metadata: authors: 0: author: PARDY, ROBERT
docna: 0: docna: Regulatory and institutional impacts of
            securities market computerization
docty: Policy Research Working Paper
subtopic: Information Technology,Capital Markets and Capital Flows,Securities Markets Policy & Regulation,Capital Flows,International Trade and Trade Rules,Crime and Society,Financial Sector Policy
teratopic: International Economics and Trade
abstracts: cdata!: Advances in information technology have
            brought new ways of structuring, operating, and supervising
            securities markets.  The Bank's policy advice in
            institutional reform of securities markets should reflect
            awareness of the opportunities and problems this presents.
            As a guide to best practice, the author provides basic
            operational and policy tools that take account of the
            importance of information technology in two securities
            market functions - trading, and clearance and settlement.
            He suggests that information technology systems pose new
            technical problems for market supervisors and can affect the
            rights and obligations of market participants.  He provides
            policy principles that take these factors into account, to
            guide the planning, evaluation, and supervision of trading
            and clearance and settlement systems that include an
            information technology component.  He explains how the
            processes and functions of a securities market can be
            performed in a variety of ways, using both manual and
            information technology approaches.   Highly sophisticated
            information technology systems are not always necessary or
            desirable, but the well-planned use of information
            technology can improve a security market's efficiency,
            fairness, and stability.  Clarity of objectives, good
            planning, and a clear grasp of operational implications are
            important in effectively evaluating proposals for developing
            securities markets with an information technology component.
repnme: repnme: Regulatory and institutional impacts of
            securities market computerization
display_title: Regulatory and institutional impacts
            of securities market computerization
listing_relative_url: /research/1992/02/699753/regulatory-institutional-impacts-securities-market-computerization
topicv3: Information and Communication Technologies
            m1326624 133,Trade m1326924 698,Criminal Justice m1326993 1014,Securities Markets m1327223 1918,Financial Sector Development m1327681 1920
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: Policy Research Department
no_of_pages: 75
author_keys: 0: author_key: 94619
model_extractions: <!-- Start of picture text -->
| ~Polky R IM4226-1 Iwo~d lwc<br>no Poliy and 8ys|m<br><!-- End of picture text -->

<!-- Start of picture text --> WPS 866<br><!-- End of picture text --> This paper- a product of the Financial Policy and Systems<sup>Division, Country Economics Department--</sup> is part of a larger effort in the department to explore ways<sup>to promote the development of sound securities</sup> markets. Copies are available free iivm the World Bank,<sup>1818 H SteetNW, Washington, DC 20433. Please</sup> contact Zena Seguis, room N9-005, extension 37665. (February<sup>1992, 69 pages.)</sup> Advances in information technology have brought new ways of structuring, operating, and supervising securities markets. The Bank's policy advice in institutional reform of securities markets should reflect awareness of the opportunities and problems this presents.

As a guide to best practice, Pardy provides basic operational and policy tools that take account of the importance of information technology in two securities market functionstrading and clearance and settlement.

Pardy suggests that information technology - systems even though they may not differ greatly from manual systems in their performance of securities market functions - pose new technical problems for market supervisors and can affect the rights and obligations of market participants.

He provides policy principles that take these factors into account, to guide the planning, evaluation, and supervision of trading and clearance and settlement systems that include an information technology component.

Pardy explains how the processes and functions of a securities market can be performed in a variety of ways, including hybrid and tandem systems, using both manual and information technology approaches. Informadon technology, especially in hybrid and tandem systems, has already spread far in emerging markets and its spread is likely to accelerate in the 1990s.

He -ives examples from emerging markets (some of which have world-class systems) and from developed markets (in some of which the systems are not as advanced).

Highly sophisticated information technology systems are not always necessary or desirable, but the well-planned use of information technology can improve a security market's efficiency, fairness, and stability. Clarity of objectives, good planning, and a clear grasp of operational implications are important in effectively evaluating proposals for developing securities markets with an information technology component

|he Policy ResesrchWorking PaperSenesdissedinates thefindings<sup>of workunder way in theBanr Anobjectiveof th series</sup> is to get these fdindsgs out qtiickly, even if presentations are<sup>less than fully polished. The fimdings, inwrlpretations, and</sup> |conclusions in these papers do not necessabily represent of ficial Bank<sup>policy.</sup>

Produced by the Policy Research Dissenmination Center
# Table of Contents

||Introduction|1................<br>I|
|---|---|---|
|II.|Initiation and Sequencing.|6|
|III.|Securities Trading .10||
||Constituent Functions .10||
||Operational Categories .11||
||<br>Policy Considerations .13||
||Conclusion .26||
|IV.|Clearance and Settlement .27||
||Main Functions .29||
||Policy Considerations .33||
||Conclusion .39||
|V.|Conclusion .40||
|Bibliography|..............................................................................................|42|

# List of Text Boxes:

|1.|Example of a Computerized Securities Market System.|_5_|
|---|---|---|
|2.|IT Introduction in an Emerging Market - Korea|8|
|3.|IT Introduction in Developed Markets - UK and USA.|9|
|4.|Operational Categories .11||
|_5._|Examples of Information Commonly Provided .15||
|6.|Examples of Algorithm Approaches .17||
|7.|Risk Review Parameters .21||
|8.|Guidelines on Access .23||
|9.|Clearance and Settlement of Securities Transactions .28||
|10.|Comparison Criteria .29||
|11.|Settlement and Securities Administration in Mexico .31||
|12.|Settlement and Securities Administration in Korea .32||

# List of Figures:

1. Matrix of Trading Characteristics .14

# List of Annexes:

I. Securities Market Functions II. Principal Features of Automation in the Korean Securities Market III. Principle Features of NASDAQ and London Stock Exchange Automated Operations IV. The Toronto Stock Exchange Computer Assisted Trading System V. Approaches to Clearance and Settlement
# Glossary of Acronyms

ACES Advanced Computerized Order Execution System (NASD) ADR American Depository Receipt CATS Computer Assisted Trading System (Toronto Stock Exchange) CDS Canadian Depository for Securities CNS Continuous Net Settlement CORS Computerized Order Routing System (Korea Stock Exchange) CSD Central Securities Depository DVP Delivery Versus Payment G30 Group of Thirty Instinet Proprietary trading system marketed by Reuters Plc. INDEVAL Instituto Para El Deposito de Valores (Mexico) KSCC Korea Securities Computer Corporation KSE Korea Stock Exchange KSSC Korea Securities Settlement Corporation NASD National Association of Securities Dealers (USA) NASDAQ " " " n Automated Quotation System OMS Order Management System (Toronto Stock Exchange) OTC Over The Counter Market SAEF SEAQ Automated Execution Facility (London Stock Exchange) SEAQ Stock Exchange Automated Quotation System (London Stock Exchange) SIAC Securities Industry Automation Corporation (USA) SMATS Stock Exchange Automated Trading System (Korea Stock Exchange) SMIS Securities Market Information Service (Korea) SOES Small Order Execution System (NASD) TSE Toronto Stock Exchange
# I INTRODUCTION

World Bank policy advice on institutional and regulatory reform of securities markets generally has the goal of improving their efficiency, fairness and stability. The Bank's advice should take account of information technology's relevance to these goals because IT has had a considerable impact on the way securities markets are structured and operated. In the two operational areas of trading, and clearance and settlement, this means assessing the traditional ways of operating and the new ways ;.iade possible by IT against a set of principles derived from the goals of efficiency, fairness and stability.

Securities market trading has traditionally been conducted by traders gathering at a central point to quote buy and sell prices and to strike a deal when prices matched. Early forums for such gatherings were coffee houses and curb-sides but these gradually gave way to the trading posts of stock exchange floors around which traders gathered to trade the stocks listed on each post. Stock exchanges began as associations of such traders who wished to gather together to trade because of shared interests and mutual trust. Over time, the exchanges came to provide a range of related services to their members such as clearance and settiement of transactions executed on the floor.' In the post World War II period, many aspects of this system have been changed by the introduction of information technology. Building on the foundations of traditional manual systems, the use of IT has come to be a central feature of securities market operations, and has been a significant influence on both the structure _aad_ behavior of the markets. In the last decade in particular,<sup>the</sup> introduction of IT has had a profoi -I mpact, not only in the large, well established markets, but<sup>also</sup> in emerging market countries.<sup>2</sup> An important change has been on the floor of the exchange. By providing the means for capturing and displaying large numbers of bids and offers for securities over a distributed network of

> Annex I provides an overview of the total securities market pmcess and describes each of its fourteen constituent functions. Readers unfamiliar with securities markets may find it a useful introduction to the subject and its terminology.

- 2 For an overview see Siegel, "The Competitive World of Electronic Trading"; Glsser, "The Intersection of Technology and Financial Services"; Saunders and White, Technology and the Reeulation of Financial Markets; and Phillips,<sup>"The</sup> Incrasing Impact of Computer Technology".
-2-

terminals, IT has fundamentally altered the way securities trading is done. Intermediaries such as stock brokers bave seen their monopoly over trading and trade information weakened as large investors and other participants gained access to real-time market information through computer networks. A<sup>high</sup> volume of trading is now done away fiom traditional stock exchange trading floors. This move away from central trading floors has forced market supervisors to consider difficult trade-offs between the efficiency benerits deriving from a larger number of diverse securities market service-providers and<sup>such</sup> problems as market segmentation which may diminish the market's price setting efficiency.

Like securities trading, clearing and settlement of transactions has changed radically in the last ten years. The physical movement of share certificates, transfer instructions and payments<sup>has</sup> been replaced in many places by "book entry" systems which rely on computer records of entitlement to securities and the automatic debiting and crediting of payment accounts. As a result, clearance and settlement can be concluded in a shorter period with consequent risk reduction and efficiency gains. On the other hand, such systems have required expanded secure custody arrangements, very accurate record keeping and changes to legal definitions of evidence of title. Market supervisors have had to develop rules and monitoring programs which attempt to protect investors' rights under the new systems.

More generally, the spread of IT in securities markets has often made the markets so dependent on automation that a systems failure is tantamount to a market failure. As a result, regulators have greater responsibility to oversee the safety and soundness of technical IT systems whose failure could have market-wide consequences. This calls for back-up and disaster recovery systems by market providers, but also improved technical capacity of the regulator to enable adequate supervision.<sup>4</sup> Emerging securities markets as well as the world's traditional financial centers are confronting these issues. Perhaps the starkest emerging market examples are found in Eastern Europe where sweeping reforms in the financial sector have ofter? included the speedy establishm-nt of a securities market infrastructure from little or no base. In some Eastern European countries the newest IT systems have been brought into operation at the very beginning of experience with the basics of market operation and supervision. Less dramatic developments are in evidence in many other emerging markets. For example, Turkey is at the first stage of a sequenced IT enhancement program from a low base, while

- 3 **Lucas** and Schwartz, **The Challenee** of Information Technoloev for the Securities Markets, p.<sup>4, call</sup><sup>**these**'second</sup> order effects' of **IT** in securities markets.

- ' **The** US SEC **release** 27445 and 29185 of November 16, 1989 and May 9, 1991 provide<sup>a good introduction to</sup><sup>**these**</sup> **issues.**
- 3 -

Malaysia and Mexico are extending already sophisticated IT systems, and in the Philippines, the supervisory authority has identified the expanded use of IT in the stock exchanges and stock brokers' offie s as a key tool in detecting and reducing market manipulation, insiler trading an; other breaches of the law.

Increasing automation of securities market functions is a trend which will increase in the 1990s, perhaps particularly in emerging markets. This is likely because competition between software and hardware providers will continue to bring costs down and because the increasingly international nature of securities market trading will encourage a convergence of standards of efficiency, fairness and stability towards those offered in highly computerized markets. An examnple of the first is the Reuters Instinet system which is less expensive now than it was five years ago and yet offers enhanced services. An example of the second is the internationally agreed standards for efficient clearance and settlement proposed by the Group of Thirty which imply the use of computerization.' On nhe other hand, it should not be assumed that a high level of computerization is necessary or desirable in all situations. For example, in small but growing securities markets, upgrading manual systems and gradually increasing the use of computer support is a viable approRch. Deciding on the appropriate pace and sequence for modernization requires a balanced consideration of Lar factors: the scope and scale of changes needed to accommodate the volume of transactions conducted on the market; the capacity of the local infrastructure, institutions and personnel to assimilate the changes; supervisory imperatives such as the need for effective market monitoring, enforcement of trading rules, and investigation of unlawful transactions; and the cap+al and recurrent costs of the modernization program in relation to the size of the market and the way the costs will be met. No single factor dominates and no simple formula applies in all situations, so striking the right balance between the four factors is a matter of country-specific analysis. !t follows that no single prescription will arise from the analysis. The range of outcomes will cover the spectrum from improved manual record keeping and paper handling, through small-scale computer assistance for these functions, to sophisticated fullycomputerized trading and clearance systems.

Nor should it be assumed that iT is the solution to securities market development in emerging market countries. In fact, IT is but one element of the institutional arrangements making up a securities m,larket. Development of the market is facilitated by improving such institutional arrangements but derives its impetus from other factors. Chief among these is the creation of a conducive

**The** G30 **proposals are** a ssed in **detail** in section IV.
-4-

business and investment environment and removal of impediments or distortions to capital-raising and investment decisions in such areas as tax and interest rate pelicies. When the macro-economic and fiscal pre.cinditions are right, a sufficient supply of quality securities and investment-seeking savings will be available to create a viable securities market. Institutional impediments to development of the market which then arise will become important areas for reform in order to allow the market to meet the needs of capital raisers and investors. This paper argues that it is likely that such reforms will include the increased use of IT and that th7 role of IT deserves careful attention but it does not assume that institutional change can itself generate the impetus for market development.

In the World Banic, SAL, FSAL and TA programs which include institution building in securities markets are becoming more common. It follows that Bank staff and country policy makers will increasingly be called on to evaluate the use of IT to enhance or detract from securities market development. The present paper is an attempt to assist that evaluation by providing basic operational and policy tools as a guide to best practice.

The paper has three substantive sections. First, the basic reasons for the move from manual to computer assisted processes in securities markets are described and the key players and their motivations in the drive for automation are identified. Examples from emerging and developed markets are used to illustrate the points made. This is followed by a section which describes the securities trading process and the potential benefits and risks associated with performing each of the trading functions via IT systems. Several operational examples are given to demonstrate the variety of approaches taken to organizing trading in a mannal, computerized or hybrid form. Then follows the core of the section, which provides nine principles to guide decision-making on the use of IT in trading systems. The next section deals in a similar way with clearance and settlement. And finally, several annexes are provided which describe each of the functions which make up the total securities market process and give details of systems in operation in both developed and emerging markets which are bench-marks of excellence. Readers unfamiliar with securities markets mnay find it useful before they begin the substantive sections to consult Annex I for an overview of the securities market process.
_-5-_

# BxI Example Of Computerized Securities Market Syste

The CATS (Computer Assisted Trading System) of the Toro. 'o Stock Exchange was the first automated market system introduced by a stock exchange. It has been used as a model in a number of developed and developing country markets: Korea, Malaysia and Taiwan followed CATS principles in developing their local systems; Tokyo, Sao Paulo, Paris, Lyon, Brussels and Madrid bought CATS from the Toronto Exchange; and exchanges in Venezuela, Portugal and the Philippines are considering installing CATS in the near future.

Price guotatign and trading characteristics. CATS is an order driven continuous auction market. The CATS screen shows the siTe of orders and the prices for each security and the identity of the intermediary who has entered the buy and sell orders in question.

Automated order execution. Each buy order which is matched by a corresponding sell order in amount and price is automatically executed. Once orders are executed, printed trade confirmations are immediately sent to both the buying and selling brokers and a record is kept for the clearing system.

Clearing and settlement. The clearing and settlement process in Canada is centralized for the country as a whole and hence is separated from the stock exchanges. Stock exchange member firms use the custodial and clearing facilities of the Canadian Depository for Securities Limiced (CDS). CATS provides an Order Management System (OMS) which links CATS, brokers' backoffices and CDS on an automated real time network.

Market surveillance. The CATS market surveillance system contains pre-set surveillance parameters for price and volume for every security. Any trading activ.ty exceeding these limits is immediately signalled to the market supervisor so that an investigation can be initiated. Computer-generated trading reports are available for daily, weekly and monthly analyses so that possible insider trading, market manipulation and other questionable trading practices can be identified at an early stage.

Market information. The CATS software includes an extensive information system which is essentially a data base obtained from real time computer to computer links to other systems. It can provide interrogatable real time data to many terminals and can be operated by the market provider or sold to a specialist information vendor. It can provide all the basic data generated by trading plus calculate various accumulations and indexes by sector, iiistrument or other grouping.

A more detailed description of the CATS system is given in Annex IV. I , . - ... .
-6 -

# 11 INIIATION AND SEQUENCING

Manual methods of trading securities were satisfactory for many years; why has IT become such an influence recently? One answer is that the availability of lower<sup>cost, fast and aczurate</sup> IT systems is a development which grew alongside the growth in secondary securities markets. But<sup>why</sup> did the markets take to IT so readily?

The answer is to be found in the fact that a central function of st, urities markets is the ..andling cf information. As the volume of that information grew and the demand for greater<sup>access to</sup> it also grew, it was natural that IT would be brought in to supplement manual processes.<sup>The price-</sup> setting mechanism at the very core of secondary securities trading requires the exposure<sup>of current bids</sup> and offers and information about recent transaction prices. Supplementary information about the enterprises which underlie the securities being traded is also important in a decision to buy<sup>or sell. Post-</sup> trade transaction processing and market monitoring are also built around the collection, assimilation and dissemination of information.

The driving force for the increased use of IT .n securities m?rkf is consequently diverse and variously motivated. First, it may be introduced to respond to the demands<sup>of intermediaries and</sup> their c!ients for more efficient execution of transactions and for access to more sophisticated<sup>trading</sup> strategies. In emerging markets this demand is strongest wben the financial<sup>sector have reached a degree</sup> of development which makes such improvements important for further progress;<sup>for example, when the</sup> volume of securities trading has grown to overwhelm existing systems or where<sup>development of viable</sup> contractual savings institutions requires that they have access to timely and accurate<sup>trading data to allow</sup> them to use modern portfolio management techniques.

Second, market providers such as stock exchanges may seek to improve market infrastructure by introducing IT to provide added value or to reduce transaction<sup>costs and enhance their</sup> position in the financial sentices market. Existing stock exchanges in<sup>many places have been spurred to</sup> such initiatives by competition from independent infcrmation providers<sup>such as Reuters Plc. which have</sup> developed a range of securities market systems which are a direct<sup>challenge to many of the r iles</sup> traditionally performed by stock exchanges.<sup>6</sup>

> **6** Twenty such proprietary electronic trading systems are registered with the US SEC. twelve of which are pressntly active.
**I**

-7

And third, securities market supervisors may require improvements in trading, clearance, settlement and market reporting systems in order to provide for greater<sup>efficiency, fa:hness, transparency,</sup> and systems stability and to provide a better platform for their own monitoring and<sup>investigatioa</sup> activities.

In emerging market countries such as Korea, Thailand, Turkey<sup>and Poland, where the</sup> govermnents have a clear policy for institutional development of the securities<sup>market, the supervisory</sup> authority bas taken the first step in the automation process and brought stock brokers<sup>and stock exchanges</sup> in as partners. In Taiwan, and to a lesser degree Hungary and Mexico, the stock exchanges<sup>have played</sup> a more active role in seeking to use computerized systems to improve the<sup>services offered and to reduce</sup> costs, with the supervisory authority supporting the sto^k exchange initiatives. The balance<sup>of recent</sup> history appears to favor government involvement at the early stages of development<sup>but a general</sup> conclusion on the optimal extent ot that involvement would be unwarranted on the present<sup>evidence.</sup> Comparing Korea, Mexico and Taiwan, for example, which have had differing<sup>degrees of government</sup> involvement, there does not appear to be evidence of one approach being overwhelmingly more successful than another: each has successfully modernized their systems, making good use of IT, to<sup>facilitate rapid</sup> market growth. Korea used an IT systems development plan as a key part of a concentrated<sup>securities</sup> market institution building program; Taiwan's stock exchange systems were overwhelmed<sup>several times</sup> by growth in the volume of trading and improved systems were devised<sup>in response; and in Mexico there</sup> has been a mix of these two, with the government actively involved in the planning and funding of<sup>the</sup> stock exchange's modernization but not directing it.

Some emerging markets which are at an early stage of development, such as Czechoslovakia and Poland, have taken the opportunity to move quickly to integrated<sup>state-of-the-art</sup> systems. This contrasts with Korea, Malaysia or Mexico which have developed a strategy<sup>for seauenced</sup> implementation of their systems. The advantage of the first approach is that the<sup>new infrastructure is</sup> capable of supporting market growth without the bottlenecks and problems of having<sup>trading volume</sup> outstrip system capacity. The disadvantage is that it adds a non-market element<sup>to what is essentially a</sup> business decision. This is b#-ause it involves "over resourcing" ahead<sup>of actual demand for the services</sup> provided. Such over resourcing is hard to justify on rate-of-return grounds unless a very rapid<sup>growth</sup> in volume to high levelr is expected. It is better considered an infrastructure expenditure with expected longer-term developmental benefits which government may wish<sup>to sponsor.</sup> Cost and system capacity are factors in this decision. A fully automated trade execution system with ancillary functions costs from US$4 to 8 million depending<sup>on the configuration. The CATS</sup>
-8-

system is in this price range anti has a capacity of 40,000 transactions per day. It is installed in Paris to handle 11,000 per day and in Brussels and Sao Pauk, to handle 5,000 per day. IG contrast, an equivalent sized price quotation and trade reporting system costs one third to one half the price of the fully automated trading system and still brings cotnsiderabl **e** fficiency and fairness gains. A well planned gradual introduction of IT support to these functions can lead to eventual full automation as market capacity grows.

Dqx II Introduction in an Emerging Market - Korea Korea is illustrative of a strong government rele in an emerging market. In the eighteen mor.ths to early 1977 the government of Korea proposed and discussed fundamental reform of the securities market. A close consultative reiationship was established with the private sector and a joint plan was developed.

IT was included in the planning process from the start: .n January 1977 the Government published a detailed IT master plan; and in September 1977 it established one of the cornerstones of the IT plan-the Korean Securities Computer Corporation ("KSCC")-to develop, own and manage IT facilities. Like the stock exchange itself, KSCC was initially Government owned but was sold to the private sector in 1986.

The first function computerized was a market information system whizi began operation in July 1978. This was followed by an order routing and broker back-office system, then development of the Korea Securities Settlement Corporation ("KSSC") in 1983 which was upgraded in 1984. KSSC is a fully automated central depository and clearance and settlement institution fully owned by the Stock Exchange. Finally, in 1988 trade execution was automated, gradually building until by January 1990, 90% of securities trades occurred on the automated system.

In summary, the process of computerization was government initiated, centrally planned and incremental. It was also part of a strong institution building effort by the govermment in the finance markets in general.

More detail on the use of IT in the Korean securities market is given in Annex II.
-9 -

Securities markets in developed countries, where IT has had a longer history, have tended to gradually automate functions as the need to do so arose, either from market or regulatory pressures, and as commercial funding of the developments became practicable. The approach taken has varied from country to country but perhaps a general pattern can be identified in which flow-of-trades and market data systems are developed first, then clearance and settlement systems, and lastly trade-related and market mon:toring systems. This is the pattern of developments in the UK and USA for example.

In part, the pattern of evolution in each place is determined by the prevailing legal and institutional structure, and commercial custom and practice. A well established stock exchange and stock broking industry may resist changes which will diminish their profit making ability and power. The UK and USA provide two examples of such resistance. Such conflicts are perhaps inevitable when rights and obligations are altered. This is dealt with more fully in subsequent sections.

# Box 3 IT Introduction in Developed Markets - UK and USA

The London Stock Exchange introduced a distributed quote display in broker's offices in 1969; an inter-broker net settlement system in 1979; computer assisted trading in 1986; and automated trade execution for small orders in 1988. The initial motivation for the enhancements came from the supervisory authority, but the Exchange itself soon took up the iaitiative. But opposition to fully automatic execution of trades continues and the great majority of trading is conducted by manual execution. Similarly a proposal to centralize and automate transfer and registration of securities has also been subject to much debate and delay over the last six years.

In the USA transfer and registration has been centralized in four deposiLries which immobilize the securities and maintain automated account records. This is much more advanced than in the UK. There are several trading systems: gL, trading on the distributed computer network of the National Association of Securities Dealers (NASD) is computer assisted, although only small orders are executed automaticaily by the system; on the New York Stock Exchange the principal trading sessions each day are floor based computer assisted trading with small order automatic execution and after hours computer network trading.

Because there are many exchanges, the US Securities and Exchange Commission (SEC) proposed a national market system to ensure that clients obtain the best prevailing price for an order. The initial SEC proposal was for a broker to market universal message switch that would automatically route orders to whichever market offered the best price. That proposal was abandoned after strong opposition from stock exchanges. The stock exchanges proposed a compromise which provides a market to market link via the Inter-market Trading System (ITS) and this was accepted by the SEC.

Annex IU describes in more detail the principal features of IT on the London Exchange in the UK and the National Association of Securities Dealers Automated Quotation (NASDAQ) market in the USA.
- 10-

# III SECURITIES TRADING

# Constituent Functions

Three functions are commonly thought of as constituting the securities trading process: display and comparison of buy and sell quotes; order matching; and order execution. These functions may be performed in more or less automated ways, together or separately, and according to a variety of rules, methods and conventions.' Quotes art displayed and compared as a key step in the price setting process - the bringing together of all the expressed buy and sell intentions of traders to be matched or to be bid up or down in response to the views other traders take to the changing value of the securities. The traditional quote display mechanism is a chalk board at a trading post on a stock exchange floor but, these days, is more often computer screens, either centralized on the exchange floor or distributed in broker's offices.

Matching occurs when the quoted buy and sell prices for a security coincide so that a deal may be struck. On a trading floor, matching is achieved by the traders calling out their bids and offers in response to the displayed quotes, and in that way identifying themselves to the other party to a trade, and indicating the terms on which they are willing to trade. Computer trading systems have a range of matching mechanisms which are designed to achieve a broadly similar result by using a set of programmed matching rules.

Trade execution is accomplished on a stock exchange floor by two dealers identifying each other and agreeing to strike a deal which they then record for later processing. Computer systems may allow dealers to follow a similar pattern of selecting their conterparties or they may automatically execute trades once they are matched according to pre-set rules of the system. In some computer systems the executed trade is "locked in" and requires no further clearance before settlement takes place. In others, the trade requires the same post-trade processing as is common with manual systems.

7 A more complete description of the total securities market process and its fourteen constituent functions is provided in Annex 1.
- 11 -

!2erational Categories There are two basic types of trading system-order driven and quote driven; three methods of determining price-continuous auction, call (or single) auction, and non-auction (or dealer market); and two possible physical arrangements-centralized or distributed (see Box 4).

While the different categories have historically been regarded as separate and, to some degree in competition, the trend now is towards integrated and hybrid systems. This trend means that market supervisors often have to consider IT policy questions concerning partial computerization and the interaction between different parallel and linked systems. The matrix in Figure 1 illustrates the permutations possible from combining the various operational categories. Many of the combinations indicated are in operation now. For example: the Korea Stock Exchange, like most continuous auction markets, opens with a call auction to clear the pre-session order build up; the NASDAQ system is an evolution from the traditional dealer market into a form of auction market because of the competition between market makers built into the NASDAQ system; and the New York Exchange switches to distributed network computer trading after the close of each day's floor trading session.

# Box Operational Categorieg

The quotes which drive the trading process may be the bid and offer prices specified in investors' orders or they may be the spread quoted by market makers. The first is called an order driven market, the second, a quote driven market.

Each may be conducted as either a continuous auction in which quotes are constantly adjusted in line with new orders coming to market, or a call auction in which the quotes collected in a trading period are executed all at once at a price calculated to clear the maximum number of orders. Another alternative is a quote driven non-auction (or dealer market) in which one market maker has exclusive right to quote a buy and sell spread for a stock and sets the quote without competition.

The physical arrangement of the market may be centralized, on a trading floor for example, or it may be distributed via a network of computer terminals. In either case, the objective is to bring together the buy and sell quotes by some means which will allow them to interplay as a price setting mechanism.
- 12 -

Figure 1 - Matrix of Trading Characteristics

||~~~~~~~~~|O<br>r<br>d<br>**8**<br>r Odr<br>~~~~ Qut Drv<br>r<br>**V**<br>**C**<br>**fi**|QC<br>u<br>o<br>t<br> <br>e<br>D D<br>r<br>**V**<br>e<br>nn|e<br>**fis**<br>t<br>X<br>d|D<br>i<br>t<br>r<br>X<br>~~~b<br>t<br>d|C<br>o*A<br>nfun<br>t<br>**C**<br>it<br>i<br>uo0<br>0<br>ac<br>**u**|1<br>A<br>t<br>**0n**|_N_<br>c|
|---|---|---|---|---|---|---|---|
|Order Driven|X||X|X|X|X||
|QuotenDriven||X|X|X|X|X|X|
|Centralized'|X|X|X|XI'|X|X|X|
|Distributed <sup>2</sup>|X|X|X'|X|X|X|X|
|Continuous Auction|X|X<sup>3</sup>|X|X|X|X7||
|Call Auction|X|X|X|X|XE|X||
|Non-Auction<br>__|.n1.|X|X|X|||X|

- 1 Often called "Floor based' in reference to the traditional stock exchange trading floor but may also be a trading room such as in Warsaw or Tokyo.

- 2 Commonly a telecommunications and computer network linking broker/dealer offices.

- 3 Requires competing market makers who continuously respond to the quotes and sales occurring across the market.

- 4 After close of centralized trading session.

- S As above.

- 6 At opening of continuous auction session to clear pre-session quotes.

- 7 As above.
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# Policy Considerations

The underlying objective of securities market superv sors is to ensure that trading takes place in an efficient, fair and stable manner.<sup>8</sup> The increased use of IT in securities markets has not changed these goals, and at base has not changed the questions that must be asked and the issues which must be pursued. On the other hand, securities market supervisors, perhaps especially in emerging markets, fmd themselves having to deal with unfamiliar concepts and terminology in dealing with IT systems and the hybrid or tandem operations which are sometimes created.

World Bank staff and local policy makers seeking to orient their planning and evaluation in these circumstances may find it useful to refer to the best practice principles described below. Their purpose is to guide analysis and questioning of IT proposals. Of course they do not provide set answers applicable in all cases - the answers will be as diverse as the situations in which the policy makers find themselves.<sup>9</sup>

**Principle 1. The system should meet and continue to meet** all **applicable legal standards, regulatory policies, and market customs and practices.**

Although screen-based trading systems may follow similar trading methods as manual systems, they may be different in their impact on the rights and obligations of market participants. For example legal and operational issues may arise from changes in contractual obligations between intermediaries, investors, system sponsors and system providers'° , and from changes in custom and practice which may include loss of the ability of brokers to choose

- 8 There is in practice some conflict between these three goals. For example, one view argued loudly on the London Exchange is that the regulator's idea of fair trading requires disclosure of more information on bids and offers than would be efficient: market makers do not want to disclose their limit order books because it would allow competitors to rtad the market and position themselves to the disadvantage of the market makers.

- 9 **The** principles presented here owe much to the report of **the** International Orgv.nization of Securities Commissions Technical Committee Working Group on "Regulation of Derivative Markets, Products **and** Financial Intermediaries".

- '° The system sponsor **is** the (authorized) market provider and host for the system **-** typically a stock exchange. The system may be developed **and** operated by a separatc entity - **the** system provider. **This** may be an information systems specialist such as Reuters Plc.
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counterparties, or to settle transactions at any time mutually agreed. In proposing computerization, system sponsors and system providers should satisfy the regulatory authority that the system meets all applicable standards even though the rights and obligations of participants may be different from those which prevailed under manual trading.

Also, because technological innovation in the IT field is rapid and tends to lead, not follow, legal innovation, the regulatory authority should seek to ensure that existing standards, rules, and policies are sufficiently flexible to allow technological innovation while at the same time not losing sight of the basic goals of fairness, efficiency, and market stability.

**Principle 2. The system should be designed to** ensure **the equitable availability of** accurate and **timely trade and quotation information to all system participants and the system sponsor should be required** to gain **the approval of the regulatory authority for the** rules **and procedures for** processing, **prioritization, and display of quotations and reporting of trades within the** system.

"System Transparency" refers to the extent to which relevant information is available in a trading system about open or unexecuted orders and completed transactions. Regulatory objectives are to ensure: (i) sufficient transparency to allow efficient trading and engender investor confidence in the fairness of the market; and (ii) avoidance of inequitable discrimination among like classes of market participants with regard to the availability of market information.

Determining what sufficient transparency is a matter of balance and judgement. Box _5_ gives examples of the types of information commonly required to be provided. The regulatory authority should decide and agree with the system sponsor or provider what information is to be available on the system and under what circumstances. These details should be reflected in the specifications for the system which are agreed by the regulatory authority. The regulatory authority should also be satisfied that the system is technologically capable of disclosing the information which it is designed to make available and, conversely, that there are safeguards to preserve the confidentiality of other information, the disclosure of which is not intended.
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5 Examples of Information Commmonly Provided: Price of the most recent transaction, Quantity of the most recent transaction, Time of the most recent transaction, Parties to the most recent transaction, Current best bid and ask prices, Quantity at tltose prices, Parties who placed those orders, Prices of bids and asks behind the best prices, Q.; ty at those prices, Partes who placed those orders, Requests for quotes in the system, Parties who placed those requests for quotes, Number of individuals currently logged-in to a particular market,<sup>and</sup> Identit of those individuals.

Principle 3. The system sponsor should be able to demonstrate to the<sup>regulatory authority the</sup> order execution algorithm used by the systern.

The term "algorithm" refers to the set of rules entered into a computerized<sup>trading system</sup> governing the processing of orders. It includes rules for<sup>matching, prioritization and execution</sup> of orders and secondarily for disclosing for each transaction<sup>the identity of the parties, the</sup> execution price, the quantity, and the time at which the transaction occurs.

A review of the proposed algorithm is a key factor in assessing<sup>whether a computerized</sup> trading system would promote the broad objectives<sup>of fairness and efficiency because the</sup> algorithm performs the same function as trading rules<sup>in a floor-based trading system. A</sup> competitive algorithm can increase the potential that the<sup>pricing mechanism will reflect accurately</sup> the prevailing market prices at any particular point in<sup>time, thus decreasing the potential for</sup> improper practices in relation to the execution of<sup>customer orders.</sup>
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In reviewing an algorithm, the regulatory authority should keep in mind the availability of infcimation about current orders and transactions in the system and should judge what degree of disclosure is relevant in each case. The information which is available to participants may vary from system to system (see Box 5).

In some instances, the extent of order exposure in an algorithm may compromise the efficiency and fairness of the market. For example, systems which identify the party who places an order for execution may facilitate the pre-arrangement of trades or the abuse of customer orders in ways which are not possible where the counterparty to the trade remains unidentified. In addition, identification of a party to an order may discourage such parties from using a screenbased trading system if they are reluctant to disclose their position in the market and the order may be transacted off-market, thus fragmenting the market and reducing its price-setting efficiency. This may be true of short sellers or large institutions whose entry into the market may alter market perceptions and move prices. These considerations should be balanced against the need to ensure that sufficient information is disclosed to ensure fairness and trading efficiency of the algorithm and to allow traders to make informed judgements when using the system.

Screen-based trading systems often provide special procedures at the opening and close of a trading session, or following a temporary shut-down. For example, a system could employ an algorithm at the opening which is different from that used for the balance of the trading session. The regulatory authority should ensure that such special procedures are compatible with the rules for the balance of the session and that they are in line with the general standards and objectives set by it.
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| Bx Examples of Algorithm AUproaches to Matching. Prioritization and Execution

Matching - Pice Priority. Orders are executed at the best prices, but the system does not grant time priority: executions are allocated among all orders at the same price regardless of the time at which they were entered into the system.

- Matching PricelTime Priority. Orders are executed at the best price first and, for orders with equal prices, according to the time of entry.

Matching - PricelPartv Priority. Orders are granted priority according to price hut among orders at the same price, priority is granted to a particular category of rmiarket partic aiFor example, public customer orders could receive priority over members' proprietary order", jr, on the other hand, market-maker ordets could receive priority over those of other participants.

Matching - Price/Quantity Priority. Orders are granted priority according to price but among orders at the same price, priority is granted according to quantity. For example, to encourage public participation small orders could receive priority, or, conversely, to encourage institutional participation, large orders could receive priority.

Matching - Price/Order Type Priority. Orders are granted priority according to price but among orders at the same price, priority is granted to a particular type of order. For instance, market orders could receive priority over limit orders.

Matching - Single Price. The maximum number of contracts possible are executed at a single market-clearing price. Such an algorithm would not necessarily have to be limited to the opening but could be employed periodically throughout the day.

Unilateral Counterpartv Selection - Price Priority. Priority is given to orders at the best price but generally a party is able to select his counterparty from among those bidding or offering at that price. The party who made the original bid or offer would have no choice as to counterparty.

Bilateral Counterpart Selection - Price Priority. Orders are executed as described in unilateral selection, but, both parties must agree -o execute the transaction with one another.

Counterparty Selection - No Priority. Parties select both price and counterparty. The algorithm executes orders which match as to price, quantity, and counterparty regardless of other bids and offers in the system.
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# Principle 4. The system should operate in a manner which is equitable to all market participants and any differences in treatment among classes of participants should be identified.

Respgnse Time. Response time is the elapsed time between the transmission of a transaction from the system user's terminal and the receipt of confirmation from the host computer that the transaction has been accepted (or rejected due, for example, to a faulty command of the system user). The need to ensure that response times are equitable for all like classes of participants (LL, market makers) is more important, from a regulatory perspective, than the actual response time. Under usual circumstances, equal response time is a matter which can be monitored by the system sponsor. To the extent possible, the host computer, system user installations, communication network and software should provide for equitable response times for all like classes of system users. Market participants (including system users and, when relevant, their customers) should be informed where equal treatment is not possible, including the extent of the inequality. It should also be remembered that response times that are considered adequate by traders under normal market circumstances might be perceived as insufficient under extreme market circumstances; for example, at times of high volume or high volatility. Variations in response time in different circumstances should be identified and explained at the outset and should be monitored by the regulatory authority.

Equalitv of Treatment. All system users should have equal ability to connect to and maintain the connection to the system. In evaluating the system in this respect, two factors should be taken into consideration: (i) the communication lines of the network and (ii) the software of the system.

In many emerging market countries, the communication lines are of poor quality and are subject to failure or disruption. Sometimes they are not available equally to all users or the quality of service differs between them. These problems should be anticipated in the system design and should be overcome to the greatest extent possible in order to ensure equality of treatment.

As for software, it should be the regulatory authority's ongoing task to verify that equitable treatment is accorded all market participants of the same class. The regulatory objective
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should be to ensure that all equivalent inputs by system users<sup>(,</sup> of the same volume and order type) are treated fairly and equally, so that, for example,<sup>order inputs of equivalent priority as</sup> specified in the documentation of the algorithm, are executed<sup>or processed as specified.</sup> Inlltaces to Other Systems. Computerized trading<sup>systems can interface to a4 least six</sup> other types of systems: (i) clearing houses, (ii) back-office<sup>systems, (iii) order-routing</sup> systems, (iv) market information systems, (v) floor trading<sup>systems, and (vi) other trading</sup> systems.

Since most, if not all, clearing house activities are automated,<sup>computerized trading</sup> systems may seek direct links with them. The interface must<sup>ensure that whatever is sent by one</sup> side is properly received by the other side. The clearing<sup>house should be able to receive the</sup> messages from the system at the same speed as they<sup>are sent and vice versa. Additionally,</sup> system sponsors, users, and administrators of interfacing<sup>non-trading systems, should be able to</sup> ascertain that all messages sent by one party are<sup>received accurately and on a timely basis by the</sup> other parties. Although these objectives may be of interest to both the<sup>system provider and the</sup> clearing house, they must be significant concerns for the<sup>regulatory authority also because of their</sup> equity and system stability implications.

Links also can be established with broker back-office<sup>and order routing systems. Such</sup> links can facilitate the crediting and supervision of customer<sup>accounts and the settlement of trades</sup> but can cause major disruption if they fail. Because<sup>there are often a large number of custom</sup> made and proprietary systems in use within the one<sup>market, unifonn efficiency and stability is</sup> difficult to ensure. The systems should therefore be reviewed<sup>to identify potential vulnerabilities</sup> or inefficiencies at normal transaction loads and peak loads<sup>when failure is most likely and most</sup> disruptive. Where vulnerabilities are identified, the<sup>regulator should ensure their removal.</sup> In some circumstances, an exchange may employ a computerized<sup>system for</sup> commencement of trading or continuation before or<sup>after normal trading hours on a floor-based</sup> manual market. In such cases, procedures must be established<sup>and disclosed to svstem users for</sup> moving open orders in an equitable way from the floor<sup>to the screen-based trading system and</sup> vice versa.

Computerized trading systems also provide<sup>the opportunity for links with other</sup> computerized trading systems. The efficiency of such<sup>interfaces with respect to capacity,</sup>
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accuracy and speed of transmission should be reviewed and particular attention should be paid to the effects of such a link on the operation of each system's algorithm. Care should be taken to ascertain that transactions entered in the network of one system intended for execution in a linked system do not provide special opportunities for abuses of the rules of either system or breaches of the applicable law.

Prindple _5._ Before implementation, and on a continuing periodic basis, the system and system interfaces should be subject to objective risk assessments to identify vulnerabilities in the system design, development, or implementation (L&, the risk of unauthorized access,<sup>internal failures,</sup> human errors, attacks, and natural catastrophes).

System sponsors and the regulatory authority should ensure periodic review of the safeguards which protect a system against unauthorized access, internal failures, human errors, attacks and natural catastrophes that might cause improper disclosures, modification, destruction, or denial of service. This review should include the physcal enviroment, system capacity, operating system software, data integrity, access controls, systems testing, documentation, internal controls and contingency plans and other safeguards which require incorporation into the design of the system.

To avoid inhibiting innovation, the regulatory authority should develop guidelines for system review rather than standards of design. The review should be objective and independent: those parties responsible for the development or operation of the system should not be the same individuals who conduct the review. The purpose of the review should be to identify vulnerabilities that may exist so that they may be assessed and addressed prior to the occurrence of a failure of the system. Box 7 briefly describes areas which should be addressed in such reviews.

The system should be designed, built and operated in such a way that the risk of downtime is reduced. The system design should include the duplication of power supply and<sup>other</sup> central components such as mainframe hardware, peripherals and communication lines.<sup>In case</sup> of a complete catastrophe, a fall-back computer site must be available and a disaster recovery plan well defined and rehearsed.
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# _i2 R _Aeiew Parametrs

Physical Environment. The physical environment of the communication facilities and central computer data center should be inspected, as should representative system user terminal sites. The regulatory authority should be satisfied with the adequacy of safeguards for the protection of each component of the system. The configuration of the system (that is, the main computer system and network) should be reviewed to identify potential points of failure, lack of back-up, and redundant capabilities.

Capacity. The capacity of a system is usually defined in terms of the number of transactions the system can process per unit of time, LL, transactions per second. The regulatory authnrity should be satisfied with the methodology employed to determine the adequacy of system capacity, and should test on a periodic basis the capacity of the system to handle average and projected peak volumes.

Qperating System Software. The regulatory authority should evaluate the computer operating system software used. All inherent weaknesses of the operating system software should be identified and any countermeasures taken to neutralize the known weaknesses should be documented and tested.

Data Integgity. The trading system should be fai"It-tolerant and preserve the integrity of data once it is entered. The procedures associated with file handling and back-up and recovery should be adequate for peak load demands when systems are most vulnerable.

Access Contrl.The controls and procedures to insure the identification and authentication of system users' terminals ane _i_ users should be reviewed (Lg, use of the passwords and user codes and other means of ensuring th t access is possible only through an authorized terminal by an authorized system user).

Systems Testing. The systems testing process should be reviewed to ensure that all functions and subsystems (including the algorithm) have been tested. The testiag should inclade system operation and all interfaces to external systems such as those used for market information, audit trail, surveillance, and clearing. Spot checking of test outputs should be included.

Documentation. The system sponsor and provider should maintain documentation which describes the system and its operation completely and accurately.

Internal Controls. Internal controls and procedures used to ensure the operation and security of the screen-based trading system should be reviewed. At a minimum, controls should exist for configuration management (&,, planning for hardware changes); software changes (including separation of function procedures); problem identification, reporting and resolution; system start-up and shutdown; system restarts; and disaster recovery.

Contingency Plans. The regulatory authority should review contingency plans to respond to major failures or catastrophes. System break-downs are not limited to hardware failures; they can occur because of hardware problems, software deficiencies, human errors, sabotage and natural catastrophe.
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Box 7 (CQnt.) Risk Review Parametes A balance must be struck between the risks of breakdown and the costs of minimizing those risks. Maintenance, replacement or catastrophe back-up agreements with hardware vendors may assist in reducing the risk of hardware failure to a minimum. Software deficiencies are of particular concern and thorough testing procedures are necessary. In addition, where software development or enhancements use assumptions which prove inadequate, the system sponsor or system provider should have procedures in place to make adjustments and corrections on a timely basis. It is imperative that all software programs are properly documented, that the documentation is available to the relevant authorities and system personnel and that the system sponsor or the system provider is staffed with persons with the skills necessary to handle software and other failures.

Adequate procedures are required to ensure that the impact on the system of any human error is minimal. As communication occurs by electronic messages and is highly impersonal, trading on screenbased systems isolates users from the system sponsor and its personnel. The system sponsor should ensure that there is adequate opportunity for dialogue between itself and system users so that each may benefit from knowledge about the system in operation.

Finally, catastrophe procedures which are designed to be used during or after a failure and before the full recovery of all of the components of the primary system is achieved should be adequate and clearly eescribed. Procedures for treatmnent of orders which are in the system before the failure should be clearly established. And there should be express agreement Ls to the allocation of liability for losses resulting from system failures.

Principle 6. Procedures should be established to ensure the competence, integrity, and authority of system users, to ensure that system users are adequately supervised, and that access to the systern is **not arbitrarily or discriminatorily denied.** Access. Computerized trading systems have the potentiel to increase tile degree of direct access to a market well beyond that which is normally available on floor trading systems. For example, computerized trading systems are not subject to the same physical limits in relation to the number of traders on the floor which exist in traditional stock exchanges. Also, unlike floor trading systems, computerized systems permit system users in diverse locations to execute transactions without going through intermediaries on the exchange premises. For these reasons, adequate and well supervised standards for use of and access to the system should be approved by the regulatory authority. Such standards should be wricten in such a way that access to the system is not denied in an arbitrary or discriminatory way.
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# Box8 Guidedines On Access

Access should be restricted to adequately trained system<sup>users who have demonstrated competence in</sup> the functions they must perform.

Access should be restricted to users adequately<sup>vetted as to authority, integrity and fitness.</sup> Consideration should be given to whether qualification<sup>standards should differ for different categories</sup> of users, V,, those doing proprietary business<sup>versus those doing customer business.</sup> Brokerage firms and the regulatory authority<sup>should make arrangements for, and devote sufficient</sup> resources to, the adequate supervision of access<sup>to the system, and the activities of all authorized</sup> users and other operators.

The regulatory authority should make adequate<sup>arrangements for, and devote sufficient resources to,</sup> the monitoring and enforcement of compliance with<sup>access and use restrictions.</sup> Adequate arrangements should be in place governing<sup>the security of terminal locations.</sup> Principle 7. The regulatory authoritv and the<sup>system sponsor should consider any additional risk</sup> management exposures pertinent to the system,<sup>including those arising from interaction with related</sup> financial systems.

Finncial-Integrity. Computerized trading systems may<sup>increase financial risks by increasing</sup> access to users other than traditional intermediaries<sup>and by extending trading hours. However</sup> they could also provide an opportunity to reduce certain<sup>risks by decreasing the number of failed</sup> trades through providing a direct interface with clearing<sup>systems, and permitting credit controls</sup> or position limits to be programmed into the system.<sup>Issues in relation to clearance and</sup> settlement are dealt with in more detail in a separate<sup>section below.</sup> Increases in Risk. The increase in the number<sup>of market participants with direct transaction</sup> execution capability which is possible in a computerized<sup>trading system could create additional</sup> risks for clearing members and, ultimately, the<sup>clearing house. Further, an important feature of</sup> computerized trading is that it facilitates<sup>continuous 24-hour trading. Ihis may imply greater</sup> trading volumes and an increase in the number of<sup>transactions executed when the banking and</sup> payments systems are closed ("out-of-hours'<sup>transactions). Each of these developments will test</sup> the robustness of existing clearing and settlement systems.<sup>The regulatory authority must assess</sup> whether current financial resource requirements for<sup>clearing members and clearing houses are</sup> adequate to meet these financial risks.
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Risk Reduction. Computerized trading systems allow a reduction and monitoring of risk not generally available to floor-based systems. For example, screen-based trading systems are structured to eliminate or greatly reduce failed trades which expedites clearing **dnd** settlement and reduces the financial risks incurr d by brokerage firms in connection with carrying uncleared trades. In fact, screen-based trading systems can be designed to interface directly with clearing systems. This could reduce risk by allowing market participants and relevant regulatory authorities to obtain position reports more quickly and, therefore, to assess risk exposure at an earlier point in time. Computerized trading systems could also facilitate the automatic enforcement of compliance with individualized position limits or credit controls by programming such restrictions into the system.

**Principle 8. Mechanisms should be in place to ensure that the information necessary** to **conduct adequate surveillance of the system for supervisory and enforcement purposes is available to the system sponsor and regulatory authority** on **a timely basis.**

There are three general issues that need to be considered in designing the surveillance features of a computerized trading system: (i) what types of information should be collected; (ii) what entity is to perform the actual surveillance functions; and (iii) how surveillance information is to be shared. Although screen-based systems may contain regulatory enhancements such as better audit trails and credit controls, such systems do not obviate surveillance and supervision. In addition, such systems may create the need for on-line access for surveillance purposes. This topic is discussed in a separate section on market supervision and surveillance.

**Principle 9. The regulatory authority and system sponsor should ensure that system users and customers are adequately informed of significant risks particular to trading through the system. The liability of the system sponsor or provider to system users and customers should be described, especially any agreements that seek** to **vary the allocation of** losses **that otherwise would result by operation of law.**

Computerized trading may reduce some of the risks of trading but they may also pose other unique risks of which customers should be made aware. For instance, because some systems may be completely order-driven, without any market-maker obligations, a significant period of time could elapse before a "matching" order is entered into the system. This exposure to the market may allow competitors to disadvantage the position of the exposed trader.
_- 25_ Similarly, where the system does not provide a means to execute complex trades such tls basket and block trades, customers should be made aware that it may be considerably more difficult to implement such strategies which in turn may impair their risk hedging and arbitrage abilities. In addition, computerized trading systems, in contrast to exchange floors, rely entirely on the functioning of the automated system. The impact of a system failure may be much greater in a screen-based trading environment.

Th4re should, therefore, be full disclosure of:

# the order execution algorithms of the system;

any rules governing allocation of liability for losses from system malfunction or operator error; any limit order protections for system orders; the interrelationship, if any, between such screen-based trading sessions and exchange floor trading sessions;

# any provision for cross-exchange access; and

any choice of legal provisions and process governing disputes arising in connection with trading in the system.

Principle 10. Procedures should be developed to ensure that the system sponsor, system provider, and system users are aware of and will be responsive to the directives and **concerns** of the regulatory authority.

Generally, markets are subject to well-defined regulatory requirements. Changing from a floor trading system to a screen-based trading system usually should not require major changes in the relationships between a market sponsor such as a stock exchange and its regulatory authority. If, however, a market sponsor contracts with an independent entity to provide certain
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key functions in connection with a computerized trading system, existing law may not adequately provide for or address the role of this provider. Regulatory authorities should develop procedures to ensure that such system providers are responsive to regulatory concerns.

In the first instance, the regulatory authority should continue to rely on its existing authority over the system sponsor. For example, the regulatory authority might direct the system sponsor to obtain from the system provider information in its custody which is relevant to the performance of the regulatory authority's responsibilities. The regulatory authority would be able to review the relationship between the system sponsor and the system provider and hold the system sponsor accountable for the responsiveness of its contractor.

In other cases, however, the regulatory authority may need to develop procedures for dealing directly with system providers. Conducting a review of computer security, for example, might require direct access to the system provider's facilities. Similarly, the regulatory authority may wish to impose requirements relating to insider trading and other market abuses which can arise from the use or disclosure of non-public information by empioyees of the system provider.

# Conclusign

These ten principles provide a basis for evaluating or supervising trading systems which include an IT component. They are designed to help policy makers and regulators focus on the key issues in seeking to achieve the basic market objectives of efficient, fair and stable trading. They focus on transparency of information and action, equity of access, and system operational efficiency and security.

The principles are of necessity general in nature and must be attuned to specific local requirements. They do not provide set answers - the circumstances of each situation will demand a different answer. As a consequence, the principles provide a guide for the exercise of judgement by securities market regulators in their particular context and do not reduce the need for sound judgement based on local knowledge.
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# IV CLEARANCE AND SEITLEMENT

If trading is at the heart of a securities market, then clearance and settlement are the veins and arteries. Each executed trade is completed only after shares are exchanged for payment. As a consequence, the way in which the clearance and settlement process is organized has a great impact on the efficiency, fairness and stability of the system as a whole.'" Clearance and settlement consists of four post-trade functions: trade comparison and confirmation; netting and calculation of obligations; exchange of securities and payment; and registration of title. The last is not strictly part of clearance and settlement but is commonly linked to it.'<sup>2</sup> It can be seen that important contractual obligations and rights to title are involved in the process of clearance and settlement, and when it is remembered that many transactions must be cleared each day, the importance of efficient and reliable systems is obvious. IT solutions have been found to be effective in many situations.

Proposals by the Group of Thirty regarding minimum performance requirements for clearance and settlement have been the starting point for a great deal of work in developed countries upgrading and reorganizing existing systems. In emerging markets too, clearance and settlement has received wide attention and two emerging market countries-Mexico and Korea-are considered to have world-class clearance and settlement systems which meet virtually all The Group of Thirty requirements.13 Because many of the policy consideration described above in relation to trading systems are to a degree "generic", they apply equally to computerization of clearance and settlement systems. On the other hand, the Group of Thirty's proposals add considerations specific to clearance and settlement. To account for this, after describing the main functions of clearance and settlement, this

- " See for **instance** DeGennaro, **"The** Effect of Payment Delays on Stock Prices".

- 12 Readers unfamiliar **with** securities **markets** should consult **Annex** I which **describes** the **total** securities market process.

- I **Group** of **Thirty,** Clearance and Settlement in the World **Securities Makets.**
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section deals with the policy issues by reference to the principles described for trading systems and The Group of Thirty proposals.

BoxL9 ClMeaance *-n-R Settlement of Securities Transactions A clearance system determines what securities trading counterparties owe and what they are due to receive. It consists of comparison of the details of a trade 2s reported by each party to determine if they agpee, and then calculation of the amount owed to etch. Clearance is followed by settlement - the exchange of securities and funds to complete'the transaction. There are three types of clearance and settlement system: (i) trade for trade; (ii) daily netting; and (iii) continuous net settlement.

Trade for trade is the most fundamental form of clearance. The buyer ensures that cash or a cash equivalent is available for the seller and the seller ensures that the securities are held in deliverable form. The two then exchange securities and funds through some agreed mechanism. The identity of the counterparty is known and exposure to various counterparties can be monitored. But because the trade for trade system generates one long chain of trades, settlement conditions have to be fulfilled at every link in the chain for it to hold: when one transaction collapses. others are affected.

Where trading volume is large, some form of netting system is needed to reduce the number of clearance transactions required and therefore reduce the likelihood of failed transactions passing down the chain. The simplest form is daily netting, of which there are two types: (i) bilateral; and (ii) multilateral. Under bilateral netting each party has one net clearance a day with each counterparty. Multilateral netting nets the transactions in each security so that parties have one net clearance a day covering all buys and sells in that security.

Continuous net settlement is a refinement of multilateral daily netting in which daily netting is employed and all open transactions at the end of the day are offset against the next day's trades. One of the major elements of the system is that a clearing agency interposes itself between the counterparties, becoming itself the counterparty to each transaction. Individual parties to a trade are thus protected. Continuous net settlement may be on a "rolling" or an "account day" basis. In the latter all trades in a certain period settle on a specific day while in the former all trades settle a set number of days after the day they are transacted.

The exchange of physical share certificates adds to the complexity of the settlement process and makes it more difficult to obtain the maximum efficiency gains possible. For this reason, some form of book entry settlement is desirable in which credit, debit and balance records are taken as sufficient evidence of title to securities and physical transfer of securities is minimized or eliminated. This may be achieved in two basic ways: (i) immobilization; or (ii) dematerialization. In the first, share certificates are retained but are held in a central depository; in the second share certificates are completely eliminated.

Payment too may be by book entry debits or credits (electronic funds transfer) rather than by exchange of cheques or other instruments. This has the advantage of avoiding possible failure to honor cheques or delays in the clearance of cheques.

Annex V provides a more detailed description of approaches to clearance settlement.
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# Main Function

Comparisga. The importance of establishing timely, efficient and rigorous trade comparison can hardly be overstated. The lack of such systems greatly increase<sup>the number of failed</sup> trades and the risk of failure in the securities processing cycle.

Failed trades can become a great problem-the New York Stock Exchange had to regularly ciose or ;ancel trading sesions in the Sate 1960s because the build-up of unseted and failed trades hadgrowr, so large that the financial soundness of brokers was threatened and clients were losing confidence in the market." Many types of comparison system are in use around the world. Some markets use electronic matching, whereas others are completely manual. Some comparison systems facilitate settlement, while others function more as an audit trail after settlement to resolve unsettled obligations. The breadth of participation is an important determinant of the level of automation and the features included in a particular system.

Box 10 Comparison Criteria Matching of trades through comparison and agreement on the following key data is an essential risk reducing element in clearance and settlement:

- date of trade

- time of trade

- market in which the trade was executed

- specific identification of security traded

- number of shares traded and face value

- execution price (and currency if relevant)

- counterparty (and clearing broker if different)

- buy/sell instructions

- trade conditions (ex or cum dividend, etc.)

- projeted settlement date

- trade identification number (a sequential identifier, not always used)

- as well as information required for matching, some systems also include audit trail infornation to facilitate market surveillance

14 Congress of the United States. Electronic **Bulls** and Bears, p. 109
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Trade Resolution. When trades are compared and successfully confirmed the process flows smoothly, but resolving unmatched trades is a test of the effectiveness of a comparison<sup>system.</sup> Depending on the system, trades at various times in the cycle may be eit; -r corre,cted<sup>or canceled.</sup> In a simple comparison system, corrections can be made by either counterparty<sup>after each</sup> has examined reports reflecting the results of the computer matching process.<sup>The brokers contact one</sup> another directly to resolve discrepancies. Unfortunately the system can stall at<sup>this point. Brokers with</sup> inefficient operational procedures mat neglect to resolve un-compared trades, even<sup>though the system</sup> repeatedly notifies them of the outstanding problem.

Two approaches are used to enforce compliance in this situation. First, some markets do not allow unresolved trades to remain on the list past sett!ement day (or even<sup>passed two days before</sup> settlement day) and force an unwinding of the transaction eitEer automatically or by manual<sup>intervention,</sup> often at a market loss to one or other party. The second approach is by use of a fully on-line system linked directly to the trading system in which mismatches are identified seconds after the transaction and are resolved with 100% certainty within minutes. This is called a "locked<sup>in' trade.</sup> Calculation of Obligations. Following matching of all trades a clearance<sup>system</sup> determines exactly what counterparties owe and what they are due to receive on settlement<sup>date. By</sup> accounting for the obligations of different counterparties, the clearance process allow<sup>funds and securities</sup> to change hands in an accurate and efficient manner. The obligations may be calculated on a variety of basis but the trend is clearly toward rolling net settlement with the participation<sup>of a central clearing and</sup> settlement organization. This minimizes the movement of both cash and securities." Exchange of Value. The ultimate test of a clearing and settlement system<sup>is its capacity</sup> for payment of obligations. Whether linked to computerized trading or not, the<sup>clearing house must have</sup> the capacity to speedily and accurately transfer title to securities and make<sup>the balancing cash payments</sup> (called delivery versus payment or "DVP"). IT systems have made possible<sup>very rapid and accurate</sup> processing of this function by relying on "book entry" transfer and payment. Several proprietary systems are available and can be scaled up or down to meet market needs. For example, the<sup>Mexican INDEVAL</sup> system is being marketed, as is the Australian Austraclear system. Such systems<sup>are relatively low cost.</sup> Payment arrangements may be subject to additional pressures when linked to computerized trading systems. The most important such pressures are out-of-hours and 24 hour<sup>trading. In these</sup> _15_ See Annex V. pp. 2-6 for a full description of neuing processes.
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circumstances the relevant regulatory authorities reviewing computerized clearance and settlement<sup>systems</sup> should assess the extent to which appropriate banking arrangements are in place to back<sup>up the payments</sup> obligations generated. For example, special arrangements may be necessary to accommodate<sup>the transfer</sup> of funds during hours when banks would normally be closed.

Rgistration. "Book entry" registration is the optimal solution to speedily concluding the clearance and settlement process. It is the extension of the electronic transfer process<sup>to the legal</sup> registration of title and is a natural development from computerized clearance.

# Box II1 Settlement and Securities Administration in Mexico

The institution responsible for clearing trades in Mexico is S.D. INDEVAL, S.A. de<sup>C.V., an</sup> organization which also acts as the central securities depository. INDEVAL was initially<sup>a government</sup> corporation but was sold to the private sector in July 1987. Ali securities<sup>placed through public offer</sup> may be accepted for custody. The services offered are:

- Safe custody and administration of securities.

- Clearance of transactions made within the stock exchange.

- Daily statement of movements and balances of deposited securities.

- Collection of principal and revenue at maturity of bonds or dividends on stock, paying out to the depositors the same day the amount is collected.

- Certificates of position for exercising voting rights at assemblies.

- Services to issuers, such as payment of dividends, subscriptions, stock dividends, exchange of certificates, keeping the stockholders register, etc., on behalf of the issuers, under specific agreements.

On the Mexican Stock Exchange transactions are "locked-in". That is to say they are<sup>settled</sup> exactly as they are recorded at trade. This makes it unnecessary to have a system<sup>for comparing data on</sup> the transactions, as this is understood in other markets in other parts<sup>of the world.</sup> INDEVAL receives from the Exchange the information on the day's transactions, procerses and clears them by crediting the balance of all of them in the position accounts<sup>of every stock firm involved.</sup> As all the securities are "endorsed in administration" in the name of INDEVAL<sup>when deposited, there is</sup> no need to make any changes in the p hysical certificates.

When a broker sells a larger quantity of a security than its real position, INDEVAL, being<sup>both</sup> the clearing and depository organization, may credit the complete amount of the<sup>transaction to the buyer,</sup> but fines the seller the equivalent of I % of the missing securities' market<sup>value for the first day, dad</sup> 0.1 % for each subsequent day. Usually, it only takes one day for brokers to cover their short positions.

Transfer of funds is carried out by the Mexican Stock Exchange which,<sup>by electronic means,</sup> charges or pays, as the case may be, the amount corresponding to each stock<sup>firm's balance. Securities</sup> must be paid the same day they are transferred. If any of the parties<sup>find a mistake on a settled</sup> transaction, it has the right to ask for a correction.

Insttuto Pam El Dep6sito De Valores
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# |Hox 12 Settlement an Securities Administration in Korea

The Korea Securities Settlement Corporation ("KSSC") was created in December 1974 to operate as the sole central depository for securities and to serve as the clearing house for the settlement of transactions conducted on the floor of the Korea Stock Exchange (KSE). The KSSC also acts as transfer and paying agent for issuing companies listed on the KSE and the OTC marken. In its role as central depository, the KSSC provides safekeeping for more than 60% of all listed shares. The services offered are:

- safekeeping of deposited securities

- book-entry delivery of securities on deposit

- book-entry pledges of securities on deposit

- collection and payment of dividends on deposited securities

- book-entry delivery of securities between participants

- separate safe custody service(Individual Custody)

- collection and payment of principal and interest on deposited bonds

- checking of securities deposited against list of stopped securities

- physical receipt and delivery of securities from/to participants

- settlement of transactions made on the floor of the KSE

- administration of beneficial owner's rights

- exercise of various rights associated with the consecutive deposit of securities

- transfer agent for registered shares

- sub-conversion agent for Korean overseas securities

- nominee function

- collection of securities transfer tax

- conversion of convertible bonds

The KSE provides an automated comparison system for its members who are counterparties of a trade, so that they may confirm the details of their trading commitments just after contracting trades. As there are very few unmatched or rejected trades under this system, the KSE has little need for a secondary trade comparison system. Additionally, the Data Correction System checks the overall format of all input thereby identifying major errors so they can be corrected immediately.

The KSE proceeds with multilateral netting based on the integrated trade data determined after the matching process is complete. The traded quantities are netted to a final long or short position by issue and securities companies who are counterparties to a trade.

The netting data is forwarded to the KSSC via magnetic tape to enter into its owr computer. Then, after identifying the position in the participant's account book, the KSSC distributes details in a report to the securities companies, concerned for settlement by the time limit for settlemeut. The KSE has entrusted the settlement of funds to the KSSC which executes delivery against payment, simultaneously effecting the delivery of securities and the payment of the corresponding proceeds.
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# Policy Considerations

G As with trading systems, the underlying objective is to ensure that securities clearance and settlement takes place in an efficient, fair and stable manner. Severai of the same policy principles apply in assessing computerized clearance and setlement systems as in trading systems. For example, computerized clearance and settlement systems must be highly reliable and secure because they contain a database of market price movements, and securities distribution and comp-rate action information (payment dates for dividends, etc) which must be processed smoothly and accurately. Those of the principles enumerated in Section III in relation to trading systems which are particularly relevant to clearance and settlement are briefly listed below. Refer to the trading systems section for discussion of each one:

- Principle 1 The system should meet all applicable legal standards;

- Principle 2 TiLe system should be designed to ensure the equitable availability of timely infbrination to all participants;

- Principle 4 The system should be designed to operate in a manner which is equitable to all participants and any differences in treatment among classes of participants should be identified;

- Principle 5 Before implementation and on a periodic basis thereafter, the system and system interfaces should be subject to objective risk assessments to identify vulnerabilities which may exist in the system design, development or implementation (eg^,, the risk of unauthorized access, internal failure, human error or natural catastrophe); and

- Principle 7 The regulatory authority should consider any additional risk management requirements arising from interaction with related financial systems.

Group gf 30. Arising from the work of Group of 30, nine proposals specific to the operation of efficient clearance and settlement systems have been developed. They have been endorsed by all major securities markets and considerable effort is being expended on bringing systems up to the standards proposed. The G30 proposals are described below and the relevance of automation to achieving the performance standards is discussed.
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Proposal **1** All comparisons of trsdes between direct market particdpants (i.e., brokers and other exchange members) should be accomplished by the first business day after trade day (C+ 1).

Lack of timely, efficient and disciplined matching systems is one of the most risk prone components of the securities processing cycle. A comparison system must ensure that all non-matching trades are returned for resolution promptly. Comparison on T + 1 (i.e., one day after the day of the trade) gives the trading parties opportunity to correct discrepancies or conflicts in order to minimize risk in the settlement system and help ensure timely settlement.

An efficient comparison system is typically operated by a stock exchange so that both parties to a trade may input data directly into a central automated matching system, which then automatically compares the trade. The basic features of such systems are:

- Trade detail reporting to counterparties

- Trade matching capability

- 'Trade error resolution capability

- Ability to "lock in" trades that match

In order to ensure that the T + 1 standard is met, the system must be designed so that trade reporting back to participants is accomplished on the night of trade date or the morning of T + I but no later than T + 1. Such reporting may be by paper delivery or electronic batch or real-time transmission of data. In all cases the regulator must ensure that the system has sufficient capacity and equitably treats all participants.

Proposal 2 Indirect market partidpants (such as 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. Where institutional investors and large traders are dominant the lack of a uniform and disciplined trade confirmation capability among them introduces asignificant element
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of risk and inefficiency into the securities processing cycle and so a limited form of institutional participation is beneficial. Such systems are called "one-sided" to distinguish them from the "two-sided" comparison achieved between direct members of a clearing house.

One-sided comparison systems exist for institutional investors who may not wish or be permitted to join a two-sided comparison system associated with an exchange because they may be unwilling or unable to participate in a risk sharing arrangement, such as that typically found in two-sided comparison systems. They may, however, wish to have access to an automated comparison system which links them, their broker, and their operational agent (such as a custodian bank) in order to receive a timely and accurate list of trades to which they are the counterparty. This allows the institution to affirm or question the trades within an established time frame.

These systems require communication systems capability which tie the participants together. The most efficient system will require a high degree of automation, with all participants having on-li. a, real time access to information, such as clearing and settlement data (to manage positions) and accounts (to manage cash). The regulatory authority should ensure that the system is capable of reliably fulfilling this expanded role.

Proposal 3 Each country should have an effective and fully developed central securities depository, organized and managed to encourage the broadest possible industry particpation.

A Central Securities Depository's ("CSD") principal function is to immobilize or dematerialize securities, thereby assuring that the bulk of securities transactions are processed in 'book entry" form. The depository system provides the basis for achieving efficient and low-risk transaction settlement. The most important feature of the book entry method is that a transfer of a given quantity of an issue from one account to another can be effected by a simple debit or credit on the books of the CSD. This is inevitably done via computer data entry.

The CSD may also have the capability for trade clearance, safe custody, and settlement/post-settlement processing of securities and information, such as corporate actions and dividend/interest processing. All these functions are greatly facilitated by automation.
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CSDs (an also be structured to include a payments system<sup>maintaining cash</sup> accounts for their members, or they may be linked to a separate<sup>payments system. In</sup> the former case, the CSD automatically processes a payment<sup>transaction by crediting or</sup> debiting the cash account of the member financial institution<sup>simultaneously with</sup> processing the securities side of the transaction. Tlis two-sided<sup>process assures that each</sup> security transaction is, in fact, 'delivery versus payment",<sup>a key ingredient in limiting</sup> risk in the settlement process.

The regulatory authority should require clear specification of the data transmission<sup>and</sup> recording techniques to be used and ensure accuracy of the records<sup>kept through regular balance</sup> calculations (usually two or more a day) and periodic audit (usually<sup>monthly).</sup> Proposal 4 Each country should study its market volumes and partildpation<sup>to determine whether</sup> a trade netting system would be beneficial in **terms** of reducing<sup>risk and promoting efficiency.</sup> For high-volume markets with a high concentration of transactions<sup>among</sup> participants, some form of netting of transactions and clearance<sup>of trades between and</sup> among market participants can minimize risk and cost. The<sup>alternatives should be</sup> analyzed in terms of the cost of building and maintaining a net settlement<sup>system, set</sup> against the cost of settling trades without such a system.

In multilateral and continuous net settlement there is a need for some<sup>form of risk sharing</sup> and trade guarantee system, since the counterparty in each of<sup>these cases is changed, either to a</sup> new counterparty, or to the clearing corporation itself. These two<sup>types of netting are especially</sup> efficient and economical in high volume marketplaces where<sup>IT capacity to support the volume</sup> can be funded.

Bi-lateral netting in which all trades in the same security between the<sup>same counterparties</sup> are netted to a final delivery versus payment are not as complex<sup>or costly and are suitable for</sup> lower volume markets which can support simpler IT installations.

The regulatory authority should carefully consider the market's medium<sup>term efficiency</sup> goals and determine its own view of what form of netting is<sup>appropriate. Whichever form is</sup> chosen, the authority should be assured that the system is capable of<sup>handling likely peak loads</sup> and treats like participants equally.
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Proposal **S Delivery versw** payment (I)VP) should be employed as<sup>the method for settling all</sup> securities transactions.

An area of substantial risk in the settlement of securities transactions<sup>occurs when</sup> securities are delivered without the simuitaneous receipt of value by<sup>the delivering party.</sup> Simultaneous exchange of value is important to eliminate<sup>the risks of price change and</sup> failure to perform according to contract. DVP effectively eliminates<sup>any exposure due</sup> to delivery delay by a counterparty. The most efficient and<sup>certain DVP occurs by</sup> automatic simultaneous transfer of title to securities and debit<sup>or credit of cash accounts.</sup> The electronic transfer of funds against book entry delivery of<sup>securities raises the</sup> prospect of direct links to the banking system and the rapid flow of<sup>substantial funds. For this</sup> reason alone the system must be made secure.

Proposal 6 Payments associated with the settlement of securities transactions<sup>should be made</sup> "same day funds".

Various methods of payment are use&- for securities settlement<sup>and portfolio</sup> servicing. In many markets what is referred to as "same day funds" are usecs,<sup>in others</sup> what is referred to as "next day funds" are used. Same day funds are payments<sup>made</sup> and received free of lien and immediately available on the same day as the corresponding transfer of securities.

Adoption of the "same day" convention will increase the efficiency<sup>of the accounting and</sup> payment systems. Consistency will also simplify the movement<sup>of payments systems towards full</sup> automation of DVP which typically operates with same day funds.

Each country should examine the feasibility of linking the clearing<sup>process with</sup> an electronic cash clearing system. All types of transactions<sup>coule be paid through an</sup> electronic cash clearing system. Eliminating cheque drawing<sup>in this way will promote</sup> greater efficiency and reduce risk.
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Proposal 7 A "Rolling Settlement" **system** should be adopted by all markets. Final settlement should occur on T + 3 (as an intrim target while systems are upgraded, final settlement should occur on T + 5).

In a rolling settlement environment, trades settle on all business days of the week. This process limits the number of outstanding trades, thus reducing market exposure. Rolling settlement, even of small volumes, is facilitated by simple automation.

Tlne primary objective is to shorten the delay between trade date and settlement date; the secondary objective is to standardize settlement time fr2mes throughout international markets. These two goals are best achieved through effic.ent automation of the settlement process. In fact in an environment which is totally centralized and automated, same-day settlement is feasible as is demonstrated in Mexico and Korea.

Proposal 8 Securities lending and borrowing should be encouraged as a method of expediting the settlement of securities tractions. Existing regulatory and taxaion barriers that inhibit the practice of lending securities should be removed.

Despite all efforts made to clear and sete securities transactions in a time frame consistent with the recommended standards, failures to deliver can occur if securities are not available. Securities borrowing has become an effective tool used by market participants to satisfy their obligation to deliver to a trading counterparty in this situation. At the same time, these borrowers incur a temporary collateralized obligation to a lending party.

However, in markets where the practice of securities lending and borrowing is new, precautions must be taken to ensure that borrowers and lenders protect themselves from undue risk in these transactions by instituting careful credit standards, contract terms, and practices. Emerging market regulators should carefully consider the risks associated with securities lending and permit its use only under controlled conditions."0

> 1 See Group of Thity, Clearance and Settlement, pp. 47-49 and 58 for a discussion of the risk of securities lending and concoiutant safeguards required.
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In addition, securities on loan should be marked-to-market (priced at current market value) at least on a daily basis to protect both parties to the loan. This is necessary to ensure that securities lending contributes to the efficiency of trade settlement and in no way increases risk to institutional lenders.

Mark-to-market revaluation is greatly facilitated by computerization as is monitoring of credit standards and maintenance of an accurate securities inventory.

# Proposal 9 Each county should adopt the standard for securities messages developed by the International Organization for Standardization [ISO Standard 77751.

No worldwide securities numbering system currently exists but for trade information to be communicated in a consistent format and handled by computers, a single numbering standard and message system would be ideal. Such a system is provided by the international ISO Standards 6166 (International Securities Identification Number ISIN) and 7775 (Securities Message Types). The ISIN number consists of a country code, a security's domestic code number, and a check digit to validate the code.

In emerging markets newly computerizing clearance and settlement it would be appropriate to adopt the ISO and ISIN systems from the outset. The reality today is that substantial investments have already been made in the infrastructure of various systems that use their own numbering and message systems. Options thus include either a conversion to the ISIN numbering system immediately, or the construction of tables that uniquely translate from an existing numbering/message system to the ISIN numbering system and ISO message format.

# Conclusion

The post-trade process of clearing and settling transactions is a crucial part of an efficient securities market. Because of its importance, internationally agreed standards have been proposed by the G30 which seek to ensure efficient, fair and stable clearance and settlement systems. These and the relevant principles described in relation to trading systems emphasize operational efficiency, financial stability and contractual certainty. Policy makers should consider the relevance of the G30 proposals to their situation and to what extent automation may be necessary. The G30 goals and relevant principles from the discussion of trading systems can be used to guide their analysis of local needs.
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# VI CONCLUSION

There are many ways of structuring and operating secondary securities markets; the diversity arising largely from legal and institutional arrangements, and commercial<sup>custom and practice</sup> peculiar to each place. Also, in the last decade, further diversity has been added by the impact of computerization. It is not simply that computerization has brought new techniques for performing securities market tasks. Rather, it has tended to change the rights and obligations of market participants, the way they relate and conduct their business, and even the way the securities market is organized and defined.

In emerging market countries, the extent of computerization and its consequent<sup>impact</sup> varies from place to place but is already far reaching: in Mexico or Korea for example, advanced systems are in place and extensive institutional and legal change has accompanied<sup>their introduction; in</sup> Turkey, a reform program has begun which includes a sequenced computerization program; and countries as diverse as Russia, Egypt, China and Colombia are considering how to make use of IT to<sup>build from</sup> a very low base to a securities market infrastructure which can support the high growth<sup>in trading</sup> expected in the medium term.

Through the 1990s it seems likely that emerging securities markets will make increasing use of computer assistance. Many of them have ambitious privatization programs and<sup>other policies likely</sup> to lead to a substantial growth in the number of securities listed and traded on the markets.<sup>To be</sup> successful, this growth will often require considerable improvement in the<sup>efficiency, fairness and stability</sup> of the markets. Two factors will tend to encourage increased computer assistance<sup>as the solution. One</sup> is the cost reduction and simplification which is occurring of many of the systems designed<sup>for securities</sup> market tasks, and the other is the tendency for standards of operational performance<sup>to converge because</sup> of the increasingly international nature of securities trading.

As a consequence, Bank staff and securities market supervisors devising institutional and regulatory reform programs will be iacreasingly called on to take into account<sup>the opportunities and</sup> problems that computerization brings. This does not mean that every reform<sup>program should emphasize</sup> computerization or that its importance will be equal in all places. On the contrary,<sup>the focus of reform</sup> should be on achieving the basic goals of efficient, fair and stable market operation.<sup>This will usually</sup>
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mean dealing with computerization questions, but the goals should lead the technology, not the other way round.

Efficiency, fairness and stability are goals common to all financial markets and the fundamental approaches to achieving them are the same in all markets - openess to entry and exit, low costs of intermediation, free flow of information, even handed supervision by an independent and knowledgeable body, and above all, confidence in the integrity and stability of the market itself. In the task of assessing the effectiveness of IT systems in meeting regulatory goals, these fundamentals apply just as forcefully. The principles described in Sections III and IV operationalize them for IT assisted trading, and clearance and settlement. They are intended as a guide to best practice in the regulation of computer assisted securities markets and, as such, as a reference point rather than as a prescription.