ACG Legal Task Force Activities in 2011

1. ACG Legal Task ForceActivities in 2011 Presentation for the 15th ACG General Meeting November, 2011 Seoul, Korea

2. Contents • What the LTF does in 2011 • What the LTF will do next

3. What the LTF does in 2011 I、Research Program Coordinated by SD&C Legal Protection of CSD/CCP in Case of Participants’ Insolvency II、Comments on Principles for FMI III、Research Program Coordinated by JASDEC Legal Application in cross-border securities transactions

4. What the LTF does in 2011 I、Research Program Coordinated by SD&C • Theme: Legal Protection of CSD/CCP in Case of Participants’ Insolvency • Distributing the Draft to LTF members • Further Feed backs from ACG members • Revising the Draft in accordance with LTF members’ feedbacks

5. What the LTF does in 2011 Report Outline • Cases research • Legal issues and risks • Precedence of rules and procedures of CSD/CCP • Validity, enforceability of settlement instructions • Enforceability of rules and contracts • Investors’ protection • Elements analysis • Securities custody, clearing and settlement system • Participants’ breach of settlement obligations • Legal environment • Legal characteristic of CSD/CCP • Legal arrangements and risk disposal • Creditor and debtor's rights and duties • CSD/CCP’s special role and privilege • Provisions of Insolvency Law • Comments and further discussions

6. What the LTF does in 2011 Main contents (Questions: totally 17) • Do the rules applicable for the process of securities depository, clearing and settlement take precedence over law of insolvency? • Does any instruction given by a participant (or a debit or credit of securities to a securities account) still have effect despite the commencement of an insolvency proceeding of participants? • Are the rules of the depository or settlement system and contracts between CSD/CCP and its participants still effective even if the participant enters into insolvency process? • Would the rights of investors be affected if the participant entering into insolvency progress? • Does investors exercise recall right to their securities in the process of the participant’s insolvency? Can investors ask to take all their securities or transfer their whole securities and cash to other securities firm once the participant entering into insolvency? • Legal relationship (participants and their clients) • Legal relationship (CSD/CCP and participants) • ………

7. Part 1: Cases Research Would CSD/CCP be affected by participants’ insolvency? No affection, 7 members For CCP only, 1 member For CSD only, 1 member For both CCP and CSD, 2 members Cases on participant’s insolvency No cases , 4 members Having cases, 7 cases

8. Part 1: Cases Research Analysis Many members encountered events of participants’ insolvency A majority of CSD/CCP not be affected Laws and regulations have been established to make sure that a CSD/CCP maintain a sound management system and the capability of performing operations and complete its operations in the event of participants’ insolvency/default.

9. Part 2: Legal issues and risks(1) Do the rules applicable for the process of securities depository, clearing and settlement take precedence over law of insolvency? Type one: Not clearly defined, 6 members Type two: Explicitly stipulated in laws, 7 members Does any instruction given by a participant (or a debit or credit of securities to a securities account) still have effect despite the commencement of an insolvency proceeding of participants? Type one: Not clearly defined, 3 members Type two: Explicitly stipulated in laws, 9 members

10. Analysis This question concerns a fundamental principle——settlement finality in payment and securities settlement system. However, under most insolvency laws, the transaction result may be particularly vulnerable, any dealings involving an insolvent person or entity are suspended from the moment of the commencement of the insolvency proceeding. The provision of “finality” in rules can make sure that a clearing and settlement process can be accomplished indubitably and the settlement of instructions can be managed without the risk under insolvency law. Part 2: Legal issues and risks(2)

11. Are the rules of the depository or settlement system and contracts between CSD/CCP and its participants still effective even if the participant enters into insolvency process? Type one: Not clearly defined, 1 member Type two: Yes, 12 members Analysis This question concerns the effectiveness of rules of the depository or settlement system and contracts between CSD/CCP and its participants. In our view, there exists relativity between the effectiveness of rules/contracts and the precedence principle analyzed in the preceding paragraph. Part 2: Legal issues and risks(3)

12. Would the rights of investors be affected if the participant entering into insolvency progress? No, 8 members separately segregate securities account held separately in investor’s own name Not clear, 1 member depends on the relationships between investors and participants Yes, 2 members Part 2: Legal issues and risks(4)

13. Part 2: Legal issues and risks(5) Does investors exercise recall right to their securities in the process of the participant’s insolvency? Can investors ask to take all their securities or transfer their whole securities and cash to other securities firm once the participant entering into insolvency? No, 4 members Not clear, 1 member Yes, 6 members Analysis This question deals with the investors’ rights and interests in insolvency proceedings. In general, most of members give affirmative reply that investors’ rights will be unaffected and they will also exercise recall right to their securities.

14. Part 2: Legal issues and risks (6) • Loss sharing rule • No, 11 members • Analysis • Loss-sharing rule will be applicable in the insolvency proceeding of a participant when there are discrepancy between the actual securities and the securities credited to the investors’ accounts. • It is not a generally applicable rule. • The methods of offsetting the shortfall are diverse.

15. 3-1. CSD/CCP’s obligation of guarantee settlement 3-2. DVP models 3-3 Settlement participants 3-4. CSD/CCP’s supervision measures 3-5. self-disciplined rules Part 3: Elements analysis

16. Analysis This question concerns some potential risks to CSD/CCP in case of participant’s insolvency. A CCP interposes itself between trade counterparts, becoming the buyer to every seller and the seller to every buyer. From the point of view of market participants the credit risk of the CCP is substitute for the credit risk of the other participants. The responsibility of CSD/CCP’s obligation of guarantee settlement may make them suffering loss. There must be a sound and transparent legal basis. Most Asian-region’s clearing and settlement institutions act as CCPs too. They will encounter similar situation of avoiding risks arising from this mechanism. Part 3: Elements analysis

17. 4-1. Legal relationship (participants and their clients) Commission / brokerage relationship: 9 members Trust relationship: 3 members Agent relationship: 6 members Others, Contractual (deposit) Relationship: 3 members 4-2. Legal relationship (CSD/CCP and participants) Principal and agent: 1 member Members or Participants: 3 members Direct contractual relationship: 6 members According to the agreement: 2 member Part 4: Legal Arrangements and Risk Disposal

18. 4-3. CSD/CCP’s special role and privilege CSD/CCP’s right of refusing to deliver securities/cash Yes: 9 members No: 1 member 4-4. legal concept of this kind of right Lien: 1 member Pledge: 2 members Otherlegal rights: 5 members Part 4: Legal Arrangements and Risk Disposal

19. Analysis Legal relations among CSD/CCP, participants and their clients are fundamental legal factors Many types relationship in laws and rule governing a system: Commission / brokerage relationship, Trust relationship, Agent relationship and others. The common and regular privilege of CSDs/CCPs’ could be described simply as refusing to deliver securities/cash, which also is thought as Lien, Pledge and just Legal right in some scope of law. The UNIDROIT Convention on Substantive Rules for Intermediated Securities, Part 4: Legal Arrangements and Risk Disposal

20. The legal framework for securities depository and clearing/settlement varies from jurisdiction to jurisdiction and reflects different legal systems. Key aspects of these areas’ legal framework should include: enforceability of transactions, protection of customer assets (particularly against loss upon the insolvency of a participant), finality of settlement, arrangements for achieving delivery versus payment, default rules, and liquidation of assets pledged or transferred as collateral. Part 5: Comments and Further Discussions

21. What the LTF does in 2011 II、Comments on Principles for FMI • Collecting the feedbacks of ACG members on CPSS/IOSCO Principles for Financial Market Infrastructures (Consultative report) • Finalizing the Draft Summary of ACG Members’ comments on CPSS/IOSCO Principles for FMI • Sending the Draft Summary above to the Secretariat of ACG • The Secretariat of ACG, on behalf of ACG, sends the Draft Summary to World Forum of CSDs (WFC) and CPSS/IOSCO

22. 1. Background Financial crisis Based on former 3 Recommendations/Principles Core principles for systemically important payment systems Recommendations for central counterparts (CCPs) Recommendations for securities settlement systems (SSSs) To harmonize and reorganize the 3 sets of standards Binding force From Recommendations to Principles

23. 1. Background Effect/Impact on the present Much more detailed requirements for risk management Responsibilities of regulatory authorities Trade repository (TR) is included in FMI for the first time Main Contents of the Consultative Report Section 1: Introduction Section 2: Overview of the key risks in FMIs Section 3: The detailed principles of FMIs: totally 24 Section 4: Responsibilities of Central banks, market regulators, and other relevant authorities for FMIs. (Totally 5)

24. 2. Introduction 1.21 Applicability of the principles to CSDs that do not operate an SSS Certain principles stated in the report would not apply to those CSDs that do not operate an SSS. The list of such principles which would not apply is enclosed. Some members feel that such principles be better more clarified. List of principles which do not apply to CSDs in India: Principle 4 / 5 / 7 / 9 / 10 / 12 / 13)

25. 3. Principle 1 – Legal Basis Principle 1 An FMI should have a well-founded, clear, transparent, and enforced legal basis for each aspect of its activities in all relevant jurisdictions. 3.1.4 / 3.1.10 Necessity and costs to secure independent legal opinions in case of conflict of laws

26. 3. Principle 1 – Legal Basis Comments Unfeasible on a practical basis for FMIs to identify and analyze ‘all potential conflicts of laws’, and Problematic to ‘obtain reasoned and independent legal opinions and analysis of the enforceability of its choice of law in relevant jurisdictions’ to help achieve legal certainty on conflict of laws issues. Some members think a certain amount of flexibility should be allowed here.

27. 4. Principle 3 – Framework for the Comprehensive Management of Risks Principle 3 An FMI should have a sound risk-management framework for comprehensively managing legal credit, liquidity, operational, and other risks. 3.3.4. Information and control systems An FMI should employ robust information and risk-control systems to provide the FMI itself and, where necessary, its participants and their customers with the capacity to obtain timely information and apply risk-management policies and procedures. Information systems should also enable the FMI and its participants to monitor their credit and liquidity exposures, overall credit and liquid limits, and the relationship between these exposures and limits

28. 4. Principle 3 – Framework for the Comprehensive Management of Risks Comments There will be differences depending on the nature of business undertaken by each FMI. In addition Any systemization is going to require close consideration of cost and effect.

29. 5. Principle 4, 7– Credit Risk & Liquidity Risk Principle 4 An FMI should effectively measure, monitor, and manage its credit risk from participants and from its payment, clearing, and settlement processes. An FMI should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence. A CCP should also maintain additional financial resources to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the [one/two] participant[s] and [its/their] affiliates that would potentially cause the largest aggregate credit exposure[s] in extreme but plausible market conditions.

30. 5. Principle 4, 7– Credit Risk & Liquidity Risk Principle 7 An FMI should effectively measure, monitor, and manage its liquidity risk. An FMI should maintain sufficient liquid resources to effect same-day and, where appropriate, intraday settlement of payment obligations with a high degree of confidence under a wide range of potential stress scenarios that should include, but not be limited to, the default of [one/two] participant[s] and [its/their] affiliates that would generate the largest aggregate liquidity need in extreme but plausible market conditions.

31. 5. Principle 4, 7– Credit Risk & Liquidity Risk Comments: Largest one or two defaults to CCP The number of defaulting participants is only one dimension Some members suggested the amount of the exposure as a result of the participant’s default is more important factor. Abundance of financial resource for CCP must take into consideration the characteristic and structure of different markets. Some members suggested that a CCP should cover one participant with largest exposure as a minimum requirement. Different CCPs should determine to adopt “cover one”, “cover two” or “cover more”.

32. 6. Principle 11 – CSDs Principle 11 A CSD should have appropriate rules and procedures to help ensure the integrity of securities issues and minimize and manage the risks associated with the safekeeping and transfer of securities. A CSD should maintain securities in an immobilized or dematerialized form for their transfer by book entry. Comments “For those CSDs that would like to engage in CCP business, they should have thorough and resourceful risk control systems” should be added in. If the CSD and CCP is the same legal entity and acts as CCP for both securities and derivatives products, the operational processes and risks must be appropriately managed for each key business area. “CSDs normally don’t engage in CCP business in derivative products. If they do have the advantage of efficiency and low costs in this business, they should engage in CCP business in derivative products through subsidiaries or other forms of separate legal entity.” should be added in the key considerations.

33. 7. Principle 13 – Participant-default rules and procedures Principle 13: Participant-default rules and procedures An FMI should have effective and clearly defined rules and procedures to manage a participant default that ensure that the FMI can take timely action to contain losses and liquidity pressures, and continue to meet its obligations. Comments: Default rules for CSDs with a retail model Some members suggested that each CSD is to determine if default exercise is appropriate and if so, the essential participants for the exercise. The flexibility is necessary as some CSDs allow for participation up to the retail investors or beneficiaries level. It may not be practical or may be impossible to engage these retail participants in default exercise.

34. What the LTF does in 2011 III、Research Program Coordinated by JASDEC • Theme: Legal Application in cross-border securities transactions • Please see presentation from JASDEC

35. What the LTF will do next I、Present Research Program Legal Protection of CSD/CCP in case of Participants’ Insolvency • Finalizing the version after the 13th Cross Training Program • Sharing research outcomes among members II、Present Research Program Legal Application in cross-border securities transactions • Focus on this theme next year

36. What the LTF will do next • III、New Research Program in 2013 • Theme: The application of title transfer collateral agreement in securities markets---suggested by SD&C • Outlines: (to be discussed) • ⅠCOLLATERAL TRANSACTIONS • ⅡCOLLATERAL AGREEMENT • Ⅲ TITLE TRANSFER COLLATERAL AGREEMENT • Ⅳ CONCLUSIONS

37. What the LTF will do next III、New Research Program Outlines (to be discussed) • Collateral Transactions • Brief introduction of collateral transactions in certain jurisdictions • Practices and Definition • Markets Overview • Collateral Agreement • Definition: a security collateral agreement or a title transfer collateral agreement • Two main choices • security collateral agreement • title transfer collateral agreement • Legislations

38. What the LTF will do next III、New Research Program Outlines (to be discussed) • Title Transfer Collateral Agreement • Characters • Legal parties • Effectiveness in certain law conditions • Analyse on the agreement items • Key issues (see next page) • Conclusions

39. What the LTF will do next • Key issues: • Does the law in your market permit a title transfer collateral agreement to take effect in accordance with its terms? If so, please specify. • Briefly describe rights and duties of the collateral taker and the collateral provider. • After what event(s) is the collateral taker entitled to realise the collateral securities ? • Does the collateral agreement, or of a set of connected agreements have close-out netting provision? • After what event(s) may a close-out netting provision be operated?

40. WE HIGHLY APPRECIATEALL MEMBERS’ CONTRIBUTIONS ! Contact info: wjniu@chinaclear.com.cn