The Global Depository

Neale Steiniger, Course Instructor

In the past few years, many hours, weeks and months have been spent trying to find the model for the most efficient stock exchange and settlement system.

Stock Exchanges have explored mergers and links to create the optimal execution mechanism. The London Stock Exchange and the Frankfurt Stock Exchange agreed to merge (the short lived IX exchange), followed swiftly by their decision not to merge. This on again - off again - courtship may be on again. Time will tell. The French, Brussels and Amsterdam exchanges, however, did agree and have successfully merged.

Their merger, the Euronext exchange, eventually included the Portugal exchange. Others are sure to follow. Or should I say, others probably will follow. Nothing is a sure thing. Back in London, the Virt-X exchange was formed to trade the blue chip UK and Swiss companies. The markets of Sweden, Norway and Denmark linked to form the Norex market. The markets in Sydney, Tokyo, Hong Kong, Toronto, Mexico, Sao Paulo, New York, Amsterdam, Brussels and France agreed to link to create the Global Equity Market.

So far these efforts have met with limited success but hopefully will lead to a more efficient, less costly marketplace. Trade processing and settlement is also in dire need of an overhaul. There has been some progress in simplifying the settlement structure as Depositories merge and link their systems. Clearstream was merged with the Deutsche Bourse while Euroclear merged with the French, Belgian and Amsterdam settlement systems. Crest, the UK settlement system also merged with Euroclear. The London Clearing House and Clearnet (the originally French, but now Euronext's clearing house) are, at the moment, independent. But, with London's derivatives market, Liffe, merging with Euronext, Crest merging with Euronext's settlement system, can a merger or linkup between the LCH and Clearnet be far away?

Elsewhere in the world, many depositories have developed links with other depositories to facilitate the settlement of each others securities. For example, the link between Canadian and U. S. depositories provide the mechanism for settling Canadian securities in the U. S. and U. S. securities in Canada. The same exists between Singapore and Australia and many other depositories.

My hope is that one day we will be able to enter instructions to our own depository who will settle a trade executed on any exchange or marketplace. By creating links, a depository enables their participants the ability to instruct their own depository to settle a trade in another country.

An example of this is Clearstream Frankfurt, Depository Trust and Clearing Corp and the German shares of Daimler Chrysler. Shares that are traded on the NYSE settle via a link with DTC, the U. S. Depository and Clearstream Fk., the German Depository. Even though traded in the U. S., the shares are held in Germany and transfer via instructions from DTC. (The shares that trade in Germany, settle directly with Clearstream Fk.) In order to be truly effective, the link would have to support shares traded in Euro or other currencies and regulatory and corporate action requirements. There is still a long way to go, but most depository associations are studying the impact of linking. Anyone who is involved with the settlement of a trade knows how desperately change is needed. Imagine, having the ability to process international trades in the same way that domestic trades are settled.

An investor or their broker has the ability to automate the processing of domestic trades. For example, a U. S. Broker electronically sends trade information to DTCC. They receive the matching results from DTC / NSCC and can query and send instructions on corporate action notices. A U. S. Institutional Investor also has the ability to automate the matching process with DTC. The same is true for a U. K. Broker settling through CREST or a Hong Kong Broker settling through CCASS.

On the other hand, if a U. S. investor or broker has executed an order in the U. K. or if a Hong Kong broker has executed an order in the U. S., the processes to settle the trade is far from automated.

To settle a trade executed in the U. K., a U. S. Investor instructs their intermediary to settle the trade. An investor's intermediary (also called their agent) is typically a Global Custodian Bank; who utilizes another agent in the country where the trade will settle - called the Local or Sub Custodian Bank. A broker may use the same type of intermediary but sometimes uses the facilities of a broker in the country where the trade will settle.

The key to a trade settling on time is twofold - the instructions being sent and the instructions matching. Before the instructions are sent, they are matched by the counter-parties. After execution, the buyer and seller enter the details of the trade into a matching system. If the trade details match, both the buyer and seller receive notification that the trade details match and they can proceed to the next step. The details are then forwarded to their agents. The Institutional Investor sends the detail to their Global Custodian, who forwards them to the Local Custodian who forwards them to the country's Depository. The agents then attempt to settle the trade as they know it. The Local Custodian Banks and /or the Local broker may have received erroneous information. In that case, the trade details that were matched by the buyer and seller are not the trade details that the agents are using to settle the trade. Both agents send queries to their customers (the buyer and seller) who determine the reason for the problem and send the corrected trade information.

Compare the difference between two U. S. brokers who executed a trade in a U. S. stock. Both brokers look at screens that show an unmatched trade and the reason for the mismatch. A quick phone call will resolve the discrepancy. On the other hand, two U. S. Brokers who executed a trade in a Hong Kong stock but sent erroneous information to their agents in Hong Kong will only be advised of the mismatch the next day by their agents. The corrected instructions are then resent - - but because of the time difference, will only arrive on the next business day. Of course, this problem would not exist if everyone used systems that provided straight through processing (STP). The trade that was matched by the buyer and seller would automatically be sent to the agents in Hong Kong. A virtual matching utility (VMU) would assure the matching of the trade by all parties. But the securities industry has given VMUs a luke-warm reception. The Global Straight through Processing Association's Transaction Flow Monitor (TFM) has closed shop. Hopefully, Omego and Sungard and other vendors will have more success. The manual processing, sending and matching of instructions is so convoluted and cumbersome that a solution is needed. A VMU is the short term solution.

The longer term solution brings us back to where we started - with depositories developing links. If the Investors and brokers could settle all trades - domestic and international - through their domestic depository, dealing in another country would be as automated as dealing in one's own market.

Neale Steiniger Neue Schaffen & Co.