Securities and derivatives
The introduction of the euro has promoted efforts to reshape and harmonise the market infrastructure for financial instruments in the euro area. The introduction of the euro has also resulted in markets becoming larger and more liquid.
It is essential for the Eurosystem that the financial market infrastructure is safe and efficient. This is necessary for the integration of money and capital markets, the smooth execution of monetary policy and the maintenance of financial stability.
Consolidation is an essential element of the integration and rationalisation of market infrastructure in the euro area. Both horizontal and vertical consolidation have been seen. Horizontal consolidation takes place within a particular level of activity, be it trading, clearing or settlement, while vertical consolidation integrates functions at different levels of activity.
Trading is an agreement between counterparties with the objective of buying and selling financial instruments. Each trade can be considered to be a contractual agreement to exchange a certain amount of financial instruments for a certain amount of cash or other assets.
The Markets in Financial Instruments Directive (MiFID) distinguishes between three kinds of trading venue:
- traditional exchanges (called "regulated markets" in MiFID);
- multilateral trading facilities (MTFs), a new category of trading platform created by MiFID in order to compete with exchanges;
- "systematic internalisers" – i.e. firms which deal on their own accounts on an organised, frequent and systematic basis by executing client orders outside regulated markets and MTFs.
In some cases, traditional exchanges hold licences as regulated markets in certain market segments (e.g. equities and derivatives) and in parallel own and/or operate MTFs.
Role of the ECB
The ECB only monitors developments in the trading infrastructure.
Clearing is the process of transmitting, reconciling and, in some cases, confirming financial asset transfer instructions prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement. As an alternative to netting, trades can be settled directly one by one on a gross basis.
Clearing services may be provided by:
- clearing houses;
- central counterparties (CCPs);
- securities settlement systems (SSSs);
- clearing members
A clearing house determines the respective obligations and it calculates the amounts to be settled. The settlement is typically carried out via a securities settlement system.
Central counterparty clearing refers to situations where the clearing house interposes itself as a buyer to the seller and as a seller to the buyer. Thus, it creates two new contracts that replace the original single contract. The legal process of replacing the original contracts is called "novation". Central counterparties (CCPs) are used for the clearing of obligations arising at various organised trading venues for securities and derivatives. Recently, they began providing their services to over-the-counter (OTC) markets.
Securities settlement systems
Similar to clearing houses, a securities settlement system determines the respective obligations of buyers and sellers which it then settles.
Generally speaking, a member of a clearing house (e.g. a custodian bank) may clear in the clearing house, in addition to its own obligations, those of its clients. In cases where both the selling and buying clients keep both cash and securities accounts with the custodian, trades between the two clients can be cleared and settled in the books of the custodian.
Settlement is the act of discharging obligations, i.e. through funds or securities transfers, between two or more parties. The settlement of a securities trade typically involves two delivery processes: the transfer of the securities from the seller to the buyer, and the transfer of funds from the buyer to the seller.
Settlement services are offered by central securities depositories (CSDs) and international central securities depositories (ICSDs), which operate securities settlement systems (SSSs). Sometimes an intermediary (e.g. a custodian) can effect settlement internally in its own books.
Central securities depositories
A central securities depository (CSD) is an entity for the issuance and holding of securities, which enables securities transactions to be processed electronically by book entry. Physical securities may be immobilised by the depository or they may be dematerialised (in which case they exist only as electronic records). In addition to safekeeping, CSDs also perform a notary function, i.e. the registration of ownership of securities on a legal record. CSDs have different types of holding structures: they may hold accounts for all final owners of securities ("direct holding"). Alternatively, in a tiered structure, intermediaries ("custodians") hold accounts with the CSD, while themselves holding accounts on their books for final owners ("indirect holding"). CSDs were originally set up to serve their national markets.
International central securities depositories
The two international central securities depositories (ICSDs) in Europe are Euroclear Bank and Clearstream Luxembourg. They were originally created to clear and settle Eurobond transactions. Over time they have come to provide a wide range of services for the clearance of domestic and international securities. They also provide value-added services such as collateral management, securities lending and the provision of cash credit. CSDs and ICSDs have developed links with each other to facilitate cross-border settlement.
Custodian banks are intermediaries which provide investors with custody, clearing and settlement services in their local market. Some have their own internal infrastructure allowing them to clear and settle transactions in-house (internal clearing/settlement) when both counterparties of a trade hold accounts with the same custodian bank. Global custodian banks have extended their range of services in order to cover several national markets. They do so by using a network of sub-custodians (local agents), providing investors with a single gateway for the cross-border holding and settlement of securities.
Securities settlement systems
In a securities settlement system, membership is governed by access criteria. Investors which buy and sell securities will generally employ different intermediaries for the settlement of such transactions.
Trades can be settled on a continuous basis, one by one, with securities and funds being transferred on a gross basis for each trade. Often, however, settlement takes place at a given point in time for a "collection of trades".
Both securities and cash may be delivered on a gross or a net basis – i.e. in accordance with different settlement models, such as "gross-gross", "gross-net" and "net-net" models.
In a securities settlement system, settlement takes place between settlement members. Membership is governed by access criteria. Investors which buy and sell securities will generally employ different intermediaries for the settlement of such transactions.
Interaction between SSSs and payment systems
When securities and funds are exchanged, delivery-versus-payment (DvP) mechanisms are generally in place. These mechanisms ensure that the final transfer of securities is carried out only if the final transfer of funds occurs.
When providing DvP facilities in central bank money, SSSs rely on two main models :
- Interfaced settlement model : the securities leg of a transaction is settled in the SSS once the cash leg has been settled in the real-time gross settlement (RTGS) system. Each settlement requires that the two systems exchange messages with each other via a communication interface.
- Integrated settlement model : both central bank money and securities accounts are held in the SSS. Consequently, both the securities leg and the cash leg can be settled in accounts held by the SSS. An interface enables the transfer of cash between the central bank money accounts in the RTGS and the cash accounts in the SSS.
Links between CSDs
Links between central securities depositories (CSDs) are legal and technical arrangements that enable securities to be transferred between CSDs through book-entry processes. This allows securities which are issued in the CSD of one country to be transferred to the CSD of another country which has an active secondary market for those securities.
A link takes the form of an omnibus account held by one CSD (the "investor CSD") with another CSD (the "issuer CSD"). A link requires the establishment of an IT interface for the transmission of instructions related to securities eligible for transfer through the link.
Links can be used to deliver securities on a free-of-payment (FOP) basis or on a delivery-versus-payment (DvP) basis. When a DvP link is used, securities are usually first delivered free-of-payment from one CSD to the other. The DvP settlement is then performed using the local DvP settlement procedures.
In a direct link, there is no intermediary between the two CSDs and the omnibus account opened by the investor CSD is managed by either the investor CSD or the issuer CSD. In an operated direct link, a third party (i.e. a custodian bank) opens and operates an account with the issuer CSD on behalf of the investor CSD. However, responsibility for the obligations and liabilities associated with the registration, transfer and custody of securities must remain with the two CSDs from a legal perspective.
Relayed links are contractual and technical arrangements for the transfer of securities which involve at least three CSDs: the investor CSD, the issuer CSD and the “intermediary CSD”.
Operators of systems can contract all or part of their operations (e.g. their IT infrastructure) for the handling of payments or financial instruments to third-party service providers. These are of critical importance for the functioning of those systems.
For the Eurosystem, a key principle is that individual system operators retain full responsibility for any activity that is material to their operations. This also includes the responsibility for ensuring that the service provider complies with applicable oversight policies.
In the field of payments and securities handling, the perhaps most prominent example of a third-party service provider is SWIFT, which provides financial messaging services. Another type of service provider can be found in the field of derivatives. Here, trade repositories aim at providing transparency on all relevant economic and legal information related to derivatives contracts.
The Society for Worldwide Interbank Financial Telecommunication (SWIFT) is a limited liability cooperative company incorporated in Belgium and owned by its members. It is the most widely used service provider for financial transactions messaging in the world. ( Swift )
SWIFT supplies secure messaging services and interface software, contributes to the greater automation of financial transaction processes and provides a forum for financial institutions to address issues of common concern in the area of financial communication services.
Over the years SWIFT has gradually expanded its business, starting in payments, moving into securities, and more recently extending to investment institutions and corporate organisations.
The Group of Ten (G10) central banks, including the ECB, perform a cooperative oversight on SWIFT. Given that SWIFT is incorporated in Belgium, the Nationale Bank van België/Banque Nationale de Belgique acts as lead overseer.
A trade repository is a support infrastructure that serves as a central registry (in the form of an electronic database) for economic and legal information related to derivatives contracts.
Information on trades is sent to the trade repository at the time of confirmation at the latest. A trade repository is a key tool for storing relevant market information and making this information available to public authorities, market participants and other interested parties. Third-party providers which offer automated services in various post-trade stages can connect to the trade repository and base their services on the records maintained by the repository. Trade repository data may also be used by central counterparties (CCPs).
Once a complete record of a contract (a "golden record") has been established, it can then be updated with any relevant new information. This means that up-to-date information required for the processing of payments, clearing, settlement and other post-trade events over the life of a contract can be obtained from the trade repository, depending on its business model.
Trade repository services were first made available in 2006 for credit derivatives.