ECONS528: FINANCIAL MARKETS, GOVERNANCE AND REGULATION CHAPTER VII : THE SECURITIES AND DERIVATIVES MARKETS

1. ECONS528: FINANCIAL MARKETS, GOVERNANCE AND REGULATIONCHAPTER VII: THE SECURITIES AND DERIVATIVES MARKETS Pierre Francotte 2013-14

2. Reading • Harris, Larry (2010), « The Economics of Trading and of Regulated Exchanges » in « Regulated Exchanges: Dynamic Agents of Economic Growth », Oxford University Press, New York. • Cantillon, Estelle & Yin, Pai-Ling (2010), « Competition between Exchanges: A Research Agenda », in International Journal of Industrial Organization, 29(3), May 2011, 329-336. • CEPS (2011), MiFID 2.0, Casting New Lights on Europe’s Capital Markets, Brussels. • CPSS-IOSCO (2001), « Recommendations for Securities Settlement Systems », CPSS Publ. N° 46 (November).

3. Reading • CPSS-IOSCO (2011), « Principles for Financial Market Infrastructures », consultative report (March). • CPSS-IOSCO (2004), « Recommendations for Central Counterparties », CPSS Publ. N° 64 (November). • Gorham, Michael (2010), « The Long Promising Evolution of Screen-based Trading », in « Regulated Exchanges: Dynamic Agents of Economic Growth », Oxford University Press, New York. • Harris, Larry, editor, « Regulated Exchanges: Dynamic Agents of Economic Growth », Oxford University Press, New York. • Schwartz, Robert.A & Francioni, Reto (2004), Equity Markets in Action, Wiley, Hoboken, New Jersey.

4. CONTENTS Introduction • Holding and Transfer • Infrastructures • Regulation of Securities and DerivativeMarkets

5. INTRODUCTION • Different holding and trading structures for securities and derivatives: • Trading is done through separate channels (OTC and exchanges) • some exchanges offer both securities and derivatives trading, but through separate channels/platforms • Netting done through separate CCPs • some CCPs offer netting for both assets, but again through separate channels/platforms • Settlement only for securities, not for derivatives: • settlement for securities in CSDs • settlement of derivative contracts typically through cash payment or delivery of goods • trade warehouses for derivatives, but only databases, not records of ownership (unlike CSDs).

6. I. HOLDING AND TRANSFER • Holding and transfer of securities • Holding and transfer of derivatives

7. A. Holding of securities • Securities holding through a « multi-tier » chain of intermediaries connecting ultimately: • end investors • to the issuer of the securities. • Ownership rights over securities preserved if proper segregation from intermediaries’ own assets at each level of holding. • precise rights and conditions for ownership preservation depend on applicable legal system, • greater complexity when chain of intermediaries in different countries (because different legal systems and need to ascertain which court would apply which law).

8. Transfer of securities • Transfers are: • agreed through trading • effected through settlement • often, but not always, after netting. • What is clearing? • process –after trading- of calculation of the respective obligations to pay and deliver the securities • it is often confused with netting or settlement (e.g., « clearing houses »), but • separate step needed prior to netting or settlement, normally effected by the netting or settlement institution.

9. Securities tradingchain

10. Trading • Trading is the agreement between the parties to make a transaction (sale, pledge, etc). • It requires agreement on all key elements: • object: which (ISIN #) and how many securities • price • time: delivery date • Key elements must be « matched » (confirmation).

11. Netting • Netting consists in transforming multiple obligations between several parties in a single debt or claim by party. • Debts to counterparty are « novated » to become new debts to CCP (new contracts replacing old one). • The debts to pay for/receive securities must be: • certain (not subject to conditions) • already due and payable (not with different future time schedules) • in same currency/ for same securities (ISIN #).

12. Examples of netting • Example of bilateral netting through CCP: • A owes 100 to B and B owes 300 to A • Netting: • B owes 200 to CCP, and • CCP owes 200 to A • Example of multilateral netting through CCP: • A owes 100 to B, B owes 300 to C, C owes 500 to A • Netting: • A has claim of 400 on CCP • B owes 200 to CCP • C owes 200 to CCP

13. Netting vs trading/settlement • Trading and settlement are required steps for every transaction, whether on exchange or OTC. • Netting is not required, but: • in last two decades, most equity markets have set up CCPs (exception: Spain, but coming) • bond transactions, including for government bonds, and repos also netted in practice • authorities are pushing for more transactions (especiallyderivatives) to go through CCPs.

14. Settlement • Settlement is the transfer of securities and, where relevant, cash, to execute the trade obligations. • Physical settlement extremely rare – done by credits/debits in accounts with CSD or intermediary. • Practice in most markets is settlement 3 days after trading (T+3): • Germany is T+2, • EU pressing for shift to T+2 across EU to reduce market risk and residual counterparty risk, • some emerging markets are still on T+ 20 or 30 for some securities.

15. Againstpayment or free of payment • Most transactions involve the transfer of securities in exchange for cash: • examples: sales, securities lending, repos, pledges • called « against payment » (A/P) • Settlement of some transactions involves only the transfer of securities with no cash involved: • example: realignement from one account to another, • called « free of payment » (FOP).

16. Delivery versus payment (DVP) • A/P transactions typically link the finality of transfers of securities and transfers of cash (DvP): • party gets final receipt of the securities only if the other party gets final receipt of the cash and vice versa. • removes credit risk (counterparty risk): • buyer gets the securities and seller gets the cash, as intended, or • at worst, buyer keeps its money and seller keeps its securities, but neither party is ever without both cash and securities. • DVP is cornerstone of risk-controlled settlement: • disconnected transfers of cash and securities highly frowned upon by regulators and now very rare.

17. DVP vs transfer of ownership • DVP (finality of transfers) is determined by rules of CSD or intermediary settling transactions • finality means the CSD/intermediary will not reverse credits, even in case of default/bankruptcy. • But transfer of ownership of securities is separate matter and is determined by law: • in some countries: ownership transferred at time of agreement (trading) • in other countries: ownership transferred at time of execution of contract (settlement).

18. B. Holding of derivatives • Derivatives are contracts, not negotiable instruments: • not held through chain of intermediaries • copies of contracts and contract details kept by each party.

19. Contractterms • Derivatives contractual terms are generally a combination of: • a master agreement (e.g., ISDA master agreement) which set the generic rules for all contracts concluded pursuant to it, • must be signed by both parties • the specific terms of individual derivative transactions (e.g., amount, price, etc): • agreed over the phone or electronic platforms (for OTC contracts) or through exchanges (on-exchange trading), • must be later confirmed in writing (normally within a few days).

20. Backlogs • In practice, transactions are sometimes conducted before master agreement is signed and confirmation of contract specifics often missing for several weeks or months. • Backlog has represented a significant exposure for individual banks and globally, • led regulators, especially in US, to threaten to prevent further activity by dealers that did not tackle backlog quickly, • prompted emergence of new services of data warehouse (trade repository) and matching support to help dealers reduce backlog on time.

21. Trade warehouses • Databases offered by a third party: • records major elements of contracts • allows parties to identify and resolve mismatches. • Main trade warehouses are DTCC (« DerivServe »), but so far mainly for CDS contracts, and Tri-Optima for interest rates • other provider: Euroclear • competing solutions being developed by derivatives exchanges because of strategic and financial value of data (e.g., CME). • EU would like development of a European solution (concern about the exclusive US regulatory oversight).

22. Trading and netting of derivatives • Derivatives can be traded OTC or on exchange: • 95% of derivatives outstandings are OTC, • on exchange trading requires standardisation of derivatives contracts. • Netting of derivatives can be done through CCP: • same legal novation mechanism as for securities • limited netting so far – also requires standardisation.

23. Close-out netting • Key clause in master agreements is close-out netting – key to reduce counterparty risk: • in case of default under a given contract by a counterparty, allows party to accelerate and net out payments under all other derivative contracts with defaulting counterparty, • but effectiveness requires that contract has been signed and be legally enforceable in relevant jurisdiction.

24. II. THE SECURITIES AND DERIVATIVES INFRASTRUCTURE 1. Exchanges 2. Central Counterparties (CCPs) 3. Central Security Depositories (CSDs) 4. International CSDs (ICSDs)

25. 1. Exchanges • What is an exchange? • Main characteristics of exchanges • Services • Annexes

26. A. Whatis an exchange? • An exchange is a « market »: a place where goods are sold and bought: • based on multilateral arrangements • governed by non-discretionary rules (cf MiFID). • Goods can be: • securities: stock and bonds exchanges • derivatives: derivatives exchanges • commodities: commodities markets, etc.

27. Regulated exchanges • « Regulated markets » (or regulated exchanges): authorised as operators of markets, as opposed to: • OTC, and also • variety of bilateral or multilateral facilities that are extensions of internalisation by broker-dealers and that are subject to some, but not all, the regulations applicable to regulated markets: • in EU: MTFs, Systematic Internalisers, etc

28. B. Services • Historically core services: • listing of new stocks (IPOs) • trading (for securities and for derivatives) • clearing (for derivatives) • But have added a number of other services over time, due to: • pressure on trading revenues, and • pressure to meet for-profit objectives following demutualisation.

29. Additional services • Additional services include (varies per exchange): • sale of data and information, including data analytics • transaction reporting for clients to regulators • services to issuers, e.g.: • help create visibility for company • help company communicate electronically with (potential) investors in market-ready format, • technology services: • outsourcing of IT platforms to other exchanges • leverage of exchange’s IT by banks • co-location of computers with clients’ computers.

30. Expansion into post-trading • Several exchanges own CCPs and/or CSDs: • most derivative exchanges have their own integrated clearing and netting (CCP) services: • CME • ICE • Deutsche Börse (Eurex) • NYSE-ENX (LIFFE) • several stock exchanges control CCPs and/or CSDs: • Deutsche Börse: German CCP+CSD, ICSD (Clearstream), • Nasdaq-OM: Nordic CCP, CSDs in Baltics and Iceland, • LSE: Italian CCP+CSD and LCH.Clearnet • in contrast, NYSE-ENX owns no equity CCP and no CSD.

31. Diversification of revenues • Multi-service exchanges generatesubstantial part of revenues fromancillary services Year: Q3,2011(exc LSE: 2010)/Source: SE’s sites.

32. C. Main characteristics of exchanges • Objectives • Liquidity • Marketmodels

33. Objectives of exchanges • Several objectives of different nature, as per Schwartz-Francioni approach (equity markets): • macroeconomic: capital allocation through secondary market • microstructure: fair and orderly price discovery • legal: investor protection through • laws and regulations • self regulatory role of exchange • operational: reliability • systems availability and data integrity • scalability (volumes) and response time (loop) • speed (latency) • social: equal treatment in terms of • availability of public information from exchange • access by individual members.

34. Liquidity • Defined as « ability to quickly trade substantial size at low cost when wants to trade » • Low cost: width of market (cost for a given quantity) • Size: depth of market (ability to trade quantity at given price) • Quickly: immediacy (time required to arrange a trade of given size at given price) • Liquidity is a major factor of attractiveness of an exchange, as it reduces bid/offer spreads (costs). • exchanges’ market models and algorithms are designed to increase liquidity of market.

35. Marketmodels • Market models of exchanges designed to achieve these various objectives and to make the exchange efficient (including by maximising liquidity) • Different types of market models: • Continuous or call auction markets, and • Order-driven or quote driven markets.

36. Continous vs call auction • Continuous market: • orders to buy/sell matched on a continuous basis. • Auction/call market: • orders to buy/sell batched at a given time of day and matched only then. • Trade-off is between flexibility and liquidity. • Many exchanges combine both models: • auction to start the day and sometimes later in the day at pre-determined times, and • continuous the rest of the day.

37. Order-drivenmarket • Market prices set by the balance of supply and demand with price set so that the largest volume of financial instruments can be traded. • Main advantages: • transparency • certainty for investors that trade takes place in accordance with order • Main disadvantage: • potential lack of liquidity.

38. Quote-drivenmarket • Registered “market makers” are required to display bid and offer prices, and in some cases the maximum ticket size to which these prices relate. • Main advantage: • Liquidity: market makers are required to meet orders for which they provide quotes. • Main disadvantage: • lack of transparency: unlike an order-driven market it does not show the flow of individual orders.

39. D. Annexes 1. Competitiveenvironment 2. Major exchanges and othertrading venues 3. Main current issues

40. Annex 1. Competitiveenvironment • Exchange environment deeply transformed in last 25 years, triggered in particular by: • regulatory steps, including: • removal of fixed commissions • incentives for competition (Reg NMS in US and MiFID in Europe) • technology innovation and in particular screen based trading, and • demutualisation.

41. Regulatoryeasing • Originally exchanges were largely « clubs » with protective rules, such as: • fixed commissions (imposed on transactions with non-members and commission unrelated to size of order) • exclusionary membership rules and exclusive access to trading for members • prohibition for members to be incorporated or quoted companies • obligation for members to bring all their business. • No real competition between trading venues (e.g., between NYSE and Nasdaq). • Costs passed on to members’ clients (in particular retail).

42. Regulatoryeasing – Cont’d • Regulators took actions to reform securities and exchange activities in 1970s-1990s: • US: mid-1970s to 1990s • main objective: reduce costs for consumers and avoid excessive fragmentation. • EU: various directives (starting with ISD 1993) • main objective: European integration • UK: Big Bang 1986; Japan: Big Bang 1997. • Dented protectionism for members and exchanges: • reduced costs for consumers • reduced margins of privileged members • increased competition.

43. Reg NMS and MiFID • Reg NMS (US) and MiFID (EU) implemented in 2007. • Many rules, but some specifically to create more competition between exchanges and from alternative trading venues. • Effectively impose that orders be directed to trading venues offering best execution • Reg NMS: rule of « order protection » (forces routing to lowest price venue) • MiFID: rule of « best execution » (not just price).

44. Screenbasedtrading • Screen based trading has replaced almost entirely open-outcry (voice) trading since mid-1980s. • Originally resisted by users of established exchanges (especially stock exchanges), slowing down the SEs’ ability to adapt to competition. • Had massive impact on market, including on: • competitive landscape • costs • risks

45. Impact – competitivelandscape • allowed exchanges that adopted it to gain market share from laggard exchanges: • DTB went from 30% to 100% of market share of bund futures market from LIFFE over 1995-98 • CME jumped from 50% to 97% market share of US futures over 2004-08 by acquiring NYMEX and CBOT leveraging its screen-based edge. • facilitated the development of alternative trading and matching venues that compete with SEs: • Alternative Trading Systems (ATS) • Multilateral Trading Facilities (MTFs).

46. Impact – competitivelandscape - Cont’d • allowed development of algorithmic and high frequency trading: • manual trading took minutes, • screen-based trading takes milliseconds • prompted new services (and fees) by exchanges: • co-location of computers of client and exchange • outsourcing of IT platforms (facilitating future alliances or mergers).

47. Impact - cost • increased volumes massively, allowing to reduce cost: • reduced bid/ask spreads (by over 90% vs 1990s) • lower broker-dealer trading fees (by 90-95% vs 1980s) • lower price of data for traders • lower exchange fees, but not as much (as exchanges had become for profit, they looked to benefit from growing volumes).

48. Impact - risk • facilitated direct access to exchange by underlying customers (e.g., hedge funds), although still under responsibility of broker, • reduced manual errors and risk of manipulation after the trade, • but created new types of risk, with potentially bigger financial impact: • manual mistake in using screens (« fat finger»), • programming bugs or design mistakes in softwares, • domino impact of algo trading programs • manipulation through HFT (e.g., cancelling of orders).

49. Demutualisation • From 1700s to 1990s, exchanges were: • de facto monopolies (often de jure as from 1980s), • not-for-profit mutuals (owned by users), • largely self-regulated. • Demutualisation: • starting in 1993 (with Sweden) - now almost all, • caused by opportunities (growth of cross-border business), but also conflicts of interests within boards, • transformation into publicly-quoted, for-profit firms, • typically self-listing.

50. Impact - demutualisation • Triggered fundamental changes: • in business approach: • forced much greater discipline (quoted companies) • gave strategic and financial means to invest • gave acquisition currency (listed shares), fuelling M&A activity. • in relationship with clients (no longer shareholders) • less cosy/consensual • competition with users • spurred IBs’ backing for MTFs (Turquoise, Chi-X, etc) • in relationship with regulators • no longer seen as quasi-arm of governments/regulators • reduced regulatory/market surveillance role in most countries • self-regulation no longer acceptable • prompted adoption of Reg NMS and MiFID.