Cross border challenges of intermediated securities: legal transparency versus operational efficiency
“The regulatory environment when it comes to identification of shareholders has to be as clear as possible. Clarity will ensure that processes are as efficient as possible across borders.”
By François-Louis Tournié, Head of Legal for Post-Trade Services, SGSS
A major challenge for custodians and other cross-border trading firms in the securities markets is identifying the correct legal framework as it relates to securities ownership and registration. Some markets have a direct holding system, in which the beneficial owner of the security is recorded directly at the central securities depositary (CSD) level. Others have an indirect system, whereby the beneficial owner of the securities is not recognised directly at the CSD level, but through the custody chain. This distinction becomes important in the event of a bank failure. In the direct model, the beneficial owner has rights to the security itself. The situation is more complex in the indirect system and depends on the level of the custody chain. The beneficial owner will be either recognised as the owner of the securities at the custodian level, or will have rights only to a receivable or indemnification that will result in cash compensation. In the latter case, ownership is recognised only at the level of the CSD or transfer agent and not at the custodian level and securities will be part of a debt scheme.
Another issue in the fragmented global legal landscape is that the time scale for the return of securities in the event of a bank failure will differ across jurisdictions. This causes uncertainty for investment clients.
Confusion also exists regarding the importance of the segregation of the securities. Segregation of the clients’ securities (from the proprietary assets of a custodian for example) should be linked directly to the recognised ownership of the security. In an indirect market such as France, ownership of the security is recognised at the level of the custodian. This means that segregation should be performed by the the custodian at the CSD level to distinguish the proprietary assets and clients’ assets of this custodian. Where the client of the custodian acts on behalf of its customers, it should also perform segregation of its own assets and assets of its clients in the custodian’s books (i.e. opening several accounts in its name in the custodian books), according to relevant regulations. For example, where this client acts on behalf of alternative investment funds, under the European Alternative Investment Fund Managers’ Directive (AIFMD), it should also distinguish the alternative investment funds assets from the assets of its other clients in the books of the custodian. But this is not the case in all European markets; Greece and Nordic markets, for example, are based on the direct model and segregation occurs directly at the CSD level.
The core legal principles in different markets underpin securities law. In France, for example, the ownership principle is enshrined in the constitution, as a ‘human right’. In the US, on the other hand, the core principle is the fact that an investor benefits from economic rights, but not necessarily ownership rights. Harmonising core legal principles would be a significant challenge and is not anticipated at this stage. There were also attempts to build a harmonised conflict of laws rule, to determine which law is applicable to the material rights attached to the securities or to the securities account. Such a rule has been delayed in Europe in the past, but the issue may be solved within the framework of T2S. As an asset servicing provider, our business is to deal with these differences and make sense of them.
In selecting sub custodians, agent banks must ensure they have a clear understanding of the local securities regulations and how ownership is defined. This should be an important principle to investigate before offering services in any market. An understanding of local market principles could mean the difference between a client losing its investment in the case of a bank failure or not. For example, the nominee principle is not recognised in Greece, therefore if an omnibus account is opened locally for investors, they will not be eligible for any compensation scheme in the event of a bank failure.
When we talk about harmonising and standardising in the securities markets, we have to be clear what we want to achieve. There are many different actors in the value chain: issuers, investors and intermediaries, who all have different objectives. There are some common issues, such as identification of the shareholder in order to exercise substantive rights attached to securities. This information is important for all actors, particularly when it comes to corporate actions or voting.
Progress has been made on harmonising and standardising some of the technical issues, such as corporate actions processing and proxy voting. However, harmonisation of the legal framework is much more difficult and involves many legal entities.
We are working in a complex world and we have to accept that. It is not easy to manage but if you don't want complexity don’t do the job - Pierre Colladon