The Law and Regulation of Central Counterparties 9781472560803, 9781849460514

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Foreword

I am greatly privileged to write the foreword to this book. It is the updated and published version of Dr Huang’s PhD thesis, which he presented at King’s College London under my supervision. This book discusses the operation of a modern Central Counterparty (CCP) from a legal and regulatory perspective. Its central theme is the creation of a single CCP or, in practical terms, a common platform for CCP clearing across different markets, and how this can be achieved in view of the continuing diversity in legal and regulatory policies still affecting them. Before discussing these issues, the book first describes in detail the modern post-trade infrastructure and moves from there to the role and functions of CCPs. In doing so, it also provides an interesting account of how the CCP concept evolved together with the markets and shows that CCP clearing is itself in fact a market product. In the meantime, the subject of CCP clearing has become highly topical and has attracted and continues to attract headlines after the recent financial turmoil. In particular, introducing CCP clearing to the Credit Default Swaps market to manage counterparty risk, to limit liquidity risk, and to increase market transparency is considered as one of the main regulatory responses to the turmoil. A book on this subject therefore could not have come at a better time with the regulatory overhaul in financial markets currently under way. It will help answer the question of what benefits a CCP can bring to the market, but it also highlights some of the risks this poses. As a result of the post-crisis regulatory focus on systemically important firms or institutions, CCPs, being one of those institutions, are now themselves brought within the discussions on a new regulatory framework. This raises the question of how best they should be regulated. In the European Union, the regulatory approach towards CCPs has been the subject of a much longer debate that preceded the recent crisis. Dr Huang discusses a number of options in this regard and argues in particular that the EU proposals to date do not go far enough to create a sufficiently responsive and robust regulatory framework for a real single European market with a single CCP to operate in. Professor Jan H Dalhuisen London, March 2010

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Acknowledgements This book is the revised and updated version of my PhD thesis entitled: ‘The Roles and Functions of Central Counterparties Clearing’. During my period of research at Kings I was privileged to have Professor Jan Dalhuisen as my supervisor. I am deeply grateful to his guidance and patience and further advice on the book’s publication. My thanks also go to Dr Joanna Benjamin of London School of Economics and Political Science and Professor Richard Dale of Southampton University. The comments and criticisms and encouragement they gave me as examiners were greatly appreciated. I am also grateful to Professor Lodewijk Van Setten of Morgan Stanley for his comments on the early draft of the thesis, and to my then LLM tutor Professor Michael Bridge, now at London School of Economics and Political Science, for his interest and encouragement. My deepest appreciation goes to my beloved parents, especially for their immense support and unrivalled understanding for the past years, to whom I am much indebted. Finally, my special thanks go to my teachers and friends whom have inspired me. I was most fortunate to have studied at the very best law schools, first at Renmin University of China, in Beijing, then at University College London, and later at King’s College London. Jiabin Huang Bloomsbury, London

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1 Introduction 1.1 The Purpose and Scope

M

ODERN POST-TRADE infrastructure for securities markets has been transformed by the immobilisation and dematerialisation of conventional paper-form securities and the subsequent introduction of book-entry systems. The advance of information technology has also contributed significantly to this transformation process. As a result, the role and functions of each segment in the post-trade infrastructure for modern markets have evolved considerably. In particular, the development of CCP clearing in securities markets reflects such evolution by facilitating both modern trading systems and payment and securities settlement systems. With their fast expansion, Central Counterparties (CCPs) are now participating in various different types of markets, including commodities markets, securities markets, and OTC derivative markets. This book takes CCP clearing in securities markets as a main example to give a historical account of the development of CCP clearing and illustrate the mechanism of CCP clearing as well as the modern role and functions of CCPs. For historical reasons, common perceptions may continue to place CCPs and other types of clearing houses within the same category.1 Both of them do indeed share some common roles, since CCPs were in fact built upon and grew out of earlier forms of clearing houses. Traditional clearing houses, those in commodities markets in particular, were initially established to provide a guarantee and help facilitate the trade settlement process. To some extent, this is also the case for CCPs. Nevertheless, the differences between them have been slowly recognised and comprehended, as will also be discussed in chapters two and three. Indeed, CCPs and other types of clearing houses2 have distinctively different features and therefore should be distinguished from one another.

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See Section 3.1, ch 3 below. Typically, they include cheque clearing houses and traditional commodities clearing houses.

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Introduction At present, the fact that these two have acquired two different definitions has shown the trend.3 As such, CCPs, as the name suggests, are the central counterparty to the transactions concerned while other types of clearing houses are, at best, acting as calculation agents in preparation for settlement. The differences extend beyond the techniques of processing and are also present in law. Legally speaking, the techniques that are used in clearing houses differ quite significantly from those used in CCPs. For example, in these other types of clearing houses, clearing members remain contractually bound to each other in relation to the underlying transactions to which they are a party. However, the intended result of CCP clearing is to replace the contractual relationships between member participants of a CCP with those of a member and the CCP exclusively. This book sets out first to clarify not only the existing common misperceptions about modern post-trade arrangements, but also those concerning the role and functions of CCPs in the post-trade cycle. This is particularly relevant to the analysis of legal issues, where fundamental concepts such as set-off and netting have been used extensively. Furthermore, the results are important for developing an adequate regulatory regime for CCPs, especially in the case that the risk-based functional approach is adopted.4 The book examines legal and regulatory aspects of the role and functions of CCPs. It endeavours to identify and examine legal and regulatory issues relating to modern CCP clearing and help to construct an adequate legal and regulatory framework, which is required to continuously support the proper functioning of CCP clearing and foster its future development. Nonetheless, it does not set out to observe any particular positive law, ie any specific jurisdiction, or put itself within the context of any particular regulatory regime. Where a particular approach or solution is adopted by a jurisdiction and is discussed in the text of this book, it is only intended to serve as an example of how a relevant legal or regulatory issue is dealt with in practice. It is submitted that over the past few decades a number of market developments, especially in time of the recent 2007–08 financial crisis, have highlighted the importance of CCP clearing for the future development of a modern robust and efficient post-trade infrastructure. Despite its importance, the current debate on CCP clearing in this sector remains unfocussed. In this respect, the purpose of this book is to establish a foundation for future research on CCP clearing, for example, by identifying the potential legal and regulatory issues, providing examples of the complications and, as the case may be, how they may be resolved by reference to the approach adopted by a particular jurisdiction.

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Also see Section 2.1.2, ch 2 below. According to this approach, the same activities are treated in the same way providing the risk is the same. For the discussion on the approach, see Section 5.2.2, ch 5 below. 4

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Chapters in Outline

1.2 The Chapters in Outline The six main chapters of this book present the following areas: (1) the modern post-trade infrastructure, (2) the role and functions of CCPs and the main features of CCP clearing, (3) the key relationships concerning CCP clearing, (4) default procedures and default by a CCP, (5) regulatory issues concerning CCPs, and (6) the case for a single multi-market CCP. Finally, conclusions are drawn.

Chapter Two Chapter two begins the analysis by explaining the general features of different segments in the post-trade infrastructure for the completion of each trade cycle in securities markets. The markets are constantly evolving with innovated products and the advance of information technology, as is post-trade processing, which is an indispensable part for the trade cycle. The main objective of this chapter is to provide an overview of the development of the modern post-trade infrastructure. It also intends to further distinguish and define various functions in the value chain of the modern post-trade arrangements. This is followed by an examination of modern payment and securities settlement systems. To that effect, different types of payment settlement and securities settlement systems are distinguished. The chapter then moves on to discuss the developments of modern book-entry securities and the indirect-holding structure. The significant development behind these is the immobilisation and dematerialisation of paper-form securities, which was first initiated in the US after the paper-work crisis in 1970s. The resulting indirect-holding structure based on book-entry accounts helps to further facilitate the development of modern post-trade processing and increased intermediation in the markets. The last two sections of chapter two discuss two main concepts, ie Delivery Versus Payment (DVP) and Straight-Through-Processing (STP). They have developed along with the transformation of the modern post-trade infrastructure and are particularly relevant to the CCP clearing processes. The concept of DVP may, at first glance, seem to be simple and straightforward. Its objective is to eliminate counterparty credit risk by, for example, linking payment systems with securities settlement systems in securities markets so that both legs of a securities transaction settle simultaneously. However, its implementation in practice is complicated by the differences between the settlement systems involved. As identified by the Committee on Payment and Settlement Systems (CPSS),5 there are three main mechanisms for achieving DVP, depending 5 Committee on Payment and Settlement Systems (CPSS), Delivery Versus Payment in Securities Settlement Systems. CPSS Publications No 6. (September 1992), at: www.bis.org/publ/cpss06.htm.

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Introduction on the types of settlement systems involved, ie gross or batch-processing and whether or not it is a real-time system. Here, the implications of this development to CCPs are examined. Another recent development in the post-trade processing is STP. It is an industry-wide initiative that requires the effort of all market participants in the value chain. Technically speaking, it is a process that standardises the message protocol so that different systems can process the transaction data in the most efficient and speedy way possible. It is a prerequisite for both a shorter trading cycle and bringing about real-time settlement. This section also tries to explore the potential role that CCPs may play in this development, the standardisation process in particular.

Chapter Three This chapter first presents a historical account of the development of clearing houses. The discussion distinguishes three main types of clearing in the markets, namely, cheque clearing, commodity clearing and CCP clearing. Looking back, cheque clearing as one of the earliest forms of clearing provided a centralised physical place to facilitate the centralised processing of cheques collected from different places. In commodities markets, clearing houses were first established by a ‘ring’ of participants in order to provide a form of guarantee to the performance of contracts for members of the ring.6 Modern CCP clearing combines the features of cheque clearing with those of commodities clearing. By distinguishing three different types of clearing, this chapter then moves on to focus on CCP clearing and explains their functional and operational aspects. It is also observed that from functional aspects CCPs play several different roles simultaneously: they act as risk manager, fund manager, payment and settlement system operator, and post-trade market facilitator.7 By looking at CCPs from these different perspectives, the evolving role of CCPs in modern markets becomes clear. In terms of CCP clearing operations, there are three main areas. They are, risk operations, treasury operations, and settlement operations. As part of trade cycles, the processing of transactions has evolved in a manner that is not easy to comprehend. It is for this very reason that the analysis in this chapter can at best serve as a snapshot. At its best, it is intended to provide a flavour of the way in which the operations of CCP clearing are arranged, bearing in mind that the arrangements may vary from market to market.

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See Section 3.1.2, ch 3 below. These roles are explained respectively in Section 3.2, ch 3. In addition, recognised CCPs also act as self-regulatory organisations. This is discussed in Section 6.3.2, ch 6 below instead. 7

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Chapters in Outline

Chapter Four Chapter four mainly focuses on the rules and regulations of CCPs that are set out to govern the contractual relationship between CCPs and their members. The contractual relationship between CCPs and their members are examined as well as its implications for the relationships down the chain, ie the relationship between clearing members and their clients. In modern markets, the flow of trades from trading to CCP clearing, and to settlement means that trades are governed by the rules and regulations of each respective system at different stages. The relevant issues here are how the rules and regulations of these different systems interact with each other and the rules clarifying the appropriate time for the application of particular rules and regulations of each system, those of CCP clearing in particular, should be clearly stated.8 The contractual relationships between CCPs and their members, the members and their clients, and CCPs and the clients of their members, form a tripartite relationship which may suggest that it falls within the scope of agency law. Nevertheless, agency law principles in these relationships, as will be argued, may have to be substantially modified in their application to facilitate the proper functioning of CCP clearing, ie managing counterparty risk. This is one of the major issues to be discussed in this section. Specifically, this section intends to identify the implications of the typical requirement of a principal-to-principal contractual relationship between a CCP and its members, and its exclusivity. To non-members accessing CCP clearing services indirectly through clearing members, the primary implication of the principal-to-principal relationship between CCPs and their members is that non-members by doing so give implied consent to be bound by market rules, ie, the contractual agreement between the CCP and the clearing member as well as the rules and regulations of the CCP. In other words, they agreed to the CCP’s rules and regulations, to which their agents, ie clearing members are subject, despite the fact that they are not direct participants of the CCP clearing system. However, as will be observed, it is not immediately clear whether non-members would be able to invoke the rules and regulations of a CCP against the clearing members. Finally, it will also be argued that non-members cannot claim directly against a CCP in respect of the underlying contracts clearing members has processed through CCP clearing for them.

Chapter Five Chapter five discusses the issues in relation to CCP clearing default procedures. It is to be observed that collateralisation, and netting and set-off are the main 8

See Section 4.1.1, ch 4 below.

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Introduction elements in the CCP clearing processes in so far as default arrangements are concerned. Hence, this chapter begins by first discussing collateralisation, ie the techniques of collateralisation, its use in financial markets, its various types of assets used for collateral, its limitations, and the relevant legal issues. In addition, the issues regarding the realisation or enforcement of collateral will also be discussed briefly. The chapter then moves on to examine netting and set-off. The definition of netting and that of set-off are then discussed with an attempt to distinguish the two. This is followed by considering different types of netting that are used in practice, namely, settlement netting, novation netting and close-out netting. In the final section, the focus is on default rules concerning both member default and CCP default. It is a common perception that for a CCP, being in default is a highly unlikely event since CCPs are structured by robust financial backing. Furthermore, the consequences would be unimaginably damaging. In this section, the default rules of CCPs are found only to cover the default of members. The possible implications of the absence of rules regarding CCP default have also been examined.

Chapter Six In chapter six, the regulatory issues related to CCPs are examined. This chapter begins by explaining the complexities in market structure and financial regulation, which are regarded as important features of modern markets. Three relevant regulatory objectives of financial regulation are identified and potential conflicts that may arise between these objectives will be discussed. The interaction between financial regulation and the markets is further explained. The case of whether there is a need for separated treatment for CCPs is then examined. As to CCPs, the risks involved and the functions carried out are to be distinguished not only from other types of clearing houses but also from other segments of the post-trade infrastructure, ie, trading and settlement. The examination has been carried out in the light of the adoption of the risk-based functional approach to regulation that is widely accepted by the markets and regulators. The second section begins with a discussion of the modern regulatory approach. A combination of self-regulation and governmental regulation now increasingly characterises regulation, especially for CCPs. This is the modern co-regulation approach whereby each mode of regulation shares separate regulatory roles. The typical membership structure of CCPs essentially requires an element of self-regulation. The modern co-regulation approach typically has a statutory framework that gives the authority of rule-making to recognised CCPs. In order to illustrate this modern approach to regulation, the third section takes the UK regulatory regime for CCPs as an example. In the United Kingdom, CCPs 6

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Chapters in Outline are subject to a separate recognition regime under the Financial Services and Markets Act 2000. The regime sets out relevant recognition requirements and puts CCPs under competition scrutiny. This chapter then moves on to discuss current situations in the European Union (EU) and examines the regulatory initiatives and public policies adopted by the EU in achieving its goal of the creation of a single pan-European market. Although the EU has adopted a regulatory framework for financial markets as a whole that promotes competition between Member States’ regulatory regimes with minimum common standards, an agreed common regulatory framework in the post-trade sector in the EU is yet to exist. As such, complications that arise in the development of CCP clearing within the EU are examined. This chapter concludes by looking forward and considering the future challenges that regulators and supervisors, especially those in the EU, are likely to be faced with. It is to be observed that the supervision model of co-operation between regulators and supervisors from different EU Member States, which is based on the ‘home country control’ principle,9 is mainly derived from the regulatory regimes in Member States and relies heavily on co-operation between Member States’ authorities. This chapter finally examines whether or not such regulatory approach is suitable for the further consolidation of the markets across border within the EU and if it is instead likely to hinder the development of a single pan-European Market.

Chapter Seven In this chapter, the advantages and disadvantages of CCP clearing in general are first discussed. This is followed by the argument for a single multi-market CCP with the exploration of the risks and benefits of a single multi-market CCP. In the third section, the developments in the EU toward a single CCP are specifically discussed. To evaluate the advantages and disadvantages of CCPs, this chapter first examines them from different perspectives, ie, the markets’ perspective, the members’ perspective, and non-members’ perspective. Indeed, there are pros and cons of introducing a CCP into a market, which in turn requires a proper assessment of risks and benefits to the market. This chapter goes further to examine whether or not a market with two or more CCPs will provide the same benefits as those with a single CCP. As its name suggests, a central counterparty means that there is only a single counterparty to participants in a specific market. At first glance, having two or more CCPs in a market may make no difference to market participants as long as they are members of one of the CCPs. However, the picture is different at the market level, as argued, since the fact that there are two or more CCPs in the market may suggest otherwise. To make the case for a 9

See Section 6.5.2, ch 6 below.

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Introduction single multi-market CCP, this chapter also draws from the analysis of the role and functions of CCPs as well as the legal and regulatory aspects, as discussed in the previous chapters.

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2 Basic Elements of Post-trade Infrastructure 2.1 Introduction

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HERE ARE IN general two categories of developed markets in a modern economy: commodities markets and financial markets.1 ‘Commodities markets’ refers to the trading of physical commodities, such as gas, oil, cocoa, wheat and plastics, to name a few. Warrants, issued by designated warehouses as ‘receipts’, are subsequently developed to represent the underlying physical commodities and facilitate trading in large volumes.2 The endorsement of those ‘receipts’ has subsequently acquired the effect of making deliveries. On the other hand, financial markets include equities, bonds, foreign exchanges (spot or future) and derivatives. In these markets, all transactions have to be settled in one way or another, either through physical/ constructive delivery or electronically via book-entry for payment settlement and/or securities settlement. The processing involved in various systems after a transaction has been agreed is commonly referred to as post-trade infrastructure.3 Clearly, underpinning the success of the above markets must be a robust and efficient post-trade infrastructure that can facilitate both payments and deliveries. In other words, it requires a shorter trading cycle which will ultimately enhance market liquidity with a good degree of certainty and result predictability.

1

RM Goode, Commercial Law, 3rd edn (London: LexisNexis UK, 2004), at 153. Introducing Electronic Transfer Systems to reduce the need of physical deliveries of warrants is another recent development in commodities markets; see, for example, the SWORD system of London Metal Exchange. 3 The main focus of this thesis is on post-trade infrastructure for financial markets, although the commodity markets may be mentioned when it is relevant. 2

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Elements of Post-trade Infrastructure

2.1.1 The Importance of Post-trade Infrastructure4 Different markets may appear to have different procedures or structures for clearing and settlement. Nevertheless, the risks that those structures pose to the markets, its participants and the economy in general are not much different. It is indisputable that the markets cannot function without clearing and settlement arrangements, as they are often compared to plumbing systems that are essential but, in effect, go unnoticed. Of course, the clearing and settlement arrangements have constantly been modernised to improve safety and increase efficiency. A safe and efficient post-trade infrastructure is not only a significant cost factor but also one of the key factors for a robust and efficient financial system. In general, post-trade infrastructure refers to an organised system of arrangements for the clearing and settlement of payment obligations and the transfer of securities between the two parties that have agreed to trade. These processes are the most essential part of securities transactions and are significant because their smooth functionality is likely to boost the confidence of investors in the markets. In essence, the role of post-trade infrastructure is to support trading and to cater for changes. The financial services industry has seen fundamental and pervasive changes in the past few years, which are mainly driven by extraordinary advances in computing and telecommunications technology. These advances in technology are not just evolutionary but, in a sense, revolutionary, as they are transforming virtually every aspect of the industry, including trading, CCP clearing and settlement.5 This has also brought significant challenges to the existing post-trade infrastructure related to how well it can adapt in a time of profound change. Furthermore, the post-trade arrangements that lag far behind the changing pace of the markets may constrain the developments of those markets.6 It is widely accepted that a robust and efficient post-trade infrastructure helps to attract investors. Suffice it to say, traders will also be less inclined to trade (or add risk premium) if they have no confidence that the actual settlement of the trade will take place within an appropriate time-frame, which in turn is partly dependent on the safety and reliability of the post-trade arrangements. Furthermore, inefficiencies in the post-trading infrastructure have been identified as a source of risk and cost in the Group of Thirty’s report—‘Global clearing and

4 For an overview on post-trade infrastructure, see also J Benjamin, M Yates and G Montagu, The Law of Global Custody, 2nd edn (London: Butterworths, 2002) ch 8; and also M Yates and G Montagu, The Law of Global Custody, 3rd edn (London: Tottel Publishing, 2009) ch 8. 5 For example, the use of algorithmic programs in trading and the advance of response time in trading systems in terms of milliseconds have made executing a great number of orders per second possible and in turn fuelled the explosion of growth in trading volumes as seen in recent years. 6 The report from the Counterparty Risk Management Policy Group II calls for urgent action to strengthen the market infrastructure for trading in advanced financial products, credit derivatives in particular. See the Counterparty Risk Management Policy Group II, Toward Greater Financial Stability: a Private Sector Perspective (27 July 2005), available at: www.crmpolicygroup.org.

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Introduction settlement: a plan of action’.7 In an increasingly globalised economy, investors have also begun to take considerable care in that regard when choosing which market to place their investments on.

2.1.2 The Changing Landscape of Post-trade Infrastructure Briefly, a trading cycle for securities transactions covers the following processes: upon a trade being agreed (‘trading’) by two counterparties it will be passed on to the clearing institutions for reconciliation and confirmation (‘clearing’8) before the completion of the trade, namely, the actual exchange of the securities and the payment (‘settlement’).9 Here, it is necessary to draw a line between trading and post-trade activities as well as pre-settlement activities and settlement. The distinction between the processes carried out in different stages is often blurred.10 This may be mainly due to the fact that the post-trade processing services are sometimes carried out in-house and sometimes by various different third parties. The table below explains the major stages in post-trade processing with CCP clearing. Trading involves a process that enables parties to enter into contracts of buying or selling financial assets. Traditionally, it had to take place in a formal exchange at a physical meeting point where trades were agreed upon vocally. Nowadays, this is not necessarily the case. Trading is now not only carried out on exchanges but also takes place via telephone, other electronic communication networks and Over the Counter (OTC). Indeed, the traditional methods of trading have been greatly challenged by the so-called electronic trading.11 For intermediaries, where and how an order from its client will be routed is dependent on several factors, such as the speed and cost of a trading system. 7 Group of Thirty, Global Clearing and Settlement: A Plan of Action (Steering & Working Committees of the Global Clearing & Settlements Study Group, 2003). 8 As the term is used in the loose sense, see Sub-section B below for a detailed discussion on the evolving clearing concept. 9 A fourth element known as ‘custody’ mainly concerns itself the safekeeping and administration of securities. Here, post-trade infrastructure is extended to include custody services. In contrast, custody is not normally included when we speak of clearing and settlement. This subject matter is out of the scope of this thesis. 10 A Bressand and C Distler of Promethee in the Central Counterparties Dialogue—001 (Paris: Promethee, April 2001) clarify how the three segments of the securities processing value-chain relate to one another will have major implications for the various services providers’ strategic positioning in the future. 11 There has been a trend that formal/official exchanges moving onto electronic trading platforms. In addition, a significant number of trades are also done through the so-called OTC markets. Recently, the so-called Alternative Trading Systems are also increasingly popular. See JH Dalhuisen, Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law, 3rd edn (Oxford: Hart Publishing, 2007) 1163–96, for further information on markets and trading. Also see Helen Allen, John Hawkins and Setsuya Sato, Electronic Trading and its Implications for Financial Systems (Bank for International Settlements (BIS) Papers No 7).

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Elements of Post-trade Infrastructure

Major stages in post-trade processing with CCP Clearing Stages

Key functions

Pre-clearing

Matching/Confirmation of securities transactions, also including trade allocation

Central Counterparty Clearing12

Interposing a Central Counterparty between the buyer and the seller, and offsetting of transactions

Settlement

Establishing the respective obligations of each trading party, making actual deliveries with finality, namely, the transfers of securities and payments

Post-settlement

Providing custody services, such as safekeeping, asset servicing, corporate action and taxation

Similarly, the activities involved in post-trade/pre-settlement processing do not always provide a clear-cut picture. With the advance of technology, post-trade processing has become ever more specialised and sophisticated. The way in which a specified trade is to be processed is partly dependent on the type of financial instruments involved and partly on what kind of processing arrangements are available. Even for the same type of transactions in a market, the processing arrangements may not necessarily be the same. A simple example is that a trade can be settled either bilaterally between the parties or via CCP clearing. Because the transactions may involve several intermediaries in between the original parties, the same process, like matching and confirmation, may also be repeated several times by various parties involved in a trade cycle. Therefore, a general reference to the post-trade infrastructure as clearing and settlement has now become imprecise, in the sense that it does not necessarily depict accurately the processes a transaction is going through after it has been agreed in the cycle. Furthermore, clearing here is used to include the processes after the transactions are agreed and before they are settled, which is considered to be the main reason behind the loose use of and confusion over the actual meaning of clearing, which will be discussed shortly. Driven by advances in technology and financial innovation in modern financial markets, the processing of trading cycles has been transformed. While the concept of CCP clearing is by no means new, it has quickly expanded into many markets in the last few years and increasingly forms a core part of modern markets. Indeed, the concept is so successful that it is now established as a key element in modern markets. Consequently, trade processing is becoming very different from what it used to be. In a market, a designated CCP enters an eligible trade when it is agreed upon and validated by the original counterparties.13 Thus, the CCP becomes buyer to the seller and seller to the buyer. As a result, the CCP 12 In case an ‘open offer’ mechanism is available in the exchange or the trading platform, the CCP actually steps in at the trading stage. See further discussion on how CCPs operate in ch 3 below. 13 So far we have seen CCPs operating in many different markets, such as commodities markets, derivatives markets, bond markets and equity markets, as well as OTC markets.

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Introduction assumes all the rights and obligations as the counterparty to two equal and opposite transactions. It should be emphasised that the resulting two transactions are completely independent from each other.

A. Central Counterparty When a CCP14 is interposed between the counterparties to financial transactions in one or more markets, it becomes the buyer to every seller and the seller to every buyer,15 namely a principal-to-principal relationship.16 It is worth mentioning that, in many markets, it remains an option for the trading parties to decide whether or not to process the trade through a CCP, while in some markets CCP clearing is compulsory for all eligible instruments. In the United States, the creation of the National Securities Clearing Corporation (NSCC) as a CCP with the concept of multilateral netting17 was a major response to the paperwork crisis of the late 1960s.18 Another primary force behind the creation of CCPs is the economic interest of capital market participants in lowering the counterparty credit risk and costs of post-trade processing.19 Suffice it to say here, the unique position of CCPs in the markets has contributed to the success of the CCP clearing concept in recent years in particular. From the perspective of member participants, CCPs have the effect of aggregating dealings/transactions with various counterparties into just a single party. An arrangement in which the original trading counterparty is replaced with a CCP also facilitates the increasingly popular phenomenon of anonymous trading due to the fact that the CCP has become the counterparty to every trade that has been processed through CCP clearing.20 This also means that there is an equal counterparty risk to the market participants in respect of those cleared trades. Without a CCP, the identity and account of the original counterparty will have to be revealed for the transactions to be processed and settled in a timely 14 A clearing house is an organisation that establishes and records the obligations arising from trading for their members and ensures that trades are settled according to the relevant rules. It is notable that a clearing house only acts as a CCP when it interposes itself as buyer to the seller and seller to the buyer. In other words, a CCP does not necessarily need to be a clearing house. 15 Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of International Organisation of Securities Commissions (IOSCO), Recommendations for Central Counterparties (Basle, Bank for International Settlements, November 2004). 16 For further discussion on the contractual relationships, see ch 4 below. 17 See Section 5.2, ch 5 below. 18 This crisis was mainly caused by the common use of paper-based securities certificates at the time, which requires physical deliveries of those certificates to facilitate the settlement, coincided by an explosion in trading volume. In addition, the then inadequate clearance and settlement arrangements also contributed to the crisis. 19 The Depository Trust & Clearing Corporation (DTCC), Central Counterparties: Development, Cooperation and Consolidation (A White Paper to the Industry on the Future of CCPs, 2000). Also see Section 7.1, ch 7 below for the advantages and disadvantages of CCPs. 20 Of course, anonymous trade may not be possible in some transactions, for example, OTC transactions like swaps, as they are normally agreed bilaterally first. See Section 7.1.2, ch 7 below for further discussion on anonymous trading as a benefit of CCP clearing.

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Elements of Post-trade Infrastructure manner and accurately. CCPs also bring in standardised risk management.21 For instance, market participants will instead have to manage their own counterparty credit risk in a market where there is no CCP clearing mechanism or third-party guarantee scheme. There is an important issue of economies of scale in this sector. It is suggested that the new emerging pattern of integration and consolidation among CCPs is one of the most important developments that will shape the global investment servicing industry over the next 5 to 10 years in the United States.22 With increasing volume of cross-border transactions, it also seems unavoidable that there will be further consolidation of the financial market in the light of globalisation. Put simply, it is just a matter of how and when. This is also true as far as the post-trade infrastructure is concerned. In connection with the CCPs, as one of the key components, consolidation is also likely to be inevitable and bring greater benefits to the markets.23 The future of CCPs has attracted much attention in the industry and it is generally accepted by the markets to be a significant development in the financial sector in the years to come.24 Two competing solutions have been proposed for the future architecture, namely, creating an integrated CCP platform or a single CCP through mergers.25 It is conceivable that the development of CCPs will also be influenced by governments and regulators. For example, differences in national laws and regulatory regimes have so far been the major hurdle for the creation of a pan-European CCP.26 Currently, CCPs operating in the markets are recognised either as clearing houses or as credit institutions.27 Strictly speaking, even though it is right to consider CCPs as part of the post-trade infrastructure, it arguably may be considered as inappropriate to subject them to the same regulatory/supervision regime as other post-trade service providers, such as Central Securities Depositories. For operational reasons, CCPs are recognised by relevant financial services 21

See ibid, for further discussion on the benefits of CCP clearing. DTCC (2000), n 19 above, at 2. 23 See Section 7.1, ch 7 below for further discussion. 24 See DTCC (2000), n 19 above. For further discussion, also see ch 6 below. 25 An integrated CCP platform with standardised protocols that enables interoperability between different systems may well involve several CCPs. See ch 6, for further discussion. 26 Instead of creating a single entity in the merger structure of the London Clearing House and French Clearnet, they remain as separate entities for regulatory and supervisory reasons: one is now called LCH.Clearnet Ltd and the other LCH.Clearnet SA. On top of this, there is a holding group called LCH.Clearnet Group, which is supervised by the French authority. See Sections 6.3 and 6.4, ch 6, for regulatory issues. 27 ‘Credit Institution’ is defined in the Council Directive, 77/780/EEC of 12 December 1977 on the coordination of the laws, regulations and administrative provisions relating to the taking up and pursuit of the business of credit institutions [1977] OJ L322/30 (First Banking Directive), as an undertaking whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account. In France, Central Counterparty Clearing Organisations like LCH.Clearnet SA are recognised and authorised as Credit Institutions for regulatory purposes. It should be noted that the coverage of French law is out of the scope of this work. For further discussion, see ch 6 below. 22

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Introduction authorities and have the right to trade with participants in the markets in which case they operate as market participants. They may not necessarily have the trading facility to do so, as traders or broker/dealers, which is the major factor that differs them from market players. This also distinguishes them from other service providers like settlement agents and custodians. The publication of the Bank for International Settlements (BIS)’s Recommendations for CCPs in 2004 also proves the need for a different regime.28 From a market operations point of view, CCPs have also brought great settlement efficiency to the markets by sitting right in the middle of trading and settlement. Furthermore, CCPs have not only helped the markets to develop standardised products and procedures (and are continuing to do so), but they can also potentially help harmonise various procedures set by different markets, and settlement procedures in particular.

B. Clearing (i)

The Concept of Clearing

The term ‘clearing’, which originally had administrative connotations, is presently used to mainly describe the process of calculating and confirming the mutual obligations of market participants. However, the use of this term is widely abused and rarely defined. For instance, it is often used to include all processes carried out after trading and before settlement when reference is made to post-trade processes with ‘clearing and settlement’. In its simplest sense, clearing is actually carried out more than once at different stages in a trade cycle, where a trade is being processed involving various intermediaries.29 Arguably, every system provides a similar form of this function. Along with market development, the meaning of clearing has evolved. It has become a more complicated, multifaceted and elusive concept, and the innovative and dynamic markets have also given it new meanings. As just mentioned above, the term ‘clearing’, when used loosely, has often referred to the processes after trading and before settlement. In addition, it sometimes also includes settlement, as is the case in commercial banking for payment settlement. This may increasingly become a misleading perception.30 It is, therefore, necessary to further distinguish the various functions carried out in the value chain to attempt to clarify the different meanings of clearing in the following manner.

28

CPSS and the Technical Committee of IOSCO, (November 2004), n 15 above. Also see ch 5

below. 29

For the examples, see below. The BIS’s CPSS and the Technical Committee of IOSCO, following the publication of Recommendations for Securities Settlement Systems in 2001, published another report Recommendations for Central Counterparties in 2004 (see n 15 above). This is significant in that CCPs are now recognised to be distinguished from Settlement Systems in the earlier report in respect to their different functions in the value chain. 30

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Elements of Post-trade Infrastructure (ii)

Clearing in Commercial Banking

Clearing is a term that originated in commercial banking, and can be traced back to over 300 years ago, when cheque clearing was first introduced.31 In fact, in commercial banking clearing has a rather different meaning, depending on the medium32 that is used for the payment. In many cases, it is also used to include the process of settlement. In essence, clearing in commercial banking here concerns off-setting of payment instructions, whereby a bank’s inflows and outflows of payments with respect to its counterparty banks in a set time-frame are calculated and offset, resulting in a single payment obligation to be settled.33 It involves the transmission and settlement of payments between accounts held at different banks.34 It is worth noting here that another feature that has to be incorporated in the clearing arrangements in commercial banking is a mechanism that allows banks to reverse the payment, for example, when cheques are dishonoured. As payment settlement systems developed further, as will be discussed in Section 2.2 below, they became further distinguished according to the characteristics of the systems. In the case of large-value payment systems, the clearing process is not recommended because of the great systemic risk it carries.35 This was the main reason why the European Union eventually adopted a real-time gross settlement system approach for large-value payments.36 Typically, these large-value payment systems are normally operated by central banks. Although they are administrators for the systems, they do not operate in the same capacity as CCPs do in their own accounts. The absence of an equivalent counterpart of CCPs in the banking system could possibly be partly explained by the existence of a central bank in the system. (iii)

Clearing in Securities Markets

Clearing in securities markets initially referred to the confirming, calculating and reconciling of obligations among trade counterparties. With the introduction of 31

See the history of cheque clearing in Section 3.1.1, ch 3 below. There are various payment methods that run through clearing; these include cheques, credit cards and direct debts etc. 33 Or as a type of netting, namely, settlement netting, to be precise. See Section 5.2, ch 5 below for further discussion on various forms of netting and their legal implications. 34 See, for example, the website www.apacs.org.uk for further information on the cheque clearing process. 35 Systemic Risk, according to A Glossary of Terms Used in Payments and Settlement Systems (BIS, March 2003), is defined as the risk that the failure of one participant in a transfer system, or in financial markets generally, to meet its required obligations will cause other participants or financial institutions to be unable to meet their obligations (including settlement obligations in a transfer system) when due. Such a failure may cause significant liquidity or credit problems and, as a result, might threaten the stability of financial markets. 36 See D Schoenmaker, A Comparison of Net and Gross Settlement (LSE Financial Market Group, Special Paper No 60, 1990). Also see the discussion of Securities Settlement Systems in Section 2.2.3 below. 32

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Introduction CCPs, it has now further expanded to include CCP clearing in some cases. The factor that may seem to be confusing is that the same process, like matching and confirming a transaction, may be carried out by various types of entities in a trade cycle.

(a) AT CENTRAL COUNTERPARTY The meaning of clearing in connection with CCPs is completely different from the general meaning that it has acquired, which, in its simplified form, is matching and confirmation of transactions. In terms of function, clearing in CCPs concentrates on trade management, position management, collateral and risk management, and delivery management. In the modern post-trade arrangement involving CCP clearing, the CCP clearing takes place prior to the clearing performed by Central Securities Depositories (CSDs).37 Distinctions must also be made between the clearing services provided by CCPs to their members and those by its members to other participants without a CCP’s membership. Apart from providing the services such as confirming and account maintenance, some members of CCPs with large client bases when providing clearing services to their clients may occasionally be able to offset obligations for their clients on their own books,38 for instance, if the counterparties of two equal and opposite transactions regarding the same class of securities happen to be the member’s clients. However, these members do not have the ability to determine the occurrence. Most importantly, they are not acting with the same legal capacity as a CCP, as will be discussed further in chapter four.

(b) BY INTERMEDIARIES FOR THEIR CLIENTS Clearing here is of an administrative nature, and the term is used in a loose way. In the United States, it is first necessary to distinguish intermediaries that are self-clearing firms39 from those that are not. In US terms, the former are also called clearing firms and the latter introducing firms.40 A self-clearing firm is a firm that handles all aspects of client activity by itself, including the steps from initiating a trade to the settlement process of the trade and the safekeeping of positions as well as cash account management. In addition, some intermediaries

37

See the discussion on CSDs below. This is typically referred to as settlement internalisation, also see n 51 below. 39 Self-clearing is a term mainly used in the US markets. Only a few hundred firms, mostly large brokerage firms and some specialists, self clear trades in the US. Also, see HF Minnerop, ‘Clearing Arrangements’ (May 2003) 58 The Business Lawyer 917–59, 919. 40 It is worth noting that clearing firms in the US may not necessarily mean they are members of a Central Counterparty Clearing Organisation, even if there is a CCP in the market. 38

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Elements of Post-trade Infrastructure tend to offer self-clearing services to their own clients.41 Self-clearing service providers have to be authorised by relevant authorities and will have to have proper operational arrangements in place and assume responsibility for their own actions. Under a typical ‘clearing’ agreement, the clearing firm, in general, assumes all direct responsibility for the execution and settlement of the transactions, custody of securities and cash balances and the extension of credit on margin transactions. Nevertheless, the specific allocation of functions is a matter of contract between the two, and this is generally determined according to the business needs of the introducing firm as well as the scope of services provided by the clearing firm.42 (c) AT CENTRAL SECURITIES DEPOSITORIES (CSDS) OR BANKING INSTITUTIONS FOR MARKET PARTICIPANTS.

CSD clearing is different from clearing which has been performed by a CCP, as it normally refers to the validating and matching of the delivery instructions in preparation for the final settlement. As mentioned above, pre-settlement arrangements like trade capture and matching may be provided by exchanges, trade associations or CSDs.43 In the case that trade capture and matching are provided by other institutions, CSDs are left with the responsibility for validating the instructions – such task may be repeated by different institutions involved in the processes, establishing the respective obligations of each trading party, settling transactions and maintaining accounts.

C. Settlement All obligations, either monetary or non-monetary, have to be fulfilled in the manner agreed upon by the parties. This also applies to securities trading. In the simplest sense, the settlement of a single individual securities transaction must involve two systems, ie a payment settlement system for payment transfer and a securities settlement system for securities transfer.44 Upon the completion of each settlement cycle, trading positions are reflected in the accounts of the 41 The key functions provided through self-clearing services by firms should be distinguished from that of CCPs in the sense that self-clearing firms, which is required to be authorised in the US as self-clear firms, do not have the same protection with regard to insolvency law and agency law. For regulatory issues, see ch 6 below. 42 Both the New York Stock Exchange (NYSE) Rule 382 ‘Carrying Agreements’ and The National Association of Securities Dealers (NASD) Rule 3230 allow firms to specify the respective functions and responsibilities under their clearing agreements. It should be noted that customer-contact functions are retained uniformly by the introducing firm. 43 For example, Euroclear, an ICSD, also operate a trade capture and matching system called ‘Euroclear Trade Capture and Matching System’. International Capital Market Association (ICMA) used to run a trade matching and transaction reporting system call TRAX. In April 2009, the system became part of Euroclear group. 44 It may not be so obvious in the case of Payment embedded Securities Settlement Systems. See Section 2.4 below for further discussion. Also see the Committee on Payment and Settlement Systems, The Interdependencies of Payment and Settlement Systems (CPSS Publications No 84, June 2008).

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Introduction systems, which is typical for modern book-entry systems. As a result, there will be a debit from the buyer’s account and a credit to the seller’s in the payment system, and vice versa in the securities settlement system.45 In a typical market, transactions that are processed with matched and validated instructions in a settlement cycle will have to be checked against their respective account holdings in order to effect the final settlement in the settlement systems. The purchasing parties that have to pay should have enough credit in the settlement accounts of the relevant payment system. On the other hand, the delivering parties will have to have sufficient securities ready before the settlement processing begins.46 As for payments, the settlement between banks could be either through a specific settlement account designed for that purpose or on the books of the central bank.47 Regarding securities, not all buyers and sellers of securities hold accounts at the CSD; instead, they may hold their securities and settle their trades through an intermediary/custodian, and the custodian may, in turn, hold its clients’ securities through a sub-custodian. The real-time link between payment systems and securities settlement systems has made possible the Delivery Versus Payment (DVP) mechanism.48 However, this linkage also means that either insufficient credit or securities will cause the settlement of the trade to fail.49 Moreover, the process is not as simple as it once was due to the advent of modern indirect-holding structures of book-entry securities.50 In this type of system, settlements for securities transactions can take effect in several different ways. Typically, the securities transactions are settled on the books of the CSD operator. In some cases, in a market that has no restrictions, a securities settlement can be internalised.51 This means that the intermediaries will be able to settle the transactions on their own books insofar as the transactions in question are matched on the books of that intermediary and, as a result, the settlement need not go through the books of the CSD. The fact that holdings of book-entry securities are reflected in accounts determines that transfers of the securities can happen in three different ways. This mainly depends on where the two counterparties to the transaction have their accounts:

45

For further discussion on indirect-holding structure, see Section 2.3 below. As it will be discussed in Section 2.2 below, settlement processing comes with different types; it can be, for example, batched processing with several cycles per day plus an overnight cycle, and real-time gross settlement. 47 Also see Section 2.2 below. 48 See Section 2.4.1 below for detailed discussion of DVP. 49 It is notable that in practice a failed settlement will not necessarily result in the delivering party being declared default. 50 See Section 2.3 below. 51 Settlement internalisation has also to be distinguished from the so-called trade internalisation. The recent development of Alternative Trading Facilities has also made the trade internalisation possible. The provider of alternative trading facilities has larger number of clients with orders that allow trades to be matched internally. 46

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Elements of Post-trade Infrastructure (i) With in-house transfer, trades then do not necessarily have to be settled through sub-custodian or upper-tier intermediary. The recent development of internalisation is a case in point, where large brokers are now able to match trades and settle them internally as their larger numbers of clients makes this possible. (ii) At intermediary level. At this level, the main difference from the in-house transfer is that the two accounts in relation to a trade are held initially by two different intermediaries and in turn these two intermediaries have a common custodian or upper-tier intermediary52 with whom each has an account. (iii) At settlement system level. This happens when the two trade counterparts are both direct participants of a settlement system for the underlying securities. In the case that there are various transactions between two counterparties, the resulting settlement may vary depending upon whether the mutual set-off is agreed.53

2.2 Payment Systems and Securities Settlement Systems 2.2.1 Introduction Before moving on to book-entry systems, securities transactions were settled through physical delivery of paper-based securities, which in turn required extensive manual work. The ever-increasing trading volume eventually made it impossible to cope with the resulting physical exchanges, leading to the famous paperwork crisis in the United States in the 1970s.54 As one response to the crisis, securities settlement systems were moved to electronic-based systems to meet the demands of increased efficiency in transaction processing in particular. Most importantly, this has been made possible through technological advances, especially speedy and secure distributed network technology and the initiative to shorten the trade processing cycle with the ultimate goal to achieve real-time processing.55 For the years to come, it is envisaged that the efficiencies of payment and securities settlement systems will continue to be improved further with the advance of technology.56 52 Upper-tier is a relative term. An upper-tier intermediary is here referred to the intermediary who holds a securities account for the other intermediary. The low-tier intermediary is thus the account holder. 53 See Section 5.2, ch 5 below for netting and set-off. 54 As mentioned earlier in n 19 above. 55 Also see Section 2.4.2 below for detailed discussion on Straight Through Processing (STP). 56 T Khiaonarong, Payment Systems Efficiency, Policy Approaches, and the Role of the Central Bank (Bank of Finland Discussion Paper 1, 2003).

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Payment and Securities Settlement It may appear to some that these book-entry systems centralise the way that securities are transferred and payments are made. However, further examination suggests the opposite may be the case.57 Suffice it to say, modern post-trade infrastructure and the legal framework has made this possible. Arguably, the existence of intermediaries in the value chain, together with the book-entry account structure has created the effect of decentralising settlement processing. As mentioned in the previous section, settlement can actually take place at various levels in the systems, ie at the level of the intermediary in different tiers. In principle, a securities transaction is settled by drawing on the buyer’s cash account and crediting the holding as the result of the purchase to the buyer’s securities account. Here, it means some transaction settlements do not necessarily have to go through a ‘settlement system’. For instance, an intermediary may have executed a trade internally for two of its clients as their orders were matched.58 As a result, there is no securities movement on the intermediary’s external books when they are held in an omnibus account59 with a subcustodian. This means that no changes are made to accounts the intermediary has with its sub-custodian for the segregation of assets purposes. The changes will only be reflected on the internal books of that intermediary. It has to be borne in mind that the sub-custodian in question may simply be a settlement agent or a custodian bank and does not need to be a settlement system. For securities transactions, the settlement process of both the payment leg and securities leg may only involve the settlement system itself when there is a payment-embedded securities system60 instead of two separated independent systems, ie, one for payment and the other for securities. In cases where the payment system is provided by a third party and is linked with the settlement system, be it a private inter-bank payment system or central bank payment system, the payment leg of the securities trade is settled accordingly in the relevant system. Both payment systems and securities settlement systems, which have been undergoing rapid and fundamental changes, are essentially arrangements that provide the users of the systems with a mechanism either to transfer funds in the case of payment systems, or to transfer ‘security entitlements’ in the case of securities settlement systems.61 They are different in that each system is designed to manage risks that are distinctive in one way or another, although both of them, in general, concern themselves with principal risk/counterparty credit risk, liquidity risk and systemic risk.62

57

See Section 2.3.4 below. For example, brokers in the US have the choice of where to route an order from his client for execution. 59 See Section 2.3.3 below for the discussion of omnibus accounts. 60 To be discussed in Section 2.2.3 below. 61 See Section 2.3 below for discussion on book-entry securities and their transfer. 62 See the sections below for further discussion on risk aspects of payment and securities settlement systems. 58

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Elements of Post-trade Infrastructure It is worth noting that recent years have also seen increasing interdependencies among payment and securities settlement systems. The drive towards Delivery Versus Payment (DVP) settlement and Straight Through Processing (STP) for financial transactions may arguably be considered as a major contributor to such development.63 Consequently, the nature of risks posed to these systems has been altered by the increased interdependencies among payment and securities settlement systems.64 The key here is that participants should have adequate risk management controls in place and relevant authorities should have appropriate policies to identify and manage those risks posed by such tighter interdependencies, systemic risk in particular.

2.2.2 Payment Systems Payment systems play an important role in a modern economy, as most economic activity depends on them. Typically, a well-developed domestic banking system consists of various different types of payment systems according to the forms and values of payment instructions such as cheques, credit cards and electronic funds transfer.65 These payment systems have a significant bearing on the functioning of financial markets. Here, we are concerned only with largevalue funds transfer systems, for they are often used in connection with financial markets and securities settlement systems. Payment systems for fund transfers are generally of two types: gross and net settlement. The trend that seems to be continuing is the widespread adoption of real-time gross settlement system (RTGS) for large-value fund transfers, which eliminates the intra-day credit risk66 that exists in net settlement systems. In the European Union, for example, a system of this kind is operated by CHAPS (Clearing House Automated Payment Systems). As global economic integration progresses, it is argued that payment systems will inevitably be consolidated and become more specialised. This, to some extent, means that the distinction of large- and small-value payment systems is likely to be less obvious than it is in the current state of affairs.67 For fund transfers, a typical process obviously involves several parties: payer, payer’s 63

See Section 2.4 below for DVP and STP. See CPSS (June 2008), n 44 above. 65 See RM Goode (2004), n 1 above, 464–75 for money and payment. Also see JH Dalhuisen (2007), n 11 above, 477–80 for modern electronic payment systems, and 1030–49 for payment and payment systems. For the US law, see Art 4 of the Uniform Commercial Code. Also see the UNCITRAL Model Law on International Credit Transfers, as adopted in May 1992. 66 Intraday credit risk as defined is the risk that incurred in net settlement system during the time interval as all the funds transfers are to be processed in the overnight settlement cycle and could be a potential trigger of systemic risk should a participant bank go into default. 67 Typical examples of the so-called small value payment systems are those for cheques, standing orders, direct debits and credit cards. Relatively speaking, the majority of the transactions processed by those systems are with smaller nominal. This is particular so when compared with large value payment systems such as those operated by central banks. 64

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Payment and Securities Settlement bank, payee and payee’s bank.68 In the simplest case, it may only involve three parties, where the payer and the payee both have an account with the same bank. Settlement of fund transfers may be through the books of commercial banks, be it in small-value or large-value cases, or those of the central bank, normally in large-value cases but it may not happen often. The use of central bank money certainly provides clear advantages over commercial bank money in the sense that it provides funds that are considered as ‘free of default risk’.69 Furthermore, what make payment systems unique are the arrangements that each settlement bank has an account with the central bank in the country in which it is operating and that at the same time banks typically have a settlement account with each other without necessarily involving the central bank. Thus, some systems settle across the books of a single settlement institution, which is usually a central bank, or among commercial banks themselves in other cases. On the other hand, other systems may settle across the books of the direct participants, with other indirect participants settling through them. In this sense, the settlement system is technically an engine that processes payment orders for participant banks. Essentially, inter-bank payment systems are private arrangements among banks to facilitate funds transfers among themselves. With the feature in commercial banking that each bank has an account with the other banks for settlement purposes, banks can settle payment obligations against each other without going through a central bank. In this case, however, each bank exposes the default risk of its counterparty banks.

2.2.3 Securities Settlement Systems Modern securities settlement systems are often highly centralised or monopolised, at the national level in particular, as they were initially established for serving their own national markets. In modern times, there is also a Central Securities Depository (CSD) at the heart of the system, operating on a membership basis. The fact that the cost of membership is relatively high and that strict criteria must be met at all time by a member, means that only a relatively small number of institutions directly participate in the system and other participants can only access the system indirectly through those direct participants. In general, depending on how each trade is settled, as agreed by the parties, securities settlement systems are either ‘gross’ or ‘net’ systems. Both types of systems have advantages and disadvantages over each other.70 Gross systems are

68

See RM Goode (2004), n 1 above, 465–6 for funds transfer terminology. Committee on Payment and Settlement Systems (CPSS), The Role of Central Bank Money in Payment Systems (Bank of International Settlements, 2003). 70 See RM Goode (2004), n 1 above, 473–5 for a comparison of net payment systems and real-time gross payment systems. 69

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Elements of Post-trade Infrastructure now gradually moving towards real-time, although not necessarily all of them,71 while net systems increase liquidity and reduce costs because the offsetting effect on the reduction of the number of transactions actually needs to go through settlement systems.72 However, this raises the issue of credit risk exposure73 during each settlement cycle. According to the type of processing, systems can also be either that of continuous settlement or batch settlement. As a result, three types of settlement systems can be further distinguished to have been operating in the markets: Continuous Net settlement (CNS),74 Batch Net Settlement (BNS) and Real Time Gross Settlement (RTGS). In a developed market, the choice of one of the above settlement methods is often available to participants. The risks embedded in each type of system vary. Likewise, the correlation between these risks differs in each system. Furthermore, the design and operations of settlement systems are also likely to be different, as they often represent modifications or enhancements to previous systems or procedures with the view of meeting local needs.75 An excellent example is provided by the development of real-time gross settlement systems in the EU in response to the need for sound risk management for large funds transfer systems in particular. Based on that infrastructure, Germany has built a hybrid payment system domestically. It is a so-called ‘queue-augmented’ RTGS system, which includes a computer algorithm that searches the queue for simultaneous and offsetting payments. This development in payment systems also pushes securities settlement systems to move to gross settlement systems.76

2.3 Modern Indirect-Holding Structure and Book-Entry Securities 2.3.1 Introduction A parallel development to building the modern post-trade infrastructure is the introduction of an indirect-holding structure for book-entry securities. In other words, the modern indirect-holding/tiered-holding account structure was developed to accommodate the vast volume of securities that change hands, as well as the move from paper-based securities to book-entry securities.77 That is mainly 71 The need for small-value transfers to settle in real-time is less viable, the cost of having a real time settlement system is relatively high. 72 See Section 5.2, ch 5 below for further discussion on netting. 73 See n 66 above. 74 CNS systems are similar to Deferred Net Settlement (DNS) system, but use a computer algorithm to check if a participant’s net debit amount is within their settlement account balance and if conditions are met, releases payments for real-time settlement. 75 BIS, Real-Time Gross Settlement (1997). 76 See the discussion of the UK CREST System with DVP arrangements in Section 2.4.1 below. 77 To be discussed in Section 2.3.3 below.

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Indirect Holding & Book-Entry Securities achieved by the two processes called immobilisation and dematerialisation, as will be discussed shortly.78 The most significant result of these developments is a unique structure of securities holding, in that securities are represented in accounts in the form of book-entry securities through intermediaries in various tiers.79 Consequently, physical transfers of traditional paper-form securities are replaced by the process of debiting one account and crediting the other account, the so-called book-entry transfer.80 This mechanism for transfers is therefore effected and reflected in changes on the books of relevant intermediaries in different tiers. In turn, the holdings of book-entry securities are recorded on electronic book entries, ie book-entry accounts, as distinct from those for traditional paper-form securities.

2.3.2 Indirect-holding Structure It would have been impossible to comprehend the trade processing for modern financial markets without understanding the basics of indirect/tiered accountholding structure first. As intermediation is one of the distinct and important features of book-entry systems, there is likely to be more than one intermediary in the chain between the investor on the one end and the central depository on the other. From settlement system operators’ perspective, it is often not practical for them to provide direct access for all;81 instead there are normally a limited number of direct members or account-holders and the majority of the rest are provided with access indirectly through those intermediaries that are themselves direct members of the system. The indirect-holding structure has been admirably described by Professor Steven Schwarcz as follows:82 78

See further discussion on immobilisation and dematerialisation in Section 2.3.3 below. JH Sommer, ‘A Law of Financial Accounts: Modern Payment and Securities Transfer Law’ (1998) 53 The Business Lawyer 1181–1215. 80 To be discussed in Section 2.3.4 below. 81 Suffice it to say, this is largely due to the cost factor and minimum membership requirements and criteria set by settlement systems. For further discussion, see Section 2.2 above on payment and securities settlement systems. 82 SL Schwarcz, ‘Indirectly Held Securities and Intermediary Risk’ (2002) 1 Uniform Law Review 3. Also see The Law Applicable to Dispositions of Securities Held Through Indirect Holding Systems, report prepared by Christophe Bernasconi, First Secretary at the Permanent Bureau, Hague Conference on Private International Law, to the Working Group of January 2001 (regarding the taking of investment securities as collateral) (November 2000 Prelim Doc No 1). It is also known as ‘Bernasconi Report’, also see R Potok, Cross Border Collateral: Legal Risk and the Conflict of Laws, (Butterworths: London 2002) ch 2; and H Kronke, The Draft Unidroit Convention on Intermediated Securities: Transactional Certainty and Market Stability (Seminar on Current Developments in Monetary and Financial Law, Washington DC, 23–27 October 2006). For the EU development, also see the work of The EU Legal Certainty Group on Clearing and Settlement at: ec.europa.eu/internal_market/ financial-markets/clearing/certainty_en.htm. 79

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Elements of Post-trade Infrastructure Under the indirect holding system, an issuer of securities generally records ownership of its securities as belonging to one or more depository intermediaries. Although physical certificates exist for most securities held through a depository intermediary, these certificates remain in that intermediary’s possession and are never delivered to third parties. The depository intermediary records the identities of other intermediaries, such as brokerage firms or banks, which had purchased interests in these securities. Those other intermediaries in turn record the identities of investors that purchase interests in the intermediaries’ interest.

In such a structure, the end investor’s rights in respect of the securities are no longer evidenced either by the registration in the issuer’s register or direct possession, as the case may be, but through his securities account with the relevant intermediary.83 At the top tier of this holding structure, a registrar or custodian records the holders of securities on its own books with which each holder has at least one account. Typically, these account-holders are relatively limited in number and the majority of them may well be holding assets for their clients down the chain. In turn, each account-holder is acting as intermediary and maintains accounts for their own clients. Conversely, the intermediaries in the lowest tier, who maintain accounts directly for the end investors, will have their accounts in the upper-tier intermediaries, who may well be a brokerage firm or a custodian bank. In book-entry securities systems, securities intermediaries have to satisfy the regulatory requirement of segregation of assets, ie the segregation of their own asset from the assets of their clients. Typically, a securities intermediary maintains external and internal securities accounts. These securities accounts can be typically divided into two types: omnibus account84 and segregated account.85 The key criterion to differentiate these two types of accounts is whether the intermediary segregates one client’s assets from the assets of the other clients. It is common for an intermediary to hold the same types of assets in a pool, in the form of an omnibus account, which are represented by a single account in his custodian or an upper-tier intermediary for his various clients, while maintaining an internal account for each respective client. Alternatively, it may also be the case

83

See the discussion on book-entry securities and securities account in Section 2.3.3 below. It is a single account for the commingled funds or positions of multiple parties. A clearing member will often maintain an omnibus account at the clearing house for all of the clearing member’s clients. In this case, the clearing member is responsible for maintaining account records for individual clients. See CPSS, A Glossary of Terms Used in Payments and Settlement Systems (BIS, March 2003). 85 It is, nevertheless, suggested that the distinction between these two accounts in law is of limited significance in normal circumstance, except when there is a shortfall. See RM Goode (2004), n 1 above, at 212. Another practical difference between omnibus accounts and segregated accounts is that for the intermediary, an in-house transfer between two of his own clients in the case of omnibus accounts needs not going through the book of his upper-tier intermediary, if any, or that of the relevant securities depository. The transfer can be effected on the intermediary’s own books, ie debiting one client accounts and crediting the other client’s account. 84

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Indirect Holding & Book-Entry Securities that the assets of a client are held by the intermediary in its upper-tier intermediary’s account.86 However, the holding pattern could become very complicated when a client’s asset may be held by an intermediary through his accounts in various different upper-tier intermediaries up the chain, ie the total nominal holding is made up of several separated smaller nominal holdings in different places.87 In principle, the account-holding feature of the indirect-holding structure distinguishes securities that are held ‘directly’ by acquiring physical possession of the certificated securities, or by being the registered owner of registerable securities, from those book-entry securities that are held ‘indirectly’ by maintaining their securities positions in their securities accounts through an intermediary. As mentioned in Section 2.2, contrary to the centralised approach adopted by introducing CSDs to facilitate securities settlement in a single or central place, this resulting tiered account-holding structure has the effect of decentralising settlement arrangements in a way that makes it possible for transactions to be settled at the choice of the counterparties, as mentioned above. For example, in the United States, book-entry securities/security entitlements under the US Uniform Commercial Code (UCC) Article 8 are deemed to be acquired by the account holder once his securities account has been credited by an intermediary for him.88 The introduction of book-entry securities, or security entitlements, raises the question of how they can be acquired and transferred in practice but also in law. The acquisition of book-entry securities goes hand in hand with the transfer. Here, there are at least three issues to be addressed by law. The first is how book-entry securities are created and acquired. The second is what constitutes a transfer between one party and the other in this indirect-holding system. The issue of remedies is the third one. In the following two sections, the nature of book-entry securities, their acquisition and transfer are examined before some concluding remarks are made.

2.3.3 Book-entry Securities To facilitate electronic trade settlement,89 securities have to be carried in a book-entry account that is distinctively different from traditional paper-based 86 Even in the cases when an intermediary maintains a segregated account for an individual client, namely, an individual account in the intermediary’s name but with the disclosure of the client in the upper-tier intermediary. In this way, the clients’ holdings are, in effect, segregated from the intermediary’s other clients. Nevertheless, the intermediary has no control of how the assets are held for him/her in the chain further up above the upper-intermediary. 87 In a cross-border holding, there are also conflicts of law issues where different parts of securities holding are subsequently subject to different laws. In this thesis, the conflicts of law issues are considered out of the scope. 88 Also, see the discussion in Sections 2.3.3 and 2.3.4 below. 89 See the discussion on settlement in Section 2.1.2 above.

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Elements of Post-trade Infrastructure securities. For registerable securities, the impact of the introduction of bookentry system may actually be insignificant.90 Indeed, financial markets adopted methods commonly known as dematerialisation and immobilisation to facilitate the indirect-holding structure and efficient transaction settlement. These two methods can be seen as two sides of the same coin, as both of them facilitate modern electronic transfer based on the book-entry system. On the other hand, the difference between them can be illustrated by the impact they have on paper-form or bearer securities. Immobilisation takes paper-form securities out of circulation and stores them in various centralised depositories whilst dematerialisation eliminates paper altogether by replacing it with electronic records. Without doubt, immobilising and dematerialising securities are necessary steps in making post-trade processing in the book-entry environment possible. In practice, these two have the effect of converting securities that have to be held directly and physically into simply being represented by a book-entry position. In law, the implications of the two are very different and far-reaching.91 Modern book-entry securities directly alter the rights of investors who would have had an absolute right which has been well established in law with respect to the direct holder of a negotiable instrument.92 At this point, it may not be immediately clear who should be regarded as the holder of the bearer securities93 in the case that they are immobilised or dematerialised. In modern times, issues as such have become less of a concern. The 1994 US Uniform Commercial Code (UCC) provides an excellent example of handling book-entry securities with an innovative approach to developing a system of law that govern all aspects of book-entry securities and deserves further attention.

90

Traditionally, the distinction is made in law between tangible and intangible assets. See J Benjamin, Interests in Securities (Oxford/New York: Oxford University Press, 2000) chs 2 and 3; RM Goode, ‘The Nature and Transfer of Rights in Dematerialised and Immobilised Securities’ (1996) 10 Butterworths Journal of International Banking and Financial Law 167–76; AO Austen-Peters, Custody of Investments: Law and Practice (Oxford/New York: Oxford University Press, 2000) 8–12. 92 The law for negotiable instruments in which physical securities have been operating for their holdings and transfers, has mainly built on the concept of negotiability. Also see JH Sommer (1998), n 80 above for a brief discussion on the law of negotiable instruments that applies to paper-based securities. As pointed by Sommer, ‘a new law [in the US] has replaced the old law of negotiable paper’. In particular, part 5 of revised Article 8 [UCC] deals with securities accounts. In effect, this has created a highly specialised law of account relationships. Also see CW Mooney Jr, ‘Beyond Negotiability: A New Model for Transfer and Pledge of Interests in Securities Controlled by Intermediaries’ (1990) 12 Cardozo Law Review 305–427. 93 In the UK, the issue regarding who is the real holder of securities in modern book-entry system has been hotly contested. The debate initially focused on who is the holder of Eurobonds, and there are several theories in that regard as discussed by Professor Ravi Tennekoon. In examining the issue associated with the Eurobond, it was argued by Tennekoon that ‘In practice this uncertainty [as to who is the bondholder] may make no difference since any purchaser who wishes to exercise his rights in respect of an Eurobond which he has purchased would invariably have a contract right as against a dealer or in the case of a dealer against the [settlement] system to demand physical delivery of the Eurobond’. He concluded: ‘Consequently, a purchaser would be able to exercise rights contained in the bond as against the issuer. See RC Tennekoon, The Law and Regulation of International Finance Student edn (London: Butterworths, 1991), 169–74. Also see JH Dalhuisen (2007), n 12 above, 806–11. 91

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Indirect Holding & Book-Entry Securities In the United States, a new legal regime for book-entry securities was brought about through its revision of Article 8 of the US UCC by adopting the approach of ‘first describe it and name it’. Article 8 of the UCC sets out the legal regime and has clearly defined the rights of an account-holder, the obligations of securities intermediaries, and third party’s rights as well as adverse claims with respect to book-entry securities. As a result, the concept of security entitlement was introduced. In principle, a securities entitlement gives the account-holder a package of rights and interests including a proportionate property interest.94 Despite the fact that Article 8–503(b) of UCC specifically states that a security entitlement is property, that package of rights does not give an entitlement holder a claim to a specific identifiable thing, nor does it give the holder the right in real as against the rest of the world.95 By contrast, their claims are instead limited only to be against his intermediary. Having said that, a security entitlement gives the holder more than just a personal claim vis-à-vis an intermediary. It acquires a further protection in case of the insolvency of the intermediary, with the compulsory segregation of clients’ assets from its own assets. Mostly importantly, this right as contained in a security entitlement also gives the entitlement holder the right to claim a pro rata share of the pool of entitlements96 that the intermediary holds for all of his clients with respect to the same underlying financial asset.97 Furthermore, UCC § 8–501(b) and (c) prescribe that a security entitlement is created as soon as the broker undertakes to create that entitlement, even if the broker does not itself hold the security entitlement.98 In other words, a security entitlement can be created by arrangements in which the rights comprising ‘the underlying assets’ are carried in a securities account. It, however, cannot be created through an arrangement in which a security is issued representing an interest in underlying asset.99 Accordingly, the accounts maintained by a Central Securities Depository (CSD) for its members are different from securities

94 In other words, an account holder of a security entitlement acquires the rights in the underlying securities with a proportionate property interest, rather than the underlying securities themselves. See § 8–102(a)(17) UCC. Also see JH Dalhuisen (2007), n 11 above, 1049–67, for further discussion on the proprietary aspects of security entitlements. 95 Simply put, a right in real is a proprietary right that gives the owner the right to claim against the rest of the world. 96 This is provided that the intermediary holds the entitlements for his clients in an omnibus account. It follows that this rule does not apply to the case when the intermediary directly holds the underlying financial asset, rather than security entitlements, for his clients. 97 The definition of financial asset is given under UCC §8–102(a)(9). §8–103 also set out the rules in details on how to determine whether certain obligations and interests are securities or financial assets. Here, financial asset is not limit to securities. 98 It is obvious that the purpose of such rule is to protect that account holder. However, this is likely to be at the price of other entitlement holders in respect to the same underlying security in the case that there is a shortfall in the pool maintained by the intermediary. 99 UCC §8–501(e).

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Elements of Post-trade Infrastructure accounts in the sense that the book entries on those accounts do not represent security entitlements.100 At this end, the CSD is considered as the actual holder of securities for its account-holders. Under the UCC, security entitlements and securities accounts101 are closely associated as some may argue that one cannot exist without the other. It follows that the relationship between an entitlements holder and his intermediary is ultimately determined by the nature of the account. In the United States, Section §8–501 of the UCC defines a securities account as an account to which a financial asset is or may be credited in accordance with an agreement under which the person maintaining the account undertakes to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the financial asset.

Suffice it to say, securities account is a consensual arrangement that entitles the account-holder to excise the rights that comprise the financial asset. It is this legal development in the United States that prompted one to go far enough and tried to systematise a new law of financial accounts specifically.102

2.3.4 Transfer of Book-entry Securities In practice, the modern way of transferring book-entry securities has removed the need for physical transfer as required in the case of paper securities transfer.103 Put simply, a transfer of book-entry securities is effected and made by crediting and debiting corresponding securities accounts.104 In this book-entry environment, transfers of book-entry securities or securities entitlements are akin to the mechanism used for fund transfers. Both types of transfer are first initiated by transfer instructions/orders. In the indirect-holding structure, a transfer order of book-entry securities may sometimes also initiate a chain of co-ordinated action between several intermediaries, which is similar to payment transfer. Nonetheless, the relationships between the parties involved in these two

100 This has taken into account the fact that in a modern indirect holding structure the underlying securities, if they are in physical form, are likely to be held through several different immediaries. There may be a few intermediaries involved before the actual holder, a Central Securities Depository in the likely case. 101 Having included a list of financial assets in the UCC, it also distinguishes securities accounts from deposit accounts. See R Ghadimi and K Rosenman, ‘Distinguishing Between Securities Accounts and Deposit Accounts Under the UCC’ (December 2000) 88 Illinois Bar Journal. 102 See JH Sommer, ‘A Law of Financial Accounts: Modern Payment and Securities Transfer Law’ (August 1998) 53 The Business Lawyer 1181–1215. 103 As mentioned, this is mainly the reason for moving into book-entry system after the paperwork crisis in the US in late 1970s. 104 HF Potter, Jr and DL McLean, ‘Introduction of Book Entry Transfer of Securities’ (1972–73) 28 The Business Lawyer 209–14. See JH Dalhuisen (2007), n 11 above, 706–8 and 722–3.

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Indirect Holding & Book-Entry Securities types of transfers are quite different. In a fund transfer the relationship is that of creditor and debtor, while the relationship between a securities account-holder and his intermediary is not. In the United States, the key to acquisition of security entitlements is the concept of control. Under UCC §8–106 (d), a purchaser has ‘control’ of a security entitlement if (1) (2) (3)

the purchaser becomes the entitlement holder; or the securities intermediary has agreed that it will comply with entitlement orders originated by the purchaser without further consent by the entitlement holder; or another person has control of the security entitlement on behalf of the purchaser or, having previously acquired control of the security entitlement, acknowledges that it has control on behalf of the purchaser.

The effectiveness of control relies on the obligations the intermediary owes to his account-holders. Another important issue is the finality of the securities transfer, or settlement finality.105 Namely, the transfer of a security, if processed according to the relevant rules, cannot be unwound. This gives the markets a degree of certainty and is particular important in facilitating trading. As was discussed previously, payment and securities settlement systems vary and come with different types of processes to accommodate various market needs. With so many different types of financial instruments and risks involved, a degree of certainty in relation to settlement finality must be provided, and rules in the relevant system need to be supported and upheld to ensure smooth functioning of settlement operations. From trading participants’ perspective, the completion of a securities transaction is believed to be reflected in the changes in their accounts, namely, at the time that the monetary balance is replaced with the securities balance or vice versa. The rules regarding transfers are often found in the form of rules and regulations of the relevant settlement systems. Most important of all is the issue of settlement finality,106 which determines that the resulting debits and credits in the accounts after each settlement cycle are deemed final and are irreversible. In the EU, however, those rules were often subject to the uncertainty of being displaced by mandatory rules such as bankruptcy laws before the Member State’s implementation of the Directive on Settlement Finality.107

105

So far, this issue is mostly discussed in the context of securities settlement systems. Finality of settlement means that the transfer of a security, if performed according to certain rules, cannot be unwound and is irrevocable. Finality has been a key objective of settlement rules since long before the indirect holding system. 107 Council Directive 98/26/EC of 19 May 1998 on settlement finality in payment and securities settlement systems (Settlement Finality Directive) [1998] OJ L166/45. The settlement finality issues in the EU will be discussed in Section 6.4.2, ch 6 below. 106

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Elements of Post-trade Infrastructure The third issue is related to the pledge of book-securities or collateralisation.108 Suffice it to say, a comprehensive legal regime that intends to cover all financial assets (including certificated securities or security entitlements) can be found in the US UCC Articles 8 and 9. One major legal innovation is the 1994 revision to Article 8, which introduced a new set of provisions designed to accommodate the use of un-certificated/book-entry securities with the expectation that the bookentry system would evolve and issuers would not need to issue certificates any more. Securities transactions are to be settled by registration on the books of the issuer according to an instruction provided to the issuer by the previous registered owner.

2.3.5 Concluding Remarks In this section, the creation and transfer of book-entry securities and the nature of securities accounts in the indirect-holding structure were discussed. It has become clear that there is a need to distinguish book-entry securities from the underlying assets they represent. Book-entry securities simply inherit the economic interests as contained in the underlying asset. At the same time, they acquire in law a special property interest that gives an entitlement holder a proportionate property interest, as opposed to the underlying asset. In essence, a book-entry securities account that carries security entitlements is an arrangement between an account-holder and his intermediary who maintains the account for him. Without doubt, this part of the law with respect to book-entry securities has become highly formalistic, which is the case in the United States. As can be drawn from the above discussion, the creation of the indirect-holding structure requires that the law that governing the transfer and pledge of bookentry securities or security entitlements be as clear and certain, if not least than what the legal regime has provided for the transfer of paper-based securities.

2.4 Relevant Developments in Shaping the Future of Post-Trade Infrastructure 2.4.1 Delivery Versus Payment (DVP): Horizontal Linkage between Payment and Securities Settlement Systems, Various Forms of DVP Delivery Versus Payment (DVP) may, at first glance, seem to be a simple and straightforward concept in law. In the simplest case, it refers to a type of 108 Issues with respect to the pledge of book-entry securities or collateralisation are to be dealt with in Section 5.1, ch 5 below.

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Developments Shaping the Future arrangement made between a buyer and a seller according to which the buyer delivers the goods to the seller and receives the purchase money from the seller at the same time, making it a simultaneous exchange. As a result, principal risk is reduced. Essentially, this is a mechanism which ensures that delivery occurs if, and only if, payment occurs.109 In practice, DVP has two aspects in securities transactions: first, it requires a proper linkage between relevant payment systems and securities settlement systems110 and, secondly, transfers in both systems are principally deemed to be final and cannot be revoked in normal circumstances. As the BIS’s DVP Report put it,111 ‘only the final transfer of a security by the seller to the buyer constitutes delivery, while only final transfer of funds from the buyer to the seller constitutes payment’. The benefits of achieving delivery versus payment in securities settlement systems have also been extensively discussed in this BIS report. In principle, as just mentioned, DVP eliminates principal risk/counterparty credit risk. However, this is likely to increase replacement cost risk/liquidity risk in the system, even in the case that principal risk is alleviated. There is a risk that the buyer of the DVP transfer may have to acquire the same class of security at a higher cost from elsewhere when that DVP fails. In reality, the drive towards achieving DVP has proved to be a rather big challenge for the industry. Not only has it come with significant costs for building the necessary link between different settlement systems, but also there are other issues, such as liquidity in the systems, which have to be addressed since they make the process extremely complicated.112 In theory, counterparty risk will no longer exist in the systems with the mechanism in place. However, the requirement for simultaneous settlements of both the cash leg and securities leg results in the practical problem of the so-called ‘gridlock’ in the whole system, as there may be time-lag between the settlement of the cash leg and that of the securities leg. Therefore, some safeguards, as will be discussed shortly, have to be introduced to address the relevant issues. The seriousness of the ‘gridlock’ in the system may increase the settlement risk and further increase systemic risk,113 so far as the financial system is concerned. As mentioned above, a fundamental requirement for achieving DVP is that the settlement of both legs of the transaction is final and irrevocable. This concept is, however, further complicated by the technical and practical nature of the existing

109 CPSS, Delivery Versus Payment in Securities Settlement Systems (BIS Publications No 6, September 1992). 110 Or two separate payment systems in different currencies for foreign exchange transactions. It is also known as ‘Payment Versus Payment’ (PVP). 111 CPSS (1992), n 109 above. 112 See Section A below on the discussion on UK CREST system for an example. 113 In this context, the systemic risk means that the resulting gridlock may increase the likelihood of the failure of the participants or financial institutions to be unable to meet their settlement obligations in a transfer system when due. In this context, such a failure may in turn cause significant liquidity or credit problems and, as a result, might threaten the stability of financial systems. Also, see the definition of ‘Systemic Risk’ in A Glossary of Terms Used in Payments and Settlement Systems (2003, Bank of International Settlements).

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Elements of Post-trade Infrastructure infrastructure, where the processing in systems differs and the risks involved also vary in each type of settlement system. Typically, the market infrastructure has been built and developed mainly to serve local market needs and according to the relevant legal regime. As a consequence, various types of securities settlement systems and payment systems have been developed across markets. Against this background, the effort to link the systems for the purpose of achieving DVP has not been very straightforward. The linkage between different types of payment systems and different types of securities settlement systems114 have led to the identification of three broad structural approaches to achieving DVP:115 + + +

Model 1: Gross, simultaneous settlements of securities and funds transfers; Model 2: Gross settlement of securities transfers followed by net settlement of funds transfers; and Model 3: Simultaneous net settlement of securities and funds transfers.

Upon further analysis, the study group drew the conclusion, from the risk management viewpoint, that the degree of protection provided against risks, and especially against replacement cost risk and liquidity risk, depends more on the specific risk management safeguards that a system utilises than on the type of model that is employed. It is noted that the linkage between payment system and securities settlement for DVP will inevitably increase the level of dependency between the two systems. Hence, the systems should be designed to be able to continue to operate independently in the case of a linkage failure or in the highly unlikely event that one of the systems fails.116 As just mentioned, achieving DVP is also beneficial to CCPs as counterparties to the transactions, since it eliminates principal risk. However, there are certain issues related to CCPs in real DVP settings, which are also common to other participants when they are part of string contracts in the systems that need to be addressed accordingly. The major problems faced by CCPs in real DVP settings can be summarised as follows: (i)

(ii)

114 115 116

Credit lines have to be provided to the CCP by both the linked securities settlement system operator and payment system operator to facilitate daily settlement operation; From the CCP’s perspective, there may be time-lag between two DVPs, the receiving end and the delivering end. As the CCP is interposed between two members with respect to two equal and opposite transactions, it needs to have funds ready for the delivery and, on the other end, securities ready for receiving payment. One

See Section 2.2 above for further analysis on settlement systems. CPSS (1992), n 109 above. See CPSS (June 2008), n 44 above.

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Developments Shaping the Future

(iii)

end cannot be completed without the other end. Hence, these two DVPs have to be executed simultaneously; and There may also be settlement failure. A CCP may have large exposure and, as a result, one of the small deliveries from the delivering parties, which makes up a large delivery to a receiving party, has failed. In this case, the CCP has to fund those deliveries.

As a result, several arrangements could be made between settlement systems and a CCP to address these problems. They include (i) intra-day credit line; (ii) auto-borrowing; and (iii) self-collateralisation. Here, it may be of help to look at a particular example in order to acquire a sense of the complexity of the DVP arrangement.

A. UK CREST 117 As early as 1998, an initiative undertaken by the Bank of England118 envisaged a single settlement system for all London-traded securities in which settlement takes place on a full DVP basis in a wide range of currencies. CREST, the UK securities settlement system, currently operates an assured payment system119 and at the same time has a link with Bank of England’s Real-time Gross Settlement system (RTGS) for payment settlement, which uses central bank funds for achieving DVP in real-time.120 The above two payment systems operate individually. It is worth noting that they are to be separated from the stand-alone CREST securities settlement system. In other words, the UK securities settlement system (CREST) is linked with two separate payment systems to provide DVP. This CREST securities settlement system is also characterised as continuous settlement processing with a netting facility. The so-called assured payment system was in place prior to the introduction of central bank money settlement. It provided settlement of three currencies: Sterling, Euros and US Dollars, and it is an end-of-day net settlement arrangement using inter-bank fund transfer. Settlement banks are only required to provide liquidity at the end of the day to meet their net obligations that arise from settlement during the day. By introducing central bank money into payment settlement systems, settlement, insolvency and systemic risk inherent in an end-of-day net payment system is reduced.121 This is particularly so when 117

CREST is now part of Euroclear Group. Bank of England, Securities Settlement Priorities Review (1998). 119 The assured payment system is based on inter-bank fund transfer and can be identified as model 2 in the BIS report mentioned earlier. The scheme provides contractually that the paying obligation is irrevocable and unconditional. It is now mainly for US dollar payments, as the other two currencies payments have been moved to Bank of England’s RTGS system. See below for further discussion. 120 The link started operating on 26 November 2001. 121 Committee on Payment and Settlement Systems, Central Bank Oversight of Payment and Settlement Systems (BIS, May 2005); Committee on Payment and Settlement Systems, The Role of Central Bank Money in Payment Systems (BIS, August 2003). 118

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Elements of Post-trade Infrastructure compared with the private inter-bank settlement systems. With real-time DVP, the purchases will settle only if the member’s settlement bank has sufficient liquidity122 immediately available to pay the receiving bank. Here, the liquidity problem may arise in the real-time settlement system with DVP arrangements and has to be dealt with. For example, to manage the liquidity efficiently, CREST and the Bank of England have introduced a number of management tools both to increase the supply of liquidity and permit efficient recycling of liquidity, and to allow CREST settlement rates and deadlines to be maintained unimpaired. Those measures include: (i) The self-collateralisation mechanism123 for the generation of additional liquidity; (ii) Efficient allocation and queuing of liquidity; and (iii) The ability to manage the liquidity needed for both CREST settlement and CHAPS payments as a virtual pool.

B. CREST DVP Process CREST as a securities settlement system operates a series of frequent settlement cycles during the day and also includes overnight processing. The process provides the best example of how two separate systems are employed to achieve DVP settlement process in a real-time setting. In this case, the gross securities settlement system is CREST and the payment system is the Bank of England’s RTGS system. This DVP process mainly comprises six steps in each cycle and has been best illustrated as follows:124 Prior to the start of each CREST settlement cycle, RTGS will earmark (1) the funds available to support CREST settlement (ie the balance on each bank’s CREST Settlement Account Group within RTGS) and notify CREST (2) across a dedicated link. CREST will reflect these balances on each bank’s Liquidity Memorandum Account (LMA) and queue transactions (3) against the earmarked liquidity using an efficient central liquidity algorithm. The CREST settlement cycle identifies those transactions that satisfy stock and credit resource checks before allocation of liquidity. Where liquidity is available (after allowance for liquidity created and unwound through the self-collateralisation process), transactions will settle (4). Finality of stock transfer and inter-bank payment will occur at the point of settlement within CREST. At the conclusion of each cycle, CREST will notify RTGS (5) of the inter-bank payments arising from the completed settlement cycle (including liquidity from selfcollateralising repos) and these will then be posted across the books of the Bank of 122 In this context, liquidity is a term used in central bank settlement systems that can be understood as a credit line provided by the central bank to a settlement bank to facilitate intraday settlement purposes. Also, see the CREST Process and the fact sheet for CREST below. 123 To put it simply, the self-collateralisation mechanism is an arrangement that allows a member of the settlement system to use an additional credit line for settlement purposes by providing other types of assets, like securities, as collateral. 124 Bank of England and CREST, Fact Sheet: Liquidity and Settlement (May 2001).

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Developments Shaping the Future England in the RTGS processor. RTGS will then release unused earmarked funds (6) and allow an opportunity for settlement banks to rebalance their liquidity before starting the process again. Contingency arrangements will exist to allow liquidity to be recycled within CREST in exceptional circumstances.

C. Self-collateralisation in CREST As seen from the previous section and the diagram inserted, self-collateralisation through earmarking of the fund is one of the main techniques used for liquidity management in the CREST system, where the securities bought by a member against the purchase price would be used to finance a further purchase. It is included in the structure of the CREST DVP settlement system; there are however several limitations in terms of the range of securities and currencies. Only certain types of security are eligible for use in this arrangement and they are to be determined by the Bank of England. Although the system provides settlement for three major currencies as mentioned, the sale and purchase of securities in Euro and US Dollar dominations are excluded from the selfcollateralisation regime. Only a certain number of participant banks are settlement banks in the central bank system and a CREST member may not necessarily also be a settlement bank or have direct access to the Bank of England’s payment. In the latter case, they can only gain access indirectly through one of the settlement banks to benefit from DVP settlements.

2.4.2 Straight-Through Processing (STP): Vertical Linkage between Different Tiers of Holding Systems Modern financial markets are characterised as multi-tiered structures with different participants. Currently, the entire trade cycle, from trade initiation to settlement, is a complex process requiring relatively significant manual work and in many cases takes several days. In a simple process, a transfer order or payment order, once initiated, may have to be passed from an intermediary to another intermediary before it finally reaches the intermediary that is a member of the settlement system for settlement.125 In a more complex transaction, there is more than one intermediary in the chain with different internal systems. As a result, an order may have to be re-inputted into each intermediary’s system due to the fact that each system may also have different messages formats. Thus, much time may be spent in the process of inputting and converting message orders. Moreover, for the market as a whole, the industry is now driven by shorter trade cycles, from 125 It may be permitted that intermediaries have the flexibility of crediting and debiting their client’s accounts despite the fact that their accounts in upper-tier intermediaries or custodians may yet confirm the correspondent holdings. Nevertheless, it should be made clear that the principle for a tier-holding structure is that the holdings are reflected accordingly in each tier from the top to the lowest.

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Elements of Post-trade Infrastructure trade date plus three days (T+3) as standard, to T+1 or even same day. Shorter settlement cycles reduce current daily settlement risk exposure for T+3. However, moving from T+3 to T+1 or even real-time is not a simple matter, as in a T+1 cycle the details of every trade must get pushed through the systems as rapidly as possible with various different entities adding data to make it ready for settlement in the following day, and the trade detail confirmation also needs to be instantaneous. Trade processing in a book-entry world is completed by passing the settlement messages through different intermediaries until they reach the settlement point, be it at intermediary level or securities settlement system level. To cope with these market challenges, each step of the trade settlement processes would need to be automated. That could enable Straight-Through Processing (STP),126 which eliminates the need for multiple repeated inputs and can help shorten the time for the trade cycle, making simultaneous processing possible. It also streamlines transactions by maintaining contact throughout processing and processes them by computer from beginning to end without manual intervention or re-keying at any of the stages. Driving down operational costs has been imperative, as financial institutions have struggled to deal with the economic environment over the past few years. Against this background, STP has become one of the focuses that have helped increase the operational efficiency required to handle large trade volumes. The ultimate goal is to achieve STP at all stages of securities transactions, from trading to settlement—namely, trading, CCP clearing and settlement and custodian services.127

126 The Definition of Straight-Though Processing has long been elusive. According to A Glossary of Terms Used in Payments and Settlement Systems published by CPSS of BIS, it is referred to as ‘the completion of pre-settlement and settlement processes based on trade data that is manually entered only once into an automated system’. SWIFT defines STP as ‘the handling of messages without resort to manual intervention or message repair, except for reasons of policy’ providing that it was given various definitions by customer banks. As far as SWIFT is concerned, it is currently focusing on improving messages quality and processing quality. 127 Annette Nazareth, of the SEC, emphasised the importance of achieving STP by saying: ‘[It] will also streamline back-office procedures, increasing efficiency to the system while minimising operational risk. Through automation, manual intervention will become the exception rather than the norm. As a result, fewer settlement fails are expected to occur, which includes those caused by human error, and accurate trade data will reach the clearing corporation and the depository more quickly. Back-office staff can then focus on processing today’s trades rather than correcting yesterday’s’. See A Nazareth, Speech: Remarks Before the Security Traders Association (Washington Congressional Conference, 2002). Available at: www.sec.gov/news/speech/spch561.htm. It was also estimated that the failure rate for cross-border trades was about 9% for mature markets, about 20% for emerging markets and about 11% overall. See A Ainsworth, ‘The Struggle for Straight Through Processing (STP)’ (Sept 2001) AIMA Newsletter. Nevertheless, it should be noted that settlement ‘fails’ may be due to a variety of reasons. In the US treasury markets, for example, it was estimated that dealer delivery fails were averaging around $3.8 billion per day between mid-1990 and 5 September 2001. See MJ Fleming and KD Garbade, ‘Explaining Settlement Fails’ (Sept 2005) 11(9) Current Issues in Economics and Finance.

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Developments Shaping the Future

A. The Drive towards STP Currently, STP is one of the hottest topics in the securities industry. At a time when trades are executed in seconds, securities settlement often remains manual and costly. Moreover, the rate of human errors in post-trade processing is still far from satisfactory. STP is therefore a big step forward in the automation process. However, an industry-wide STP has to be achieved both internally and externally from an individual financial institution’s perspective.

(i)

Shortening Settlement Cycle

On the one hand, a shorter settlement cycle reduces settlement risk and, on the other, it is likely to increase market liquidity. The goal of shortening the settlement cycles, ie moving from the present T+3 to full cycle of T+1 or even same day is sound, but this largely remains a longer-term goal, as it requires full co-operation from different participants in the markets.

(ii)

Automation

The case for STP is most desirable for settlements for cross-border transactions. In evaluating high settlement costs for transactions across different European member states, the Giovannini Report128 identified that it takes 11 intermediaries and 14 instructions between various participants for a cross-border trade to settle. Following that, is it right for Counterparty Risk Management Policy Group II in its report to urge the automation process to be accelerated, disregarding the question of whether such automation will necessarily provide short-term economic benfits or not?129

(iii)

Cost Reduction

To remain competitive and meet the needs of investors, market participants need to reduce costs by increasing efficiency. This will be a powerful motivator for securities industry participants to implement the technology and new processes required for STP. SWIFT, the financial telecommunications network, has estimated that the total annual cost to the securities industry of a lack of STP is in the tens of billions, which is money that is being wiped off the bottom line of every broker/dealer, fund manager and custodian that has to deal with nonstandard transactions. 128 The Giovannini Group, Cross-Border Clearing and Settlement Arrangements in the European Union (November 2001) 15. 129 The Counterparty Risk Management Policy Group II, Toward Greater Financial Stability: a Private Sector Perspective. 27 July 2005, at: www.crmpolicygroup.org/.

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Elements of Post-trade Infrastructure

B. Benefits It may be said that the term ‘STP’ is not helpful, as it is not easy to define and means different things to different players in the financial sector. Operationally, the implementation of industry-wide STP ensures that various information passes seamlessly and electronically with speed between parties involved in the transaction process. The benefits of the fully realised STP are obvious and include greatly shortened processing cycles, reduced settlement risk, and diminished operating costs with fewer human errors.

C. Challenges Of course, one key to achieving STP is exception management. In the real world, mistakes or errors cannot be ruled out. When they happen, intervention will be required to effectively make corrections in time. Solutions also have to be in place to bridge the gaps between institutions’ own internal systems and to electronically link with their counterparties and custodians. The result of failure by financial services firms to deal with that in a structured and automated environment will be increased operational error, lost efficiency and higher costs. Common message standards and market practices have been seen as the way to enhance STP. The wide adoption of standards that will reduce communications expenses and create economies of scale while creating a universal standard presents an immense challenge. The improvement of STP rates for trades will no doubt reduce failure rates and operational risks. However, to build industry-wide STP architecture not only requires substantial capital investment and other resources but also may call for organisational changes.130 The challenges to achieving full STP do not simply come from its scale. Some, like fund managers, are still unconvinced of the risk and benefits of STP after the failure of the Global Straight-Through Processing Association’s Project ‘the Transaction Flow Manager’.131 Indeed, the benefits of STP are well recognised, and there is an important issue to be considered in achieving STP, namely, whether it is possible to mitigate the risks involved. Furthermore, STP may be less desirable for individual firms, smaller-size ones in particular because the complexity, cost and magnitude of changes required for a fully efficient STP processing environment are enormous. This makes the task of large-scale STP implementations much more difficult to accomplish. In the United States, the Securities Industry Association’s (SIA) postponement of the next-day settlement 130 See DTCC, Straight-Through Processing: a New Model for Settlement (White Paper, January 2002) for the example of the steps taken by settlement systems to prepare for STP. 131 The Global Straight-Through Processing Association, or GSTPA, was formed in 1998 with the objective of promoting fast and efficient flow of cross-border trade information, improving the accuracy and completeness of the information, and enabling standardised interconnectivity among the various market participants. Its membership represented over 95 of the leading investment managers, broker-dealers and global custodians in more than 19 countries. It collapsed in November 2002 after the project was launched three months earlier, partly because of tough market conditions.

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Developments Shaping the Future deadline (T+1 originally planned for 2005) makes the point. OMGEO132 is another industry initiative, which is still alive, and its Central Trade Manager (CTM) is said to be a big improvement on local matching, though it may not necessarily help enhance industry-wide STP as it deals only with internal STP and does not address the sequential nature of the trade processing cycle where the risk and costs lie. Another challenge is the control of trade flow in the full STP environment. While the full automation without human intervention of trade processing is the ultimate distinction for achieving STP, this may result in participants not being able to control the trade flow when there is no additional mechanism available for doing so. In some cases, participants may want to maintain a degree of control on the flow of transactions through settlement cycles where they can take the trades out and reinsert them into the systems as they so wish. While the benefits of having a higher STP rate are widely accepted, each financial institution tends to develop its own understanding of STP, which has resulted in the absence of a single authoritative definition. In the United States, the SIA STP Project Office has developed a list of key projects,133 and calls for meeting the STP goal regardless of the settlement cycle. The comprehensive list covers 14 key areas, including standards, codes of practice and rule changes to help the industry move to STP.

D. The Role of CCPs in STP Process For its central position between trading and settlement, CCPs play a strategically important role in achieving STP. A full and efficient technical integration in modern markets could not have been possible without them. Furthermore, CCPs have long been underpinning the markets they serve through standardising products and establishing standard procedures. To achieve a full scale of STP will necessarily involve adopting a proper use of standards, for example, the message format. As will be discussed in chapter three, CCPs also play a role in prompting use of standards. Therefore, by their very nature they can help speed up the process of achieving industry-wide STP.

E. Market Development Euronext.Liffe, the European derivatives exchange, is providing a new straightthrough processing platform that will, for the first time, allow dealers to execute all the stages of an OTC trade through a single service. This makes trading easier and helps reduce costs and operational risks. Participants are paying increasing attention to trading costs that have resulted from new European regulations, such as Basel II, which effectively raises capital adequacy requirements. 132 133

See www.omegeo.com for further information. See the list at: www.sia.com/stp/html/codes_of_practices.html.

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Elements of Post-trade Infrastructure The full implementation of STP requires a radical change of the existing operational structure, which was designed and developed in light of manual order input and match. As a result, this will inevitably affect the relationship between participants in the markets. Over the year, the settlement processing has improved in terms of capacity and efficiency. Nevertheless, the fundamentals for existing settlement processing procedures were designed in the environment where trade instructions are input and matched. In other words, currently settlement operations have been mainly focusing on unmatched trades. As mentioned earlier, a full STP environment would mean that trade settlement instructions are generated and processed automatically without human intervention. Hence, the existing rules that apply to the arrangement without STP may not necessarily fit for that with STP. As a result, the legal implications have to be considered carefully to facilitate future changes,134 and if necessary, amendments to the relevant rules to provide legal certainty are anticipated.

2.4.3 Concluding Remarks As discussed, the arrangements to make DVP possible across different types of payment and settlement systems in practice have been a rather complex process with a great degree of technicality. It requires that sound risk management is in place to help mitigate various risks involved. In relation to STP, it becomes obvious that at present the development is still at its very early stage. This makes the full impact of such development on the post-trade infrastructure very difficult to envisage at present. The importance of such development should not, nevertheless, be discounted, as it has the potential of revolutionising the future landscape of post-trade infrastructure.

2.5 The Future of Post-Trade Infrastructure In previous sections, the basic elements and processes of modern post-trade infrastructure for book-entry securities have been described in detail. It follows that various functions in the post-trade processes have been defined and distinguished, CCP clearing in particular. Most important of all, it was argued that the concept of CCP clearing must be properly understood. The dynamic nature of modern markets nevertheless reminds us that post-trade processes are constantly evolving to cater for the changes. Hence, the exact flow of the post-trade processes and the meaning of terms used may be likely to evolve accordingly. Whilst it is accepted by some that the precise structure is best left to markets to decide, as market forces are deemed to be the best means of ensuring that 134

Also see J Benjamin (2000), n 91 above, 238–47 for STP.

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The Future of Post-trade Infrastructure markets need are met, there is also a strong argument that a combination of regulatory initiatives and market forces is required.135 In the light of the fact that there is no consensus at present regarding what the final architecture of an efficient and robust post-trade infrastructure should be, fragmentations in the markets may still have to be gradually eliminated.136 This also leads to the argument by others that regulatory initiatives by the relevant authorities are needed to provide clear guidelines or policy.137 As discussed in Section 2.4, DVP and STP are two key market developments in creating horizontal and vertical linkages between payment and securities settlement systems respectively in this modern post-trade infrastructure. Furthermore, such developments could also help accelerate the standardisation of the post-trade processing. Without doubt, it is conceivable that their developments have the potential of shaping the future of post-trade infrastructure. In addition, the recent financial crisis has highlighted again the importance of a robust and efficient post-trade infrastructure. It is fair to say that these systems will continue to evolve, regardless of what the future architecture of the infrastructure will be. Such is the nature of the risks embedded in the respective system. Therefore, it is important that risks in the post-trade infrastructure should be well understood and managed accordingly, in particular the risks that have evolved as a result of the increasing interdependencies among payment and securities settlement systems. Without doubt, a robust and smooth functioning post-trade infrastructure depends on continuing effective risk management. It is well understood that building an efficient and robust post-trade infrastructure is a common goal. Modern markets are fast-changing and dynamic, and it is the interaction of numerous key factors—such as, advances in technology, regulatory policies, market culture and economics—that will ultimately decide the future of post-trade infrastructure. One thing that seems to be certain is that the future structure of the post-trade infrastructure will keep evolving to accommodate market developments. Without doubt, this poses a great challenge to relevant authorities and regulators that are tasked with developing an adequate legal and regulatory framework to facilitate market developments as such.

135

See Section 7.3, ch 7 below. For detailed findings on fragmentation in the post-trade infrastructure, see the Committee of Wise Men, Initial Report on the Regulation of the European Securities Markets (Brussels, 9 November 2000); and the Committee of Wise Men, Final Report on the Regulation of the European Securities Markets (Brussels, 15 February 2001) (they are also known as the Lamfalussy reports); The EU Commission’s Second Communication on Securities Clearing and Settlement, at: ec.europa.eu/ internal_market/financial-markets/clearing/communication_en.htm. 137 As will be discussed in chs 6 and 7 below. 136

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3 The Functional and Operational Aspects of Central Counterparties 3.1 Origins and Historical Development

T

HE HISTORICAL DEVELOPMENT of clearing houses including CCPs has been largely overlooked in academic literature. CCP clearing was developed from the concept of clearing, which can be traced back to as early as 1463 in places like Lyons where fairs were organised at set intervals in which bankers accepted bills of exchange, compared accounts and then settled them in money the following day. Furthermore, the concept is a development of the Roman commercial law principle of compensatio, which means ‘a defendant’s claim to have the plaintiff ’s demand reduced by the amount that the plaintiff owes the defendant’.1 It is also the origin of modern netting and set-off. The principle of clearing remains largely unchanged, although its mechanism has been transformed as a result of ever increasing trading volume and the change of settlement means, such as new payment instruments and new contractual techniques. The scope of its application has also been expanded with the emergence of new market products like interest-rate swaps. As a result, the concept of clearing with the help of CCPs has gone beyond the simple function of simplifying settlement processes.2 To examine the impact that clearing organisations have had on the markets and the role of CCPs, it is necessary to understand their origins first. To do this, we must revisit the historical development of clearing houses and CCPs. Here, it is first necessary to distinguish the clearing houses in banking and those in commodity and financial markets;3 although bank clearing houses are considered to be equivalent to market clearing houses, they are different despite the use of the word clearing in both terms. They share some similarities in their historical development, but in modern times, bank clearing houses do not fulfill many of 1

BA Garner, Black’s Law Dictionary, 7th edn (St Paul MN: West Group, 1999). See below for discussion of the modern roles and functions of CCPs. 3 For the sake of clarity, the former are called bank clearing houses and the latter market clearing houses hereafter. 2

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Origins and Historical Development the functions of market clearing houses. The nature of bank clearing houses remains largely unchanged, as they operate as associations without becoming counterparty to transactions. Nor do they explicitly guarantee the performance of transactions or facilitate actual settlement.4 In contrast, market clearing houses have evolved. In a modern economy with diverse market structures and many different types of financial products, the development of various approaches to accommodate and facilitate smooth operations is inevitable. It may be right to say that the CCP clearing function is an alternative approach in conjunction with others like risk-sharing schemes or insurance schemes. Indeed, the markets have a loose usage of language, and we should not be confused with the institutions that bear the same name but have their distinctive functions. Whilst it could be argued that history has not greatly influenced the development of the modern markets, it is hoped that a revisit will provide some background knowledge of how the concept of CCP emerged and prepare for a better understanding of its role and functions. Furthermore, the purpose of a short historical account is to demonstrate the close relationship of bank clearing houses and market clearing houses, which includes commodity clearing houses and CCPs (as will be discussed in Sections 3.1.2 and 3.1.3 below). Despite the passage of time, it seems that this intimacy has not dissipated, and indeed concepts in financial markets did and do closely interweave. Besides, not all markets have been through the same evolutionary process. The ever-increasing volumes, both in banking and in the markets, affect the mechanics of clearing operations but do not alter the fundamental principle of compensatio in a significant way. Instead, it has now brought many more benefits than when it was initially introduced.5

3.1.1 Cheque Clearing6 (Timeline: from 1773) Clearing, in a wider sense, is here defined as ‘the process of transmitting, reconciling and, in some cases, confirming payment orders … prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement’.7 Briefly, the development of bank clearing, cheque clearing in particular, can be summarised into three main steps: (i) initially, actual cheques and hard cash are delivered, (ii) then cheques exchange, cash is replaced by certificates from banks, clearing houses and then the central bank, 4

They are also different from settlement system operators. For the advantages and disadvantages of CCP clearing, see Section 7.1, ch 7 below. 6 The word ‘cheque’ is used in a generic sense and is meant to include all other types of payment instructions for clearing. See FR Andrews, ‘The Operation of the City Clearing House’ (1941–42) 51 Yale Law Journal 582–607, for a detailed historical account. 7 BIS, A Glossary of Terms Used in Payments and Settlement Systems (March 2003). It is also noted that the term is used sometimes (imprecisely) to include settlement. 5

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CCPs: Functional and Operational Aspects and (iii) finally, transfer of payment is effected by debit and credit on the books of central banks or, in some cases, inter-bank accounts. Bank clearing houses are designed to facilitate inter-bank handling of payment instructions in preparation for settling obligations resulting initially from bills of exchange and cheques. As mentioned, organised bank clearing houses have existed for more than 200 years in the banking sectors. The first cheque clearing house is generally believed to have been founded in 1773 in London,8 though its founding members were mainly private bankers, and it was established without any favour or the participation of the central bank—Bank of England.9 It was introduced to simplify the exchange and settlement process among banks and bring order to what had been a complicated web of exchanges by centralising and streamlining the process in a central place. They were commonly established as associations and remain the same in modern times; at least, this is the case in the banking industry. While in banking the essential role of clearing houses remains largely unchanged, it has been expanded to facilitate new payment instruments that have been developed in modern days. In response to the evolving needs of the industry, clearing houses have also turned themselves into modern administrative organisations that strive to meet the demands of a modern, larger and more complex banking industry. It is, nevertheless, worth mentioning that the role of clearing houses undoubtedly went beyond just that quite early on. For instance, clearing houses helped calm market panic.10 In the Panic of 1857 in New York, what were then known as Clearing House Loan Certificates were issued by the Clearing House and used as quasi-currency for a member to settle accounts and discharge his payment obligations to other members.11 In the absence of a central bank in existence at the time, the clearing house association was effectively performing the central banking function in providing liquidity to the system. It was also at that point that clearing houses started to play an active role in settlement by using clearing house certificates as instruments for effectively settling payment obligations. In the early days, the regular clearing of cheques,12 the process of exchanging physical cheques among banks, was restricted by distance to small geographical areas and mainly based in a particular city. The best examples can be found in the two great financial centres on either side of the Atlantic: London and New York.

8 It is suggested that there is evidence of earlier clearing arrangements between banks in Edinburgh. 9 ES Schenck, ‘The Evolution of the Clearing House’ (1907) 23 Banking Law Journal 399–404. 10 M Corrington, ‘The Clearing House as a Guarantor against Panics’ (1923) 30 Banking Law Journal 347–52. 11 The legality of Clearing House Loan Certificates was subject to much debate at the time. See RH Timberlake Jr, ‘The Central Banking Role of Clearinghouse Associations’ (February 1984) 16(1) Journal of Money, Credit and Banking 1–15. 12 See the then clearing process on FR Andrews, ‘The Operation of the City Clearing House’ (1941–42) 51 Yale Law Journal 582–607.

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Origins and Historical Development On the east side, London started on a large scale with town clearing and country clearing.13 On the west side, New York had only developed equivalent town clearing. With the fast expansion of the economy, it did not take long for New York to overtake London in terms of scale and sophistication. Around the 1850s, with growing business volume and inadequate exchange practices, American banks turned to consult the London Clearing House system model.14 The subsequent advent of central banks also had an impact on the development of bank clearing houses, in the United States in particular. This was clear at the time that the Federal Reserve Act15 was adopted in 1913, and speculation arose about the possibility that Federal Reserve Banks would assume a clearing house function, which was subsequently proved to be unfounded.16 Only much later did the Federal Reserve indeed itself start operating an automated clearing house. However, the services provided by clearing houses were not affected. Today, one of the significant developments in bank clearing is the recent move to electronic clearing systems for payment instruments including cheques, direct debit, credit cards and other electronic payments. The current situation in the United States provides a good example in this development. The effort in the United States to replace paper cheques with digital ones for clearing with the backing of the new law—the Check Clearing for the 21st Century Act (the Check 21 Act), which was introduced in October 2004—presents a significant step forward.17 Digital copies of cheques, the legal equivalent of the original cheques recognised by the Act, are generated and sent to the clearing house cheque clearing system for electronic processing. This clearing process is also called ‘cheque truncation’. By doing so, it eliminates the need for the physical exchange of cheques between banks and also allows paper items to be truncated early in the collection or return process. The Check 21 Act now facilitates truncation through expanded use of electronic processing technologies to improve the efficiency and reduce the cost of the check collection system. The law provides for a new type of negotiable instrument called ‘substitute check’,18 which can be used to replace the original paper cheque without an agreement. It is designed to foster innovation in the payments system and to enhance its efficiency by reducing some of the legal impediments to cheque truncation. Substitute cheques can be delivered to the

13

See ES Schenck (1907), n 9 above. The clearing house in London established in 1770s was known as the London Banker’s Clearing House and has no connection with the London Clearing House known in commodity and financial markets. See JJ Grant et al, Grant on the Law relating to Bankers and Banking Companies (London: Butterworth, 1924) 70. 15 The Act, as amended, is in 12 United States Code §221 et seq (1940). 16 FR Andrews (1941–42), n 12 above. 17 For a comprehensive and critical discussion, see C Felsenfeld and G Bilali, The Check Clearing for 21st Century Act—A Wrong Turn in the Road to Improvement of the US Payments System (2006) 85 Nebraska Law Review 52. Available on the Social Science Research Network electronic library at: ssrn.com/abstract=651481. 18 See §3 of the US Check Clearing for 21st Century Act. 14

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CCPs: Functional and Operational Aspects bank if it still wants to continue receiving paper cheques. A substitute cheque is the legal equivalent of the original cheque and includes all the information contained on the original cheque. However, the law does not require banks to accept cheques in electronic form nor does it require banks to use the new authority granted by the Act to create substitute cheques.

3.1.2 Commodity Clearing (Timeline: from 1883) The roots of the modern commodities markets can be found in the buying and selling of agricultural products, dating back to the time of the ancient Sumerians.19 For a commodities market to be established, the first step is a broad consensus on the variations in the product that make it acceptable/unacceptable for one purpose or another. To people at the time, the idea of an interchangeable commodity or guaranteed delivery was to some degree a myth. It was and is still true that trading a commodity is not different from trading any other physical product. Indeed, it was also not possible for the commodity contract itself to make the product totally uniform (for example, always with the same quality), or get itself to the delivery point safely and on time. Inevitably, the quality and quantity of traded commodities were major issues surrounding the underlying commodity that needed to be addressed in order to promote trading and boost the confidence of the markets. To achieve that, traders must have enough confidence that their transactions will be honoured. After all, it is for traders themselves to decide whether or not to take the risk of non-performance, and the seller’s reputation may be taken in account. The observation of that confidence is always required between market participants for them to trade promptly. Clearing houses were first established as a dependent body to the exchanges, to help grade the quality of underlying commodities as well as set other relevant standards like quantities, which were essential to permit the tradability of contracts in the markets. In addition to that, some incentives were also introduced to prompt adherence to standards in order to make grading work effectively. At this point, the credit risk issue had not yet been addressed or was deferred as a result of the above arrangements. The exchangeability/fungibility of the contracts was enhanced after groups of traders formed ‘rings’ in which they agreed to accept each others’ contracts as substitutes. This was called ‘ring settlement’,20 a primitive form of modern multilateral settlement. In doing so, it allowed the group of buyers and sellers to net their positions and to settle the accounts between themselves. Furthermore, the markets also soon required each member to place adequate margins as performance bonds to show their intention of honouring the contracts. Clearing houses emerged as an administrator for the 19 See the online Encyclopedia at: en.wikipedia.org/wiki/Commodity_markets, for a brief overview of the historical development of commodity markets. 20 See The Clearing Corporation (Chicago Board of Trade), A History: Trusting, Growing, Leading, Clearing, at: www.clearingcorp.com/about/our-history.html.

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Origins and Historical Development markets, taking responsibility in matters regarding the margin deposited by each trading member as a goodwill/guarantee for performance of the contracts. In addition, a set of rules was introduced and incentives brought in to promote trading in an orderly manner. On the trading side, paper-based only trading was made possible through the standardisation of contracts, paving the way for easy trading and easy transfer. Thus, trading of contracts is somewhat detached from the underlying commodity in the sense that contracts are standard in quality and quantity. To standardise and trade contracts in the delivery of such items is one of the ways to render trade itself more smooth and predictable. On the delivery side, warrants were subsequently introduced to substitute for the actual commodity, mainly for ease of trading as the volume of goods traded increased. The arrival of warrants also made the grading of the commodity possible; permitting the interchangeability of the contracts, and thus simplifying the settlement of contracts as it can then be achieved by delivery of correspondent warehouse receipts or warrants. An institutional structure to facilitate the trading and performance of the contracts for commodity markets was thus established. This early development in the markets, as mentioned above, must also be attributed to the clearing houses whose work has often not been recognised. Clearing houses later started to act as guarantors of transactions themselves in the market to their members. The commodity markets were then able to provide an assurance that obligations resulting from transactions would be honoured. As mentioned, clearing houses also helped the market to introduce new standardised contracts with regard to the underlying commodity traded, and are still doing so nowadays. It was in this way that the trading of contracts in the markets as exchangeable instruments became possible. Eventually, this exchangeability or fungibility element has been added into traded contracts, partly because of the effort of the markets to grade the quality of the underlying commodity. Before transforming themselves as central counterparties, the functions of the clearing houses in commodity markets were generally comparable to those of bank clearing houses, though the latter did not and still do not act as guarantors.

3.1.3 Central Counterparty Clearing (Timeline: from 1888) The concept of the CCP clearing mechanism, whereby a clearing organisation entered into transactions with buyers and sellers, acting as counterparty to the transactions in its own capacity, first emerged from commodity markets. The changing roles of administrative clearing houses into CCPs can be briefly summarised as follows: (i) they both had the role of setting procedures and making rules and regulations regarding the clearing of trades; (ii) clearing houses operated as mere administrators or at best guarantors to trades, while CCPs

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CCPs: Functional and Operational Aspects stepped into the shoes of buyers and sellers in their own capacity; and (iii) CCPs further expanded the clearing from operating only in an individual market to multiple markets.21 In the United Kingdom, the history of LCH.Clearnet Ltd (formerly London Clearing House) provides the best example in this respect. Its history goes back to 1888, when it was initially established with the name ‘London Produce Clearing House’; then in 1973 it changed to ‘International Commodities Clearing House’.22 It was meant to serve commodity markets as a CCP.23 It has since expanded the services beyond commodity markets, to options and futures markets, derivatives markets, energy markets, Over-The-Counter (OTC) markets as well as equity markets. As a result of the merger between London Clearing House and its French counterpart, Clearnet in 2004, LCH.Clearnet has become one of the leading central counterparty clearing houses in the European Union, positioning itself well at the pan-European level. With the subsequent structural changes after the merger, LCH.Clearnet is now an independent public company. In the United States, the then Board of Trade Clearing Corporation (BOTCC)— established by the Chicago Board of Trade (CBOT) membership in 1883, now the Clearing Corporation—initially served as a wholly-owned division of the CBOT ‘to facilitate the administration of complex multi-party settlement for the buyers and seller that formed the “ring” without providing guarantor function’.24 In 1925, The Clearing Corporation was established as an independent CCP, following the 1903 petition calling for independent clearing.25 Apart from the development of CCPs in commodity markets we have seen, another structure similar to it has also been used in OTC derivative markets, which can be marked as an example of financial structure innovation—the Special Purpose Vehicle (SPV) structure. In OTC derivative markets, products are customised and tailor-made to meet the special needs of customers, which are often different from the standardised contracts that are traded in the formal/ official markets. A special purpose company may be set up, for both risk management purposes and for achieving better credit rating, normally as a subsidiary corporation of the parent company or sponsor, designed to serve as counterparty for swaps and other credit sensitive derivative instruments. It is otherwise known as a ‘Derivatives Product Company’ (DPC). It is essentially a subsidiary that exists solely as a secure home for some of its parent’s financial 21

See Section 5.2, ch 5 below on netting and set-off. See ‘International Commodities Clearing House’ in E Carew, Language of Money 3 (New South Wales: Allen & Unwin Pty, Limited (Australia), 1996), at: www.anz.com/edna/dictionary. asp?action=content&content=international_commodities_clearing_house. 23 It is often said that London Produce Clearing House (now LCH.Clearnet Ltd) first became known as a central counterparty. As we can see from the discussion in the Section 3.1.2, it is clear from the history of the Clearing Corporation in the US that the CCP concept was introduced long after clearing houses first served as an administrator and then a guarantor. Yet, there is a lack of evidence that London followed a similar route to develop the CCP concept. 24 See n 20 above. 25 ibid. 22

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Origins and Historical Development transactions, contracts, and derivative products. The DPC’s credit rating typically exceeds that of the parent company because the parent company collateralises it with a large amount of capital, compared to the credit exposure that DPC counterparties have. It is also insulated in various ways from the parent’s liabilities. In case the parent is insolvent or bankrupt, the DPC might either continue (continuation structure) or terminate (termination structure). The primary techniques that a DPC uses to manage market risks are the so-called ‘mirror transactions’ with the sponsor of the DPC.26 This structure is identical to what CCPs do, since the contract between the original buyer and seller is replaced by two equal and opposite contracts with the CCP. Accordingly, it led to the conclusion that the DPC structure ‘provides some of the benefits of the exchange-clearinghouse system while preserving the flexibility and decentralisation of the OTC market’.27 In the context, the exchange-clearinghouse system refers to the CCP clearing system. While the mirror transactions insulate the DPC against market risk, the DPC is exposed to credit risk from the potential failure of its sponsor, the parent company. In turn, the sponsor posts collateral with the DPC to address this risk. Each DPC has a quantitative risk assessment model that uses probabilities of failure and the extent of losses from past experience to simulate the extent of the DPC’s current credit risk exposure. To some extent, it is fair to say that this innovation of DPC is a contractual and organisational form that attempts to reproduce the benefits of CCPs in a decentralised way.

3.1.4 Concluding Remarks As can be seen, the scope of bank clearing houses has expanded along with the emergence of new payment instruments, whilst the principle behind them has remained intact. Their counterparts in commodity markets, on the other hand, have not only quickly expanded to other new markets and new financial instruments but also have also revolutionised their principles and further transformed into modern CCPs. The role of market clearing houses has transformed from simply managing margins, and offsetting trade obligations in ways similar to what bank clearing houses do for payment obligations, to finally become a CCP. Thus, they distinguish themselves from bank clearing houses. As mentioned in Section 2.1.2, chapter two, the absence of an equivalent counterpart of CCPs in the markets in the banking industry could possibly be explained by the different structures and the existence of central banks in banking. In the banking industry, the structure is a decentralised one in which banks have accounts with each other, although those settlement banks have the option to settle the transactions in their central bank accounts. In the markets, 26 27

According to the definition of a DPC by the credit rating agency Moody’s, October 1993. ibid.

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CCPs: Functional and Operational Aspects the fact that post-trade infrastructure is rather fragmental is just one of the many factors contributing to the emergence of CCPs. As will be discussed in chapter six, markets with CCP clearing also bring benefits both to the markets and their participants.28 Suffice it to say, the arrival of new electronic trading systems makes the discretion to choose trade counterparties even more difficult. The idea of having a CCP in the trading systems eases concerns by providing a visible counterparty with credibility. For trading parties, the CCP also provides an equal counterparty risk on every trade, which clearly offers an advantage in respect of counterparty risk management. Without a CCP, on the other hand, market participants as counterparties may have to monitor every other counterparty for risk management purposes. The transformation of clearing houses from an administrative entity aiming to provide operational efficiencies to risk-bearing CCPs is no doubt a significant step in modern market development.

3.2 The Functional Aspects of CCPs A CCP29 is a specialised institution that has various functions30 from the viewpoints of market participants, for example, markets, trading firms, regulators, and central banks.

3.2.1 CCP as Risk Manager Primarily, the introduction of the CCP concept in the markets is to deal with the counterparty credit risk of settling the transaction and of a default by one of its members. The role of CCPs as risk manager in the markets is not proactive but passive, in the sense that they have to accept trades as long as the set criteria are met such as the type of transaction and margining requirements, and this requires that CCPs must be robust enough, with adequate financial resources to handle the aftermath in the event of a member’s failure. As part of the collateral management, adjusting margin rates for each type of financial contract and changing the percentage of ‘haircut’31 of eligible collateral are two main tools at hand. As CCPs concentrate risks, proper management and a transparent risk control policy are the keys to their success.32 Failure to implement the policy in a rigorous 28

See further discussion on the benefits of CCPs in ch 6 below. See an example of the then role of the London Clearing House as a CCP, in A Lamb and E Swan, ‘United Kingdom: the Role of the London Clearing House’ (1996) 3(3) Futures & Derivatives Law Review 9–22. 30 Also for the role of CCPs as Self-Regulatory Organisations, see Section 6.3.2 in ch 6 below. 31 BIS, (March 2003), n 7 above. 32 See Section 7.1, ch 7 below. 29

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The Functional Aspects of CCPs way may result in serious damage and unforeseeable consequences to both the CCPs and the markets. It should be noted that proper functioning CCPs do not eradicate those risks but simply redistribute and spread the risks across the markets. Each financial product has distinctive risk characteristics, which require CCPs to evaluate them accordingly. In the markets, various types of risks are inter-related and one interacts with the other. CCPs as risk managers not only have to focus on the risks assumed for the transactions they have entered but also risk arising from other aspects, especially those related to their operational functions. CCPs have to try to spread the risk across the market in the most even and broadest way possible and to prevent a concentration of risk on one particular institution. For instance, limits have to be set for the guarantees that each bank can issue for participant members. The risk management function starts right from the very beginning in approving membership applications. A set of membership criteria is published and updated from time to time, and members have to comply with the requirements. Ongoing monitoring is also in place, which means in order to maintain its membership status each member has to continue to meet the requirements during the course of membership. One of the advantages of CCP clearing for participants is that the risk management function in relation to counterparty risk is centralised, with a systematic approach to better determination of each participants’ resulting exposures with an adequate level of collateral requirements. As risk managers, CCPs have to carry out several functions that are identical to what market participants do for managing counterparty credit risk, but on a rather larger scale with much bigger portfolios. The Committee on Payment and Settlement Systems in its report ‘Recommendations for Central Counterparties’, has outlined numerous risks that a CCP commonly faces.33 They are counterparty credit risk, liquidity risk, settlement bank risk, custody risk, investment risk, operational risk, and legal risk. The report further recommends approaches to risk management. Fundamental to all of the risks that CCPs are required to manage effectively is counterparty credit risk, which is the risk of the inability of a counterparty to complete the transactions, resulting in a loss of the other counterparty. Counterparty credit risk is further divided into two types: replacement cost risk and principal risk. As more and more securities settlement systems have introduced DVP, the principal risk as defined34 is eliminated. It follows that, in the event of a member default what the CCP is left exposed to is replacement cost risk.

33 CPSS and Technical Committee of IOSCO, Recommendations for Central Counterparties (BIS, November 2004). It covered the major risks that a CCP faces and established a framework for assessment and implementation of the recommendations. Also see European Association for Clearing Houses (EACH), ‘Standards of Risk Management Controls Used by Central Counterparty Clearing Houses’ (2001). 34 Principal risk is defined by BIS in its glossary of terms in payment and securities settlement systems as ‘the risk that the seller of a security delivers a security but does not receive payment or that the buyer of a security makes payment but does not receive delivery. In this event, the full principal value of the securities or funds transferred is at risk’.

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CCPs: Functional and Operational Aspects In the markets, stress tests are commonly used by financial firms and are also believed to be beneficial to central banks and financial regulators. It is also a primary tool for CCPs to calculate the exposures and try to predict the adequate level of financial resources that are needed. Stress tests may use various approaches, including historical and hypothetical scenarios, to calculate the impact on portfolios. Usually, firms that carry out those tests will use a combination of various approaches with further adjustment, since stress tests themselves have certain limitations.35 The risk control measures that could be deployed by CCPs include membership requirements, ongoing monitoring of member’s crediting ratings, and margining system. In addition, CCPs also maintain a comfortable level of financial resources and have the power to increase members’ contribution to default funds when it is deemed necessary. Collateralisation too plays a significant part in CCPs’ risk management approach. The cornerstone of CCPs’ risk management is to manage its expected exposures to its counterparties by taking collateral to cover the risk exposure. To calculate this exposure, a CCP typically employs tools such as risk modelling and stress tests to assess the price movements in the underlying assets in previous years and focuses on some of the largest one-day price movements over the set period. A one- or two-day equivalent measure is then scaled according to the price movement. The collateral is then calculated based on a set formula. Nevertheless, this is very much a two-way street. CCPs are in the same position as their member participants and other participants in the markets, and have to rely on the markets as well as their participant members to operate and perform their functions. Therefore, to CCPs, an overall risk policy must be set in the broadest possible way. As previously mentioned, maintaining a determined credit rating is also one of the requirements. In some markets, where members are not rated by rating agencies, the CCP will then have to monitor their financial performance with its own risk management methods.

3.2.2 CCP as Fund Manager Currently, the most common approach to risk management by CCPs is to have a default fund as part of the CCP’s line of defence against member defaults. The default fund is basically made up of a pool of funds contributed by member participants. As mentioned earlier, having adequate financial resources is a crucial factor for the smooth functioning of CCP clearing. During normal market conditions, the daily management of those financial resources is also considered as key. The financial resources, which may vary from corporation to corporation depending on its specific structure, will normally consist of each 35 As BIS put it, they are often neither transparent nor straightforward. See BIS, Stress Testing by Large Financial Institutions: Current Practice and Aggregation Issues (April 2000) 14.

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The Functional Aspects of CCPs participant member’s margin, members’ total contribution to the default fund, and the corporation’s own capital. As a result, there is a pool of different types of assets that is ready to be deployed by a CCP. In the event of a member’s default, these different financial resources are used in an orderly way, which may vary; but normally the margins and default fund contribution collected from the defaulting member will be the first to be used to meet the losses incurred. If that is still not enough to cover losses then it will be absorbed by the reserved profits, then the pool of the default fund, insurance cover and the CCP’s own capital. The main reason for CCPs investing those financial resources rather than leaving them idle is that the return expected from investment can help generate additional revenues to partially offset the costs of their operations. At the back of the investment of those resources, the CCP must be able to return margins when changes in members’ portfolios has resulted in the reduced requirement of margin. Therefore, the investment should be conducted in such a way that its primary function of margining is not affected. In some cases, a CCP may be obliged to provide a return to the members on any cash deposited with them as collateral. Similar to other fund managers in the markets, CCPs have to implement adequate strategy and manage the portfolio trading daily. While there are various strategies for fund managers to choose as long as they are adopting the investment policy of the fund, the strategy that CCPs adopt has to be conservative and funds should be invested in short-term financial products or those that are believed to be liquid and less volatile. Most importantly, it should not, in the worst case scenario, jeopardise the smooth operations of collateral management that is central to a functioning CCP. In principle, these funds are often invested in very short-term bank deposits such as overnight or by way of secured lending. This, in theory, makes the market risks on these investments negligible, but it does not mean that it is a risk-free investment. Central to the collateral management is liquidity risk, where there is a risk in converting one asset into another in order to meet the recall of margin. In a way, the investment means a shift from one financial asset to another in a set period and the liquidity of those assets differs. It is often the case that the goal of investment is to achieve the best possible return, but for CCPs it is important that the way they invest has to give first priority to the smooth operations of their collateral management. In other words, the margining operations should not be compromised in any way, given that the main purpose of these financial resources is to provide a safety net in the event of a member’s default. Assets like cash that form part of the default fund are legally free to be disposed of or to be re-used by the CCP as long as it is agreed to or allowed under the terms of the financial collateral arrangement. For cash as collateral, there is no limitation of the right to re-use under general laws. For securities as collateral, it is more cumbersome. In the European Union, the direction is likely to move closely to cash collateral after the introduction of the 55

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CCPs: Functional and Operational Aspects EU Directive on Financial Collateral Arrangements,36 which goes beyond the original objective of providing an exemption from registration to financial collateral arrangements by giving the right of re-use provided that the collateral taker and provider have agreed to it. In effect, the Directive further exempts the re-use of collateral from the requirement of registration and thus there is no risk of re-characterisation of the underlying collateral arrangement.37 Ultimately, the important point lies in the way that the funds are to be invested so that the proceeds can offset some of the CCP operating costs, as it is often argued. A rigorous investment policy has to be set out with regard to the investment activity in the funds. The investment risk taken should be within the tolerance level and has to be spread across the markets to avoid concentration in a particular sector or market. Arguably, the market risk of the investment of those funds by a CCP tends to be negligible when a conservative investment policy is implemented. Nevertheless, CCPs as investors also face several risks that are common to fund managers in relation to the nature of investment activities. Typically, there are credit, market and liquidity risks,38 both against the banks with which they place funds and the securities issuers in case of secured lending. Hence, rigorous risk controls have to be put in place and implemented.

3.2.3 CCP as Payment and Settlement System Operator When it comes to settlement of the trades, CCPs play a significant role in setting the procedures. Given that a significant proportion of trades are through CCPs, they are also an important factor in the settlement systems as seen by the system operators. Moreover, in some cases, CCPs are also performing identical functions to that of the operators for payment and settlement systems.39 For instance, they may make specific rules and procedures with respect to payment and securities settlement so as to facilitate their smooth operations. As to payment transfers, to facilitate margining operations, a CCP typically makes contractual arrangements with a certain number of banks as well as with all of the members of the CCP. According to that arrangement, it sets the rules regarding settlement procedures and acts as the operator of the scheme.40 This scheme can be seen as an individual payment settlement system, since it has all of the basic elements of a payment system and operates across several private banks with contractual rules governing the transfers of payment. It is rational to 36 Council Directive 2002/47/EC of 6 June 2002 on financial collateral arrangements [2002] OJ L168/43. 37 ie the risk that the collateral arrangement could be void for failing to meet the registration requirements. 38 See CPSS and the Technical Committee of IOSCO, Recommendations for Central Counterparties (BIS, November 2004). 39 As an administrator and operator of a market system, be it a settlement system or CCP clearing system, they also make rules and procedures in relation to the functioning of each respective system. 40 See Section 3.3.2 below for how the scheme operates.

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The Functional Aspects of CCPs integrate all payment-related transfers in one system for the CCP and to extend the use of that system for settlement of those payment-settlement-only transactions. These transactions typically do not need to involve any securities settlement system or physical delivery of any sort. A CCP’s payment scheme for margining purposes41 can be feasibly extended to serve the settlement for the above-mentioned transactions. In this way, the CCP is very much operating as an operator of ‘payment settlement systems’, since it sets out the rules of ‘that system’, where the final payment transfer may not necessary settle in central banks but in inter-bank accounts. A so-called Protected Payment Scheme (PPS) arranged by LCH.Clearnet is a typical example of that, even though the infrastructure for the scheme is provided by a third-party bank.42 In commodity markets, the administration of the settlement process is another major area of involvement for CCPs. For ‘futures’ contracts, very few of them are actually taken to expiry, though it is still important for those contracts that are to be settled by physical delivery. Driven mainly by the increasing volume of trades, the physical transfers of warrants have also been moved to electronic platforms. London Mercantile Exchange’s (LME) SWORD system43 provides the best example. In January 1999, the LME and the then London Clearing House launched a joint initiative called SWORD, which became operational in July 1999. The SWORD system is an electronic transfer system for LME warrants, which are produced in a standard format with a barcode. Warehouse companies issuing these warrants ensure that the details are known to SWORD, which acts as a central database, holding details of ownership, and is subject to stringent security controls. The ownership of LME warrants can be transferred between SWORD members in a matter of seconds and all rent payments are automatically calculated.

3.2.4 CCP as Post-trade Market Facilitator As to trading, exchanges or trading platforms can organise their trading systems in three ways, which are: quote-driven, order-driven or a combination of both. Increasingly, trading platforms are hybrid systems, namely, a combination of quote-driven and order-driven systems.44 A market maker normally has to be an 41 Cash as collateral. For accepting securities as collateral, there is normally an arrangement with the relevant CSD to operate an account specifically for holding the securities collateral. 42 See Section 3.3.2, ch 3 below for further information regarding how the PPS scheme operates. 43 See the website www.lme.co.uk/what_sword.asp. 44 London Stock Exchange is an example, which has a quote-driven system called Stock Exchange Automated Quotation System (SEAQ) and an order-driven Stock Exchange Electronic Trading Service (SETS) which is the formal name for the electronic trading order book that handles trades for major leading companies traded on the London Stock Exchange. The SETS combines features of the existing SETS and SEAQ services, and is the London Stock Exchange’s other trading service for FTSE250 and other leading non-order book securities. See the website of London Stock Exchange: www.londonstockexchange.com.

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CCPs: Functional and Operational Aspects authorised person in the market and is a firm operating in a quote-driven system by continuously quoting bid and offer prices. It therefore, ‘makes’ a market as the name suggests. In the hybrid systems, market makers not only compete with each other on the quotes and quantities but also on orders in the limit order book. Market makers are essentially market liquidity providers, quoting bid and offer prices continuously in a financial instrument with the purpose of making profit on the spread between the buying and selling price.45 Even in a trading platform without designated or official market makers, market makers nonetheless exist.46 In that system, it is for the trade matching system of a trading platform to decide whether or not a deal has been agreed upon when a buyer’s bid and a seller’s offer are matched. Where there are official market makers in the markets, unofficial market makers are also free to operate. The major difference between them is that broker/dealers have to trade with official market makers, especially when they are trading on behalf of their clients. Unofficial market makers do not have the power to require that everyone should deal with them. In addition, it is an obligation for an official market maker to provide quotes continuously during the course of trading, but it is not the case so far as unofficial market makers are concerned. On the other hand, one of the advantages that CCPs offer is that they can help increase market liquidity,47 although they are not the sources of liquidity. A difference between market makers and CCPs is that market makers take market positions and make profits from the spreads, while CCPs take no market position and charge fees for their CCP clearing services. After trade, parties to all transactions for CCP clearing have the CCP as their respective counterparty, which could be compulsory or optional, as mentioned above. As a result, each participant in the market will only have to deal with the CCP. This arguably creates a level playing field for all member participants in terms of counterparty risk management. To some extent, both market makers and CCPs play a passive role. Arguably, market makers on the trading side and CCPs after-trade work hand-in-hand to contribute greater liquidity to the markets, since, at trading level, markets makers provide liquidity and CCPs increase market liquidity through their off-setting of trade obligations, resulting in a lesser number of settlements typically. When an order, be it buying or selling, matches the quote provided by the market maker as obliged, the maker has to accept the trade, since his role is to make the market. Similarly, CCPs have to accept all the eligible trades from members so long as the set criteria are met, such as sufficient margin cover. The market maker takes the

45 For an economic study on the impact of market structure on market liquidity, see M Wahrenburg, Jorg Bochow, Duong Nguyen and Peter Raupach, What do Market Makers Achieve? Evidence from a Large Scale Experimental Stock Market (November 1999), at: www.wiwi.unifrankfurt.de/schwerpunkte/finance/wp/375.pdf. 46 See the online encyclopedia: en.wikipedia.org/wiki/Market_making. 47 See the discussion of the advantages of disadvantages of CCPs in ch 7.

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The Operational Aspects of CCPs trade only with the intent to sell the trade to someone else, usually in a rather short period of time or vice versa. The longer the waiting time, the more risk he bears in terms of prices. Clearly, a market maker has to fine-tune the spread low enough to remain competitive and attract buyers and sellers, while at the same time making reasonable returns from the risks taken. A market with narrow spreads that are quoted by market makers attracts investors. A robust and proper functioning CCP also helps boost the market confidence, and investors are more likely to trade in that market. Furthermore, clearing houses historically played the role of helping the market to develop standardised products, as we can see from the previous discussion in Section 3.1, chapter three. This function has been inherited by CCPs in modern times and has expanded further. Consequently, they could in a way be deemed as post-trade market facilitators.

3.3 The Operational Aspects of CCPs48 As to the operations in CCPs, the clearing operations may differ from market to market according to the type of financial products cleared as well as market practices. Special arrangements may have to be arranged to facilitate some special types of financial instrument. Hence, it is not possible to cover all of them here. For the purposes of illustration, we will focus on the common approach of clearing operations and may refer to some financial instruments where distinctions can be made from time to time. Among the three market segments discussed in chapter one, CCP clearing is right in the middle of trading and settlement. Thus, the clearing operations are closely associated with the other two stages. At the front end, eligible financial instruments for CCP clearing have to be executed or agreed upon according to trading rules and routed to the clearing system. At the other end, contracts are to be settled in relevant settlement systems and may sometimes require physical delivery where special arrangements are needed. In some other cases, the CCP may extend the use of its specially arranged payment scheme49 to settlement for the markets where there are cash-settlement-only transactions involved, for example, the Protected Payment System (PPS), which is used for settlement of interest-rate swaps in LCH.Clearnet’s SwapClear, as will be discussed shortly.

48 The work of this section has been very much drawn from the time the author spent at LCH.Clearnet Ltd in London. This section was only meant to give a snapshot and may not cover all aspects of CCP clearing operations. 49 The specially arranged payment scheme is mainly used for the transfers of cashes as collateral for margining purposes. It has to be specially arranged to fit the purposes of the CCP’s operations. See the discussion in Section 3.3.2 below.

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CCPs: Functional and Operational Aspects To ensure that smooth and timely trade settlement occurs, CCPs commonly have to roll out stringent risk-control measures, including rigorous access criteria, daily calculation of member positions for assessing the CCP’s exposure, margining and substantial financial back-up. Operationally, CCPs have to incorporate a number of unique functions to each type of instrument they handle. For CCPs that are operating in various different markets and for various types of products, the operations are relatively more sophisticated. As a result, this section is divided into the following three sub-sections: Risk Operations, Treasury Operations, and Settlement Operations, in order to provide an overview on the operational aspects of a CCP.

3.3.1 Risk Operations50 Risk operations mainly cover the following aspects:51 (i) approval of membership; (ii) maintaining independence of risk operations; (iii) adjusting margin level and determining haircut percentage of collateral; (iv) carrying out stress tests; and (v) monitoring the movement of market prices and deciding margin calls. It is important that an independent decision is made on matters related to risk management within a CCP, to control the risk exposures for the soundness of the markets as well as itself. Typically, this is achieved by setting up an independent risk department within a CCP overseen by a risk committee. The department advises on margin levels and is responsible for initial margin methodology, administers and makes recommendations on membership application, is responsible for policy on banking exposures related to money lent and the acceptance of guarantees from bankers to member, and determines what type of collateral is acceptable and what haircuts should be applied to that collateral. As far as CCPs are concerned, they are not different from the other trading participants in the market, as they expose themselves to the risk of their members being in default. Similarly, participant members also expose themselves to the default of CCPs, although in theory it is a highly unlikely event. In normal market conditions, the CCP is isolated from market risk as a result of two equal and opposite contracts with members when all members are solvent. In the event of a member default, the CCP’s position becomes unbalanced and it inherits the defaulting member’s position. This exposes the CCP itself to the market risk before all the open positions with the defaulting member are either transferred or closed out. In the meantime, the CCP has to continue to perform in relation to 50 The Risk Operations is an area where highly sophisticated financial models and advanced information technology systems are utilised. Obviously, a detailed discussion of these areas is out of the scope. 51 See London Clearing House, Market Protection—the Role of LCH: Regulatory Framework, Structure and Governance, Legal and Contractual Obligations, Risk Management, Default Rules, Financial Backing (2002).

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The Operational Aspects of CCPs the transactions it has with non-defaulting members. With immediate effect, the default procedures will accordingly be triggered.52 The main objective of daily risk operations is to arm the CCP with adequate resources for it to be able to stand intact in the event of default, and continue to provide services to the markets. CCPs cannot guarantee that there will not be any event of default. From a risk management perspective, they are instead to monitor and try to identify the events that are likely to have an effect on members’ ability to perform obligations and to react, as soon as possible, with all possible measures in hand and eventually limit the loss as a result of one or more member defaults. This is the central thesis of risk management in CCPs. Furthermore, risk management concerns all other risks arising from its operations. They include default risk, custody and investment risks, operational risk, risks involved in money settlements and physical deliveries, and risks in links between CCPs.53 As mentioned in Section 3.2.1 above, stress testing is the primary tool for CCPs but it is not a perfect one. Accordingly, adjustment is required. For example, the CCP has to decide the risk factors, the way in which they are to be combined and the range of values within a set period. After the results have been worked out, the CCP still has to identify the likely implications. For daily risk operations, CCPs mainly concern themselves with adjusting adequate margins with respect to each member’s market positions. The need for margining is an obvious case. Upon close monitoring, the movements in the markets during the day and the changes of each member’s portfolios resulting from trading, the risk operations determine when and whether to make margin calls and intra-day margin calls in particular. Prescribed specific formula and algorithms are set for each type of financial contract so as to calculate initial margin and variation margin. Take LCH.Clearnet’s EquityClear for LSE equity transactions as an example. Equity Risk Analysis (ERA) is used as the margin algorithm and is run several times a day. The ERA is based on three important factors: historical simulation, portfolio buckets for stocks with valid price history using observed two-day price moves over the previous 252-day period, and flat-rate buckets ranging from 5–100 per cent for stocks with no price history such as new issues. To achieve a better result of Equity Risk Analysis, various manual inputs are needed, namely, positions, prices and parameters. Another example is LCH.Clearnet’s SwapClear. In this case, for the purposes of margining, the future cash-flows of each swap are discounted to establish the Net Present Value (NPV). The variation margin is charged according to the change in NPV from the previous day. For initial margins, the CCP uses Portfolio Approach to Interest Rate Scenarios (PAIRS),

52 53

See Section 4.8 below for discussion of default rules. CPSS and Technical Committee of IOSCO (2004), n 33 above.

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CCPs: Functional and Operational Aspects which is essentially a historical simulation approach and selects the historic scenario that causes the largest net loss on the total portfolio in the base currency.

3.3.2 Treasury Operations54 One of the main functions of the treasury team is to act as the operator of a specially arranged payment system—as is the case in LCH.Clearnet Ltd in London—which is essentially similar to that of Direct Debit. This contractual arrangement among the CCP, members and banks is mainly needed to ensure the smooth functioning operation of collateral management. The system basically covers all of the transfers relating to funds in various currencies for all markets, excluding the cash-only settlement of cleared transactions like securities trades. The treasury operations also cover the settlement side of treasury investment activities. In addition, all cash and securities as collateral are managed by the treasury. The treasury team oversees all of the margin cover callings and postings and ensures that the margins due are properly transferred to and from the CCP and members before set deadlines with respect to cash currencies as well as securities, when used for collateral. In the case of securities as collateral, transfer of securities is normally achieved via Free of Payment (FOP) and is normally a responsibility of Treasury Operations. There are three major areas covered by treasury operations: (i) funding for the CCP itself in different markets such as credit lines or bank guarantees; (ii) cover calling postings for initial margins, variation margins, overnight and intra-day margins; and (iii) support for the CCP’s investment activities like tri-party repo transactions, foreign exchanges, money market deals, secured lending and Certificates of Deposit (CD) deals. Due to different market practices and members’ special requests, some daily adjustments have to be made accordingly as part of daily operations.

A. Specially Arranged Payment Scheme 55 The privately arranged payment scheme is essentially a closed inter-bank payment system, which operates across several participant banks.56 For example, the scheme used by LCH.Clearnet is called the Protected Payment Scheme (PPS). Under the PPS scheme, the CCP will have obtained a mandate from every 54 This section is based partly on the observation in Treasury Operations of LCH.Clearnet Ltd and also on the presentation material provided by Clare Bradnock of LCH.Clearnet Ltd in Overview of Treasury Operations. 55 LCH.Clearnet Ltd has a similar system called Payment Protected System. Other CCPs also run similar payment schemes that are particularly required for margining operations. In 2005, the Bank of England, the central bank, accepted LCH.Clearnet Ltd as a settlement bank. Since then, the Bank of England is acting as the concentration bank for the scheme. 56 The banks so chosen are normally settlement banks of central banks with high credit rating, thus the settlement banks risk are minimised.

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The Operational Aspects of CCPs member and accordingly has the authorisation to directly credit or debit the member’s account in the relevant bank. Essentially, the settlement arrangement between the participant banks of the scheme has to be a real-time gross settlement system for margining purposes, and all the payments have to be final and irrevocable.57 It is a prerequisite that each clearing member has to have a proper banking arrangement and an account with one of the participant banks in the payment scheme. The CCP has an account in each participant bank. In order to simplify the operations and to reduce the number of payment instructions across the participant banks, a so-called ‘concentration process’ is incorporated in the scheme. One of the participant banks is selected to act as ‘concentration bank’, since the CCP’s long balances in the participant banks will be transferred into that bank and vice versa. As a result, the CCP’s account balances in the other participant banks are kept at zero most of the time. Here, this operation is somewhat comparable and identical to that of a bank clearing house.

B. Margining Operations As mentioned earlier, there are two main types of margin: initial margin and variation margin. Initial margin is reviewed periodically, eg, monthly or quarterly, and the past trading records of each member are also taken into account. Variation margin is calculated daily by mark-to-market and is passed through from one member to another by the CCP, leaving the CCP flat at all times. In addition to that, there is also the intra-day margin, which is used for adjusting the level of initial margin in case there is a large move in the market during the day. Typically, margins are covered with cash in specified currencies, securities subject to certain criteria such as G7 government bonds, and bank guarantees provided by banks that are above certain credit ratings. The CCP would normally have a list of the acceptable currencies, securities and bank guarantees, which is updated from time to time. The main difference between the two is that in general securities, bank guarantees and cash are accepted as collateral for initial margin but only cash is used for variation margin. The CCP makes public and regularly updates the types of securities and the currencies that it will accept. To reduce possible same-day cover callings/margin calls, members tend to choose either to leave excess collateral in the margin account or to use excess cash in the ‘banking account’.58 Therefore, there is no need for cover calling if there is sufficient excess cash available to cover the margin needed. Only when the extra margin required exceeds the available cash should the CCP make the cover

57 In the EU, this sort of private arrangement may fail outside the application of the Directive on Settlement Finality (Council Directive 98/26/EC of 19 May 1998 on settlement finality in payment and securities settlement systems [1998] OJ L166/45), since the scope of the Directive is limited to systems as defined in Art 2(a). 58 Namely, the account in one of the participant banks under the payment scheme.

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CCPs: Functional and Operational Aspects calling. In the case that there is excess collateral for the margin, the cash part of the collateral will be released from the cover account if the so-called ‘auto-repay’ option is chosen. For the so-called auto-repay programme, in cases of cash as collateral, the margin is calculated daily according to market fluctuations, which will result in the movement of the margin between members and the CCP. As it is often the case that members will leave excess cash or securities collateral in the account, they can then choose to have the excess cash automatically repaid to their banking accounts after the margin of the day is confirmed. Those who do not have auto-repay can call and ask for the excess cash to be transferred back to their PPS accounts before the deadline set by the CCP. Otherwise, the cash will stay with the CCP and interest as determined by the agreement will be paid to the member. In turn, the excess cash would be then used by the CCP to invest. The types of financial instruments that are accepted by a CCP as collateral typically include cash, securities, and bank guarantees. A list of specific currencies, securities instruments and acceptable bank guarantees is updated constantly by the CCP and available to the clearing members. Securities used for collateral are utilised and any excess that remains is unutilised. Utilised securities are accordingly charged an accommodation fee by the CCP while unutilised securities are not. In turn, the CCP is normally charged a custodian fee by the relevant custodian whether or not the securities are utilised as collateral. Bank guarantees are also commonly accepted as collateral. Upon a pre-determined event of a member, the bank that issued the guarantee will have to pay the nominal amount. As far as CCPs are concerned, a cap for the total nominal amount of the guarantees on each bank has to be set to best spread the risk and prevent possible default of a bank and the concentration of risk on a particular bank. Another relevant issue here is that of Re-hypothecation.59 Suffice it to say, re-hypothecation is a technique mainly used to make it possible for a collateral taker to take extra economic advantage of the assets taken as collateral by deploying them for other purposes.60 To avoid legal uncertainty, the practice of re-hypothecation was onerous, as consent is needed from the collateral provider for whom the collateral taker is in turn holding the securities. Moreover, the collateral lodgement and release required a high degree of manual and paper work. In the European Union, the implementation of the Directive on Financial Collateral Arrangements, which is mainly to simplify the procedure and bring greater legal certainty,61 has also gone far enough to make the re-use of collateral

59 For detailed discussion on this issue, see J Benjamin, Interests in Securities (Oxford/New York: Oxford University Press, 2000). 60 eg securities lending. 61 Council Directive 2002/47/EC of 6 June 2002 on financial collateral arrangements [2002] OJ L168/43. The Directive has adopted the ‘place of relevant intermediary approach’, the so-called PRIMA, which applies to the cases where conflict of laws issues arise and the relevant applicable law

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The Operational Aspects of CCPs possible, so long as the collateral provider in question has explicitly given consent in the agreement.62 Thus, it can be argued that the re-hypothecation issue is no longer relevant.

C. Operations for Other Services Other services that are provided by Treasury Operations mainly include settlements for all the investment activities carried out by the Treasury trading team. In this sense, it is a back office and the treasury investment is the front office. As mentioned above, the CCP normally invests its financial resources in a number of ways. The most common way is in money market transactions. The treasury operations for money markets transactions can be briefly described as follows. After all of the overnight margin calls have been confirmed, the Treasury Operations will be in a position to work out the monies available for treasury investment. In some cases, there may be a netted outflow rather than an inflow. The exact figures can only be confirmed after the deadline for cash movements, as members without auto-repay can withdraw their excess cash up until that time. All of the subsequent money market deals, such as overnight deposit lending done by treasury investment, are sent to the treasury operations to be confirmed and executed. Transfer instructions are accordingly inputted into the concentration bank’s banking system.

3.3.3 Settlement Operations for CCPs63 As discussed in Section 2.1.2, chapter two, the function of clearing is carried out after trade and before settlement and attracts close attention, as the process significantly reduces the volume of settlements and subsequently the rate of failed trades. At this point, a clearing house may only operate as a calculation agent. Since the concept of CCP clearing was introduced the role of clearing houses has changed. They therefore take the legal position as counterparty and act as the buyer to every seller and the seller to every buyer. As a result, the main focus has shifted to risk management for clearing houses, as risks are concentrated on clearing houses themselves. The major practical benefit of using this CCP concept is that its members can remove much of counterparty credit risk from their balance sheets through would be accordingly deemed the law of the place of the relevant intermediary. See JH Dalhuisen, Dalhuisen on Transactional and Comparative Commercial, Financial and Trade Law, 3rd edn (Oxford: Hart Publishing, 2007) 814–16 and 1066. 62

Art 5 of the EU Directive on Financial Collateral Arrangements, Directive 2002/47/EC. This section explains the essential elements of operational procedures and the stages of the operations. Again, it is in principle based on the author’s observation while at LCH.Clearnet Ltd. This is served as an example and may not be seen as a common operational approach. 63

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CCPs: Functional and Operational Aspects bilateral netting.64 Additionally, every transaction remains completely anonymous, also in the clearing and settlement process (the so-called ‘Post-Trade Anonymity’65). Trades will only remain anonymous if they are transacted through the trading systems that support trade anonymity. A CCP may also enhance risk management based on the risk-based margining; participants in this case are offered a centralised risk-management service with prompt assessment and provision of the risk positions and margin requirements. Moreover, a CCP itself has to bear the risk that one or more of its counterparties, as members, may default. Finally, with so-called ‘netting’, the delivery and payment obligations are netted on a regular basis, which enables a prompt assessment of the net obligations and a reduction of the total settlement volume. In reality, settlement failure cannot be eradicated completely. This could happen due to either the delivering party not having sufficient securities or the receiving party not having sufficient funding. The diagram below shows the relationship between CCP netting cycles and the settlement cycles of a settlement system, be it an overnight or daylight cycle. In addition, it also shows the use of re-introduction of failed trades by a CCP between the processes of two different cycles. In a DVP environment, as discussed in Section 2.4, chapter two, no exchange for failed trades will happen as a result. From the operational point of view, the main responsibilities of a CCP’s settlement operations include confirming the trades received for clearing, constantly monitoring settlement statuses and avoiding the holding of any bond positions. Accordingly, actions are to be taken to make partial deliveries if that is the case, and to reintroduce failed trades and the remaining part of the trades resulting from partial delivery into the next netting run. In the case of LCH.Clearnet, its positions need to be reconciled as it is operating across different depositories. It should be noted that settlement failure does not normally result in the member who failed to deliver being declared as in default. There exists a certain degree of tolerance in the market. On the contrary, margin calls are the exception, as the default is probably more likely to be declared when the member fails to meet the calls. CCPs can literally operate in all types of settlement systems, be it a continued net settlement system or a real-time gross settlement system. This difference lies in the way that settlement instructions are routed.

A. Trade Registration In general, there are two ways to register trades onto a CCP’s clearing system for clearing; one is called novation and the other open offer. The major difference between these two methods lies at the validation of the trade. In open offer, the relevant trading system or exchange will validate the trade that is shown to have the CCP act as central counterparty as long as it meets the criteria set by the CCP. 64 65

See Section 5.2, ch 5 below. See Section 7.1, ch 7 below.

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The Operational Aspects of CCPs Netting Cycle:

Settlement cycle ends

Failed trades Reporting

re-introduced

Netting run

Netting run Partial and Daylight Settlement

While in novation, the CCP has the responsibility to either register the trade once the criteria are met or otherwise reject it and inform the parties in question accordingly. Once trades are successfully registered, confirmations of acceptance will normally be sent by the CCP to the counterparties to the trades. This is considered as the moment when the CCP becomes buyer to the seller and seller to the buyer. Trades that are rejected will be shown on the system and the reason for rejection may well be that the trades did not meet criteria. Most of the time, this is because the instructions arrived after the relevant cut-off time. Consequently, the original counterparties to the rejected trade will then be advised to arrange the settlement themselves. As soon as the trade is registered and accepted by the CCP system, the underlying obligations of the trade and the underlying contractual relationship between the CCP and each respective member to the trade are legally established.66 In the case that the trade is registered through novation, the original trade is hence terminated. It is also right at this moment that the rules and regulations of the exchange or trading system that govern the agreed trade are replaced by those that relate to the CCP.

B. Pre-netting Before a netting run for the next day settlement, the following checks are to be conducted. First, the total number of trades sent from the various trading systems 66

For further discussion, see Section 4.1, ch 4 below.

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CCPs: Functional and Operational Aspects with respect to each market, that have settlement day as the next day, are to be confirmed either verbally or through email. Secondly, the overnight settlement reports are constantly being checked against incoming settlement messages to ensure that the status of all trades is updated prior to the passing of the final settlement deadline. It is worth noting that failed trades do not necessarily mean that the failing party is in default, as the trades will still settle some time in the future. Since the CCP does not in principle hold a position, partial deliveries,67 as the case may be, will then be forced onto the receiving counterparties through daylight settlement. And then the remaining balance, together with those failed trades, are re-introduced into the system used for netting calculation for next forthcoming netting run. Effectively, they have been rolled over. In some markets, the failed trades will not be re-introduced and are rolled over for settlement on the next business day.

C. Netting Process Here, netting is a process whereby the counterparties could net the transactions off to a single delivery and/or a single payment in respect to a particular instrument.68 European Central Bank defines it as an agreed offsetting of positions or obligations by trading partners or participants. The netting reduces a large number of individual positions or obligations to a smaller number of obligations or positions. As discussed, netting may take several forms that have varying degrees of legal enforceability in the event of the default of one of the parties. This computing process may seem to be simple and straightforward at first. However, given the vast volume and the ever more complex financial products to be processed, this is no longer the case.

D. Post-netting The main objective for this post-netting check is to see if there is a need for internal movement across different depositories in order to square up positions for the CCP. Netting can reduce the number of settlements; however, it cannot completely avoid cross-border settlements,69 either for the CCP or the members. The result is that the CCP may be left with a long position with a depository in 67 For example, in the case that the CCP is expecting to receive two transfers in order to make up a single delivery. However, one of the transfers it expects to receive does not happen as a result. In this case, the CCP can force the receiving party to accept partial delivery since the CCP does not have what it needs to make a single delivery. 68 See Section 5.2, ch 5 below for the legal aspects of netting. 69 A cross-border settlement in this context means that the settlement of a transaction involves one of the counterparties to transfer its holding of securities from one depository to another depository. For example, a cross-border settlement instruction by a CCP may include a transfer of a particular Eurobond from Clearstream to Euroclear in order to facilitate the transaction settlement in Euroclear. Of course, this transfer order can also be a separate instruction.

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The Operational Aspects of CCPs one market and short with another. As the risk involved in cross-border movement70 is greater, the CCP is less inclined to deliver itself. One of the members involved in the relevant transactions would then be bound to make the crossborder transfer. Overall, that member is still better off as a result, as his total amount of deliveries has been reduced.

E. Settlement Take bond transactions as an example. They are settled either through Delivery Versus Payment (DVP) or Free of Payment (FOP). For CCPs, the majority of Repo (Sale and Repurchase) and cash bond transactions are now settled through Delivery Versus Payment (DVP), which means that the settlement of a trade will simultaneously result in the movement of bonds and payment. In other words, it means that there must be sufficient bonds and cash for the successful settlement. The situation becomes more complicated with CCPs, as there are two back-toback trades that need to be settled. As mentioned earlier, two scenarios may delay the settlement of a trade and cause the settlement to fail. The first scenario is when the delivering party does not have sufficient bonds and in the second scenario, the receiving party does not have sufficient cash available for the supposed settlement cycle. As far as CCPs are concerned, securities positions may be more easily managed than cash positions. Where there is an auto-borrowing programme with a relevant CSD in place, the CCP will still be able to make the delivery and receive payments when the delivering party to the opposite trade failed to make the delivery. According to a typical borrowing programme with a CSD, a CCP typically does not need to make any payment. Therefore, in making the delivery of securities, the CCP in return receives cash payment. To make use of the surplus payment received in return for that securities delivery, the resulting fund is usually being moved out of the settlement account to earn higher interest through other investment activities, normally overnight. Here, the CCP will have a borrowing position at one end and a buying contract at the other. As failed trades are normally rolled over to the following day and DVP is the prerequisite for successful settlement, the funds will then need to be returned to the ICSD account to prepare for the receipt of the bonds and the subsequent return of the borrowing to the depository. Different central depositories are likely to have different settlement deadlines for a settlement cycle, and settlements of transactions can happen between overnight processing and before the settlement deadline. For the markets whose settlement deadline is before the CCP’s cut-off time for netting, failed trades could then be re-introduced for the next cycle. For those markets that have a later 70 A settlement bridge has been built between Euroclear and Clearstream for cross-border settlement of securities transactions but not in a strict DVP environment. In other cases, there may require a third party agent to complete the cross border transfer adding other risk factors that makes trading party less inclined to do so.

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CCPs: Functional and Operational Aspects settlement deadline which is after the CCP netting cut-off time, there is no need for re-introduction for the failed trades and they will be left to settle outside of the CCP netting process. Here, the trades that have a past settlement date will have priority at the beginning of the following settlement cycle. For example, this is the case in Euroclear.

F. Major Factors that Affect Settlement Operations (i)

Auto-borrowing Programme71

After a CCP netting process, as the case may be, a CCP can expect that for some transactions it is to receive several separate deliveries so as to make onward deliveries. It often happens that one of the receiving trades failed to settle, causing the CCP to be unable to make the onward delivery, as there are insufficient securities. If this has happened during an overnight settlement cycle, the CCP would be able to borrow the bonds from the depository. Therefore, the onward delivery will be settled. As a result, the central counterparty will be holding the cash amount for the borrowing bonds. There is a possibility that the trade could still settle later before the final deadline and the bonds borrowed would be automatically returned through receipt of the bonds from delivering party. Hence, no funding issue arises. It is noted that only when the final deadline passes is a trade considered to have definitely failed. Here, the treasury team comes in to play its role, as it will move the cash amount out of the account to earn higher interest overnight. The failed trade will either be re-introduced or wait to be settled in the following settlement cycle. The treasury team would then need to move the cash back into the account to have sufficient cash for settling the failed trade the following day. Consequently, the funding issue arises. (ii)

Partial Deliveries and Re-introduction

In a perfect settlement environment, CCPs would be able to make the deliveries and pass them onward and vice versa without the need for partial deliveries. However, it is unavoidable that in some cases there may be different nominal amounts in several opposite transactions and sometimes an unequal number of transaction settlements although the overall positions of CCP remain equal and opposite as a result of netting with various counterparties. Operationally, the operations are to do all they can to avoid this from happening by making a partial delivery or taking a partial delivery in some exceptional cases, especially when it is close to the deadline/cut-off time of the last settlement cycle for the day, as there is a high risk that the CCP may not be able to deliver onward the bonds received before the settlement deadline. In addition, the funding issue would also 71 This service normally provided by CSDs to their members and may also be arranged between agent banks and their clients, in this case, the CCPs.

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The Operational Aspects of CCPs arise in the case that the CCP failed to deliver onward the securities that it has received. The three diagrams below serve as an example of the flow in the case of a failure by one of the clearing members to make a delivery. One should bear in mind that in normal circumstances a CCP does not take any market position, ie the positions of the CCP are expected to be flat with equal and opposite trades. As the final settlement deadline for the day approaches a CCP that is left holding securities positions will have less chance to make full delivery. The CCP will then face the choice of whether or not to make a partial delivery and re-introduce the remaining failed part before the following netting run. Alternatively, it can take a risk by waiting for the delivery of the remaining trades from the other parties so that it can settle the trades altogether. When the settlement system has a late final settlement deadline, ie it is after the next netting run and the CCP does not do partial delivery, the CCP would have to decide whether they would need to borrow the bond or buy in the market to have sufficient bonds for onward delivery. The netting runs are made at the end of or after the mandatory settlement window. The trades would therefore have been processed by either partialling or re-introduction. This would depend on how many bonds they need to make up enough for onward delivery and whether the delivering party has the right to borrow to enable the transactions to be settled successfully later. (iii)

Shaping

To increase the settlement efficiency, trades are sometimes ‘shaped’ with certain sizes (the nominal amount of a transaction) and they are determined by the CCP according to the market condition for the specific instrument and its liquidity. In some markets, there is no need to introduce this policy and for those markets with shaping in place the sizes of shaping may vary according to different market conditions. As a result of shaping, a large single trade will basically be divided into several ones with smaller nominal amounts. Consequently, there will be numerous settlement instructions. In principle, shaping applies to settlements for settlement liquidity reasons. Shaping is different from partial delivery in the sense that it is compulsory as long as it is introduced to the market. On the other hand, partial delivery is optional and normally it is a choice for the CCP to decide whether make a partial delivery or accept it, at least this is the case in some markets. Consequently, the offsetting of trades may not necessarily result in a single settlement when shaping applies.

G. UK CREST CREST, a UK-based securities settlement system, also provides a very good example of CCP clearing operating in a real-time settlement system that is using central bank money for settlement of sterling-denominated securities.72 CREST 72 The CREST system was discussed as an example in the context of DVP in Section 2.4, ch 2 above.

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CCPs: Functional and Operational Aspects settles all the trades in central bank money to eliminate the settlement bank risk. Principally, CCPs are not recognised as a bank by the Central Bank, Bank of England. Consequently, an exemption is given to the CCP, LCH.Clearnet in this case, for operational purposes and there are some special arrangements in place because the payment settlement system is a real-time gross system. For example, the CCP has no rights to borrow securities, since the CCP is not recognised as a credit entity by the payment settlement operator, the Bank of England. However, there is a facility called CAP73 as a credit line which is available to the CCP in order to bridge the time-lag between two different equal and opposite DVPs. In this case, the CCP is the counterparty to both DVPs, and the CAP facility is in place to help increase settlement efficiency. In CREST, trades are settled on the same day and there are two different deadlines: one for DVP settlements and the other for Free-of-Payment (FOP) settlements. The netting process by the CCP normally results in three different types of settlement. These may be DVP movements, bond-only movements (FOP) and cash-only movements. In this real-time gross settlement environment, the need for splits of transactions is compelling in the case that the CCP is settling the trades with different nominals. In this arrangement, the relevant exchange allocation rules determine the proportions of underlying transactions that have settled in the case that a net settlement was split and one of them has not settled.

3.4 Concluding Remarks It is anticipated that the historical account of the origin of CCP clearing helps demystify the modern CCP clearing mechanism. This does not, however, come without limitation, for CCP clearing is continuing to transform itself and evolves in order to serve the dynamic modern markets in which it is operating. By discussing the development of clearing mechanism, it is argued that CCP clearing is distinctively different from other types of clearing houses both in risks and in operations, despite the fact that they share a similar operational objective, namely, to increase the settlement efficiency. Furthermore, it is also argued that it is important that the role and functions of CCPs be clearly understood, for this is essential for creating an adequate legal and regulatory framework for CCP clearing.

73 European Central Bank defines CAP as: Quantitative limits on the funds transfer activity of individual participants in a system; limits may be set by each individual participant or may be imposed by the body managing the system. Limits can be placed on the net debit position and the net credit position of participants in the system.

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4 Legal Issues: The Key Relationships A well-founded legal basis is critical for the safe and reliable operation of a central counterparty, and for minimising the potential for financial system instability to arise from its operation. The operator of the central counterparty is responsible for identifying and minimising legal risk. The legal basis of a central counterparty includes its operating rules and written procedures, and contractual agreements between participants and service providers. These should be enforceable given the underlying legislative, regulatory and common law framework within which a central counterparty operates.1

T

HERE IS ALSO an urgent need for transparent statutory provisions to be introduced, as the case may be, in order to build and sustain a robust legal structure for CCP clearing operations and for the contractual provisions between the parties to be precise, straightforward and comprehensive.2 Indeed, ‘the market is entitled to expect the law … to facilitate the efficiency and stability of the market …’.3 The legal risk is characterised as ‘the risk of a loss occurring because of the unexpected application of a law or regulation or because of inability to enforce a contract’.4 Obviously, a transaction may be unenforceable in a legal system for a number of reasons. In order to minimise the likelihood of this happening, each party will look for certainty as to the validity of the transaction, the legal status of the counterparty, and the legal status of the consideration received. The same risks exist irrespective of where the transaction is entered into. However, where an element, such as the place of agreement, the consideration, or the counterparty is located abroad, the risks tend to appear to be greater due to a lack of familiarity with the foreign legal environment.

1 Reserve Bank of Australia, Financial Stability Standard for Central Counterparties—Guidance (May 2003), at: www.rba.gov.au/PaymentsSystem/StdClearingSettlement/central_counterparties_ guidance.html. 2 See Legal Framework, Clearnet (now LCH.Clearnet SA) 2002. Copy in author’s possession. 3 Financial Markets Law Committee, Issue 3—Property Interests in Investment Securities (Bank of England, July 2004), at 8 para 4.1. 4 See LCH.Clearnet SA, Types of Risks, at: 84.14.12.79/management/types_risks.asp.

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Legal Issues: The Key Relationships Moreover, the concept of CCP clearing was initially introduced to deal mainly with counterparty credit risk, as explained in Section 3.2.1, chapter three. One main legal risk which accompanies that clearing mechanism is that the procedures that have been developed to manage relevant risks are not supported by the law under which the CCP is operating.5 Suffice it to say, the rules and regulations of a CCP, which form the major part of the contractual framework between a CCP and its members, have gone beyond the contractual effect that binds only the counterparties to the contact. They have acquired the status of market rules in some markets and in some cases bylaw status.6 In other words, they have further implications for other participants in the markets such as clients of clearing members, which will be discussed in Sections 4.5 and 4.6 below. This also shows that it is essential that the law recognises the significance of the CCPs’ role in financial systems and provides the necessary legal framework to underpin their operations. One of the key objectives of establishing a contractual framework for CCP clearing is, as far as participants involved in the CCP clearing are concerned, to provide certainty and result predictability.7 From the perspective of parties, this is considered as one of the most important issues, especially in terms of legal risk mitigation. As some may suggest, the status and effectiveness of CCP clearing rules could be subject to legal challenges and cause uncertainty. Given the increasingly vital role of CCP clearing in a modern financial system, to repeat, it is crucial that there is an adequate legal framework available to support the requirements for robust CCP operations and recognise the status of the rules and regulations of the CCP in question. As just mentioned above, the rules and regulations of CCPs themselves as market rules may further acquire the status of bylaws.8 The starting point here is to identify the precise rights and obligations

5 Also see discussion on netting and set-off in Section 5.2, ch 5 below, and on default by a clearing member in Section 5.3, ch 5 below. 6 The legal status of CCP clearing rules and regulations may be regarded as bylaw in Common law countries like the UK, see RM Goode, ‘The Concept and Implications of a Market in Commercial Law’ (1990) 24(2) Israel Law Review 185–210. However, Sir Roy Goode later in his book on Commercial Law points out that ‘the status and effect of market rules and usages may be a matter of some uncertainty’. The key here is to distinguish those rules that are promulgated under statutory powers and those that are not. For the latter, ‘they can take effect only by express or implied contract’. See RM Goode, Commercial Law, 3rd edn (London: LexisNexis UK, 2004) 157. Also, see the UK regulatory regime in Section 6.3.2, ch 6 below. 7 See Committee on Payment and Settlement Systems (CPSS) and and the Technical Committee of International Organisation of Securities Commissions (IOSCO), Recommendations for Central Counterparties (Bank for International Settlements, November 2004). Recommendation 1: Legal Risk, 13–16. In general, this is similar to what legal documentations are trying to achieve in practice. See RC Tenekoon, The Law and Regulation of International Finance Student edn (London: Butterworths, 1991) 20. 8 For example, in the UK, see RM Goode (1990), n 6 above. Those rules and regulations, however, have rarely been tested in court. As some argue that this may lead some to raise doubt of their effectiveness in law. It is particularly so with respect to issues relating to collateralisation and default rules, as will be discussed shortly. See ch 5 below for the discussion on default rules.

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Introduction between participants in a CCP clearing system, namely, CCPs, clearing members, and clients of clearing members. This also is one of the main objectives of this chapter. As the Committee on Payment and Settlement Systems indicated, careful drafting of a CCP’s rule book and contracts to ensure that the obligations of a CCP, its counterparties and agents are clear and that laws of relevant jurisdictions support the application of its rules is an important tool for mitigating legal risk.9 Certainly, the effectiveness of CCP clearing will be put at risk if the legal framework is not robust and sound. Participants in the markets that carry out the business have built their relationships through a web of contracts on which their business relationships are based. This inevitably results in greater complexity of the law governing the relationships. The relationships between those participants in CCP clearing, right at the core of the markets, provide one of the best examples here. Suffice it to say, the essential legal framework for CCP clearing is mainly built upon various forms of contract, which includes clearing agreements, clearing rules and clearing regulations as well as the procedures.10

4.1 Introduction To complete a typical trade cycle in modern markets, transactions flow from trading to a CCP clearing system and to the relevant settlement system. Accordingly, they are to be governed at each stage by the relevant rules and regulations of each system. As far as rules and regulations are concerned,11 a line has to be clearly drawn between the time that trading rules apply and the time that CCP clearing rules apply, ie when the CCP enters the transactions through either novation or open offer.12 This is because different CCPs may have different arrangements that result in different times with potential risk differentiation; see the discussion on the significance of timing in Section 4.1.1 below. In case of an open offer, it may suggest that the time when a transaction is deemed to have been entered into with the CCP in question will have to be determined by the exchange/trading system rules. Where novation is used, the matter of whether or not a transaction is successfully novated is to be determined by the CCP clearing rules concerning transaction registration. As will be discussed below, either way, both of them are typically subject to conditions imposed by a CCP, such as 9 Committee on Payment and Settlement Systems, Recommendations for Central Counterparties (BIS, November 2004) 12, para 3.32. 10 As will be discussed shortly. 11 Rules and regulations of regulated exchanges and trading platforms as well as those of recognised CCPs and settlement systems are generally regarded as markets rules, and in some jurisdictions bylaw. See the discussion on regulatory issues in ch 6 below. 12 As mentioned in Section 3.2.3, ch 3 above, these two mechanisms are used for eligible transactions to be registered with or processed by a CCP.

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Legal Issues: The Key Relationships margin requirements and in some cases trading limit.13 As for those transactions that have been rejected by the CCP, they will then have to be settled mutually by the members themselves, ie, the original counterparties. In respect of an individual transaction that is to be processed through a CCP, certain original terms and conditions of that transaction may have to be amended, as they are subject to the rules and regulations of the CCP in question.14 In other words, the relevant rules and regulations of the CCP have overriding power over the original terms and conditions of the transactions. This is mainly to accommodate the mechanism of CCP clearing, once the transaction has been novated or, in some cases, through open offer, and as a result the CCP becomes a party to the transaction. As mentioned earlier, the rules and regulations of CCPs typically consist of the following: clearing agreements, clearing procedures and clearing regulations.15 Together, they form the major part of the legal framework for CCP clearing. In principle, a clearing agreement requires a member to agree that all transactions sent to the CCP will be processed exclusively according to the CCP’s rules. Clearing procedures set the procedures for market operations and every possible eventuality according to which each member of the CCP has to carry out their obligations. These procedures cover areas like member defaults and business continuity plans. As mentioned above, this chapter focuses on contractual relationships built through CCP clearing that form a major part of the legal framework on which CCPs operate. The relationships between parties involved will be examined. In this chapter, the contractual relationships between the clearing members and the CCP, those among clearing members themselves, between clearing members and their clients, and between the CCP and non-members accessing the services through a clearing member will be discussed in detail. The relationships between these parties have further implications for the relationships among other market participants down the chain. Therefore, it is important that a proper analysis be carried out. In this chapter, the relationship between clearing rules and trading rules will first be examined, before the general rules governing the acceptance of transactions by a CCP clearing system are looked at. This is followed by a detailed discussion of the key contractual relationships concerning various parties in relation to CCP clearing.

13 The amount of trades that a clearing member is able to process through CCP clearing is normally dependent on the financial collateral it has deposited with the CCP as initial margin. In some special circumstances, a CCP may decide to put a transaction limit on a particular member for the risk control purposes. Also see Section 4.1.2 below. 14 It is submitted that there is no possibility of conflicts between the rules of CCPs and other master agreements or rules of trading systems since the transactions that have been registered onto the CCP clearing system will automatically give the precedence to the rules of CCPs. In other words, there is an element of exclusivity in the rules of CCPs. For example, see LCH.Clearnet SA, n 2 above. 15 At least this is the case in LCH. Clearnet Ltd. In other CCPs, the rules and regulations may not necessarily be so clear-cut and follow the same layout but similar framework can be identified. For example, the rules and procedures of the National Securities Clearing Corporation (NSCC) in the US.

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Introduction

4.1.1 Trading Rules and Clearing Rules As just mentioned, transactions may flow from a trading system to a CCP clearing system and finally reach a relevant settlement system to complete the cycle. As a result, they are subject to the specific rules and regulations of the systems as they flow from one system to the other. This section focuses on the relationship between the rules and regulations of trading systems and that of CCPs.16

A. Trading In terms of market functions, the essential feature of a trading system, or an exchange, or a trading platform is to provide a mechanism for price discovery and matching, through either a bid-offer or quote system or a hybrid one,17 so that two parties can agree to a transaction. In a typical market, it is for the members of a CCP first to enter into a binding contract between themselves as a result of the transaction-matching excise. Where there is a CCP in the market and the parties also choose to use the CCP clearing services, the transaction in question is then to be routed to the CCP clearing system and then novated as agreed by the original buyer and the original seller, resulting in the existing contract being terminated and replaced with two new contracts. In law, novation is essentially more difficult to achieve than other transfer techniques such as assignment, due to the fact that if the novation is to be effective the consents of all parties to the old and new contracts must be obtained. In the markets, the requirement of counterparty consents is satisfied by means of contractual stipulation in advance. Here, the use of novation does provide some distinct advantages that are valuable to the markets. They are: ‘to reduce risk; to eliminate performance under intermediate contracts in a chain; and to facilitate disintermediation and the off-loading of unwanted assets and liabilities’.18 As will be discussed shortly, there is a timing issue, namely, when the original contract is terminated and when the contracts between the CCP and its member come to life. In the case that novation is used, it is usually assumed that the time is when the transaction is accepted and registered in the CCP clearing system. In 16 The issues related to the relationship between the rules and regulations of settlement systems and that of CCPs are omitted since similar analogy can be drawn from the discussion in this section. As far as settlement systems are concerned, CCPs mainly concern themselves issues like settlement finality and bankruptcy laws that are applicable to the settlement system in question. 17 New York Stock Exchange completed their phase 1 for their hybrid trading system in April 2006. See press.namct.com/content/view/5989/139/: ‘The NYSE Group has completed the first phase of the NYSE Hybrid Market with the addition of 2,703 NYSE listed issues in a matter of two days, this is a phase that commenced back on December 15, 2005. Features of the Phase I included e-Quotes, c-Quotes, s-Quotes, g-Quotes, reserves and layering of quotes among other functionality. Phase II implementation will begin shortly and will give specialist the ability to narrow spreads and provide price movement electronically for the first time. This will change the scope of trading on the floor as we know it’. 18 RM Goode (1990), n 6 above. Also, see the discussion on netting in Section 5.2, ch 5 below.

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Legal Issues: The Key Relationships other cases where the exchange/trading platform and the CCP have the arrangement of the so-called ‘open offer’ in place, there is no substitution issue and no need for novation, since there is no contractual relationship between the buyer and the seller.19 In this situation, it would normally be assumed, though inexplicit, that the designated CCP becomes the counterparty to the seller and the buyer as soon as the transaction has been agreed. It follows that this open offer mechanism is assumed to have been embedded in a trading system, and as a result, the contractual relationship between the CCP and the buyer, as well as that of the CCP and the seller, are established as soon as the price has been agreed.

B. Trading/Exchange Rules v CCP Clearing Rules In practice, it may be the case sometimes that the extent to which trading rules continue to apply to transactions that go to CCP clearing or the time when clearing rules come into effect are not clearly defined under relevant rules. This is not normally specified in either the rules and regulations of exchanges/trading systems, or those of central counterparties. Unless otherwise specified, the assumed time at which the CCP clearing rules apply may be the time that a transaction’s registration to the CCP system is accepted. Technically speaking, a system interface20 is typically designed to administer all transaction instructions that are sent from members to the CCP. As a result, members will be notified if one of their transactions has been rejected for not satisfying the conditions prescribed in the rules and regulations as the case may be. For example, it may also be the case that the transaction was sent after the system’s cut-off time.21 In the United States, however, where there is also no clear definition of when clearing rules apply, the issue may be further complicated by the fact that the National Securities Clearing Corporation (NSCC) also provides comparison and transaction recording services,22 since transactions that are not matched cannot be processed further to the next stage, namely, CCP clearing. Doubts may also be raised as to whether the time is when the registration of the transaction is accepted by the system, ie, the CCP clearing rules apply at the stage of transaction-matching.23 In the United Kingdom, the CCP LCH.Clearnet Ltd does

19

For example, this is the case in London Stock Exchange. See Section 4.1.2 below. To put it simply, a system interface is a programme of CCP clearing system that designed to communicate with its members systems and receiving transaction data from the members. 21 A system cut-off time is a specified time before which the transactions have to be received for processing to begin in that cycle. As there are normally more than one cycle during the day, there may also be separate different times. See Section 4.1.2 below on conditions for trade acceptance. Also see CCP clearing operations in Section 3.3, ch 3 above. 22 Rule 5, Rules and Procedures of the NSCC, as of 15 September 2005. 23 If that is the case, the risk of transactions being unmatched for settlement is upon the CCP as a counterparty to the transaction. Where in the UK, the CCP LCH.Clearnet do not bear any risk of that kind since it is a requirement of transaction registration that the settlement instructions for the transaction have to be matched before they are sent to the CCP. 20

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Introduction not provide transaction-matching services. Therefore, it may be feasible to determine the timing at which the transactions are subject to the rules and regulations of the CCP.

C. The Timing Issue The time at which the substitution of the CCP as counterparty occurs is significant in law. For both clearing members and CCPs, the time at which the substitution of the CCP as counterparty to the transactions occurs is a critical issue, as it determines when the CCP becomes the counterparty and assumes the rights and obligations to the transactions.24 It also determines the changes of applicable rules to the transaction in question. This is especially relevant in the event of a member’s default.25 Furthermore, it is also relevant when the netting is commenced, although this may be a matter of contractual construction and interpretation.26 Ultimately, the timing very much depends on the rules set by the CCP in question as well as the mechanism it uses.27 As pointed out above, it is provided in some CCPs’ rules that substitution does not take place until a transaction is matched and until it has been registered with or accepted by the CCP clearing system. As a result, unmatched/unregistered transactions remain, in principle, the responsibility of the counterparties involved, subject to the rules of the exchange. 24 It was also emphasised in the Committee on Payment and Settlement System’s Clearing Arrangements for Exchange-traded Derivatives (Basle, Bank for International Settlements, March 1997), ‘A critical issue for both clearing members and the clearing house is the time at which the substitution of the clearing house as counterparty occurs. The rules of some clearing houses provide that substitution does not take place until a transaction is matched or until it has been registered on the books of the clearing house. Under such rules, unmatched (or unregistered) transactions are, in principle, the responsibility of the counterparties involved, subject to the rules of the exchange and the exchange’s arbitration procedures. In many cases, however, market participants may not be able to utilise the most basic protection against the counterparty risks that accompany such responsibility, that is, the ability to avoid trading with counterparties that they view as uncreditworthy; to maximise market liquidity and to ensure that client orders are treated fairly, exchanges often require transactions to be executed at the best price available, regardless of the creditworthiness of the counterparty. In the event of default by the counterparty, a CCP could well make a business decision to assume the obligations arising from all transactions that were ultimately matched, even if substitution had not occurred prior to the default. Still, when a clearing house’s rules allow it to decline to be substituted, it is apparent that the clearing house is preserving the option to force the counterparties to bear any counterparty losses on such transactions. Although improvements in the speed and accuracy of transaction matching and registration systems have diminished such direct exposures to counterparties, the timing of substitution of the clearing house as central counterparty continues to have important implications for the distribution of counterparty risks between the clearing house and its clearing members’. 25 See further discussion in Section 5.3, ch 5 below. Also see M Chamberlain, ‘The Legal Framework within which UK Exchanges and Clearing Houses Operate’ (Jan 1997) 4 European Financial Services Law 20–24. 26 See RM Goode (1990), n 6 above. 27 As mentioned in previous sections, there are two methods in use: novation and open offer. Novation is the most common one.

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Legal Issues: The Key Relationships As mentioned earlier, the significance of these two different mechanisms is that the timing of the application of the rules and regulations of the CCP varies depending on which mechanism is used. Furthermore, the timing is also significant in the way that it may affect the netting positions. As for a CCP, it may be a common way to process all the transactions with netting on the due settlement date just before a settlement cycle is available in the settlement system.28 However, it may be so construed contractually that there is a retrospective effect, so the time of netting is deemed to be at the time when the transactions have been registered with or accepted by the CCP clearing system. This is indeed significant in the case of a member’s default where the positions of members have to be determined according to the transactions to which the CCP is legally the counterparty.29

4.1.2 The Conditions for Transaction Acceptance/Registration As mentioned earlier, certain conditions have to be met before a transaction can be registered or accepted by a CCP clearing system. It is also the step when additional terms are added into the contract for a transaction that is to be cleared by the CCP. Most important of all, both the counterparties to the transaction that is to be registered onto the CCP clearing system must be members of the CCP and have agreed to process through the CCP clearing.30 In addition to that, before a transaction is registered with and confirmed by a CCP, it has to satisfy several conditions typically imposed by the CCP. First, the transaction must be among the types of transactions that are eligible for CCP clearing. Secondly, the instructions for the transaction must be matched prior to being sent to the CCP’s registration system. Last, but not least, there must be enough collateral in the account of the members as counterparties to the transaction at the time specified by the CCP. Apart from the mentioned conditions, a CCP, for reasons of maintaining a degree of flexibility, may reserve the right to introduce any other new conditions that it deems to be necessary measures in respect of a particular member, even without giving a reason. A CCP also typically reserves the right to decline transactions, namely, to prevent itself from being interposed as the substituted counterparty as an exception. In normal circumstances, this right is triggered by certain prescribed events as follows: (a) a clearing member, by registering a transaction, may breach the trading limit imposed by the CCP, or (b) the margin level may be insufficient 28

For CCP clearing operations, see Section 3.3, ch 3 above. Also see Section 5.3, ch 5 below for default procedures. 30 For example, LCH.Clearnet Ltd, in its Clearing House: General Regulations (April 2010), states that ‘[it] shall not register an original exchange contract … in the name of a Member unless such contract has been confirmed … by or on behalf of a Member as a buyer and a Member as a seller who thereby have consented to such contract being registered in his name’ (Regulation 9: ‘Registration’, para (a)). 29

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Introduction for the additional transaction(s) to be registered on the system. In some special situations, a CCP may also (c) decline to accept the transactions on the grounds of its own protection or the protection of the market.31 This gives, as argued, the CCP greater flexibility to manoeuvre, especially in some highly unlikely events as well as at times when the markets are volatile. Among others, the margin requirement is one that is most closely associated with the conditions for transaction registrations. In order to register new transactions to a CCP clearing system, members are normally required to furnish it with cover for initial margin.32 In the United Kingdom, the CCP LCH.Clearnet Ltd for the London Stock Exchange also provides a mechanism called ‘open offer’33 in addition to the normal process through novation.34 mentioned in chapter three, this open offer mechanism establishes the contractual relationship between the CCP and the buyer and that of the CCP and the seller, and it is deemed that no relationship ever existed between the buyer and the seller that have their transaction orders matched via the Exchange. Hence, there is no need of novation. However, the rules of the exchanges do not normally set out exactly what will happen if the transaction, for whatever reason, has been rejected by the CCP later.35 Since no contract between the buyer and the seller ever existed, the question arises whether the rejection by the CCP will automatically form a contractual relationship between the buyer and the seller with respect to the transaction in question. It is important for a CCP to make the rules in this regard absolutely clear and for the participants to abide by them to eliminate uncertainty or abuse. For instance, there may be fears that a CCP may exploit the option it preserved in the rules and regulations of declining the transactions, to force the counterparties to bear any counterparty losses on the transactions in question as the result of the transaction not being able to be processed through the CCP. Furthermore, the exact ways in which the transactions are to be handled in case they have been declined by the CCP may be unclear, as pointed out earlier. Issues also have to be clarified as to what the precise responsibilities of the two original counterparties are with respect to the rejected transactions. For example, what are the rights of the original counterparty when a transaction is not accepted by a CCP due to the other original counterparty? This may be a matter to be decided according to the

31

Regulation 9 of Clearing House: General Regulations of LCH.Clearnet Ltd (April 2010). See Regulation 12: ‘Margin and Cover for Margin’ of LCH.Clearnet Ltd’s, Clearing House: General Regulations (April 2010). Also see ch 3 for discussion on collateral. Furthermore, this also explains the reason that members tend to leave excess collateral with a CCP as discussion in ch 3 above on operations. 33 The open offer mechanism is stipulated by market rules. 34 Here, it is worth noting that novation is treated differently by civil law and common law. In civil law, novation of contracts in simplest sense is regarded as same contract with a third party replacing one of the counterparties to the contract. In contrast, the result of novation in common law is the original contract is replaced by a new one and ceased to exist. 35 Eg the Rulebook of London Stock Exchange stops short of setting out the rules on such eventuality. 32

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Legal Issues: The Key Relationships rules of the relevant exchange or trading system. Where there is no such rule, the matter will have to be resolved by the original counterparties.

4.1.3 The Results Irrespective of what terms the original parties may have agreed to, which cover the transactions at the time of trading, they normally agree that the transactions are to be subject only to the rules of the CCP when submitting the transactions to, and requesting acceptance by, the CCP.36 The effect is that the economic terms of those transactions that have entered into the CCP clearing system remain intact. Furthermore, it is suggested that there is no possibility of conflict between the CCP rules and other transaction agreements, ie, the rules and regulations of trading systems and settlement systems to which the transaction may have been subjected.37 As a result of the application of CCP clearing rules, there are some privileges38 granted to the CCP in areas such as imposing additional margining requirements and some special arrangements39 for transaction settlement to facilitate smooth CCP clearing operations. Besides the terms and conditions contained in the original transactions, some additional terms may also be imposed from the time when a CCP is interposed between the original counterparties.40 These terms are governed by a separate agreement between the CCP and its members, which also determines the conditions of a CCP becoming the counterparty to its members’ transactions. For those transactions to be processed through CCP clearing, the rules and regulations of the CCP take effect and apply to the rest of the life of the transactions.41 It is also worth noting that certain restrictions on the CCP’s obligations and liabilities, which are likely to be included in its rules and regulations, may also be imposed on the transactions.42

4.2 Overview of the Key Relationships From a trading perspective, a transaction in the markets may typically involve several different intermediaries, as an order is initiated from an end investor, and 36

See, for example, the rules and regulations of LCH.Clearnet Ltd in the UK. For example, it is explicitly stressed by the London Stock Exchange that there is no possibility of such conflicts. In any unlikely case, it is argued that the rules of the CCP clearing systems take the precedence. 38 These privileges are referred to in the additional terms added to the contracts by the CCP clearing rules and regulations. See the discussion in Section 4.3 below. 39 See Section 3.3, ch 3 above for the arrangements for CCP clearing operations. 40 See Section 4.3 below. 41 On the other hand, for those transactions that either failed to, or were not chosen to register onto the CCP clearing system, the market trading rules apply. 42 To be discussed in Section 4.3 below. 37

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Overview of the Key Relationships this causes a chain reaction, as it were, through which a lower-tier intermediary instructs his upper-tier intermediary to transact until the one that executes the order in the market. In this case, there may be a double or treble agency or more. In general, it is submitted that the economic benefits resulting from the transactions will consequently shoot through to the end investors. In that respect, the lower-tier intermediary is acting as the agent of the end investor and the upper intermediary as the agent of the lower intermediary, and so on and so forth. Therefore, it is suggested that there may well be at least three agencies under which each intermediary acts in his own name and is liable for the transaction towards the person he deals with. The resulting benefits, nevertheless, are for his undisclosed principal and will ultimately be passed to the end investor.43 As also mentioned in chapter two, modern markets are typically structured through various tiers of contractual relationships. At the core of these relationships between market participants is the contractual relationship of CCPs and their members, which has a sequential effect on the relationships between parties further down the chain, as will be examined in the sections below. The relationships between parties directly involved in CCP clearing first include that of the CCP itself and its members/direct participants.44 It is, however, necessary to go beyond these directly involved parties and include the clients of those CCP members. Accordingly, the analysis here will focus on these first- and second-tier relationships, ie, that of CCPs and their members, and that of clearing members and their clients. This may, at first glance, suggest a tripartite relationship as far as

43 In the context of CCP clearing, however, it is not clear whether the benefits that are derived from processing transactions through CCP clearing, the resulting cost-savings in particular, are to be passed down the chain at all. Arguably, the end benefits that are to be passed down the chain may not include all the benefits. Take collateral as an example. For some, they may not require the clients to deposit collateral. But for others who require collateral from the clients, it is not clear if their clients actually receive any benefit at all resulting from the off-setting of collateral at CCP level. Also see Section 7.1.2, ch 7 below for a general discussion on the advantages and disadvantages of CCP clearing from members’ perspective. As a feature of transactions offsetting through CCP clearing, the greater the number of transactions that are going through CCPs, the better the chance of offsetting and the greater the cost savings (See the mechanism of CCP clearing in Section 3.1.3, ch 3 above). Therefore, clearing members that have large trade volumes with many clients are likely to benefit the most from CCP clearing. As to an individual client, especially those with limited volume of trades, the chance of offsetting may not be as great as its intermediary’s. This is also true for those lower-tier intermediaries compared with the upper-tier intermediaries. At the top tier, clearing members normally aggregate all the client’s transactions in a single client account in a CCP and this is likely to maximise the benefit of offsetting. As a result, clearing members are more likely to maximise the cost savings. Therefore, it may be necessary here to distinguish those benefits resulting from the transactions from those arising from CCP clearing. 44 Direct participants are mainly referred to all members of a CCP, but a typical membership structure for a CCP includes different types of members. For example, there is so-called Non-clearing member and general clearing members, both of them are direct participants of the CCP. Non-clearing members are firms that do not acquire clearing member status nevertheless by entering a special agreement with the CCP they can access the services. Compared with general clearing members, they may have to meet different criteria in order to enter the agreement with the CCP and acquire such status. See discussion in Section 4.3 below.

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Legal Issues: The Key Relationships these parties are concerned and may subsequently attract the application of other branches of law apart from contract law, such as general agency law. Certainly, agency law has played a significant part in developing and shaping those contractual relationships, especially in modern, highly intermediated markets, given the fact that CCP clearing relationships have been developed on the basis of the existing legal framework. Arguably, it is considered that the application of the general law of agency in CCP clearing relationships has been substantially modified by clearing agreements and the rules and regulations of CCPs as required for them to perform market functions, ie managing counterparty risk and other associated risks. The result is that the application of agency law in these clearing relationships, at its best, may not have the same result as it would otherwise have in other cases. Specifically, the principal-to-principal relationship between a CCP and its members is imposed as market rule with respect to transactions processed through CCP clearing. It was also intended that no resulting relationship should be established between a CCP and clients of its members or non-members in any circumstance. Consequently, this may lead some to suggest that the implication is to rule out the application of agency law completely in respect of the relationship between CCPs and their members.45 Given that the contractual arrangements for CCP clearing have been developed under the existing legal framework, it may be helpful first to look at the law of agency. In principle, the analysis of agency law46 has traditionally been based on two important factors: first, the analysis is largely divided into the internal and external relationships between the three parties involved, namely, between the agent and the principal, the agent and the third party, and the principal and the third party.47 The external relationship between the agent and the principal has binding effect on the internal relationship, from an agency law perspective, as an exception to the traditional agency principle of, ‘he who acts through another is deemed in law to do it himself ’. Secondly, the analysis is based on whether the principal is disclosed or not whereby upon disclosure the direct relationship between the principal and the third party is established. Under common law, whether or not the undisclosed agent has had the intention to act for its principal is also a factor to be considered.

45 An approach adopted by the UK to resolves the complication caused by this external and internal agency relationships is to adopt the mandatory rules that rules out any agency transactions that can be registered for CCP clearing. In addition, any agency transaction that has been registered will require the original clearing member (A) to be replaced by another clearing member (B). As a result, the clearing member A acting as an agent for its own client will establish a principal-toprincipal relationship between his client and clearing member B in respect of that transaction. As far as the CCP is concerned, an equal and opposite transaction is between clearing member B with him, rather than clearing member A. See Rules 5201 and 5231 of the London Stock Exchange Rulebook (April 2010). 46 See F Reynolds et al, Bowstead and Reynolds on Agency, 18th edn (London: Sweet & Maxwell, 2005). Also see JH Dalhuisen, Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law, 3rd edn (Oxford: Hart Publishing, 2007) 430–46, for detailed discussions on this matter. 47 JH Dalhuisen (2007), n 46 above, 433.

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Overview of the Key Relationships The general principle of agency law prescribes that an agent is not liable for the acts or contractual commitments of its principal upon disclosure.48 In common law, this has been substantially modified by rules of industry organisations, as is particularly the case in financial systems.49 The general law of agency also allows a third party to explicitly exclude a principal from having any rights under the contract made with an agent.50 As a result, an agent will be acting as principal with respect to that contract. Some have suggested that a chain of contracts is thus formed with two back-to-back contracts: one between the agent and the third party, and the other between the agent and the principal. In the case of CCP clearing, it would be a contract between the CCP and its clearing members from the external perspective of agency and as a mirror contract between the clearing member and its client from the internal perspective of agency.51 It is submitted that, in this way, the interests of the client should be protected in the event of the clearing member’s insolvency. As a result, the CCP will not have to deal with the clients of its clearing members directly. Yet, the internal aspects of the relationship between the clearing member and its clients may not be as simple, as will be discussed in Section 4.5 below. On the other hand, it is also perceived that a person who acts in his own name vis-à-vis a counterparty does not prevent an agency in respect of the principal of that agent, for this can be seen as an undisclosed agency. The benefits resulting from the transactions could still shoot through to the client. In that respect, however, it is suggested that here the issue of the principal being disclosed or undisclosed is less relevant. Put in the context of CCP clearing, whether or not the principal is disclosed may be less relevant also, for this will not change the requirement of contract as principal by CCPs in any way. In other words, whether the principal is disclosed or not does not change the principle of CCP clearing that no direct contractual relationship is to be established between the CCP and its members’ clients, as is typically a CCP clearing requirement. This is so despite the fact that the members act in their own names between the CCP and its clients and for their own account and risk. Consequently, it is intended that clients of the members have no contractual rights against the CCP whatsoever.

48

HG Beale (ed), Chitty on Contracts, 29th edn (London: Sweet & Maxwell, 2004) vol 2, 57. An example for this can be found in the UK with respect to self-regulatory organisations. See Section 4.3, ch 4 below for the discussion. 50 See HG Beale (ed) (2004), n 48 above, vol 2, 54. 51 Also see JH Dalhuisen (2007), n 46 above, 430–46 for the discussion of the internal and external relationships of agency. 49

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Legal Issues: The Key Relationships

4.3 The Relationship Between CCPs And Their Members The rules that govern the relationship between a CCP and its members include first the trading rules, and secondly the clearing rules that eventually supersede the terms and conditions of underlying transactions to the extent that those rules are applicable. As for CCP clearing, the principal-to-principal requirement is also one of the main features that distinguish a CCP from other merely administrative clearing houses,52 since the nature of the relationship between a CCP and its members is principal-to-principal with respect to transactions being processed. In contrast, the relationship between those operators of administrative clearing houses and their members is not of that nature. Primarily, a CCP is to fulfill the obligations under the terms of the transaction in question as counterparty to each of its members. They are carried out in accordance with the provisions of the CCP’s rules and regulations and are subject to restrictions contained in them.53 Notably, it is submitted that the benefits of the performance by the CCP of those obligations are typically conferred only upon its members as principals. This means that any right or benefit of the performance is restricted only to the CCP and each of its members. With regard to the enforcement of the rules and regulations, the rights of third parties are also explicitly to be excluded in the regulations. As a result, a CCP or its members may not confer any benefit on, or give any right to enforce any provision of the regulation or any of the other regulations to, any person who is not a member, which also includes clients of a clearing member. In general, the restrictions on a CCP’s obligations and liabilities may vary depending on the type of contracts as well as on the type of market systems. Nevertheless, there are restrictions on a CCP’s liabilities,54 as they are commonly imposed in the form of the CCP’s rules and regulations. For instance, a CCP shall not be liable in respect of a claim made against it regarding a delivery contract by a member concerning the tender given by the CCP or the performance of the CCP’s obligations. A CCP also normally imposes exclusion of liability, for

52 As discussed in Section 2.1.1, ch 2 above, there is no central counterparty as such in some administrative type of clearing houses such as cheque clearing organisations and payment systems. Therefore, the contractual arrangement in that kind of systems is multilateral whereby each member of the clearing system contracts with the others with respect to the cheques concerning that member. 53 Regulation 1, Clearing House: General Regulations. LCH.Clearnet Ltd (April 2010). 54 For instance, in the UK, s 291 of Financial Services and Markets Act 2000 provides the restriction on CCPs’ regulatory functions. ‘Regulatory functions’ are defined in the section as ‘the functions of the recognised body so far as relating to, or to matters arising out of, the obligations to which the body is subject under or by virtue of this Act’. Also see further discussions on regulatory issues in ch 5 below.

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Between CCPs and Their Members example, in respect of those resulting from external events like temporary market closure. It is stated in the regulations of LCH.Clearnet Ltd in the United Kingdom that [a CCP] shall not have any liability whatsoever to any Member or any other person … in contract, tort (including, without limitation, negligence), trust, as a fiduciary or under any other cause of action in respect of any damage, loss, cost or expense of whatsoever nature suffered or incurred by a Member or any other person …55

Nonetheless, not all liabilities of CCPs can be excluded altogether; for instance, a CCP cannot exclude any liability for any fraud or willful default on the part of the CCP. Similarly, the primary obligation of members of a CCP is to meet the obligations under the terms of the (open) contracts in question as counterparty. To maintain sufficient financial resources and robust operational capacity to meet obligations arising from participating in the CCP, a CCP typically has arrangements in place to ensure, on an ongoing basis, that membership requirements are met by each member and that every member is sufficiently solvent with respect to its transaction positions with the CCP. This is achieved partly by having financial collateral arrangements in place—also called margin requirements—whereby each clearing member is obliged to place a sufficient amount of collateral determined by the CCP in accordance with the rules and procedures. As the case may be, when the CCP may deem it necessary to obtain detailed information of the client positions of a particular clearing member, the member is also obliged to provide it. Indeed, another important obligation of clearing members is that they must waive the right to invoke professional secrecy; namely, they must not invoke professional secrecy obligations to refuse inquiries by the CCP regarding the clients of members. As noted above, different CCPs may administer their membership structures differently,56 but all have a common goal of subjecting their members to adequate counterparty credit risk management. Hence, different members may be found to have different member statuses within the same CCP. However, this should not confuse us with respect to the cleared transactions themselves from a contractual standpoint. The key here is that in contract, each member of a CCP is regarded as counterparty to the transactions for his own account. As explained in chapter three, a single transaction is split into two equal and opposite contracts resulting from the CCP clearing mechanism. Even though each of the two original counterparties to the transaction may be subject to a different CCP membership status, this factor will not affect their contractual rights and obligations towards the contracts with the CCP in question, and these rights and obligations, with 55

Regulation 39, para (a) of LCH.Clearnet Ltd’s Clearing House: General Regulations (April 2010). For LCH.Clearnet Ltd, there are clearing member status, dealer status and non-clearing member status. The main difference between these members are different initial margin requirements are set differently. There are only two types of members: members and non-clearing members in the NSCC in the US. 56

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Legal Issues: The Key Relationships respect to the transactions, should be identical as far as the two original counterparties as members are concerned. Nonetheless, the contractual relationships between CCPs and their members/ direct participants are not different from those that have been derived from the original transactions between the clearing members as original counterparties in economic terms. To that extent, those terms are intact. Typically, the rules and regulations provide a CCP with some privileges57 that counterparties to a transaction would not normally have if the transaction were to be settled mutually instead. This is primarily to facilitate risk management requirements,58 as well as the smooth operations of CCP clearing.59 In doing so, some additional terms have been added into the contracts, as agreed between the CCPs and their members, in the form of the CCP’s rules and regulations. In principle, they serve as additional terms and conditions to the contracts for the transactions that entered into CCP clearing. Typically, members of a CCP,60 1.

2.

3.

Agree to follow the CCP’s rules and regulations; The rules and regulations set out the framework for CCP clearing operations, which also cover the procedures from membership administration, to membership monitoring, to specific operations for a particular type of financial contract,61 to margin requirements and default events. Agree that they will notify the CCP, with specified notice periods, of material changes in their circumstances, of insolvency, or loss of authorisation to transact; Even though there is a membership monitoring programme carried out by the CCP, this rule will ensure that the CCP is to be informed in advance of certain material events that may affect the financial soundness of its members. Moreover, this provides the CCP with the advantage of acting promptly in the case of an event that is likely to cause members difficulty or possibly result in default and allows it to take measures as it deems necessary, even before the default is declared. Agree to contract with the CCP as principal; The contractual requirement of contracting as principal is central to the objective for the CCP clearing operations, ie, to manage counterparty risk. This obliges a CCP to make the effort to contain the risks to the limited number within its reach, namely, its members. The effect of this contractual

57 For example, in a settlement system without DVP arrangement or in the commodities markets that require physical deliveries, a CCP will normally have the right to receive the bargain prior to the delivery or vice versa. 58 As part of risk management measures, set-off and netting between principals are relatively simple and straightforward compared with those involved third parties with agency issues. 59 For clearing operations, see Section 3.3, ch 3 above. 60 A Lamb and E Swan, ‘United Kingdom: the Role of the London Clearing House’ (1996) 3(3) Futures & Derivatives Law Review 9–22. 61 For example, there are separate rules and procedures for swaps transactions and for securities repos.

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Between Clearing Members Themselves agreement is to displace the application of agency law that may arise when members are acting as agents for their clients. Agree the obligations of the CCP in respect of transactions registered with it; Compared with dealing with normal counterparties, members are expecting to give certain privilege with regard to its contractual obligations as counterparty to the transactions. Agree to a confidentiality agreement that allows the CCP the discretion to provide relevant information to financial regulators or those that have legitimate reasons for inquiry. The fact that a CCP helps bring more transparency into the markets is also reflected here, whereby a CCP has the right to disclose information regarding its members to relevant authorities. Also, see discussion on the benefits of CCP clearing in Section 7.1, chapter seven below.

4.

5.

4.4 The Relationship between Clearing Members Themselves As far as the original counterparties to the transactions are concerned, all the contractual rights and obligations between them, ie clearing members, are extinguished at the time of novation. In case of open offer, they have never come into existence, as it is deemed that there was no contract between the original counterparties. In other words, it is for the integrity of the CCP clearing mechanism that no contractual relationship between the original seller and buyer is in existence upon registration and acceptance by the CCP. This means that among CCP clearing members/participants, each of them is contractually isolated from the others in such a way that they only have rights against and obligations towards the CCP under those open contracts resulting from the CCP clearing mechanism. The principal-to-principal relationship is established between the CCP and each of its members respectively so far as the cleared transaction is concerned. Through the mechanism of novation, as is often the case, the original contractual relationship between two counterparties as members is short-lived, namely, from the time that the transaction was matched and confirmed on exchange or trading platform to when it has been registered onto the CCP clearing system, ie novated. In other words, it means that once a transaction has been novated, the contract between the original buyer and seller regarding the transaction in question is terminated and ceases to exist.62 There is, therefore, no contractual relationship between the two original counterparties themselves any more. Alternatively, through open offer, the CCP steps in as soon as the price is matched 62

See Section 4.1 above.

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Legal Issues: The Key Relationships on the exchange/trading platform and the transaction is deemed to be with the CCP, who contracts as the seller to the buyer and as the buyer to the seller. It is deemed here that the original seller and buyer have never formed any contract with regard to the transaction. Hence, there is no contractual relationship established between clearing members in that respect. Nevertheless, the same result is achieved through these two mechanisms; namely, the CCP is interposed between the original seller and buyer. In terms of risk management, this achieves the definite transfer of counterparty credit risk from the original counterparty to the CCP, an essential mechanism for achieving the objective of CCP counterparty credit risk management. Alternatively, the relationships between clearing members themselves can also be understood in the way that the contractual link between two clearing members arising from the original contract has been cut off once a CCP steps in and is acting as the central counterparty. Nonetheless, it should be noted that as members of the same CCP, they do share some common rights and obligations according to their CCP clearing agreements and under the rules and regulations of that CCP. Furthermore, as members of the same CCP, clearing members do share some common responsibilities with regard to the CCP clearing operations as discussed.63 Therefore, it may be right from this perspective to suggest that the relationship between clearing members is thus at best indirect.

4.5 The Relationship64 Between Clearing Members and their Clients It is submitted that the relationship between clearing members and their clients in general may not always be clear-cut: in some cases, the relationship between clearing members and their clients is principal-to-principal, but in other cases, it is characterised as an agency relationship.65 The fact that clearing members are required to act as the counterparty to the transactions vis-à-vis a CCP may play a role here, at least for those transactions processed through CCPs. It is also necessary to note that the end parties to a transaction are of importance in the sense that they determine the way transactions are to be processed, ie, whether or 63

See discussion in Section 4.3 above on the relationship between CCPs and theirs members. There are substantial amount of literature contributing to this area in the US, the liability of the clearing firms in particular. See HF Minnerop, ‘Clearing Arrangements’ (May 2003) 58 The Business Lawyer 917–60; HF Minnerop, ‘The Role and Regulations of Clearing Brokers’ (May 1993) 48 The Business Lawyer 841–68; WJ Fitzpatrick and RT Carman, ‘An Analysis of the Business and Legal Relationship between Introducing and Carrying Brokers’ (1984) 40 The Business Lawyer 47–67; and JM Bellwoar, ‘Bar Baron at the Gate: An Argument for Expanding the Liability of Securities Clearing Brokers for the Fraud of Introducing Brokers’ (1999) 74 New York University Law Review 1014–56, to name a few. 65 Committee on Payment and Settlement Systems, Clearing Arrangements for Exchange-traded Derivatives (Basle, BIS, March 1997) 12. 64

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Between Clearing Members and Clients not it is through CCP clearing. This is one of the major factors to be considered in determining whether the CCP principal-to-principal requirement applies to those transactions. The key is that the exact nature of the legal relationship between a clearing member and its clients depends on the contractual provisions. Here, it is therefore necessary to distinguish the type of clearing services66 that clearing members provide to their clients. In managing the accounts for their clients, clearing firms acting as intermediaries clear and settle transactions for them. Clearing members often serve as intermediaries in their provision of clearing services to their clients, which may include individuals, the so-called introducing firms and firms that have no direct access to CCP clearing. For that purpose, transactions here are typically divided into two types: the so-called street-side transactions and customer-side transactions.67 As far as the customer-side transactions are concerned, they are not subject to the CCP clearing rules when they are not processed through CCP clearing. As for the processing of transactions, customer-side transactions can be internalised and there is no need for them to be processed through CCPs and sothey have no effect on the clearing firm’s external accounts. In such cases, the clearing firm is acting as agent for both of his clients since both of their accounts are maintained by the same clearing firm. In this section, the focus will also be on the legal relationship between the clearing arrangements at the two different tiers; namely, that of CCPs and clearing members, and that of clearing members and their clients.

4.5.1 The Nature of the Relationship Modern CCP clearing process is book-entry account-based. Each clearing member has at least one account with the CCP clearing system for the purpose of transactions processing.68 In the case of a clearing member acting for himself as well as for his clients, separated accounts are to be set up with the CCP in the name of protecting the clients’ assets. Typically, client transactions of the same clearing member are processed through a special client account held within the clearing system. However, the type of the accounts here has no role in determining the relationship between the CCP and its clearing members. In principle, a CCP deals with its clearing members exclusively on a principal-to-principal basis, as mentioned earlier. In relation to those transactions that are processed through a CCP by clearing members for their clients, the impact of the CCP clearing 66 As has been observed in ch 3, CCP clearing is distinctively different from other types of clearing, which includes those that do not process through CCPs. 67 They are US jargons. See HF Minnerop, ‘Clearing Arrangements’ (May 2003) 58 The Business Lawyer 917–60, 927. 68 It should be noted that some clearing members may have several accounts with a CCP. For example, a clearing member of LCH.Clearnet may have one house/proprietary account and one or more client accounts.

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Legal Issues: The Key Relationships arrangement on the legal relationship between clearing members and their clients, nevertheless, should not be overlooked.69 In a modern market, a client is able to either have a sole intermediary taking care of the whole process of the transaction or choose a transaction to be executed by one intermediary and processed by the other. To put it simply, the fact that different stages of transactions can be handled by different parties makes the contractual relationships between those involved ever more dynamic. The complex nature of the legal relationship between clearing members and their clients also results from the various ways that clients can choose to handle their transactions.70 Depending on the type of orders, a transaction that is executed by a clearing member for its client can be done either as agent or as principal for that client. In general, it is fair to say that the exact nature of the relationship between clearing members and their clients is largely determined by the contract between them and other mandatory regulatory obligations71 that clearing members owe to their clients as service providers. For transactions that are processed through the books of the clearing member internally, that clearing member acting as party to the transaction for one of his own clients simultaneously acts as the counterparty, ie as principal, to the transaction for the other client. There are conditions attached to such an arrangement, which include, that no conflict of interests arise, and that the clearing member acts within his obligations to his clients and without breaching his regulatory duties.72 Here, it may be argued that some principles of agency law nevertheless apply to the relationship between clearing members and their clients in processing the transactions, as in the form of regulatory protections.

4.5.2 The Relationship between the Two Different Clearing Arrangements In CCP clearing, the clearing arrangement between a CCP and clearing members (first-tier) implies that the arrangement between clearing members and their clients (second-tier) will ultimately be affected. This is particularly the case when some of the terms in the first-tier clearing arrangement—such as the requirement of contract as principal—are recognised as market rules or even bylaws, as mentioned at the beginning of the chapter. Given the close relationship between these two clearing arrangements, it may be argued that those terms with market 69 In such cases, a solution may be needed to ensure that the clearing member and its CCP remain acting as principal. See Section 4.5.3 below for the approach adopted by London Stock Exchange as an example. 70 BIS, Clearing Arrangements for Exchange-traded Derivatives (1997) 21. 71 Eg these obligations may, depending on the services clearing members provide and the client classification, include know your customer, best execution, and conflicts of interest etc. 72 See HG Beale (ed) (2004), n 48 above, vol 2, 24.

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Between Clearing Members and Clients rule or bylaw status in first-tier clearing arrangements should be treated as implied terms for the second-tier clearing arrangement.73 Under English law, for example, the implication of a contractual term is in principle a matter to be decided by the court. It is submitted that the intention of the parties as deduced from the surrounding circumstances is a key factor to be considered in deciding whether or not a term is implied.74 A term that has not been expressed may also be implied if it was so obviously a stipulation in the agreement that the parties must have intended it to form part of their contract.75 It is also necessary that a distinction be drawn between rules related simply to the conduct of business and those related to substantive rights.76 In practice, clearing members and their clients will expressly incorporate all the relevant CCP clearing rules and regulations, typically referred to as relevant market rules, in their agreements. On the other hand, it should not be assumed that it is also true the other way around. To what extent the clearing agreement between a clearing member and its clients has a legal effect on the clearing agreement between a CCP and the clearing member remains unclear. Furthermore, how will it ultimately affect the rights and obligations of clients of clearing members? The position of clearing members and that of their clients will be further discussed in the sections below.

4.5.3 The Legal Position of Clearing Members affected by CCP Clearing In its simplest sense, a clearing member is acting as an agent for its clients (internal relationship). On the other hand, one of the requirements regarding the external relationship is that each member is to contract as principal and the CCP is to deal with the members only. Consequently, a clearing member is acting as agent in relation to the internal relationship and as principal with regard to the external relationship. Arguably, the analysis of the tripartite relationships through internal and external internships may seem problematic from common law perspective. In the United Kingdom, a remedial approach has been adopted in upholding the CCP clearing principle that the relationship between a CCP and its member is principal to principal.77 Rule 2165 of the London Stock Exchange (LSE) prescribes that, ‘[an] order submitted by a clearing member in a central counterparty security as agent, will be treated as a principal transaction’. In cases that 73

See RM Goode (2004), n 6 above, at 157–9. Also see Section 4.6.1 below. cf Johnstone v Bloomsbury HA [1992] QB 333; Yarm Road Ltd v Hewdon Tower Cranes Ltd [2002] EWHC 2265, (2002) 85 Const LR 142. 75 See HG. Beale (ed) (2004), n 48 above, vol 1, 775. 76 RM Goode (2004), n 6 above, 159. 77 Rules of London Stock Exchange (May 2004) (Core Non-trading Rules), Rule 2165: ‘An order submitted by a clearing member in a central counterparty security as agent, will be treated as a principal transaction’. 74

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Legal Issues: The Key Relationships clearing member C1 is acting as an agent for a transaction that’s been accepted by a CCP, a retrospective rule is applied78 and brings in a separate clearing member C2 so that in relation to a CCP transaction, clearing member C1 is acting as a principal. As a result, clearing member C1 becomes agent for its client and no contractual relationship with the CCP is established with respect to that agency transaction. As far as CCPs are concerned, such rules effectively eliminate the possibility of any of their clearing members acting as agent. Clearing members are thus dealing on a principal basis as against the CCP and its clients. However, by adopting such a remedial approach the rules of LSE have also failed to address the implications of such approach. How do the resulting tripartite relationships between clearing members C1, C2 and client C affect the rights and obligation of the three regarding the transaction? For example, what regulatory obligations does clearing member C2 owe to client C when it becomes the counterparty to the transaction, if any? How will this approach affect the relationship between the agent clearing member C1 and clearing member C2, given that the idea of introducing a CCP is to mitigate counterparty risk of other clearing members to a CCP? Another question would be what are the implications of the rules for the fundamental principle of CCP clearing whereby clearing members no longer have any contractual relationship with each other in respect of transactions processed through the CCP? The analysis of the liability of clearing firms as intermediaries was largely derived from the law of agency. Here, ‘the key to agency is always that an agent initiates or completes a legal act or obtains a discharge for others and does not normally incur liabilities or acquire rights of his own’.79 With regard to the application of agency law, some types of relationships may be subsumed under the law of agency but its full consequences do not apply, as discussed at the beginning of this chapter. In addition, under agency law a third party, when dealing with an agent, is allowed to explicitly exclude any principal (disclosed or undisclosed) from acquiring any rights under the contract made with that agent. Consequently, the third party is dealing with the agent exclusively with respect to the contract matters regardless of the agency relationship underlying it, ie between the agent and the principal. In other words, the principal has rights under the agency contract against its agent only. This is likely to be the case with respect to CCP relationships. In applying the agency analysis to CCP clearing, the relationship between CCPs, clearing members and their clients may arguably suggest an example of incomplete agency. Contrary to that, clearing members are bound by a CCP’s rules and regulations to act as principal, as observed earlier. As market practice, clearing members are typically authorised to provide the services to

78 ibid, (Settlement), Rule S201: A clearing member which deals both as principal and agent in respect of central counterparty transactions must use a separate General Clearing Member entity to clear its agency business. 79 JH Dalhuisen (2007), n 46 above, 433.

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Position of Clients of Clearing Members their clients. In carrying out the regulated functions, clearing members at the same time owe corresponding duties to their clients under the regulations.

4.6 The Position of Clients of Clearing Members For clients of clearing members, the major concern is the extent to which they are affected by the clearing arrangement between CCPs and clearing members. To see the relationship between clearing members and their clients as the internal aspect of agency raises the question of what are the implications of the external relationship between CCPs and clearing members. It may constructively introduce the so-called back-to-back contracts between them. In that context, the agent is acting as principal to the third party and as agent with respect to the real principal in this tripartite relationship at the same time. From what has been discussed in previous sections, the position of the clients of clearing members or participants further down the chain may not seem to be clear as a result of the contractual arrangement up in the chain, ie, the relationship of CCPs and their members. This also raises the question of how best the interests of the clients can be protected, end investors in particular. Under general agency law, according to the analysis of the relationship between broker and client,80 it is sometimes the case that clearing members are outside the fiduciary scope altogether. Indeed, it may be possible that some aspects of the relationship between clearing members and their clients can be deemed fiduciary.81 However, it looks problematic to apply traditional agency law simply to the relationship between clearing members and their clients, as will be discussed below. Furthermore, there are some basic protections available to clients of clearing members as far as their assets are concerned. Among them, account segregation is one of the most important principles. This principle is also an essential tool of risk segregation, whereby a CCP commonly segregates the clearing member’s own dealings from their clients’ dealings with two or more separate accounts, ie client’s account and clearing member’s proprietary account.82 This is also important in the sense that it provides a basic protection for the clients in case of default. According to LCH.Clearnet Ltd rules, in the event of default by a 80

J Glover, Commercial Equity: Fiduciary Relationships (London: Butterworths, 1995) 62–7. A discretionary account impose the broker’s fiduciary duties while non-discretionary account does not. See J Glover (1995), n 80 above, 62. 82 See R Dale, ‘Derivatives Clearing Houses: the Regulatory Challenge’ (1997) 12(2) Journal of International Banking Law 46–55. Recently, a detailed analysis to explore the rights of customers in light of the proposed centralised CDS clearing solutions has been carried out. See Report to the Supervisors of the Major OTC Derviatives Dealers on the Proposals of Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin, 30 June 2009. The report examines customer protection issues including asset segregation and portability at the CCP clearing level by looking into existing arrangements at major CCPs in the US and Europe. 81

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Legal Issues: The Key Relationships member, assets in its client account(s) or any related collateral cannot be utilised by the CCP to offset the loss incurred by the defaulting member. In other words, the assets in client accounts of a clearing member will not be available to meet any obligation resulting from that member’s default.

4.6.1 The Effectiveness and Implications of Implied Terms: Clearing Rules and Regulations as Implied Terms Terms like ‘Contract as Principal’, as agreed between the CCP and its clearing members, are embedded in the form of clearing rules and regulations. They have binding force on the internal relationship between clearing members and their clients. The resulting effect is that these terms are generally considered to serve as implied terms of agreements between the clearing members and their clients. The clients of clearing members, by transacting on the market, are bound by the CCP rules as part of the market rules. The major concern with regard to the effect of clearing rules and regulations is whether or not clients of clearing members, as non-members, can invoke the clearing rules and regulations as implied terms against a member or the CCP since they are subject to it themselves. As mentioned earlier, the rules and regulations of CCPs normally exclude rights of third parties.83 This seems to suggest that non-members have no right to invoke the rules and regulations against the CCP for their own benefit but they are, nevertheless, bound by those rules and regulations. As mentioned above, under modern agency law a third party is allowed explicitly to exclude any principal from having any rights under the contract made with the agent. The question then arises as to how the rights of the clients in this context are protected. The answer will most likely be in the negative, at least in a case when the claim is against the CCP and if that claim is also based on contract, since there is no established contractual relationship between them as a result. Clearly, there is no contractual relationship between the CCP and the clients of clearing members as intended. With respect to the relationship between clearing members and their clients, it is also not clear whether those implied terms in the form of the CCP rules and regulations can be invoked by the clients at all.

4.6.2 The Rights of Clients of Clearing Members Clients of clearing members are normally market participants that do not participate directly in a CCP clearing system. As non-members, they must enter The report is not more than a fact-finding excise and shows the differences and complexity of the arrangements in existence. However, this could be seen as a major step in setting out a common framework for CCP clearing. 83

See Section 4.3 above.

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Position of Clients of Clearing Members into a clearing agreement with a member of the CCP in order to get access to CCP clearing. It is worth noting right away that these non-members must be distinguished from the so-called non-clearing members84 since, as clients of clearing members, these non-members have, in essence, no direct contractual relationship with the CCP whatsoever. To repeat, the effect of the CCP clearing arrangement may be that the agency relationship between clearing members and their clients is bound by the explicit condition of contracting as principal with the CCP under the clearing agreement. As stated earlier, in some cases clearing firms acquire agency status as a result of providing clearing services to their clients.85 Assuming that the relationship between the clearing member and its client is characterised as that of agency, it follows that the internal relationship of the agency agreement between the clearing member and its client may be intact. In contrast with the results of a typical agency agreement, however, the external relationship or the direct legal relationship between the CCP and the client has not been established as the result of the act by the clearing member as agent. Again, this could be largely due to the fact that it is commercially inconvenient for the CCP to deal directly with non-members and it is not viable from the counterparty risk management perspective to manage a potentially huge number of clearing member clients in the markets. It would not be possible to do so either. Furthermore, the CCP, as a third party, does not have any interest in the identity or nature of non-members or anyone outside of its clearing system. Nevertheless, clients of clearing members as non-members have to abide by the CCP clearing rules and regulations as market rules. Accordingly, any claim a non-member may wish to file against the CCP for loss suffered by its acts or omissions must not rely on contract. The ultimate question to ask is what rights the clients of clearing members as non-members have. Furthermore, the question should be asked whether or not the clients of clearing members, as non-member of CCPs, are confined to claim only against their agents, ie clearing members. If that is the case, to what extent they can exercise their rights against their agents? Under English law, for example, any claim a non-member may wish to pursue against the CCP for ‘loss suffered by its acts or omissions must lie either in tort, eg for negligence, or in the domain of public law by way of judicial review’.86 By the same token, it is thought that the court will not readily treat an exchange or a CCP as being under a duty of care to non-members so as to be liable for any pure economic loss.87

84 Non-Clearing Members (NCMs) are direct participants of a CCP with special clearing agreement. 85 HF Minnerop, ‘Clearing Arrangements’ (2003) 58 The Business Lawyer 917–60, 918. 86 RM Goode (2004), n 76 above, 159. 87 Some may go a step further to argue that a CCP may nonetheless be susceptible to judicial review on the basis that the decision can be set aside if the procedure adopted is unfair or the decision wholly unreasonable.

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Legal Issues: The Key Relationships In the United States, in a case88 regarding an action filed by a customer against both his introducing firm and the clearing firm, it was held on appeal that the plaintiff was a third-party beneficiary of the clearing agreement. By analogy, it is submitted that although a client, as a non-member, is not a party to the clearing agreement between the CCP and its members, it may nevertheless be considered as a third-party beneficiary to that arrangement for the purposes of client asset protection. As mentioned at the beginning of this chapter, the general provisions of CCPs prescribe that the rights of third parties are to be excluded with respect to the benefits and rights conferred by the members, including the assets involved. A non-member may at best be regarded as a third-party beneficiary to the clearing arrangement between the clearing member and the CCP. It nevertheless cannot directly claim against the CCP for the rights of third parties which have been explicitly excluded by the CCP.

4.7 The Relationship between CCPs Themselves Typically, a sole CCP is introduced to serve a particular market individually. Therefore, CCPs are normally isolated from each other in respect to the markets they serve. Only after the introduction of two CCPs by the pan-European exchange Virt-X89 has a link between two CCPs been established. For CCPs, to link with each other could be a complicated arrangement in terms of counterparty risk management and settlement arrangements,90 although the communication linkage between them is in some ways fairly straightforward. The case of Virt-X is further complicated by the fact that the two CCPs LCH.Clearnet and SIS x-Clear are operating in different jurisdictions. For the exchange Virt-X, the link between these two CCPs takes the form of each one being the member of the other; namely, CCP A is a member of CCP B and at the same time CCP B is a member of CCP A. This arrangement may not therefore be so different from that of CCPs and their clearing members. Nevertheless, there are some additional arrangements between the linked CCPs, such as providing access to each other’s flow of transactions for CCP clearing. The rationale behind the decision of setting up the link between various CCPs cannot be more obvious. This type of arrangement is believed to provide a choice of CCPs and in economic terms to increase competition as well as improve 88 See Flickinger v Harold C Brown & Co, 759 F Supp 992 (WDNY), affirmed in part reversed in part, 947 F 2d 595 (2nd Cir 1991). It should be noted that the clearing house was not included as defendant in this case. 89 Virt-X is a SWX Group company. See the website: www.virt-x.com/index.html for further information. 90 A conflict of laws issue (of which law is to govern the relationship between the two CCPs) would arise when they are operating in two different jurisdictions. The conflict of laws issues are out of the scope of this thesis.

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Concluding Remarks inter-operability. However, the notion of competitive inter-operability between CCPs is, as argued,91 untested. What’s more, there is no existing example of linked CCPs competing to provide central counterparty clearing services to exchanges or market users. In the case of Virt-X, coincidently each CCP is mainly serving the members from its own jurisdictions. Inter-operability also creates a range of legal, credit and operational risks as well as more general challenges to effective regulation and oversight.92 As for the contractual relationship between the two linked CCPs, it is not different to that of CCPs and their members, ie a principal-to-principal relationship. From a clearing participant’s point of view, the market structure of two or more CCPs in that market may not seem to be so different from one single CCP in that market in terms of transaction netting. A market with more than one CCP does achieve the objective of offering a choice. However, in practice there are also concerns that the arrangement would actually increase the costs for a clearing participant, which may be significant when there is a need to maintain multiple memberships with multiple CCPs. Also, the additional costs of process harmonisation for them and CCPs may also be substantial. Furthermore, the efficiency of the use of collateral by a member in two or more CCPs is also questionable compared with a single pool of collateral for a CCP in one market. It has also been observed that the arrangement of linked CCPs will also introduce some additional risks.93 In the case where there is more than one CCP in a particular market, some may question whether there is indeed a true central counterparty in that market.

4.8 Concluding Remarks As discussed in Section 4.1.1 above, a CCP becomes the buyer to every seller and the seller to every buyer by one of the two market mechanisms, ie novation or open offer. By examining the CCP rules and regulations, for example, those of LCH.Clearnet Ltd, it is argued that the procedures for transactions by open offer must be further clarified. It should be made clear in the CCP rules at what point in time a transaction is deemed accepted into a CCP system when transactions 91 See Cleary, Gottlieb, Steen & Hamilton LLP, Comments on the Further Remedy Option regarding Interoperability of Central Counterparties (Euronext NV, September 2005). 92 In terms of legal risks, for example, it was suggested that links may present legal risk arising from differences between the laws and contractual rules governing the linked systems and their participants, including those relating to novation or open offer, netting, collateral arrangements and settlement finality, as well as conflict of laws. Also see Cleary Gottlieb Steen & Hamilton LLP, Comments on the Further Remedy Option regarding Interoperability of Central Counterparties (Euronext NV, September 2005). 93 Basle, Clearing Arrangements for Exchange-trade Derivatives (Bank for International Settlements, March 1997) 40. Typically, the additional risk involved would include legal risk.

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Legal Issues: The Key Relationships are processed through open offer. Similar to the procedures set out for transaction by novation, there should also be procedures in place to be followed by the original counterparties when the transaction via open offer was rejected subsequently. The key factor in so far as the CCP clearing relationships are concerned is that, in respect of market contracts processed through CCP clearing, a CCP is only dealing with its clearing members on the principal-to-principal relationship basis. In other words, a CCP acts as principal vis-à-vis its clearing members exclusively, despite the actual nature of the underlying transaction. As far as those market contracts are concerned, no contractual relationship should ever be established between the CCP and a non-member by any means. From the above discussions, there are several implications in relation to the typical requirement of a principal-to-principal relationship between a CCP and its members and its exclusivity. To non-members accessing CCP clearing services indirectly through clearing members, the primary implication of the principalto-principal relationship between CCPs and their members is that non-members, by doing so, give consent to be bound by market rules, ie the contractual agreement between the CCP and the clearing member as well as the rules and regulation of the CCP. In other words, they impliedly agree to the CCP’s rules and regulations, to which their agents, ie clearing members are subject, despite the fact that they are not direct participants of the CCP clearing system. However, as observed, it is not immediately clear whether non-members would be able to invoke the rules and regulations of a CCP against its clearing member. Finally, it is argued that as a result, non-members cannot claim directly against a CCP in respect of the underlying contracts clearing members have processed through CCP clearing for them.

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5 Default Procedures and CCPs’ Default

I

NSOFAR AS CCP clearing default procedures are concerned, it is necessary to examine collateralisation and netting as well as set-off in depth, for they are at the heart of effective default management by CCPs. Suffice it to say, the success of CCP clearing is ultimately tested and determined by the effectiveness and enforcement of these procedures. For daily operation, the mechanism of collateralisation is used continuously, e.g. in margining. In this context, netting and set-off are closely connected to collateralisation and will also be examined in detail. In this chapter, discussion on default procedures concerning both clearing members and CCPs will then follow. As will be discussed in Section 5.4, default procedures are triggered by a series of events prescribed by a CCP. These events can be broadly categorised into two types. The first type is an event that also results in the commencement of insolvency proceedings with respect of a member. The second type is the event that a defaulting member is not legally insolvent but is deemed by the CCP as not solvent. It could also be triggered by the fact that the clearing member has been in breach of relevant exchange rules. Simply put, the main objective of default procedures for clearing members is to close out the defaulting member’s positions with the CCP in an orderly manner so that the CCP can carry on functioning as normal. At the end, the chapter moves on to discuss default procedures for CCPs and concludes with some remarks.

5.1 Collateralisation and Financial Collateral Arrangements The collateralisation technique is one of the most important risk management tools in financial markets, and so it is to CCP clearing. The main purpose for taking collateral is to protect the collateral taker from a default of the collateral provider. In principle, financial instruments with inherently low credit and 101

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Default Procedures and CCPs’ Default liquidity risk are typically preferred for collateralisation purposes. These instruments in general include high credit-rated government securities and cash.1 Collateral is widely used in various financial transactions including residential mortgages, secured consumer lending, corporate finance, bank treasury and funding, payment and clearing systems and general bank lending. Moreover, CCPs and operators of both payment systems and securities settlement systems also rely heavily on collateral to ensure smooth operation and manage the risks involved, such as the risk of a member’s default. Several changes in the markets have contributed to the fast growing use of collateral in the markets.2 Both the wider range of participants and the significantly increased volumes of transactions prompt the relevant risks to be better managed. The structural changes in financial operations also require the adoption of techniques to manage and reduce settlement risk. As for settlement, the transfer of collateral often takes the form of Free of Payment (FOP)3 and it is operated through a special purpose account, namely a collateral/margin account, as distinguished from normal trading accounts. Given the increasing importance of the use of collateral in the markets, legal certainty in relation to its characterisation, realisation and enforcement has become one of the important preconditions for the proper functioning of markets. Legal concepts and instruments in relation to financial collateral arrangements have to be carefully constructed to meet practical needs. It is also essential that effective procedures for enforcement be in place. In other words, the collateral framework will not be of any use without efficient enforcement rules in the event of default.

5.1.1 Types of Collateral In theory, any asset with value can be used as collateral. In practice, assets that are to be used as collateral in the markets normally have to meet certain criteria. All of the eligible types of assets are normally decided by the collateral takers, for example, CCPs and central banks, and the list is reviewed and updated from time to time. As mentioned earlier, the types of eligible collateral generally accepted are normally liquid and less volatile assets. This means that the range of collateral is either securities (bonds in most cases) with good credit rating and less volatility, or cash. Pressure has been building up to accept assets with lower quality and higher volatility because of the scarcity of high-quality collateral in 1 Cash is in theory the perfect collateral but normally there is only a limited range of currencies eligible mainly because of exchange rate risk and volatility. Acceptable currencies are often those of G7 countries. 2 BIS, Collateral in Wholesale Financial Markets: Recent Trends, Risk Management and Market Dynamics (BIS, 2001). 3 As opposed to Delivery Versus Payment (DVP), FOP is a settlement instruction that only requests a delivery of securities from one party to the other without payment. See Section 2.4.1, ch 2 above, for the discussion on DVP.

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Collateralisation the markets, especially during the crisis. This makes some go further to suggest that it is foreseeable that financial instruments like equities that are regarded as highly volatile may be accepted as collateral in the near future. As regards securities collateral, collateralisation shifts the credit risk of the trade counterparty to that of the issuer of the underlying securities being used as collateral, even though the collateral provider is not discharged. To manage the risk of sudden price shifts in the underlying securities, a discount of the mark-to-market price is applied, which is known as ‘haircut’.

5.1.2 The Use of Collateral As mentioned earlier, collateral is widely used in financial markets for many types of transaction.4 As a risk mitigation arrangement, it can also be used in cases where financial institutions extend the credit of their members/clients. Here, we mainly focus on collateral arrangements for Payment and Securities Settlement systems and CCPs.

A. Collateralisation in DVP Arrangements When payment systems are linked with securities settlement systems and are used as the payment method for securities transactions to provide a full DVP setting,5 there is a need to increase liquidity for settlement efficiency. Collateralisation is thus introduced to serve this very purpose. The technique used here is called self-collateralisation,6 which is an arrangement whereby securities being transferred can be used as collateral to secure risks involved in the transfer process.7

B. Collateralisation in Payment Systems8 Payment systems, either net or gross, have to be designed to achieve maximum liquidity9 and with all possible safety. A trade-off between liquidity and safety in a system must be made. In this context, the use of collateral is one of the most important control mechanisms for system operators to reduce the risk of a participant’s failure and to prevent the existence of systemic crisis. From an 4 For the use of collateral from wholesale market perspectives, see Committee of the Global Financial System, Collateral in Wholesale Financial Markets: Recent Trends, Risk Management and Market Dynamics (BIS, March 2001). 5 For example, the UK CREST that is discussed in Section 2.4.1, ch 2 above. 6 See Self-collateralisation in Section 2.4.1, ch 2 above. 7 BIS, A Glossary of Terms Used in Payment and Securities Settlement Systems (BIS, March 2003), ‘Self-collateralising’. 8 See J Francisco and C Muñoz, Collateral Use in Payment Systems (EFMA 2003 Helsinki Meeting, November 2002). 9 In its simplest sense, liquidity here means that payments between members of settlement system flow and are made in time.

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Default Procedures and CCPs’ Default operational perspective, gross payment systems are characteristically distinguished from net payment systems.10 The use of collateral in payment systems as a safeguard measure to provide a credit facility to participants, to some extent, some may argue, helps bring net payment systems and gross payment systems closer and allows members of both systems to hold the same amount of reserves.11 This resulting impact on the relationship between a payment system and a securities settlement system is to be appreciated in the sense that the use of collateral in payment systems ultimately requires payment systems to take account of, for example, the procedures of the relevant securities settlement system where securities are used as collateral, as opposed to two stand-alone settlement systems.

C. Collateralisation in CCPs Essentially, the collateralisation techniques used by CCPs and payment systems are mainly to facilitate the management of their credit exposures to their members. However, CCPs’ approach to collateralisation differs from that of payment systems in that it includes a set of three different types of margins, namely, initial margin, intra-day margin and variation margin. It may be helpful to understand them by treating each of the above margin types individually. However, the three must be viewed as a ‘collective risk management system’.12 For CCPs, the collateral is used for initial margining where CCPs normally accept a range of securities and currencies to serve as collateral for the trades. The rate of the initial margin will be set according to the type of products and transactions, and is reviewed from time to time, be it quarterly or semi-annually. Since participants’ market positions change all the time as a result of day-to-day trading, a mechanism is necessary to bring the margin level up to date. Here the concept of intra-day margining comes in. Whilst the intra-day margin can be seen as a daily adjustment for initial margining purposes, it should be distinguished here from variation margin. Variation margin is a result of the daily mark-to-market mechanism utilised for transactions like Swap transactions or other Derivatives. As mentioned earlier in chapter three, CCPs typically have back-to-back transactions and take no trade position. From a CCP’s perspective,13 variation margin is collected from one member who is in the money and passed on to the other who is out of the money. Therefore, it is a zero-sum game where CCPs simply facilitate the resulting transfers. 10 See Section 2.2, ch 2 above for the discussion on payment systems and securities settlement systems. 11 Here, whether or not less collateral will be required for net systems than that of gross systems is rather an empirical question. 12 See LCH.Clearnet, Market Protection: The role of LCH: regulatory framework, structure and governance, legal and contractual obligations, risk management, default rules, financial backing (2002) 27, 19. 13 See further description on CCPs margining in Section 3.3.2, ch 3 above.

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Collateralisation In principle, clearing members as collateral providers have broad rights of withdrawal and substitution as well as access to particular securities pledged as collateral, upon appropriate notice to collateral takers.

5.1.3 The Limitations of Collateralisation It is first worth noting that collateral should not be seen as a panacea, as many would suggest. The use of financial assets like securities as collateral adds to the issuer’s default risk, a factor that cannot be ignored even though issuers of those securities for collateral normally have high credit ratings and the price of those securities are relatively less volatile. This has been the major factor in determining what assets can be used as collateral despite the fact that, in theory, any asset can serve the purpose. Furthermore, the value of certain types of collateral may vary so rapidly in extremely volatile market conditions that its protection may not be as effective as originally surmised. Consequently, the wide use of financial collateral arrangements in the markets has also contributed to the resulting scarcity of high-quality collateral. In addition, the protection provided by collateral is also limited significantly by potential operational delays, as it may need to meet the relevant legal requirements. For instance, the procedures for the lodgement of collateral are particularly tedious. In the European Union, it is expected that the implementation of the EU Financial Collateral Directive14 will simplify the process.

5.1.4 Characterisation and Realisation The primary legal issue surrounding financial collateral arrangements is the risk of re-characterisation, whereby the arrangement is classified. This ultimately affects the realisation of the financial collateral in question. Using assets as collateral may need topping-up in two cases: first, the value of the collateral may fluctuate and result in a deficit in the margin account; and secondly, the market situation or the whole portfolio of the collateral provider may change, resulting in the need for more collateral. During the course of collateralisation, a collateral provider will, in general, retain the right to substitute the assets provided as collateral with other assets. The substitution right is important for collateral providers, as it helps them accommodate both short- and long-term funding and trading strategies. This may give rise to the effect of creating a new pledge and/or changing the nature of the existing one and may result in a lower priority in the insolvency of the collateral provider. The key here is that it does not matter whether the collateral is arranged through retention of title or outright transfer; the collateral taker is under an 14

Directive 2002/47/EC of 6 June 2002 on financial collateral arrangements [2002] OJ L168/43.

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Default Procedures and CCPs’ Default obligation to return equivalent assets upon appropriate notice by the collateral provider. The provision that the collateral provider has the right of withdrawing excess collateral, as Sir Roy Goode put it, does not convert the charge into a floating charge,15 as the debtor is not being given a general release in advance to deal with the securities in the ordinary course of business, and is subject to checks that the excess does exist and that other agreed criteria are met.16 Again, it cannot be stressed enough that the importance of default procedures, especially when it comes to the enforcement of these procedures, is key to the success of the CCP clearing mechanism. While there is no definition with regard to ‘default arrangements’ in the EU Directive on Settlement Finality, the UK implementation of the Directive defines it in regulation 2(1), of the Financial Markets and Insolvency (Settlement Finality) Regulations 199917 as the arrangements put in place by a designated system to limit systemic and other types of risk which arise in the event of a participant appearing to be unable, or likely to become unable, to meet its obligations in respect of a transfer order, including, for example, any default rules within the meaning of Part VII or any other arrangements for – (a) (b) (c)

netting, the closing out of open positions, or the application or transfer of collateral security.

As far as CCPs are concerned, the main objective of their default arrangements is to enable them to react proactively in an attempt to manage counterparty credit risk effectively.18 Arguably, it is ultimately to prevent potential systemic risk and limit the other risks that may be caused by the member’s default in the first place, given the position of a CCP in the markets. If one or more clearing members appear to be unable, or likely to become unable, to meet their obligations in

15 Floating charge is essentially ‘a lien that continues to exist even when the collateral changes in character, classification, or location’. See Black’s Law Dictionary on floating lien. 16 RM Goode, Legal Problems of Credit and Security, 3rd edn (London: Sweet & Maxwell, 2003) 226. In the EU, according to Art 2(2) of the EU Directive on Financial Collateral Arrangements (n 14 above), any right to withdraw excess financial collateral does not mean that the financial collateral has not been provided to the collateral taker. Moreover, the Directive has also gone a step further and explicitly permitted the re-use of financial collateral by a collateral taker so long as it was agreed/ allowed under the collateral arrangement. 17 Financial Markets and Insolvency (Settlement Finality) Regulations 1999 (SI 1999/2979). 18 In the report Recommendations for Central Counterparties by the Bank for International Settlements, it is emphasised that ‘a strong legal framework will support the rapid deployment of the collateral held by a CCP when a participant defaults on its obligations or becomes insolvent. This aspect of the legal framework is critical because delay in the use of collateral may prevent a CCP from meeting its obligations as expected. The legal framework will accomplish this goal if the rules and contracts for operating a CCP and the obligations of its participants are enforceable, and a CCP has the unimpeded ability to liquidate collateral and close out transactions’. See Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of International Organization of Securities Commissions (IOSCO), Recommendations for Central Counterparties (BIS, November 2004).

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Collateralisation respect of cleared contracts, the CCP can take steps to discharge the rights and liabilities of the clearing member in question and close out the relevant positions. Default rules and procedures are not only an integrated part of CCP clearing operation but essential to the ability of a CCP to manage counterparty credit risk for the markets it serves. The primary objective of having the default procedures in place is to enable the CCP to function continuously in the event of member default so that it is able to perform its obligations to its members without possible disruption to the other members and the markets. Furthermore, it is required by law in some cases, as one of the recognition requirements, that a CCP must have the default rules in place to deal with a default event in order to be registered as a recognised body in an authorised market.19 They are the procedures that will ultimately lead to the closing out of open positions, which are triggered by one of the described events20 that is deemed default, either by a clearing member or by a CCP.21 The ultimate issue is related to the way in which the financial resources are to be handled and how the subsequent losses, if any, are to be allocated and who will have to bear them. Therefore, it is necessary that the default procedures are as transparent as possible. As recommended, one of the key issues is that ‘a CCP’s default procedures should clearly state what constitutes a default and permit a CCP to promptly close out or effectively manage a defaulting participant’s positions and to apply collateral or other resources’.22 In the process of implementing default procedures in relation to one or more of its clearing members, the CCP is nevertheless under the contractual obligation to settle all the contracts with respect to all other clearing members. In other words, the rights and obligations between the CCP and all other non-defaulting members should not be affected by the proceeding of default procedures. As pointed out by Sir Roy Goode, a creditor is entitled to exercise the rights and remedies given to him by contract (self-help) and by law (judicial).23 The default procedures of a CCP can be characterised as self-help. This gives the CCP a right to accelerate the ‘defaulting’ clearing member’s liability, to withhold his own performance under the contract, or to terminate the contract by reason of the

19 For example, to gain the recognition as a Recognised Clearing House in the UK a CCP is required to have default rules. See further discussion in Section 5.3 below. 20 The prescribed events that will trigger default procedures are normally detailed in the CCP’s default rules, and they are not limited to liquidation or insolvency proceedings. In other words, the default rules and procedures are triggered if a member appears to be unable or be like to become unable to meet his obligations. This also enables the CCP to take preliminary actions in the run up of the liquidation or insolvency of a member. 21 However, the focus has so far mainly been on the default concerning members of CCPs rather than the CCPs themselves. Moreover, no procedures can be founded with regard to the default of a CCP in CCPs rules and regulations. 22 Committee on Payment and Settlement Systems (CPSS) and Technical committee of the International Organization of Securities Commissions (IOSCO), Recommendations for Central Counterparties (BIS, November 2004) 29. 23 RM Goode (2003), n 16 above.

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Default Procedures and CCPs’ Default default triggered by one of the prescribed events. It also has the right to realise the collateral deposited by that member, and the right to set off the debts. According to section 159 of the UK Companies Act 1989, for example, the proceedings of a recognised clearing house for purposes of the insolvency distribution rules were granted in effect the status of a self-contained insolvency distribution scheme for contracts and changes deemed markets contracts and markets charges.24 The regulatory regime will be discussed in detail in chapter six below. Suffice it to say, the default rules of the CCP, as required by Schedule 21 of the Companies Act 1989, must provide for the rights and liabilities of the defaulting member, and in particular must provide for sums payable by or to the defaulting member in relation to different contracts, to be aggregated or set-off so as to produce a net sum.25 Consequently, it is for the net sum to be set off against any property provided by the defaulting member as cover for margin if payable to the CCP, and to be aggregated with any property provided by the defaulting member as cover for margin.26 In addition, so far as CCPs are concerned, the main objectives of having default rules in place are not only to satisfy what the law of the market requires but to provide the CCP with a speedy and robust procedure to respond to the event, which is likely to impair the ability of its member to meet its obligations, and to resolve it in an orderly manner. Most importantly, this enables the CCP to continue to carry out its market functions as normal and to minimise the impact on the market of the default event. Furthermore, it also helps the CCP avoid the need to resort to the lengthy legal procedures including insolvency, as well as avoiding a significant degree of legal uncertainty since the outcome is typically determined by local law through litigation, bankruptcy and other legal proceedings.

5.2 Netting and Set-Off Netting is a relatively new term when compared to set-off,27 which has long been established.

5.2.1 Netting First, it is fair to suggest that netting is foremost about practicality and risk management. In trade settlement, the use of netting mechanism is likely to 24

Also see the discussion on UK regulatory regime in Section 6.3, ch 6 below. Sch 21, paras 2(1), (2), 9(1), (2). Sch 21 paras 1(4), 9(2). See RM Goode, Principles of Corporate Insolvency Law, 3rd edn (London: Sweet & Maxwell, 2005) 31. 27 See SR Derham, The Law of Set-off, 3rd edn (Oxford: Oxford University Press, 2003), for a comprehensive analysis on set-off. 25 26

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Netting and Set-Off significantly reduce the volumes of settlement transfers and hence lowers transaction costs. In terms of risk management, this concept serves to limit the exposure of a party to the net amount of total claims that it has towards another party. To the market as a whole, netting may also be seen by some to have considerably reduced liquidity risk in the financial systems. In contrast, some may argue that the systemic risk with respect to financial systems as a whole remains the same, it is just the possible negative impact that may be reduced with proper risk management. Netting agreements, which may simply be a contractual provision, often take the form of master agreements, which have been developed to eradicate uncertainties on the enforcement level. A case in point is the International Swaps and Derivatives Association (ISDA) Master Agreement, which is widely adopted by market participants. The common goal of the netting arrangements in these agreements is to provide a netting scheme that is effective in every single jurisdiction. The ISDA Master Agreement, which has now been further revised to cover a wide range of financial and commercial transactions, in essence represents one of the most important netting schemes. In financial markets, there are four institutional netting arrangements.28 They are: (1) bilateral position netting, (2) bilateral netting by novation, (3) multilateral position netting, and (4) multilateral netting by novation and substitution.29 At the modern clearing level, the netting arrangement is covered by the CCP’s rules and regulations. The effects of these structures may vary and are dependent on whether there is a CCP or a clearing house simply acting as agent.30 The fundamental importance of these structures to a resilient market, given their effect on systemic risk, has increasingly gained recognition and is also recognised by the relevant jurisdiction. In doing so, the relevant laws applying to these netting arrangements have to provide a degree of certainty, which is required for the markets to operate and recognise the results they are meant to achieve. Here, it may be helpful to take a closer look at different types of netting before examining the processes involved in default procedures in detail, including the use of close-out netting, and the impact on other non-defaulting members.

5.2.2 Definition and Distinctions It is true that the terms ‘netting’ and ‘set-off ’ are often used interchangeably. This, to some extent, suggests a close relationship between the two. Indeed, netting was born out of the regime of set-off, and it is still subject to it in many jurisdictions.

28 Group of Experts on Payment Systems of the Central Banks of the Group of Ten Countries, Report on Netting Schemes (Angell Report) (Basle, BIS, February 1989). 29 As opposed to three legal forms of netting identified in Section 5.2.2 below. 30 Also see Section 3.1, ch 3 above, for the discussion on CCP clearing and cheque clearing.

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Default Procedures and CCPs’ Default While it is difficult to draw a definitive line between the two, consideration should be given to the trend of the market development of new contractual techniques.31 Set-off, as Sir Roy Goode defines it, is the right of a debtor who is owed money by his creditor on another account or dealing, to secure payment for what is owed to him by setting this off in reduction of his own liability.32 Different forms of set-off may be further distinguished in law. For example, set-off is broadly categorised into three types under English law: contractual, statutory or equitable.33 It is observed that contractual set-off distinguishes itself from other forms of set-off as it is recognised as a substantive defence. We can also see that there is a tendency to distinguish netting from set-off as a contractual arrangement, in order to avoid the re-characterisation risk of netting as set-off and thus subject it to legal uncertainty, particularly in bankruptcy or winding up proceedings. Some forms of set-off, including contractual set-off, may be displaced by the insolvency set-off. This explains why contractual arrangements for interest-rate swap transactions are characterised as contracts of difference. It is not possible to find a universal definition suiting every type of arrangement called ‘netting’ in the financial world. This is due, in part, to the fact that terms tend to be used loosely in the markets, and various forms have been developed to accommodate specific types of transactions. It is therefore impossible to draw a comprehensive definition without referring to its various forms. Nevertheless, it is still useful to look at some general definitions that have been provided in literature. Philip Wood defines netting as ‘the ability to set off reciprocal claims on the insolvency of counterparty’. The author further points out that netting is often merely another term for set-off and is used by the markets for processes that involve more than just a set-off of debts.34 Although Alastair Hudson distinguishes netting from set-off and considers netting to be the financial technique and set-off to be the legal remedy, he is, nevertheless, of the opinion that netting is constructed by using the set-off technique. Professor Dalhuisen also defines it as a ‘contractual adaptation of the set-off ’.35 Sir Roy

31 Such as swap transactions that are structured as contract of difference, which distinguish itself from set-off as in that way there exists only a single claim not two, which presupposed by set-off, in the swap transactions. See further on JH Dalhuisen, Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law, 3rd edn (Oxford: Hart Publishing, 2007) 1021–4. 32 RM Goode (2003), n 16 above, 237. While first admitting that it is difficult to define set-off comprehensively, Rory Derham defines it in general as the setting of money cross-claims again each other to produce a balance. See SR Derham (2003), n 27 above. 33 The distinction of these three types of set-off under English law is out of the scope of this thesis. However, for excellent discussions on this subject from an English perspective, see SR Derham, (2003), n 27 above. 34 P Wood, Title Finance, Derivatives, Securitisations, Set-off and Netting (London: Sweet & Maxwell, 1995) 152. 35 JH Dalhuisen (2007), n 31 above, 487.

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Netting and Set-Off Goode sees netting as both the procedure for, and the outcome of, a contractually completed set-off.36 Netting agreements thus can be characterised as a contractual extension of the set-off principle. It is worth noting here that in the United Kingdom ‘netting’ has obtained a legal definition through the Financial Markets and Insolvency (Settlement Finality) Regulations 1999. In regulation 2(1), it is defined as the conversion into one net claim or obligation of different claims or obligations between participants resulting from the issue and receipt of transfer orders between them, whether on a bilateral or multilateral basis and whether through the interposition of a clearing house, central counterparty or settlement agent or otherwise.

Given the above definitions of netting, the term may simply be a derivative form of set-off. To understand precisely what netting refers to, it is then necessary to make distinctions between the different types of netting agreements.37 Netting can be broadly divided into three legal forms: (a) settlement netting or position netting, (b) novation netting and (c) close-out netting. The structure and characterisation of these different netting types can also be very different, depending on the type of transactions they support. It is therefore of importance to clearly describe and differentiate each of those types. In the markets, both settlement netting and novation netting operate in different ways under various schemes, and they therefore can be further divided into four distinct institutional types.38 They may be distinguished with regard to their bilateral or multilateral nature, the legal character of the net amounts due and whether a CCP exists. As mentioned earlier in this chapter, they are: (a) bilateral position netting; (b) bilaterally netting by novation; (c) multilateral position netting and (d) multilateral netting by novation and substitution.39 As already pointed out, it is important to continue to draw a distinction between set-off and netting even though the one is the extension of the other.40 As will be shown later, the mechanisms of set-off and netting as used in both contracts and CCP clearing arrangements are used to achieve different results. In English law, there must be an element of mutuality in order for set-off to apply.41 Set-off is thus essentially bilateral in law, for the requirement of mutuality has to be satisfied. Netting, however, can be arranged in a way to achieve multilateral

36

RM Goode (2003), n 16 above, 242. P Wood (1995), n 34 above, suggests that there are two categories of netting: settlement netting and default netting, where the first netting obviously encompassing also novation netting. See also RM Goode, Commercial Law, 3rd edn (London: LexisNexis UK, 2004) 472–5, as he distinguishes between contract netting and settlement netting. 38 BIS (1989), n 28 above. 39 Such categorisation, however, ignores the actual mechanism utilised by each type of netting. 40 To further distinguish the two concepts, Sir Roy Goode pointed out that while set-off in its legal sense is confined to cases including money obligations, netting includes delivery obligation. See RM Goode (2003), n 16 above. 41 However, ‘[Mutuality] does not require that the claims should arise at the same time, nor that there should be any connection between them’. SR Derham (2003), n 27 above, 441. 37

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Default Procedures and CCPs’ Default effect whether or not there is a CCP in place.42 Another difference can be seen in netting used in interest rate swap transactions whereby they are now, as a standard market approach, construed as contracts for difference,43 which means that there is not any cross-claim between counterparties to the swap transaction but rather one single claim resulting from the theoretical two-way cash flow.44 In law, the implication is that transactions structured in such a way have no element of set-off, as the law of set-off has no application. Other issues, such as third-party claims, are also excluded as far as the transaction itself is concerned. Each party may continue to receive or pay interest arising from the original transaction from or to the third party respectively. Under English law, mutuality is one of the key elements in relation to rights of set-off. Mutuality in fact refers to two characteristics, that the demands must be between the same parties, and that they must be held in the same capacity, right, or interest.45 The requirement of mutuality precludes the set-off of claims of third parties against the amount due to the company in liquidation. Put into the context of a CCP clearing system, the mutuality requirement is satisfied, as set-off is applied to the mutual debts between the CCP and the defaulting clearing member. As discussed in chapter four, it is well established that the relationship between a CCP and its clearing members has to be principal-to-principal. By contrast, in a traditional clearing house, for instance, a cheque clearing system, it is doubtful exactly who has the claim to payment against the defaulting member where that clearing house is merely acting as an agent. Similarly, this was demonstrated in the British Eagle case46 where the IATA was simply acting as agent in providing a clearing mechanism.

5.2.3 Settlement Netting Settlement netting in its simplest sense is a calculation process used for settlement efficiency. The purpose of this kind of netting is, in general, to provide a single delivery of netted obligation so as to effectively discharge all of the original gross obligations between two parties upon contractual arrangement. Under the English rigid set-off regime, without a settlement netting agreement, each of the obligations may be regarded as separate and distinct so that 42 See examples of netting in payment systems where for settlement efficiency reason a net amount is reached for each clearing member and mutuality element is lacking. Conversely, mutuality is established in the case of central counterparty in financial markets. The reason for such mutuality existed in a CCP clearing arrangement is that the CCP is acting as counterparty to all the transactions concerning each of its clearing members, ie on a principal-to-principal basis. For payment systems, no similar central counterparty clearing mechanism is yet introduced to date. The operator of a payment system is simply acting as agent calculating and offset positions for its members. 43 See JH Dalhuisen (2007), n 31 above, 483–95 and 1210–12 for swaps. 44 See JH Dalhuisen (2007), n 31 above, 490. 45 SR Derham (2003), n 26 above, 441–2. 46 See Section 5.2.3 below.

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Netting and Set-Off each party is obliged to deliver them gross. Here, set-off only applies between claims that are connected, which means that claims should have their origin in the same contract or legal relationship.47 This is the so-called mutuality, which is an indispensable element of set-off.48 In a simple clearing scheme, as opposed to CCP clearing, the clearing house acts as an agent for calculating all delivery obligations and provides net balance results for clearing members prior to the relevant settlement date. However, there has been an attempt to construct it by arrangement, as we can see from the British Eagle case.49 As will be discussed shortly, a key issue that affected the outcome of that case was the effectiveness of the netting process of payment obligations. In this case, it was constructed in the way that the resulting net obligations merely came into effect on each settlement date. As a result, each clearing member remained responsible for each gross obligation with other members, not the netted balance as they intended. The relevant issues were discussed in the British Eagle case as the House of Lords decided the scope and validity of clearing arrangements in the case of the liquidation of one of the participants in the scheme. In that case, a ‘clearing house’ was set-up to settle debts between airlines, which carried passengers and freight on behalf of each other and enabled participants to net amounts owned between each other. British Eagle, a member of that ‘clearing house’, went into liquidation and owed large sums to the ‘clearing house’, while Air France, which was also a member participant to the clearing scheme, owed a large sum to British Eagle. It was held by the majority of the Lords that the sum payable to it by other members of the ‘clearing house’, prior to the commencement of the liquidation, was recoverable by the liquidator of British Eagle because the clearing agreement was not effective in a bankruptcy if it was not executed prior to the winding up.50 In this case, the crucial issue is the nature of the relationship between the clearing members and the clearing house. With the International Air Transport

47 48 49

SR Derham (2003), n 26 above, 43–5. ibid. British Eagle International Air Lines Ltd v Compagnie Nationale Air France [1975] 1 WLR 758

(HL). 50 In this regard, the way that the clearing house operated raises a timing issue. ‘The timetable which is laid down is as follows. Clearance of accounts for one month will close on the 30th day of the following month. Thus “claims” in respect of any transportation effected in the month of September must be received by October 30. Then the clearing house must complete the processing of members’ claims within five working days. On completion of such clearance the clearing house will send telegraphs or telegrams (in code) to members telling them the balances either owed to or by the clearing house and within three days of the sending of these telegrams the clearing house will despatch (inter alia) Form Three. Then, seven days after the sending of the clearing house cable there is what is called call day. “Settlement by debtors” (meaning settlement by debtors to the clearing house) must be made before the close of banking business on call day. Then, on completion of “debtor settlements” the clearing house settles “creditors” (meaning creditors of the clearing house). Such settlement is effected in pounds sterling and U.S. dollars according to procedure, which is notified to members. The clearing house is allowed seven days after the date when those who are its debtors must pay before it need discharge the accounts of those who are its creditors’. See n 49 above.

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Default Procedures and CCPs’ Default Association (IATA) acting merely as an agent in providing a clearing mechanism, its clearing members nevertheless had direct claims to payment against each other. In contrast, the claims would have been simply a net resulting balance that British Eagle had with IATA if IATA were acting as principal. From that perspective, it can be argued that the case would have been decided differently if the clearing house IATA were structured as a CCP with continuous netting51 at the time.

5.2.4 Novation Netting Novation netting is usually seen as a form of netting arrangement. The content of novation netting agreements can be very different depending on the type of financial products covered. It often can be seen in bilateral foreign exchange transactions, repos and swap agreements. It is generally perceived that there are two types of novation netting—bilateral and multilateral. It is bilateral in cases where it only concerns two different counterparties with various bilateral transactions. It is multilateral in cases where it involves three or more counterparties with one or more transactions. However, novation netting is, in essence, bilateral.52 This multilateral aspect of novation is ill-conceived, although a multilateral effect is achievable and it is typically facilitated through a third party, ie simply an agent, without undertaking any transaction exposures with regard to the contracts in question or a CCP.53 In the latter case, the CCP is exposed to the counterparty credit risk of its members when, by novation, it becomes the counterparty to contracts. It becomes obvious that in case of CCP clearing the netting of transactions is only between a CCP and each of its members. Therefore, it is bilateral, rather than multilateral. As we can also see, this is essentially novation combined with bilateral netting to achieve a multilateral netting effect from a clearing member’s perspective. As far as CCP clearing is concerned, the novation is an important step in achieving a multilateral netting outcome at the time when the CCP becomes a buyer to the seller and a seller to the buyer. In some cases, novation may not be considered to be part of netting but rather the prelude to it.54 It is necessary here to understand how the novation process has been misconceived to be two types: bilateral netting and multilateral netting, as they operate to achieve different results before netting. Initially, novation is 51

Also see Section 2.2, ch 2 above for payment and securities settlement systems. RM Goode (2004), n 37 above, 472. 53 According to BIS’s Report on Netting Schemes (see n 28 above), there are two institutional multilateral netting schemes: multilateral positions netting and multilateral netting by novation and substitution. 54 JH Dalhuisen (2007), n 31 above, 490. Sir Roy Goode, on the other hand, identified that netting also involves ‘a process that leads, automatically or by unilateral action by one party, to consolidation of the mutual claims into a single net balance’. Also, see RM Goode (2005), n 26 above, 217. 52

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Netting and Set-Off used as one of the transfer methods with respect to debts, such as a loan sale,55 whereby a new creditor replaces the existing loan with the consent of the debtor. Hence, the debt is transferred due to a new agreement being formed, and the agreement between existing creditor and the debtor terminated. In this sense, the subject-matter of novation is obviously the loan agreement. The novation used for netting is similar to that in a loan sale from the original trading parties’ perspective, as contracts with various parties were novated to a CCP. The difference is that in the former case there is always one contract, while the latter case results in two contracts,56 one between the original seller and the CCP and the other between the original buyer and the CCP. Furthermore, in bilateral netting, novation is also different from the above two, in that a new contract is continuously formed to replace existing transactions and new contracts. The most significant point is that despite the fact that their economic effects are similar, novation netting has gone further onto the contractual level while contractual set-off and contractual netting may only operate on the level of delivery obligations, either monetary or non-monetary. Novation has come to be seen as a valuable market tool serving at least three distinct purposes: to reduce risk, to eliminate performance under intermediate contracts in a chain; and to facilitate dis-intermediation and the off-loading of unwanted assets and liabilities.57 In the case of dealings between two parties, novation netting can be constructed as a process involving continuous consolidation of new contracts with existing ones between two parties in the normal course of business.58 In economic terms, the use of either novation or set-off creates similar results, since both of them result in a single net balance. The real difference between the two is the timing of legal effect. Novation netting has immediate effect so long as a new contract is agreed, while a set-off has to be deferred until the due date. Furthermore, novation netting may, in some cases, be construed to exceed the scope of set-off in the way that the underlying crossclaims are distinguished because of the mechanism of continuous novation. As mentioned, novation netting can be structured to have a multilateral effect. In that case, it is also referred to as multilateral netting by novation and substitution by BIS.59 Briefly, this CCP clearing process involves two steps. First, upon registration all contracts are novated and the clearing house thus becomes

55 RC Tennekoon, The Law and Regulation of International Finance (London: Butterworths, 1991) 103–23. 56 The original contract between the buyer and the seller is novated and replaced by two identical contracts: one between the buyer and the CCP and the other the seller and the CCP. The economic terms in these two new contracts are normally the same to the original contract that had been terminated. 57 This solution severs as an excellent example to avoid the necessity for obtaining the counterparty’s consent every time it is desired to substitute a new party is, as in the case of CCP clearing, to utilise the mechanism of the rules of the market. See Roy M Goode, ‘The concept and implications of a market in commercial law’ (Spring 1990) 24(2) Israel Law Review 185–210. 58 JH Dalhuisen (2007), n 31 above, 483. 59 BIS (1989), n 28 above.

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Default Procedures and CCPs’ Default the CCP, Next, prior to the due settlement date, contracts between the CCP and each member which are of the same type are novated again and result in a single netted contract. With such an arrangement, the result of the British Eagles case would have been different, for the clearing house would have been entitled to combine both the account of the plaintiff and that of the defendant. This may suggest that potential issues may arise regarding the characterisation of such operation as there is an element of set-off. Nevertheless, some argued that no question of set-off should arise in novation netting.60

5.2.4 Close-out Netting Close-out netting is a process triggered by a prescribed event that permits a party to a financial contract to terminate the contract if the counterparty becomes insolvent, to calculate the termination values of the obligations of the parties, and to set-off the termination values calculated so to arrive at a net amount payable by one party to the other.61 The essence of close-out netting is that the non-defaulting party may, upon the occurrence of a prescribed event, accelerate all outstanding or un-matured contracts, terminate them, and net their value by mark-to-market.62 As noted by Philip Wood,63 the object of close-out netting is to reduce exposures of open contracts if one party becomes insolvent. Thus, close-out netting is applied to obligations without the same maturity date and even to those of different natures. In contrast, contractual netting deals with obligations that are due and liquidated on the same date. Close-out netting, coupled with novation, can be seen as an arrangement endeavour that provides another safeguard against challenges by applicable bankruptcy laws when contractual netting is in doubt. The application of close-out netting depends on the construction of the agreement. It may apply to monetary obligations only or non-monetary obligations or both. For non-monetary obligations, a mechanism of converting them into monetary obligations is normally agreed upon in financial markets before they are able to further set-off the existing monetary obligations, thus reaching a netted balance of monetary obligation. As discussed earlier, contractual set-off is ultimately to be tested when a party files for bankruptcy or commences winding-up proceeding. All other forms of set-off are to be displaced by mandatory insolvency set-off. The contractual arrangement runs the risk of being invalid when exemptions are not provided in relevant insolvency rules. 60 ‘[E]ach new contract is automatically consolidated with existing contracts to produce a new contract (novation) involving a single net indebtedness’. See RM Goode (2004), n 37 above, 472. 61 Netting Sub-Committee of the Companies and Securities Advisory Committee (Australia), Netting in Financial Markets Transactions (Final Report, June 1997) para 1.1. 62 SR Derham (2003), n 27 above, 730–31. 63 P Wood (1995), n 34 above, 153.

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Default by a Clearing Member Close-out netting provisions in the case of CCP clearing are part in its default rules and procedures. The effectiveness of these rules may not be significant to a clearing house that acts as an agent, but it plays a vital role when the clearing house acts as a CCP. To provide legal certainty for the smooth operations of financial markets, it is necessary to have the netting arrangement—both contractual and close-out—exempted from the application of relevant insolvency laws.64

5.3 Default by a Clearing Member The importance of default procedures cannot be underestimated. As recommended, [a] CCP’s default procedures should be clearly stated, and they should ensure that the CCP can take timely action to contain losses and liquidity pressures and to continue meeting its obligations. Key aspects of the default procedures should be publicly available.65

Primarily, the default rules and procedures of a CCP provide a special regime for handling clearing member default, which binds all parties and is exempted from the applicable insolvency laws. One of the ultimate objectives of such default rules is to eliminate any other obstacle that may prevent a CCP being able to continue to function and meet its obligations towards other clearing members in a member default situation.66 A CCP is, in normal circumstances, financially robust67 enough to withstand one or more clearing member defaults. Therefore, speedy execution of transparent and effective default procedures is crucial to the continuous functioning of the CCP. In the event of a default, the CCP default rules take precedence over the general principles of relevant insolvency law68 and preserve the rights of set-off, rights to close out contracts and to net obligations, as well as preventing the practice of ‘cherry-picking’, to the extent that the CCP’s rules and regulations are in that respect supported by law.69 Those rights embedded in default rules also normally prescribe the post-default procedures of 64 CCP close-out netting is normally operating under a special regulatory and insolvency regime. For example, see Section 6.3, ch 6 below for the UK regulatory regime. 65 See Recommendation 6, Recommendations for Central Counterparties (Basle: BIS, November 2004). 66 Also, see the ISDA Master Agreements for the definitions of default events. 67 See Section 3.2, ch 3 above, for how a CCP arranges in terms of financial resources so to make it financially robust and unlikely to get into difficulty in the event of one or more clearing member default. 68 For instance, see the EU Financial Markets and Insolvency (Settlement Finality) Regulations 1999 (SI 1999/2979), reg 14. 69 ie a safe harbour is provided so that general principles of insolvency law are not to be applied in the case that the CCP is a recognised clearing house by law. See ch 6 for the discussion on regulatory regimes.

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Default Procedures and CCPs’ Default a CCP and give certainty of effectiveness with a degree of transparency. It is further suggested that this consequently protects the integrity of the markets in which that CCP is operating. Arguably, a CCP may be vulnerable to legal challenges in handling a default situation according to its rules.70 Contrary to common principles of insolvency law,71 the effect of default rules is to provide to the CCP the default member’s assets, which serve as collateral for the transactions that have been processed through the CCP. This type of rule is principally inconsistent with the pari passu principle of insolvency law, which favours all of the general creditors rather than some particular creditors. Therefore, measures have to be taken to reduce the risk of a possible challenge to these rules and procedures and enable the CCP to take rapid and decisive actions in order to protect its risk as well as the integrity of the markets it serves. Furthermore, it is of paramount importance that the CCP’s default rules are supported in all relevant legal jurisdictions.72 The resulting legal uncertainty may have the effect of reducing participants’ confidence in the markets. It has been well illustrated what the consequences would be when such legal provisions are not in place to protect the actions taken by the CCP in accordance with its default rules. The uncertainties caused in Singapore and Japan during the collapse of Barings Bank induced many others to plan to adopt similar safeguards. Furthermore, the handling of the collapse of Barings also showed that it is important for clearing houses to have clear internal procedures for handling defaults. They should not only include ‘the power to negotiate the price of closing out positions outside the market but also arrangements with certain members to close out defaulted positions in accordance with clearing house instructions with confidentiality’.73 In essence, the default procedures cover two major issues, the first is the closing out of positions and second is the calculation of the consequential loss resulting from the close-out and the exercise of collateralisation provisions. Consequently, ‘[such] rules are essential to the ability of the clearing house to participate in the provision of an efficient and secure system for the trading of financial instruments’.74 As far as CCPs are concerned, the key objective of the default rules is to give the CCP the capability of closing out a defaulter’s position as quickly as possible in order to limit its market exposure. The ability of the CCP to close out all of the positions with the defaulting member in a reasonably quick manner is crucial. In a modern market, any delay or uncertainty may result in further

70 European Association for Clearing Houses (EACH), Standards of Risk Management Controls used by Central Counterparty Clearing Houses (November 2001). 71 To be discussed in the section below. 72 Although some suggest it may not be necessary to be all, see M Chamberlain, ‘The Legal Framework Within Which UK Exchanges and Clearing Houses Operate’ (1997) 4 European Financial Services Law 20–24. 73 A Lamb and E Swan, ‘United Kingdom: the Role of the London Clearing House’ (1996) 3(3) Futures & Derivatives Law Review 9–22. 74 See M Chamberlain (1997), n 72 above.

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Default by a Clearing Member serious damage to the CCP in financial terms as well as affecting the integrity and stability of the market in which it operates. In addition is the concern that the CCP might be subject to legal action, which would deprive it of the ability to use the collateral deposited or would require it to reinstate any margin already utilised. There is also likely to be an issue relating to the setting aside of transactions that constitute preferences and transactions at undervalue. This may possibly breach the margining and security provisions of clearing houses and result in the repayment of monies that could have been used by the clearing house to finance market operations.

5.3.1 Commencement of Default Procedures A CCP normally prescribes in its rules the events that are considered by it as a trigger for the clearing member being declared in default. A clearing member is required to notify the CCP of any event in relation to it that may affect its membership. Upon the notification, a decision will have to be made by the CCP as to whether the event is deemed to be one of the prescribed events and whether to commence the default procedures. In that respect, it is worth noting that a CCP may in certain circumstances declare a default before a member has actually failed to meet an obligation.75

A. The Prescribed Events that Trigger Default Procedures The prescribed events that trigger the commencement of default procedures include those relating to insolvency or winding-up proceedings and those relating to events that show a clearing member may become unable to meet his obligations. These events can be further categorised into five types:76 1.

The clearing member fails duly to perform or is in breach of any term of the CCP’s Rules and Regulations. If such clearing member is also a member of related regulated markets or of any regulatory body, the events will also extend to include any breach of their rules and regulations; The second category is related to the performance of trade obligations, ie the clearing member is in default in the payment due to the CCP or in making or accepting a tender, or fails to pay any sum due; The third category covers events in relation to bankruptcy and liquidation proceedings; The clearing member is dissolved, either being a partnership or a registered company; and Any distress, execution or other process is levied or enforced or served upon or against any property of the clearing member.

2.

3. 4. 5.

75

See, for example, Rule 3, Default Rules of LCH.Clearnet Ltd (March 2004). According to Rule 5, Default Rules of LCH.Clearnet Ltd (March 2004). Also, see the ISDA Master Agreements for the definitions of default events. 76

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Default Procedures and CCPs’ Default

B. Procedures to be Followed Upon acceleration of un-matured claims against a defaulting member, the procedures to be followed eventually lead to the close-out of all the open positions in relation to those claims as against the defaulting member and a final net sum (be it ‘in the money’ or ‘out of the money’). Here, there are two initial steps to be taken by a CCP once a clearing member’s default is declared. They are the termination of open contracts in question and the discharge of the defaulting member’s rights and obligations.77 One way to the termination is to transfer the open contracts in relation to the defaulting member to the account(s) of the other member(s). A CCP can also choose to hedge market risk in respect of those defaulting contracts. If that is the case, the CCP will hedge market risk in the name of the defaulter. Upon the discharge, the CCP is to produce all sums payable by or to the defaulter in respect of contracts. They will then be aggregated or set off so as to produce a new sum. The resulting net sum (either in the money or out of the money) will then either be further set off against the cover of margin deposited by the defaulting member, or be aggregated with that cover to reach a final net sum.78 This calculation process involves an element of conversion, ie the conversion of non-monetary claims into monetary ones via the mark-to-market mechanism. Another key step, which is also likely to be the case when the close-out of the contracts results in the defaulting member being out of the money, is the realisation of financial collateral, or the enforcement of financial collateral arrangements, as deposited by the defaulting clearing member. Simply put, it is to realise the collateral to offset the shortfall, and return the excess as the case may be. In the case that the proceeds cannot cover the loss, the CCP’s own financial resources (first default fund) are used. Where securities are used for collateral, it will be through sale by way of public or private sale for the account of the defaulter and without being obliged to obtain the defaulter’s consent or any court order, and the CCP has power to appoint any person to execute the sale for such purpose in the name and on behalf of the defaulting member.

C. Close-out of Positions Essentially, the end result of the default procedures is to convert all the crossclaims, either monetarily or by physical delivery, between the CCP and the defaulting member, into a single net monetary obligation. In practice, close-out of positions may include auctioning the positions and hedging the positions.79 77

For example, Rule 3, LCH.Clearnet Ltd, Default Rules (March 2004). Rule 8, LCH.Clearnet Ltd, Default Rules (March 2004). For instance, the steps that LCH.Clearnet may take under its Default Rules are also illustrated by the actions taken in the four defaults: Drexel Burnham Lambert failed to meet margin calls; Woodhouse Drake & Carey and Griffin Trading Company failed to meet regulatory requirements; Barings went into administration. The Default Rules stipulate that LCH may declare a default before 78 79

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Default by a Clearing Member The key here is that close-out netting only operates upon the occurrence of one of the default events as prescribed in the CCP’s default rules. The analysis of close-out netting often failed to identify the conversion of obligations, another key element in the close-out netting process. In a close-out netting, open or un-matured contracts of one counterparty are likely not only to involve monetary obligations but also delivery obligations. In order for set-off to operate, the conversion of all delivery obligations into monetary obligations is necessary, since it is not possible for set-off to directly apply to delivery obligations.80 In relation to the closing out of positions, different default procedures may also be used according to the type of defaulting contract and its market condition. For liquid products, the traditional procedures for handling a default by a CCP prompt the CCP to enter the market and to replace the contracts, in order to hedge against further loss on the open positions resulting from the terminations of the defaulting member’s trades. For illiquid products that are cleared, for example, a different default management process has recently been adopted by SwapClear, which is operated by LCH.Clearnet Ltd in London. The initial goal of the process is to reduce and mitigate the risk exposure of the CCP in the event of default by a clearing member. If initiated, the process would be monitored and managed by a default management group. Traders from clearing members would be seconded to SwapClear to manage the defaulter’s portfolio. They would be charged with neutralising the risk in the portfolio by entering into new OTC derivative contracts with non-defaulting clearing members. Once risk-neutralised as much as possible, the portfolio would be divided by currency and auctioned to surviving members. The default management group would determine a reservation price for the auction, and if a surviving clearing member’s bid exceeded that reservation price, the auction would be deemed successful. If not, the auction would fail. In the event of a failed auction, the portfolio would be divided equally among surviving clearing members active in that currency and novated, at a price determined by SwapClear, to those members. Under the new procedure, a non-defaulting SwapClear member would bear the risks of entering the markets to hedge open positions created by a default only if it is a successful bidder for one or more currencies at the auction or if one or more auctions fail and it is assigned its share of contracts because it has outstanding positions with SwapClear in those currencies. In the report,

a member has failed to meet an obligation [Default Rule 3]. Accordingly, ‘it may close-out and settle open contracts of the defaulter [Default Rules 6(b), (c), (f), (i), (j)]; transfer open positions to another member, subject to the latter’s consent [Default Rule 6(g)], with or without associated margin cover [Default Rule 6(h)]; enter into new exchange contracts in order to hedge the market risk of the defaulter’s open position [Default Rule 6(l)] or to enter other, off-market contracts for the same purpose [Default Rule 6(m)]’. See LCH.Clearnet (2002), n 12 above, 27. 80 This is the case at least under English law as set-off only applies to monetary obligations. See SR Derham (2003), n 27 above.

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Default Procedures and CCPs’ Default although the effort to enhance default procedures has been acknowledged, the effectiveness of the new default management procedures for some is still one of the key concerns. Nevertheless, the ultimate objective of these two procedures is to limit the loss and enable the CCP to calculate its exact exposure to the defaulting member so as to reach a final net sum by setting off against the collateral deposited by that member. Without doubt, the effectiveness of these procedures will always be the subject of scepticism unless it has been tested in actual events. One thing which is certain is that a speedy close-out of defaulting positions is important in the sense that for every open position, there is an equal and opposite position that the CCP is exposed to as a counterparty to another clearing member and is required to perform and meet the obligations regardless of the fact that there is a defaulting member.

5.3.2 The Effect of Default Procedures on Other Clearing Members and Third Parties As a founding goal for CCP clearing, each clearing member of a CCP has been isolated from the default risk of the other clearing members and is only exposed to that of the CCP instead. In other words, what CCP clearing sets out to achieve is that a defaulting member poses no risk to the other non-defaulting members so long as the CCP stands solvent. It is generally anticipated that a well-managed CCP as so constructed shall be able to withstand the losses from one or more members defaulting at the same time and continue to honour its contractual obligations towards all other non-defaulting clearing members. As a result, the impact on non-defaulting members shall be none, provided that the financial resources the CCP has for dealing with two or more clearing members in default at the same time can cover the loss suffered as a result.81

5.4 Default by a CCP Although much of the focus has been on issues regarding the default of clearing members, issues concerning the possible default of a CCP have rarely been mentioned and have not yet been fully examined. To date, no literature has been devoted to this specific topic. It might be right to assume that a properly run CCP with adequate membership criteria and rigorous risk controls is much less likely than its members to get into difficulty or even become insolvent. Furthermore, it is widely accepted that it is a highly unlikely event that a CCP may get into difficulty or even become insolvent, given the fact that in some cases it has the 81

See the line of defence a typical CCP has for dealing with clearing member default

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Default by a CCP explicit backing of a central bank—as is required by law, for example, in France in the event that there is a potential consequence of market instability.82 Nevertheless, it is often the case that the situation is not as clear in other jurisdictions when there is a financial crisis with a CCP. Undoubtedly, markets generally expect the central bank or other relevant authorities to intervene in the event of market distress, which is likely to be the aftermath of a defaulting CCP. The incidents of past clearing house failures83 nevertheless do remind us that it is not entirely remote. It is therefore necessary to prepare for such an eventuality and construct a framework. In so far as past clearing house defaults are concerned, the clearing houses were mainly acting as agent for all the members rather than as principal, as a CCP is. These incidents may therefore not be so comparable when the subject-matter concerned here is CCP clearing. At best, the ways of how those defaults were handled can serve as guidelines to construct a framework for CCPs. Needless to say, the impact of a CCP being in default, both on its members and the market(s) it serves, would be much more significant simply because it is typically acting as counterparty to other major participants in the market. Given a CCP’s position in the markets,84 adequate default procedures for CCP clearing can contribute to the avoidance of uncertainty and minimise the disruption to market operations. The lack of default rules and procedures would also mean that there was a great uncertainty as to the exposure clearing members would have towards their CCP in the event that the CCP went into default. This would make it impossible for the members to assess and manage counterparty risk when it came to the CCP, as opposed to the counterparty risk a CCP was established to manage. Without doubt, a defaulting CCP would most likely result in enormous losses for its members in relation to the market contracts to which the CCP was the counterparty. The financial resources that they had contributed to the CCP might also be in jeopardy, although the explicit purpose of such funds is to be deployed in the event that the collateral provided by a defaulting member is not enough to cover the loss incurred. Hence, it is doubtful as to whether those financial resources can be utilised when a CCP is in default, especially when there is no explicit provision that gives permission to the CCP to use these resources. One of the lessons learnt from the recent 2007–08 financial crisis is that the lack of crisis resolution arrangements for investment banks has contributed to a greater degree of uncertainty in the markets, and arguably a deepening of the crisis or the delay of a possible speedy recovery. The subsequent regulatory responses to the crisis may prove to be beneficial for CCPs, since CCPs are

82

See Legal Framework, Clearnet (now LCH.Clearnet SA) 2002. Copy in author’s possession. There have been three clearing house defaults to date, e.g. the failure of clearing houses in Paris in 1973, Kuala Lumpur in 1983, and Hong Kong in 1987. 84 As discussed in chs 2 and 3 above. 83

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Default Procedures and CCPs’ Default regarded as systemic important institutions for the reason that they are providing an integrated function to modern markets.85 As a result, the scope of the crisis management will necessarily cover the situation when a CCP falls into difficulties. Nevertheless, the undesirable moral hazard issue resulting from the perception of market participants that such firms will be considered too big to fail has to be addressed properly. As a systemic important institution, a CCP being allowed to fail may not simply be the best solution. A takeover by another CCP is also an option, though a smooth transition is paramount and may require the support from all stakeholders and other relevant authorities. In constructing a default resolution framework for CCPs, the main objective is to have an arrangement in place to enable a default by a CCP to be resolved in an orderly fashion without systemic disruption. In addition, the following issues need to be considered: 1.

2. 3.

The first is concerning moral hazard. As shown in the recent 2007–08 financial crisis, the ‘too big to fail’ theory has damaged the level playing field that market regulations have been trying to create. The second issue is to minimise the disruption to the smooth functioning of the markets and the financial system. And Finally, as a matter of counterparty risk management, there is a desire of the CCP clearing members/participants to know exactly their ultimate counterparty exposures to their CCP. In addition, it is the fact that members/ participants are typically significant players in the markets.

To repeat, the main objective of introducing the CCP clearing mechanism to a market is to manage counterparty credit risk and, most importantly, to prevent the chain reaction or ‘domino effect’ that may eventually cause systemic risk to the markets. As said, the structure of CCP clearing is typically organised in a way that the CCP has robust financial resources to withstand the impact of two or more of its clearing members being in default. Not many in the markets would disagree that a default by a CCP within a financial system would have a catastrophic effect on the system as a whole and even cause panic and damage investors’ confidence in the markets. With the potentially serious and devastating consequences to the markets of a defaulting CCP, there is an urgent need to study the possible economic impact, to build a robust legal framework for such an eventuality, and thus reduce the uncertainty to the markets.

85 In the UK, there is a recent proposal to require banks to draw up recovery and resolution plans, otherwise known as ‘living wills’, for themselves, as a response to the 2007–08 financial crisis, may also shed some light for CCPs. It is not clear, however, whether the proposal will go far enough to cover CCPs. See Financial Service Authority, A Regulatory Response to the Global Banking Crisis: Systemically Important Banks and Assessing the Cumulative Impact (Turner Review Conference Discussion Paper, 09/4, October 2009).

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Concluding Remarks

5.5 Concluding Remarks Despite the various theories on both netting and set-off and the relationship between the two, it is important that they are put in context and be differentiated and treated accordingly under the law. As far as CCP clearing is concerned, the entire life-cycle of CCP clearing involves repeated use of both netting and set-off.86 It includes transaction set-off, novation netting, and settlement netting, as well as close-out netting if default procedures87 have been triggered by a defaulting member. As for default procedures, it is clear that they should be recognised and supported by the jurisdiction(s) within which the CCP is operating. The relevant laws should ensure that the default rules and procedures, once triggered, are enforceable and cannot be challenged. In particular, the resulting single net sum of the close-out netting and the realisation of the financial collateral provided by the defaulting member, as the case may be, need to be legally enforceable and valid under the relevant insolvency regime. Furthermore, it is argued that the default regime should not only cover the case where a clearing member is declared as in default, but also the event when a CCP falls into difficulty. It is argued that there should be an initiative to build a framework for effective resolution arrangements. Such framework should address at least three major issues as mentioned in the previous section. In particular, there are uncertainties in relation to the ultimate exposure that clearing members would have towards the defaulting CCP.

86 87

As can be seen in the description on the operational aspects of CCP clearing in ch 3 above. See Section 5.3 above, for the discussion of default by a clearing member.

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6 Regulatory Issues

I

N THIS CHAPTER, the purposes and objectives of financial regulation are to be first discussed.1 What we are concerned here are those objectives that are particularly relevant to CCPs, for example, a fair, efficient and transparent market and the reduction of systemic risk. The regulatory framework in relation to CCPs is then examined with examples that are drawn mainly from the United Kingdom. As the interest of central banks in the development of CCP clearing grows, especially in relation to systemic risk, the regulatory issues with respect to the bank’s role in it will also be discussed briefly. At the European level, regulatory issues relating to the drive towards a single panEuropean market are examined as well as the regulatory responses to the 2007–08 financial crisis. Where appropriate, references are made to other regulatory regimes like those in the United States.

6.1 The Purposes and Objectives Of Financial Regulation 6.1.1 The Purposes and Objectives of Financial Regulation Three common objectives for financial regulation are regarded as providing the basis for an effective system of regulation. They are: (1) the protection of investors; (2) ensuring that markets are fair, efficient and transparent; and (3) the reduction of systemic risk (stability).2 For investor protection, a distinction is 1 Financial regulation in a board sense include public regulation and self-regulation. Hereafter, it refers to public regulation unless specified otherwise. 2 International Organization of Securities Commissions (IOSCO), Objective and Principles of Securities Regulation, adopted September 1998. Based on those three objectives, the IOSCO has further developed 30 principles under 8 categories. Also see JH Dalhuisen, Dalhuisen on Transnational and Comparative Commercial, Financial and Trade Law, 3rd edn (Oxford: Hart Publishing, 2007) 915–28. M Brunnermeier, A Crocket, C Goodhart, AD Persaud and H Shin, The Fundamental Principles of Financial Regulation (Geneva Reports on the World Economy 11, 2009).

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Purposes and Objectives of Regulation commonly made between retail investors and those in wholesale markets. The main reason for drawing such a line is that different types of investors require different degrees of regulatory protection. As for the markets, regulation is used as a tool for promoting better functioning of markets in order to achieve the goal of better market efficiency and stability. These regulatory objectives obviously interact with each other, as achieving one objective may benefit the others. Some objectives of financial regulation may in some cases find themselves conflict with each other. A typical example is the reduction of systemic risk and ensuring an efficient market.3 Hence, these objectives should not be considered as stand-alone but instead as an integrated system. In essence, the main purpose of financial regulation is to address all regulatory concerns. In particular, financial regulation initially seeks to address insolvency risk through regulating excessive risk-taking by banks,4 be it by way of public regulation as a form of governmental intervention to reduce the impact of a market participant’s failure on the system as a whole, or by market discipline, eg in the form of self-regulation, through which market participants seek to minimise the impact of one insolvent participant on the others.5 In so far as CCPs are concerned, there are three relevant regulatory concerns in determining the objectives of regulation.6 One is the concern for the market integrity. This concern stems from the so-called ‘public good’ argument. It is submitted that in a market economy, a well-functioning financial market is a public good. Furthermore, confidence in the regulatory framework for a financial system is also considered as one of them. The second concern is the reduction of systemic risk. As will be further discussed in chapter seven below, CCPs by their nature contribute to the reduction of systemic risk. The third is about creating a level playing field. As for CCPs, addressing this concern results in the recent drive towards inter-operability between different CCPs.7 Consequently, these main regulatory concerns in turn justify the regulatory intervention. While the rationale for financial regulation is generally accepted, the scope of regulatory intervention remains subject to much debate. This is also true with the structures and models of financial regulation.8 To achieve the objectives of 3 The conflicts between different regulatory objectives will also be further discussed below in the context of the interaction between regulation and the markets. 4 JH Dalhuisen (2007) n 2 above, 1097. 5 Self-regulation as a form of regulation is to be discussed further below. 6 For further discussion on the rationale for regulation, see CA Goodhart, Financial Regulation (London: Routledge, 1998) ch 1. Also, see Section 6.2.3 below for the regulatory concerns in relation to CCPs from central banks’ perspective. 7 Also, see further discussion in ch 7 below. 8 In achieving these common regulatory objectives, financial regulation has been structured in several different ways in different countries. Four different approaches have been identified, they include ‘institutional supervision’, ‘supervision by objectives’, ‘functional supervision’, and ‘singleregulatory supervision’. For detailed description of these four approaches, also see GD Giorgio and CD Noia, Financial Regulation and Supervision in the Euro Area: A Four-Peak Proposal (Wharton Financial Institutions Center, University of Pennsylvania, Preliminary Version: January 2001). For discussion on various institutional models, see M Taylor. ‘Twin Peaks’: A Regulatory Structure for the

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Regulatory Issues financial regulation, regardless of how financial regulation is structured, financial supervision carries out two key functions: prudential supervision (including both macro-prudential and micro-prudential) and conduct of business supervision.9 So far as financial supervision is concerned, essentially the key task is to ensure that regulatory and market standards have been observed continuously by market participants within the financial system. Drawing from the perception of market participants, on the other hand, it has been argued by some that regulation must be justified on the ground that it is needed to provide protection of others and that the benefit of this exceeds the cost. This approach is much associated with the emphasis of market discipline, which will be discussed further shortly. Suffice it to say here, market discipline with a threat of bankruptcy to the participants is fundamental to the success of a market economy, not just limited to a wellfunctioning financial system. The 2007–08 financial crisis has exposed certain weaknesses in financial regulation and supervision, as some may argue, especially a lack of appropriate oversight on systemic risk. Ensuring financial stability has thus become a top concern to be addressed at present. It has become obvious now that to achieve such objective, competent authorities need to focus not only on the soundness of individual institutions but also on systemic risk and the interconnectedness of the system.10 It seems inevitable for going forward that the scope of financial regulation is to be expanded as a result, particularly in relation to prudential regulation and potentially controversial product regulation. Furthermore, the argument for limiting the scope of financial regulation has become rather weak after the latest crisis, as some argue that market discipline has failed.11 It is submitted that the gaps in regulation as identified above have to be addressed and the scope of regulation will have to expand as a result. To simply expand the scope of regulation would arguably not bring the necessary reforms to create the regulatory framework needed for an increasingly globalised market. Instead, the focus on regulatory reform should aim at creating a dynamic and New Century (London: Centre for the Study of Financial Innovation, December 1995); M Taylor. Peak Practice: How to Reform the UK’s Regulatory System (London: Centre for the Study of Financial Innovation, October 1996); JH Walsh, ‘Institution-based Financial Regulation: A Third Paradigm’ (2008) 49(2) Harvard International Law Journal 381–412. 9

See JH Dalhuisen (2007) n 2 above, 1103. Also, see C Goodhart (1998), n 6 above, at xvii. This is the rationale behind the recent regulatory approach to identify systemic important institutions. 11 However, this is subject to much debate. The causes to the recent 2007–08 financial crisis have become much clearer now. Numerous articles and reports have discussed the causes of the crisis in great detail. They include: Lord A Turner. A Regulatory Response to the Global Banking Crisis (The Turner Review) (Financial Services Authority, March 2009); J De Larosière et al, The High Level Group on Financial Supervision in the EU (the De Larosière Report) (Brussels, February 2009); and US Department of the Treasury, A New Foundation: Rebuilding Financial Supervision and Regulation (White Paper, 17 July 2009), to name a few. Suffice it to say here, the main cause to the crisis can attribute to the global macro-imbalance that has been on the rise in the last decade. It is arguable that the failure of market discipline can only, at its best, be considered as one of many other contributors to the crisis. 10

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Purposes and Objectives of Regulation robust regulatory framework that is capable of identifying and addressing the gaps between the regulation and the markets resulting from the interaction between financial regulation and the market, which will be discussed shortly. There has been a set of proposals representing a major increase in the scope of regulation of institutions, products and markets.12 These proposals seek to extend the application of existing regulatory standards, thereby avoiding potential conflicts.13 It has also been further argued that the increase in regulatory burden is justified by the high cost of the alternative, as shown in the 2007–08 financial crisis. Consequently, the responses for strengthening the regulatory framework include: extending the scope of financial regulation to include microprudential supervision and to cover systemically important institutions; and the strengthening of the infrastructure, for example, the regulatory initiative to introduce CCP clearing for OTC credit default swaps, which has been identified as a way of improving the transparency of the markets. To better understand the need for creating a dynamic and robust regulatory framework, however, it is necessary here to examine the interaction between financial regulation and the markets.

6.1.2 The Interaction Between Financial Regulation and the Markets The interaction between financial regulation and the markets, which may be characterised as a constant matching and mismatching in their respective structures, results in regulation going through the cycle of regulation, de-regulation and re-regulation on the one hand,14 and markets reacting with innovations, eg in financial products and their structure on the other. The interaction consequently creates not just gaps in regulation, but a consistent pattern of matching and mismatching between the structure of the underlying regulatory framework and the actual structure of the markets it regulates.

12 A Carvajal, R Dodd, M Moore, E Nier, I Tower and L Zanforline, The Perimeter of Financial Regulation (International Monetary Fund, 26 March 2009). 13 Others go as far as to argue for deliberate over-regulation. For instance, Buiter argued that ‘sweeping reform be introduced as soon as possible, before the defenders of the financial status quo are able to collect themselves and launch as massive PR campaign to close the door on radical reform … [I]f over-regulation, indeed destructive over-regulation is the immediate result, then so be it. It is easier to negotiate sensible modifications to a framework characterised by over-regulation than it is to add sensible regulation from a framework characterised by under-regulation’. See WH Buiter, Lessons from the Global financial Crisis for Regulators and Supervisors (Paper presented at the 25th anniversary Workshop ‘The Global Financial Crisis: Lessons and Outlook’ of the Advanced Studies Program of the IFW, Kiel, 8–9 May 2009). 14 Professor Dalhuisen also distinguishes the regulation, de-regulation, and re-regulation of the capital flows from the regulation, de-regulation, and re-regulation of the financial services. See JH Dalhuisen (2007) n 2 above, 1101.

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Regulatory Issues One of the main responses by the markets to regulation is through innovation.15 Here, innovation takes two main forms: one is innovation in the market structure and the other is innovation in financial products.16 This has been demonstrated by two recent market trends in the United States; the shift from regulated intermediaries to less regulated entities and the shift from traditional intermediation to capital market.17 To some extent, innovations in market structure and financial products are driven by achieving cost efficiency and regulatory arbitrage.18 As a result, financial regulation has both negative and positive effects on innovation. Nevertheless, it is submitted that the essence of financial regulation is that the regulation should be proportionate without stopping innovation.19 Indeed, regulation is mainly about striking the balance between anticipating regulatory issues and stifling innovation. In other words, financial regulation should not distort the rapid and beneficial innovation in the markets, while still reacting proportionately to the regulatory challenges that innovation poses. Despite the fact that different structures of financial regulation have been adopted in different countries,20 arguably it remains true that markets have been segmented essentially into traditional product lines; for example, banking, securities, and insurance. In the past decade, the drives towards removing barriers to entry and restrictions of investment diversification as well as on various types of ownership structure, together with innovation and technological advances, increased competition, and globalisation, have resulted in a blurring of the dividing line between financial sectors and of the traditional distinctions which used to apply across different types of market participants and products. For market participants, this is demonstrated by an increase in the number of institutions that have operated across traditional sectoral boundaries. In addition to the regulatory gaps resulting from the blurring of the dividing lines in the financial market structure, and the fact that financial regulation is largely focused on the market structure within its own borders, the slow response of financial regulation and a lack of proper understanding about the dynamics of

15 Having said that, financial innovation can also be driven to facilitate the needs of investors and markets. The development of CCP clearing provides a very good example here. 16 Examples of such innovation can be found in the development of the concept of CCP clearing as discussed in ch 2 above, and the concept of securitisation. 17 As observed by CK Whitehead, see CK Whitehead, Reframing Financial Regulation (2010) 90(1) Boston University Law Review 1. 18 LJ White, Technological Change, Financial Innovation, and Financial Regulation: the Challenges for Public Policy (Wharton Financial Institutions Center, University of Pennsylvania, #97–33, May 1997). 19 In observing the interaction between the regulation and the market, various approaches have been put forwarded on the structure of financial regulation. Whitehead examines the interaction between markets and financial regulation and proposes a new approach to reframing financial regulation, as distinguished from the existing regulation that is based on traditional business categories. See CK Whitehead (2010), n 17 above. Also, see Section 6.4 below for the discussion of the latest EU proposals on financial regulation and supervision. 20 See n 8 above.

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Purposes and Objectives of Regulation markets are contributed to by poor co-ordination between national regulators at the international level.21 The recent decade has seen significant increased volume of cross-border financial transactions as the pace of globalisation accelerates. Nevertheless, financial regulation remains largely divided by national borders, while markets have become increasingly interconnected. As mentioned earlier, one of the regulatory objectives is to create a fair, transparent, and efficient market. The post-trade infrastructure, as an integrated part of a modern financial system, caters for the needs of the markets it serves. The complexities of modern financial markets are partially reflected by the complex engineering in the modern post-trade infrastructure, as discussed in the first chapter. These complexities can further be characterised by the need to support a wide range of financial transactions, taking into consideration the regulatory framework it is subject to, which primarily seeks to protect market integrity and investor interests. So far as CCPs are concerned, the objective is to ensure that they contribute to the improvement of market efficiency as well as the minimisation of systemic risk. As will be discussed in the chapter seven below, CCPs by their nature can help the markets achieve both objectives so long as adequate risk management and controls are in place. In fact, the post-trade infrastructure performed remarkably well in the 2007–08 financial crisis. This may nonetheless be attributed to the drives towards the reduction of systemic risk in those systems drawing from the past events, ie the paperwork crisis in the late 1960s and the 1987 market break in the United States.22 To sum up, better regulation should be the main objective for the reform of financial regulation that is currently underway in light of the 2007–08 crisis. With the increasing complexities in modern markets and the ever-more innovative market structures and financial products that are accompanied by corresponding operational structures, the relatively slow pace of change that characterises public regulation as a means of government intervention is increasingly inappropriate for achieving the objectives of market efficiency and stability. Thus, a better regulatory framework will not only have to address the gaps in regulation and regulate the risks posed by the markets, but also take account of the market dynamics, in particular as a result of the constant interaction between financial regulation and the markets.

21 As a result of the recent 2007–08 crisis, global cooperation has been further strengthened. In particular, the Group of Twenty (G20) agreed in April 2009, among others, to replace the Financial Stability Forum as the Financial Stability Board (FSB) with a strengthened mandate; to require the FSB to collaborate with the International Monetary Fund (IMF) to provide early warning of macroeconomic and financial risks and the actions needed to address them; and to extend regulation and oversight to all systemically important financial institutions, instruments and markets by. See the Communiqués issued by G20 on 2 April 2009, at: www.g20.org/pub_communiques.aspx. 22 See the discussion in ch 2 above.

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Regulatory Issues

6.2 Regulatory Approaches 6.2.1 The Modes of Financial Regulation As to the modes of regulation, they are generally divided into two different types: self-regulation and public regulation.23 Public regulation here refers to regulation as a form of government intervention to address the ‘public good’ concerns mentioned earlier. As for self-regulation, self-regulatory functions24 are often found in a wide range of activities, especially the practising of professional occupations like legal services, medical services and financial services, to name but a few. In particular, self-regulation as an integrated part of the regulatory framework has a long history in financial services.25 Indeed, different regulatory regimes are adopted in different jurisdictions. Nonetheless, it is still common now-a-days that different elements of regulation have been allocated to different bodies including Self-regulatory Organisations (SROs) and other competent authorities, and the responsibility for regulation is shared between public and private agents. The key here is to strike a balance between self-regulation and public regulation. Whilst these two types of regulation are considered to be complementary to each other,26 self-regulation has certain advantages over public regulation, which include flexibility, expertise and speed.27 It has long been recognised that with slow pace of regulatory change, financial innovation is always one or more steps ahead of regulation. Thus, there is a need to design a regulatory regime that can reduce the reliance on rigid rules which may be easily evaded via financial innovation. Arguably, self-regulation, in adding a dynamic element to the regulatory framework, plays an important role here in addressing the regulatory gaps resulting from the interaction between the regulation and the markets. As a result of the formalisation processes in recent decades, self-regulation is now typically subject to regulatory oversight. This has 23 For an overview of the models in use, also see The SRO Consultative Committee of the International Organization of Securities Commissions, Model for Effective Regulation (IOSCO, May 2000). For a comparison of European and American approaches, see JH Dalhuisen (2007), n 2 above, 1192–5. 24 Notably, it has to distinguish those with pure self-regulation from the so-called co-regulation where regulatory responsibilities are shared by self-regulatory organisations and competent authorities. For discussion on self-regulation, see A Ogus, ‘Rethink self-regulation’ (1995) 15(1) Oxford Journal of Legal Studies 97–108. The author argues that ‘when combined with some measure of external constraint each [model of self-regulation] has the potential, at least in some contexts, to meet the traditional criticisms and to generate outcomes which may be superior to those emanating from conventional public regulatory forms’. 25 For a historical comparison of financial regulations in the US, EEC and Japan, see JH Friedland, The Law and Structure of the International Financial System (Westport CT/London: Quorum, 1994). 26 LC Gower, Review of Investor Protection (London: HMSO, 1985) 40–68. 27 The contractual relationship between a Self-Regulatory Organisation and its members provides more flexibility as it allows the Organisation to react more quickly. Also see A Ogus (Spring 1995), n 24 above.

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Regulatory Approaches been the case for exchanges and traditional clearing houses as well as CCPs. This approach, which is also known as co-regulation with statutory oversight, involves a combination of self-regulation and statutory oversight and a split of responsibilities, with competent authorities being assigned legal power to secure relevant regulatory objectives.28 It is arguable that there is no clear-cut answer to the question of whether the market should be regulated primarily by self-regulation or by public regulation, even though the recent 2007–08 financial crisis has given much weight to the argument for more prescriptive and tougher regulation.29 A regulatory framework with self-regulation operating within it may be considered to ensure the integrity of the market to the extent that it is properly supervised by competent authorities. Here, the key is to place greater reliance on internal risk management through self-regulation of the relevant segment of the financial services industry.30 To that effect, it also follows that public regulation should be kept to a minimum so as not to lead to over-regulation or hinder market innovation.31 Furthermore, some have also suggested that ‘self-regulation, typically involving a unique combination of private interest with government oversight, is an effective and efficient form of regulation for the complex, dynamic and ever-changing financial services industry’.32 It is nevertheless hard to deny that self-regulation comes with drawbacks. The main concern is that there is a risk in self-regulation that self-interest may outweigh public interest. Arguably, the recent 2007–08 financial crisis exemplified that as it was considered to be one of the causes to the crisis.33 This in turn justifies the need for appropriate regulatory oversight. Hence, there is a stronger case for the co-existence of self-regulation and statutory oversight under the co-regulation approach. It is arguable that the emphasis should nevertheless be on public regulation. Needless to say, an effective co-regulation approach, under which the two forms of regulation are interdependent on each other, would 28 For example, in the EU the Lisbon European Council in endorsing the Financial Services Action Plan (FSAP) in March 2000 has also noted that ‘co-regulation, self-regulation or agreement between the social partners could sometimes provide more effective regulatory solutions, as opposed to public regulation’. See further discussion in Section 6.4 below. 29 Also, see the discussion on the rule-based regulatory approach and principle-based approach shortly. 30 CA Goodhart (1998), n 6 above. 31 Recent financial crisis has also highlighted the importance of finding the balance between the two modes of regulation. 32 The SRO Consultative Committee of the International Organization of Securities Commissions, Model for Effective Regulation (IOSCO, May 2000). For the discussion on self-regulation, also see Section 6.3.2 below. 33 It is true that a wave of regulation normally follows the crisis. After the recent 2007–08 financial crisis, there have been sets of proposals in various countries and also at international level for regulatory reforms, although the question remains as to how far reaching it will be. Various reports have been published in 2009 with recommendations to undertake regulatory reforms, for example, the UK Turner Report, the de Larosière Report for the EU, and the report by the US Treasury. See Lord Turner (2009), n 11 above; J De Larosière et al (2009), n 11 above, and Department of Treasury, A New Foundation: Rebuilding Financial Supervision and Regulation (2009).

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Regulatory Issues mainly depend on the following two key aspects: the first is the flexibility of and transparency in the regulatory framework and the second concerns its accountability. In light of the 2007–08 financial crisis, the recent debate has also focused on whether financial regulation should be based on principles or rules.34 Behind the reliance on a principle-based regulatory regime, as opposed to the so-called rule-based regime, is the market discipline approach.35 In general, principlebased regulation refers to a set of principles determined by the goal of addressing regulatory concerns and achieving the prescribed regulatory objectives. Under the principle-based approach, competent authorities typically issue accompanying guidance on implementing these principles for firms under their supervision to ensure compliance with relevant regulations.36 As discussed in the previous section, some regulatory objectives may find themselves in conflict with each other in some cases with unintended consequences. Here, the problems with the conflicting regulatory objectives are considered to be one of the reasons for the adoption of the principle-based approach as opposed to the rule-based approach. This principle-based approach emphasises that modern financial markets are dynamic and constantly changing. To repeat, it is therefore important that regulation can respond rapidly to the pace of change in markets and so allow regulatory principles and practice to continue to develop for the benefit of market users. In contrast, any set of prescriptive rules would be unable to address such changing market circumstances and practices at all times and would inevitably inhibit beneficial market innovation.37 Furthermore, one of the key features of regulation is its abstraction, which enables it to embrace innovation brought by new technology and not to be limited to solutions only. Finally, it is submitted that possible changes in the nature of financial regulation may lead to new regulatory risks that could arise because of some market participants seeking to avoid the new regulatory controls by adopting innovative financial products and structures. As was pointed out, the rule-based approach at this level may not be effective and there remains a need to develop regulation based on the principle-based approach at the level of the financial system.38 It

34 AI Anand, ‘Rules v. Principles as Approaches to Financial Market Regulation’ (2009) 49 Harvard International Law Journal Online, 7 April 2009. 35 For market discipline approach, see the discussion in the previous section above. 36 This is the case in the UK, where the implementation of regulation by the FSA is accompanied by relevant guidance issued in its supervision manual. 37 In addressing that ‘the design of financial regulation is not straight-forward’, the authors further described the interaction between regulation and the markets as ‘[w]hen everyone is baying for more, tougher regulation, it is not needed, (because everyone is risk averse). When such regulation is badly needed, no one wants it, (since the good times are expected to roll on). This suggests that financial regulation should be focussed, primarily rule-based, (because discretion will be hard to use during periods of boom/euphoria), and time and state-varying (light during normal periods, increasing as systemic threats build up).’ See M Brunnermeier et al (2009), n 2 above. 38 See K Alexander, ‘Principles v. Rules in Financial Regulation: Re-assessing the Balance in the Credit Crisis’, Symposium at Cambridge University, 10–11 April 2008.

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Regulatory Approaches should be pointed out that the flexibility of the principle-based approach itself does not come without shortcomings. For example, some have argued that the principle-based regime in the United Kingdom failed to take into account the aggregate effects of risk-taking on the financial system.39 Nevertheless, arguably the real issue seems to be the deficiencies in the regulatory oversight under the modern co-regulation approach with statutory oversight.40

6.2.2 The Risk-based Functional Approach Here, the risk-based functional approach to financial regulation also deserves some attention. In the past few decades, modern financial regulation has shifted its focus from market to participants and financial products.41 It followed that a shift of regulatory focus from markets to participants resulted in the adoption of the so-called risk-based functional approach. This risk-based approach is the present model that is being hotly debated.42 According to this approach, the same activities are treated in the same way provided that the risk is the same. As suggested, a risk-based functional approach to regulation has to be implemented in two steps: first, the risks arising from a particular institution undertaking a particular activity should be assessed. It follows that a regulatory framework is then established to ensure that concerns about systemic risk and investor protection are addressed.43 Under this approach, it is part of the regulator’s 39 Nevertheless, the 2009 Turner Report re-affirms the importance of the principles-based framework for UK financial regulation despite the shortcomings identified in the 2007–08 financial crisis. In the report, Lord Turner also prescribed five propositions that underpin the theory of efficient and rational markets. They are: 1. Market prices are good indicators of rationally evaluated economic value; 2. Securitised credit has improved allocative efficiency and financial stability; 3. Mathematical analysis can deliver robust quantitative measures of trading risk; 4. Market discipline can be used as an effective tool in constraining harmful risk taking; and 5. Financial innovation can be assumed to be beneficial. See Financial Services Authority, The Turner Review: A regulatory Response to the Global Banking Crisis (Turner Report), March 2009. 40 See further discussion in Section 6.4 below, for the current development in the EU. 41 As observed, the shift was made in the US under the 1933 Securities and 1934 Securities Act, and after the Big Bang in 1986 in the UK, see JH Dalhuisen (2007), n 2 above, 1116–20. 42 The EU Commission proposed the adoption of this approach on regulation in its Communications, in line with the work undertaken by the CPSS-IOSCO and the ESCB/CESR. See Summary of the Responses, Communication on Clearing and Settlement in the European Union—The Way Forward, (2004) 11. 43 For example, ‘[i]n its infringement decision against Clearstream Banking AG, the Commission distinguished between institutions offering primary clearing and settlement services, which can effect changes to entitlement on the central register, and those which can offer only secondary clearing and settlement. Secondary clearing and settlement by intermediaries is described as ‘either in the form of mirror operations that reflect in the accounts of their customers the result of primary clearing and settlement or as a result of internalised transaction in cases where the buyer and seller happen to hold accounts with the same intermediary’ but acknowledge that no intermediary was able to internalise all transactions with all potential counterparties for all securities safekept in Clearstream Banking AG’. See MEMO/04/705, 2 June 2004, Clearstream: Questions and Answers on Commission Decision for further information.

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Regulatory Issues responsibilities to ensure that the relevant roles and responsibilities are clearly understood and are accepted by all parts of the market and regulatory structure.44 To achieve the regulatory objectives, the proposition is that the legal and regulatory framework itself has to be robust because the robustness of the framework not only reduces unnecessary legal and regulatory uncertainties but maintains some flexibility to accommodate the innovations and changes in the markets.45 As noted, regulatory regimes that have a relatively slow rate of reform, along with the gaps between financial innovation and support from the law, are seen by market participants as factors that add to the level of legal risk faced by them. However, it is generally accepted that in a dynamic market a degree of uncertainty is unavoidable. Therefore, establishing an adequate regulatory regime becomes the main focus of the debate. Here, the UK regulatory regime provides an excellent example of the ‘riskbased approach’ to regulation.46 In essence, the approach needs to be followed so that the risk management procedure of regulated institutions can succeed.47 Insofar as the CCPs are concerned, Chapter 4 of the RIE and RCH Sourcebook, which is contained in Consultation Paper 39 issued by the UK Financial Services Authority in 2000, sets out the revised risk-based supervisory approach that is to be adopted with regard to recognised bodies.48

44 Furthermore, there are two sides concerning this risk-based functional approach. While some agree that the functional approach should be risk-based and take into account the risk profile of the entities concerned and the competitive environment in which they operate, others insist that any regulatory framework should be based on a purely functional approach that takes no risk considerations into account. See European Commission, Summary of Responses, Communication on Clearing and Settlement in the European Union—the Way Forward (2004). 45 See LE Bergmann (SEC), Speech: The US View of the Role of Regulation in Market Efficiency (International Securities Settlement Conference, 2004). 46 The UK regulatory regime for CCPs is to be discussed in Section 6.3 below. 47 R McCormick, ‘Legal Risk Management; Red Flags and Risk Scenarios’ (2006) Butterworths Journal of Banking and Financial Law (02) 51–7. 48 ‘[It] allows the FSA to make regular, comprehensive assessments of the risk that a UK recognised body will be able to discharge its specific obligations. It contains specific provisions concerning the UK recognised body’s internal review and control procedures, risk assessment components (including financial resources, supervision of members, business environment, operational infrastructure and governance), supervisory programme and feedback procedures. Recognised bodies will also be expected to issue an annual plan in accordance with the requirements set out in the Sourcebook. Chapter 4 also contain further provisions concerning complaints, default rules and directions and de-recognition’. See W Blair, Banking and Financial Services Regulation, 3rd edn (London: Butterworths, 2002) 592–8.

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Regulatory Approaches

6.2.3 The Interest of Central Banks It is also necessary to highlight the ever-increasing interest of central banks in CCP clearing.49 Generally, central banks have always had a great interest in the safety and efficiency of payment and securities settlement systems.50 As mentioned in chapter two, the increasing use of collateral in both payment and securities settlement systems has made the systems more closely linked, and the possibility of overlap is greater than ever. Certainly, disruptions in the functioning of clearing and settlement systems could substantially affect financial markets. Similar to the payment and securities settlement systems, CCPs are playing an increasingly important role in the markets as CCP clearing becomes an essential segment in modern markets. Given the role of CCPs in both payment and securities settlement systems and the risks involved in using CCP clearing, central banks also have an intrinsic interest in their safe and efficient functioning. This is also because of the potential impact of a major disruption by a CCP on the central bank’s key responsibilities, namely, the smooth implementation of monetary policy and the smooth functioning of the payment system.51 The regulatory functions of central banks, ie, formal and systemic oversight, are relatively new compared to its traditional functions as banks which provide payment and settlement services to other banks.52 These functions are carried out by monitoring existing and planned systems, and assessing them against the central bank’s regulatory objectives. In general, central banks are involved in overseeing post-market securities systems for several reasons: first, these systems are essential to the proper completion of financial transactions. As a result, if they malfunction, the systems could potentially disrupt the entire financial system and spread systemic risk. Secondly, securities settlement systems maintain close links with payment systems; and thirdly, but importantly, their smooth operation is important for the implementation of monetary policy.53 Central banks’ main concerns in respect of CCP clearing have long been recognised and were well summarised as follows:54

49 For how CCP clearing affect the oversight of central bank from the statistic point of view, see C Wright, Central Counterparty Clearing and Settlement: Implications for Financial Statistics and the Balance of Payments (Bank of England, 2004), for how CCP clearing affect the oversight of central bank from the statistic point of view. 50 See Committee on Payment and Settlement Systems, Central Bank Oversight of Payment and Settlement Systems (Bank for International Settlements, May 2005). 51 In April 2006, a conference on issues related to central counterparty clearing was organised jointly by European Central Bank and Federal Reserve Bank of Chicago. See www.ecb.int/events/ conferences/html/ccp.en.html, for further information. 52 For the role of central banks in general, see S Valdez and J Wood, An Introduction to Global Financial Markets (Basingstoke: Palgrave Macmillan, 2003) ch 3. 53 See www.banque-france.fr/gb/sys_mone_fin/missions/3a.htm. 54 See European Central Bank, ‘Consolidation in Central Counterparty Clearing in the Euro Area’ (August 2001) ECB Monthly Bulletin 69–77.

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Regulatory Issues — Concentration of risk: central counterparties concentrate risk more than any individual participant in a decentralised market; as a result, the consequences of an inappropriate design of the system or of inappropriate management would be correspondingly larger than for individual market participants; — Moral hazard: given the potential systemic effects of the failure of a major clearing house, there is a risk that the market participants will assume that central banks will bail out an ailing central counterparty (“too big to fail” effect); — Information asymmetry: market participants may hesitate to trade with counterparties they have little information about. This is particularly true in times of financial crisis when there is a general suspicion that counterparties may be close to collapse. The existence of a single counterparty reduces the level of information asymmetry only if there are no doubt about the solvency and competency of the central counterparty clearing house itself. If there are fears about the solvency of a central counterparty, the whole market might stop trading; — Race to the bottom: competition between central counterparties entails the risk that these service providers may try to improve competitiveness by applying more lenient risk management standards; — Contagion effects: clearing houses typically undertake activities, which support the securities settlement process, such as the matching and netting of trade orders. Problems on the clearing side could, therefore, spill over to the settlement side; and — Moreover, in the case of cross-product clearing and/or cross-currency clearing, there is the risk of contagion from one market to another in the event of the failure of a central counterparty (or even in the event of doubts over the creditworthiness of the central counterparty).

As a result, the regulation and oversight of CCPs require the involvement of both central banks and other competent authorities. In the BIS 2004 report,55 it was recommended that ‘central banks and securities regulators should cooperate with each other and with other relevant authorities’, each with clearly defined objectives, responsibilities, roles and policies so that CCPs are able to operate in a predictable environment and to act in a manner that is consistent with those policies.

55 Committee on Payment and Settlement Systems (CPSS) and Technical Committee of the International Organization of Securities Commissions (IOSCO), Recommendations for Central Counterparties (Bank for International Settlements, November 2004) Recommendation 15, 48–50.

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CCPs and the Regulatory Regime

6.3 CCPs and the Regulatory Regime56 In general, a modern regulatory regime for CCPs can be characterised as co-regulation with a separation of regulatory functions. In other words, it is an arrangement in which self-regulation and supervision are underpinned by a statutory framework. An approach is emerging whereby CCPs assume responsibility for issues like membership administration, while others like conduct of business fall under the supervision of the financial authorities, as assigned by the statutory framework.57 Indeed, the legal and regulatory framework provides the foundation for self-regulation to the extent that the legislation itself requires relevant institutions to develop self-regulation. It is also clear that self-regulation plays an important role, though indirectly, when the enacted legislation in fact codifies rules already in existence, and this is also the case in CCPs, as we shall discuss shortly below.58

6.3.1 The Need for Separated Treatment for CCPs As discussed in chapter three, the important role of CCPs in fostering the development of modern markets cannot be underestimated, not to mention their role in reducing counterparty and operational risk in the markets. It is therefore essential that they are themselves subject to appropriate regulatory framework. For historical reasons, clearing houses are subject to the same regulatory regime as prescribed markets, including investment exchanges and trading platforms, with respect to recognition requirements and supervision and oversight. Here, it is worth noting that CCPs have been operating in both regulated markets and unregulated markets. In a regulated market, typically no one is permitted to carry out designated investment services unless authorised by the competent authority or exempted under the relevant laws. To operate in a regulated market, CCPs either are authorised, or are recognised by the relevant competent authorities or have received an exemption from them. In addition, the clearing members of CCPs as counterparty to their CCPs would typically be significant players in the markets. As a result, the nature of risks involved is significantly different from those of other types of clearing houses.59 56 In this section, the UK regulatory framework including FSMA 2000 and other relevant statutes are used as the primary example to elaborate the necessity of a comprehensive regulatory framework for CCPs. 57 For example, IOSCO Principle 7 provides that ‘SROs should be subject to oversight of the regulator and should observe standards of fairness and confidentiality when exercising powers and delegated responsibilities’. 58 See the example of the UK regulatory regime in Section 6.3.3 below. 59 Also see the discussion about the differences between traditional clearing houses and CCPs in Section 3.1, ch 3 above.

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Regulatory Issues In the United Kingdom, for example, CCPs and other clearing houses are subject to the same regulatory regime as other prescribed markets including investment exchanges and trading platforms. CCPs fall within the scope of the same regulatory regime that is designed for Recognised Investment Exchanges (RIE) and Recognised Clearing Houses (RCH). According to the RIE and RCH Sourcebook,60 the recognition requirements for investment exchange and clearing houses are broadly the same, apart from the fact that recognised clearing houses are not subject to the requirement in relation to proper market conduct and disclosure of information.61 Nonetheless, it should be pointed out that this is a separate regime from the authorisation regime adopted through the Financial Services and Markets Act (FSMA) 2000. In contrast, the regulatory regimes for exchanges and clearing houses have been separated in the United States after the paper-work crisis in the 1970s. Instead, they are more often seen there as part of the post-trade infrastructure and subject to the regime for clearing and settlement as a whole. Therefore, they are in general subject to the same regulatory regime as for securities settlement systems. For the same reason, CCPs in the United Kingdom have been subject to the regulatory framework established for clearing houses in general.62 Having witnessed the transformation of clearing houses in general and CCPs in particular,63 and the evolving roles they are playing in modern markets as described in chapter two, some may be surprised to find that the regulatory regimes to which CCPs have been subject, remain largely unchanged. Furthermore, CCPs are still largely subject to the regime that was designed for clearing houses in the United Kingdom, despite the fact that efforts have been made to provide a better regulatory framework for CCPs. As discussed,64 CCPs are notably distinctive from other types of clearing houses both in law and in operations. In addition, the nature of the risk involved in CCPs is also different from those involved in operating a regulated exchange or trading platform.65 Therefore, it is argued that it is increasingly inadequate to subject them to the same regulatory regime as those of clearing houses. In addition, CCPs are increasingly taking part in processing a variety of products in various types of

60 The basic aim of this type of Sourcebook, as part of the architecture of the regulatory system, is to pull together the information the market needs. 61 See RIE and RCH Sourcebook, CP39 (FSA 2001) para 2.12. Also, see below for further discussion. 62 Hereafter, clearing houses and CCPs are used interchangeably for the regulatory purposes in this chapter. 63 For historical accounts of clearing houses and central counterparties, see Section 2.1, ch 2 above. 64 See Section 3.1, ch 3 above. 65 See further discussion on the risks involved in CCPs in Section 3.2.1, ch 3 above and Section 7.1, ch 7 below.

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CCPs and the Regulatory Regime markets. This results in them being simultaneously subject to various different regulators and not only those competent authorities in financial and commodities markets.66

6.3.2 CCPs as Self-Regulatory Organisations As mentioned in chapter three, CCPs are, in principle, treated as self-regulated institutions through their rules and regulations, by which their members abide. As just noted, clearing houses had been operating on the basis of self-regulation long before the formal regulatory regime was established.67 Since then, CCPs, together with investment exchanges and other types of clearing houses, have normally been treated as a category of Self-Regulatory Organisations (SROs) in the regulatory regime of the market they serve. As time goes by, the selfregulatory functions are now subjected to a greater degree of formalisation/ codification as well as external controls. In the process of formalisation, the legal and regulatory framework in the form of regulation and supervision provides the external controls over CCPs.68 As far as SROs are concerned, ‘[in] most jurisdictions, the model has shifted from the pure self-regulatory model, so that both the market authority and the regulator perform regulatory responsibilities. However, the extent to which self-regulation is used varies’.69 In essence, self-regulation—as opposed to governmental regulation—means that the necessary rules and procedures are adopted within the private sector. Generally, the principle of self-regulation applies to the organisation and supervision of market operations and to the rules governing exchange and clearing house/CCP memberships. As a result of this self-regulatory approach, the CCP is granted a degree of autonomy that is specifically determined. A central element in this regard is that the self-regulation of a CCP is under the overall supervision of the relevant authorities. To ensure CCPs’ ability to adapt to changing circumstances, the relevant regulatory regime

66 For example, in the US, the oversight of futures CCPs is the Commodity Futures Trading Commission (SEC), not the federal regulator the Securities Exchanges Commission. In the UK, LCH.Clearnet Ltd is under the supervision of over 14 regulators in 5 jurisdictions, which also includes the Financial Services Authority, for the markets in which it is operating. 67 For a historical account of clearing houses in general, see ch 3 above. 68 The US provides a good example here. The federal regulatory system has delegated authority to SROs, for example, the New York Stock Exchange and the Financial Industry Regulatory Authority. For a comparative approach to the analysis of the relationship between framework legislation and self-regulation, see J Zufferey and M Tschanz-Norton, Regulation of Trading Systems on Financial Markets (London: Kluwer Law International, 1997) ch 7. 69 The Technical Committee of the International Organization of Securities Commissions, Supervisory Framework for Markets (IOSCO, May 1999) 11.

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Regulatory Issues provides a framework that contains only a limited number of primarily fundamental rules, and otherwise provides an adequate degree of leeway for selfregulation. The relevant authorities for supervision and oversight also have to ensure that the relevant legal and regulatory rules are established and are complied with. Nevertheless, the approach of self-regulation does come with certain limitations.70 Indeed, self-regulation requires that the regulatory framework in place gives a form of formal guarantee in relation to the effectiveness of the rules made by those SROs and at the same time provides those SROs with sufficient authority to regulate. The weaknesses of self-regulation mean that substantive limits to its scope of application should be defined, namely, the areas in which only legislators should act, if action is required. A statutory framework is then needed to clearly assign the responsibilities and the oversight and regulatory functions to each interested party. Similar to self-regulatory exchanges, CCP clearing regulation provokes principal objections in the areas of conflicts of interest and competition.71 Here, the main challenge is to draw a clear line between the self-regulatory function by CCPs and the supervisory function by supervisors and regulators. Furthermore, the US experience72 also shows that it has to be made absolutely clear that the clearing rules promulgated by CCPs and approved by the relevant authority cannot be challenged under the law, in order to provide a degree of coherence and certainty.73 In the following section, the regulatory regime in the United Kingdom will be considered, as the regime provides one of the most comprehensive regulatory regimes for CCPs and is an excellent example of a modern approach to regulation that incorporates the model of co-regulation.

70 The criticisms of self-regulation have been mainly on the issues of potential abuse and anti-competitive practices. Also see the discussion below. 71 AC Pritchard, ‘Self-Regulation and Securities Markets’ (Spring 2003) 26(1) Regulation 32 (The Cato Institute). As pointed out, [such] problems with exchange regulation, while manageable, have important implications for the scope of regulatory authority allocated to exchanges. 72 See Depository Trust & Clearing Corporation (DTCC) Press Release, Federal Court Dismiss Lawsuit against DTCC (2 June 2006). 73 Issues relating to the mode of regulation are seen by Sir Roy Goode as one of the significant policy tensions generated by the markets. It was pointed out that ‘[i]n English law, [the custom and usages] take effect as implied terms of the contract. The same is true of formal rules issued by the exchange. Unless these are promulgated under statutory powers, they can take effect only by express or implied contract. In the normal case, it is a term of membership of the market that members undertake to the exchange and to each other to observe the rules. The effect is to underpin each bilateral sale and purchase contract with a multilateral network of market rules. This, of course, assumes that the rules themselves are intended to have legal force and not simply to the rules of commercial convenience’. See RM Goode, Commercial Law, 3rd edn (London: LexisNexis UK, 2004) 157–8 and 161.

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CCPs and the Regulatory Regime

6.3.3 The UK Regulatory Regime The introduction of Financial Services and Markets Act (FSMA) 2000 may appear to have led to the dismantling of self-regulation in the industries, as SROs were a feature of the pre-FSMA 2000 regime. As to the development of the regulatory regime for CCPs in the United Kingdom, there are still arguably some elements of self-regulation in play74 and the approach hence may be categorised as one of ‘self-regulation’ with statutory oversight. Furthermore, such regulatory regime can arguably be characterised as rule-based, with the backing of contractual arrangements. In general, the regulatory system in the United Kingdom with respect to SROs can be characterised as a pyramid. At the top of the pyramid is the regulator. At the lower level are the SROs that are given the responsibility for the conduct of the market. The lowest level of oversight is conducted by the market intermediaries who are responsible for training and educating parties about the applicable laws and supervising their activities. In other words, the regulatory system distinguishes between areas in which the regulator makes the rules and areas in which the SROs make the rules. In financial services, the FSMA 2000 also requires the regulator75 to take into account the public interest and that of investors in the context of its own rule-making as well as that of monitoring the SROs’ rule-making. Commenting on the financial regulatory regime76 in a conference in 1998, Howard Davies, the then chairman of the Financial Services Authority, stated: In legal form, the change we are introducing is a move away from self-regulation to a system based on statute. This will require us to establish new procedures for market consultation. The legal foundation of the regime we are about to replace was, for the most part, a contract between the regulated and the self-regulator organisation, albeit of course within an over-arching statutory framework. That structure created a set of trade association like conditions, with practitioners involved at every point, in rule

74 Arguably, there is still an element of self-regulation in this regulatory regime for CCP Clearing although it may not be as apparent as the self-regulatory framework for Lloyd’s created under the Lloyd’s Act 1982. This remains the case after Financial Services and Markets Act 2000 where Financial Services Authorities has even effectively delegated market regulation and supervision to Lloyd’s. Moverover, under FMSA 2000 a recognised CCP is granted with the rule-making power, see Sub-section D below. Also see ‘The FSA’s Approach to Regulation of the Market Infrastructure’, Financial Service Authority Discussion Paper (January 2000). 75 According to s 2 of Financial Services and Markets Act 2000, the four objectives in exercising the specified functions for the Financial Services Authority are: market confidence; public awareness; the protection of consumers; and the reduction of financial crime. 76 With the introduction of Financial Services and Market Act 2000, the Financial Services Authority became the single regulator in the UK. For the regulatory changes in the 1980s, see P Howells and K Bain, Financial Markets and Institutions, 4th edn (Harlow: Financial Times Prentice Hall, 2004) 364–78.

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Regulatory Issues setting, disciplinary procedures and in the governance of the regulator. There are prescribed balances between practitioners and public interest members on the Boards of all the self-regulators.77

As to CCPs, the markets and relevant authorities consider these entities to be necessarily expert in the operation of the markets and to have strong incentives in ensuring that they function in a proper manner. Under the regulatory approach, it is required that CCPs meet the requirements set out by law and obtain recognition from relevant authorities in order to operate in the regulated markets. In the United Kingdom, this is conducted through the so-called recognition regime rather than the authorisation regime.78 The recognition and exemption regime for CCPs is included in Part XVIII of the FSMA 2000. In essence, this regime can be characterised as the ‘three processes approach’, namely, recognition, oversight, and enforcement. The UK authority, the Financial Services Authority, is given the power by the FSMA 2000 to issue directions to recognised bodies to take steps to comply with the recognition requirements. This confers immunity on the recognised bodies from civil action by their members in respect of the performance of the regulatory functions. The recognition requirements set out in the FSMA 2000 in relation to clearing houses also allows the Treasury to set out and amend the relevant criteria by order.79 Here, it is necessary to mention the regime for overseas clearing houses as part of the regulatory framework, which is contained in section 292(1) of the FSMA 2000.80 Under the regime, the FSA has the authority to make a recognition order under section 292(2) at its discretion where the applicant’s home regulatory regime has requirements at least equivalent to the recognition requirements here taking into account the supervision effected and the rules and practices of the application, as well as the fact there are adequate procedures for dealing with persons who cannot complete market contracts. In addition, as a host regulator, the FSA is also required to consider whether the applicant and the applicant’s home supervisory authorities are able to and are willing to co-operate in information sharing. Furthermore, detailed provisions of the requirements are set out, following the FSA’s assumption of responsibility for the supervision of Recognised Overseas Clearing Houses (ROCHs). These include provisions concerning applications, relevant recognition requirements, competition scrutiny, supervision, notification rules and powers of direction and de-recognition. Consequently, these will

77 H Davies, ‘Risk Managenment’ (Speech), Federal Reserve Bank of Atlanta Financial Markets Conference, Miami Beach, Florida, 27 February 1998. 78 For the discussion of the recognition regime, also see A Alcock, The Financial Services and Markets Act 2000—A Guide to the New Law (Bristol: Jordan, 2000) ch 11, and W Blair, Banking and Financial Services Regulation, 3rd edn (London: Butterworths, 2002) 592–8. 79 The Financial Services and Markets Act 2000 (Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001. 80 W Blair, Banking and Financial Services Regulation, 3rd edn (London: Butterworths, 2002) 598.

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CCPs and the Regulatory Regime ensure that the FSA is satisfied that the recognised body concerned delivers a standard of investor protection equivalent to that delivered by UK-recognised bodies. Without doubt, the FSA relies to large extent on the supervision conducted by the applicant’s home authorities in carrying out its supervision functions. As far as the Treasury is concerned, the regime also contains new provisions regarding notification requirements, including annual reports and information concerning any serious disciplinary action taken. In addition, sections 288 and 289 of the FSMA 200081 list the types of documentation required for the application by a CCP. The further detailed recognition requirements for CCPs are set out in Parts III and IV of the Schedule to the FSMA 2000 (Recognition Requirements for Recognised Investment Exchanges and Clearing Houses) Regulations 2001,82 ie Part III ‘recognition requirements for clearing houses’ and Part IV ‘recognition requirements applying to clearing houses: default rules in respect of market contracts’.

A. Market Contracts, Market Charges and Default Rules From the regulatory perspective, market contracts, market charges and default rules are three essential components of CCP clearing. According to FSMA 2000,83 market contracts are widely defined as, [any] contract that is subject to the rules of the clearing house and entered into by the clearing house for the purposes of or in connection with the provision of clearing services for a recognised investment exchange is a market contract.

81 Section 288 of Financial Sservices and Markets Act 2000 (c 8). ‘(1) Any body corporate or unincorporated association may apply to the Authority for an order declaring it to be a recognised clearing house for the purpose of this Act. (2) The application must be made in such manner as the Authority may direct and must be accompanied by— (a) a copy of the applicant’s rules; (b) a copy of any guidance issued by the applicant; (c) the required particulars; and (d) such other information as the Authority may reasonably require for the purpose of determine the application. (3) The required particulars are— (a) if the application makes, or proposes to make, clearing arrangements with a recognised investment exchanges, particulars of those arrangements; (b) if the applicant proposes to provide clearing services for persons other than recognised investment exchanges, particulars of the criteria which it will apply when determining to whom it will provide those services’. Section 289 also provides that the Authority may require the applicant to provide such further information as it considers necessary and in the form it may direct for the determination of the application. 82 Financial Services and Markets Act 2000 (Recognition Requirements for Recognised Investment Exchanges and Clearing Houses) Regulations 2001 (SI 2001/995). 83 Section 286(4) the Financial Services and Markets Act 2000 refers it, in the case of a recognised clearing house, to the meaning provided in section 155(3) of the Companies Act. Also see n 84 below.

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Regulatory Issues In addition, the provisions in Schedule 21 of Companies Act 198984 regarding market contracts continue to apply and prevent liquidators from attempting to unwind contracts made through CCPs. The definition of market charges is a charge whether fixed or floating, granted— … in favour of a recognised [CCP], for the purpose of securing debts or liabilities arising in connection with their ensuring the performance of market contracts.85

A charge is deemed as a ‘market charge’ so long as it is granted partially for the above purposes with the effect of that specified purpose.86 The so-called ‘collateral security charges’ are associated with market charges. As discussed in chapter three, default rules are compulsory as required by law. It has been a major concern that the integrity of markets is at risk due to the uncertainty that the provisions87 of insolvency law may apply to CCP clearing. A compulsory regime for default rules is implemented as one of statutory recognition requirements, namely that recognised CCPs must have default arrangements in place. The provisions introduce additional requirements that must be satisfied

84 ‘Market contract’ is defined in ss 155(2) or 155(3) of the Companies Act 1989 (c 40). Section 155 (as amended) reads, as follows [Text of section superseded, 11 August 1998]: ‘(1) This Part applies to the following descriptions of contract connected with a recognised investment exchange or recognised clearing house. The contracts are referred to in this Part as “market contracts”. (2) Except as provided in subsection (2A), in relation to a recognised investment exchange this Part applies to— (a) contracts entered into by a member or designated non-member of the exchange with a person other than the exchange which are either (i) contracts made on the exchange or on an exchange to whose undertaking the exchange has succeeded whether by amalgamation, merger or otherwise; or (ii) contracts in the making of which the member or designated non-member was subject to the rules of the exchange or of an exchange to whose undertaking the exchange has succeeded whether by amalgamation, merger or otherwise; and [(b) contracts entered into by the exchange with its members for the purpose of enabling the rights and liabilities of that member under transactions in investments to be settled.] A “designated non-member” means a person in respect of whom action may be taken under the default rules of the exchange but who is not a member of the exchange. (2A) This Part does not apply to contracts falling within paragraph (a) of subsection (2) above where the exchange in question is a recognised overseas investment exchange. (3) In relation to a recognised clearing house, this Part applies to contracts subject to the rules of the clearing house entered into by the clearing house for the purposes of or in connection with the provision of clearing services for a recognised investment exchange. (4) The Secretary of State may by regulations make further provision as to the contracts to be treated as “market contracts”, for the purposes of this Part, in relation to a recognised investment exchange or recognised clearing house. (5) The regulations may add to, amend or repeal the provisions of subsections (2) and (3) above’. 85 Companies Act 1989 Pt VII, s 173 ‘Market Charges’, para (1)(b). 86 ibid, s 173(2). 87 These provisions cover areas like, the insolvency, winding up or default of a person who is party to certain market transactions, the effectiveness of charges given to secure obligations in connection with such transactions, and rights in relation to property provided as cover for margin in relation to such transactions.

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CCPs and the Regulatory Regime by CCPs if they are to be recognised. Consequently, it obliges them to have default rules so that in the event of a member of the CCP appearing to be unable to meet his obligations in respect of certain market contracts action may be taken in respect of unsettled market contracts to which he is a party.88 The ultimate objective of these default rules, as set out in the Act, is to verify the status of the default rules and procedures by law and to produce a net sum with respect to the defaulter’s trading positions. Here, two key definitions require careful observation. The first is ‘defaulter’, which under the Financial Markets and Insolvency (Settlement Finality) Regulations 1999, means a person in respect of whom action has been taken by a designated system under its default arrangements.89

The second is ‘default arrangements’, which is defined as the arrangements put in place by a designated system to limit systemic and other types of risk which arise in the event of a participant appearing to be unable, or likely to become unable, to meet its obligations in respect of a transfer order, including, for example, any default rules within the meaning of Part VII or any other arrangements for— (a) (b) (c)

netting, the closing out of open positions, or the application or transfer of collateral security.90

In respect of the charge and the action taken to enforce such a charge,91 the general law of insolvency is effectively subject to the provisions of regulation 19 of the 1999 Regulations.92 Therefore, there needs to be some modifications in the 88 89

Schedule 21 of the Companies Act 1989 (c 40). Financial Markets and Insolvency (Settlement Finality) Regulations 1999 (SI 1999/2979) reg

2(1). 90

ibid. ibid, reg 18. 92 ibid, reg 19. ‘Administration orders &c (1) The following provisions of the Insolvency Act 1986 (which relate to administration orders and administrators) do not apply in relation to a collateral security charge— (a) sections 10(1)(b) and 11(3)(c) (restriction on enforcement of security while petition for administration order pending or order in force); and (b) section 15(1) and (2) (power of administrator to deal with charged property); and section 11(2) of that Act (receiver to vacate office when so required by administrator) does not apply to receiver appointed under such a charge. (2) However, where a collateral security charge falls to be enforced after an administration order has been made or a petition for an administration order has been presented, and there exists another charge over some or all of the same property ranking in priority to or pari passu with the collateral security charge, on the application of any person interested, the court may order that there shall be taken after enforcement of the collateral security charge such as steps as the court may direct for the purpose of ensuring that the chargee under the other charge is not prejudiced by the enforcement of the collateral security charge. (3) Sections 127 and 284 of the Insolvency Act 1986 (avoidance of property dispositions effected after 91

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Regulatory Issues law of insolvency so that the market charges, as they may be characterised, taken by a CCP are exempted. Accordingly, the subsequent modifications have been included in the Regulations.93 According to Section 159(1) of the Companies Act 1989, (a) (b) (c)

a market contract, the default rules of a … recognised [CCP, and] the rules of a recognised [CCP] as to the settlement of market contracts not dealt with under its default rules,

are effectively not to be regarded as invalid at law simply on the grounds of inconsistency with insolvency law. Furthermore, the power of office-holders and of the court under the Insolvency Act 1986 are not to be exercised in a way that

commencement of winding up or presentation of bankruptcy petition), section 32(8) of the Bankruptcy (Scotland) Act 1985 (effect of dealing with debtor relating to estate vested in permanent trustee) and any like provision or rule of law affecting a protected trust deed, do not apply to a disposition of property as a result of which the property becomes subject to a collateral security charge or any transactions pursuant to which that disposition is made’. 93 Financial Markets and Insolvency (Settlement Finality) Regulations 1999 (SI 1999/2979) reg 13: ‘Modifications of the law of insolvency (1) The general law of insolvency has effect in relation to— (a) transfer orders effected through a designated system and action taken under the rules of a designated system with respect to such orders; and (b) collateral security, subject to the provisions of this Part. (2) Those provision apply in relation to— (a) insolvency proceedings in respect of a participant in a designated system; (b) insolvency proceedings in respect of a provider of collateral security in connection with the functions of a central bank, in so far as the proceedings affect the rights of the central bank to the collateral security; but not in relation to any other insolvency proceedings, notwithstanding that rights or liabilities arising from transfer orders or collateral security fall to be dealt with in the proceedings. (3) Subject to regulation 21 nothing in this part shall have the effect of disapplying Part VII’. Reg 14: ‘Proceedings of designed system take precedence over insolvency proceedings (1) None of the following shall be regarded as to any extent invalid at law on the ground of inconsistency with the law relating to the distribution of the asserts of a person on bankruptcy, winding up, sequestration or under a protected trust deed, or in the administration of an insolvent estate— (a) a transfer order; (b) the default arrangements of a designated system; (c) the rules of a designated system as to the settlement of transfer orders not dealt with under its default arrangements; (d) a contract for the purpose of realising collateral security in connection with participation in a designated system otherwise than pursuant to its default arrangements; or (e) a contract for the purpose of realising collateral security in connection with the functions of a central bank’. Reg 15: ‘Net sum payable on completion of action taken under default arrangements (1) The following provisions apply with respect to any sum which is owed on completion of action taken under default arrangements by or to a defaulter but do not apply to any sum which (or to the extent that it) arises from a transfer order which is also a market contract within the meaning of Part VII, in which case sections 162 and 163 of the Companies Act 1989 apply subject to the modification made by regulation 21’.

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CCPs and the Regulatory Regime prevents or interferes with the settlement of a market contract falling outside the default rules of a recognised CCP—section 159(2)(a). In addition, any person in control of any assets of a defaulter or in control of documents of or relating to a defaulter is obliged to give a recognised CCP the assistance it requires for proceedings under its default rules. Such a person need not provide information or documents that he may refuse to provide on grounds of legal professional privilege in proceedings in the High Court. Any original documents provided under these provisions are to be returned forthwith after the completion of the default proceedings—section 160.

B. Roles of Relevant Authorities From the authorities’ perspective, there are two main types of risk needing mitigation with respect to CCPs: (i) risk of abusive and/or anti-competitive domain; and (ii) systemic risk and investor protection issues caused by the absence of minimum safety standards and appropriate regulations. As part of the recognition process, applicants are subject to competition scrutiny as specified in the FSMA 2000.94 This competition scrutiny involves four different authorities, which are Financial Services Authority, the Treasury, the Office of Fair Trading (OFT) and the Competition Commission. Each plays different roles at different stages as specified in the Act, which can then be divided into two categories: one type of role is administration and enforcement and the other is competition scrutiny. The Act sets out the procedures and the role of each authority. The procedures contained in the Act can be briefly summarised as follows: Before a recognition order is issued, the application has also to be subject to competition scrutiny where the proposed rules and arrangements of the CCP are to be examined. In processing the application, the authority in charge is required to send the Treasury and the OFT a copy of any regulatory provisions and information in its possession in the application for recognition. The further detailed procedures for scrutiny are set out in Part XVIII, Chapter II of the FSMA 2000. As required, the OFT is to issue a report as to whether— (a) (b)

a regulatory provision … has a significantly adverse effect on competition or a combination of regulatory provisions … have such an effect.95

Here, it is worth noting that the regulatory provisions and practices of recognised bodies are kept under review from time to time. A further report has to be made by the OFT to indicate, according to its findings, whether or not a regulatory provision or a combination of regulatory provisions has a significantly adverse 94 95

See Financial Services and Markets Act 2000 (c 8), Part VI, 95: ‘Competition Scrutiny’. FSMA 2000, s 303(3).

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Regulatory Issues effect on competition. In doing so, the OFT was also conferred with the power to request and obtain the necessary document or information needed from any relevant person.96 As to the role of the Treasury, in addition to taking part in the correspondent competition scrutiny,97 it also plays an important role in approving a recognition order. With regard to the approval of recognition, the Treasury may make additional regulations as part of the requirements for recognition. Normally, the applicant must abide by these regulations on a continuous basis if it is to maintain the recognition status.98 The Treasury may refuse to approve the making of the recognition order only if they consider that the exceptional circumstances of the case make it inappropriate for them to give their approval.99 Furthermore, for those additional regulations relating to default rules, the approval of the Secretary of State is also required. Both the FSA and the Treasury have a role in the administration of application of recognition and the enforcement for ongoing supervision. To put it briefly, ongoing supervision generally includes specified areas such as notification,100 modification or waiver of rules,101 power to give directions,102 revoking recognition103 and complaints about CCPs.104

C. Competition Issues: A Special Competition Regime With the concern that the strength of market position may be exploited, it was decided that it was necessary for the competition scrutiny regime to be able to consider whether a CCP is exploiting its strong market position.105 Accordingly, the regulatory provisions of the applicant106 are sent to the OFT for the assessment of whether the CCP have a ‘significantly adverse effect on competition’. However, it is necessary to point out that the competition regime to be applied in CCPs is different from those found in the Competition Act 1998.107 Under sections 311 and 312, of the FSMA 2000, certain prohibitions adopted in the Competition Act 1998 are excluded when applying the scrutiny to recognised bodies like CCPs for recognition purposes. The purpose of these two sections is 96

ibid, s 305. See Sub-section (c) below for competition issues. 98 FSMA 2000, s 286. 99 ibid, s 307. 100 ibid, ss 293 and 295. 101 ibid, s 294. 102 ibid, s 296. 103 ibid, ss 297 and 298. 104 ibid, s 299. 105 Lord McIntosh of Haringey, the then government spokesman in the House of Lords, HL Deb Vol 612, 9 May 2000, col 1513. 106 These include rules, guidance, clearing arrangements, membership criteria and any other information that may be considered as assisted. 107 This Act has brought the UK competition law in line with that the regime under Arts 81 and 82 of the EC Treaty [2003] OJ L1/1. 97

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CCPs and the Regulatory Regime to provide exemption from the above general competition regime with respect to the regulatory provisions of a recognised body, like a recognised CCP, and the practice and enforcement or conduct associated with those provisions. The relevant authorities are here only concerned with the competition issues of the practices of CCPs in their capacities as regulators of CCPs. It is worth noting that any other commercial activities of CCPs are to be subject to the normal competition regime. Section 2(1) of the Competition Act 1998 sets out the Chapter I prohibition.108 The Chapter I prohibition is based on Article 81 of the EC Treaty.109 It prohibits agreements that affect trade within the United Kingdom and which have as their object or effect the prevention, restriction or distortion of competition within the United Kingdom. Agreements will only fall within the Chapter I prohibition and Article 81 of the EC Treaty if they have an appreciable effect on competition, but excluding those agreements that relate to the regulatory provisions. Article 81 of the EC Treaty and the Chapter I prohibition set out how this will be determined. Whether an agreement is considered to have an appreciable effect will depend on a number of factors, including the market share of the businesses involved in the agreement. However, agreements such as to fix prices or impose minimum resale prices will generally be seen as capable of having an appreciable effect, regardless of how small the businesses involved are. The draft consultation guideline on market definition gives details of how market shares are calculated. Section 18(1) of the Competition Act 1998 sets out the Chapter II prohibition.110 Similarly, the Chapter II prohibition of the Competition Act 1998 is based on Article 82 of the EC Treaty.111 It prohibits conduct that amounts to an abuse of a dominant position112 within the United Kingdom (or any part of it) and which affects trade within the United Kingdom.

108 Competition Act 1998 (c 41), s 2(1). For a general discussion on the Chapter I prohibition, see M Furse, Competition Law of the EC and UK, 4th edn (Oxford: Oxford University Press, 2004) 202–209. 109 Art 81 of the EC Treaty prohibits agreements which may affect trade between Member States and which have as their object or effect the prevention, restriction of distortion of competition within the common market. For a general discussion on Art 81 of the EC Treaty, see M Furse (2004), n 108 above, 141–85. 110 For a general discussion on Chapter II prohibition, see M Furse (2004) n 108 above, 264–68. 111 Art 82 of the EC Treaty prohibits conduct which amounts to an abuse of a dominant position within the common market which may affect trade between Member States. For a general discussion on Art 82, see M Furse, (2004), n 108 above, 231–63. 112 Competition Act 1998 (c 41) s 18: ‘Abuse of dominant position (1) Subject to section 19, any conduct on the part of one or more undertakings which amounts to the abuse of a dominant position in a market is prohibited if it may affect trade within the United Kingdom. (2) Conduct may, in particular, constitute such an abuse if it consists in— (a) directly, or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage;

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Regulatory Issues At the end of the scrutiny, a report is to be made by the Commission to conclude whether the regulatory provision or practice or the combination of them, which is the subject of the report, has a significantly adverse effect on competition (no report is produced if it considers that no useful purpose would by served by it). The report has to state whether the effect is justified, and if not, suggest what action, if any, the Treasury ought to direct the Authority to take.

D. The Effect of Recognition Given the discussion in the previous section, it becomes obvious that CCPs’ operational arrangements as discussed in chapter two are in line with the framework laid down by the recognition requirements. While the recognition regime introduced under the FSMA 2000 did not require any change to the existing practice of CCPs, there are several benefits from recognised status. Three principal benefits in relation to CCPs have been well summed up as follows:113 1.

A statutory immunity for the recognised body, its staff and any recognised nominee for acts or omissions in the conduct of its regulatory functions; Senior management and other employees of the recognised body do not have to become approved individuals subject to the FSA’s direct discipline; and The FSA cannot make rules under its general rule-making powers for a recognised body.

2.

3.

It is recognised that without these immunities and privileges, CCPs would not be able to perform their functions and carry out the regulatory role with a degree of certainty, since these criteria for recognition are necessary for the market functions to be carried out and for the CCPs to fulfill their role in the markets.114 After it has been determined that all the recognition requirements are met, a CCP normally receives a recognition order that is to be issued with a specified (d) making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of the contracts. (3) In this section— “dominant position” means a dominant position within the United Kingdom; and “the United Kingdom” means the United Kingdom or any part of it. (4) The prohibition imposed by subsection (1) is referred to in this Act as “the Chapter II prohibition”’. A dominant position essentially means that the business is able to behave independently of competitive pressures, such as other competitors, on that market. The OFT will look at a range of factors in determining dominance, including: — its market share—generally, a business is unlikely to be considered dominant if it has less than 40 per cent; and — the number and size of competitors and the potential for new competitors to enter the market. 113

A Alcock (2000), n 78 above. Although it may be true that it is still possible to set up a CCP without regulatory recognition, it carries potential risks, particularly in relation to the enforcement of default procedures. Also, for a discussion for the role and function of CCPs, see chs 1 and 2 above. 114

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CCPs and the Regulatory Regime commencement date if the authority is satisfied with the applicant and has decided that recognition is to be granted.115 Upon recognition, it is provided that [a] recognised [CCP] is exempt from the general prohibition as respects any regulatory activity that is carried on for the purposes of, or in connection with, the provision of clearing services by [the CCP].116

Without doubt, one of the most important elements in the regulatory framework is to provide a safe harbour for the CCP’s operations and give exemptions from the application of the general insolvency laws, of which at least the following general rules could potentially obstruct the operations of CCPs. First, the closing-out of individual transactions is potentially void after insolvency without the court’s consent; secondly, multi-lateral netting may be treated as a breach of the pari passu principle;117 and thirdly, collateral held by a CCP may be challenged as an improper preference. It was first recognised in principle that the default rules of recognised CCPs shall not be regarded as invalid at law on the grounds of [their] inconsistency with the law relating to the distribution of the assets of a person in bankruptcy, winding up or sequestration, or in the administration of an insolvent estate.118

Having those potential obstructions to the proper functioning of CCPs in mind, the recognition requirements of the FSMA 2000 now require that a recognised clearing house has the arrangement to net off a defaulter’s contracts into a single sum. According to the Schedule to the FSMA 2000 (Recognition Requirements for Recognised Investment Exchanges and Clearing Houses) Regulations 2001,119 the rules of a CCP must provide (a)

(b)

for all rights and liabilities of the defaulter under, or in respect of, unsettled market contracts to be discharged and for there to be paid by or to the defaulter such sum of money (if any) as may be determined in accordance with the rules; for the sums so payable by or to the defaulter in respect of different contracts to be aggregated and set off to produce a net sum;

If that sum is payable by the defaulter to the CCP, it is (c)

115 Even if the financial authority FSA is satisfied that the recognition requirements are met, it is not compelled to grant recognition. Special procedures are to be followed if it refuses an application for the recognition, see s 298(1) Revocation of FSMA 2000. 116 FSMA 2000, s 285(3). 117 For an earlier case, see British Eagle International Airlines v Cie National Air France [1975] 1 WLR 758 (HL). Also see the discussion of the case in Section 5.2.3, ch 5 above. 118 Section 159 Proceeding of exchange or clearing house take precedence over insolvency procedures, Companies Act 1989, Pt Vii, s 158. 119 (Recognition Requirements for Recognised Investment Exchanges and Clearing Houses) Regulations 2001 (SI 2001/995), Schedule, Part IV, para 25.

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Regulatory Issues (i)

…to be set off against any property provided by or on behalf of the defaulter as cover for margin (or the proceeds of realisation of such property) so as to produce a further net sum;

On the other hand, if payable by the CCP to the defaulter, it is (ii)

… to be aggregated with any property provide by or on behalf of the defaulter as cover for margin (or the proceeds of realisation of such property)

Finally, the rules are to provide (d)

for the certification by or on behalf of the [CCP] of the sum finally payable.

In addition, as a recognised clearing house in the United Kingdom, a CCP is also exempt from the need for authorisation under the FSMA 2000 to carry on investment business and is not subject to Conduct of Business rules under the FSA Handbook as deriving from the FSMA. As a result, the task of supervising market conduct and enforcing breaches of market rules is left entirely to the CCP. Therefore, CCPs continue to perform certain regulatory functions.120 In general, it is observed that it is appropriate to have a different regulatory regime for ‘conduct of business’ issues for wholesale businesses as opposed to retail ones. The need for conduct of business regulation in wholesale markets is less evident, as it is assumed that participants in that market are professionals. This is also the case for participants of CCPs. Furthermore, it is not restricted in terms of what products it can clear or how those products are traded (whether on exchange, or on automated trading systems that are not recognised as exchanges, or traded bilaterally between members ‘over the counter’). According to Section 285(3) of the FSMA 2000, a CCP is exempt from the general prohibition as respects any regulated activity that is carried on for the purposes of, or in connection with, the provision of clearing services by it. Upon recognition, the CCP is accordingly exempt from the need for authorisation under the FSMA 2000.121 This means that the conduct of business rules set out in the FSMA 2000 will not apply. Nevertheless, the CCP is continuously subject to the oversight and supervision of the authority.

120 In carrying out the regulatory functions, the recognised CCP’s liability is limited. See FSMA 2000 s 291: Liability in relation to recognised body’s regulatory functions: ‘(1) A recognised body and its officers and staff are not to be liable in damages for anything done or omitted in the discharge of the recognised body’s regulatory functions unless it is shown that the act or omission was in bad faith. (2) But subsection (1) does not prevent an award of damages made in respect of an act or omission on the ground that the act or omission was unlawful as a result of section 6(1) of the Human Rights Act 1998. (3) “Regulatory functions” means the functions of the recognised body so far as relating to, or to matter arising out of, the obligations to which the body is subject under or by virtue of this Act’. 121 The regulatory processes adopted in the UK are in three steps: authorisation, supervision and enforcement. See M Chamberlain, ‘Regulatory Processes—Authorisation, Supervision, Enforcement’ in M Blair and G Walker (eds), Financial Services Law (Oxford: Oxford University Press, 2006) 113–48.

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Current Situation in the EU

6.4 Current Situation in the European Union 6.4.1 The Current EU Initiatives It is commonly accepted that significant progress has been made in implementing the Financial Services Action Plan (FSAP), which was endorsed by the Lisbon European Council,122 to create a single and integrated European Market. Back in 2001, the ‘Lamfalussy Report’ identified that the regulatory framework within the EU was considered to be ‘too slow, too rigid, complex and ill-adapted to the pace of global financial market change’ and the needs of modern markets, and the legal framework was not in place for a single European financial market.123 As an alternative approach to a single regulatory authority, which was considered to be politically not feasible then, the committee adopts a ‘level 4’ approach to streamlining the regulatory processes.124 The existing regulatory framework based on the Lamfalussy level 4 approach has been developed under the remit of the European Commission, which can be traced to the Lisbon Treaty. In other words, the approach was adopted in light of the limited power the European Commission has. In recent years, there has been some consolidation at the EU level through this Lamfalussy process to identify and eliminate barriers to creating a single market.125 As also identified by the Lamfalussy committee, the implementation of the FSAP has been hindered by the lack of consistency and clarity as to the transposition of texts agreed at the European level in a consistent way. In addition, the differences in legal systems and taxation of different cultures have played a key role. Another important feature is the mutual recognition regime between ‘home’ and ‘host’ Member States. The objective of adopting such regime

122 The original source lies with the European Community Treaty (Treaty of Rome as amended) Arts 67–73. It requires Member States to ‘progressively abolish between themselves all restrictions on the movement of capital belonging to persons resident in the Member States and any discrimination based on the nationality or on the place of residence of the parties or on the place where such capital is invested’. The FSAP (COM(1999) 232 final) concerns the creation of a single market across the EU as a whole. It includes a set of measures to be implemented by 2005 to fill gaps and remove barriers in order to provide a legal and regulatory framework, which facilitates the EU integration of financial markets. Also see HM Treasury, the Financial Services Authority and the Bank of England, The EU Financial Services Action Plan: A Guide (31 July 2003). 123 A Lamfalussy et al, Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (Lamfalussy Report) (Brussels, 15 February 2001). 124 See J Lawson, S Barnes and M Sollie, Financial Market Stability in the European Union: Enhancing Regulation and Supervision (Organisation for Economic Co-operation and Development, Economics Department Working Paper No 670, 20 February 2009), fig 3. 125 The Lamfalussy process was launched in 2001. The process essentially put in place procedures to deal with rapidly changing financial markets and the legislative burden under the FSAP. Its goal was to facilitate decision-making on financial legislation and regulation and to achieve rapid progress towards harmonisation. It was initially designed to address the challenges in securities regulation but was later extended to the banking and insurance sectors in 2004.

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Regulatory Issues is to create a competitive element between Member States. This was considered an alternative solution to creating a single market without a single European regulatory body. In creating the legal and regulatory framework for a single market, the EU has adopted the approach of minimum harmonisation, whereby Member States are required to harmonise the essential areas of financial regulation. These minimum standards to be implemented in Member States are established in the form of European Directives. Member States are not required to adopt a particular structure of financial regulation. States may use a single regulator or divide those responsibilities between two or more bodies. Furthermore, EU Directives have traditionally adopted a functional approach to financial regulation by requiring the same type of activity to be subject to the same regulatory rules, even though the activities may be performed by different types of market participants. As a result of the recent 2007–08 financial crisis, a more centralised approach in financial supervision, as proposed, is now justified, as it has been identified that national approaches to financial supervision are no longer adequate to handle systemic issues. The recent De Larosière Report126 identified the shortcomings of the existing mainly national-based regulatory systems within the European Union with examples of inconsistent transposition and application of the EU legislation by Member States. These hinder the effort of creating a genuinely harmonised set of core rules within the European Union. The authors are of the opinion that ‘to identify and remove those national exceptions would improve the functioning of the single financial market, reduce distortions of competition and regulatory arbitrage, or improve the efficiency of cross-border financial activity in the EU’. On the approach to supervision, in response to current market turmoil, the de Larosière Group127 has also set out a new regulatory agenda and recommendations to build stronger co-ordinated supervision within the European Union, based on the Lamfalussy approach. Proposed European Supervisory Authorities include a European Banking Authority (EBA), a European Insurance and Occupational Pensions Authority (EIOPA), and a European Securities and Markets Authority (ESMA). In the European Union, various elements of markets still reflect different Member States’ origins and traditions, and thus hinder market integration. This is particularly so for the post-trade infrastructure, which has developed in ways that reflect different national needs and preferences. In turn, these differences are also reflected in the different regulatory regimes adopted by different Member

126 In October 2009, the European Commission in October adopted additional legislative proposals to strengthen financial supervision in Europe. In addition to proposals to create a European Systemic Risk Board, it was to create a European System of Financial Supervisors (ESFS). Furthermore, three supervisory agencies will also be created: European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), and European Securities and Markets Authority (ESMA). See J de Larosière et al (2009), n 11 above. 127 J de Larosière et al (2009), n 11 above.

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Current Situation in the EU States. This seems unfit to meet the needs of establishing a truly single panEuropean market. In relation to CCPs, the regulatory regimes in different Member States for CCP clearing remain significantly different. For example, in France, CCPs are recognised as credit institutions so they are also subject to the supervision of the French central bank, while in the United Kingdom, central counterparties are regulated as recognised clearing houses. In theory, this may potentially cause a problem, as credit institutions are eligible for the principle of ‘home country control’128 under the Directive on Markets in Financial Instruments (MiFID) regime,129 while a recognised clearing house is not. As far as CCPs are concerned, they remain subject to regulation that is divided along the borders of each Member State within the European Union, especially in relation to its location.130 A harmonised regime has not yet been created for CCPs. As identified in the European Commission’s Communication on Clearing and Settlement, there is no agreed common regulatory/supervisory framework.131 Consequently, despite the fact that some provisions of the MiFID dealing with CCPs have only addressed open access to CCP clearing systems, access to or use of foreign CCP clearing systems for maintaining the smooth operation of the markets may still be denied by state regulators.132 Moreover, it is a fact that the regulatory regimes for CCPs remain unchanged133 in Member States despite the evolving roles of CCPs and the efforts of harmonisation to create a single market with the introduction of several EU Directives in the past years. At the EU level, the CCP clearing services did not seem to have caught the eye of drafters of the early Investment Services Directive.134 As a result, they are not eligible for the ‘home country control’ scheme under that Directive, which

128 This home country control principle is enshrined in several EU Directives. Also see Section 6.5.2 below. 129 Council Directive 2004/39/EC of 21 April 2004 on markets in financial instruments, amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC and repealing Council Directive 93/22/EEC [2004] OJ l145/1. Also see Section 6.4.2 below. 130 See D Chan, ‘EuroCCP Barrier 2: Location of Clearing and Settlement’, Meeting of the Clearing and Settlement Advisory and Monitoring Experts’2 Group, 20 October 2008. For example, in France, there is a requirement for CCP to have ‘credit institution’ status if clearing for Frenchdomiciled trading venue (France). In Germany, CCPs are required to acquire ‘credit institution’ status if service provided to German-domiciled participants, with a possibility for exemption. In Italy, CSD members are prohibited to settle CCPs’ transactions, as there is a requirement for the CCP to be a direct CSD member. 131 European Commission, Clearing and Settlement in the European Union—The Way Forward COM(2004) 312 final, Brussels, 28 April 2004, 7. Available on the web at: ec.europa.eu/ internal_market/financial-markets/clearing/cesame_en.htm. Also to be discussed shortly. 132 It is considered that non-discriminatory access is a key precondition for competition on the markets for clearing and settlement. See K Gunter, ‘Competition in the Post-Trade Markets: A Network Economic Analysis of the Securities Business’ (2006) 6:1 Journal of Industry, Competition and Trade 45–60. 133 See Section 6.3 above. 134 Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field [1993] OJ L 141/27. By contrast, custodian services are within the scope of the Directive, which means custodians are eligible for the passport scheme. This, though, comes with a condition. For the

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Regulatory Issues would have allowed them to operate in other Member States under the home country control. This principle of home country control is to be discussed shortly. According to the then proposed second revision of the Directive on Investment Services (ISD), which became MiFID, the activities of the ‘regulated market’ encompassed all activities relating to the entry, display, processing, execution and confirmation of orders that were undertaken under the rules and on the systems of a ‘regulated market’ from the point at which such orders were received by the market facilities to the point at which confirmed trades were transmitted for subsequent finalisation (clearing and/or settlement). This consequently implied that CCP clearing was not within the scope of the passport regime and that the CCPs could not freely provide services in other Member States on the basis of authorisation and supervision undertaken by the competent authority in its country of authorisation, and/or establish branches for conduct of business subject to common operating and organisational requirements and based on clear division of enforcement responsibilities between competent authorities.135

In the final proposal of the ISD, the definition of ‘regulated market’ was subsequently revised as a multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments—in the system and in accordance with its nondiscretionary rules—in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorised and functions regularly and in accordance with the provisions of Title III.136

The definition was finally adopted in the text of the MiFID as the proposed revision of the ISD was eventually abandoned. Under the MiFID, the effect of the above revised definition remains that CCP clearing is not included in the home country control regime or the so-called passporting regime. Hence, CCPs under the MiFID cannot passport its services to other Member states. The trend, as seen in the exchanges’ demutualisation and conversion into a for-profit model, is believed to continue and expand further to other segments in the markets such as CCPs. One of the main challenges in respect of CCPs is

purposes of the Directive, custody is an ancillary service (see MiFID Annex 1, Section B). Therefore, it is not eligible in itself unless the custodian is also passporting in respect of an Annex 1, Section A service. 135

Annex 1: Revised Orientations, Revision of the Investment Services Directive (93/22/EEC) 4. Council Directive 2004/39/EC of 21 April 2004 on markets in financial instruments (see n 128 above), Art 4(1)14). 136

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Current Situation in the EU similar to that of exchanges,137 ie, the separation of the self-regulatory function from other market functions. Indeed, the potential regulatory issues with respect to exchanges’ evolving role and functions are those concerning the regulatory role of CCPs and those relating to the regulation of CCPs in a broadest sense. For instance, the European Commission in July 2006, in pressing for further consolidation in post-trade infrastructure, proposed a voluntary code and set out a timetable for the markets with a three-phase roadmap. The first phase is to achieve price transparency and service providers have to make public the prices charged for each service. An inter-operability protocol between different systems is to be agreed upon and implemented in the second phase, while the final phase aims at the complete unbundling of all services. The expected further consolidation in financial markets within the European Union and across the globe poses greater challenges to both the regional regulatory regimes and the regulators and other relevant authorities. On the one hand, the regional regulatory regimes have to be able to adapt to the possible consolidation of markets. On the other, consolidation across the borders is bound to increase the competition between different regulatory regimes and requires the co-operation between regional authorities as well as different authorities to further co-operate with each other in order to foster the development. As proposed, the EU Directive on Clearing and Settlement would set up a common regulatory framework covering all the functions carried out by the various institutions in clearing and settlement. This would bring in mutual recognition regime to clearing and settlement. In additional, it has been proposed that the directive would also set down rules on disclosure requirements, accounting separation and the unbundling of specific services. To ensure competition, there would also be a comprehensive right of access for all clearing and settlement providers to all EU markets. As argued earlier, the risks involved in CCPs are significantly different from those in other post-trade infrastructure, regardless of the fact that they are both integrated functions in modern financial markets. As such, the proposal to create a common regulatory framework for those functions may result in the risks being inadequately regulated. Consequently, there is potentially a need for a stand-alone EU Directive on CCP clearing as an alternative to the above proposal to bring about a harmonised regime at European level and to introduce the passporting regime to CCPs, as well as setting a common supervision regime with the modern co-regulation approach, as discussed in Section 6.2 above. Under the mutual recognition regime, there would be no further requirement for a CCP to obtain local licences or exemptions if the CCP met the home state regulator’s requirements. The home and host Member State regulators share information regarding supervision of a 137 Technical Committee of the International Organization of Securities Commissions, Regulatory Issues Arising from Exchange Evolution (International Organization of Securities Commissions, March 2006).

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Regulatory Issues CCP through memoranda of understanding. Indeed, this harmonisation at European level will need to be matched by amendments to the legal requirements at the national level. The increased interest in post-trading infrastructure is best reflected in the growing number of public policy initiatives and studies that have been carried out in recent years, in the European Union in particular. The 1998 Financial Services Action Plan is the central piece of all EU initiatives to create a single pan-European Market.138 As part of the implementation of the plan, one of the most recent significant steps with respect to CCPs is the Communication on Clearing and Settlement published by the European Commission in 2004. The Commission’s work contrasts somewhat with that of the European Central Bank, which has joined forces with the Committee of European Securities Regulators with the aim of establishing common standards for securities settlement systems and for central counterparties at the European level in order to create a level playing field. In the European Union, creating a level playing field with competition acting as one of the driving forces is considered as one of its top priorities. Nevertheless, this has to be balanced against other regulatory objectives, namely, creating a safe and efficient market, as pointed out at the beginning of this chapter. Of three main aspects concerned in the Communication,139 the proposal of a common regulatory and supervisory framework is the most relevant one in relation to CCPs. As set out in the Communication as part of the effort in achieving those objectives, the Commission stated that one of the major policies is to pursue ‘the adoption of a common regulatory and supervisory framework that ensures financial stability and investor protection. This framework, [as it is expected] would lead to the mutual recognition of systems and their effective integration’.140 The Commission also maintained the view that the regulatory framework should be flexible and adequate to embrace further developments in the practices and opportunities by current and future services providers. Meanwhile, it is recognised that regulation should be the last resort, only after the market participants and the information technology fail to move themselves towards an efficient and robust market. In response to the Commission’s Communication on Clearing

138 See the official website: ec.europa.eu/internal_market/finances/actionplan/index_en.htm for further information. There are also some other initiatives taken by the following bodies: The G30, the Giovannini Group, the European Commission, and CESR/ECB. For an overview on these initiatives, also see KM Löber, The Developing EU Legal Framework for Clearing and Settlement of Financial Instruments (European Central Bank, Legal Working Paper Series No 1, February 2006) and the Bank of New York, The Changing World of Securities Processing in Europe A review of the Current Industry Initiatives (November 2004). 139 COM(2004) 312 final (n 131 above). The three main aspects with regard to the commission’s overall approach are: (1) right of access; (2) common regulatory and supervisory framework and (3) governance—accounting separation and unbundling of services. 140 See European Commission, Summary of Responses, Communication on Clearing and Settlement in the European Union—the Way Forward, 2.

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Current Situation in the EU and Settlement, the European Parliament passed a resolution.141 This resolution states that ‘the EU should resort to legislation where there is clear risk of market failure and where legislation is an effective and proportionate way to remedy clearly identified problems’, and it ‘sees no evidence that the providers of clearing and settlement services are poorly regulated at national level’. Furthermore, there is a concern that a regulatory regime for post-trade services as a whole, which limits the granting of access rights to investment firms only and fails to extend them to infrastructure service providers, would not provide the necessary flexibility to cater for the markets. Given the distinctive nature of CCP clearing operations, this would be difficult to implement in practice for the reason that it may prevent the effectiveness of counterparty credit risk management. So far, the relevant EU Directives that have been implemented by Member States, so far as CCPs are concerned, include the Directive on Financial Settlement, the Directive on Financial Collateral Arrangements and the Directive on Markets in Financial Instruments. These are to be discussed in the following section.

6.4.2 The EU Directives The regulatory principle in the EU that the future architecture of the post-trade infrastructure is best left to market participants to decide applies to CCP clearing. The rationale has been to leave the issues concerning consolidation to the markets, bearing in mind that regulatory oversight and supervisory issues can drive the actions of participants in the markets.142 Currently, there are two special EU Directives that are in force with respect to clearing and settlement in general, namely, the EU Directive on Settlement Finality and the EU Directive on Financial Collateral Arrangements.143 While the objective of these two directives is to cover clearing and settlement systems, which also includes CCP clearing systems, they mainly address the issues associated with securities settlement systems. In addition, the MiFID is another relevant and more general Directive that became effective in November 2007.

A. The EU Directive on Settlement Finality The Directive on Settlement Finality has been implemented by Member States as planned. The United Kingdom implemented it by passing the Financial Markets 141 European Parliament resolution on clearing and settlement in the European Union (2004/ 2185(INI)). Available at: www.europarl.europa.eu/sides/getDoc.do;jsessionid=307FC3A11CD0AF3A 06B03B812840C972.node1?language=EN&pubRef=-//EP//TEXT+TA+P6-TA-2005–0301+0+DOC+ XML+V0//EN (visited in May 2010). 142 K Ripatti, Central Counterparty Clearing: Constructing a Framework for Evaluation of Risks and Benefits (Bank of Finland Discussion Paper 30/2004, February 2004). 143 Directive 2002/47/EC of 6 June 2002 on financial collateral arrangements [2002] OJ L168/43. There has been much discussion in literature on the interpretation and implementation of those Directives. In this section, the discussion is limited to the relevant issues to CCPs.

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Regulatory Issues and Insolvency (Settlement Finality) Regulations 1999.144 The Directive provides a safe harbour from the general provisions of insolvency law for the operations of designated systems including payment and securities settlement systems as well as CCPs. By providing such certainty, it allows financial transactions that have entered into such a designated system to be subject to the rules and regulations of that system, in a participant’s insolvency in particular. Arguably, the settlement finality issue is only directly relevant to payment and securities settlement systems, rather than CCPs. The reason that CCP clearing systems were also included in the Directive may be attributed to the misunderstanding at the time of drafting that CCP clearing was considered to be part of settlement systems. In other words, CCP clearing and settlement were not clearly distinguished.

B. The EU Directive on Financial Collateral Arrangements The EU Directive on Financial Collateral Arrangements does not refer to CCP clearing in any way explicitly. Nevertheless, according to the definition of financial collateral arrangement in the Directive,145 the collateral arrangements of CCPs are within the scope for the purposes of the Directive.146 The creation, adjustment, and enforcement of collateral in the arrangements147 are thus upheld and protected. The relevant requirements and procedures set out in the collateral arrangements are also simplified. Furthermore, the close-out netting provision is also recognised.148 As discussed, the financial collateral arrangements by CCPs are an essential part of its credit risk management mechanism. Any doubt with respect to the legality and enforcement of the arrangements would possibly erode the integrity of the CCP clearing operations and compromise the market’s confidence. The introduction of the Directive on Financial Collateral Arrangements with its implementation in Member States149 has provided that assurance across the EU. For CCPs operating in the EU, the Directive essentially provides the assurance of

144

As discussed in Section 6.4.2 above. For the discussions on collateralisation and financial collateral arrangements, see Section 5.1, ch 5 above. 146 Also termed as margining arrangements. See Directive 2004/39/EC (n 135 above) Art 1. It is worth noting that the conflict of law issues concerning financial collateral arrangements is also addressed in the Directive by adopting the Place of the Relevant Intermediary Approach (PRIMA). Also see the official website of the Hague Conference on Private International Law, at: www.hcch.net/ index_en.php?act=conventions.text&cid=72&zoek=prima. The conflict of laws issues are, however, out of the scope of this thesis. 147 Directive 2004/39/EC (n 129 above) Arts 3, 4, and 6. 148 Directive 2004/39/EC (n 129 above) Art 7. 149 For excellent comments on the UK implementation of the EU Directive on Financial Collateral Arrangements, see D Turing, ‘New Growth in the Financial Collateral Garden’ (2005) 20(1) Butterworths Journal of International Banking and Financial Law 4–9. 145

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Current Situation in the EU the enforceability of financial collateral arrangements. As a result, the recharacterisation risk of financial collateral arrangements by CCPs in the EU has been eliminated.

C. The EU Directive on Markets in Financial Instruments Directive (MiFID) The Directive, which came into effect in November 2007 is to establish the conditions under which authorised investment firms and banks could provide specified services or establish branches in other Member States on the basis of home country authorisation and supervision.

The aim is to harmonise the initial authorisation and operating requirements for investment firms including conduct of business rules [and also provide for] the harmonisation of some conditions governing the operation of regulated markets.150

The delays in its implementation at the Member State level, however, have caused some uncertainty about the implementing measures, for example. Although the scope of the Directive does not directly cover CCPs,151 it does require Member States to provide equal rights of access to CCP clearing without restriction of the use.152 According to the scope of the Directive, which is to apply to investment firms and regulated markets, independent CCPs do not necessarily fall within the applicable principles of the authorisation and supervision regime based on ‘home country control’. It is also questionable whether the principle applies to those CCPs that are owned by and part of regulated markets,153 ie, regulated exchanges/trading platforms. Another issue is regarding those CCPs that are authorised and regulated as credit institutions in Member States like France.154 Explicitly, the Directive does intend to apply a substantial number of provisions to credit institutions authorised under Directive 2000/12/EC when they are providing one or more investment services and/or performing investment activities.155 150

Directive 2004/39/EC (n 129 above) recital (1). Directive 2004/39/EC (n 129 above) Art 1. 152 Directive 2004/39/EC (n 129 above) Art 34(1). For further discussion on the access issues, see Klaus M Löber, The Developing EU Legal Framework for Clearing and Settlement of Financial Instruments (European Central Bank, Legal Working Paper Series No 1 February 2006) 27–9. 153 Directive 2004/39/EC, Art 4(1)14), defines ‘regulated market’ as ‘a multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments—in the system and in accordance with its non-discretionary rules—in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorise and functions regularly …’. 154 The further examination of French regulatory regime is out of the scope of this thesis. 155 See Directive 2004/39/EC (n 129 above) Art 1(2). 151

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Regulatory Issues

6.4.3 The Challenges to the EU Regulators and Supervisors In financial services, the European Union aims to position itself in order to compete globally, not just to create a single internal market. The European Commission was clear that the best framework had to be created in order to achieve this.156 In the absence of a single super-national regulator in the European Union, the regulatory task, as part of creating a single pan-European market, relies heavily on co-operation between various regulators and supervisors. The existing model of co-operation, which has its historical base along national borders, has been adopted primarily to bring about regulatory competition between EU states. It is arguable that this has not effectively adapted to the consolidation in the markets across borders. Although it may be difficult to achieve, further integration and consolidation in the markets also mean that the regulatory framework needs to incorporate a model for supervisory co-operation so that CCPs that operate cross-border can avoid being subject to the oversupervision of multiple regulators and supervisors, which would inevitably increase the cost and its complexity.157 As mentioned briefly above, the future consolidation in CCP clearing within the EU requires increased co-operation between regulators and supervisors in different Member States under the existing regulatory approach.158 As we have also seen, a CCP is increasingly operating in more than a single specific market or within a single Member State. This has resulted in them being subject to different regulatory regimes in different Member States. Hence, the co-operation between regulators and supervisors should not limited to similar sectoral regulators in different Member States, it also has to include all relevant oversight bodies and competent authorities for the various markets in which a CCP may be operating within a particular Member State. In its 2004 Communication, the European Commission suggested that the proposed regulatory framework should incorporate a model for supervisory co-operation.159 It was anticipated that this would increase the consistency of supervisory practices. The Commission also considered that a similar model should be introduced in the clearing and settlement sector including CCPs. This

156 C McCreevy, Stock Market Consolidation and Security Markets Regulation, Europe Annual Lecture at SUERF (Société Universitaire Européenne de Recherches Financières, Brussels, 30 November 2005). 157 European Commission, COM(2004) 312 final (n 131 above), 18. 158 For further discussion on the case for a single CCP in the EU, see Section 7.3, ch 7 below. 159 European Commission, COM(2004) 312 final (n 131 above). However, according to the Parliament’s response to the Commission, the proposition is that it was not in favour to adopting new legislation without evidence that existing legislation is inadequate. See European Parliament Resolution on Clearing and Settlement in the European Union (Kauppi Report). Also see European Parliament resolution on the communication from the Commission to the Council and the European Parliament entitled Clearing and settlement in the European Union: main policy issues and future challenges (Andria Report). Available at: ec.europa.eu/internal_market/financial-markets/clearing/cesame_en.htm.

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Current Situation in the EU model of supervisory co-operation would be mainly based on the so-called ‘home country control’ principle as adopted in several other EU Directives.160 As explained in the Communication, the principle provides that the supervision of an entity for the activities carried out in its home country or abroad through a branch or by way of provision of services, is the responsibility of the home country authorities. [Furthermore] [i]t also provides that foreign subsidiaries of these entities are supervised by the authorities of the Member State where the subsidiary is established. The host country authorities, on the other hand, retain responsibility for certain issues, such as the supervision of the liquidity of branches, monetary policy implementation measures etc.161

Finally, it was intended that such supervisory model would also provide ‘a framework for the regular exchange of information and cooperation between supervisors’. To create a single European market is without doubt an ambitious goal from the outset, given the differences in market practices and cultures among Member States. Essentially, the challenge is to create an efficient, transparent and competitive single European market. Following the 2007–08 financial crisis, the European Commission, in addressing the gaps identified in and adopting the recommendations made in the De Larosière Report,162 made proposals in September 2009 to transform the existing ‘level 3’ Committees into three new European Supervisory Authorities to further enhance the implementation of the relevant regulation and the co-operation between Member State regulators.163 In achieving the creation of such a single European market, the cross-border issues remain a major challenge to the regulators and supervisors within the European Union; for instance, the practicalities of supervision and crisis management are greatly complicated as the number of relevant authorities increases. Furthermore, the increase in interdependence and interconnectedness between Member States within the European Union as they are further integrated means that the actions by national authorities in a Member State are likely to have considerable implications for the financial stability in the others. The complications caused by the great number of relevant Member State authorities’ getting involved in supervision and crisis management were also exemplified in the recent 2007–08 crisis. Indeed, it is the Member State authorities’ limit in focusing on their own individual state in supervising the markets. As the interdependence between different Member State increases, problems in the financial system in one Member State are more likely to spill over to the other Member States.

160 For example, The Market in Financial Instruments Directive (MiFID), Directive 2004/39/EC, 21 April 2004. 161 COM(2004) 312 final (n 131 above) 18. 162 See J de Larosière et al (2009), n 11 above. 163 The proposals also include creating a European Systemic Risk Board (ESRB).

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Regulatory Issues In so far as creating a single European market is concerned, the existing regulatory framework was identified as one of the barriers.164 Among them, to foster the further consolidation of CCPs in turn requires that there is a common regulatory framework. The merger case of the London Clearing House and French Clearnet in which the two were prevented from creating a single entity165 also suggests that the existing regulatory regime at the EU level may not be fit for purpose to facilitate the developments of market consolidation. It is without doubt that the structural issues in post-trade infrastructure are highly complex. Currently, there are many proposed solutions to creating a robust and efficient infrastructure within the European Union.166 As the integration and consolidation in the markets progress, firms that operate across Member States within the European Union become common. Presently, the issue with CCPs operating across different Member States comes with the burden of having to deal with various different regulators across different Member States, while regulators and supervisors in Member States also have to co-operate closely with each other in the form of the college for joint supervision. It is not clear which regulator should react promptly in the case of market disturbances that result in the CCP having difficulty in carrying out its market functions. This is the same for central banks, as CCPs are also sometimes seen as an integral part of the financial systems. Indeed, the answer to whether or not the central bank will have to step in and act as the lender of last resort in the case of a CCP failure that result in markets losing confidence remains as yet unclear.

6.5 Concluding Remarks In discussing the purposes and objectives of financial regulation, three relevant objectives to CCPs were explained. In explaining that the purpose of regulation is to address regulatory concerns like maintaining market integrity and the reduction systemic risk, it was argued that regulatory objectives should not be 164 The Giovannini Group, Cross-Border Clearing and Settlement Arrangements in the European Union (2001), Barriers Relating Legal Certainty, 54. The Legal Certainty Group, as created by the EU Commission, published its first formal advice on clearing and settlement in August 2006. The group also identified some legal barriers with particular examples as annex to the Advice. However, they are only limited to the following three issues regarding the treatment of interests in securities held with an intermediary, corporate action processing and the issuer’s ability to choose the location of its securities. See The Legal Certainty Group, EU Clearing and Settlement Legal Certainty Group Advice (Brussels, 11 August 2006). 165 That was the initial proposed merger structure but was not allowed by the regulators for unspecified reasons. In the author’s view, they are likely to be political reasons as Member States are taking into account of their national interests. Consequently, the merger structure is that the two entities remain to be two separated entities and remain to be regulated and supervised by its home country authorities and are under the control of an umbrella holding company. For further discussion, see ch 7 below. 166 See Section 2.5, ch 2 above.

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Concluding Remarks considered as stand-alone but instead as an integrated system. The constant interaction between financial regulation and the markets requires that regulatory processes be transparent and provide that regulatory outcomes give a good degree of predictability. In observing the constant interaction between financial regulation and the markets and the gaps in regulation as a result, it was argued that creating a dynamic and robust regulatory framework should take into account both the gaps and issues identified in regulation and should regulate the risks posed by the markets resulting from the interaction between financial regulation and the markets. With regulatory reforms on the way following the 2007–08 financial crisis, there is a strong argument to extend the scope of public regulation and have self-regulation replaced. However, it has to be pointed out that, as observed, self-regulation is considered as an integrated and essential part of CCPs. On regulatory approaches, the modern approach of co-regulation with regulatory oversight has also been explained. It was further emphasised that striking the right balance between self-regulation and public regulation is one of the keys to achieving better regulation. Furthermore, in so far as CCPs are concerned, the key matter as argued is that a recognised CCP should be empowered by self-regulatory functions under the modern regulatory approach. In law, for instance, this will also further distinguish recognised CCPs from those unrecognised ones to the extent that they would be provided with the insolvency protections as discussed in Section 6.3.3 above. It was further submitted that regulation, particularly in relation to CCPs, should be principle-based and risk-based with a functional approach. This is also key to creating a dynamic and robust regulatory framework to facilitate the constant interaction between financial regulation and the markets, as observed earlier. Furthermore, the interest of central banks with the particular concern of systemic risk in the financial system was also discussed. In elaborating the need for an appropriate approach to regulating CCPs and for the co-operation between different competent authorities, the UK regulatory regime in respect of CCPs was discussed, in particular the special competition regime and other protections provided to a recognised CCP. As for the current situation in the European Union, the regulatory responses to the 2007–08 financial crisis in enhancing supervision and oversight at the EU level are clearly welcome. Nevertheless, it was argued that the key challenge in creating a single European market remains cross-border issues. As the markets within the EU are expected to be integrated further and CCPs are expanding further into other markets and across borders, under the existing EU regulatory framework, a great degree of close co-operation between relevant regulators and supervisors will be required to ensure that the regulatory objectives are achieved. This consequently highlights the concerns of the practicalities of supervision and crisis management that are greatly complicated as the number of relevant authorities increases. Furthermore, the increase in interdependence and interconnectedness between Member States within the European Union as they are 167

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Regulatory Issues further integrated means that the actions by national authorities in a Member State are likely to have considerable implications for financial stability in the others, as evidenced in the recent crisis. Having said that, the recent proposal to create three European supervisory agencies, which was introduced mainly to address the regulatory gaps identified in the 2007–08 financial crisis, may not necessarily go far enough to create a regulatory framework for a real single European market.

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7 The Case For a Single Multi-market Central Counterparty

I

SSUES CONCERNING POST-TRADE infrastructures have become a major focus of concern among market participants, financial authorities, regulators, central banks and academic scholars, particularly in the European Union. For the EU, the objective is to help bring about an efficient and robust, single pan-European financial market and to give it a competitive edge in the global financial markets. It is widely accepted that the post-trade infrastructures, including CCP clearing, hold an important key to achieving this objective. Nevertheless, it has long been identified that European financial markets in general are still ‘seriously inefficient in many areas and their evolution is considerably slower than is widely believed within the industry’.1 As noted before, the post-trade sector within the European Union has been identified as a major area of inefficiency. The potentially important role of CCP clearing in the expected further consolidation in post-trade sectors has also been highlighted in a 2005 study.2 Market participants interviewed in this study were quoted as believing that priority should be given to CCPs as the potential for their further consolidation promises to be greater than that of Central Securities Depositories (CSDs),3 in so far as market consolidation is concerned. As previously mentioned, the mechanism of CCP clearing essentially concentrates risks, from the various counterparties to the trades to a single specialised entity that actively manages those risks. Essentially for its success, this arrangement should be backed by

1 Charteris Consultants, European Financial Markets 2001—Revolution or Evolution? (2001). In the paper, it was stated that, ‘although the needs for reform were recognised, many of the investment banks had an interest in preserving the status quo with little incentives to press for reform in areas like the processing of trades in particular.’ Furthermore, the authors argued that a radical change was unlikely ‘because the major investment banks [as intermediaries] benefit by integrating trading, clearing and settlement for their customers,’ namely, by bundling the services all together rather than providing a choice of each service. 2 Bourse Consult, The Future of Clearing and Settlement in Europe (Corporation of London, City Research Series: Number Seven, December 2005). 3 See Section 2.2.3, ch 2 above.

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The Case for a Single Multi-market CCP robust financial resources and rigorous risk management measures.4 It is believed that this largely contributes to the success and popularity of CCP clearing in modern markets. CCPs, with their strategically important position in the markets, have multidimensional effects on the markets. From the vertical perspective, they sit right in the middle between exchanges/trading platforms and payment and securities settlement systems. From the horizontal perspective, the expansion of CCP clearing services is not only on a cross-border or cross-market basis so that geographical elements become less relevant, but also on a cross-sector basis because the CCP clearing mechanism can be used in any type of market with significant volumes. From a third perspective, a CCP occupies the central position between its member participants by interposing itself between buyers and sellers. Indeed, some CCPs, like LCH.Clearnet Ltd in London, have been effectively operating across various different types of markets (not only in financial markets but also in commodities and derivatives markets) and have the potential to expand further to literally any other type of developed markets. Hence, the traditional way of looking at CCPs in a particular market is no longer appropriate and is also likely to be outdated. As discussed in chapter three, CCPs operating in different types of markets may perform various additional functions according to the specific market structure, but the core functions, eg counterparty credit risk management5 with transaction set-off and netting, remain the same in principle. In addition, the economics of scale for CCP clearing may play a decisive role in future consolidation, by which a CCP can extend and maximise the benefits that it brings an individual market to many other markets by operating across them as a single entity. This will be discussed shortly. As far as the future consolidation of CCP clearing is concerned, there are a few initiatives to create a single integrated CCP, such as the EuroCCP project for the European markets, proposed by the European Securities Forum.6 Also, there is a

4

See the discussion in Section 3.2, ch 3 above. Meanwhile, the recent development of CCPs has also attracted the attention of some international institutions. In 2004, the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) and the Technical Committee of IOSCO published a joint consultative report that sets out comprehensive standards for risk management of CCPs in financial markets. Essentially, a CCP is interposed between original sellers and buyers in financial transactions in such a way that enables collective risk management in the markets. Indeed, CCPs are central in risk management arrangements, which are also the focus of the BIS report. It also includes guidance regarding methodology for implementation of the recommendations. See the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of International Organization of Securities Commissions (IOSCO), Recommendations for Central Counterparties (Bank for International Settlements, November 2004). 6 European Securities Forum (ESF), EuroCCP—ESF’s Blueprint for a Single Pan-European Central Counterparty (2000). This is to be distinguished from the UK regulated EuroCCP established by DTCC for cross-Atlantic transactions. See Section 7.3.1 below for further discussion. 5

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Pros and Cons of CCP Clearing proposal on a global scale, ie a global CCP7 as proposed by the US Depository Trust and Clearing Corporation (DTCC). However, this latest proposal is not without criticism, which mainly comes from those who opt for the vertical approach and therefore prefer bringing trading, clearing and settlement under one control.8 In terms of future consolidation, there are other alternatives for creating a single integrated CCP, for instance, a cross-market regional partnership formed by several CCPs, or a ‘loose’ alliance of CCPs that delivers some value-added services to participants.9 As to the way forward, it is commonly agreed that markets are best positioned to decide the future of market infrastructures, which is also a policy approach adopted by the European Commission.10 However, this may, to some extent, become a source of uncertainty, especially when there is no appealing solution that clearly takes the lead. A clearer message is what investors and participants in the markets want. In terms of post-trade infrastructures, market participants want an infrastructure that is robust and efficient, and that provides lower cost services. It is necessary to point out at the outset that the assessment of the risks and benefits of CCP clearing and the key factors in deciding the future structure of CCP clearing are mainly economics-related. As will be seen, the assessment of advantages and disadvantages of CCP clearing has attracted significant attention from economists in the past years, especially following the collapse of Lehman Brothers. It is nevertheless submitted that the relevant laws and policies can also play a role in fostering the developments. In this chapter, in preparation for the evaluation of risks and benefits of a single CCP for the markets in Section 7.2, there is first a discussion of the advantages and disadvantage of CCP clearing in general in Section 7.1. In Section 7.3, the focus will mainly be on the current development of CCP clearing in the European Union.

7.1 Advantages and Disadvantages of CCP Clearing Some recent developments in the markets, within the European Union in particular, highlight the increasing popularity of CCPs, like the ever-increasing

7 Depository Trust & Clearing Corporation (DTCC), The Central Counterparty Dialogue—Year 001 (Paris: Promethee, 2001), at: www.dtcc.com/Publications/ccp.pdf. 8 There are also two alternative solutions to creating a single multi-market CCP. One of them is to link several CCPs together and form a cross-market regional partnership, and the other is a ‘loose’ alliance of CCPs delivering some value added services to participants. See P Tsien, ‘Central Counterparties: A Time for Action’ in DTCC, The Central Counterparties Dialogue—Year 001 (Paris: Promethee, 2001). Available on the website: www.dtcc.com/Publications/ccp.pdf. 9 P Tsien, ‘Central Counterparties: A Time for Action’ in DTCC, The Central Counterparties Dialogue—Year 001 (Paris: Promethee, 2001). Available at: dtcc.com/Publications/ccp.pdf. 10 See Section 7.3 below, for the EU developments.

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The Case for a Single Multi-market CCP volumes of cross-border or non-domestic transactions.11 As discussed in chapter two, CCPs have been constantly evolving to accommodate market developments. A second market development is the so-called best execution requirement, which is regarded as an important regulatory obligation in modern markets12 and requires execution intermediaries to find the best possible deals for their clients. Its aim is to protect investors and foster market efficiency. This consequently makes the management of counterparty credit risk increasingly difficult in practice, since the best price becomes a decisive factor and may lead to disregarding the counterparty credit risk of the party that offered that price. In addition, a third development is the recent move to quote-driven trading systems, particularly in Europe. This is also seen as a major factor that contributes the move towards anonymous trading as part of a trading strategy. To some extent, assessing the advantages and disadvantages of using CCPs is not a trivial task.13 Given that every market structure is different depending on the type of products and settlement systems involved, the benefits and risks of CCPs in each particular market may not necessarily be the same.14 Indeed, a proper analysis has to be put into context; differences in market structures do exist and are sometimes significant.15 Hence, the results can vary significantly as well. For those markets without CCPs, it may be true that there is no compelling case for introducing a CCP. Ultimately, the assessment should be subject to a specific evaluation as far as an individual market is concerned. A proper evaluation of CCP clearing helps increase the understanding of the mechanism. Before moving on to the evaluation of the advantages and disadvantages of CCP clearing, it is first useful to consider the concept of efficiency briefly. As an economic concept, efficiency has long concerned scholars as well as practitioners. It is said that ‘[the] term efficiency is used to describe a market in which relevant information is impounded into the price of financial assets’.16 This is informational efficiency. In contrast with informational efficiency, operational efficiency, in financial terms, emphasises the way in which resources are employed to facilitate the operation of the market.17 As a type of efficiency, operational efficiency is a major concern in the context of post-trade processing. Little has 11 For the role of CCPs in this regard and an economic analysis of the advantages and disadvantages of CCPs, see F Giordano, Cross-border Trading in Financial Securities in Europe: The Role of Central Counterparty (European Capital Markets Institute Short Paper No 3, 2002). See DTCC, ‘Central Counterparties: Development, Cooperation and Consolidation’ (A White Paper to the Industry on the Future of CCPs, October 2000). 12 For example, best execution is required under the EU Markets in Financial Instruments Directive (MiFID), which is to be implemented in member states. See Section 6.4.2, ch 6 above for further discussion. 13 K Ripatti, Central Counterparty Clearing: Constructing a Framework for Evaluation of Risks and Benefits (Bank of Finland Working Paper 01/04, February 2004). 14 For example, see ch 2 above for the different types of payment and settlement systems. 15 See the discussions in chs 2 and 3 above regarding the market structures. 16 E Dimson and M Mussavian, ‘Market Efficiency’ in SB Dahiya, The Current State of Business Disciplines (Spellbound, 2000), 959–70, 959. 17 ibid.

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Pros and Cons of CCP Clearing been done in this respect in European markets, and evidence for economic analysis of the costs and benefits of CCPs is still being gathered. This type of analysis has proven to be difficult given that the underlying structure is complex and sometimes fragmented. A further question, following the evaluation of the advantages and disadvantages of CCPs, is whether there should be one or more CCPs in the markets. The latter issue will be discussed in Section 6.2 below. In this section, the advantages and disadvantages of CCPs are to be examined from three different perspectives, namely, markets, members of CCPs and non-members. It should be submitted at the outset that some of the advantages and disadvantages of CCP clearing are shared by these three different participants.

7.1.1 From the Markets’ Perspective For the markets, having a CCP with generally robust financial resources and a good credit rating that provides market participants with a financially sound counterparty with which to trade is likely to be a positive factor. Overall, a CCP clearing structure benefits the two other major segments in the trade cycle, namely, trading and settlement. For exchanges and trading platforms, the benefits of having a CCP in place as discussed above may be easily identified. As just mentioned, having a CCP eases the major concern of participants about the credibility of the other counterparty to the transaction in the market. With the performance of the transactions seemingly guaranteed18 by a CCP, participants have fewer disincentives to be inactive in the markets. For settlement systems, CCPs help reduce redundant settlements19 significantly and boost the system’s capacity in such a way that large volumes of transactions are set off before going to the settlement system. Given the nature of CCP clearing, the greater the volume of the transactions in a cycle, the more obvious the off-setting benefits that it offers.20 Furthermore, the potential to extend an existing CCP clearing operation to new markets can be achieved with limited costs, especially compared with building a new one for that market. The external effect of cost-saving boosts the potential for extending the CCP services into other new markets, which brings the benefits of lower-cost set up and great expertise. A well run CCP, in turn, helps to further increase trading volumes and market liquidity, as the concerns of counterparty credit risk are eased. The existence of a 18 Contrary to what markets used to believe, a CCP acting as the counterparty to a trade does not legally amount to a guarantee in performance. See ch 3 above. 19 They are referred to the settlement instructions for transactions that might otherwise need to be processed by relevant settlement systems without CCP clearing. Also, see n 37 below for compression rate. 20 See F Russo, The Evolving Role of Central Counterparty Clearing Houses, JEL Classification F33, F36, G30 (Roma, Universita Luiss Guido Carli, 2002) 238.

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The Case for a Single Multi-market CCP CCP can further contribute to market transparency.21 In particular, the ability of a CCP to better monitor each member participant’s aggregate exposure in relation to the trades processed through clearing may also be seen as a credible measure for better risk arrangement.22 Furthermore, the pooling of financial resources via centralised collateral management to manage counterparty risk effectively enables more efficient management and utilisation of financial resources in the event of a participant default. This in turn helps to stop a potential domino effect, ie a default of one participant in the market causing other participants to default. It also makes markets more resilient, since the financial resources managed by the CCP can provide ‘a safety net’ to the markets. Yet, the benefits that CCPs offer must not be exaggerated, given the fact that they only deal directly with member participants,23 the number of which is often limited. Likewise, in a market the number of financial products that are eligible for CCP clearing is also limited. A CCP usually does not cover all products that are traded in a particular market, mainly due to the uncomfortable level of the liquidity and market risk of the instruments. Another concern is that in the markets currently dominated by big players, with the help of CCPs to further reduce the costs, smaller players that cannot meet the membership criteria and have no direct access to a CCP risk being played out of the markets.24 By its very nature, CCP clearing concentrates counterparty credit risk.25 This type of concentration of potential risk may cause systemic risk and result in damage to financial stability in the financial system as a whole, as far as the markets are concerned.26 While clearing services provided by a CCP may reduce the probability of liquidity crises and protect against indirect forms of markets contagion,27 there are two main issues in relation to the so-called asymmetry of information: adverse selection and moral hazard.28 Firms with above-average creditworthiness may choose not to use a CCP, for it reduces their comparative credit advantage. An example of adverse selection can be found when margin 21 R Dale, ‘Derivatives Clearing Houses: the Regulatory Challenge (1997) 12(2) Journal of International Banking Law 46–55. 22 However, the aggregate exposure of each member participant that a CCP is able to monitor is limited to the trades that are registered with it, and typically, not all transactions of a member firm are going through CCP clearing. 23 See the discussion on contractual relationships in ch 4 above. 24 For the benefits from non-members’ perspective, see Section 7.1.3 below. 25 From a market participant perspective, a CCP, by acting as a buyer to every seller and a seller to every buyer, concentrates counterparty credit risk that the participant would otherwise have been spread across various counterparties into one, ie the CCP, with respect to the CCP transactions. 26 B Hills, D Rule, S Parkins and C Young, ‘Central Counterparty Clearing Houses and Financial Stability’ (June 1999) Financial Stability Review (Issue 6). 27 F Russo (2002), n 20 above. 28 Asymmetry of information raises questions including those of moral hazard and possibility of abusing informative advantages. The existence of a CCP may in fact serve as a disincentive to risk management since members are relying on the CCP to manage the counterparty risk properly. Furthermore, it may prompt members to take excessive risk. In addition, the CCP is in a strong position to monitor participants’ overall trading portfolios, in order to realise the real exposure of every member. It is easy to imagine how such information could be abused, if not properly secured.

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Pros and Cons of CCP Clearing requirements are uniformly set based on the credit standing of the average participant. Firms with better credit standings may be unwilling to use CCP clearing, since they are able to save on margins by trading mutually. Trades through a CCP will be more attractive for those less creditworthy firms. This may, as suggested, result in CCPs’ failure to attract a good proportion of firms with good credit rating if the number of firms that opt for avoiding the use of CCP clearing is significant.29 ‘Moral hazard’ refers to a scenario in which the markets may be convinced that CCPs are too big to fail and may therefore lower the incentive for participants to act prudently with regard to managing exposure to counterparty credit risk of CCPs. As pointed out by the Bank of England,30 it remains unclear whether a CCP generates better incentives to members to manage counterparty credit risk. In a market without CCPs, counterparties to the transactions are exposed to risks throughout the trade-processing period. Consequently, they have the direct incentive to manage risks actively and effectively. Interposing a CCP can be seen as a tool that mitigates the task of counterparty risk management collectively for market participants, as the risk exposure is transferred to the CCP itself. This may also seem to be a disincentive and market participants may take excess risk in that respect. As noted earlier, a CCP concentrates risk and is responsible for counterparty credit risk management in the market it operates, as it becomes the trade counterparty to its member participants. Therefore, the failure of a CCP has the potential to disrupt the markets it serves. When it operates in several markets the impact of a CCP default in one market will possibly spread further to other markets, eventually creating systemic risk for the whole financial system.

7.1.2 From Members’ Perspective Indeed, the benefits that CCPs offer are not only limited to the market as a whole but extend to individuals and their member participants in particular. The benefits of using CCPs for market participants have been well summarised by Kirsi Ripatti, and are divided into four categories: trading benefits, risk benefits, balance sheet benefits and operational benefits,31 of which the following deserve closer consideration. 29

See F Giordano (2002), n 11 above, 43. This issue was first raised by the Bank of England in its Financial Stability Review, see B Hills, D Rule, S Parkins and C Young (June 1999), n 26 above. 31 From the market participants as members of a CCP, the benefits of using CCPs are best summarised by K Ripatti (2004), n 13 above, 10–11, as follows: ‘1. Trading benefits + The facilitation of full post-trade anonymity through the introduction of CCP benefits both markets and trading platforms and their customers. + CCPs help to narrow trading spreads, which allows a trader to offer tighter spreads to buy-side institutional clients and in turn attract further trading activity to the order books. 2. Risk and capital benefits 30

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The Case for a Single Multi-market CCP (1)

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Anonymous trading allows firms to withhold their trading positions from before the trading to the completion of the trade. Without a CCP in place, for the purpose of transaction processing, the account details of the two original counterparties to a transaction have to be revealed to each other, as they are necessary for trade processing and settlement even in a market that has a trading system that facilitates anonymous trading. Therefore, the resulting positions may be exposed to the other party. Having a CCP in place means that the CCP is the counterparty to the trade throughout the processing of the transaction and therefore eliminates the need to reveal identities for trade processing purposes as far as the original counterparties are concerned. In other words, CCP clearing simply extends the anonymous trading to the rest of the trade cycle. For trading, this is significant for large firms, as it will minimise undesired speculation in the markets while large trades are being executed. For a member, one of the main advantages of using a CCP is that there will first be a significant reduction in risk resulting from the off-setting of buys and sells. As already mentioned, a CCP allows the original counterparties to a transaction to remain anonymous, as long as the trading was first facilitated in this way at the exchange/trading platform. In addition, CCPs eliminate the burden of monitoring multiple counterparties to the transactions with various credit ratings for pre-settlement risk, and provide the member participants with a single and financially robust counterparty. In contrast, in a market without CCP clearing, trading parties may be concerned about the credit rating

The introduction of Basel II will add on efficient capital allocation and reinforce the need for banks to allocate the capital necessary to support their operations more efficiently + It will in general decrease counterparty credit risk. Use of a CCP offers two credit exposure enhancements. First, it facilitates multilateral exposure netting, which typically reduces overall credit exposure. Secondly, it consolidates bilateral exposures into a single low risk exposure with a CCP 3. Balance sheet benefits + Increased return on capital via cost reduction. + Improved credit stand. Firms may choose to retain the released capital and thereby improve their credit standings (contribution to profitability). + Reduced leverage ratios. Use of a CCP in the repo market has further benefit by enabling users to net cash assets and liabilities and reduces leverage ratios 4. Operational benefits + CCPs can reduce back office tasks for longer run. Use of a CCP and its risk management methods introduces significant savings at the operational level. + Reductions in overall market costs. While discussion of costs often focuses on merger activity at the settlement level, much of this anticipated saving can be achieved at the clearing level through the expansion of netting and choice in settlement platforms + Netting cuts settlement costs via fewer trades proceed to settlement. Cost reductions are valuable also for private investors + Increased STP. By standardising market processes, documentation and systems and processing trades through a single channel, STP can be increased greatly and costs reduced, thus optimising the level of capital required to support operational risk’. +

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Pros and Cons of CCP Clearing

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of counterparties with best price and may have to turn down offers, which would compromise their profitability. This can potentially be resolved by introducing a CCP, which would allow the search for the best execution to be isolated from the concerns about the counterparty risk, since trading parties would have a financially sound CCP as counterparty to the trade. In a market with diverse trading participants, the routing of trade orders and flow of transactions are often found to be very complex within modern book-entry systems. This is especially the case for post-trade processing in a modern market, and the settlement orders may normally involve several intermediaries. With a CCP in place, the flow can be streamlined in such a way that reduces a significant amount of flow involving intermediaries in the middle of the chain, which is increasingly the case in a modern market structure that is highly intermediated. From an individual participant’s perspective, interposing a CCP between himself and a web of counterparties in relation to a significant number of transactions in effect offers a much better chance of off-setting those transactions. Instead of having to mutually deal with each counterparty for a vast amount of transactions, CCPs simplify the processing of transactions for participants, who then need only deal with a single counterparty instead. As noted earlier, the number of trading opportunities is likely to increase with the introduction of a CCP because it makes it easier for market participants to manage counterparty credit risk.

As discussed in the previous section, CCP clearing in turn helps increase market liquidity, stimulates trading, reduces transaction costs and improves the functioning of markets. These aspects are also beneficial to all participants in the market. Indeed, the benefits to members of CCPs are obvious but not always the same;32 this is largely dependent on the trading volumes of the individual member as well as the CCP’s credit risk control. On the other hand, some economists have attempted to evaluate the benefits of CCPs by dividing them broadly into two types, ie qualitative and quantitative. A study concluded that the markets might see the qualitative aspects and efficiency as more beneficial than the quantitative cost-saving advantages.33 Here, one of the major benefits of CCP clearing is the significant reduction of settlement costs and failure. It is estimated34 that it could save up to 70 per cent of its European clearing and settlement costs by leveraging cross-market clearing solutions. Furthermore, it is also estimated that, in the European Union, around 15 per cent 32 By the nature of CCP clearing, the larger the volume of the trades a participant has with a CCP, the bigger the savings. 33 European Securities Forum (ESF), EuroCCP—ESF’s Blueprint for a Single Pan-European Central Counterparty (December 2000). 34 See DTCC (2001), n 7 above.

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The Case for a Single Multi-market CCP of all non-domestic transactions fail and around 30 per cent fail in developing markets. In lowering the costs, the volume of transactions is also a determining factor, as suggested by a study conducted by Z/Yen Ltd.35 Through interposing a CCP between a trading counterparty and many others, with the off-setting of mutual obligations that follows, a significant amount of redundant movements of payments and securities, in terms of delivery, is reduced. Thus, it not only reduces the amount of settlement fees paid by participants but also frees up the capacity of relevant payment and securities settlement systems. Members experience two types of costs for using a CCP:36 direct costs and indirect costs. The costs include the costs of using the CCP clearing services and the indirect cost-savings that emerge as a result of CCP clearing. The one-off fixed cost of building the link with the CCP is in the former category of costs. The latter, indirect, costs mainly include costs associated with risk management and trade processing, efficient use of collateral and capital requirement saving. The use of a CCP means that there are additional direct costs such as the service charge. However, these are largely off-set by the reduction of settlement fees and other indirect costs such as those associated with counterparty risk management and trade processing and are dependent on the number of counterparties to settlement. Here, the United States provides the best concrete example of the efficiency that a CCP can achieve. The National Securities Clearing Corporation (NSCC), one of the main CCPs in the United States, normally achieves a 95 per cent ‘compression’ rate,37 which in turn results in the reduction of settlement values through netting. As estimated, on the busiest trading day in the United States back in 2000, transactions of a gross value of US$722 billion were netted down to a net settlement value of just US$21.7 billion, a rate of 97 per cent. It is also suggested that a rate of 85 per cent can be achieved by introducing a CCP clearing structure in the London market.38 While the direct savings and costs are less difficult to assess, understanding those indirect savings resulting from the use of CCP is more complicated. The reduction of indirect costs is mainly derived from margin requirements, settlement costs, and, most significantly, capital adequacy requirement netting. Nonetheless, these indirect cost savings could be the most significant with the

35

Z/Yen Ltd, Competitive Cost Benchmarking Study: Equity and Debt Products (2002). E Linton and M Starks (NERA Economic Consulting), The Direct Costs of Clearing and Settlement: An EU-US Comparison (Corporation of London, 2004). 37 Here, the compression rate refers to the ratio between the number of trade settlement instructions that are eliminated as a result of CCP netting and the total number of trade settlement instructions would have to be processed through gross settlement. 38 D Cruickshank, Speech: The Evolution of EU Securities Markets: Next Steps for Clearing and Settlement (Madrid, 18 October 2005). It should be noted that London Clearing House was a clearing house and only transformed itself to be a CCP until the late ’90s. Likewise, a clearing house was established by the New York Stock Exchange in the US in 1892 but only became a true CCP in 1920. For further discussion, see the origins and historical development of CCPs and Clearing Houses in Section 3.1, ch 3 above. It is worth noting that the data quoted provides a clue of the increased efficiency even it is somehow outdated and more recent data is not available. 36

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Pros and Cons of CCP Clearing efficiency39 that is gained through CCP clearing. To sum up, the benefits of CCPs should not be easily exaggerated especially when balanced against the risks that they pose to the whole financial system in case of failure.

7.1.3 From Non-members’ Perspective The question of what benefits non-members—which refers to those participants that have no access to the CCP clearing directly—can gain from CCP clearing is far from clear. This issue has rarely been examined. In a typical CCP structure, the majority of those that are not members of CCPs are small players in the markets. Given the existing structure, smaller players, with relatively low volumes of transactions, and hence a very low chance of having transactions off-set with the CCP, have fewer benefits or even no benefits as a result, and may not be able to maximise the benefits that CCPs could potentially offer. As already noted, CCPs cannot provide access to everyone for risk management reasons. Membership administration is, in fact, one of the measures that CCPs use to manage risks effectively. The membership requirements, as a measure of counterparty risk management, are an integral part of the standards40 of risk management controls, together with membership evaluation and monitoring. The access criteria41 and their administration are the issues of focus. For some participants, it could be seen as a mechanism that ensures they will be treated fairly. Without CCP membership, the only alternative option for nonmembers is to access the services through members of CCPs indirectly. Even if they can access the CCP services through its members, the benefits are still likely to be limited when compared with those enjoyed by members. This is because the greater the volumes of transactions that go to CCP clearing, the better the chance of maximising the off-setting effect. Given the relatively low volumes that small players deal with, they have no fair chance of competing with big players that also normally happen to be members of CCPs. It is argued, however, that with the right membership structure a CCP can enable small players to stay in the market.42 This kind of structure may also enable the benefits to be shared by all participants in the market if possible. To achieve this, a change in the existing CCP membership structure is most likely needed, for example, creating a special category of membership with different criteria and margin requirements to admit smaller players as clearing members when they otherwise would not be able to meet the general membership requirements as set.

39

See the discussion below. See the Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of International Organization of Securities Commissions (IOSCO) (2004), n 5 above. 41 The access issue is in a sense also a topic of the competition debate regarding CCPs. 42 See K Ripatti (2004), n 13 above. 40

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The Case for a Single Multi-market CCP

7.1.4 Concluding Remarks Arguably, the recent popularity of CCPs across some markets may have led some to argue that the direct and indirect benefits that CCP clearing offers to the markets outweigh the disadvantages. It is apparent that costs are among the main catalyst in the developments. This is particularly true in the case of developed markets that have significant trading volume, although it does not suggest that CCPs should be introduced to every market. The assessment of advantages and disadvantages of CCP clearing from different perspectives helps us to understand better the benefits that CCP clearing can bring. As argued, the benefits of CCP clearing should not be easily exaggerated, as the risks it poses have to be addressed and managed properly. Furthermore, it was submitted that the benefits to other market participants as non-members, who are likely to be small players in terms of volume in the market, do not seem to be clear. Nevertheless, a more efficient market with CCP clearing benefits all participants either directly or indirectly.

7.2 The Case for a Single Multi-Market Central Counterparty 7.2.1 The Raison D’être for a Single Multi-market CCP The calls for consolidation and re-organisation of the existing post-trade infrastructures and the expected central role of CCP clearing in this development have provided some strong points in favour of those who argue for creating a single CCP.43 The current structure for post-trade infrastructures is inefficient due to various, mainly historical and cultural reasons, which are the major factors that contribute to higher costs for complex cross-border transactions, as is particularly the case in the European Union. At present, it is recognised that harmonisation efforts are the key to cost reduction and process simplification. For instance, in the European Union the Giovannini Report proposes the adoption of market standards as an effort to remove barriers and harmonise market practices.44 Despite all of the differences in market infrastructures, the objective of the post-trade infrastructures for a market, as previously mentioned, is essentially the same: to build a robust and cost-efficient infrastructure. The efficiency issue was one of the main causes for action after the US paperwork crisis in 1970s. The re-organisation of the post-trade infrastructures that followed was the result of the most intense studies ever conducted in the 43

See F Giordano (2002), n 11 above, and F Russo (2002), n 20 above. The Giovannini Group, Second Report on EU Clearing and Settlement Arrangements (Brussels, April 2003). Also see Section 7.3 below. 44

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The Case for a Single Multi-market CCP industry. At the time, CCP clearing was on the radar and as early as 1976, a study known as ‘the Mendelson Study’45 that was submitted to the US financial authority, the SEC, attempted to investigate the economies of scale in integrating CCPs. As mentioned above, the CCP services are similar to those that have a network nature,46 ie, the more extensive the network of users and the more business they put through a single service, the more effective and efficient that service becomes.47 To some, the impact of integrating CCPs into a single CCP is believed to have both long-term and short-term benefits. Certainly, the one-CCPone-market model deserves to be challenged48 and this pattern of a single CCP serving one market in one country is changing, in the European Union in particular.49 In the European Union, the case for a single CCP is also central to the debate related to the creation of a single pan-European financial market.50 As to the architecture of the post-trade infrastructures as a whole, there are two major approaches: the so-called ‘vertical silo’ solution51 and the ‘hourglass’52 model. The major issue here is how to strike a balance between achieving the best possible efficiency and creating a level playing field with a degree of competition.53 To some, the idea of a single CCP for the markets may seem to be premature. However, the potential benefits of a single CCP are not constrained to a single individual market.54 As mentioned at the beginning of the chapter, CCP clearing has multi-dimensional effects on the markets. Similarly, in the vertical dimension, a single CCP could help bring efficiency to the settlement and reach further into the whole trade cycle. In the horizontal dimension, it could help extend the services into many more new markets with far less costs than new setups would incur. As already seen in chapter two, CCPs are now extending clearing services into many more markets and the mechanism of CCP clearing

45

M Mendelson (2000), as cited in European Securities Forum (ESF) (2000), n 6 above, 6. Thus, it is comparable with railway network, telecommunication network and the likes. For a discussion on competition issues, see D Helm and T Jenkinson, Competition in Regulated Industries (Oxford: Oxford University Press, 1998). 47 See Bourse Consult (2005), n 2 above, 27. 48 This is largely an argument from competition perspective. See A Bressand and C Distler, ‘When Clearing Matters: CCPs and the Modern Securities Industry’s Value Chain’ in DTCC, The Central Counterparties Dialogue—Year 001 (Paris: Promethee, April 2001). 49 Euronext was the first in the EU to consolidate and create Clearnet as a single CCP serving several markets. Also see the discussion below. 50 See Section 7.3.2 below for further discussion. 51 This is represented by a vertical integration between trading platforms and clearing and settlement structure. 52 The model refers to a structure where a single CCP links a plurality of trading platforms and settlement systems. 53 The competition issue as seen from the US experience may not be appropriate to be taken as an overriding issue in clearing and settlement industry. 54 See the benefits of a single CCP in Section 7.2.2 below. 46

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The Case for a Single Multi-market CCP has a great potential to be extended. The great potential that a single CCP could offer is coverage of the services that can possibly be extended without substantial extra costs. Some have suggested that an integrated platform with various CCP operators provides participants with a choice of CCPs, and access to one CCP results in access to all. This is the present structure of LCH.Clearnet Group because, after failing to create a single entity, it now attempts to bring an integrated platform and offer a choice of CCPs.55 The future development of LCH.Clearnet could be significant, as the group serves several markets within the European Union and covers most of the financial markets and commodities markets. It was also seen by many as an important step to linking all of the CCPs together and achieving inter-operability with common standards, which may have been considered to be an intermediate step towards a single pan-European CCP. The benefits and risks associated with the establishment of a single CCP for both financial institutions and markets will be examined below. Some points that will be made in the following sections also refer to the economic efficiencies that are primarily associated with the emergence of a single CCP.

7.2.2 The Benefits of a Single Multi-market CCP Some of the benefits of having a single multi-market CCP are inherited from CCP clearing. More than that, a single CCP for multiple markets could also magnify the benefits that a CCP brings to an individual market, as discussed in the previous section. Furthermore, some other potential benefits may make the proposition ever stronger. Among them is further significant cost reductions on a larger scale. With a single CCP, the standardisation of processing is also likely to be less difficult to bring about. It is significant that different market practices accompanied by different processing systems were some of the barriers identified to have contributed to the much higher costs in cross-border transactions. In a developed market economy, there are various types of markets. The trend is that participants are increasingly active not only in an individual market but in several different ones simultaneously. It is not uncommon to see market participants actively taking part in various markets, ranging from commodities markets to securities markets as well as ‘over the counter’ (OTC) markets. For securities markets, it may be possible to have a single securities settlement system, as is the case in the United States. However, it may be less likely to have a single system for all types of markets. The advantage of a single CCP is that it could possibly provide a single access point to all of the markets it serves and maximise the scale of economics. 55 The integration plan suffered a serious technical setback recently. The development of the so-called Generic Clearing System, the integrated platform, was eventually abandoned in 2006.

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The Case for a Single Multi-market CCP A CCP incurs substantial fixed costs to develop, upgrade and operate its own system. Because such systems often have a similar basic architecture, a merger of them or a common platform among several systems is likely to be an efficiencyenhancing arrangement. In addition, this is also likely to benefit market participants, such as the investment banks and brokers that engage actively in crossborder transactions. These institutions currently face significant access costs to build connections with a variety of systems as well as constant system upgrades. A single CCP not only eliminates duplicated investment for linking with several CCPs and the cost of maintenance and system upgrading, but also creates cost savings to users in the form of reduced default fund contributions and fees. Moreover, there are direct benefits to be gained in several ways. The opportunity cost will be lowered significantly with direct access to several markets at a lower cost. It may also benefit end investors by lowering the implicit costs through the provision of greater liquidity. With the effects of a CCP in place, wider trading opportunities are created by the resulting increase in efficient trading position netting, which in turn benefits the relevant exchanges or trading platforms. A consolidated CCP system could also help bring forward the standardisation process of the data formats used by the financial industry. Operational economies of scale can arise from the establishment of compatible or shared platforms. This could give rise to compatible CCP platforms, eliminating the need for redundant investment in different systems. In this respect, it should be less costly for banks and brokers to connect to a single pan-European CCP, for example, than to a large number of small local systems that often have incompatible standards and data formats. The result of a study responding to the question asking56 why one CCP is cheaper than many provides first-hand evidence about the virtues of a single CCP. It was also mainly for this reason that the decision was made in the United States to choose Chicago Board of Options Exchanges (CBOE) Clearing Corporation to serve three options markets: CBOE, American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (formerly the PBW stock exchange). A single options CCP would be much less expensive to operate than interfacing separate CCPs, and there would be less chance of human input error. Generally, a single CCP is also beneficial to the markets since it eliminates the need for duplicated investments in operations.57 As was already noted, a CCP that operates in various markets can also leverage its expertise from one market to help other exchanges and trading platforms to develop new products and the procedures with respect to how those products are to be cleared and settled. In addition, tailor-made financial products, such as those in the dynamic OTC markets, can also be structured in standardised forms to be traded in markets with the help of the CCP. For example, standardised interest-rate Swaps may

56 57

European Securities Forum (ESF) (2000), n 33 above. ie the need to build an individual CCP clearing system for each individual market.

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The Case for a Single Multi-market CCP soon be traded in a standardised form providing them with a more liquid market. Furthermore, exchanges or trading platforms ought to compete with each other based on the speed of execution and prices as well as the depth of the market. In a vertical silo structure, the price of clearing and settlement may not necessarily reflect the real cost of the services and will be used to subsidise the trading platform to compete with other trading platforms/exchanges. Arguably, a single CCP could also possibly break the stranglehold of the vertical silo structure58 and should put an end to their anti-competitive behaviour59 and increase pricing transparency.60 A more fundamental consideration is evaluating the advantages of a single pool of financial collateral, which is the likelihood in a single system. A consolidated pool of financial sources could consequently increase the efficient use of collaterals in comparison with the multiple pools of collateral that exist today in the different CCP clearing systems in various markets. This could also help reduce the shortage of good-quality collateral in the markets. Furthermore, the possible impact on collateral savings can be enormous for participants who gain efficient collateral management, since a single CCP will have the potential to offer cross-product margining,61 which further reduces the need for collateral and frees up capital. Arguably, there is some other ultimate potential yet to be realised, eg, a much larger scale of margining savings, which to some market participants goes well beyond the argument for further cost reductions on clearing fund contribution.62 Clearly, the more products a CCP serves, the greater the opportunities for savings. As previously mentioned, for firms that trade frequently with various counterparties and have a web of bilateral exposures as a result of their activities in the market, the volumes and liquidity could potentially be boosted and increased through netting off the positions with the CCP in the trade cycle. However, for firms with lower trading volumes, the benefits are bound to be more limited.

58 An example of this vertical silo structure is the Deutsch Börse’s business model to provide trading and post-trade services including clearing and settlement 59 One of the various types of activities that is considered as anti-competitive is unreasonable bundling/tying of services. See Citigroup, The Optimal Market Struture for Clearing and Settlement in the EU (July 2004) 56. A case in point is Deutsch Börse, which operates a typical vertical silo trading system that also includes clearing and settlement. 60 See F Russo (2002), n 20 above. 61 Cross-product margining allows members to offset positions in different products against each other before margin is calculated. It, therefore, results in less onerous margin requirements and frees up extra capital. 62 E Saunderson, ‘Cutting Costs’ Futures & Options World, (402), 1 November 2004. at: http:// www.fow.com/Article/1385266/Issue/26557/Cutting-costs.html, and see also NSCC ‘Document No 22’, June 1976 Memorandum to the SEC.

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The Case for a Single Multi-market CCP

7.2.3 The Risks of a Single Multi-market CCP Likewise, some of the risks posed by having a single multi-market CCP are inherited from CCP clearing. In the previous section, it was noted that the benefits of CCP clearing could be magnified by establishing a single CCP. So can the risks it may pose. Generally, the potential risks that a single CCP may pose to the markets can be categorised as being of two types: those arising generically from the CCP services, as discussed in Section 5.1 above, and those arising from the lack of competition. The first category includes information asymmetries and misuse, risk concentration, and operational overloading and failure. In addition, there may be potential issues concerning the management of the default fund and ensuring a consistent level of monitoring of members and the possibility of the CCP default.63 For the second category, the major risks that result from a lack of competition include those associated with cost-efficiency and less incentive for technological improvement and innovation. Moreover, some suggest that it may also endanger specialisation.64 This section will mainly focus on concerns related to the lack of competition. As an economic principle, the desire to achieve market efficiency,65 operational efficiency in particular, is believed to maintain the forces of competition. In practice, it is not possible to satisfy all of the conditions for perfect competition and it therefore follows that markets normally experience less-than-perfect competition conditions. To apply the principle to post-trade infrastructures may also not seem to be as appropriate, especially when the US experience is drawn upon. The Bradford case66 in the United States has shown that in the 1970s the competition issue was simply a factor of, but not the paramount objective for the post-trade segments, although this was not the issue upon which the court had to decide. A debate in the United States in the 1970s included both legal and economic arguments and addressed the merits of horizontal unification versus competition from multiple vertically-siloed CCPs.67 In fact, the US House Committee identified two separate objectives, one for the national market system and another for the clearing system. Accordingly, it was emphasised that the objective of clearing and settlement was to establish a safe and cost-efficient

63

See F Giordano (2002), n 11 above. For example, in the US, the DTCC is recently criticised for that. See ‘DTCC Dismisses Priority Criticisms’ Financial Times, 5 July 2006, 37. 65 See E Dimson and M Mussavian (2000), n 16 above. 66 Bradford National Clearing Corporation v Securities and Exchange Commission 590 F 2d 1085 (1978). 67 See the appendix of the United States Court of Appeal, docket number 77–1199, Bradford National Clearing Corp against Securities and Exchange Commission for a complete discussion of anti-trust issues and applicable case law. Also see the case as referred to in n 66 above. The concept of both direct and indirect membership in a horizontally unified clearing system has proven sufficiently robust to accommodate new types of trading spaces such as ECNs and ATSs. 64

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The Case for a Single Multi-market CCP infrastructure.68 It was clear that the drafters at the time understood the need to separate trading systems and post-trade infrastructures, which results in two separate objectives.69 The rule imposed by exchanges that tied trading with clearance and settlement was subsequently abolished. At the time, the significant differences70 between CCPs and Central Securities Depositories (CSDs)71 in terms of function were not distinguished, and instead clearing and settlement were seen as an integrated whole. As just mentioned, the abandonment of the tying rule between exchanges and clearing and settlement, before the 1975 amendment to the Securities Act in the United States, prepared for setting out separated objectives for national market systems and national clearing systems. Upon the approval of the National Securities Clearing Corporation (NSCC), the national clearing agency,72 the US

68 The Securities Act of 1933 was subsequently amended to enable the establishment of a national market system, and to encourage fair and efficient handling of securities transactions. It is worth noting that the then drafters of the 1975 US Securities Acts Amendments clearly defined two separate goals for trading platforms/exchanges and clearing and settlement. One of the objectives for the national market system is to enhance fair competition among brokers and exchange markets. However, this was omitted in the objectives for the national clearing system and instead the promptnesses and the development of uniform standards and procedures were emphasised. 69 It is worth noting that the difference between CCP clearing and settlement was not made at the time. 70 See ch 3 above, and also see BIS (2004), n 5 above. 71 See Section 2.2, ch 2 above. 72 The clearing agency was then defined in Section 3(a)(23) of the Securities Exchange Act of 1934, US as follows: ‘A. The term “clearing agency” means any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities. Such term also means any person, such as a securities depository, who (i) acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry without physical delivery of securities certificates, or (ii) otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates. B. The term “clearing agency” does not include (i) any Federal Reserve bank, Federal home loan bank, or Federal land bank; (ii) any national securities exchange or registered securities association solely by reason of its providing facilities for comparison of data respecting the terms of settlement of securities transactions effected on such exchange or by means of any electronic system operated or controlled by such association; (iii) any bank, broker, dealer, building and loan, savings and loan, or homestead association, or cooperative bank if such bank, broker, dealer, association, or cooperative bank would be deemed to be a clearing agency solely by reason of functions performed by such institution as part of customary banking, brokerage, dealing, association, or cooperative banking activities, or solely by reason of acting on behalf of a clearing agency or a participant therein in connection with the furnishing by the clearing agency of services to its participants or the use of services of the clearing agency by its participants, unless the Commission, by rule, otherwise provides as necessary or appropriate to assure the prompt and accurate clearance and settlement of securities transactions or to prevent evasion of this title; (iv) any life insurance company, its registered separate accounts, or a subsidiary of such insurance company solely by reason of functions commonly performed by such entities in connection with variable annuity contracts or variable life policies issued by such insurance company or its separate accounts; (v) any registered open-end investment company or unit investment trust solely by reason of functions commonly performed by it in

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The Case for a Single Multi-market CCP Securities Exchange Commission (SEC) imposed several requirements.73 For example, one of the requirements was that the NSCC established full interfaces or appropriate links with the clearing agencies of designated regional exchanges. Constrained by the limits of the information technology of the time, one of the major concerns was that systems for trade comparisons were still not yet developed for the markets. Indeed, the creation of the NSCC in the late 1970s was very much event-driven in the light of the aftermath of the paperwork crisis. The eventual approval of the DTCC did raise similar concerns regarding single monopoly issues. The results of the study commissioned by the SEC were published in 1975, when the United States was deciding on how to integrate seven vertical silos in which exchanges owned settlement systems. As was pointed out, three models of integration were proposed before the creation of the DTCC was approved:74 (1) interlinking the seven settlement systems, ie inter-operability or the US ‘spaghetti solution’, which is estimated to produce savings of 9.6 per cent of total costs; (2) maintaining and linking three settlement systems, which, in the theoretical interest of competition and innovation, was estimated to produce savings of 32.7 per cent; or (3) moving to one settlement system, by facing up to governance and regulatory challenge of a monopoly, which was estimated to produce savings of 63.5 per cent. In the end, the single settlement system solution was chosen despite the considerable opposition from parties with vested interests, namely, the exchanges that owned the settlement systems and relied on that revenue stream. In modern times, the development and competition between the world’s major trading platforms and exchanges may also shed some light on understanding the nature of the competition in the sectors. It is a fact that, to trading platforms/ exchanges, diverting liquidity from one to another is very difficult to achieve unless it is shown that there is a cost or strategic advantage, which means, unfortunately, that maintaining competition between them in practice is far from easy.75 As to the post-trade sector, it is suggested76 that the answer to ensuring fair and non-discriminatory access and therefore efficiency lies in either the creation of a single clearing system in Europe or insisting on inter-operability, allowing for

connection with shares in such registered open-end investment company or unit investment trust, or (vi) any person solely by reason of its performing functions described in paragraph (25)(E) of this subsection’. 73 See L Bergmann, Speech: The US View of the Role of Regulation in Market Efficiency (International Securities Settlement Conference, London, 2004). 74 D Cruickshank, Speech: The Evolution of EU Securities Markets: Next Steps for Clearing and Settlement (Madrid, 18 October), at: www.londonstockexchange.com/en-gb/about/Newsroom/ Media+Resources/Speeches/speech11.htm. 75 N Cohen, ‘Regulator Tries to Avoid Monolithic Monopolies with LSE Bid’, Financial Times, 24 November 2005, 24. 76 D Henry, Clarifying and Setting Access to Clearing and Settlement in the EU (Working Paper, 2005).

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The Case for a Single Multi-market CCP the ‘reciprocal and seamless use of information between different systems’.77 In the latter case, however, the multi-CCP model may not be able to reap the benefits of what a CCP can bring and instead may substantially reduce the economics of scales that should have been achieved by a single CCP for that market. As discussed in chapter six, the recent developments of CCPs have also shown that a separate treatment is needed to distinguish CCPs from CSDs.78 For example, the alternative proposed models for consolidation among CSDs in the European Union do no more than find a better way of linking the CSDs, unless a single CSD is created.79 For market participants, the proposed consolidation adds an additional layer to the chain and further introduces additional intermediary risk. With respect to CCP clearing, the consolidation of CCPs may not necessarily introduce additional intermediary risks—as in the case of CSDs—to the participants, provided that the rights and obligations would be transferred to the chosen CCP as a result. At present, all exchanges or trading platforms using CCPs have only contracted with a single CCP to provide CCP clearing services, with the exception of Virt-X80 with its multi-CCPs model: LCH.Clearnet and SIS x-clear. This model was also proposed by the London Stock Exchange (LSE) in 2006 when it announced it would bring in SIS x-clear as the second CCP. However, at the competition level, none has successfully challenged an existing CCP so far to become a viable alternative CCP. Several factors have contributed to the lack of competition:81 (i) Network effect: the more transactions in the same asset that are cleared by a single CCP, the greater the potential for netting efficiencies. A CCP that already nets a large number of trades in one security will therefore have an advantage over any new entrant; (ii) Economy of scale: the major operating costs for a CCP business appear to be fixed in nature, and the variable costs of clearing additional trades appear to be low. It is therefore difficult for a new entrant with small volumes to compete on equally low per-trade clearing costs; (iii) Switching costs: clearing members have to invest in technology that efficiently connects them to the CCP for STP.82 Once a user has made this investment, the cost of switching to another CCP may be high; and (iv) Complexity of multiple CCPs: All the CCPs concurrently serving the same

77 Deutsche Bank Research, Clearing and Settlement in the EU: Structures and Policy Options (2003) 23. 78 Also see Section 6.3.1, ch 6 above. 79 B Scott-Quinn and K Walmsley, New Frontiers in Clearing and Settlement (International Securities Market Association, 1999) 39–49. 80 See Section 7.3.1 below. 81 Citigroup, Comments on the ‘Overview of EU25 Securities Trading, Clearing, Central Counterparties, and Securities Settlement (Non-confidential version, 2004). Also, see the special competition regime in the UK as discussed in Section 6.3.3, ch 6 above. 82 Namely, Straight Through Processing, see Section 2.4.2, ch 2 above.

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The Case for a Single Multi-market CCP trading market need to agree terms with each competitor and to assume counterparty risk on each other. This is because trading parties may choose to use different CCPs and they do not know in advance, nor could they be in a position to influence, which CCP their counterparties will use. Multiple CCP arrangements can be commercially, operationally, legally and financially complex to establish and maintain. In addition, it is submitted that the issue regarding the ownership structure of CCP clearing is important in the competition debate. Drawn from other network utility sectors,83 as telecommunications and electricity markets where there is a great public interest, it is argued by some that CCPs should be structured as public utilities, since they should be regarded as part of the market infrastructure. Without a doubt, a robust CCP is of great interest to the markets as a whole as well as to the economies. Further to this argument, there is the issue of maintaining a degree of competition, which is generally accepted as paramount in a market economy in economic terms. Here, some analogy may also be drawn from what is happening to exchanges. The business nature of CCPs is also similar to that of exchanges in the sense that they are increasingly driven by technological advances and innovation, which is a pronounced element in generating productivity rise.84 According to Schmiedel, evidence is found in exchanges that demutualised ones exhibit higher technical efficiency than mutuals.85 Here, it is also necessary to mention one of the most important market developments. In the last decade, there has been a wave of demutualisation in the markets,86 stock exchanges in particular. Among the 50 largest exchanges in the world, about half of them are now either demutualised or publicly listed.87 This wave of demutualisation has been confirmed as having a positive impact on cost efficiency,88 and further supports the view that ownership has a direct impact on management and that a for-profit exchange can operate more efficiently in order to respond and adjust adequately to technological advances and changes in the regulatory and economic environment. It is also suggested that the public listing of an exchange with a widely dispersed shareholder base is the ultimate step of this restructuring.89 Having drawn the conclusion that the case for an Initial

83

See D Helm and T Jenkinson (1998), n 46 above. H Schmiedel, Total Factor Productivity Growth in European Stock Exchanges: A Non-parametric Frontier Approach (Bank of Finland Discussion Paper 11, 2002). 85 H Schmiedel, Technological Development and Concentration of Stock Exchange in Europe (Bank of Finland Discussion Paper 21, 2001). 86 It is a term that used to describe the transformations of exchanges governance structure into for-profit companies from those with mutually owned structure in financial markets. 87 See Figure 1: ‘Governance Type of Exchanges 1999–2003’ in B Serifsoy, The Impact of Demutualization and Outsider Ownership on Stock Exchange Performance—Empirical Evidence (Frankfurt: Goethe University, 2005). 88 H Schmiedel (2001), n 85 above, 22. 89 R Aggarwal, ‘Demutualization and Corporate Governance of Stock Exchanges’ (2002) 15(1) Journal of Applied Corporate Finance 105. 84

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The Case for a Single Multi-market CCP Public Offering (IPO) cannot be advocated from a technical efficiency perspective, others may suggest that a demutualisation process that retains the exchange’s customers as its main owners but realigns the ownership structure seems promising from the technical efficiency point of view.90 The future ownership structures of a single CCP may continue to be subject to hot debate, as are the pros and cons of the different proposals. This has to be left for the markets to decide. To sum up, the creation of a single CCP is not without risks and indeed there are shortcomings in having a single CCP in the markets. Some of these disadvantages have been inherited from CCPs in general. Nevertheless, it is argued that the risks that a single CCP poses are manageable. As the idea of a single CCP is increasingly accepted, the task is to first identify the potential risks and develop a set of management tools to effectively manage them.91 Without doubt, there are some hurdles such as technological advances, issues like those regarding reporting, accounting and transparency, as well as products traded cross-border under different regulatory regimes. A common regulatory framework that will provide minimum harmonisation of the abovementioned issues will certainly help. This is apparently what the European Union has been trying to achieve, to be discussed in Section 6.3 below. It is believed, however, that with an increased understanding of the business and the risk involved, it is only a matter of time before these hurdles are overcome.

7.2.4 The Global CCP Initiative Originally, the initiative for a global CCP was inspired by the cross-border activities that have accelerated in the past decade. In 2000, the DTCC published a white paper in an effort to bring a global perspective to the development of CCPs.92 However, the paper stopped short of prescribing a single CCP solution, since only issues that require discussion were identified. Following the publication of the white paper, a conference was held in London in 2001 entitled ‘The Central Counterparties Dialogue’. It was also recognised that ‘[t]he next generation of clearing capabilities will be challenging and expensive, with every region of the world planning major infrastructure investments in the next five to ten 90 B Serifsoy, The Impact of Demutualization and Outsider Ownership on Stock Exchange Performance—Empirical Evidence (Frankfurt: Goethe University, 2005) p 29. On the other hand, a recent empirical study argues against the case for an IPO, and is of the view that ‘a demutualization process that retains the exchange’s customers as its main owners but realigns the ownership structures … seems promising from a technical efficiency point of view’. It is concluded that the rationale behind an IPO seems not primarily driven by efficiency-enhancing motives, it is rather used as a solution vehicle for the diverging interests between large international financial intermediaries and small local brokers. See B Serifsoy, ibid. 91 An example of such work includes the BIS publication of Recommendations for Central Counterparties in 2006. 92 DTCC, Central Counterparties: Development, Cooperation and Consolidation (A White Paper to the Industry on the Future of CCPs, 2000), at: www.dtcc.com/ThoughtLeadership/whitepapers/ ccpwp.pdf.

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The EU Developments years’, and that the services providers ‘must address issues of cross-border risk and capital optimization and avoid duplicating investments wherever possible’. On the other side of the Atlantic, the European Central Bank reserved doubts and stated that the further consolidation in CCP clearing sectors ‘may or may not lead to the creation of international or global clearing houses’.93 Notably, it did assert the right to get involved in the oversight of these CCPs ‘given its interest—as the euro’s central bank of issue—in the smooth functioning of such systems’.94 In light of the collapse of Credit Default Swaps market (CDS) following the Lehman Brothers default in 2008, there was a call for creating a single global CCP for CDS as one of the regulatory responses. It was obvious then that the advantages of having a CCP for the CDS markets had been recognised. In the event, however, the call was short-lived as it was not considered viable under current regulatory and economic environment. Whilst the global initiative was short-lived, the attention paid to the important role of CCPs in modern markets from regulators’ perspective has been on the rise.

7.3 The European Union Developments95 The European Union has seen that more CCPs have been established in the past decade as they are considered to be an integral part of a modern market.96 In recognising the important role of CCPs and the recent developments within the European Union, work has been started on the regulatory side to identify areas in CCP clearing that need to be harmonised at EU level so as to eliminate potential barriers, especially those contributing to higher costs.97 In comparison with the United States, the relatively small size and continuing separation of the markets by national borders in the European Union, characterised as fragmental, may at first glance suggest that post-trade processing is more costly and less efficient, especially for cross-border or non-domestic transactions. In the past few years, cross-border activities among Member States as well as the volumes of the transactions have been increasing. As a result, the post-trade infrastructure that supports these activities has come into the limelight. Among various studies on the costs of clearing and settlement in the European Union, a 93 European Central Bank (ECB), Eurosystem’s Policy Line with regard to Consolidation in CCP Clearing (Policy Note, September 2001). 94 ibid. Also see the discussion of the interest of Central Banks in CCP clearing in Section 6.2.3, ch 6 above. 95 This section will mainly focus on the EU but comparison with the situation in the US will be made where appropriate. 96 For example, the EuroCCP established by the US DTCC, and CME Clearing by the Chicago Mercantile Market, to name a few. 97 The Clearing and Settlement Advisory and Monitoring Experts’ Group (CESAME group), Solving the Industry Giovannini Barriers to Post-trading within the EU 28 November 2008.

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The Case for a Single Multi-market CCP comprehensive study98 on the direct costs, commissioned by Corporation of London, compared the situation in the European Union with that of the United States and mainly focused on the settlement side. However, the cost of clearing was not distinguished from the cost of settlement and neither was the correlation between the two costs highlighted. Lanno and Levin99 took into account the effect of netting on the costs as well as the role of International Central Securities Depositories (ICSDs).100 They found that the gap of the costs for cross-border transactions between the European Union and the United States was far less than previously estimated: 1.86 times to be precise.101 Their further findings concluded that the domestic settlement institutions in the European Union are as cost-efficient as the DTCC in the United States.102 Furthermore, it was also pointed out by Raymond Parodi103 that the United States failed to design ‘a netting and aggregation function’ in 1970s, which has now become a major obstacle in the move to a shorter trading cycle for the US markets. In addition, despite a high efficiency rate achieved by the CCP, ie a record 97 per cent reduction in value on a peak day volume of US$722 billion, institutional settlement is not included and instead has been taking place gross. To repeat, there is clearly an urgent need for further consolidation and integration within the European Union in order to achieve the goal of creating a single pan-European market.104 However, both the way in which this consolidation should take place and the future architecture of the post-trade infrastructure will need time to take shape given that this is primarily for market forces to decide. As noted, the developments in the EU offer one of the most exciting phenomena in the world markets and are constantly making newspaper headlines. The 1999 Financial Services Action Plan guided and supported all of these developments, which were to be implemented through proposals in the Lamfalussy Report.105 To date, the plan has not yet been fully implemented and is still far from reaching its projected achievement. In this section, the current situation in the European Union will be examined to prepare for the discussion of the role of a single CCP in an inefficient market in the following section. The lesson learned from the debates in the European Union is that a great amount of work remains to be done, as the existing structure is far from satisfying. There is no doubt that maintaining the status quo is unacceptable for anyone in the markets.

98

See E Linton and M Starks (2004), n 36 above. K Lanno and M Levin, The Securities Settlement Industry in the EU—Structure, Costs and the Way Forward (Centre for European Policy Studies (CEPS), December 2001). 100 See Section 2.2, ch 2 above. 101 It was at one point estimated that the costs in the EU is 10–12 times higher than in the US. 102 After the publication, the result was challenged by the DTCC. 103 See DTCC (2001), n 7 above, 10. 104 European Central Bank, ‘Consolidation in CCP Clearing in the Euro Area’ (August 2001) ECB Monthly Bulletin 69–77. 105 Final Report of the Committee of Wise Men on the Regulation of European Securities Markets (Brussels, 15 February 2001), at: ec.europa.eu/internal_market/securities/docs/lamfalussy/wisemen/ final-report-wise-men_en.pdf. 99

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The EU Developments In response to the growing conviction in the markets that the creation of a pan-European CCP could foster and facilitate market developments, the European Commission is still disinclined to opt for imposing a solution and insists that ‘the market must decide on the degree or nature of the consolidation which should take place’.106 It is submitted that by providing the same access to the markets, a single CCP can also help increase the competition among exchanges and trading platforms. This can be seen in the example in 2004 when the London Stock Exchange introduced the Dutch Trading Service and forced Euronext to reduce its trading fees for Dutch stocks by an average of 30 per cent. In this case, the same post-trade arrangement was used by both the LSE and Euronext.107

7.3.1 The Current Situation As noted above, one of the objectives for the European Union is to create an integrated European financial market. The European Union is well aware that ‘if the EU financial market is to compete on a global scale, it must be deep, liquid, efficient, safe, transparent and cost-effective’. Again, lowering costs is the main drive in the post-trade sector. In the European Union, the costs of clearing and settlement are usually compared to those of the US markets, which are often viewed as a benchmark. The estimate of further cost savings by the Securities Industry Association is to be approximately $US2.7 billion a year if the barriers identified in the paper ‘Making Financial Information Flow’ by the Harvard Research Group108 are overcome. The result of the study109 carried out by the NERA Economic Consulting and the Corporation of London shows that there is a significant gap between the costs of clearing and settlement in the United States and Europe. Within the European markets, clearing and settlement costs of cross-border transactions were, at their highest level, estimated to be 10–12 times more than those of domestic transactions. It is still up to six times more than those of domestic settlements, as mentioned by Charlie McCreevy, the then Internal Market Commissioner of the European Union, on 13 September 2005 when addressing the 14th Annual Europe-USA Investment Funds Forum in Luxembourg.110 The 106 C McCreevy, Stock Market Consolidation and Security Markets Regulation in Europe (Annual Lecture at SUERF, 30 November 2005). 107 In contrast, the same effort by Deutsche Börse in late 2003 did not result in the same fee reduction by Euronext, it is notably that though Deutsche Börse did not use the same clearing and settlement infrastructures. 108 Harvard Research Group, Assessment: Clearing and Settlement—Making Financial Information Flow (2003). 109 E Linton and M Starks (2004), n 36 above. The study compared the direct costs of clearing and settlement for an equity transaction in Europe and the US. 110 C McCreevy, Fund Management—Regulation to facilitate competitiveness, growth and change (14th Annual Europe-USA Investment Funds Forum, Luxembourg, 13 September 2005). See: www.euractiv.com/Article?tcmuri=tcm:29–144214–16&type=News.

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The Case for a Single Multi-market CCP Giovannini report111 (2001) stated that the removal of cost inefficiencies in clearing and settlement is a necessary condition for the development of large and efficient financial infrastructures. The relationship between the market structure for the provision of clearing and settlement services and the delivery of the two criteria of safety and efficiency is also complex.112 From the economic analysis point of view, the principle that competition is essential and beneficial has been challenged. In terms of market architecture, the European markets can broadly be divided into two groups. On the one hand, there are institutions such as Clearstream and Spanish MEFFclear, representing the vertical approach, and on the other, Euronext and LCH.Clearnet, representing the horizontal approach.113 According to a recent study,114 a shift in the markets to focus on CCPs among other segments in the post-trade infrastructures signals the potential role that they can play to create a single Pan-European Market. It is broadly expected that priority is to be given to the consolidation of CCPs over that of CSDs. In this context, it is necessary to consider again the role of CCPs in the value chain and the way in which a single CCP can contribute to achieving that goal. The debate over CCP clearing provisions was further spurred by the takeover bids for the London Stock Exchange (LSE) in 2005 in which both Deutsche Börse, which owns Eurex Clearing, and Euronext considered buying the London Stock Exchange. The Australian Macquarie Bank also joined in the bidding. In 2006, the bids for LSE were further twisted when a substantial amount of shares were purchased by NASDAQ, which made it the biggest shareholder of the company. In the meantime, the announcement of a merger between the New York Stock Exchange and Euronext to create a transatlantic exchange was also made.115 The UK Competition Commission’s scrutiny of the proposals with respect to the LSE bids116 has so far focused on the clearing business. One of the rulings of the Competition Commission regarding the possible bids for the London Stock Exchange was to limit the control of the parent exchange on the CCP. This eases the possible tying rule that existed in the United States before the 1970s. In deciding the case of the bids for London Stock Exchange, the Commission was looking at the introduction of inter-operable central counterparties as a means of addressing the anti-competitive effect of a future merger of the LSE

111 The Giovannini Group, Cross-border Clearing and Settlement Arrangements in the European Union (Brussels, 2001). 112 Citigroup, The Optimal Market Structure for Clearing and Settlement in the EU—Citigroup Response to the Communication on Clearing and Settlement from the European Commission (2004). 113 For horizontal approach and vertical approach, see the discussion at the beginning of this chapter. 114 See Bourse Consult (2005), n 2 above. 115 The merger was finally competed in April 2007. 116 Competition Commission, Reference relating to the Anticipated Acquisition of London Stock Exchange plc by Deutsche Börse AG or Euronext NV—Notice of Possible Remedies under Rule 11 of the Competition Commission Rules of Procedure (2005), at: www.competition-commission.org.uk/ inquiries/ref2005/lse/index.htm.

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The EU Developments with either Euronext or Deutsche Börse.117 This may imply that the intention of the regulator was to prevent the further creation of ‘vertical silos’, which was then the main recurring theme of the Central Counterparties Dialogue conference in 2001. This may be significant for those who argue in favour of the competitive horizontal approach. The Commission also concluded that any acquisition of the UK market would ‘substantially lessen competition’ by having direct control or influence over the provision of clearing services and by requiring customers to use their respective clearing services. The implications of this recent development in the post-trade infrastructures, and the CCP clearing segment in particular, deserve further consideration. As the European markets are integrating and expanding in both size and volume, the use of CCPs is set to increase. Across the European Union, there are currently two major CCPs: LCH.Clearnet and Eurex Clearing. Additionally, there are six, mainly nationally-based CCPs: OMX Clearing for Sweden and Finland, NOS in Norway, Cassa di Compensazione e Garanzia in Italy and MEFFClear in Spain. In the meantime, new participants are joining, for example EuroCCP and CME Clearing. X-clear, which was set up by the Swiss Financial Services Group (FSG) in 2002, has been providing CCP clearing services since March 2003 and acting as the domestic CCP of Virt-X, together with LCH.Clearnet Ltd. It is considered, however, that only recently has the effort to consolidate the sector been initiated. For example, Euronext in 2001 merged the clearing houses of three countries into a single entity called Clearnet. It then served as the sole counterparty for trades on Euronext equity and derivatives markets. This was followed by the merger with London Clearing House in late 2003 to form the LCH.Clearnet Group. Meanwhile, an interesting development in Europe deserves some further attention. Virt-x successfully introduced the first pan-European Central Counterparty Service (CCP)118 for cross-border trading by offering a choice of CCPs: LCH.Clearnet Limited (LCH.Clearnet) and SIS x-clear AG (SIS x-clear). In theory, each member of Virt-x can choose which CCP they want to use, with both LCH.Clearnet and SIS x-clear standing as CCPs to their members and offering full clearing services across all eligible Virt-x traded securities. The interoperation between LCH.Clearnet and SIS x-clear results from orders being matched between LCH.Clearnet members and SIS x-clear members. This is achieved by the CCPs operating accounts within each other’s operations. LCH.Clearnet Ltd members and SIS x-clear members see only their own CCP as counterparty. Additionally, each CCP sees only its own members, with the other CCP being both the contractual and settlement counterparty for a trade executed by a member of the other CCP. This model of multiple CCPs serving a single market may seem to facilitate a level of competition between CCPs. The main advantage of this model is that the 117 See ‘Interoperable CCPs May Hold Key to LSE Competition Issues’, Finextra News, 6 September 2005. Available on the website: www.finextra.com/fullstory.asp?id=14229. 118 Also see the website: www.virt-x.com/clearing/clearing.html.

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The Case for a Single Multi-market CCP participants can choose to deal with the transactions with their local CCP even the original cross-border transactions that involve counterparties in different jurisdictions. However, the model of multiple CCPs in a single market does not offer more than what a CCP does in general. The only significant difference is that this model facilitates a trading system that operates across-border. The full economies of scale and potential efficiencies were not realised. It is worth mentioning that beyond the European Markets, there is also an initiative to establish a cross-Atlantic CCP link: the so-called EuroCCP project.119 The DTCC set up the EuroCCP, which has obtained recognition from the UK regulatory authorities, to support the cross-border European NASDAQ market. This is the first central counterparty to offer cross-border clearing and netting for European and US securities traded in Europe. As stated, the reason spurring development of this groundbreaking venture was Nasdaq Europe’s selection of DTCC to develop a central counterparty to deliver a seamless clearing and settlement approach, so as to reduce the operational costs, inefficiencies and risk associated with cross-border transactions.

7.3.2 The Argument for A Single Pan-European CCP The traditional focus on post-trade infrastructures has now shifted from CSDs to CCPs, as they promise to hold the key to the creation of a Pan-European Market. For historical reasons, clearing and settlement organisations within the European Union were established along national borders, in line with how stock exchanges have been established. A recent report120 commissioned by Corporation of London explicitly calls for the merger of LCH.Clearnet and Eurex Clearing as a step towards the creation of a single pan-European CCP. ‘The main benefits of a European CCP will come from consolidation of clearing for the biggest markets’, the authors of the report argued and, ‘the core of this concept, therefore, must be the bringing together of LCH.Clearnet and Eurex Clearing’. In addition, it was argued that capital adequacy for operational risk will be a critical driver behind a single pan-European CCP.121 There have also been considerable market demands for a merger of the European CCPs in order to create a pan-European CCP. With strong network externalities, such a CCP could maximise the benefits of netting

119 European Central Counterparty Limited (EuroCCP), a relatively newly established clearing subsidiary of DTCC, was welcomed as a full member of The Federation of European Securities Exchanges (FESE). The Federation is the association of regulated securities and derivatives markets in Europe and has 29 full members and seven associate members. This announcement was made at the Sixth European Financial Markets Convention, hosted and organised by FESE in Brussels May 30–31, 2002. See: www.dtcc.com/Publications/dtcc/jul02/euroccp.html. 120 See Bourse Consult (2005), n 2 above. 121 B Taylor, Capital Adequacy for Operational Risk will be a Critical Driver behind a Pan European Central Counterparty (CCP) (2001).

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The EU Developments and provide significant cost savings. The European Securities Forum (ESF), an association of global and European investment banks, has also argued this case forcefully.122 Following Euronext’s acquisition of London International Financial Futures and Options Exchange (LIFFE), the merger of the London Clearing House and the French Clearnet SA was finalised in 2004. This has been generally recognised as a significant step towards creating a European-wide CCP. While the merger of the London Clearing House and Clearnet was widely seen as a major step towards the creation of a pan-European CCP, it stopped short of creating a single entity due to the concerns of the regulators. This may lead some to believe that creating a single pan-European CCP in the current market and regulatory environment may not be feasible.123 On the other hand, others have gone further to suggest that the choice of monopolies could be the preference of market participants, given the unique position and functions of CCPs. This should be the ultimate goal of achieving an efficient pan-European Market and has to be taken into account if steps are to be taken in the short term. The concern that ‘one size does not fit all’ is not unfounded. Indeed, it is admitted that the biggest challenge in creating a single CCP is to find a solution that meets the diverse needs of different markets. The UK competition commission’s remedy ruling124 regarding the takeover bids for the London Stock Exchange also put the CCP services in the limelight. It highlighted the importance of the independence of the CCP LCH.Clearnet Ltd in this case, which is essential to a robust and efficient CCP.125 At that time, in deciding the merger case of LCH.Clearnet, it was claimed by the regulators that a single CCP was not allowed at the time of the merger between the then London Clearing House and the Clearnet SA in 2004.126 As a result, there remain two separate parties: LCH.Clearnet Ltd and LCH.Clearnet SA, in two separate jurisdictions owned by the holding company LCH.Clearnet Holding Group. The then chief executive of LCH.Clearnet Group, David Hardy, addressed127 the impact of recent further consolidation between exchanges, the impracticality of offering a choice of CCPs, and the concerns of possible monopoly abuse by a single CCP. To conclude, the author raises doubts that markets will be able to reach a solution on how the market is to further consolidate on its own and directly calls for the European Commission to offer guidance and intervention in conjunction with 122

See European Securities Forum (ESF) (2000), n 6 above. See the discussion of the regulatory challenges in ch 6 above. 124 See Competition Commission (2005), n 116 above. 125 See ch 3 above. 126 See A Lamb, ‘Roadmap to the Future’ (International Securities Services Association Symposium, Wolfsberg, Switzerland, June 2004). However, as to the creation of Clearnet SA as a single CCP for all Euronext markets in 2000, there was a level of cooperation between member state regulators. French, Belgian and Dutch authorities reached an agreement to work in cooperation to establish a homogenous legal framework for markets in the three countries and provide for joint supervision. Also see the regulatory issues in the EU in ch 6 above. 127 D Hardy, ‘The Case for a Single European Clearing House’ Financial Times, 7 June 2006, 17. 123

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The Case for a Single Multi-market CCP market action in order to achieve a more integrated financial market that would benefit the long-term interests of users all across Europe. In the absence of a single EU regulator, the approach to the regulatory framework is mainly based on the ‘home country control’ principle and derives from the home country regulatory regime. In the post-trade sector, a common regulatory framework does not yet exist, and is urgently needed for further consolidation in the sector. As the Markets in Financial Instruments Directive (MiFID)128 does not cover CCP clearing, the European Commission proposed to expand the ‘home country control’ principle in financial markets to the posttrade sector.129 It was argued in this thesis that the approach may not be sufficient to foster the consolidation across borders within the EU of CCPs in particular. In the absence of a common regulatory framework, the expected further consolidation in the post-trade sector poses a great challenge130 to the supervision and oversight model adopted by the European Union, which requires a high level of co-operation between Member States’ regulators and supervision. Having examined the initiatives and public policies concerning the creation of a single pan-European financial market, further consolidation in the markets is likely to require further changes to the existing regulatory framework adopted by the European Union.131 In other words, the current approach at policy level to the regulatory framework, even with the ‘home country control’ regime, is unlikely to provide the right environment for further consolidation among CCPs in particular, or for the creation of a single pan-European CCP in the near future. A shift in the policy approach in the European Union to a more proactive one is needed, as the markets may take a long time to reach a solution.

7.3.3 Future Prospects In the coming years, co-operation and consolidation among CCPs are, without doubt, set to increase both within the European Union132 and across the globe.133 In an ideal world, a single robust multi-market CCP with effective risk management, operating within the EU or even across the globe, would be able to maximise the effects of transaction off-setting and better risk management with 128 Council Directive 2004/39/EC of 21 April 2004 on markets in financial instruments, amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC and repealing Council Directive 93/22/EEC [2004] OJ l145/1. 129 Commission of the European Communities, Clearing and Settlement in the European Union— The Way Forward, COM(2004) 312 final. 130 See Section 6.4.1, ch 6 above. 131 See Section 6.4, ch 6 above. 132 Needless to say, in the EU, this is mainly driven by the initiative to creating a single market. 133 It may not be so evident but the Central Counterparty Dialogue held in 2002 somehow shows the industry has increasingly realised the need for such cooperation. The further transatlantic consolidation is also evident as New York Mercantile Exchange (NYMEX) has just announced to forge an alliance with LCH.Clearnet and will offer a new range of products for clearing through it. See ‘Nymex forges alliance with clearing house LCH’ Financial Times, Friday, 7 March 2008, 30.

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Concluding Remarks more efficient collateral management for the markets. In practice, the approach of maintaining a level of competition in financial services, as emphasised in the European Union, may seem more likely. Therefore, the policy adopted by the European Union to let market forces decide the future architecture of post-trade infrastructure is unlikely to change. This means that for CCP clearing there is likely to be a number of CCPs competing with each other in the near term. To optimise the economics of scale in that setting, links between CCPs will have to be established so as to provide a real choice of CCPs. This requires trading platforms/exchanges to give access to those CCPs that come with standardised information technology formats and an inter-operability protocol between different systems.

7.4 Concluding Remarks The advantages and disadvantages of CCP clearing were discussed from three different perspectives, ie that of markets, members and non-members. It was argued that the direct and indirect benefits that CCP clearing offers to markets outweigh the disadvantages. This was followed by the assessment of the risks and benefits of a single multi-market CCP. It was submitted that the creation of a single CCP is not without risks and there are shortcomings in having a single CCP in the markets, although some of these have been inherited from CCP clearing. Nevertheless, it was argued that these risks are manageable and can be remedied and mitigated by the benefits it provides. In making the case for a single multi-market CCP, the concern of the lack of competition was recognised and addressed. It was also pointed out that such a CCP will have a limited number of members and serve limited types of products. It was further argued that promoting competition in the sector should be considered as a factor rather than an objective in fostering the development of future post-trade infrastructure, the consolidation of CCP clearing in particular. In the last section, the focus was on the developments in the European Union. At present, the EU is undergoing significant changes in the markets, and further consolidation in the industry is expected. As mentioned at the beginning of this chapter, however, a radical change initiated by the market participants is arguably not very likely. Given that market forces are not likely to be strong enough to determine the future architecture of post-trade infrastructure, it is argued that clearer policy initiatives and guidelines are needed. It was further argued that a single pan-European multi-market CCP is viable and should be given priority in the development of creating a single Pan-European market.

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8 Conclusions

T

HE CONCLUSIONS ARE drawn in respect of the following three main areas: (1) modern post-trade infrastructure with the emphasis on the role and functions of CCPs, (2) the contractual and regulatory arrangements for CCP clearing, and (3) the case for a single multi-market CCP.

8.1 Modern Post-Trade Infrastructure This book first observed the development of modern post-trade infrastructure and has clearly defined the main elements of modern post-trade arrangements and their respective features in the trade cycle. The immobilisation and dematerialisation of paper-form securities, which were also discussed, the innovative nature of the markets, and the advance of information technology, were identified as the main drivers behind the transformation of post-trade infrastructure. In this context, it was argued that the transformation of CCP clearing, along with the development of modern post-trade infrastructure, has positioned CCPs as one of the leading forces for the future development and further consolidation in the post-trade sector. In addition to the transformation of modern post-trade infrastructure, the two current industry developments, namely, the use of DVP settlement and the drive towards a full industry-wide STP were also discussed in detail. Given the historical role that CCPs have played in helping to introduce standardised market products, it was argued that CCPs also have a pivotal role to play in the process towards full STP at the core of the markets. The historical account of the developments of clearing houses and the exploration of the multiple roles of CCPs with the typical daily operations they carry out have shown the extent of the transformation of CCPs. It was argued in this book that CCP clearing is distinctively different from other types of clearing houses both in risks and in operations, despite the fact that they share a similar operational objective, namely, to increase the settlement efficiency. Furthermore, it was also argued that it is important that the role and functions of CCPs be clearly understood. With the clear understanding of the role and functions of CCP clearing, it was further 200

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The Legal and Regulatory Framework argued that the future development of CCP clearing will play an important role in re-shaping the future post-trade infrastructure and its further consolidation.

8.2 The Legal and Regulatory Framework As recommended,1 there ought to be a well-founded, transparent and enforceable contractual and regulatory framework for each aspect of a CCP’s activities in all relevant jurisdictions. Here, the key is to uphold the rules and regulations of a recognised CCP system and ensure that they are enforceable, especially in relation to default arrangements, in the relevant jurisdiction. The book explained that in modern markets trades flow from one system to another in order to complete a trade cycle and are therefore subject to the rules and regulations of each system respectively. It was argued the rules and regulations of each system have to be clearly stated and the precise time that they apply to trades be clarified. This is particularly important and significant in the case of CCP clearing, as it determines the time when the CCP itself is interposed between the original counterparties and assumes the rights and obligations of the transactions. This is also a key difference that distinguishes CCPs from other trading and settlement systems. As to the contractual framework, the book observed that general agency law and other relevant laws need to accommodate the smooth functioning of CCP clearing by upholding the contractual arrangements governing the tripartite relationship of CCP clearing. In particular, it should be upheld that the relationship between a CCP and its clearing members in relation to contracts processed through CCP clearing is always principal-to-principal. Another key factor in the tripartite CCP clearing arrangements is the exclusion of rights of third parties in the form of the rules and regulations of a CCP. This means no other parities, for example, clients of a clearing member, can establish a contractual relationship with the CCP in relation to the transactions processed through CCP clearing or file any claim directly against the CCP. It was therefore argued that the tripartite relationships between a CCP, clearing members and the clients of clearing members have to be clearly defined. Despite the nature of the relationship between a clearing member and its client, a CCP does not as a result establish any relationship between itself and that client. The implications of the contractual relationship between CCPs and their members, which is regarded as the core of the chain of contractual arrangements in the markets, are far-reaching for participants further down the chain.2 It was submitted that while non-members 1 Committee on Payment and Settlement Systems (CPSS) and Technical Committee of the International Organization of Securities Commissions, Recommendations for Central Counterparties (Basle: BIS, November 2004). 2 For example, non-members as clients of clearing members.

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Conclusions may be treated at its best as the beneficiaries for the contracts processed through CCP clearing they have no direct right against the CCP and can only claim against their agents, which in this case would be the clearing members. As discussed in chapter five, financial collateral arrangements and default managements for CCP clearing are closely connected. It was argued that they should be enforceable under relevant laws so to ensure speedy and robust CCP default procedures in handling a clearing member’s default. Despite the fact that there are various theories on netting and set-off and the relationship between the two, it was argued that they are put in the context and be treated accordingly by law. Specifically, it was also noted that the entire life cycle of CCP clearing involves repeated use of both netting and set-off.3 It includes transaction set-off, novation netting, and settlement netting, as well as close-out netting if default procedures4 have been triggered by a defaulting member. It was concluded that the transformation of modern CCP clearing coincided with the development of the new netting techniques. Under the modern approach, the regulatory and statutory framework should grant the rules and regulations of CCPs the status of market rules and at the same time provide a safe harbour with the explicit exemption of the application of general agency and insolvency laws. Such an approach is particularly important in the case of a clearing member’s default, which also affects the enforcement of financial collateral arrangements used by CCPs. As discussed, the default rules set out by CCPs enable the CCP to close out positions of a defaulting member in a rapid and predictable way to limit the damages caused by the defaulting member so that the CCP is able to continue to operate in the markets. Therefore, it was argued that the statutory framework must provide the legal certainty needed for CCP clearing given the important role CCP clearing plays in the financial system. As to the rules regarding CCP default, it was observed that the default arrangements of CCPs commonly only cover member default, and rules concerning CCP default cannot be found. It was also submitted that uncertainty may arise in the absence of such rules. There is an urgent need, as argued, to put rules and procedures in place for a defaulting CCP. It was further emphasised that striking the right balance between selfregulation and public regulation is one of the keys to achieving better regulation. Furthermore, in so far as CCPs are concerned, the solution as argued is that a recognised CCP should be empowered by self-regulatory functions under the modern regulatory approach. In law, for instance, this will also further distinguish recognised CCPs from those unrecognised ones to the extent that they would be provided with the insolvency protections discussed in Section 6.3.3 above. The typical membership structure for CCP clearing requires an element of self-regulation. This book has observed that the modern regulatory approach to

3 4

As can be seen in the description on the operational aspects of CCP clearing in ch 3. See Section 5.3, ch 5 above, for the discussion of default by a clearing member.

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A Single Multi-Market CCP CCP clearing has shifted to co-regulation within a statutory framework, as distinguished from the old self-regulatory regime. Under the modern approach, the services and rule-making functions of CCP clearing have been separated. In effect, market rules or bylaw status is granted to the rules and regulations of CCPs, as those rules and regulations are also subject to the supervision and oversight of competent authorities. It was concluded that this modern approach to the regulatory framework for CCPs, with co-regulation underpinned by a statutory framework, provides the flexibility that is needed for their continuous innovation. This provides legal certainty for the rules and regulations of CCPs, which is essential for their functioning in a modern dynamic market environment. It was further submitted that regulation, particularly in relation to CCPs, should be principle-based and risk-based with a functional approach. This is also key to creating a dynamic and robust regulatory framework to facilitate the constant interaction between financial regulation and the markets, as observed earlier. Looking forward, CCP clearing will continue to play an increasingly important role in modern market developments that will shape the future post-trade infrastructure. To foster the future development of CCP clearing, the basic requirements from a particular jurisdiction would be a legal and regulatory framework that, first, understands the importance of CCP clearing in modern markets, secondly, recognises the status of the CCP clearing rules and regulation, and last, but not least, provides legal certainty with regard to the enforcement of CCP default procedures.

8.3 A Single Multi-Market CCP As mentioned in chapter seven, CCP clearing occupies a strategically important position in the markets, particularly from both the vertical and horizontal dimensions. It was admitted that the debate on advantages and disadvantages of CCP clearing is largely an economic one. It was argued that it is important that a proper assessment in each market of the risks and benefits of CCP clearing must be carried out prior to its introduction. Furthermore, adequate arrangements must be in place so that the risks can be managed properly and effectively.5 By examining the advantages and disadvantages of CCP clearing from three different perspectives, ie that of markets, members and non-members, it was argued that the overall direct and indirect benefits that CCP clearing offers outweigh the disadvantages. Furthermore, it was argued that the disadvantages of CCP clearing can be remedied. 5 For example, the Financial Services Authority in the UK together with the central bank, Bank of England, have carried out the assessment of the arrangements by LCH.Clearnet Ltd against the recommendations by the CPSS-IOSCO, see Financial Services Authority, Assessment of LCH.Clearnet Limited against the CPSS-IOSCO Recommendations for Central Counterparties (June 2006).

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Conclusions The case for a single multi-market CCP was made particularly in light of the expected further consolidation of post-trade infrastructure in the European Union. It was argued that CCP clearing is to play a significant role in this development. One of the main risks posed by creating a single multi-market CCP is that from a competition perspective. It was submitted that the competition issue concerning a single multi-market CCP remains to be hotly debated. It was further argued that promoting competition in the sector should be considered as a factor rather than an objective in fostering the development of future posttrade infrastructure, the consolidation of CCP clearing in particular. Furthermore, as argued, the risks of a single CCP are outweighed by the benefits. In addition, it was also observed that the key to the risks and benefits of a single CCP here is the governance of such a CCP with better organisation structure and provide greater price transparency. It was submitted that the creation of a single CCP is not without risks. There are shortcomings in having a single CCP in the markets, although some of these have been inherited from CCP clearing. Nevertheless, it was argued that these risks are manageable. In making the case for a single multi-market CCP, the concern of the lack of competition was also recognised and addressed. It was argued that promoting competition in the sector should not be considered an objective of fostering the development of future post-trade infrastructure, but simply as a factor, for the future consolidation of CCP clearing in particular. In so far as the EU is concerned, it was argued that market forces are not likely to be strong enough to determine the future architecture of post-trade infrastructure, and policy initiatives are needed. It was further argued that a single panEuropean CCP is viable and should be given priority in the development of creating a single Pan-European Market. In making the case of a single multimarket CCP, it was finally argued that the creation of a single CCP should remain a long-term goal if it was not achievable in the nearer future.

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Select Bibliography AGGARWAL, REENA, ‘Demutualization and Corporate Governance of Stock Exchanges’ (2002) 15(1) Journal of Applied Corporate Finance 105. ALCOCK, ALISTAIR, The Financial Services and Markets Act 2000 (Bristol: Jordan, 2000). ALLEN, FRANKLIN and HERRING, RICHARD, Banking Regulation versus Securities Market Regulation (The Wharton School: University of Pennsylvania, July 2001). ALLEN, HELEN, HAWKINS, JOHN and SATO, SETSUYA, Electronic Trading and its Implications for Financial Systems (Bank for International Settlements (BIS) Papers No 7) ANDREWS, FLETCHER R, ‘The Operation of the City Clearing House’ (1941–42) 51 Yale Law Journal 582–607. ASSOCIATION OF PRIVATE CLIENT INVESTMENT MANAGERS and STOCKBROKERS, EUROPEAN ASSOCIATION OF SECURITIES DEALERS ET AL, Innovation Competition Diversity Choice: A European Capital Market for the 21st Century (London, 21 May 2002). AUSTEN-PETERS, AO, Custody of Investments: Law and Practice (Oxford/New York: Oxford University Press, 2000). BALÁŽ, PETER, ‘Netting in Financial Markets’ Parts I–IV BIATEC (The National Bank of Slovakia) Vol XIII, 01/2005–04/2005. BANK OF ENGLAND, Securities Settlement Priorities Review (September 1998). BEALE, HG (ed), Chitty on Contracts, 29th edn (London: Sweet & Maxwell, 2004). BELL, ABRAHAM and PARCHOMOVSKY, GIDEON, What Property Is (February 2004) SSRN.COM/ABSTRACT=509862. BELLWOAR, JOHN M, ‘Bar Baron at the Gate: An Argument for Expanding the Liability of Securities Clearing Brokers for the Fraud of Introducing Brokers’ (October 1999) 74 New York University Law Review 1014–56. BENJAMIN, JOANNA, Interests in Securities (Oxford/New York: Oxford University Press, 2000). BENJAMIN, JOANNA, Financial Law (Oxford/New York: Oxford University Press, 2007). —— The Oxford Colloquium on Collateral and Conflict of Laws (London: Butterworths, 1998). BENJAMIN, JOANNA, YATES, MADELEINE and MONTAGU, GERALD, The Law of Global Custody, 2nd edn (London: Butterworths, 2002). BERGMANN, LE (SEC), Speech: The US View of the Role of Regulation in Market Efficiency (International Securities Settlement Conference, London, February 2004). BILL, THOMAS, ‘Changing Legal Principles’ (April 1996) Legal Executive 34–35. BLACK, JULIA, ‘Constitutionalising Self-regulation’ (1996) 59(1) Modern Law Review 24–55. BLAIR, MICHAEL and WALKER, GEORGE (eds), Financial Services Law (Oxford: Oxford University Press, 2006).

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Select Bibliography BLAIR, WILLIAM, Banking and Financial Services Regulation, 3rd edn (London: Butterworths, 2002). BLISS, ROBERT and STEIGERWALD, ROBERT, ‘Derivatives Clearing and Settlement: A Comparison of Central Counterparties and Alternative Structures’ (Fourth Quarter 2006) 30(4) Economic Perspectives. BODART, PAUL, The Changing World of Securities Processing in Europe. A Review of the Current Industry Initiatives (The Bank of New York, 2004). BOURSE CONSULT, The Future of Clearing and Settlement in Europe (Corporation of London: City Research Series: Number Seven, December 2005). BOWSTEAD, WILLIAM ET AL, Bowstead and Reynolds on Agency, 18th edn (London: Sweet & Maxwell, 2006). BRADLEY, CAROLINE, ‘Private International Law-Making for the Financial Markets’ (2005– 06) 29 Fordham International Law Journal 127. BRIDGE, MICHAEL G, Personal Property Law, 3rd edn (Oxford: Oxford University Press, 2002). —— The International Sale of Goods (Oxford: Oxford University Press, 1999). BRITTON, RICHARD, SPEECH: ‘Consolidation, Multiplication, Evaporation: How Will the European Market for Bond Trading Platforms Develop?’ (Tradetech Fixed Income, London, 28 January 2003). BUITER, WH, Lessons from the Global financial Crisis for Regulators and Supervisors (Paper presented at the 25th anniversary workshop ‘The Global Financial Crisis: Lessons and Outlook’ of the Advanced Studies Program of the IFW, Kiel, 8–9 May 2009). ‘Capital Markets: Creating a Competitive EU Market in Clearing and Settlement’ (May 2003) (6) Competition Law Insight 11. CAREW, EDNA, The Language of Money 3 (New South Wales: Allen & Unwin Pty, Ltd (Australia), 1996). CARVAJAL, ANA, DODD, RANDALL, MOORE, MICHAEL, NIER, ERLEND, TOWNER, IAN and ZANFORLIN, LUISA, The Perimeter of Financial Regulation (IMF Staff Position Note, SPN/09/07, 26 March 2009). CHAMBERLAIN, MARGARET, ‘The Legal Framework within which UK Exchanges and Clearing Houses Operate’ (January 1997) 4 European Financial Services Law 20–24. CHARTERIS CONSULTANTS, European Financial Markets 2001—Revolution or Evolution? (2001). CHESINI, GIUSY, ‘Changes in the Ownership Structure of Stock Exchanges: from Demutualisation to Self-listing’ (Paper presented at the X International ‘Tor Vergata’ Conference on Banking and Finance, Competition, Financial integration and risks in the Global Economy, University of Rome, 5–6 December 2001). CITIGROUP, ‘Citigroup Comments on the Overview of EU25 Securities Trading, Clearing, Central Counterparties, and Securities Settlement (2004, Non-confidential version). CLEARING CORPORATION, THE (Chicago Board of Trade), A History: Trusting, Growing, Leading, (2000). www.clearingcorp.com/about/our-history.html. ‘Clearing the Way The Role of the Central Clearing Counterparty is Still Widely Misunderstood, but When Spreads are Tight, Demand Soars’ (2001) International Securities Finance, Part 5, 38–9. CLEARY GOTTLIEB STEEN & Hamilton LLP, Comments on the Further Remedy Option regarding Interoperability of Central Counterparties (Euronext NV, September 2005).

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Select Bibliography CLIFFORD CHANCE, ‘New Proposals for Recognition Requirements for Investment Exchanges and Clearing Houses’ (March 1999) Financial Regulation Report 11–2. COMMITTEE OF WISE MEN, Initial Report on the Regulation of the European Securities Markets (Brussels, 9 November 2000). —— Final Report on the Regulation of the European Securities Markets (Brussels, 15 February 2001). COMMITTEE ON PAYMENT and SETTLEMENT SYSTEMS (CPSS), Central Bank Oversight of Payment and Settlement Systems (CPSS Publications No 68, May 2005). www.bis.org/publ/cpss68.pdf. —— Clearing Arrangements for Exchange-traded Derivatives (Basle, March 1997). www.bis.org/publ/cpss23.pdf. —— Delivery Versus Payment in Securities Settlement Systems (CPSS Publications No 6, September 1992). www.bis.org/publ/cpss06.pdf. —— The Contribution of Payment Systems to Financial Stability (May 2000). www.bis.org/publ/cpss41.pdf. —— The Interdependencies of Payment and Settlement Systems (June 2008). www.bis.org/publ/cpss84.pdf. —— Recommendations for Securities Settlement Systems (November 2001). www.bis.org/publ/cpss46.pdf. COMMITTEE ON PAYMENT and SETTLEMENT SYSTEMS (CPSS) and Technical Committee of the International Organization of Securities Commissions (IOSCO), Recommendations for Central Counterparties (Basle, BIS, November 2004). www.bis.org/publ/cpss61.pdf. COMMITTEE ON THE GLOBAL FINANCIAL SYSTEM, Collateral in Wholesale Financial Markets: Recent Trends, Risk Management and Market Dynamics (March 2001). www.bis.org/publ/cgfs17.pdf?noframes=1 —— Stress Testing by Large Financial Institutions: Current Practice and Aggregation Issues (April 2000). www.bis.org/publ/cgfs14.pdf. ‘Core strengths’ (2004) 154(936) The Banker 63–4. CORRINGTON, MURRAY, ‘The Clearing House as a Guarantor against Panics’ (1913) 30 Banking Law Journal 347–54. COUNTERPARTY RISK MANAGEMENT POLICY GROUP II, THE, Toward Greater Financial Stability: A Private Section Perspective (27 July 2005). CRANSTON, ROSS, Principles of Banking Law, 2nd edn (Oxford: Oxford University Press, 2002). CRUICKSHANK D, Speech: The Evolution of EU Securities Markets: Next Steps for Clearing and Settlement (Madrid, 18 October 2005). DALE, RICHARD, ‘Derivatives Clearing Houses: the Regulatory Challenge’ (1997) 12(2) Journal of International Banking Law 46–55. DALHUISEN, JAN H, Dalhuisen on Transactional and Comparative Commercial, Financial and Trade Law, 3rd edn (Oxford: Hart Publishing, 2007). —— Dalhuisen on International Commercial, Financial and Trade Law, 2nd edn (Oxford: Hart Publishing, 2004). DAVIES, HOWARD, SPEECH: (Federal Reserve Bank of Atlanta Financial Markets Conference, Florida, 27 February 1998).

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Select Bibliography DE LAROSIÈRE, J ET AL, Report. The High Level Group on Financial Supervision in the EU (De Larosière Report) (Brussels, February 2009). ‘Delivery Versus Payment in Central Bank Money in Crest Payment Finality and Selfcollateralisation’: legal issues paper (September 2000). DEPARTMENT OF TREASURY (US), Financial Regulatory Reform—A New Foundation: Rebuilding Financial Supervision and Regulation (White Paper, 2009). DERHAM, SR, The Law of Set-off, 3rd edn (Oxford: Oxford University Press, 2003). DEUTSCHE BANK RESEARCH, Clearing and Settlement in the EU: Structures and Policy Options (2003). DIMSON, E and MUSSAVIAN, M, ‘A Brief History of Market Efficiency’ (1998) 4 European Financial Management 91–103. —— ‘Market Efficiency’ in SB Dahiya, The Current State of Business Disciplines (Spellbound, 2000) 959–70. DOMBALAGIAN, ONNIG H, ‘Self and Self-Regulation: Resolving the SRO Identity Crisis’ (2006–07) 1 Brook. Journal Corporate Financial & Commercial Law 317. DOUGLAS, BAIRD G ET AL (eds), Commercial and Debtor-creditor Law: Selected Statutes (New York: Foundation Press, 2002). DUFFIE, DARRELL and HAOXIANG ZHU, Does a Central Clearing Counterparty Reduce Counterparty Risk? (Preliminary Draft: 19 February 2009). DEPOSITORY TRUST & Clearing Corporation (DTCC), Central Counterparties: Development, Cooperation and Consolidation. A White Paper to the Industry on the Future of CCPs (October 2000). —— Straight-Through Processing: a New Model for Settlement (White Paper, January 2002). —— The Central Counterparties Dialogue—Year 001 (Paris: Promethee, April 2001). EISENBERG, LARRY K and NOE, THOMAS H, ‘Systemic Risk in Financial Networks’ (2001) 47(2) Management Science 236–49. EUROPEAN CENTRAL BANK, ‘Consolidation in Central Counterparty Clearing in the Euro Area’ (August 2001) ECB Monthly Bulletin 69–77. —— The Eurosystem’s Policy Line with regard to Consolidation in Central Counterparty Clearing (Policy Note, September 2001). EUROPEAN COMMISSION COMPETITION DG, Overview of EU25 Securities Trading, Clearing, Central Counterparties, and Securities Settlement (February 2004). EUROPEAN FINANCIAL MARKET LAWYERS GROUP, Proposal for an EU Directive on Collateralisation (June 2000). —— Protection for Bilateral Insolvency Set-off and Netting Agreements under EC Law (October 2004). EUROPEAN SECURITIES FORUM (ESF), EuroCCP—ESF’s Blueprint for a Single Pan-European Central Counterparty (2000). FANCOTTE, PIERRE, ‘Settlement at the Crossroads’ (1 June 2002) Banker 54–55. FELSENFELD, CARL and GENCI BILALI, The Check Clearing for 21st Century Act—A Wrong Turn in the Road to Improvement of the US Payments System (2006) 85 Nebraska Law Review 52. ssrn.com/abstract=651481. FINANCIAL MARKETS LAW COMMITTEE, Issue 3—Property Interests in Investment Securities (Bank of England, July 2004). AVAILABLE AT HTTP://www.fmlc.org/papers/fmlc3_3_july04.pdf

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Select Bibliography FINANCIAL SERVICES AUTHORITY The FSA’s Approach to Regulation of the Market Infrastructure (Financial Services Authority Discussion Paper, January 2000). ——, Assessment of LCH. Clearnet Limited against the CPSS-IOSCO Recommendations for Central Counterparties (June 2006). FITZPATRICK, WILLIAM J and CARMAN, RONALD T, ‘An Analysis of the Business and Legal Relationship between Introducing and Carrying Brokers’ (November 1984) 40 The Business Lawyer 47–67. FLETCHER, IAN F and CRABB, LETITIA, The Law of Insolvency, 3rd edn (London: Sweet & Maxwell, 2002). FOX, DARREN, The Case for a Single European Central Counterparty (February 2001). www.eurosf.com/upload/publications/ The%20Case%20for%20a%20Single%20European%20Central%20Counterparty.pdf. FRANKLIN, ALLEN and HERRING, RICHARD, Banking Regulation versus Securities Market Regulation (The Wharton School, University of Pennsylvania, 11 July 2001). FREY, WERNER, ‘Examining the Evolution towards an Integrated Pan-European Settlement Infrastructure’ (Speech) (February 2003). WWW.EUROSF.COM/UPLOAD/PUBLICATIONS/ ESF%20TRADE%20TECH%20CONFERENCE%20JAN03.PDF. FRIEDLAND, JOHN H, The Law and Structure of the International Financial System (Westport CT/London, Quorum, 1994). FURSE, MARK, Competition Law of the EC and UK, 4th edn (Oxford: Oxford University Press, 2004). GHADIMI, R and ROSENMAN, K, ‘Distinguishing Between Securities Accounts and Deposit Accounts Under the UCC’ (December 2000) 88 Illinois Bar Journal. GIORDANO, FRANCESCO, Cross-border Trading in Financial Securities in Europe: the Role of Central Counterparty (European Capital Markets Institute, December 2002). GIORGIO, DI GIORGIO and CARMINE, DI NOIA, Financial Regulation and Supervision in the Euro Area: A Four-Peak Proposal (The Wharton Financial Institutions Center, University of Pennsylvania, Preliminary Version: January 2001). GIOVANNINI GROUP, THE, Cross-Border Clearing and Settlement Arrangements in the European Union (Brussels, November 2001). —— Second Report on EU Cross-Border Clearing and Settlement Arrangements (Brussels, April 2003). GLEESON, SIMON, Financial Services Regulation (London: Sweet & Maxwell, 1999). GLOVER, JOHN, Commercial Equity: Fiduciary Relationships (London: Butterworths, 1995). GOODE, ROY M, Commercial Law, 3rd edn (London: LexisNexis UK, 2004). —— Legal Problems of Credit and Security, 3rd edn (London: Sweet & Maxwell, 2003). —— Payment Obligations in Commercial and Financial Transactions (London: Sweet & Maxwell, 1983). —— Proprietary Rights and Insolvency in Sales Transactions, 2nd edn (London: Sweet & Maxwell, 1989). —— Principles of Corporate Insolvency Law, 3rd edn (London: Sweet & Maxwell, 2005). —— ‘The Concept and Implications of a Market in Commercial Law’ (Spring 1990) 24(2) Israel Law Review 185–210. —— ‘The Nature and Transfer of Rights in Dematerialised and Immobilised Securities’ (1996) 10 Butterworth Journal of International Banking and Financial Law 167–76. GOODHART, CHARLES A, Financial Regulation (London: Routledge/Bank of England, 1998).

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Select Bibliography GOWER, LC, Review of Investor Protection (London: HMSO, 1985). GRANT JJ ET AL, Grant on the Law relating to Bankers and Banking Companies (London: Butterworth, 1924). GREENSTED, R. ‘The Long Climb to EuroCCP’ (1 October 2001), The Banker Supp (STP) 14–16. GROUP OF EXPERTS ON PAYMENT SYSTEMS OF THE CENTRAL BANKS OF THE GROUP OF TEN COUNTRIES, Report on Netting Schemes (Basle, Bank for International Settlements, February 1989). GROUP OF THIRTY, Global Clearing and Settlement (Washington DC: Group of Thirty, 2003). —— Global Clearing and Settlement: A Plan of Action (Steering & Working Committees of Global Clearing & Settlements Study Group, 2003). —— Global Clearing and Settlement: Final Monitoring Report (Global Monitoring Committee, 2006). GULAMHUSEINWALA, I, ‘The Right Model at the Right Time’ (3 January 2005) The Banker 51. HARVARD RESEARCH GROUP, Assessment: Clearing and Settlement—Making Financial Information Flow (2003). HAMILTON, JENNY, ‘Regulation of Financial Services’ in L MacGregor et al (eds), Regulation and Markets Beyond 2000 (Dartmouth: Ashgate, 2000) 243–68. HAYTON, DAVID J, The Law of Trusts, 4th edn (London: Sweet & Maxell, 2003). HELM, D and JENKINSON, T, Competition in Regulated Industries (Oxford: Oxford University Press, 1998). HENRY D, Clarifying and Setting Access to Clearing and Settlement in the EU. Working Paper. 2005. HILLS, BOB and RULE, DAVID, Financial Stability Review: Counterparty Credit Risk in Wholesale Payment and Settlement Systems (November 1999). HILLS, BOB ET AL, ‘Central Counterparty Clearing Houses and Financial Stability’ Financial Stability Review (Issue No 6) 98–114 (Bank of England). HOWELLS, PETER and BAIN, KEITH, Financial Markets and Institutions, 4th edn (Harlow: Financial Times Prentice Hall, 2004). INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS (IOSCO), Model for Effective Regulation. Reports of the SRO Consultative Committee (May 2000). —— Objectives and Principles of Securities Regulation (September 1998). —— Supervisory Framework for Markets. Report by the Technical Committee (May 1999). —— Towards a Legal Framework for Clearing and Settlement in Emerging Markets (November 1997). www.riskinstitute.ch/142800.htm. ‘Is the European getting a Single Central Counterparty’ (2002) 19(1) Banking Technology 28–32. [no name was provided] Kent, Pen. ‘Central Counterparties and Settlement Risk Reduction’ (February 2001). KHIAONARONG TANAI, Payment Systems Efficiency, Policy Approaches and the Role of the Central Bank (Bank of Finland Discussion Papers, 2003). KRONKE, HERBERT, The Draft Unidroit Convention on Intermediated Securities: Transactional Certainty and Market Stability (Seminar on Current Developments in Monetary and Financial Law, Washington DC, 23–27 October 2006).

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Select Bibliography KROSZNER, RANDALL S, ‘Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearing Houses and Recent Over-the-Counter Innovations’ (March 1999) 31(3) Journal of Money, Credit & Banking 600. KROSZNER, RANDALL S, ‘Lessons from Financial Crises: The Role of Clearinghouses’ (December 2000) 18(2)–(3) Journal of Financial Services Research 157–71. LAMB, ANDREW, ‘Roadmap to the Future’ (International Securities Services Association Symposium, Wolfsberg, Switzerland, 2004). LAMB, ANDREW and SWAN, EDWARD, ‘United Kingdom: the Role of the London Clearing House’ (1996) 3(3) Futures & Derivatives Law Review 9–22. LAMBE, GERALDINE, ‘Laying the GSTPA’s Ghost to Rest’ (2003) 152(923) The Banker 94–6. LANGTON, JOHN L, Speech: ‘Overview of the Key issues affecting the European Securities Markets’ (The 16th Annual European Finance Convention, 3 December 2002). LANNO, K and LEVIN, M, The Securities Settlement Industry in the EU—Structure, Costs and the Way Forward (Centre for European Policy Studies (CEPS), December 2001) LARGE, JACK, ‘Europe Moves to Real-time Gross Settlement’ (1996) Corporate Finance, Supp SFI(142), 26. LEVIN, MATTIAS, ‘Clearing and Settlement in the European Union’ (June 2001) Financial Regulation International 1–4. LINTON, ESSIE and STARK, MARY, The Direct Costs of Clearing and Settlement: An EU-US Comparison (Corporation of London, June 2004). LOADER, DAVID, Clearing, Settlement and Custody (London: Butterworth Heinemann, 2002). LÖBER KLAUS M, The Developing EU Legal Framework for Clearing and Settlement of Financial Instruments (European Central Bank, Legal Working Paper Series No 1, February 2006). LONDON CLEARING HOUSE, Market Protection—The Role of LCH: Regulations Framework, Structure and Governance, Legal and Contractual Obligations, Risk Management, Default Rules, Financial Banking (2002). LONDON ECONOMICS, Overview of EU25 Securities Trading, Clearing, Central Counterparties, and Securities Settlement (February 2004). LOSS, LOUIS and SELIGMAN, JOEL, Fundamentals of Securities Regulation, 4th edn (New York, Aspen, 2004). —— Securities Regulation, 3rd edn (Boston/New York: Little, Brown Aspen, 1989). MACHALE, JIM, ‘Electronic Netting of Payments’ (1995) 8(5/6) Credit and Finance Law 37–38. MAGUIRE, FRANCES, ‘Consolidation Saving Still Remain a Dream’ (2004) 154(938) The Banker 43–5. MCCORMICK, ROGER, Legal risk in the financial markets (Oxford: Oxford University Press, 2006). MCCREEVY, C, Stock Market Consolidation and Security Markets Regulation in Europe (Annual Lecture at SUERF, 30 November 2005). MCCREEVY, C, Speech: Fund Management—Regulation to facilitate competitiveness, growth and change (14th Annual Europe-USA Investment Funds Forum, Luxembourg, 13 September 2005). MILNE, ALISTAIR, Competition and the Rationalisation of European Securities Clearing and Settlement (September 2004). MINNEROP, HENRY F, ‘Clearing Arrangements’ (May 2003) 58 The Business Lawyer 917–60.

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Select Bibliography —— ‘The Role and Regulations of Clearing Brokers’ (May 1993) 48 The Business Lawyer 841–68. MOKAL, RIZWAAN JAMEEL, ‘Priority as Pathology: The Pari Passu Myth’ (2001) 60 Cambridge Law Journal 581. MUÑOZ CALLADO and FRANCISCO, JOSÉ, Collateral Use in Payment Systems (EFMA 2003 Helsinki Meeting, November 2002). MURAWSKI, CARSTEN, The Impact of Clearing on the Credit Risk of a Derivatives Portfolio (October 2002). www.fmpm.ch/docs/6th/Papers_6/Papers_Netz/SGF643.pdf. NAZARETH, ANNETTE L, Speech: Remarks Before the Security Traders Association (Washington Congressional Conference, 2002). NETTING SUB-COMMITTEE OF THE COMPANIES and SECURITIES ADVISORY COMMITTEE, Netting in Financial Markets Transaction. Final Report (June 1997). NIELS, GUNNA ET AL, ‘Unclear and Unsettled: The Debate on Competition in Clearing and Settlement of Securities Trades’ (2003) 24(12) European Competition Law Review 634–39. NIEMEYER, JONAS, An Economic Analysis of Securities Market Regulation and Supervision: Where to Go after the Lamfalussy Report? (SSE/EFI Working Paper Series in Economics and Finance, No 482, 14 December 2001). ORGANISATION FOR ECONOMIC CO-OPERATION and DEVELOPMENT (OECD), Systemic Risks in Securities Markets (Paris: OECD, 1991). OGUS, ANTHONY, ‘Rethink Self-Regulation’ (Spring 1995) 15(1) Oxford Journal of Legal Studies 97–107. PAN, ERIC J, ‘Harmonization of U.S.-EU Securities Regulation: the Case for a Single European Securities Regulator’ (2003) 34 Law & Policy in International Business 499–536. POTTER, HF JR and MCLEAN, DL, ‘Introduction of Book Entry Transfer of Securities’ (1972–73) 28 The Business Lawyer 209–14 POTOK, RICHARD, Cross Border Collateral: Legal Risk and the Conflict of Laws, (Butterworths: London, 2002). PROCTOR, CHARLES, Mann on the Legal Aspect of Money, 6th edn (Oxford: Oxford University Press, 2005). REACH, PHILIPP and LÖBER, KLAUS, ‘Post Trading of Securities: Shaping the European Response to Legal Barriers’ (2009) 4 Journal of International Banking and Financial Law 211. RESERVE BANK OF AUSTRALIA, Financial Stability Standard for Central Counterparties— Guidance (May 2003). RIPATTI, KRISI, Central Counterparty Clearing: Constructing Framework for Evaluation of Risks and Benefits (Bank of Finland Discussion Papers, 30/2004). ROGERS, JAMES S, ‘Policy Perspective on the Revised UCC Article 8’ (June 1996) 43(5) UCLA Law Review 1413–56. RUSSO, FILIPPO, The Evolving Role of Central Counterparty Clearing Houses (Roma: Universita Luiss Guido Carli, 2002). SAWYER, DAVID and TRUNDLE, JOHN, ‘Core Principles for Systemically Important Payment Systems’ (June 2000) Financial Stability Review 126–35. SAUNDERSON, EMILY, ‘Cutting Costs’ Futures & Options World, (402), 1 November 2004. at: http://www.fow.com/Article/1385266/Issue/26557/Cutting-costs.html.

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Select Bibliography SETTEN, LODEWIJK VAN, LECTURE NOTE: ‘Settlement Finality and Financial Collateral’ (London, 10 January 2003). SCHENCK, EDWIN S, ‘The Evolution of the Clearing House’ (1907) 23 Banking Law Journal 399–404. SCHMIEDEL, HEIKO, Technological Development and Concentration of Stock Exchange in Europe (Bank of Finland Discussion Paper 21, 2001). —— Total Factor Productivity Growth in European Stock Exchanges: A Non-parametric Frontier Approach (Bank of Finland Discussion Paper 11, 2002). SCHOENMAKER DIRK, A Comparison of Net and Gross Settlement (LSE Financial Market Group Special Paper No 60, 1990). SCHWARCZ, STEVEN L, ‘Intermediary Risk in a Global Economy’ (2000) 50(6) Duke Law Journal 1541–607. SCOTT, HAL S and WELLONS, PHILIP A, International Finance, 8th edn (New York: Foundation Press, 2001). SCOTT-QUINN, B and WALMSLEY, JK, New Frontiers in Clearing and Settlement (International Securities Market Association, 1999). SECURITIES INDUSTRY ASSOCIATION (SIA), Background Note on the Organisation in the US Market for Clearing and Settlement (the Cross-Border Subcommittee of the Securities Industry Association for the European Commission, May 2005). SERIFSOY, BARIS, The Impact of Demutualization and Outsider Ownership on Stock Exchange Performance—Empirical Evidence (Frankfurt: Goethe University, 2005). SERIFSOY, BARIS and WEISZ, MARCO, ‘Settling for Efficiency—A Framework for the European Securities Transaction Industry’ (2007) 31(10) Journal of Banking and Finance 3034–57. SHIRREFF, DAVID, ‘Clear as Mud in a Minefield’ (October 1998) Euromoney 10–12. —— ‘How Liquid Can You Get?’ (May 1999) Euromoney, 10–11. SIMMONS, MICHAEL, Securities Operations: A Guide to Trade and Position Management (Oxford, John Wiley & Sons, Ltd, 2002). SOMMER, JOSEPH H, ‘A Law of Financial Accounts: Modern Payment and Securities Transfer Law’ (August 1998) 53 The Business Lawyer 1181–215. TAPKING, JENS and YANG, JING, Horizontal and Vertical Integration in Securities Trading and Settlement (European Central Bank, Working Paper Series 387, 2004). TAYLOR B, Capital Adequacy for Operational Risk Will be a Critical Driver behind a Pan European Central Counterparty (CCP) (2001). TAYLOR M, ‘Twin Peaks’: A Regulatory Structure for the New Century (Centre for the Study of Financial Innovation, London, December 1995). —— Peak Practice: How to Reform the UK’s Regulatory System (Centre for the Study of Financial Innovation, London, October 1996); TECHNICAL COMMITTEE OF THE INTERNATIONAL ORGANIZATION OF SECURITIES COMMISSIONS, Regulatory Issues arising from Exchange Evolution (IOSCO, March 2006). TENNEKOON, RAVI C, The Law and Regulation of International Finance Student edn (London: Butterworths, 1991). TIMBERLAKE, RH JR, ‘The Central Banking Role of Clearinghouse Associations’ (February 1984) 16(1) Journal of Money, Credit and Banking 1–15. TURING, DERMOT, ‘New Growth in the Financial Collateral Garden’ (January 2005), (1) Butterworths Journal of International Banking and Financial Law, 4–9. TURNER, A, A Regulatory Response to the Global Banking Crisis (The Turner Review) (Financial Services Authority, March 2009)

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Select Bibliography VALDEZ, STEPHEN and WOOD, JULIAN, An Introduction to Global Financial Markets, 4th edn (Basingstoke: Palgrave Macmillan, 2003). WAHRENBURG, MARK, BOCHOW, JORG, NGUYEN, DUONG and RAUPACH, PETER, What do Market Makers Achieve? Evidence from a Large Scale Experimental Stock Market (November 1999). www.wiwi.uni-frankfurt.de/schwerpunkte/finance/wp/375.pdf WALSH, JH, ‘Institution-based Financial Regulation: A Third Paradigm’ (Summer 2008) 49(2) Harvard International Law Journal 381–412. WARREN, MANNING G, ‘The Harmonization of European Securities Law’ (2003) 37(1) Harvard International Law Review 211–40. WHITE, LAWRENCE J, Technological Change, Financial Innovation, and Financial Regulation: the Challenges for Public Policy (Wharton Financial Institutions Center, #97–33, May 1997). WHITEHOUSE, GEOFF, ‘Unclear and Unsettled’ (Dec–Jan 2001–02) Financial Regulation International 1–4. WHITTAKER, ANDREW, ‘Confronting the Regulatory Challenge’ (March 2005) 20(3) Journal of International Business and Financial Law 98–9. WILSON, PAUL, ‘The Benefits of One-Stop Shopping’ (April 2005) Portfolio International, Supp CUS 9. WOOD, PHILIP R, English and International Set-off (London: Sweet and Maxwell, 1989). —— Regulation of International Finance (London: Sweet & Maxwell, 2007. —— Set-off and Netting, Derivatives, Clearing Systems (London: Sweet & Maxwell, 2007). WORTHINGTON, SARAH, Equity (Oxford: Oxford University Press Clarendon Law Series, 2003). —— Personal Property Law (Oxford: Hart Publishing, 2000). —— Proprietary Interests in Commercial Transactions (Oxford: Oxford University Press, 1996). YATES, MADELEINE and MONTAGU, GERALD, The Law of Global Custody, 3rd edn (Sussex, Tottel Publishing, 2009), Chapter 8. ZENINA, ZHANNA A, Case Study: Meger of the London and Frankfurt Stock Exchanges (International Finance Seminar, May 2001). ZUFFEREY, JEAN-BAPTISTE and TSCHANZ-NORTON, MARGARET, Regulation of Trading Systems on Financial Markets (London: Kluwer Law International. Geneva Financial Center Foundation, 1997). ZWEIGERT, KONRAD and KÖTZ, HEIN, An Introduction to Comparative Law (trans Tony Weir), 3rd edn (Oxford: Clarendon Press, 1998). Z/Yen Ltd, Competitive Cost Benchmarking Study: Equity and Debt Products (2002).

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Index A

C Central Bank, 57, 160, 166, 191, 192 Regulatory functions of, 137 The concerns of, in CCP clearing, 137–8 The interest of, in CCP clearing, 137–8 Central Counterparties (CCPs) CCPs as fund manager, 54–6 CCPs as payment and settlement operator, 56–7 CCPs as post-trade market facilitator, 57–9 CCPs as risk manager, 52–4 CCPs as self-regulatory organisations, 141–3 Legal and regulatory framework, 136, 139 Margining operations, 63–5 See also margin Risk operations, 60–2 See also a single central counterparty; CCP clearing Settlement operations, 65–72 Treasury operations, 62–5 Central Counterparty (CCP) Clearing, 13–8 Advantages and disadvantages, 171–3 Historical development, 44–52 Need of separate treatment, 139–41 Origins, 44–52 Privileges, 82 Risk operations, 60–2 See also Central Counterparties (CCPs) Settlement operations, 65–72 Treasury operations, 62–5 Terms and conditions, 88 UK regulatory regime, 143–54 Central securities depositories (CSDs), 17, 18, 169, 186, 192 Check Clearing for the 21th Century Act, 47 Chicago Board of Trade, 50, 183 Clearing, 11, 44, 15–8 Cheque clearing, 16, 45–8 Commodity clearing, 48–9 Definition, 15 In securities markets, 16–8 In commercial banking, 16 Origins, 44 Clearing agency, 186 n 72 Clearing and settlement, 10, 15, 66, 137, 140, 157, 159 Clearing arrangements, 18, 91–3, 95, 97–8, 111, 113, 201

Anonymous trading, 13, 66, 172, 176 Agency law, 82–5, 92–6, 189, 201 External aspect of, 84 General principles of, 85, 95 Internal aspect of, 84, 96 Undisclosed agency, 85 Account segregation, 95–6 Advance of technology, 12, 20 Auto-borrowing programme, 35, 69–70 A single central counterparty, 171, 180–90 Benefits, 182–4 Competition issues, 187–9 From markets’ perspective, 173–5 From clearing members’ perspective, 175–9 From non-members’ perspective, 179 Risks, 185–90 Single access point, 182–3 Standardisation, 182 The ownership structures of, 189–90 The raison d’être for, 180–2 A single European market, 181 Challenges to regulators and supervisors See also Financial Services Actions Plans (FSAP) Advance of technology, 10, 12, 20, 43, 143

B Bank clearing house, 44–7, 49, 63 See also central counterparties; cheque clearing; market clearing house Bank for International Settlements (BIS), 15 Book-entry securities, 19, 24, 27–32, 42 Acquisition of, 27 Definition, 27–30 Holding of, 19 Holder’s rights, 26, 28 Transfer of, 19–20, 30–2 Book-entry systems, 21 See also book-entry securities Bradford National Clearing Corporation v Securities and Exchange Commission, 185 British Eagle International Air Lines Ltd v Compagnie Nationale Air France, 112, 113–4, 116 Bylaw, 74, 92–3

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Index Clearing house, 44–52 Past failures, 123 See also bank clearing house; central counterparties; market clearing houses Clearing House Automated Payment Systems (CHAPS), 22 Clearing member, 86–95 Legal position, 93–5 See also non-clearing member Clients of clearing members, 95–8 Rights of, 96–8 See also non-member Clearing procedures, 76 Clearing rules, 75–80 Collateral, 101−5 See also collateralisation Transfer of, 205–8 Types of, 102–3 Use of, 102–5 Collateral management, 54−6, 62, 174, 184, 199 Collateralisation, 32, 35–7, 101 Characterisation, 105–8-7 In CCP clearing, 104–5 Limitation of, 105 Purposes of, 101–2 Realisation, 105–8 See also financial collateral arrangements; self-collateralisation; derivatives product company Committee of European Securities Regulators (CESR), 160 Communication on clearing and settlement, 157, 160 Compensatio, 44–5 Competition Act 1998, 150–2 Chapter 2, 151 Section 2(1), 151 Competition Commission, 149–52 Control Definition, 31 Contract as principal, 85, 92–8 See also principal to principal Co-regulation, 132–5, 139, 142, 159, 167, 203 Corporation of London study, 178 n 36, 192, 193, 196 Counterparty credit risk, 52, 65, 172, 174 Credit default swaps, 129, 191 CREST, 35–7 Self-collateralisationm, 37

D Dalhuisen, Jan, 110 De Larosière report, 156, 165 Default By CCPs, 122–4 By Clearing Members, 79–80, 117–22 See also netting; set-off

Default arrangements, 106, 146–8, 201–2 Definition, 106, 146–8 See also default procedures Default fund, 54–6, 120, 185 Default procedures, 107, 117–22 Commencement of, 119–22 Its importance in CCP clearing, 117 Objectives, 122 Triggering events, 119 Default risk, 23, 105, 122 Delivery Versus Payment (DVP), 19, 22, 32–7, 69 Approaches, 34 Problems, 34–5 See also CREST Dematerialisation, 25, 28, 200 See also immobilisation Demutualisation, 158, 189–90 Derivatives Product Company (DPC), 50–5 Direct debit, 62 See also protected payment scheme

E Economies of scale, 14, 40, 181, 183, 196 EU Directive on CCP Clearing, 159 EU Directive on Financial Collateral Arrangements, 56, 162–3 EU Directive on Settlement Finality, 31, 106, 157–8, 161–3, 198 EuroCCP, 170, 195–6 European Association of Clearing Houses (EACH), 53 n 33, 118 n 70 European Commission, 155, 157, 159, 160, 164, 165, 171, 192, 197, 198

F Federal Reserve Act, 47 Fiduciary, 87, 95 Financial collateral, 56, 105, 120 See also collateralisation; financial collateral arrangements Financial collateral arrangements, 56, 87, 101–2, 105, 120 See also collateralisation; EU Directive on Financial Collateral Arrangements Financial crisis (2007/8), 123–4, 128–9, 131, 133–5, 156, 165, 167–8 Financial innovation, 12, 132, 135–6 Financial regulation, 126–38 Gaps in, 128–9 Modes of, 132–5 Objectives of, 126–7 Purposes of, 127 Risk-based functional approach, 135–6 Scope of, 127–8

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Index London International Financial Futures and Options Exchange (LIFFE), 41, 197–8 London Mercantile Exchange (LME) SWORD System, 57

See also co-regulation Structures of, 128 Weaknesses in, 128 Financial Services Action Plans (FSAP), 155, 160, 192 Financial Services and Markets Act 2000, 140, 143 Part XVII, Chap 11, 149 Section 285(3), 154 Section 292(1), 144 Section 311&312, 150 Financial supervision, 128, 156 Finality, 31, 36 Fund transfer, 22–3, 30–1, 35, Free of payment (FOP), 62, 69, 72, 102

M Margin, 63–5 Initial margin, 63 Types of 63 Variation margin 63–4 Market charges, 148 Definition, 146 Market clearing house, 44–5, 51 See also bank clearing house; central counterparties; clearing house Market contracts, 144–8, 123, 153 Definition, 146 n 84 Market efficiency, 172, 185 Markets in Financial Instruments Directive (MiFID), 163, 198 Market makers, 57–8 Moral hazard, 124, 138, 175 Multi-market CCPs, 180–91 Multiple CCPs, 98, 188–9, 195–6 Mutuality, 111–2, 114

G Giovannini report, 39, 180, 194 Global Straight-Through Processing Association, 40 Government regulation, 141 See also public regulation; self-regulation Group of Thirty, 10–1 Goode, Roy, 9, 106, 107, 110–1

H N Holding, 19–20, 25–32, 57, 64 See also control Home and host, 159 See also home country control Home country control, 157–8, 163, 165, 198

National Securities Clearing Corporation (NSCC), 13, 78, 178, 186 Negotiable instrument, 28 n 92, 47 Netting, 62–9, 108–17 Bilateral netting, 66 Close-out netting, 116–7 Construction of, 116 Definition, 109–12 Multilateral netting, 114 Novation netting, 114–6 Purposes of, 108–9, 112, 114, 116 See also set-off Settlement netting, 112–4 Types of, 109, 111 Netting cycle, 66–9 Network effect, 188 Non-clearing member, 97, 83 n 44 See also clearing member; non-member Non-member, 76, 84, 96–98, 179 See also clients of clearing members Novation, 66–7, 75, 77–8 See also netting, novation netting

I Immobilisation, 1, 3, 25, 28, 200 See also dematerialisation Implied terms, 93, 96, 142 n 73 Indirect-holding structure, 19,25–7 Information asymmetry, 138 Investment Services Directive, 157 See also Markets in Financial Instruments Directive Inter-operability, 99, 127, 159, 182, 187, 199 International Swaps and Derivatives Association (ISDA) Master Agreement, 109

L Lamfalussy report, 155–6, 192 Level 4 approach, 155 LCH.Clearnet Ltd, 50, 57, 59–72, 98 Legal risk, 53, 73–5, 136 Lehman default, 171, 191 Lisbon treaty, 155

O Open offer, 12 n 12, 66–7, 75–6, 78, 81, 89 See also novation Office of Fair Trading (OFT), 149–50

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Index Omnibus account, 21, 26 See also segregated account Over the Counter (OTC), 11, 50, 154, 182

P Pari passu principle, 118, 153 Paper-form securities, 25, 28, 200 Payment instructions, 16, 22, 46, 63 See also settlement instructions Payment systems, 20–3 Inter-bank, 23 Large value, 16 Real time Gross Settlement (RTGS), 122 Post-trade infrastructure, 9–43 Challenges to, 10 Future of, 169 Role of, 10 Principal to principal, 5, 13, 84, 89–100, 112, 201 Principle-based regulatory regime, 134 Protected payment scheme (PPS), 57, 59, 62–3 Public regulation, 127, 131, 132–3, 167

R

Continuous Net Settlement (CNS), 24 Real Time Gross Settlement (RTGS), 24 Self-clearing, 17–8 Segregated account, 26 Set-off, 44, 108–112 Definition, 110 See also netting Types of, 110 Settlement, 11, 18 Settlement failure, 66 Settlement instructions, 42, 66, 71 See also payment instructions Self-regulatory Organisations (SRO), 132, 141–2, 143 Self-regulation, 132, 139, 141–4 See also co-regulation; government regulation Schwarcz, S, 25–6 SIS x-Clear, 98, 188, 195 SwapClear, 59 Straight-through Processing (STP), 22, 37 The drive towards, 39–41 The role of CCPs in, 41–2 Stock Exchange Automated Quotation System (SEAQ), 91

T

Receipts, 9, 49 See also warrants Recognition, 139–41, 196 Requirements, 139–40 See also UK regulatory regime, 143–54 The effect of, 152–4 Within the EU, 155–61 Recognised clearing house, 144 Registerable securities, 27, 28 Regulated market, 139, 144, 158, 163 Definition, 158 See also Over the Counter Re-hypothecation, 64 Replacement cost, 33–4, 53 Rings, 48 Ripatti, Kirsi, 175

Trade registration, 66–7, 80–2 Conditions, 80 Trading rules, 75–80 Timing, The significance of, 79–80 Transfer Finality, 31, 36 Tripartite relationships, 83, 93–4, 95, 201 The Treasury, 144–5, 149–50

U UK Regulatory Regime, 143–5 Exemptions, 154 Uniform Commercial Code (UCC, 1994), 27, 28–30 Article 8, 27, 29–30, 31 UK Companies Act 1989 Section 159, 108, 148

S Securities accounts, 21, 26–32 See also book-entry securities Types, 26 Security entitlements, 27–32 See also book-entry securities Securities Industry Association, 40 Securities intermediaries, 26, 29 Securities settlement systems, 23 Batch Net Settlement (BNS), 24

V Virt-X, 98–9, 188, 195

W Warrants, 9, 29, 57

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