WORKING PAPER SERIES INTERLINKING SECURITIES SETTLEMENT SYSTEMS A STRATEGIC COMMITMENT? NO. 427 / JANUARY 2005. by Karlo Kauko

WORKING PAPER SERIES NO. 427 / JANUARY 2005 -CFS RESEARCH NETWORK ON CAPITAL MARKETS AND FINANCIAL INTEGRATION IN EUROPE INTERLINKING SECURITIES SETTLEMENT SYSTEMS A STRATEGIC COMMITMENT? by Karlo Kauko

WORKING PAPER SERIES NO. 427 / JANUARY 2005 -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 http://www.ecb.nt or from the Socal Scence Research Network electronc lbrary at http://ssrn.com/abstract_d=634022. 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-00101 Helsnk, Fnland; e-mal: karlo.kauko@bof.f

-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 http://www.eu-fnancal-system.org. 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 29 60311 Frankfurt am Man, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Man, Germany Telephone +49 69 1344 0 Internet http://www.ecb.nt Fax +49 69 1344 6000 Telex 411 144 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, http://www.ecb.nt. ISSN 1561-0810 (prnt) ISSN 1725-2806 (onlne)

CONTENTS Abstract 4 Non-techncal summary 5 1 Introducton 7 1.1 Securtes settlement systems and lnks 7 1.2 The securtes market as a network ndustry 8 1.3 Outlne of the paper 9 2 Assumpton of the basc model 10 2.1 Agents 10 2.2 Investor behavour 11 2.3 Cross-border settlement 13 2.4 Costs 14 2.5 Fees collected by the CSDs 15 2.6 Order of moves 16 3 Solvng the model 16 3.1 Secondary market tradng volumes 16 3.2 Competton between IFs 17 3.2.1 Domestc securtes and domestc customers 17 3.2.2 Domestc customers and foregn securtes 18 3.2.3 Prcng by the custodan IF 18 3.3 Prcng by the CSDs 20 3.3.1 Prces for secondary market servces 20 3.3.2 Prces for prmary market servces 21 4 Commtment to proft maxmsng prcng 22 4.1 Assumptons 22 4.2 Solvng the model 23 5 An dle lnk as a commtment 24 5.1 Assumptons 24 5.2 Solvng the model 25 5.3 The lnk and the posted fee 28 5.4 Alternatve cases 29 6 Conclusons 30 6.1 Summary of man results 30 6.2 Comparson wth prevous lterature 31 6.3 Dscusson 32 References 35 European Central Bank workng paper seres 37 3

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

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

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

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

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

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

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

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

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) 1 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

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) 1 2 2 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

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

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

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

The second order condton s 2 2 2 2 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) 1 2 1 2 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 3.2.1 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

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. 3.2.3 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

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 = 2 2 2 (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

If the number of segments s very large (n >> 0), ths approaches γ f = α + c, whch s comparable to the fee for prmary market transactons wth domestc servces (3.3). 3.3 Prcng by the CSDs 3.3.1 Prces for secondary market servces When the CSD actually chooses the secondary market fee (p ) nvestors partcpaton constrant has become rrelevant because the decson to partcpate n the prmary market has already been made. Instead, the prce elastcty of demand prevents the CSD from chargng nfntely hgh prces. At the secondary market stage the CSDs decde nothng but the fee for secondary market transactons. Because there are n segments n each country, and because one segment of the domestc country makes transactons through the custodan IF, there are n+1 segments makng transactons through the custodan IF and n 1 makng transactons through other IFs. The total volume of secondary market transactons by foregn segments equals n*θ, the volume of secondary market transactons by each domestc segment s θ, the net amount of secondary market transactons to be settled at the CSD s x(n*θ + θ ). For each transacton settled at the CSD, be t a secondary or prmary market transacton, the CSD ncurs the cost c. Hence, the proft of CSD s Π = n 1)(p c) θ + x(nθ + θ )(p c) + (n + 1)( α c) + (n 1)( β c) (3.12) ( and the optmsaton condton s Π p 0 (3.13) / = PROPOSITION 1. The secondary market fee s hgher than the margnal cost (p > c) When p = c, dfferentatng the proft expresson (3.12) wth respect to p yelds Π / p = = (n 1) *1* θ + x{n( θ = (n 1) * θ + (n 1) * (0) * ( θ / p ) + θ + x(n * θ / p ) + x(n * θ / p }* (0) + 0 + 0 = + θ ) > 0 + θ )1 + 20

Therefore f p = c, the CSD could ncrease ts proft by chargng a slghtly hgher prce ( Π / p > 0). Therefore t would be optmal to ncrease the prce so that p > c. QED Bascally ths result s rather trval. Both CSDs are pure monopoles because no other nsttuton can offer CSD servces wth domestc securtes. Each CSD has monopoly power, and there s no reason not to use t. Hence, CSDs charge monopoly prces, and these prces are hgher than the margnal cost. The result s not lmted to very large values of n (n >> 0). It goes wthout sayng that ths outcome cannot be Pareto optmal because the demand for servces s prce elastc. 3.3.2 Prces for prmary market servces The CSDs have a pure monopoly poston n the prmary market. Because there s no competton n the prmary market, t s ratonal to set the fee at the reservaton level. At ths stage the CSDs have no possbltes to commt themselves to any partcular future secondary market prcng polcy. The only decson varables are α and β. Investors understand that the secondary market fee (p ) wll be determned at a later stage accordng to condton (3.13). Whatever the CSDs do at the prmary market stage, they cannot convnce nvestors about any other secondary market prcng polces. Prmary market prces do not affect proft maxmsng secondary market prces because d 2 Π /dp dα = 0 and d 2 Π /dp dβ = 0. Utltes from secondary market tradng (Us) do not depend on prmary market fees, and they can be consdered as exogenous constants at ths stage. When prmary market fees of IFs are determned accordng to (3.6) and (3.11), the partcpaton constrant of foregn nvestors (2.3) can be rewrtten U + F γ 0 U + F ( α β + α n + 2cn) / n 0 (3.14) And the partcpaton constrant of domestc nvestors (2.1), when the prmary market fee s determned accordng to (3.3), can be rewrtten U + F γ 0 U + F ( β + c) 0 (3.15) The CSD has no reason not to charge the hghest prces that do not volate the partcpaton constrants (3.14) and (3.15) of foregn and domestc nvestors. It follows that α = F + Fn c(1 + 2n) + U + nu ]/(n + 1) β = F + U c (3.16) [ 21

where the Us are determned by the formulas (2.2) and (2.4) and antcpated secondary market fee (p ), whch s hgher than the cost (c). For most parameter values, α < β. 4 Commtment to proft maxmsng prcng 4.1 Assumptons In secton 3 the CSDs could not pre-commt themselves to any secondary market fees. The only way to convnce nvestors that buyng securtes n the prmary market s reasonable was to set prmary market fees low enough to guarantee a non-negatve total net utlty even when the CSD sets ts secondary market prces at the monopoly level. * A new concept, the posted fee ( ), s now ntroduced to facltate the p analyss. The posted fee s the proft maxmsng secondary market fee for a transacton n domestc securtes when the CSD can commt tself to t n a credble and observable way before nvestors make any decsons. Both CSDs choose a posted fee. As to the commtment, there are two possbltes. The CSD cannot commt tself to the posted fee. In ths case the posted fee s completely rrelevant, t wll not be mplemented at the secondary market stage, nvestors pay no attenton to t, and t has no effect on anythng. The CSD can commt tself to the posted fee. Investors partcpaton decsons depend on t because a lower fee ncreases nvestors wllngness to partcpate. In ths case feasble prmary market fees can be expressed as * functons of. p Events happen n the followng order * 1. Both CSDs choose the posted fee to be charged n the secondary market ( p ) 2. CSDs set the prmary market fees (αs and βs). 3. Issuers and nvestors make a bndng commtment ether to ssue securtes or not to ssue. 4. CSDs set the secondary market fees (p s). If the CSD has made a bndng * commtment, the fee must equal the posted fee (p = ) 5. IFs decde whether or not to enter the market. IFs set ther fees (w s, ν s and γ s). 6. Investors choose IFs. 7. Securtes are ssued, secondary market trades are agreed, cleared and settled. p 22

4.2 Solvng the model Let us assume the CSD can make a bndng commtment to the posted fee. How hgh or low should the fee be to maxmse profts? PROPOSITION 2 If the CSD can commt tself to p = of CSD mples p c f n >> 0. * p, proft maxmsaton PROOF If n >> 0 result (3.10) mples that the followng holds as an approxmaton; w = ν + c + h = xp + 2c. θ and θ are determned accordng to (3.1). w s determned accordng to (3.4), and w accordng to the above result. The prmary market fees α and β can be expressed as functons of the posted * secondary market fee,. The hghest possble and therefore proft maxmsng p prmary market fees are determned accordng to (3.16). β = F + U c When n >> 0, α can be approxmated as α = F + U 2c * The proft Π s determned accordng to (3.12). The optmal posted fee ( ) satsfes the followng condton when all these ndrect effects are taken nto * account, ncludng the total mpact of on θs (determned accordng to 3.1) and ts mpact on α and β. dπ p Lmp 2 d Π / dp * n QED * 2 = {c(n 1+ 2x + nx )}/(n 1+ 2x x / dp = 0 * *2 = c 2 2 = [ n(1 + x ) + (1 x) ]/[2b ] < 0 maxmum p 2 2 + nx 2 ) p Ths result dffers from proposton 1 because causaltes between Us and prmary market fees dffer. In the basc model the actual secondary market fee and prmary market fees were not related at all. When the CSD set the fee, t was too late to affect the partcpaton decson. Now, t s assumed that nvestors decsons are de facto based on the actual secondary market fee. The CSDs cannot gnore the mpact of the secondary market fee on partcpaton decsons. The mpact of the actual fee on feasble prmary market fees must be taken nto account. 23

The CSD can ncrease ts proft f t fnds a way to make a strategc * commtment to the optmal posted fee. The CSD would make no profts n p secondary market servces, but t would be able to charge hgh fees n prmary market operatons. Interestngly, f the number of segments s very large, the CSDs secondary market servces are prced at margnal cost. Accordng to standard mcroeconomc theory ths s socally optmal. Ths result s clearly ntutve. If the CSD has commtted tself to prce at the margnal cost n the secondary market, t utlses ts market power n the prmary market only. In ths market such monopoly power mples nothng but a harmless transfer of wealth from nvestors to shareholders of the CSD. Hence, the CSDs can ntroduce a Pareto mprovement and capture all the benefts themselves. Because the custodan IF has a handful of domestc customers, the CSD cannot be a perfect prce dscrmnator between domestc and foregn customers. Hence, the result on Pareto optmalty holds as a mere approxmaton wth large numbers of nvestor segments. When the number of segments ncreases, the relatve mportance of the domestc nvestor segment n the total clentele of the custodan IF gradually dmnshes. 5 An dle lnk as a commtment 5.1 Assumptons The analyss of the secton 4 s completely rrelevant unless the CSDs can commt themselves to the proft maxmsng posted fee. In ths secton t wll be demonstrated that two lnked CSDs can help each other to make such a commtment. In the absence of the lnk, the CSDs had completely non-related operatons. They nether competed nor cooperated. Now, the two CSDs agree on an arrangement that on the surface may seem to ntroduce competton. However, f one analyses the stuaton at a deeper level, t s an nstrument of cooperaton. Each CSD opens an omnbus account wth the other CSD. Both CSDs can offer custodal servces to domestc IFs and ther customers. When the customers of domestc IFs nvest n foregn securtes, the securtes can be pooled on the omnbus account of the domestc CSD wth the foregn CSD. However, IFs can also use a foregn custodan IF, f they prefer ths opton. Hence, there are two competng channels for cross-border transactons. When IFs have chosen whch servce supplers they wll use n the prmary market, they cannot use the alternatve channel n the secondary market because the book-entres cannot be freely transferred between the omnbus account of the foregn custodan IF and the domestc CSD. 24

The Model Agreement between European CSDs of the European Central Securtes Depostores Assocaton (ECSDA) ncludes a secton of a very general nature on fees to be pad by the CSD whose customers securtes are pooled on the omnbus account. Here, these fees between CSDs are modelled n a smplstc way. The two CSDs agree on the followng prcng. There s nothng but a fee for each prmary market transacton. Whenever an nvestor segment of country j buys securtes ssued n CSD n the prmary market and the securtes are pooled on the omnbus account of CSD j wth CSD, CSD j must pay a constant unt access fee (a ) n the prmary market to the CSD. The access fees charged by the two CSDs may or may not dffer. There s no fee for openng the account and no secondary market fee between CSDs. CSDs ncur costs wth foregn securtes n both prmary and secondary markets. These costs equal those n the basc model. The cost of regsterng one foregn securty on the omnbus account of an IF s c, and the cost of ncreasng or decreasng the number of securtes on the account of an IF n the secondary market s c tmes the number of securtes. The fees charged by a CSD can dffer for domestc and foregn securtes. The fee charged to the custodan IF for a prmary market transacton wth domestc securtes s now denoted α. The fee charged to another domestc IF for a prmary market transacton n a domestc securty s β. If the lnk s n use, domestc IFs can conduct prmary market transactons n foregn country j securtes through the domestc CSD, and they must pay a prmary market fee β j for ths servce. The fee to be pad by IFs for secondary market transactons s denoted p for a domestc (country ) securty and p j for a foregn securty. The order of events s the same as n secton 4.1. The access fee (a ) and the prmary market custodan fee (β j ) are chosen at the second stage smultaneously wth the prmary market fees for domestc securtes (α, β ). The fee for a secondary market transacton n a foregn securty s chosen at stage 4. IFs choose between the domestc CSD and the foregn custodan IF at stage 5. Because ths s an attempt to explan why lnks may beneft CSDs even when they are not n use, the detaled analyss s manly restrcted to cases where the lnk s not utlsed. 5.2 Solvng the model When the lnk s n place, the two CSDs fnd themselves n a knd of Bertrand competton for transactons n securtes regstered n the country. At the stage 4 the decson varable of each CSD s the secondary market fee (p). The prmary market access fees (a s) and the prmary market fees (αs and βs) have already been decded at stage 2. The domestc CSD offers servces to country j IFs through a domestc custodan IF, whereas the foregn CSD j offers servces drectly to ts local IFs. However, ths competton dffers from the standard Bertrand competton of economcs textbooks. The CSD offers servces through the domestc custodan IF, not drectly to the foregn IFs, whereas the CSD j 25

offers servces drectly to ts domestc IFs. The CSD offerng the lowest fee (p) does not necessarly get the customers because the prmary market fees (α s and β s) affect the IFs choces between domestc custodan CSD and foregn custodan IF, and because the custodan IF n country charges a prce that would normally dffer from p. Fgure 1. Competton n the secondary market CSD Free secondary market servces CSD j p Competng servces p Custodan IF ν IF IFIFIFIF IF IFIFs IFs fnd themselves n an extremely compettve stuaton and they must choose the opton that provdes customers wth more utlty. They cannot charge fees that exceed costs. Let us assume there s a fee (p ) that satsfes the followng two condtons. The prce enables CSD j to make a margnally postve proft n foregn securtes f nvestors use the lnk. If IFs use the domestc CSD and the lnk, ther customers get a margnally postve net utlty from country securtes. How wll the exstence of such a potental fee affect nvestors decsons at the prmary market stage? Interestngly, t wll make country j nvestors wllng to partcpate, even f the prmary market fees (αs and βs) are hgher than n the secton 3. The reason s smple. The lnk elmnates the monopoly of the foregn CSD. If the lnk s n place, no secondary market prce of CSD (p ) would both lead to a negatve total net utlty for country j nvestors and be sustanable n the compettve stuaton. If the prces of CSD were too hgh to leave country j nvestors wth a non-negatve net utlty from country securtes, CSD j would 26

undercut wth a sutably low secondary market fee (p ), capture the market and make profts. Whatever CSD does at the stage 4, t cannot force foregn nvestors to accept a negatve net utlty. It cannot practce monopoly prcng because t s not a monopoly. Hence, nvestors understand that the total net utlty they get from partcpatng cannot be negatve, and they decde to buy securtes n the prmary market. Is t possble for the CSDs to artfcally construct a stuaton where CSD j can offer a prce that satsfes the two above-mentoned condtons, but s unable to offer, wthout makng losses, a prce that would be even more compettve? Let us assume country j IFs use domestc CSD j and the lnk to conduct transactons wth country securtes. The secondary market fee (p ) that leaves nvestors wth nothng but a margnally postve total net utlty after tradng costs satsfes condton (2.3). When (2.4) s substtuted for U, the condton (2.3) can be wrtten as 2 b * θ b * θ (p + c) * θ + γ = ε (5.1) 1 2 F ε s an arbtrarly small postve constant. Lettng ε = 0, and substtutng [( b1 (p + c)) /(2b2)] for θ and [β + c] for γ, condton (5.1) can be rewrtten as 4 p = b c 2* b ( β F c) (5.2) 1 2 + If β F c, the custodan CSD can at stage 4 extract all the surpluses from country j nvestors wth a hgh secondary market fee and formula (5.2) has a real root. If the value of p ndcated by (5.2) s less than b 1 /2, whch would be the unconstraned monopoly prce 5, ths s also the proft maxmsng value of p. Lower fees would mply less revenue and hgher fees would volate nvestors partcpaton constrants. CSD j s free to choose at stage 2 a value of β that satsfes both crtera, e such that β F c and formula (5.2) wll mply that p < b 1 /2. If CSD j wants to partcpate n the mutually benefcal cooperaton wth the peer CSD, t must choose such a sutable prmary market fee β. If t does not, the peer CSD has no ncentve to open the lnk. CSD can choose an access fee (a ) that leaves CSD j wth nothng but a margnally postve proft from operatons through the lnk even f CSD j charges 4 Mathematcally there are two values of p that satsfy the condton (5.1) p = {b 1 c 2* [b2(β F + c)]} and p = {b 1 c + 2* [b 2 (β F + c)]}. However, the hgher potental p s not meanngful. It would mply negatve secondary market turnover, whch would make the term (p + c)*θ postve, as f customers could earn money by usng negatve amounts of expensve servces. 5 Surprsngly, the cost parameter c has no mpact on the optmal monopoly prce. The reason for ths s smple. It has been assumed that IFs and CSDs have the same cost parameter. If IFs costs ncrease, the demand faced by the CSD weakens, whch lowers the optmal prce. Ths effect and the drect mpact of own costs on the optmal fee by the CSD offset each other. 27

the hghest possble secondary market prce (p ) whch s determned by the condton (5.2). When p s determned accordng to condton (5.2), there s only one value of a that wll lead to zero profts from CSD j operatons n country securtes. Ths value s determned as follows. n{ β a + (p c) θ c} = 0 When (3.1) s substtuted for θ, (p + c) for w and (5.2) for p, ths yelds a = 2F 3c β + (b 2c) ( β + c F) / b (5.3) 1 2 When the value of a s margnally lower than the value ndcated by formula (5.3), country j nvestors know that Bertrand competton n the secondary market cannot lead to a stuaton where nvestors total net utlty from country securtes wll be negatve. If CSD tred to charge a secondary market prce that leads to negatve net utlty, foregn IFs would choose CSD j and the lnk, because CSD j could earn profts by offerng prces that would allow country j nvestors to acheve a hgher total net utlty. Therefore country j nvestors decde to partcpate at stage 3. However, because the access fee (a) has been optmsed to enable CSD j to earn nothng but a margnally postve proft, Bertrand competton wll lead to a stuaton where the lnk s not n use. In Bertrand competton between unequally matched rvals, the cost effcent nsttuton gets all the customers. If CSD charges a secondary market prce that enables nvestors to get a margnally hgher utlty than what CSD j can do wthout makng losses, t could earn a clear proft, not just a margnal one. Its cost effcency has not been artfcally handcapped. 5.3 The lnk and the posted fee What does the analyss on prcng by two lnked CSDs have to do wth the posted fee dscussed n secton 4? Two lnked CSDs can commt themselves n cooperaton to the posted fees n the secondary market by openng the lnk and settng the prces accordng to the results presented n secton 5.2. CSD j must set the maxmal prmary market fees that do not volate domestc and foregn * nvestors partcpaton constrants when p =, and set an access fee (aj) jj p jj accordng to (5.3). Moreover, t should set a sutable prmary market fee β so that formula (5.2) has a real root and mples a value of p < b 1 /2; otherwse the peer CSD mght not be wllng to cooperate. When the moment to set secondary market prces comes, the peer CSD would capture all the foregn customers f CSD j tred to charge a secondary market fee hgher than the posted fee. It could 28

charge a lower fee p jj, but there s no reason to do so because a lower fee would * mply less revenue. Therefore the commtment to s credble. The lnk wll enable the CSD to earn a proft that would be unattanable f the lnk were not n place. By openng the lnk the CSD can tself create a sutable compettor. The compettor should be cost-effcent enough to convnce sceptcal would-be customers about reasonable future secondary market fees, but not compettve enough to capture the market. The optmal combnaton of prmary and secondary market fees would not be feasble wthout ths lmted competton. If there were no lnk, the CSD could not convnce any nvestor that the future secondary market fee (p ) s not sgnfcantly hgher than c. p jj 5.4 Alternatve cases It has been proven that an dle lnk s better for CSDs than no lnk at all, but t has not been proven that there s no alternatve that would enable CSDs to make even more profts. The exstence of sgnfcantly better cases should be mpossble because, at least wth a large number of nvestor segments (n>>0), an dle lnk leads to a Pareto optmal prcng outcome where the CSDs capture all the surpluses. Would t be possble to construct examples where the lnk s n use, the outcome s Pareto optmal and all the surpluses are captured by the CSDs? In the lght of the assumptons, the lnk s about as cost effcent as the custodan IF system, and no substantal mprovement n overall cost-effcency could be acheved by channellng transactons through the lnk. Moreover, the CSDs mght not be able to capture all the surpluses. An artfcal handcap should be mposed on the CSD of the ssuer s home country, and ths handcap should prevent t from coverng ts costs wth secondary market fees that would enable nvestors to get substantally postve net utlty. If there were no such handcap, the CSDs would contnue prce competton far beyond the pont where nvestors partcpaton constrant s satsfed. It mght even be proftable to charge a fee that s lower than the cost (p < c) f ths enables the CSD to capture the market and collect fee revenue for prmary market transactons. Ths would mply a transfer of wealth from CSDs to nvestors. It s dffcult to magne what such an artfcal handcap could be. Perhaps the two CSDs could try to explctly agree on secondary market prces (p s), but such agreements would breach anttrust laws n most jursdctons. It s certanly much smpler to mpose an artfcal handcap on the custodan CSD. Moreover, t has not been proven that the lnk would actually be a credble commtment. Rasng the fee n the secondary market sgnfcantly above the cost would nduce foregn IFs to use the lnk, but domestc nvestors do not have ths opton. Collectng hgh fees n the secondary market from domestc nvestors mght be a better strategy than collectng low fees from domestc and foregn customers alke. Moreover, f nvestments come va the lnk, the CSD earns access fee revenue. If these effects domnate, the lnk wll have no mpact on 29

feasble prmary market fees because no nvestor would be convnced that CSDs choose posted fees at stage 4. The credblty of the lnk as a commtment probably depends on the parameter values. If almost nothng can be netted at the custodan level (x 1), and f a very low value of b 2 mples hgh volumes of secondary market tradng, secondary market transactons va the custodan CSD wll become an unwelcome economc burden that should be avoded. If F = 2c and β = c, formula (5.3) mples that access fees pad by the custodan CSD cannot compensate for the loss because they are zero. Moreover, because U ncreases when b 2 decreases, the CSD loses substantal amounts of prmary market fee revenue from foregners (α ) f the lnk s n use. At least wth * parameter values such as these the commtment to s credble. p 6 Conclusons 6.1 Summary of man results Ths paper presents a model of the securtes settlement ndustry, wth prmary focus beng on cross-border settlement. There are two countres each nhabted by one ssuer, a CSD, a large number of nvestment frms and a large number of nvestors. Nether ssuer can use the foregn CSD. Transactons n foregn securtes must be channelled through a custodan nvestment frm n ssuer s home country. CSDs have monopoly power n both prmary and secondary markets. There s no ordnary prce elastcty of demand n the prmary market, only a smple reservaton prce, mplyng that the monopoly power causes nothng but a transfer of wealth to the CSD. Ths may be non-desrable from the pont of vew of dstrbuton, but there s no msallocaton of resources. The secondary market outcome, n contrast, cannot be Pareto optmal because the volume of transactons s prce elastc and servces are offered by a monopoly. Investors antcpated future welfare losses are reflected n the fees the CSDs can charge n the prmary market. Next, the mpact of a lnk between the two CSDs s analysed. Because foregn nvestors can now make transactons through ther domestc CSD and the lnk, there s competton n the secondary market, even though the competton s lmted to transactons by foregn nvestors. By allowng the peer CSD to offer competng servces, a CSD can tself create a compettor. Unlke companes n ordnary ndustres, t has the possblty to choose the knd of compettor t wll have. By chargng a sutable access fee the CSD optmses the cost-effcency of ts rval. An deal compettor wll be cost-effcent enough to convnce foregn would-be customers of the exstence of adequate compettve pressures n the future but not effcent enough to capture the market. Ths enables the CSD to charge monopoly prces n the prmary market rather than n the secondary 30

market, whch turns out to be a Pareto mprovement. The CSD manages to capture all the benefts by chargng hgh prmary market fees. 6.2 Comparson wth prevous lterature The model dffers from many prevous contrbutons on network ndustres and access fees because the two CSDs of the model are not compettors n the tradtonal meanng of the word. Nether of the CSDs could begn to compete wth the peer CSD on ts own ntatve. The two CSDs offer parallel rather than competng networks. The novelty of ths paper s the use of a sutable access fee as a strategc commtment to an optmal future prcng polcy. The knd of commtment descrbed n ths paper cannot be made unless customers choose the servce provder before they choose the volume of servces to consume. The servce provder s chosen before customers choose the volume of consumpton n many other network ndustres, ncludng moble phone operators and credt card companes. Hence, the basc dea mght be applcable to other ndustres. Even though ths paper presents poneerng work, t has, at least on the surface, certan analoges wth prevous contrbutons. Economdes (1996) has presented a dfferent reason why a company n a network ndustry mght voluntarly nvte competton. An exclusve holder of a technology mght voluntarly dspose of ts monopoly poston, share the technology and nvte entry f t needs other companes to create the crtcal mass for a breakthrough. The argumentaton has lttle n common wth the above analyss of CSDs. Armstrong (1997) argued that competton could and should be ntroduced n the telecommuncatons ndustry n connectons between networks, not wthn a customer base that currently uses the same servce suppler. Mantanng the local network generates fxed costs. One of the few ways to acqure fundng for these costs s to allow the network provder to use ts monopoly power. Introducng multple competng systems n nterconnectons between networks, nstead, mght be a sustanable Pareto mprovement. In both the analyss of Armstrong and the above model of CSDs, the Pareto mprovement s due to the ntroducton of competng channels between the two networks, whch helps to abolsh monopoly dstortons n the allocaton of resources. In ths sense the models are very smlar. However, n the Armstrong model customers beneft from ntensfed competton, not the companes themselves. Crampes and Laffont (2001) present dfferent results. They argue that n the case of the electrcty ndustry, t s not partcularly mportant to prevent monopolst practces n the operatons of nternatonal lnks. The man reason for ths concluson s that domestc and foregn electrcty are perfect substtutes, and the market share of mported electrcty s too margnal to enable the mporter to abuse ts market power. In the model presented above, the stuaton s entrely dfferent because foregn and domestc securtes are not substtutes. If nvestors objectve functons were dfferent, and f foregn and domestc securtes were 31

close substtutes, the welfare mplcatons of the lnk mght change. The two CSDs would compete for nvestors even at the prmary market stage. Openng the lnk would make t easer for nvestors to nvest n foregn vs domestc securtes, thereby ntensfyng competton between the two CSDs. Ths would probably be welfare mprovng. However, the CSDs mght not be wllng to open the lnk because competton would mply a transfer of wealth to nvestors. In ther analyss of competng platform ndustres, Callaud and Jullen (2001) explctly model access and usage prces. These prces can be compared to prmary and secondary market fees n the above model. However, the results of ther analyss are not applcable to the stuaton analysed n here because n the model of Callaud and Jullen both types of customers can choose between frms. Unlke Mlne (2002) ths paper s based on a rather smplstc vew of the role of the CSD. Mlne proposes that, f necessary, government regulatons should be ntroduced to enhance competton n non-core operatons of CSDs. In ths paper these knds of addtonal servces are not explctly modelled. If they were ncluded n the formal model, the basc result of the potental use of the lnk as a strategc commtment mght reman unchanged. The results have clear analoges wth some prevous contrbutons that have analysed the prcng of captve products. Razors and razor blades can be used as an example of ths knd of prcng (Glck & Cameron 1999). Manufacturers may underprce razors and make them ncompatble wth other manufacturers' blades. Profts would be made by abusng the monopoly power n the market for blades. Prmary market transactons n the above model are the equvalent of razors and secondary market transactons the equvalent of blades. Establshng the lnk could be compared to manufacturers' jont decson to make ther products compatble. 6.3 Dscusson The model s based on the assumpton that the CSDs maxmse profts. In many countres CSDs are owned by ther drect customers, manly banks and nvestment frms. Does ths mply that the assumpton of proft maxmsaton s napproprate, and that the CSDs try above all to provde ther customers wth nexpensve servces? Interestngly, a jontly owned upstream suppler mght maxmse the wealth of ts shareholders by maxmsng ts own profts, even f ths mples excessve monopoly prces mposed on shareholder-customers. If the shareholdercustomers compete fercely among themselves, they cannot make any profts themselves. Whatever the prce of the ntermedate good, t s reflected as such n the prces pad by end-customers. If the jontly owned suppler s able to earn monopoly profts, the surpluses can be shared among shareholders. Ths may be the only potental source of pure profts for the shareholder-customers. No compettve forces would put pressure on ths dvdend ncome. Park and Ahn 32

(1999) have presented a detaled analyss of a jontly owned upstream suppler as an mplct cartel. In many countres the securtes ndustry satsfes many of the above-mentoned condtons. Typcally there s only one CSD, one of the purest monopoly stuatons one can fnd. The CSD s often owned by fnancal nsttutons, and competton between securtes brokers seems to be tough. The model has certan emprcal predctons. If CSDs open lnks, they wll ncrease fees that do not depend on the volume of secondary market tradng, such as fees related to ssuance, fees that depend on the number of securtes on an account, fees for havng an account wth the CSD, and annual fees charged to ssuers. Fees related to secondary market tradng, n contrast, would be reduced. Unfortunately statstcs on the relatve shares of dfferent sources of fee revenue are not readly avalable. It mght be possble to comple some of these data usng nformaton publshed by CSDs themselves. One could try to complement ths nformaton wth estmatons based on prce lsts publshed by CSDs and data on turnover n securtes markets. The lnk s lkely to be a credble commtment f a relatvely large number of customers could opt for t. Ths alternatve s avalable to foregn nvestors only. If foregn nvestors account for only a margnal part of the total flow of nvestments, t s dffcult to convnce anyone that the rsk of losng these customers would somehow affect future secondary market prcng by the CSD. Hence, a logcal concluson s that the lnk s more lkely to be a credble and therefore useful commtment f cross-border nvestors account for a very large share of the whole securtes market. Ths emprcal predcton s clear-cut; more dle lnks would be establshed f and when the volume of cross-border nvestments ncreased. Ths seems to accord wth realty, even though there may be other more obvous explanatons for the observaton. The outcome wth the lnk s economcally effcent n the sense that t approaches Pareto optmalty. To a certan extent ths result s due to the fact that the CSDs can prce dscrmnate between IFs at the prmary market stage. The result has clear analoges wth the old fndng that a monopoly behaves Pareto optmally f t s a frst degree or perfect prce-dscrmnator. Nevertheless, the man ntuton of the argumentaton does not depend on ths detal. If t were assumed that the CSDs cannot prce dscrmnate n the prmary market between foregn and domestc nvestors, the lnk could stll be used as a tool to ntroduce some competton. Its exstence would convnce nvestors as to reasonable future prces for secondary market servces, thereby rasng the prce that could be charged n the prmary market. The usefulness of an dle lnk as a strategc commtment may be questonable unless the two CSDs can commt themselves not to close t mmedately when ssuers and nvestors have agreed on prmary market transactons. In lght of artcle 12 of the ECSDA model agreement, closng the lnk would be easy. Ether party can termnate the contract at any tme, by gvng proper notce. If the lnk s closed, the CSD whose customers securtes are pooled n the omnbus account must wthdraw the securtes. By makng the perod of notce long enough, the CSDs can commt themselves not to close the lnk mmedately. Moreover, n a 33

34 real lfe stuaton, closng the lnk mght cause reputaton problems. Needless to say, such reputaton problems could also lmt the freedom of choosng sutable secondary market prces. However, the lnk certanly does not weaken the credblty that CSDs are not gong to abuse ther monopoly power n secondary market operatons. Moreover, the model yelds some polcy mplcatons concernng possble prce regulatons. The prevous economc lterature ncludes a great deal of analyss on access fee regulaton. The results of ths paper can hardly be used as an argument n favour of any regulatons of access fees between the two CSDs. The outcome wth the lnk s almost Pareto optmal and t s unlkely that any government nterventon would mprove the stuaton. If the governments of the two countres are more nterested n nvestors costs than n Pareto optmalty, they could try to regulate the access fee. However, the CSDs mght react by not openng the lnk. Openng the lnk under effectve prce regulatons would make the CSDs compete. If the regulated prce were much lower than the strategcally optmsed prce analysed n the secton 5 of ths paper, competton would cause a transfer of wealth from CSDs to nvestors. As to other prce regulatons, the exstence of lnks between CSDs mght make t less useful to regulate secondary market prces. If the lnk s not n place, mposng the regulaton on fees for secondary market transactons would, at least n lght of ths model, cause a Pareto mprovement. Regulatng prmary market prces may not be advsable because t could cause allocatve dstortons, especally f the CSDs are lnked. If the CSDs could no longer capture all the surpluses, there would be a more pronounced dsparty between allocatve effcency and CSD profts, whch would bas the ncentves of the CSDs.

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415 How persstent s dsaggregate nflaton? An analyss across EU15 countres and HICP sub-ndces by P. Lünnemann and T. Y. Mathä, November 2004. 416 Prce settng behavour n Span: stylsed facts usng consumer prce mcro data by L. J. Álvarez and I. Hernando, November 2004. 417 Staggered prce contracts and nflaton persstence: some general results by K. Whelan, November 2004. 418 Identfyng the nfluences of nomnal and real rgdtes n aggregate prce-settng behavor by G. Coenen and A. T. Levn, November 2004. 419 The desgn of fscal rules and forms of governance n European Unon countres by M. Hallerberg, R. Strauch and J. von Hagen, December 2004. 420 On prosperty and posterty: the need for fscal dscplne n a monetary unon by C. Detken, V. Gaspar and B. Wnkler, December 2004. 421 EU fscal rules: ssues and lessons from poltcal economy by L. Schuknecht, December 2004. 422 What determnes fscal balances? An emprcal nvestgaton n determnants of changes n OECD budget balances by M. Tujula and G. Wolswjk, December 2004. 423 Prce settng n France: new evdence from survey data by C. Loupas and R. Rcart, December 2004. 424 425 An emprcal study of lqudty and nformaton effects of order flow on exchange rates by F. Breedon and P. Vtale, December 2004. Geographc versus ndustry dversfcaton: constrants matter by P. Ehlng and S. B. Ramos,. 426 Securty fungblty and the cost of captal: evdence from global bonds by D. P. Mller and J. J. Puthenpurackal,. 427 Interlnkng securtes settlement systems: a strategc commtment? by K. Kauko,. 38