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- Permanent Link:
- http://ufdc.ufl.edu/AA00055680/00003
Material Information
- Title:
- Study of international clearing and settlement: Volume V, Supra Regional Topics
- Series Title:
- Study of international clearing and settlement
- Creator:
- United States. Congress. Office of Technology Assessment
- Publisher:
- U.S. Congress. Office of Technology Assessment
- Publication Date:
- 1989
- Language:
- English
- Physical Description:
- 164 pages.
Subjects
- Subjects / Keywords:
- Clearing of securities ( LCSH )
Clearinghouses (Banking) ( LCSH ) Stock exchanges and current events ( LCSH )
- Genre:
- federal government publication ( marcgt )
Notes
- General Note:
- This report is a part of collection of expert papers on clearing and settlement. These paper are a part of Study of International Clearing and Settlement.
Record Information
- Source Institution:
- University of North Texas
- Holding Location:
- University of North Texas
- Rights Management:
- This item is a work of the U.S. federal government and not subject to copyright pursuant to 17 U.S.C. §105.
- Classification:
- Y 3.T 22/2:2 El 2/11/ V.5/Supra. ( sudocs )
Aggregation Information
- IUF:
- University of Florida
- OTA:
- Office of Technology Assessment
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PAGE 1
"\ 3 .i.)..) Ji: E ::i / 11 I v. '5 \ s 4 p ('a__ Collection of expert papers on clearing and settlement, Vols. II -V. These1 paprs are part of Study of International c~earing and Settlement, Vol. I, Bankers Truat Company, 259 pp., October 1989. This collection is organized as follows: North America, Parts 1 and 2; EurJpe; Northeast Aaia/Australia; and Supra llegional Topics. VOLUME V: SUPRJ\ REGIONAL TOPICS 1. international Securities Reg~lation in a Global Electronic Environment, Alger B. Chapman, Chicago Board Options Exchange, undated, circa 1989. 2. temarka Before the Federal Reserve Bank of Richmond Payment Systea Symposium, E. Gerald Corrigan, Federal Reserve Bank of Nev York, Nay 25, 1989. 3. Global Custody Issues, Robert Kay, Morgan Stanley Trus~ Co., undated, circa 1989. 4. ArrangeMnts for the Regulation and Supervision of Securities Markets in OECD Countries, Organization for Economic Cooperation and Development, undated. 5. Characteristics of the International Stock Market of the Future," Robert M. Reiss, National Asso~iation of Securities Dealers, Inc., undated, circa 1989. 6. clearing Issues, presented at American Law Institute/American Bar Aasociation Broker-Dealer Regulation Conference, Jan. 13, 1989, 'nloaas A. Rusro and Susan D. Brown, Cadwalader, Vickershaa & Taft. 7. tovarda a Fraaevork for a Financial Markets Infrastructure, Ian Shepard and Linda Tullberg, Australian office of KcKinsey & Co., Apr. 2v, 1989. 8. Global Custody Issues, Kare V. Simons and Keith J. Fulmer, Price Waterhouse, Kar. 7, 1989. 1'b1 doc\aent vaa prepared for th OTA lack1round Paper, Trading Armand the G 1tsk; A 1AAt1 l1cprlgt11 Narkc and Jn(orwatlon Tchnology, July 1990 and the report 11sgrgplc 1911 1D4 1t1r1; Vele &1curlgt11 Markt and Infon,tlon flsbne191Y, Septeaber 1990. 1'bi docuaent does not necessarily reflect the aalJtical flndinaa of OTA, its Advisory Panel, or lt Technology AaseasMnt loard.
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INTERNATIONAL SECURITIES REGULATION IN A GLOBAL ELECTRONIC ENVIRONMENT Alger B. "Duke" Chapman Chairman & CEO Chicago eoard Options Exchange This contractor document was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Inforaation Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This docl.lDent does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board.
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International Securities Regulation in a Global Electronic Environment Introduction By any measure, markets have become increasingly global. The October 1987 market break slowed this trend for a short time but the pace has picked up again. At the same time, the symbiotic relationship between markets worldwide was brought home to investors as we experienced a major global revaluation of securities within a few days during the market break. The emergence of global investment management, se~uritization of the government and corporate borrowing process, the development of powerful international investment banking and brokerage firms operating around the clock, the blurring of the lines between traditional functions of financial intermediaries, all have been driven by three phenomena. First, the volatility that has appeared in currencies, interest rates and inflation rates, and the dramatic swings in trade balances have caused markets to interlink and have driven asset and liability managers to find new mechanisms to evaluate and manage the risk that has been created. Second, the dramatic shortening of the time frame within which information is available, almost anywhere in the world, and the ability to analyze that information to create action plans has been an outcome of the increasingly rapid change in the ?Ower and speed of computers and electronic data transmission. Third, the entry into the financial markets of a generation of quants, who in earlier times might have been lured by the space program or Silicon Valley, has resulted in the rapid adoption of new technology to managing risk against investment object;.ves. There are several clearly global financial markets at this time, including currencies, eurobonds and U.S. Government bonds, where these instruments can be traded in the major financial capitals of the world in size. Others a~e rapidly developing such as gilts, Yen bonds and institutional grade U.S. equities. The last five years have seen a dramatic expansion of financial options and futures markets. The dramatic growth of options and futures on stock market indexes, futures on U.S. Treasury bo~ds and futures and options on currencies have added new dimensions to managing the risks inherent in the large pools of institutional capital that have been created to provide for retirement funds and to assist investors and savers who feel lost in these rapidly changing institutionally dominated markets. Tables I VI provide a glimpse of the dramatic growth and the internationaliz1tion of these markets. Table VII shows the rapid growth of financial futures and options listed on exchanges around the world.
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Table I EUROBOND ONDERWRITINGS: 1979 -1988 (in $billions) 1979 16.S 1980 24.3 1981 27.S 1982 46.8 1983 47.2 1984 78.6 1985 134.S 1986 182.7 1987 143.1 1988 181.4 Source: IDD Information Services ,. .. 2 2
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IV EUROBOND UNDERWRITINGS 1979 1988 200-------------------------------, 180 180 140 120 )' -;;-c 0 =100 r.: a. .___, 80 eo -to 20 a 1 1<,qGO 1ca 1<0 1c,qco ,c,qca 1cqca ,c-qro ,cqco ,cqro <,q
PAGE 6
Table II INTERNATIONAL EQUITIES: 1984 -1988 1984 236 1985 328 1986 472 1987 493 1988 508 Stocks traded on at least one market outside the domestic market. Source: Euromoney 4 3
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II II
PAGE 8
IX) Ol .x L. (/) lf J 0 w E -0 r-(X) CX) Om (0 "'L E w ,-Ill C 0 Ol G) ,, ...J >- < I z; zv ,, Q (X) ~O) IO 0 z .... a= CD m -f w 0 I-E z C 0 .. v 0 CD Ol ... 0 C 0 'V ,, e .. J 8 I 8 0 0 u 0 s sa91nb3 JO J;qWnN II 3A
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Table III IN'l'BRHA'l'IONAL EQUITY 'l'RANSACTIONS: 1979 1988 (in $millions) U.S. Purchases Foreign Purchases and Sales of and Sales of Foreign stocks u.s. stocks Total 1979 10,051 43,887 53,938 1980 17,941 75,168 93,109 1981 18,925 75,542 94,467 1982 15,667 79,862 95,529 1983 30,327 134,130 164,457 1984 30,733 122,648 153,381 1985 45,664 159,049 204,713 1986 99,486 277,483 376,969 1987 107,416 481,407 668,823 Jan.-Sept. 1988 107,267 288,208 395,475 Annualized 1988 143,023 384,277 527,300 Source: U.S. Treasury Bulletin .. 6 4
PAGE 10
II II
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INTERNATIONAL EQUITY TRANSACTIONS 1979 -1988 700000---------------------------IOOOOO 800000 ~-400000 .,, C ), 0 = r= !300000 200000 100000 -D 1 1.:,. ,.-, .hu, .. onrJ S.alt\: Foreign Purchases and Sales Total Purchaaea and Salea o I ~ 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 r Annuallzed baaed on Jan. Sept.. 1988 7Yeor 111
PAGE 12
Table IV U.S. EQUI'l'Y JIDTOAL FUNDS WITH FOREIGN IHVESTMERTS: 1984 -1988 (in $millions) 1 2 International Funds Global Funds ?fumbftr Amount Number Amount 1984 13 1,169.1 16 4,019.6 1985 24 2,486.0 19 5,450.6 1986 35 7,186.1 22 8,282.0 1987 47 6,982.3 34 10,449.2 1988 59 6,831.8 45 11,151.1 1 Two-thirds or more of portfolio is invested at all times in equity securities in companies located outside the U.S. 2 Portfolio may consist of any mix of U.S. and foreign equity securities. Source: Investment Company Institute ,~. Q '-' 5
PAGE 13
II II
PAGE 14
UI > U.S. EQUllY MUTUAL FUNDS WITH FOREIGN INVESTMENTS 1984 -1988 200--------------------------20000 180 180 ,..or 120+ D Number r'\1 n c-u n ': I I I I 18000 18000 I I I I T1-4000 I I I I T12000 en C: 0 -I ,oat I t 10000 I eo+ Te000 0 I I t:1/./A I V//21 I I 80-'I I I I t'l//A I r/,/A I -,-e000 ..a -4000 20 2000 0 1 e".'.I ruAt 1-vi 1-<<1 l't:r
PAGE 15
ln a, U.S. EQUITY MUTUAL FUNDS WITH FOREIGN INVESTMENTS 1984 -1988 (in $millions) International Funds 1 Global Funds2 Number Amount Number 1984 13 1,169.1 16 1985 24 2,486.0 19 1986 35 7, 186.1 22 1987 47 6,982.3 34 1988 59 6,831.8 45 1 Two-thirds or more of portfolio is invested at all times in companies located outside the U.S. 2 Portfolio may consist of any mix of U.S. and foreign equity secunties. 10 Amount 4,019.6 5,450.6 8,282.0 10,449.2 11,151.1 1'1
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1975 1980 1985 1988 1993 Table V INTERNATIONAL INVESTMENTS OF PENSION FUNDS: 1975 -1993 (in $billions) Total 6 21 85 217 530 U.S. Pensions 0 3 25 62 162 Source: InterSec Research Corporation
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II II
PAGE 18
INTERNATIONAL INVESTMENTS OF PENSION FUNDS 1975 -1993 eoo--------------------------------------------, CJ'I rn )II C aoo ..00 .2 = .JOO .a 200 100 Total Rl ,.,.~. f-'~11~,i~ns o 1 P?"'//1 l?'VL
PAGE 19
Table VI FOTORS AND OPTIONS EXCHANGES LISTING FINANCIAL PRODUCTS: 1978 VS. 1988 Region 1978 United States 6 United Kingdom 1 Continental Europe 1 Asia 0 Canada 2 Latin America 0 Australia 0 Total 10 1988 14 2 8 4 4 3 2 37 Source: Courtesy of James J. McNulty, O'Connor and Associates 7 ,... ,,.. 12
PAGE 20
II II II
PAGE 21
..., )I FUTURES AND OPTIONS EXCHANGES LISTING FINANCIAL PRODUCTS 1978 vs. 1988 Region 1978 1988 United States 6 14 United Kingdom 1 2 Continental Europe 1 8 Asia 0 4 Canada 2 4 Latin America 0 3 Australia 0 2 Total 10 37 I' 1~ VI
PAGE 22
Table VII PIRARCIAL PUTIJRES ARD OP'.rIONS LISTED OR DCBAIIGES Region 1978 United States 12 United JCingdom 1 Continental Europe 1 Asia 0 Canada 2 Latin America 0 Australia 0 Total 16 1988 93 27 22 13 10 20 20 205 Note: All equity options on individual stocks are counted as one product per each exchange listing equity options. Source: Courtesy of James J. McNulty, O'Connor and Associates 14 8
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II II
PAGE 24
0C) )' FINANCIAL FUTURES AND OPTIONS LISTED ON EXCHANGES Re_gion 1978 1988 United States 12 93 United Kingdom 1 27 Continental Europe 1 22 Asia 0 13 Canada 2 10 Latin America 0 20 Australia 0 20 Total 16 205 r: .... .. ,.. J. ~) VII
PAGE 25
A Possible Future Scenario There is a growing awareness of the need for coordinated regulation of this global activity. The pace of change is increasing so that it is not unreasonable to imagine a highly sophisticated international marketplace where everything is traded but nothing is listed, an institutional marketplace linked by a sophisticated satellite transmission network where institutional traders communicate modem to modem and bids and offers are taken by touching a screen producing a locked-in trade with price and volume information disseminated to all participants. Trades would be cleared and settled by a "WorldClear" system which might electronically link to existing clearing houses for national markets and to Cedel and Eurocl~ar. Daily net balances would be reached for each participant and consolidated in the WorldClear system where money b:1.lances would be settled and transfer of financial instruments would be accomplished by bookkeeping entry only. National markets would operate on the peri~hery of this global system. As now, instruments of local interest would trade as well as a. home market in government securitios and home country corporate bonds, stocks, etc. Home cocntry securities with international interest would trade in both markets. The global market would be dominated by several dozen international trading organizations, banks and investment firms with billions of dollars of capital. It would be a trading rather than agency business. These same firms would probably also dominate the major national markets. An examination of the Eurobond and Forex markets gives us an insight into the developing electronic global market. They represent institutional markets dominated by big, well-capitalized participants trading around the clock and operating with limited national government regulation. Growing Awareness of Regulatory Needs Prior to October 1987, international financial regulatory cooperation was driven by a number of factors including insider trading cases, money laundering situations and the need for stronger capital adequacy standards. Progress was slow with agreements worked out in a limited number of situations, but bank secrecy laws in many jurisdictions made meaningful progress difficult. The different ethos, country by country, has made it difficult to arrive at common standards. A perfect example is insider trading which is not a crime in some countries and, where illegal, is pursued with different degrees of diligence around the world (see Exhibit I; Wall St. Journal article by Craig :Foreman). Significant 9 (l
PAGE 26
progress has been made by the central banker's Cooke Committee culminating in a 12 country agreement concerning bank capital adequacy standards. The October 1987 market break and the subsequent analysis convinced most market participants and regulators that coordination by national regulators is required to deal with systemic risk arising from the impact of globalization on national markets and on giant, multi-market investment organizations. The failure of one or two can impact everybody. Trouble in one market spreads to others like a virus and national regulators do not have a full grasp of the activities of their home domiciled investment firms as they participate around the world. Also, jurisdiction is limited for national regulators to deal with foreign domiciled investors and investment firms operating in their national markets. As the markets continue to globalize the amount of activity being transacted in this expanded regulatory environment could surpass that which occurs collectively in the national markets. As this happens, the impact on the system of a failure and the loss of ability to protect domestic investors from abuses in the global system, will multiply. Thus, the need for coordination amongst national regulators. For through expanded coordination at the national level, market participants can be regulated and unsophisticated investors can be protected/informed without imposing an international regulatory hierarchy to top off the pyramid. This, in my view, would be an unnecessary burden on the global market of the future. The market will be an institutionalprofessional market dominated by well capitalized, multi-market participants. Each will have a nexus to national markets and a place of home jurisdiction where regulation t1ill apply. Every meeting of international regulators and self-regulators focuses on this need for coordination and cooperation to deal with the forces of globalization. The agendas for meetings of IOSCO, the OECD Working Group, The Group of Thirty, the F.I.B.V. and many others involve sessions focused on these needs. Exhibit II is an incomplete list of agencies, organizations, and self-regulators that must deal these problems. Many organizations are at work already with the SEC, the SIB, DTI and the Ministry of Finance working on problems of coordination, capital adequacy, insider trading, exchange of information and developing memoranda of understanding. An Ideal Regulatory Environment Assume for discussion a 21st century global market where individuals have a small role while institutions dominate. A market where trading occurs via an electronic network and intermediaries are highly competitive and global with very large capital bases developed during an extended period of consolidation. In this market trading occurs on a world basis. Also assume an umbrella 10 r17
PAGE 27
clearing system with continuous net settlements and a bookkeeping entry only receive and deliver system (The certificateless society). In this ideal regulatory environment, regulatory problems have been solved in most areas, for example: 1. Disclosure rules are uniform internationally. The accounting rules for companies whose securities are traded have been harmonized internationally so that ready comparisons can be made for analytical purposes. 2. Information is readily available to participants in the global market. 3. Trades are cleared under the umbrella of a central clearing organization which is linked to clearing organizations in national markets. 4. Positions of intermediaries are netted on a global position basis and ownership is transferred by bookkeeping entry. S. Regulatory standards have been coordinated between home country regulators and jurisdictional reach has been negotiated for national regulators pursuing violators in their home markets. 6. Capital adequacy standards have been agreed to for all participants in the international market which will be administered by the regulators in the participants home country. These are a few of the basic needs of an efficient regulatory framework for the 21st century global market. But where are we now? Clearly not far from the beginning. To date we have a few bilateral agreements and a number of nonempowered international organizations. In moving towards a regulatory structure aimed at this new global market each country has the jurisdictional hooks on which to hang a regulatory scheme that protects its nationals by regulating the information flow and the intermediaries that operate within its jurisdiction. In addition to bank and securities regulators we might look to the postal telephone and telegraph as means to gain jurisdiction over this new international electronic market as data transmission and real time communication are its lifeblood. Uncoordinated country-by-country regulation will push this market off shore or to the jurisdiction of convenience which will be defined by the lowest common denominator of regulation. We don't want this powerful electronic marketplace, made up of institutional participants, to end up flying the Liberian Flag or some financial equivalent. The system-wide risks are too great because one or two major participants could bring the system down if capital adequacy standards are not established cross border 11 .. '.
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Many of the traditional home market regulatory requirements may not be necessary because of the institutional character of the market but coordinated home country regulation is a must to protect the global financial system from unexpected shocks. The history of global cooperation indicates that the task ahead is extremely difficult. In a world where cooperation is slow and difficult in protecting the environment or feeding the starving we do have an example or two such as the World Health Organization and GATT. Also where national security is involved national alliances such as NATO have been effective. The Tasks Ahead Let us look at a few of the tasks along the way. Within each national market most of these issues have been difficult to bring forward to the current state of the art. Imagine the complexity of moving them to an acceptable common level for a global market. First. Financial issues such as: 1. Accounting. How to find a common standard for measuring the performance of companies whose securities are traded in the global market. 2. Auditing. What is the common set of audit standards as it relates to these companies? How about accounting and audit standards for determining capital adequacy of participants in the global market? 3. Taxes. How do we deal with the different methods and levels of taxation in each country? Taxes alone can drive the market to a flag of convenience. Remember the start of the Eurobond market. 4. International Clearing. Do we want a common clearing entity as an umbrella linking all clearing organi~ations so we can arrive at global one account clearing? How do we achieve this? s. Risk Management and Capital Adequacy Standards. It became evident after the events of October '87 that capital adequacy and risk management standards needed to be further developed and strengthened. The dramatic market moves of that period were met without failure by all but a_ few relatively minor participants and ~hough the system suffered from a liquidity crunch it was spared the added burden of a major financial failure. Fortunately these events happened at the end of an unprecedented 5 year bull market in which capital, built through retained earnings, provided a cushion for the market break shocks. We may not be so lucky the next time. 12 r r
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6. As finance has changed, and the lending process has become securitized, large global players are assuming major balance sheet risk through trading positions, bridge loans. etc. The need is clear for a primary focus in this area. 7. Surveillance and enforcement become more difficult matters in a global environment. In crossing national borders one man's crime becomes another man's profit opportunity. The tradition of legally hiding capital for flight, or from the tax collector, is alien to the U.S. and many other common lawbased countries but is a way of life in most of the rest of the world. National vs. International Interests Where do we go from here? Can we reach the outline of the suggested ideal covered earlier? The process of arriving at coordinated regulation of the global market and its participants will involve an unusually high level of cooperation. National interest will stay in the forefront, naturally. There must be coordination and negotiation in an environment that will be open to change where participating regulators can anticipate change and be pro-active working with the major market participants. My suggestions for a beginning is that regulators of the home countries of the major capital markets (U.S., Japan and the U.K.) form a task force to be advised by senior representatives of the major market participants who would form advisory groups on specific subjects. This group would establish goals and objectives that would lay out the critical path to an optimum system of regulation for the new and growing global markets. The other pieces can be added later with advisory groups of accountants, lawyers, etc., making their contribution where appropriate. The working group must be small enough to make progress but still represent those countries and markets participants with the biggest stake in its success. 13 .... j <.J
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FRIDAY IAfllllDAY. FEBRUARY It 11, 1 PM.a I Exhibit I THE WALL STREET JOURNAL. I._.,_.,.._"' T'\ ..... 1 =============~jLunur~1~========== Extent of Europe's Inside Trading Evokes Image of Cowboy Country' BJ CL\IG FOIUIAN s,-,,11.....,atTN8WA&A,S__,J_ ... LONDON EVEN FROM THE Otn'SIDE. Insider tndlnr Is obvious In Europe. In one of every four British takeovers, shares of the tariet company move 211"1. or more 1n the month before the announcemenL In Wes& Germany, share prices routinely rise in advance of favorable earn1acs reports. And la Italy, the head of European oper:ulons for one of Wall Street's blnesc lavesunent banks says, "no initial public offerinr Is launched wilhoul lnllllSive Insider infonnallon. Co to Italy, Fr:uice or Spain and you an Ill cowboy country." Jaslder lndlnr "Is very common al the moment," says a European COmmllldsy Commission official la Bnmels. la some European couatrtes. Ill adds, "I& ls coasldered a nry Mnnal consequence. and nae a bad lhlnr, ID pnlft& from laformaUoa (yaul hafllltll to have." SUCH DECLARATIONS ARE BORNE our by two years of European lladllaa dW read like a dishonor roll of Insider tradinr. A dozen scandals Ill four European countries have laYolved suspicious tndlnr In some of lurape's bestknown companies, 111d a few of America's too. Consohdaced Cold Flelcls PLC and Grand Meuapolltu PLC, Sterllnr Drur Inc. aad niucltlndustrles Inc., Soclelt Oeneru1 and LVMH Moel HenDessy Louil Vwnoa are amonr lboll whose shares have beea Ule subJect of possible Insider tndlnr. BIil If lmlder tradlnr ts rampant In Europe, It's hardly the crime It ls la America: Never has anyone In Europe been sen& ID prison for ll. In West Cermuy aad Italy, It lsn'l even a crtm1. Spain and Switzerland outlawed It oaly wltllln the past year. IYID la Brtcua, wllere It has beta a crtmt stnce 1 and authorities ncall ala1 caaYic:dons, tilt unhes& punlsbment so far wu a one-year ___. prtsaa nntence ud a nae of as,oao IH3.SGO). That went to fonner Morpn Grenfell Croup PLC Investment banker Geoffrey Collier, wllo pleaded euillY In 1917 to two lnsidtr-tra.dinr counts. WHILE MUCH OF THE FUROR over France's Pechlney SA affair Is pollUcal ralller than Hnanclal, the scaada1 no doubt will add pressure on European Sovtmments to reconsider lhtlr stances on insider tradlnr. Jn the Pechlney affair, Investors close to Frencb President Francois Mitterrand's rovenunent alleredJy proOted tram knowledp of state-owned Pechlney's plus to buy Trtancle lndustrtes lac. of lhe U.S. But Ult obstacla ID effectl rerulalioa and enforcement are lnunemt. rnclllnc beyond lht obwtous problem of eacb country tak11ir a dlfftre11t postUon on whars permissible and what Isn't. Tltraupouc Eurol)e, wllen oaly about IOf. of people own equities, mmpand willl 25'1e In die U.S., then ii no tndlllon of sllarellolder lnfonnalion. No slnrle rqulatory or lavestlptlv1 body has Ult power to look at several markets, and lJlose cllarpl wilh pursulnr possible violations pnerally are anonymous burnucrats with mlnlnlat resources. INDEED, I\IOST OF THE INSIDERTRADINC acllvl&y under lllvestlption In Europe recently hu been discovered by Uae U.S. Securities and Eachanse Commission. ll wu Uae SEC lhat paclled up evidence of unusuJ acuva&y In Trlanrle stock a week before the Peclliney bid. With a lludret of SHU miJllon and a staff of 2.aaa, the SEC"s resources dwarf lhose .C 111111 of Euro,e'1 wa&dldocs combined. 11:urapeau. 1a,s Manard Law ScllOOI Prof. Lau11 Lou, "an now uouc when IUl1 U.S. wul a few decadn ap" when It comes to pn111C11tloa. Ill& rwsaarca arn't llle only problem. Even when 11111tlclOU1 acUwtsy II ldalUled. lllv11Upl111111 Jua seem to fade away. Consider tllese aampla: On Ju. t, 1. Buel-baNd F. Hoffmann.La Roelle II Co. laulldltd 1 llkllMr bid for Sterllnr Drur lac. Bui.....,.. saw It camtnr.Judctnr i., 1111 --, 1....,... cltmud ror SttrUar ..,.. befon lht bid wu I NIL la New Tort. .Amerlcu SIGcll llclwlp IIIUbl surveUlace m11111en dltectld volume so 11 111 1111111 Ult ..,.a level III saaa., ,..,.,..,.,.,.,.,c--, r
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Extent of Europe's Inside Trading Evokes Image of Cowboy Country' c ......... ,,.,_ ,,.,, ..... Jllll days belorw die oner wu --.I. Slertlnl's 1ioa prtce rose n.11 ta SK.ITS Ill ll"ldtar Just Nian Ille WlICIIIIIBL fte U.S. SIC traced m suplclOIII lnllllf ro Swta.rtaad aad w .. Cenn:aar ... aallllt -UIIIUllce .... o(ftelall IIIDII CIIIIIU1el 1nc111ar dawll pauiDI parcllua of Slertlnr 111an1, pu11eu1ar1, .., ... Cenn:an baalls Klinf -lllllde llllanna&lon. WIii Cftmu atld Swlll 1u&11on1111 COlplrlled. bu& no dlSclpllur, acUOII w:as lalra. TIie wane penally aa,Oermaa -id llaN lacad. la aa, case, wu dlsaarl'fflenl ., praflll under I Y0&11111a,y c:ade IC pncuce -, !nun aac1 llanllen. In Slpeamber, Lallcloll dnlen befu am1c1ar lftlWlllr demand for eonsao1a ..... Prtca cllmbld u purdluen of ell opllla-wldcll proYlde IN rlpl IO buy lllans a& a Ibid pnce laer-bailt up 14,-. aalre. Muell al Ille demand ns lram two Llacllllatalll laaadadana. a, Sip&. II, iu demllld 111d spWed Inca INIIIUIIJ 111Ubt.0Yer llleaat lllne days. ..._.rc...aakllllanlwur.rumn ~ll'lellllll.cllllllBUIIISlllna WHarlm Inell In Jafta---111111. 0a SepL za. Mllllrm SA aaam :14 a 11a1u1e tlUIWff 111d for OIIIIGald. Brttlla's DlpuUaa& of Tnde 111d lacllllrJ bepa to IDYemr,&e IN U'ldlnr OcL .. Bu& ........ lupecfan Aid Ille, caldll'l draw aa, cwl1111en allaal wllllMr Ille ..... ICllYICy amalllled IO ....., tndlar.111 pan. llllJ wwn stymied "' lJlcldeulela bullrMCNCJ laws_. lwa II dlaC bada'l belll die cue. llllplctorl .......-1 llave braulll& clwps ..... Brllllb IU&llorltla b&Ye balled lallllr-cradlll CINI peacllar a Jllllpnml die ddlddaa al 111er,11, .. oblliallll' ......, lllfonnallma. ne IIIICll'lalDIJ 1111111 ftaot la& Aprtr1 1Cq1dual of a I.Olldaa ..,w,mH wllo a lawer
PAGE 32
Exhibit II International Regulation Efforts in regulating international activity have been and are being made by professional and independent associations, regulatory agencies, clearing organizations and self-regulatory organizations. Some examples include the following: 1. Associations 2. 3. 4. Association of International Bond Dealers Cooke Committee-Bank for International Settlements Federation Internationale des Bourses de Valeurs Group of Thirty International Accounting Standards Committee International Bar Association International Council of Securities Dealers Associations International Federation of Accountants International Organization of Securities Commissions Regulatory Agencies SEC Memorandums of understanding wich authorities in: Switzerland Japan United Kingdom Brazil Canada (in discussions with France) Self-regulatory Organizations AMEX -European Options Exchange (EOE) re: XMI CME Tokyo Stock Exchange re: Nikkei Futures CBOT Tokyo Stock Exchange re: TOPIX Futures SIMEX Tokyo Stock Exchange re: Nikkei Futures Agencies.:. Self-regulatory Organizationa SEC is considering uniform standa4ds for foreign debt exemptions from SEC registration requirements. Exemptions allow futures and options on those securities to be marketed and traded in the U.S. (Currently, exemption are on a case-by-case basis; fourteen have been granted. ) CFTC has allowed the first foreign options to be marketed in the U.S., namely, options products on the Montreal Stock Exchange, Sydney Futures Exchange, and SIMEX. ,., 16
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s. Clearing Organizations Options Clearing Corp. (OCC) -EOE re: XMI International Securities Clearing Corp. (ISCC) -Japan Securities Clearing Corp. (JSCC) ISCC -International Stock Exchange ISCC -CEDEL ISCC -Singapore Stock Exchange re: NASD-SESDAQ quotation link. -Euroclear I would like to acknowledge the research support provided for this paper by Cynthia Buciak of the CBOE's Research and Planning Department. 17 r.
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Arthur Andersen & Co., Financial MArkets: 1988. BIBLIOGRAPHY %11. Globalization c~ the International Implications and Opaortunities, Chicago Bank for International Settlements, Recent Innovations in International Banking. Basle, 1986. Grundfest, Joseph, Regulating the International Capital Markets: A II!! Perspective. paper presented before the Chartered Association of Certified Accountants, London, ,.987. KPMG, Global Capital Markets, London, 1988. Securities and Exchange Conunission, Internationalization of the Securities Markets, Washington, o.c., 1987. Symposium: %bl. Internationalization of the Securities Markets, Boston University International Law Journal, Volume 4, Number 1, Winter 1986. r 18
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IDAU:S BEFOU THI nDDAL USDVE 8AlK or llICIDIORD PADWl't SYSTIII SYMPOSIUK IIAY 25, 1988 VILLUJISIUI.C, VIR.CINIA BY E. GD 4LD COR.R.ICAN PUSIDENT RDDAL USDVE BA1QC or NEV YOll This contractor doc\lDent was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulla and Bears: U.S. Securities Marketa and Information Technology, Sept. 1990. Thia document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technoloay Assessment Board. r,
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REMARKS BEFORE THE FEDERAL RESERVE BANK OF RICHMOND PAYMENT SYSTEM SYMPOSIUM MAY 25, 1988 WILLIAMSBURG, VIRGINIA BYE. GERALD CORRIGAN PRESIDENT, FEDERAL RESERVE BANK OF NEW YORK Good afternoon ladies and gentlemen. Let me begin by ezpressing my gratitude to Bob Black and his colleagues at the Richmond Fed for their efforts in organizing this timely and important conference. Let me also, Bob, apologize at the outset for taking some liberties with your program insofar as the subject matter of my remarks is concerned. That is, rather than focusing on the direct subject of payments risk, I would like to share with you some of my thoughts regarding the evoluti~n of thinking and practices regarding trade clearing and settlement practices associated with securities and other financial transactions. In focusing on this area I want to put emphasis on bow we may be able to strengthen clearing and settlement arrangements and thereby further strengthen the workings of our financial and payments systems more generally. Specifically, while there has been --and rightly so --a great deal of attention focused on operational, liquidity and credit characteristics of large-dollar payment ,7 .:,;,
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-2 -systems such as Fedwire and CHIPS, there are literally dozens of other important trade clearing and settlement systems for funds, securities, futures, options and other financial instruments which also warrant a high level of attention. This is especially true since, one way or another, these other systems generally achieve their final settlement on or through Fedwire or CHIPS or both. The importance of these clearing and settlement systems was forcefully illustrated in the weeks of October 19 and October 26 when the plunge in equity prices here and abroad brought a number of these clearing and settlement systems under great stress. Indeed, many observers, myself included, are of the opinion that the greatest threat to the stability of the financial system as a whole, in that period, was the danger of a major default in one of these clearing and settlement systems. Clearing and settlement systems that directly interact with major large-dollar payment systems are of interest from a public policy perspective for a number of reasons, but the most important, by far, is because the linkages inherent in such systems necessarily raise important questions about systemic risks. That is, a major mechanical breakdown, liquidity problem or, even worse, default in one of these systems has the potential to seriously and adversely affect all other direct and indirect participants in the system, even those that are far removed from the initial source of the problem. Unlike
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-3 -many other types of financial problems, a major disruption in one of these systems can occur suddenly and can spr~ad rapidly. These traits of large clearing and settlement systems can be especially worrisome because all too often their legal, technical and operational characteristics ares~ complex that the direct and indirect users may not fully understand the nature and scope of the risks and exposures --including intra-day exposures --that they are incurring. Against that background, I would like to share with you my thoughts as to the key characteristics that should be associated with clearing and settlement systems. Indeed, to the extent there is agteement as to the essential characteristics of strong clParing systems, those characteristics can then be used as something of a yardstick against which particular clearing systems for financial instruments can be evaluated. Taken as a whole, the driving force behind this ezercise is to suggest a series of criteria which can work to reduce risks --especially systemic risks -in clearing and settlement systems for financial transactions. We can look at the whole structure of systems as an inverted pyramid. At the top are the dealers and parties entering into the financial transactions in the pits at the exchanges or over-the-counter. On the next lower level would be trade netting arrangements, such as securities, futures and (I 1:, ...
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4 -options clearing corporations. These trade netting systems then settle through other systems and the funds settlement for these systems, in turn, are made by clearing-house checks, or through CHIPS, or ultimately, at the bottom of the pyramid, through Fedwire --where each payment is processed and settled almost simultaneously. The key to containing and reducing risks in this inverted pyramid is the finality of payment for the maze of underlying transactions associated with each layer of the pyramid. Having introduced the concept of finality, let me hasten to add that I suspect that any self-respecting group of lawyers could probably debate for hours as to what the term means. For my part, let me rely on a practical, common sense definition: in its purest form, finality means that at the very instant an institution receives an advice of payment or confirmation of delivery through a system for a particular transaction, the money in question is good money, even if at the next instant the sending institution goes bust. Under this definition, there are two elements to consider: first, the prompt discharge of counterparty obligations and, second, the financial strength of the instrumentalities through which obligations and payments are discharged. In recognizing these elP~ents, it is apparent that finality is crucial in efforts to contain systemic risk because the more we do to achieve finality as quickly as possible, the more able we are to contain problems at their source. r
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-5 -To my way of thinking, Fedwire possesses a pure form of finality. At the moment a depository institution receives an advice of credit from a Reserve Bank, the institution and its customers are prepared to have the obligations of their counterparties discharged because the Reserve Bank provides immediate and irrevocable funds and because reserve balances provide a universally acceptable medium for payment. Some other payment, clearing and settlement systems operate under procedures that raise the prospect that payments and/or transactions could be revoked after they are made but before they are finally settled. The presence of provisionality within these systems reflects a variety of considerations including the liquidity and credit risks confronted by the system. Other systems depend upon preserving the unquestioned credit standing of the central clearing corporation. However, in either case, there are reasonable and prudent steps which can and should be taken by any clearing or settlement system to minimize potential problems and thereby strengthen the clearance and settlement process. Achieving true finality when securities and/or securities derivatives are involved can be even more complex in that most such clearing and settlement systems involve some form of netting before delivery, settlement, and payment mechanisms come into play. In these instances, final payments are generally made against receipt of what is, in effect, .. -. .ii Jl
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-6 -netted positions of securities. A first question is whether the netting has effectively discharged the counterparties' obligations on each of the underlying transactions and, with respect to funds settlement, replaced them with an intermediary's credit obligation. A second question is whether participants in a clearing or settlement system are prepared to accept the credit of the intermediary or whether the intermediary's settlement obligations are finally discharged only when net-settlement money transfers are made over Fedwire. The amount of time between the point at which a particular financial transaction is made and the point at which the payment for the transaction is truly final can vary enormously, depending both upon the type of instrument in question and upon whether one is considering the original contractual obligations of the counterparties or the settlement obligations of the clearing corporation and its participants. For ezample: Clearing and Delivery Type of Transaction Purchase or sale of equities on certain foreign ezchanges Purchase or sale of mortgage-backed ~ecurities when-issued trades in government securities ,. ,-~ '-J '-' ...... Maximum Time to Final Payment counterparty trades, up to several months counterparty trades, up to 30 days counterparty trades, up to 15 days
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Purchase or sale of domestic equities Futures and options transaction Large-Dollar Payments CHIPS payment Fedwire transfer -7 -counterparty trades (net against clearing corp.) discharge within 5 days clearing corp. to participants, 2 days more total 7 calendar days counterparty trades, immediate discharge clearing corp. to participants, early next day bank to bank, up to 11 hours receiving customer, same day or next day (depending on availability) bank to bank, almost instantaneous receiving customer, same day (depending on availability given by receiving bank) In citing these examples, I do not mean to imply that time alone is the only or always the most important factor in seeking to contain systemic risks. Obviously, other factors which I will turn to in a moment enter into the picture. However, it does seem clear to me that an overriding goal in our efforts to strengthen clearing, settlement and payments systems, should be to reduce, to the maximum extent possible, the amount of time between when a financial transaction is entered into and the time when both parties to the transaction know with certainty that the valuables to be delivered and the payment corresponding to the transaction is final and irrevocable. Being realistic, however, there are both
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-8 -trade-offs and limits as to how far we can and should go in seeking to narrow the timing gap between when financial transactions are made and when they are truly final. Fortunately, there are also devices which can help manage and reduce the risks posed by the timing gaps in the process. But, under any set of arrangements achieving finality as quickly and as safely as possible is the key to stronger clearing, settlement, and payment systems. By extension, a crucial property of such systems is that they should be structured in a way in which it is transparent to all participants as to when transactions and payments are final and when they are not. While transparency and finality are crucial features of clearing and payment systems, designing systems that achieve those results in a satisfactory fashion is not an easy matter. However, it seems to me that there are three generic groups of traits of clearing and settlement systems that are relevant to the larger question of containing both direct and systemic risks in the operation of such systems. These are the operational, structural, and financial features of such systems. I. Operational features While there is virtually a complete consensus that major clearing and settlement systems should have the highest degree of operational reliability and integrity possible, I'm not always sure that it is fully appreciated just how important I'" j A ..:,; i~.
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-9 -these operational features are and how difficult and expensive it may be to achieve them. For example, it is clear beyond doubt that a major operational breakdown in one of the systems --particularly if it occurs while business is in progress or if it lasts more than one business day --can give rise to serious liquidity if not credit problems among the participants. In addition, the operational and control features of such systems constitute a vital link in the ability of participants to keep track of positions and exposures -including on an intra-day basis --and are thus crucially related to the all-important credit decision-making process within and among clearing and settlement systems. When looked at in this broader light, it seems to me that there are several key design and operational features that we should look for in any clearing and settlement system that, by its nature or its size, carries with it systemic risk considerations. Among the more important such features, three strike me as worthy of note: First, all such systems should be designed with adversity in mind. In the first instance, this means having in place systems and multi-level back-up that can cope with a wide range of potential problems and not simply problems of an operational nature. ...J .....
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10 -Having said that, it is clearly not possible or desirable to design a system that is fail-safe, but it is possible and essential to ensure that operational traits of such systems are capable of dealing with a broad range of contingencies. As an extension of this, a very high level of security and control devices to guard against fraud and other abuses is obviously critical. In short, a high degree of availability, reliability, flexibility, and integrity is essential even if costly. Second, all such systems should have on-line, real-time information access systems so as to provide participants and the system operator --and when necessary, the authorities --with prompt access to information needed to make informed credit and other decisions. Here too, such systems are costly --but so is the alternative ,-. .... ,_;
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-11 -Finally, all such systems should have design and operational features that go as far as possible in reducing or at least immobilizing the movement of paper instruments and paper flows. This is important in its own right but is also relevant from the point of view of risk containment because the reduction of paper flows facilitates the goal of more rapid trade comparison, netting, and ultimate final settlement of transactions. As an extension of all of this, the matter of possession and control of collateral is also of importance. As noted above, these essential operational features of clearing and settlement systems clearly imply that welldesigned systems are going to be expensive systems. In a highly competitive world that reality raises the specter of competition in laxity --something we must rigorously guard against. Like it or not, there is no such thing as a five and dime version of a clearing and settlement system, and it is up to the users of such systems to make it their business to satisfy themselves that they are not part of, and are not exposed to, clearing and settlement systems that are not up to r 1 ,..,
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12 -the high~st standards of operational design. Low transactions costs are obviously a great aid to market efficiency and liquidity but not to the point where low transactions costs are achieved at the ezpense of high standards of operational reliability, security, and integrity. Fortunately, the track record of all major clearing and settlement systems in the U.S. is very good even though we have had a few near misses. My point in stressing these features is, therefore, made in the interests of strengthening an already strong track record --a goal that becomes all the more important as markets and institutions here and abroad become even more closely linked and as the volume and complezity of financial transactions increase at a rapid pace. II. structural features In considering the structural features of clearing and settlement systems it is especially important to keep in mind that many, if not most, such systems rely on one form or another of shared risk or shared liability. While arrangements differ from place to place and from time to time, the general practice is that, in the event of a default of one of the members, the clearing corporation is obligated to make good on the default either through liquidation of the defaulting participant's margin or collateral and/or through some kind of r l
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-13 a 1hared assessment on all other members. The credit and financial interdependencies resulting from these arrangements --especially when they arise in the context of otherwise tightly linked and volatile markets --stand at the forefront of the reasons why structural features of clearing and settlement systems are so important. Against that background, there are several structural features of these systems which strike me as especially noteworthy: First, standards for participation or membership in clearing and settling entities should be explicit and meaningful. Specifically, criteria for membership --especially in entities that have shared risks --should, at a minimum, include strong capital adequacy requirements, proven operational soundness and high standards of professional and ethical management, as well as demonstrated access to ample sources of credit and liquidity short of the central bank. Open access is important but not at the expense of credit standards. Strong members can sponsor and be responsible for those not ready for direct ) ":l Uv
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-14 -participation. There is also the question of whether --as a general rule --members of clearing corporations and the clearing corporations themselves should be subject to a heightened degree of official oversight. A second key structural feature of clearing and settlement entities is that they should have in place clear rules that specify the obligations and rights af clearing firms, their customers, the clearing corporation itself, and the corporation's settlement banks. This is not to say that these entities should not have some flexibility in addressing problems. But the clarity of their respective rights and obligations is especially important in times of stress, including the event of default or bankruptcy of individual parti,:ipants.
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15 -Third, it is also important that clearing systems provide the structural capability for the entities themselves, individual members, creditor banks and supervisors to be able to assess and limit positions and exposures -including on an intra-day basis --as needed. Ideally, that capability should exist across instruments, across markets, across exchanges and across clearing corporations since it is not uncommon for individual firms --or large customers of individual firms to have sizeable positions in a variety of instruments in a variety of different exchanges. In this regard, there is also a question in my mind as to whether it makes sense, in the long run, to have transactions in a wide range of agricultural, industrial material and financial instruments clP-red and settled in the same clearing entity.
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16 -Fourth, the most important structural features of clearing and settlement systems, however, are those which relate to the manner and certainty with which the settlement takes place. As noted earlier, a strong clearing and settlement system must have sound information systems, and it must have the ability to effect trade comparisons in a prompt and efficient manner. Assuming these features are in place, the settlement systems must also: o have a well understood and binding mechanism for netting positions of individual participants --and by eztension their customers. This, I might add, is easier said than done, especially since ill-conceived netting systems can, among other things, become a smoke screen behind which abuses can occur. It is also true that multilateral netting arrangements present difficult legal and credit problems growing out of the contingent liabilities that can arise in the event ....
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-17 -of a default on the part of a direct or indirect party. Needless to say, therefore, if the netting mechanism is flawed, the achievement of final net-settlement also is suspect. o assuming the mechanisms for netting -including procedures for dealing with fails to deliver securities --are in place, the next thing that is needed are settlement rules that, among other things, provide participants ample time and opportunity to secure and deliver the cash and/or securities that are required of each participant and their customers. Since the act of settlement may often involve drawing on credit facilities at banks, this implies the need to ensure that creditors are able to make informed and explicit credit decisions. It also implies that seemingly unimportant things, such as disparities in operating hours and days of doing business between banks and exchanges, can become important in times of stress. ,, 43
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-18 -o the next thing that is important is that the settlement mechanism have access to a reliable and trusted method for achieving final net settlement. Here too, the manner, timing and precise circumstances in which final settlement is achieved should be clear and explicit. As a practical matter, that seems to me .to require that, in many if not most circumstances, clearing and settlement systems will need to have the capacity --through settlement banks --to effect payment for their net-settlement obligations over Fedwire. And, if net settlement is to be effected over Fedwire, I believe the net-settlement transfers should be made in such a manner --as is the case, for example, with CHIPS that the purpose of the transfers is explicit and clear to all, including to the Fed itself. In other words, transparency should be a central part of the process of final net settlement
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19 -so that credit decisions --including those made by the Fed --can be explicit. Regardless of whether net settlement is achieved via the Fed or otherwise, it is important that the Fed or some other settlement agent have strong assurances that the settlement will stick. That is why the concept of settlement finality is so important. That concept is one which says that the clearing entity seeking to achieve final settlement has in place the financial resources and commitments --whether in the form of reserves, collateral, committed bank lines, guarantees, or some other arrangements --to ensure that, in the event of a problem or a default, settlement will still take place. Absent those resources and commitments, the danger in times of stress is that one or more parties will refuse to participate in the settlement, thereby triggering potentially substantial losses for the clearing corporation and, ,..,,., r, .. ., ... .:. '-"
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-20 -through it, other members. Needless to say, the consequences of such an event could be very serious indeed. III. Financial Features The last, and in many respects, the most important feature of clearing and settlement systems, which I want to comment on, relates to their financial strength and resiliency .. Here, I have in mind the nature and size of the financial, credit, and liquidity cushions that are available with certainty to be able to meet contingencies and problems that may arise. In this regard, the earlier discussion has already referred to the importance of strong operational controls and the transparency of the settlement and credit decision-making processes associated with such systems, but there is more to it than that. The ultimate line of defense insofar as the financial strength of these systems is concerned is, of course, the capital adeqvacy of the participating members and the extent to which informed, rigorous, and explicit credit judgments are associated with all aspects of the system. But, even if we assume that capital standards are adequate and we assume that all participants are diligent in their monitoring of and control over exposures, the case for further elements of strength in financial and liquidity characteristics within clearing and settlement systems is clear. It is for this
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-21 -reason that most, if not all, such systems rely on some combination of member deposits and/or guarantees, together with margins to establish a liquid clearing fund which is intended to serve as something of a financial buffer to enable the clearing system to absorb various forms of shocks ranging from large and sudden price changes to defaults. However, the size and composition of such cushions can vary appreciably from one clearing system to another --a result that in and of itself may not be bad. However, because the consequences of a major default in one of these systems can be so severe, I, for one, believe we should err on the side of being quite conservative in our judgment as to what constitutes an adequate measure of capital and liquidity support for clearing and settlement systems. To me, that implies that we should look carefully at the following: the capital structure of firms which are members of clearing corporations. the size, composition, and nature of the deposits that members are required to post with the ezchange or clearing corporation as a condition of participation, including the question of ,., i 1"1 -~
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-22 -the liquidity and certainty with which such funds are available quickly to meet emergencies. the level and structure of margins with particular emphasis on ensuring that margins provide a sufficient cushion to protect the integrity of the marketplace generally, and that they can play this role without having to rely prematurely on the liquidation of positions in order to generate the cash needed to start up in the morning or to keep the exchange or the clearing corporation whole. Clearly, the appropriate level of margins can vary from one market or clearing system to another depending, among other things, on the amount of price volatility and the time to final settlement. However, the potential range of factors that can produce a significant default in a clearing mechanism is wide. There is no analytical tool which can, with precision, evaluate the probability of
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23 -such events. Yet, however low the probability, the consequences of such a default can be so 3evere that the need for a conservative and prudent standard should be extended to our approach toward margins. In doing so, we need to ensure that margins themselves are not subject to a competition in laxity. In short, margins matter. In addition to adequate clearing funds, deposits, and margins, I also believe a strong case can be made that major clearing systems should have access to an identifiable pool of liquidity and/or collateral, again, short of the central bank. This might include the presence of firm, committed lines of credit at commercial banks on the part of members and perhaps the cleating corporation itself. It might also involve arrangements for the establishment of a pool of liquid collateral in satisfactory form that can be brought to bear either to secure positions or to
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-24 -facilitate external financing; or, it might involve some kind of financial guarantees. However, its precise form is not as important as the concept; namely, seeking to add an extra element of certainty to the settlement process. Finally, I also believe that a case can be made to give greater attention --to at least consider the question of whether there may be a role for some device that can limit or contain the total amount of exposure any participant can incur within and across a series of interdependent clearing mechanisms. This would not be easy to accomplish, but, in my view it is worth some thought. The thrust of these comments is not to suggest that there is any one specific formula which can tell us in a fail-safe manner what constitutes adequate financial cushions for each and every clearing and settlement system. That is neither achievable nor desirable. Rather, the point is that the financial underpinnings of these systems are of great importance --including from a public policy perspective.
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25 -Thus, as I said earlier, judgments about what is adequate should be made with a cautious and conservative bias and should be made in a manner that realistically takes account of both the dangers and the consequences of default. These remarks are already too long, but in point of fact, I have only scratched the surface. For ezample, I have not even referred to the complexities that arise in connection with off-shore clearing and settlement systems or those which, in one way or another, involve multiple currencies cutting across national boundaries. Similarly, I have not even touched on the question of direct linkages among clearing systems, much less on what can be done to better integrate ezisting systems. Those subjects will have to wait for another time. But, in a way, that is appropriate because I believe that the primary thrust of current efforts should be to ensure that ezisting systems are all that they can be and should be. As I said early on, the importance of the safety and integrity of payments systems is now widely accepted; what I am suggesting is that, if we really care about the safety of the payments system, we must also care about the safety and integrity of related clearing and settlement systems which ultimately operate through the payments system.
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GLOBAL CUSTODY ISSUES BY J.OBElT lit HOJ.GAN STANLEY TllUST COMPANY UNDATED, CIJ.CA 1989 This contractor document was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board. r. r-') ~,_
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GLOBAL CUSTODY ISSUES Recant years have witnessed a boom in overseas investing, especially in foreign equities. The benefits of enhanced returns and reduced risk are clear. However, the difficulties ara numerous. Time differences, tax laws and settlement procedures all cause headaches. The solution increasingly being adopted by investors is to appoint a global custodian to administer their funds. The custodians will settle and safekeep securities traded worldwide, and provide thei~ clients with detailed reports on their portfolios. Time consuming but vital chores like tax reclamation and income collection will be covered by the custodian, thereby freeing investment managers and clients for real decision making and analysis. In conducting its role the global custodian fulfills four essential purposes namely: 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 format for reporting and valuation of securities held in custody, c) ensuring its sub custodians in each country receive standardized information concerning transactions irrespective of the client or fund manager involved, d) providing essentially an clients that their interests, safekeeping, protection of rights appropriately safeguarded. insurance protection to its in terms of physical and entitlements, will be For provision of these services global custodians receive various revenues, mainly fees and their profit margin derives from operational efficiency and their ability to in effect "buy wholesale and sell retail". The complexity of the business, involving anywhere from 25-40 countries and hundreds of institutional clients, requires constant investment in people, technology and the management of "vendor" relationships. In considering issues associated with conduct of this business the remainder of the paper is divided into three sections, settlement, safekeeping and reporting. It is not intended to present detailed analysis in each area but rather to illustrate, generally or by specific example, the kinds of problems requiring constant attention. The detail itself, which is often country specific, is available for many countries and security types from major global custodians including Morgan Stanley Trust Company. r,.
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1. Issues Associated With settlement Attachment A illustrates a typical international securities transaction. Whilst some trades are simpler, involving for example no U.S. broker, many are more complex. The number of parties involved in the transaction is considerable and they are often widely separated by time zone and language. The global custodian is prospectively a victim, in terms of the quality of service it can provide, of any inefficiency, and yet has no control over the choice or operation of any of the other parties with the exception of its sub custodian. The first problem faced by the global custodian, is that the period between trade date and settlement date is not uniform 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 timeliness of instructions received by the sub custodian and local executing broker, as well as the consistency of such instructions. Timeliness of what is an international communications flow requires all parties to have a reasonable degree of technological sophistication which is not always available. Accuracy too, benefits from automation. However, automation in turn requires a level of discipline, for example in format of messages and identification of securities, which is not always readily accomplished. Thus the first issue faced by the global custodian is that, through no fault of its own, it may be unable to ensure settlement of a transaction, and not even be able to confirm it has passed accurate instructions into the Local Settlement system, prior to contractual settlement date. Secondly, and related to the first issue, is the fact that many Local Settlement Systems involve no matching of transactions between parties prior to Settlement Date, and none, except the eurobond market, involve an automated matching process. The global custodian therefore has only limited opportunity to know in advance of Settlement Date, that a trade is going to fail. Being unable to control or predict failing items has 3 further consequences for the global custodian. Firstly an international securities transaction typically has associated with it a foreign exchange trade in which the investing institution buys or sells the foreign currency used to settle the purchase or released from the sale. This transaction may involve a whole series of additional parties who have no reason to communicate, or even know of the other parties. Settlement of these foreign exchange trades, which cannot be made contingent on settlement of the associated
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securities trade, result in unanticipated credit or debit balances on the cash accounts maintained by the global custodian with its sub custodian. Charges are not necessarily recoverable by the global custodian, if for example the "failing party" is a local executing broker. Secondly local market settlement is rarely effected on a strict delivery or receipt versus payment basis. Timing differences between movement of cash and movement of securities vary from a few hours to a number of days. Often there is no market mechanism to pro;ect institutional investors or global custodians from the effects of bankruptcy of a counterparty. Finally, due to the physical nature of settlement in many markets, some involving "bearer" instruments and the inefficiencies associated with clearing physical securities, temporary (i.e. 1 or 2 day) fails are the norm in many markets, including Japan and U.K. Given this, the sub custodian will often not bother to notify the global custodian of failed items until 2 to 3 days after Settlement Date. In summary therefore the inability to predict settlement of trades, local market inefficiency and risk and the lack of post Settlement Date communication of failed trades lead to numerous undesirable consequences for the global custodian including: unanticipated, uncontrollable counterparty credit risk, inability to provide adequate returns on unanticipated "idle" cash balances, unpredictable levels of "failed" trades, accidental acceptance of fraudulent securities. Whilst in most markets mi tigants do exist to cover the above consequences, at least to some extent, the global custodian's role as a "fiduciary" makes it impossible to pass all risks and financial consequences in terms of opportunity costs onto its clients. This hidden "insurance" cost is often not discussed explicitly with clients as part of the fees being paid. Global custodians are required to provide service in an ever increasing number of "fringe" markets in response to client and fund manager pressure. Th~ consequences are potentially worrying, especially if global custodians are not able to take sufficient time to fully evaluate the risks entailed, whether these be operational costs being assumed to cover market inefficiency or outright risk due to the legal and regulatory environment in the country concerned. It is however perhaps worth noting that all these risks exist for the investor, irrespective of whether or not a global custodian is used. By virtue of size, experience and local market expertise, a global custodian is better able to ,., I -,. ..J
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analyze, evaluate and in turn take steps to minimize the risks as well as having capital to protect the underlying investor be they institutions or individuals. 2. Issues Associated With Safekeeping As with domestic U.S. securities, international securities can be either bearer or registered in form. Each type creates its own set of issues for the global custodian associated with title, corporate actions and control. Bearer securities By giving value i.e. money, for bearer securities, the global custodian is totally reliant on its sub custodian to verify the authenticity of the instrument presented and physical security of the investment once received. The global custodian cannot do anything itself in either of these areas except through the terms of its contract with its sub custodian and through its own insurance. Whilst instances of fraud are not common they have occurred, though consequences thus far have been borne by the brokerage rather than custodian community. Bearer securities, usually carry no voting rights, and require physical "coupon" presentation to effect collection of dividends. Even where voting rights are available, the procedures involved in exercising them are such as to make such exercise impossible for practical purposes. Because their involvement is negligible, holders of bearer securities may not be informed on matters of corporate governance which will be decided by "voting" shareholders. Notification may appear but only in local language press. As a result of these obstacles it is virtually impossible for a global custodian to facilitate exercise by a fund manager of what may be regarded, by U.S. regulation, their fiduciary responsibilities. Finally, since the beneficial ownership of bearer securities is unknown, all dividends are paid in a way that ensures any taxes withheld at source are effectively not reclaimable. Registered Securities Registered securities obviously have marked advantages in a number of respects compared with bearer instruments. Physical possession and control is of less concern, since certificates are usually easily replaced if lost or stolen. Also the certificate itself, without an associated ownership transfer document, is of no value. Unfortunately whilst physical security presents less of a problem, the nature of registration poses its own issues in many countries. Almost without exception, the reregistration ......
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process undertaken by a sub custodian and conducted by local registrars is inefficient. In many cases the registrars have no incentive, financial, regulatory or otherwise, to improve efficiency of service. Thus the delay in reregistration is typically measured in weeks and in certain countries in months. To the extent that a corporate action ( e. g dividend, stock split, tender etc.) occurs during this period the new owner is effectively disenfranchised and his/her rights remain with the seller. For tne global custodian this can lead to a number of operational consequences. Firstly, as with bearer securitie~, the ability to provide proxy information in a timely and meaningful way, is virtually impossible. Secondly_, in some markets, such as Japan, failure to effect timely reregistration results in outright forfeiture of dividends due, back to the seller. If this occurs as a result of failure by the global custodian, it will bear the financial consequences. Thirdly, even when the beneficial owner, is entitled to participate in a voluntary action, registration delays may defer notification until after the deadline for action has occurred. Finally, and most importantly from an efficiency perspective, even in those markets (e.g. U. K and Australia) where a fairly formal "market claim" procedure exists for recovery of dividends paid inadvertently to the seller as a result of registration delays, the process is extremely lengthy and time consuming. It leads to multiple partial payments of dividends to clients, overall loss of interest on these late paid amounts and an extraordinary level of administrative burden on the global custodian in reconciling and pursuing claims on behalf of its clients. In addition to the generic safekeeping issues associated with bearer and registered securities three other areas are worthy of comment, cash management, withholding tax and "rights" issues. As noted in the settlements section, inadvertent long cash balances may exist at sub custodians as a result of failed trades and overdrafts may also occur. Typically the investment vehicles available to a global custodian for its clients are very limited and offer significantly "below market" rates of return. Global custodian.::; are constantly under pressure to provide alternative vehicles which are not necessarily practical. More importantly, in some countries, overdrafts are illegal and can result in penalties as well as interest charges. These penalties may not re able to be r 1 .. .....,,
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passed on to clients, with the global custodian therefore having to bear the cost. In many countries, taxes are withheld at source. In some cases, as a result of various taxation treaties, some or all of the taxes withheld may be reclaimable. The procedures for effecting such a reclaim are country specific, but can generally be characterized as complex, manually intensive, time consuming and in many cases only marginally productive. Forms are almost invariably in foreign languages and no help is provided on their completion. The global custodian, whilst not a tax adviser, is required to be knowledgeable on these subjects and is expected to file for reclaims and collect them. "Rights" issues are a uniquely U.S. problem. Such rights offerings, made by foreign companies, are not registered under SEC rules. As such they cannot be "offered for sale" in the U.S. Many companies, fearful of incurring censure from the SEC therefore preclude participation (i.e. exercise of their "rights") by U.S. registered holders of securities. To the extent that its clients are desirous of exercising "rights" the global custodian is placed under pressure to find a way to deal with the matter. By definition the outcome is unsatisfactory for all concerned. 3. Issues Associated With Reporting And Valuation A critical element in the service provided by global custodians is the provision of valuation services to institutional clients such as mutual funds and pension plans. Often these are used to provide additional analytic data on the performance of fund managers and are directly utilized in calculation of net asset values. Given the public nature of much of this activity it is perhaps surprising that the "inadequacies" of the international markets are not more frequently called into question. Basically any valuation is only as good as the data used in compiling it. This data is in the form of securities prices, foreign exchange rates and accrual information. Many international securities prices, especially in the less liquid, emerging markets, are not widely available. Often no "official" closing price exists and in some markets days or weeks may pass without a trade being done against which to assess a price. The global custodian is heavily dependent on its local agents to provide prices which in turn are manually fed into valuation systems. The potential for error is considerable. Even automated pricing services are constrained by local market inaccuracies, ( for example information is obtained in one Far Eastern market through observation from the public gallery of stock exchange trading). ,. _-:-; ... i.. ..
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Foreign exchange rates are much more readily available and can be verified for accuracy with many outside sources. There the problem is not one of lack of data, but rather the fact that global foreign exchange markets are never closed. The problem exists with determining what constitutes an appropriate time of day to declare as the rate for fixing valuations. Given the volatility of these markets, a small time difference can mean a major impact on net asset value. In addition, there is no official foreign exchange market, all deals. are conducted on an OTC basis, and so no independent determination is available. Accrual information is weak in both equities and fixed income. The dividend cycle in different markets is widely divergent ranging from a one day process in bearer securities to 3 months in Japan. In some markets ex-date and record date may precede the announcement of the dividend rate by some weeks. Accruals are by definition at best estimates of realizable earnings. In addition, reclaim of excess withholding taxes is uncertain as to timing, and in some markets actual payment. Accruals can easily overstate realizable net asset value whilst treating payments on a "cash" basis may understate the position. In addition, as noted earlier, corporate action information is not always timely or accurate, leading to further valuation complications. Whilst any securities valuation system is subject to some data inadequacies, those applicable to daily priced mutual funds investing internationally are especially problematic. In times of serious market volatility, or even dislocation, these problems could be very costly for global custodians, fund managers and plan sponsors. summary The world of international investing in equities and debt instruments presents significant opportunities and a large number of serious obstacles. The role of the global custodian has been to facilitate exploitation of the opportunities whilst assuming the burden of dealing with the operational, administrative and financial risks associated with the business. The exact balance between risk and reward has not always been thoroughly thought through by the institution prior to entering the business and often, only once embroiled in the business, do the problems become apparent. Whilst no significant financial problems have occurred so far, it should not be assumed that such an eventuality is impossible, especially as fund managers move into emerging markets with less stable political structures. Global custody is not for the "fainthearted" or the naive. It is a costly business involving control of massive ...
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and complex flows cf information, extensive technological investment and the use of external resources disposed across the globe. With the right commitment however, it can provide a unique opportunity to U.S. institutions to participate in the economic expansion of the world outside the U.S. r r ~! .... \
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ATTACHMENT A U.S. Pension Plan INTERNATIONAL SECURITIES TRADE FLOW Fund Manager Trade Date Trade Date + 1 Global custodian Trade Date+ 2 Sub Custodian Settlement Date Local Settlement System r,. Executing Broker US Trade Date Executing Broker Local Settlement Date
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All.ANGEMENTS FOR THE REGULATION AND SUPERVISION OF SECURITIES MARKETS IN OECD COUNTRIES ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT UNDATED This contractor document was prepared for the OTA Backgrotm.d Paper, Trading Around the Clock: Global Securities Markets and Information Teclmology, July 1990, and OTA Report, Electornic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This document does not necessariLy reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board. r ..
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SPECIAL FEATURE ARRANGEMENTS FOR THE REGULATION ANO SUPERVISION OF SECURITIES MARKETS IN CECO COUNTRIES CONTENTS I. INTRODUCTION ANO SUMMARY OF ISSUES II. BROAD OBJECTIVES ANO PRINCIPLES OF SECURITIES MARKET REGULATION ANO SUPERVISION III. OVERVIEW OF EXISTING REGULATORY ANO SUPERVISORY AUTHOP.ITIES IN SECURITIES MARKETS IV. SCOPE, METHODS AND TECHNIQUES OF SECURITIES MARKET SUPERVISION V. POLICY ISSUES FOR FURTHER CONSIDERATION A. Differences in Comprehensiveness of Coverage of Regulation B. Fragmentation of Supervisory Authority C. Problems of Internationalised Securities Markets 0. Investor Protection and Macro-Prudential Risk 17 r ,_, ') u ,_;
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I. INTRODUCTION ANO SUMMARY OF ISSUES The rapid development of securities business in CECO countries, the internationalisation of securities markets and the growing importance of these markets in the process of financial intermediation have attracted increasing interest among financial officials and economic policymakers in CECO Member countries Cl). This interest has deepened in light of the events of October 1987 as it has b1come apparent that instability In securities markets could have serious repertussions for the whole financial system and indeed for the who 1 e economy due, inter a 1 i a, to the 11 nks with the bank 1 ng system and the risks of i111quidity in times of cr1sis. Reflecting this heightened concern, the OECD's Comm;tt~e on Financial Markets CCHF> 1n the autumn of 1987 began an Investigation Into existing mechanisms to regulate and supervise securities markets in Member countries, 1n order to meet two pressing needs: first, to develop an adequate store of factual material concerning such mechanisms and, second, to formulate some preliminary cor.clusions as to whether existing mechanisms are fully adequate to deal with the current realities of dynamic Internationalised securities markets that are closely integrated with the remainder of the financial system (2). The present investigation Into market supervision is only the most recent in a longer-term worl-.. programme on securities. In response to the rapid development of securities business 1n the 1980s, the Committee on Financial Markets had as earlyas 1984 begun a broad work programme on securities markets, which included the publication In 1987 of a major study analysing issues related to the access of foreign Institutions to the securities markets of Member countries (3). In the course of 1987, and especially following the October 1987 market break, the Committee decided to intensify Its work on securities markets and to give special emphasis to developing a better understanding of the functioning of securities markets as part of an efficient and stable financial system. The Committee's survey of regulatory systems for securities markets reveals considerable diversity of tradition, doctrine, inst1tutiona1 structure and practice. Furthermore, most of the systems now In place were developed when securities markets were far less sophisticated than they are today and far 1 ess interconnected with other markets, both domestic and I nterna ti ona 1 The forces which have led to the increased internationalisation of securities markets are a 11 expected to continue exerting a powerfu 1 1 nfl uence in the coming years, and a reversal of the processes of liberalisation, deregulation, and technological advance Is considered neither feasible nor desirable. Accordingly, many countries are now In a process of reviewing their regulatory and supervisory frameworks with a view to adapting them to today's increasingly complex and globalised securities market. There is a growing awareness that securities market activities Involve risks that have become comparable to the systemic risks involved In banking. Thus, It Is increasingly felt that factors contributing to such risks need to be addressed along with the more traditional basic objectives of Investor protection and efficient mark.et functioning. In Its assessment of the current situation with respect to the supervis I on of security markets In OECD Member countrl es, the Committee on Financial Markets has ,denttfled the following Issues, which are sunmarised below In order of their Increasing seriousness and discussed more fully tn Section V. 18 r,
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A. Differences in comprehensiveness of Coverage of Regula.ions Hhile legislation in a few countries is framed in such a way that anyone offering securities or investment services to the public is subject to specific regulation and supervision, in some other Member countries institutions or operations not meeting specific criteria are not covered by securities market regulation. Examples of this latter case which are found In some countri ~s include the over-the-counter markets, the futures and options markets, and certain securities activities carried out by firms which are not organised as banks or brokers. In the current process of reassessing t~e adequacy of regu-latory frameworks and supervisory mechanisms, the authorHies in some countries have given a relatively high priority to rectifying this situation in cases where it is felt appropriate to bring such Institutions or activities within the official regulatory framework. Further efforts :iy national authorities may be needed to achieve an adequate comprehensiveness of regulatory and supervisory systems. e. Fragmentation of ReguJ1tory Authority A different problem can arise where supervision is carried out on the basis of functional criteria, and different markets are supervised by different bodies. Supervisory systems may not adequately reflect the degree of integration that exists among markets or the ful 1 variety of operHions performed by a single institution. Given the manner In which tasks are distributed, there is an evident risk of fragmentation of the regulatory and supervisory authority over financial Intermediaries engaged in a wide scectrum of securities activitfes. The several official bodies in question may nave mandates and policies that vary significant.ly and that at times may be contradictory. c. Problems of Internationalised Securities Markets At the international level, the problems cited in the two previous paragraphs are likely to be magnified --and thtir solution Is likely to be rendered more difficult because the nature of securities business Is evolving in a way that makes it progressively less feasible to exercise national control using traditional methods. Institutions doing securities business are typically active in several nationa1 markets with different institutional and regulatory characteristics. Moreover, several securities markets have developed which have already outgrown the boundaries of any one national regulatory regime. Notwithstanding the growing international 1sation of markets, t:ie international dimension of securities business is not fully reflected in supervisory and regulatory approaches. Little International agreement exists concerning regulatory doctrine. In addition to differing national standards, numerous international jurisdictional uncertainties exist. As an important example, unlike the case for banking, securities superv1sors have not yet agreed on the distribution of responsibility between the home-mark.et and host-market authorities for the supervision of international securities firms. Hh11e there have been several significant strides In enhancing co-operation among regulatory authorities in the past few years, --in particular, bilateral agreements to enforce regulations against mark.et 19 ;, ...
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manipulation --considerable further co-operative efforts are needed to create more transparent secur1 t1 es markets. to assure equa 11 ty of compet1ti ve opportunity (the "level playing field"), and to reach agreements and understandings designed to m1nimiu the potential of developments In a gi'len securities market having destabiltsing effects on other market segments and the financial system as a whole. o. Investor Protection and Macro-Prudent1a] Rtsk In the past, securities market regulation has been undertaken primarily with the goal of investor protection In mind. Rules governing Investor protection seek to assure that the Investing public ts not subjected to fraudulent, deceptive or manipulative practices by Issuers of securities or by market professionals. The traditional means of achieving this goal are: a> to establish and enforce rigorous standards of disclosure fc.r securities, derivative products and other comparable instruments offered to the public; and b) to monitor proftssional practices related to new issues and secondary market trading so as to prevent market manipulation and other malpractices. The above functions continue to be necessary to the operation of securities markets. But the challenges of today's ~arkets give rise to additional regulatory concerns. In particular, the rising importance of securities markets in the financial systems of CECO countries, tne ;rowing concentration in the securities industry, the effects of new tecnnologies, tne nature of the risks now being borne by securtti es market I ntermedtari es and the links between the securities market and the banking and payments system all suggest that the :occurrence of serious mtsfunctions in the securities 1111rketi would have the potential to destabilize the entire financial system. Furthermore when the global nature of securities business ts added, It is plain that a misfunctioning cf any larg~ national or international ~arket nas the potential to affect all CECO countries. It should be stressed that, In the view of the Co11111i ttee, the above concerns do not call for any systematic increase in official Interference witn securities markets. On the contrary, ongoing efforts to reduce barriers to market access in financial markets and to seek the progressive liberalisation of the remaining controls on capital movements and International activities in the financial services sector should be pursued. Furthermore, any generallsea attempt to prevent investors from assuming rtsk would be an inappropriate response. Risk-taking and risk diversification are necessary features of a market economy. It is also Important that steps dealing with the risks borne by securities market intermediaries, in particular, provisions for emergency liquidity --do not have the effect of encouraging intermediaries to take even greater risks. Rather, the C011111ittee"s approach will be to consider how securities market supervision might best oe adapted to the realities of a highly competitive, dynamic and globaltsed marketplace. There is a clear need for better understanding how the recent changes in these markets have affected the incidence of macro-prudential rtsk in the system and what prudential responses are desirable. 20 ( ... ""' I...
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Tht remainder of thts article ts structured In the following way: In Stctior. II the note dtscussu general prtnctples and objectives of securities market regulation and supervision. In Section III some broad observations are madt about the organtsattonal and lnstttuttonal features of securities markets regulation and supervision tn Member countries. In Section IV, the article discusses some of the specific securities-related activities that are monitored t n Member countries and some of the procedures and techniques :.is ed tn monttortng those activities. In Section V, an Initial dtscusston is presented as to whether current regulatory systems are fully adequate to deal wtth present global securities markets and whether some perceived regulatory gaps, omissions or Inadequacies may extst. II. BROAD OBJECTIVES AND PRINCIPLES OF SECURITIES MARKET REGULATION AND SUPERVISION In all OECD countries tt ts viewed as a legitimate function of government to axarci sa some degree of survet 11 ance over securities-re 1 a ted activities as part of the duty of government to create an environment In wnicn productivt economic activity can take place. The responsibility of governments with respect to ftnanctal markets Is slgntftcantly greater t~an in purely commercial transactions, especially tn the case of banking whicn !"las baste "macroaconomtc" functions such as operating a country's payments system, safeguarding the savings of small depositors and serving as a vehic1e for implementing monetary poltcy. Thus, banking institutions are subject .to special regulation and supervtston and the authorities exercise significant control over risks taken by banks. While offi ct a 1 control over rtsk-tak t ng t n the securities markets is substantially less than tn banking, the authorities still exercise some control tn thts field although the offtctal responstbtltty differs according to the character of the Investment or the nature of the activity. The finance ministry and/or the central bank have considerable supervisory roles ~it~ respect to the government securities market and the money market. The central bank ts often an active part1c1pant tn these markets. Thus, while investors tn these markets must bear the full interest-rate risk, the authorities usually accept considerable responsibility for maintaining market liquidity. Outside these sectors, whtle the central bank and the finance ministry usually assume no res pons t b 11 ty whatsoever to protect investors or securities market intermediartes from losses, or even from ultimate failure, there have been some instances when central banks have, under very specific conditions, Intervened to supply ltqutdity to some segments of securities markets when it seemed that a possible crtsts might have had tmpltcattons for the financ~al system as a whole. Regard1 ng markets in securities issued by private entities, mos.: OEC:l governments believe that It ts tn the public interest to maintain markets for invest ,nts which have the confidence of the public and to which the public Is wtlltng to commit tts savings. This does not mean that such regulation seeks or should seek to r1mov1 risk, for rtsk-taktng ts a critical function of a market economy and Investors must be free to determine the degree of risk they wtsh to accept. Nevertheless, Investors must be fully informed of the nature of risk and protected from fraudulant, deceptive or manipulative practices. 21 r .... ....
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Additionally, the investor is normally expected to assume only the risk inherent in his own investment, rather than additional risks associated with the possible insolvency or misconduct of an Intermediary. A closely-related goal of securities regul~tion Is to ensure that operations in the markets are conducted under predictable, understandable and transparent ruies that do not give special advantage over the general Investing public to those possessing privileged information or having s;iecial connections to investors, issuers of securities, or market Intermediaries. For example, information concerning prices at which assets are sold as well as fees and commissions related to securities-related business must be matters of publi: Information. Furthermore, rules should be established governing the use and release of Information which may affect the market for specific s acuri ties .. Most OECO countries make a distinction between securities offered to a small number of Institutional investors (private placements> and a general public offer of an Investment Instrument. Rules governing securities traded privately or among professionals are often considerably le~s rigorous than those governing publicly offered investments. Hhile these broad principles guide virtually all OECO countri~s in regulating securities markets, Important nuances are apparent. 'T'~us, regulatory authorities In some countries will approve new Instruments such as financial futures and options if it Is clear that the financial community wishes to deal in such Instruments. Authorities in other countries wi 11 take a more cautious approach and try to ascertain whether such Instruments are related to genuine Investment or hedging needs before approving their Introduction. Some reasons for adopting a more restrictive view towards allowing the public to assume risk are that the authorisation of trading techniques or operations which seem basically speculative in character might a> undermine confidence In the financial system or b) increase volatility in financial markets. Views also differ among countries as to the responsibility of Institutions underwriting new issues of securities or offering invest:nent advice. !n so111e cases, the regulatory doctrine 1s that the underwriter or Intermediary has no responsiblity to the investor as long as all required Information is disclosed according to prescribed regulations. Other regulators believe that underwriting or advising about securities is the equivalent of sponsoring those securities. One Important objective of supervision and regulation that has gained in significance with the deregulation and internationalisation of the securities industry 1s to assure that the regulatory system as a whole does not give unfair advantage to one group of participants. Even within countries, competition among different categories of Institutions which previously were restricted to limited segments of the financial mark.et is now increasingly common. Internationally, firms active In ~ecurities markets come from varying Institutional and regulatory settings. Some are banks or have close banking connections and thus may be subject to specific supervisory controls over risk-taking, while institutions which have no banking tie are not necessarily bound by such restraints. On the other hand, Institutions with banking connections may have direct or Indirect access to central bank 22 .....
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support. At the same time, national rules requ1r1ng institutional separation between banking and securities business may have differential effects on competition in the various market segments. Moreover, there exist differences in prudential practice and in taxation regimes which may create disparate results as institutions compete in the international market place. In brief, it is increasingly felt that achieving equivalence of regulatory burden for all market participants should become an urgent objective of securities market regulation witn a view to contributing to an effective levelling of the playing field both at nitional and international level. It is important to stress that, in general, systems to regulate and supervise securities markets were originally not designed to assure the overall stability of the financial system, and most regulators have no particular mandate to do so. Regulatory and supervisory systems were primarily designed to protect _investors from fraud or manipulation or losses arising in connection with the failure of intermediaries. It may well be that by enforcing rigorous investor protection rules, the macroeconomic goal of stable markets will be assisted, but this is an issue for discussion rather than a self-evident proposition. III. OVERVIEW OF EXISTING REGULATORY ANO SUPERVISORY AUTHORITIES IN SECURITIES MARKETS A. Sources of Institutional Diversity .. The factual information developed in the course of the investigation into supervisory and regulatory systems indicates that the existing regulatory situation in OECD countries is complex and diverse. Regulatory systems governing securitie, markets often consist of a heterogeneous combination of I aws, decrees, orders and rules that mix functi ona 1 and Ins tituti ona I criteria of application. This is iargely explained by the fact that secuTities markets include many different act1viti .. s with different institutional arrangements, market participant5 and business practices. Reflecting this uneven development, securi-ries market regulation also 1s often less comprehensive than, for instance, banking regulation; and, indeed, some securities-related activities have so far remained unregulated in a number of countries. Furthermore, the authorities generally rely on self-regulation by market professionals to a far greater extent than in other areas of financial regulation. One source of the great diversity of regulatory systems for securities markets is that the historical experience of OECD countries differs considerably and most regulatory systems were not established at any particular time, but rather evolved over long periods. In countries with federal structures, both national and sub-national governments often played a role in the development of regulatory systems. Securities business often began as an extension of ordinary commercial trading and was frequently self-regulated while stock exchanges were private assoc1at1ons. Often, at s:>me point in the history of national financial systems, and in response to particular problems, the authorities perceived the need to systematize existing private self-rgulatory arrangements in some sectors of the market in order to create a more formal regulatory framework. However, there are also 23 I I
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cases where the authorities still perceive that in some market sectors self-regulation without formal legal status is sufficient. This diversity of regulatory systems also reflects the diverse i nst1tuti ona 1 structures of the fi nanci a 1 systems of the CECO countries. An institutional separation between banking and securities activities is required in some CECO countries (mainly the U.S. and Japan) at this time but other countries have had histories of institutional separation as well. Another model of a financial structure is the system of universal banking, as exists in several European countries, (e.g. in Austria, Germany and Switzerland) under which banks are allowed to engage In the full range of securities operations and have traditionally played a preponderant role in the securities markets. A third system (e.g. Canada and the United Kingdom) 1s where banking and securities Cor investment) activities are viewed as separate operations but where no institutional separation is required. Under this system banks frequently do some portion of their securities business through specialised subsidiaries, rather than through the parent bank itself. B. Institutional Patterns of Securities Market Regulation Despite the great variety of institutional forms that exist in OECO countries, one can still generalise about the way in which OECD securities regulation systems are structured. A basic difference is whether specific institutions exist for the enforcement of investor protection rules or ~nether this task is assigned to some other body, for example, the official agency responsible for banking supervision. The main reason for having a separate system for securities supervision rather than having a single authority to supervise banking and securities is that the nature of investment business is viewed as sufficiently different from that of banking to require a separate regulatory structure. In particular, unlike the banking supervisor who is often interested in minimising risk-taking, the securities market sucervisor tries to create a fair and transparent frarr.ework for risk-taking. Where the securities and banking supervisors are the s~me, a single authority is responsible for the smooth operation of the entire financial market in all its aspects. By contrast, in countries where authority rests with different bodies, there may be overlapping and uncertainties about final responsibility. In some countries no specific institutions for securities regulation have been established and therefore the banking supervisory authorities assume a dominant role in the supervision of securities activities. This occurs in cases where banks are active throughout the fu 11 range of securities activities --frequently in countries with "universal banking" systems. Countries which adhere to this basic pattern include Austria, Belgium, Denmark, Finland, Germany, Luxembourg, Norway, Portugal, Sweden and Switzerland. Banks are required to observe certain professional standar1s when soliciting funds for investment from the public and with respect to disclosure, segregation of customers funds, and trading practices. Also. the banking supervisors normally seek to determine capital adequacy, some,;1mes requiring additional capital for securities business beyond what is required for banking business. The supervisors also monitor bank behaviour for possible conflicts of interest between banking and securities operations. Supervisory powers may be delegated or mandated tJ a self-regulatory body, such as a stock exchange, which may be responsible for monitoring 24 ''
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trading practices, licensing intermediaries and for sett;ng standards for admission of securities to trading and quotation in the secondary market. !t should be noted that even in cases where the bank.;ng superv;sors essential 1y assume all responsibility for securities mark.et surveillance, there are a few cases (Finland, Germany and Switzerland) in which some significant aspects of the securities business (i.e. the stock. exchanges) are not under the control of the banking supervisors. There are significant differences in the legal status of the self-regulatory bodies responsible for surveillance in these cases. Thus, the exchanges are under state (Laender) supervision in Germany, have no specific official status in Finland and are partly regulated ar.d supervised at a cantonal level and partly operate as private companies in Switzerland. Unlike the cases in which the banking supervisors supervise sec:.Jrities activities, legislators in some other countries perceive a need for a specialised regulatory system for securities. Such structures ex;st both in countries requiring institutional separation of banking and securities and in some countries where banks are active ; n the ful 1 range of securities business. A typical h;erarchical regulatory structure would delegate er mandate authority downward in the following pattern: a) National legislature (securities law); b) Ministry; c> Official securities-regulatory agency; .. d) Private self-regulatory organisation
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c. Division of Responsibility Between Banking and Securities Market Supervisors Inasmuch as many OECD countries have supervisory bodies for banking and for securities markets, some decision must be made concerning the distribution of responsibility between the two sets of authorities. Even in those countries with the strongest provisions mandating the separation of banking and securities business, commercial banks do significant amounts of securities business: in the United State~. for example, in government securities, municipal securities and money markets. In many countries, the central bank and the finance ministry assume considerable responsibility for the operation of the government bond market. Moreover, in many cases, the banks and other financial institutions may be among the major issuers of debt securities and hence the banking supervisory authorities bear some indirect res pons i bi 1 i ty for the soundness of a large share of the bond market as well. In the two countries where national law requires the strictest separation of banking and securities (Japan and the United States), banking supervisors assume responsibility only for the supervision of banks and their activities in the government bond markets and for certain aspects of the money market. Otherwise, securities business is basically regulated by the formal securities supervision bodies as described above. In many OECD countries: where banks are active in a wide range of securities-related activities there is some sharing of responsibility oet~ee,, the banking inspectors and securities market supervisory bodies. The exact distribution of functions between the two sets of regulators differs among countries. Many of the securities market monitoring functions, such as requiring that banks engaged in securities business set aside additional capital for such activities and overseeing banks securities promotional activities with the public, may be performed by the banking supervisors. In many cases some overlapping of authority will occur. For example, in a country where both banks and brokers may receive orders from the pub 1 i c, the banking supervisors may supervise the banks performance of this function whi1e the securities regulators may fulfill the same role for brokers. Countries in which this pattern prevails include France, Italy, the Netherlands and Spain. In Spain forma 1 arrangements exist to share the supervisory responsibility between the banking and securities authorities. In the United Kingdom an institution doing either banking or investment (i.e. securities) business is subject to supervision by at least one specific agency. Those engaged in both acttvtt1es are subject to the supervision of at least two bodies. Normally, one agency is designated the "lead" supervisor depending upon the business in which the institution is predominantly engaged. IV. SCOPE, METHODS ANO TECHNIQUES OF SECUR!TIES MARKET SUPERVISION Some of the broad investor protection functions that are commonly performed by securities market supervisors in OECD countries are discussed in the next few paragraphs. The specific oversight responsibility ~n any given market may be assigned to a supervisory agency, or some combination of sucn agencies as desert bed in the preceding sectt on. As regards stock. exchanges and other recognised self-regulatory bodies, regulatory frameworks often 26 II -
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delegate or mandate considerable regulatory and supervisory powers to the management boards/committees of the exchanges them~~lves. The degree of official surveillance exercised over such self-regulat4on differs markedly among countries. For example, in the United States, the SROs set rules governing trading practices, but these are closely monitored by the SEC. In Germany, the stock. exchanges, which are under State (Land) supervision, set admission and listing requirements within the framework. of broader Federal legislation. A. Setting Standards for Securities and Der1vat1ve Products and Establishing Disclosure Requirements This form of investor protection sets minimum standards to forbid the offering of instruments with deceptive or substandard disclosure practices through regulations concerning the kind of securities and derivative products that may be issued and trade1 on primary or secondary markets. Regulations stipulate the conditions that issuers of securities must meet such as authorisation procedures, disclosure requirements relating to new issue or admission-to-quotation prospectuses and regular information that issuers whose securities are traded in secondary markets must provide. This kind of requirement is intended to assure that those offering an investment instrument to the public provide sufficient information relative to the nature and risk. of the investment in order to enable the investor to decide whether he wishes to accept such risk.. Most OECO countries have such arrangements for investor protection in place. B. Protection of Investors Against Misconduct and failure of securities Market Intermediaries The purpose of these regulations is to assure the public that intermediaries are actually holding their clients' fu_nds separately from those of the firm, investing in accord with instructions, not exposing customers to problems of insolvency of the firm, executing client instructions In accord with established practice and reporting transactions accurately to clients. Among the specific regulatory tools used in pursuit of this objective are: a) licensing requirements for intermediaries; b) capital requirements; c) reporting requirements and related inspections: d) codes of conduct: e) definition of violation of securities laws by intermediaries; f) procedures for complaints and investigation relating to violation of securities laws and related enforcement procedures; g) requirements regarding internal arrangements of banks and securities firms for monitoring risks arising in connection with securities business: and h) regular prudential inspections by the supervisory authorities. The institutions subject to such regulation may be those normally engaged in investment activities, such as banks, brokers dealers or mar~et makers. Other institutions that may be subject to inspection, Cor additional inspection) by virtue of their activities may include: a) members of organised, or recognised, securities markets (brokers, dealers, banks, etc.); b) institutions or persons carrying out brokerage (agency) business or trading securities on own account inside or outside the stock exchange; c> institutions engaged in discretionary portfolio management; d) institutions engaged in the management of collective investment funds and 27 r,' I:
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in the distribution of collective investment fund certificates; e> institutions or persons providing investment advisory services; f) institutions engaged 1n the dissemination of mark.et information, notably information on credihorthiness Crating agencies> or quotations (information vendors). Regulations governing professional conduct of securities mark.et intermediaries and specifying what institutions or activities are subject to supervision may be found in various parts of national legislation. In some cases enforcement and regulation may be mainly left to the stock. exchanges themselves. Finally, owing to the specific terms of national supervisory systems, some institutions may be subject only to incomplete supervision, or possibly no supervision at all. (The problem of differences in coverage of regulation will be discussed 1n Section V.) The most comprehensive regulatory framework.~ 1n this regard are found 1n the United Kingdom (under the Financial Services Act of 1986) and in the United States. In both cases a 11 intermediaries engaged in securities-related activities are subject to 11 cens i ng requirements, codes of conduct and capita I requirements; and there are comprehensive regulatory frameworks for prosecuting violators of securities I aws. c. Regulation Designed to Ensure the Proper Functioning of Markets To ensure the fair and effective functioning of markets, procedures are established to set predetermined and predictable rules governing purchase and sale on primary and secondary markets for securities, derivative products and similar instruments that are tran:.parent and efficient, and do not praviae special advantages to those with information obtained :rom privileged sources. Rules are alro set governing the rele~se of Information. A closely related function is to monitor trading on securities exchanges and In similar marketplaces. Maintaining the liquidity of such markets is an important related objective; th~s is normally accomplished by establishing rules of procedure and designating specific functions, for example, to maintain markets in specific securities, to particular types of intermediaries. o. Regulations Designed to Ensure the Proper Functioning of Clearing, Sett)ement and Depository Systems 1n securities Markets Control 1n this area is sometimes exercised through licensing and capitai requirements applying to members, loss compensation fund arrangements and regular reporting requirements and Inspections. Regulatory frameworks of this kind may be seen as closely related to arrangements concerning the functioning of markets. In a few countries the authorities use the facilities offered by computerised clearing, settlement and depository systems for ~ark.et surveillance purposes. In some countries some or all of these functions are carried out by government entities. E. Begulat1on of Co11ect1ve Investment Institutions Quite a number of countries have special legislation and/or regulations governing the operation of collective Investment funds (unit trusts, investment trust, mutual funds etc.> and the distribution of collective 28 ,. I J I ..
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investment fund certificates. The move to regulate collective investment activities 1s a classic case of the traditional motive of investor protection. In severa 1 countries unscrupulous marl<.eti ng techniques and the sale of substandard collective investment instruments led to losses by retail investors, which prompted the introduction of regulations designed to assure that any collective investment securities offered to the publ;c would be subject to official scrutiny. In the United States a law covering investment companies was introduced in the 1940s. In Europe a move in this direction ~as first made ~n the 1960s under the impact of the rapid spreading and promot1cn of this p.articular form of savings instrument when numerous instances of misconduct on the part of the promoters of certain schemes were uncovered. r-ance, Germany and Switzerland may be mentioned in this context. '!'his .. a~ followed by a second wave of regulatory effort in this field in the i980s (e.g. Denmark., Finland, Italy, Spain and Turk.ey). Laws governing collec<:he investment activities may concern the instrument itself, for instance by stipulating compensation for those distributing the instrument, requiring a statement of investment policy, placing limits on borrowing and requiring detailed disclosure of investments. In addition, some countries set rules about the marketing of such instruments or require the establishment of a company that is directly subject to national law in order to enable t~e authorities to tal<.e action against misconduct. A Directive adopted In 1985 oy the EC will co-ordinate the regulations Imposed upon collective invest:r.eno: undertakings in transferable securities CUCITS) established in 'Tlemoer s-:1-:es of the EC. F. Regulation of Government Securities Markets Another feature of recent trends in securities market regulation (not necessarily requiring changes in legislation) has ~een the re-organisation of the primary and secondary markets for government securities in which centn 1 banks Cacti ng in their function as agents of the government> often p 1 ay a leading role. Hhile in many countries government securities are sti 11 traceo on stock. exchanges llk.e other securities with one single price f;(ing ~e,. session, several countries also have markets in which government sec:.irit~es are continuousl~ traded by banks and/or other professional dealers. A numoer of countries have reformed, or are in the process of reforming, rules and practice~ applying to both primary and secondary markets in government securities; it appears that in this process the organisation and structure of the US government securities mark.et increasingly serves as a model, notaoly as regards the functions of mark.et makers. France, Italy, Sweden and, above all, the United Kingdom may be mentioned in this context, although there are ot~er countries in which central banks play an important role in operatirig t~e mark.ets for government securities. Hhi 1 e the efforts to re-organ I se government securities rnark.ets ~a"e been directed essentially towards improving the depth and liquidity af :~ese markets in order to enable the mark.et to accommodate heavier new ls sue 3.na trading volumes, there have ilso been regulatory moves aimed at strengthening the safety a11d financial soundness of the trading system by al lowing banks to merge with broker-dealer firms, thereby Increasing the capital base of these firms. Such regulatory measures have recently been taken In the United Kingdom (via changes in corresponding Stock Exchange rules), Canada, France and Italy. Reforms in the same direction are being prepared In Spain. These regulatory developments have also to be seen in the context of government 29 ,, t .. ~
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efforts to increase the scope for competition in securities trading and, in this connection, to end the monopoly position of stock. exchange member firms which has had a long tradition in a number of countries CSelgium, France, Italy, Portugal and Spain). G. Regulation of financial futures and Options Markets Not a 11 OECD countri as have markets for futures and options. Among those countries which have such markets, only a few have in place comprehensive regulatory frameworks; this is the case for Australia, France, the United Kingdom, and the United States and more recently also 1n Japan. However, even in cases where forma 1 supervisory arrangements exist. supervisory authority is often fragmented among various derivative products and between derivative and cash markets. In the United States, futures and options business began 1n markets for commodities and thus the trading, settlement and regulation of financial futures retains some link to convnodi ties futures. Other countries in wh1 ch markets In these der1 vati ve products have been set up more recently rely, for the t~me being, on self-regulation in this field. This 1s notably the case in New Zealand, Sweden and Switzerland. In other countries 1n which over-the-counter markets In these instruments have developed In recent years the authorities seem to be urging market participants to set up organised and self-regulated trading systems with a view to ensuring an improved functioning and visibility of these markets. H. Regy}at1on of Information vendors Finally, 1t should be mentioned that the activities of information vendors using nationwide (or even worldwide) screen-based dissemination systems pose certain problems for securities market regulation; all the more so as these systems can be easily adapted to serve as order execution systems. The question for regulators might indeed be whether such systems do not already constitute over-the-counter markets in securities that ought to ~e supervised for investor protection purposes. V. POLICY ISSUES FOR FURTHER CONSIDERATION The foregoing survey of regulatory and supervisory systems for investment markets in OECO countries shows considerable diversity of tradition, doctrine, institutional structure and practice, a diversity whic~ is understandable since mechanisms for securities market surveillance arose ;n ~astly differing circumstances in different OECO countries. Furthermore, ~ost systems were developed when securities markets were far less sophisticated than they are today and were conceived as closed national systems rather than as a part of an Increasingly internationalised sec,rrities mark.et. Many countries are now in a process of reviewing their regu 1 a tory and supervisory frameworks 1n securities markets tn the light of the basic objectives of adequate investor protection and efficient market functioning, partly In response to the tnternationalisation of securities markets in the 30 '.
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1980s. The process of regulatory reform is gathering further momentum in the aftermath of the stock market break of October 1987. There is increasing awareness that securities market activities involve risks that are comparable to the systemic risks inherent in banking and that. according 1 y, the basic question arises as to what e>Ctent e>Cisting regulatory and supervisory arrangements are adequate to deal with current market realities. A. DJfferences in coverage of Regulation In the United States and the United Kingdom legislation is framed in such a ,1ay that anyone in offering securites or investment ser,ices to '::ie public Is explicitly subject to regulation (4). In several other countries. however, because of the way In which legiilation Is framed, either on an Institutional or an operational basis, thos~ Institutions or operations not meeting some specific criteria for Inclusion in the regulatory scneme may not be subject to regulation. For example, a fir1n engaging in securities ousiness without a deposit-taking licence In Italy or Switzerland is not subject to any specific supervision and Is liable only Lnder the commercial codes. In several countries, institutions engaging In certain other securities-related activities e.g., the administration of private wealth Including portfolio management or investment advisory services w11i ch are not organised as a ban!<. or broker are not subject to any special supervision. In several c::,untries, over-the-counter markets in bonds and equities and/or In financial futures ana options are not regulated under e>Cisting laws. In some countries, Foreign Intermediaries which establish offices mainly to collect orders for execution abroad and which receive no funds directly from clients are not subject to specific regulation and supervision. The f.1ct that an activity or Institution is not included in a specif~c regulatory or supervisory system does not necessarily mean that a "gap" that should be filled exists. The legislators of some countries are aware that some activities do not fall within the scope of existing regulation and at times are satisfied that the existing regime, which may include self-regulation with liability only under the civil or criminal codes, is sufficient. An example of this is the unregulated securities market in Germany. In the current process of reviewing regulatory frameworks and supervisory mechanisms efforts are being made to Identify ommissions and to remove undesired gaps in cases where the authorities perceive them to exist. For example, some countries have found it necessary in recent years to introduce special regulatory frameworks for the activities of brokers operating outside the stock exchanges. Denmark, the Nether I ands. Norway and Sweden may be mentioned in this context. Switzerland recently proposed to ammend the decree to Its Banking Act to cover companies without deposit-taking licenses that engage in certain financial operations; the proposed change is aimed at a> issuing houses, b) finance companies that are heavily involved in off-ba 1 ance-sheet transact Ions, and c > compan1 es that ref1 nance themse 1 ves by accepting credits from banks, from finance companies and insurance companies or from other institutional investors. Similarly, in France the recent report on fi nanci a 1 futures markets C the "Oeguen report"> noted that certain securities operations (e.g. discount brokers and portfolio managers> were not currently regulated and recommended that they be included under future legislation. A proposed directive dra.fted by the EC Commission would cover 31 ~
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some of the securities-related activities carried out by non-bank financial firms. B. Fragmentation of Supervisory Authority A different problem can arise where supervision is carried 01..t on the basis of functional criteria, and dif1erent markets are supervised by different bodie!I. Supervisory systems may not adequately reflect the degree of integration that exists among markets or the full variety of operations performed by a single institution. This problem is characteristic of countries with more tha~ one supervisory authority and is of less significance in countries with universal banking systems where the bank super~isory author1ties have substantial responsibi 11ty for secur1ties market supervision in the sense that they have to supervise the securities acti vi ti es of banks. However, as stated above, in a few countries (e.g. Finland, Germany and Swtizerland) the stock exchanges are supervised by different bodies. In actual practice, firms active in securities maric.ets nowadays are unlikely to conform to the pattern that existed when most investor protection legislation was enacted. A typical international securities firm is lik.ely to engage in dealing in government bonds, futures and options, ~oney market paper, euro-bonds, equities and corporate bonds issued or tracted in severa 1 countries. Given the manner in. which supervisory tasks are distributed, one often finds fragmentation of regulatory authority over such an entity .-.ithin a country, the centra 1 bank may oversee government bond dea 1 i ngs and i,oney market operations; another agency may be res pons i b 1 e for the supervision of the markets for corporate securities and a third for futures and options. Some activities may be left to self-regulation and others may not oe supervised at all. The approach of the United Kingdom of assigning a "lead" supervisory agency for the supervision of an institution simultaneously engaged in several activities recognises this problem, but even this innovation has its limitations, since the firm's activities may tJe spread throughout several countries with different institutional and regulatory systems. Most reports is sued in the United States in the wake of the 19th October 1987 market break indicated that several sub-sectors of the market were regulated as if each were independent when in actua 1 fact the market is best seen as a sing 1 e entity. Similar conclusions were reached in the report of a special group on futures markets (the "Oeguen report") in France. Under certain circumstances, action taken by one regulatory authority may counteract those of other authorities. For ex amp 1 e, a firm may trade trie same equity in two markets in the same country. In disorderly conditions, one regulator may declare a trad~ng halt while trading is allowed to continue i:i another market. In an env1 ronment of fa 111 ng prices and 1 arge order Imbalances, one regulatory body may increase margin requirements to prevent speculative behaviour, whi 1 e another body may lower requirements to prevent forced liquidation. Similarly contradictory policies can arise if regulators in a cash market for a given asset were to issue instructions which frustrate the effect of Instructions issued by those responsible for regulation of the related derivative product. A significant difference can arise In times of turbulence if one regulator urges an intermediary to keep trading in order to 32 "-
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maintain market liquidity while another regulator seeks to have the fir"! minimise trading to limit tts risk of failure or to prevent large pri1.e drops. In brief, a typi ca I securities ft rm is often subject to regu 1 a ti on by several regulatory bodies with mandates and regulatory policies that may >1ary significantly, and that at times may be contradictory. The authorities of some Member countries have recently begun to recognise the problem of regulatory fragmentation and to take certain corrective actions. For example, in France following the publication the "Oeguen report", a special group was formed to be known as the Capital Markets Liaison Co11111ittee . The Commit~ee wt 11 be chaired by the Of rector of the Treasury, and .,,,; 11 have as its other members, the Governor of the Bank of France, the Chairman of the Stoc1e. Exchange Board, the Chat rman of the Stock Exchange Tran sac ti ons Corr.miss: on and the Chicago Mercantile Exchange
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the agreement, both exchanges noted that ow;ng to arbitrage between the futures and cash markets, both exchanges actually formed a single market. In Switzerland, the Federal Ministry of Finance recently establ;shed a working group to study possible problems in the capital markets and to reconvnend needed changes, including possible changes in the regulatory system. One of the principal topics to be examined will be the current status of the Swiss stock exchanges some of which are under cantonal law and some are organised as private associations; Cin addition, all securities may be traded off the exchanges). c. Problems of Internationalised securities Markets The problems noted in Sections A and B may be magnified in cases where a securities f1 rm is active in the securities markets of severa 1 countries simultaneously. As one important example, capitalisation standards differ greatly among countries and it is not clear whether or to what exte'1t the capital in the home country is available to support the firm's oceratiJns in other countries. Traditionally, the concept of ~arket regulation for investor pr,tection has meant that a single official entity, operating under a single securities law, has the power to set standards of quality and disclosure for cr;mary !nd secondary offerings of securities, to monl tor a 11 trading practices ; n -::ios e securities and to exercise prudential supervision over intermediaries wi-::iin the country concerned. While this hypothetically desirable situation ~ay be absent in any given domestic market because of the prob I ems of perceived "gaps" In regulation or "fragmentation" of supervisory powers, these problems could in principle be overcome by changes In national legislation. In the cast of an Internationalised market such a solution 1s not possible because certain key elements of supervision are not ammenable to national control. Much of the Increased Internationalisation of securities markets stems from new technology, particularly from the development of screen-based systems for price quotation, and in some cases for the execution of trades as wel 1. Traditionally, securities markets supervision was possible because trading took place on an exchange floor and it was relatively easy to establish procedures to route orders to trading pos; ti ans and to set ru 1 es for trading. In some ways, screen-based trading can make superv1s ion easier because an electronic .record of transactions can be made available to sucervisors. On the other hand, as screen-based trading extends across national front;ers, the task of supervising the market and the intermediaries operat;ng in it becomes more difficult and raises complex legal questions. The longest-standing example of an Internationalised securities mark.et Is the euro-bond market. Institutions participating in this mark.et are located in several countries, although a majority are in London. Each participating institution is supervised by the banking and/or securities regulators of its country of establishment. Euro-bonds are often listed in London and Luxembourg and hence are subject to the listing requirements in those jurisdictions. Trading rules for the secondary market are set by the Association of International Bond Dealers CAIBO), which has been given recognised investment exchange status in the United Kingdom. Clearing and settlement for euro-bonds are largely handled by two independent commercial organisations CEuroclear and Cedel). In essence, the euro-bond mark.et has 34 ..... I
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such character1st1cs that 1t cannot be sa1d to bt under the suoervision of a single national SUDtrvlsory body, though essential UDects of the .,,aritet, namtly tht lnttrmtdiaries ooerating tn It, are subject to suoerv1s1on 1n tnetr countries of establishment. Anothtr tnmDlt of an Increasingly Internationalised 1T1arket stemmi.,g from screen-based trading ts the international secondary market In eQui-:1es tstabllshtd by the International Stock Echange In London, t~e so-cal 1ed ''Stock EAchange Automated Quotation System International" ~arttet, and the London extension of the ~at1ona1 Association of Secur-:cs ~eaiers Automated Quotation System C~ASOAO> :narket of the United Sta-:es. .l consldtrable amount of cross listing now occurs between -:nese ':~'Jl/ International marktts and the resoectlve national markets. A trsder In 'JS sharts In London frequtntly has two scr11ns, ont for SEAO International !M ont for NASDAQ each d1sD1aylng to somt extent shares In the same comoanies. It 1s cltar, this rnarktt has become tffectively internationalised. ~1th the sDrtad of I ncrtastd cross 1 is ting, more scrttn-based trading and the ;row Ing geographic disDersion of participants, the phenomenon of internationaiised stcurities dealing may well reach Important dimensions. There are, examplt, plans for txtending the NASDAQ 1 Ink to Singapore. l='urthermore, ~ne or more large securities dealers established In ont country may act as ~ar~e: makers for sharts of fore I gn comDani es wni ch are not 11 s tea ; ., trre '~ca 1 rnarktt, but rather in another country. Such f1 rms may acceot orjen ''":m rtstdtnts of sevtral countries including the country in i,htch the sl"are Is 11sttd. Thus, 1nvtstors may nave tht ODtion of dealtng in the snare \n 1-:s rtcognt Std home rnarktt or in ant or 1110re off short markets". ~h; s increasingly cOfllllOn practtc,can cltarly wtaktn the suoerv1sory effectiveness of tht authorittts of tht homt country. At tnttrnattonal ltvtl, thert art numtrous jurtsdlctional uncertainties In tht fttld of securttfts rtgulatton and suDervtston. Unltkt the banking su01rvtsors, s1curlttes supervisors have not yet agreed on an established ,1an for the dfstr1bution of responstblllty between tht home-market and -=~e host-1111rket authorities. It wu noted tarlhr that securities !'1r.,,~ :an establish offtcts oft'short to collect ordtrs for txtcutlon tn the home ITlarket, but tn many casts homt-marktt suoervtsion ts superftctal stnct tht Investor ca non-rtsldtnt) ts only partly subjtct to domtstlc-tnvtstor protection laws. Othtr COIIP 11 cat1 ans may art st. If a ucurt tt es ft rm wht ch 1s not a bank obtains a dtooslt .. taklng llctnce tn a untvtrsal banking country, the local banking tnsptctors, undtr acctDttd princtplts of banking suoervtslon, nor:nally dtptnd upon tht banking SUDtrvtsors of tht firm"s homt country !'or the ultt1111tt v1rtftcation of tht soundness of tht local branch or subsidiary. This IDProach tncounttrs dt fft cu 1 tits wntn the hn 1
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whtrtvtr possible, would be preferable to ensurt ovtrall consistency of regulatory frameworks. Beyond this there are other Important Issues tn International securities markets which are as serious as market manlpulat~on and have not been addressed tn etthtr bilateral or multilateral fora. Notwithstanding the considerable progress which has been made among EC countries, har1110ntzatlon of standards for disclosure In connection with ':he t ntroductl on of securl ti es and derivative products on prl mary and secondary markets has not advanced Slbstant1ally and little If any progress has been ~ade tn reaching agreements designed to mtntmtst the potential of developme~ts in the securities ~arkets to destabilise the remainder of the financial system. Clearly, tt ts not desira0le to have securities business gravitate ':o those marlc.ets wnere regu I a ti on ts mos': 1 ax or to have count rt es compete for International 0ustness by r,eglecttng to offer high standards of supervision. The experience of OECD countries suggests hat costly and unnecessary regulation can drive operations to offshore centres but that reasonable supervision creating deep and transparent markets that Inspire Investor confidence can actually attract business. 0. Investor Protection and ~aero-Prudential Risks Havl ng surveyed some poss I b I e shortcoml ngs In the area of i nves ':or protection, It seems appropriate to address a more baste question, name1J whether the terms of reference wt th which rnos t securities markets regu 1 a t~rs operate are sufficient to deal with all the risks Inherent In securities market operations. As the discussion up to this point has made clear, the main goal of securities mark1t supervision Is Investor protection, by which is m11nt to assura that Investors are not subjected to Inadequate disclosure or manipulative trading practices. At the same time, It Is not clear that even If alt market segments were subject to official Investor protection regulation, and If all rtlated supervision were fully co-ordinated at both a national and International level, that this would be sufficient to safeguard fully the public Interest from other important risks. For exam0le, an Important question Is the extent and nature of ri sk.s borne by securltits marktt Intermediaries as o~posed to those borne by Investors. The natur1 of risks currently assumed by securities marlc.et intermediaries may be such that in times of crisis they might Impose unacceptable external costs on the entire financial and payments system and ultimately on the entire economy. !n tht first place, a phenomenon of concentration ts talc.Ing place In wort d securities markets. As the abi 1 ity to dea I t n more than one mark.et segment and more than one national market and to offer competitive terms have become necessary to survival In today"s markets, consolidation and the formation of heavily capitalised securities firms has become the rule. This tmp11 es a> that a change of expectations In a sma 11 number of I arge mark.et participants now has greater impact than in the past; and b) that the failure of any major Intermediary would have wider consequences than before. Most lntermedtarhs are likely to dtal In several markets simultaneously, including markets for equtti es 1s sued and traded In severa 1 countries, mar ic.ets for various types of domtstic and International bonds, the government securities markets of several countries, futures and options and money markets. Most major securities f1rms have significant operations 1n foreign exchange mark1ts, acquisitions and mergers, and some deposit-taking capability as 36 ,., I j I -.;, ....
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wtll. The risks faced by Intermediaries dealing In these 'Tlarlcets are of several kinds, Including credit risk, iz. the risk of default of a customer or counterparty, a r1sk that Is compounded If the Intermediary extends credit to the cus tamer, position r1 sk < the risk of adverse price movements on an Inventory of securities or on short sales>: and under~rlting risk. To these should be added the risks assumed by designated market makers, I.e. intermediaries which have soma obligation to continue aealing even In times of massive order Imbalances. As recent experience has shown. i nstab11 I ty can be sudden and generalised and it can affect all ma"ttet se9ments and 0artlc10ants simultaneously. The oveNhelm1ng nature of the October 1987 break :ar-:'y reflects the Increasingly strong links among ~ark.et segments and among national markets, and the speed with which markets, due to tec:inology 3M derivative products, can compress Into a matter of hours an adjust:nent ,mien might have taken months in earlier times. If widespread insolvency threatens to Inflict fatal losses on a large number of lntermed1ar4es simultaneously, It is doubtful whether the banking and payments system could be shielded from the consequences of such securities markets turbulence. Links between banking and securities activities are closer than ever before. Thts Is true not only in countries wit'i '.lniversal banking systems, but even In those countries that maintain some secaration, where banks do large volumes of securities business through their branches and subsidfarles abroad and deal at home In government bonds, '!!Oney 'Tlar~et Instruments and derivative products illhich all no" form part of a unified market .. 37 ( I '). ..
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NOTES ANO REFERENCES 1. In this article the terms "securities" and ''investment" are Jsed broadly to include derivative products, (i.e. financial futures and options, and similar instruments>. 2. Tht term ''deregulation" refers to the removal of administrati'le and anti-competitive measures and should not be ~isinterpreted as meaning a lowering of regulatory and supervisory standards notably as regards prudent1a 1 supervision. "Regulation" general! y refers to 1.Q.i.tlll legislation Claws, decrees, etc.> relating to securities markets, not to legislation such as the commercial code dealing with business in general. "Suoervision" refers to ongoing oversight of operat~ons rather than the simple issuing of rules. 3. International Trade in Services: securities. CECO. Paris 1987. 4. In the discussion in t~is section, the term ''regulation' 'Tleans recognised regulation, regardless of what organisation di rec-:1y undertakes such regulation. ''Securities mark.et regulation" refers -:o legislation specifically dealing with securities or derivative produc': markets. not to general business regulation. 5. The Standard and Poor's 500 index is a sampling of equities representing some 80 per cent of the share value of the ~YSE. 38 I ..
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CHARACTERISTICS OF THE INTERNATIONAL STOCK MARKET OF THE FUTURE PREPARED FOR U.S. OFFICE OF TECHNOLOGY ASSESfMENT BY ROBERT N. RIESS NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. UNDATED, CIRCA 1989 This contractor document was prepared for the OTA Background Paper, Trading Around the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990, This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board. .. ''
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Characteristics or the International Stock ~arket of the Future Prepared for US Con~ress Office ot Technolo~y Assessment by Robert~ Riess ~acional Association of Securiti~s Dealers, Inc There is more than a little risk invol~ed in preparin~ a oaper rather ~randiosely purportin~ to describe the characteristics of the international ~tock market of the future. Two or three short years aio, one mi~ht have confidently predicce~ Chae intermarket linkages were certain to drive the lnternacionalizacion of securities markets. In fact, the few such linka~es that have been established, includin~ the one between the ~ASDAO system in the US and the Internacional Stock Exchange (ISE) in London, have not fully lived up to expectations. This is not to su~gest that lncermarket linkages have failed to provide any benefits to the international marketplace. Quite the contrary, linkages between organized markets that regulate and are themselves regulated will be significant, necessary factors in the evolving international marketplace. Indeed, the cooperative effort that led to the linka~e between ~ASDAO and the !SE resulted in an understanding of each other's market and an appreciation of each other's environment that might never have been achieved otherwise. Even more important, the linkage resulted in a degree of regulatory cooperation between two non-governmental bodies that is unique in the industry. If lntermarket linkages are only part of che picture, what is missin~? What are the likely characteristics of the international stock market of the future? Seven characteristics may be identified that will together or in some combination shape the international marketplace. These, moreover, are factors
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that will characterize a centralized international mark~tplace. [ndividual firms will interact with such a centralized marketplace in a number )f wav~. There are large, fully inte2rated fir~s with si2nificant internatL1nal capabilities already which "pass the book'' in their internationailv traded securities amon~ their local offices. Similarly, there are other tir~s. ~ften quite large in their local marketplaces, which are nevertheless re~ional" with respect to the international marketplace. These two types of fir~s will play different roles--che former mi2hc interact with a central market from ~ultiple locations around the world, while the latter mi2hc rely 1n their local market co provide an interface. The objective of an effective international ~arket should be c1 bri,2 buyers and sellers to~ether in an appropriately re2ulated and liquid market wherever and whenever they wane to trade. A market with the characteristics described below would io a lon2 wav towards reachin~ this obiective wnile atcemptin~ to accommodate existin2 market practices and preserve invest~ents in systems and processes already in place. These seven characterisct~s are: 1. Separate hybrid dealer market 2. Screen-based with central database and international network J. Multiple nodes in continuous, 24-hour operation 4. Inte2rated with domestic markets and dealers' systems 5. Internacional tier of securities 6. Appropriately regulated with online market surveillance 7. Effective clearance and settlement If any one of these characteristics were co be singled out as preeminent, it would be effective clearance and settlement. Trading systems, quotation systems, intermarket linkages, however sophisticated and efficient, cannot by themselves support an effective market without effective pose-trade support. In the followin~ discussion of marketplace characteristics, che characteristics of an international clearance and settlement facility are similarly sec forth. Market systems and their supportin2 networks can be built readily--it may very well turn out that bridging all of the dissimilar and incompatible clearing and settlement facilities is not feasible. !f that 2 r
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proved true, more radical ~teps like the establishment of 3 central deoositorv or the creation of ~lobal deoositary receipts miiht have to be taken. Separate hybrid dealer market A ~ASDAQ-like, competin~ dealer structure will form the basis f~r a separate international market. This market structure has important inherent advantages, especially in the international context. Competitively determined prices 1uickly and accurately reflect market conditions. When the market is ~eographically dispersed, a competing dealer structure is, in fact, the ~ost efficient means of price discovery. ~ultiple market makers provide ~reater Liquidity for less-frequently traded stocks, as many international issues are likely to be, and ~reater continuity of tradin~ throu~h all market conditions. A market structured like ~ASDAO also very effectively supports onli:ie '!larl
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execution, can satisfy any trade reporcin~ requirements or transmit instructions for settlement on behalf of the market participants. For transactions ne~ociaced over che telephone and executed manuallv, Jn on-line contirmacion facility will compare and report trade details automatically. ~ASDAO's Automated Confirmation Transaction (ACT), che AIBD's TRAX, and the ~SE's SEOUAL are examples of current on-line confirmation systems. ~ultiple nodes in continuous, 24-hour operation The system of network nodes, local hosts and distributed databases will be available co any participant in any time zone ac any time of the day. This would not, however, require chat any particular node or host be capable of 2~hour operation, only that the system as a whole would be accessible throu~hout 1 24-hour period. Some market participants will operate onl~ durin2 their normal business hours, others will seek to transact ~usiness whenever che~ can find a willing cradin~ partner. A liquid lncernational market will have to accommodate the needs of both. Integrated with domestic markets and dealers' systems The international market will achieve maximum liquidity for the issues Lt trades if participants have access to the home markets of the issuers as well as the international market. Therefore, means will be provided for electronic access between the international market and domestic markets, and between dealers' systems and the international market. The worldwide trend away from floor-based auction markets and towards development of automated competing dealer markets will facilitate linkages between the international market and local domestic markets. This access will be particularly easy for markets like NASDAQ. International tier of securities Only a limited number of securities will have international interest at any given time. This selection process will be driven by investment interest and not by a listing procedure. Securities may move into and out of the international market freely. 4 f ; : ~.
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Appropriately re,ulated with on-line market surveillance For maximum credibillty and acceptabillty in local jurisdictions, the international market will have co demonstrate that it provides an aopropriate Level of supervision. The level of automation in this market not only lends itself to, but would probably require, online market surveillance of participants' activities. The type of online market surveillance developed for ~ASDAQ should be a model for this. The professional nature of che incernacional market ar~ues for a re~ulacory approach appropriate co the needs of che participants. The iophiscicated institutional investors who will almost certainly account for most of the activity in this market do not require manv of the mechanisms put into place to protect the interests of small investors. At a minimum, the international market will provide facilities f~r the ~ollection ~r tr3nsac:ion Jetail~. Trade repor:i~2 and dissemination are now quite common, ;ervin~ tJ promote transparency and addinR necessary information to the process of price formation. Effective clearance and settlement For any international market co be fully liquid and effective, reliable and efficient clearance (le, comparison, confirmation) and settlement (le, payment and delivery) facilities must be provided. These facilities should be uniform and consistent throughout the market, providing for standardized settlement cycles and procedures. The followir~ factors will characterize the clearance and settlement system supportin~ the international stock market of the future: l, Centralized transaction collection 2. Method of clearinR at participant's option 3. Clearin~ contingency fund 4. Book-entry deliveries of immobilized securities S. Sin~le worldwide position per security per participant 6. Open positions and fails marked to the market 7. Efficient banking arrangements, netted money 5 I.
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Centralized transaction collection Transactions in the international market will be locked-in, either ~t the time of e~ecution (by an OCT-like facility) or throu~h an online confirmation (an ACT-like facility), and will be reported to a central database throuch the network of distributed hosts. Just as the tradin~ market will interact with local domestic markets throu~h automated linka~es and other interfaces, the market's central clearance and settlement facility will need to interact with its local counterparts. In many cases, actual settlement wil~ take place within a Local market's facility, and centralized collection of trade details and mana~ement of the various interfaces will ease the participants' burden of dealin~ with time zones and distance. ~ethod of cl~arin~ at particioant's ootion ~ost settlement systems around the world rely on trade-for-traae (TFT' processini, often with physical deliveries of certificates. In ,om~ ~reas. :~e functional equivalent of balance orders mi~ht be issued, still for physical delivery, while in yet others, electronic book-entry delivery of ownership interest in deposited securities ls possible. Only in the US is large-scale netting of transactions, as embodied in the Continuous ~et Settlements (CNS) system as operated by the National Securities Clearing Corporation (~SCC), the normal course of settlement for nearly all transactions. Furthermore, usin~ 1988 as a benchmark, over 92% of all CNS deliveries in the US are made via bookkeepinR entry (at OTC, the Depository Trust Company), and each delivery in turn represents ten trades netted to~ether. In 1987, over 92 billion shares of stock with a market value of nearly S3 trillion were on deposit at OTC. The efficiency of CNS coupled with book-entry deliveries at a central depository is very attractive, and contributes to control of costs and risk in a manner highly desireable in the international marketplace. ~any market participants would elect to use a CNS facility if it were available. However, not all market participants or securities will be eli~ible for CNS processin~. Therefore, the clearance and settlement facility should allow participants to choose their settlement method based on a particular trade's characteristics and their individual requirements. 6
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Clearinc contincencv fund [n a CNS system, the identity of individual trades and counterpart1e9 disappears after comparison and nett inc. Wh:n oper:itin~ in the C~S mode. t~e international rurket's clearinc facility ~~11 accept the compared or locked-in obli~ations of its participants, qtandinv in the ~iddle for payment and receipt of money on settlement day. To protect itself and its members from default, a contin~ency fund similar to NSCC's will be required. The fund is made up of deposits of cash or liquid negotiable instruments by each participant based upon level of activity. Book-entrv deliveries of imobilized securities Efficient, continuous operation of an international ~arket cannot ~e ~chieved if physic3l securities movements are required. The ,ettlement facility will include a centralized depository capable of deliveries effec:ea by electronic book-entry, with the securities remainin~ immobili~ed in t~e issuer's home country. Single worldwide position per security per participant Through li"kages with local clearing and depository facilities, each international market participant should be able to maintain a single position in each security traded in either the international or home market. This will provide for the maximum flexibility in capital mana~ement. Open positions and fails marked to the market Open positions in the CNS mode, and failed deliveries in the TFT and balance order modes, will be marked to ch~ market usin~ the latest available price for the ~ecurity in question. This will permit continuous trading with the minimum achievable counterparty risk to participants. Efficient bankin1 arran1ements, netted money Participants will be required to maintain demand accounts in each currency in which they will settle positions or trades, in banks accessible electronically to the central settlement facility. The settlement currency will normally be the trading currency of a security, in moat cases the home 7
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currency of the l11uer. All money 1ettleaent1 wtll be net ln each currency. tn ,u ... ry, then, one can envt1lon a separate lnternattonal ,arket ~a,ed on prtnclpl11 and procedure, that are already well understood. tt1 objective wtll be to brtn~ to1ether bld1 and offer,, and buy and tell order,, wherever and at whatever houri lt 11 co1t effective to do 10 for lt1 parttctpant1. lt wtll be an effective worldwide urketplace ln which trading ts not inhibited by tncoapatible 1y1tea1, distance, ct zone1, or the risk and tnefftctency of today's 1ettleMnt procedure,. tn the end, the real rtsk wtll lle not ln de1crlbtn1 the future, but ln t1nortn1 it1 demands. 8 I I ~
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CLEAllING ISSUES PUS!NTED AT AMEIICAN IAV INSTITUTE/AMERICAN BAR ASSOCIATION llOlll-DEAL!R lt.!GUIATION CONFElt.!NC! VASHINGTON, D.C. JAIUAR.Y 13, 1989 IY Thomas A. Russo Susan D. Brovn Cadvalader, Vickersham & Taft Nev York, Nev York December 6, 1988 This contractor doctmient was prepared for the OTA Background Paper, Trading Around the Clock: Global SecuritJes Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology A9sessment Board. ,,
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As Updated 1/24/89 ALI/ABA SECURITIES BROKER-DEALER REGULATION CONFERENCE WASHINGTON, D.C. 0 0 0 0 0 0 0 0 January 13, 1989 CLEARING ISSUES Topics include: Liability of FCM upon Clearinghouse Default Finality of Payments Post-Market Break Legislative Proposals Brady Commission and Working Group Recommendations Cross-Margining Circuit Breakers Frontrunning Third Party Custodial Accounts Thomas A. Russo Susan o. Brown Cadwalader, Wickersham & Taft New York, New York December 6, 1988 .... ..
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I. CLEARING ISSUES. A. Background. 1. The Settlement Process. In the aftermath of the October 1987 market break, participants in the futures industry have taken a hard look at the risks and uncertainties inherent in the clearing system, and considered various proposals on how these risks can be reduced. One particular focus of attention has been the functioning of the settlement process for the major commodities exchanges located in Chicago, the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT). Each day, hundreds of millions of dollars flow through the clearinghouse of each exchange in the form of margin payments. A clearinghouse may be a part of the exchange, as in the case of the CME, or a separate entity, as in the case of the Board of Trade Clearing Corporation (BOTCC). Initial margin is the amount the customer must post with his futures commission merchant ("FCM") (the futures equivalent of a broker-dealer) in order to open a position, and which the FCM in turn posts with the clearinghouse as a performance bond to assure that any obligations owed on the positions will be met. Each day, the open positions are "marked to market" by the clearinghouse against the current day's settlement price. The clearinghouse then issues instructions to the FCMs directing them to collect additional monies, called "variation margin," from customers whose positions have declined in value from the previous day, and credits those amounts to FCMs whose customers' positions have increased in value from the previous day. 2. Variation Margin. Variation margin is paid and collected by the CME Clearinghouse and the BOTCC through the same four settlement banks: Continental Illinois National Bank and Trust Company of Chicago, The First National Bank of Chicago, Harris Trust and Savings Bank and The Northern Trust Company. All member FCMs of both clearinghouses are required to maintain accounts for the payment and collection of variation margin with at least one of the four settlement banks. Each FCM maintains two accounts with at least one of these settlement banks, one non-segregated -,i ('
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account for its own proprietary trades and one segregated account for the funds of its customers. The clearinghouse maintains a variation account with each settlement bank. At both clearinghouses, settlement variation is calculated after the final trade reconciliation at approximately midnight central standard time.: At approximately 5:00 a.m. the following day, the clearinghouse instructs each of the four clearing banks as to the total pay or collect for each FCM that clears through that bank. "Pays" are any amounts receivable from the FCM's accounts and "collects" are any amounts payable to such FCM' s accounts. Variation margin is calculated for an FCM' s customers on a net bas is. Thus, an FCM whose customers had more losses than gains must deposit cash in its customer account at the clearinghouse equal to the net loss. For example, an FCM with eleven customers who each lost $2,000 and ten customers who each gained $2,000 must pay $2,000 in variation margin to the clearinghouse. If the FCM's customers have net losses, the settlement bank will debit the FCM's customer account (or house account in the case of the firm's own losses) and credit the variation account of the clearinghouse with the amount of the pays. Likewise, in the event of net gains the amount of the collects will be debited from the variation account of the clearinghouse and credited to the FCM's customer or house account, as appropriate. Taking into consideration all clearing members, the amount of pays will exactly equal the amount of collects. The clearinghouse variation account at each settlement bank will show a net debit or credit. One of the settlement banks serves as the concentration bank to balance the net debits and credits to the clearinghouse variation account with each settlement bank. A settlement bank in which the clearinghouse variation account has a credit balance will wire transfer that balance to the concentration bank. Banks at which the clearinghouse variation account has a debit balance will receive a wire transfer All times referred to herein are central standard time. -2.. ... ~l
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3 4. 5. froru the concentration bank in the amount of the debit balance. Intra-day Calls. In addition to the early morning call for variation margin, the CME Clearinghouse and the BOTCC routinely issue a 2:00 p.m. intraday variation margin call which FCMs and Lheir settlement banks must usually pay within an hour. The BOTCC has made a regular 2:00 p.m. margin call since before the market break. The CME Clearinghouse instituted such a regular 2:00 p.m. margin call on March 1, 1988, at which time the CME Clearinghouse revised its agreements with the settlement banks to provide that the intra-day call must be met in cash by 3:00 p.m. In times of extreme price volatility, the clearinghouses may make more frequent calls for variation margin. Agreements with the Settlement Banks. By written agreement between the clearinghouse and each of the four settlement banks, the banks are required to notify the clearinghouse by 7:00 a.m. to confirm that fund transfers will be made in accordance with the settlement instructions. If the FCM's account with a settlement bank does not contain sufficient funds to cover the amount owed by the FCM to the clearinghouse, the bank must at 7:00 a.m. make a credit determination whether to extend intra-day unsecured credit to the FCM for the purpose of meeting the margin call. The clearinghouses necessarily view the settlement banks' 7:00 a.m. confirmations that fund transfers will be made as irrevocable commitments, as they rely on receiving such amounts so that variation collects can be paid. Similarly, in the case of a 2:00 p.m. intra-day variation margin call, the agreements provide that payments must be made by 3:00 p.m. If the FCM's account does not contain adequate funds and the FCM fails to transfer the necessary funds to the settlement bank in time for the 3:00 p.m. settlement, the settlement bank must make a credit determination whether to meet the call. Need for Certainty. The potential for disruption of the clearing system becomes obvious when we realize that a large default by a single firm could have a ripple effect throughout the system, by leading to defaults of other firms and FCMs who are relying on the receipt of payments from the clearinghouse to cover amounts owed to their -3-,. .. J. ,. l ,'
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customers. Similarly, any delay of payment creates unwelcome uncertainty. The smooth functioning of the system depends on variation amounts being promptly paid and then distributed to customers to whom they are owing. The importance of this issue was highlighted recently by Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System, in his remarks before the Annual Convention of the Securities Industry Association, in Boca Raton, Florida on November 30, 1988. Chairman Greenspan expressed particular concern that the insolvency or default of one or more participants in the clearing system could spread rapidly across other markets, and urged the continuation of efforts to strengthen the clearing system. See Section III.B.5. of this outline. B. Liability of an FCM to customers in the Event of a Clearinghouse Default. One significant question raised by the settlement process described above is what is the FCM's obligation to pay variation margin due to its customers when it has not yet received payment of margin collects from the clearinghouse. This section of the outline analyzes possible sources of such an obligation to customers. 1. The Segregation Requirement. The segregation requirements of Section 4d(2) of the Commodity Exchange Act (CEA) and related Commodity Futures Trading Commission (CFTC) regulations obligate an FCM to treat the funds of each of its commodity customers (including funds "accruing" to customers as a result of their trades) as belonging solely to that customer and prohibit an FCM from commingling those funds with the funds of any other person, subject to an exception allowing bulk segregation of customer funds. The segregation provisions also require an FCM to deposit its own funds to maintain proper segregation if necessary to prevent the funds of one commodity customer from being used to margin the positions of other customers. (See Section 2. below) However, the segregation provisions do not by their terms impose liability on an FCM to use its own funds to pay amounts of variation margin to its customers before the FCM has received such amounts from a clearinghouse. -4-,
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The segregation requirement is a safeguard intended to assure that commodity customer funds are not used to cover the general obligations of an FCM and are not otherwise lost or misappropriated in circumstances such as an FCM's insolvency. The legislative history of the segregation provisions reveals that the term "accruals" in those provisions refers only to an FCM' s obligation to credit amounts actually received to the accounts of customers.2 The segregation requirement was never intended to guarantee the financial integrity of the commodities exchanges or their clearinghouses. The CFTC, in its Advance Notice of Proposed Rulemaking on the Regulation of Hybrid and Related Instruments, 52 Fed. Reg. 47022 (December 11, 1987), specifically recognized that the clearinghouses, not FCMs, are the ultimate guarantors of the integrity of exchange-traded futures and options transactions. 2. Agency Law Principles. An FCM acts as agent for its customers in executing, carrying and clearing their trades on an exchange and depositing margins for those positions with the exchange's clearinghouse. At the same time, in effecting customer orders on an exchange, the FCM acts as principal in relation to the clearinghouse that accepts and clears the trades. Under general principles of agency law, an FCM is not liable to its customers for the loss of their funds deposited with a clearinghouse since the FCM has acted at the customer's direction. Similarly, in collecting amounts due from a clearinghouse an FCM is acting as collection agent, and is liable to its principal, the customer, only for amounts actually recovered. 2 Prior to enactment of the CEA in 1936, the prevailing practice was that variation margin received by an FCM from a clearinghouse on open customer positions was not paid to customers upon receipt by the FCM, but only upon the closing of the positions at a profit. As a result, amounts accruing to customers as a result of favorable price fluctuations were subject to theft or misappropriation by the FCMs. The term "accruing" in the segregation requirement was therefore used to refer to variation margin received by the FCM from a clearinghouse, but not yet paid to customers. -51 \.
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The common law of agency simply imposes on the agent-FCM a duty to act in good faith and with reasonable care in accordance with the instructions of its customers. Assuming the FCM exercises due care in clearing trades and neither knows nor has reason to know of a clearinghouse insolvency, the FCM should not be held liable under agency law for customer losses because of a clearinghouse default in the payment of variation margin. The customer must look to the clearinghouse to recover amounts not received by the FCM from the clearinghouse. Under CFTC Rule 1. 2 2 an FCM has a duty to use its own funds if necessary to make up a segregation deficiency resulting from the default of a customer, to avoid having the funds of one customer used to margin the positions of another customer. This duty is consistent with the common law of agency as the FCM (with respect to the nondefaulting customer) may be viewed as an agent for a partially disclosed principal (the defaulting customer), a relationship which normally makes an agent separately liable to another non-defaulting principal. However, in the case of the clearinghouse's payment default, the FCM (with respect to the non-defaulting customer) may be viewed as an agent for a fully disclosed principal (the clearing organization), a relationship in which an agent is normally not separately liable. 3. Exchange and Clearinghouse Rules. Commodities exchange rules impose liability on a member FCM to pay variation amounts due the clearinghouse whether or not the FCM receives such amounts from its customers, but do not obligate an FCM to pay amounts due to customers which are not received from the clearinghouse. See, ~, CME Rule 827 and BOTCC By-law 512. The clearinghouse guarantees the payment of variation margin to those FCMs with net gains even if it is unable to collect all the variation margin owed to it by FCMs with net losses. In the event of such a default, the clearinghouse would fund its obligation to pay variation margin in part by requiring payments by non-defaulting firms. For example, the rules of the CME provide for a right of assessment against members which is intended to allocate the risk of a default in the system among all of its participants rather than -6,-1'1 l "1
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the particular firms which entered into trades with the defaulting firm. To make FCMs liable to their customers for a variation margin payment default by a clearinghouse would undercut this predetermined system of risk allocation. Indeed, if FCMs were made to be the guarantors of clearinghouse payments to customers above and beyond their exposure to clearinghouse rights of assessment, the risk of adverse ripple effects flowing from a clearing member default would be magnified. c. Finality of Payments. 1. Settlement Bank Confirmations. By contractual agreement between the clearinghouse and each settlement bank, the bank is required to confirm to the clearinghouse by 7:00 a.m. that it will make all payments called for in the settlement instructions.3 Settlement procedures for both the CME and the CBOT depend on the settlement banks' 7:00 a.m. irrevocable confirmations that variation payments will be made. In some cases, the FCM's account at the settlement bank may lack sufficient funds to cover the payment, and the bank would be extending credit when it makes this confirmation. The bank may extend such credit based upon its pre-existing relationship with the FCM or some other comfort it receives as to the FCM's ability to pay. A similar extension of credit may occur where the settlement bank disburses variation collects to FCMs with net gains before such funds are received from the concentration bank. The clearing system necessarily views payment confirmations by settlement banks as final. The clearinghouse relies on such confirmations in allowing the FCM to continue to Eiffect trades and maintain open positions on the exchange, and other settlement banks rely on the confirmations in disbursing variation collects in anticipation of receiving amounts due from the concentration bank later that day. The CFTC, after reviewing the written contractual agreements between various clearinghouses and their settlement banks after If a settlement bank notifies the clearinghouse that it will not make payment on behalf of an FCM, the FCM would be considered in default and emergency financial procedures would be instituted. -7,.
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the market break, found that some of those agreements did not specifically address the banks' obligations to guarantee payments or the finality and irrevocability of payments confirmed to the clearing organization. As the CFTC recommended in its Follow-up Report on Financial eve sight of Stock Index Futures Markets During October 1987 (Division of Trading and Markets, January 6, 1988), the CME and BOTCC have since revised their standard agreements with the settlement banks to make explicit the finality of such payment confirmations. 2. Timing. As mentioned in Section A. above, hundreds of millions of dollars of daily margin obligations flow through the clearing and banking systems on the basis of the settlement banks' 7:00 a.m. confirmations that payments will be made. However, it is not clear whether and at what point in time a settlement bank is legally bound to advance those funds in the event: of e:ubsequent payment defaults. The suspen.se is less great in the case of intra-day margin calls. Those payments must usually be made within one hour and FCMs are generally able to transfer the required funds in time. However, even with respect to intra-day calls, there is the risk that a Fedwire bottleneck could temporarily prevent such fund transfers and thereby delay 3ettlement. On the morning of October 20, the settlement banks were reluctant to make the 7:00 a.m. confirmation of payment until they were able to confirm with their customers that their customers' margin calls, which in many instances exceeded existing intraday lending practices, would be met that day. At the CME, by 7:20 a.m., the four settlement banks confirmed that fund transfers had occurred or would occur for all but one of the member FCMs. Final confirmation for that firm was made prior to 8: 3 O a. m. Actual payments to the CME' s clearinghouse accounts at the several settlement banks occurred throughout the day and were not completed until nearly 6: oo p. m. However, relying on the bank confirmations that all payments would be made, some settlement banks began crediting their customers' accounts with collects at approximately 11:45 a.m. Because payments out of the settlement banks were finished -8-
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3 4. s. before all margin payments were collected, the settlement banks evidently extended intraday credit on behalf of certain of their customers. According to the Brady Commission Report, the banks were uncertain whether these intraday extensions of credit would be covered by the end of the day. Similarly, FCMs that paid funds to their customers early in the day were overextended until their variation margin accounts were credited later in the day. Critical Importance. Finality of payment is critical because it provides a level of certainty in the settlement process. As variation collects precisely equal variation pays, once payment confirmations have been made and are irrevocable, no settlement bank or FCM need be concerned that it will not receive transfers of variation collects. Settlement banks due to receive net collects will be secure that funds will be received within the settlement day. OCC lawsuit. That the issue of finality is a very real concern and not one 1 imi ted to the commodities exchanges is evident from the current lawsuit between The Options Clearing Corporation (OCC) and Irving Trust Bank arising out of the events of October 19 and 20, 1987. OCC's contract with each settlement bank provides that the settlement bank is required to notify occ if any of the settlement instructions will not be honored, and unless such notice is given, the bank is obligated to make debits and credits at the time of settlement in accordance with OCC's settlement instructions. occ alleges in its complaint that Irving Trust failed to give such notice of dishonor on October 19 or October 20, 1987, but two weeks later notified occ that it would not honor settlement instructions to credit OCC's account in the amount of $1.826 million. Possible Solutions. a. Redraft contractual agreements. Agreements between the clearinghouses and the settlement banks have been redrafted to make clear that the banks' early morning confirmations, as well as any intra-day payments, are final and irrevocable. See the Recommendations of the President's Working Group on Financial Markets at Section III.B.J(a) (i) of this -9-1 1 .... '-'-.
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outline. However, other steps should also be explored. b. Add more settlement banks. In order to confirm payment at 7:00 a.m. or intra-day, particularly in the case of an unusually large variation margin call, a settlement bank often must make a credit determination with respect to the FCM. If the settlement bank is unable to confirm payment, perhaps because it lacks adequate information as to the FCM's overall credit position, severe consequences can result to the FCM, including the liquidation of its open positions. Therefore, it may be prudent to broaden participation in the settlement process for the Chicago commodities exchanges to include other banks, including banks in New York. This change would enable clearing firms to use their primary bank as settlement bank. The primary bank would have the advantage of full knowledge of the clearing member's total commitments and capacity to pay and would therefore be in a better position to make an informed credit determination in time for the 7:00 a.m. deadline. Increasing the number of settlement banks should also strengthen the settlement system by spreading the risk of an FCM default. c. Maintain credit facilities. The Interim Report of the President's Working Group on Financial Markets (See Section III.B.J(b) (i) of this outline) recommended that federal regulators consider requiring FCMs to have credit facilities in place that would support large payments to clearinghouses. d. Institute settlement bank guarantees. Individual FCMs and their settlement banks could agree on a dollar amount up to which amount the settlement bank would automatically pay any obligation of the FCM to the clearinghouse for variation margin. The maximum amount of the guarantee could be reset periodically by agreement of the FCM and the settlement bank to reflect any changes in the FCM's credit position. However, once that initial credit determination were made, the clearing system would be assured of the prompt payment of variation -10 .. \..," '-'
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margin (up to the maximum of the guarantee) by the settlement bank. As occurs today, the FCM would transfer funds to the settlement bank within a couple of hours to cover the amount of any credit extended. The more steps that are taken to assure finality of payments so that payments confirmed will actually be made, thus guaranteeing the movement of funds throuqh the system within the settlement day, the less 1 ikely a clearinghouse default of the kind described in B. above becomes. II. POST-MARKET BREAK: SELECTED LEGISLATIVE PROPOSALS." A. Two legislative proposals would give Reserve Board (FRB) authority to requirements for futures contracts. the Federal set margin 1. Rep. Leach, "Securities Futures Market credit Protection Act", H.R. 3597, 100th Cong., 1st Sess. (1987), would amend the CEA to require the FRB to set margin requirements for futures on groups or indexes of securities and options on such futures. However, a preliminary report of the House Banking Committee following its hearings on H.R. 3597 concluded that federal regulation of futures margins would likely be counterproductive, resulting in costly and inflexible margin levels that would impair the efficient functioning of the futures markets. 2. Sen. Heinz, Amendment to the Federal Reserve Act, ~1847, 100th Cong. 1st Sess. (1987), would grant the FRB authority to set futures margins in order to prevent "excessive speculation" having substantial adverse effects on the banking system, credit markets, or the economy. B. Other measures woulc! create nev entities to improve oversight anc! coordination of the financial markets. 1. Sen. Wirth, "Financial services oversight Act", S. 1891, 100th Cong., 1st Sess. (1987), would establish an independent agency, the Financial For a discussion of additional legislative proposals, see "Market Reform Proposals anc Actions" by Brandon Becker and David L. Underhill of the SEC's Division of Market Regulation (September 26, 1988). -11-, 1 .. .... '--'' '\,
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Services oversight Commission {comprising the Chairmen of the FRB, Federal Deposit Insurance Corporation (FDIC), Federal Home Loan Bank Board (FHLBB), SEC and CFTC, the Comptroller of the currency, the President of the National Association of Insurance Commissioners, and a Chairman and Vice Chairman appointed by the President) whose principal tasks would be to define the types of activities in which certain financial institutions can. engage and coordinate rulemaking and enforcement action among federal and state regulatory agencies. 2. Sen. Proxmire, "Intermarket Coordination Act of 1988," s. 2256, 100th Cong., 2d Sess. (1988), as amended, would formalize the existence of the President's Working Group on Financial Markets by establishing an Intermarket Coordination Committee comprising the Chairmen of the FRB, SEC and CFTC and the Secretary of the Treasury, or their designees. The bill recognizes that the markets for equity securities, stock index futures and stock index options have become closely linked and involve common regulatory issues that are beyond the ambit of any one agency. The committee is a means for these agencies to work together to develop a more coordinated system of regulation including: a. Improved intermarket coordination of clearing and settlement systems. b. Harmonized margin requirements across marketplaces. c. Circuit breakers coordinated across marketplaces. d. Information systems adequate for market surveillance and enforcement. e. Coordinated contingency planning for market emergencies. f. Effective methods for detecting and prohibiting intermarket frontrunning. The Senate Agriculture Committee has reviewed the Proxmire bill and given the bill its informal blessing. However, following Senator Proxmire's retirement, it is unclear whether the current bill -12-1 .:.. \J t
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will be reintroduced by the Banking Cammi ttee in the 101st Congress. J. For a discussion of the interim findings of the President's Working Group on Financial Markets, established by Executive Order No. 12631 (March 18, 1988), which consists of the Undersecretary for Finance of the Treasury Department, and the Chairmen of the FRB, SEC and CFTC, see section III.B. of this outline. c. azc Leqilativ Propoals by Davids. Ruder, Chairman, azc. tropod uendllent to the securities Exchange Act. 1. 2. Em1rqency Authority/Trading Halts. Authorize the SEC in an emergency to act temporarily to alter, supplement, suspend, or impose requirements or restrictions as to hours of trading, position limits, and clearance and settlement. This authority could be used in an emergency to relax or to impose more stringent requirements. The SEC would also have authority to suspend summarily all trading in all or any non-exempted securities on any exchange or otherwise for a maximum of 24 hours, subject to extension with approval of the President and subject to Presidential override. An "emergency" would be defined to mean a major market disturbance characterized by a substantial threat of sudden and excessive fluctuations of securities prices that threaten fair and orderly markets or a substantial disruption of the safe and efficient operation of the securities clearance and settlement system. Bportina Requirements. a. Large Traders. Authorize the SEC to adopt reporting rules in order to monitor the impact on the securities markets of large transactions (by volume or fair market value or exercise value) in publicly traded securities and related transactions in equity index futures and options on such futures. b. Risk Assessment for Holding Company Systems. Authorize the SEC to require reports from associated persons of all brokers, dealers and government and municipal securities broker-dealers regarding activities which -13r .. 1 . --'-.
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have the potential to affect materially their financial or operational condition. J. coordinated Clearing. Direct the SEC with the CFTC (by amendment to the CEA), in consultation with the FRB, to establish linked, coordinated or centralized facilities for clearance and settlement of transactions in securities, securities options, futures contracts and options thereon, and commodity options, and to report back on progress in two years. 4. Margin. By amendment to the CEA and the Securities Exchange Act, margin authority would be vested in the FRB, with authority to set prudential initial and maintenance margin levels delegated to the futures and securities selfregulatory organizations ("SROs"), subject to review by the CFTC and SEC, respectively. The FRB would retain the right to adopt rules superseding those of the SROs. s. Jurisdiction. By amendment to the CEA and the federal securities laws, jurisdiction over equity index futures and options thereon would be transferred from the CFTC to the SEC. III. TWO MAJOR STOl>IBS OP THI HARDT BREAK. A. Recommendations of the Report of the Presidential Task Poree on Market Mechanisms, January 1988 (The Brady commission Report). 1. Single Regulator. one agency (most logically the FRB) should coordinate the few regulatory issues which have an impact across related markets, such as clearing and credit mechanisms, margin requirements, circuit breaker mechanisms such as price limits and trading halts, and information systems for monitoring intermarket activities. (This idea is reflected in the Proxmire croposal described in Section II.B.2. and in the activity of the Working Group on Financial Markets described in the next section.) Note: To date, the FRB has rejected a broader role as an intermarket regulatory referee or "quarterback." However, the FRB is part of the President's Working Group. -141 ... --1,,1
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2. Unified Clearing. Clearing systems for stocks, stock index futures and stock options should be unified across marketplaces to reduce financial risk by: 3. a. Enabling a centralized clearinghouse to assess accurately intermarket exposure among all member firms. b. Helping lenders to assess the risk exposure of market participants acr-ss markets. c. Reducing the volume and coordinating the timing of margin flows. Note: There has as yet been no significant progress toward a unified clearing system, although the timing of variation margin calls has been coordinated between the CME and BOTCC. The CME and BOTCC have also revised their agreements with settlement banks to clarify and standardize their contractual relationships with the settlement banks. consistent Margins. Margins should be made consistent across marketplaces to control speculation and financial leverage. a. The FRB should set margin requirements for all equity-related instruments. b. Margins on stock index futures should be consistent with margins for professional market participants in the stock market (20 to 25 percent), but should reflect the difference between the two market segments. c. Cross-margining should be allowed. Margin requirements would then reflect the true intermarket risk exposure of the participants. Note: After the crash, the margin requirement for speculative positions was raised. The CME now resets initial speculative margins for stock index futures contracts to equal 15 percent of the value of the contract as determined quarterly. CME margins on the S&P 500 futures contract have been increased to $20,000 speculative initial margin (compared to $4,000 for hedgers) The CBOT margins on the Maj or Market -15-
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Index (MMI) futures contract have been increased to $15,000 speculative initial margin (al though the initial margin for hedgers was lowered in November 1988 to $2,500). However, the NYFE lowered the initial margin requirements on its Composite Index Futures Contract in November 1988 to $4,000 (from $6,000) for speculators and $2,250 (from $4,000) for hedgers. Also, cross-margining has been implemented for certain proprietary trades. Section IV.A.2. of this outline. The CFTC has generally opposed increased margin requirements on the grounds that higher margin levels do not reduce market volatility. For a discussion of this point, see Section II.B.2. of this outline. 4. Circuit Breakers. Circuit breakers such as price limits and coordinated trading halts should be implemented across markets. s. a. Circuit breakers provide a "time-out" in turbulent markets which: i. Limits credit risks. ii. Facilitates price discovery. iii. Reflects the natural limits on the capacity of markets to absorb massive one-sided volume. Note: Circuit breakers went into effect on the first anniversary of the market break. See Section IV.B. of this outline. Better Information. Information monitoring systems should be established to assess market conditions, diagnose developing problems and uncover potentially damaging abuses. Stock exchanges need to develop an information system which details trades and trading times by customer. Note: The Working Group on Financial Markets has given high priority to improving communication among staffs of the various regulatory agencies and SROs have made efforts to improve communication and information sharing among the exchanges and their respective clearinghouses. In particular, the securities and futures exchanges have developed a hot-line capability so that there -16-, ; ,.; I -... .4 Ji.
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can be instant communication among all relevant markets in a crisis. Such improvements are in addition to the information sharing system already in place among the futures clearinghouses in the United States. This system, which was in the process of being developed even before October 1987, provides for the sharing of variation debit and credit information, option premium pay and collect information, and original margin surplus and deficit information relating to the common members of the futures clearinghouses. 6. Frontrunning. The Brady Commission also identified the issue of intermarket frontrunning as warranting the attention of regulators. This issue arises where broker-dealers and FCMs trade for their own accounts in anticipation of and to profit from the execution of orders for their customers in different marketplaces. See Section IV.C. of this outline. B. Recommendations of the Interim Report of the Working Group on Financial Markets, Submitted to the President, May 1988. 1. Trading Hal ts. Coordinated trading halts should be instituted to allow for a cooling-off period in times of high market volatility. In summary, all U .s. markets for equity and equity-related products (stocks, stock options, and stock index options and futures) would halt trading for one hour if the Dow Jones Industrial Average ( DJIA) declines 250 points from the previous day's close. A second closing, for two hours, would occur if the DJIA declines another 150 points ( 400 points from the previous day's close). 2. Note: The NYSE has since agreed to trading halts in a one-year pilot program. Section IV.B. of this outline. such See Keep Present Margin Levels. current maintenance margin levels for stocks, stock index futures and options are adequate to protect broker-dealers, FCMs and clearinghouses from investor and trader defaults on their margin obligations. -1711 : ..:. ... >,
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a. Higher margin levels would impose unacceptable costs to market participants and reduce market liquidity and efficiency. b. Alternative protections against the risk of price movements include capital requirements, intra-day variation margin payments, and clearing fund guarantee deposits. c. The prudential maintenance margin on individual stocks should be significantly higher than on stock index futures contracts because stock indexes have smaller percentage price variability than individual stocks and more frequent margin payments. d. Chairman Gramm of the CFTC believes the current approach to futures margin ( set by SROs with emergency authority in the CFTC) is appropriate. Chairman Greenspan of the FRB and the Treasury favor giving each SRO's regulator the authority to disapprove margin rule changes. Chairman Ruder, echoing the SEC legislative proposal, agrees that the SEC and CFTC should have authority to disapprove margin rules of their respective SROs, but would vest residual authority in the FRB to resolve disputes between the SEC and CFTC over proper margin levels and to adjust margin levels based on leverage and investor protection conc_erns. e. Chairman Ruder believes that options and futures margin levels should be increased to reduce leverage and dampen volatility. f. Support for Chairman Ruder's view that increases in margin requirements reduce market volatility is found in an article published recently in the Federal Reserve Board Quarterly Review which addressed the question whether initial margin requirements curb speculative excesses in the stock market and reduce stock price volatility. The article concluded that, according to the available empirical evidence, there is an economically and statistically significant negative relationship between initial margin requirements and stock market volatility. Higher initial margin requirements were found to be associated with a reduction in both -18-
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3. actual and "excess" stock market volatility (.L.b, volatility over and above that caused by the variation of current and expected future dividends and discount rates). See Gikas A. Hardouvelis, "Margin Requirements and Stock Market Volatility," FRBNY Quarterly Review (Summer 1988). Strengthen settlement systems. Steps should be taken to reduce uncertainty and increase coordination in clearing and settlement systems. a. Efforts should be made to establish a clear, uniformly held understanding of each participant's obligations in the clearing and settlement process. i. Contracts between clearinghouses and their clearing banks should be clarified to assure certainty that bank confirmations of payments to the clearinghouses are irrevocable. SEC and CFTC should monitor progress of SROs towards finalizing revised settlement agreements. Note: The CME and the BOTCC have since concluded agreements with their settlement banks which specify that payment obligations are final once confirmed. ii. It is important to confirm that the payment of variation margin collects is guaranteed by the clearinghouses, regardless of whether funds are received from the FCMs owing such amounts. b. Facilitation of timely payments by those obligated to make or finance such payments. i. Consider requiring FCMs to have secure facilities in place that will support large payments to clearinghouses. ii. Review adequacy of clearinghouse guarantee funds, in conjunction with credit lines, to cover the counterparty risk assumed by the clearinghouse under its traditional guarantee. iii. Increase sharing information among -19-r 1 ,,. ., L' ..:... ..I.. :;, of pay and collect clearinghouses to
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4. 5. enable them to assess the payment obligations and exposures of FCMs. system-wide position iv. Increase coordination of margin calls and settlements. Since October 1987, the Chicago futures clearinghouses and the OCC have increased their use of intra-day margin calls. The BOTCC and CME have coordinated the timing of their daily and intra-day settlements, and the timing of the occ settlements should also be harmonized. c. Exploration of methods to reduce cash flows and simplify settlement. The Working Group recommended a trial cross-margining program for non-customer accounts. The Working Group also recommended the exploration of futures style margining for options, netting of cashflows on a contractual basis (among clearinghouses), shortening the five-day settlement for stock transactions, and the integrated clearing of stock and derivative options and futures products. Note: margining contracts. The SEC and CFTC have approved crossof proprietary accounts for OCC/ICC See Section IV.A.2. of this outline. Improve Communication. Enhancing intermarket, inter-agency and international communication and information sharing to identify and address problems quickly. Chairman Greenspan's Remarks. In a speech before the Securities Industry Association in Boca Raton, Florida on November 30, 1988, Alan Greenspan, Chairman of the FRB, identified progress on a number of the Working Group's recommendations on how to reduce strains and risks in the clearing system. He noted that the following corrective measures have already been taken or are under way: a trial cross-margining program; efforts to coordinate the timing of margin collection and payments; newly established or enhanced communications systems among the clearinghouses; and increased capital requirements for certain market participants. -20-., .L ,.
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IV. MAJOR ISSUES AND REFORMS. A. cross-Margining. 1. Basic concept. Certain assets, stock indices, government securities and foreign currencies in particular, are now the subject of exchange trading in options {a securities product), as well as futures and options on futures {commodities products), thereby creating an opportunity for intermarket hedging and arbitrage. For example, it is possible to hedge a short position in index options on the Chicago Board Options Exchange {CBOE) with a long position in index futures on the CME. However, each "leg" of the position has been margined separately by the appropriate clearinghouse, with the result that an intermarket hedger must post higher margin than is warranted by the risk of the positions taken together, which unnecessarily increase~ the cost of intermarket hedges. Cross-margining involves margining both legs of an intermarket hedge as a single position. The limited risk of the combined position justifies lower margin and the clearinghouse is protected against the bankruptcy of the FCM by its security interest in the combined position. In January 1986, the Intermarket Clearing Corporation {ICC), a subsidiary of occ, proposed that FCMs be allowed to carry both the securities and commodities legs of intermarket hedge positions in a single ICC account. The proposal raises significant regulatory issues because different segregation requirements for customer assets apply under the commodities and securities laws and because, in the event of bankruptcy, there may be a conflict regarding the distribution of assets in a cross-margining account between the Bankruptcy Code {applicable to FCMs) and the Securities Investor Protection Act {SIPA) (applicable to securities broker-dealers). 2. Update. a. The SEC and CFTC recently approved the crossmargining of CCC-cleared securities options with futures positions traded on contract markets and cleared by ICC. Such crossmargining would apply to proprietary accounts -21r ., :: ...... ..
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only. Contracts subject to cross-margining would include the PHLX/PBOT foreign currency contracts and the NYSE/NYFE options and futures on the NYSE Composite Index. b. The CME and occ have proposed a crossmargining system for certain transactions. In addition, there are reduced intermarket spread margins for the new CBOE 250 stock index (a CBOT futures contract which is traded on the floor of the CBOE). The CBOT has reduced margins on spreads involving positions in the S&P 100 (OEX) or S&P 500 options used in conjunction with the new futures contract, which has an effect that is similar to cross-margining. 3. Benefits. 4. a. Lowered cost of maintaining intermarket hedges would eliminate the present deterrent to intermarket spreading and arbitrage, which transactions enhance market liquidity and improve the efficiency of intermarket pricing. b. Cross-margined offsetting contracts may afford better protection to the clearinghouse than cash margin. c. Enhanced ability to assess risk exposure of clearing firms engaged in commodities and securities activities where intermarket spread positions are concentrated in a single clearinghouse. d. A first step toward developing a more efficient, unified commodity clearing system similar to occ on the securities side. Criticisms. Cross-margining has been criticized by Roger Rutz, President and CEO of the BOTCC. See Roger o. Rutz, "The Myth and Reality of Intermarket Cross-Margining," Intermarket (August 1988) Among other things, the article argues that: a. Implementation of cross-margining would reduce the amount of money held as original margin deposits at the various clearinghouses, increasing risks to the clearing--22-
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houses and thus to other FCMs and clearing member firms in the event of a default. b. It is inconsistent to argue that stock index futures margins should be raised and also that cross-margining, which lowers margins, should be implemented. See Recommendations of the Brady Commission at Section III. A. 3. of this outline. c. Cross-margining by lowering the cost of establishing intermarket positions could cause increased program and intermarket arbitrage trading which may increase market volatility. d. The liquidity problems faced by FCMs during October 19th and 20th, 1987 were the result of differences in the timing of settlements and cash flows between markets, not the lack of cross-margining. Such liquidity problems are best solved by adopting futures-style margining for options and stocks. e. If cross-margining had been in place during the market break, banks would have been no more willing to lend funds on intermarket positions because banks are currently unable to obtain perfected security interests in intermarket positions. B. Circuit Breakers. 1. Purpose. The purpose of circuit breakers is to slow any downward spiral in securities and commodities prices by temporarily halting trading. As the Brady Commission noted in its report, the "time-out" that circuit breakers provide: a. Allows significant market-related information to be disseminated, thereby facilitating price discovery. b. Allows more rational decision-making by participants, the exchanges and regulators. c. Helps the exchanges' computer systems to keep pace with trading activity, -23-r 1 ,;:; -~ "-'
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2. The following proposals have been approved by the SEC and CFTC. a. The NYSE, in a one-year pilot program, plans to halt stock trading for one hour whenever the DJIA falls 250 or more points from the previous day's close. If the DJIA falls an additional 150 points, trading would halt for two hours. b. The CME has instituted a JO-point price limit on the S&P 500 stock index futures contract, and agreed to a coordinated NYSE-CME trading halt if the DJIA falls 250 points. If after reopening the S&P 500 stock index futures contract were to fall another 20 points, CME trading would halt for two hours, and would be halted for the day after a 50 point drop. c. The CBOE, which trades stock index options, plans to halt trading when the NYSE stops trading after 250-and 400-point declines. The CBOE will also stop trading ten minutes after the CME reaches its 30-and 50-point circuit breakers. c. Frontrunning. 1. Description. The October 1987 market break raised concerns about "frontrunning" abuses using stock index futures contracts. "Frontrunning" resembles insider trading in the securities law context. In general terms, the practice involves a broker trading for his own account in one market to take advantage of his knowledge of material, non-public information about a customer's imminent transaction in another market. For example, a broker's trading in index futures immediately prior to and with knowledge of a customer's stock transactions that favorably impact the value of the underlying index might constitute frontrunning. Note: Frontrunning refers only to trading based on knowledge of another person's (usually a customer's) transactions. However, trading to take advantage of one's own imminent transaction in a related market may be considered to be a form of manipulative activity. Frontrunning also highlights the inherent conflict of interest created when the broker acts -24,. 1 .." -~"I
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2. both as agent for customer orders and as principal for proprietary trades. The broker as principal may have an incentive to maximize the market impact of customer trades, which conflicts with his duty as agent to minimize trading costs. A proposed rule barring intermarket frontrunning was submitted by the NYSE to the SEC for approval in October 1988 based on agreements which the NYSE reached with the CME and the New York Futures Exchange (NYFE). The rule, which is described below, states that it will be a violation of exchange rules for a member or person associated with a member to trade a stock index future or option with knowledge of an impending stock program transaction, or vice versa. The prohibition does not apply to legitimate hedging of equity positions in the futures markets. Details of the NYSE/CME and NYSE/NYFE Agreements. These exchanges have adopted a uniform policy which defines ( for the first time) and prohibits certain intermarket frontrunning between their respective equity and futures markets. The policy, as described in NYSE's October 31, 1988 submission to the SEC, prohibits a member or person associated with a member from executing for an account in which such member or person has a direct or indirect pecuniary interest, or for which such member or person exercises investment discretion, certain transactions to take advantage of material, non-public information which can reasonably be expected to have an immediate, favorable impact in relation to such transactions. Any member or person executing or causing the execution of such transactions may be in violation of just and e~-uitable principles of trade under NYSE Rule 476. However, the mere violation of an NYSE Rule does not, under normal circumstances, give rise to a federal cause of action. The policy does not require any showing that another individual has been harmed before the exchanges can bring charges of intermarket frontrunning. a. Covered Transactions. i. A transaction in any stock index futures contract, or option on a stock index futures contract entered with knowledge of the imminent execution of another person's stock program transaction. -25-, ., .!.. ~ \
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ii. A stock program transaction entered with knowledge of the imminent execution of another person's order in stock index futures contracts or options on stock index futures contracts. b. Transactions not covered. i. A bona fide hedge of a risk assumed by the member or person in facilitating the execution of any other person's stock program orders. ii. Legitimate proprietary market strategies involving a stock program and a related stock index futures transaction. c. An additional transaction covered only by the NYSE/NYFE agreement is a transaction in any stock index option entered with knowledge of another person's order in stock index futures contracts or options on stock index futures contracts. Exclusions similar to those described in b. above apply for legitimate hedging and proprietary trading strategies. J. other Initiatives. a. As it is not clear whether prohibited under federal commodities laws, the SEC considering whether to adopt specific prohibition on frontrunning. frontrunning is securities or and CFTC are by regulation a intermarket b. In October 1987, the NASO Board of Governors adopted an Interpretation of Article III, Section l of the NASO Rules of rair Practice which states that the frontrunning of block transactions is conduct inconsistent with just and equitable principles of trade. Members who violate such principles are subject to NASO disciplinary action. c. The Intermarket Surveillance Group, made up of securities SROs, with the participation of the futures exchanges and the SEC and CFTC, have formed a Sub-group on Futures/Securities Intermarket Regulation to define intermarket frontrunning and to discuss ways in which information can be shared between futures and -26-1 ') .. ..._ l
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securities exchanges to facilitate detection and enforcement. d. In April 1988, the Senate Committee on Banking, Housing and Urban Affairs held hearings on frontrunning. In addition, the House Subcommittee on Telecommunications and Finance reportedly plans to hold hearings on intarmarket frontrunning and other forms of market manipulation. 4. Enforcamant Problems. Effective enforcement will depend on accurate reporting and identification of customer and member firm trades. D. Third Party ~utodial Accounts 1. Description. At present, mutual funds trading futures contracts and options on futures contracts are prohibited from depositing initial margin amounts directly with an FCM. Section 17 ( f) of the Investment Company Act ( ICA) and SEC rules require that a registered investment company maintain securities and similar investments and cash only with a qualified custodian which, according to the SEC staff, does not include an FCM with respect to commodities transactions. Instead, mutual funds must deposit their initial margin in a separate account at a custodian bank. Variation margin is usually permitted to flow directly between the FCM and the fund. However, any daily variation margin payments due the fund must be paid promptly by the FCM to the custodian upon demand. Use of third party custodial accounts is intended to limit a mutual fund's exposure in the event of the insolvency of the FCM. What protection these accounts offer is unclear. The CFTC staff does not view a third party custodial account as a separate segregation account. Therefore, the CFTC staff has stated that in the event of an FCM insolvency the assets in the custodian account are subject to pro rata diatribution in accordance with the commodity broker subchapter of the Bankruptcy Reform Act and the CFTC's bankruptcy rules. Mutual funds are not the only users of third party custodial accounts. certain pension plans and other institutional participants (such as -27-, 1 : .;_,~ ._
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endowment funds and foundations) also have elected to use such accounts. Although the Department of Labor has not required pension plans subject to regulation under ERISA to use third party custodial accounts for futures trading, cautious fiduciaries may insist on such arrangements because of perceived benefits in the event of FCM or clearinghouse insolvency as noted above. 2. Drain on Broker Liquidity. To satisfy CFTC, exchange and clearinghouse rules, the FCM must use its own financial resources to post original margin with the clearinghouses with respect to the positions of third party custodial account customers. The Brady Commission report identified these third party custodial accounts as a significant source of "liquidity pressure" during the crisis last October, as brokers were required to satisfy substantial original margin obligations using their own capital and credit lines. According to industry estimates, the amount of initial margin which must be posted each day by an FCM which carries sizeable fund positions may be as high as $50,000,000. This drain on liquidity is compounded when exchange and clearinghouse margin requirements are raised during periods of market volatility. Section III.A.3. of this outline. J. An Exemptive Rule. The SEC staff is currently considering an exemptive rule under ICA Section 17 ( f) which would permit a registered investment company to deposit-. original margin directly with the FCM. If such a rule were adopted, those pension plan fiduciaries who now insist on third party custodial accounts as a matter of prudence, partly due to their required use by mutual funds, would likely reevaluate the need for such arrangements. The CFTC might also reconsider its acceptance of such third party custodial accounts if the accounts were no longer required under the federal securities laws. Such an exemption would involve no greater risk to the fund's initial margin amounts as such amounts would be protected against conversion by the FCM by the segregation requirements of the CEA and CFTC rules. Furthermore, the fund's initial margin amounts which are held in the FCM's customer margin account at the clearinghouse could be reached by the clearinghouse only in the event -28-
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of a deficiency in that account that the FCM failed to make up out of its own funds. Such an FCM default would be extremely unlikely, given the conditions in any exemptive rule that would probably permit only the most financially secure FCMs to carry fund accounts. Furthermore, as noted ab~ve, it is unclear at best whether the use of third party custodial accounts provides any greater protection to funds in the event of an FCM insolvency. .. -29r,
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TOWARDS A FRAMEWORK FOR A FINANCIAL MARKETS INFRASTRUCTURE Paper prepared by Ian Shepherd & Linda Tullberg of McKinsey & Company* April 20, 1989 Submitted to the Congress of the United States Office of Technology Assessment Sponsored Study on International Clearing & Settlement This contractor document was prepared for the OTA Background Paper, Trading Arolllld the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This document does not necessarily reflect the analytical findings of OTA, its Advisory Panel, or its Technology Assessment Board. Ian Shepherd is a Principal in lhe Australian office of McKinsey & Company. Linda Tullberg is an Associate in lhe Australian Office. They are part of a team which undertook a major study of opportunities in intemalional financial market systems in 1988. The study, which was undertaken for a group of lhree major Australian clients, focused on issues of cross-market and cross-border settlement, and considered how lhe mechanisms for trading and settlement could be integrated to substantially reduce risk. I ; ..:,_ ~-.
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INTRODUCTION TOWARDS A FRAMEWORK FOR A FINANCIAL MARKETS INFRASTRUCTURE As world financial markets evolve and become increasingly interdependent, the need for a better infrastructure to support trading, clearing, and settlement of financial transactions is increasingly apparent. Technological advances supporting information dissemination and analysis have been a prime force in driving market interdependence, but the industry has only recently begun to apply advanced technology to support mechanisms for execution, clearing, and settlement. Support for cross-market transactions, in particular, is in its infancy. Execution and settlement mechanisms within product markets and regions vary greatly in function and in level of automation, and the linkages between them are frequently poor. The fragmented nature of today's infrastructure has led to high risk and cost, panicularly for participants trading across product markets and across borders. Further integration of the mechanisms must occur if risk and cost are to be contained and financial markets are to evolve. A key issue is whether the industry can collectively manage the process of integration to ensure the resulting infrastructure meets three important objectives: 1 It provides the functionality to support trading in the financial markets of the future, as boundaries between product and geographical markets become increasingly blurred 1 It represents an efficient capital investment for industry participants 1 It supports free and open competition wherever possible, both in the operation of the markets and in the operation of the mechanisms which support the markets. In order to meet these objectives, we believe that an international institute should be formed to develop a framework for financial market operations. The framework would specify a conceptual model for securities market operations and provide a set of standards to enable existing and new mechanisms to be integrated. The institute should be cooperatively owned and funded by market participants. Although cooperatively owned, it should be staffed independently and have sufficient autonomy to ensure that the proposals developed are in the best interests of the industry and do not reflect sectional interests. Further, the institute should be well resourced with sufficient staff and capital to allow the framework to be developed as quickly as practicable and to enable some prototyping of systems which reflect the new standards. The following sections of this paper outline the reasons why the establishment of an international institute is an appropriate response to emerging integration of the financial market infrastructure, and describe a role for Congress: 1 A framework is needed to guide the development of market mechanisms 1 A widely-owned but independently-operated international institute is the best means for developing the framework 1 Congress has a role to play in fostering the establishment of the institute. ,. .. ,....,
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A FRAMEWORK IS NEEDED m GUIDE DEVELOP;MENT We believe the case for the development of an industry framework to guide the process of integration can be supported by examining how integration is currently occurring, assessing the likely outcomes of that current approach, and considering how a suitable framework could avoid adverse outcomes: t The current process of integration is constrained by the industry structure and conduct 1 A laissez-faire approach to managing integration may have adverse results 1 An industry framework can guide the process of integration to ensure better outcomes. These aspects are discussed in detail below. Current Process of Integration Constrained by lndusn:y Structure The demand for cheaper and more effective ways to trade across markets and across borders is already leading to some integration of market mechanisms. The integration is occurring in three ways: t Organizations such as stock exchanges are automating their systems and establishing bilateral linkages with other organizations. Linkages have been forged, with varying success, between stock exchanges, between futures exchanges, and between clearing organizations. Various industry organizations are working towards establishing uniform approaches to clearing and settlement within product markets. The Group of Thirty's work on international equity clearance is an example of moves to establish standards. t Many organizations are extending their mechanisms to service other products and regions. For example, Euroclear and CEDEL have extended their services to support clearing for international equities. Many exchanges are extending their product range and systems into new arenas. The International Stock Exchange's move to capture global stocks and the CME-Reuters' development of GLOBEX are representative developments. t Intermediaries and institutions are integrating disparate trading and clearing mechanisms within their own premises. A large number of vendors are providing systems which allow a single interface to multiple markets for traders. Back-office systems have been slower to evolve; however, systems are being developed to interface in-house systems with multiple-clearing organizations. These developments have been accompanied by the development of regional and global networks, usually provided by third parties, to support both trading and settlement. Reuters and Telerate dominate quote provision and automated trading networks; Reuters I.P. Sharp, FITEL, and AIBD provide third-party or market-owned confirmation networks. ,., ... ,.~ _;._ ,.:, ( 2
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These developments are making some advances in addressing the issues raised by cross-market and cross-border trading; however, the response overall remains fragmented. With few exceptions, the initiatives reflect and reinforce the existing industry structure and procedures. Stock exchanges are developing their own systems independently of futures exchanges and commodities exchanges in most regions; funds transfer systems are being developed largely independently of the clearing systems which generate a major part of the payment volume. The industry structure represents the major impediment to achieving substantial change. Lack of vision, concern with protecting individual interests, and the regulatory structure all limit moves toward an infrastructure which efficiently and effectively supports the growing economic interdependence of markets: 1 Lack of vision about the potential of technology is often a significant constraint. Participants tend to rely on experience gained within their own segment of the industry and limit solutions accordingly. For example, the traditional separation between the securities industries and banking industries means the possibilities of linking the banking infrastructure with that in the securities industry have not been fully explored. A link between trading systems and banking systems could potentially eliminate settlement risk by enabling funds to be locked in at the point of trade, yet there have been no moves to establish such links. 1 The concern of participant organizations to protect existing capital investment and revenues limits their support for any initiatives which could accelerate industry restructuring. A current example is the emergence of screen-based trading systems, such as GLOBEX. Intermediaries are concerned about these systems leading to disintermediation in the profitable institutional market. Traditional exchanges feel threatened by the growth of over-the-counter markets which screen trading supports. As the experience with establishing Instinct shows, participant organizations will often use regulatory barriers to try and prevent the establishment of competitor systems. Concern for protecting one's own interests leads to suspicion of any initiative by other participant organizations to resolve problems affecting the industry as a whole. There is a natural perception that the initiative will be undertaken in a way which enhances the competitive position of the proponent 1 Regulatory structures reinforce the existing industry structure. Because of the central nature of financial markets, the industry is, necessarily, more highly regulated than most others. Further, in most countries, regulatory authorities for securities and banking remain separate, despite the growing interrelationship of activities such as futures trading and foreign exchange trading. The level of regulation and the separation of regulatory functions inhibit the development of more integrated mechanisms. ; 3
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Laissez-faire Approach to Integration roa.v have Adverse Results In the absence of a coherent framework, the constraints presently inherent in the current industry structure will continue to dictate the process of integration of the market infrastructure. Systems developed along existing market boundaries will be patched together rather than redeveloped within the context of a broader vision. A few players, possibly those currently on the fringe of the industry, such as telcos, may utilize technology to create "new-game" trading environments which capture liquidity from more traditional markets. Existing organizations will attempt, with varying success, to constrain the spread of these initiatives through self regulation of their members or through appeals to regulatory authorities or governments. Rationalization of the industry will eventually result; however, the process will be slow, and neither the process nor the outcome may be in the best interests of the industry or those connected with it. The problems of a laissez-faire approach are threefold: The current fragmented approach to integration will not substantially reduce the risk of trading for individual firms, nor reduce the systemic risk threatening the world financial system. The 1987 market break showed the potential for a major financial system crisis. As cross-market trading grows, it becomes increasingly difficult for clearing houses and financial institutions to monitor the overall exposure of participants. Initiatives such as cross-margining will assist, if successful; however, until systems are developed and linked in such a way that avoidable risk is eliminated, the threat to the financial system will remain. The current approach will lead to inefficient capital investment in systems. Capital may be invested in developing or adapting systems that are incompatible with each other or do not provide the functionality needed to support emerging market operations. Unnecessary duplication of infrastructure components is likely. Experience with technology investments in banking and other industries demonstrates that firms seldom obtain competitive advantage through investments in technology, because competitors can quickly duplicate systems. If opportunities do exist to add value through systems operations, a third party can enter the market and supply the system as a utility service to all players. Reuters and Telerate have largely based their businesses on this principle. The current approach may lead to an industry structure which does not encourage sufficient diversity or competition in the operation of markets and the supply of the systems to support the market. If no framework exists for separately-owned regional and market systems to interconnect in a flexible and efficient manner, then the demands for global and cross-market trading are likely to be serviced in two ways. Firstly, the major market organizers and clearing houses could extend their products and services to capture the major products traded. Smaller market organizers will be starved of liquidity. Secondly, organizations with sufficient capital could provide global networks to support trading and settlement for over-the-counter type markets. Under either scenario, the result may be an unacceptable concentration of ownership in the operation of markets and the systems which support them. ,-. ., .. .:.. .:.. : 4
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A Framework Can Guide the Process of 1oteuation An industry framework cannot resolve all the issues of industry structure; however, it can assist the process of integration in two imponant ways: t A framework could provide a conceptual model of financial market operations which encompasses the emerging trends in financial markets and the opportunities created by technological advances. In the course of developing a model, key constraints of vision can be addressed. The questions which must be considered include: What are the differences and similarities between various product markets? Can generic definitions be developed which enable a common infrastructure to be utilized for a range of markets? The different market environments, product characteristics, and means of financing these products suggest that they are very different. However, if the fundamental elements are examined, there is considerable similarity. Most products can be consiciered as a series of exchanges of value over a period of time, with the value of exchanges determined by a set of rules related to a range of external variables. Recent academic literature defines all products as variations of an option. If a "building-block" approach to financial instrument characteristics can be adopted, a flexible systems infrastructure could be developed to readily support both existing products and a wide range of new products. Products may become increasingly defined and managed in accordance with the customer segment they are constructed for, rather than the mechanism by which they are traded and settled. Modern database technology, which treats rules to be executed as a form of readily-modified data, could be applied to implement this approach. Which elements of the systems infrastructure can and should be shared? What is the best form of ownership and management for the shared components? Development of a shared infrastructure does constitute a "levelling" of the playing field and large players may be inclined to resist it. Others, however, have learnt from experience in areas such as retail banking. The experience shows that investment in dedicated technology results in high fixed costs but seldom yields competitive advantage, because competitors will respond with equivalent investments and third parties will set up utility companies. If suitable shared infrastructures are available, participants of all sizes can benefit. Small and medium firms can establish market niches unhindered by the need for heavy technology investment. Larger firms can use their capital to establish competitive advantage in other ways. -,_ 5
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How can regional differences in regulation, taxation, and investor preferences be accommodated? Variations in regulation and taxation reflect local economic and cultural variables and it is naive to expect uniformity in areas such as standards for issuers for some years to come. Diversity of investor preferences creates opportunities for a wide range of players and can enhance market stability. With a suitable approach to market mechanisms, it may be possible to incorporate these variations as rules within the systems infrastructure. Regional interest also extends to the perceived risks of having the physical systems supporting markets outside borders. Emerging technology may allow systems that are physically distributed but which appear to the users to be fully integrated or "seamless". Unless regional environments can connect in this fashion, trans-national organizations that can offer a fully-integrated service will capture liquidity from the national markets and a measure of control will be lost. How can emerging technology be applied to reduce avoidable risk? For example, can links be established between banking systems, clearing systems, and trading systems which enable cleared funds to be locked in at the point of trade? Could an integrated infrastructure support the coordination of margin requirements and associated cash flows to avoid the credit problems experie:iced during the 1987 market break? Consideration of these issues may lead to a fresh view of how markets may be organized and supported. A suitable process would define a new model for financial market u.,erations, free of the constraints of the existing industry structure. The model would then be refined in light of the existing infrastructure and options developed for how the industry may efficiently move towards integration. The development of a model cannot, of itself, diminish the power of those with a vested interest in the status quo. Nevertheless, it can provide a reference point for regulators and participant organizations in discussing change. 1 A framework would form the basis for developing industry standards which enable existing and new mechanisms to interconnect. The availability of standards enables companies to invest capital in systems without being locked in to a particular vendor or into an operating environment which cannot be adapted to industry changes. Standards also encourage diversity in the supply of equipment, allowing participants a greater choice of equipment and enabling them to link diverse components. Work has been undertaken in the area of standards by various industry groups such as FIBV, ISSA, and SWIFf. A recent study, undertaken by the private sector based Group of Thirty, has resulted in practical recommendations for change in a number of areas. Efforts to date, however, have largely been undertaken in the context of the current industry structure, and have principally addressed the issue of equities. The development of a comprehensive framework, based on a new model for the industry, can build on the existing work to establish a set of standards suitable for the entire industry. The standards definition process must define industry-specific standards and endorse appropriate computer and communications standards such as the Open Systems Interconnect model. Standards organizations such as CCITT and ISO have an ongoing programme of standards development in the arena of computer systems interconnection, communications, and securities identification, and these must be incorporated into the industry framework. ... ...;,.I..) 6
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AN INTERNATIONAL INSTITIJTE IS THE BEST WAY TO DEVELOP A FRAMEWORK A range of approaches is possible for developing an industry framework. The approach most commonly used has been the formation of committees of representatives from industry organizations. While these committees have played a useful role in the past. they are frequently hampered by lack of resources and tensions arising from conflicting interests of participants. A formally-constituted international institute which is widely owned, independently operated, and well resourced offers a number of advantages: 1 Wide ownership, representative of the market. would encourage commitment to the result 1 Independent operation would encourage a framework which is innovative and provides the best approach for the industry overall Generous resourcing would encourage effective and practical results. These attributes of the proposed institute are discussed further below. Wide Ownership Representative of the Market would Encourage Commitment to the Result Despite the difficulties which can arise from having many owners, equity participation by a representative group of players is one of the best ways to encourage commitment to the recommendations of the institute. If major players are outside the process, they may be reluctant to support initiatives or may actively oppose them. If the institute is seen to be representative, regulators and self-regulatory organizations will find it easier to gain the agreement of market participants to change. Independent Operation would Encourage Best Results for the Industry Overall Independent operation does not mean complete autonomy from the participating organizations; as with any company, the management of the institute must ultimately be accountable to its shareholders. However, the shareholders should exercise their influence through a board of management, not through "hands-on" management or through secondment of their own staff. Participant organizations would also be informed and consulted through distribution of papers for comment and periodic symposiums. 7
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An independent approach to staffing will allow individuals to be selected on the basis of their experience and ability to contribute, not merely on the basis of their membership of a particular shareholder organization. Staff would not be burdened with having to represent an organization's interests and could freely support proposals which may not be to the advantage of particular players. Where the staff recruited are released from participant organizations, it would be on the understanding that the individual was not to act as a representative of the organization and would not repon back to that organization without the agreement of the board. Generous Resourcing would Encourage Effective and Practical Results The institute should be well resourced with sufficient capital to attract and remunerate full-time staff of the highest quality and to allow prototype systems to be developed. High-quality experienced staff are essential to developing an innovative and practical framework. The process of development will not only require a solid understanding of the issues and problem-solving ability, but also the ability to consult with and command respect from the many organizations who will make inputs to the process and approve its output. Prototyping of systems is needed for two reasons. Firstly, it would ensure the model and standards are practical and can be implemented with available technology. Secondly, it would provide a tangible means of demonstrating the model and the standards to participant organizations. CONGRESSHASAROLETOPLAY The formation of an international institute to develop a comprehensive framework for financial market operations would provide a firm basis for industry development in the future. There are successful parallels for such private sector developments. CCITT, for example, has played a strong role in the development of standards for telecommunications companies. The Group of Thirty has shown that private sector organizations in the securities industry can cooperate on issues of concern. The establishment of the institute should ultimately be the responsibility of industry participants; however, governments have an important role to play. As the formation of the National Securities Clearing Corporation in the 1960s showed, the industry frequently needs direction and encouragement from government and its agencies. A suitable next step for Congress would be to charter the appropriate agencies, such as the U.S. Treasury and the Federal Reserve, to initiate discussions with foreign counterparts to determine if they would actively support organizations in their region participating in an industry-based institute. April 20, 1989 I .8.
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I OFFICE OF TECHNOLOGY ASSESS~IENT SPONSORED STl'DY on CLEARING AND SETTLEMENT OF SECURITIES WORLD\VIDE GLOBAL CUSTODY ISSUES This con tractor document was prepi:1red for the OTA Background Ppaer, Trading Around the Clock: Global Securities Markets and Information Technology, July 1990, and OTA Report, Electronic Bulls and Bears: U.S. Securities Markets and Information Technology, Sept. 1990. This docurnen t does not necessarily reflect the analytical findings of OTA, its Advisory Panel or its Technology Assessment Board. Prepared by: l\larc V. Simons Price Waterhouse. Boston Keith J. Fulmer Price Waterhouse. ~r11 Yori. 7-l\lAR-89 -----------------------------Price Watl!rhouse
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I. II. OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY O~ CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE TABLE OF CONTENTS Introduction to Global Custody Critical Issues In Global Custody A. Aaent Banks and Networks I. Regul:ition 2. Issues B. Income and Interest Collections I. Overview Issues C. Valuation and Corporate Action Notifications I. Overview Issues D. Tax Wlthholdlna and Reclamation I. Overview 2. Issues E. Safekeeping I. Overview 2. Forms of Delivery 3. Book Entry/Centr:il Depositories 4. Issues F. Settlements I. Overview ., Impact of Overse:is Settlements 3. Methods of Settlement 4. Issues G. Information Technology I. Overview 2. Issues H. Conclusion I i ~'-' .. 1-2 J 5 5 6 6-7 8-9 9-10 I I I I 12 12-13 ~ ~ ~-15 15-16 17 17-19 20
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES lnrroduslion 10 Global Cusrody --\I-\R-89 The role of the glob:11 custodian is to provide safekeeping and income collection ser\'ices for investors in foreign securities. As part of their safekeeping responsibilities, the custodi:in o, Nse~ the settlement process (exchange of cash for securities), provides foreign exchange :ind wire transfer services, receives or delivers securities (in either book-entry or physic:il certific:ue form 1. :ind m:iintains proper records of custol"'er trans:ictions and securities held in overse:is d('posiiories. Income coUecrjon services include, collecting dividend and interest payments, notific:ition of pro"< y or c:ipit:il change information, and filin1 tax reclamation notices to foreign tax authorities fur reb:ites of taxes withheld on income earned. Cle:irl y. the U.S. based global custodian bank can not maint:iin :in actual presence in e., _. r :, ,_, e rse:1s m:1rketpl:1ce. Due to economics, foreign regulations and familiarity with local securiri_.s pr:.i.:1i-:es: U.S. b:ised custodian banks will usually designate a local bank as its representative to perform settlement, s:ifekeeping :ind income collection functions. The collection of intern:uion:il lo.::11 b:111ks performing these activities on beh:ilf of the U.S. custodian are called subcustodi:ins or :1gen1 b:rnks. The U.S. glob:il custodi:in establishes 3 worldwide communications network (e.g. Telex. S\\ IFT or propriet:iry network) to communic:ite with its subcustodi:ins. ln,e1uon in Forei1n S,suriliH The predominant U.S. based investors in international securities are U.S. pension fun.Js. ., hi.:h !1~!.! :ippro~im:nely S60 billion in foreign investments in 1988. The increased diversifi.::1ri0n ,Jr' pen-si,:11 ~unds into intern:ition:il securities has continued to grow substantially over the p:ist 1en :, e:us. Ir i~ estim:ued th:it U.S. pension funds are expected to invest over SI trillion in intern:ition:tl m:111-;;;>ts !:, the end of the century (Pension and Investment Age). Alloc:ition of assets into intern:11ion:1l investments should incre:ise from about 3% (as of July, 1988) to at least 20%. Trend11 or ERISA Forcl10 Assets Period 1988 1987 1986 198S 1984 1983 1982 1981 1980 1979 Forei1n Assets (In billions> 60 so 4S 33 16 12 7 s 3 2 % or chotc + 20 + II + 41 + 100 + 37 + 67 + JS + 58 + 89
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I. OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES lnrroducrion to Global Custody Trends of ERISA Foreign Assets (continued) There h:ts :ilso been 3 marked incre3sed by U.S. retail investors into internation31 and glob:11 mutu:11 funds. International funds invest exclusively in off-shore foreign investments, while global funds m:ty incorpor3te some U.S. denominated securities in addition to foreign securities. .-\s of IJ~cember 31, 1988. total assets (in millions) for intern3tional equity funds were $6,832, global equity funds were SI I, 151 :ind global bond funds were $3,024. This represented an decre3se/incre:tse of -2.15":,. 6.7% :ind 41.5% in net :issets respectively over the prior twelve month period. (Investment Comp:111y Institute. December 30, I 988). Global Custodians St:ttistics published for net assets under glob3l custody vary widely. Frequently, these figur.~ include assets of non-U.S. based investors or may include double counting in situations \\ her~ domestic b:tnks :ict 3s glob::il custodi3n for other domestic custodi3n b::inks. Additional!~. :1 l:rnk m:ty consider itself a global custodi::in in c::ises where it performs customer recordkeeping hu: u ;~~ :1 l:irger glob::il custodian bank's network of subcustodi:m banks for actu::il safekeeping :rn,1 111~ m~ collection functions. Our :inalysis of these published figures indicates :i need for ::i nwre st:ind:irdized method of obtaining :ind defining glob:il custody :issets. In lieu of existing q:111.Lir,!~. we h:ive provided the following chart of U.S. based fund :issets held by global custodi:rn 1-:tnks lnsfilurion State Street Bank Chase M:inhattan Bank Bank of America B:inkers Trust Irving Trust Boston Safe Deposit Citibank Northern Trust Mellon B3nk/Pictet H::irris Trust Morgan Stanley Trust First W::ichovia Continent31 [llinois Security P3cific Wilmington Trust First RepublicBank National Bank/Detroit First Pennsylvania Bank B::ink of New York Norwest B3nk Minnesota Centerre Trust United St3tes Trust Citizens & Southern Trust Ameritrust Mercantile-Safe Deposit First lnterst::ite Bank First Trust M::irshall & llsely Trust Source: Pension & Investment Age, August 22, 1988) 2 'i 1 ,:_ 'J { $'s in Millions 17,850 16,036 5,500 5,000 4,500 4,300 4,259 2,500 1,900 1,800 1,670 1,570 1,500 1,200 I, 143 510 500 300 263 220 154 134 100 91 88 24 10 8
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Crilk:il Issues in Glob:il Custody A. Agent B:inks :ind Networks I. Regulation Overview 7-\l.\R-89 The lack of uniform regulations governing the use of depository and book-entry securities have raised a host of regulatory and legal issues conf:onting investors in foreign securities. Of particular concern 3re the variability of rules govP.rning the terms of custody :tgre~ments. depositories and clearing agents on behalf of U.S. based investors. The following regul:ttor> and legal issues 3re not intended to be an exh3ustive treatment of the subject, but r::uher :111 illustr3tion of the legal complexities surrounding international custody relationships. The Uniform Commercial Code The Uniform Commercial Code protects the ownership interest of parties to a securiti,'s transaction executed in the United States. Within an international context. the :ippk:1!:ilit:, of the UCC will depend on the location of the parties and the securities. the place .1 !i~r:: t!1:: tr:tnsaction occurs and the parties choice of law (UCC 1-105). Furthermore. under regulations proposed by the United States Department of the Treasury, the rights of 1.1'.1rt:~~ in U.S. government transactions would be determined under federal law r:ither th:rn th:: Lcc and where securities are handled through an account with a non U.S. custodi:rn. the LJ.1 within the custodian's jurisdiction would apply. The Investment Company Act of 1940 Among the more definitive regulations covering custody relationships with respe:t tL, mutu:il funds are those found in the Investment Company Act of 1940. Rule I 7f-4 under th, Investment Company Act of 1940 regulates the activities of registered in,esrnient -.:li111p~rnies with respect to the custody of securities held in their portfolios. Under this rule. :1 registered investment company may deposit securities with a clearing agent or depository provided that certain conditions are satisfied. These include the following; ( I ) the investment company has a system reasonably designed to prevent the giving of un:tuthorized instructions, (2) the agreement with the depository or cle3ring agent requires that sl',,:urities be promptly delivered to the investment company and (3) the arrangement is :ippro1 ed by the investment company's board of directors. Under the Investment Company Act, Rule 17f-5, a registered investment company m:-iy maintain securities with a foreign custodian provided that (I) the arrangement is re1 iewed :ind approved annually by the fund's board of directors, (2) the investment comp:1 n y s :1ssers :ire adequately insured in the event of loss and are not subject to a security interest on behalf of the custodian and its assets are freely transferrable, (3) adequate records :tr~ maint:iined identifying the assets of the fund (4) the company's independent auditors h:1,e access or confirmation of the records, (5) the company receives periodic reports or its :issets and activities, and (6) the board of directors est3blishes a system to monitor its foreign custody rel3tionship. Additional capitalization requirem :s are set forth to define eligible foreign custodians that have (I) shareholder equity in excess of $200,000,000 or ( 2) :1 majority owned subsidiary of a qualified U.S. bank or holding company, org:rnized outside of the United States with shareholders equity in excess of $100,000,000. ,. -3 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES \VORLDWIDE GLOBAL CUSTODY ISSUES 11. Critical Jssues in Global Custodv A. Agent Banks and Networks (continued) 2. Issues -\I-\ R-S') The ability of the global custodian to provide superior service is directly dependent upon the quality of its agent bank. The types and quality of services offered by local banks S('ning as subcustodians vary markedly within and among countries. Often the choice of eligible subcustodian banks is limited and frequently the same local bank is utilized by one or mor~ U.S. global custodians. Investment Knowledge and Services Mitigating the risks involved in safekeeping of customers securities and properly :1-:.:nunting for cash movements requires strong internal controls and relatively sophisticated su1i11,Jrt systems. Specific subcustodians services are further evaluated on their ::ibility to: :,,11:r,Jl receipts :ind deliveries of securities, properly debit/credit customer cash ::iccounts. :'r ,111,,11:, collect interest payments, notify customers of proxy :ind capital change inform:1ti0,:i. ;i1:: .1:,.i track tax reclamations, minimize settlement fails and quickly communicate inf,Jrm:iti,.,n t< the global custodian. Accounting and recordkeeping procedures vary widely :im,rn~ Jg~r banks. Most subcustodians were unprepared to handle the volume of security tr:11b:1.:t1,;11s ,Jr the demands of periodic reporting required by U.S. investors. In smaller internation:11 markets, there were few local banks to choose from that met either the agent b::1111-: capitalization requirements or the demands of securities processing sophistication. Business Considerations The variability of international bank regulations and local practices places a gre:1rer emphasis on the global custodian to ensure uniformity of busines!i practices among its :ig~nt banks. Custodians should review the credit worthiness of its agent banks :ind the :1d,qu:1.::. of its internal controls including: vault storage of securities, accessibility of :iuditors l:'oth internal and external), physical and data security, and compliance with government:il regulations that control or supervise the banks. Additionally, levels of insurance -.:-01 .:>r:.1ge. financial stability, political changes (e.g. nationalization), relevant legal litigation :.111d impending regulatory legislation should be continuously monitored. Processing Standards U.S. based investors and custodians are accustomed to a relatively automated :.1nd standardized securities trading environment in this country. Our settlement pr:1ct ices :1 re interwoven within our sophisticated automated securities settlement and recordkeeping systems. Unfortunately, the investment opportunities presented in the intern:1rional n1:.1rkets have uncovered an array of disparate settlement regulations aggravated by intense!~ 111:1nu:1I recordkeeping practices. This situation has resulted in high costs of securities settlements and persistent risks to settlement failures. Compounding this lack of lutomation is the absence of a universal method of communications between banks, brokerage houses, clearing agents, and depositories. It is difficult for global custodians to receive or transmit settlement advices, security prices. capital changes or delivery instructions in a standard message format over a common communications medium. Additionally, there is no uniform agreement as to how securities should be uniquely identified using a uniform numbering convention. -4 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Cri lie al Issues in Global Custodv B. Income and Interest Collections I. Overview 7\I.-\ R-89 Portfolio managers require timely notification of interest and dividend payments including: interest rate, ex-date, record-date, and payment date. Fund performance c:rn be effl'-:tecl without prompt crediting or notification of :nterest income. Given the lack of :1 uni., ers:11 corporate action notification system, the agent banks assume a major responsibilir:in obtaining timely notification of this information and relaying it back to the glob:11 custodian. Collecting this wealth of data, verifying its accuracy, collecting the intertst payments and promptly notifying the appropriate portfolio manager is a critic:11 responsibility of the agent bank. 2. Issues Timelv Collections Dividends are collected in local markets by the agent banks (on behalf of the .:-u~r, .. _:i.in 1 :1:1j credited to the custodian's bank account on the agent books (frequently referr::d t., .1 .i 'nostro' account). Four significant issues affect the timing of dividend collection. Fi1st. agent banks must track income due on failed trades, whereby the purchaser would not h: registered with the paying bank or stock transfer agent in time to receive the inco111t.1 payment. Second, universally published sources of dividend announcements Jre not ::i, :1iL!cl:: to the global investor, which places the emphasis on the agent banks to obtain this information from local newspapers and periodicals. Third, partial payments of di,i.lends to the agent banks require lengthy reconciliations between the agent and the custodi::rn b:1nl-; to ensure that the investor is entitled to the proper payment amount. Fourth, there is frequently a delay by agent banks in promptly crediting the custodian's account on :1 timel: basis, thereby raising the probability of interest being earned on the float. Cash Accounts Although dividends and interest payments are frequently paid in the local currenc:of the security, it is likely that customers will require funds to be converted into another currenc:-. For example, funds received in one local currency could be used to pay for securities purchased in another local currency. Frequently, delays will occur when interest p:1:,ments are credited to an 'omnibus' account or cash account held in the name of the glob:11 custodian on behalf of all customers. These accounts aggregate cash received by the :igent bank across all global custody accounts. The global custodian must perform ::i det:iiled ,.;:1sh reconciliation each day to further segregate individual client balances. Unusual tr:1d i ng volumes, high income collection periods or problems encountered in the reconcili:1cio11 processes can impact the timing of income payment remittances to customers. 'Guaranteed' Income Pavments Consistent delays in receiving income payments has been a chronic problem to L' .S. b:ised investors. In the past, global custodians have dismissed this issue as an unfortun:1te :idjun-:t to investing globally. Pressed by increased competition, several global custodians h:1, e recently reexamined ways to improve efficiency in the timing of collection and remitt:inces. They have started to put pressure on their agent banks to collect and credit their accounts within stipulated time periods. These collection periods may vary by country, but most foll within ten days of the contractual payment date. f' 5 -
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11. OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLD\VIDE GLOBAL CUSTODY ISSUES Critical Issues in Global Custody C. Valuation and Corporate Action Notification I. Overview The receipt of timely and reliable security pricing and corporate action inform::ition is :1 critical function of the global custodian. Clients must be notified of impending capir:tl change information (e.g. tenders and merger offers) in time to meet election deadlines. This also requires that customer positions must be updated and verified before trade :id,. ices :-ire sent out for further customer instructions. Collecting this information is :1 prime responsibility of the subcustodian within each local market. The lack of :1 comprehensi1,e and international corporate action and pricing service requires subcustodi:rns to st:iy :1bre:1st of these events through continuous review of local publications and exchange ::innouncements. 2. Issues Exchange Rates There is virtually no uniformity in the timing and use of currency exch:rnge nres us::d t~ U.S. investors to convert foreign holdings back into U.S. dollars. The probkm is p:1rri.:ul.ir!:, pertinent to U.S. based mutual funds, who must convert their holdings b:.ick into L'S. ,J,J!IJr' to meet daily deadlines in publishing fund net asset values. The lack of standards to .:orm i either the time of day or source of exchange rates could have an imp:ict on the fund's reporting of (1) currency exposure, (2) pricing of forward contracts (using interpol:ited nt~<, and (3) U.S. dollar basis of its foreign holdings. Securitv Prices Obtaining and verifying foreign securities prices is a primarily manual and time -:onsuming task. Given the absence of a uniform security numbering convention and !Jck of uni'-ers:1!1: published sources for market prices, security valuations are often subjecti,e :ind prone to error. It is not unusual to find investment managers using multiple sources to comp:ire :1nd verify the accuracy of foreign prices. The problem becomes more acute in sm:iller :ind more exotic markets where there are little or no automated quotation services. Th is issue not on I~ impacts the investor's ability to adequately value their foreign investments, but could e:isil~ distort the value of collateral used for pledging in futures and security lending :icri,ities. Corporate Actions By far the least reliable information provided by suppliers in both completeness :ind timeliness is the notification of upcoming corporate actions. The problem is most Jc u re when investors need to make decisions on corporate actions which have specific time horizons. The difficulty of obtaining corporate action information is compounded by: o the lack of a universal security and corporate action identification system. o disparate capital change practices among countries -6 -.. ...:.. .t !'.
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11. OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES Critical Issues in Global Custody C. Valuation and Corporate Action Notification 2. Issues Corporate Actions (continued) 7 -\ I-\ R -S <") o Inability to obtain complete information from a single source within a local market o (nconsistencies in the reporting of dividend rates (gross or net of withholdingJ :unong countries The most significant issue occurs when fund managers are not notified on a timely b:1s is to act upon capital changes, such as mergers or tender offers. These situations c:rn result in financial loss to funds when investment managers fail to meet deadlines set by the se:urities registrar or transfer agent. Reliance on Agent Banks The global custodian relies heavily on its local subcustodiar. bank to provide io-::11 nnrl-.;::t prices and corporate action information. Lack of automated sources and inconsisten-:ies in procedures used across subcustodians require the global custodian to establish sep~u:ite internal departments to verify the accuracy and completeness of information rellyed by its subcustodians. -7 _/" i ...:... .: t::
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11. OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES Crilic:al Issues in Global Custodv D. Tax Withholding and Reclamation 1. Overview : \ I.-\ R s 'I Most foreign countries impose an income tax on dividends and interest payments p:iid by companies, whose securities are issued within their borders. These payments Jre received by U.S. investors net of applicable withholding taxes. The amount of tax withheld varies by country, asset type and investor tax status. Reciprocal tax treaties between the United St:1tes and most foreign governments allow U.S. investors to reclaim a portion of the tJx withheld by foreign governments. Subcustodians within each country are directed by the global custodian to file with the appropriate government authority for the reclaimable amount due the U.S. investor. The difference between the amount of tax withheld ::ind the reclJirn:.1ble portion is recognized as a direct foreign tax expense. The timeliness in receiving the reclaimable portion of the withholding tax \aries significantly by country. Certain countries notably Italy and United Kingdom h:t\e teen historically slow in remitting the reclaimable tax back to the U.S. investor. This Ins :,__,r.:e,.i some U.S. investors to reclassify this reclaim receivable as reserves (e.g. write uffi inste:1..:l j: income. The following table illustrates withholding rates for interest and dividend payments Jmong the predominant international markets. Along each withholding rate is the applicable tre'.'.::. rate accorded U.S. investors within each country. The difference between the country withholding rate and the U.S. treaty rate is the tax reclaim rate or that portion of the withheld amount which is reclaimable back to the U.S. investor. Interest Country W/H Argentina 15.75 Australia 10 Austria 0 Belgium 25 Brazil 25 Canada 25 Denmark 0 Finland 30 France 45 Hong Kong 17 Italy 12.5, 15,30 Japan 20 Korea, Rep. of 25 Luxembourg 0 Mexico 21 Netherlands 0 New Zealand 15 Norway 0 Singapore 33 South Africa 10 Spain 20 Sweden 0 Withholding Rates Dividend U.S.Treaty W/H 17 .5 30 20 15 25 25 10, 15 25 30 25 25 0 12.5,15 30 10 20 12 25 15 50 25 10 30 25 15 20 30 -8 -U.S.Treaty 15 10 15 15,0 15,5 I 5,5 5,10,15 5,10,15 15 10,15 7.5 15 15 15 15 "l : ::, _;_ .:.' # Tre:11ie-; 8 21 40 41 16 37 42 46 70 0 36 38 26 15 0 40 21 .. p 0 25 19 24
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OFFICE OF TECHNOLOGY ASSESSI\IENT SPONSORED STUDY ON CLEARING AND SETTLEI\IENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical fsi;ues in Global Custody D. Tax Withholding and Reclamation I. Overview (continued) Interest Country W/H Switzerland 35 Taiwan 20 Thailand 10,25 United Kingdom 27 United States 30 West Germany Withholding Rates Dividend U.S.Treaty W/H 5 35 35 20 0 30 25 U.S.Treaty # Treaties 15 ..,., 15 0 20 83 40 50 Source: Price Waterhouse guide 'Corpor::ite Taxes: A Worldwide Summary", 1988. 2. Issues 7 \f .. \ R 8 9 The tax withholding and reclamation process for non-residents presents three distin.;t :ir::1~ of concern; ( 1) staying abreast of t::ix law changes, (2) promptly filling for tax recl:tims :uL~ (3) determining the appropriate amount of time before reclassifying reclaim receivables :i:: reserves. Staving Abreast of Tax Laws Tax treaties between the United States and foreign governments invariably expire :ind :ire subsequently redrafted. Global custodians must stay in close contact with foreign government tax authorities to ensure that proper rates are being applied by their subcustodians for subsequent filing of tax reclaims. Asset category -Dividend payments are generally taxed at a higher rate th:in interest payments. Company tax status Certain industries or companies can have reduced withholding r'.ltl'S Investor tax status Investment companies can apply for tax exempt status or negoti:ite individually for a lower withholding rate. Debenture characteristics Taxes on interest payments can depend on the ye:u of the issue, the length of term, the number of days to maturity, or the form of registr:ition. Relationship between company and investor tax rates -The withholding :ind. or re.:l:iim amounts can depend on the amount of taxes the company had already paid on the distribution. Investor's percent ownership of the company -If the investor owns a certain percent:ige of the company. the tax rate can be reduced. Treaty renegotiations -Even when both the withholding and treaty rates are known for :1 certain income distribution, renegotiations occur and can change the rates retroactively. -9 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical fssues in Global Custodv D. Tax Withholding and Reclamation 2. Issues Both withholding and treaty rates are based upon a number of factors, such as: Applying for Tax Reclamation -:-\I -\ R S '' Procedures for filling for tax reclaims and the elapsed time encountered before p::i~ 111ents :u-:.> made vary dramatically by country. While countries such as Switzerland and \\'esc Glrm::in :, have been known to refund tax reclaims within one to six months, other countries. mosc notably Italy and the United Kingdom are notoriously slow in processing claims. In t'::icc. Italy has rarely processed and -:iaid a claim for withholding taxes. From a financial statement standpoint, the filing of the tax reclaim represencs :in :1dditi,Jn:il income receivable owed the U.S. investor. This receivable is subject to periodic re, ::lu:Hi~-11 at the current exchange rates. Since the receivable could remain on the in\estors L,_,,;L: t._ r prolonged periods of time (frequently years), the U.S. dollar value of the origin:11 t:1, re.:i:lim receivable could change dramatically. The longer the tax reclaim receivable rem:i1ns outstanding the greater the currency exposure is to the U.S. investor. Determining Reserves Eventually even the most optimistic investors must realize that the likelihood of re.:t'i, ,r.g :i tax reclaim diminishes over time. It is suggested that the investment m:in:iger consult .\ ich the fund's auditors to determine when the appropriate time has transpired to recl:1ss 11~ the t:ix receivable as a reserve or "write off". Clearly, this judgement is based upon hiswri.::1! experience within each foreign country. -10 -~ 1 ''.' ~~"-
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES 11. Crilical Issues in Global Custodv E. Sarekeeping I. Overview 7-\I.-\R-89 The primary role of the global custodian is to ensure that securities held by their cus romers are properly safegJJarded and maintained in a secure location. Actual safekeeping of securities in a location where they are traded is preferable to transferring certificates back to the United States. This minimizes the likelihood of {I) securities being lost or stolen. (: 1 additional postal and insurance charges and (3) settlement failures due to del::iys in deli, er:, of certificates on settlement date. The responsibility of safeguarding securities in each local market is undertJken b> the :1g:11t bank. The global custodian, through its worldwide communications network. e:isily i:11~::1.:t~ with its agent bank to ensure that securities are properly handled :ind controlled. bu:1:1.:~ of securities can be made in either certificate or book-entry form. 2. Forms of Delhery Registered and Bearer Certificates Securities issued and delivered in physical certificate form can either be (I) register\.'.! i:1 ,h~ name of the owner or (2) issued in 'bearer' form, where ownership is determined b:-rh: ~;..::1! possession. Registered certificates are the safest form of ownership since certific::ites .:::!1 only be transferred using a mmdard transfer deed authorized by the owner or its :ig:nr. It is common practice for global custodians and their agent banks to register cerrific::ttes !n .1 nominee name (assigned to a custodian bank) which corresponds to a specific custo111-:r. Certificates along with the approp1 :ate transfer forms are forwarded to the stod registn: .r transfer agent for registration into the nominee name. The use of this type of ..:errifi.::He :~ prevalent in the United States, United Kingdom, Japan, Hong Kong, AustrJli::i. Sing:ip,Jr~ .111-.! r-.-talaysia. Book Entrv The term 'book entry' refers to an automated and certificateless system of recording beneficial ownership of securities. In the United States, several book entry depositories h:1._ e been established such as; the Federal Reserve Bank for U.S. treasury issues, Depository Tru~t Company (OTC) for equities aiid some types of bonds, and The Mortgage B::tcked Se.:uriti~s Clearing Corporation for mortgage-backed securities. Overseas book entry depositories are located primarily in Europe. These institutions :ir\.' owned by banking and brokerage concerns within a given country. Within Europe. ne::irl:, 80% of all outstanding Euroissues are held with CEDEL or Euro-Clear. These internJtiornl clearing organizations will either deposit (I) physical certificates with custodian bani-.~ in different countries or (2) through book-entry systems with national central depository organizations. Securities can be held in 'collective safekeeping', whereby specific cerrific::ite numbers are replaced with an automated recordkeeping system. This permits tr:rnsfors of securities between accounts without physically moving certificates. 'Individual' safekeeping in non-fungible accounts (i.e. where physical certificates are issued to each depositor J is possible in certain countries for clients of custodian banks. This method is more cost!\ th:111 book-entry and is used sparingly in cases of non-fungible issues or when required by ioc::il regulations. ,. -11 -
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'7 -\ I -\ R -S () OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES 11. Critical Issues in Global Custodv E. Safekeeping 3. Book Entry/Central Depositories Countrv Australia Austria Belgium Brazil Canada Denmark Fed. Rep. Germany France Hong Kong lta I y Japan Luxembourg Mexico Netherlands Norway Singapore South Africa Spain Sweden Switzerland United Kingdom United States ~Issues Delavs in Registration Central Depositories/Clearing Agencies None Werpapiersammelbank (OeKB-WSB) C.I.K., Euro-Clear Rio de Janeiro, San Paulo Stock Exchanges Canadian Depository for Secur. Ltd. (CDS) Vaerdipapircentralen (VP-Centralen) Kassenvereine SICOVAM None (proposed, 1990) Banca d'ltalia, Monte Titoli S.p.A. Japan Securities Clearing Corp. (JSCC), Bank of J -\fl-\, CEDEL INDEVAL Necigef None None None None Vardepapperscentralen VPC AB SEGA SEPON, Central Gilts Office (CGO) DTC, MSTC, Phila. Trust Co., PSDTC, FRB .. Delays in registration of physical certificates by either the agent bank or tr::insfer ::igent c::rn lead to potential difficulties in meeting delivery deadlines if the security is subsequently sold. Additionally, registration of certificates near a corporate action or dividend record date can frequently lead to missed notifications or interest payments. In these in,1:111-.;es. ti,:: agent bank must file a market claim to the previous owner (or his agent) of the se.:urit~ to obtain the dividend or new shares. Risks in Bearer Certificates Bearer certificates are payable to the holder. This method of physical ownership f:1-:ilit::1tes the transfer of certificates, since ownership is synonymous with physical possession. It is extremely difficult to prove ownership if the securities are lost or stolen in tr:insit. This requires the investor to pay additional fees for insurance to cover the potenti::11 for il)~s. -12 -r
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical Issues in Global Custody E. S:irekeeping -4. Issues (continued) Book Entrv Systems Central depositories employing book-entry systems are not prevalent outside of Europe (with the exception of Japan). Even among the various European depositories there is no ..:oncensus on how to identify securities using a common numbering/identification scheme. This l:ick 0f uniformity makes it particularly difficult for global custodians and their agent b:inks to commonly identify securities across international markets. Securities Lending Global securities lending has incre::ised significantly in the p::ist ye::ir prim::irily with J:1::1:1r1~~_. stocks. The attractive returns earned by funds are used to offset the high glob:1! ..:us:~..!:. costs. U.S. investors will lend securities through the custodians agent bank :ind r;;>::i.-: collateral (usually cash, U.S. Tre::isury bonds or letters of credit) in return. The k,.: :>. .! securities are removed from the depository or agent bank v::iult :ind subsequent!~ r:::i:,:~: .: in either registered or bearer form. Although the investor remains the leg:il 0\1 ner .;r !1: securities, the transfer of title introduces two significan~ risks. First, di\ idends or int;;>r~s: payments declared during the term of the loan will be paid to the borrower. This requ:r!~ the agent bank to tr:ick and file claims for income rightfully due the investor. Se..:onJ. changes in market or currency value will trigger a corresponding incre::ise or decre:i~e in !::.> value of the collateral. ,. J 1 : -, i 3 --.....
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Criric:11 Issue, in Global Custodv F. Settlements I. Overview Security settlement is the process by which c:ish is exchanged for securities. The el:1pc;ed time between the date of purchase/sale (referred to as the trade date) and the d:ite p:1~ ment is exchanged for legal ownership of the security (e.g. settlement date) is referred to Js the 'settlement period'. This elapsed time is necessary to allow brokers :ind their respe.:ti\ e custodians to issue tr:ide confirmations and delivery instructions in prep:ir:ition for settlement of funds :ind securities. Settlement periods :ind practices governing 'good delivery' v:iry by country. The r:?L:ti.,el~ smooth oper:ition of U.S. m:irkets owes much of it success to sophistic:ited centr:il .:l-.':mng systems which interface directly with book-entry depositories :ind custodi:in netw0d, Overall, the U.S. m:irket employs a st:ind:udized method of settling securit~ tr:ins:1.:::-,::; This lies in sh:irp contr:ist to overse:is markets which l:ick both st:ind:ird settlement ;'r :1.:r1.::.>s Jnd sophistic:ued networks and support systems. Compounding these problems :tr:.> differences in time zones :ind l:inguage b:irriers. The explosion of overse:is in.,!-t ::~ ~ :: s !,. U.S. pension and mutu:il fund m:ingers since 198~ h:is overwhelmed loc:il .:le:1r:1r..:-: .1:: .! settlement systems, which :ire prim:irily p:1per b:ised. ?. Impact or Overseas Settlements In contr:ist to the 2-3 percent f:iil rate of New York Stock Exch:inge tr:ides JnJ th:: r::::::.-i_. low costs incurred in domestic settlements, overse:is tr:iders frequently incur :i -H} f .: ii ~:i :~ with single security tr:ins:iction charges re:iching upw:irds to 150 b:isis points. Tht.'~;: .:t::irg~c:in often include exch:inge fees, st:imp duties, loc:il t:ixes :ind custody h:indling .:h:ir~::F:iilure to settle tr:ins:ictions on time presents additional costs to investors through :!:. imposition of pen:ilty fees (e.g. Sp:iin), reduced liquidity :ind lost opportunit~ in u1:!1:-:11g either :inticip:ited or previously committed funds. These problems :ire so per\:lSi\e !!ut !hi.' Securities Industry Associ:ition h:is taken an :ictive role through its lntern:ition:11 Oper:iri,Jns Association (SIA) division to develop global solutions to these problems. J. l\lerhods or Settlement Securities can settle in one of two methods; delivery versus p:iyment or settlement 111 non local currency. Deliverv versus pavment Delivery of securities versus payment is the standard method of security settlement useJ in the United St:ues. This pr:ictice is reenforced by the New York Stock Exch:inge Rule 3g governing the rules for payment and delivery periods. Within :a foreign context. this meth,J,I works as follows; a U.S. investor pl:aces :an order with a loc:al (foreign) broker to purch:1se :i U.K. security. The U.S. broker sends instructions to the loc:il broker to deli,er securities ,Jn settlement d:ite to the global custodian. The global custodi:in (based upon simil:ir instructions) receives the securities in exch:inge for p:ayment in U.K. pounds. This is the most predominant payment method used in international m:arkets. 14 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY O~ CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES 11. Crilkal lssYCs lo Global Cusrody F. Senlemenls J. l\lelhods or Senlement (continued) Non-local Settlements "' -.\ I -\ R 8 ) Some investment manasers prefer to execute a foreisn security trans3ction with :i brnker for settlement in his own currency, rather than local currency. This method is frequently used in cases where U.S. investors arranse a foreign security transaction with :i L'.S. bro~~r. whi.:h is paid for in U.S. doll:irs. The U.S. broker in turn, executes the tr:ide with his -:ounterp:in broker in the loc:il market and pays for the security in local currency, thereb~ :issuming th~ foreign exch:inge exposure. On settlement date; the U.S. broker receives payment in L" S. doll:irs from the custodian. The loc:il broker is instructed to deliver the securities w !hl' 3Sent b:ink on beh:ilf of the U.S. investor. The 3gent b:ink in turn will recei\e th~ ~.:.:uri::, without the custom:iry exch:inge of p:iyment. -' Issues Risk to u .S, Investors U.S. money m:in:igers, brokers 3nd custodi:ms find it difficult to e:isily m:ike thl'ir '.\ .::, through a worldwide environment of conflicting settlement regul::itions :ind -:ustoms .. 1thi :intiquated or nonexistent technology. The incidences of tr::ide fails in some -:ountril.'s (notably Italy, Spain :ind France) :ire so prevalent, th:it some fund m:in::igers h:t\ e :il::rndon~ .! these markets :iltogether. Even the United Kingdom experienced serious problems fl)l!o\\ ing signific:int volume incre:ises in 1987. Sever:il custodi:ins predict th:it the Hong Kong :rn,l Singapore will be the next m:irkets to experience signific::int settlement del:iys if \ olumes dram:itic::illy incre:ise. For U.S. investors, inefficient cle:iring :ind settlement pr:ictices gener:ite dire-:t loss~s \\ hit. the cost of cle:iring :i security in the United States is me:isured in cents, corresponding charges in overseas markets c:in re:ich S200, or more in c:ises where :i tr:ide fails to s~ttle. incurring both broker interest and stock exchange charges. The incidences of trade f:iilures will inevitably incre:ise :is investors seek even more exotic markets such :is Th::iil::ind, the Philippines, Chile, India and New Guine:i. It is likely th:tt these markets could repe:it New Zealand's experience in 1986, when volume surged ~80 percent forcing the exchange to close for six days to catch up on p::iperwork. SeUleroenr Concensus Settlement problems in intern:ition:il securities inv:iri:tbly confront the lack of st3ndardization in communic:iting instructions to overse::is p:irties. The issues :ire n01 in the actual transmission of d3t3, but r:ither in the need to intelligently route, process. -. eri:\. tr:insfer :ind store security trans3ction information :imong the particip:ints to th~ ~r:i,ll. IS r 1 ... IJ \..
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical Issues in Global Custody F. Settlements -' Issues Settlement Concensus (continued) ".' -\ 1.-\ R -~ iJ The International Society of Securities Administrators is an organization established by multin::itional banks to promote efficiencies in securities processing. Other industry groups. such as the lntern::ition::il Operations Association (JOA) and the SIA in conjunction with private clearance and communications concerns (e.g. ISCC, FITEL, SWIFT) are indepenJ~ntl:, trying to forge a worldwide standard for securities settlement and clearance practices. Clearly, this emphasis by U.S. investors to "Americanize" world markets has not been universally accepted by the major foreign exchanges. A truly global market can onl~ o.:.:ur when the issue of seitlements has been standardized throughout the international m::irk~ts. (n developing alternatives to the current problems with O\'erseas settlements two issut', quickly surface. First, a standard message format(s) should be adopted which pro, ick' J uniform method of communicating cash settlement and delivery instructions. s~.:ond. !,_;_\:l communications networks used by depositories, clearing agents, brokers :tnJ glob:11 .:ust,.:,diJ::, should be c::ipable of transferring information and facilitating interaction :1mo11g tr:1d, participants. .. Securitv Identification Compounding the settlement problems is the absence of a universally recognized st:trhl:lrd -Jt' security identification. Unlike the United St::ites, where CUSIP number is the ::ic::ept~d f,")r:11 of specifically identifying securities, overseas exchanges use a variety of numbering conventions. Although there have been efforts to create a universal identifier, such .1s th~ International Securities Identification Number (ISIN), there has been no concensus rt'J.:h~...I by the global exchanges. The IS(N numbering st1ndard preserves the U.S. stand:trd CL.SIP format (9 digits) by preceding the number with a two letter country code and ::ippending :1 check digit for p::irity. Although (SIN is g:iining support from SWIFT. NSCC. ISCC. \lid'-'~~. Securities Clearing Corp., Euoro-Cle:ir and Cedel, it is not widely used. SEDOL ( St~~--k Exchange Daily Official List) the standard used by the International (London) Stock Exchange is used prim:irily by money managers and global custodians in the L'nited St:tt~~-On July 16, 1987 the Depository Trust Company (OTC) issued a memor:rndum to its u5:.'rs describing the implementation of an International (nstit'Jtional Delivery (HD) system. Th:.' initial stage of this system will provide a mechanis~ for brokers and custodians to electronically communicate settlement instructions and receive/deliver instructions. However, the system will not support any automated linkages to foreign cle:tring :ind depository organizations. 16 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical Issues in Global Custodv G. Information Technology I. Overview Securities information systems for Global Custody can be grouped into three distinct yet interrelated components: (I) trade capture, (2) settlement and clearance and ( 3) safekeeping and accounting. Using a rather simplistic approach, the interplay of these systems will work in the following manner. Trade capture systems control the entry of transaction data by th~ broker or investment manager providing the initial source for security information such :15: security description, net proceeds, customer, contra broker, settlement loc:i t ion :ind ~lt.s i g 11:1 r.',! custodian. This information is passed to a settlement/clearance network (e.g. ISCC. FITEL. SWIFT, DTC-110), which reformats the data for transmission through a communic'.ltiuns network to the overseas clearing bank, depository and global custodian. The clearing t:rnh acknowledge the transaction as authorization to move funds to settle the trade. The depository in turn, is instructed to receive or deliver securities on behalf of the customer. The global custodian posts the information to its safekeeping records and upd'.ltes the customer's holdings. Issues Svstems Integration A major challenge to U.S. global custodians is the need to upgrade existing s'.lfeke~pin :11:.: accounting systems. This situation is even more imperative for their agent b:inks throughcL:t the world. The ultimate goal is for the custodian and its client to be in const:int re:il tim~ contact with each other with reg:ird to all relevant information such :is. the progress of :i trade or dividend payment. Additionally, the custodian should be capable of inst'.lntly updating customer positions. Collectively, these capabilities are commonly referred to :is J "single delivery" system, which provides all customer and custodian information on one screen through a single system. Most custodians would acknowledge that their :ibility to remain competitive is based upon providing timely and accurate information '.lt a competiti, cost. This requires significant investment in the following suoport systems. Trade Capture Typically, an investment manager will instruct his custodian of a security tr:ide through manual trade tickets, which are frequently telecopied to the custodian. The tr:ide information is then provided to a Telex operator for transmission to the appropri:ite '.I.gent bank and concurrently entered into the custodian's securities accounting system. The risks inherent in this paper based approach are many; (I) lost telecopies, (~) data entry errors :ind (3) inconsistencies between Telex information and corresponding securities :iccounting d'.lt:1. The elimination of paper documents begins at the source. Custodians could provide :in automated interface between the investment manager and its back office systems. Tr'.lde data could be entered directly by the investment manager onto the custodi:in's systems. verified by the custodian and automatically routed to the agent banks and securities accounting system. -17 ., ,.. ~. _;_~~
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical Issues in Global Custodv G. Information Technology 2. Issues (continued) ~tlement and Clearance Systems 7-~lA R-89 In the United States, settlement of security trades has largely been automated through the use of depositories and clearing agents such as OTC and NSCC. The benefit of these servi.;es is the ability to ele~tronically link the distribution of trade and settlement d::it::i betwl:'en th::> various parties to the trade. The timing of settlement, methods of communic::itions :ind procedures for confirmation are uniform and widely accepted. It is unlikely that a uniform standard of settlement practices will emerge from the rn:ijor international markets in the near future. However, several industry cle:iring :igents Jnd private software companies are competing for the acceptance of a standard mecli:inisrn to communicate securities data throughout the world. The major players in this ::iren::i :-ire: Reuters "Instant Link" product, DTC's "International ID" system, Fite I Ltd.'s EQL' I:--: ET system, and the S.W.I.F.T (Society for World-wide Interbank Financial Telecommuni.;:itions; network. S.W.I.F.T. has earned the endorsement of the ISSA who has recommended :o its members (primarily global custodians) that "standard formats for securities industr;, information should be developed further, and international networks, such ::is S.\\'.I.F.T shcrtlld be encouraged to increase their support of uniform message stand::irds :-ind sysre:ns (ISSA 4th Symposium, May, 1988) Safekeeping and Accounting Svstems From the U.S. investor's viewpoint, the global custodian's recordkeeping and reponing systems are one of the most important criteria in evaluating custody services. In its rule :1s the investor's "books of record" the custodian must (I) adhere to GA.AP (Regul::ition S-:\ fr,r mutual funds) accounting standards (for custodians offeri~g accounting services), (:J pro\ ide information required for regulatory compliance, (3) maintain tax reporting d::it:i for nonexempt companies, (4) properly account for all securities held in overseas depositories :rnd 5 l maintain detailed records of all security and income transactions. Since 1985, U.S. investments in foreign securities have grown by almost S30 billion representing an approximate growth rate of 85 percent. This surge in intern::ition::il :1..;ti\ it:, has overwhelmed the capabilities of both the global custodian and their agent b::inl(s b:i..;1-: office systems to keep pace with increased trading volumes and adequately process new investment types. The initial reaction of most global custodians was to retrofit foreign processing capabilities within their existing domestic securities accounting systems. This approach was generally very difficult to implement and control, given the complexities ot foreign investments and the requirement to maintain both local and U.S. doll:ir b::ised accounting records. The number of U.S. banks offering global custody services has grown sign ific:intly in response to investor interest in foreign investments. The majority of global cusrocti:ins h::i\e actively pursued this business while racing against their competitors to buy or de\elop comprehensive multicurrency accounting systems required to support the diverse needs of investment companies, pension funds and insurance companies. As a result, glob:tl -:ustod i;1n systems continue in a transitional mode as custodians scramble to strengthen their systems capabilities. -18 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEr-.lENT OF SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Critical Issues in Global Custody G. Information Technology 2. Issues (continued) Information Services 7 \ 1.-\ R -S 9 The lack of readily available securities information. such as security prices, corpor:He action notices and fundamental data on companies, places an additional burden on the custod i:rn to provide a more information based service. Although this data is avail:ible for L' .S. se.:uriries from several sources (e.g. Interactive Data Corp., Knight Ridder and Bridge D::1t:i Ser\ ices i. information on international securities is largely left to the discretion of the glob::11 custodian. Since investment managers look to their global custodians to pro\ ide this ~l::tt:i ,Jn a timely basis the custodians must turn to either EXTEL or Telekurs to pro\ ide ::1n automated source, which is expensive and occasionally incomplete in its CO\er::1ge .. -\::Jent banks are used to augment these services, especially in smaller markets where inform:i.ci,~n i, not readily accessible or universally published. The costs incurred by the custodi::1n tJ provide this information adds to the relatively high fees charged for global cuswd~ ,l'r., i:~ There is little doubt that pressure on global custodians to provide these sen i.:,'s \\ ill dramatically increase in the coming years. Customers will expect to receive this inf1H:11:1ti,_;:1 instantly. This will be the first step in developing value-added services that will pro\ id-: real-time valuation reporting, dividend announcements. performance measuremc,nt. risk analysis, analytics and supporting graphics. Customers will be given the ability to :i.::::-ss :i1h! interact directly with their custodians records to create their own tailored investment rt'p,.i:t,. -19 -
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OFFICE OF TECHNOLOGY ASSESSMENT SPONSORED STUDY ON CLEARING AND SETTLEMENT Of SECURITIES WORLDWIDE GLOBAL CUSTODY ISSUES II. Crilic:11 Issues in Global Custody 1-1. Conclusion In reviewing the role of the global custodian and the difficulties inherent in overseas in, esting. the issues of standardization and automation are clearly the most compelling problems confronting the U.S. global investor. The U.S. securities industry is deeply committed to developing and promoting settlement :ind depository standardization throughout the major overseas markets, as evidenced by the efforts of the International Society of Security Administrators and the Securities Industry Associ:1tion. The consolidation of the European markets in 1992 should also be viewed as a positi,e step in the ongoing evolution of market standardization. Automation of global securities movement and control is the most vit:il component of efficient international markets. The state of overseas automation is antiquated :ind ineffecti, e when compared against a highly sophisticated and capital intensive domestic technology st:111d:1rd. It will be several years before the major European markets :ire capable of matching the:le'-el of automated settlement and depository sophistication that U.S. investors have come to .:',pe:r in the U.S. markets. The prospect for technology :idvances in more exotic intrrn:i.ti,rn:i.l rn:i.rk.:"ts is less encouraging. The primary concern of U.S. Investors is liquidity and protection. Increase U.S. interest in global investments will severely test the ability of international markets to keep p:ice with anticipated market demand. This expected surge in global trading volume could e.ucerb::ite efforts of foreign markets to implement both uniform settlement practices and sophistic:1ted trading technologies. Until this goal is :ichieved, the global custodian will continue to pl:i.~ :1 dominant role in ensuring that the interests of U.S. investors are adequately protected 20 -
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