ECONS528: FINANCIAL MARKETS,
GOVERNANCE AND REGULATION
CHAPTER VII: THE SECURITIES
AND DERIVATIVES MARKETS
Pierre Francotte
2013-14
1
Reading
• Harris, Larry (2010), « The Economics of Trading and of
Regulated Exchanges » in « Regulated Exchanges: Dynamic
Agents of Economic Growth », Oxford University Press, New
York.
• Cantillon, Estelle & Yin, Pai-Ling (2010), « Competition
between Exchanges: A Research Agenda », in International
Journal of Industrial Organization, 29(3), May 2011, 329-336.
• CEPS (2011), MiFID 2.0, Casting New Lights on Europe’s
Capital Markets, Brussels.
• CPSS-IOSCO (2001), « Recommendations for Securities
Settlement Systems », CPSS Publ. N° 46 (November).
2
Reading
• CPSS-IOSCO (2011), « Principles for Financial Market
Infrastructures », consultative report (March).
• CPSS-IOSCO (2004), « Recommendations for Central
Counterparties », CPSS Publ. N° 64 (November).
• Gorham, Michael (2010), « The Long Promising Evolution of
Screen-based Trading », in « Regulated Exchanges: Dynamic
Agents of Economic Growth », Oxford University Press, New
York.
• Harris, Larry, editor, « Regulated Exchanges: Dynamic Agents
of Economic Growth », Oxford University Press, New York.
• Schwartz, Robert.A & Francioni, Reto (2004), Equity Markets
in Action, Wiley, Hoboken, New Jersey.
3
CONTENTS
Introduction
I. Holding and Transfer
II. Infrastructures
III. Regulation of Securities and Derivative
Markets
4
INTRODUCTION
• Different holding and trading structures for securities and
derivatives:
– Trading is done through separate channels (OTC and
exchanges)
• some exchanges offer both securities and derivatives trading, but
through separate channels/platforms
– Netting done through separate CCPs
• some CCPs offer netting for both assets, but again through separate
channels/platforms
– Settlement only for securities, not for derivatives:
• settlement for securities in CSDs
• settlement of derivative contracts typically through cash payment or
delivery of goods
• trade warehouses for derivatives, but only databases, not records of
ownership (unlike CSDs).
5
I. HOLDING AND TRANSFER
A. Holding and transfer of securities
B. Holding and transfer of derivatives
6
A. Holding of securities
• Securities holding through a « multi-tier » chain of
intermediaries connecting ultimately:
– end investors
– to the issuer of the securities.
• Ownership rights over securities preserved if proper
segregation from intermediaries’ own assets at each
level of holding.
– precise rights and conditions for ownership preservation
depend on applicable legal system,
– greater complexity when chain of intermediaries in
different countries (because different legal systems and
need to ascertain which court would apply which law).
7
Transfer of securities
• Transfers are:
– agreed through trading
– effected through settlement
– often, but not always, after netting.
• What is clearing?
– process –after trading- of calculation of the
respective obligations to pay and deliver the
securities
• it is often confused with netting or settlement (e.g.,
« clearing houses »), but
• separate step needed prior to netting or settlement,
normally effected by the netting or settlement institution.
8
Securities trading chain
TRADING
EXCHANGES
OTC
NETTING (NOT ALWAYS)
CCP
SETTLEMENT
CSDs
CUSTODIAN BANKS
9
Trading
• Trading is the agreement between the parties
to make a transaction (sale, pledge, etc).
• It requires agreement on all key elements:
– object: which (ISIN #) and how many securities
– price
– time: delivery date
• Key elements must be « matched »
(confirmation).
10
Netting
• Netting consists in transforming multiple
obligations between several parties in a single
debt or claim by party.
• Debts to counterparty are « novated » to
become new debts to CCP (new contracts
replacing old one).
• The debts to pay for/receive securities must be:
– certain (not subject to conditions)
– already due and payable (not with different future
time schedules)
– in same currency/ for same securities (ISIN #).
11
Examples of netting
• Example of bilateral netting through CCP:
– A owes 100 to B and B owes 300 to A
– Netting:
• B owes 200 to CCP, and
• CCP owes 200 to A
• Example of multilateral netting through CCP:
– A owes 100 to B, B owes 300 to C, C owes 500 to A
– Netting:
• A has claim of 400 on CCP
• B owes 200 to CCP
• C owes 200 to CCP
12
Netting vs trading/settlement
• Trading and settlement are required steps for
every transaction, whether on exchange or
OTC.
• Netting is not required, but:
– in last two decades, most equity markets have
set up CCPs (exception: Spain, but coming)
– bond transactions, including for government
bonds, and repos also netted in practice
– authorities are pushing for more transactions
(especially derivatives) to go through CCPs.
13
Settlement
• Settlement is the transfer of securities and, where
relevant, cash, to execute the trade obligations.
• Physical settlement extremely rare – done by
credits/debits in accounts with CSD or intermediary.
• Practice in most markets is settlement 3 days after
trading (T+3):
– Germany is T+2,
– EU pressing for shift to T+2 across EU to reduce market
risk and residual counterparty risk,
– some emerging markets are still on T+ 20 or 30 for some
securities.
14
Against payment or free of payment
• Most transactions involve the transfer of
securities in exchange for cash:
– examples: sales, securities lending, repos, pledges
– called « against payment » (A/P)
• Settlement of some transactions involves only
the transfer of securities with no cash involved:
– example: realignement from one account to another,
– called « free of payment » (FOP).
15
Delivery versus payment (DVP)
• A/P transactions typically link the finality of transfers
of securities and transfers of cash (DvP):
– party gets final receipt of the securities only if the other
party gets final receipt of the cash and vice versa.
– removes credit risk (counterparty risk):
• buyer gets the securities and seller gets the cash, as intended, or
• at worst, buyer keeps its money and seller keeps its securities,
but neither party is ever without both cash and securities.
• DVP is cornerstone of risk-controlled settlement:
– disconnected transfers of cash and securities highly
frowned upon by regulators and now very rare.
16
DVP vs transfer of ownership
• DVP (finality of transfers) is determined by rules
of CSD or intermediary settling transactions
– finality means the CSD/intermediary will not reverse
credits, even in case of default/bankruptcy.
• But transfer of ownership of securities is
separate matter and is determined by law:
– in some countries: ownership transferred at time of
agreement (trading)
– in other countries: ownership transferred at time of
execution of contract (settlement).
17
B. Holding of derivatives
• Derivatives are contracts, not negotiable
instruments:
– not held through chain of intermediaries
– copies of contracts and contract details kept by
each party.
18
Contract terms
• Derivatives contractual terms are generally a
combination of:
– a master agreement (e.g., ISDA master agreement)
which set the generic rules for all contracts
concluded pursuant to it,
• must be signed by both parties
– the specific terms of individual derivative
transactions (e.g., amount, price, etc):
• agreed over the phone or electronic platforms (for OTC
contracts) or through exchanges (on-exchange trading),
• must be later confirmed in writing (normally within a few
days).
19
Backlogs
• In practice, transactions are sometimes
conducted before master agreement is signed
and confirmation of contract specifics often
missing for several weeks or months.
• Backlog has represented a significant exposure
for individual banks and globally,
– led regulators, especially in US, to threaten to
prevent further activity by dealers that did not tackle
backlog quickly,
– prompted emergence of new services of data
warehouse (trade repository) and matching support
to help dealers reduce backlog on time.
20
Trade warehouses
• Databases offered by a third party:
– records major elements of contracts
– allows parties to identify and resolve mismatches.
• Main trade warehouses are DTCC
(« DerivServe »), but so far mainly for CDS
contracts, and Tri-Optima for interest rates
• other provider: Euroclear
• competing solutions being developed by derivatives
exchanges because of strategic and financial value of data
(e.g., CME).
• EU would like development of a European solution
(concern about the exclusive US regulatory oversight).
21
Trading and netting of derivatives
• Derivatives can be traded OTC or on exchange:
– 95% of derivatives outstandings are OTC,
– on exchange trading requires standardisation of
derivatives contracts.
• Netting of derivatives can be done through CCP:
– same legal novation mechanism as for securities
– limited netting so far – also requires standardisation.
22
Close-out netting
• Key clause in master agreements is close-out
netting – key to reduce counterparty risk:
– in case of default under a given contract by a
counterparty, allows party to accelerate and net
out payments under all other derivative
contracts with defaulting counterparty,
– but effectiveness requires that contract has been
signed and be legally enforceable in relevant
jurisdiction.
23
II. THE SECURITIES AND DERIVATIVES
INFRASTRUCTURE
1. Exchanges
2. Central Counterparties (CCPs)
3. Central Security Depositories (CSDs)
4. International CSDs (ICSDs)
24
1. Exchanges
A.
B.
C.
D.
What is an exchange?
Main characteristics of exchanges
Services
Annexes
25
A. What is an exchange?
• An exchange is a « market »: a place where
goods are sold and bought:
– based on multilateral arrangements
– governed by non-discretionary rules (cf MiFID).
• Goods can be:
– securities: stock and bonds exchanges
– derivatives: derivatives exchanges
– commodities: commodities markets, etc.
26
Regulated exchanges
• « Regulated markets » (or regulated
exchanges): authorised as operators of
markets, as opposed to:
– OTC, and also
– variety of bilateral or multilateral facilities that
are extensions of internalisation by brokerdealers and that are subject to some, but not all,
the regulations applicable to regulated markets:
• in EU: MTFs, Systematic Internalisers, etc
27
B. Services
• Historically core services:
– listing of new stocks (IPOs)
– trading (for securities and for derivatives)
– clearing (for derivatives)
• But have added a number of other services
over time, due to:
– pressure on trading revenues, and
– pressure to meet for-profit objectives following
demutualisation.
28
Additional services
• Additional services include (varies per
exchange):
– sale of data and information, including data analytics
– transaction reporting for clients to regulators
– services to issuers, e.g.:
• help create visibility for company
• help company communicate electronically with (potential)
investors in market-ready format,
– technology services:
• outsourcing of IT platforms to other exchanges
• leverage of exchange’s IT by banks
• co-location of computers with clients’ computers.
29
Expansion into post-trading
• Several exchanges own CCPs and/or CSDs:
– most derivative exchanges have their own integrated
clearing and netting (CCP) services:
•
•
•
•
CME
ICE
Deutsche Börse (Eurex)
NYSE-ENX (LIFFE)
– several stock exchanges control CCPs and/or CSDs:
•
•
•
•
Deutsche Börse: German CCP+CSD, ICSD (Clearstream),
Nasdaq-OM: Nordic CCP, CSDs in Baltics and Iceland,
LSE: Italian CCP+CSD and LCH.Clearnet
in contrast, NYSE-ENX owns no equity CCP and no CSD.
30
Diversification of revenues
• Multi-service exchanges generate substantial part of
revenues from ancillary services Year: Q3,2011(exc LSE: 2010)/Source: SE’s sites.
LSE
NYSE-ENX
DBörse
11%
33%
0%
12%
17%
40%
32%
50%
35%
41%
22%
2.50%
Equities trading & listing
Derivatives trading
Post trading
IT & Data
31
C. Main characteristics of exchanges
• Objectives
• Liquidity
• Market models
32
Objectives of exchanges
• Several objectives of different nature, as per SchwartzFrancioni approach (equity markets):
– macroeconomic: capital allocation through secondary market
– microstructure: fair and orderly price discovery
– legal: investor protection through
• laws and regulations
• self regulatory role of exchange
– operational: reliability
• systems availability and data integrity
• scalability (volumes) and response time (loop)
• speed (latency)
– social: equal treatment in terms of
• availability of public information from exchange
• access by individual members.
33
Liquidity
• Defined as « ability to quickly trade substantial
size at low cost when wants to trade »
– Low cost: width of market (cost for a given quantity)
– Size: depth of market (ability to trade quantity at
given price)
– Quickly: immediacy (time required to arrange a trade
of given size at given price)
• Liquidity is a major factor of attractiveness of an
exchange, as it reduces bid/offer spreads (costs).
– exchanges’ market models and algorithms are
designed to increase liquidity of market.
34
Market models
• Market models of exchanges designed to
achieve these various objectives and to make
the exchange efficient (including by
maximising liquidity)
• Different types of market models:
– Continuous or call auction markets, and
– Order-driven or quote driven markets.
35
Continous vs call auction
• Continuous market:
– orders to buy/sell matched on a continuous basis.
• Auction/call market:
– orders to buy/sell batched at a given time of day and
matched only then.
• Trade-off is between flexibility and liquidity.
• Many exchanges combine both models:
– auction to start the day and sometimes later in the
day at pre-determined times, and
– continuous the rest of the day.
36
Order-driven market
• Market prices set by the balance of supply and
demand with price set so that the largest
volume of financial instruments can be traded.
• Main advantages:
– transparency
– certainty for investors that trade takes place in
accordance with order
• Main disadvantage:
– potential lack of liquidity.
37
Quote-driven market
• Registered “market makers” are required to display
bid and offer prices, and in some cases the maximum
ticket size to which these prices relate.
• Main advantage:
– Liquidity: market makers are required to meet orders for
which they provide quotes.
• Main disadvantage:
– lack of transparency: unlike an order-driven market it
does not show the flow of individual orders.
38
D. Annexes
1. Competitive environment
2. Major exchanges and other trading venues
3. Main current issues
39
Annex 1. Competitive environment
• Exchange environment deeply transformed in
last 25 years, triggered in particular by:
– regulatory steps, including:
• removal of fixed commissions
• incentives for competition (Reg NMS in US and MiFID
in Europe)
– technology innovation and in particular screen
based trading, and
– demutualisation.
40
Regulatory easing
• Originally exchanges were largely « clubs » with protective
rules, such as:
– fixed commissions (imposed on transactions with nonmembers and commission unrelated to size of order)
– exclusionary membership rules and exclusive access to trading
for members
– prohibition for members to be incorporated or quoted
companies
– obligation for members to bring all their business.
• No real competition between trading venues (e.g.,
between NYSE and Nasdaq).
• Costs passed on to members’ clients (in particular retail).
41
Regulatory easing – Cont’d
• Regulators took actions to reform securities and
exchange activities in 1970s-1990s:
– US: mid-1970s to 1990s
• main objective: reduce costs for consumers and avoid excessive
fragmentation.
– EU: various directives (starting with ISD 1993)
• main objective: European integration
– UK: Big Bang 1986; Japan: Big Bang 1997.
• Dented protectionism for members and exchanges:
– reduced costs for consumers
– reduced margins of privileged members
– increased competition.
42
Reg NMS and MiFID
• Reg NMS (US) and MiFID (EU) implemented in
2007.
• Many rules, but some specifically to create more
competition between exchanges and from
alternative trading venues.
• Effectively impose that orders be directed to
trading venues offering best execution
– Reg NMS: rule of « order protection » (forces routing
to lowest price venue)
– MiFID: rule of « best execution » (not just price).
43
Screen based trading
• Screen based trading has replaced almost
entirely open-outcry (voice) trading since mid1980s.
• Originally resisted by users of established
exchanges (especially stock exchanges), slowing
down the SEs’ ability to adapt to competition.
• Had massive impact on market, including on:
– competitive landscape
– costs
– risks
44
Impact – competitive landscape
– allowed exchanges that adopted it to gain market
share from laggard exchanges:
• DTB went from 30% to 100% of market share of bund
futures market from LIFFE over 1995-98
• CME jumped from 50% to 97% market share of US futures
over 2004-08 by acquiring NYMEX and CBOT leveraging its
screen-based edge.
– facilitated the development of alternative trading
and matching venues that compete with SEs:
• Alternative Trading Systems (ATS)
• Multilateral Trading Facilities (MTFs).
45
Impact – competitive landscape Cont’d
– allowed development of algorithmic and high
frequency trading:
• manual trading took minutes,
• screen-based trading takes milliseconds
– prompted new services (and fees) by exchanges:
• co-location of computers of client and exchange
• outsourcing of IT platforms (facilitating future
alliances or mergers).
46
Impact - cost
– increased volumes massively, allowing to reduce
cost:
•
•
•
•
reduced bid/ask spreads (by over 90% vs 1990s)
lower broker-dealer trading fees (by 90-95% vs 1980s)
lower price of data for traders
lower exchange fees, but not as much (as exchanges
had become for profit, they looked to benefit from
growing volumes).
47
Impact - risk
– facilitated direct access to exchange by underlying
customers (e.g., hedge funds), although still under
responsibility of broker,
– reduced manual errors and risk of manipulation after
the trade,
– but created new types of risk, with potentially bigger
financial impact:
•
•
•
•
manual mistake in using screens (« fat finger»),
programming bugs or design mistakes in softwares,
domino impact of algo trading programs
manipulation through HFT (e.g., cancelling of orders).
48
Demutualisation
• From 1700s to 1990s, exchanges were:
– de facto monopolies (often de jure as from 1980s),
– not-for-profit mutuals (owned by users),
– largely self-regulated.
• Demutualisation:
– starting in 1993 (with Sweden) - now almost all,
– caused by opportunities (growth of cross-border
business), but also conflicts of interests within
boards,
– transformation into publicly-quoted, for-profit firms,
– typically self-listing.
49
Impact - demutualisation
• Triggered fundamental changes:
– in business approach:
• forced much greater discipline (quoted companies)
• gave strategic and financial means to invest
• gave acquisition currency (listed shares), fuelling M&A activity.
– in relationship with clients (no longer shareholders)
• less cosy/consensual
• competition with users
• spurred IBs’ backing for MTFs (Turquoise, Chi-X, etc)
– in relationship with regulators
•
•
•
•
no longer seen as quasi-arm of governments/regulators
reduced regulatory/market surveillance role in most countries
self-regulation no longer acceptable
prompted adoption of Reg NMS and MiFID.
50
Consolidation
• Consolidation:
– first within countries
• NYSE and Nasdaq acquired local exchanges within US,
• CME acquired CBOT and NYMEX
• domestic consolidation in European domestic markets and now
Asia (e.g., Tokyo-Osaka stock exchange mergers - 2011).
– then within regions
• Euronext , OMX, LSE-Borsa, Euronext-LIFFE
• DBörse: strong vertical model, but no SE acquisition
• limited M&A (other than domestic) in Asia
– cross-Atlantic mergers before regional completion:
• NYSE-Euronext
• Nasdaq - OMX
• NYSE-ENX – DBörse?
51
Vertical integration
• Expansion to CCP services:
– Derivatives exchanges have their own CCP
• in US: CME, ICE, etc
– DTCC historically not a CCP for derivatives – now partnership
with NYSE
• in Europe: DBörse (Eurex clearing), Euronext-LIFFE
– LSE has limited derivative activity
– Stock exchanges historically relied on
independent CCPs for equity transactions:
• Euronext, LSE: LCH.Clearnet
• but DBörse built its own CCP for German shares.
52
Vertical integration – Cont’d
• Exchanges generate flows to CCPs and CSDs and
have been looking to own and control the entire
chain:
– produces some vertical cost synergies (rather limited),
– gives greater strategic agility
• faster roll out of products and services
• facilitates M&A expansion to similar vertical silos
– makes clients more « captive » (vertical « silos »)
•
•
•
•
constrains external competition
allows price packaging across levels (cross-subsidies?)
prompted Code of Conduct, forthcoming free access rules
key issue in DG Competition review of DB-NYSE/ENX merger.
53
Annex 2. Major exchanges and other
trading venues
• Competition for derivatives exchanges is OTC market:
– pure bilateral OTC, or
– inter-dealer platforms, using request-for-quote model (RFQ)
• Competition for stock exchanges strongly encouraged by
regulators in US (Reg NMS) and EU (MiFID) as from 2007:
– by broker-dealers under bilateral trading services
(internalisation- dark pools, systematic internalisers),
– by alternative trading systems with multilateral trading
services (multilateral trading facilities – MTFs under MiFID),
– by OTC markets.
• Partial reversal by regulators now as focus shifts to
transparency (e.g., proposed MiFID II - 2011).
54
SEs vs ATS
• Alternative trading venues have gained
significant market share from traditional
stock exchanges, especially for blue chips:
– US: NYSE and Nasdaq have less than 50% market
share together
– UK: LSE has about 55%
• BATS has become largest trading venue in
Europe.
– has captured 23% of equity trading in Europe.
55
Trading volumes by trading venues
56
Major regulated stock exchanges
Capitalisation
NYSE-Euronext (US)
13,791
Turnover
NYSE-Euronext (US)
8,731
Nasdaq OM (US)
4,068
Nasdaq OM (US)
6,008
LSE group
3,849
Shanghai
2,219
Tokyo
3,655
Tokyo
2,202
NYSE-Euronext (Eur)
3,248
Shenzen
1,551
Shanghai
2,804
LSE group
1,531
Hong Kong
2,712
NYSE-Euronext (Eur)
1,129
TMX
2,231
Korea
1,014
Deutsche Börse
1,622
Deutsche Börse
898
BM/Bovespa
1,553
TMX
825
Source: WFE 06/2011
Turnover: electronic order book
57
2. Central Counterparties
A. What is a CCP?
B. Annex
58
A. What is a CCP?
• Entity that interposes itself, in one or more markets,
between the counterparties to the contracts traded,
– becoming the buyer to every seller and the seller to every
buyer and
– thereby guaranteeing the performance of open contracts.
• Shifts counterparty risk to CCP
• Scope:
– securities and/or derivatives trades
– applies to trades between CCP members (benefit of
concentration).
59
CCPs and risk
• Impact of CCPs on counterparty risk:
– reduce risk massively through netting, but
– also concentrate risk on themselves by becoming
counterparty to every trade.
• CCPs could be source of systemic risk if failed:
– need to reduce residual risk (close-out netting)
– should not « overuse » CCPs (e.g., for illiquid assets
or non-standardised assets)
– need strong protection measures, in addition to
CCP’s capital (which is often small in relation to risk).
60
CCPs protection against risk
• Five mechanisms:
– criteria for admission as member of CCP
– initial margins
• typically cash or highly liquid securities
• purpose is to protect CCP during transition after default
and prior to close out netting and sale of collateral
– variation margins (daily)
• cash
• covers for valuation changes of collateral (cf repos)
– other collateral
• default funds from members, third party guarantees, etc
– CCP own capital.
61
C. Annex - CCP
• Risk Management – CCPs
• Major CCPs
• Major current issues
62
Risk management: CCPs
•
Year:2011/Source: BIS
63
Major CCPs – securities
CCP - United States
Ownership
Activity
DTCC – US
Users and exchanges
All securities
CCP - Europe
Ownership
Activity
LCH.Clearnet -
• Users (83%) and
exchanges (17%)
• LSE controlled
• Bonds and repos
• Equities: LSE
• Equities: Euronext
• Equities: MTFs
Domestic CCPs
Domestic exchange
• Equities
- Eurex Clearing (DBörse)- Germany +
Ireland
- Cassa di Comp (LSE) - Italy
- Etc
EMCF
ABN-AMRO (78%) +
Nasdaq OM (22%)
• Equities: several MTFs
Euro-CCP
DTCC
• Equities: several MTFs + Nasdaq OMX
64
Major CCPs – derivatives
CCP – United States
Ownership
Activity
Exchange-linked CCP
• CME
• ICE
• Nasdaq OM
• NYSE-ENX
Individual exchange
Trades on exchange (interest
rate, commodities, energy,
fixed income and equity
derivatives, etc).
NY Portfolio Clearing
DTCC (50%) + NYSE (50%) • Fixed income derivatives
CCP - Europe
Ownership
Activity
LCH-Clearnet
• Users and exchanges
• LSE controlled
Full range (incl. interest
rates on SwapsClear)
Eurex Clearing
Deutche Börse
Full range
ICE Clear Ltd
ICE
Energy + CDS
NYSE Clear LIFFE
NYSE-ENX – soon
acquired by ICE
Full range
CME Clearing Europe
CME
Commodities
65
Consolidation
• ICE is acquiring NYSE-ENX, including NYSE
Clear LIFFE
• Euro-CCP and EMCF are merging
– To be owned (each for 25%) by:
•
•
•
•
Nasdaq OMX
ABN AMRO (Clearing Bank)
DTCC
BATS-Chi-X
66
Major current issues
• CCPs part of vertical silos
• Regulatory push for CCP clearing for OTC
derivatives
• Concerns about CCPs being single points of
failure – need to strengthen resilience.
• ECB location requirements for clearing of
EUR-denominated trades.
– UK lawsuit against European Commission
67
Vertical silos
• Neutrality of CCPs that are part of vertical silos
– Deutsche Börse/Eurex CCP for German equities
– Acquisition of LCH.Clearnet by LSE (51%)
– Regulatory focus:
• Part of 2007 voluntary Code of Conduct sponsored by the
Commission, but failure to change behaviours
• Possible issue in context of DG Competition’s approval of
NYSE-ENX /DB merger,
• Possible EU regulation/directive on open access by CCPs
(EMIR).
68
Clearing of OTC trades
• Regulatory push for OTC derivatives to be
cleared and netted through CCPs.
• Concerns:
– most derivative contracts: bilateral and OTC
• backlogs and legal documentation weaknesses
• often inadequately collateralised
– Bear Stearns, Lehman failures:
• lack of clarity about bilateral positions and even more
overall cross-dealers positions, and
• risk of contagion (systemic risk).
69
Clearing of OTC trades – Cont’d
• G-20 response to the financial crisis calls for all
standardised OTC derivatives to go through CCPs
by end 2012, with in 2011 only:
– 50% of IRS contracts,
– 20-30% commodity derivatives,
– less than 10% CDS
• Expected impact:
– force greater and systematic collateralisation, and
– give fuller cross-dealers picture.
70
EUR trade clearing location
• ECB wants all CCPs that have large EUR
activity to be located in a Eurozone country:
– officially driven by lender of last resort
considerations
– would force a CCP like LCH.Clearnet to shift from
London to continent
• UK government has begun legal action against the
ECB/EU before Court of Justice
• UK concerned about attempts to weaken London as
financial centre.
71
3. Central Securities Depositories
A.
B.
C.
D.
What is a CSD?
Services
Risk profile
Annex
72
A. What is a CSD?
• Institution that is the ultimate holder, and often
register, of the securities of a market on behalf
of investors and is closest to the issuer in the
securities holding chain.
• CSDs have two main functions:
– safekeep the securities of the market through
immobilisation of the stock of securities, and
– effect transfers of the securities through accounting
movements in accounts of investors/intermediaries
in its own books (securities settlement system).
• No physical movement of securities for transfers.
73
Reduce risks and inefficiencies
• CSDs were created primarily to reduce risks
and increase efficiency for the investor
community, because immobilisation of
securities and book-entry transfers:
– reduces risk of losses or thefts (safekeeping in
vaults), and
– allows immediate and secure transfers and retransfers without the need to wait for actual
delivery of certificates.
74
From immobilisation to
dematerialisation
• Immobilisation implies that physical certificates are
warehoused.
• Dematerialisation means that there is no physical
certificate and that legal ownership is represented by
a book entry.
• Progressive move towards dematerialisation:
– France started in Europe (1984), followed by other
markets: Belgium, UK, NL, etc
– simplifies legal framework
– has political connotations (« wealth register » used for
wealth tax, makes fraud by investors more difficult for
bearer bonds).
75
Status of CSDs
• CSDs are part of the securities market
infrastructure and have a special status:
– specific regulatory framework (more demanding
rules and some special treatment) designed to
minimise risk-taking and protect investors
– assets of investors are not on balance sheet of CSDs,
– CSDs are typically not bank, with some exceptions:
• Germany’s CSD (Clearstream Banking Frankfurt)
• ICSDs
76
B. Services
• CSDs offer two main services:
– holding of assets: notary function for issuers and
safekeeping of domestic assets for investors,
– settlement of transactions in central bank money (cash
transfers in accounts with the central bank).
• Have developed range of additional services, such as:
–
–
–
–
–
basic corporate action and tax services
collateral management
securities lending (for some CSDs)
proxy voting for investors
shareholder-related services for issuers.
77
Monopolies?
• CSDs have a monopolistic position only for the
notary/safekeeping service.
• For other services, they compete with local
custodians and ICSDs, including settlement:
– in some markets local custodians effect more than
half of settlement transactions in their own books.
– Target 2 Securities (ECB platform for settlement in
central bank money) not meant to be a competitor,
but outsourcing solution for CSDs:
• but it will erode settlement profit margin of CSDs like
competition would.
78
Governance – two models
• Historically, CSDs were set up and owned:
– by market participants (mutuals), or
– by stock exchange (which was itself a mutual).
• Major objective of market was not to maximise
profit, but to ensure low risk, low cost services
to market.
• Most CSDs remain mutuals, including
– CSDs that are part of Euroclear: UK, France, Belgium,
NL, Ireland, Sweden, Finland.
– DTCC in US,
– most CSDs in Asia.
79
For-profit model
• In last 10-15 years, as exchanges have
demutualised, the CSDs they owned have
become more « profit-oriented »:
– Germany (Deutsche Börse),
– Italy (Borsa Italiana),
– Spain (BME),
– Hungary (Keller),
– Norway (VPS).
80
Central banks as CSDs
• Central banks used to be the CSD for their
government debt in many countries:
– most have transferred responsibility to the local CSD
(e.g., UK, France, Spain, NL) over the last decades,
– some central banks remain CSDs: US (Fed), Belgium,
Greece, Hong Kong,
– ECB is taking back settlement responsibility with T2S.
• Raises questions of rules applicable to a public
sector entity carrying out commercial activities
while acting as regulator.
81
New CSDs
• Global custodians entering the market and
setting up own CSDs:
– Bank of New York Mellon
– JP Morgan with LSE
82
Major domestic CSDs
40
1800
36
35
1600
30
1400
DTCC
25
20
Euroclear
CSDs
16
15
Clearstream
CSDs
10
5
5
0
1700
1200
1000
800
600
428
400
200
92
0
Depot in trillion of $
Year: 2010 Sources: DTCC, ECB
Turnover in trillion of $
83
C. Risk profile
• Limited credit and market risk
• Operational risk
• Risk containment
84
Limited credit and market risk
• CSDs are designed to take limited risks:
– no credit risk
• CSDs do not provide credit to facilitate settlement as
settlement is generally done with central bank money
(except CSDs-banks for foreign securities, e.g.,
Germany)
• some CSDs take some limited credit risk on domestic
securities (through advance of interest and dividend
payments and through ex post fee charging),
– minimal market risk (only on own assets, e.g.,
capital assets).
85
Major risk is operational risk
• The main risk for CSDs is operational risk:
–
–
–
–
computer systems failures
software design failures
manual mistakes
thefts or losses in vaults, fraud, etc
• Consequences for market efficiency could be large:
– inability to make reliable transfers would affect
functioning of the market and have spill over effect on
trading and lending more generally as posting of
securities collateral could be affected
– could trigger questions on ownership rights.
86
Risk containment
• Therefore, CSDs:
– are expected by their market (clients, issuers)
and by the regulators to take extraordinary
measures to mitigate operational risks:
• computer back-ups, with regular testing
• automation of tasks (reduced risk of manual errors)
• special testing of software changes with market
participants before launch,
– limit their liability in case of problems
(mutualising risk among market participants).
87
Limited capital requirements
• Non-bank CSDs have generally limited capital
requirements because of the nature and
limited magnitude of risks:
– so far determined by each domestic regulator (no
pan-European regulation), although forthcoming
CSD directive will likely specify a requirement,
– regulators often set capital requirement in terms
of cost base (e.g., 6 months cost base) to allow
for an orderly unwind in case of failure.
88
D. Annex - CSDs
• Size
• CSDs by region
• Major current issues
89
Size
• By definition, CSDs have effectively all of the
domestic securities of the country in their books,
– even if securities are held by intermediaries, they are
sub-deposit in CSD,
– with some limited exceptions:
• some physical securities may remain « under the mattress »
• private companies’ shares may remain in companies’ books.
• In contrast, settlement of transactions can be
internalised in books of intermediaries (e.g.,
custodian banks), in which case no settlement in CSD:
– in some markets, estimates that about 50% of settlement
takes place in custodian banks’ books.
90
Assets on deposit
• Total assets on deposit:
– in EU CSDs: €31.2 trillion, with over half in Euroclear group,
– in US: $36.5 trillion (DTCC).
EU CSDs depot end 2010
Source: ECB
11.00%
9.00%
13.00%
52.00%
Euroclear CSDs
Clearstream CSDs
Italy
Spain
All other CSDs
15.00%
91
Turnover
• US settled about $1.7 quadrillion per year
• EU CSDs settled in 2010 about €510 trillion, of which half in Euroclear
CSDs.
EU CSD turnover in trillion of €
Year: 2010 Source: ECB
5%
Euroclear CSDs
15%
13%
12%
Clearstream CSDs
55%
Italy
Spain
All other CSDs
92
CSDs by region
• Europe
• US and Asia
93
Europe: new competitive environment
• Historically, CSDs have offered a limited range of services at
low risk and moderate cost:
– safekeeping of securities and record-keeping,
– book entry settlement in central bank money (i.e., cash
movements in accounts of the central bank, not of the
CSD or of banks),
– basic corporate action service (collect and pass on to
clients interest and dividend payments from issuers,
management of standardised/automated corporate
actions, etc)
– sometimes, standardised collateral management services
(France, UK), services to issuers, such as proxy voting
(UK), information about shareholders (France, Belgium),
etc.
94
Need to adapt under competitive
pressures
• CSDs had historically limited competition:
– mostly from own clients, which internalised part of the
settlement activity in their own books for transfers
between two clients of the bank,
– from ICSDs for securities that were traded offshore (e.g.,
German bunds).
• But competition has broadened in Europe, especially
after the launch of the EUR, which prompted an
increase in cross-border trading and settlement:
– greater competition from banks and ICSDs,
– new competition from other CSDs, and
– new competition from issuer-servicing providers (e.g.,
Computershare).
95
Exacerbated by T2S and clearing
• Core profitability of European CSDs has been
weakened by competitive pressures, and, in
addition:
– most large markets have introduced CCPs to
reduce counterparty risk and post-trading costs:
• CCP netting can reduce settlement activity by > 90%;
– ECB has decided to offer pan-European
settlement in central bank money, which would
wipe out CSD margins on settlement services.
96
Moving up the value chain
• To survive, European CSDs are seeking to move
up the value chain:
– more sophisticated services on domestic securities
(corporate actions, issuer services, information
services, securities lending, collateral management,
etc)
– new services on foreign securities, competing
directly with other CSDs, ICSDs and custodian banks
(which are also their clients and sometimes their
shareholders),
– with uncertain prospects of success.
97
Impact on role and risk profile of CSDs
• Competitive approach will change risk profile:
– several CSDs will seek to become banks (necessary to
offer attractive service on foreign securities)
• only if forthcoming EU rules allow it
– better service often means more customised
approach and therefore greater operational risk,
– time to market requirement and low cost in a
competitive market will test safety standards, and
– limited liability approach will be under pressure.
98
Strategic partnerships
• European CSDs will struggle to survive on a stand
alone basis:
– T2S impact,
– the largest CSDs are already part of a broader group:
• Euroclear CSDs part of Euroclear group with seven markets (over
50% of European market) and with a largest ICSD in the world,
• German CSD part of Deutsche Börse group (vertical structure)
and the second largest ICSD in the world (Clearstream),
• Italian CSD part of London Stock Exchange group.
– competition and regulatory costs will increase.
• Will likely force other CSDs to secure their local
anchor (e.g., with stock exchange or government)
and/or join another group.
99
US and Asian CSDs
• Two CSDs in US:
– Federal Reserve for government securities
– DTCC for all other securities:
• is also a CCP and a derivatives data warehouse,
• seeks to expand geographically by leveraging its scale
and US financial actors’ presence abroad.
• Asian CSDs still very domestically oriented:
– generally mutuals,
– their future likely to be determined by evolution
of their country’s stock exchange.
100
Major current issues
• New regulation to be applied to European CSDs:
– unrelated to the crisis,
– driven by Commission’s desire to codify framework
and ensure resilience of CSDs,
• Combined impact of T2S, stock exchange
consolidation, and new regulation on European
CSD landscape:
– core profitability under threat,
– potential increase in risk profile (see above).
101
4. International CSDs
A.
B.
C.
D.
What is a ICSD?
Size
Services
Annex
102
A. What is a ICSD?
• Hybrid organisations:
– CSDs for « international securities », such as
Eurobonds,
– custodian bank-type providers for domestic
securities.
• Result of historical factors:
– started as pure CSDs for Eurobonds in late
1960s/early 1970s
– progressively added new products and services,
starting in the 1970s,
• to leverage economies of scale and scope
• with support of their clients/shareholders (mutuals).
103
Two main ICSDs
• There are two large ICSDs, both in Europe:
– Euroclear (HQ in Brussels)
– Clearstream (HQ in Luxembourg)
– other hybrid CSDs:
• SIS: extension of the Swiss CSD (ICSD for Swiss banks),
• Clearstream Frankfurt: German CSD (ICSD for German
clients),
• most domestic European CSDs ambition to become
ICSD as strategic positioning (cf above),
• DTCC is also ambitioning a role as « investor CSD ».
104
B. ICSDs’ size
Depot in € trillion
(ECB-2010)
Turnover in € trillion
63
5.1
Euroclear
Clearstream
10.3
277
105
C. Services
• ICSDs offer a much broader range of services
than CSDs.
• ICSDs are:
– like CSDs for Eurobonds
• Compete with one another and with some CSDs (DTCC
in US)
– like local custodians for other products (shares,
domestic bonds, funds, etc)
• Compete with pone another and with local custodians
across the world.
106
Operating in a competitive
environment
• Euroclear and Clearstream compete with one another,
but are not a duopoly:
– for international securities, competition with DTCC for
issuance business:
• for international securities issued in USD, DTCC has larger market
share than the two ICSDs.
– for domestic securities, ICSDs act as custodian bank-type
providers and compete with custodian banks (half a
dozen multi-market custodians and about 20-30 domestic
custodians across Europe).
• ICSDs have larger market shares in bonds
• custodian banks have larger market shares in equities (where
local market intimacy is critical and the liquidity is in local
market).
107
Service range
• Offer all the services of CSDs, but with greater
customisation and proactivity for clients and with
more sophisticated tools:
– safekeeping of securities (use sub-custodians),
– settlement of transactions in multi-currency (>40
currencies)
– corporate action servicing
– collateral management services
– securities lending (to avoid settlement fails)
– investment fund routing and servicing
– issuer services (as CSDs for international securities)
– and… credit (ICSDs are banks) to facilitate settlement.
108
Single purpose banks
• Both ICSDs are banks for the single purpose of
facilitating settlement and related services.
• Reflected in their balance sheet and capital
structure:
– relatively small balance sheet
– high capital ratios
– very low credit risk:
• intra-day credit,
• uncommitted lines of credit
• collateralised (in EB: 99% secured) with assets deposited in
the ICSD.
109
Credit needed for settlement efficiency
• Securities settlement effected on a deliveryversus-payment (DVP) basis
– requires that buyer have cash or (collateralised)
credit line with ICSD at time of transfer (otherwise
securities not transferred),
– otherwise settlement « fails » and neither cash, nor
securities are transferred,
– cost of settlement fails very large (cost of borrowing
cash for at least one day):
• 1% fails of settlement in Euroclear Bank alone costs clients
€ 730 million/year (based on 5% interest rate).
• cost of fail, even for only 1 day, is often a multiple of the
profits on the trade for client.
110
Short term, collateralised, credit
• ICSDs provide mainly very short term credit (intraday or overnight for one day):
– generally use whole stock of own securities in ICSD as collateral,
– credit reimbursed with proceeds of immediate resale or onward
transfer of securities to underlying client.
• Credit is oil in the system and was « island of
stability » during 2007 liquidity crisis:
– while inter-bank lending (especially overnight) froze completely
late 2007, ICSDs did not have problems getting liquidity and
continued to provide settlement-related credit to clients,
– without it, financial markets would have suffered much greater
strains, as trades would have failed.
111
D. Annex - ICSDs
• Comparison with CSDs and global custodians.
112
ICSDs vs CSDs
Service
CSDs
ICSDs
Safekeeping
Yes
Through sub-custodians
or through CSDs
Settlement
Central bank money settlement
Mostly mono-currency
Commercial bank money
Multicurrency
Corporate actions
Standardised
Broader and more
proactive
Collateral Mgt
Only a few, generally limited
Highly developed,
including triparty
Securities lending
Only a few
Yes, for fail-curing
Funds
A few
Yes, highly developed
Issuer services
Yes
Yes, for Eurobonds
Credit
As a rule no (some exceptions)
Yes – for settlement
related activities
Fees
Very low/standardised
Low/standardised
113
ICSDs vs global custodians
Services
ICSDs
Safekeeping
Use CSDs/subcustodians Use ICSDs/subcustodians
Settlement
Yes
Use ICSDs/subcustodians
Corporate actions
Yes
Enriched from ICSDs/subcustodians
Highly proactive
Collateral Mgt
Yes
Some, mostly use agents/ICSDs
Securities lending
Fail curing only
Street lending (proactive)
Funds admin &
accounting
No
Yes
Credit
Intra-day,collateralised
settlt related activities
Extensive, for range of activities
Insourcing of back
offices
No
Yes
Risk analysis/advice No
Yes
Fees
High/customised
Low/standardised
Global Custodians
114