WORKING PAPER SERIES INTERLINKING SECURITIES SETTLEMENT SYSTEMS A STRATEGIC COMMITMENT? NO. 427 / JANUARY by Karlo Kauko

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1 WORKING PAPER SERIES NO. 427 / JANUARY CFS RESEARCH NETWORK ON CAPITAL MARKETS AND FINANCIAL INTEGRATION IN EUROPE INTERLINKING SECURITIES SETTLEMENT SYSTEMS A STRATEGIC COMMITMENT? by Karlo Kauko

2 WORKING PAPER SERIES NO. 427 / JANUARY CFS RESEARCH NETWORK ON CAPITAL MARKETS AND FINANCIAL INTEGRATION IN EUROPE INTERLINKING SECURITIES SETTLEMENT SYSTEMS A STRATEGIC COMMITMENT? 1 by Karlo Kauko 2 In 2005 all publcatons wll feature a motf taken from the 50 banknote. Ths paper can be downloaded wthout charge from or from the Socal Scence Research Network electronc lbrary at 1 Thanks are due to Juha Tarkka, Charles Kahn,Tuomas Takalo and semnar partcpants at the Bank of Fnland research department for several nsghtful comments and to Jens Tapkng for valuable dscusson. 2 Bank of Fnland, PL 160, FIN Helsnk, Fnland; e-mal:

3 -CFS Research Network on Captal Markets and Fnancal Integraton n Europe Ths paper s part of the research conducted under the -CFS Research Network on Captal Markets and Fnancal Integraton n Europe. The Network ams at stmulatng top-level and polcy-relevant research, sgnfcantly contrbutng to the understandng of the current and future structure and ntegraton of the fnancal system n Europe and ts nternatonal lnkages wth the Unted States and Japan. After two years of work, the Workng Paper Seres s ssung a selecton of papers from the Network. Ths selecton s coverng the prorty areas European bond markets, European securtes settlement systems, Bank competton and the geographcal scope of bankng actvtes, nternatonal portfolo choces and asset market lnkages and start-up fnancng markets. It also covers papers addressng the mpact of the euro on fnancng structures and the cost of captal. The Network brngs together researchers from academa and from polcy nsttutons. It has been guded by a Steerng Commttee composed of Frankln Allen (Unversty of Pennsylvana), Gancarlo Corsett (European Unversty Insttute), Jean-Perre Danthne (Unversty of Lausanne), Vítor Gaspar (), Phlpp Hartmann (), Jan Peter Krahnen (Center for Fnancal Studes), Marco Pagano (Unversty of Napol Federco II ) and Axel Weber (CFS). Maro Roberto Bll, Bernd Kaltenhäuser (both CFS), Smone Manganell and Cyrl Monnet (both ) supported the Steerng Commttee n ts work. Jutta Heeg (CFS) and Sabne Wedemann () provded admnstratve assstance n collaboraton wth staff of Natonal Central Banks actng as hosts of Network events. Further nformaton about the Network can be found at The jont -CFS Research Network on "Captal Markets and Fnancal Integraton n Europe" ams at promotng hgh qualty research. The Network as such does not express any vews, nor takes any postons. Therefore any opnons expressed n documents made avalable through the Network (ncludng ts web ste) or durng ts workshops and conferences are the respectve authors' own and do not necessarly reflect vews of the, the Eurosystem or CFS. European Central Bank, 2005 Address Kaserstrasse Frankfurt am Man, Germany Postal address Postfach Frankfurt am Man, Germany Telephone Internet Fax Telex ecb d All rghts reserved. Reproducton for educatonal and noncommercal purposes s permtted provded that the source s acknowledged. The vews expressed n ths paper do not necessarly reflect those of the European Central Bank. The statement of purpose for the Workng Paper Seres s avalable from the webste, ISSN (prnt) ISSN (onlne)

4 CONTENTS Abstract 4 Non-techncal summary 5 1 Introducton Securtes settlement systems and lnks The securtes market as a network ndustry Outlne of the paper 9 2 Assumpton of the basc model Agents Investor behavour Cross-border settlement Costs Fees collected by the CSDs Order of moves 16 3 Solvng the model Secondary market tradng volumes Competton between IFs Domestc securtes and domestc customers Domestc customers and foregn securtes Prcng by the custodan IF Prcng by the CSDs Prces for secondary market servces Prces for prmary market servces 21 4 Commtment to proft maxmsng prcng Assumptons Solvng the model 23 5 An dle lnk as a commtment Assumptons Solvng the model The lnk and the posted fee Alternatve cases 29 6 Conclusons Summary of man results Comparson wth prevous lterature Dscusson 32 References 35 European Central Bank workng paper seres 37 3

5 Abstract Central securtes depostores (CSDs) have opened mutual lnks, but most of them are seldom used. Why are dle lnks establshed? By allowng a foregn CSD to offer servces through the lnk the domestc CSD nvtes competton. The domestc CSD can determne the cost effcency of the rval by chargng sutable fees, and prevent t from becomng more compettve than the domestc CSD. By nvtng the compettor the domestc CSD can commt tself not to charge monopoly fees for secondary market servces. Ths enables the domestc CSD to charge hgh fees n the prmary market wthout volatng nvestors partcpaton constrants. JEL classfcaton : G29, L13 Keywords: securtes settlement systems, central securtes depostores, network ndustres, access prcng 4

6 Non-techncal summary Mutual lnks between central securtes depostores (CSD) n dfferent European countres have been opened up. A CSD can have an omnbus securtes account wth a foregn peer CSD. An omnbus account s one n whch a member pools securtes owned by ts own customers. Thus, a domestc nvestor or nvestment frm can hold securtes ssued n another country on a domestc securtes account wth the domestc CSD. Securtes held by all these domestc customers are pooled on the omnbus account of the domestc CSD wth the foregn CSD. Secondary market transactons n foregn securtes can be processed through the lnk and the domestc CSD. However, n the lght of most of the avalable nformaton, these lnks are seldom used. It s possble that these lnks have no potental for becomng an effcent way to channel cross-border transactons n securtes. Ths mght explan why these lnks are barely used; but why would dle lnks be establshed n the frst place? Ths paper approaches ths queston from the pont of vew of ndustral organsaton theory. CSDs are assumed to be proft-maxmsng natonal monopoles. They offer two knds of servces. Frst, they offer servces related to ssuance of new securtes. At a later stage, they offer servces related to secondary market transactons between nvestors. Because the monopoly cannot credbly commt tself to low future fees for secondary market transactons, the CSD must charge relatvely low prces for prmary market transactons. If t tred to abuse ts monopoly power n the prmary market, no securtes would be ssued n the system. It turns out that the lnk can be used as a tool that allows the CSD to charge hgher fees for prmary market transactons. If the lnk s n place, at least foregn nvestors can make transactons n securtes wthout usng the CSD where the securtes have been orgnally ssued. Thus, the CSD has dsposed of ts monopoly stuaton, and when nvestors decde whether to nvest n securtes n the prmary market or not, they understand that future fees for secondary market transactons wll be reasonable. Interestngly, the domestc CSD can determne the cost effcency of the rval. The foregn CSD cannot process transactons wth domestc securtes wthout servces offered by the domestc CSD. The domestc CSD can charge sutable fees, and prevent the foregn rval CSD from becomng more compettve than the domestc CSD. An deal compettor s one compettve enough to prevent future monopoly prcng but not suffcently compettve to capture the market. By nvtng the compettor and by optmsng ts cost-effcency the domestc CSD can commt tself not to charge monopoly fees for secondary market servces wthout runnng the rsk of losng customers. Ths enables the domestc CSD to charge hgh fees n 5

7 the prmary market wthout dscouragng nvestors from nvestng n securtes n the prmary market. 6

8 1 Introducton 1.1 Securtes settlement systems and lnks The key functons n securtes markets are tradng, clearng and settlement. In a tradng system nvestors smply agree on buyng and sellng securtes. Ths s of no use unless the trades are mplemented. Clearng nvolves verfcaton and matchng of trades and calculaton of the partes oblgatons. In the settlement process securtes are transferred from seller to buyer and the payment from buyer to seller. Securtes settlement systems are essental market nfrastructure nsttutons. In a typcal modern system there s a central system n each country, or possbly several systems for dfferent types of securtes. The nature of the settlement system may depend on the structure of the book-entry system. The central bank or state treasury may be a member, but most members are prvate companes n the fnancal ndustry, such as banks and nvestment frms, whch partcpate n the central settlement system on behalf of ther customers. In the followng, these fnancal nsttutons are smply referred to as nvestment frms (IFs). Paper-form securtes have become rartes, havng been largely replaced by book-entres, e entres n a specal securtes account system. Many countres have a so-called tered book-entry system n whch there s a central securtes regster at the central securtes depostory (CSD). Indvdual nvestors normally cannot have accounts at the CSD. The central regster conssts of settlement system members accounts. Many, f not most, accounts are omnbus accounts. An omnbus account s an account n whch a member holds pooled securtes owned by ts own customers. The CSD may know the total amounts of securtes owned by the customers of each member, but may have no detaled nformaton on ndvdual nvestors holdngs. The IF keeps detaled accounts on the holdngs of ndvdual customers n ts own system. An account wth such a custodan IF could also be an omnbus account; an IF wthout an account at the CSD can open an account wth another IF and use t to pool the securtes of ts customers. Often such customer-ifs are foregn nsttutons. Investors face potentally sgnfcant swtchng costs n a tered book-entry system because t s not possble to sell securtes wthout usng the servces of the custodan CSD. The offcal polcy of the European Unon s to enhance the ntegraton of fnancal markets. The EU Commsson publshed ts fnancal servces acton plan (EU 1999) a few years ago. The plan contaned several proposals on regulatory changes needed to speed up ntegraton of the market for fnancal servces. Many of the proposed reforms have already been accomplshed, as concluded n the progress reports, but the market s stll fragmented. There are more than 20 securtes settlement systems n the EU area. Most of the centres are natonal rather than nternatonal nsttutons. Cross-border settlement s more cumbersome and costly than settlement at the natonal level (Govannn et al 7

9 2001), and proposals to smplfy t have been presented (see e.g. Mlne 2002 and Lenonen 2003). The nterlnkng of settlement systems s a potentally effcent way to avod some of the problems. CSDs can open lnks between themselves. When such a lnk s opened the domestc CSD opens an omnbus account wth the foregn CSD. Securtes owned by domestc nvestors are pooled on ths omnbus account. The domestc CSD keeps detaled records of the holdngs of the clenteles of dfferent domestc IFs, and the IFs arrange the accountng at nvestor level. Several lnks have already been establshed between CSDs n the EU area. Unfortunately t s nearly mpossble to fnd data on the use of these lnks, but many ndustry practtoners clam that they are barely used. Why do CSDs establsh such lnks even though fnancal nsttutons do not use them? It has been argued that the lnks are not a compettve alternatve because of legal uncertantes, or because delvery-versus-payment wth central bank money cannot be arranged through them. These shortcomngs may be of mportance, but they hardly consttute a credble explanaton to the exstence of dle lnks. Why do CSDs open such lnks f these lnks do not enable CSDs to offer servces that would satsfy customer requrements? Is there any ratonal reason to do so? Ths paper s an attempt to present a potental explanaton to the exstence of dle lnks. It s proposed that an dle lnk wth a peer CSD can help the CSD commt tself to reasonable secondary market fees, whch enables t to charge hgher fees n the prmary market. 1.2 The securtes market as a network ndustry Telecommuncatons, power supply and payment systems are often classfed as network ndustres. Shy (2001) presents a lst of typcal characterstcs of network ndustres. Complementarty, compatblty and standards Externaltes n consumpton Swtchng costs and lock-n Sgnfcant economes of scale n producton A natonal securtes market nfrastructure slo, consstng of tradng, clearng and settlement systems, satsfes many of these crtera. Swtchng costs can be substantal, especally n a tered book-entry system. Because nvestors prefer more to less lqudty, there may be sgnfcant postve externaltes at stake n nvestors decsons to consume servces of the securtes ndustry. There seem to be substantal economes of scale and scope n the stock exchange ndustry (Hasan & Malkamäk 2001), and notably n the securtes settlement ndustry (Schmedel, Malkamäk & Tarkka 2002). 8

10 Rochet and Trole (2001) have argued that many network ndustres are platform ndustres, e servce provders that need two knds of customers who need to nteract. If ether of the customer types s mssng, the other group wll not be nterested n the servces offered by the company. For nstance, a credt card company needs both consumers who are wllng to pay wth the card and merchants who are wllng to accept them. To an extent, a natonal securtes market nfrastructure slo s a platform ndustry because t needs both nvestors and ssuers. Competton n platform ndustres has been analysed at least by Callaud and Jullen (2001); n ther model both types of customers can choose between the two cybermedares. In many cases the network s operated by a monopoly, although other companes can provde servces va the network. The owner of the network would normally charge a fee for such access. Laffont and Trole (1994) presented one of the frst analyses of access prcng n a network ndustry. In ther model a monopoly both operates a network and produces servces that are suppled through t. Other companes can produce comparable servces, but they cannot delver them to customers wthout usng the network controlled by the monopoly. Laffont and Trole focus manly on the need and possbltes to regulate the monopoly. Even though the securtes ndustry can be consdered a network ndustry and securtes markets are of paramount mportance to the economy, very few analyses have been done that treat the securtes market nfrastructure as a network ndustry. In hs polcy-orented paper, Mlne (2002) apples the access prcng regulaton approach to CSDs. He concludes that the book-entry functon and a few related servces are a natural monopoly, at least at ssuer level. On the other hand, CSDs offer a wde range of servces that can be offered by competng frms f the CSDs do not prevent competton by abusng ther control over the book-entry system. He argues that certan core functons should be left to a monopoly whereas competton should be ntroduced n all other clearng and settlement related servces, preferably at the European level. A regulaton on terms and prcng of access could be mplemented to prevent abuse of CSDs monopoly poston n potentally compettve operatons. Although both Mlne s paper and the analyss of the sequel here apply the concepts of network ndustres to CSDs, the approaches are entrely dfferent. No attenton s pad here to the possblty of separatng dfferent CSD operatons, and no attenton s pad to the applcablty of government regulatons. 1.3 Outlne of the paper The assumptons of the basc model are presented n the secton 2, and the soluton of the model n the secton 3. The model descrbes a world consstng of two dentcal countres. In each country there s a CSD and a large number of nvestment frms (IFs). Both countres are nhabted by one ssuer and a large number of nvestors. Nether of the two ssuers can use the foregn CSD. Nether 9

11 can nvestors use foregn nsttutons servces. Investors transactons wth foregn nvestments must be channelled through a custodan IF n the home country of the ssuer. CSDs have monopoly power n respect of both securtes ssuance n the prmary market and trade among nvestors n the secondary market. There s no ordnary prce elastcty of demand n the prmary market f the fees are below the reservaton level, mplyng that the monopoly power results only n a transfer of wealth to the CSD. The secondary market outcome cannot be Pareto optmal because the monopoly CSD faces a prce elastc demand. Antcpated future welfare losses n the secondary market are reflected n the fees the CSDs can charge n the prmary market. The secton 4 analyses how a CSD can ncrease ts proft f t can commt tself to an optmal secondary market fee. Ths posted fee s lower than the fee wthout commtment, and, under certan condtons, approaches Pareto optmalty. If the commtment s credble, the CSD can charge hgher fees for prmary market servces wthout volatng nvestors partcpaton constrant. In secton 5 t s demonstrated that a lnk between two CSDs can be used as a strategc commtment to the optmal secondary market posted fee. Because foregn nvestors can transact va ther domestc CSD and the lnk, there s competton n the secondary market. A CSD can create a sutable compettor for tself by allowng the peer CSD to offer competng servces. The deal compettor should be compettve enough to convnce would-be customers of the exstence of compettve pressures but not compettve enough to capture the market. The man results are revewed n the conclusons secton 6. Secton 6 also presents a few addtonal nsghts and a couple of polcy mplcatons of a very prelmnary nature. 2 Assumpton of the basc model 2.1 Agents There are two dentcal countres, 1 and 2, whch are denoted and j ( j). In each country there s a local securtes nfrastructure consstng of a natonal central securtes depostory (CSD) and a large number of dentcal Investment frms (IFs). All these undertakngs try to maxmse profts. Each country has a large number of nvestors. These nvestors are dvded nto segments, whch may be geographc regons or customer categores. There are n segments n each country. The CSDs act as central securtes regsters. Each securty ssued n a CSD s home country must be regstered wth that CSD. Each natonal CSD runs the central securtes settlement system for domestc securtes. The CSDs have no customers other than domestc nvestment frms (IFs) whch are settlement system 10

12 members of the domestc CSD. They offer servces to nvestors but have no securtes portfolos of ther own. The book-entry system s tered; the central regster at the natonal CSD conssts of domestc IF s omnbus accounts. Investors securtes are pooled on these omnbus accounts. Investors and foregn IFs cannot open accounts wth the CSD but they can open accounts wth domestc IFs. If country j nvestors want to nvest n securtes of country, they must open accounts wth domestc country j IFs. Each IF n country j can open a securtes account wth a country IF, and the securtes are pooled n an omnbus account of ths custodan IF. Securtes are traded n two markets. They are frst ssued n the prmary market and thereafter traded n the secondary market. Secondary market trades between customers of dfferent domestc IFs are settled at the CSD. The IFs earn revenue by chargng fees for the settlement servces, e unt prces per settled securty. Each IF sets two secondary market prces to be pad by nvestors, one for a settlement order for a domestc securty and another for a settlement order wth a foregn securty. The fee pad by a country nvestor for a transacton n a domestc securty s denoted w and the fee pad for a transacton n a foregn (country j) securty s denoted w j. Each IF also sets two unt fees for prmary market transactons, one for a domestc (country ) securty (γ ) and another for a foregn (country j) securty (γ j ). There s free entry nto the IF ndustry and the market s hghly contestable; no IF can make profts n the equlbrum. There s one would-be ssuer n each country. 1 The ssuer must ether use the domestc CSD or abstan from ssung securtes. In real lfe ssuers can often choose between CSDs of dfferent natonaltes, but usng a foregn CSD can be partcularly dffcult and costly. For nstance, f a corporaton that s to be publcly quoted wants to ssue ts shares n a foregn system t should establsh a holdng company n the desred country and put all the operatve unts under the new holdng company, whch would then be quoted on the stock exchange, nstead of the former parent company. Prce formaton n the secondary market s gnored n the model. 2.2 Investor behavour Investors have a utlty or objectve functon. No IF can successfully offer servces to more than one segment, and no nvestor can use an IF based n another segment. As to functonal forms and parameter values, the segments are dentcal. Investors get utlty from four sources: 1) from holdg domestc securtes after ssuance, 2) from holdng foregn securtes after ssuance, 3) from tradng n domestc securtes n the secondary market, 4) from tradng n foregn securtes 1 If one assumes that there are several dentcal ssuers n each country the model becomes somewhat more complcated, but ths would probably not lead to any essentally dfferent results. 11

13 n the secondary market. These utltes are addtve, so that the total utlty s smply the sum of utltes from the four sources. When securtes are ssued, each segment buys a gven number of domestc securtes and the same number of foregn securtes. These quanttes of securtes are exogenous and are normalsed to one domestc and one foregn securty. Each domestc nvestor segment n country s wllng to buy domestc securtes n the prmary market f the followng partcpaton condton holds U + F γ 0 (2.1) F s the net utlty from holdng domestc securtes, defned as the dfference between gross utlty and the fee pad to the ssuer n the prmary market. U s the antcpated net utlty from tradng n securtes n the secondary market. Secondary market tradng takes place n several rounds. Each nvestor segment realses a need to trade n securtes n the secondary market durng each of these rounds. Ether the segment sells a part of the securtes portfolo or t nvests more n the same asset. The sgn of a segment s transacton can change from round to round. Deals agreed n dfferent rounds cannot be netted n the settlement system. If a segment buys now and sells at a later stage, the two deals must be settled separately. All nvestors of a gven segment are dentcal, and they always make smlar secondary market transactons. The utlty of each domestc nvestor segment from tradng securtes n the secondary market s U = b θ b θ w θ (2.2) θ s the total number of securtes traded n the secondary market durng all the rounds, and the b s are exogenous parameters of the utlty functon. The parameter b 1 descrbes nvestors wllngness to trade, and the parameter b 2 ndcates the rate at whch ths need s satated. θ 0; θ may be greater than +1. If there were only one round of secondary market tradng the analyss should be restrcted to cases where θ < 1. An nvestor who holds m securtes cannot sell m+1 securtes wthout buyng more of the same asset. If there are several rounds, t s possble that an nvestor segment sells more securtes than t has bought n the prmary market because the segment can buy more of the asset between two sales. Secondary market tradng (θ ) s the nvestors decson varable at ths stage. Secondary market tradng affects nvestors utlty n the same way rrespectve of whether t satsfes the need to sell or to buy. In the lght of emprcal evdence, transacton costs reduce the volume of securtes tradng, but they do not seem to have much mpact on securtes prces. (Barclay, Kandel & Marx 1998) 12

14 As to foregn securtes, nvestors objectve functon s bascally smlar. Each foregn nvestor segment n country j s wllng to buy securtes ssued n foregn country f the followng condton holds: U + F γ 0 (2.3) where γ s the fee charged by country j IFs for prmary market transactons wth country securtes and U s the net utlty (after transacton costs) of nvestors from secondary market tradng. The net utlty from holdng foregn securtes after ssuance (F) equals the net utlty from domestc securtes. The utlty from secondary market tradng n foregn securtes s U = b θ b θ w θ (2.4) Bascally there s no dfference between ths functon and functon (2.2), except that the values of w may dffer, leadng to dfferent volumes of tradng and dfferent levels of utlty. These utlty functons are not drectly derved from any portfolo allocaton theory, but they predct behavour not nconsstent wth, say, the CAPM. Investors prefer to dversfy across countres unless the transacton costs are too hgh. The wllngness to trade n the secondary market could be due to, say, fluctuatons n ncome and varatons n consumpton possbltes. 2.3 Cross-border settlement There s no competton between IFs based n dfferent countres. Investors cannot use servces offered by foregn IFs. When they trade n foregn securtes, they use a domestc IF. When IFs compete for domestc customers transactons n foregn securtes the market s segmented exactly as the market for servces n domestc securtes. No IF can become a settlement member at the foregn CSD. Foregn IFs must partcpate through a local custodan IF. Each IF n country has an omnbus account at a local IF n foregn country j. Any IF n country j can act as such a custodan. Strctly speakng, all the IFs n the model are custodans because all of them keep customers securtes, but here the term custodan IF refers to an IF wth foregn customers. Because remote access to settlement systems s not partcularly commonplace n real lfe (see Govannn & al, p. 8) whereas remote access to tradng s, one could not readly nterpret ths model as a descrpton of tradng systems. If an IF n country j decdes to offer custodal servces to foregn IFs, t sets two prces for such servces. 13

15 The fee charged by the custodan IF n country j for each prmary market transacton s denoted γ jf, where j denotes the country and f customers foregn natonalty. The unt fee per secondary market transacton to be pad by IFs n country to the custodan IF n country j s denoted ν j. The market for servces to be offered to foregn IFs s not segmented. Investors and IFs have no preferences concernng would-be custodan IFs. If one of them charges lower fees than ts rvals, t gets all the customers. Securtes are settled on a net bass at the CSD. The law of large numbers mples economes of scale n custodal operatons. If the orders from dfferent nvestor segments were of equal magntude and completely non-correlated, the expected value of the absolute value of the number of securtes to be settled wth the CSD would grow lnearly wth the square root of the number of segments. However, sales and purchases by dfferent nvestors cannot be ndependent draws from the same dstrbuton because they must sum to zero. Every sale s matched by a purchase. In any case, a large and dverse customer base helps the custodan IF to economse n relatve terms on secondary market fees pad to the CSD because the expected value of securtes to be settled at the CSD grows less than proportonately wth the amount of customers. When one domestc segment and all foregn IFs use the same custodan IF, the net volume of orders the IF must settle wth the CSD s x(nθ + θ ), where x s a nettng parameter (0 < x < 1). 2.4 Costs The CSD has operatonal costs c per processed securty. The same parameter apples to both prmary and secondary market transactons. Regsterng a securty on the account of an IF n the prmary market costs c. The cost of ncreasng or decreasng by one the number of securtes on the account of an IF n the secondary markets s also c. Internalsed trades, e trades settled at IF level, are cost-free to the CSD. The CSD may have some fxed costs, whch would mply economes of scale, but because these fxed costs are not reflected n optmal prcng, they can be gnored n the model. 2 The IFs of country j ncur four knds of costs: 1. Fees charged by the domestc CSD. 2. Fees pad to a foregn custodan IF. The fee for secondary market transactons s ν tmes the number of foregn securtes settled. The unt fee for prmary market transactons s γ f per securty. 2 Prevous emprcal research suggests that there are sgnfcant economes of scale n the securtes settlement ndustry. (Schmedel, Malkamäk & Tarkka 2002). Ths could mean that assumng the exstence of fxed costs would be realstc. 14

16 3. Operatonal costs n the prmary market. The cost s c tmes the number of medated securtes. The cost parameter c s the same as for the CSD. 4. Operatonal costs n the secondary market. The cost of servces n domestc securtes equals c tmes the number of domestc securtes settled n the secondary market. The cost s the same rrespectve of whether the customer s an nvestor or another IF. When a custodan IF settles a securty nternally between the accounts of two customer IFs, the cost s c per customer IF. The cost of servces n foregn securtes s c tmes the number of settled securtes. Because the same c parameter apples to all the IFs and to both CSDs, there are no dfferences n the cost effcency of dfferent nsttutons. As wll be seen, there are no meanngful equlbra for secondary market tradng unless b 1 > 2c. Nether IFs nor CSDs ncur costs n secondary markets f securtes are smply held n an account and no transactng takes place. Because there are no synerges between servces related to foregn and domestc securtes, there could be many knds of IFs. An IF may offer customer servces for both foregn and domestc securtes. Another IF may offer servces for domestc securtes only, or specalse n foregn securtes and not offer any servces for domestc securtes. The most realstc nterpretaton of the model may be that there s only one IF n each segment, whch offers servces for both domestc and foregn securtes. However, no such assumpton s necessary. 2.5 Fees collected by the CSDs The IFs have to pay the CSD a unt fee for each securty ssued n ts central bookentry regster. There are two prmary market fees n the model. α s the fee pad by a custodan IF wth foregn customers and β the fee pad by an IF wth domestc customers only. In a typcal real lfe stuaton the CSD cannot make any of ts fees drectly condtonal on the natonalty of the customers of the IF. However, the CSD could create ndrect ways to prce dscrmnate. The CSD could charge a certan fee per securty f the number of securtes on the account does not exceed the number of securtes bought by one segment, and another fee f the number of securtes exceeds ths celng. To a large extent ths objectve can be acheved by chargng a separate fee for openng the account. If t were assumed that the ssuers pay an mportant part of the fee, nothng essental would change n the model outcomes. The fee would be reflected n the mnmum prmary market prce requred by ssuers, and the fee burden would be passed on to nvestors. Now, nstead, IFs and nvestors pay the fee n a more drect way. As to real lfe nterpretatons, these prmary market fees may nclude a number of dfferent fees, especally fees for the prmary market transactons themselves. They mght also nclude fees pad by ssuers on a monthly bass and fees pad by IFs for havng an omnbus account wth the CSD. The common denomnator of these knds of fees s that they cannot be avoded by not tradng n 15

17 the secondary market, and CSDs customers must ether pay them or commt themselves to payng them at an early stage. Prcng n the secondary market s smple. The CSD can charge a constant unt fee for each securty settled at the CSD. The fee charged by CSD j and pad by the IF s denoted pj. Ths fee s the same, rrespectve of the customer s natonalty. If an IF nternalses trades, e settles them between two customers n ts own system, the CSD cannot charge any fees. 2.6 Order of moves Events happen n the followng order. 1) CSDs set the prmary market fees (αs and βs). 2) Issuers and nvestors agree or do not agree on prmary market transactons. 3) CSDs set the secondary market fees (p s). 4) IFs set ther fees (w s, ν s and γ s). 5) Investors choose IFs. 6) Securtes are ssued, secondary market trades are agreed, cleared and settled. Ths s a full nformaton game. All the agents can mmedately observe all the others decsons. The only thng that cannot be calculated beforehand s the sgn of transactons of dfferent nvestor segments at the 6 th stage, even though t s known that some wll sell and some buy. Even the sze of transactons can be calculated beforehand. 3 Solvng the model 3.1 Secondary market tradng volumes Investors have only one optmsaton decson to make n the secondary market, namely the number of securtes to buy or sell. The sgn of the transacton, e whether they sell or buy, s determned by exogenous factors not analysed n ths model. At ths stage the costs of prmary market transactons are sunk costs and are completely rrelevant to decson makng. Domestc and foregn nvestors optmsaton condtons can be derved by dfferentatng formulas (2.1) and (2.3), when (2.2) and (2.4) have been substtuted for U and U. U U / θ / θ = 0 = 0 16

18 The second order condton s U / θ = U / θ = 2b2 < 0, and the extreme values are maxma. These condtons yeld the followng unque solutons: [ b w ]/[ 2b ] θ = [ b w ]/[ 2b ] θ = (3.1) Unsurprsngly, the wllngness to trade (b 1 ) ncreases the volume of turnover whereas the rate at whch the need s satated (b 2 ) dmnshes t. In any meanngful equlbrum wth secondary market tradng by both domestc and foregn nvestors, b 1 > w and b 1 > w. If these condtons were not satsfed the margnal cost of tradng would exceed the margnal beneft wth any non-negatve amount of secondary market tradng. 3.2 Competton between IFs Domestc securtes and domestc customers If there s only one IF n the segment, and f the IF has no foregn customers, t earns the followng proft from servces wth domestc securtes. ( = γ β c) + (w p c) θ 0 (3.2) where (γ β c) s the proft from prmary market transactons and (w p c)θ the proft from secondary market transactons. If there are several IFs n the segment, both the revenues and the costs are multpled by the market share, and the exstence of multple IFs has no mpact on prces. Because the IF has no market power t must charge fees equal to margnal costs. The fee pad by domestc nvestors for domestc securtes s γ = β c (3.3) + Wth secondary market servces the zero proft condton can be wrtten as w θ p θ cθ = 0 w = p c (3.4) + These prces reman unchanged f there are multple IFs n each segment; all the revenues and expendtures n the zero proft constrant (3.2) are smply multpled by the market share. 17

19 3.2.2 Domestc customers and foregn securtes There are no synerges between servces wth foregn and domestc securtes. Therefore the fees for servces wth foregn securtes can be analysed ndependently of the fees for servces wth domestc securtes. Because of free entry and constant returns to scale no IF can make profts n the equlbrum. The proft of an IF offerng nothng but servces wth foregn securtes, f t s the only ncumbent IF n the segment, s γ γ c + (w c ν ) θ 0 (3.5) f = Because of a lack of market power, the margnal cost of each servce must equal the margnal cost. As to servces wth prmary market transactons, the zero proft condton yelds γ γ c = 0 γ = γ + c 0 (3.6) f f = In secondary market operatons the zero proft constrant of a country j IF n medatng country securtes can be wrtten as ( w c ν) θ = 0 w = ν + c (3.7) These prces reman unchanged f there are multple IFs n each segment; all the revenues and expendtures n the zero proft constrant (3.5) are smply multpled by the market share Prcng by the custodan IF When the would-be custodan IFs compete for settlement orders from abroad, the market s not segmented, and all the IFs compete among themselves. The possbltes to nternalse trades n the secondary market cause ncreasng returns to scale, whch mples that Bertrand competton wth dentcal servces leads to a stuaton where there s only one custodan IF that actually enters the market. Ths outcome has some analoges wth the result of Yanelle (1989); f the supply of deposts s lmted, and f Bertrand competng banks are subject to ncreasng returns to scale, there wll be only one bank wth a postve market share, but t cannot make profts. Bascally any of the IFs could be the one that captures the market. No IF would be able to cover ts costs n the hghly contestable busness f t operated wth a volume that does not mnmse average costs. Any rval IF could undercut ts prces by operatng at the optmal scale. The zero proft constrant of the custodan IF n secondary market transactons s 18

20 n( ν c) θ x(nθ + θ )p + (w c) θ 0 (3.8) = Obvously there are several combnatons of ν and w satsfyng ths zero proft constrant (3.8). However, there s only one combnaton that cannot be proftably undercut by a rval IF, namely the one where the fee for domestc servces s determned accordng to equaton (3.4). If the IF charges a hgher fee for transactons comng from abroad (ν ) and a lower fee for domestc transactons, any IF of another market segment could undercut the fee for cross-border transactons, keep ts fee for domestc transactons unchanged and make a postve proft. If the custodan IF tred to charge a lower fee for transactons from abroad (ν ) and a hgher fee for transactons from the home market, another would-be IF of the same segment would undercut wth a lower w and get all the customers of the segment. When w s determned accordng to (3.4), w accordng to (3.7) and the θ s accordng to (3.1), condton (3.8) yelds 3 b1n+ npx ν = (b n+ np x) 4n{ c n+ p (1 x) cp (nx+ x 1) + b {cn+ p (nx 1+ x)}} 1 2n (3.9) 1 Wth a very large number of segments ths result can be approxmated as Lmν n = xp + c (3.10) The fee equals the cost, whch s ntutve n a hghly contestable ndustry. The proft from prmary market operatons s γ + n*γ f (n+1)*c (n+1)*α = 0. Because γ s determned accordng to (3.3), ths yelds (β +c) + n*γ f (n+1)*c (n+1)*α = 0 γ = ( α β + α n cn) / n (3.11) f + 3 Strctly speakng there s another value of ν that satsfes the condton (3.8), at least n mathematcal terms, namely ν = [b 1 n+np x+ (b 1 n+np x) 2 4n c 2 n+p 2 (1 x) cp (nx+x 1)+b 1 {cn+p (nx 1+x)} ]/(2n). However, ths hgher value has no meanngful nterpretaton. It mples zero profts because the fee would mply a very small or even negatve turnover. If x = 1, t mples θ = 0. If there s no turnover, there s no revenue and no costs, and the proft s zero. It would be easy for any IF to undercut ths fee. Any fee between the two values of ν that satsfy the (3.8) would mply postve IF profts, whch should not be possble n the hghly contestable ndustry. 19

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