Jusletter IT

The aim of this paper is to analyze currently very often used area of securities settlement systems on capital market from the perspective of contemporary Czech law and also the law of the European Union with regard to practical examples of existing legal institutes. Securities settlement systems serve historically for ex post settlement of trades on capital market. The need for these systems was given because of complicated nature of these trades – it is needed to transfer the property rights to securities and money at the same time and the nature of legal relations regarding securities is often very complex. The European-wide legal regulation of securities settlement is very similar among states partly according to the directives unifying the regulation and partly according to natural evolution of European countries' legal systems.

Trades with securities are trades having securities as the object of the transaction when the ownership to security or more securities is transferred from one person to another. Usual subjects are buyer who has extra money and demand of security and seller that has extra security and demand of money.

Trades on capital market are in the most general way divided to the trades on regulated market,¹ trades in multilateral market system,² trades on commodity exchanges,³ and trades executed outside organized market (so called OTC – over the counter – trades that are typical for collective investment securities, bills of exchange traded by private individuals and trades with documentary au porteur securities). Trades on capital market include three basic groups: trades with shares, trades with bonds and trades with other securities or investment instruments.⁴

The object of the settlement is mutual claims and obligations between participants of the trade – that is between buyer and seller. The process of settlement consists of clearance of claims and obligations forming object of the settlement. The settlement of capital market trades is one of basic subsystems of the capital market.⁵ Trades on capital market are contracted in real time during the stock exchange day. Stock exchange day is only working day, it does not include state holidays nor free days nor weekend days.

Securities settlement systems' purpose is to settle mutual claims and obligations from the trades with investment instruments (especially from securities but not limited to) in book-entry form.⁶ ‏

Besides being an electronic based information system the securities settlement system is a legal subject executing securities settlements on a market or on more markets. It has legal regime of particular state. For example legal the relations coming from the participation in the securities settlement system operated according to the Czech law must be regulated by the Czech law – even when the participants are subjects having the official seat in the another country.⁷

Securities settlement system must have at least three participants making actions in their names, number of participants making actions on behalf of other persons is not limited.⁸

Securities settlement system must be operated with professional care – this duty is in accordance with general commercial law principles of duties during the execution of entrepreneurial activity.

In the Czech Republic main act regulating securities settlement is the Act on Business Activities on Capital Market No. 256/2004 Sb. as amended.⁹ Securities settlement is regulated along with the regulation of investment instruments (including securities) registration for instruments in book-entry form. General regulation on regulated market, multilateral trading system, public offering of securities is also applied.

Main reason for securities settlement existence is to assure clear executing of trades on capital market when contracting a trade takes about minutes but its settlement takes about days. Settlement includes ex post dealing with formal requirements of trade and providing correct continuance of trade with fulfilling of all requirements set by law for every party of the trade.¹⁰ Historically we can find following still effective reasons for separating trade contracting from trade settlement:

• need of changing ownership records in central securities depository which may be separated from the regulated market,
• complexity of capital market relations,
• speed of stock exchange trades,
• need of securities verification and legal titles verification after trade, and
• need of error-resistant trades.

When we observe securities settlement system from a systemic view, that is as information system, it is receiving information about existing contracts that must be processed (from investment firms and other subjects – from automated server or from human user) and sending output to central securities depository¹¹ changing current state of registered securities. It also sends payment order to payment system committing the money transfer or processing payment order itself.

There are two groups of securities settlement systems participants that send input or receive output from the system. Both groups have different legal standing. Participants of the securities settlement systems are not the customers of service providers but service providers themselves.¹²

Participants in narrower sense of the word may be called intrinsic participants and include banks, savings and credit unions, investment firms, investment companies while taking care of the customer's property, public law subjects based on legal acts or persons with their guarantee, foreign similar subjects and the Czech National Bank.¹³ All intrinsic participants have responsibility for their obligations from the system and they act inside the system in their own name. Participants of a system in the broader sense include intrinsic participants along with three special institutions executing three service functions – settlement agent, central counterparty and clearing institution. These three special institutions are extrinsic participants – their main feature is that they do not act in their own name inside the system. There may be more institutions securing every functions and one subject may also secure more functions. According to the law the operator of securities settlement system is also the participant of his own system.

The supervision over Securities Settlement Systems is performed by the only authorized body – the Czech National Bank,¹⁴ which is the body independent from the state – the Czech Republic. The Czech National Bank is in particular entitled to inspect the compliance with the legal rules and the Securities Settlement Systems rules (in case of changes in the rules of the Securities Settlement System it is necessary to get ex ante the Czech National Bank approval). Further it is entitled to decide about permissions of a settlement system operator division or merger¹⁵.

One of the most important rights of the Czech National Bank in the field of Settlement System Supervision is the right to request relevant information and documents, which could be distinguished by regularity. That means on one hand the Czech National Bank is entitled to get regular information¹⁶ necessary for exercise supervision such as changes in the composition of the settlement system participants or changes in details on settlement system participants, on the other hand has power to get irregular information¹⁷, for example about winding-up with liquidation, changes in the object of business, changes of registered office, start and end of its participation in each settlement system.

The operator of Securities Settlement system needs to obtain a licence from the Czech National Bank before the beginning of its activities.¹⁸ Acquisition of Securities Settlement System operator licence takes place in the special type of administrative procedure and on the base on application proceeded by the Czech National Bank. The licence for the Securities Settlement System operator shall be granted only for indefinite period of time. Licence applicant has to fulfil complex and detailed requirements for obtaining a licence for the operation of Securities Settlement Systems.¹⁹

Basic action for settlement is the order for settlement that is given by the participant of securities settlement system. Therefore the customer whose securities are traded has no legal connection to this order. All transfers are based on the order. Settlement order submitted by the participant during the trade processing is irrevocable from some time – moment of irrevocability start is set by the rules of securities settlement system.

Transfers executed in the settlement processes include:

Step 1) may be omitted when securities are transferred without counter value paid by person receiving the securities (donation of securities).

In other possibilities both 2 reciprocal steps are executed - transfer of money owned by buyer in favour of seller and transfer of security or investment instrument owned by seller in favour of buyer. Therefore the trade including both transfers is the paid trade and is contracted as Sales Contract regulated by the Commercial Code.²⁰ In the second stated case the donation agreement regulated in the Civil Code is used adequately. Special types of trade are the loan of securities when security ownership is transferred too but only for the specified time, barter contract when both sides of trade are formed by security ownership transfer and provisory conveyance of title.²¹

Money transfer processing in securities settlement is usually left up to the payment system. It means when the trade includes money transfer the securities settlement system sends the data on this transfer electronically to the payment system which then executes the transfer. Data in the minimal way must include the account number of previous securities holder, the account number of new securities holder and transferred amount. Any more data that are transferred depend on written contract that must exist between securities settlement operator and payment system.

Price for specific trade is set by the contract and with exceptions regarding some trades by institutional investors and by state bodies price to be selected for trade it is not limited. These exemptions include for example cases of compulsory offer of joint stock company retaking and the misuse of internal information. Changes of stocks' current value after the contract do not affect the process of settlement. Current value for the purpose of specific trade and therefore the price of bought and sold securities are fixed in the moment of trade contracting.

Some markets allow only trades contracted for officially set price – so called bounding quotation. These markets do not allow contract parties to select price different from this quotation.

Principles of time organization of settlement may be either:

• Rolling Settlement when settlement takes place ex post after a settlement cycle in the order of trade confirmations (contracting) that is recommended by Bank for International Settlements and G30 and practically is used in most of cases,²² or
• Account Period Settlement when all settlement takes place at the end of a period (for example at the end of the day).

When rolling settlement principle is used trades on capital market are not settled inside the same day as they are contracted. The day when they are contracted is called the registration day and for the purpose of shortcut this day is proclaimed day T. Trades are settled ex post to the day of registration. The time between the day of registration and the day of settlement is set by the rules of settlement system and is also reflected in the rules of regulated market or multilateral market system.

Basic two scenarios of transfers are:

The usual principle used on capital markets is Delivery versus payment that is also recommended to states by the Bank for International Settlements mainly because when it is used along with real time settlement risks are minimized.²³ The current practice is that real time settlement is not really possible and the securities settlement is made ex post. There are risks that one side of the transfer (security ownership vs. money) fails and trade must be rolled back – sometimes more chained trades must be rolled back.

The Group of 30 recommended in 1989 that settlement T+3 should be used. T+3 settlement means the trade settlement is executed on rolling basis at most 72 hours from the time of trade contracting. This time limit of settlement is practically used in majority of securities settlement systems around the world.²⁴ The exceptions are NASDAQ OMX Exchange in Iceland for bond transactions which uses T+1 settlement, Deutsche Boerse Frankfurt with Electronic system XETRA (Frankfurt) which use T+2 settlement and in the Czech Republic the SKD system operated by the Czech National Bank – System for short-term bonds that settles trades in the same day.

For maintaining the registrations of book-form securities and for providing interfaces for securities settlement systems there has to be a central register of investment instruments. It usually exists as the institution in the form of central depository (who must be the joint stock company). Its only goal usually is operating the register itself - the information system. For example in the Czech Republic the central depository exists and prepares its activities but the central register of investment instruments is still operated by the Prague Securities Centre existing as the allowance organization of the state. Changes to this register are committed by the securities settlement system assigned to specific capital market. Sometimes securities settlement system also works as a central securities depository, for example in Iceland.

This register is general register containing information on majority of securities issued in the state of the register. Securities registered in the register are called securities having general registration. Securities that are registered outside the register are securities having independent registration – usually they are registered either by the investment firm or by the depositary of investment fund. There may also be securities registered only in the register of the issuer of the security not present in the central registration (for example documentary stocks of joint stock company). And there is last group of securities – those not needing any registration – like cheques.

European Community Legislation is usually divided into legally binding hard law and soft law with only recommendatory character.

The most important one among the hard law acts is the Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in payment and securities settlement systems which reduces the risk associated with participation in securities settlement systems, in particular when there is a close connection between such systems and payment systems, and establishes sufficient links between all the securities settlement systems with a view towards promoting maximum transparency and legal certainty of transactions relating to securities. The reduction of systemic risk requires mainly the finality (is necessary to ensure that transfer orders cannot be revoked after a moment defined by the rules of the system) of settlement and the enforceability of collateral security. Collateral security is meant to comprise all means provided by a participant to the other participants in the payment and/or securities settlement systems to secure rights and obligations in connection with that system, including repurchase agreements, statutory liens and fiduciary transfers. This directive was implemented into the Czech law system in § 86 Act. No. 256/2004 Sb., on Business Activities on the Capital Market, as amended.

Following legal act of Community’s hard law is the Directive 2002/47/EC of the European Parliament and of the Council of 6 June 2002 on financial collateral arrangements that was created for the provision of securities and cash as collateral under both security interest and title transfer structures including repurchase agreements (repos), which should contribute to the integration and cost-efficiency of the financial market as well as to the stability of the financial system in the Community, by supporting the freedom to provide services and the free movement of capital in the single market in financial services. This directive focuses in particular on bilateral financial collateral arrangements.

Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments (MiFID) bounds Member States that they shall not prevent investment firms and market operators operating an MTF from entering into appropriate arrangements with a central counterparty or clearing house and a settlement system of another Member State with a view to providing for the clearing and/or settlement of some or all trades concluded by market participants under their systems.²⁵

In soft law we can find Guideline of the European Central Bank of 26 April 2007 on a Trans-European Automated Real-time Gross settlement Express Transfer system (TARGET2) (ECB/2007/2), which brings the idea of TARGET 2 – single IT platform enabling settlement of securities in central bank money over the euro area/EU/EEA. Guideline of the European Central Bank of 31 August 2000 on monetary policy instruments and procedures of the Eurosystem (ECB/2000/7) and Hague Convention of 5 July 2006 on the Law Applicable to Certain Rights in Respect of Securities Held with an Intermediary recommends to provide legal certainty and predictability as to the law applicable to securities that are now commonly held through clearing and settlement systems or other intermediaries.

Securities settlement systems are used for automated settlement of capital market trades. They usually operate ex post after contracting of trade that is settled and clearance of mutual rights and obligations of buyer and seller (or similar subjects in case of securities donations and other special cases) takes place. This paper was aimed at analyzing current status of legal regulation on Securities Settlement Systems in the European Union. Besides communitary regulation authors used intrastate regulation from Czech Republic but tried to stay as general as possible. Also the theory coming from the recommendation documents of Bank for International Settlements and other international organizations was explained and analyzed.

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