The Future of Financial Markets

The Future of Financial Markets David G. Mayes The Future of Financial Markets Also by David Mayes ADJUSTING TO EMU ...

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The Future of Financial Markets David G. Mayes

The Future of Financial Markets

Also by David Mayes ADJUSTING TO EMU (with B. Ardy, I. Begg, D. Hodson and I. Maher) WHO PAYS FOR BANK INSOLVENCY? (with A. Liuksila) IMPROVING BANKING SUPERVISION (with L. Halme and A. Liuksila) PUBLIC INTEREST AND MARKET PRESSURES (with W. Hager, A. Knight and W. Streeck) MODERN PORTFOLIO THEORY AND FINANCIAL INSTITUTIONS (with D. C. Corner) SOCIAL EXCLUSION IN EUROPEAN WELFARE STATES (with R. Muffels and P. Tsakloglou) SOCIAL EXCLUSION AND EUROPEAN POLICY (with J. Berghman and R. Salais) THE EVOLUTION OF THE SINGLE EUROPEAN MARKET SOURCES OF PRODUCTIVITY GROWTH THE SINGLE MARKET PROGRAMME AS A STIMULUS TO CHANGE (with P. E. Hart) INEFFICIENCY IN INDUSTRY (with C. Harris and M. Lansbury) THE EVOLUTION OF RULES FOR A SINGLE EUROPEAN MARKET (editor) 1 Industry and Finance 2 Rules, Democracy and the Environment 3 Social and International Issues FOREIGN DIRECT INVESTMENT AND TRANSITION (editor with G. Csaki and G. Foti) THE EXTERNAL IMPLICATIONS OF EUROPEAN INTEGRATION (with others) ACHIEVING MONETARY UNION (with A. Britton) A NEW STRATEGY FOR SOCIAL AND ECONOMIC COHESION AFTER 1992 (with I. Begg) THE EUROPEAN CHALLENGE A STRATEGY FOR THE ECU (with A. Britton and Ernst & Young) SHARPBENDERS (with P. Grinyer and P. McKiernan) INTEGRATION AND EUROPEAN INDUSTRY (with M. Macmillen and P. van Veen) THE EXCHANGE RATE ENVIRONMENT (with S. Brooks and K. Cuthbertson) APPLICATIONS OF ECONOMETRICS THE PROPERTY BOOM INTRODUCTORY ECONOMIC STATISTICS (with A. C. Mayes)

The Future of Financial Markets David G. Mayes Bank of Finland London South Bank University University of Stirling

with Iftekhar Hasan, Timo Iivarinen, Karlo Kauko, Kari Kemppainen, Tanai Khiaonarong, Kari Korhonen, Harry Leinonen, Markku Malkamäki, Alistair Milne, Kirsi Ripatti, Heiko Schmiedel, Oz Shy, Juha Tarkka, Jukka Topi

© David G. Mayes 2006 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2006 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 13: 978–0–333–99844–1 hardback ISBN 10: 0–333–99844–8 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 15

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Contents List of Tables

vi

List of Figures

viii

Preface

x

Acknowledgements

xiv

1

Introduction

1

2

The Payment System: Structure, Efficiency, Innovation and Regulation

12

3

Technical Efficiency in Stock Markets

60

4

Securities Settlement Systems

97

5

E-Money: an Addendum

146

References

163

Index

171

v

List of Tables 2.1 2.2 2.3 2.4 2.5 2.6 2.7

3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10

3.11 3.12 3.13

3.14

Means of non-cash retail payments General characteristics of large value payment systems Payment flows in TARGET and GDP in EU countries, 2003 Average unit cost estimates of 31 payment systems by region in 2001 Regression results of log-linear cost function Cost and revenue estimates of payment services provided by the Bank of Thailand, 1998 Changes in payment market share in Canada, Finland, Thailand, United Kingdom and United States, 1996 and 2000 Variables used Representative output statistics for individual stock exchanges 1997 Distribution of cost and revenue structures of stock exchanges 1989–98 Descriptive statistics large sample 1989–98 Summary of panel data set of European stock exchanges Regression parameters large sample, 1993–98 Relative efficiency large sample Changes in efficiency scores Correlates of efficiency Maximum-likelihood estimates for parameters of translog stochastic cost frontier function for European stock exchanges Ranking and descriptive statistics of inefficiency scores of European exchanges Malmquist productivity index sample of European stock exchanges summary of annual means, 1994–99 Malmquist productivity index by size, type and organisational form of European stock exchanges 1994–99 Impact of network on market performance Ordinary least squares estimates

vi

15 23 25 36 38 39 40

65 72 74 75 76 77 78 79 80 81

83 85 86

90

List of Tables vii

3.15 3.16 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9

4.10 4A.1 4A.2 5.1 5.2

Impact of network on market efficiency Ordinary least squares estimates Impact of network access on market capitalisation and operating cost The stages of securities trading, clearing and settlement Stock and derivatives exchanges and CSDs in the euro area 2004 CREST payment banks and the currencies in which they offer settlement facilities Global custodians US$bn Settlement institutions in the sample Average key performance ratios for selected settlement institutions, 1993–2000 Costs regressed on output proxies Translog cost regressions, 1993–2000 Decomposition of single- and multi-product scale economies in translog and loglinear model specifications according to size and geographical location Relative efficiency of individual settlement institutions Barriers identified in the Giovanni Reports Variable definitions and data sources E-money systems in the van Hove (2004b) survey Main obstacles for e-cash to replace CB money

92 93 99 103 114 115 125 128 131 132 133

135 144 145 151 159

List of Figures 1.1 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10

2.11 3.1 3.2 3.3 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9

Network of European stock and derivative exchanges in 2004 SIC, Fedwire, TARGET, CHIPS, BOJ-NET Cut-off time and processing cycle Central settlement at the ECB via TARGET Number of cashless payments per inhabitant in EU countries, 2000 Cashless payments per capita in the EU 1994 to 2001 Cost and revenue estimates of 10 retail payment systems in 2001 Cost and revenue estimates of 21 retail payment systems in 2001 Comparison of unit cost estimates under alternative policy approaches Different structures for the payment system E-settlement stamps are produced by e-settlement modules, which are closely integrated with banks’ payment systems A dedicated interbank network connects all banks and the central bank with each other for payment processing Choosing the frontier Distribution of cost inefficiency among European stock exchanges over 1985–99 (Model I) The structure of the market The six stages of a domestic securities trade and the information flows between institutions Consolidation in European clearing and settlement Consolidation models The overall structure of the network-based securities processing infrastructure The FOP-process between two custodians The normal DVP-process between two custodians Decentralised settlement flows Clearing and settlement costs across the value chain (euros) Cost and volume of settlement instructions, 1993–2000 viii

5 26 29 30 32 32 35 35 39 43 45

46 66 84 95 100 110 111 116 121 122 123 127 129

List of Figures ix

4.10 4A.1

4A.2 5.1 5.2 5.3

Cost and value of deposited securities, 1993–2000 The e-settlement modules are integrated into the payment and securities processing systems in custodians’ and banks’ systems The e-settlement stamp is an encrypted part of the normal transaction messages If e-cash can replace CB money, when? Zones of E-money, currency and debit card use Extent of adoption of E-money

130 144

145 149 153 156

Preface This is the third in a series of books looking at problems in the future development of the monetary and financial system. They all look at the issues from a small country perspective and indeed reflect the concerns that exist in the Bank of Finland about the ways in which it will have to exercise its responsibilities in the future. In the first of these, Improving Banking Supervision, which I wrote with Liisa Halme and Aarno Liuksila, we were motivated by the experience of the Nordic banking crises at the beginning of the 1990s and the wish to learn the lessons. The main message in that book was that supervisors, especially in small countries cannot hope to achieve the financial stability they desire on their own. A large portion of what is required is that the banks themselves should want to manage their risks in a prudent manner. The main force for achieving that would be market discipline, through a regime of adequate public disclosure and a structure of corporate governance that enabled market signals to be translated into action. We took as our example another small open economy, New Zealand, that had introduced a regime of that form in 1996. The analysis threw up a number of problems in a European environment. The first was that it was not clear that sufficient information could be disclosed. In the EU/EEA banks have an element of choice over where and how they incorporate and one country cannot run a regulatory system that is materially different from those in the alternative locations. There is thus a degree of ‘regulatory arbitrage’. Secondly, it became clear that the neat idea of having an institution that was sited in a single market and offered clear market instruments that related just to its business was the exception rather than the rule. The larger institutions run across borders so the debt they raise or their share price relates to the whole organisation and not just that under the control of the local authority. Furthermore the larger institutions are not just banks but also offer insurance and other services. There is thus a difficulty in getting public indicators of the health of the banking business. Two things therefore seemed inevitable: the responsibility of supervision would be higher than prima facie desirable and that the supervisors and authorities would need to collaborate across borders in a much more integrated manner than had been envisaged when the single European financial market was designed. More than the simple homex

Preface xi

host arrangements would be needed. The problem came out most acutely when we addressed the problem of bank failure – which of course was what lay at the heart of the Nordic crises. In the early 1990s the banks had been primarily national. If they had remained so, it would have been possible to change the rules to offer a clear incentive for prudence. In our view, the Norwegian authorities had been able to follow the more desirable route in the crisis, by intervening when banks became insolvent and effectively taking them into public management until they could be resolved and recapitalised. Thus shareholders could expect to lose their money and senior management their jobs. Such strong action was not possible under Swedish and Finnish law. We were therefore concerned that assertions that banks would not be bailed out in the future would not be believed. Loans were made and banks merged and considerable taxpayer funds employed. This could be an important moral hazard. Aarno Liuksila and I therefore decided to write a second book purely on this aspect, Who Pays for Bank Insolvency?, and bring together a group of experts in the field from round the world to assess the proposals. We argued that the only way to get countries to agree on how to resolve banks was to try to catch them and intervene before losses were so large that they caused a systemic problem. Before that point, resolution could take place without any significant commitment of taxpayer funds. These issues are still under discussion, but two developments have pushed them up the European agenda. The first is the decision by Nordea, the most significantly cross-border bank in Europe, to seek to become a European company, headquartered in Sweden but with branches rather than subsidiaries in Denmark, Finland and Norway (and Estonia). The Deposit Insurance Directive has been reopened and discussions have developed with CEBS, the new Committee of European Banking Supervisors. Secondly, Basel 2 forces supervisors of a financial grouping to come to a joint agreement on how risk management is to be handled and hence they have to come into much closer co-operation than entailed by the original home-host rules. The topic is thus moving steadily forward. The present book should have been the second in the series, taking the horizon onto much of the rest of the financial system beyond the banks. However, the strength of the debate on the first issues led us to defer it. There are some striking contrasts between the two areas. The first is that for financial markets the issue of European integration has been an even stronger driving force. Globalisation and the introduction of the euro have meant that efficient European markets are needed both to ensure European investors get efficient access to the assets available

xii Preface

and that European firms are able to tap the world’s capital to finance their development. This gives the contrast we noted in a piece of parallel work with Geoffrey Wood on The Structure of Financial Regulation (Mayes and Wood, 2006). Whereas in banking the generalised view is that if anything the system is now over-regulated and the role of the market needs to increase, the problem in financial markets is that the ‘market’ itself has difficulty coming to socially optimal decisions. Financial markets are in many respects networks and therefore require commonly agreed standards – not just technical standards but rules for governance and for access as well. There is thus a clear positive role for the authorities to play in trying to steer the market towards the exploitation of network externalities that will increase efficiency, reduce costs and encourage innovation. Added to this is the need for the authorities to ensure sufficient strength in the financial system that it will be stable in the event of unusual shocks, under the mandate to maintain ‘financial stability’. This facet of ‘industrial organisation’ has been a feature of the Bank of Finland’s research into financial markets over the years. The Bank has three main research themes: the Future of the Financial Services Sector; Modelling Monetary Policy; and the problems of transition, which now focus on Russia and China, and are handled in a parallel unit, labelled the Bank of Finland Institute for Economies in Transition. This present book is different in character from the other two, for although I have written every word, all of the research is drawn from the work of colleagues, whose names are listed on the title page. I have taken illustrations and tables from Discussion Papers they have produced over recent years (all of which are available on the Bank’s website www.bof.fi). The research unit in the Bank, which was a separate department until early 2005, does not have permanent staff, apart those who supervise or support it. The researchers come for periods of six months or more from the policy departments in the Bank or from outside, in a series of Fellowships that are open to competition. While all of the research I have drawn on was done within the Bank, three of the authors actually remained within the Financial Markets Department while making their contribution, one person has left the Bank and the remaining people who now have external affiliations were visiting researchers. The use I have made of the material is my own responsibility. There is, however, a third strong theme, which underlies the research discussed here, which is technological change and the role of Information and Communication Technology in particular. Innovation in the ICT field features very highly in the success of the Finnish economy in

Preface xiii

recent years and the work within the Bank is no exception. Not only have Harry Leinonen and Kimmo Soramäki, who is now at the ECB, designed payment and settlement system simulators that are used by central banks round the world to test out their systems and optimise the design of replacements (Leinonen, 2005) but they have also devoted a lot of thought to what a new much more distributed financial system might look like. It represents almost a paradigm shift from the increasing centralisation and scale approach that is currently characterising much of thinking and provides an important contrast in considering how the future might develop. It addresses the network nature of financial markets very directly and in common with the associated work on networks that is reported, provides what I hope is a contribution that will stimulate the way thinking about the future of financial markets goes over the coming years. The next book, on Asymmetry, is in the pipeline but that is another story. DAVID G. MAYES

Acknowledgements This book is a joint effort with fourteen colleagues who have been in the Bank of Finland for all or part of the last five years, working on this topic. They are listed below with their current affiliations. Indeed, others in the Bank, took numerous to name, have also contributed in various ways and I am grateful to them all. Those who have contributed are not to blame for what I have chosen to do with their work. Particular thanks are due to Harry Leinonen, who has patiently corrected some of the misconceptions I have had about how the financial system works and might work. Thanks also to Alistair Milne, who although only with us for a reasonably short period, was liberal in advice and comments. The book itself was produced at the suggestion of Juha Tarkka, who was responsible for the research department and hence the research programme for virtually the entire period. I am grateful to the Bank of Finland for providing the facilities for this work. General apologies are due to my colleagues and to the publisher for the various delays when more pressing policy issues and projects have elbowed this work aside. My wife has had to bear the brunt of my frustrations and has been invaluable in helping me prepare the typescript for publication. Those whose work has been used extensively are in alphabetical order: Iftekhar Hasan, who is currently Cary L. Washington Professor at the Lally School of Management and Technology, Rensselaer Polytechnic Institute and still a frequent visitor to the Bank; Timo Iivarinen, Karlo Kauko and Kari Kemppainen who are in the Financial Markets and Statistics Department; Tanai Khiaonarong, who is now in the Bank of Thailand; Kari Korhonen, Financial Markets and Statistics Department; Harry Leinonen, who is Advisor to the Board; Markku Malkamäki, who is now in the private sector working for Pohjola; Alistair Milne, who is Senior Lecturer in Banking, Cass Business School, City University in London and remains a visiting scholar at the Bank; Kirsi Ripatti, Financial Markets and Statistics Department; Heiko Schmiedel, who has moved to the European Central Bank; Oz Shy, who is Professor, Department of Economics, University of Haifa; Juha Tarkka, Advisor to the Board and Jukka Topi, Financial Markets and Statistics Department. I am grateful to the Bank of Finland for permission to include the wide range of charts and tables that have been drawn from its Discussion Paper series and from its Studies in Economics and Finance. These xiv

Acknowledgements xv

are individually identified in the text. The full Discussion Papers are all available from the Bank of Finland website http://www.bof.fi/eng/ 6_julkaisut/6.1_SPn_julkaisut/index.stm and the Studies are also available free of charge from the Bank. I am grateful to the European Central Bank for permission to use the material in Table 4.2 from Occasional Paper no. 33 ‘Integration of Securities Markets Infrastructures in the Euro Area’, July 2005. I am grateful to CrestCo for permission to use the material in Table 4.3 on CREST settlement banks and currencies in which they offer settlement facilities drawn from http://www.crestco. co.uk/home.html#http:77www.crestco.co.uk/basic/products/operational/settlement-banks.hmtl in December 2005. I am grateful to Global Custody for permission to reproduce the material in Table 4.4 on the largest global custodians and their assets under custody which is drawn from www.globalcustody.net. Finally I am grateful to The Corporation of London to reproduce Figure 4.8 from page 79 of their City Research Series no. 1, ‘The Direct Costs of Clearing and Settlement: an EU–US Comparison’. Several of the studies have been revised and published in the international journals or will be in the near future.

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1 Introduction

Three features characterise the development of financial markets over recent years: rapid growth, integration among countries and technological change. They seem set to characterise the future for some time to come as well. In Europe, there has been a deliberate attempt to unify markets mainly through the efforts of the EU authorities. This attempt has two main facets. The first tries to remove the barriers that exist as a result of different national administrations having designed systems with their own interests in mind. The second is more positive and involves deliberately trying to harmonise systems so that there can be a single market, for example, with the attempt to create a Single European Payments Area (SEPA)1 and, most obviously, with the introduction of the euro. However, in the case of financial markets, regulatory concerns mesh with technological change. Financial markets are network industries. There is a trading platform and buyers and sellers. No one is willing to make the investment in the platform or in connecting to it if they do not believe the others will do so. Either some dominant players with deep pockets have to decide to move or elaborate negotiations are needed to agree protocols and get the system started. Here regulators can sometimes play the role of the honest broker bringing the different groups together. Nevertheless there is a huge problem of vested interests and sunk costs in existing national systems. If the new international system more closely approximates the systems of one country then it has a head start in the investment for the wider system. The development of a completely new system for foreign exchange transactions through CLS (Contin-

1

See Schmiedel and Schönenberger (2005), for example.

1

2 The Future of Financial Markets

uous Linked Settlement) is quite unusual in this regard, particularly since it is a private sector enterprise that provides benefits to customers through reducing costs, risks and the demands on liquidity but also helps the authorities in their role of trying to ensure a stable system in which people have confidence.2 In this book we take a tour of the problems, the way they are developing, the ways they could proceed and the benefits these could deliver. This gives us considerable implications for policy, which is really the purpose of the book. We start with the most familiar market, that for payments, moving from cash through current systems towards a focus on possible future electronic payment systems that operate as simply as the Internet, without the need for central parties. From the individual’s point of view, transactions could be via a computer or a mobile phone as well as through the conventional routes of retail outlets, whether through machines or over the counter with human beings. One of the features, which is immediately apparent, is how different countries currently are in their use of the different payments media – cash, cheques, debit cards, credit cards and so on. Changes in the use of these different media have been equally dramatic. We deal with e-money separately at the end of the book, not because it is conceptually different but because unlike the other systems that have developed far faster than people imagined two or three decades ago, e-money has stalled in many respects. We may have cards with stored value that enable us to use telephones or travel on public transport and be charged at the time but such cards are not (yet) substituting for cash, whose use is actually rising in some of the countries where it had reached the lowest levels. Our concern in that last chapter is to explain why it has stalled and what that implies for any further developments.

2 In some respects, perhaps the most vivid illustration is currency. Cash persists as a major medium of exchange even though it is in many respects inefficient. The authorities decide on what is legal tender, which inhibits some innovations and the ordinary user is insulated from many of the costs that are involved for the other parties to the transactions, particularly the banks and indeed the central bank. Market solutions are rare unless either the network fails, as in the case of the long Irish bank strike in 1970, or the threat of loss considerable. Simply changing the currency, as with the introduction of the euro, was a colossal exercise, involving political agreement at the highest level and costing a noticeable percentage of GNP.

Introduction 3

There have been few studies of the relative efficiency of payment systems, in the main because it is extremely difficult to get hold of the data. Many of the systems are publicly owned and do not disclose the information. However, in a limited study Tanai Khiaonarong got round this by sending a questionnaire to a sample of system proprietors to get the necessary information. The results are striking. Not only do the costs of undertaking transactions vary by a factor of more than 100 but there is also a wide range of experience in the extent to which they cover their costs. Some manage to get as far as making a small profit, while many are directly subsidised even before allowing for any subsidy towards their overheads. Such subsidies may of course be socially desirable if they help establish the credibility of the system and the development financial markets. However, it is not obvious that many subsidies have been subject to careful cost–benefit analysis. To some extent the differences among systems are exaggerated as they run from very high volume batched low value retail payments to high value real time gross settlement. Nevertheless the comparisons suggest that the scope for cost reduction is large for most systems. It is not clear quite what this implies for an optimal structure, as economies of scale suggest an ever larger and more centralised system. However, this could make the system more cumbersome, less willing to change and the impact of any problems more general. It also provides problems for regulation if monopolies are created, particularly when they are publicly owned, and some system to ensure efficiency and fair pricing would be required. In the public sector it is important to separate the operating and oversight roles. We do not take a stand on the specific design of systems but the requirements for collateral and the timing of clearing all have an impact on relative costs and efficiency. They also affect the nature of the risks in the system. The Leinonen and Soramäki simulators help provide a tool for exploring the different outcomes which might occur with various pricing, security and incentive structures Moving on from payments, we turn to securities markets, where the process of integration is much more complicated and difficult to see through. In the case of payments we face a series of national systems that are very inefficiently linked, even in the case of the euro area, where there is no problem of foreign exchange. Instead of dealing directly with one another through a network they deal mainly through the central banks, who have their own network, TARGET, which is itself changing fast.


Thus cross-border transactions are much more expensive than their domestic counterparts, unless undertaken through the credit card networks (although they may charge handsomely for the foreign exchange leg). The European Commission is seeking to force improvement by compelling banks to charge the same for transactions in the euro area whether or not they run across borders. Such price equalisation is easy to achieve; whether cost equalisation follows is a different matter. It may simply mean that domestic transactions subsidise cross-border transactions. Even in the United States, retail payments are primarily in the region of the payer, even when dealing with national enterprises. Indeed it is mainly the Internet that has changed behaviour by enabling a much easier physical separation between buyers and sellers. Of course catalogue purchases were commonplace in rural areas before that. However, securities markets are more complicated than the simple two-sided networks that are often presented, as both parties need access to banks, the transactions need to settle and the securities themselves need to change ownership. When discussing the railway network, people usually separate the two-sided arrangement between those running trains and those using them and the network from the payment for tickets, which is treated as a separate network. In the same way, the distribution networks for goods and services are normally treated separately from the payments we have just been describing. We focus largely on stock markets and do not place so much emphasis on money markets, bond markets or derivatives markets. These are quite complicated enough in the European environment (see Figure 1.1, drawn from Schmiedel (2004) ). Most countries have their own stock markets which deal with the issuance and trading of shares in larger companies incorporated in their borders. Behind these national stock exchanges lay the settlement systems for completing the transactions and the securities depositories in which the register of ownership is kept. However, increasingly, although the bias is strongly in favour of the home country, investors wish to access a much wider range of markets both to diversify risk and obtain higher yields. This is normally a much more complex procedure, even if the orders can be placed readily, as brokers who have access to the market normally have to be located in the country itself or at least have a ‘seat’ on that exchange. One of the more dramatic shifts in the European landscape came with the shift of much of the bund market from LIFFE in London to Eurex in Frankfurt through the introduction of electronic trading, which enabled London dealers to operate directly through Eurex using terminals in their own offices.

AUSTRALIA HONG KONG SÃO PAULO TOKYO TORONTO

ICELAND

NOREX

NOREX

OSLO

GEM

HELSINKI

STOCKHOLM

IIWAY

OM

TALLINN RIGA VILNIUS

NOREX

ICE KEIRA

NOREX

BALTIC EXCHANGES

COPENHAGEN

DUBLIN LONDON LSE

AMSTERDAM

EURONM

EUREX WARSAW

BERLIN

NEW YORK EURONEXI NYSE

LIFFE EURONM

BRUSSELS TRADEPOINT

FRANKFURT DEUTSCHE BORSE

NEWEX

LUXEMBOURG NASDAQ

NASDAQ EUROPE

VIENNA PARIS

LJUBLJANA

EURONM

VIRI-X

EUREX

EURONM BUDAPEST

IX

CHICAGO CBOT CME

EUREX ZURICH ATHENS

MONTREAL SINGAPORE SOUTH AMERICA

MILAN

GLOBEX

Legend: LISBON/PORTO

Figure 1.1

MADRID

Equities Growth Markets Being negotiated

Derivatives Failed

Network of European stock and derivative exchanges in 2004

5

Source: Schmiedel (2004, p. 184).


We, therefore, focus primarily on efficiency and the potential gains that are available from a more integrated European market. However, regulatory concerns and the role of governance feature strongly in the discussion. Traditionally stock markets were mutual organisations owned by their trading members. However, such forms of governance seem to have been slow to adopt technical change and the competition is moving them towards becoming faster acting, for profit companies. This then raises issues about how to ensure fair access and pricing for brokers, investors and the exchanges themselves as they form linkages. It also raises the issue of the role of the authorities and the central bank in particular in encouraging and managing change. Where the system has appeared deficient, central banks have been prepared to enter the market as providers themselves, the most obvious recent example in Europe being the development and implementation of TARGET, the real time gross settlement system for the euro, through which predominantly large value inter-bank payments can be routed, using linkages between the central banks (on a hub and spoke basis). Indeed the introduction of real time gross settlement has been a major innovation round the world as central banks seek to reduce the risk to the system from building up payments only to find that one party to the system fails, exposing the others to a whole set of unexpected losses. The biggest concern of the authorities is in the credibility and ‘stability’ of the financial system as such. They are concerned to have a system which is efficient and in which the public has confidence – the Reserve Bank of New Zealand summarises this as ‘promoting a sound and efficient financial system’.3 Perhaps surprisingly these objectives tend to be rather vaguely spelt out in central bank acts or corporate plans. Schinasi (2005) for example offers a variety of definitions that have been used in practice before advancing some of his own. This means that they have a strong interest in the various parts of the financial system being resilient to shocks, particularly what might be described as operational risks. Thus systems have to be able to cope with computer failures, failures of major players, disasters, like the 9/11 impact on the New York financial market, fraud and so on. However, the system needs to be robust in other respects, rapidly detecting and correcting errors, avoiding delay, providing clear legal certainty etc.

3

http://www.rbnz.govt.nz/about/index.html.

Introduction 7

Part of the problem has been to define what parts of the financial system are essential for its smooth running, such that public confidence can be maintained. In the field of banking it has been possible to stress that this does not involve individual institutions. Even in the context of some banks being thought ‘too big to fail’ in the sense that if they stopped operating it would be too traumatic for the financial system as a whole, it has been possible to devise ways that the legal personality of the bank is terminated and the existing but now valueless shares extinguished (see Mayes et al., 2001; Mayes and Liuksila, 2003, and Hüpkes, 2004, for example). What has to be kept going is the operations, not ownership. Maintaining stability does not mean that losses will be avoided but that risk-taking is done consciously and the consequences of the realisation of the risks fall on those who take them, with limited collateral damage for the rest of the system and the population at large. However, while the failure of any individual broker might have very limited consequences, except where they are major market makers, because of their number and the protection that is afforded to investor funds, the failure of an exchange or a central counterparty or the destruction of a CSD would constitute a systemic event of a size that would damage confidence and have a much wider impact. In these circumstances the authorities are likely to have very extensive requirements to try to make sure that the system is resilient (see for example, BIS, 2005, which sets out the principles central banks should apply).4 These systemic effects are euphemistically labelled ‘negative externalities’. However, what the design is intended to do is create positive externalities, particularly from the existence of a large network. Until relatively recently, the bulk of the focus was on these two aspects – efficiency and system security. But now this has spread to a desire to make sure that participants are aware of the risks and that those offering services to the public are managing their risks in a prudent and transparent manner. This has been particularly clear in the field of banking, with Basel 2, but it is a general concern. Thus the emphasis is now more on trying to get market participants to behave in a prudent manner in the pursuit of their own interests rather than simply on providing a safety net in the form of insurance and close regulation.

4 This includes as an Appendix the so-called ‘Lamfalussy Principles’ that were established in 1990.


In Chapter 4 we go on from the consideration of the efficiency of stock markets to consider the whole system of securities settlement and the operation of central securities depositories. Here as in the case of the markets themselves and the payment system there are major problems in how integration should take place in a fair manner. We present the current dilemma but contrast it with a radical network approach that has been set out in detail by Harry Leinonen (Leinonen, 2003, 2004). The current dilemma is that there are likely to be efficiency gains from operating a single integrated system right down from operating the market system through clearing to the settlement process, including the central securities depository. Thus one could get a vertically integrated ‘silo’ in handling particular securities. However, while in theory it might be possible to visualise a market in which a number of such silos operate in parallel it is more likely that one would end up with either a single Europe-wide silo, roughly as they have for settlement in the United States, or that parts of the European system would remain separate in a number of national or perhaps regional silos. Competition therefore appears to be inhibited and could only occur for particular functions in the system, such as broking and custody services. Horizontal integration also has its advantages, in increasing liquidity and offering economies of scale. If the system is to remain competitive then the silos need to be permeable at each stage and permit access to outsiders. This is particularly difficult when trying to handle the custodian banks who compete by offering an integrated package of services to the customer from advice, trading and managing the portfolio, right through the payment and settlement services down to looking after the services (in a book entry sense since most securities these days are ‘dematerialised’ and there is no certificate or other physical title to look after and move round). Custodian banks need access to the system on an equal basis if they are to be able to compete. If the same way, CSDs and providers of central services could be more profitable if they were to offer a wider range of facilities to customers. However, if one group has to meet more stringent rules because of their systemically important role than the other it is difficult to offer an equal basis. The more radical solution which we consider involves not a tight network or centralised system but a very open one that operates in a manner more akin to the Internet, where it is not necessary to spell out the precise route for a transaction, simply to specify its key characteristics in terms of the securities involved and the identity of the accounts

Introduction 9

for payment/receipt. Having a central counterparty is normally thought to reduce systemic risk and decrease costs through economies of scale. However, it might be that in the way that the Internet and linked local processors has taken over from the linking of a few megacomputers over the last two decades, so there could be a revolution in the framework for handling securities. Currently the restrictions in the system start from the process of issuing the security in the primary market. Normally it has to be issued on a particular market using the rules and legal basis of that market. That market will tend to be the home market of the enterprise or entity on whose behalf the security is being offered. Despite the dematerialisation the register for the security will then be kept as part of that jurisdiction. This then affects the whole process of trading in the secondary market as in some sense the location of the security is already pinned down, inhibiting the routes and means by which it can be resold and bought till it reaches its maturity (if any). There are clear differences of interest depending where you start from, and each party can be expected to argue their corner. Large financial centres and large financial institutions want to retain and expand their position in the global market. Small financial centres and smaller institutions see their competitive position being eroded and in some sense moving away from them. However, in an Internet-style environment, physical location and indeed scale become much less relevant (Theirstein and Schamp, 2003). What smaller and more remote providers of services want is access to the general system. In the Internet environment, despite some reasonably limited overhead costs such access is virtually free, as long as the provider conforms to the basic protocols and standards. In a financial services environment, however, regulation is often not similarly tuned and indeed has been heavily influenced by the needs of the large institutions. In the same way that providers of services have concerns, so do customers. Investors and borrowers in remote locations do not wish to be disadvantaged by that location. Traditional relationships, if not faceto-face, tended to be local. Venture capital, for example, is not normally provided without considerable knowledge of the entrepreneur even if the provider of the capital is remote from the specialised agent who is setting up the deal. Similarly ‘home bias’ seems to exist in the structure of portfolios that people are willing to hold. If the local capital market starts moving away then it may be more difficult to raise funds. However, the trends are neither clear nor necessarily consistent. To pick one of the more extreme European examples, the presence of


foreign banks as the dominant feature of the Estonian market means that Estonian borrowers have much more ready access to foreign capital than was previously the case. As is typically the case in transition economies, one would expect external finance to be clearly positive in net terms. The securities market is now part of OMX and hence an integral part of the Nordic network. In theory that should also mean an improvement in the market. Having access to a wider expertise and not just that in the Tallinn market should assist Estonian companies in raising capital. The local authorities thus face a range of concerns in trying to make sure that they can fulfil their remit of an efficient and stable financial system in which people can have confidence. If much of that system is moving outside their jurisdiction they have to rely on others, not just as providers but as supervisors. One of the key issues is that these more global or foreign-based system may be a considerable improvement when the system is functioning well. However, those supervisors and providers may have little responsibility for the consequences that are systemic in the local market. The withdrawal of a major provider could be a systemic event in a small market, when it is a relatively minor business decision for a large multinational financial institution. In the banking environment we could label this as ‘responsibility without power’ (Mayes, 2005). Gaa et al. (2001) provide a helpful tour d’horizon of the issues facing small countries as financial markets become more global, more integrated and hence less specifically related to the concerns of the local authorities in trying to ensure well-functioning and stable financial markets for the benefit of economic development and welfare within their jurisdiction. There is also some data available for us to be able to explore the efficiency of various settlement systems and this is undertaken using the same general approach as for stock markets for a panel of 16 of the largest settlement and depository systems in the world over the years 1993 to 2000. Again costs per instruction and the costs of holding securities vary very widely. There are clear economies of scale, so it appears that substantial efficiency gains could be obtained at all scales and from increasing the scale. Nevertheless it is difficult to get fully satisfactory measures of the activities of these institutions, so the conclusions remain general. However, given the orders of magnitude involved it seems likely as in the earlier stages of the financial system that the nature of the financial infrastructure and its costs could be dramatically different in 20 years time. Exploiting technologies that are known today offers considerable scope for gain, to say nothing of those still to be developed.

Introduction 11

The book ends on a note of caution, however. One area where change has been rather less than might have been expected 20 years ago is emoney, at least in a form where it can be used in face-to-face retail transactions. Drawing heavily on the work of Oz Shy and Juha Tarkka, we explore in some detail what characteristics there would have to be in the benefits to customers and merchants and the structure of costs and fees for such a system to have a role to play between that of cash and existing debit and credit cards. The issue is complicated by the existence of multifunction cards; nevertheless, given that the true costs of handling cash are obscured from customers it is not difficult to show that the scope for e-money may be limited if the start up costs are going to be high. As with all new network industries, providers need to be confident that the particular system in which they invest is going to be adopted and not rapidly superseded as with Betamax video tapes. We end with an exploration of the barriers that are perceived in the industry. Technical difficulties help but the strong position of banks as providers of the obvious substitutes could limit the ability for others to introduce new systems. In Europe this has been aided by regulation, which tends to require e-money providers to be treated as credit institutions (banks) even if they are not advancing any credit. In a sense they might be viewed as some sort of ‘payment institution’ that has a more limited range of functions and hence is subject to different regulation because the range of risks is different. The problem is to try to treat e-money providers on an equivalent basis to their competitors, especially when their competitors provide a wider range of services. E-money forms part of the framework of the financial system if it takes off on any scale and therefore needs to be subject to the same constraints that apply regarding confidence in the system. Even though activities may not be related it is the perception that matters for confidence and not necessarily the reality. E-money is going through another surge of development in some European markets and its likely chances of success vary with the alternative instruments that are in current use, as it alters what e-money might drive out. It remains to be seen whether this is going to be a limited success as on the previous occasions or if this time there will be a major change. Central banks have already thought through what they would do if the demand for currency fell substantially. Indeed they have even thought through what they would do in running monetary policy if the demand for central bank money were to fade away. Currently this is all in the realm of theory and speculation.

2 The Payment System: Structure, Efficiency, Innovation and Regulation

It is easy to under-estimate the importance of the payment system and its contribution to the economy because it is largely out of sight. In some countries the costs of the payment system can amount to 3 per cent of GDP (Humphrey et al., 1997, p. 33). The costs of making payments can differ across countries by an order of ten, which could have a major impact on the development of the financial system and the ability to respond rapidly to new challenges and opportunities. This is particularly true for the exploitation of cross-border transactions in the EU. These issues could readily merit a book on their own. However, these aspects of financial ‘plumbing’ tend to be regarded as dull compared with banking and monetary policy. In this chapter, after a short introduction summarising the nature of the payment system and its structure, we consider just three main issues that affect the likely future development of the system: • its efficiency in various countries round the world and the scope for improvement by moving to best practice; • the nature of innovation in the industry and the potential for new more efficient systems both within and between countries; • the role of regulators in shaping the future. Our agenda in tackling these issues has been threefold. In the first place, like most central banks, the Bank of Finland has a responsibility for ensuring efficient working of a reliable payment system which all can access. Second, the creation of the euro area and the single market for financial services in the EU and wider European Economic Area is providing a new challenge to payment systems that have in the past been aimed primarily at the domestic economy with only rudimentary 12

The Payment System: Structure, Efficiency, Innovation and Regulation 13

linkages across borders. As a Eurosystem central bank we have a direct stake in the success of this enterprise; indeed of course we provide part of the payment system ourselves (BoF-RTGS, which handles 90 per cent of the interbank transactions in Finland by value (1 per cent by volume)). However, much of the success will come not from our actions as a provider or user but as regulator of the framework in which the private sector operates. Lastly, Finland has been active in many areas of information technology and communications, and the payment system is no exception. Not only is the POPS on-line netting system for express transfers (owned and operated by the banking system) one of the earliest in its field but the Bank of Finland’s payment and settlement system simulator (BOF-PSS2, Leinonen and Soramäki, 2003) is used by central banks and payment system designers round the world testing out their systems. The first issue is of efficiency simply from the huge variety in the systems currently available across the world, in terms of their structure, their functions, their ownership and the nature of the technologies they employ. As a result there is substantial variation in the costs and efficiency of these systems. This has been perpetuated because payment systems are not merely primarily national in character but in most countries there is considerable monopoly in the provision of services and little opportunity for competition. Moreover the public sector plays a major role in many systems. These elements mean that with a few exceptions it has been difficult to obtain information about the relative costs of different systems on a basis in which one could have much confidence. This lack of information has been tackled in a survey and analysis by Khiaonarong (2003), which forms the basis of section 2.2 of this chapter. As information about best practice becomes more widely available so the proprietors of the different payment systems will start to benchmark their own efforts against best practice elsewhere. Such efforts will be reinforced by the pressure from their customers who find that they are paying substantially more for their services than are their counterparts in other countries. Governments and legislators will also exert pressure when they discover that their taxpayers are having to finance inefficiency, whilst other countries are able to operate unsubsidised systems with lower costs to the user. The pressure for innovation, which is discussed in section 2.3 reflects the surprise that despite the widespread advances of ICT in related fields, particularly the Internet, payment processing by and large remains relatively slow and cumbersome. It seems odd that most transactions


cannot be completed in something akin to real time. One might expect to be able to use mobile devices to complete a transaction, provided suitable means of encryption and verification can be devised. This work draws heavily on Leinonen (2000, 2004) inter alia. The final section 2.4 is complementary to the previous two in asking whether regulation has played an inhibiting role despite the strong political pressures for creating a single market and the increasing extent of cross-border transactions. It draws on Kemppainen (2003).

2.1 The structure of the payment system In most circumstances a variety of different payment systems are available, starting from the traditional barter of swapping one good or service for another, perhaps in a sequence of transactions so that the buyer ends up with the good or service he or she wants. Such barter systems can be very sophisticated, such as those applying in Russia after the collapse of the Soviet Union (Nesvetailova, 2003). However, these systems represent a regression from the usual money based systems, even back beyond commodity based systems, where at least some intervening medium of exchange was used, be it silver, gold, precious stones or even something more mundane like packets of cigarettes. For small value transactions, the normal means of payment remains notes and coin. The currency may not even be that of the domestic economy, if there is cause to question its value or if there is an easy convertibility at no cost as exists in currency board countries with oneto-one or other round value exchange rates. Indeed in border regions multiple currencies may circulate. In these circumstances, as soon as the money changes hands, the transaction is complete. Once larger sums are involved cash becomes less attractive and the means of payment involves a claim on an intermediary, although it could constitute a direct promise to pay by the buyer at some other time or location. Normal retail payments that do not involve cash usually involve either a paper or electronic transaction rather than simple word of mouth. Sometimes an electronic transaction also involves a written component. The key ingredient is that the payment process is physically separate from delivery of the good or service and is undertaken by third parties whom the buyers and sellers trust (at a cost they find acceptable). Clearly the payment options change once the buyer and seller are physically separated at the time of making the purchase/ placing the order.

The Payment System: Structure, Efficiency, Innovation and Regulation 15 Table 2.1

Means of non-cash retail payments

(barter) (commodity) Paper based Bearer securities Cheque Bank and Post Office Giro Electronic* EFTPOS/debit card Credit card ATM payments Cards relating to specific organisations payments over the Internet Direct debit e-money *Many cards offer both paper-based and electronic payments.

The normal range of options for payments is indicated in Table 2.1.1 Some of these are available only at the point of sale and others when the parties are in separate locations. However, even where they have common names there are variations in the way in which the different means are used on various countries. In Finland, for example, when cheques were in use they were mainly for paying larger sums in shops. Cheques were not normally sent through the post to companies in order to pay an invoice nor taken with a paying-in slip to a bank. Instead a signed giro slip was sent or taken to the payer’s bank (branch). The effective range of means is large. The relative use of such payment methods has changed dramatically in recent years; see Snellman (2000) for Finland, Bolt (2003) for the Netherlands, Furst et al. (1998) for the US and Hancock and Humphrey (1998) for a wider survey. Over the course of the 1990s the number of electronic transactions by bank customers increased by a factor of more than 10 in Finland, assisted by the low starting point. The number of cards and the value and volume of transactions has changed much less (25 per cent for the number of cards and a doubling in the case of the value of transactions). This of course reflects their relative starting

1

The payment system literature is littered with jargon (BIS, 2003). We have tried to avoid the worst, such as that indicating whether transactions are between consumers ‘c2c’ or businesses ‘b2b’ or the combinations thereof ‘b2c’, ‘c2b’.


point. The use of cash, though still the lowest in the EU at around 2 per cent of GDP, has risen slightly during the 1990s, although the number of automated terminals (ATMs) has fallen and the number of bank branches has halved. (This last, and the halving of the number of bank employees, was in part a consequence of the banking crisis of the early 1990s than simply a reflection of the nature of the change in payment systems.) There is an extensive literature on why people prefer one form of payment to another, surveyed in Mantel (2000) for example, depending upon their circumstances and the nature of the transaction but that lies beyond the scope of this chapter. The use of e-money has not however blossomed (van Hove, 2004b) and the Avant system, which was launched in Finland in 1993 and developed into its second phase in 1997 has not been very successful. The use of pre-payment cards for public transport, particularly in the Helsinki region has however become universal, partially assisted by discounts but mainly because there is no choice for multiple trip tickets. The take-off into widespread use of new electronic payment methods, whether e-money, use of mobile communications devices (m-payments) or new Internet methods has been just around the corner for some time and the position as of late 2004 is described in ECB (2004c). One simple reason why such innovations may fail to emerge is that the consumer does not normally have any means of determining the costs of the different means of payment. ‘Effectively, consumers face no marginal cost whatever type of payment instrument they choose to use’ (Bolt, 2003, p. 18). They can appreciate the immediate ease or difficulty and judge the security of the particular arrangement but most of the cost is hidden from them. They do not usually pay a transaction fee at the time. If they do then this is likely to reflect only some of the costs and may very well be bundled up in a bank charge that appears at the end of the month or quarter, where there all sorts of factors offset against each other. Most importantly cash is treated as if it were costless in transactions, except in cases where it is discouraged because the recipient fears being robbed and physically harmed in the process (van Hove, 2004a). van Hove (2000) estimates the social cost of the cash system in Belgium at 0.6 per cent of GDP. The central bank has a role in trying to see whether the proper price signals can emerge (Wellink, 2002) and we discuss in sections 2.3 and 2.4 how a more market-driven approach to change in the payment system might be achieved. There is a big step in complexity between cash payments and the simplest paper-based system. Indeed as we discuss in section 2.3 new technological developments are likely to reduce that complexity.


In the case of a cheque, the sequence of steps involved in completing a financial transaction is quite complicated: 1. The purchaser writes the cheque in favour of the seller and hands it over. 2. The seller then takes the cheque to his own bank. 3. The bank then presents cheques for payment by the banks on which they are drawn (the purchaser’s bank). 4. The purchaser’s bank deducts the sum from the purchaser’s balance. 5. The purchaser’s bank credits the seller’s bank, usually through some form of intermediary that may be the central bank or some other clearing house. 6. The seller’s bank adds the sum to the seller’s account. The parties will also require confirmation at various stages that the transfers have taken place as requested. There are thus at least five parties involved: • • • • •

the purchaser the seller the purchaser’s bank the seller’s bank and the clearing house.

It is ‘at least’ because the seller’s or purchaser’s banks may not have direct access to the clearing house. This, of course, does not include the nature of the delivery of the goods or services which are being bought, which may be withheld in whole or in part until the transaction has been completed and the money is firmly in the seller’s account. Whereas a cash transaction leaves little uncertainty – although the seller may not have title to the goods or the cash may be counterfeit – there is additional uncertainty with a cheque, unless in some way it is backed up, say by a bank card or the transaction is ‘authorised’ over the telephone. The purchaser may not have adequate funds available so their bank may refuse to pay, the purchaser may stop the cheque before payment is completed. Similarly the seller may fail to deliver the goods or services. However, in the case of financial instruments, such as bonds, shares and other securities, which are held in electronic registers, their transfer between buyer and seller will form part of the process of settlement, as we note in Chapter 4.


Banks generally batch cheques before presenting them (daily) although there are on-line systems. There are variations on the stage at which the information on the cheque is turned into electronic format and how far round the system the cheques are transported. (Cheques used to be returned to the writer after they had been paid.) These days imaging may be used so that the cheque itself does not have to be transported very far. The giro system is similar but contacted through a post office or other non-bank financial institution. Clearly the process is simplified if the buyer and the seller hold accounts with the same bank. These days it would not matter if the accounts were held in the same branch of the same bank, they would still be sent for processing centrally (regionally) just as if they came from different branches. A bank that is not a member of the system has to act through a member of the system (as a correspondent bank) if it wishes to participate. (Correspondent banking has been a common feature of international banking, whereby a bank in one jurisdiction maintains an account with a bank in another jurisdiction so that it can make cross-border payments. The correspondent bank is then the member of the foreign payment system.) Normally, regulators insist that the clearing system should be open to any registered bank on equivalent terms to the existing members, otherwise this would be a prohibitive barrier to entry to any new banks. A key feature to note in this process is that there is normally only one route for the ‘clearing’ of cheques – the process of verification and then crediting from one bank to another. This form of ‘payment system’ involves banks as entry points and clearing through an intermediary rather than transport of cheques between two banks and the transport of the balance in some form between them. The intermediary handling the clearing system may be privately or publicly owned.2 The processor will charge a fee for each item processed, usually on a non-

2

In a survey of the 15 EU and 11 EMEAP (Executive Meeting of East Asia-Pacific Central Banks and Monetary Authorities) Khiaonarong (2003) finds that half retail payments systems are operated by private companies, and around a quarter by the central bank, the remainder being joint ventures between the two. There were 39 systems in the 26 countries at the time of the survey in 2001/2, not all of which were cheque processing and clearing systems. (EMEAP countries at the time were Australia, People’s Republic of China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, Philippines, Singapore and Thailand.) Fry et al. (1999) suggest a range of determinants of the form of ownership of clearing systems, including the number of banks involved and the level of economic development.


profit-making basis.3 The interbank payments on the batches of cheques will normally go through the central bank. Like other network industries, the costs involved tend to result in there being a single network rather than multiple overlapping systems.4 There is a large set up cost to have the necessary processing systems and then very considerable economies as the number of payments and number of participants increases. There is some competition in the United States but in general most competition tends to lie at the margin between retail and wholesale payments – wholesale systems will try to attract large ‘retail’ payments and vice versa. Inherently such paper-based systems will be relatively slow. Even in a small country it would be difficult to conceive of the system working on a same day basis. An electronic system could on the other hand get much closer to real time. This complicated payment system is a function of history. Nevertheless, it forms the basis of the main payment systems today even if they are undertaken purely electronically. Thus payment with a debit card by machine, say for a train ticket, that is verified by a PIN code (personal identification number) and not through any signature still has to go through an electronic version of the same sequence. The system is not a direct network. There are, however, some short cuts in the electronic system. If a payer uses their own computer then it may be possible to skip a stage. For example, in the Finnish system, one can buy an airline ticket direct using a bank account. Having logged into the airlines reservation system and gone through the usual process of selecting a flight and agreeing a fare, the system switches to the customer’s bank Internet system once payment is to be made. On successful completion of the sequence, the system reverts to the airline’s site and the ticket and confirmation are issued. The form of verification is thus different with the payer providing adequate indication that he has instructed his bank to pay. It is not normally necessary to await the arrival of confirmation in the seller’s bank account, although it can be for large value items. Confirmation can be immediate if both parties use the same banking group. A similar arrangement applies to payment through ATM machines outside the home. In countries like Finland, where the cheque system

3 Sometimes on a substantially loss-making basis in the case of some publiclyowned systems according to Khiaonarong (2003). 4 In some respects of course it is not really correct to refer to many payment systems as a network as they have the form of a star, with all payments needing to be routed through the centre. In a genuine network the payments could be made in any direction between the participants, although nodes might well exist.


was abandoned over two decades ago, a customer who is not using a card in a shop or paying over the Internet can visit an ATM, which will be sited in bank lobbies, railway stations and other prominent places – just in the same manner (but in a smaller quantity) as cash machines. However, these payment ATMs largely replaced other routes of giro payments; it was debit cards that were the most widely used replacement for cheques. ATM systems can vary, as to whether a joint venture provides the service for a number of banks or whether each bank provides its own ATMs, sometimes allowing customers of other banks to use them as well, perhaps for an extra fee. The same process as cash withdrawal applies, using a card and then a PIN. Most requests for giro payment by sellers contain bar codes, so it is only a matter of swiping them and confirming the transaction. Otherwise all of the detail has to be entered by hand, which can be less than exciting on a cold day in a rather open location. It is not surprising that the Internet has rapidly become the preferred route for payment. One can also hand in a paying slip over a bank counter, usually in return for a higher charge, as it uses more of the bank staff’s time, but these are all different routes into the same system. These systems will be electronic versions of the cheque processing system, described as automated clearing houses ACHs. No doubt as time passes other means of electronic entry will be possible such as the mobile telephone (Leinonen, 2000). The principal difference is that instead of the seller initiating the payment sequence through its bank by depositing a cheque, it is the purchaser that initiates the sequence by instructing its bank. Thus in this case the purchaser’s bank debits the purchaser’s account and pays the seller’s bank through the ACH and the seller’s bank then credits the seller’s account. The major credit card systems are, however, separate, even if they are owned by banks, but employ the same principle. Here the heart of the system is the network, with the Visa and MasterCard worldwide networks. Again the members of the system are banks. Although the name on the card may be an airline or supermarket chain rather than a bank, the company on the label will be using a bank to issue the card. The company may gain extra sales but the difference is not really anything more than badge from the point of view of the issuing bank. The payment sequence is similar to the sequence for cheques we have just described only the network is different. The seller or the good or service (usually described as a ‘merchant’) routes all its physical and electronic receipts through a bank that is a member of the credit card


network;5 the credit card network requires payment from the bank that has issued the credit card to the bank the merchant uses. The network charges an interchange fee and the merchant’s bank recovers that by a charge on the merchant. Merchants thus receive less than the purchaser pays. The purchaser in this case does not pay immediately but monthly after receiving a bill from the issuing bank. At this point the ordinary cheque or electronic payment system comes into operation. The purchaser has to pay the issuer by using normal means of payments. Thus the issuer receives payment through the bank payment system. There are thus at least two payment systems involved, as the merchant will want to route the payment from the credit card company through to whichever bank it uses for its transactions. Since the credit card system is international the arrangements can become rapidly more complicated. The network principle is the same for the American Express and Diners Club charge cards but there the issuer of the cards and the owner of the network are the same. Thus, while Visa and MasterCard are ‘open’ networks the charge card networks are closed. Store cards are a different arrangement as they are simply between the customer and the store and are effectively just deferred and aggregated credit arrangements. Normally this will be administered by a financial institution. Despite their name, credit cards are primarily payment instruments rather than credit instruments – in the face of high interest rates many customers pay their bills in full each month. Credit cards have attained their position to quite an extent because of the cost and inconvenience of other means of conducting transactions. In some ways this is surprising as credit cards themselves are costly to administer even without regard to the extent of fraud. However, that cost falls on the merchant rather than the purchaser and is hence hidden. To be more literal, the cost of the system is in many respects passed on all of the merchant’s customers, if credit card holders are charged the same as cash-paying customers. The importance of credit cards as transactions vehicles has been recognised with the rise of debit cards. In their simple form, these operate as an electronic substitute for cheques and require the buyer to have an adequate balance in their account at the time of the transaction (or very shortly thereafter) as the sum involved is debited

5

The merchant’s bank is usually known as the ‘acquirer’ – see Hunt (2003) for a clear exposition of the common jargon in this field.


directly to the buyer’s account, rather than with a predictable delay or with opportunity for deferment beyond a small minimum (up to the credit limit) in the case of a credit card. In some cases the same card can perform either function and the purchaser can choose which at the time. These ‘debit’ cards are sometimes referred to as EFTPOS (electronic funds transfer (at) point of sale) cards, although they can be separately defined (Humphrey, 2001). There are many different combinations available on cards, some debit cards may offer overdraft facilities, those operated via the Visa and MasterCard networks are effectively ‘off-line’ in that they are routed via the credit card network and only reach the customer’s bank after a delay; others operate on-line and are routed direct to the customer’s bank and hence are debited to the customer’s account the same day or possibly the next (McAndrews, 1997). Where transactions occur regularly, the parties can make a prior arrangement that limits the degree to which the complete sequence has to be undertaken each time. It can be initiated by the purchaser in the form of a standing order, which is then executed at given intervals by the purchaser’s bank or by direct debit where it is the seller that sends the particular request for payment to the purchaser’s bank, which holds an authority to pay out without recourse to the customer. The request for payment thus goes the opposite way round the cycle with the setter being the originator.

2.1.1 Wholesale payment systems While the payment arrangements we have described cover the vast majority of transactions they do not cover the majority of transactions by value. These are the large-scale transactions conducted between the banks themselves, usually through accounts at the central bank, which constitute the heart of the system. In the past banks tended to defer payments and netted out transactions as far as possible (DNS, deferred net settlement). Typically in a paper-based system banks acquired claims during the day and submitted them for batch processing at the end of the day. Now, central banks have instituted real time systems to encourage more immediate transactions without extensive netting and reduce the risk that systemic problems are built up. These are labelled real time gross settlement systems (RTGS). In a DNS system banks are effectively able to build up credits with each other until the point at which net settlement takes place. This creates a credit risk but it means that banks require less liquidity. A third type of system has also emerged (McAndrews and Trundle,

The Payment System: Structure, Efficiency, Innovation and Regulation 23 Table 2.2

General characteristics of large value payment systems

General features

Payment processing

Risk control

• • • • • •

• Time of settlement • Finality • Liquidity and credit facilities • Message flow • Queuing • Assets used

• • • •

Ownership Governance Participation criteria Rules Legal basis Pricing

Exposure limits Collateral Loss sharing Time of settlement

2001) which permits continuous net settlement (CNS), such as the PNS (Paris Net Settlement) system in France.6 The key features which distinguish the three systems are time in the case of DNS – payments can be deferred – liquidity in the case of RTGS – payment must be collateralised – and interbank credit in the case of CNS. Hybrids also exist which allow an element of other systems, the RTGSplus system set up in Germany in 2001 allows forms of queuing. CNS systems can also require liquidity in advance. In a CNS system such as PNS in France or CHIPS in the United States, the bank posting the liquidity can set bilateral and multilateral limits A computer algorithm then tries to clear payments, using a combination of rules, such as the order in which they arrived in the system, their size or their number. Payments that cannot be cleared will be queued until sufficient liquidity is available. Rules apply as to when the necessary liquidity is to be supplied to clear the queue, if liquidity is available. Under RTGSplus, banks can choose whether to queue payments or push them through immediately, bypassing the queue. The difference is that payments are not netted but of course receipt of one gross payment permits payment of another if the liquidity limit is biting. Iivarinen (2004) suggests that we can helpfully characterise large value payment systems by three general groups of criteria set out in Table 2.2, which makes the extent of possible variety very obvious. The general features have clear implications for how the system might be regulated. While the central bank, a bankers association or a group of commercial banks may be the owners they can exert control over the organisation in a variety of ways which take different account of the interests of other stakeholders. If the organisation wishes to be able

6

PNS is being merged into the French RTGS system.


to use central bank money the central bank may be able to exercise an effective veto even though it may be only a minor shareholder or not even an owner. Similarly, while open access is a common requirement for systems that have a substantial monopoly character, the owners expect that there will be adequate screening of potential entrants by the authorities. Thus if any registered bank could join, there would need to be adequate control over who could become a registered bank. Similarly, the legal status of the organisation affects how breaches of the rules can be addressed. This is a particularly significant issue if much of the business is to be conducted across borders. Foreign customers will expect methods of redress that can be credibly enforceable. Pricing, the final item in the column, probably generates the most controversy, not just because of the nature of subsidy to public sector run systems which may distort competition, but also because of the way in which pricing systems can be used to control entry even if open access is in theory possible. The focus of most discussions, to which this chapter is not an exception, is on the central column of the payment process itself. We have already noted the difference between real time and the various forms of delayed settlement as well as how liquidity is provided and the importance of the queuing facilities but discussion of message flow is deferred until section 2.3 where the options are considered. However, risk is very much a concern for central banks over and above that of the participants because of their responsibility for the stability of the financial system as a whole. Payment systems obviously need to have a means of handling the standard credit risk, i.e. that the paying bank fails to pay, as we have already mentioned. This can be handled by insisting that the payer has to put up enough collateral or imposing credit limits that are covered by the central bank or by risk sharing among all the participants. However, the solutions to credit risk can impose liquidity difficulties on the system. A bank can then fail to pay, not because it is insolvent but because it has insufficient liquidity – it has reached its credit limit or has run out of eligible collateral – probably because it in turn is waiting for large payments from other banks. This failure is one of timing and can result in the system grinding to a halt – to which the term ‘gridlock’ has been applied as discussed in the next section. They also need to have structures that help them manage the normal operational risks – equipment can fail, power can be cut off, people make mistakes and fill in the wrong details on payment instructions, security systems are breached and fraudulent transactions are entered, etc.


The payment system is also at risk to outside events. Natural disaster can not only affect the operation of the system directly but also the demands on it, resulting in a rush of transactions just when the system is frail. However, many of the outside risks are man-made from legislation or even technical change which means that the system starts to become obsolete and people take their business elsewhere. Some of these risks are potentially systemic in the sense that the operation of the financial system as a whole will be affected. Such systemic risks do not have to be ‘real’ to come into effect. Belief is sufficient. An expectation that there may be difficulty in receiving payments in the future will result in immediate action. Banks will not pay out if they can avoid it and will try to expedite the inward flows. Such an expectation may be based on a completely false rumour and the central bank needs to ensure that the system design is such that rumours do not dent confidence. The rapid response to the possible consequences of the 11 September 2001 disaster in New York is a case in point. Central banks immediately made it clear that they would provide all the liquidity necessary to keep the system going and would sort out any ensuing problems later. Hence even if some banks were incapacitated the remainder could continue and temporary debts could be run up. Table 2.3

Payment flows in TARGET and GDP in EU countries, 2003

Country

Name of system

Germany France Spain UK Italy Netherlands Belgium Ireland Austria Luxembourg Finland Greece Portugal Denmark Sweden

RTGSplus TBF SLBE CHAPS Euro BI-REL TOP ELLIPS IRIS ARTIS LIPS-Gross BoF-RTGS HERMES SPGT KRONOS Euro RIX

Annual turnover in RTGS system (€bn)

Source: Derived from Iivarinen (2004).

128544 96327 70208 31180 24761 21365 13558 5502 5177 4755 3645 3343 3255 3208 1897

No. of Share of working days cross-border to turnover payments in annual GDP total value (%) 4 4 3 13 13 5 5 6 11 1 10 12 10 15 36

27.9 20.0 7.3 76.4 34.2 55.6 75.4 38.9 54.1 68.2 41.2 48.4 60.7 98.7 96.1


2.1.2 The European framework As soon as we get beyond the national picture, relationships become much more complicated outside the credit card framework, even within (a) number of payment transactions, daily average per year

800

Thousands

700 600 500 400 300 200 100 0 SIC

Fedwire

TARGET

1999

2000

2001

CHIPS

BOJ-NET

2002

(b) value of payment transactions, daily average per year EUR billion 2 500 2 000 1 500 1 000 500 0 Fedwire

TARGET 1999

Figure 2.1

2000

CHIPS 2001

BOJ-NET 2002

SIC, Fedwire, TARGET, CHIPS, BOJ-NET.

Source: National central banks.

SIC


the euro area where there is a common currency. The national payment systems do not have a simple extension into the international framework. In Europe this is largely because only 1 per cent of transactions run across borders even now and hence the need to run wider systems has been more limited. The ESCB central banks (i.e. not just the Eurosystem members) have addressed this at the wholesale level and have set up a linked RTGS system called TARGET (Trans-European Automated Gross settlement Express Transfer), which is currently developing towards a more uniform framework, with enhanced functionality, based on some of the national systems, imaginatively labelled TARGET2. Initially it has just been a means of linking the different national RTGS systems and had very few common features. The participating systems are shown in Table 2.3.7 The key feature to notice is the sheer scale. While TARGET was running at around 270,000 transactions a day in late 2004 of which nearly a quarter were cross-border, the average daily value was approaching 2trillion€ (around a third of which was crossborder). In the national terms shown in Table 2.3 this means that transactions equivalent to an entire year’s GDP were being undertaken within a maximum of 13 working days in each of the euro countries. As a contrast with the US, Fedwire, which handles domestic payments, processes about twice as many transactions per day as TARGET but a similar value.8 CHIPS (Clearing House Interbank Payment System) which handles about 95 per cent of cross-border USD transactions processes a similar number of transactions to TARGET but the value is about two-thirds that of Fedwire. Figure 2.1 shows how the three systems compare. The Japanese (BOJ-NET) and Swiss SIC (Swiss Interbank Clearing) also shown in the Figure are clearly different in structure with SIC having a large retail element and BOJ-NET a more strongly large value focus than TARGET.9 Luxembourg and the UK stand out among the EU countries in Table 2.3 because of their special status in financial markets. With a large number of international banks being headquartered in Luxembourg to take advantage of the favourable tax

7 This picture predates the accession of the 10 new members to the EU and hence to the ESCB on 1 May 2004. 8 It is not immediately obvious what the appropriate exchange rate is for this comparison. 9 The SIC figures do not include Swiss euro payments, which are largely handled by the Swiss Euro Clearing Bank (SECB) in Frankfurt running a system called euroSIC. SIC also has the interesting feature that charges rise during the day to encourage early submission and to reduce the chance of gridlock.


and regulatory framework the payments are out of proportion and in the case of the UK, despite not being a member of the euro area, it has euro payments on a larger scale than all but Germany, France and Spain. It would also show substantial US dollar large value payments. However, the picture is not all that transparent as some systems include monetary policy transactions through repos, which will clearly distort the value figures. The importance of the cross-border element varies substantially by country (Table 2.3, col. 5). The figures for Belgium will be affected by the presence of the Euroclear Bank in its territory, which will pick up many European level securities transactions. There has been a new feature in the international payment landscape since September 2002 that may affect the way in which TARGET develops, with the launch of CLS (Continuous Linked Settlement). CLS now provides facilities for eliminating the settlement risk for 15 of the world’s major currencies. While treatment of this forms part of Chapter 6 it is worth noting here that the routing of payments for 3trillionUSD of the world’s daily foreign exchange transactions has changed and now goes through the accounts of CLS Bank, which is jointly owned by, currently, 71 of the world’s largest financial institutions. Their accounts at CLS Bank act as the conduit for payments made by themselves and other banks. Previously the two halves of foreign exchange transactions were handled separately with the risk that only one half might be completed. Now the two halves of the transaction are matched by CLS before they are undertaken, so it is on what is known as a payment.vs.payment basis, and the danger that a bank will part with one currency without receiving the other is removed. Although TARGET only handles transactions in euros, these may relate to foreign exchange activity. While there are links between individual banks in the different countries in the form of correspondent banks and networks among the giro and co-operative banks, Eurogiro and TIPANET (Transferts Interbancaires de Paiements Automatisés), respectively, the main link is through the Euro Banking Association through the EURO1 system of its principal members. (Other banks can participate on a correspondent basis, using a EURO1 member as a correspondent bank.) This is not surprisingly a very expensive system, a point recognised by the European Commission, which is requiring banks to equalise the cost to customers of within country and between country payments by 2006 (under Regulation (EC) 2560/2001). The STEP 1 system, which was itself only established in 2000 has therefore been developed into a pan-European ACH (PE-ACH) in STEP 2 to create a more cost efficient system in April 2003 (Kemppainen, 2003). EURO1 handles about twice the volume of cross-border


transactions as TARGET but only about half of the value, reflecting the emphasis of TARGET on the high value end of the spectrum. As Leinonen (2000) pointed out, much of the difficulty in setting up a cross-border system is that the participants need to use the same protocols, otherwise banks and bank accounts could have different electronic codes in sending and receiving countries, requiring either manual intervention or complex translation programmes. This process is clearly eased by the SWIFT network. SWIFT stands for the Society for Worldwide Interbank Financial Telecommunication and provides the normal means of interaction among banks round the world using a secure system SWIFTNet on the Internet. It provides the messaging service for TARGET and EURO1. SWIFTNet includes the realtime service FIN for managing financial transactions between countries. In EURO1 each payment is taken one at a time and executed on a same day basis, with the time for entry into the system starting at 0730 in the morning (Central European Time: CET) and closing at 1600. During the working day requests are processed continuously through the STEP1 system, which is open for new requests up till 1400. (This is shown diagrammatically in Figure 2.2.) Provided that the transactions requested lie within the limits for the sending and receiving banks they can be processed or queued if they do not. (There are two limits, a bilateral limit credit limit set by each

STEP1 Start-up

STEP2 Cut-off for value D

Potential Net Balance sent to banks

STEP1 Balances at Zero

Sending STEP1 Payments

07:30

14:00

16:00

14:10

STEP1 Processing

Capacity Transfers

EURO1 Processing Figure 2.2

Cut-off time and processing cycle (all times are in CET)

30 The Future of Financial Markets secured by collateral ECB Liquidity Pool

EBA Settlement Account 16:30

NCB

NCB EBA 16:15

Short Bank

Figure 2.3

16:35 16:05 S.W.I.F.T

Long Bank

Central settlement at the ECB via TARGET

bank with respect to each partner in the range 5–30€ mn and overall limits for each bank of credits granted to and by it of 1€ bn each.) The participants can see the queue. After the system has closed to new messages at 1400 each bank is informed of its current net position and the banks that are short need provide adequate funds through their settlement banks by 1600 when EURO1 closes for new instructions. If this does not occur then the remaining payments in the queue will be moved the following day as balances are zeroed each day. The settlement process is then completed through TARGET (where all payments have to be collateralised). Each bank that is short sends its payment instructions to its national central bank (NCB) to pass on to the ECB where the EBA settlement account is held (as shown in Figure 2.3). Once all payments are made the ECB then sends the balances back to the banks that are long through their respective NCBs in TARGET. STEP2 matches EURO1 as it processes the bulk of payments that are not so time critical overnight. Instructions have to be made by 2200 (CET) for settlement at 0730 the following morning when EURO1 opens. SWIFT sorts out the net bilateral payments that have to be made between the participating banks and after settlement sends back the confirmations and the detail necessary for audit and tracing, including the information on invalid instructions and items not settled. This automated system thus achieves what is described as straight-through processing (STP) using SWIFT standards, so that the entire task is completed on the basis of the initial instruction without the need for further intervention. Progress on getting towards a European level payment systems seems very slow (Tumpel-Gugerell, 2004). The European banking system is


hoping to have such a single payment area in place by 2010. They have formed a European Payments Council, EPC (www.europeanpaymentscouncil.org) to try to advance this with working groups on each of the main means of payment. This reflects both the fact that this is an issue for the private sector to decide and organise and that since it is a network system, there needs to be widespread agreement at the outset if it is to become accepted. The role of central banks and the Eurosystem in particular is to promote the smooth and efficient operation of the payment system but this does not entail that they have to provide it. In November 2002 the EPC adopted the Credeuro standard for basic bank-to-bank credit transfers, which requires execution time within three days at the same cost as a within-country transfer. (This of course is well short of the next day standards that typically apply to within country payments. Some such as Norway and the Netherlands have reached same day execution.) Banks in the member states have been steadily signing up to this voluntary standard and the associated Interbank Convention on Payments, ICP, which states that the payer pays the sending bank’s charges and the payee pays the receiving bank’s charges, both in line with whatever is the system for payments within the sending and receiving countries, respectively. Thus, these are standards for cross-border transactions not area-wide standards that apply equally to all transfers whether within countries or across borders. Parallel work on direct debits has been completed and is due for adoption after consultation in March 2006. Card payments across borders, which have been functioning effectively for some considerable time, do not meet these new standards and are also in the process of amendment. We thus see an interaction between the authorities, usually in the form of the central bank, and private sector associations in trying to develop these cross-border standards. In section 5.4, we focus on this interaction between the authorities in laying down regulations and providing parts of the payment system directly and the private sector, in which the banks are, which has to come to voluntary but generally adopted agreements, if the system is to function. Typically large value payment systems tend to be central bank owned, while retail systems are privately owned, normally by a consortium of the banks in a particular country. Of 72 payment systems studied by Khiaonarong (2003) in the EU and Asia-Pacific, 44 per cent were central bank owned, 32 per cent private and the remaining 24 per cent jointly. Figure 2.4 gives a good idea of the substantial heterogeneity of payment systems used within the EU countries but cross-border transactions by individuals are dominated by cards, as these offer the only


Number 120 100 80

Credit transfers

60

Direct debits

40 Card payments Cheques

20 0 FI

AT BE DE DK ES FR GR IE

Figure 2.4

IT

LU

NL PT SE UK

Number of cashless payments per inhabitant in EU countries, 2000.

Source: European Central Bank.

reasonably easy means other than cash for anything except large payments. The structure of actual payments cannot thus be taken as an indication of customer preferences, simply as a reflection of cost and availability. Nevertheless it shows that attempts to create a single market will encounter both a great variety of requirements and priorNumber 220 2001 200 Difference 2001–1994 (number of transactions)

180 160 140 120 100 80 60 40 20 0 –20 –40 BE

Figure 2.5

DK

DE

GR

ES

FR

IE

IT

LU

NL

AT

PT

Cashless payments per capita in the EU 1994 to 2001.

Source: Leinonen (2004).

FI

SE

UK


ities among the member countries but also the scope for far-reaching changes if customers were to be able to enjoy the very different balance of costs and facilities that apply in other member states. This structure has been changing rapidly in recent years and the number of cashless transactions has been rising in most European countries (Figure 2.5). The somewhat anomalous picture reflects the fact that size of payments is not reflected and some batching may have occurred.

2.2 The efficiency of the payment system In what follows we consider the costs of the payment system in a narrow sense, namely, within the inter-bank framework. However, a proper review of the system and a consideration of how it should and may change requires considering the costs that occur within banks and the costs that occur to their customers. Thus, for example, a new interbank system may turn out to be much more costly than it appears if it imposes heavy costs on the banks in updating their own computer systems and working practices. A reduction in transaction costs within the system might not result in a reduction in cost to the customer once the costs to the bank are included. By contrast there may be major gains to the customer from increased speed and ease of use that are not reflected in the bank or inter-bank costs. In some respects the net benefits can be revealed by the nature of the quantitative response of transactions rather than simply by unit costs. The extent of efficiency gains that can be achieved by shifts in the nature of the payment system can be large. Humphrey et al. (2000) estimated that over 1 per cent of GDP could be saved by a move from the cheque to a fully electronic system (since that date the US has increased the electronic element in cheque processing so the gains would now be lower (Santomero, 2004) ). Humphrey et al. (2001) applying a similar methodology to Norway suggested that having a fully electronic payment system at the bank level could save 0.6 per cent of GDP. Even so what we are considering here is largely just productive efficiency in the sense of what can be in a particular framework. Nevertheless it will in effect consider some aspects of ‘allocative efficiency’ as more than one form of payment system is investigated. What it does not do is discuss dynamic efficiency in the sense that the system responds to the needs of the customers and providers in the face of rapidly evolving technology (Wallis Committee, 1997). We return to this issue in the final section of the chapter. More important from the central bank’s perspective than some of these technical efficiency issues are possible costs from the risks


inherent in the system, whether simply from system failure in a practical operating sense or from losses stemming from the failure of a participating bank. It is these risks which make central banks impose harsh requirements for system robustness and the avoidance of credit risk. They will also impose requirements for liquidity on the system so that it does not get grid-locked – i.e. so that the system does not stop because bank A is waiting for a payment from bank B before paying bank C, while bank B is waiting for a payment from bank C before paying bank A, and bank C is waiting for the payment from Bank A before paying bank B and so on. One of the major functions of the BoF-PSS2 simulator is to explore the danger of gridlock and work out how a system can economise on liquidity without any risk of compromising its efficient operation.

2.2.1 The survey of payment systems Information on the performance of payment systems is not normally published so the information in the study was collected directly by asking the participating central banks. Some information was also available in ECB (2002) and EMEAP (2002) and information is available on Canada and the United States. The study (Khiaonarong, 2003) covered the US, Canada, the 15 EU countries plus the 11 EMEAP countries. (EMEAP stands for the Executives’ Meeting of East Asia Pacific Central Banks and Monetary Authorities, which is the largely informal organisation through which they co-ordinate their activities. The members are Australia, the People’s Republic of China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Singapore and Thailand.) Unfortunately eight central banks regarded the information as confidential and were not willing to disclose it even with a guarantee of confidentiality. It is highly unlikely that they form a random sample as banks with very efficient and unsubsidised systems would have little to lose from demonstrating their efficiency. Even so this resulted in data on 31 systems, 21 large value and the remaining 10 retail. While the retail systems, which tend to be owned by the private sector in the main cover their costs (Figure 2.6) the same cannot be said for large value systems, mainly owned by central banks, where several fall a long way short of cost recovery (Figure 2.7). The systems with noticeably over 100 per cent recovery were in the main building up resources for major change rather than simply making profits. It is immediately obvious that there is a huge range in size (the scale in the two Figures is logarithmic) with the revenue of the largest system 5,000 times as large as the smallest. North America dominates with some

The Payment System: Structure, Efficiency, Innovation and Regulation 35 USD

Cost recovery ratio 250 %

1 000 000 000 revenues expenses cost recovery ratio 100 000 000

200 %

10 000 000

150 %

1 000 000

100 %

100 000

50 %

0%

10 000 1

Figure 2.6

2

3

4

5

6

7

8

9

10

Cost and revenue estimates of 10 retail payment systems in 2001.

90 per cent of the total activity. There is also considerable variation in how costs are recovered, whether by per item fees, annual (monthly) fees or payments for other services, such as accelerated payment. The comparisons should therefore be treated with care. Clearly, in attempting to consider efficiency rather than a simple exposition of unit costs it is necessary to try to explain how the structure of the system has an effect. The average size of the transaction, the number of transactions and the role of the public sector in the system will clearly affect its costs (especially since Khiaonarong, 2003, reports

100 000 000

Cost recovery ratio

USD

revenues expenses cost recovery ratio

10 000 000

200 % 180 % 160 % 140 % 120 %

1 000 000

100 % 80 %

100 000

60 % 40 %

10 000

20 % 0%

1 000 1

Figure 2.7

2

3

4

5

6

7

8

9

10 11 12 13 14 15 16 17 18 19 20 21

Cost and revenue estimates of 21 retail payment systems in 2001.

36 The Future of Financial Markets Table 2.4 Average unit cost estimates of 31 payment systems by region in 2001 (US$) No. of systems

Average unit cost

Standard deviation

European Union Large-value systems ACH systems Cheque systems

10 2 —

1.5364 0.0061 —

1.3285 0.0047 —

EMEAP Large-value systems ACH systems Cheque systems

9 2 3

1.1479 0.0246 0.0317

1.0346 0.0100 0.0234

North America Large-value systems ACH systems Cheque systems

2 2 1

0.8436 0.0080 0.0446

0.4980 0.0102 —

Total Large-value systems ACH systems Cheque systems

21 6 4

1.3039 0.0129 0.0349

1.1375 0.0113 0.0201

Region/system

Notes: Figures are for 2000 in 3 countries and forecast for 2002 in 2 countries. Source: Survey questionnaire.

that the per transaction subsidy in the eleven cases in which they occur, out of twenty-one, ranged from 0.26cents to 1.88$). Table 2.4 shows that, as one might expect, large value systems are clearly more costly to run per transaction than their retail counterparts, while automated systems (ACHs) are an order of magnitude cheaper to run than chequebased systems. (All quoted before subsidy.) With only a limited number of datapoints it is not really possible to follow the same strategy as in Chapter 3 and estimate a fully fledged trans-logarithmic frontier cost function. It is however, possible to be less ambitious and simply see how the individual observations relate to a log-linear cost function. ln UCi = αi + β1 ln VOLi + β2 ln GDPCi + β3 ln SIZEi + β4 MINi + β5 PUBi where: UC = unit cost for inter-bank payments instruction (cheque, ACH or funds transfer and settlement activity);


VOL = total number of payment instructions; GDPC = gross domestic product per capita; SIZE = ratio of size of transaction value to number of payment instructions. While the number of transactions should reduce the per unit cost through economies of scale and the average value of each transaction should increase it (large value systems will be more expensive to run than their retail equivalent), the greater the economic development of the country, GDPC, the greater will be the cost of labour and possibly the complexity of transactions undertaken. However, Khiaonarong goes on to argue that the structure of public sector involvement is likely to have a major effect. He uses a 3 point scale – (i)

The minimalist approach where — the central bank owns and operates only core inter-bank funds transfer systems — the private sector owns and operates a majority of inter-bank funds transfer systems — the central bank does not compete with the private sector — the central bank pricing policy is based on full cost recovery. (ii) The competitive approach where — the central bank owns and operates major inter-bank funds transfer systems — the private sector owns and operates competing inter-bank funds transfer systems — the central bank competes directly with the private sector under the level playing field principle — the central bank pricing policy is based on full cost recovery, including imputed costs. (iii) The public service approach where — the central bank owns and operates a majority of inter-bank funds transfer systems — the private sector does not compete with the central bank — the central bank pricing policy is based on variable cost recovery, including subsidisation of at least the fixed cost. These are represented by the two variables MIN = 1 if minimalist approach (0 otherwise); and PUB = 1 if public service approach (0 otherwise).

38 The Future of Financial Markets Table 2.5

Regression results of log-linear cost function Dependent variable: unit cost

Explanatory variables Intercept lnVOL

Model 1 Parameter estimates




3.8307 (5.2032)**

–3.5922 (–1.9324)

–3.9959 (–2.3426)*

–0.6692 (–0.2777)

–0.5753 (–7.7389)**

–0.6787 (–10.5868)**

–0.4903 (–5.1732)**

–0.6075 (–6.8339)**

0.5143 (2.0601)*

0.4776 (1.5672)

0.1784 (2.3927)*

0.1698 (2.6792)*

lnGDPC

0.8835 (4.2081)**

lnSIZE MIN

–1.9421 (–3.6358)**

PUB

–1.0482 (–1.5660)

R2-adjusted F-statistics N

0.6625 59.89 31

0.7858 56.05 31

0.8179 44.43 30

0.8675 38.98 30

Notes: t-statistics are reported in parenthesis. Significant at 1% (**) and 5% (*) level.

Perhaps surprisingly it is the competitive system that records the highest costs (Table 2.5), after allowing for the effects of scale and wage costs. The minimalist system results in lower costs than its public service counterpart. This result may stem in part from the rather unbalanced sample that is available Figure 2.8. One might have thought that in the US, which is the most obvious example of the competitive approach, costs would be lower. It is clearly not just a matter of the usage of cheques, as Khiaonarong considers Australia, Canada, Finland and the UK as examples of the minimalist approach and only Finland does not use cheques. In the public service approach, typified by Thailand, the central bank is effectively subsidising much of the fixed cost. The bulk of the system, the Electronic Cheque Clearing System, fully covers the variable cost but only half of the fixed cost (Table 2.6). The RTGS system on the other hand (BAHTNET) which covers all the high value transactions and represents the major action to reduce systemic risk, did not cover the variable cost (in 1998). However, at that stage the system was only three years old and the high fixed cost may

The Payment System: Structure, Efficiency, Innovation and Regulation 39 Unit cost, USD 10 Minimalist (large-value) Competitive (large-value) Public Service (large-value) Minimalist (retail) Competitive (retail) Public Service (retail)

1

0.1

0.01

0.001

0.0001 3

5

7

9

11

13

15

17

Number of payment instructions (log)

Figure 2.8 Comparison of unit cost estimates under alternative policy approaches. Notes: USD amounts are reported on a logarithmic scale. Number of payment instructions is reported as logarithmic values. Source: Author’s calculations. Table 2.6 Cost and revenue estimates of payment services provided by the Bank of Thailand, 1998 (THB million, except as noted) Full Variable cost cost recovery recovery (TR-TC) (TR-VC)

Total transaction volumes

Total revenues (TR)

Total costs (TC)

Variable costs (VC)

BAHTNET ECS Media Clearing

243,127 53,773,018 1,397,379

6.3 62.2 0.8

48.5 88.1 22.2

8.9 37.9 10.1

–42.2 –25.9 –21.4

–2.6 24.2 –9.3

Total

55,413,524

69.3

158.8

56.9

–89.5

12.3

Payment service

Notes: BAHTNET and Media Clearing cost figures are based on 1997. ECS cost figures are based on 1996. Low increases in input prices before 1998 are assumed. Source: Adapted from Jitsuchon and Khiaonarong (2000, p. 15).

have partly reflected its youth. Khiaonarong also notes that despite this attempt to provide a relative subsidy to electronic payments the system has not been very successful in achieving that migration.

40 The Future of Financial Markets Table 2.7 Changes in payment market share in Canada, Finland, Thailand, United Kingdom and United States, 1996 and 2000 Percentage share of volume

Percentage share of value

Country

1996

2000

1996

2000

Canada ACSS LVTS

99.90 0.101

99.92 0.08

38.14 61.86

17.03 82.97

Finland BOF-RTGS PMJ POPS

0.04 99.88 0.08

0.12 99.62 0.26

73.55 21.08 5.38

90.11 2.78 7.11

Thailand Cheque Clearing2 BAHTNET Media Clearing

99.60 0.11 0.293

93.79 0.84 5.37

93.77 6.22 0.01

30.29 69.57 0.13

United Kingdom CHAPS BACS Cheque and Credit Clearing

0.30 51.24 48.46

0.47 61.71 37.82

91.58 3.96 4.46

95.66 2.47 1.87

United States4 CHIPS Fedwire Fed Cheque Clearing Private ACH Fed ACH

0.27 0.42 82.37 1.63 15.31

0.26 0.47 76.29 2.68 20.29

54.92 41.27 2.00 0.23 1.58

41.59 54.06 2.02 0.34 2.00

Notes: 11999 figures. 2ECS and provincial cheques. 31997 figures. 41996 figures are unavailable for private cheque clearing houses and direct exchanges. Sources: Bank for International Settlements (2001), European Central Bank (2002), and EMEAP (2002).

In the five countries that publish sufficient data for it to be possible to identify how the structure of the system has been changing it is clear that in the main there has been a marked movement towards electronic payments in recent years and that RTGS systems have been successful in capturing the large majority of value (Table 2.7). Volumes have been migrating towards ACHs in most of the countries shown. While this is not a random sample by any means it is likely to be illustrative of the rapid changes that are taking place across the world. The scope for efficiency gains is by no means exhausted even within existing frameworks. Simple consolidation onto a smaller number of


sites has achieved major gains in the US. In the longer term the reorganisation of TARGET (TARGET2 is due to go live in 2007) should reduce the number of different platforms and hence limit the cost (ECB, 2004a). The intention is to move to a Single Shared Platform (SSP) and given that most transactions are routed through the Deutsche Bundesbank, Banque de France and Banca d’Italia (69.1 per cent by volume and 59.4 per cent by value in 2003) they are likely to provide the basis for the platform. However, there are trade-offs. In order to encourage volume to move towards an RTGS system the temptation is to increase the range of functions that the service offers, moving it somewhat towards the CNS systems by including queuing features when there is insufficient liquidity. However, even simply revealing more information about the costs of operation of the central bank system may help improve allocation. In the US this is mandatory, along with pricing on a full cost recovery basis including an element of normal profit. Other countries such as Denmark and Sweden are revealing more about their costs and fees on a frequent basis. This should enable the limiting of some conflicts of interest. Central banks have a mandatory concern for the integrity of the payment system and hence may feel that they have to offer the services themselves if the private sector is unable or unwilling to do some in order to fulfil the mandate. However, so as not to distort the system the nature of financing needs to be clear. If the central bank is prepared to subsidise the reduction in systemic risk, which the private sector is not prepared to bear voluntarily then it needs to be able to compute it and distinguish it from the other costs. In small countries it is unrealistic to suggest that there can be much competition among payment systems, so whether publicly or privately owned they can exploit their monopoly position to be slower in introducing change and lower costs. They may also be unwilling to offer slimline services to some participants. Thus smaller players who would have less benefit from a wide range of netting operations and queuing features may in effect be incurring higher charges than they would in any open market if the pricing system does not allow any unbundling and merely offers discounts for volume or value. The dominance of large banks or particular system providers may affect the pricing structure. Most providers are, however, unable to extract monopoly profits as a result of the regulatory structure or their mutual or public sector ownership structure. To some limited extent simply by providing comparable information it is possible to encourage increased benchmarking within the publicly


owned schemes so that the various central banks can see where they stand and can be in a better position to determine what best practice is. Within the Eurosystem the exchange of information involved in trying to design future steps as an area should also help improve the position compared to where each country had its own currency and was hence naturally separated.

2.3 The technological development of the payment system As discussed in a series of papers by Harry Leinonen and colleagues (Leinonen, 2000; Leinonen et al., 2002; Leinonen, 2004) the current payment system has developed from its paper-based antecedents and is still generally based on the same concepts rather than on the network approach that governs the Internet and indeed many public utilities. In the traditional environment payment instructions are collected, processed and then transported again, with instructions to the paying bank and confirmation to the receiving bank. It is not a matter of whether the system is batched or not, RTGS systems are centralised – on the central bank. There may even be a hierarchy where the payer’s or payee’s bank has to deal through a higher level or settlement bank to complete the transaction.10 The new SWIFTNet system has broken away from this and operates in a network environment, as has the Pankkiverkko system in Finland. This is illustrated in Figure 2.9. It is no longer necessary to go through a centralised clearing house (option 2) as the participants can deal with each other through the network. But some form of network administration is required (option 3) rather than the direct bilateral contact of option 1. The key feature of a network system is that each bank merely needs to have an entry point to the network. It does not need a direct connection to each other bank. Thus, as in making a phone call, both parties need to be connected to the same network but they do not need to have any regard for the routing that was used to connect them. However, there are limits as to how far this simplification can go. Payments between banks in the inter-bank network have to be ‘settled’ in the sense that payment is actually finalised. The common solution is

10

There are various complications in practice whereby there is an element of hierarchy in the network with lower level institutions reaching the network through participating banks. In CLS, for example, two further levels are identified: 3rd parties are banks that are not members but route payments through members, while 4th parties [sic] are in turn customers of those banks.

The Payment System: Structure, Efficiency, Innovation and Regulation 43 1. Decentralised bilateral Service Provider

2. Centralised star Service Provider

Service Provider

3. Bilateral network with centralised adminstration

Service Provider

Clearing House Service Provider

Service Provider Service Provider

Network Admin Service Provider

Figure 2.9

Service Provider

Different structures for the payment system.

to use ‘central bank money’, i.e. liabilities issued by their respective central banks (some private sector payment systems use their own funds). This central bank money therefore has to be a part of the network. While SWIFTNet is providing the basis for a network system, this piece of interlinkage is not currently in place. Leinonen (2000) and Leinonen et al. (2002) offer such a way forward. The key ingredients for such a system to work are: • a common form of messaging and identification – ease of use • a very high level of security and verification • low cost, not just in the processing itself but in the interest incurred/foregone in providing the liquidity and collateral • stability and reliability of the system. However, as for any network, it will only work if everybody uses it. The normal problem is how to get the system started when the investment required is very considerable. No one wants to invest in a system that is not adopted by others. There is no first mover advantage in this case because a payment has to be made to other banks. The receiving bank must also participate. Moreover, unless payments are also being made in the opposite direction by the same route, the liquidity costs of maintaining more than one route will make it uneconomic. A switchover from one system to another is therefore likely to come quickly. This is obviously aided in central bank based or other firmly managed systems where the old system can be phased out as the new one is phased in and the two do not need to operate in parallel or competition. One key issue, which is not identified in the list above is the fee structure. This has an extensive literature of its own and is dealt with


in Chapter 4 (Rochet and Tirole, 2002; Schmalensee, 2002; Wright, 2001; Shy and Tarkka, 2001). It is crucial in determining the success of new systems. As noted above, initial subsidisation is one of the routes used to capture the burst of market share necessary for the system to get established. Fortunately most of the key ingredients are now falling into place. SWIFTNet is providing a common form of messaging. With the International Bank Account Number (IBAN), which has been largely implemented in Europe already, it is possible to identify all customer accounts exactly, so there is no confusion over who is the payer and the payee. The banks’ servers will act as the nodes of the system but they need to be able to access the software which enables the route to the address to be determined automatically. The credit card systems (Visa and Mastercard) have similar unique identifiers for card holders and merchants in a common framework. Negotiating common standards is a difficult process. Although there are purely technical concerns which may argue in favour of a particular configuration, because it is faster, cheaper, offers more facilities, etc. much of the pressure will come from customer banks who like features of their own systems and are reluctant to change partly because of the extra costs involved. In such circumstances there is a considerable danger that the new system will be complex and hence rather expensive. The problems are particularly intense when there is a competition among providers for a single system. It is not always possible to have an Airbus-style solution where each gets to produce some of the parts nor indeed is such an approach necessarily efficient. TARGET2 in particular faces these difficulties. Although the Internet is full of horror stories about various means of corrupting the system through viruses and hijacking messages through fraud it appears to be possible in the more closed arrangement of interbank payments to apply systems of encryption and verification that remain a step ahead of those who hope to profit from perverting it – a step sufficient at least to obtain the confidence of the users. The PKI (public key infrastructure) for example appears to offer adequate scope for successful encryption that banks are prepared to adopt. A closed system with a limited number of users known to each other is different from an open system like the Internet. The system of checking would require the common arrangement of ‘four eyes’, i.e. an equivalent of a check between the two back offices of the front offices’ deal – there is an independent controlling function in the banks. In the event of a problem it would be possible to stop it spreading immediately. Only the part of the system immediately affected need halt and alternative routes may be available.


This encryption is particularly necessary for validating the link that is missing at present, namely the ‘stamping’ of the payment that it has been settled in central bank money. (This stamping is a bit like the electronic equivalent of obtaining a cashier’s cheque from the clearing organisation, which may be the central bank.) As Leinonen (2004) points out it is the attachment of this stamp that is necessary to make the payment go through, as without this confirmation it is difficult to establish the way in which it is confirmed that the payment is final and indeed credibly settled. For this system to work it has to offer straight-through processing (STP). Once initiated by the payer it is completed automatically, despite passing through a series of stages that validate it. (A similar sequence would apply to transactions initiated by the payee, such as direct debit, where the paying bank has an authorisation from the payer to complete the transaction at the payee’s request.) In this ‘e-settlement’ framework the ability to attach the electronic stamp has to be devolved to the paying bank in some form or other. Leinonen (2004) likens it to placing a branch of the central bank in each of the participating commercial banks (see Figure 2.10 for a representation of the process). Having obtained its central bank money from the central bank, this can be attached to the payments until the line of credit runs out. In practice the line of credit could be topped up by the bank itself or automatically topped up as transactions on the other side of the account occur, obtaining central bank money from the transactions of others. In this dispersed manner, the process of applying a stamp will not involve entering a long queue at the central authority but something that can happen automatically in the paying bank itself and hence at low cost. The important difference between this and the traditional network is that the system is not physically centralised on the central banks but

Bank payment system

Receiving bank Network acc. platf. E-settlement module

Payment Payment network network

Bank payment E-settlement sysmodule tem Network acc. platf.

customer accounts

customer accounts

Sending bank

STP, network based, end-to-end, all through real-time process

Figure 2.10 E-settlement stamps are produced by e-settlement modules, which are closely integrated with banks’ payment systems.


Bank 1

Bank 2

Bank 3

Bank 4

Interbank Interbank network network

Central Bank

System Administration Site

Figure 2.11 A dedicated inter-bank network connects all banks and the central bank with each other for payment processing.

that the central bank and the administrator of the system are part of the network (Figure 2.11). In a network system each of the parts can work on its own initiative with the ability to use central bank money in real time. This implies that the central bank needs to download sufficient liquidity to the participating bank’s e-settlement module at the beginning of the working day on instructions from the bank to be deducted from the bank’s balance at the central bank and top it up on request during the day. The administrator supports the communication system – it does not perform the payment processing, that occurs in the system itself. At the end of the day the remaining balance would be returned to the central bank. Clearly credit would be possible but this is not an essential feature of a workable system. A bank could be required to collateralise all transfers of liquidity from the central bank completely. Indeed the idea of the daily cycle is in itself in many respects outdated. There is no reason in a global system while the whole process cannot be continuous. There is no physical processing taking place and with an automated process there is little in the way of decisions needed to be taken unless some part of the system fails, which cannot be rerouted. For example, a bank could run out of liquidity, which could present somewhat different problems for keeping the system going than if it happened overnight. This is, however, a generalised problem in a continuous system, which removes the opportunity to have a stay at least once every twenty-four hours. The same is true of a batched or netted system, which enables delay and queuing to ensure adequate funds are available without the need to liquidate assets in a hurry at a discount. One of the features of this discussion is an assessment of how


much liquidity the banks will have to have available. Clearly they will make this decision themselves, no doubt advised by their supervisors. There would be no need for a different level of liquidity from under RTGS for the same set of transactions but e-settlement could encourage more transactions and more liquidity. There are other features of continuous systems that need to be borne in mind. Some of the mechanisms for countering risk that are available in a system that embodies delay are not available in real time. It could affect the use of derivatives for example and will certainly affect the use of collateral, a point we return to in the next chapter. In a sophisticated system, queuing would be possible, as would demands for accelerated payment (at a cost), to try to manage shortages of liquidity. Indeed, automatic calls to stabilise if problems seem possible could be built in to the system. Bilateral netting would also be possible when banks can see they are accumulating a joint problem. Multilateral netting would be more difficult as that implies the actions of a central party. However, if the delays were anything other than trivial in a real time system it would bring the credibility of the bank into question. For this reason it is sometimes suggested that the normal system would have a short delay and that ‘real time’ would not mean seconds for any but accelerated payments but perhaps a number of minutes. This would in itself reduce some of the demands on the capacity of the system. At present this remains a prospect that can only be achieved in theory as there is no full system that is up and working. The BoF-PSS2 simulator (Leinonen et al., 2002 and Leinonen and Soramäki, 2003) shows that the necessary performance can be achieved and indeed can estimate the extent of the likely gains. Clearly it is possible to go further, even with the technology that we have to hand at present and without speculating about what functionality could be available over the next few years. Given how wrong we would have been speculating 20 years ago about what could be achieved today there is no reason to assume we would be any better at predicting outcomes in 2025. The most obvious steps are that mobile communications could be used. It is already the case that payments can be made over the Internet wherever the payer happens to be. Clearly the same can be achieved with respect to the decentralised payment system we have just described. The third generation that is just becoming available offers much better opportunities for transferring bulk information quickly and securely. However, as addressed in Chapter 4 perhaps the biggest changes are likely to occur in the way in which people can hold their funds if payments can be largely in real time and low cost. There has already


been a substantial switch in the United States towards mutual fund accounts, whereby the a depositor can operate an account based on stock and bond portfolio in a manner largely similar to a bank account, with the ability to make immediate payments. At present much of this flexibility comes from the actions of the mutual fund in managing the portfolio. However, if the whole process of transfer of securities can also be in something akin to real time then the liquidity structure of people’s portfolios will be fundamentally altered and we can expect major changes in behaviour as a consequence, which will affect both customers and service providers in the financial sector. The question to ask is why such changes, which appear so obviously beneficial are so slow in coming through. We have already noted the main ingredients. In a network industry no one wants to move until they are certain that they are backing the right system. There are considerable costs to be sunk in the change in terms not just of equipment and software but in the reorganisation of the business and retraining – the benefit to the provider needs to be obviously greater than the cost given the risks. Furthermore, there are restrictions to the extent that change can be driven by the normal forces of competition. It is possible to have competing systems; these exist between the banks and post office giro systems at present and between various credit card networks. One of the reasons for the popularity of the card network, although it may be expensive to merchants and hence to all customers as price discrimination is widely forbidden, is that it is so much simpler than the alternatives, particularly across borders where the processing systems are much more efficient than those for credit transfers. (Relative costs may change, however, when the credit transfer system is improved.) Once recorded in the shop no further action is necessary by the consumer until the card account needs paying and even that may be automatic. All of the complications in terms of currency conversion and routing through the banks are someone else’s problem and the net result is considerably cheaper in both financial and time consumption senses. Credit card systems also offer considerable opportunities to reverse or revise the transaction if it turns out that the product is inferior or its price higher than those of competitors. It is therefore packaging other services into the transaction. Nevertheless, in networks the normal competitive pressure is in the provision of services across the network not in the construction of the network itself. Thus, while the providers of the using services may be anxious to see the network arrive, the network providers may be not so driven, particularly if current systems are profitable to them.


However the aspect which concerns the central bank most is how far the regulatory framework encourages or inhibits change. Clearly with all the concerns over security and stability the regulators will be cautious. Caution may of course spill over into a more comprehensive brake on change rather than an encouragement. This is the subject of the next section.

2.4 The regulation of the payment system It seems to be very difficult for countries and currency areas to achieve the sorts of payment systems they would find optimal, not least because that would imply international agreement on a topic where there are wide differences in current practice. The desirable system itself continues to change in the face of rapid technical innovation. As we noted in the first section, the structure of the system and the payment instruments that are most widely used in each area at a particular time are strongly dominated by history, economic sophistication and geography. Small countries with relatively concentrated banking systems and a strong legal mandate may be able to institute change much more readily. Santomero (2004), for example, points out that in the US they are trying to speed up the process of cheque clearing through imaging and avoiding substantial transportation, whereas, in many parts of Europe, such as Finland, cheques ceased to be used over 20 years ago and the agenda relates to getting the electronic retail system closer to real time. Such path dependence is a common phenomenon (Liebowitz and Margolis, 1995). Changing the system is expensive and requires the co-operation of powerful vested interests who have a lot at stake. This tends to mean that the system lags what is desired by customers and hence by the authorities on their behalf. Getting change therefore involves some combination of encouragement and action by the authorities, including both compulsion and a degree of public sector provision of facilities. While the set up costs of a new payment system may be large, it is not normally beyond the resources of the commercial banking system; the question is whether they can agree to do it. Public sector involvement normally appears necessary to achieve the necessary pace, particularly where the aspects of design relate more to limiting systemic risk than increasing the returns for the individual providers and customers. Thus a degree of subsidy may be normal, although not in the case of the US. In the case of TARGET2 in the euro area the intention is to make an explicit judgement of the size of the public benefit


provided by the system in addition to the direct benefit to the users and to charge for the public benefit through the central banks. Thus the public benefit will in effect be paid for through taxation as the dividends that the central banks pay to their respective governments will be lower by the amount of that charge. One reason for the low investment or underproduction in networks such as the payment system is that many of the beneficiaries of the installation are external to the installer, e.g. the customers benefit as well as the provider (McAndrews, 1997). While the total benefit may well justify the cost of the installation the benefit to the installer alone may not. It is normally difficult to make the financial transfers necessary to get the installation because those who do not contribute can nevertheless get a ‘free ride’ and enjoy the benefits. Hence, unless all participate, those who would be providing the subsidy, quite possibly to competitors, will be reluctant to pay. There are, however, good examples from financial markets, such as the provision of terminals by Deutsche Börse when it moved to electronic trading, thereby taking the Bund (10-year German bond) futures market from LIFFE in London almost overnight. If it had relied on the hope that traders would pay for and install the terminals themselves then the switch might never have occurred. For the market to operate enough traders have to participate. Each individual participant would have to gamble that the others would also make the investment. Once achieved, however, it became ‘irreversible’ and clearly paid off for Deutsche Börse. However, such competitive investments in new markets can fail and bring down the investor, as exemplified in the case of e-money described in Chapter 5. In general, the authorities are seeking to get as much market pressure and influence as they can on the process of change, subject to their over-riding concerns for the quality of the system. However, if those market pressures are weak they need to look for other means of revealing demand and the potential opportunities. Ganguly and Milne (2002) have some suggestions based on the lack of competition they see in the UK retail payment system. The authorities are thus concerned both with the structure of the system and its governance, with particular regard to its reliability, openness and cost.11 Hence they tend

11 The Wellink Report (2002) into the Dutch retail payment system focuses on just these areas. The role of Interpay, the organisation owned by the banks, which runs the routing system monopoly between customers, retailers and their respective banks, was particularly singled out for attention and recommended change. Only the banks had a say in the governance of the system and the consequent pricing.


to prescribe rules for its operation in these regards but rely much more heavily on the private sector for the determination of the technical standards and protocols to be agreed. Private sector providers in effect operate under some sort of performance contract. Quite how the authorities proceed depends on their legal role. However, it should be noted that while network industries tend to be characterised by excess inertia, they can also be characterised by excess momentum, where insufficient regard is paid to the changeover costs incurred by the existing users (Katz and Shapiro, 1994). In extreme cases that means that the innovation may not be taken up, as has been suggested for some examples of e-money (Kemppainen, 2003). Central banks usually have a mandate that requires them to ensure the smooth and efficient functioning of the payment system (Fry et al., 1999). It normally does not lay down the method by which this is to be achieved. Where the public sector is also the (monopoly) provider of the services it is possible to agree and implement the necessary standards but it is by no means clear that such a system would be efficient, as it lacks competitive pressure. In the face of this market ‘failure’, or at least ‘imperfect performance’, there will inevitably be problems in the way in which the public sector seeks to intervene to rectify it. The Rivlin Committee (1998) in the US explored the conflicts of interest that face the Federal Reserve, as simultaneously a provider of services and a regulator of the payment system. However, the inherent monopoly features of the payment system stems from ‘the underlying economic characteristics of payment systems. Network effects place a natural limit to the extent to which competition is possible between payment systems’, as the Cruickshank Review in the UK puts it (HM Treasury, 2000, p.3). As a result ‘to deal with these problems requires sustained intervention’. The stage is thus set for extensive public sector action even where there is a strong role for the private sector as in the UK. In the US Roger Ferguson (then a member of the Board of Governors and not its Vice-Chairman, the post then held by Alice Rivlin) noted that: The Rivlin Committee concluded that the Federal Reserve should continue to provide check and ACH services, with the objectives of enhancing efficiency, promoting integrity, and ensuring access. Given the Federal Reserve’s current dominant market position in these services and the risk of disruption if the Federal Reserve were to exit quickly, this conclusion makes sense. The Committee also concluded that we should play a more active role, working collaboratively with providers and users of the payment system, to help


evolve strategies for moving to the next generation of payment instruments. (Ferguson, 1998) Thus direct provision, even at the retail level, is seen as essential to carrying out the task, not just of regulation but with the explicit acknowledgement that this reflects the extent of the Fed’s existing role in the system as a provider. However, it is difficult to find examples where there is no public provision. Even in Hong Kong, which is generally towards the more market end of the spectrum, payment and related services are provided by Hong Kong Interbank Clearing Limited, which is jointly owned by the Hong Kong Monetary Authority and the Hong Kong Association of Banks. The HKMA has been the primary driver for change. The BIS (2003, p. 2) in summarising what central banks do in the field of payment systems is rather more cautious in providing advice: Policies relating to the efficiency and safety of retail payments should be designed, where appropriate, to: (a) address legal and regulatory impediments to market development and innovation; (b) foster competitive market conditions and behaviours; (c) support the development of effective standards and infrastructure arrangements; (d) provide central bank services in the manner most effective for the particular market. It clearly sees the problem as being one where the authorities, albeit unwittingly, act as a brake on the process of change. In the European environment the authorities are clearly trying to force the pace of change because market forces are not delivering a competitive single market. If that were because there is no demand then the authorities would be imposing costs, but if it is because the incumbents could lose some of their profit opportunities and will be incurring risks that they do not otherwise need to face because of natural protection in a network industry then the impetus for official action is obvious. A key issue is still to ‘foster’ the productive pressures that market competition can bring. As Leinonen (2004, p. 25) puts it ‘Cooperation is essential in order to build a payment infrastructure and competition is needed to ensure efficiency.’ However, the authorities do not simply have to operate, regulate or control to achieve change. Subsidisation, promotion of research, recommendations and even revelation of gains made


in other jurisdictions can advance the process. The setting up of the ePayment Systems Observatory (www.epso.info) by the ECB is good illustration of how revelation can be advanced and the Bank of Finland’s payment system simulators (Leinonen and Soramäki, 2003; Koponen and Soramäki, 1998) are an illustration of how practical tools can be provided. However, few central banks have collected the necessary information to establish the relative costs of different payment methods – some Nordic central banks to the contrary (Gresvik and Øwre, 2002; Guibourg and Segendorf, 2004) and the Wellink Report (2002) in the Netherlands. However, in general such studies as there are relate to private costs and the social costs remain largely unestimated (van Hove, 2004a). Competition can occur at two levels. There can be competing standards and competition among providers within a given standard. These have been described as ‘competition for the market’ and ‘competition in the market’ (Kemppainen, 2003; Hancock and Humphrey, 1998). These two operate in different directions. Achieving common basic standards is of benefit to all network participants as it maximises the size of the market and hence the potential returns. However, once in the network it is in the interests of any particular provider to try to protect (and grow) their market share by providing a unique set of services that competitors cannot emulate. Providers will tend to make initial entry to their services both easy and cheap but try to make the transactions costs of moving to another provider as high as possible to discourage exit.12 This practice of trying to bundle the products is the subject of close scrutiny by supervisors, as it may not be in the interests of the customers, who may want only a few of the services (McAndrews, 1997). In the European environment the Commission and the Eurosystem have been keen to try to get common standards apply, as they are apprehensive that competing standards would be inefficient and impose costs on customers. This therefore will limit competition for the market, although that will be maintained through the existence of competing means of payment. Inefficient and expensive traditional systems will encourage the emergence of competing lower cost, heavily electronic systems with functionality limited to the areas of highest demand. The particular European approach is affected by the role of the main two players. The Commission is responsible for initiating legislation that will apply across the EU/EEA and for ensuring that the single internal market 12 Switching costs for moving an account and associated customer activities from one bank to another can be as much as 6 per cent of the average account balance (Shy, 2001).


in financial services becomes a reality. It is thus primarily driven by the rules it can produce to regulate and shape behaviour. The European System of Central Banks and through it the ECB, on the other hand, has a direct requirement for the payment system as such (Article 105(2) of the Treaty and Article 22 of the Statute), ‘the ESCB shall promote the smooth operation of payment systems’. It therefore can be and is directly involved, with the provision of the cross-border RTGS system for high value payments TARGET and the national systems which TARGET links. Beyond that, however, it has tended to try to encourage rather than compel change, leaving the latter to the Commission. In its publications it has set out the barriers and assessed progress in their achievement, while simultaneously providing practical help to the banking system in seeking ways forward (ECB, 1999, 2000, 2001, 2004b). The exception over compulsion is in the quality of operation of the system and the qualifications for being a provider, which is limited to credit institutions, as these directly affect ‘smooth operation’.13 Nevertheless, the ESCB affects the nature of the development of the system by the access it offers to central bank money by limiting access, particularly to credit institutions; also other developers are put at a disadvantage, a point the Bank of England is investigating (King, 2004).14 The two European authorities have tried to act in two dimensions, laying down some basic rules on the one hand and trying to act as a catalyst to get the private sector to agree on the other.15 Regulation EC

13

This in itself could be an inhibitor to change as some of the most innovative ideas have come through companies operating over the Internet, who would like to have rapid and efficient payment services to support the provision of their other products and services available over the same network. In practice competition has been stronger with alternative credit institution-backed system such as Visa Direct, Western Union and MoneyGram, rather than with mobile phone operators and other non-banks such as Vodaphone, PayPal and Paybox. 14 ‘Wider membership of CHAPS might permit a further reduction in that [interbank credit] risk and make financial system more resilient in a crisis. Our intention is to understand better what are the barriers to wider membership and how they can be lowered.’ (p. 4). 15 Although the two authorities are independent and have a degree of overlap in their responsibilities, they seek to co-operate both formally and informally. Nevertheless, as Kemppainen (2003) points out there is a risk of too extensive regulation as a result of having two sources (more than two in practice, as the competition and financial market regulation arms of the Commission are clearly separate) and a risk or insufficient co-ordination between national and European authorities.


2560/2001 is a good example of the former, compelling banks to offer equal charges to domestic and cross-border payments for retail payments up to €12,500 (€30,000 as from 1 January 2006).16 The authorities can manage to ensure that some of the greatest barriers to establishment of new network standards are avoided. They can recognise only one player as the developer of the standard. They can insist on open access so that no participant faces the threat of exclusion. Similarly, they can insist on principles of operation that ensure fair burden sharing so that it is more difficult for some users and providers to free-ride on the pioneering efforts of others. Thus far, however, they have not been very successful in getting competition among providers within the common framework. In the European case, while there is a clear demand among customers for an efficient cross-border system there is a weaker economic case for the providers. The pace has therefore been driven more by the authorities than by the market. The national systems dominate and hence there is a natural wish to avoid the needs of the smaller cross-border market imposing generalised costs on the within-country system. Clearly if the international system were to be based quite closely on the national system of one or a few countries this would pose disproportionate costs on some participants and confer an international competitive advantage on others. There is therefore a tendency to try to work out how to bolt the different national systems together to form a European system rather than to create a truly European network from scratch. One of the biggest issues in ensuring competition comes from the existence of economies of scale and the determination of appropriate pricing structures for an open network. Clearly the system will be of most use if all banks are connected to it, even if indirectly through a full-scale member. Hence, there is an incentive to ensure that the entry fees are low and not averaged across all participants irrelevant of scale. Similarly the cost per transaction tends to fall as we noted in section 2.2 as the number of transactions rises. The cost per transaction varies very little according to the value of the transaction. However, at this point the interest of the central bank may diverge from those of other participants. It has a strong interest in making sure that large

16 This could of course simply ensure that domestic payments become more expensive so as to cover the higher costs of cross-border payments.


value transactions are undertaken successfully. Failures with large transactions, if at all frequent, could damage the integrity of the system as a whole. With small transactions, the participants can readily compensate any of those who suffer, irrelevant of fault. While small scale transactions may be much larger in volume so that the same failure rate would imply a much larger number of failures the effect on the system may be much smaller as their share of total value is small. The central bank also needs an effective large value payment system so it can conduct monetary policy successfully. However, in many respects what the central bank needs to provide is something that will function properly in a crisis – ‘a clearing house of last resort’ as it has been described (Bech and Köppl (2004). It needs to be able to step in if either the system starts to suffer from liquidity problems such as gridlock or knock-on solvency problems from the failure or anticipated failure of a significant bank or a significant number of banks at the same time. Clearly it would create a moral hazard if this facility were to be created and no additional constraints were placed on private sector systems to restrict the need to call on such a last resort.17 The simplest approach (Galos and Soramäki, 2004) might be to insist that a private sector payment system (EURO1 in the EU case) holds a large enough collateral pool that it can meet the likely problems revealed in simulations. (The Leinonen and Soramäki (2003) simulator provides a tool for doing this.) This would imply an increase in the collateral pool by a factor of five, which would impose a considerable cost on the system.18 Humphrey and Pagés (2005) estimate that this cost lies between 15 and 42 cents per transaction at the level at which the European payment system has been operating in

17 Köppl and Lienonen (2004) point out that the ‘tiering’ of the payments system becomes endogenous under these circumstances. When the system is working normally it is cheaper for banks to move back up the system. Small institutions then do not need to bear the costs of direct access to the RTGS system and the intermediate ‘correspondent’ banks with which they deal can also limit some of the costs of RTGS by netting transactions among their clients. If difficulty threatens then banks will not want to risk the mutual exposures and far more transactions will be pushed into the RTGS. 18 There is some debate about how the collateral could be held. In effect it could remain with the central bank, which would impose a charge on the private payment system equivalent to the insurance cost, if the participants found this preferable to posting the collateral themselves.


recent years. However, this is replacing a credit risk by a collateral cost, so the former should be costed as well in any comparison. Increasing the collateral requirements for a DNS like EURO1 and increase the functionality of an RTGS, as is intended for TARGET2, makes the two systems converge – the collateral removes the systemic risk and the increased functionality enables the organised deferral of payments that the participants seek so they can reduce the amount of collateral they have to post. In general, however, the intention is to try to reduce costs to encourage cross-border transactions. Central banks thus have an interest in pushing larger transactions into the large-value payment system, which they typically provide. They would therefore tend to slant the scale of charges such that it encouraged that shift. Very high value transactions will naturally be attracted by the security of the central bank based network and could therefore in effect be used to cross-subsidise the more marginal transactions. The reverse applies in the retail sector, where there is no real prospect of very small transactions migrating to the central bank system. Hence those can be charged relatively highly so that the retail systems can also reduce their relative charges on the larger payments to retain them in the retail system. Norges Bank has encouraged the use of price incentives to get customers to switch from older less efficient paper-based systems to their electronic counterparts (Gresvik and Øwre, 2002). However, the ability of the central bank run system to dominate the market and act as a Stackelberg leader, even if there is a duopoly, as in the EU with TARGET and EURO1, means that the competition problems have not been solved (Kauko, 2004b). However, there is some debate as to whether the economies of scale are large enough to warrant the existence of a sole provider, especially in a market as large as the EU (Mason and Valleti, 2001). Regulating a monopoly supplier presents a considerable challenge, especially when, as in the case of the RTGS system, it is the Eurosystem itself. Regulating access pricing may be the way forward but external competition may be more effective. It might indeed be possible to hive off the running and development of the RTGS system after it has got properly established, as has been the case in New Zealand. In any event there are some sensitive issues to be resolved in the governance of the TARGET2 system. The ESCB needs to protect its independence but auditing and assessment mechanisms as are available through Congress in the United States for Fedwire do not exist in the same way through the


European Parliament and the Court of Auditors. Clearly the ESCB needs to have objectively verifiable assessments of the strength of its drive for efficiency, minimising costs and seeking innovations to the benefit of users and society at large. It is a difficult task to assess the extent of back-up facilities that need to be in place or the risks that need to be covered. While formal methods can be used, ultimately judgements have to be made. In particular, the ESCB needs an objective assessment of the judgement of the size of the public benefit contribution it makes to limiting full cost recovery (itself a term capable of substantial interpretation) and to the pricing structure it adopts for entry fees and transaction charges. Since TARGET2 is a major innovation and designed to have a progressive impact on the payment system there will problems in how its introduction should be priced. Charges can only cover costs in prospect and so an estimate has to be made of market share, not just in the first year but in more mature operation, which in turn requires an estimate of future market size. Only then can the charges be set so as to cover cost in the long run, allowing for normal discount factors. This requires not just an ex-post assessment of the public benefit element to be deducted but a forecast. It is not surprising that this discussion thus has to be conducted in the open given the large sums at stake. The problems for such network industries are inherent. The ECB (2001, p. 4) argues that ‘The lack of competition among banks also explains the lack of progress with regard to the price level of crossborder credit transfers, whereas a lack of co-operation on standards and infrastructures explains the lack of progress in reducing the cost of processing cross-border transfers’ (emphasis in original). The emphasis in their actions since then, however, has been on the latter issue (ECB, 2004b). Concentration in the industry has increased over the years. However, as Leinonen (2004, pp. 29–30) points out, central banks must also bear some of the responsibility for the slow progress: ‘central bank clearing and processing operations tend probably to have a bias towards safety and stability over efficiency … Subsidisation of public payment systems will crowd out competing private systems and hence reduce the competition and efficiency of the market.’ Subsidisation of cash operations in particular can be unhelpful. Production and distribution costs for coins and low value notes can be higher than their seignorage. Unfortunately this mispricing also applies in the banking sector, where many retail payment instruments are subsidised (van Hove, 2004a). However, some of these difficulties arise from a lack of


transparency that does not have to be perpetuated. Regulators of other network industries have gone to great lengths to try to expose the cost and pricing structures so that the actions of the providers can be judged. Just the same is necessary for the payment system.

3 Technical Efficiency in Stock Markets

Much of our understanding of the way stock exchanges may develop will depend on empirical evidence on their structures and how they have been evolving over recent years. If we can see that there are strong economies of scale, for example, then we can expect that the larger stock exchanges will either drive the smaller out of business as barriers between them fall or that the smaller exchanges will merge so that they can compete successfully with their larger counterparts. Similarly we might expect that if there is a wide range of efficiency among exchanges that persists over time despite the reduction in barriers then it will be possible for a variety of exchanges to remain in business as other sources of competitive advantage clearly exist. In this and the subsequent chapter we explore the efficiency of stock exchanges, considering both their cost and revenue structures. We employ two main approaches: stochastic frontier analysis, which assumes that it is possible to parameterise the productive behaviour in the industry and data envelopment which is nonparametric. They each have their disadvantages. We begin however by considering what it is that stock exchanges actually do so that we have a basis for the comparisons.

3.1 The business of stock exchanges Stock exchanges provide facilities for the trading of securities. These can involve a whole range of equities, bonds and derivatives and indeed commodities. There are two key steps in the process. The first is that the original enterprise that wishes to raise funds has to organise the issuance of securities. In one sense their interest stops there as they have then raised the finance. Stock exchanges then provide facilities 60

Technical Efficiency in Stock Markets 61

for the purchasers to resell these securities to third parties. The bulk of the activity then relates to the trading of existing securities. However, for these securities to be marketed, or listed, on the exchange the issuer has to comply with a variety of rules such that subsequent purchasers can judge the value of the securities being sold and hence the price they are prepared to pay. In the main these rules will relate to the information about the issuing company or institution that has to be provided, its frequency, the nature of its independent verification and other requirements for good corporate governance. Securities provide a continuing stream of dividends to their holders and the current price of the security will reflect the expected future stream of such dividends and hence judgements over the long-term success of the company in which the investment has been made. The company’s own ability to borrow and to raise further capital will depend upon its valuation in the stockmarket. The exchange is thus providing a service for the original issuers, as their ability to sell the securities in the first place will be affected by the opportunity for resale and the conditions under which that takes place. Obtaining a listing on a reputable exchange hence provides value for the company. These listing related services are thus different in nature from the market for secondary trading in the securities. The first service is provided for each issuer (for each security to an extent) while the second is provided for each trader each time they trade. The first service therefore relates to the number of securities listed on the market and the second to the amount of secondary trading that is taking place. These are not just different services but they are provided largely for different people. However, the secondary traders also derive benefit from the rules which lay down the rights that the holders of the securities have over the behaviour of the company, particularly in the case of equities where the purchasers will be the owners of the company and have voting rights in general meetings. The nature of the competitive process will vary across these two groups of services. Listing is a more location specific activity than trading. A company and its physical assets will be in particular locations, probably quite concentrated in the case of smaller companies coming to the market for the first time. It will therefore tend to try make the initial placement of the securities locally. The financial companies advising on the issue and those underwriting it will want to be very well informed about the company and hence able to value the security. Local presence makes it easier to get that information and make the decisions. The same will tend to apply to the initial purchasers even if


they rely on professional advisers, who themselves need to evaluate the company making the issue. Subsequent traders have much more accumulated information to go on and can operate at arms length. What then becomes important to the trader is the cost and quality of services available for trading in a particular security or type of security. If costs, efficiency and reliability of trading are not the same on different exchanges, secondary market traders will tend to move their business. Traders are not merely interested in getting the best price but in having access to information about trading and opportunities (without giving away too much about their own actions and intentions). This involves not merely having a highly liquid market where the stocks in question are readily traded but having some variety in the types of trade permitted. Where the liquidity is low the scope for trading in more than one market place becomes limited. The functions of listing and providing a marketplace for trading are sufficiently different in character that Steil (2002) argues that they are paired in traditional exchanges largely for reasons of history. Indeed it might make a lot of sense to split the two functions since they not only have very different purposes but require completely different resources and technical bases. Listing in the main is a ‘regulatory’ function in the sense that the authorities need to make sure that the listing company provides the necessary information to the timeliness and quality required. This information requirement is necessary for the operation of the marketplace but it does not have to be provided by the marketplace itself. Steil suggests that the listing function could be provided, like ratings, by independent agencies. He even suggests this could be on a competitive basis. It would still of course be necessary to provide a means of issuing the security in the first place as opposed to simply organising the secondary market. The motivation for suggesting the separation between listing and trading reflects two findings elsewhere (Domowitz and Steil, 1999). First, that there are considerable efficiency gains available to exchanges from automation. Moreover the traditional mutual ownership of exchanges makes it difficult to agree and implement the necessary automation. Exchanges that are purely trading platforms do not need mutuality, as they can exist separately from their members. In a traditional open-outcry market, the market is made by its members. As Steil puts it, without the members there is an empty room. Second, there tends to be some conflict of interest when the members own the exchange. The danger is that the exchange that controls the primary listing can then impose conditions on other exchanges. It is perhaps


partly for this reason that the UK Financial Services Authority has acquired the role of being the primary listing agency from the London Stock Exchange.

3.2 Methodology As mentioned earlier there are several ways of approaching the measurement of the relative performance of firms within an industry. However, these can be grouped readily into parametric and nonparametric approaches. In a parametric approach it is necessary to set out some form of production or cost function that describes the industry and then consider how each individual firm deviates from it. In the non-parametric approaches it is not necessary to go to the same level of generalisation. It is merely necessary to compare the outputs/costs recorded by firms with their inputs. In this second case one can observe efficiency directly if one firm encounters higher costs with the same or less inputs than another. In both cases the general idea is to generate a ‘frontier’ representing the best performance that can be achieved and then compare actual performance with it. The measure of ‘efficiency’ that is recovered in this framework relates to ‘technical inefficiency’ (Farrell, 1957), where the combination of inputs/outputs is assumed fixed. In this sense the inefficient exchange is achieving less than is possible with the given inputs or is more costly than necessary in achieving the given outputs. This concept is to be distinguished from ‘allocative inefficiency’, where different input/ output combinations would reduce the overall cost. In the first case the exchange is operating inside the frontier whereas in the second it is operating on a sub-optimal section of the frontier.1 As discussed elsewhere, there may also be ‘scale inefficiency’, if relative costs can be cut by changing all inputs in proportion. Various techniques exist for estimating the frontier, the simplest being to estimate the function and then shift it linearly outwards until it passes through the most extreme observation in the data. However, this involves rather strong assumptions. Except in very homogeneous industries, say, different branches of the same bank, the common cost

1

If it is both technically and allocatively inefficient at the same time then the allocative inefficiency will be with respect to the position if the input combination were projected radially to the respective output or cost frontier.


or revenue function will be merely an approximation so we should allow for a stochastic element in the frontier itself. Inefficiency can then be represented as a further element bounded at zero: Tcit = f (Xit, Zit) + Iit + uit

(3.1)

where Tcit refers to total costs of exchange i in year t, Xit is a set of variables representing the determinants of costs, such as output, input prices, quality, technological change, etc. and the Zit are other identifiable variables that may affect inefficiency, such as ownership structure, market concentration, hours of opening, type of trading platform, etc. The effect of any omitted variables will be caught by the stochastic residual uit. Jondrow et al. (1982) suggest that the Iit should be interpreted as the factors affecting inefficiency that are systematic and controllable by the exchange if they wish while the uit represent the uncontrollable element. The latter would include technical failures, external disasters, etc. This division is actually somewhat tricky in practice as the precautionary systems implemented to avoid downtime are an integral part of the production choice. In any event it needs to be reasonable to assume that the omitted uit are N(0, σ2u) and E (Iit, uit) = 0, ∀i, t. It remains to decide upon the form of the Iit. The commonest assumption is that the Iit are drawn from a half Normal distribution truncated at zero. However, it is not particularly clear why inefficiency should have that particular shape. In Mayes et al. (1994) we experimented with both the exponential distribution and the truncated normal. These had a relatively small impact either on the parameters of the frontier or on the estimates of inefficiency. However, this result for production functions in Australian manufacturing industry might well be different from cost functions for stock exchanges. Nevertheless we followed the common assumption. In Mayes et al. (1994) we also consider a variety of functional forms before settling on the translog, which is also the common decision in the literature. The translog has the obvious advantage of greater generality and flexibility than the CES or Cobb–Douglas alternatives. However, with a large number of parameters and a small data set significance levels for many of the coefficients can be small. In all of the cases described here the translog was also applied following the general form of J

lnTCit = α0 + ∑ αj ln Xijt + +

1 2

j =1 L L

1 J J 2∑∑

j=1 k=1

∑ ∑ δim lnZilt Zimt + Iit = uit l=1 m=1

L

βjk lnXijt ln Xikt + ∑ γl Zilt l=1

(3.2)


where J is the number of variables in X and L the number of variables in Z, indexed by j, k and l, m respectively. Clearly both ␤ and ␦ must be symmetric. Table 3.1

Variables used

Cost TC

TC

total operating expenses

NCOM

number of listed companies

VCOM

market capitalisation

VTRADE

total value of shares traded

NTRADE

number of trades

X3

PCAP

total capital expenditure (buildings, IT systems and equipment)/book value of capital

X4

PLAB

total labour cost per employee

Outputs X1 X2

Input prices

Performance X5

SMI

market index growth (%)

X6

T

technological change (time trend)

Z1

ASSET

total financial and nonfinancial assets

Z2

CAPITAL

total capital

Z3

CONCAP

largest 5 companies % share of market * capitalisation

Z4

CONTRADE

most traded 5 companies % share of market capitalisation

Z5

AGE

years in business

Z6

VELO

annualised ratio of turnover to market capitalisation

Z7

DER

dummy = 1 if also derivative exchange

Z8

ETRADE

dummy = 1 if automated

Z9

REMOT

dummy = 1 if remote access allowed

Z10

OWNER

dummy = 0 if mutual

Z11

RMERGE

dummy = 1 if merged during last 3 years

Z12

THOURS

number of hours open during the trading day

Z13

TECHCOST

technology and automation related cost/total cost

Characteristics

Note: All currencies converted to US$; all variables except dummies in natural logs. *In Hasan et al. (2002) this is the largest 3 firms only.


The variables used in estimation are shown in Table 3.1. The set of X variables determining costs are partitioned in three: outputs, inputs (prices), performance. The performance variables allow for technological change and the performance of the particular market in the year in question. Linear homogeneity is required for input prices (which is normally achieved by dividing through the cost and price variables by the price of labour). In the case of Hasan et al. (2002) the estimation is in two parts with the Z variables only being applied in the second stage as explanations of inefficiency. This may result in inefficient estimates (Mayes et al., 1994).

3.2.1 Data envelopment The DEA approach offers a useful opportunity for trying to break down where the sources of improvement in efficiency in securities markets come from. The stochastic frontier production function analysis of the previous section allows us to pin down which variables may be contributing to inefficiency. It is not so well suited to the answering of questions about the way in which developments in the markets appear to be going and where the sources of efficiency improvement are. Mayes (1996) offers an example of trying to break down the sources of productivity growth in a parametric framework in chapters 2 to 4 and five examples of DEA analysis in chapters 10–14. The specific route followed here (Schmiedel, 2002) follows chapters 10 and 14 in Mayes (1996) by Tulkens and Malnero and Førsund using Malmquist indexes

y

B

E

A F C

0

x Figure 3.1

D

Choosing the frontier


as this enables a breakdown of productivity growth according to technological change, technical efficiency and scale efficiency. As a first step DEA enables the computation of a piecewise frontier of what is feasible based on the observations in the dataset. The term DEA arises simply because the frontier envelopes all the datapoints. There is more than one means of estimating the frontier. Tulkens (1996) prefers a ‘step’ approach, where the frontier strictly describes only what has been achieved, see Fig 3.1, whereas a linear programming approach, as used in the research discussed here, effectively links the extreme observations. Thus if points A, B and C are actual observations, the stepped line CDAEB includes only activities that are clearly feasible. All points along BE involve, say, producing just as much of output x with given resources as at B, which has actually been achieved, but less y (and is clearly inefficient in this respect). Similarly any point along CD can be achieved as it involves as y as C but less x. Points along CB however remain hypothetical. In theory since both C and B have been achieved, they could be used together to produce linear combinations. However, this makes assumptions about divisibility and the similarity of the technology used in achieving both B and C. It is therefore debatable whether point A should be deemed as lying on the frontier or inside it, depending upon which of the two sets of assumptions are followed. This clearly affects the measurement of efficiency for any points that are not on the frontier under both methods. The key difference between DEA and the stochastic frontier approach is the stochastic element. The DEA analysis we have described is essentially static in character. It compares the efficiency of each observation with a benchmark. Thus the technical efficiency of point F compared with A is 0F/0A. As soon as it is necessary to compare samples, particularly the same exchanges in different time periods then the problem is more complex as there will be a second benchmark. What is achieved in the second sample may lie outside the frontier of the first sample. Indeed the two frontiers may cross each other. The idea behind the use of the Malmquist (1953) index is that with multiple inputs and outputs it is possible by linear programming to compute the performance of an individual exchange compared to both benchmarks (Caves et al., 1982). Furthermore the use of this comparison enables us to decompose the change in the performance of any individual member of the sample into a change in efficiency and a change in the benchmark (Färe et al., 1994). It is common to label the change in the benchmark as a change in technology.


Thus for any exchange i, the Malmquist index M 1,2 of the change in i performance between periods 1 and 2 is composed of 1,2 1,2 M 1,2 i = Ti × Ei

(3.3)

where the technical efficiency change E 1,2 i = Ei2 / Ei1 , Eit being technical efficiency of exchange i in period t relative to the frontier of period t. (Eit = 1 – Iit.) Technology change T 1,2 is the geometric mean of the change in the i particular exchange relative to the two frontiers 1/2 T 1,2 = [(Ei12 / Ei2)(Ei1 / Ei21)] i

Here Eits is the efficiency of exchange i in period t measured relative to the frontier in period s. Thus substituting in for the two components of (3.3) the Malmquist index is usually defined as 1/2 M 1,2 i = [(Ei12 / Ei1)(Ei21 / Ei2)]

(3.4)

which is the ratio of the performance of exchange i in period 1 compared to the frontiers in periods 1 and 2 to the performance of the same exchange in period 2 relative to the two frontiers. We can further divide the efficiency change into a technical efficiency and a scale efficiency component (Coelli et al., 1998) by permitting variable returns to scale in contrast to the constant returns implied in the previous analysis. This entails calculating technical efficiency with respect to both variable returns, V, and constant returns to scale, C, using the same data. For any observation the scale effect can then be described as the ‘difference’ between the two measures of technical inefficiency. It is normal to express this difference in ratio terms so that the decomposition can be multiplicative. Thus we need to express technical efficiency Eit relative to a frontier type reflecting the form of returns to scale. For example, Eits , where s = V, C. Hence E Cit = EVit Sit

(3.5) EVit,

where Sit is the scale efficiency component, the ‘pure’ technical efficiency component and E Cit = Eit as expressed in (3.4) and in the discussion up to that point. Hence we can reformulate (3.3) as 1,2 V1,2 1,2 M1,2 × Si i = Ti × E i V1,2

V

V

1,2

1,2

(3.6)

where E i = E i2 / E i1 and S i = Si2 / Si1. S i thus becomes the measure of scale efficiency used in the analysis and EV1,2 the measure of ‘pure’ it technical (pure in the sense of excluding the scale element).


3.3 Database Over the years we have built up a database on 49 stock exchanges, of which 28 are registered in Europe, for the period 1985 to 1999. The exchanges covered and the information used in the anlyses are shown in Tables 3.1 and 3.2. The initial study by Malkamäki (1999) used a cross section of 37 exchanges for 1997, while Schmiedel (2001) covers 17 of the major European exchanges for the period 1985–99, Hasan and Malkamäki (2000) 38 exchanges across the world for 1989–98 and Hasan et al. (2002) add another six exchanges to that same period to give 44 exchanges worldwide for 1989–98. All of these studies use translog frontier cost functions. Finally Schmiedel (2002) uses 16 European exchanges for 1993–9 in his DEA study of total factor productivity. In each case the studies have used as many exchanges as possible for the data that needed to be included. The Schmiedel (2002) study uses balanced data sets whereas the other studies are unbalanced with very substantial attrition in the years before 1993. The data come from a variety of sources including annual reports of the individual exchanges, various issues of the International Federation of Stock Exchanges (FIBV) Yearbook, IMF International Financial Statistics (IFS) and stock exchange Internet sites. National currencies are converted into US$ and deflated using data from the IFS. Given the discussion of the previous sections it is natural to define the two output variables X1 and X2 in terms of the two facets of the services of stock exchanges, viz. the number of companies listed and the turnover on the exchange. However, it is not immediately clear what form these variables should take, since costs and fees will vary both according to size of company and to the size of trades. Thus comparative analysis was also undertaken using the value of the companies and the number of trades (labelled VCOM and NTRADE in Table 3.1). Of course not all the trades that take place are of the same sort. It was not possible to provide any comparable division by type but it was possible to determine whether exchanges also handle derivatives contracts, DER. In considering inputs, we are even more constrained in our choice by the information available than in the case of outputs. A simple measure of labour costs is usually available, as is the number of employees. While it would make a lot more sense to consider costs for comparable types of employee, this is not possible from these sources of data. No adjustment is therefore possible for skill levels and other pertinent variables. Similarly on the capital side it would be particularly helpful


to strip out the IT element from other parts of cost as the nature of the trading platform is a key feature of the competitiveness of exchanges. This is possible to do for some of the exchanges, labelled TECHCOST in Table 3.1, and is hence included in estimates with restricted samples (Hasan et al., 2002). Otherwise the best that can be achieved is simply to classify the type of trading system and ETRADE separates out the automated exchanges. Furthermore among the automated exchanges it was also possible to determine whether remote access (REMO) was available. Remote access in this sense describes cross-border trading as obviously all automated exchanges are remote in a more direct sense, once computer terminals are being used to effect the transactions. These variables form part of Z, (Z7, Z8, Z9, Z13), the explanation of variations in inefficiency rather than modifications to the components of the cost function as such. (These are therefore not interacted with the other terms.) The two input price variables included in X are therefore simple measures of capital and labour prices, X3 and X4, which can be obtained from the various published accounts. The remaining two variables in X allow for the changes in technology from year to year, T, and the performance of the stock market in the year in question, SMI. Technological opportunities are assumed to be available to all exchanges at the same time, although in practice technical change takes a considerable period of time to implement and such changes are ‘lumpy’, making substantial progress, usually embodied in a major IT development or access agreement to another exchange. While it is common to treat technological change simply as an intercept shift there is no reason why it should not affect any of the cost factors involved and hence it has been used as a full argument in the cost function in its own right. SMI has been treated in the same way. It is also possible to explore some of the other characteristics of markets that might effect their cost structures and include them in the explanation of variations in cost that would otherwise be interpreted as inefficiency. However, all of the other factors are assumed only to affect efficiency directly and not to alter the shape of the cost function. These variables, included in Z, can be categorical or continuous. They fall into two main groups, those which affect the environment in which the exchange operates and those which reflect the characteristics of the exchange itself. For example, an exchange that it is dominated by just a few stocks will have rather different characteristics from one where many stocks make up the same overall value. Hasan et al. (2002) and Schmiedel (2001) argue that concentration (CONCAP and CONTRADE measure concentration by share of market capitalisation and by share of trading respectively, Table 3.1) will tend to decrease


efficiency. However, it is not immediately obvious why this should be the case unless there are clear inefficiencies in low traded or illiquid stocks. This is to be distinguished from inefficiencies in the pricing of the stock as far as investors are concerned. There may easily be some economies of scale in trading in highly liquid stocks and it is those stocks where competition among exchanges may be greater and hence the incentive to efficiency would be larger. (Profitability would of course be similarly lower if the competitors are skimming off the most profitable parts of the market.) Higher rates of turnover (VELO) might similarly be expected to lead to greater efficiency. The remaining Z variables relate to the characteristics of the exchange itself. Larger exchanges may be more efficient (variables, ASSET and CAPITAL in Table 3.1) as may be older more established exchanges (AGE). Newer exchanges are likely to be technically most advanced but they may have heavy investment costs to overcome. Similarly exchanges that have recently merged may encounter increased costs in the period of rationalisation (MERGER). One aspect which stands out in the literature is the question of ownership (Di Noia, 2001; Hart and Moore, 1996; Pirrong, 2000; Steil, 2002). It is widely thought that the traditional mutual exchanges have more difficulty in introducing radical change. If a large number of participants have to be convinced before any major investment can take place, decisions may be delayed and indeed some avoided altogether. A for-profit or at least demutualised exchange (OWNER) may be able to be more efficient in this regard and have a stronger incentive to competitiveness. Domowitz and Steil (2002) estimate that demutualisation and the adoption of a fully electronic trading platform could reduce trading costs by around 30 per cent for the NYSE and NASDAQ and as much as 70 per cent for some of the European exchanges. The remaining variable, used in some of the regressions, considers whether having longer opening hours (THOURS) increases or decreases efficiency. Here there are competing forces. Being open longer may add to costs but it will also tend to add to revenues as traders do not have to move to a different time zone to get an active market. The arguments applied to retail markets for consumer goods and services would apply here as well.

3.4 Descriptive statistics The sample of exchanges used in this study is very heterogeneous. As Table 3.2 (drawn from Hasan and Malkamäki (2000) ) shows, they range in size in terms of number of companies from 28 in Tallinn to


5,487 on the NASDAQ in 1997. The three US exchanges, London and Tokyo dominate when it comes to market valuation of the companies listed. When it comes to the number of transactions and their value the results are even more dispersed. While the NYSE and NASDAQ still dominate, trading on the Frankfurt exchange tends to exceed Tokyo. (The nature of trading on the Taiwan exchange is clearly different.) Such diversity will always raise the question of whether it is reasonable Table 3.2

Representative output statistics for individual stock exchanges 1997 Value of trading transactions USD m

Number of companies 1000

Market value USD m

Number of companies listed

North America Amex* Chicago* Montreal* NASDAQ NYSE Toronto* Vancouver**

143230 198325 44715 4481682 5777602 305626 6479

5001.5 10011.9 1934.6 98960.4 102550.4 11142.2 2081.2

124606 2142753 422694 1737510 8879631 567635 6615

710 268 557 5487 2626 1420 1429

South America Sao Paulo**

191505

1871.0

255478

537

3798.6 3733.3 2300.0

468897 33784 138938 14700 93766 1139 825233 73322 49371 61095 1876 1996225 33892 290383 66503 676311 10817 264711 575339 12135

348 210 265 49 249 28 2696 126 102 259 78 2513 284 388 217 924 91 261 428 143

Europe, Africa, Middle East Amsterdam** 281248 Athens 21248 Brussels** 34055 Budapest* 7039 Copenhagen 46886 Tallinn 1573 Germany* 1072935 Helsinki 36428 Dublin 17470 Istanbul 59584 Ljubljana 548 London 1925809 Luxembourg 1052 Madrid 139229 Oslo 48176 Paris 415818 Prague 7770 Stockholm 176356 Switzerland* 569510 Warsaw 7981

1018.9 122.4 27815.5 568.1 261.3 20552.0 131.4 9673.4 47.0 7891.8 829.8 37000.0 4836.0 6130.0 3500.0

Technical Efficiency in Stock Markets 73 Table 3.2 Representative output statistics for individual stock exchanges 1997 – continued Value of trading transactions USD m Asia, Pacific Australian* Hong Kong* Jakarta** Tokyo* Kuala Lumpur New Zealand Osaka Philippines** Taiwan Thailand**

156271 453900 41378 898579 164482 9720 2223803 19890 1254543 25259

Number of companies 1000

Market value USD m

Number of companies listed

6141.0 32601.0 2972.5

295411 413323 29050 2160585 93182 29889

1219 658 281 1865 703 190 1275 221 404 431

21580.0 517.1 1834.0 1850.0 154345.0 8730.0

31212 296808 22792

* Costs include costs from derivative exchange activities in addition to the costs from stock exchange activities. ** Costs include costs from stock and derivative exchange activities and securities settlement.

to treat the whole sample as a single ‘industry’ governed by a common technology. The sample is too small to test adequately for homogeneity across various groups within it. We can, however, get a slightly better feel for the nature of the discrepancies between exchanges on a regional basis, simply by considering the mean and range of the main variables for the main regions distinguished in Hasan et al. (2002), as shown in Table 3.3. If we take the average values for each region, South America stands out for having a relatively low labour cost, a high cost/revenue per trade and low listing fee income. Europe and North America stand out for the high technology cost. However, when it comes to the distribution of costs and revenues there is not surprisingly more overlap. The range is particularly large for Asia Pacific. In frontier analysis it is particularly important to guard against outliers. Extreme values that occur because of special factors can distort the whole assessment of what is feasible. An exchange may concentrate on an unusual part of the market or not separate out non-trading/listing activities sufficiently in its accounts for example. Table 3.4 gives an indication of the structure of the four regions in terms of the variables used in estimation.

Table 3.3

Distribution of cost and revenue structures of stock exchanges 1989–98

74

Region Combined

Asia Pacific

Europe

N. America

S. America

ATC 000US$

81.645

64.848 (2.964–356.148)

62.166 (1.524–452.758)

168.474 (17.612–564.666)

49.890 (6.832–83.276)

ATC/NTRADE

16.17

14.46 (0.9–63.8)

(2.1.26.5)

(3.8–36.6)

(9.9–62.5)

ATC/VTRADE

1.05

1.08 (0.15–7.4)

1.24 (0.2–8.3)

0.92 (0.13–3.9)

1.39 (0.32–4.1)

32.13

29.48 (24.4–35.1)

34.83 (30.16–38.2)

37.14 (35.8–41.0)

21.95 (13.2–27.6)

8.91

12.69 (8.4–13.1)

9.38 (1.5–10.1)

6.32 (4.0–9.6)

6.90 (6.2–7.3)

TECHCOST/ATC

11.89

3.95 (0.30–9.5)

14.65 (1.01–26.8)

16.23 (8.2–22.8)

4.93 (4.2–5.5)

ATR 000US$

99.587

78.996 (7.970–372.477)

78.857 (1.651–561.327)

193.921 (19.110–634.380)

72.451 (8.079–91.762)

ATR/NTRADE

21.76

15.09 (1.10–10.5)

22.63 (4.8–29.8)

19.04 (4.12–44.27)

48.63 (10.2–76.5)

ATR/VTRADE

2.28

2.01 (0.3–10.5)

3.25 (1.03–12.56)

1.82 (0.21–6.8)

1.66 (0.36–3.9)

LFEEINC/ATR

18.97

14.45 (1.9–16.8)

18.06 (1.8–34.3)

21.49 (8.0–32.2)

6.71 (2.4–10.1)

TFEEINC/ATR

38.66

43.97 (10.41–70.31)

51.92 (40.1–70.2)

40.31 (34.6–46.3)

36.97 (19.6–49.4)

LAB/ATC OFFICE/ATC

11.5

17.15

36.84

Notes: Variables are defined as earlier: ATC(R) is average total cost (revenue); (N)VTRADE (Number) Value of trades; LAB is employee cost; OFFICE is office and related costs; TECHCOST is technology costs; LFEEINC is listing fee income and TFEEINC trading fee income.

Table 3.4

Descriptive statistics large sample 1989–98

Region All Asia-Pacific Europe North America South America

No. exchanges

NCOM

NTRADE mn

49 14 22 8 5

776 642 618 1425 470

12.1 16.1 5.8 23.0 1.6

Value of equity market $mn return 377 200 278 1062 96

23.2 9.3 33.8 17.1 34.8

Mkt value/ GDP %

CONCAP Top 3

87.6 62.1 78.3 128.5 41.4

22.7 18.5 27.3 12.8 36.9

ETRADE OWNER 0.74 0.89 0.82 0.55 0.22

0.11 0.06 0.19 0.00 0.00

Turnover ratio 63.6 66.9 63.9 55.6 61.3

Note: NCOM, NTRADE, CONCAP, ETRADE and OWNER defined as in Table 3.1.

75


Summary of panel data set of European stock exchanges

Exchange

Study

Exchange

Study

Euronext Amsterdam Bolsa de Bilbao Barcelona Stock Exchange Bolsa de Madrid Euronext Brussels Copenhagen Stock Exchange Deutsche Börse AG Helsinki Stock Exchanges Istanbul Stock Exchange London Stock Exchange

Both DEA SF Both Both Both Both Both DEA Both

Bourse de Luxembourg Oslo Bors Euronext Paris OM Stockholm Exchange Swiss Exchange Wiener Börse Tallinn Stock Exchange Budapest Stock Exchange Iceland Stock Exchange Warsaw Stock Exchange

Both Both Both Both Both SF SF Both SF DEA

However, for much of the analysis we have had to rely on much smaller samples of exchanges shown in Table 3.5, which have a greater degree of homogeneity and provide data on all of the variables in our stochastic frontier study for the years 1985–99. Of the 20 European exchanges shown in Table 3.5, 17 were included in the stochastic cost function study (SF) and 16 in the data envelopment analysis (DEA). (Thirteen exchanges are therefore included in both studies.) The latter study only covers the years 1993–9.

3.5 Estimation results 3.5.1 Worldwide results Estimates for the larger sample used the two-stage method. Results for Stage 1, just including the X variables in the regression are shown in Table 3.6. Both translog cost and revenue functions are quite reasonably consistent with the data. It is the number of companies quoted on the exchange which acts as the main driving variable. While the value traded also contributes to revenues, it is interesting to note that it tends to reduce costs. Costs rise with input prices but fall both with market growth and over time as technology can be expected to improve. Revenues on the other hand as might be expected rise in response to market growth and over time. Efficiency levels, shown in Table 3.7, are quite high for the average figures, with only 15–20 per cent of costs and revenues explainable by inefficiency. By the end of the sample in 1998 the difference from best practice has shrunk by 5 per cent in the case of revenues and 10 per cent in the case of costs in only five years. As the ranges reveal there is much more variation within the totals. There is a 10 per cent range in 1998 on the cost side for example, which is surprisingly small given

Technical Efficiency in Stock Markets 77 Table 3.6 Variable

Regression parameters large sample 1993–98 Revenues

Constant

188.0500 (0.18)

X1

1.0441*** (29.83)

X2

Costs 2.7550 (1.26)

Variable

Revenues

Costs

X1 X5

–0.2855** (2.03)

–0.2803*** (3.08)

1.0932*** (24.45)

X2 X5

0.1304** (2.86)

0.1188*** (3.98)

0.3832** (2.32)

–0.3079* (1.70)

X3 X5

0.3562 (1.34)

0.4034* (1.85)

X1 X1

–0.0405* (1.73)

0.0409** (2.04)

R(IPROD)

0.0567* (1.91)

–0.0733** (2.37)

X2 X2

0.0302 (0.40)

0.0561 (0.29)

X1 X6

0.0592 (2.22)

–0.0663** (2.30)

X1 X2

0.1088** (2.73)

–0.1445*** (3.54)

X2 X6

0.2955 (1.26)

0.0001*** (7.00)

X4

–0.5695** (2.53)

0.6244** (2.32)

X4 X6

–0.0248 (0.13)

0.0654 (1.45)

X4 X4

–0.0120 (0.16)

0.0367 (0.31)

X5 X6

0.3420** (2.52)

–0.0366** (2.74)

X1 X4

0.2540* (1.83)

–0.3100*** (4.21)

Derivative Dummy

X2 X3

0.1520** (2.07)

0.1807** (2.26)

Log-likelihood

–4.3201

λ

X5

0.6158** (2.08)

–0.4875** (2.05)

3.0544** (2.42)

3.0046** (2.39)

σ

X5 X5

0.0467*** (4.51)

0.0340** (2.68)

4.8842** (2.37)

5.0074** (2.36)

N

–0.6670*** –0.6542*** (14.62) (145.64)

102

–564.053

102

***, **, * indicate significance at 1%, 5% and 10% levels respectively. X variables are in logarithms, except X6, which is a linear trend. IPROD = Industrial production. t-statistics are reported in parenthesis.

the differences in the types of exchanges involved. Average technical inefficiency in UK manufacturing industry over the period 1980–1990, for example, was 40 per cent (Mayes, 1996) and in no case was it below 18 per cent in any industry in any year. Even the case of branches of the same bank in Belgium (Tulkens and Malnero, 1996) average efficiency was normally only 92–95 per cent and the range included values as low as 50 per cent. The striking feature of these results is the improvement over time in relative terms with a very considerable narrowing on best practice even after allowing for technical change (Table 3.8). The natural conclusion would be to attribute this to the opening up of financial markets over the period. Generalised preconceptions seem to be borne out with the highest cost efficiencies in North America, followed by Europe, Asia-Pacific and South America. The gain in efficiency in Europe is particularly striking.


Relative efficiency large sample Revenue

Cost

Combined Sample

82.60 (65.0–97.7)

85.04 (68.4–98.6)

Asia-Pacific

76.51 (69.4–96.3)

80.62 (74.2–92.2)

Europe

82.28 (65.0–94.1)

85.28 (75.8–95.1)

North America

85.29 (71.0–97.7)

89.64 (85.2–98.6)

South America

72.6 (66.3–88.4)

75.39 (68.4–86.1)

1993

79.11 (65.0–90.1)

80.16 (72.6–86.8)

1998

84.06 (72.2–97.8)

91.76 (83.7–93.6)

Note: Distribution range is given in (parenthesis).

Relative efficiencies also seem to fit preconceptions relating to type. Automated exchanges are more efficient than their auction counterparts. Adding derivatives or having a profit motive also seems to be correlated with greater efficiency. The pattern simply by size is not quite so obvious. Here there is some tendency for both larger and smaller exchanges to do better than their middle-sized counterparts – perhaps a reflection of the opportunities for gain from size on the one hand and specialisation on the other. Progress on revenue and cost efficiency has not been identical. The greatest progress in revenue efficiency appears to have occurred in North America despite that region already showing the highest efficiency. Interestingly enough it is the auction exchanges that show the better revenue efficiency compared with their automated rivals, although the latter are improving faster. However, up to this point this is only a discussion of the results that include the X variables in the cost and revenue functions and not the Z variables that reflect other characteristics that differentiate exchanges. Hence the ‘efficiency’ measures described thus far are not necessarily a comparison of like with like. These factors are taken into account in Table 3.9. On the cost side it is clear that automation, having a forprofit organisation and having a larger number of exchanges in a country is associated with greater efficiency. This last implies that com-

Technical Efficiency in Stock Markets 79 Table 3.8

Changes in efficiency scores Costs

Regions and organisation set up

Combined score 1993

Revenues

1998

Combined score

1993

1998 84.06

Combined

85.04

80.16

91.76

82.60

79.11

Asia-Pacific

80.62

82.84

85.26

76.51

74.22

84.36

Europe

85.28

84.23

93.68

82.28

78.35

85.61

North America

89.64

86.83

90.05

85.29

82.38

93.54

South America

75.39

72.64

83.76

73.90

64.06

75.02

Automated

86.69

83.92

92.65

84.92

80.25

87.56

Auction

82.21

79.17

88.36

89.21

89.07

92.04

Exchanges with Derivatives

86.34

83.21

92.73

85.47

84.32

90.21

Equity Only Exchange

82.27

79.32

89.01

86.21

83.18

88.53

Profit Motivated

89.27

83.06

92.66

84.36

77.30

93.02

Co-operative & Non Profit

81.06

79.55

86.48

78.72

73.02

84.51

10 Largest

85.42

85.90

90.25

91.70

77.42

91.60

Middle 10

86.06

83.68

80.23

84.31

80.51

90.12

10 Smallest

80.25

83.60

85.36

85.94

78.33

84.29

petition may help increase efficiency. The technology variable that is included is weakly significant but reflects the extra costs in addition to the difference incurred by having an automated exchange. It is not quite so clear how to interpret the negative effect of dominance by a small number of companies. The expectation is that trading in a few large companies will be more efficient in a market sense, as the market will be deeper, pricing clearer and bargains easier to match. Whether that alters the cost structure for the exchange is another matter. Size of the market and the amount of business as represented by the last two variables in Table 3.9 appear to have little importance. Trading hours on the other hand does, and not surprisingly adds to costs. The matching consequences can be found on the revenue side of the account. Here size and turnover do matter and longer trading hours clearly are associated with better revenue performance, offsetting their cost. The profit motivation has a particularly strong positive effect while the existence of competition not surprisingly appears to reduce


Correlates of efficiency Costs

Variables/ratios

Revenues

parameters

t-statistics

parameters

t-statistics

Intercept

0.318

61.12***

0.460

3.97***

Technology Cost to Total Cost

0.194

1.92*

0.001

1.60

Listing fee

—

—

0.052

1.48

Trading fee

—

—

0.001

0.74

Cost efficiency Equity + Derivatives # Automated Market #

—

0.099

1.43

0.032

—

1.04

0.063

1.81*

0.193

2.07**

0.027

1.01

–0.0001

1.83*

–0.0008

0.82

Number of Exchanges in the Country

0.013

2.02**

–0.003

1.99**

Profit Motivated #

0.044

3.21***

0.134

3.26***

Top 3 Firms’ Market Share in the Exchange

Recent Mergers # Trading Hours Per Week

0.005 –0.018

0.64 2.29**

–0.029

1.09

0.027

2.03**

Turnover Ratio

–0.001

0.67

0.0002

1.81*

Log of Market Index

–0.003

0.84

0.019

2.14**

Model Statistics Adjusted R2

0.3902

0.2130

F-Statistics

4.89***

10.61***

84

84

Number of Observations

***, **, * = significant at 1%, 5% and 10% levels respectively. # = Binary variables.

revenue efficiency. There is also some gain from having derivatives as well as equity trading. While technology has a clear positive effect on cost efficiency, as found also by Litan and Rivlin (2001), for example, the impact on revenues has the expected sign but appears of limited significance. Lastly, the impact of the striking development of mergers in recent years does not appear to be reflected in an impact on cost or revenue efficiency in this formulation. Digesting a merger might be expected to put downward pressure on both cost and revenue efficiency in the short run but this may be difficult to capture in a simple variable when the nature of the synergies and linkages between markets vary considerably.


3.5.2 The European picture While many of the parameters of the cost frontier shown in Table 3.10 are weakly determined, this is common for this type of model (Mayes, 1996) and the translog specification is clearly superior to the null of Table 3.10 Maximum-likelihood estimates for parameters of translog stochastic cost frontier function for European stock exchanges Model I Variable

Model II

Coeff.

Std. error

Coeff.

Std. error

3.714 1.813 0.497 0.108 –0.010 –0.060 1.068 –0.070 –0.175 0.036 –3.930 0.099 –0.436 0.139 –0.403 0.007 –0.006 0.025 –0.013 0.060 0.108

1.004 0.843 0.324 0.133 0.021 0.103 0.410 0.038 0.113 0.056 0.653 0.240 0.316 0.145 0.129 0.166 0.006 0.053 0.026 0.023 0.082

1.965 1.198 0.642 0.161 –0.011 –0.080 1.087 –0.062 –0.126 –0.003 –2.958 0.273 –0.249 0.065 –0.163 — — — — — —

1.019 1.133 0.456 0.132 0.019 0.096 0.461 0.035 0.096 0.052 0.727 0.140 0.208 0.094 0.102 — — — — — —

0.389 –0.880 –0.296 1.061 –0.565 0.104 0.259

0.129 0.291 0.238 0.338 0.267 0.029 0.231

0.199 –0.789 –0.484 1.103 –0.074 0.123 0.159

0.344 0.676 0.292 0.345 0.350 0.097 0.826

Cost frontier model Constant X1 X2 X 1X 1 X 2X 2 X 1X 2 X3 X 3X 3 X 3X 1 X 3X 2 X5 X 5X 5 X 5X 1 X 5X 2 X 5X 3 X6 X 6X 6 X 6X 1 X 6X 2 X 6X 3 X 6X 5 Inefficiency model Constant Z7 Z8 Z9 Z10 σ2 = σ2u + σ21 2 2 γ = σ1/σ No. obs. Loglikelihood Mean inefficiency

109

109

–25.975

–35.557

0.289

0.189

Note: X variables are in logarithms, except X6, which is a linear trend.


the simpler Cobb–Douglas formulation with a Log-likelihood ratio (λ) of 77.64 compared to χ 20.95 = 25.00. The extent of the rapid change over the 15-year period of the data is reflected in the importance the inclusion of the technical change variable, λ = 16.05 (χ 20.95 = 12.59), and the considerable difference in the coefficient structure between Model I in Table 3.10 that includes the technical change parameters and Model II that does not. (As in the previous case this is a joint test of all the (six) extra parameters involved.) The performance of the market also affects its cost structure as measured by X6 , λ = 18.60 (χ 20.95 = 12.59). Finally it is also worth noting that, given the rest of the model, the hypothesis that there is no technical inefficiency, i.e. γ = 0, is also clearly rejected λ = 17.90 (χ 20.95 = 11.91). (Joint one-tailed likelihood ratio tests of the significance of the Z variables, as in Battese and Coelli (1995), also reject the null hypothesis of no effect on efficiency.) We see that as in the previous larger sample, also trading in derivatives, being automated and having a for-profit ownership structure is associated with lower costs. Allowing remote access on the other hand tends to result in a higher cost structure. This may reflect the initial costs of investing in these facilities. However, it does not imply that the investment is mistaken if this considerably reduces the direct costs for the market participants. Even if the costs on the exchange are higher the costs to them of trading may be substantially reduced by not having to have a local presence in the market. Schmiedel (2001) also reports, from a separate regression, that having a larger asset base tends to result in lower costs. There is likely to be a clear source of gain simply from being larger. Newer exchanges tend to have lower costs, while the importance of the top five firms in market capitalisation does not seem to show any significant relationship with costs. Average inefficiency in these European exchanges appears to be rather higher at 0.289 than in the larger sample. The range of efficiency shown in Table 3.11 is particularly interesting. Although there are some small differences in ranking depending upon the particular model chosen, there is a step difference between the first six exchanges and the rest. The range of efficiency is considerable. (Note that these figures relate to the 15 year period 1985–99 as a whole and therefore do not indicate the efficiency simply in the last year of observation.) The importance of size is obvious with a range of 10 percentage points in cost efficiency between the five largest and the five smallest exchanges. It is immediately clear that efficiency has been improving over time (even after allowing for the technical change that has taken place during the period). This is particularly clear if we consider the progress of the individual exchanges shown in Figure 3.2.

Technical Efficiency in Stock Markets 83 Table 3.11 Ranking and descriptive statistics of inefficiency scores of European exchanges Exchange Swiss Exchange Euronext Brussels Euronext Amsterdam Budapest Stock Exchange Deutsche Börse AG Barcelona Stock Exchange Copenhagen Stock Exchange Tallinn Stock Exchange Bolsa de Madrid Bourse de Luxembourg Helsinki Stock Exchanges Euronext Paris OM Stockholm Exchange Iceland Stock Exchange Oslo Bors London Stock Exchange Wiener Börse 1985–1989 1990–1994 1995–1999 combined 1985–1999 top 5a) a) medium a) smallest 5

Model I 0.0345 0.0408 0.0466 0.0466 0.0719 0.0845 0.1915 0.1955 0.2235 0.2606 0.3365 0.3924 0.4136 0.4258 0.4489 0.4629 0.5288 0.4520 0.3223 0.2302 0.2888 0.2329 0.3059 0.3319

Exchange Euronext Brussels Swiss Exchange Budapest Stock Exchange Euronext Amsterdam Deutsche Börse AG Barcelona Stock Exchange Helsinki Stock Exchanges Bourse de Luxembourg Iceland Stock Exchange Tallinn Stock Exchange Bolsa de Madrid Copenhagen Stock Exchange Euronext Paris London Stock Exchange Oslo Bors OM Stockholm Exchange Wiener Börse 1985–1989 1990–1994 1995–1999 combined 1985–1999 a) top 5 a) medium a) smallest 5

Model II 0.0293 0.0295 0.0310 0.0314 0.0922 0.1024 0.1684 0.2027 0.2139 0.2156 0.2221 0.2267 0.2459 0.2495 0.2535 0.2652 0.6356 0.2245 0.1753 0.1891 0.1885 0.1461 0.1935 0.2478

Notes: The estimates in this table are average and individual inefficiency scores of European financial exchanges over the time period 1985–1999. The coefficients are listed in ascending order so that those stock exchanges with the lowest inefficiency level are ranked first. Note that an accurate interpretation of these scores is valid only under the specific stochastic frontier formulations. a) the grouping of the stock exchanges is constructed according to the value of capitalisation of the respective market.

In the first five years almost no exchanges were within 10 percentage points of the frontier; indeed almost all were over 30 percentage points away from it. There have been sharp shifts between each five year period such that the distribution in the most recent period has much more of the exponential character one would expect, with most exchanges near the frontier. Thus not only is technological improvement shifting the frontier itself but exchanges are moving closer to the frontier. Considerable variety thus remains. While continuing improvement and competition may tend to erode the remaining differences still further, there is room for specialisation among exchanges. Insofar as

84 The Future of Financial Markets 60

Percentage

50

40

30

20

10

0 70-more

60–70

50–60

40–50

30–40

20–30

10–20

0–10

Range of Inefficiencies 1995–1999

1990–1994

1985–1989

Figure 3.2 Distribution of cost inefficiency among European stock exchanges over 1985–99 (Model I)

they offer different services then one can expect their cost structures to differ and not fit rigidly to a single cost frontier, however well it can be identified.

3.5.3 Non-parametric estimates The DEA allows us to take our consideration of efficiency in European stock exchanges forward a further step. By constructing Malmquist indexes we can decompose the year by year changes into the three components of Technical Change, Pure Technical Efficiency and Scale Efficiency described in equation (3.6). This decomposition is shown in Table 3.12 along with the composite measure of Efficiency in column (1). (Col (1) = Col (3) × Col (4) and Col (5) = Col (1) × Col (2) = Col (2) × Col (3) × Col (4).) We thus observe from the mean value of the Malmquist index that average annual rate of total factor productivity growth over 1994–9 was 5 per cent. Schmiedel (2002) shows that this figure varies a lot according to the sample of exchanges and to the measures of output used. However, some features remain clear. Technical change is the most important contribution, although it is extremely uneven over the particular years. With such a small sample one or two major changes dominate. If anything scale efficiency seems to be worsening. This would follow from some of the major exchanges managing to reap

Technical Efficiency in Stock Markets 85 Table 3.12

Malmquist productivity index sample of European stock

exchanges summary of annual means, 1994–99 Year

Efficiency change (1)

Technical change (2)

Pure technical efficiency (3)

Scale efficiency (4)

Malmquist index (5)

1994 1995 1996 1997 1998 1999 Mean

1.346 1.161 0.918 0.869 0.846 0.798 0.972

0.840 0.919 1.174 1.420 1.076 1.147 1.080

1.206 1.112 0.991 0.896 1.117 0.844 1.020

1.116 1.043 0.926 0.970 0.758 0.945 0.953

1.130 1.066 1.078 1.234 0.910 0.915 1.049

Note: All Malmquist index averages are geometric means. (1993 = 1)

increasing economies of scale and hence altering the shape of the frontier. Table 3.13 helps explain this more closely by showing the Malquist index, broken down by different types of exchange. Here we see not surprisingly that there is no scale efficiency change for the larger exchanges as it is they that are setting the pace. Smaller exchanges have been improving their relative scale efficiency as have the newer exchanges and mutualised exchanges. For automated exchanges technical change is actually faster than productivity change, again a picture one might expect if the organisation could not fully adjust to the opportunities offered by the new technology immediately. With continuing innovation such a situation can continue for quite a while. It is noticeable that the smallest exchanges are not making much headway either in technological terms or in technical efficiency terms and their relative improvement is occurring through an increase in scale efficiency. This latter point fits in well with the conclusions of Hasan et al. (2002) where the economies of scope and scale vary considerably among different regions and types of exchanges. In particular they find that the larger exchanges, especially in North America but also in Europe face considerable economies of scale. Hence they conclude that mergers or alliances among them would reap considerable gains. Indeed in Malkamäki (1999), where only a single year is used in the assessment, the recommendation is that the nature of any agreement between exchanges could vary with the function. In particular, he argues that there are likely to be greater gains from amalgamating trading activities but that listing offers fewer gains from scale. Hence European exchanges might wish to keep separate identities for listing purposes but try to

Malmquist productivity index by size, type and organisational form of European stock exchanges 1994–99

Exchange characteristics and organisational setup

Efficiency change (EFFCH)

Technical change (TECHCH)

Pure technical efficiency (PECH)

Scale efficiency (SECH)

Malmquist index (MALM)

No. employees >300 100–300 0–100

1.024 1.041 1.041

1.134 1.172 1.068

1.001 0.984 0.978

1.033 1.081 1.052

1.100 1.196 1.075

Total assets US$ mn >80000 40000–80000 0–40000

0.933 1.073 1.088

1.226 1.111 1.040

0.935 0.984 1.019

1.001 1.121 1.058

1.106 1.160 1.106 1.121

Recently established exchanges

1.097

1.054

0.936

1.173

Older exchanges

1.016

1.138

1.004

1.014

1.114

Auction

1.001

1.167

1.014

1.000

1.108

Automated

0.957

1.170

0.963

0.986

1.093

Equity only exchanges

1.076

1.114

1.009

1.075

1.157

Exchanges with derivatives

0.951

1.122

0.941

1.010

1.029

Cooperative exchanges

1.157

1.033

1.025

1.148

1.137

De-mutualised

0.953

1.174

0.961

0.989

1.101

Top 5 markets

1.001

1.167

1.014

1.000

1.108

Medium markets

0.957

1.170

0.963

0.986

1.093

Smallest markets

1.157

0.999

0.980

1.186

1.133

Note: All currencies are converted to US$ and inflation adjusted.

86

Table 3.13


co-operate in trading. For the smaller exchanges, particularly elsewhere in the world, the picture is different. There the economies are more limited. This has two implications, first, that continuing independent existence makes sense but, second, that altering the nature of the possibilities through technological change as described in the foregoing analysis, could open up the scope for collaboration. More automated exchanges, for example, offer greater opportunities for exploiting economies of scale.

3.6 Implications of the empirical analysis It is clear from the empirical analysis that there is considerable variety in the cost and revenue structures of stock exchanges both within Europe and worldwide. It seems clear that the main exchanges in North America tend to be the most efficient, assisted in part by their greater size. To some extent European exchanges could match these levels of efficiency by amalgamation but it is also apparent that the two main activities of exchanges, trading and ‘listing’ (i.e. dealing with the listed companies) are rather different activities subject to different scale and cost patterns. While there are clear gains from expanding trading, size does not appear to be so important for listing. Given the importance attached elsewhere to listing in the country of origin, this suggests that there may well be merit in alliances between exchanges to share common trading platforms while maintaining individual listings and not just outright merger. Secondly, it is clear that there are strong gains to be made through technical change particularly through the use of automation. However, the continuing variance suggests that there are roles for specialist exchanges and that a uniform platform is not likely to be the outcome. Nevertheless, it is clear that expanding activities to include derivatives can be advantageous to the more automated systems. Thirdly there is a clear relationship between ownership and governance structures and efficiency and profitability. As with all of this analysis these are observed correlations in small samples, not clear aspects of causation. Nevertheless the literature on governance issues (Hart and Moore, 1996; Pirrong, 2000, for example) strongly supports this contention. Lastly there is a clear set of implications for regulation. Securities market trading and indeed listing runs not just internationally but globally. While thinking in Europe may understandably be dominated by the process of creating a single financial market, European exchanges


are competing with their overseas counterparts, particularly in North America, for business. Inappropriate regulation will on the one hand drive business not just to other centres in Europe but outside Europe altogether, as was experienced in the reverse direction by the impact of adverse US regulation on the creation of euro-markets in the 1960s. On the other hand, inadequate regulation in one regime will spill over into other jurisdictions as the holders of assets are spread round the world. Thus the quality of accounting in US companies is just as important for European investors as it is for US investors, for example. Overall evidence suggests that, on average, European financial exchanges operate at a 20–25 per cent higher cost level compared to the efficient benchmark exchange. The estimates also indicate that European exchanges have experienced steady improvements in their relative technical efficiency scores over the sample period. Nevertheless, it was found that in more recent years trading service providers in Europe still operate at a significantly less efficient level than the predicted benchmark. Graphical evidence on the distribution of inefficiency scores over the sample period is consistent with the finding of substantially increasing but persisting differences in technical efficiency among European exchanges. Moreover, sub-sample results show that large exchanges outperform their smaller counterparts in terms of higher efficiency. The evidence presented suggests that exchanges’ operating efficiency is related to: size, ownership, trading quality, market concentration, integration of other trading activities, and first-generation automated trade execution technologies. However, no efficiency enhancing effect was found for years in business and second-generation cross-border trading facilities. In this second case it is perhaps too early to tell.

3.7 Network effects One clear feature of the European environment that we have noted (Hasan and Schmiedel, 2003) is the trend for developing linkages among the various stock exchanges. Cybo-Ottone et al. (2000) provide an early survey and classification of forms of linkage, identifying 100 deals in the 1990s alone, most of them in the last three years. There are several forms in which these linkages have been taking place. One followed by NASDAQ has been effectively to open up a branch NASDAQ Europe with local partners. This then gives access to the main NASDAQ market through a portal that is subject to the local regulations. A second has been outright merger as has occurred with Euronext and the exchanges in Amsterdam, Paris, Brussels and Lisbon. However, legal merger does not determine the form that the practical merger will take, as


exchanges could literally operate as a single entity or remain completely separate. In practice most such mergers are seeking to use as much as possible in the way of common systems but it is difficult to get beyond some of the requirements of national rules, particularly for issuance, so that the national organisations remain, particularly in equity markets.2 Some mergers are more effectively acquisitions as in the case of the OM Group in Sweden and the HEX Group in Finland, which are now together in a new grouping called OMX. OMX Exchanges owns and operates the exchanges in Copenhagen, Stockholm, Helsinki, Tallinn, Riga and Vilnius. It is driven by a common technology base, OMX Technology. OM tried and failed in a bid to gain control of the London Stock Exchange in 2000. However, the OM case highlights two forms of linkage, the legal and the technical. One route is to buy (or merge with) another exchange, the second is to sell it the technology (or agree on a common technology). More arms-length arrangements are also possible with cross-trading and cross-membership, a relationship that Euronext has with the Warsaw, Swiss and Luxembourg stock exchanges for example. There is a NOREX alliance between OMX and the Norwegian and Icelandic exchanges. Similarly, interconnections can be put together to enable investors to access a wide range of markets, such as through the Global Equity Market linking 10 major exchanges. Domowitz (1995) labelled these ‘implicit mergers’ and thought that they were going to be the dominant way forward as they require a lower level of agreement. The arrangements have proved rather easier to put together in derivatives with Eurex linking Deutsche Börse and the Swiss Exchange and LIFFE now integrated with the other derivatives systems in Euronext. These arrangements offer a number of network externalities, the most obvious being that with increasing size markets become more liquid and it becomes much easier to match orders and obtain a competitive price. Similarly with competition among the different participants offering services on the network, margins tend to get squeezed and customers can hence trade more cheaply. However, much of the analysis of the actual and potential benefits is theoretical or descriptive (Shy and Tarkka, 2001; Di Noia, 2001; Cybo-Ottone et al., 2000, Domowitz and Steil, 1999). Our interest here is in using the database discussed in section 3.3 to explore whether there appear to be gains from network activities already visible in practice (Hasan and Schmiedel, 2003).

2

Euronext sets this out clearly on its website: http://www.euronext.com/ editorial/wide/0,5371,1732_997839,00.html.

Table 3.14

Impact of network on market performance Ordinary least squares estimates

Independent variable/ratios model Intercept Access to network (Yes=1–No=0)

90

Dependent variable Market capitalisation 1 Parameter (t-statistics)

2 Parameter (t-statistics)





6.784 (30.16)*** 2.772 (7.89)***

7.314 (44.03)***

11.43 (65.01)***

17.965 (70.52)***

17.819 (78.53)***

17.550 (76.93)***

Extent of network involvement

1.618 (6.84)*** 0.304 (5.98)***

Total number of exchanges linked through network

0.413 (2.62)***

Total number of stock exchanges linked through the equity network

0.566 (3.49)***

Total number of stock exchanges linked through a networked market for growth or techoriented companies

0.401 (4.81)***

Total number of stock exchanges linked through derivative network Adjusted R-squared F-statistics Number of obs.

0.352

0.302

0.239

0.105

0.118

0.144

52.60***

39.03***

28.68***

9.80***

12.19***

23.17***

120

120

120

120

120

120

***, **, * portray significance at the 1, 5, 10 per cent levels respectively.


In this analysis Hasan and Schmiedel (2003) seek to explore whether a range of network variables offer explanations of market performance, growth, efficiency and relative costs in addition to the characteristics described in earlier sections. Only a small number of variables can be computed from Internet sites, the annual reports of the individual stock exchanges and the International Federation of Stock Exchanges (FIBV).3 These include ACCESS – 1 if there is network access, 0 otherwise NDN – number of network connections available on this exchange NNM – number of network connections available on this exchange and on those to whom it is connected. The last of these attempts to give a full idea of network externalities even though a user would not normally be trying to access all of the network in this way. The analysis is further differentiated by the type of market the exchange addresses: equity or blue chip markets; new and high technology markets; derivatives. Individually, there is a clear relationship between each of the factors and both market performance (market capitalisation) (Table 3.14) and market efficiency, as measured by turnover velocity (Table 3.15) and somewhat weaker relationships with growth in market capitalisation, transaction costs of trading and the operating costs of the exchange (not shown). Nevertheless, there are no perverse coefficients and all coefficients are larger than their standard errors. However, without having any control factors the network variables will be picking up other sources of variation as well. Unfortunately it is difficult to come up with a set of control variables that are themselves independent of network effects. Hasan and Schmiedel try: • GDP per capita • the share of private sector activity in GDP • a measure of accounting and disclosure standards using the CIFAR index4 • concentration of ownership by the top 3 firms in the Exchange 3

Other data sources used for the rest of the information are the IMF International Financial Statistics (IFS) and Elkins/McSherry Global Trading Cost Analysis. 4 See La Porta et al. (1997, 1998) for a well-known instance of the use of this index.

Table 3.15

Impact of network on market efficiency Ordinary least squares estimates

Independent variable/ratios model Intercept Access to network (Yes=1–No=0)

92

Dependent variable Market capitalisation 1 Parameter (t-statistics)






6.784 (30.16)***

7.314 (44.03)***

11.430 (65.01)***

17.965 (70.52)***

17.819 (78.53)***

17.550 (76.93)***

2.772 (7.89)***


1.618 (6.84)*** 0.304 (5.98)***


0.413 (2.62)**

Total number of stock exchanges linked through the equity network

0.566 (3.49)***

Total number of stock exchanges linked through a networked market for growth or techoriented companies

0.401 (4.81)***

Total number of stock exchanges linked through derivative network Adjusted R-squared F-Statistics Number of obs.

0.094

0.056

0.090

0.045

0.042

0.104

8.50***

6.28***

9.71***

5.06**

4.77**

11.30***

114

114

114

114

114

114


Table 3.16

Impact of network access on market capitalisation and operating cost Dependent variables (parameters, t-statistics in parentheses)

Independent variables/ratios

Exchange operating cost

Market capitalisation

Model

1

2

3

1

2

3

Intercepts

14.637 (7.08)***

15.500 (8.15)***

14.810 (7.76)***

0.005 (6.66)**

0.001 (6.84)***

0.005 (6.63)***

Access to network (Yes=1–No=0)

0.227 (1.98)**

–0.001 (1.73)* 0.631 (2.76)**


— 0.181 (1.96)**


—

— –0.001 (1.66)* —

— — –0.003 (0.39)

GDP Per Capita (thousands of USD)

0.023 (1.52)

0.033 (1.94)*

0.031 (1.79)*

–0.001 (4.70)***

–0.001 (5.41)***

–0.001 (5.18)

Concentration of private sector to GDP

1.603 (4.87)***

1.508 (4.90)***

1.499 (4.77)***

0.001 (0.99)

0.001 (0.67)

–0.003 (3.18)***

Accounting standard

0.065 (5.05)***

0.060 (4.71)***

0.063 (5.00)***

0.0015 (0.43)

0.001 (0.41)

0.001 (0.55)

3-firm concentration on the exchange

–0.026 (2.51)**

–0.014 (1.84)**

–0.016 (2.03)**

–0.001 (5.68)***

–0.001 (3.02)***

–0.004 (3.18)***

Transaction cost of trading

–0.030 (1.47) —

–0.124 (1.30) —

–0.002 (0.94) —

Number of exchanges in the country

–0.700 (1.44)

–0.061 (1.19)

Adjusted R-squared F-statistics

0.739 14.06***

0.715 16.88***

Log of market capitalisation

106

106


—

—

–0.001 (1.08)

–0.001 (5.79)***

–0.004 (5.17)***

–0.084 (1.49)

–0.001 (3.60)***

–0.002 (4.03)***

–0.006 (4.31)***

0.723 16.33***

0.653 16.89***

0.659 9.87***

0.640 9.33***

106

92

92

92

93

Number of obs.

—


• number of exchanges in the domestic country • transaction cost • market capitalisation. (Obviously since the last two are also used as dependent variables they are only used as control variables in the other cases.) These work in a complex manner, as is illustrated in Table 3.16. Only the concentration ratio appears important for all five measures of ‘performance’ of exchanges. In the case of market capitalisation and its growth the CIFAR index and the share of private activity in GDP are important determinants. In the remaining three cases the CIFAR variable becomes trivial and the private sector share variable weaker. Here, however, it is GDP per capita that is more important, along with the number of exchanges within the domestic market in the case of the two cost variables, as one might expect with competitive pressure. It does therefore appear that the more networked exchanges appear to have lower costs, greater efficiency and greater market capitalisation and growth. This does not of course entail causation and one might well want to argue that the more competitive exchanges will tend to be competitive in both features and price. In a segmented market, it is also not possible to argue that the less networked exchanges will tend to be driven out. Nevertheless, there is considerable prima facie evidence in these results to suggest that there are clear network externalities. This is a rather more positive result than that of Cybo-Ottone et al. (2000, p. 224) who argue that network effects are only relevant ‘after reaching a huge “customer base” ’. These data, however, relate to the period 1996–2000. In the period since then amalgamation and linkages among exchanges have continued to blossom. A subsequent study might therefore be able to derive improved results. As Saloner and Shepard (1995) illustrate with ATMs it is the time path that is crucial in observing network effects.

3.7.1 The problem of access pricing In the main the discussion about the linking of stock exchanges has been dominated by the legal difficulties of operating across borders, regulatory constraints, the problems of technical compatibility and governance. The issue of access pricing which tends to dominate much of the literature on networks more generally has not played such a role, primarily because it has been difficult to set up a network with a common technology, like the wireless telephony network, or the electricity grid, railway or gas pipelines. In the next chapter we discuss in more


detail how such a network approach to the securities market might work, taking the process all the way through to settlement and the CSDs. Here we draw on the work of Shy and Tarkka (2001), because it suggests that in some respects linkages among stock exchanges do not pose quite such difficulties as linkages in other networks. Shy and Tarkka (2001) characterise the market by suggesting that investors have a choice of brokers, who in a divided system are members of one market, whereas assets are of course distributed across all the markets. (They look at the primary market, which makes the analysis rather easier as new issues are normally made on one market, although others can use linkages to them.) As set out in Figure 3.3 an investor

Investors

0

x1

x2

1

Broker 1

Broker 2

Stock Exchange A

Stock Exchange B

θ

(1–θ) Listed Shares

Figure 3.3

The structure of the market


will deal with a broker who can deal with both markets but who will have to pay premium for dealing with the foreign market. In Figure 3.3, there are three groups of investors, those between 0 and x1 who deal with broker 1, those between x2 and 1 who deal with broker 2 and the remainder, who decided not to trade. Typically one market will be bigger than the other and since that will tend both to reduce unit costs and improve liquidity it will tend to mean that the broker in the larger market facer lower fees, some of which he can pass on to the investor. When there is an alliance, the cost of undertaking a foreign transaction will fall, depending on the size of the access fee, but the exchanges can raise their charges to brokers as there is now something more like a single system. In turn the brokers will have more difficulty passing these increased fees on as investors now have more effective choice among brokers as the importance of location falls. Interestingly enough, Shy and Tarkka find that collusion between the two exchanges over the setting of the access fee is likely to be beneficial for overall welfare and indeed that fee is likely to be zero. Indeed the social optimum would involve some degree of cross-subsidy so as to get more of the investors into the market. Under an Efficient Component Pricing Rule (Laffont and Tirole, 1996) the entrant would compensate the incumbent for loss of profit. However, after taking fixed costs into account it appears more efficient for the access fee to be proportional to the entrant’s share of the market. Since alliances are likely to bring down the costs of trading in foreign shares, there should be an overall welfare gain, which will be reflected in the profitability of exchanges. How that gain affects brokers and investors is more contingent. Stock exchanges are crucially different from some other networks as those forming the alliance do not provide services direct to the customer (investor) but to the broker. In some respects this may put pressure on brokers, especially if large investors could in effect deal directly with exchanges. However, brokers may also find they can increasingly match trades without using the exchanges. One effect of the increasing liquidity, lower transaction costs and developing automation may be that there is more convergence between brokers and exchanges, possibly aided by the change in the corporate form of exchanges from ownership by their members to becoming a listed company themselves. Integration is thus likely to alter the nature of competition. Even if exchanges in Europe become very large, as in the US, there will continue to be competitive pressure from off-exchange transactions.

4 Securities Settlement Systems

In the chapter on payment systems, the issue of settlement – the final completion of the transaction to the satisfaction of the parties concerned – was largely deferred, because it is a much more substantive issue in the context of securities transactions. In the case of unidirectional payments, only one transaction has to be completed. However, in the case of securities, the security has to be ‘delivered’ to the purchaser in return for the payment.1 This creates two complications, first the matching of the two legs of the transaction and second that an additional system is required that holds and allocates titles to the securities. The first complication also exists where one payment is made in return for another as for example in currency transactions. The key issue here, however, is that several further layers are required in the transaction process. In the case of non-cash payments, the buyer and seller need to have the payment routed through at least two levels of intermediary, one which holds the buyer’s and seller’s financial claims in some form of an account and the second which transfers the claims from one intermediary to the other, usually in the form of some sort of clearing house, which may be the central bank. In the case of securities at least

1 Some transactions do not involve payments at all but are simple deliveries (FOP, Free of Payment) or delivery versus delivery. A simple example would be the transfer of collateral in response to bond lending or various forms of swaps where securities are exchanged. However, one of the disadvantages of current systems is that this can be difficult to achieve without extensive intermediation as is discussed later in the chapter.

97


four more institutions are added so that the transactions can be taken through the three steps of trading, clearing and settlement:2 • The parties need to have some sort of ‘market’ through which to deal in the securities, although nothing stops people trading directly at some price they find agreeable. • In most cases the parties will need to act through some institution that can trade on that market, although they could act direct. • There normally needs to be some clearing house that sorts out the obligations of the buyers and sellers – this may be in the form of a central counterparty CCP. • There needs to be some registry or central securities depository CSD that holds the titles to the securities and can reassign the titles as a result of the transactions. It is these depositories that will normally provide settlement services. The proviso ‘at least’ applies because there may be various levels of intermediaries; more than one depository may be involved for example. As soon as transactions are cross-border then the complexity is considerably increased. Table 4.1 summarises the six stages that characterise securities trading, clearing and settlement.3 The way in which 2

The terms involved do not always have precisely the same definitions but the following drawn from ECSDA the European Central Securities Depositories Association should prove helpful (CESR/ECB(2004) also has a very helpful glossary): Central Securities Depository (CSD): an entity which holds and administers securities and enables securities transactions to be processed by book entry. (In addition to the safekeeping and administration of securities a CSD may incorporate clearing and settlement functions.) Some CSDs are international, operating across borders (ICSDs). Clearing the process of transmitting, reconciling and, in some cases, confirming payment orders or security transfer instructions prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement. Custodian: an entity, often a bank, which safekeeps and administers financial assets on behalf of others and which may provide various other services. Security Settlement System (SSS): a system which permits the holding and transfer of securities, either free of payment (FOP) or against payment (DvP). It comprises all the institutional arrangements required for the settlement (and sometimes the clearing) of securities trades and the safekeeping of securities. Settlement of securities occurs on securities deposit accounts held with the CSD, ICSD or institution in charge of operating the system. Settlement: an action which discharges obligations in respect of funds or financial transfers between two or more parties. 3 Linton and Starks (2004) suggest an 8-stage breakdown, where the main addition is to separate out the custody function.

Securities Settlement Systems 99

‘buyers’ and ‘sellers’ use these various institutions is affected by their type. We can usefully distinguish between: • The ‘retail’ sector where individuals and small scale investors deal in small parcels of securities through brokers, retail banks and other intermediaries offering generalised services. • The wholesale sector, which is financial institutions trading on their own behalf and on that of clients, including the retail, which they will tend to aggregate, also covering a wide range of instruments including derivatives – such institutions tend to want the more standardised services provided by (I)CSDs. • Large scale international investors, who may be wealthy individuals but are usually institutions of some form, such as pension funds – such investors tend to want the personalised service provided by (global) custodians. There is no particularly neat way in which we can set out the picture of how the parties inter-relate, except at the risk of oversimplifying. Table 4.1

The stages of securities trading, clearing and settlement

Order

The investor (typically an asset manager) instructs the broker to execute the trade

Execution

via some trading system. This could be through an exchange but nowadays a large number of trades are executed via alternative trading systems such as electronic networks.

Matching

The brokers on each side of the trade confirm the various details of the trade (security, quantity, price, arrangements for settlement, etc.); and obtain positive confirmation from the investor (referred to as affirmation) that the trade complies with the original order.

Netting

A considerable reduction in the value and volume of securities trades for settlement can be achieved, by netting off-setting cash and security flows. The maximum potential for netting is when there is a single central counter-party so that all flows can be reduced to a single daily payment and single net amount due for each security.

Clearing

The positioning of securities and the arrangement of payment prior to settlement (the term clearing often also covers matching and netting, but this more restrictive usage is convenient).

Settlement

The final transfer of ownership of securities and corresponding cash payments.

Source: Milne, 2005.


Trading system e.g. equity exchange

1. Buy/sell order

Investor e.g. Asset Manager

Broker/dealer (Investment Bank) 3. Matching (affirmation)

2. Trade 3. Matching (confirmation)

4. Netting 5. Clearance 5. Payment instruction

5. Clearance Custodian

5. Clearance Commercial bank

6. Settlement (delivery report)

Central counterparty 4. Netting Settlement service provider

Bilateral counterparty 2. Trade information flows (those entirely to the right of the dashed vertical line) are omitted from this diagram 4. Netting 5. Clearance

5. Clearance

5. Clearance Central Securities Depository

6. Settlement (delivery instruction)

Figure 4.1 The six stages of a domestic securities trade and the information flows between institutions

The picture that Milne (2005) offers to match Table 4.1, shown here as Figure 4.1, is somewhat daunting. Even by listing only the parties involved on one side of the trade and those through which they have to deal to get through to settlement, there are eight parties and seventeen relationships in Figure 4.1. Completing the picture by including the other side of the trade would add four more parties and at least five more relationships, as we need a second investor, broker, custodian and bank. The top part of Figure 4.1 relating to the trade itself lies outside this so it is assumed that the trading parties have agreed and confirmed what they want to do and the result merely has to be carried through to final settlement. This would also cover over-the-counter (OTC) transactions, whether on Nasdaq and other systems stocks or for bonds and derivatives. The next step down, the netting process, reflects the way in which the number of trades that have to go all the way through to settlement can be reduced by aggregation. Figure 4.1 covers the case where there is a central counterparty, which acts as legal counterparty in all matched trades. While it has no net position of its own, since there is a buyer and a seller in each case, and acts as the means of passing on the necessary information to the institutions involved in settlement it can play an important role in both the netting of trades and reducing the risks. The bottom of Figure 4.1 then sets out the settlement process where the key players are the settlement provider, who organises the process


and the securities depository that actually ‘holds’ the security or rather the list of who the immediate holders of the security are. These settlement providers play a key role as they not only ensure that the desired trades go through, payment is made and the security transferred but they offer other services to clients to make sure that their costs are reduced and trading and stock holding made more efficient. This includes not just managing the cashflow to keep down the demands on the clients’ liquidity but stepping in when something goes wrong with a transaction and either funds or the security are not available at the right time. Effectively this is done by lending in both cases, although the client would need to have collateral or some form of margin to cover it. These settlement providers will normally be the (I)CSDs or (global) custodian banks, so some of the steps shown may take place within the same institutions (or at least between different arms of the same institutional group). The exploration of the structure of costs by Lannoo and Levin (2001) suggests that the ‘extra’ services and not just settlement of each transaction per se make the greater contribution to value added and that this is the area where there is strong competition. The access of non-CSD participants to CSDs so that they can provide the services on a competitive basis is thus an important issue that we shall come back to later. There are two generalised business models in play for covering the framework described by Figure 4.1, both of which exist in Europe at present. The first, exemplified by Deutsche Börse, is to combine the steps of providing the exchange, clearing and settlement. This form of vertical integration is often known as the ‘silo’ approach. The second is to provide each of the steps separately but allow each layer to access different players in the other layers. Thus traders in a particular exchange may have access to different clearing and settlement systems. A clearing house may act for several exchanges and may deal with different CSDs. Thus each layer may have a degree of horizontal integration. These two models are in most senses incompatible. In the silo approach once the choice over where to trade has been made then the trader is locked into a particular system. Insisting that opportunities for competition should exist at various levels is equivalent to rejecting the concept since silos tend to dominate their domestic markets. However, to quite an extent the alternative horizontally integrated system may also involve a substantial degree of locking in, as again exchanges tend to deal with a single settlement system. Until recently opinion has been rather divided on which model is to be preferred but now the view seems to be that if there is to be integra-


tion it should be horizontal rather than vertical as this provides an easier opportunity for competition (Tapking and Yang, 2005). However, if the vertical route prevails then at least access should be permitted to the basic book entry system at pricing on a par with that available internally in the silo (Serifsoy and Weiss, 2005). The European market has historically been strongly divided along national lines, with each country having differences in structure, institutions, legal framework, detailed regulations and technical standards and requirements. This means that many of the European systems are of relatively small scale and relatively inefficient as a result of their protected position. There is thus potentially the scope for considerable gain if these inefficiencies could be reduced let alone if new systems could be adopted that draw on the rapid advances in information and communication technology (ICT). One of our aims in this chapter is to explore the extent of these inefficiencies and hence the potential, drawing primarily on Schmiedel et al. (2002), as it has been little studied elsewhere. Securities clearing and settlement has been described as the most important area of inefficiency in European financial markets (Cruikshank, 2001) so we make that a particular focus. In integrating the European market, the authorities face a difficult task, as favouring one or other system would tend to determine the outcome.4 Genuine continuing competition is likely to be difficult to achieve. Within the member states there is little competition already. Hence in current circumstances the stakes are high with a small number of major systems hoping to dominate the entire market, following the example of the US. In the United States the system is already largely integrated at the exchange, clearing and settlement levels. While there are several exchanges, these tend to be focused on different products and run right across the country, rather than being regional and offering a wide range of products. The process of alliance building and merger in Europe has not got this far. Clearing and settlement is even more concentrated, with the Depository Trust & Clearing Corporation (DTCC), which comprises the main depository, the Depository Trust Company (DTC) and the clearing house, the National Securities Clearing Corporation (NSCC) along with the Fixed Income 4

For a full discussion of the current status of the process of European integration in the area see Koskenkylä (2004), particularly chapter 5, pp. 117–42, by Kirsi Ripatti, ‘Integration of Exchange Operations and Clearing and Settlement Systems’. This covers the measures being taken by the authorities as well as the initiatives in the market.

Securities Settlement Systems 103 Table 4.2

Stock and derivatives exchanges and CSDs in the euro area 2004

Country

Exchanges

CSDs

Austria

Vienna Stock Exchange

OeKB

Belgium

Euronext Brussels

NBB-SSS Euroclear Bank

Finland

OMX exchanges

APK

France

Euronext Paris

Euroclear France

Germany

Deutsche Börse AG Berliner Börse Börse Düsseldorf BÖAG Börsen AG Bayrische Börse AG Börse Stuttgart AG

Clearstream Frankfurt

Greece

Athens Exchange

BOGS CSD SA

Ireland

Irish Stock Exchange

NTMA

Italy

Borsa Italiana S.p.A.

Monte Titoli

Luxembourg

Luxembourg Stock Exchange

Clearstream Luxembourg

Netherlands

Euronext Amsterdam

Euroalear Netherlands

Portugal

Euronext Lisbon

Interbolsa SITEME

Spain*

Barcelona Stock Exchange Bilbao Stock Exchange Stock Exchange of Madrid Valencia Stock Exchange MEFF Renta Variable

Iberclear SCL Bilbao SCL Barcelona SCL Valencia

Source: Schmiedel and Schönberger (2005). * There is a common holding company for the Spanish exchanges, Bolsas y Mercados Españoles (BME).

Clearing Corporation that handles government and mortgage-backed securities, under a common holding company. In Europe, as we noted in Chapter 3, exchanges have consolidated considerably and are now largely national. It is in clearing where the consolidation has been greatest. (Table 4.2 shows the number of exchanges and CSDs in the euro area at the end of 2004.) There are three main players in the European field, Eurex Clearing/Clearstream, which is part of the Deutsche Börse group, LCH-Clearnet, which is part of Euronext, which is combination of the French, Belgian and Dutch markets and LIFFE, the London futures exchange, and lastly OMX, which covers the main Nordic and Baltic markets. The London Stock


Exchange, which is the largest single market currently remains outside these two systems but has considered a merger with Euronext, two attempts at merger with Deutsche Börse having failed. OM has also tried unsuccessfully to come to an agreement with the LSE. The landscape has been changing quite rapidly, so at the time of reading the picture may look different again. It might, for example, have proved a sensible step in global integration for there to be a transatlantic link up. The scope for speculation is considerable. The London Clearing House, LCH, merged with Clearnet, a Euronext subsidiary – joint operations started at the beginning of 2004. After the over-riding official pressure for integration in the EU and the business pressures we have mentioned, the driving force for change is largely technology but it is heavily buttressed by risk management. The framework of the system can continue to change because it is now almost entirely electronic. Securities have been largely ‘dematerialised’ in the sense that they are book entries in an electronic database and owners no longer have paper certificates that establish their title. Given the frequency with which securities change hands, including those involved with monetary policy operations, it would be impossible to operate with a paperbased system. Nevertheless, the structure of the system tends to reflect its paper-based origin with settlement typically being after three days (T + 3, in the industry jargon) rather than in real time as one might expect.5 The authorities seek a system that will operate to a high standard without technical failures so that people can have confidence in it. With a monopoly system it is difficult to devise means of maintaining efficiency and encouraging innovation. Indeed Ripatti (2004, p. 49) argues strongly that ‘[U]nlike trading, competition is not the top priority [for post-trading]: efficiency and risk minimisation rank higher. … attention needs to be paid to preventing infrastructure providers from competing by reducing risk management standards or the transparency of risk allocation. Systematic risk avoidance is the foremost task of [the] post-trading system, and well-designed standards for systems and procedures, accepted by the authorities, are paramount.’ In any case, however much the authorities may want competition it is difficult to see how they achieve it in a coherent manner. As Ripatti goes on to point out there are two opposing problems: 5

Even though settlement is now normally by T+3, much of the process for delivery and payment takes place on the same working day; i.e. T+1 to allow for overnight processing. (There are variations on the timing within the day.) It is the settlement that takes till T+3. Pressure for speeding up the processes and having general standards has been international, led inter alia by the Group of Thirty (2003), which has a study group on the issue.


• ‘competition is usually the principal driver for consolidation’, i.e. what the competitors are trying to do is become the unique European provider; • ‘real competition is difficult in the face of separate jurisdictions, pricing differences and national identity questions’. Thus to have real competition on a continuing basis between rival systems may not be a plausible outlook. Division of markets either by type or jurisdictions into what are largely monopolies although they run across some borders, as is happening at present, may be the longerterm outcome. The principal demand by investors is to see what is described as straight through processing STP. Although there is some variety in understanding what it means in practice, the fundamental idea is that it should be able to initiate buy or sell instructions electronically and for them to then be completed (quickly) without the requirement for any further human interaction. All of the steps from execution through matching, netting, clearing and settlement should be automatic, providing adequate detail about the order and the parties have been input correctly. Currently this is far from the case in cross-border transactions, where many parties have to be involved and extra actions taken, all of which takes time. The clearing and settlement costs per se are normally only a small part of the total (Lannoo and Levin, 2001) and it is what are described as the ‘back office costs’ in handling the transactions which dominate. The more complex the path and the more institutions that have to be involved the higher these costs are likely to be. Nevertheless, we could be reaching the point that a much more revolutionary approach to the structure is possible, making use of the network solutions that have revolutionised some other areas of commerce. Leinonen (2003) has suggested some of the most comprehensive proposals for these changes, so we explore this in some detail. However, automation only takes the system so far, as it will still be the case that a trade may not go through and hence one party my get an exposure that has to be filled by a second trade at whatever happens to be the then prevailing price – what can be described as ‘replacement cost risk’. In a real time system such risks are reduced as a failure would be rapidly recognised and the market is less likely to have moved a long way. The use of central counterparty netting can also help the management of replacement cost risk particularly in periods of sharp price changes. In this chapter we therefore deal with three aspects of this system: • we discuss how the future system in Europe might be organised and develop in the face of changing technology


• we consider the efficiency of the different systems • we discuss the implications for the regulation of the system.

4.1 The future of the European system There is a temptation to look at the simplicity of the clearing and settlement system in the United States, and particularly to look at its costs, and conclude that Europe should go for a single system. ChanelReynaud and Chabert (2005, p. 2) characterise this as: • a unique platform for trading securities (or more realistically several interconnected trading facilities) • a European clearing house for ensuring security of transactions • a central bank in charge of settlement in euro • a European Central Securities Depository managing a unique Securities Settlement System. The next section of this chapter shows that there are major gains to be reaped from exploiting economies of scale. However, getting the European system to look like the US one would involve a major programme of harmonising national markets. Even if the recommendations of the two Giovannini Reports (2001, 2003) for the European Commission, which considered the barriers and how they might be removed, were to be fully implemented this would still fall short of a single unified and centralised European system. The Reports themselves see their work in terms of providing a framework under which consolidation could take place. The ways in which a market where the 15 barriers identified by Giovannini (see Appendix Table 4A.1) have been removed could develop are actually several, of which a single system, at the clearing and settlement stages at any rate, is only one.6 6

Milne (2005) characterises these as: 1. national and proprietary differences in technical standards and procedure for the interface between various security settlement and custodian systems; 2. limitations on investors choice of preferred supplier of different aspects of clearing and settlement services; 3. national differences in the settlement periods, operating hours, and settlement deadlines; 4. differences in the arrangements for the collection of taxes (withholding taxes, capital gains taxes, and stamp-duties) and the granting of tax relief; 5. differences in the legal treatment of securities pledges and bilateral netting.


In this chapter we restrict ourselves to a discussion of post-trade processing. We do not consider the detail of the process of European integration, as this is covered in Koskenkylä (2004), for example, nor the progress of the Lamfalussy process, particularly the work of CESR in assisting the harmonisation and standardisation of European regulation and practices. Milne (2005) argues that it is not necessary to legislate for harmonisation on such a grand scale as the Giovannini Reports (and the Commission in accepting them) foresee. He argues that the key blockage to having a competitive European system lies in having ‘fair access’ to the underlying book entry function of CSDs and competing custodian banks. Such fair access may require accounting separation and a form of ‘access pricing’. We consider this in the last section of the chapter. Leinonen (2003) also argues that the list of what needs to be agreed and harmonised is relatively limited (but crucial) involving technical standards, institutional structure and legal and regulatory requirements. However, he promotes a very specific way of restructuring the processing in the system so as to make it real time or at least T + 0. We therefore consider this specifically in some detail. However, we first explore integration in terms of the existing framework.

4.1.1 Developing the existing framework In the foregoing we followed the normal division of the post-trade process into clearing and settlement. In crude terms, clearing involves sorting out what transactions have to take place and settlement involves actually completing them. If all trades were taken individually then this would be conceptually simpler but in practice, as set out in Table 4.1, it is normal to try to aggregate transactions among the parties and then only settle the net positions. We consider first some issues related to the clearing process and then some to settlement.

4.A The role of central counterparties (CCPs) Although when a trade is executed it is in effect a bargain between the current owner of the security (the seller) and the buyer, in practice the transaction is nowadays usually cleared through a central agency that acts as counterparty to both sides of the transaction. It acts as the buyer with respect to the seller and as the seller with respect to the buyer.7 However, both buyers and sellers are themselves normally

7

Implementing this involves novation as the claims are reassigned.


acting through agencies that have the right to access the central counterparty.8 They cannot trade direct. This means that at each step the parties are able to manage their risks. The initial agent for the buyer or seller faces the risk that their counterparty will not pay/deliver. The central counterparty in turn only faces risks related to a known group of agents on whom it can impose a set of rules to limit the risks. Typically this will involve guarantee funds, margin payments and other forms of insurance. The use of CCPs developed most vigorously in derivatives markets as the exposures can be quite long lasting and hence the risks need to be particularly carefully managed. Although every transaction needs to be completed in full, in practice agents will have transactions on different sides for the same security or both buying and selling contracts with the same counterparty. The ease of transaction, cost of margin and the extent of the exposure can be considerably reduced by netting. The bigger the counterparties the greater the possible extent of the netting. The DTCC in 2004 estimated that around 97 per cent of trades were netted most days. Of course the extent to which netting is possible depends on the interval over which trades are allowed to accumulate before being processed. A real time system would effectively operate gross. Having a CCP enables netting not merely to be bilateral between each pair of agents but multilateral for each agent with respect to all of the others. This offers important cost gains, as well as the reduction in counterparty risk. A further gain of using a CCP (Ripatti, 2004) is that it becomes easier for the beneficial buyers and sellers to remain anonymous as they are no longer transacting directly with each other. By having a string of transactions with the same CCP agents can also manage their liquidity more readily. CCPs have an obvious attraction to regulators as they make the management of the systemic risk more obvious and limit the number of parties that need to be directly supervised in this regard. However, if there is a single counterparty its continued existence and operation are obviously essential to the functioning of the financial system and this will expose the regulator to the possibility of moral hazard. The CCP will know that the authorities will try to keep it going in the event of problems, so in theory it might choose to manage risk, particularly operational risk, a little less closely than if it thought it would bear the full consequences of any problems (Kahn et al., 2003). The practice as opposed to the theory is less clear and may depend in part on the governance structure and hence in the ability of the CCP

8

Even more levels could be involved.


to pass on investment costs to users and get agreement on changes in the first place. If the EU were to move towards a single CCP system as in the US then this would be limiting competition in this regard. However, this is very much the way that markets want to go. Probably the best known example came in foreign exchange transactions with the development of CLS (continuous linked settlement). In foreign exchange transactions, two transactions have to be matched, the delivery of one currency in return for the delivery of the other by the same due date. However, this is payment vs. payment and does not involve delivery versus payment. It is difficult on a bilateral basis to ensure that both payment legs are undertaken together and the parties always face the risk that only one will be completed. With CLS Bank acting as a central counterparty, neither leg is completed until CLS receives the funds. Were one leg to fail the transaction in the other leg is reversed by CLS and the originator does not lose. As in all CCP arrangements the party is exposed to the CCP but the CCPs’ creditworthiness is likely to be much superior to that of any other specific counterparty. Indeed since they are part of the fabric of the financial system it is unlikely that the authorities would allow them to fail, even where, like CLS and the main European CCPs in the securities market, LCH.Clearnet and Eurex Clearing, they are privately owned institutions. LCH.Clearnet and Eurex Clearing are both complex institutions and form a group of organisations offering CCP and other services (Ripatti, 2004). LCH.Clearnet offers CCP services to a variety of markets principally in the UK, France, Belgium, the Netherlands and Portugal. It covers equities, bonds, derivatives and other contracts. Many of the markets are served by different entities although the platforms are becoming increasingly integrated. LCH and Clearnet are not currently planning to form a single clearing house, if only for reasons of legal difficulty, and the UK and French arms are separately incorporated as LCH Clearnet Ltd and LCH Clearnet SA. There has been a match-ing merger between CREST and Euroclear at the settlement stage. Eurex Clearing on the other hand, operating through the ‘silo’ framework acts as the clearing house for the Eurex exchanges in Frankfurt and Zürich (although it also has other linkages including the US). Figure 4.2 gives a brief characterisation of the way the two systems have moved thus far, with consolidation that has taken place in the Finnish system on the left-hand side for comparison. Clearly there are three obvious directions that the system could go in further consolidation as outlined in Figure 4.3. It could stay the same (col. 1). There could be further amalgamation of the clearing framework into a single

110 The Future of Financial Markets Vertical/horizontal consolidation SwedishDer Silo Le Silo Finnish Silo V E R T I C A L C O N S O L I D A T I O N

T r a d i n g

Deutsche Bö rse

Euronext

LSE

Clearnet

LCH

Euroclear

Crest

OMHEX C l e a r i n g

S e t t l e m e n t

Figure 4.2

Eurex Clearing

NCSD Clearstream

HORIZONTAL CONSOLIDATION

Consolidation in European clearing and settlement

Source: Koskenkylä (2004).

system (col. 2). Or there could be amalgamation of the whole of the clearing and settlement systems (col. 3). Column 3 would then look like the US, with multiple markets all entering a single clearing and settlement system (even if parts of the system are effectively separate both in practice and administratively because the markets they address are separate, they are under a common legal group and are technically similar). We have not considered amalgamation of markets as that is neither a reality nor a prospect even in the US. If the model of column 2 were followed, then the interesting question is whether this would meet the network structure envisaged by Milne (2005) in providing a common routing system but still allowing competition among different systems when it comes to settlement and depository services. Views vary on whether horizontal or vertical integration is to be preferred. Tapking and Yang (2005) conclude for example that it is horizontal technical integration that is the greater benefit but that vertical inte-


Model 1.

Model 2.

Exchange

Exchange

Exchange

CCP

CCP

CCP

SSS

SSS

SSS

Model 3.

Exchange Exchange Exchange Exchange Exchange Exchange Exchange Exchange

CCP

SSS

CCP

SSS

SSS SSS

CCP = Central Counterparty SSS = Securities settlement system

Figure 4.3

SSS

SSS

Consolidation models

Source: Bank of Finland

gration is still better than no integration. Until there is serious progress on the removal of legal barriers between various national markets a single CCP is not in prospect. Interim amalgamations on the basis of what is legally possible and practically profitable could actually make moving to ‘optimal’ European structures in the long run more difficult because of the costs sunk in the interim schemes. Iori (2004) provides what appears to be a unique simulation study of systemic risk in securities clearing systems according to the trade-off between waiting so that more netting can be undertaken and processed quickly so that replacement risk can be reduced.9 (Securities lending is not permitted in the model to help reduce the consequences of some of the failures.) While the default rate is higher in the gross settlement 9 Devriese and Mitchell (2005) also consider simulations of systemic risk in a gross settlement system upon the failure of a major participant. Not surprisingly the impact is greater when the number of players is smaller but simply provision of liquidity to try to handle the liquidity risk is insufficient. With T+2 settlement considerable problems can be built up on the settlement rather than the payment leg. While securities lending should help address this, the occurrence of an important failure would greatly reduce the willingness to lend securities. Furthermore with the lag, the market disruption is not contained within a single day but spills over at least as far as T+3, as was the case with September 11, running the risk of a more substantial loss of confidence


system (relatively frequent processing) the knock on (systemic) effects of any given default under netting are much greater. The sensitivity of the netting system depends on how well balanced the holding of shares is at the outset and on the number of different stocks in the market. In an unbalanced system the risk of default rises with the number of stocks whereas it falls in the balanced case. It is thus very difficult to decide which of the two approaches will offer the lower systemic risk as it depends on the structure of the market. A particular issue which has loomed far larger in the past is the importance of the governance system of CCPs. Traditionally they were mutual bodies, owned by many of those who wished to use them. (The actual format of this joint ownership might allow the earning of surpluses that are redistributed among the members.) They were the way the participants in the market had found to develop a robust and mutually acceptable system for handling post-trade clearing. More recently, however, the trend has been to form for-profit companies to do the same job, in which participants may be shareholders. With the merger of LCH and Clearnet it has even been possible to put the two forms together. Both forms of governance pose problems: mutuality because it may be difficult to get enough agreement to change or to find funding to finance investment in new systems. In any case there need to be clear rules permitting new entry under fair conditions so that the incumbents do not freeze out others and exploit their monopoly position. The for-profit approach on the other hand might bear too little regard to the needs of the users (Köppl and Monet, 2005a) and hence increase trading costs. The most common example comes in the allocation of the costs associated with implementing new technology and systems which can be structured to fall more on the user than the shareholders. In a competitive situation they can of course be structured the other way round, as with Deutsche Börse’s ‘capture’ of the bund market from London by offering terminals to clients. However, probably the most important issue, certainly for regulators concerned is how the CCP handles default risk. LCH.Clearnet Ltd for example in the UK uses margin calls from its clearing members for trades to cover the estimated exposure from the member’s failure during the course of trading. The clearing members have to hold an account with a bank that participates in the LCH.Clearnet’s payment system and that bank will use that account to meet the margin calls on the instructions of the member. (The system uses SWIFT.) An initial call is made at the start of the trading day and this may be augmented or reduced during the day in the light of the observed trading. However, there is also a default fund to which the members have to con-


tribute that can help cover any deficiencies if the margin is not sufficient to cover the default. Beyond that it can call on insurance, and its own funds and profits. The FSA as the supervisor is keen to ensure that the margin calculations are satisfactory and also has concerns in its assessment of the strains to the system to look at the knock-on risks that could build up if the failure of one major member reflects simultaneous pressures on the others. In any case there are prior and concurrent requirements for membership which include both adequate capital and operational levels.

4.B Custodians, settlement systems and securities depositories In the structure set out in Figure 4.3 the common matching required is between the exchange and the CSD, where in the absence of cross-listed securities, the exchange and the CSD are in the same country/jurisdiction. An investor from another country then needs to get access to the foreign exchange through an intermediary and have a means of handling the fact that title to the asset resides in the foreign CSD. Where there are cross-listings, then trade is possible on another exchange and there can be a relationship among CSDs to transfer a stock when necessary between them so that there is still a match between the exchange and the CSD even though the stocks were not matched initially. In this case there is now an opportunity for competition and we explore later the framework considered by Kauko (2003; 2004a). However, although the agreements may exist this route is not heavily used, partly because of cost and partly because of legal certainty. In dealing with a CSD it is necessary to use the services of a bank with whom the CSD has an agreement. If we take the example of CREST in the UK this involves some 15 banks (Table 4.3) including the Bank of England as it uses CREST to settle its daily open market operations and hold the collateral provided by it markets counterparties in its RTGS system. If one wanted to deal with a CSD in another country, only a few of the banks in that list could handle the business directly. Normally it would be necessary to use another or a correspondent bank in that country, which had a similar agreement with the other CSD. Indeed the central bank can operate as a correspondent if the transaction is to be routed through TARGET.10

10

The role of central banks in handling cross-border collateral in order assist the liquidity needs of the RTGS payment systems is a notable part of cross-border transactions. Even the US Federal Reserve makes substantial use of its accounts at Euroclear and Clearstream for foreign collateral assets to support discount window lending (Manning and Willison, 2005).

114 The Future of Financial Markets Table 4.3 CREST payment banks and the currencies in which they offer settlement facilities Settlement currency Name Bank of England Bank of Scotland Barclays Bank plc Citibank N.A. Clydesdale Bank Co-operative Bank Deutsche Bank A.G. Lloyds TSB Bank plc HSBC Bank plc NatWest Bank Royal Bank of Scotland Standard Chartered KAS Bank N.V. Bank One N.A. ABN AMRO Bank N.V.

GBP

EUR

USD

✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

✓ ✓ ✓ ✓

✓ ✓ ✓

✓

✓

✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Source: CrestCo.

ICSDs only offer an alternative route in a fairly limited sense. The ICSDs deal primarily in bonds and it is really only in this framework that they are ‘international’. They are heavily involved in the Eurobond market using a variety of currencies (as opposed to bonds denominated in euros offered on a particular national market). Insofar as they handle equities for more than one market, as is the case in Euroclear, for example, at present they operate separately for each jurisdiction though using common platforms and ultimately a ‘single platform’ (legal as opposed to technical mergers, as Tapking and Yang (2005) put it). It is thus perhaps multi-national rather than international in this respect. In trying to move more towards an international framework it is planning Euroclear is intending to move to offering a single operating account that can be used across its markets as part of what it describes as Euroclear Settlement for Euronext-zone Securities (ESES) (Euroclear, 2005). The practice, however, is that this direct handling of securities is difficult and expensive and hence investors tend to use ‘custodians’ as intermediaries. The custodian, normally a bank, performs a range of services for the investor, such as ensuring that the appropriate taxes are paid. To complicate the analysis, CSDs themselves can act as custo-


Global custodians US$bn

Provider JP Morgan Bank of New York State Street Citigroup BNP Paribas Securities Services Mellon Group UBS AG Northern Trust Société Générale Investors Bank and Trust RBC Global Services Credit Suisse Group Brown Brothers Harriman Credit Agricole Group Wachovia BA-CA HVB Group Ixis Investor Services Nordea Bank UniCredito Italiano SpA Banca Intesa PFPC SEB Merchant Banking Dexia Fund Services ING Fortis Bank

Total assets under custody 10154 9859 9497 6640

Cross-border 1897 2761 4405

3397 3259 2652 2600 1518

2728 1019

1470 1355 1232

263 723

1155 1138 996 933 623 608 577 550 462 453 382 375 370

863 373

1000

80 140 300 350

96

Source: globalcustody.net

dians, thus to some extent they are competitors as well as performing complementary functions. There are layers of custodians. It is the subcustodian directly involved with the trading that has the information on the ‘owner’, although the entity that the custodian deals with may also be an intermediary so it can be quite a complex channel to get through to the final beneficial owner. At the other end of the scale is the custodian which deals directly with the CSD. Such custodians can be national in character, dealing with individual markets but increasingly it is the global custodians, who deal across borders who provide the services that help get round the difficulty that investors face in contracting in many different markets. (Table 4.4 sets out the scale of global custody.)


Clearly the actions of the authorities, in encouraging particular approaches to the integration of European securities markets, can have important effects upon the competitive advantage of these different players. The sheer complexity of the current system creates the need for such intermediaries and the reduction in barriers between countries that might permit more horizontal merger or at least close and well functioning linkages has obvious attractions. This is an obvious area where the authorities have to guard against regulatory capture. The issue is extremely technical and the custodians and CSDs will naturally employ the main experts and be the obvious source of advice. There is therefore a strong argument for taking a step back and considering more radical changes, which is what we do in the next section.

4.1.2 A new approach to securities processing infrastructure It is possible to think about the nature of the clearing and settlement system in a different way from the rather institutional one adopted thus far and instead think of it in terms of the structure that would be

Issuer’s registrar 1

Issuers (ISINxx)

Issuers’ service provider Issuers (ISINxx)

Issuers (ISINxx)

Issuers’ service provider

Issuer’s registrar 2

em

Issuer’s registrar n

Central Bank l

em

em

em

Interinstitutional Interinstitutional network network (TCP/IP based (TCP/IP based e.g. SWIFTnet)

System administrator

eg SWIFTnet

Central Bank m em

ee ) ee

Investor’s custodian 1

Investor’s custodian 2

Investor’s custodian p

Asset manager

Investors (ICAN xp IBAN yp)

ee

Investors (ICAN x2 IBAN y2)

ee

Investors (ICAN x1 IBAN y1)

ee

Settling exchange 1 Settling exchange i Guaranteed exchange j Non-guaranteed exchange k

Asset manager

Figure 4.4 The overall structure of the network-based securities processing infrastructure


necessary to enable the system to work in ‘real time’ across all the players that have been described. However, instead of centralising to make everything work through a single hub as in the middle case of Figure 4.3, this could be treated as a network as in Figure 4.4. (This and the rest of the section are drawn from Leinonen (2003), where there are some small differences in terminology from that used thus far.) This approach is many respects driven by two contrasting thoughts. The first is the reaction to what the advances in ICT seem to have been able to achieve in other areas of commerce, including financial markets, by thinking in terms of networks rather than centralised institutions. The second is to question whether it is in fact simply scale that generates the main route to reducing costs, or whether it is automation of the processes, faster and better information and access to specialised services in a highly competitive framework that make the real difference. As Figure 4.4 suggests, we can boil down the system into three sorts of parties who need to be directly linked: • those who hold the register or list of securities, the CSD • those who organise the trading, the exchange • those who hold the securities accounts for investors, custodians. This system, as shown, also involves central banks in order to simplify the security of the payments side of the transaction (where it exists) but clearing bank money could be used instead. However, it needs to be concentrated as far as possible to minimise the demands for liquidity. The linkage among the parties would take the form of a secure internet. In the system each security held by a custodian is uniquely defined with a number ISIN for an omnibus account which is held with whichever CSD registers the security – the security can be moved between CSDs at the request of the issuer. Each investor’s securities account is also uniquely identified by an ICAN (an International Custody Account Number) which would follow exactly the same idea that every bank account can be uniquely identified by an IBAN (International Bank Account Number).11 Clearly this entails a single system and format, as for example in SWIFTnet discussed in Chapter 2. Any transaction would also require a unique number and the message would require a code that enables the parties to establish that all the parts of the transaction have

11

See The European Committee for Banking Standards, www.ecbs.org, for a description. This is an ISO standard 13616 (2003).


been completed (Leinonen describes this as SATC, system audit trail code).12 Clearly new international standards would need to be agreed before such a system were adopted, which will take time. This system enables there to be competition among CSDs and custodians, provided the appropriate legal frameworks exist. Moreover it breaks the links in the silo system we have discussed in the previous sections providing the opportunity to get round the idea of necessary monopolies. It also reduces the need for central counterparties, as being able to access central bank money through the banking system lessens the importance of netting the securities transactions themselves in order to economise on liquidity. While this system could work in real time, where purchasers have to put up the cash up front and sellers the securities, it would also be possible to defer or batch the system so that current trading patterns can be followed and traders can accept buy and sell orders without necessarily having the counterparties to hand at the time. In the same way, if transactions can be accomplished within a particular custodian’s omnibus account then no instruction to the CSD is required. Technology, market pressures and in Europe, in particular, the desire by the authorities to integrate markets are all driving towards rapid change in the post-trade processing system for securities. Modern IT systems are altering the patterns and levels of costs. They are also altering the pattern of risks and not just in operational terms. Simply being able to speed up the process of transaction alters the nature of exposures. If exposures are reduced then the need for hedging is reduced and the cost of transacting is further reduced. In the traditional framework the implication is that increasing the scale of operation reaps considerable economies and that is certainly the message of the next section which looks at the economies of scale in the systems operating over the period 1993–2000. However, these economies can be realised in networks in a different way through the positive externalities of people being able to use the same systems. Standardisation in itself will cut costs and enable smaller scale operators within the network to operate at the frontier of efficiency. The arguments developed in the last section which run against this relate to the advantages of multilateral netting in reducing credit risk and in lowering the requirements for liquidity. In many respect it 12 FOP transactions are clearly less complex than their DvP counterparts and the system would need to record which type of transaction is involved so that it does not look for a payment leg in an FOP transaction (or fail to look for the payment in DvP).


reflects the same sorts of arguments that are advanced in the operation of the payment system but does not necessarily imply the same pattern. Real time gross settlement reduces the credit risk for any individual transaction but it increases the demands on liquidity so that payers may need to wait for incoming transactions. Hence there are demands for netting facilities. Similarly there are differences depending upon the size of the transactions. Batching up the large numbers of low value transactions can make a lot of sense as speed is no longer so important and the net payments required tend to be close to zero. However, the elements of processing cost that are affected by scale per se rather than the complexity of undertaking cross-border transactions are quite small by comparison. Leinonen (2003) argues that there are three dimensions along which any system needs to be evaluated: • time • credit risk • liquidity cost. It is possible to make everybody better off by choosing the optimal timing. However, in the euro area where liquidity is free this is less important than in the US, where it has a cost. In low value, high volume transactions, the gains from netting are reasonably invariant to the length of time interval during the day that is chosen for the process. However, netting requires the existence of gridlock resolution tools as each party may be waiting for the others. By operating at least the first part of the transaction rapidly, it would at least be possible to find out about the problems quickly and correct elementary typing and other mistakes. While there is a clear demand for the cost advantage of second class mail, it is rather more difficult to understand why customers would have much of a preference for a small cost gain for slower securities processing. Leinonen (2003) likens it to the demand for slower email – there is little rationale for any such facility. Rapid processing through to settlement is likely to cut down the need for customer capital. The demand for less than real time processing comes more from the nature of the trading environment. On purely automatic trading platforms it is possible to trade only with immediately matched orders. However, substantial trading is on the basis of an intermediary being prepared to accept an order on one side of the account in the expectation of being able to match it on the other side at some time in the not too distant


future. They are prepared to run the risks involved, particularly the market risk that by the time they make the matching trade the price will have moved adversely. The motivation is rather the opposite, that by exploiting the short run variations in price they may be able to make a small gain on the transaction in addition to their fees. Daily fluctuations can be in either direction, but there may be some opportunities for profit for those who can judge which way the market is moving from the customer transactions in the pipeline. In any case they can hedge to limit their exposures, at a cost. The authorities’ primary concern is two-fold. They wish to ensure that systemic risk is strictly limited so that they can fulfil their objectives of maintaining financial stability and having a financial system in which people have confidence. But they also wish to make sure that the system is efficient and that there are no market ‘failures’. Meeting the first tends to imply having clearly identifiable and substantial providers of the system who can be regulated and supervised effectively so as to ensure the achievement of the objectives. Meeting the second implies having a competitive or at least a contestable environment. A network approach would certainly tend to help achieve the second of these as even small new players could gain entry in a relatively open environment. However, the first looks more difficult as the network approach essentially removes the need for some sort of central body in the clearing system. (The existence of such centralised bodies is still possible within this framework and we go on to explain this later but for the time being we stick to the pure network approach in order to develop the ideas more clearly.) It is the network itself that handles the transactions and looks after the routing of them. In some respects therefore the systemic risks are clearly reduced in the network framework as a problem in one institution could be more localised than one in the central counterparty through which all transactions flow. Indeed in the Devriese and Mitchell (2005) simulations of systemic risk in SSSs the knock-on effects are trivialised if the system is real time. However, it is the rather amorphous nature of the network approach, illustrated in Figure 4.4 by the cloud-like margin to the network that presents a prima facie difficulty to the authorities in ensuring that their job is being undertaken satisfactorily. As the figure shows, in this system, there is central control but not central processing. Each of the parties needs to conform to the standards. In many respects the key element to the system is how one could be convinced that the payment is being made and the securities transferred in an automatic environment. The ingredients for this lie in the


circles containing the letters (ee) and (em), which stand for electronic settlement and electronic monitoring modules respectively. These modules are hardware secured systems (servers) provided by the registrar/ CSD on the one hand for the omnibus securities accounts of the custodians and by the central bank or (‘administrator’ if it is private money that is being used in settlement) on the other. Leinonen suggests these might be viewed as ‘automated branches’ of the registrar/central bank. All of the participants are connected through a secure internet exemplified most obviously by SWIFTnet. These modules enable settlement of both securities and the payments. The registrar and central bank e-settlement modules have a monitoring facility of the actions by the custodians, hence the m in the (em). Thus in the case of SWIFTnet the modules would be connected to the network through the network access platform CBT (customer business terminal). Transactions would then take place through the normal SWIFT messages. The e-settlement modules would work like the attachment of a central bank draft to a paper message in former systems, by adding an encrypted ‘stamp’ to the message which can only be decrypted by another module. These are illustrated graphically in Appendix Figures 4A.1 and 4A.2. Custodians, CSDs and the central bank/source of private money would update their systems as the information comes in. The system is perhaps best explained by example. If we take an FOP transaction initially so as just to focus on the transfer of the security

Sending : CEM

Sending : CUSS

Receiving : CUSS

Receiving : CEM

1: Transfer information 2: E-Settlement stamp

3: Stamped intercustody transfer 4: Validate transfer

5: E-Settlement stamp 6: E-Settlement stamp 7: Stamped transfer confirmation 8: E-Settlement stamp 9: Transfer confirmed

Figure 4.5

The FOP-process between two custodians


(Figure 4.5) we are dealing with simply with a transfer from one custodian to another. Labelling the custodians as CUSS and their e-settlement modules as CEM, we get the sequence as shown in the figure. The sending custodian has to issue the instruction for the security to be transferred. When this instruction is confirmed from the omnibus account at the CSD the message receives the ‘stamp’ and is sent to the other custodian, who then passes it on to its own CSD. When the receipt has been acknowledged this encrypted confirmation is passed back to the original sender and when this is completed the process is complete. The custodians would be responsible for informing the beneficial owners. In case of DvP the payment leg has to be added (Figure 4.6). This means that a third message has to go between the custodians. Message 1 sets up the security transfer, message 2 sets up the confirmation of the security transfer as in the FOP case but now adds the payment transfer. Message 3 confirms the payment transfer, each message containing the appropriate stamps.

Sending : CEM

Sending : CUSS

Receiving : CUSS

1. Debit seller’s securities account

Receiving : CEM

2. Debit buyer’s money account moneyaccount

3: Transfer information 4: E-Settlement stamp 5: Stamped intercustody securities transfer

6: Validate transfer Search for associated payment 7: E-Settlement stamp 8: E-Settlement stamp

10: E-Settlement stamp 11: Transfer and payment confirmed

9: Stamped transfer confirmation and interbank payment 12. Stamped payment confirmation

stamp 13. E-settlemen stamp 14.Overall Overallconfirmation 14. confirmation

15: Credit seller’s seller’s money money account account 16. Credit buyer’s securities securities account account

Figure 4.6

The normal DVP-process between two custodians


As mentioned earlier this exposition covers the case of a completely decentralised system for ease of explanation. If the system is to incorporate current arrangements then it has to cope with the existence of central counterparties. For such a system to work effectively internationally and in real time it is still necessary to agree to the same technical standards. It is merely that the routing of instructions becomes more complex as the trade has to go through the CCP as in part A of Figure 4.7. The decentralised model as described in Figure 4.5 is set out in part B with the three main messages between the two custodians listed. With the CCP the custodians do not converse directly but individually with the CCP. The CCP does the matching of the sellers and

A. Centralised securities transfer with decentralised central bank money Registrar/CSD

Cust. A

Cust. B

Central Bank E-settlement module (CB money)

3.

E-settlement module control procedures

1. Transfer order 4. Payment with e-settlement

2. Payment with e-settlement

E-settlement module (CB money)

Seller’s custodian A

5. Final confirmation

E-settlement module (CB money)

Buyer’s custodian B

B. Completely decentralised model

Central Bank

Registrar/CSD E-settlement module control procedures

E-settlement module (sec. + money) Seller’s custodian A

E-settlement module (sec. + money) 1. Conditional securities transfer 2. Payment, CB-money transfer 3. Final confirmation

Figure 4.7

Decentralised settlement flows

Buyer’s custodian B


buyers, receiving the order to transfer the security from the seller’s custodian for which it pays and receiving the payment from the buyer against which it transfers the security. In his paper Leinonen (2003) covers three other forms of current exchange arrangements, two of which are also labelled in Figure 4.4. The parties may agree their transaction privately, as is common when one major investor buys a block of shares from another. Since this involves significant influence over the company such trades will not be at market prices over an exchange. Secondly one can have trading over an exchange without a central counterparty or guarantee and last the interim case where the clearing processes that provide the guarantees are separate from the SSSs as in the middle case in Figure 4.3. There is no requirement for these systems to be real time. The CCP system illustrated in Figure 4.7 can use deferred net settlement if this is the way the CCP chooses to operate. Thus the CCP can operate with credit limits and with collateralised short positions on various securities if it wishes. In a real time system the securities have to be available for the transaction to be settled, whereas in a deferred system a transaction can be agreed even though the securities need to be acquired at the end of the day. In the same way liquidity has to be available in order to make the payments. On the payments side therefore there will either have to be some form of intraday credit available or more likely some form of pledge or repo-based collateral. The securities used as collateral have to be on the bank’s books and not drawn from the customer accounts with the custodian (unless borrowed with permission). There is a clear distinction between the way deposits are handled on the bank’s books and securities are held on behalf of customers in the custodian function. Leinonen’s work sets out a blueprint of what the new network system could look like and the standards that need to be agreed. Actually getting such a system adopted is a different matter. Agreeing standards is usually a matter for the industry, assisted by regulatory minimum requirements. He assumes that regulators would have to take a leading role for two main reasons. First, because the cost of change involved could be considerable and therefore, as in any network, all participants need to be convinced that the others will also join before they will incur it. Second, there will be losers as well as gainers among the providers and hence there is considerable incentive for the potential losers to drag out the process, particularly if they think that a centralised outcome might eventuate instead with themselves at the centre. As is well known from Akerlof (1970) it is readily possible to achieve a sub-optimal outcome

Table 4.5

Settlement institutions in the sample

Region/code

Settlement institution

Country

CSD/ICSD

Years

Clearstream Luxembourg Euroclear Bank

Luxembourg United Kingdom

ICSD ICSD

1999 1999–2000

APK CrestCo Clearstream Frankfurt Monte Titoli Necigef SegaIntersettle Euroclear France (formerly Sicovam) Danish Securities Centre VPC Verdipapirsentralen

Finland United Kingdom Germany Italy Netherlands Switzerland France Denmark Sweden Norway

CSD CSD CSD CSD CSD CSD/ICSD CSD CSD CSD CSD

1997–2000 1997–2000 1994–2000 1996–2000 1993–1999 1995–1997; 2000 1999–2000 1993–2000 1995–1998 1994–1998

Canadian Depository for Securities Depository Trust & Clearing Company

Canada United States

CSD CSD

1993–2000 1993; 1995–2000

Hong Kong Securities Clearing Company Japan Securities Depository Center

Hong Kong/China Japan

CSD CSD

1993–1998 1996–1998

Europe CED EB Europe (excl. ICDS) APK CRE DBC MON NEC SEG SIC VP VPC VPS North America CDS DTC Asia-Pacific HSC JAS

125


where there are impediments to competition, especially if the costs sunk in the existing system are large enough (David, 1985). We therefore devote the next section of the chapter to the discussion of costs and the final one to the discussion of how regulation might contribute to its more efficient organisation.

4.2 The efficiency of securities settlement system The driving force behind the changes in both the US and Europe thus far has been that increasing the scale of the securities settlement system will generate economies. However, the quantitative evidence to support this is limited, with the exception of Schmiedel et al. (2002), on which this section is based. Using a panel of 16 of the largest depository and settlement service providers in the world for the years 1993 to 2000 (Table 4.5)13 they estimate cost functions that show that a doubling of the scale of the institutions in Europe and Asia-Pacific would only increase costs by two-thirds. In the case of Europe it would be possible to achieve such a doubling not just by increasing current transactions but by amalgamating national systems or developing the international systems. Such cross-border amalgamation seems a much less likely prospect in Asia-Pacific. While the US provides the extreme observations and the basis for assessing the scope for improvement elsewhere, it is difficult to speculate on the scope for gain in the US itself, as this would involve going outside the sample space. Information on costs is hard to come by. Lannoo and Levin (2001) offer one major source of estimates but while use of published data is likely to confound a number of different cost structures (Linton and Starks, 2004) more detailed information is likely to relate to a single time period and therefore still make comparison and inference as to what could be achieved in different circumstances difficult to make. The information shown in Figure 4.8, which is drawn from Linton and Starks (2004) attempts to separate out the costs by the stage in the transaction chain to which it relates. They describe it as a ‘bottom-up’ approach as opposed to the ‘top-down’ approach used by Schmiedel et al. (2002) in Table 4.7, where they take total costs and divide them by the number of transactions to get an idea of average cost per trade. However, even though the Linton and Starks (2004) sample is limited 13 This is, of course only a sample and there some 33 securities settlement systems in the EU alone, more than one for each of the 25 member states, although there are only 20 CSDs.


Recording

Matching

Clearing

Netting

Settlement

US

0.070

0.27

0.013

—

0.019

Switzerland

—

—

0.10

—

0.26

—

0.212

0.31

0.5

0.53

Germany

Italy

—

0.21

0.81

Denmark

UK Figure 4.8

0.12

0.29

0.19

Clearing and settlement costs across the value chain (euros)

Source: Linton and Starks (2004).

to six countries they are still only able to give an impressionistic view. By any count, clearing and settlement costs in the US are clearly below those in Europe, while costs within Europe vary and seem to be affected by the structure of the system. It is immediately obvious from Table 4.6, however, that costs per transaction in securities settlement have been falling over time (col. 1), although not strikingly so. (The mnemonics used for the variables are defined in Appendix Table 4A.1 along with the data sources used in the study.) At the same time income per transaction has not fallen and operating margins appear to have risen. Costs have fallen relative to the value of the securities held, which is not surprising given that the value of securities has risen strikingly over the period, particularly in the US. The subsequent fall in value will have increased the ratio again. However, the costs of each transaction are not strongly affected by the size of the deal and by no means proportionate. The two European ICSDs stand out in terms of cost from all the rest, graphically reflecting the problem that cross-border trading in Europe can be more than 10 times as expensive as the similar domestic transaction. Within Europe, the range of unit costs is of the order of 2, if we exclude the two extreme values. However, since the CSDs are providing

128 The Future of Financial Markets Table 4.6 Average key performance ratios for selected settlement institutions, 1993–2000 Years/ region/ code

OPCOST/ NSETT (%)

1993–1996 1997–2000 1993–2000

OPINC/ OP NSETT MARGIN

OPCOST/ OPINC/ NSETT/ VDEP VDEP VDEP

3.43 3.22 3.33

3.74 3.77 3.75

8.18 14.56 11.39

0.035 0.009 0.022

0.037 0.011 0.024

0.0099 0.0028 0.0063

29.02

35.57

18.41

0.015

0.015

0.0008

53.64

65.79

18.46

0.010

0.012

0.0002

12.81 1.58 3.72 3.93 5.88 6.73 3.15 5.03 5.17 6.43

21.60 2.31 4.39 6.71 5.97 7.80 4.31 6.13 6.47 6.94

40.69 31.37 15.29 41.46 1.54 13.68 26.83 17.97 20.00 7.48

0.077 0.031 0.033 0.060 0.035 0.042 0.029 0.071 0.054 0.141

0.091 0.045 0.041 0.091 0.036 0.050 0.040 0.088 0.067 0.152

0.0044 0.0166 0.0125 0.0097 0.0072 0.0066 0.0099 0.0148 0.0198 0.0196

3.86 3.11 40.54

5.10 3.82 49.61

24.27 18.52 18.29

0.042 0.060 0.013

0.060 0.072 0.017

0.0115 0.0204 0.0004

2.93 2.90

3.12 2.92

6.37 0.80

0.063 0.007

0.067 0.007

0.0236 0.0026

4.42 2.64

7.79 3.22

43.26 18.09

0.100 0.141

0.176 0.150

0.0212 0.0166

Europe (ICSD) Clearstream Luxembourg Euroclear Bank Europe (excl. ICSDs) APK CRE DBC MON NEC SEG SIC VP VPC VPS Europe All excluding ICSDs ICSDs North America CDS DTC Asia-Pacific HSC JAS

Notes: All currency and price-related figures are inflation-adjusted and expressed in US$. OPCOST is operating cost in thousands US$; OPINC is operating income in thousands US$; NSETT is the number of settlement instructions processed in thousands; VDEP is the value of securities deposited in the system in millions of US$.

a variety of services and not a single homogeneous settlement transaction some variety in the costs is to be expected unless each of them provided exactly the same services in the same proportions. If we exclude the ICSDs the average unit costs in Europe are similar to those

Securities Settlement Systems 129 4.5

Cost/value of deposited securities (log)

4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 6.5

7

7.5

8

8.5

9

9.5

10 10.5

11 11.5

12 12.5

Number of settlement instructions (log) Figure 4.9

Cost and volume of settlement instructions, 1993–2000

in the US ($3.11 compared to $2.90) but this is strongly influenced by the UK, which, at $1.58 for the largest European system, has a noticeable effect on the EU average. The prima facie case for economies of scale is strong, both in terms of unit costs as the number of transactions rises (Figure 4.9) and as the value of securities in the depository rises (Figure 4.10). However, to establish the extent to which this is just a function of whether the CSDs are of different types rather than whether CSDs of any given type seem to show economies of scale requires more careful analysis. The way forward used in Schmiedel et al. (2002) is to employ a series of total cost functions along the lines set out in Chapter 3. Here total cost depends upon the outputs of the CSDs, the costs of their inputs and the technology available at the time. Schmeidel et al. assume that this can best be represented by including a a trend or a dummy variable for each year of observation in case the development of technology is rather irregular. They take into account the fact that the ICSDs are clearly different in character from domestic CSDs and identify them with a dummy variable as well. Unfortunately the information available on both outputs and inputs is limited. As shown in Appendix Table 4A.2, it is possible to distinguish both the number of transactions and their value. The number of

130 The Future of Financial Markets –1.5

Cost/value of deposited securities (log)

–2.0 –2.5 –3.0 –3.5 –4.0 –4.5 –5.0 –5.5 25

26

27

28

29

30

31

32

33

Value of deposited securities (log) Figure 4.10

Cost and value of deposited securities, 1993–2000

transactions (NSETT) is quite a reasonable approximation to the settlement services provided by CSDs but it is more difficult to get an idea of the value of ‘depository services’, such as safe-keeping and administration (dividends and interest payments need to go to the beneficial owners). A simple solution would be to assume that these are proportionate to the value of the securities in the depository (VDEP). Obtaining information on other costs from annual reports and other published sources is even more difficult and the most obvious information is to try to get an idea of labour costs. Schmiedel et al. use GDP/ head as a measure although this will include other sources of income and include those not in the labour force. Van Cayseele and Wuyts (2005) are able to obtain a little more information by restricting their sample to (eight) European CSDs (and excluding the two ICSDs), 28 observations in all. This enables them to identify the number of clients/accounts with the CSD. This helps disentangle the number of trades from the amount processing that is likely to be needed given netting and other client based services. Similarly the number of different securities being traded also gives a

Securities Settlement Systems 131 Table 4.7 Intercept NSETT

Costs regressed on output proxies 4.0878*** (9.26)

–1.7455*** (3.35)

0.7189*** (15.17)

VDEP

0.5998*** (23.99)

–0.7885 (1.58)

0.3563 (0.67)

0.2410*** (4.78)

0.3703*** (6.81)

0.4468*** (11.51)

0.3411*** (7.72)

ICSD

1.2452*** (4.22)

Trend

–0.0347* (1.81)

R2-adjusted

0.7510

0.8832

0.9096

0.9266

F-statistics

230.17***

575.56***

383.21***

240.91***

77

77

77

77

N

Notes: Regressions are estimated using OLS panel estimation on pooled settlement institution data for 1993–2000. The dependent variable represents total operating costs. All are log variables. t-values are reported in parentheses. Superscripts ***, **, * indicate significance levels of 1%, 5%, and 10% respectively.

basis for cost as that relates to the services that have to be provided for a particular security – payment of dividends, notification of options, etc. These two are then the ‘output’ variables included their total cost function (which is also trans-log) and not NSETT and VDEP, although these could perhaps be better thought of as scale variables. As is clear from Table 4.7, even in a simple log-linear format the Schmiedel et al. explanation of total costs works quite well. Both NSETT and VDEP have separate effects on costs, although they are clearly also related to each other. Only the trend is a rather weak characterisation. Attempts to use a translog specification including the input cost and cross-product terms (as set out in Chapter 3) improves the explanation slightly in overall terms but leaves most of the individual coefficients rather poorly determined (Table 4.8) – unfortunately a rather common experience in estimating such functions (Mayes, 1996). The input variable appears to work reasonably well. This then gives a basis for estimating the effects of scale, using the two sets of parameter estimates shown in Table 4.8. If we take the second column, as that involves both aspects of CSD activity it is necessary to calculate elasticities with respect to a combination of the two outputs NSETT and VDEP. Following Baumol et al. (1988), Schmiedel et al. assume that a simple linear combination (in logarithms) of the two variables is appro-


Translog cost regressions, 1993–2000

Intercept

68.1059*** (3.40)

91.1888 (1.34)

NSETT

–2.0939 (1.09)

0.9173 (0.20)

VDEP NSETTSQ

–0.6864 (0.20) 0.0449** (2.17)

–0.0393 (0.43)

VDEPSQ

–0.0660 (0.84)

NSETT*VDEP

0.1277 (0.77)

GDPC

–10.7234*** (4.36)

–16.8055* (1.63)

GDPCSQ

0.4740*** (6.62)

0.7205** (2.10)

GDPC*NSETT

0.1936 (0.92)

–0.2273 (0.61)

GDPC*VDEP

0.2391 (0.84)

ICSD

2.8810*** (12.85)

3.1596** (2.36)

TIME

–0.0514*** (2.85)

–0.0522*** (2.98)

R2-adjusted

0.9367

0.9471

F-statistics

161.77***

124.76***

77

77

N

Notes: Regressions are estimated using panel estimation on pooled settlement institution data for 1993–2000. All regressions are OLS estimates. The dependent variable represents total operating costs. All are log variables except for binary variables. t-values are reported in parentheses. Superscripts ***, **, * indicate significance levels of 1%, 5%, and 10% respectively.

priate.14 This then gives a line or ‘ray’ along which the economies of scale can be computed. Given that the form of the translog cost function is

14

The estimated relationship they obtain is: VDEP = 10.913*** + 1.070***NSETT (13.80) *** denotes significance at 1%.

(12.59)

R2 = 0.6475

F = 158.48***


lnTC = α0 + α1 ln Q1 + α2 ln Q2 + β11 (ln Q1)2 + β22 (ln Q2)2 + γ ln GDP + β12 ln Q1 ln Q2 + ∑δk ln GDP ln Qk k + λ1ICSD1 + τ1Trend

(4.1)

where Q1 is NSETT and Q2 VDEP, we can compute the economies of scale S as the reciprocal of the sum of the elasticities with respect to the two outputs at any given point: ∂lnTC 1 = ∑ ∂lnQ (4.2) i S i where

∂lnTC ∂lnQi = αi + 2βii ln Qi + βij ln Qj + δi ln GDP

(4.3)

i = 1,2. Table 4.9 shows the results computed at various points along the ray, where the first three columns show the scale elasticities with respect two NSETT, VDEP and their combination and the last column shows S, the measure of economies of scale. It is immediately apparent that doubling the scale has a much stronger effect on costs with respect to number of transactions than with respect to value of securities held. Second it is clear that the scope for economies of scale diminishes the larger the scale – as is to be expected. In the case of the US the economies are of the order of 1.2 (a 1.2 per cent rise in scale would see costs rise by only

Table 4.9 Decomposition of single- and multi-product scale economies in translog and loglinear model specifications according to size and geographical location1 Category First quartile Second quartile Third quartile Fourth quartile Median Europe, Canada All Excl. ICSD ICSD US Asia-Pacific 1

∂ln TC ∂ln Q1

∂ln TC ∂ln Q2

1/S

S

0.497 0.513 0.555 0.613 0.534 0.525 0.498 0.534 0.694 0.563

0.144 0.185 0.175 0.162 0.180 0.182 0.188 0.180 0.143 0.173

0.640 0.698 0.730 0.775 0.714 0.707 0.686 0.714 0.837 0.736

1.562 1.433 1.370 1.291 1.400 1.414 1.458 1.400 1.194 1.358

Based on median number of settlement instructions processed in each group.


1 per cent).15 In the European context the potential gains are much greater with ratio around 1.4 and approaching 1.6 for the smallest quarter of exchanges. It is noticeable that percentage increase in costs associated with an increase in the value of securities in the depository does not seem to change much with size. These results are quite robust to the form of the total cost function. The log-linear model of Table 4.8, for example, only results in changes in S in the second decimal place. It is hence clear that if the European system could be reconstructed on a scale similar to that of the US that there would be substantial gains, even allowing for the extra costs incurred by ICSDs. It was argued earlier that it is possible to interpret the time trend as representing technological change. We can therefore estimate this effect by differentiating (4.1) with respect to the trend variable, which gives coefficients of the order of –0.04 and –0.05 in Table 4.9. This implies a 4–5 per cent decline in costs each year irrespective of the scale of the CSD. As a final step it is worth comparing the performance of the individual CSDs with the mean values generated by the model, as a measure of relative efficiency (Table 4.10). This done by calculating the residuals from the model regression, which therefore shows performance given the level of outputs and inputs. A more sophisticated approach would be to use the cost frontier technique applied in Chapter 3, as then it would be possible to allow for scale as well. In Table 4.10 the CSDs are referred to by the mnemonics derived in Table 4.5. Column 1 (Model I) is the model shown in column 1 of Table 4.8 and column 2 (Model II) is the model from column 2 of Table 4.8, the principal difference being that the second Model includes both outputs. Thus negative numbers imply that costs are lower than implied by the model and positive ones higher. Given that these values are in logarithms, they represent a substantial range in performance. Clearly one would want to consider whether a given CSD was different from the general run in terms of the services it provided or specific regulatory costs before drawing any conclusions. Nevertheless those with clearly positive outcomes have prima facie some questions they might want to ask themselves about the level of their efficiency. Taking the European market overall it is clear that costs could be substantially reduced if national markets could be amalgamated. However,

15 Given the structure of the data set the US is effectively operating as the least cost benchmark against which the other can be judged.


Code CRE JAS NEC MON VPS VP CDS ECB CED DTC HSC SEG VPC DBC SIC APK

Relative efficiency of individual settlement institutions Model I [1 output, 1 input, trend, ICSD] –0.3068 –0.2943 –0.2807 –0.2117 –0.1500 –0.1440 –0.0060 0.0000 0.0141 0.0272 0.1014 0.1473 0.1894 0.2589 0.3102 0.4658

Code

Model II [2 output, 1 input, trend, ICSD]

NEC CRE MON VP SEG DTC VPS ECB CED CDS JAS VPC DBC HSC SIC APK

–0.2936 –0.2769 –0.1893 –0.1552 –0.0777 –0.0419 –0.0085 0.0000 0.0112 0.0228 0.0744 0.0974 0.1958 0.2071 0.2150 0.5372

Notes: The coefficients reported in this table are calculated as residuals from the models including outputs, input, and binary variables. The scores are listed in descending order according to the relative efficiency levels of the individual settlement institutions.

unless that amalgamation were to be total, the gains from running a number of markets together on a common platform but technically separate because of legal, language and other distinctions might be considerably lower. In particular the gains will be substantially lower if the process of moving between markets is difficult both for the transactor and for the movement of the security. Payments are slowly becoming easier to make across borders within the euro area but it is by no means clear that securities depository is getting as far. Even where linkages exist they are often little used for reasons we explore in the next section. The van Cayseele and Wuyts (2005) results enable these conclusions to be developed a little further. First of all it appears that the minimum efficient scale for number of securities is very large, 25,000. However, the minimum efficient scale for number of clients is only 1,500. Thus prima facie it is more difficult to justify monopoly for custody than it is for settlement. However, the cross product term is also significant and negative, indicating that there are some economies of scope in running the two functions together. The idea of magnitude that they offer is that a CSD with 2,000 clients and 5,000 securities would show


an increase in costs of between 3 per cent and 5 per cent if it were to be separated. It would thus require specific calculations to consider the relative benefits from lower cost of permitting various competitive structures against which the costs of monopoly pricing can be judged.

4.3 The regulation of securities markets There are many issues surrounding the process of reregulation to try to encourage and achieve a genuinely European scale securities clearing and settlement system. The ECB and CESR,16 the Committee of European Securities Regulators have produced a set of 19 standards for the EU, which are in turn based on the CPSS-IOSCO (2001) recommendations for international standards. These relate to ‘safety, soundness and efficiency’ and are in many respects an interim measure pending an EU Directive on the subject (European Commission, 2004). While these standards are intended to help promote ‘efficient structures and market-led responses to development’, ‘cost-effective settlement of [securities trading markets] transactions’, ‘limit and manage systemic risk’, they do not address the sort of detailed technical agreements that would be necessary to integrate systems nor to create the international network foreseen in Section 4.1.2. Of the various concerns the one we focus on here is access. Standard 14 (p. 65) is on that subject: CSDs and CCPs should have objective and publicly disclosed criteria for participation that permit fair and open access. Rules and requirements that restrict access should be aimed at controlling risk. Standard 16 also encourages the move towards STP (straight through processing).17 However, for all the joint committee’s emphasis on competition it has difficulty addressing the primary problem that provision of the

16

ECB/CESR (2004). Access cannot simply be addressed on its own as there are features of the operation of the system that have to be built into the structure of the basic facilities to which there is access. One of the most obvious of these is the levying of taxes by the appropriate national administration, whether in the form of stamp duty on the transaction or withholding tax on some beneficial income. This in itself will encourage an element of tax arbitrage (Milne, 2005) and add to the already heated debate about how to handle tax competition in the EU.

17


book entry function gives an inherent competitive advantage that limits competition in the associated settlement services in which the greater profits and value-added lie. Liquidity tends to be the key issue here (Holthausen and Tapking, 2004). There are positive network externalities from being large. These will apply whether it is a CSD or a custodian who is supplying the services and it is unlikely that anything other than a monopoly will achieve this as multiple systems would have to have links between them.18 The associated services in custody and the associated services that can be provided by a CSD for the company on whose behalf the security is issued do not offer the same externalities. They offer economies of scale and indeed there may be some economies of scope but accepting that network externalities in the settlement system lead to a single provider does not imply that the single provider should have a monopoly position in the services as well (van Cayseele and Wuyts, 2005). However, the fact that they can combine them gives the CSD a competitive advantage but not necessarily one that works to the cost benefit of the other parties.

4.3.1

Access pricing

We noted that access pricing provided the key to many of the problems related to the regulation of networks. Kauko (2004a) points out that there are especially difficult problems in trying to overcome the ability of CSDs to exploit their position to the cost disadvantage of investors. In a cross-border environment a foreign investor always has to go through an indirect route to effect the settlement of the security. The three main choices are: • directly accessing a participant in the foreign market • using a participant in the domestic market and then working through links between CSDs • using an agent (such as a global custodian) who can operate across borders through a local agent.

18 In the Holthausen and Tapking (2004) model the result is never complete monopoly in their competition between a single CSD and a single custodian as investors have different preferences for ancillary services provided. However, the CSD will tend to have a higher market share and be able to exploit its monopoly position as the sole provider of the book entry system by imposing an extra cost on the custodian. It does not however follow that this will necessarily be suboptimal from a welfare point of view as the regulator will want to take wider social costs into account.


The options of dealing with the foreign CSD direct as in the framework set out section 4.1.2 or through the creation of truly international CSDs as with Eurobonds is not an immediate prospect, even if they would be appropriate ways to go. If they were a reality they would give five possible competing channels. As established in section 4.2 it is difficult to resist the argument that the economies of scale exist to such a high level, that the settlement (book entry) function for any security should be concentrated in a single CSD. The problem then is to ensure that this monopoly does not extend to custodial services where the economies of scale become quite small at much lower numbers of clients. Fortunately the issue has now been receiving quite a lot of academic interest in the last couple of years and a coherent set of implications has emerged.19 A fragmented system is likely to be the worst of all possible worlds, particularly with the impediments to competition that exist in the European framework, and will continue to exist even if the Giovannini proposals were to be extensively addressed. The market on its own will not exert sufficient competitive pressures to overcome the legal and technical barriers both because of incumbent advantage and because of the scale of investment required without the guarantee of success. At the other end of the spectrum a completely monopolised and vertically integrated system, although it might make it easier to offer STP, is likely to offer some inefficiencies, even if it reaps all the economies of scale available, as regulatory pressure is likely to be less effective than genuine competition. The most favourable outcomes are likely to come where those parts of the market that are not a natural monopoly are contestable and indeed actively contested – subject to regulation of the monopoly element to ensure openness. If a monopoly is essentially one-sided, with a single provider and many customers, the way it should be dealt with will normally be clearly different from that of a network, where there are not only a range of customers but also a range of suppliers of services that can be provided across the network. The efficiency of the system will depend upon the system of charges in both directions, very much along the lines of the discussion of interchange fees in Chapter 4. It is, however, clear from the discussion of the previous section that it is a nontrivial matter to sort out what the basic book entry costs are for a transaction and what the costs are of providing connection to the system for each

19

See Chabert and El Idrissi (2005)


accredited participant (the ‘membership fee’ so to speak). It is clearly in the interests of the providers to structure the system and their costs in a way which will encourage users to opt for the range of profitable additional services that are necessary for them to manage custody helpfully for clients – rather than obtain the services from other providers. This issue of the role of complementary goods or services in determining the outcome of what is effectively a competitive process of standard setting is well known from other contexts, computer software being an obvious example where there are both Microsoft and AppleMac systems to comply with. Perhaps most importantly, it makes sense to structure the system so that it covers the main activity – within national boundary trading – efficiently rather than the lesser crossborder activity, although in part it is the cost which affects this difference in the level of activity. Much of the argument about which structures may be preferable are based only on theory. While the Giovannini reports outline the barriers that exist they do not quantify them. Some of the papers submitted to their enquiry suggest magnitudes. London Stock Exchange (2002), for example, suggest that in the European market, introducing interoperability among the (seven) existing systems might reduce costs by around 10 per cent, linking the three main systems would reduce costs by a third, whereas having a single settlement system could produce savings of two-thirds. Linton and Starks (2004) seem to be largely alone in trying to sort out what the relative costs might be of the three routes we have just outlined. They do not go on to hazard estimates for these case by case but do emphasise the potential gains from interoperability but argue that the scope remains small until the legal and regulatory barriers addressed by Giovannini (2001, 2003) are reduced. Milne (2005, p. 691) argues (emphasis added) that: Such access pricing regulation is a relatively simple policy intervention. All that is needed is European Union level legislation requiring that securities depositories: • account separately for their basic depository functions, namely book entry changes, distinguishing this functions from all other clearing and settlement services they provide • offering access to book entry to a wide range of market participants, and adhering to widely accepted industry standards so that none of these market participant faces huge problems of access


• imposing a requirement to charge all the same prices and membership fee, on a basis that can be justified as cost recovery, or cost recovery plus reasonable profit margin, on their separated book entry costs. While it is not clear if such a simple approach would be so simple to apply in practice it has the attraction that some of the hard decisions about what structures to approve could be avoided if it succeeds in removing the monopoly advantages which are inherent in the current set up. Milne is very optimistic that if any provider can have access to the securities on an equal basis then it will be possible to let the market decide what the most attractive solution is and indeed allow market forces the role of driving down costs to the lowest achievable levels on a continuing basis. This would mean that the authorities only had to focus on the authorisation of effective access at present and that efforts to achieve harmonisation merely need to focus on the technical provisions as in the work of Leinonen (2003) highlighted in section 4.1.2. Remaining at the theoretical level, Rochet (2005), argues very similarly that vertical integration of a CSD and a custodian bank is likely to reduce competition unless alternative banks are offered a comparable charging structure. If the entry price is considerable then customers will have to pay a margin for using that alternative route. Any improvement in costs through the increased size could be offset for many clients if there is a fixed fee which is kept but lower variable fees in line with the reduced marginal cost. If the regulator is to succeed in reducing the barrier to entry it has to be able to get sufficient information on the detail behind the costing so it can try to determine whether costs are being allocated properly across the two activities. Unless the regulator can cut through the obscurity of internal pricing between the arms of this integrated structure it will have difficulty determining what the correct access fee is to enable competition on an equal basis. If the necessary transparency can be achieved then there is no need to outlaw vertical integration. However, if in the case of an ICSD it has been able to achieve sufficient horizontal and vertical integration, then access pricing may have little role to play because there is too little substitutability among the different routes to settlement. Even if regulators are not able to establish the appropriate starting points for access fees with any accuracy, one way that regulation can go to try to ensure increasing efficiency is evidenced by the ‘CPI–x’ approach devised by OFTEL in the UK. Under that scheme, regulators decide on the minimum quality of service that needs to be provided, in


this case determined by the needs of systemic stability (perhaps by an extension of the standards being applied by the ECB and national regulators under CESR/ECB (2004) ). They then appraise what is thought to be the scope for efficiency gains (x) and set a maximum allowable change in access prices of a measure of the general price level less the estimate of x. Since we are not discussing a consumer product it is not immediately apparent that the CPI (HICP) is the best general price index to act as a normaliser but the principle still applies. The drawback given present circumstances is that detailed regulation of the form this implies is not currently applied at a European level. Both the starting point and the ongoing assessment of the x factor would have to be applied by the relevant national regulator, irrespective of whether we are discussing CSDs or ICSDs. In any case this is a competition issue rather than a purely financial sector issue, so there is scope for discussion over who the relevant regulator should be. As Milne (2005) points out, the vertically integrated CSD will tend to have an advantage over other service providers not simply in terms of any such price distortions that it can introduce but simply to the extent that it can enjoy economies of scope (as discussed in the previous section). Clearly if a degree of national monopoly remains and there is no single CSD then competition is not going to be very effective unless there are common standards in operation as discussed in section 4.1.2. In any case the incumbent advantage will depend upon the extent of switching costs. While a custodian might offer various inducements to attract new customers, subject to careful scrutiny of the risks, the current provider can make exit difficult if a lot of the back office systems have had to be tailored to the particular provider. The more the sunk costs that have to be written off/new systems implemented the greater is the advantage. Without these common communications standards it would be difficult for any external customer or supplier to link in on equal terms because it would have to have systems that were compatible with more than one system, thereby incurring extra costs and being at a competitive disadvantage. It is not that every customer or provider has to be linked in with every other for there to be effective competition. Milne likens it to the airline industry with it hub and spoke structure. These structures are not wheels with a rim or hard boundary. Individual locations can be joined to several hubs which will give several routing choices though not normally a direct connection between one location and another. There is a different way of looking at where the element of contestability could occur. Kauko (2003, 2004a) argues that the point to look


at is the initial competition among CSDs to be the monopoly holder of the register for a given security. If the issuer of the security in the primary market were to be offered a serious competitive choice and if indeed they could subsequently shift the security register from one CSD to another fairly costlessly then perhaps the problems of competition in the secondary market would be offset as the issuer could react to attempts by the CSD to drive up prices in the secondary market by exploiting its monopoly. At present this does not really exist except in some derivatives markets. In most cases a national issuer faces only one CSD. Occasionally there are counter-examples, for example, when a number of Israeli ICT companies issued in the US at the height of the dotcom boom. Large issuers can also crosslist. In general therefore this seems an unlikely route to go and the competition opportunity that concerns regulators is mainly that over choice of settlement provider. While it is relatively easy to explain how legal and technical barriers may inhibit the use of links between CSDs, Kauko (2003) explains why CSDs open such links even if they scarcely use them. If the link exists then it could be used and that in itself makes the secondary market contestable. This means that the CSD’s opportunity to exploit its position in the secondary market is more limited. Its pricing will therefore be more aggressive in the primary market where the opportunity for getting round the national monopoly is more limited. If a CSD can commit itself to allowing more competitive pricing in the secondary market then that will make its services more attractive in the primary market.20 This is because of the network externalities available from increasing the size of the secondary market, which will be assisted by the competitive pricing. Agreeing to have the link to the foreign CSD thus provides the opportunity for foreign investors to trade using their own CSD and the link.21 It is thus a form of commitment device. However, the idea that one might encourage European market integration by insisting that the fee for transactions through the cross20 In the model the outside option for the issuer is to raise debt instead of equity since the CSD has a national monopoly and the issuer cannot exercise foreign markets direct, which is a slight exaggeration of reality but not so much as to negate the point being made. 21 Some other constraints also have to be introduced, one of which is that the fee for transfers between CSDs is fixed per transaction and there is no set up fee for having access nor discount as the number of transactions increases. These simplify the algebra. While their abolition would alter the sharpness of the conclusions the lines of argument would not be affected; the credible threat of competition alters CSDs’ behaviour without the link actually having to be used.


border link should be the same as that for domestic transactions is questioned in Kauko (2004a). Because of domestic monopoly power the domestic CSD could increase its price in the domestic market to cover the extra cost imposed on it for making a loss on the more expensive cross-border operations. This ability will be limited either by the profit-maximising charging structure or by the point at which competitors can open an indirect channel to address the market: If policy makers want to enhance integration of financial markets, they must concentrate on eliminating the fundamental causes of obstacles to cross-border settlement. Encouraging the private sector to develop new ways to bypass barriers that remain basically unchanged may be much less useful. It is always possible that access to a detour is controlled by an institution with monopoly power. The institution could easily benefit from its monopoly position and capture all the benefits from the detour. (p. 742) The model which Kauko uses assumes the existence of oligopoly and with the exception of the role of custodians this might be the best basis for discussion of the likely competitive effects. In this regard, Köppl and Monnet (2005b) suggest that it would in theory be possible to follow a different route for effective competition, as the market is probably big enough to permit two vertically integrated systems to operate. Whereas it looks as if each of the European level players Euronext and Deutsche Börse are monopolising different parts of the market, so they do not compete head on, we could consider the circumstance where they are both compelled by regulators to offer the full range of services for every security, through the equivalent of crosslisting. In this way it would not be necessary to treat the depository/ book entry side as being a ‘natural’ monopoly and insist that different banks could then have equal access to it but to allow duopoly even at that stage. Then there would be a choice. However, this neglects the usual result of duopoly which is for the two players to carve up the market effectively between them and for one to act as the price leader in one subset of markets and the other in the remainder. Even in these circumstances Takping and Yang (2005) suggest that vertical integration within each market, to capture economies of scale might well be preferable to fragmentation. Clearly the greater the importance of cross-border trading ex post and the more the regulatory change encourages that trade the more sensible it is to focus policy on the cross-border rather than the domestic market.

144 The Future of Financial Markets Appendix Table 4A.1 Barriers identified in the Giovannini Reports, ordered by the sequence in which it was recommended they should be tackled (Barrier number) 1. Operating hours and settlement deadlines should be harmonised (7) 2. National differences in the information technology and interfaces used by clearing and settlement providers should be limited via an EU-wide protocol (1) 3. Intra-day settlement finality in all links between settlement systems within the EU should be guaranteed (4) 4. Settlement periods for all systems within the EU should be harmonised (6) 5. National rules relating to corporate actions, beneficial ownership and custody should be harmonised (3) 6. National differences in securities issuance practice should be eliminated (8) 7. All financial intermediaries established within the EU should be allowed to offer withholding agent services in all of the Member States (11) 8. Any provisions requiring that taxes on securities transactions be collected by local systems should be removed (12) 9. There remains a need for a legal framework across the EU under which whenever securities are held using an intermediary, it is the accounts of that intermediary that establish ownership of those securities (13, 14, 15) 10. National restrictions on the location of clearing and settlement and on the location of securities should be removed (2, 9) 11. Practical impediments to remote access to national clearing and settlement systems should be removed (5) 12. Restrictions on the activities of primary dealers and market makers should be removed (10) Drawn from Giovannini (2003, pp. 49–51).

E-settlement module

Receiving custodian InterInterinstitutional institutional network network

Network acc. platf. E-settlement module

customer custody accounts

Network acc. platf.

Custody system

Custody system

customer custody accounts

Sending custodian

STP, network based, end-to-end, all through real-time process

Appendix Figure 4A.1 The e-settlement modules are integrated into the payment and securities processing systems in custodians’ and banks’ systems

Securities Settlement Systems 145 Appendix Table 4A.2

Variable definitions and data sources

Variables

Coefficients

Definition and measurement units

OPINC

TR

Total operating income in US$’000

Annual reports 1993–2000

OPCOST

TC

Total operating cost in US$’000


P1

Gross domestic product per capita in US$’000

IFS Yearbooks

NSETT

Q1

Number of settlement instructions processed in the system in thousands

Annual reports 1993–2000; ECB (various issues) Blue Book; BIS (various issues) Payment statistics

VDEP

Q2

Value of settlement instructions processed in the system in US$mn

Annual reports 1993–2000; ECB (various issues) Blue Book; BIS (various issues) Payment statistics

Sources

Inputs GDPC Outputs

Others TIME

T

Linear time trend variable

YEAR

YR94–00

Dummy variables for the years 1994–2000

ICSD

D1

Binary variable for ICSD = 1, otherwise 0

Receiver’s Transaction envelope Custody Address

Transaction details...


Central Bank e-settlement stamp

End of transaction

Appendix Figure 4A.2 The e-settlement stamp is an encrypted part of the normal transaction messages

5 E-Money: An Addendum

An area where forecasts made 25 years ago, before European financial integration was firmly on the agenda, are rather surprisingly astray, is e-money. With the rapidly rising use of credit cards at the time and the replacement of paper-based giro by ATMs, in Finland at least (see Chapter 2 on payments), one would have expected that notes and coins would be steadily replaced by electronic cards (purses – see Box for a definition) for low value transactions.1 Trial schemes were already being undertaken and the technology for reliable transactions exists and is in use. As it is, although notes and coins in circulation A definition of an electronic purse The key characteristics of an electronic ‘purse’ are that it is a ‘card’, whose value is purchased in advance, that can be used for a range of payments for different goods and services in different outlets for typical everyday small value retail payments that would otherwise have required coins or low denomination notes. A further requirement that is sometimes added to differentiate such cards from debit cards is that the transaction can be completed on the spot between the card and the reader without recourse to a base station to check account information through a telecommunications link.2

1

See Wenninger and Laster (1995) and ECB (1998) for definitions of what constitutes electronic purses and e-money in this context. 2 Strictly speaking they could be any shape or size sufficient to incorporate the electronic chip but there is now a worldwide standard size for cards, although thickness varies a little.

146

E-Money: an Addendum 147

have fallen substantially in most countries compared to nominal income, this is more a result of the rise in the use of credit and debit cards for larger value transactions and the development of secure interest bearing highly liquid alternatives for cash balances. However, in the lowest use countries, such as Finland, the downward trend has ceased and if anything currency use is rising slightly faster than nominal GDP/consumers expenditure. Statistics are distorted somewhat by the introduction of the euro, which resulted in the recall of almost all the legacy currency, the markka, and hence a reduction in the idle hoards of cash, at least temporarily. Some of the recent increase may therefore be a rebuilding, particularly if some cash is being used to evade taxation or complete illegal transactions. Insofar as that is the case, the trend would peter out and the proportion of transactions in currency become more stable or even resume their decline. A similar argument with the same effect is that the decline in inflation to low levels, accompanied by a reduction in real interest rates, has made the holding cost of currency for transaction purposes negligible (Markose and Loke, 2002). Added to this is the increased convenience in being able to get currency without cost from ATMs at any time of day or night and to be able to get ‘cash back’ at supermarkets and elsewhere with debit cards.3 Electronification of transactions has of course blossomed during the period. Use of personal computers, which were only just appearing 25 years ago along with messaging, in both bank giro payments and Internet purchases with credit card accounts, has revolutionised consumer transactions and a similar revolution has taken place in business transactions. However, it is not this side of what can broadly be described as e-money that we are discussing in this chapter but the replacement of notes and coins in small scale transactions. There have been some changes. Single use cards have spread, for public telephones, for example. The combination of the mobile phone and the introduction of the euro killed off the remaining coin-operated public telephone boxes, to continue the Finnish example. There is now very little use of cash in payment for the public transport system in the Helsinki area. Most people, except short-term visitors, use electronic cards that either store a sum of money that can be decremented each 3 It is like a return to the days when it was possible to cash personal cheques for small sums in shops where they knew you. Credit risk aside it actually assisted the retailer by reducing the amount of cash to be taken to the bank or available to be stolen from the till.


time a trip is made or offer unlimited travel for a period of time. However, parking meters and most vending machines were worth converting to take euro coins or notes (and to take credit cards in the higher cost locations). In some other countries (for example, Austria, Netherlands and Switzerland, according to van Hove (2004b) these have become a target for e-money. In many respects cash is rather a nuisance compared with an electronic purse. It is bulkier, cannot be renewed without going to an outlet (except for borrowing from family and friends) it is anonymous so proof of ownership after temporary loss is difficult – a stolen or lost card can be cancelled and replaced at limited cost. It is of course familiar and people may believe that it is more reliable to use in machines. However, one might have thought that some of the familiarity value would have evaporated with the introduction of the euro, indeed there was a small upward step in the usage of e-money in the months either side of the introduction of the new notes and coins (van Hove, 2004b). While casual empiricism suggests that failure to read cards is no more likely than failure to accept coins and notes, there is always the worry that a machine may irrevocably wipe out the entire value of the card or indeed swallow and not return the card. Systems are available that enable cards to be reloaded via a home computer or via a mobile phone, so that it could be done anywhere, although the equipment to do so is not costless.4 Nevertheless, simple practicality from the point of view of the user does not seem enough to explain the outcome. In one sense we should not be surprised how tenacious people can be in holding on to the use of currency. As Capie et al. (2003) point out, even hyperinflation drives people into other media of exchange only partly. Many people still expect that take off to widespread use of e-money is just around the corner. Gormez and Capie (2000) found that 35 per cent of those in the industry thought that e-money would replace notes and coin altogether and a further half expected at least partial replacement (see Figure 5.1). What is more striking is that nearly a quarter thought the replacement would occur within five years (i.e. by 2005) and a further third within 10 years. However, the key reasons advanced for current failure were on the one hand technical difficulty and on the other lack of co-operation by banks. The idea that people 4

A mobile phone itself offers the opportunity for e-payments. A Helsinki travel ticket can be bought over the phone with proof of payment being a screen code that can be shown to anyone inspecting tickets. The capacity of SIM cards is quite sufficient to perform these extra services. We do not however explore this further.


Before 2020 11%

After 2020 17%

Before 2015 17% Before 2005 22%

Before 2010 33%

Figure 5.1

If e-cash can replace CB money, when?

did not want it was not particularly highly rated in this admittedly slanted sample. What is perhaps more surprising is that the e-money innovation has not been more enthusiastically adopted by traders and providers. The threat from theft, for example, is decidedly different. There would be little threat of violence from trying to do the equivalent of robbing the till, although that threat would still exist for the contents of shops. In general the transactions would be largely inward – the shop does not need to carry the equivalent of a float – although there may be the opportunity to reload cards from facilities held by the card provider and there might be scope for refunds. However that would be at the risk of the provider rather than of the retail outlet. There is no need to take cash to the bank or pay a security company to do so. Cards might be stolen or simply fraudulently created but it is not clear how that risk should be balanced against the risk of not recognising counterfeits. The simple handling costs are likely to be lower not just than cash but also than credit or debit cards (or cheques). Except for periodic reloading by the customer and downloading by the merchants into their bank accounts there is no need to include a fourth or further parties such as the payer’s bank. It is not clear how much the stream of transactions rather than simply the balance would need to be recorded. What is missing from this discussion is the investment that is necessary to get the system set up in the first place. While it may be


relatively small from the point of view of the either the merchant or the customer this is unlikely to be true for the provider. Given the lack of success of previous schemes, each new scheme tends to proceed carefully, with pilot testing and measured introduction. Yet the trouble with any such network scheme is that it only works if it is widely used – the ‘chicken and egg problem’ described in Kemppainen (2005).5 The scale of the investment required for success and the likelihood of success given the lack of common standards or a general accepted format may mean that it is relatively unlikely that a successful introduction will take place until the relative costs and benefits change or a general set of standards are agreed. Getting this latter agreement is itself a problem as the current providers have a strong interest in the agreed standard being compatible with their own. The problem does not appear to be simply in the availability of cards. According to van Hove (2004b), coverage in schemes in Austria, Belgium, Germany, Luxembourg and the Netherlands have been between 80 per cent and 100 per cent of households.6 In this chapter we explore why e-money may not (yet) have received widespread acceptance from the point of view of the network economics that has pervaded this book and consider whether there is a role for the authorities to play either at a national or international level. In the discussion thus far we have neglected the interests of the central bank, which may be threefold. In addition to their role in ensuring the efficient and reliable running of the financial system, they are the provider of notes (and sometimes coins) and earn much of their income from doing so – seignorage. Both their balance sheet and their net income would be affected by substantial growth in e-money. Finally there is the question of whether the rise of e-money would have an effect on monetary policy. We consider these aspects in the final section.

5.1 E-money, a network failure? We can approach the usage or rather lack of usage of e-money from two directions. One is to look at the individual case and consider what

5 Markose and Loke (2002) demonstrate that diffusion rates in a network are crucially affected by the proportion of outlets at which the card can be used and the proportion of customers who use or are expected to use the card. Even with only modest rates of decay in enthusiasm, a system can fail in a fairly sparse network. 6 van Hove’s investigation covers 16 major schemes in the EU over the period 1995 to 2002, see Table 5.1.

E-Money: an Addendum 151 Table 5.1

E-money systems in the van Hove (2004b) survey

Scheme

Country

Introduced

Avant Cash CASH Chipknip Danmønt Euro 6000 Geldkarte MEP/PMB miniCASH MINIpay Monedero 4B Moneo Proton Quick Visa Cash

Finland Switzerland Sweden Netherlands Denmark Spain Germany Portugal Luxembourg Italy Spain France Belgium Austria Spain

1997 1997 1997 1996 1993 1997 1996 1995 1999 1997 1996 1997 1996 1996 1996

governs people’s decisions to use or offer e-money facilities for a transaction and the costs and prices that they face and set. The other is to consider penetration of the market as a whole and how the process of general acceptance might develop. What we cannot do is get much in the way of empirical evidence. Van Hove’s (2004b) survey gives only a rather impressionistic view (Table 5.1). Studies of the penetration of debit/credit card usage, while they generate adequate data, really only indicate the direction an argument might run.7 In a survey of 10 OECD countries over the years 1990–1998,8 Markose and Loke (2002), for example, are able to show that cash usage has increased with the fall in the nominal rate of interest on bank deposits, the rise in real consumption, the increase in the number of ATMs and the fall in the cost of ATM transactions. At the same time it has fallen with the increase in EFTPOS terminals and the coverage of cards across merchants. This gives them the following picture: where card and terminal penetration was already high in the early 1990s, cash usage has tended to increase as the ATM cost and interest rate fell, and as consumption rose. In countries where card and terminal penetration was lower but firmly on

7 Work on the introduction of ATMs and other means of changing payment media would also be instructive, Humphrey et al. (1996), for example. 8 The countries are: Belgium, Canada, Denmark, Finland, France, Italy, Portugal, Spain, UK, US.


the rise, this tended to be the dominant factor and cash usage fell. It is quite a large step to try to calibrate the effects of card and terminal increase and loading cost decline for the case of e-money but one can at least infer the directions of the effect and suggest under which conditions each of the parameters would tend to dominate the overall impact. Let us start with the individual case decisions. The usage of e-money at a detailed level depends on the decisions of • customers, • merchants and • the card issuers. The customer can usually pay with currency as that is legal tender, although that may not actually be true at the point of consumption. Pre-payment may be required, or a machine may only take cards. E-money is a possible substitute for low value transactions and debit cards for higher value transactions, as indeed are credit cards. In his book on the economics of network industries Shy (2001) explicitly considers the case of e-money, drawing on a rather wider treatment in Shy and Tarkka (1998). They assume that customers can rank preferences for e-money, currency and debit or charge cards along a spectrum of increasing price of a transaction (Figure 5.2), assuming that they are all on offer, and that this choice is based on the expected cost. These costs relate to what they label • ‘physical’ aspects – time and effort involved – loss of card/cash • monetary aspects – loss from transaction error – interest foregone – transaction fees – initial fees and costs for having the facility. Importantly and realistically, Shy and Tarkka assume there is no charge for undertaking the transaction by any of the available routes. This may not be true in practice if a bank imposes a book entry charge for transactions, which would include those on a debit card but this does not alter the logic of the ranking in Figure 5.2 as debit cards only normally cut in at higher value transactions. A transaction fee would simply increase that initial value. The reason it is important is that the true costs of any particular means of payment are hidden from the customer. As pointed out in Chapter 2, cash handling is quite expensive. Not only do coins and notes have to be designed, tested and minted/

E-Money: an Addendum 153 e-money 0 value of transaction

decided by customer

Figure 5.2

currency

debit cards

decided by merchant

Zones of e-money, currency and debit card use

printed in the first place but they have to be stored securely, distributed, counted, returned to banks and central facilities for quality/ counterfeit checking etc. These costs are recovered from other charges to customers and the seignorage earnings of the monetary authority. This means that the advantages of using currency are inflated in the eyes of the consumer when taking decisions about holding or using it compared to the actual costs involved. These handling costs introduce difficulties into the analysis because some of them are discrete. The frequency of merchant’s trips to the bank will not be so much proportional to the amount of cash as related to working days. Thus if e-money were to drive out cash completely then the cash handling system could be abandoned altogether. When they co-exist, costs may actually be higher even though that co-existence conveys benefits to the parties concerned. Interestingly enough, even without these hidden costs for cash transactions, Shy and Tarkka rank e-money as the least costly medium for customers. Certainly where systems are highly automated for e-money users this will be true as they do not have to join the queue to pay. Shy and Tarkka assume, to make the discussion simpler, that the customer would be holding equal amounts of cash or stored value on the card so that the probability of loss outside the transaction is the same. Of course one might lose only part of the cash if it is not a single note or coin. It would therefore be possible to introduce some differences here. They also assume that the interest foregone is the same.9 The differences lie in the time involved and the loss from transaction error. If it is quicker to 9 It is worth noting that the interest foregone is slightly more complicated depending on the comparator. With a debit card money does not leave the customer’s account until around the time of the transaction, probably the end of that day. Whereas with e-money or currency it depends how long beforehand the card was reloaded or the cash acquired (over the counter, from an ATM or cash back in debit card transaction). With a credit or charge card the money does not leave the account until up to six weeks after the transaction and incurs no interest charges if the account is paid in full by the due date.


use e-money then the changeover to using currency will come at the point that the risk of transaction error exceeds the valuation of the time benefit. These are personal assessments and hence will vary and will depend on the circumstances in the store/sale point and indeed on the customer’s prior e-money and currency holding decisions. Shy and Tarkka (1998) are able to place the onus on the decision about whether to use e-money or currency on the buyer, as they assume that the merchant is not facing a cost in implementing the e-money facility and hence that the choice is actually available. In practice that may not be true. Nevertheless, if the merchant is obliged to take cash, which is more time-consuming for the transaction, and e-money is not associated with greater risks of loss through theft or operational error, then the decision over whether to use currency or e-money will still lie with the customer. However, the choice over whether to use a debit/charge/credit card lies in the hands of the merchant/issuer. Buyers would always use these cards for all transactions given the chance, as they have a lower interest cost, no particular cost of delay and no danger of non-recoverable electronic errors. (The only reasons they could have for not exercising this choice is the wish to remain anonymous and the inability to obtain a card, say because they do not have a bank account.) It is implicit in this discussion that e-money issuers and debit and other card issuers are different entities. In practice electronic purses are usually issued by subsidiaries of banks so the distinction may not hold. In the Finnish case the Avant purse is issued by a joint subsidiary of the main banks, indeed it is a subsidiary of the company that runs the ATM system for these banks. As is common in other countries, Avant is then an additional function that can be added to cards issued by these banks and value can be uploaded onto the card from any of the normal ATMs.10 The amount of equipment needed to run these systems is then more limited both for the customer and the merchant because of this compatibility – in some countries the standard merchant terminal has dual functionality for debit/credit cards and e-money.11 This does not invalidate Shy and Tarkka arguments although it may change some of the parameter values.

10 www.avant.fi. The participant banks charge about 30 eurocents for an upload. Van Hove (2004b) notes that in some countries most people who have the relevant cards do not know that they also have electronic purse capability. 11 This dual functionality exists in Portugal so that while the use of the card fell rapidly the number of terminals with e-money functionality rose steadily.


Debit card issuers tend to have three fees:12 • a fee for the merchant to participate in the scheme, which includes any equipment and processing systems needed, that might vary across merchants • a fee for each transaction that is invariant to the size of the transaction and • a fee that is a percentage of the value of each transaction. Assuming that such discrimination is permitted and the merchant has chosen to install the debit card facility, the merchant will choose whether to accept a debit card for any small transaction according to whether the fixed and percentage fees for a transaction are lower than the combination of time cost of a currency transaction, the risk and the cost of interest foregone. This determines the second point of changeover in Figure 5.2. Since the two changeover points are determined by different people (the customer and the merchant) then the region of use of currency might not exist and a customer might wish to switch directly from e-money to a debit card depending upon the size of the transaction.13 The key issue then from the point of view of the success of e-money is whether the merchant decides to implement the system, given the choice of the customers and the costs imposed by the card issuer. The fee structure decided on by a card issuer will depend upon the market structure. In a competitive industry, the issuer needs to be able to recoup the cost of installation, maintenance, etc. from the merchant. This cost will fall with the number of merchants connected, as the overall cost of having the system is not likely to rise in line with the size of the system but more slowly. Connection costs per merchant

12 We use the short hand ‘debit’ to stand for all three types of debit, charge and credit cards, as the principle is the same. We assume these are unrelated issuers and that we are not discussing store cards or other cards within a group where the having of the card is a sales device quite possibly attracting a loyalty bonus. 13 van Hove (2004b) reports that evidence from Iceland, Denmark and Sweden suggests that debit cards have been so successful in moving the lower boundary of their use to small transactions that there is insufficient window for e-money to flourish. Thus currency survives because it can handle some transactions which e-money cannot and hence although the picture laid out in Figure 5.2 may be correct it is e-money that does not take off. This could be illustrated in Figure 5.3 if the B’B’ curve were to be below instead of above the CC curve for its entire length.


may well not vary much by scale. In a monopoly the issuer can extract all the surplus from the merchant by charging a fixed fee per transaction up to the extent of the cost of the extra time used in currency transactions and a percentage fee up to the risk the merchant perceives from having to hold the currency (theft, etc.). However, such fees need to exceed the connection cost otherwise the issuer is better off if the merchant does not join at all. Given the proportionate element in the fee structure, this means that some merchants with a small turnover will be excluded. Notice that the effective result is the same, whichever the market structure. The merchant will not take the e-money system in the competitive case unless it thinks it can recoup the installation cost that the issuer charges. The issuer will not offer the e-money system to the merchant (at no charge) unless it thinks it can recoup the installation cost from the subsequent fees. The return across the transactions has to cover the installation cost.

D′ B

B′ D

C

B′

C B

e-money e-money

currency

D debit cards

debit cards D′

Figure 5.3

Extent of adoption of e-money

Note: Solid vertical lines show the case where there are three zones and the dashed vertical line one where there are only two and no currency zone.


What matters therefore for e-money to be introduced is the relationship between the number of buyers per merchant willing to use e-money according to the value of the transaction (BB in Figure 5.3) and the cost of installing the system compared to the cost to the merchant of a currency transaction (CC in Figure 5.3). If BB is too low/CC is too high, then e-money will not be introduced. This is the case illustrated by B’B’ in the Figure. If the value at which debit card use becomes viable, shown here by the DD lines, is before that where currency becomes viable (as shown by D’D’) then currency would be squeezed out. Of course the relationships may be more complex and Shy and Tarkka (1998) show a case where BB is U-shaped, which results in there being more than one zone in which e-money is used. We have also discussed the case where e-money could be squeezed out, as van Hove (2004b) suggests has been the case in Iceland, Denmark and Sweden, because the debit card lower limit is so low that the demand for e-money use is insufficient for the BB curve ever to be above the CC curve. In this case, shown in Shy and Tarkka’s Figure 5, there is only currency and debit cards and even though e-money might be cheaper in terms of marginal cost for low value transactions, the market is too small to outweigh the spreading of the set up and other fixed costs. This would be a little surprising if e-money were to be part of dual use card and reader systems. But if the debit card system is run off-line, at least for small transactions, this might result in debit cards being sufficiently close to e-money in practice that having the separate e-money function is not worthwhile. Van Hove’s (2004b) survey suggests that e-money may be failing for a number of different reasons. In the Nordic countries it may not offer sufficient advantage over other electronic means of payment. To take a simple example: to pay by cash in many carparks you need to insert your ticket in a payment machine, pay, collect the change and the reprogrammed/printed ticket and then reinsert it in the machine by the barrier to be allowed out. If you pay by debit card on the other hand you simply insert the ticket in the machine at the barrier, then the debit card, and after that remove the debit card and the reprinted ticket to exit. This tends to be simpler than cash although it would not be quite as efficient as using a proximity reader for an e-purse. In the ‘Mediterranean’ countries on the other hand, it may be that there is insufficient willingness to use electronic methods of payment per se so that e-money (along with debit, credit and charge cards) does not have a large enough market to be viable. Lastly, in the intermediate cases, the difference in success may be due to the network externalities avail-


able in the way the schemes have been introduced. Thus those with a good coverage of outlets in a given area may be more successful than those introduced more widely with a large card issue but no corresponding concentration of points of use. Apparently, parking meters, vending machines and public transport have all proved fairly attractive locations, particularly where there is no opportunity for change and exact money is required in unmanned locations. Austrian, Dutch and Swiss systems are cited in this regard. Clearly if, as in Finland or with SNCF in France or the London underground, a specific pre-paid card system is in use successfully already then a more comprehensive e-purse will find it more difficult to break into the market.

5.2 A regulatory need? From the foregoing it seems clear that while e-money might well be a cost efficient means of payment in many advanced economies, particularly in urban areas, various factors combine in the market to inhibit its successful introduction at present. The question at issue is whether this constitutes a market failure that is worthy of action by the authorities or whether it is just a reality which means that this particular improvement in efficiency is not cost effective. The usual lines of argument advanced for regulatory intervention are problems in agreeing standards or distortions in the competitive environment. Not surprisingly, over half of the respondents from the industry covered in the Gormez and Capie (2000) interviews wanted the authorities to make their regulatory position clear up front and did not want them to operate in ‘reactive’ mode. Clearly no operator would want to make all the investment and then find that the authorities destroy its competitive position. The most obvious area in which this could occur would be if e-money issuance were restricted to banks. The early expectation was that several network operators with large customer bases, such as telephone and transport companies might be able to produce cards that were usable for their own products and for a range of other suppliers/outlets. However, the practice, as revealed in the van Hove (2004b) survey, is that banks and other financial service providers have been heavily involved, particularly where the e-money functionality can be added to existing cards and terminals. It now seems relatively unlikely that banks will find e-money a serious source of external competition. This is supported by a lack of enthusiasm by the ECB for non-bank (i.e. non-credit insti-

E-Money: an Addendum 159 Table 5.2

Main obstacles for e-cash to replace CB money

Obstacle

Percentage citing

Technical Infrastructure

47

Interoperability

41

Costs and Profitability for Issuers

31

Security

25

Critical Mass of Customers

25

Cross Border Issues

23

Privacy

22

Legal Framework

19

Costs for the Customers

17

Others

17

tution) participation.14 The Report on Electronic Money (ECB, 1998) was one of the ECB’s earliest publications.15 The respondents in Gormez and Capie (2000) did, however, suggest that co-operation (or rather its lack) with banks was an important inhibiting factor. Unfortunately the survey only asked about technical barriers in an indirect manner. Problems of inter-operability were remarked on by only 40 per cent of respondents (Table 5.2). In one sense this is not surprising because most of the current schemes are

14 15

This was no surprise as the EMI (1994) had come to the same conclusion. ECB (1998) imposes seven main requirements on e-money issuers: 1. they must be subject to prudential supervision; 2. the rights and obligations of the participants must be clearly defined and disclosed, and enforceable in law; 3. they must maintain adequate technical, organisational and procedural safeguards to prevent, contain and detect threats to the security of the scheme (particularly counterfeiting); 4. they must be protected against criminal abuse, particularly moneylaundering; 5. they must supply all the necessary monetary statistics required by central banks; 6. they must be legally obliged to redeem all e-money against central bank money on demand by the holder; 7. they must be open to the imposition of reserve requirements by central banks.


national and not international. However, that in itself could imply that the cross-border barriers are prohibitive (less than 25 per cent of respondents remarked on the existence of cross-border barriers as being important). This lack of concern for the cross-border aspect may to some extent reflect the introductory state of the product, as its main competitor, the euro, is most clearly a cross-border payment medium – a clear advantage for small scale transactions. It depends very much on location whether international tourism/business travel is a significant source of small scale payments. Secondly, since there is little if any competition among schemes but competition with different payment media, inter-operability is of limited importance. In any case with multi-function cards and readers it is already achieved. It is more difficult to say whether the structure of the rest of the payment system inhibits the introduction of e-money unduly. There is a clear case made in Chapter 2 that currency transactions are subsidised and that this presents a considerable barrier to other low value payment media. If the fee for the main competitor is zero, then e-money either has to be provided at the same price and offer more helpful features or be offered at a subsidy. In practice this is precisely what is done with transport pre-payment cards. The per trip ticket cost is less than the cash payment on the spot. Indeed with season tickets there has long16 been an incentive to buy in advance that considerably exceeds the value to the company of the interest-free loan that it entails and ignores the saving in time that the passenger has in not having to queue for a ticket every day. It does not, however, ignore the gain to the company from the reduced need to employ staff at peak times and from the reduced threat to lone employees from violence in the course of theft. It is perhaps worth addressing a final remark to the conflict of interest facing the central bank as the regulator of e-money and the provider of currency from which it derives much of its income. (Aspirant) e-money providers might be forgiven for thinking that central banks have an incentive to stack the deck against them. However, as institutions in the public eye central banks have to be very transparent about how they balance functions. Some like the Bank of Finland have sought to exit as much of the ‘manufacturing’ side of currency production and distribution as possible and hand it over to private companies

16

No doubt railway buffs will enjoy finding out exact dates but season tickets became the norm on commuter railways into London in the second half of the nineteenth century.


and the banks, and pay them for the services provided. In this way both services can be provided competitively rather than through public monopoly and, it is hoped, at better value for money for the user. At the very least careful separation of functions and identification of costs is required. It is, however, the income side where the main conflict lies, as seignorage provides the main income even in a low inflation environment. This would have to be supplemented from other sources but the quid pro quo of insisting on value for money and requiring central bank budgets to be highly scrutinised like the rest of the public sector, subject to maintaining the integrity of the independence of monetary from detailed government intervention would be widely welcomed. The harsher question, rebutted firmly by Goodhart (2000) inter alia, is that if e-money in all its forms were to dominate, the central bank might find itself unable to run a coherent monetary policy because it loses its hold over financial markets. This is of course a step far beyond small value transactions no longer requiring notes and coins. It could apply in the world of electronic payment and settlement where central bank money was no longer thought necessary. But that would imply that central banks with their recourse to the taxpayer could not create both the extra credibility and the specially secure assets that markets would want. They would still be able to influence interest rates by open market operations in these instruments – without needing to go as far as transacting directly in private sector securities (Mayes and Toporowski, forthcoming). Seeing notes and coins disappear for many small transactions would not impose sufficient pressure on central banks to lead them to outlaw such innovations. However, as Goodhart (2000) points out in the same article, it would highlight the use of currency for transactions where people wished to remain anonymous, which is the area the main central banks would wish to avoid, as many such transactions might be of doubtful legality. They are already subject to heavy restraint through anti-money laundering techniques. What a central bank certainly is concerned with, as reflected in ECB (1998), is that whatever is used as money in the bulk of transactions has to be as reliable and secure from counterfeiting as currency. The requirement for retaining confidence in the financial system extends to all aspects of the system of payment including the medium. Any collapse in an e-money system that had replaced currency in small scale transactions would have a disastrous effect on the economy. Central banks need to be convinced that e-money does not increase the risk. It is not clear that the private sector would necessarily reflect that particular social cost and so a clear hand of regulation can be


expected in this field. As Goodhart points out, those who are hoping for e-money to be a road to a modern form of free banking will be disappointed.

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163

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Index access, 6 pricing, 57, 94–6, 137–43 affirmation, 99 alliances, 85, 87, 96 allocative efficiency, 33 inefficiency, 63 anti-money laundering, 161 automated clearing house (ACH), 20, 28, 36, 40, 51 ATM, 16, 19, 94, 142–3, 150–1, 154 Avant, 154 back office costs, 105 bank failure, xi Bank of Finland, x, xii, xiv, 13, 52–3, 160 barrier to entry, 140, 144 barter, 14 Basel 2, xi, 7 benchmark, 13, 88 best practice, 13, 76 bond lending, 97 book entry, 137, 139, 143 brokers, 95–6 Bund, 50 bundling, 53 burden sharing, 55 cash, 2, 11, 16–17, 147, 149, 151 handling, 152 caution, 49 central bank, 160–1: money, 43, 45, 159, 161 counterparty (CCP), 7–9, 98–100, 107–16, 118: netting, 105 securities depository (CSD), 7–9, 98, 101, 107, 117, 135–42 CES function, 64 CHAPS, 154 charge card, 21, 153

cheque, 15, 17, 38, 49, 147 processing, 33 CHIPS, 26–7 CIFAR, 91, 94 clearing, 18, 98, 99 house, 43, 97–8, 101 Clearnet, 110, 112 Clearstream, 110, 113 Cobb–Douglas, 64, 82 collateral, 46, 56, 124 collusion, 96 Commission, 53 commitment device, 142 Committee of European Banking Supervisors (CEBS), xi Securities Regulators (CESR), 107, 136 common standards, 150 competition, 8, 41, 48, 52, 57–8, 71, 79, 104, 141, 143, 160 for the market, 53 in the market, 53 complementarity, 139 concentration, 70, 93 connection, 42, 138 costs, 155 contestability, 120, 138, 141 Continuous Linked Settlement (CLS), 1, 28, 42, 109 net settlement (CNS), 23, 41 corporate governance, x, 61 correspondent bank, 18, 156 cost, 126–7, 129 efficiency, 158 frontier, 134 function, 63 recovery, 34, 37, 41, 58, 140 cost–benefit analysis, 3 counterfeit, 149 counterparty, 7, 109 Court of Auditors, 58 CPI-x, 140

171

172 Index Credeuro, 31 credit cards, 11, 20–1, 44, 48, 147, 152 risk, 22, 34, 57, 118, 147 CREST, 109 CrestCo, xv cross -border transactions, 12 listing, 142–3 Cruikshank Review, 51 currency, 152 conversion, 48 custodian, 98, 99, 117, 124, 137, 141, 143 banks, 8, 101, 140 custody, 8, 137 customer business terminal, 121 data envelopment analysis, 60, 66–9, 84 debit cards, 11, 21, 147, 152–3, 155–7 deferred net settlement (DNS), 22, 57, 124 delivery, 97 versus payment (DvP), 98, 109, 122 dematerialisation, 9, 104 demutualisation, 71 Deposit Insurance Directive, xi Depository Trust & Clearing Corporation (DTCC), 102, 108 Company (DTC), 102 derivatives, 78, 80, 87, 89, 142 Deutsche Börse, 50, 101, 103, 110, 112, 143 diffusion, 150 direct debits, 31, 45 dividends, 61 duopoly, 143 economies of scale, 3, 8, 10, 55, 57, 60, 71, 85, 118, 129, 132–3, 137–8 scope, 135, 137 Efficient Component Pricing rule, 96 efficiency, 12, 33–42, 58 EFTPOS, 22, 151

electronic cards, 146 monitoring module, 121 payment, 2 purse, 146, 148, 158 settlement, 121 EMEAP, 18, 34 e-money, 2, 11, 16, 50–1, 146, 162 encryption, 14, 45 ePayment Systems Observatory, 53 e-settlement, 45–6, 144 stamp, 145 Estonia, 10 Eurex, 4, 103 Clearing, 109–10 euro introduction of, xi, 1–2, 147–8 EURO1, 28, 30, 57 Eurobond, 111, 133 ???? Euroclear, 109–10, 113–14 Settlement for Euronext-zone Securities (ESES), 114 eurogiro, 28 Euronext, 88–9, 110, 143 European Central: Bank (ECB), xv, 53–4, 136, 158–9; Securities Depositories Association (ECSDA), 93 integration, xi Payments Council (EPC), 31 System of Central Banks (ESCB), 54, 57–8 Eurosystem, 31 execution, 99 exponential distribution, 64 externalities, 7, 137 failure, 56 Federal Reserve, 51, 113 Fedwire, 26–7, 57 fees, 155–6, 160 structure, 43 FIN, 29 finality, 23 financial stability, x, xii, 6 Finland, xii, 15, 146–7, 154 first mover advantage, 43 four eyes principle, 44 fraud, 21

Index 173 free banking, 162 of payment (FOP), 98, 118, 121 ride, 50, 55 frontier, 63–4, 68, 118 functionality, 57 Giovannini Reports, 106–07, 138, 144 giro, 18 Global custodian, 137 Custody, xv globalisation, xi governance, xii, 4, 50, 87, 112 structure, 108 gridlock, 24, 34, 56 resolution, 119 guarantee funds, 108 handling cost, 149, 153 hedging, 118, 120 home bias, 9 Hong Kong, 52 Monetary Authority (HKMA), 52 horizontal integration, 8, 101, 140 merger, 116 ICSD, 114, 127, 129, 134 imaging, 49 implicit merger, 89 inertia, 51 information and communications technology (ICT), xii, 13 infrastructure, 52 innovation, 12 insolvency, xi installation cost, 156 Interbank Convention on Payments (ICP), 31 payments, 19 International Bank Account Number (IBAN), 44, 117 Custody Account Number (ICAN), 117 Internet, 4, 8, 9, 13, 16, 19, 29, 42, 47, 54, 147 interoperability, 139, 159–60

Interpay, 51 intraday credit, 124 investment 150 Irish bank strike, 2 ISIN, 117 Lamfalussy principles, 7 process, 107 LCH.Clearnet, 103, 109 lending, 101 LIFFE, 4, 50, 89, 103 linear homogeneity, 66 linkages, 95 liquidity, 22, 34, 43, 46, 56, 117–18, 137 listing, 61–2, 87 London Clearing House (LCH), 104, 110, 112 Stock Exchange (LSE), 63, 89, 103–4, 110 loyalty bonus, 155 Malmquist index, 66–8, 84–6 margin payments, 108 marginal cost, 140 market capitalisation, 91 discipline, x failure, 51, 120, 158 makers, 7 risk, 120 matching, 99 membership fee, 139–40 merchant, 154–56 mergers, 60, 71, 80, 85, 87 messaging, 43 minimum efficient scale, 135 mobile communications, 47 phone, 148 monetary policy, 56, 161 monopoly, 137 moral hazard, 56, 108 multi-function card, 160 multilateral netting, 118 mutual fund, 48 mutuality, 62, 112

174 Index NASDAQ, 71, 88 National Securities Clearing Corporation (NSCC), 102 netting, 22, 41, 47, 56, 99, 108, 112, 119, 130 network, xiii, 20, 42, 46, 48, 117, 118, 124, 138, 150 effects, 51, 88–96 externalities, xii, 91, 94, 142, 157 failure, 150–58 industries, 1, 58 New Zealand, x, 57 non-parametric, 63 Nordea, xi Nordic banking crises, x–xi Norges Bank, 57 Norway, xi NYSE, 71 OM, 89 omnibus account, 118 OMX, 10, 89, 103, 110 open access, 55 market operations, 161 outcry, 62 operational risk, 108 order, 99 over the counter (OTC), 100 ownership, 71, 87 structure, 82 pan-European ACH (PE-ACH), 28 Pankkiverkko, 42 parametric approaches, 63 path dependence, 49 payment and settlement system simulator (BOF-PSS2), 13, 47, 56 systems, 3, 12–59, 160 versus payment, 109 performance contract, 57 ratio, 128 PIN-code, 19–20 point of sale, 15 POPS, 13

positive externalities, 118 network externality, 137 post office giro, 48 trade processing, 118 primary market, 142 production function, 63–4 profitability, 71, 87 proximity reader, 157 prudential supervision, 159 public benefit, 50, 58 disclosure, x key infrastructure, 44 queuing, 41 real time gross settlement (RTGS), 3, 6, 22, 27, 38, 40, 42, 46–7, 57, 119, 159 RTGSplus, 23 regulation, 49–59, 87–8, 136–43, 158–62 regulatory arbitrage, x remote access, 70 replacement cost risk, 105 repo, 124 Reserve Bank of New Zealand, 6 revenue efficiency, 78 risk, x management, xi Rivlin Committee, 51 safeguards, 159 scale inefficiency, 63 secondary market, 62, 142 secure internet, 117 securities lending, 111 markets, 3–4 settlement, 8 securities depositories, 113–16 security, 43, 49 seignorage, 150, 153 service provider, 43 settlement, 8, 98, 99 provider, 100–01 systems, 97–145

Index 175 SIC, 28 silo, 8, 101, 109–10, 118 SIM card, 148 Single European Payments Area (SEPA), 1 Shared Platform (SSP), 41 social costs, 53 solvency, 56 stability, 49 Stackelberg leader, 57 stamp duty, 136 stamping, 45, 122 standards, xii, 31, 51–3, 58, 106, 124, 141 STEP1, 28–9 STEP2, 30 stochastic frontier analysis, 60 stock exchanges, 60, 113 markets, 60–96 store card, 21 straight through processing (STP), 30, 45, 105, 136 sub-custodian, 115 subsidies, 4, 58–9 sunk costs, 141 swaps, 197 SWIFT, 30–31, 112, 121 SWIFTNet, 29, 42–4, 117, 121, switching cost, 53, 141, 158 system audit trail code (SATC), 118 systemic risk, xi, 9, 41, 49, 111, 112, 120

TARGET, 3, 6, 26–7, 29, 41, 54, 113 TARGET2, 44, 49, 57 tax arbitrage, 136 technical efficiency, 60–96 inefficiency, 63, 77 technological change, xii, 1, 68, 84–5 Thailand, 38 theft, 149 TIPANET, 27 title, 113 too big to fail, 7 traders, 61 trading, 87 hours, 79 platform, 62 transactions, 4, 14, 35 cost, 94 fee, 152 translog, 64, 131 cost function, 76, 132 frontier cost functions, 69 revenue function, 61 transparency, 140 truncated normal distribution, 64 turnover, 71 unit cost, 35, 39 UK, 51 US, 49, 51, 102, 134 venture capital, 9 vertical integration, 140, 143 withholding tax, 136

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