades is Improving IntemationaJ Settlement," the Junc, 1989, report by the Federation Internationale des Bourses de Valeurs (FIBV). The FIBV report endorses the recommendations of both the Group of Thirty and the EEC report. The FIBV also makes three other recommendations. They arc: There should be more aoss-natioaal border links between depositories, in markets where there is a bnsiu,aa need and sufficient transactional volume. These links between depositories should include as wide as possible a spectrum of securities and services for market participants. Scc:urities should be immobilized in a depository in the home market of the security. Settlement of croa-natioual border trades of stocks and bonds should be by book entry only, rather than through the physical delivery of securities certificates. Book entry transfer of title should be done at a depository in the home market of the traded security, or, at an international depository. 33 The term Romag Settlement meana that tbe settlement date ii aJways the trade: date plus a specific number of days, for emnple, T + 3. Page 20S
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Study of International Ccarin1 ucl SettJemcnt Trend& Asa result of the research done for our study, we were also able to identify some aspects of international trading which might benefit &om standardimion. They arc: L Rules limiting market access differ from country to country. Foreign investors in Japan, for example, are restricted from purchasing shares in some types of companies, including communications, broadcasring and transportation. 2. Listing requirements (regulations on the specific financial information that an iuucr of stocks or bonds must make public) vary greatly from one market to the next. 3. The capacity of the intematioDa1 baalring system to provide same day' funds with real-time finality of settlement is not uniform: citbcr in terms of central bank timing of finality of settlement or in terms of syncbroamtioa of bank and clearing house holiday schedules. 4. There are great differences between co~ in the amount of taxes which are withheld from dividends paid to foreign investors. Th~~re are also problems in governments being slow or completely recalcitrant in refunding funds which were withheld in~ of the actual amount of tax that was due. S. The types of collateral requirements which are accepted vary widely according to individual country, clearing-entity, and the type of financial instrument which is being traded. 6. There is great variety between clearing entities oa the existence, size, and composition of guarantee funds to protect the clearing entity ( and by extension, its members) against the liabilities of a default. 7. Laws concerning the traas-border data Oow of customer information lack any type of uniformity and inhil:rit the international pooling of risk information. 8. There is no consistency between countries in laws on the rights of foreign investors in the C\al of a bankruptcy. 9. The capabilities of global cmtodians and their wociated agent banks (sub-custodian banks, handling transactions in a specific local market) vary widely. While there is obviously great value in the recommendations of the Group of Thirty, the EEC, and the FIBV, we must bear in mind that these proposals constitute only a starting-point for improvement, not an end-point. Indeed these recommendations may well represent the maximum that the private sector is capable of achieving without action oa the part of local governments. (Please refer to the expert paper submitted by Mc.Kinsey for a discussfon of how these governmental-type issues could be addressed.) Former SEC chairman David Ruder commented on this subject on May 15th, 1989: "Some items forfuturecoordination notcontaiMdin the Group of Thirty's recommendations incluM capital OMquy standards for rnarlca participants, information sharing among cleating entitia about risk positions of joint membm, and the interaction of derivative markets.,, Given the growing importance of the world's futures and options markets ( especially in light of their desire to move quickly toward 24-hour trading), it would not appear uarcasonable to seek early standardization of the clearing and settlement practices of these markets, which are no 1~ diverse than the securities markets. Page206
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Study of lntemational Cearing and Settlement Trends Harmonization should not be confused with the notion of unified clearing" ( a proposal that the c:urrem system of individual clearing entities serving specifi.-excbanges be set aside in favor of one large centralized clearing mechanism for all kinds of transactions). According to Ruder, again on May 15th: "Marled panicipant.f gowrally have conduded that one central ckaring entity for all intemational equity transactions is not fasibk in tM short run." In seeking out standarciimion there dearly is a trade-off between safety and cost. If our analysis were to be limited, however, to the qut.Sdon of fails (defaults on trades), we could say that the fail rate is likely to decline as a result of the Group of Thirty's recommendations. This would both increase safety and deer~ costs for market participaats. But, in considering other aspects of the clearing and settlement process (for example, a switch to international standards on collateral requirements), cbange would come at a price (in this case, it would be a tradeotf between inacased safety and increased cost to market participants). The forum docs not exist to decide on a government-to-government basis the degree of uniform safety cspectcd in markets to permit foreign investors to operate there. The market participant is left to bis own devi~34 to size up the risk that is present in any given international market. This can aeatc instability because the market participant may or may not have an adequate understanding of the in&astructura1 clearing and settlement risks in a given market, even though he may be quite familiar with the operational characteristics of that marketplace. The Basie conference on capital adequacy standards for banks cow
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STUDY OF INTERNATIONAL CLEARING AND SETTLEMENT 5. FOREIGN PERSPECTIVES Page 209
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TABLE OF CONTENTS Sec;tlog S Foreip Penpectiva: Ccaring and Settlement in the U.S., Seen by Poreip Invaton The VICW Prom Canada The VICW Prom Japan Page 210 209 211 212
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5 CLEARING AND SE'ITLEMENT IN THE U.S., AS SEEN BY FOREIGN INVESTORS Study of International Oearing and Settlement Foreign Perspectives Given the globalization of the markets, it is important for the players involved in the clearing and settlement industry in the United States to understand how foreign market participants view U.S. systems, processes and attitudes: The View From Canada The Canadian view, expressed by Robert Tunderman of CDS, is as follows: "17u, Canadian perspecti~ on tM U.S. ckaring and dqository stnlCtU1e is unique. While we tn a seJ"I"* sOW!l'eign Stall!, our prmjmity lad.r .American market participants to view Canada a a domatic rqion. 17ais kavu the Canadian market participant at a disadvantage, at times, since tM praaica are dilfemtt in each count,y." Elaborating on one s~ch disadvantage, Tunderman comments: "US. practices and synmu are limiud by a local viewpoinL An inability to provide reporting and settlematt in a cummcy other than U.S. dollar.rand to use a settlement cycle other than tM local settlement calendar givu a pa,ochiaJ appearance to Canadian participants." Tunderman also disames risk-averting mttbaoisrns serving trading going in both directions across the border between Canada and the U.S.: risks may be nuuu sevoe through an unfamiliarity of both market participants and ckaring organiz,ations with each other's local market practices. The implementation of recip,ocal omnibu.r settlement llnJa between ckaring organizations allows for risks to be bonw by tM local and k11own marled participants. Eada clearing organization assumes responsibility for its participants without having to monitor foreign counterparties. Mutual t1Wt among clearing organizations to monitor their own participants is a pre-requisite for this mechanism." Tundcrman makes a case for the need for the U.S. financial community to adjust its view of the Canadian investor: "Canada, while a separau count,y, is often trtated as a domestic extension by U.S. securities firms. 'IM prmimity of the two countries along with the great similarity of trading and satlemmt practices lead toward this treatment. There needs to be a development of awareness of Canadian identity as distinct from the domestic American one." Page 211
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Study of lntcmaaonai Ccarin1 and Settlement Foreign PcnpcctiYa The View From Japan Nomma Securities, in its expert paper included in this phase of our study, cites the following two difficulties with U.S. trading practices and philosophies: 1. "In Japan, f~ to deJiwr stock certijit:ata or pay for tM stock catijicatu rtceived on an appointeddlM is considaed atronelyimgulllr, andinvuton at large~ a strong aversion to nu:h failure. It is a common praaic, among brolcer-deakn to charge to the defaulting party interest lost through such f aibw.,, 2. "lapanae invuton buying or selling suritia in the United Statu are rtquind by law or by company rulu to submit a number of documents (for emmpk, a statement of resolution of tM board of directon for opening and account) whida do not exist under the company law fua Japan J or are simply not customa,y practice.. Many invuton complain that the nua in tM United Statu should~ maM more fleribk to allow Japanese invuton to mbstituU other documents for suda required papen." .. Pap212
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STUDY OF INTERNATIONAL CLEARING AND SETILEMENT 6. SURVEY RESULTS Page 213
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TABLE OF CONTENTS Section 6 Sun,:y Raulta 6.1 Raulta of the Oearing House and Exchange Suniey 6.2 Raulta of the Market Participant SUIYCf Pap214 213 219 233
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6 SURVEY RESULTS Study of lntemational Cearing and Settlement Suney Results Aa part of our research for this study on international clearing and settlement, we administered l'WO surveys. The sum.,v of bttcrnadAMi Ce and Settlement Ocarina Beuse, md ExclJanm;s was sent to clearing houses, excbanp ud dtpositories around the world in order to determine the issues important to the institutions that provide clearing and settlement service., to world markets. Ilm Slim! d Intematiopal Oeariu &id Settlement Market Participants was sent to institutions who trade in those markets in order to get the user's perspective on the clearing and settlement m~banisms working ( or not working) therein. The body of our study, Volume I, is our synthesis of the expert papers provided to us for this study. The papers disc:u.u JSSues of importance to the experts and tJie orgaointions that they represent. The suney results summarized here arc meant to supplement these papers and our synthesis, by providing views &om a much larger audience regarding die effectiveness of the clearing and settlement process, and the iaucs and risks therein. Surveys were sent to members of industry associations such as the Securities Industry AsM>ciatio~ the Futures Industry Association, and the Federation Internationale des Bourses de V aleurs. In order to increase geographical reach, we a.ucd exchanges and clearing houses to provide us with names and addresses of a sampling of their membership. A Japanese translation was provided to survey recipients located in Japan. We received 39 responses to our clearing house and exchange survey, representing a response rate of 37%. Respondents include: 1 A Terme Internationale de France Amsterdam Stock E,:cbange/Effectenclearing Austraclear Limited Australian Stock En:baoge Board of Trade Cearing Corporation Bolsa de V alore., Montevideo Bolaa de Va.lores de Rio Janeiro Bolaa de Valores de Sao Paulo Bourse de Luxembourg Capital Market Authority Chambre de Compensabon du Marche A Terme International Coffee, Sugar & Cocoa Clearing Corporation Frankfurter Kas.,enverein AG Hong Kong Securities Clearing Co., Ltd. Madrid Stock Evbaogc Manila Stock Exc:banp Midwest Securities Trust Co. Minneapolis Grain EYcbange New 2.ealand Stock Excbangc Osaka Securities E1:cbaoge 1 One mpoadcnt requa&cd anonymity. France Netherlands Australia Australia United States U~y Brazil Brazil Grand Duchy of Luxembourg Egypt France United States West Germany Hong Kong s Phfilipines United States United States New Zealand Japan Page 215
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Study of llltemationaA Cearinl:: Settlement Survey ti Schweizerische Effekten-Giro AG Securities Ocaring Automated Network Services, SDN. BH. Stock C1earina Co~ration of Philadelphia/Philadelphia Depository trust Company Stock Excbang-= of Singapore, Ltd. Taiwan Stock Eu:banfl Corp. The Board of Trade o ICans&1 City The Canadian Depository for Securities The Chicago Board Options ycbanr, The Chi~ Mercantile Exchange The Pacific Stock Excbange The Tel Aviv Stock !;"cw: Ltd. Thc Tokyo Commodity ngr. Thc Tokyo Grain &cbange Tokyo Stock En:baage Tram-Canada Options Inc. Vancouver Stock Evbange V ocrdipapircentralen Zurich Stock Evbange Switzerland Malaysia United States SingaJ>ublic of China United States Canada United States United States United States Israel Japan Japan Japan Canada Canada Denmark Switzerland We received 157 responses to our market participant survey, representing a response rate of 8%. Respondents include:Z ABN Capital Markets Corp. Ace ICoeki Co., Ltd. Adams, Block &. Coe Securities, Inc. American Pacific Securities Corp. Anderson &. Bysma, Inc. Associated Planners Securities Corp. Australian Mutual Provident Society Banco Popolare Commcrcio & lndustria Bank of Italy Banque de Neutlizc, Schlumberger, Mallet (NSM) Banque Panbas Barclays de Zocte Wedd Gov. Securities Bateman Eicbler, Hill Richard.,, Inc. Bcrbbirc Capital Corp. Berliner Handels-und Frankfurter Bank Bielfeldt & Company Block-Kdy Company Boston Institutional Services, Inc. Brown&. Groover, Inc. Bl'OMI Brothers Harriman & Company Bryaa, Worley&. Company, Inc. Caisse Centtale des Banques Populaires Caisse des Depots et Coasignatioas Ca Securities, Inc. 1"".~11 d. '-'411A51M hwestors Semccs, Lt Carret Securities, Inc. Cartwright & Goodwin, Inc. Century Investors of America, Inc. 2 26 respondents requeaed anonymity. Pap216 United States Japan U nitcd States United States U nitcd States United States Australia Italy Italy France France United States United States United States West Germany United States United States United States United States United States U nitcd States France France United States United Kingdom United States U nitcd States United States
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Clartcr Imestment Group, Inc. Chemical Bank Fm:d Income Churcbill Securities, Inc. CL-Alaanders Rouse ~e ), Ltd. Qmtal FiaaariaJ Securities Corp. Commeraal Imestmeat Alternatives, Inc. Cooper Imestments, lac. Coughlin and Company, Inc. County NatWest Securities Corp~ U.S.A. Crandall Vickery & Company, Inc. Credit Commercial de France CRT Services, hie. Cuna Brokerage Services, Inc. D. P. Green&. Company D. G. Bank D.R. Dwyer Company Daiwa Securities Ameri~ Inc. Sccuritics, Inc. Diamant Imestment Corp. Dimn Bretscber Noonan, Inc. Dominick &. Dominick Futures, Inc. DresdncrBankAG Drcsd Burnham Lambert, Inc. Drcsd Burnham Lambert Holding, Ltd. Drcsd Burnham Lambert (Asia), Ltd. Dupree &. Company, Inc. East/West Securities Company Edward D. Jones & Company Emanuel &. Company Ezcution Services, Inc. PBS Capital Markets Financial Ocaring &. Services Corp. Fmser lnvestmems Company First Albany Corp. rll'St Canada Securities International, Ltd. FU'St Chicaao Investments Services, Inc. rust Maratlion Securities, Ltd. Frank Ruucll Company G. X. Clarke &. Com~y Garvey Commodities Corp. Geisel Grain Company Gill &. Assoc., Inc. Harold Dance Brokerage Harris Trust and Saving., Bank Herbert B. White &. Company Hom.on Securities, Inc. Integrated Resources Equity Corp. llm:mnent Account Services Corp. Investors Northwest, Inc. J. M. SaMoon &. Company (PrE), Ltd. J. P. Morgan Securities, Inc. Jett Investment Co. Jordan Sandman Were, Ltd. Julius Baer Sccuritics, Inc. Keefe, Bru,ette &. Woods, Inc. Kleinwort Benson Government Securities, Inc. Study o( International Cearing and Settlement Sumy Results United States United States United States S!nPpore UmtedStates United States United States United States United States United States France United States United States United States West Germany United States United States United States United States United States United States West. Germany United States United Kingdom Japan United States United States United States United States United States United States United States United States U ailed States Canada United States Canada United States United States United States United States United States United States U ailed States United States United States United States United States U nitcd States S!nPpore UmtcdStates United States New aalaati U nitcd States United States U nitcd States Page 217
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of lntemational Cearin& and Settlement Suney Raults Lakeside Bank I ;mgiJI & Company Lewco Securities Corp. Liquidity Fund Investment Corp. Mark Securities, Inc. Martin Nelson & Company Muus Securitic., Company Maxwell Noll, Inc. McCaulhan Dyson Futures, Ltd. Mciw., & Co=~.lnc. Meescbaert-Ro Soc. de Bourse Merrill Lynch Midland Doherty, Ltd. ML&Company MOfP. Keegan & Comeauy Mumcipal lzMston Service, Inc. Mumcipal Securities, Inc. M~hy Favre, Inc. National Australia Bank National Nominees, Ltd. New England Discount Brokerage, Inc. Newbridge Securities, Inc. Nomura Securities Company, Ltd. Nomura Securities NorthweQ: Investment Services, Inc. Ocean Securities Corp. Owen Reeder Pembroke Clearing Corp. Prudential Bache Securities R.B.C.DominionSccuritics,Inc. R. G. Knox Corp. Richard J. Attooelli & Company Robertson, Colman & Stephens S-S-T Clearing Company, Inc. S. G. Warburg & Company, Inc. S. J. Wolfe&. Company Sage Rutty&. Company, Inc. Seattle-Northwest Securities Securities Corporation of Iowa Seidler Amdcc Securities, Inc. SLS Securities Company Spellman Capital Corp. Stone & Youngberg Sullivan & Cromwell Talley McNeil & Tormey, Inc. The Bank of Tokyo, Ltd. The Chicago Corporation Traub & Comyany, Inc. Union Bank o Switterland Union Planters Investment Bankers Group W;tgncr Stott Clearing Corp. Wheat rU'St Securities, Inc. William R. Hough & Company United States United States United States United States United States United States United States United States Australia United States France United States Canada United States United States United States United States United States Australia Australia United States United States United States Japan United States United States United States United States United States Canada United States United States U Diced States United States United States U Diced States United States United States United States U Diced States U Diced States United States U Diced States United States United States Japan U Diced States U Diced States Switzerland U Diced States United States United States U Diced States We extend our thanks to each person and/or organization which took the time to complete our questionnaire. Given our response rate, we consider these survey results indicative of world opinion, yet we are cautious as to drawing definitive conclusions from the data. Page 218
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Study of IntemationaJ Cearing and Settlement Survey Results SURVEY or INTERNAnONAL CLEARING AND SETrLEMENT: CLEARING eousa AND EXCHANGES 6.1 RESULTS or THE CLEA.RING HOUSE AND EXCHANGE SURVEY The responses to the following quemoas are included in this section: ld: Country of~ Incorporation (home office). 1h: Which Clf the following instnments do you clear or match: equities, sovereign. obligations, li: lj: 3a: cor~ obligations, futures, ~as, other derivatm: instruments (such as mortgage-backed securities. etc..}, ph~cal rommodities, other (please s~)? Which of the fouowing instruments do you settle: equities, sovereign obligations, corporate obligatjons, futures, op,tjQns, other derivative instruments ( such as mortgage-backed securities, etc..), ehysical commoclities, other (please specify)? What JS the tiJI!~ period between trade date and settlement date? Please list any linages betwn ,our o~nizarion and any clearing/settlement organizations in your country ~= and cxiving linkages). 3b: Please list any between your organizatilln and any other clearing/settlement o-pnizarions in other countries (~posed and existing linkages). Sa: Is the clearig system in your market primarily electronic or paper-based? Please specify c1ec:troaic, paper-based, combination? 5b: Is the sc;ttlc;ment system in your market primarily electronic or paper-based? Please specify c1ec:troaic, paper-based, combination? Sc Arc the interfaces between the clearing member firms and the clearing and settlement system in your market primarily electronic or paper-based? Please specify electronic, paper-based, combination? Page 219
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SURVEY OF INTERNATIONAL CLEARING AND SETIU:MENT: CLEARING HOUSD AND EXCHANGES Question ld: Country of Clearing Incorporation (home office) GEOGRAPHICAL DISTRIBUTION OF RESPONDENTS 12 -----~::::~:::~--------~~-----------.... ......... 1 : 6 .,____.l_l.i:1.1:li:1 .. 1.i.i_.1.1.i_:1 .. _:_.._.. ___ !_m~--m-----+!.!_l_l_l.l_l_l_l.l_i.i_i_i_.t----------------i ..-------1:~mmJ------t : 1--+lllllli...,.______.~lll!l!l)-----.i.:.!l.:.1_;_::_1_; __ 1.::_:.:1_:_!,..,___1-:i ------1 @m: :1111111 I ...... 0 _______________________ ........_ ___________ MORTB AMERICA LJ # OP RESPONDENTS EUROPE N.E. ASIA/ AUSTRALIA MIDDLE EAST SOUTH AMERICA Of the 38 _r,esp:,ndents to our survey, approximately one-third were incorporated in North America and one-third in the Northeast Asia/ Australia region. The remaining one-third of the respondents were spread acroa Europe, the Middle East and South America. Page 220
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Study of International Cearing and Settlement Survey Results SURVEY OF INTERNATIONAL CLEARING AND SETI'LEMENT: CLEARING HOUSES AND EXCHANGES Question 1h: Which of the following instruments do you clear or match: equities, sovereignobligatio~ corporate obligations, futures, o~oas, other derivanve instruments (such as mortgage-backed scc:urities, etc.), physical commodities, other (please specify)? PROFILE OF CLEARING RESPONDENTS NUMBER OP RESPONDENTS !QUITIIS W ROfflAIIIJCA SOY. OBLIG. CORP. OBLJC. FUTURES OPTIONS OTHER D!RIV. PHY. COMM. OTHER II EUIOPI II u. illA/AUSThLlA IIIDDLI !ASI' [ID SOUTH AMERICA Many of our respondents clear more than one instrument; the average is 2.5 instrument types per respondent. The breakdown for the 38 respondents is: Instmmc;nt ~uitics Soereip ob~tioas Corporate obligations Futures contracts Options Other derivatives Physical commodities Other I of Respondents 25 16 20 12 11 5 2 7 Page 221
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Study of International Cearia= Settlcmcnt StllWJ ts SURVEY or INTERNATIONAL CLEARING AND SE1TLEMENT: CUCARING HOUSES AND EXCHANGES Question li: Which of the foll~ instruments do you settle: equities, sovereign obliptions, corporate obligations, futures, o}'!iom, other derivative instruments ( such as mortgage=backed securities, etc.), physical commodities, other (please specify)? PROFILE OF SETTLEMENT RESPONDENTS IQVJTIIS CJ ,om AIIIIC.l lfUMBBR OP R!SPOlfDBlfTS SOTDICI OnJG. COIP. OILJG. ,UTVID omon OTID DIIIY. II !IJIOPI II u. ASIA/ AllfflALJA MIDIJU llSI' PIT. COIIII. OTl!I [II] SOUT11 AMERICA Many of our respondents settle more than one instrument; the average is 2.S instrument types per respondent. The breakdown for the 38 respondents is: ~uitics Sovereign ob~oas Corporate obligations Futures contracts Options Other derivatives Physical commodities Other f of Respondents 24 15 19 15 12 4 3 s These figures are similar to the profile of clearing respondents (Question lh). Pap222
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Study of International Cearing and Settlement SuM:y Results SURVEY or INTERNATIONAL CLEARING AND SETTLEMENT: CLEARING HOUSES AND EXCHANGES Question lj: What is the time period between trade date and settlement date? SETTLEMENT DA TE: T+? A VIRAGI or DAYS 8.0 .,._ ___________________________ _, 7.0 8.0 ~-0 4-.0 3.0 2.0 1.0 0.0 EQUITIES LJ ~fflAIIIIC.\ Ill SOV. OBLIC. CORP. OBLIG. FUTURES OPTIONS OTHER DERIV. PKT. COMM. II EUIOPI II u. ASJA/Aum,w ~,oou wr [Il) s00111 AMERICA Settlement date varies by instrument by region. Page 223
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SURVEY or INTERNATIONAL CLEARING AND SETl'LEMENT: CLEARING HOUSES AND EXCHANG~ Question 3a: Please list any linkages between your organization and any clearing/settlement organizari"as in your country (proposed and eTisting linkages)? RESPONDENTS WITH DOMESTIC LINKS I OP RESPONDENTS JOffl lUIICl :::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::. I U ill1/1DSTUI.U :::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::.:::::.:.-:-:::::::::::: ::: .. mmLI UST :::::::-:::::::: SODTI llDICl ........................... 0 LJ NO LINKS Pap224 2 6 8 10 II LINKS 12
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Situdy of Intemational Cearing and Settlement Survey Results SURVEY OF INTERNATIONAL CLEARING AND S~MENT: CLEARING HOUSES AND EXCHANGES Question 3b: Please list any linkages between your 0'83aization and any other clearing/ settlement 0'83Dizations in other countries (proposed and existing linkages)? RESPONDENTS WITH INTERNATIONAL LINKS I OP RESPONDENTS IOffl llDICl ~~~..:: .... ...:.:".".::..::: ...:.::.::::".::.:..:..::.:.:..: !UIOPI .:.:. .. :.:. .. :.:. .. :.:. .. .. :.:. .. .. .. .. .. .. .. :. .. .. :.:. .. .. :. .. :. .. .. 1.t W/lDSnWA :::::::::::::: ::::::: :::::::::::::::::.:::: ::::::::::::::::..:::.::::":::: ::.: ::: WIDDLI UST ::::::::::.:::::::::::::::. SODTB lllllCl ...................................................... 0 CJ NO LINKS 2 6 8 10 II LINKS 12 The Middle East respondents have no links, either domestically or internationally. In South America. our respondents report domestic links but no international links. The converse is true for the NE Asia/ Australia region. Both types of links occur frequently in both North America and Europe. Page 2lS
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Study of L.:at.emational Cearinl!: Settlement Surwy ts SURVEY OF INTERNATIONAL CLEARING AND SETrLEMENT: CLEARING HOUSES AND EXCIIANGF..S Question Sa: Is the clearing system in your market primarily electronic or paper-based? Please specify electronic, paper-based, combination. Question Sb: Is the settlement system in your market primarily electronic or paper-based? Please specify electronic, paper-based, combination. Question Sc: Arc the intcrfara between the clearing member firms and the clearing and settlement system primarily electronic or paper-based? Please specify electronic, paper-based, combination. We scored a response of electronic as 2 points, combinatio'tl as 1 points and paper based as 0 points. We then ave~d this over the number of respondcms in e: ,ch category for each question. The results arc summamed in the following grid: Cearu,g Settlement Interfaces North .America 1.6 1.6 1.3 Europe 15 1.5 1.3 NE Asia/ Australia .2 0.9 0.9 Middle East 1.0 1.0 0.5 South America 1.7 1.0 1.3 Page226
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Study of International Cearing and Settlement Survey Results SURVEY OF INTERNATIONAL CLEARING AND SETTLEMENT: CLEARING ROUS~ AND EXCHANGES Question 9: Are trade positions netted each day, yes or no? ARE TRADES NETTED DAILY # OP RESPONDENTS ,om llDla ::::::::::::::::::::::::::::::: ::::::::::::::::: ::::::::: :;:: ::::: ::::::::: ::::::::: ::::: :;::::;:::::: ::::::::: ::::: ::; :: : ; :::: :::: : : ::: EIJIOPI .:.:.:.:.:.:.:.:.:.:.:.:.:.:.:.: .. ML W/1USTIW.l .. ... DJ.I llff ::.:.:.:.:.:::::::::.:.::::::::::: SODTB 11DIC1 ::::::::::::::::::::::::::::::::::::::::::::::::::: 0 2 4 6 8 Q TRADES ARE NETTED II TRADES ARE ~OT NETTED ~!!!!!!!!~~~ 10 Ne~ is practiced to some degree in all 5 regions of the world. Of the 38 respondents, 20 net trades each day. Page 227
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Study of lntemationat Cearinl!:: Settlement Survey ts SURVEY OF INTERNATIONAL CLEARING AND SETrLEMENT: CLEARING HOUSES AND EXCHANGES Question 12: Does your 0"83uizarion guarantee the trade transactions for each party, yes or no? RESPONDENTS WITH TRADE GUARANTEES # or HSPOlfDBlfTS tlDDIJ llff ::::.:.:.::::: : som 111mc1 .. ... ...... ................ 0 6 8 10 12 Q GU ARANT!! OFFERED (II NO GUARANTEE OFFERED Guarantees are offered in each region, although they predominate in North America, Europe and NE Asia/ Australia. Of the 38 respondents, 20 offer trade guarantees. Page 228
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Study of lntemationa! Cearing and Sett!emenc Survey Resu!ts SURVEY OF INTERNATIONAL CLEARING AND SE'ITLEMENT: CLEARING HOUSES AND EXCHANGES Question 14: Does your organization have a clearing house guarantee fund? RESPONDENTS WITH CLEARING HOUSE GUARANTEE FUNDS I OP RISPOHDIMTS IOffl lllDJCl :::::::~::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::::: :::::::: tJDDLl UST 0 2 6 8 10 12 0 HAVE GUARANTEE FUNDS Ill DO NOT HA VE GUARANTEE FUNDS Guarantee funds are more pervasive in North America than in any other region. Of our 38 respondents 17 stated they had a guarantee fund, 10 of which were in North America. P:ige 229
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Study of International Oearing IDd Settlement Sur.,ey Results SURVEY OF INTERNATIONAL CLEARING AND SETrLEMENT: CLEARING HOUSES AND EXCHANGES Question 18a: What is the percentage of trades that fail to clear in your market? Question 18b: What is the percentage of trades that fail to settle on the due date in your market? DAILY ''FAILS'' ilDDUUST SOOT! UDIC1 0 LJ CLEARING 10 This chart should be read as follows: RANG! OP PERCENT CITED 15 20 25 30 II SETTLEMENT 4-0 Our North American respondents cited answers ranging from 0% to 10% in response to the question of what percentage of trades fail to clear in their market. Their responses for settlement fails ranged from 0% to 30%. In the Middle East and in South America, the respondents stated that they had no clearing fails. Similarly, South American respondents stated that they had no settlement fails. We suspect that the term "fail" is cultW'aily biased; the definition of what constitutes a fail is not standardized by country and is often due to cultural mores and experience. Pap 230
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Study of lntemationai Oearin1 and Settlement Survey Rcsuit.s SURVEY OF INTERNATIONAL CLEAR.ING AND SETI"LEMENT: CLEAR.ING HOUSa AND EXCHANGES The following questions were asked to solicit the viewpoints of respondents on various subjects concerning general industry philosophies and trends. We therefore present the results for the industry in total, rather than by geographical region. Question 21: What is your opinion on the practice of' aou-margining' evbange members' settlement ~tioas with other evbangr.s or clearing houses? Do you think this idea is useful and/ or viable? Of the 19 responses to this qucstioo.i 13 stated that the idea is useful and/ or viable. Question 22: What is your opinion on the practice of sharing risk position information among clearing/settlement organizations for the purpose of reducing members' exposure risks? Of the 20 responses to this questio"9 18 stated that the sharing of risk position information among clearing/settlement organizations was useful or absolutely essential. Question 24: What arc the clearing and/ or settlement risks that affect your organization? The three major risks cited were: Bisi Cited Credit Delayed delivery Payment risk f of Respondents 7 3 2 Page 231
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Question 25: What are the risks in the payments side of the clearing and settlement process (including credit and funding)? The two major risks cited by respondents were: Ri;sk Clted Credit F"mality of payment f of iMPQadcnts 6 4 Question 26: What imprOements or changes would you like to see in the way that payments systems work in clearing and settlement? The major improvements cited were: lmpmw;mc;nt Same day funds Usiq electronic funds transfer instead of checks f of Respondents 8 6 Question Z'l: What improvements or changes would you like to see within your country's or international clearing and/or settlement process? The major improvements cited were: Imgrovemc;nt Standardaatioa of settlement times internationally Centralized depository in other countries Increased automation Question 29: What are the major trans-border settlement issues? I of Respondents 8 6 3 Of the 19 responses to this question, 17 stated that lack of standardization is a major transborder issue. Page 232
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Study of International Cearing and Settlement Suivcy Results SURVEY or INTERNATIONAL CLEARING AND SETnEMENT: MARKET PARTICIPANTS 6.2 RESULTS OF THE MARKET PARTICIPANT SURVEY We report here on the results of the following questions in our survey: ld: le: 12: 14: 15a: lSb: 16a: 16b: 17a: 17b: 18a: 18b: 19: 20: 22: Country of incorporation (home office). Countnes of Operations. Is the clearing and settlement system in your market primarily electronic or paper-based? What percentage is c.lectronic? Does the clcanng and/or settlement process in your market adequately meet your ;cizarioa's needs? (yes or no) do you consider to be the tflree most significant risks in clearing ( or matching trades) domemcally? What do you consider to be the three most significant risks in clearing ( or matching trades) internationally? What do you consider to be the three most significant risks in settlement domestically? What do you consider to be the three most significant risks in settlement internationally? What do you consider to be the three most significant problems in clearing ( or matching trades) domestically? What do you consider to be the three most significant problems in clearing ( or matching trades) internationally? What do you consider to be the three most significant problems in settlement domestically? What do you consider to be the three most significant problems in settlement internationally? Do you recommend any changes in your domestic clearing and settlement system? (yes or DO) If yes, which changes? Do you recommend changes for clearing and settlement systems in other countries to facilitate global trading? (yes or no) If yes, what changes? Which aitical clearing and settlement problem should the United States Congress address, if any, and what would hr, the ideal solution for your business needs? Page 233
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Study of International Cearin= Settlement Surwy ti SURVEY OF INTERNATIONAL CLEARING AND SETnEMENT: MARKET PARTICIPANTS Question ld: Country of clearing incorporation (home office) GEOGRAPHICAL DISTRIBUTION OF RESPONDENTS 14,0 ..-------------------------120 100 80 60 40 20 0 ___________ t_h_t\_/_/.l_td ______ tr_T:: __ :?._n~_::::;_:::.n __ NORTH AMERICA Hd # OF RESPONDENTS EUROPE N'.E. ASIA/ AUSTRALIA The vast majority of responses were received from market participants with home offices in North America. This was to be expected, since very few surveys were mailed to market participants outside the United States. Those names were provided by clearing houses and exchanges located in foreign markets. If a U.S. subsidiary of a foreign corporation stated that its home office was in the United States or Canada, it would be considered for the purposes of this survey to be in the North America category. Pagc234
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Study of International Cearing and Settlement Survey Results SURVEY OF INTERNATIONAL CLEARING AND SETl'LEMENT: MARKET PARTICIPANTS Question le: Countries of Operations NUMBER OF COUNTRIES OF OPERATION 120 100 80 60 4,0 2 :::::::::::::::::::: 0 ____ .. ... ... ... .... ... ... _________________ .. _._. __ ... _. ----NORTH AMERICA W 1 COUNTRY EUROPE N.E. ASIA/ AUSTRALIA Ill MOR! THAN 1 COUNTRY Approximately 61 % of the North American Respondents stated that they trade in markets in one country. Approximately 39% of the North American Respondents trade in markets in more than one country. If a respondent listed only one country of operation and it was different from its country of incorporation ( question ld), it is considered for the purposes of this survey to have business in only one country. Page 235
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Study of lAtcmational Cearinl:: Settlement Sum:y ts SURVEY OF INTERNATIONAL CLEARING AND SETTLEMENT: MARKET PARTICIPANTS Question 12: Is the clearing and settlement sygcm in your market primarily electronic or paper-based? Please specify. What percentage is electronic? HOW ELECTRONIC ARE YOUR MARKETS? IN PERCENT 70 ---------------------------------, 60 ~o 4-0 30 20 10 NORTH AMERICA 0 1 COUNTRY OF OPERATION The percentages were calcu1ated as follows: ::::::::: EUROPE N.E. ASIA/ AUSTRALIA II MORE THAN 1 COUNTRY OF OPERATION For each resp:,ndent who provided an estimate as to the percent to which their market was electronic, their response was included in the calculation. These responses were separated by region, and the answers within the region were averaged. In North America, the average percent to which firms operating only within one country view the clearing and settlement pr~ as electronic is 45%. In contrast, the average percent to which those firms in North America operating in more than one country view the clearing and settlement process as electronic is 68%. Of course, the de$1"ce to which C&S processes within a country are considered to be electronic depends upon the particular markets the firm trades in. It is difficult to infer from this data whether North American institutions view the international C&S process as being more electronic, or whether the international players arc larger and therefore possibly exposed to the C&S procedures in more domestic markets than are the firms operating in only one country category. Page236
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Study o( International Cearing and SettJement Survey Results SURVEY or INTERNATIONAL CLEARING AND SET11.EMENT: MARKET PARTICIPANTS Question 14: Does the clearing and/or settlement process in your market adequately meet your o.-ganizarion's needs? (yes or no) IS CLEARING AND SE'ITLEMENT ADEQUATE FOR YOUR NEEDS? I OP RISPOHDIMTS Ill-J@mmmmmmmmimmmmmmmmmmmmmmmmmmm@1111mrn;rn!in@mr 111111am trnmmmmmmmm11trn; --... .. IUll/&lltrlC 0 LI ADEQUATE 20 40 60 II [NADEQUATE --------------80 100 75% of those North American firms with operations only in one country thought that the C&S process in their markets were adequate, as opposed to 62% of the North American firms which trade in markets in more than one country. This is particularly interesting in light of the responses to Question 12, in which survey participants were asked to determine the percent to which their markets were electronic. Those North American firms with operations only in one country indicated that the degree to which the process was electronic was < 50%, yet 75% of these respondents felt the C&S process adequately met their needs. Page 237
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Study of International Oearia= Settlement Suney ta SURVEY or INTERNATIONAL CLEARING AND S~MENT: MARKET PARTICIPANTS Question lSa: What do you consider to be the three most significant risks in clearin& ( or matching trades) domestically? Risk Cited Risk that a couaterparty to a trade may not pay for or deliver securities Unmatched trades not resolved in a timely manner Computer error Humaneff'Or Problems with physical delivery of securities f of Respondents 34 33 15 15 1 Question 1.Sb: What do you consider to be the three most significant risks in clearina ( or matching trades) internationally? Unmatched trades not resolved in a timely manner Risk that a counterparty to a trade may not pay for or deliver securities Timetables for the clearinJ of trades vary from market to market Differences in the underp,aning, of the clearing process (laws, regulations, etc.) Lack of an international standard for identifying securities #: of Respondents 16 15 8 8 7 Both domestically and internationally, the two most often cited risks by our survey respondents were the risk that a counterparty might not pay for or deliver securities, and, the risk that unmatched trades might Dot be resolved in a timely manner. We find it particularly noteworthy that relatively large numbers of our survey respondents cited the same risks. We expect that had we provided a checkoff list of risks (rather than as.king an opcn-euded question), the number of respondents citing these risks as important issues would be even greater. Page 238
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Study of International Caring and Settlement Sum:y Rcsuils SURVEY or INTERNATIONAL CLEARING AND SETrLEMENT: MARKET PARTICIPANTS Question 16a: What do you consider to be the three most significant risks in settlement domestically? Bisk Cited Risk that a countcryarty to a trade may not pay for or deliver securities Wrong security delivered for settlement D~Plib?' error ..,._ ( .-....1:.... L-d f L-de . Wl~ a traw;; a w--a partner ua DO recor O tra as it IS described by the counterparty) Lack of delivery versus payment service ( delivery of securities and payment are on the same day) I of Resmmdents 36 15 14 12 11 Question 16b: What do you consider to be the three most significant risks in settlement internationally? Risk Cited Foreign Evbange Risk Risk that a countc~arty to a trade may not pay for or deliver securities Payment S~cm Risk Wrong security delivered for settlement Tunetablcs for the settlement of trades vary from market to market I of Respondents 17 13 10 9 8 Page 239
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Study of IotemarionaJ Cearin~ Settlement Survey IS SURVEY OF INTERNAnONAL CLEARING AND SETI'LEMENT: MARKET PARTICIPANTS Question 17a: What do you consider to be the three most significant problems in clearing ( or matching trades) domestically? Problem, Otcd Unmatched trades not resolved in a timely maDDer Participant's broker did not agree on terms of the trade as represented by the counterparty Human error Delays in broker confirmation of trades Lack of immobili7.ation of securities # of Respondents 2S 12 11 10 8 Question 17b: What do you consider to be the three most significant problems in clearing ( or matching trades) internationally? Problem Cited Differences in the underpinnings of the clearing proceM (laws, regulations, etc.) 11D1etables for the clearing of trades vary from market to market The need for linkages between clearing entities in various countries. Unmatched trades not resolved in timely manner Lack of an international standard for identification of securities Page240 I: of Respondents 10 10 9 9 8
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Study of International Ocaring and Settlement Survey Results SURVEY OF INTERNATIONAL CLEARING AND SETILEMENT: MARKET PARTICIPANTS Question 18a: What do you comider to be three most significant problems in settlement domestically? Problem Cited Insufficient automation of settlement process Lack of de~tory /inadeq_uacies of depository Delays in delivery of sccunties Wrong security delivered for settlement # of Respondents 12 10 8 8 Question 18b: What do you comider to be three most significant problems in settlement internationally? Problem Cited 'iunetables for the settlement of trades vary from market to market Lack of de~ory Differences in the underpinnin~ of the settlement process (laws, ~ons, banking practice, etc.) Difficulties ~tcd with transfer of funds and payment systems I of Respondents 14 9 8 7 Page 241
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Study of International Ccarin= Settlement Surwy ti SURVEY OF INTERNATIONAL CLEARING AND SE'ITLEMENT: MARKET PARTICIPANTS Question 19: Do you recommend any changes in your domestic clearing and settlement system? (yes or no) If yes, which changes? DO YOU RECOMMEND CHANGES IN YOUR HOME COUNTRY DOMESTIC The changes recommended are as follows: Recommended Chan~s Inaeascd standardization of the clearing and settlement process Inaeascd automation of the clearing process, especially so as to include a greater variety of financial instruments Implement unified clearing Implement the Grouo of Thirty's recommendations Implement or inaeasc the dematcrialization of securities Align banking and e"tcbange holidays Go back to pnysical delivery of securities Settle all trades on the day after the trade (T + 1) Create a centrali7.ed depository Inaeasc the protections for investors in the event of the bankruptcy of a brokerage firm Page 242 I of Respondents 13 12 6 4 3 2 1 1 1 1
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Study of International Cearing and Scttlemen t Survey Results SURVEY OF INTERNATIONAL CLEARING AND SETrLEMENT: MARKET PARTICIPANTS Question 20: Do you recommend changes for clearing and settlement systems in other countries to facilitate global trading? (yes or no) If yes, which changes 1 DO YOU RECOMMEND CHANGES IN OTHER COUNTRIES INTERNATIONAL The changes cited are: Recommended Chanacs I of Respondents Implement the Group of Thirty's Recommendations 6 Implement unified clearing 5 Inacased standardization of the clearing and settlement process 4 Create more links between clearing and settlement entities in various l countries Inaeased automation of the clearing process, so as to include a 1 greater variety of financial instruments Increase the dematerialization of securities 1 Allow stock loan/borrow arrangements 1 Not every respondent who said changes were necessary made a specific recommendation. Page 243
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Study of International Oearin~1 Settlement Suney ta SURVEY OF INTERNATIONAL CLEARING AND SETrLEMENT: MARKET PARTICIPANTS Question 22: Which aitical clearing and settlement problems should the United States Congress address, if any, and what would be the ideal solution for your business needs? Recommendations for Coneressional Action Support standardization efforts for global trading Support immobilization of securities Support inaeasing the standardization of the clearing and settlement Re:=caring house funds to have same day availability Provide a unified regulator for all U.S. markets Align banking and exchange holidays Moilify SEC re~ons to addrCM international trading issues Support the regional clearing of securities Provide asmtancc in the clearing of mortgage-backed securities Clarify insurance 01f book entry of securities" Implement 24-hour FcdWire Other recommendations not easily classified I of Respondents 9 7 5 3 3 2 2 1 1 1 1 11 As is evident from the above survey responses, our survey participants have identified a wide variety of policy wues which they feel would benefit from CongreMional action. 15 of cu: survey participants, however, indicated that they do not wish to see inaeased Congressional involvement in issues affecting the clearing and settlement industry.
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Study of International Ocaring and Settlement Survey Results SURVEY OF INTERNATIONAL CLEARING AND SETrLEMENT: MARKET PARTICIPANTS This chart provides a breakdown on how many of our survey participants responded to our question ( number 22) about the need for Congrewonal action. SHOULD THE U.S. CONGRESS TAKE ACTION TO IMPROVE THE CLEARING Al'lD SETTLEMENT PROCESS? Survey responses saying that congress should take action were coded "yes" for inclusion in the above chart. Those rCSt>4?DSCS stating that Congress should not take action were coded "no"; survey participants who either declined to answer the question or indicated that they had no opinion were coded "no opinion." Page 245
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STUDY OF INTERNATIONAL CLEARING AND SETTLEMENT 7. l\1ARKET BREAK REPORTS Page 247
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TABLE OF CONTENTS Sectfon 7 Market Break Reports: Review of tbe '87 Market Break Reports as They Relate to Oearing and Settlement 247 Page 248
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7 REVIEW OF TIIE '87 MARKET BREAK REPORTS Study of International Cearing and Settlement Market Break Reports AS THEY RELATE TO CLEARING AND SE'ITLEMENT The many studies that have been done, by various organizations, on the performance of the clearing and settlement industry during the October 1987 market break in the U.S. have often left an impression that the problems of clearing and settlement were on a par with those of the markets themselves. (Indeed one report, that of the Brady Commissio~ recommended a complete restructuring of the domestic U.S. system through the aeation of a link between ail U.S. clearing houses.) In this section of our study, we will attempt to re~ that impression. At the same time, we will take a look at the actions which the clearing and settlement industry and its U.S. regulators have taken to correct deficiencies in the process which existed prior to October 1987: deficiencies which in many cases played no role in the events of the market break. To provide some t-ype of international perspective, we felt it would be interesting to also include, for comparison purposes, the reports of the Bank of Englanti and the London Stock Exchange. The market break was a global one. Ocaring and settlement itself has taken on a global dimension as a result of inacascd foreign participation in markets around the world. In that vein, these two reports provide some "balance," lest we view the problems of clearing and settlement as being solely those of our domestic system, rather than being the endemic issues they are, in terms of the operation of the world's markets. As noted in the SEC report (Chapter 11, The IntemationaJ Capital Markets"): "U.S. institutions an active purchasen of both U.K. and Japanese securities. Accordingly, the opeation of those markets dirtctly affects a large number of U.S. participants." Similarly, in "Global FUU111c~" (November, 1988), it is noted that U.S. corporations are also doing significant issuance activity abroad, adding yet another dimension to the situation. And, of course, we are now bP.gjnning to see a growth in foreign-denominated instruments traded in U.S. markets. To evaluate the performance of the U.S. clearing and settlement system, we must consider not only how we view it, but aJso how foreign entities trading here see it. The converse is true of clearing and settlement systems abroad. As such, a sort of international continuum is formed. In that light, it is interesting to compare the concerns of U.S. industry observers viewing the events of October 1987 -as opposed to the concerns of observers in another country (in this case, the United Kingdom). In order to begin any analysis of the diverse reports which were published in response to the October 1987 market break, it is useful to begin by examining the areas in which these reports found common ground in terms of problems and solutions. The reports eumined in this analysis are as follows: the Brady Commission; The President's Working Group on Fmanciai Markets (Interim Report); the October 1987 Market Break Report by the Division of Market Regulation of the SEC; the Final Report on SlOck lru:ia FUlUn!S and Cash Market Activity of tM Commodity Fwures Trade Commission; Foilowup Report on Financial Oversight of Stock Index Futuru Markets During October 1987 (CFrC); the Congressional testimony of Federal Reserve Board chairman.Alan Greenspan; the Bank of England study; the report by the International Stock Exchange in London (the ISE); the report by the Chicago Mercantile Exchange (CME); and the report by the Chicago Board of Trade (CBOT). Page 249
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Study of Intemational Cearing and Settlement Market Break Reports The following chart shows some of the major areas identified by several reports: Create a Ouifytbc Centralized Lcpl Status of System to the Monitor Obliptioa Create a Man.et locurred by a Unified Puticiput BankWben it Regwatory POlitiom within Facilitate Guarantea Enviroament andac!Ola Create~ Tunely Jlayment to rorall 1111mm well Unk Between Payments to Settle P"mancial uGencral AllU.S. Meet a Trade or lutrwnents in a Mart.ct Oaring Settlement Margin Cail Country Conditiolll Housa Obligations Brady Commiaion Yes Yea Ye1, The Iaterim Yes yes. staff by Yes Report of tbe having more President's exchanging of Worting Group information OD F'maacia! Mamts SEC DiYilioa of Yes Y....s Manet Regwalion CFTC Yes Yes Yes Greenspan Yea Yes Testimony lntemationaJ Yes Stoct Exchange Chicago Board of Trade Allow Brokers to Crea-Margin their House Accounts Acroa Several Exchanges Yes Yes Adopted tnai program after publication of the report Adopted triaJ program after pubJication of the report No (spccfic. disagreement noted) The first ~ue which is identified as a common concern in many of the reports is reflected in their recommendation that regulators should clarify the legal status of the obligation incurred by a bank when it guarantees payment to settle a trade or margin call. This recommendation seeks to address the concern by clearing houses over the risk that exists between the time a bank pledges to make a payment and the time the payment is actually made. Equities in the U.S. are paid for with clearing house checks which are, in essence, next-day funds guaranteed by a clearing house bank. The system for futures and options is different. In those markets.. a call for margin is a means of insuring the investor's ability to meet his obligations. The margin call in futures and options is made to ab~ on behalf of its customer (the customer in this case being a clearing member of the exchange issuing the margin call). Page 250
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"'I Study of International Cearing and Settlement Market Break Reports Responding to margin calls (prior to Odober 1987), banks would either actively or passively endorse their willingness to pay. Pas.uve endorsement, or I don't caJJ you by a certain dme, it's okay, poses one type of problem. However, even when a bank gives an active endorsement, there is a time period between that commitment and the actual movement of funds. This time lapse is a risk period, because there is always the posubility that something could happen at the bank to prevent payment. In several of the reports, it is argued that options and futures clearing houses should firm up the legal agreements with their settlement banks to lock in payment at the same time that the banks confirm their willingness to meet the settlement obligation of the clearing member. The ISE study in London addr~ this subject in terms of the payment system risk. and it saw no real need for change in this area. This condition existed prior to the October 1987 market break, but it was put into the spotlight at that time, because of the feeling of insecurity the p~ generated. Even now, when the relevant domestic clearing housm have firmed up their agreements with their banks, there remains the risk that on any given day, a settlement bank will refuse to make a margin commitment (something which is really a acdit decision on the part of the bank). The second proposal which emerged from the market break reports even though the Brady Report was the only one to advance the idea was the recommendation that a single clearing mechanism (i.e., a link between all clearing houses) be established to clear and settle trades of all types of fmancial instruments in the United States. This proposal is known as "unified clearin(. The Brady Report also recommended that a single government agency be given the authority to coordinate: clearing and credit mecbaoisrns~ margin requirements; and information systems for monitoring activities across marketplaces. This proposal is based on the view that all activities in the U.S. markets (securities, futures, and options) are best coordinated by one entity and that entity should be the Federal Reserve Board. The Federal Reserve Board, under Federal Reserve Chairman Alan Greenspan., appears unwilling to take on the mantle of intcrmarkct coordinator. The recommendation to have a single regulatory agency oversee the clearing and settlement process was introduced by the Brady Commission in the context of the issues stemming from the October 1987 market break. Noncthclc:M, there is no evidence that if a unified regulator bad existed prior to the market break that the market break would not have happened or would have evolved differently. A third recommendation in several of the repo~ on the market break is the proposal that, in order to improve the assessment of risk, a system should be created to monitor market participant holdings in various markets, as well as general market conditions. A reasonable case can be made by a variety of sources for the sharing of risk information in times of market turmoil Nevertheless, one must bear jn mind that at least when a firm's financial viability was at risk, this information sharing process DID occur during the market brc~ despite the fad that there was no formal system in place. Indeed, since Odobcr 1987, a variety of formal and informal information sharing arrangements have been established which do not compromise competitive information. It is safe to say that there is a good deal of resistance within the clearing and settlement industry to the concept of sharing information. One reason for this resistance is the fear that it might be difficult to separate risk-sharing information from the type of information which could give an unintended competitive advantage to the firm receiving the information. Addressing this concern, there has been considerable discu.uion of the need to establish a barrier, or cmncse Wall., between the part of an institution which is sharing information and another part of the same institution which might be able to use that information for com pctitivc advantage. Page 251
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Study of International Oearin& and Settlement Mamt Break Rq,or1a Another concern is that in order for ina~ information sharing to be effective, there would have to be improvements within the operations of the organizarinns involved in the information sharing. Many firms need to improve their knowledge of aou-market and aoss-product positions within their own holding., and those of their customers. Participants in the information-sharing network would also have to improve their own ability to assimilat., shared position information. F'mally, there is the concern that some o,gauizations in the clearing and settlement industry might not be ready to incorporate this new data into their dccwon-making pr~ For example: would a bank, having been supplied risk information pertaining to the positions of its customers on October 19th, have been any more able to make intelligent acdit decisions? While discu.uions on this subject continue, there has been some fragmented movement towards the sharing of risk data between knowledgeable parties (for example: between the NYSE and the CME, as is noted in the CFTC Division of Trading and Markets "Contract Market Duignation,. memorandum on the CME's application for the trading of ~akkci futures contracts). In addition there are several other risk sharing initiatives underway including some which are aoss-border in nature. A fourth area of concern in the market break reports is the desire for timely p"'yments to meet settlement obligations. The rccoilllDendations in this are~ which range from sharing data on payments and acdits to extending the hours of the FcdWire, arc not new. In a fragmentary fashion, these ideas had been discussed prior to the market break, in mectinp between clearing houses.. banks, and regulators. The fact that the markets have evolved faster than the banking system's ability to move money in support of those markets is a given. But given the underlying aedit implications for the banks, simply speeding up the payments still may not insure that the payments will be made. An earlier opening of the FcdW'tre could be helpful in supporting the Chicago futures clearing houses~ and an macased sharing of pay and collect dara could improve the feeling of confidence in a customer's ability and willingness to pay. These measures, however, would only saatch the surface of the issues relating to banks and the clearing and settlement process. The final item mentioned which is a matter of common ground in many of the reports on the market break, is the recommendation for aoss-margining of the accounts of clearing house members. This is a subject which is covered elsewhere in this study and will not be repeated here, except to note that there are respected opinions on bolh sides as to the value of this proposal.1 While not trying to cover all of the issues discussed in these reports, two very obvious conditions are noteworthy. FU'St, the Brady Commission arrived at a broad series of macro-level conclusions about the centralization of regulation and the clearing process itself. These are conclusions which are not shared by olher major studies of the problems of clearing and settlement. The Brady Commission report, in the conclusion to its executive summary, also equates the level of criticality for changes recommended in clearing and settlement wilh the same level of importance that it assigns to changes recommended for the markets that the clearing houses serve. As time has provided an improved perspective on the performance of clearing and settlement during the October 1987 market break ( a luxury not afforded the authors of the Brady report), it has become inacasingly clear that the domestic U.S. ( and indeed, the international) clearing and settlement function did not fail. Yes, the prOCCM was stretched, perhaps even close co its breaking point during 1 See Section 4.S cross-Margining" for more information on the subject of C1"055-margining. Pap 2S2
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Study of International Cearing and Settlement Market Break Reports the week of October 19th, 1987; and yes, the process is in need of further improvement. But neverthel~ it is true that during the market break, the clearing and settlement industry did perform its intended function, with all the appropriate safeguards intact. An interesting counterpoint to our discussi,;,n of the Brady Comrnis.,.iQn's report on a unified regulatory environment is provided by the McKinsey expert paper, included in this study. The McKinsey paper suggests that the Brady Commisuon's recommendation might be right: if it were argued from the point of view that the industry should be restructured for the purpose of achieving the maximum competitive advantage (as opposed to just risk reduction). Another observation which emerges from the study of these reports is the clear impression that the indu.my is aware of its own shortcoming., and areas needing improvement and is willing to take an actiw role in its own transformation. And in fact, as subsequent reports on the market break have shown, the industry has charted a path for improvement which is beyond that envisioned by the Brady Cornmiion. Page 253
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Study of International Cearing and Settlement Martet Break Reports The following chart tracks the path that the industry is taking in its own transformation, and the degree to which progress has been made on each component of that transformation: Recommended Action Step Progress Toward Implementation The CFrC and SEC shouJd moaitm the prograa ol Self The Ccaring Corporation. the Ciicago Rcgwa~ Orpnmtiona in tbe opciom and funua martc11 Mercantile Exchange Oearing Ho111e Division and the ill tbcir Ott to Cmaliz.e reviled sctttcmcnt bank apeemcnra. Board of Trade Oeuing Corporation have finalized their revised settlement bank agreements. The CFTC and the SEC sbouJd clarify the lepi mtul of the obUptioa illcurred by a bank wbea it panatea payment to settle a trade or margin call. Undaway (CPTC compk:tcd) Federalreplatonlhoukl rcvicwcunatpaymcnt facilities and Undctway COllli*r wtlat further pnadcntial rnCMUrea are ncccuary to facilitacc timcJy paymeats. Cearing <>rpnmtiom &bowd reYicw the adequacy of clearing Undctway mcmbcr guarantee fund contributions. Rcgwatonand Oearing bousashoukl explore tbe desirability Undetway of coaveningponiouof emtingseaaritiesand futures clearing organization guarantee funds to cash or cash equivaJents. CearinJbolllCa should im~nt comprehcllliYe procedu.rea Undctwayvia the Intermarkct Information System in the to provide a centralized ta coUection facility for payment funares market at SOTCC. Discussions an: aJ.so underway information relating to clearing and scttlemcnL to indude options and equities. Securities Qcaring Group ~t in place for securities and options cieanng OrpmDbODL = snouJd esrablilh syacms procedures to In place at CME and CBOT. Progress reponed a, NYSE. same-day trade rnacehing. A.MEX and NASO. Thcresbowd be a link between the CP'TC data buc ( concaining information oa the siacua of funares martet panicipanu' Open issue. CFrC has improved its database. boktinp) and similar data bucs to be created for the equities and optiona markers. Cearing houla in tbe futun:1 and options martcts shouki Underway harmonm: the timing of margin calls. Cearing houses sboukl consider imptcmenung Pilot underway c:roa-margining. R.cgwaaon of opriom ma.mes should e.xpk>n: the 111e of funm:s-ayie margining. U ndcr active COfllideration. Shonen 5 day settlement period for equities trades. U ndcr active considcraticn The tremendous amount of activity demonstrated on the preceding chart clearly indicates that the domestic U.S. clearing and settlement system is making progress towards resolving those issues raised in analyzing its performance in October 1987. The progress is not, however, uniform nor universally agreed to. Many of the proposed changes above have ardent proponents and opponents, with good economic sense on both sides of the discussion. Each of these major issues and their debates, where appropriate, are discussed in our summary. Progress on the recommendations reached in the various reports, with the exception of the Brady Commiion maao-level concepts, has been substantial and ongoing, even if the actual complete resolution of these issues is still some time off. Page 2S4
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Study of International Cearing and Settlement Manet Break Reports One subject which was cnrnio,..d in any of these market break reports, but for which no recommendations emerged, is the need for banks to keep the aedit pipeline open, where possible and appropriate, in times of market turmoil This omiMion needs to be addrCMCd because any systematic approach to improving clearing and settlement must involve the issue of continuing to make acdit available to effect settlement. Some of the issues relating to the credit process which are in need of further study include: the way that banks provide aedit to market participants Bank Letters of Credit issued under one economic circumstance and drawn down in another (for example, a customer has a losing portfolio in a downward spiraling market) the trend on the part of U.S. fioaarial services firms to seek out lower cost funds available from foreign banking institutions. For the purposes of our study, wc took the market break reports as a launching point for our research, which instead focused on what the industry is doing today -both operationally and in terms of risk amelioration. Since these reports were written, the world has changed and various groups are proposing to change it even funher. The jmmiaencc of 24-hour-a-day trading; the migration of pension funds from U.S. markets to foreign markets; the Group of Thirty's recommendations for the standardization of the international clearing and settlement process for equities; the European Economic Community report on securities settlement in Europe: all envision an industry moving away from the starting point dealt with by the market break reports which wc have just reviewed. Those reports, like this study, have only a limited point-in-time value because the industry structure continues to evolve to the point where the basis for the reports atrophies with time. Page 255
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STUDY OF INTERNATIONAL CLEARING AND SETTLEMENT 89 TECHNOLOGY IN CLEARING Ai~D SETTLEMENT P gc 257 ..
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TABLE OF CONTENTS Section 8 Technology in Ocaring and Scttltment 2S7 Page 258
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8 TECHNOLOGY IN CLEARING AND SETTLEMENT Study of International Oearing and Settlement Technology For a complete disawion of technology the degree to which it is utilized, its impact, and its risks -the reader is referred to the IBM Report which is a part of this study. (Sec volume IV.) We have also discussed technology in less detail in a variety of sections including Section 3.10: "R.isks Associated With Technology, Including Security Risks" and Section 4.7: "Automation of the Qearing and Settlement Process." Page 259
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STUDY OF INTERNATIONAL CLEARING AND SETILEMENT INDEX Page 261
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INDEX ACC,48 Amo Commodities Corporation ACE See CEDEL and Euro-clear System ADRs, 43, 162 American Depository Receipts -D~ 43 AFFM, 106 Australian Financial Futures Market Agency Securities See U.S. Government Securities GSCC, 63 Issuers, 61 AIBD,83 Association of International Bond Dealers AKV,94,97,188,189 Deutscher Auslandskassenverein AG As depository for foreign issues, 97 Gl.obal Bearer CertificaJe, 97 Link with CEDEL, 97, 188 Link with CIK, 188 Link with Euro-clear, 97, 188 Link with ISCC, 41 Link with JSCC, 97, 188, 189 Owned by, 94 Settlement at, 97 Settlement through the KV, 97, 188 Alberta Stock Exchange, 69 American Bar Association, 136 AMEx,53 American Stock Exchange Argentina Tax Wuhholding & Reclamation, 173 ASX, 101, 104 Australian Stock Exchange Australian. National Guarantee Furu:4 105 FAST, 103, 105 Interface to Clearing House, 104 Interface to the Banking System, 105 JECNET, 104 Option Markets, 107 Re1(Ulatwn, 192 SEATS, 104 Settlement, 105 Trade Guarantee, 105 Traded Instruments, 104 AURORA SeeCBOT Austraclear, 102, 105, 107, 158 Matching & Settlement Process, 107 Membership, 107 Regulation, 192 Securities Lending, 107 Trade Guarantee, 102, 104, 107 Australia, 103 See ASX, AFFM, Austraclear & SFE Automation of Clearing & Settlement, 198 Equity Markets, 104 Futures Markets, 106 ICCH, 91, 106 Money Market Securities, 107 Need for a depository, 104, 105 Netting of Securities Positions, 197 Options Markets, 107 Outlook for International Standards, 169 Payment Systems, 104, 106 Tax Withholding & Reclamation., 173 Austria Outlook for I ntemational Standards. 169 Tax Withholding & Reclamation., 173 Trans-Border Data Flow Restrictions, 166 Automation of Clearing & Settlement See Technology & Computer Security By Country, 198 Clearing House Survey Results, 226 Impact on Information Sharing, 203 Market Participant Survey Results, 236 Bank Law, 134 Bank of Japan, 113 (Central Bank of Japan) SeeBOJ-NET As registrar of Government Bonds, 122 Money Market Instruments, 124 Banking System and, 28 ASX Clearing House, 105 Pa~ 263
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INDEX BOTCC, 48 CDS, 71 CEDEL, 80 Euro-clear, 84 Futures Markets, 52 GSCC, 64 HKSCC, 110 ICCH, 92, 106 /SE, 90 Kv, 97 NSCC, 37 OCC, 55, 58 OSE, 121 PTC, 67 SCCP, 39 SICOVAM, 86 TSE, 121, 124 Bankruptcy Law, 135, 141, 143 Banlauptcy Act, 140 International Application of, 135, 144 Lack of "Conflict of Law" Provisio"7 144 Payment Systems, 148 SIP A Liquidation Proceeding, 140 UCC, 135, 141 Banks, 14S, 161 See Banking System and Failure of, 145, 146 Generic Roles, 145 Holidays, 13 Universal Bank, 153 Banque de France, 86 (Central Bank of France) Baskets of Instruments Defined, 14 Behof, John, 195 Federal Reserve Bank of Chicago Belgium Linkages, 188 Outlook for International Standards, 169 Tax Withholding & Reclamation, 173 Beneficial Ownership Defined, 105 In A~ 105 In GNMA pools, 66 InJapan, 112 In U.K, 88, 89 Role of Transfer Agent, 162 BFE, 59, 91 Baltic Futures Exchange BIS, 133, 146, 148 Bank for International Settlements Board Lot Defined, 108 BOJ-Net, 1.22, 124 Book-entry Transfer or Ownership Defined, 14 Agency Securities, 62 AKY, 97 ASX"; 103, 105 Bank of Japan, 122 BEO (Book-Entry-Only), 201 CDS, 70, 71 CEDEL, 79 Dematerialization, 200 -203 DTC, 35, 36, 68, 69, 160, 187 Federal. Reserve, 61, 62 FIBV, 205 Global Custody, 174, 175 GNMAs, 65 Group of Thirty Discussion of; 201 GSCC, 61 HKSCC, 103, 110 Immobilizatio"7 200 -203 In cross-border Transfer of Securities, 201 In Europe, 75 In U.S., 4 Jndivi.dua/, Investor, 178 /SE, 89, 90 JASDEC, 102, 118, 119 JSCC, 103, 115 -119 Kv, 95, 96 Market Participant SunJey Results, 24~ MSRB, 68 MSTC, 187, 188 Municipal Securities, 68, 69 Options on Futures, 60 OSE, 103 PHILADEP, 39 PTC, 65 SICOVAM, 85, 188 TALISMAN, 89 Pa~ 264
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INDEX TAURUS, 90 Transfer Agents, 161 U.S. Treasury Securities, 61, 62 Vancouver, 188 BOTCC Board or Trade Clearing Corp. Clearing and Settlement Process, 46 CME, 45 Default, Protection Against, .J7 Guarantee Fund, 51, 137 Interface to Chicago Board of Trade, 45 Interface with Banks, 48 Margins, 46, 47 Matching, 46 Regulation., 193 SAFE, 47, 50 Segregation of Customer Funds, 47 Trade Guarantee, 46 Brazil Automation of Clearing and Settlement, 198 Netting of Securities Positions, 197 Regulation., 192 Tai: Withholding & Reclamation., 173 Trans-border Data Flow Restn'ctions, 166 Briggs, William, 37, 136, 138, 143 Stock Clearing Corp. of Philadelphia Broker-dealers Defined, 87 Bundesbank, 97 (Central Bank oCWest Germany) Callahan, Mary Ann, 41 -43 In.temational Securities Clearing Corp. Canada Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 Outlook for International Standards, 169 Regulation., 192 Tai: Withholding & Reclamation., 173 Trans-border Data Flow Resmctzons, 166 CBOE, S3 Chicago Board Options Exchange CBOT, 45, 59, 153 Chicago Board or Trade AUROR/4181 C~48,49 COMEX Clearing Association Guarantee Fund and .Assessments, 137 CCC, 48, 49 Commodity Oearing Corp. Guarantee Fwui and Assessments, 137 CDS, 69, 70 Canadian Depository for Securities .. Ltd. Clearing and Settlement Process. -:o Contiru..wu.s Net Settlement, 70 Interface to Banking System 7l Interface to Particioants, 71 Link with other Organizations, -/.0, 139 Securities Lending, 71 Trade Confinnation., 70, 71 CEDEL, 77,202 CentraJe De Llvraison De V aJeurs Mobillieres ACE, 79 Clearing and Settlement P.,-ocess. 79 Credit Facilities, 80 Cross-border links, 80 Interface to Banking System, 80 Interface to Clearing i\1embers, 78 link with AKY, 97, 188 Link with ISCC, 40 Securities Lending, 81 Volume at, 77 Central Gilts Offic~ 89 CFrC, 25, 153 Commodity Futures Trading Commission Cross-Margining, 57 FISMOU, 166 Market Break Reports, 249, 250, 254 Position Limits, 51 Segregarion of Customer Funds, 47, 51 Page 265
PAGE 287
INDEX Chamberlain, Jam~ 130 International Oearing Systems Inc.. Ch~ K. w., 108 Stock Exchange or Hong Kong Chapman, Alger B., 17, 185 Chicago Board Options Exchange CHAPS,90, 149 Clearing House Automated Payment System CHIPS, 147 149, 161 Clearing House Interbank Payments System Circuit-breaker, 182, 184, 186 Oearing -De[ine4 23 Clearing & Settlement Process Defined, 11 Oearing Agent Banks -De[ine4 63 Clearing House Defined, 4 Default, Protection Against, 136, 137, 142 Guarantee Fund and Assessments, 136, 137 Risk Reduction, 51 Ris~ 144 Clearing House Interfaces, ~odel of. 27,28 Clearing Member -De[ine4 5 Clearing Member, Interfaces to Banks, 28, 146 CDS, 71 CEDEL, 78 Clearing House, 27 Euro-clear, 82 ISCC, 44 KV, 98 NSCC, 37 ace, 57 SCCP, 39 S/COVAM, 86 Cl\1E,S9,1S0, 1S3,186 BOTCC, 45 Cross-Margining, 57 DAR, 138 GLOBE<, 48, 106, 124, 181, 184 Gross Margining, 50 Guarantee Fund and Assessments, 137 Link with SIME<, 187, 189 Margins, 50 Regulation of, 193 SPAN, 50, 138 Trade Entry, 49 Trade Guarantee, 50 Trade lvf atching, 49 CNS Continuous Net Settlement Defined, 35 CDS, 70 Extended Hour Trading, 182 NSCC, 35 SCCP, 38 Collate~ Risk o~ 154 -158 COMEX. 48, 59 Commodity Exchange., Inc. Comptroller or the Currency .'dSRB, 67 Transfer Age~ 162 Coopers and Lybrand, lJS, 199 CRC~49 Chicago Rice & Cotton Exchange Credit Generic role, 25 In Futures \1 arkets. 5 2 Letter of Credit, 25, 151, 15 2 Line of Credit, 25 Market Volatility, 152 Settlement Banks, 5 2 Tripartite agreement define~ 80 Types of Collateral. 150. 151 Cross-border Trading, 184, 185 EEC Study of Cross-border Settlement, 188 Volume of, 144, l.J5 Cross-margining, 8 Defin.ed, 194 CME/OCC, 57, 195 During October 1989 }d arket Volatility, 196 October '87 Atf arket Break Reports, 252, 254 Page 266
PAGE 288
INDEX With bank financing, 196 CSCCC,48 Coffee, Sugar & Cocoa Clearing Corp. Guarantee Fund and Assessments, 137 CSCE, 48, 59 Coffee, Sugar & Cocoa Ex~hange CUSIP,202 Committee on Uniform Securities Identiftcation Procedures Custody See Global Custody Daiwa Securities Ameri~ In~ 11.3, 18S, 186 Delivery versus Payment Often referred to as oVP" Defined, 96 CElJEL, 80 Euro-clear, 83 Group of Thirty Recommendarion.. 147, 205 HKSCC, 102., 110 JSCC., 117, 121 Kv, 96, 98 }darlcet Participant Survey Results. 239 Risk Reduction and, 147 SCCP, 39 SICOV AM, 86. 87 Dematerialization, 161, 200 -203 Definition.. 14 Australia. 103 France, 85 Hong Kong, 103, 110 A1unicipal Secun'ties, 68 Denmark Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 Outlook for I ntemationai Standards, 169 Regulation in., 192 Tax Withholding & Reclamatio~ 173 Trans-border Data Flow Restrictions, 166 Depositories, 14, 62, 162 Defined, 4, 62 AKY, 97 Austraclear, 107 Australia, 104, 105 Bania and, 28 Book entry transfer of title, 14 CEDEL, 80 Clearing House and, 28 Dematerializarion of securities, 14 DTC, 34 37 EEC Study Recommendations, 205 Euro-clear, 84 Fungibility of securities, 141 Group of Thirty Recommendations, 204 Immobilization., 14 /SCC, 41 JASDEC, 118, 119 KV, 94 OCC, 58 SICOVAAf, 85 Depository lnterf aces to Federal Resen,,e, 28 JSCC. 118 NSCC. 34 OSE, 121 SICOVAM. 85 Depository Receipts D~ 113 OTC .. 28, 35, 36, 39, 42, 55, 67, 1 U, 118, 160, 171 Depository Trust Company ADR.s, 43 FAST, 162 ID System, 39 Link with JfSTC, 187 1Wunicipal Securities, 6 7 Regulation of, 19 3 Due Bill Defined, 116 DVP See Delivery versus Payment DWZ, 94, 95 Deutsche Wertpapierdaten-Zentrale GmbH Pa~ :.67
PAGE 289
INDEX ECU, 87,131 European Currency Unit EEC, 13, 168, 189 European Economic Community Study of Cross-border Settlement, 188, 200,205 Egypt Automation of Clearing & Settlemenl, 198 Netting of Securities Positions, 197 Equities -pefined,24 Buying on margin, 24 Clearing & Settlement in Australia, 104 Clearing & Settlement in Canada, 69 Clearing & Settlement in France, 84Ciearing & Settlement in Hong Kong, 108 Clearing & Settlement in lap~ 114 Clearing & Settlement in the U.K., 87 Clearing & Settlement in the U.S., 34 Clearing & Settlement in West Germany, 94 F aiJwe of a Brokerage Finn, 139 Euro-dear, 81,202 ACE, 79, 83 Banks artJi 84CEDEL, bridge to, 82 Clearing & Settlement Process, 83, 84 Credit Facilities, 83 Depositories and, 84 EUCLID, 82 Fungibility of .securities, 84 Link with AKY, 97, 188 Owned by, 81 Participants and, 82 Securities Lending, 84 Services Offered, 82 Volume, 81 Eurobonds, 77, 81 See CEDEL and Euro-dear AIBD, 83 Exchanges, Interfaces to ASX Clearing House, 104 BOTCC, 45 Clearing House, 27 Clearing Member, 28 DWZ, 95 ICCH, 92 ISCC, 40 /SE, 88 JSCC, 114 NSCC, 34 OCC, 53 SBF (for SICOV AM), 86 SCCP, 38 U.S. Futures Clearing Houses, 4S Experts Papers Complete list begins on page iii Cross Reference to Issues, 16 Failure to Pay or Deliver, 135 Counterparty Risk Bankruptcy Law, 135 France, 87 H,;ng Kong, 110 lap~ 102.113 }darker Participant Swvey Results. 130 NSCC, 36 TSE, 116 West Germany, 96 FAST Australian Stock Exchange. 103 Depository TnLSt Company, 162 FDIC,62,67, 134,146,162 Federal Deposit Insurance Corporation FederaJ Reserve, 25, 150, 152 See FedWire Bank Failure, 145, 146 Book-Entry Transfers, 62 Buying equities on margin, .J4 Depositories and, 28 GSCC and, 63, 64 Treaswv Securities Settlement, 61 -65 U.S. Government Securities, Agencies, 61 U.S. Government Securities, Treasuries, 61 FedWire, 7, 48, SO, 52, 61, 62, 66 -68, 131, 146, 147, 149, 161, 182, 184, 252 See Federal Reserve Extending FedUtire Hours, 183 Page 268
PAGE 290
INDEX FIBV, 13, 168 Federational Internationale des Bourse de Valeun Recommendations, 205 Ymality of Payment, 146. 150 Defined, 147 Australia, 106, 107 Availability of Funds, 147 Belgium, 149 Canada, 72, 149 France, 149 In &tended Hours Trading, 184 Italy, 149 Japan, 121, 122, 149 JSCC, 117 Netherlands, 149 Sweden, 149 Switzerland, 149 United Kingdom, 149 United States, 149 West Gennany, 149 F"mancial Instrument -Defined, 3 F"mland Outlook for International Standards, 169 Tax Wzthholding & Reclamation, 173 For.ht, Theodore, 16, 72, 139 141 Securities Investor Protection Corp. Foreign Exchange, 130 134 Also referred to as F /X Defined, 130 Forward Market, 131 Market Statistics, 131 Netting of, 132 134 Risks in,, 132 Settlement Process, 131 Spot Market, 131 FOX, S9, 91 London Futures and Options Exchange France See SICOVAM Automation of Clearing & Settlement, 198 Outlook for International Standards, 169 Tax Withholding & Reclamation, 173 Trans-border Data Flow Restrictions, 166 Fully-Disclosed Brokers Defined, 33 Fungible, 79, 84 Defined, 141 Futures-style Margining, 195, 196 Futures Markets Defined, 24 Clearing Member Default in, 51 DAR, 138 Dollars At !wk Gross Margining, 50 Guarantee Fund and.Assessments, 51, 137 Information Sharing, 187 Initial Margin, 50 Intra-day Margin, 50 Net Margining, 50 Opti.ons on See Options on Futzues Original Margin, 24 Position Limits, 51 Protection from Clearing House Collapse, 143, 144 Risk Reduction in, 51 Role of Credit in, 52 SAFE, 47, 50 Segregation of Customer Funds, 51 Settlement Banks, 52 Settlement in, 50 Settlement Payment Risks, 150 Standard Portfolio Analysis of Ris~ 50,138 TIMS, 50 Variation 1Wargin, 24, 50 Gall, J.E., 104 National Australia Bank Ltd. Gilt~ged Stock Defined, 87 G lenni~ D. J. L., 108 Hong Kong Shanghai Bank Global Custody, 13, 174-178 Pa~ ~69
PAGE 291
INDEX DefinerJ,, 17 4 Failed Trades, 175 Immobilization, Impact of, 178 Risks, 176, 171 Role of, 174 Securities Lending, 160 UCCand, 135 Volumes, 160,175 Global Mutual Fund Defined, 43 GLOBEX, 48, 106, 124, 181 GNMA Government National Mortgage Association Securities Defined, 64 MBSCC, 65 PTC, 64 GOVIES See U.S. Government Securities Group of Thirty, 12, 13, 147, 168, 170, 176, 178, 185,197,201,202,243 Summary of Recommendations, 204, 205 GSCC, ,1, 63, 64 Government Securities Clearing Corp. Banks and, 64 Netting, 63 Notification of Settlement Obligations, 64 Transaction Adjustment Program, 64 Volumes, 63 Guarantee Funds, 28, 136 138, 142, 143 -Defined, 5 Guarantee Funds outside the U.S., 91, 106, 123, 142, 143 SIPC, 140 Types of Collateral, 156 U.S. Clearing Howes, 37, 51, 56, 137 Haircut Defined, 67, 153 PTC, 67 Hamana, Masayoshi & Shimizu, Toshitsugu, 114, 118, 121 Tokyo Stock Exchange Hampton, Fred, 160, 167, 201 Depository Trust Company Hiatt, John & Kustusch, James M., 53, 57, 18', 194 Options Clearing Corp. HKSCC, 108 110 Hong Kong Securities Clearing Co., Ud. Banks and, 110 Clearing & Settlement Process, Old, 108, 109 Clearing & Settlement Pmre.ss, Proposed, 110 Hoessric~ Hans-Joachim & Ruetzel, Heinz, 94, 185, 186, 201 Deutscher Auslandskassenverein, AG Hong Kong See also HKSCC Automation of Clearing & Settlement, 198 Hon~ Kong Stock Exchange, 102, 108 Nettzng of Securities Positions, 197 Outlook/or International Standards, 169 Regulation of, 192 Tax Withholding & Reclamation, 173 Hosking, Les, 106 Sydney Futures Exchange Hubbar~ P.; Reed, P. & Kopin, B., 185 Chicago Research & Trading Group, Ltd. IB~ 10, 111, 113, 114, 118, 120, 158, 159,164,165,200,259 Technology in Clearing & Settlement ICC, 48, 57, 137 Intennarket Clearing Corp. Guarantee Fund and Assessment, 137 ICCH,9194 International Commodities Clearing House Ltd. Pa~270
PAGE 292
INDEX Australian Stock Exchange and, 101 Banks and, 92 Clearing&: Settlement Process, 92 -94 Collateral, 93 Exchanges and, 89, 91, 92, 101, 106 Guarantee Fund, 106, 143 Letter of Credit, 93 Margins, 92 Netting, 92 Owned by, 91 Payment System and, 93 Ritmlation of, 192 SFE and, 106 ICSI, 133, 139 International Clearing Systems, Inc. Immobilization, 102, 200 -203 Definition, 14 FIBV Recommendations, 205 Individual Investor and, 178 Japan, 102, 113 Municipal Securities, 68 West Gennany, 95 Information Sharing, 14,170,203 SEC Monitoring Coordination Group Securities Clearing Group 1987 Market Break Reports, 251 Bank Access to, 157, 203 BOTCC lntermarket Information System, 138, 187 NSCC, 37, 138 Obstacles to, 203 OCC, 56 Trans-border Data Flow Restrictions, 166 Infrastructure of Clearing & Settlement Defined, 11 Initial Margin See also Margin Banks and, 145 BOTCC, 46, 47 ICCH, 92 OSE, 123 Protection against defaults and, 138 TSE, 123 U.S. Futures Markets, 50 International Banking, 1S2 154 International Mutual Fund Defined, 43 International Options Clearing Corp., 70 International Practices-Differences in, 167 170 Comparative Chart by Country, 169 Recommendations to Overcome Differences, 167, 168 Investor Protection Australian National Guarantee Fund, 105,106 Banlauptcy Law, 135 Canadian National Contingency Fund, 6, 72 Futures Markets, 6 Global Custody, 175 Non-regulated Markets, 6 SIB Contingency Fund, 6 SIPC, 6, 139, 141 UCC, Article 8, 141 West German Deposit Insurance Fund, 98 IPE, S9, 91 International Pertoleum Exchange London Irish Futures and Options Exchange, 91 ISCC, 40, 159, 188, 202 International Securities Clearing Corp. American Depository Receipts (ADRs), 43 Banks and, 44, Clearing &: Settlement Process, 41 Clearin House Links, 42 Custodial Links, 42 Depository links, 41 Global Compass System, 44 Interface to Clearing Members, 44 Link toAKY, 41 Link to /SE, 42 Link with JSCC, 42, 119, 120 Mutual Funds, 43 Netting, 43 PORTAL, 43 Pag,271
PAGE 293
INDEX Servicing foreign clients, 40 Servicing U.S. clients, 40 Sponsorship, 40 Trade Guarantee, 41 ISE, 87, 90, 170 International Stock Exchange Central Gilts Office, 89 CHAPS, 90 Clearing & Settlement Process, 88 Instruments traded on, 87 Link with ISCC, 40, 42 LinkwithJSCC, 189 Link with MCC, 189 Options, 89 SEPON, 88 SEQUAL, 89 Settlement, 90 Settlement Period, 88 TALISMAN, 42, 88 -90 TAURUS, 88, 90 Trading Volume, 87 Israel Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 ISSA, 13, 87 International Society of Securities Administrators Italy Outlook for International Standards, 169 Taz Withholding & Reclamation, 173 Japan See also JSCC, JASDEC, TSE and OSE Automation of Clearing & Settlement, 198 Bonds, Clearing & Settlement of, 122 Clearing Houses, 111 Cross-border trading, 114 Delivery versus Payment, 121 Depositories, 112 Exchanges, 111 Foreign Investment in, 124 Foreign Securities in, 119 Futures Markets, 122 -124 Immobilization of Securities, 113 Market Structure, 112 Netting of Securities Positions, 197 Options Market, 124 Outlook for International Standards, 169 Payments in, 121 Regulation in, 192 Risk in, 112, 113 Taz Withholding & Reclamation, 173 Trans-border Data Flow Restrictions, 164 Zengin, 122 JASDEC, 102, 113, 118, 119 Japan Securities Depository Center See also JSCC, TSE, OSE and Japan Domestic Securities, 118 Foreign Securities, 119 Osaka Stock Exchange, 121 JSCC, 103, 112, 113, 121, 158 Japan Securities Clearing Corp. See also JASDEC, TSE, OSE and Japan Bonds, Clearing and Settlement of, 122 Book-entry of Securities, 115, 117, 118 Due Bills, 116 Fails in, 116 Interface to Depository, 118 Interface with TSE, 114 JASDEC 118 Link with AKv, 97, 188, 189 Link with CDS, 189 Link with ISCC, 40, 42, 119, 120 Link with /SE, 189 Link with Madrid Stock Exchange, 189 Link with NASE (Amsterdam), 120, 189 Link with SICOVAM, 120, 189 Payments, 115 Settlement, 117 Trade Guarantee, 115 Kay, Robert, 160, 174 177, 185, 186, 200 Morgan Stanley Trust Company Pap272
PAGE 294
INDEX KCBOT, 48, 59 Kansas City Board of Trade KCBOTCC,48 Kansas City Board of Trade Clearing Corp Guarantee Fund and Assessments, 137 Regulation of, 193 Kessler, Dr. Joerg-Ronald, 188 Author of EEC Study on Settlement Kolb, Joseph, 144, 167, 184, 185, 199 Security Pacific National Trust Company Kona Outlook for International Standards, 169 Tar Withholding & Reclamation, 173 Kuroda, lwao, 124 Bank of Japan KV, 94 98 Kassenvereine Bania.and, 97 Collective Safe Custody, 95 Delivery versus Payment, 95, 96, 98 DWZ, 94, 95 Landeszentralbanken, 97 Link with AKY, 97, 188 Link with NECIGEF (Amsterdam), 188 Link with OEKB (Austria), 188 Link with SICOV AM, 188 Members and, 98 Owned by, 94 Protection against defaults, 98 Regulation of, 193 Securites Lending, 96 Unsettled Trades, 96 Letter of Credit, 255 Collateral as, 151, 156 ICCH, 93 Japan, 111, 123 Liechtenstein Trans-border Data Flow Restrictions, 166 LIFFE, 59, 91 .London International Financial Futures Exchange See also ICCH Linkages Clearing House & Exchange Survey Results, 224, 225 Clearing Houses, 189 Depositories, 188 Domestic, 186 EEC Report, 189 Exchanges, 189 FIBV Report, 205 International, 187 Other, 189 LME, 59,91 London Metal Exchange Locked-in Trades Defined, 34 Australian Stock Exchange, 104 National Securities Clearing Corp., 34 Luxembourg Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 Regulation of, 192 Tax Withholding & Reclamation, 173 Trans-border Data Flow Restrictions, 166 LZB,97,98 Landeszentralbanken Makler Defined, 95 Malaysia Automation of Clearing & Settlement, 198 ICCH, 91 Netting of Securities Positions, 197 Regulation of, 192 Margin See Initial Margin See Margin, Equities Market See Variation Margin, Original Margin Differences in, 3 Protection against defaults, 138, 144-Pagt273
PAGE 295
INDEX Margin, Equities Mtu8i!i on short sale, 44 NYSE rules, 45 Role of Federal Reserve, 44 Margin, Equities Market Buying on, 44, 45 SCCP, at, 38 Mark to Market Defined, 111 Market Break Reports, Oct. 1987, 249 -2S5 Bank of England Report, 249 Banking Agreements, 250 Brady Commission, 249 -254 CFIC, Reports of, 249, 250, 252, 254 Chicago Board of Trade Report, 249, 250 Chicago Mercantile Exchange Report, 249 Comparison of, 250 Cross-margining, 252 Greenspan, Alan, Testimony of, 249 Information Sharing, 251, 252 International Stock Exchange Report, 249,250 Pro~ on Recommendations, 254 SEC, Report of Div. of Market Regulation., 249, 250, 254 Timely Payments, 250, 252 Unified Clearing, 250, 251 Unified Regulation, 250, 251 Market Maker Defined, 87 MATIF, 59, 8S Marche A Tenne Des Instrument Financiers MBSCC, 61, 65, 66 Mortgage-Backed Securities Clearing Corp SeePTC GNMAs, Clearing &: Settlement of, 65 -67 MCC,39,202 Midwest Clearing Corp. Guarantee Fund &Assessment, 137 Link with /SE, 189 LinkwithNSCC, 187 Link with OCC, 187 Municipal Securities, 67 McKinsey & Co., 13, 103,168,206, 253 see Shephard, Ian & Tullberg, Linda McPartland, John & Taylor, Kim, 181, 182, 184 Chicago Mercantile Exchange Mexico Taz Withholding & Reclamation, 173 Trans-border Data Flow Restrictions, 166 MGE,48, 59 Minneapolis Grain Exchange MIDAM,59 MidAmerica Commodity Exchange MONEP,85 Paris Options Market Montreal Stock Exchange, 69 SeeCDS Mooney, Charles, 139 -141 U Diversity of Pennsylvania Mortgage-Backed Securities See PTC, MBSCC Defined, 64 Issuers of, 64 MSRB, 67 69 Municipal Securities Rulemaking Board See Municipal Securities MSTC, 187 Midwest Securities Trust Co, Link with OCC, 187 Link with SICOV AM, 188 Link with Vancouver Stock Exchange, 188 Regulation of, 193 Muller, George, 77 CEDEL Municipal Securities, 67 69 Clearing & Settlement Process, 68 DTC, 67, 68 Issues, 68 Market Partidpant Survey Responses, 69 MCC, 67 MSRB, 67-69 Pa.274
PAGE 296
INDEX NSCC, 67 SCCP, 67 Mutual Funds See Global Mutual Fund See International Mutual Fund ISCC, 43 MWDTC,28 MidWest Depository Trust CO. NASD, S3, 139 National Association of Securities Dealen GSCC, 63 Link with Stock Exchange of Singapore, 189 MSRB, 67 OTC, 139 Netherlands See Nominee Amsterdam Stock Exchange Automation of Clearing & Settlement, 198 Outlook for International Standards, 169 Ta% Withholding& Reclamation, 173 Netting, 196, 197 See CNS & Foreign Exchange -D~ 8 AaSX; 105 Austraclear, 107 Bank for International Settlement, 133 Banlauptcy of Counterparty, 133 Bilateral, 132, 139 Group of Thirty Recommendations, 204 GSCC, 63 HKSCC,110 ICCH, 92 JCS/, 133 JSCC, 116 Multilateral, 132, 133, 139 Novation, 133, 139 OSE, 120 PTC, 66 Risk reducing of, 133, 134 Societe des Bourses Francaises, 86 New Zealand Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 New Zealand Futures Exchange, 91 Rq,dation of, 192 Tta Withholding & Reclamation, 173 ~lkkei 225 Stock Index, 14 Nominee Defined, 88 Australia, 105 Hong Kong, 109 United Kingdom, 89 Nominee Amsterdam Stock Exchange, llO, 189 Nomura Securities, 114, 118, 119, 122, 185, 186, 212 Norway Outlook for International Standards, 169 Tta Withholding& Reclamation, 173 Trans-border Data Flow Restrictions, 166 NSCC, 34, 37 40, 43, 112, 118, 171, 202 American Depository Receipts, 43 Balance Order Accounting, 36 Banks and, 37 Clearing & Settlement Process, 34 -36 Qearing Member Default Protection, 138 Clearing Members and, 37 Continuous Net Settlement, 35 -37, 138 Guarantee Fund and .Assessment, 37, 137 Information Sharing, 37 Link with MCC, 187 Municipal Securities, 67 NASD, 139 Netting, 35 OCC, 55 Protection against Collapse, 143 Regulation of, 193 Risk and Risk Reduction, 36 Stock Exchanges and, 34 Trade for Trade settlement, 36 Trade Guarantee, 35, 68 Pap275
PAGE 297
INDEX NYCE,48,59 New York Cotton Exchange NYFE,48,59 New York Futures Exchange NYMEX, 48, 59 New York Mercantile Exchange Guarantee Fund &Assessment, 137 NYSE, 53, 114, 186 New York Stock Exchange occ, 53 -S8, 152 Options Clearing Corp. See Options Markets Banks and, 58 C/MACS,58 Clearing & Settlement Process, 53 Clearing Member Default, 56 Clearing Members and, 57 CME, 57 Cross-Margining, 57 Delivery, 55 Depositories and, 58 DTC, 55 Exchanges and, 53 Foreign Cun-ency Options, 55 Guarantee Fund & Assessment, 56, 137 /CS/, 133, 139 Information Sharing, 56 Link with MCC, 187 Link with MSTC, 187 Link with Trans Canada Options, 189 Margin, 54, 56, 57 Marie to Market, 54 Netting, 57 NSCC, 55 Premium Obligations, 53 Regulation of, 193 Risk & Risk Reduction, 55 TIMS, 57, 138 Trade Guarantee, 55 Trade Matching, 53 Options Markets SeeOCC See Options on Futures Defined, 3, 24, 53 Awtralian Stock Exchange, 107 Clearing Howe Collapse, 143 Closeout~ Contracts, 54 Delivery o Equity-related Options, 55 Equity-re ed Options, 53 58 Foreign Currency Options, 55 /SE, 89 Japan, 101, 111 Margins, 24, 54, 56, 60 Marie to Market, 54 OSE, 112, 124 Premium Obligatio~ 53 Role of buyer and seller, 53, 54 TIMS, 138 Types of Contracts, 53 Options on Futures, 58 60 D~ 58 Clearing & Settlement Process, 59 Margins, 60 Premium Obligations, 59 Original Margin -D~24 OSE, 112, 114, 120 Osaka Stock Exchange Banks and, 121 Clearing & Settlement Process, 120 Depositories and, 121 Futures Contracts, 112, 122 GLOBEX,124 Guarantee Fund, 123 JASDEC, 121 JSCC, 121 Margin on futures contracts, 123 Netting, 120 New Secorui. Sectio~ 112 Nikkei 225 Contract, 122, 123 Options Contracts, 112, 124 OSF50 Contract, 122, 123 OTC Market, 139 Over-the-counter Market SeeNASD Pacific Stock Exchange, 181 Panama Trans-border Data Flow Restrictions, 166 Pap:Z76
PAGE 298
.. INDEX Payment Systems, 14' 150 See FedWire, CHAPS, BOJ-NET & CHIPS See Finality of Payment 7 Australia, 104 Belgium, 149 Canada, 149 Checks and, 150 Extended Hours Trading and, 182 -184 Foreign Exchange and, 131 France, 149 Group of Thirty Recommendations, 147, 20S Italy, 149 Japan, 149 Market Participant Swvey Results, 241 Netherlands, 149 Overdraft Limits, 150 Reliability of, 146 Risk of Unwind, 147 Sweden, 149 Switzerland, 149 United Kingdom, 149 United States, 149 West Gemzany, 149 PBOT,48 Philadelphia Board of Trade PFE,48 Pacific Futures Exchange Philippines Automation of Clearing & Settlement, 198 PHILADEP, 37, 39 Philadelphia Depository Trust Co. PHLX,39,S3 Philadelphia Stock Exchange Position Limits, 47 Pozdena, Randall, 181,183. San Francisco Federal Reserve Bank Premium Obligations Defined, 53, 59 Primary Dealers, 63 PSA, '5 Public Securities Association PSE, 53,171 Paciflc Stock Exchange PTC, 28, ,1, 64 67 Participants Trust Co. Banks and, 67 Clearing & Settlement Process, 66 FedWue, 66, 67 GNMAs, 64, 65 Guarantee Fund, 67 Haircutting Equity Collateral,, 67 MBSCC, 65, 66 Netting, 66 PSA, 65 Risk Reduction, 66 Services Offered, 65 Trade Guarantee, 66 Transaction Volume Processed, 66 Regional Interface Operation Defined, 39 Registrars Defined, 26 Bank of lap~ as, 122 in Hong Kong, 109 in U.K, 89 Role of, 162 SICOVAM, as, 85 Regulation, 13, 168, 190 194 1987 Market Break Reports, 251 Australia. 102, 192 CFI'C, 190,191,193 Comparison of Regulation by Country, 192, 193 Comptroller of the Cun-ency, 190 Federal Reserve, 61, 63, 67, 190 Global Custody, 176 Japan, 102, 192 SEC, 190, 191 Reiss, Robert N., 18S, 186 NASD RELIT SeeSICOVAM Reuten GLOBE<, 48, 106, 124, 181 Richards, Angus, 104 Australian Stock Exchange Right of Assessment, 136, 137 Page 271
PAGE 299
INDEX Futures Market, 51 ICCH, 91 U.S. Clearing Houses, 137 Riley, Raymond & Foley, Michael, 161, 162 Securities Transfer Association Risk, 161178, 147 178 Availability & Reliability Information, 170 Banking System, 145 Clearing Entity Collapse, 143 Clearing House Protection on Trades, 136 Defaulls on non-Clearing House Trades, 139 Delay in Resolving Unmatched Trades, 129 Differences in International Practices, 167 F ai1ure of a Brokerage Finn, 139 See Investor Protection & SIPC F aiJure of Collateral, 154 Failure to Pay or Deliver, 129, 130, 135 Foreign Exchange; 130 Global Custody, 174, 176, 177 Human or Computer error, 129 Increased Trading Volume, 158-161 Also Includes Discussion of Technology International Banking, 152 International Regulation, 194 Japan, perception of Risk in, 113 linkages, 187 Payment System, 146 Tax Withholding, 172 Technology & Computer Security, 163 -166 Trades in Unregulated Markets, 139 Transfer Agents, 161 -163 Rolling Settlement, 205 -D~ 90 Group of Thirty Recommendations, 205 Ruder, David, 204, 206, 207 Former Chairman or SEC Russo, Thomas, 136 Caldwalader, Wickersham & Taft Rutz, Roger; BOTCC, 45, 48, 49, 51, 136, 137, 143, 194, 204 SAFE,47, SO SeeBOTCC Simulation Analysis / Financial Exposure SBF,8' Societe des Bourses Francaises SCCP, 37 39, 67, 138, 143 Stock Clearing Corp. or Philadelphia Banks and, 39 Blotters, 38 Clearing & Settlement Process, 38 Clearing Members and, 39 Exchange and, 38 Margin44ccounts, 38 Monitoring Members Positions, 138 Omnibus Account, 38 Protectwn against Collapse, 143 Purchase and Sale System, 38 Regional Interface Organization, 38 Specialist Margin Account, 39 Trade Matching, 38 SEC, 25, 55, 56, 63, 65, 67, 140, 152, 249,250,254 U.S. Securities and Exchange Commission 1987 Market Break Reports, 249, 250, 254 Cross-Margining, 57 Monitoring Coordination Group, 37 Securities Clearing Group, 37, 187 Transfer of Securities Ownership, 162 Securities Clearing Group, 37, 187, 254 Securities Lending, 71, 205 Defined, 71 Austraclear, 107 CDS, 71 CEDEL, 81 Euro-clear System, 84Globai Custodians, 160 Globalization, 185 PapZ78
PAGE 300
INDEX S/COVAM, 87 SIPC, 141 West Germany, 96 Securities Numbering Systems CUSIP, 202 Committee on Unifonn Securities Identification Proceedures Group of Thirty, 202, 205 lnfonnation Sharing and, 203 !SIN, 202 lnt'l Securities Identification Number Market Participant Survey Results, 240 SEDOL, 202 Stoclc Exchange Daily Official, List SEGA, 158 Schweizerische Eff'ekten-Giro AG Settlement See Settlement, Multi-currency See Settlement Period Defined, 23 Settlement, Multi-currency CEDEL,79 Euro-clear, 84-Globalization of, 184ICCH, 93 /SE, 90 S/COVAM, 87 Settlement Banks See Banking System and Settlement Period Asx;105 Bonds in Japan, 122 BOTCC (Margin), 46 CDS, 71 Clearing House/Exchanges Survey Results, 223 Differences in, 12, 13 Eurobonds, 83 Futures in Japan, 123 Hong Kong, 109 ICCH (Margin), 92 ISCC, 41 /SE, 88 JSCC, 115 KVs, 95 Municipal Securities in the U.S., 68 NSCC, 35 OCC (Margin), 54 Options on Futures (Margin), 60 OSE, 120 PTC, 66 SCCP, 38 SICOVAM, 86 U.S. Futures (Margin), 49, 50 U.S. Treasuries, 62 SFE, 59, 102, 106 Sydney Futu~ Exchange Cle~~ Settlement Process, 106 GLOBE<., 106 Guarantee Fund, 106 SYCOM, 106 Shepherd, Ian & Tull berg, Linda, 17, 18,171 McKinsey & Co. SIA, 144 Securities Industry Association SIAC,37 Securities In~ustry Automation Corp. SICOV AM, 84 87 .SOCiete lnterprofessionnelle Pour La Compensation Des Valeun Mobilieres Banks and, 86 Clearing & Settlement Process, 86 Dematerialization of Securities, 85 Depositories and, 85 Future Development, 87 Instruments settled, 85 Link with FKV, 188 Link with foreign Depositories, 40, 85, 188, 189 Members and, 86 RELIT, 87 S.LT., 86 SBF, 86 Securities Lending, 87 Settlement Volume, 85 SIMEX,59 .Singapore International Monetary Exchange Link with CME, 187, 189 Pag~ 279
PAGE 301
INDEX Simons, Marc & Fulmer, Keith, 135, 160, 174, 176, 185,186,200,202 Price Waterhouse Singapore See also SIMEX Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 Outlook for International Standards, 169 Regulatjon of, 192 Stodc Link with NASD, 189 Taz Withholding & Reclamatio~ 173 SIPA, 140 Securities Investor Protection Act See SIPC Liquidation Proceeding, 140 Treasury Department, role of, 140 SIPC, 139 141 Securities Investor Protectim Corp. Guarantee Fund, 140 lrzstory, 139 Limits on Protection, 141 Membership, 140 Protection of Brokers, 141 Protection of Lenders & Borrowers, 141 Refund Guarantee, 139 SIPA, 140 Treasury Department, role of, 140 South Africa Taz Withholding & Reclamar..o~ 173 Spain Automation of Clearing & Settlement, 198 Madrid Stock Exchange Link with JSCC, 189 Outlook for International Standards, 169 Taz Withholding & Reclamatio~ 173 SPAN, SO, 138 SeeCME Standard Portfolio Analysis or Risk STA Securities Transfer Association See Transfer Agents Standardization, 13, 204 207 See FIBV, EEC, ISSA, Group or Thirty Bank Holidays, 13 EEC Study RecommendatiQns, 205 FIBV Study Recommendations, 205 Global Custody, 175 Globalizatio~ 114, 184-, 185 Group of Thirty Recommendations, 204 Stock See Equities -Defined, 3 Super Margin Call at BOTCC, 47 Survey Results/Clearing Houses, 21S, 216,219 232 Automation of Clearing, 226 Automation of Clearing Member Interfaces, 226 Automation of Settlement, 226 Cross-margining, 231 Domestic Linkages, 224 Failed Trades, % of, 230 Guarantee Fund, 229 Instruments Cleared, Profile of, 221 Instruments Settled, Profile of, 222 International Linkages, 225 Netting, 227 Payments Process, 232 Recommendations for Overal.l Process, 232 Recommendations for Payment Process, 232 Respondents, Profile of, 220 Rirks, 231 Settlement Period, 221 Sharing Inforr1ution, 231 Trade Guarantee, 228 Trans-border Settlement Issues, 232 Survey Results/Market Participants, 216 218,233 24S Adequacy of Domestic Process, 237 Congressional Action, Need for, 244-, 245 Degree of Automation of Process, 236 Domestic Clearing Problems, 240 Page 280
PAGE 302
INDEX Domestic Clearing Risks, 238 Domestic Settlement Problems, 241 Domestic Settlement Risks, 239 International Clearing Problems, 240 International Clearing Risks, 238 International Settlement Problems, 241 International Settlement Risks, 239 Recommended Domestic Changes, 242 Recommended International Changes, 243 Respondents, Profile of, 234, 235 Swap Defined, 167 Sweden Outlook for International Standards, 169 Taz Withholding & Reclamation, 173 SWIFl',202 .Society for Worldwide Interbank F"mancial Telecommunications Defined, 80 Globalization of Securities Trading aN4185 Switzerland Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 Outlook for International Stan.dard.s, 169 ReRUlation of, 192 SGA, 158 Taz Withholding & Reclamation, 173 Trans-border Data Flow Restrictions, 166 Synthetic Currencies SeeECU Taiwan Automation of Clearing & Settlement, 198 Taz Withholding & Reclamation, 173 TALISMAN, 89 TAURUS, 88, 90 Tu Withholding & Reclamation, 13, 172 174 Globalization aN4 185 Issues aN4 13 Reclaiming, 172, 174 T az Treaties, U.S. & other coWllries, 173 Tuneliness, 172 TCS, 116 Tosho Computer Systems Technology & Computer Security, 10, 163 16', 259 Impact on Global Custody, 177 Thailand Outlook/or International Standards, 169 Tax Withholding & Reclamation, 173 Third-party debit authority KV, 98 TIFFE, 112 Tokyo International Financial Futures Exchange TIMS, 138 SeeOCC Theoretical lntennarket Margin System Toronto Futures Exchange, 69 See Trans Canada Options, Inc. Toronto Stock Exchange, 69 See CDS Trade Guarantee Defined, 50 Asx; 105 Austraclear, 102, 107 BOTCC, 46 Foreign Exchange, 132 GSCC, 64 HKSCC, 110 ICCH, 92 ISCC, 41 Issues, 6 JSCC, 115 NSCC, 35 NSCC for Municipals, 68 OCC, 55 P'l'C, 66 Relalionship to Clearing House Risk, 144 U. S. Futures Clearing Howes, 50 Pa~28I
PAGE 303
INDEX West Germa,cy, 98 Trade Matching ASX (Locked-in Trades), 104 BOTCC, 46 CDS, 70 DWZ95 Eurobonds, 79, 83 GSCC, 63 Hong Kong, 108 ICCH, 92 ISCC, 41 /SE, 88 MBSCC, 66 NSCC, 34 NSCC for Municipal Securities, 68 OCC, 53 Options on Futures, 59 OSE, 120 SCCP, 38 U.S. Futures Clearing Houses, 50 U.S. Treasuries, 62 Trans-border Data Flow Restrictions, 164 16', 170 f nformation Sharing and, 203 Rules and Laws, by Country, 166 Trans Carada Options, 70 occ and, 189 Regulation of, 192 Transfer Agents, 161 -163 Defined, 14 Automation of, 162 Regulated by, 162 Role of, 162 STA, Recommendations of, 163 Trends, 181 207 Automation, 198 Cross-margining, 194 Extended Hour Trading, 181 -184, 189 Immobilization & Dematerialization, 200 Increased Globalization, 184 -186 Information Sharing, 203 Linkages, 186 Linkages -Clearing House, 189 Linkages Depository, 188 Linkages -Domestic, 186, 187 Linkages Exchange, 189 Linkages-Imemational,187,188 Linkages Other, 189 Netting, 196 Regulation, 190, 191, 193, 194 Standardization, 204 TSE, 112, 114, 158 See Japan and JSCC Tokyo Stock Exchange Banks and, 121 Bonds, 122 CORES, 114, 116 CORES-F, 123 Futures Contracts, 112, 122 Guarantee Fund, 123 JSCC, 113 -120 Margin on futures contracts, 123 ReRl,UQlion of, 192 res, 116 TOP/X 115, 122, 123 Trade Comparison, 116 Tunderman, Robert, 69,211 Canadian Depository ror Securities,. Ltd. U.S. Treasury Department GSCC, regulator of, 63 ucc and, 135 U.S. Treasury Securities, 61 64 Clearing & Settlement Process, 62 fJ4. FedWue, 62 Finalily of Securities Settlement, 63 GSCC, 63 Role of Federal Reserve, 61 Types of, 61 ucc, 6, 135, 141 Uniform Commercial Code American Bar Association and, 136 Holding securities in fungible bulk, and, 141 Leners of Credit and, 151 United Kingdom See ICCH and ISE Outlook for International Standards, 169 Regulation of, 192 Tax: Withholding & Reclamation, 173 Pa.282
PAGE 304
INDEX Trans-border Data Flow Restrictions, 166 United States See BOTCC, CME, OTC, NSCC, OCC&SCCP Automation of Clearing & Settlement, 198 Foreign Perspectives of U.S. Practices, 125, 211, 212 Netting of Securities Positions, 197 Outlook for lntemational Standards, 169 ~nof,193 Tar WuhholdLig & Reclamation., 173 Trans-border Data Flow Restrictions, 166 Uruguay Automation of Clearing & Settlement, 198 Netting of Securities Positions, 197 Regulation of, 192 Ussber, Keith, 107 Austraclear Vancouver Stock Exchange, 69 See Vancouver Stock Exchange Service Corp. Link with CDS, 188 Link with MSTC, 188 Regulation of, 192 Vancouver Stock Exchange Service Corp., 69, 189 Variation Margin Defined, 24 Banks and, 145 BOTCC, 46 1CCH, 92 OSE, 123 Protection against defaults and, 138 TSE, 123 U.S. Futures Clearing Houses, 50 Wertpapiersammelban.ken, 94 SeeKV West Canada Clearing Corp., 188 West Germany, 94 98 Automation of Clearing & Settlement, 198 Investor Protection, 98 Netting of Securities Positions, 197 Outloolcfor International Standards, 169 Regulation of, 193 Securities Deposit Law, 201 Ta% Withholding& Reclamation, 173 Trans-border Data Flow 1?.estrictions, 166 Woldow, Robert, 34, S6, 61, 63, 136, 138, 143, 204 National Securities Clearing Corp. Yoshioka, Hajime, 114, 120 Osaka Stock Exchange ~gin System, 122 See F"mality of Payment Pap183
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