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5.5 FEATURES OF CCPS AND CLEARING HOUSES
5.5.1 The Committee for Payment and Settlement Systems' Statistics

The Committee for Payment and Settlement Systems (CPSS) annually produces statistics on payment, clearing and settlement systems for a selection of countries (the so-called CPSS countries). The most recent publication can be found on the BIS/CPSS website at
www.bis.org/list/cpss/index.htm
.

In the section on comparative tables, you will find features on the following infrastructural systems (shown in
Table 5.6
):

  • Interbank funds transfer systems (PS);
  • Exchanges and trading systems (TRS);
  • Central counterparties and clearing houses (CCP);
  • Central securities depositories (CSD).

TABLE 5.6
Features of selected central counterparties and clearing houses

Category
Meaning
Comments
CCP or clearing house
The entity is a central counterparty (CCP) or a clearing house (CH).
Owner/manager
Central bank (CB), commercial banks (B), a stock exchange (SE), another CCP (CCP)/clearing house (CH) or other type (O).
If owner and manager differ, both are provided. If (fully or partially) owned by an exchange, a CCP or a clearing house, the name of that entity is provided as well as the share of its ownership rights.
Relationship with exchange
  • Internal (int)
  • Parental (par)
  • Independent from the exchange (indep).
  • The CCP belongs to the same entity as the exchange, or
  • The CCP is a subsidiary of the exchange, or
  • The CCP is independent from the exchange.
Relationship with CSD
  • Internal (int)
  • Parental (par)
  • Independent from the CSD (indep).
  • The CCP belongs to the same entity as the CSD, or
  • The CCP is a subsidiary of the CSD, or
  • The CCP is independent from the CSD.
Intra-day margining
Routine and/or event-driven.
When event-driven, price-driven (P) or size-driven (S).
Products/markets cleared
Securities (SEC), derivatives (DER) and/or repos (REP).
Currencies
ISO code of the cleared currencies.
Securities settlement agent
Agent that settles the securities leg of the transaction:
  • CSD
  • Central bank (CB)
  • Commercial banks (B)
  • Other (O).
The information is given per product and per currency.
Cash settlement agent
Agent that settles the cash leg of the securities transaction:
  • Central bank (CB)
  • Commercial banks (B)
  • Other (O).
The information is given per product and per currency.
Links to other CCPs
Such links can be based on cross-participation (cross) or on common systems.
The number of links is provided per currency area.

Source:
CPSS/BIS (online). CPSS 116. Available from
www.bis.org/list/cpss/index.htm
. [Accessed Monday, 27 January 2014]

5.6 SUMMARY

Transactions executed on-exchange and off-exchange (for products that are centrally cleared) must be cleared and settled. Clearance is the preparation for settlement and takes place in a central system known as either a clearing house or a central counterparty.

Both systems receive instructions from both counterparties to a transaction (i.e. the buyer and the seller) and will attempt to validate the information, check asset availability (cash and securities/derivatives) and match the buyer's information to the seller's. Only once these processes have been completed successfully can the transaction be settled. Settlement information is then passed on to another entity, a central securities depository, where ownership records are updated.

A clearing house does not assume any counterparty risk in the process; if one party fails before settlement, the risk lies with the counterparty.

As soon as a central counterparty validates and matches the buyer's and seller's information, it novates the transaction and becomes the counterparty to the buyer and, separately, the counterparty to the seller. This protects the buyer from the seller and vice versa. However, the CCP now has counterparty risk exposure to all its participants – a potentially huge risk.

To mitigate the counterparty risk, CCPs operate a risk-management system whereby participants contribute to a default fund, post collateral and pay margin, with the CCP itself maintaining a reserve fund and holding equity. In the event that a counterparty defaults, the CCP attempts to cover any losses using a waterfall-based line of defence that starts by netting the defaulting party's positions and ends by using its equity.

We saw the example of how LCH.Clearnet was able to deal successfully with the Lehman Brothers' default in 2008 without having to go down the waterfall too far. Nevertheless, there is the risk that a CCP could default as a result of one or more of its participants defaulting and, for this reason, the CCPs must establish robust risk-management practices, making changes where necessary.

NOTES
CHAPTER 6
Securities Depositories (CSDs and ICSDs)
6.1 INTRODUCTION

We have seen in previous chapters the roles of the exchanges and trading platforms together with the clearing houses and central counterparties. We have also seen the relationships between both types of infrastructure in terms of management and ownership.

The asset types that are traded and cleared include bonds, equities, exchange-traded derivatives and centrally cleared OTC derivatives.

We are now at the stage where a third type of infrastructure plays an active role: the local (or national) and international central securities depository (CSD). As with the clearing houses and CCPs, CSDs can share certain characteristics with other CSDs but can also differ.

Please note that CSDs play no part in derivatives other than when contracts with securities as the underlying assets are exercised.

This chapter will help you to:

  • Understand the purpose of the CSDs and ICSDs;
  • Take a detailed look at a selection of these depositories;
  • Appreciate the bilateral links between CSDs and ICSDs as well as mergers and acquisitions;
  • Consider the different types of customer of the depositories and the services offered to them.
6.2 HISTORICAL CONTEXT

Until the late 20th century, securities were represented in certificated form, i.e. investors would hold physical share and bond certificates. These certificates could be held in one of several ways:

  1. By the investor.
  2. By a legal representative of the investor (e.g. a solicitor).
  3. By the investor's stockbroker.
  4. By the investor's bank (and deposited in the bank's vault or in a safety deposit box).

Securities could either be in registered form or in bearer form. For registered securities, the investor's name would be recorded on the issuer's register and noted on the certificate. For bearer securities, the investor's name would not be recorded on either the certificate or the issuer's register.

We can perhaps conclude that the safekeeping of securities was decentralised, with the physical certificates held either by the investor or by the investor's agent. It wasn't until the late 1960s and early 1970s that this situation changed.

In addition to the form of securities, there were other factors to be considered. For example:

  • Clients, stockbrokers and banks communicated with each other by telephone, mail or telex. Furthermore, instructions to make payments and deliveries were sent by authenticated/tested telex and, on occasion, by authenticated telephone calls.
  • Investment in overseas markets tended to be confined to the major markets (e.g. New York, Tokyo and the various European financial centres).
  • Securities settlement was a manual process by which stockbrokers' messengers would deliver parcels of certificates to their purchasing counterparties and collect certificates from their selling counterparties, both in exchange for cheques by way of payment.

As more markets opened and investment activity (both domestically and cross-border) increased, this situation was not sustainable and something had to be done to enable securities to be held securely and for settlements to become more efficient.

Evidence of this could be found in the new Eurobond market that had been established in the early 1960s. Whilst new issuance and secondary market trading occurred in the United Kingdom and continental Europe, the physical bonds were held in New York. Indeed, the majority of deliveries and payments were made there too. By 1967, things had become so bad that deliveries were being delayed by months, resulting in a large number of settlement fails. One trading house based in London had settlement fails that amounted to three times its capital. This situation had the potential to destroy the market.

As a consequence of this paper logjam,

“… three enduring institutions emerged. Between them, they provided a framework in which the business could survive and progress. In the Association of International Bond Dealers (AIBD), the market forged a mechanism for self-regulation and collective expression. In Euroclear, and later Cedel, it developed mechanisms that spanned primary and secondary markets, combined depository, clearing and settlement operations in one, and worked hand-in-hand with the banking system to provide settlement-related liquidity
.”
1

You will notice that these two organisations were clearing mechanisms as well as depositories for the one particular type of security that had no domicile (i.e. a Eurobond).

Euroclear and Cedel (now known as Clearstream Banking Luxembourg) were not the only organisations that were established to handle the depository business. Depositories began to spring up in markets that would handle either a single asset type (e.g. equities only) or a range of asset types (e.g. equities, bonds and money market instruments). The key feature was that the security types that these new depositories were looking after were domestic in nature.

Examples of countries where depositories were being established around this time included the following:

  • Canada – 1970;
  • USA – 1973;
  • Japan – 1984;
  • Singapore – 1987.

Plus:

  • Euroclear – 1968;
  • Cedel – 1970.

Today we refer to the domestic depositories as
central securities depositories
(CSDs) and the two Eurobond depositories as
international central securities depositories
(ICSDs).

6.3 DEFINITIONS
6.3.1 Domestic (Local/National) CSDs

A CSD is either the physical entity or the system that facilitates the settlement and safekeeping of securities and ensures the reconciliation of participant accounts. Securities can be kept safe in immobilised or dematerialised form.

Settlement generally occurs in book-entry form.

6.3.2 International CSDs

An ICSD is a depository that settles trades in international and various domestic securities, usually through direct and indirect links with agents in the domestic markets. The best-known ICSDs are Euroclear Bank and Clearstream Banking Luxembourg. The Eurobond market developed partly in response to operational and regulatory inefficiencies in domestic bond markets.

There is some terminology contained within the definitions that requires some explanation:

  • Securities in immobilised form:
    The physical certificates are represented by electronic records against which purchases are credited and sales debited. The physical certificates are not used for settlement purposes (i.e. they are immobilised).
  • Securities in dematerialised form:
    The physical certificates are represented by electronic records (as with immobilisation above) and subsequently destroyed.
  • Book-entry settlement:
    This is the settlement and movement of securities and/or cash by electronic debits and credits rather than the physical movement from seller to buyer (or payer to payee).
6.4 CENTRAL SECURITIES DEPOSITORIES
6.4.1 Features of CSDs and ICSDs

The main features of these organisations can be found in
Table 6.1
.

TABLE 6.1
Features of selected central securities depositories

Features
Meaning
Comments
Types of securities held
(DOM)
(INT)
(B)
(C)
(G)
(E)
(O)
  • Domestic securities
  • International securities
  • Bonds
  • Certificates of deposit
  • Government securities
  • Equities
  • Other types of securities
Owner/manager
(CB)
(B)
(SE)
(O)
  • Central bank
  • Commercial banks
  • Stock exchange
  • Other type of owner
Securities settlement system
Name of the settlement system(s) with which the CSD is associated.
Closing time for same-day transactions
Latest time of the day at which transactions can be sent to the system for settlement on the same day.
Links to other CSDs
Direct links
Indirect links
  • Based on cross-participation
  • Through local agents
Delivery lag (T+
n
)
Time lag between entering into a trade and its settlement.
Intra-day finality
Yes
No
  • System offers intra-day finality
  • System does not offer intra-day finality
DVP mechanism
The link between a securities transfer system and a funds transfer system which ensures that delivery occurs if payment occurs.
Currencies
ISO codes of currencies in which settlement can be made.
The cash settlement agent that settles the cash leg of the securities transactions
(CB)
(B)
(SE)
(O)
  • Central bank
  • Commercial banks
  • Stock exchange
  • Other type of agent

Source:
CPSS/BIS (online). CPSS 116. Available from
www.bis.org/list/cpss/index.htm
. [Accessed Monday, 27 January 2014]

A selection of CSDs together with the features highlighted in Table 6.1 can be found on pages 524 to 527 in CPSS 116 (you downloaded this previously).

A full list of CSDs can be found on the websites of the five regional associations; we look at these later in this chapter.

6.4.2 Functions of CSDs

You will now be able to appreciate that the safekeeping of securities has predominantly changed from being fragmented (i.e. held by investors and/or their agents) to being centralised through the introduction of the CSDs.

Safekeeping

The prime function of a CSD, therefore, is the safekeeping of securities. This might include all types of security (money markets, equities and bonds) or only one type (e.g. equities only).

When a security is issued, the issuer arranges for 100% of the bond or shares to be delivered to the appropriate CSD. Depending on the local market convention, the issue may be in any of the formats mentioned earlier:

  1. Immobilised:
    The whole issue might ideally be represented by one certificate or by many certificates. For example, ABC issues USD 1 billion of bonds. There may be one
    certificate with a face amount
    2
    2
    of USD 1 billion or 1 million certificates each with a face amount of USD 1,000 or 200,000 certificates each with a face amount of USD 5,000. The optimal situation would be safekeeping just a single certificate per issue.
  2. Dematerialised:
    The whole issue would be represented by either one certificate or some form of receipt from the issuer.
  3. Definitive certificates:
    The whole issue would be fully certificated, for example, ABC issues 50 million shares that would be deliverable to buyers in one of the following ways:

    An investor buys 5,000 shares and receives:

    • 1 certificate for 5,000 shares, or
    • 5,000 certificates for 1 share each, or
    • 100 certificates for 50 shares each, or
    • any other combination.

Please note that Option 3 (definitive certificates) would result in the CSD delivering the physical certificates to the purchaser or its agent.

In Options 1 and 2, there is no need to deliver physical certificates as the deliveries and receipts of securities are recorded by book entry only, as the example in
Table 6.2
shows.

TABLE 6.2
Transaction example

Transaction
Securities Settlement Account
Cash Account
Investor buys 5,000 shares against payment of EUR 20,000.00
5,000
EUR (20,000.00)
Investor's securities settled position
5,000
Broker's position pre-trade
7,500
Broker sells 5,000 shares against payment of EUR 20,000.00
(5,000)
EUR 20,000.00
Broker's position post-settlement
2,500

The CSD reports to both buyer and seller that their transactions have settled and that:

  • The investor now holds 5,000 shares (plus cash debit);
  • The broker now holds 2,500 shares (plus cash credit);
  • The CSD is now safekeeping 7,500 shares, as shown in
    Table 6.3
    .

TABLE 6.3
Settled safekeeping positions at the CSD

Entity
Number of Shares
Investor
5,000 shares
Broker
2,500 shares
Total
7,500 shares

In this example, the investor and the broker are participants of the CSD. The CSD regards the investor and the broker as being the owners of these shares. This might suggest that any type of entity can be a participant of a CSD. Whilst there are exceptions, the general rule is that participants tend to be locally based sell-side institutions such as broker/dealers, local banks and non-bank financial institutions. This would suggest that the following entity types are excluded for direct participation in a CSD:

  • Private investors (retail), both local and foreign;
  • Foreign banks;
  • Foreign sell-side institutions;
  • Foreign non-bank institutions.

For this group, the only way to access the CSD will be indirectly through local entities that are participants in the CSD (as shown in
Figure 6.1
).

FIGURE 6.1
CSD participation

There are exceptions to this general rule; for example, there are CSDs that allow the private investor direct access (e.g. Finland, Sweden, UK and Ireland and Singapore). As with any “system”, such as a payment system or clearing/settlement/safekeeping system, CSDs are exposed to systemic risk
3
3
and must exercise caution in terms of who they accept as participants.

Settlement

Settlement is the final step in a securities transaction, and the transfer of ownership takes place within the CSD. The CSD will receive the results of the clearing from the CCP or clearing house and pass appropriate entries over the securities accounts held by the CSD. This includes:

  • Primary market activities: Receiving new securities from the issuers and their issuing agents;
  • Secondary market activities: Settlement of transactions (trading, repo, securities lending, free deliveries, etc.).
Income Collection

Dividends and interest payments (coupons) are paid by the issuers' paying agents, who, in turn, pay the CSDs. The CSDs then credit their participants with the income.

Corporate Actions

Again, the issuing and paying agents are involved on behalf of the issuers. We cover corporate actions plus proxy voting in Chapter 11.

These services can be regarded as being “core” or “basic”. They are essential in the overall safekeeping and administration of the securities. However, CSDs might offer additional services.

Securities Financing

This includes securities lending, repo and sell/buy-backs.

Collateral Management

Participants (and their clients) can use their securities to finance their daily activities by pledging securities as collateral. The CSD manages the benefits (income and corporate actions) and provides assurance to lenders that they have control over the pledged securities.

Data and Repository Services

CSDs hold vast amounts of data which can be used to deliver other services, for example, the USA's Depository Trust & Clearing Corporation (DTCC) also provides:

  • The DTCC General Collateral Finance Repo benchmark index which tracks the average daily interest rate paid for repo contracts;
  • Reference data services that help to standardise legal entity identifiers;
  • A global trade repository service which acts as a single transaction-reporting interface between the participants that execute derivatives transactions and the regulators that need access to the positions information.

More information can be found on the DTCC website:
www.dtcc.com/data-and-repository-services.aspx
.

6.4.3 The Changing World of CSDs

In 1989 following its landmark study on clearance and settlement problems, the Group of Thirty (G30) published nine recommendations
4
4
that resulted in numerous industry reforms across the globe. In particular, Recommendation 3 made reference to CSDs:

In retrospect, G30's Recommendation §3 assumed that each country/market would support between one and three CSDs. On the whole, whilst this has been the situation in the majority of markets, in one particular region there has been a consolidation in the ownership of local CSDs. This region is Europe and the consolidation has been driven largely by the two ICSDs, Euroclear Bank and Clearstream Banking Luxembourg.

Table 6.4
shows the local CSDs that are owned by Euroclear SA/NV.

TABLE 6.4
Euroclear ownership of CSDs

Country
Status
Formerly Known As … (Year Taken Over by Euroclear)
Euroclear Bank
ICSD
Transferred from Morgan Guaranty in 2000
France
CSD (1949)
SICOVAM (Euroclear France – 2001)
UK and Ireland
CSD (1996)
CrestCo (Euroclear UK and Ireland – 2002)
Netherlands
CSD (1977)
NECIGEF (Nederlands Centraal Instituut voor Giraal Effectenverkeer) (Euroclear Netherlands – 2001)
Belgium
CSD (1967)
CIK (Caisse Interprofessionnelle de Dépôts et de Virements de Titres) (Euroclear Belgium – 2002)
Finland
CSD (1997)
APK (Suomen Arvopaperikeskus Oy) (Euroclear Finland – 2008)
Sweden
CSD (1971)
VPC (Vardepappercentralen) (Euroclear Sweden – 2008)

Table 6.5
shows the local CSDs that are owned by Clearstream International, part of the Deutsche Börse Group.

TABLE 6.5
Clearstream ownership of CSDs

Country
Status
Formerly Known As …
Clearstream Banking Luxembourg
ICSD
Centrale de Livraison de Valeurs Mobilières – Cedel
Clearstream Banking Frankfurt
CSD
Deutsche Börse Clearing (formerly Deutsche Kassenverein – DKV)
Luxembourg
CSD (2011)
–

In addition, ten CSDs launched Link Up Markets in March 2009 – a joint venture to establish a common infrastructure allowing for interoperability between CSDs and introducing efficient cross-border processing capabilities (see
Table 6.6
).

TABLE 6.6
Link Up Markets

Clearstream Banking Frankfurt
Oesterreichische Kontrollbank AG (Austria)
Cyprus Stock Exchange
SIX SIS AG (Switzerland)
Hellenic Exchanges (Greece)
STRATE (South Africa)
IBERCLEAR (Spain)
VP Lux
MCDR (Egypt)
VPS (Norway)

Source:
Link Up Markets (online) “The joint venture partners of Link Up Markets”. Available from
www.linkupmarkets.com/home.asp?Page=Organization
. [Accessed Monday, 3 February 2014]

Elsewhere around the world, a network of bilateral relationships amongst the CSDs has arisen (see
Figure 6.2
). These inter-CSD links enable participants of a CSD in one country to indirectly access the CSD of another country, making it more straightforward to hold foreign securities without the need to open a participant account directly with the foreign CSD.

FIGURE 6.2
Inter-CSD links

One example of a CSD in country “A” offering its clients direct access to the exchange and OTC markets of country “B” relates to the Austrian CSD, CSD.Austria. It was announced in September 2013 that CSD Austria and the Russian National Settlement Depository (NSD) had launched an international direct link to the Russian securities market.
5
5
This link was made possible as foreign CSDs are allowed to open foreign nominee accounts with the NSD.

Since then the NSD has established further links with the Central Depository of Armenia and opened the Russian corporate bond market to international investors through links with Clearstream Banking Luxembourg and Euroclear Bank.

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