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Competition in the post-trade markets: A network
economic analysis of the securities business
Diskussionsbeiträge // Institut für Verkehrswissenschaft und Regionalpolitik, No. 101 [rev.]
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Albert-Ludwigs-Universität Freiburg im Breisgau Suggested citation: Knieps, Günter (2005) : Competition in the post-trade markets: A network economic analysis of the securities business, Diskussionsbeiträge // Institut für Verkehrswissenschaft und Regionalpolitik, No. 101 [rev.], http://hdl.handle.net/10419/47436
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zbw Leibniz-Informationszentrum Wirtschaft Leibniz Information Centre for Economics Published in: Journal of Industry, Competition and Trade, Vol. 6, No. 1, 2006, pp. 45-60
Competition in the post-trade markets:
A network economic analysis of the securities business by Günter Knieps Discussion Paper Institut für Verkehrswissenschaft und Regionalpolitik No. 101 – July 2004 – Revised Version March 2005
In order to analyse the role of competition in the post-trade markets a normative network economic analysis of the securities business is provided. The theory of monopolistic bottlenecks constitutes the theoretical reference point for this analysis in order to identify stable network specific market power. It is shown that clearing and settlement are competitive value-added telecommunications services and therefore do not justify ex ante market power regulation. Precondition for competition on the markets for clearing and settlement is nondiscriminatory access to the complementary technical regulatory function – the notary function (authenticity, registry, links between competing end custodians).
The controversy surrounding the competitiveness of post-trade markets in the securities business is currently on top of the agenda to achieve an integrated European capital market. In that respect traditional network sectors are increasingly being referred to. The European Financial Service Round Table (2003, p.2) maintains, for example, that clearing and settlement service providers are infrastructures that have the characteristics of a natural monopoly. As a result, access to clearing and settlement facilities would require regulation. In this context, post-trade services are compared to railways, airports, and telecommunications infrastructures in particular.1 As a consequence, post-trade services would demand far-reaching regulatory measures similar to those established in the telecommunications, energy or railway sectors. These measures include, for example, provisions guaranteeing open network access at regulated tariffs, discussion of the need for vertical unbundling, provisions on unbundled network access etc.
The matter of whether or not comprehensive rights of access and choice should be guaranteed at every level of the trading and settlement chain by means of EC regulations is also a subject of controversial discussion with regard to post-trade services.2 The current debate surrounding the introduction of regulatory measures on the markets for clearing and settlement draws parallels to the traditional network sectors.
The hypothesis that clearing and settlement as a whole constitutes a network infrastructure in need of regulation is based on the assumption that clearing and settlement represents an essential facility. As a basic infrastructure this would have to be separated from all other commercial activities in the financial and “Clearing and settlement infrastructures benefit from a natural monopoly – granted de facto, if not by law.... As a result, access to these infrastructures is compulsory for financial intermediaries, who serve retail and institutional investors. Their roles can partly be compared to that of railway, airport or telecommunication infrastructures.
As such, they must be adequately regulated and supervised as long as the barriers to competition in this field are not removed.” (European Financial Services Round Table, 2003, p. 2).
Cf. Commission of the European Community, Communication from the Commission to the Council and the European Parliament, Clearing and Settlement in the European Union, – The way forward, COM (2004) 312 final, Brussels, 28.4.2004.
stock exchange sector.3 In order to evaluate these types of hypotheses the application of network economics is essential for thoroughly examining the potential for competition on the post-trade markets. A normative analysis, of whether or not a need for regulation of stable network-specific market power can be established in the post-trade markets’ value chain is of key significance. Depending on its findings, cost allocation and pricing decisions on the markets for clearing and settlement should be left to the flexibility of market participants (within the framework of general competition law), or, alternatively, sector-specific market power regulation is justified.
The paper is structured as follows: Based on the securities trading value chain, section 2 will demonstrate how the functions of clearing and settlement can be differentiated from the notary function, and enhanced custody services. Section 3 starts with an explanation of the theory of monopolistic bottlenecks, which can be used as a basis for distinguishing between parts of a network where competition functions efficiently and other parts with stable, network-specific market power. Section 4 explores the opportunities for potential and active competition on the post-trade markets in securities. In particular, it is shown that clearing and settlement are value-added telecommunications services, which means that these markets are competitive.
Alongside the problem of regulating network-specific market power, matters of technical regulation are also of significance as part of this paper. Although technical regulatory functions can also have implications for competition policy, the latter differ fundamentally from regulatory intervention applied to discipline network-specific market power. In section 5, the layering scheme of network economics is introduced and applied to post-trade markets in securities trading.
The technical regulatory functions in the area of the notary function are examined more closely. Building on the differentiation between technical regulatory “The centralised organisation for securities clearing and settlement that can be found in most of the European countries constitutes an essential facility necessary for all market transactions. … These infrastructures are therefore analogous to the electricity grid, gas pipelines, or telephone system but with the added factor of importance to the economic well-being of the EU Member States concerned.” (Citigroup, 2003, pp.
functions and services on different network layers, this section centres on the need for non-discriminatory access to these technical regulatory functions.
2. Characteristics of post-trade markets In order to analyze the role of competition on post-trade markets, closer appraisal of the securities trading value chain is needed.
2.1 The securities trading value chain
Four consecutive stages can be identified in the securities trading value chain:
(1) Information stage (pre-trade phase), where investors collect information in order to make investment decisions.
(2) Order-routing stage, where securities orders within the banking system are placed on an over-the-counter/OTC market or a stock exchange.
(3) Trading stage, where securities are traded and a suitable counterparty has to be found. At this stage a price is set for a specific volume. Trading can take place with either newly issued securities (primary market) or with securities that have already been placed (secondary market). Trading can take place either via a stock exchange (with differing levels of automation on trading platforms) or within or directly between credit institutions and securities service providers.
(4) Post-trade stage; this covers the functional elements of clearing, settlement, the notary function, as well as enhanced custody services (e.g. of distribution of investment income). Clearing and settlement are services that arise from securities trading (e.g. Giddy, Saunders, Walter, 1996, p. 987). Clearing refers to the calculation of the bilateral net liabilities from the purchases and sales of a securities transaction. Settlement means the conclusion of a securities transaction, i.e. the exchange of securities against a cash counter value. The focus of the notary function is to maintain an issuer account as a “memorandum account” (authenticity) as well as a periodically distribution by issuers to the owners of the securities (registry). Downstream custody services cover the implementation of capital services as well as corporate actions (cash capital increases, exchange offers, etc.).
It is important to differentiate between activities on the trading stage and activities on the post trade stage. Central counterparties (CCPs) belong to the trading stage. A CCP interposes itself between counterparties to financial contracts traded in one or more markets, becoming the buyer to every seller and the seller to every buyer. Therefore, CCPs take principal risks facing in particular the counterparty credit risk as well as the liquidity risk. In analogy to ancillary banking services, capital requirements, guarantee funds and other banking regulations are recommended for CCPs (Bank for International Settlements, 2004).
Those regulations should not be confused with proper regulation of market power on the post-trade markets.
2.2 Organizational and institutional alternatives to clearing and settlement
The securities business is linked to numerous accounting processes that occur at different points in the value chain. A basic distinction has to be made between account movements in the settlement of securities transactions at end-customer level (business relationships between investors and their principal bank) and those at earlier stages. Furthermore, a distinction should be made between two different types of end customer within the securities transaction value chain: the issuers, who distribute new securities via an underwriter and trading in securities that are already in circulation.
There are different organizational / institutional alternatives for trading in securities; depending on this, the necessary clearing and settlement functions are carried out by different market participants. These include: commercial banks (intra-bank trading: over-the-counter /OTC), transaction banks, end custodians (Central Securities Depository -CSD-)4, International Central Securities Depositories (ICSDs) as well as global financial services providers (Global Custodians).5
2.3 Distinction of clearing and settlement from the notary function The notary function has to be differentiated into authenticity and registry. Authenticity means the confirmation of the authenticity of the securities holdings.
The registry function can generally be rephrased as “keeping legal record of ownership of securities” (securities deposit).6 The registry function responds the needs of securities issuers. In contrast to bank notes, where proof of authenticity is sufficient but information on the distribution to the different owners is completely irrelevant, securities generate earnings that are in general periodically distributed by issuers to the owners of the securities. The prerequisite in this case, therefore, is that issuers have access to the necessary information.
Clearing and settlement on the one hand and the notary function on the other represent fundamentally different functions of the post-trade value chain. It is important to note that the notary function is not an integral component of settlement. The transfer of ownership takes place within the settlement process, even if registration has not yet taken place or will not take place at all on the issuer’s account (cf. Horn, 2002, p. 11). The transfer of securities ownership from seller This paper uses the term “end custodian”, equivalent to the term “Central Securities Depository” (CSD) which is more common in general use. The standard international term Central Securities Depository (CSD) is confusing insofar as, for example, pursuant to the German Safe Custody Act (Depotgesetz – DepotG), more than one “Wertpapiersammelbank” may operate as collective custodian, making the term end custodian more apt. The use of the term end custodian is advantageous, therefore, as it does not suggest terminologically that only one securities depository can exist; furthermore, this use makes clear that it is possible to have a chain of several intermediate custodians.
For more detailed explanations of the different providers and their various roles in clearing and settlement, see e.g. Bank for International Settlement, 1995, Annex 3, pp. 46-57; Bank for International Settlement, 2003; Kröpfl, 2003, pp. 28-32.
The term “registration” is introduced in the sense of a notary function. The term “registration” therefore does not focus on different kinds of shares.