This article takes an objective appraisal of the current developments in both the clearing of securities as well as settlement, with particular emphasis on Europe. These are compared to similar developments in derivatives and commodities. Finally, some of the more far-sighted developments in settlement are explored in terms of their potential benefit and impact on the existing market landscape.
The outcome of clearing and settling securities transactions is that the seller gets paid and the buyer gets title to his stock.
The key question to be addressed is: Why is this process so difficult?
The European context
Recently, Europe has emerged as the place where major issues in the securities market are to be decided. The issue of consolidation of stock exchanges has been fought and, so far, lost in Europe. The focus of market participants was then brought to bear on settlement, with a call for the amalgamation and consolidation of the central securities depositories (CSDs) -- the organisations responsible for the settlement of securities transactions -- from the large and expanding population of stock exchanges and 'execution platforms'.
This also failed. Attention then was brought to bear on the clearing houses, with representatives of market users agreeing, in public, that the right European structure for clearing was a single central counterparty serving the transaction stream between Europe's execution venues and the various settlement systems. This was the 'hour glass' structure, where competition between exchanges for execution and competition between settlement systems would be separated by a single European central counterparty, from which it was expected that industry efficiency and cost reduction would result.
This appeared to trigger in a number of market servicing organisations' immediate recognition of the 'value generating' potential of clearing houses, which led to a rapid increase in new central counterparty clearing houses in the European markets (XClear and European Central Counterparty being just two).
The accepted emphasis in European securities markets continues to be on consolidation. The prevailing view is that market infrastructure in Europe is too fragmented and therefore expensive to operate as a whole. The immediate solution is to have less of it -- fewer stock exchanges, one central counterparty and fewer settlement systems. Yet, with the exception of the Euronext organisation, little serious consolidation has resulted. Alliances are being discussed and some valuable efforts to find common standards and practices between settlement systems have been made by ECSDA (European Central Securities Depositories Association), although neither of these initiatives actually removes surplus capacity from the marketplace.
Identifying the problems
The failure rate of securities transactions in Europe, arguably the most sophisticated trading market, is reported by a leading settlement agent to be 15%. This poor performance has given rise to a number of significant studies into the issues raised which have in turn catalysed a number of separate initiatives. In no particular order these include:
- Lamfalussy -- Wise Men Report
- Giovannini -- Report into EU Clearing and Settlement
- G-30 -- new recommendations in Global Clearing and Settlement
- European Securities Forum -- user lobby group
- European Central Securities Depositories Association
- Global Straight-through Processing Association -- GSTPA
- Central Counterparties Association
These initiatives have a variety of remits and backing ranging from governments and central banks through to industry/user groups. Their agenda and objectives also cover a wide range of targets, although they share one principal goal in attempting to bring to pass greater efficiency in post transaction processing -- clearing and settlement.
At a distance they would appear to have achieved remarkably little, given the industry and the increasing political pressure that is being brought to bear. The proof of this lies in the continuing fragmentation and variety of processes, independent of both governance and management of the organisations involved.
Indeed, the current G-30 initiative has established a remarkable consensus on the prime causes of the industrial problem from a wide ranging series of interviews with investment banks, investors, custodians, clearing houses, settlement systems, exchanges and brokers. One of the principle causes is claimed to be failure of 'interoperability' which describes the ability of different market services, such as clearing houses and settlement systems, to work in harmony.
The main contributors to the lack of interoperability are the absence of agreed terminology and market practices and the many different ways in which information is presented and recorded from top to bottom in the transaction chain. This, surprisingly, is true within certain national markets as much as in cross-border equities markets. The most significant contributor to this is the lack of standardisation in legal, regulatory and taxation rules and practices between one national market and another. One example of this problem is the wide variety of legal approaches to the concept of 'property'. So if something goes wrong during the process of clearing and settlement, ownership of the asset being transferred may be hard to define. And of course if something has gone wrong, it is highly likely that each counterparty has a vested interest in the outcome and goodwill cannot necessarily be relied upon to resolve the situation.
The transaction chain
Title to traded assets is a pretty basic concept in the process of transaction performance. Frequently, it is not until the laws of property in question have been tested in court that the precise position in current and past transactions can be relied upon.
There is a predictable and sequential flow of events and processes that must take place after trading to achieve satisfactory transaction performance. Some are by-passed as the specific market participants are prepared to accept additional risks which other markets are not. But in general the flow can be represented as follows:
Surprisingly, though, 'clearing and settlement' are often used as a single term, rather in the way that sales and marketing are frequently used in blended form -- the two terms being brought together to disguise the fact that the individual meanings of the functions are not fully understood or appreciated. In terms of the development of market infrastructure it is increasingly relevant to consider them as separate and distinct processes, since an important body of opinion in the market is keen to see clearing and settlement delivered on a separate basis.
In Europe the issue was handed over by the industry to politicians, when the EU competition commissioner, Mario Monti, was asked to review the competitive aspects of clearing, settlement and execution combined in what are termed 'silos'.
Silos describe the grouping of a stock exchange, clearing house and settlement system in one organisation. The alternative to silos are 'service providers', where each process is delivered by separate and distinct organisations, the implication being that this enables more transparent and competitive pricing.
In individual geographic markets, it is sometimes hard to understand the argument between silos and service providers where there are effective monopolies, and in Europe cross- border competition in the execution, clearing and settlement of domestically-issued equity and fixed income has yet to joined on any scale.
The nature of the traded asset has a large impact on the functional market infrastructure required to handle transactions efficiently. Similarly, the method by which transactions are executed points to the sophistication of the clearing and settlement processes required.
Equities are traded in greater volume than most corporate bonds. For settlement, the transfer of title to shares is made clear through transparent processes delivered by sophisticated organisations, the central securities depositories (CSDs), and increasingly supported by regulatory oversight. Significantly, corporate bonds may be settled through both CSDs and the ICSDs -- Euroclear and Clearstream. These two organisations have presided over the smooth operation of the Eurobond market for some thirty years. The Eurobond market has, during this time, offered both the primary and secondary markets global, multi-currency and multinational settlement, with cross-border transactions being the rule rather than the exception.
Whilst domestic market service organisations have been wrestling with cross-border issues, the Eurobond market has smoothly encompassed global bonds which add domestic linkages to CSDs. This adds domestic populations of investors to the Euromarket contingent and is increasingly applied to equities.
The reason why, in aiming to provide the best service to their domestic equity markets, CSDs did not surrender their domestic and cross-border process flows to the ICSDs (as Sicovam appears to have done with Euroclear Paris) raises a number of sensitive and vital issues.
- Costs -- domestic organisations contend that the ICSD tariffs are significantly more expensive than their own.
- Control -- the ICSDs have traditionally been owned and controlled by the large multinational broker-dealers, rather than market participants more domestically aligned.
This is where the real barriers to consolidation lie. Although high profile cross-border transactions are dominated by a comparatively small number of large broker-dealers, domestic transactions involve a much more diverse population of intermediaries, many of whom are both powerful in their domestic context and are less interested in the needs of cross-border transactions. Consolidation of market infrastructure, therefore, carries different levels of appeal to domestic players whose local power-base may be disproportionately large in comparison to their market share. And within their own domestic markets, many of the European providers compare very favourably with the US on a cost per basis.
However, the Centre for European Policy Studies recently published its own view, following the Lamfalussy report. This outlined that the best way of providing market infrastructure most appropriate to the needs of the European marketplaces lay in allowing the forces of competition to prevail. Also, that allowing the various providers to compete for the transaction flows of national and cross-border markets would result in efficient and cost-competitive services.
Is this the climate likely to allow the development of genuine user-driven solutions to the problems?
Providers with large monopolistic market positions are not likely to cede their markets without a fight. Domestic markets will take some convincing that their legal, taxing and regulatory frameworks should be disbanded. So under the competition option it seems unlikely that significant changes will happen quickly.
However, solutions to the problems of administering cross-border transaction flows have been around for many, many years. These include depository receipts, nominee accounts, global custody and various trust-based initiatives.
As illustrated below, these instruments vary from the well known, such as American and global depository receipts -- ADRs and GDRs -- to more arcane structures. They all, in some form, rely upon the continuing inability of different geographical markets to achieve common standards and processes and therefore seek to provide a fungible bridge between them. Either they adopt a dominant set of standards, as in the case of ADRs adopting US standards and market processes and CDIs using UK market practices, or they seek to find an acceptable compromise as 'global shares' aim to do.
Commodities
Transactions in commodities involve transfers not only of ownership, but also, frequently, commitments in terms of the movement and physical delivery of the agreed consignment. In addition, successful settlement of a commodity transaction requires the buyer to formally accept the quality and physical terms of the delivery for the transaction.
Unlike securities, where transfer of property involves, at worst, the receipt of a bearer certificate, and can be quickly achieved soon after transaction, settlement of commodity transactions can take place a significant time after execution. For example in the electricity market, deliveries against a forward electricity contract are delivered over a year after the transaction was executed. As the experience of Enron has shown, within that period a number of major market problems can arise to render successful delivery uncertain.
Yet the electricity markets remain outside the auspices of clearing houses and settlement systems, although scheduling agents perform valuable roles in terms of identifying the route for the transfer of property between seller and buyer.
Warrants of entitlement
Physical delivery under a commodity futures contract is not, as is often amusingly claimed, a large wagon arriving at the buyer's front door with several tonnes of grain or metal on board, but rather takes place through the allocation by the clearing house of a bearer document of title -- a warrant of entitlement. This document gives the holder legal claim to a quantity of the physical commodity held by a warehouse within the network of the futures exchange's delivery locations. Invariably, the quality of the commodity will be of an acceptable commercial standard, which could be sold efficiently and immediately in the open market place. All the document holder must do is arrange for collection and pay for storage since the time of transfer of title.
Typically, as these warrants of entitlement are allocated to open buyers in the market, they are immediately handed on, via a sale, to other open buyers, or are actually used as strategic supplies for commercial operations.
The point is that these warrants act on the exchange as 'securitised' quantities of the physical commodity, much in the way a banknote was, in the past, securitised gold. The advantages of a warrant are that is it easier to handle for the purposes of satisfying transactions, whilst the variable factors which govern its value (quality, condition, etc) are standardised. The warrants are supported by formal dispute resolution machinery and, ultimately, effective redress against the deliverer and/or store-keeper.
So providing the means for warrants to be transferred between counterparties in exchange for good payment removes the majority of the traditional process and quality risks of commodity transactions on futures exchanges.
If the warrants were then to be made available in electronic form, via computer records, the performance of commodity transactions would move to new levels of security and efficiency.
Contracts
Within the context of clearing and settlement, contracts include derivatives -- futures and options, but also swaps and contracts for differences (CFDs). Transactions in contracts are now mainly confined to agreements between counterparties to exchange cash-flows relating to defined and stipulated events. No transfer of title of the underlying asset takes place.
Settlement of contracts therefore amounts to accurate (or at least acceptable) valuation techniques of the counterparties' contracts, an assessment of the balance of payments and a single cash transfer.
Registration
Share registration is a securities service that is often overlooked. In a registered as opposed to bearer market, providing shares are efficiently deregistered from a seller's name and registered into the buyer's name, and the various entitlements from share ownership flow to investors, little thought is given to the function of the registrar.
However, as pressure builds to smooth the movement of securities across markets and jurisdictions, so more focus may come to bear on how registers of members can help cross-border trading.
A company is required by law to hold a list of its registered shareholders. Commonly, this is delegated either to external specialist companies, such as registrars or stock transfer agents, or to the market infrastructure itself. The UK currently occupies a middle ground with a well-developed industry of share registrars but where the legal record of holders of dematerialised shares (about 85%) is in the computers of Crest, the UK CSD.
Transactions in registered shares are literally the transfer of title to those shares from a seller to a buyer. This can be achieved by altering the holding of the seller on the register and increasing the holding of the buyer. Obviously, these can simply be two adjustments to a computer record, irrespective of the impact of those transactions in the marketplace.
This computer record then drives all dividend entitlements, eligible voting and participation in new issues and other corporate actions. The computer record can record foreign names and addresses, apply conditions on incoming transfers (such as limits on foreign shareholders) and can interface with similar computer records held in other countries and jurisdictions. In fact, arrangements can be made so that a particular transfer of title can automatically remove stock from a register in one country and automatically increase the holdings in another.
So, in this case, where is the difficulty in moving stock around the world, from one market to another?
Depositories
Whether they act as the settlement system of one country, or the custodian for a settlement system in another, depositories basically maintain records of holders in securities. These records, again, drive the various investor services and entitlements. Often the only difference between these records and those of the registrar is the fact that the registrar has responsibility to the issuing company, whilst the depository owes its duty to investors.
Custody
Custodians hold records of the securities held by their investor customers to ensure that they are correctly represented to the issuing company in terms of their entitlements. Custodian and depository records are often reconciled to the records of the registrar.
Record-keeping
Within most modern markets a network of records exists which, if taken together, could track electronically every holding of investors, including those in certificate form (through the register), every securities transaction and every movement in title across every market.
Even those markets that remain in bearer format can either trace ownership through the participant records of closed systems, such as Euroclear and Clearstream, where the global notes themselves act as registers (albeit at high-level) as they record daily the respective collective holding of the participants of each settlement system.
Outside these organisations, the trend has been for the Euromarket retail investors to hold their investments through custodian banks, and therefore, on record.
The future
It should not be beyond the imagination of the markets collectively to spot the opportunity in linking these record-keeping organisations with the objective of developing improved transfer capabilities from one market to another and across borders. This would be accompanied by increased levels of service efficiency experienced by investors, for example in receiving entitlements, and increased efficiency of capital raisings through rights and secondary offerings. This potential was demonstrated most impressively by the British Telecom rights issue in 2001 which was the first electronic rights issue and, at GBP5.9bn, one of the biggest ever.
The linking of registers in this way is fundamental to the recent Global Registered Shares (GRS) product that has been developed principally for linking European markets with American markets. At the time of writing, GRS programmes have been established for the US listings of Deutsche Bank, UBS, Daimler Chrysler and Celanese. As GRSs compete with ADRs, their elder brethren, they are faced with the challenge of gaining acceptance in the broker marketplace, and also overcoming the critical reaction that new products often meet in securities markets.
The howls of fury over the competitive potential of GRSs will be nothing compared to the likely reception from the securities markets over a new potential development that is already on the drawing board. Termed Digital Bearer Securities, the concept draws heavily from the technology behind 'digital cash', where payments can be beamed from one 'electronic wallet' to another, without any intermediation. The recipient of digital cash receives spendable value from the sender and relies on the technology to avoid fraud, theft or erroneous payment.
Digital Bearer Securities use the same approach to the transfer of title -- beaming from one 'electronic portfolio' to another. In fact delivery verses payment would be achieved through simultaneous exchange of 'beamed' title to the securities in question, for the agreed consideration in electronic cash. Once the two 'beamed events' have taken place no further communication is necessary between buyer and seller. No confirmation is necessary because, as with more traditional bearer securities such as Eurobonds, title to the securities passes at exchange.
The buyer is henceforth responsible for care and security of his electronic securities, stored neatly in his electronic portfolio, and for future allocation of 'shapes' to investor customers.
The transaction remains invisible to the issuing company until either they need to undertake a roll-call of investors, or there is a dividend distribution, AGM or other routine event in the corporate calendar. At this point, investors can either identify themselves to the 'registrar or paying agent' via the web, or directly to the company.
There is much thought yet to be given to bring this concept to full industrial strength, which is being done. But the idea has merit in offering a vastly different approach to the business of trading and settling securities.
Whether the development of post-transaction administration can be left to the market to prosecute sufficiently quickly and even-handedly, or whether external influences from regulators, legislators and politicians are required, is not strictly for debate. What is for debate is in which direction this development should go and how far and fast.
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