Trading Around the Clock: Global

Securities Markets and Information

Technology

July 1990

OTA-BP-CIT-66

NTIS order #PB90-254087
Recommended Citation:

U.S. Congress, Office of Technology Assessment, Trading Around the Clock: Global

Securities Markets and Information Technology--Background Paper, OTA-BP-W-66

(Washington, DC: U.S. Government Printing Office, July 1990).

For sale by the Superintendent of Documents

U.S. Government Printing Office, Washington, DC 20402-9325

(order form can be found in the back of this report)
Foreword

The world’s stock exchanges evolved from centuries-old markets of money lenders,

currency traders, and commodity dealers. La Bourse, the Paris stock exchange, dates back to

1183. Amsterdam’s Effectenbeurs was formed around the trading of shares in the Dutch East

India Company in 1602. The London Stock Exchange was organized in the 17th century.

Stock exchanges in the United States, while latecomers, have a unique and colorful

history of their own, characteristic of our young nation. Wall Street, a narrow thoroughfare in

lower New York City, has become the symbol of U.S. enterprise, initiative, and prosperity. . .

but also of greed and chicanery. It was there that securities were first traded about 1725, along

with the auction of commodities such as tobacco, wheat, and even slaves. The New York Stock

Exchange, the first established in the United States, was chartered in 1792. Modern computer

and information technologies now support market-makers and brokers, and runners and ticker

tapes have given way to computer screens.

International telecommunications systems now link markets around the world with

instantaneous communications. Technology is rapidly turning the stock exchanges into a

seamless global market, open 24 hours a day. This situation presents both opportunities for

the Nation and problems that Congress needs to understand.

This background paper assesses the effects of information technology on securities

markets and the current status of global securities trading. It compares securities markets and

clearing and settlement mechanisms in Japan, the United Kingdom, and the rest of Europe with

those in the United States. Finally it identities emerging questions about international markets

and national regulatory regimes.

Trading Around the Clock precedes the forthcoming OTA report on domestic securities

markets and information technology, Electronic Bulls and Bears, both requested by the

Committee on Energy and Commerce and the Committee on Government Operations of the

House of Representatives.

OTA gratefully acknowledges the help of many people who have contributed to this

study as advisory panel members, workshop participants, contractors, and reviewers. As with

all OTA reports, however, the content is solely the responsibility of OTA and does not

necessarily constitute the consensus or endorsement of the advisory panel, workshop

participants, or the Technology Assessment Board.

u Directo r

iii
John Bachman

Securities Markets and Information Technologies

Advisory Panel

Managing Partner

Edward D. Jones& Co.

John C. Baldwin

Director

Utah Department of Business Regulation

Paul F. Glaser, Chairman

President, Quotron Systems, Inc.

Allan Bretzer

Vice President

Midwest Stock Exchange

William Brodsky

President and Chief Executive Officer

Chicago Mercantile Exchange

Eric Clemens

Professor

Wharton School

University of Pennsylvania

James B. Cloonan

President

American Association of Individual Investors

Jack A. Conlon, Jr.

Executive Vice President

NIKKO Securities Co., Inc.

Janine Craane

Financial Consultant

Merrill Lynch, Pierce, Fenner & Smith, Inc.

Gene L. Finn

Chief Economist and Vice President

National Association of Securities Dealers

Richard Grasso

President and Chief Operating Officer

New York Stock Exchange

William Haraf

Vice President

Citicorp

Robert E. Litan

Senior Fellow and Director of Center for Economic

Progress and Employment

Brookings Institution

James Martin

Executive Vice President

Teachers Insurance Annuity Association

College Retirement Equities Fund

Martin Mayer

Journalist

Robert McEwen

President

Conference of Consumer Organizations

Charles McQuade

President

Securities Industry Automation Corp.

Susan Phillips

Vice President

University of Iowa

Peter Schwartz

President

Global Business Network

Howard Sherman

Department of Economics

University of California, Riverside

Robert Shiller

Cowles Foundation

Yale University

Hans R. Stoll

Director

Financial Markets Research Center

Owen Graduate School of Management

Vanderbilt University

Alan Strudler

Research Scholar

Institute for Philosophy and Public Policy

University of Maryland, College Park

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the advisory panel members.

The panel does not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full responsibitity for the

report and the accuracy of its contents.

iv
Trading Around the Clock: Global Securities Markets and

Information Technology

OTA Project Staff

John Andelin, Assistant Director, OTA

Science, Information, and Natural Resources Division

James W. Curlin, Program Manager

Communication and Information Technologies Program

Project Staff

Vary T. Coates, Project Director

Charles K. Wilk, Senior Analyst

Danamichele Brennen, Inhouse Contractor

Steven Spear, Research Assistant

Mark Anstine, Research Assistant

Administrative Staff

Liz Emanuel, Office Administrator

Karolyn St. Clair, Secretary

JoAnne Price, Secretary
Workshop Participants

Clearing & Settlement

Andrea Corcoran

Commodities Futures Trading Commission

Dennis Dutterer

Chicago Board of Trade Clearing Corp.

Dennis Earle

Bankers Trust Co.

Roberta Green

Federal Reserve Bank of New York

John Hiatt

Options Clearing Corp.

Jonathon Kalman

Securities and Exchange Commission

Gerard P. Lynch

Morgan Stanley Co., Inc.

John W. McPartland

Chicago Mercantile Exchange

Junius Peake

The Peake/Ryerson Consulting Group, Inc.

Michael Reddy

Merrill Lynch World

Robert Woldow

National Securities Clearing Corp.

Technology in Securities Markets

Richard Breunich

Merrill Lynch & Co., Inc.

Ron Dale

Midwest Stock Exchange

Patricia Hillman

Bank of Boston

George Kenney

American Stock Exchange

Robert M. Mark

Manufacturers Hanover Trust Co.

Harold McIntyre

Citibank Financial Institutions Group

John Parady

Pacific Stock Exchange

Junius Peake

The Peake/Ryerson Consulting Group, Inc.

Joe Rhyne

Quotron Systems, Inc.

Donald D. Serpico

Chicago Mercantile Exchange

Casimir Skrzypczak

NYNEX Corp.

Donald Solodar

New York Stock Exchange

Shyam Sunder

Carnegie-Mellon University

Richard Van Slyke

Polytechnic University, New York

R.T. Williams

R. Shriver Associates, Inc.

Scenarios on International

Securities Trading

Peter Bennett

International Stock Exchange

Eric Clemens

University of Pennsylvania

James Cochrane

New York Stock Exchange

Roberta Green

Federal Reserve Bank of New York

David Hale

Kemper Financial Services

Martin Mayer

Journalist

Todd Petzel

Chicago Mercantile Exchange

Peter Schwartz

Global Business Network

Michael Wailer-Bridge

International Stock Exchange

Manning Warren III

University of Alabama School of Law

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the workshop participants.

The workshop participants do not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full

responsibility for the report and the accuracy of its contents.

w’
Reviewers and Contributors

Alden Adkins

Securities and Exchange Commission

Anthony Ain

Securities and Exchange Commission

David Aylwood

National Strategies, Inc.

(for Reuters, International)

Brandon Becker

Securities and Exchange Commission

John Behof

Federal Reserve Bank of Chicago

Peter Bennett

International Stock Exchange

Mary Ann Callahan

International Securities Clearing Corp.

James Cochrane

New York Stock Exchange

Andrea Corcoran

Commodity Futures Trading

Commission

Richard J. Cowles

Consultant

John P. Davidson III

Chicago Mercantile Exchange

Harry Day

New York Stock Exchange

Dennis A. Dutterer

Chicago Board of Trade Clearing Corp.

Dennis Earle

Bankers Trust Co.

Susan Ervin

Commodity Futures Trading

Commission

Giulia Fitzpatrick

Bankers Trust Co.

Jane F. Fried

Bankers Trust Co.

Gary Ginter

Chicago Research & Trading Group,

Ltd.

Roberta Green

Federal Reserve Bank of New York

John Hiatt

Options Clearing Corp.

Dan Hochvert

NYNEX Corp.

Brian Hunter

American Bankers Association

Jonathan Kalman

Securities and Exchange Commission

Peter Karpen

First Boston Corp.

Richard Ketchum

Securities and Exchange Commission

Thomas Ketchum

EuroClear, Brussels

Olaf E. Kraulis

The Toronto Stock Exchange

Wayne Lutheringshausen

Options Clearing Corp.

Gerard P. Lynch

Morgan Stanley & Co., Inc.

Robert M. Mark

Manufacturers Hanover Trust Co.

Harold McIntyre

Citibank Financial Institutions Group

John W. McPartland

Chicago Mercantile Exchange

Morris Mendelson

University of Pennsylvania

Thierry Noyelle

Columbia University

G.W. Palmer

AT&T Bell Laboratories

Junius Peake

The Peake/Ryerson Consulting

Group, Inc.

Joseph Rosen

Rosen, Kupperman Associates

Thomas Russo

Cadwalader, Taft, Wickersham

Anthony Saunders

New York University

Martha Scanlan

Federal Reserve

Board of Governors

Jeffrey M. Schaefer

Securities Industry Association

Robert Schwartz

New York University

Joel Seligman

University of Michigan

School of Law

Donald D. Serpico

Chicago Mercantile Exchange

Yuji Shibuya

Nomura Research Institute

Roxanne Taylor

Quotron Systems, Inc.

Paula Tossini

Futures Industry Institute

Christian Trudeau

Montreal Exchange

Richard Van Slyke

New York Polytechnic University

Manning Warren III

University of Alabama School of Law

Robert Woldow

National Securities Clearing Corp.

NOTE: OTA appreciates and is grateful for the valuable assistance and thoughtful critiques provided by the reviewers and contributors.

The reviewers and contributors do not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full

responsibility for the report and the accuracy of its contents.

vi”
Contractors

Robert G. Angel

Digital Equipment Corp.

Eric Clemens

University of Pennsylvania

Robert de Contreras

International Business Machines Corp.

Dennis Earle

Bankers Trust Co.

Frances Grace

Editor

Peter Karpen

First Boston Corp.

Don McNees

Peat Marwick, Main& Co.

Junius Peake

The Peake/Ryerson Consulting Group, Inc.

Monica Roman

Trading Technology, Inc.

Peter Schwartz

Global Business Network

Charles M. Seeger III

Chicago Mercantile Exchange

Marming G. Warren III

University of Alabama School of Law

NOTE: ~Aa~=h*mdk~@Mfortivduable=sk~ce andthoughtfulcritiquesprovidedbythecontractors.~e contractors

do not, however, necessarily approve, disapprove, or endorse this report. OTA assumes full responsibility for the report and

the accuracy of its contents.

viii
Contents

Page

Chapter 1. The Evolution of a Global Securities Market ● 

INFORMATION TECHNOLOGY FOR GLOBAL MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE MEANING OF GLOBALIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

COMPETITORS IN WORLD SECURITIES TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CLEARING AND SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .*

COMPETITION AND REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THREE SCENARIOS FOR GLOBALIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Scenario l: A Cooperative Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Scenario 2: An International Regulatory Regime . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Scenario 3: Conflict and Disintegration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

IMPLICATIONS OF THE SCENARIOS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Chapter 2. Information Technology for Global Markets ...... ... . .

THE EMERGING GLOBAL DATA COMMUNICATIONS INFRASTRUCTURE... . . . . . . . . . . .

Public and Private Global Networks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Systems for the Transmissionof Financial News and Market Data . . . . . . . . . . . . . . . . . ● . . . . . . . . .

Electronic Trading Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

TECHNOLOGICAL BARRIERS To 24-HOUR TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . ....*..*

THE PROBLEM OF STANDARDS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● ...*... .

Chapter 3. The Extent of International Securities Trading . . . . . . . . . . . . . . . . . . .... . . . . . .

TRENDS DRIVING GLOBALIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .*..*... . . . .

Communications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Interdependence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. ● . . . . . . . . ●

Capital Imbalances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Financing National Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Institutional Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Regulation and Deregulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● . . . . . . .

Privatization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

OBSTACLES TO INTERNATIONAL SECURITIES TRADING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

HOW "GLOBALIZED" ARE SECURITIES MARKETS? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Cross-listing of Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

International Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Opening National Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Passing the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Product Links Between Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Multinational Initial Offerings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

International Mutual Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....,.. . . . . . . . . . . . . . . .

RISKS INHERENT IN GLOBALIZATION OF SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . .

Chapter 4. Americans Competitors in Global Securities Trading . . . . . . . . . ......... .... ●

JAPAN . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Recent Trends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

How the Market Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .,..,... . . . . . . . . . . . .

Derivative Products Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Over-the-Counter Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Clearing and Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Market Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Tokyo as a World Center for Securities Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE UNITED KINGDOM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

How the Market Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Clearing and Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Market Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The London International Financial Futures Exchange(LIFFE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

London as a World Center for Securities Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

THE EUROPEAN COMMUNITY MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The EC’s 1992 Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ● . . . . . . . . . . . . . . . . . . . . . . . .

1

1

2

2

3

4

5

7

8

8

8

11

11

12

13

16

19

19

23

25

26

26

26

27

27

28

28

28

29

29

30

32

32

34

34

35

35

37

37

38

38

40

41

42

42

43

43

44

47

47

47

48

48

49
Page

Chapter 5 Internationa1 Clearing and Settlement: What Happens After the Trade . . . . . . . . . . . . 55

THE GOALS OF CLEARING AND SETTLEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

HOW CLEARING AND SETTLEMENT WORKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

RISKS FROM DIFFERENCES IN CLEARING AND SETTLEMENT MECHANISMS . . . . . . . . . 57

EFFORTS TO REDUCE THE DIFFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

UNRESOLVED PROBLEMS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

POLICY ISSUES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Risks Associated With Default . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

Risks Associated With the Payment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

Information Sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66

Inadequate Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Standardization and Harmonization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

Shortening the Time to Settlement and Providing Same-DayFunds . . . . . . . . . . . . . . . . . . . . . . . . . . 68

IS AN INTERNATIONAL REGULATORY BODY NEEDED?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

Chapter 6. The Regulation of Global Securities Trading ... . . . . . . . . . . 71

COMPETITION AND REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

TWO KINDS OF REGULATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

BANKING AND SECURITIES MARKETS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73

REGULATORY INSTITUTIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

ENFORCEMENT OF SECURITIES REGULATIONS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74

HARMONIZATION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

AMERICAN LEADERSHIP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

Appendix. Clearing and Settlement in Major Market Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81

Acronyms and Glossary ● .. . . . . . . . . . ● ......... ....,.. ...0..0. 100

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . ● ..*. 105

Boxes

Box Page

3-A. Exogenous Events and U.S. Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

4-A. EC Securities Law Directives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

6-A. International Organizations Related to Coordination of Securities Regulation . . . . . . . . . . . . . . . . . . . 77

Figures

Figure Page

2-1. Overview of International Trading Through NASD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

3-1. Evidence of the World’s Markets on Oct. 13,1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

3-2. Market Capitalization of World’s Stock Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

3-3. Foreign Holdings of U.S. Financial Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

3-4.TradingAroundtheWorldandNearlyAroundtheClock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

5-1. Interfaces Among Clearing Participants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

5-2. Settlement Date:T+? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

Tables

Table Page

3-1. Comparison of Major Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

3-2. Total Cross-National Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

5-1. Group of Thirty: Current Status of International Settlement Recommendations-Equities . . . . . . . . . . 61

5-2. Recommendations From Major International Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

x
Chapter 1

The Evolution of a Global Securities Market

As national economies are linked together by

the exchange of goods and services and by

public and private communications networks,

global securities markets develop. American

securities markets, among the world’s best in

liquidity, efficiency, and fairness, should stand

out in this expanded arena, provided they do not

fall behind in technological and financial innovation. But securities trading on a global scale

brings with it new risks, as well as beckoning

opportunities. American investors and American regulators and policymakers are seeking to

understand these risks and appraise the demands

that they will place on markets, market participants, and their regulators.

This background paper describes the forces

encouraging the development of international

securities markets, the obstacles that must be

overcome, and the major sources of unnecessary

risk. It provides some estimates of the present

extent of cross-border trading, and describes the

largest and most active organized markets-our

competitors in providing securities-related services—in Japan, the United Kingdom, and the

rest of the European Community. It also describes the important clearing, settlement, and

payment mechanisms that support major markets. Finally, it outlines the questions to be faced

as the span of securities trading stretches beyond

the scope of national regulatory regimes.

This background paper prepares the way for

a forthcoming OTA report, Electronic Bulls and

Bears: Securities Markets and Information Technology, which will probe policy issues arising

from the impacts of communications and computer technology on traditional market structures and practices, and their ability to meet the

demands implied by global securities trading.

INFORMATION TECHNOLOGY FOR

GLOBAL MARKETS

Global telecommunications shrink distances

and time differences, tie together national economies, and thus encourage the growth of securities trading across national boundaries. The

rapidly increasing capacity and declining cost of

communications and computer systems make

these trends sure to continue. The emergence of

multinational corporations with presence throughout the world is also hastening the globalization

of securities markets. The needs of large institutional investors for cross-national investments

to diversify or to hedge their portfolios is

another strong driver.

The technology for global trading is basically

in place, in the form of public and private

communications networks, the specialized computercommunications systems used for market data

dissemination, and—just poised for take-off—

automated systems for ‘round-the-globe, ‘roundthe-clock trading. The integration of the world

economy means that multinational enterprises

and their products and services become known

to investors throughout the world, reducing the

information barriers that have in the past inhibited international securities trading. Significant

obstacles remain, because international standards and effective international regulatory

protections are not yet developed.

The growth in demand for international

market news and market data (quotations, last

sale prices, volume), together with the effects of

the digitizing of data, has led to brisk competition among information services vendors, and to

a turbulent restructuring of that industry. Electronic trading systems being developed both by

information vendors and by forward-looking

exchanges could become the international exchanges of the future. At present, they are

essentially unregulated. These changes are forcing two issues into new prominence:

. Who owns digitized data at various stages

of its processing and dissemination, who

can enforce ownership rights, what constitutes ‘‘value added, ” and how should

digitized data be priced?

– l -
2 ● Trading Around the Clock: Global securities Markets and Information Technology

● Should proprietary trading systems be regulated as organized markets (like exchanges),

and if so, by whom?

It is by no means certain that U.S. markets

will remain in the forefront of the movement

toward ‘round-the-clock global securities trading. While U.S. futures exchanges and our

over-the-counter market are acting aggressively

to put worldwide electronic networks in place,

the U.S. stock exchanges have been slower to

act. Meanwhile, securities exchanges in many

countries are moving toward highly automated

markets.

The lack of international standards will be

increasingly important; for example, standards

that apply to international financial services,

especially securities trading, need attention

urgently. Government involvement in standardssetting appears to be essential if new sources of

operational risk are to be minimized.

THE MEANING OF

GLOBALIZATION

Foreign currency exchange and markets for

government debt securities have long been

international. To the extent that there is still

argument about the future of global securities

trading, it focuses on how quickly 24-hour

trading will emerge, and to what degree it will

extend to corporate equities. A two-tier market

system could develop, with international electronic trading of the shares of 500 to 1,000

multinational corporations, and domestic (country of domicile) trading on traditional exchanges

and over-the-counter markets of most other

corporate securities. Or—although this is less

likely—traditional exchange-based, face-toface markets could lose out entirely to the

competition of electronic systems.

There is growing evidence, especially since

the October 1987 market break and the October

1989 break, that securities markets around the

world are linked. They tend to move in parallel

in response to economic and financial news, and

to react sharply to stress in other markets.

Although there has been relatively little response in other markets to sharp declines in

Tokyo Stock Exchange prices in early 1990, the

anxious attention of market observers around

the world attests to the general recognition that

this stability may be precarious.

“Globalization of equity securities trading”

is a term that covers a variety of related growth

trends. It includes the cross-listing of securities

in several countries, cross-national portfolio

diversification and hedging, holding membership (generally through affiliates) in another

country’s exchanges, legal or contractual ties

between exchanges, electronic systems for 24-

hour trading, “passing the book,” the development of cross-national stock index derivative

products, and related phenomena such as multinational primary offerings of stock and international mutual funds. All of these are now

growing, although at different rates.

There are nevertheless major obstacles, such

as legal, regulatory, and cultural differences

between nations and markets. Some of these

differences impose serious risks on investors,

market organizations, and other financial institutions. These new or aggravated risks are often

poorly understood by individual investors and

perhaps by professional investment managers.

In the worst case, the failure of major market

participants (e.g., securities firms or banks) with

heavy commitments in several countries could

have gravely detrimental results for national

financial and payment systems and possibly for

entire economies.

COMPETITORS IN WORLD

SECURITIES TRADING

Our rivals as centers of international securities trading today are Japan and the United

Kingdom. The potential integration of a European securities market, with the European

Community’s 1992 Initiative, will bean important factor in future competition. Other nations

are or may become niche competitors.

The Tokyo Stock Exchange (TSE) vies with

the United States as the world’s largest securi-
—.

Chapter l—The Evolution of a Global Securities Market ● 3

ties market in terms of capitalization and trading

volume. It has the advantage of a strong

economy with many multinational corporations,

a concentration of capital that may exceed

domestic investment opportunities, a large retail

customer base, and supportive government policy. It is not as ‘‘international’ as London’s

markets nor as accessible to foreign investors as

either London or New York, because of regulatory, institutional, linguistic, and cultural barriers. Transaction costs and listing costs are

relatively high.

London’s International Stock Exchange (ISE)

is also among the four or five largest markets

(usually following the TSE, the New York Stock

Exchange, the Osaka Stock Exchange, and

NASDAQ, the U.S. over-the-counter market);

and it is the most international major market,

with nearly a quarter of its listings and a quarter

of its transactions involving foreign issues.

However, in the aftermath of deregulation and

automation—the ‘Big Bang’ of 1986-and the

market crash in 1987, the ISE has serious

problems, including the growth of off-market

trading that threatens to cause market fragmentation. Spreads and commissions, two components of transaction costs, are very low; but

settlement costs are disproportionately high.

Strenuous efforts are underway to solve these

problems.

Other European markets, especially the German exchanges, the Paris bourse, and the Swiss

exchanges, are making vigorous efforts to

increase their volume, automate their activities,

and modernize their regulatory regimes. The

European Community intends to achieve regulatory harmonization and an integrated, strong

“European trading arena” in services by 1992,

including eventually an integrated European

securities market. This is a goal rather than an

achievement, and there are many obstacles, but

substantial progress has already been made.

CLEARING AND SETTLEMENT

The most critical problems for international

securities trading, but also the most concerted

efforts at problem resolution, are in the area of

clearing and settlement. Clearing and settlement

systems for financial instruments differ greatly

within and across countries, in procedures, in

timing of settlement, in the institutions involved, and in the degree, nature, and locus of

risks. These differences in countries’ systems

are important because: 1) systems traditionally

used for domestic trading are now being called

upon to accommodate international participants;

2) the integrity and efficiency of a nation’s

clearing, settlement, and payment system are

important to its internal financial and economic

stability and its ability to compete with other

nations; 3) the failure of a foreign clearing entity

could affect a U.S. clearinghouse through the

financial failure of a common clearing member;

and 4) the growing number of U.S. investors in

foreign markets may be unaware that risk levels

in some foreign markets can be much higher

than those in our domestic markets.

To improve efficiency and reduce risks, the

world’s clearing and settlement systems must be

coordinated with each other in a number of

ways. Both the private sector and regulators in

the United States and other countries have begun

to take, or are considering, actions to accomplish

the needed improvements. A number of international studies are in general agreement on the

types of improvements needed. These studies

have been done by the European Economic

Commission, the Federation International des

Bourses de Valeurs (FIVB), the Group of

Thirty, the International Society of Securities

Administrators, and Bankers Trust Co. (the last

as contractor to OTA). One of the shared

conclusions of these studies is that the world’s

major clearing and settlement systems should be

“harmonized” in selected ways in order to

strengthen them and prepare for the emerging

global trading environment.

The private sector in the United States, with

encouragement from regulators, is making impressive progress in paving the way for needed

improvements, but many are complex, timeconsuming, and costly. In some areas legislation

is likely to be needed, e.g., to make it possible
4 . Trading Around the Clock: Global Securities Markets and Information Technology

to eliminate all, or most, physical certificates for

securities and to align holidays observed by

banks and financial markets. In other cases, U.S.

regulators will need to take action.

In many cases, U.S. and foreign government

cooperation will be needed to effect change. Six

major concerns need to be addressed: risks

associated with default; risks associated with the

payment process; information sharing; progress

in technology development; standardization;

and shortening the time to settlement using

same-day funds. The attention to date by various

organizations to international clearing, settlement, and payment systems has been helpful,

but these efforts are unlikely to provide needed

continuity, and have not addressed all financial

products, such as derivative products (e.g.,

stock-index futures and options). Because of the

diversity, complexity, and universality of issues

likely to continue to arise over the next decade,

a single international body should be considered

to facilitate world cooperation in addressing

these issues.

COMPETITION AND

REGULATION

Many complex problems and unnecessary

risks arise from differences between nations in

regulations and in regulatory objectives, and

from the lack of international machinery for

monitoring, surveillance, and governing of global

markets. Significant risks associated with international securities markets are related to substantial differences among nations and markets

in:

●

s

●

prudential regulation (i.e., investor protection rules, such as disclosure requirements

or safeguards against market manipulation

or fraud);

capital requirements, accounting practices,

and other factors relating to the financial

integrity of market professionals and intermediaries, brokers, dealers, and traders;

and

margining systems, clearing and settlement

mechanisms, and payment systems, especially important because they may involve

systemic risks to financial institutions that

are involved in the markets of several

countries.

There are also important differences in the

activities permitted to certain market participants (e.g., separation between banking and

securities activities, or separation of broker/

dealer functions).

Differences among nations in regulation of

securities markets are a factor both in risks and

in competition among markets. There are sharp

disagreements about the effects of market regulation on competition among markets for customers. Some market participants stress that

regulatory costs add to transaction costs, and

oppose most regulation on the grounds that it

could drive securities trading (both domestic

and international) to overseas, less regulated

markets. This concern could lead to ‘regulatory

arbitrage, ’ or a movement to reduce regulatory

supervision of markets to the level of that in the

least regulated competitive market.

However, there are two broad categories of

market regulation: access regulation, and prudential regulation. In most countries, there has

been a movement toward access deregulation in

the last few years; i.e., reducing the barriers to

broad participation (including foreign participation) in organized markets or exchanges, and

this has encouraged internationalization. In

some countries, there has at the same time been

a movement toward strengthening prudential

regulation, or rules aimed at protecting investors

against unrecognized risk or against market

fraud, abuse, and manipulation. This is sometimes called "re-regulation, " and it is also often

done for the purpose of attracting investors,

especially international investors. (Neither movement has been obvious in the United States,

which already had better investor protection

laws than many countries, and few if any

barriers to foreign participation.)

The problems of enforcing national regulations are complicated by the difficulty of

investigating and correcting abuses that origi-
Chapter l—The Evolution of a Global Securities Market ● 5

nate overseas or involve participants outside of

the country’s borders. In the United States,

legislation is being considered that strengthens

the powers of U.S. regulatory agencies to

cooperate with foreign regulators. Cooperative

efforts are complicated by laws in some countries that restrict the disclosure of financial data,

i.e., privacy and secrecy laws.

Free market proponents argue that regulatory

differences between nations are best resolved by

deregulation in all nations, letting market forces

and competition decide which risks are acceptable to investors. But in most markets and in most

countries, there is a movement toward seeking

“harmonization” of regulations and cooperative enforcement of standards of fairness and

honesty. Many industry groups and international associations in the private sector, as well

as regulatory authorities in the major market

countries, are participating in these efforts.

However, at the policy setting level and at the

negotiating level there are substantial disagreements about what “harmonization” should

mean. Even among regulatory agencies in the

United States, there appear to be significant

differences in the approach to harmonization of

regulations. There are several different approaches loosely designated as ‘commonality’

(universal regulations); “comparability” (acceptance of substantially equivalent rules); “national treatment” (each country subjecting domestic and foreign institutions to the same rules

within its borders); and ‘‘mutual recognition”

(a country allows foreign institutions to operate

within its borders under the rules of their

countries of origin). The last two of these

approaches actually do not require, or constitute,

harmonization.

There are several movements underway involving either governmental bodies or private

sector associations, or both, to achieve greater

harmonization. Stronger initiatives by U.S.

governmental agencies may be needed to encourage such efforts, or to assert U.S. leadership

on behalf of such efforts, in order both to protect

U.S. investors and institutions and to enhance

our competitive position vis-a-vis global securities trading.

THREE SCENARIOS FOR

GLOBALIZATION

These trends suggest several scenarios for

possible regulatory responses to the globalization of securities markets. The scenarios outlined below are intended merely to focus

discussion on the implications of international

securities trading, and are not suggested as fully

developed strategies or policies.

The present political, economic, and regulatory environment for international securities

trading consists largely of informal or contractual institutional arrangements and bilateral

agreements between national regulatory authorities. The future regulatory framework for world

markets could be a continuation and extension

of these evolutionary developments; or strikingly different frameworks might develop. They

could come about as a result of severe market

breaks and disruptive economic and political

events, or as a result of initiatives shared by

private and public financial institutions and

regulatory authorities around the world.

Many forces, acting together at many levels,

could influence such developments. At the level

of the global economy, the process of continuing

economic development is driven by such forces

as the impacts of major economic imbalances,

national economic and finance policies, trade

patterns, inflation rates and interest rates. It will

also be shaped by political events-e. g., change

in Eastern Europe, the unification of Germany,

and the European Community’s 1992 Initiative.

At another level, the evolution of financial

markets will be shaped by the course of

technological and product innovation and the

behavior patterns of key players—multinational

and translational business enterprises, securities underwriters, institutional investors, securities firms, exchanges, banks, clearing organizations, information services vendors, and national regulatory authorities.
6 ● Trading Around the Clock: Global Securities Markets and Information Technology

The pattern of technological innovation is an

important factor in the behavior of securities

markets. Innovation in technology and in financial instruments could contribute to sustained

liquidity and expansion; but it is also possible

that innovation could outpace the capability of

market participants to comprehend and control

its effects, or could merely be a drain on

resources and attention without contributing to

economic utility. Accelerating obsolescence of

information technology could diminish the return on investment, eventually discouraging

innovation. Financial product innovation can

draw new investment into securities markets or

drive out some traditional investors. Some

financial innovations (e.g., stock-index futures)

have certainly dramatically increased the linkages between different kinds of capital markets,

with secondary impacts that are not yet wellunderstood and are the subject of much controversy, especially in the United States and Japan.

[These forces are discussed in a forthcoming

OTA report, Electronic Bulls and Bears: Securities Markets and Information Technology.]

Peter Schwartz, of Global Business Network,

ties together the economic, political, and market

possibilities into five models of international

securities trading: These are:

●

●

●

Fragmenting Markets-Conflicts of interest, political friction, and protectionism

inhibit the process of integration of financial markets. Costly and unreliable technology adds to the burdens on market

participants. Key players see no value in

creating an international framework for

regulation of securities trading.

Regional Markets-Integration occurs at

the regional level as part of a protectionist

world of trading blocs, with diminished

interbloc trading, and possibly with new

capital controls.

Integrating Markets-Multinational trading blocs develop, but are not an impediment to global integration. They provide

useful models for complex multilateral

economic regimes. Agreements on general

principles are a step along the path toward

●

●

broader multilateral regulatory regimes.

The OECD is the model of a regional

organization in which the political capability for agreeing on very complex issues can

be developed.

Stratified Markets—A two-tiered market

develops, with the off-market, large bloc

institutional investors constituting a global

marketplace and an array of smaller domestic retail markets.

Global Markets-New technology, the

global economy, and the commercial strategies of financial companies and their

customers and suppliers, drive the evolution of global financial markets. They

develop within a regime of bilateral cooperative agreements, but the world is moving toward a 24-hour trading day operating

mainly in commercial networks outside of

recognized markets and their regulators.

This is, like the Eurobond market today, an

arena for professionals.

Although many others could be fashioned by

varying one’s assumptions, three possible scenarios for international securities regulation are

outlined below. The first assumes a gradual and

orderly transition from the present. If international securities trading expands through gradual evolution and there are no major economic

or political disruptions or global market crashes,

this is a highly likely scenario; it appears to be

the probable one for global securities markets.

But reason and goodwill can be defeated by

“accidents of history. ” Disruptions have often

been the triggers of change, sometimes undesirable change and sometimes change for the

better.

The second and third scenarios acknowledge

the possibility of drastic disruption and discontinuity. Either of these scenarios could develop if

changes in the marketplace outrun the market’s

ability to adjust, regulate, or even comprehend

its implications. Either might result from a

major market disruption, as large or larger than

the break of October 1987. Such a disruption

might be set off, for example, by a sharp decline

in the Japanese market, the after-effects of the
Chapter 1—The Evolution of a Global Securities Market ● 7

bankruptcy of one or two major U.S. securities

fins, or changes in currency value related to

unification of Germany or other events in

Eastern Europe or the Soviet Union, or the

Japanese real estate market. While a market

break might begin as an internally caused

‘‘accident, it is more likely to result from an

economic environment of weak profits and price

volatility. Continuing economic imbalances,

widening recession, and the inflationary boom

that would likely follow could set the stage for

one or the other of these scenarios.

Scenario 1: A Cooperative Framework

A series of efforts, already underway in 1990,

leads to the slow development of an effective

international regulatory structure.

●

o

●

There continues to be a stable, “fairly

prosperous economy. The industrialized

world enjoys slow but steady and unbroken

growth, low inflation, and unemployment

of less than 6 percent. Interest rates follow

a somewhat higher path trailing the slow

decline in the U.S. fiscal deficit. International imbalances slowly unwind, currency

volatility diminishes as a result, and there

are no major shocks or disruptions.

As capital investment in new technology

increases, and productivity improves, the

stage is set for higher growth and accelerating investment, placing great demand on

international capital markets. A continuing

bull market supports a climate of sustained

financial innovation. Today’s multidomestic markets with limited international activity move toward ever more

international flows.

The true global marketplace begins to

develop in the off-market trading arena

used by large institutional investor/

professionals. As the structure of markets

gradually becomes ever more stratified,

and the systemic risks associated with them

become more apparent, the pressure for

some regulatory response mounts.

Economic integration begins at a regional

level and moves toward the global level in

the first decade of the new century. Cooperation is embodied in the development of

the international information systems and

the regulatory agreements required to foster increasing integration. Emerging regional blocs are the vehicles for greater

global cooperation rather than sources of

conflict.

The integration of the European Community leads to a closely linked European

Market centered in London. Many of the

issues resolved in that process became the

basis for wider international agreements

(e.g., prospectus standards).

A major step in the process is the continuing development, following the path earlier

taken by the Cooke Committee,l of the

International Organization of Securities

Commissions (IOSCO) technical committee as an effective, permanent organ for

setting the agenda for agreements and

preparatory steps. The Group of Thirty

provides continuing encouragement and

support. A high degree of collaboration

ensues between private-sector financial

leaders and regulatory authorities in the

major market countries.

During the 1990s a new regulatory framework gradually emerges out of the slow

accumulation of bilateral agreements, or

Memoranda of Understanding (MOUs).

This is a very modest regulatory regime,

with limited overt organization.

Through the collaborative actions of these

several bodies a schedule of agreements

emerges focusing initially on the risks

associated with settlement and common

lb the lg70~ ~ ~ge ~mr of foreiw m~~tio~ ba~ si~ted ~ ~ndon s~~ ,sw~~ serious concerns: over disparities h WCOU.Uthg

standards, over who would act as lender of last xesort if one of these branches failed, etc. The Bank of England proposed the establishment of an

international Standing Committee of regulators, established in 1974 [now called the Cooke Committee after its chairmam Peter Cooke]. The Standing

Committee developed the Basle Concor&G a set of international principles for handling a banking crisis. The concept here is that the technical committee

of IOSCO (already established and working) or a similar permanent committee of another intermtional organization might quasi-formally assume many

of the coordinating functions of an international regulatory body.
8 ● Trading Around the Clock: Global Securities Markets and Information Technology

conditions for capital adequacy. The issues

of futures markets and questions of multiple listings and multinational share offerings are slowly resolved. Common accounting standards take even longer.

Scenario 2: An International

Regulatory Regime

The average growth rate might be slightly

lower or slightly higher than in the cooperative framework scenario, but economic

variables swing widely. Exchange rates,

interest rates, and inflation rates interact in

a period of flux driven by unmanaged

imbalances and cascading shocks.

Some event—a severe earthquake in New

York or Tokyo, a financial scandal in

London’s Eurobond market-triggers a

general crisis in already stressed securities

markets.

The major market disruption creates the

political will to establish an institutional

regulatory regime at the international level,

although none of today’s international

financial institutions, such as the World

Bank, the IMF, or the Bank of International

Settlements, or IOSCO, provide a completely adequate model.

Galvanized by necessity, nations act rapidly and effectively to set up a new

institution and enforce its decisions. U.S.

Government and private sector representatives play a leading role in the negotiations.

The U.S. Congress articulates a forceful

policy of support for the new institution; at

its instructions, the regulatory agency begins a rigorous assessment of marketsrelated laws, regulations, procedures, and

policies to identify necessary changes and

adaptations.

The economic volatility does not inhibit

technology-based investment, but actually

accelerates change as the downswings

facilitate the write-off of obsolete capital

and the upswings support new investment—

Schumpeter’s model of “creative destruction.’ A volatile early 1990s leads to

higher growth and increasing integration of

the global marketplace.

Scenario 3: Conflict and Disintegration

A break occurs, as a result of a fundamental

currency reevaluation crisis, that is severe

enough to seriously erode confidence.

Market discontinuity and economic downturn lead to increasing friction rather than

cooperation. Slower recovery and a bear

market result as there are vicious cycles of

mounting damage.

Market growth slows dramatically or reverses, and becomes more volatile. There

is widespread loss of confidence. Lack of

resources and motivation are almost insurmountable barriers to innovation.

Efforts for international regulatory cooperation wither quickly.

IMPLICATIONS OF THE

SCENARIOS

Effective response to a major securities market break will in the future require international

as well as domestic actions. The central issue

may be how to prevent a liquidity crisis from

becoming a solvency crisis. This requires a

better understanding than we have now of how

large a market break could occur, how and why

it might happen, and how to restore confidence

afterward. In some markets, there may also be

unexamined risks of overstraining key systems

(e.g., clearing and settlement) in a roaring bull

market. These uncertainties are probably as

poorly understood as the risk of a major market

break.

International securities markets may be moving toward a structure that is efficient, stable,

and adequately well-regulated. This outcome is

likely if there are no cataclysmic changes from

today’s situation, either generated internally (by

behavior of the participants, or by failure of

basic market structures) or generated by macroeconomic events outside of the markets. As

internationalization continues, it will be important to deal with the perils of “regulatory

arbitrage’ if competition tempts participants to
Chapter I—The Evolution of a Global Securities Market ● 9

move trades to the cheapest, least regulated

markets.

It is increasingly likely that there will be a

stratified or two-tier market structure. This

could mean a divergence of interests between

the large, wholesale, institutional, global transaction market and the domestic, retail market.

What have been considered off-market activities

(nonorganized, negotiated trading on proprietary systems, perhaps unregulated) may come to

dominate global equity markets for the securities of at least 500 to 1,000 translational or

global companies in the future.

The central problem will become one of

systemic risk. Will there be a lender of last

resort? Will the real risks devolve onto commercial banking systems, and national payment

systems? How can volatility in the global

market be kept from cascading onto domestic

markets, where the consequences might be

greater? How can the global economy be

protected from excessive risk from the unregulated international securities market?

It is clear that the U.S. Congress will necessarily have a critical role to play with regard to

the globalization of securities trading. At a

,

minimum, Congress will be called on for

oversight and guidance of U.S. regulatory bodies and executive agencies—the Securities and

Exchange Commission, the Commodity Futures

Trading Commission, the Federal Reserve Bank

Board of Governors, and the Department of the

Treasury, all of whom will be involved in

framing the position of the United States in the

evolution of an oversight, supervisory, or regulatory regime for international securities trading. It is not clear that these authorities now hold

a common view of the interests of the United

States with regard to either: a) the kinds of

aggressive actions and innovation needed to

compete in offering services and products to

investors around the world, or b) the degree of

risk inherent in international trading and the

desirability of working with other nations to

develop a stronger regulatory regime to reduce

these risks.

In this critical situation, it may be necessary

for the U.S. Congress to articulate a clear

statement of the national interest for the guidance of regulators, as it did in 1934 with the

Securities Exchange Act, and in 1975, with the

Securities Exchange Act Amendments.
Chapter 2

Information Technology for Global Markets

Four forces have caused international securities

trading to increase:

advances in information technology-telecommunications and computers;

the development of a global economy with

multinational corporations needing both international communications and international sources

of capital;

the emergence of huge institutional investment

funds needing cross-national diversification;

regulatory changes, especially access deregulation that opened stock exchanges to foreign

membership in many countries.

The technology for international securities trading is in place, and its capabilities will continue to

increase. The emerging global communications

infrastructure has evolved at three levels: 1) public

and private communication networks using cable,

microwave, and satellite transmission; 2) communications technology used by providers of market

information services; and 3) specialized electronic

securities trading systems.

THE EMERGING GLOBAL DATA

COMMUNICATIONS

INFRASTRUCTURE

International securities trading requires a system

for efficient, rapid, and secure transmission of

market data, transactions messages, and payment

instructions. The infrastructure to do this has developed rapidly over the last 25 years and is continuing

its turbulent development. Four technological trends

contributed to this development:

. expanding computer capability and declining

costs;

● digitization of data, and the resulting convergence of computer and telecommunications

technologies;

. satellite communications development; and

● fiber optics development.

Improved computer performance and declining

costs have resulted from improvements in basic

computer technology, very large-scale integration

(VLSI) technology, materials (e.g., use of gallium

arsenide in production of chips), and computer

architectures and software.3 In 1960, it cost about

$75 to do 1 million computer operations; in 1980 it

cost 0.1 cent. By 1997 computer costs are expected

to decrease still further. Computers make it possible

to use telephone systems to transmit, store, and

distribute electronically encoded information; they

also control the switches that route information

through a network.

“Digitizing’ is the translation of information

from traditional analog forms such as pictures,

speech, or written/printed characters, into discrete

binary-coded electronic signals for processing, storage, or transmittal. This makes possible the fusion of

telecommunication and information-processing technologies. It allows man-to-machine communication

not possible with a conventional telephone, and has

prompted the carriers to build multi-media communications systems by combining facsimile, data, and

video with voice transmittal capability.4 Since the

1970s, AT&T, MCI, Sprint, and other communications carriers around the world have been upgrading

their existing networks to high-capacity digital lines.

Fiber-optics Provides broad bandwidths that allow

the transmission of high-speed video images as well

as the capacity to move large volumes of data.

Development of broadband integrated services digital networks (B-ISDN) can eventually provide

efficient broadband interconnection for all communication services-transmitting voice, data, video,

and text. ISDN is still in the early commercialization

stage.

l’rhis ~tion tiWS l.KXWiIy on an CZ@SI OTA repo~ U.S COngreSS, Office of Technology Assessment critical connections: CO?t??WnicUZiOnfOr

the Future, O’E4-CIT-407 (Washington DC: U.S. Government Printing Office, January 1990), especially ch. 3, “New Technologies and Chan@ng

Interdependencies in the Communication Infrastructure.”

WL.SIkllows the placement of over 100 logical oprmtions on a single integrated circuit chip, a capaMMy that has been doubling about every 18 montbs.

%J.S. Congress, OTA, op. cit., footnote 1, p. 46.

4u.s. Cowess, OTA op. cit., footnote 1. See also, Tosh.io Kosuge, “Telemmmunications,” in Peter Robinso~ Karl P. SauvanC and Vishwas P.

Govitrikar (eds.), Electronic Highways for WorZd Trudk (Boulder, CO: Westview Press, 1990), pp. 223-238.

–11–
12 ● Trading Around the Clock: Global Securities Markets and Information Technology

These developments shape all parts of the communications infrastructure: 1) switching or networking technology; 2) transmission technology; and 3)

terminal technology.s Switching technology consists of computer hardware and software for routing

messages and establishing a communication channel, and thus provides the “intelligent” part of the

network. Manual switches and electronic analog

switches are being replaced with digital switches.

Some superfast packet switches6 can now transmit

hundreds of thousands of packets per second; by the

late 1990s, with optical switching, even greater

speeds will be practical. Software development will

determine the rate of further improvements in

cost/performance ratios.

With more powerful microprocessors, faster computing speeds, and larger memories it is now

possible to put control functions for the network not

only in the central switch, but also at. nodes

throughout the system. This software-driven and

software-defined communication infrastructure--

“the intelligent network’ ’encourages the introduction of new value-added services using modular

software.

Keeping pace with advances in switching technology are advances in transmission technologies:

optical fiber or coaxial cable and radio or broadcast

technology, which includes satellite, microwave,

and for local use, cellular broadcast communications. Customers usually do not know or care how

the message was transmitted, but differences in these

technologies result in major differences in the type

of electronic signals that can be transmitted, the

quality of transmission, the range of frequencies that

can be used, the speed of transmission, the confidentiality and security of the transmission, and the cost.7

Terminal equipment is that found at the customer

end of the network, usually telephones or computer

terminals. Many of these terminals now contain

information-processing capability.

Advances in global communications infrastructure technologies will probably accelerate. Nevertheless, there is some danger that network interdependence may slow innovation, because once users

have invested in equipment conforming to a particular standard, they will be reluctant to purchase

equipment that is incompatible even if it is otherwise

superior. 8

Public and Private Global Networks

Telecommunication services are provided in many

countries by state-owned monopolies, that typically

use INTELSAT and regional satellite and cable

facilities to transmit international communications.

In the United States, telecommunications have

traditionally been provided by governmentregulated private-sector fins. The United Kingdom, Japan, Hong Kong, and other countries are

moving toward private or private-government systems.9 A user in one country who wants to connect

with an online database in another country most

often does so with a modem (a device that allows

digital signals from a computer to be transmitted

over analog telephone lines), through a longdistance telephone connection. Telephone companies in different countries pass calls along through

interconnections across different technologies-a

message often travels through microwave, satellite,

and cable transmission facilities.

Public telephone systems have encouraged the

development of computer networks. A computer

network is a collection of computers-whether

minicomputers, mainframes, or supercomputers—

that communicate with each other using common

protocols, over transmission links that can be cable,

satellite, or ordinary telephone lines. The networks

may be local area networks (LANs) or long-distance

networks (wide area networks, or WANs). They

allow any computer in the network to access and use

computer programs or data stored on any other

network computer.

In the United States, the unbundling of some

communication services and the divestiture of AT&T

have encouraged business users to assemble their

own networks. Deregulatory changes encourage the

5Komge, op. Cit., footno~ 4“

6p~&e~.~fitc~~y~tem dividc~s~~nl~~gesinto~y Shortblocks orpackcts tit c~~rollted independently throughnummus geographically

distributed switching nodes.

7GR~ Feketekuty, *’International Network Competition in Telecommunications, “ in Robinson et al., op. cit., footnote 4, pp. 257-287.

W.S. Congress, O’IA, op. cit., footnote 1, p. 43.

%. Brian Woodrow, “Trade in Telecommunications and Data Services: A ‘Constitutional’ Analysis,” m“ Robinson et al., op. cit., footnote 4, pp.

15-42.
Chapter 2--Information Technology for Global Markets ● 13

unbundling of services by allowing users to separately purchase communication services or functions

that were formerly available only as a single unit (the

kind of end-to-end service once offered by the

AT&T Bell System). Unbundling has encouraged

the development of value-added services, and may

be carried further by the development of “open

network architecture” (ONA), which allows service

providers to buy elemental network functions and

reconfigure them to meet their particular needs. True

ONA requires further advances in software development, and it may in the end not be acceptable to all

users because it transfers to them the problems of

network planning and management.10

A striking feature of modern global telecommunications is the development of private networks to

serve the needs of individual translational enterprises. Once data are digital, corporate networks

allow translational corporations to perform corporate functions in any country. Many large financial

institutions like Citibank, American Express, Salomon Brothers, major stock exchanges, and other

kinds of multinational corporations such as IBM,

Digital Equipment Corp., Unisys, General Motors,

and Britain’s Imperial Chemical Industries, have

developed their own networks, using satellite capacity and transmission lines leased from communication companies. IBM, for example, has “a global

communications network that ties together its installations in 145 countries. There are also privately

owned data networks that serve many corporations,

such as Telenet Communications.

Digital data and the declining costs of telecommunications have resulted in a proliferation of information services providers, and in the development of

closed user-group networks—i.e., SWIFT,ll and

Reuters Limited, the international news service.

Global networks are “making previously untradable services tradable.” In the past, vendors could

offer such services in the foreign market only

through foreign affiliates.12 Data services, which

make use of international telecommunication circuits, are offered in many countries on a competitive

and unregulated basis. International data services

have normally used established monopoly transmission arrangements, but alternative distribution possibilities are opening up; for example, domestic

satellite providers in one country may sell crossborder capacity or specialized services in bordering

countries.

These developments are strongly resisted by the

government-controlled public telephone and telegraph authorities (PTTs) in European and Third

World countries. In some countries there are restrictive laws governing the use of communications

technologies and systems to protect the state monopoly. Such legal, regulatory, and political barriers will

be serious problems for some time, although there

are strong indications that these barriers are breaking

down because communication is essential to competition in today’s world economy. Foreign competition tempts corporations to move their activities to

other countries, where business conditions are more

favorable.

Systems for the Transmission of Financial

News and Market Data13

Communications between exchanges, over-thecounter markets, and clearing organizations in

different countries, as well as communications

between investors and their brokers in one country

and markets in other countries, are for the most part

handled through the same communication modes

used by other business enterprises-i.e., leased

transmission lines. A portion of these communications are handled by specialized information services vendors. The rapid, broad dissemination of

market data is an essential element in making

securities markets both efficient and fair. It is largely

accomplished today by information services vendors using a variety of public communication

modes.

Advances in technology and restructuring of its

costs are having a profound effect on the structure of

the information services industry. They may induce

vendors to move into more specialized, value-added

services. It is possible that systems being developed

by the vendors for their own competitive reasons

lm.s. Congress, OTA, op. cit., footnote 1.

lls~s~d~ for Swiew for Worldtide ~ter~nk Ffinc~ Telecommunications; it is a system ~OW@ bxand other fmnc~ kLStihltiOllS,

including brokerage fins, to exchange payment instruction or clearing messages.

12-1 p. sauva~ ~~semices and Dab Semi@s: ~troduction, “ in Robinson et al., op. cit., footnote 4, pp. 3-15.

13~s sation &aws on a ~n~actor repo~ prepa~ for OTA by MoniM Ro~“F~c~~o~tionsemic~ Vendors,” August 1989.
14 ● Trading Around the Clock: Global Securities Markets and Information Technology

could become the real international exchanges of

tomorrow, as markets become more global, and

computer-based trading and telecommunications

become strategic advantages. Vendors are ahead of

exchanges in preparing to field global electronic

trading systems. However, vendors will have to

work out interfaces with clearing and settlement and

other systems (see ch. 5).

As early as 1850 there was a market for international financial information services; Paul Julius

Reuter began using carrier pigeons to fly stock

market quotations between Brussels and Aachen,

Germany. The opening of the first underwater

telegraph cable in 1851, connecting Dover and

Calais, allowed Reuter to start delivering market

data and financial news from London to Continental

Europe. Because of high start-up and low marginal

costs, vendors could be more efficient than user

firms in information gathering (as is still true today,

for the most part). The company Reuter founded,

Reuters Holdings PLC, is now one of five companies

that dominate the market for securities and futures

market data (prices and quotations). The other four

are Quotron Systems Inc., Automatic Data Processing Inc. (ADP), Telerate Inc., and Knight-Ridder

Inc.14 These five companies have approximately

400,000 terminals worldwide.15

The market for financial information can be

divided into three broad categories: 1) general

financial news,2) quotes and sale prices for exchangetraded instruments, and 3) quotes and prices for

over-the-counter instruments. (The latter two are

different markets because the sources of data are

different, and because of differences in trading

practices and trading technology.) Financial information vendors either gather general financial news

themselves or select and carry reports from leading

news organizations. Quotes (bids and offers), lastsale prices, and volume information-including

those for most stocks, all commodity and financial

futures, and all options-are generated by markets

and sold to vendors. In foreign exchange (forex) and

fixed-income (bond) markets, where there are no

centralized marketplaces, price information is contributed by banks and securities firms to vendors.

Dow Jones & Co., Inc., is the leading provider of

financial news in the United States, but Reuters has

an edge over Dow Jones in financial news that

affects forex and freed-income prices because of

Reuters’ vast international communications network. Other providers of on-line financial news

include Knight-Ridder, Associated Press, McGrawHill Inc., Financial News Network, and Market

News Service.

Quotron Systems has long dominated the market

for U.S. stock market data, but ADP is a strong

competitor. Outside the United States, the leader is

Reuters (based in the United Kingdom), which

recently entered the U.S. market for stock prices. In

the past, Reuters supplied market data and news for

foreign exchange, money market instruments and

commodities in the United States, but not for

equities. The internationalization of the securities

markets has prompted foreign vendors such as

Reuters and Telekurs of Switzerland to enter the

U.S. market. The relative ease of acquiring and

distributing price information for exchange-traded

instruments has also attracted new competitors,

including PC Quote Inc., and ILX Systems, a new

venture backed by International Thomson Organization.

At the same time, U.S. companies such as

Quotron and ADP have been expanding their

operations overseas. The growing interrelationship

among the equities, futures, freed-income, and

foreign exchange markets has also led to diversification among vendors who traditionally specialized in

one market. Telerate Inc., which holds a near

monopoly in the market for U.S. Government

securities prices, has entered the equities market

through its recent acquisition of CMQ Communications Inc., the leading provider of stock quotes in

Canada.

The relative ease with which any vendor can

obtain data from the leading North American stock

markets and many of their foreign counterparts has

changed the market for centralized market trade data

into a commodity market, in the sense of relatively

undifferentiated bulk goods, competing in terms of

price. It has increased the competition among

vendors so much that in order to maintain their profit

14@o&on is now ~m~ by Citimw; Tel~@ is now o~~ by ~W Jones & CO., hc., Iong Tel~mte’s majority shrth)ld~.

15~ ~~ly 1989, 42G,~ were ~~po~ ~~o~ding to MC ~o ~d K~eth Ng, Reuters Holdings pm(New York NY: (hlb~saChS & CO,,

February 1989), p. 5. There maybe some double counting here due to screens displaying more than one vendor’s data, and there has probably been some

contraction due to securities f- reducing their labor force.
Chapter 2--Information Technology for Global Markets ● 15

margins and to generate as much revenue per

terminal as possible, vendors are trying to add value

to the product through new technology or some

special feature. Third-party suppliers are now encouraged to offer historical information, research,

analytics, and tailored news services through the

terminals of financial information vendors such as

Quotron, Reuters, and Bridge. The vendors typically

keep for themselves 30 to 40 percent of the revenue

generated by third-party products.l6

The commodity or bulk nature of equities trade

data has no parallel in the fried income and foreign

exchange markets, which depend on data contributed by dealers, banks or other organizations. But

the largest securities firms have announced plans (at

the end of April 1990) for a joint venture to distribute

government bond data 24 hours a day. This network

would include all 844 primary bond dealers and four

major interbroker dealers, who execute trades for all

dealers,

Reuters created the market for real-time foreign

exchange data in 1973, when it first put computer

terminals on the desks of banks’ traders and persuaded them to enter their rates into the system.

Reuters does not pay banks for contributing their

quotes to the service, but charges subscribers a flat

monthly fee. While Reuters is the strongest in the

forex market, Telerate is a competitive alternate

service. This benefits forex traders by providing a

back-up quotation system and by assuring competition for Reuters. It was difficult for Telerate to gain

a place in forex until Reuters agreed to permit its

subscribers to install “binco boxes" —bank inhouse computers—that let them simultaneously

update their rates on Reuters and Telerate. Without

the binco boxes, Telerate’s forex market coverage

was often slightly behind because dealers posted

their rates on Reuters first.17

The financial information business is still growing, and continues to attract aggressive competitors.

This may eventually bring down prices for information services. In the meantime, both the integration

of markets and technological change are creating

upheaval and uncertainty among financial information vendors. As recently as 5 years ago, a dealer’s

desk would typically hold a Reuters terminal and

perhaps one from Telerate. Because markets did not

greatly affect one another, there was no need for

most traders in one market to be watching other

markets .18 The technology generally used was a

dumb terminal connected to a vendor’s host computer by dedicated telephone circuits. But as a

number of niche services sprung up, traders ended up

with more and more dedicated terminals on their

desks. Many of these were later replaced with

personal computers, to allow local storage and

manipulation of price information. The video switch

eliminated the clutter of terminals on traders’ desks

by allowing several screens to be controlled by a

single keyboard, and became an important part of

trading rooms in many countries.

Several other technological advances in the early

and mid- 1980s also irrevocably changed the delivery of financial information. In addition to using

dedicated telephone lines, vendors began exploring

other alternatives, such as broadcasting data by FM

sideband and satellite. In the United States, commodity market data vendors began in 1981 to use

small, low-cost, receive-only satellite dishes which

were particularly effective for one-way broadcast

communications such as financial quotations. They

are now used by vendors such as ADP, Dow Jones,

Knight-Ridder, PC Quote, Reuters, and Telerate.

Although dedicated interactive networks remain the

primary delivery mechanism of financial information vendors, financial data accounts for about 63

percent of the approximately 114,000 data broadcasting satellite receiving sites in operation in

1989.19

It is often cheaper for securities firms to buy

hardware off the shelf than it is for them to lease

equipment from vendors. In addition, the securities

firms want to be able to choose whether to use a

dumb terminal, a PC, or a UNIX-based workstation,

and they would like industry-standard hardware that

can be integrated with the fins’s other systems. In

recognition of this, Reuters recently stopped manufacturing terminals and Quotron plans to sell off-the16Roq op. cit., footnote 13.

170~m-~jor mom for Tel~atess ~Wss fi ~e~afig tie forei~ exc~nge ~ket we s~d tO include two foreign exchange brokers ~ging

for Telerate to carry their quotes, the availability of AP-Dow Jones foreign exchange news on Telerate, and the need for U.S. Merest rate data.

18Howwer, fie&~ome ~ders~ways~ven~~ to follow tie fore@ exc~WeWkets since currency pric~ adintemstrates ~cIosdyhlkd.

19wate~ Info*on StXViCeS, “DataBroadcasting Marketplace,” New Yorlq NY, 1989.
16 ● Trading Around the Clock: Global Securities Markets and Information Technology

shelf equipment. ADP is also moving to industrystandard hardware.

Vendors have begun to offer their data in digital,

as well as analog form, to satisfy the demand for

analytical tools. Receiving a stream of digital data

(rather than a pictorial image on screen) gives users

more flexibility in viewing, analyzing, and using

data--e.g., the ability to create customized composite pages. This has created a dilemma for financial

information vendors because neither exchanges or

vendors are sure how best to price digital information.

This has become a highly controversial issue: who

owns the data, who has access rights to it, who can

reformat and resell it, and when does reformatting

constitute value-added service? The fees paid by

customers have in the past been based on the number

of terminals or display devices authorized to receive

information in analog form. Resolving the datapricing issue will become more complicated and

more difficult as international data services become

even more fiercely competitive.

Electronic Trading Systems

The commodity nature of data and the diminished

role of information vendors as systems providers are

causing vendors to move toward offering transactional services, using automated execution systems,

Citicorp and McGraw-Hill failed with the GEMCO

electronic commodity trading system a few years

ago. The World Energy Exchange and the International Futures Exchange of Bermuda (INTEX) both

failed to convert open outcry traders to screen-based

trading in the futures market. But these and other

failed ventures in automated trading have not

deterred Reuters, which in 1987 bought Instinct

Corp., a registered broker/dealer offering an electronic securities trading system that began in the

1970s. Instinct is now executing trades of an average

of 13 million shares a day (including both NYSElisted and over-the-counter stocks), a volume still

tiny by comparison with the approximately 273

million shares traded by the New York Stock

Exchange and NASDAQ together on an average

day. Reuters hopes, however, that exchanges will

begin using Instinct or another Reuters-developed

system during the hours when their trading floors are

closed.

Reuters launched the Monitor Dealing Service in

1981 to allow forex traders to negotiate transactions

over their terminals instead of telephones. This

system has been successful, perhaps in part because

of its built-in audit trail. In 1989, between 30 and 40

percent of the $640 billion traded each day in the

interbank foreign exchange market took place on the

Monitor Dealing Service.20

Telerate did not until recently offer forex dealers

a transactional system such as Reuters’ Monitor

Dealing Service, but it has now launched a conversational, or on-line, dealing system through a joint

venture with AT&T, known as The Trading Service.

This service allows dealers to have multiple “conversations, ” that is, talk to several dealers at once,

unlike the Monitor Dealing Service.

Reuters is taking another step forward in automated trading with an enhanced version of the

Monitor Dealing Service and a centralized order

database facility. While the original Dealing Service

facilitates one-on-one negotiation between two traders, Dealing 2000 will emulate an auction market

where bids and offers from multiple parties are

exposed. This is designed to replace ‘‘blind”

brokers, who act as middlemen in foreign exchange

trading. The system will display the aggregate size

of all bids and offers at each price, but will not

disclose the identities of the dealers participating.

Quotron has not moved as rapidly as Reuters, but

reportedly has electronic execution facilities in

development for both foreign exchange and fixedincome markets. It has been aggressively marketing

Currency Trader, which allows corporate customers

of Citicorp to automatically execute foreign exchange trades of $500,000 or less.

Whether the foreign exchange market will accept

the automated trading Reuters is offering through

Dealing 2000 is still uncertain, but the technology

used in that system was adapted for GLOBEX, a

futures trading system being jointly developed by

the Chicago Mercantile Exchange (CME) and Reuters.

CME is one of two Chicago futures exchanges

trying to develop systems for ‘ ‘24-hour trading,’ or

the execution of transactions at a geographical

distance or outside of trading hours of local markets,

CME and the Chicago Board of Trade (CBOT) first

~ank of International Settlement’s statistics.
Chapter 2--Information Technology for Global Markets ● 17

separately and now jointly, are taking the calculated

risk that their own automated system--if successful--

may eventually put out of business their traditional

form of market, the “open outcry” or pit auction

system. They may recognize the likelihood that

international markets will eventually be fully automated and free of the constraints of time and

distance, and know that if they do not take the lead,

others outside the industry will do so.

This has come about because foreign futures

exchanges began to compete directly with U.S.

futures exchanges. There are financial centers in

Auckland, London, Paris, Frankfurt, Zurich, Hong

Kong, Tokyo, Singapore, and Sydney which now

operate futures and options exchanges as well as

stock exchanges. Because they began to offer their

own local versions of U.S. contracts, investment

firms were able to offer these products to customers

without regard to trading hours in the United States.

This trend drove the threatened exchanges to consider accommodating 24-hour trading.2l

The first attempts to meet this competition took

the form of mutual offset agreements. such as the

one between The Chicago Mercantile Exchange

(CME) and the Singapore International Monetary

Exchange (SIMEX) for Eurodollar and foreign

currency contracts. ‘‘Offset’ (in this context) means

that one can open a position in one country and close

it in another, and pay only one brokerage fee.

CME/SIMEX was for a time one of the most

successful of the many offset agreements attempted

by exchanges, although only marginally so.

Another response was to lengthen trading hours;

for example, CBOT began both an earlier opening

(7:20 a.m.) and an evening session,

In September of 1987, the CME announced that it

would develop-together with Reuters-an electronic futures and futures-options trading network,

the Post (Pre) Market Trade System, later renamed

GLOBEX for “global exchange. ” CME members

accepted the idea, with the assurance that GLOBEX

was strictly an off-hours system, and in return for

receiving a portion of the revenues generated by

GLOBEX. 22 On June 20, 1988 in London, England.

the CME and Reuters Holdings PLC reached an

agreement to adapt the new Dealing 2000 transaction system for the purpose. The network will

operate only after normal CME hours of trading and

will link investors in North America, Asia and

Europe.

GLOBEX, when it opens in mid-1990, will be an

interactive data communications network linking

individual user terminals with a central computer at

Reuters. For entry of orders, trader terminals consisting of keyboard, monitor. and printer will be located

in the offices clearing members and individual

members (including overseas members) who are

qualified and backed by a clearing member. (See ch.

5 for an explanation of the responsibility of clearing

members.) Administrative terminals, in the offices

of clearing members only. would also receive

confirmations of all trades resulting from orders

entered into associated trader terminals. The terminals will display the 10 best bid and 10 best offer

prices, along with the quantity bid or offered; the last

sale price, and other data.

Reuters will provide the computer hardware and

software and also make available other Reuters

services (e.g., news and cash market quotations)

through GLOBEX terminals. The exchange will

determine the instruments. and the rules and procedures for trading, and will provide clearing facilities.

auditing, compliance, and market surveillance, Despite Reuters being a British company. the joint

effort is largely seen as a globally strategic move for

the preservation and enlargement of the U.S. position in commodities and financial futures trading, It

may also be a harbinger of global ● ● floor-less* ●

trading in the future. It is significant, however. that

Reuters has recognized the value of partnership with

an organized and regulated marketplace, the futures

exchange.

MATIF (the French financial futures exchange)

has already agreed to use GLOBEX for after-hours

trading, and exchanges in other countries are also

‘lKaren Fierog, “How Technology Is Tackling 24-hour Global Markets,’” Furures, June 1989, p. 68.

‘The rights conferred by membership in CME, or “a sea~” are to be divided into access to pit trading and access to hd.ng through GLOBE.X.

Members will have the right to “lease” one of these rights; e.g., a pit trader can lease to someone else, presumably overseas. his access to GLOBE.X

thus generating additional income. If GLOBEX (or other electronic trading s>xtems) comes to domina te futures trading, the increase in value of their

access to it will pre sumably compensate the pit members for this competition.
18 ● Trading Around the Clock: Global Securities Markets and Information Technology

expected to participate, when various regulatory

issues are worked out.23

In 1989 the CBOT unveiled plans for another

off-hours global system, “AURORA.” While the

GLOBEX system is an automatic order matching

system, AURORA attempts to emulate the traders in

the pit with icons (symbols) that allow traders to

select the counterparts to their trade. The CBOT

claimed that AURORA will capture ‘‘all of the

economic advantages of the auction market combined with the advantage of the ability to conduct

trading from any location in the world."24 One

interesting feature of both AURORA and GLOBEX

is that they adjust the timing of all bids and offers to

equalize for distance; i.e., the speed with which they

are posted depends on the transmission time for the

most distant trader active at that time.

AURORA also tabulates bids and offers by

contract month, reports who traded how much with

whom, and keeps a running tabulation of his

positions for the trader. It automatically sends

matched trades through for clearing by the Board of

Trade Clearing Corp. The system uses Tandem

mainframe computers, Texas Instrument artificial

intelligence components, and Apple computer graphics.

There were complaints from the financial futures

community about the need to install two terminals,

and in May 1990, immediately after the Japanese

Ministry of Finance announced that it would permit

Japanese firms to subscribe to GLOBEX, CME and

CBOT announced they would merge the GLOBEX

and AURORA development efforts. The details of

this agreement are not yet negotiated. AURORA

may survive as an optional user interface. The

operation of GLOBEX may be delayed until mid1991.

The London International Financial Futures Exchange developed an electronic trading system,

Automated Pit Trading System or AFT, which like

the AURORA system, emulates open-outcry trading. APT is now trading about 4,000 orders a day,

but is growing, and LIFFE may soon list thinly

traded contracts only on APTS. The system is used

now to extend trading hours to cover the European

trading day, but it is not a 24-hour system and will

not be available outside the United Kingdom. LIFFE

says that the cost of high-speed communications

links for worldwide trading is prohibitively high.25

However, this could change if the LIFFE system

proves popular.

There are also automated trading systems at the

Irish Futures and Options Exchange, the London

Futures and Options Exchange, the New Zealand

Futures and Options Exchange, the Sydney Futures

Exchange, the Tokyo Grain Exchange, and the

Tokyo International Financial Futures Exchange.

These trading systems, like those in stock markets,

were not designed for 24-hour trading, but possibly

could be adapted. Some of them were specifically

designed for trading after exchange-hours.

Reuters’ success in recruiting exchanges to use its

automated trading facilities is not limited to the

futures market. The Chicago Board Options Exchange and the Cincinnati Stock Exchange have

agreed to form a joint venture with Reuters and

Instinct to create a worldwide system for entering,

routing, and executing options listed on the CBOE

and equities traded by the Cincinnati Stock Exchange, the only fully automated securities exchange in the United States.

The New York Stock Exchange recently announced its intention to study the feasibility of

off-board 24-hour trading systems. The over-thecounter dealers represented by the National Association of Securities Dealers (NASD), plan to extend

their automated quotation system, NASDAQ, to the

United Kingdom, allowing NASD members both in

the United Kingdom and in the United States to

make markets in several hundred issues during

normal U.K. trading hours, and to use NASDAQ

services during the-se hours. If approved

Securities and Exchange Commission, the

will be open from 4 a.m. to 4 p.m. eastern

by the

system

time (9

~Atonepoi.ng it was thought that the Sydney Futures Exchange and the ImndonInternational Financial Futures fichange -)M tidy si~~

agreements or were ready to do so. ‘fhe agreements with LIFFE were reported to have broken down because of a demand by CME for “exclusivity,”

i.e., that LIFFE not join other systems and not list contracts that would compete witi CME products. David BurtoQ Chairman of LIFFE, as quoted in

“Unraveling a Technology ‘lhngle,” Fuzures adoptions, special supplement to Euronwney, July 1, 1989.

~t,A~O~—EOS,J~ ~omotio~ literature distributed by ~OT.

~“Europe Forges Ahead in the Technology Race,” Fufures adoptions, Special Supplement to Eummoney, July 1, 1989, p. 2.
Chapter 2--Information Technology for Global Markets ● 19

a.m. to 9 p.m. London time).26 NASD dealers will

have a choice, on a security-by-security basis, of

being a U.S. market-maker, a European marketmaker, or an international market-maker, and their

workstation capability will be defined accordingly.

All NASDAQ market services except for its automated small order execution system (SOES) will be

available internationally. NASDAQ already shares

quotes with both the London and Singapore stock

exchanges, for 700 and 35 cross-listed securities,

respectively. Automatic intercontinental execution

and trade confirmation will now be possible over the

link.

NASD will also introduce, in 1990, an electronic

system for global trading of unregistered (privately

issued) foreign and domestic debt and equity securities. The PORTAL27 system will allow users to dial

up a special NASD host computer for both primary

and secondary market trading; participants will also

be able to use their NASDAQ workstation for

secondary trading. All sales will be negotiated

(investors will get quotations, last-sale price, and

volume details on screen, in major currencies but

will work with a dealer). PORTAL will lock in

transactions and allow settlement by electronic book

entry through the International Securities Clearing

Corp. [See figure 2-l.]

TECHNOLOGICAL BARRIERS TO

24-HOUR TRADING

Technology risks, such as communications outages, are an important factor in 24-hour trading. Line

outage and other contingency plans must be coordinated over several countries, different languages,

staggered time zones and varying numbers of

telephone companies. For example, to maintain a

dedicated circuit from New York to Tokyo can

involve from five to seven telecommunications

companies. This makes contingency plans difficult

to formulate. Global operations require competent

and experienced management at all levels around the

clock.

Although technology costs are declining relative

to capabilities and services offered, at the same time

development costs, operational costs, and maintenance costs of automation have risen. Automated

systems rapidly become obsolete as new technologies develop; they require sophisticated management information systems and technical infrastructures, with high re-engineering costs. Regulatory

rules often influence or even dictate technologies

that must be used. These rules in many cases have

had a positive impact on the industry. For example,

The New York Stock Exchange’s rule number 387

requires all member firms to confirm their trades

with institutional clients through the Depository

Trust Co.’s automated Institutional Delivery system

or its equivalent to be eligible for the delivery v.

payment function--i.e., to pay for securities only

when actually received (by book entry) and not

before. But other regulatory, legislative, and political processes inhibit automation, including disputes

over regulatory jurisdiction and foreign legislation

prohibiting dissemination of some data. Resistance

to change, respect for tradition, and social customs—

which may reflect deeply rooted institutional relationships, strong economic interests, or cherished

values-also significantly impede automation in

some foreign countries.

THE PROBLEM OF STANDARDS

Electronic 24-hour/global trading has several

problems yet to be solved. One is the issue of

international regulation to control global market and

credit risk and to coordinate post-trade procedures.

Another is the lack of global data standards.28 Two

levels of standards are important, those that affect

communication of data in general, and those that

particularly affect securities trading. The needs for

%ere will be two new kinds of market-makers on NASDAQ after this system opens-lhrqxan-ody market-makers from 4 a.m. to noon eastern

time and international market-mdcers from 4 a.m. to 4 p.rm, in addition to existing U. S.-or.dy market-makers. Market-makers will make the choice on

a security-by-security and ~-w-~1 “ 1 basis. NMD Executive Digest, Jtie 1989.

~~R~s-s for ~v~e OHeringS, Resales, ~d TIWQ through Auto~ted L*ges.

nsmdsmgem~m~els, Speciticationsor criteriafortechnolog, designed to allow technologicdapplicationa coming ffomdiffe=tproduc~

to be ihteroperable. Interoperability allows users to mix and match components of, for example, communication systems and also makes it easier for

them to migrate to a new syst~ phasing out older equipment gradually. Standards may be set by custom or general consent, by market forces, or more

formally by authority. In the United States, standar~whenthey exist-are set by industry, often through professional associations. Standards-setting

in the United States is becoming more politiciz@ especially in communications standards, simx the Bell System no longer sets standards de facto. See

U.S. Congress, OTA, op. cit., footnote 1, pp. 297-299.
Figure 2-1--Overview of International Trading Through NASD

Depositories

Custodial Banks

II ●

l t

P

International

m

J l

‘EFAR

E@EN

SYSTEM

Price Information and

International Order Flow

I

Local Firms

International Firms “Passing the Book” International Firms “Passing the Book” International Firms Us. Europe Far East

SOURCE: National Association of Securities Dealers.
Chapter 2--Information Technology for Global Markets ● 21

global standards range from technical standards and

common languages to bank holidays.29

International standards are becoming increasingly

important for 24-hour trading; these problems are

not new to the general demands of international

commerce. The need for standards has arisen in

many other fields, from railroad and air transportation to early telegraph, telephone, and most recently,

computer-to-computer, facsimile, and digital voice

communications. In each of these cases, countries

developed their own systems, often independently of

one another, often with little concern for future

international standardization or harmonization with

other countries’ systems.

As needs for international commerce emerged,

countries typically moved to develop a set of

compatible international standards. This often led to

establishing an international organization to facilitate or coordinate worldwide standards-making.

Some of these, like the International Organization

for Standards (ISO), became permanent. The same

pattern of evolution is happening today in the

financial securities field. A half dozen international

bodies are currently studying some aspect of standardssetting for international trading or regulation of

these markets.

Standards that affect the financial trading industry, including markets, clearinghouses, brokerage

and banking industries, information service industry, etc., are established in many different forums.

The U.S. subgroup of ISO and the American

National Standards Institute set industrial standards

for information processing and other technical

subjects. The principal international bodies include

ISO, which is the most influential; the Comite

Consultatif International Telegraphique et Telephon

(CCITT); and recently several new international

bodies, composed of representatives of the private

sector and governments, have also been formed.

Standards developed by these organizations are

formulated by consensus (75 percent of the IS0

body must approve a proposed standard prior to

acceptance and promulgation). After a standard is

formulated, its adoption by member firms is still

voluntary.

Technology standards are critical in terms of “the

weakest link. ’ That is, if the technical performance

or capacity of a market participant, or clearing

member, is below those of the market or clearinghouse, then the benefit of the market’s or clearinghouse’s technology is compromised. There is no

minimum standard required today for the technology

a broker or futures commission merchant must have,

either internationally or domestically, in order to

offer its clients the best access to price information

or to clearing services.

Developing compatible standards for trading financial instruments is as important to international

commerce as having the same gauge railroad tracks

in neighboring countries. The standards now being

focused on by national and international bodies

eventually will provide the infrastructure for largescale global trading. Until then, obstacles, risks, and

inefficiencies will remain in international trading.

Two types of standards30 are important for both

domestic and international trading of securities, and

particularly for clearing, settlement, and payments

systems. The first type is technical standards, the

second includes standards governing details of the

process by which trading takes place and the

infrastructure that supports trading.

Technical standards would include those that

apply to international communications in general—

e.g., international digital network standards for

worldwide voice, data, and graphics services. Historically, there have generally been two sets of

communications standards, the CCITT standards of

the International Telecommunications Union followed in most of the world, and U.S. standards that

evolved more or less de facto through the dominance

of the Bell System in the United States.31 U.S.

%M&ringbankholidays is a serious problem; &cause, whenb~ are CIOSed securities transactions cannot be settled, and more importantly credit

cannot be provided for market participants, to assure continued liquidity. Consider the consequences if the October 1987 market crash had occurred 1

week earlier, on Columbus Day. U.S. exchanges were open but U.S. banks were closed, and critically important credit would not have been available

to bolster market liquidity.

~AMOU@ only tSVO Utegofies of standards are used here, other treatments might use four categories: process, risk assessment, tiastic-, ~d

procedures. Some of the examples cited in this section do not lend themselves to the adoption of uniform standards, but rather needed improvements

can be adected through harmonimtion. In some countries, for example, it is illegal to disclose or transmi t overseas information concerning a person’s

financial position. As another example, them are also problems in assessing risks that stem from different accounting practices in various countries.

slIthie~de SolapOOl, “Competition and Universal SeIViCe,” “mHany Shooshan (cd.), Disconnecting Bell, The Zmpact of the AT& TDivestiture (New

YOIIG NY: Pergamon Press, 1984), p. 119.
22 ● Trading Around the Clock: Global Securities Markets and Information Technology

equipment suppliers have increasingly had to adopt

standards set internationally, in order to compete in

world markets.32 Two major sets of standards, for

ISDN and for open systems interconnection, are

currently being debated in various international

meetings and consultations. With the planned integration of the European Community (EC) market in

1992 (ch. 4) there are even stronger reasons for U.S.

industry to coordinate its standards with those of the

rest of the world. The EC established a European

Telecommunications Standards Institute in 1988 for

standards development.33 A continuing industrywide effort is needed to coordinate U.S. standards

with evolving global standards.

Some basic technical standards are essential for

financial communications. One example is a universal standard for international communications message formats that facilitates instantaneous identification of the exact details of a trading., the nation

and firm originating the trade, the number of shares

or contracts being traded, the price, and the identity

of the transactors.34 Other examples include technical details of how screen-based trading should occur

globally and the minimum level of technology to be

used by all participants.

Procedural standards are even more important.

They apply to operational aspects of trading, clearing, and settlement; e.g., such as the method for trade

matching, number of days to settle a trade, use of a

depository for holding equities, use of a recognized

numbering system for identifying financial instruments and transactions, formats for data transmission, the method of payment, etc. Infrastructure

standards refer to the method of regulation, mechanisms to protect the clearinghouse against the

financial failure of a clearing member, existence of

funds to protect customers of a failing broker or

futures commission merchant, bankruptcy laws to

adjudicate the disposition of customer assets if a

broker fails, credit processes at banks, clearinghouse

guarantees, etc.

These standards govern the specific dimensions

of investor-protection regulation and fiscal responsibility. Prospectus standards (disclosure of information about a new issue), accounting standards, and

ownership standards35 are especially important in

international trading.

Neither technical standardization nor harmonization of regulations will come easily, cheaply, or

swiftly. Some markets will have to make costly

changes, while others will need more modest changes.

Even modest changes can prove very difficult and

time-consumin g to implement because of the complexity of effecting change in established procedures, and because any change can challenge vested

interests.36 Some changes may be implemented by

the private sector alone, but others will require

government assistance, in the form of changes to

regulation or legislation.

Government involvement in standards-setting, in

the United States, is controversial. There is a long

history of resistance to it from within the government as well as by industry. But business firms have

little experience, and in many cases little interest, in

protracted international negotiations. At a minimum, encouragement, facilitation, and leadership

from government will be needed. More active

government participation in developing international standards related to securities trading will

probably be critical, because other governments are

deeply involved in the standards-making process.

3W.S. Congress, OTA, op. cit., footnote 1, pp. 295-300. For example, computer vendors andtelecommunication carriers had to adopt tie c~x.m

standard for electronic mail. Also, the Federsl Communications Commission has tried to speed up the U.S. standards-setting process for high definition

television because standards are being developed and adopted in other countries.

qqThis institute is f~nced by all of the European PTTs and major tekcommu.nications suppliers.

34T@y, ~ch com~ ~i~ o~ syst~ for iden-trade dati informatio~ so there is little compatibility among tiese syst~ ~te~o~Y.

Recommendations have beenmade by the Group of Thirty to adoptISO standard 6166, which provides a uniform structure for the International Securities

Identification Number, and standard 7775, which deals with the uniform structure of securities messages, i.e., the message types. However, no country

has to date implemented either standard. Additional inter-depository/clearing system message standards are being developed.

sscom~es tier as to tie de~tion of a “share” and what rights are i.ncluded+.g., shareholder vo~g @@ts.

36~s ~&n &e e=rieme of tie U.S.~ Force of tie ~oup of ~,attemp~g to b@ about ch~e h cl-and settlement plVCeSXS,

as discussed inch. 5, according to OTA staff discussions with Gerard Lync& a Managing Director at Morgan Stanley, Inc. and head of the U.S. Working

Group of the Group of Thhty, December 1989.
Chapter 3

The Extent of International Securities Trading

Global trading of securities is rapidly developing.l The foreign exchange (currency) and government bond markets are already thoroughly internationalized. Most international securities trading now

involves debt securities rather than equities. To what

extent this globalization will also apply to corporate

equities, and how quickly, is somewhat uncertain,

but by most measures it is well underway. There is

already growing cross-border trade in the shares of

many giant multinational companies. Most exchanges have opened their membership to foreigners. Some exchanges are already offering derivative

products (e.g., stock-index futures contracts) based

on stocks that are listed and traded in the markets of

a different nation.

Securities markets are already globally linked in

still another sense. Because of the growing interdependence of national economies around the world,

their securities markets tend to move in parallel,

especially in times of stress.2 This parallel movement was illustrated in the crash of October 19-20,

1987, and again on October 13, 1989, when markets

around the world saw a sharp decline (figure 3-l). In

the first 3 months of 1990, when the Japanese Nikkei

Index lost about 25 percent of its value in a series of

spasmodic declines, it was widely feared that other

markets would also drop. This did not happen,

apparently because there were specific domestic

reasons for the Japanese market’s behavior, but there

were definite ripple effects in U.S. and European

markets, and it is not yet certain that their relative

immunity to Japan’s problems will last.

The globalization of securities markets raises an

important question for U.S. policymakers: What

actions need be taken to assure the position of the

United States as a world center for securities trading

and other financial services? The claim is often made

that U.S. markets are the best in the world in terms

of liquidity, efficiency, and fairness, but they have

increasingly strong competition. In 1980 the United

States accounted for 55 percent of world stock

market capitalization, but that stood at 35 percent in

1990, having dropped for a time to a low of 32

percent 3 (see figure 3-2). The Tokyo Stock Exchange was the world’s largest from 1987 to 1989,

but then fell back to 34 percent in 1990 as a result of

large declines in market prices. Japan’s first rank in

1987 to 1989 raised fears in some quarters that the

United States is falling behind in global securities

trading. Market capitalization alone is not a good

measure of market strength, or of trading performance; it is affected by many other economic conditions. 4 But rightly or wrongly, the performance and

vigor of securities markets is often taken as an

indicator of the health of an economy, and thus has

significant political implications.

Additional risk to U.S. investors is also a public

policy concern. As the globalization of securities

markets continues, Congress will need to address

several questions:

lm chapter draws on amend OTA contractor reports, including: tic K. Clemens, Principal Investigator, witi St.epk p. BroW ~vi

%nkateswaran, and Bruce W. Weber, “Globalization of Securities Markets” (Philadelph@ PA: Wharton School, University of Peansylvar@ July

1989); Peter Schwar@ “Scenarios for Regulation of International Securities Trading” (San Francisco, CA: Global Business Network Nov. 3, 1990);

Manning Gilbert Warren III, “Securities Regulation in the European Communities” (Tuscaloo~ AL: University of Alabama Law Schoo~ August

1989); KPMG Peat hfarwic~ “The Competitive Position of Commercial B-in the Global Securities Markets: An International Study,” 1989.

~or example, in most markets equity prices rose from August 1982 until September 1987. During the 6-day trading period from the end of Oct. 9

through Oct. 19,1987 (Oct. 20 for Japan), the Dow Jones Industrial Average declined by 30 perce@ the NASDAQ Composite Index by 18 perce@ the

ISE Financial Times 100 Index by 13 percent and the l’b~o Stock Exchange Nikkei 225 Index by 17 percent. NASD Special Committee of the

Regulatory Review ‘I&&Force, “Quality of Markets,” p. 17. See also, Federal Reserve Bank of New YoI& “The International l%msnus“ sionof Stock”

GeorgeM. vonFurstenberg and Bang NamJeo~ “International Stock Price Movements: Links and M~gw,’’BrootingsPapers onEconom”cActivity,

No. 1 (Wash@to@ DC: Brookings IrIstitutiom 1989), p. 165; and “Price Disruption in October 1987,” and “InternationalLink ages Among Equities

Markets,” QuurterZy Review, vol. 13, No. 2, Summer 1988.

%tal world capitalization was about $9.4 trillion. Japanese share of world capitalimtiodrose from 17 percent in 1980 to 45 percent in 1989. Data

suppli&l to OTA by International Finance Corp. and the New York Stock Exchange. Figures for the end of 1988 were even more striking: world total

capitalhtion was $9 trillion, United States 30 perccn~ Japan 42 percent. The 1990 figure for Japan is from the Finuna”al Times, March 1990, p. 40.

%the 1980s the United States had arecessio~ and the value of the currency few which affected the rate of capitalization. Japanese markets expanded

because of the success of Japanese industry, Japan’s capital surplus, its high savings rate, and the Japanese Government’s use of the stock market as an

instrument of economic policy in privatizing government-owned industry and restructuring financial services. Three national companies have been

privatized: Japan Tbbacco, Japan National Railways, Nippon Telephone& Telegraph.

–23-
24 ● Trading Around the Clock: Global securities Markets and Information Technology

Figure 3-l—Evidence of the World’s Markets on Oct. 13,1989

Bangkok: down 6%

Hong Kong: down 6.5%

Taipei: down 3.3%

I IllSeoul: down 0.7%

Tokyo: down 1.8%

I

Toronto: up 1.46%

New York: up 3.43%

London: down 3.2%

Paris: down 5.4%

Oslo: down 11.3%

Frankfurt: down 12.8%

I

I

I Wellington: down 8.5%

Sydney: down 8%

Manila: down 5.92%

Singapore: down 10%

Kuala Lumpur: down 11.5%

SOURCE: Washington Post, Oct.17, 1989.

What additional risks to U.S. financial systems

might result? How can unacceptable risks be

avoided?

Will U.S. investors be adequately protected in

global investing?

How can the United States encourage the

development of worldwide cooperative or regulatory mechanisms for trading in international

securities?

Alan Greenspan, Chairman of the Board of

Governors of the Federal Reserve System, recently

told a congressional committee that the delays and

uncertainties of trade execution, clearing, and settle11 I

Athens: down 10.05%

I

Zurich: down 10.2%

Madrid: down 5.3%

Lisbon: down 7.6%

ment across national boundaries are serious problems: “It is the float that creates systemic risk.”5 He

called for harmonization of national regulations and

standards to eliminate artificial reasons to favor one

market over others.

These risks may grow worse as globalization

continues. Grant L. Reuben, an international banking expert, warns, ‘‘. . the enormous volume and

speed of transactions and the cross-border integration and interdependence of institutions and markets

have magnified both the impact and speed that a

problem in one national market has on others.”6

50A te~~ony on J~= 14, 1989, ~ H~g~ on ~te~tio@~tion of sec~ties ~~, before tie Subcommittee on kld.kS, SCMte

Committee on Banking, Housing, and Urban Affairs. Systemic risk is a condition that threatens the stability of the national fmcial system or payments

systerrq for example, the catastrophic failure of a major f~cial institution accompanied by cascading failures as the institutions on the opposite side

of that institution’s transactions in turn are unable to meet their obligations, causing their own creditors to be unable to pay still others, etc.

%mnt L. Reubeu Deputy Chairma n of the Bank of Montreal, ‘‘Implications of Globalization for Regulation and Safety,’ remarks at the Financial

Globalization Conference, Chicago, IL, Nov. 2, 1989.
Chapter 3-The Extent of International Securities Trading ● 25

Figure 3-2—Market Capitalization of World’s Stock Markets

Market value of total shares (billion U.S.$)

80001 A

~ Switzerland

~ Franc e

A--- Canada*

5000

4000

3000

i

1000

0

$A

A

West Germany

United Kingdom

Japan**

United States***

1978 1980 1982 1984 1986 1988

Toronto Stock Exchange

● TSE only

● **NYSE

SOURCE: Internationalization of the Securities Markets 1988. Federation of German Stock Exchanges Annual Report, 1988.

TRENDS DRIVING ●

GLOBALIZATION ●

Institutional investors, and to a lesser degree

individual investors, trade in the markets of more

than one country in order to find higher rates of ●

return at acceptable risk, to diversify their portfolios,

or to take advantage of other hedging techniques.

The forces encouraging the rapid expansion of

international securities trading are: ●

. the declining costs of international communications;

increasing world trade and interdependence

among national economies;

concentration of capital in countries with relatively limited opportunities for domestic investment, especially Japan;

the necessity in some countries, especially the

United States, of financing government debt

(this led the United States, for example, to

encourage foreign trade in Treasury bonds);

the growth of large institutional funds such as

mutual funds and private and government

pension plans, with a need to diversify their

investments and hedge their risks;
26 ● Trading Around the Clock: Global securities Markets and Information Technology

the changes in regulation of financial services

in many countries, opening their markets to

foreign participants; and

the increase in international public offerings,

especially as a result of privatization of governmentowned industries in several countries.

Communications

The growing availability of telecommunications

and computers reinforces the effects of these trends.

Not only is information technology necessary for

global trading of securities; it stimulates all kinds of

trade among nations, familiarizingg potential investors with many translational corporations and their

products and services. This reduces one historical

barrier to trading of corporate securities outside of

their home market-the lack of knowledge about

underlying values on the part of foreign investors.

Telecommunications brings increased access to

economic, industrial, political, and social information, both through the public media and through

specialized information services. This is not an

unmixed benefit. The speed with which information

is transmitted between markets can have an adverse

effect, if it forces decisionmaking at apace too rapid

for the exercise of discretion. Communication of

trade data is, moreover, not sufficient for disclosure

of risk in securities trading. Basic data on many

European, Asian, and South American corporations

are not available, and there is little trans-border

financial research and analysis available to investors.

In the early morning of October 19, 1987, hours

before the New York markets opened, U.S. portfolio

managers who anticipated a sharp drop in value of

equities tier the previous week’s slide, began

selling shares in London. One mutual fund was said

to have unloaded $95 million of equities,7 illustrating the ease with which both information and capital

can flow across national boundaries.

Interdependence

World trade patterns in goods and services

encourage world trade in securities. Not only do

multinational corporations become familiar in many

countries, but they need to raise capital in the local

currency for plant, property, equipment, and daily

operating expenses. International trading of corporate securities grew sharply in the 1970s and 1980s.

After the 1987 market crash, there was a temporary

reduction in international trading. Most agree that

international trading incorporate equities is likely to

be limited to stocks of “world class” corporations.

There are already at least 500 corporations whose

issues trade internationally.

It is possible that a two-tier market will develop,

with trading in these securities conducted in one to

three world markets, with participants passing their

trading books from London to New York to Tokyo,

while other securities are traded only in their local

market or time zone. The implications of such a

two-tier market are uncertain. Already European

securities market planners and developers are debating whether there should be different systems,

different procedures, and different rules for retail

customers and international/professional traders.8 In

the United States, the Securities and Exchange

Commission (SEC) has approved a new rule (144a,

Apr. 19, 1990) that will allow institutional investors

greater freedom in trading private placement securities by exempting many such securities from registration requirements if they are not available to

individual investors.

Capital Imbalances

Another force driving the globalization of securities trading is that some countries have accumulated

‘‘excess capital’ not matched by productive domestic investment opportunities. That money is available for investment through the securities markets of

other countries. One example is Japan, with its high

volume of exports. European investors also find that

their domestic markets cannot meet their investment

demands. 9

International imbalances lead to a flow of capital

across national boundaries that some economists

view with concern. In the United States, the growing

Federal deficit has been financed to a significant

degree by foreign purchases of Treasury bonds.

bMelam~ “ThePainful Tru@” The InternationalEconomy, July/August 1988, p. 59. Melamed is Chamnan “ of the Executive COmmittee of

the Chicago Mercantile Exchange, This figure was put at $90 million in the Report of the Presidential Thak Force on Market Mechanisms (The Brady

Commission), January 1988, p. 30. Some O’lA informants and advisors believe it was much larger.

%YIX disc~sions with oflkials of the International Stock Exchange in IxmdoQ March 1990.

%oy C. Smi@ “International Stock Market Transactions,” New York’ sFinanciuZiUarkets: The Chdenge of Globalization, Thierry Noyelle (cd.)

(Boulder, CO: Westview Ikess, 1989), p. 8.
Chapter 3--The Extent of International Securities Trading ● 27

There is concern that we have become dependent on

an inflow of foreign capital that could be cut off, or

could undergo sharp price increases (see figure 3-3).

But U.S. policy with regard to international securities trading has been that the unimpeded flow of

capital funds across national boundaries is basically

advantageous both to countries requiring additional

capital funds and those seeking markets for surplus

capital funds.10 Consequently the United States has

placed few restrictions on foreign portfolio investment, and those are chiefly for informationgathering. 11 SEC disclosure rules, for example,

apply to foreign as well as domestic issuers, and this

is a problem for some companies whose home

countries do not have similar requirements.

Figure 3-3-Foreign Holdings of U.S. Financial Assets

Billions of dollars

1400

1213.9

1200

i 1074.9

1000

800

600

400

200

0

1980 1981 1982 1983 1984 1985 1986 1987 1988

SOURCE: Goldman Sachs Portfolio Strategies, December 1988.

Financing National Debt

Foreign investment in the United States was

essential to economic development in our first

hundred years. In the middle of the 19th century

foreigners held about half of Federal and State debt

and a quarter of municipal debt. During the next six

decades foreigners invested heavily in such burgeoning American industries as steel and railroads.

Only during World War I did the United States cease

being a debtor nation for a few decades as European

nations liquidated U.S. holdings to raise money for

the war.12

Further growth of the U.S. deficit and uncertainty

about the stability of the dollar could inhibit foreign

investment. It has probably caused some shift in

Japanese equity investments from the United States

to Canada, Europe, and Australia.13 In 1980, 41

percent of foreign activity in U.S. securities was in

corporate equities, but this has fallen steadily, to 9

percent in the first half of 1989, as U.S. Government

debt became the focus of foreign investment; the

proportion of foreign activity in Treasury bonds rose

from 53 to 87 percent.14

Institutional Investors

The growth of institutional investment funds such

as pension funds and insurance funds, especially in

the United States, is a major force encouraging

international securities trading.15 Public and private

pension plans represent large concentrations of

funds that must be invested, and’ many institutional

investment managers want to diversify fund holdings outside of their own country to protect against

loJ~u5w.Allem “CapitdNWket Changes inthe United Kingdo~ JSPSXL West~, and Singapore, A Brief Survey,” Congressional Research

Service Report 88-49-E, Jan. 14, 1988, p. 2.

ll~eme some limitations on direct foreign investment in specific industries such as energy, maritime, _ COm.m~~tiOnS, @b_.~

International Investment Survey Act of 1976 (22 U.S.C. 3101 et seq.) mandated a study of the extent of foreign investment to be performed every 5

years, and the Domestic and Foreign Investment Improved Disclosure Act (part of the Foreign Corrupt Practices Act of 1977, Public Law 95-213)

~ed ~Yone a~uirins 5 percent of the equity securities of an SEC-registered company to disclose ci”tuxmship and residence. Michael Seitzinger,

Foreign Investment in the United States: iUajor Fe&ral Restrictions, Congressional Research Service Report 88-164 A, Feb. 23, 1988.

l?l’bid. rn 1988, total foreign direct investment inU.S, plants and machinery was $326.9 billiou compared to U.S. d~t ov~ investment of $308

billion. But the U.S. investment is oldeq its current value is probably much higher. Some experts say tbat the returns on foreign investment here are

significantly lower than returns on U.S. investment overseas. See, for example, Stephen Kindel, “Return of the Native,” Finana”aZ WorZd, Jan. 9, 1990,

p. 20.

13111E U.S. share of these Japanese institutional invesbrmts droppedfkom 55 percent in 1986 to 51 percent in 1987, according to Yasuhko“ u-

“Japanese Imumnce Companies: Our Strategy for Irtvesting in Ameriw” The International Economy, July/August 1988, pp. 64-65. Mr. Ueyama is

president of Sumitomo Life Insurance Co. These figures were confiied by the International Securities Clearing Corp. in 1990, but more recent figures

are not available.

14s~tia ~m~ A5m~tioQ C’Foreign ~tivi~ Repofi$’ JSIL 25, 1989, p. 5 and update by telephone, Novembes 1989. Foreign activi~ in

corporate bnds dropped fkom 5.3 to 2.6 percent during the period 1980-88.

ls~dominanceof institutional traders differs to someextentbycountry. InEurope, thelargestholders of equities srebiginstitutiona, andlsrgebanks

usually handle investments for individual investors in a discretionary mode. InJap~ 69 percent of equities are held by corporations or institutions, but

these tend not to be traded. Individuals do about 42 percent of the securities trading.
28 ● Trading Around the Clock: Global Securities Markets and Information Technology

both potentially adverse currency fluctuations and

domestic economic recessions.

16 The value of crossborder portfolio investments by U.S. private-sector

pension plans grew from $21 billion in 1980 to $225

billion by the end of 1988.17

Some doubts about the value of this diversification as a kind of transnational hedging have emerged

because of the way markets behaved in October

1987. As described in The Economist:

. . . the world’s 23 largest stock markets fell together

during the October crash; and . . . most of them

tracked each other closely for months. The correlations between stock markets during and after the

crash were uncanny and unprecedented.18

This lessens the protection against risk to be

achieved by international diversification. The correlation in market behavior is to some extent inevitable, given the interactions between interest rates and

currencies, although precipitous drops in Tokyo

stock prices in the first quarter of 1990 had only

slight immediate effect on other markets. Because of

the swift flow of information and the ease of shifting

investments from one market to another, a precipitous decline in one marketplace could at any time

alarm investors in other marketplaces and cause

them to react. But international diversification also

has other benefits, and is likely to remain attractive

to institutional investors.

Regulation and Deregulation

Deregulation in the United Kingdom, Japan, and

France has also encouraged international trading by

increasing the access of foreigners to those national

markets and their securities firms. This kind of

deregulation may be called “access deregulation.”

There has been a general worldwide trend toward

access deregulation, and at the same time a worldwide trend toward increased prudential regulation

(sometimes misleadingly called “re-regulation”),

aimed at stronger investor protection. London’s

dramatic access deregulation in 1986, called “Big

Bang,’ stimulated other European exchanges to

improve their quotation and settlement systems,

broaden exchange membership, and lengthen trading days.

Privatization

Another force encouraging the cross-national

holding of equities has been the privatization in the

United Kingdom and Japan of-very large industries

that had been owned by the state. More stock had to

be offered for sale than could be absorbed by

investors in a single country, so there have been

many stock issues that are offered in several

countries at the same time, with each country’s

allotment, or “tranche,” consisting of millions of

shares.

OBSTACLES TO INTERNATIONAL

SECURITIES TRADING

Although there are strong forces encouraging

globalization, there are also many obstacles:19

lack of liquidity in smaller markets;

government policies or regulations designed to

exclude foreign participants from national markets;

other legal barriers such as exchange controls,

discriminatory taxes, and deposit requirements;

differences at the interface of banking and

securities activities;

difference in clearing, settlement, and payment

systems;

nongovernmental but officially condoned practices (in effect, non-tariff trade barriers) which

exclude foreign interests, such as restrictions

on membership in exchanges;

IGFrom 1985 to 1987, U.S. Wmion plans increased their foreign equity holdings by $19 billio~ while their holdings of U.S. Witks d-m~ by

$47 billion. SmitlL op. cit., footnote 9. At the end of 1988, U.S. private-sector pension funds had $52,5 billion in foreign investment. United Kingdom

private pension plan investment overseas was $69 billion at the end of 1988, Japanese private pension plan investment overseas was $33 billion. Foreign

private-sector pension plans hadapproximately $62.4 billion in portfolio investments intheUnited States at the end of 1988, and this hadgrownto $67.7

billion by June 1989. (Information provided by Intemec Research Corp., November 1989.)

ITFi~s for 1980 ~d 1987 ~m SEC SW Report to U.S. Semte comrnitt~ on B-g, Housing, and Urbm A.ffti Ud U.S. HOW Of

Representatives Committee on Energy and Commerce, “Internationalization of Securities Markets,” 1987, p. 88; 1988 figure provided by Intemec

Research Corp. to OTA, November 1989.

lsBy~ne set of me-ements, the ~~e~tion~W~nthe23 biggest stoc~kets, whichw~ ().222 for more ti5ye~ before tiCr~ W= ().’755

at the time of the-crash and has since then remained about 50 percent higher than the pre-crash figure. “Why Stockmarkets Move Together,” The

Economist, Mar. 11, 1989, p. 77.

lgf$~~~o~ T~de in Services: fkXllrkies,” summary of a report by the OECD Committee on Financial Markets, in OECD, Finuncia2 Market

Trenak, May 1987, pp. 15-43.
Chapter 3—The Extent of International Securities Trading ● 29

● differences as to accounting practices, regulatory structures, capital adequacy requirements,

and investor protection standards;

. differences in corporate organization; and

. other social, cultural, or behavioral barriers.

The risks imposed by these difficulties, and

particularly by the lack of standardized or harmonized methods of trading, clearing, settling, and

making payment are serious. Many international

trades fail to settle on time, often because as many

as 12 financial institutions maybe intermediaries to

a single securities transaction.20 (See ch. 5.)

Laws and regulations in some countries forbid

various kinds of participation in securities markets

by foreigners. Tax laws may also inhibit foreign

activities or reduce their profitability. Activities that

are permissible in one country are illegal in others.

Less formal but pervasive social and cultural

differences are also important. Outsiders may not be

able to operate efficiently because of ignorance of

language or culture or lack of necessary professional

contacts. They may find it hard to recruit and

manage indigenous staff. Access to bank loans may

be difficult. In Japan, for example, long-established,

interlocking, and stable relationships between domestic companies and banks put foreign firms at a

competitive disadvantage.

One important difference between national securities markets is the extent to which banks are

allowed to participate. In the United States, the

Glass-Steagall Act of 1933 separated banking and

securities-related activities. Japan’s Article 65 is

modeled after the Glass-Steagall Act. Until recently,

Canada also placed legal barriers between banks and

most securities markets activities. Most other countries have ‘universal banking,” meaning that banks

can do underwriting and otherwise participate fully

in securities markets, and banks are often the

dominant participants in those markets. The general

international trend has been toward more homogeneous regulatory treatment of financial institutions

within countries.21 This is true even in the United

States, as Federal regulatory authorities--the Comptroller-General (Department of the Treasury) and the

Federal Reserve Board-have gradually relaxed the

interpretation of the Glass-Steagall Act to allow

banks and bank-holding companies to edge into

some securities-related activities.

HOW “GLOBALIZED” ARE

SECURITIES MARKETS?

Several kinds of activities are subsumed in

‘‘market globalization,’ a term that is often loosely

used. They are:

●

●

●

●

●

●

●

●

A

cross-listing stocks and bonds issued in Country A on the exchanges of Country B;

investors of one country buying and selling

foreign stocks in foreign markets, through

foreign brokers;

opening a country’s stock markets to foreign

brokers and dealers who serve both foreigners

and nationals;

legal or contractual ties between exchanges in

different countries;

“passing the book” or 24-hour trading, i.e.,

shifting the control of trading to colleagues in

other countries and time zones;

multinational offerings of stock;

international mutual funds; and

cross-national stock index derivative instruments.

Cross-listing of Stock

simple form of internationalization of markets

is listing stocks issued in Country A on exchanges in

Country B. The value of cross-border offerings of

bonds, including foreign and Eurobonds, grew from

$38 billion in 1980 to $238 billion in 1988. The

value of cross-border offerings of equity-related

securities grew from $200 million in 1983 to $20.3

billion in 1987.22

London’s International Stock Exchange (ISE) is

the most “internationalized” of the world’s big

exchanges, with 23 percent of the companies whose

stock is listed on the ISE being foreign companies.

The Tokyo and New York Stock Exchanges, which

are larger markets, have far fewer foreign companies

listed (table 3-l); in 1989, the NYSE listed 82

~Jllni~W.P~e, “ACasefor StandardS inIntemational Financial Markets-Jan. 1, 2000,” a discussion paperpmp~edfor tie~~~Mee@

of the International Organization of Securities Commissions, Sept. 1-4, 1987, Rio de Janeiro, Brazil.

21~MG pa -C. ~~~ Coqetitive ~Sition of c~erc~B* ~ tie Glo~ S-ties-J@s: AII kte~tio~ S~dy,” COXItrtiCtOr

report prepared for the Office of Technology Assessment January 1990.

~s~ op. cit., footnote 14, PP. 58-59.
30 ● Trading Around the Clock: Global Securities Markets and Information Technology

Table 3-l-Comparison of Major Markets

Tokyo Stock New York London Stock

Exchange Stock Exchange NASDAQ Exchange (lSE)

Annual average trading volume

[$ billion] . . . . . . . . . . . . . . . . . . . . . $2,234 &1 ,356 $ 347 $ 361

No. of listed companies, 1988 1,683 1,681 4,451 2,580

—Domestic . . . . . . . . . . . . . . . . . . 1,571 1,604 4,179 1,993

—Foreign . . . . . . . . . . . . . . . . . . . . 112 77 272 587

% Foreign . . . . . . . . . . . . . . . . . . . . 6.7% 4.6% 6.1% 22.7%

SOURCE: Office of Technology Assessment, 1990.

foreign stocks or ADRs23--3.7 percent of its listings. In the frost quarter of 1990, this rose to 93

listings, and their trading accounted for 5.8 percent

of total share volume.24 NASDAQ includes 196

foreign issues and 96 ADRs, 5.7 percent of listings.

Several smaller markets, particularly in Europe,

are more “international” Of stocks listed on the

The Netherlands exchange, 56 percent are non-

-domestic; Germany, 49 percent; Switzerland, 42

percent; and France, 32 percent.

Most stocks are still traded only in their country

of origin. But London’s SEAQ International regularly quotes 750 foreign equities, with continuous

quotes in about 350 of them, resulting in trades

valued at about £ 1 billion daily, compared to £ 1.4

billion in domestic equity trades and £ 10 billion in

bonds. 25 In Tokyo about 120 foreign issues are

traded, generally less than 2 percent of total volume,

but recently this has risen to about 7 percent.

Euromoney magazine reported in mid-1988 that

there were 487 stocks with an active and liquid

market in at least one trading center outside of its

home Country.26 The home country, for 60 percent of

these stocks, was either the United States, Japan, the

United Kingdom, Australia, or Canada.

Obtaining a listing on the Tokyo Stock Exchange

(TSE) has become an important element in the

global strategy of many export-oriented U.S. companies. Corporations are attracted by the large amount

of capital available for investment and by the belief

that Japanese investors are more interested in

long-term growth and less concerned with very

short-term performance than are U.S. investors.

Some multinational corporations also reason that

listing in Japan improves their corporate image in

that country, helping them to attract a Japanese work

force. Obtaining a listing on the TSE is, however,

complicated and costly.

In the United States, foreign firms who want to list

their securities on a U.S. exchange or NASDAQ may

register them with the Securities and Exchange

Commission (SEC), thereby subjecting themselves

to our reporting provisions.27 The SEC has, as noted,

recently approved a rule exempting from reporting

requirements companies offering private issues only

to large institutional investors.28

International Portfolios

Another measure of internationalization is crossnational portfolio investment, the degree to which

Country A’s investors buy stocks issued in Country

B. For all countries, investment in non-domestic

securities was $250 billion in 1984 and $1,281

billion in 1987, a fivefold increase in 3 years (table

3-2). This strong growth in cross-national investment inequities was reversed temporarily in 1988 as

an aftermath of the 1987 crash. New foreign

~Non.u,s. corporations Wishg to bve their equities securities traded in the United States can choose to hWe them lmkd w acti~ Sws or m

AmericanDepository Reeeipts (ADRs). AnADR is a receipt issued by aU.S. b@ conversable into a specified number of shares deposited in the issuing

eoqmration’s country of domicile. An ADR may be freely traded in the ADR marke~ related to but distinct from the market in the actual shares. Should

a U.S. holder wish to obtain the shares, the ADR is presented to the U.S. depository bank for cancellation and reregistration before the original shares

ean be delivered to the holder. Price information on an ADR is in U.S. dollam and maybe easier to get than the price of underlying shares; purchasem

of ADRs pay domestic rather tban foreign trading commissions.

~~o~on supplied by the NYSE Washington office, Apr. 2, 1990.

nS~Q kte~tio~ statistics.

~Euro~n~, Iv@ 19*8.

~But not t. some o~r ties, such ~ ~= gove~g ~eholder proxy votes. Regist~g is optio~ ~ess me foreign issuer @ mOre dUll 3~

record shareholders in the United States, more than $3 million in total assets, and is engaged in business affecting interstate commerce.

~R~e 144A, approved Apr. 19, 1990.
Chapter 3--The Extent of International Securities Trading ● 31

Table 3-2—Total Cross-National Investment

Total

Year (billions of dollars) Change

1984 . . . . . . . . . . . . . . . . . . . . . . . $250 –

1985 . . . . . . . . . . . . . . . . . . . . . . . $40 0 +60%

1986 . . . . . . . . . . . . . . . . . . . . . . . $75 0 +88%

1987 . . . . . . . . . . . . . . . . . . . . . . . $1281 +71%

1988 . . . . . . . . . . . . . . . . . . . . . . . $1031 -19.5%

SOURCE: Securities Industries Association. Global Equity Analysis Reports.

investment in Japanese, American, British, Canadian, and West German equities in 1988 dropped

much more than did domestic trading in those

stocks.29 In the highly internationalized London

market, foreign trading in U.K. equities dropped

nearly 30 percent, while all trading in U.K. equities

dropped less than 5 percent.30 Only Japanese investors made more overseas equity trades in 1988 than

in 1987. Although reduced, the 1988 cross-border

equities trading was still above that of 1986 and over

three times the amount in 1984.

In 1950, foreign investors held a little more than

2 percent of U.S. securities; in mid-1988 it was

nearly 12 percent.31 Foreign investors hold nearly 22

percent of U.S. Treasuries (however, the holdings of

corporate bonds increased faster than holdings of

Treasuries). Foreign investors held about 6 percent

of U.S. equities in mid-1988.

The large growth of foreign portfolio investment

in the United States could be risky in a way that

direct investment is not. Multinational firms monitor

their currency exposure and stand ready to make

massive shifts in response to changing conditions.

Factories or farmlands will not be moved outside of

the country, but foreign capital can be withdrawn in

a matter of minutes or hours.32 This could amplify a

market decline, turning it into a rout. [See box 3-A.]

In February 1990, as the Tokyo Stock Market went

into a several-day decline for the frost time in years,

this concern was voiced by a number of financial

experts.

Box 3-A—Exogenous Events and

U.S. Markets

U.S. markets could be thoroughly shaken by

seemingly unrelated events in far-away places.

Noting that some seismologists are predicting

possibly devastating earthquakes in the vicinity of

Tokyo, Tokai Bank generated the following scenario:

. . . Tokai Bank has estimated the damage that

would be caused to financial markets if there were

a repeat of the 1923 earthquake, a 7.8 on the Richter

scale, that reduced Tokyo to rubble and left 142,000

people dead. The bank’s conclusion is that America’s stock and bond markets would be reduced to

rubble too.

. . . (W)ith one-third of Tokyo’s reclaimed land

liquefying into mud, reconstruction would cost

Y119 trillion ($847 billion). Japanese institutions

would have to sell investments in America, sending

stock and bond prices tumbling and interest rates

soaring worldwide. Side-effects would be global

stagflation and a worsening of the Third-World debt

problem.

The hypothetical earthquake that the bank sent

rumbling through its computer model knocked 4.8

percent off Japan’s gross national product for the

current calendar year, causing the world economy to

shrink 0.3 percentage points in 1989. The economic

effects would go on reverberating for years . . . .

SOURCE: The Economist, July 15,1989, p. 7. (Condensed)

On the other hand, a strong case can be made that

foreign capital, especially Japanese capital,. has

acted effectively to stabilize American financial

markets in recent years. David Hale, an international

economist, says,

In 1987 and 1988, the Bank of Japan purchased

over $55 billion of U.S. securities in order to

stabilize the dollar. The Ministry of Finance often

used moral jawboning to prevent Japanese institu-

=oreign individuals and institutions made purchases and sales of $288.3 billion iu all U.S. securities msrkets in the firat 9 months of 1988, which

was doti 19.8 percent from the firat 9 months of 1987. AU transactions in foreign equities made on U.S. markets were also down in the same three

-sby 24.3 percenti to $107.3 billion.

~S~ties~d~~es ~=i~oQ G[o~[E~’~A~ly~sRepo~, vol. ~, Noe 5, J~y 7, 1$)8$). Japanese illVtXtOIS’ nOtpllNhSSSS Of fOre@l Securitk?

in 1980 was $4 billiou in 1988 it was $87 billio~ and in the fust 7 months of 1989 it was already $55.3 billion.

31Jefi~ ~. &.~efm ~ David G. Strom “my ~ the ~s About Fore@ ~ves~@” C)@/enge, ~y-Jme 1989, pp. 31-35. F- S1’e

baaed on Federal Reserve Flow of Funds, U.S. ‘Ihsury.

WnecommentatorW eges thatJapanesefund managers “triggeredthecrash”(~ 198’7) @dump@U.S.~“es 5 days earlier, causing a collapse

in bond prices and a resulting rise in interest rates that led to widespread selling of equities. R._ Murphey, “Power Without Purpow: ~~~

of Japan’s Global Financial Dominance,” Harvard Business Review, March-April 1989. But this report is not widely accepted.
32 ● Trading Around the Clock: Global securities Markets and Information Technology

tional investors, from dumping dollar securities

during periods of exchange rate uncertainty.33

Richard Koo of the Nomura Research Institute told

the Joint Economic Committee of Congress,

During 1986 and 1987 . . . when the dollar and

financial markets around the world came precariously close to total collapse, Japanese authorities

tried to keep investors in dollars by telling them how

much good the U.S. had done for Japan after the war,

and how important it was for Japan to stay with the

dollar to prevent the total collapse of the world

financial system.34

Opening National Exchanges

Cross-country exchange membership and brokerage is another form of internationalization. Many

countries have opened their exchanges for membership by foreign firms within the last 5 years, or have

allowed foreign firms to buy or buy into their

domestic securities houses for the first time. For

example, the first 6 foreign members were allowed

to join the Tokyo Stock Exchange in February 1986,

and in 1988 16 more seats were made available to

non-Japanese firms.35 Other foreign firms probably

want seats, even though membership costs are high.

There are at least 47 foreign securities houses with

branches in Japan; most were reported to be losing

money in 1988-89. Four large Japanese firms trade

overseas (Nomura, Daiwa, Nikko, and Yamaichi),

and are reported to have invested $350 million in

building up their American businesses. These are

very large fins, so their international business

accounted for only 1 percent of their pre-tax profits

in 1987-88, down from 5 percent the previous year.36

Many American stockbrokers sought to operate in

London’s markets after the 1986 deregulation.

Merrill Lynch, the first U.S. firm with an affiliate on

the London Exchange and among the frost to apply

for a primary dealership in government bonds, spent

many millions of dollars in London on computers,

staff, and anew headquarters. Merrill Lynch became

the second largest Eurobond underwriter, and by

1987 it had a staff of 1,600 in London.37 Other major

U.S. securities firms and banks also made major

efforts to build business in London. But after the

October 1987 crash, they sharply reduced their

London staff. All foreign brokerage houses in

London were reported to be losing money in 1988

and 1989. The unprofitability of such foreign

ventures causes some observers to doubt that international securities trading will grow as much, or as

rapidly, as enthusiasts had predicted. But a more

likely outcome is that as international trade increases, a few very large securities firms will

eventually dominate the field.

Passing the Book

Twenty-four-hour trading is what many think of

as “globalization.” This occurs when a firm has

facilities in locations around the world, and passes

its “book” (i.e., control of its active trading)

between those locations across time zones, in order

to trade some instrument such as U.S. Treasury

bonds around the clock.38 (See figure 3-4.) Most

24-hour trading now is in foreign exchange and

bullion, not equities.

There is some skepticism as to how prevalent

24-hour trading in equities will become. One study

called 24-hour trading a myth, and said,

Many of those who profess to trade for 24-hours

acknowledge that they do so to maintain a “global”

profile, not because 24-hour trading is a prime goal

in itself.39

Other skeptics, attuned to the traditional, face-toface form of trading prevalent in New York and

Chicago, say that trading is an intensely personal

activity and traders will neither be able to stay awake

24 hours or to let someone else trade for them. This

33David D. H~e, “The J~~ese h4inistry of Finance and Dollar Diplomacy During the Late 1980’ s,” July 1989 manuscript, provided to OTA by

the author, who is a senior vice president of Kemper Financial Services, Inc.

~Testimony on Oct. 17, 1988.

35s~ went t. ~efica~, 4 t. British ~,~d 2 ~ch to Fr@ch, W=t ~~~~d Swiss f-.Motohiro IIca, “Foreign SCZWM= Fhms,”

The Japan Economic Journal, Summer 1988, p. 39.

36~s is an~om~ jomst~s es~te; .s= ‘fc~Japan7s Saties F~Keep theFlag Fl@g?” The Econo~”st, Dec. 3,1988, pp. 85-86. OTA

was unable to obtain this information from the Japanese firms.

37Cr~g Fo- “MerrillScaleS Down Imndon ~itbm,” The Wall Street Journal, June 15, 1988, p. 20.

38Forei~ exc@e ~s 1oW ken a ~how _ket. About $350 bil~on ~ fo~i~ c~ncy tr~sactiom tie pla@ ev~ @, colllp~~ tO d)ollt $5

billion daily on the NYSE. S. HanSell, “The Computer That Ate Chicago, “ Institutional Investor, February 1989, pp. 181-188.

sgGzo&z capital Mar~et~, ~ ~MG rqo~ (~ter~: KPMG ~t~tio~~lce, peat -ckMcL,titock Publications, 1988), p. 16.
Chapter 3--The Extent of International Securities Trading ● 33

Figure 3-4-Trading Around the World and Nearly Around the Clock

Keyed to eastern daylight time/local hours shown adjacent to each session

I I I I I I II I

I

I 1 I

I I I

I I

I

I I

9 Midnight 3 6 9 Noon 3

1

Tokyo

Hong Kong

London

New York

I I IClosed\ I 9 to 11 a.m.; 1 to 3 p.m. I I

T+’+Closed

9 a.m. to 5 p.m.

SOURCE: Office of Technology Assessment.

10 a.m. to 12:30 p.m.; 2:30 to 3:30 p.m.

—

—

will probably not be a major barrier if 24-hour The most extensive, vigorous, and competitive

trading turns out to be profitable.

Richard D. Ketchum, Director of the SEC’s

Division of Market Regulation, claims that for most

equities there will not be sufficient 24-hour order

flow to encourage profitable risk-taking by market

makers. This is different, he points out, from foreign

currency and government bond markets ‘‘where

ownership of the underlying assets have truly spread

worldwide and relevant news regarding those markets occurs around the clock and around the globe."40

This projection too depends on continuation of

present conditions of ownership and information

flow that tend to concentrate liquidity primarily in

one home market. These conditions may already be

changing.

U.S. broker-dealers may be likely to try 24-hour

trading because they already have a large investment

in information technology. Salomon Brothers opened

a 24-hour desk in New York when the Chicago

Board of Trade began evening trading in May 1988.

Their business in futures and options is covered from

New York during the hours that the U.S. or Tokyo

markets are open, and from London when the

London International Financial Futures Exchange

(LIFFE) is open.

24-hour trading (except for currency) may eventually be in futures contracts.41 The Nikkei index is

traded on the SIMEX exchange in Singapore, as well

as Osaka, and is approved for trading on the Chicago

Mercantile Exchange (CME). LIFFE trades Japan’s

government bond futures and the Chicago Board of

Trade (CBOT) announced (Nov. 21, 1988) that they

would also do so. When CBOT expected that TSE

was about to begin trading a T-bond futures contract

in competition with CBOT’s contract, the Chicago

exchange responded by beginning to trade during

evening hours, 6 to 9:30 p.m. c.s.t., Sunday through

Thursday. Four months later, the Philadelphia Exchange began operating from 7 to 11 p.m. e.s.t.,

Sunday through Thursday and from 4:30 to 8 a.m.

e.s.t., Monday through Friday, to accommodate

traders in London and Tokyo. Thus, competition

among exchanges, or the fear of it, is stimulating

24-hour trading.

The New York Stock Exchange may find it

difficult to extend its trading hours because of its

labor-intensive trading system.42 It will be hard to

find a second shift of specialists, at least until

24-hour trading has become a highly developed

activity-and then it would probably be too late to

~S@tement by Richard G. Ketchum, “Challenges Facing the StZdkX Musq,” at a meeting June 16, 1989, sponsored by Business Week and

Securities Week, manuscript provided to OTA by the author. The statement represents the personal views of the author, not a statement of SEC policy.

41~fiu~N~@wachi, ”Financial Futures: Round-the-Clock Trading Expected to Spread in Tokyo,” Tokyo FinancialMarkets, a Special Survey

of The Japan Econonu”c Journal, Summer 1988.

42The NYSE us a ~fis~or desi~t~ mmket.~er, system ~d hades must go ~ugh he sp$cfit post (with some (XCeptiOnS) when the

floor is open for trading. Floor trading is supported by automated order routing systems and other forms of automation. See OTA’s forthcoming report

on information technology and domestic securities markets.
34 ● Trading Around the Clock: Global Securities Markets and Information Technology

capture this market. Under the pressure of rapid

development of international trading, however, the

NYSE has recently announced “plans to explore

off-hours trading.” According to James Cochrane,

the Exchange chief economist:

By working with industry participants and exchange customers to assess current off-hours activity, trading procedures, and market needs, the NYSE

is developing a strategic approach to emerging

global markets. What roles extended hours, available

technologies, and key market participants will play

in these strategies have not yet been announced by

the Exchange.43

Product Links Between Markets

Non-American exchanges are copying innovative

instruments developed by the U.S. exchanges. The

chairman of CBOT has complained that “[CBOT]

contracts are being Xeroxed overseas. ”44 There are

many new derivative products (futures and options)

markets in Europe, Scandinavia, and Japan, at least

36 in all outside the United States. Chicago markets

did more than three-quarters of the world’s futures

trading only 5 years ago. This was down to 60

percent in mid-1989, and the TSE’s yen government

bond futures contract is now the world’s most

heavily traded. The rapid spread of derivative

products markets in competition with U.S. futures

and options markets has stimulated a greater willingness at the CME and the CBOT to try technology as

a way to compete in the international arena.

The French MATIF, opened in 1986, is now the

third largest futures exchange in the world. The

fourth largest is the London International Financial

Futures Exchange (LIFFE), which is trading, among

other non-sterling products, a futures contract on

10-year German Government bonds. A contract on

the same German lo-year bonds will be traded by the

West German Deutsche Terminborse, which opened

in January 1990 as a fully computerized exchange,

operating through monitor screens connected to a

central computer.45

The European Options Exchange in Amsterdam

was the first in Europe, and has many international

links. MONEP is the French options exchange. The

London Traded Options Market (LTOM) trades

options on equities and a stock index. There are

others in Stockholm, Zurich, and Denmark; options

markets are planned in Finland, Norway, and

Ireland. Trading in options began in Japan in June,

1989, at the Osaka Stock Exchange, with a contract

based on the Nikkei 225 index, but there was already

a large volume of off-market (private) options

trading.

The U.S. Commodity Futures Trading Commission (CFTC) and the SEC have both approved the

CME’s plan to trade a futures contract based on

Morgan Stanley Capital International’s index, representing a basket of 1011 stocks issued in 18

countries. The Coffee, Sugar & Cocoa Exchange is

now trading a futures contract based on its International Market Index (50 foreign stocks primarily

available only outside the United States), and

AMEX is trading an options contract also based on

that index.

Whether these index futures or option contracts

will succeed remains to be seen. There may not be

enough buyers and sellers to assure liquidity. On the

other hand, institutional investors may use them to

provide “an international component” to hedge

portfolios, or for other trading strategies such as

asset allocation. Some institutions are prevented by

local law or by their charters from investing abroad,

but would be able to use these U.S. futures contracts.

Multinational Initial Offerings

Initial stock offerings on a multinational basis

also encourage international trading. Many countries do not have enough depth in their capital

markets to accommodate large new equity offerings.

France, for example, was faced in 1986 with

privatizing companies worth about $30 billion, at a

time when the total value of listings on the Paris

bourse was only about $80 billion.% Very large

issues of stocks may be underwritten in several

countries at the same time. Multinational offerings

are often underwritten as different tranches with

separate underwriters. They are increasing as corporations seek to diversify their stockholder base, to

increase the recognition of their products and

As~ner t. OTA Aug. 14, 1989.

~Ja_ti~=, “fitures and Optiom, “ Financial World, Aug. 23, 1988, pp. 27-29.

4S~o~on ~ovid~ ~ OTA ~Me~gese~c~ COrp., New York NY, NOV. 23, 1989.

%roup of Thirty, “Symposium Background Paper: The Globalization of Equity Markets,” Imndo% Sept. 15-16,1986.
Chapter 3-The Extent of International Securities Trading ● 35

services in a broader market, to fund foreign

employee benefits schemes, to facilitate foreign

acquisitions, or to defend against take-overs.

International Mutual Funds

These are an alternative to active portfolio trading

and let investors hedge against changes in one

country’s economic conditions without the disadvantages of trading in a foreign country with

insufficient information. Some European countries,

especially Luxembourg, have tried to get American

investment companies to offer U.S. mutual funds in

Europe, but legal and tax differences make it

difficult for U.S. mutual funds to operate in Europe. 47

International mutual funds managed by U.S.

investment companies for American investors became popular in the early 1980s as the dollar

weakened (as foreign currencies appreciated against

the dollar, the net asset value of funds denominated

in those foreign currencies increased). While returns

for many international mutual funds have been

superior to most U.S. funds over the last 5 years,

some investors in international mutual funds were,

however, reported to be disappointed as it became

clear that diversification does not necessarily avoid

cyclical risk (for example, the recession of 1982 and

the crash of 1987 were worldwide).48 The funds are

also highly vulnerable to currency fluctuations.

Third World country funds are relatively thinly

traded; large infusions of money, from a pension

fund, for example, can swing the market violently,

and under stress it can be difficult to get out of the

market because there are too few potential buyers.

The number of international mutual funds nevertheless continues to grow. The Investment Company

Institute says there are 75 international funds (twothirds of their portfolio from outside the United

States) and 80 global funds (some U.S. securities).

RISKS INHERENT IN

GLOBALIZATION OF

SECURITIES MARKETS

If all of the legal, regulatory, and social barriers to

globalization of securities trading are overcome,

important systemic risks remain. In times of crisis,

the failure of major intermediaries could “impose

unacceptable external costs on the entire financial

and payments system and ultimately on the entire

economy. ’ ’49 There is a strong trend toward concentration and consolidation of securities firms, so that

the failure of any major intermediary will be likely

to have wider consequences than in the past,

especially when such intermediaries deal in many

markets or in many nations. There was no cascade of

failures when Drexel Burnham Lambert went bankrupt, but this is little assurance that it could not

happen in the future.

Several kinds of risks are inherent in securities

trading and are likely to be affected by an increase

in translational securities activities. They include

credit risks, position risks, transaction risks, and

systemic risks.50

Credit risk (also called counterpart risk) is the

possibility that one party to a transaction may not

deliver, or that a borrower may not repay a loan, or

that an intermediary in a transaction (e.g., a payment

bank or a clearinghouse) may fail. This risk is much

the same in domestic and international trades, but it

may be made worse by internationalization because

it is harder to make judgments about the reliability

of counterparties, the quality of assets, or the degree

of protection afforded by disclosure rules. Credit

risk is increased as participants trade in several

domestic and foreign markets, where regulatory

standards and safeguards may vary widely. (See ch.

4.) On the other hand, greater opportunities to

divers@ activities may help to reduce total credit

risk. Many countries are now acting to improve their

clearing, settlement, and payment mechanisms, and

in some cases the sharing of information (see ch. 5),

and this should moderate the increased credit risk.

dT_tiomofmu~= ~mmew~t~mn~ a,sarerequirernents foraccounting procedures and for disclosures, andfort.hetimes whm~iti

gains must be paid out.

4sKenne& J@wU ~d Jeff ~d~ “IIItemtiorMI Funds: What Factors A.ff=t Thd Returna,” AMA JownaZ, my 1988, p. g.

4g&_tion for ~n~c ~o~on ~~elopmen~ ‘$~wemnts for the R-bon ~Sup-ision of Securities ~htsin OECD

Countries,” Financial Market Trends 41, Novembex 1988, p. 36.

SOS- remarks made by Grant L. Reu@ ~Uty~of the Bank of Montreal, at a F“mancial Globalization Conference in Chicago, Nov. 2,

1989; the address was entitled “Implications of Globalization for Regulation.”
36 ● Trading Around the Clock: Global Securities Markets and Information Technology

Position risk is that which threatens entire institutions with sudden failure: insufficient assets to meet

the demands of depositors, borrowers, investors, or

creditors. This could be associated with: 1) a drying

up of liquidity (when assets exist but cannot be

reclaimed and redirected), 2) significant change in

the value of securities being held for trading or other

uses, or 3) adverse changes in foreign exchange rates

or interest rates. International trading can reduce

position risk by offering a greater choice of markets,

more opportunities to hedge, and a greater variety of

trading strategies. On the other hand, globalization

of markets tempts traders to trade in environments

where they do not understand all of the dangers and

may lack buffers such as back-up lines of credit.

Operational risk is the danger that comes from

breakdowns in telecommunications, computer systems, established institutional procedures and structures (including market-making mechanisms), and

other “mechanical” aspects of securities trading.

Technology provides powerful capabilities for getting things done, and for guarding against the human

risks of error, inattention, incompetence, misfeasance, and malfeasance. But technology entails its

own risks of breakdown and misuse, which almost

certainly increase with internationalization. Technologically sophisticated systems have failed in all

countries, including the United States, for example,

telephone networks, electric power distribution systems, and air traffic control systems. The ability ’to

develop and maintain technological systems is not

the same in all countries. Technological backups

may be inadequate or untested, or may fail for the

same reasons that the primary system fails. In late

1989 and early 1990, for example, a severe drought

in the Philippines caused a shortage of hydroelectric

power, causing blackouts and making it impossible

to depend on electric systems in the financial

Sector. 51

In addition, dependency on technological systems

increases the vulnerability when the system fails,

because manual skills, interpersonal relationships,

and alternative means of operating have often been

forgotten or lost. In global trading, some of these

alternative and backup procedures have never been

developed. At the same time, expectations of speed

and efficiency have increased because of technology, and so the impact of breakdown maybe greater.

There is a further risk of unknown dimensions that

comes with internationalization--sy stemic risk. That

is the extent to which securities market credit,

position, or transaction risk could threaten the basic

financial industries, the payment system, or the

economic performance of nations. On this question

there are many opinions but little useful evidence.

There are two complementary approaches to reducing risk: 1) private sector efforts to improve and

strengthen both technological systems and institutional interfaces, and 2) governmental efforts to

improve and harmonize regulatory safeguards. Many

countries are now revising their regulatory frameworks. According to the Organization of Economic

Cooperative Development:

There is increasing awareness that securities

market activities involve risks that are comparable to

the systemic risks inherent in banking, and that

accordingly, the basic question arises as to what

extent existing regulatory and supervisory arrangements are adequate to deal with current market

realities. 52

These efforts are discussed in chapter 6 of this report.

Sl~rd@ to w~m-Vice President for International Development International S=tities~-COT., MY lm.

%3EcD, op. cit., footnote 49, p. 31.
Chapter 4

America% Competitors in Global Securities Trading

In the competition for leadership in global securities trading, America’s chief competitors at present

are Japan and the United Kingdom.1 The European

Community is making a strong effort to integrate

and strengthen the securities markets of its member

nations (which include the United Kingdom) into a

trading arena that can compete on equal terms with

the United States and Japan. There is much skepticism, even among proponents, that this can be

achieved in the near future, but the EC countries, as

well as other nations such as Canada, Australia,

Singapore, and Hong Kong are, or could become,

niche competitors.

Institutional investors have the incentive, the

information access, and the technological infrastructure to trade across national boundaries. In making

the decision to do so, they balance several factors:

price, liquidity, cost (including regulatory costs),

and safety (i.e., transparency and fairness). Some

markets with high investment returns are limited or

risky.

The conventional wisdom about market liquidity

has been that the trading for a specific security will

always concentrate in one marketplace. With technology making possible nearly instantaneous comparison and arbitrage of prices (eventually on a

24-hour basis), that rule may not forever hold true.

There could be more than one liquid market, or the

active market for a stock may migrate from one

country to another or from one time zone to another.

The serious constraints on international trading at

present are the lack of essential protective regulations or enforcement in some countries (see chs. 3

and 6), and clearing and settlement risks (see ch. 5).

As these barriers are reduced, competition to serve

international investors will increase. In this competitive arena, the United States’ position may depend

ultimately on the advantages it can get from

information technology and from prudential regulation that assures transparency and fairness.

JAPAN

The Tokyo Stock Exchange (TSE) was the

world’s largest market in value of investments from

1987 to early 1990. It had been a bull market for 7

years, growing from $370 billion in 1980 to $2,803

billion in 1987, interrupted only briefly by the

October 1987 crash. In February 1990, its prices

began a steep, spasmodic decline. This had little

immediate effect on other major markets, but some

experts worry that if the Japanese market should

really crash, its investors might be forced to pull

their money out of other markets to cover the losses,

causing the crash to spread around the world.

The TSE traces its institutional history back to

1878, but it was organized in its present form during

the United States occupation of Japan, and stock

trading began in April 1949. There are several

exchanges in Japan, but the TSE handles about 86

percent of transactions by volume and by value. The

Osaka Exchange accounts for roughly 10 percent,

the Nagoya for about 4 percent, and others less than

1 percent together.2 The TSE is described in its own

literature as a quasi-government organization, and

‘‘a place for domestic and foreign investors to invest

their assets . . . [and] by making it easy for enterprises or the nation to raise capital, it also makes an

important contribution to economic development. ”

Traditionally Japanese corporations depended

heavily on debt financing (typically less than 20

percent of corporate capital has been equity); and

most of that came from banks rather than from

securities markets.3 But large Japanese firms now

raise over 60 percent of their funds in the capital

market.4

1~ ~~pt= &aw~ on ~v~ o~ ~on~ctm ~fis, including: ~c K. Clemom, princip~ hvestigator, with Stephen P. Broad, Rav’i

%dcateswara~ and Bruce W. Weber, “Globalization of Securities Markets” (Philadelpl@ PA: Wharton School, University of Pennsylvan@ July

1989); Peter Schwar@ “Scenarios for Regulation of International Securities Trading” (San Francisco, CA: Global Business Network NOV. 3, 1990;

Manning Gilbert Warren III, “Securities Regulation in the European Communities” (lhscalooa AL: University of Alabama Law Schoo~ August

1989).

~okyo Stock Exchange, 1989 Fucf Book, p. 17.

sThe GT GuUe to World Equity Markets J988 (lmndon: Euromony publications, 1988).

ds~t~ent by ~~o Kadoti, of~e ~s~of F~ce, ~ tie 14~ ~USI Conference of IOSCO, in Venice, Sept. 18-21, 1989.

–37–
38 ● Trading Around the Clock: Global Securities Markets and Information Technology —

Recent Trends

TSE began trading foreign stocks in December

1973, with six listed foreign stocks.5 In 1985 the

number began to rise dramatically, and reached 120

by early 1990.6 The average daily turnover of

foreign stocks is about 790,000 shares compared to

over 1 billion total daily volume.7

Japan’s primary market for government bonds

was virtually closed to foreigners until 1986. When

there was a new government bond issue, Japanese

banks, securities firms, and life insurance companies

would form an underwriting syndicate and divide up

the issue among themselves for distribution.8 Foreign banks and securities firms were not members of

the syndicate but were occasionally allotted a small

part of the issue. In 1989, Japan moved to a partial

auction system for selling 10-year bonds.

The number of foreign member-firms on the TSE

has increased slowly, to 22 in 1989. After the stock

market crash in 1987, the 45 foreign securities firms

in Tokyo began to reduce their staffs. In the year

ending September, 1988, 39 of the 45 foreign firms

in Tokyo had net losses, but during the next year,

they were by most accounts doing well.9 They

account for only about 5 to 7 percent of trading

volume, possibly because they lack good retail

channels (the active sector of the market is trading

by individual investors).

The TSE still has fixed commissions (except for

large trades, for which commissions have recently

been unregulated). Traders try to turn over as many

shares as possible, as often as possible, to capture

gains, because the ratio of dividends to prices is very

low.10 Both domestic and foreign traders concentrate

on the relatively few Japanese institutional investors

seeking short-term profits. This usually means

buying and selling Japanese securities, because

information about them is most quickly available.

Foreign investors for the last 5 years have been net

sellers, and their share of trading has fallen from 10

to 2 percent.

How the Market Works

Trading at the TSE takes place as a continuous

order-driven market, where buy and sell orders

interact directly. There are no official marketmakers, no specialists, and no affirmative obligation

to make markets. All securities must be traded

through an authorized securities dealer. The Big

Four securities houses: Nomura, Daiwa, Nikko, and

Yamaichi, together account for about 40 percent of

the trading, for their own accounts and for customers

(in 1960, the same four firms accounted for 70

Percent) .11

In Japan, institutions and corporations hold the

majority of stocks, but tend not to trade them.

Individuals do most of the trading. Ownership of

shares of companies listed on the eight exchanges in

Japan in 1988 was as follows:12

Percent

Banks and other financial institutions . ..........44.6

Business corporations . . . . . . . . . . . . . . . . . . . . . .. .24.9

Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23.6

Foreigners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.6

Securities firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5

Investment trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4

Government/local government . . . . . . . . . . . . . . . . . 0.8

There are two kinds of exchange membersregular and Saitori. Regular securities company

%lb&o Stock Exchange, 1989 Fact Book, p. 19.

6Da~ ~ppfi~ by ~+ Yuji Shibuya of the Nom= Re-h ~ti~te, Tokyo, F= 81.2.277.~98, NOV. 15, 1989, updated co-sy Of the

International Securities Clearing Corp., May 1990.

7~@o f$t~k Exchange, 1989 Fact Book.

KO Sakai, “GovernmentBondM arket: More Liberalizadon Measures Urged ’Ib Raise Foreign Share,” TheJapanEcononu”cJournal, Summe r 1988,

p. 28.

Whe Wall Street Journal, reported on Aug. 16, 1989, that Salomon Brothers, Merrill LyncQ Goldman Sachs, and Morgan Stanley Japan Ltd. are

doing well in Jap~ but “on the whole, foreign losers vastly outnumber the winnerS. (Marcus W. Brauchli, “U.S. Brokerage Firms Operating in Japan

Have Mixed Results,” p. 1. See also “Gaij@ Gaij@ Gone,” The Economist, Jan. 14,1989, p. 69. In 1990, most new reports say that Anerican securities

firms in Tbkyo”are making money. (Financial Tz”mes Special Section on Japanese Markets, III-ix, Mar. 15, 1990.)

~oshuo N~@_ ~~~~~e of the~nt si~tion and the ~blems of ~vestorRo~tion in Jap~,” present~ at the NASAA Conference

in Washingto~ DC, Apr. 26, 1990.

llR~Bro~ *+M~m.S~~FirmS prO~~u@~irB_ L*,” Fi~nciaJTj~s,s~i~Sect.iononJapanese Markets, @. 15,1990,

HI-vi. “

12These fiWes ~ from ~ TSEJ’act Book J989, p. 92, which d~s not expl~ why they add to lo2.Apercent. It is likely tit “investment h’llsts,

2.4 percent” overlaps with the figures for banks and other financial institutions, Foreign ownership peaked in 1984, at 6.3 percent.
Chapter 4--America’s Competitors in Global Securities Trading ● 39

members, like broker/dealers in the United States,

receive orders from customers or trade for their own

account. They execute trades through four Saitori

members, who match buyers and sellers. Saitori

members are not analogous to U.S. market-makers

since they can neither trade for their own account nor

accept orders from public investors. They record a

match of buy and sell orders but do not become a

counterpart to a trade.

In executing large block orders (300,000 shares or

more), a regular member can act as both seller and

buyer. However, in active stocks the proportion of

block trades was only 6.5 percent in 1988,13 because

institutions tend not to trade as much as individuals.

TSE trades only listed securities, and a decision

by the Exchange to list a security must be approved

by the Minister of Finance. Listed foreign stocks and

bonds may be denominated in either yen or foreign

currency but exchange settlement is chiefly denominated in yen. Japanese stocks often trade at much

higher price-earnings ratios than American stocks,

averaging 65: 1 as compared to 12: 1 at the New York

Stock Exchange (NYSE), in part because earnings

are not consolidated due to corporate cross-listing

and in part because of differences in accounting

practices.

Most of the stocks are traded only on the

Computer-Assisted Order Routing and Execution

System (CORES). Exchange member companies

have on-line terminals in their main offices to send

in orders and receive verification. In the TSE

Computer-Assisted Trading Room Saitori clerks

monitor the computers, which automatically match

orders on their “Book Display Device” or display

screens. When a transaction is completed, the notice

is sent to a Trade Report Output Device in the office

of the firm that placed the orders, and recorded on the

Saitori members’ Trade Report Printers.

There are three kinds of stocks:

. First Section issues, the most actively traded

stocks (1,169 in 1989), of which only the 150

most “blue-chip’ trade on the stock exchange

floor, while the rest trade on CORES;

Photo credit: Courtesy of Tokyo Stock Exchanges

Tokyo Stock Exchange computer-assisted trading room

. Second Section stocks (434 listed), all trade on

CORES; and

● Foreign Division listings (120),also trade on

CORES.

Of the 1,723 listed issues in 1989,1,573 are traded

only electronically. However the other 150 issues,

which trade on the floor, represent about 78 percent

of all trading volume by shares.14 Stock Price display

boards immediately display the price information.

The layout of the Exchange floor is much like that of

the NYSE, but the hand signals used by the traders

are more like those used at the Chicago futures

exchange.

Only First Section stocks can be traded on margin.

The customer deposits guarantee money at a prescribed rate with the securities company, and can

also use securities as collateral (they are given a

special “loan value”). The customer pays interest

until he returns the money borrowed from the

securities company. For individual investors, about

39 percent of transactions were margined in 1988, an

8 percent increase in that year. The use of margins

had been declining since 1982, although the value of

margined transactions had continued to rise (as

much as 39 percent in 1988).15

A market information system conveys quote and

price information to the offices of the securities

ls~~o sitificha~e, Fact Book 1989, p. 16.

14~~e f@e~ ~em ~ppli~ by NOm~~ R~~h ~ti~te, NW Yom ~, J~~1990+ ~CTSE Fact B~~k 1989 tists comparable fi~ fOr

1988: of 1,8(X2 listed stock (1,690 domestic, 112 foreign), 1,652 am traded on CORES and 150 on the floor.

15T@o Stock Exchange, Fact Book 1989, p. ~.
40 ● Trading Around the Clock: Global Securities Markets and Information Technology

Photo credit: Courtesy of Tokyo Stock Exchanges

Tokyo Stock Exchange stock trading floor

companies, the media, and information vendors as

well as to the stock price display boards on the

trading floor. However, no vendor is permitted to

provide real-time digital price or quote streams to

investors away from the floor.

The bond trading floor is much like the stock

trading floor. Member companies place orders by

telephone directly to Saitori members in a special

government bond block trading room. However,

most bond trading is over the counter, including

large block trading in government bonds and yendenominated foreign bonds.

Since there are no market-makers or specialists in

the TSE, the function of keeping an orderly market 16 When there is a major is handled in other ways.

order imbalance in a listed stock, the Exchange posts

a “special bid quote” or a “special asked quote”

that is better than the last sale price. This can be

renewed or modified every 5 minutes until it elicits

enough orders to reestablish some equilibrium.

Another way of controlling ups and downs is the

daily price limit (which is imposed on the basis not

of a percentage change in price but an absolute yen

limit). Listed stocks cannot be traded at a price that

exceeds the limit of price fluctuation from the

closing price of the previous day (the permitted

fluctuation is proportional to the price level, i.e., a

high-priced stock can fluctuate more than one

selling at a much lower price.) Finally, there are

temporary trading halts when the market becomes

too volatile.

Derivative Products Markets

In 1985 the Tokyo Exchange started anew market

for long-term Japanese government bond futures.

Trading is conducted largely by computer. In 3

years, this has become one of the major financial

futures markets of the world. Access to futures

trading is open not only to regular member firms, but

also to non-member securities companies and banks.

In June 1987, the Osaka Securities Exchange

began trading on stock average futures, using a

bundle of 50 blue-chip stocks traded in Osaka.

Trading in cash-settled TOPIX futures at the Tokyo

Exchange and the Nikkei 225 futures at the Osaka

both began on September 3, 1988.17 This was

described as an opportunity “to offset general

market risk, gain financial protection, maintain

profitability, invest in the market as a whole, and

arbitrage between futures and cash markets. ’ A

representative of the Ministry of Finance, Sadaaki

Hirasawa, said that government policy would encourage the development of futures markets with

“high priority for protecting the position of investors and other market participants.”18

1%id., p. 12.

IT~e Nikkei AverWe Share Wce ~dex is simih to the Dow Jones, and is built on the prices of 225 First Section stOckS. The prinCipd d~culty

with tbis index is that it is not weighted and the Tokyo stock price index (TOPIX) was developed in 1969 to remedy this-it is the weighted average

of all First Seetion stocks.

~ssa-fimaw% “Catc@UpFaS~” Look Japan, July 1988, p. 10.
Chapter 4--America’s Competitors in Global Securities Trading ● 41

But on December 8,1988, the Nikkei 225 first fell

nearly 200 points in the first 15 minutes of TSE

trading and then jumped 300 points in the final 30

minutes. Program trading led by U.S. firms was

blamed. On the day before, there was an unprecedented volume of trading in stocks, as traders took

advantage of price differences between stocks and

stock-index futures on the first contract expiration

date for contracts.

A month later (Jan. 13, 1989) the president of the

exchange said publicly that the exchange might

move to restrict arbitrage trading between stocks and

stock-index futures because arbitrage by foreigners

might induce “excessive volatility and confusion.’ ’19

Before Japan’s second witching hour, March 7,

1989, there was worry that a sell-off could drop the

Nikkei by as many as 1,000 points. Accordingly, the

exchange followed the example of the Chicago

Mercantile Exchange and changed the rules so that

the settlement price for TOPIX futures is based on

the opening stock prices the day after expiration. The

Exchange also changed stock margins from 30 to 40

percent.20In December 1989, two New York firms—

Salomon Brothers and Morgan Stanley-who had

publicly announced that they would cease program

trading in the United States, were reported to be

actively program trading in Tokyo, arbitraging

between the two stock indexes, the Nikkei and

TOPIX.21 The vice-chairman of Salomon Brothers,

Stanley Shopkorn, was quoted22 as saying,

The Japanese have an ability to monitor and make

sure the market works in a more orderly fashion.

They don’t have the fears that U.S. investors have

regarding index arbitrage.

But on February 26, 1990, after the Tokyo market

dropped by 11.5 percent in a week, program trading

was again blamed for the break. The Tokyo Stock

Exchange imposed restrictions on computerized

program trading between the futures and cash

markets, and the Ministry of Finance was reported to

have called in large institutional investors and

leading brokers to discuss the market situation.23

After further declines in the market, U.S. firms were

asked in early March to restrict their program

trading.24

It is thought that program trading in Japan is

mostly done by U.S. fins. To do program trading,

brokers need to sell huge blocks of stocks, which

may depress the prices of those stocks. In Japan,

companies may identify which broker was selling

the stock and punish them by withholding underwriting or other business from that company. The

U.S. firms say, however, that much of their program

trading is on behalf of large Japanese insurance

companies and trust banks.25 In the midst of the

renewed controversy about program trading, in

March 1990, Nomura Securities Co. (the largest

securities firm in the world) announced that it would

begin program trading, and had hired an experienced

American securities expert to oversee their new

activity .26

Futures and options trading, nevertheless, is

growing rapidly.27 Three index options contracts

began trading in mid-1989. The volume of trading in

the most popular of these, the option on the

Nikkei-225, has grown to about 65,000 contracts per

day.

Over-the-Counter Market

About 250 companies are listed on Japan’s

over-the-counter market; to be listed requires that an

average 2,000 shares are sold per month.28This

19@o~d h C’~@o &change my Act To Curb Arbitrage Trades,’ Wall Street Journal, Jan. 13, 1989p. C 14,

m,4By BeU, Book, and Cmdle, “ The Economist, Mar. 4, 1989.

Z1-CU.S. Fi.rms Using Rogram Trading Make Tokyo Stock Market JumF,” Wall Street Journal, Dec. 9, 1989, p. C 1.

22SW B@ett, “~@ fibi~ge for U.S. Finns, ” New York Times, Dec. 19, 1989, p. D 5.

23~c.yo N_o~ and st~anwags~l, “~~o Curbs Arbi@age “f’rading,” Financial Times, Feb. 27, 1990, p. 1.

~WCUS Brauchli and Masayoshi Kanabayasbi, “U.S. Brokers Asked in Japan lb Curb Program Trading, Wall Street Journal, Mar. 9, 1990.

~Ibid.

~~c~el R. Sesit and Craig l’brres, “Nomura To Plunge Into Program Trading on Global Scale, Challenging U.S. Lead,” The Asian Wall Street

Journal Weekly, Mar. 19, 1990, p. 27.

27Tr~ding fi the N&k&225 ~d TopJ’x fi~~ contracts, added togeth~, is now higher ~trading in the U.S. Stintid & poor 500 index flltur~

(according to Andrew Freemam “Japanese Contracts Could Overtake U.S. Equivalents, “ in the special section of Japanese markets, Financial Times,

Mar. 9, 1990) but such comparison can be misleading. Because of differences in U.S. and Japanese margining systems, it is customary to sell and

repurchase more frequently, to capture profits.

~Assetznternational, NOV. 20, 1989, P. 9.
42 ● Trading Around the Clock: Global Securities Markets and Information Technology

market grew at a rate much slower than expected

until mid-1989, but thereafter became more active.

The Japan Securities Dealers Association has developed anew electronic quotations system modeled on

the NASDAQ (National Associates of Securities

Dealers Automated Quotation) system in the United

States; it will be called JASDAQ.

The over-the-counter market was the locus of the

“Recruit-Cosmos” influence-peddling scandal, in

which senior government officials, including the

finance minister, made large profits by buying a

company’s stock just before, and selling it just after,

it was approved for over-the-counter sale. The Japan

Securities Dealers Association, which is the selfregulatory organization for the over-the-counter

market, has now proposed new, tighter, regulation to

prevent this kind of insider trading.

Clearing and Settlement

All clearing and settlement for stocks is handled

by the Japan Securities Clearing Corp. (JSCC), a

subsidiary of the TSE, and is usually done on the

third business day after the trade. The failed-trade

rate is less than 1 percent. Recently, high volumes of

trading are pushing this system to its limits, and a

“back office” (after-the-trade paperwork) crisis is

threatened. (See Appendix A: Clearing and Settlement, for a detailed description.)

There is a book-entry clearing system; however,

JSCC is technically required to return the deposited

share certificates to the owners once a year and

whenever a shareholder requests it. This is a major

burden on the institutions and the market. Discussions on how to improve the system have gone on for

many years. A Central Depository and Clearing of

Securities Law was enacted in 1984, but the new

Depository Center that it sought to create is not yet

operating; it may begin in late 1991. Settlement

costs in Japan are very high compared to other

markets.

For foreign stocks, clearing and settlement is

through full book-entry transfer at the JSCC, which

has cooperative agreements with overseas public

clearing organizations, securities depositories, and

commercial banks that keep the underlying foreign

shares in the home country.

Market Regulation29

The TSE is a non-profit corporation, selfregulating but under the close supervision of the

Ministry of Finance. Many changes have been made

in the regulatory and tax structure since 1987.

Exchange members themselves proposed new rules

to curb stock manipulation, to make initial public

offerings more competitive, and to dismantle procedures that allow stock to be transferred to selected

people at advantageous prices (as in the recent

Recruit-Cosmos scandal).

TSE publications prominently emphasize a determination to guarantee the public interest and protect

investors, and they tie this to “the principle of

auction,’ which is defined as time and price

priority. 30 Rules say that financial statements and

any other company news that may influence the

prices of securities must be “disclosed accurately,

promptly, and impartially, at the appropriate moment without delay. ” Nevertheless the Japanese

markets are far from transparent. The Ministry of

Finance announced in January 1989 that it would

tighten stock-ownership disclosure rules, making

them similar to U.S. and British regulations.31

Although insider trading has always been against

the rules, neither violations nor reprimands were

made public, and most market participants reportedly did not consider them a serious violation of

either law or ethics. In early 1989 Japan for the first

time provided criminal penalties for insider trading.

Japan’s Securities Exchange Act of 1948 has many

investor protection clauses patterned after those in

U.S. laws, but according to a leading Japanese critic

of the markets, the laws ‘‘have not been satisfactorily enforced.”32 Shuzo Nakashima, of the Hijiribashi Law Firm, identifies two reasons for this: 1)

because of cross-holding of shares among corporations, the interests of other shareholders can be

“ignored and neglected most of the time’ and 2)

~SOmS: “Regulations of the Tc@o Stock Exchange,” 1986; “Constitution of the TolqIo Stock Exchange,” 1986; “Listing Regulations of the

‘Ibkyo Stock Exchange,” 1984; “A Listing Guide for Foreign Companies,”no date; all supplied by the ‘lbkyo Stock Exchange.

-t is, the lowest-priced offer and the highest-priced bid has fnt priority, and if two are placed at the same price, priority is given to that received

first.

qltis W. Bmuchl~ “Jap~~e Regulators Seeking lb Tighten Rules orMtock-Ownership Disclosure, “Asian Wall StreetJournal, Jan. 23,1989,

p. 18,

32N~ op. cit., footnote 10.
Chapter 4--America’s Competitors in Global Securities Trading ● 43

enforcement is neglected because the regulating

authority (the Securities Bureau of the Ministry of

Finance) is chiefly concerned with the growth of the

Japan securities industry and its brokerage firms.

Mr. Nakashima lists as major problems insider

trading, price manipulations, churning, and fraud by

securities advisers.

Japan, like the United States, legally separates

banking from securities markets, the Glass-Steagall

Act having been the model for Japan’s Article 65,

adopted during the American Occupation. As in the

United States, this separation has been made less

effective by a combination of deregulation and

technology. The largest banks are demanding universal banking (i.e., permission for banks to engage

in all kinds of financial activity, including securities

trading) while the securities firms want to preserve

the separation. The Ministry of Finance is reported

to be considering a compromise in which banks

could set up brokerage subsidiaries and securities

firms could open bank subsidiaries.33

This issue has been complicated by the impending

introduction of GLOBEX (discussed in ch. 2), the

electronic trading system being introduced by the

Chicago Mercantile Exchange and Reuters. Japanese banks began planning to put GLOBEX terminals in their offices for trading interest rates and

currency futures, and later stock index futures and

options. But the banks were for a time discouraged

by the Ministry of Finance; but on May 21,1990, the

Ministry of Finance approved the use of GLOBEX

terminals.

Tokyo as a World Center for

Securities Trading

Japan is often mentioned as America’s top competitor in securities trading, primarily because the

Tokyo Stock Exchange rivals the NYSE as the

world’s largest market. It is not, however, as

intimationalized as London, nor as accessible to

foreign traders or investors as either New York or

London. Language, culture, and high startup costs

are all significant barriers.

Most of Tokyo’s trading is concentrated in a few

major issues; the 30 most active stocks account for

about 46 percent of volume by transactions and 39

percent by value. No one is allowed to deliver

real-time digital price data by electronic systems to

investors. Frequent trading halts may alarm some

foreign investors who are not accustomed to circuitbreakers. There is a trading tax in Japan, of 0.30

percent of the value of the transaction. Commissions, particularly for retail customers, are high

compared to other markets, and the paper-based

settlement system, which does not centralize settlement between brokers and custodians, is expensive

for institutional traders. Investor protection is weak.

So long as Japan’s economy is strong, however, its

securities markets will continue to be strong competition for those in the United States.

THE UNITED KINGDOM

London is the other major competitor to New

York stock markets and Chicago futures markets in

world trading. The International Stock Exchange of

the United Kingdom and the Republic of Ireland

(ISE, or informally, the London Stock Exchange)%

is the most “internationalized’ of the major markets, with 1,987 domestic and 707 foreign listings

(23 percent). It trades listed bonds and equities,

unlisted securities, and options.35 The ISE is now

struggling to adjust to changes brought about by

deregulation, automation, and the crash of 1987, but

it has many advantages as a center for global trading.

Foreign shares account for about a quarter of all

transactions at the ISE.

The ISE is among the world’s largest stock

markets by capitalization, but usually ranks after

Tokyo, New York, NASDAQ, and Osaka. The

average number of ‘‘bargains’ (trades) per day

increased by 42 percent from 1983 to 1988, but the

average number of shares traded increased by 192

percent (to 408.5 million), reflecting an increase in

the number of large blocks.

London is also the home of the 7-year-old London

International Financial Futures Exchange (LIFFE)

SS,’Jap_@eF~cti Deotiow ~~ the ~lz,” The Econo~”st, my 20, 1989, P. 87.

~Sep~ti exc~%es in ei~t citie~bndo~ Be~@ B~ Btitol Dubl@ Glascow, Liverpoo4 and Manchester-were merged in 1973.

The London Stock Exchange was renamed the International Stock Exchange in 1986. Spicer & Oppenheimer, Stock Markets Around the Worki (New

Yoa NY: Job Wiley& Sons, 1988); pp. 207 ff.

3S~Ufis~ s~~ties ~ket~dles ismes of ~mp~es @t~nOt&ted~~ethey wish tOASe SIAk sums of money thanlistingrequires,

wish to release a smaller percentage of total equities, or have too short a trading reeord. There is an over-th~counter market for equity and corporate

bonds.
44 ● Trading Around the Clock: Global Securities Markets and Information Technology

and the center of the Eurobond market, although

neither is part of the ISE.36 The Eurobond market is

an over-the-counter market operated by banks and

stockbrokers. Its investors are principally institutions, and Japanese firms have come to dominate

Eurobond underwriting.

Most major American and Japanese securities

firms are members of the ISE, but none has

succeeded in capturing a significant market share in

U.K. securities. American firms have done well in

marketing advisory services, banking services, and

in mergers and acquisitions.

In October 1986, the British Government deregulated the securities market, an event known as “Big

Bang.” Fixed minimum commission rates were

abolished. Mandated separation of brokering and

dealing functions (“single capacity”) was also

abolished; firms could now operate as both brokers

and dealers, trading for customers and for themselves. Big Bang opened up the markets. British

banks were allowed for the first time to become

full-service financial institutions; they can underwrite securities and can own brokerage houses.

Restrictions on foreign membership ended. Foreign

banks can now own up to 100 percent of British

brokerage fins. Most of the leading firms in the ISE

are now corporations, many owned by international

banks and finance houses. Before deregulation, they

were all partnerships and the London Stock Exchange was much like a gentlemen’s club.

The change in market structure was profound; the

Council of the International Stock Exchange says:

Indeed it was thought that these changes in

working practice were so great that it would not be

possible to implement them in a staged manner but

they would all have to be implemented in a “big

bang. ”37

The ISE Planning Committee “had been worried

that insufficient market-making capacity would

come forward,’ but instead ‘the degree of oversubscription was awesome. ”38 The rigorous competition among them contributed to serious adjustment

problems. Nevertheless, business volumes increased

significantly after Big Bang, by some 85 percent for

customer business and an equal proportion through

‘‘inter-market-maker dealings.

How the Market Works

ISE modeled its new electronic trading support

system-Stock Exchange Automated Quotations

(SEAQ)--after the National Association of Securities Dealers Automated Quotations system

(NASDAQ) in the United States, deliberately rejecting the specialist system in favor of competing

market-makers. Quotations are displayed on the

computer network, and transactions can take place

either by telephone or on the floor. In fact, the floor

was quickly abandoned,39 and all trading takes place

by telephone. The distinction between exchange and

over-the-counter trading effectively disappeared.

The ISE’s competing market-makers are required to

try to make continuous markets in the stocks in

which they deal from 9 a.m. to 5 p.m., but they do not

have the affirmative obligation to trade their inventory that NYSE specialists have.

After deregulation, commissions paid by institutional investors dropped to about 0.2 percent of

transaction value, or moved to a “net price, free of

commission” basis.40 In spite of the halving of

commissions, The Financial Times reported in

October 1987 that London stock exchange firms had

earned much higher income over the year ‘‘as a

result of the upsurge in turnover during the past year,

particularly from small investors. ”41

Immediately after Big Bang, market-maker firms

spent millions on computer systems. Big Bang led to

rapid expansion (the number of market-makers on

ISE grew from 5 to 31). Competition was intense.

After the 1987 crash, the drop in trading volume put

—

36Sc~aent ad ~u~t~y for Emobonds we dir~t~ by tie Association of ~ternatio~ Bond ~ers(-D) and proc~s~ either by Ewoclear, in

Brussels, or Cedel in Luxembourg.

37~~ReviW of the c~~al Market in U.K. Equities,’ A Comtdtative D ocument from the Council of the International Stock Exchange ~ereaftercited

as “Council of the ISE”], May 1989.

%bid,, p. 6.

3~tis ~p~mostof the~e. ob~~ersmport~ton~t. 19.20,1987, wh~~eNewYorkexc@ef loor and Chicago pitS were bedlam, the bndon

floor was eerily empty. All action was “upstairs” in the members’ offices and trading rooms.

‘%l’’here is a value-added tax of 15 percent on commissions, a transfer stamp of 0.5 percent on purchases, and a levy of fO.80 on trades of over flOCKl

to funce the regulatory fkamework. It was announced in March 1990, that the transfer stamp duty will be eliminated when a new computerized

registration Systeu described later in this chapter, is completed.

dlcfiveWo-‘<SE Firms Stock Up on Earnings,” Finuncial Times, OCt. 27, 1988, p. 14.
Chapter 4--America’s Competitors in Global Securities Trading ● 45

the London securities industry into a period of

severe cost-cutting and budget-tightening. By March

1989, it was reported that British brokerage houses

had lost $2 billion since Big Bang, and had

eliminated thousands of jobs.42

There have been continuing problems for ISE. A

year after the crash, there was evidence that an

increasing amount of business was being done

off-exchange using market prices available on SEAQ.

The Council of the ISE concluded that ‘the threat of

fragmentation was very real.”43 SEAQ required

traders to post on its computer display their bids and

offers and the quantity of shares for which they are

prepared to deal at that price. For this “transparency” big market-makers paid a price. Smaller,

competing market-makers could “dump” stocks on

them or raid their inventories, thus conveniently

closing out their own positions at the end of each

trading day.44 When two large market-maker firms

announced that they were reducing the size of deals

that they would guarantee to transact at their

SEAQ-quoted prices, the ISE dropped its “inter-marketmaker obligation,” the requirement that marketmaking firms deal with one another at the quoted

prices.45 A second change in the roles allowed

reporting of large trades to be delayed until the

following day, so that traders can buy and sell large

blocks of securities without immediately moving the

market price.

The rationale for these “temporary” changes was

that they would lead to market-makers displaying

more realistic sizes on SEAQ. While there might be

an immediate reduction in inter-market-maker business and large block trades, it was hoped that some

firms would provide more competitive prices in

large trades in the knowledge that they could sell off

large blocks through retail outlets and their positions

would not be jeopardized by having to deal with

their competitors at these favorable prices.

Subsequent analysis of response to the changes

indicates that there has been an increase in the

proportion of deals done “at the touch” (i.e., at the

best bid/offer on SEAQ) and no significant decline

in intra-market liquidity, but also no immediate

increase in large trades on the exchange--the trend

to off-market trading had not reversed.

The rule changes made the market less “transparent,’ and decreased the flow of information. Lasttrade prices for large blocks are not at once available.

This made it difficult to provide efficient indexes for

purposes of pricing derivative products.46 It tended

to create a ‘‘two-tier’ market by encouraging

market-makers to reserve their best prices for large

clients, buying or selling large size blocks at

negotiated prices. SEAQ was therefore less reliable

at reflecting true market prices. In fact, however

institutions often continued to deal among themselves and stay away from the exchange altogether.

Although some critics blame the “automation” of

the market (meaning the demise of its trading floor

activity) for its problems, others appear to fault the

exchange for poorly conceived, poorly planned, and

poorly integrated systems. For example, a recent

editorial in The Economist said,

Punished by the inertia brought on by internal

dissent, the exchange has never truly found its place

in the decartelized world that followed the City of

London’s Big Bang in October 1986. . . . Member

firms have lost hundreds of millions of pounds in the

fierce competition to trade British equities. The

efficiency of this screen-driven money-loser has

highlighted, in turn, the awful inefficiency of London’s paper-pushing settlement system-as well as

the mish-mash of technical systems that makeup the

market’s creaky infrastructure.47

The editorial identified two problems with the ISE

related to technology: a) the difficulty of using the

same system to serve both small private clients and

large institutional investors, and b) the separation of

domestic and international markets with separate

rules and trading systems.

42Most American Banks had bought British firms lost money, Chase Manhattan bank ended its equity operation in London in January 1989 with

a $40 million loss. Security Pacific Corp. and Citicorp also lost money.

43Council of ISE, op. cit., footnote 38, p. 7.

44In the United States, NASD found it desirableble to prohibit the use of NASDAQ’ small-order execution system by professional traders, who would

“pick off’ market-makers’ displayed quotes before the market-makers could react to news or rumors affecting the value of stock.

45Under the older market-makers had to trade with clients, agency brokers, and others market-makers at the price they had listed on SEAQ. Under

the new rule market-makers must trade at that price with clients and agency brokers, but not with other market-makers.

46The index usually used to indicate the performance of the ISE, is the Financial Times/Stock Exchange 100 Share Index, or FTSE.

47"Tower or Indecision," The Economist, Feb. 24, 1990.
46 ● Trading Around the Clock: Global Securities Markets and Information Technology

An editorial in the Financial Times, on the other

hand, suggested that the exchange’s central divisions and services should be “unbundled’ and

broken apart, made to “stand on their own feet.”48

The editorial said,

Nor, given the exchange’s current maze of electronic services, many of them in urgent need of

overhaul, is it clear why member firms should want

to be tied to the exchange by the sort of electronic

umbilical cord envisaged by the Elwes group [an ISE

policy committee that is described below].

In other words, there appears to be a general

disquiet and dissatisfaction with the ISE, but little

consensus on the nature, the causes, or the treatment

of the problem. There is a continuing debate about

the structure of the exchange. Some members advise

better integration of ISE’s domestic and international trading (now handled by separate divisions at

the exchange). Others take an opposite approach,

arguing that there should be different procedures,

different technology, and different rules for professional/

international trades and for retail/domestic trades,

possibly even a return to the trading floor for the

latter—an institutionalized two-tier market. A third

school believes that ISE’s major problem is simpler—

cut-throat competition among its now 25 marketmakers-and can be solved only when some of them

are shaken out.

By early 1990, the exchange was considering

reverting to its old rules, restoring the obligations of

market-makers for firm bids and offers, dealing with

all customers at displayed quotes, and reporting

large trades’ prices immediately. These changes

were recommended by an internal policy subcommittee called the Elwes group. The Elwes Report

asserted its conclusion that:

. . .within the developing European and International

environment, whilst SEAQ and the Competing

Market Maker System, with telephone negotiation,

will remain pre-eminent as a means of transacting

large securities business, there will be a growing

acceptance of automatic execution systems for small

business as well as greater demand for efficient limit

minding and execution facilities especially for the

less liquid securities.49

The report said the role of the exchange was

 shrinking, as trading migrated away from the exchange to off-board trading, creating the danger of

fragmentation of the central market. The committee

emphasized the importance of encouraging retail

clients, and its continued belief that a quote-driven

system, rather than an order-driven system50

‘‘should be the mechanism for trading EK equities.’

There were four primary recommendations:

●

●

●

●

the introduction of a central limit order facility;

mandatory preferencing of orders, requiring

brokers to direct their orders over telephone or

proprietary dealing systems to market-makers

displaying the best price (rather than one not

displaying the best price, but willing to trade at

the best price);

an “order exposure” rule for agency crosses

and matching principals, requiring their orders

to be exposed to a market-maker and take

account of existing limit orders,

requiring market-makers to meet a minimum

quote size, with larger trades published as to

size immediately and as to price 90 minutes

later.

The preferencing recommendation was aimed at

the problem that unless a market-maker is assured of

a reward (increased order flow) for making the best

bid/offer, there is no incentive to make competitive

prices and narrow the price spread, especially if by

so doing he allows his competitors to “hit” him at

that price. The price-discovery function of the

market is threatened, and the central market may

become irrelevant. The report recommended that the

old rules obligating market-makers to make firm

prices in size for brokers dealing as principals be

reinstated. The committee also called for efforts to

improve cost-effectiveness (especially improvement

of the settlement system).

Following the release of the Elwes Report, the ISE

began restructuring, by eliminating 80 percent of its

committees and eliminating 350 jobs, with further

48"Future of the Stock Market" [Lead editiorial], London’s Financial Times, Mar. 2, 1990, p. 18.

49Its chairman was Nigel Elwes of Warburg Securities. The Report of the Special Committee on Market Development “Review of the Central Market

in UK Equities,” March 1990.

50 In the United States, the National Association of Securities Dealers’ Automated Quotation system (NASDAQ), used by over-the-counter dealers,

is a quote-driven system. The New York Stock Exchange uses “order-driven” systems, meaning that the customer bids and offers, rather than dealers’

quotes, are the basis of matching buyers and sellers to determine a going price.
Chapter 4--America’s Competitors in Global Securities Trading ● 47

reductions expected. The exchange was to be

reorganized into three divisions, each of which will

have its own managing director, management board,

and responsibility for its own computer systems and

rule-making. The three divisions will be: 1) a

primary markets division to carry out regulatory

responsibilities and provide services for corporate

issuers, 2) a trading markets division to manage

secondary trading, and 3) a settlements division. The

exchange said that the restructuring was to ‘‘bring

focus to its disparate operations and introduce a

more commercial environment for its managers. ’ ’51

The chief executive of the exchange emphasized in

interviews that an immediate task would be the

“rationalizing” and “re-engineering” of the many

large computer systems serving the various trading

markets.

In spite of its problems, SEAQ was given credit

for strong performance on October 16, 1989, when

European markets fell sharply following the 7

percent drop in the U.S. stock market the previous

Friday.52 The ISE index value dropped 9 percent but

regained most of that before the end of the day.

SEAQ continued to quote real-time prices throughout the slide and thereby drew trades from the French

bourse, which closed, and Frankfort, where the

market fell 13 percent.

Clearing and Settlement

Equities and corporate bonds are traded in 2-week

“account periods.” All trades done in a given

account period are scheduled for settlement on the

sixth business day after the end of the account

period. Thus settlement may be as late as 16 business

days or 21 calendar days after the trade. Clearing and

settlement costs are high. (See AppendixA: Clearing

and Settlement, for a detailed description.)

Settlement between brokers and market-makers is

through a central clearing service, TALISMAN,

owned by the ISE and linked to company registrars.

Individual investors, but not institutions, must settle

with their broker whether or not the broker has

satisfied his part of the settlement. For government

securities, there is a computerized book-entry transfer system, operated by the Bank of England, and

settlement is normally on the next business day.

Market Regulation

The Financial Services Act of 1986 is now the

basis of Britain’s securities markets regulation. The

ISE is a registered investment exchange, whose

members must belong to a self-regulatory organization such as The Securities Association (TSA),

which also oversees the Eurobond market and

corporate finance activities. Both the ISE and TSA

come under The Securities and Investment Board,

which authorizes exchanges and self-regulatory

organizations, and is itself overseen by the British

Government Department of Trade and Industry. The

ISE and TSA share responsibilities for investor

protection.

Big Bang represented access deregulation, but not

prudential deregulation. The United Kingdom has

more investor protection and related regulation than

other European countries.53 Because of the European Community’s 1992 Directives, aimed at harmonization of regulation, there may be pressure to

relax these regulations. The British securities industry reportedly shares a consensus that the 1986

Financial Services Act and the resulting level of

prudential regulation is too burdensome and could

detract from London’s competitiveness.54

The London International Financial Futures

Exchange (LIFFE)

LIFFE is not part of the ISE,55 but its presence

adds strength to London’s position in securities

trading, as does the presence of the Eurobond

Market. LIFFE was organized in 1982. It trades

futures contracts on interest rates, currency rates,

51 As reported by Richard Waters, "London SE Sharke-up Cuts 350 Jobs, Most Committees,” in the Financial Times, Mar. 22, p. 1.

52During and after the 1987 crash there were criticisms of ISE performance as there were of other national exchanges. The Exchange rejected proposals

breakers be instituted. There were complaints that some market-makers did not answer their telephones to avoid having to deal; but later

evaluation indicated that much of this could be blamed on lack of telephone line capacity. The Council of ISE reports that: “Institutions in general

acknowledged they had been able to divest in some lines of stock with market makerswhose motivation in entering into bargains could only have been

loyalty to their customers and their duty under the rules of the exchange.. . [T]he market makers were net buyers of securities to the value of L.250

million . . .“ Council of ISE, op. cit., footnote 38, p. 7.

53Sir David Scholey, "Deregulated Competition or Competitive Deregulation?” Institutional Investor, April 1989, PP. 12-13.

54Based on interviews conducted by E. Clemens and others for OTA, op. cit., footnote 1.

55On Apr. 4, 1990 there was an announcement in London that LIFFE and the London Traded Option Market which is part of ISE, would merge;

the form of this merger is not yet clear.
48 ● Trading Around the Clock: Global Securities Markets and Information Technology

and on the stock index. It also trades American-style

options contracts.56

In its promotional literature, LIFFE stresses the

advantages of its position between the Far East and

North America, when “. . the gap between the end

of trading in the Far East and the start of trading in

Chicago can be as much as six hours.”57 LIFFE is

developing an electronic trading system, Automated

Pit Trading System or APT, that emulates openoutcry trading, and is similar to the AURORA

system developed by the Chicago Board of Trade

(see ch. 2). APT is intended to extend trading hours

to cover the European trading day, but it will not be

a 24-hour system and will not be available outside

the United Kingdom (LIFFE says that the cost of

high-speed communications links is prohibitively

high) .58

London as a World Center for

Securities Trading

London has a long tradition as an international

financial center, and is now the most internationalized of the major securities markets. The liquidity

and depth on the ISE are generally good. Very large

positions are routinely moved at the ‘touch price,”

or the best buy or sell quote on SEAQ. Until rule

changes in February 1989 (allowing traders to delay

reporting deals over £ 100,000) transparency was

considered to be excellent (market-makers had

argued that there was too much transparency). It is

now less transparent, but the 1989 rule changes may

be reversed. Market surveillance is considered to be

good.

Spreads and commissions have been driven down

by competition and are now very low; however,

settlement costs are disproportionately high. For 8

years there have been plans to end the use of share

certificates by developing a computerized share

register—‘‘Transfer and Automated Registration of

Uncertified Stock,’ or TAURUS. It was delayed by

“Big Bang” and the post-1987 decline, and the

ISE’s efforts to complete the design have been

criticized as too costly by registrars and banks (many

of whom have vested interests in the paper-based

system, since it provides them with fees).

Since the introduction of SEAQ International, as

much as 25 percent of the total turnover in French

and German stocks on a given day has involved at

least one counterpart in London. After Sweden, in

1986, imposed a trading tax of 1 percent on both

sides of a trade, trading volume in shares of 10

Swedish companies rose temporarily in London, to

5 times the volume on the Stockholm bourse.59 Now

15 firms make market in the& Swedish shares on

SEAQ International.

Nevertheless, the ISE has serious problems. The

competition between London’s markets and those

on the continent is strong. How this competition will

develop in the context of the European Community’s 1992 initiative is uncertain.

THE EUROPEAN COMMUNITY

MARKETS

Europe has 39 stock exchanges, as well as some

uncentralized or over-the-counter markets and informal, off-exchange trading networks. European stock

markets, apart from London’s, are not now strong

competitors to the major market countries. However,

one of the major objectives of the Commission of the

European Community (EC) is to create and strengthen

a European securities trading arena. Significant

progress has been made in harmonizing securities

laws and regulations--i.e., making them similar and

more compatible with the goal of achieving effective

harmonization by 1992.

There are proposals to establish a European

equities exchange network on which a “Single

European List” of shares of 300 large European and

foreign corporations would be traded, through an

intermarket trading system, like the Intermarket

Trading System (ITS) in the United States. On the

other hand, Andrew Hugh Smith, chairman of the

ISE, has proposed that SEAQ-International be the

56 There are two kinds of opions. Conventional or “traditional” options, sometimes cdkxi European-style options, Can be titten on ~Y list~

securily, are for a period of 3 months, are traded over the counter, are not transferable, and must be exercised on a specific &y. “Traded options” or

American-style options am available on speciilc securities, for 3,6, and 9 months, and may be cashed by sale. Both kinds of options can be written in

both the United States and Europe. LIFFE options are American-style options and include options on futures. See LZFFE: An Zmroduction, published

by LIFFE.

5T~id0

5S*CEWOP Forges Ahead in the Technology Race,” Furures and Options, Special Supplement to Euromoney, July 1, 1989, p. 24.

5g’’Taking Stock Home,” The Economist, May 28,1988, p. 102.
Chapter 4--America’s Competitors in Global Securities Trading ● 49

international marketplace, under a‘ ‘joint initiative’

of the ISE and the German Federation of Stock

Exchanges, based in Frankfort. The Federation of

European Community Stock Exchanges is planning

“le PIPE,” a network to distribute market data from

and among 12 EC member countries. This could, in

time, develop into a trading system.

The EC has a consumer potential that is 1.5 times

that of the United States and 3 times that of Japan,

but the EC countries do not have a strong tradition

of individual investment in securities. Their exchanges are, however, already ‘‘international. ” A

number of them have recently been deregulated to

give broadened access to their markets, and some

have begun ambitious programs of automation. The

EC must therefore be considered a potential competitor in global securities trading.

Of the 12 EC countries, the United Kingdom,

already discussed, has about 35 percent of total

market capitalization, West Germany has about 13

percent, and France nearly 12 percent. West Germany began, in 1989, a screen-based system (IBIS)

for displaying market data on major stocks at eight

West German exchanges. The Paris bourse is

making significant investments in technology in an

effort to strengthen and expand its market share.60 It

has, in the past 6 years, created four new markets,

for: 1) issues of small companies (the Second

Marche), 2) futures contracts (MATIF), 3) options

(MONEP), and 4) money market funds (Inter-SVT).

France has also restructured the stock exchange for

broader capitalization, re-privatized its governmentcontrolled banking system, and lifted all foreign

exchange controls.

Other European markets are also being strengthened and are undergoing technological and regulatory changes. Individual ownership of securities is

not widespread in Europe.61 Even in the United

Kingdom, which has the most well-developed securities markets, less than 3 percent of households

owned corporate shares in 1980 compared to about

19 percent the United States,62 although this increased in the 1980s because of privatization of

some British nationalized industries. Probably for

this reason, there were no strong customer protection

regulations in Europe; most European countries did

not mandate full disclosure, prohibit insider trading,

or have securities regulatory agencies. With the

privatization of state-owned enterprises in several

countries, bringing with it national policies for

encouraging stock ownership, prudential securities

regulation began to emerge. No comprehensive

national securities laws were enacted until recently,

under prodding by the Commission of the EC and

following several widely reported stock market

abuses.

The EC’S 1992 Initiative

The Commission of the EC recognized from its

beginning in 1957 that there should be special

benefits from the integration of financial services

markets, due to the “unique pivotal role played by

financial services in catalyzing the economy as a

whole." 63 But there was little progress for nearly 30

years. In 1985 the Commission of the EC issued a

White Paper, “Completing the Internal Market,”64

an ambitious legislative proposal to achieve a single

market by the end of 1992. The White Paper

proposed 300 directives aimed at regulatory harmonization among the member states.65 In 1986,279

White Paper proposals (and a Dec. 31, 1992,

deadline for implementation) were incorporated in

an Amendment to the Treaty of Rome, entitled the

Single European Act. This strengthened the legal

framework for development of a common market.

In these directives the EC did not seek to establish

identical regulatory regimes, but instead prescribed

basic essential principles with a requirement of

%iscussion with Paris bourse officials, Apr. 2, 1990.

61B. de Cties, GT Gui& to World Equ@ Markets 1988, 101; Euromoney Public, 1988, p. 113.

62’’Into the Provinces,” The Economist, Nov. 12, 1988, p. 131; also SEC, “Internationalization of Securities Markets,” Staff Report to U.S. Senate

Committee on Banking, Housing, and Urban Affairs and House of Representatives Committee on Energy and Commerce, 1987.

Gsceccti, The European chllenge 1992: The Benefits of a Single Market, 1988, P. 37.

~CoWZeting the ~nterna/ Market: white paper from the Commission to the European COunCil, COM (85) 310m,June 14.1985.

~Und~ the Treaty of Rome, “directives” proposed by the 17-person Commission (2 representatives each from the 5 largest countries and 1

representative each fmm 7 smaller member states) and unanimously accepted by the EC Council of Members, must be implemented by mtional

legislation within each member state within a prescribed period of time. The directives are binding in terms of mult but national legislatures have some

discretion as to ‘‘choice of forma and methds.” l%ieffky, Van Door% and Lowe, “The Single European Market: APractitioner’s Guide to 1992,” 12

B.C. Znt’2 & Comp. L. Rev., 1989, pp. 357, 360. The Single European Act of 1986 amended the Treaty to substitute a “qualifled majority” for the

requirement of unanimity in approval of directives by the Council.
50 ● Trading Around the Clock: Global Securities Markets and Information Technology

mutual recognition. This appears to have made

acceptance of the proposed directives much easier.

About half of the 279 directives issued have been

approved by the EC Council of Ministers, meaning

that they are now mandatory. Some of these

directives directly create supranational securities

law; others are company law directives that provide

the foundation and complement the securities regulations. Directives adopted or proposed in the field

of securities regulation include the Stock Exchange

Directives enacted prior to the Single European Act

of 1986, and more diverse proposals dealing with

mutual funds, prospectuses, investment services,

and insider trading (box 4-A.) The last three reflect

a change in the EC’s approach from seeking

commonality to seeking reciprocity. All of these

directives rest on the foundation of full disclosure

and equivalent protection built by the company law

directives.

EC’s company law and securities law directives

seek to create a global common market for securities

trading by establishing regulatory harmony and a

higher level of prudential regulation to make European exchanges more attractive to foreign and

domestic investors. Regulatory harmony should

provide European investors with greater opportunities for portfolio diversification. Increased prudential regulation-safeguards against investor abuse

and more comprehensive disclosure obligations—

should promote public confidence in both primary

and secondary securities markets and should also

result in development of a European database on

publicly held corporations. This will facilitate wider

knowledge of European companies among investors, analysts, and advisers around the world, and

could result in stronger demand for EC company

securities. 66 It is also hoped that greater liquidity in

the securities markets will promote the use of

securities to fired acquisitions of other businesses;

and that this will result in economies of scale.

Finally, increased prudential regulation should make

it easier for EC corporate issues to satisfy the

regulations of stricter national authorities (e.g., the

United States) and thus expand the opportunities for

EC companies to raise capital outside of Europe,

reducing the cost of capital.

There may also be substantial benefits for non-EC

fins, including those from the United States. They

will be confronted with stronger competition from

European firms expanding to pan-European operations, but the directives should also result in a more

level playing field for U.S. firms, because the

European companies will be subjected to more

stringent prudential regulations (and thus some costs

they have not incurred in the past). U.S. firms,

having met more stringent U.S. regulations, will

have no serious difficulties or additional costs in

complying with EC requirements.

It appeared for a time that the benefits of the newly

integrated single market would be denied to non-EC

fins. Under Article 58 of the Treaty of Rome,67 all

firms organized within an EC state are considered

“nationals” and accorded regulatory parity, presumably without regard to the origin of their capital.

This would apply to EC-incorporated subsidiaries of

U.S. firms (although not to branches of U.S. firms).

However, the reciprocity and mutual recognition

provisions of some of the EC securities law directives, especially the proposed Investment Services

Directive (see box 4-A), seemed to contradict

Article 50’s ban on discrimination. The EC ‘‘White

Paper” also reflected a Commission policy that

concessions should be extracted from non-member

states in exchange for the benefits,68 and this was

reiterated in the Cecchini Report, which said:

In return, EC governments will have the right to

expect appropriate responses from the community’s

economic partners abroad, notably the U.S. and

Japan. If the fruits of the European home market are

to be shared internationally, there must also be a fair

share-out of the burdens of global economic responsibility, with market opening measures extended

internationally on a firm basis of reciprocity.69

This caused non-EC firms to fear that they would

not have access to the “single market” and would be

at a disadvantage relative to EC firms. The proposed

Investment Services Directive, for example, could

66CCCCW op. cit., foomote 64, p.%.

67’’ Coqa~es or f-fom~ ~ accor~m with the law of a member state and having their registered offke, ~td aas~tio% or @ciPle

place of business within the Community shall.. . be treated in the same way as national persons who am nationals of member states.”

6sCo@eting thelnternal Mar~t, White p~perfiom the co~”~~on to theE~opean co~il, COM (85) 310 m; pm. 19, the Ody ~CrCXICC tO

non-member states, says: “Moreover, the commercial identity of the community must be considered so that our trading partners WW not be given the

benefit of a wider market without themselves making similar concessions.”

@cecch@ op. cit., footnote 64, pp. XIX-XX.
Chapter 4--America’s Competitors in Global Securities Trading ● 51

Box 4-A—EC Securities Law Directives

The Admission Directive (No. 79/279), adopted in 1979, is intended to facilitate greater interpenetration of

member states’ securities markets, thereby contributing to establishment of a European Capital market. Together

with two other directivesl, it is intended “to establish. . . a coordinated information policy on securities.” The

directive assumes agreements with non-member states to recognize listing particulars, but the non-member

states’ laws must give equivalent protection to investors, and the non-member state must also provide reciprocity

to the EC member-states. For the United States (and Canada) which have significantly more comprehensive

disclosure requirements, it is unlikely that reciprocal accords can be negotiated in the foreseeable future.

The directive provides minimum requirements for listing, to construct a regulatory floor for equivalent

protection for investors throughout Europe. It contemplates a “subsequent closer alignment of rules,” which

might be accomplished either by further directives strengthening the requirements, or by requiring mutual

recognition which would effectively lower them (any exchange, as a political and economic matter, would be

unable to impose stricter requirements on domestic firms than on firms from other member states).

The Listing Particulars Directive (No. 80/390), adopted in 1980 and sometimes called the Information

Directive, requires extensive disclosure to the general public (some member states had required disclosure only

to regulatory or self-regulatory bodies). It requires an information sheet with common disclosure standards and

a prescribed format, so that for the first time investors and analysts can make comparisons easily on a

multinational basis. This directive influenced the SEC in its development of U.S. disclosure forms for foreign

issuers. 2

In 1987, the EC Council of Ministers amended the Listing Particulars Directive to include a mutual

recognition directive (once approved in a member state, listing particulars must be recognized by other member

states, and no additional information may be required). This means that a state with more stringent disclosure

requirements is in the position of imposing more disclosure and greater costs on its domestic issuers than foreign

issuers must meet. Almost surely this will mean lowering disclosure requirements to the existing lowest common

denominator.

The Interim Reports Directive (Mp... 82/121) adopted in 1982, requires issuers of equity securities listed on

member-state exchanges to publish certain financial reports at six month intervals. It is intended for investor

protection.

The Public Offer Prospectus Directive (No.89/298), adopted in 1989 after 10 years of controversy, protects

investors by requiring risk-related information from corporations in the form of a prospectus. There are regimes

for both listed and unlisted securities but because the directive was adopted after lengthy negotiations it is riddled

with exemptions that reduce its scope: exemptions for private placements, certain small offerings, minimum

purchase offerings, exchange offers, employee offerings, eurobonds, and euroequities. Eurosecurities were

exempted because the industry repeatedly threatened to trade elsewhere. The disclosure requirements are not as

strict as those in the United States. The directive does however embody the principle that investors throughout

the EC should be protected, and should be provided equivalent protection.

The directive does not require member states to give mutual recognition to issuers from non-member states

even if they comply with its disclosure requirements. It authorizes negotiations based on reciprocity (mutual

recognition and substantial equivalence of regulatory regimes). Since companies in the United States and Canada

will have met higher domestic requirements, they would like to be allowed merely to file a notice of their home

country prospectuses, but reciprocity for EC members with lower disclosure requirements will be a sticking

point.

The Mutual Funds Directive (No. 85/611), adopted in 1985 but amended in 1988, is intended to establish

equivalent protection for investors in collective investment funds throughout the EC and to promote the

circulation of these securities throughout the Community on “a level playing field. ” The provisions relate to

authorization, supervision, structure, activities, and”disclosure obligations. Once a mutual fired is authorized by

1~~~w-, D&&e No. 80/390, and Interim Reports, Dtitive No. smzl.

2SEC ~l_Noo 3+1635 1 (Nov. 29, 1979); R. H-, “~Re-onof ~Is~ eand Trading of Securities inthe United States

and-b European Economic Community: A Compariso~” 3 J. Cwnp. Corp. L. & Sec. Reg. 129, 132-22 (1981).

Continued on next page
52 ● Trading Around the Clock: Global Securities Markets and Information Technology

Box 4-A—EC Securities Law Directives--Continued

one member state under these provisions it may be marketed in all other member states with the home state

generally responsible for supervision and control.

The directive does not apply to the closed-end type funds. The fund must offer collective investment in

transferable securities, of capital raised from the public, operating on the principle of risk spreading; and its units

must be repurchased or redeemed at the holder’s request out of the fund’s assets, directly or indirectly. According

to industry spokesmen in the United States, this directive could serve as the basis for international agreements

beyond [EC] boundaries,” facilitating the internationalization of mutual funds.3

The Proposed Investment Services Directive, newly proposed by the Commission in 1988, would establish

mutual recognition of member states’ authorization and supervision of investment firms. This would mean a

single license for investment firms acting as brokerage agent, dealer, market-maker, portfolio managers,

underwriter, or investment advisor anywhere in the EC. [Because banks and other credit institutions in the EC

also provide investment services, a proposed Second Banking Directive contains similar provisions.] The home

state must determine, before authorization, that the firm has sufficient financial resources to conduct the services

that are to be provided; that the managers are of good reputation and experience; that the controlling shareholders

of the firm are suitable; and that the firm submits a suitable business plan.

The directive requires member states each to promulgate prudential rules requiring investment firms to

maintain sound administrative and accounting procedures and internal controls; to segregate investors’ assets

from the firm’s own accounts; to participate in a general compensation fund to protect investors against the firm's

default or bankruptcy; to provide regular information to the home state supervisory authority; to maintain

adequate records; and to be organized in a way that minimizes conflicts of interest among the firm and its clients.

Under the directive as it now stands, investment firms will continue to be regulated under the capital requirements

and general business rules of the home member state, although EC directives in these two areas maybe developed

later. A state’s authority to regulate local activities of investment firms from other member states is largely

removed by this directive,4 but cooperation between home state and host state in preventing abusive practices

is required by the directive.

Again, the most controversial aspect of this proposed directive is the issue of reciprocity. Investment firms

(and their subsidiaries) from non-member states cannot enjoy the benefits of the directive’s “single license”

unless the fro’s home state provides reciprocal treatment to all EC investment firms. However, there is a

grandfather clause, and foreign firms may rush to incorporate as EC subsidiaries before the adoption and effective

date of the directive. The related proposal for a Second Banking Directive modified the strict reciprocity

requirement to require only “national treatment” (regulatory parity with domestic firms), and it is possible that

this proposed Investment Services directive will also be so amended.

The Insider Trading Directive. First proposed in 1987, revised in 1988, and adopted by the Council of

Ministers on June 19, 1989 (ratification not yet complete), this directive seeks to provide equivalent protection

against insider trading for all EC investors. When it was first proposed in 1987 only three member states

(Denmark, France, United Kingdom) had criminal penalties for insider trading. In the United States, securities

regulators have not rigorously or officially defined insider information,5 but this directive defines it as:

. . . information which is unknown to the public of a specific nature and relating to one or more issuers of transferable

securities, or to one or more transferable securities, which, if it were published, would be likely to have a material

effect on the price of the transferable security or transferable securities in question,6

This directive is almost certain to be approved7; at present only Belgium, Ireland, Italy, and West Germany

have yet to enact insider trading legislation. However, some observers fear that judges may still treat insider

trading as “a gentlemanly misunderstanding rather than a crime."8

3( ‘EC D~~tive on Mum F~ds May Serve as Basis for Global Agreement, 1~ SaYs,’ 20 Sec. Reg. &L. Rep. (BNA) 1922 (Dec.

2, 1988).

4Each s~te rem limited power to restrict investment fii’ conduct when necessary for “the public goo~” a concept based on

Articles 36 and 56 of the Treaty of Rome.

Ssee sympo~um: Defining Insider Trading, 39 Ala. L. Rev. 337-558 (1988).

6COM (88) 549, 0~. Eur,Comm. (No.C 277) 13 (Oct.27, 1988).

7Nelsom ~~EC M~ms NW /@oral in unit~ p@” Wa/ZSt. Jour~l, June 19, 1989, p. C g.

8~~~i@ Tr~ing in EwOp: A D~t IX@” The Economist, My 20, 1989, p. 86.
Chapter 4--America’s Competitors in Global Securities Trading ● 53

deny a single EC license to EC-incorporated subsidiaries of U.S. fins; they would not be entitled to

home-country control, i.e., authorization and supervision by the member-state in which they are

incorporated unless equivalent treatment is granted

by the United States. Because of differences in the

scope and structure of the U.S. regulatory system,

this equivalent recognition is politically unlikely.

After strong protests, an amendment to the directive

is being considered which would use the principle of

national treatment rather than reciprocity.

It is less likely that the same change will be made

in the reciprocity and mutual recognition provisions

of other directives, including those dealing with

Admission, Listing Particulars, and Public Offer

Prospectuses (see box 4-A). The U.S. requirements

regarding stock exchange listings and public offerings, administered by the SEC, are significantly

stricter than EC requirements. They are not interchangeable with EC requirements and cannot be

waived by the SEC to accommodate EC issuers,

even though SEC has considerable regulatory flexibility, and has stated that it would favor recognition

of the disclosure documents of foreign issuers if their

home state provided reciprocal treatment and the

disclosures were based on substantially equivalent

standards. 70

The basic problem is that the regulatory regime

envisioned in EC securities laws directives, adopted

and proposed, provides less protection for investors

than is mandated in the United States. They include

many exceptions and exclusions which greatly

reduce the scope and effectiveness of the directives.

For example, the Eurosecurities market-the largest

European securities market-is exempted from the

Public Offer Prospectus, although a number of

problems have arisen with regard to interest and

currency swaps, distribution methods, and disclosure. 71 In some areas there are as yet no EC

directives. Among the number of regulatory areas

not yet addressed are: rules of fair practice or

essential standards to govern the conduct of EC

investment firms; real-time publication of quotations, prices, and trading volume to assure market

transparency. Participants in European securities

markets will continue to be confronted by 12 sets of

conflicting laws (or absence of law) dealing with

essential areas of regulation in areas not covered by

EC directives.

As yet, EC has no institutional mechanism for

coordination and enforcement of the new regulatory

system it is creating. Little has been done to

harmonize enforcement. The directives provide for

cooperation among authorities, but is likely that in

some member states there is strong enforcement and

in others, almost none.

There are two striking points to note about the EC

1992 initiatives in securities trading. First, EC has

managed both to improve prudential regulation and

to increase regulatory harmony-two goals that

might have been assumed to be contradictory.

Second, it may demonstrate that regulatory harmony

can be achieved at least on a regional level. This

suggests that harmony could also be achieved

among the other OECD states, if the United States

plays a strong role in promoting this goal.

70ifSEC policy s~tment on Re@tion of ~t~mtio~ Securities Markets, ” SEC Rel. No. 33-6807, NOV. 14* 1988.

71seepo Stob,Gzo~z ~toc~ ~arkefR@om, 1988, pp. 126-147. me mpid gIO~ of sw~s ~d options hM Id to less review of credit risk and

failure to obtain collateral and a number of defaults have resulted. Prof. Manning Warre@ III, op. cit., footnote 1, makes the point that despite assertions

to the contrary the Eurosecurities market is to a large extent a retail market, and Euroequity offerings especially have large potential for abuse because

of “gaping hopes in member state regulations, ’ unregulated sales pitches and timing pressures.
Chapter 5

International Clearing and Settlement:

What Happens After the Trade

“Clearing and settlement” is the processing of

transactions on stock, futures, and options markets.1

It is what happens after the trade. “Clearing”

confirms the identity and quantity of the financial

instrument or contract being bought and sold, the

transaction price and date, and the identity of the

buyer and seller. It also sometimes includes the

netting of trades, or the offsetting of buy orders and

sell orders. “Settlement” is the fulfillment, by the

parties to the transaction, of the obligations of the

trade; in equities and bond trades, “settlement”

means payment to the seller and delivery of the stock

certificate or transferring its ownership to the buyer.

Settlement in futures and options takes on different

meanings according to the type of contract.

Trades are processed differently depending on the

type of financial instrument being traded, the market

or exchange on which it is traded, and the institutions involved in the processing of the trade (i.e., an

exchange, a clearinghouse, a depository, or some

combination). 2 The clearing and settlement mechanisms and institutions in the United States, the

United Kingdom, and Japan are described in the

appendix. The differences in countries’ clearing and

settlement are important because clearing and settlement systems used for domestic trading are now

being called onto accommodate international participants. The integrity and efficiency of a nation’s

clearing and settlement systems are important to

both its internal financial and economic stability and

its ability to compete with other nations.

Many markets have ‘clearinghouses’ that handle

both the clearing process and some of the settlement

process. This is the most common system in the

United States for exchange-traded financial products. Many markets, including the U.S. markets,

have “depositories,” that hold stocks and bonds for

safekeeping on behalf of their owners.

Where clearinghouses do not exist (e.g., in some

European markets), depositories may take on functions of clearinghouses. Depositories may transfer

ownership of stocks and bonds by ‘‘book entry” (a

computer entry in the depository’s record books)

instead of physical delivery of certificates to the

buyer,3 which saves time and money. There are also

markets in which exchanges perform some of the

clearing and settlement functions (e.g., London’s

International Stock Exchange), and markets in

which neither clearinghouses nor depositories exist

(e.g., until very recently, foreign exchange, or

“forex,” markets).

THE GOALS OF CLEARING

AND SETTLEMENT

Differences in the clearing and settlement process

among countries are often linked to historical,

economic, and cultural factors in their laws and

customs. These differences can expose international

investors to extra risk in some instances. Perceptions

of the purposes of the clearing and settlement

process vary widely among countries. In the United

States and Canada, where public policy supports

broad public access to the markets, the reduction of

risk, through the clearinghouse as an intermediary,

is a major goal of clearing and settlement. These

policies are reflected in a hierarchy of protections for

the clearinghouse, including minimum capital requirements for clearinghouse members.

In many other counties, risk reduction is imposed

before trading takes place, by controls on who is

allowed to participate, or by the participants ‘knowing their trading partners,’ and, in equities, by

reducing the time allowed to settle a transition. In

these markets, clearinghouse guarantee funds are

lb ~rw~ ~~ c~ptm, Om hm mli~ hmvily on a contractor report by Bankers T~t CO.! “Study of International Clearing and Sett.lemenC”

vols. I-V, Octobex 1989, to which scores of institutions and individuals around the world contributed expert papers and/or served on the Bankers Trust

advisory panel. This report is hereafter referred to as “Bankers Trust report.” OTA has also used the discussions of an expert workshop held at OTA

on Aug. 22, 1989.

% the United States, equities markets clearinghouses reduce risks by netting payments, among their other precautions to reduce cleiuinghouse risk.

These precautions are disparate among nations. Futures markets worldwide are becoming more similar in terms of guarantees for trades.

qD~v~ve instnunents such as futures and options also change ownership or contractual rights Vk book m~.

–55–
56 ● Trading Around the Clock: Global Securities Markets and Information Technology

generally small or nonexistent,4 and settlement is

seen merely as a delivery function, rather than as a

mechanism for risk reduction.

These different views of the purpose of clearing

and settlement have become significant as more

investors begin trading in markets other than their

domestic markets. U.S. investors, accustomed to

domestic markets where safeguards are in place,

may assume that the clearing and settlement of their

trades in a foreign market has risks comparable to

those in the United States, where there are guarantees provided by clearing and settlement organizations.

The chief aims of clearing and settlement in the

United States and some other countries are efficiency and safety. The faster and more accurately a

trade can be processed, the sooner the same capital

can be reinvested, and at less cost and risk to

investors. Therefore, as markets become global, one

could expect that investment capital will flow

toward markets that are most attractive on a riskreturn basis, and that also have efficient and reliable

clearing and settlement systems.

The soundness of clearing and settlement systems

in one nation can also impact other nations. The

failure of a clearing member at a foreign clearinghouse could affect a U.S. clearinghouse through the

impact on a common clearing member. To reduce

the risk of such an occurrence, different countries’

clearing and settlement systems must be coordinated

with each other, for example, by sharing risk

information and harmonizing trade settlement dates.

Both the private sector and Federal regulators have

begun to take steps in this direction. It is doubtful

that the private sector can achieve the needed

changes without national governments taking a

prominent and concerted role.

HOW CLEARING AND

SETTLEMENT WORKS

Many kinds of organizations are involved in

clearing and settlement. Their functions vary from

market to market, and not all of these organizations

exist in every country. For instance, clearinghouses

play a key role in the United States and some Asian

markets; but in many European markets, depositories are more important.

A key role of a clearinghouse is to assist in the

comparison of trades and sometimes, as in the

United States, also to remove counterpart risk from

the settlement process. Clearinghouses can provide

the buyer with a guarantee that he will receive the

securities--or other interest-he purchased, and

provide the seller with a guarantee that the payment

will be received.s

In the United States, the clearinghouse has a

number of working relationships, or interfaces, with

other institutions (figure 5-l). A trade in the United

States (as well as in Japan, Canada, and some other

countries) cannot settle through the central systems

until it has been matched, i.e., buyers’ and sellers’

records of the trade are compared and reconciled. A

clearinghouse has an interface with a market in

which trades are executed and from which the

clearinghouse receives information on the trades.6

The clearinghouse may receive previously “lockedin’ ‘ trades (trades which have already been

matched), or it may match the trades itself.

A second interface is with its clearing members,

i.e., the member firms of an exchange or market. A

clearing member delivers trade information to the

clearinghouse and may hold positions both for itself

(proprietary positions) and on behalf of its customers. Other traders in a market, who are not clearing

members, must clear their trades through a member

of a clearinghouse for that market. A clearinghouse

controls the risks of the clearing and settlement

process through its relationships with its clearing

members. For example, it may have minimum

capital requirements for clearing members, use

margins or mark-to-market procedures, and require

that its clearing members place collateral in a

guarantee fund as protection against default by other

clearing members. In the event of the failure of a

clearing member, the clearinghouse may also have

the ability to assess all other clearing members. It

may also provide its clearing members with a

trade-matching service and notify members about

the way a trade is to be settled (the settlement date,

4B~eA ~St s~dy, op. cit., footnote 1, P. 142.

SForty.one ~ment of the ~spondents to a Westion in an international survey conducted tis pm of the Btiers T~st s~dy s~ted titthe risk tit

a counterpart to a trade may default, i.e., not pay for or deliver securities, is one of the three most signiilcant risks in settlement domestically. Bankers

Trust study, op. cit., footnote 1, vol. 1, p. 239. Despite such fears, such defaults seldom occur.

%e clearing entity could alternatively receive information about a trade directly from two market participants.
Chapter 5--International Clearing and Settlement: What Happens After the Trade ● 57

Figure 5-1-interfaces Among Clearing Participants

Retail Instltutional

customer customer

an accounting system for immobilized or dematerialized instruments, and/or as a central vault for the

physical instruments themselves, interfaces with the

banks as custodian. It may also, as custodian, have

an interface with the banks for payment.7

SOURCE: Office of Technology Assessment, 1990.

and the way payment and delivery or transfer of

ownership will be accomplished).

A third interface is with clearing and credit banks.

The clearinghouse and the banks work together in

the payment and collection process, since clearinghouses today do not have direct access to the

payment system, e.g., FedWire in the United States.

The banks also provide credit to clearing members.

In the securities markets-but not typically in

futures and options markets-there is often a fourth

interface with the depository. The depository records and arranges the legal transfer of ownership of

securities, and holds securities for safekeeping. The

clearinghouse instructs the depository on how the

transaction is to be settled. The depository may act

as an agent, on behalf of the clearinghouse, to

receive funds to settle the transaction.

In addition to the relationships between clearinghouses, markets, depositories, and banks, these

organizations also have relationships with each

other. Clearing members of a designated market deal

with the banks to settle with the clearinghouse and

to obtain credit. There is an important relationship

between the banks and the depository. When a bank

acts in a custodial role, e.g., delivering securities and

receiving payments in behalf of its customers,

instructions on payment and title transfer are sent to

the bank by the customer. The depository, in turn, as

RISKS FROM DIFFERENCES IN

CLEARING AND SETTLEMENT

MECHANISMS

These differences-the use of guarantee funds,

the time allowed to settle a trade, etc.—in countries’

clearing and settlement systems are a major constraint on global trading and may impose risks on

traders and investors. Defaults in a national clearing

and settlement process can propagate through other

national systems, since multinational financial institutions may be active in several national markets.

Collapse of a major settlement system could endanger financial systems in both its own and other

countries.

Even in day-to-day operations, differences in

clearing and settlement systems and in their performances constrain some kinds of trading. For

example, in Japan, settlement in equities and bonds

is normally on the third day after a trade (T+3) and

in the United States it is normally on the fifth day

(T+5). An investor trading General Motors (GM)

stock on both the New York Stock Exchange

(NYSE) and the Tokyo Stock Exchange (TSE)

would have trouble perfectly arbitraging his holdings. If the investor were to buy GM shares on the

NYSE and simultaneously sell them on the TSE,

because the U.S. settlement period is 2 days longer,

the GM shares would be delayed by 2 business days

for the Japanese settlement. If the investor were to

buy GM stock on the TSE and sell GM stock that

same day on the NYSE, the shares could be available

for the NYSE settlement because that is 2 days later

than Tokyo’s. The Japan Securities Clearing Corp.

(JSCC)--through its link with International Securities Clearing Corp. (ISCC) in the United States—

holds the U.S. shares at The Depository Trust Co.

(DTC); therefore instead of physical movement of

certificates there simply would be a book entry

delivery at DTC. The average number of days for

settlement of various financial instruments in different countries differs widely (figure 5-2). The number

~our depositories in the United States now have links to the Federal Reserve System. These are The Depository Trust Co., the Midwest Securities

Trust Co., the Participants Trust Co, and the Philadelphia Depository Trust Co.
58 ● Trading Around the Clock: Global Securities Markets and Information Technology

Figure 5-2-Settlement Date: T+?

Average number of days

8.0

7.0

6.0

5.0

4,0

3.0

2,0

1.0

0 , 0

Equities Sovereign Corporate Futures Options Other Physical

obligations obligations derivatives commodities

- North America = Europ e ~ N.E. Asia/ Australia

- Middle East = South America

SOURCE: Bankers Trust Co., “Study of International Clearing and Settlement,” OTA contractor report, October 1989,

of days for settlement varies widely among countries

in each geographical region. As a result, harmonized

clearing and settlement is needed.

Trading in European markets, unlike in the United

States, mostly does not rely only on stock exchanges. 8 In Japan, there is as yet no central

depository, but there is a clearing and custody

system at TSE. Many European countries have

depositories, but their functions vary from country to

country, and are often different from U.S. depositories.

There are three principal models for clearing and

settlement in the world’s major stock markets. The

first model has no centralized depository or independent clearinghouse beyond the stock exchange.

The exchanges usually perform as many of the

clearing and settlement functions as are feasible.

These include trade matching, confirmation, and

some type of settlement facility-usually a central

location where market participants can deliver and

receive securities and payments. The equities market

in the United Kingdom is an example.

The second model of clearing and settlement is

one in which there is a central depository structure,

with trade matching and confirmation services

provided by the exchanges. Once trades have been

matched and confirmed, the trade data are sent to the

depository for settlement. There are variations on

this model with differing degrees of settlement

services provided by the depository. The depository

may offer book-entry transfer of ownership of

immobilized securities, with limited provisions for

varying payment methods. Or the depository may

provide book-entry transfer of dematerialized securities and the ability, through direct links to local

payment systems, to simultaneously and irrevocably

transfer funds for each settlement. An example is

West Germany and its Deutscher Kassenverein

(KV) depository system.9

The third model has not only a stock market and

a central depository, but also a clearinghouse that

stands between the stock market and depository to

reduce risk. The stock market, along with the

clearinghouse, provides trade matching and confirmation services. A trade is confirmed by the market

participants and is then passed to the clearinghouse,

which substitutes itself as the counterpart to each

trade. This gives a degree of financial assurance to

the markets since the clearinghouse will honor the

obligations of a clearing member if necessary. The

clearinghouse then passes the trade information to

the depository for delivery versus payment10 on the

settlement date. An example is the United States

equities market.

In most European equities markets,ll there are no

central clearing organizations that assume the role of

counterpart to every trade or provide other kinds of

mechanisms to ensure the financial integrity of all

market participants in the clearing and settlement

phase. Where there is no third-party guarantee

mechanism for trade settlement, market participants

are forced to choose their counterparties based on

their own credit assessment.

But when a market ceases to be a closed structure

with only a select group of participants who know

% most cases, the majority of trades are among banks, and occur off the exchange. In these off-exchange tmdes, bankers or brokers interface with

the depository, bypassing tie exchange, except possibly for reporting trades,

%ms-Joachim Hoessrich and Heinz-Klaus Ruetzel, “Clearance and Settlement in Germany,” expert paper contributed to OTA contractor report

by Bankers Trust Co., op. cit., footnote 1.

lo~~~~vewv~s paWent*~ (DVP) ~d “=eive Verw paym~t” are te~ which mean that the buyer and the seller =ch sa@ their ~~ement

obligations (to pay and deliver) on the same day. A closely related term is “true DVP,” which means that the buyer and the seller simultaneously make

good on their settlement obligations. An example of true DVP would be a trade settled through a depository, in which the depository simultaneously

transferred the funds and the ownership of the traded f~cial instrument.

Ilwith the excqtion of the Paris Bourse.
Chapter 5--International Clearing and Settlement: What Happens After the Trade ● 59

each other, the market must implement some standardized processes which can offer a guarantee of

financial integrity. When a national market encourages international participation, it must try to ensure

the continuing financial integrity of the market. The

current focus in Europe on the standardization or

harmonization of clearing, settlement, and depository systems is in preparation for the common

market in 1992. (See ch. 4.) The movement toward

increased coordination of clearing and settlement

systems is, however, worldwide, stemming from

recognition of the increasing internationalization of

securities trading.

EFFORTS TO REDUCE THE

DIFFERENCES

Improvement of clearing and settlement for global

or cross-border trading in equities is being addressed

by the Group of Thirty, an independent, non-profit

organization of businesspersons, bankers, and representatives of financial institutions from 30 developed nations. The Group of Thirty addresses multinational financial and economic issues, including

Third World debt. The Group’s recommendations

for the world’s securities markets are aimed at

‘‘maxhizin g the efficiency and reducing the cost of

clearance and settlement,” and thereby reducing

risk. They set target timetables of 1990 for some

objectives and 1992 for others. In a report released

in 1989,12 the Group concluded that:

While the development of a single global clearing

facility was not practical, agreement on a set of

practices and standards that could be embraced by

each of the many markets that makeup the world’s

securities system was highly desirable, . . . and

(reached) agreement that the present standards were

not acceptable.

Their recommendations are:

1.

2.

3.

4.

5.

6.

7.

8.

By 1990, all comparisons of trades between

direct market participants (i.e., brokers, dealers, and other exchange members) should be

compared within 1 day after a trade is executed, or “T+l.” 13

Indirect market participants-institutional investors, or any trading counterparties which

are not broker/dealers-should be members of

a trade comparison system which achieves

positive affirmation of trade details.

Each country should have an effective and

fully developed central securities depository,

organized and managed to encourage the

broadest possible industry participation.14

Each country should study its market volumes

and participation to determine whether a trade

netting system would be beneficial in terms of

reducing risk and promoting efficiency.

Delivery versus payment should be the method

for settling all securities transactions.

Payments associated with the settlement of

securities transactions and the servicing of

securities portfolios should be made consistent

across all instruments and markets by adopting

the “same day” convention.15 (No date has

been set for achieving this objective.)

A “rolling settlement” system16 should be

adopted by all markets. Final settlement

should occur on T+3 by 1992. As an interim

target, final settlement should occur on T+5 by

1990 at the latest, except where it hinders the

achievement of T+3 by 1992.

Securities lending and borrowing should be

encouraged as a method of expediting the

Wroup of Thirty, Clearance and Settlement Systems in the World’s Securities Markets (New York & bndom -h1989), P. 1.

%the United statos, where there is increasing use of automated trading systems in the stock exchanges and OTC markets, @ _ for

comparison and automatic submission to the clearing system is automatically recorded, Such systems now process two-thirds of NYSE transaction

volume; a large proportion of AMEX volume; and one-third of OTC equity volume. These transactions are pre-matched and reported directly to the

clearing sys~ and have been reported on T+l since the mid-1980s. Both the NYSE and AMEX have on-line trade correction facilities. The rules of

the National Securities Clearing Corp. require that all trade data not already locked in by the automated trading systems must be reported by both trading

counterparties by 2 a.m. on T+l.

1dThe pfi~p~ function of a Cmti securities depository is to immobilize or dematerialize securities. This function permits the processing of

transactions in “book entry” form, which is the basis for achieving efficient and low risk settlement of transactions by transferring ownership from one

account to another by a simple debit or credit on the booka of the depository.

15 Some W~ts use ~~medayt~ ~ds (the PaPent k f~on ~sme &y), while others u “next~y” funds for setiement. Adoption of a single

method will improve the eftlcieney of the accounting and payment systems, set the stage for subsequent full automatio~ and facilitate other

improvements such as finality of payment, irrevocability, and bank guarantees.

16~ a ro~~ setflaat~sta,@ades ~~e on w busin~s &ys of tie w~ which limits the number of ou~~ding (unsettled) trades dredU@S

market exposure to risk. The goal for the long team is same-day settlement.
60 ● Trading Around the Clock: Global Securities Markets and Information Technology

9.

settlement of securities transactions.17 Existing regulatory and taxation barriers that inhibit

the practice of lending securities should be

removed in 1990.

Each country should adopt the technical standard for securities messages developed by the

International organization for Standardization

(ISO Standards 7775 and 6166).18

Table 5-1 compares nine of the Group of Thirty

recommendations with the present status of clearing

and settlement procedures in 21 countries, including

the United States. Major changes will be required by

many countries in order to meet these recommendations by 1992.19 In the United States, which is

well-positioned relative to other countries, automated systems will facilitate trade matching on the

trade date and settlement of all trades within 3 days.

But, in the United States, there are non-technological

barriers to fully achieving the accelerated trade and

settlement objectives, some of which have been

acted on recently. For example:

●

●

●

More stocks must be immobilized in book entry

form; this means that retail customers may have

to abandon their pattern of receiving certificates of ownership for their stock shares.

The pattern of mailing personal checks to pay

for stock purchases will have to change to a

more rapid payment method such as electronic

bank-to-bank transfer of guaranteed funds.

The Federal Reserve System’s Regulation T,

which addresses margin-regulations for broker/

dealers, has just been modified. Since the

maximum allowable time for clearing and

settlement of trades in the United States is

different from those of many other countries,

●

some flexibility is needed in tying the customer’s time period for payment to the foreign

settlement date. In March 1990, Regulation T

was modified to allow the maximum time for

payment to agree with the foreign settlement

period, provided that period does not exceed

the current U.S. 35-day maximum allowable

period for settling cash (delivery against payment) transactions.20

Changes also have been made in the margining

of foreign securities in U.S. accounts- with

foreign currency-denominated cash and securities.21

Implementation plans for the Group’s recommendations were initiated or considered by its members’

governments beginning in the spring of 1989. The

U.S. Working Committee of the Group of Thirty met

in May 1989 with representatives from exchanges,

the National Association of Securities Dealers

(NASD), clearing corporations, transfer and depository firms, banks, regulators, and others, to begin

discussing the recommendations. The U.S. Advisory, Steering, and Working Committees reconvened a meeting on March 1, 1990 to discuss

progress on the recommendations on same-day

funds and shortening the time to settlement. These

and other issues are being accommodated by the

Federal Reserve Board (FRB). David Ruder, then

SEC Chairman, noted at the 1989 meeting that the

Group’s recommendations are consistent with published policy objectives of the Securities and Exchange Commission.22 He also listed other areas that

require attention, such as capital adequacy standards

for market participants, information sharing among

clearing entities, and the interaction of derivative

ITS~ties lending ~d borm~ has become an effective tool wed by market participants to satisfy their obligations to deliver or pay a _

counterpart. In its absence, a failure to deliver can have the consequence of creating a series of additional failed transactions as one party’s failure to

receive becomes the cause of its failure to deliver on its obligations.

1s’l”he 1S0 is a worldwide standards-making body. ISO standard 7775 applies to Securities Message ~s; standard 6166 appfies to rn~tio~

Securities IdentificationNumbex. Currently, no worldwide securities numbaing system is in use. Countries each use their own unique numbering system

for identiiicatio~ rendering them impractical for cross-border transactions.

~% OIOUP of~met in ~ndon in mi&Marck 1990, to discuss worldwide progress toward implemmting its nine recommendations. See

aearance and Settlement Systems Status Reports: Spring 1990, Group of Thirty, New York and Umdou which covers the progress of 17 countries.

While the obstacles facing each nation and the efforts required of each to comply with the recommen&tions are disparate, there was general acceptance

of the recommendations.

%ee 55 Fed. Reg. 11158, Mar. 27, 1990. This 35-day period is separate from the 5-day and 3-day settlement periods discussed e~where. It mf~

to the maximum allowable time period for settlement in the event of unavoi&ble delay, e.g., a payment lost in the m@ and it does not apply to reasons

such as a customer being unable or unwiUing to make payment or deliver securities.

zl~id:

22poEV s~aent of tie U.S. s~~tiw ~d fic~e Commission “Re@ation of the ~te~tio~ s~urities ~ets,” November 1988 @

Release No. 33-6807, Nov. 14, 1988; Fed. Reg. 46963, Nov. 21, 1988.
Chapter 5--International Clearing and Settlement: What Happens After the Trade ● 61

Table 5-l--Group of Thirty: Current Status of International Settlement Recommendations-Equities

Recommendation No. 1 2 3 4 5 6 7 8 9

Institutional Central Rolling

Comparison Comparison Securities Securities Settlement Same-Day Securities

Country on T+1 System Depository Netting DVP on T+5 Funds ISO/lSIM Lending

Australia ........,,. Yes

Austria . . . . . . . . . . . . Yes

Belgium . . . . . . . . . . . No

Canada . . . . . . . . . . . . Yes

Denmark . . . . . . . . . . Yes

Finland . . . . . . . . . . . . Yes

France . . . . . . . . . . . . Yes

Germany . . . . . . . . . . Yes

Hong Kong . . . . . . . . . Yes

Italy ,...,,.., . . . . . Yes

Japan . . . . . . . . . . . . . Yes

Korea . . . . . . . . . . . . . No

Netherlands . . . . . . . . Yes

Norway . . . . . . . . . . . Yes

Singapore . . . . . . . . . Yes

Spain . . . . . . . . . . . . . Yes

Sweden . . . . . . . . . . . Yes

Switzerland . . . . . . . . Yes

Thailand . . . . . . . . . . . Yes

United Kingdom . . . . . Yes

United States . . . . . . . Yes

No

No

No

Yes

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

Yes

Yes

No

Yes

Yes

Yes

No

No

Yes

Yes

No

Yes

No

Yes

Yes

No

No

No

Yes

Yes

Yes

No

Yes

No

No

No

Yes

No

No

No

No

No

No

Yes

No

Yes

No

No

No

No

No

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

No

Yes

Yes

Yes

No

Yes

Open

Weekly

Fortnightly

T+5

T+3

T+5

Monthly

T+2

T+1

Monthly

T+3

T+2

T+5

T+6

T+5

Weekly

T+5

T+3

T+4

Fortnightiy

T+5

No

Yes

Yes

Yes

Yes

No

Yes

Yes

No

Yes

No

No

No

Yes

No

No

No

Yes

Yes

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

No

Yes

No

Yes

Yes

Yes

No

Yes

No

Limited

Limited

Yes

No

Yes

No

Yes

Limited

Yes

Yes

No

Limited

Yes

SOURCE: Updated from A Comparative View: The Group of Thirty’s Recommendations and the Current U.S. National Clearance and Settlement System,

(New York City,NY:MorganStanley& Co.,June 1989),

markets.23 Officials of U.S. regulatory agencies are

supportive of the U.S. Committee’s efforts.24

The Group of Thirty is not alone in exploring

many of these issues; other international groups

have attempted to develop consensus on some of the

issues in clearing, settlement, and payment systems.

These organizations include the Federation Internationale des Bourses de Valeurs (FIBV),25 the Bank

for International Settlement (BIS),26 the International Society of Securities Administrators (ISSA),27

the European Community (EC),28 and the International Organization of Securities Commissioners

(IOSCO).29 Their activities reflect a growing international concern for making the world’s markets

more stable and compatible, and for reducing

avoidable risk.

The FIBV Task Force includes representatives

from the Tokyo Stock Exchange, the International

Stock Exchange, the VP (Denmark’s depository

system), the Amsterdam Stock Exchange, the ISCC

in the United States, Euroclear, CEDEL, the Group

of Thirty, SICOVAM, ISSA, and IOSCO. The FIBV

Task Force met in December 1989 to discuss how

countries might proceed, and again in March 1990 to

23Davids. Ruder, 4cI&M&s on the (MmIp of Thirty Report on International Clearance and Settlement,” May 15, 1989.

~Commenta by G. Corrig~ President of the Federal Reserve Bank of New York and Commissioner Mary Shapiro, SEC, at tie *h 19N meeting

of the U.S. Committee.

~~e FIBV smdy “Improving hte~tioti Settkmen~’ June 1989, focused on the settlement of cross-national border trading. This report endorses

the recommendations of the EEC and Group of Thirty reports and also makes additional recommendations.

~nBIS’S GIOUp of Experts on payment Systems, Committee on Interbank Netting Systems is working on a study of multilateral netting schem=

~For infoMutio~ see ISSA Handbook on Clearing and Settlement in the world’s markets, updated regulmly. An edition covering 28 cowtries and

the Euromarkets was published in May 1990.

~~e EEC’s “study onhnprovements in the settlement of Cross-Border Securities Transactions in the European Community,’ fOCUSd on tie need

for eentmlized depositones.

~Gern~ de -z@em, ~~cl-~d Setdmen6° rqo~ to the 14th Annual Conference of IOSCO, Venice, September 1989; tie adoption of

a resolution in 1986 that promotes investor protection through surveillance and mutual enfomement assistance; and the establishment of a tecbnical

committee to review rnajorproblems in international securities transactions and working groups to address specitlc topics, such as offerrings of securities

on an international basis and multiple listings, the problems with existing memoranda of understanding among markets, and international clearing and

settlement. IOSCO has been studying issues related to capital adequacy for non-bank securities fii and is exploring ideas for risk-based capital

~~U21CY standards.
62 ● Trading Around the Clock: Global Securities Markets and Information Technology

continue its efforts. The FIBV Task Force30 has

agreed to the following steps:

promote the development of links between

national markets;

assist one another by exchanging plans and

procedures for implementation (a Practice which

has already begun);

standardize communications message formats,

terminology, and legal agreements;3l and

assist each other in understanding the ramifications of their individual decisions on international trading.32

The Commission of the EC commissioned a

report 33 with recommendations that to date have not

gained wide support among EC countries. It is

unlikely that the EC will adopt the report’s recommendations soon, but will await the results of other

international efforts. The report’s recommendations

focused on the need for central depositories in

Europe, not on clearinghouses; therefore, many of

the recommendations do not apply to the United

States.

ISSA, whose officers are directors of six major

international banks, produces handbooks on clearing

and settlement in world markets to promote progress

in securities administration. Key issues in clearing

and settlement were identified in an ISSA conference in 1989.34

Among other efforts to improve elements of the

clearing and settlement process are:

. The Committee on Banking Regulations and

Supervisory Practices of the Bank for Interna-

●

tional Settlements has designated a working

group on traded securities, which is currently

exploring issues including the risk-based capital standard and explicit treatment of position

risk for banks.

The SEC and U.K. regulators have entered into

a bilateral agreement under which the U.K.

regulators will waive their capital adequacy

requirements with respect to particular U.S.

broker/dealers that have branches in the United

Kingdom, if the SEC provides certain information to their U.K. counterparts.35 The SEC is

exploring bilateral agreements on the subject of

sharing information for enforcement purposes

and, through IOSCO, is looking into the

feasibility of multilateral agreements toward

this end.

Although several of these groups have some

members in common, each of the efforts is proceeding independently,36 and there are several points of

agreement among the most prominent groups (table

5-2). These proposals and efforts are a starting point

for improvement, but some of these will require

action by the national governments. 37

The reforms suggested by the Group of Thirty and

other organizations are being taken seriously in the

United States. Several recent reforms have been

made in the U.S. equities markets, many of which

predate the recommendations of the Group of Thirty.

These include:38

. Trade Processing

—The NYSE in 1988, began developing an

on-line trade reconciliation system which

~ormation on the FIBV Task Force is based on a December 1989, interview with Mary Ann CaUahruq ISCC, who attended the last Task Fome

meeting.

31A5 in many Other areas where international harmonization or sm~“ tion is in its infancy, there area surprisingly large number of specialized

terms used in different ways for comparable functions by various countries, a situation which hinders cross-national border trading.

3ZAS an e~ple of the latter, the Hong Kong Stock Exchange has already decided to implement a 2-day settlement period. Such a short period ~

pose problems for settlement of cross-national border trades.

ssJorg-Rol~d Kessler, ‘Study on Improvements in the Settlement of Cross-Border Securities Transactions inthe Euro~~onomic COIUIXIMtY,’

1989.

MISSA Sppsi- 4‘Glob~ %xrities Investments: Processing Issues and Solutions, ’ SwitzerlancL my 1989.

Ssundm ~ag=mm~ tie SEC wi~ now u~+ re@ators if it becomes awme that a pfic~~ broker-d~er’s fincid or opellitioti CC)Il&tkXl

is impaired, and U.K. regulators will provide reciprocal services.

~~e fact that some of the same people, including regulators, participate in a number of these groups protides a m~ of coordination

internationally,

sTSee, for ex~ple, GOUP of ~, “u.S. Working tioup Report on Compressing the Settlement PeriocL” NOV. 22 1989; md B*em Tmst CO.+

op. cit., footnote 1, p. 206.

38For ~ ev~ution of Progess on fiplemenfig tie r~mm&tiom of tie president’s worm Group on F~ci~ Mketsrek~ to c1*

and settlemen~ see U.S. Congress, General Accounting Offke, Clearance and Settlement Reform: The Stock, Options, and Futures Markets Are Still

at Risk, GAO/GGD-90-33 (Gaithersburg, MD: April 1990).
Chapter International Clearing and Settlement: What Happens After the Trade ● 63

Table 5-2—Recommendations From Major

International Studies

Report

Aspect of operation ISSA EEC G-30 FIBV

Two-sided trade matching . . . . . . . . . —

One-sided trade comparison . . . . . . . —

National central securities

depository a . . . . . . . . . . . . . . . . . . . Yes

Evaluate securities netting . . . . . . . . . Yes b

Delivery versus payment . . . . . . . . . . Yes

Rolling settlement . . . . . . . . . . . . . . . Yes

Same-day funds . . . . . . . . . . . . . . . . . Yes d

Use of ISO standards for message

formatting . . . . . . . . . . . . . . . . . . . . Yes

Lending for settlement . . . . . . . . . . . . Yesf

Cross-border Central Securities

Depositories should be linked . . . . Yes

Securities should be immobilized in

country of issuer . . . . . . . . . . . . . . . Yes

—

—

Yes

Yesc

Yes

Yes

Yese

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

—

—

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

aDepositories for securities are already widely used in the United StateS.

blncluded as part of the risk reduction/resolution recommendation in the

report.

clncluded as part of the risk reduction/resolution recommendation in this

dincluded as a subset of the dellvery versus payment recommendation of

this report.

elncluded as part of the currency accounting recommendation of this report.

flncluded as part of the risk reduction/resolution recommendation in this

report.

SOURCE: Bankers Trust Co. adapted from Federation International des

Bourses de Valeurs (FIBV) document.

has evolved into its current Overnight Comparison System.

—The National Securities Clearing Corp. (NSCC)

implemented earlier input and output time

frames to facilitate trade matching on the day

after the trade (T+l).

—The NSCC is participating as part of the

Group of Thirty, U.S. Working Committee,

in the evaluation of ways to shorten the

timetable for settling equities trades to T+3

(from the current T+5).

—The NASD has implemented a Trade Acceptance Reconciliation System (TARS) for

same day or next day automated reconciliation of unmatched trades and is currently

phasing in its Automated Confirmation Transaction (ACT) system for same day comparison of all trades not already locked in

through automated execution systems.

● Risk Management

—Information sharing of the financial positions of participants’ who are active in

multiple markets is being worked on by the

Securities Clearing Group (SCG), which

represents U.S. clearing organizations serving equity and equity options markets. This

group is working to develop a system for

sharing settlement, margin, and clearing

fired at-risk exposure information about joint

members. 39 An earlier, continuing effort in

the futures industry (the BOTCC’s system)

to share pay-collect information is being

expanded to include options issued by the

Options Clearing Corp. (OCC). (There is still

some concern by the OCC about the confidentiality and perishability of data, and unintentional competitive advantage.) In the United

States, the trend is toward interfacing existing centralized risk information systems for

derivative markets with the emerging centralized risk information system for equities

markets.

—The NSCC has proposed to the SEC changes

in its criteria for assessing risk-based contributions to guarantee funds from clearinghouse

members, and to make earlier calls for

additional contributions. Due to a recent

change, now only 70 percent of an NSCC

clearing member’s collateral may be in the

form of letters of credit. In addition, the

NSCC’s Board of Directors has approved,

and NSCC has obtained, a bank line of credit

of $200 million.40

—The SEC proposed an increase in capital

adequacy requirements of full-service broker/

dealers from the present $100,000 to $250,000

to be phased-in by January 1994.41

—The OCC initiated an intra-day margin call

procedure directly to the clearing member’s

clearing bank, in contrast with the earlier

procedure of contacting the member and

allowing 1 hour for payment.

—The OCC has increased the initial net capital

requirement upon application for clearing

member status from $150,000 to $1 million.

4oData from Robert Woldow, Executive Vice President and General Counse~ NSCC, March 1990.

41 SEC Rel~e No. 3~2724g, “MpOsed Rukmakhg on Broker-Dealer Net Capital Requirements,” S28-89, Sept. 15, 1989.
64 ● Trading Around the Clock: Global Securities Markets and Information Technology

UNRESOLVED PROBLEMS

In futures markets differences exist both domestically and internationally. There is some commonality, however, for financial safeguards in U.S. domestic futures markets. These safeguards include: original margins for clearing members based on trades

carried for their customers and their proprietary

accounts; daily and intra-day marking-to-market and

calling of variation margins; initial and maintenance

margins for customers; clearinghouses serving as

guarantors of trades; posting deposits by clearing

members, which are callable by the clearinghouse;

systems for monitoring the risk positions of both

clearing members and customers; and large trader

reporting.

Clearinghouses have tended to structure themselves as fortresses, able to contain significant

damage to their systems from internal causes with a

hierarchy of safeguards or “firebreaks.” Assumptions underlying the adequacy of firebreaks are

increasingly less valid because of the growing

linkages between futures, equities, and options

markets; these linkages have become international.42

Exogenous forces could prove overwhelming,

e.g., either a general crisis in the financial markets,

or a failure of one or more large banks or broker/

dealers for reasons unrelated to the financial markets

themselves. In such a case the ability of a clearinghouse to assess its members, after it exhausted all of

its margin and guarantee funds, would be ineffective.43

Some key questions for market regulators are:

. whether the financial standards at individual

markets and clearinghouses within their jurisdictions are satisfactory;

what improvements are needed, in cooperation

with other regulators, to strengthen the contribution of their markets toward improving the

overall financial integrity of the national financial system; and

what improvements are needed, in cooperation

with authorities in other countries, to strengthen

the financial integrity of futures, options, and

equities markets internationally, and to contribute to an overall strengthening of the international financial system.

There is also the question of how to supervise

groups that invest in a variety of financial instruments and markets internationally. Current systems

are not able to achieve this, although they make

some efforts to provide a picture of the overall

financial risk of such participants.

Concerns about whether or not futures margins

levels in the United States are set appropriately have

been addressed by the President’s Working Group

on Financial Markets, which concluded that they are

set in a prudential manner and recommended no

changes in margin-setting systems.44 45 Nevertheless, Federal Reserve Board Chairman Alan Greenspan noted his concern that futures margins that are

set too low tend to be raised during periods of market

turmoil, reducing liquidity when it is most needed.%

Shortening the interval between trade execution

and the collection of margins could be a benefit, by

reducing the exposure of clearing members before

the clearinghouse’s payment guarantee is effected,

and the exposure of the clearinghouse in the interval

between the provision of the guarantee and collection of margin payment.

42~c~el H+tt, s~Or Adv&r, F~ce ~d ~dus~ Departmen$ B@ of ~l~d, “F~ci~ ~tegrity of Futures Markets,” pleSented at the

Futures and Options Market Regulators Symposium in Burgenstoc~ Switzerland, September 1989.

A3Rog~ Rum, ~ef ~ative offl~er, BOT’CC, be~eves titin a g~~~ f=~ ~ket ~sis sce~o, here cotid & a complete WOnOdC

collapse, ortheFRB, aslenderof Iastresort and provider of liquidity to the financial syst~ will act to stabilize market conditions. In the second scenario,

the FRB would probably rescue a large bank and the government might have no choice but to do the same for a large non-bank brokerdealer. Expert

paper contributed to OTA contractor study by Bankers Trust Co, op. cit., footnote 1.

Although the recent experience in the liquidation of Drexel,B-Lambert casts doubt on the concept of afmbeing too large for thegovexnrnent

to allow to fr@ and provides credibility to some alternative criteria for a government rescue actio~ such as the broader impact of such a failure.

~~terim Report of the President’s Work@ Group on FiIEUE id A&rkets, May 1988, p. 5: “.. current minimum margin requirements provide an

adequate level of protection to the fmcial system. . .“ More recently, however, the Administration appears to have taken a different view, namely,

tbatfhturesmargins areset too low, and that a single Federal agency should have day-to-day oversight “toharmonizemargins between futures and stocks

to protect the public.” Testimony of Robert R. Glauber, UnderSecretary of the Treasury for P“mance, before the Senate Committee on Agriculture,

Nutritio~,and Fores~, May 8, 1990.

*There is* the view that bightZ illitiill_ with less frequent reviews might be safer than today’s lower margins and more fkequent reviews.

Hewitt, op. cit., footnote 41.

46~ testimony of Alan Greensp~ ~Federal Reserve Board, before the Senate Committee on Banking, Housing and Urban AHairs, Mar.

29, 1990. He said: “I was shocked” about the margin setting behavior in the futures markets in October 1989.
Chapter 5--International Clearing and Settlement: What Happens After the Trade ● 65

There are advantages for firms that are members

of several exchanges in having their positions at

each exchange confirmed, registered, and guaranteed at the same time. Simultaneous transfers of

funds could be made by their settlement banks in

payment of margins. The advantages would be far

greater (but achievement more difficult), ,if settlements were synchronized between financial futures

and options markets. The synchronization of settlement timetables across time zones is theoretically

possible once settlement periods of less than a full

day are achieved.

Is a member-owned clearinghouse that is backed

by the assets of its owners safer than an independent

clearinghouse, such as London’s International Commodities Clearing House, that is owned and backed

by strongly financed shareholders, i.e., banks? This

depends on whether the guarantee is more robust if

backed by a special reserve fund, the assets of its

member-owners, external credit lines, guarantees or

insurance arrangements, or by a combination of

these.47 This also depends on the liquidity of the

assets involved.

Large risk exposures to single customers have

been a source of financial problems in futures

markets in some countries (but not in the United

States). In the United States, the Commodity Futures

Trading Commission (CFTC) has had a large-trader

reporting process since before the October 1987

market break. Similar information-sharing procedures are needed to monitor exposure in international futures markets.

POLICY ISSUES

Six areas of major concerns need to be addressed:

● risks associated with default;

. risks associated with the payment process;

. information sharing;

. technology;

. standardization and harmonization;

● shortening the time to settlement and providing

same-day funds.

Risks Associated With Default

Investors need to be made aware of the differences

in the amount of protection provided by various

foreign markets. For example, there are no international standards for guarantees (by clearing organizations, banks, and others)--either for the protection

of investors or to prevent the collapse of financial

institutions.

In the United States, the Securities Investor

Protection Corp. (SIPC)48 provides a level of protection to market users in equities, bonds, and equityrelated options markets. The protections afforded by

exchanges and clearinghouses in futures markets to

market users vary and are extended mainly to

clearing members of the exchange’s clearinghouse.49

Insurance can never completely cover all losses.

Some failures in securities markets are resolved in

the United States through bankruptcy proceedings

under the Federal Bankruptcy Code. The Bankruptcy Code relies largely on State laws to determine

rights to property. These may include State commercial law that often relies on the Uniform Commercial

Code (UCC).50 The UCC is being reexamined to

reflect the realities of today’s marketplace, especially where it applies to third-parties holding

securities. Laws dealing with bank liquidation also

need to be updated and made more consistent with

other bankruptcy laws.51 In nonregulated markets,

such as foreign exchange, there is little investor

protection.

The SIPC in the United States, the Canadian

National Contingency Fund, or the United Kingdom’s Securities Investment Board contingency

fund are possible models for international markets

gT~ the United Stites, ~~r the 1987 crash the size of guarantee funds was increased and greater cash deposits were rtX@Xi in place of tink letters

of credit, and the size of letters of credit outstanding with futures clearinghouses ffom any single bank was limited.

4SSIPC insmes an investor’s acco~ts Up to $xI0,000 for securities and cash against certain types of loss, e.g., the default of a broker. ‘l’’his includ~

a maximum of $100,000 in cash per account. Securities Investor Protection Act, 1970.

g~t Shouldh noted that customers’ losses stemming from Futures Coremission Merchants’ insolvencies have been rare. Insolvency losses horn 1938

to 1985 amounted to less than $lOmillion. Nationzd Futures Association study CwtowrkcountProrection, Nov. 20, 1986, p. 13. The basic protection

is the statutory requirement that 100 percent of customer funds be segregated. Commodities Exchange Act, sec. 4d(2). Also, customers have first priority

in commodity brokers insolvencies under the Federal Bankruptcy Code and CFTC bankruptcy regulations.

50’l”he UCC is accepted on a State-by-State basis and amendments to it would still leave open the possibility of non-uniform treatment by the various

States. The American Bar Association has a current project that is seeking improvements to this area.

51~ ~fia ties, Cmtomem were inched t. keep ~ss=sion of their s~~ties ~rtificat~. Mom r~ntiy, my buyers of securities tend to kive

their certMcates on deposit with third-parties, e.g., banks, brokers, depositories.
66 ● Trading Around the Clock: Global Securities Markets and Information Technology

which do not now have any protection for investors.

Canada uses private insurance, while the United

States and the United Kingdom use government

guarantees. These are topics that warrant the attention of governments and the private sector.

Risks Associated With the Payment Process

There have been recent innovations in the way

payments are made for transactions. Increased volume of trading has heightened the stress on payments systems. Issues that have arisen concerning

payment risk include: delayed or inadequate bank

credit, timetables for finality of settlement, and

netting procedures. Problems may arise with 24-

hour trading systems, for example, margin calls

when banks are closed.

Bank officials need to be more familiar with the

processes and risks of clearing and settlement to

make better and more expedient credit decisions,

particularly in times of severe market volatility. At

such times, the lack of adequate information on

which to base credit decisions may force some banks

to restrict credit earlier than necessary.52 This could

exacerbate a downward market spiral. Knowledge

about the riskiness of various financial instruments

and trading techniques are important for lenders.

Educational efforts of this kind are receiving some

attention by the private sector, but more is probably

needed.

The timetable for finality of settlement is a

problem. Some payment systems, such as the FRB’s

FedWire, offer immediate finality of settlement;

other payment systems offer “end of the day”

finality of settlement,53 and others are on later

timetables. 54 The shorter the time to finality of

payment, the less is the clearinghouse risk. Timetables for finality of payment of settlement vary

within the United States and internationally.55 The

private sector and the regulators must harmonize

disparate systems, at a minimum to provide sameday finality of payment.

Netting of payments reduces the stress on payment systems by requiring market participants to

pay (and receive) only the difference between the

amounts each owes and is owed by others. This

increases liquidity for market participants and reduces the risk that a market participant will default

on either payment or delivery of securities. There is

consensus among experts that legally binding netting should be expanded, for payments and for

securities delivery obligations. This issue must be

addressed internationally by the private sector and

regulatory authorities.

Information Sharing

In most kinds of financial transactions, a lender

(e.g., a bank) will have access to information about

the past creditworthiness and the current financial

risks of a potential borrower. However, there is no

central source of risk information for financial

markets participants in spite of the large amounts of

money often involved. Some organizations in the

clearing and settlement industry have arrangements

among themselves for sharing risk information

about market participants either formally or informally. Such arrangements are limited in scope, and

creditors are at a disadvantage because increasingly

market participants trade on more than one exchange, in more than one market, and in the markets

of more than one country.56 57

sz~e Clearing Orgtitiom and Banking Roundtable is addressing methods to assure that clearing mernbcm have adequate credit dtig ties of

market turmoil. Them are currently concerns for the privacy and contldentiality of clearing members tbat hinder the attractiveness of the concept of a

single center for complete information on all members’ positions in all markets. This organization was started by the CME and BOTCC to begin a dialog

among futures and equity-related clearing organizations, their Federal regulators, and clearing banks.

ss~e~~fii~of settl~entis avai~bleonly in the United States (through FedWire) andin Switzerland. The CHIPS system in theunittd Smta,

the CHAPS system in the United Kingdom and the SAGI’ITAIRE system in France are examples of payment systems which offer end-of-day finality

of settlement.

~s~ B~ms Trust repo~ op. cit., footnote 1, vol. 1, p. 149.

SsResWndmts t. a smey conducted by B~~s Trust Co. iden~~ the use of “~~&y ~ds” ~d ‘ ‘using el~troflicfids Emfa inst~d Of

checks” as the major improvements that they would like to see in the way that payment systems work in clearing and settlement. In answer to another

quesfionon what changes or improvements respondents would like to see in the clearing and/or settlement process, the two most frequent responses were

“standardization of settlement times internationally” and “centralized depositories in other countries. ”

56About 39 ~rcat of tie North ~eric~ respondents to tie s~~ conduct~ by B~ers Tmst stat~ tit they trade in markets k mOl_e dWl One

country. Bankers Trust study, op. cit., footnote 1, vol. 1, p. 235.

57while u-se cl~@ouses oWrate ~ sfigle ~kets, 20 ~rcmt of their me~r~tiein mo~ tin one market. General ACCOllI@ offiCe,

op. cit., footnote 37, p. 4.
Chapter5--International Clearing and Settlement: What Happens After the Trade ● 67

There is a general consensus that risk information

should be shared,58 but there is fear that risk

information might give an advantage to potential

competitors. Increased automation could facilitate

information sharing. This could lead to the development of a common format for reporting and distributing risk information, and standards for the timely

delivery of risk information. Standards also are

needed for evaluation of different risks in different

markets: for example, a given dollar amount of

financial obligations in one market may not equal

the risk of a like financial obligation in another

market.

Bilateral links for sharing information have been

developing among clearinghouses, depositories, and

regulators in various countries; these have set the

stage for more global sharing of risk information.

However, there are often legal restrictions on the

flow of information across national borders.59 It is an

issue that requires government and private sector

attention if it is to be resolved satisfactorily.

Inadequate Technology60

Technology may or may not have a significant

impact on clearing and settlement at low trading

volume; but during high volume, technology is often

a key to efficient clearing and settlement. Most of the

U.S. clearing and settlement system is technologically advanced, although there are some areas

needing improvement. However, the clearing and

settlement industry worldwide (including many

brokerage firms and banks) are operating at an

inadequate level of technology to meet the increasing demands of the markets.

Cultural, legal, regulatory and economic factors

sometimes work as barriers to increasing the level of

automation. For example, some countries prohibit

the transfer of equity ownership through electronic

book entries. Others restrict the importation of

automation and communication equipment and require domestic sources. These are areas where it will

be necessary for governments as well as the private

sector to make decisions about appropriate actions.

While clearinghouses have made significant

strides in upgrading technological levels, the benefits of these upgrades can be diluted if all clearing

members are not sufficiently advanced technologically to respond to new requirements of the clearinghouse for which the technology was intended. In

some cases, the weakest technological link may

limit the responsiveness of the system during

operational stress, particularly under high-volume

conditions. These are areas where, inmost countries,

the private sector will have to take the initiative to

bring about needed changes.

Standardization and Harmonization

Uniform codes of operation, or standards, for both

the process61 and the infrastructure62 of clearing and

settlement would make it easier to link the world’s

clearinghouses and depositories. There is strong

motivation by regulators, the Self-Regulatory Organizations (SROs), and the private sector, for

standardization to meet the demands resulting from

globalization of world markets. But progress in this

area is likely to be slow because of the complexity

of effecting change. The United States (with respect

to equities and options markets) and a few other

countries have standardized their domestic systems

both in the process and the infrastructure, although

there are notable differences among them.

Operating hours and daily schedules for banks and

financial markets are not uniform, either domestically nor internationally. Banks, including the cen5S~e B~rs Trust -~y of fit~tio~ cleouses~d exc~ges r~ived 18 out of 20 respo~s favo~ the shar@ of risk pOSitiOn

information “as useful or absolutely essential” among clearing and settlement organizations for the purpose of reducing clearing members’ exposure

rislm Bankers Trust study, op. cit., footnote 1, vol. 1, p. 231.

5!)As ~-lw, Bel@~ ~d swi~~d ~ve s~ct privacy ~~s which ~trict them of a client’s ~o~tio~ Such as trade details, witb third

parties. IBu “Study of Clearance and Settlement for the U.S. Congress-OT&” Aug. 1, 1989, pp. 7, 39. This report is incorporated in the O’E4

contractor report, Bankers Trust Co., op. cit, footnote 1.

@This section is based on “IBM Study of Clearance and Settlement for the U.S. Congress-01%’ Aug. 1, 1989, Ibid. The IBM study is based’on

opinions of participating experts from the world’s major exchanges and clearing organizations.

Gltt~Wess$* ~fm t. owmtio~ ~tiom filu~ ~de ~tc~,the number of days to clear a tmde, number of days to setfle a ~de~ ‘e ‘e

of a depository for holding equities and keeping records of ownership, the use of a recognized numbering system for identifying financial instruments,

fo~ta for data ~missio~ and the method of payment.

Gzt{-ticwe,t ~fem t. ~ of ~~ny nonor~o~ f-esn=-to -e~cl-~d ~~eme~ proc~s work b a COllsiStent d

stable manner. These include the method of regulatio% mechanisms to protect the clearinghouse against the financial failure of a clearing member, a

reserve of funda to protect customers of a failing broker or futures commission mercmt, banlmptcy laws to adjudicate the disposition of customer assets

if a broker fails, credit processes at banks, clearinghouse trade guarantees, capital adequacy guidelines, and bilateral tax treaties among nations.
68 ● Trading Around the Clock: Global Securities Markets and Information Technology

tral bank, maybe closed even if financial markets are

open.63 This disparity becomes increasingly important as market participants invest in more than one

country. The FRB, SEC, CFTC, and the Treasury

Department must first face this issue in the United

States.

Many investors in the world’s equity markets deal

with global custodians for clearing and settlement.64

Therefore, no matter how significant the improvements in the clearing and settlement process, the

gains in efficiency can be diluted unless parallel

improvements are made by global custodians.65

Currently, there are no standards that define a global

custodian, 66 yet these are important to achieving

smooth-working global markets. This needs to be

addressed at the international level by both private

sector and government regulators.

Markets around the world compete to be agents

for capital transfer, and have made innovations to

improve their competitive positions. Before and

after the October 1987 crash, the private and public

sector have taken steps to reduce systemic market

risks. These risk-reduction efforts include increased

co-operation among the world’s regulatory bodies.

But efforts to improve clearing and settlement

systems-domestically and particularly in some

foreign countries-likely will fall short unless

change occurs in: 1) process, and 2) the infrastructure. Many gaps in the infrastructure (methods of

regulation, taxation, customer protection) exist, but

have not yet received adequate attention.

Effective reforms in clearing and settlement will

have to be undertaken on an international scale. The

private and public sectors in the United States can

act as leaders in the evolution of improvements in

the domestic clearing and settlement industry, but

they face serious constraints in achieving worldwide

improvements unless their efforts coincide with

those of other countries. Both private sector and

government actions are required.

Shortening the Time to Settlement and

Providing Same-Day Funds

The need for standardization, or harmonization, of

clearing and settlement is manifest by the various

international standards-setting efforts already underway.67 One example of the need for standardization

is shown by the differences among countries in the

number of days to settle a trade for different financial

instruments. This is a case in which the private sector

likely will require the support of national governments to establish minimum standards for harmonizing international clearing and settlement. The United

States, for example, must shorten the settlement

period for equities. This most likely would require

immobilization of securities in a depository, and the

public would also benefit from a change to same-day

funds.68

The elimination of physical delivery of certificates is the key to automating the clearance and

settlement systems. This has been achieved legislatively in France, where certificates are dematerialized (i.e., paper certificates are eliminated and

computer-based records are substituted), and in

Germany, Switzerland, Euroclear, and CEDEL (the

international clearing and settlement firm) by using

nominee custodians to centrally transfer ownership

by book-entry. The United Kingdom has established

a depository nominee (SEPON) for the book-entry

transfer of ownership between market-makers. The

system will be extended to other exchange members

and some institutional investors,’ and the United

Kingdom has plans to implement a book-entry

transfer approach for all transactions. Japan and

Hong Kong have enacted legislation that requires

automated book-entry clearance and settlement systems.

The U.S. Working Committee of the Group of

Thirty concluded that the greatest deterrent to

achieving shorter settlement at the retail level, or the

‘‘customer-side,‘‘ is the physical delivery of certifi63~~ isme, fm ~u~~ s~te~, _fi~~ ~ Feb. 8, 1~ meting of theB-~d CIXOUW Round@ble, wherc members _to

hold further discussions. The problem is far more complicated internationally and far from being resolved.

64A ~lob~ ~~~ is a *tit holds s~ties~oh financial instruments in multiple markets on bdlidf of in~~tio~ investo~.

fiFor mm on this Subjech see Bankers Tmst Co., op. cit., footnote 1, vO1. 1, p. 174.

% International Society of Securities Administrators may begin to develop standards for global custodians in 1990.

67B~=TW6 fiits-Cy of cl-~~~=entp~~pmts worldwide, *MI tie qu~tio~ Which Critical c1-W settlement probl~

should theU.S. Congress address, if any... ? The three most ffequent responses forattentionby Congress were: support stmhdmtioneffurta for global

trading; support immobilization of securities; support increasing the standardization of theckaring and settlement process. It should be pointed out that

a significant number of U.S. respondents did not want increased congressional involvement in issues aHecting the clearing and settlement industry.

~lBM study, op. cit., footnote 58, PP. 20,22.
Chapter 5--International Clearing and Settlement: What Happens After the Trade ● 69

cates (which some retail investors insist on) and

reliance on the postal system to accomplish this.@

The retail customer must pay his broker on or before

the settlement date. Each side requires the delivery

to the broker of either “good funds” or certificates

in a timely fashion. There is no easy way to

accomplish these “deliveries” today, without substantial changes for the retail investor or added

expense for investors who wish to hold a certificate.

The Group of Thirty’s recommendation for a

change from next-day funds to same-day funds

(SDF) for the settlement of securities transactions

has no deadline for implementation, but some expect

it to be in place in the United States during the

1990s.70 The adoption of SDF should contribute to

risk reduction and would add uniformity and simplicity across all instruments and markets.

However, the U.S. Working Committee, while

recommending the eventual adoption of same-day

funds for the United States, recognizes the need for

assessing a number of complex issues associated

with its adoption. There are substantive technical

issues and the requirement for significant behavioral

changes that warrant study before the changeover.

Today’s automated payment systems, for example,

are considered to be not yet sufficiently developed or

‘‘user-tiendly’ to be viable alternatives to the

postal system.

A second issue is that although most major futures

clearing corporations in the United States settle in

same-day funds, there are important exceptions, e.g.,

NSCC and the six regional equities clearing corporations and depositories. Further work is needed to

examine how these systems would have to be altered

to accommodate an SDF environment.71

A third issue concerns implementing guidelines

issued by the Federal Reserve System to mitigate

systemic risk that could be caused by a failure of a

private payment system (i.e., a clearing agency)

participant to settle its obligations.72 The guidelines

are seen as difficult to apply within NSCC and DTC

for the clearing of corporate securities and municipal

bonds, and therefore will require additional study .73

Ongoing efforts by the U.S. private sector have

been laudable. Yet, some of the issues raised by

shortening the time to settlement and same-day

funds, among others, will require continued assistance from regulatory bodies and, in some cases, the

U.S. Congress, since they are not within the ability of

the private sector to resolve.

IS AN INTERNATIONAL

REGULATORY BODY NEEDED?

Although the private sector is already dealing

with many issues, government assistance is likely to

be needed, for example, to effect changes in laws,

such as those needed for the immobilization of

securities certificates.74 The several private sector

studies do not fully address all financial instruments,

e.g., derivative products, that must also be addressed

to accommodate the linked markets of today, nor do

these studies address all of the process and infrastructure areas that must be examined. The private

sector alone cannot implement the recommended

changes fully since consensus will be required

among market participants, regulators, and national

governments.75

Some of the organizations’ efforts aimed at

harmonization have been peripheral to their primary

missions, or one-time activities. The efforts of U.S.

regulatory agencies, that seek incremental improvements through bilateral agreements, although sustained, are slow. Pressures for harmonization are

growing, and piecemeal efforts to address these

global needs may be inadequate. In other fields of

international interaction, such as telecommunica-

@~oup of ~, op. cit., footnote 36.

~Mmo~dum from The DTC to the Group of Thirty, U.S. Working COmmitt% J~. 4, 19W.

71~id.

T~ede~~~~e system Docket No. R-(X565, “Policy Statement on Private Delivery-Against-Payment SyStemS,” RIN 7100-~76, June 16, 1989.

73~oup of~,U.S. Wo~ Comm.ittW Report on Same Day Funds Convention, Fe- IWO.

VASW, GIOUP of ‘III@, op. cit., footnote 36, pp. 6-10.

75The ~oup of~~found ~tb~d~co~~~ es~nti~ to -gpro~ss~~oni~ inte~tio~ @s@ smtids and procedures

both in the United States and in other countries. Yet there are indications that important issues, such as the dematerkdization of securities certificates,

may be difilcult to change in the United States in the near term. Some Americans also fear that the recommended reforms, if adopted internationally,

could make other markets more competitive with U.S. markets, weakening our competitive advantage. In spite of such concerns, the Group of Thirty

is making considerable progress, as of late 1989, according to Oerard Lynch Managing Director, Morgan Stanley, who has played a leading role in

developing consensus among U.S. participants. Discussions with OTA staff, December 1989.
70 ● Trading Around the Clock: Global Securities Markets and Information Technology

tions and air and sea transportation, international

decisionmaking and standardization, or harmonization, have long been recognized as essential. International consensus and standardization are critical to

making global trading practices uniformly acceptable. This suggests to some people a need for an

international body to facilitate the process.

Others argue against such action, because other

countries may resent the United States trying to

change their markets, and fear that this resentment

would generate resistance to U.S. proposals. Nations

have different objectives for clearing and settlement

and contrasting views on the best approaches to

accomplishing them; some view the protection of

investors as paramount (as a number of countries,

including the United States, have historically done),

while other nations have as their primary objective

greater market share. Some people suggest that the

United States might be disadvantaged if it were to

focus too narrowly on issues such as safety and

soundness while other countries focus on gaining

market share.

Perhaps one of the greatest problems in achieving

a safer global clearing, settlement, and payment

system is parochialism.76

The alternative to developing or adapting an

international standing body to focus on major issues

is continued reliance on informal or bilateral agreements—the present approach. These approaches

warrant close examination by the U.S. Congress.

At any rate, since the financial markets are private

markets which involve the public interest, the role of

the Federal Government will have to be played out

in concert with suitable private-sector institutions to

achieve public policy goals. Many issues need

international attention, including:

●

●

●

●

●

●

●

●

●

legal issues in cross-border trading,

information sharing across markets and across

national borders,

the minimum level of technology to be used by

various participants with regard to clearing and

settlement,

international regulation of markets,

the critical interface between international markets and banks,

means of protecting clearinghouses from externally caused major disruptions,

minimum financial standards for clearinghouses

(i.e., capital and guarantees),

standards for global custodians, and

surveillance and enforcement.

The ability of the United States to unilaterally

develop new standards and procedures for international clearing and settlement is limited. As the need

to develop a broad consensus on these issues in

international forums increases, U.S. regulators must

become more knowledgeable about other countries’

regulations, practices, customs, and laws, and more

proactive in seeking accommodations. Federal regulators will need a shared, consistent view of the

minimum standards for clearing, settlement, and

payment systems on an international basis.

This subject is discussed in a forthcoming OTA

report, Electronic Bulls and Bears; Securities Markets and Information Technology, along with complications associated with U.S. regulatory responsibilities divided among the Securities and Exchange

Commission, the Commodity Futures Trading Commission, the Treasury Department, and the Federal

Reserve System.

76A oneob~~erputit: “ . . that unckrthe guise of safeguarding the system and making it more effective and efllcient, the evolution of theregulatmy

system internationally will continue to be distorted in order to advance narrow nationalistic and protectionist puxposes. ‘lb the extent tbat this occurs,

less progress will be made in advancing the primary objectives of regulatio~safety and soundness, competitio~ integrity and consistency. In additio~

theinternational system will fallshortofitspotentialto facilitate economic growthanddevelopment.>’ @anti.,.Reuba~Deputy “ C2@rman of the Bank

of Monlreal, “Implications of Globalization for Regulation and Safety,” a talk at the November 1989, Financial Globalization Confenmce in Chicago.
Chapter 6

The Regulation of Global Securities Trading

Global trading in securities runs into complex

problems and unnecessary risks because of the

differences among national regulatory policies and

structures. There is no international mechanism for

regulating transborder activities, nor any way for a

nation to enforce its own regulations beyond its

sovereign reach, except insofar as there are cooperative agreements between nations.1 The risks, discussed in chapters 3 and 5, include both unrecognized risk for investors who make decisions based

on unrealistic expectations of fairness or institutional integrity, and wider systemic risks that might

result, for example, from the failure of a major firm

with heavy commitments in several countries. At

best, there are many complex problems that result

merely from differences among nations in market

structures and procedures, in the relationships between securities markets and the banking system,

and especially in the regulations that govern these

activities.

COMPETITION AND

REGULATION

Many market participants in many countries argue

that these differences in regulatory regimes are best

resolved through deregulation in those countries

with the more regulated markets. Advocates of ‘free

markets,” generally opposed to regulation, use the

threat of international competition to counter any

consideration of regulatory action. They are quick to

argue that additional U.S. regulation or taxation, or

even the maintenance of existing levels of regulation, will “drive the markets overseas.” This

argument may or may not be correct, but it is initially

suspect because for many of those who make it, it is

obviously self-serving. The argument should therefore be closely examined.

Free market advocates assume that trading will

inexorably shift to the least regulated market because it is the least expensive to use, or the “most

efficient.” Regulation can significantly add to the

cost of doing business. Mandated costs appear to

have caused trading to shift at some times in the past.

For example, the Eurobond market developed in

London after a U.S. “interest equalization” tax in

1964 discouraged the issuance of debt in the United

States by foreign borrowers. A significant amount of

trading in German government bonds is said to have

moved to London to avoid tax in Germany. However, many examples of movement off-shore offered

by free market advocates cannot confidently be

attributed to a single simple cause.

The concept of the pull of less regulated markets

is probably too simple for several reasons. First,

active markets have some natural protections. There

is a strong tendency for securities to trade in the most

liquid market, nearly always in the country of origin.

Attempts by a second exchange to compete for

volume trading in an existing heavily traded product

nearly always fail. As noted several times in this

report, this situation may change, especially when

the product is offered in a different time zone. But for

trading to shift to another place, the attracting market

would have to begin with ample depth, i.e., enough

participants at all times to provide liquidity to those

wishing to trade.

The more dubious assumption is that the least

regulated market is necessarily the most efficient

market, or the most attractive market to investors. It

seems likely that some degree of regulation is

desired or even demanded by participants for their

own protection. Beyond this is the question of how

much systemic risk modern industrial nations are

prepared to assume as the price of participation in

world financial markets. Policy concerning financial

institutions and markets has been, in nearly all

countries and at all times, “protectionist,” because

of the concern of national governments about

monetary control, savings, capital formation, and

financial systems. The policy issues related to

globalization of securities trading center on how

much less or how much more protectionist financial

regulatory policy should be in response to technoIGA~ ~~ he Pwt cov~ gwds, nots~ms, SemiW industries ~included for tie f~t time in tie most current round of GA~ negotiations,

but once a general agreement is reached on trade practices in the international services sector, it will still have to be translated into specflc agreements

for different types of services.

–71–
72 ● Trading Around the Clock: Global Securities Markets and Information Technology

logical change and the increasing global mobility of

capital.2

TWO KINDS OF REGULATION

It is important to recognize that there are two quite

different kinds of securities markets regulation.3 The

first, which can be called access regulation, is aimed

at protecting domestic markets and their participants

from outsiders; i.e., restricting access to the market

to maintain the privileges and benefits of “membership in the club.” In recent years major market

nations have reduced these barriers; this has been a

primary thrust of deregulation in the United Kingdom and France, for example, and even in Japan

greater access has been opened for foreigners,

although more slowly.4

The second kind of regulation may be called

“prudential regulation” and is aimed at assuring

investors of fair and equal treatment, by regulating

trading practices, abolishing fixed commissions,

making sure that investors are informed about risks,

and requiring the availability of information about

prices, fees, commissions, and factors influencing

prices. Most governments consider it in the public

interest to maintain markets that are fair and have the

confidence of the public. However, some countries

put much greater emphasis than others do, on

assuring investors of fair and equal treatment. In the

United States, broad participation in securities

markets and stock ownership has been valued as a

way of democratizing the economy, and investor

protection is emphasized. In some countries, there

have never been many “small investors” or household investors, and most market participants are

large institutions, assumed to be able to look after

themselves.

The exposure of stock market fraud over the last

3 years in several countries-the United States,

Japan, France, West Germany, and Canada-has

given rise to demands for new or more seriously

enforced prudential regulation or deregulation.5 West

Germany, Belgium, Spain, Italy, and Ireland have

passed or are considering new laws forbidding

insider trading or providing stiffer penalties. In

Japan, insider training was against the law, but until

recently it was not considered a serious offense.

When detected, offenders might be reprimanded, but

usually not publicly.6 A stricter law has been passed

since the scandals last year, but enforcement is weak.

In the United States, some people who favor

deregulation have suggested that investor protections should now be relaxed because institutional

investors, guided by professional money managers,

need less protection than the traditional small

investor. On the other side, some say that more

regulation may be needed to protect the growing

number of participants in mutual and pension funds

against abuse and mismanagement by fiduciary

agents; and some suggest that deregulation in the

United States has begun to threaten essential investor protections, by subtly shifting to emphasize not

the “small investor” but the “informed investor,”

implying a philosophy of “caveat emptor,” or let

the buyer beware.7

Prudential regulation of markets still differs

widely from country to country.8 Regulatory agencies in some countries approve nearly any new

trading products, such as index futures contracts,

that are proposed by the financial community; other

?llds formulation borrows from a formulation by David D. Hale, Kemper Financial Services Inc., in “How European Economic Integration and

Japanese Capital Power Will Produce Managed Trade in American Financial Services During the 1990’ s,” an ad&ess to the Athens College Alumni

Association Fourth International Economic Conference, 1989. However, Mr. Hale is not responsible for the permutations of his question used in this

chapter.

sMuchof t.hema~in this section~wsonm Gilbert Warren~ “SecuritiesRegulation in the European Communities,’ acontractorx’eport

to the OftIce of Technology Assessment, Aug. 1, 1989.

4- are no barriers to foreign membemh“p onU.S. exchanges other tban the requirement tbat members have anoffke in the United States. In 1977

the NYSE further broadened access to trading by providing for (in addition to the traditional purchase of a “seat”) leasing of seats, electronic access

membershl“ps, andafewphysical access memberships with limited participation on the trading floor without other attributes ofmembership. The National

Association of Securities Dealers has never had barriers to foreign membership. Information provided by the NYSE and NASD.

SFor a brief summary of insider trading rules prior to recent changes see An&ew N. GWS, Jr., “Internationalization of the Securities Trading

Markets,” Houston Journal ofZnternationalbw, vol. 9, No. 1, Autumn 1986, pp. 44-49.

6_We~ermd~WdK@4 “The Stock Market in Japam An@emiewand_ysk, “ Congressional ResearchService ReportforCongress,

Mar. 15, 1988.

70’IA workshop on “The Small Investor,” IWiy 1, 1990.

SW -on ~ws ~vily on ~~z~nts for tie R-don ~d Supervision of Securities ~kets ~ OECD Countries,” in OJ3CD: Finuna”uZ

Market Trendk 41, November 1988. Most of the summary statements below apply therefore to OECD countries, which includes all major markets.
Chapter 6--The Regulation of Global Securities Trading ● 73

countries are more restrictive, on the grounds that

some forms of trading are basically speculative and

may lead to excessive volatility or undermine

confidence in the financial system. Some major

market countries heavily regulate securities underwriters and investment advisers; others require only

that there be disclosure of basic information..

Countries also differ in the degree to which

competition among financial institutions is restricted--

e.g., whether banks can engage in securities underwriting and related activities. Several countries have

recently removed regulatory barriers that formerly

separated banks, thrifts, securities houses, and other

financial companies. In other countries, chiefly the

United States and Japan, there are still some legal

restrictions that may affect the participation of banks

in international securities activities.

These differences result in part from historical

circumstance-the way in which national banking

and payment systems evolved, and when and under

what conditions the existence and importance of

securities markets were first recognized. In part, they

result from differing perspectives on the distinction

between private and public sectors (i.e., how capitalistic or how socialistic an economy is). A third factor

is the constitutional structure of the government: in

federal systems regulatory responsibility may belong either to provincial or central government, or be

dispersed.

BANKING AND SECURITIES

MARKETS9

In most countries, banks are major participants in

securities markets and securities-related activities.

In the United States and Japan, the policy has been

to protect the banking system from security market

risks. Banking and securities activities are separated.

People making bank deposits are assumed to be

trying to safeguard their assets, and are thus given

more protection; their deposits are guaranteed up to

a certain limit by government insurance, and the

types of liabilities that banks may incur are limited.

Those investing in securities knowingly and by

choice assume risks, in return for the opportunity to

profit; they are nevertheless protected to the extent

of seriously enforced laws against fraud and manipulation, requirements that the investors’ risk be

disclosed to them, and insurance protection against

the failure of a securities firm. Separation of banking

and securities activities tends to result in large

independent securities houses such as those in the

United States, Canada, and Japan. OECD analysts

conclude that in such systems there may be greater

acceptance of innovative products than there is in

universal banking countries.10

A universal bank system is more common;

countries with universal banking (which include

Austria, Denmark, Finland, West Germany, Luxembourg, The Netherlands, Norway, Sweden, and

Switzerland) allow banks to engage in the full range

of financial activities.

11 These countries assume that

the risk of financial failure in any one activity is

reduced by the bank engaging in a broad range of

activities-a form of diversification.

A third system allows either banks or brokers to

receive customer orders for securities transactions,

but requires the trading to take place through

independent intermediaries. The activity of dealing

for a proprietary account is separated from the

activity of trading as an agent for customers. This

may constrain the range of services that stockbrokers

offer. This system is used in Belgium, France,

Greece, Ireland, Italy, Portugal, and Spain.

These differences in the securities-related powers

of banks result at the international level in the issue

of national treatment v. reciprocity .12 “National

treatment’ means that a country applies the same set

of requirements and regulations to both domestic

institutions and foreign institutions operating within

its boundaries. In most regards this should provide

a ‘‘level playing field’ and promote competition.

But in the United States, where national laws

%laterial in this section is drawn in part from OECD, op. cit., footnote 8. See also OECD, “International Trade in Services: Securities,” FinunciaZ

Market Trends 37, May 1987; and OECD, ZnternationalTrade in Sem’ces:Banking (I%@ 1988); Bank for International Settlements, RecentInnovations

in International Banking, April 1986; and Banking and Payment Services, materials for an International Symposium sponsored by the Board of

Governors of the Federal Reserve Systeu Washington DC, May 1989.

lOOECD, op. cit., footnote 8, pp. 19-20.

ll~west&rrnany and Austria anyone engaging insecurities trading must obtain a banking license. In the other countries, some fmcialfm which

do not accept deposits maybe licensed to engage in securities activities without banking licenses.

12See OE~, ]nterMtioMl Tr~e in Sewices: Banking, pp. IS-ZO, se ~o An&w T. Hook and M. AIxrto Alvarez, “COXLIpditiOn From Foreign

Banks,” Chapter 10 of Federal Resave Bank of New York NY, Recent Trends in Commercial Bank Profitability, A Staff Study, September 1986.
74 ● Trading Around the Clock: Global Securities Markets and Information Technology

separate banking and securities activities, the banks

of universal-banking countries are prevented from

engaging insecurities-related activities because they

are officially banks. European countries whose

banks are officially excluded in this way could in

theory demand “reciprocity,” or access to U.S.

markets as a condition for allowing U.S. institutions

to participate in their markets. The official U.S.

position13 is that:

The United States considers reciprocity in financial services to be inconsistent with the internationally accepted principles of national treatment and

non-discrimination . . . The national treatment approach used by the U.S. Government in financial

services seeks to ensure that foreign firms in the

United States and U.S. firms in foreign countries are

given “equality of competitive opportunity” with

domestic firms.

The European Community has as one goal of its

“1992 initiative” the establishment of a single

European market in banking and securities activities. The 1992 Initiative originally included a policy

of reciprocity, which has recently been modified.

REGULATORY INSTITUTIONS14

The institutional structures for regulating securities markets differ widely. In universal banking

countries, one regulatory or supervisory agency may

cover all financial activities15; in the United States,

securities markets, futures markets, bond markets,

and banks have different regulators. In some countries, primary supervision over securities trading is

generally carried out by self-regulatory bodies, such

as stock exchanges, under the oversight of a

regulatory agency. This is the case in the United

States, and it is also the case in Finland, West

Germany, and Switzerland, where securities and

banking supervisory functions are not separated. In

countries with a federal structure, primary responsibility for supervising markets may be assigned either

to the national government, as it is in the United

States, or to provincial or state governments, as it is

in Australia, Canada, and West Germany. In the

United States and the United Kingdom, any entity

offering securities or investment services to the

public is regulated, but in some countries such as

Italy and Switzerland, some parties-e. g., over-thecounter dealers-are not covered.

Other differences relate to collective investments

such as mutual funds; there are different prudential

requirements about corporate structure, fees, and

management compensation. The United States has

rigorous prudential requirements; many European

countries are just beginning to develop tougher

requirements after major losses by investors. There

have been some efforts to harmonize standards. The

European Community has just adopted common

standards for mutual funds its member countries.

The differences in accounting practices and standards, and in capital adequacy requirements for

various kinds of financial institutions and market

participants are very important and very difficult to

resolve. Some of these differences were discussed in

chapter 5, on clearing and settlement.

ENFORCEMENT OF SECURITIES

REGULATIONS

As securities trading is further globalized, regulators responsible for investor protection face the

difficulty of supervising activities that flow through

electronic systems and networks across national

boundaries. Currently, the U.S. market regulatory

agencies (the SEC and the CFTC) have limited

authority to assist foreign authorities with investigations of violations of foreign laws from a U.S.

location. When a foreign government needs U.S.

assistance with market investigations, it must ask for

a court order to compel testimony or evidence. But

it is often undesirable to have a public hearing while

an undercover investigation is in progress. A bill

now before Congress, the International Securities

Enforcement Act (H.R. 1396), would strengthen

SEC authority for cooperative enforcement by

increasing its ability to punish brokers, dealers, and

investment advisors for overseas violations, giving

the agency greater discretion over the release of

information, and allowing the agency to accept

reimbursement from foreign securities authorities

for costs of investigations that SEC would conduct

for them.

13h ~sue pap~fiom tie TJ.S. Dep~ent of the Treasury entitled “EC Single Market: Banking and Securities” provided by the ~temational Trade

Administratio~ U.S. Department of Commerce, Aug. 1, 1989.

IAMuch of tie materi~ in this sectiom not otherwise cited, is drawn from OECD, op. cit., footnote 8.

15This includes: Austria, Belgium, Denmar IG Finland, West Germany, Luxembourg, Norway, Portugal, Swedeq and Switzerland.
Chapter 6--The Regulation of Global Securities Trading ● 75

In cases where U.S. markets are abused or

manipulated from overseas, the SEC’s investigative

power is limited when the evidence is located

elsewhere. When the SEC seeks help from a foreign

government, it must make a formal request under the

terms of the Hague Convention or exert pressure on

U.S. branches of overseas financial institutions. The

SEC has been required to go through long negotiations or court proceedings to obtain information

about transactions through foreign banks or securities houses. As Charles Cox, a former SEC commissioner, explained:

All nations with securities markets may face the

dilemma of deciding whether to protect their markets

from foreign-based fraud, or to live with markets

where some participants can defraud others with

impunity. . . . The acceptable alternative is to develop ways of sharing surveillance and investigative

information, and to formalize these arrangements in

bilateral or multilateral understandings.16

Formal agreements have not been completely

effective. In spite of the Hague Evidence Convention some nations refuse to disclose information, and

the legal mechanism of letters rogatory have been

inadequate for gathering evidence for litigation.17

While the United States accepts the idea of government access to financial data for the purpose of

enforcing securities laws, some nations view this as

a violation of confidentiality and may have secrecy

or blocking statutes that forbid the release of such

information.18 Secrecy laws recognize confidentiality as a fundamental right and forbid any disclosure

of a customer’s financial information, including

business records and accounts, without personal

permission. Blocking laws protect national rather

than individual interests, and are intended to prevent

the disclosure of information by citizens as parties to

foreign litigation, or to prevent any foreign government from conducting investigations and imposing

its policies within their borders, as an invasion of

sovereignty.19

In 1985, the SEC proposed the idea of “a waiver

by conduct,” meaning that anyone who traded in

U.S. markets would be held legally to have waived

the right to prevent the SEC from investigating. But

the concept was widely viewed as politically unacceptable because it infringed on the sovereignty of

foreign governments and created tension with friendly

nations.

To encourage cooperation from other nations, the

SEC is seeking legislation to authorize it to issue

subpoenas and take dispositions in this country on

behalf of foreign securities regulators or law enforcers. 20 It also wants the power to bar from U.S.

securities markets people who have been convicted

in foreign courts of certain financial abuses. This,

however, raises questions of legal rights or justice,

because foreign governments may lack safeguards

which are considered essential in the United States

for those accused of crimes, or may have very

different standards of proof.

HARMONIZATION

Many people argue that a worldwide securities

regulatory body is needed, but others believe that a

broadly multinational institution with strong authority is not feasible, at least at present. They look to a

less drastic solution: “harmonizing” regulation by

reducing the differences (or the effect of differences)

in national regulatory regimes.

Harmonization is the process of reducing regulatory disparities among mutually accessible markets,

through the development of common or mutually

compatible regulatory regimes, standards, and practices.21 Advocates hope that harmonization would

lessen the threat of “regulatory arbitrage,” or

allowing competition among national securities

markets to force prudential regulation down to the

lowest common denominator. Critics fear that harmonization could raise the threat of “regulatory

imperialism” in which less regulated markets are

Iwles COX, “Transactions: Blocking the Success of Market Links,” Maryland Journal ofInternational Labor and Trade, vol. 11, 1987, p. 215.

l~id., p. 217.

lsB~onBecker~Tho~ Etter(Securities and ExchangeCommis sion), “JnternationalClearanc eand Settlemen6° 16 BrookZynJ. 271,292-293,

1988.

WA SEC ~v=tig~on of ~spiciow ties o~x ~ fom~ cow~es indica~ tit some U.S. ad foreign investors avoid SEC surveillance

by executing transactions through financial institutions in countries with secrecy and blocking laws. “Problems With the SEC’s Enforcement of U.S.

Securities Laws in Cases Involving Suspicious Trades Originating Abroz@” House Report 100-1065, Oct. 6, 1988.

20H.R. 13%, The International Securities Enforcement Act, now before the Senate.

21W-mop. cit., footnok 3. S* W ~er, “Re@@S F

inancial Services in the Unite dKingdom-AnAmerican Perspective,” 44 Buw”ness Luw

323, 1989; and Bernard, “The United Kingdom Financial Services M 1985: A New Regulatory Framework” 21 InternationaZLuw 3431987.
76 ● Trading Around the Clock: Global Securities Markets and Information Technology

forced to become more regulated. Pessimists fear

that the effort to achieve harmonization may itself

become a form of regulatory arbitrage.

The term “harmonization” itself has in this way

become controversial, and because it is controversial

it has become difficult to define. Different stakeholders, or interest groups, tend to define the term in

ways that imply different objectives as well as

different approaches. It is necessary to recognize, at

least, that harmonization allows for two approaches.

The first, “commonality,” means the development

of uniform international rules, such as uniform

disclosure requirements, enforced in all countries.

The second, sometimes called “reciprocity” or

“comparability,’ calls only for substantially equivalent minimum standards.

The North American Securities Administrators

Association (NASAA) recently urged the creation of

global minimum standards of investor protection;

this is a commonality approach to harmonization.

The International Organization of Securities Commissions (IOSCO)22 is attempting to develop disclosure requirements for multi-jurisdictional securities

offerings. IOSCO is also working with the International Accounting Standards Committee to develop

common accounting rules and standards. Other

international securities organizations working toward commonality, or universal standards, are listed

in box 6-A.

The SEC and Canadian provincial regulatory

authorities have proposed reciprocal recognition of

prospectuses in connection with certain types of

offerings from specific kinds of issuers; the requirements for these perspectuses, although not identical

in the several jurisdictions, show ‘substantial equivalence.” This is the comparability approach. The

approach of the European Community, in attempting

to harmonize securities market regulation among its

members, has shifted pragmatically from commonality to comparability.

“Substantially equivalent rules” could be sought

on a global basis either gradually through a multinational forum or program, or through a series of

informal arrangements. Informal arrangements in

the past have not been very effective. The International Association of Securities Commissions has an

organized program for exchange of information, but

the meetings have had little impact.23 Bilateral

agreements through non-binding memoranda of

understanding (MOUs) have been somewhat more

successful. They provide flexibility for regulators to

work out techniques of securities enforcement in a

reamer consistent with domestic law, taking account of differing legal systems and culture rather

than demanding complete uniformity. They may

reduce the need for case-by-case negotiation that can

deplete regulatory resources and cause nearly endless delays, but they are a clumsy solution; each

country could find itself with many MOUs that are

different from one another. The SEC has MOUs with

Canada, the United Kingdom, and Switzerland. The

CFTC is party to MOUs with the United Kingdom

and has arrangements with Australia, Canada, and

Singapore for sharing information from monitoring

and surveillance activities.

The risk with a policy of reciprocity with substantial equivalence is that countries with the most

stringent regulations will be led to interpret “substantial equivalence’ too broadly. They may begin

to interpret their own rules more loosely and enforce

them more slackly, in order to attract or retain

foreign investment in the face of competition from

countries with less prudential regulation. Then

domestic firms will demand regulatory parity in

order to compete with foreign fins, and this

becomes a form of prudential deregulation through

leveling downward--i.e., another form of regulatory

arbitrage.

Many market participants and many regulators,

although eager to engage in international trading of

securities and derivative products, are critical of the

objective of harmonization. For example, in the

United States, CommissionerAlbrecht, of the CFTC,

recently told a public meeting that:24

Unfortunately, harmonization is a word that those

of us at the Commodity Futures Trading Commission, as well as many in the futures industry, have

come to view with a great deal of suspicion. . . . At

~OSCO includes securities regulators from more than 40 countries.

~B~ker ., and Etter, op. cit., footnote 18; - Note (Needham), “Insidex Trading Liability,” 16 Brooklyn J. 357,381-385, 1988.

MWMXUP. ~br~ht, “mo-htamtio~ Re@tion of Futures and Options Ivlmketa,” a Speech to the Conference on Futures nd @tiom

Markets in the 1990’s-Innovatio~ Regulation and Jurisdictio~ co-sponsoredby the Commodity Futures Trading Commission and the Futures Industry

Institute, Washington DC, May 2, 1990$
...—— - —

Chapter 6--The Regulation of Global Securities Trading ● 77

Box 6-A--International Organizations Related to Coordination of Securities Regulation

The International Organization of Securities Commissions (IOSCO)

Membership: Securities Regulators from about 40 countries. (SEC is the principle U.S. representative with CFTC

as an associate member.)

Aims: Coordination, exchange of information, mutual assistance related to standards and surveillance.

Mechanism: Technical committee and working groups on multinational equity offerings, accounting and auditing

standards, capital requirements and financial ’data, enforcement information exchange, off-market trading, clearing

and settlement, futures markets.

Federation Internationale Des Bourses de Valeurs (FIBV)

Membership: 33 stock exchanges.

Aims: To facilitate exchange of information. Recently concentrating on clearing and settlement, disclosure

requirements, listing procedures.

Mechanism: voluntary information exchange.

Group of Thirty

Also called The Consultative Group on Economic and Monetary Affairs.

Membership: 30 individuals from world-class banks, multinational corporations, government agencies, and

academia.

Aims: To increase policymakers understanding of international economic and financial issues and explore the

international effects of public and private decisions.

Mechanism: Ad hoc committees.

Organization for Economic Cooperation and Development (OECD)

Membership: 24 developed nations. Representation by ambassadors and at selected meetings by cabinet-level

officials.

Aims: Encouragement of economic growth, expansion of world trade. Looks at securities coordination in terms

of international flow of travel.

Mechanism: Permanent research staff, participation of ministers with authority over securities and other financial

institutions.

International Councils of Securities Dealers and Self-Regulatory Associations

Membership: Formed in 1988, membership includes four SROs (Canada, Japan, the United Kingdom, the United

States) and three Securities Dealers Associations (Canada, Japan, the United States).

Aims: To aid and encourage the sound growth of the international securities markets by promoting and

encouraging harmonization in the procedures and effective regulation of those markets, thereby facilitating

international securities transactions and by promoting mutual understanding and the sharing of information among

the members.

the international level, some calls for harmonization tions of foreign firms as they would those carried out

should also be viewed with suspicion. by domestic firms; mutual recognition means that a

country would allow foreign entities to operate

Commissioner Albrecht called on governments to within its jurisdiction as long as they complied with

. . recognize the importance of relying on market the regulations of their country of origin and “as

forces, saying “Competition is the best harmonizer, long as the rules of the firm’s country of origin are

the best regulator of market forces.” Commissioner comparable to our own. ’ However, the CFTC

Albrecht said that with regard to cross-national participates in international discussions and negotiatrading, “the CFTC favors a policy combining tions related to harmonization.

national treatment with mutual recognition,’ and he

defined the two terms as follows: national treatment The SEC has indicated a somewhat different

requires authorities in each country to treat opera- approach, saying that an effective regulatory struc-
78 ● Trading Around the Clock: Global Securities Markets and Information Technology

ture for an international securities market must

include:

●

●

●

efficient structures for quotation, price, and

volume information dissemination, order routing, order execution, clearance, settlement, and

payment, as well as strong capital adequacy

standards;

sound disclosure systems, including accounting principles, auditing standards, etc.; and

fair and honest markets, through investor protection legislation, surveillance, and enforcement cooperation.=

At the end of 1989, the SEC signaled its intention

of encouraging international cooperation in regulatory affairs by creating an Office of International

Affairs that will report directly to the chairman of the

Commission. The office is to set up informationsharing agreements with other countries and direct

cooperative enforcement efforts. The CFTC also

actively participates in many international regulatory cooperative activities.

Many countries are now reviewing their regulatory frameworks in response to the internationalization of markets. According to OECD:

There is increasing awareness that securities

market activities involve risks that are comparable to

the systemic risks inherent in banking, and that,

accordingly, the basic question arises as to what

extent existing regulatory and supervisory arrangements are adequate to deal with current market

realities. 27

The EC’s 1992 initiative (see ch. 4) provides an

example of how harmonization could be achieved

among major market nations, given sufficient incentive and leadership. If successful, the EC initiative

may stimulate further action toward broad multinational cooperation. The 1992 directives are aims, not

yet achievements, but enough has been done toward

integrating European markets to make it likely that

the EC will become a significant factor in international securities trading.

AMERICAN LEADERSHIP

It seems reasonable to conclude that the United

States now has, in the aggregate, the largest and most

liquid securities market and futures market in the

world, and possibly the most efficient, innovative,

and fair markets in the world—although there are

certainly challenges on several of these fronts.

Assuming that Congress believes that it is in the

public interest to maintain this position, what must

be done to assure our competitive position, while

safeguarding the interests of U.S. investors, financial institutions, and most importantly, the public at

large?

A number of international cooperative efforts are

underway to achieve harmonization of regulation.

The problem for policymakers is how to be sure that

the United States encourages this movement and

provides leadership for it, without becoming a

victim of “regulatory arbitrage” in which countries

with much lower levels of prudential regulation set

the norms. This calls for coherent and consistent

policy positions that American negotiators can

present and defend.

One need is to prevent the erosion of the

framework of prudential regulation that Congress

has erected since 1934, as an unintended byproduct

of the effort to achieve harmonization. The second

need is to clarify and reassert congressional guidance over the evolutionary development of securities markets as they face the challenge of global

trading. There may be differences between the two

U.S. regulatory agencies in their approaches to

international regulatory harmonization that could

confuse and hamper American leadership in defining a desirable regime for global securities trading.

A statement of policy similar to that underlying the

Securities Act Amendments of 1975 maybe needed.

This implies something of a dilemma for U.S.

policymakers. A general trend toward deregulation

and non-intervention has been apparent in the

United States as well as in other countries, during the

1980s. On the other hand, the United States sees

many of the advantages of its chief competitor,

Japan, as resting on the close relationship between

financial institutions, industry, and government, so

that Japanese investment banks operate in a market

guided and insured by the government. There is

legitimate concern that unnecessary regulation might

interfere with the ability of exchanges, over-the-

~C~R@ation of~~rmtio~ s~~ti~ ~kets, ” Policy Statement of the United States Securities and fictinge CO* sion, Washington DC,

November 1988.

~OECD, Op. cit., footnote 8, p. 31.
Chapter 6--The Regulation of Global Securities Trading ● 79

counter markets, and financial information systems

developers to experiment and innovate. There is fear

that excessive regulation might make markets less

efficient and drive trading to overseas exchanges.

There are also encouraging signs that some U.S.

markets are prepared to take a lead in developing the

technology and institutional mechanisms for global

trading; in this regard the futures markets are far

ahead of the stock exchanges.

Large institutional investors want greater transaction speed, mobility, and opportunities for diversification, and there are already strong indications that

they will seek more freedom from the clock than the

traditional exchange trading hours and floor mechanisms can accommodate. U.S. stock exchanges are

so far slow to show any interest in adopting

automated trading systems that bypass or compete

with traditional dealer intermediaries or that operate

around the clock.28 U.S. regulators may need to

actively encourage market officials to take a longterm view of market development, and U.S. regulators themselves may have to be encouraged to do so

by the U.S. Congress.

~A forthcoming OTA report, Electronic Bulls and Beardecun”ties Markets andhtfonnation Technology, ~cusses tiese issu~.
Appendix

Clearing and Settlement in Major Market Countriesl

Clearing and Settlement in the United States

Three clearinghouses and three depositories serve the

Nation’s 7 stock exchanges, NASDAQ, and other over-thecounter dealers; 9 clearinghouses serve the 14 futures

exchanges; and 1 clearinghouse serves all the equities

options markets.2 The major clearing members, who also

clear for non-clearing members of a clearinghouse, tend

to be highly automated for lower costs and greater

operating efficiency. For safety purposes, U.S. clearinghouses also tend to be financially structured such that a

failing clearing member can be isolated quickly and its

problems resolved without a ripple effect.

While arrangements between clearinghouses and their

clearing firms vary, the general goal is that the clearinghouse maintain adequate resources and commitments to

assure settlement if a clearing firm or its non-clearing firm

customer defaults. These include capital requirements for

members, claims on items in process, if any, as well as

claims on the defaulting member’s remaining assets on

deposit with the clearinghouse (e.g., cash, letters of credit,

Treasuries, or securities posted as collateral for margin).

The clearinghouse also has claims on other assets of the

failed clearing member. The clearinghouse’s guarantee

fired is another resource. Finally, the clearinghouse can

make assessments against other clearing member firms.

This succession of fallbacks is a buffer against shocks

ranging from sudden large drops in the prices of securities

and futures to defaults by members. As a result, there have

been few cases of a failure of a clearing member in the

United States, and no instances of a failure of a

clearinghouse. 3

Equities Clearing Organizations

The National Securities Clearing Corp.--NSCC processes 95 percent of all equities trades in the United States.

It is jointly owned by the principal equities markets: the

New York Stock Exchange (NYSE), American Stock

Exchange (AMEX), and National Association of Securities Dealers (NASD). It serves 1,800 brokers, dealers,

banks, and other financial institutions, through about 400

direct participants.

NSCCsS clearance and settlement process normally

requires five business days. Trade information is received

either in the form of locked-in trades already matched by

the computer systems of the exchange or market; or, as

buy and sell data reported by market participants. The

latter still must be compared and buy and sell orders

matched. Locked-in trades are entered directly in the

NSCC computer system on the same day as the trade. This

sharply reduces the need for the matching of buy and sell

orders at the clearinghouse level. On a typical day, about

75 percent of the trades on the NYSE are locked-in (a

smaller proportion by dollar value).4 Figures A-1 and A-2

illustrate the steps in the NSCC's clearing and settlement

of retail and institutional customers’ trades, respectively.

Securities which are held for NSCC members by The

Depository Trust Co. (DTC), and whose ownership can

therefore be transferred within DTC via its computer

book-entry system, are also eligible for settlement

through the Continuous Net Settlement (CNS) computer

system. This includes the preponderance of trades settled

through the NSCC. NSCC becomes the counterpart to

each trade; it guarantees that the settlement obligations of

the trade will be met—both the obligation to deliver

securities and the obligation to make payment. For

locked-in trades, NSCC’s guarantee takes effect at

midnight on the day (T+l) that the counterparties to the

trade have been notified that the trades matched.

Trades that do not match begin a reconciliation process

that is being shortened and by the end of 1990 will occur

on the day following the trade (T+l). Those that remain

unmatched by T+3 are returned to their originating

marketplace for face-to-face negotiation. With the increasing number of trades locked-in at the marketplaces,

and with the availability of on-line reconciliation systems

at these marketplaces, the need for this process is being

eliminated.

l~pmp~ ~apP~ OTA brefi~ heavily on a contractor report by B@era Trust CO., “Study of International Clearing and Settlement”

vols. I-V, contractorreportprepaxed for the Offkeof Technology Assessmen~ October 1989, to whichmanydozens of institutions and individuals around

the world contributed expert papers and/or served on the Bankers Trust advisory panel. OTA has also used the discussions of an expert worbhop held

at OTA on Aug. 22, 1989.

*or information on the clearing and settlement of U.S. Treasury and government agency securities, mortgagdacked securities, and municipal

securities, see Bankers Trust Repo~ op. cit., footnote 1.

3@e ~~not= ~tthe o~y si~ationhe cmen~sion inwhichthe the Natio~ Securities Clxcorp. (whichcl~ the vut majority of Wuitb

trades ~ the United States) could fai~ would require a major external triggering event, such as the collapse of one or more major U.S. banks causing

the failure of one or more NSCC clearing banks or major clearing members. (Robert Woldow, NSCC, at a meeting of experta on clearing and settlemen~

OTA, Aug. 22, 1989.) The events of October 1987 in the United States-when the payment system began to become clogged-were perceived as

potentially disastrous.

4S~ce Auust 1989, the NSCC &gm c~p~ ~des tit~ not locked-in during the ~ly morning hours C)f T+l.

-81–
82 ● Trading Around the Clock: Global Securities Markets and Information Technology

Figure A-l-Clearance and Settlement of Retail Customer Trades

[ STEP I. TRADE DATE (T)

MARKETPLACES

Order (I) Execute (2)

SELLING + SELLING +

Retail 1 Broker I

I Customer 1 IA I

I Execute (2) Order (1)

1 + BUYING ] 4- 1 BUYING ]

I —

I t i I , r ~ - l

A

-- L.----J + I

Confirm (3) Trade Trade

Details (4) Details

1 ~ CLEARING

I CORPORATION

I

STEP 2. TRADE DATE + 1 ( T + 1 )]

[ SELLING

L

Retail

Customer

A

SELLING (

Broker

A I

I

L-_---J-l B

Confirm (3)

(4)

Results I I I

I Results

of

w

(5) + CLEARING

k

+ ( 5 ) of

Comparison CORPORATION Comparison

I

(Trade Comparison) I

]STEP 3. TRADE DATE +4 (T+4 )

r

SELLING

Retail

Customer ‘::::’ b m :

~

~ r

1 CLEARING

CORPORATION

(Trade Netting and Issuance of

Receive/Deliver Obligations)

(6)

1 1 B J

(1) Retail Customers give orders to buy and sell stock to their respective Brokers,

(2) Brokers execute Retail Customers orders in the Marketplaces.

(3) Brokers confirm back to their respective Retail Customers that the trades were executed.

(4) Brokers submit details of trades executed in the Marketplaces to the Clearing Corporation.

(5) Clearing Corporation generates reports back to the Brokers indicating the results of comparison.

(6) Clearing Corporation nets the trades.

(7) Clearing Corporation issues projection reports indicating net

SOURCE: NSCC, 1990.

receive/deliver obligations to the buying and selling Brokers,
Appendix--Clearing and Settlement in Major Market Countries . 83

Figure A-l-Clearance and Settlement of Retail Customer Trades-Continued

[STEP 4. TRADE DATE + 5 (T+ 5 } ]

(8)

SELLING Shares SELLING

(13)

BUYING 1Shares BUYING

Broker Retail

B Customer

(9) (12)

Shares CLEARING Shares

CORPORATION

i

t

Instructions +(lOa) (1 la)

SELLING BUYING

Broker A Acct CLEARING CORPORATION ACCOUNT Broker B Acct

Ishares (10b)! shares +[11b ) \ shares I

I DEPOSITOR Y I

(16)

SELLING Money SELLING

Retail Broker

L.YI.- I

Aw

(14)

BUYING Money BUYING

Broker Retail

Money Money

(Money Settlement)

(8) Selling Retail Customer A gives shares to selling Broker A to satisfy delivery obligation.

(9) Selling Broker A deposits selling Customer A’s shares in its account at the Depository.

(lOa) Clearing Corporation instructs Depository to debit selling Broker A’s account and credit Clearing Corporation’s account with the shares;

(lOb) Depository debits selling Broker A’s account with the shares and credits Clearing Corporation’s account.

(1 la) Clearing Corporation instructs Depository to debit Clearing Corporation’s account and credit buying Broker B’s account with the shares;

(1 lb) Depository debits the Clearing Corporation’s account with the shares and credits buying Broker B’s account.

(12) Buying Broker B requests withdrawal of shares from its account at the Depository In order to deliver to Retail Customer B,

(13) Buying Broker B delivers the shares to its buying Retail Customer B.

(14) Buying Retail Customer B pays buying Broker B for shares received.

(15a) Clearing Corporation advises buying Broker B of net pay amount for shares received;

Buying Broker B delivers a check to Clearing Corporation for the requested amount,

(15b) Clearing Corporation advises selling Broker A of net collect amount for shares delivered;

Clearing Corporation issues check to selling Broker A for the specified amount.

(16) Selling Broker A pays selling Retail Customer A for shares delivered.

SOURCE: NSCC, 1990.
84 ● Trading Around the Clock: Global Securities Markets and Information Technology

Figure A-2-Clearance and Settlement of Institutional Customer Trades

STEP 1 ––—– TRADE DATE ( T )“-’

MARKETPLACES

— –T–

Execufe (2) I

I

Execute(2)

+—–—– . L + -

[ S ELLIN G

{ Order I SELLING–

Instltut!onal

J

Broker

Customer -1 ~

A L- ——.—J

BUYING 4 {Order BUYING -

Institutional

(1) Customer

B

Broker

0

Trade 1 Trade

Details (3 )

I

Details (3)

~’–—- l

CLEARING

CORPORATION

. . ———————- _. .-. . ,

STEP 2 – – TRADE DATE + 1 ( T + 1 ) ,

(6)

‘SELLING - I ID SELLING ]

(6)

1

-

- BUYING j ID BUYING

Institutional

Customer

B

Broker Confirmation

B +

Institutlonal I Confirmation

Customer I ~ ‘

-

A

[

Broker I

A ,

-.J

‘+ (4)

I Results of CLEARING

Comparison CORPORATION

(Trade Comparison)

I Results of I

{

Comparison

ID , ~ ID

Confirmation

(5) ‘ + +

Confirmation

(s)

SELLING I

Broker B I Bank B

Account ( Account

I

Broker A

Account I Accoun t

1 DEPOSITOR Y

ISTEP 3. TRADE DATE + 3 ( T + 3 ) OR TRADE DATE + 4 ( T + 4 ) —~

— —

..— —

(7b)

SELLING Institutional:= ID Affirm;:.

~ —

Customer +

A I

(8b) ~-.%–

BUYING ID r-BUYING

Broker Broker Affirm

+ “[-- -

Institutional

A B Customer

.-;–_ .

CLEARING

CORPORATION

(7a)

[ ID

i Affirm

[8a)

ID

Affirm I

I

\ CUSTODIAN I SELLING I CLEARING CORPORATION ACCOUNT BUYING CUSTODIAN ]

~ - Bank A Account I BrokerA Broker B Bank B

F

+ J

] Account Account Account

F-”-””- L - L–-.—_ . . . ..—

DEPOSITOR:::-:--”- Y 5

Instltutlonal Customers give orders to buy and sell stock to their respective Brokers

Brokers execute Instltutlonal Customers orders In the Marketplaces

Brokers submit details of trades executed m the Marketplaces to the Clearing Corporation

Clearing Corporation generates reports back to the Brokers indicatlng the results of comparison

Brokers send ID confirmation to the Custodian Banks of their Customers

Brokers send ID confirmation to their respective Institutional Customers

Selling Instltutlonal Customer A sends ID affirmation to Custodian Bank A to deliver securities on settlement day (T+5) to Its’ Broker (A)

Selling Instltutlonal Customer A sends 1D affirmatlon to selling Broker A indicating that Custodian Bank A WIII deliver

the securities to it on settlement day

(1)

(2)

(3)

(4)

(5)

(6)

(7a)

(7b)

(8a) Buying Instltutional Customer B sends ID affirmation to Custodian Bank B, notifylng it to receive securities on settlement day from its’ Broker (B)

(8b) Buying Institutional Customer B sends ID affirmation to Broker B, instructing it to deliver securities to its’ Custodian Bank (B)

on settlement day

SOURCE: NSCC, 1990.
Appendix--Clearing and Settlement in Major Market Countries . 85

Figure A-2-Clearance and Settlement of Institutional Customer Trades-Continued

ISTEP 4. TRADE DATE + 4 ( T + 4)]

Selling Instit. Customer

r SELLING

Broker A

I A I

I 1 — ~

‘STEP 5. TRADE DATE + 5 ( T + 5 ) J

SELLING - SELLING

Institutional I Broker

Customer A

A d

I CUSTODIAN I SELLING

I

Bank A I Broker A

Account I Account

I shares I shares -

I (11 ) (12b)

CLEARING

CORPORATION

(Trade Netting and Issuance of

Receive/Deliver Obligations)

(9)

+ BUYING 1 BUYING

CLEARING

CORPORATION

—

(12a) (13a)

Instructions ~+

I

CLEARING CORPORATION ACCOUNT

I BUYING

Broker

B I

I

— .

I BUYING –

I

Institutlonal

Customer I

B ’

.

(13b)

DEPOSITOR Y

lSTEP 6. TRADE DATE+ 5 (T+5) 1 e

~D•Œ ‘

b

’’gat’ie !

I CORPORATION~

1’ I (Money Settlement) I ‘ 1

I

I CUSTODIAN I

I SELLING CLEARING CORPORATION ACCOUNT BUYING I CUSTODIAN I

(9) CIearlng Corporation

-IJ::E

nets the trades 2

(10) Clearing Corporation issues projection reports Indlcatlng net receive/delwer obligations to the buying and selling Brokers.

(11) Custodian Bank A instructs Depository to transfer shares from its account to selling Broker A’s account,

Depository debits Custodian Bank A’s account and credits selling Broker A’s account with the shares

(1 2a) Clearing Corporation Instructs Depository 10 debit selling Broker A’s account and credit its’ account,

(12b) Depository debits selling Broker A’s account and credits Clearing Corporation’s account with the shares

(13a) clearing corporation instructs Depository to debit Shares from its account and credit shares to buying Broker B’s account,

(13b) Depository debits Clearing Corporation’s account with the shares and credits buying Broker B’s account

(14) Buying Broker B instructs Depository to transfer shares from its account to Custodian Bank B’s account,

Depository debits Broker B’s account and credits Custodian Bank B’s account with the shares

(15) Custodian Bank B pays buying Broker B for shares received

(16) Monies from Custodian Bank B to Broker B are used by Broker B to meet Its settlement obligation to the Clearlng Corporation

(17) Clearlng Corporation receives rnonies from Broker B and pays to Broker A

(18) Monies from Clearlng Corporation to Broker A are used by Broker A to meet Its payment obligatlon to Custodian Bank A

SOURCE: NSCC, 1990.

El

BUYING

Institutional

Customer

B
86 ● Trading Around the Clock: Global Securities Markets and Information Technology

Using the CNS system, the NSCC calculates each day

a net long or short securities position for each CNSeligible security that was traded by the clearing member

on that day. The number of settlement transactions and the

gross amount of the clearing member’s obligation either

to deliver securities or to make payment is adjusted by the

amount of any securities or payments that it would receive

as a result of other trades of the same security. This type

of calculation process is known as netting. It reduces the

total number of securities to be delivered or received, and

the number and size of aggregate cash payments. As a

result of this process of offsetting obligations, the NSCC

estimates that movement of about five-sixths of the total

daily transactional volume of owed securities and cash

payments otherwise required on the settlement date is

eliminated. Netting may indirectly increase market liquidity by reducing the gross amount of funds necessary to

meet settlement obligations. After netting through CNS,

the NSCC then informs the DTC of the net amount that

each counterpart owes in securities on the settlement

date, T+5. The DTC, using its book entry system, records

the transfer of ownership by debiting the securities

account of the delivering counterpart and crediting the

account of the receiving counterparty.6 Payment on the

settlement date is in the form of a certified check, payable

to the NSCC. When settlement cannot be made on ‘the

settlement date-e. g., when the securities are not available in the participant’s DTC account-these obligations

remain in the CNS system and are carried forward and

netted with the next day’s obligations.

Securities that are not eligible for the CNS system may

be settled either through balance order accounting or on

a trade-for-trade basis. These other forms of settlement

comprise a very small percentage of trades settled through

NSCC.

In 1989, the fail rate-the percentage of trades which

do not settle on the settlement date-in trades cleared

through CNS was 8.13 percent of the total net dollar value

of cash and securities due on the settlement date. Since the

NSCC takes the counterpart position and guarantees the

settlement of all CNS-matched trades, NSCC is exposed

to various credit, market, and non-market risks.7 The ways

in which clearinghouses protect themselves against such

risks are critically important.

NSCC protects against credit risk, first of all, by

retaining a lien over securities which the receiving

participant has not paid for. For trades not settled by T+5,

NSCC uses a mark-to-market procedure to limit its

market risk until settlement does occur. Market risk is

kept to l-day’s market movement by adjusting members’

settlement obligations to current market prices. Members

pay or are paid at settlement based on the current value of

their open positions on and after T+5, rather than their

value when they made the trade. In the interim, until the

position settles, members pay or receive the net difference

in market price movement. NSCC’s guarantee fund for

CNS takes account of potentially adverse movements on

trades which have not settled before T+5. It is based on the

total size of all positions open. These include those

pending (before settlement); trades settling on T+5; and

trades for which T+5 has passed and settlement has not

occurred. In addition, a percentage of the market value of

securities for next-day (T+l) delivery must be deposited

in order to protect the NSCC in the event the member

defaults. This calculation is done daily for all members

and can be collected more frequently than the monthly

norm. All NSCC clearing members are required to

contribute to the guarantee fund. NSCC’s total funds on

deposit, not including lines of credit, totaled over $400

million in 1989 and 1990.

The NSCC also maintains a full compliancemonitoring system to ensure its continuing ability to

judge the creditworthiness of its participants.8 It shares

risk information with other SEC-registered clearinghouses, both through the SEC’s Monitoring Coordination

Group and the Securities Clearing Group. NSCC and a

number of futures clearinghouses are now discussing

proposals for increasing the sharing of risk information;

e.g., data on market participants’ holdings on various

exchanges.

The NSCC is linked to its clearing members by means

of the Securities Industry Automation Corp. (SIAC),

which operates NSCC’s technology base. Most participants now have direct computer links; only about 1

percent of the full-service members continue to report

trades via computer tape.

All payments to NSCC are on a net basis; i.e., the

NSCC calculates each clearing member’s total credit and

5This appendix tiscussesinterdealer and institutional (street-side) settlement only. Concerning depository functions, a broker cm make *1’f.lement

with his institutional customer through DTC’S ID program. A description of customer (retail) settlement is provided by the Securities and Exchange

Commission in vol. II of the OTA contractor report: Bankers Trust, op. cit., footnote 1.

GStock held by DTC is in nominee name and appears on the books of the transfer agent of the issuing company. h a typical -reaction, the -=

agent would not be involvedin the change of ownership. The change in ownership between the parties to the transaction would occur solely on the books

of DTC. If, however, a broker or his customer wishes to have the shares registered in his own name, he instructs DTC to send the appropriate quantities

of stock currently in street name, to the transfer agen~ who would then send the reregistered shares directly to the broker.

7C~t risk refers to the possibility that a p@cipz@ might not pay for or deliver securities. Market risk reftXS to tie priCe Cqes of the -v.

Non-market risks include loss of dq human error, systems failure, or any breakdown caused by any factor other than creditor market factors.

8NSCCJS STARS system monitom project~ settkrnent exposures from the time trades are matched until they are titimatelysetfl~. NSCC also

employs a series of exception reporting mechanisms to detect security concentratio~ settlement pattern changes, and security price changes.
Appendix--Clearing and Settlement in Major Market Countries ● 87

debit positions and nets to a single figure that is either

owed to NSCC or is owed by NSCC. Payment to NSCC

is by certified check. Funds are concentrated in one

central clearing bank. If a certified check is not received

on the settlement date, then payment via FedWire is

required the next morning. NSCC pays selling members

with regular bank checks, but intends to move towards the

increased use of electronic payments as one way to

improve the settlement process.

The International Securities Clearing Corp.—ISCC

is a subsidiary of the NSCC and is an SEC-registered

clearinghouse. It was founded in 1985 to assist in clearing

and settlement and to provide custody services for

securities traded among American brokers and banks and

their counterparties across national borders. It has links

with clearinghouses and depositories in foreign markets,9

including:

●

●

●

●

the International Stock Exchange (ISE), in London;

the Centrale de Livraison de Valeurs Mobilieres

(CEDEL), in Luxembourg;

20 depositories and custodians in Europe and Asia,

indirectly linked by means of a conduit provided by

CEDEL;

the Japan Securities Clearing Corp. (JSCC), the

Tokyo Stock Exchange’s clearing and custody

organization;

the Central Depository subsidiary of the Stock

Exchange of Singapore; and

the Canadian Depository for Securities (CDS), in

Toronto, linked through NSCC.

ISCC also serves as the clearing system for the NASD’s

PORTAL market for foreign private placements exempt

from SEC registration by virtue of Rule 144A. (See ch. 3.)

Futures Clearing Organizations10

The Board of Trade Clearing Corp.—The Chicago

Board of Trade (CBOT), which handles the greatest

volume of futures contracts trades in the United States,

has its own separately incorporated clearinghouse, the

Board of Trade Clearing Corp. (BOTCC). With approximately 139 clearing members, the BOTCC is by far the

largest clearing organization serving the futures markets.

The Chicago Mercantile Exchange (CME) is the largest

U.S. futures exchange when measured by another yardstick, the average total value of open futures and options

on futures contracts. CME has a Clearinghouse Division.

This system and other U.S. futures clearinghouses, are

similar (although not identical) to that at the BOTCC.ll

BOTCC has an on-line trade entry/trade capture system

that allows it to receive over 75 percent of its trade

information through on-line terminals (with the user

keying in data). The remaining 25 percent of trade

information is reported by means of computer-tocomputer transmissions. In addition, members of the

BOTCC that are also members of the CME may use the

BOTCC’s on-line trade entry/trade capture technology to

send trade information to the CME. About 20 percent of

the CME’s trade information arrives at the CME clearinghouse through the BOTCC trade entry/trade capture

technology.

Once a trade has been captured, BOTCC employs a

two-sided matching system in which both the buy and sell

sides of a trade are submitted to the trade comparison

system for matching. This capability provides the benefits

of comparisons on the day of the trade, and a match by

broker and by counterbroker as well as a match within the

clearinghouse. This is the standard for futures markets in

the United States, except for the New York Mercantile

Exchange (NYMEX), which uses a one-sided trade

matching system, in which ‘‘sell’ information is put into

the system and the clearing member with the “buy”

information must confirm the data at a later time.

BOTCC’s guarantee to clearing members that the

settlement obligations of the trade will be met begins at

the moment a trade has been matched and registered. At

that time, typically about 1 hour after the final trade

submission, the clearinghouse becomes counterpart and

guarantor to every trade.

In all U.S. futures markets, both buyer and seller make

a good faith deposit to the clearing member firm; this is

‘‘original margin. "

12 The amount required per contract is

determined by the exchange, and is due from both parties

to the trade on the morning of the day after the trade (T+l).

Most clearing members maintain substantial excess

original margin deposits in their clearing account at the

BOTCC. The amount of margin a clearing member owes

is calculated by the clearinghouse based on the value of

his open contracts and an assessment of the amount of risk

those contracts involve. The BOTCC uses its risk

assessment computer system SAFE [Simulated Analysis

9The ISCC is also discussing the possibility of setting up another 1- with the Societe Interprofessiormelle pour la Compensation des Valeurs

Mobilieres (SICOVAM), the French central depository, and with Societe des Bourses Francais, the broker clearing system at the Paris Bourse.

lohluchof tie information in this swtion is based on Roger D. Rutz, ‘Clearance, Paymen~ and Settlement Systems, in the Futures, optiOnS, and Stock

Markets,” Feb. 24, 1989, a contributed paper in the OTA contractor report: Bankers Trust, op. cit., foomote 1.

llFor de~~ on tie cle~g ad se~ement processes at tie o~er U,S. fi~es cle~houses, see OTA contractor report by Bankers ‘h@ Op. Cit.,

foomote 1.

~ZT’Ilis @@MI m~gin deposit is a perfo~nce bond to protect the fwciai integrity of the clearinghouse in the event that the cl-g f~ is ~ble

to meet a margin call or to make or take delivery. Original margin refers to deposit of funds in the form of cask government securities, or letters of credit.

There are two levels of margin: the fwst is from the customer to the f~ the second is from the fm to the clearinghouse.
88 ● Trading Around the Clock: Global Securities Markets and Information Technology

of Financial Exposure] to evaluate clearing member

firms’ credit, and uses the CME’s SPAN to determine the

amount of margin owed.13

There are two methods of calculating original margin:

gross margining and net margining. Gross margining

requires a clearing member to post original margin on all

the long and short positions in these accounts; they cannot

be used to offset each other in case of a deficiency. By

contrast, with net margining the margin owed by each

clearing member is calculated on the difference between

all the long and short positions, calculated separately for

proprietary accounts and customer accounts. The BOTCC

figures original margin on a net basis, as do most U.S.

futures clearinghouses; the exceptions are the CME

Clearinghouse Division and NYMEX, which figure

original margin on a gross basis.

The BOTCC’s trade-matching process, from the time

it guarantees settlement obligations to the posting of

original margin by clearing members, may take 7 hours.14

During this timelag, the BOTCC carries the full risk.

Clearing members demand that trades become guaranteed

as quickly as possible, since this is the point at which

counterpart risk should be eliminated.

Besides original margin, futures clearinghouses also

calculate and collect variation margin.15 The amount

reflects the changes in the value of a clearing member’s

open contracts. Variation margin may be collected daily,

or more often. The BOTCC routinely issues one morning

call and supplemental intra-day variation margin calls

(usually around 2 p.m. c.s.t.).16 One purpose of routine

intra-day variation margin calls (and payments to clearing

members with profitable trades) is to reduce the magnitude of the following morning margin call, which is

always made at 6:40 a.m. c.s.t. on the day following the

trade date (’I’+ 1). As a result of this system, the BOTCC

typically collects (and pays out) by about 2:30 p.m. c.s.t.

on the date of the trade between 60 and 95 percent of the

final settlement calls that would otherwise have been

made at 6:40 a.m. c.s.t. on the following day. This reduces

the clearinghouse’s risk because the shorter the period of

time between trade execution and settlement, the more

certain it is that a clearing member will be able to meet its

obligations. In general, the more frequently a clearinghouse settles (marks to market) trades each day, and

requires its clearing members to post margin, the greater

is the financial integrity of the clearing system.

Lines of Defense—In the futures markets, the maximum potential default liability represents at most only

one business day’s market movement. This is the first line

of defense for the clearinghouse. The BOTCC segregates

and nets proprietary and customer open positions of each

clearing member across commodity futures and options

contracts to calculate the amount of both the original and

variation margin of each clearing member. The BOTCC’s

SAFE system calculates each clearing firm’s potential

exposure to an adverse move in prices.

Margin deposits are the second most important line of

defense in protecting the clearinghouse from a default by

a clearing firm which could affect other clearing members. The Commodity Futures Trading Commission

(CFTC) requires that all clearing members maintain two

bank accounts for settlement and two safekeeping accounts for original margin. One set of bank and safekeeping accounts is for original and variation margin for

customer positions, while the other set is for original and

variation margin for proprietary and non-customer (affiliated firm) positions.17

Another line of defense for the clearinghouse is its net

capital requirements for clearing members. In addition, all

U.S. futures clearinghouses share certain types of “risk

information’’--data on amounts paid and collected by

clearing members in the form of both original and

variation margin, reflecting their overall exposure, and

amounts paid by clearinghouses to clearing members,

representing reductions in the amount of risk faced by a

clearing member.

Still another line of defense in protecting the clearinghouse from default by a clearing firm is its authority to

issue a‘ ‘super’ margin call if the BOTCC determines that

a customer or proprietary position represents a clear and

immediate danger (i.e., a particular market condition

could cause a substantial amount of a clearing firm’s

capital to be depleted because of customer defaults). The

clearing member would then be required to deposit the

additional “super” margin (in the form of cash, U.S.

Treasury securities, or letters of credit) within one hour of

receiving the call. Finally, the segregation of customer

funds, clearing member net capital requirements, and

13~e CME biw its OWQ risk management computer system-SPAN (Standard Portfolio Analysis of Risk)--for detm the amount of margin.

The fatures industry (with the exception of the Intermarket Clearing Corp. (ICC), which uses the system known as TIMS) is moving towards adopting

SPN as the standard for calculating margin.

ld~went of ~g~ mWt be ~ ~e+y tids+.g., those provided by the Federal Reseme’s Fed* el@~Qic PaY’meQt sYs~em.

15V~tion~@ me the cash flow required to mark positions to market. They flow through the cl-g organization to the clearing member on

the other side of the trade,

160f~e U.S. fi~es Clemouses, the cmC1e@o~ Divisio~ the Comx cl~g~socfitio~ and the Coffee, Sugm~d @cOa ClCorp. ah issue routine daily intraday variation margin calls. The others have the capability of doing soon an as-needed basis; e.g., in times of severe

market volatility.

IT’r’he segregation of customer and proprietary funds is a requirement of Section 4d(2) the COQUQOd@ Exc@e ~t.
Appendix--Clearing and Settlement in Major Market Countries . 89

ongoing financial surveillance, each contribute to bolstering the integrity of these markets.

If, despite margin calls, a clearing member nevertheless

defaults on the settlement obligations of the trade, the

clearinghouse has several protections against liability for

the default. The clearinghouse may liquidate the clearing

member’s positions and original margin, sell his exchange membership, use his contributions to the clearinghouse guarantee fired, use the clearinghouse guarantee

fund and its committed lines of credit, assess all clearing

members, where permissible, and finally, use the clearinghouse’s capital.

All U.S. futures clearinghouses have funds available to

protect themselves against default by their members;

these are primarily made up of mandatory contributions

from clearing members.18 They fluctuate in size. Most

U.S. futures clearinghouses, but not the BOTCC19 or

Kansas City Board of Trade Clearing Corp., also have the

power to assess their members, if the amount of a clearing

member default cannot be covered by capital funds and

the guarantee fund.

The BOTCC uses four settlement banks, all based in

Chicago. The BOTCC’s morning payment process (6:40

a.m. c.s.t.) precedes the opening of the FedWire system

and hence requires the settlement bank to extend credit on

behalf of some clearing members. At times, this credit

extension may not be fully collateralized, and thus is a risk

for those settlement banks.

Clearing members must maintain accounts at settlement banks for the payment of original and variation

margin, including final settlement payment. When the

clearinghouse determines the amount of margin owed, the

clearinghouse notifies the clearing member’s bank of this

amount. The bank then examines the clearing member’s

assets (cash, government securities, lines of credit),

gathers incoming payments from the clearing member

(via FedWire, if it is available at the time the bank is

making the decision), and makes a commitment to the

clearinghouse as to whether it will honor the margin call

by forwarding the funds to the clearinghouse.

If the clearing member does not have sufficient assets

to meet its margin obligations, the bank’s decision is

whether to extend credit to the clearing member. When a

settlement bank decides that it cannot meet the financial

obligations of a market participant, the participant will ask

his credit banks for credit. This process generally works

well, but it depends on two assumptions: first, that the

market participant will be able to reach the account

officers at the credit banks within the permitted time; and

second, that the credit banks (which do not always

coordinate a market participant’s various lines of credit)

will not extend more credit than a clearing member is

worth. Generally, these assumptions are sound, as firms

usually have a predetermined credit line. But, if a firm is

having difficulty, if the firm’s needs come during a period

of market stress, a settlement bank may decide not to

honor a margin call, and this could result in the

clearinghouse liquidating the clearing member’s customer positions, after attempting to transfer these positions to another clearing member.20

Clearinghouses, in respect to intra-day margin payments batch process trades rather than processing each

trade as it is executed. Thus, a clearinghouse may not be

able to eliminate their risk instantaneously by shifting it

to clearing members. One reason the clearinghouses are

forced to do batch processing is that the banking system

moves too slowly to accommodate any other method. For

instance, Chicago banks generally use paper-based processes to move money among clearing members.

The working interface between the clearinghouses and

the banks survived with difficulty under immense strain

in October 1987.21 In further improving this interface,

there are cost-benefit trade-offs. The existence of a

Clearing Organization and Banking Roundtable that

provides settlement bankers, clearing organizations, and

regulators with a forum for regular discussion of these

tradeoff issues, is some evidence that the system is

moving towards a more secure, less volatile, but still

competitive, state.

Options Clearing Organizations

The Options Clearing Corp,--OCC is the common

entity serving all securities options exchanges in the

United States22 The OCC clears and settles options trades

for the Chicago Board Options Exchange (CBOE); the

American Stock Exchange (AMEX); the Philadelphia

Stock Exchange (PHLX); the New York Stock Exchange

lsne BOTCC does not bve a guarantee, or clearing fund, but does require clearing members to purchase its capital stock when fieY me fitt~

to membership, which is similar to a guarantee or clearing fund. The relative number of shares of stock that a BOTCC clearing member must pumhase

is adjusted semi-annually to reilect its open positions and trading volume. Other futures clearinghouses have guarantee funds based on capital, trading

volume, or open positions. Rutz, op. cit., footnote 10, pp. 23-27.

1% mid-lg8g, the BOTCC estit~ as $325 million the total value of its available trust fpnd, lines of cred.i$ and ckXu@ghOuse @Pi~.

~oradditionalinfonnation, see AndreaM. Corcoranand SusanC. Erv~ “Maintenance of Market Strategies in Futures Broker Insolvencies: Futures

Position Transfers From Troubled Firms,” Was~ingfm und Lee Z.uw Review 44:849, 1987, pp. 849-915.

zl~m is di==mment ~o~ p~cip~ts ~emselves aS to whether these systems “survived with diffkU.lty,” “~ely ~~ed,” or Perfofi

otherwise. Nevertheless, many improvements have bee~ and are, being implemented to strengthen the clearing and settlement process.

22~ WC clws ~ exc~~~ad~ s=fities Optiom, For de~s oncl- ~d se~ement of optiom on fu~es con~cts, see Bankers Trust CO.,

op. cit., footnote 1.
90 ● Trading Around the Clock: Global Securities Markets and Information Technology

(NYSE); the Pacific ‘Stock Exchange (PSE); and the

National Association of Securities Dealers (NASD).

Unlike the clearinghouses already discussed, the OCC

does not do trade comparison, since it receives locked-in

data on compared trades from each of the exchanges. The

exchanges have chosen to keep their own trade-matching

systems as a means of competitive differentiation. The

data on matched trades is sent to the OCC by computer on

the day of the trade. The OCC then must calculate the

amounts of money that are owed and due the next day

(T+l) by the buyer and the seller. In the case of the buyer,

the entire amount of money owed to the OCC is called the

“premium obligation,” or “premium,” and is paid in

cash. The premium, while paid to the OCC, is passed on

to the writer of the option. To the buyer of the option, the

premium is the amount he pays to lock in the possibility

of an advantageous movement in the price of the

underlying security. To the writer of the option, the

premium is the maximum amount of profit he can expect.

If the market moves against the writer, the premium

might, at best, offset only a small portion of the option

writer’s losses.

The writer of the option always owes margin to the

OCC each day that the option contract is in effect but has

not been exercised by the holder. This margin23 is similar

to the margin owed by the buyer or seller of a futures

contract, essentially ‘good faith’ money which serves as

an assurance to the OCC that the writer of the option has

the financial ability to meet the potential obligations of the

option that he has sold. The amount of margin owed

reflects changes in the market price of the option as well

as a portion of the total amount that he would have to pay

if the option were exercised.

On the day after the trade (T+l), the OCC notifies the

buyer of the amount of cash premium which is owed; at

the same time, the writer of the option is notified by the

OCC of the amount of margin that is owed Both amounts

are due on T+l. On the next day (T+2), and each day

thereafter until expiration, exercise, or closeout24 of the

option contract, the OCC calculates and then collects

margin from the writer of the option.

Margin thus reflects the adjusted daily value of the

option writer’s open positions (the total amount of money

which he could be forced to pay if the options he sold were

to be exercised by the holders). The OCC marks to market

(determines the adjusted value and liability of each

member’s open positions) at the end of each trading

session. If the options contract loses value, the OCC

reduces the amount of margin required. When the holder

of an option contract decides to exercise it and actually

buy or sell the underlying product of the option, the

person who originally sold the option is not necessarily

the same person that OCC will require to fulfill its terms.

Instead, the OCC randomly assigns a clearing member to

honor the delivery or purchase obligations of the option,

from the pool of all clearing members who sold options

with identical contract terms.

For example, when an IBM option is exercised, the

OCC assigns a clearing member with a short position and

then sends delivery instructions to an equities clearinghouse such as the NSCC, which incorporates instructions

to deliver or receive into its Continuous Net Settlement

(CNS) system. Any obligations not netted out through

normal CNS procedures are settled by instructions to a

depository (e.g., the DTC). Delivery of the IBM stock is

then made by transferring it from the seller’s account into

the buyer’s account at the depository, subject to the CNS

system.25

When a foreign currency option is exercised, the

foreign currency underlying the option contract is delivered to the OCC’s cash account at a designated overseas

bank, and then transferred to the account of the market

participant who is buying the foreign currency. The

designated foreign exchange delivery bank may be any

bank designated by the parties involved in the transaction,

not necessarily one of the OCC’s settlement banks.

The OCC provides its clearing members with a

guarantee on the morning of the day following the trade

(T+l), after the buyer of the option has paid the premium

obligation,26 The OCC guarantee protects the holder of an

option against the possibility that the option writer might

default on the payment or delivery obligations of the

option.

Lines of Defense—The OCC’s first line of defense

against the potential for clearing member default is its

continuing monitoring of the creditworthiness of its

clearing members. The options exchanges have limits on

the aggregate amount of open positions that any one

market participant may carry at any one time. These are

net limits-i. e., the market participant’s short positions

are offset by his long positions. The clearing members’

zsFOrmarginpaymen@ the (XX accepts cash and collateral including: bank letters of credi$ U.S. Tnasury obligations, the actiqitim ~d@Y@

particular option contracts, and various other stocks. Additionally, margin obligations can be reduced through corresponding long positions in othex

options which have the effect of reducing net exposure.

~The “clos~ut” is when a writer or holder of an option contract enters into another option COntraCti -w~ OffSet@g Positiom

~~aNSCC ~comomtes delivew ~~ctiom ~to i~ ~S ~stem, NSCC rather tin ocC ass~es responsibility for, ~d guarantees, deliveries

and payments.

2~~fd~a~ec~e~th~e SEC, cmenflyvn~g approv~, Whichwouldprovide WC clefigme~rswith~ UncOnditiO@_@

on the morning of T+l.
Appendix--Clearing and Settlement in Major Market Countries . 91

positions are monitored daily by the exchanges in respect

to these position limits.

The Securities and Exchange Commission (SEC), the

exchanges, and the OCC also monitor market participants

in respect to capital adequacy and other financial requirements. The OCC is a part of the information-sharing

arrangement among all seven SEC-registered clearing

entities, as well as a participant in the pay-collect risk

information system operated by BOTCC.27 The OCC uses

a monitoring system to quantify the potential risk of each

clearing member under different market scenarios, including large price movements. The system evaluates the

risk in participant’s stock, options, and futures positions.

The OCC’s second line of defense against clearing

member default is the margin that the clearing members

have on deposit. If this is insufficient to cover the default,

the OCC can turn to its guarantee fund, made up of cash

and government securities.28 In the event of a default by

a clearing member, after closing out the defaulting

clearing member’s positions, the OCC follows five steps

to cover any residual liability from a default:

●

●

●

●

●

First, any margin that the defaulting clearing member has on deposit with the OCC is applied towards

the liability of the default.

Second, if that amount is insufficient, the OCC takes

the defaulting clearing member’s contribution to the

guarantee fund and applies it towards the liability of

the default.

Third, if that amount is still insufficient, the OCC

may use its guarantee fund to cover-whatever portion

of the liability is outstanding.29

Fourth, if that still isn’t enough to cover the full

liability, the OCC has the right to assess its members

for the remaining amount of the liability.30

Finally, the OCC, like the NSCC and futures clearing

organizations, may also take legal action as a creditor

to recover any sums that are owed by the defaulting

clearing member. The amount that can be recovered

in this way is limited by bankruptcy law.

At the end of each trading day, the OCC has an

overnight processing cycle during which it calculates the

net amount which each member either owes or is owed.

The net figure reflects, among other things: a) the cash

premium obligation due on each new long position; and

b) the margin due for each new short position. The OCC

then sends payment instructions to the settlement bank

The netting is done on a multilateral basis; i.e., the status

of all of a clearing member’s holdings in the options

market is taken into consideration in arriving at the daily

net payment obligation to the OCC.

The OCC has two different methods for calculating

margin-one for options on equities and another for all

other types of options (foreign currency, government

securities, or stock indexes). In both cases, the margin

required from the writer of an option is equal to the current

market price of the option, plus a cushion to cover the risk

of a change in the current market price. But for all

non-equity options, as well as all options and futures

contracts cleared by the Intermarket Clearing Corp., the

OCC uses the Theoretical Intermarket Margin System

(TIMS). TIMS evaluates each clearing member’s overall

risk profile and then sets the total margin owed. The OCC

was the first clearing organization in derivative markets

to change from a fixed or flat rate of margining (per

contract) to highly sophisticated computational methods.

Rules have been submitted to the SEC to expand the use

of TIMS to include setting the margin on equity options.

The CFTC and the SEC have approved applications

from the OCC and the CME to allow cross-margining of

stock index options, futures, and options on futures for

proprietary trading accounts of clearing members. Crossmargining between the CME and OCC started in October

1989.31 OCC also offers cross-margining through an

agreement with its affiliate, the Intermarket Clearing

Corp. (ICC). The ICC clears trades for the New York

Futures Exchange, the Philadelphia Board of Trade,

Amex Commodities Corp., and the Pacific Futures

Exchange; therefore, OCC members can use their holdings on those exchanges to offset the status of their open

positions at the OCC.

The extent to which OCC and ICC offer crossmargining is however limited. The CFTC, concerned

about safety, market stability, and liquidity, has not

zTRob~ Woldow, “~earan ce and Settlement in the U.S. Securities Markets,” February 1989, expert paper contributed to O’JX’S contractor repom

Bankers Trust Co. report, op. cit., footnote 1.

zWhe total amount required in the guaranteed fund is recalculated mont.hly. As of December 1989, the guarantee, or clearing fund, PIUS a 1~ p~ent

. .

muumal additional assessment for which OCC clearing members are unconditionally liable, was about $450 million. The amount of the fund varies in

proportion to the amount of clearing members’ liability. It is always equal to 7 percent of the average daily aggregate rnarginrequirements of all clearing

members in the previous month. Each clearing member must contribute an amount equal to his pro-rata share of outstanding contracts in the previous

month.

z~e OCC has r~enfly amended its rules to include using its own retained ehgs at the discretion of its Board of Directors.

%Iot all U.S. clearinghouses, however, have these assessment powers. See Bankers Trust Co., op. cit., footnote 1, vol. 1, p. 137.

Slsee John~att and James M. Kus~sch ctC1~ance and Settlement of D~vative FinancW ~s~ents,” April 1989; and John P. Behof, “Issue

Summary: Intermarket Cross-Margins, for Futures and Options,” The Federal Reserve Bank of Chicago, May 1989. Both are expert papers included in

the OTA contractor report by Bankers Trust Co., op. cit., footnote 1.
92 ● Trading Around the Clock: Global Securities Markets and Information Technology

approved expansion of cross-margining beyond proprietary accounts of major market-makers.32

The OCC has approximately 190 clearing members.

The clearing member brokerage firms transact business

for their proprietary accounts, other brokers who are not

clearing members, and institutional and retail customers.

The link between OCC and its clearing members is

automated: OCC requires that all members submit

post-trade information through OCC’s on-line Clearing

Management and Control System (C/MACS).33

The OCC allows its members to choose from a

selection of designated settlement banks. There are

currently 16, but the OCC is flexible and may designate

a member’s primary banking institution (concentration

bank) as an approved settlement bank. The OCC maintains accounts at each of these settlement banks, and

instructs the banks on each trading day as to the debits and

credits that are to be made to the OCC’s accounts and

those of the clearing members.

There are controversial proposals to institute futuresstyle margining for options, which seem to have support

recently. These are discussed in a forthcoming OTA

report on domestic securities markets.

Clearing and Settlement in the

United Kingdom34

The International Stock Exchange

The International Stock Exchange of the United

Kingdom and the Republic of Ireland Limited (ISE) in

London, also operates exchanges in Belfast, Birmingham,

Dublin, Glasgow, and Manchester/Leeds. It trades U.K.

equities, gilt-edged securities,35 and other fixed-income

instruments, international equities, and options. The

average daily trading volume from January to September

1988 was 31,213 trades. (See ch. 3 for a detailed

description.)

The ISE settlement system is undergoing a transition.

Today it is still primarily paper-based, but there are plans

for an electronic depository to eliminate the need for

certificates by permitting paperless transfer of title. This

system, TAURUS, is scheduled to be introduced in phases

beginning in 1991 and to be fully operational in 1993.

The clearing and settlement process is managed by the

ISE for all of its member firms. It is a two-part process

consisting of a trade-matching system (called the Checking System) and a computerized settlement system,

TALISMAN (Transfer Accounting and Lodgement for

Investors, Stock Management for Principals), introduced

in 1979. TALISMAN settles securities trades between

ISE members, including centralized routing of the securities to the registrars for transfer of title.

Trade settlement in the U.K. equities market usually is

scheduled for the sixth business day after the end of each

2-week dealing/trading period (also known as the account

period); all trades done during the 2-week account period

are scheduled to settle on the same day. Trading firms

have the option of settling their trades on a schedule other

than the account period, if this is agreed upon by the

trading parties. This can occur any time after the second

day following the trade (T+2), but this is rare.

At the end of the trading day, member firms enter the

day’s trade data into the ISE’s Checking System either

directly through a PC data transmission to the Exchange’s

computer, or by delivering a computer magnetic tape to

the nearest Stock Exchange Centre. The Stock Exchange

computer validates and compares all trades. Unmatched

trades then have to be resolved, amended or canceled. For

TALISMAN eligible securities,36 the selling broker must

obtain from its customer, or its own inventory, the actua1

share certificates and a signed TALISMAN Sold Transfer

(TST) form, which authorizes the transfer of the security

title from the current beneficial owner to SEPON (the

ISE’s nominee name) .37 The paperwork which includes

the certificate, the TST, and a control document called the

Sale Docket, after being properly signed, is then deposited

at the nearest ISE TAMS MAN Centre.

ISE staff verify the documents and record the deposit

on the computer. The security certificates and other

documents must then be sent to the company registrar to

3~~on ~tmiew by owSm with senior CITC ofllcials, Octobm 1989.

33~ttmd Kustuscb op. cit., footnote 31.

~Muchof thernaterial in this section is based on an expestpaperwrittenby the ISEfor the OTAcontractorreport: Bankers Trust CO., op. cit., foo~ote

1.

sSGilt.~g~ ~~ties ~ debt ~~ents ism~ by the U.K. ~ve~ent. The= st~ks pay a fm@ variable or tidex-w~ rate Of hl@lXt, ~d

are co~idered risldree since their interest and capital are guaranteed by the government.

36Some Othm, non-~ISm se~emmts can~occw at tie ISE through physic~ defiv~ and pa~nt, Stice thema- Systim Op~t~

independently from ‘I14LISMAN, ewm securities which am not Z4LISMAN-eligible can be validated and matched by the Checking System. But after

securities trades are matched, the ISE offers a central physical delivery area that allows such settlement among brokers to occur in one central place.

The Stock Exchange’s Central Stock Payment Department takes in securities from sellers and delivers them to the buyers. At the same time, it takes

the paynient from the buyer and gives it to the sellm. This is a man~ labor-intensive process.

qvAnofieeis apnorcompny~whose _eWfitiesm~ldor@~onbehalfof ~oth~~mn orcompanywhois thetrueowner. SEPON

stands for Stock Exchange Pool Nominee. This is the ISE’S limited liability nominee company in whose name TALIS W-eligible securities are held

prior to settlement.
Appendix--Clearing and Settlement in Major Market Countries ● 93

transfer the share registration from the customer’s name

into the name of SEPON. The ISE’s broker/dealers and

market-makers who maintain trading accounts within

TALISMAN can, through this SEPON-nominee account,

legally hold stock in uncertificated form. The recording

into SEPON must occur before any stock exchange

TALISMAN settlement can take place.

When broker/dealers and market-makers trade for their

own accounts, or act as principals, TALISMAN effects a

simple book-entry transfer of title without any need for

transfer forms or certificates, Approximately 7,000 securities issues can be settled through TALISMAN, most of

the securities registered in the United Kingdom and

Ireland.

This clearing and settlement process does not apply to

all of the financial instruments traded on the ISE. Options

are cleared and matched by ISE, but are settled through

the International Commodities Clearing House in London. U.K. Government gilt-edged stocks, also traded on

the exchange, are validated and matched through the

ISE’s checking system, but settled through the Central

Gilts Office.38 Foreign equity trades are matched through

an on-line comparison system called SEQUAL,39 then

settled by the broker independently of the ISE, in the

security’s home market.

The ISE does not take counterpart positions to trades.

Market participants are not given a guarantee that the

trade will settle, only that if securities are delivered, then

either payment will follow, or the securities will be

returned. The ISE’s services traditionally have facilitated

the post-trading processes for its members only. However, through the recent development of Institutional Net

Settlement (INS), the ISE has begun to coordinate

institutional customer settlements as well.

Payment on the settlement date may be through

TALISMAN, outside TALISMAN, through cash settlement, or through the Central Gilts Office, depending on

the type of security and the preference of the TALISMAN

participants. “Through TALISMAN” means that the

TALISMAN computer system keeps track of each

member’s payment obligations. These payments are

netted each day so that each member need only make or

receive one payment a day at the nearest TALISMAN

Center. “Outside TALISMAN” means that trading

parties maintain their own payment records and eitherpay

the counterpart directly or deliver a check to the Stock

Exchange’s Central Stock Payment Department, to be

passed on to the selling party. Cash settlement occurs

when the trading parties agree to settle their trade on a

different schedule from the official account period, the

day after the trade for Gilts and on the second day after the

trade for equities.

Generally, payments for stock exchange trades are

made by check in British pounds, Irish pounds, or U.S.

dollars. Approximately half of the brokers make sterling

payments through CHAPS, London’s interbank electronic payment system. The rest use London’s Town

Clearing bank checks.

The ISE still has a fragmented and largely paper-based

settlement system. TALISMAN capability alone is inadequate to support a major financial center. There are plans

to establish a paperless settlement system, called TAURUS, an electronic depository service, to enable members

to keep their securities in dematerialized40 form with

book-entry transfer of title on settlement.4142 The ISE

also plans to move towards a rolling settlement cycle to

replace the existing 2-week trading account period with a

further 6-day settlement period.43 One issue that remains

under discussion is how the ISE would be able to assure

listed companies that they would still be able to quickly

identify and communicate with their shareholders.

The International Commodities

Clearing House (ICCH)

ICCH44 is an independent clearinghouse which provides matching, clearing, settlement, delivery management,

and trade guarantee services for five futures and options

ss~e Centi mts Office is a service jotitiy developed and funded by the Bank of England and the ISE for the settlement of U.K. Government

obligations.

39- provid~ by the ISE, but different fhm tie~~syst~

@Delnateri@ed Cetilcates of ownership are those that no longer have paper certificates and exist only as computer entries.

AlmURUS will, h its titi~ stiges, COV~U.rC. equities. The Centnd ~ts offke already in operation is a fully dematerialized el=~otic depositow

for U.K. Government Issues or Gilts.

A~mn~on is p~m~ @ ~ ism~ by s~~~r 1990 specifying TAURUS requirements, ~d *KP~ciP~ts to ~gin ~eir

implementation work for the introduction of TAURUS. “The ISE Announces Detailed Plans for the Future of Settlement in the United Kingdo~” ISE

News Release, Mar. 9, 1990. These plans are described in “A Prospectus for Settlement in the 1990s,” ISE, March 1990, and project a date of March

1991 for the completion of the infrastructure, which includes: the use of the Institutional Net Settlement service, and the phased replacement of magnetic

tape and paper transfer systems; the phase-in of book entry transfer, i.e., dematerialization of certificates, between October 1991 and December 1993;

and the introduction of an initial 5-day rolling settlement (to be shortened to 3 days later) and a full delivery v. payment system by October 1992. ‘Ihese

steps are projected to save over f200 over a I@year period and sre consistent with the Group of Thirty’s recomxntmdations.

43~e tem ~~m~ ~~aent~~ mm ~tie ~~aent &te is ~ways tie -de &te plus a sp~ific number of &ys. For example: T+3.

%umnary of expert paper by the ICCH for the Bankers Trust Repo@ “Study of International Clearing and Settlement” op. cit., footnote 1.
94 ● Trading Around the Clock: Global Securities Markets and Information Technology

exchanges in London. 45 The ICCH also provides clearing

and settlement services to exchanges in New Zealand,

Australia, Hong Kong, Kuala Lumpur, and Paris. It

provides electronic screen trading systems for three

exchanges; the New Zealand Futures Exchange, the Irish

Futures and Options Exchange, and the London FOX.

ICCH is organized into two divisions: the Recognized

Clearing House, which handles the London-based operations; and the ICCH International Financial Markets,

which is responsible for international operations and

computer systems. The clearinghouse is owned by a

group of six shareholder banks,46who are the ultimate

guarantors of the clearinghouse’s obligations. Ownership

status has implications primarily in the case of default by

a clearing member. In a clearinghouse owned and

operated by one exchange, all of the clearing members are

ultimately liable for the obligations of a member who fails

to perform. In the case of an independent clearinghouse,

such as ICCH, the ultimate liability of meeting a failed

member’s obligations rests with the shareholders, not

with the clearing members. This raises the question of

potential conflict of interest among shareholders, clearing

members, and customers of clearing members.47

ICCH has approximately 200 clearing members in

London who trade at the five exchanges. These members

act as clearing agents for their own in-house trades,

customers’ transactions and non-clearing members

trades. While trading is primarily by means of open outcry

on exchange floors, once a trade is struck, both the buying

and the selling party are required by the exchanges to

enter the trade data into the exchange’s computer

matching system within a specified time. The exchange

system matches the trade data and makes the matches

available on-line to the floor brokers for confirmation. A

matched and confirmed order is sent immediately by data

transmission feeds to the ICCH’s system for settlement.48

Trade data is processed by the clearinghouse on a

continuous basis rather than in a batch cycle at the end of

the day. Members can monitor their settlement positions

through the management information system at any time

during the day. At the end of a trading day, members can

look at a terminal to see what their initial and variation

margin calls will be on the following morning.

ICCH becomes the counterpart to every trade. ICCH

further decreases risks to clearing members because it

performs this function across multiple exchanges, netting

members’ positions out into a single margin and settlement figure. This process is called multilateral netting by

novation. Usually the clearinghouse makes one margin

call every day before the start of the day’s trading, but in

periods of high market volatility, it reserves the right to

make more frequent intra-day variation margin calls. For

example, on October 19, 1987, ICCH made four intra-day

margin calls.

ICCH accepts approximately 30 banks as settlement

banks, including some foreign banks’ branches within the

City of London. Each clearing member typically has at

least two sterling-denominated accounts at his settlement

bank; one for segregated funds (e.g., those of individual

investors) and one for non-segregated funds (in-house,

non-clearin g members, and non-segregated customer

funds). In addition, each member may hold foreign

currency denominated accounts at the settlement bank to

cover margin and settlement payments in Deutsche

marks, yen and U.S. dollars. The clearinghouse also keeps

accounts at each settlement bank, multiple accounts if

different currencies are involved.

Every morning at 8 a.m., messengers deliver printouts

to each clearing member’s settlement bank detailing daily

margin payments and credits. The banks have until 10

a.m. to credit or to debit the accounts of members. The

banks use ICCH’s “Protected Payment System,” which

functions in the same way as third party debit authority in

the United States.49 If a bank has any problems in meeting

a margin call for a member, the bank must notify the

clearing house by 10 a.m. One of the risks of the margin

settlement is that banks do not have to commit payments

to the clearinghouse on behalf of a member until after

trading begins in the morning. The opening hours vary at

each exchange, but the London International Financial

Futures Exchange for instance, starts trading at 8:15 am.

This could result in a member accumulating adverse

trading positions before yesterday’s margins have been

committed to by the settlement banks. It could become a

problem during periods of high-market volatility.

Asney Ue the Baltic Futures Exchange (which trades contracts for cattle, pigs, soybean meal, potatoes, and freight ~dexes); the ~t~tio~

Petroleum Exchange (which trades contracts for gas oil, crude oil, heavy fuel oil, and leaded gasoline); the London Futures and Options Exchange (FOX)

(which trades contracts in coffee, cocoa, and sugar); the Imndon International Financial Futures Exchange (IJFFE) (which trades a range of contracts

including currencies, interest rates, bonds and indexes); and the I.xmdon Metal Exchange (which trades contracts for aluminw lead, copper, nicke~ zinc

and silver).

AGNatio~ Wes-ter, Barclqrs BarIQ Lloyds Ba@ Midland B@Royal Bank Of !lcotkmd, ad s~~~e~

47~ 1989, a cl-me-r defa~t ~-~ on the NW Z-rid Futures fic~ge. cmtom~ of the other clearing members wme subjected tO

an invoicing-back procedure which in some instances, created losses for them.

48Wi~ tie exception of the a~c~~exc~g~ (the B~tic Futures Exc~nge and FO~, ~ch of the exc~~ operates its own llWChiIlg iUld

confhmation systems. The agricultural exchanges depend on ICCH for both trade matching and confiition.

4~e Cle-ouse cm tell tie set~aentba~ to move money from amember’s ac~~tatthe b~ to the cle~ghouse’s account at the Setdment

bank without a new authorization from the member.
Appendix--Clearing and Settlement in Major Market Countries ● 95

Since ICCH is a net margin clearinghouse, each

morning it submits one number to the appropriate

settlement bank for either payment or credit of nonsegregated accounts and segregated accounts. Collateral,

such as a letter of credit, can be pledged to the

clearinghouse as a guarantee against trading on multiple

exchanges. If the ICCH did not net margin requirements

across these exchanges, this practice would increase

settlement risk. As it is, the member has the benefit of

incurring reduced payment risk and cost. ICCH accepts

letters of credit (also known as bank guarantees), cash and

U.K. Treasuries as collateral for margin payments. It is

moving towards accepting U.K. Gilts and U.S. Treasury

Notes as collateral but there are some legal issues that

must be worked out; both of these instruments are held in

decertified form in depositories and can therefore not be

physically delivered as collateral to the clearinghouse.

The possibility of pledging these securities on behalf of

the clearing house is being investigated.

Clearing and Settlement in Japan

In many ways securities markets in Japan and the

United States are similar, in other ways they are very

different. Both countries have multiple equity exchanges,

and in both, one or two of these exchanges handle most

of the total trading volume in securities. In Japan, this is

the Tokyo Stock Exchange. 50 However, Japan’s over-thecounter market is minuscule compared to that in the

United States. In contrast with the well-established

national depository system in the United States, there is

no national, central depository in Japan, but one is now

being established.

In Japan, as in the United States, the clearing and

settlement process varies according to the type of

financial instrument traded (i.e., futures, equities, options). 51 To a greater extent in Japan, different financial

instruments are traded on the same exchanges, and the

clearing of both securities and derivative products are

handled by the same organization, but the different

instruments are cleared separately. In the United States,

by contrast, equities, futures and options generally are

traded on separate exchanges as well as processed by

different clearinghouses.

The Japanese futures market adheres to the mark-tomarket principle in requiring payment of margin, but

payment is not due until the third day after the trade. Japan

and the United States differ in the types of collateral

which are acceptable as margin payments; Japanese

clearing houses do not accept bank letters of credit as

collateral, but they do accept listed securities. The reverse

is true in the United States.52

In Japan, there are many unwritten rules or protocols

that must be followed in the clearing and settlement

process. 53 The Japanese Government, especially the

Ministry of Finance (MOF), has a much stronger influence on the day-to-day management of the brokerage

business than do regulatory agencies in the United States.

But more importantly, the Japanese cultural emphasis on

the importance of honor and conformity, concepts which

relate to the reputation and behavior of companies and

their employees, help to explain the punctual settlement

practices in Japan. Trades do not fail in Japan, generally

speaking, because it is dishonorable not to meet one’s

obligations. Further, those who do not meet their obligations risk being put out of business.54

Although there is not a widespread concern in Japan as

to the possible volume-induced stress on the clearing and

settlement system, Japan’s financial services industry

would like to see some improvements in it. Issues which

are currently under discussion include:

. The reduction of physical movement of securities: in

addition to Japan’s setting up a central depository for

securities, the Bank of Japan is creating an on-line

depository for Japanese government bonds.55

~&x ch. 4 for detailed description of the Tokyo Stock &change.

sl~e OptioIIS ~ket in Japan had until recently been a private, off-exchange, large volume market. In June 1989, options m tie Nikkei 225 ~d=

began trading on the Osaka Stock Exchange.

52~ tie Ufitd Stites, however, fi~es ~le~@ome5~ve be~ to view letters of credit u a less d~irable fo~ of cowter~. Securities (with the

exception of U.S. Treasury obligations) are not accepted as collateral byU.S. futures clearinghouses. They are, however, accepted by the Options Clearing

Corp., which handles the clearing for all exchange-traded options in the United States.

53For e~ple, protocol dictates that delivering an institutional trade and collection of payment be done by pr-~ement o~Y.

54”If shares are not available for delivery in Tokyo, a broker issues a letter of guaranty, essentially a promise to deliver later, to its clients. The client

then pays the broker, with the knowledge that they own the stock and it will be delivered shortly. A safekeeping receipt is delivered on trade &te, with

the shares following when available. The Japanese allow the use of letters of gusranty with domestic counterpardes, but acceptance for foreign

participants varies from one custodian to the next.” Quoted from Daiwa Securities AxnencaInc., “Viewpoint: Perception and Opinions of a Non-United

States Parented Firm Doing Business in the United States and World Securities Markets, ” Summer 1989, p. 4, contributed paper in OTA contmctor

report, Bankers Trust Co., op. cit., footnote 1.

55Nomura Securities, “The Securities clearing and Settlement System in Japaq” Februq 1989, contributed paper in OTA contractor report by

Bankers Trust Co., op. cit., footnote 1; Toshitsugu Shimizu, “settlement System of ‘Ibkyo Stock Exchange,” Oct. 5, 1988, ibid.; interviews with

Masayoshi Hamam and Toshitsuqu Shimizu of the Tolqo Stock Exchange, Mar. 8, 1989, Bankers Trust Co., op. cit. footnote 1; and IBM, “Study of

Clearance and Settlement for the U.S. Congress-OTA,” Aug. 1, 1989, also part of the OTA contractor report by Bankers Trust Co., op. cit., footnote

1.
96 ● Trading Around the Clock: Global Securities Markets and Information Technology

. Same-day funds: except for Japanese government

bonds, the settlement of all stock exchange trades in

Japan is through checks, which do not clear until the

next day. Some risk could be removed from the

settlement process if payment were to be made in

same day funds, via an electronic funds transfer

system. 56

The Japanese securities industry is also discussing

ways to facilitate cross-national border trading for both

Japanese investors and foreign investors. Some possible

improvements include:

●

●

●

Immobilization of securities in their home market:

the Japanese securities industry supports this, as well

as the creation of bilateral and possibly multilateral

linkages among depositories and clearinghouses.57

Elimination of Depository Receipts (DRs): the Tokyo

Stock Exchange advocates this as part of immobilizing securities.58

International harmonization of settlement times; as

noted, equity settlement in Japan takes 3 days, and in

the United States 5 days.

The Tokyo Stock Exchange (TSE)

Japan Securities Clearing Corp. (JSCC)—The TSE

has a division known as the Clearing Administration

Department, which is the planning and rule-making body

for all matters concerning clearing and settlement.59 It

supervises the overall process, but the bulk of the

day-to-day clearing and settlement process is entrusted to

the Japan Securities Clearing Corp. (JSCC), a wholly

owned subsidiary of the TSE. All of the approximately

120 members of the TSE are regular members of JSCC,

so there are no exchange members who are not also

clearing members. All must maintain a clearing office in

Tokyo and a banking relationship with each of the 13

approved clearing banks.60

JSCC settles cash-market equity trades (both domestic

and foreign), a variety of bond trades, and futures

contracts (TOPIX)61 and U.S. government bonds traded

on the TSE. For equities trades, cash settlement and the

transfer of shares from seller to buyer occurs on the same

day (3 days after the trade date), but the payment and

securities delivery processes are separate. JSCC is not

involved in the payment process, which is handled by the

TSE’s Clearing Administration Department; JSCC takes

care of the securities delivery. The transfer of title to

securities is handled through JSCC’s computer Book

Entry Clearing System and through physical delivery of

paper securities certificates.

Neither JSCC nor the Clearing Administration Department take the counterpart position to trades. Nor are any

other formal guarantees made by either organization to

assure that the payment and securities delivery obligations of settlement will be met.62

All equities are processed by JSCC’s computerized

Book Entry Clearing System and are settled in one of four

ways:

1.

2.

3.

4.

“Regular way settlement”: normally, on the 3rd

day following the date of the trade; 99 percent of the

TSE’s stock transactions are settled in this way.

Cash transactions: settlement is on the day of the

trade (T+O); however, if both parties agree, settlement can be on the day after the trade.

Special agreement: settlement is scheduled at the

seller’s option, for a specified day within 15 days of

the trade date. This method is primarily used when

the counterparties to the trade are geographically

separated from each other by a considerable distance.

When issued: this method of settlement is used for

purchases of securities which either have not yet

been issued, or, for some other reason are not yet

available for delivery to the buyer. Contracts for

these types of securities trades are settled on the 4th

business day after the trade. After the shares have

been issued the stock exchange determines a date

after which “when issued” transactions may no

longer be performed.

Less than 1 percent of the transactions at the TSE end

in a failure to deliver shares on settlement day. If,

however, there is a default on either payment or delivery

S6SW IBM Aug. 1, 1989, op. cit., footnote 55.

sT~ Japm s~ties CIWUI@ COrp. (JSCC), which clears transactions for the Tc@o Stock Exchange @sE), c~entiy maintains linkages with

depositories and/or clearing houses in nine countries. See interview with Masayoshi Hamana and paper by T@hitsugu Shimuzu, op. cit., footnote 55.

SsDqository R~eip@ me domestic rweipts for the shares of a foreign-based corporation which are on deposit inabankvaulc or ac~tidmsitory,

in that corporation’s domestic market. A DR for a foreign stock can be purchased in a domestic market which does not list the underlying stock itself.

Ibid.

59stw~ on~ To@o s@-.k&c~e MC traded by ~o ~~entmc~odso ‘rhe 150 most active stocks me trad~~~y on the -c@ f100r. The

TSE recently announced that it is developing an electronic order book for these 150 issues which may be in use in late 1990. All other domestic and

foreign stocks are traded through CORES, the Computer-Asisted Order Routing and Execution System. See Ch. 4: Americans Compefitorsin Securities

Trd”ng. AISb see Harnana and Shimimq op. cit., footnote 55; and IBM repo~ op. cit., footnote 55.

me TSE rotates among these banks on a month-to-month cycle.

61~~T0p~~J me ~~o Stwk price~dexfi~es con~cts, Jap~’s equivalent of the Standard and Poor’s 500 index futures contracts onus. stocks.

bz~e TSE does provide for interest and peualties on those OCCaSiOXld MM titf~.
Appendix--Clearing and Settlement in Major Market Countries ● 97

of securities, the TSE requires that the trade be cleared or

canceled within four additional business days.63

For “regular way” settlement, procedures differ according to whether the trade was done on the floor or

through the CORES (automated execution) system. For

floor trades, specifics of the transaction are written on

trade slips which are transmitted via optical character

reader and computer terminals to the member firms which

are counterpart to the trade. As for electronic trades, the

trade data is automatically transmitted to the counterparties. Trade data is compiled overnight by computer and

transmitted to the JSCC before the exchange re-opens the

next morning. If either counterpart finds an error,

corrections must be made by contacting the TSE by the

afternoon of T+l.

Settlement is always on a net basis, in respect to both

the payment and securities. Accordingly, by the morning

T+2, JSCC advises the counterparties on their net

settlement obligations. By 4 p.m. on T+2, each net seller

firm advises JSCC as to how it intends to provide shares

for settlement (i.e., book entry or physical delivery), and

each buyer firm advises JSCC as to how it wants to

receive the shares due to it. The seller delivers securities

by means of either the JSCC’s computer book entry

system or through the physical delivery of certificates by

mid-day on the third day following the trade. Payment is

also made on T+3, but is by bank check (next day funds)

rather than electronic funds transfer.

Since finality of settlement is thus delayed on the

payment side, this settlement cannot be said to offer true

delivery versus payment (simultaneous settlement of the

delivery and payment obligations of a trade). On the

morning of the fourth day following the trade, the

payment obligation for settlement is netted into a single

.

Most TSE transactions do not involve physical delivery

of certificates. In only 15 percent of all TSE transactions

do both buyer and seller request that the actual certificates

be part of the settlement. In 41 percent of TSE trades, both

counterparties request settlement through JSCC’s book

entry system. The result is that book entry is used for

either receipt or delivery of securities in about four-fifths

of all transactions.64

Depository Functions-Although currently clearing

and settlement is done in Japan without a central

depository, this is expected to change in October 1991, in

respect to domestic stocks. The central depository to be

set up by financial services industry and the government

regulatory agencies is to be called the Japan Securities

Depository Center (JASDEC).65 All the details have not

yet been worked out, but the plan is for JASDEC’s

relationship with the JSCC to be similar to that between

the National Securities Clearing Corp. (NSCC) and the

Depository Trust Co. (DTC) in the United States.

Alternative ways to streamline the custodial and depository aspects of clearing and settlement for foreign stocks

are being discussed. JSCC has recommended that it

increase the number of its linkages with foreign clearing

houses and depositories.

Currently, JSCC’s book entry clearing system transfers

TSE-listed stocks directly between accounts, but a major

problem is that this is done on the basis of stock exchange

rules, not on the basis of law. In order for re-registration

to occur before each record date, JSCC returns the

deposited share certificates to the shareholders (it will also

do so at any time its members request it). JASDEC’s

Central Securities Depository System will immobilize

physical certificates, providing for book entry share

transfer facilities, and tracking real ownership.66 The

securities that will be eligible for such processing are

listed share certificates, OTC share certificates of the

Japan Securities Dealers Association (which is developing a new electronic market, JASDAQ, modeled on

NASDAQ), and warrants listed on stock exchanges.

Participants in the central depository will be required to

obtain written permission from their clients in order to

immobilize share certificates, and then will be responsible

for opening and maintaining deposit accounts for the

client. Share certificates will be transferred to the name of

the central depository and kept in joint custody. Every

Japanese exchange and clearing house will open a share

account at JASDEC. JASDEC will also handle bookentry deliveries of over-the-counter securities.

63rf ~~ is ~ defa~t on the securities delivery, the seller may issue a “due bill” to the TSE (an IOU, actually a bank check for the money amount

of the failed trade). The due bill is deposited with the TSE until the seller’s obligation has been met. If the seller should default on the delivery, the TSE

will turn the due bill over to the buyer. The due bill is a contractual agreement between the seller and the TSE, and is covered by exchange rules and

regulations and defaulting sellers are subject to TSE penalties.

isasti op. cit., footnote 56.

6S~ $$~w CO~g Central Depository and Book-Entry Deliveries for Share Certificates and Other Securities” which authorized the creation

of JASDEC was passed in May 19S4. Development work on JASDEC began in December 1984; the target date for implementation is October 1991,

66~thiswy, the services provid~ at JASDEc will be similar to those provided by the XMJRUS @nmsferand Auto~t~Re@t@ion of unc~~

Stock)”book-entry computer system used by the International Stock Exchange in Ixmdon.
98 ● Trading Around the Clock: Global Securities Markets and Information Technology

The Osaka Securities Exchange (OSE)67

OSE has 94 exchange members and an additional four

non-member special participants, admitted in order to

trade in futures contracts. Unlike the TSE, the OSE trades

options as well as securities and futures. The options are

based on the Nikkei 225 index; trading began in June,

1989.

Clearing and settlement of options contracts is handled

by the OSE’s own clearing department. All members of

the OSE are also clearing members. The process at the

OSE is similar to that at the TSE, with a few notable

differences. First, all trade data comes in via trade slips

and optical character recognition (OCR) reader the OSE

does not yet have electronic trading, although it will begin

sometime in 1990. Secondly, all equities are settled

through physical delivery instead of by book-entry

transfer of title. The OSE does, however, plan to make use

of the JASDEC depository and custodial capabilities,

when it opens, but will retain its own clearing department.

Special Features of Japan’s Markets

Japanese Banks and Settlement-Japan does not now

offer “delivery versus payment” service, because stock

exchange payment is generally made through checks

which do not clear until the next day. This poses a risk for

the seller, since there is always the possibility that a check

may bounce.

The exchanges decide which banks are clearing banks

(TSE has 13 clearing banks, OSE has 8). Clearing

members must maintain an account with each of those

banks, but do not give their banks third-party debit

authority (i.e., blanket authorization to debit a clearing

member’s account at the instruction of the clearinghouse).

The exchanges receive payments from members and

deposit them into an exchange account at one of the

approved banks,68 collecting all monies owed to it for that

day before disbursing money from the same bank account

to members who are net sellers. Both the TSE and the OSE

set and annually review individual payment limits for

each of their members; within these limits the member

may present uncertified checks for settlement obligations.

Futures Contracts69--TOPIX and Japan and U.S.

government bond futures contracts are traded on the

Tokyo Stock Exchange. Osaka Securities Exchange Stock

Futures (OSF50)70 and Nikkei 225 futures contracts are

traded on the Osaka exchange. Eurodollars, yen, and

Euro-yen contracts are traded on the newly created Tokyo

International Financial Futures Exchange (TIFFE). Trading for both the latter contracts has been computerized

since it began, in October 1988. TOPIX futures contracts

are traded through the TSE’s CORES-F system.

Whereas open positions in the Nikkei 225 Stock

Average are settled in cash on the last trading day of the

contract, open positions on the last trading day of the

OSF50 contracts are settled by physical delivery of shares

of the 50 underlying stocks. The OSE’s clearing department requires both the buyer and the seller of an OSF50

or Nikkei 225 futures contract to deposit as initial margin

a minimum of 9 percent71 of the sales/contract value (with

a minimum of 6 million yen). One third of the initial

margin payment must be paid in cash. After the first day

of the contract, additional margin is owed depending on

price fluctuations in the market, after daily marking to

market. Additional margin is due when a loss due to

adverse market price fluctuations exceeds 3 percent of the

sales or total contract value.

TOPIX futures are settled in the months of March,

June, September, and December. Customer margin requirements are similar to those at the OSE for OSF50

contracts, an initial margin of either 9 percent of the value

of the transaction or 6 million yen. Members must also

pay margin of 6 percent or more of the price of the

contract.

Government bond futures are settled on the 20th of

March, June, September and December. Banks and

non-TSE member securities companies may use accounts

at JSCC to clear Japanese Government futures contracts.

The TSE and the OSE accept as collateral to meet

margin requirements for futures any of the following:

cash, any securities listed on any Japanese exchange,

stocks registered with the Japan Securities Dealers

Association, or beneficiary certificates of the securities

investment trusts. Bank letters of credit are not accepted

as collateral. Payments are due from clearing members for

the netted position of each type of futures contract. The

Osaka Securities Exchange maintains a Settlement Fund

and a Default Compensation Reserve Fund System which

cover participants against the default of other exchange

members. These funds are for the trading of all instruments on the Exchange, including futures contracts. The

TSE also has a guarantee fund, which totals 5 billion yen.

GTrnfomtion in this section is based on the IBM repo~ op. cit., footnote 56, on the response to questions posed to Mr. Y05hioh of the O* Stool

Exchange by OTA contractor, Bankers Trust Co., op. cit., footnote 1, and an interview by OTA contractor, Bankers Trust Co., with Messrs. Yoshibzuu

Oritani, Eiji Hirano, and Iwao Kuroda, Bank of Japan, March 1989.

GsTheexc~ges~~ acco~ts at eachof the clearing banks, although only one is used at any one time. The exchanges mtatewh.ichof me cIX

banks they use according to a defined schedule (i.e., the OSE rotates every 10 days; the TSE, once each month).

Gwo~tion supplied by the TSE and the OSE, in OTA contractor report by Bankers Trust Co., op. cit., foO~Ote 1.

T~e OSFSO is almost a dormant market.

TIU.S. fi~es margins are generally 3 to 5 percent.
Appendix--Clearing and Settlement in Major Market Countries ● 99

International Trading72—The TSE currently lists 120

foreign stocks. JSCC advocates building and maintaining

custodian relationships in the country where these securities were issued. Clearing and settlement communications

can then be handled through business linkages (i.e.,

dedicated communication lines) between depositories and

clearing houses. Trades in foreign securities listed on the

TSE are cleared through JSCC’s book entry system. They

are held by JSCC in the issuer’s home country, either

through a link to that country’s depository, or in a custody

account through a bank in that home country. JSCC has

linkages for this purpose with Australia, Canada, the

Netherlands, Germany, France, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

Both the TSE and the JSCC feel that there are

significant advantages to the book entry approach,

combined with overseas custody linkages, because the

efficiency of equity clearing is based on the ability of

investors to fulfill the delivery obligation by either

book-entry receive or delivery on the settlement date

(T+3). Settlement of transactions on behalf of nonresidents is usually more complicated than settlement for

domestic clients, because information must pass through

a series of intermediaries. So, at least with linkages, it is

easier for the nonresident to deposit securities locally in

the home country, where most custody is. This eliminates

a risk for the TSE-member broker, who remains obligated

to settle on T+3, and otherwise might have difficulty

receiving the physical shares from clients in time for

settlement.

U.S. securities comprise 70 percent of the foreign

securities traded on the TSE. The TSE has a special

arrangement with the International Securities Clearing

Corp. (ISCC) in the United States, through which U.S.

shares traded in Japan are kept for JSCC by ISSC on

deposit at The Depository Trust Co. (DTC) in New York

City. In the same way, JSCC acts as a custodian for

Japanese securities which are being traded on some

exchanges outside Japan. Currently, it provides this

service to depositories in the Netherlands and France and

is discussing with ISCC the possibility of acting as a

depository for Japanese stocks being traded by ISCC

participants in the United States.

Tz~o~tion in tb,is s~tion is based on a paper by Nomura Securities, in the OTA contractor report by Bankers Trust CO., op. cit., footnote 1.
Acronyms and Glossary

ACT

ADP

ADR

AMEx

BIS

BOTCC

CBOE

CBOT

CCITT

CEDEL

CFTC

CME

CNs

DTC

DVP

EC

FIBv

FRs

G-30

GAO

GM

ICC

ICCH

IOSCO

ISCC

ISE

IS0

ISSA

ITS

JASDEC

JSCC

Acronyms

—Automated Confirmation Transaction

[System] (NASD)

—Automatic Data Processing, Inc.

—American Depository Receipt

—American Stock Exchange

—Bank for International Settlement

—Board of Trade Clearing Corp.

-Chicago Board Options Exchange

—Chicago Board of Trade

-Comite Consultatif International

Telegraphique et Telephon (International

Telecommunications Union)

—Commodity Exchange Act

—Centrale de Livraison de Valeurs

Mobilieres

—Commodity Futures Trading Commission

(U.S.)

-Chicago Mercantile Exchange

-Continuous Net Settlement

—Depository Trust Corp.

-delivery-versus-payment

—European [Economic] Community

—Federation International des Bourses de

Valeurs

—Federal Reserve Board (U.S.)

—Federal Reserve System

-Group of Thirty

-General Accounting Office

-General Motors

—Intermarket Clearing Corp.

—International Commodities Clearing House

(U.K.)

—International Futures Exchange of

Bermuda

—International Organization of Securities

Commissions

—International Securities Clearing Corp.

—International Stock Exchange of the

United Kingdom and the Republic of

Ireland (in London)

-Organization for International Standards

—International Society of Securities

Administrators

—Intermarket Trading System

—International Telecommunications Union

—Japan Securities Depository Center (Japan)

—Japan Securities Clearing Corp.

KCBTCC —Kansas City Board of Trade Clearing

Corp.

KV —Deutscher Kassenverein

LIFFE —London International Financial Futures

Exchange

MATIF —Financial Futures Market (France)

MOF —Ministry of Finance (Japan)

MONEP —Paris Options Market (France)

MOU —Memoranda of Understanding

MSE —Midwest Stock Exchange

NASD —National Association of Securities Dealers

NASDAQ —NASD Automated Quotation system

Nikkei 225 —Nikkei 225 futures contracts (Japan)

NSCC —National Stock Clearing Corp.

NYMEX —New York Mercantile Exchange

NYSE —New York Stock Exchange

OCC -Options Clearing Corp. (U.S.)

OECD -Organization for Economic Cooperation

and Development

ONA -Open network architecture (of computer

systems)

OSE -Osaka Stock Exchange (Japan)

OSF50 -Osaka Securities Exchange Stock Futures

(Japan)

OTC -Over-the-counter

PHLX —Philadelphia Stock Exchange

PSE —Pacific Stock Exchange

—Postal, Telegraph, & Telephone

[Authority]

S&P 500 —Standard & Poor 500 Stock Index

SCG —Securities Clearing Group

SDF —Same-Day Funds

SEAQ -Stock Exchange Automated Quotation

system (London)

SEC —Securities and Exchange Commission (U.S.)

SEPON —The Stock Exchange POol Nominee (U.K.)

SIAC -Securities Industry Automation Corp.

SICOVAM -Societe Interprofessionnelle pour la

Compensation des Valeurs Mobilieres

SIMEX -Singapore International Monetary

Exchange

SIPA -Securities Investor Protection Act

SIPC -Securities Investor Protection Corp. (U. S.)

SPAN -Standard Portfolio Analysis of Risk

SRO —Self-Regulatory Organization

T+l —Trade Date Plus One Day

TALISMAN —Transfer Accounting and Lodgement for

Investors, Stock Management for

Principals (U.K.)

TARS —Trade Acceptance Reconciliation System

(NASD)

TAURUS —Transfer and Automated Registration of

Uncertified Stock (U.K.)

-1oo-
Acronyms and Glossary .101

TIFFE —Tokyo International Financial Futures

Exchange

TIMS —Theoretical Intermarket Margin System

TOPIX —Tokyo Stock Price Index Futures

TIMS —Theoretical Intermarket Margin System

TOPIX —Tokyo Stock Price Index Futures

Contracts (Japan)

TSE —Tokyo Stock Exchange

UCC —Uniform Commercial Code (U. S.)

Glossary

Access Deregulation: Changes in national laws or

regulations that open the counties markets, especially

membership on exchanges, to foreign participation.

American Depository Receipt (ADR): A receipt signifying ownership of shares in a foreign corporation.

Transactions are made in the ADR in lieu of transactions in the security, which is usually held by a trustee.

The ADR is usually issued by a foreign branch of an

American bank.

American-Style Option: A put or call option that can be

exercised at any time before expiration; all listed

options are of this kind, including those on European

exchanges. See “Option” and “European-Style Option. ”

Amex: American Stock Exchange, in New York, the

second largest U.S. stock exchange.

Analog Signals: Resemblance or correspondence; used to

describe traditional forms of electronic information

such as pictures, speech, or written and printed

characters, as opposed to digitized information.

Arbitrage: The simultaneous or closely related purchase

and sale of the same product or related products in

order to take advantage of price differences between

them (which are presumed to be unrealistic and

temporary). Arbitrage often involves stock and either

futures or options; it may involve a basket of stock and

a stock-index futures contract.

AURORA: An electronic system for the international

trading of futures contracts being developed by the

Chicago Board of Trade; it is now to be merged with

the GLOBEX system (see GLOBEX) but details have

not been worked out.

Bear Market: A market with generally declining prices.

See “Bull Market.”

Block: A large number of shares of a single stock; usually

defined as 10,000 shares or shares whose value is at

least $200,000.

Bond: A debt security; a long-term promissory note

evidencing corporate or government debt, which pays

interest to the holder.

Book-Entry: An item in a depository’s computer records

that identifies, or is used to transfer, ownership of

stocks or bonds.

Broker: A securities firm or individual that represents

customers in transactions (i.e., trades as an agent). See

“Dealer.”

Bull Market: A rising market; that is, a market with

generally rising prices. See “Bear Market.”

Call: See “Option.”

Capital Markets: Markets where debt and equity securities are traded. Includes private placement as well as

organized markets and exchanges.

Capitalization (of an exchange): The total value of listed

securities.

Cash Market: The market in which transactions are

completed immediately and assets will be delivered in

return for payment; as contrasted with a futures market.

Cash markets include organized, self-regulated exchanges and over-the-counter markets for stock and

commodities.

Churning: Excessive trading of securities or other

products by a broker or floor trader, usually in order to

generate commissions. A form of market abuse.

Clearing or Clearance: The processing of transactions in

stock, futures, or options markets, in which the buyer’s

and seller’s records of a transaction are matched, in

preparation for settlement. Clearing includes confirming the identity and quantity of the security or contract

being bought and sold, the transaction price, date, and

identity of the buyer and seller. In some clearing

organizations, it also includes the netting of trades.

Clearing Member: A securities firm that is a member of

both an exchange and its clearing organization; a

clearing member handles (for a fee) the clearing of

transactions of other members of the exchange who are

not clearing members, as well as its own clearances.

Clearing Organization: An organization that handles

clearing and (sometimes) settlement; clearing organizations do not exist in some countries.

Closing a Position: Eliminating an investment from

one’s portfolio, either by selling it or (in futures and

options trading) making an offsetting transaction—

e.g., a purchase of a futures contract offsets the sale of

a futures contract.

Counterparty: Either party (buyer or seller) to a transaction.

Custodian: A bank or other financial institution that

keeps stock certificates and other assets for a customer

(an individual, corporation, mutual fund, or pension

fund).

Dealer: A securities firm or individual acting as principal

(trading for a proprietary account) rather than as agent

(trading on behalf of a customer). If a firm acts as
102 ● Trading Around the Clock: Global Securities Markets and Information Technology

principal in some transactions and as agent in others,

it is called a broker/dealer.

Debt Security: An instrument representing money borrowed, such as a bond, a bill, a note, or commercial

paper. It specifies a fixed amount of money, a date or

dates of maturity (repayment), and usually a fixed rate

of interest or discount on the original purchase price.

Delivery v. Payment: A settlement term, meaning that

delivery of a security requires payment at the same

time; in effect, a cash-on-delivery transaction.

Dematerialized: Existing only in the form of electronic

records, in lieu of a paper certificate (e.g., a dematerialized security).

Depository: Organizations that hold stocks and bonds for

safekeeping, on behalf of their owners.

Derivative Products: Tradable futures and options contracts for which the pricing depends on (i.e., is

derivative of) the price of a specified asset, such as a

stock, a commodity, or the basket of stock represented

in a stock index such as the Standard& Poor 500.

Digitization of data: The translation of data from

traditional (analog) forms such as pictures or printed

figures and text to binary-coded electronic signals.

Dow Jones, or Dow Jones Averages: Market indicators,

issued by the Dow Jones & Co., to indicate changes in

price of groups of stocks: for example, industrial,

transportation, utility, and composite groups of stocks.

Efficient Market: A market in which the prices of

securities immediately reflect all available informaion; for "free market” advocates, a market in which

prices are relatively unloaded or “distorted” by

transaction costs, taxes, regulatory costs, or other

additions to fundamental stock value.

Equity Security: An instrument representing and conveying ownership interest in a corporation, i.e., stock.

Eurobond: A bond sold in a country other than the one

in whose currency the bond is denominated; for

example, a U.S. bond sold overseas.

Eurodollar: A U.S. dollar on deposit in a foreign bank;

usually a European bank, possibly a foreign branch of

a U.S. bank.

European-Style Option: An option that can be exercised

only on its expiration date, rather than before that date.

See “Option” and “American-Style Option.”

Foreign Exchange: Foreign currency market; foreign

currency is bought and sold for immediate or future

delivery.

Forex: The informal market for foreign currency.

Fourth Market: Securities transactions made directly

between institutions, without the intermediation of

brokers or dealers.

Futures Contract: An agreement to buy or sell a

commodity (including financial instruments) for delivery in the future, at a specified price. Each party to the

contract is obligated either to fulfill the terms of the

contract or to offset the contract by entering into an

opposite transaction. The latter (the most commonly

chosen alternative) can be done because the clearing

organization becomes one counterpart to all transactions.

GLOBEX: An electronic system for international trading

of futures contracts, developed by Reuters and the

Chicago Mercantile Exchange, scheduled to become

operational in 1990-91.

Group of Thirty: An independent, non-profit association

of business persons, bankers,- and representatives of

other financial institutions from 30 developed nations,

who address major global financial topics at policy

levels.

Hedge: Protecting one position by taking an offsetting

position. Typically, one takes a position in a futures

market opposite to a position in a cash market (a

commodity or stock market) in order to minimize the

risk of loss from an adverse price change. An

institutional investor may use stock-index futures to

hedge an indexed stock portfolio. Other means of

hedging include selling short, buying a put option, or

selling a call option.

Index: A market indicator that represents the average

price of a specific basket or portfolio of stock.

Index arbitrage: The simultaneous purchase/sale of the

basket of stock represented in an index (such as the

Standard & Poor 500) and of the stock-index futures

contract for that index in order to profit from temporary

differences in their price.

Insider Trading: Trading a security on the basis of

confidential or privileged information, to which one

has access as an “insider” (e.g., as an officer, director,

or attorney) of the corporation issuing the security.

This is illegal in many countries, because it disadvantages other investors.

Instinct: A proprietary electronic securities trading system, owned by Reuters, that does about 13 million

trades per day.

Institutional Investor: An institution with a large

portfolio, such as a mutual fund, a public or private

pension fund, a labor union, or an insurance company;

the trading is usually the responsibility of a professional money manager.

Intermarket Trading System: An electronic network

linking stock exchanges in the United States, allowing

orders to be routed from one exchange to another

exchange offering a better price.

Investment Banker: A firm that underwrites stock,

advises other firms on how to raise capital, arranges

acquisitions, etc. See “Underwriting.”
Acronyms and Glossary .103

Liquidity: The characteristic of a market (or of a listed

security) with enough potential buyers and sellers to

allow large transactions without a substantial change

in the prevailing price.

Listed Security (also listed option, listed future): One

that has been accepted for trading by an organized and

regulated securities exchange. Unlisted securities are

traded in the over-the-counter market.

Locked-In Trades: Transactions that are matched and

confirmed by computer, usually at the place of the

trade, before being sent to a clearing organization.

Long Position: Shares (or other instruments) owned by

an investor or dealer.

Maintenance Margin Call: A call for additional funds to

be put into a margin account because of an adverse

market movement.

Margin: In securities markets, the amount that must be

deposited with a broker by one buying securities-the

broker extends credit for the remainder of the purchase.

In the United States, minimum margin requirements

are set by the Federal Reserve Board of Governors. In

U.S. futures markets, both buyers and sellers put down

initial margins, which are defined as performance

bonds or good-faith deposits to assure that the trader

will fulfil the contract. The minimum margin requirement is set by the clearing entity of the futures

exchange. If the futures price moves adversely, the

investor will be called on (daily or more often) to put

up more money or collateral.

Marked-to-Market The daily or intra-daily adjustment

of settlement obligations (in futures and options

markets) to reflect current market prices. Marking-tomarket determines the amount of margin that must be

held, and is done by clearing organizations to limit

their risk to one day’s market movement.

Market-Maker: A dealer who makes firm bids and offers

at which he will trade. In some markets (e.g., the U.S.

over-the-counter market and the International Stock

Exchange) there are competing market-makers; in

others (e.g., the New York Stock Exchange) there is

one designated market-maker for each stock, called a

specialist.

Mutual Fund: A fund operated by an investment

company that raises money from the public (by selling

shares) and invests it in stocks, bonds, options,

commodities, or money market securities.

Netting: The determination of the difference between

one’s total credit and total debt positions, which results

in a single amount that a market participant either owes

or is owed.

Offset: (1) In futures markets: to close out or cancel a

position by taking an equal, opposite position-for

example, one offsets purchase of a futures contract by

selling a futures contract of the same kind. (2) In

international trading, to open a position in one country

and close it in another, under an agreement between the

two exchanges.

Open Outcry: The method of trading on commodities

(and futures) exchanges, where traders shout out their

buy and sell offers.

Option: A contract conferring the right to buy (call) or to

sell (put) a security at a designated price during a

specified period.

Over-the-Counter: A market where stock transactions

take place through dealers, but not on or through an

exchange or centralized market.

Passing the Book: Transferring the responsibility for

portfolio trading from one location to another in a

different time zone, in order to trade for more hours of

the day-the ultimate is “24 hour trading. ”

Pit: The floor of a futures exchange, surrounded by tiered

platforms on which traders stand to shout their bids and

offers (see ‘Open Outcry”).

Position: An investor’s or dealer’s stake in a security or

in a market. A long position equals the number of

shares owned. A short position equals the number of

shares owed.

Price-Earnings Ratio: The current market price of a

stock divided by its earnings per share.

Private Placement: The distribution of securities, not

listed on an exchange or organized over-the-counter

market, to a small number of usually institutional

investors. Such placements are exempt from many

SEC and state registration requirements.

Program Trading: The simultaneous purchase (or sale)

of a large, diversified portfolio of stocks, ordinarily

using a computer to handle the complex order routing.

Prospectus: A description, e.g., of an issue of stock,

giving essential information about the stock for the

benefit of potential buyers; (in the United States) a

summary of the registration statement filed with the

SEC.

Prudential Regulation: Regulation aimed at assuring the

fairness of a market, and protecting the investor from

fraud, manipulation, or unrecognized risk.

Put: See “Option.”

Rolling Settlement: An arrangement whereby trades can

be settled on any business day, as opposed to one or

more designated days for each trading period.

Same-Day Funds: Payment is final on the same day it is

made (checks do not represent same-day funds,

because it may take them several days to clear, during

which the receiver of the check does not have access

to the money).
104 . Trading Around the Clock: Global Securities Markets and Information Technology

SEAQ International: The automated trading support

system used to facilitate translational trades at London’s International Stock Exchange.

Seat: Membership on an exchange.

Secondary Market: The market in which stocks are

traded after their initial issuance and placement. The

exchanges and other markets discussed in this report

are all secondary markets.

Security: An investment contract conveying participation

in a common enterprise, in which there is expectation

of profit resulting from the efforts of others; this

includes stocks, bonds, and options, but not futures

contracts.

Settlement: Payment to the seller and delivery of stock

certificates (or other means of transferring ownership)

for the buyer.

Short Position: The number of shares (or other instruments) owed by an investor or dealer; see ‘short sale.

Short Sale: The sale of a security which is settled by

delivery of borrowed securities (rather than securities

owned by the seller). Generally, the seller expects to

buy securities later, at a lower price, to cover the short

sale.

Specialist: An exchange member who acts as designated

market-maker on an exchange for one or more stocks;

the specialist’s functions are: 1) to assist other

members on the floor find buyers or sellers with whom

to trade, 2) to hold and execute limit orders (orders to

buy or sell when the market reaches a certain price) for

other brokers, 3) to buy for or sell from his own

inventory when necessary to provide liquidity and to

moderate or smooth out price jumps, and 4) through

these and related means to maintain a fair and orderly

market.

Standards: A criterion established by authority, custom,

or general consent as a model or a measure of quality,

quantity, form, size or some other parameter. In

information technology, for example, general conformance to a standard makes possible interoperability or

interconnectivity of systems.

Third Market: Trading exchange-listed securities over-the

counter rather than on the exchange.

Treasuries: Bills, bonds, and notes issued by the U.S.

Treasury.

Underwriting: The act of buying new issues of securities

from issuing corporations, and reselling them. This is

one of the activities of investment bankers, but it is

usually carried out through the formation of an ad-hoc

syndicate.

Universal Banking: The most common bank regulatory

arrangement, whereby banks can engage in most

financial activities, including securities underwriting

and trading. In the United States and Japan, in contrast,

banks are restricted from engaging in many securitiesrelated activities, including underwriting.
Index

access deregulation 4, 11,28,47

American-Style Option 48

Amsterdam Stock Exchange 61

Arbitrage 4,9,37,40-41

Article 65 (Japan) 29,43

Associated Press 14

Auckland 17

AURORA 18,48

Automatic Data Processing, Inc. (ADP) 14,15, 16

Bank for International Settlement 61,62

Bankruptcy Code (U.S.) 65

banks 2, 4-5, 14, 22, 29, 32, 37-38,4043, 48, 57, 62,

64-67,70,73-75,78

Big Bang 3,28,4445,4748

bond dealers 15

bond markets 23,33,74

book entry 19,55,58,60

Canada 14,27,29-30,37,55-56, 66,72,74, ’76

capital imbalance 26

capitalization of stock markets 23

CEDEL 61,68

Chicago Board of Trade 16,33-34,48

Chicago Board Options Exchange 18

Chicago Mercantile Exchange 16-17, 33-34, 41, 43

Cincinnati Stock Exchange 18

Citicorp 16

clearing and settlement 3-4, 8,37,42,55-70,74

goals of 3,55-56

interfaces 14

models of 3

Comite Consultatif International Telegraphique et Telephon 21

Commodity Futures Trading Commission (U.S.) 9, 34,

65,70,76

crash of October 19872,6,28, 32

cross-listing of stocks 29

cross-national diversification 11,28-30

custodian 43, 57,67-68,70

default 4,56-57,65-66

Denmark DV 34,61,73

depositories 42,55-58,62,67,69

deregulation 3-5,11,28,32,43-44,47, 71-72,76,78

Deutscher Kassenverein 58

digital data 13,16

Dow Jones & Co., Inc. 14-15

enforcement 5,37,43,53,62,70,74, 76,78

Eurobonds 29

Euroclear 61,68

Eurodollar 17

European Community 1-3,5,7,21,37,47,61, 74,76

Federal Reserve System 24,60,69-70

Federation Intemationale des Bourses de Valeurs FIBV 3,

61

finality of payment 66

Financial News Network 14

firebreaks 64

foreign membership in exchanges 11, 14-17, 19,44

foreign portfolio investment 27,31

forex 14-16,55

Frankfort 42

fraud, abuse 4,43,49-50,72-73,75

futures 2,4,6,8-9,14,16-18, 21-22,23,33-34,39-41,43,

47,49,55,57,63-65,69-70, 72,74,76,78-79

futures exchanges:

Chicago Board of Trade 16-18,33-34

Chicago Mercantile Exchange 16-17,33-34

LIFFE (London) 18,33

MATIF (Paris) 17,34,49

GEMCO 16

Glass-Steagall Act 29,43

global custodians 68,70

GLOBEX 16-18,43

Greenspan, Alan 24,64

Group of Thirty 37,59-63,68-69

recommendations of 62

U.S. working committees of 60,63,68-69

harmonization 3-4,21-22,24,47-49,59, 65,67-70

Hong Kong 12, 17,37,68

ILX Systems 14

individual investors 2,25-26,39,42

information services vendors 1,5, 13

information sharing 4,60,63,65-67,70

information technology (computers, telecommunications)

1,6,11,26,32-33,36,37, 39

initial offerings 34

Instinct 16

institutional investors 1,5-6,25-28,30-31,34, 37-38,41,

44,46,59,68,72,79

International Futures Exchange 16

International Organization for Standards 21,76

International Society of Securities Administrators 3,61

International Telecommunications Union 21

International Thomson Organization 14

Irish Futures and Options Exchange 18

Japan (see stock exchanges, clearing organizations) 1-2,

6,12,23,25-34,37-38, 4044,50,55-58,60,72-73,

78

Japan Securities Clearing Corp. 57

Knight-Ridder 14-15

–l05-
106 . Trading Around the Clock: Global Securities Markets and Information Technology

large block trades 45

London (also see stock exchanges) 3,7-8,14,16-18,26,

28-30,32-34,43-45,47-48, 55,65,71

London Futures and Options Exchange 18

margins 15,39,41,56,63-65

Market News Service 14

Memoranda of Understanding (MOU) 7,76

Merrill Lynch 32

Monitor Dealing Service 16

mutual funds 2, 26,29, 35,50

NASD, NASDAQ 3,16,18-19,30,4244,60,63

national debt 27

National Securities Clearing Corp. 57,63

national treatment 5,53,73-74,77

networks (communications) 1-2,6, 11-12, 15, 36,48, 74

New Zealand Futures and Options Exchange 18

Nikkei 23,33-34

obstacles to international trading 1,3-4,8, 13, 19,28-29,

37,46,60,67

options 4, 14, 17-18,23,34,41,43,48-49, 55,57,63-65,

67

Paris 17

Paris bourse 3,34,49

Portal 19

portfolio diversification 2,50

President’s Working Group on Financial Markets (U. S.)

64

privatization 26,28,49

Quotron 14-16

reciprocity 6,73-74,76

regulation 4-6, 8, 19, 21-22, 24, 26, 28-29, 32-33, 37,

4244,47-50,53,60,62, 68,70,71-72,74,76-78

access regulation 4, 72

prudential regulation 4,28,37,47,50,53,72, 75-76,

78

regulatory arbitrage 4, 8,75-76, 78

Reuters 13-18,43

risk management 63

risks 1-5,7-9, 19,21,23-26,28,31,33, 35-36,37,55-59,

61-70,71-73,78

rolling settlement 58

Salomon Brothers 13,33

same-day funds 4, 60, 65-69

scenarios 5-8

SEAQ International 30,44-49

Securities and Exchange Commission (U.S.) 21,26,30,

59

Securities Investor Protection Corp. 65

SICOVAM 61

Singapore 17, 19,33

Singapore International Monetary Exchange (SIMEX)

17,33

standards 1-2,5,7-8, 19,21-22,24,28,33,35, 53,59-60,

64-65,67-68,70,74-76, 78

stock exchanges:

International Stock Exchange (United Kingdom) 3,29,

4344,55,61

New York Stock Exchange 3,16,18-19,29,33,38,57

Tokyo Stock Exchange (Japan) 2,23,30,32,37,41,43,

57,61

Sydney 17, 18

Sydney Futures Exchange 18

24-hour trading 33,55

technological innovation 6

technology 1, 11, 13-16,19,21-22,26,33-34, 36,37,43,

4546,49,65,67,70

Telerate, Inc. 14-16

Tokyo Grain Exchange 18

Tokyo International Financial Futures Exchange 18

Trade Acceptance Reconciliation System (NASD) 18

trading systems (automated) 1-2, 11, 14, 16, 18,46,70

transaction costs 3-4

trends driving globalization of markets 25-26

two-tier market 26,46

Uniform Commercial Code 55

universal banking 43, 73-74

Zurich 17,34