Jodi G. Seariata

Jodi G. Scarlata was a visiting scholar at the Federal ReserveBank of St. Louis when this paper was written. David H. Kellyand Lynn Dietrich provided research assistance.

Institutional Developments inthe Globalization of Securitiesand Futures Markets

-anINANCIAL TRANSACTIONS such as the buy-

ing and selling of securities, commodities, foreignexchange and bonds, have increasingly involvedindividuals and firms from different countries.For example, a Japanese resident might purchaseU.S. dollars with Japanese yen (a foreign ex-change transaction) to buy shares of IBM on theNew York Stock Exchange (a securities transac-tion). To accommodate such transactions, futuresand securities exchanges have expanded theservices they offer their users, adding numerousfinancial instruments, engaging in cooperativeefforts across exchanges and introducing com-puter-based technologies.

The globalization of world markets providessignificant benefits, including greater opportuni-ties for investors to diversify risk, and access tobroader markets for demanders of funds. Inter-national trading in financial instruments, how-ever, does pose risks, some of which can bemitigated by coordination between global finan-cial markets.

This paper describes recent institutional de-velopments in the globalization of financial mar-kets and discusses the advantages and disadvan-tages of these innovations. The paper openswith a brief overview of the various transna-

tional developments that are occurring in worldsecurities and commodities markets. It then ad-dresses both the benefits of expanding financialmarkets and the costs that accompany the move.Risk factors and standardization of proceduresare highlighted as issues of concern as financialcenters globalize. The paper closes with a dis-cussion of the Group of Thirty proposal for thecoordination of clearing and settlement in worldsecurities markets.

The trend toward internationalization of finan-cial markets can be illustrated by highlightingthe rapid increases in transactions in a fewmarkets. For example, cross-country activity,when measured as the volume of foreign trans-actions in securities of U.S. firms (aggregatepurchases and sales), grew from $75.3 billion in1980 to $361.4 billion in 1990.’ Similarly, U.S.transactions in securities of foreign firms (aggre-gate purchases and sales) grew from $17.85 bil-hon to $253.4 billion between 1980 and 1990.2 In

futures and options markets, 20 new exchanges

lAbken (1991), p. 3. 2lbid

18

were established worldwide between 1985 and1989, bringing the total to 72.~Likewise, nearly40 million futures and options contracts weretraded worldwide in 1988, an increase of ap-proximately 186 percent since 1983.~Eurodollarinterest rate futures saw an especially largechange, increasing almost 70 percent annuallybetween 1983 and 1988.~

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The globalization of financial and commoditymarkets involves numerous activities and institu-tional developments that facilitate access to for-eign markets, whether by a trader or a security.One of these activities is the cross-listing ofsecurities in several countries. Cross-listing sim-ply means, for example, that a firm in the UnitedStates lists its stocks on a London exchange. In1990, the International Stock Exchange (ISE) ofLondon had one of the highest percentages (23percent) of foreign company stock listings.8

Another trend is cross-country hedging andportfolio diversification. A U.S. trader, for exam-ple, can diversify a portfolio composed of U.S.stocks by buying stocks of a U.K. firm in Lon-don through a London broker. Globalization canalso mean holding membership in another coun-try’s exchanges. For example, after “The BigBang” of 1986 in London, many US. securitiesfirms and banks apphed to buy seats on Londonexchanges!

A third trend in the internationalization offinancial markets is called “passing the book,”whereby control of trading is passed betweentraders at exchanges around the globe. Thisenables 24-hour trading of a financial instrument.An example of this would be a U.S. investmentfirm trading from New York during U.S. andJapanese hours and from its London desk duringU.K. hours. The more common practice of pass-

ing the position book between time zones is ac-tually to transfer the handling instructions be-tween traders. An example is a New Yorkcurrency trader who instructs the trader at hisSingapore office to track the price of a currencyduring evening hours in New York. When themarket reaches a particular price, the Singaporetrader will buy or sell, depending on instructionsfrom New York.

One trend that does not involve actual tradingis the underwriting of corporate securitiesthrough offices outside the home country. Anunderwriter is a firm that buys an issue ofsecurities from a company, then resells it to in-vestors. For the company issuing the securities,underwriting provides a guarantee that a certainamount of money will be derived from the saleof the securities that can be used for capital ex-penditure. A large stock issue may have under-n’riters from several countries, for example, tocompensate for a country whose capital marketdoes not have the depth to handle large securi-ties offerings.8 The distribution of underwritersacross several countries provides the issuingfirm with a wider access to funding.°Investors,on the other hand, obtain a broader selection ofsecurities.

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More recently, the development of automatedtrading has received substantial attention. Auto-mated or electronic trading systems allow agentsto make trades via computer, without the “openoutcry” or pit auction system.’°Interestingly,the development of much of the current auto-mation is an extension of technological innova-tions originally developed for domestic markets.It is clear, however, that this automation has af-

3Baer, Evanoff and Pavel (1991), p. 11.4lbid.5Eurodollar deposits are dollar-denominated deposits out-side the United States. Eurodollar interest rate futures con-tracts are futures contracts on the interest rates on thesedeposits. The figures are from Baer, Evanoff and Pavel(1991), p. 11.

6For the New York Stock Exchange, the figure was 3.7 per-cent. U.S. Congress, Office of Technology Assessment(1990), p. 29.7The Big Bang was a deregulation effort for British financialmarkets which began on October 27, 1956. Examples ofchanges to the London equity markets are the end of fixedcommission rates; barriers between order-taking brokers

established. The SIB is a non-governmental version of theSecurities and Exchange Commission (SEC) in the UnitedStates. Khoury (1990), p. 129.

8Depth means that there are enough buyers and sellers ina market that a large transaction will not affect the price.

9An example is the privatization of French companies in1986, where the value of these newly privatized companieswas approximately $30 billion, but the total value of list-ings on the Paris Bourse was only about $50 billion. U.S.Congress, Office of Technology Assessment (1990), p. 34.

‘°Openoutcry occurs on an organized exchange when ord-ers between buyers and sellers are traded between thirdparties in anonymity. The buyer/seller enters into a con-tract with the exchange or its representativeclearinghouse.and risk-taking market makers were broken down; and, the

self-regulating Securities and Investment Board (SIB) was

fected the globalization of financial markets con-siderably.

The National Association of Securities DealersAutomated Quotations (Nasdaq) was one of theearliest developments in financial market com-puterization, beginning in 1971. Nasdaq pro-vides computer listings of price information forseveral thousand companies. By 1982, the Na-tional Association of Securities Dealers (NASD)had produced the National Market System, whichprovided investors with information as saleswere completed, and by 1991, had developedthe Private Offerings, Resales, and Tradingthrough Automated Linkages (PORTAL) system.”From a computer terminal, PORTAL enablesusers to trade in unregistered domestic and for-eign debt and equity securities.”

Nasdaq has established computer telephonelinkage as well as automated trade executionand international clearing and settlement withthe International Stock Exchange of London andthe Stock Exchange of Singapore. Nasdaq hassince become a significant market for the listingof foreign securities, trading approximately $6billion in foreign securities as of 1991, up fromthe $2.6 billion in 1985.’~Thus, Nasdaq providesthe cross-listing of securities, together with therapid trade execution of an automated system.

The growth of international trading has alsoaffected futures and options exchanges in theUnited States. The fact that traders could accessinstruments and overseas markets after normalU.S. trading hours had ended, provided a motiva-tion for many of the extended-hour and 24-hourtrading initiatives (see shaded insert for examplesof extended trading hours and table 1 for auto-mated trading systems).

A significant portion of U.S. financial instru-ments, futures and options is traded at exchangesthroughout the world. That is, foreigners do nothave to use the Chicago Mercantile Exchange totrade Eurodollar contracts, a CME staple. For

example, in 1989, a third of the trade in con-tracts offered by the CME originated outside ofNorth America.’~In 1989, 10 percent of theCME’s daily volume was transacted overnight inan overseas exchange while the CME wasclosed.” Furthermore, in 1985, the CME andChicago Board of Trade together accounted for83 percent of all futures volume. By 1990, thefigure had fallen to 55 percent.’6 The attempt toregain market share instigated such CME expan-sions as extended trading hours and automatedtrading systems.

Perhaps the most ambitious project in auto-mated trading is Globex, an attempt to create a24-hour trading market originally proposed in1987 by the CME.’7 Globex is an electronic tradeexecution system whereby traders enter buyand sell orders that are matched automaticallyaccording to price and time priority.’~Originat-ing as a strictly off-hours trading system, thepurpose of Globex is to enable continued activetrading beyond the CME’s regular tradinghours. The CME intends to use Globex to accessmarkets after its own close of business and re-gain some of the market share lost to foreignexchanges.

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The significant changes accompanying the in-ternationalization of financial trading systems al-low for the realization of substantial gains; atthe same time, globalization also exacerbates therisks already present in financial trading. Themost significant of these gains and risks aredescribed below.

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One of the most important areas of progressis the speed with which information is processedand disseminated to market participants. In-creased flow of market data provides greater

“PORTAL uses a book entry settlement system with nophysical delivery, eliminating the problem of unmatchedtrades. PORTAL is currently the only fully automated clear-ing and settlement system in the United States. Clearingand settlement issues, book entry and matching trades willbe discussed in more detail later in the text.

‘2Unregistered securities are not registered with the Securi-ties and Exchange Commission (SEC). They are issued ina limited volume or by small companies.

‘35ee Nasdaq (1991), p. 16, for the 1991 figure, and NASD(1991), p. 15. for the 1985 figure.

l4Hansell (1959), p. 187.

“Ibid.‘6CheslerMarsh (1991), p. 33.

“The Chicago Board of Trade has since become a par-ticipant with the CME in the Globex project.

“For detailed reading on automated trading systems, seeDomowitz (1990).

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gy increases the familiarity of foreign corpora-tions and their operations. This spread of infor-mation reduces one of the traditional obstaclesto foreign investment and opens up both savingsand investment opportunities for firms and in-dividuals. The payoff is a more efficient alloca-tion of capital and, thus, a stimulus to productionand real output.

Likewise, the advent of almost immediatetransfer of information around the globe reducesthe informational discrepancies between marketparticipants. Arbitrageurs, of course, attempt toprofit from price discrepancies. The more peoplehave access to the same information, however,the more likely price discrepancies will be spot-ted and acted upon. The divergence of pricesfrom their no-arbitrage relationship (which pro-vides profit potentials), will be quickly arbitragedaway as both the quantity and speed of infor-mation transfer is enhanced!°

Another benefit of internationalization is ac-cess to markets otherwise inaccessible. As men-tioned earlier, the Chicago Mercantile Exchangewill be accessible after regular trading hoursthrough Globex. Not only will U.S. traders nowbe able to operate after U.S. trading hours, butforeign traders can also use Globex to operateduring their own regular trading hours. Newmarkets enable investors to introduce diversityinto their portfolios in both the type of instru-ment and the country from which it is issued.Just as computerized systems, such as Globex,facilitate diversification and accessibility, so toocan other methods, such as cross-exchange list-ings and cross-memberships.

Trading in financial assets, whether donedomestically or across national boundaries, in-volves risk. Some of these risks are more impor-tant in an international setting than a strictlydomestic setting. They occur primarily at vari-ous stages of the clearing and settlementprocess. Unlike risks commonly associated withprice uncertainty, the risks in clearing and set-tlement procedures involve uncertainty aboutthe timely payment of funds and the transfer ofassets in financial trades.

An example of a typical securities transactioncan provide a clear illustration. Once a securitiestrade is executed, the member firms involvedsubmit the trade information for confirmationto the clearing agent. The trade is then com-pared and matched by computer for accuracyand the information on the trade is sent to therelevant members on either the day of thetrade or the day after. If both parties concurwith the conditions of the trade, the trade isready for settlement. At present, settlement insecurities occurs five days after the trade in theUnited States.

Using this example, the next section will brieflydiscuss the concepts and institutions in clearingand settlement procedures before introducingthe specific risks of globalization.

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“Clearing” a trade involves the confirmation ofthe type and quantity of the financial instru-ment being traded, the transaction date andprice, and the identification of the buyer andseller. “Settlement” means the fulfillment of theobligations of the transaction. In equities andbonds, for example, settlement means paymentto the seller and delivery of the security certifi-cate or transfer of ownership to the buyer.

The clearing and settlement process dependson the institutions that facilitate transactions.Commodities and securities exchanges providethe facilities for traders to conduct their busi-ness, establish and enforce trading rules, collectand distribute market and economic informationabout prices, and provide an institutional frame-work for arbitrating and settling disputes.

Another institution—the clearinghouse—compares trades between parties and can re-move risk from the settlement process.2’ Aclearinghouse places itself between the buyerand seller, ensuring that the buyer receives theinstrument purchased and the seller receivespayment. That is, by becoming the counterpartyto all trades, the clearinghouse guarantees everytrade. Each participant has a net obligation withthe clearinghouse to buy or sell the security

t0An example of a no-arbitrage condition is that the differ-ence between the cash and futures price of a storablecommodity, at any point in time, should reflect carryingcosts of storing the commodity until maturity. If the pricedifferential exceeds carrying costs, then there exists an in-

centive to enter the market, that is, to buy today and sellat the higher futures price.

21Trade comparison involves confirming and matching theterms of the trade to ensure accuracy.

Table 1Automated Trading Systems

Systemt ____~R9nsor Purpose Instruments

Access New York Mercantite Computerized screen traoing Energy futures and futures-Exchange (NYMEX) system to automatically match options for crude oil. heat-ng

trade on a first-in-first-out oil, gasoline, propane aridbasis. Allows traders lo natural gasselect a standtng bid or offer(but are blind to thecounterparty chosen).

Automated Pu Trading London International Intenoed to extend tradung FT-SE 100 index futures andCAPT) Financial Futures hours to cover European most of LIFFE’s main

Excnange (LIFFE) trading day Its aim is to contractscopy the life o’ the tradingfloor on to a computer screen

EJV (Electronic Joint Gollaooration between Trading system that allows Currently restricted toVenture) F:rst Boston. Goldman dealers to buy and sell Treasury bills and notes with

Sachs. Morgan Stanley. securIties electronically maturity of less than threeSalomon Brotners. using voice-activated computer years Once established, itShearson Lehman and tecnnology. Also provides expects to extend cove’ageCitbank price and analytic services to all maturit.es

Euroquote European Community (E~ A European-wsde share trading EC stocksnational stock exonanges system Wit combine prco infor-

mation from 12 EC exchangesinto an electronic feed f

0r sub-

scribers Eventually. may oe-come a full trading system andintegrate Euroquote wth a set-tlement system to decrease thecost and difficulties of settlingcross-country transactions. (Thisproposal has since been aban-doned by the chairmen of Eu-ropes national stockexchanges)

Globex Chicago Mercantile An automated t’ading system Traded instruments will beExchange (CME). Reuters w:tt, anonymous buy and sell :ntroduced in three separateand Chicago Board of orders that are matched Dy waves 1) financial futuresTrade ~CBOT) price and t-me (See text and options e.g - Eurodoltar

for detailsi futures, futures and optionson Eurodollar currencies_Deutschemark. yen poundsterling. Canadian and A’us-t’alan dollars Swiss francLIBOR. and US Treasurybond aid note futures aidoptions. 2) equity-relatedprooucts: ano 3) aq’iculture-related futures.

23

Table 1 (continued)Automated Trading Systems

Systemt ..J!°~L. Purpose — _~jnst~p~ftts —

Quotron System Inc Current testing of the Joint protect to develop a Trades •n foreign excnangeprototype nvolves Tne computer system tiatBank ot America. Barclays automatically matches anoBarnc. Chase Manhattan executes ioreign exchar-geBank. Cnemical Bank. traoes.Citibank. ~red’t Suisse.Lloyds Banic. Midland Bank.Morgan Guaranty NationalWestminster. Swiss Bankcorp. and Union Bank ofSwrtzertand.

Swss Options and Owned by Switzerlands Fully automated trading and Futures and options on the 13E~nancialFutures three leading stock clearung system. where undertytng stocks and theExchange ~SOFFEX~ excnanges and tve quotes and orcers are Swiss Market Index tSMll a

largest banks recorded sorted and basket of Swtzerlands 24matcned automatically leading stocksThe computer screen is com-posed of five segments. eachw.th oifterent types ot unforma-ton and automatically updateothroughout the oay.

tOf these systems. only LiFFE’s APT system ano SOFFEX are currently .n operationNOTE For a more extensive survey ot automated systems. see Peter A. Abken Glooatizat.on of Stock Futures. and

Options Markets. Federal Reserve Bank of Atlanta Economic Review ~July/August1~91l

based on her net position with other participantsin the clearinghouse.

A third institution—the depository—is an or-ganization (not necessarily part of an exchange)that holds stocks and bonds for safekeeping onbehalf of their owners. It has a computerizedaccounting system to record and transfer owner-ship of securities between participants by in-tegrating a book-entry system with a moneytransfer system.22

The procedures for clearing and settlementvary across countries. At present, there arethree common methods of clearing and settle-ment. Each involves various combinations of thethree central institutions involved in futures andsecurities markets.

The first model is exemplified by the UnitedKingdom’s equities market. In this model, thereis neither a central depository nor a separateclearinghouse. Instead, the stock exchange itselfis responsible for trade matching and confirma-tion as well as providing a location for the deliv-ery and receipt of securities and payments be-tween traders.~~

The second model, exemplified by Germany’sDeutscher Kassenverein depository system, hasno independent clearinghouse, but does have acentralized depository and a stock exchange thatprovides the matching and confirmation oftransactions. Once matched and confirmed, thetrade information is sent to the depository forsettlement.~~

22A book-entry system means a credit or debit to a cus-tomer’s account will transfer securities between buyer andseller. A money transfer system transfers the funds be-tween the parties to the trade, such as a wire transfer

23U.S. Congress, Office of Technology Assessment (1990),p. 5B.

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The third model, as seen in the U.S. equitiesmarket, contains all three institutions: a stockmarket, a central depository and an indepen-dent clearinghouse. For example, the NationalSecurities Clearing Corporation (NSCC), whichprocesses 95 percent of all equities trades in theUnited States, is jointly owned by the New YorkStock Exchange, the American Stock Exchange,and NASD.25 The majority of the securities forNSCC members, in turn, are held by the Deposi-tory Trust Company. The stock market and clear-inghouse together match and confirm transac-tions. The clearinghouse also places itself be-tween counterparties to trades, then passestrade information to the depository.28

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Credit (or counterparty) risk occurs when oneside of the transaction does not settle in full,either when due or on a later date. The exis-tence of counterparty risk, which is of minimalsignificance in many U.S. markets because of aclearinghouse, can be critical in an internationaltransaction. The clearinghouse, generally wellcapitalized, guarantees that all trades will be hon-nored. In many international transactions, how-ever, no clearinghouse exists. Thus, a traderlacks information about the counterparty’s relia-bility. Varying regulations on foreign tradingmay make it even more difficult to ascertain thesafeguards available to a trader in that market.

Closely related to credit risk is liquidity risk,which is the risk that trades will not be settledat the appointed time, but at some undeterminedtime thereafter.27 At settlement, counterpartiesare exposed to both credit and liquidity risks.Liquidity risk occurs because settlement maynot occur on the specified date; credit risk occursbecause the other party may not deliver at all.Thus, at settlement, the parties may not knowwhether the problem will be one of liquidity orcredit. The settlement of international trades

can exacerbate the problem of simultaneouslyexchanging securities for payment because oftime zone differences.28

Another risk, replacement cost risk, occurswhen the price of the security changes betweentrade and settlement. When one party has de-faulted and the price of the instrument changes,then one of the parties involved would be ad-versely affected by the price change and suffer’a loss in replacing the transaction. In foreignmarkets, the potential for adverse changes inthe exchange rate can exacerbate this risk.

Operational risk occurs because of the possiblefailure of computer systems, telecommunicationsor institutionalized procedures during trading.Given the heavy reliance on technology in ac-cessing financial markets abroad, this issue is ex-tremely important in determining the success orfailure of new trading systems. The precautionstaken by the CME for its Globex system—an im-portant part of its initial proposal to the Com-modity Futures Trading Commission, a govern-ment regulator of futures exchanges—are a goodexample of this.29

Yet another risk, especially worrisome to regu-lators, is systemic risk. Systemic risk occurswhen credit risks stemming from operational orfinancial problems result in agents exiting themarket, which, in turn, threatens the industry.The inability of one financial institution to makeits payments can cause other participants to beunable to meet their financial obligations in atimely manner. In the banking sector, this istypified as a run from deposits to currency. Infutures and options, it occurs when agents nolonger trade through standard channels like anexchange. For example, if members of an ex-change begin trading elsewhere, the financialstability of the exchange is threatened as mem-

bers withdraw their financial collateral.’°

25U.S. Congress, Office of Technology Assessment (1990),p. 81.

tmmFor related readings on clearance and settlement systems,see the monographs prepared by the Payment SystemStudies Staff of the Federal Reserve Bank of New York inthe references to this paper.

27A temporary inability to convert assets into cash is oftenassociated with liquidity risk while bankruptcy of a counter-party is associated with credit risk. For a more detaileddescription, see Federal Reserve Bank of New York(February 1989).

29Examples of CME precautions include measures to pre-vent unauthorized individuals from accessing the system,such as four different identification codes; termination of acomputer operator’s session if nonstandard instructionsare entered; and, in the failure of the central computer,recovery would involve automatic switchover to a back-upmainframe, taking approximately 60-90 seconds. SeeCFTC (1989), pp. 125-32.

3mFor further reading on systemic risks, see OECD (1991).

2mFor further reading on market risks, see Baer and Evanoff(1990).

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The October 1987 stock market crash, withworldwide repercussions, revealed weaknessesin the clearing and settlement system. Manyfeared that the default of a major market playercould threaten the financial systems of manycountries. This prompted world financial lead-ers to work toward global coordination. Theclearing and settlement of trades was consi-dered one of the most crucial aspects of thiscoordination.

In 1989, the Group of Thirty issued a report,Clearing and Settlement Systems in the World’sSecurities Markets.31 Based on its examination,five critical deficiencies in the clearing and set-tlement systems across countries were iden-tified:

[1] Absence of compatible trade confirmationand matching systems for both domestic andinternational trades;

[2] Varying settlement periods across the differ-ent markets;

[31 Absence of delivery versus payment in somemarkets;

[4] Absence of standardized trade guarantees;

[5] Absence of book entry processing for settle-ment of securities transactions in severalmarkets.

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Trade confirmation and matching, also knownas trade comparison, is the process of confirm-ing and matching the terms of a trade to ensureaccuracy (for example, the issue, price, quantityand counterparties) and is usually done by aclearinghouse (although sometimes by an ex-change or by the parties themselves, in the for-ward foreign exchange market). If not confirmedand matched, a chain reaction of failed trades ispossible as subsequent trades are made on theassumption that earlier trades will be success-fully completed.

Rapid trade comparison shortens the amountof time between when the trade is made andwhen it is successfully matched. This reducescredit risk by reducing the amount of time an

agent has to opt for defaulting on a trade. Inthe international context, delays of hours in adomestic market may result in a delay of daysfor international trades. Requiring all investorsto obtain membership in a trade comparisonsystem and achieving a compatible system acrossinternational markets can reduce the delays andcredit risks involved in diverse systems.

The second deficiency is unequal settlementperiods, which can increase settlement risk andpotential default. Settlement t1sk occurs whenthere are gaps in the timing of payments andreceipts on settlement date.32 The harm of dif-ferent settlement periods is that, as mentionedearlier, traders or investors who are active par-ticipants in the market make later trades contin-gent on the assumption of the successful settle-ment of earlier trades. Hence, the harm is two-fold—the default of an earlier counterparty andthe dependence on this trade that couldjeopardize subsequent trades. As with manytrade issues that require timeliness, delays insettlement can be exacerbated if spread acrossdifferent trading hours and time zones.

While this is costly in a domestic market, theinvestment of a U.S. agent dealing in interna-tional markets can be even more costly becauseit is also subject to the economic conditions offoreign countries and exchange rates. Adversechanges in the exchange rate can turn a minorloss into a significant one in the presence ofcurrency risk. i’hus, for agents moving betweeninternational markets, an uncertain settlementperiod combined with an uncertain exchangerate can increase financial losses.

The growing volume of trades has led to anumber of techniques where, to reduce thenumber of settlement transactions, trades arenot processed one at a time. ‘Netting” is a sys-tem whereby transactions are aggregated, sothat debit and credit positions offset each other,leaving a participant with one final position inthe market of owing or being owed. Nettinggreatly increases the liquidity of the market andthe trader’s flexibility because, rather than post-ing collateral for every trade, the trader isresponsible only for the net settlement dehit.~’

31The Group of Thirty is a private sector organization thattakes its membership from financial sectors such as ex-changes, banks and investment houses.

32Setttement risk encompasses both liquidity risk and creditrisk.

33Board of Governors of the Federal Reserve System andthe Federal Reserve Bank of New York (1990), p. 40.

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26

There are three main choices for a nettingsystem- The first is bilateral netting, wherebyall trades in the same security and between thesame parties to the trade are netted to one finaldelivery versus payment (DVP).34 For example, ifRalph sells 100 shares of British Mohair to Sam,then buys back 75 shares of British Mohair fromSam, the net position is that Ralph must deliver25 shares to Sam. This is the narrowest of thethree netting options.

The second is multilateral netting (or dailynetting), which, unlike bilateral netting, allowsfor different counterparties in the nettingscheme. In this instance, all trades in the samesecurity are netted to a final debit or credit po-sition for each participant.

The last option is continuous net settlement,whereby all trades in a particular security arepooled by issue to a final debit or credit posi-tion for the day and any unsettled trades arecarried over and offset against the next day’strades. In practice, the clearing corporation sub-stitutes as the counterparty to the trade in con-tinuous net settlement.

The type of netting system implemented de-pends on the volume of the market. Establishinga multilateral or continuous net settlement sys-tem is a costly procedure, requiring a risk-sharing arrangement among members, a clear-ing corporation (as with continuous net settle-ment) and powerful computer systems to handlethe volume of trades. The costs of such a sys-tem may exceed the costs of operating withonly a bilateral system. This is especially true inlow-volume markets where bilateral netting canbe a feasible and less costly alternative. A pro-posal for a multilateral netting system in thehigh-volume foreign exchange market was exa-mined in 1988 by members of FXNET, a bilater-al netting system.35 Representatives of leadinginternational banks, responding to FXNET’s ques-tionnaire, felt that a major benefit would be toreduce processing costs.36

This is especially relevant in markets expand-ing their foreign membership. If netting is desir-able because it reduces the number of trades to

~~DVPis a payment system whereby the debits and creditsof a trade are applied to the parties’ accounts simul-taneously.

35For further reading on the netting of foreign exchangetransactions, see Gilbert (1992).

36Minutes of FXNET Multilateral Netting Steering Committee,(1989).

process, it becomes even more so as marketsservice no longer just domestic, but a growingnumber of foreign clients. In the FXNET ques-tionnaire, respondents stated that, “Cross-borderaspects of multilateral netting should be consi-dered early in the process, as they will be moreimportant than with bilateral netting.”37 Withthe addition of cross-border traders increasingthe transactions volume a market handles, anetting system would simplify the re-peated payments that would be introduced.

Whichever netting system is chosen, the desir-able settlement time frame is a rolling settle-ment system. In such a system, trades settle onall business days of the week, scheduled thesame number of days after the trade.3°Thus,the presence of a standardized settlement periodand a netting system is a crucial aspect to mov-ing between international markets with securityof settlement.

CC/i,, .t’nnnent

The third finding by the Group of Thirty isthe absence of delivery versus payment (DVP) insome markets. DVP is a two-sided payment sys-tem that simultaneously debits or credits thecash account of one member and makes thecorresponding entry on the securities side ofthe transaction. This reduces the settlement riskthat occurs when there is a discrepancy be-tween the timing of payments and receipts onsettlement date.

The Group of Thirty, arguing the need forprompt two-sided payments, has recommendedinterim procedures: risk can be reduced by de-livering securities only against a certified checkor by employing a mechanism whereby deliveryand payment are done simultaneously althoughthrough different systems. In either case, netsettlement of cash and securities is completedby the end of the day.

Even without a formalized DVP, methods canbe developed to minimize settlement risk byhaving both parties to a trade settle their ac-counts simultaneously. With markets in differenttime zones and, thus, different operating hours,allowing each side of a trade to settle at a differ-

“Ibid.~°TheGroup of Thirty recommends the implementation of a

rolling settling system by 1992 so that final settlement oc-curs three days after the trade.

tr~C’CAACAC ~CCAC,C: cCACCCC’ ,.flrC’~C~C CCC

ent time could result in a next-day payment, notone within the hours of the first settlement.

The fourth deficiency is the absence of stan-dardized trade guarantees. A trade guaranteeensures that all compared or netted trades willbe settled, based on the conditions on whichthey were compared, even in the event of coun-terparty default. To assure trade guarantees,each member of the comparison and nettingsystems assumes the default risk of the system.

A standard method of providing a guaranteeis to establish a general clearing fund based onmember contributions. When a default occurs,the losses are first extracted from the defaultingparty’s clearing fund contribution. If that contri-bution does not meet the full amount of the loss,the remainder is charged against the clearingcorporation’s general clearing fund.

The international environment adds an extrafacet to these guarantees. Since membership isbecoming increasingly international, a majorfinancial loss can strain the capacity of the cor-poration to handle the failure immediately. Ob-taining permission for access to additionalfunding, for example, could cause unnecessarydelays. Thus, the maintenance of additionalsources of funds, like member deposits or ac-cess to bank lines, becomes crucial in an inter-national setting. To ensure the integrity of thecorporation and, thus, the market, trade guaran-tees provide a measure of security and stabilityin the face of potential failures.

The last issue to be addressed in global coor-dination is the absence of book entry processingfor settling securities transactions in severalmarkets. Before addressing book entry, howeyer,other institutions surrounding this processshould be introduced.

The first of these is a central securitiesdepository (CSD).~~The primary activity of aCSD is to immobilize and dematerialize securi-ties so that they can be processed in the moreefficient book entry method. Immobilization of

39The strict definition of a CSD requires that a countryshould have only one depository. In practice, however,more than one may exist. This type of system can be ef-fective as long as there is linkage between the entities tocoordinate trade information. The United States has sever-al depositories.

securities means that the physical documents(for example, share certificates) are stored atthe depository, eliminating their actual move-ment when ownership changes. Dematerializa-tion means that no physical securities with titleof ownership are issued. Securities exist solelyas computer records.

Transfers of certificates are done by book en-try, where a simple credit and a balancing debitto customers’ computerized accounts on thebooks of the CSD will transfer securities fromone account to another. Immobilization and de-materialization replace the more risky and time-consuming process of transferring the securitiesin paper form whenever a transaction is made.Transfers of stocks trade-by-trade introduce aneedless complication to the clearing and settle-ment system, which becomes even more compli-cated if it involves delivering them to investorsworldwide.

The Group of Thirty has proposed ninerecommendations found in table 2 to correctthe preceding five deficiencies. The status of theGroup of Thirty recommendations are listed intable 3. This table depicts the extent to which21 countries have made progress on theserecommendations. While the United States hasaccomplished more than most of the countriessurveyed, the fact that so many countries havenot finalized these policies, and may not by1992, has implications for the eventual timetableof global coordination.~°

Currently, there is no well-defined regulatorystructure for the global marketplace. Whileregulatory authorities exist in specific countries—for example, the Securities and Exchange Com-mission has the regulatory authority, oversightand arbitration of securities disputes in the U.S.stock market—the international arena has nosimilar agency to govern global financial rela-tions. In its absence, voluntary coordination ofclearing and settlement systems can help reducethe risks that lead to defaults, failures and po-tential disputes between legal and regulatoryauthorities. Thus, there are potential gains if

4eIn addition to the Group of Thirty proposal, other groups,such as the Working Group on Financial Markets havestudied clearing and settlement issues.

Table 2Group of Thirty Recommendations

The fol~ovwngare nine recommendations put forth by the Group of Th’rly to correct tne deficienciesit tunas in the coordination of clearing and settlement syslemslne numbers in brackets a’e tne rele-vant defcuencues presented in the sectuo-i. Global ~oordunatuon.that these recommendations address

• By 1990. all comparisons of traoes between aired market particupants Ce.. brokers, brok-er/dealers and other exchange members) should be accompI~shedby T. 1 (the first day &terthe trade). [1]

• Indirect market partucupants (such as ,nstututionai investors or any tradng counterparlues tnatare not broker/dealersl shoulo. by 1992 be members of a trade comparuson system thatachuoves positive affirmation of trade deta’ls. 11]

• Each country should nave an effect,ve and fully oevelopod central securities deposutory. or-ganuzod and managed to encourage the broadest possuble undusvy particupat!on tdu’ectlyand indu’-ectly) o~1992. [3 5~

• Each country shoulo study uts marKet volume and partuc’patuon to determune whethe~a tradenettung system would be benefucual •n (arms of ‘educng risk and promot;ng effucuency If anettung system would be appropruate. it should be umplementeo by 1992. ;2~

• Deluvery versus payment (DVP) should be employed as tne method for settlung all securt’estransactuons. A DVP system should be un place by 1992 ~3 5]

• Payments assocuated wuth the settlement of secur t.es transactuons and the servucng ofsecurutues porlfolios should be made consustent across all unstruments and mar..ets by adopt-ing the same day funds conventuon. [21

• A Rolling Settlement” system should be aoopted by all markets. Final settlement shoulo oc-cur on T+3 by 1992 As an ruer:m target. funal settlement should occu’ on TkS by 1990 atthe latest, save only where ut hunders the achuevement of Ti 3 by 1992 ~2]

• Securt:es lendung and borrowuna should oe encourageo as a method of expedutnq the set-tlement of secur.t.es transaciuons. Exustunq regulatory and taxaton barruers that ,nhubrt thepract.ce of lendung securtues should be removed by 19902 [~1

• Eacn country should adopt the standaro for securufles mossages developed by the Interna-tuona Orgar’uzatuon for Standardizat,on [ISO Stanoard 7775] In part;cula~countrues shouldadopt the SIN numnerung system for securutues ssues as derned in the ISO Standard 6166.at east for coss-DorOer transactions Tnese standards should be universally appIueo by1992.

‘Group of Thirty tMa-cr 1989).For info’mation on securutuos ler.dng. see Paul C Lipson. Bradley K. Sabel. arid Frank Keane. Secu-rities Lending (Fede-al Rosarve Bank of New York. August 1989)

tlit (liLttitlt2 LIM(I -,t’ttli’rtuu-rui .,\~tirtN iipt’r~iliI1t2 iii lnli-rri,ititurr;ui i’timrIi’tiliiuri tirititig tiriauuiiil

cii,ruui’,,lu- rl1Ltrl~t’t.,arc iiuir’iiu!l;ited .trtrcu!lg global market, i’~!mining rapiull\ and ha,~in-~diui’illiritriti,il rui,ir’kt’t-, hi-ru-lit. ‘~urhas urn titraririal ii-.triiriluriK lien

rirLirkets ,ititl t’\ltiiiliii ti’adiii~houir’. I lti—’,ei’ilititiZt’7. liiit~i’\ Vt ate unit nit hunt ru,.ts. I )ninr,—tic rule—. arid n-gttlatiuri LilY riot .iitlirteril~al’rguartk tin a ..\sIlirr lli,tl rrj)i’r’.ilt’. iii itt iii

I HR tlisrtis~iouiha’ attempted tu prr-~c’uttart rr’ea~nigl~iiitvrriali trial i-un rr’onriiint.in tn len ol i~~ite~that art’ u-u_i rrenIl~ tit intere “I and iii~ci rrrrrrntal rurnrmirutii’~ ar-i’ acldi-essiuigri the ~Iuhalciatiuut nt hiram-jul market.. I lit- hr rwrtl to iriregr.ite nti’r-nati,utal e\liati~iiili to

h’rkzigt— among iiittrtiattnriai mar ket~I~ it in— rarjhtate the ronti iui’cl sate andteri-,l both Iii pu-Rate inn t—,tnr’ ,utul tn riLitiiiuill gi’tinth il tirizilithil in,,tflnllvtit5 ,uid thui4tnernlnii-uit.—, n liii ch’’,irv stalilt duune’.tjc ,nntl tant tluntrti lit. llti”~emarkets -.enc II is iliarintir’rlttinriLil tiuanciiil surtili’-,. that trim-h \\ ni’k rerllani~.

Table 3Current Status of the Group of Thirty’s Recommendations for InternationalSettlement—EquitiesRecommendation Ne I 2 3 4 5 6 7 8 9

Institutional Central Delivery RollingComparison Comparison Seountles Securities versus Settlement Same-Day Securities

Country on Ti-P System Depository Netting Payment en T-i-52

Funds 1SOIISM Lending

Austratma Yes No No No Yes Open No No YesAustria Yes No Yes No No Weekly Yes No NoBetgium No No Yes No Yes Fortntghtty Yes No YesCanada Yes Yes Yes Yes Yes T-i-5 Yes No YesDenmark Yes No No No Yes T÷3 Yes No YesFintand Yes No No No Yes 1÷5 No No NoF ance Yes No Yes No No Monthhy Yes No YesGermany Yes No Yes No Yes T-i-2 Yes No NoHong Kong Yes No No No Yes T+1 No No Limitedttaty Yes No Yes No Yes Monthly Yes No LimitedJ pan Yes No No Yes Yes 1÷3 No No YesKorea No No Yes No Yes T-i-2 NQ No NoNethertands Yes No Yes Yes Yes T 5 No No YesNorway Yes No No No Yes 1+6 Yes No NoStngapore Yes No No No Yes 1-i-S No No YesSpain Yes No No No No Weekly No No L’mttedSweden Yes No Yes No Yes I S No No YesSwutzertand Yes No Yes No Yes T÷3 Yes No YesThailand Yes No Yes Yes Yes 1±4 Yes No NoUnited Kingdom Yes Yes No Yes No Fortnightty No No LimitedUnited States Yes Yes Yes Yes Yes I S No No Yes

SOURCE Updated by the Office of Technology Assessment, July 1990 from A Comparative View The Group of Thirty’sRecommendations and the Current US National Clearance and Settlement System (Morgan Stanley & Co June 1989).11÷1means the first day after the trade

21÷5 means five days after the trade

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