The subject of clearance and settlement of securities transactions is of relevance to central banks for at least three major reasons.

The subject of clearance and settlement of securities transactions is of relevance to central banks for at least three major reasons.

First, some central banks themselves operate clearance and settlement systems, generally for transactions in local governmental debt securities. This is, for instance, the case in the United States, where the Federal Reserve Bank of New York operates the Fedwire system, which settles U.S. Treasuries transactions. Such is the case also in Argentina, Belgium, Greece, Italy, New Zealand, Spain, and the United Kingdom (whose Central Gilts Office actually services not only U.K. gilts, but also Irish gilts), among others. The trend may be for central banks to shed this responsibility (e.g., in France, the Netherlands, Mexico, and soon England), but even then, the central bank sometimes remains a major shareholder of the clearing system to which the role has been transferred (e.g., France).

A second reason is that many central banks are direct users of the services of clearance and settlement systems. Central banks hold a significant part of their external reserves in the form of securities, such as U.S. Treasuries, U.K. gilts, German bunds, or Japanese JGBs. They also hold positions in their own countries’ government securities. These portfolios of securities are typically not held by the central banks in their own vaults, but rather with a clearance and settlement system (for instance, over 50 central banks are direct participants of the Euroclear System) or with a custodian bank.

Third, many central banks are interested in clearance and settlement systems in a regulatory or supervisory capacity—some because they directly regulate one or more clearing and settlement systems, many because they supervise banks and other financial institutions that are the main users of these clearing and settlement systems, and all because they are responsible for the stability of their country’s currency and financial markets, and the failure of a clearance and settlement system could, just as that of a payment system, have systemic risk consequences for these financial markets.

This presentation will be in four parts. It will first review the supervisory environment for clearance and settlement systems. It will then describe the manner in which securities are, in practice, held and transferred and the consequences of this process. It will give a brief reminder of the basic services offered by clearance and settlement agents. It will discuss in detail some of the risks associated with clearance and settlement activities.

Supervision of Clearance and Settlement Activities

Because of potential systemic implications, central banks, together with securities commissions, have sharpened their focus over the past few years on the identification and management of the systemic risks associated with clearance and settlement activity, both domestic and international (i.e., cross-border). This focus has helped bring to light that clearance and settlement activities were not always adequately supervised or regulated in all countries. It is now spurring an effort to encourage greater disclosure of risks and, where possible, harmonization of regulatory treatment and supervision of clearance and settlement systems.

On one end of the supervision spectrum stands the Euroclear System, the world’s largest clearance and settlement system for internationally traded securities. It clears and settles about U.S. $40 trillion worth of securities transactions per year in any of the over 100,000 different securities that are accepted for settlement (which include Eurobonds, but also domestic governmental and corporate fixed income securities, equities, warrants, depositary receipts, and other types of securities from over 30 countries). Its users are all professional institutions active in the international financial markets, such as banks, broker-dealers, inter-dealer brokers, and central banks, as well as certain insurance companies, fund managers, and even corporations with sophisticated treasury operations, from over 80 different countries.

The Euroclear System is market-owned and is operated under contract by Morgan Guaranty Trust Company of New York, the main banking subsidiary of J. P. Morgan and Co. Morgan Guaranty created the Euroclear System 30 years ago (in 1968), and, in view of the critical importance that this function quickly took for the financial markets, it transferred ownership of the Euroclear System in 1972 to the market, specifically to a company set up for that purpose (Euroclear Clearance System, plc) owned by about 125 of the main users of the System. This company later set up a subsidiary (Euroclear Clearance System Société Coopérative) to which it transferred much of its governance responsibility regarding the Euroclear System. This cooperative company, of which every client of the Euroclear System is entitled to become a shareholder, is thus responsible for taking all major policy decisions concerning the system (including the budget, fees to be charged, the custodians to be used to actually safe keep the securities held in the system, and so on).

Because of its expertise, Morgan Guaranty has been retained by the cooperative to operate the Euroclear System in accordance with the rules set in the contract between them. Morgan Guaranty operates the Euroclear System in its own name through a dedicated unit of its Brussels branch, called the Euroclear Operations Centre (hereinafter referred to as “Euroclear”). This unit is supervised by four separate authorities, two in the United States and two in Belgium. Because it is an integral part of the branch of a New York State chartered bank, it is supervised by the Federal Reserve Bank of New York, as well as by the New York State Banking Department. In Belgium, it is supervised by the Banking and Financial Commission, the financial watchdog of financial institutions that are established in Belgium, and also by the Belgian National Bank, which has been granted specific supervisory responsibilities over clearance and settlement systems in Belgium.

Such an intense supervisory oversight is unparalleled in the world. Most clearance and settlement institutions are supervised by a single regulator, which may be the central bank, the securities commission, or even a special body. In some countries, there is no clear supervisory regime. In fact, in several countries, at least until very recently, clearing and settlement activities have remained largely unsupervised, either legally or de facto. To understand this, it is necessary to describe how securities are actually held and how securities transactions are settled.

Clearance and Settlement and Multi-Tier Holding of Securities

First, let us define “clearance” and “settlement” of securities transactions. The clearance of a transaction consists of calculating, for each member of the clearing system and for a given period (typically one day), the amount of securities this member must deliver and the amount of cash that it must pay for the receipt of securities. Clearance involves no transfer of assets (cash or securities), but merely the calculation of the obligations to transfer. It is obviously a very simple process in settlement systems where each transaction is processed individually (on a “trade by trade” basis), but is much more complex when the system works on the basis of bilateral or even multilateral netting of the daily transactions of its clients. In such a case, cash and credit limits will typically be established for each member, thereby containing the exposure that any one member of the system can have on other members, which must be reflected in the clearance process. Settlement is the actual transfer of the assets: delivery of the securities and payment of the cash. As explained below, most of these transfers take place through debits and credits to securities and cash accounts, rather than through physical remittance of assets.

In the settlement systems (such as Euroclear) that do not use netting, both clearance and settlement are effected by the same entity and are, in reality, not dissociated steps. In contrast, where netting is involved, the two steps are often handled by separate institutions, with the clearance system “feeding” the results of the clearing to the settlement agency (e.g., in the United States, where the Government Securities Clearing Corporation (GSCC) and the National Securities Clearing Corporation (NSCC) are clearing systems and the Depository Trust Company (DTC) acts as the settlement system).

As intimated above, investors who acquire securities do not, in practice, tend to hold them physically in their vaults or under their mattresses at home (with the notable exception of the so-called “Belgian dentist,” who apparently attaches great importance to confidentiality about his wealth, including vis-à-vis the tax authorities). Indeed, physical holding of securities by the end investor would be both risky and very inefficient when the time comes to sell the securities. In many securities markets, securities must be delivered to the buyer within three days of the trade (the so-called trade plus three, or T+3, rule). Some markets are even moving to a T+0 rule, meaning that delivery of the securities must be made the same day as the trade. Investors selling securities they hold in physical form themselves would clearly face difficulties delivering the securities within such a short period of time, especially as, in practice, the delivery is made through the seller’s broker or bank, which would need first to receive the securities from the seller and deliver them on his behalf. Securities delivery in physical form would be particularly daunting for international trades. Considering that a number of investors sell securities very quickly after buying them, often less than three days after purchase, it is critical that securities be delivered on time to buyers.

As a result, it must be obvious that, in any sophisticated and active securities market, if more than a small proportion of the investors physically held and transferred their securities themselves, major delays in deliveries would quickly develop, creating bottlenecks and ultimately jeopardizing the liquidity of the market. The same problems would arise if the holder of the securities wished not to sell the securities, but merely to exercise rights attached to them (such as receiving interest or dividends, exercising options or offers emanating from the issuer, or voting at general assembly meetings of shareholders).

Thus, investors generally ask a financial intermediary to hold their securities for them, typically the bank or broker whom they use to buy and sell their securities. When the investor decides to sell the securities, he simply places the necessary order with his agent, without the need to bring or mail the securities to this agent. The investor can also ask this same intermediary to exercise the rights attached to the securities in accordance with his instructions.

In turn, the intermediary is also unlikely to hold these securities in physical form within its own vaults, much for the same reasons as the investor does not. It will deposit these securities with another intermediary (for instance, if these are foreign securities, it will deposit them with a local custodian bank of the country of issuance, the local central securities depository of the country, or an international clearing institution like Euroclear, which will itself hold them locally). Through a chain of such deposits and redeposits, the securities issued in a given country are physically held in an ultimate repository in that country, where the liquidity of the market in these securities generally resides. Many countries have, for this purpose, set up a special institution, called a central securities depository (CSD), where the securities either may or must, by law, be safekept. Where this is mandated by law, the local CSD has a monopolistic position as regards the safekeeping of the securities (although not, as explained below, as regards clearance and settlement). This mandatory “warehousing” is achieved in some countries through dematerialization of the securities (i.e., by law, the securities do not exist anymore in any physical form and are represented merely by a computer entry in the accounts of the CSD). In other countries, therefore, the centralized process is not compelled, but merely encouraged with a varying share of the stock of the countries’ securities immobilized in the CSD. For Eurobonds, market practice had instituted Euroclear and Cedel (the other international clearing institution, set up in Luxembourg) as the CSDs, but in the last years Eurobonds have also been deposited with local CSDs.

This process of multi-tier holding of securities (i.e., book-entry holding through a chain of successive depositories) has served markets’ needs very well. It has led to substantially reduced costs and risks, and has increased the liquidity of the markets by allowing for faster and safer turnaround of securities portfolios, even intra-day. The concept is simple. With the securities certificates warehoused in the CSD, all transfers take place through movements in the accounts of the seller and the buyer of the securities (or more generally of the transferor and the recipient, since the underlying transaction need not be a sale, but could be a pledge or any other form of transfer). This is called a “book-entry” transfer of securities. When the transaction takes place between two members of the CSD, the transfer is effected by movements in their respective accounts within the CSD. The CSD then not only plays its primary role of central depository, but also acts as clearance and settlement agent.

However, not all, or even necessarily the majority, of the transfers are made in the books of CSDs. If the transaction is between two clients of the same intermediary that has an account with the CSD, the transfer may be made through movements in the respective accounts of these two clients in the books of the intermediary, without any impact on the intermediary’s position held in the CSD. In this case, the CSD is only playing its primary role of safekeeper of the underlying securities. For instance, a significant share of the settlement of U.S. Treasuries transactions is effected in the books of two major banks, Chase and Bank of New York, rather than in Fedwire. Similarly, more cross-border transactions in German bunds settle in the books of Euroclear than in the books of the German local CSD. Where settlement occurs is, in the final analysis, a matter of service quality and cost efficiency.

This shows that clearance and settlement are activities that may be conducted by more than a single institution per country, typically with several local or foreign custodian banks active in this field, in addition to the local CSD, Euroclear, and Cedel.

Custody, Securities Lending, Credit, and Collateral Management Services

Securities safekeeping and clearance and settlement have historically been considered straightforward activities, involving only limited and well-understood risks. This may have been true 20 years ago when volumes of transactions were still relatively low, transactions essentially domestic, and the activities of intermediaries quite simple. But the capital markets have evolved tremendously over the past two or three decades and so have these lines of business. Volumes have skyrocketed (as an illustration, the annual value of transactions settled in Euroclear went from U.S. $5.7 trillion in 1991 to U.S. $38 trillion in 1997). In particular, cross-border transactions have grown substantially. And the range of services expected from clearance and settlement institutions has broadened.

Local custodian banks, Euroclear, and Cedel provide—and at least some of the national CSDs now have the ambition to follow suit—a range of sophisticated services beyond pure safekeeping and clearance and settlement, including core custody, securities lending, collateral management, and credit services.

Custody services include collection for clients of interest and dividend payments from the issuers; exercise of rights, such as options, warrants, and exchange offers attached to the securities; tax services such as withholding tax exemption at source or tax reclaims for exempted investors; and voting at shareholder or bondholder meetings, all of this in accordance with client instructions.

Securities lending is a particularly useful service for traders who sell securities short (i.e., selling before covering the position, with the intention to obtain the necessary amount of securities by the time the obligation to deliver the securities matures). Traders often cover their delivery obligations by purchasing the securities for receipt the same day they must deliver. Should this purchase not be executed (for instance, because the counterparty fails itself to deliver for any reason), the trader would fail to settle its trade and would be exposed to the funding costs of his buyer, which is a significant penalty that can wipe out the profits of the trade or even more. Therefore, traders are keen to have access to a securities lending program that allows them to borrow any necessary securities at the last minute, as the cost of borrowing is only a fraction of the cost of failing to deliver.

Euroclear has been able to develop such a lending program, where securities are being lent for an attractive fee by other Euroclear participants whose securities would otherwise have remained idle and thus would have generated no return. However, as the Euroclear experience shows, for lending and borrowing programs to be successful, the clearing and settlement institution that runs them must not only have a very efficient algorithm in its systems ensuring optimal allocation of the lendable positions to achieve high settlement efficiency, but it must also have an attractive fee tariff for both lenders and borrowers, and furthermore have as clients a critical mass of both potential lenders and borrowers matching one another’s supply and demand.

Availability of credit is another critical service sought in particular by financial institutions, such as broker-dealers, whose business involves buying and reselling securities, often the same day. Broker-dealers almost always require credit facilities to bridge the period of time that runs from the moment they must make the payment for the purchase and the moment they collect the proceeds of the resale of the securities. Euroclear (i.e., Morgan Guaranty), Cedel, and local custodians are able, thanks to their bank status, to offer credit facilities to their clients. Few CSDs can do so, as they are generally not banking institutions and have too limited capital to warrant this kind of activity. Obviously, as an exception to this rule, central banks that act as CSDs and operate a clearance and settlement system, such as the Federal Reserve, often provide credit facilities at least to their domestic banks.

Clients who borrow securities or receive credit for payment of securities transactions will be expected to collateralize all or part of this credit exposure, whether they borrowed from the clearing and settlement system or from a third party. Because of the market disruption that failures or near-failures of major market players (such as Maxwell, Barings, and others) may cause, the trend is clearly toward the collateralization of most credit exposure. This trend is being reinforced by the requirement of the European Central Bank that credit provided by national European central banks through TARGET be “adequately” (which means fully) collateralized. Accordingly, there is an ever-increasing need for collateral to be mobilized and used in the most efficient way. In part, because of this need, market participants are seeking collateral management assistance. In response, third-party agents, such as Euroclear, offer margining and margin-call services, which consist of ensuring that the value of the securities put up as collateral continues to cover adequately the credit exposure (including an appropriate “haircut”) notwithstanding fluctuations of their stock market quotations. They also offer “substitution” services, allowing debtors who have submitted collateral in the form of securities from a given issue (e.g., U.S. Treasuries), which they would like to recuperate for trading purposes, to substitute other securities (e.g., German bunds) for the same value.

New Risk Profile

The emergence of such new services and the phenomenal growth in volumes potentially entail a new risk profile for clearing and settlement systems and for their clients. Central banks and securities commissions accordingly have increased their focus on risks arising in connection with the holding of securities and the clearance and settlement of securities transactions. Two regulatory groups have played a prominent role in this connection: the Committee on Payment and Settlement Systems (CPSS) of the Group of Ten countries, the secretariat of which is organized by the Bank for International Settlements, and the International Organization of Securities Commissions (IOSCO). In particular, in 1995, the CPSS published a well-documented report on Cross-Border Securities Settlement, cataloging and reviewing the various risks arising in the context of clearance and settlement, especially in a cross-border environment: principal risk, custody risk, credit risk, legal risk, and others. Many of these risks are apt to have systemic implications, in the sense that their materialization could spread the disruptive consequences beyond the party initially affected to other institutions linked to it and, potentially, the whole financial industry. Also, in 1997, the CPSS and IOSCO developed, together with representatives of national and international CSDs, a standard questionnaire on risk transparency relating to CSDs (known as the BIS-IOSCO Disclosure Framework for Risk Transparency) to which all CSDs have been asked to respond and make public. These groups have emphasized the need to give investors complete and understandable information on the risks involved and on the controls that are put in place to manage these risks.

A review of all those risks is beyond the scope of this paper. Two types of risks, however, deserve special attention: principal risk and custody risk.

Principal Risk and Delivery Versus Payment

Historically, the risk that has attracted the greatest attention has been the principal risk (or counterparty risk), namely the risk that the buyer of securities does not receive the securities for which he has paid or that the seller does not receive payment for the securities he has delivered. Typically, this risk materializes when the delivery of the securities and the payment of the cash are not synchronized, and one of the parties to the transaction goes bankrupt before both sides of the transaction are completed. Either the buyer is declared bankrupt after receiving the securities but before making payment or the seller is declared bankrupt after receiving payment but before delivering the securities (this latter scenario is more unusual as it is, in practice, rare for the payment for securities to be effected ahead of delivery).

The most effective way of eliminating principal risk is for the CSD that settles the transaction to offer what is called delivery versus payment (DVP). DVP is the mechanism whereby the CSD ensures that securities delivery and cash payment are conditional upon each other. There are different ways in which this can be achieved, and the CPSS has categorized them under three models (the so-called BIS models 1, 2, and 3) in a report published in 1992. A CSD can achieve DVP by ensuring that the securities delivery and the cash transfer take place simultaneously and that both transfers are immediately final (meaning that they are both irrevocable and unconditional when they occur). This is the most secure form of DVP (BIS model 1), but only a few CSDs (such as the Federal Reserve, Euroclear, and a few others) have been able to develop it. Generally, it requires that the CSD provide credit facilities or at the very least be connected on-line with a payment system where credit is available.

CSDs can also ensure DVP without arranging the simultaneity of the transfers of the securities and the cash, provided that the transfer that takes place first (in practice, the transfer of the securities) is reversed if the other transfer fails to occur. This is how many CSDs operate (BIS model 3), reflecting the fact that they are generally not involved in the cash transfer, which typically is effected through one of the local payment systems. In this model, the risk of reversal (also called “unwind”) may last from a few hours to a full day in some markets. The assurance of reversal by the CSD in case of nonpayment provides the seller with the comfort that he is not exposed to principal risk but, as discussed in more detail below, creates another form of risk, sometimes unbeknownst to those who might suffer from its consequences.

Because of the seriousness of principal risk (the counterparty is exposed to the risk of loss for the full value of the transaction), in the 1980s, both the Group of Thirty (a securities industry group) and the CPSS called for the widespread use of DVP mechanisms by CSDs. As countries came to the realization that the absence of some DVP mechanism for the settlement of their securities could adversely affect the willingness of foreign investors to invest in their securities, notable progress has been achieved over the past two decades toward the elimination of principal risk. Still, DVP is not yet available from CSDs in all markets, especially, albeit not only, in some emerging markets.

Custody Risk

Custody risk has been defined as the risk of loss of securities held in custody, occasioned by the insolvency, negligence, or fraudulent action of the custodian or sub-custodian.1

Nonprofessional investors who deposit securities with third parties do not always fully appreciate the legal and financial consequences of doing so. The layman generally understands that cash deposited with a bank becomes the property of the bank, and that he is therefore exposed to the risk of bankruptcy of this bank. The reason for this transfer of ownership is that cash is fungible (except for cash held in a safe deposit box): a client who deposits 100 notes of $10 expects—and is entitled—to receive back, not the very same notes bearing the same serial numbers, but any dollar notes for an amount of $1,000. In most countries, under rules of common law, the deposit of fungible assets legally carries the transfer of ownership of the assets to the depository, making the depositor a mere creditor exposed to the risk of bankruptcy of the depository.

Securities are also generally held on a fungible basis by the various depositories through which they are held. This is an economic necessity to maintain the liquidity of the securities markets and permit efficient and low-cost safekeeping and transfers of securities. Therefore, under these rules of common law, most securities traded in the world would have become the property of the custodians and CSDs that hold them for the account of investors. This is a result that the legislators in most countries have found unacceptable, both socially and financially, and have avoided through specific legislation. For instance, in Belgium, a special piece of legislation, Royal Decree No. 67 of November 10, 1967, as amended, provides that, notwithstanding fungibility, securities that are held in accordance with the terms of this decree remain the property of the depositors (in fact through a form of co-ownership over the pool of securities of the same issue), thereby protecting the depositor against the risk of bankruptcy of the depository. The relevance of this Royal Decree extends beyond the relatively modest Belgian securities markets, since it applies to the securities held in the Euroclear System (representing over U.S. $2.4 trillion of assets on deposit). Also, this piece of legislation has come to be regarded internationally as a model legal regime applicable to the holding, transfer, and collateralization of securities held on a fungible basis. Similar rules of law may now be found in several other countries, including Revised Article 8 of the Uniform Commercial Code in the United States, upon which Professor Rogers will elaborate in a separate paper.2

However, in some countries, there appears to be no legislation explicitly avoiding the transfer of ownership of securities held on a fungible basis, thus leaving it to legal scholars and courts to develop legal arguments sustaining the same conclusion. The absence in many jurisdictions of case law on the matter also means that some residual measure of risk may still exist in some markets so that, in case of bankruptcy of the depository, the assets on deposit would be treated by a bankruptcy court as part of the estate of the bankrupt institution. This shows how legal uncertainty may contribute to a form of custody risk.

In practice, however, losses of securities on deposit with a CSD or other intermediaries derive more often from theft, fraud, or physical disappearance of the securities certificates than from the bankruptcy of the depository. In that case, it is essentially the terms of the contract between the depositor and the depository that determine who bears the risk of loss (for instance, some depositories limit their liability by contract to cases of gross negligence on their part). Of course, even if the depository is liable, the ability of the depositor to obtain full compensation is subject to the financial soundness of the depository. If the loss is so significant as to cause the bankruptcy of the depository, the depositor whose securities have been lost would have a mere claim for monetary compensation, rather than a right of ownership over securities, and would thus likely not be fully compensated. This is why it is standard practice for custodians and CSDs to contract insurance coverage for losses of securities on deposit with them (for instance, Euroclear has a $500 million policy).

Besides this typical form of custody risk, a new form of less well-known custody risk has been attracting increasing attention in recent years. It derives from the practices of CSDs and other custodians seeking to satisfy the needs of clients who buy and resell securities value the same day (same-day turnaround). CSDs and custodians can rather easily support same-day turnaround when the market’s payment and securities settlement infrastructure allows for intra-day transfers of securities with immediate finality (e.g., BIS model 1 structures). It is more problematic where there are inefficiencies in the settlement structures of the market, for instance, where the payment and the securities settlement systems are desynchronized. Ironically, this custody risk is to some extent the byproduct of the implementation of the DVPBIS model 3 mechanism by a number of local CSDs. In a way, the elimination of one risk (principal risk) has led to the emergence of a new form of another risk (custody risk), each borne in the final analysis by different clients.

This risk exists when the CSD or custodian bank (let us generically call them “settlement agents”) gives one of its clients availability of securities that it has not yet received for the account of this client, or that it has received for the account of the client but the receipt is not final and is therefore still subject to reversal (unwind).

Both practices may confer significant advantages to the particular client who receives early availability of the securities, thereby enabling the settlement agent to position its services more competitively. Early availability allows clients to benefit from same-day turnaround capabilities and therefore avoid the funding costs associated with settling purchases on a given day and onward sales only the next day.

At the same time, these practices potentially expose the other clients of the settlement agent to a risk of securities loss. However unlikely this may be, what would happen if the settlement agent failed to receive the expected securities? Or if the provisional receipt was reversed? Unless the client who has already onward-delivered the securities happens to have a sufficient amount of securities of the same issue in its account, which is unlikely, the unwind would create a “hole” (a negative position) in the securities account of the client. This hole would need to be covered to ensure that the aggregate position in the books of the settlement agent in that issue correspond to the amount of actual securities of that issue held by this agent.

Typically, the rules of settlement agents require the client who received the early availability of securities to cover that hole by acquiring at his own expense the necessary securities. However, this client may prove unable to acquire the securities if, for instance, the market in that particular security has turned “dry” and no securities can be found, which may occur for less liquid securities. Or the client in question may have become insolvent, and its liquidator may not wish to spend cash to buy the securities. In such cases, the hole would still need to be covered by allocating the loss pro rata to the other clients holding a position in the missing securities or by redebiting the client who purchased the securities from the failing client. This allocation thus amounts to a form of loss sharing by these other clients.

Notwithstanding this risk, it seems to be standard practice in a number of markets for CSDs to credit their clients before finality, and for custodians to deliver securities on a client’s behalf before the client has brought in the securities, at least when it is expected that the securities will be received shortly. This practice amounts to a short-term bridge loan of the securities to avoid the effects of a time discrepancy between securities deliveries and securities receipts. This time discrepancy arises when the two transactions (receipt and onward-delivery) settle in the books of different settlement agents whose settlement processings do not match efficiently. For example, if a custodian settles transactions in its books in the morning and the local CSD settles its own transactions in the afternoon, the custodian is unable to offer same-day turnaround in its books with the same securities if it waits for the settlement of the receipt in the CSD’s books in the afternoon before it allows the delivery of the securities. In order to offer same-day turnaround, some custodians allow delivery in the morning in anticipation of the receipt in its account with the CSD in the afternoon. They effectively “advance” securities until the receipt settles in the afternoon. Since the client that receives early securities availability does not yet have the securities at the time the delivery is made, this delivery is necessarily covered with the pool of securities of the same issue that the custodian holds for its other clients. This practice is called “drawing on the pool” (or “tirage sur la masse” in French).

Drawing on the pool can be done in a fashion that is more or less controlled, depending on the custodian’s own internal and regulatory standards. In the final analysis, however, controls may minimize the risk of loss for the other clients, but do not eliminate it. In most jurisdictions, the custodian must have obtained proper authorization from these other clients, lest this practice constitute illegal activity. In some markets (such as possibly Luxembourg), the authorization may be granted directly by law, so that the agreement of the clients is not legally required. In most markets, agreement of the clients must be obtained. Aside from the issue of legal authorization, the question arises, however, as to whether clients sufficiently understand these practices and their potential implications.

Unwinds by CSDs may lead to the same type of consequences. As mentioned above, it is standard practice for CSDs that operate under the DVP BIS model 3 to credit clients with receipts of securities in their books before cash payments are final. In practice, the securities transfers occur a few hours, or sometimes even a day, before final payment for the securities is made. As it is only final payment that makes the securities transfer final itself (thus removing any risk of unwind), the securities transfer remains provisional for some hours. It is also common practice on the part of many custodians to give availability of securities to their clients on the basis of these “non-final” receipts. Should the cash payment not materialize for any reason (e.g., as a result of the intervening bankruptcy of the buyer of the securities), the CSD would unwind the provisional securities transfer in accordance with its DVP rules. If, in the meantime, the buyer has already transferred the securities to another party, a hole could emerge, with the same consequences as for drawing on the pool.

The risk of unwind by a CSD is probably very small in most markets, and can be seen as less serious than the risk deriving from drawing on the pool since, at least in this case, the securities have been received before the delivery is allowed. In fact, so far, there does not seem to have been any actual case of an unwind by a CSD that would have caused any securities loss. The risk is, however, not the same with respect to all CSDs. The duration of the unwind risk may go from a few hours to a full day or longer; the events that could trigger an unwind may be more or less limited; guarantee funds limiting the risk of unwinds in case of bankruptcy may or may not exist and, if they exist, may vary in amount. Also, the consequences of unwinds on the CSD’s clients may differ, depending on how the unwind would be effected. These are all questions that users of settlement agents crediting before finality need to ask themselves.

The March 1997 BIS-IOSCO Disclosure Framework for securities settlement systems referred to above calls for detailed disclosure on these questions, and a number of CSDs have already produced disclosure reports in response to this call. The first Euroclear disclosure report was published in 1997, and it is updated every year.

Drawing on the pool and credits before finality are techniques used by settlement agents to neutralize the negative consequences of timing mismatches between settlement structures: lack of synchronization between the local CSDs’ settlement systems and those of custodians (drawing on the pool) or between local market securities settlement systems and cash payment systems (unwind risk). But this does not mean that these techniques, and the associated custody risks, should be seen as unavoidable fatalities. There are indeed other ways to address or at least limit these risks to truly exceptional cases. For instance, in Euroclear, there is no tirage sur la masse, as its securities lending program allows clients to borrow necessary securities at special pricing conditions to properly fund their securities deliveries. The short-term securities bridge loan is then explicit with the lender of the securities fully aware of, and remunerated as agreed for, the loan. As for the finality gap, it can be addressed through improvements in the securities and cash settlement structures at the local market level, and in particular through the development of interconnected real-time platforms (RTGS) for both cash and securities. Improvements in the settlement infrastructure of settlement agents linked to the local markets can also contribute significantly to safer alternatives. For instance, the development of real-time settlement platforms for securities transactions such as those offered or soon to be offered by the British and French CSDs, and by Euroclear, help offer same-day turnaround without unwind risk. The market will be best served when CSDs and custodians also make the necessary infrastructure investments to meet the market demands for same-day turnaround without generating, as a result, potential systemic risks for the financial markets.



My background is in securities law, rather than banking law. And for a time, at least here in the United States, bank lawyers had little to talk about with securities lawyers, even when the subject was what we in the United States call commercial law. We would be talking about quite different subsets of commercial law. Bank lawyers about bank deposits and collections, funds transfers, letters of credit, maybe commercial paper; and, securities lawyers only about investment securities, their holding or transfer, or collateralization.

Now that trading markets in government securities have grown to such proportions, when lines between banks and securities firms have become so blurred, when so many kinds of assets have become securitized, and securities have become such a dominant means of collateralization for loans and credit risk exposures, indeed, when the principal forms of wealth-holding in our civilization have become investment securities, and these are largely held in securities accounts with securities intermediaries, there is a reason, a need, that we talk with each other and about the same subset of commercial law—governing investment securities.

I think this is especially important for central bank lawyers to recognize. How a central bank manages its money supply involves self-transacting in government securities. It’s also the case that a central bank often acts as a fiscal agent for the sovereign when government securities are issued and runs the book-entry system for holding and transferring government securities. And, as important, if not more so, when a central bank is called on to be a lender of last resort, the reason may well be stresses in the capital market that expose the banking system to overwhelming credit exposure.

Now some of us, and I include in this myself, have learned the hard way that transactions in the capital market have two distinct stages and that it is risky to neglect that fundamental fact. In the first stage, I group primary issuance and secondary trading contracts—primary issuance involving underwriters, issuance houses, and the like—and secondary trading involving the stock markets and other mechanisms for secondary market trading in outstanding securities, performed by brokers and other intermediaries in the market as agents for the investors. It needs to be emphasized that what I call this first stage of capital markets, the trading market, involves only agreements to buy and sell contracts. The actual purchase and sale is the separately identifiable second stage when money passes and ownership changes. Now without timely completion of this second stage, the first stage, the market and its pricing, is meaningless. The second stage is a time that has variously been called clearance and settlement, trade processing, back-office operations; but it really is front burner in the attention of central banks and regulators, or should be.

Our discussion this morning will be focused on the law affecting this second stage, not the law affecting the first stage. The second stage, clearance and settlement, is a vital underbelly of capital markets. And it’s necessary to the efficient, reliable, and practicable operation of securities markets and of the indirect holding system that supports it.

And as will be described in more detail later, the holding system that is so necessary in order to make clearance and settlement operate efficiently involves tiers of intermediaries, not simply one tier, but several tiers of intermediaries. And there are implications, legal implications, to that which we will be discussing this morning.

Now the time span between the two stages, between trade and settlements, is itself an element of risk. A trade conducted at 100 in a moving market that goes, say, to 80 or 120 at the time of settlement, exposes the intermediaries in the transaction to significant risk that the counterparty will not perform at settlement time.

Shortening that settlement cycle, the time between trade and actual money passing and ownership changing, reduces the chance that the market will move a threatening distance within that time span. That’s the reason that the Group of Thirty so strongly recommended several years ago that shortening the time between trade and settlement to a standardized three-day cycle worldwide would be so important. Those time spans had ranged from as much as three weeks or more in some countries. Most countries are now at the three-day settlement cycle stage. Some markets, of course, are even less, which is to be applauded. In the United States, our corporate securities cycle was shortened from five days in next-day funds, to three days in same-day funds. The U.S. government securities settlement cycle has long been next-day settlement and same-day funds.

An important part of settlement is delivery against payment. The extent to which payment is made without transfer of ownership having occurred or transfer of ownership occurs without payment having been made is a separately identifiable area of risk. And the achievement of simultaneous delivery versus payment (DVP) by a settlement system is an important objective also identified by the Group of Thirty’s recommendations.

The risk of nonperformance of a securities transaction at settlement is not simply a risk that only the immediate parties bear. In large enough numbers, that risk can quickly be spread to counterparties in other transactions of the immediate parties. Because the transaction between the immediate parties failed, one or more of those parties may be unable to perform transactions with other counterparties. This becomes especially dangerous if such failures and transactions lead to insolvencies of one or more major intermediaries that cascade through the market and cause yet additional failures. This is called systemic risk, a term with which many of you are already familiar. The containment of systemic risk is a major objective of central banks and securities regulators. A coordinated approach to systemic risk is extremely important indeed. Shortened settlement cycles and DVP, important as they are, are not the only, nor are they a sufficient means to contain systemic risk in capital markets.

Now, we shall perhaps say something about additional steps that can be taken, but we will not be developing in any systematic way, all the ways—regulatory and operational—to contain systemic risk in capital markets. We shall be principally discussing the regime of underlying property and commercial law that is the necessary legal base for the way ownership of interests in corporate enterprises and other organizations that issue securities are held, transferred, and pledged in today’s circumstances. It is important here only to note that such law is a significant ingredient in a program that contains systemic risk in capital markets.

Why? Because uncertainty and cumbersomeness in the legal rules that determine whether an investor or secured lender has the rights those terms signify affects the liquidity of the market and the willingness of investors and lenders to participate in it. In times of market stress particularly, legal uncertainties, such as whether a lender in a troubled market can quickly and assuredly obtain a perfected security interest with priority and, if there is a default, realize on the collateral, are problems. Deficiencies in those respects are a deterrent to continued liquidity in the market and can cause or badly exacerbate a crisis.

It is hardly necessary for this audience, to describe the multi-tiered structures by which investment securities are held worldwide. On the other hand, it may be useful to emphasize the significance of that and the extent of it.

Most investors, especially institutional investors, hold their investments in securities accounts with banks or brokers. The securities that emanate from the issuers can be in either certificated or uncertificated (sometimes called dematerialized) form. The relevance of that fact ends with the entity that holds the securities directly. In most cases that entity is a central securities depository, sometimes called a CSD or an ISD (an international securities depository like Euroclear), or in the United States a clearing corporation or clearing agency.

But after one looks at that direct holding from the issuer by the central securities depository, whether it is in certificated or uncertificated form has or should have little bearing on the law governing the relationships between the central securities depository and its participants, being the banks and brokers, or the relationship between the banks and brokers and their customers. And it is the commercial law that affects those relationships about which we are principally interested.

Now, remember the ownership interest at the lower-tier levels is reflected in account statements from the immediate intermediary. And the means for recording that ownership interest are largely electronic blips.

I don’t think it’s unfair to say that in some countries the legal basis for such a securities holding system, one that can provide certainty to participants in the system, has not caught up with the actual structure and the business realities. It’s commonplace to say that capital markets have become transnational. Thus, even if some countries have modernized their commercial laws governing investment securities, the fact that others have not leads to considerable problems. There is a real need for harmonization of such laws. That doesn’t mean that there should be a single statute adopted in all countries. Account must be taken that in each of our countries the legal systems have different bases and contexts. But it is to be hoped that at least certain principles can be agreed upon, and then those principles engineered into the respective legal systems so that the result is substantially uniform across countries.

I shall only signal here a few essential principles. Somehow account has to be taken that the investments are held through these intermediary levels in fungible bulk, that those holdings must be immune from insolvency risk and risk of attack by creditors of the intermediaries, and that the applicable law needs to be based on the location of the intermediary, rather than on the location of a stock certificate or the place of incorporation of the issuer or the location of the customer or a balancing of contacts among the issuers. There needs to be certainty and predictability about the choice of law.


See CPSS’s Report on Cross-Border Securities Settlement, 1995.


See herein James Steven Rogers, Legal Risk in the Securities Settlement System, Chapter 9.