The Law of Securities, Commodities and
Bank Accounts
ELGAR FINANCIAL LAW
Series Editor: Takis Tridimas, Queen Mary, University of London, UK
This important series comprises high quality monographs on a wide range of
topics in the field of financial law, hosting work by established authors of
international reputation, alongside younger and more emerging authors. The
series is synonymous with original thinking and new, challenging research. The
subjects under consideration range from financial services law, through
securities regulation, to banking law and from financial fraud, through legal
aspects of European Monetary Union and the single currency, to the legal
workings of international financial institutions.
Titles in the series include:
Law and Corporate Finance
Frank B. Cross and Robert A. Prentice
Secured Transactions Reform and Access to Credit
Edited by Frederique Dahan and John Simpson
Financial Regulation in Crisis?
The Role of the Law and the Failure of Northern Rock
Edited by Joanna Gray and Orkun Akseli
Law Reform and Financial Markets
Edited by Kern Alexander and Niamh Moloney
Regulating Credit Rating Agencies
Aline Darbellay
The Law of Securities, Commodities and Bank Accounts
The Rights of Account Holders
Marek Dubovec
The Law of Securities,
Commodities and Bank
Accounts
The Rights of Account Holders
Marek Dubovec
Senior Research Attorney, National Law Center for
Inter-American Free Trade and Visiting Professor,
James E. Rogers College of Law, University of Arizona, USA
ELGAR FINANCIAL LAW
Edward Elgar
Cheltenham, UK + Northampton, MA, USA
© Marek Dubovec 2014
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system or transmitted in any form or by any means, electronic, mechanical
or photocopying, recording, or otherwise without the prior permission of the
publisher.
Published by
Edward Elgar Publishing Limited
The Lypiatts
15 Lansdown Road
Cheltenham
Glos GL50 2JA
UK
Edward Elgar Publishing, Inc.
William Pratt House
9 Dewey Court
Northampton
Massachusetts 01060
USA
A catalogue record for this book
is available from the British Library
Library of Congress Control Number: 2013954380
This book is available electronically in the ElgarOnline.com Law Subject
Collection, E-ISBN 978 1 78254 902 4
ISBN 978 1 78254 901 7
03
Typeset by Columns Design XML Ltd, Reading
Printed and bound in Great Britain by T.J. International Ltd, Padstow
Dedicated to Boris Kozolchyk
Contents
viii
xi
Preface
List of abbreviations
Introduction
PART I
1
SECURITIES ACCOUNT RELATIONSHIPS
1. Introduction to Part I
2. Securities account relationships
3. Transfers of intermediated securities, finality and security
interests
4. Summary of Part I
PART II
21
46
68
81
BANK ACCOUNT RELATIONSHIPS
5. Introduction to Part II
6. Bank account relationships
7. Funds transfers, finality and security interests
8. Summary of Part II
PART III
87
113
132
153
COMMODITY ACCOUNT RELATIONSHIPS
9. Introduction to Part III
10. Commodity account relationships
11. Commodity transfers, finality and security interests
12. Summary of Part III
159
187
202
218
Conclusion
Index
222
233
vii
Preface
This book originated out of a doctoral thesis I wrote at the University of
Arizona, James E. Rogers College of Law. The thesis, originally completed in the summer of 2009, has been updated and enriched numerous
times with new material, however the focus, substance and analysis have
not changed. This book examines legal aspects of the relationships
between intermediaries and their customers based on securities, bank and
commodity accounts. Initially, it was the transformation in the holding of
securities to an intermediated system that drew my attention to the topics.
Realizing the wealth of literature that already existed at that time, and the
many more books and academic articles written since then on the subject,
I decided to focus my writings on the comparison of the structure, rights
in, transfers of, and security interests over securities, funds and commodity contracts held in accounts.
For quite some time both funds and commodity contracts have been
held in accounts maintained by intermediaries. More recently, traditional
security certificates have been largely replaced with entries in electronic
accounts. The holding of these assets in accounts complements their
trading, which has also been brought onto electronic platforms. Accordingly, securities and commodity contracts are no longer issued and
exchanged for funds in their physical form. Rather, intermediaries
complete transfers by entries to bank, commodity and securities accounts.
This account-based nature of these holding systems brought to light a
number of legal issues and highlighted the inadequacy of laws that
facilitate transactions completed by physical delivery of assets. The
nature of rights associated with these assets has also been affected, most
prominently for securities held in accounts. The account-based nature of
assets permeates all aspects of the holding, including clearing and
settlement of the transaction, the transfer between customers and the
granting of security interests to creditors. These aspects are the primary
focus of this book.
This book not only compares the three major account-based systems
but it does so from a comparative law perspective. While developed
countries have established efficiently functioning account-based systems,
this is not the case in the majority of developing countries that are yet to
viii
Preface
ix
implement or modernize their accounts holding systems. This is true not
only in terms of the technological infrastructure of such systems but also
in terms of the governing legal framework. In order to remain competitive in the global marketplace and increase the cost-efficiency of commercial transactions as a whole, developing countries should strive to
ensure that their accounts systems reflect modern technological and legal
standards. Their successful functioning also requires an adequate regulatory framework governing the conduct of all participants. This book
addresses neither the technological nor regulatory aspects of the three
account-based systems but it is limited to the commercial law aspects of
their operation.
My foremost debt is to Boris Kozolchyk, who inspired me to write on
this topic and who subsequently chaired the doctoral committee for my
original thesis. The other two members of the committee, David Gantz
and Dale Furnish, provided invaluable guidance and suggestions that
enriched not only the content of the thesis, but also its structure and flow
of ideas. José Maria Garrido and Bill Henning provided insightful
criticism along the way and Elizabeth Pocock, fellow attorney at the
National Law Center for Inter-American Free Trade, assisted immensely
in the final stages of preparing the book for publication, for which I am
very grateful. In discussions, many others have made me understand the
issues covered in this book further. I would also like to thank my
employer, the National Law Center for Inter-American Free Trade, for
making it possible to enroll in and obtain the doctoral degree while
maintaining full-time employment. Lastly, and of no less significance, I
would like to thank my wife Mariya and son Ivan. That being said, all
and any errors contained in this book are solely my own responsibility.
I hope that this book will foster a better understanding of each of the
types of accounts examined and the nature and scope of the differences
among them as well as their governing legal regimes. Even though this
book examines only the fundamentals of account-based systems, it may
inspire legislators to re-think their approach to regulating account-based
rights and thus contribute to reform and modernization of this area of the
law. Legal reforms designed to facilitate commercial transactions have
proven to be an important driving force of economic development. The
ability of participants in a commercial marketplace to complete their
transactions expeditiously, at a low cost and with minimum risks fosters
economic development by increasing the revenues of businesses and
employment as well as by reducing operational costs.
My main objective was to identify the underlying principles that
should be embodied in modern legislation underpinning the law of
accounts. Many of these principles are common to all three accounts
x
The law of securities, commodities and bank accounts
systems but some exhibit peculiarities. This identification process and
analysis of the underlying principles is an attempt to conceptualize the
emerging law of commercial accounts. This conceptual framework
should assist the reader in understanding this area of law, facilitate its
evolution and contribute to the modernization of legal frameworks in
need of reform.
Abbreviations
BM&F
BMV
CBLC
CBOE
CBOT
CCP
CEDEVAL
CEVAL
CFTC
CHIPS
CME
CSD
Deceval Reglamento
DTC
DTCC
DVP
ECB
EU
EU Financial
Collateral
Directive
EU Regulation
648/2012
EU Settlement
Finality Directive
EuroCCP
Brazilian Mercantile and Futures Exchange
Bolsa Mexicana de Valores (Mexico)
Brazilian Clearing and Depository Corporation
Chicago Board Options Exchange
Chicago Board of Trade
Central counterparty
Central de Depósito de Valores (El Salvador CSD)
Central de Valores (Costa Rica CSD)
Commodity Futures Trading Commission
Clearing House Inter-Bank Payments System (US)
Chicago Mercantile Exchange
Central securities depository
Resolución 0816 del 26 May 2011 emitida por la
Superintendencia Financiera de Colombia,
Reglamento de Operaciones Deceval S.A.
(Colom.)
Depository Trust Company (US)
Depository Trust & Clearing Corporation (US)
Delivery-versus-payment
European Central Bank
European Union
Council Directive 2002/47/EC on Financial
Collateral Arrangements, 2002 O.J. (L 168)
Council Regulation 648/2012 on OTC Derivatives,
Central Counterparties and Trade Repositories,
2012
Council Directive 98/26/EC on Settlement Finality
in Payment and Securities Settlement Systems
1998 O.J. (L 166)
European Central Counterparty Limited
xi
xii
The law of securities, commodities and bank accounts
EuroCCP Rules
European Central Counterparty Limited Rules (1
October 2012)
Geneva Securities
UNIDROIT Convention on Substantive Rules for
Convention
Intermediated Securities (2009)
German Banking Act Gesetz über das Kreditwesen, 9 September 1998
(Federal Law Gazette I S.2776)
Hague Securities
Convention on the Law Applicable to Certain
Convention
Rights in Respect of Securities Held with an
Intermediary (2006)
HTA
Hedge-to-arrive
IADB
Inter-American Development Bank
IMF
International Monetary Fund
Indeval Regulations Indeval, Reglamento Interior
IOSCO
International Organization of Securities
Commissions
LVFTS
Large-value funds transfer systems
MexDer
Mercado Mexicano de Derivados, S.A. de C.V
(Mexico)
Mexican Securities Ley del Mercado de Valores [LMV] (Securities
Market Law
Market Law) Diario Oficial de la Federación
[DO], 30 December 2005
MiFID
Council Directive 2004/39/EC on Markets in
Financial Instruments, 2004 O.J. (L 145)
NS
Net settlement
NSCC
National Securities Clearing Corporation (US)
NYSE
New York Stock Exchange
OAS
Organization of American States
OTC
Over-the-counter
PSD
Payment Services Directive (EU)
ROFEX
Rosario Futures Exchange
RTGS
Real-time gross settlement
Ley
de Anotaciones Electrónicas de Valores en
Salvadoran Law
Cuenta
(Law on Electronic Entries of Securities to
on Electronic
Accounts)
Diario Oficial [DO] 57, 22 March 2002
Entries
(2002)
SEC
Securities and Exchange Commission (US)
SELIC
Sistema Especial de Liquidação e de Custódia
(Brazilian CSD)
Abbreviations
SINPE
xiii
El Sistema Nacional de Pagos Electrónicos (Costa
Rica)
SIPC
Securities Investor Protection Corporation (US)
SIPS
Slovak Interbank Payment System
SITRAF
Sistema de Transferência de Fundos (Brazil)
Slovakian Payments Zákon o platobnom styku, 19 September 2002,
Law
(Z.z. 510/2002)
Slovakian Securities Zákon o cenných papieroch a investičných
Act
službách, 9 November 2001 (Z.z. 566/2001)
(Slovk.)
SPEI
Sistema de Pagos Electrónicos Interbancarios
(Mexico)
STR
Sistema de Transferência de Reservas (Brazil)
SWIFT
Society for Worldwide Interbank Financial
Telecommunication
TARGET2
Trans-European Automated Real-time Gross
Settlement Express Transfer
UCC
Uniform Commercial Code
UNCITRAL
United Nations Commission on International
Trade Law
UNCITRAL Model UNCITRAL Model Law on International Credit
law
Transfers (1994)
UNIDROIT
The International Institute for the Unification of
Private Law
Introduction
Ordinary commercial transactions are typically concluded in two phases.
The first involves an agreement to sell and buy. For example, Steve
agrees to sell IBM stock or 100 bags of corn to Brian who in turn
commits to pay the purchase price. These agreements are composed of
reciprocal promises to deliver and pay. The second phase of these
transactions involves performance of these promises, which in this case
will be delivery of the stocks or corn in exchange for payment. This
second phase is known as settlement. Commercial transactions and
undertakings consist of these two components. First, parties agree or
promise to do something and second they execute or settle those prior
promises.
For the most part, intermediaries facilitate the completion of both
phases. Securities brokers execute their customers’ orders to sell IBM
stock and then credit the proceeds of those sales to the customers’
securities accounts. Banks issue letters of credit at the request of
customers and then pay the beneficiaries by crediting funds to their
deposit accounts if they present complying documents. Futures commission merchants execute their customers’ orders to purchase commodity
contracts on commodity exchanges and then credit those contracts to
commodity accounts. These intermediaries and the functions they perform have become the cornerstone of contemporary commercial transactions. Banks facilitate transfers of funds, securities intermediaries
execute their customers’ orders to buy and sell investment securities and
futures commission merchants acquire commodity contracts for their
customers. The contemporary commercial marketplace cannot function
effectively without ensuring that participants are able to undertake such
promises. Of equal importance is the need for the marketplace to be
equipped with modern legal and technological mechanisms to settle
promises, make the corresponding rights acquired upon execution of
those promises available to investors and allow investors to dispose of
such rights efficiently. Intermediaries not only play a significant role in
the first phase of commercial transactions but they also ensure that the
1
2
The law of securities, commodities and bank accounts
second phase is completed efficiently. They do so primarily by maintaining accounts for their customers, to which they make credit and debit
entries representing rights and assets resulting from transactions.
These two phases of commercial transactions are completed in different segments or ends of the marketplace. One segment, which may be
referred to as the ‘front-end’, is the market in which assets, such as
shares, bonds and commodity contracts are issued and traded. The
front-end thus involves the exchange of promises, execution of buy and
sell orders and conclusion of agreements. Historically, front-end transactions were completed in personal meetings between buyers and sellers
and later in the form of distance selling with the parties entering into
contracts remotely. These transactions are now executed at centralized
markets, including stock exchanges such as the New York Stock
Exchange (NYSE) and commodities exchanges such as the Chicago
Mercantile Exchange (CME). In these markets, assets are issued, listed
and traded among investors remotely. The front-end is the environment
for floor traders, brokers and banks that execute sell and buy orders. This
environment is based on electronic communication channels through
which orders to buy and sell securities, commodity contracts and transfer
funds are submitted and executed.
The other segment of the marketplace, referred to below as the
‘back-end’, is where transactions concluded in the front-end are ultimately settled. The back-end involves the actual transfer of assets. Unlike
the front-end, represented by transactions conducted on stock and
commodities exchanges, the back-end has remained largely ignored and
hidden from the sight and interest of investors as well as the public at
large.1 The function of the back-end is to ensure that investors will be
able to enjoy the rights they have acquired no matter how risky or safe
these rights are. The back-end is not concerned with the quality or
marketability of financial assets and its mechanisms equally process
transfers of safe instruments such as AAA-rated government bonds and
risky instruments such as junk bonds issued by low-rated corporations.
The back-end is the quiet mechanism ensuring investors that they receive
what they originally bargained for.
Entities operating in the back-end include central securities depositories such as the Depository Trust Company (DTC), central counterparties such as the CME clearinghouse and administrators of large-value
funds transfer systems (LVFTS) such as the US Federal Reserve Banks.
1
Nathalie Aubry, Regulating the Plumbing of Europe, 23(11) J.I.B.L.R. 578
(2008).
Introduction
3
These entities do not operate a trading marketplace. Instead, they supply
the technological framework in which transactions executed in the
front-end are settled and commercial assets are delivered from sellers to
buyers, debtors to creditors and vice-versa. Overall, the two segments
complement each other and their co-existence may be illustrated as
follows.
Suppose that Brian instructed his securities intermediary Morgan
Stanley to buy shares of IBM and commodity contracts for the delivery
of corn. Morgan Stanley executed his order to buy the stock on the
NYSE. Similarly, a commodities trading unit of Morgan Stanley executed
Brian’s order on the CME to buy the corn commodity contracts. Brian
received confirmation that both trades were successfully executed. Once
Brian’s orders are executed on the NYSE and on the CME, the
transactions proceed to the settlement phase, which entails the transferring of assets. The IBM stock and the corn commodity contracts will be
transferred to Brian’s securities and commodities accounts and in
exchange his accounts will be debited for the funds corresponding to the
purchase price of the stock and commodity contracts. In this illustration,
settlement is the exchange of funds for securities and commodity
contracts. Modern settlement mechanisms for such transactions do not
rely on the physical delivery of security certificates for cash or checks.
Instead commercial assets whether they are securities, commodity contracts or funds are held in accounts maintained by intermediaries and
transferred by electronic book entries to such accounts. Custody and
maintenance of securities, bank, and commodity accounts, and the
transferring of assets to and from such accounts, are all back-end
functions.
A number of differences exist between front-end trading and back-end
transfers. From the commercial perspective, the most important difference is the distinction between the discrete notions of the contract and
account relationship. While a front-end transaction is centered on a
contract to buy or sell securities or commodity contracts, the ensuing
back-end transfer is based on a pre-established relationship. This relationship exists in the form of an account maintained by an intermediary
whose rights and duties are not necessarily derived from a specific time
and transaction-circumscribed contract. For example, in the front-end, a
contract is entered into between sellers and buyers, such as when Brian
chooses to buy IBM stock from another investor who wants to sell.
Subsequently the back-end transfer creates, or more typically modifies,
the relationship between Brian and his intermediary Morgan Stanley
when Morgan Stanley credits the IBM stock to Brian’s securities account.
Although the focus of this book is on this relationship, transactions that
4
The law of securities, commodities and bank accounts
are executed in the front-end will nevertheless be explained in a summary
fashion before a discussion of the back-end functions is introduced.
Securities, bank and commodity accounts are special types of relationships that differ from other types of accounts, such as accounts receivable
or credit card accounts. The entity obligated on these commercial
accounts is an intermediary that is typically a financial institution. In
contrast, an account receivable may be owed by a retailer that has just
purchased a shipment of toasters from a manufacturer agreeing to pay the
purchase price within 90 days. Commercial accounts also hold items of
property belonging to customers that credit card accounts and receivables
do not. The quality of commercial accounts is reinforced not only by
creditworthy intermediaries but also through mandatory insurance, segregation of customer assets from those of the intermediaries and strict
regulation. For instance, banks that are authorized to maintain deposit
accounts are subject to capital reserves and securities intermediaries are
subject to the requirement to segregate customer assets from their own.
Credit card issuers are not required to segregate their customers’ assets
from their own because they do not hold any assets, and ordinary
accounts receivable are not required to be insured through mandatory
schemes.
The back-end systems for the holding and transfers of securities, funds
and commodity contracts are all critical components of the contemporary
commercial marketplace. This marketplace also includes derivatives
(such as swaps), the investment activities of insurance companies, special
purpose vehicles that purchase mortgage loans and issue mortgagebacked securities and the like. All these segments have their respective
front and back-ends. However, this book focuses only on those segments
in which the rights of participants are incorporated into commercial
accounts maintained by intermediaries and that are available to individual
investors. Analyses of the various types of securities, commodity contracts and monetary items, their functions, uses and risks are also outside
the scope of this book.
The ultimate objective of this book is to identify a set of principles that
underlie securities, bank and commodity account relationships. This book
attempts to explain how securities, funds and commodity contracts are
transferred, who account holders and intermediaries are, what the nature
of the relationship is between the two, what the connection is between
these relationships, what the rights of account holders are against their
intermediaries and how account holders may use their assets as collateral.
Another equally important objective is to provide recommendations on
reforms and modernizations of the law of commercial accounts in
developing countries.
Introduction
5
This book is divided into three Parts, which separately address the
back-ends transfers of I) securities, II) funds and III) commodity contracts. Each of these Parts will examine:
1)
2)
3)
4)
5)
6)
7)
8)
historical evolution of transactions and relationships in securities,
payments and commodities markets;
transformation from property rights in identifiable assets to intangible rights against intermediaries;
structure of holding systems where accounts are maintained;
top-level relationships between a central entity and their (clearing)
participating intermediaries;
lower-level relationships between intermediaries and their account
holders;
rights of account holders against their intermediaries;
transfers of account-based rights; and
security interests in account-based rights.
HISTORICAL EVOLUTION
Each Part includes a short history of the transaction and the particular
relationship into which it evolved. While the purpose is not to provide a
detailed historical report, some of the key developments in each area are
highlighted. It will be demonstrated that securities, bank and commodities transactions trace their roots to the era of Hammurabi, where the
first primitive securities and commodity contracts were introduced. The
historical summary then proceeds with a discussion of the particular
aspects of Roman law that had a significant impact on the evolution of
modern account-based relationships. It will be argued that modern
accounts in which intermediaries hold assets for their customers, to a
certain extent, rely on the law of deposit as developed by the Romans.
The sections on history then examine the medieval practices shaped by
merchants, primarily during the trade fairs. Many of these business
practices laid the foundation for the later development of negotiable
promises to pay and to deliver, which in turn, over time, became the
backbone of many modern commercial undertakings. This medieval era
culminated in the establishment of the first organized exchanges for
securities and commodity contracts as well as rudimentary account-based
relationships. The sections will then examine the practices of English
goldsmiths in the seventeenth century. By accepting deposits and issuing
6
The law of securities, commodities and bank accounts
receipts that represented deposited money and valuables, these goldsmiths had a considerable impact on the development of modern money
and credit.
Lastly, these sections will cover the last decades of the twentieth
century, since it was a time that witnessed a number of transformative
processes in the marketplace. Securities began to be immobilized within
central securities depositories (hereinafter CSD) and dematerialized in
the form of electronic entries to accounts maintained by intermediaries.
Balances on bank accounts gradually replaced banknotes and checks as
the primary payment mechanism in commercial transactions. Commodity
exchanges introduced new futures and options contracts and clearinghouses facilitated their holdings in accounts with intermediaries.
CHARACTERIZATION OF THE RIGHTS OF ACCOUNT
HOLDERS: THE TRANSFORMATION FROM PROPERTY
RIGHTS IN IDENTIFIABLE ASSETS TO FUNGIBLE
RIGHTS AGAINST INTERMEDIARIES
The history sections in the Introduction to each Part will set the stage for
an analysis and characterization of the rights conferred on holders of
contemporary accounts. The nature of rights held by contemporary
investors has changed alongside the transformation from a transaction
between a seller and a buyer to the established relationship between a
seller/buyer and his intermediary. Historically, sellers dealt directly with
buyers and their dealings involved direct exchanges of securities or
commodities for payment. No third party facilitated these exchanges.
These transactions involved both the trade and its settlement completed
by transferring possession of the physical securities and cash.
Nowadays, most commercial transactions involving securities and
commodity contracts, and many transactions involving goods, are not
concluded in the presence of the seller and the buyer. Instead, the parties
order their intermediaries to buy/sell securities and commodity contracts.
Intermediaries do not deliver security certificates to their customers but
credit and debit their accounts. Unlike physical delivery of cash and
certificates between two parties, in this case, intermediaries facilitate
trading, transfers and settlement. A similar transformation occurred on
the seller’s side with respect to the form of payment. Instead of receiving
cash, intermediaries credit their customers’ accounts. The bilateral transaction that previously involved an exchange of security certificates for
payment in cash has been replaced with a relationship under which
Introduction
7
intermediaries electronically transfer funds, securities and commodity
contracts. One can identify two different levels of fungibility present in
the three types of account relationships. On the one hand, securities and
commodity account holders retain property rights to their fungible assets
while bank account holders’ rights are of a contractual nature. Funds
deposited to bank accounts become ‘ultrafungible’ because the depositors
lose any property rights thereto.
THE PYRAMIDAL STRUCTURE OF ACCOUNTS
HOLDING SYSTEMS AND THE LINKAGE
Accounts relationships between intermediaries and their customers are
units in a larger structure of accounts holding systems. These systems
operate in a pyramid-like model, which typically consists of at least three
different levels.2 At the bottom of the pyramid are investors who enter
into transactions, which are reflected by credits and debits to their
commodity, securities and bank accounts maintained by intermediaries.
These individual account relationships between investors and intermediaries constitute the bottom level of securities, bank and commodity
accounts holding systems. The upper or intermediate level is populated
by intermediaries and their respective arrangements with other intermediaries and central entities. Similar to the bottom level, these arrangements are represented by accounts maintained by intermediaries for one
another. Only some intermediaries have been authorized to access central
entities, and therefore those that have not must establish a relationship
with one of these clearing intermediaries. Finally, at the top of the
pyramid are the operators of LVFTSs, CSDs and commodity clearinghouses. These central entities maintain accounts for their participating
(clearing) intermediaries. Unlike the Egyptian pyramids that were built
from stone and mud bricks, the commercial system pyramids are
assembled from intangible account relationships.
The account-based systems that involve securities, funds and commodity contracts are closely linked. This linkage is legal and, risk-based as
well as technological. Furthermore markets, central entities, intermediaries and investors are connected on a global level through modern
2
Edward Gerald Corrigan, Perspectives on Payment System Risk Reduction,
in THE U.S. PAYMENT SYSTEM: EFFICIENCY, RISK, AND THE ROLE OF THE
FEDERAL RESERVE: PROCEEDINGS OF A SYMPOSIUM ON THE U.S. PAYMENT
SYSTEM SPONSORED BY THE FEDERAL RESERVE BANK OF RICHMOND 129, 130
(David B. Humphrey ed., KLUWER ACADEMIC PUBLISHERS, BOSTON, MA, 1989).
8
The law of securities, commodities and bank accounts
communications systems.3 With the advent of new technologies, access to
various segments of the marketplace located in different parts of the
world has become almost effortless. One may buy commodity contracts
on a futures exchange established in Europe and use a US-based
intermediary to hold those contracts in a commodity account. Of course,
these connections also have the potential to expose accounts holding
systems to various risks, the most critical being systemic risk, or the risk
of the failure of one institution causing a domino effect of collapses to
the other institutions.4 Every level of the accounts holding system is
exposed to a certain degree of risk and uncertainty. While failures at the
bottom level should not endanger the stability of the entire system,
default of a critically important intermediary or the central entity may
expose the entire system to the domino effect of failures. Central entities
are typically viewed as systematically important and subject to special
regulation and supervision.5 The higher in the pyramid a failure occurs,
the higher the chances of systemic failure.6 Central entities and particularly clearinghouses are one of the systematically important connectors
3
Robert C. Merton & Zvi Bodie, A Conceptual Framework for Analyzing
Financial Environment, in THE GLOBAL FINANCIAL SYSTEM, A FUNCTIONAL
PERSPECTIVE 3 (Dwight B. Crane, Robert C. Merton, Kenneth A. Froot, Zvi
Bodie, Scott P. Mason, Erik R. Sirri, André F. Perold & Peter Tufano eds.,
HARVARD BUSINESS SCHOOL PRESS, BOSTON, MA, 1995); DALVINDER SINGH,
BANKING REGULATION OF UK AND US FINANCIAL MARKETS 24 (ASHGATE
PUBLISHING LTD., HAMPSHIRE, UK, 2007) and Peter Allsopp, Bruce Summers &
John Veale, The Evolution of Real-Time Gross Settlement: Access, Liquidity and
Credit, and Pricing, in FINANCIAL INFRASTRUCTURE SERIES: PAYMENT SYSTEMS
POLICY AND RESEARCH 10 (The World Bank, 2009).
4
Corrigan, supra note 2, at 130. The European Central Bank defined
systemic risk as ‘one institution’s inability to meet its obligations that makes
other institutions unable to meet their obligations, resulting in significant
liquidity and credit problems that threaten the stability of, or confidence in,
markets.’ Diana Chan, Florence Fontan, Simonetta Rosati & Daniela Russo, The
Securities Custody Industry, European Central Bank, Occasional Paper Series
No. 68, 34 (August 2007), available at http://www.ecb.int/pub/pdf/scpops/
ecbocp68.pdf (last visited 9 December 2013).
5
The DTC has been designated as a systemically important financial
market utility by the US Financial Stability Oversight Council, see http://www.
treasury.gov/initiatives/fsoc/Documents/2012%20Appendix%20A%20Designation
%20of%20Systemically%20Important%20Market%20Utilities.pdf (last visited 9
December 2013).
6
The Committee on Payment and Settlement Systems of the Bank for
International Settlements in its Consultative Report on Principles for Financial
Market Infrastructures 5 (2011) found that ‘… FMIs (payment systems, central
Introduction
9
for the three types of holding systems. Ben Bernanke, until January 2014
Chairman of the Board of Governors of the Federal Reserve System,
observed that clearinghouses provide one of the links that connect
individual segments of the financial marketplace and, more specifically,
that the clearing and settlement systems of commodity and securities
markets are closely interconnected with the banking system.7
THE CLEARINGHOUSE AND RELATIONSHIPS AT THE
TOP LEVEL
All three accounts holding systems for securities, funds and commodity
contracts are supported by a central entity that provides specialized
services at the top of the pyramid. The central entity may perform various
functions, including ensuring stability in the system and protecting its
participants against the risk of default. However, the primary role of
central entities is to provide clearing and settlement, also known as
post-trade services. Clearing is less glamorous than trading but is the core
function of modern commercial systems and significantly increases
market efficiency.8 Both clearing and settlement processes occur after
trades between individual buyers and sellers have been executed. Clearing is a process that involves administrative functions, such as matching
trade data submitted by intermediaries, as well as risk management that
involves, inter alia, novation of transactions.9 In contrast, settlement is
the final transfer (delivery) of assets, such as securities and commodity
contracts, in exchange for funds. Each of the three Parts in this book will
examine in detail the clearing and settlement functions.
Most securities holding systems are supported by an entity that
performs clearing and settlement functions. However, unlike in the
commodities accounts systems, a number of securities central entities do
not become counterparties to all securities transactions. In payments
securities depositories, securities settlement systems and central counterparties)
also concentrate risk. If not properly managed, FMIs can also be sources of
financial shocks, such as liquidity dislocations or credit losses …’.
7
Ben S. Bernanke, Clearing and Settlement during the Crash, National
Bureau of Economic Research Conference: Stock Market Volatility and the
Crash, Dorado Beach (16–18 March 1989) in 3(1) REV. FIN. STUD., 1990, at
139.
8
TINA P. HASENPUSCH, CLEARING SERVICES FOR GLOBAL MARKETS 1
(CAMBRIDGE UNIVERSITY PRESS, NEW YORK, NY, 2009).
9
Robert R. Bliss & Robert S. Steigerwald, Derivatives Clearing and
Settlement: A Comparison of Central Counterparties and Alternative Structures,
4Q ECON. PERSP. 22 (2006).
10
The law of securities, commodities and bank accounts
systems, the operator does not become the central counterparty to every
obligation to pay and receive payment. If Morgan Stanley is obligated to
pay one million dollars to JP Morgan Chase, the Federal Reserve Bank
will neither become the beneficiary of the Morgan Stanley credit transfer,
nor assume an obligation to pay JP Morgan Chase. Fedwire, operated by
the Federal Reserve Banks, merely credits and debits transfers to the
banks’ accounts.
Clearing and settlement in securities and commodities accounts systems entail processes not characteristic for clearing and settlement in the
bank accounts system. Furthermore, clearing and settlement of funds in
the bank accounts systems involve only the ‘cash leg’ in which one
participant makes a transfer and its bank account is debited, and the other
participant receives the transfer and its bank account is correspondingly
credited. In contrast, clearing and settlement in securities and commodities accounts systems also modify proprietary rights to securities and
rights to future delivery of commodities that are transferred in exchange
for payment. These and other differences will be further examined in the
respective Parts.
RELATIONSHIPS AT LOWER LEVELS BETWEEN
INTERMEDIARIES AND ACCOUNT HOLDERS
Intermediation is at the core of the law of accounts holding systems.10
Intermediaries perform a number of critical functions, including to:
1)
2)
3)
4)
5)
6)
7)
8)
establish and maintain accounts for their customers;
execute customers’ orders to transfer assets and funds in and out of
those accounts;
perform clearing functions for certain transactions of their customers;
provide credit to their customers;
enable third parties to perfect security interests in assets and funds
maintained in accounts;
provide advisory services;
facilitate enforcement of corporate rights embedded in securities;
and
reduce monitoring costs for customers.
10
Joseph H. Sommer, A Law of Financial Accounts: Modern Payment and
Securities Transfer Law, 53(4) BUS. LAW. 1181, 1200–1 (1998).
Introduction
11
While in developed economies intermediaries specialize in servicing
particular areas of the marketplace with a clear distinction among
securities intermediaries, commodity intermediaries and commercial
banks, in many developing countries, banks are the dominant intermediaries through which investors can access all three accounts holding
systems.11
The objects of accounts relationships between intermediaries and their
customers are fungible assets of an intangible nature, including funds,
securities and commodity contracts. Fungibility benefits issuers, obligors
and holders of these assets because assets divided into standardized units
are much easier to trade.12 These fungible assets are dealt and transferred
by values, numbers, and other measurements, and held as such in
accounts.13 One of the main objectives of this book is to explain the
nature of these relationships. All three types of account relationships
trace their roots to the law of irregular and regular deposits, as developed
by the Romans. Under the irregular deposit, ownership rights to deposited assets were transferred from the depositor to the depository, and this
deposit became the basis for modern bank account relationships. In
contrast, under the regular deposit, the depositor remains the owner and
the depository obtains ‘naked’ possession, without any rights to dispose
of the object deposited. For centuries, securities, money and commodities
were placed with intermediaries for regular deposits (custody).14 This
type of deposit presently exists in the form of safe-deposit boxes
provided by intermediaries. It will be argued below that modern accounts
holding structures now rely instead on irregular deposits because they
dispense with the appropriation of rights to specific items of property.
Gradually it became a common practice for intermediaries to commingle the property of their customers. Once commingled, the depositor
could no longer trace his rights to specific securities, banknotes or
commodities. The inability to trace rights to specific objects transformed
11
See AUGUSTO DE LA TORRE & SERGIO L. SCHMUCKLER, EMERGING
CAPITAL MARKETS AND GLOBALIZATION, THE LATIN AMERICAN EXPERIENCE 4
(STANFORD UNIVERSITY PRESS, PALO ALTO, CA, 2007).
12
Eva Micheler, The Legal Nature of Securities: Inspirations from Comparative Law, in INTERMEDIATED SECURITIES, LEGAL PROBLEMS AND PRACTICAL
ISSUES 131, 145 (Louise Gullifer & Jennifer Payne eds., HART PUBLISHING LTD.,
OXFORD, UK, 2010).
13
DAVID COX, PROPERTY RIGHTS IN MONEY 24 (OXFORD UNIVERSITY PRESS,
OXFORD, UK, 2008).
14
‘Custody’ may have different meanings and is not typically a legal term of
art. Edward H. Klees, How Safe Are Institutional Assets in a Custodial Bank’s
Insolvency?, 68(1) BUS. LAW. 103, 105 (2012).
12
The law of securities, commodities and bank accounts
the ownership into a different kind of right. For funds deposited to a bank
account, the ownership right became a contractual claim against the bank
for repayment of the funds. The bank account has become a credit
relationship. For commodities, ownership right became a co-ownership
interest in the bulk belonging to multiple depositors, and eventually a
contractual claim against the intermediary. Holders of securities have
been granted a special right (security entitlement) in some jurisdictions
that does not fit into any of the existing categories of property rights. In
contrast to this special right, many civil-law jurisdictions apply
co-ownership property concepts to the rights of securities accounts
holders.
RIGHTS AND PROTECTIONS OF ACCOUNT HOLDERS
Account holders must be provided an assurance of safety and protections
against losses that may be sustained by the improper conduct of an
intermediary. Otherwise, account holders may be reluctant to hold their
assets through intermediaries. As a result, appropriate protective mechanisms must be built into accounts holding systems. The demand for such
protective measures has been recently increased as a result of failures by
major intermediaries, including Lehman Brothers, Washington Mutual,
MF Global and the largest Colombia broker, Interbolsa S.A. The
accounts holding systems studied in this book provide a variety of such
protective measures, including regulation and capital reserve requirements that in combination create a safety net for the rights of account
holders.15 The safety net is composed of different components in each of
the three accounts holding systems.
The primary safeguard for customers of commodity and securities
intermediaries is the requirement to segregate the customer property from
that of the intermediary. In other words, the intermediary may not
maintain its own securities and commodity contracts in the same account
with the securities and commodity contracts of its customers. Customers
also regularly deposit funds with their securities and commodity intermediaries for trading purposes. Similarly, such funds must be segregated
from the funds belonging to intermediaries. In contrast, bank customers
do not have the right to demand that the bank segregate their funds from
its own funds because upon deposit the bank becomes the owner of such
15
Jerry W. Markham, The CFTC Net Capital Rule – Should a More
Risk-Based Approach be Adopted?, 71 CHI.-KENT L. REV. 1091, 1098 (1996).
Introduction
13
funds.16 Upon deposit, there is no longer a distinction between ‘their’ and
‘the bank’s’ own funds. As a consequence of segregation, commodity and
securities intermediaries are obliged to maintain the same quantity of
securities and commodity contracts that are credited to the accounts of
their customers. On the other hand, banks are required to maintain only
fractional reserves against the deposits of their clients, which allows them
to use deposit funds for loans and similar activities.
Insurance of claims is the primary safeguard for bank account holders,
yet it is only a secondary safeguard for the holders of securities accounts.
In the case that insurance coverage is insufficient, bank account holders
have a claim against the general assets of the intermediary. In other
words bank depositors’ uninsured claims will be satisfied from the
general assets of the bank within the class of unsecured claims. The
rights of securities account holders are protected first by segregation and
second, in the case of shortfalls, by insurance. If insurance does not cover
all losses, the accounts holders then have a claim to pro-rata distribution
of the intermediary’s own unencumbered assets of the relevant issue.17
Their claims are secured to the extent that the intermediary maintains
securities. As for the rights of commodity account holders, their primary
safeguard is the segregation of assets. In the past, legislative proposals to
institute mandatory insurance protecting customers of commodity intermediaries have been repeatedly rejected in the United States. However,
such proposals have been recently revived in the aftermath of a number
of failures by commodity intermediaries such as MF Global. Additionally, absent of any insurance coverage, when the claims of commodity account holders have not been satisfied in full, holders may assert
their claims pro-rata with other unsecured creditors against the commodity intermediary.
Accordingly, rights of securities accounts holders are protected by
segregation, secured claims against the intermediary’s assets and insurance. Rights of commodity accounts holders are also protected by
segregation and unsecured claims against the intermediary’s assets, but
remain uninsured. Finally, rights of deposit accounts holders are protected by insurance and unsecured claims against the insolvent bank’s
general estate but their claims do not relate to any segregated assets.
16
Harry Boul, Money in the Bank Is Not Money, and It’s Not in the Bank,
XXXI(3) AM. INSOL. INST. J. 22, 23 (2012).
17
Joseph H. Sommer, International Securities Holding and Transfer Law, 18
ARIZ. J. INT’L & COMP. L. 685, 695 (2001).
14
The law of securities, commodities and bank accounts
TRANSFERS OF ACCOUNT-BASED RIGHTS
Since settlement of contemporary commercial and financial transactions
does not rely on the physical delivery of money, security certificates and
actual commodities, the law must recognize an alternative transfer
mechanism that ensures that the transferee effectively acquires the
bargained-for rights, and that those rights are immune from the claims of
third parties. It will be demonstrated that the common transfer mechanism for all three types of accounts systems is book entries. Rights to
securities, funds and commodity contracts are effectively acquired and
transferred by book entries made by intermediaries to the accounts of
their customers. However, since book entries are merely accounting
functions, the law must provide for the consequences of such entries.
Credits and debits mechanically transfer securities, funds and
commodity contracts as well as modify relationships of customers with
their intermediaries. From the mechanical perspective, credits and debits
do not transfer identifiable assets such as specific banknotes or security
certificates. Instead, ‘the title to the value’ is transferred, rather than a
title to an identifiable asset or to the money itself.18 These transfers
modify the relationship between the customer and his intermediary. From
the customer’s perspective, the value of such relationships may increase
or decrease over time as transfers are credited or debited to the account.19
Alan Greenspan, the former Chairman of the Board of Governors of the
Federal Reserve System, explained that when a funds transfer is completed, the monetary claim of the transferor against the bank is reduced
and almost simultaneously the monetary claim of the beneficiary against
its bank is increased.20
From a legal perspective a book entry causes rights or value to be
transferred by novation. Book entries to accounts do not rely on the
traditional concepts of assignment and negotiation because of the phases
in which book-entry transfers are effectuated. These phases are: 1) the
extinguishment (modification) of the original obligation and 2) establishment of a new obligation (or modification of the already existing one).21
COX, supra note 13, at 165.
Book entry transfers reflect changes in liability to the account holder.
PHILIP R. WOOD, SET-OFF AND NETTING, DERIVATIVES, CLEARING SYSTEMS 323
(2nd edn., SWEET & MAXWELL LTD., LONDON, UK, 2007).
20
Ibid., at 270 and Alan Greenspan, Remarks on Evolving Payment System
Issues, 28(4), Part 2, JOURNAL OF MONEY, CREDIT AND BANKING 689, 691
(1996).
21
J. B. Ames, Novation, 6(4) HARV. L. REV. 184, 185 (1892).
18
19
Introduction
15
The negotiability doctrine is inapplicable to transfers in modern accounts
holding systems because of the absence of writings. Yet the goal of
negotiability, which is to free the asset of conflicting claims and liability,
remains important for intermediated account-based systems.22 Professor
Rogers, the Reporter for the 1994 revision of the Uniform Commercial
Code (UCC) Article 8, noted that negotiability rests on the assumption
that abstract rights are embodied in writings that are physically held or
delivered to the claimant of these rights.23 In contemporary systems
rights are no longer transferred by delivery of writings. Professor Rogers
added that ‘one must constantly bear in mind that what matters is not the
instruments themselves, but the abstract rights represented by the instruments, and that the objective is to design an effective system of title
recognition for the abstract rights’.24 Abstract rights have been divorced
from writings and have become embedded in securities, bank and
commodity accounts, which provide an effective system of title recognition.
In addition to the recognition of novation, laws and rules that govern
securities, bank and commodity accounts systems must clearly identify
the moment at which the transfer order, as well as the actual book entry,
becomes final and irreversible.25 Finality of transfer is one of the most
important features in all three accounts systems. The high velocity of
transfers and the millions of transactions that are processed on a daily
basis require clear and predictable rules of finality. Each Part of this book
will examine the finality rules present in the particular accounts holding
system.
22
Charles W. Mooney, Jr. & Hideki Kanda, Core Issues under the UNIDROIT (Geneva) Convention on Intermediated Securities: Views from the United
States and Japan, in INTERMEDIATED SECURITIES, LEGAL PROBLEMS AND PRACTICAL ISSUES 69, 95 (Louise Gullifer & Jennifer Payne eds., HART PUBLISHING
LTD., OXFORD, UK, 2010).
23
James S. Rogers, Negotiability, Property, and Identity, 12 CARDOZO L.
REV. 471, 480 (1990).
24
James S. Rogers, Negotiability as a System of Title Recognition, 48 OHIO
ST. L.J. 197, 224 (1987).
25
Robert R. Bliss & Chryssa Papathanassiou, Derivatives Clearing, Central
Counterparties and Novation: The Economic Implications, 20 (8 March 2006),
available at http://www.ecb.int/events/pdf/conferences/ccp/BlissPapathanassiou_
final.pdf (last visited 9 December 2013).
16
The law of securities, commodities and bank accounts
THE USE OF ACCOUNT-BASED RIGHTS AS
COLLATERAL
Account holders may not only sell their rights but they may also use
them as collateral to secure obligations. Account-based rights are very
valuable collateral for three particular reasons. First, the value of
securities, funds and commodity contracts is easily determinable because
there is a public market for all of them. Second, account-based rights are
highly liquid. In other words, securities and commodity contracts may
easily be disposed of, practically immediately upon default of the
borrower. Finally, perfection of security interests in account-based rights
may be achieved without having to satisfy onerous formalities typical for
most secured transactions in some jurisdictions. Despite the attractive
collateral value of rights held in securities, bank and commodity
accounts, only a few jurisdictions (e.g., Canada and the United States)
provide for comprehensive special rules on taking security interests in
such rights and accounts.
Security interests typically become effective against third parties once
the creditor has taken some action to make them public. This is typically
achieved by filing or registration. Publicity of security interests in
account-based rights is achieved through the presence of an independent
third party – i.e., the intermediary – that functions as the bookkeeper for
all transactions with the account-based rights, whether outright transfers
or collateral arrangements. Perfection of security interests in accountbased rights should depend on the ability of the secured creditor to
control the collateral also allowing the debtor to retain disposal rights.26
Nevertheless, in some economies filing (registration) continues to play an
important role and is viewed as the only mechanism that provides
sufficient transparency for collateral arrangements. Each Part of this book
will analyse and compare the requirements for perfecting security interests in account-based rights.
26
See Luc Thévenoz, Intermediated Securities, Legal Risk, and the International Harmonization of Commercial Law, 13 STAN. J.L. BUS. & FIN. 384, 443
(2008), for a similar recommendation with respect to security interests in
securities and bank accounts.
Introduction
17
LEGAL REGULATION – IDENTIFICATION OF BEST
PRINCIPLES
The ultimate objective of this book is to identify the key principles and
features that underlie contemporary accounts holding systems. A number
of efforts to bring about some level of harmonization on an international
level have already failed. Drafters of future legislation should realize that
the new world of securities, bank and commodity accounts is based upon
mechanical communications, intangible rights and relationships.27 The
core of the emerging law of commercial accounts addresses the relationships between customers and their intermediaries rather than the property
rights to identifiable assets.28
Rapid development of commercial markets outpaces not only legal
regulation but also the implementation of tools for mitigation and more
effective management of risks.29 In a number of jurisdictions laws still
focus on and regulate transactions with identifiable assets and property
rights while transactions in contemporary markets involve intangible and
fungible assets and account-based relationships.30 Legislators must take
responsibility for adopting efficient rules on enforcing rights, protecting
investors and adequately regulating participants in these systems.31
Legislation and regulation of account-based rights must be comprehensive and take into account the linkages among the three accounts holding
systems. The call for effective legislation governing these systems has
been made by the most prominent figures in contemporary finance.
Bernanke, until January 2014 Chairman of the Board of Governors of the
Sommer, supra note 10, at 1183.
Ibid. at 1184.
29
Donald L. Kohn, The Evolving Nature of the Financial System: Financial
Crises and the Role of the Central Bank, Speech at the Conference on New
Directions for Understanding Systemic Risk, New York (18 May 2006).
30
ERICA JOHANSSON, PROPERTY RIGHTS IN INVESTMENT SECURITIES AND
THE DOCTRINE OF SPECIFICITY 1 (SPRINGER-VERLAG BERLIN HEIDELBERG,
BERLIN, GERMANY, 2009).
31
Governments should also be mindful and supportive of self-imposed
industry regulations. However, self-regulation standing on its own will not work
without a government-sponsored and effective oversight framework. See Andrea
M. Corcoran, Ronald B. Hobson, Gregory J. Kuserk, Karen K. Wuertz & Derek
West, Designing a Derivatives Complement to Cash Markets in Developing
Countries, in INTER-AMERICAN DEVELOPMENT BANK, FOCUS ON CAPITAL, NEW
APPROACHES TO DEVELOPING LATIN AMERICAN CAPITAL MARKETS 373 (INTERAMERICAN DEVELOPMENT BANK, WASHINGTON, DC, 2003).
27
28
18
The law of securities, commodities and bank accounts
Federal Reserve System, referred to such legislation as the ‘software’ of
the financial system, and said that:
I want to construe ‘financial infrastructure’ very broadly, to include not only
the ‘hardware’ components of that infrastructure – the physical systems on
which market participants rely for the quick and accurate execution, clearing,
and settlement of transactions – but also the associated ‘software,’ including
the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both
sides of each transaction.32
Bernanke’s ‘software’ (legal infrastructure) and ‘hardware’ (organizational infrastructure) will be referenced throughout this book. The
Conclusion of this book identifies a set of principles underlying contemporary account-based relationships.
32
Ben S. Bernanke, Reducing Systemic Risk, Speech at the Federal Reserve
Bank of Kansas City’s Annual Economic Symposium, Jackson Hole, Wyoming
(22 August 2008), available at http://www.federalreserve.gov/newsevents/speech/
bernanke20080822a.htm (last visited 9 December 2013).
PART I
Securities Account Relationships
1. Introduction to Part I
Securities markets provide venues for companies to raise capital by
issuing shares and bonds and for interested parties to invest. Over the last
few decades, securities markets have transformed into electronic impersonal venues that are more accessible to the public at large.1 Many of
these changes are ‘visible’ to a lay person. Every individual with access
to the Internet may easily locate quotes from securities markets, monitor
prices of shares, download reports from analysts or watch footage from
the NYSE and other exchanges. Anyone can also observe what securities
markets ‘are doing’ at any particular moment. Today passive observation
through electronic technology has become effortless and practically
cost-free.
Securities markets also underwent other critical changes that may be
less visible to a lay person. For years, the NYSE, the London Stock
Exchange and the Deutsche Börse were traditionally associated in the
minds of many with trading floors, populated by brokers wearing
uniform-like jackets shouting, running, waving their hands and throwing
paper tickets around. Gradually floor trading has been replaced with
electronic technologies and now instead of raising their hands, accepting
orders and making notes on paper tickets, brokers sit in their offices and
execute orders electronically. Investors no longer fax or call their orders
to buy or sell securities and brokers no longer call a trader on the floor to
execute such orders. Presently investors log-in to their trading accounts
such as through the websites of intermediaries and place their orders
electronically. The issuance of orders and their execution is practically
seamless.
Electronic communication technologies have also impacted the actual
settlement of trades, or the processes that occur after the trade is
executed, even though the transformation of settlement processes is less
1
Marek Dubovec, Securities Holding Patterns and Their Impact on the
Rights of Securities Holders: Lessons for Developing Nations, in LATIN AMERICAN COMPANY LAW: A COMPARATIVE AND ECONOMIC DEVELOPMENT PERSPECTIVE, VOL. 1, 213, 214 (Boris Kozolchyk & Francisco Reyes eds., CAROLINA
ACADEMIC PRESS, DURHAM, NC, 2013).
21
22
The law of securities, commodities and bank accounts
visible to the lay person. Investors in Mexico City need no longer worry
how their recently purchased IBM certificates will be delivered to them.
They no longer should be concerned with what might happen if the
certificates are lost or stolen in transit. Electronic communications make
the transfer of IBM shares possible by electronic bookkeeping entries to
securities accounts maintained by intermediaries. Securities are no longer
mailed in envelopes or handed over in face-to-face meetings. In terms of
modernization and implementation of new technologies, the back-end
transfer functions have been keeping pace with the front-end trading
functions in that both have become almost exclusively electronic. That
being said, electronic trading with securities is a front-end function and
therefore is not the subject of this Part.
This Part of the book examines the transformation from settlement of
trades by physical deliveries of certificates to the electronic transfers
effectuated by book entries to securities accounts. It analyzes both the
‘hardware’ (organizational and structural infrastructure) and the ‘software’ (legal infrastructure) of contemporary securities transfer systems.
The discussion of the software component includes an analysis of legal
rules applicable to the relationships that form the securities holding
systems. The most advanced software components, as they have been
formulated to implement the US Article 8 of UCC, are compared with
those in the European Union (EU) and Latin America. It will be
demonstrated that the EU Member States’ frameworks have not been
harmonized similarly to the United States’ laws. The relevant EU
Directives ‘fell short of creating a wholly consistent and sound set of
legal provisions governing the acquisition, disposition, enforcement, and
priority of rights in intermediated securities’.2 Latin American laws differ
from UCC 8 and the EU legal frameworks in many aspects, including the
degree of formalities required for the perfection of security interests.
It will be argued that socio-economic context is an important factor
that determines both the legal infrastructure and the functioning of
securities holding systems in the specified jurisdiction. Recommendations
to implement one or another type of the securities holding systems
should not be formulated without understanding the functions of securities markets in those jurisdictions. This is especially true in those
Luc Thévenoz, Intermediated Securities, Legal Risk, and The International
Harmonization of Commercial Law, 13 STAN. J.L. BUS. & FIN. 384, 398 (2008).
See further CHANGMIN CHUN, CROSS-BORDER TRANSACTIONS OF INTERMEDIATED SECURITIES, A COMPARATIVE ANALYSIS IN SUBSTANTIVE LAW AND PRIVATE
INTERNATIONAL LAW 118 (SPRINGER-VERLAG BERLIN HEIDELBERG, NEW YORK,
NY, 2012).
2
Introduction to Part I
23
economies and cultures where companies may or may not be accustomed
to raising funds in capital markets, where investors may or may not trust
the market value of securities, and where intermediaries are generally
distrusted.
This book seeks to lay out a path to modernization of the legal
infrastructure that governs domestic systems for the holding of securities.
Such modernization is a necessary step towards achieving harmonization
across borders. The international lawmaking community has already
undertaken important projects in the area of holding securities to support
increasingly globalized markets.3 First, the International Institute for the
Unification of Private Law (UNIDROIT) drafted the UNIDROIT Convention on Substantive Rules for Intermediated Securities (the Geneva
Securities Convention) that was signed on 9 October 2009.4 As stated in
the overview of the project, the objective of this Convention was to
‘improve the legal framework for securities holding and transfers, with a
special emphasis on cross-border situations’.5 This special emphasis was
identified because the number of failed deliveries of securities was and
remains significantly higher in cross-border transactions as compared to
domestic transactions.6 Second, the predecessor to the Geneva Securities
Convention was a project undertaken by the Hague Conference on
Private International Law that resulted in the adoption of the Convention
on the Law Applicable to Certain Rights in Respect of Securities Held
with an Intermediary (Hague Securities Convention).7 The Hague Securities Convention determines the applicable law for rights and obligations
3
Wayne Gray & Robert M. Scavone, Retreat from a Federal Securities
Transfer Presence: Next Stage in the Development of the Canadian Securities
Settlement System, 27 B.L.F.R. 375, 379 (2012).
4
The full text of the Geneva Securities Convention and working documents
are available at http://www.unidroit.org/english/conventions/2009intermediated
securities/main.htm (last visited 9 December 2013).
5
Given the functional and minimalistic approach taken in the drafting of the
Geneva Securities Convention, some authors have criticized it for not providing
sufficient predictability and legal certainty. CHUN, supra note 2, at 34.
6
Explanatory Memorandum to the proposed Regulation on Improving
Securities Settlement in the EU and on Central Securities Depositories (CSDs),
at 2 COM(2012) 73 final (7 March 2012), available at http://eur-lex.europa.eu/
LexUriServ/LexUriServ.do?uri=CELEX:52012PC0073:EN:PDF (last visited 9
December 2013).
7
The full text of the Hague Securities Convention is available at http://
hcch.e-vision.nl/index_en.php?act=conventions.text&cid=72 (last visited 9
December 2013). See also Sandra M. Rocks, The Hague Convention on the Law
24
The law of securities, commodities and bank accounts
in relationships based on securities accounts and does not deal with
substantive issues related to the holding of securities in accounts with
intermediaries. Both of these Conventions reflect the prevailing practice
of holding securities in accounts maintained by intermediaries.8
The conventional relationship in which the investor holds a certificate
and/or was registered on the books of the issuer has been replaced by an
intermediated holding structure in which the rights of shareholders are
represented by balances on securities accounts. This new pattern of
securities holding also impacts the cost of operating in the stock market.
Rudimentary clearing and settlement structures for intermediated securities increase the cost in many countries, including those in the Caribbean
and Latin America.9 In many developing countries, the number of
companies listed on the local securities exchanges has dwindled.10 To
stop the outflow of public listings, the Inter-American Development Bank
(IADB) recommended the following changes for developing countries:
to establish systems to facilitate the comparison of trade details, clearance and
settlement of securities by delivery versus payment (DVP); to implement risk
control systems to reduce the operational risk; to create independent central
depository systems for the safekeeping, immobilization and dematerialization
of securities; and to facilitate the settlement process and other aspects of
custody.11
This is a challenge that currently faces many developing countries not
only in Latin America but also in Eastern Europe, Africa and Asia.
Without a modern infrastructure for the holding and transferring of
Applicable to certain Rights in Respect of Securities Held with an Intermediary,
36 U.C.C.L.J. 1 (2003).
8
The two Conventions neither duplicate nor compete against each other.
Christophe Bernasconi & Thomas Keijser, The Hague and Geneva Securities
Conventions: a Modern and Global Legal Regime for Intermediated Securities,
13(3) UNIF. L. REV. 549, 550 (2012).
9
Kenroy Dowers, Felipe Gomez-Acebo & Pietro Masci, Developing a
Strategy for Reforming Capital Markets in Latin America and the Caribbean, in
INTER-AMERICAN DEVELOPMENT BANK, FOCUS ON CAPITAL, NEW APPROACHES
TO DEVELOPING LATIN AMERICAN CAPITAL MARKETS 8 (INTER-AMERICAN
DEVELOPMENT BANK, WASHINGTON, DC, 2003).
10
See AUGUSTO DE LA TORRE & SERGIO L. SCHMUCKLER, EMERGING
CAPITAL MARKETS AND GLOBALIZATION, THE LATIN AMERICAN EXPERIENCE 58
(STANFORD UNIVERSITY PRESS, PALO ALTO, CA, 2007).
11
The IADB found that 19% and 27% (respectively) of companies delisted
their shares from the stock exchanges in Brazil and Argentina in 2002. Dowers,
Gomez-Acebo & Masci, supra note 9, at 12, 23.
Introduction to Part I
25
securities and interests therein, the liquidity of these domestic securities
markets will be negatively affected. Less liquid markets are characterized
by the issuance of very few securities, the presence of very few buyers
and very low trading volumes. As a result, businesses are not able to raise
capital and economic development in these countries languishes.
Establishment of securities holding systems and enactment of the
relevant legislation must also address the increasing danger of systemic
risk. The 1994 revision of UCC 8 was prompted by considerations to
address systemic risk.12 In this context, Professor Rogers noted that while
‘commercial law cannot protect against the failure of one’s own intermediary; it can help protect against the risk that an investor will suffer as
a result of the failure of someone else’s intermediary’.13 While investors
may manage intermediary risk by due diligence or by taking out
insurance against losses, systemic risk is unpredictable and unmanageable by individual investors. Laws already adopted in a number of
economies recognize that adequate management and reduction of systemic risk is critical for the efficient functioning of securities markets and
their supporting accounts holding systems.14
This Part seeks to highlight the new concepts of holding securities in
accounts with intermediaries and explain the processes and functions
involved in the intermediated holding systems. The desire to manage
systemic and other risks underlies all these reforms and is relatively well
understood. What is missing is the understanding of these related
concepts, such as the nature of rights to account-based securities and
rights against the intermediary and the form of transfers and their legal
nature in addition to other functions that underpin a modern intermediated holding structure.
PROTOTYPICAL TRANSACTION
Before introducing a concise history of securities, one needs to first
understand the context in which transactions with securities are executed,
the markets where securities are traded and the parties that are involved.
Suppose that Brian bought 100 shares of IBM from Steve. The agreement
James S. Rogers, The Revision of Canadian Law on Securities Holding
Through Intermediaries: Who, What, When, Where, How and Why, CA. BUS. L. J.
49, 65 (2007).
13
Ibid.
14
See L. 964, julio 8, 2005, Diario Oficial [D.O.] 45.963 (Colom) art.
1(a)(3).
12
26
The law of securities, commodities and bank accounts
between Brian and Steve to sell the stock was a front-end trade between
two parties. Once Brian and Steve agreed on all of the details of the trade
they then met in Brian’s office where they exchanged the stock certificates for banknotes. Delivery of the certificates against the banknotes is
the back-end function. This transaction involved a trade, that is, an
agreement to buy the stock for a certain price, and its settlement, that is,
the delivery of certificates in exchange for the banknotes. Only the seller
and the buyer themselves are involved.
Presently, this type of transaction would be concluded through intermediaries on a stock exchange such as the NYSE. If Brian wanted to buy
100 shares of IBM, he would not call potential sellers trying to find out
who is willing to sell for the price Brian is willing to pay. Instead Brian
would instruct his intermediary (e.g., Charles Schwab) to buy the stock
for him. Brian would issue a ‘buy order’ to Charles Schwab to be
executed on the NYSE, where IBM shares are traded. For the purposes of
this illustration, assume that Steve instructed his intermediary JP Morgan
Chase to sell 100 shares of IBM for the market price. Unlike in the first
scenario, the transaction now involves four parties: the buyer, the seller
and the two intermediaries. Once the trade is completed, Brian and Steve
will exchange money for securities. However they will not meet each
other to exchange the certificates for cash. Instead Charles Schwab will
credit Brian’s securities account with 100 IBM shares and JP Morgan
Chase will debit Steve’s securities account for the 100 IBM shares. Since
this transaction was not gratuitous, payment must also be made. Accordingly, Charles Schwab will debit Brian’s cash balance on the securities
account for the purchase price of the stock and JP Morgan Chase will
credit Steve’s cash balance on his securities account with the sale price of
the stock. Credits and debits to the securities accounts of Brian and Steve
are the back-end functions. As discussed below in detail, these entries to
Brian’s and Steve’s accounts do not affect the relationships at the top
level between IBM and the CSD or those between the CSD and its
participating intermediaries.
The back-end functions may thus involve delivery of tangible assets,
such as certificates against banknotes, or transfers of intangible assets
made by credits and debits to securities accounts. Contemporary securities markets rely on the latter transfer mechanism – credits and debits to
securities accounts maintained by intermediaries for their customers. This
illustration of the prototypical transaction and the parties involved is
characteristic for most jurisdictions. However, laws governing transactions with securities, their clearing, settlement, holding and transfers
differ widely. It would be impossible to cover every type of market and
their related legal frameworks in this book. Instead the following
Introduction to Part I
27
jurisdictions will be referred to throughout this Part and compared with
one another when appropriate.
The securities holding system of the United States and its legal
infrastructure will be used as the main reference point in this Part
because it is one of the most advanced systems in terms of transactional
volumes and legal infrastructure. The largest securities exchange of the
United States is the NYSE, which trades shares of approximately 8000
issuers from 55 countries, representing almost 40 percent of global
trading in shares.15 In 2011, the DTC, which is the US-based CSD, had
US$ 39.5 trillion worth of securities on deposit.16
German securities exchanges are also an important player in credit
markets. Deutsche Börse Group Frankfurt Stock Exchange is the largest
securities exchange in Germany and the third largest in the world with
close to 7000 listed companies from over 80 countries.17 Clearstream
Banking Frankfurt is the CSD for securities issued in Germany18 and in
2011 it had €5.8 trillion worth of international and €5.2 trillion worth of
domestic securities on deposit.19
The technological and legal infrastructure of the US and German
securities holding systems will be contrasted with those in developing
countries, including Brazil, Mexico, Costa Rica, El Salvador and Slovakia.20 These developing countries typically only host a single nation-wide
securities exchange, such as the Bratislava Stock Exchange in Slovakia or
the Bolsa de Valores in El Salvador. Yet within this category of
developing countries two groups must be distinguished: 1) economies in
15
See NYSE Euronext, Company Overview, available at http://www.nyx.
com//en/who-we-are/company-overview (last visited 9 December 2013).
16
See DTCC, Transaction Statistics and Performance, available at http://
www . weforum.org / industry-partners / depository-trust - clearing-corporation-dtcc
(last visited 10 December 2013).
17
See Deutsche Börse Group, Statistics, available at http://xetra.com/xetra/
dispatch/en/kir/navigation/xetra/200_listing/500_statistics (last visited 9 December 2013).
18
See Clearstream, CSD Services, available at http://www.clearstream.com/
ci/dispatch/en/kir/ci_nav/1_settlement/025_csd (last visited 9 December 2013).
19
In 2011, Clearstream Banking Frankfurt settled over 116 million transactions. See Deutsche Börse Group, Global Presence, 115–16 (Annual Report
2011), available at http://deutsche-boerse.com/dbg/dispatch/en/binary/gdb_
content _ pool/ imported_files /public_files /10_downloads /12_ db_annual_ reports /
2011/10_complete_version/Annual_Report_2011.pdf (last visited 9 December
2013).
20
DE LA TORRE & SCHMUCKLER, supra note 10, at 45.
28
The law of securities, commodities and bank accounts
which securities markets are relatively efficient and growing in significance and 2) economies in which securities markets are in disarray and
practically ignored by issuers and investors alike. As a result, the needs
of these two groups in terms of establishing a modern securities holding
system differ. Slovakia, Brazil and Mexico belong to the first group of
developing countries. The Slovakian CSD, Centrálny Depozitár Cenných
Papierov SR (CSD Slovakia), settled approximately 120 000 transactions
in 2011 worth over €40 billion.21 In Mexico, the Bolsa Mexicana de
Valores (BMV) listed shares of 135 companies as of August 2012.22 The
Mexican CSD, Indeval, had over 15 billion pesos worth of securities on
deposit in 2011 and on a daily basis settled transactions worth in excess
of US$ 270 million.23 In 2008, the Sao Paulo Stock Exchange Bovespa
merged with the Brazilian Mercantile and Futures Exchange (BM&F) to
create BM&F Bovespa.24 For 2011, the daily trading volume averaged
6.5 billion real out of which 2.3 billion real was traded by foreign
investors.25 As of July 2011, 467 companies listed their shares at BM&F
Bovespa.26 Bovespa’s CSD, the Brazilian Clearing and Depository Corporation ‘CBLC,’ had 1.1 trillion real of securities on deposit as of June
2011.27
As highlighted in a working paper published by the International
Monetary Fund’s (IMF) research staff assessing Central America: ‘…
Centrálny Depozitár Cenných Papierov SR, Annual Statistics (2011),
available at http://www.cdcp.sk/dokumenty/statistika/Statistics_2011_en.pdf (last
visited 9 December 2013).
22
See Grupo BMV, Listado de Empresas Emisoras, available at http://
www.bmv.com.mx/wb3/wb/BMV/BMV_empresa_emisoras/_rid/177/_mto/3/_url/
BMVAPP/emisorasList.jsf?st=1 (last visited 9 December 2013).
23
Indeval, 1 Trimestre (February 2012), available at http://www.indeval.
com.mx /wb3/wb /indeval /archivos_publicos /_vtp/indeval /1c85_boletin /_rid/81/_
mto /3 /Newsletter_Feb12.pdf?repfop=view&reptp=1c85_boletin&repfiddoc = 463
&repinline=true (last visited 9 December 2013).
24
See BM&F Bovespa, What the Exchange Does, available at http://www.
bmfbovespa.com.br/en-us/intros/intro-about-us.aspx?idioma=en-us (last visited 9
December 2013).
25
BM&F Bovespa, 2011 Annual Report, 62–4, available at http://www.
bmfbovespa.com.br/en-us/bmfbovespa/download/BMFVOVESPA-Relatorio-Anual2011.pdf (last visited 9 December 2013).
26
Patrı́cia Pellini, Latin American Roundtable, Stock Exchanges as an
Engine for Corporate Governance Improvements: Reaching out to Non-listed
Companies (30 November 2011), available at http://www.oecd.org/daf/ca/
corporate governanceprinciples/49287485.pdf (last visited 9 December 2013).
27
See CBLC in Numbers, available at http://www.bmfbovespa.com.br/en-us/
intros/intro-securities.aspx?idioma=en-us (last visited 9 December 2013).
21
Introduction to Part I
29
private capital markets in several countries are under-developed in terms
of size, liquidity, and a number of issues relative to some regional peers
…’.28 In Central America bank loans are the preferred source of
financing, with corporate debt second and equity financing a distant
third.29 In May 2008 the securities markets of Costa Rica, El Salvador
and Panama together traded shares of only seven companies with the
total value of trades equaling US$ 650 000.30 The shares of the 90
companies listed on stock exchanges in these three countries were highly
illiquid.31 The IMF found that secondary trading was practically nonexistent with only 1 to 3 percent of issued shares trading annually.32
From January to the end of August 2012, the Costa Rican CSD,
Central de Valores (CEVAL), settled transactions worth approximately
US$ 180 million.33 The Salvadoran CSD, Central de Depósito de Valores
(CEDEVAL), had just over US$ 5 billion of securities in its custody as of
January 2012.34 This predominantly statistical overview of the selected
securities markets and related holding systems is relevant for an understanding of the account-based framework that exists in these economies.35
BRIEF EVOLUTION OF SECURITIES
This section examines the evolution of securities dating back to medieval
times when raising capital by issuing securities first became popular. The
other two Parts of this book examine the history of money and commodities from the era in which the origins of holding those assets through
intermediaries can be traced. Securities entered the scene when medieval
28
Hermant Shah, Ana Carvajal, Geoffrey Bannister, Jorge Chan-Lau & Ivan
Guerra, Equity and Private Debt Markets in Central America, Panama and the
Dominican Republic, IMF Working Paper WP/07/288, 5 (2007).
29
Ibid., at 8.
30
Peter Krupa, To Build an Equity Market, CENTRAL AMERICA, Issue 8, 16
(June/July 2008).
31
Dubovec, supra note 1, at 217.
32
Shah, Carvajal, Bannister, Chan-Lau & Guerra, supra note 28, 35.
33
Bolsa Nacional de Valores, Actividad de Mercado, available at http://
www.bolsacr.com/principal/index.php?action=estadisticas-negociacion (last visited 9 December 2013).
34
CEDEVAL en Estadı́sticas, available at https://www.cedeval.com/
estadistica_custodia_local_internacional.php (last visited 9 December 2013).
35
For further information about the Latin American securities markets see
Dubovec, supra note 1, at 216–17.
30
The law of securities, commodities and bank accounts
governments were looking for sources to finance their military activities.36 Unlike contemporary bonds, the ability of the issuing government
or city to service the debt and honor redemption requests in a timely
fashion depended primarily on the success of the wars.37 Even though
bonds were issued as unsecured promises to pay, the war loot functioned
as a quasi security. The marketability of governmental bonds was initially
restricted. Bonds were bought by a small number of wealthy individuals
who could bequeath or sell them but usually only within the same group
of investors. A public market for securities did not exist at this time and
no special intermediaries were employed to take custody of the certificates.
Concentration of government bonds in the hands of a chosen few
persisted until the sixteenth century. The profile of a typical bondholder
changed in the sixteenth century when guilds, ecclesiastical and charitable institutions emerged as the dominant investors.38 Limited circulation
and the holding of bonds by a small number of investors were well suited
for the then existing transfers mechanism – book entries made by their
issuers. Accordingly, when investors decided to sell their bonds they
informed the issuer who then recorded the transfer on its books. Transfers
of Venetian government bonds completed by book entries laid the
foundation for modern securities transfers systems that rely entirely on
mechanical credits and debits to securities accounts.39
The strength and reliability of the promise to pay that backed up these
bonds led to their transformation into payment instruments. Thus, in
addition to being instruments of finance, bonds came to be recognized as
the equivalent of cash.40 Fixed-rate bonds and shares issued by jointstock companies in England and the Netherlands were recognized as
36
Some authors trace the first issuance of a security to twelfth century
Venice, in which long-term municipal debt was issued: MICHAEL BLAIR QC &
GEORGE WALKER, FINANCIAL MARKETS AND EXCHANGES LAW 7 (OXFORD
UNIVERSITY PRESS, OXFORD, UK, 2007).
37
EDWARD J. SWAN, BUILDING THE GLOBAL MARKET, A 4000 YEAR HISTORY
OF DERIVATIVES 117 (KLUWER LAW INTERNATIONAL, HAGUE, NETHERLANDS,
2000). The nominal interest rate on bonds issued by Italian states between the
thirteenth and fifteenth centuries ranged between 2.8% in Genoa, 5% in Venice,
and 12% in Florence: WILLIAM N. GOETZMANN & K. GEERT ROUWENHORST,
THE ORIGINS OF VALUE: THE FINANCIAL INNOVATIONS THAT CREATED MODERN
CAPITAL MARKETS 156 (OXFORD UNIVERSITY PRESS, OXFORD, UK, 2005).
38
Ibid., at 158.
39
SIDNEY HOMER & RICHARD SYLLA, A HISTORY OF INTEREST RATES 94
(4th edn., WILEY, HOBOKEN, NJ, 2005).
40
SWAN, supra note 37, at 117.
Introduction to Part I
31
negotiable by the end of the seventeenth century, and price quotations for
such bonds were made available at the Amsterdam and London Stock
Exchanges.41 The establishment of securities markets with readily available prices for negotiable shares and bonds, significantly widened access
to credit for companies that used to rely on funding provided by the
owners and family members.42 Negotiability and the establishment of
public securities exchanges attracted investors, who previously had not
been able to buy bonds for investment or speculative purposes. The fact
that bonds were negotiable bearer instruments equivalent to cash exposed
their holders to significant risks, including loss and theft.43
The money-like features, presumed ownership, and full negotiability of
these bearer securities that could ultimately be transferred free of
defenses eventually led their holders to deposit these securities for
safekeeping and custody with specialized intermediaries. The figure of a
commercial intermediary thus emerged as a reaction to the gradual
development of securities markets. Initially, the function of the intermediaries was to provide safe custody service, similar to the services of
warehouse operators. The intermediary was an entity distinct from the
issuer of the security, and its main function was to take the security into
custody and protect it against the risks of loss and theft. Securities
transactions thus experienced an important transformation that introduced
a crucial player to the existing relationships between the issuer, investor
and transferees – an intermediary. The initial role of the intermediary was
to keep the security safe and only later did the intermediary also begin to
perform other functions, such as the transfer of rights to securities and
provision of loans. Although, the seventeenth century intermediary was a
mere safe-keeper, its emergence had a significant impact on the evolution
of the securities holding system.
The deposit of securities with an intermediary established a relationship with the holder. This type of relationship was based on a contract of
deposit, in which the depositor retained ownership rights and the
intermediary became the possessor of the security. The intermediary had
a duty to segregate the deposited securities and maintain them as
THOMAS MUNCK, SEVENTEENTH CENTURY EUROPE 113 (ST. MARTIN’S
PRESS, BASINGSTOKE, UK, 1990).
42
Ibid.
43
Absence of any identification of the transferor and transferee makes bearer
securities excellent mechanisms to hide transactions from governmental authorities. See JAMES S. ROGERS, THE END OF NEGOTIABLE INSTRUMENTS, BRINGING
PAYMENT SYSTEMS LAW OUT OF THE PAST 50 (OXFORD UNIVERSITY PRESS, NEW
YORK, NY, 2012).
41
32
The law of securities, commodities and bank accounts
identifiable to individual depositors. This type of deposit is known as
‘regular’ or ‘special’. The duties and functions of the intermediary with
respect to deposited securities are similar to those of the ordinary
warehouseman of commodities. As will be demonstrated in Part II, the
relationships between depositors and custodians of other valuable assets,
such as gold and money, were also those of owners and bailees
(custodians), in which the depositors retained ownership rights in the
particular assets. Only later did such custody transform itself into a
system whereby money and securities of depositors were allowed to
commingle. As a result of such commingling, the traceable ownership
rights of depositors were disintegrated and replaced with different rights.
Consequently, the nature of deposits of securities, as well as money,
made it impossible for individual depositors to assert traceable ownership
rights.44
Gradually the ownership right of a depositor was transformed into a
proprietary interest enforceable against his intermediary.45 In contemporary securities holding systems, this proprietary interest is classified
differently in various jurisdictions in the catalog of existing property
rights and includes a co-ownership right in the pool of fluctuating assets,
a co-possessory right to an immobilized security, and an equitable right
that is based on a trust relationship or a security entitlement.46 Whereas
the right of a depositor of money shed all of its proprietary features, the
contemporary right of a security depositor still includes a proprietary
element.
44
Roman law introduced the concept of an irregular deposit that did not
require restoration in specie. Under the irregular deposit, once possession of the
asset, such as money, passed to the depository so did its ownership. The
depository acquired the right to commingle and re-use the deposited object. See
J.A.C. THOMAS, TEXTBOOK OF ROMAN LAW 278 (ELSEVIER SCIENCE & TECHNOLOGY BOOKS, PHILADELPHIA, PA, 1976).
45
Intermediaries also provide individualized custodial services in which the
customer retains absolute ownership rights with respect to the deposited securities. See German Safe Custody Act, § 2.
46
See ROY GOODE, HIDEKI KANDA & KARL KREUZER, EXPLANATORY
REPORT ON THE HAGUE CONVENTION ON THE LAW APPLICABLE TO CERTAIN
RIGHTS IN RESPECT OF SECURITIES HELD WITH AN INTERMEDIARY 10 (MARTINUS
NIJHOFF PUBLISHERS, HAGUE, NETHERLANDS, 2005).
Introduction to Part I
33
DEMATERIALIZATION AND IMMOBILIZATION OF
SECURITIES
Securities have traditionally been transferred by their physical delivery
and/or through entries on the issuer’s books. Transfers of securities
completed by physical delivery and registration on the issuer’s books are
suited for closely held securities with only a few investors and for shares
that trade only occasionally. Given the small market capitalization and
the low volume of trading in the Central American markets, physical
transfers of certificates and registration on issuers’ books may work well
for the relatively occasional transfers of securities. While these modes of
transfers should be sufficient to support the low volume of trading, it
does not mean that more efficient and less costly mechanisms should not
be implemented. The volume of trading is just one aspect that affects the
transfer mechanism; efficiency, security, cost and the introduction of
electronic securities, along with other related aspects are also equally
relevant.
The traditional transfer mechanisms that rely on physical delivery of
certificates do not work efficiently for publicly traded securities that
change investors frequently. Registration capabilities of issuing companies with thousands of security holders that are located all over the
world may not keep up with the large volume of trading. Physical
transfers increase transactional costs, often result in late delivery and
impede the liquidity of securities.47 As the volume of securities trading
increases, traditional transfer mechanisms are rendered obsolete.
The Process of Dematerialization
In securities markets, electronic technologies were deployed not only to
facilitate trading, but also to make settlement more efficient and less
costly. The benefits of fully electronic front-end trading would have been
severely undermined if the trades executed on electronic exchanges had
to be settled by the manual delivery of certificates. Accordingly, both the
front and back-end functions should be dematerialized. In this section
dematerialization should not be understood as only a technological
47
Investors also face the risk of certificates being lost, stolen, or counterfeited during the course of transport. For instance, in 2004, 1.7 million physical
certificates were lost in the United States. See the DTCC, News and Information
for DTCC Customers, Naked Short Selling and the Stock Borrow Program, Issue
Index, March 2005.
34
The law of securities, commodities and bank accounts
transformation but should also be thought of as a legal concept.48 The
following paragraphs document dematerialization in the United States
occurring in the late 1960s, after the increasing volume of securities
trading and enduring inefficiencies in settling those transactions led to a
‘paper crunch’.49 The way that Wall Street was doing business at that
time did not differ too much from the ways of the late nineteenth century:
The tape was still a paper tape spewing out from a ticker. Paper stock
certificates were stored by each broker, necessitating armies of runners to
move them about the Street as they were traded. Brokerages had telephone
clerks at the stock-exchange floor. The clerks would write out the orders to
buy and sell, which would be phoned in from the headquarters. The clerks
would hand them to floor brokers, who would execute the orders and hand the
clerk a confirmation, which went back to the back-office to be recorded.50
Dematerialization is a process that converts paper certificates into electronic entries. For such transformation to be accomplished, the law must
recognize this new breed of electronic securities and adequately protect
the rights of those that purchase and take a security interest in such
securities. While the form of securities changes, the relationship of the
investor against the issuer typically remains unaffected.51 Upon adoption
of dematerialization laws a new form of uncertificated security emerges.
This form of security is constituted and evidenced by entries on the
issuer’s books. Unlike transactions with a security certificate, transfers of
uncertificated securities do not require the delivery of writing to the
purchaser. However, legal measures related to dematerialization did not
Ley de Anotaciones Electrónicas de Valores en Cuenta (Law on Electronic
Entries of Securities to Accounts) Diario Oficial [DO] 57, 22 March 2002 (El
Salvador) [hereinafter Salvadoran Law on Electronic Entries] defines dematerialization as ‘a process that results in juridical transformation of securities to
annotations in accounts.’
49
CARL S. BJERRE & SANDRA M. ROCKS, THE ABCS OF THE UCC ARTICLE
8: INVESTMENT SECURITIES 2 (2nd edn., AMERICAN BAR ASSOCIATION, CHICAGO,
IL, 2004) and DTCC, A Proposal to Fully Dematerialize Physical Securities,
Eliminating the Costs and Risks They Incur, A White Paper to the Industry, 3
(July 2012).
50
John S. Gordon, The Solution Became the Problem, BARRON’S, 27 August
2012, at 45.
51
Jennifer Payne, Intermediated Securities and the Right to Vote in the UK,
in INTERMEDIATED SECURITIES, LEGAL PROBLEMS AND PRACTICAL ISSUES 187,
194 (Louise Gullifer & Jennifer Payne eds., HART PUBLISHING LTD., OXFORD,
UK, 2010).
48
Introduction to Part I
35
entirely replace certificated and bearer securities and most laws typically
continue to recognize and regulate all three types.52
The 1977 revision of the US UCC Article 8 (UCC 8) was based
entirely on the idea of dematerialization and envisaged a system where
transfers of dematerialized securities would be completed by issuers on
their books.53 In Europe, laws providing for dematerialized corporate
securities were first adopted in Denmark and France in 1981 and 1982
respectively.54 In Central America, Costa Rica provided for electronic
securities in the 1998 Law on the Securities Market (Ley Reguladora del
Mercado de Valores) and El Salvador adopted its law on dematerialized
securities, the Law on Electronic Entries of Securities Held in Accounts
(Ley de Anotaciones Electrónicas de Valores en Cuenta), in 2002
(hereinafter called ‘Salvadoran Law on Electronic Entries’). Despite the
adoption of these measures many companies in these two countries today
still prefer to issue shares in certificated form to monitor the identity of
the security holders.55 In addition, a number of countries have adopted
laws that preclude the issuance of certain types of securities in certificated form.56 However, these dematerialization reforms did not lead to
the establishment of intermediated account-based systems because the
issuer itself remained the entity empowered to complete transfers of
uncertificated securities.
Despite the laws’ anticipation of the widespread use of dematerialized
securities, in the United States the system in which intermediaries
maintain accounts for their customers and transfer securities between
accounts essentially emerged from the bottom up. The market practice
ignored the 1977 revision of UCC 8. As noted by Professor Mooney
‘although uncertificated (electronic) securities were seen as a response to
the paperwork crunch, the depository system and technology-aided
methods of clearance and settlement basically solved that problem even
52
See the definition of security in UCC § 8-102(15) (1994) that refers to a
security certificate in bearer form, a security certificate in registered form, and a
security transfer which may be registered on the books of the issuer.
53
EGON GUTTMAN, MODERN SECURITIES TRANSFERS, § 1:8 Statutory Evolution (3rd edn., THOMSON WEST, BOSTON, MA, 2007).
54
See Article 94-II of the 1982 Finance Law that became effective in
November 1984. Sylvie Hebert, Certificateless Shares in France, J.B.L. 60
(1987) and Diana Chan, Florence Fontan, Simonetta Rosati & Daniela Russo,
The Securities Custody Industry, European Central Bank, Occasional Paper
Series No. 68, 8 (August 2007).
55
Shah, Carvajal, Bannister, Chan-Lau & Guerra, supra note 28, at 92.
56
See DTCC, A Proposal to Fully Dematerialize Physical Securities, supra
note 49, at 1.
36
The law of securities, commodities and bank accounts
before the revised UCC 8 was promulgated in the 1990s’.57 What
emerged in the United States was a system where intermediaries, rather
than issuers, recorded the respective transfers on the accounts they
maintained for their customers. Issuers’ records were being quickly
replaced with the accounts of intermediaries as the source of rights and
transfers. This market practice necessitated yet another legal development
that would establish a framework to recognize the rights created and
transferred by book entries made by intermediaries.
Immobilization and Central Securities Depositories
In contemporary markets, most securities have ceased to circulate as
certificates and instead are immobilized with intermediaries. Upon depositing securities with an intermediary, subsequent transfers can be completed by entries to the accounts maintained by the intermediary.58 This
process is similar to the immobilization of banknotes and coins that
allows the bank to transfer the funds belonging to the customer by
electronic entries to the customer’s bank account. Securities may be, and
typically are, immobilized in a specially designated institution, known as
the CSD, or with a financial institution that offers custodial services to its
clients. The process of immobilization at the CSD does not necessarily
involve the elimination of certificates.59 Securities may be immobilized at
the CSD by: 1) deposit of the physical certificate or by 2) the CSD being
registered as the security holder on the books of the issuer in a
dematerialized form.60 The latter has become the more predominant form
of immobilization but corporations and financial entities still issue
securities in the form of a single certificate that represents the entire issue
and that is delivered as such to a CSD.61
Charles W. Mooney, Property, Credit, and Regulation Meet Information
Technology: Clearance and Settlement in the Securities Markets, 55-SUM LAW
& CONTEMP. PROBS. 131, 140 (1992).
58
Dubovec, supra note 1, at 219.
59
Benjamin Geva, Recent International Developments in the Law of Negotiable Instruments and Payment and Settlement Systems, 42 TEX. INT’L L.J. 685,
688 (2007). The US DTCC annually accepts over 50 000 physical certificates for
deposit. See DTCC, A Proposal to Fully Dematerialize Physical Securities, supra
note 49, at 9.
60
HANS VAN HOUTTE, THE LAW OF CROSS-BORDER SECURITIES TRANSACTIONS 52 (SWEET & MAXWELL LTD., LONDON, UK, 1999).
61
See JOANNA BENJAMIN, INTERESTS IN SECURITIES, A PROPRIETARY LAW
ANALYSIS OF THE INTERNATIONAL SECURITIES MARKETS 24 (OXFORD UNIVERSITY PRESS, OXFORD, UK, 2000).
57
Introduction to Part I
37
Physical certificates may be immobilized at the CSD in two forms: 1)
a jumbo certificate or 2) a global certificate.62 The fundamental difference between the two types is that whereas a jumbo certificate may be
divided into individual paper certificates upon request of the investors,
the terms and conditions of global certificates preclude the possibility of
their division into individual securities.63 The jumbo security may also be
initially delivered to the CSD in the form of multiple certificates that
altogether represent the entire issue. However, the holders of rights to the
global certificate may not require their intermediaries or the CSD to issue
individual certificates representing any proportions of the global certificate.
As there are different types of securities, there may also be different
types of CSDs. Most countries have established a special CSD for
corporate (private) securities and another one for government (public)
securities. The former take custody of securities issued by private entities
such as corporations, banks and insurers. These CSDs are organized as
private entities that are independent of the government. In contrast, other
CSDs, typically operated by central banks, are organized to take custody
of securities issued by governments and their instrumentalities.64 In the
United States the DTC is the CSD for privately issued securities and the
Federal Reserve System is the CSD for government securities. Similarly,
in Brazil the Special System for Settlement and Custody (Sistema
Especial de Liquidação e de Custódia) or SELIC is the CSD for
securities issued by both the Brazilian government and Banco Central do
Brasil and the Brazilian Clearing and Depository Corporation (CBLC) is
the CSD for private securities. This duopoly of CSDs also exists in Costa
Rica where the National System for Book-Entry Registration of Securities has two components: 1) for public securities managed by the Central
Bank of Costa Rica and 2) for private securities managed by authorized
private CSDs including CEVAL.65 This Part deals only with the depositories of private securities.
CSDs for private securities are typically organized as corporate entities
or as banks that are owned by holding companies or securities exchanges.
62
See Ley del Mercado de Valores [LMV] (Securities Market Law), art. 282,
Diario Oficial de la Federación [DO], 30 December 2005 (Mex.) [hereinafter
Mexican Securities Market Law] and Salvadoran Law on Electronic Entries, art.
2(d).
63
GUTTMAN, supra note 53, at § 1:9.
64
Dubovec, supra note 1, at 219–20.
65
Ibid., at 220.
38
The law of securities, commodities and bank accounts
Euroclear S.A./NV, a European-based CSD, comprises individual domestic CSDs that are part of the structure under the umbrella parent company
– the Euroclear Plc.66 The other major European CSD, Clearstream, is
wholly owned by the Deutsche Börse.67 In the United States, the DTC is
a subsidiary of the Depository Trust & Clearing Corporation (DTCC).68
DTCC is a holding company that consolidated the DTC, the National
Securities Clearing Corporation (NSCC), previously formed by the
NYSE, the American Stock Exchange, and the National Association of
Securities Dealers. DTCC provides clearing and settlement for equities,
corporate and municipal bonds, government and mortgage-backed securities, money-market instruments and over-the-counter derivatives.69
CSDs in most developing countries also operate as corporations. The
Slovakian CSD is a joint-stock company fully owned by the Bratislava
Stock Exchange70 and the Mexican CSD, Indeval, is organized as a
sociedad anónima whose shareholders are stockbrokers, banks, insurance
companies and other entities, including the Mexican Stock Exchange.71
The Brazilian CBLC is a subsidiary of the Bovespa Holding Group, which
operates the stock exchange and is owned by its members, including stockbrokers and banks.72 In El Salvador, it is a legal requirement for CSDs to
66
Euroclear, Our Structure, available at https://www.euroclear.com/en/about/
our-structure.html (last visited 9 December 2013).
67
Clearstream, About Us, available at http://www.clearstream.com/ci/
dispatch/en/kir/ci_nav/about_us (last visited 9 December 2013).
68
About DTCC, The Depository Trust Company (DTC), available at http://
www.dtcc.com/about/businesses-and-subsidiaries/dtc.aspx (last visited 9 December 2013).
69
Larry Thompson, DTCC: An Overview (August 2013), available at http://
dtcc.com /~ /media / Files / Downloads /About / government-relations / LThompsonDTCC-Overview-Aug2013.ashx (last visited 10 December 2013).
70
According to § 99 of the Securities Act, the CSD may not transform into
another corporate form. As of May 2012, the Slovakian CSD had 19 participants.
Centrálny Depozitár Cenných Papierov SR, Základné fakty, available at http://
www.cdcp.sk/general/cinnost.php#zakladne_fakty (last visited 9 December
2013).
71
David F. Muñoz, Arturo Palacios & Miguel de Lascurin, Modeling,
Simulation and Analysis of a Securities Settlement System: The Case of Central
Securities Depository of Mexico, 17(33) J. ECON. FIN. & ADMIN. SCI. 48 (2012).
72
Brazilian Clearing and Depository Corporation – CBLC, available at
http://www.brazilcompany.com/html/clbc.html (last visited 9 December 2013).
Introduction to Part I
39
be organized as sociedades anónimas.73 Finally, the Costa Rican CSD,
CEVAL, is a subsidiary of the local stock exchange.74
Immobilization of securities is a concept and practice that has been
embraced uniformly in the vast majority of economies. Developed, as
well as developing, economies have established CSDs for public and
private securities. While similarities among these CSDs exist in terms of
their structure and organization, many differences may be identified,
particularly in the process of transferring and acquiring securities, the
nature of the rights thereto, the granting and perfecting of security
interests, etc. These and other characteristics and differences are examined below.
THE TYPOLOGY OF DIRECT AND INTERMEDIATED
HOLDING SYSTEMS
The corollary to the immobilization of securities is the gradual erosion of
the direct relationship between the issuer and the holders of its securities.
Intermediaries took on the role of facilitating the enforcement of rights
embedded in immobilized securities and thus the nature of holding
systems has morphed from direct to the so-called intermediated. In a
direct holding system the investor, who is in possession of a security
certificate and/or is registered on the issuer’s books, may enforce his
rights directly against the issuer. The investor is not claiming through an
intermediary and therefore the issuer’s obligations correspond to the
rights of individual investors. Security holders and issuers are in privity.
Transfers of securities in a direct holding system are effectuated by
delivery of certificates or registration on the issuer’s books. In an
intermediated holding system the investor is neither in possession of a
security nor registered on the issuer’s books. The investor does not deal
directly with the issuer but instead holds a securities account with an
intermediary, which may also be the CSD. Its rights to the security may
be enforced through the intermediary. In this case the security holder is
not in privity with the issuer but with its intermediary. Transfers of
73
Ley del Mercado de Valores (Securities Market Law), arts. 74–78, Decree
809, Diario Oficial [DO] 73-bis, 21 April 1994 (El Salvador).
74
See Bolsa Nacional de Valores, Subsidiarias de la BNV, available at
http://www.bolsacr.com/principal/index.php?action=subsidiarias (last visited 9
December 2013).
40
The law of securities, commodities and bank accounts
securities in an intermediated holding system are completed by book
entries to securities accounts maintained by intermediaries for their
customers.
Co-existence of Direct and Intermediated Holding Systems
Direct and intermediated holding systems are not mutually exclusive. In
most markets a few securities are held directly and the majority is held
through intermediaries. Laws governing the holding of securities also
reflect the co-existence of these two holding patterns. Even the Geneva
Securities Convention recognizes that multiple systems may function in
parallel and does not require the contracting states to entirely replace
their existing systems with an intermediated holding system. Most laws
provide security holders with the right to order their intermediaries to
change the holding pattern from intermediated to direct and vice-versa, if
available. The holder of a certificated security may endorse a certificate
that he is holding directly, place it with an intermediary and receive a
credit to his securities account. Conversely, a securities account holder
may request that the intermediary debit his account and deliver a security
certificate unless the execution of such request is prohibited by the terms
of the issuance. This possibility to change the holding pattern is not
different than depositing and withdrawing cash from a bank account. The
bank account holder may similarly change the holding with respect to his
cash from direct to intermediated and vice-versa.
The right to change the holding pattern for securities may be incorporated in the substantive law, such as in UCC § 8-508, the German Safe
Custody Act § 7 or Article 56 of the Salvadoran Law on Electronic
Entries, which subjects an intermediary to a duty to comply with the
account holder’s order to change the holding. The right of investors to
change the holding pattern may also be included in a subsidiary
legislative measure, such as the rules governing operations of the German
CSD, Clearstream, that provide for the right of withdrawal of certificates
from the central custody.75
75
Clearstream, Deutchse Börse Group, General Terms and Business Conditions of Clearstream Banking Aktiengesellschaft, art. 41 (1 February 2004). For
Mexico, see S.D. Indeval, Reglamento Interior, art. 23º [hereinafter Indeval
Regulations].
Introduction to Part I
41
Some securities immobilized with CSDs prohibit their rematerialization or transformation from electronic securities to certificates.76 Accordingly the duty of the intermediary to change the holding
pattern is not absolute, as the terms of some securities provide that the
issuer will register only a depository on its books.77 In developed
economies, such as the United States and Germany, it is not a common
practice for investors to request certificates or for issuers to re-materialize
electronic securities. However, this remains a practice in some developing
countries such as in El Salvador.78
This discussion begs the question of whether to reform the existing
legal framework for the holding of securities to provide only for the
intermediated type of holding, therefore discarding entirely the possibility of holding securities directly. While most of this discussion may
suggest that the future lies in intermediated holding, it is expected that
many securities will remain directly held. Similarly, there are transactions
that are routinely settled by payment in cash. Although this may not be
practical, cultural attitudes and local practices are not uniform. It is also
possible that technological advances and market practices will make the
direct holding of securities once again the norm in the future. Even the
Prefatory Note to UCC 8 acknowledges that ‘it is not clear whether the
long-term evolution will be toward decreased or increased use of direct
holdings’.79 Finally, strong views to achieve more transparency in securities markets and to be able to identify the ultimate holders of securities
are also expected to have a significant influence on the type of holding
used in the future. Laws should therefore preserve the flexibility noted
above and leave it up to the market to develop the most efficient holding
pattern from the bottom-up rather than imposing such a pattern by
regulation.
Intermediated Systems and their Variations
While in the not so distant past literature focused primarily on the
transformation from direct to intermediated holding systems, recently the
spotlight has shifted to focus on the classification of various types of
Under Depotgesetz (the German Securities Deposit Act), 1 November
1995 (BGB1. S.2512), § 9a(3), the issuer is not obligated to honor the request of
an investor to issue a certificate if the securities were issued under such
restrictions.
77
See Official Comment 1 to UCC 8-508 (1994) on the restrictions that are
frequently included in municipal bonds.
78
Shah, Carvajal, Bannister, Chan-Lau & Guerra, supra note 28, at 92.
79
Prefatory Note to UCC Article 8 (1994) Investment Securities, at II. A.
76
42
The law of securities, commodities and bank accounts
intermediated holding systems and the identification of their intricate
features.80 The project that led to the adoption of the Geneva Securities
Convention gave momentum to this shift towards identification and
classification.81 Structurally, all intermediated holding systems look alike.
The securities holding pyramid is composed of the CSD at the top,
intermediaries in the middle and accounts holders at the lower-level.
However the nature of rights and the individual components of accounts
relationships differ significantly. One may distinguish between two
fundamental types of intermediated holding systems: 1) indirect and
2) transparent.
While indirect holding systems have uniform features and structures,
the typology of transparent holding systems is far from uniform. A
typical characteristic of an indirect holding system is that the CSD
remains unaware of the identity of particular account holders other than
its participating intermediaries. In contrast, in transparent holding systems the CSD preserves a relationship with, and knows the identity of, all
account holders. In indirect holding systems, the relationships between
the CSD and intermediaries and the relationships between the intermediaries and account holders are independent one from one another. In
transparent systems middle-level entities maintain accounts for investors
but the purpose of such holding is merely administrative. Only transfers
recorded at the CSD level have constitutive effects. This Part of the book
refers to these entities as account operators because the securities
accounts they maintain and book entries they make neither transfer nor
constitute rights to securities. Thus, one needs to distinguish account
operators that provide administrative functions in transparent systems,
from actual intermediaries that effect transfers of securities in indirect
holding systems. In transparent systems only CSDs are actual intermediaries.
80
For a discussion of direct and indirect holding systems see BJERRE &
ROCKS, supra note 49; Philipp Paech, Harmonising Substantive Rules for the Use
of Securities Held with Intermediaries as Collateral: The UNIDROIT Project, 4
UNIF. L. REV. 1140 (2002); and Steven L. Schwarcz & Joanna Benjamin,
Intermediary Risk in the Indirect Holding System for Securities, 12 DUKE J.
COMP. & INT’L L. 309 (2002).
81
For a discussion of various types of intermediated holding systems see
Working Paper Regarding So Called ‘Transparent Systems’ prepared by the
Secretariat on the Basis of Contributions Submitted by Delegations to the GCE,
Doc. 44 (October 2006).
Introduction to Part I
43
TYPES AND FORMS OF SECURITIES AND FINANCIAL
ASSETS
Preceding sections distinguished between directly-held securities and
those that are held through intermediaries. Directly-held securities
include bearer certificates, registered and uncertificated securities. It will
be argued below that while the scope of direct holding systems is based
on a closed-end list of securities, the scope of intermediated holding
systems is much more flexible.
UCC 8 provides three requirements for a security to fall under the
scope of the direct holding rules:
1)
a security must be represented by a security certificate in bearer or
registered form or the transfer of such a certificate may be
registered by the issuer;
it must be one of a class or series or must be, by its terms, divisible;
and
it must be of a type dealt in or traded on securities exchanges or
securities markets, or it must be a medium for investment that, by
its terms, expressly provides that it is a security governed by Article
8.82
2)
3)
If securities are held through an intermediary, the UCC 8 rules regulating
the indirect holding system become applicable and securities qualify as a
type of ‘financial asset’.83 The definition of a financial asset in conjunction with the definition of a securities account establishes the scope of
the UCC 8 indirect holding system.84 Professor Rogers noted that the
definition of securities account is as critical for the indirect holding
system as the definition of security is for the direct holding system.85 An
instrument may become a UCC 8 financial asset upon the undertaking of
the intermediary to the account holder to execute instructions related to
the enforcement of the rights embedded in the financial asset.
The UCC 8 category of financial assets includes:
UCC 8-102(15) (1994).
BJERRE & ROCKS, supra note 49, at 6–7.
84
UCC 8-102, Official Comment 9.
85
Rogers, supra note 12, at 49 and 59. UCC 8-501(a) (1994) defines a
securities account as ‘an account to which a financial asset is or may be credited
in accordance with an agreement under which the person maintaining the
account undertakes to treat the person for whom the account is maintained as
entitled to exercise the rights that comprise the financial asset’.
82
83
44
1)
2)
The law of securities, commodities and bank accounts
securities;
obligations of a person, or shares, participations or other interests in
a person or in property, which are of a type dealt in or traded on
financial markets or are recognized as a medium of investment; and
any property that is held by a securities intermediary in a securities
account if the securities intermediary has expressly agreed with the
other person that the property is to be treated as a financial asset.86
3)
The common denominator for all three categories of financial assets is
their susceptibility of being credited to and held in a securities account.
This attribute of being ‘creditable’ to a securities account determines
whether or not an instrument qualifies as a financial asset under UCC 8.
Whether or not an asset is traded on official markets and whether or not
it is a debt obligation or a share is irrelevant for the UCC 8 indirect
holding rules. Professor Rogers observed that ‘the rules of the indirect
holding system are rules about how property is held, not what that
property is’.87 As long as an asset may be credited to a securities account,
it will be treated as a financial asset.
A similar distinction between securities and other financial assets has
been drawn in EU law. The EU Financial Collateral Directive provides
for a concept of financial instrument that includes shares, equivalent
securities in companies, bonds, and other forms of debt instruments
provided they are negotiable on the capital markets, as well as any other
securities that grant the right to acquire shares or bonds.88 Similar to the
UCC concept of financial assets, the EU’s financial instrument includes
traditional securities and other assets tradable in capital markets. Unlike
UCC 8, the EU Financial Collateral Directive does not provide for any
asset to be treated as a financial instrument when the intermediary merely
agrees or undertakes to hold it as such. The EU’s financial instrument,
limited only to those assets that are transferable and of which market
value may be easily established, is therefore narrower, less flexible and
less accommodative for instruments that may emerge in the future. Even
so, it also seems to provide more predictability and clarity than UCC 8.
UCC 8-102(9) (1994).
Rogers also stated that ‘the indirect holding system rules could just as well
apply to a banana as to a bond’. Rogers, supra note 12, at 55.
88
Council Directive 2002/47/EC on Financial Collateral Arrangements, art.
2(1)(e), 2002 O.J. (L 168) [hereinafter EU Financial Collateral Directive]. See
also Council Directive 2004/39/EC on Markets in Financial Instruments, art.
4(2)(14), 2004 O.J. (L 145) [hereinafter MiFID] that defines financial instruments by reference to Section C of Annex I.
86
87
Introduction to Part I
45
Article 2(XXIV) of the Mexican Securities Market Law contains a
definition of securities that is very broad and includes a wide variety of
financial instruments but limits these instruments to those that are
susceptible to trading in securities markets. This qualification is similar
to that included in the EU law, which seems to exclude non-financial
assets with values that cannot readily be established in the securities
market. The Indeval Regulations in Article 1.2 do not provide any
specific definition of securities and, instead, refer to the definition
included in the Law on Securities Market. The Salvadoran Law does not
limit the securities to those that have a financial nature or of which the
value must be readily determined. Accordingly, the scope of the Salvadoran intermediated regime is more flexible than Mexico’s, which is
limited to those assets susceptible to trading in securities markets.
From the previous discussion, it becomes clear that legislation to
regulate intermediated holding systems must clearly determine its scope
by defining securities, financial assets/instruments and securities
accounts. These definitions should be based on the susceptibility of
financial assets/instruments to be credited to a securities account.
Reliance on a laundry list of various types of securities and other
numerus clausus enumerations is inapposite in the contemporary marketplace that evolves and changes quickly.89 The scope of legislation
regulating intermediated holding systems must be determined on the
basis of a flexible criterion that would allow ready accommodation of
new securities and other financial assets to facilitate their trading and
transfers. However, this approach should incorporate an objective
criterion that requires assets held in securities accounts to have a
financial nature and market-based value.
89
The definition of security should be flexible but also ensure legal certainty.
Guiliano G. Castellano, Towards a General Framework for a Common Definition
of ‘Securities’: Financial Markets Regulation in Multilingual Contexts, 13(3)
UNIF. L. REV. 449, 457 (2012).
2. Securities account relationships
CSD RELATIONSHIPS
Immobilization of securities with CSDs changed the pattern in which
securities are held and transferred. In contemporary intermediated holding systems CSDs play a critical role. Accordingly it is necessary to
examine the relationships that CSDs typically engage in including:
1)
2)
3)
the relationship with the issuer of the security;
the relationship among CSDs; and
the relationship of the CSD vis-à-vis its participating intermediaries.
The relationships of the CSD with the issuer, with other CSDs, and with
its participants are characterized similarly in transparent and indirect
holding systems. First, the relationship of the CSD with the issuer is
direct. Second, the relationships among multiple CSDs and the relationships of the CSD and its participating intermediaries are account-based.
Third, the relationship of the intermediaries with direct access to the CSD
against the issuer is indirect because these intermediaries may assert their
claims only against the CSD and have no privity with the issuer. These
upper-level relationships are complemented by the relationships of the
CSD participating intermediaries with other intermediaries and the ultimate account holders. As discussed below, all of these relationships are in
some respects dependent on one another yet in other respects completely
independent of one another.
Delivery of a global or jumbo certificate to a CSD or the CSD’s
registration on the issuer’s books creates a relationship between the two.1
This relationship may be characterized as direct and it is similar to the
relationship between the issuer and its shareholders that hold certificated
1
The Canadian Supreme Court in TELUS Corporation v. CDS Clearing
and Depository Sevices Inc., 2012 BCSC 1350 characterized the role of the CSD
as follows: ‘CSD acts as registered shareholder on behalf of financial institutions,
investors, brokers, and other entities known as “participants”.’
46
Securities account relationships
47
securities. However, there is an important difference between these two
types of relationships. In exercising its functions as the central depository, the CSD is not an investor that acquires ownership or other interests
in the security for investment purposes.2 Furthermore, the CSD is not
authorized to create a security interest in the deposited securities because
it has no rights thereto.3
In some systems, the CSD may maintain an ‘issuer account’ or
‘registry’ for the issuer. In this role, the CSD functions as a custodian or
guardian of the integrity of the security.4 The Salvadoran CEDEVAL
must maintain an electronic depository registry for emissions of securities (Registro Electrónico de Depósito de Emisiones) in which the
emissions and any acts that purport to modify or have juridical effects on
the emissions must be recorded. Similarly the Slovakian CSD is required
to establish an issuer’s register.5 None of these functions make the CSD
an intermediary of the issuer because the issuer accounts and registers are
still not securities accounts of the nature analyzed in this Part. The CSD
is an intermediary only with respect to its participants and other CSDs
for whom it maintains securities accounts.
In contemporary markets, many securities are acquired by investors
located in jurisdictions other than that of the issuer. Access of investors to
foreign securities markets is greatly facilitated by: 1) international CSDs
that serve multiple domestic securities markets and 2) links established
among domestic CSDs. Domestic CSDs may deposit certificates with
international CSDs or establish mutual accounts with each other to
facilitate transfers of securities on a cross-border basis.6 These inter-CSD
links may be established in different formats, which may authorize the
CSD to participate at another CSD as an ordinary intermediary or be
entitled to customized services.7 Irrespective of the types of services, this
See Official Comment 14 to UCC 8-102 (1994).
See, for instance, Salvadoran Law on Electronic Entries, art. 34.
4
DERMOT TURING, CLEARING AND SETTLEMENT IN EUROPE 392 (BLOOMSBURY PROFESSIONAL, LTD., HAYWARDS HEATH, UK, 2012).
5
Central Securities Depository of the Slovak Republic, Rules of Operation,
Part III – The Rules for Registration of Issues, Rule 6 (November 2011).
6
These relationships are typically regulated by formal agreements. See
CEDEVAL General Internal Regulation, art. 2(i) that defines the ‘international
custody contract’ that CEDEVAL may enter into with foreign CSDs.
7
See Zákon o cenných papieroch a investičných službách, § 99(4)(e), 9
November 2001 (Z.z. 566/2001) (Slovk.), available at http://www.nbs.sk/_img/
Documents/_Legislativa/_UplneZneniaZakonov/Z5662001.pdf (last visited 9
December 2013) [hereinafter Slovakian Securities Act].
2
3
48
The law of securities, commodities and bank accounts
relationship is formalized as a securities account.8 Such inter-CSD
securities accounts have the same features as the accounts established for
lower-level intermediaries. Accordingly, CSDs may act as ordinary
securities intermediaries.9 CSDs in developing countries often seek to
establish relationships and accounts with CSDs in developed economies
to facilitate access for local investors to securities issued and traded in
foreign markets. A number of Latin American CSDs have been granted
access to the DTC.10
CSDs facilitate the holding and transfers of securities and for this
purpose they maintain securities accounts for intermediaries and investors. Once the security is immobilized with a CSD, intermediaries may
acquire securities by obtaining credits to their securities accounts. Only
those intermediaries for whom the CSD maintains securities accounts and
that have been previously authorized may have direct access to the
CSD.11 Intermediaries authorized to participate directly at the CSD are
typically large banks and other institutional investors. In some systems
(e.g., El Salvador’s CEDEVAL), only legal entities are allowed direct
access to the CSD and natural persons may be only indirect participants.12 In other systems (e.g., Brazilian CBLC), even natural persons
may be direct participants at the CSD.13 Regulations and CSD rules may
further divide the participants into a number of categories depending on
the types of services to which these participants have been granted
access.
As a condition to establishing a securities account, intermediaries are
typically required to execute an agreement with the CSD and consent to
The Slovakian CSD allows participation of foreign CSDs through ‘holder
accounts’. Ibid., § 105a(3). In addition, linked CSDs typically execute an
agreement that may be based on the ECSDA Model Agreement Template; see
http: //www.ecsda.eu /site/uploads/ tx_doclibrary/2001_03_Model_Agreement_01.
pdf (last visited 9 December 2013).
9
The UNIDROIT Securities Convention in art. 1(d) defines ‘intermediary’
to include a central securities depository.
10
See DCV, DTCC Sign Agreement to Expand Offerings, Capabilities, available at http://www.bnamericas.com/news/banking/DCV,_DTCC_sign_agreemeent
_to_expand_offerings,_capabilities (last visited 9 December 2013).
11
See CEDEVAL General Internal Regulation (Reglamento General Interno
Central de Depósito de Valores S.A. De C.V. CEDEVAL) (2002) art. 2(g).
12
Ibid.
13
Best Brazil, Brazil Market Profile, 52 (February 2012), available at
http://www.bestbrazil.org.br/media/Market%20Profile.pdf (last visited 9 December 2013).
8
Securities account relationships
49
the terms and conditions of the service that will be provided.14 Securities
accounts maintained by the CSD for its participating intermediaries
represent the second level relationship in the holding chain. The relationship between the CSD and its participants differs from the one against the
issuer. The issuer-CSD relationship is direct because the CSD holds a
security certificate or is registered on the issuer’s books. In contrast, once
the CSD participants acquire rights to the security, they will neither be
registered on the issuer’s books nor will they receive possession of the
security. From the legal relationship standpoint, their rights against the
issuer are indirect.
CLEARING
In many systems, CSDs provide a wider range of functions including
clearing, netting and settlement services. Clearing occurs between the
trade and settlement and may be defined as the process which definitively
establishes the obligations to deliver securities and transfer funds.15 In
other words, the fundamental function of clearing is to establish the
amounts of securities and funds to be credited or debited to accounts. At
a minimum, clearing involves a comparison and confirmation of the
transactional details provided by the trading platform to the clearing
entity. In this sense, clearing is limited to administrative functions. When
clearing also involves netting, it performs the additional function of
reducing the number and value of transactions with securities that are
eventually settled on accounts maintained by intermediaries. However,
clearing may not necessarily involve a netting component. Clearing may
be performed either in the centralized form in which outstanding trades
are netted and the final position is calculated – ‘the clearinghouse
clearing’ – or by the imposition of a central counterparty that novates all
outstanding contracts and becomes the counterparty to every contract –
14
See CEDEVAL General Internal Regulation art. 2(b) that defines securities account contract (contrato de cuenta de valores) and European Central
Counterparty Limited Rules, Rule 2, Section 2: Participant’s Agreement of the
EuroCCP Rules (1 October 2012) [hereinafter EuroCCP Rules].
15
See L. 964, julio 8, 2005, Diario Oficial [D.O.] 45.963 (Colom), art. 9.
CBLC, Operating Rules, Rule 3.14 defines clearing as ‘the process of calculating
the mutual obligations of counterparty market participants, on a net basis, for the
exchange of securities and money by way of settlement of mutual net settlement
obligations’.
50
The law of securities, commodities and bank accounts
‘the central counterparty clearing’. The advantage of the central counterparty clearing for securities transactions is the reduction of risk but the
downside is its relatively high cost.16
Upon receipt of trade information, the clearinghouse will first compute
all outstanding obligations to deliver between the intermediaries and then
will net any obligations that cancel each other out. Netting reduces
multiple delivery obligations that would otherwise overlap each other
into a single delivery obligation. Under the clearinghouse clearing,
outstanding obligations are reduced to a single obligation through netting
and the clearinghouse acts as a mere calculation agent instructing some
intermediaries to deliver securities and others to submit payments. The
clearinghouse does not assume any obligation to transfer, and thus the
obligations remain enforceable between the intermediaries.
Clearing of obligations to deliver securities may also be effectuated in
the form of central counterparty clearing. In this type of clearing, a
central counterparty (CCP) interposes itself between the original contracting parties.17 This additional step is performed by novation. This
type of clearing involves three separate functions: 1) calculation of
trades, 2) novation and 3) netting. The first function is administrative and
entails mechanical comparison of trade details. The two other functions
entail risk management directed towards the reduction in counterparty
risk.18 CCPs provide a special financial risk management service that
neutralizes counterparty risk.19 Due to novation, the satisfaction of
ultimate delivery obligations differs in the systems that utilize these two
types of clearing functions. While in the clearinghouse clearing systems
securities are delivered directly between the participants, in the central
TURING, supra note 4, at 16.
Council Directive 98/26/EC on Settlement Finality in Payment and
Securities Settlement Systems, art. 2(c), 1998 O.J. (L 166) [hereinafter EU
Settlement Finality Directive] defines central counterparty as an entity which is
interposed between the institutions in a system and which acts as the exclusive
counterparty of these institutions with regard to their transfer orders.
18
For a definition of ‘counterparty risk’ see Council Regulation 648/2012
on OTC Derivatives, Central Counterparties and Trade Repositories (4 July 2012)
art. 2(11), 2012 O.J. (L 201) 1.
19
Christian Chamorro-Courtland, Central Counterparties (CCP) and the
New Transnational Lex Mercatoria, FLA. ST. U. BUS. REV. 57, 60 and 115
(2011).
16
17
Securities account relationships
51
counterparty clearing securities are delivered to the CCP and then from
the CCP to the participating intermediary entitled to receive delivery.20
As a result of novation, the original delivery obligation between two
intermediaries is broken up into two new delivery obligations that involve
the CCP. These two new obligations are independent from one another
and, after novation, the CCP is contractually required to perform on one
obligation even if its counterparty defaults on the other.21 Novation
results in the intermediaries eliminating the risk of one another’s default.
However, on the downside, CCPs concentrate credit risk, creating a
potential systemic collapse if a number of CCP counterparties default.22
For this reason, CCPs must have in place adequate risk management
measures that preserve their capital.23 Furthermore CCPs must concern
themselves only with the clearing of securities transactions.24 The
counterparty risk is further managed by netting, a process that is typically
effectuated by the CCP upon novation. In securities markets, intermediaries typically enter into a number of transactions with respect to the
same security daily.25 In CCP systems, their mutual obligations are both
novated and netted, resulting in a significant reduction in final delivery
obligations.
20
MATTHIAS HAENTJENS, HARMONISATION OF SECURITIES LAW, CUSTODY
AND TRANSFER OF SECURITIES IN EUROPEAN PRIVATE LAW 46 (KLUWER LAW
INTERNATIONAL, ALPHEN AAN DEN RIJN, NETHERLANDS, 2008).
21
JOANNA BENJAMIN, INTERESTS IN SECURITIES, A PROPRIETARY LAW
ANALYSIS OF THE INTERNATIONAL SECURITIES MARKETS 24 (OXFORD UNIVERSITY PRESS, OXFORD, UK, 2000).
22
JIABIN HUANG, THE LAW AND REGULATION OF CENTRAL COUNTERPARTIES 174–5 (HART PUBLISHING LTD., PORTLAND, OR, 2010) and TINA P.
HASENPUSCH, CLEARING SERVICES FOR GLOBAL MARKETS 45 (CAMBRIDGE
UNIVERSITY PRESS, NEW YORK, NY, 2009).
23
Jean-Claude Trichet, Issues Related to Central Counterparty Clearing,
Speech at the joint European Central Bank-Federal Reserve Bank of Chicago
Conference, Frankfurt (4 April 2006), available at http://www.bis.org/review/
r060411c.pdf (last visited 9 December 2013).
24
The NSCC, the central counterparty for over 50 million transactions
executed daily on US securities exchanges, maintained a cash clearing fund of
US$ 7 billion and a US$ 6.275 billion line of credit as of October 2011. DTCC,
Proposal to Launch a New Cost-Benefit Analysis on Shortening the Settlement
Cycle, at 6–7 (December 2011).
25
HASENPUSCH, supra note 22, at 25.
52
The law of securities, commodities and bank accounts
In the United States, the NSCC performs clearing functions for
transactions with securities settled through the DTC.26 The NSCC acts as
a middleman that assumes the delivery and payment obligations of the
original parties and, in that capacity, reduces the settlement requirements
for trades by 98 percent.27 The Supreme Court of Nevada summarized
the clearing procedures of the NSCC and its interactions with the DTC as
follows:
After the NSCC calculates a broker’s payment or delivery obligation with
respect to a specified security for a designated trading period, the broker
normally owes or is owed shares of that security. The NSCC then transmits
that information to the DTC for processing. For the selling broker, the DTC
compares the broker’s share delivery obligation, if any, to the amount of that
share held in the broker’s DTC account, to determine whether the broker
possesses enough shares to fulfill his delivery obligation. If enough shares are
present in the selling broker’s DTC account to fulfill that delivery obligation,
delivery of those shares occurs by sending the shares through the NSCC to
the DTC account of the party owed the securities, the buying broker.28
In 2007, the European Central Bank (ECB) conducted a survey of
domestic central clearing systems in the EU Member States.29 The ECB
survey found that there were nine CCPs operating in the EU countries of
Austria, France, Germany, Greece, Hungary, Italy, Spain, Sweden and the
United Kingdom. As a result of integration and mergers, multinational
clearing entities have been established to clear securities transactions
executed in a number of EU markets. For instance, Belgian, French,
Dutch and Portuguese local clearing entities merged together to form
LCH.Clearnet S.A., which now provides CCP clearing for transactions
A similar clearing structure exists in Canada where the Ontario Securities
Commission appointed the CSD to provide central counterparty clearing services. CDS Participant Rules, Release 3.3. (January 2009), available at http://
www.cds.ca/cdsclearinghome.nsf/Downloads/-EN-CDSParticipantRules3.3/$File/
CDS+Participant+Rules_3.3_en.pdf?OpenElement (last visited 9 December
2013).
27
DTCC, The US Model for Clearing and Settlement, An Overview of
DTCC, 3 (2007).
28
Nanopierce Techn. v. DTC, 168 P.3d 73, 78 (St. C. NV, 2007).
29
George Kalogeropoulos, Daniela Russo & Andreas Schonenberger, Link
Arrangements of Central Counterparties in the EU – Results of an ESCB Survey,
in The European Central Bank, The Role of Central Counterparties, 50 (July
2007), available at http://www.ecb.eu/pub/pdf/other/rolecentralcounterparties
200707en.pdf (last visited 9 December 2013).
26
Securities account relationships
53
executed in securities markets of any of the included countries.30 More
recently, European Central Counterparty Limited (EuroCCP) was established to provide organizational support for cross-European securities
trading, clearing and settlement. Presently it clears securities transactions
from eighteen European markets.31 Despite the regionalization of clearing services within the EU, a single pan-European clearing and settlement system along the lines of the US DTCC system has yet to be
established.32
The clearing landscape in developing countries of Latin America is
split between systems in which clearing services are provided and
systems in which clearing is absent. One of the few clearing entities in
Latin America is the Brazilian Clearing and Depository Corporation,
CBLC, which provides CCP clearing services. In Mexico, Contraparte
Central has been providing CCP services for securities immobilized with
Indeval since 2004. A study undertaken by the IMF concluded that in
Central America the concepts of netting and clearing are not well
understood and, as a result, the legal framework governing clearing is
inadequate.33 The clearing process at the Salvadoran CSD, CEDEVAL, is
limited to the submission of trade details from the stock exchange and
their confirmation by counterparties.34 A number of systems in Latin
America, including Bolivia, Ecuador, Honduras and Panama, do not
provide any clearing services at all.
30
LCH.Clearnet S.A. is owned 73.3% by users, 10.9% by exchanges and
15.8% by Euroclear. See LCH.Clearnet, About Us, available at http://
www.lchclearnet.com/about_us/ (last visited 9 December 2013).
31
EuroCCP is a clearing subsidiary of the US DTCC. See EuroCCP,
Overview: The EuroCCP Advantage, available at http://www.euroccp.co.uk/
about/ (last visited 9 December 2013).
32
Establishment of such a system was strongly advocated by the former
Chairman of the London Stock Exchange, Don Cruickshank; see Nathalie Aubry,
Regulating the Plumbing of Europe, 23(11) J.I.B.L.R. 578, 580 (2008).
33
Hermant Shah, Ana Carvajal, Geoffrey Bannister, Jorge Chan-Lau & Ivan
Guerra, Equity and Private Debt Markets in Central America, Panama and the
Dominican Republic, IMF Working Paper WP/07/288, 16 (2007).
34
CEDEVAL, Manual de Operaciones, Capı́tulo VI, Compensación y
Liquidación de Valores, at A. Proceso de Compensación, available at https://
www.cedeval.com/pdf/mop_cedeval.pdf (last visited 9 December 2013).
54
The law of securities, commodities and bank accounts
SETTLEMENT
Clearing, if provided in a particular system, precedes the settlement, or
the process that involves the actual transfer of securities between
securities accounts. The settlement of a transaction with securities
involves two transfers: 1) a transfer of securities and 2) a transfer of
funds. The CSD will effectuate the first transfer by crediting and debiting
the securities accounts of the intermediaries. This type of settlement is
effectuated centrally when the transfers are settled through the CSD.
However, many transfers are completed on a decentralized basis by
intermediaries, such as when two customers of the same intermediary
execute a transaction with the same security, one buying and the other
selling. This transaction will be settled by the intermediary effectuating
credits and debits to the respective customer accounts without involving
the central clearing and settlement facilities.
Intermediaries that participate at the CSD must also open bank
settlement accounts typically with the central bank or with one of the
authorized settling banks. If a central counterparty clearing is provided in
the system, the clearing entity must also have established a deposit
account for the purposes of transferring funds in the settlement of
securities transactions. In the United States, the DTC authorizes settling
banks to open bank accounts at a Federal Reserve Bank to effectuate
payments in the settlement of securities transactions.35 In Europe, participants at the Clearstream Germany system must open a bank account with
the Bundesbank and grant Clearstream the authority to submit payment
orders for the purpose of settling securities transactions.36 A similar
structure was adopted in Slovakia, in which transfers of securities at the
Slovakian CSD are settled against payments on the bank accounts
maintained by the Slovakian National Bank.37 Brazil and Mexico have
35
DTCC Rules and Procedures, Rule 9(d) (June 2009). Settling banks must
sign agreements with the DTCC to function as such.
36
Clearstream, Deutchse Börse Group, General Terms and Business Conditions of Clearstream Banking Aktiengesellschaft, art. 9(1)(a) (1 February 2004).
If the participant does not have an account at Bundesbank, it may request a
correspondent banking institution with such an account to authorize Clearstream
to make respective entries in the account to settle transactions entered into by the
participant.
37
Central Securities Depository of the Slovak Republic, Rules of Operation,
Part IV – The Rules on Clearing and Settlement (July 2007) art. 1(2)(l).
Securities account relationships
55
adopted a similar central settlement design.38 Maintenance of bank
accounts by the central bank for CSDs, securities intermediaries and
officially designated settling banks protect the securities settlement
system against the insolvency and credit risk of a financial institution.
Transfers among bank and securities accounts maintained for CSD
participants are typically completed on a delivery-versus-payment (DVP)
basis. A DVP settlement may operate on a net basis, whereby individual
transfers are netted and only a single entry is made, or on a gross basis,
in which both the payment and transfer of securities occur in real time.39
DVP settlement completed on a gross basis minimizes counterparty risk,
eliminating situations in which one party receives securities but then fails
to provide payment or vice-versa. Many securities settlement systems
regardless of the size of securities markets, the volume of transactions or
the liquidity of secondary markets, provide DVP settlement services. In
the United States, the DTC Rule 9A – Transactions in Securities and
Money Payments – established the basis for the DVP settlement.40 Latin
American CSDs, including those in Brazil,41 Mexico42 and Costa Rica,43
also effectuate settlement on the DVP basis. Similarly in Europe,
Clearstream Germany, Clearstream Luxembourg, and the smaller CSD in
Slovakia, provide for DVP gross settlement.44
Clearing and settlement functions of CSDs and other intermediaries are
significantly impacted by the legal and regulatory requirements to settle
38
For Brazil see Banco Central do Brasil, BM&FBOVESPA Securities,
available at http://www.bcb.gov.br/?BMFSECURITIES (last visited 9 December
2013) and CBLC, Rule 3.19, which defines settlement account as ‘an account
that CBLC, as a provider of settlement services, holds with the Central Bank …’.
For Mexico, see Indeval Regulations, art. 28º.
39
ECB, Settlement Fails – Report on Securities Settlement Systems (SSS)
Measures to Ensure Timely Settlement, 2 (April 2011), available at http://
www.ecb.int/pub/pdf/other/settlementfails042011en.pdf (last visited 9 December
2013).
40
DTCC Rules and Procedures, Rule 9(A) (June 2009).
41
See Banco Central do Brasil, BM&FBOVESPA-CBLC, available at http://
www.bcb.gov.br/pom/spb/ing/securitiesderivativesforeign/cblcingles.asp (last visited 9 December 2013).
42
Indeval Regulations, art. 27º.
43
THE WORLD BANK, MASSIMO CIRASINO, JOSÉ ANTONIO GARCÍA, MARIO
GUADAMILLAS & FERNANDO MONTES-NEGRET, REFORMING PAYMENTS AND
SECURITIES SETTLEMENT SYSTEMS IN LATIN AMERICA AND THE CARIBBEAN
141–2 (THE WORLD BANK, WASHINGTON, DC, 2007).
44
For a list of European CSDs and the types of settlement services that they
provide see ECB, Eligible SSSs, available at http://www.ecb.int/paym/coll/coll/
eligiblesss/html/index.en.html (last visited 9 December 2013).
56
The law of securities, commodities and bank accounts
transactions within a certain number of days after the trade was executed.
These requirements are known under acronyms such as T+3 and T+1 in
which the ‘T’ stands for the day of trade. Regulations require intermediaries to make the respective entries to the accounts they maintain a
certain number of days after the trade was concluded in a securities
market. The settlement cycles differ in individual systems, but generally
vary from T+0 to T+5. These cycles also vary for the settlement of
transactions with individual types of securities and are generally longer
for shares than for bonds.45 Currently the global trend is to implement
measures leading to the reduction of the settlement cycle to T+2 for
securities transactions, aligning them with that of foreign exchange
transactions.46
ACCOUNT RELATIONSHIPS AT LOWER TIERS AND
RIGHTS TO SECURITIES
The preceding section identified the top-tier entities and examined the
functions they perform in contemporary securities holding systems. The
traditional relationship between the issuer of securities and investors
incorporated in a security certificate or registration on the issuer’s book
has been replaced with an account-based relationship in the form of
securities accounts. These securities accounts are not maintained by
issuers for their individual investors but by CSDs and lower-level
intermediaries. Contemporary laws on the holding of securities focus on
relationships represented by securities accounts instead of the actual
security. These account-based relationships may take various forms and
be subject to different rules. Depending on the characterization of
account holders’ rights to securities, systems may be classified into two
categories: 1) those that apply the traditional proprietary concepts that
allow account holders to trace their rights to the security deposited with a
CSD and 2) those that provide for a new legal concept, such as the
security entitlement that does not allow for tracing through the tiers of
intermediaries.
In most systems today investors hold securities in the form of
electronic entries to securities accounts. Like possession of a bearer
ECB, supra note 39, at 3.
OMGEO, How to Make Settlement More Efficient and Less Risky: The
Global Move towards Shorter Settlement Cycles as a Significant Driver
of Operational Change, 3 (2012) available at https://www.omgeo.com/
settlementpaper (last visited 9 December 2013).
45
46
Securities account relationships
57
security or registration on the issuer’s books, a securities account
establishes the right to securities or financial assets. This right of the
account holder is quantitatively determined by the balance on his
securities account which is the equivalent to the aggregate value of
certificated securities that the investor may possess. However, the account
balance does not speak to the quality of the rights to securities. By
looking at the balance on a securities account, one may not determine
whether the investor has ownership rights, other property rights or
contractual claims.
First, it is important to determine whether the rights acquired by
account entries are proprietary or contractual. Generally property rights
provide a person with priority over the rights of third parties and, in the
context of securities holding, protect the investor against the insolvency
of his intermediary. Property rights, whether in the form of absolute
ownership or limited proprietary interests, ensure that the account holder’s claim against the intermediary will be satisfied from the assets that
the intermediary maintains for the investor. The property interests of
account holders are limited because they may be enforceable only against
the intermediary, as in a security entitlement, or they may be shared
pro-rata with other investors, as in co-ownership. The remaining question
is to determine the nature of these proportional proprietary interests that
could include co-ownership, indirect co-possession, an interest in trust
property, etc.47 The following section contrasts two predominant
approaches to the characterization of pro-rata proprietary interests in the
context of intermediated holding systems: 1) the fashioning of new legal
concepts, such as the security entitlement, and 2) the application of
co-ownership concepts.48
A New Legal Concept
The holding systems of Canada and the United States are known as
indirect. Under these laws pro-rata proprietary interests of account
Classification of the account holders’ rights depends on their jurisdiction.
José M. Garrido, The Loss-sharing Rule in the Insolvency of Financial Intermediaries, 15(3–4) UNIF. L. REV. 779, 781 (2010).
48
Marek Dubovec, Securities Holding Patterns and Their Impact on the
Rights of Securities Holders: Lessons for Developing Nations, in LATIN AMERICAN COMPANY LAW: A COMPARATIVE AND ECONOMIC DEVELOPMENT PERSPECTIVE, VOL. 1, 213, 221–4 (Boris Kozolchyk & Francisco Reyes eds., CAROLINA
ACADEMIC PRESS, DURHAM, NC, 2013).
47
58
The law of securities, commodities and bank accounts
holders are characterized as security entitlements.49 The 1994 revision of
UCC 8 introduced a number of important concepts to support the already
existing indirect holding system. During the drafting of the revised UCC
8 the interest of the account holder in an indirectly held security was
described and then labeled a security entitlement.50 A securities account
consists of the sum of all the security entitlements maintained therein.
The approach of the drafters was both practical and functional in that
they captured the function of the rights in the security entitlement
concept. The Canadian Uniform Securities Transfer Act, modeled on the
1994 revision of UCC 8, also followed this functional approach.51
Professor Rogers recalled the following discussion on the security
entitlement during the UCC 8 drafting process:
Several of the early drafts avoided explicit mention of the concept of
‘property interest’ on the theory that the use of the older language might be
problematic. It is certainly true that a security entitlement is not a property
interest in some specific item held by the intermediary, of the sort that might
be asserted against someone else to whom that specific security has been
transferred … However, many lawyers who were involved in the project
warned that lawyers from other legal systems would be confused if it were not
possible to provide a simple answer to the question ‘Is a security entitlement
a property interest?’ In response to those concerns the language used in the
statute was changed to make it possible to provide a simple, unambiguous
answer to exactly that question. The answer is ‘Yes. A security entitlement is
a property interest.’ The text makes this point absolutely clear.52
So what kind of a property interest is a security entitlement? Professor
Guttman answered that ‘a security entitlement represents a distinct
property interest embodying rights in a financial asset, but does not
49
See UCC 8-102(17) (1994) and Part VI of the Canadian Uniform
Securities Transfer Act.
50
Mohamed F. Khimji, Intermediary Credit Risk – A Comparative Law
Analysis of Property Rights in Indirectly Held Securities, J.B.L. 287, 316 (2005).
51
Mohamed F. Khimji, The Securities Transfer Act – The Radical Reconceptualization of Property Rights in Investment Securities, 45 ALBERTA L. REV.
137, 138 (2007). See further RONALD C.C. CUMING, CATHERINE WALSH &
RODERICK J. WOOD, ESSENTIALS OF CANADIAN LAW, PERSONAL PROPERTY
SECURITY LAW 35–6 (IRWIN LAW INC., TORONTO, ONTARIO, 2005).
52
James S. Rogers, The Revision of Canadian Law on Securities Holding
Through Intermediaries: Who, What, When, Where, How and Why, CA. BUS. L. J.
49, 61 (2007).
Securities account relationships
59
represent a property interest in the underlying financial asset itself’.53
The critical difference being that the object of the latter is an identifiable
security certificate whereas the object of the former is the rights held in
the account maintained by the intermediary. Accordingly, an entitlement
holder does not have the same ownership rights to the security as a
holder of the actual certificate. UCC 8-102(a)(17) defines security
entitlement as a bundle of ‘the rights and property interest of an
entitlement holder with respect to a financial asset’. The entitlement
holder is thus vested with a number of contractual rights and a proprietary interest. Additionally the property interest bundled within the
particular security entitlement is not derived from the issuer, the CSD or
an upper-tier intermediary and these third parties do not actually know
who the account holder is. It is only the relevant intermediary who knows
the identity of the entitlement holder and the quantity of his holding. For
that reason, the first feature bundled within the security entitlement is
that its holder remains unknown to other participants in the indirect
holding chain with the exception of his own intermediary.
The property element embodied in the security entitlement is ‘the
investor’s interest in its account with the intermediary’.54 The account
holder may not exercise any property rights directly against the issuer,
the CSD or other intermediaries. The property interest exists only in the
account relationship with the intermediary.55 As an illustration, if IBM
issued 1000 shares and an intermediary acquired 100 shares of that total,
the intermediary would acquire a 10 percent undivided share to the IBM
stock deposited with the CSD. If, subsequently, the intermediary sold 50
IBM shares to one of its customers, that customer would acquire an
undivided 50 percent interest in the intermediary’s undivided 10 percent
interest. The customer would not acquire a 5 percent interest in the IBM
stock enforceable against the CSD because his claim would remain
enforceable only against the intermediary.56 The entitlement holder is in
privity only with the intermediary that maintains the securities account to
53
EGON GUTTMAN, MODERN SECURITIES TRANSFERS, § 11A:1 (3rd edn.,
THOMSON WEST, BOSTON, MA, 2007).
54
Charles W. Mooney, Beyond Negotiability: A New Model for Transfer and
Pledge of Interests in Securities Controlled by Intermediaries, 12 CARDOZO L.
REV. 305, 310 (1990).
55
The property interest of entitlement holders originates from their intermediaries. E. Perry Hicks, Transfer Restrictions in the Indirect Holding System:
Is Alienability in the Form of Holding?, BUS. L. TODAY 1, 2 (2012).
56
Steven L. Schwarcz, Intermediary Risk in Global Economy, 50 DUKE L.J.
1541, 1548 (2001).
60
The law of securities, commodities and bank accounts
which the entitlement is credited and may not assert his rights against
any other participant, including the CSD.57 Likewise, the entitlement
holder’s rights are not traceable through the tiers of intermediaries to
other account-based relationships.58
The proprietary interest of the securities account holder corresponds to
the intermediary’s duty to maintain financial assets that match the
aggregate of all security entitlements it is holding for its customers.59
Accordingly, the proprietary interest protects the entitlement holder
against the intermediary and any creditors of the intermediary, including
the insolvency trustee.60 This element also localizes any potential losses
within the particular account relationship, leaving other account relationships unaffected. This insulation of individual account relationships is
based on the principle of privity of contract. Sommer explained the
privity of contract function as follows: ‘Privity does to account relationships what negotiability does to property relations. Privity cuts off
adverse claims, and abolishes the relevant history of the account.’61
The fact of existence of a security entitlement within the particular
account relationship is also supported by the mode of its creation. A
security entitlement may be established when the intermediary actually
credits securities to an account or it may be deemed established by law.
The constitution of a security entitlement may, under some circumstances, be divorced from the account entry and be created at the moment
when the intermediary accepts a financial asset for credit to the securities
account.62 If the intermediary was obligated to credit the customer’s
account, but failed to do so, the security entitlement is deemed to have
been established from the moment the duty of the intermediary to create
such a credit in the customer’s account arose. The intermediary may also
credit its customer’s account before it receives a credit to its own
account.63 In this respect, Official Comment 2 to UCC § 8-501 provides
UCC 8-102(a)(7) (1994).
ROYSTON MILES GOODE, LEGAL PROBLEMS OF CREDIT AND SECURITY
215 (3rd edn., SWEET & MAXWELL, LONDON, UK, 2003).
59
See UCC 8-504(a) (1994) and Official Comment 1.
60
Dubovec, supra note 48, at 222.
61
Joseph H. Sommer, Commentary: Where is the Economic Analysis of
Payment Law?, 83 CHI.-KENT. L. REV. 751, 755 (2008).
62
UCC 8-501(b) (1994).
63
See Amicus Curiae Brief by the Security and Exchange Commission
(SEC) in Whistler Investments, Inc. v. DTCC, 2008 WL 3876577 (9th Cir. 2008)
at 10.
57
58
Securities account relationships
61
that ‘… what circumstances give rise to security entitlements turns on the
intermediary’s conduct … ’.
In summary, what are the features characteristic of the property interest
embedded within a security entitlement? First, it is not an ownership
right to a specific asset. Second, it is an interest in the pool of financial
assets shared pro-rata with other entitlement holders. Third, the rights
embedded in the security entitlement are enforceable only against the
intermediary that maintains the relevant account. Fourth, the intermediary
has the duty to maintain sufficient assets that must correspond to the
security entitlements of its account holders. Fifth, its constitution may be
independent of the account entry arising at the time the intermediary
becomes obligated to credit the customer’s account.
Traditional Proprietary Concepts
Some systems have not adopted specialized laws to address the rights of
investors to securities held in accounts with intermediaries and, by
analogy, apply the traditional proprietary concepts, such as those incorporated in Civil Codes. Others have adopted special custody laws that
specifically characterize the rights of account holders yet, overall,
reforms in many systems have not been as far-reaching as those in the
United States. The first jurisdictions that reformed their securities transfer
laws to accommodate the new system of account-based intermediated
holding were Belgium and Luxembourg. These jurisdictions characterized the interest of account holders as co-ownership rights in a pool of
fungible securities.64 Belgium and Luxembourg became pioneers primarily because they became the host countries to the then largest CSDs –
Euroclear and Clearstream, respectively. Legal reforms in other European
and Latin American countries were implemented much later with the
establishment of their respective domestic CSDs.
German law applies the concept of possession to characterize the rights
of account holders. Article 868 of the BGB (German Civil Code) creates
64
MICHAEL BLAIR QC & GEORGE WALKER, FINANCIAL MARKETS AND
EXCHANGES LAW 210 (OXFORD UNIVERSITY PRESS, OXFORD, UK, 2007) and UK
Financial Markets Law Committee (2004), Analysis of the need for and nature of
legislation relating to property interests in indirectly held investment securities
with a statement of principles for an investment securities statute – Report, Issue
3 Property Interests in Investment Securities available at http://www.fmlc.org/
Pages/papers.aspx (last visited 9 December 2013). Co-ownership was also the
underlying concept of the previous 1977 revision of UCC Article 8 of 1977. See
Mooney, supra note 54, at 403–4.
62
The law of securities, commodities and bank accounts
a structure in which intermediaries possess the security for their account
holders constructively (indirectly). German scholars argued that account
holders are thus vested with an indirect right to possession of the
security.65 One may wonder how possession, albeit constructive, fits into
a system that is based on electronic accounts and entries and in which the
only tangible object may be the global or jumbo security immobilized
with a CSD. Paradoxically, it is the global security that provides the
answer to this question. When the CSD is in possession of the global
security it may be characterized as direct.66 Intermediaries and account
holders who claim rights to the immobilized security may be said to have
an indirect (constructive) possessory right. This theory relies on the
possibility of tracing the account holders’ rights through the chain of
intermediaries to a common source – the immobilized security. One may
explain this possessory right as the right to possession that gives the
account holder the right to shared control over the certificate.67 It is a
type of possessory interest that is based on the control rights of the
account holder to a tangible object rather than on its physical custody.
Since the adoption of the Securities Deposit Act in 1972, German law
also classifies the rights of securities account holders as co-ownership
interests if the securities are held in the form of collective safe custody.68
Accordingly, in Germany the rights of account holders are characterized
as both co-possessory under the Civil Code and as co-ownership under
the Securities Deposit Act.69 The principles of indirect possession incorporated in Article 868 of the BGB, joint possession as reflected in the
General Terms and Business Conditions of German Clearstream Banking,
and co-ownership as reflected in the Securities Deposit Act create
65
Bernd Geier, Comparison of the Electronic Securities Settlement Systems
for the Secondary Securities Markets in Germany and England, 23(3) J.I.B.L.R.
97, 102 (2008) and EVA MICHELER, PROPERTY IN SECURITIES, A COMPARATIVE
STUDY 189 (CAMBRIDGE UNIVERSITY PRESS, CAMBRIDGE, UK, 2007).
66
See General Terms and Business Conditions of German Clearstream
Banking, which, in art. 8(1)(b), provide that the CSD is the direct holder of
possession.
67
Khimji also observed that control serves as a means of identifying the
party that has the ability to alienate investment securities. This is akin to the
notion of constructive possession. Khimji, supra note 51, at 162.
68
Depotgesetz, § 6(1). Collective safe custody is defined in § 5.
69
CHANGMIN CHUN, CROSS-BORDER TRANSACTIONS OF INTERMEDIATED
SECURITIES, A COMPARATIVE ANALYSIS IN SUBSTANTIVE LAW AND PRIVATE
INTERNATIONAL LAW 118 (SPRINGER-VERLAG BERLIN HEIDELBERG, NEW YORK,
NY, 2012).
Securities account relationships
63
unnecessary complexity, although in practice, no operational difficulties
have arisen.70
In a number of other EU jurisdictions, including Slovakia, the rights of
account holders are classified as co-ownership interests.71 Under the
co-ownership theory, individualized property rights in a specific asset no
longer apply and investors instead have a right to a pro-rata share
corresponding to the quantity of securities credited to their securities
accounts.72 Some of these countries have adopted special custody laws
that preempt the property concepts enshrined in the Civil Codes. In
Slovakia fungible securities are kept in bulk safekeeping (deposit) and
investors acquire joint ownership to such securities subject to the special
regime of securities laws.73 The joint ownership to securities held in bulk
is excluded from the application of the general rules on joint ownership
incorporated in the Slovakian Civil Code.74 The joint ownership right of
an investor therefore becomes a pro-rata share to the bulk.75
Latin America in general follows the property law classifications that
are characteristic of the EU jurisdictions and applies the concept of
co-ownership to characterize the rights of securities account holders.76
Brazil characterizes the rights of accounts holders as that of
co-ownership, with the CSD functioning as the fiduciary owner of the
immobilized security for the benefit of accounts holders.77 Accordingly, it
preserves the relationship between the CSD and individual beneficial
owners that is established by a duty of the intermediaries to allocate all
securities at the beneficial-customer level to a particular securities
account number.78 In Central America, Article 15 of the Salvadoran Law
on Electronic Entries provides that the rights of account holders are of a
Ibid., 195–6.
Slovakian Securities Act, § 39(3) characterizes the rights of investors as
‘joint property’. See further Peter Baláž, Implikuje účet majitel’a cenných
papierov depozitný vzt’ah?, 59(3) JUSTIČNÁ REVUE 383, 385 (2007).
72
Clearstream Banking Luxembourg, General Terms and Conditions, art. 11
(January 2006).
73
Slovakian Securities Act, §§ 39(3) and 42.
74
Ibid.
75
Ibid. See also § 39(2) under which a separate custody for individual
securities, segregated from the same securities of others, is also available.
76
See Resolución 0816 del 26 May 2011 emitida por la Superintendencia
Financiera de Colombia, Reglamento de Operaciones Deceval S.A. art. 27
(Colom.) [hereinafter Deceval Reglamento], which defines the rights of account
holders to the immobilized security as ‘collective ownership’.
77
Dubovec, supra note 48, at 224.
78
Best Brazil, supra note 13, at 50.
70
71
64
The law of securities, commodities and bank accounts
co-ownership nature.79 It is noteworthy that the Mexican Securities
Market Law, the Internal Regulation of Indeval, and its Manual, do not
define the nature of rights to securities credited to accounts.
The co-ownership right may allow for the tracing of accounts holders’
interests to the security deposited with the CSD. If the intermediary
acquired 100 shares of the total number of 1000 shares issued by IBM,
the intermediary would acquire a 10 percent undivided share to the IBM
stock deposited with the CSD. If subsequently the intermediary sold 50
IBM shares to one of its customers, that customer would not acquire an
undivided 50 percent interest in the intermediary’s undivided 10 percent,
as in the indirect holding system. Instead, the customer would acquire a 5
percent interest in the IBM stock enforceable against the CSD.
PROTECTION OF INVESTORS’ RIGHTS
The core protection for investors holding their securities in intermediated
systems is the duty of their intermediaries to ‘allocate’ securities to their
account holders’ rights. Intermediaries may satisfy this duty by holding
or maintaining sufficient securities to satisfy all claims of their account
holders.80 In indirect holdings systems, intermediaries regularly maintain
financial assets of their account holders on a fungible basis in an omnibus
account with an upper-tier intermediary.81 These omnibus accounts are
segregated from the proprietary accounts of the intermediary but individual securities and financial assets are not allocated to particular
customers of the intermediary.82 Accordingly the upper-tier intermediary
knows only that the omnibus account holds financial assets belonging to
the customers of the lower-tier intermediary but does not know the
identities of these customers. The account holders do not acquire specific
property interests in the financial assets maintained in the omnibus
account but their interests extend pro-rata to the entire account.83 The
concept of a pro-rata proprietary interest is characteristic of the law
79
Salvadoran Law on Electronic Entries, art. 15 provides: ‘Los valores
anotados podrán poseerse en copropiedad’.
80
See Official Comment 3 to UCC 8-504 (1994).
81
Omnibus accounts have advantages, such as that they allow for net
settlement, and disadvantages, such as that they require loss-allocation formulas.
TURING, supra note 4, at 238.
82
CCPs regularly set up clearing member accounts separately from those of
their customers. HUANG, supra note 22, at 91.
83
UCC 8-503(b) (1994).
Securities account relationships
65
concerning bailment of fungible goods, such as grain and oil. Professor
Rogers observed that UCC Article 7, dealing with documents of title and
bailment relationships, is based on the ‘proportionate ownership’
approach that is similar to the rule applicable to the rights of investors to
securities held in bulk.84 This pro-rata property interest protects bailors/
investors against the bailee/securities intermediary’s insolvency and the
claims of their creditors because the entitlements are not property of the
intermediary.85 As a consequence, the securities intermediary may not
grant a security interest in the financial assets which it maintains for its
entitlement holders without their consent.86
In transparent holding systems, financial assets of investors must also
be separated or segregated from those of the intermediary.87 While
customer securities must be segregated, intermediaries in transparent
systems are mere conduits that facilitate the holding of their customers’
co-ownership rights against the CSD. CSDs in transparent systems
distinguish between the proprietary accounts of intermediaries and those
that they maintain for customers. Under German law, customer securities
may be commingled with those of the intermediary only when the
customer expressly waives the requirement of segregation.88 These two
types of accounts are designated as such in the CSD’s records.89 In
Brazil, CBLC is not authorized to open omnibus accounts for intermediaries.90 As a result, in the case of a default by either the intermediary
or one of its account holders, the rights to securities of the other
84
James S. Rogers, Negotiability, Property, and Identity, 12 CARDOZO L.
REV. 471, 485 (1990).
85
Ibid., 486. However, the pro rata rule provides comparatively weaker
protection to the direct holding system in which investors are protected by
specificity in the form of direct ownership to identifiable assets. Garrido, supra
note 47, at 788.
86
UCC 8-504(b) (1994).
87
Insolvenzordnung (InsO), 5 October 1994 (BGB1. I S.2082) (F.R.G.)
[hereinafter German Insolvency Code] § 47 provides that the securities are not
part of the intermediary’s insolvency estate and must be returned to the customer.
88
IOSCO, 2013 Survey of Regimes for the Protection, Distribution and/or
Transfer of Client Assets, Collated Responses to the Client Protection Survey,
Germany, at 141, available at http://www.normativafinanciera.com/normafin/
hemero.nsf /0/3704d483226f67a9c1257b0f003322fe / $FILE/3%20-%20Appendix
%20B%20 -% 20Collated%20Responses %20to %20the % 20Client % 20Asset %20
Protection%20Survey.pdf (last visited 9 December 2013).
89
Article 2(j–k) of the CEDEVAL Internal General Regulation defines
‘proprietary account’ and ‘account of a third party’.
90
OXERA, What Would be the Costs and Benefits of Changing the
Competitive Structure of the Market for Trading and Post-Trading Services in
66
The law of securities, commodities and bank accounts
non-defaulting customers are unaffected and their securities may not be
used to cover any shortfall.91 The Salvadoran CEDEVAL also maintains
‘nominative accounts’ for all investors. These investors must sign an
agency agreement with a direct participant to represent them in dealings
with CEDEVAL.92 The account operator thus satisfies its allocation duty
by having the CSD open an individual-specific account for all investors
to which their securities will be credited. In the case of a shortfall, if the
claims of the intermediary’s customers may not be satisfied in full, they
will be entitled to a proportional distribution and the resulting loss, or at
least a portion thereof, will be covered by insurance.93
In addition to the laws and regulations, rules of the CSD and
clearinghouses also provide for similar protections of customers’ rights to
securities. Rule 2, Section 2.3 of the EuroCCP Rules expressly requires
its participating intermediaries to deal with their house accounts separately from their client accounts. The proposed EU CSD Regulation goes
even further in that it enables CSD participants to segregate accounts of
each of their customers.94 This segregation at the customer level is not a
requirement and therefore it is up to each CSD to decide whether to offer
to keep such records for its participating intermediaries.95 In February
2013, the International Organization of Securities Commissions issued a
consultation report entitled ‘Recommendations Regarding the Protection
of Client Assets’ in which it set forth eight principles. Principle 1 requires
intermediaries to maintain accurate and current records with respect to
the client assets, including their nature, amount, location and ownership
status.
Allocation and segregation are the primary protection of customers’
rights. However, it may be the case that the intermediary fails to satisfy
its allocation duty and does not maintain sufficient securities to satisfy all
claims of its customers. Most jurisdictions provide additional protection
Brazil?, 37 (June 2012), available at http://www.oxera.com/Oxera/media/Oxera/
downloads/reports/Report-1-Brazil.pdf?ext=.pdf (last visited 9 December 2013).
91
Best Brazil, supra note 13, at 54.
92
See CEDEVAL, Manual de Operaciones, supra note 34, at Capı́tulo I,
Servicios y Participantes, C.2.
93
See Depotgesetz, § 32(3).
94
Explanatory Memorandum to the proposed Regulation on Improving
Securities Settlement in the EU and on Central Securities Depositories (CSDs),
available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:
52012PC0073:EN:PDF (last visited 10 December 2013) at 8. Article 35(1) also
provides that ‘… a CSD shall keep records … to distinguish … the securities of
a participant from the securities of any other participant …’.
95
Ibid., art. 35(3).
Securities account relationships
67
mechanisms in cases such as these. Primarily these mechanisms are
designed in the form of compensation funds that cover losses up to a
certain threshold. Some intermediaries offer their customers supplementary insurance beyond the statutory insurance cap.96 The US Securities
Investor Protection Act created the Securities Investor Protection Corporation (SIPC) with the mandate to cover losses incurred by customers of
securities intermediaries of up to US$ 500 000.97 Within the EU, Article
2(1) of the Directive 97/9/EC on Investor-Compensation Schemes mandates every Member State to establish at least one compensation scheme
to cover the customer claims of up to € 20 000.98 The EU Commission
recently proposed amendments to this Directive that would, amongst
other changes, increase customer coverage to € 50 000.99 In Brazil,
Article 76 of Instruction No. 461 issued by the Brazilian Securities and
Exchange Commission provided the basis for the creation of a lossrecovery mechanism to cover any potential losses that might be incurred
by investors due to the actions of, or omissions by, intermediaries.100
Edward H. Klees, How Safe Are Institutional Assets in a Custodial Bank’s
Insolvency?, 68(1) BUS. LAW. 103, 120 (2012).
97
15 U.S.C. § 78aaa et seq. (2013). SIPC does not cover certain investments, including commodity futures contracts. In re MF Global Inc., 2013
Bankr. LEXIS 1578 *4 (S.D.N.Y. Bkrt. 2013).
98
Slovakian Securities Act § 87(2) provides that individual customer claims
will be satisfied up to € 50 000.
99
See European Parliament Proposal for a Directive amending Directive
97/9/EC on Investor-compensation Schemes COM(2010)0371, at Recital 12.
100
Bovespa implemented this requirement in the form of the Investor
Compensation Mechanism (MRP). OXERA, supra note 90, at 40.
96
3. Transfers of intermediated securities,
finality and security interests
One of the fundamental rights of account holders is to transfer their
securities. Outright transfers, such as sales, are typically completed by
book entries whereby the account of the transferor is debited and the
account of the transferee is credited. However, book entries are equally
utilized by creditors that receive credits of encumbered securities to their
accounts. Both types of transfers are effectuated by intermediaries in the
same way banks execute payment orders of their depositors. The purpose
of this chapter is to analyse the mechanics of transfers and their effects
on the rights of account holders.
Transfer is an act that changes the owner or fragments the rights to the
security. It is functionally equivalent to the delivery of an asset that
occurs upon or after the conclusion of a purchase agreement. Transfer
may be accomplished differently depending on the type of asset being
transferred. Transfers of securities add an extra layer of complexity
resulting from the various forms of the holding systems. On the one
hand, while transfers of securities in a direct holding system may involve
an issuer that registers the names of transferees and issues new certificates, transfers in intermediated holding systems do not require any
entries on the issuer’s books.1 The common feature for transfers of all
forms of securities, irrespective of the type of holding, is the assistance of
the transferor who transmits an order to the intermediary to cause the
security to be transferred.2
1
Marek Dubovec, Securities Holding Patterns and Their Impact on the
Rights of Securities Holders: Lessons for Developing Nations, in LATIN AMERICAN COMPANY LAW: A COMPARATIVE AND ECONOMIC DEVELOPMENT PERSPECTIVE, VOL. 1, 213, 225 (Boris Kozolchyk & Francisco Reyes eds., CAROLINA
ACADEMIC PRESS, DURHAM, NC, 2013).
2
Egon Guttman, Investment Securities as Collateral, 36(3) U.C.C.L.J. 3, 12
(2004).
68
Transfers of intermediated securities
69
TRANSFERS OF INTERMEDIATED SECURITIES
Given the intangible nature of securities held in accounts, it is not
surprising that laws that regulate intermediated holding systems uniformly use the concept of transfer as opposed to the concept of delivery
of possession.3 The book-entry transfer system for securities operates
similarly to the system for transfers of funds between bank accounts.4 No
items of property, such as written certificates or bank notes, change
holders in either system. Instead the balance on the transferor’s account is
reduced while a balance on the transferee’s account is increased. Book
entries made to securities accounts substitute for the physical delivery of
certificates and registration on the issuer’s books.5 The possession based
negotiability title recognition system for security certificates has been
replaced in intermediated systems by the records of intermediaries.6
The mechanics of book entries to accounts raises the question whether
rights are transferred by negotiation or assignment.7 It has been argued
that novation is the mechanism that transfers rights in a book-entry
accounts system. Professor Rogers explained that:
what matters is not the instruments themselves, but the abstract rights
represented by the instruments, and that the objective is to design an effective
system of title recognition for the abstract rights … there seems to be a
general tendency to evolve away from the negotiability system in favor of
various formal or informal systems relying not on possession of the instruments but on the records of financial institutions.8
3
Egon Guttman, Transfer of Securities: State and Federal Interaction, 12
CARDOZO L. REV. 437, 441 (1990).
4
Charles W. Mooney, Beyond Negotiability: A New Model for Transfer and
Pledge of Interests in Securities Controlled by Intermediaries, 12 CARDOZO L.
REV. 305, 403–4 (1990).
5
Luc Thévenoz, Intermediated Securities, Legal Risk, and the International
Harmonization of Commercial Law, 13 STAN. J.L. BUS. & FIN. 384, 386 (2008).
6
James S. Rogers, Negotiability, Property, and Identity, 12 CARDOZO L.
REV. 471, 485 (1990).
7
The Geneva Securities Convention does not take a position on the type of
legal theory supporting transfers of intermediated securities by book entries nor
does it provide that a book-entry transfer is accomplished by novation, assignment, negotiation, or otherwise.
8
James Steven Rogers, Negotiability as a System of Title Recognition, 48
OHIO ST. L.J. 197, 224 (1987).
70
The law of securities, commodities and bank accounts
Novation does not cause a transfer or passage of one investor’s rights to
another. Instead, upon novation the transferee acquires a bundle of rights
distinct from the bundle held by the transferor.9
The effects of book entries made at an intermediary level may differ in
systems. In some systems, book entries made to securities accounts
maintained by an intermediary will suffice to make the transfer effective
between the transferor and transferee, as well as render it effective
against third parties.10 No entries are required to be made to the accounts
of any entity other than the relevant intermediary. Accordingly, the
settlement system is decentralized in such systems.11 In other systems
entries at the intermediary level are not sufficient to render the transfer
effective against third parties.12 They become effective only upon a book
entry made at the CSD level. Legislation, under which CSDs in these
systems are constituted, typically includes in the list of the functions of
the CSD the completion of transfers and perfections of security interests.13 Entries made by account operators do not constitute, transfer or
novate any property rights in these systems.14
THE CONCEPTS OF FINALITY AND INDEPENDENCE
Finality is crucial in many areas of commercial law, particularly those
that involve sequels of credits and debits. The concept of finality may
take on a variety of meanings not only of the legal type but also of the
Official Comment 5 to UCC § 8-501 (1994).
See UCC § 8-501(b) (1994).
11
JIABIN HUANG, THE LAW AND REGULATION OF CENTRAL COUNTERPARTIES
27 (HART PUBLISHING LTD., PORTLAND, OR, 2010).
12
CHANGMIN CHUN, CROSS-BORDER TRANSACTIONS OF INTERMEDIATED
SECURITIES, A COMPARATIVE ANALYSIS IN SUBSTANTIVE LAW AND PRIVATE
INTERNATIONAL LAW 118 (SPRINGER-VERLAG BERLIN HEIDELBERG, NEW YORK,
NY, 2012).
13
See Slovakian Securities Act, § 22 and Salvadoran Law on Electronic
Entries, art. 2(c).
14
In the EU, the Legal Certainty Group, which has been studying the
possible harmonization of the substantive securities transfer laws, observed that:
‘the effects of a book entry by the intermediary are merely evidentiary or
administrative and no title to the securities is acquired or disposed of’. Klaus
Lober & Ulrik Rammeskow Bang-Pedersen, Legal Certainty Group, Subject 1
(‘book-entry securities’), Extract from the Draft Report: Validity of Credits, 5
(ECB, 13 November 2007).
9
10
Transfers of intermediated securities
71
purely technical type, such as the irreversibility of a book entry.15 One of
the critical elements affecting the finality of transfers is their (in)dependence on other transfers involved in the related relationships. For instance,
under one approach a debit entry to a securities account of the transferor
may not be effective and final unless a corresponding credit entry is made
to the account of the transferee. Under the opposite approach, the debit
entry to the transferor’s account may become final even before a
corresponding credit entry is made to the transferee’s account. Furthermore, the effectiveness, and thus finality, of the transfer may depend on
the validity of the underlying transaction executed in the front-end.
Consequently, in alternate systems the steps for transfers to become
final will differ. In the systems where account relationships are independent from one another, finality applies to every single relationship between
the account holder and his intermediary. Finality is internal to individual
relationships. This may not be the case in the systems where the transfer
is final only once the CSD has made a book entry.16 This is because the
account operator’s book entry is merely administrative and thus incapable
of providing finality.17 Here finality is external to account relationships
because factors outside the particular account relationship, such as entries
made by the CSD, affect finality.
Finality of transfers inevitably impacts the rights of transferors who
may not have actually authorized such transfers, did so mistakenly or
who have been defrauded. In contemporary systems that transfer billions
of securities on a daily basis, the unwinding of sequels of transactions
due to some subsequently discovered defenses or errors could potentially
destabilize their integrity and reliability. Instead of unwinding the entire
chain of transfers, errors should be cured by corrective book entries
between the two affected parties, a remedy already used in many
systems.18 Corrective transfers restore the position of the account holder
15
HIDEKI KANDA, CHARLES MOONEY, LUC THÉVENOZ, STÉPHANE BÉRAUD,
ASSISTED BY THOMAS KEIJSER, OFFICIAL COMMENTARY ON THE UNIDROIT
CONVENTION ON SUBSTANTIVE RULES FOR INTERMEDIATED SECURITIES 169
(OXFORD UNIVERSITY PRESS, OXFORD, UK, 2012).
16
For Costa Rica see Reglamento del Sistema de Anotación en Cuenta, art. 1
& 9 [D.O. 198] (17 October 2006).
17
Klaus M. Lober & Ulrik Rammeskow Bang-Pedersen, supra note 14.
18
See CEDEVAL, Manual de Operaciones, Capı́tulo VI, Compensación y
Liquidación de Valores, at A. Proceso de Liquidación, available at https://
www.cedeval.com/pdf/mop_cedeval.pdf (last visited 9 December 2013).
This approach is also recommended by the EU Legal Certainty Group. See Hans
Kuhn & Franziska Loew, Legal Certainty Group – Information about non-EU
Legal Systems, MARKT/G2/MT/ccD (2005) 9489, 11 (25 January 2006).
72
The law of securities, commodities and bank accounts
prior to the unauthorized or ineffective book entry without disrupting the
already executed chain of transfers.
Independence is also crucial in the context of defenses and equities
present in underlying contracts for the sale of securities and their impact
on account relationships. Systems that allow such defenses to be raised
against intermediaries undermine the finality of transfers, potentially
compromising the entire integrity of the transfer system. The EU Legal
Certainty Group observed that jurisdictions approach the interrelationship between the underlying transaction and its settlement by
credits and debits to securities accounts from one of two different
perspectives. Under the first approach an account relationship between
the account holder and its intermediary is independent of the underlying
transaction to purchase the security. Under the second approach the
validity of the book entry is conditional or causal on the validity of the
underlying contract. The first approach is the one that provides more
predictability and certainty in securities transfer systems.
SECURITIES AS COLLATERAL
Securities are one of the most desirable collateral assets to secure loans
due to their liquidity, the relative ease in their valuation and the efficient
methods for their disposal upon default. The securities industry has
developed two fundamental forms for using securities as collateral. First
the creditor can take a security interest in the securities of the borrower
who will remain the owner. Second the creditor and debtor may enter
into a repurchase agreement whereby the creditor acquires title to the
securities and assumes an obligation to transfer the securities back to the
debtor at a higher price sometime in the future.19 This financing
technique is also known as a repurchase or repo transaction.20 A repo
involves two simultaneous transactions – the sale of the security and an
agreement to repurchase it sometime in the future for the original
In Europe, central banks of France and Belgium became heavy users of
repos in early 1990s. See Collateral Initiatives Coordination Forum, Collateral
Fluidity, A White Paper, at 4 (November 2012), available at http://www.
icmagroup.org /assets /documents /Regulatory /CICF/Collateral-Fluidity-WP-7Nov
2012.pdf (last visited 9 December 2013).
20
The repo borrower pays a ‘repo rate’ which is a special form of interest
rate. DERMOT TURING, CLEARING AND SETTLEMENT IN EUROPE 483 (BLOOMSBURY PROFESSIONAL, LTD., HAYWARDS HEATH, UK, 2012).
19
Transfers of intermediated securities
73
purchase price plus a pre-determined interest.21 Security interests and
repurchase transactions may be collectively referred to as ‘collateral
arrangements’.22 It should also be noted that creditors regularly prefer
collateral in the form of bonds and other debt securities as opposed to
equity securities whose market value is more volatile.23
The following paragraphs discuss the requirements to render collateral
arrangements perfected, i.e., effective against third parties. Perfection of a
security interest and its effectiveness against the world (erga omnes)
presupposes a public notice of its existence. The purpose of providing
public notice is to inform third parties about existing and potential
encumbrances in the borrower’s assets.24 When dealing with securities,
the creditor must be mindful of the various holding patterns and the
applicable perfection requirements.25
Perfection by Control
With the increase in dematerialization and intermediation, control has
emerged as the relevant perfection mechanism for security interests in
intermediated securities and securities accounts. In its function, control
over intangible rights is similar to possession over tangible objects. The
legal consequences of transferring possession and control to the creditor
are the same – holders of possession or control enjoy the right to dispose
of the underlying asset upon default of the debtor. As long as the creditor
21
In re Comark, 145 B.R. 47, 49 (9th Cir. BAP, 1992). See also CMN
Resolution No.4040 (CMN Res.4040/2011), which amended CMN Resolution
No. 3339 of 26 January 2006 (CMN Res. 3339/2006), governing repo operations
(operações compromissadas) in Brazil, issued by the Brazilian Monetary Council
(Conselho Monetário Nacional – CMN) and Walter Stuber & Adriana Maria
Godel Stuber, Brazil: Bonds – Repo Operations, 27(7) J.I.B.L.R. 115 (2012).
22
See EU Financial Collateral Directive art. 2(1)(a) and Chapter V of the
Geneva Securities Convention. The economic substance of both transactions is
the same. Steven L. Schwarcz, Distorting Legal Principles, 35 J. CORP. L. 697,
719 (2010).
23
Joanna Benjamin, Securities Collateral, in THE REFORM OF UK PERSONAL
PROPERTY SECURITY LAW: COMPARATIVE PERSPECTIVES 223, 228 (John de Lacy
ed., ROUTLEDGE, LONDON, UK, 2010).
24
For the types of interests that should be subject to public notice achieved
by registration see Marek Dubovec, UCC Article 9 Registration System for Latin
America, 28(1) A.J.I.C.L. 117, 118 (2011).
25
Dubovec, supra note 1, at 226.
74
The law of securities, commodities and bank accounts
is empowered to dispose of the collateral without further consent of the
debtor it has control.26
However, under a possessory pledge, the debtor gives up access to the
collateral and thus its productive use. Dispossession also protects the
creditor’s interest because effectively the debtor is unable to transfer
the collateral to a third party free of the security interest. While arguably
providing a form of public notice, dispossession also provides an
important measure of protection. Lack of possession by the debtor should
raise a red flag and induce the third party to conduct further inquiry. With
control, the security arrangement may be structured so that the debtor
retains access to the collateral. Retention of access to encumbered
securities under a security interest perfected by control rather than by
public registration or delivery of possession may raise concerns with
respect to insufficient public notice. As illustrated below, for this reason a
number of economies do not recognize control as the functional equivalent of public registration and delivery of possession.
Control may exist in two different forms – either absolute or shared.27
Under absolute control the debtor does not retain any rights to deal with
the encumbered securities. A book entry indicating that the securities
have been transferred to and are being held in the creditor’s account
typically achieves this result. This type of control should not raise any
public notice concerns as the debtor would not appear to be authorized to
deal with the encumbered securities. Control is shared if the disposal
rights are divided between the debtor and creditor. Despite sharing the
disposal rights the creditor effectively acquires control and perfects its
security interest as long as the execution of its disposal rights is not
contingent upon the debtor’s consent; that is, the intermediary is obligated to execute the creditor’s disposition orders without obtaining
further consent from the debtor. Control agreements typically achieve this
result and no book credit entry needs to be made to the creditor’s
26
Official Comment 1 to UCC 8-106 (1994) and RONALD C.C. CUMING,
CATHERINE WALSH & RODERICK J. WOOD, ESSENTIALS OF CANADIAN LAW,
PERSONAL PROPERTY SECURITY LAW 223 (IRWIN LAW INC., TORONTO, ONTARIO,
2005). Negative control in the form of contractual restrictions imposed on the
borrower to dispose of the securities may not be sufficient to perfect a security
interest. Ben McFarlane & Robert Stevens, Interests in Securities, Practical
Problems and Conceptual Solutions, in INTERMEDIATED SECURITIES, LEGAL
PROBLEMS AND PRACTICAL ISSUES 46 (Louise Gullifer & Jennifer Payne eds.,
HART PUBLISHING LTD., OXFORD, UK, 2010).
27
For a further discussion of the typology of control see Benjamin, supra
note 23, at 223, 259, who distinguished positive and negative control that may
exist in the form of either legal or operational control.
Transfers of intermediated securities
75
account. This is the type of control that may raise public notice issues
because there is neither a transfer of securities to the creditor’s account
nor public registration.
To achieve absolute control encumbered securities may be transferred
by a book entry to the creditor’s securities account or to a special
collateral account.28 They may also be flagged as encumbered by a
designating entry but remain in the debtor’s securities account. The
designating entry is contemplated in the Geneva Securities Convention
under which the intermediary effectively earmarks certain securities in
the borrower’s account as being subject to a security interest.29 Such a
designation or earmark will also be indicated on any statements and other
documentation related to the account.30 All of these three types of book
entries should provide sufficient public notice to third parties.
In those systems where entries made by intermediaries have constitutive effects and convey property interests, security interests may be
perfected by the intermediary’s entry itself.31 Involvement of the relevant
intermediary is sufficient to render the collateral arrangement perfected
without any action of the CSD or the issuer. Therefore whether or not
control has been validly created will be determined only from the
relationship between the debtor, his intermediary and the creditor. This
type of perfection is similar to that utilized for goods stored in a
warehouse whereby the bailee issues a warehouse receipt or acknowledges receipt of goods and their holding for the creditor. In contrast, in
other systems where intermediaries’ entries only have administrative
effects, security interests must be perfected at the CSD level where the
book entries constitute and transfer rights.32 Whether or not control has
been validly constituted will depend on factors outside the debtorintermediary-creditor relationship, such as an action of the CSD.33
28
In German practice, securities of the debtor are typically transferred to a
special account for pledged securities. CHUN, supra note 12, at 187–8.
29
The draft EU Securities Law Directive provides for earmarking as the
special method of disposing of account-based securities, including the creation of
security interests. TURING, supra note 20, at 231.
30
However, third parties should not rely on account statements that are
essentially snapshots of the state of affairs at a particular point in time and the
account affairs may have changed subsequent to its issuance. KANDA, MOONEY,
THÉVENOZ & BÉRAUD, supra note 15, at 24.
31
UCC 8-106(d)(1) (1994).
32
See Slovakian Securities Act, § 45(2).
33
Comments of the Brazilian Delegation to the Working Group on so called
Transparent Systems (March 2007), available at http://www.unidroit.org/english/
76
The law of securities, commodities and bank accounts
Shared control is typically established pursuant to an agreement among
the account holder, his intermediary and the creditor.34 Professor Guttman explained that a control agreement does not transfer mere trading
authority to the creditor but it transfers a limited property right in the
form of a security interest to the creditor.35 Trading authority may remain
vested with the debtor. Control agreements are typically trilateral in
nature, binding the debtor, the creditor and the intermediary that maintains the debtor’s securities account.36 Under US law, the control
agreement does not bind the intermediary unless it has become a party to
such an agreement.37 The intermediary is not obligated to enter into a
control agreement even if requested by the account holder. Similarly, the
intermediary may not do so on its own unless requested by the account
holder.38 A trilateral control agreement subject to US law typically
provides that ‘The intermediary will not change the name or number of
the Account … without the prior written consent of Creditor. Intermediary will send copies of all statements and confirmations concerning
the Account to each Debtor and Creditor … .’39 The key obligation of the
intermediary assumed in a control agreement is to abide by instructions
as to the disposition of the securities submitted by the creditor without
further consent of the debtor.
documents/2007/study78/s-78-062-e.pdf (last visited 9 December 2013) and
Slovakian Securities Act, § 50(2-3).
34
See Geneva Securities Convention, art. 1.
35
EGON GUTTMAN, MODERN SECURITIES TRANSFERS, § 5:5 (3rd edn.,
THOMSON WEST, BOSTON, MA, 2007).
36
The intermediary will not be a party to the security agreement that remains
a private matter between the debtor and the creditor.
37
First National Bank of Palmerton v. Donaldson, Lufkin & Jenrette Securities Corp., 1999 U.S. Dist. LEXIS 3275 *9 (E. Dis. Pen., 1999). United Hudson
Bank v. PNC Bank New England, 2006 Conn. Super. LEXIS 255, *5 (Superior
Court of Connecticut, Judicial Dist. of Stamford-Norwalk at Stamford, 2006).
Delivery of the security agreement or an assignment agreement purporting to
create a security interest in the securities to the relevant intermediary is not
sufficient to perfect a security interest. In re Jerimiah L. Richards, 336 B.R. 722,
729 (East. D. Vir. Richmond Div. 2004). The court also rejected the argument
that delivery of the financing document to the intermediary amounts to the
creation of an equitable lien. Ibid., at 730. Similarly, a power of attorney granted
to the secured creditor to act in the name of the account holder is not sufficient
to perfect a security interest by control under UCC. See Official Comment 5 to
UCC 8-106 (1994).
38
UCC 8-106(g) (1994).
39
Sandra M. Rocks, Securities Account Control Agreement, SL051 ALIABA 513, 518 (2005).
Transfers of intermediated securities
77
The Geneva Securities Convention allows bilateral agreements and
notices thereof to bind the intermediary, recognizing that such collateral
arrangements are valid in many jurisdictions.40 The UCC approach is
protective of the rights of intermediaries but arguably at the expense of
account holders, who may not be able to utilize their securities as
collateral unless the intermediary becomes a party to a control agreement. In contrast, the Geneva Securities Convention effectively renders
intermediaries the deciders of priorities as they will have to determine in
which order notices of control were received. An approach that requires a
trilateral control agreement but that limits the intermediary’s right to
refuse to become a party to such an agreement would balance the
interests of all parties involved.
Many secured transactions laws permit the debtor to use assets while
encumbered by a perfected security interest primarily for economic
reasons.41 However such laws do so at the expense of the creditor having
to provide sufficient public notice, such as by registration. In some
economies publicity of the security interest achieved through the intermediary may not be adequate and comparable to that of registration. As a
result, only a form of absolute control is available. This is particularly the
case in those jurisdictions that are yet to recognize non-possessory
security interests in general. In these jurisdictions, the control agreement
contradicts the fundamental requirements for publicity of security interests because the debtor ostensibly remains the owner or retains the right
to deal with the collateral. The argument follows that an inquiry with an
intermediary is not as transparent as registration in a publicly available
registry. Even under the EU Financial Collateral Directive it remains
questionable whether control required for perfection of a collateral
arrangement could be satisfied by entering into an agreement that leaves
the disposal rights with the debtor. In other economies, intermediaries’
records serve as a functional equivalent of a public registry. The role of
the intermediary is functionally no different than that of warehousemen,
carriers and other entities that issue representative documents of title that
their holders use as collateral.
Book entries and control agreements are typically utilized in transactions where a third-party lender provides secured credit. Alternatively
the intermediary may also provide financing to its account holders and
such loans are common in practice. Account holders utilize these loans
KANDA, MOONEY, THÉVENOZ & BÉRAUD, supra note 15, at 24.
See EU Financial Collateral Directive, art. 5(1)(4) and UCC 8-106(f)
(1994).
40
41
78
The law of securities, commodities and bank accounts
especially for the acquisition of new securities. In the securities industry
such securities are known as purchased on margin and the credit provided
by the intermediary is known as a margin loan.42 In a margin transaction
the account holder does not pay the entire purchase price for the
securities and uses the credit provided by his intermediary.43 The
intermediary thus functions as an entity that maintains accounts for their
customers as well as a creditor that provides purchase money financing to
account holders. In the latter case the intermediary uses the purchased
securities as collateral to secure the margin loan that it extended to the
customer.
Under some laws,44 such security interests of intermediaries are
perfected automatically and the intermediary is not required to register a
public notice or enter into a special collateral/control agreement with the
customer.45 The securities purchased on margin and those that have been
fully paid for by the customer must be segregated by the intermediary.
Segregation of such securities prevents the intermediary from using fully
paid for securities in its own business, including securing the intermediary’s own loans. For margin securities the intermediary will typically request an authorization to re-pledge the same securities.46 Third
Kenneth C. Kettering, Repledge and Pre-Default Sale of Securities Collateral Under Revised Article 9, 74 CHI.-KENT L. REV. 1109, 1112 (1999). The
securities margin lending market may be driven either by borrowers who seek
specific securities to satisfy their settlement obligations and to cover short
positions, or by lenders who seek to obtain funding by using securities as
collateral. Rasiah Gengatharen, Margin Loans: Secured Credit or Secured
Lending, 23(11) J.I.B.L.R. 595, 596 (2008).
43
The intermediary, in turn, would typically obtain a loan from a third party
securing that loan by repledge of its customers’ margin securities. Ibid.;
Kettering, supra note 42, at 1115–16. As of the end of March 2013, the margin
debt at NYSE member firms stood at US$ 379.5 billion which was just shy of
the record set in July 2007. Alexandra Scaggs & Steven Russolillo, Investors
Rediscovering Margin Debt, WALL STREET JOURNAL C 1-2 (10 May 2013).
44
UCC 9-206(a–b) and 9-309(10) (1999), UCC 8-106(e) (1994) and Official
Comment 6 to UCC 8-106 (1994).
45
On the risks and costs created by automatic perfection see Schwarcz,
supra note 22.
46
NYSE Rule 402(b). Customer Protection – Reserves and Custody of
Securities, SEC Rule 8c-1 and Rule 15c2-1, and Depotgesetz art. 12(1). See also
17 C.F.R. § 240.8c-1 (2012) and Explanatory Memorandum to the EU Financial
Collateral Directive, Section 2.4 and Recital 19, and the US Supreme Court
decision in Provost v. United States, 269 U.S. 443, 454 (1925) recognizing the
power and authority of the intermediary to re-pledge the customer’s margin
securities, to the extent of the advances made by the intermediary. On the
42
Transfers of intermediated securities
79
parties will find out about the encumbrance by inquiring with the
intermediary. Again in some economies this arrangement may raise the
issue of sufficient public notice similar to that described in relation to a
control agreement.
Perfection by Filing
Many jurisdictions have devised mechanisms that allow creditors to
perfect their security interest other than by control.47 The Geneva
Securities Convention recognizes non-control perfection mechanisms but
it does provide for the priority of security interests perfected by one of
the Convention recognized mechanisms.48 This priority provided to the
control-type of perfection mechanisms reflects the market practice in
some economies where creditors seldom utilize filing or central registration to perfect their security interests.
Other jurisdictions operate special registries solely for the purpose of
registering documents that create collateral interests in account-based
securities.49 Such specialized registries typically require registration of
both consensual security interests and non-consensual liens that remain
ineffective against third parties unless properly registered.50 While arguably this form of perfection provides sufficient public notice, the registration procedure in these jurisdictions is typically cumbersome. A
registration form must commonly be accompanied by a written confirmation regarding the content of the security agreement that is signed by
both the debtor and the creditor.51 Similarly, a request to register a
statutory lien must be accompanied by a valid decision establishing the
lien.52 Furthermore public notice is not provided by registration but rather
by transferring the encumbered securities to a pledge account and
stripping the borrower of disposal rights. This is because registries of this
kind (e.g., in El Salvador) are not typically accessible to the public.
consequences of the Lehman failure on the rehypothecation costs see Schwarcz,
supra note 22, at 710.
47
See also Geneva Securities Convention, art. 13.
48
Ibid. art. 19(2).
49
See Slovakian Securities Act § 45(1–2) that mandates the CSD to maintain
a lien register and CEDEVAL, Manual de Operaciones, supra note 18, at
Capı́tulo I, Gravámenes, Embargos y Prendas Reglamento, Section I.
50
Slovakian Securities Act § 47(1).
51
Ibid.
52
Ibid., § 52(2).
80
The law of securities, commodities and bank accounts
While registration may be a useful perfection mechanism it should not
be made subject to onerous requirements. One may contrast the requirements imposed by UCC Article 9 and the law of El Salvador. A security
interest in intermediated securities held by CEDEVAL becomes perfected
when the following four conditions have been cumulatively satisfied:
1)
2)
a security agreement is concluded in a notarized public deed;
such security agreement is delivered to the CSD that registers it
under the respective securities account;
the intermediated securities granted as collateral are transferred to a
securities account maintained for the creditor; and finally
the CSD transmits a notice of the security interest to the stock
exchange where the security is listed.53
3)
4)
In contrast, under UCC 9, only a one-page financing statement must be
filed with the relevant office.
One of the primary objectives of the EU Financial Collateral Directive
was to reduce the formalities necessary for the creation, perfection and
enforcement of collateral arrangements. To this end, Recital 10 of the
Directive provides that ‘execution of documents in a particular form,
notarization or other formal validation of the document, a filing with an
official body or registration in a public register should not be required in
the EU Member States’. Nevertheless implementation of the Directive in
Member States varies and interested parties should examine the applicable local law to determine which formalities are required.54 While the
trend in EU countries is to move away from requiring excessive
formalities this does not yet seem to be the case in Latin America. The
contemporary pattern of holding securities through electronic accounts
necessitates the enactment of rules facilitating the efficient perfection of
security interests.
See Salvadoran Law on Electronic Entries, arts 36 and 41.
Ewa Klima, The Implementation of Directive 2002/47 on Financial
Collateral Arrangements, 21(4) J.I.B.L.R. 203, 207 (2006).
53
54
4. Summary of Part I
Securities transfer law is an area of commercial private law that regulates
the holding and transferring of securities including the creation of
encumbrances. All of these processes occur in the back-end environment
subsequent to the execution of a trade with securities within particular
securities holding systems that may be classified on the basis of
relationships into the direct and intermediated holding systems. The latter
exist in a number of varieties. This Part focused primarily on analyzing
the distinctive features of intermediated holding systems.
Rights and duties of market players participating in contemporary
securities holding systems should be clearly set out in a legislative
framework that addresses, at a minimum, the following features and
functions. Securities no longer circulate in the form of certificates but are
immobilized at CSDs and transferred by entries to electronic accounts
maintained by intermediaries. Accordingly, laws must recognize the
validity of securities maintained in accounts with intermediaries and
provide such accounts with legal effects equivalent to those for certificated, bearer and uncertificated securities. As Professor Goode writes, ‘in
most countries the law has yet to catch up with these developments’.1
This lack of appropriate legal regulation perpetuates the risk of legal
uncertainty.2
Securities transfer laws have been moving away from an approach
based on the nature of security (certificated vs. uncertificated) to one
based on the type of holding (intermediated vs. direct).3 The key feature
of securities held in intermediated systems is their capability of being
1
Roy Goode, Foreword to INTERMEDIATED SECURITIES, LEGAL PROBLEMS
AND PRACTICAL ISSUES (Louise Gullifer & Jennifer Payne eds., HART PUBLISHING LTD., OXFORD, UK, 2010).
2
Louise Gullifer, Ownership of Securities, The Problems Caused by Intermediation, in INTERMEDIATED SECURITIES, LEGAL PROBLEMS AND PRACTICAL
ISSUES 5 (Louise Gullifer & Jennifer Payne eds., HART PUBLISHING LTD.,
OXFORD, UK, 2010).
3
Sandra M. Rocks & Penelope L. Christophorou, Memorandum Regarding
the Uniform Version of Article 8 of the Uniform Commercial Code and the
Treatment of Investment Property under the Uniform Version of Article 9 (with
81
82
The law of securities, commodities and bank accounts
credited to a securities account. Legislation governing modern securities
holding systems should provide for a broad category of financial assets
and securities that may be held in such accounts. Susceptibility of being
credited to a securities account, coupled with the ability to objectively
determine the market value of the security, should be the only requirements for the holding of securities in accounts with intermediaries.
Legislation should facilitate the holding of securities both directly and
through intermediaries as these two securities holding patterns co-exist
with each other.
A difficult question arises when the legislator is presented with a
choice of the type of intermediated holding system. The role of the
legislator is to select the appropriate holding structure most suitable for
their particular domestic market. So far countries have been divided.
Common-law countries and Quebec have implemented indirect holding
systems based on new property concepts embedded in securities. However, the majority of economies still adhere to the transparent pattern for
the holding of intermediated securities that relies on traditional proprietary concepts such as co-ownership.
Intermediated holding systems are supported by modern and highly
efficient clearing and settlement systems that apply novation and netting.
These functions may not be necessary if the volume of transactions and
the risk of a systemic catastrophe are negligible. Yet efficient settlement
systems that complete transfers of securities in exchange of funds on a
DVP basis should be implemented in all systems, irrespective of transactional volumes.
One of the most important tasks for the legislator is to define properly
the property right of investors who hold their securities in accounts with
intermediaries. In contemporary intermediated systems investors no
longer enjoy identifiable ownership rights to the security. The departure
from direct rights against the issuer necessitates a redefinition of the
rights embedded in securities held in accounts. These rights have been
cast as co-ownership interests, joint possession, security entitlements, etc.
The common denominator for all these classifications is the proprietary
interest that is granted to account holders. The bottom-line rule is that
rights of account holders in all systems must be protected by proprietary
interests.
Addenda Regarding Book-Entry Regulations and International Developments),
SK090 ALI-ABA 249, 252 (2005).
Summary of Part I
83
Once the rights are adequately defined, legislation should provide for
an effective mechanism for their constitution and transfer. In an intermediated holding system, rights of investors are constituted by entries
made to securities accounts and evidenced by balances on such accounts.
There is a significant difference between various types of intermediated
holding systems with respect to the nature of securities accounts. While
accounts maintained by relevant intermediaries in some systems are the
source of rights and the intermediaries’ entries transfer rights to securities, accounts maintained by operators in other systems have mere
administrative functions and their entries do not constitute or transfer
rights.
Legislation should also provide for efficient transfer mechanisms. In
intermediated holding systems securities are customarily transferred by
book entries, and such transfers should provide the same legal effect as
delivery of a certificate and registration on the issuer’s books. Legislation
should also recognize that book entries transfer rights to securities by
novation effectively replacing negotiation as the primary transfer mechanism. Many jurisdictions already recognize novation as a transfer
mechanism for intangible rights. An explicit reference in securities
transfer laws may be necessary to provide clarity for transfers effectuated
by book entries.
Finality is also an important concept underlying contemporary securities transfer systems. Efficient systems for transfers of securities must be
supported by clear and predictable rules on finality. The speed and
volume of transactions with securities requires that transferees be able to
rely on the credits made to their accounts. Legislators may find the rules
governing the finality of payments useful as a guideline. Typically, the
finality of transfer coincides with the credit entry made by the intermediary to the transferee’s account. Legislators should refrain from
crafting rules that postpone the occurrence of finality beyond making a
book entry. Account holders should be able to rely on book entries made
to their accounts without being concerned that the entry might be later
cancelled and their rights revoked.
Lastly, legislation governing accounts holding structures should provide for effective rules on using intermediated securities as collateral. In
this new environment, the concept of control has replaced possession,
delivery and registration as the principal perfection mechanism. Perfection of a security interest by control requires that the creditor be placed in
a position to exercise disposal rights over the securities without any
further consent of the debtor. Many jurisdictions rely on the traditional
methods of perfecting security interests that require absolute disposition
of the debtor. Access to financing secured with intermediated securities is
84
The law of securities, commodities and bank accounts
further hindered, in some jurisdictions, by onerous formalities such as
notarization of the security agreement and its delivery to the CSD.
Legislation in developing countries should remove as many formalities as
appropriate and thus reduce the cost of credit.
Modernization of securities transfers systems and recognition of
account-based relationships is important to attract foreign investors.
These investors may be reluctant to buy securities when faced with
onerous requirements, formalities, excessive costs and legal uncertainty
in general. A legal system providing for a modern securities holding
structure would benefit the economy and entice foreign capital to local
markets. Otherwise local markets that are isolated and characterized by
negligible trading volumes will likely remain illiquid and will thus fail to
provide an efficient source of financing. Harmonization of securities
transfer laws on the basis of the Geneva Securities Convention and the
eventual ratification of the Convention itself would provide more clarity
and certainty than reliance on conflict of law rules.4
4
Gabriel Moss, Intermediated Securities: Issues Arising from Insolvency, in
INTERMEDIATED SECURITIES, LEGAL PROBLEMS AND PRACTICAL ISSUES 61, 68
(Louise Gullifer & Jennifer Payne eds., HART PUBLISHING LTD., OXFORD, UK,
2010).
PART II
Bank Account Relationships
5. Introduction to Part II
Money is a human creation. It originated in the form of metals and coins
and now exists and circulates in the form of banknotes and bank deposits.
Like the systems for transferring securities examined in Part I, the
systems for transferring money have undergone a significant transformation. Contemporary money transfer systems no longer rely on physical
delivery of cash but now rely on electronic entries to deposit accounts
maintained by intermediaries. The holding system for money is intermediated and largely electronic. Promises to deliver securities, transfer
money or offset commodity contracts may be analyzed in the context of
the front-end and back-end environments. Similar to Part I of this book
on securities account relationships, this Part also does not deal with
front-end transactions that result in money transfers, such as the sale of
goods.
The functioning of modern commercial societies requires that monetary value be transferred expeditiously, efficiently and at a reasonably
low cost. All contemporary payment devices such as funds transfers,
letters of credit, negotiable instruments and credit cards share an important feature: a device used (e.g., payment order, check, debit card, etc.)
only represents an obligation or promise to pay and is not the money
itself. When someone accepts a negotiable instrument or agrees to be
paid by a letter of credit he does not acquire any money in the legal
sense. The law deems only coins and banknotes authorized by the
government as money. However, it is monetary obligations and promises
that are at the core of contemporary payments systems.1 These obligations and promises circulate in the marketplace in the form of debits and
credits to deposit accounts.
Sections included in this chapter are concerned with the transformation
of payments effectuated by physical transfers of monetary objects, such
as the delivery of banknotes into electronic funds transfers completed by
book entries to bank accounts. Various types of money are identified and
contrasted including everything from actual money, such as coins and
1
LINDA J. RUSCH, PAYMENT SYSTEMS, PROBLEMS, MATERIALS, AND CASES
1 (2nd edn., WEST GROUP, ST. PAUL, MN, 2003).
87
88
The law of securities, commodities and bank accounts
banknotes, to bank money, which is essentially balances on deposit
accounts. Once this historical and technological transformation is illustrated, the focus of this Part will shift to examine the legal infrastructure
of the back-end systems in which these funds circulate. In the words of
Ben Bernanke, both ‘the hardware’, i.e., the organizational infrastructure,
and ‘the software’, i.e., the legal framework of funds transfer systems, are
examined.
Contemporary back-end systems for the holding of money are intermediated and similar to securities accounts holding systems in that they
are structured as pyramids with a central entity at the top. However the
nature of rights granted to account holders is uniform across jurisdictions
and as such it is not necessary to classify money holding systems into
various categories. In other words, all deposit account holders, no matter
their jurisdiction, are granted contractual rights enforceable against their
depository institutions.
As in the case of holding systems for and transfers of securities, on the
international level rules regarding payments are included in the United
Nations Commission on International Trade Law (UNCITRAL) Model
Law on International Credit Transfers (UNCITRAL Model Law).2 However, the UNCITRAL Model Law has not fulfilled its aspiration to
become the basis for future legislation in the area of funds transfers and
is yet to be implemented by any jurisdiction. Similar to securities
accounts holding systems, there is no effective international regime to
govern the holding and transfers of money. However, contemporary
money holding systems exhibit similar features in terms of legal rights as
well as functions provided therein.
The enormous growth of funds transfers deserves not only the attention
of legislators but also regulators. High-value funds transfers may pose
systemic risks that central banks and other regulators must take into
account, and implement adequate safeguards against.3 Like securities
accounts systems, any legal reform considered should address systemic
2
UN Communication on International Trade Law, UNCITRAL Model Law
on International Credit Transfers, UN Doc. A/RES/47/34, (1992), available at
http: // www.uncitral.org / pdf / english/texts / payments / transfers /ml-credittrans.pdf
(last visited 11 December 2013) [hereinafter UNCITRAL Model Law].
3
One of the objectives of the Slovakian National Bank is to contain
systemic risk. See the National Bank of Slovakia, Payment System Oversight in
the Slovak Republic, 5 (2003), available at http://www.nbs.sk/en/paymentsystems/oversight/business-continuity (last visited 11 December 2013). In 2002,
the Central Bank of Brazil restructured its LVFTS with the objective to reduce
systemic risk. Best Brazil, Brazil Market Profile, 36 (February 2012), available
Introduction to Part II
89
risk. The failure of an important banking institution that maintains
deposit accounts and executes payment orders for thousands of customers
may have a negative impact on the entire economy, particularly within
financial markets. Without banks and their payment services an enormous
number of commercial transactions will not be completed. Proper management of risk in the bank accounts holding system is also critical for
the functioning and completion of transfers in securities and commodity
accounts systems.
This Part seeks to explain the fundamental concepts underlying bank
accounts systems such as: the nature of the rights of depositors against
banks; the functions provided by central entities; the form of settlement;
the modes of transfers and their legal nature as compared to traditional
transfers initiated by the deposit of checks; the finality of payment; and
the creation of security interests in funds deposited in bank accounts.
While Part I focused primarily on the explanation of the fundamental
concepts underlying securities accounts systems this Part assumes that
the reader already understands the key concepts underlying bank
accounts systems. With this assumption in mind the discussion focuses
predominantly on the concepts that differentiate bank accounts and
securities accounts systems.
PROTOTYPICAL TRANSACTION
As in the other two Parts of this book it may be useful to illustrate and
distinguish between front-end transactions and back-end holding systems.
Suppose that Brian’s US company wants to market high-quality shoes
manufactured in Italy. He has located a manufacturer of shoes in Italy,
Silvio, and signed a distribution agreement to supply the shoes to retail
stores. A sale contract between Brian and Silvio for the shoes is a
front-end trade. It is a transaction that involves a contract between the
two parties that also regulates transportation, insurance and provides for
the issuance of various certificates of quality, quantity and origin. Brian
orders the first container with 1000 boxes of shoes for US$ 50 000 and
flies to Milan to meet Silvio in his office. Brian brings a briefcase with
US$ 50 000 in cash. In exchange, Silvio provides Brian with a bill of
lading confirming shipment of the shoes. This delivery of the bill of
lading against the banknotes is a back-end function. This deal involves:
1) a transaction, an agreement to buy the shoes for a certain price and 2)
at http://www.bestbrazil.org.br/media/Market%20Profile.pdf (last visited 11
December 2013).
90
The law of securities, commodities and bank accounts
its settlement, the delivery of the bill of lading against banknotes. Only
the seller and buyer are involved.
Presently very few people would even think of doing business this way
and instead would use the following model. After completing his first
order, Brian orders his bank to ‘wire’ US$ 50 000 to Silvio. The bank
executes Brian’s order by a debit to his bank account and a credit to a
bank account of Silvio’s bank. For one bank to credit an account of
another bank, they must maintain a correspondent banking relationship.
More commonly, Brian’s bank will route its payment order through a
central payments system and Silvio’s bank will credit his deposit
account. As illustrated, the back-end functions may involve transfers of
tangible assets, such as banknotes, or transfers of intangible assets, such
as funds held in bank accounts. Settlement of the obligation to pay by
transferring intangible assets involves the relationships between Brian
and his bank and Silvio and his bank. This form of payment is no longer
a bilateral transaction in which the buyer delivers cash to the seller.
Contemporary payments are accomplished within relationships
between banks and their account holders in practically all economies
with large-value payment systems. While structurally (the ‘hardware’)
large-value payment systems in both developed and developing countries
are comparable, they differ in terms of the legal infrastructure (the
‘software’). The US legal infrastructure for funds transfers is more
developed and elaborate than in the rest of the world, which still relies on
the law of deposit to regulate the transfer of funds.
This Part will reference jurisdictions representative of different systems
in terms of size and transactional complexity. The US Fedwire is the
world’s largest electronic payments system that operates on a real-time
gross settlement (RTGS) basis. In 2011, the average daily value of
payments routed through Fedwire was US$ 2.6 trillion.4 The net settlement system and the RTGS system are the two main types of central
payment systems. Their respective features and functions are explained
below. In some countries, such as Brazil and the United States, both
systems co-exist.
The second point of comparison will be the payments system of the
EU. The EU has adopted a number of legal measures to regulate funds
transfers binding the Member States. The Eurosystem operates TARGET2 (Trans-European Automated Real-time Gross Settlement Express
Board of Governors of the Federal Reserve System, 98th Annual Report,
136 (2011), available at http://www.federalreserve.gov/publications/annualreport/files/2011-annual-report.pdf (last visited 11 December 2013).
4
Introduction to Part II
91
Transfer), which is an RTGS system for transfers of funds denominated
in euros. In 2011 the average daily total value transferred was €2.3
trillion.5 EURO1 is the main net settlement system for intra-European
transfers and as of March 2013 its daily volume averaged at €210 billion
in transferred funds.6
In Latin America, the systems of Brazil, Costa Rica and Mexico will
be the main reference points for this Part. Brazil operates both an RTGS
(Sistema de Transferência de Reservas (STR)) and a net settlement
system. On 30 January 2013, the STR settled approximately US$ 294
billion in payments, which is indicative of its daily settlement volumes.7
SITRAF (Sistema de Transferência de Fundos) is the other Brazilian
payments system that became operational in December 2002. SITRAF is
a hybrid settlement system operated on the basis of a continuous net
settlement whose daily average value of payments in December 2012 was
the equivalent of US$ 6.8 billion.8 The Central Bank of Costa Rica
operates the RTGS system SINPE (El Sistema Nacional de Pagos
Electrónicos). However, daily statistics of the SINPE are not available to
compare with the other systems mentioned above.9 Finally, the Central
Bank of Mexico operates an RTGS known under the acronym SPEI
(Sistema de Pagos Electrónicos Interbancarios). In 2013, the average
daily value of payments for SPEI was approximately US$ 680 billion.10
5
ECB, Target2 (October 2012), available at http://www.ecb.eu/paym/pdf/
Sibos_2012_Target2.pdf?8189c51bc95919d6c07c8b63b82fb196 (last visited 11
December 2013).
6
EBA Clearing, Statistics on EURO1/STEP1, available at https://www.
ebaclearing.eu/Statistics-on-EURO1%2fSTEP1-N=E1_Statistics-L=EN.aspx (last
visited 11 December 2013).
7
Banco Central do Brasil, Sistema de Pagamentos Brasileiro – SPB,
available at http://www.bcb.gov.br/pom/spb/ing/evoldiariaPlanx_i.asp (last visited 11 December 2013).
8
Banco Central do Brasil, Statistical Data, available at http://www.bcb.
gov.br/Pom/Spb/Ing/cip_i.asp?idpai=PAYSYSDATA (last visited 11 December
2013).
9
Banco Central de Costa Rica, Estadı́sticas de Servicios en SINPE,
available at http://www.bccr.fi.cr/sistema_pagos/estadisticas/ (last visited 11
December 2013).
10
Banco de México, Sistemas de Pago, available at http://www.banxico.
org.mx/SieInternet/consultarDirectorioInternetAction.do?accion=consultarCuadro
&idCuadro=CF252&sector=5&locale=es (last visited 11 December 2013).
92
The law of securities, commodities and bank accounts
BRIEF EVOLUTION OF MONEY
While the understanding of money and its various forms and functions is
important to introduce the ensuing discussion, an understanding of
deposit relationships is also critical to the analysis of modern bank
account relationships. The historical overview that follows highlights
some of the key developments in the history of transactions with money
and traces the emergence of deposit accounts. Traditionally, money has
been defined by identifying its functions, including those of:
1)
2)
a medium of exchange;11
a unit of account that expresses the value of obligations or
commodities; and
a storage of economic value.12
3)
Since early commercial societies, all of these functions have been
performed by a variety of assets, including commodities, metals, coins,
negotiable instruments, banknotes and balances on deposit accounts.
Some of these ‘money-like assets’ have already become obsolete (e.g.,
commodities), while others are slowly falling into disuse (e.g., checks).
One may trace the earliest signs of money and deposits to the era of
Hammurabi. In this period, deposit banking as we know it today did not
exist. Instead, a deposit relationship existed in the form of safekeeping,
whereby depository institutions accepted assets for deposit and agreed to
restore them upon demand of the depositor in specie.13 In other words,
deposited assets had to remain readily identifiable, segregated, and could
not be commingled. Additionally, the exact same asset had to be returned
on demand. Depositors retained ownership of the deposited assets, and
Cox highlighted that the legal conception of the medium of exchange
function is narrower than the economist’s because it is concerned primarily with
the performance and discharge of obligations. David Cox, The Case of Mixed
Monies: Confirming Nominalism in the Common Law of Monetary Obligations,
70 CAMBRIDGE L.J. 144 (2011).
12
DAVID COX, PROPERTY RIGHTS IN MONEY 7–9 (OXFORD UNIVERSITY
PRESS, OXFORD, UK, 2008). What distinguishes money from all other objects of
trade is its function as a medium of exchange and the functions derived
therefrom. See also Carl Menger, Money, translated by Leland B. Yager with
Monika Streissler in CARL MENGER AND THE EVOLUTION OF PAYMENTS SYSTEMS, FROM BARTER TO ELECTRONIC MONEY 38 (Michael Latzer & Stefan W.
Schmitz eds., EDWARD ELGAR PUB., CHELTENHAM, UK, 2002).
13
SIDNEY HOMER & RICHARD SYLLA, A HISTORY OF INTEREST RATES 29
(4th edn., WILEY, HOBOKEN, NJ, 2005).
11
Introduction to Part II
93
their relationship against the safekeepers was that of bailor(s) and
bailee(s). The bailor remained the owner and the bailee acquired mere
possession without the right to use or commingle the assets. Modern
banking in its early form did not emerge in Greece14 and Rome until the
fifth and fourth century BC respectively.15
Unlike the Hammurabi-era deposit, which was in fact a safekeeping
relationship based on ownership, Roman law introduced another type of
deposit, which allowed commingling and imposed a duty on depository
institutions to return deposited assets of an equivalent value. Under this
type of deposit the restitution in specie was not required. Roman law16
recognized two types of deposit contracts: 1) regular and 2) irregular.
Under the regular deposit the depository institution acquired the right of
possession while the depositor retained ownership. Since the depository
did not acquire ownership to the deposited asset, as current banks do with
respect to funds, it was not allowed to use the deposited object.17 The
relationship between the bailor and bailee was based on ownership.
Professor Watson argued that with respect to money and the evolution of
banking, regular deposit took money out of circulation and hampered the
credit function.18
Roman law also recognized another type of deposit that did not require
restoration in specie – the irregular deposit.19 Under the irregular deposit
once possession of an asset such as money passed to the depository so
did the ownership right thereto. By virtue of that passage of ownership
the depository acquired the right to commingle and re-use the deposited
object. Consequently, the depositor–depository institution relationship
14
The Greek bankers were known as ‘trapezites’ whose main function was
to verify the value of coins: JEAN ANDREAU, BANKING AND BUSINESS IN THE
ROMAN WORLD 36 (CAMBRIDGE UNIVERSITY PRESS, CAMBRIDGE, UK, 2004).
15
Ibid.
16
Roman law recognized four types of real contracts: 1) mutuum, 2)
commodatum, 3) pignus and 4) depositum. These real contracts became binding
as of the moment of the transfer of a thing. Accordingly, only movable things
could be made subject to the real contracts, such as the Roman law depositum.
J.A.C. THOMAS, TEXTBOOK OF ROMAN LAW 271 (ELSEVIER SCIENCE & TECHNOLOGY BOOKS, PHILADELPHIA, PA, 1976).
17
Ibid., at 276. In Greece, the regular deposit was confined to non-financial
transactions that involved deposits of legal documents and valuables. See
EDWARD E. COHEN, ATHENIAN ECONOMY AND SOCIETY: A BANKING PERSPECTIVE 113 (PRINCETON UNIVERSITY PRESS, PRINCETON, NJ, 1992).
18
ALLAN WATSON, ANCIENT LAW AND MODERN UNDERSTANDING: AT THE
EDGES 29 (UNIVERSITY OF GEORGIA PRESS, ATHENS, GA, 1998).
19
THOMAS, supra note 16, at 278.
94
The law of securities, commodities and bank accounts
was transformed from that of the bailor–bailee to that of the creditor–
debtor. The irregular deposit, as developed by the Romans, inspired many
legal systems with civil-law origins. Professor Zimmermann traced the
modern rules that underpin current accounts in the German Civil Code to
the Roman institution of the irregular deposit.20 The German Civil Code,
in turn, influenced a number of jurisdictions that follow the Germanic
legal tradition.21 Latin American jurisdictions also adopted the concept of
the irregular deposit that applies to bank account relationships.22
In addition to the classification of deposits, the Romans also provided
the basis for modern account relationships, including the concept of an
account as the register of debts and other expenses. Performance of the
depository’s functions in Rome – taking deposits and providing credit –
was based on the underlying concept of account (ratio).23 The Roman
Digest provided the following definition of account: ‘account is made up
of mutual affairs which consist of accepting and collecting payments,
lending, and paying off one’s debts’.24 The Roman concept of account
resembles a modern bank account relationship that also involves accepting deposits, making payments and extending loans. In terms of organization, Roman bankers’ accounts were similar to the register of expenses
of a household that was maintained by the father of the Roman family.25
The banker’s register (rationes) was arranged in alphabetical order of
depositors individually listed on a separate page.26 All transactions with
respect to the particular depositor were recorded on the same page. The
banker’s register was not only a tracking system for debts and depositors’
claims but also served important procedural functions. In the event of a
legal dispute, the banker was required to present an original or a copy of
20
REINHARD ZIMMERMANN, THE LAW OF OBLIGATIONS: ROMAN FOUNDATIONS OF THE CIVILIAN TRADITION 219 (JUTA AND COMPANY, CAPE TOWN,
SOUTH AFRICA, 1993).
21
The Roman law irregular deposit had also been incorporated into the texts
of Socialists Civil Codes as an underlying concept of the relationship between
the depositor of fungible assets, such as grain and meat, and a custodian.
OLIMPIAD S. IOFFE, SOVIET CIVIL LAW 270 (M. NIJHOFF, BOSTON, MA, 1988).
22
See CÓDIGO CIVIL [C. CIV.], art. 2246 (Colom.) that regulates deposit of
money and provides for restoration in genre and CÓDIGO CIVIL [C. CIV.], art.
2188 (Arg.) that classifies deposits into regular and irregular.
23
ANDREAU, supra note 14, at 17.
24
Uplian Digest 2.14.47.1, reprinted in Ibid., at 44.
25
RICHARD BROWN, A HISTORY OF ACCOUNTING AND ACCOUNTANTS 29
(A.M. KELLEY, NEW YORK, NY, 1968).
26
Ibid., at 30.
Introduction to Part II
95
the records related to the account of the person involved in the dispute.27
Some authors observed that the Roman register of accounts, and the
effects of book entries evidencing debts and transfers, became the model
for the organization of medieval banking.28
The depositor had the power to make dispositions with its credit
balance recorded on the register of the banker. Roman law also validated
settlement of debts by the transfer of bank credit.29 The actual money
thus became immobilized in the form of the irregular deposit and the
claims were settled in ‘book-entry money’.30 In Rome the debtor and
creditor could visit the bank and order the banker to debit the account of
the debtor and credit the account of the creditor. Alternatively, the debtor
could ‘give his banker a payment order’ to pay the creditor.31 These
orders were issued primarily by fathers of rich families and delivered to
the bankers by slaves.32 Accordingly, transfers of money were transforming into an impersonal service. Andreau found that Roman bankers
maintained deposit accounts even with one another to complete correspondent transfers.33
The moneychanger emerged as an important figure in the medieval
period.34 His main function was to ‘exchange the currency’ needed to
settle debts but also to transfer funds to distant locations without the
actual transmission of money. For these purposes moneychangers maintained offices or correspondent relationships with local counterparts.
Customers of moneychangers could thus send payments, in various
currencies, to merchants and sellers located in different parts of Europe
where a correspondent of the moneychanger maintained an office. In the
ANDREAU, supra note 14, at 46.
Abbott P. Usher, The Early History of Deposit Banking in Mediterranean
Europe, Vol. LXXV, HARV. ECON. STUD. 11 (1943).
29
Ibid., at 4.
30
Meir Kohn, Early Deposit Banking, Working Paper 99-03, 2 (1999),
available at http://www.dartmouth.edu/~mkohn/Papers/99-03.pdf (last visited 11
December 2013).
31
ANDREAU, supra note 14, at 42.
32
BROWN, supra note 25, at 30.
33
ANDREAU, supra note 14, at 43.
34
ALICE TEICHOVÁ, GINETTE KURGAN-VAN HENTENRYK & DIETER ZIEGLER, BANKING, TRADE AND INDUSTRY: EUROPE, AMERICA AND ASIA FROM THE
THIRTEENTH TO THE TWENTIETH CENTURY 175 (CAMBRIDGE UNIVERSITY PRESS,
CAMBRIDGE, UK, 1997).
27
28
96
The law of securities, commodities and bank accounts
second half of the fourteenth century, the moneychangers of Bruges
adopted a payment system based on book entries.35
Medieval bankers performed a variety of functions that required an
initial funding in the form of deposits. Charters from the late thirteenth
century authorized individuals in Lille and Bruges to engage in moneychanging but more importantly also in ‘receiving money on deposit’.36
The deposits they accepted were of the irregular nature.37 Lopez provides
the following example of a medieval deposit contract:38
Genoa, November 7, 1200
I, Oberto, banker of Pollanexi, acknowledge that I have received from you,
Maria, wife of Rolando Generifico, 50 Genoese … I am to keep them in the
bank and employ them in trade in Genoa as long as it shall be your pleasure;
and I promise to give you the profit according to what seems to me ought to
come to you. Moreover, I promise to return and to restore the aforesaid 50
Genoese or just as much instead of them, myself or through my messenger, to
you or to your husband or to your accredited messenger, within eight days
after you tell me and make the request, and similarly to give you the profit;
otherwise the penalty of double and the seizure of my goods as security …
Deposits of funds and other valuables with medieval bankers were
documented in deposit contracts and by written instructions (book
entries) in the banks’ ledgers.39 Book-entry credits represented and
constituted deposits, transfers and extensions of loans.40 Bankers’ ledgers
provided a trustworthy record of transactions whose legitimacy was
buttressed by the banker’s oath as to the accuracy and truthfulness of the
ledger.41 Book entries that effectively transferred monetary claims
became a valid method for satisfaction of debts. According to the 1248
Statute of Douai, debtors could satisfy their debts by assignment of
deposit balances to the creditor when both individuals were customers of
35
RAYMOND DE ROOVER, MONEY, BANKING AND CREDIT IN MEDIEVAL
BRUGES 203 (MEDIAEVAL ACADEMY OF AMERICA, CAMBRIDGE, MA, 1948).
36
Ibid., at 202–3.
37
Ibid., at 247.
38
ROBERT S. LOPEZ & IRVING W. RAYMOND, MEDIEVAL TRADE IN THE
MEDITERRANEAN WORLD 214 (COLUMBIA UNIVERSITY PRESS, NEW YORK, NY,
1955).
39
Ibid., at 212.
40
Usher, supra note 28, at 11.
41
Mier Kohn, supra note 30, at 3.
Introduction to Part II
97
the same banker.42 The banker’s ledger was thus elevated to the status of
a public register of deposit contracts and the source of rights to money.43
Nevertheless, before the 1500s, dispositions with bank credit by way of
written orders were sporadic.44 The practice at the fairs of Champagne
was to orally dictate the order to the banker who executed the transfer by
a bookkeeping entry in the presence of both the depositor and the
transferee.45 The entry in the banker’s ledgers thus remained the only
evidence of the transaction.46 Only later did a written payment order
emerge.47
Gradually money as corporeal property in the form of gold and coins
was replaced with intangible property – a promise of the banker. The
transition from bailment of specific corporeal property to an irregular
deposit and bank credit was progressing.48 However, it was not entirely
completed until the era of the seventeenth century English goldsmiths
who, in addition to providing deposit, custody and credit services, also
issued negotiable instruments that represented the rights to money. These
instruments made the claims to money highly mobile. From the legal
perspective, goldsmiths transformed the promise to pay from assignable
to negotiable. Withers observed that ‘the original note, issued by a
goldsmith in the form of a receipt for metal deposited, took the form of a
promise to pay metal, and so passed as currency’.49 Cox also noted that
‘the issuance of receipts by goldsmiths in 17th century England was in
fact the issuance of first bank money’.50 Depositors were given a highly
liquid instrument in the form of a demand note to money that in fact
functioned as money and book entries ceased to be required to complete
transfers.
Money in the form of goldsmiths’ notes was dealt with as an intangible
right to receive the amount of gold or other precious metal represented by
the note. The intrinsic value of notes was rooted in the belief that they
42
DE ROOVER, supra note 35, at 262.
Usher, supra note 28, at 11.
Ibid., at 8.
45
DE ROOVER, supra note 35, at 263.
46
Ibid., at 265.
47
CHIARA FRUGONI, BOOKS, BANKS, BUTTONS: AND OTHER INVENTIONS
FROM THE MIDDLE AGES 53 (COLUMBIA UNIVERSITY PRESS, NEW YORK, NY,
2005).
48
JOHN R. COMMONS, LEGAL FOUNDATIONS OF CAPITALISM 256 (TRANSACTION PUBLISHERS, PISCATAWAY, NJ, 1995).
49
HARTLEY WITHERS, THE MEANING OF MONEY 24 (SMITH, ELDER & CO.,
LONDON, UK, 1909).
50
COX, PROPERTY RIGHTS, supra note 12, at 47.
43
44
98
The law of securities, commodities and bank accounts
were convertible into gold or coins.51 Negotiable notes issued by goldsmiths and other intermediaries introduced the credit function of money.
This function was made possible due to the requirement to maintain only
fractional reserves.52 Accordingly, the value of notes and loans issued by
the goldsmiths exceeded the value of gold and metals that they held on
deposit. Notes became a universally accepted means of payment even
though they were only fractionally supported by gold or coins.
Similar to the medieval Italian moneychangers, English goldsmiths
used accounting entries in their ledgers to record deposits.53 Only initial
deposits were recorded but the subsequent transfers were completed by
delivery of notes and checks without the necessity of accounting entries.
Notes and checks issued by the goldsmiths thus facilitated the settlement
of debts without any actual transfer of coins or gold and without having
to submit orders to the goldsmith to make any entries.
The goldsmiths also provided safekeeping services. At first the safekeeping relationship was proprietary in nature because the goldsmith had
a duty to return the gold to the customer who also retained title upon his
request. Since the goldsmith was a bailee of the gold, this relationship
was based on property.54 Gradually the goldsmiths transformed from
bailees into lenders and began lending the gold left with them on deposit.
This practice also changed the relationship between the goldsmith and
the depositor from that of the owner and bailee to that of the debtor and
creditor. This originally proprietary relationship thus transformed into
one based on contract.55 The depositor lost his ownership rights and in
exchange acquired a contractual claim against the goldsmith.
Contemporary deposit relationships and transfers of funds are based on
the same principles. The main difference between the practices of
goldsmiths to contemporary relationships is the mode of transferring
WITHERS, supra note 49, at 23.
Intermediaries transformed themselves from mere custodians to banking
institutions when they realized that it was unnecessary to carry gold or other
precious metal reserves equal to 100% of their demand notes. They began to lend
out all but a fraction of the gold. Randall D. Guynn, Modernizing Securities
Ownership, Transfer and Pledging Laws, A Discussion Paper on the Need for
International Harmonization, 19 (Capital Markets Forum, 1996).
53
FRANK T. MELTON, SIR ROBERT CALYTON AND THE ORIGINS OF ENGLISH
DEPOSIT BANKING, 1658–85 96 (CAMBRIDGE UNIVERSITY PRESS, CAMBRIDGE,
UK, 1986).
54
Bruce A. Markell, Symposium of Revised UCC Article 9, From Property
to Contract and Back: An Examination of Deposit Accounts and Revised Article
9, 74 CHI.-KENT L. REV. 963, 966 (1999).
55
Ibid., at 967.
51
52
Introduction to Part II
99
funds. This mode is no longer dominated by written negotiable promises
but instead occurs by electronic payment orders and entries made by
banks. Electronic transfers further increase the mobility of bank money
because transferees get access to funds much faster than if accepting
written promises representing claims to such funds.
DEMATERIALIZATION OF MONEY
Money originated as a tangible object, first as a commodity, then as gold
and eventually as a banknote before gradually transforming itself into a
modern-day account-based right. Today the substance of money is bank
credit that exists in the form of customers’ balances on deposit accounts
maintained by banks.56 When Brian opens a bank account and deposits
US$ 1000 at a local branch of Bank of America, he will receive a credit
to his new bank account. His money in the form of cash or check will
turn into a balance of US$ 1000 in his account. While the legal nature of
money changes, its essence and the fundamental functions do not.57
The essential function of banks is the creation and transfer of bank
money.58 In order for bank money to be created, someone must incur a
debt. For instance, a depository bank (Bank of America) incurs a debt to
its depositor (Brian) when it accepts a check for deposit.59 This debt may
be modified later when the bank accepts incoming wire transfers for
Brian’s account or executes his orders to transfer funds out of the
account. Modern money exists in the form of debt and many regular
transactions performed by banks, whether the collection of checks or the
transferring of funds in and out of deposit accounts, involve debts. Such
debts are represented in the form of balances on deposit accounts. The
reliance on coins and banknotes in modern commercial societies is
gradually diminishing.60 Very few commercial transactions are settled
56
COX, PROPERTY RIGHTS, supra note 12, at 44 and TOM GRECO, JR.,
MONEY, UNDERSTANDING AND CREATING ALTERNATIVES TO LEGAL TENDER 5
(OXFORD UNIVERSITY PRESS, OXFORD, UK, 2001).
57
BARBARA ANN GOOD, CHANGING FACE OF MONEY: WILL ELECTRIC
MONEY BE ADOPTED IN THE UNITED STATES? 16 (GARLAND PUBLISHING INC.,
NEW YORK, NY, 2000).
58
Usher, supra note 28, at 3.
59
Similarly, a credit card company creates money and credit when it allows
its card holders to use the credit balance for purchases.
60
For instance, only about 3.5% of all the money in the UK economy
circulates in the form of coins and banknotes. COX, PROPERTY RIGHTS, supra
note 12, at 43.
100
The law of securities, commodities and bank accounts
other than via electronic funds transfers by electronic book entries to
bank accounts.
Coins and banknotes are particularly inept to settle obligations arising
in contemporary commercial and financial transactions, including those
that involve payments for ordinary goods, securities or other financial
instruments. The amount of physical money circulating in any economy
is dwindling. Even consumer and retail payments are increasingly
completed by electronic transfers through the use of credit and debit
cards.61 Similar to security certificates, money has been immobilized or
taken out of circulation and substituted for claims to money represented
by balances on deposit accounts that are transferable by book entries.
The process of immobilization of money preceded that of securities.
While the process involving money has already been completed, immobilization of securities with financial intermediaries is still ongoing. As in
the case of the securities markets, in which certificates held directly
against issuers and financial assets maintained in accounts with intermediaries co-exist, physical money co-exists with bank money. Dematerialization of money significantly decreases the cost of payments, as
expensive check-clearing systems may eventually be phased out.62
Alan Greenspan noted that ‘a key historical innovation that allowed the
development of modern payment systems was the deposit balance that is
freely transferable’.63 The free transferability of bank money has been
facilitated by the domestic and world banking systems that ‘circulate
money much like blood moves through the circulatory system of a living
organism’.64 According to Greenspan, ‘electronic funds transfer systems
have not altered the fundamental structure of the payment system; they
merely decreased the time for the transmission of payment instructions
and reduced the float’.65
61
ROBERT GUTTMANN, CYBERCASH: THE COMING ERA OF ELECTRONIC
MONEY 6 (PALGRAVE MACMILLAN, NEW YORK, NY, 2003).
62
BENTON E. GUP, THE FUTURE OF BANKING 143 (QUORUM BOOKS,
WESTPORT, CT, 2003).
63
Alan Greenspan, Payment Systems Research and Public Policy Risk,
Efficiency, and Innovation, 28(4) Part 2 JOURNAL OF MONEY, CREDIT AND
BANKING 689, 690 (1996).
64
Thomas C. Baxter, Jr. & Raj Bhala, Proper and Improper Execution of
Payment Orders, 45 BUS. LAW. 1447 (1990).
65
Greenspan, supra note 63, at 690.
Introduction to Part II
101
THE TYPOLOGY OF FUNDS HOLDING SYSTEMS
The payments system is the whole technological and legal framework
that facilitates consumer as well as commercial transactions. The World
Bank defines a payments system as ‘the entire matrix of institutional and
infrastructure arrangements and processes in a country for initiating and
transferring monetary claims in the form of commercial bank and central
bank liabilities’.66 Typically, the framework for consumer transactions
operates separately from the one established to process commercial
payments. This Part is concerned only with LVFTSs and the related
framework of banking relationships that process payments by making
entries to deposit accounts. It does not cover payment systems such as
that provided by PayPal because such systems do not effectuate payments
in ‘bank money’.67 LVFTSs process transfers individually as compared to
the networks for collecting checks and completing credit cards payments
that processes transactions in bulk. Individual processing makes LVFTSs
more expensive to use and thus limited to high-value payments.68
Unlike securities holding systems, the organization of bank accounts
and funds holding systems is largely uniform. They may not be classified
into direct, indirect or transparent. The absence of structural and legal
differences among funds holding systems may largely be attributed to the
fact that no property rights are held in bank account relationships. The
rights of depositors against their banks are solely contractual.
From the structural perspective, one may characterize bank accounts
holding systems as ‘indirect’ because rights and obligations exist only
within the particular customer–intermediary (bank) relationship. The
nature of bank account relationships is such that customers neither have
66
Ibid. Greenspan similarly defined the payment system as ‘a mechanism
that provides an infrastructure for transferring money’; THE WORLD BANK,
MASSIMO CIRASINO, JOSÉ ANTONIO GARCÍA, MARIO GUADAMILLAS & FERNANDO MONTES-NEGRET, REFORMING PAYMENTS AND SECURITIES SETTLEMENT
SYSTEMS IN LATIN AMERICA AND THE CARIBBEAN 2 (THE WORLD BANK,
WASHINGTON, DC, 2007), ANDREW G. HALDANE, STEPHEN MILLARD & VICTORIA SAPORTA, GENERAL INTRODUCTION, THE FUTURE OF PAYMENT SYSTEMS 2
(ROUTLEDGE, NEW YORK, NY, 2008). Payment systems may also be described as
‘organized arrangements for transferring value between participants and the
circulation systems for the lifeblood of economies – money’.
67
Bruce J. Summers & Kirstin E. Wells, Emergence of Immediate Funds
Transfer as a General-Purpose Means of Payment, 3Q ECON. PERSP. 97 (2011).
68
BENJAMIN GEVA, THE LAW OF ELECTRONIC FUNDS TRANSFERS, 1–3,
§ 3.02 Overview, [1] Wire Transfer Systems (MATTHEW BENDER & CO., US,
2013).
102
The law of securities, commodities and bank accounts
any rights against banks, other than the bank that maintains their relevant
deposit account, or payment system operators, such as the central bank.
In both indirect holding systems for securities and bank accounts,
account holders may assert their rights solely against the intermediary
that maintains their relevant securities or bank account. The difference is
that the rights of securities account holders are proprietary while those of
bank account holders are contractual.
Funds holding systems constitute an important component of the
monetary and financial system of every economy. An IMF study
observed that an efficient payments system is critical for the development
of modern financial markets, including those for securities and inter-bank
money products.69 Funds holding systems support practically every other
financial and commercial system where transactions are settled in ‘bank
money’. All of these systems are being increasingly interconnected and
funds holding systems have truly become the circulation system that
facilitates the settlement of critical financial and commercial transactions.70 One of the most critical connections of funds holding systems
is the one they share with the securities settlement systems.
In the majority of economies there is only a single LVFTS that sits at
the top of the funds holding system. LVFTSs are typically operated by
central banks but some, such as Clearing House Inter-Bank Payments
System (CHIPS) in the United States, may be owned and operated by
private consortia of banks and financial institutions. These systems
complete settlement of commercially important transactions by debits
and credits to the participants’ bank accounts.71 Generally there are two
fundamental types of LVFTSs: 1) the RTGS system in which payments
are settled immediately and 2) the net settlement (NS) system in which
settlement occurs only at the end of the day. However many LVFTSs are
hybrid systems and incorporate features of both types.72 For instance the
Central Bank of Brazil (Banco Central do Brasil) operates a hybrid
system, SITRAF, in which transfer orders may be settled immediately by
Summers & Wells, supra note 67, at 1.
Stephen L. Harris & Stephanie Heller, Symposium: Rethinking Payments
Law: Introduction to Rethinking Payments Law: Appendix: A Proposal for
Consideration of a Unified Payments Law, 83 CHI.-KENT. L. REV. 477, 485
(2008).
71
See Article 2o.III of the Mexican Payments Law that defines settlement
(liquidación) as ‘los cargos y abonos realizados en las cuentas de los Participantes’.
72
DERMOT TURING, CLEARING AND SETTLEMENT IN EUROPE 419 (BLOOMSBURY PROFESSIONAL LTD., HAYWARDS HEATH, UK, 2012).
69
70
Introduction to Part II
103
credits/debits to the accounts maintained by the central bank or in a batch
after netting.73
Below these top-level relationships between the operator of LVFTSs
and participating banks, the structure and nature of relationships is
largely uniform. Banks complete transfers of funds by debit and credit
entries between each other as well as for their customers. Accordingly,
the following paragraphs focus only on the typology of funds holding
systems from the perspective of LVFTSs.
It should be emphasized that the operators of LVFTSs are neither
parties to funds transfers nor intermediaries acting for third parties.74
Operators do not become central counterparties to payment orders that
are lodged by the participants. This feature distinguishes bank accounts
holding systems from securities and commodity systems where: 1) a
clearing entity becomes the central counterparty to every transaction and
2) intermediaries internally clear transactions for their customers. A
payment system operator merely books transfers to the bank accounts of
its participants without providing any central counterparty clearing functions. Similarly, a bank transferring funds of one customer to another
merely makes the relevant credit and debit entries.
LVFTSs must also be distinguished from communication networks that
transmit payment orders and other banking data such as the Society for
Worldwide Interbank Financial Telecommunication (SWIFT) network.
SWIFT only communicates instructions to credit and debit accounts and
does not maintain accounts for participants, execute payment orders or
provide any clearing and settlement services. SWIFT is a mere messenger that performs the functions previously provided by telex, fax and
electronic data interchange. More than 62 LVFTSs providing payments
services in over 90 countries rely on SWIFT to communicate with their
participants.75
73
See http://www.bcb.gov.br/?SITRAF (last visited 11 December 2013).
Every SITRAF participating institution must make an initial deposit to the
SITRAF settlement account at the Central Bank.
74
Fed. Reserve Banks, Operating Circular No. 6 Funds Transfers Through the
Fedwire Funds Service, § 5.3 (Effective 12 July 2012), available at http://www.
frbservices.org/files/regulations/pdf/operating_circular_6_07122012.pdf (last visited 11 December 2013) [hereinafter FED Circular 6].
75
See http://www.swift.com/solutions/solutions/solution_for_payments_
clearing/index.page (last visited 11 December 2013).
104
The law of securities, commodities and bank accounts
Real-time Gross Settlement Systems
RTGS systems are those that ‘effect final settlement of interbank funds
transfers on a continuous, transaction-by-transaction basis throughout the
processing day’.76 In other words payment orders are executed as they
are entered into the payment systems and the bank accounts of participating banks are adjusted simultaneously. The RTGS systems, typically
operated by central banks, provide intraday finality and eliminate credit
risk – i.e., the risk that a banking institution will not have sufficient funds
to cover its daily payments at the end of the business day.
Since the first RTGS system – the US Fedwire – was established in
1985, the number of systems has grown exponentially.77 The first
European country to implement an RTGS system was Denmark and the
first country in Latin America to do so was Uruguay.78 TARGET2, the
payment system established within the EU to process large-value transfers, is also an RTGS system. These systems effectively eliminate the risk
that a transfer will be revoked and provide liquidity to beneficiary banks,
who may use the funds as soon as their accounts are credited. A number
of LVFTSs have also been recently ‘upgraded’ from the NS to RTGS
model. For instance in April 2002, the Brazilian STR implemented the
RTGS model, thus ensuring irrevocable and unconditional finality.
In some aspects RTGS systems vary. For instance some RTGS systems
require that participating banks have sufficient funds in their central bank
accounts to process payment orders. Otherwise orders to transfer funds
exceeding the account balance of the participant shall be rejected. Only
when the bank replenishes its account may the payment order be
re-submitted for execution. The Brazilian LVFTS is representative of this
category.79 In other RTGS systems payment orders are not automatically
rejected if the account balance of the transferor is insufficient. Execution
of such orders may be temporarily suspended by the operator’s internal
processing system and will be released for execution once the transferor
has replenished the balance. The Mexican LVFTS is representative of this
type. Still, in some other RTGS systems central banks provide credit
See http://www.bis.org/publ/cpss22.htm (last visited 11 December 2013).
Morten L. Bech & Bart Hobijn, Technology Diffusion within Central
Banking: The Case of Real-Time Gross Settlement, Federal Reserve Bank of New
York Staff Reports, Staff Report No. 260, (September 2006), at 2.
78
Ibid., at 9.
79
Banco Central do Brasil, Brazilian Payment System, 9 (September 2009),
available at http://www.bcb.gov.br/Pom/Spb/Ing/TheBrazilianPaymentSystem.
pdf (last visited 11 December 2013).
76
77
Introduction to Part II
105
known as ‘daylight overdraft’ to the participants in cases in which their
balances are insufficient. In these systems the payment order will be
executed if the originator is authorized to draw on the credit made
available by the central bank.80 For instance, the Slovakian RTGS system,
operated by the National Bank, provides an intraday overdraft facility
that must be fully collateralized by securities81 and the intraday credit
must be repaid by 1p.m. on the same trading day.82 Finally, in certain
other systems the participants may be able to draw on their reserves that
are required to be held with the central bank for monetary policy
purposes.83 LVFTSs may also use a combination of these options. For
instance the central bank may provide credit but when the credit limits
are exhausted the execution of payment orders will be temporarily
suspended. In these varieties of RTGS systems there is little need for a
loss-sharing arrangement because settlements do not fail for the insufficiency of funds.84
The Federal Reserve Bank may request repayment at any time if it deems
itself insecure and provides notice to the account holder. Federal Reserve Banks,
Operating Circular 1, Account Relationships (effective 1 February 2013), available at http://www.frbservices.org/files/regulations/pdf/operating_circular_1_
02012013.pdf (last visited 11 December 2013) [hereinafter FED Circular 1],
§ 5.2. The Fed charges fees, requests collateral and imposes credit limits to
manage its exposure to the participants. Antoine Martin & David C. Mills, An
Economic Perspective on the Enforcement of Credit Arrangements: The Case of
Daylight Overdrafts in Fedwire, FRBNY ECONOMIC POLICY REVIEW, September
2008, at 161 & 165. Although collateralization of most daylight overdrafts is not
explicitly required, a significant amount of the Reserve Banks’ exposure is
secured by collateral.
81
Decision of the National Bank of Slovakia No. 6/2003 provides details on
the collateralization of intraday credit. The securities must be registered in the
system operated by the National Bank of Slovakia. Customers’ securities, and
those already subject to a security interest, are not eligible as collateral. The
value of securities must exceed the amount of intraday credit by 2%.
82
Ibid., § 4(5). If the borrower does not repay the debt, the pledged
securities may be taken in satisfaction of the outstanding debt. Ibid., § 7(2).
83
Peter Allsopp, Bruce Summers & John Veale, The Evolution of Real-Time
Gross Settlement: Access, Liquidity and Credit, and Pricing, in FINANCIAL
INFRASTRUCTURE SERIES: PAYMENT SYSTEMS POLICY AND RESEARCH 18 (The
World Bank, 2009).
84
TURING, supra note 72, at 418.
80
106
The law of securities, commodities and bank accounts
Net Settlement Systems
Unlike RTGS systems operators of NS systems do not credit and debit
accounts of the participants as soon as payment orders are executed. It is
not necessary that operators even maintain any accounts for participants.
The settlement is typically deferred until the end of the business day,
when the sums of all transfers are aggregated and only a single credit or
debit entry is made to the participants’ accounts. The end-of-the-day
settlement is the result of during-the-day clearing and netting. Clearing in
NS systems does not significantly differ from clearing in securities
clearing systems. The clearing process in NS systems involves calculation of positions and then multilateral netting or offsetting of overlapping
balances.85
NS systems are a significant minority to the RTGS systems.86 With the
enormous increase in the volume and number of payments handled by
such systems, regulators became concerned about the risk that a participant would not be able to settle its obligations at the end of the day after
netting has been performed. As a result NS systems began their transformation into RTGS systems. The World Bank labeled the 1990s as the
decade of this transformation.87
The Canadian Payments Association operates an NS system – the
Large Value Transfer System (LVTS).88 The LVTS provides intraday
finality with settlement to be completed by the Bank of Canada at 7:30
p.m. every day as a result of clearing and netting of outstanding
obligations.89 Payment orders may not be revoked as soon as they have
been logged into the system even though the participants’ accounts shall
not be adjusted until the end of the day.
85
For instance, Official Comment 4 to UCC § 4A-403(b) (1989) provides
that ‘this provision is intended to invalidate any arguments that multilateral
netting is not valid because mutuality of obligations is not present’.
86
Bech & Hobijn, supra note 77, at 1. ‘Historically, settlement of interbank
payments has been achieved through end-of-day netting systems.’
87
THE WORLD BANK, MASSIMO CIRASINO ET AL., supra note 66, at 6.
88
Bank of Canada, Canada’s Major Payments Systems, available at http://
www . bankofcanada . ca / financial-system / payments / canadas - major - payments systems/ (last visited 11 December 2013).
89
Intraday obligations of the participants must be secured with eligible
collateral that includes government-issued debt securities, high-rating corporate
and municipal securities, etc. Bank of Canada, Neville Arjani & Darcey
McVanel, A Primer on Canada’s Large Value Transfer System 18, (March 2006),
available
at
http://www.bankofcanada.ca/wp-content/uploads/2010/05/lvts_
neville.pdf (last visited 11 December 2013).
Introduction to Part II
107
In the United States, the RTGS Fedwire system co-exists with the
CHIPS system that was established in 1970 as an NS system. CHIPS
processes and settles over 350 000 payment orders with the daily
aggregate amount averaging US$ 2 trillion.90 Since its establishment the
system has been modified to the extent that there is a minimal difference,
in terms of achieving finality, from Fedwire. In its present form CHIPS
belongs to the category of hybrid systems.
CHIPS participants send and receive payment orders during the
business day but the orders are not released if the sender has insufficient
funds in the pre-funded account to cover the amount of the payment.91
Release of a payment message into the CHIPS system bestows an
obligation on the sender to pay the amount of the payment message.92
The moment of release of the message is critical because it establishes
finality of the transfer and the transferor’s right to cancel the order
terminates.93 CHIPS is not a banking institution that maintains accounts
for its participants so at the end of the day it sends payment orders over
the Fedwire to credit or debit the accounts of such participants. Obligations of the CHIPS participants are ultimately settled on the accounts
maintained by the New York Federal Reserve Bank. The CHIPS account
at the Reserve Bank must be pre-funded by its participants with the sums
they expect to transfer during the day.94 The funds may be transferred
only pursuant to instructions submitted by CHIPS as an agent of the
participants.95
Clearing House Interbank Payments System, Self-Assessment of Compliance with Core Principles for Systematically Important Payment Systems, 1
(November 2007) [hereinafter CHIPS Self-assessment].
91
Clearing House Interbank Payments System, Rules and Administrative
Procedures, Rules 2(c) and 12(e) (March 2012) [hereinafter CHIPS Rules].
CHIPS is eligible to issue ‘funds-transfer system rules’ under UCC 4A-501(b)
(1989). However these Rules govern only the relationships of CHIPS and its
participants. Relationships of participants between one another and their customers are outside the scope of the Rules.
92
CHIPS Self-assessment, at 5.
93
CHIPS Rules, at Rule 2(d).
94
CHIPS prefunded balance account is defined as ‘a special deposit account
established at the Federal Reserve Bank of New York for the joint benefit of all
funding participants to hold balances pursuant to the CHIPS Prefunded Balance
Account Agreement’. CHIPS Rules, at Rule 1(5).
95
Ibid., at Rule 12(a)(2).
90
108
The law of securities, commodities and bank accounts
EURO1 is an EU-based NS payment system operated by EBA Clearing.96 Transfers processed through EURO1 are final and irrevocable.
However, the accounts of participants at the ECB are settled at the end of
the day.97 During the business day participants have a single amount that
they owe or that is owed to them. This amount is continuously adjusted
with incoming and outgoing transfers.98 EURO1 thus operates similarly
to CHIPS.
TYPES OF MONEY
This section examines the various types of money with the objective to
define the scope of the bank accounts holding systems that fall under this
Part. The following paragraphs look at monetary assets and values held in
bank accounts and distinguish between account-based money and the
money that circulates outside of bank accounts systems. It has been said
that ‘next to language, money is the most important medium through
which modern societies communicate’.99 Money is not only an important
communication tool but it is also an indispensable device that facilitates
economic development. Economies could not have transformed from
subsistence to specialized production and distribution of goods and
services unless a medium of exchange had been created.
Over the centuries various objects and rights functioned as money.
Money in the form of coins first emerged near Troy in the Kingdom of
Lydia. They were of equal weight and size, which eliminated the need to
weigh them before every transaction could be completed. Their value
EBA Clearing was established in 1998 by 52 banks with the objective to
operate a large-value payment system. EBA Clearing, The Leading Private
Provider of EURO Clearing Services, available at https://www.ebaclearing.eu/
About-EBA-CLEARING-N=EBACLEARING-L=EN.aspx (last visited 11
December 2013).
97
For a detailed description of EURO1, see EBA Clearing, EURO1: The
Pre-eminent Private Euro Clearing and Settlement System, available at https://
www.ebaclearing.eu/EURO1-N=EURO1-L=EN.aspx (last visited 11 December
2013).
98
EBA Clearing, EURO1 Takes Advantage of an Innovative Legal Structure,
available at https://www.ebaclearing.eu/Legal-basis-N=E1_Legalbasis-L=EN.
aspx (last visited 11 December 2013).
99
BERND WIDDIG, CULTURE AND INFLATION IN WEIMAR GERMANY 79
(UNIVERSITY OF CALIFORNIA PRESS, BERKELEY, CA, 2001).
96
Introduction to Part II
109
could easily be determined by simply counting the coins.100 For centuries
coins were the primary means of payment until the medieval moneychangers and then the English goldsmiths began issuing demand notes.
Presently coins as money are largely obsolete in commercial transactions.
The primary use of coins is in consumer transactions for the purchase of
low value items.
Professor Rogers observed that:
The important characteristic of a specie-based monetary system is that money
is completely reified. A gold or silver coin that the sovereign has minted and
declared to be current coin of the realm is money; it does not represent money
or substitute for money; it is money.101
Property law can sufficiently govern the rights of parties where payment
is made by delivery of coins. Contractual rules and account relationships
are not necessary or applicable to regulate payments with coins. Similarly, property law is sufficient to govern transfers of bearer securities
and physical commodities.
Paper money emerged as a medium of exchange not by way of law but
by way of custom when the goldsmiths and other custodians began
issuing notes.102 Notes were initially issued by non-bank or quasi-bank
intermediaries in turn affecting the purchasing power and acceptability of
such notes. If the creditworthiness of the issuer was unknown or
questionable sellers were reluctant to accept the notes in payment.
Modern currency is not issued by individual banks but by central banks
under the authority of governments.103 Currency is thus a banknote that
The Lydians produced the first coins from a natural mixture of gold and
silver. JACK WEATHERFORD, THE HISTORY OF MONEY 29–31 (THREE RIVERS
PRESS, NEW YORK, NY, 1997).
101
James S. Rogers, The Irrelevance of Negotiable Instruments Concepts in
the Law of the Check-Based Payment System, 65 TEX. L. REV. 929, 931–2
(1987).
102
Menger, supra note 12, at 33.
103
In Juiliard v. Greenman, 110 U.S. 421 (1884) the US Supreme Court held
that: ‘… Under the power to borrow money on the credit of the United States,
and to issue circulating notes for the money borrowed, its power to define the
quality and force of those notes as currency is as broad as the like power over
a metallic currency under the power to coin money and to regulate the value
thereof. Under the two powers, taken together, Congress is authorized to
establish a national currency, either in coin or in paper, and to make that currency
lawful money for all purposes, as regards the national government or private
individuals …’.
100
110
The law of securities, commodities and bank accounts
expresses a promise of the government to pay the bearer on demand.104
In a banknote system bank credit is used as a medium of exchange
because individual banknotes are complete reifications of the money
substitute – bank credit.105 In other words just like the transfer system for
coins, the transfer system for banknotes is proprietary. Property law
determines when coins and banknotes are delivered and payments get
completed.
Coins and notes have been issued exclusively under the authority of
governments. This monopoly is also reflected in the legal definitions of
money.106 In the United States, UCC § 1-201(a)(24) defines money as ‘a
medium of exchange currently authorized or adopted by a domestic or
foreign government…’. The EU Maastricht Treaty Article 105a provides
that the ECB is the exclusive body to authorize the issuance of banknotes, which may be issued by the ECB itself or states’ central banks.
Similarly, Article 4 of the Mexican Central Bank Law provides that
‘Banco de México shall be the sole entity authorized to issue bank notes
and order the minting of metallic coins, as well as to put into circulation
both types of currency …’.107 Checks, credit, and debit cards that are
commonly used in commercial and consumer transactions are not money
in the legal sense.
In the context of a banknote payment system the nature and functions
of notes must be distinguished from checks. Withers observed that:
The use of the note involves the element of belief to a much greater extent
than that of the check. Whereas the exchangeability of the former depends on
the credibility of the central bank that issues currency, the liquidity of the
latter depends on the solvency of the drawer. This element of belief in credit
makes the extensive use of checks possible only in a community which has
reached a high stage of economic civilization and that which is also blessed
with a high level of general honesty among its members.108
104
CHARLES PROCTOR, MANN ON THE LEGAL ASPECT OF MONEY 25 (6th
edn., OXFORD UNIVERSITY PRESS, OXFORD, UK, 2006).
105
Rogers, supra note 101, at 932.
106
This is not the case of the Model Law that defines ‘funds’ or ‘money’ in
art. 2(h) as ‘includes credit in an account kept by a bank …’.
107
For a similar exclusive right granted to the Central Bank of Costa Rica
see Ley Orgánica del Banco Central de Costa Rica, art. 44, 3.11.1995, (Ley No.
7558), which provides: ‘El Banco Central de Costa Rica tendrá el derecho
exclusivo de la emisión de billetes y monedas en el territorio nacional’.
108
WITHERS, supra note 49, at 32.
Introduction to Part II
111
Unlike banknotes checks do not reify or represent money. While money
is transferred by delivery of the banknote sanctioned by a government,
delivery of a check does not transfer any money or bank credit.
Accordingly, property law does not determine whether payment occurs
when one tenders a check. A check is a mere instruction ordering the
drawee bank to transfer bank credit but it is not a medium for the transfer
of bank credit.109 Once this instruction in the form of a check is properly
presented and honored, the transfer of bank credit is executed by book
entries to bank accounts. A check performs similar functions as oral
instructions submitted to medieval moneychangers to debit the account of
the transferor and credit the account of the transferee.110
Another type of money is bank money. Payments and settlement of
debts in contemporary commercial transactions require the assistance of
intermediaries. Intermediaries such as commercial banks maintain
deposit accounts for their customers and provide the means to manage
effectively the rights embedded in such bank account relationships.
Banks place themselves between the suppliers of funds and the users of
those funds.111 ‘Bank money’, that is to say the money embedded in bank
accounts, has become the primary means of payment in financial markets
and the key provider of credit.112 Central bank money is also a type of
bank money with the exception that it is more certain and robust than
commercial bank money.113
Money is now largely embedded in bank deposits that people customarily refer to as ‘their money’.114 However bank deposits do not fall
under the legal definition of money because they are neither authorized
nor adopted by a government. Bank money is an intangible right to sue
Rogers, supra note 101.
Ibid., at 935–6.
111
Edmund M.A. Kwaw, The Evolving Law on the Eurobank-Customer
Relationship and the Common Law: The Need for Clarity, 32 SYRACUSE J. INT’L.
L. & COM. 87, 91 (2004).
112
PHILIP R. WOOD, SET-OFF AND NETTING, DERIVATIVES, CLEARING SYSTEMS 266 (2nd edn., SWEET & MAXWELL LTD., LONDON, UK, 2007).
113
TURING, supra note 72, at 217. Allsopp, Summers & Veale, supra note 83,
at 7.
114
Stephen Millard & Victoria Saporta, Central Banks and Payment Systems,
Past, Present and Future, in THE FUTURE OF PAYMENT SYSTEMS 23 (Andrew G.
Haldane, Stephen Millard & Victoria Saporta eds., ROUTLEDGE, NEW YORK, NY,
2008).
109
110
112
The law of securities, commodities and bank accounts
the bank.115 The relationship between the bank and its depositor, who
placed currency into a safe-deposit box, is not a general (irregular)
deposit type of relationship but a custodial type of relationship (i.e.,
regular deposit). A custodial relationship, or regular deposit, does not
generate ‘bank money’. However, an irregular deposit generates bank
money, creating what are essentially liabilities of banks that then function
as the essential medium of exchange in modern commercial and financial
transactions.116 The bank’s liability corresponds to the customer’s right to
draw on the credit balance or any overdraft facility, if available, and to
instruct the bank to make payments from such an account.117
Bank money is embedded in a deposit relationship; it is neither an
object nor a traceable property right. While a bank deposit account is a
relationship between the account holder and its bank, it may be a
property right in the eyes of third parties. For instance, secured lenders
may take a security interest in the deposit account and judgment creditors
may levy on the deposit account. These proprietary aspects of the bank
deposit relationship are explored in Chapter 7 in the context of security
interests in deposit accounts. Bank money, however, exists only within
the depositor-bank relationship. If the funds leave the relationship, such
as by a funds transfer, the relationship is modified but its components do
not travel with the transfer.
Brian McCall, Money, Money Everywhere but not a Drop to Secure: A
Proposal for Amending the Perfection Rules for Security Interests in Money and
Deposit Accounts, 74 TENN. L. REV. 669, 672 (2007).
116
James S. Rogers, The New Old Law of Electronic Money, 58 SMU L.
REV. 1253, 1261 (2005).
117
COX, PROPERTY RIGHTS, supra note 12, at 12.
115
6. Bank account relationships
The central bank payment is a unique form of payment because it results
in a claim on an institution that cannot go bankrupt, i.e., the central bank.
The counterparty credit and liquidity risks are not present in central bank
payments.1 In contrast, completion of a payment using a private bank’s
money not only depends on a sufficient amount of funds being held in
the bank account but also on the bank’s creditworthiness.2
Payments effectuated at the top level through a central system are
typically subject to a special regulatory framework adopted by the central
bank (e.g., the Central Bank of Mexico) or a private operator of the
system (e.g., CHIPS).3 Transfers made over the Fedwire are regulated by
Regulation J issued by the Board of Governors of the Federal Reserve,
which incorporates UCC Article 4A,4 and FED Circular 6, which is
binding on the parties to a funds transfer made through the Fedwire.5
1
Hans J. Blommestein & Bruce J. Summers, Banking and the Payment
System, in THE PAYMENT SYSTEM, DESIGN, MANAGEMENT, AND SUPERVISION 22
(Bruce J. Summers ed., INTERNATIONAL MONETARY FUND, WASHINGTON, DC,
1994).
2
Kenneth A. Froot, Incentive Problems in Financial Contracting, Impacts
on Corporate Financing, Investment, and Risk Management Policies, in THE
GLOBAL FINANCIAL SYSTEM, A FUNCTIONAL PERSPECTIVE 273 (Dwight B.
Crane, Robert C. Merton, Kenneth A. Froot, Zvi Bodie, Scott P. Mason, Erik R.
Sirri, André F. Perold and Peter Tufano eds., HARVARD BUSINESS SCHOOL PRESS,
BOSTON, MA, 1995).
3
Some authors observed that in the United States the law embodied in
statutes is being replaced by the regulations and operating circulars issued by the
Federal Reserve. Sarah Jane Hughes, Duty Issues in the Ever-Changing World of
Payments Transactions: Is It Time for New Rules?, 83 CHI.-KENT. L. REV. 721,
722 (2008).
4
Regulation J does not incorporate the New York or other state version of
UCC Article 4A, but the uniform model promulgated by the National Conference
of Commissioners on Uniform State Laws (NCCUSL). See Mark Sneddon,
Symposium: Is the UCC Dead, or Alive and Well? International Perspectives,
The Effect of Uniform Commercial Code Article 4A on the Law of International
Credit Transfers, 29 LOY.L.A.L.REV. 1107, 1121 (1996).
5
Fed. Reserve Banks, Operating Circular No. 6 (Effective 12 July 2012),
available at http://www.frbservices.org/files/regulations/pdf/operating_circular_
113
114
The law of securities, commodities and bank accounts
Such circulars and regulations supersede any inconsistent provisions of
UCC 4A.6 Rights and obligations of participants in CHIPS are governed
by the New York version of UCC 4A and the CHIPS Participant
agreements.
EU Member States have also adopted specific legislation regulating
rights and obligations of parties to funds transfers and the operation of
central payment systems. These national enactments implemented certain
EU Directives and Regulations, particularly Directive 97/5/EC on Crossborder Credit Transfers,7 Directive 98/26/EC on Settlement Finality in
Payment and Securities Settlement Systems (EU Settlement Finality
Directive), Payment Services Directive 2007/64/EC (PSD) and Regulation 2560/2001 on Cross-Border Payments. Furthermore, regulators in
EU Member States have issued rules and decisions that govern the
operations of central payment systems.8 Implementation of these Directives and Regulations also affected relationships at lower levels, as will
be examined further in this chapter. Finally, the operations of TARGET2
are governed by the amended ECB’s Guideline 2007/2.9
In Latin America the Central Bank of Mexico issued Circular 2019/95
to regulate transfers of funds. The Circular requires participants in the
central payment system to maintain special accounts (cuenta única) to
credit and debit all executed orders.10 Similarly the Central Bank of
Costa Rica issued a special regulation to govern some aspects of funds
transfers executed through its central payment system (Reglamento del
Sistema de Pagos). Article 2 provides definitions of some key terms such
6_07122012.pdf., art. 1.1. Pursuant to art. 1.2, each Reserve Bank has issued an
identical Circular 6.
6
See UCC 4A-107 (1989).
7
The scope of this Directive was very limited in that it applied only to
transfers of up to the equivalent of ECU 50 000.
8
See Rozhodnutie Národnej Banky Slovenska zo 16. októbra 2012 č.
7/2012 o pravidlách platobného systému SIPS (National Bank of Slovakia,
Decision 7 of 16 October 2012 on regulation for payment system SIPS)
[hereinafter NBS Decision 7], available at http://www.nbs.sk/_img/Documents/_
Legislativa/_Vestnik/ROZ7-2012.pdf (last visited 11 December 2013).
9
See the ECB Guideline and amendments thereto at http://www.ecb.int/ecb/
legal/1003/1349/html/act_11949_amend.en.html (last visited 11 December
2013).
10
Banco de México, Operaciones de la Banca Múltiple, at M. 72.22.2,
available at http://www.banxico.org.mx/sistema-financiero/disposiciones/dirigi
das / instituciones-de-credito /disposiciones-dirigidas-a-las-instituciones-de-cre /dis
posiciones-dirigidas-a-las-instituciones-de-ban/otras/circular-2019-95-.html (last
visited 11 December 2013).
Bank account relationships
115
as the originator (cliente origin), the beneficiary (cliente destino) and the
bank account (cuenta de fondos). Pursuant to Article 39, all bank
accounts opened and maintained for individuals by financial institutions
that participate in the central payment system must be identified by the
number of the account owner. In addition, every payment order submitted
by the financial institution on behalf of its client must indicate the
number of the originator as well as the number of the beneficiary. These
regulations also include rules that set forth the requirements participants
must meet in order to gain and continue to have access to the central
payment system.
Access to large-value payment systems, whether RTGS or net settlement systems, has traditionally been restricted only to banks and large
financial institutions.11 However, the World Bank found that in many
RTGS systems non-banks are also granted direct access.12 For instance a
CSD is eligible for membership at the Slovakian Interbank Payment
System (SIPS).13 Nevertheless, like other central systems for clearing and
settlement of securities and commodity contracts, controlled access
protects all participants against the risk of default. Only well-capitalized
and supervised institutions qualify for membership.
Payment system operators typically impose various conditions on
access, such as connection to the SWIFT network or other secure
message networks, adequate capitalization, establishment of a bank
account for settlement of payment transactions, etc.14 Participants at the
Canadian payment system must be members of the Canadian Payments
Association, a non-profit organization that owns and operates the payment system, must also be connected to the SWIFT network, establish
settlement accounts with the Bank of Canada and enter into an agreement
11
Only banks and other financial institutions may participate in CHIPS. For
the list of the 48 participating institutions see the Clearing House, About CHIPS,
Customers, available at http://www.chips.org/about/pages/033742.php (last visited 11 December 2013).
12
Peter Allsopp, Bruce Summers & John Veale, The Evolution of Real-Time
Gross Settlement: Access, Liquidity and Credit, and Pricing, in FINANCIAL
INFRASTRUCTURE SERIES: PAYMENT SYSTEMS POLICY AND RESEARCH 13 (The
World Bank, 2009).
13
NBS Decision 7 at § 2(2) lists the types of institutions eligible for a
membership.
14
Ibid., § 3(1)(c). For a list of requirements to participate in EURO1 see
EBA Clearing, Admission, available at https://www.ebaclearing.eu/AdmissionN=E1_Admission-L=EN.aspx (last visited 11 December 2013).
116
The law of securities, commodities and bank accounts
that permits the Bank of Canada to provide loans and take collateral.15
These are typical of the type of requirements that applicants for membership in a central payment system must satisfy.
Some payment systems may also allow different categories of membership. Participants at the US Fedwire system are classified as correspondents or respondents.16 Correspondents are institutions that maintain
master accounts with a Federal Reserve Bank to which credits and debits
may be made on behalf of their respondent institutions.17 Thus a
respondent institution may not settle its payment transactions directly but
only through a master account of a correspondent.18 Member banks and
depository institutions, as defined in the Federal Reserve Act, as well as
other entities are eligible to apply for a correspondent membership. Every
correspondent must sign a standardized master account agreement that is
appended to the FED Circular 1.19
EURO1 distinguishes between participants and those with a subparticipation status. Sub-participants are typically branches and subsidiaries of participants thus gaining direct access to EURO1. However,
sub-participant transfers are included within the overall liquidity position
of the main participant.20
The Slovakian payment system also categorizes its participants into
direct and indirect. Direct participants maintain accounts with the
National Bank of Slovakia that are used for settlement purposes. Indirect
participants are non-bank entities for which the National Bank does not
maintain settlement accounts.21 A primary example of an indirect participant is the Bratislava Stock Exchange, which uses the central payment
15
Bank of Canada, Neville Arjani & Darcey McVanel, A Primer on
Canada’s Large Value Transfer System, 11 (March 2006), available at http://
www.bankofcanada.ca/wp-content/uploads/2010/05/lvts_neville.pdf (last visited
11 December 2013).
16
A correspondent must be one of the institutions listed in Federal Reserve
Banks, Operating Circular No. 1, Account Relationships, § 2.2(c) (Effective 1
February 2013), available at http://www.frbservices.org/files/regulations/pdf/
operating_circular_1_02012013.pdf (last visited 11 December 2013) [FED Circular 1].
17
Ibid. § 2.7.
18
Ibid.
19
The list of account agreements and forms is available at http://
www.frbservices.org/forms/account_services.html#oc1 (last visited 11 December
2013).
20
EBA Clearing, supra note 14.
21
National Bank of Slovakia, SIPS, The Slovak Interbank Payment System, 7
(2004) (on file with author).
Bank account relationships
117
system for the settlement of securities transactions. Every applicant must
file a request for membership and sign a contract with the National Bank
of Slovakia available in standardized form on the bank’s website.
Additionally, every applicant must satisfy the requirements provided in
the Slovakian Act on the Payment System.22
Participants in the Costa Rican central payments system, SINPE, are
called ‘associated entities’ (entidades asociadas).23 In order to participate
in SINPE these entities must comply with various conditions and
requirements set forth in the Regulations issued by the central bank and
other applicable norms.
Membership at payment systems is limited and strictly regulated. Since
the central payment system supports the entire economy it is critical that
only well-capitalized and regulated institutions are granted access.
Smaller banks or non-bank institutions may be allowed indirect access
through a direct participant or correspondent.
The relationship between the central bank operating a high-value
payment system and its participants is account-based.24 Participants must
sign membership contracts and establish settlement accounts for payment
purposes. The central bank then credits and debits participants’ deposit
accounts with the transfers that they send and receive. In addition to
settlement account services, central banks provide settlement credit
services in which they extend credit facilities in the form of overdrafts to
cover outgoing payments in the case that account balances are insufficient.25 It may be the case that some participants utilize only
settlement account services without having access to the credit services
of the central bank, or participants may have access to both services,
directly or indirectly, through an agent.26
Similar to central securities depositories, central banks that operate an
LVFTS also enter into relationships with entities other than their own
participants. The German Bundesbank maintains around 200 euro
Zákon o platobnom styku, 19 September 2002, (Z.z. 510/2002), available
at http://www.nbs.sk/_img/Documents/_Legislativa/_UplneZneniaZakonov/Z5102002_567-08.PDF (last visited 11 December 2013) [hereinafter Slovakian Payments Law].
23
See Reglamento del Sistema de Pagos, issued by Banco Central de Costa
Rica (27 March 2009), available at http://costarica.eregulations.org/media/
reglamento%20del%20sistema%20de%20pagos.pdf (last visited 11 December
2013), art. 3.
24
NBS Decision 7, at § 12(1).
25
Allsopp, Summers & Veale, supra note 12, at 9.
26
Ibid., at 10.
22
118
The law of securities, commodities and bank accounts
accounts for foreign business partners as well as approximately 65
foreign currency accounts abroad for the purpose of settling payments.27
The National Bank of Slovakia maintains correspondent accounts with a
number of commercial and central banks, including the Deutsche Bank
and Federal Reserve Bank of New York.28 The Federal Reserve Bank of
New York also offers correspondent banking services.29 All of these
relationships are account-based, whereby central banks maintain accounts
for one another or their business partners.
Special account relationships exist within the TARGET2 system,
which facilitates secure and expeditious funds transfers within the EU.30
From a legal perspective each central bank acts as a separate system
operator within TARGET2. For instance, the German system is called
TARGET2-Bundesbank and the Slovakian system is called TARGET2SK.31 Authorized financial institutions that are members of a state’s
RTGS system may also become direct participants in TARGET2. A
financial institution wishing to participate in TARGET2 is required to
execute the standard contract with the central bank which sets forth the
conditions of participation.32 Direct participants may then provide correspondent services and access to TARGET2 for non-members that are
Deutsche Bundesbank Eurosystem, Correspondent Banking, available at
http://www.bundesbank.de/Navigation/EN/Core_business_areas/Payment_systems/
Correspondent_banking/correspondent_banking.html (last visited 11 December
2013).
28
The full list of correspondents is available at Národná Banka Slovenska,
Zoznam korešpodenčných bánk, http://www.nbs.sk/sk/operacie-na-financnychtrhoch/zoznam-korespodencnych-bank (last visited 11 December 2013).
29
It opened the first correspondent account for a foreign central bank in
1913. Federal Reserve Bank of New York (FRBNY), International Affairs,
President’s Letter, 2 (2013), available at http://www.newyorkfed.org/banking/
fed_brochure.pdf (last visited 11 December 2013).
30
Deutsche Bundesbank Eurosystem, Payment Systems, available at http://
www.bundesbank.de/Redaktion/EN/Standardartikel/Core_business_areas/Payment
_systems/payment_systems.html (last visited 11 December 2013).
31
Deutsche Bundesbank Eurosystem, TARGET2 – An Integrated Europe for
Individual Payments, available at http://www.bundesbank.de/Redaktion/EN/
Standardartikel/Core_business_areas/Payment_systems/target2.html (last visited
11 December 2013) and NBS Decision 7 at § 1(1).
32
The standard contract that must be executed by Slovakian financial
institutions with the National Bank of Slovakia is available at https://
www.nbs.sk /_img / Documents / BANKY/ MPS / TARGET2 / Zmluva_o_ucasti_v_
T2SK.pdf (last visited 11 December 2013).
27
Bank account relationships
119
characterized as indirect participants.33 Each direct participant must hold
a payment transaction account in TARGET2 that is administered by the
central bank that operates the state’s RTGS system to which the direct
participant belongs.34
BANK ACCOUNT RELATIONSHIPS AT LOWER TIERS
AND RIGHTS TO MONEY
A typical relationship between a customer and its bank involves two
elements that are relevant in the context of this Part: 1) the depositary
relationship and 2) the funds transfer relationship. The depositary relationship is concerned with the opening of an account and deposits or
withdrawals of funds. The funds transfer relationship regulates transfers
of funds from and to the deposit account.35 In most jurisdictions (e.g.,
Slovakia), the funds transfer relationship is regulated as part of the
depository relationship. Typically, Civil or Commercial Codes provide
for deposit account contracts and regulate funds transfers as their integral
element. Funds transfers at the highest level are regulated in special laws
and regulations issued by central banks. In other jurisdictions (e.g., the
United States), funds transfers are regulated in a specific law separate
from deposit account relationships. This law (e.g., UCC 4A) may be
applicable to all relationships in the holding structure, irrespective of the
level. The following paragraphs examine relevant aspects of both of these
relationships.
Bank Deposits
Customers may enter into two fundamental types of depositary relationships with banks, known as: 1) irregular (general) and 2) regular
(special).36 The distinction between the irregular and regular deposit has
33
Deutsche Bundesbank Eurosystem, TARGET2 – Participation, available at
http://www.bundesbank.de/Navigation/EN/Core_business_areas/Payment_systems/
TARGET2/Participation/participation.html (last visited 11 December 2013).
34
Bundesbank Eurosystem, TARGET2 – Services, available at http://www.
bundesbank.de/Navigation/EN/Core_business_areas/Payment_systems/TARGET2/
Services/services.html (last visited 11 December 2013).
35
In addition to these two functions, banks also provide other services such
as loans, credit cards, collections, etc.
36
See Marine Bank v. Fulton Bank, 69 U.S. 252, 256 (1864) in which the US
Supreme Court stated ‘there are two types of deposits; one where the bank
120
The law of securities, commodities and bank accounts
a number of consequences. For instance, the bank’s right of set-off may
or may not be available depending on the classification of the deposit as
either irregular or regular. For the irregular deposit the bank may be able
to exercise its right of set-off. In contrast, the regular deposit does not
permit offsetting an asset against a debt and the proper remedy instead
may be foreclosure or forfeiture.37
Under the regular deposit the relationship between the depositor and
the bank is that of bailor and bailee.38 It is not a relationship based on
contract but is instead based on property. The depositor does not
surrender ownership rights to the bank and the bank does not acquire any
rights to use or commingle the object of deposit. This type of relationship
is established when the bank accepts cash or other valuables for
‘safekeeping’. Unlike in the case of the irregular deposit, cash held in a
safe-deposit box may not be commingled with the funds of other
depositors. The bank has a duty to restore the identical asset to the
depositor on demand.39 The core of this relationship is not a transferable
account balance but a fiduciary duty of the bank to care for the property
of its depositors.
Civil-law jurisdictions regulate depository relationships in their Civil
and Commercial Codes.40 In Mexico, bank depository relationships are
regulated in the General Law on Negotiable Instruments and Credit
Operations (Ley General de Tı́tulos y Operaciones de Crédito of 27
August 1932) rather than in the Civil or Commercial Code. Under the
regular type of deposit the bank undertakes to receive certain items into
its custody in exchange for the customer’s obligation to pay a fee for the
bank’s services. Money and other valuables may be given in regular
deposit and ‘they will be locked in a safe box and a key to the safe box
given to the depositor’.41 The depository is required, on demand, to
becomes bailee of the depositor who retains title to the deposited funds; and the
other where the depositor relinquishes title to the funds and loans it to the bank’.
37
Carl v. Republic Sec. Bank, 282 F.Supp. 2d 1358 (So. Dist. Fl. 2003).
38
Scammon v. Kimball, 92 U.S. 362, 369 (1876).
39
Obchodný zákonnı́k, (Slovakian Commercial Code) 5 November 1991,
(513/1991 Z.z.), § 706, available at http://www.szk.sk/files/legislativa/1991-513_
znenie_20130201.pdf (last visited 11 December 2013).
40
See BGB §§ 372-386 and Slovakian Commercial Code §§ 700–7 that
provide for ‘a contract on deposit of an item left for safekeeping with a bank,’
and CÓD. CIV. (Arg.), art. 2188 that provides ‘El depósito voluntario es regular o
irregular’.
41
This is the wording in CÓDIGO CIVIL [C. CIV.], art. 2246 (Colom.).
Bank account relationships
121
return the deposited asset with any accrued proceeds (e.g., dividends
collected with respect to a stock).
In the absence of specific statutory regulations, it is up to the courts to
determine the nature of deposit. US courts have held that a special
deposit may be created by an express or implicit agreement that the bank
will hold funds for safekeeping with ownership remaining with the
customer.42 The first step is for the court to analyse the terms of any bank
account agreement to determine the nature of the deposit. If an agreement
has not been executed or is ambiguous, the second step for the court is to
determine whether the bank had actual knowledge of the source of the
deposited funds. For instance, if the bank was aware of an interest of a
third party in the deposited funds the court will establish a special deposit
was made by implication.43 The bank may gain such knowledge when,
for instance, the bank account is designated as a ‘Security Escrow
Account’.44 In contrast, names and indications on checks and deposit
slips may not impute such knowledge to the bank.45
Unlike the regular deposit that is based on property, irregular (general)
bank deposits are based on contractual rights. A general bank deposit is
essentially a loan transaction whereby the depositor lends funds to the
bank in exchange for receiving credit to his bank account. Under
the general deposit, customers transfer ownership and the right to use the
funds to the bank and the relationship between the depositor and the bank
is that of a creditor and debtor.46 If the account balance is positive the
depositor is the creditor and the bank is the debtor. If the balance is
negative, such as when the depositor overdraws the account balance, then
the positions are reversed. At the core of this relationship is the
transferable bank account balance that is of a contractual nature. According to Professor Ellinger ‘the essence of the contract of banker and
Carl v. Republic Sec. Bank, 282 F.Supp. 2d 1370 (So. Dist. Fl. 2003).
Aetna Cas. & Sur. Co. v. Atlantic Nat., 430 F.2d 574, 577 (5th Cir. 1970)
and Carl v. Republic Sec. Bank, 282 F.Supp. 2d 1369 (So. Dist. Fl. 2003).
44
Nardi v. Continental Nat. Bank, 559 So.2d 307, 309 (District Ct. of Appeal
Fl, 3rd Dist. 1990).
45
In Sony Corp. of Am. v. Bank One, 85 F.3d 131, 139 (4th Cir. 1996), the
court held that special words on checks and deposit slips have a mere recordkeeping function that in no way earmark the transferred funds.
46
CHARLES PROCTOR, MANN ON THE LEGAL ASPECT OF MONEY 7 (6th edn.
OXFORD UNIVERSITY PRESS, OXFORD, UK, 2006).
42
43
122
The law of securities, commodities and bank accounts
customer is the bank’s right to use the money for its own purposes, and
its undertaking to repay it on demand’.47
In civil-law jurisdictions the bank deposit is classified as an irregular
deposit.48 The Slovakian Commercial Code regulates the current account
contract (the irregular deposit) in Articles 708–715. The current account
is equivalent to a checking account that is used for day-to-day purchases
and other retail payments. Articles 716–719a regulate the deposit account
contract that is a type of a savings account. Both of these banking
contracts are based on the irregular deposit. In Mexico the irregular
deposit of money is governed by the General Law on Negotiable
Instruments and Credit Operations. Pursuant to Article 267 the deposit of
a certain sum of money transfers ownership to the depository. This Law
also provides detailed rules on the opening of checking accounts and
related transactions. The Central Bank of Mexico also issued regulations
that govern bank deposits, various banking operations as well as some
aspects of transactions with funds deposited in accounts.49
Absence of statutory rules leaves the questions related to the nature of
deposits and the mutual rights and duties of depositors and banks to the
courts. In Bank of the Republic v. Millard 77 U.S. 152, 155 (1869), the
US Supreme Court noted that ‘… it is an important part of banking to
receive deposits, but when they are received, unless there are stipulations
to the contrary, they belong to the bank, become part of its general funds,
and can be loaned by it as other moneys’.50 The irregular bank account
relationship does not involve the actual money as it is merely a
representation of the creditor-debtor relationship.
47
E.P. ELLINGER, E. LOMNICKA & R.J.A. HOOLEY, ELLINGER’S MODERN
BANKING LAW 122 (4th edn., OXFORD UNIVERSITY PRESS, OXFORD, UK, 2006).
48
BENJAMIN GEVA, BANK COLLECTIONS AND PAYMENT TRANSACTIONS,
COMPARATIVE STUDY OF LEGAL ASPECTS 71 (OXFORD UNIVERSITY PRESS,
OXFORD, UK, 2001). See also CÓD. CIV. (Arg.), art. 2189.
49
Circular 2019/95 relativa a las operaciones activas, pasivas y de servicios
de la banca múltiple, issued 20 September 1995, available at http://www.
interacciones.com/storage/Circular_2019-95_Banxico.pdf (last visited 11 December 2013).
50
See the decision of the US Supreme Court in Scammon v. Kimball, 92 U.S.
362, 369–70 (1876) in which the court held ‘under the type of deposit that is
known as general, the title to the money passes to the banker and the resulting
relationship is that of debtor and creditor’.
Bank account relationships
123
Protection of Customers
The regular deposit protects the depositor by recognizing his property
rights to the object of the deposit. Items on regular deposits, including
those held in custodial, trust and fiduciary accounts, are not subject to the
claims of the bank’s creditors.51 With respect to funds held in irregular
deposits the customer has no property rights and is regarded as an
unsecured creditor who shares pro-rata with other depositors. However,
such a customer is not left unprotected against the woes of its bank. Bank
customers’ contractual (unsecured) rights to demand the repayment of
deposited funds are reinforced by deposit insurance provided by governments.52 In addition to mandatory insurance schemes in which licensed
banks must participate and contribute to, some states have set up
supplementary voluntary deposit insurance schemes. For instance,
German private banks may become members of the Deposit Protection
Fund of the Association of German Banks and German public banks may
participate in the Voluntary Guarantee Fund of the Association of
German Public Sector Banks.53 An unsecured claim of the depositor
against the bank may, through various insurance schemes, become as safe
as a property right to money.54
Edward H. Klees, How Safe Are Institutional Assets in a Custodial Bank’s
Insolvency?, 68(1) BUS. LAW. 103, 104 (2012).
52
For Mexico, see El Instituto para la Protección al Ahorro Bancario
(IPAB), available at http://www.ipab.org.mx/ (last visited 11 December 2013);
for Germany, Gesetz über das Kreditwesen, 9 September 1998 (Federal Law
Gazette I S.2776) [hereinafter German Banking Act] § 23a, according to which
banks and financial institutions have a duty to inform their customers about the
deposit guarantee; and for the United States see 12 U.S.C. § 1821(a)(1) (2013).
53
IOSCO, 2013 Survey of Regimes for the Protection, Distribution and/or
Transfer of Client Assets, Collated Responses to the Client Protection Survey,
Germany, at 160, available at http://www.normativafinanciera.com/normafin/
hemero.nsf /0/3704d483226f67a9c1257b0f003322fe/$FILE /3%20-%20Appendix
%20B%20 - %20Collated %20Responses %20to %20the %20Client %20Asset %20
Protection%20Survey.pdf (last visited 11 December 2013).
54
Insurance limits vary across the countries. Most of them are capped, but
some systems offer unlimited protection. Some schemes of insurance for bank
deposits are based on the principle of co-insurance. DALVINDER SINGH, BANKING
REGULATION OF UK AND US FINANCIAL MARKETS 193 (ASHGATE PUBLISHING
LTD., HAMPSHIRE, UK, 2007).
51
124
The law of securities, commodities and bank accounts
REGULATION OF FUNDS TRANSFER RELATIONSHIPS
As highlighted above, bank money derives its value from legal claims
against the banks that maintain deposit accounts for their customers.55
Legal claims against the bank are of a contractual nature and the bank
account holder is not granted any traceable property rights to coins or
banknotes that he deposits.56 The contractual nature of the depository
relationship is also a basis for the funds transfer relationship. As a
consequence of the absence of specific money and identifiable property
rights in the depository relationship, funds transfers do not affect any
property rights or circulate actual money. Instead they modify contractual
relationships.
In some jurisdictions funds transfer services are regulated as a component of the depository relationship and the law of deposit provided for
in Civil and Commercial Codes. However a number of European and
Latin American countries recently adopted specific legislation governing
transfers of funds, which largely applies to the relationships at the top
level between the operator of a LVFTS and its participants. In the United
States the law of payments has been codified in UCC 4A for about 20
years.57 UCC 4A applies to any funds transfer relationships irrespective
of the level in which they arise. Nevertheless, the law that governs funds
transfer relationships is a relatively new phenomenon. A legal framework
to govern funds transfers became a necessity in the 1990s after the check
system was pushed aside by the use of funds transfers.58
Funds transfer law is unique because it affects the movement of much
larger volume of funds than the law of checks and other negotiable
instruments.59 Absence and uncertainty of the rules applicable to funds
55
See also CARL MENGER, Money, translated by Leland B. Yager with
Monika Streissler in CARL MENGER AND THE EVOLUTION OF PAYMENTS SYSTEMS, FROM BARTER TO ELECTRONIC MONEY 36 (Michael Latzer & Stefan W.
Schmitz eds., EDWARD ELGAR PUB., CHELTENHAM, UK, 2002).
56
DAVID COX, PROPERTY RIGHTS IN MONEY 12 (OXFORD UNIVERSITY PRESS,
OXFORD, UK, 2008).
57
UCC Article 4A (1989) was amended in 2012 to implement a change
brought about by the Dodd-Frank Wall Street Reform and Consumer Protection
Act that amended the federal Electronic Funds Transfer Act, effective as of
February 2013. The UCC Article 4A Amendment expressly excludes remittance
transfers from its scope.
58
James S. Rogers, Unification of Payments Law and the Problem of
Insolvency Risk in Payment Systems, 83 CHI.-KENT. L. REV. 689, 690 (2008).
59
Raj Bhala, The Inverted Pyramid of Wire Transfer Law, 82 KY. L.J. 347,
349 (1993).
Bank account relationships
125
transfers may present a significant risk in the entire payment system.60
Presently, in an environment where almost every individual and institution uses funds transfers, adequate regulation of the relationships, rights
and duties implicated in funds transfers merits attention.
In the United States, prior to the codification of the law of funds
transfers in UCC 4A rights and obligations arising from funds transfers
were governed by banking contracts (deposit account agreements) and
the law of negotiable instruments, particularly the rules applicable to
payments by checks.61 The law of checks provided guidance to the
participants, but only to a certain extent because this payment mechanism
is totally different from a funds transfer. Nevertheless, US courts found a
number of important analogies within the checks law to resolve complex
issues involved in funds transfer relationships.62 Gradually the old
statutes that formed the negotiable instruments law developed for a
paper-based world have become insufficient to regulate the world of
electronic payment systems.63
Given the importance of LVFTSs, UCC 4A was drafted in a ‘machine
code’ that provided very little room for variation by agreement.64 UCC
4A may be supplemented by funds transfer system rules issued by
Jeffrey C. Marquardt, Payment System Policy Issues and Analysis, in THE
PAYMENT SYSTEM, DESIGN, MANAGEMENT, AND SUPERVISION 134 (Bruce J.
Summers ed., INTERNATIONAL MONETARY FUND, WASHINGTON, DC, 1994).
61
Some authors observed that this contractual regulation of funds transfers
was unfair to the user community because banks regularly reserved the right to
unilaterally change the terms of account agreements. Peter A. Alces & Jason M.
Hopkins, Carrying a Good Joke too Far, 83 CHI.-KENT. L. REV. 879, 886 (2008).
62
The 2nd Circuit court in the Delbrueck case used the finality of cashier
checks rules as the benchmark to determine the finality rule for funds transfers.
Delbrueck & Co. v. Manufacturers Hanover Trust Co., 609 F.2d 1047 (2d Cir.
1979).
63
Thomas C. Baxter Jr., The UCC Thrives in the Law of Commercial
Payment, Symposium: Is the UCC Dead, or Alive and Well? Practitioners’
Perspectives, 28 LOY. L. A. L. REV. 113, 122 (1994). See also Stephanie Heller,
An Endangered Species: The Increasing Irrelevance of Article 4 of the UCC in
an Electronic-Based Payments System, 40 LOY. L.A. L. REV. 513 (2006), who
noted that ‘The rules on bank collection set forth in U.C.C. Article 4 (2002)
(supplemented by federal statutes and regulations issued by the Board of
Governors of the Federal Reserve System) are increasingly losing their relevance
as the bank collection process shifts away from paper check processing and
moves toward electronic processing.’
64
Joseph H. Sommer, Commentary: Where is the Economic Analysis of
Payment Law?, 83 CHI.-KENT. L. REV. 751, 759 (2008) and Rogers, supra note
58, at 704.
60
126
The law of securities, commodities and bank accounts
operators.65 The scope of UCC 4A is built around the key concept of
‘funds transfer’. This concept is broader than ‘wire transfer’ because it
applies irrespective of the form in which the payment order is submitted
to the bank, including by wire, over the phone or through other electronic
means.66 UCC 4A defines a funds transfer as ‘the series of transactions,
beginning with the originator’s payment order, made for the purpose of
making payment to the beneficiary of the order’.67 The definition
contemplates issuance and execution of multiple payment orders that are
needed to complete a typical funds transfer. For its completion it requires
an acceptance of the payment order by the beneficiary’s bank. Transactions that involve retail transfers, such as those initiated by debit cards,
will be covered by other laws such as the Electronic Funds Transfer Act
(EFTA).68
In civil-law jurisdictions, Civil and Commercial Codes still provide the
fundamental legal framework for the bank deposit relationship and
related transfers of funds that arise below the top level. These provisions
apply in conjunction with the rules set forth by the relevant EU
Directives, such as the PSD, as implemented by the Member States.
Nevertheless, domestic laws of EU Member States differ with respect to
a number of issues, including the characterization of intermediary banks
as substituted agents, sub-agents, etc. and the finality of payment.69 The
Directives themselves also deviate from UCC 4A in a number of aspects,
such as their expansive scope that applies to debit transfers and consumer
transactions.
The Codes provisions may apply as they were originally written or as
they have been modified recently pursuant to the implementation of
supranational rules embodied in EU Directives. As will be seen below
some civil-jurisdictions have enacted special payments codes to regulate
funds transfers at all levels supplementing the Codes provisions that
apply to the low-level relationships. Germany implemented the EU
65
See THOMAS C. BAXTER JR., STEPHANIE A. HELLER & PAUL S. TURNER,
THE ABCS OF THE UCC, ARTICLE 4A: FUNDS TRANSFERS 17 (2nd edn.
AMERICAN BAR ASSOCIATION, US, 2006).
66
Prefatory Note to UCC Article 4A (1989).
67
Ibid., § 4A-104(a).
68
EFTA is to consumer payments as UCC Article 4A is to commercial
payments. Baxter, supra note 63. See also Thomas C. Baxter, Jr. & Raj Bhala,
Proper and Improper Execution of Payment Orders, 45 BUS. LAW. 1447, 1450
(1990).
69
BENJAMIN GEVA, THE LAW OF ELECTRONIC FUNDS TRANSFERS, § 4.06, [4]
Allocation of Risks: Default by a Bank Other than that of the Beneficiary
(MATTHEW BENDER & CO., DANVERS, MA, 2013).
Bank account relationships
127
Settlement Finality Directive that resulted in amendments to its Civil
Code. Under Article 676(f) of the BGB, the bank has a duty to open a
current account for the customer and to credit/debit payments to the
account. Article 676(a) of the BGB provides that by entering into a bank
transfer contract the bank assumes a duty to the customer to make a
specified amount of money available to the beneficiary. In the case that
the completion of a funds transfer requires involvement of an intermediary bank, the originator’s bank is required to submit a payment
order to the intermediary to make the funds available to the beneficiary’s
bank for credit to the beneficiary’s account. The bank is also obligated to
notify the customer of any information related to the identity of the
transferor for incoming transfers and of the purpose of the transfer.70
The BGB also regulates relationships between banks involved in funds
transfers in the form of inter-bank contracts. Article 676(d) provides for
an inter-bank payment contract pursuant to which ‘an intermediate
banking institution assumes a duty to another banking institution to
forward a funds transfer amount to another banking institution or to the
banking institution of the beneficiary’. Accordingly, an intermediary bank
assumes an obligation to execute a payment order it receives from
another banking institution by issuing its own payment order addressed
to another intermediary bank or to the beneficiary’s bank. BGB thus
provides for two specific funds transfer contracts: 1) one that regulates
the relationship between the originator and its bank and 2) another that
applies between the originator’s bank and any intermediary bank. However, the regulation of wire transfer relationships is not as comprehensive
in the German Civil Code as it is under UCC 4A.
Slovakia has implemented the relevant EU Directives by enacting the
Law on Payments. Pursuant to Article 1 it regulates execution of
domestic and cross-border payments, issuance and use of electronic
payment mechanisms, establishment and functioning of payments systems, oversight of payments systems, and resolution of disputes that arise
in payment systems. The Law on Payments is very comprehensive and
supplements the regulation of deposit accounts and the rights of account
holders to dispose of funds included in the Commercial Code. Article 2
provides definitions of funds transfer, payment order, originator, beneficiary and other terms typical for payment systems.71 The payment
BGB art. 676(a).
A funds transfer is defined as ‘an action undertaken on the basis of a
payment order submitted by an originator to an executing institution with the
intent to make the funds available to the beneficiary’. A payment order is defined
70
71
128
The law of securities, commodities and bank accounts
system operator is also obligated to issue and publish payment systems’
rules in the national language.72
Civil and Commercial Codes of a number of Latin American jurisdictions provide only skeletal rules on the bank-customer funds transfer
relationship. Such legal regulation of funds transfers is based on checks
and generally outdated. The Costa Rican Commercial Code includes
rules governing a current account contract.73 Under this type of a contract
the depositor acquires the right to dispose of its funds. However, the
Commercial Code of Costa Rica presumes that such dispositions shall be
made exclusively with checks.74 The right to dispose of the funds by
payment orders must be expressly agreed on in the current account
contract because it is not presumed.75
On the international level, UNCITRAL adopted a Model Law to
provide guidelines for domestic legislators in crafting legislation governing funds transfers. However the Model Law covers only international
credit transfers. Although the Model Law was inspired by UCC 4A, on
many issues it deviates and even provides rules that are contradictory to
the US law, such as the possibility of banks facing liability for consequential damages.76 In addition, one of its defects is the failure to
anticipate the existence of funds transfer systems’ rules.77 In comparison
to UCC 4A the Model Law provides wider latitude for the parties to
account agreements to vary their respective rights and obligations.
Variations to the statutory text agreed to in bank account agreements may
as an ‘unconditional and certain instruction of the originator, in written or
electronic form, to an executing institution to transfer funds’.
72
Slovakian Payments Law § 37(1).
73
See also CÓD. CIV. (Arg.), arts 771–96, which regulate current accounts
(cuentas corrientes) in Title XII and provides for its two types: one maintained
by commercial entities (cuenta corriente mercantil) and the other maintained by
banks (cuenta corriente bancaria).
74
Similarly, CÓD. CIV. (Arg.) does not provide any rules on funds transfers
or related rights and obligations.
75
CÓD. COM. (Costa Rica), art. 612 provides: ‘Los giros contra los fondos en
cuenta corriente bancaria se harán exclusivamente por medio de cheques, sin
perjuicio de las notas de cargo que el depositario emita, cuando para ello
estuviere autorizado’.
76
Sneddon, supra note 4, at 1127. Consequential damages, as long as they
were foreseeable, may also be recovered under the laws of many civil-law
jurisdictions. See GEVA, supra note 69, at § 4.06, [4] Allocation of Risks: Default
by a Bank Other than that of the Beneficiary.
77
In the United States, system rules are effective even if they contradict
UCC Article 4A provisions governing the rights and obligations between
participating banks. See UCC 4A-501(b) (1989).
Bank account relationships
129
undermine certainty, predictability and finality of payments. Article 2(a)
of the UNCITRAL Model Law defines a credit transfer as a series of
operations, beginning with the originator’s payment order, made for the
purpose of placing funds at the disposal of a beneficiary. This definition
is similar to the UCC 4A definition of funds transfer.78
NATURE OF FUNDS TRANSFER RELATIONSHIPS
The following paragraphs examine the nature of funds transfer relationships in light of the preceding overview of their regulation. When banks
execute payment orders they do not transfer any property of the depositor
because the relationship between a bank and its depositor does not
involve any items of property that belong to the depositor. Thus banks
executing payment orders submitted by their customers transfer their own
funds. Similarly, when they accept incoming payment orders and credit
deposit accounts of their customers, funds credited to the customers’
accounts become property of the bank and customers acquire contractual
claims for the repayment of funds enforceable against the banks.
One may then ask what exactly is the relationship of the bank against
an account holder when it executes or accepts a payment order? Is the
bank an agent of the customer or does it act as an independent entity that
is contractually bound to execute payment orders? If the bank is an agent
of the customer, can the customer claim and attempt to enforce its rights
against the other banks involved in the chain of transfers?
The agency theory characterizing the relationship between the originator and its bank in a funds transfer does not apply under UCC 4A. UCC
4A-212 expressly provides that ‘a receiving bank is not the agent of the
sender or beneficiary of the payment order it accepts, or of any other
party to the funds transfer, and the bank owes no duty to any party to the
funds transfer’. Accordingly, a bank is neither an agent of the originator
nor that of the beneficiary. Rather it is an independent entity that is not
liable under agency rules when it executes payment orders. Under UCC
4A the bank is liable only for the breach of its duties provided for in the
account agreement and applicable funds transfer law. The EU Directives
and Member States’ laws do not provide any characterization for the
customer-bank funds transfer relationship. Professor Geva argued that
‘under the civil law, the entire relationship between a customer and a
bank, under which the latter is to carry out the former’s payment
78
See UCC 4A-104(a) (1989).
130
The law of securities, commodities and bank accounts
instructions, may be regarded as a mandate’.79 The bank is thus treated as
an agent of the customer for purposes of executing his payment orders as
well as for purposes of accepting payment orders for his account.
The nature of the funds transfer relationship should be examined from
the perspective of the rights of depositors in the funds on deposit with
their banks. When the beneficiary’s bank receives a funds transfer for its
customer it credits his account. By giving the beneficiary credit for the
incoming transfer, the bank does not act as an agent because it receives
funds in its own right as a borrower vis-à-vis the customer. The
beneficiary’s balance is increased and, correspondingly, so is the debt of
the beneficiary’s bank owed to the depositor. For an agency to exist the
bank must deal with a property of the depositor. A new agency
relationship does not arise every time a credit is made to the customer’s
bank account. Instead, the existing debtor-creditor relationship is modified as reflected in the adjustments to the account balance.80
Proper characterization of relationships between the account holder
and its bank in a funds transfer as either an agency or a loan contract
is also relevant to determine the relationships between individual transfers involved in a chain. The question is to what extent the funds transfer
relationship affects other relationships that gave rise to the initial
transfer or the relationships that arise subsequently after the original
transfer in the chain of transfers. First, the relationship that involves a
transfer of funds should be independent from any underlying transaction
that created the obligation to pay and pursuant to which the payment is to
be effected. If the originator agreed to buy inventory for its business that
turns out to be defective, the originator should not have any right to
unwind a previously completed funds transfer or sue the seller’s bank.
The effectiveness of the funds transfer should be abstract from the
effectiveness of the underlying transaction.81 Just as a bank that issued a
letter of credit need not be concerned with any underlying transaction, so
should not the bank that executed a payment order. This is the first level
of independence that should be present in funds transfers.
The second level of independence should be recognized among the
individual funds transfer relationships including:
GEVA, supra note 48, at 89. See also GEVA, supra note 69, at § 4.06, [2]
Basic Concepts: Characterization, Irrevocability and Discharge.
80
Edmund M.A. Kwaw, The Evolving Law on the Eurobank-Customer
Relationship and the Common Law: The Need for Clarity, 32 SYRACUSE J. INT’L.
L. & COM. 87, 129 (2004).
81
COX, supra note 56, at 72.
79
Bank account relationships
1)
2)
131
the relationship between the transferor and his bank;
the relationship between the transferor’s bank and the beneficiary’s
bank; and
the relationship between the beneficiary’s bank and the beneficiary.
3)
These relationships should also be independent of each other. As a
consequence, the originator of a funds transfer should not be able to
assert rights against any other entity involved in the chain of transfer,
with the exception of its own bank that executed the payment order.
Banks should not owe any duties to participants in funds transfers other
than the immediate parties that they deal with. This is the rule under
UCC 4A where intermediary banks neither owe any duties to originators
and beneficiaries nor act as their agents. The independence of funds
transfer relationships is based on the principle of ‘privity’.82 Sommer
explained that ‘payment systems are built on contract; they rely on bank
money; bank money relies on bank deposits; bank deposits are debt
obligations; debt is contract. Payment transactions are built from these
contractual units.’83 Privity, that is characteristic for these contractual
units or relationships, ensures that participants in a particular contractual
relationship may not assert any claims against participants in other
contractual units. Sommer equated privity with negotiability of rights and
concluded that ‘like negotiability, privity demolishes the history of the
account, providing finality’.84 Privity not only insulates funds transfer
relationships from one another, it also provides the finality of payment,
as will be further examined in the next chapter.
Sommer noted that payment law is based on principles of ‘privity’ and
‘nominalism’. The latter will not be discussed in this chapter because privity by
itself is sufficient to justify independence of funds transfer relationships. Sommer, supra note 64, at 751.
83
Ibid. at 754.
84
Ibid. at 760.
82
7. Funds transfers, finality and security
interests
The nature of money whether coins, banknotes, or funds in bank
accounts determines the relevant legal rules governing transfers. Recall
from an earlier discussion that coins and banknotes are items of property
whereas funds held in deposit accounts are in their nature contractual
claims against banks. Cox noted that ‘A transfer of corporeal money
involves an alteration in the spatial location of money with consequent
changes in the parties’ rights to possession and ownership of it. In
contrast, a transfer of incorporeal money involves an adjustment of the
debt liabilities owed by the depository institutions to the transferor and
transferee’.1 Accordingly, property law governs transfers of physical
money while contract law determines when a transfer of account-based
funds occurs. The following paragraphs are concerned only with the
latter.
TRANSFERS OF ACCOUNT-BASED FUNDS
When one analyses a transfer of funds between bank accounts one must
forget about property and one must think in terms of contract rights and
debt liabilities. Physical location, possession and delivery are relevant
only in the analysis of transfers of coins and banknotes, similar to
transfers of security certificates and actual physical commodities. The
consequence of the nature of bank account relationships as debt liabilities
is that in a funds transfer, the transferor’s title to the money is not
transferred for the depositor is not the owner thereof. What is transferred
is ‘the title to the value’ rather than a title to an identifiable asset.2 The
value is represented in a claim of the depositor against its bank.
Depending on the involvement of banks and central payments systems
funds transfers may be classified into three categories: 1) intra-bank
DAVID COX, PROPERTY RIGHTS IN MONEY 31 (OXFORD UNIVERSITY PRESS,
OXFORD, UK, 2008).
2
Ibid., at 165.
1
132
Funds transfers, finality and security interests
133
transfers, 2) inter-bank or correspondent transfers and 3) central payment
system transfers. In an intra-bank transfer the depository institution
maintains accounts for both the transferor and transferee and completes
the transfer by adjusting its own debt liabilities against both the transferor
by debit and against the transferee by credit. Both entries are made
concurrently or with a short delay. In an inter-bank transfer deposit
accounts of the transferor and transferee are maintained by different
banks. Accordingly, at least two banks are involved. These two banks
may maintain correspondent bank accounts, also known as nostro and
vostro accounts, with one another and complete the transfer by entries to
those accounts. Alternatively the two banks may maintain correspondent
accounts with a third bank that will debit the account of the transferor’s
bank and credit the account of the transferee’s bank. However, banks do
not maintain such accounts with all correspondents and if this is the case
a central payment system, such as the Fedwire, will be utilized. With the
increasing volume of payments the correspondent transfer system has
been, to a large extent, substituted by central payment systems.3
The funds transfer process is initiated by delivery of an instruction to
the bank. This instruction may either be a check or payment order. In the
case of a check the payor first hands it over to the payee who in turn
delivers the check to his bank for collection. In this process funds are
pulled from the payor’s account. In contrast a payment order is delivered
by the payor directly to his bank, which will then push funds to the
payee’s bank. A payment order is a mere instruction addressed to the
bank that does not transfer any funds on its own.4 The payment order is
not considered an item of property.5 Other than the receiving bank that
executes it, no third party has any rights and duties with respect to such
a payment order.6 Accordingly, both the check and payment order trigger
the payment process but the funds flow in opposite directions. Depending
on the type of payment instruction submitted to the bank, funds transfers
3
BENJAMIN GEVA, BANK COLLECTIONS AND PAYMENT TRANSACTIONS,
COMPARATIVE STUDY OF LEGAL ASPECTS 9 (OXFORD UNIVERSITY PRESS,
OXFORD, UK, 2001).
4
Roger Cowie, Cancellation of Wire Transfers under Article 4A of the
Uniform Commercial Code: Delbrueck & Co. v. Manufacturers Hanover Trust
Co. Revisited, 70 TEX. L. REV. 739, 741 (1992).
5
E.P. ELLINGER, E. LOMNICKA & R.J.A. HOOLEY, ELLINGER’S MODERN
BANKING LAW 209 (4th edn. OXFORD UNIVERSITY PRESS, OXFORD, UK, 2006).
6
Official Comment 3 to UCC 4A-402 (1989).
134
The law of securities, commodities and bank accounts
are either debit (check) or credit (payment order) transfers.7 This chapter
is concerned only with credit transfers that are initiated by payment
orders.
Payment orders are subject to certain requirements as to their content
and form. One of the critical data elements that must be indicated in a
payment order is the identification of the beneficiary. Customarily, the
transferor is responsible for supplying the correct name of the beneficiary, the account number of the beneficiary and the bank code of the
beneficiary’s bank. If the name, bank account number or other information refers to a non-existent beneficiary, the receiving bank may not be
able to accept the payment order.8 If the payment order includes a name
that is different than the name associated with the bank account number
indicated in the same payment order, the beneficiary’s bank may rely on
the bank account number and credit such account.9 Reliance on the
number facilitates automated processing of payment orders.10
Funds transfers adjust contractual relationships (debt liabilities) among
banks and account holders. Such transfers may theoretically be characterized as being accomplished by: 1) negotiation, 2) assignment or 3)
novation. For a transfer to be accomplished by negotiation delivery of
some document (e.g., a banknote) that reifies intangible rights is
required. Only transfers of banknotes involve writings and thus satisfy
the requirements for negotiation. Similarly, only bearer securities and
documents of title representing commodities may be transferred by
negotiation. A payment order to transfer funds is not a negotiable
instrument that embodies any rights to money. This leaves the remaining
two options to characterize transfers of funds.
In an assignment the assignee is said to step into the shoes of the
assignor. However, in a funds transfer the transferee does not acquire
the same asset or rights that previously belonged to the transferor.11 The
7
Benjamin Geva, Payment Finality and Discharge in Funds Transfers, 83
CHI.-KENT. L. REV. 633, 636 (2008).
8
UCC 4-207(a) (1989).
9
Ibid., 4-207(b)(1). The beneficiary’s bank is not required to determine
whether the name and number refer to the same person.
10
PSD permits payors to identify the payee by a unique identifier. Pursuant
to art. 74, if a payment order is executed on the basis of the unique identifier, the
payment order shall be deemed to have been executed correctly with regard to
the payee designated by the unique identifier. In contrast, if the unique identifier
provided by the payer is wrong, the payment service provider shall not be liable
for erroneous execution.
11
COX, supra note 1, at 171.
Funds transfers, finality and security interests
135
transferor does not assign its claims against the bank to the transferee.12
The transferee acquires a new claim against his own bank when the bank
accepts the payment order. The transferor’s rights are modified (reduced)
against his bank and the rights of the transferee are correspondingly
increased against his own bank. No proportion of the transferor’s rights is
passed or assigned to the transferee. This is also the case for transfers of
account-based securities whereby a claim of one securities account
holder against his intermediary is not assigned to another account holder.
The assignment theory seems to support only one type of funds transfer
where the originator and the beneficiary are the same person, such as
when a customer is transferring funds between two of his own
accounts.13
Given the mechanics of funds transfers, novation should be the proper
characterization.14 When banks debit and credit accounts of their customers their respective rights are newly created or their existing rights are
modified. Similar to transfers of account-based securities, transferees do
not acquire any assets or rights that previously belonged to their
transferors.
When banks execute payment orders they transfer their own funds. As
a consequence, creditors of the transferor or a transferee should not be
able to attach any funds transferred by intermediary banks. Intermediary
banks neither hold any property of account holders nor are they in a
contractual relationship with the originator or beneficiary. UCC
4A-502(d) is illustrative of this concept in that it provides that ‘the
creditor may not serve process on any bank other than the beneficiary’s
bank with respect to a payment by the originator to the beneficiary’. The
Official Comment 4 then adds:
‘Under English law, regardless of the number of banks involved in a funds
transfer process, there is not a single assignment.’ Roy M. Goode, Concepts of
Payment in Relation to the Expropriation or Freezing of Bank Deposits, 2(2)
J.I.B.L. 80, 81 (1987).
13
Explanatory Note 49 of the UNCITRAL Secretariat to the Model Law on
International Credit Transfers notes that ‘in such a case, completion of the credit
transfer obviously does not change the legal relationship between the originator
and the beneficiary’. See also COX, supra note 1, at 171.
14
Novation is recognized in civil-law jurisdictions as a mechanism that
extinguishes debts. See CÓDIGO CIVIL [C. CIV.], art. 1687 (Colom.) that defines
novation as a substitution of the existing obligation that results in discharge of
the existing obligation. CÓDIGO CIVIL [C. CIV.], art. 2213 (Mex.) provides that
novation occurs when interested parties agree to substitute an existing obligation
for a new one.
12
136
The law of securities, commodities and bank accounts
A creditor of the originator can levy on the account of the originator in the
originator’s bank before the funds transfer is initiated, but cannot reach any
other funds because no property of the originator is being transferred. A
creditor of the originator cannot levy on property of the originator and until
the funds transfer is completed it may not levy on the account of the
beneficiary because the beneficiary has no property interest in the funds
transfer prior to its completion by acceptance of the beneficiary’s bank.
Intermediary banks must be protected from creditors’ processes and
injunctions. Any injunction served on an intermediary bank attempting to
enjoin the bank from executing a payment order should be ineffective.15
Such attachments should not be allowed, not only on legal grounds but
also due to policy considerations (e.g., protection of international banking) and practical considerations (e.g., increased costs).16 While UCC 4A
strictly prohibits attachments to be served on intermediary banks, New
York courts have found grounds and ways to circumvent the restriction.
In particular, federal maritime law has become the source of arguments
justifying the legality of attachments.17 Interests of individual claimants
that seek to attach property of others to secure a potential source of
payment for future judgments conflict with interests of the banking
community. The legal system should provide rules that fairly balance the
interests of both groups, such as by providing and enforcing remedies
capable of attaching funds but only at the originator’s or beneficiary’s
bank not while they are in transit.
FINALITY
The critical moment for any transfer of funds, securities or other
account-based rights is its finality. Only when the transfer becomes final
may its recipient rely on it and rest assured that it will not be revoked or
Official Comment to UCC 4A-503 (1989).
In Reibor Int. Ltd. v. Cargo Carriers, 759 F.2d 262, 268 (2nd Cir. 1985),
the court held that ‘a decision permitting attachment of funds transfers might
have disruptive consequences for the state banking system and international
banking practices’. Recent decisions of US courts also denied requests for
continuous service of attachment orders, arguing that it would have disruptive
effects on the New York banking industry. See Cala Rosa Marine Co. Ltd. v.
Sucres Et Deneres Group, 2009 WL 274486 *4 (2009).
17
See Winter Storm Shipping Ltd. v. TPI, 310 F.3d 263 (2d Cir. 2002);
Navalmar (U.K.) Ltd. v. Welspun Gujarat Stahl Rohren, Ltd., 2007 WL 1200067
*9 (S.D.N.Y. 2007); and General Tankers Pte. Ltd. v. Kundan Rice Mills Ltd.,
475 F. Supp. 2d 396, 398 (S.D.N.Y. 2007).
15
16
Funds transfers, finality and security interests
137
cancelled by the transferor or a third party. Finality is of utmost
importance in funds transfers because payments in a significant majority
of financial and commercial transactions are completed as such. Furthermore, funds transfers and deliveries of financial assets such as securities
are interconnected and rely on one another. Finality may be defined as ‘a
receipt of 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 bankrupt’.18 The finality of a funds transfer thus translates into the beneficiary
receiving the equivalent of cash.19 The following paragraphs examine two
types of finality in the context of funds transfers: 1) the finality of a
payment order and 2) the finality of a funds transfer (payment). Accordingly, finality is present in two different contexts: 1) between the
originator and its bank and 2) between the beneficiary’s bank and the
beneficiary.
The fundamental rule with respect to execution of payment orders is
that the receiving bank has no duty to execute the order unless it has
previously agreed to do so. If the originator has an insufficient balance on
its account the bank may refuse to execute the order. Once the bank
decides to reject a payment order a notice of rejection must be provided
to the originator.20 With respect to the finality of payment orders the
general rule is that the originator may revoke a payment order before it is
executed by the bank. However, mere receipt of revocation instructions
by the bank prior to execution may not be sufficient. In addition, the
revocation must be received in sufficient time to allow the bank to act.21
The deadline when a revocation must be received may be regulated in
See Edward Gerald Corrigan, Perspectives on Payment System Risk
Reduction, in THE U.S. PAYMENT SYSTEM: EFFICIENCY, RISK, AND THE ROLE OF
THE FEDERAL RESERVE: PROCEEDINGS 130 (David B. Humphrey ed., KLUWER
ACADEMIC PUBLISHERS, BOSTON, MA, 1988). Corrigan also added that ‘finality
is the key to the containing and minimizing risks that are presented at each level
of the payments pyramid’.
19
Jeffrey C. Marquardt, Payment System Policy Issues and Analysis, in THE
PAYMENT SYSTEM, DESIGN, MANAGEMENT, AND SUPERVISION 136 (Bruce J.
Summers ed., INTERNATIONAL MONETARY FUND, WASHINGTON, DC, 1994).
20
UCC 4A-210 (1989) and PSD art. 65 provide that ‘where the payment
service provider refuses to execute a payment order, the refusal and, if possible,
the reasons for it and the procedure for correcting any factual mistakes that led to
the refusal shall be notified to the payment service user’.
21
Under UNCITRAL Model Law art. 12(1), a payment order may not be
revoked by the sender unless the revocation instruction is received by the bank in
a manner sufficient to afford it a reasonable opportunity to act before the actual
18
138
The law of securities, commodities and bank accounts
funds transfer system rules or private agreements between the parties. In
the CHIPS system ‘release’ of a payment message determines its
finality.22 Release of a message to the CHIPS operating system is
analogous to the execution of a payment order under UCC 4A and
unreleased payment messages do not trigger an obligation to pay.23 Upon
release of a payment message the sender may no longer revoke the order.
In contrast, upon submission of a payment order to a bank under UCC
4A the sender may still revoke the order unless it has been accepted. On
average 77 percent of all CHIPS payment messages are released within
one second of receipt24 and only about 3 percent are not released for
more than 15 minutes.25 Acceptance and release are thus the critical
actions that establish finality.
In the EU, finality of transfer and payment orders is regulated in the
EU Settlement Finality Directive, which applies to both payment orders
as well as to orders to transfer securities.26 The objective of the EU
Settlement Finality Directive is to ensure that transfer orders cannot be
revoked after a moment defined by the rules of the system.27 However,
the Directive does not provide a uniform finality rule and instead defers
to the rules of the system to which a payment order is submitted.28 A
report issued by the European Commission found that ‘none of the EU
Member States has any legislation to define the “moment of entry” of a
payment order; all Member States defer to the system’s rules’.29 For
instance, Article 34 of the Slovakian Payments Law provides that an
order becomes irrevocable from the moment of its acceptance by the
payments system, which is defined in the rules of such payments
time of execution. UCC 4A-211(b) (1989) with respect to modification and
cancellation of payment orders is similar.
22
Upon release of a payment message, the obligation is deemed to be finally
settled and the receiver is deemed to have received payment for purposes of UCC
4A-209(2)(b). Clearing House Interbank Payments System, Self-Assessment of
Compliance with Core Principles for Systematically Important Payment Systems,
1 (November 2007), at 16.
23
Ibid., at 29.
24
Ibid., at 25.
25
Ibid., at 21.
26
EU Settlement Finality Directive Recital 1.
27
Ibid., Recitals 2 and 14.
28
Ibid., art. 5.
29
Report from the Commission, Evaluation Report on the Settlement Finality Directive 98/26/EC (EU 25), at 7.
Funds transfers, finality and security interests
139
system.30 In TARGET2 some payment orders submitted by participants
may be queued instead of immediately executed or rejected. Such orders
whose execution is suspended while in a queue may be revoked by the
sender.
In Latin America the Costa Rican Regulations on Payments System
(Reglamento del Sistema de Pagos) do not provide for a rule that
establishes the moment of finality. In contrast, the Mexican Payments
Law provides for unconditionality of transfer orders31 as well as their
finality and irrevocability in Article 11.
With respect to the rules on finality of payment orders the emerging
approach among the jurisdictions examined above seems to be that the
originator may revoke a payment order only prior to its execution/
acceptance by the receiving bank or its lodgment to the central payments
system. Furthermore, the receiving bank must also be afforded a reasonable timeframe to act on the instruction to cancel. Funds transfer
legislation typically defers to the system rules to provide specific
regulation that determines the finality of payment orders.
Finality of transfer must be distinguished from other concepts underlying funds transfer law, including discharge, irreversibility and unconditionality. Discharge is a concept that affects the originatorbeneficiary relationship, while finality of payment affects the
beneficiary’s bank-beneficiary relationship.32 Discharge means the satisfaction of an underlying monetary obligation that gave rise to the funds
transfer.33 It may be achieved by a funds transfer, delivery of cash, honor
of a check, etc. In contrast there is no underlying obligation to be
discharged by the beneficiary’s bank vis-à-vis the beneficiary. Finality
See also Rozhodnutie Národnej Banky Slovenska zo 16. októbra 2012 č.
7/2012 o pravidlách platobného systému SIPS (National Bank of Slovakia,
Decision 7 of 16 October 2012 on regulation for payment system SIPS),
available at http://www.nbs.sk/_img/Documents/_Legislativa/_Vestnik/ROZ72012.pdf, at § 15.
31
Article 2o.V defines a payment order as ‘la instrucción incondicional
dada por un Participante, a través de un Sistema de Pagos, a otro Participante
en ese mismo Sistema de Pagos, para que ponga a disposición del beneficiario
designado en dicha instrucción, una cantidad determinada en moneda nacional
o extranjera …’. UNCITRAL Model Law defines payment order in art. 2(b) as
‘an unconditional instruction …’.
32
Geva, Payment Finality, supra note 7, at 668.
33
UCC 4A-406(b) (1989) provides for discharge of an obligation owed by
the originator to the beneficiary. Official Comment 2 further explains that a
discharge is completed by the replacement of the obligor of the obligation, i.e.,
the originator for the beneficiary’s bank.
30
140
The law of securities, commodities and bank accounts
may be achieved simultaneously with discharge but that is not the general
rule. Finality does not mean an absolute irreversibility of payment in the
sense that it eliminates all rights of the originator to recover a payment
that was made by mistake or fraud. Laws provide remedies to recover
such payments but their enforcement should not lie in the unwinding of
individual payments in the chain of transfers.34 Lastly, finality does not
allow for conditionality, which distinguishes funds transfer law from the
law that regulates the collection of checks. This is because a bank
account of the customer who deposited a check for collection may be
immediately credited but the final payment or settlement is not made
until the check is honored by the payor’s bank. In contrast, credits in
funds transfer systems are not conditional or temporal. Once the beneficiary’s bank accepts a payment order and credits the beneficiary’s
account the payment should become final. As a result of conditionality
the moment when finality occurs differs between the credit and check
transfer systems.35
Wood defines payment as ‘the conferring of an unconditional claim in
favor of the creditor against a bank acceptable to the creditor in the
amount of the agreed payment’.36 Finality of payment determines when
the beneficiary acquires such a claim. Under UCC 4A a payment
becomes final when the beneficiary’s bank pays the beneficiary, which
occurs upon acceptance of the payment order.37 A payment order may be
accepted only by the beneficiary’s bank. The originator’s bank and any
other intermediary banks do not accept payment orders that they receive
but they execute them by issuing their own orders.38 Acceptance by the
beneficiary’s bank must be absolute and UCC 4A invalidates any
The fact that a payment has become final does not mean that it cannot be
unwound on the basis of, for instance, being a preferential transfer under the
insolvency law. The return of funds ordered by the insolvency court should not
affect the originally settled transfer. DERMOT TURING, CLEARING AND SETTLEMENT IN EUROPE 412 (BLOOMSBURY PROFESSIONAL LTD., HAYWARDS HEATH,
UK, 2012).
35
Marquardt, supra note 19, at 136.
36
PHILIP R. WOOD, SET-OFF AND NETTING, DERIVATIVES, CLEARING SYSTEMS 266 (2nd edn., SWEET & MAXWELL LTD., LONDON, UK, 2007).
37
When the bank accepts the payment order it becomes obligated to pay the
beneficiary. Official Comment 2 to UCC 4A-405 (1989).
38
Execution of a payment order is in fact issuance of a new payment order
that is intended to carry out the sender’s order. Official Comment 2 to UCC
4A-209 (1989).
34
Funds transfers, finality and security interests
141
agreement that allows the bank to recover payment from the beneficiary.39 Unconditional acceptance produces finality of payment under US
law. Professor Geva noted that ‘upon acceptance, the bank’s incurring of
the debt to the beneficiary is tantamount to finality of payment; it
constitutes both a mode and result of acceptance’.40
Under US law acceptance, and thus finality, is not necessarily synonymous with the crediting of the beneficiary’s deposit account. Acceptance
is broader than crediting a bank account and may also occur under UCC
4A-209(b) by notification of payment to the beneficiary, receipt of
payment from the sender, or on the opening of the next funds transfer
business day following the payment date of the order. Recall from Part I
that a security entitlement may be acquired under UCC 8-501(b) upon
receipt of a financial asset and its acceptance for credit by the intermediary. In other words a security entitlement may be constituted even
before the securities intermediary formally credits a securities account of
its customer. Similarly, a payment may occur and become final when the
bank receives funds from the sender even before it formally credits an
account of the beneficiary.
The EU Settlement Finality Directive and other rules issued by
regulators and operators of central payment systems focus primarily on
the finality of the payment order and the right of the originator to revoke
such an order. They neither address the finality of payment nor the
concept of acceptance. Likewise, one of the frequently cited deficiencies
of the UNCITRAL Model Law is the absence of a ‘receiver finality rule’.
This gap creates an uncertainty as to the moment from which a credit
made by a bank to an account becomes irrevocable.41
In general, civil-law jurisdictions rely primarily on the straightforward
rule of crediting the beneficiary’s account to establish the finality of
payment. Professor Geva found that this objective test is followed in
Germany, Switzerland, Quebec and Japan.42 In Germany, for the finality
of payment Article 676(a)(4) of the German Civil Code defers to the
Ibid. at 4A-405(c).
Geva, Payment Finality, supra note 7, at 646.
41
At the heart of the problem is the ‘execution period’ concept that allows a
receiving bank ‘one or two days’ to execute a payment order. Raj Bhala, Paying
for the Deal: An Analysis of Wire Transfer Law and International Financial
Market Interest Groups, 42 U. KAN. L. REV. 667, 682–9 (1994).
42
GEVA, BANK COLLECTIONS, supra note 3, at 212. See also BENJAMIN
GEVA, THE LAW OF ELECTRONIC FUNDS TRANSFERS, § 4.06, [2] Basic Concepts:
Characterization, Irrevocability and Discharge (MATTHEW BENDER & CO.,
DANVERS, MA, 2013).
39
40
142
The law of securities, commodities and bank accounts
system rules and thus indirectly recognizes the crediting of an account as
the point at which transfers become final. The German Federal Supreme
Court held that notification to the creditor is unnecessary to complete the
payment.43 Accordingly no action other than credit to the beneficiary’s
account is required to establish finality. Under Article 676(g) of the
German Civil Code the beneficiary’s bank must credit an account of the
customer within a fixed period of time. In the case that no agreement
between the bank and its customer exists, the bank must credit the
customer’s account within one banking day after the day on which it
received the payment.44 Credit to the beneficiary’s account also produces
the finality of transfer in Slovakia. Neither the Slovakian Commercial
Code nor the Payments Law provides a clear finality rule. Instead both
defer to the rules applicable to the SIPS administered by the National
Bank of Slovakia, under which banks acquire the right to dispose of the
funds once SIPS credits the bank’s account with the incoming wire
transfer.
The Brazilian payment system also follows the approach under which
substantive law defers to the system rules to establish a finality rule. In
Brazil the finality of payment coincides with the moment of posting the
credit to a settlement account. Only thereafter is the participant notified
that it received the credit but the notification itself is irrelevant to
establish finality.45 In Mexico, banks that participate in the central
payment system must execute customers’ payment orders within ten
minutes after they have received them. Recipient banks must then credit
payments to their customers’ accounts within ten minutes after a payment
is received from the originator’s bank. Although these deadlines do not
provide a clear finality rule, it may be inferred that the payment becomes
final when the beneficiary’s bank receives payment from the originator’s
bank and credits the beneficiary’s account.46
43
See the decision 25 January 1988, BGHZ 103, 143, cited in CHARLES
PROCTOR, MANN ON THE LEGAL ASPECT OF MONEY 172 (6th edn., OXFORD
UNIVERSITY PRESS, OXFORD, UK, 2006).
44
If the bank fails to credit the account of the customer, pursuant to an
agreement or the fallback rule provided in the Civil Code, it shall be responsible
for interest for the duration of the delay.
45
Banco Central do Brasil, Brazilian Payment System, 10 (Sep. 2009). See
also Banco Central do Brasil, Reserves Transfer System – STR, available at
http://www.bcb.gov.br/?STREN (last visited 11 December 2013).
46
Some authors argue that in the Mexican system, payments become final
when the bank receives a settlement notice which may precede the actual credit
to its account. See Bruce J. Summers & Kirstin E. Wells, Emergence of
Funds transfers, finality and security interests
143
The preceding paragraphs examined the finality of transfer in the
systems that provide central payment services on an RTGS basis. NT
systems also provide intraday finality even though deposit accounts of
the participants are not adjusted until the end of the day. In NT systems
the moment that establishes finality of payment does not coincide with
the crediting of the recipient’s account. CHIPS provides intraday finality
although the relevant accounts of its participants are not finally settled
until the end of the day when CHIPS sends payment orders over Fedwire.
FUNDS CREDITED TO BANK ACCOUNTS AS
COLLATERAL
Funds maintained in bank accounts are used not only for payment
purposes but may also secure obligations such as loans provided to bank
account holders.47 The asset that is taken as collateral is not any actual
money or physical object but is the rights of depositors against their
banks. These rights may be encumbered as original collateral or claimed
as proceeds arising from the disposition of some other collateral (e.g.,
sale of inventory). On an imaginary liquidity scale deposit accounts are
the most liquid type of collateral and creditors ordinarily rely on the bank
account balances of their debtors for the repayment of secured debts.48 In
the case of default it is much easier to satisfy an outstanding debt by
debiting a credit balance from a bank account than selling inventory in an
auction.
Sommer explained the nature of a security interest in deposit accounts
and funds credited to accounts as follows:
Immediate Funds Transfer as a General-Purpose Means of Payment, 3Q ECON.
PERSP. 104 (2011).
47
On the use of money to secure obligations between counterparties to a
derivative contract see Sterling H. Dietze, Is Cash Collateral King Again in
Quebec?, 28 B.F.L.R. 277 (2013).
48
UN Commission on Int’l Trade Law, UNCITRAL Legislative Guide on
Secured Transactions, UN Sales No. E.09.V.12 (2010) [hereinafter UNCITRAL
Legislative Guide] refers to a security right in a right to payment of funds
credited to a bank account. See Recommendation 26 on the creation of a security
right. UCC 9-314(a) (1999) provides that a security interest may be perfected in
a deposit account. Some authors argue that security interests may be created only
over the right to payment of funds credited to the bank account rather than the
bank account itself. N. ORKUN AKSELI, INTERNATIONAL SECURED TRANSACTIONS
LAW, FACILITATION OF CREDIT AND INTERNATIONAL CONVENTIONS AND INSTRUMENTS 157 (ROUTLEDGE, ABINGDON, UK, 2011).
144
The law of securities, commodities and bank accounts
the point is that the deposit account is indeed a floating security interest,
which ebbs and flows; one day, the secured creditor might have no security
(the account is overdrawn) and the next day it might be oversecured. The
security interest is in the debt; there is no property in the flow. The security
interest does not attach to the funds in any way. It attaches to the promises of
the bank relating to the deposit account. In this sense, the deposit account is
similar to an account or other receivable. A security interest attaches to the
monetary obligation of the account debtor and not to any funds that the
account debtor might have to satisfy the obligation with. The deposit account,
like an account receivable, is a discrete property item.49
Until recently, secured transactions laws did not regulate security
interests in deposit accounts.50 This was primarily because banks could
exercise their rights of set-off, sufficiently protecting their interests, and
third parties that did not maintain deposit accounts could have arranged
with the debtor to open a special pledge account in which the proceeds of
the debtor’s collateral were to be deposited. Countries intending to
reform their secured transactions regimes are encouraged to include rules
on security interests in bank accounts so as to create a comprehensive
legal framework that regulates all types of interests in personal property
of the debtor. If bank accounts were to be excluded from the secured
transactions law it should, at a minimum, address the potential conflict of
the right of set-off with a security interest in the proceeds of some
collateral that takes the form of funds deposited in a bank account.
A security interest in a bank account is economically and functionally
similar to the right of set-off.51 However, legally set-off is not a security
interest rather it is a defense to the claim for payment as well as a form
of payment that discharges mutual obligations.52 Generally the following
four conditions must be satisfied before a bank may exercise its right of
set-off:
1)
2)
the debtor must have deposited ‘its own’ funds to the bank;
the funds may not be deposited for a special purpose or with
restrictions;
On file with the author.
UNCITRAL Legislative Guide also promotes lending secured with deposit
accounts and provides rules that facilitate such lending.
51
See the exclusions listed in UCC 9-109 (1999) one of which is set-off.
WOOD, supra note 36, at 5 noted that set-off shares similar economic functions
with a security interest, but it does not involve any transfer of property.
52
Ibid., at 4.
49
50
Funds transfers, finality and security interests
3)
4)
145
the depositor must owe an existing debt to the bank;53 and
mutuality of obligations between the bank and depositor must be
present.54
In the case of regular (special) deposits in which the bank does not
become the owner of deposited funds, the relationship between the
depositor and the bank is that of a bailment which prevents the bank from
exercising its right of set-off. In contrast in the case of irregular deposits
that represent the creditor-debtor relationship, the bank may exercise its
right of set-off provided that all other requirements are satisfied.
In the United States the bank’s right of set-off remains uncodified.55 In
civil-law countries set-off is regulated in Civil and Commercial Codes.
Also the EU Financial Collateral Directive recognizes set-off in Article
4(b) as a tool that the creditor may utilize when enforcing a financial
collateral arrangement. Under the common-law approach and any laws
following the German legal system, the debtor has to assert the defense
of set-off. However, in civil-law countries that follow the French tradition
set-off automatically extinguishes mutual debts.56 Legal systems in Latin
America follow the French automatic approach to set-off.57 The Mexican
Federal Civil Code regulates the right of set-off in Title V and Article
2186 provides that qualifying mutual debts are automatically extinguished by operation of law. In contrast, under Article 388 of the German
Civil Code set-off must be accomplished by declaration or demand by
one of the parties. Slovakian law follows the German Civil Code and
provides that the bank has the right to claim reimbursement for the
expenses incurred with respect to the execution of payment orders and
53
Difficulties arise when one of the debts become existing and matured
because of its automatic acceleration on the occurrence of an event such as the
filing for insolvency.
54
JOHN P.C. DUNCAN, PHILIP F. FRANKLIN, BRUCE PRIDDY & HOWARD
RUDA, 4-39 ASSET BASED FINANCING: A TRANSACTIONAL GUIDE, Interests in
Borrowers’ Depository Accounts, § 39.02[3] (MATTHEW BENDER & CO., US,
2007).
55
A few states, including Kansas and South Dakota adopted specific
legislation to govern the right of set-off.
56
DUNCAN, FRANKLIN, PRIDDY & RUDA, supra note 54, at § 39.02[2].
57
CÓDIGO CIVIL [C. CIV.] arts 1714–23 (Colom.) regulate set-off. Similar to
the French Civil Code, set-off occurs automatically, by the operation of law,
without knowledge of the parties.
146
The law of securities, commodities and bank accounts
may exercise its right of set-off against the customer’s balance.58
However the bank must first make a demand to exercise its right of
set-off.
Set-off rights may thus be statutory, common-law or contractual. Even
in the presence of a specific legal regulation banks routinely reserve
set-off rights in their standard bank account agreements. Accordingly,
depending on the domestic legislation banks may have to take a number
of steps to be able to enforce their set-off rights.
Similarly, the process of granting a security interest in a deposit
account involves several steps, including creation and perfection. The
first task for a creditor is to classify properly the deposit account and
funds contained therein as a particular collateral type. Proper classification is important for both the creation of a security interest as well as its
perfection. Some secured transactions laws classify deposit accounts as a
separate collateral type and provide specific definitions and rules for such
accounts while other laws neither provide for a specific type nor include
any definitions. Under the latter types of laws it may still be possible to
create and perfect such security interests unless bank accounts, and funds
deposited in such accounts, are expressly excluded from the scope of
those laws.
UCC Article 9 (UCC 9) recognizes deposit accounts as discrete
property items and provides for a special collateral type and definition of
such accounts.59 The UCC 9 definition of a deposit account focuses on
the debtor-creditor relationship.60 Similar to UCC 9 the EU Financial
Collateral Directive provides for a specific collateral type under the
definition of cash that means ‘money represented by a credit to an
account, or similar claims on repayment of money (e.g., money market
deposits) excluding banknotes’.61 Accordingly, the EU notion of cash is
similar to the UCC notion of deposit account. The EU definition of cash
does not seem to correspond to the ordinary meaning of cash and may be
misleading particularly for some less sophisticated users. Under both
COM. C., § 711(1) (Slovk.).
UCC 9-102(29) (1999) defines deposit account as ‘a demand, time,
savings, passbook, or similar account maintained with a bank’. In turn, UCC
§ 9-102(8) defines bank as ‘an organization that is engaged in the business of
banking. The term includes savings banks, savings and loan associations, credit
unions, and trust companies’.
60
Bruce A. Markell, Symposium of Revised UCC Article 9, From Property to
Contract and Back: An Examination of Deposit Accounts and Revised Article 9,
74 CHI.-KENT L. REV. 963, 974 (1999).
61
EU Financial Collateral Directive Recital 19 and art. 2(1)(d).
58
59
Funds transfers, finality and security interests
147
legal frameworks the critical element that determines the classification of
property as cash or a deposit account is that it must be an obligation
owed by a bank or financial institution. Legal money, such as banknotes,
is excluded because it is not a claim on a bank. EU Member States
generally do not classify deposit accounts as a specific collateral type in
their domestic secured transactions legislation.62 Consequently, special
perfection and priority rules for security interests in funds credited to
deposited accounts do not exist within the EU.
The Organization of American States Inter-American Model Law on
Secured Transactions (OAS Model Law) does not provide a specific
collateral type or a definition of deposit account.63 This is also the case in
Mexico. However, the absence of a specific type and definition does not
impede the ability of creditors to use deposit accounts as collateral under
the OAS Model Law and the local laws in Latin America. Guatemala and
Honduras are the pioneering jurisdictions in Latin America whose laws
expressly provide for security interests in deposit accounts.64
As noted earlier, bank accounts are special types of receivables owed
by banks. This special status may require particular forms of perfecting
security interests in deposit accounts. This is also because ordinary
businesses that owe debts to others are not typically subject to special
legislation such as bank secrecy laws. Furthermore, banks should not be
excessively burdened by their customers’ arrangements with third-party
creditors and forced to determine priorities among conflicting security
interests granted to multiple third parties. Finally, the interests of banks
should be protected when third parties creditors attempt to enforce their
allegedly perfected security interests in deposit accounts that they claim
as proceeds of some other collateral. The following paragraphs discuss
the two main forms of perfection for security interests in deposit
accounts: 1) control and 2) filing.
Perfection by Control
As in the case of account-based securities, control is the functional
equivalent of delivery of banknotes or coins. Control may involve only
62
See CIV. C. (Slovk.) (Občiansky zákonnı́k), 1.4.1964 (40/1964 Zb.) art.
151(d)(1).
63
ORG. OF AM. STATES (OAS), MODEL INTER-AM. LAW ON
SECURED TRANSACTIONS (2002), available at http://www.oas.org/dil/cidipvi-securedtransactions_eng.htm (last visited 11 December 2013).
64
See Ley de Garantı́as Mobiliarias, Decree No. 182-2009, art. 2, 28 de
enero del 2010, DIARIO OFICIAL [D.O.] [hereinafter Honduran LGM].
148
The law of securities, commodities and bank accounts
the debtor and a bank that is also the creditor, as in a situation in which
the creditor itself takes possession of the collateral. Control may also
exist in the form of a trilateral arrangement that involves the debtor, bank
and a third-party creditor, similar to a situation in which a third party
holds possession of the collateral on behalf of the creditor. However,
there is a significant difference between possession of cash and control of
funds. Under control, the debtor’s right to dispose of the funds is not
necessarily frozen yet this is typically the case when the debtor is
dispossessed of the collateral. Like a creditor with a perfected security
interest in account-based securities, the creditor with control acquires
‘management rights’ over the bank account. In this regard this security
interest is in essence non-possessory.
Control has been incorporated into a number of secured transactions
laws to allow creditors to perfect their security interests in funds credited
to bank accounts.65 The EU Financial Collateral Directive provides in
Recital 9 that ‘in order to limit the administrative burdens for parties …,
the only perfection requirement which national law may impose …
should be that the financial collateral is under the control of the collateral
taker …’. However, the Directive does not define what constitutes control
or whether it may arise in more than one form, thus control is subject to
interpretation by domestic courts. In contrast, UCC 9 clearly defines
control and sets out the steps necessary for its achievement. The
UNCITRAL Legislative Guide on Secured Transactions also defines
control and a control agreement in its Terminology section, and includes
specific rules on perfecting security interests by control in Chapter III.
Control may be achieved differently depending on whether the creditor
is the bank that maintains the relevant deposit account or a third party. If
the bank that maintains the deposit account takes control, the security
interest is automatically perfected without the bank having to file a
financing statement in a registry or having to sign a special control
agreement.66 The first type of control is automatic and it may be taken
only by the bank that maintains the deposit account. This type of
automatic control is functionally similar to the bank’s right of set-off.
Third parties do not have the option to perfect their security interests
automatically because they do not maintain deposit accounts. Such a
creditor may either become the bank’s customer with respect to the
deposit account or it may enter into a trilateral agreement with the debtor
65
66
Ibid. art. 5(7) defines control.
UCC 9-104(a)(1) (1999).
Funds transfers, finality and security interests
149
and the bank.67 Perfection by control in which the creditor becomes a
customer with respect to the deposit account is primarily used for
blocked accounts in which the debtor does not need immediate access to
the funds in the account to pay its operating costs.68 In terms of the
debtor’s rights to dispose of the encumbered collateral, it is similar to the
absolute control over intermediated securities or a possessory pledge. If
the debtor needs to retain access to the funds the parties may execute a
trilateral control agreement. He may enjoy the use of funds until the
creditor submits instructions to the bank enforcing its right of control.69
This type of control adequately balances the rights of all three parties
involved. It allows the debtor to use the funds in its business, it grants the
creditor the right to block the use of funds and it also protects the
interests of the bank. Recall, however, that many jurisdictions do not
recognize control agreements with respect to account-based securities
and like these securities this is also the case with respect to funds held in
deposit accounts.
UCC 9 and the UNCITRAL Legislative Guide provide that a control
agreement must be concluded among three parties who are the account
holder (borrower), the depository bank and the creditor.70 While a control
agreement under UCC 9 and the UNCITRAL Legislative Guide requires
signatures of the three parties, this is not the case under the EU’s
Financial Collateral Directive. The Directive provides that an agreement
between the depositor and the creditor without the requirement to obtain
acknowledgment from the bank may arguably be sufficient to establish
adequate control over the bank account. The ‘EU control’ may thus be
established bilaterally without knowledge of the bank. This approach
forces banks to resolve potential conflicts of priority and react to
demands of unknown creditors who claim to have acquired control.
Legislation in a number of Latin American countries, including the
already enacted laws in Colombia, El Salvador, Guatemala, and
See the definition of control with respect to a right to payment of funds
credited to a bank account in the Terminology of the UNCITRAL Legislative
Guide.
68
Markell, supra note 60, at 987.
69
In the instruction, the creditor may also order the bank to transfer the
funds to the creditor or to a designated third party. Sandra M. Rocks, Perfection
without Filing: Often the Better (and Sometimes the only) Way, PLI ORDER NO.
8836, 281 (2006).
70
UNCITRAL Legislative Guide 34 (‘control exists … if the depository
bank has concluded a control agreement with the grantor and the secured
creditor’).
67
150
The law of securities, commodities and bank accounts
Honduras follow the UCC 9/UNCITRAL approach that requires participation of all three parties for a control agreement to be enforceable.71
Banks in these jurisdictions supported the inclusion of control agreements on the condition that such security interests would not be perfected
without their knowledge and consent.
Secured transactions laws should not prejudice the set-off rights of
banks. Accordingly, the bank may exercise its rights even if the deposit
account is subject to a security interest perfected by filing or via a control
agreement in favor of a third party, unless the bank has expressly waived
such a right. However, under some circumstances set-off will not be
available against a secured creditor when the creditor acquired control by
becoming the bank’s customer with respect to the deposit account.72 In
this case the mutuality of obligations required for set-off is absent. Even
though the debtor owes a debt to the bank, the bank does not owe a debt
to the debtor but to the creditor. Creditors seeking to perfect their security
interests via control agreements regularly demand that the bank waives
its right of set-off.
Perfection by Filing or Registration
Filing or public registration has been the traditional method for perfecting security interests in all types of personal property. However, jurisdictions have taken a number of approaches when it comes to the
possibility of perfecting security interests in deposit accounts by filing,
and the priority of such perfection vis-à-vis security interests perfected
by control. On the one hand – in the systems such as UCC 9, the
Colombian and the Honduran Secured Transactions Laws – filing may
not be sufficient or permissible to achieve perfection of a security interest
in deposit accounts.73 The proposals to permit perfection by filing were
rejected in the initial stages of the UCC 9 revision process by the banking
industry.74 The bankers claimed that filing would subject the banks to a
duty to determine priorities and deal with unknown parties. The same
argument applies to perfection through a bilateral control agreement.
Furthermore, it was argued that this possibility may even undermine the
71
See the definition of control in Ley por la cual se promueve el acceso al
crédito y se dictan normas sobre garantı́as mobiliarias (Colom.), L. 200, art. 8,
14 May 2013 [hereinafter Colombian LGM]; and Honduran LGM, art. 5(7).
72
UCC 9-104(a)(2) (1999).
73
Ibid., § 9-312(b)(1), Colombian LGM, art. 36 and Honduran LGM, art.
15(5).
74
Markell, supra note 60, at 983.
Funds transfers, finality and security interests
151
efficiency of the payment system.75 Many authors have rejected these
arguments and pointed out the advantages of filing.76 For instance, filing
could be a useful tool limiting the debtor’s opportunities to defraud the
creditor. Control over a deposit account does not prevent the debtor from
opening a new account at a different bank and siphoning off the funds to
that bank account. Perfecting a security interest by filing would extend
perfection to all deposit accounts that the debtor may open.77
Recommendation 49 of the UNCITRAL Legislative Guide allows
filing to perfect a security interest in deposit accounts as an alternative
method to control. However it also recommends that in the case that a
security interest has been perfected by filing, the creditor must obtain a
court order to initiate enforcement.78 In other words a security interest
may be perfected by filing but the bank’s compliance with attempted
enforcement measures undertaken by the creditor requires a court order.
The OAS Model Law also arguably permits filing to achieve perfection
of a security interest in deposit accounts. Article 3(V) defines ‘movable
property collateral’ without excluding deposit accounts and Article 10
provides that ‘a security interest in any type of collateral may be
publicized by registration …’ Accordingly a deposit account would be
treated as an ordinary account receivable and a security interest would
require registration for perfection purposes. However, the countries that
have thus far implemented the OAS Model Law introduced special rules
on deposit accounts and provided for the possibility of perfection by
control.
75
Having rejected the proposals for filing, UCC Article 9 provisions ‘protect
the integrity of the Fed payment systems in that they give banks control over the
settlement of their balances in the payment system’. Steven Walt, After Article 9:
Security Interests and Bank Setoffs in Consumer Deposit Accounts, 125 BANKING
L.J. 224 (2008).
76
Brian McCall, Money, Money Everywhere but not a Drop to Secure: A
Proposal for Amending the Perfection Rules for Security Interests in Money and
Deposit Accounts, 74 TENN. L. REV. 669 (2007) at 694 argued that ‘an objection
that filing would impede the functioning of the banking system and the finality
of payment should be dismissed’.
77
Ibid.
78
UNCITRAL Legislative Guide Recommendation 175.
152
The law of securities, commodities and bank accounts
Approaches to Perfection
Barring full or partial79 exclusion of deposit accounts from the scope of
secured transactions laws, four approaches to regulating security interests
in deposit accounts may be identified. Under the first approach (as in the
OAS Model Law and Mexico), a bank account is treated as any other
ordinary receivable and a security interest in it may be perfected by
filing, notification or another mechanism provided for the perfection of
security interests in accounts receivable, depending on the domestic law.
This approach ignores the special nature of deposit accounts and may not
provide acceptable protection to the banking industry. Under the second
approach (as in UCC 9, Guatemala and Honduras), filing is not permitted
and only control achieves perfection. This approach has proven to be the
most acceptable to the banking industry. The third approach is represented by the UNCITRAL Legislative Guide, which recommends both
filing and control for the perfection of security interests with the priority
given to the creditor who perfected by control. This approach seems to
balance fairly the rights and interests of bank and non-bank creditors.
Finally, the EU Financial Collateral Directive provides for control but
does not define what steps are necessary to achieve such control. This
approach is problematic because it allows control without consent of the
bank.
For a jurisdiction that contemplates reforming its secured transactions
law, the first approach should not be adopted. If deposit accounts are
treated as ordinary accounts receivable, the banking community is
expected to oppose the reform as it would subject it to an increased duty
to monitor notifications of assignment and public registries, effectively
becoming the enforcer of priorities. The second or third approaches are
much more credit-friendly and bank-protective. Adoption of the third
approach would align the perfection of security interests in deposit
accounts with the perfection of security interests in securities accounts
and allow non-bank creditors the means to perfect their security interests
if the bank has refused to enter into a control agreement. The fourth
approach is unacceptable because the lack of definition of control creates
legal uncertainty and potentially puts undue burdens on banks.
79
See UCC 9-109(d)(13) (1999), which excludes from its scope assignments
of deposit accounts in consumer transactions.
8. Summary of Part II
Payment systems are essential components of contemporary commercial
infrastructures. Without efficient payments systems the settlement of
transactions with securities, commodity contracts and other instruments
would be impractical, complicated and expensive. Sellers of securities
and other financial assets, as well as providers of services, would be
reluctant to fulfill their sides of the bargain unless they were assured that
a payment is not only forthcoming but also expeditious. Funds transfers
have replaced checks as the dominant payment mechanism for the
settlement of commercial and financial transactions. Although the practice of paying via funds transfers is quickly developing and expanding,
that is not always the case of the law that supports funds transfer
systems.
Over the previous two decades a number of LVFTSs, especially in the
form of RTGS, have been established. In parallel, national laws of many
countries have been reformed and a number of international drafting
efforts, at the EU and UN levels, have been undertaken to address the
structure of modern payment systems that are composed of bank account
relationships. Most jurisdictions have enacted laws and promulgated
regulations to govern funds transfers. However, many of these laws and
regulations apply only to the relationships at the top level between the
operator of the LVFTS and its participants. On the lower levels, legal
regulation relies on the concepts underlying payments by checks. Legislators in such jurisdictions should recognize the differences between
payments by checks and wire transfers. This is particularly the case of
Latin American Civil Codes that recognize bank account contracts and
depository relationships but largely address only payments by checks. A
legislative framework governing funds transfers must address, at a
minimum, the following features and functions.
Money no longer circulates in the form of coins and banknotes. In
modern economies money circulates in the form of claims against banks
embedded in bank accounts (bank money). Claims against banks are
transferred and payments are made by electronic entries to bank accounts
maintained by intermediaries (banks). Accordingly, laws should recognize funds transfers from/to bank accounts as a valid form of payment
153
154
The law of securities, commodities and bank accounts
that discharges underlying obligations. Legal definitions of money
exclude funds credited to bank accounts because they are not authorized
by governments. Bank account funds transfers do not involve transfers of
tangible assets and property rights but are completed by adjustments of
contractual debts owed by depository banks to their customers. Funds
transfers should be recognized as producing the legal effect on underlying obligations equivalent to the delivery of cash and banknotes.
However, to distinguish payments by funds transfers from those in cash
they require regulation that is based on contracts separate from property
law. For the most part this aspect has already been adequately addressed
in the legislation of the jurisdictions examined in this Part.
Funds transfers are completed within a particular legal (software) and
structural (hardware) framework. In terms of the hardware, central
payment systems come in two forms: 1) RTGS and 2) NT systems. The
RTGS model has become the dominant type of system and the few
jurisdictions without any LVFTS should implement the RTGS model due
to the number of benefits highlighted above. The RTGS model does not
rely on clearing and netting but provides immediate booking of all
transfers to the deposit accounts of participants as soon as they are
processed. Unlike in securities transfer systems clearinghouses and
central counterparties are not utilized by LVFTSs.
While the previous Part distinguished between the various types of
securities holding systems, bank accounts holding systems may not be
divided structurally into direct, indirect and transparent. The structure of
bank accounts holding systems, as well as the relationships on which
they are built, are uniform. Bank account holding systems recognize and,
with some minor exceptions, protect the independent nature of individual
bank account relationships and prevent third parties from claiming rights
under relationships that they are not parties to. When executing payment
orders banks act as independent entities. From the nature of bank account
relationships it should be apparent that banks deal with deposited funds
as their own and do not act as agents dealing with property of their
principals, i.e., deposit account holders. Bank accounts holding systems
are indirect because rights of the parties exist only within the particular
relationship. For instance, bank account holders may not assert claims
against intermediary banks or operators of central payment systems. The
principles of independence of relationships should be incorporated into
legislation governing funds transfers.
Unlike in the case of securities accounts systems in which jurisdictions
have adopted different classifications for the rights of account holders
(e.g., security entitlement, co-ownership, etc.), since the time of Roman
law, the right of the depositor against his bank has been characterized
Summary of Part II
155
either as proprietary under the regular deposit or as contractual under the
irregular deposit. Only the latter provides the basis for modern bank
account and funds transfer relationships. Proprietary types of deposit are
used only for specific purposes, such as when money or other valuables
are segregated and kept identifiable in safe-deposit boxes. Safekeeping
relationships based on property may be found in other areas of commercial relationships as well (e.g., custody of securities and physical
commodities). Although the right of the depositor against its bank is
merely contractual, it is typically protected by deposit insurance that
provides almost as effective a protection as property rights.
Laws and regulations should also adequately characterize transfers of
rights to funds and recognize that the traditional concepts of negotiation
and assignment do not apply to funds transfers. Funds transfers neither
involve writings that reify rights to money required for negotiation nor
assign the right of the transferor against its bank to a transferee.
Legislation should recognize that book entries made to deposit accounts
transfer rights to funds by novation. Many jurisdictions already recognize
novation as a transfer mechanism. An explicit reference in payments laws
may be necessary to provide clarity and legal certainty for transfers
between deposit accounts. Novation is the key transfer mechanism for
both securities held in accounts as well as for funds maintained in
accounts.
A critical element of every transfer is its finality that determines the
moment from which the transferee acquires irrevocable rights to the
funds. Efficient systems for transfers of any account-based rights, including securities, funds and commodity contracts, must be supported by
clear and predictable rules on finality. Finality must be distinguished
from discharge, absolute irreversibility and conditionality. Two types of
finality rules were identified in the context of funds transfers: the finality
of a payment order and the finality of transfer (payment). While the
former applies between the transferor and its bank, the latter applies to
relationships between the transferee’s bank and the transferee (beneficiary). The finality of a payment order is regularly established upon its
execution by the receiving bank. Most payments have been automated
and the bank may not be able to cancel the previous execution once its
internal system for processing payment orders is already in motion.
Finality of transfers typically coincides with a credit entry made by the
bank to the transferee’s bank account. Legal systems that lack clear rules
on the finality of transfer should refrain from applying the law of checks
by analogy. A credit entry made upon the deposit of a check is merely
provisional and does not become final until the check is honored. Finality
and irrevocable acquisition of rights should not be delayed beyond
156
The law of securities, commodities and bank accounts
making a book entry. Legislation should clearly provide that a transfer is
final when a book credit entry is made or at some earlier-in-time point
when the bank accepts the payment order. At the same time the law
should preserve the right of the transferor to recover payments made by
mistake or fraudulently. Such recoveries should not be permitted by
unwinding executed transfers but only by enforcing remedies outside the
chain of transfers.
Legislation should provide for effective rules on using funds credited
to bank accounts as collateral. Only recently, a number of secured
transactions laws extended their scope to deposit accounts that may be
used as original collateral. Secured transactions reform projects should
enable the taking of security interests in deposit accounts. These laws
should not rely on the traditional definitions and perfection mechanisms
that apply to other intangible rights such as accounts receivable. A bank
account is a special type of receivable that must be recognized as such in
secured transactions legislation. Two mechanisms for the perfection of
such security interests have emerged: 1) filing and 2) control. Filing is
the traditional method for perfecting security interests in all personal
property. However, with respect to deposit accounts it has been rejected
in some jurisdictions as harming the interests of the banking industry.
Other laws permit filing but subject its priority to control, the primary
mechanism for perfecting security interests in funds credited to deposit
accounts. Perfection of security interests by control requires that the
creditor be placed in a position to exercise ‘management rights’ over the
funds without further consent of the debtor. Recognition of control as a
perfection mechanism, and the form in which it is incorporated into a
legal framework, raise a number of policy and practical issues that should
be considered in the drafting of the legislation.
Modernization of funds transfer and supporting bank accounts holding
systems is critical for economic development. Contemporary commercial
and financial transactions must be supported by efficient legal and
structural frameworks for funds transfers. This Part attempted to highlight
the fundamental principles of such a framework. The critical principles
and features include independence of bank account relationships, the
RTGS model, novation as the transfer mechanism, finality of transfer,
and facilitation of security interests. Many of these principles and
features are common to both securities and bank accounts holding
systems.
PART III
Commodity Account Relationships
9. Introduction to Part III
Similarly to the systems in which securities and funds circulate, systems
for the holding and transferring of commodity contracts underwent a
significant modernization process in which deliveries of actual commodities against immediate cash payments were replaced with an exchange of
promises tradable like securities. Commodities trading became centralized and supported by webs of account relationships that facilitate
transfers. Like securities markets, contemporary commodity markets for
the acquisition and trading of commodity contracts are electronic, having
replaced the markets populated by human traders who executed and
confirmed trades by exchanging paper tickets.1 Commodity intermediaries execute orders of their customers on centralized exchanges and
maintain commodity accounts for their customers.
The essence of commodity contracts and commodity accounts is a
contractual promise. Unlike in a traditional spot contract in which an
asset is sold and its possession delivered to the buyer in exchange for a
purchase price, the buyer of a promise embedded in a commodity
contract is not acquiring an asset expecting its delivery. He is acquiring a
right to demand delivery of the underlying commodity.2 This promise is
‘delivered’ to the buyer by his intermediary, which credits the buyer’s
commodity account.
Since the establishment of centralized commodity markets, sellers no
longer need to find buyers for their products and for the right price. Long
before the harvest the seller may acquire a commodity futures contract to
sell his corn through an intermediary who will then credit the seller’s
commodity account. For this commodity contract there must be another
party willing to buy the corn in the future whose intermediary will also
1
‘The world’s largest operator of commodity exchanges, CME Group,
considers selling its buildings that house trading floors, as a sign of the quick
adoption of computer trading.’ Jacob Bungle, For Sale: Top Location (and
Trading History), WALL STREET JOURNAL, 21 March 2013, at C1.
2
‘Futures exchanges deal in contracts for sale or purchase of a commodity
that are final and enforceable.’ Ray L. Ross, Financial Consequences of Trading
Commodity Futures Contracts, 15(2) ILL. AGRI. ECON. 27 (1975).
159
160
The law of securities, commodities and bank accounts
make an entry in the commodity account of the buyer. Contracts are held
in the form of electronic bookkeeping entries in commodity accounts and
settled by similar electronic offsets or deliveries of electronic warehouse
receipts.
This Part is not concerned with the trading of commodity contracts but
examines the transformation from the settlement of trades by physical
exchanges of commodities for cash to electronic acquisitions and transfers by book entries to commodity accounts. It analyses both the
‘hardware’ (organizational and structural infrastructure) and the ‘software’ (legal infrastructure) of contemporary systems for the holding of
commodity accounts. Throughout this Part, it must be borne in mind that
there are two distinct worlds of relationships that arise as a result of
commodities trading – one in which actual commodities are sold and
bought and another in which rights to commodities are held. These two
worlds co-exist but are populated by the entirely different types of market
players. The world of physical commodities and their delivery is controlled by growers, farmers, sellers, buyers and other entities that handle
actual commodities in their ordinary course of business. In contrast, the
world of rights to commodities is controlled by financial ‘paper traders’
who frequently lack the mentality for the world of physical products.3 In
their ordinary course of business, these paper traders deal with promises,
commodity contracts and commodity accounts. Paper traders neither
inspect commodities to determine their soundness or place of origin nor
deliver warehouse receipts to settle transactions.
Executory promises to future delivery of commodities belong to the
broader family of derivatives contracts whose function is not to facilitate
consummation of commercial transactions by delivery, but effectively to
distribute the risks inherent in such transactions. Derivatives, such as
futures contracts and commodity options, are risk-shifting mechanisms
that deal in rights and promises independent of the underlying asset.4 The
nature of the promise is a monetary obligation to pay the difference in
price rather than to make/take delivery of a commodity. For this reason
organized commodity markets attract commercial entities that deal in
commodities in their ordinary course of business, such as growers of
corn, but also attract speculators who take the other side of commodity
contracts, thus relieving commercial entities of their risks. If these
promises were not in their nature monetary obligations but required
3
LISA ENDLICH, GOLDMAN SACHS, THE CULTURE OF SUCCESS 99–100
(ALFRED A. KNOPF, NEW YORK, NY, 1999).
4
Jayashree B. Gokhale, Hedge to Arrive Contracts: Futures or Forwards,
53 DRAKE L. REV. 55, 57 (2004).
Introduction to Part III
161
actual delivery, speculators, such as investment banks, hedge funds and
small-scale retail investors, would not participate in such commodity
markets. Promises to deliver that are settled by actual delivery are not
traded on organized commodity markets but instead are largely traded in
over-the-counter (OTC) markets for forward and spot contracts.5
Organized commodity markets for future delivery presuppose the
existence of a risk that is marketable and transferable.6 However,
commodity markets deal only in those marketable risks that are of a
commercial nature, such as volatility in the market price of corn,
volatility in the exchange rate of the US dollar against the euro, volatility
in the price of government bonds, etc. In contrast, non-marketable risks
are ‘the risks whose occurrence is so unpredictable or governed by
imponderables that no reasonable odds could be given’ (e.g., the risk of
whether a new product will successfully sell in the market).7 Institutionalized commodities trading involves transfers of marketable risks that
necessitate the creation of a centralized system supported with commodity accounts holding structures. These marketable risks trade separately
from actual commodities, exist embedded within commodity contracts,
and are held in accounts maintained by commodity intermediaries.
This Part primarily seeks to explain and compare the legal infrastructure that governs systems for the holding of commodity contracts.
This analysis conceptualizes these systems within the larger framework
of global financial markets and seeks to provide guidance to the legislator
in future modernization of the infrastructure. Unlike the holding systems
for securities and funds, no international framework, whether binding or
model-like, governs the operations of commodity holding systems. The
main objective of this Part is to highlight the benefits of commodity
contracts and markets for standardized promises of future delivery, as
well as to provide a justification for modernization of the legal framework governing their functioning. The fact that commodity markets trade
in and hold marketable risks in accounts also raises a question as to the
5
Sometimes the terms ‘market’ and ‘exchange’ are used interchangeably.
MICHAEL BLAIR QC & GEORGE WALKER, FINANCIAL MARKETS AND EXCHANGES
LAW 19 (OXFORD UNIVERSITY PRESS, OXFORD, UK, 2007).
6
Kenneth A. Froot, Incentive Problems in Financial Contracting, Impacts
on Corporate Financing, Investment, and Risk Management Policies, in THE
GLOBAL FINANCIAL SYSTEM, A FUNCTIONAL PERSPECTIVE 256 (Dwight B.
Crane, Robert C. Merton, Kenneth A. Froot, Zvi Bodie, Scott P. Mason, Erik R.
Sirri, André F. Perold and Peter Tufano eds., HARVARD BUSINESS SCHOOL PRESS,
BOSTON, MA, 1995).
7
Ibid., at 257.
162
The law of securities, commodities and bank accounts
necessity to protect the participants and the uninvolved from the failures
of such markets.
PROTOTYPICAL TRANSACTION
Before providing a historical overview of commodity transactions and the
relationships involved one must understand the context in which commodity contracts are acquired/held and identify the parties involved.
Suppose that Steve is a farmer that grows corn. Brian owns a pig farm
and wants to buy some corn from Steve for feed. Steve stores his corn in
a warehouse operated by a third party. Once Steve and Brian agree on all
details of the sale, they meet in Steve’s office where they exchange the
warehouse receipts representing corn for banknotes. Suppose that Steve
endorses and hands over warehouse receipts to 500 kilos of corn and
Brian brings US$ 5000 in cash. This transaction involves 1) an agreement
to buy corn for a fixed price and 2) its settlement by delivery of
warehouse receipts for banknotes. Only the seller and the buyer are
involved and they consummate their transaction without any involvement
of intermediaries. This type of transaction is known as the spot contract
and it is not concluded in an organized commodity exchange.
Now suppose that Brian expects the price of corn to increase in the
near future and wants to buy as much corn as he can at the present
market price. He can buy the corn now and take its delivery. However,
this may be impractical because he will have to pay for storage before the
corn is consumed. Steve’s other option is to enter into a contract for
future delivery whereby he agrees to sell corn for the current market
price six months later. Steve will deliver the corn to Brian in six months
and Brian will pay Steve at the same time. Brian may be required to
provide a down payment when the contract is signed. Delivery of corn in
exchange for payment, to be performed in six months, is the back-end
function. This type of transaction is known as a forward contract and it is
also not concluded in an organized commodity exchange. Brian may thus
buy corn on a spot or forward basis and take its delivery now or in the
future.
Organized commodity markets provide Brian with another opportunity
to fix the price of corn for the foreseeable future. Brian may order his
intermediary (e.g., Goldman Sachs) to acquire futures commodity contracts to buy corn. To acquire a futures contract, Brian must submit an
order to Goldman Sachs that it will execute on the Chicago Board of
Trade (CBOT) or some other commodity exchange. CBOT and similar
commodity exchanges provide a ready market for buy and sell orders for
Introduction to Part III
163
futures commodity contracts. If Brian’s buy order is matched by a sell
order the contract to take delivery of corn in six months will be
concluded. For the purposes of this illustration assume that Steve
instructed his intermediary (e.g., RJO Futures) to acquire a futures
contract to sell corn in six months for the price quoted today at the
CBOT. Submission of orders, their execution and matching on a
commodity exchange are all front-end functions. Unlike in the case of
spot and forward contracts, this transaction involves four parties: Brian
the buyer, Goldman Sachs his intermediary, Steve the seller, and RJO
Futures his intermediary. How then do Steve and Brian receive their
respective rights to the future delivery of corn?
Steve and Brian never meet each other and do not exchange actual
commodities or warehouse receipts for cash. Instead Goldman Sachs will
credit Brian’s commodity account with the futures contracts to buy corn
and RJO Futures will credit Steve’s commodity account with a futures
contract to sell corn. This crediting of commodity accounts will complete
one portion of the transfer – the acquisition of futures contracts. Goldman
Sachs will then debit Brian’s account for the purchase price (margin)
corresponding to the corn futures contracts and RJO Futures will also
debit Steve’s account for the portion (margin) of the purchase price for
the corn futures contract that he acquired. These entries to Steve’s and
Brian’s commodity accounts are an essential back-end function. In
commodity markets the back-end functions may thus involve transfers of
tangible assets, such as warehouse receipts against banknotes, or transfers
of intangible rights to delivery of commodities made by bookkeeping
entries to commodity accounts. Organized commodity markets, such as
the one where Steve and Brian enter into their futures contracts, are not
venues for the delivery of actual commodities. Such commodity markets
deal only with promises to make and take delivery that are consummated
(performed) by payment.
The preceding illustration of the prototypical transaction and the
relationships involved is characteristic of commodity markets and their
related holding systems in a number of economies. These markets and
holding systems, whether situated in developed or developing countries,
exhibit similar features. Unlike in the case of securities holding systems,
laws governing clearing, settlement, holding and transfers of commodity
contracts are based on the same fundamental principles. As in the
preceding two Parts, commodity markets from jurisdictions that represent
different systems and regions have been selected for points of comparison. Central America has not been selected as a reference market in this
Part because no country in that region has established an organized
commodity exchange.
164
The law of securities, commodities and bank accounts
US commodity markets, in many aspects, have provided a model for
the establishment of contemporary commodity markets. Established in
1848, the CBOT was the world’s first commodity exchange. In 2007 it
merged with the CME to create the world’s largest commodity exchange.
For the month of January 2013 the CME Group traded 240 million
contracts.8 CME Group trades contracts to delivery of agricultural
commodities, energy products, metals, and various financial assets but
also trades contracts on some exotic assets such as weather and real
estate products.9
One of the largest commodity exchanges in the world is Eurex, which
is jointly operated by Deutsche Börse AG and SIX Swiss Exchange. In
January 2013 the daily trading volume at exchanges that belong to the
Eurex Group averaged 8.7 million contracts.10 Eurex trades contracts to
future delivery of financial assets, agricultural commodities as well as
metals. It is a fully electronic trading platform without floor brokers. In
the eastern part of the EU Slovakia’s Commodity Exchange Bratislava
(CEB) was founded in 1992 and commodity contracts may be traded
electronically as well as through authorized floor brokers.11 However,
presently the exchange does not offer contracts to future delivery of
financial assets.
A 2008 study by the Futures Industry Association found that 39
percent of all global futures trading was concentrated in North America,
28 percent in Asia-Pacific, 23 percent in Europe and slightly less than 5
percent in Latin America.12 Latin America is characterized by the lowest
presence of commodity and securities trading among these regions. The
Argentinian commodity exchange, Rosario Futures Exchange (ROFEX),
Chicago Mercantile Exchange Group (CMEG), Exchange Volume Report
– Monthly, January 2013, available at http://investor.cmegroup.com/investorrelations/releasedetail.cfm?ReleaseID=737570 (last visited 11 December 2013)
19.
9
Trading Volume, FUTURES INDUSTRY, January 2013, at 13.
10
Deutsche Börse AG, Average Daily Volume of 8.7 million Contracts at
EUREX Group in January (1 January 2013), available at http://deutsche-boerse.
com /dbg /dispatch/en /notescontent /dbg_nav/press/10_Latest_Press_Releases/30_
Eurex/INTEGRATE/mr_pressreleases?notesDoc=C1B8B27A2F1715D8C1257B0
5005E0067&newstitle=averagedailyvolumeof8.7million&location=press (last visited 11 December 2013).
11
CEB History is available at http://www.en.kbb.sk/About%20CEB/ (last
visited 11 December 2013).
12
Galen Burghardt & Will Acworth, 2008 A Wild Ride, Global Futures and
Options Volume Rises 13.7%, but Credit Crisis Damages Liquidity in the Core
Markets, FUTURES INDUSTRY, March 2009, at 17.
8
Introduction to Part III
165
was chosen as the reference point for Latin America in this Part instead
of Brazil because it is an example of an agricultural commodity exchange
that emerged from pre-existing market practices. ROFEX trades futures
contracts and options to delivery of agricultural commodities and financial assets. In its fiscal year ending July 2011 its financial derivatives
division traded over 54 million contracts and its agricultural derivatives
division traded contracts related to over 8 million tons of agricultural
products.13 The efforts to establish a commodity exchange in Mexico
date back to the 1994 initiative of the Mexican Stock Exchange and the
central securities depository Indeval. The Mexican Stock Exchange
financed the establishment of the commodity exchange – Mercado
Mexicano de Derivados, S.A. de C.V (MexDer) and Indeval provided
technological and financial support to the clearinghouse Asigna, Compensación y Liquidación (Asigna). In the month of January 2012 over 16 000
trades were executed on MexDer, totaling almost 4 million futures
contracts.14 Currently MexDer does not provide a market for futures
contracts to delivery of agricultural commodities and its trading platform
is restricted to financial assets. This context is important for the upcoming discussion concerning the types of commodity contracts, the structure
of exchanges and clearinghouses, the rights and obligations of parties
involved and the settlement of transactions.
BRIEF EVOLUTION OF COMMODITIES
The following paragraphs highlight the key developments in the history
of trading with commodities from which the present-day structure of
organized commodity markets evolved. Since contemporary systems for
the holding of commodity accounts are in their nature intermediated, the
historical overview begins in the era when the first intermediaries became
involved in transferring commodities. Intermediation was also a crucial
milestone in the development of modern banking and securities holding
systems. While goldsmiths were instrumental in the evolution of the
custody of money and securities, religious temples laid the foundation for
the custody of commodities. To facilitate grain trading, temple granaries
often provided space for warehousing of grain, established quantity and
13
ROFEX, Annual Report and Financial Statements, Fiscal Year 102, 1
(August 2010–July 2011).
14
MexDer, Market Statistics, January 2012 available via http://
www.mexder.com.mx/wb3/wb/MEX/estadisticas (last visited 11 December
2013).
166
The law of securities, commodities and bank accounts
quality standards and provided clearing services.15 They systematically
catalogued stored commodities and even developed a color-coding system that they used to identify individual types of assets.16 The temples
provided an assurance of availability and quality of grain to be delivered
in the settlement of commodity contracts.
The second important time period in the evolution of commodity
contracts was medieval Europe. The fairs of Champagne17 organized in
the twelfth century were probably the first marketplace formally based on
contracts for future delivery.18 Trading at the fairs was ongoing throughout the week with the settlement of accounts and outstanding debts
reserved for the last few days.19 Despite the deferral of settlement, both
promises to pay and to deliver were enforceable from the moment they
were incurred. Furthermore, the emerging medieval code of mercantile
law informally codified the existing practices related to the methods of
sampling, inspecting and grading of commodities.20 Similar to the system
of weights and finesses that facilitated the exchangeability of precious
metals as money, the commodities grading system was one of the key
factors that made commodity contracts easily transferable.21
The recognition of executory promises in the medieval fair practice,
and standardization of commodities grading systems, facilitated trading
in ‘commodity rights’. Soon the promises to deliver and pay incurred
during a particular fair were to be settled at the next fair. This further
deferral of settlement led to the creation of an impersonal market in
15
EDWARD J. SWAN, BUILDING THE GLOBAL MARKET, A 4000 YEAR
HISTORY OF DERIVATIVES 36 (KLUWER LAW INTERNATIONAL, HAGUE, NETHERLANDS, 2000).
16
Richard L. A. Sterba, The Organization and Management of the Temple
Corporations in Ancient Mesopotamia, 1(3) ACADEMY OF MANAGEMENT REV.
16, 18 (1976).
17
For a general description of trading practices used at the Champagne fairs
see R. D. Face, Techniques of Business in the Trade between the Fairs of
Champagne and the South of Europe in the Twelfth and Thirteenth Centuries,
10(3), ECON. HIST. REV. 427–38 (1958).
18
RICHARD J. TEWELES, CHARLES V. HARLOW & HERBERT L. STONE, THE
COMMODITY FUTURES GAME, WHO WINS?, WHO LOSES?, WHY? 6 (MCGRAWHILL, NEW YORK, NY, 1974).
19
Ibid.
20
Ibid., at 7 and JULIUS B. BAER & OLIN GLENN SAXON, COMMODITY
EXCHANGES AND FUTURES TRADING, PRINCIPLES AND OPERATING METHODS 8
(HARPER, NEW YORK, NY, 1949).
21
Randall S. Kroszner, Can the Financial Markets Privately Regulate Risk?
The Development of Derivatives Clearing Houses and Recent Over-the-Counter
Innovations, 31(3) Part 2 JOURNAL OF MONEY, CREDIT AND BANKING 3 (1999).
Introduction to Part III
167
which the promises of parties needed to be formalized in writing. The
medieval fairs spawned a formalized contract that evidenced an obligation to deliver a commodity sometime in the future and that became
known as a lettre de faire.22 The written promise incorporated in a lettre
de faire was first personalized to the original holder, who claimed the
promised goods at the next fair. However, shortly thereafter the holders
of these written promises began transferring them to other buyers in
anticipation of the next fair.23 The original holders were either not able to
attend the next fair or realized they could make a profit if the price of the
goods increased in the interim. The market practice and the speculative
element thus transformed the lettre de faire from a personalized obligation to deliver into a negotiable document of title, a forerunner to the
modern warehouse receipt.
The promise of the buyer to pay incurred during the fairs also
underwent significant changes. A lettre de faire was exchanged for a
formal obligation to pay in the future. Accordingly, the transaction was
concluded by incurring two future obligations, to deliver and to pay. Like
the obligation to deliver, which was reified in writing, the obligation to
pay the purchase price in the future was incorporated into a written form
– the bill of exchange. Some fairs even began to specialize in liquidating
and settling obligations to pay represented by such bills of exchange.
Braudel described the Piacenza as follows ‘No merchandise came to the
fair, and very little cash, but literally masses of bills of exchange, which
in fact represented the entire wealth of Europe, with payments by the
Spanish Empire as the mainstream’.24 Trading in bills of exchange
became institutionalized when the Antwerp Exchange was established in
1531.25
These medieval fairs spawned a new type of transaction with commodities, in which both the obligations to deliver and to pay were to be
performed in the future. Furthermore, both of these executory promises
were formalized in writing and eventually became transferable through
TEWELES, HARLOW & STONE, supra note 18, at 7.
Ibid.
24
FERNAND BRAUDEL, THE WHEELS OF COMMERCE 91 (UNIVERSITY OF
CALIFORNIA PRESS, BERKELEY, CA, 1982).
25
In Antwerp, speculation proliferated and hedgers placed bets on the safe
return of ships, on the possibility of Philip II visiting the Netherlands, or the
purchase of herrings before they had been caught. E.E. Rich & C.H. Wilson, Vol.
V The Economic Organization of Early Modern Europe in THE CAMBRIDGE
ECONOMIC HISTORY OF EUROPE 330–1 (CAMBRIDGE UNIVERSITY PRESS, CAMBRIDGE, UK, 1977).
22
23
168
The law of securities, commodities and bank accounts
market practice. Written promises were still closely related to the
underlying commodity and eventually performed by its delivery. Only
later, with the establishment of centralized commodity exchanges, did
these written promises become divorced from commodities and cease to
be performed by actual delivery. Some authors observed that ‘the stock
and commodity exchanges of the United States … are the direct or
indirect outgrowth of these medieval fairs’.26
Gradually, individualized promises were being transformed into fungible contracts. The transferability of rights to commodities and their
divorce from the individualized characteristics were facilitated by two
important factors: 1) reification of rights in written documents and 2)
standardization/grading of commodities. An efficient commodities market
requires that promises, both to pay and to deliver, be fungible, standardized and easily transferable. In medieval times goods were custom-made
and manufactured on the basis of pre-existing orders. With the advent of
modern manufacturing processes and improvements in growing techniques, standardized products and equal-quality crops began to be
produced and grown. The standardized manufacturing procedures and
grading of agricultural products facilitated the emergence of transferable
promises to deliver. Enforceability and transferability of rights to future
delivery of commodities, whether individualized or stored in bulk,
became recognized in the European markets in the sixteenth century.27
Having recognized the enforceability of contract promises for future
delivery and having taken advantage of the proven viability of the
standardized grading system for commodities, England created one of the
first modern commodity exchanges when Thomas Gresham established
the Royal Exchange in Lombard Street.28
The next milestone in the evolution of commodity markets was the
trading of tulips at the beginning of the seventeenth century in the
Netherlands. The Dutch tulipomania introduced an important element to
commodities trading when it opened access to the general public.29
Professionals as early as the 1550s had traded in Baltic grain and North
BAER & SAXON, supra note 20, at 9.
SWAN, supra note 15, at 144.
28
TEWELES, HARLOW & STONE, supra note 18, at 7. The Royal Exchange
was modeled after the Antwerp Exchange. See Rich & Wilson, supra note 25, at
348.
29
MIKE DASH, TULIPOMANIA, THE STORY OF THE WORLD’S MOST COVETED
FLOWER & THE EXTRAORDINARY PASSIONS IT AROUSED 116 (GOLLANCZ, LONDON, UK, 1999).
26
27
Introduction to Part III
169
Sea herring for future delivery but these markets had remained inaccessible to the common people.30 The primary driving force behind the
staggering expansion of tulip trading was the widespread acceptance of
credit sales. Buyers acquired rights to growing tulips by tendering written
promises of payment, known as payment notes, which obligated them to
pay the purchase price on delivery. In exchange, sellers issued delivery
notes to the buyers committing to deliver the flowers sometime in the
future. Flowers were thus no longer sold only when they were in
the possession of sellers and were being sold when they were still in the
ground.31 Trading in and settlement by delivery of actual commodities
morphed into the trading in and settlement by delivery of promises – a
promise to deliver was exchanged against a promise to pay. The tulip
payment and delivery notes are similar to those traded and transferred at
the medieval fairs but with one noticeable difference. The holders of the
‘tulip promises’ were speculators from the general public, while the
holders of the ‘fair promises’ were merchants who entered into these
contracts for legitimate commercial purposes.
The first centralized exchanges of the kind that still exist today for
trading in rights to future delivery of commodities were established in the
mid-nineteenth century in the United States.32 Organized commodity
markets will be explained in the rest of this Part as those in which futures
commodity contracts and commodity options are traded and held by
investors in commodity accounts with intermediaries. The nineteenth
century exchanges were not organized with the purpose of acquiring/
transferring rights to commodities in the form of futures contracts. The
primary purpose for the establishment of the CBOT in 1848 was to
provide a general meeting place for merchants where they could discuss
and resolve commercial issues.33 On the other side of the Atlantic, the
London and Liverpool commodity markets also originated as informal
30
JAN DE VRIES & AD VAN DER WOUDE, THE FIRST MODERN ECONOMY,
SUCCESS, FAILURE, AND PERSEVERANCE OF THE DUTCH ECONOMY 1500–1815
150 (CAMBRIDGE UNIVERSITY PRESS, CAMBRIDGE, UK, 1997).
31
DASH, supra note 29, at 114.
32
The first evidence of organized trading dates before the Civil War when
Chicago became the center for trading in commodities. GEORGE WRIGHT
HOFFMAN, FUTURE TRADING UPON ORGANIZED COMMODITY MARKETS IN THE
UNITED STATES 9 (UNIVERSITY OF PENNSYLVANIA PRESS, PHILADELPHIA, PA,
1932).
33
JONATHAN LURIE, THE CHICAGO BOARD OF TRADE 1859–1905 25 (UNIVERSITY OF ILLINOIS PRESS, CHAMPAIGN, IL, 1979). Similarly, the corporate
charter of the New York Cotton Exchange authorized it to provide a suitable
space for trading to its members. Kenneth J. Lipartito, The New York Cotton
170
The law of securities, commodities and bank accounts
gatherings of merchants.34 These nineteenth century commodity
exchanges functioned as modern-day medieval fairs. Their utility was
limited in that they provided a mere forum where transactions in
commodities were concluded and settled. Only later, at the beginning of
the twentieth century in the United States and in the late nineteenth
century in Europe, did organized commodities exchange models supported with multilateral settlement of contracts structured around a
central clearinghouse emerge.35 This became possible by the introduction
of common grading standards. These standards added an important layer
of predictability and certainty, thus elevating commodity contracts to the
category of highly liquid and marketable financial instruments.36
Initially the nineteenth century futures contracts were based (written)
exclusively on agricultural commodities.37 The first standardized futures
contract for delivery of grain was traded on the CBOT in 1865.38 In
contrast to the market price stabilizing function of the first agricultural
futures contracts traded in Chicago, many European countries viewed
futures commodity contracts negatively at that time. In 1896 Germany
entirely outlawed all futures trading in grains39 and the French parliament
unsuccessfully attempted to replicate the German prohibition in 1898.40
Exchange and the Development of the Cotton Futures Market, 57(1) BUS. HIST.
REV. 50, 54 (1983).
34
See Ross Cranston, Law Through Practice: London and Liverpool
Commodity Markets c. 1820–1975, LSE Law, Society and Economy Working
Papers 14/2007, at 3.
35
Robert Bliss & Chryssa Papathanassiou, Derivatives Clearing, Central
Counterparties and Novation: The Economic Implications 11 (8 March 2006),
available at http://www.ecb.int/events/pdf/conferences/ccp/BlissPapathanassiou_
final.pdf (last visited 11 December 2013).
36
LURIE, supra note 33, at 26.
37
European Central Bank, Daniela Russo, Terry L. Hart & Andreas
Schonenberger, The Evolution of Clearing and Central Counterparty Services for
Exchange-Traded Derivatives in the United States and Europe: A Comparison,
Occasional Paper Series No. 5, 10 (2002).
38
PETER G. ZHANG, BARINGS INSOLVENCY AND FINANCIAL DERIVATIVES 31
(WORLD SCIENTIFIC PUBLISHING CO. PTE. LTD., SINGAPORE, 1995).
39
Paragraph 65 of the Law provided that dealing in futures on exchanges in
grain and mill products is forbidden. Hans Hirchstein, Commodity Exchanges in
Germany, in ANNALS OF THE AMERICAN ACADEMY OF POLITICAL AND SOCIAL
SCIENCE, VOL. 155, PART 1: ORGANIZED COMMODITY MARKETS 208, 210
(AMERICAN ACADEMY OF POLITICAL AND SOCIAL SCIENCE, PHILADELPHIA, PA,
1931).
40
Arthur G. Peterson, Futures Trading with Particular Reference to Agricultural Commodities, 7(68) AGRIC. HIST. 68, 76 (1933).
Introduction to Part III
171
Commodity exchanges that emerged at the turn of the twentieth
century were largely developed from the bottom-up. In other words the
incentive for their creation came from the private sector and associations
of merchants that had already standardized their mutual dealings in the
spot market. These uniform practices, whether regarding the grading of
commodities or standardized contractual terms for delivery, became the
template and building blocks for the organized trading in rights to
commodities. Since their inception many commodity markets that transplanted existing practices from the spot market became commanding
players in their relevant economies. An ECB study confirmed that
‘establishment of futures exchanges requires familiarity of the designers
with the organization of the underlying spot market, payment terms and
arrangements for delivery of the physical commodity or financial instrument’.41
Intermediaries that traded on commodity exchanges and maintained
records of executed contracts for their customers came to play an
increasingly important role. These intermediaries established accounts to
which the commodity contracts of their customers were credited and
debited. In addition, they greatly facilitated the actual settlement of
commodity contracts by their offset or exchange of warehouse receipts
for payment, as will be examined below. Similar to securities intermediaries, commodity intermediaries operate in the front-end, where they
facilitate trading and the execution of orders, as well as in the back-end,
where they maintain commodity accounts and effectuate the settlement of
contracts.
DEMATERIALIZATION AND IMMOBILIZATION OF
COMMODITIES
The preceding section traced the transformation from trading and settlement by the exchange of a physical commodity for cash, to the exchange
of promises to deliver and pay in the future that are evidenced in writing.
Eventually these promises to deliver and pay became fungible and
subject to trading at commodity exchanges that currently operate largely
as impersonal electronic trading venues. This dematerialization of trading
processes is similar to the dematerialization of securities trading and the
settlement of transactions in both securities and commodity contracts is
accomplished electronically. However, there is a significant difference in
41
ECB, Russo, Hart & Schonenberger, supra note 37, at 9.
172
The law of securities, commodities and bank accounts
terms of the dematerializing of the underlying asset, whether it be
securities and money on the one hand or commodities on the other. In the
context of commodities, the dematerialization process is not the same as
for securities and money because physical commodities, such as grain or
corn, did not suddenly become electronic. In contrast, banknotes and
security certificates have been largely replaced with electronic entries to
accounts maintained by intermediaries. In commodity markets actual
commodities still exist in their physical form and it is the rights to their
delivery and obligations to pay that have been dematerialized. Entries to
accounts in all three holding systems represent claims against intermediaries. However, the nature of these claims differs, as will be
explained with respect to commodity accounts below.
Commodities have also been immobilized but in a form different from
the central deposit of securities. Contracts that are traded at commodity
markets are supported by actual commodities that are stored in authorized warehouses. There is a connection between entries in commodity
accounts and stored commodities similar to the connection between
entries in securities accounts and the immobilized security held by the
CSD. However, this connection is only seemingly similar because
commodity account holders do not acquire any property interest until
they exercise their rights under commodity contracts, while securities
account holders acquire a property interest in the security when their
account is credited. The second difference is in the volume of claims that
are credited to accounts maintained by securities and commodity intermediaries, respectively. While in general the number of securities credited to accounts of investors should not exceed the number of securities
represented by the security immobilized with the CSD, the number of
contracts credited to commodity accounts typically far exceeds the
volume of commodities stored in warehouses and ready for delivery in
settlement of commodity transactions.
THE TYPOLOGY OF THE SYSTEMS FOR THE
HOLDING OF COMMODITY CONTRACTS
This section identifies the assets that underlie commodity contracts and
options. It then classifies the commodity accounts holding systems into
types depending on the asset covered by the commodity contracts held in
accounts with intermediaries. The following paragraphs classify various
commodities and assets into three main categories: 1) agricultural products, 2) metals and 3) financial assets. Commodity markets may specialize in commodity contracts written on one of these types of assets or may
Introduction to Part III
173
offer a combination of all three. Some commodity exchanges specialize
in agricultural commodity contracts (e.g., the Minneapolis Grain
Exchange), others in contracts to future delivery of metals (e.g., the
London Metal Exchange) and some in contracts written on financial
assets (e.g., the Mexican Derivatives Exchange).
Commodity laws and regulations issued by commodity exchanges
typically define the term ‘commodity’, setting forth the types of assets on
which commodity contracts can be written and traded. In Slovakia the
Law on Commodity Exchange in Article 2 defines commodity as ‘a
tangible object or natural force, including a product, energy and metals,
with the exception of gold …’. Article 2(4) of the Charter of the
Bratislava Commodity Exchange provides a list of which commodities
rights to delivery may be traded. This list includes: metals, fuels,
chemical products, electrical energy, emissions, exchange rates and
dozens of agricultural products.
Whether or not the commodity exchange specializes in contracts
written on one or more types of asset will have a significant impact on
the back-end settlement procedures. On the one hand the vast majority of
commodity contracts written on all types of assets are settled by offset.
However, for those that are settled by actual delivery, commodity markets
must have appropriate mechanisms in place that allow commodity
accounts holders to take possession of and pay the purchase price for the
relevant commodity. Accordingly, on the front-end, commodity markets
may be structured similarly and operate electronic trading platforms
while on the back-end the accounts holding systems may have to be
supplemented with the appropriate settlement mechanism to complete the
actual delivery of assets.
Historically the first commodity markets of the nineteenth century
dealt in agricultural contracts. Shortly thereafter the first organized
markets for metal contracts emerged.42 While contracts written on
agricultural commodities and metals have been traded, held in accounts
with intermediaries and settled for well over a century, contracts on
financial assets emerged only later in the 1970s. In 1986 the Nobel Prize
winner Merton Miller singled out financial futures as the most significant
financial innovation of the previous 20 years.43 Since then, financial
intangible assets have become the driving force of contemporary
commodity markets.
42
The London Metal Exchange was established in 1877, see http://
www.lme.co.uk/who.asp (last visited 11 December 2013).
43
Merton H. Miller, Financial Innovation: The Last Twenty Years and the
Next, 21(4) JOURNAL OF FINANCIAL & QUANTITATIVE ANALYSIS 459, 463 (1986).
174
The law of securities, commodities and bank accounts
The common feature of all of these commodity markets is price
fluctuations in the underlying assets that expose all involved parties to a
risk. For instance, agricultural producers face uncertainty regarding
payment for their crops that may result in substantial losses if prices
sharply fall before the sale. The farmer may eliminate this market risk by
transferring it outright under a contract or by acquiring an option to
transfer it in the future.44 Hedging through commodity contracts allows
the risk of price fluctuations to be transferred to whoever is willing and
financially capable of bearing such a risk.45 Commodity markets with
their supporting accounts holding systems were established to provide
protection against such risks and potential losses. Commercial risks of
this nature existed already in pre-commercial society. Emery noted that:
The primitive man who started on a hunt, or who planted corn, necessarily
took a risk of failure. The game might be scarce, or the crop might fail. These
were risks of production, and were borne necessarily by the producer. But as
soon as our primitive man began to kill more game or raise more corn than
was needed for individual use, in the hope of bartering his surplus for more
desired commodities, he began to incur a risk of quite another kind. However
successful his production, it would profit him nothing unless he found others
who wanted his commodities and had other commodities to exchange, that is,
unless there was a demand for his goods.46
Commodity markets and accounts holding systems equip the involved
with a mechanism to insure against the risk that they might not sell their
crops, metals or shares at all or sell them below the incurred costs. Risk
insurance is the primary function of commodity markets.47 All commodity contracts held in accounts with intermediaries, whether written on
agricultural commodities, metals or financial assets, embed this risk
element. A US Circuit court noted that:
44
Scott P. Mason, The Allocation of Risk, in THE GLOBAL FINANCIAL
SYSTEM, A FUNCTIONAL PERSPECTIVE 162 (Dwight B. Crane, Robert C. Merton,
Kenneth A. Froot, Zvi Bodie, Scott P. Mason, Erik R. Sirri, André F. Perold and
Peter Tufano eds., HARVARD BUSINESS SCHOOL PRESS, BOSTON, MA, 1995).
45
‘… immediate beneficiaries of healthy futures markets are the producers
and processors of commodities who can minimize the risk of loss from wide
fluctuations in cash market prices by hedging on the futures markets …’ NRT
Metals, Inc. v. Manhattan Metals, 576 F.Supp. 1046, 1050 (S.D.N.Y. 1983).
46
HENRY C. EMERY, SPECULATION ON THE STOCK AND PRODUCE
EXCHANGES OF THE UNITED STATES 103 (AMS PRESS, NEW YORK, NY, 1896).
47
MERTON H. MILLER, MERTON MILLER ON DERIVATIVES 79 (JOHN WILEY
& SONS, INC., US, 1997).
Introduction to Part III
175
hedging is a manufacturer’s or merchant’s insurance against price fluctuation
of materials, and no more demnatory than insurances of property and life,
which in one sense are wagers that the property will not be destroyed during
the term, and that the life will not fail in less than the expectancy in the
actuaries’ tables.48
The market for this type of insurance is the commodity market that
effectively permits the transfer of certain risks to those who are willing to
bear them.49 Merton Miller argued that derivatives markets, such as
futures markets, are selling insurance that protect against risks.50 This
insurance is sold at commodity markets and held in accounts with
intermediaries. The inherent function and objective of commodity markets may be best summarized by quoting Rule 1002 of the MexDer
Internal Regulations:
The futures contracts market is established in order to contribute to the
strength of the Mexican financial system, to make its participants more
competitive by offering contracts that facilitate risk management and control
and that diversify positions and investment strategies.
COMMODITY MARKETS FOR AGRICULTURAL
PRODUCTS
Agricultural commodities must possess certain characteristics and features before they may become subject to commodity contracts. The
following paragraphs identify these features. The first requirement is the
uncontrolled output of the product and its unrestricted demand and
supply. Supply controls are considered to be one of the main obstacles to
the establishment of agricultural commodity markets.51 Many developing
countries impose artificial controls on outputs of some products that they
deem of public interest. Such measures then prevent or significantly
inhibit the establishment of commodity markets for those products.
Second, the price of every agricultural product must fluctuate in
response to supply and demand. Volatility in the market price of
commodities creates an interest in hedging the risk of price fluctuations.
Board of Trade v. L. A. Kinsey Co., 130 F. 507, 512 (7th Cir. 1904).
BAER & SAXON, supra note 20, at 15.
50
MILLER ON DERIVATIVES, supra note 47, at 82.
51
Sidney Hoos, Futures Trading in Perishable Agricultural Commodities,
6(4) Part 1, JOURNAL OF MARKETING 358, 363 (1942) and BAER & SAXON, supra
note 20, at 12.
48
49
176
The law of securities, commodities and bank accounts
Production of agricultural commodities faces the perpetual risk of price
fluctuations that may be managed through two fundamental mechanisms:
1) hedging/speculation or 2) government price-fixing.52 The more the
volatility in price increases, the higher the demand for the transfer of risk
becomes.
Third, an active and un-manipulated trading of agricultural products in
the spot market with predictable patterns of supply and demand is a
necessity.53 Melamed observed that ‘Successful futures contracts need, at
a minimum, 20 to 25 percent commercial participation. You cannot make
a market just for speculators.’54 If there is no connection to the
underlying spot market and only speculators enter into commodity
contracts for future delivery, such a market does not fulfill its ultimate
goal to manage the market risk. In commodity markets without participation of any commercial interest, what is held in commodity accounts is
not a market risk but a risk of a speculative nature.
The fourth requirement is that the units of the commodity be interchangeable or, fungible. Fungibility is necessary because speculators buy
on the basis of established grades and descriptions without examining
samples of the commodity.55 The success and increase in liquidity of
commodity contracts significantly depends on the adoption of uniform
grading procedures,56 which eliminate the need for subjective judgments
about the quality of the commodity.57
52
BOB TAMARKIN, THE NEW GATSBYS, FORTUNES AND MISFORTUNES OF
COMMODITY TRADERS 86 (WILLIAM MORROW AND COMPANY, NEW YORK, NY,
1985).
53
Andrea M. Corcoran, Ronald B. Hobson, Gregory J. Kuserk, Karen K.
Wuertz & Derek West, Designing a Derivatives Complement to Cash Markets in
Developing Countries, in FOCUS ON CAPITAL, NEW APPROACHES TO DEVELOPING
LATIN AMERICAN CAPITAL MARKETS 345–7 (Inter-American Development Bank,
2003).
54
LEO MELAMED, ESCAPE TO THE FUTURES 174 (JOHN WILEY & SONS,
INC., US, 1996).
55
BAER & SAXON, supra note 20, at 110.
56
Ben S. Bernanke, Clearing and Settlement during the Crash, National
Bureau of Economic Research Conference: Stock Market Volatility and the
Crash, Dorado Beach (16–18 March 1989) in 3(1) REV. FIN. STUD., 1990, at 133
& 141.
57
Judgments of quality became standardized. Abbott Payson Usher, The
Technique of Medieval and Modern Produce Markets, 23(4) J. POL. ECON. 365,
370 (1915).
Introduction to Part III
177
Fifth, the commodity must be divisible into multiple standard grades.58
Grades and qualities of commodities are documented by authorized and
licensed warehouse operators that issue warehouse receipts and certificates of quality. All agricultural commodities that may be potentially
delivered in settlement of commodity contracts must typically carry an
exchange certificate.59 Exchanges license warehouses that store inspected
commodities ready for delivery under executed contracts.60 Licensed
warehouses that issue warehouse receipts representing rights to delivery
of various commodities are the guarantors of quality.61
Sixth, the commodity must be durable and storable.62 Originally,
commodity markets developed to provide a hedge for producers of
storable commodities produced seasonally.63 Although many agricultural
commodities are durable some, such as cattle, eggs or butter lack this
feature. Yet, at some point in history even rights to delivery of perishable
commodities were traded on commodity exchanges and held in accounts
with intermediaries. For instance, at the end of the nineteenth century a
futures market for eggs developed64 and later in the early 1960s, a futures
market in live beef-cattle briefly functioned.65
Seventh, the system for establishing commercial grades must be free of
a subjective human factor.66 Commodity markets, particularly for beverages and foods do not exist. National tastes significantly differ and such
commodity markets could function only to a limited extent on a domestic
level. Finally, uniformity in the production and growing processes is
required.67 Wide disparities in the quality and production to this day
prevent the establishment of commodity markets in a number of
BAER & SAXON, supra note 20, at 112.
Chicago Mercantile Exchange, Rulebook, § 707, available at http://
www.cmegroup.com/rulebook/CME/I/7/7.pdf (last visited 11 December 2013)
[hereinafter CME Rulebook]. The Exchange Certificate must also bear the
signature of the president of the clearinghouse and must indicate the grade of the
commodity as well as the expiration date of the certificate.
60
Typical requirements for a warehouse to be approved by a futures
exchange are listed in the CME Rulebook § 703.A.
61
BAER & SAXON, supra note 20, at 87.
62
Ibid., at 118.
63
T. A. Hieronymus, Futures Trading in Hogs, 6(2) ILL. AGRIC. ECON. 1
(1966).
64
Ibid., at 2.
65
J. Marvin Skadberg & Gene A. Futrell, An Economic Appraisal of
Futures Trading in Livestock, 48(5) J. FARM ECON. 1485 (1966).
66
BAER & SAXON, supra note 20, at 119.
67
Ibid., at 120.
58
59
178
The law of securities, commodities and bank accounts
commodities. These eight features are critical for agricultural commodities to become a subject of contracts traded on commodity exchanges
and held in accounts with intermediaries.
COMMODITY MARKETS FOR METALS
Commodity markets in metals, first established in the second half of the
nineteenth century, began to flourish with the onset of the industrial
revolution. At that time many metals were imported to Europe from
different parts of the world but mainly Latin America. Effective trading
depended on telecommunication technologies since traders needed to
know when the ships would arrive at the shores of England. This was not
an issue for the agricultural commodity markets in the United States that
traded rights to commodities produced locally. Trading on metal
commodity exchanges was facilitated by the invention of the telegraph
that allowed traders to obtain information on the sailing of ships and their
estimated arrival.68 Since then trading volumes have grown.
The first metals subject to commodity contracts were copper and tin.
Presently many metals are traded on commodity markets and the
resulting contracts are held in accounts with intermediaries. The New
York Mercantile Exchange, a member of the CME Group, is the venue
for the trading of crude oil, gasoline, heating oil, natural gas, electricity,
propane, coal, uranium, environmental commodities, gold, silver, copper,
aluminum, platinum and palladium. Similarly to agricultural commodities, differences in production processes have prevented the establishment of commodity markets in many metals, such as iron ore. The
variability of ore in the levels of impurities and moisture makes it less
fungible, which makes establishing benchmark prices more complicated.69 Like agricultural commodity markets, operators of commodity
exchanges license warehouses that store metals ready for delivery under
commodity contracts.
68
London Metal Exchange, History, available at http://www.lme.co.uk/
who_ourhistory.asp (last visited 11 December 2013).
69
Liam Denning, At the Dawning of a New Iron Age, THE WALL STREET
JOURNAL C6 (9 March 2009).
Introduction to Part III
179
COMMODITY MARKETS FOR FINANCIAL
INSTRUMENTS
Commodity contracts may also be written on financial assets, including
currencies, securities or stock indexes. Unlike in the case of agricultural
products, a uniform grading and standardization system did not need to
be developed for intangible financial assets because securities and
currencies are, by their nature, issued and circulate in a standardized and
homogenous form. A major obstacle to the emergence of commodity
markets in intangibles had been artificial price controls. One of these
price-control measures was the fixed exchange rates system established
pursuant to the 1944 Bretton Woods Agreement. As a result of this
artificial fixing of exchange rates, commercial entities did not have
sufficient incentives to hedge their currency risks.
This all changed in 1972 when the United States abandoned the fixed
exchange rates system and the currencies were permitted to fluctuate
(float). In 1972, the CME obtained an authorization to offer the first
currency futures contract.70 As a reaction, in 1974 the US Congress
expanded the definition of commodity in the Commodities Exchange Act
to include currencies.71 Accordingly, currency became a commodity
covered by the legislation regulating commodity contracts.72 Commodity
contracts for future delivery of securities, such as stocks, bonds and stock
indices, were introduced shortly thereafter.73
Commodity exchanges that trade in financial instruments must also
take into account the possibility that an investor decides to take delivery
of the underlying asset, such as shares. Accordingly, their infrastructure
must include appropriate delivery mechanisms. Nevertheless, settlement
by offsetting financial commodity contracts has established itself as the
70
Kip Schlegel, Crime in the Pits: The Regulation of Futures Trading, in
ANNALS OF THE AMERICAN ACADEMY OF POLITICAL AND SOCIAL SCIENCE, VOL.
525, WHITE-COLLAR CRIME 59, 61 (AMERICAN ACADEMY OF POLITICAL AND
SOCIAL SCIENCE, PHILADELPHIA, PA, 1993).
71
CFTC v. Standard Forex, Inc., 1993 WL 809966 *8 (1993).
72
See CFTC v. Int’l Foreign Currency, 334 F.Supp.2d 305, 312 (E.D.N.Y.
2004).
73
The Chicago Mercantile Exchange introduced the futures contract on
S&P 500 in 1982. Tamarkin had the following to say about stock index futures:
‘It is like trading a fantasy because unlike a carload of wheat or $100 000 of
treasury bonds, stock index futures can’t be delivered. Speculators buy and sell
contracts for the imaginary delivery of an imaginary portfolio of stocks at a fixed
date’. TAMARKIN, supra note 52, at 89.
180
The law of securities, commodities and bank accounts
norm. This type of settlement, rather than actual delivery, eliminated the
risks and costs associated with clearing and transferring a large number
of securities underlying commodity contracts.74
TYPES OF COMMODITY CONTRACTS
This section identifies and examines various types of commodity contracts. Like funds and securities that are held in bank and securities
accounts maintained by intermediaries, only certain commodity contracts
are held in commodity accounts with intermediaries. It will be recalled
that security certificates and banknotes are outside the securities and
bank accounts holding systems. Similarly, certain types of rights to
commodities and related contracts are excluded from the commodity
accounts holding system.
Commodity contracts may be classified into two categories: 1) contracts that are traded on officially organized commodity markets (e.g.,
futures exchanges); and 2) contracts entered into outside official
exchanges, in the OTC markets. Both of these types of contracts are held
in commodity accounts but of a different nature and type. Exchangetraded futures contracts are held in one type of account, which is separate
from an account established for investors that trade OTC derivatives such
as swaps. The requirement to maintain separate commodity accounts for
different types of contracts is necessitated by the different risk profile
embedded in the contracts.75 This section is concerned primarily with the
exchange-traded commodity contracts.
The typical examples of exchange-traded commodity contracts are
futures and options.76 Futures are executory contracts of a fungible nature
that provide for deferred delivery of a commodity of the fixed grade,
quantity and price.77 Paragraph 1.2.5 of the Rulebook of the Argentina
André F. Perold, The Payment System and Derivative Instruments, in THE
GLOBAL FINANCIAL SYSTEM, A FUNCTIONAL PERSPECTIVE 63 (Dwight B. Crane,
Robert C. Merton, Kenneth A. Froot, Zvi Bodie, Scott P. Mason, Erik R. Sirri,
André F. Perold and Peter Tufano eds., HARVARD BUSINESS SCHOOL PRESS,
BOSTON, MA, 1995).
75
Futures Industry Association, Protection of Customer Funds, Frequently
Asked Question, Version 2.0, 2 (June 2012).
76
Recently OTC swaps have been converted into exchange-traded futures.
See Will Acworth, Futurization: Market Participants Clash, 23(2) FUTURES
INDUS. 36, 37 (2013).
77
Salomon Forex, Inc. v. Tauber, 8 F.3d 966, 970–1 (4th Cir. 1993).
74
Introduction to Part III
181
Clearing S.A. defines a futures contract as ‘the instrument with standardized terms and conditions that is traded on a futures exchange and
approved as part of the rules of the Clearinghouse’.78 The fungible nature
of futures contracts reduces transactional costs because the terms of the
contract need not be negotiated by the parties. Just like an investor that
buys a share of GE does not negotiate any terms of the security neither
does a purchaser of a futures contract.
Futures markets operate similarly to financial markets. Futures markets
neither ensure delivery of commodities nor provide a forum in which
transactions may be consummated by transferring actual lots of commodities. The primary function of futures markets is to provide insurance
against market and credit risks.79 Futures contracts are regulated in
special commodity laws that also govern the functioning of futures
exchanges. For a commodity contract to be governed by a commodity
law it must be of the nature of a futures contract that is traded on a
futures market. OTC commodity contracts, such as forwards and hedgeto-arrive agreements, are typically regulated by general contract law.
Like futures contracts, options are risk management tools that allow
commercial entities effectively to reduce, eliminate and otherwise manage risks. An option conveys a contractual right to buy or sell a
commodity at/by some fixed date and at the pre-determined (striking)
price.80 Options began to be traded on official exchanges more than a
century later than the first futures contracts, when the first options
exchange – the Chicago Board Options Exchange (CBOE) – was
established in 1973.81 Options traded on official exchanges are subject to
special commodity laws that also govern futures contracts. The structure
of options exchanges is similar to the structure of futures markets, with a
Similarly, MexDer, Internal Regulations § 1001 (January 21, 2013), available at http://www.mexder.com.mx/wb3/wb/MEX/MEX_Repositorio/_vtp/MEX/
1ea7_reglamento_interior_mexder/_rid/21/_mto/3/MexDer_Internal_Regulations_
Jan_21_2013.pdf (last visited 11 December 2013), defines futures contract as ‘a
standardized legal agreement specifying the term, amount, quantity and quality, among
other features, to buy or sell an underlying asset at a certain price, to be settled at a
future date’. See also German Banking Act § 1(11)(1).
79
BAER & SAXON, supra note 20, at 138.
80
British American Commodity Options Corp. v. National Association of
Commodity Options Dealers, 552 F.2d 482, 484 (2d Cir. 1977) and Commodity
Futures Trading Commission v. The American Board of Trade, 473 F.Supp. 1177,
1183 (S.D.N.Y. 1979).
81
For the history of CBOE see About CBOE, available at http://
www.cboe.com/AboutCBOE/History.aspx (last visited 11 December 2013).
78
182
The law of securities, commodities and bank accounts
clearinghouse at the top and clearing members and other intermediaries
that maintain commodity accounts for individual investors at the lower
levels.
An option involves a unilateral promise which binds the option holder
to do nothing.82 In other words an option holder is not required to do
anything and may let his right to exercise the option simply expire.83 The
fundamental differences between futures contracts and options may be
summarized as follows:
1)
2)
3)
the premium for an option (a contango fee) is nonrefundable and
covers commission and costs; in contrast a futures contract requires
margin that varies according to the value of the contract;
the option conveys only rights but no obligations whereas a futures
contract conveys both rights and obligations; and
an option holder profits if the price of the underlying commodity
exceeds the fee, while the futures contract holder profits if the price
of the futures contract exceeds the purchase price on the spot
market.84
Options are issued, traded and held in two fundamental types: 1) a call
option that conveys the right to buy the underlying asset at a fixed price
and at or within a pre-determined time; and 2) a put option that conveys
the right to sell the underlying asset at a fixed price within or at a
pre-determined time. In terms of the timing of settlement, there are two
types of options: 1) ‘American options’ that may be exercised any time
before their expiration and 2) ‘European options’ that may be exercised
exclusively on their expiry date. Rule 110 of the MexDer clearinghouse
Asigna Internal Regulations defines American Style Option as ‘an option
contract that gives the buyer the right to exercise the put or call option at
any time within regular Exchange trading hours, before the expiration of
the contract’. The European Style Option is defined as ‘an option
82
Commodities Futures Trading Commission (CFTC), Characteristics Distinguishing Cash and Forward Contracts and ‘Trade’ Options, 50 FR 39656,
39658 (30 September 1985).
83
Rulebook of Argentina Clearing S.A. (ed. no. 7, 9 July 2010), available at
http://www.argentinaclearing.com.ar/English/legal_members/files.aspx (last visited 11 December 2013), § 1.2.8 defines an option as ‘a standardized contract in
which the buyer, upon payment of a premium, obtains the right but not the
obligation to buy or sell an underlying asset’.
84
Commodity Futures Trading Commission v. U.S. Metals Depository Co.,
468 F.Supp. 1149, 1155 (S.D.N.Y. 1979).
Introduction to Part III
183
contract that allows the buyer to exercise the put or call option only on
the expiration date’.
The following paragraphs identify the types of commodity contracts
that are concluded in OTC markets. OTC contracts are privately negotiated and generally excluded from commodity laws. These contracts are
not held in commodity accounts with exchange-traded futures and
options. A forward contract is probably the most common type of OTC
contract for future delivery, whereby two parties agree to sell and buy a
certain quantity of commodities at a fixed price. A forward contract
creates an obligation for the buyer to take delivery of the specific grade
of a commodity and to pay the purchase price.85 Correspondingly, the
seller undertakes to sell and deliver such commodity at a fixed price
regardless of the fluctuations in the commodity’s market price. Accordingly, for both parties the quality of the commodity, its purchase price
and the place and time of delivery are of significance. Obligations of the
parties are negotiated and not pre-established in a standardized agreement. Forward contracts are regularly used to acquire the underlying
commodity and in parallel to hedge against price risks.86 This is not the
case of futures and options that are not traded with the intent to
make/take delivery of commodities. The forward market is primarily used
by producers of commodities that require the ingredients or components
for their own business operations and manufacturing processes.
Commodity laws have traditionally exempted certain transactions for
immediate and future delivery from their scope. First, spot transactions in
which delivery is executed instantaneously are excluded because they
lack a ‘future element’. These types of sales are executed contracts that
do not provide the same opportunities for speculation and manipulation
because the risk of price fluctuations is effectively eliminated by immediate performance.87 The second notable exemption from commodity
laws applies to forward contracts. Even though forwards defer performance of the obligations, their exemption from commodity laws is justified
because ‘they allow farmers to sell part of the next season’s harvest at a
set price to a grain elevator or millers’.88 In other words, both ‘forward
promises’ are undertaken by commercial entities in the regular course of
their business with the intent to be settled by delivery of the actual
The forward buyer may pay the purchase price on delivery or pre-pay for
the commodity, in which case it finances the production of the commodity.
86
CFTC, Statutory Interpretation Concerning Forward Transactions, 55
Fed. Reg. 39,188 (25 September 1990).
87
Salomon Forex, Inc. v. Tauber, 8 F.3d 966, 970–1 (4th Cir. 1993).
88
See H.R.Rep. No. 345, 67th Cong. 1st Session 7 (1921).
85
184
The law of securities, commodities and bank accounts
commodity against payment. Commodity laws deal primarily with executory promises that are typically closed out by offset, while sales laws deal
with promises that the parties perform by actual delivery. The promise of
actual delivery of the commodity exempts forward contracts from
commodity laws.89
In practice it is frequently difficult to determine whether the particular
agreement is a forward or futures contract judging solely from the
contractual terms.90 Proper classification of these two types of commodity contracts requires factual inquiry and evaluation of various aspects of
the individual relationship. Courts and regulators in their classification of
contracts, as either forwards or futures, consider the following: whether
both parties are commercial entities; whether there was any negotiation
concerning the mechanics of the transaction; whether the parties agreed
on the precise quality of the commodity involved, a particular delivery
point, or a fixed delivery date; whether their ability to make/take delivery
was sufficiently demonstrated; and whether their established practice is
indeed to make/take delivery under such contracts.91 Negotiations are not
characteristic for futures contracts that are standardized, interchangeable
and traded on organized exchanges.92
Courts and legislators may distinguish futures and forward contracts on
the basis of the following criteria. First, forwards are individualized
tailor-made contracts that reflect the requirements of the contracting
parties. Second, since delivery of the actual commodity plays an important role in the forward contracts market, typically only merchants enter
into such contracts.93 Third, forwards typically set forth a specific
delivery obligation. If the understanding between the parties is in terms
of contracts rather than in terms of specific quantities and one of the
parties is required to post a margin such contract has a strong indicium of
a futures contract.94 Fourth, under a forward contract that contemplates
delivery, only the commodity of the specific grade agreed on may be
delivered to the buyer. In contrast, under a futures contract the seller may
Grain Land Coop v. Kar Kim Farms, 199 F.3d 983, 990 (1999).
Nagel v. ADM Investor Servs., 217 F.3d 436, 440 (7th Cir. 2000).
91
CFTC, Characteristics Distinguishing Cash and Forward Contracts and
‘Trade’ Options, 50 Fed. Reg. 39656, 39658 (30 September 1985). See also NRT
Metals, Inc. v. Manhattan Metals, 576 F.Supp. 1046, 1051 (S.D.N.Y. 1983).
92
REFCO PRIVATE CLIENT GROUP, THE COMPLETE GUIDE TO FUTURES
TRADING 5–6 (JOHN WILEY & SONS, INC., HOBOKEN, NJ, 2005).
93
Salomon Forex, Inc. v. Tauber, 8 F.3d 966, 970–1 (4th Cir. 1993).
94
NRT Metals, Inc. v. Manhattan Metals, 576 F.Supp. 1046, 1051 (S.D.N.Y.
1983).
89
90
Introduction to Part III
185
choose one of the deliverable grades permitted by the rules of the futures
exchange.95 Fifth, the margin requirement is an inherent feature of
futures contracts.96 In contrast, the performance of obligations of the
parties under a forward contract is not typically guaranteed by a margin.
Sixth, settlement by offset that is typically accomplished in futures
markets is not available for forward contracts that are settled by actual
delivery of commodities.97 Other factors, such as restrictions against
assignment without consent of the parties, provision for exchange-style
offset and presence of a clearinghouse, will be indicative of the nature of
the contract.
The borderline between forward contracts and futures may occasionally become blurred. In practice many hybrid contracts that combine
some features of forwards and futures have emerged. These hybrid
commodity contracts are known in the US market as hedge-to-arrive
contracts (HTAs).98 The US Appellate Court for the Seventh Circuit
observed that an HTA contract is an agreement for the sale of a fixed
quantity of commodity for delivery at a specific time in the future for a
price fixed by reference to the futures price for a particular month on the
futures exchange.99 This determination of the purchase price on the basis
of a quotation at a futures exchange is one of the hedging or speculative
features of HTAs that distinguishes them from the traditional forwards.
Even though the purchase price is fixed by reference to the price of a
futures contract, HTAs do not fundamentally alter the parties’ underlying
obligations to exchange the commodity for funds.100 Their users are
mainly farmers who sell the future year’s crop.101
This right granted to the seller is one of the primary reasons for the buyer
of a futures contract to close it out prior to the delivery month. Otherwise the
buyer would be obligated to accept a commodity of any quality within the
designated range, even if it did not meet her requirements. The Delivery
Requirement: An Illusory Bar to Regulation of Manipulation in Commodity
Exchanges, 73(1) YALE L. J. 171, 173 (1963).
96
BAER & SAXON, supra note 20, at 135.
97
CFTC v. CO Petro Marketing Group, Inc., 680 F.2d 573, 580 (9th Cir.
1982).
98
Charles F. Reid, Note: Risky Business: HTAs, the Cash Forward Exclusion and Top of Iowa Cooperative v. Schewe, 44 VILL. L. REV. 125, 134 (1999).
99
Lachmund v. ADM, 191 F.3d 777, 779 (7th Cir. 1999).
100
In re Rawlin L. Stovall, CFTC Docket No. 75-7 *3 (1979).
101
Edward M. Mansfield, Textualism Gone Astray: A Reply to Norris,
Davison, and May on Hedge to Arrive Contracts, 47 DRAKE L. REV. 745, 747
(1999).
95
186
The law of securities, commodities and bank accounts
Swaps are agreements that may also create a right to delivery of a
commodity. While futures contracts on crude oil and heating oil have
been traded on commodity exchanges for decades, futures contracts on
jet fuel are not yet publicly tradable, which has an impact on the business
of airlines operators.102 Airlines thus manage the risk of rising market
price for jet fuel by entering into a commodity swap. Despite the
establishment of many clearinghouses for the clearance of OTC swaps,
they are not held in commodity accounts maintained by intermediaries of
the kind studied in this book and thus will not be discussed further.103
102
See CFTC Staff Report on Commodity Swap Dealers & Index Traders
with Commission Recommendations, 11 (September 2008), available at http://
www.loe.org/images/content/080919/cftcstaffreportonswapdealers09.pdf (last visited 11 December 2013).
103
One of the first such clearinghouses – the Clearing Corp. – was sponsored by
a bank consortium that included Goldman Sachs, Deutsche Bank, Morgan Stanley
and other financial institutions. Doug Cameron & Serena Ng, Bank Group to Start
CDS Clearinghouse, Product Complex to Expand later; Exchanges’ Efforts, THE
WALL STREET JOURNAL, C7 (Friday, 30 May 2008). For the regulation of clearing of
OTC instruments see Council Regulation 648/2012 on OTC Derivatives, Central
Counterparties and Trade Repositories, 2012, available at http://www.cssf.
lu /fileadmin/files/Lois_reglements /Legislation/Reglements /Rdg_UE_648_2012_
EN.pdf (last visited 11 December 2013) [hereinafter EU Regulation 648/2012].
10. Commodity account relationships
The organization of back-end systems for the holding of commodity
accounts is similar to that of securities and funds. All of them are
pyramid-modeled with a central entity at the top and a network of
relationships among intermediaries and account holders forming the
lower tiers of the pyramid holding structure. However, a number of
differences in terms of relationships and functions can be identified. For
instance, clearing is an important function performed by central securities
settlement systems yet it is less important in RTGS payment systems.
The organization of central clearinghouses for commodity accounts
systems is similar to that of securities settlement systems. Yet as
examined below many differences exist between the two.
RELATIONSHIPS
At the top of the commodity accounts holding system sits a commodity
clearinghouse. Similar to securities clearing and LVFTSs, only authorized
intermediaries may access the commodity clearinghouse. Membership is
a privilege and license1 that is typically non-transferable.2 Individual
investors establish commodity accounts with intermediaries, which either
directly or through other intermediaries, known as clearing brokers, have
access to the clearinghouse.3 Accordingly, two types of intermediaries
1
Membership privileges may be withdrawn for cause at any time. See
CME Rulebook (available at http://www.cmegroup.com/rulebook/CME/I/7/
7.pdf) § 901.
2
Clearing licenses issued by Eurex, and the rights arising under them, may
not be transferred in any way by clearing members. Clearing Conditions for
Eurex Clearing AG § 2.1.6 (Eurex04e, 15 July 2013), available at https://
www.eurexchange.com/blob/exchange-en/3138-136778/238376/28/data/clearing_
conditions_en_ab_15_07_2013.pdf.pdf (last visited 11 December 2013) [hereinafter Eurex Clearing Conditions].
3
At Argentina Clearing S.A., all brokers are required to enter into a broker
registration agreement with a clearing member to gain access to the clearing
services. The broker also acknowledges that the clearinghouse shall act as the
counterparty to every contract. Argentina Clearing Rulebook (available at
187
188
The law of securities, commodities and bank accounts
participate in commodity accounts systems: 1) clearing members who
have direct access to the clearinghouse and 2) non-clearing members who
do not deal directly with the clearinghouse.4 Clearing members have an
account relationship with the commodity clearinghouse.5 Non-clearing
members may enter into a standard clearing agreement with a clearing
member with whom they also have an account relationship.
Applicants for a clearing license must satisfy various conditions
including minimum operational and financial requirements.6 As a condition of receiving the clearing license, applicants must enter into a
clearing agreement with the clearinghouse.7 Only once all the prescribed
requirements have been complied with and the application for membership approved will the applicants be authorized to act as clearing
members.
Clearinghouses maintain commodity accounts for clearing members in
which they hold the intermediaries’ commodity contracts and those of the
intermediaries’ customers. Regulations governing operations of clearinghouses typically include a general definition of account. Rule 110 of the
Mexican Asigna Internal Regulations defines account as ‘a set of
transaction records that the Clearinghouse maintains for each Clearing
Member, and on the basis of which clearing and settlement is carried
out’.
Authorized intermediaries may become eligible to clear both their own
(proprietary) trades and those of their customers, or only their own,
depending on the type of the clearing license they have received.8 This is
similar to securities clearing intermediaries, who may clear their own
trades only or who may also clear those of their customers. If clearing
members are authorized to clear their own trades as well as those of their
http://www.argentinaclearing.com.ar/English/legal_members/files.aspx) § 2.5.1.
Similarly, commodity intermediaries that are not clearing members at Eurex must
sign an agreement with an eligible clearing member to clear their trades with the
clearinghouse. Eurex Clearing Conditions § 1.1.5.
4
For a definition of ‘clearing member’ see EU Regulation 648/2012, art.
2(14).
5
Argentina Clearing Rulebook § 1.2.22 defines clearing member as ‘the
legal person authorized by the clearinghouse to register, clear and settle trades
for proprietary account or for its customers’ accounts’.
6
Ibid., § 2.1.2.
7
Eurex Clearing AG shall grant a clearing license upon the conclusion of
the appropriate clearing agreement in the form appended to its internal regulations. Eurex Clearing Conditions § 2.1.1(2).
8
Ibid., § 2.1.2.
Commodity account relationships
189
customers9 they must have two types of commodity accounts with the
clearinghouse – one for their proprietary positions and one for the
positions of their customers. Accordingly, for each clearing member
Eurex Clearing AG maintains a ‘principal’ account for the holding of
contracts entered into by the clearing member and an ‘agent’ account for
the customers’ contracts.10 The two accounts must be segregated from
one another and customers’ positions may not be used to cover losses in
the clearing member’s proprietary account.11
However, the clearinghouse does not establish and maintain customer
accounts for each individual client of the clearing intermediary. Instead
clearinghouses may maintain an ‘omnibus’ or ‘global’ account for
clearing members with respect to their customers’ property.12 Mexican
Asigna is authorized to maintain ‘global accounts’ for its clearing
members’ customer contracts. A global account is defined in the Asigna
Internal Regulations, Section 110, as ‘an account in which transactions
for one or more clients are recorded …’. Clearing members then
segregate non-proprietary contracts on their own books and maintain
accounts for their individual customers. This type of holding by the
clearinghouse in a non-segregated customer account is more costefficient than individualized customer holding.
Commodity contracts acquired by clearing members for their proprietary and customer accounts are executory promises that may be enforced
by demanding delivery. Futures contracts contemplate delivery and
investors must be prepared to make/take delivery in case they fail to close
out the outstanding futures contracts before the delivery month. After
9
Asigna, Internal Regulations, 202 provides that clearing members may
enter into, clear and settle transactions as proprietary or for third parties,
available at http://www.mexder.com.mx/wb3/wb/MEX/MEX_Repositorio/_vtp/
MEX/1eb9_reglamento_interior_asigna /_rid / 21/_mto /3/ Internal_Rules_Asigna.
pdf (last visited 11 December 2013).
10
Eurex Clearing Conditions § 4.2.1.
11
17 Code of Federal Regulations (C.F.R.) §§ 1.20–1.30 (2012) and Argentina Clearing Rulebook § 3.3.1.
12
The omnibus account structure is commonly used to facilitate relationships
among brokers, especially when operating in different jurisdictions. The omnibus
account structure is an efficient way to bunch customer trading activity into a
single account, saving money through economies of scale and allowing for trades
executed by many brokers to be consolidated at a single global broker. In fact, a
brokerage firm may establish an omnibus account with its own affiliate at a
foreign exchange. Customers often prefer to have all of their trading conducted
through a single account carried out at one firm, rather than at multiple affiliates
of that firm.
190
The law of securities, commodities and bank accounts
clearing the clearinghouse will become the counterparty to delivery
obligations under the futures contract. In order to protect itself against the
risk of default the clearinghouse customarily requests the clearing
members to post margins to assure the performance of their obligations
to pay and to deliver. Clearing margins are posted in the form of cash,
securities, letters of credit or a combination thereof.13 Typically the
futures margin varies from 10 to 20 percent of the value of the relevant
obligation under the futures contract. For the maintenance of margins
clearinghouses establish collateral clearing accounts to which margin
payments are deposited.14 Clearinghouses also maintain securities pledge
accounts to which clearing members transfer securities for margin
purposes.15
In addition to margins some clearinghouses have implemented other
protections against clearing members’ default. The CME clearinghouse
has the right, on default of a clearing member, to foreclose on such
member’s security deposit,16 its performance bonds and even to sell its
commodity exchange seat. The CME clearinghouse also holds a first
priority security interest in the membership rights.17 Clearing members
are bound by the provisions in the CME Rulebook to refrain from
seeking a court order to stop the actions of the clearinghouse.18 Accordingly, a default of the exchange member may result in the loss of its
exchange membership rights. Enforcement of these remedies will lead to
JULIE COLLINS & MARK MELIN, THE CHICAGO BOARD OF TRADE HANDBOOK OF FUTURES & OPTIONS 65 (MCGRAW-HILL, NEW YORK, NY, 2006). The
13
Board of Directors of the Argentinian Rofex Clearinghouse reserves the right to
approve assets, in addition to letters of credit, commercial bonds and other
payment undertakings, as eligible for margin. Argentina Clearing Rulebook
§ 1.2.15. While various financial instruments may be posted to satisfy the initial
margin, typically only cash is allowed to satisfy variation margin calls. DERMOT
TURING, CLEARING AND SETTLEMENT IN EUROPE 363 (BLOOMSBURY PROFESSIONAL LTD., HAYWARDS HEATH, UK, 2012).
14
Eurex Clearing Conditions § 4.4.
15
Securities pledged by clearing members to cover margin calls issued by
Eurex are transferred to a pledge account maintained by Clearstream Banking
AG. Ibid., § 3.2.2(3).
16
A security deposit must be provided by every clearing member as security
for its obligations.
17
CME Rulebook § 902.F.
18
Ibid., § 802.A. If any security deposits are used to cure the default, the
clearing member must replenish the security deposit prior to the close of business
on the next banking day.
Commodity account relationships
191
the termination of the account relationship between the clearinghouse and
the affected member.
Clearinghouses are also connected to LVFTSs, through which they
complete settlement of commodity contracts. In many systems clearinghouses have direct access to LVFTSs by virtue of deposit accounts
maintained by the central bank. In other systems clearinghouses effectuate settlement through agent banks that are authorized to access the
LVFTS.19
CLEARINGHOUSE AND CLEARING FUNCTIONS
A clearinghouse is a critical component of the commodity accounts
holding system. Originally commodity clearinghouses did not perform
central counterparty services and functioned comparably to bank clearing
houses.20 In that role they reconciled and recorded positions taken by
counterparties and performed related administrative functions. Today,
clearing functions typically performed by commodity clearinghouses are
similar to central counterparty clearing in securities holding systems.21
Both holding systems rely on a clearinghouse that novates existing
delivery obligations and inserts itself as the central counterparty. The
definition of clearinghouse in Chapter II of the Rulebook of Argentina
Clearing S.A. aptly summarizes the functions of a commodity clearinghouse. It defines clearinghouse as: ‘a limited liability company whose
purpose is to register, clear and settle futures contracts, options contracts
and other derivatives contracts, and to act as the counterparty in every
trade executed on the futures exchange’. Central counterparty clearing
significantly reduces the risk of default.
The first clearinghouses supporting commodity markets were established at the end of the nineteenth century in Europe. The Liverpool Corn
Trade Association formed its clearinghouse in 1883 and the Tea Clearing
Peter Allsopp, Bruce Summers & John Veale, The Evolution of Real-Time
Gross Settlement: Access, Liquidity and Credit, and Pricing, Financial Infrastructure Series: Payment Systems Policy and Research, 16 (The World Bank, 2009).
20
JIABIN HUANG, THE LAW AND REGULATION OF CENTRAL COUNTERPARTIES
49 (HART PUBLISHING LTD., PORTLAND, OR, 2010).
21
Some authors argued that CCPs play a much more significant role in
derivatives markets than in the clearing of securities transactions. TINA P.
HASENPUSCH, CLEARING SERVICES FOR GLOBAL MARKETS 12 (2009).
19
192
The law of securities, commodities and bank accounts
House was established in 1888.22 The US-based CBOT established its
clearinghouse in the 1920s.23 Contemporary commodity accounts systems utilize a clearinghouse that may be organized either as a department
within a commodity exchange or as an independent entity.24 The largest
commodity exchanges in the world, the CBOT and the CME, implemented a common clearing link in November 2003, through which the
CME began providing clearing services to the CBOT and, thus, the
world’s largest clearing organization for futures contracts was created.
Eurex operates Eurex Clearing AG, which is the central counterparty
clearinghouse for its futures contracts and options.25 A similar organization has taken hold in developing countries. In Mexico, MexDer
operates its clearinghouse Asigna, Compensación y Liquidación.
The commodity clearinghouse becomes the counterparty to every
contract entered into on the commodity exchange(s) for which it provides
clearing services. As the CBOT Handbook of Futures & Options highlights, in central counterparty clearing financial obligations are not
created between the parties, but rather vis-à-vis the clearinghouse.26 The
central counterparty is used for clearing of futures as well as options
contracts.27
As in securities markets, clearing is completed in several stages.
Commodity account holders may instruct their intermediaries to execute
trades on a commodity exchange. Once the trade has been executed,
intermediaries for both the seller and buyer then submit trade details that
typically include the type of contract, its expiration, price, etc. to the
clearinghouse electronically.28 In systems such as that of Brazil where the
22
See Ross Cranston, Law Through Practice: London and Liverpool
Commodity Markets c. 1820–1975, LSE Law, Society and Economy Working
Papers 14/2007, at 16–17.
23
REFCO PRIVATE CLIENT GROUP, THE COMPLETE GUIDE TO FUTURES
TRADING 2 (JOHN WILEY & SONS, INC., HOBOKEN, NJ, 2005).
24
DAVID LOADER, CLEARING AND SETTLEMENT OF DERIVATIVES 35 (ELSEVIER LTD., OXFORD, UK, 2005).
25
Eurex is jointly operated by Deutsche Börse AG and SIX Swiss Exchange.
26
COLLINS & MELIN, supra note 13, at 60.
27
See Eurex Clearing Conditions, Chapter II, Part 3, § 3.1(1), which provides: ‘Eurex Clearing AG shall be a contracting party to all deliveries and
payments arising out of the exercise and assignments of Options contracts’.
28
Originally, trade details used to be submitted to the clearinghouse in
duplicate on paper sheets printed in different colors; one in red ink listing sales
for the day and the other in black or blue listing purchases for the day. Bibb v.
Allen, 149 U.S. 481, 494 (1893). See also JULIUS B. BAER & OLIN G. SAXON,
COMMODITY EXCHANGES AND FUTURES TRADING, PRINCIPLES AND OPERATING
Commodity account relationships
193
trading and clearing systems are integrated, the trade details are automatically transmitted from the trading to the clearing platform.29 Once
the contract details are submitted for clearing, the matching engine
operated by the clearinghouse compares them. If the data does not match,
the contract will not be cleared and the intermediaries must then
reconcile the discrepancies.30 When the data has been successfully
matched the commodity contract may proceed to the second stage of
clearing, which involves its novation.31
Novation of commodity contracts is accomplished in two phases. First,
the contract entered into by the intermediaries will be extinguished.
Second, the clearinghouse will become the counterparty to the original
contracting parties. This process results in two new contracts. Rule 804
of the CME Rulebook expressly provides that: ‘upon such substitution,
each clearing member shall be deemed to have bought the contracts from
or sold the contracts to the clearinghouse, as the case may be, and the
clearinghouse shall have the rights and be subject to all the liabilities of
such member with respect to such transaction’.32 The CME Rulebook
thus clearly specifies the function and result of central counterparty
METHODS 171 (1949). Clearing members of MexDer use access codes to log in
to the electronic system. This form of electronic access to the clearinghouse is
legally equivalent to a written signature under the Mexican law. MexDer, Internal
Regulations (available at http://www.mexder.com.mx/wb3/wb/MEX/MEX_
Repositorio/_vtp/MEX/1ea7_reglamento_interior_mexder/_rid/21/_mto/3/MexDer
_Internal_Regulations_Jan_21_2013.pdf) (last visited 11 December 2013) § 10006.
29
Best Brazil, Brazil Market Profile 87 (February 2012), available at http://
www.bestbrazil.org.br/media/Market%20Profile.pdf (last visited 11 December
2013).
30
At the CME, they must do so before the opening of the next trading day.
CME Rulebook § 809.
31
In certain futures markets, the clearinghouse does not novate already
concluded contracts and interpose itself between the two contracting parties. For
instance, the Eurex Clearing AG becomes the immediate party to every exchange
contract by making an open public offer that has a binding effect. Robert Bliss &
Chryssa Papathanassiou, Derivatives Clearing, Central Counterparties and
Novation: The Economic Implications 20 (8 March 2006), available at http://
www.ecb.int/events/pdf/conferences/ccp/BlissPapathanassiou_final.pdf (last visited 11 December 2013). See also TURING, supra note 13, at 26 who argues that
open offer is simpler than novation because in the former system the parties are
deemed to have never executed a contract that is subsequently novated.
32
Similarly, Argentina Clearing Rulebook § 2.4.1 provides that the clearinghouse acts as the counterparty in each contract and guarantees the performance
of every trade that it has registered.
194
The law of securities, commodities and bank accounts
clearing. After novation is completed, the new contracts with the clearinghouse will have the same terms as the original one.
COMMODITY ACCOUNT RELATIONSHIPS AT LOWER
TIERS AND RIGHTS TO COMMODITIES
Account relationships between intermediaries and their customers represent the lower tier of relationships in the commodity accounts holding
structure. The structure of commodity accounts holding systems is
similar to those for securities and funds. Only authorized intermediaries
have access to the CSD, the commodity clearinghouse and the central
payment system. These (participating) intermediaries in turn maintain
accounts for other (non-clearing) intermediaries and individual investors.
The relationship between an investor and his commodity intermediary
is represented in a commodity account. This account-based relationship is
similar to those present in securities and bank accounts holding systems.
In all of the systems, intermediaries maintain accounts for their customers, to which they book securities, funds and commodity contracts.
The establishment of a commodity account with an authorized intermediary is a typical requirement for participation in commodity markets.33 As part of execution of the account agreement the account holder
must receive the necessary risk disclosure statements, such as the CFTC
Risk Disclosure Statement for Futures and Options. Commodity account
agreements typically include disclosures that highlight the risks inherent
in commodity contracts, including their speculative nature that in turn
does not render them a conservative investment. The standard commodity
client account agreement with the Argentina Clearing S.A. includes the
following warning: ‘Futures and options trades require constant supervision. They entail a high risk … A benefit can rapidly change into loss
as a consequence of price variations. Operating with Futures and Options
requires knowledge and good judgment.’34 A similar duty to provide full
33
Ibid., § 2.6.1 provides that clearing members shall require their clients to
sign an account opening agreement according to the model form approved by the
Clearinghouse.
34
Similarly, a typical commodity account agreement concluded with US
intermediaries provides that: ‘Customer acknowledges that trading in commodity
contracts is a speculative activity involving leverage and rapidly fluctuating
markets. Despite such risks, customer is willing and able to assume the financial
risks and other hazards of trading commodity contracts.’ Advantage Futures LLC
Commodity Futures Customer Agreement, art. 4 (on file with author).
Commodity account relationships
195
risk disclosures has been imposed by German courts on local financial
intermediaries.35
In a commodity account agreement the customer typically authorizes
the commodity intermediary to purchase and sell commodity contracts
for the customer’s account. The intermediary also assumes responsibility
for the execution, clearance and carrying out of actions that pertain to the
settlement, acceptance and delivery of commodities. The customer is
responsible to indemnify the intermediary for the satisfaction of its duties
with respect to the customer’s orders.36 In the client account agreement
with Argentina Clearing S.A., the client acknowledges that the broker
shall act as the client’s agent. Some account agreements and relevant
laws even defer to the general regulation of commission agents. In
Slovakia the relationship between a commodity intermediary and its
customers is subject to the contract governing commission agency
included in §§ 577–590 of the Commercial Code.37 Commodity account
agreements customarily include provisions that alert account holders to
the fact that the clearinghouse will be the counterparty to all their
commodity contracts.
In addition to a commodity account agreement the relationship
between the customer and its intermediary is also subject to the rules,
usages and customs of the particular commodity market.38 Commodity
account agreements typically contain a clause whereby the customer
acknowledges that it will be bound by the regulations, rules and other
circulars issued by the commodities exchange and its clearinghouse. In
the Argentina Clearing S.A. standard commodity account agreement, the
customer must acknowledge that he will be bound by the terms of the
35
The German intermediaries were then held liable for losses sustained by
the ill-informed investors. See Norbert Horn, Germany, in EUROPEAN BANKING
LAW: THE BANKER-CUSTOMER RELATIONSHIP 63, 75 (Ross Cranston ed., 2nd
edn., ROUTLEDGE, UK, 1999).
36
RICHARD J. TEWELES, CHARLES V. HARLOW & HERBERT L. STONE, THE
COMMODITY FUTURES GAME, WHO WINS?, WHO LOSES?, WHY? 54 (MCGRAWHILL, NEW YORK, NY, 1974).
37
See Slovakian Law on Commodity Exchange (Zákon o komoditnej burze),
No. 92/2008 (14 February 2008), available at http://www.kbb.sk/files/92_
2008.pdf (last visited 11 December 2013); art. 2(6). However, if the intermediary
trades for its own account, it is not subject to the rules on commission agency.
Rules of the Commodity Exchange Bratislava, Annex 8: Guarantee-Settling
System KBB 1, § 5 (30 July 2010), available at http://www.kbb.sk/en/category/
index/exchange-rules/ (last visited 11 December 2013).
38
Perin v. Parker, 126 Ill. 201, 212 (1888).
196
The law of securities, commodities and bank accounts
agreement, rulebook of the clearinghouse, the exchange bylaws, resolutions promulgated by these entities and regulations issued by the National
Securities Commission.39 In the United States the issue of whether or not
investors are bound by the usage of the particular commodity market was
subject to protracted litigation and ultimately resolved by the US
Supreme Court in Bibb v. Allen in which the court held:
It is settled by the weight of authority that where a principal sends an order to
a broker engaged in an established market or trade, for a deal in that trade, he
confers authority upon the broker to deal according to any well-established
usage in such market or trade, especially when such usage is known to the
principal, and is fair in itself, and does not change in any essential particular
the contract between the principal and agent, or involves no departure from
the instructions of the principal; provided, the transaction for which the broker
is employed is legal in its character, and does not violate any rule of law, good
morals, or public policy.40
RIGHTS IN COMMODITY CONTRACTS AND
COMMODITY ACCOUNTS
Commodity contracts are seldom settled by actual delivery of the
underlying asset. This type of settlement is characteristic for forward
contracts and spot sales. Forward and spot commodity contracts transfer
property rights to identified or identifiable commodities. In contrast, on
commodity exchanges title to commodities does not pass by acquiring or
offsetting a futures or option contract. A futures contract conveys only a
contractual right to demand delivery sometime in the future. This right to
delivery does not materialize until the last month of the effectiveness of
the futures contract and still may be terminated by set-off prior to its
expiration.41
39
Law on Commodity Exchange (Slovk.); art. 29(1) expressly provides that
parties involved in commodity trading are bound by the applicable laws, account
agreements that they have entered into, rules of the exchange, any established
practice and a code of ethics issued by the exchange. Article 6 also authorizes
exchange operators to issue rules governing its operation that are subject to
approval by the Ministry of Commerce.
40
Bibb v. Allen, 149 U.S. 481, 489–90 (1893).
41
Telford Taylor, Trading in Commodity Futures – A New Standard of
Legality?, 43 YALE L. J. 63, 90 (1933).
Commodity account relationships
197
In order for a property interest to arise for a commodity, the commodity must both exist and be identified in the contract.42 A promise to sell
goods sometime in the future does not convey property rights to the
buyer until the goods are identified. Prior to identification neither
property rights nor risk passes to the buyer. Goods intended to be
delivered under a futures contract are not identified as that of the buyer
when the futures contract is acquired. Only when the commodity account
holder decides to take delivery of the commodity under a futures contract
may he acquire property rights. If, however, the futures contract is
terminated before the commodity account holder becomes obligated to
take delivery, no property rights will arise.
Trading in futures contracts does not involve a transfer of warehouse
receipts as a sign of identification when the futures contract is entered
into. The warehouse receipt is not delivered to the buyer until he decides
to take delivery during the delivery month. The commodity account
holder’s rights arise as contractual and, customarily, terminate in the
same form. He does not bear any risk of damage, loss or destruction of
the commodity.43 Futures contracts transfer a different kind of risk, which
is the risk that the price of commodities may rise or fall. This market or
price risk is independent from the property-related risk.
This distinction between contractual and property rights may also be
demonstrated on the example of commodity contracts to the future
delivery of securities. Acquisition of a bond issued by a corporation
conveys a property right in the bond. The investor may be an owner, a
co-owner or have a security entitlement, depending on the securities
holding pattern. In contrast acquisition of a futures contract conveys only
the promise that a buyer and seller will exchange property rights to the
underlying security in the future.44 By dealing in futures contracts one is
dealing not in the actual security but in claims to delivery of the
security.45
Parties to commodity contracts for future delivery have both contractual rights and obligations to settle the contract by either offset or
delivery. It should be recalled that commodity option holders have no
similar obligation and may let their options expire. In other words, while
42
See UCC 2-105(1) (2003) and Andrew G. L. Nicol, The Passing of
Property in Part of a Bulk, 42(2) MODERN L. REV. 129 (1979).
43
Taylor, supra note 41, at 90.
44
REFCO PRIVATE CLIENT GROUP, supra note 23, at 5–6.
45
GEORGE WRIGHT HOFFMAN, FUTURE TRADING UPON ORGANIZED
COMMODITY MARKETS IN THE UNITED STATES 111 (UNIVERSITY OF PENNSYLVANIA PRESS, PHILADELPHIA, PA, 1932).
198
The law of securities, commodities and bank accounts
an affirmative action is required to settle a futures contract, inaction by
the option holder will terminate his rights under the option. Like a futures
contract an option holder does not acquire any property interest in the
underlying asset. Rights of the option holder are merely contractual and
the writers of options are not required to hold the asset that the option
references.
The characterization of rights under commodity contracts held in
accounts with intermediaries as contractual is evident in the case of
insolvency of a commodity account holder. The claim of the clearinghouse, which is its counterparty, shall be classified as an executory
contract rather than a proprietary or secured claim. Similarly, goods that
may be acquired under a futures contract may not be attached by a
creditor of the commodity account holder because he has no property
interest in the goods. The creditor may serve its attachment order only
against the contract and not against the goods.
PROTECTIONS OF COMMODITY ACCOUNTS
HOLDERS
Commodity account holders acquire contractual rights under futures and
options contracts. Unlike securities account holders, they do not acquire
any property rights to the underlying commodities until they exercise the
right to take delivery.46 Accordingly, their rights are similar to those of
bank account holders. Neither of these account holders has any property
rights to the funds or commodities. Consequently, property law protects
only the rights of securities account holders.
The rights of securities and bank account holders against their intermediaries are protected by mandatory insurance. In the case that a
securities intermediary or a bank is declared insolvent, claims of their
account holders, up to a certain cap, will be paid out from insurance
funds typically administered by governmental agencies. In contrast,
claims of commodity account holders are not covered by a similar
mandatory insurance scheme. In the United States proposals to create an
insurance mechanism for the protection of commodity account holders
were studied extensively in the 1970s. At that time the CFTC concluded
that insurance is not necessary due to ‘the high level of public confidence
46
If the account holder has deposited specifically identifiable assets with an
insolvent intermediary, such as a warehouse receipt to be delivered in settlement
of a futures contract, the account holder may be entitled to its return and such
asset does not become subject to the pro-rata sharing rule.
Commodity account relationships
199
in the safety of funds and the cost-inefficiency of insurance coverage’.47
Furthermore, insolvencies of commodity intermediaries are not as common as insolvencies of securities intermediaries and banks.
However, the calls for a possible insurance protection recently resurfaced in the aftermath of the insolvencies of some major commodity
intermediaries such as MF Global. In December 2012 a number of
stakeholders, including the CME Group, launched a study on the
feasibility of adopting an insurance framework for the US futures
industry.48 The CME also voluntarily implemented the Family Farmer
and Rancher Protection Fund, which provides coverage of up to US$
25 000 to individual farmers for the losses incurred by a failure of their
intermediaries.49 In the absence of insurance customers may be tempted
to argue that their property is held in a securities account and that they
are entitled to the protections available to customers of failed securities
intermediaries, including a claim against an insurance fund.50
Although losses incurred by commodity account holders are not
insured, commodity exchanges may impose a requirement to take out
insurance for general damages caused by intermediaries. For instance, the
Slovakian Bratislava Commodity Exchange requires every intermediary
to take out insurance as a condition of issuing a trading authorization.51
However, such insurance may not be sufficient to cover all losses
resulting from insolvency. Private insurance is not a replacement for
mandatory insurance schemes along the lines that have been established
for bank account holders. Recent insolvencies prove that some form of
insurance may be necessary to protect commodity account holders.
Commodity account holders’ assets, which include commodity contracts as well as funds and other property provided as margin, are
47
Jack M. Platt, Legislative Proposal, Commodity Futures Account Protection, 6 HOFSTRA L. REV. 173, 183 (1977).
48
Joanne Morrison, Futures Industry Moves Forward with Enhanced Customer Protections, 23(1) FUTURES INDUSTRY 39 (2013).
49
CME Group, Family Farmer and Rancher Protection Fund, available at
http://www.cmegroup.com/clearing/family-farmer-fund.html (last visited 11
December 2013).
50
In re MF Global Inc., 2013 Bankr. LEXIS 1578 (S.D.N.Y. Bkrt. 2013). In
this case, one customer of MF Global argued that palladium certificates held in a
commodity account constitute securities entitled to protections under SIPA. Ibid.,
*5. The critical element that distinguishes between a customer of a securities
intermediary and that of a futures commission merchant is the entrustment of
cash or securities for the purposes of trading securities. In re Madoff Inv. Sec.
LLC, 708 F.3d at 426 (2d Cir. 2013).
51
Law on Commodity Exchange art. 26(5) (Slovk.).
200
The law of securities, commodities and bank accounts
protected against insolvency of their intermediaries by the requirement of
intermediaries to segregate their proprietary assets from customer
accounts.52 Similarly, in the securities holding system the intermediary
must segregate its own proprietary securities account from the securities
accounts of its customers. In the commodity intermediary’s insolvency,
the account holders have the highest priority and are entitled to the return
of customer property.53 Even if the intermediary failed to segregate some
property belonging to account holders such assets shall be treated as
customer property subject to the highest priority.54
Funds of commodity account holders of the same intermediary may be
commingled and held in a single account at a bank or similar authorized
institution.55 Individual customer-by-customer segregation would be
operationally cumbersome and expensive to implement.56 Intermediaries
may be required to obtain an acknowledgment of the depository institution that the funds deposited with it by the intermediary belong to its
customers.57 It is important for regulatory agencies to verify that such
funds have in fact been deposited and that the amount corresponds to the
amount owed by the intermediary to its customers. When the customer
property is insufficient to satisfy the claims of account holders in full,
recourse may be had to other estate property.58
As a reaction to the recent failures of commodity intermediaries in the
United States, regulators and self-regulating agencies have been studying
proposals to institute measures that would allow for more efficient
monitoring of the commodity account holders’ assets held by intermediaries. The US-based National Futures Association has partnered with
52
US commodity intermediaries must hold customer assets, including funds,
separate from their own house property. 17 C.F.R. § 1.20 (2012). Joanne
Morrison, An LSOC Tutorial: A New Customer Protection Model for Cleared
Swaps Begins, 23(1) FUTURES INDUS. 32 (2012).
53
US Bankruptcy Code, 11 U.S.C. § 766 (2013) and the CFTC Rules
implementing the Commodity Exchange Act, 17 C.F.R. § 190.01-10 (2012). The
term ‘customer property’ is defined in the 11 U.S.C. § 761(10) (2013). CFTC
Rules further identify fifteen different categories of customer property.
54
Brief of the CFTC Pursuant to the Court’s 17 November 2011 Order, In re
MF Global, Case No. 11-2790 (MG) SIPA, at 4.
55
Futures Industry Association, Protection of Customer Funds, Frequently
Asked Question, Version 2.0, 3 (June 2012).
56
Ibid., at 7.
57
National Futures Association, NFA Regulatory Requirements 3 (May
2013), available at https://www.nfa.futures.org/NFA-compliance/publicationlibrary/regulatory-requirements-guide.pdf (last visited 11 December 2013).
58
C.F.R. § 190.08(a)(1) (2012).
Commodity account relationships
201
the CME Group to create an automated system that would allow for the
daily monitoring of all customer segregated funds held by commodity
intermediaries.59 Segregation of customer assets coupled with efficient
monitoring of those assets, are the two essential protective measures of
the rights of commodity account holders.60 With the increasing number
of insolvencies and losses sustained by customers of failed intermediaries, the pressure on instituting some minimal insurance coverage
will increase.
Morrison, supra note 48, at 38.
Authorization to act as a commodities intermediary may also require
submission of an operational plan for maintaining segregation.
59
60
11. Commodity transfers, finality and
security interests
Assets such as funds and securities circulate in the marketplace and
between accounts. Funds have relatively unlimited longevity and their
existence is not terminated when they are transferred between bank
accounts. Such transfers cause only a modification in the claims of
depositors. Securities also have a relatively long life-span. Bonds may
have limited maturities (e.g., a 5-year bond) but shares may exist
indefinitely until the company goes bankrupt, decides to repurchase them
or transforms into a privately held company. Transfers do not terminate
securities and, like funds transfers, they only modify rights of account
holders against their intermediaries. Accordingly, both funds and securities do not cease to exist when they are transferred from one account to
another.
In contrast to funds and securities, commodity contracts have limited
longevity. The life of a futures contract essentially involves only two
phases: 1) when an investor enters into a futures contract and the
intermediary credits his commodity account; and 2) when the investor
acquires another futures contract that offsets the original futures
contract. The second stage thus terminates the existence of both futures
contracts, which offset one another. This process of offsetting commodity
contracts is also known as ‘close out’. The other form of settling a
commodity contract is by delivery of the underlying commodity. Rules
governing the operation of commodity exchanges and associated clearinghouses typically provide for the possibility to settle a commodity
contract either in cash or by delivery.1 Commodity account holders,
unlike their securities and bank account counterparts, do not transfer
commodity contracts to one another. Instead they enforce their rights
embedded in commodity contracts by acquiring offsetting positions or
making/taking delivery of the underlying commodity. Accordingly, it
would be misleading to refer to transferring commodity contracts within
See Argentina Clearing Rulebook (available at http://www.argentina
clearing.com.ar/English/legal_members/files.aspx) (last visited 11 December 2013)
§ 1.2.14.
1
202
Commodity transfers, finality and security interests
203
the commodity accounts holding system. While securities and bank
account holders exercise their rights by ‘transferring away’ their interests
in securities and claims against banks, commodity account holders
exercise their rights by acquiring offsetting positions or enforcing delivery obligations. A transfer of securities and funds completed by a book
entry is thus similar to the acquisition of an offsetting position or
making/taking delivery of the underlying commodity. A holder of a
commodity contract, whether written on an agricultural commodity,
metals or financial assets, has two options: 1) to offset the commodity
contract, or 2) to make/take delivery of the commodity.
OFFSET
Futures contracts have traditionally been settled by offset that does not
involve delivery of a warehouse receipt or commodity. Instead offset of
commodity contracts is effectuated by payment of price differences.2
Offset has been recognized as a legitimate and enforceable settlement
mechanism since the beginning of the twentieth century, when the US
Supreme Court rendered the decision in Christie.3 Since the Christie
decision, offset has been deemed to have the same legal effects as actual
delivery.4 The settlement of commodity contracts by offset is justifiable
on a number of legal and practical grounds. Legal arguments revolve
around the nature of commodity contracts as transactions in which parties
deal with promises rather than commodities. A promise may not be
physically delivered but only settled by some form of set-off that
discharges the mutual obligations of the parties. Practice-oriented arguments allude to the facts that inadequate infrastructure in some markets
simply does not allow efficient physical deliveries over long distances.5
The offset in commodity markets operates as follows. Suppose that
Steve and Brian, through their intermediaries, Goldman Sachs and RJO
This feature or ability to offset obligations distinguishes futures contracts
from forwards and similar agreements. See CFTC v. Int’l Fin. Servs., 323 F Supp
2d 482 (S.D.N.Y. 2004).
3
Board of Trade v. Christie Grain & Stock Co., 198 U.S. 236, 248–50
(1905).
4
See also Lyons Milling Co. v. Goffe & Carkener, Inc., 46 F.2d 241, 247
(10th Cir. 1931).
5
Golaka C. Nath & Thulasamma Lingareddy, Commodity Derivative Market and its Impact on Spot Market 2, available at http://papers.ssrn.com/sol3/
papers.cfm?abstract_id=1087904 (last visited 11 December 2013) (January
2008).
2
204
The law of securities, commodities and bank accounts
Futures, enter into a futures contract. Steve acquires rights to sell corn
and Brian acquires a right to buy corn. Upon execution, of their
respective orders, which are matched on a commodity exchange, the
futures contract is cleared and two new contracts with the clearinghouse
are established. As a result of clearing, Steve has the right to sell 100
kilos of corn for US$ 500 in six months and Brian has the right to buy
100 kilos of corn for US$ 500 in six months. The clearinghouse becomes
the counterparty to both Steve and Brian on their respective contracts.
Now suppose that Steve wants to close out his futures contract. He does
not intend to make delivery of the corn, whether or not his futures
contract is profitable. Suppose four months later, just before the delivery
month, the same futures contract for delivery of 100 kilos of corn trades
for US$ 450. Steve may acquire the same futures contract to buy 100
kilos of corn for the current market price of US$ 450. Once Steve
acquires this second corn futures contract it will be again cleared and the
clearinghouse becomes Steve’s counterparty. Now Steve is the seller
under the first futures contract where he agreed to sell for US$ 500 to the
clearinghouse. Steve is also the buyer of corn under the second futures
contract where he agreed to buy from the clearinghouse for US$ 450.
Steve and the clearinghouse have two offsetting contracts, whereby Steve
agreed to sell for US$ 500 and buy for US$ 450. These two obligations
offset one another with the result that Steve will collect US$ 50 from the
clearinghouse and the two futures contracts will get closed out.
However, the clearinghouse is not the party that ultimately bears the
loss, i.e., by paying Steve his profit of US$ 50. As mentioned earlier, for
every ‘long’ there is a ‘short’. With respect to the second contract that
Steve acquired for US$ 450, there must be a seller. Suppose that Brian
does not want to take delivery and decides to enter into a futures contract
to sell 100 kilos of corn for the then market price of US$ 450. After
clearing, Brian’s two contracts against the clearinghouse will be novated
in a manner equivalent to Steve’s contracts. However in Brian’s case, he
bought for US$ 500 and sold for US$ 450 so he owes US$ 50 to the
clearinghouse.
Settlement by offset is feasible only if the commodity market is
sufficiently liquid. In an illiquid market with a few participants who trade
only occasionally, the participants may be forced to make/take delivery if
they are not able to acquire offsetting positions prior to the delivery
month. Offset may also be difficult to achieve in OTC markets in which
the contracts are customized by the parties.
Offset is accomplished by the payment of price differences. In the
previous illustration, Brian owes the clearinghouse US$ 50 and the
clearinghouse owes US$ 50 to Steve. The clearinghouse will not send a
Commodity transfers, finality and security interests
205
check to Steve or credit his bank account. Neither will it collect payment
directly from Brian. Instead it will deal with Steve’s and Brian’s
intermediaries, Goldman Sachs and RJO Futures, who are its clearing
members. The clearinghouse will collect payments from and make
payments to the clearing members for all commodity contracts that their
customers offset. To complete such payments clearing members must
maintain settlement bank accounts.6 Establishment of a settlement bank
account with a financial institution approved by the clearinghouse is
typically one of the requirements for granting a clearing license. The
offset settlement could not be accomplished without the cooperation of
banks.7
PHYSICAL DELIVERY
Although exchange-traded commodity contracts are rarely settled by
actual delivery, they all contemplate that the commodity account holder
may be required to make or take delivery unless he closes out before the
delivery month.8 The delivery month is the last month when the futures
contract expires. The possibility to make/take delivery applies only to
futures contracts. In contrast, option contracts holders do not have any
obligation to make/take delivery and may let their options expire. The
commodity account holder is alerted to the possibility of having to
make/take delivery in the account agreement. Commodity account agreements regularly provide for the right of the account holder to submit
6
REFCO PRIVATE CLIENT GROUP, THE COMPLETE GUIDE TO FUTURES
TRADING 6 (JOHN WILEY & SONS, INC., HOBOKEN, NJ, 2005). The Commodity
Exchange Bratislava requires its participants to open deposit accounts at one of
the authorized banks. The Rules of the exchange provide for three types of
deposit accounts: 1) a type A account that is held by the exchange itself and to
which participants post their margin payments; 2) a type B account that is held
by a participant in order to effect payments for delivered commodities; and 3) a
type C account that is held in order to receive payments for exchange transactions. Rules of the Commodity Exchange Bratislava, Annex 8: GuaranteeSettling System KBB 1, § 2 (30 July 2010), available at http://www.en.kbb.sk/
Guarantee%20systems/ (last visited 11 December 2013).
7
LEO MELAMED, ESCAPE TO THE FUTURES 185 (JOHN WILEY & SONS, INC.,
US, 1996).
8
H.S. Irwin, Legal Status of Trading in Futures, 32 ILL. L. REV. 157
(1937–1938) and RICHARD J. TEWELES, CHARLES V. HARLOW & HERBERT L.
STONE, THE COMMODITY FUTURES GAME, WHO WINS?, WHO LOSES?, WHY? 61
(MCGRAW-HILL, NEW YORK, NY, 1974).
206
The law of securities, commodities and bank accounts
offsetting instructions to the intermediary with respect to the futures
contracts that mature in the current month. Such instructions must be
received by the intermediary a certain number of days prior to the last
trading day.9 The delivery obligation is also reiterated in the confirmation
that the intermediary sends to its customer after execution of an order to
acquire a commodity contract.
The possibility of settlement by actual delivery under futures contracts
is the factor that connects commodity markets with the spot (cash)
market.10 Otherwise, commodity contracts traded on exchanges would
remain purely speculative instruments.11 The correlation between
commodity contracts and the physical market was included as one of the
guiding principles prepared by IOSCO, which were endorsed at the G20
Summit in November 2011.12 According to Principle 3, the commodity
contract must be designed to reflect price conditions in the underlying
market and facilitate the convergence of prices.13
As described above, futures contracts may be written on a variety of
assets, including agricultural commodities and financial instruments.
Delivery of corn is obviously completed in a different setting than the
delivery of a security. For this reason commodity exchanges provide for
various mechanisms to accomplish settlement by delivery depending on
the nature of the underlying asset.14 To settle a contract by physical
delivery, commodity exchanges and clearinghouses promulgate rules
either as part of the Rulebook (Regulations) or in a special supplement.
Argentina Clearing S.A. published ‘Instructions for Delivery of Goods’
which governs physical settlement. According to Article 1.1, the Instructions complement, but do not replace, the Rulebook.
Advantage Futures LLC Commodity Futures Customer Agreement, art. 15
Liquidating Instructions (on file with author).
10
Irwin, supra note 8, at 156.
11
In Volkart Bros. Inc. v. Orville L. Freeman, 311 F.2d 52 (5th Cir. 1962),
the US 5th Circuit court observed that: ‘The legality of every futures exchange
rests on the obligation of the parties to the futures contract to deliver or take
delivery of the commodity unless the contract has been liquidated by offset on
the exchange.’
12
IOSCO, Survey on the Principles for the Regulation and Supervision
of Commodity Derivatives Markets, 6 (October 2012), available at http://
www.iosco.org/library/pubdocs/pdf/IOSCOPD393.pdf (last visited 11 December
2013).
13
Ibid., at 8.
14
See CME Rulebook, Chapter 7, Delivery Facilities and Delivery Procedures, available at http://www.cmegroup.com/rulebook/CME/I/7/7.pdf (last visited 11 December 2013).
9
Commodity transfers, finality and security interests
207
Recall the illustration where Steve acquired two futures contracts for
delivery of 100 kilos of corn that offset one another. Failure to offset a
futures contract will trigger the customer’s obligation to provide the
intermediary with adequate instructions including a warehouse receipt to
complete delivery. In the case that the customer becomes obligated to
take delivery, the customer must provide sufficient funds to cover the
purchase price. As part of their risk management, some commodity
exchanges, such as the CME, authorize clearing members to assess their
account holders’ ability to make/take delivery prior to the last day of
trading in the particular contract. If the clearing member determines that
the account holder may not be able to settle its commodity contract by
physical delivery the clearing member may liquidate the contract by
offset.15
Delivery under a futures contract is accomplished like delivery in spot
and forward markets – by exchange of a warehouse receipt for funds. The
process of actual delivery on the commodity exchange involves a number
of steps. First, the account holder (Steve) submits delivery instructions to
its intermediary who in turn notifies the clearinghouse as to the intention
to make delivery. However, the clearinghouse does not make/take delivery and instead it identifies the buyer (the other side of the contract such
as Brian) and notifies him of his duty to take delivery. Since the number
of ‘sell’ futures contracts always matches the number of ‘buy’ contracts
there will always be a buyer or seller ready to make/take delivery. The
following paragraphs illustrate the settlement by delivery at the CME and
Argentina Clearing S.A.
To settle a commodity contract by delivery through the CME the seller
must tender a standardized delivery notice to the clearinghouse.16 The
notice must indicate the net invoice price that is calculated on the basis of
the last settlement price of the commodity contract. Transferable notices
reference a commodity or a warehouse receipt that is to be delivered by
the seller.17 The transferable notice serves two functions: 1) to notify the
Ibid. § 716.
Ibid. § 713.
17
A transferable notice typically refers to the warehouse receipt that
represents the commodity to be delivered under the futures contract and includes
the following language: ‘We have on hand ready for delivery the following
described Warehouse Receipts, and hereby make tender to you of the same, in
fulfillment of our contract of sale.’ GEORGE WRIGHT HOFFMAN, FUTURE TRADING UPON ORGANIZED COMMODITY MARKETS IN THE UNITED STATES 194
(UNIVERSITY OF PENNSYLVANIA PRESS, PHILADELPHIA, PA, 1932). For similar
language in the transferable notice see JULIUS B. BAER & OLIN GLENN SAXON,
15
16
208
The law of securities, commodities and bank accounts
buyer that the seller is ready to make delivery, and 2) to temporarily
replace the warehouse receipt in the settlement of outstanding futures
contracts so as to avoid its loss or destruction.18 The clearinghouse will
then forward the delivery notice to the clearing member that holds the
oldest contract to take delivery of the particular commodity. The buyer
who received a delivery notice must then pay the invoice price. Submission and transmission of delivery notices is commonly done electronically.
Similarly, Argentina Clearing S.A. requires sellers under commodity
contracts to submit delivery notices for the outstanding futures contracts
that they intend to settle by physical delivery between the first and
fifteenth day of the last contract month.19 The clearinghouse shall then
notify the buyer to whom it has assigned the delivery notice. Such buyers
must submit an Application for Assignment of Delivery Notice to the
clearinghouse.20 The notification shall be accomplished by transmitting a
bill of sale for the goods.21 Clearinghouses may also charge reasonable
fees for facilitating the delivery of underlying assets. The Argentina
Clearing S.A. requires buyers to pay a fee of 1 percent of the invoice
price.22
FINALITY
The preceding Parts distinguished finality of transfer orders and finality
of actual transfers. The first finality rule applies between the sender of an
COMMODITY EXCHANGES AND FUTURES TRADING, PRINCIPLES AND OPERATING
METHODS 183 (HARPER, NEW YORK, NY, 1949): ‘We pledge ourselves to deliver
on the day specified for delivery, to the last acceptor thereof, documents upon
written notice of the holding of this notice given to us by the last acceptor hereof
before 4pm on the day this notice is issued. This notice is to be delivered to us
simultaneously with our delivery of the documents to the last acceptor hereof.’
(Emphasis added.) See also H.J. Loman, Commodity Exchange Clearing Systems, in ANNALS OF THE AMERICAN ACADEMY OF POLITICAL AND SOCIAL
SCIENCE, VOL. 155, PART 1: ORGANIZED COMMODITY MARKETS 100, 102
(AMERICAN ACADEMY OF POLITICAL AND SOCIAL SCIENCE, PHILADELPHIA, PA,
1931).
18
HOFFMAN, supra note 17, at 193.
19
Argentina Clearing S.A., Instructions for Delivery of Goods – Argentina
Clearing, § 2.2 (2nd edn., 2008) (on file with the author).
20
Ibid. § 2.3.
21
Ibid. § 2.5.
22
Ibid. § 1.2.
Commodity transfers, finality and security interests
209
order and its intermediary while the second applies between the beneficiary of the order and its intermediary. The first type of finality as it
regards an order submitted by the account holder to his intermediary also
applies in commodity accounts holding systems. However, the second
type of finality applies in commodity accounts systems to a limited extent
because commodity account holders do not transfer commodity contracts
between each other. Accordingly, the finality of transfer will be limited to
the acquisition of a commodity contract that is associated with a book
entry made by a commodity intermediary to an account of its customers.
Commodity intermediaries may specialize only in the execution of
orders and rely on other intermediaries for clearing, or they may provide
full services.23 When an intermediary receives an order from a customer
it must time-stamp the order and indicate the account and order number.24 Generally an order may no longer be revoked after it has been
executed by the intermediary.
Transfers of securities and funds are accomplished by modification of
the relationships between intermediaries and their account holders.
Account holders may dispose of securities and funds by ordering their
intermediaries to transfer them to designated transferees. The account
balance of the transferor is then reduced and the account balance of the
transferee is correspondingly increased. This is not the case with transfers
of commodity contracts in which the acquisition of an offsetting futures
contract effectively modifies only the relationship between the commodity account holder and his intermediary. There is no sequel of transfers
when one closes out a futures contract. All actions are performed within
the particular commodity account holder-intermediary relationship.
Unlike in the case of securities and funds transfers in which third parties
rely on the finality of preceding transfers, the finality of acquisitions and
offsets of commodity contracts is internal to the particular commodity
account relationship. Account agreements between commodity intermediaries and their customers establish when the customer acquires a
futures contract and when the futures contract is considered closed out.
Like securities and bank accounts, entries made by intermediaries to their
customer accounts determine the finality of acquisitions and offsets.
FIA, Order Handling Risk Management Recommendations for Executing
Brokers, 4 (2012), available at http://www.futuresindustry.org/downloads/Order_
Handling-Ex_Brokers.pdf (last visited 11 December 2013).
24
National Futures Association, NFA Regulatory Requirements 2 (May
2013), available at https://www.nfa.futures.org/NFA-compliance/publicationlibrary/regulatory-requirements-guide.pdf (last visited 11 December 2013).
23
210
The law of securities, commodities and bank accounts
COMMODITY CONTRACTS AND COMMODITY
ACCOUNTS AS COLLATERAL
Commodity contracts, commodity accounts and actual commodities may
all function as collateral under commercial loans. From the perspective of
secured transactions laws the following assets should be distinguished:
1)
exchange-traded commodity contracts (e.g., futures) and commodity accounts;
OTC commodity contracts (e.g., forwards); and
actual commodities and documents of title (e.g., warehouse
receipts).
2)
3)
All of these assets are subject to different rules under secured transactions laws. Whereas secured transactions laws in many jurisdictions
have, for decades, recognized pledging of commodities and representative documents of title, the taking of security interests in commodity
contracts and accounts remains largely ignored in statutes and in practice.
The hedging function of commodity contracts provides protection
against price fluctuations not only to the merchant but also to a secured
creditor that finances the underlying asset or the entire business of the
merchant. From the secured creditor’s perspective the value of its
collateral may increase if the price risk has been hedged. Suppose that
Steve, who grows corn, exports his crop. Steve’s business operations are
financed by a revolving bank loan secured with growing and future crops,
equipment and accounts receivable. The value of the crop may fluctuate
in the absence of long-term contracts that fix the purchase price.
Consequently, the creditor is exposed to a potential risk of deterioration
in the market value of the collateral and may face the risk of the debtor’s
default if the market price of the crop significantly decreases. To hedge
against this risk the creditor may require Steve to enter into a futures
contract to sell corn. The bank could then take a security interest in such
a futures contract and thus protect the value of its collateral.
Banks regularly provide credit at a reduced cost if the price of the
commodity pledged as collateral has been hedged.25 According to some
studies, banks lend up to 10 percent or even 20 percent more if the
commodity provided as collateral is hedged.26 As one author noted,
HOFFMAN, supra note 17, at 380–2.
HAROLD S. IRWIN, EVOLUTION OF FUTURES TRADING 53 (MIMIR PUBLISHERS INC., MADISON, WI, 1954).
25
26
Commodity transfers, finality and security interests
211
‘banks rely less on the word of mouth and more on the security implied
in the hedge’.27 Consequently, the ability of the creditor to effectively
manage and reduce risks should translate into a lower cost of credit for
the borrower.
It should be highlighted that the collateral value of a futures contract
fluctuates and may be either profitable for the borrower and the creditor
or at times, may turn negative when the market moves against the
borrower. For instance, Steve entered into a futures contract to sell corn
in six months for the price of US$ 100 but at the expiration of the
contract the market price of corn increases to US$ 110. Steve will close
out the futures contract and sustain a loss of US$ 10, but will be able to
sell his corn for US$ 110 in the spot market. The collateral value of such
futures contract will be zero. In contrast, if the market price of corn
decreased to US$ 90 Steve would close out the futures contract, take the
profit of US$ 10 and sell his corn for the market price of US$ 90. In this
case a security interest in the futures contract and its cash proceeds is
extremely valuable to the creditor. In both situations the collateral value
is underpinned by either the increasing market price of corn in the spot
market or by potential gains on the futures contract.
In the United States, UCC Article 9 governs security interests in
personal property including commodity contracts and commodity
accounts. Official Comment 6 to UCC 9-102 explains that the most likely
situation in which a creditor takes a security interest in a commodity
contract is when it finances inventory of a commodity that is susceptible
to price fluctuations. UCC 9 is one of the few laws that: 1) provides for
security interests in commodity contracts or commodity accounts, and 2)
draws a distinction between futures and forwards. UCC 9 classifies
commodity futures contracts and commodity accounts within a broader
collateral type of investment property, along with securities and financial
assets, security entitlements and securities accounts.28 This broader
classification of security and commodity assets under a single collateral
type resulted from the pattern in which both these categories of investment property are held. Commodity contracts as well as securities are
carried in their respective accounts with relevant intermediaries. However, only exchange-traded commodity contracts are carried in commodity accounts maintained by intermediaries and only this category of
27
Kenneth J. Lipartito, The New York Cotton Exchange and the Development
of the Cotton Futures Market, 57(1) BUS. HIST. REV. 50, 50–1 (1983).
28
UCC 9-102(a)(49) (1999) and Saskatchewan, Personal Property Security
Act,§ 2(1)(x.1) (1993) (SS) [hereinafter Saskatchewan PPSA].
212
The law of securities, commodities and bank accounts
commodity contracts is classified as investment property under UCC 9.29
OTC commodity contracts fall under the residual category of ‘general
intangibles’.30 Perfection by control is not available for commodity
contracts and commodity accounts that do not qualify as investment
property under UCC 9.
In the jurisdictions where secured transactions laws do not expressly
provide for the taking of security interests in commodity contracts, it is
possible for creditors to take such security interests by complying with
the rules on the creation and perfection of security interests in executory
contracts. Many jurisdictions provide for a catch-all category of ‘rights’
or ‘claims’, or refer generally to ‘any rights’ that may be used as
collateral. Such categorizations seem to be broad enough to include
executory promises in the form of commodity contracts. Special provisions are provided in Chapters III and IV of the OAS Model Law for
taking security interests in accounts receivable and non-monetary claims.
Under the OAS Model Law a security interest in a forward contract may
be created by complying with the rules on accounts receivable and
non-monetary claims. A claim under a futures contract may also be used
as collateral by complying with the rules on accounts receivable. The
OAS Model Law and secured transactions laws in the vast majority of
jurisdictions do not distinguish between futures and forwards.
The EU Financial Collateral Directive applies to financial collateral
that is defined in Article 2 to include cash and financial instruments.
However, commodity contracts and accounts do not fall under the scope
of the Directive. Article 1(k) of MiFID expressly excludes ‘persons
whose main business consists of dealing on own account in commodities
and/or commodity derivatives’ from its scope. Security interests in
commodity contracts and commodity accounts are thus not covered.31
Accordingly, for regulation of security interests in commodity contracts/
accounts one must resort to the local law of EU Member States. None of
the EU Member States has enacted legislation or specific rules that would
29
UCC 9-102 (1999) Official Comment 6 provides that the UCC Article 9
investment property covers only the category of contracts that fall under the
jurisdiction of the CFTC.
30
This classification would most likely apply to rights to payment as well as
to rights to delivery under OTC contracts. Mark A. Guinn & William L. Harvey,
Taking OTC Derivative Contracts as Collateral, 57 BUS. LAW. 1127, 1140
(2002).
31
The EU Financial Collateral Directive provides for the perfection of
security interests by control only for financial instruments and funds.
Commodity transfers, finality and security interests
213
facilitate collateralization of commodity contracts and accounts. Typically, the laws of EU Member States provide that a security interest may
be created over a thing, a right or other monetary asset, as long as it is
transferable.32 Accordingly, a commodity contract may be used as
collateral unless its transferability has been restricted. Generally,
exchange-traded commodity contracts are not subject to any restrictions
on transfer and OTC contracts may be transferred by assignment.
Laws in many jurisdictions neither provide for a specific type of
commodity property collateral nor do they provide for a special perfection mechanism for such security interests. Jurisdictions in which viable
commodity exchanges have been established and where businesses
regularly enter into contracts for future delivery of commodities should
adopt more specific rules to encourage creditors to use commodity
contracts and commodity accounts as collateral. International rules and
recent legislative projects in the area of secured lending entirely exempt
commodity contracts from their scope. Article 4(2) of the 2001 UN
Convention on the Assignment of Receivables in International Trade
exempts assignments of receivables that arise from contracts concluded
on regulated exchanges, including spot, forward, future, option or swap
agreements involving commodities.33 This category of exempted financial
contracts has been carried over to the UNCITRAL Legislative Guide.34
Consequently, jurisdictions that contemplate a modernization of their
secured transactions laws must seek guidance elsewhere. In this regard
the legal framework adopted in UCC 9 may be a model.
Perfection by Control
After the creditor has adequately classified and described commodity
contracts or accounts in the security agreement, the creditor should
perfect its security interest in order to obtain protection against competing claimants. For security interests in commodity contracts and
See CIV. C. art. 151(d) (Slovk.).
United Nations Convention on the Assignment of Receivables in International Trade, 12 December 2001, G.A. Res. 56/81, 56th Sess., U.N. Doc.
A/RES/56/81 (31 January 2002), available at http://www.uncitral.org/pdf/
english/texts/payments/receivables/ctc-assignment-convention-e.pdf (last visited
11 December 2013).
34
UNCITRAL Legislative Guide on Secured Transactions, UN Sales No.
E.09.V.12 (2010), 20.
32
33
214
The law of securities, commodities and bank accounts
commodity accounts, two perfection mechanisms are generally available:
1) registration (filing) and 2) control.35
Under UCC 9 a security interest in commodity contracts and commodity accounts may be taken either by the intermediary that maintains the
commodity account or by a third-party creditor. The UCC 9 rules for
perfection by control vary depending on whether the creditor is the
intermediary or a third party. The intermediary may perfect a security
interest in its customer’s commodity contracts and commodity accounts
automatically upon attachment.36 Under UCC 9 automatic perfection is
also available to banks and securities intermediaries that maintain the
relevant accounts. Upon opening a commodity account the customer
typically grants a security interest to his intermediary in all assets carried
in such account, including those to be acquired in the future. A security
interest of a commodity intermediary may also cover funds that are used
by the customer for the acquisition of commodity contracts. In addition
to granting a security interest, the customer regularly acknowledges in
the account agreement that the intermediary has the right of set-off
against the customer’s property for margin, commissions and fees
incurred by the customer.
Securities intermediaries regularly provide margin loans to their customers to purchase securities. Margins are also used in the commodities
industry but play a very different role. Melamed summarized the differences between the two markets with respect to margins as follows:
Securities market margin is a direct measure of the creation of bank credit. It
determines the proportion between the amount paid for securities and the
amount borrowed for their purchase. There is no such relation in futures
markets. In future markets, margin acts as a surety or security deposit.37
A futures contract margin is a sign of good faith functioning as an
assurance against the risk of the customer’s insolvency.38 In contrast, a
35
UCC 9-313(a) and 9-314(a) (1999). Compare also Saskatchewan PPSA
§§ 24–5.
36
Ibid., 9-309(11). 9-106(b)(1) provides that ‘a secured party has control of
a commodity contract if the secured party is the commodity intermediary with
which the commodity contract is carried’.
37
LEO MELAMED, ON THE MARKETS, TWENTY YEARS OF FINANCIAL
HISTORY AS SEEN BY THE MAN WHO REVOLUTIONIZED THE MARKETS 112 (JOHN
WILEY & SONS, INC., US, 1993).
38
PETER G. ZHANG, BARINGS INSOLVENCY AND FINANCIAL DERIVATIVES 52
(WORLD SCIENTIFIC PUBLISHING CO. PTE. LTD., SINGAPORE, 1995).
Commodity transfers, finality and security interests
215
securities margin is an extension of credit corresponding to the proportion of the purchase price of a security. Securities margin conveys to the
customer a right to the security – a property right – while a futures
margin represents only a promise to acquire an asset in the future – a
contractual right.39 Since the securities margin is a down payment and the
outstanding balance is an extension of credit by the intermediary the
customer pays interest on the amount owed. In contrast the futures
margin is not a down payment and the intermediary does not extend
credit for the remaining portion.40 Because commodity intermediaries do
not extend margin loans to their customers they do not take purchase
money security interests in their customers’ commodity contracts.
Margins in commodity markets are significantly lower than those
required in securities markets because they neither reflect a proportion of
the purchase price nor are they considered extensions of credit.41
Typically, on US commodity exchanges margins range from 2 percent to
15 percent of the value of the commodity contract but the intermediary
may demand a higher margin.42 In Slovakia the required minimum
margin is 2 percent of the value of the commodity contract.43 Commodity
margins are assessed on a daily basis and must be paid before the
opening of the next trading day.
A security interest in commodity contracts and commodity accounts
may also be taken by a third party. However, automatic perfection is not
available to non-intermediary creditors. Pursuant to UCC 9 a creditor
may perfect its security interest in an exchange-traded commodity
contract and/or a commodities account by having the intermediary, the
debtor and itself execute a control agreement.44 The control agreement
will obligate the commodity intermediary to follow instructions of the
creditor regarding the application of any value distributed on account of
Ray L. Ross, Financial Consequences of Trading Commodity Futures
Contracts, 15(2) ILL. AGRI. ECON. 27 (1975).
40
In fact, commodity intermediaries (e.g., CME clearing members) are
prohibited from providing loans to their customers to cover margin calls. CME
Rulebook § 930.G. Equally, the clearinghouse is typically prohibited from
providing any financing to the clearing members to cover their margin requirements. See Argentina Clearing Rulebook (available at http://www.
argentinaclearing.com.ar/English/legal_members/files.aspx) § 5.1.4.
41
Futures margins may be compared to money held in escrow by a realtor on
the sale of real estate. Ross, supra note 39, at 27.
42
REFCO PRIVATE CLIENT GROUP, supra note 6, at 7.
43
Rules of the Commodity Exchange Bratislava, supra note 6, at Annex 8,
§ 3.
44
UCC 9-106(b)(2) (1999) and Saskatchewan PPSA § 2(1)(1.1.c).
39
216
The law of securities, commodities and bank accounts
the collateral without further consent of the debtor. In a typical control
agreement the commodity intermediary confirms that it will maintain a
commodity account ‘number 123’ for the customer and covenants not to
change the name or the account number without prior consent of the
creditor. The intermediary also regularly covenants not to enter into other
control agreements without the creditor’s consent.
The control agreement will typically permit the commodity account
holder to perform additional transactions with the encumbered commodity account. The trading authority thus remains with the commodity
account holder while the creditor acquires the power to dispose (management rights) of the encumbered property. Upon concluding a control
agreement the commodity intermediary will assume the duty to comply
with all instructions received from the creditor to liquidate any commodity contracts without further consent of the account holder. Typically, the
creditor will exercise its management rights with respect to the commodity collateral only when the debtor defaults. If the creditor has taken
control over all commodity contracts held in the commodity account it
will be deemed to be perfected with respect to the entire commodity
account.45 In US practice, creditors take security interests over the entire
commodity account rather than over individual commodity contracts
credited to such account.46
As demonstrated in the preceding two Parts, some jurisdictions have
traditionally refused to recognize perfection of a security interest via a
control agreement. The criticism of control agreements and the concept
of control in general mentioned in the context of securities accounts
apply equally to commodity accounts. Control agreements permit the
debtor to deal with the collateral until the creditor decides to exercise its
control rights. In some jurisdictions with unreformed secured transactions
laws, this division of rights between the debtor and creditor may be
inconsistent with the requirement that the debtor be stripped of all indicia
of ownership, possession and control over the collateral.
Perfection by Filing
Filing is the other perfection mechanism that is utilized by creditors to
perfect their security interests in account-based rights. Many jurisdictions
expressly allow filing for security interests in account-based securities
and, by default in absence of rules to the contrary, also with respect to
45
46
UCC 9-106(c) (1999).
Official Comment 6 to UCC 9-102 (1999).
Commodity transfers, finality and security interests
217
deposit accounts. While many secured transactions laws and special laws
provide for the perfection of security interests in account-based securities
and funds credited to bank accounts, this is less common for commodity
contracts and accounts.
The UNCITRAL Legislative Guide recommends that security interests
in commodity contracts and accounts be excluded from the scope of
general secured transactions laws. If a jurisdiction implements this
recommendation and has not otherwise regulated such security interests
there will be a legal vacuum that may prevent creditors from utilizing
commodity contracts and accounts as collateral. A contrary interpretation
may lead to the conclusion that what is not expressly excluded falls under
the scope of secured transactions laws. In these laws, such as those
adopted in Colombia, Slovakia, etc., a security interest may arguably be
created and perfected by complying with the rules for security interests in
accounts receivable, monetary or non-monetary claims. Perfection of
such security interests would require filing in the registry of security
interests. Filing is also an alternative perfection mechanism for security
interests in securities accounts and, in some jurisdictions, deposit
accounts.
UCC 9 has adopted a different approach and included specific rules on
the perfection of security interests in investment property, including
commodity contracts and accounts. Under UCC 9, perfection may be
accomplished by both control and filing. However, the priority rules
subordinate a security interest perfected by filing to a security interest
perfected by control, irrespective of their respective time of perfection.47
Control is thus the superior perfection mechanism that overrides even the
traditional first-in-time, first-in-right rule and primes an earlier security
interest perfected by filing. A similar priority rule also applies to security
interests in account-based securities.
47
UCC 9-328(1) (1999) and Saskatchewan PPSA § 35(2).
12. Summary of Part III
Commodity contracts, commodity accounts and commodity exchanges
have become important risk management tools. They are integrated
within the business and legal infrastructure of a number of economies
that have recognized the value of commodity markets and their positive
influence on economic development. However, the contribution of
commodity markets to economic growth is frequently underestimated and
occasionally even altogether ignored. Although commercial entities
should benefit from the presence of commodity markets by having access
to a mechanism that enables them to effectively manage their risks,
critics often blame commodity markets for price increases and throw
them into the same category as gambling and betting. This criticism is
driven by the misunderstanding of the nature of risks involved in
commercial activity.
Stakeholders in developing countries should become familiar with the
functions of organized commodity markets in order to assess whether
their establishment would support economic growth. Understandably, this
area of commercial activity and law is not as noticeable as securities
markets and payment systems. However, just as companies utilize
securities markets to raise capital by issuing shares and bonds, commodity markets provide similar opportunities to hedge against risks and
reduce the cost of capital. Commercial risks inherent in commercial
activities became valuable and highly liquid assets. These risks were
packaged into commodity contracts and began to be traded on organized
commodity markets.
Organization of efficient commodity markets requires understanding of
the rights conveyed by commodity contracts. Unlike the traditional sale
contracts with deferred delivery that are consummated by actual transfer
of possession of the commodity, exchange-traded commodity contracts
do not convey any property rights to the underlying commodity. They
exist independently of property rights in actual commodities and they
reside in accounts held by commodity intermediaries. Commodity contracts consist of an exchange of executory promises. Customarily parties
to such contracts neither perform their obligations by delivery of the
actual commodity nor transfer any property rights.
218
Summary of Part III
219
Such contractual promises have been standardized and are now commonly traded on commodity exchanges. It is important to distinguish
between, on the one hand standardized exchange-traded commodity
contracts, such as futures and options and, on the other hand, commodity
contracts that are individualized and executed in OTC markets. Only the
former should be made subject to special commodity laws. Regulation of
the latter should be left to private agreements and contract law. However,
the legislator should tread carefully so as not to exempt too many
contracts or include those that should be excluded from commodity laws.
The scope of commodity laws must remain flexible so as to include new
commodity contracts and related instruments that frequently emerge from
the industry practice.
Commodity markets may be established to trade rights to future
delivery of a variety of commodities and financial assets. Commodity
markets originated as venues for exchanges and holding of rights to
delivery of agricultural commodities. Due to de-regulation of various
financial instruments (e.g., trading in currencies), commodity markets in
financial assets have become the dominant force. Many commodity
markets recently established in developing countries (e.g., Mexico)
provide for futures and options contracts on financial assets, such as
currencies and securities. The scope of commodity laws and the type of
assets subject to centralized commodity trading significantly impacts the
back-end infrastructure and particularly the tools necessary to complete
settlement.
The structure of organized commodity markets is largely uniform, with
US exchanges and clearinghouses serving as the model for many
systems. The critical component of every trading, as well as the holding,
system for commodity contracts is the clearinghouse. The commodity
clearinghouse performs functions similar to the clearinghouse in a
securities settlement system. They both reduce the counterparty risks and
facilitate the settlement of transactions.
Unlike in the case of payment and securities settlement systems every
commodity contract is subject to mandatory clearing at the clearinghouse. The clearinghouse becomes the central counterparty to all
exchange-traded commodity contracts. As a result, it must be wellcapitalized and regulated. In practice, established and reputable clearinghouses provide clearing functions for multiple commodity markets.
Although the clearinghouse is the central counterparty to every commodity contract, it does not deal directly with individual commodity account
holders. Only authorized clearing intermediaries have access to the
clearinghouse. Such clearing members clear their own, as well as their
customers’, commodity contracts.
220
The law of securities, commodities and bank accounts
Since the rights of commodity account holders are of a contractual
nature, certain mechanisms must be provided to assure their protection. It
was demonstrated in the previous Part that the rights of bank account
holders against their banks are similarly contractual and that the main
tool to protect bank account holders is mandatory insurance. Rights of
securities accounts holders are protected by property law as well as
mandatory insurance. Insurance protection has not been provided for
commodity account holders. The only protection of the rights of
commodity account holders is strict segregation of their commodity
contracts from the contracts entered into by the intermediary for its own
account. However, whether this protection is adequate and whether some
form of insurance should be mandated is being questioned in the
aftermath of insolvencies of major commodity intermediaries.
Commodity contracts and markets deal only with executory contractual
promises. The vast majority of these promises are settled by offset.
Participants in commodity markets acquire offsetting contracts and settle
their obligations by the payment of differences. For such settlement to be
successfully accomplished, adequate and efficient connections with the
payment system must be provided. Many commodity exchanges trade
contracts to delivery of securities. A proper mechanism for potential
delivery of securities must also be provided. In the case of security
futures, all three types of commercial systems for bank, commodity and
securities accounts interact. The security futures contract is held in a
commodity account and when the holder elects to exercise the right to
take delivery, the security will be transferred between securities accounts
in exchange for payment by credits and debits to bank accounts. For
agricultural commodities and metals, exchanges must maintain adequate
storage facilities that warehouse products ready for delivery under
commodity contracts.
Commodity contracts have become an important factor that affects the
decision of creditors to provide credit. From its marginal role, the
commodity contract developed into valuable collateral. Lenders routinely
discount the actual market value of the collateral to account for the
potential risks in price fluctuations. If this risk is eliminated the creditor
may safely rely on the actual collateral value of the commodity.
Commodity contracts effectively eliminate this risk and allow borrowers
to access credit on more reasonable terms. Legislators should take note of
the growing role of commodity contracts and provide for legal rules that
would allow creditors to take security interests in commodity contracts
and accounts at a reasonable cost. Control mechanisms that are increasingly used in the securities industry for perfecting security interests in
account-based securities are easily adaptable to security interests in
Summary of Part III
221
commodity rights held in accounts. Furthermore, an easily accessible
registration system should also be established for the perfection of
security interests, not only in commodity property, but in any personal
property.
Globalization of economies and dematerialization of trading in
commodity contracts, and their holding in commodity accounts, broadened access for foreign investors. Even though cross-border transactions
with commodity contracts do not pose challenges as serious as those of
the cross-border holding of securities, international cooperation on a
regulatory level may be desired. Regulators in different countries already
cooperate on more general informational and oversight levels. Further
cooperation, particularly with respect to the effort to harmonize rules on
the perfection of security interests in commodity contracts and accounts,
has the potential to broaden access to credit. Commodity exchanges may
not function properly without adequate back-end functions. Robust
trading activity requires modern hardware and software for holding and
liquidating commodity contracts held in accounts. The main objective of
this Part was to examine these back-end processes and highlight the
necessary components of a modern organized commodity market.
Conclusion
This book attempted to explore and analyse the fundamental features and
legal aspects of an emerging trend in commercial practice, which is the
holding of assets in accounts with intermediaries. Such holding is a
relatively new structural and legal phenomenon based on principles
developed over the millennia. In the last couple of decades, the holding
systems for rights to securities, funds and commodity contracts have
become not only integrated within the commercial marketplace but have
also overshadowed many other traditional areas of commercial law. Local
and international legislators no longer attempt to modernize the law of
negotiable instruments, payments by check, deposits, bailments or paperbased documents of title;1 instead their focus is gradually shifting to the
law of account relationships.2
Traces of the emerging law of account relationships may be found in
international instruments drafted by UNCITRAL, UNIDROIT and other
international organizations. Reforms in other areas of commercial law
inevitably touch on some aspects of accounts relationships, whether they
be the reforms of secured transactions laws and their regulation of
security interests in account-based rights or the reforms of insolvency
laws and their protection of the rights of account holders in the case of an
insolvency of the intermediary. Account-based rights have come to play a
significant role in commercial transactions. Hence there is a need for
examination of account-based systems, their functions and fundamental
features in order to craft efficient rules that no longer rely on traditional
concepts such as transfer by negotiation.
The primary function of account-based systems is to facilitate clearing
and transfers of executed transactions. Clearing, transfers, delivery and
settlement are all back-end functions that result from a trade. Once an
1
Some experts have even called for the abolishment of the law on
negotiable instruments. See JAMES STEVEN ROGERS, THE END OF NEGOTIABLE
INSTRUMENTS, BRINGING PAYMENT SYSTEMS LAW OUT OF THE PAST xvii
(OXFORD UNIVERSITY PRESS, NEW YORK, NY, 2012).
2
‘In modern economies, the financial infrastructure rests largely on intermediaries …’ José M. Garrido, The Loss-sharing Rule in the Insolvency of
Financial Intermediaries, 15(3-4) UNIF. L. REV. 779 (2010).
222
Conclusion
223
agreement to purchase a security or acquire a commodity contract for
payment of a certain sum is reached, the financial asset (a security or a
commodity contract) must be transferred to the buyer and payment
provided to the seller. The agreement between the seller and buyer is a
front-end function that is in the nature of a transaction. The transfer of
assets in exchange for funds is in the nature of a relationship that
involves intermediaries holding accounts for the seller and the buyer.
This book examined only the back-end features and components that are
embedded in accounts relationships between investors and their intermediaries.
Accounts systems for the holding of securities, funds and commodity
contracts have many common features but also differ in a number of
aspects. While bank accounts holding systems have already been established in all jurisdictions, developing countries only recently began
implementing new legal and technological structures for securities
accounts systems. However, commodity accounts systems are still absent
in many jurisdictions. Successful implementation and functioning of
accounts systems requires that local stakeholders understand the differences and various functions performed by each of the three individual
accounts systems. This book sought to highlight those functions and
features, contrast them in the jurisdictions that have already established
such systems and compare the three individual accounts systems with
one another. The objective of the author was not to criticize, evaluate or
recommend which system to adopt in particular jurisdictions, because
there is no uniform one-size model that fits all requirements and local
conditions. The objective instead was to analyse the existing systems,
explain their individual components and suggest the basis for appropriate
legal regulation. Exposure to and understanding of the contemporary
accounts holding systems should facilitate modernization and possible
harmonization of commercial laws, including those that govern the
accounts holding systems. Although securities, bank and commodity
accounts systems are regulated in different laws, they all address a set of
common features and characteristics. The similarities outnumber differences and in the future could potentially lead to adoption of a law or
code of commercial accounts.
In the design, development and implementation of a system for the
holding of assets in accounts with intermediaries, the features listed
below should be adequately reflected. It is expected that in the near
future the majority of jurisdictions will have implemented accounts
systems for securities, funds and commodity contracts. This area of
commercial practice is evolving fast and new products, procedures and
mechanisms are constantly introduced. The law governing accounts
224
The law of securities, commodities and bank accounts
systems should be flexible enough to anticipate future developments and
support innovation of both the hardware and software.
FEATURE 1: RIGHTS TO SECURITIES, FUNDS AND
COMMODITY CONTRACTS ARE INTANGIBLE
Each of the three Parts included a section in the Introduction on the
evolution of the particular type of asset and the relationships involved. It
has been demonstrated that possession and ownership of tangible items,
such as security certificates, banknotes and warehouse receipts transformed into intangible rights embedded in accounts. Securities, money
and commodities no longer circulate in the marketplace exclusively as
tangible objects. They have been supplemented and, to a large extent,
already replaced with intangible claims and rights held in accounts
maintained by intermediaries.
For now the world of tangible securities, money and commodities
co-exist with that represented by intangible rights held in accounts. It
may be expected that in the future, securities and bank accounts will
become the only and exclusive vehicle for the holding of rights to
securities and funds. However, this cannot be the case of commodity
accounts that may never entirely replace tangible commodities. While
securities and bank accounts are the perfect substitute for security
certificates and money, commodity accounts and contracts supplement
actual commodities. Commodity accounts are the perfect substitute only
for the risk management function.
FEATURE 2: DIFFERENT LAWS APPLY TO TANGIBLE
AND INTANGIBLE ASSETS
It has been demonstrated in each Part that tangible objects and intangible
rights to securities, money and commodities are covered by different
legal rules. Part I distinguished between the direct holding systems, in
which the rights to securities may be embedded in a tangible object, such
as a bearer or certificated security, and intermediated holding systems, in
which the rights are entirely intangible because they are embedded in
securities accounts maintained by intermediaries. Part II distinguished
between legal money such as coins and banknotes, in which the rights are
derived from their possession, and bank money, in which intangible
rights are embedded in deposit accounts maintained by banks for their
customers. Finally, Part III distinguished between actual commodities,
Conclusion
225
such as corn, and intangible rights to delivery of such commodities
sometime in the future, which are held in commodity accounts.
The law should reflect this distinction between tangible objects and
intangible rights. On the one hand, legal rules applicable to directly held
securities, legal money and actual commodities are and should remain
based on absolute ownership, possession and other proprietary rights. On
the other hand, legal rules applicable to indirectly held securities, bank
money and commodity contracts held in accounts should be divorced
from the traditional property concepts of ownership and possession. In
the case of securities accounts, these rules should be based on special
proprietary concepts, such as security entitlement and indirect
co-ownership. For bank accounts that are contractual creditor-debtor
relationships, the law of contract should be sufficient. Finally, property
law is implicated in commodity contracts only when commodity accounts
holders decide to exercise their rights to make/take delivery, which
occurs rather infrequently under transactions executed at organized
commodity exchanges.
FEATURE 3: ACCOUNTS HOLDING SYSTEMS
CONTRIBUTE TO ECONOMIC DEVELOPMENT AND
INCREASE LIQUIDITY
All three accounts holding systems support critical functions of economies without which commercial and financial transactions could not be
efficiently completed. Securities markets provide a forum for corporations, banks, governments, utilities and other issuers to raise capital.
Without proper and efficient systems for the holding and transferring of
securities, access to capital facilitated through securities markets would
be significantly hampered.3 Commodity markets provide a forum for
merchants, agricultural producers, banks and other investors to effectively
manage commercial risks. Without these hedging mechanisms, the risks
inherent in commercial activities would have to be borne by the involved
parties. Absence of such hedging tools increases operational costs and
impedes the ability of businesses and economies to grow. As in securities
markets, commodity markets could not function properly without a
See AUGUSTO DE LA TORRE & SERGIO L. SCHMUCKLER, EMERGING
CAPITAL MARKETS AND GLOBALIZATION, THE LATIN AMERICAN EXPERIENCE 2
(STANFORD UNIVERSITY PRESS, PALO ALTO, CA, 2007).
3
226
The law of securities, commodities and bank accounts
modern and efficient system for the holding and transferring of commodity contracts through commodity accounts. Finally, the contribution of
payment and bank accounts holding systems is the most evident. Practically no commercial transaction, save for barter, could be completed
without an efficient payment system. Commercial activity would be
considerably impeded if businesses could not satisfy their obligations to
pay easily by instructing their banks to transfer funds to sellers and
providers of services.
Most transactions with securities, funds and commodity contracts
involve the element of time that may render them speculative.4 Investors
buy bonds maturing in years, enter into commodity contracts that convey
the right to delivery of a commodity in months and undertake to pay for
financial assets and other products sometime in the future. However, the
speculative element of these systems is outweighed by their contribution
to economic development. Former US President Theodore Roosevelt
highlighted the positive impact of these systems back in 1934 in the
aftermath of the Great Depression, when he said: ‘it is my belief that
exchanges for dealing in securities and commodities are necessary and of
definite value to our commercial and agricultural life’.5
Effective management of risks stimulates economic growth; however,
only sufficiently liquid markets may achieve effective risk management.
Securities or commodity markets with very few participants and transactions do not allow businesses to raise funds and hedge their risks. Such
markets distort market prices because the fewer investors that participate
in a market, the more market prices experience severe fluctuations. These
markets are unpredictable and unreliable. For those markets to attract
more investors, a particular organizational and legal infrastructure, identified in the following features, is needed.
FEATURE 4: CLEARINGHOUSES SUPPORT MODERN
ACCOUNTS HOLDING SYSTEMS
Central entities at the top of accounts holding structures provide a
number of critical services that include: the administrative comparison of
Abbott Payson Usher, The Technique of Medieval and Modern Produce
Markets, 23(4) J. POL. ECON. 365, 367 (1915).
5
President Roosevelt’s Message to Congress, 78 Cong. Rec. 2264 (1934).
See also John V. Rainbolt II, Symposium on Commodity Futures Regulation,
Regulating the Grain Gambler and his Successors, 6 HOFSTRA L. REV. 1, 9
(1977).
4
Conclusion
227
trade details, the act of becoming the counterparty to every contract, the
netting of outstanding obligations and settlement.6 Central entities ensure
that systems for the holding and transfers of securities, funds and
commodity contracts operate smoothly and that they effectively manage
and distribute risks. Bernanke assimilated the clearinghouse to a bank
because they both facilitate trading and transfer procedures.7
The functions of central entities differ in the three accounts holding
systems. A clearinghouse as such does not exist in RTGS systems for
payments. Instead operators of such systems ensure that transfers of
funds are completed almost instantaneously by credits and debits to the
participants’ bank accounts but they neither compare any trade details nor
become counterparties to any funds transfers. Clearing functions are
performed only in those payment systems that are based on the net
settlement model.
In contrast, central entities in securities and commodity accounts
holding structures perform additional functions. In securities accounts
holding systems, the clearinghouse may calculate/net individual transfers
of securities or become the central counterparty to every transfer. As a
central counterparty the clearinghouse minimizes the risk of default in
delivering securities/commodity contracts against funds. Not all securities
markets are supported by a clearinghouse that provides central counterparty services. Particularly in developing countries, the clearinghouse
provides only the administrative functions of comparing transfer details,
aggregating individual transfer obligations and netting out mutual obligations to deliver. Commodity markets have, for over a century, relied on
clearinghouses to provide central counterparty services.
6
Bernanke classified the functions of clearinghouses into two categories: 1)
operational that involves trade entry, trade matching and trade clearance and 2)
financial that involves the reduction of risk, establishment of capital requirements, collection of margins and provision of guarantees in case of failure of a
clearing member. Ben S. Bernanke, Clearing and Settlement during the Crash,
National Bureau of Economic Research Conference: Stock Market Volatility and
the Crash, Dorado Beach (16–18 March 1989) in 3(1) REV. FIN. STUD., 1990, at
135–6.
7
Bernanke provided an analogy to the function of a bank that in the check
collection process must identify the parties to the transaction and then debit/
credit the corresponding accounts. The clearinghouse engages in a similar
activity where it identifies the transaction and records debits and credits. Ibid., at
140.
228
The law of securities, commodities and bank accounts
FEATURE 5: RELATIONSHIPS THAT CONSTITUTE
ACCOUNTS SYSTEMS ARE STRUCTURED IN TIERS
Accounts holding systems are organized as pyramids with multiple layers
of relationships. Participation at a particular level of the pyramid may be
restricted only to certain entities. For instance, only authorized intermediaries may access central entities. Restrictions on access are imposed
to protect the integrity of the holding and transfer systems.8 Clearinghouses, CSDs and operators of LVFTSs deal only directly with wellcapitalized and regulated entities (intermediaries). Furthermore,
arrangements they enter into with participating intermediaries are regularly collateralized and guaranteed. Those intermediaries that do not have
direct access to central entities must enter into a clearing agreement with
one of the participating intermediaries. Accordingly, three levels of
relationships may exist in a holding system:
1)
2)
3)
between the central entity and participating intermediaries;
between the participating intermediary and non-participating intermediaries and other customers; and
between the non-participating intermediary and its customers.
FEATURE 6: ACCOUNT RELATIONSHIPS ARE
INDEPENDENT
Rights of account holders do not relate to any underlying tangible assets.
Accordingly, the account holder may not claim a particular security, a
banknote or a bag of corn stored in a warehouse as belonging to him.
These intangible rights are appropriated to a specific asset only when the
securities account holder requests the intermediary to replace a book
entry with a security certificate, a bank account holder withdraws cash or
the commodity account holder settles his futures contract by acquiring a
warehouse receipt. However, none of these account holders may assert
claims and enforce their account-based rights against other participants in
the holding chain. Rights of individual account holders are enforceable
solely against their intermediaries, that is to say, the entities that they
have an account relationship with.
8
DERMOT TURING, CLEARING AND SETTLEMENT IN EUROPE 344 (BLOOMSBURY PROFESSIONAL LTD., HAYWARDS HEATH, UK, 2012).
Conclusion
229
Securities accounts holders may enforce their rights only against the
intermediary that maintains the relevant account and, in the case of
transparent systems, also against the CSD which is the top-level intermediary. However, they may not claim that securities held by other
intermediaries for their own customers belong to them and sue such
intermediaries and their account holders. Similarly, bank account holders
may not enforce their rights to funds against banks that do not maintain
deposit accounts for them or against the operator of a LVFTS. Likewise,
commodity account holders may not enforce their rights against entities
other than their own intermediary. Such holders may not sue other
commodity account holders or their intermediaries for non-performance.
Such isolation of individual account relationships is an effective risk
management tool that minimizes the systemic risk. If an intermediary
becomes insolvent, its account holders should not be able to assert claims
against other participants in the holding chain and potentially cause their
failure. The risk should be contained within the relevant account relationship and losses borne equally (pro-rata) among the account holders.
FEATURE 7: TRANSFERS REQUIRE EFFECTIVE AND
LEGALLY BINDING SETTLEMENT MECHANISMS
Settlement follows clearing and involves the actual transfer of assets. As
a result of settlement account holders acquire some assets in exchange
for funds. Only once the transfer has been completed does the transferee
acquire rights to securities, funds or commodity contracts. Settlement of
transactions with securities and funds differs from the settlement of
transactions with commodity contracts. Unlike the settlement of securities transactions and payment obligations that actually involve transfers
of assets, the settlement of commodity contracts does not result in a
transfer of the underlying commodity from one party to another.9 Instead
it is regularly completed by offset in which one contract position cancels
out another.
Accounts holding systems should be supported by modern and efficient
infrastructure (the ‘hardware’) for the settlement of transactions. Such a
settlement system does not rely on manual delivery of tangible assets but
instead on electronic entries made by intermediaries to the accounts of
their customers. Settlement systems providing support to securities, bank
Robert R. Bliss & Robert S. Steigerwald, Derivatives Clearing and
Settlement: A Comparison of Central Counterparties and Alternative Structures,
4Q ECON. PERSP. 22, 23 (2006).
9
230
The law of securities, commodities and bank accounts
and commodity accounts holding systems must be properly aligned to
facilitate and allow for seamless transfers of securities against cash as
well as offsets of commodity contracts against funds. Legal rules (the
‘software’) must ensure that settlement mechanisms effectively and
irrevocably transfer rights to securities, funds and commodity contracts.
FEATURE 8: BOOK ENTRIES TO ACCOUNTS
EFFECTUATE TRANSFERS OF RIGHTS BY NOVATION
Transfers of account-based rights are completed by credits and debits
made by intermediaries to the accounts of their customers. Electronic
entries have effectively replaced other traditional forms of transfer, such
as the physical delivery of an object. Transferors and transferees no
longer complete transfers directly between themselves but they instruct
their intermediaries to deliver and receive rights on their behalf. This
operational transformation of the form of transfer from manual to
electronic also changed the legal nature of such transfers. The reduction
(debit) and the resulting increase (credit) in two different account
balances are characterized in law as novation.10
Rights do not get transferred between accounts by assignment or
negotiation. For any rights to be assigned, a claim of the transferor must
pass to the transferee. This is not the case of transfers between accounts.
A transferee of securities or funds acquires rights that are different from
the rights of the transferor because the transferor’s rights are enforceable
only against his intermediary. For any rights to be negotiated, a writing
that reifies the underlying rights must be passed from hand to hand. In
this respect, Sommer observed:
Negotiable instruments are similar to accounts, except that rights exist by
virtue of possession of an authentic physical instrument, rather than being an
account holder. The necessary communication is embedded in a unique piece
of paper. But thanks to computers, we are generally shifting from negotiable
instruments and other physical tokens to account-based systems of holding
and transferring rights … These account-based systems all rely on authenticated messages to establish rights, and authenticated records to evidence the
rights established by the messages.11
10
PHILIP R. WOOD, SET-OFF AND NETTING, DERIVATIVES, CLEARING SYSTEMS 270 (2nd edn., SWEET & MAXWELL LTD., LONDON, UK, 2007).
11
Joseph H. Sommer, International Securities Holding and Transfer Law, 18
ARIZ. J. INT’L & COMP. L. 685, 697 (2001).
Conclusion
231
What negotiation achieves for transfers of abstract rights, demolishing
the history of the rights, novation achieves for the transfer of accountbased rights. Both protect the transferee from the defenses and claims
assertable against the transferor.
FEATURE 9: BOOK ENTRIES ESTABLISH THE
FINALITY OF TRANSFER
One of the most critical aspects of account-based transfers is the finality
of transfer. Transferees must be assured that the rights they acquire are
irrevocable and that transferors may not later unwind the entire chain of
transfers. However, finality is not as important a feature in commodity
accounts holding systems as it is in the systems for the holding and
transfer of securities and funds. Transfers of commodity contracts are
typically accomplished by offsets that cause the commodity contract to
be extinguished rather than passed from the transferor to the transferee.
In other words, a commodity contract initially acquired and credited to a
commodity account of a customer may not be later transferred by debit
and credit to an account of another customer. This sequence of transfers
is typical for securities and bank accounts systems.
In a funds or securities transfer, balances of accounts holders are
adjusted respectively by their intermediaries. Crediting the transferee’s
account typically establishes the finality of transfer. Unlike provisional
entries in the check collection system, credits transferring securities,
funds and commodity contracts should be final. This finality system
should be supplemented by effective remedies for erroneous and fraudulent transfers. However, such remedies should be enforced only outside
the accounts holding system and not reverse any already executed entries.
FEATURE 10: SECURITY INTERESTS IN
COMMERCIAL ACCOUNTS AND THE RIGHTS HELD
IN SUCH ACCOUNTS
Account-based rights are highly liquid and their value may be easily
established. These characteristics make them attractive collateral for
lenders who may easily dispose of them in the case of a borrower’s
default. Yet many secured transactions laws provide inadequate mechanisms for the taking and perfecting of security interests in account-based
rights and accounts held by intermediaries. Some countries have already
232
The law of securities, commodities and bank accounts
enacted legal rules to facilitate collateralization of loans with accountbased securities. However, only very few provide similar rules for funds
held in bank accounts and only a handful extend their scope to commodity contracts and commodity accounts. As a result of the inadequate
regulation, or complete absence thereof, lenders must be creative in
properly structuring loans secured with the account-type of collateral.
Secured transactions laws should embrace the notion of control for the
perfection of security interests in rights held in securities, bank and
commodity accounts. Control must be flexible and in effect convey to the
creditor ‘management rights’ that may be exercised either pre- or
post-default. Control should not transfer securities, funds or commodity
contracts absolutely to the creditor, as is characteristic for the possessory
pledge. As with most other types of collateral, such as inventory and
receivables, the borrower should be able to deal with it and re-use it in
his business. While registration enables perfection of non-possessory
security interests in inventory, receivables, equipment and other types of
collateral, control achieves perfection for ‘non-possessory’ security interests in account-based rights. Publicity of security interests perfected by
control is, at times, questioned on the basis of insufficient public notice.
This concern may be ameliorated by the duty of intermediaries to provide
information to third parties through the debtor about the nature of the
arrangement. Creditors and bailees in possession of the collateral are
subject to a similar duty to disclose relevant information.
Index
account
omnibus 64–65, 189
operators 42, 66, 70–71
pledge 79, 144, 190
agricultural commodities 164–165, 170,
173–178, 203, 206, 219–20
bank account
holder 7, 13, 40, 102, 124, 143, 154,
198–99, 203, 220, 228–9
and relationships 11, 92, 94, 101, 111,
113–32, 153–4, 156
bank money 88, 97, 99–102, 111–12,
124, 131, 153, 224–5
Bernanke, Ben 9, 17–18, 88, 227
Bolsa Mexicana de Valores (BMV) 28
Brazilian Clearing and Depository
Corporation (CBLC) 28, 37, 53
Brazilian Mercantile and Futures
Exchange (BM&F) 28
central counterparty (CCP) 10, 49–54,
103, 191–3, 219, 227
see also clearing and central
counterparty
Central de Depósito de Valores
(CEDEVAL) 29, 47–9, 53, 66, 80
Central de Valores (CEVAL) 29, 37, 39
central payment system 90, 114–17,
133, 141–2, 154, 194
central securities depository (CSD) 6,
26–9, 36–42, 46–9, 53–6, 59–71,
75, 80–81, 115, 165, 172, 194,
228–9
Chicago Board Options Exchange
(CBOE) 181
Chicago Board of Trade (CBOT) 162–4,
169–70, 192
Chicago Mercantile Exchange (CME)
2–3, 159, 164, 177–179, 190, 192,
199, 201, 207
and Rulebook 177, 187, 190, 193,
207
clearing
and central counterparty clearing
50–54, 103, 191–2
and clearinghouse clearing
49–50
and settlement systems 9, 82, 187,
219, 229
clearinghouse 6–9, 50, 66, 154, 165,
170, 181–2, 185–96, 198, 202,
204–208, 219, 226–8
Clearing House Inter-Bank Payments
System (CHIPS) 102, 107–8,
113–15, 138, 143
Clearstream 27, 38, 40, 54–5, 61–2
commodity
accounts 3–8, 13, 15–17, 89, 159–
163, 165, 169, 171–3, 176, 180,
182–3, 186–203, 205, 209–16,
218–232
clearinghouse 7, 187–8, 191–194,
219
contracts 1–16, 87, 153, 159–66,
169–85, 188–91, 193–9, 202–3,
205–32
exchanges 1, 6, 159, 162–5, 168,
170–73, 177–9, 185–6, 190, 192,
196, 199, 202, 204, 206–8, 213,
215, 218–21, 225
intermediary 13, 194–5, 200, 209,
214–6
intermediary and insurance fund
198–9
laws 173, 181, 183–4, 219
233
234
The law of securities, commodities and bank accounts
market 159–65, 168–80, 191,
194–96, 203–204, 206, 215,
218–21, 225–7
trading 196, 219
Commodity Futures Trading
Commission (CFTC) 194, 198
control 73–9, 83, 115, 147–52, 156,
160, 175, 179, 212–17, 220, 232
and agreement 74, 76–9, 148–50,
152, 215–16
see also perfection
co-ownership 12, 32, 57, 61–5, 82, 154,
225
delivery versus payment (DVP) 24, 55,
82
dematerialization
and commodities 171–2, 221
and money 99–100
and securities 24, 33–5, 73
deposit
and irregular 11, 32, 93–5, 97, 112,
119–120, 122–3, 145, 155
and regular 11, 93, 112, 119–23, 155
Depository Trust Company (DTC) 2,
27, 37–8, 48, 52–5, 60
Depository Trust & Clearing
Corporation (DTCC) 38, 53
document of title 167
see also warehouse receipt
EU Financial Collateral Directive 44,
77, 80, 145–6, 148, 152, 212
EU Regulation 648/2012 50, 186, 188
EU Settlement Finality Directive 114,
138, 141
Eurex 164, 192
and Clearing AG 187–9, 192–3
European Central Bank (ECB) 8, 52,
108, 110, 114, 171
European Central Counterparty Limited
(EuroCCP) 53
Rules (EuroCCP Rules) 14, 66
fairs of Champagne 97, 166
Fedwire 10, 90, 104, 107, 113, 116, 133,
143
financial assets 2, 43–5, 57, 60–1, 64–5,
82, 100, 137, 153, 164–5, 172–4,
179, 203, 211, 219, 226
financial instruments 45, 100, 170, 179,
206, 212, 219
financing statement 80, 148
finality 70–72, 83, 104, 106–7, 131,
136–43, 155, 209, 231
of order 89, 114, 126, 129, 131,
137–43, 155, 208
rules 15, 83, 125, 138–9, 141–2, 155,
208
of transfer 15, 71–2, 83, 107, 137–9,
142–3, 155–6, 208–9, 231
forward contract 162–3, 183–5, 196,
212
futures
commission merchant 1, 199
see also commodity intermediary
contract 159–60, 162–3, 165,
169–70, 173, 175–6, 179–86,
189–92, 194, 196–9, 202–11,
214, 219–220, 228
exchange 6, 8, 159, 164, 171, 175,
177, 180–2, 185, 214
Geneva Securities Convention 23, 40,
42, 75, 77, 79, 84
German Banking Act 123
goldsmiths 5–6, 97–8, 109, 165
grading system 166, 168, 170–71, 176,
179
Hague Securities Convention 23
hedge-to-arrive (HTA) agreements 185
holding system
indirect 42–4, 46, 58, 64, 82, 102,
transparent 42, 65
immobilization 24, 33, 36, 39, 46, 100,
171
INDEVAL 28, 38, 45, 53, 64, 165
insurance 4, 13, 66–7, 174–5, 198–9,
220
Inter-American Development Bank
(IADB) 24
Index
International Monetary Fund (IMF)
28–9, 53, 102
International Organization of Securities
Commissions (IOSCO) 206
investment property 211–12, 217
large-value funds transfer systems
(LVFTS) 2, 7, 90, 101–105, 115,
117, 124–5, 153–4, 187, 191,
228–9
law of commercial accounts ix, 4, 17
lien 79
management rights 148, 156, 216, 232
margin 78, 163, 182, 184–5, 190, 199,
214–15
Mercado Mexicano de Derivados, S.A.
de C.V (MexDer) 165, 175, 182,
192
Mexican Securities Market Law 37, 45,
64
MiFID 44, 212
National Securities Clearing
Corporation (NSCC) 38, 52
negotiable instruments 87, 92, 97, 120,
122, 124–5, 134, 222, 230,
net settlement (NS) 90–91, 102, 106,
115, 227
netting 49–51, 53, 82, 103, 106, 154,
227
non-clearing members 188
novation 9, 14–5, 50–1, 69–70, 82–3,
134–5, 155–6, 193–4, 230–31
NewYork Stock Exchange (NYSE)
2–3, 21, 26–7, 38, 78
offset 87, 106, 120, 160, 171, 179,
184–5, 196–7, 202–9, 220, 229–31
see also set-off
options 182–3
Organization of American States (OAS)
147
Model Law 147, 151–2, 212
over-the-counter (OTC) 38, 161,
180–81, 183, 186, 204, 210,
212–3, 219
235
payment order 54, 68, 87, 89, 90, 95, 97,
99, 103–107, 115, 126–45, 154–6
Payment Services Directive (PSD) 114,
126
perfection
by control 73–9, 147–51, 212,
214–16
see also control
by filing and registration 79–80,
150–52, 216–17
of security interest 73, 83, 150–51,
216
pledge
possessory 74, 149, 232
account 79, 144, 190
privity 39, 46, 59–60, 131
pro-rata claims 13, 57, 61, 63–5, 123,
108, 229
real-time gross settlement (RTGS)
90–91, 102, 104–7, 115, 118–19,
143, 153–4, 156, 187, 227
repo 72–3
Rosario Futures Exchange (ROFEX)
164–5
Salvadoran Law on Electronic Entries
34–5, 37, 40, 63
secured transactions law 77, 144,
146–8, 150, 152, 156, 210,
212–13, 216–17, 222, 231–2
securities
directly-held 43
entitlement 79, 80, 84
holding system 9, 22, 25, 27–8, 31–2,
56, 81–2, 101, 154, 163, 165,
191, 200
intermediary 3, 44, 65, 141, 198
uncertificated 34–5, 43, 81
Securities Investor Protection
Corporation (SIPC) 67
segregation 4, 13, 65–6, 78, 200–201,
220
set-off 120, 144–6, 148, 150, 196, 203,
214
settlement account 54, 115–17, 142,
229
236
The law of securities, commodities and bank accounts
Sistema de Transferência de Fundos
(SITRAF) 91, 102–3
Sistema de Transferência de Reservas
(STR) 91
Sistema Especial de Liquidação e de
Custódia (SELIC) 37
Sistema Nacional de Pagos
Electrónicos (SINPE) 91, 117
Sistema de Pagos Electrónicos
Interbancarios (SPEI) 91
speculators 160–61, 169, 176, 179
spot contract 159, 162
swap 4, 180, 186, 213
SWIFT 103, 115
systemic risk 8, 25, 88, 229
Trans-European Automated Real-time
Gross Settlement Express Transfer
(Target2) 90, 104, 114, 118–19,
139
transfer of funds 54, 90, 130, 132, 136
tulipomania 168
UN Convention on the Assignment of
Receivables in International Trade
213
UNCITRAL Legislative Guide on
Secured Transactions 148–52,
213, 217
UNCITRAL Model Law on
International Credit Transfers 88,
128–9, 141
Uniform Commercial Code (UCC)
Article 4A (UCC 4A) 113–14, 119,
124–31, 135–8, 140–41
Article 7 (UCC 7) 65
Article 8 (UCC 8) 15, 22, 25, 35–6,
41, 43–4, 47, 58–9, 141
Article 9 (UCC 9) 78, 80, 146,
148–50, 152, 211–17
warehouse receipt 75, 160, 162–3, 167,
171, 177, 197, 198, 203, 207–8,
210, 214, 228
electronic 160