Cross Border Settlement and Regional Bond Market Integration

1. Cross Border Settlement andRegional Bond Market Integration November 4-6, 2005 Shanghai, China Noritaka Akamatsu The World Bank

2. Contents • Background • Alternative channels of cross border settlement • Existing networks of global custodians in the region, • Institutional networks and system linkages among existing clearing houses and CSDs in the region, • Risk management issues, • Legal and regulatory infrastructure for ownership security and settlement finality, • Multi-currency fund settlement arrangements, • Business, political and technical feasibility of a regional clearing house. • Capital account liberalization requirements, • Strategy

3. Background • Efficient and secure settlement is critical to promoting cross border trading of bonds in the region. • Unless the settlement is possible, secure and efficient, investors will not trade across national borders. • How can a trade between, e.g., a Korean investor and a Thai counterpart in Malaysian bonds kept in custody in Hong Kong be settled? • National CSDs are now being linked up. But their settlement modes differ because each of them is designed to serve for domestic needs. • Banking services are weak and different DVP modes prevail in different national markets. • Bilateral links have not been a popular channel of cross-border settlement except when it involves an ICSD.

4. Background - continued • International investors without direct access to national CSDs rely on global custodians and their local agents. • Liquidity pressure on local agents as repos (a popular instruments in cross border trading) and/or back-to-back transactions grow. • Any room for use of an ICSD or creation of a regional CSD?

5. Trading needs and patterns • Investors have a need and interest to manage exposures to regional risks and currencies. • Often seek liquid government securities market where risk-adjusted interest rate is attractive and exit is easy to manage exchange rate risk. • OECD experience • Government securities repos and back-to-back trades by dealers and market makers have grown rapidly. • Those created a pressure on intermediaries in the settlement chain (e.g., local agent sub-custodians).

6. Alternative channels National CSD Local agent Local agent Local agent Country of issue Other countries Global custodian ICSD National CSD Non-resident counterparty Non-resident counterparty Non-resident counterparty Non-resident counterparty Non-resident counterparty Direct access Local agent Global custodian ICSD CSD-to-CSD Source: Cross-Border Securities Settlement, March 1995, CPSS, BIS

7. Alternative channels ofcross border settlement – 1 • Direct access to local CSD. • Non-resident often not permitted. • Local money settlement arrangement necessary. • Use of a local agent (custodian). • Often provides pre-matching services and even settlement on its own book. But custody risks are involved. • Use of bilateral links among national CSDs. • A national CSD is often exclusively linked to a national stock exchange, which limits non-resident investors’ access to non-listed securities. • Links are created primarily to allow domestic parties to trade in foreign securities rather than to trade across the border. • Banking and cash management services are weak, and different DVP models prevail.

8. Alternative Channels – 2Use of global custodian • Offer a single entry point for investors in multiple markets. • Have a network of local agent sub-custodians (some of which may be their own branches or subsidiaries). • Inexpensive service compared to separately accessing local custodians and other service providers thanks to economies of scale and scope despite IT investment required. • Provide multi-currency banking services and management of cash and securities positions. • Internal settlement over its own book. • Can handle settlement of back-to-back trades.

9. Alternative Channels – 3Use of ICSD • Provide a single entry gateway to multiple markets as does a global custodian. • Able to settle internally over its own book with direct links to national CSDs. • I.e., can handle settlement of back-to-back trades. • In Europe, those links were exploited to settle European government securities over ICSDs. • Inexpensive service for core clearing and management of cash and securities positions. • Use existing ICSDs or create a new regional ICSD in Asia??

10. Alternative architectures in Europe • Networking CSD model. • Bilateral links among national CSDs, making each other a sub-depository (e.g., European Financial Superhighway by ECSDA) • Hub and spoke model (ICSD) • Euroclear • Single CSD model (ICSD) • Creation of Clearstream by merger between Deutsche Borse clearing house and Cedel. • Controlling ownership of Clearstream by Deutsche Borse may be an impediment.

11. Regional networks of global custodians Global custodians active in emerging markets cross-border transactions • Bank of New York • JP Morgan (including Jardine Fleming) • State Street • Citibank • Deutsche Bank • PNB Paribas Those in bold Italic have • Northern Trust strong local presence and • ABN-AMRO Mellon client base in Asia. • HSBC • Morgan Stanley Global Custody • MeesPierson

12. Regional networks of global custodians - continued • But there are differences among them. E.g., • State Street: presence in regional hubs only but not in each individual country nor does it directly participate in local CSDs. • Citibank: presence in each individual country (i.e., local as well as global custodian) and directly participate in local CSDs. • Their business strategies differ. • State Street: serving for global investors and interested in serving as a regional hub for international and intra-regional settlement. • Citibank: not interested in being a regional hub because it directly participate in local CSDs and can directly serve local clients (i.e., able to internalize regional settlement).

13. Agent sub-custodiansin East Asia 1999 2000 2001 • China (mainland) 5 4 5 (Hong Kong) 6 7 7 • Indonesia 4 4 5 • Japan 6 5 9 • Korea 12 4 10 • Malaysia 10 5 9 • Philippines 5 4 5 • Singapore 6 5 8 • Thailand 9 5 9 . Q.How many of them are branches or subsidiaries of global custodians?

14. Networks & linkages among clearing houses and CSDs Clearing houses and CSDs in the region. • China CGSDTC and CSDCC • Indonesia BI-SSSS, KSEI and KPEI • Japan BOJ-Net and JASDEC • Korea KSD • Malaysia MCD, SCANS • Philippines ROSS, SCCP and PCD • Singapore Central Depository Ltd. • Thailand Bhatnet 2 and TSD

15. Risk management Issues: How to ensure cross border DVP? • Systemic risks in links among settlement systems. • Local sub-custodians under pressure to receive and redeliver securities on the same day. • How to settle back-to-back trades? • Links have been being built among CSDs and between CSDs and ICSDs. • Local CSDs built to meet local needs only. • Different modes of DVP even when they are said to be achieved over electronic books.

16. Multi-currency cross-border fund settlement • Are continuous linked settlement and CLS Bank needed to support the settlement in regional currencies? • CLS bank has an account with each central bank in the region. • Participating banks have an account with sub-accounts for different currencies at CLS bank (as well as accounts at the central bank). • Participating bank pays to CLS bank account at the central bank by use of RTGS system, or instructs its nostro agent to pay to CLS bank account at the central bank of the agent’s economy. • Is use of CLS Bank possible? • CLS Bank does not provide settlement in Asian currencies other than Japanese yen. • Create a regional CLS bank?? Does it make business sense??

17. Multi-currency cross border fund settlement - continued If a regional CLS bank should be created, • Who should own / govern / participate in it (I.e., governance)? Should it be another subsidiary of CLSS? • Global custodians serving for the settlement in regional currencies. • Local custodians • Central banks as well? • Where should it be located? • Center of the regional time zone? • In a jurisdiction whose legal framework is acceptable to as many participants as possible?

18. Multi-currency fund settlement- continued • Cross-border DVP is essential. • National CSD must achieve DVP domestically in order to enable cross-border DVP. • DVP settlement instructions must be sent to the central bank and custodian. • How to ensure settlement finality? • Between banks and between a bank and CLS bank at each central bank. • Under what law? Law of the jurisdiction in which CLS bank is located? Laws of the jurisdictions of the central banks involved in each transaction? English law?

19. Legal & Regulatory Infrastructure • Conflict of laws and legal risks in defining settlement finality and managing cross border collateral. • Most government securities in the region are demeterialized and recorded as electronic entries. • They are registered in domestic registries (central bank registries or CSDs), but where are they kept in custody? • How can legal finality of settlement of offshore transactions in such securities be achieved and ensured? • Need a common legal basis to which all the jurisdictions and market participants in them can agree? • Article 9(2) of EU Settlement Finality Directive

20. Legal & Regulatory Infrastructure • Definition of settlement intermediaries. • Legal status of “securities” differ across countries. • Finality of delivery and payment • Concept of “bankruptcy”

21. Capital account liberalization • Exchange control on capital account transactions • Role of central banks in implementing the exchange control and its implications for cross border securities trading. • Taxation of cross-border securities transactions.

22. Business, political and technical feasibility • Is it politically feasible to establish a new regional ICSD? Does it make business sense? • Information technology (IT) enables • Building bilateral links among national CSDs • Building bilateral links between ICSDs and national CSDs. • Global custodians to provide sophisticated customer services for institutional investors, alluring them to outsource not only backoffice but also some midoffice functions while global custodians themselves to outsource “core clearing” to ICSDs. • Substantial IT investment is required, and communication protocol and messaging standards need to be established. • Requires training of staff.

23. Strategy • Make various channels of competition open. • Policy support to encourage competition among national CSDs to become a regional ICSD. • Coordinate to ensure system connectivity. • A CSD owned by and serving for a national stock exchange will be out and can only be a spoke? • A CSD serving for government securities has competitive advantage from economies of scale and scope? • A CSD operated by the central bank cannot compete for profit and beyond the national border? • A national CSD open to direct participation by global custodians may become a regional ICSD? • A country that is to house a regional ICSD must have a liberal capital account.

24. Links with other initiatives • Mutual acceptance of regional sovereign bonds as collateral for central bank intra-day credit. • Use of ABC bonds as such collateral?