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Securities Settlement Systems
C H A P T E R
50 Securities Settlement Systems D.C. Donald The Chinese University of Hong Kong, Shatin, Hong Kong SAR, China
O U T L I N E Definition
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Disadvantages of the Depository Model
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The Legal Requirements for Transferring Securities
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Ameliorating the Disadvantages of the Depository Model
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The Creation of the Contemporary Depository Model
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The Legal Characteristics of Settlement in the Currently Dominant, Depository Model
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The Future of Securities Settlement Glossary Further Reading Relevant Websites
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DEFINITION Securities settlement is the process of transferring to the buyer ownership of the security bought and to the seller ownership of the purchase price. On an organized securities market, trades occur through the matching of orders on an order book, in an auction, or by a market maker. The work of a broker or dealer in executing such orders can be thought of as the ‘front office’ work of the securities market. The matching of orders is then followed by the ‘settling’ or fulfillment of such orders. This process of securities settlement is often referred to as the ‘back-office’ function of trading, as it actually takes place ‘post-trade.’ Beyond the contractual commitment to deliver a specific amount of securities or cash, settlement conveys ownership of such securities or cash to the buyer or seller, respectively. Securities settlement is determined by four primary concerns. First, settlement must fulfill the legal requirements for transferring ownership of the relevant securities from the seller to the buyer and must therefore fulfill the requirements of applicable property and commercial law. As securities settlement avails itself of existing systems for interbank funds transfers (see Payment and settlement systems in this volume) to make cash payments, attention is focused primarily on delivering property in
Handbook of Key Global Financial Markets, Institutions, and Infrastructure http://dx.doi.org/10.1016/B978-0-12-397873-8.00035-9
securities, rather than in cash. Second, the settlement process as a whole should be safe, so that if an entity serving as an intermediate link in the process were to enter insolvency while securities or cash are in its possession, ownership of such securities or cash would unquestionably rest with the buyer or seller rather than the insolvent entity. Third, the process must be efficient and cost-effective, so that the market it serves can compete internationally. A factor related to efficiency in some markets, such as the European Union, is that national systems of settlement should be able to connect to each other to allow transnational trading; this is referred to as ‘interoperability.’ Fourth, settlement should preserve the nature of the transferred securities so that security holders can exercise the rights certificated in the security against the issuer. This last aspect of securities settlement has been given a much less central position by regulators than the first three. Rather, the impact of securities settlement systems on shareholder and bondholder rights has been typically raised by regulators and scholars focusing on corporate governance and the collective action of bond holders. As securities are becoming less likely to be evidenced by paper, and more are ‘uncertificated,’ evidenced only electronically through entries in registers, those aspects of the settlement process designed to overcome the obstacles connected with transferring
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paper certificates should gradually be replaced by processes with a less disruptive impact on the rights of shareholders and bondholders.
THE LEGAL REQUIREMENTS FOR TRANSFERRING SECURITIES In most jurisdictions, securities exist in both ‘bearer’ and ‘registered’ forms. Although these two forms have different requirements for effective transfer, both forms have in common that they are ‘negotiable instruments,’ whose certificated rights and face value are not affected by the claims of third parties when transferred to a good faith buyer without knowledge of such claims. This aspect of ‘negotiability’ makes a market for securities possible in a way that, say, a market for mortgage loan contracts is not, because the buyer receives the security free of all unknown claims a third party may have against the seller. This dramatically reduces transaction costs. Buyers need not undertake an investigation into the history of the securities they purchase, provided that they take the securities in good faith (bona fide) without knowledge of any claim against the seller’s title to the security. This shield for commercial activity, a creature of law, is found in most jurisdictions. In order for securities to enjoy negotiability, however, the law requires that the instruments have certain characteristics and that their transfer meets certain requirements. Pursuant to the commercial and property laws of many jurisdictions, bearer securities merely require a voluntary transfer of possession, and thus are relatively simple to transfer. As the certificate itself is the only proof that the bearer may exercise the rights embodied in the security, due presentment of the certificate is both necessary and sufficient to exercise such rights. The main obstacles to the safe and efficient settlement of transactions in bearer securities are thus posed by the physical bulk of the paper and risk of losing certificates. If the securities are held in the vaults of a trusted intermediary, a transfer of ownership can also take place by the seller instructing the intermediary henceforth to hold the securities for the account of the buyer, rather than the seller. This dramatically reduces the two primary risks connected with transferring bearer securities and leads to transactions centering on claims against the intermediary rather than the securities certificates themselves. The principal difference of registered securities is that the rights attaching to the security may be exercised only by the named person or her agent. Transfer therefore involves a change in the registered owner of the security. Early registered securities, such as those used by the seventeenth-century Dutch East India Company, were often uncertificated, and thus could be transferred only through amendment of the company’s register of
members. When registered securities, particularly shares of stock, are certificated, they have a number of legal requirements for the effective transfer of all certificated rights. At the most basic level of property law, ownership of a registered security may also be transferred by a simple, voluntary delivery of possession of the certificate. This would be a transfer of ownership of a registered share without endorsement or amendment of the register of security holders, just as is done for the transfer of a bearer security. However, a buyer who receives delivery of an unendorsed registered share would likely neither be able to demand entry on the register of members nor have good title as a bona fide purchaser in the face of competing claims to the security. In this way, there would be no ‘negotiability’ in the transfer, and as explained above, such negotiability is the main reason for using the security form. A broadly applicable formulation of the requirements for achieving negotiability is found in Article 8 of the US Uniform Commercial Code, which in turn resembles those of the Convention on International Bills and Notes prepared by the United Nations Commission on International Trade Law (UNCITRAL). Under Article 8, }8-303, in order to qualify as a ‘protected purchaser,’ the buyer of a security must (1) give value, (2) not have notice of any adverse claim to it, and (3) obtain control of it. A ‘protected’ purchaser acquires the transferred interest in the security free of any adverse claims. The concept ‘protected purchaser’ (rather than the more traditional figure of the bona fide buyer) receiving a negotiable instrument originated in the UNCITRAL Convention. The most effective form of ‘control’ over a registered security is to have it registered in the holder’s name, and thus the requirements for rightfully demanding registration can be seen as indirectly contained in the statutory definition. Further, the concept of ‘good delivery’ in connection with a transaction on a securities market may include provision of assistance as necessary to effect the buyer’s registration in the security holders’ register. To this end, the purchaser may demand that the seller provides proof of authority to transfer and other documents requisite to obtain registration of transfer. Such other requisite documents could include a signature guarantee, letters of administration, and tax documentation. If a signature guarantee is provided, the guarantor will bear any costs arising from a lack of authority to transfer. The transfer processes described above show that, for bearer securities, holding the certificates in an intermediary can reduce costs deriving from the transport of certificates as well as the risk of their loss, and that, for registered securities, even in a direct transaction between seller and buyer, the transfer of a certificated registered share entails a significant amount of paperwork. Either the certificate or a stock power must be endorsed by the seller, the signature guaranteed, authority to
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transfer title documented, and the stock certificate and the other documentation delivered, not to mention the registration of transfer on the stockholders’ list, the destruction of the old certificate and the issue of a new one. Because a transaction on a securities exchange will involve more parties, the necessary paperwork increases, as each party demands the basic documents plus any others considered necessary to decrease risk. On a market using manual securities settlement, the transaction could entail the following: If a seller is not a broker, dealer, or market maker, he will instruct a broker to sell and the broker will transfer the order to the exchange floor/trading system or a market maker, where it will be matched wholly or partially with one or more buy orders. Once the order is executed, the seller will have to deliver the executed certificate to his broker so that the selling broker can deliver it to the buying broker, market maker, specialist, or central counterparty (CCP). Once the buying broker receives delivery, she will have to deliver to the issuer’s transfer agent with a request for registration of transfer on the stockholder list. The latter, after inspecting all necessary documentation, will register the transfer, cancel the old certificate, and issue a new certificate to the buyer. Beyond endorsement of the certificate and its delivery, each stage of the transaction will demand the documents, guarantees, and assurances that constitute ‘good delivery’ on the respective exchange. The amount of manual paperwork for the sale of a single share can therefore be significant, and in a high-volume environment, the backlog caused by the paperwork connected with traditional securities settlement can cripple a market.
THE CREATION OF THE CONTEMPORARY DEPOSITORY MODEL Indeed, a backlog of securities settlement brought the New York securities markets to a near halt in 1970, in a disaster referred to with names like the ‘paper crunch,’ ‘paper blizzard,’ or ‘back-office crisis.’ Up until the 1970s, most American securities firms took care of their securities transfer paperwork through the manual work of clerks. As trading volume on the New York Stock Exchange (NYSE) more than quadrupled during the 1960s, firms were unable to settle transactions quickly enough to meet outstanding delivery obligations, even though the NYSE closed 1 day per week and held abbreviated trading hours in order to give members time to catch up on their paperwork, so that over 100 brokerage firms eventually either entered bankruptcy or were acquired by stronger competitors. The US Securities and Exchange Commission (SEC) convened a conference of experts in 1971 to consider solutions for the securities settlement crisis, and industry experts offered either a
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decentralized, electronic model or a centralized depository model as possible securities settlement structures. The decentralized model was conceived along the lines of the electronic concept employed in the National Association of Securities Dealers Automatic Quotation (NASDAQ) system, which had been introduced little more than a year earlier. It would have linked issuers’ transfer agents in a computer network to the stock exchanges, so that transfers of uncertificated (dematerialized) securities could be electronically recorded by book entry transparently under control of the issuers. In this model, the ‘account’ on which transfers would have taken place would also have been the ‘register’ in which the securities were originally created by the issuer. Transfer would have taken place through deregistration of the seller and registration of the buyer, following the standard rule for transfer of uncertificated securities (a voluntary transfer of control over the security through reregistration). The other suggestion made in 1971 was to create a centralized depository in which paper share certificates would be kept in custody (immobilized), so that interests in such shares could be transferred by book entries on the depository’s accounts. Using this model, securities themselves would remain registered in the name of the depository (or its nominee) and would themselves not be transferred; rather, claims against the depository registered as the owner of the securities would be traded. This depository model was by no means new: it was used at least as early as 1873 by the Vienna Gyro and Depository Association in Vienna, Austria. Both models would have eliminated the troublesome physical delivery of shares, but use of the first model would have required issuers themselves to actually ‘dematerialize’ share certificates. In the United States, for the equity market alone, that would have meant coordinating a change to the corporate laws of all 50 states to allow uncertificated stock. While use of the second model allowed issuers to keep issuing paper certificates, it meant that intermediaries would create a kind of uncertificated, derivative claim against the pools of securities deposited in the vault of the depository, and the nature and transfer of such claims had never been clearly provided for in commercial and property laws of most jurisdictions. The options discussed presented basic examples of what is referred to as ‘dematerialization’ (elimination of paper certificates) and ‘immobilization’ (taking paper certificates out of circulation by placing them in vaults). A report that the SEC prepared on the 1971 conference explained that most market participants backed the model using an electronic network to transfer dematerialized securities, but were concerned that it could not be implemented quickly and safely, given the state of the law and of technology in 1971. Also, a number of industry experts argued that investors would not voluntarily
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switch from paper to electronically evidenced securities. The depository option presented the significant advantage that the NYSE already operated a Central Certificate Service (CCS) that employed the model. As a result, in the United States, the depository model was adopted and enforced by the enactment of }17A of the Securities Exchange Act of 1934, which instructed the SEC to “use its authority . . . to end the physical movement of securities certificatesin connection with the settlement among brokers and dealers of transactions in securities . . .” The CCS was in 1973 transformed into The Depository Trust Company (DTC). Deposited securities were registered in the name of ‘Cede & Company,’ DTC’s nominee. During the same period, the National Securities Clearing Corporation (NSCC) was created to act as the clearing agent of the NASD. In 1999, DTC and NSCC became subsidiaries of a newly created holding company, the Depository Trust and Clearing Corporation (DTCC), which is a stock corporation owned primarily by major US banks and brokers. NSCC currently serves as the CCP for the US securities markets. A CCP, as the name suggests, is placed at the center of the market as a buyer to all sellers and a seller to all buyers, thereby assuming all settlement risk. Because CCPs are at the center of all the market’s transactions, they can net the short (debt) and long (credit) positions between market participants, thus reducing their transactional exposures outstanding at any one time. The determination of a participant’s obligations, whether or not it involves netting, is sometimes referred to as ‘clearing,’ and thus the process of determining the amount due and making delivery of such amount is referred to as ‘clearing and settlement.’ The activity of a CCP is addressed in more detail below. It has been estimated that the DTCC system includes more than 99% of the depository-eligible securities in circulation on the US capital markets. DTCC and its subsidiaries hold over $25 trillion in securities in custody and process well over $85 million in transactions during an average business day. NCSS has over 4000 clearing participants, whose short and long positions against each other NSCC nets multilaterally, so that well over 90% of the volume of securities traded must not actually be delivered within the securities settlement system. Of course, this does not mean that over 90% of transfers are obviated; the lower stream obligors must still make ultimate delivery of the sold securities to the buyer.
THE LEGAL CHARACTERISTICS OF SETTLEMENT IN THE CURRENTLY DOMINANT, DEPOSITORY MODEL The institutional arrangements for securities settlement established in the 1970s in the United States have become the world’s standard settlement model as
currently recommended by international bodies such as the Bank for International Settlements, the Group of Thirty, and the European Commission. As said, this model was used in Europe long before it was officially adopted in the United States, and at the time US banks recommended that it be implemented in New York, Morgan Guaranty was operating a depository-based securities settlement system, ‘Euroclear,’ in Brussels, Belgium. At present, best practice recommends that a settlement system includes a central securities depository (CSD) or international central securities depository (ICSD), which should directly or indirectly hold a large portion of the securities traded on the respective market in ‘securities accounts’ for market participants. This is ‘immobilization’ of securities. The securities will be partially ‘dematerialized’ in that a ‘global certificate’ representing up to all of the outstanding securities of a class will be the only piece of paper actually deposited in the CSD or ICSD. Although the status of such ‘global certificates’ as securities is subject to some dispute (they are not one of a series, but one of a kind), this issue remains of little importance because a global certificate will in practice be transferred only once – from the issuer to the depository shortly after issuance. Thereafter, only claims to the securities certificated in the global certificate will be transferred. A CCP should assume the counterparty risk of system participants for trades in securities on the relevant market, net out the crossing obligations between system participants, and debit or credit the netted amounts on CSD securities accounts. The third main component is a link to a network of cash accounts, preferably supported by central bank funds. The basic structure of the system is thus quite simple, and follows its purpose of bringing securities (held with the depository) to the buyer and cash (held in accounts linked to the system) to the seller, by mediation of an entity (the CCP), which not only assumes and distributes default risk but also nets down the total amount of securities and cash that must exchange hands within the settlement system. Best practice also requires that the securities be delivered at the same time as the cash (this is referred to as ‘delivery versus payment’). It is the central position of the CCP that allows it to net the short and long positions of all trading participants. In a market with a CCP, the contract of each seller will run to the CCP as will the contract of each buyer. If the CCP performs the market’s matching function (i.e., the next step following orders triggering each other on an order book, the generation of a clearing price in an auction, or a market maker’s accepting buy and sell orders, depending on the market structure used), it is simple to have the sales contract first to come into existence directly with the CCP; alternatively, it would be possible for a contract between the buyer and the seller to form, and subsequently be novated into two contracts with
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the CCP. When a settlement system is designed, considerations such as the treatment of a novation under the bankruptcy laws of the jurisdiction(s) whose participants will trade through the system will be highly relevant. The soundness and safety of a settlement system require that securities and cash be successfully delivered even in the case of the failure of a settling participant. The CCP will often be a corporation owned by the main market participants, who will have provided for loss allocation in the case that a counterparty of the CCP fails to deliver the promised securities or cash. From an operational point of view, a system’s safety is also increased by the CCP having to credit or debit much smaller netted sums to settling participants than the aggregate amounts involved in the underlying transactions. Although in the case of retail and other downstream trades, such netting does not reduce the number of transactions that ultimately must be completed (the seller must receive cash and the buyer must receive securities), at the level of the direct participants of the CCP, the reduction of transaction costs can be significant. For example, if participant A should deliver 200 shares of XYZ Inc. and should receive 100 shares of the same company, the CCP can calculate a net delivery obligation for A of 100. The same will be done on the cash leg of the transaction, so that if A should receive $2000 for its XYZ shares and should pay $1000 for the shares, A’s net credit will be only $1000. On the cash leg of the transaction, the CCP can further net down the already net figures (referred to as a ‘net–net sum’). For example, if A has a net credit of $1000 for the XYZ shares, and a debt of $2000 for 200 EFG Inc. shares it is buying, the CCP can then calculate a net–net debt of $1000 for A during the settlement cycle. Thus, the CCP would instruct the CSD to debit A’s securities account by 100 XYZ shares and credit it with 200 EFG shares, while debiting A’s cash account by $1000. The CSD and the network of banks make the shares and the cash available for the rapid credit/debit processing of the CCP. As explained in the previous section, securities settlement revolves around a CSD or ICSD because, when modern settlement systems were being established, experts believed that ‘immobilizing’ paper securities in the custody accounts – so that claims to CSD accounts could be electronically transferred between accountholding participants – was superior to ‘dematerializing’ the paper certificates so that securities themselves could be traded electronically. The result of establishing this depository system was that the securities issued by listed companies were no longer transferred. Rather, claims to pools of such securities held in the accounts of a CSD or its participants were traded. As this manner of settling transactions in securities circumvented the requirements of commercial law (e.g., endorsement and delivery of the certificate and registration of the investing owner) for
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negotiability of securities, it could not guarantee good delivery free of third-party claims without significant change of the commercial law. In the United States, this change took place in 1994 through amendment of Article 8 of the UCC, primarily through the insertion of a new Part 5, ‘Security Entitlements.’ The principles contained in Article 8 have been transplanted into the laws of a number of countries and have greatly influenced the shape of two international conventions: the 2006 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary (conflict of laws) and the 2009 UNIDROIT Convention on Substantive Rules for Intermediated Securities (transfer of property). The new principles of commercial law created by the above measures essentially allocate negotiability to claims on the accounts of entities holding custody accounts. The US term for such claims is ‘security entitlement,’ which is a claim to a certain number and kind of securities held in an account with an intermediary. In }8-503 UCC, this claim is given the status of a pro rata property right in all the securities of the relevant type held by the account-holding intermediary. Unlike other property rights, the circumstances under which the ‘owner’ may exercise his claim against third parties is very limited – only if the intermediary illegitimately transfers the securities, enters insolvency, and the liquidator fails to take adequate action to recover them. This attenuated form of property right which looks much more like a contract right against the intermediary has been disputed and largely rejected by a number of countries, most notably Germany. The creation of a property right in immobilized securities serves the primary purpose of providing strong protection to an investor in the case of the intermediary’s insolvency; it is not, however, the centerpiece of negotiability, which is freedom from third-party claims at the time of transfer. The UCC addresses this point similarly, by statutorily providing exactly the protection required: a securities intermediary that acts on an effective transfer instruction (referred to as an ‘entitlement order’) is not liable to a person with an adverse claim unless the intermediary acts contrary to an injunction or restraining order, or in collusion with the wrongdoer. Articles 18 and 23 of the 2009 UNIDROIT Convention reach a similar result. Thus, like the transfer of a certificated negotiable instrument, the good faith purchaser (UNIDROIT prefers the word ‘innocent’) of a claim to immobilized securities will be protected from flaws in the title of the seller. A court, not an intermediary immersed in the flow of the market, will have to evaluate the validity of an alleged adverse claim. Similarly to the endorsement of a certificate, an ‘entitlement order’ must be given by an appropriate person or such person’s legal representative in order to be effective. On the NYSE, a system of automatic
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‘medallion’ guarantees has been created to facilitate and accelerate this process of guaranteeing the signature on an entitlement order.
DISADVANTAGES OF THE DEPOSITORY MODEL The efficient operation of the currently dominant depository model of securities settlement for registered securities requires the securities to be registered in the name of a depository, its nominee, or another intermediary in order to facilitate speedy settlement. This creates the famous distinction between the ‘registered’ owner of the securities and their ‘beneficial’ owner. Under most laws that apply to rights certificated in securities, no provision is made for ‘beneficial’ owners. Under corporation law in countries that issue registered shares, a shareholder is defined as someone who is registered on the shareholders list, not a person who has title – beneficial or otherwise – to shares. The same rule will apply under the terms and conditions of bonds issued in registered form. Under UCC }8-207, an issuer has the right to deal solely with the registered shareholder in respect to rights arising out of a share of stock, not with someone claiming the status of beneficial owner. Thus the first effect of the depository system of securities settlement is to shift power to exercise all rights of ownership attaching to the relevant securities from the investor to the financial entity in the settlement system in whose name the securities are registered. A second, related effect is to disrupt the line of communication between the issuers of securities and their holders. In cases of both shares of stock and bonds, issuers communicate with security holders by sending notices, meeting convocations, invitations to exercise rights and other communications to the addresses provided by registered holders of the security. In the depository system, names and addresses of the ‘beneficial’ holders of securities will remain generally unknown to the issuer absent further action by the intermediary, either voluntarily or pursuant to requirements of law. The communication problem was well known to the SEC at the time the depository model was imposed by mandatory force of law in 1975. During slightly more than a decade after the legislative imposition of immobilization, the SEC issued rules which require issuers of listed shares (who may only see one shareholder of record, Cede & Co.) to inquire of registered holders whether they hold such shares for clients, and if so, to distribute adequate numbers of such communications to client ‘beneficial’ owners along the chain of intermediaries. Some corporation laws, such as the US Model Business Corporation Act, also allow corporations to provide that beneficial owners may themselves exercise the
rights attaching to shares, provided that the relationship with the registered owner is sufficiently proven. The EU’s 2007 Shareholder Rights Directive also provides for such right. In separate studies conducted in the United Kingdom by Paul Myners and by Oxford Economic Research Associates (Oxera), it was discovered that attempts to pass communications and votes along a chain of financial intermediaries to the ‘beneficial’ owners of securities can lead both to lost votes and to losses suffered by securities holders and issuers amounting to hundreds of million euros. A second major disadvantage of the depository model stems directly from the need to make claims to securities accounts negotiable. A claim to securities held in custody arises for an investor when the intermediary credits the account of the investor. If, when the intermediary does not have enough securities on deposit to cover the claim, the investor’s claim would be invalid or only partial, then the securities market based on such claims would not offer the essential element of negotiability. In fact, each purchase of a security would have to be preceded by an inquiry into the holdings of the intermediary, exactly the state of affairs that negotiability is designed to eliminate. To obviate such time consuming precautions, laws governing the depository system (see, e.g., }8-501 UCC and Article 11, UNIDROIT Convention) provide that a claim to securities is created by a credit of such securities to the claim holder’s account, regardless of whether the intermediary actually has such securities in its holdings. A separate duty that intermediaries must hold sufficient quantities of all customer securities (see, e.g., }8-504 UCC and Article 24, UNIDROIT Convention) attempts to reduce the dangers of such ‘overissue.’ If, however, intermediaries behave negligently or fraudulently by selling claims not backed by deposited securities, amounts of securities exceeding those actually issued can come into circulation. When investors ultimately attempt to exercise their claims against the issuer, the danger of these excess or ‘shadow’ securities can come to a head. Imposing strict standards on intermediaries can reduce this problem, but not ultimately eliminate it. The problem is a price the market pays for making claims against a number of different intermediaries’ holdings negotiable.
AMELIORATING THE DISADVANTAGES OF THE DEPOSITORY MODEL As explained in the preceding sections, the strength of settling securities transactions in the depository model is that claims on account, rather than securities, are transferred. For registered securities, this means that the information on the registered holder is essentially eliminated so that the various functions the law ascribes to
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such information (identifying and communicating with security holders) cannot be performed as envisaged by law. A number of techniques have been tried to ameliorate this negative impact of immobilization. In 1997, when registered shares began to return to common use in Germany, Deutsche Bo¨rse Clearing (now Clearstream Bank) developed a settlement system (referred to as CASCADE-RS) designed to retain information regarding each ‘beneficial’ shareholder, so as to eliminate the need for a distinction between beneficial and registered shareholders. The system was designed to combine the advantages of being able rapidly to transfer fungible securities, for which no endorsement or registration is necessary, and the information provided to issuers by registered securities. The essential elements of the system are that only global (not individual) certificates are used, these are held by Clearstream Bank, and that for a brief period during the transfer process the registered securities certificated by the globals are registered to no one. In the classical model of transferring registered securities, stock certificate X might be transferred from seller A to buyer B with appropriate endorsement and delivery. In CASCADE-RS, if a given share of stock is sold by seller A, it will momentarily join all the other shares sold by other sellers in a pool of undesignated shares; at the same time, one of these shares will then be designated to buyer B, as will other shares be designated to other buyers. Thus, the transfer does not take place from seller A to buyer B, but rather the sold shares form a pool of undesignated shares which can then be attributed to buyers. The transfer still regards claims against the global certificate held by Clearsteam Bank, but if the information of the ultimate investor is provided, these claims can be registered to individual, ‘beneficial’ shareholders and reported to the issuer to allow the shareholder to exercise rights and the issuer directly to communicate. In 2008, it became mandatory on both the NYSE and the NASDAQ Stock Market to offer shareholders the possibility of ‘direct registration.’ New shares listed on these exchanges must be eligible to participate in this ‘direct registration system’ (DRS), which means that they may not offer investors the possibility of receiving individual certificates, so that although a global certificate will continue to be deposited with DTC, no further paper will be in circulation. A retail investor will at the time of making a purchase state on her instruction to the broker whether she wishes to hold her shares in her own name or through her broker in the name of Cede & Co. If she indicates no preference, the shares will automatically be placed in her name. The buyer then holds an uncertificated security extracted from the custody of DTC, with the registered owner changing from ‘Cede & Co.’ to that of the investor. The act of entering a buyer’s name on the stockholders list constitutes ‘delivery’ under the UCC, as
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it places the security in the ‘control’ of the buyer, and is thus a valid transfer with full protection of negotiability. Because the DTCC system is, however, structured to deal in claims on accounts rather than uncertificated securities, in order to sell the directly registered shares, the shareholder must have the securities reregistered in the name of Cede & Co. so that a claim on a DTC account may be traded. Essentially, the DRS offers a bridge between the two structural alternatives of dematerialization and immobilization: on the one hand, uncertificated securities may be held directly with issuers, but such shares cannot be transferred unless they are reregistered in the name of Cede & Co. so a claim on immobilized securities can be traded. In the United Kingdom, the Companies Act 2006 and the related Uncertificated Securities Regulation 2001 provide for the disclosure of information regarding beneficial ownership to issuers. As such, the UK law sets a premium on transparency but does not specify a system to achieve this end. This is a significantly different stance than that taken in the United States, where the Exchange Act of 1934 first imposed immobilization and later action of the SEC then encouraged NYSE and NASDAQ Stock Market rules to require use of DRS.
THE FUTURE OF SECURITIES SETTLEMENT At present, the issuance of paper certificates is rapidly becoming a rarity on organized markets. For the reasons discussed in the preceding sections, issuers and markets have sought to eliminate paper in order to increase transaction efficiency and reduce risks. Government debt led this trend in a number of major markets. Germany dematerialized part of its debt issues as early as 1910, and then all of them in 1972; in 1981, France began dematerializing its entire market by legislative decree; the US government followed in 1986, by completely dematerializing its government securities, and required new issuers on US securities exchanges to issue uncertificated securities as from 2008. With the disappearance of paper, the central function of the depository model – allowing cumbersome paper to be traded as claims on custody accounts – is losing its significance. It can therefore be expected that the depository model will gradually be displaced by a model in which securities settlement systems manage security holder information for sellers, buyers, and issuers. The shape and speed of this development will depend on regulatory and economic incentives.
Glossary Central counterparty A central counterparty (CCP) is a corporation that serves as the buyer for every seller and the seller for every
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buyer on a given market. The use of a CCP substitutes the credit risk of the CCP for the credit risk of each individual buyer or seller. Central securities depository A central securities depository (CSD) is an entity in which a large portion of the securities in circulation on a market are held in custody, so that claims to the securities accounts it holds may be traded instead of the securities themselves. Clearing and settlement Clearing is the determination of a system participant’s obligations in cash or securities, whether or not it involves netting, and settlement is the delivery of such amount of cash or securities. Dematerialization The elimination of paper securities certificates and their replacement with electronic book entries. Direct registration system The direct registration system is a component of the NYSE and the NASDAQ Stock Market and allows an investor to hold shares in his own name directly with the issuer when not trading them, and to transfer the securities into the name of an intermediary in order to trade them. Endorsement Endorsement, sometimes spelled indorsement, is the signature of the registered owner’s name on a security certificate, together with the name of the transferee, indicating a desire to transfer. Immobilization Placing paper security certificates into the vaults of intermediaries such as CSDs so that claims on securities accounts may be traded through book entries rather than the securities themselves.
Further Reading Benjamin, J., Yates, M., Montagu, G., 2002. The Law of Global Custody. Butterworths, London. Committee on Payment and Settlement Systems (CPSS) Technical Committee of the International Organization of Securities Commissions (IOSCO), 2001. , Recommendations for Securities Settlement Systems. Committee on Payment and Settlement Systems (CPSS), Technical Committee of the International Organization of Securities Commissions (IOSCO), Washington, DC. de Vauplane, H. (Ed.), 2005. 20 ans de de´mate´rialisation des titres en France: Bilan et perspectives nationales et internationales. La Revue Banque, Paris. Donald, D., 2008. Der Einfluss der Wertpapierabwicklung auf die Ausu¨bung von Aktiona¨rsrechten: Eine Untersuchung der Entstehungsgeschichte und Auswirkungen des amerikanischen ‘Indirect Holding System’. Peter Lang, Bern.
European Commission, 2004. Clearing and Settlement in the European Union – The Way Forward. COM. p. 312. Communication from the Commission to the Council and the European Parliament, COM/ 2004/0312. Goode, R., 1996. The nature and transfer of rights in dematerialized and immobilized securities. In: Obitah, F. (Ed.), The Future for the Global Securities Market, 107 Oxford. Oxford University Press, Oxford. Guttman, E., 2010. Modern Securities Transfers. Thomson West, Eagan, MN. Heinsius, T., Horn, A., Than, J., 1975. Depogestz – Kommentar zum Gesetz u¨ber die Verwahrung und Anschaffung von Wertpapieren vom 4 Februar 1937. De Gruyter, Berlin, NY. Myners, P., 2004. Review of the impediments to voting UK shares. Report to the Shareholder Voting Working Group. Oxford Economic Research Associates (OXERA), 2004. Corporate action processing: what are the risks? Available at http://www. dtcc.com/downloads/leadership/whitepapers/2004_oxera.pdf. Simmons, M., 2002. Securities Operations. Chichester. The Giovannini Group, 2001. Cross-Border Clearing and Settlement Arrangements in the European Union. Report to the European Commission. Available at ec.europa.eu. The Group of Thirty, 1989. Clearance and Settlement Systems in the World’s Securities Markets. The Group of Thirty, Washington, DC. The Group of Thirty, 2003. Global Clearing and Settlement: A Plan of Action. The Group of Thirty, Washington, DC. US Securities and Exchange Commission, 1971. Study of Unsafe and Unsound Practices of Brokers and Dealers. House Document 92–231.
Relevant Websites www.bis.org – Banks for International Settlements. www.clearstream.com – Clearstream, Part of Deutsche Borse Group. www.dtcc.com – DTCC, The Depository Trust and Clearing Corporation. www.cesr-eu.org – ESMA. www.euroclear.com – Euroclear, Post-trade made easy. http://ec.europa.eu – European Commission, The EU Single Market. www.iosco.org – OICU-IOSCO, International Organization of Securities Commissions. www.group30.org – The Group of Thirty, Consultative Group on International Economic and Monetary Affairs, Inc.
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50 Securities Settlement Systems D.C. Donald The Chinese University of Hong Kong, Shatin, Hong Kong SAR, China
O U T L I N E Definition
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Disadvantages of the Depository Model
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The Legal Requirements for Transferring Securities
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Ameliorating the Disadvantages of the Depository Model
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The Creation of the Contemporary Depository Model
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The Legal Characteristics of Settlement in the Currently Dominant, Depository Model
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The Future of Securities Settlement Glossary Further Reading Relevant Websites
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DEFINITION Securities settlement is the process of transferring to the buyer ownership of the security bought and to the seller ownership of the purchase price. On an organized securities market, trades occur through the matching of orders on an order book, in an auction, or by a market maker. The work of a broker or dealer in executing such orders can be thought of as the ‘front office’ work of the securities market. The matching of orders is then followed by the ‘settling’ or fulfillment of such orders. This process of securities settlement is often referred to as the ‘back-office’ function of trading, as it actually takes place ‘post-trade.’ Beyond the contractual commitment to deliver a specific amount of securities or cash, settlement conveys ownership of such securities or cash to the buyer or seller, respectively. Securities settlement is determined by four primary concerns. First, settlement must fulfill the legal requirements for transferring ownership of the relevant securities from the seller to the buyer and must therefore fulfill the requirements of applicable property and commercial law. As securities settlement avails itself of existing systems for interbank funds transfers (see Payment and settlement systems in this volume) to make cash payments, attention is focused primarily on delivering property in
Handbook of Key Global Financial Markets, Institutions, and Infrastructure http://dx.doi.org/10.1016/B978-0-12-397873-8.00035-9
securities, rather than in cash. Second, the settlement process as a whole should be safe, so that if an entity serving as an intermediate link in the process were to enter insolvency while securities or cash are in its possession, ownership of such securities or cash would unquestionably rest with the buyer or seller rather than the insolvent entity. Third, the process must be efficient and cost-effective, so that the market it serves can compete internationally. A factor related to efficiency in some markets, such as the European Union, is that national systems of settlement should be able to connect to each other to allow transnational trading; this is referred to as ‘interoperability.’ Fourth, settlement should preserve the nature of the transferred securities so that security holders can exercise the rights certificated in the security against the issuer. This last aspect of securities settlement has been given a much less central position by regulators than the first three. Rather, the impact of securities settlement systems on shareholder and bondholder rights has been typically raised by regulators and scholars focusing on corporate governance and the collective action of bond holders. As securities are becoming less likely to be evidenced by paper, and more are ‘uncertificated,’ evidenced only electronically through entries in registers, those aspects of the settlement process designed to overcome the obstacles connected with transferring
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paper certificates should gradually be replaced by processes with a less disruptive impact on the rights of shareholders and bondholders.
THE LEGAL REQUIREMENTS FOR TRANSFERRING SECURITIES In most jurisdictions, securities exist in both ‘bearer’ and ‘registered’ forms. Although these two forms have different requirements for effective transfer, both forms have in common that they are ‘negotiable instruments,’ whose certificated rights and face value are not affected by the claims of third parties when transferred to a good faith buyer without knowledge of such claims. This aspect of ‘negotiability’ makes a market for securities possible in a way that, say, a market for mortgage loan contracts is not, because the buyer receives the security free of all unknown claims a third party may have against the seller. This dramatically reduces transaction costs. Buyers need not undertake an investigation into the history of the securities they purchase, provided that they take the securities in good faith (bona fide) without knowledge of any claim against the seller’s title to the security. This shield for commercial activity, a creature of law, is found in most jurisdictions. In order for securities to enjoy negotiability, however, the law requires that the instruments have certain characteristics and that their transfer meets certain requirements. Pursuant to the commercial and property laws of many jurisdictions, bearer securities merely require a voluntary transfer of possession, and thus are relatively simple to transfer. As the certificate itself is the only proof that the bearer may exercise the rights embodied in the security, due presentment of the certificate is both necessary and sufficient to exercise such rights. The main obstacles to the safe and efficient settlement of transactions in bearer securities are thus posed by the physical bulk of the paper and risk of losing certificates. If the securities are held in the vaults of a trusted intermediary, a transfer of ownership can also take place by the seller instructing the intermediary henceforth to hold the securities for the account of the buyer, rather than the seller. This dramatically reduces the two primary risks connected with transferring bearer securities and leads to transactions centering on claims against the intermediary rather than the securities certificates themselves. The principal difference of registered securities is that the rights attaching to the security may be exercised only by the named person or her agent. Transfer therefore involves a change in the registered owner of the security. Early registered securities, such as those used by the seventeenth-century Dutch East India Company, were often uncertificated, and thus could be transferred only through amendment of the company’s register of
members. When registered securities, particularly shares of stock, are certificated, they have a number of legal requirements for the effective transfer of all certificated rights. At the most basic level of property law, ownership of a registered security may also be transferred by a simple, voluntary delivery of possession of the certificate. This would be a transfer of ownership of a registered share without endorsement or amendment of the register of security holders, just as is done for the transfer of a bearer security. However, a buyer who receives delivery of an unendorsed registered share would likely neither be able to demand entry on the register of members nor have good title as a bona fide purchaser in the face of competing claims to the security. In this way, there would be no ‘negotiability’ in the transfer, and as explained above, such negotiability is the main reason for using the security form. A broadly applicable formulation of the requirements for achieving negotiability is found in Article 8 of the US Uniform Commercial Code, which in turn resembles those of the Convention on International Bills and Notes prepared by the United Nations Commission on International Trade Law (UNCITRAL). Under Article 8, }8-303, in order to qualify as a ‘protected purchaser,’ the buyer of a security must (1) give value, (2) not have notice of any adverse claim to it, and (3) obtain control of it. A ‘protected’ purchaser acquires the transferred interest in the security free of any adverse claims. The concept ‘protected purchaser’ (rather than the more traditional figure of the bona fide buyer) receiving a negotiable instrument originated in the UNCITRAL Convention. The most effective form of ‘control’ over a registered security is to have it registered in the holder’s name, and thus the requirements for rightfully demanding registration can be seen as indirectly contained in the statutory definition. Further, the concept of ‘good delivery’ in connection with a transaction on a securities market may include provision of assistance as necessary to effect the buyer’s registration in the security holders’ register. To this end, the purchaser may demand that the seller provides proof of authority to transfer and other documents requisite to obtain registration of transfer. Such other requisite documents could include a signature guarantee, letters of administration, and tax documentation. If a signature guarantee is provided, the guarantor will bear any costs arising from a lack of authority to transfer. The transfer processes described above show that, for bearer securities, holding the certificates in an intermediary can reduce costs deriving from the transport of certificates as well as the risk of their loss, and that, for registered securities, even in a direct transaction between seller and buyer, the transfer of a certificated registered share entails a significant amount of paperwork. Either the certificate or a stock power must be endorsed by the seller, the signature guaranteed, authority to
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THE CREATION OF THE CONTEMPORARY DEPOSITORY MODEL
transfer title documented, and the stock certificate and the other documentation delivered, not to mention the registration of transfer on the stockholders’ list, the destruction of the old certificate and the issue of a new one. Because a transaction on a securities exchange will involve more parties, the necessary paperwork increases, as each party demands the basic documents plus any others considered necessary to decrease risk. On a market using manual securities settlement, the transaction could entail the following: If a seller is not a broker, dealer, or market maker, he will instruct a broker to sell and the broker will transfer the order to the exchange floor/trading system or a market maker, where it will be matched wholly or partially with one or more buy orders. Once the order is executed, the seller will have to deliver the executed certificate to his broker so that the selling broker can deliver it to the buying broker, market maker, specialist, or central counterparty (CCP). Once the buying broker receives delivery, she will have to deliver to the issuer’s transfer agent with a request for registration of transfer on the stockholder list. The latter, after inspecting all necessary documentation, will register the transfer, cancel the old certificate, and issue a new certificate to the buyer. Beyond endorsement of the certificate and its delivery, each stage of the transaction will demand the documents, guarantees, and assurances that constitute ‘good delivery’ on the respective exchange. The amount of manual paperwork for the sale of a single share can therefore be significant, and in a high-volume environment, the backlog caused by the paperwork connected with traditional securities settlement can cripple a market.
THE CREATION OF THE CONTEMPORARY DEPOSITORY MODEL Indeed, a backlog of securities settlement brought the New York securities markets to a near halt in 1970, in a disaster referred to with names like the ‘paper crunch,’ ‘paper blizzard,’ or ‘back-office crisis.’ Up until the 1970s, most American securities firms took care of their securities transfer paperwork through the manual work of clerks. As trading volume on the New York Stock Exchange (NYSE) more than quadrupled during the 1960s, firms were unable to settle transactions quickly enough to meet outstanding delivery obligations, even though the NYSE closed 1 day per week and held abbreviated trading hours in order to give members time to catch up on their paperwork, so that over 100 brokerage firms eventually either entered bankruptcy or were acquired by stronger competitors. The US Securities and Exchange Commission (SEC) convened a conference of experts in 1971 to consider solutions for the securities settlement crisis, and industry experts offered either a
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decentralized, electronic model or a centralized depository model as possible securities settlement structures. The decentralized model was conceived along the lines of the electronic concept employed in the National Association of Securities Dealers Automatic Quotation (NASDAQ) system, which had been introduced little more than a year earlier. It would have linked issuers’ transfer agents in a computer network to the stock exchanges, so that transfers of uncertificated (dematerialized) securities could be electronically recorded by book entry transparently under control of the issuers. In this model, the ‘account’ on which transfers would have taken place would also have been the ‘register’ in which the securities were originally created by the issuer. Transfer would have taken place through deregistration of the seller and registration of the buyer, following the standard rule for transfer of uncertificated securities (a voluntary transfer of control over the security through reregistration). The other suggestion made in 1971 was to create a centralized depository in which paper share certificates would be kept in custody (immobilized), so that interests in such shares could be transferred by book entries on the depository’s accounts. Using this model, securities themselves would remain registered in the name of the depository (or its nominee) and would themselves not be transferred; rather, claims against the depository registered as the owner of the securities would be traded. This depository model was by no means new: it was used at least as early as 1873 by the Vienna Gyro and Depository Association in Vienna, Austria. Both models would have eliminated the troublesome physical delivery of shares, but use of the first model would have required issuers themselves to actually ‘dematerialize’ share certificates. In the United States, for the equity market alone, that would have meant coordinating a change to the corporate laws of all 50 states to allow uncertificated stock. While use of the second model allowed issuers to keep issuing paper certificates, it meant that intermediaries would create a kind of uncertificated, derivative claim against the pools of securities deposited in the vault of the depository, and the nature and transfer of such claims had never been clearly provided for in commercial and property laws of most jurisdictions. The options discussed presented basic examples of what is referred to as ‘dematerialization’ (elimination of paper certificates) and ‘immobilization’ (taking paper certificates out of circulation by placing them in vaults). A report that the SEC prepared on the 1971 conference explained that most market participants backed the model using an electronic network to transfer dematerialized securities, but were concerned that it could not be implemented quickly and safely, given the state of the law and of technology in 1971. Also, a number of industry experts argued that investors would not voluntarily
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switch from paper to electronically evidenced securities. The depository option presented the significant advantage that the NYSE already operated a Central Certificate Service (CCS) that employed the model. As a result, in the United States, the depository model was adopted and enforced by the enactment of }17A of the Securities Exchange Act of 1934, which instructed the SEC to “use its authority . . . to end the physical movement of securities certificatesin connection with the settlement among brokers and dealers of transactions in securities . . .” The CCS was in 1973 transformed into The Depository Trust Company (DTC). Deposited securities were registered in the name of ‘Cede & Company,’ DTC’s nominee. During the same period, the National Securities Clearing Corporation (NSCC) was created to act as the clearing agent of the NASD. In 1999, DTC and NSCC became subsidiaries of a newly created holding company, the Depository Trust and Clearing Corporation (DTCC), which is a stock corporation owned primarily by major US banks and brokers. NSCC currently serves as the CCP for the US securities markets. A CCP, as the name suggests, is placed at the center of the market as a buyer to all sellers and a seller to all buyers, thereby assuming all settlement risk. Because CCPs are at the center of all the market’s transactions, they can net the short (debt) and long (credit) positions between market participants, thus reducing their transactional exposures outstanding at any one time. The determination of a participant’s obligations, whether or not it involves netting, is sometimes referred to as ‘clearing,’ and thus the process of determining the amount due and making delivery of such amount is referred to as ‘clearing and settlement.’ The activity of a CCP is addressed in more detail below. It has been estimated that the DTCC system includes more than 99% of the depository-eligible securities in circulation on the US capital markets. DTCC and its subsidiaries hold over $25 trillion in securities in custody and process well over $85 million in transactions during an average business day. NCSS has over 4000 clearing participants, whose short and long positions against each other NSCC nets multilaterally, so that well over 90% of the volume of securities traded must not actually be delivered within the securities settlement system. Of course, this does not mean that over 90% of transfers are obviated; the lower stream obligors must still make ultimate delivery of the sold securities to the buyer.
THE LEGAL CHARACTERISTICS OF SETTLEMENT IN THE CURRENTLY DOMINANT, DEPOSITORY MODEL The institutional arrangements for securities settlement established in the 1970s in the United States have become the world’s standard settlement model as
currently recommended by international bodies such as the Bank for International Settlements, the Group of Thirty, and the European Commission. As said, this model was used in Europe long before it was officially adopted in the United States, and at the time US banks recommended that it be implemented in New York, Morgan Guaranty was operating a depository-based securities settlement system, ‘Euroclear,’ in Brussels, Belgium. At present, best practice recommends that a settlement system includes a central securities depository (CSD) or international central securities depository (ICSD), which should directly or indirectly hold a large portion of the securities traded on the respective market in ‘securities accounts’ for market participants. This is ‘immobilization’ of securities. The securities will be partially ‘dematerialized’ in that a ‘global certificate’ representing up to all of the outstanding securities of a class will be the only piece of paper actually deposited in the CSD or ICSD. Although the status of such ‘global certificates’ as securities is subject to some dispute (they are not one of a series, but one of a kind), this issue remains of little importance because a global certificate will in practice be transferred only once – from the issuer to the depository shortly after issuance. Thereafter, only claims to the securities certificated in the global certificate will be transferred. A CCP should assume the counterparty risk of system participants for trades in securities on the relevant market, net out the crossing obligations between system participants, and debit or credit the netted amounts on CSD securities accounts. The third main component is a link to a network of cash accounts, preferably supported by central bank funds. The basic structure of the system is thus quite simple, and follows its purpose of bringing securities (held with the depository) to the buyer and cash (held in accounts linked to the system) to the seller, by mediation of an entity (the CCP), which not only assumes and distributes default risk but also nets down the total amount of securities and cash that must exchange hands within the settlement system. Best practice also requires that the securities be delivered at the same time as the cash (this is referred to as ‘delivery versus payment’). It is the central position of the CCP that allows it to net the short and long positions of all trading participants. In a market with a CCP, the contract of each seller will run to the CCP as will the contract of each buyer. If the CCP performs the market’s matching function (i.e., the next step following orders triggering each other on an order book, the generation of a clearing price in an auction, or a market maker’s accepting buy and sell orders, depending on the market structure used), it is simple to have the sales contract first to come into existence directly with the CCP; alternatively, it would be possible for a contract between the buyer and the seller to form, and subsequently be novated into two contracts with
II. KEY MARKET, INSTITUTIONS, AND INFRASTRUCTURE IN GLOBAL FINANCE
THE LEGAL CHARACTERISTICS OF SETTLEMENT IN THE CURRENTLY DOMINANT, DEPOSITORY MODEL
the CCP. When a settlement system is designed, considerations such as the treatment of a novation under the bankruptcy laws of the jurisdiction(s) whose participants will trade through the system will be highly relevant. The soundness and safety of a settlement system require that securities and cash be successfully delivered even in the case of the failure of a settling participant. The CCP will often be a corporation owned by the main market participants, who will have provided for loss allocation in the case that a counterparty of the CCP fails to deliver the promised securities or cash. From an operational point of view, a system’s safety is also increased by the CCP having to credit or debit much smaller netted sums to settling participants than the aggregate amounts involved in the underlying transactions. Although in the case of retail and other downstream trades, such netting does not reduce the number of transactions that ultimately must be completed (the seller must receive cash and the buyer must receive securities), at the level of the direct participants of the CCP, the reduction of transaction costs can be significant. For example, if participant A should deliver 200 shares of XYZ Inc. and should receive 100 shares of the same company, the CCP can calculate a net delivery obligation for A of 100. The same will be done on the cash leg of the transaction, so that if A should receive $2000 for its XYZ shares and should pay $1000 for the shares, A’s net credit will be only $1000. On the cash leg of the transaction, the CCP can further net down the already net figures (referred to as a ‘net–net sum’). For example, if A has a net credit of $1000 for the XYZ shares, and a debt of $2000 for 200 EFG Inc. shares it is buying, the CCP can then calculate a net–net debt of $1000 for A during the settlement cycle. Thus, the CCP would instruct the CSD to debit A’s securities account by 100 XYZ shares and credit it with 200 EFG shares, while debiting A’s cash account by $1000. The CSD and the network of banks make the shares and the cash available for the rapid credit/debit processing of the CCP. As explained in the previous section, securities settlement revolves around a CSD or ICSD because, when modern settlement systems were being established, experts believed that ‘immobilizing’ paper securities in the custody accounts – so that claims to CSD accounts could be electronically transferred between accountholding participants – was superior to ‘dematerializing’ the paper certificates so that securities themselves could be traded electronically. The result of establishing this depository system was that the securities issued by listed companies were no longer transferred. Rather, claims to pools of such securities held in the accounts of a CSD or its participants were traded. As this manner of settling transactions in securities circumvented the requirements of commercial law (e.g., endorsement and delivery of the certificate and registration of the investing owner) for
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negotiability of securities, it could not guarantee good delivery free of third-party claims without significant change of the commercial law. In the United States, this change took place in 1994 through amendment of Article 8 of the UCC, primarily through the insertion of a new Part 5, ‘Security Entitlements.’ The principles contained in Article 8 have been transplanted into the laws of a number of countries and have greatly influenced the shape of two international conventions: the 2006 Hague Convention on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary (conflict of laws) and the 2009 UNIDROIT Convention on Substantive Rules for Intermediated Securities (transfer of property). The new principles of commercial law created by the above measures essentially allocate negotiability to claims on the accounts of entities holding custody accounts. The US term for such claims is ‘security entitlement,’ which is a claim to a certain number and kind of securities held in an account with an intermediary. In }8-503 UCC, this claim is given the status of a pro rata property right in all the securities of the relevant type held by the account-holding intermediary. Unlike other property rights, the circumstances under which the ‘owner’ may exercise his claim against third parties is very limited – only if the intermediary illegitimately transfers the securities, enters insolvency, and the liquidator fails to take adequate action to recover them. This attenuated form of property right which looks much more like a contract right against the intermediary has been disputed and largely rejected by a number of countries, most notably Germany. The creation of a property right in immobilized securities serves the primary purpose of providing strong protection to an investor in the case of the intermediary’s insolvency; it is not, however, the centerpiece of negotiability, which is freedom from third-party claims at the time of transfer. The UCC addresses this point similarly, by statutorily providing exactly the protection required: a securities intermediary that acts on an effective transfer instruction (referred to as an ‘entitlement order’) is not liable to a person with an adverse claim unless the intermediary acts contrary to an injunction or restraining order, or in collusion with the wrongdoer. Articles 18 and 23 of the 2009 UNIDROIT Convention reach a similar result. Thus, like the transfer of a certificated negotiable instrument, the good faith purchaser (UNIDROIT prefers the word ‘innocent’) of a claim to immobilized securities will be protected from flaws in the title of the seller. A court, not an intermediary immersed in the flow of the market, will have to evaluate the validity of an alleged adverse claim. Similarly to the endorsement of a certificate, an ‘entitlement order’ must be given by an appropriate person or such person’s legal representative in order to be effective. On the NYSE, a system of automatic
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‘medallion’ guarantees has been created to facilitate and accelerate this process of guaranteeing the signature on an entitlement order.
DISADVANTAGES OF THE DEPOSITORY MODEL The efficient operation of the currently dominant depository model of securities settlement for registered securities requires the securities to be registered in the name of a depository, its nominee, or another intermediary in order to facilitate speedy settlement. This creates the famous distinction between the ‘registered’ owner of the securities and their ‘beneficial’ owner. Under most laws that apply to rights certificated in securities, no provision is made for ‘beneficial’ owners. Under corporation law in countries that issue registered shares, a shareholder is defined as someone who is registered on the shareholders list, not a person who has title – beneficial or otherwise – to shares. The same rule will apply under the terms and conditions of bonds issued in registered form. Under UCC }8-207, an issuer has the right to deal solely with the registered shareholder in respect to rights arising out of a share of stock, not with someone claiming the status of beneficial owner. Thus the first effect of the depository system of securities settlement is to shift power to exercise all rights of ownership attaching to the relevant securities from the investor to the financial entity in the settlement system in whose name the securities are registered. A second, related effect is to disrupt the line of communication between the issuers of securities and their holders. In cases of both shares of stock and bonds, issuers communicate with security holders by sending notices, meeting convocations, invitations to exercise rights and other communications to the addresses provided by registered holders of the security. In the depository system, names and addresses of the ‘beneficial’ holders of securities will remain generally unknown to the issuer absent further action by the intermediary, either voluntarily or pursuant to requirements of law. The communication problem was well known to the SEC at the time the depository model was imposed by mandatory force of law in 1975. During slightly more than a decade after the legislative imposition of immobilization, the SEC issued rules which require issuers of listed shares (who may only see one shareholder of record, Cede & Co.) to inquire of registered holders whether they hold such shares for clients, and if so, to distribute adequate numbers of such communications to client ‘beneficial’ owners along the chain of intermediaries. Some corporation laws, such as the US Model Business Corporation Act, also allow corporations to provide that beneficial owners may themselves exercise the
rights attaching to shares, provided that the relationship with the registered owner is sufficiently proven. The EU’s 2007 Shareholder Rights Directive also provides for such right. In separate studies conducted in the United Kingdom by Paul Myners and by Oxford Economic Research Associates (Oxera), it was discovered that attempts to pass communications and votes along a chain of financial intermediaries to the ‘beneficial’ owners of securities can lead both to lost votes and to losses suffered by securities holders and issuers amounting to hundreds of million euros. A second major disadvantage of the depository model stems directly from the need to make claims to securities accounts negotiable. A claim to securities held in custody arises for an investor when the intermediary credits the account of the investor. If, when the intermediary does not have enough securities on deposit to cover the claim, the investor’s claim would be invalid or only partial, then the securities market based on such claims would not offer the essential element of negotiability. In fact, each purchase of a security would have to be preceded by an inquiry into the holdings of the intermediary, exactly the state of affairs that negotiability is designed to eliminate. To obviate such time consuming precautions, laws governing the depository system (see, e.g., }8-501 UCC and Article 11, UNIDROIT Convention) provide that a claim to securities is created by a credit of such securities to the claim holder’s account, regardless of whether the intermediary actually has such securities in its holdings. A separate duty that intermediaries must hold sufficient quantities of all customer securities (see, e.g., }8-504 UCC and Article 24, UNIDROIT Convention) attempts to reduce the dangers of such ‘overissue.’ If, however, intermediaries behave negligently or fraudulently by selling claims not backed by deposited securities, amounts of securities exceeding those actually issued can come into circulation. When investors ultimately attempt to exercise their claims against the issuer, the danger of these excess or ‘shadow’ securities can come to a head. Imposing strict standards on intermediaries can reduce this problem, but not ultimately eliminate it. The problem is a price the market pays for making claims against a number of different intermediaries’ holdings negotiable.
AMELIORATING THE DISADVANTAGES OF THE DEPOSITORY MODEL As explained in the preceding sections, the strength of settling securities transactions in the depository model is that claims on account, rather than securities, are transferred. For registered securities, this means that the information on the registered holder is essentially eliminated so that the various functions the law ascribes to
II. KEY MARKET, INSTITUTIONS, AND INFRASTRUCTURE IN GLOBAL FINANCE
THE FUTURE OF SECURITIES SETTLEMENT
such information (identifying and communicating with security holders) cannot be performed as envisaged by law. A number of techniques have been tried to ameliorate this negative impact of immobilization. In 1997, when registered shares began to return to common use in Germany, Deutsche Bo¨rse Clearing (now Clearstream Bank) developed a settlement system (referred to as CASCADE-RS) designed to retain information regarding each ‘beneficial’ shareholder, so as to eliminate the need for a distinction between beneficial and registered shareholders. The system was designed to combine the advantages of being able rapidly to transfer fungible securities, for which no endorsement or registration is necessary, and the information provided to issuers by registered securities. The essential elements of the system are that only global (not individual) certificates are used, these are held by Clearstream Bank, and that for a brief period during the transfer process the registered securities certificated by the globals are registered to no one. In the classical model of transferring registered securities, stock certificate X might be transferred from seller A to buyer B with appropriate endorsement and delivery. In CASCADE-RS, if a given share of stock is sold by seller A, it will momentarily join all the other shares sold by other sellers in a pool of undesignated shares; at the same time, one of these shares will then be designated to buyer B, as will other shares be designated to other buyers. Thus, the transfer does not take place from seller A to buyer B, but rather the sold shares form a pool of undesignated shares which can then be attributed to buyers. The transfer still regards claims against the global certificate held by Clearsteam Bank, but if the information of the ultimate investor is provided, these claims can be registered to individual, ‘beneficial’ shareholders and reported to the issuer to allow the shareholder to exercise rights and the issuer directly to communicate. In 2008, it became mandatory on both the NYSE and the NASDAQ Stock Market to offer shareholders the possibility of ‘direct registration.’ New shares listed on these exchanges must be eligible to participate in this ‘direct registration system’ (DRS), which means that they may not offer investors the possibility of receiving individual certificates, so that although a global certificate will continue to be deposited with DTC, no further paper will be in circulation. A retail investor will at the time of making a purchase state on her instruction to the broker whether she wishes to hold her shares in her own name or through her broker in the name of Cede & Co. If she indicates no preference, the shares will automatically be placed in her name. The buyer then holds an uncertificated security extracted from the custody of DTC, with the registered owner changing from ‘Cede & Co.’ to that of the investor. The act of entering a buyer’s name on the stockholders list constitutes ‘delivery’ under the UCC, as
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it places the security in the ‘control’ of the buyer, and is thus a valid transfer with full protection of negotiability. Because the DTCC system is, however, structured to deal in claims on accounts rather than uncertificated securities, in order to sell the directly registered shares, the shareholder must have the securities reregistered in the name of Cede & Co. so that a claim on a DTC account may be traded. Essentially, the DRS offers a bridge between the two structural alternatives of dematerialization and immobilization: on the one hand, uncertificated securities may be held directly with issuers, but such shares cannot be transferred unless they are reregistered in the name of Cede & Co. so a claim on immobilized securities can be traded. In the United Kingdom, the Companies Act 2006 and the related Uncertificated Securities Regulation 2001 provide for the disclosure of information regarding beneficial ownership to issuers. As such, the UK law sets a premium on transparency but does not specify a system to achieve this end. This is a significantly different stance than that taken in the United States, where the Exchange Act of 1934 first imposed immobilization and later action of the SEC then encouraged NYSE and NASDAQ Stock Market rules to require use of DRS.
THE FUTURE OF SECURITIES SETTLEMENT At present, the issuance of paper certificates is rapidly becoming a rarity on organized markets. For the reasons discussed in the preceding sections, issuers and markets have sought to eliminate paper in order to increase transaction efficiency and reduce risks. Government debt led this trend in a number of major markets. Germany dematerialized part of its debt issues as early as 1910, and then all of them in 1972; in 1981, France began dematerializing its entire market by legislative decree; the US government followed in 1986, by completely dematerializing its government securities, and required new issuers on US securities exchanges to issue uncertificated securities as from 2008. With the disappearance of paper, the central function of the depository model – allowing cumbersome paper to be traded as claims on custody accounts – is losing its significance. It can therefore be expected that the depository model will gradually be displaced by a model in which securities settlement systems manage security holder information for sellers, buyers, and issuers. The shape and speed of this development will depend on regulatory and economic incentives.
Glossary Central counterparty A central counterparty (CCP) is a corporation that serves as the buyer for every seller and the seller for every
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buyer on a given market. The use of a CCP substitutes the credit risk of the CCP for the credit risk of each individual buyer or seller. Central securities depository A central securities depository (CSD) is an entity in which a large portion of the securities in circulation on a market are held in custody, so that claims to the securities accounts it holds may be traded instead of the securities themselves. Clearing and settlement Clearing is the determination of a system participant’s obligations in cash or securities, whether or not it involves netting, and settlement is the delivery of such amount of cash or securities. Dematerialization The elimination of paper securities certificates and their replacement with electronic book entries. Direct registration system The direct registration system is a component of the NYSE and the NASDAQ Stock Market and allows an investor to hold shares in his own name directly with the issuer when not trading them, and to transfer the securities into the name of an intermediary in order to trade them. Endorsement Endorsement, sometimes spelled indorsement, is the signature of the registered owner’s name on a security certificate, together with the name of the transferee, indicating a desire to transfer. Immobilization Placing paper security certificates into the vaults of intermediaries such as CSDs so that claims on securities accounts may be traded through book entries rather than the securities themselves.
Further Reading Benjamin, J., Yates, M., Montagu, G., 2002. The Law of Global Custody. Butterworths, London. Committee on Payment and Settlement Systems (CPSS) Technical Committee of the International Organization of Securities Commissions (IOSCO), 2001. , Recommendations for Securities Settlement Systems. Committee on Payment and Settlement Systems (CPSS), Technical Committee of the International Organization of Securities Commissions (IOSCO), Washington, DC. de Vauplane, H. (Ed.), 2005. 20 ans de de´mate´rialisation des titres en France: Bilan et perspectives nationales et internationales. La Revue Banque, Paris. Donald, D., 2008. Der Einfluss der Wertpapierabwicklung auf die Ausu¨bung von Aktiona¨rsrechten: Eine Untersuchung der Entstehungsgeschichte und Auswirkungen des amerikanischen ‘Indirect Holding System’. Peter Lang, Bern.
European Commission, 2004. Clearing and Settlement in the European Union – The Way Forward. COM. p. 312. Communication from the Commission to the Council and the European Parliament, COM/ 2004/0312. Goode, R., 1996. The nature and transfer of rights in dematerialized and immobilized securities. In: Obitah, F. (Ed.), The Future for the Global Securities Market, 107 Oxford. Oxford University Press, Oxford. Guttman, E., 2010. Modern Securities Transfers. Thomson West, Eagan, MN. Heinsius, T., Horn, A., Than, J., 1975. Depogestz – Kommentar zum Gesetz u¨ber die Verwahrung und Anschaffung von Wertpapieren vom 4 Februar 1937. De Gruyter, Berlin, NY. Myners, P., 2004. Review of the impediments to voting UK shares. Report to the Shareholder Voting Working Group. Oxford Economic Research Associates (OXERA), 2004. Corporate action processing: what are the risks? Available at http://www. dtcc.com/downloads/leadership/whitepapers/2004_oxera.pdf. Simmons, M., 2002. Securities Operations. Chichester. The Giovannini Group, 2001. Cross-Border Clearing and Settlement Arrangements in the European Union. Report to the European Commission. Available at ec.europa.eu. The Group of Thirty, 1989. Clearance and Settlement Systems in the World’s Securities Markets. The Group of Thirty, Washington, DC. The Group of Thirty, 2003. Global Clearing and Settlement: A Plan of Action. The Group of Thirty, Washington, DC. US Securities and Exchange Commission, 1971. Study of Unsafe and Unsound Practices of Brokers and Dealers. House Document 92–231.
Relevant Websites www.bis.org – Banks for International Settlements. www.clearstream.com – Clearstream, Part of Deutsche Borse Group. www.dtcc.com – DTCC, The Depository Trust and Clearing Corporation. www.cesr-eu.org – ESMA. www.euroclear.com – Euroclear, Post-trade made easy. http://ec.europa.eu – European Commission, The EU Single Market. www.iosco.org – OICU-IOSCO, International Organization of Securities Commissions. www.group30.org – The Group of Thirty, Consultative Group on International Economic and Monetary Affairs, Inc.
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