Infrastructure Debate April 2008 Tim Reucroft – Koen Vanderheyden Infrastructure Debate April 2008

Agenda Clearing & Settlement The existing Russian model The PWC/DLA PIPER/TM recommendations Account holding in Russia Best practice in Clearing & Settlement What is missing in Russia CSD consolidation The case for a single CSD Examples from around the globe The value in consolidation

The existing Russian Model

The existing Russian Model

The PWC/DLA PIPER/TM Recommendations Exchange Trades: optional interposition of a CCP Settlement instructions: Clearing via a central matching utility Clearing and Settlement in a single CSD via consolidation of settlement depositories, settlement chambers and part of the clearing houses – adoption of the Standard Model Mandatory CSD for securities with independent registrars, with exclusive right to a nominee account at the registrar. Mandatory electronic links with registrars Combined net and gross settlement RTGS settlement in central bank funds. Interim measure – in commercial bank funds. The CSD should not be a (full service) bank Fails management supported by stock lending at the CSD Central information source to support asset servicing Rationalisation of Registrars Information on beneficial owners Access by foreign intermediaries Wholesale model with unlimited levels – not the three tier approach. The retail model is not possible under Russian legislation

Account Holding in Russia Clearing & Settlement Account Holding in Russia

The Retail Model Issuer CSD and Central Registrar Legal & beneficial ownership investor investor investor investor investor Foreign nominee Foreign nominee Beneficial owner Beneficial owner All domestic accounts held at the first level, each beneficial owner has its own account at the CSD The CSD acts as central registrar – the notary that grants legal title. (Other registration functions can be carried out by third party registrars e.g. Calling AGMs, paying dividends etc). Genuine nominee accounts only allowed for foreign participants Also known as the Direct Holding model Structure results in millions of accounts at the CSD No intermediaries required. Participants act as Account Operators to maintain details across millions of accounts

Sub registers reduce the number of accounts at the CSD. Retail Model - Spain Not a wholesale model: legal title based on entry into the main/secondary register, each beneficial owner has its own account at the secondary register. The CSD plus secondary registers act as central registrar – the notary that grants legal title. (Other registration functions can be carried out by third party registrars e.g. Calling AGMs, paying dividends etc). Sub registers reduce the number of accounts at the CSD. Similar system in Romania.

Indirect Holding Model Common Law Approach -UK Primary register: legal ownership Issuer CREST Securities Holding trust assets and own Intermediary assets Equitable interest (trust) Investor Only the upper tier intermediary holding directly from the issuer will have legal title to securities. Transfer of the legal title is effected by delivery (in the case of bearer securities) or by amendment of the register operated by or for the issuer (in the case of registered securities). A transfer on the books of an intermediary constitutes a disposition of an equitable interest. The intermediary holds the securities as beneficial owner of an interest in the securities, held by the intermediary on an express or implied trust. Where the intermediary holds the securities for its account holders in a common pool, the individual investor is co-owner with other investors. The intermediary cannot use the securities for its own purposes without authorisation from the investor and the assets are not available to the general creditors of the intermediary. The electronic transfer within CREST’s book-entry system represents the legal transfer of title to UK securities. CREST is the de facto registrar for dematerialised instruments: there is no time lag between settlement and registration.

Indirect Holding Model Civil law approach Single CSD Intermediary Intermediary Property Legal & Beneficial owner Intermediary Legal & Beneficial owner Legal & Beneficial owner Foreign nominee No restriction on the number of levels. Recognition of foreign intermediaries and nominee structures is required under Unidroit. The Legal & Beneficial owner is the one at the bottom of the chain in accordance with Russian law. PRIMA applicable (Place of the Relevant Intermediary Account). Intermediaries are licensed depositories that act via nominee accounts. These are omnibus accounts, under designated segregation, that allow efficient settlement. Also known as the Wholesale Model. Typically only several hundred accounts at the CSD.

Indirect Holding Model Issues relating to Russia Limitation of levels Access by and recognition of foreign intermediaries Central information source to support corporate actions Rationalisation of Registrars Information on beneficial owners Legal nature of interests in securities Legal/systemic risk Other legal issues relating to indirect holding systems

Limitation of levels Registrar CSD Depository Depository Depository Nominee account CSD Depository Depository Depository Russian Depository Depository Investor Investor Foreign Intermediary Foreign Intermediary Foreign Intermediary Custodian Custodian Custodian Limitation is not flexible, Problems foreign intermediaries/ nominees, Limited tiers might be interpreted as sub registers (direct holding system instead of indirect holding system), Limited tiers are suggested in order to ensure transfer of information on beneficial ownership to the CSD and the registrar. This is an operational problem, which should be solved by imposing technical requirements on CSD participants and/or specific license requirements for intermediaries opening securities accounts for their clients. A limitation of levels will not solve the problem, Limited tiers should only be envisaged to the extent required for the for limitation of custody risk.

Recognition of foreign intermediaries Single CSD Intermediary Intermediary Legal & Beneficial owner Intermediary Foreign Intermediary / nominee Legal & Beneficial owner Legal & Beneficial owner intermediary Issue: Under current Russian legislation, the last intermediary in the chain within Russia is deemed to be the beneficial owner, even if it is a foreign nominee. The issue is then that a nominee, which is not normally the beneficial owner, becomes one purely because of its position in the chain of intermediaries. A foreign global custodian who is in this position finds itself as the beneficial owner of the securities, with all the legal complications and balance sheet implications this brings.

Access by foreign intermediaries through foreign CSDs Registrar Nominee account CSD Depository Depository Depository Depository Depository inv inv inv Foreign CSD Foreign CSD Assumptions: Foreign CSD has direct account with single Russian CSD. The regulators have an MOU in place. Russian CSD relies on foreign CSD conducting surveillance and know your customer tests. Issues: - The foreign CSD will operate nominee accounts and will not know the identify of the final beneficial owners, - The foreign CSD will only open an omnibus account with the Russian CSD and a lot of the transactions will be internalised, - Links between CSDs are complex and carry very little traffic (the exception is DTCC/CDS), - If this route were mandatory for foreign investors it would be unacceptably expensive (to use the services of a foreign CSD that is not geared up to provide the level of customer service demanded of global custodians). Conclusion This is not a feasible alternative. Foreign intermediaries should be allowed to open nominee accounts with Russian intermediaries.

Central information source to support corporate actions Can the investor effectively benefit from the rights flowing from the securities? Exercise of investor’s rights should not be hampered just because the securities are intermediated. The solution is to channel corporate actions efficiently through the system, upstream and downstream. Issues: Passing down corporate information to the investor: All licensed intermediaries should be required to provide details of corporate actions to the intermediary immediately below them in the chain Passing up corporate information to the issuer: All licensed intermediaries should be required to provide details of beneficial ownership at the request of the intermediary immediately above them in the chain. Facilitating the exercise of rights vis-à-vis the issuer Exercise of rights upon authorisation/instruction Goal: maintain key functions of securities in the intermediated system, in particular in a cross border situation Difficulties: neutral and functional technique to channel corporate actions between investor and issuer. A single CSD could play an important role as central information source (part of the participant requirements): in cross-border situations: retranslation of the relationship investor/issuer into the account-holder/intermediary relationship, taking into accountnational corporate law.

Rationalisation of Registrars The main function of Russian registrars is keeping up to date the registers for the issuers. The registrars should not charge transaction costs to the investors but only to the issuers. In case there is a single CSD, rationalisation is expected to follow from two requirements of the CSD: Only the single CSD can maintain a nominee account at the registrar. The registrar will need to connect with the CSD electronically, meeting information requirements in a timely manner complying with STP standards. The need to adopt electronic messaging and STP standards will require registrars to invest in their business. The business case for such an investment will not be justified where the registrar only acts for a single (or a few) issuer(s). This is likely to encourage rationalisation.

Legal nature of interests in securities Two main models Co-ownership No co-ownership Co-ownership of a (notional) pool of (fungible) securities with revindication right in case of insolvency France: Euroclear France and any intermediaries standing between Euroclear France and the investor’s immediate intermediary administer the system and maintain records of the accounts held at the various levels but do not have any proprietary rights in the securities. Registration of an investor as the holder of securities in an account with an authorised financial intermediary gives the investor a property right in the securities concerned. Belgium, Luxemburg, Germany, UK (Trust) Seems to be the model that is the closest to the Russian model

Legal / Systemic Risk Legal / Systemic Risk Tools: Settlement Finality, Innocent acquirer rule Upper tier attachment, collateralisation, … (UNIDROIT), CPPS-IOSCO Recommendations

Settlement Finality Settlement Finality is fundamental to the elimination of systemic risk and legal risk in the settlement of securities: In order for intermediaries to credit customer accounts and for account holders to deal with securities, they must have sufficient confidence that a transfer will not be reversed. Finality is concerned with the enforceability of a valid agreement in the event of the transferor’s insolvency; and the revocability of the transfer (or underlying transfer agreement) for lack of validity or on other grounds.

Settlement Finality Finality should be enhanced by national law/ system rules that: clearly prescribe the way in which transfer orders are made;. (2) indicate the moment at which the transfers become irrevocable; and (3) disapply insolvency rules that render void transfer orders that are made before insolvency commences. EU: Settlement Finality Directive gives transfer rules of certain designated settlement systems precedence over national insolvency rules. Global: articles 13 and 24 of the draft UNIDROIT Convention.

Avoiding legal/systemic risk Moment of entry into the system (SFD / UNIDROIT) Protection against unwinding in case of the insolvency of a participant No unwinding netting No reversal debit or credit Legal basis: SFD / UNIDROIT No hour zero rules Protection as from the moment of entry into the system as defined in the system rules Acceptance for settlement (CPSS-IOSCO principle 9) A transaction that has been submitted to the system and has passed all its risk controls is “accepted by the system for settlement” and cannot be removed from the settlement process without violating CPSS-IOSCO principle 9 & BIS CP IV. Protection required against credit exposures in net settlement systems, because there is a delay between acceptance by the system for settlement and its final settlement (no unwinding allowed in case of shortfall). Time In order to ensure settlement in case of initial failure to settle, the CSD should adopt collateralization mechanisms (legal basis: UNIDROIT).

Innocent Acquirer rule Protection of innocent purchasers of securities from adverse claims promotes liquidity and reflects the commercial expectations of investors. Where tracing is possible, the general approach should be to favour an innocent transferee who purchases misappropriated securities without notice of pre-existing interests in the securities in order to address: the need for speed and efficiency to enhance liquidity of securities (which benefits all participants). the practical difficulty in clearing and settlement systems of investigating title. The legal and systemic risk resulting from the reversal of transfers. Article 14 of the draft UNIDROIT Convention protects an account holder from adverse claims where the account holder does not at the time its account is credited, have knowledge of an adverse claim with respect to the securities.

Upper Tier Attachment Article 19 draft UNIDROIT CONVENTION: creditors of an account holder must not be allowed to attach their debtor’s intermediated securities at the level of higher tier intermediaries, the CSD or the issuer.

Other wholesale model issues addressed by the UNIDROIT Convention The rights of the account holders (Chapter II). Transfer of intermediated securities ( Chapter III): Ways of acquiring and disposing of securities by credit and debit to a securities account, invalidity of debits and reversal (protection of account holders and the stability of the system) (Art. 13) priority among competing interests (Art. 15 ). Integrity of the intermediated holding system (Chapter IV): insolvency issues, instructions to the intermediary, the requirement that an intermediary hold sufficient securities of any description, limitations on obligations and liabilities of intermediaries, allocation of securities to account holder’s rights, loss sharing in case of insolvency of the intermediary and the effect of debits and credits and instructions on the insolvency of operators of or participants in securities settlement systems. Relationship with the issuer of securities (Chapter V) Special provisions with respect to collateral transactions (Chapter VI): Validity and recognition, enforcement, Right of use, margin calls, substitutions, disapplication of certain insolvency rules, close-out netting, etc.

Best Practice in Clearing & Settlement

Best Practice in Clearing & Settlement Conformity with the Standard Model Old New Exchange Exchange Exchange: Risk trading CCP: Risk concentration CSD: Risk minimisation Settlement CCP Clearing CSD Registration Asia Pacific is getting better, South America still has some way to go. Look at the problems Korea had with this.

Best Practice in Clearing & Settlement “Nothing good happens between trade date and settlement date” Buy Sell 1 Match trade details Investor Buy 2 Confirm trade Investor Buy 3 Affirm trade Buy Custodian 4 Give-up trade Investor Custodian 5 Calculate average price Investor Custodian 6 Advise settlement shapes Custodian CSD 7 SSI

Best Practice in Clearing & Settlement Central Matching Utility (VMU) Trade agreed Trade matching For OTC transactions. For transactions not supplied by the exchange to the CSD Confirmation/Affirmation Give-ups, Give-ins Average pricing Splits and allocations Settlement Preparation Netting calculation Optimisation algorithm SSI database Blocking or reserving of cash and securities Trade matching is not required for transactions supplied directly by the exchange to the CSD. Otherwise known as locked in trades. DVP settlement end of T+0 end of T+1 end of T+2 Settlement Day T+3 Trade Shape Settlement Shape Clearing The clearing process can be complicated if there are many participants and substantial cross-border flows from different time zones. The final settlement should be straightforward if all the clearing has been properly carried out.

Best Practice in Clearing & Settlement Investors Broker/ Dealers Custodians Confirmation Average Price Affirmation Allocations SSI Give-ups Give-ins Broker/ Dealers Investors Central Matching Utility Custodians Without a CMU, each investor needs to maintain a link with every broker they use and every custodian. Similarly each broker needs to maintain a link with every investor and custodian. This requires multiple bespoke links. With a CMU, each investor maintains only a single point of contact. All the matching functions can be performed in the CMU.

Best Practice in Clearing & Settlement Broker/ Dealers Investors Exchange Registrars Central Matching Utility Prime Brokers CCP Issuers Custodians CSD SWIFT Regulator We still need to decide how the infrastructure links to the CMU

Clearing & Settlement What’s missing RTGS CLS Integrated central bank model Single CSD Stock lending and borrowing market Central registrar Central source of information Central VMU

The case for a single CSD CSD Consolidation The case for a single CSD

The case for a single CSD Benefits of a single CSD Coherent interface for foreign investors Avoids duplication – economies of scale from a natural monopoly Acts as a regional champion Potential location for a central VMU Central registrar Encourages harmonisation (the opposite effect of competition)

The case for a single CSD CSDs meet the criteria laid down by the European Court of Justice in order to be considered as essential facilities: They offer all users services they cannot provide themselves and for which the value increases with the increase in the number of users. Those services require the implementation and management of network systems, that could not be easily duplicated given the costs and implementation delays. They are essential to all participants operating in the competitive financial services sector, who could not conduct their business without access to these infrastructures at a competitive and economic price. These infrastructures were put in place to limit the risks incurred in the financial markets by mitigating the risk of default or error, and to promote to promote economies of scale.

Examples from around the globe CSD Consolidation Examples from around the globe

Examples Examples USA Spent 20 years consolidating its infrastructure UK GCO and money market instruments migrated from Bank of England to CRESTCo. Italy Bank of Italy withdrew from depository activities Spain Central bank passed fixed income settlements to Iberclear. Croatia Migrated long term and short term fixed instruments to equity CSD SDA China Created a single holding company for all CSD operations.

The value in consolidation CSD Consolidation The value in consolidation

The value in consolidation Demutualisation Demutualisations CREST, JASDEC, VPS, CDCP, HKSCC, UAE DFM A lot of CSDs started life by being separated out from their exchange. Jordan SDC is a mutual CSD, Qatar DSM is effectively state owned Tadawul converted into a joint stock company (Saudi Capital Market Company) with a capital of SR1.2 billion, fully owned by the state-owned Public Investment Fund Listings Italy, Spain, Mexico, Greece, Germany, Hong Kong, Iceland (since acquired), Malaysia, Singapore, Poland (pending), Slovakia (pending) Peru, Argentina (pending)

The value in consolidation Recent Examples When will Russia be in a position to list its own infrastructure like Deutsche Borse or Helex or BME? Listing provides the currency to participate in globalisation.