Financial Markets Operations Management (22 page)

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

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

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

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

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

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

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

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

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

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

This chapter will help you to:

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

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

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

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

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

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

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

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

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

As a consequence of this paper logjam,

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

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

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

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

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

Plus:

• Euroclear – 1968;
  
• Cedel – 1970.
  

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