Page 1 Infrastructure Debate April 2008 Tim Reucroft – Koen Vanderheyden.

Infrastructure Debate

April 2008

Tim Reucroft – Koen Vanderheyden

© 2008 Thomas Murray Ltd & DLA PIPER UK LLP.

Clearing & Settlement

The existing Russian modelThe PWC/DLA PIPER/TM recommendationsAccount holding in RussiaBest practice in Clearing & SettlementWhat is missing in Russia

CSD consolidation

The case for a single CSDExamples from around the globeThe value in consolidation

Agenda


The existing Russian Model

Equities Fixed Income

Exchanges

Clearing/CCPs

Securities Settlement

DCC NP NDC

RTS SE

RTS CC

MICEXMICEX SE

MICEX

ETD Derivatives

MICEX SH

RTS SE MICEX SE

NP NDC

MICEX

MICEX SH

NP NDC

MICEX

MICEX SH

MICEX SE

NP NDC

MICEX

MICEX SH

MICEX

DCC

RTS SH MICEX SH

MICEX

Cash Settlement RTS SH

NP RTS

DCC

NP RTS

RTS SH

RTS SE

Equities Fixed Income

Exchanges

Clearing/CCPs

Securities Settlement

DCC NP NDC

RTS SE

RTS CC

MICEXMICEX SE

MICEX

ETD Derivatives

MICEX SH

RTS SE MICEX SE

NP NDC

MICEX

MICEX SH

NP NDC

MICEX

MICEX SH

MICEX SE

NP NDC

MICEX

MICEX SH

MICEX

DCC

RTS SH MICEX SH

MICEX

Cash Settlement RTS SH

NP RTS

DCC

NP RTS

RTS SH

RTS SE


MICEX Group – functional diagram

Central Bankof Russia

NDC

JP Morgan, BoNY,

Ost -West Handelsbank

Govt Bonds GKO/OFZ MMIs

Foreign currencies

MICEX controls DVPTrades are locked in

NDC controls DVP

Gazprom Clearing

MICEX SH

SDC

MICEX MICEX SE

Payment System

OTC

Negotiated OTCREPO market

Classic market pre-funded

On-exchange

OTC

MICEX(Clearing technical centre)

EquitiesFix incomeDerivatives

Roubles

MICEX Group – functional diagram

Central Bankof Russia

NDC

JP Morgan, BoNY,

Ost -West Handelsbank

Govt Bonds GKO/OFZ MMIs

Foreign currencies

MICEX controls DVPTrades are locked in

NDC controls DVP

Gazprom Clearing

MICEX SH

SDC

MICEX MICEX SE

Payment System

OTC

Negotiated OTCREPO market

Classic market pre-funded

On-exchange

OTC

MICEX(Clearing technical centre)

EquitiesFix incomeDerivatives

Roubles

The existing Russian Model


1. Exchange Trades: optional interposition of a CCP

2. Settlement instructions: Clearing via a central matching utility

3. Clearing and Settlement in a single CSD via consolidation of settlement depositories, settlement chambers and part of the clearing houses – adoption of the Standard Model

4. Mandatory CSD for securities with independent registrars, with exclusive right to a nominee account at the registrar. Mandatory electronic links with registrars

5. Combined net and gross settlement

6. RTGS settlement in central bank funds. Interim measure – in commercial bank funds. The CSD should not be a (full service) bank

7. Fails management supported by stock lending at the CSD

8. Central information source to support asset servicing

9. Rationalisation of Registrars

10. Information on beneficial owners

11. Access by foreign intermediaries

12. Wholesale model with unlimited levels – not the three tier approach. The retail model is not possible under Russian legislation

The PWC/DLA PIPER/TM Recommendations


Account Holding in Russia



• All domestic accounts held at the first level, each beneficial owner has its own account at the CSD• The CSD acts as central registrar – the notary that grants legal title. (Other registration functions can be carried out by third party

registrars e.g. Calling AGMs, paying dividends etc).• Genuine nominee accounts only allowed for foreign participants• Also known as the Direct Holding model• Structure results in millions of accounts at the CSD• No intermediaries required. Participants act as Account Operators to maintain details across millions of accounts

CSD andCentral

Registrar

Beneficialowner

Foreignnominee

Beneficialowner

Foreignnominee

investorinvestorinvestorinvestorinvestor

The Retail Model

Legal & beneficial ownership

Issuer


Retail Model - Spain

First tier of the Register

Second tier of the Register

Issuer Iberclear (CSD)

Intermediary

Investor

• Not a wholesale model: legal title based on entry into the main/secondary register, each beneficial owner has its own account at the secondary register.

• The CSD plus secondary registers act as central registrar – the notary that grants legal title. (Other registration functions can be carried out by third party registrars e.g. Calling AGMs, paying dividends etc).

• Sub registers reduce the number of accounts at the CSD.• Similar system in Romania.


Indirect Holding ModelCommon Law Approach -UK

Primary register: legal ownership

Securities Holding trust assets and own assets

Equitable interest (trust)

Issuer

CREST

Intermediary

Investor

• Only the upper tier intermediary holding directly from the issuer will have legal title to securities. Transfer of the legal title is effected by delivery (in the case of bearer securities) or by amendment of the register operated by or for the issuer (in the case of registered securities).

• A transfer on the books of an intermediary constitutes a disposition of an equitable interest. The intermediary holds the securities as beneficial owner of an interest in the securities, held by the intermediary on an express or implied trust. Where the intermediary holds the securities for its account holders in a common pool, the individual investor is co-owner with other investors. The intermediary cannot use the securities for its own purposes without authorisation from the investor and the assets are not available to the general creditors of the intermediary. The electronic transfer within CREST’s book-entry system represents the legal transfer of title to UK securities. CREST is the de facto registrar for dematerialised instruments: there is no time lag between settlement and registration.


SingleCSD

Foreignnominee

Legal &Beneficial

owner

Intermediary Intermediary

Intermediary

Legal &Beneficial

owner

Legal &Beneficial

owner

• No restriction on the number of levels.• Recognition of foreign intermediaries and nominee structures is required under Unidroit.• The Legal & Beneficial owner is the one at the bottom of the chain in accordance with Russian law.• PRIMA applicable (Place of the Relevant Intermediary Account). • Intermediaries are licensed depositories that act via nominee accounts. These are omnibus accounts, under designated segregation, that

allow efficient settlement.• Also known as the Wholesale Model.• Typically only several hundred accounts at the CSD.

Indirect Holding ModelCivil law approach

Prop

erty


Indirect Holding ModelIssues relating to Russia

1. Limitation of levels

2. Access by and recognition of foreign intermediaries

3. Central information source to support corporate actions

4. Rationalisation of Registrars

5. Information on beneficial owners

6. Legal nature of interests in securities

7. Legal/systemic risk

8. Other legal issues relating to indirect holding systems


CustodianCustodian Custodian

ForeignIntermediary

ForeignIntermediary

ForeignIntermediary

Registrar

CSD

Nominee account

DepositoryDepository Depository

InvestorDepository InvestorRussianDepository

• Limitation is not flexible, • Problems foreign intermediaries/ nominees,• Limited tiers might be interpreted as sub registers (direct holding system instead of indirect holding system),• Limited tiers are suggested in order to ensure transfer of information on beneficial ownership to the CSD and the registrar. This is an operational problem, which

should be solved by imposing technical requirements on CSD participants and/or specific license requirements for intermediaries opening securities accounts for their clients. A limitation of levels will not solve the problem,

• Limited tiers should only be envisaged to the extent required for the for limitation of custody risk.

Limitation of levels


SingleCSD

intermediaryLegal &

Beneficialowner

Intermediary Intermediary

Intermediary

Foreign Intermediary

/ nominee

Legal &Beneficial

owner

Legal &Beneficial

owner

Issue: Under current Russian legislation, the last intermediary in the chain within Russia is deemed to be the beneficial owner, even if it is a foreign nominee. The issue is then that a nominee, which is not normally the beneficial owner, becomes one purely because of its position in the chain of intermediaries. A foreign global custodian who is in this position finds itself as the beneficial owner of the securities, with all the legal complications and balance sheet implications this brings.

Recognition of foreign intermediaries


ForeignCSD

ForeignCSD

Registrar

CSD

Nominee account

DepositoryDepository

DepositoryDepository Depository

invinv inv

Assumptions: Foreign CSD has direct account with single Russian CSD. The regulators have an MOU in place. Russian CSD relies on foreign CSD conducting surveillance and know your customer tests.

Issues: - The foreign CSD will operate nominee accounts and will not know the identify of the final beneficial owners,- The foreign CSD will only open an omnibus account with the Russian CSD and a lot of the transactions will be internalised,- Links between CSDs are complex and carry very little traffic (the exception is DTCC/CDS),- If this route were mandatory for foreign investors it would be unacceptably expensive (to use the services of a foreign CSD that is not geared up to provide the level of customer service demanded of global custodians).

Conclusion This is not a feasible alternative. Foreign intermediaries should be allowed to open nominee accounts with Russian intermediaries.

Access by foreign intermediariesthrough foreign CSDs


Can the investor effectively benefit from the rights flowing from the securities?

Exercise of investor’s rights should not be hampered just because the securities are intermediated. The solution is to channel corporate actions efficiently through the system, upstream and downstream.

Issues:

Passing down corporate information to the investor: All licensed intermediaries should be required to provide details of corporate actions to the intermediary immediately below them in the chain

Passing up corporate information to the issuer: All licensed intermediaries should be required to provide details of beneficial ownership at the request of the intermediary immediately above them in the chain.

Facilitating the exercise of rights vis-à-vis the issuer

Exercise of rights upon authorisation/instruction

Goal: maintain key functions of securities in the intermediated system, in particular in a cross border situation

Difficulties: neutral and functional technique to channel corporate actions between investor and issuer. A single CSD could play an important role as central information source (part of the participant requirements): in cross-border situations: retranslation of the relationship investor/issuer into the account-holder/intermediary relationship, taking into accountnational corporate law.

Central information source to support corporate actions


Rationalisation of Registrars

1. The main function of Russian registrars is keeping up to date the registers for the issuers.

2. The registrars should not charge transaction costs to the investors but only to the issuers.

3. In case there is a single CSD, rationalisation is expected to follow from two requirements of the CSD:

I. Only the single CSD can maintain a nominee account at the registrar.

II. The registrar will need to connect with the CSD electronically, meeting information requirements in a timely manner complying with STP standards.

4. The need to adopt electronic messaging and STP standards will require registrars to invest in their business. The business case for such an investment will not be justified where the registrar only acts for a single (or a few) issuer(s). This is likely to encourage rationalisation.


Legal nature of interests in securities

Two main models

Co-ownership No co-ownership

Co-ownership of a (notional) pool of (fungible) securities with revindication right in case of insolvency

Belgium, Luxemburg, Germany, UK (Trust)

Seems to be the model that is the closest to the Russian model

France: Euroclear France and any intermediaries standing between Euroclear France and the investor’s immediate intermediary administer the system and maintain records of the accounts held at the various levels but do not have any proprietary rights in the securities. Registration of an investor as the holder of securities in an account with an authorised financial intermediary gives the investor a property right in the securities concerned.


Legal / Systemic Risk

Tools:Settlement Finality, Innocent acquirer rule

Upper tier attachment, collateralisation, … (UNIDROIT), CPPS-IOSCO Recommendations

Tools:Settlement Finality, Innocent acquirer rule

Upper tier attachment, collateralisation, … (UNIDROIT), CPPS-IOSCO Recommendations

UnwindingDeliveries/Payments are reversed

CP lack liquidity to Deliver/ pay others

Liquidity Crisis liquidity or credit problems

If widespread: System instability and financial markets instability

Large Part. Failure, Insolvency, fails to pay/deliver

misappropriation

Legal / Systemic Risk


Settlement Finality

Settlement Finality is fundamental to the elimination of systemic risk and legal risk in the settlement of securities: In order for intermediaries to credit customer accounts and for account holders to deal with securities, they must have sufficient confidence that a transfer will not be reversed.

Finality is concerned with the enforceability of a valid agreement in the event of the transferor’s insolvency; and the revocability of the transfer (or underlying transfer agreement) for lack of validity or on other grounds.


Settlement Finality

Finality should be enhanced by national law/ system rules that:

(1) clearly prescribe the way in which transfer orders are made;.

(2) indicate the moment at which the transfers become irrevocable; and

(3) disapply insolvency rules that render void transfer orders that are made before insolvency commences.

EU: Settlement Finality Directive gives transfer rules of certain designated settlement systems precedence over national insolvency rules.

Global: articles 13 and 24 of the draft UNIDROIT Convention.


Time

Moment of entry into the system (SFD / UNIDROIT)Moment of entry into the system (SFD / UNIDROIT)

Acceptance for settlement (CPSS-IOSCO principle 9)Acceptance for settlement (CPSS-IOSCO principle 9)

Protection against unwinding in case of the insolvency of a participant Protection against unwinding in case of the insolvency of a participant

Protection as from the moment of entry into the system as defined in the system rules Protection as from the moment of entry into the system as defined in the system rules

Legal basis: SFD / UNIDROITLegal basis: SFD / UNIDROIT

Protection required against credit exposures in net settlement systems, because there is a delay between acceptance by the system for settlement and its final settlement (no unwinding allowed in case of shortfall).

A transaction that has been submitted to the system and has passed all its risk controls is “accepted by the system for settlement” and cannot be removed from the settlement process without violating CPSS-IOSCO principle 9 & BIS CP IV.

In order to ensure settlement in case of initial failure to settle, the CSD should adopt collateralization mechanisms (legal basis: UNIDROIT).

No hour zero rules

No unwinding netting

No reversal debit or credit

Avoiding legal/systemic risk


Innocent Acquirer rule

Protection of innocent purchasers of securities from adverse claims promotes liquidity and reflects the commercial expectations of investors.

Where tracing is possible, the general approach should be to favour an innocent transferee who purchases misappropriated securities without notice of pre-existing interests in the securities in order to address:

the need for speed and efficiency to enhance liquidity of securities (which benefits all participants).

the practical difficulty in clearing and settlement systems of investigating title.

The legal and systemic risk resulting from the reversal of transfers.

Article 14 of the draft UNIDROIT Convention protects an account holder from adverse claims where the account holder does not at the time its account is credited, have knowledge of an adverse claim with respect to the securities.


Upper tier attachment

Intermediary (or CSD)

Intermediary

Intermediary

Creditors Investor

Article 19 draft UNIDROIT CONVENTION: creditors of an account holder must not be allowed to attach their debtor’s intermediated securities at the level of higher tier intermediaries, the CSD or the issuer.

Upper Tier Attachment


The rights of the account holders (Chapter II).

Transfer of intermediated securities ( Chapter III):

Ways of acquiring and disposing of securities by credit and debit to a securities account, invalidity of debits and reversal (protection of account holders and the stability of the system) (Art. 13) priority among competing interests (Art. 15 ).

Integrity of the intermediated holding system (Chapter IV):

insolvency issues, instructions to the intermediary, the requirement that an intermediary hold sufficient securities of any description, limitations on obligations and liabilities of intermediaries, allocation of securities to account holder’s rights, loss sharing in case of insolvency of the intermediary and the effect of debits and credits and instructions on the insolvency of operators of or participants in securities settlement systems.

Relationship with the issuer of securities (Chapter V)

Special provisions with respect to collateral transactions (Chapter VI):

Validity and recognition, enforcement, Right of use, margin calls, substitutions, disapplication of certain insolvency rules, close-out netting, etc.

Other wholesale model issues addressed by the UNIDROIT Convention


Best Practice in Clearing & Settlement



Registration

Exchange

CCP

CSD

Old New

Settlement

Exchange: Risk trading

CCP: Risk concentration

CSD: Risk minimisation

Clearing

Exchange

Conformity with the Standard Model

• Asia Pacific is getting better, South America still has some way to go.• Look at the problems Korea had with this.



Buy SellMatch trade details

BuyInvestor

Confirm trade

BuyInvestor

Affirm trade

Buy Custodian

Give-up trade

CustodianInvestor

Calculate average price

CustodianInvestor

Advise settlement shapes

Custodian CSDSSI

1

2

3

4

5

6

7


“Nothing good happens between trade date and settlement date”


end ofT+0

end ofT+1

end ofT+2

Settlement Day T+3

Clearing

Tradeagreed

Trade matching• For OTC transactions. • For transactions not supplied

by the exchange to the CSD

Trade matching is not required for transactions supplied directly by the exchange to the CSD. Otherwise known as locked in trades.

Confirmation/Affirmation

• Give-ups, Give-ins• Average pricing• Splits and allocations

Settlement Preparation

• Netting calculation• Optimisation algorithm• SSI database• Blocking or reserving of cash

and securities DVPsettlement

Central Matching Utility (VMU)

• The clearing process can be complicated if there are many participants and substantial cross-border flows from different time zones.• The final settlement should be straightforward if all the clearing has been properly carried out.

TradeShape

SettlementShape



Investors Broker/Dealers

Custodians

CentralMatching

Utility

• Without a CMU, each investor needs to maintain a link with every broker they use and every custodian. Similarly each broker needs to maintain a link with every investor and custodian. This requires multiple bespoke links.

• With a CMU, each investor maintains only a single point of contact. All the matching functions can be performed in the CMU.


Custodians

Confirmation

Average Price

Affirmation

Allocations SSI

Give-ups Give-ins Allocations




Custodians

CentralMatching

Utility

• We still need to decide how the infrastructure links to the CMU

Issuers

Exchange

CCP

CSD

Registrars

PrimeBrokers

SWIFT

Regulator



• RTGS• CLS• Integrated central bank model

• Single CSD• Stock lending and borrowing market• Central registrar• Central source of information• Central VMU

What’s missing



The case for a single CSD

CSD Consolidation


• Coherent interface for foreign investors• Avoids duplication – economies of scale from a natural monopoly• Acts as a regional champion• Potential location for a central VMU• Central registrar• Encourages harmonisation (the opposite effect of competition)

Benefits of a single CSD



CSDs meet the criteria laid down by the European Court of Justice in order to be considered as essential facilities:

• They offer all users services they cannot provide themselves and for which the value increases with the increase in the number of users. Those services require the implementation and management of network systems, that could not be easily duplicated given the costs and implementation delays.

• They are essential to all participants operating in the competitive financial services sector, who could not conduct their business without access to these infrastructures at a competitive and economic price.

• These infrastructures were put in place to limit the risks incurred in the financial markets by mitigating the risk of default or error, and to promote to promote economies of scale.



Examples from around the globe

CSD Consolidation


Examples

USA Spent 20 years consolidating its infrastructureUK GCO and money market instruments migrated from Bank of England to CRESTCo.Italy Bank of Italy withdrew from depository activitiesSpain Central bank passed fixed income settlements to Iberclear.Croatia Migrated long term and short term fixed instruments to equity CSD SDAChina Created a single holding company for all CSD operations.

Examples


The value in consolidation

CSD Consolidation


Demutualisations

CREST, JASDEC, VPS, CDCP, HKSCC, UAE DFM

A lot of CSDs started life by being separated out from their exchange.

Jordan SDC is a mutual CSD, Qatar DSM is effectively state owned

Tadawul converted into a joint stock company (Saudi Capital Market Company) with a capital of SR1.2 billion,

fully owned by the state-owned Public Investment Fund

Listings

Italy, Spain, Mexico, Greece, Germany, Hong Kong, Iceland (since acquired), Malaysia, Singapore,

Poland (pending), Slovakia (pending)

Peru, Argentina (pending)

Demutualisation



Aquirer TargetValue $ millions

Market Cap

Exchange NASDAQ OMX 5,161takeovers NYSE Euronext 10,200

Euronext LIFFE 800NYSE Amex 260

NASDAQ Philly 652

Infrastructure Greece 2,300IPOs Spain 4,640

Brazil 7,700 20,000Euroclear 600Peru CSD 72

When will Russia be in a position to list its own infrastructure like Deutsche Borse or Helex or BME? Listing provides the currency to participate in globalisation.


Recent Examples

Page 1 Infrastructure Debate April 2008 Tim Reucroft – Koen Vanderheyden.

Documents

Transcript of Page 1 Infrastructure Debate April 2008 Tim Reucroft – Koen Vanderheyden.