учебный год 2023 / Haentjens, Harmonisation Of Securities Law. Custody and Transfer of Securities in European Private Law

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result in a cost reduction. In most systems, both delivery and payment obligations are therefore netted, which is performed by either a CSD, ICSD, or a separate entity that specialises in clearing and netting (clearinghouse).10

To complicate matters further, centralised netting is generally organised in either a clearinghouse or central counterparty system.11 In a clearinghouse system, the clearing house calculates the net positions of all its participants’ obligations or all their transfer orders.12 At the end of the trading cycle, the clearing house submits the netted orders to the settlement agent (typically a CSD or ICSD and a central bank), to which it is usually duly authorised, and the settlement agent credits and debits the participants’ accounts accordingly. Although the functions of the clearing house and settlement agent can be combined in one institution, the participants hold securities and/or cash accounts only with the settlement agent and the clearing house does not become a (central) counterparty to its participants.

In a central counterparty system on the other hand, the central counterparty (‘CCP’) is interposed between all participants’ transactions and in that capacity takes over their obligations by novation.13 Thus, for all transactions, a seller has to deliver securities to the CCP instead of to the buyer, whilst the buyer has to make his payments to the CCP instead of to the seller. The CCP consequently also takes over all the risks attached to non-performance by a defaulting party,14 and the use of a CCP therefore results in a considerable reduction of settlement risk.15 Then, i.e. after a trading day, the CCP usually nets all the obligations, thereby reducing ‘all outstanding residuals to a single debit/credit between itself and each member (rather than a multiplicity of bilateral exposures between members).’16 But the netting may also take place ex ante, i.e. prior to the novation.

10Cf. BIS Glossary 2003 on netting: ‘an agreed offsetting of mutual obligations by trading partners or participants. The netting reduces a large number of individual positions or obligations to a smaller number of obligations or positions.’ If positions are netted, individual transactions can hardly be reversed, since a single reversal would require the unwinding of the entire set-off process, with serious and systemic consequences for other participants. The legal framework would therefore have to ensure the finality, i.e. non-reversibility, of securities transactions in settlement systems based on netting. For the EU, the Settlement Finality Directive aims at the elimination of that risk; see VEREECKEN & NIJENHUIS (2003), and infra, Ch. 9.3.3 and 10.2.8.

11VAN SETTEN in VEREECKEN & NIJENHUIS ET AL. (2003), 264-272.

12Cf. art. 2(e) SFD and see VAN SETTEN in VEREECKEN & NIJENHUIS ET AL. (2003), 267.

13Cf. art. 2(c) SFD. But a CCP can also merely guarantee its participants’ obligations; SCOTT (2006), Ch. 10, 11.

14See BENJAMIN (2003), 173-174, for a discussion of a CCP’s possible reactions in the case of a party’s default.

15Especially in the reduction of replacement cost risk and principal risk; see infra, s. 4.4.2. The present author is grateful to Professor W.A.K. Rank for pointing out that novation is preferred over assignment or assumption precisely for this reason, i.e. because the CCP thus assumes risk without assuming the defenses that the defaulting party might have.

16VAN SETTEN in VEREECKEN & NIJENHUIS ET AL. (2003), 269. See also Giovannini Group Report, 5 and BENJAMIN (2003), 128.

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Although similar, the netting by a CCP and a clearing house must be distinguished, as in a CCP system, the net balance has to be paid/delivered to or by the CCP, whereas in a clearinghouse system, the net balance is paid/delivered between the participants themselves through accounts with the settlement agent. For that purpose, the CCP’s participants maintain socalled clearing member accounts with the CCP, and consequently hold both a clearing member account with the CCP and a securities and cash account with the settlement agent.

4.3 SETTLEMENT

4.3.1 Typical sales and security arrangements

Notwithstanding the reality that most securities transactions are concluded at an institutionalised market and are consequently cleared and settled via a CCP, and mindful of the fact that parties to a sale are normally unaware of each other’s identity and merely order their intermediaries to buy or sell securities of a certain type,17 a typical example of a purely domestic settlement (securities side) would be as follows.

Assume seller (A) and buyer (B) are clients of the same intermediary, a participant of the national CSD. Upon A’s transfer order, this intermediary debits A’s account and credits B’s account. The intermediary’s account with the CSD remains unchanged, as the transfer can be perfected solely on the books of the intermediary. But if seller (A) and buyer (C) are not clients of the same financial intermediary, seller A orders his intermediary (X), a participant of the CSD, to debit his securities account. Intermediary X then debits A’s account and the CSD consequently debits X’s account. The CSD then credits Y’s account, Y being investor C’s intermediary. Finally, Y credits C’s account, by which the transfer is completed.18 In practice, however, Y often credits C’s securities account before Y’s account with the CSD is correspondingly credited.19

Again, it has to be borne in mind that these are highly simplified fact patterns, and provide typical examples of securities transfers only. Other than for sales, securities are increasingly used as collateral to secure loans,20 and the settlement of these loan agreements does not always involve the transfer of collateralised securities. Collateral may be provided by means of

17ROGERS (2005), 53 et seq.

18See Giovannini Group 2001 Report, 11 for a schematic overview of settlement in a domestic context.

19See also Ch. 10.2.5.

20See, e.g., POTOK (2001), 55 and GOODE (2002), 3.

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a transfer of title, e.g. as part of a repurchase agreement, but also by the creation of a security interest, e.g. a pledge.

Repurchase agreements have become a common method to secure loans, especially between large financial institutions. Under such an agreement, the borrower typically sells a certain volume of securities that corresponds to the amount of the loan, and at the same time agrees to repurchase the same volume of equivalent securities at a later point in time for the price of the loan plus interest. In a similar agreement, but one that is prompted by a need for securities rather than for money, a certain volume of securities is borrowed under the condition that the same volume will be returned at a later point in time plus interest to the initial lender (securities lending).21PT TP In both types of transactions, the collateralised securities are transferred as described above.

In general, security interests can be created either with or without the transfer of the collateralised securities to the collateral taker or a third party, but, especially in jurisdictions with a civil law tradition, some form of dispossession is required to render the security interest effective against third parties. In the case of a possessory pledge, the same procedure is followed as described above with regard to an outright transfer between investors A and B or A and C, the sole difference being that the transferred securities are operationally marked as pledged securities in B’s or C’s account. But it would also be commonly characterised as a possessory pledge when the collateralised securities remain registered in the collateral giver’s name, but are (operationally) marked or flagged as pledged securities.22PT TP

Other ways to create a security interest include the following:23PT TP

•the collateral provider, his intermediary and the collateral taker enter into a (tripartite) control agreement. In this situation, the securities are not transferred to another account;

•the collateral taker is the same entity as the collateral provider’s intermediary, and the collateralised securities are recorded in a special pledged account in either the collateral provider’s or the collateral taker’s name;

•the collateral taker is the same entity as the collateral provider’s intermediary, and the intermediary and the collateral provider enter

21TP PT See, e.g., KEIJSER (2006), 11-13. For repurchase agreements, the International Securities Markets Association and the Bond Market Association (currently: the International Capital Market Association and the Securities Industry and Financial Markets Association, respectively) have drafted a standard Global Master Repurchase Agreement, while securities lenders may use the Global Master Securities Lending Agreement drafted by the International Securities Lenders Association.

22TP PT See Ch. 10.2.9.

23PT TP OOI (2003), 230 et seq.

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into a control agreement. The securities are not transferred to another account; and

•the collateral taker is the same entity as the collateral provider’s intermediary, and the collateral provider and his intermediary enter into a repurchase agreement. The collateralised securities are transferred from the collateral provider’s to the intermediary’s account.

4.3.2Cross-border dimensions

As noted in the previous chapters, securities are transferred less and less within a purely domestic context and securities markets are international to an ever greater extent, i.e. parties to the same transaction are increasingly likely to be members of different markets, while the securities, the object of their transaction, may be located in yet another jurisdiction. In this crossborder context, the distinctive feature of settlement is “that it involves gaining access to a settlement system in another country and/or the interaction of different settlement systems.”PT24TP

Currently, foreign settlement systems can be accessed in multiple ways, including:25TP PT

•Direct access, as a participant of the foreign CSD where the securities have been issued and deposited. Because membership of a

foreign CSD usually involves stringent (capital) requirements, this option is not widely used.26P P

•Access to the foreign CSD via a local agent, usually a participant of that CSD. This is the most commonly used option.27P P

•Access to an ICSD, either directly as a participant, or indirectly via a local agent. ICSDs have established direct links with multiple CSDs and through their agents. This option used to be particularly popular for the trade in fixed-income instruments, but it has expanded to all

kinds of securities trades. Consequently, its participants can often settle their transactions solely on the books of the ICSD.28TP PT

•Access to a global custodian. These custodians have direct access to national CSDs through a network of sub-custodians, which may be either subsidiaries of the global custodian or local agents.

24TP PT Giovannini Group 2001 Report, 7.

25TP PT Giovannini Group 2001 Report, 8. See id., at 8 for a schematic overview of the possible links in cross-border settlement and id., at 13 for a schematic overview of cross-border clearing and settlement of equities, bonds and derivatives. See also CPSS/IOSCO Recommendations 2001, 42-43.

26PT TP Giovannini Group 2001 Report, 8, with reference to surveys conducted by the BIS.

27TP PT Ibid.

28PT TP CPSS/IOSCO Recommendations 2001, 42.

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•Access to the foreign CSD via the domestic CSD. An increasing number of links between national CSDs have been established, but these links often do not offer payment facilities.

These multiple permutations and the myriad of links among custodians result in a far from transparent network. Moreover, even within the EU, different states have different policies with regard to the accessibility of links to nonresident traders and settlement institutions. In addition to the harmonisation and modernisation of the legal framework for securities custody and transfer, the European Commission has therefore expressed its intention to liberalise and integrate existing securities clearing and settlement systems.PT29TP The European Parliament, however, recently adopted a motion in which it stated that it saw no need for a framework directive on the regulation of clearing and settlement providers.30PT TP

On the global level, legal literature has developed several solutions to the present fragmentation, including the ‘worldclear model’, the ‘global hub model’, and the ‘spokes model’.31PT TP In the worldclear model, a global CSD would assume all the functions of current CSDs and act as a true global custodian for all securities, which would be extremely efficient, but might not be warranted for reasons of competition and systemic risk. In the global hub model, an ICSD would function as a hub for all CSDs, so that bilateral links between CSDs would not be needed. In the spokes model on the other hand, the bilateral links between CSDs would be intensified so as to improve the present situation in which not all links are reciprocal and far from all CSDs maintain sufficient links with other CSDs.32PT TP The general consensus, however, seems to be that the integration of clearing and settlement systems should be left to the market, but although the market has seen substantial integration over the last decade,33PT TP none of the solutions has yet materialised.

29TP PT Communication from the Commission to the Council and the European Parliament, Clearing and Settlement in the European Union – The way forward, COM(2004) 312 final, at 8.

30PT TP Motion of the European Parliament of June 6 2005, A6-0180/2005 final, 14.

31TP PT See, e.g., BENJAMIN (2003), 224 and SCOTT (2006), Ch. 10, essentially based on the Morgan Guaranty Trust Company Report Cross-border Clearance, Settlement and Custody: Beyond the G30 Recommendations (1993).

32PT TP Cf. CPSS/IOSCO Recommendations 2001, 43.

33TP PT Testify, for instance, the (intended) transatlantic merger of the stock exchanges Euronext and NYSE. See Ch. 9.3.2 on the integration that has taken place in the European clearing and settlement industry.

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4.4 DISCERNED RISKS

4.4.1 Systemic risk

Before 1968, the risks imminent in financial markets and particularly those connected with securities transfers received very little attention from practitioners and academia alike, but the materialisation of those risks during the paperwork crisis of 1968 and the late 1980s have made the subject more popular ever since.34 More particularly, several risks have been distinguished since then which may jeopardise the stability of the financial market.

The main distinction is made between specific and systemic risks.35 Systemic risk refers to the danger that the failure of one market participant may undermine the stability of the market as a whole, as the interdependent relationships of current financial markets may involve that one party’s failure initiates a spill-over effect or a chain reaction that affects other market participants.36 Systemic risk is enhanced by the consolidation of financial markets,37 for fewer participants now represent larger parts of the market(s), and is further increased by the integration of global financial markets, for almost all financial market participants now form part of a larger interdependent network.38

Thus, because of their central role, CSDs and ICSDs are more susceptible to generate systemic risk than other market participants. More generally, payment systems and the financial markets as a whole depend to a large extent on the functioning of securities settlement systems, and confidence in the safety and reliability of those systems is therefore of critical importance.39 But an outdated legal infrastructure, in combination with dramatic changes in market practice, may undermine that confidence and exacerbate the possibilities of systemic risk materialising.40

34Especially since 1987, when a major US firm in the securities industry became bankrupt and trading on the NYSE could consequently not be resumed until the United States Government intervened; see, e.g., DE MAREZ OYENS & FRAENKEL (1990), 166 and REITZ (2005), 360.

35GOODE (1996), 167.

36Cf. BIS Glossary 2003.

37BENJAMIN (2003), 130.

38Explanatory Report on the Hague Securities Convention (2005), 4.

39CPSS/IOSCO Recommendations 2001, 41.

40See ROGERS (1996), 1436-7, referring to a speech by Alan Greenspan, then Chairman of the Federal Reserve Board: ‘(…) the greatest threat to the liquidity of our financial markets is the potential for disturbance to the clearance and settlement process for financial transactions.’ Cf. MOONEY (1990), 315 arguing that a modernisation of securities custody and transfer law reduces systemic risk. See also SOMMER (1998), 1194-1197.

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4.4.2 Specific risks

Apart from systemic risk, all market participants have to manage specific risks connected with the functioning of the securities settlement system,41 which include settlement risk and pipeline liquidity risk, referring to the risk of a loss of capital due to ‘holes’ in the chain of settlement.42 Here, most attention will be devoted to settlement risk, which comprises other categories of risks such as custody risk, credit risk, liquidity risk, and legal risk.43

While operational risk is generally understood so as to arise from ‘deficiencies in systems and controls, human error or management failure,’44 custody risk specifically refers to the risk of loss of securities held by intermediaries because of theft, fraud in general or other causes. As more intermediaries are interposed, which is almost inevitably the case in crossborder settlements, this risk becomes both greater and more difficult to assess.45 Yet it can be countered by an adequate legal framework and the strict enforcement of regulatory supervision, which might include a requirement that intermediaries separate their own assets from the assets they hold for their clients.46 Further, links between national CSDs could also contribute to the reduction of custody risk, as that would reduce the need to interpose yet more intermediaries to settle cross-border.

When custody risk materialises, it can result in the materialisation of credit risk, which is further distinguished as pre-settlement or replacement cost risk and principal risk.47 Replacement cost risk refers to the risk that a party does not perform after the trade has been made, but before any settlement has been realised, i.e. before the securities are delivered and the corresponding money has been transferred. The loss or unrealised gain, if any, is therefore measured by the difference between the market price of the securities at the moment of non-settlement and the contract price agreed upon with the defaulting party.48 The risk is reduced by risk management by the central

41See EFMLG 2003 Report, 11.

42GOODE (1996), 167. In some publications, settlement risk is used in a narrower sense to refer to what is here called principal risk; see CPSS/IOSCO Recommendations 2001, 36 and MOLONEY (2002), 711.

43See also MOLONEY (2002), 711-712, KERN (2002), 441 and DALHUISEN & VAN SETTEN (2003), 127-128.

44CPSS/IOSCO Recommendations 2001, 40. As an example of operational risk materialising, the mistake by the Japanese brokerage firm Mizuho may be referred to. Mizuho intended to sell 1 share of J-Com for ¥610,000 ($5,065), but instead offered 610,000 shares for ¥1 a piece. The value of these shares together was then $3.1 billion. Because of very strict finality rules of the Japanese clearing and settlement system as well as exchange rules, the order could not be reversed, as a consequence of which the loss could amount to more than ¥30 billion ($250 million); CNN press report of December 9, 2005. See also Ch. 10.2.8.

45CPSS/IOSCO Recommendations 2001, 43.

46See Ch. 10.2.5.

47CPSS/IOSCO Recommendations 2001, 39.

48GUYNN (1996), 50 n.8.

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counterparty (‘CCP’) and binding netting regimes that ensure the settlement of trades, and by shorter settlement cycles, i.e. by shorter intervals between trade and settlement.

In most securities markets worldwide, the current interval between trade and settlement is three days, or T+3. Developments are underway, however, to shorten that interval to T+2, T+1, or even T+0.49 But because all intermediaries that are interposed between seller and buyer must usually reenter the data necessary for settlement, shorter settlement cycles are difficult to realise. Unfortunately, a recent initiative to achieve Straight Through Processing (‘STP’) by automation of the post-trade processing that would thus avoid the re-entry of data, seems not to have been successful.50

As another form of credit risk, principal risk materialises when a counterparty does not perform after its own obligation has been perfected, so that a buyer risks the loss of the money he transferred and a seller the securities he delivered, which thus represents the entire value of the transaction.51 Principal risk therefore substantially contributes to systemic risk, but can be mitigated by mechanisms of delivery versus payment (‘DVP’) and the use of a central counterparty.52

In the instance that credit risk materialises, materialisation of liquidity risk may be the result. Liquidity risk involves the possibility that because of nonperformance by a counterparty, a seller or buyer is in sudden need of cash or securities, respectively, in order to meet his own obligations. The liquidity of the market determines the efficiency by which that need may be satisfied, but (risk) management by the CCP,53 infrastructure consolidation and securities lending facilities may contribute to the reduction of liquidity risk.54 Moreover, strong DVP mechanisms help to prevent the realisation of liquidity risk and its systemic consequences.55

49 See BENJAMIN (2003), 172. Clearnet, the European clearing house for the Euronext exchanges (see Ch. 9.3.2), already provides for T+2 settlement, while the New York based CSD DTCC discusses its objective to achieve a T+1 settlement cycle in the DTCC 2001 White Paper.

50BENJAMIN (2003), 173.

51In cross-currency settlement contexts, this risk is commonly referred to as Herstatt risk; see CPSS/IOSCO Recommendations 2001, 39 and BENJAMIN (2003), 129.

52See RANK ET AL. (1997), 51, CPSS/IOSCO Recommendations 2001, 39, DALHUISEN & VAN SETTEN (2003), and SCOTT (2006), Ch. 10, 11.

53SCOTT (2006), Ch. 10, 12.

54See BENJAMIN (2003), 129.

55CPSS/IOSCO Recommendations 2001, 40.

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4.4.3 Legal risk

Legal risk refers to the possibility that the applicable law results in a loss of capital because it does not support the rules of the securities settlement system, the performance of related arrangements, or the property rights and other interests held through a settlement system.56 In other words, its correct application might lead to consequences that are unforeseen by the parties to a particular transaction and contrary to their initial intentions.57 Assuming that the applicable law is clear and known, legal risk might arise because of the internal unsoundness of that law, as it might not provide a solution to the problem at hand, contain contradicting rules, or, more generally, might not fit (market) reality or be impedingly burdensome or complicated. Finally, that law might be subject to frequent and unforeseeable changes (legal instability).58

Legal risk is particularly exacerbated in a cross-border context where it might be unclear both what the applicable law is and where the proceedings will be brought, and different conflict of laws rules may thus refer to different applicable systems of law (legal uncertainty). Moreover, foreign law and especially complex foreign securities laws are little known and may thus withhold intended legal effects, or decree legal effects other than originally intended by the parties. For instance, the applicable law might impose perfection requirements which have not been met by the parties to a securities transaction because the applicable law was unknown to them. As a second example, a conflict of laws rule might state that the substantive law of the forum determines whether a transfer classifies as a transfer of title or as a pledge. Thus, a judge might classify a particular securities transaction as a pledge, although the parties intended it to be a transfer of title due to their unfamiliarity with that particular applicable law (recharacterisation risk).

More generally, legal risk is most likely to materialise in the case of a custodian’s insolvency, when the interests of both securities accountholders, and the custodian’s creditors are truly tested.59 One of the most typical risks with regard to book-entry securities therefore results from the fact that in an intermediary’s insolvency, priority conflicts between creditors and accountholders might arise, which are ultimately determined in a way that is

56CPSS/IOSCO Recommendations 2001, 40. Legal risk has also been considered a subcategory of operational risk, which then more generally involves “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people or systems or from external events.” See Consultative Document of the New Basel Capital Accord, 94 as quoted by BENJAMIN (2003), 129.

57Cf. H. WAGNER (2005), 31.

58H. WAGNER (2005), 30-31. Cf. Explanatory Notes to the Preliminary Draft UNIDROIT Securities Convention, 44.

59As a consequence, these situations appear to present the most relevant issues for market participants; cf. BENJAMIN & YATES (2002), 62.

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contrary to the parties’ expectations (intermediary risk).60 That risk becomes particularly acute when the intermediary concerned has either intentionally or unintentionally acted as being fully authorised to dispose of his clients’ assets.

Legal risk in the field of capital markets materialises dramatically in times of stress, and intensifies the other risks just discussed, thus substantially contributing to systemic risk.61 Specifically, legal risk may deter parties from entering into uncertain and costly international transactions, and thus lead to a dramatic devaluation of securities and the unavailability of credit. As noted above, legal risk in the field of securities custody and transfer law has particularly increased during the last decades because of the fundamental change in market practices from physical certificates to an intermediated holding system with immobilised or dematerialised securities, without the legal framework keeping pace. An enormous increase in volume of securities transactions that are settled cross-border and the growing reliance on collateral62 adds to the higher urgency of addressing legal risk in the field of capital markets.63

As an obvious solution, legal risk would be reduced by the unification of conflict of laws rules, so that they unanimously determine the applicable law, and by the modernisation and harmonisation of substantive securities laws, so that they can be readily known, are easily accessible and support current market practices and structures. Neither, however, has yet been accomplished.

60Cf. SCHWARCZ (2001), and see Ch. 10.2.5 and 11.2.5.

61CPSS/IOSCO Recommendations 2001, 41. Cf. the CPSS 1995 Report, 55, arguing that the difficulty to obtain full understanding of the rules and law governing the settlement process directly contributes to systemic risk.

62See POTOK (2001), 55 and LÖBER (2006), 7.

63Cf. Explanatory Notes to the Preliminary Draft UNIDROIT Securities Convention, 36 and 44-

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