Communication from the Commission to the Council and the European Parliament - Clearing and settlement in the European Union - Main policy issues and future challenges
Date: 2002-05-28
Institutions: European Commission
Subjects: competition, financial equalisation, financial market, issue of securities, securities, stock-exchange transaction

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 28.5.2002
COM(2002) 257 final

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE
EUROPEAN PARLIAMENT

Clearing and settlement in the European Union
Main policy issues and future challenges

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE
EUROPEAN PARLIAMENT

Clearing and settlement in the European Union
Main policy issues and future challenges

Clearing and settlement are the processes by which securities market transactions are finalised
and are integral to the functioning of the financial system. In the context of completing the
internal market for financial services,
is crucial to have efficient (i.e. cost-effective,
competitive and safe) clearing and settlement arrangements for the EU as a whole. The
existing clearing and settlement arrangements within the EU are largely efficient in respect of
domestic securities transactions. However, these arrangements are national-based and do not
combine to provide efficient post-trade processing of cross-border transactions. Without
provision for efficient cross-border clearing and settlement, the full benefit of an internal
market for financial services cannot be realised.

it

the inefficiency in EU cross-border clearing and settlement derives from
Much of
fragmentation due to national differences in technical requirements/market practice,
tax
procedures and laws applying to securities. Moreover, in the absence of a common regulatory
approach to clearing and settlement activity, concerns over operational and prudential risks
may also act as an impediment to the development of cross-border activity. The creation of an
integrated clearing and settlement environment is, therefore, an essential pre-condition for
efficient post-trade processing of all securities transactions within the EU. To this end, the
Commission has identified two main policy objectives.

The first objective is to remove barriers to the finalisation of individual cross-border
transactions in the form of national differences in technical requirements/market practice, tax
procedures and laws applying to securities. The Commission considers that the removal of
barriers related to technical requirements will be primarily in the hands of the private sector.
Nevertheless, national and EU authorities can play a role in removing these barriers by
encouraging harmonisation through the development of standards. The remaining barriers will
require public intervention, as in the case of defining the legal system that is applicable to
securities transactions and holdings in the EU.

As the removal of barriers alone would not necessarily result in a fair and competitive
environment, the second objective is to remove competitive distortions or unequal treatment
of entities performing similar clearing and settlement activities. A fully integrated EU
clearing and settlement infrastructure would require that rights of access to systems be
comprehensive, transparent, objective and, above all, effective. Market participants should not
be constrained in making investment decisions by the location of counterparty, securities or
infrastructure. There should be generalised access (i.e. by all markets, infrastructure providers
and market participants) to all necessary systems. A first step in achieving this objective is
envisaged in the proposed revision of the Investment Services Directive, which provides for
the possibility of choice of systems for post-trade activity. The parallel application of
competition policy can be used to reinforce these measures.

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Integrated and competitive EU clearing and settlement arrangements must be consistent with
high standards of market integrity and financial stability. To this end, a common view is
required on an appropriate regulatory and supervisory framework for the providers of clearing
and settlement services. This is the motivation behind the complementary initiative by
securities regulators and central banks, to develop common standards. The implementation of
these standards should go along way to reducing the concerns of regulators about use of
systems in other Member States. However, common standards may prove to be insufficient to
provide a fair and stable framework for cross-border use of clearing and settlement systems. If
this were the case, some high-level principles (e.g. defining relevant functions, authorising
providers and governing their ongoing supervision) could be enshrined in law at EU level.
Provisions relating to any capital regime, default
the risk management
techniques for these institutions could also be addressed in this context.

rules, and/or

This Communication does not discuss the merits of different architectures or models for
providing pan-EU clearing and settlement services. The choice of architecture should be
to legitimate public-policy constraints (e.g. adequate
determined by the market, subject
competition, appropriate investor protection and minimised systemic risk.) However, it is
essential to create an environment in which market forces can deliver the most appropriate
architecture for an efficient clearing and settlement infrastructure for the EU.

This Communication is the first step toward developing a policy on clearing and settlement in
the EU. Comment from all interested parties is invited by 31 August 2002. Comments should
be sent to DG MARKT F2, European Commission, B-1049 Brussels. E-mail address: markt-
clearing-settlement@cec.eu.int

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I

INTRODUCTION

Efficient, structurally sound financial markets are more competitive and more attractive to
issuers and investors globally1. If the EU financial market is to compete on a global scale, it
must be deep, liquid, efficient, safe, transparent and cost-effective. An assessment of the
attractiveness of a market will be affected not only by direct costs of using the markets and
systems, but also the functionality provided, and less direct considerations such as efficient
use of collateral. If the costs of using European clearing and settlement systems are too great,
or if the infrastructure does not support the desired functionality, then market participants
might not invest in those markets or use other, potentially more risky, methods to achieve the
finalisation of cross-border transactions. Investors clearly need access to the markets that they
wish to invest in. For example, they need to be able to buy and hold equities issued by firms
in any member state at a reasonable cost. Excessive cross-border costs must be eliminated,
and increased legal, or other, risks arising from inefficient clearing and settlement minimised,
in order to attain a truly integrated securities market in the EU.

The nature of the problems in this area has become clearer recently. The subject of clearing
and settlement has been touched on indirectly in the Commission’s two consultations on
upgrading the ISD. The initial report of the Giovannini Group2 describes the current European
clearing and settlement landscape3 and a further report, examining possible developments in
the clearing and settlement architecture will be produced later this year. The Group of Thirty
(G30)4 are currently preparing recommendations on how to minimise risk and maximise
efficiency in the operations of these systems. The European System of Central Banks (ESCB)
and the Committee of European Securities Regulators (CESR) have launched a joint Working
Group to discuss issues of common interest in the field of clearing and settlement.5 In
particular, they are considering the adoption of common standards for clearing and settlement
entities in Europe, based on the CPSS-IOSCO6 Recommendations7 and the standards of risk
management developed by the European Association of Central Counterparty Clearing
Houses (EACH).

Using the information available through these various exercises, this consultative document
explains overall Commission policy on this subject and possible courses of action. Comments
are invited from the European Parliament and the Council, national
regulatory and
supervisory authorities, other EU level and national organisations and federations, market
practitioners, institutional investors, infrastructure providers and all other interested parties.
Comment is welcome both on the general policy approach and on the specific questions
highlighted in the text.

1

2

3

4

5

6

7

The Lisbon European Council stressed the importance of establishing within the Union, by 2005, a fully
integrated and efficient single financial market. The Stockholm European Council Conclusions also
underlined the crucial role played by financial markets in the overall economy of the European Union.
A group of experts that advises the Commission on capital market issues.
Cross Border Clearing and Settlement Arrangements in the European Union (November 2001) in
European Commission Economic Paper No.163
(http://europa.eu.int/comm/economy_finance/giovannini/clearing_settlement_en.htm)
A high level consultative group on international economic and monetary affairs.
The Commission is an observer on the Working Group.
Committee on Payments and Settlements Systems of the G10 central banks and International
Organisation of Securities Commissions.
Recommendations for Securities Settlement Systems, Report of the CPSS-IOSCO Task Force on
Securities Settlement Systems, November 2001. These have been accepted globally by central banks
and securities markets regulators as representing minimum standards for systems involved in the
finalisation of transactions.

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II

WHAT IS CLEARING AND SETTLEMENT & WHY DOES IT MATTER?

Clearing and settlement functions are the processes by which transactions in securities or
derivatives are finalised – so that the buyer receives the financial instrument and the seller
receives the corresponding payment.8 Colloquially these are sometimes said to be the
pipeworks of financial markets. The process involves several components, not all of which
will necessarily apply to each and every transaction:

–

–

–

–

–

–

Confirmation of the terms of any trade;

Calculation of the obligations arising for the parties involved – the process of
Clearance, which can result in net or gross obligations;

A Central Counterparty can interpose itself between the two parties to a trade,
becoming the counterparty to both sides of the transaction;

Delivery of the securities involved, accompanied by a corresponding payment, in
order to achieve settlement.

The safekeeping and administration of securities in Custody;

Registration, where applicable, of ownership of securities on a legal record.

Clearing and Settlement
of a Securities Trade

---------------------

Confirmation

Clearance

Payment

Delivery

Settlement

Custody

Source: Giovannini Group

Efficient post-trading processes are essential to allow market participants – issuers, investors
and intermediaries – to operate effectively in an integrated EU financial market. Accordingly,
efforts to improve pan-EU clearing and settlement arrangements must be made in parallel
with implementation of the Financial Services Action Plan.

Moreover, central counterparty, clearing and settlement systems are important for the stability
of the financial system: securities settlement systems hold the assets that are used to secure
payments in the large value payment systems and as collateral in monetary policy operations;
central counterparties are a single focal point for risk in the markets that they serve. The risk

8

For reasons of simplicity, in this Communication the term “clearing and settlement” is used generically
to encompass the full range of activities that may be involved in the finalisation of a transaction.

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management practices and overall oversight of these systems are important to ensure that the
financial system is efficient, liquid, orderly and robust.

III

THE CURRENT SITUATION

Interest in pan-EU financial activity has increased

Market practitioners are calling for improvements in efficiency and reductions in the cost of
finalising cross-border transactions. They express a variety of concerns: large banks and
investment firms, active in a number of markets, want to be able to centralise their securities’
holdings in a single system in order to make most efficient use of collateral and to minimise
costs. Institutional investors want to see a reduction in the cost of investing in a diverse
portfolio of stocks across the EU. Issuers want access to deep and liquid markets, where they
can readily raise capital. Retail investors want access to the widest range of stocks possible at
a reasonable cost and without additional complexity. In order for these conditions to be met,
the full range of pre- and post-trading systems across Europe must form an effective,
integrated network.

Traditionally, in domestic markets, all exchange transactions in securities were finalised using
the system(s) located in the same country as the exchange. A number of factors are causing
this former one-to-one relationship to break down. Participants on the exchanges are no
longer limited to domestic players. Securities are now traded on more than one exchange or
on other, non-domestic platforms which have an international membership and are, very
often, incorporated in countries other than the securities traded. Hence the traditional model
whereby the location of settlement is determined by the location of trading may no longer be
appropriate for all market participants.

Current EU cross-border clearing and settlement arrangements are inefficient

Current arrangements for the finalisation of securities transactions in the EU are generally
efficient at a national level but are too complex and costly for a single financial market across
the Union. By way of illustration, the diagram below shows the multiplicity of channels that
are used to access settlement systems in other Member States.

Channels for Cross-Border Settlement

International Investor

ICSD

Global
Custodian

Home Country
CSD

Local Agent

Local CSD

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Source: Giovannini Group

Much of the complexity can been ascribed to fragmentation, with the degree of fragmentation,
and correspondingly of risk and cost, varying according to the type of security, of transaction
jurisdictions involved. There are numerous systems, with differing
and the different
specifications and characteristics. This
the technology,
connections, knowledge and training required to undertake transactions across borders in the
EU. Different market and system rules, different membership requirements, different legal
jurisdictions must all be understood and complied with in order to ensure the safety and
finality of transactions.

increases the complexity of

The costs of undertaking securities transactions in the EU are difficult to quantify. They vary
according the security involved, the type of transaction, the nature of the counterparty, the
size of the transaction, the jurisdictions and the systems involved. Recent studies confirm that
the post-trade processing costs of a cross-border (inter-system) securities transaction in the
EU are multiples higher than for a corresponding transaction within a national market.
Comparisons are sometimes made to the cost of post-trade processing in the US, where the
national market also exhibits lower costs than those involved in cross-border transactions in
the EU. These higher costs in the EU comprise both direct costs resulting from membership of
systems and transaction fees, and other, less observable costs, which can both be traced to the
existence of barriers that arise from the fragmented infrastructure of EU financial markets.
The Giovannini Report identified a list of such barriers.

Current EU legislation

The instruments that make up the EU regulatory framework for clearing and settlement do not
combine to provide a comprehensive framework covering the full range of activities and
functions involved in the finalisation of transactions. Nor do they cover all the types of
institution that are involved in such activities. In fact, recently institutions have begun to
break away from their traditional, clearly defined roles resulting in a blurring of the borderline
between activities performed by different entities. This in turn has led to calls for a ‘functional
approach’ to regulation, under which the regulatory regime for each activity would be
governed by reference to the inherent risks of that activity, not by reference to the type of
institution undertaking the activity. Thus, entities providing the same functions/services
would be subject to the same rights and obligations. The current EU legislative instruments
are the Settlement Finality Directive (SFD), solvency ratio provisions of the Banking Co-
ordination Directive, the Capital Adequacy Directive (CAD) and, partially, the Investment
Services Directive (ISD). A fuller description of the current legal framework is attached at
Annex I.

Risks related to the activities of clearing and settlement

The risks arising from different types of post-trade activity must be adequately managed and
monitored. In a cross-border context, not only the technical capacity and risk management of
the systems themselves are critical, but also the technical links between those systems, and the
legal relationships between them.9Risks relate both to whether the failure of a single
participant would have knock-on effects on other members, or on the system itself, as well as
the potential impact of a failure in the system on the stability of the wider financial system.

9

Annex 4 of the Recommendations of CPSS-IOSCO Joint Task Force contains a description of how the
settlement of cross-border trades can give rise to particular risks: Custody and legal risks may be
increased by the involvement of multiple agents and multiple jurisdictions; the nature of risk involved
in a particular transfer is also affected when settlement occurs outside the CSD of issue, or when cross-
system settlement occurs.

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The interests of public policy bodies therefore cover macro financial stability issues, market
regulatory issues and prudential supervision of both the central counterparty, clearing and
settlement entities themselves, and their members. In a fully integrated network of post-
trading services across the EU, the prudential and operational risks would be highly complex
and require careful management in order to safeguard the overall integrity of the clearing and
settlement infrastructure and by extension the financial system as a whole.

IV

EU OBJECTIVES

There are two main policy objectives in order to achieve an integrated EU post-trading
environment. First,
individual cross-border
transactions, and thereby increase the efficiency of cross-border clearing and settlement in the
EU.

to remove barriers to the finalisation of

Second, to remove any distortions and constraints in the EU post-trading environment so that
different players can compete. Those providing the same functions should be subject to
equivalent rules and obligations and have equivalent rights. Trading and post-trading
infrastructure should not restrict or distort activity nor should there be additional constraints
on the performance of cross-border (as opposed to domestic) activity.

The policy objectives described above are designed to create the conditions for a market-
driven process of restructuring the post-trading industry. Underlying these objectives are a
number of principles: the extension of consumer choice; the fostering of competition; and the
maintenance of financial stability and investor protection.

V

HOW TO ACHIEVE THE OBJECTIVES

These objectives can be achieved by a combination of actions, which are described below.

1

Remove Barriers to the Finalisation of Individual Cross-Border Transactions

The first objective involves removing those obstacles that impose costs and risks on those
undertaking cross-border transactions. The Giovannini Report divided barriers into technical
or market practice barriers, barriers relating to tax procedures and legal barriers.

Technical & Market Practice Barriers

Some of these barriers relate solely to technical requirements, others to market practice. This
latter group are more complex, being sometimes embodied in law, sometimes the result of
stock exchange rules and sometimes simply convention in that Member State.

Annex II lists the market practice and technical barriers identified in the Giovannini Report
and presents a possible set of actions designed to address this category of barrier. The
technological and systems aspects fall primarily to the private sector. It should be for the
market to decide what combination of systems, technology and/or links will best meet its
needs. Actions such as the implementation of communication standards and systems
harmonisation would all contribute towards inter-operability, i.e. to allow systems to inter-
connect, compete or integrate.

Inter-operability involves a three step process:

–

Establishing definitions of the various functions involved in finalising transactions.

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–

–

Establishing common processes and methods for each stage of the transaction chain
– membership criteria, settlement periods and timetables, netting procedures and risk
management.

Adopting harmonised communication links and standards for messages.

The technical capability already exists to deliver inter-operability of systems, but there has
been little progress in this direction in the EU. There are a number of explanations for this:
First, continued uncertainty over the final outcome of the integration process has resulted in
reluctance to invest in change. Second, some cite the continued presence of tax and legal
barriers as an inhibiting factor. However, the lack of progress may also be put down to
perverse incentives among infrastructure owners, management and users. These arise either
in some way from the current fragmented
because the parties involved derive profit
environment, or because those who would bear the costs of technical developments are not
the ones who stand to gain the most from them.

National and EU-level public authorities should seek to find ways to overcome this market
failure and undertake complementary actions. Some possible courses of action are detailed in
Annex II. For example, national authorities can remove restrictions embodied in their law and
simplify procedures for issuance and for corporate actions. The work by the ECB/CESR Joint
Working Group to develop common principles and standards will also help to reduce
divergence in market practice.

Restrictions on settlement location that result in the need to access multiple systems were
cited as the second most important barrier by respondents to the Giovannini questionnaire.
The Commission has included a provision in its proposals for a revision of the Investment
Services Directive10 that would enable market participants to choose their location of
settlement. The envisaged right would allow institutions to decide where to settle transactions
and hold securities on the basis of their own business needs. They could therefore choose to
centralise holdings in a single system or combination of systems, making the selection on the
basis of cost, efficiency, access to funding, level of service or other considerations important
to them. This would reduce complexity and allow for more efficient management of
collateral. The Commission should also work to ensure that the legal framework for securities
transactions is supportive of cross-border activity.

Is the combination of actions outlined in Annex II the best approach to the removal of this
category of barrier? Which actions should be priorities?

Tax Barriers

Differences in the procedures used in national markets for the collection and refund of taxes
impact directly on cross-border financial activity. The Giovannini Report singles out two
specific tax barriers that relate more directly to clearing and settlement. Both of these concern
the ability of institutions to provide tax services regardless of their country of establishment.
Some, but not all national authorities have already removed restrictions on the categories of
institution that are able to provide services in their country.

10

A revision to the ISD is envisaged for the end of 2002. A further consultation on this proposal was
launched in March).

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Some tax barriers raise broader, more fundamental issues for the operation of European
the processing of,
financial markets. The complexity and variety of procedures for
particularly, withholding and capital gains taxes result in higher costs and the need to use the
services of intermediaries with local knowledge. The recent proposal from the Commission
for a savings tax directive,11 builds on the principle of information exchange between member
states. The savings tax directive will establish minimum requirements for identification by the
paying agent of the beneficial owners and their residence. This is likely to have a positive
impact on the administrative burden for the institutions involved.

More broadly, different categories of trade, such as secured loans, swaps and repos, receive
different tax treatment across borders. These inconsistencies throw up technical barriers, but
are not in fact related to clearing and settlement systems, except where they are used as the
means to implement procedures.

Further study by the Commission is required in this area, in order that technical differences in
the procedures for handling taxes related to securities markets do not continue to hamper the
ability of market participants execute their optimal trading and investment decisions. Work
has begun: for example, in a Communication to the Council and the European Parliament12
the Commission identifies specific tax obstacles to cross-border economic activities in the
internal market and proposes a series of targeted remedial measures. Among the many issues
identified in this paper was the potential source of obstacles and distortions existing in the
area of double taxation conventions.

Legal Barriers

The legal basis for clearing and settlement systems, participation in those systems, holdings
and transfers of securities in the systems should be sound and transparent, both in the normal
course and in the event of insolvency or default. This is particularly important in the EU,
where it is increasingly possible for the securities, the counterparties to a transaction, the
trading platform and the systems used for finalisation of the transaction to be in different
jurisdictions. The barriers identified in the Giovannini Report arise from the application of
conflict of law rules, different legal regimes governing securities and their transfer and the
treatment of bilateral netting.

Conflicts of law

There is no single legal regime governing securities transactions within the EU. Cross-border
business often raises uncertainties over the applicable law for transactions which are cleared
or settled in different jurisdictions. Existing legislation at EU level has been designed to
provide greater legal certainty as regards the determination of the applicable law from the
different jurisdictions involved.

The Settlement Finality Directive (SFD) and the proposed Collateral Directive (CD) both
contain provisions that represent an evolution from the principle that the applicable law
should be that of the jurisdiction where a security (or entitlement in respect of a security) is
located. Instead, the security is to be treated13 as being located at the relevant register, account
or system where it has been recorded. This principle is known as PRIMA (Place of the
the SFD and CD rules apply only in limited
Relevant Intermediary Approach). But

11

12

13

Proposal for a Council Directive on taxation of savings income in the form of interest payments
Towards an internal market without corporate tax obstacles 23 October 2001 (COM (2001) 582 final).
SFD Article 9(2) and CD draft Article 10

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circumstances: the SFD only to securities offered as collateral to central banks and to payment
and settlement systems, and the CD only to securities offered as collateral. The principle of
PRIMA also underlies the proposed Hague Convention on Indirectly Held Securities which is
planned to be finalised during 2002. The Convention deals with the law applicable to
proprietary rights in indirectly held securities and would unify the approach used in all
jurisdictions adopting the convention. The Commission supports the intention behind the
development of the Convention and is currently examining the compatibility of
the
Convention as drafted with Community legislation. It would bring law into line with existing
market realities in Europe, whereby the location of the account on which book entry securities
are held is generally regarded as being the location of the security.

Diversity of legal regimes governing securities and their transfer

Given the substantial divergence in the legal treatment of securities across the EU,14 it has
been suggested that the optimal solution would not stop at achieving certainty as regards
determining which law is applicable, but would also require achieving a uniform legal
treatment of securities across the EU. This implies creating a special
legal regime for
securities – a “uniform securities code”. Such a regime would be far from easy to design,
especially for equities, because of the many links with national property, company, succession
and insolvency law in Member States. The Commission therefore believes that it is not a
solution that could be agreed upon in the short term.

Are further measures, beyond the adoption of the Hague Convention, required to achieve
effective resolution of conflicts of law in the EU?

Would adoption of these measures be sufficient to resolve the main legal uncertainties for
securities transactions in the EU?

If not, is a ‘securities code’, establishing a uniform legal treatment of securities across the
EU, either necessary or desirable?

2

Remove distortions and constraints in EU Post-trading Environment

The second objective is also essential for the creation of an environment which is supportive
of greater cross-border activity. Such activity should be free from constraint, without
jeopardising market integrity or financial stability. This requires the removal of distortions or
inequalities in the treatment of the same activities. Next, all markets, infrastructure providers
and market participants should be able to access all necessary systems, regardless of their
location. Fully integrated markets require that rights of access to systems be comprehensive,
transparent and non-discriminatory and, above all, effective. The parallel application of
competition policy can be used to reinforce these measures.

Level playing field between institutions involved in clearing and settlement

The current regulatory arrangements in the EU reflect a traditional institutional approach to
regulation and result in an uneven treatment of clearing and settlement activity. Outside the
provisions of the SFD, only those clearing and settlement entities that are licensed as banks or
investment firms are covered by EU legislation. In the context of ensuring competition

14

And the open-ended nature of the type of instruments that may be described as securities.

11

between entities providing the same services across Europe, it is important to establish a level
playing field.

One of the issues that has arisen as part of the process of revision of the ISD, is the treatment
of bank-licensed custodians and Central Securities Depositories (CSDs) not licensed as banks.
Custody is a non-core service under the ISD, such that investment firms (and banks) with a
passport to provide core services can also provide custody on a cross-border basis. Custody
services have been widely interpreted to include settlement of securities across accounts at the
custodian. This therefore amounts to a passport for bank/investment firm licensed custodians
to provide settlement across the EU. No corresponding right exists for those CSDs that are
neither banks nor investment firms. However, as custodians expand the range of their
activities, the boundary between the services provided by custodians and those of settlement
systems is becoming less clear, such that the members of the systems could be seen as
competitors to the systems themselves for certain services, for example asset servicing. The
consultation on the ISD has highlighted this regulatory imbalance and has led to calls for a
clear legal framework covering the activities of clearing and settlement.15

Another area where the treatment of banks/investment firms differs to that of non-bank
custodians and infrastructure providers is capital adequacy. At present, two institutions
undertaking the same business could be subject to different regulation, and hence have
different obligations and rights either domestically or across the EU. To achieve a level
playing field would require that
to the same treatment.
However, no common definitions of post-trading activities exist at EU level to assist in the
determination of own capital requirements or of capital treatment for exposures to particular
entities. The 1996 paper of the Basel Committee dealing with treatment of multilateral netting
under the Accord provides some “minimum standards” for clearing houses. However, there
are no equivalent standards in European legislation containing a common view on the precise
activities conducted and the attendant risks.

the same activities be subject

Does the creation of a level playing field require that common functional definitions of
clearing and settlement activities be developed at EU level?

Which post-trade activities should such definitions encompass?

The SFD protects transfer of collateral security provided in connection with a system, which
includes transfers to central counterparties or clearing houses. However, it is sometimes
argued that the implementation of the Directive has not resulted in the desired uniform
treatment across Europe of the definition of finality or of the full range of risks involved in
operation of or participation in systems. The Commission is required to present a report on the
application of this directive to the European Parliament and the Council. A study has been
launched for this purpose and its results will be available in 2003.

15

Many respondents to the Giovannini Group questionnaire and ISD consultation argued that common
EU principles are needed for the authorisation, supervision and capital adequacy of clearing houses.
Common principles were seen as ensuring a level playing field for clearing houses and as minimising
the risk of regulatory arbitrage among market participants.

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Rights of Access and Choice to clearing and settlement processes

Existing legislation

The ISD currently allows that remote members of regulated markets be allowed access to the
clearing and settlement systems of that market. Central counterparty clearing house and
settlement systems therefore can and do accept members located in other Member States.
Membership criteria form the first line of risk management for a system, so institutions
wishing to become direct members must be technically, financially and legally capable of
fulfilling their obligations. However, the membership criteria applied by the system must be
reasonable, objective and transparent and that such criteria be uniformly applied. More
specifically, there should be no discrimination, including with regard to the functionality
offered, on grounds of type or location of the entity applying for membership.

Orientations for ISD revision

The March 2002 proposals relating to clearing and settlement in the consultation on a revised
ISD would grant elements of choice to both markets and investment firms in the routing of
trades for clearing or settlement. Market participants could make use of central counterparty
clearing facilities in other Member States for off-market transactions and have the right to
choose the location of the settlement of their transactions, provided that the necessary links
are in place for their system of choice to be used. Regulated markets could have the right to
make use of the services of central counterparties established in another member state for
some or all transactions, subject to approval of the competent authority responsible for
oversight of the market.

Limitations on the current proposals

Neither the existing ISD, nor the plans for its revision contain truly comprehensive rights of
access and choice. They address some of the restrictions facing participants on location of
settlement, but do not offer a corresponding right for central counterparties and central
securities depositories to become members of other clearing and settlement systems. EU
legislation could be used to create rights of access and choice for and between all types of
entity involved in the clearing and settlement process. Consideration would need to be given
to whether there are efficiency or risk management arguments that point to the maintenance of
‘default’ routing of transactions to central counterparties.

Should EU legislation be used to provide comprehensive rights of access and choice across
and between all levels of the trading and settlement chain?

These rights of access and choice will not result in increased integration or competition if they
cannot be exercised effectively. In addition to the technical, operational and legal issues
described above, there are also concerns about the actions of national regulators, who would
have the right to object on grounds of adverse implications for the smooth operation of the
market. In the absence of agreed standards for the authorisation, oversight and supervision of
these systems, national authorities may have concerns about use of systems in other
jurisdictions for the finalisation of transactions on their markets, or involving their institutions
and investors. Common, objective criteria for regulators to assess the risks posed by different
systems and links are required in order to avoid arbitrary restriction of access and choice.

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What factors should market regulators be concerned with in deciding whether to grant use of
a system in another member state?

Development of common regulatory view

At present there is no agreed common regulatory status for central counterparties, settlement
systems and custodians in the EU. If inter-connectivity and consolidation of systems are to
develop in Europe, then it
to consider now the issues arising for public
authorities, in order that national differences in regulatory practice do not act as a drag on
market development.

is important

Currently, cross-border co-operation and communication between authorities with an interest
in a system or its participants is arranged directly between those authorities as and when
mergers and joint ventures arise. As cross-border mergers and links develop, so there will be
an increase in the burdens on regulators to achieve effective supervision of these functions. It
becomes ever more important to have clarity over the applicable supervisory regime (i.e.
which authority, among the different ones that might be involved in cross-border clearing and
settlement, is competent in the supervision of that cross-border business).

The process underway through the ECB/CESR Joint Working Group to develop a common
view on a broad range of aspects in relation to these systems can only serve to improve
understanding of the current landscape and achieve greater convergence on the issues of
particular regulatory concern in relation to different systems and activities. The Group has
also undertaken a consultation exercise, and will draw on the responses in the development of
any European adaptation of the CPSS/IOSCO Recommendations.

is possible that common industry and/or regulatory standards may not be
it
However,
sufficient
to provide a fair and stable framework for cross-border use of clearing and
settlement systems. They may leave room for continued constraint on the exercise of rights of
access and choice. In this case, some high-level principles could be enshrined in a legal
framework at EU level. These could be enshrined in a form of framework directive covering
aspects such as the authorisation, supervision,
techniques, default
arrangements, or capital treatment of such institutions.

risk management

Is there a need for framework legislation governing these functions at EU level?

If so, what particular aspects should be included in any such legislation?

Competition policy

The major force for facilitation of competition between undertakings providing clearing and
to ensure open access and
settlement
interoperability of networks. However, the parallel application of the competition rules is also
necessary.

initially come from measures

services will

Articles 81, 82 and 86 of the Treaty (the EU competition rules) apply to undertakings in all
sectors of the economy, including clearing and settlement.

Article 81 prohibits agreements between undertakings that can have an appreciable effect on
trade between Member States and which have as their object or effect
the prevention,
restriction or distortion of competition. With the exception of certain "hardcore restrictions"
such as price fixing, market sharing and output limitation, agreements can only infringe

14

Article 81 where they are entered into by undertakings with sufficient market power as to
cause negative market effects. Article 82 is a provision that places particular obligations on
undertakings holding a dominant position on the market. Efficient businesses are run with a
view to establishing strong market positions, to a point which may result in significant market
power. Holding a dominant position is not wrong in itself, if it is the result of the firm's own
effectiveness. But if the firm exploits its dominant position to stifle competition, there is an
anti-competitive situation which may constitute an abuse with the meaning of Article 82 of
the Treaty.

Article 86 gives the Commission the responsibility to check that Member States (as well as
those undertakings concerned) comply with the Community competition rules, when they
grant exclusive or special rights to undertakings,

The Commission services are in the process of conducting an in-depth ex officio inquiry of
the clearing and settlement sector. The addressees of this inquiry are market participants
including banks, trading platforms, and clearing and settlement systems. The purpose of the
inquiry is to ensure that Community competition policy is being properly respected in this
important sector.

The Commission has already identified a number of possible competition concerns in the field
of clearing and settlement

–

–

–

First, some market participants have indicated that certain settlement systems may be
engaging in discriminatory pricing and the application of dissimilar conditions to
equivalent transactions.

Secondly, exclusive arrangements may exist between exchanges and clearing and
settlement systems which restrict competition in clearing and settlement services.

Thirdly, some market participants have pointed out the possible risk of excessive
prices being charged for clearing and settlement services where (i) the clearing
and/or settlement system is controlled by a trading platform and (ii) trades on that
platform have to be cleared and/or settled in that system (so-called “vertical silos”).

The ex officio procedure will examine whether any of these possible concerns are justified,
and if so whether they can be addressed under the EU competition rules.

VI

THE NEXT STEPS

This Communication draws together a number of the highly-interconnected issues and the
various strands of work currently underway in Europe on this subject. It sets out the current
thinking of the Commission in this area and seeks views on the best steps forward.

Reaction is sought by 31 August 2002, both to the paper as a whole, and to the specific
questions highlighted in the text. These are reproduced below for ease of reference.

Following reaction to this consultation, the Commission will be better placed to consider what
action(s) could be appropriate in this area. Some possible actions could be further legislative
measures to improve legal certainty for securities transactions, or a proposal for a framework
directive defining the functions and conditions of business of clearing and settlement entities.

15

At the same time, a number of other initiatives will produce input into the debate:

–

–

–

The Giovannini Group will publish its second report, providing their own view on
where the priorities for action in this area should lie and examining possible models
for the future.

The Group of Thirty will produce its recommendations to improve the global
clearing and settlement landscape.

The ECB/CESR Joint Working Group will continue their work on harmonisation at
the level of supervision and oversight.

inform the
All of these elements, alongside the responses to this Communication will
Commission in deciding what
its next steps should be. Around the end of 2002 the
Commission will produce a document outlining the results of this policy review and the
consultation process, including setting out any further steps that it intends to take.

Questions to which specific response is sought

Is the combination of actions outlined in Annex II the best approach to the removal of this
category of barrier? Which actions should be priorities?

Are further measures, beyond the adoption of the Hague Convention, required to achieve
effective resolution of conflicts of law in the EU? Would adoption of these measures be
sufficient to resolve the main legal uncertainties for securities transactions in the EU?

If not, is a ‘securities code’, establishing a uniform legal treatment of securities across the
EU, either necessary or desirable?

Does the creation of a level playing field require that common functional definitions of
clearing and settlement activities be developed at EU level? Which post-trade activities
should such definitions encompass?

Should EU legislation be used to provide comprehensive rights of access and choice across
and between all levels of the trading and settlement chain?

What factors should market regulators be concerned with in deciding whether to grant use of
a system in another member state?

Is there a need for framework legislation governing these functions at EU level? If so, what
particular aspects should be included in any such legislation?

16

ANNEX I: EU LEGISLATIVE POSITION

The regulatory framework is mainly composed of the Settlement Finality Directive (SFD),
solvency ratio provisions of the Banking Co-ordination Directive, the Capital Adequacy
Directive (CAD) and, indirectly, the Investment Services Directive (ISD).

Settlement Finality Directive (98/26/EC). The purpose of the SFD is to reduce the systemic
risk associated with participation in payment and securities settlement systems, and in
particular the risk linked to the insolvency of a participant in such a system. As such it
contains provisions establishing the finality and non-revocability of transfer orders and
payment netting; on the non-retroactivity of insolvency proceedings; on the insolvency law
which is applicable to claims and obligations in a payment/securities settlement system; on
the insulation from insolvency proceedings of collateral posted in connection with
participation in a system and on the law applicable to cross-border provision of collateral.

Banking Co-ordination Directive/ Capital Adequacy Directive (93/6/EEC, 98/31/EC,
98/33/EC). There are two aspects of these directives and any future revisions that are relevant
to clearing and settlement entities. First, the treatment of exposures to central counterparties,
settlement systems and custodians. Second,
the capital requirements of the institutions
themselves.

Article 2(9) of Directive 93/6/EEC states that “exposures incurred to recognised clearing
houses and exchanges shall be assigned the same weighting as that assigned where the
relevant counterparty is a credit institution.” There is no common EU definition of a
‘recognised clearing house’. Directive 98/33/EC gives the competent authorities of Member
States the right (until 31 December 2006) to exempt OTC contracts from counterparty risk
requirements if a central counterparty clearing house is used and all current and future
exposures are fully collateralised on a daily basis. It is not clear whether this latter exemption
extends to institutions from a jurisdiction other than the one in which the central counterparty
is authorised.

There are no specific capital requirements imposed on entities providing central counterparty
services. However, some European central counterparties are banks, and therefore fall within
the scope of the legislation. Central counterparties in Europe employ a number of different
models to ensure that they have adequate resources of a liquid, high-quality nature to cover
the risks that they incur.

Direct claims on settlement systems tend to arise only where the system itself operates as a
bank. Direct claims would be treated as for a claim on any other bank. As far as the capital
requirements for the systems themselves are concerned, only those systems that are banks or
investment firms would be subject to capital requirements. However, as noted above, non-
bank systems do not have exposures to their members and therefore are not subject to
counterparty credit risk.

Investment Services Directive (93/22/EEC) The ISD gives authorised investment firms (and
banks) a passported right of direct or indirect access to clearing and settlement facilities
provided for members of regulated markets throughout the EU.

The proposed Directive on Financial Collateral Arrangements, COM(2001)168 final, [on
which the Council reached an orientation agreement on 13th December 2001,] seeks to resolve
the main problems affecting cross-border use of collateral in wholesale financial markets. The
Directive creates an effective and simple Community regime for the creation of collateral

17

arrangements making it possible for market participants to conclude such arrangements in the
the EU. As such it provides limited protection of collateral
same manner throughout
arrangements from some rules of insolvency law. It creates legal certainty with regard to
cross-border provision of collateral, in the form of book-entry securities, by extending the
principles already applied under the Settlement Finality Directive to determine where such
securities are located. Finally, it restricts the imposition of onerous formalities on either the
creation or the enforcement of collateral arrangements. The limitation of administrative
burdens will also promote the efficiency of cross-border operations of Central Banks and
payment and securities settlement systems covered by the Settlement Finality Directive,
which does not deal with such matters.

18

ANNEX II: POSSIBLE ACTIONS TO ADDRESS MARKET PRACTICE AND
TECHNICAL BARRIERS

identified in

Barrier
Giovannini Report

Possible
private sector

action

by

Possible
national authorities

response

of

Possible co-ordinated action at
EU level

of

communication
Inclusion
standards as part of any EU
recommendations.

of

for
a
Setting
implementation of standards in
respect of Eurosystem activity.

deadline

Facilitation of rights of access
and
single
market legislation – e.g. ISD.

through

choice

Development of common view
on oversight of
to
facilitate cross-border use

systems

Differences
standards
interfaces

in

IT
and

Adoption of EU-wide
standards
for
communication between
between
systems
and
their
systems
members (ISO 15022)

and

National
restrictions
resulting in use of
multiple systems

Differences in rules
processes
and
relating to corporate
actions

of

Implementation
standardised
communication between
CSDs (ISO 15022)

Absence of intra-day
finality
between
systems

Ensure intra-day finality
in
between
systems

links

Measures
restrictions
national law

to
embodied

remove
in

Co-ordination/
information
sharing with other Member
States to facilitate cross-
border use

to

Measures
processes
physical documentation).

simplify
(e.g. need for

Impediments
remote access

to

to

operate
Systems
non-
transparent,
discriminatory
access
criteria. All members to
same
be
facilities
regardless of
location.

afforded

National differences
in settlement periods

Harmonisation

National differences
in
operating
hours/settlement
deadlines

Harmonisation
operating
harmonisation
transparency
deadlines.

of
hours,
and
of

Remove legal
preventing
exercise
rights of remote access

restrictions
of

Facilitate access to systems –
e.g. through ISD

Development of common view
on principles governing access
to systems

Support
through
standards

for

harmonisation
recommendations/

ECB
conformity with TARGET.

standards

require

EU standards/

Recommendations
scope?

to broaden

19

Differences
issuance practice

in

Development of
day
standardisation
communication
6166)

intra-
links,
of
(ISO

Examine issuance practice
and reduce complexity e.g.
in process for allocation of
ISINs

of

communication
Inclusion
standards as part of any EU
recommendations.

Restrictions
on
location of securities

Restrictions
on
activity of primary
dealers and market
makers

to
embodied
place

remove
Measure
in
restrictions
of
law
issue/registry to place of
settlement

tying

the
restrictions

Consider
need for
integrated market
remove

continued
in
and

Facilitate choice of location of
settlement through ISD

Develop legal
support
throughout EU

framework to
transfers of securities

Facilitate choice of location of
settlement through ISD

Develop legal
support
throughout EU

framework to
transfers of securities

20