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Cross-Border Equity Trading, Clearing & Settlement in Europe

White Paper

Cross-Border Equity Trading, Clearing & Settlement in Europe


White Paper

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Contents

Contents
Executive summary 5

Introduction

1 1.1 1.2 1.3 1.4

Status quo of European equity markets Characteristics Level of efficiency and innovation in domestic European equity markets Engines of efficiency and innovation Summary

7 7 7 9 14

2 2.1 2.2 2.3 2.4

Incremental costs Total incremental costs of cross-border equity trading in Europe Potential scenarios of cross-border trades Cost comparison of domestic and cross-border trades Summary

15 15 16 18 25

3 3.1 3.2

Improvement of efficiency Possible measures by European Commission and national governments, legislators and regulators Possible measures driven by market participants

26

26 28

List of figures

33

Glossary

34

References

36

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Executive summary

Executive summary
Despite a high degree of market segmentation, European equity markets are surprisingly efficient, even when compared with the larger US market. The total transaction costs for domestic security transactions in the two most efficient European markets are on a par with the New York Stock Exchange. Top European exchange organizations are highly innovative and active cross-border. A high degree of electronic trading, widespread remote membership networks, extensive usage of open order books, high straight-through processing rates, successful derivatives and growth stock markets exist. The principal engine of this positive development has been the fight for a strong market position in Europe amongst demutualized exchange organizations. The for-profit orientation and public listing of stock exchange organizations were instrumental in this respect. Evidence strongly suggests that for-profit organizations are preferable to utility structures on the clearing and settlement level also. Allegations that were recently brought forward against the model of vertically integrated exchange organizations cannot be substantiated. A closer analysis actually shows significant advantages of the vertical model in terms of efficiency and innovation, and also demonstrates that vertical integration is consistent with open access at all levels of the value chain. While domestic European markets are highly efficient, investors and issuers face incremental costs for cross-border trading and cross-border equity holdings 1), which can be estimated to be around 4.3 billion per year. This sum appears high, but it should be noted that the UK stamp duty, an engine of inefficiency in the domestic UK equity market, incurs costs of about one and a half times this amount to shareholders of UK companies alone. Some 40 percent of the annual difference of 4.3 billion between domestic and cross-border trading costs is driven by the need for regulatory translation as a result of different laws, taxes, rules for corporate actions, etc. Another 20 percent (less than 1 billion per year) of these costs can be influenced by intermediaries, exchanges, clearing houses and central securities depositories (CSDs) through measures like harmonization of market practices, as well as industry consolidation. The remaining 40 percent of incremental costs are a consequence of different languages and cultures and lower cross-border trading volumes caused by behavioral reasons like investors home bias. An analysis of the total transaction costs of a cross-border wholesale and retail trade shows that cross-border wholesale trades cost 30 percent more and retail trades 150 percent more than a corresponding domestic trade. Increasing cross-border flows and strong competition for cross-border equity transactions at the trading, clearing, settlement and custody levels will reduce such differences between cross-border and domestic transactions. To further reduce the incremental costs in cross-border equity trading, several measures are necessary. Clearing houses and settlement systems need to build links between one another or to cooperate by other means wherever it is economically necessary and feasible from a technical, legal and risk perspective. Furthermore, there is a need for co-operation between market participants and market institutions to standardize industry practices. However, for such industry activity to yield significant improvements, substantial harmonization through regulators and legislation will be required.
There are two main types of cross-border equity trades depending on the settlement location. In cross-system settlement, foreign stocks are settled at a foreign CSD. In contrast to this, intra-system settlement refers to the settlement of foreign stocks at the investors home CSD.

1)

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Introduction

Introduction
The introduction of the euro as a physical currency on 1 January 2002, was only the latest and most visible sign of the accelerating efforts to integrate the European capital markets. Much more important for industry participants are the ongoing initiatives by the European Commission and other public as well as private institutions to further this integration and to reduce costs for crossborder trading, clearing and settlement in Europe. Other measures aimed at integrating the European capital markets should be pursued in parallel, however. These should be predominantly targeted at increasing the diversification of portfolios of European investors as a shift from a domestic toward a European or even global orientation promises to result in significantly improved risk/return trade-offs. Deutsche Brse and Clearstream International welcome the European Unions determination to integrate the capital markets. We support this initiative and would like to contribute to the discussion of how to improve the efficiency of the European securities market infrastructure. This paper presents our view on the state of the European trading, clearing and settlement industry (chapter 1), analyses the incremental costs of cross-border trading, clearing and settlement (chapter 2) and discusses ways how these costs can be reduced (chapter 3). This paper concentrates on secondary cash equity markets, as these are at the centre of the ongoing discussions about cross-border trading, clearing and settlement. A glossary is provided in the appendix to this White Paper to define some of the technical terms used in the trading, clearing and settlement industries.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

1 Status quo of European equity markets


An analysis of how to improve the integration of the European equity markets must be based on an understanding of their main characteristics. This chapter will show that given their high extent of fragmentation, European equity markets are actually operating at a high level of efficiency. An understanding of the reasons for this efficiency will be necessary to ensure that proposals for improvement and thus change will not jeopardize well-functioning existing structures. 1.1 Characteristics Compared to their US counterparts, European secondary equity markets are characterized by several structural disadvantages, most of which are very difficult to influence and will change only gradually over the coming years. The most important of such characteristics is the high degree of fragmentation: the largest European market, London, generates only about 23 percent of the transaction volume in the largest US market. 2) Even though the European Union works toward integration between its member states, Europe remains segmented into 15 different cultural, legal, taxation and regulatory environments. While some barriers to true integration, like differences in market practices which developed historically, can be gradually overcome through concerted and ambitious initiatives, other barriers like 11 different languages will persist. Because of these many differences, small players concentrate on their local markets; by our estimate, approximately 60 percent of all equity trading is still purely domestic. Another disadvantage of European equity markets compared with their US counterparts is the less developed equity culture. Total market capitalization relative to GDP in Europe is on average 16 percent lower than US levels and in many smaller European countries significantly below that level. This also contributes to the limited size of national markets. 1.2 Level of efficiency and innovation in domestic European equity markets Given these disadvantages compared with the United States, one may be surprised that the European cash equity markets are generally characterized by a high level of efficiency. Transaction and liquidity costs are an adequate measure of a markets efficiency. Transaction fees can be directly influenced by exchanges, clearing houses and CSDs. Additionally, through its market model and technology, an exchange organization can also have significant impact on investors liquidity costs. Both transaction fees and liquidity costs are compared internationally by the US consultancy Elkins/McSherry. A recent analysis conducted in 2001 shows that the most efficient European markets like Euronext and Deutsche Brse are actually more efficient than the New York Stock Exchange (NYSE) although the latter has a 5-6 times higher trading volume and a corresponding potential for economies of scale (cf. figure 1).

2)

A trading volume of 4.8 trillion in London in 2000 compares with 22.2 trillion for the largest US market, i.e. Nasdaq (FIBV data, including OTC transaction figures).

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

Figure 1: Exchange-influenced transaction costs for equity trading *

Basis points Deutsche Brse Euronext ** NYSE *** Madrid Milan LSE **** 9.0 9.5 14.9 15.3 17.8 12.3 1.2 1.3 0.6 1.5 1.4 25.0 10.2 10.8 15.5 16.8 19.2 37.3

Basis points 25 20 15 10 5 0
Milan Madrid Euronext Deutsche Brse NYSE *****

10

12

14

Liquidity costs Trading, Clearing & Settlement and other fees

Trading volume trillion

* ** *** **** *****

Country data taken as proxy for a countrys dominant stock exchange Weighted average of Paris (60 percent), Amsterdam (38 percent) and Brussels (2 percent) stock exchanges Different trading system leads to low fees, but higher liquidity costs Average of UK sell orders and UK buy orders; high cost of trading mainly due to stamp duty Given high volume in New York, relatively high transaction costs in US Source: Elkins / McSherry, Global Universe Market Cost Report: Quarter 1, 2001; FIBV (US$1= 1.12).

The reason for the low liquidity costs of Euronext and Deutsche Brse expressed in the Elkins/McSherry study as the difference between execution price for sample transactions to the average of a days open, high, low and closing price 3) lies with efficient trading systems with widely used electronic open limit order books. London Stock Exchanges liquidity costs are also below NYSEs levels, but total transaction costs on its domestic market are skewed by the UK stamp duty. In summary, the low overall transaction costs on the most efficient European exchanges are due to relatively low fees and efficient market models and trading platforms. The higher transaction volume in the US is of particular importance for the level of settlement costs, as this is a largely fixed cost-driven business with very large economies of scale. Given the high level of fragmentation in Europe, it is therefore surprising that the difference between US and European costs is relatively small.

3)

This proxy for liquidity costs used by Elkins/McSherry is only a very rough approximation to the actual liquidity costs consisting of the average bid-ask spread and the market impact (i.e. adverse move in price) of a trade. Elkins/McSherry data is used because currently no better independent global comparison of total trading costs is available. Due to Elkins/McSherrys methodology, very liquid markets are difficult to compare with rather illiquid (e.g. emerging) markets.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

Figure 2: Settlement costs according to the Giovannini report *

Operating income per transaction after netting

Operating income per transaction before netting

Settlement transactions before netting million

CBF (Germany) ** CREST (UK) DTCC (US) Euroclear (France)

2.15 2.44 2.77 6.60 0.40

2.15 2.44

125 59 1,586

2.00

135

* Method of relating operating income (includes custody and other income, thus only rough proxy for settlement costs) to transaction number understates pre-netting costs and overstates post-netting costs ** Giovannini: The number of [CBF] is for stock-exchange trades only, therefore operating income per transaction overstated Source: Giovannini report commissioned by the European Commission, NSCC (only for DTCC costs per settlement transaction)

After netting 4), costs at some European CSDs are even lower than in the United States, as figure 2 shows. Comparing operating income per transaction between the EU and the US, a recent CEPS report 5) found that domestic settlement costs after netting in the EU are on average only 8 percent higher than in the US.6)

1.3 Engines of efficiency and innovation A number of engines of efficiency and innovation can be identified within European equity markets. The most important of these are advanced technology and high innovation, demutualization, and strong competition of industry participants. Advanced technology and high innovation The most efficient European equity markets are characterized by advanced technology and a high degree of innovation across all levels of the transaction processing chain, contributing to a high rate of straight-through processing. Most noteworthy is the early introduction of electronic trading systems in all major European markets. Disintermediation efforts to reduce automation and commission costs were significantly advanced by the launch of the NSC system in Paris in 1995 and the introduction of similar electronic trading platforms in London (SETS) and Frankfurt (Xetra) in 1997.

4) 5)

6)

Netting refers to settlement netting. Cf. CEPS 2001, p. ii; domestic after-netting costs: Operating income of European CSDs without ICSDs to exclude distortions from the higher costs of cross-border settlement which will be analysed in the following chapter. A comparison based on after-netting costs is appropriate if the focus lies on the efficiency of settlement organizations, which usually receive netted transactions. A pre-netting analysis includes the efficiency of clearing houses in the analysis. A number of major European market places do not yet offer settlement netting but plan to introduce it soon (e.g. Deutsche Brse with its announced Equity Central Counterparty).

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CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

These systems helped Europe to establish an early lead over the United States with fully electronic open limit order books. Following the success of the Nasdaq exchange in the US, growth stock markets were introduced around Europe during the 1990s (e.g. AIM in the UK, Neuer Markt in Germany, and Nouveau March in France) and have started to compete in the new issues market of European technology and other growth stocks. Through innovation and customer orientation, Eurex and Liffe managed to establish a significant lead over their US competitors in the fast growing segment of derivatives markets. While not all European markets offer a central counterparty for equity trading (ECCP) yet, this efficient clearing solution is quickly evolving as a new industry standard in Europe, with up to eight markets expected to have developed an ECCP by 2003. As the cost comparison has shown, Europes processes for the settlement of domestic securities are highly automated and sophisticated. Similarly efficient systems exist for international bond settlement through the two ICSDs Euroclear and Clearstream International, while cross-system equity settlement still involves significant costs which are discussed in detail in chapter 2. Demutualization The trend toward demutualization started with the Paris, Madrid and Frankfurt stock exchanges in 1988, 1989 and 1991 respectively, and continued with the Stockholm exchange in 1993, the Amsterdam and Milan stock exchanges in 1997, the Brussels and Lisbon stock exchanges in 1999, and finally the London Stock Exchange (LSE) in 2000. The trend is further supported by the listing of some of the demutualized organizations which started in 1998 with the acquisition of the Stockholm stock exchange by the listed OM Group, and was accelerated as figure 3 illustrates in 2001 by the listings of the three largest European exchanges: Deutsche Brse went public in February, and Euronext and LSE followed in July of that year. The principal effect of demutualization was that exchange organizations shifted to the governance model of private companies with professional management, clear responsibilities and control, and transparent accounting. They also took a for-profit-orientation. Although their shareholder structure remained almost unchanged with intermediaries dominating, European exchange organizations quickly improved their offerings, expanded in non-traditional areas such as information products or the organization of markets in non-financial instruments, as discussed in further detail below.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

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Figure 3: Migration from mutual structures to public companies

Paris Demutualization 1988 1990 Madrid

Frankfurt 1992 1994 Stockholm 1996

Amsterdam Milan 1998 1999

LSE 2000 2001 2002 Zurich (planned) Euronext LSE 2000 2001 2002 Madrid (planned) Milan (planned) Lisbon (Euronext)

Brussels Lisbon Stockholm*

IPOs

1998 1999

Deutsche Brse Europe s largest exchanges

* Acquired by OM (public since 1987)

Horizontal cross-border competition among exchanges, clearing houses and (I)CSDs Horizontal competition is a powerful engine of efficiency and innovation in Europe. Cross-border competition can be found across the entire securities industry value chain, a conclusion supported by CEPS in its recent report 7). In the cash equity markets, international competition for new issues has grown strongly over the past years. Through remote membership, foreign investors receive efficient access to local capital markets. Deutsche Brse, for example, currently offers remote access to around 650 international members from Europe, the United States and the Far East. As a result, London members, for example, trade about as many contracts on Eurex as on Londons Liffe (cf. figure 4). Deutsche Brses internationalization and therefore competition drive is further supported by its Global Markets Concept, under which selected European and US blue-chip stocks are traded on Xetra using hybrid market models. Furthermore, German retail investors have access to 10,015 foreign stocks traded on the Frankfurt floor of Deutsche Brse and independent regional exchanges where brokers provide liquidity for retail investors.

7)

Since the early 1990s, the EUs banking, insurance and security markets have been open to cross-border competition. (CEPS 2001, 1)

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CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

Figure 4: Remote access the example of Deutsche Brse

650 members

Eurex: contracts traded by London members vs. Liffe total turnover million contracts

15 16

14 13

17 17

14 15

15 16

15 18

14 15

2001 Access to US market for European exchanges restricted by SEC and CFTC Eurex Liffe Xetra: percentage of volume traded by foreign members 30

15 Xetra / Eurex Members outside Germany Access points Location of business unit Tokyo Hong Kong 0 2000 2001

Similar pan-European initiatives are also pursued by the LSE with the internationalization campaign of its AIM growth market and its SEAQ system to support the large OTC market for international stocks in London. Cross-border competition in equity trading is increased further by new market entrants like virt-x, which offers trading in 629 European blue chips; new alliances like Nasdaq Europes partnership with the Berlin Stock Exchange, who jointly aspire to capture European cross-border flows; or mergers as in the case of Euronext, which is the combination of several European exchanges including those of France, Belgium and the Netherlands. Competition in derivatives trading is even stronger, as the fierce battle between Eurex and Liffe for capital market derivatives in the late 1990s has shown. As a result, prices for the trading of derivatives have dropped significantly. Recently, the competition has shifted emphasis from prices to the most innovative product offering and improved remote access networks. Cash bond trading is the most international of the three businesses mentioned here. Thus, the degree of competition is high among Eurex Bonds, BrokerTec, EuroMTS and others competing within existing or planned product offerings for domestic, European and international bond trading. International competition in clearing and settlement is relatively strong. Eurex Clearing, Clearnet and LCH are either already competing for existing domestic and international clearing businesses, or have ambitious expansion strategies. European central securities depositories (CSDs) are increasingly interlinked, which results in efficiency gains for market participants and requires CSDs

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

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to keep innovating and updating their systems. Clearstream, for example, has already three Delivery versus Payment (DvP) and seven Free of Payment (FoP) links with other (I)CSDs, which also continue to build bilateral links to each other. Another aspect which is often overlooked is the existing competition between CSDs and custodians. They have an overlapping service offering. CSD links allow CSDs to compete with custodians for the international settlement agent and custody business. Increased competition between market organizers and intermediaries Demutualization, innovation and new entrants (virt-x, Jiway) resulted in horizontal competition between exchanges. However, competition between exchanges and intermediaries (brokers, custodians, etc.) remained low before exchanges went public, because demutualized exchanges were still owned by intermediaries. Market organizers (like exchanges, but also CSDs and clearing houses) provide the framework for securities transactions and can significantly impact the demand of end customers for intermediary services. The larger the scope of services that market organizers are directly or indirectly offering to investors and issuers, the smaller the intermediary fees that can be charged by banks and brokers. The benefits from increased competition are already evident. Exchange organizations have introduced or are planning to offer retail and foreign brokers direct access to their infrastructure, thereby disintermediating intermediaries such as local wholesale brokers. They offer information systems to end-investors (e.g. Deutsche Brses range of information on its web site) or organize markets (e.g. for exchange traded funds) which substitute higher-margin products of intermediaries to the benefit of end-investors. Likewise, they are subject to competition from intermediaries. For example, wholesale brokers are already internalizing a portion of their order flow (i.e. matching customer order flow against their own market making) taking volumes off exchanges. Today, retail order flow is fully internalized in the UK through five retail service providers, and many brokers are planning to also internalize continental retail order flow. These measures reduce the transparency of the trading process as well as the liquidity on the public market, leading to higher costs for investors in the long run, because the possible savings in transaction fees are very small compared with the adverse effect of increases in liquidity costs (see figure 7 below for a comparison of the relative importance of transaction fees versus liquidity costs). Therefore, for-profit-oriented exchange organizations have no room to abuse their position as market organizers due to the increased competition, but are critically important as independent proponents of maximum liquidity and efficient direct access solutions for market participants.

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CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Status quo of European equity markets

1.4 Summary Figure 5 summarizes our analysis of the status of the European capital markets. It shows that there have been substantial improvements during recent years. As a result, transaction fees on European exchanges decreased by almost 50 percent, while trading volumes tripled. This highly positive track record promises further market-driven improvements in the European capital markets in the years ahead.

Figure 5: Transaction fee and trading volume development in Europe

Domestic transaction fees on European exchanges*, 1996 2000 Average, basis points 4 3 2 1 0 1996 1998 2000
47 %

Trading volume on European exchanges*, 1996 2000 US$ trillion 12 9 6 3 0 1996 1998 2000
20 3%

* Nine of Europes largest exchanges; London excluded from transaction fee analysis because of the distorting effect of stamp duty. Source: Elkins / McSherry data as reported in Institutional Investor, McKinsey analysis

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

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2 Incremental costs
While it could be demonstrated in the preceding chapter that Europes domestic trading systems function highly efficiently, cross-border trading does incur higher costs. A detailed analysis of these costs is necessary to understand which reduction measures would be most effective.

2.1 Total incremental costs of cross-border equity trading in Europe We estimate the total incremental costs of cross-border equity cash trading and cross-border equity holdings in Europe at approximately 4.3 billion per year, excluding liquidity costs. These consist of about 2.3 billion in higher commissions, 1 billion in cross-border settlement fees, and 1 billion in higher cross-border custody fees. 8) For comparison, it should be noted that the UK government raises a significantly larger sum through its stamp duty on share purchases of UK stocks. 9) Thus, one albeit major distortion of a domestic equity market exceeds the overall incremental costs of cross-border equity trading in Europe. We estimate that approximately 40 percent or 1.7 billion per year results from cost drivers that can only be influenced by the European Commission, national governments, legislators and regulators. Roughly 20 percent (less than 1 billion) are due to cost drivers that intermediaries, exchange organizations, clearing houses and CSDs can influence. The remainder (another 40 percent) cannot be influenced by any of these institutions and industry players (cf. figure 6).

Figure 6: Incremental cross-border equity trading costs in Europe


bn. 2001 (estimates) 15 50 70 ~ 40 ~ 20 10 ~ 40 55 20 20 2.3 1 1 4.3

Percent Higher broker commission Higher CSD and settlement agent costs Higher custody costs Total 30 30

Who can influence cost drivers?

EU, member states Different laws, taxes, and regulatory environments Different corporate actions Different currencies ( , ) Low degree of automation caused by need for regulatory translation Intermediaries, exchanges, CSDs Different market practices Fragmented trading, CSD industry

1.7

0.9

1.7

Others / not influenceable Low volumes (home bias) Different languages

8)

9)

The estimate is based on adjusted McKinsey / JP Morgan estimates for equity turnover and equity holdings in Europe in 2001 and the analysis from chapter 2.3. Incremental trading commission is calculated by multiplying the estimated non-proprietary equity trading volume in the European Union (~ 13 trillion; double-counted) with the estimated percentage of cross-border trading (~35 percent; excluding intra-system transactions for which cross-border commission and settlement costs are similar to domestic ones) and the estimated incremental commission of 5 basis points. Incremental settlement costs are calculated with an estimated average transaction size of 150,000 and an average cost of 25 per transaction settled cross-border (adjusted for ~20 percent proprietary trading volume in Europe). Finally, incremental custody costs are calculated by multiplying the estimated total cross-border equity holdings in the European Union (~3.7 trillion) with the estimated incremental custody fee of ~2.8 basis points. The UK governments forecasts for stamp duty revenues from the sale of shares for the 2000-2001 tax year are 4.5 billion (~7.3 billion) according to a survey of the UK tax system by the Institute for Fiscal Studies.

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CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

The European Commission, national governments, legislators and regulators have power over the most important cost drivers. These are different legal and tax systems and different regulatory environments. E.g. complex and different legal requirements for transfer of title in securities result in different processes in different countries. Corporate actions (e.g. stock splits, dividend payments, etc.) differ in the various countries, which leads to higher costs, especially in the cross-border custody area. Different tax treatment and the handling of country-specific taxes (in particular stamp duty) result in complex translation processes and costs. The existence of two major currencies (euro, Sterling) is another cost driver. The need for this regulatory translation leads to a low degree of automation. Furthermore, there is no uniform language for the processing and reporting of transactions in different countries. We estimate that these drivers account for roughly 30 percent of the incremental cross-border commissions and settlement fees respectively and for 70 percent of the higher custody costs. 10) Intermediaries, exchanges and CSDs are mainly responsible for the coexistence of different market practices on different market places. Costs are also driven by scale disadvantages of a fragmented trading, clearing and settlement industry. This is, on the other hand, a prerequisite for competition, and a catalyst for innovation and efficiency. The factors discussed here account for about 15 percent of the higher commission costs, 50 percent of the higher settlement costs and 10 percent of the higher custody costs, in our opinion. The main factor that cannot be influenced in the short nor medium term is the low (but increasingly growing) cross-border trading volume due to the home bias of European investors, i.e. the tendency to over-invest in domestic stocks at the expense of international diversification. 11) As trading, clearing and settlement are industries with strong economies of scale, low volumes result in higher costs. Thus, if Europeans invested a larger share of their portfolios in foreign stocks, cross-border trading costs would automatically decrease. At the same time, European investors would come closer to an optimally diversified portfolio, thus improving their portfolios risk / return profile. Other barriers that cannot be influenced but increase cross-border costs are different languages and cultures. Together, these drivers can explain approximately 55 percent of the broker commission increase and 20 percent of the incremental settlement and custody costs, respectively. In the following section, we give a more detailed analysis of these cost drivers, their relative importance compared with purely domestic costs, and the impact on investors and issuers economics.

2.2 Potential scenarios of cross-border trades Depending on the countries and types of stocks involved, a relatively large number of alternatives exists to trade foreign stocks. The two most important factors influencing the total costs per trade are liquidity costs and settlement location. Liquidity costs depend on the market where the trade takes place. In a stocks home market, liquidity is usually highest, which reduces bid-ask spreads, as well as market impact. Thus, liquidity costs will usually be lowest there.

10) 11)

These and the following percentage figures: rough estimates by McKinsey industry experts See, for example, Schiereck / Weber, 2000.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

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Settlement can take place in two ways: intra-system or cross-system. In the case of intra-system settlement, settlement takes place at a CSD to which the seller and buyer or their broker are directly connected. In case of cross-system settlement, stocks are typically traded on the issuers home market exchange and settlement takes place at the issuers home market CSD, to which the investor or his broker is not directly connected. Settlement access to this foreign CSD is an important cost driver in cross-border stock transactions. If, for example, a German investor wants to buy a French blue-chip stock through a German broker with an account at the German CSD Clearstream Banking Frankfurt (CBF), he has several options for purchasing this foreign stock. Firstly, he can decide to buy the stock through the electronic trading platform Xetra, the Frankfurt floor, or any regional exchange which lists the stock. In all of these cases, settlement would take place at CBF. If the seller also holds his stock in CBF, CBF would only need to transfer the stock from one of its accounts to another. This intra-system transaction would not be different from a domestic intra-system transaction and would therefore generally incur similar costs as a domestic transaction.12) Secondly, the investor may also decide to trade the stock on the issuers home market in France. He can do so either by trading on the French trading platform Euronext Paris or by completing an OTC trade. In both cases, the settlement location would be Euroclear France, the French CSD. Assuming that the German investor or his brokers are not connected to Euroclear France, a crosssystem settlement would need to take place, either through a direct link between the two CSDs Euroclear France and CBF or through custodians who could transfer the stock because of their own or their partners connections to both CSDs. A third possibility would be to use alternative trading systems like virt-x, Jiway, Nasdaq Europe, or any other platform where the stock is traded. Such platforms usually have their own specific settlement systems. Finally, trading could also be done internally within the brokers proprietary platform, which would result in easy settlement within the brokers systems, but might have a substantial impact on liquidity costs as was discussed in chapter 1.13) In the aforementioned example, the trades on German platforms with intra-system settlement would incur low direct transaction fees but relatively high liquidity costs, because the volume of French stocks traded on German platforms is limited. This would tend to increase bid-ask spreads as well as market impact 14). This trading method is therefore best suited for retail investors who want to trade small order sizes where direct transaction fees are more important, as they are usually levied on a per-transaction, not on a per-volume basis. Liquidity costs are less relevant here, as market impact is minimal and the higher bid-ask spread is a percentage of the transaction volume rather than an absolute sum. Additionally, convenience considerations will make retail investors favor trading on the local market with subsequent intra-system settlement. In contrast to Germany, where an adequate market-making model for retail orders of foreign stocks exists, retail

12)

13) 14)

In the case of Deutsche Brses Xetra system, exchange and settlement fees for domestic and foreign stocks are the same. Because of the lower volume in foreign stock transactions, Clearstream charges a higher fee for intra-system settlement for most foreign stocks compared to most domestic stocks. This fee, however, is still significantly cheaper than any form of cross-system settlement. These cases will not be analysed here in depth because of their relatively low volumes. Market impact is the effect an order has on the price of the security. The higher the trading volume, i.e. the more liquidity, the easier large orders will be absorbed by the market and the smaller adverse price movements will be.

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CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

investors in many other European markets might be forced to trade foreign stocks abroad, thus having to face the higher costs of cross-system settlement. For wholesale investors with large trading sizes, liquidity costs are the dominant cost factor. They will therefore tend to trade in the market with the highest liquidity, which is usually the issuers home market. The additional costs for cross-system settlement are less relevant, as their percentage effect is minimal. An exception are stocks that are heavily traded, and therefore very liquid, on the investors home market. This can often be the case for the shares of companies that come from a relatively small home market, and that are consequently traded in high volumes on the major global exchanges (e.g. Nokia in New York, London and Frankfurt).

2.3 Cost comparison of domestic and cross-border trades Figures 7 and 8 show the difference between the total transaction costs of a domestic and a crossborder wholesale and retail trade respectively. The result of the analysis is that the total cost of wholesale trades is about 30 percent higher for foreign trades compared with a respective domestic trade and typically 150 percent higher for retail trades. However, those foreign stocks that have high trading volumes on the investors home market can be traded at substantially lower costs. This is shown in figure 7. The results of this bottom-up analysis are supported by a recent UBS study which estimated that cross-border trading in Europe is about twice as expensive as domestic trading. A typical wholesale trade Figure 7 shows that the wholesale investors will typically trade stocks on the market with the highest liquidity, which would usually require cross-system settlement. On average, total transaction costs in this scenario are only about 30 percent of what they would be if the same stock was traded intra-system (24 to 33 basis points compared to 86 to 96). The following four cost components are considered in calculating the total transaction costs: commission payments to brokers and other intermediaries, exchange related fees, custodian fees for cross-system settlement, and liquidity costs. Commissions tends to be somewhat higher for dealings on a foreign exchange. According to an LSE study on trading costs on the London Stock Exchange, the difference is typically some 5 basis points.15) Interestingly, for wholesale investors, these 5 basis points can be up to 90 percent of the incremental charges for the trade in the foreign security. Recently, cross-border commissions came under increasing pressure; however, this remains the largest driver for cross-border wholesale transactions. Exchange-related fees, on the other hand, can be assumed to be the same on the domestic as well as the foreign platform.16) In the case of trading on the most liquid marketplace (which would require cross-system settlement), liquidity costs 17) would also be the same as for domestic trades.

15) 16)

17)

No recent comparable study for commission costs in Germany is available. For clarity of analysis and comparability, all examples are calculated using Deutsche Brses Xetra Premium 1 all-inclusive fee for trading, clearing and settlement. The liquidity cost estimate is based on the daily closing bid-ask spread relative to the closing price of the five most liquid domestic stocks and the three most liquid foreign stocks on Xetra, LSE and Euronext, using Bloomberg data from Q2 to Q3, 2001. The liquidity costs are assumed to be 50 percent of the spread. The domestic (foreign) spread assumptions are (in basis points): 18 (142) on Xetra, 20 on LSE, 5 (157) on Euronext. The LSE foreign spreads could not be estimated as volume was too low on the exchange itself (most foreign stocks are traded over-the-counter in London). Thus, the average liquidity costs were estimated at 3 to 10 basis points on domestic exchanges and 70 to 80 basis points on foreign exchanges, as liquidity costs are 50 percent of a stocks bid-ask spread.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

19

Figure 7: Total costs of a typical wholesale trade of about 200,000

Total costs basis points (estimates)

Preferred option

Domestic stock (benchmark)

3 10 15 0.6 negligible

19 26 1 1.5

Foreign stock intra-system

70 80

86 96

15 15 0.6 negligible

Foreign stock cross-system 20 0.6 *

3 10 0.5 2.5**

24 33

+30%

35

Commission

Exchangerelated fees

Custodian fees per transaction

Liquidity costs ***

Total transaction costs

Annual custody costs ****

* ** *** ****

Some exchanges with higher charges for foreign shares (e.g. LSE) Including cross-system settlement fees Spread as proxy for liquidity costs; market impact and opportunity costs not quantified Corporate measures and similar core custody services paid annually Source: LSE survey, industry experts estimates, McKinsey analysis

The remaining 2 to 10 percent of the total cost difference to domestic trades are per-transaction custodian fees for the cross-system settlement process. These fees typically range between 10 and 50 per transaction (i.e. between 0.5 and 2.5 basis points for a 200,000 transaction). The fees will be at the lower end of the range if transaction turnover between the two different markets is high and therefore efficient links between the relevant CSDs have been built to satisfy this demand (see chapter 3 for a closer analysis of the economic viability of building links). Annual custody costs for holding foreign stocks may or may not be higher than for holding domestic stocks. If the foreign stocks are listed on a domestic exchange, custody costs can be as low as those for domestic stocks. If not, custody costs can go up to 5 basis points and in some cases even higher. 18)
18)

Industry specialists estimates for domestic (1 to 1.5 basis points) and cross-border custody (3 to 5 basis points).

20

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

This analysis does not explicitly consider additional costs, e.g. for back-office, that are hard to quantify. Back-office costs are mainly driven by the level of automation and straight-through processing. They will be substantially higher for cross-border trades due to different accounting standards, laws, tax systems, languages, IT systems, etc. In summary the current settlement solutions are relatively efficient for wholesale investors and should not significantly deter trading in foreign stocks. To reduce costs, it seems most promising to negotiate commission levels, given their substantial impact on total transaction costs. Typical retail trade Figure 8 shows the example of a German retail investor trading for 5,000 through an online broker. For the benchmark case, a purely domestic trade, total costs would amount to around 23 to 67 basis points. As in the case of wholesale investors the largest of these cost components would be commission costs. For retail investors, broker commissions are substantially higher than in the wholesale case. For a 5,000 order, online brokers charge between 10 and 25 which translates into 20 to 50 basis points. This does not change if foreign stocks are traded on the local exchange, but for trades on foreign exchanges, commissions are usually higher and can go up to 86 basis points. 19) Liquidity costs are the same for retail investors as for wholesale investors. However, because of the higher relative importance of the other cost components, liquidity costs are less relevant here. Additional third party charges are exchange and settlement fees that brokers may or may not pass on to their clients in addition to their commissions. For intra-system trades, such fees are seldom passed on, but this is different when substantial cross-system settlement fees are levied. The amount of the additional fees passed on to the investor will vary dependent on the brokers additional margin, but will typically start at 17 (US$ 15) for transactions in US stocks and can reach 100 or more for trades of stocks from less important markets.

19)

McKinsey survey amongst 14 German online banks, 2001

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

21

Figure 8: Total costs of a typical online broker retail trade of about 5,000

Total costs basis points (estimates)

Preferred option

Domestic stock (benchmark) 20 50

3 10 07

23 67 0 15

Foreign stock intra-system

70 80

90 137

+150 %

20 50

0 7*

0 15

Foreign stock cross-system

3 10 35 200

58 296

0 15 20 86

Commissions of online brokers

Additional third-party charges **

Liquidity costs ***

Total transaction costs

Annual account costs ****

* Some exchanges with higher charges for foreign shares (e.g. LSE) ** Levied by brokers for trading, clearing, and settlement (including cross-system settlement fees) *** Spread as proxy for liquidity costs; in some markets liquidity costs expressed by broker commission rather than spreads; market impact and opportunity costs not quantified **** Most online brokers without charge; very few with higher costs for foreign equities Source: Industry experts estimates, McKinsey analysis and survey, FMH-Finanzberatung survey

Expressed in basis points, the charges for cross-system settlement (included in the bar named additional third-party charges in figure 8) make trading on foreign exchanges expensive for retail investors. Consequently, retail investors will tend to prefer intra-system trades in foreign stocks even though they face higher liquidity costs of 70 to 80 basis points. In total, transaction charges for intra-system foreign equity trading are about 150 percent above those for transactions in domestic stocks.

22

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

In summary, retail trading in non-domestic stocks is hindered by higher costs. Consequently, the most promising short-term solution to reduce costs for retail investors are attractive market models on the investors home market, such as Deutsche Brses US and European Stars offerings on Xetra. They offer total transaction fees similar to a trade in domestic stocks and very low liquidity costs due to hybrid market models. Special case: Trading in very liquid foreign stocks Previous analyses are based on the assumption that liquidity is only high for domestic stocks. This does not always have to be the case. Figure 9 compares the benchmark case of a standard domestic trade to the costs of trading a foreign stock with high liquidity on the investors home market and the costs of trading the same foreign stock on its own home market. Perhaps Nokia is the most prominent example, being one of the most heavily traded stocks globally. The chosen example is a trade of 200,000 in Nokia shares by an investor based in Germany on Deutsche Brses electronic trading platform Xetra and on Nokias Finnish home market.

Figure 9: Total costs of a wholesale trade of about 200,000 in Nokia stock

Total costs basis points (estimates)

Preferred option

Domestic trade in Nokia (benchmark)

13.5 15.0 0.6

29.1

negligible

Nokia traded intra-system (Xetra) 15.0 0.6 0

17.0*

32.6

+10 %

Nokia traded cross-system (Helsinki) 20.0 0.6

13.5 3.8 **

37.9

Commission

Exchangerelated fees

Additional settlement fees

Liquidity costs ***

Total transaction costs

* Spread only slightly higher than Helsinki because of high trading volume on efficient exchange ** Including cross-system settlement fees *** Liquidity costs (bid-ask spread) of Nokia relatively high because of high volatility of tech stocks

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

23

The analysis shows that for Nokia, liquidity costs, the major exchange-influenced cost factor, are only slightly higher on Xetra than in Helsinki. They are 13.5 basis points in Nokias home market, a relatively high number compared to the more typical average of 3 to 10 basis points for home markets in Europe. This can be attributed to the high volatility of technology stocks in general. The liquidity costs on Xetra (17 basis points) are only slightly higher, due to high trading volume on an efficient trading platform. The commission for domestic and cross-border transactions is the same as in the standard cases. The fees for the trade on Xetra are 0.6 basis points, including all clearing and settlement fees. The exchange fees in Helsinki are assumed to be the same, and the costs of cross-border settlement between Germany and Finland amount to 3.8 basis points. In the example, the total costs of trading on the wholesale investors home platform Xetra is lower than on the issuers home market. The incremental cost of trading this foreign stock is caused exclusively by slightly higher liquidity costs and amounts to only around 10 percent of the cost of trading in a purely domestic context. Special case: Trading of selected foreign stocks with hybrid market models For most blue chips whose liquidity is mainly concentrated on the home issuer market, trading on the investors home market can be attractive if lacking liquidity is compensated by a hybrid market model, i.e. an order driven market which is supported by market makers if sufficient liquidity is otherwise not available. One such initiative is the Xetra Stars segment, which was launched in September 2001 with 200 US stocks and which has since been expanded to include European stocks as well. While all hybrid market models have their limitations for large wholesale trades, they can give in particular retail investors access to foreign stocks at total trading costs reasonably close to those available in the domestic market (cf. figure 10).

24

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

Figure 10: Total costs of a retail trade of about 5,000 in Intel stock *

Total costs basis points (estimates)

Preferred option

Intel traded on Nasdaq (benchmark)

20 50

07

~2

22 59

Intel traded on Xetra (US Stars) 20 50 07

~24

44 81

+ 50%

Intel traded cross-system on Nasdaq

35 70 **

~2

57 158

20 86

Commissions of online brokers

Additional third-party charges

Liquidity costs

Total transaction costs

* For the Nasdaq figure, the liquidity cost estimate is based on the daily closing bid-ask spread relative to the closing price using Bloomberg data for January and February 2002. As Bloomberg does not provide Xetra data only, Deutsche Brses own Xetra transaction data was used to calculate the bid-ask spreads for all trades during February 2002. Liquidity costs are assumed to be 50 percent of the spread. ** Additional third-party charges for US transactions tend to be on the lower end of the range given in figure 8.

The analysis in figure 10 shows that while liquidity costs are still much lower in the stocks home market (Nasdaq in this example) than abroad, the hybrid market model allows retail investors to purchase this stock at prices close to those normally paid by wholesale investors (cf. figure 7). Through Deutsche Brses hybrid market model of Xetra US Stars, the incremental costs of crossborder trading, clearing and settlement could thus be cut by roughly two thirds from an incremental cost of around 150 percent (cf. figure 8) to an incremental cost of only around 50 percent (cf. figure 10).

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Incremental costs

25

2.4 Summary On an all-inclusive cost basis, cross-border transactions are less expensive than often alleged. For a typical wholesale trade, costs are about 30 percent higher than domestic trading costs; for a typical retail trade, costs are about 150 percent higher than domestic costs. The cost disadvantage is less pronounced for foreign stocks that are traded in high volumes on the investors home market (like Nokia on Xetra) or for foreign stocks which are traded under hybrid market models. Even less significant than the total incremental costs is the percentage of the cost increase that is driven by inefficiencies in the settlement system. For wholesale investors, these are not more than 2 to 8 percent of total trading costs in foreign stocks. However, in absolute terms, the costs for translation services, estimated at about 4.3 billion per year, are still significant. It is therefore necessary to reduce such translation costs, the most important drivers of which are different legal, tax, and regulatory environments. Some ideas on how to approach these issues are presented in the following chapter.

26

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

3 Improvement of efficiency
The European Commission, national governments, legislators and regulators, as well as industry participants like intermediaries, exchanges, clearing houses and settlement organizations, pursue a common goal: the reduction of the costs of capital in Europe. Lower cross-border transaction and custody costs are one key lever to achieving this goal. In the preceding chapter, we estimated the total incremental cross-border transaction and custody costs to be 4.3 billion per year. In the following chapter, we want to discuss measures to reduce these costs and possible actions to be taken by the different entities and industry players mentioned above. While our analysis of necessary measures differentiates between authorities like the European Commission or national governments and industry players, it should be noted that a close co-operation between those two groups is most promising. Such co-operation is already happening on various areas and should be strengthened even further in future. A successful process should ultimately result in a reduction of European cross-border costs of up to 2.6 billion, or around 60 percent. A significant residual cost basis will remain, as lower transaction volumes as well as language and cultural barriers will persist into the foreseeable future.

3.1 Possible measures by European Commission and national governments, legislators and regulators As discussed in the previous chapter, the harmonization of laws, tax systems and regulations to reduce the need for regulatory translation services is the most important lever for decreasing crossborder trading and custody costs. The principal issues to be addressed by the European Commission, national governments, legislators and regulators relate to three areas. The substantial differences between national legal systems which still lack harmonization lead to high costs as well as to uncertainty and risks. The tax regimes of the member states are unfavorable to cross-border trading and settlement, subjecting market participants to high transaction costs. Finally, there are also some legal restrictions that hinder players to act freely in a competitive market. The legal treatment of securities is regulated differently across Europe. Firstly, there are differing national rules for corporate actions in the member states of the Union. Special problems in crossborder transactions arise when a corporate action has to be executed while the transaction is still in progress, because the diverging legal systems differ on when beneficial ownership of a stock is transferred. Harmonization in this area has been described as essential for the integration of the equity markets in the Giovannini report. With respect to the actual transaction, the availability of bilateral netting for different situations varies across legal systems and has therefore to be assessed for the actual case in hand at substantial cost. Secondly, uncertainty about the legal treatment of a transaction is caused more generally by the fact that interests in securities are far from being treated equally in all member states. This is especially important in the context of collateralization, where different techniques required by the various laws for creating pledges or the transfer of full ownership make cross-border transactions much more complicated than domestic ones. The resulting uncertainty increases costs of transactions in two ways. It requires knowledge about the legal systems of all relevant countries, which is expensive to maintain. But even if this knowledge is provided, a residual legal risk remains, which

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

27

is much higher in the complex international context than for comparatively simple domestic transactions. The existence of this residual risk has to be factored into the costs of cross-border transactions. A further level of complexity and consequently another increase in transaction costs due to higher direct costs of legal services and higher risks is caused by the existence of different rules for conflicts of law in the various member states. Another major area that can naturally only be addressed by the European Union and national governments and legislators is taxation. Not only can securities transactions, dividend payments, etc., have tax consequences in many ways, but these differ for all countries. On the one hand, this inhibits cross-border securities transactions for similar reasons as those which stem from more general legal differences, i.e. there are high costs due to unfamiliarity with all those foreign tax systems that may potentially be involved in cross-border transactions. A risk of unfavorable or even double taxation results. As tax law and taxation procedures are notoriously complicated, only harmonization of the applicable areas can reduce the consequential costs. On the other hand, the national tax requirements, e.g. for withholding taxes and for capital gains taxes, often come at a high cost to foreign and international intermediaries and subsequently to their customers. First, the majority of member states restricts the ability to provide at-source relief from withholding taxes to entities established within their jurisdiction. Foreign intermediaries incur a high extra cost to provide this service to their clients. Furthermore, reporting requirements imposed on intermediaries that frequently require substantial manual intervention impose an even higher cost burden on foreign players as they often do not have the potential to exploit economies of scale. More generally, access to national tax authorities is typically significantly more difficult and subsequently more expensive for foreigners who have to struggle with the requirement to file taxes in the local language along with an administration that is principally oriented to serving the needs of national taxpayers. Beyond the general lack of harmonization of both the legal bases for securities transactions and the relevant taxation, there are also some restrictions that apply to the international securities markets. These restrictions reduce the potential of competing providers and market models to make international securities trading, clearing, and settlement more efficient. Primary dealers and market makers are constrained in their cross-border activities. Settlement on the primary-market must often occur locally. Equally, some member states require securities to be deposited in the local settlement system only. The UK is a good example of a country where taxes and other regulations directly increase transaction costs in addition to significantly restricting international competition. The stamp duty charged from sales of stocks is highly complex in its administration which makes it very difficult and expensive to build efficient links with CRESTCo, the UK CSD. In addition, the complex process of levying this tax and a number of other particularities, like nominee account requirements, distort competition between CRESTCo and foreign CSDs in favor of the UK institution. This results in higher costs to investors through reduced international co-operation and a protected monopoly position on the part of the UK CSD.

28

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

The importance of harmonization efforts has been prominently underlined by recent reports of industry experts, such as the Wise Men and the Giovannini group reports. The authors concluded respectively: [The main factors slowing down market integration] are differences in legal systems and taxation 20) and [] tax regimes and legal systems act as effective barriers to the efficient delivery of clearing and settlement services. 21) The removal of regulatory barriers will allow market forces to create an integrated European capital market. While new legislation is important to foster harmonization, it should not interfere with the ongoing, market-driven innovation and consolidation process to avoid further unnecessary inefficiencies.

3.2 Possible measures driven by market participants Our analysis has shown that market participants like intermediaries, exchanges, clearing houses and CSDs can reduce cross-border transaction and custody costs by up to 1 billion per year. Most of these costs are due to the involvement of a large number of banks and brokers acting as custodians and sub-custodians for the settlement of many cross-border transactions. A reduction of these costs will be the result of an ongoing development of efficient solutions, which has been apparent already over the past couple of years. The three main measures that market participants can influence are closer co-operation with one another, e.g. in the form of building mutual CSD links, international consolidation along or across the industry value chain, and agreement on common industry standards insofar as local laws and regulations permit such harmonization efforts. European CSDs have set up links with one another whenever they are the best means to reduce costs for customers. Clearstream Banking Frankfurt (CBF), for example, has a total of ten bilateral links to other CSDs. Through these ten links, about 76 percent of all foreign securities traded on Deutsche Brses cash markets are being settled. This analysis shows that more than three-quarters of all cross-border trades on Deutsche Brse are with countries to which links already exist. The only two major trading partners without links are the UK and Canada, each with a trading volume of about 4 percent 22). Due to a high dispersion of trading flows, coverage of all trades through links would require the establishment of links to 66 countries. Because of the high fixed costs associated with setting up such links, this would be a highly inefficient project. The example shows that market demand is sufficient to ensure that links are established wherever needed leading to cost savings for participants. Where trading volumes are low, custodian networks offer an alternative solution to links. Figure 11 shows that settlement costs per transaction through the custodian network decrease significantly as the number of transactions with that country increases. However, not all links are fully utilized. The reason for these persistent inefficiencies are cross-border barriers like laws, tax systems, etc., but also business practices of banks and brokers, who prefer the service of global custodians a typical example of effective competition.

20) 21) 23)

Wise Men Report, February 2001 Giovannini Report, November 2001 The complex treatment of the UK stamp duty is the biggest obstacle to building a link to this country

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

29

An example for a particularly efficient solution is the US link. The United States is the highest turnover country; therefore, settlement costs per transaction (equities) are by far the lowest at only 5. One should note that this low price is only possible because of the large market demand for such transaction processing. If links were enforced for less liquid markets (in one of the other three groups in figure 15 for example), total costs might even increase to compensate for the high initial investment and operating costs for such a link. As CBF is currently the only German CSD 23), settlement of equities has to take place there. This does not apply to the more international bond business, however, where a highly efficient link with Euroclear allows the clients of Eurex Bonds, a subsidiary of Deutsche Brse, to settle their trades in Clearstreams main European rival.

Figure 11: Clearstream settlement costs per transaction through custodian network*

60 50 40 30 20 10 0 44,000 3,000 184,000 500,000 1,000,000 1,500,000 2,000,000 US stocks Average of 10 low liquidity countries Average of 8 lowest liquidity European Union countries Average of 9 highest liquidity countries other US

Number of transactions per month on German exchanges


* Clearstream price list (March 2002) is taken as an example. The transaction number is as of October 2001 for all German exchanges.

Apart from setting up links, institutional consolidation is another important field which is likely to help reduce cross-border costs in the future. Groups of large intermediaries, e.g. the European Securities Forum (ESF), have argued that one organizational structure (horizontal integration) might be preferable to another (vertical integration) and that regulators should exert pressure for consolidation to run along these lines. However, this would be highly counterproductive. Market forces have worked very well so far in producing efficient results. Horizontally consolidated institutions tend to be better at avoiding duplication of systems and achieving economies of scale. These benefits must be weighed against the dangers generally associated
The fact that trades in stocks which are subject to collective safe custody on German exchanges must be settled exclusively in Clearstream is due to legal requirements: securities subject to collective safe custody (Wertpapiere in Girosammelverwahrung) must be held in a Wertpapiersammelbank ( 5 Depotgesetz). Only Clearstream Banking Frankfurt is currently a Wertpapiersammelbank according to German law ( 1 (3) Depotgesetz) although any other bank could apply for a licence as a Wertpapiersammelbank. The Exchange Rules of the Frankfurt Stock Exchange merely refer to this legal situation.

23)

30

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

with monopolies, like lack of innovation and reluctance to keep improving operational efficiency. In the context of clearing and settlement organizations, the increase of systemic risk through horizontal integration also needs to be considered. Vertically integrated organizations, on the other hand, are appreciated by their member firms for offering efficient straight-through processing (STP). Main advantages are substantial cost savings, achieved by aligning customer interfaces and reducing their required number. At the same time, STP also reduces processing risks as transaction handling can be highly automated due to an integrated process chain. Additionally, cost savings through synergies of integrating five platforms, namely those for the cash and derivatives markets, for clearing, settlement and information distribution, allow for efficiency improvements which translate directly into lower costs for members. Enhanced legal certainty, increased speed, safety and risk management, the utilization of a joint knowledge and talent pool and frictionless co-operation on working group level are further reasons why the majority of leading financial centres is organized in a vertically integrated way in some form or another. There is, for example, vertical integration of clearing and settlement in the United States, trading and clearing in France, as well as trading, clearing and settlement in Germany. In a recent report on the future of equity trading in Europe, McKinsey and JP Morgan argued that whether the horizontal or vertical model were to be preferred depended on numerous assumptions and that no definite conclusion could be made. Instead, the two organizational forms should be left to compete against each other in the consolidation market, just as has happened over the past several years. As figure 12 shows, such consolidation is an ongoing process that has even accelerated in recent years and has been sometimes horizontal and sometimes vertical. Deutsche Brse, for example, completed two horizontal mergers (DTB and Soffex to form Eurex; Deutsche

Figure 12: Most important cross-border consolidation in Europe since 1997

Date 09 / 1997 * 05 / 1999 * 03 / 2000 * 09 / 2000 ** 09 / 2000 * 06 / 2001 ** 10 / 2001 *

Entities (and countries) involved Eurex: Merger of DTB (Germany) and Soffex (Switzerland) Clearstream International: Merger of Deutsche Brse Clearing (Germany) and Cedel International (Luxembourg) Euroclear / SICOVAM (France) merger Euronext: Merger of Paris, Amsterdam, and Brussels exchanges Euroclear / Necigef (Netherlands) / CIK (Belgium) merger virt-x: Merger between Tradepoint (UK) and the Swiss blue chip market Euronext acquires Liffe

* Date of announcement ** Date of launch of new entity

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

31

Brse Clearing and Cedel International to form Clearstream) and is currently in the process of completing a vertical transaction (Deutsche Brse and Clearstream). However, some competitors fear that vertical integration will lead to nontransparent prices at the expense of market participants. This view cannot be substantiated. In contrast to the pricing systems of most major competitors, Deutsche Brses Xetra pricing system, for example, is transparent without hidden costs or extra charges, e.g. for partial trade execution. Members are charged an all-in price including Clearstream settlement fees that are passed on to Clearstream by Deutsche Brse. Additionally, the pricing system offers attractive prices for retail and wholesale traders through its floor and cap system. Finally, total costs of trading, clearing and settlement on Deutsche Brse are lower than its competitors prices in almost all cases (cf. figure 13).

Figure 13: Price comparison (trading, clearing and settlement)

Trade on LSE *** Small firm * Euronext Deutsche Brse (Xetra)

Order size 1,500 1.68 2.53 1.50 25,000 2.63 3.70 1.50 100,000 6.91 7.45 6.00 17.50 20.48 1,500,000 30.33

LSE *** Large firm ** Euronext Deutsche Brse (Xetra)

1.40 1.14 1.50

2.35 2.31 1.50

6.50 6.06 6.00 19.09 17.50

26.72

* 100,000 orders p.a.; proprietary trading in domestic equities only ** 3,000,000 orders p.a.; proprietary trading in domestic equities only *** Assuming even share of LSE-Originator and LSE-Aggressor trades during continuous trading; auctions and crossing assumed to be 20 percent of all trades; partial executions considered Source: Price lists, industry experts interviews, Deutsche Brse, all data as of mid-2001

It was also alleged that excessive clearing and settlement prices might be employed to cross-subsidize the trading platform which is exposed to more competition than settlement organizations. This allegation is also unfounded, as Deutsche Brses subsidiary Clearstream is among the CSDs with the lowest settlement fees in Europe (cf. figure 14). Additionally, members do not pay higher settlement fees on the Frankfurt trading floor and regional exchanges than Deutsche Brse does for settlement of Xetra trading to Clearstream within the framework of the all-in pricing described above.

32

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Improvement of efficiency

Figure 14: Domestic equity settlement costs per transaction in major EU countries according to Giovannini report
Germany (Clearstream) Italy UK France Denmark 0.40 0.72 0.90 1.13 2.28

Source: Giovannini report 2001

Agreement on common industry standards is another area where market participants will continue to cooperate to reduce the costs of cross-border trading, clearing and settlement. This will involve highly ambitious programs like the move toward a T+1 settlement model, as well as goals within easier reach like the standardization of opening hours and convergence in technical requirements. These efforts will be pursued by the European Commission and national governments in line with the standardization measures which are often required as a basis for adapting systems and procedures within the industry. With the growing importance of cross-border trading, it will become increasingly important to offer low costs to international investors. The desire to keep ahead of their competitors will be a powerful incentive for industry participants to keep driving down the costs of cross-border trading, clearing and settlement. They will do so ideally in a market environment where regulators ensure fair competition between industry participants so that the most efficient systems, organizational forms, and product and service offerings will prevail.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE List of figures

33

List of figures
Figure Figure Figure Figure Figure Figure Figure Figure Figure 1 2 3 4 5 6 7 8 9 Exchange-influenced transaction costs for equity trading Settlement costs according to the Giovannini report Migration from mutual structures to public companies Remote access the example of Deutsche Brse Transaction fee and trading volume development in Europe Incremental cross-border equity trading costs in Europe Total costs of a typical wholesale trade of about 200,000 Total costs of a typical online broker retail trade of about 5,000 Total costs of a wholesale trade of about 200,000 in Nokia stock Total costs of a retail trade of about 5,000 in Intel stock Clearstream settlement costs per transaction through custodian network Most important cross-border consolidation in Europe since 1997 Price comparison (trading, clearing and settlement) Domestic equity settlement costs per transaction in major EU countries according to Giovannini report 8 9 11 12 14 15 19 21 22 24 29 30 31

Figure 10 Figure 11 Figure 12 Figure 13 Figure 14

32

34

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Glossary

Glossary
AIM (Alternative Investment Market) The London Stock Exchanges market for shares of smaller companies (established in 1995). Central counterparty (CCP) In cash market trading, the central counterparty enables exchange and OTC transactions to be executed anonymously because it acts as an intermediary between the parties to the trade, thereby assuming the risk of non-performance on the part of the buyer or seller. In the context of clearing procedures for derivatives transactions, it enables participants to handle all aspects of trading via a single system. Central Securities Depository (CSD) An organization that records holdings of securities and provides mechanisms for their transfer. Clearing The netting and settlement of claims and liabilities arising from securities and derivatives transactions; the determination of the bilateral net debt of buyers and sellers involved in exchange transactions. Clearing is typically performed by a central institution known as a clearing house. Clearing house An organization that provides central counterparty services, e.g. London Clearinghouse, Eurex Clearing, Clearnet. Delivery versus Payment Link (DvP link) In the settlement process, a type of link between CSDs for the transfer of traded securities and funds. It ensures that delivery occurs simultaneously with payment. In comparison to an FoP link, a DvP link reduces settlement risk. Custody In the securities trading context, the service of holding securities in a CSD account for account of another person. International custodians enable beneficial ownership of a security to be maintained and transferred without having an account with the CSD where this type of security must be held. Equity Central Counterparty (ECCP) A central counterparty for equity trading. Eurex (European Exchange Organization) European futures and options exchange organization; a joint subsidiary of Deutsche Brse AG and the SWX Swiss Exchange. Eurex is also the name of the corresponding trading and settlement system. Euronext Exchange resulting from the merger of the Paris, Brussels, Amsterdam and Lisbon stock exchanges. Free of Payment Link (FoP-link) In the settlement process, a type of link between CSDs where the transfer of securities occurs independently of payment. International Central Securities Depository (ICSD) A CSD that settles trades in international securities and in various domestic securities, usually through direct or indirect (through local agents) links to local CSDs. There are two ICSDs in the EU: Clearstream International and Euroclear. Liffe (London International Financial Futures and Options Exchange) A market for exchangetraded derivatives.

CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE Glossary

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Link A technical and contractual connection between CSDs that allows cross-system settlement. Liquidity costs The costs that a buyer or seller of a security has to incur to create liquidity. A proxy is the spread between buy and sell quotes or orders. The more liquid the market for a security is, the lower the cost to create the liquidity needed for the intended transaction, i.e. the lower the liquidity costs. Market impact The effect a single order has on the price of the security. The higher the trading volume, i.e. the more liquidity, the easier large orders will be absorbed by the market and the smaller adverse price movements will be. Netting Procedure for determining net positions In this procedure, long and short positions are offset against one another. The resulting net position forms the basis for risk management and serves as the starting point for determining margin requirements. Neuer Markt The market segment for high growth and technology companies at Deutsche Brse. Nouveau March The market segment for high growth and technology companies at the Paris stock exchange (now Euronext). Open limit order book An order book, i.e. a list of (not yet matched) offers to buy and sell a security at various prices, which is transparent for participants before they enter their orders. Retail trade A small trade with a typical transaction size of about 5,000, initiated by private investors for their own portfolios. Settlement Completion and fulfillment of a financial transaction i.e. the delivery of the security or commodity in exchange for the equivalent in cash. Straight-through processing (STP) The fully automated and therefore swift, safe and efficient processing of a securities transaction, from order placement, to delivery vs. payment, to the subsequent safe custody of the security. Wholesale trade A large trade with a typical transaction size of about 200,000, initiated by institutional investors like investment or pension funds. Xetra Deutsche Brses electronic trading system, which is the leading platform for blue-chips.

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CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE References

References
Centre for European Policy Studies (CEPS), The Securities Settlement Industry in the EU Structure, Costs and the Way Forward, December 2001. Elkins/McSherry, Global Universe Market Cost Report, Quarter 1, 2001. European Commission, DG Internal Market, Final Report of the Committee of Wise Men on the Regulation of European Securities Markets, February 2001. European Commission, DG Internal Market, Overview of Proposed Adjustments to the Investment Services Directive, September 2001. London Stock Exchange (LSE), Survey of London Stock Exchange transactions 2000, 2001. McKinsey & Company, JP Morgan Securities Ltd., The Future of Equity Trading in Europe Balancing Scale, Scope and Segmentation, February 2002. National Securities Clearing Corporation (NSCC), Rules & Procedures, October 2001. Schiereck, Dirk / Weber, Martin, Bleibe im Land und rentiere dich klglich: Der Home Bias, Forschung fr die Praxis, Band 9, Working paper, Behavioral Finance Group, University of Mannheim, 2000. The Giovannini Group, Cross-Border Clearing and Settlement Arrangements in the European Union, November 2001. The Institute for Fiscal Studies (IFS), A Survey of the U.K. Tax System, Briefing Note No. 9 prepared by Stuart Adam and Chris Frayne, November 2001. UBS Financial Services Group, Equity Trading in Europe, presentation at the JP Morgan Banks Conference, February 2002. World Federation of Exchanges (FIBV), Table 1.4.A Value of Share Trading 2000, August 2001.

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