CISI Securities & Investment Workbook

Global
Securities
Operations
The Official Learning and Reference Manual

9th Edition, April 2013
This workbook relates to syllabus version 8.0 and will cover

examinations from 1 July 2013 to 30 June 2014
PROFESSIONALISM INTEGRITY EXCELLENCE

G lobal S ecuritieS o perationS
Welcome to the Chartered Institute for Securities & Investments Global Securities
Operations study material. This workbook has been written to prepare you for the Chartered
Institute for Securities & Investments Global Securities Operations examination.
PubLIShEd by:
Chartered Institute for Securities & Investment
Chartered Institute for Securities & Investment 2013
8 Eastcheap
London
EC3M 1AE
Tel: +44 20 7645 0600
Fax: +44 20 7645 0601
WRITTEn by:
dr Robert Currie
TEChnICAL REVIEW by:

Kevin Petley, Chartered FCSI
SEnIOR REVIEW by:

Jonathan beckett ACSI
This is an educational manual only and the Chartered Institute for Securities & Investment
accepts no responsibility for persons undertaking trading or investments in whatever form.
While every effort has been made to ensure its accuracy, no responsibility for loss occasioned
to any person acting or refraining from action as a result of any material in this publication
can be accepted by the publisher or authors.
All rights reserved. no part of this publication may be reproduced, stored in a retrieval
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Warning: any unauthorised act in relation to all or any part of the material in this publication
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A Learning Map, which contains the full syllabus, appears at the end of this workbook. The
syllabus can also be viewed on the Institutes website at www.cisi.org and is also available
by contacting Customer Support on +44 20 7645 0777. Please note that the exam is based
upon the syllabus. Candidates are reminded to check the Candidate update area of the
Institutes website (cisi.org/candidateupdate) on a regular basis for updates that could affect
their examination as a result of industry change.
The questions contained in this manual are designed as an aid to revision of different areas
of the syllabus and to help you consolidate your learning chapter by chapter. They should not
be seen as a mock examination or necessarily indicative of the level of the questions in the
corresponding examination.
Workbook version: 9.1 (April 2013)

F oreword
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Ruth Martin
Managing director
ContentS
Chapter 1: Securities 1
Chapter 2: Main Industry Participants 49
Chapter 3: Settlement Characteristics 79
Chapter 4: Other Investor Services 113
Chapter 5: Aspects of Taxation 143
Chapter 6: Risk 155
Glossary 177
Multiple Choice Questions 195
Syllabus Learning Map 213
It is estimated that this workbook will require approximately 70 hours of study time.
1
Securities
1. Securities Investment 3
2. Shares (Equities) 6
3. Debt Instruments 9
4. Warrants 18
5. Depositary Receipts (DRs) 21
6. Collective Investment Vehicles 23
7. Securities Identification Numbers 28
8. Issue Methods in the UK 30
9. Principles of Trading 34
10. Exchange-Traded and OTC Transactions 36
11. Order-Driven and Quote-Driven Markets 37
12. Programme and Algorithmic Trading 39
13. Multi-Listed Shares 40
14. Settlement Periods for Equities and Bonds in the

Selected Markets 41
This syllabus area will provide approximately 10 of the 50 examination questions

Chapter One
2 Global Securities Operations

Securities
Securities
1. Securities money to finance research, to buy new

equipment, to take on and train new staff, to
Investment modernise their infrastructure and to finance
the acquisition of other companies. To access
Companies periodically need to raise funds to
this investment capital, companies may issue
finance new developments in their business.
securities in the name of the company that they
To do so, they have a range of options open to
then sell to the investor community.
them.
One technique for doing so is for the company to
One method that a company can use to raise
issue and sell shares in the company, a strategy
new money is to take out a loan from a bank.
known as equity financing. A person who buys
The company will subsequently be required
shares (a shareholder) becomes a part-owner
to pay back the principal on the loan (ie, the
of the company. In return for investing money
sum initially borrowed), plus an agreed rate of
in the company, the shareholder shares both in
interest, at an agreed date in the future.
the risks borne by that company (in a limited
It may be cheaper, and more in keeping with way) and in the profits that it generates.
the strategic objectives of the company, to raise Shares represent a security in the company
these funds through the capital markets. and can be sold to other investors, either via a
stock exchange (exchange-traded) or through
Capital markets bring together companies direct communication between investors
looking for money with investors who have themselves or agents acting on their behalf
money to invest. Companies need development
Global Securities Operations 3

Chapter One
(commonly known as over-the-counter (OTC) 1.1 Why Do Investors Buy

or off-exchange trading), or via multilateral
Securities?
trading facilities (MTFs).
The fundamental goal from an investors
Another way that a company can generate
standpoint is to optimise the level of return
funds through the capital markets is to sell debt
generated from its investments at a level
in the company by issuing bonds and other
of risk that the investor is willing to accept.
debt-related securities (debt instruments).
This risk/return balance is integral to the
In simple terms, the company (the issuer)
investment process. Commonly, investments
issues an IOu that it sells to investors (the
that hold greater potential for generating
bondholders) in return for cash. These loans will
sizeable returns also carry higher risk that the
typically be established for an agreed period of
investment will lose money, or may need to be
time and the issuer will repay (redeem) the
written off altogether.
loan on a specified date when the loan matures
(the redemption date). however, the investor is A number of factors make securities
not required to hold the IOu until it is repaid. investments attractive:
If the investor wants to realise money before
this point, they may sell this IOu to another U Superior performance as a long-term
investor. These loans may pay a fixed or investment, securities may deliver higher
variable rate of interest to the bondholders on returns than holding money in a bank cash
agreed dates throughout the period of the loan. deposit account. however, securities are not
guaranteed to outperform cash investments
Just like companies, governments, municipal and investors must make an informed
authorities and other public bodies also borrow decision about the projected rates of return
money to finance development projects (ie, to that will be delivered by equities, fixed income
build schools, roads, hospitals) or to manage securities, property and other potential asset
their daily running costs. These bodies may classes over the term of their investment.
also issue bonds and other debt instruments U Diversification investing in a diverse
to raise this finance (eg, government bonds, range of securities (eg, different types of
municipal bonds). however, since they are not equities issued by companies in different
companies, governmental bodies do not issue economic sectors and different markets, a
shares. spread of government and corporate debt
instruments with different times to maturity),
Companies regularly employ investment
alongside other categories of investment
banks to help them to issue equity and
(eg, property, precious metals, commodities
bonds that are carefully tailored to investors
and collectibles, such as fine art), allows the
needs. Investment banks may also underwrite
investor to spread risk across the investment
securities issues to ensure that the issuer
portfolio. because not all parts of the economy
is able to raise the amount of capital that it
deliver the same level of performance at the
needs. In order to raise finance through the
same time, exposure to a range of different
capital markets, the securities issue must be
sectors enables the investor to diversify their
appealing to the investor community, offering
investment risk, providing a broad spread
an instrument that will be appropriate for
of growth and income opportunities as the
the investors investment objectives and
economy grows. by spreading risk further
financial circumstances. Issuers are creating
across a range of global markets, this adds
increasingly sophisticated types of financial
additional diversity to the asset portfolio.
instrument designed to offer an attractive
U Regulatory oversight securities markets
return at a level of risk that the investor is
globally are usually closely regulated,
prepared to bear.
affording protection to the investor against
malpractice and systemic risk.

Securities
U Liquidity the market in many securities is 2. Income payments the investor may be
relatively liquid, meaning that a buyer can paid income (ie, dividends or interest) on
be found without either delay or a significant the securities that they have bought.
effect on market price when the investor Equities investors (ie, ordinary share-
wishes to sell a security, and vice versa. If holders) may be entitled to a share
an investor feels that the market for certain of any profits that the company has
securities is likely to move up or down, it is made through a dividend payment that is
important that the investor can increase or approved at the company annual general
reduce the size of their securities holdings meeting (AGM).
without delay in response to these market bondholders will usually be paid a fixed
trends. rate of interest (known as the coupon) at
U High volume, low relative costs many fixed intervals throughout the period of
securities trade in high volume in securities the loan.
markets on a daily basis. Consequently, the
costs of securities trading can be relatively
low compared with trading in some other
1.3 Who Invests in
categories of investment. Securities?
For the sake of simplicity, we have referred so
far to an individual investor who has purchased
1.2 Sources of Investment
stocks and bonds in order to realise an income
Return and a potential capital gain on their initial
Equities and fixed income products offer two investment. however, pension schemes, life
principal avenues for generating return on insurance companies, mutual funds and other
investment: institutional investors also invest widely in
securities markets in order to generate returns
1. Capital appreciation if the price of on the investments that they hold on behalf of
the security rises, the investor has an their members.
opportunity to sell the asset in order to
realise a profit. The principle of buying and Members and sponsors of pension funds, for
selling securities is in many ways similar to example, will pay into the scheme throughout
buying and selling used cars, gold coins, or their working life and will expect to receive
other tradeable items: the investor aims an income from the pension scheme on
to buy securities at market price and later retirement. These monies will be invested by
sell for a higher price in the hope that the pension scheme in a range of financial
they will be able to realise a capital gain instruments, including equities and fixed
on their investment. If the company is income instruments, to meet the liabilities
generating strong profits then the share that the pension scheme will have to pay to its
price is likely to rise as demand for the members when they retire.
stock increases. For example, if the investor Governments and sovereign wealth funds may
buys 100 shares in a company called AbC also invest in international capital markets to
Manufacturing Company at 0.80 per share, optimise investment return and to provide a
and later sells these shares when the price diversified portfolio of assets that will afford
has risen to 1.60 per share, the investor protection against movements in global
will have realised a profit (or capital gain) markets.
of 80, ie:
Investment management companies (often
Capital gain = (100 x 1.60) (100 x 0.80) known also as asset managers or fund
= 160 80 = 80. managers) will invest in securities markets,
either:

Chapter One
1. to generate investment returns for investors property of the ordinary shareholders. hence,
(eg, private investors, pension funds) who ordinary shares are often known as equities.
have paid money into the funds that they The money that a company raises by issuing
manage; or ordinary shares and selling them to investors is
2. to generate returns on the companys own called equity capital.
account by investing its own money. This
situation, where the investment company unlike debt capital, which is borrowed money,
acts as principal for the invested funds, is equity capital does not need to be repaid
known as a proprietary investment. since it represents continuous ownership of the
company. In return for investing in the company,
Investment banks have traditionally been high- ordinary shareholders are part-owners of the
volume players in global securities markets, company and have rights to:
trading both as principal in order to generate
investment returns on their own accounts, U attend and vote at shareholder meetings,
and as agency traders, placing trades on including the annual general meeting (AGM)
behalf of third-party clients. Investment and any extraordinary general meeting
banks historically have not catered directly (EGM);
for the retail investor, but have concentrated U receive the annual report and accounts;
on providing services to corporations, U share in the companys profits by receiving a
governments and other financial institutions. dividend paid on each share that the investor
In some cases, however, they may also provide holds (although in some circumstances the
investment services to wealthy private banking directors may elect not to pay a dividend);
clients, often known as high net worth U participate in the appointment and removal
individuals. of company directors;
U share in the remaining assets of a company if
having provided a brief introduction to the it goes into liquidation;
world of securities investment, and to the U receive a capitalisation (bonus) issue in
functioning of capital markets, we will now look proportion to their existing holdings;
more closely at the characteristics of some of U participate in rights issues or other offers of
the broad range of securities available to the new shares;
investor. U be consulted in special circumstances (eg,
when a merger is proposed);
U additional benefits, or perks (eg, eligible
2. Shares (Equities) shareholders in a construction company may
be offered a discount on the price of a new
All listed companies issue ordinary shares, but
property, and eligible shareholders of a train
some may also issue preference and deferred
company may be offered discounts on the
shares.
price of rail travel typically, the company
will specify a minimum number of shares that
2.1 Ordinary Shares must be held to qualify for these benefits).
In some instances, a company may issue ordinary

Learning Objective 1.1.1
shares that do not carry voting rights (known as
Understand the characteristics of ordinary non-voting shares). holders of this type of
shares: ranking in liquidation; dividends; voting share will not be entitled to vote on company
rights/non-voting shares; deferred shares; resolutions at any AGM or extraordinary general
registration; bearer/unlisted securities; transfer meeting (EGM).
restrictions
Deferred shares are part of the ordinary
capital of a company and offer holders the
Equity is the residual value of a companys
same rights as ordinary shares, with the
assets after all its liabilities have been taken
exception that they do not rank for a dividend
into account. The equity of a company is the

Securities
until specified conditions are met, at which U The exchange will provide regular reporting
time they are then said to rank pari passu with on sales and purchases of listed securities.
the ordinary shares. For example, a dividend U disposal of shares by company directors
may not be paid until a specified date has been and associated persons must be publicly
reached, or until the company has reached a disclosed.
specified level of profitability. U Companies wishing to list on a registered
stock exchange will typically be subject to a
detailed investigation designed to safeguard
2.1.1 Share Registration
the integrity of the exchange and to offer a
In the uK, and many other major markets, degree of protection to investors that they
the shareholders name and address will be are buying securities in a bona fide company;
recorded electronically in the issuers register listing is also subject to regulatory approval.
of shareholders, maintained by the company U The liquid nature of exchange trading can
registrar or transfer agent, plus on CREST, the facilitate price determination; typically, prices
legal register. Legal title to the share will rest of listed securities will move up and down
with the person whose name appears on this according to supply and demand across
shareholder register. Share registration and potential buyers and sellers active on the
transfer of legal title are covered in Chapter 4. exchange.
Some countries place restrictions on the sale Unlisted securities are those that are
or transfer of certain categories of shares to not listed on a registered exchange. These
non-resident investors. See Section 2.1.4. securities will be traded off-exchange or over-
the-counter.
In some jurisdictions, takeover regulations
require that a shareholder make an open offer
to acquire shares from all remaining public 2.1.3 Bearer Securities
shareholders when his/her holding reaches a
historically, new issues of equity resulted in
specified threshold limit (eg, in the uK, this
the issue of share certificates in the name
threshold is currently 30% of a companys
of the shareholder. Some markets continue
issued capital).
to issue and process certificated securities.
If the security is unregistered, legal title will
2.1.2 Listing rest with the investor who physically holds the
security (the bearer). This is known as a bearer
Listed securities are those that have been
security. A bearer security is a security where
accepted for trading on a registered stock
no registration of ownership is required and
exchange. To list their securities, issuing
proof of ownership lies in physical possession
companies must, typically, fulfil conditions
of the security certificate. The investors name
specified under the listing requirements of the
does not appear on the security and, thus,
stock exchange.
anyone who presents the certificate has the
The listing process may offer a number of right to receive the cash value. dividends are
benefits to the issuer and the holder of the normally reclaimed by detaching coupons from
security: the certificate.
U The security is traded in a regulated and

orderly marketplace. 2.1.4 Transfer Restrictions
U The exchange can provide a liquid market In some jurisdictions, and for certain securities,
for the security those wishing to sell the restrictions may be applied on how, and to
security can find potential buyers, and vice whom, securities may be transferred. For
versa. example:

Chapter One
1. In some instances, securities may not be

sold to foreign investors, or foreign investors
may be restricted from holding more than
a specified percentage of the total issued
capital in specified companies or sectors, or
must report to the regulatory authorities,
the exchange and/or the depository when
the size of their holding exceeds a specified
percentage of the total issued shares in a
company.
2. In some circumstances, securities holders
may be restricted from selling or transferring
securities in quantities of less than 1,000, or
some other specified block/lot size.
3. Restrictions may be placed on transfer of
securities when the issuer is subject to
bankruptcy or legal proceedings.
4. Issuers in some jurisdictions may place
restrictions on the transfer of securities for
Example
a given period after issuance, conversion or
other form of change in status, without the Consider the following preference share: 3%
issuers explicit consent. preference dividend 0.40.
This is a preference share with a nominal value

2.2 Preference Shares of 0.40 per share that carries a dividend of
3%. Hence, it will pay a dividend income of 3%
Learning Objective 1.1.2 of 0.40 every year for every share issued. If a
Understand the characteristics of preference company has issued 100,000 of these shares at
shares: ranking in liquidation; dividends; nominal value then it will have received:
voting rights/non-voting shares; cumulative/
100,000 x 0.40 = 40,000 from shareholders
non-cumulative; participating; redeemable;
on issue.
convertible
It will pay an annual dividend of:
by issuing preference shares, companies may
40,000 x 3% = 1,200 each year.
raise share capital without diluting the ownership
rights of ordinary shareholders. Preference
shares are part of the companys total share Preference shares do offer some important
capital, but do not represent part of the benefits over ordinary shares:
companys equity share capital. Consequently,
preference shareholders do not have a share in U holders of preference shares take preference
the rising profitability of the company. over the ordinary shareholders for
dividend payments and payments following
Characteristics of preference shares are: liquidation. If the company were to go
into liquidation, if there are sufficient funds
U Preference shareholders have no voting
available, preference shares would be repaid
rights.
at nominal value (or par value, namely 0.40
U Preference shareholders are paid a fixed
in the example above) before any repayment
dividend per share, which is established at
was made to ordinary shareholders (see
the time of issue and does not increase with
Figure 1).
rising profits of the company.

Securities
This indicates that the 0.40 per share

Figure 1: Payment of Obligations preference share carries an entitlement to a
After Liquidation 3% dividend and will be redeemed in 2015.
If a preference share is a participating

If a company goes into liquidation, or is wound
preference share, then the shareholder has the
up, the assets are generally sold and the
right to participate in, or receive, additional
proceeds will be paid out in the following order:
dividends over and above the fixed percentage
1. Fixed-rate loans and bonds secured on the dividend discussed above. The additional
assets of the company. dividend is usually paid in proportion to any
2. Preferential creditors. ordinary dividend declared.
3. Floating rate loans and bonds secured on
Preference shares may be convertible. If the
the assets of the company.
shares are convertible then the shareholders
4. Unsecured loans and bonds and other
have the option, at some stage, of converting
unsecured creditors.
them into ordinary shares.
5. Subordinated loan stocks.
6. Preference shares.
7. Ordinary shares.
3. Debt Instruments
U Preference shareholders may be entitled to Learning Objective 1.1.5
a fixed dividend even when no dividend is Understand the characteristics of fixed income
paid to ordinary shareholders. A preference instruments: corporate bonds; eurobonds;
shareholder is not guaranteed a dividend convertible bonds; government bonds; discount
every year, since the company may decide securities; floating rate notes; coupon payment
not to pay a dividend at all. However, if the intervals; coupon calculations (may be tested by
company does decide to pay a dividend, the use of simple calculations); accrued interest
preference shareholders have the right to calculations (may be tested by the use of simple
receive their dividend before the ordinary calculations) (actual/actual, 30/360); clean
shareholders in all circumstances hence the and dirty prices; mortgage-backed securities,
term preference. asset-backed securities; index-linked bonds
Preference shares may be cumulative or

non-cumulative. If a dividend is not paid, Debt instruments are (generally) interest-
cumulative shareholders receive the dividend bearing securities issued when a borrower
carried over, and the company must pay these wishes to raise a specified amount of cash in a
shareholders before it can pay any other specified currency. As with equities, an issuer
dividends. In the example on the previous (ie, a company, government or government
page, if the 1,200 for 2011 is missed, then agency) sells bonds to investors in order to
preference shareholders will receive 2,400 in raise capital. However, unlike with equities, the
2012 (assuming the company is in a position borrower promises to:
to pay a dividend in 2012). Non-cumulative
U repay the capital to the investor at an agreed
shareholders simply lose the dividend if it is not
date in the future (except in the case of
paid, as a normal shareholder would.
perpetual or undated bonds); and
A preference share may be redeemable, U make periodic interest payments (known
which means that at some time in the future as the coupon) to the investor throughout
the company will buy it back. Redeemable the loan period (except in the case of zero
shares usually look like this: coupon bonds).
3% cumulative preference share Corporate bondholders (ie, holders of debt

of 0.40, 2015 instruments issued by a company) typically bear

Chapter One
Example
Take as an example an investor who is prepared to lend 1,000 to a company for five years and
assume that interest rates are 7% per annum. In return for that loan, the company issues the lender
with a bond. The bond is a legal acknowledgement of the debt and, under the terms of the bond, the
company makes a number of promises to the lender.
The two main promises are:

U To pay interest on the bond at 7% a year. This interest payment is called the coupon and, in this
case, will be 7% x 1,000 = 70 a year.
U To repay the capital of 1,000 in five years time. The repayment value of 1,000 is called the
nominal value of the bond.
Graphically, the cash flows would be as follows:
INVESTOR
Maturity
1,000
Year 1 Year 2 Year 3 Year 4 Year 5
Issue
Year 0
7% or 70 7% or 70 7% or 70 7% or 70 7% or 70
Bond + 1,000
ISSUER
a lower risk in the company than shareholders. company may pay no dividend on ordinary
hence, in the long-term, returns on equities shares. however, it will still be required
may be higher than on bonds (though bonds to pay interest on bonds and other debt
may outperform equities for more prolonged securities.
times during this period). This additional return
generated on equities, compared with bonds, is From the perspective of a company issuing
known as the equity risk premium. bonds:
bonds typically carry lower risk than equities U bond issues typically allow the issuing
because of the following factors: company to obtain fixed-term finance at
lower cost than it could via a bank loan;
U bondholders have a prior claim on the U bondholders do not represent part of the
companys assets relative to shareholders. companys equity share capital. hence,
hence, if the company goes into liquidation, issuing bonds does not dilute the ownership
shareholders will face a higher likelihood that of the company;
they may lose their money than bondholders. U bondholders do not share in the rising
U The return that the bondholder will usually profitability of the company, nor do they
receive is fixed at the time of issue and will carry other corporate ownership privileges
be predictable if the bond is held until the held by shareholders.
redemption date. Specifically, the bondholder
will receive an interest payment at fixed The term coupon comes from the traditional
intervals throughout the period of the loan feature of bond certificates where coupons
and will be repaid the par value of the bond were attached to the certificate. These were
at maturity. In contrast, shares have no fixed cut off and submitted to the company in order
maturity and the shareholders return will be to claim interest entitlement. Many bonds are
dependent on the companys profitability and now dematerialised (that is, paper certificates
a number of other factors. In lean years, the have been eliminated and bonds are held

Securities
and registered electronically, with transfer The coupon reflects the interest rate payable
of legal title also taking place electronically) on the nominal amount. however, an investor
or immobilised (where the share certificate will have paid a different amount to purchase
is held by a central depository and, again, the bond, so a method of calculating the true
transfers and legal title are registered return is needed. The return, as a percentage
electronically), but the term coupon is still of the cost price, which a bond offers is often
used to denote the periodic interest payment. referred to as the bonds yield. The interest
paid on a bond as a percentage of its market
The coupon rate is the rate of interest paid
price is referred to as the flat or running
on the nominal value (also known as the face
yield. This is calculated by taking the annual
value, par value or redemption value) of
coupon and dividing by the bonds price and
the bond.
then multiplying by 100 to obtain a percentage.
The coupon might be paid every six months
or annually. Referring back to the example Risk of Default
above, if the bond paid a semi-annual coupon, The price of a bond will reflect interest rates.
then 35 would be paid every six months. uK It will also reflect the risk that the issuer of the
government bonds (known as gilts) and uS bond will fail to meet the two promises to pay
government Treasury bonds both pay a semi- interest and to repay the capital on maturity.
annual coupon. Occasionally a bond may pay a This is known as default risk.
quarterly coupon, eg, some floating rate notes.
It is difficult to quantify default risk with the
With some bonds, the coupon is paid without same precision as yields, but the investor
tax being withheld. This is termed a gross must draw on as broad a range of risk
payment. Other bonds pay the coupon with measures as possible in order to evaluate the
tax withheld. This is termed a net payment. expected return on a bond investment against
Whether payments are made gross or net the associated risks borne in holding this
depends on the tax legislation of the country instrument.
concerned, but the coupon rate in the title of
the bond will always be the gross amount. For large issues of bonds, such as those taking
place in the eurobond market (see Section
When the bond reaches its redemption date, it is 3.1.4), there are specialist rating agencies (for
said to mature and the bond is then redeemed. example Standard & Poors, Moodys, Fitch),
In the example, the bond was issued with a which give each bond issue a credit rating
five-year maturity. After one year has elapsed, that reflects the agencys assessment of the
it will have a four-year maturity. The repayment likelihood of default. The most secure bonds
of the principal of the loan at maturity is not are given an AAA rating, referred to as triple
usually subject to withholding tax. A, according to Standard & Poors rating. bonds
that are less secure will have a lower price, and
bonds are typically classified as short, medium
thus a higher yield, than a triple A-rated bond.
and long maturity. The uK debt Management
bonds with a Standard & Poors rating of bb or
Office (dMO), for example, which issues uK
below are considered to be speculative/junk/
gilt securities (ie, uK government bonds),
high-yield/sub-investment grade rather than
categorises gilt maturities as follows:
investment grade.
U Short: 07 years.
U Medium: 815 years.
U Long: 15+ years.
3.1 Types of Fixed Income
Instrument
Gilts with a maturity of less than three years
are sometimes labelled ultra-short. Gilts with bonds are typically labelled according to
a 50-year maturity, which have been issued by who issues the bond, which market they are
the dMO since 2005, are sometimes labelled issued in, and any defining characteristics that
ultra-long. differentiate the instrument from a standard
fixed-interest bond.

Chapter One
3.1.1 Government Bonds 3.1.4 Eurobonds

The bonds issued by politically stable and A eurobond is a bond issued by a company
traditionally economically strong governments, and sold to investors outside the country
such as the uS, Germany and the uK, are where the currency is employed. For example,
typically among the most secure marketable a uS-denominated bond sold outside the uS
investments in the world. The risk of default on (designed to borrow uS dollars circulating
sovereign debt (as government debt issues are outside of the uS) would typically be referred
generically known) in more volatile developing to as a eurodollar bond. This may, for example,
economies, and some struggling European represent a dollar-denominated debenture
economies, is significantly higher. issued by a dutch company through an under-
writing group consisting of a syndicate of
Governments may issue debt instruments investment banks (eg, dutch, uK and uS
denominated in their domestic currency or in a investment banks).
foreign currency. Whereas governments rarely
default on domestic currency government debt, Coupon payments on eurobonds are subject
default on foreign currency government debt to the tax legislation of the country where the
is more common. Sovereign risk is the name payment is effected. Interest on bonds held in
given to the risk that a government will fail to a recognised clearing system (ie, Euroclear and
honour its debt obligations to foreign creditors. Clearstream) is typically paid gross. For more
about eurobonds see Section 8.4.
Widely traded government bonds include:
uS Treasury bonds or Treasury notes 3.1.5 Convertible Bonds

uK Gilt-edged securities (or gilts)
A convertible is a bond that gives the holder
Japan Japanese government bonds the right, but not the obligation, to convert
(JGbs) the bond into a specified number of underlying
German bunds, bobl and Schatz shares (normally ordinary shares) of the issuing
French OATs and bTAns company on terms that are set out at the
time of issue of the bond. Convertible bonds
commonly pay lower interest than straight
3.1.2 Domestic Bonds
bonds, but provide greater opportunity for
This is a bond issued by a borrower resident capital gain if the price of the underlying shares
in the country of issue, denominated in the of the company appreciates during the loan
local currency and regulated by the regulatory period. In the same way as regular bonds,
authority of the jurisdiction concerned. For holders of unconverted bonds at maturity retain
example, a bond issued by a uS company in uS the right to redeem the bonds at nominal value.
dollars in the uS is a uS domestic bond.
The conversion rate is the number of shares
that are received for each bond. For example,
3.1.3 Foreign Bonds an investor exercising a convertible bond with
a conversion rate of two would receive two
A foreign bond is one issued by a foreign issuer
shares for each bond exercised.
in the local currency in the local market. For
example, a uS dollar bond issued in the uS by
a non-uS company is a foreign bond. Foreign 3.1.6 Discount Securities
bonds are often given colloquial names:
A discount bond is a bond issued at a price that
Name Currency Issuer Market represents a discount to the redemption price
yankee uS dollar non-uS uS at maturity. Zero coupon bonds represent
Samurai yen non-Japanese Japan one form of discount security. This type of bond
bulldog Sterling non-uK uK does not pay interest, but the price paid by
the investor to acquire this bond at the time of
Matador Euro non-Spanish Spain

Securities
issue is at a discount to the capital redemption to securitise this package of loans by issuing
price at maturity. As such, the investor receives securities underpinned by cash flows from
no coupon income, but receives a capital gain the pool of underlying loans which can be
at redemption. bought and sold by investors just like any other
tradeable securities. On purchase, the AbS
This type of issue may be attractive for
holder will acquire the right to a share of the
companies wishing to borrow money to finance
cash flows resulting from loan repayments, but
a project that has a long development time. As
will also take on the risk of potential default by
such, they do not wish to be paying out coupon
borrowers on their repayments.
payments throughout the loan period when
income generated by the project may be low,
but would prefer to repay a capital lump sum at 3.1.9 Mortgage-Backed Securities
redemption, when it is hoped that the project (MBSs)
will be well established and generating sizeable
An MbS is a type of asset-backed security (see
returns.
above) that uses a single mortgage, or a pool
discount securities may also be attractive of mortgage loans, as collateral. Investors
to investors because of, for example, tax receive payments derived from the interest and
considerations and the timing of cash flows. principal of the underlying mortgage loans.
3.1.7 Floating Rate Notes (FRNs) 3.1.10 Index-Linked Bonds
A floating rate note is like a bond, except that Index-linked bonds (variable or floating rate)
its coupon is linked to a floating interest rate. are fixed-income securities where the coupon
For example, an FRn might pay a semi-annual payment (ie, the income) and the principal (the
or quarterly coupon linked to a reference or price at which the bond will be redeemed) are
benchmark rate, such as the London Interbank adjusted to take into account movement in
Offered Rate (LIbOR). This is the rate of retail prices. In the uK, this adjustment may
interest at which banks will lend to one another be made according to movement in the Retail
in London and is often used as a basis for Prices Index (RPI), for example.
financial instrument cashflows.
Example
A company might issue an FRn if it believes
that interest rates will fall in the future and Assume that an index-linked bond is issued at
it does not want to lock into a high fixed its par value of 100, with a 2% coupon.
coupon rate; or it may wish to issue an FRn
if it has floating rate receipts so as to match Consider that, over a five-year term, retail
the interest rate basis of its receipts and prices rise by 25%. As a result, the bond will be
payments, thereby hedging against unexpected redeemed at 125.
and/or adverse changes in interest rates.
The interest paid on these bonds will also
increase by 25% over this five-year period,
3.1.8 Asset-Backed Securities such that the bond pays a real interest rate of
(ABSs) 2%. Thus, the interest paid after five years will
be 2% on the revised redemption value of 125
Asset-backed securities are securities issued (which is equivalent to 2.5% on the original
against a pool of loans which may be credit 100 nominal value).
card debt, student loans, automobile loans,
property loans or other types of loan contract.
In creating an AbS, the originator of the loan

will typically sell a pool of its outstanding
loans to a third party. The buyer may elect

Chapter One
3.2 Clean and Dirty Prices When a price is quoted for a debt security that
includes the accrued interest, this is known as the
Interest entitlements on uK gilt-edged dirty price.
securities, and on many other fixed income
securities, are paid twice per year. during the
period leading up to the next value date for 3.3 Calculating Accrued
a coupon payment, interest will accrue on a Interest on Bonds
daily basis. If the security is sold during this
When a bond is sold, the accrued interest will
period, the seller typically has an entitlement
need to be calculated and added to the clean
to any interest that has accumulated since the
price that the buyer pays the seller.
last coupon date. Market convention dictates
that the buyer will normally compensate the If the trade date is after the record date (see
seller for this accrued interest at the time of Chapter 4, Section 5.5), the coupon will be
settlement. hence, the accrued interest due to paid to the seller and the accrued interest then
the seller will be added to the buyers purchase subtracted from the clean price.
cost and forwarded to the seller.
The first of these is known as a cum-interest
In many jurisdictions, the transaction price transaction and the second is known as an
actually quoted for the debt security must ex-interest transaction.
exclude the accrued income. This is known as
the clean price.
under uK tax law, for example, the clean price

and accrued interest must be quoted separately
for accounting and tax declaration purposes.
The capital value (as valued on transaction date
by the clean price) will be subject to capital
gains tax rules, whereas any accrued income
will be taxed under income tax rules.
Example: Cum-Interest Transaction

A cum-interest transaction is agreed. 200,000 5% Treasury 2012 are traded on 3 March for settle-
ment on 4 March. Graphically:
15 January Trade date 3 March
(due seller)
181 days
Pay date Settlement Pay date

15 January 4 March 15 July
The interest due to the seller can be calculated by the following formula:
days of accrual
Accrued interest = nominal value x coupon for the period x
days in coupon period

Securities
The days of accrual will be between the day of the most recent coupon payment (15 January) and the
day before transaction settlement date (3 March), both days included, which is 48 days, and there are
181 days in the coupon period.
More generally, it will be annual coupon/number of coupons in the year. This would give:
Accrued interest = nominal value x annual coupon x days of accrual

no. of coupons days in coupon period
The accrued interest is added to the clean price.
Example: Ex-Interest Transaction

An ex-interest transaction is agreed. 200,000 5% Treasury 2012 are dealt on 10 July for settlement
11 July. Graphically:
Trade date Settlement date

10 July 11 July
181 days
11 July 14 July
(due buyer)
Pay date Record Date Pay date

15 January 8 July 15 July
The accrued interest on an ex-interest transaction is called rebate interest. The rebate interest is
deducted from the clean price.
The days of accrual are the days from the day of the transaction settlement date (11 July) through to
the day before the next coupon payment (14 July), both days inclusive, which is 4 days.
3.3.1 Accrual Conventions U uK corporate bonds pay interest based on

Actual/365-day convention;
There are four common methods of calculating U uS corporate bonds pay interest based on
the interest payable on interest-bearing bonds. Actual/360-day convention;
These are called interest rate conventions. U eurobonds generally pay interest based on
Some bonds will use a 30/360 convention, while the 30/360 day convention; and
others will use the actual number of days in the U most government bonds pay interest based
month or year. Each convention differs slightly on the Actual/Actual convention.
in the assumptions about the calculation of
the period over which interest is payable. The
conventions change depending on the market,
for instance:

Chapter One
30/360
This case assumes and bases the calculation on there being 30 days in each and every month and
360 days in a year.
For example, if XyZ bonds are acquired on settlement date 1 April and sold for settlement day 2 July,
the buyer would receive all the interest accrued during the period 1 April to 1 July (ie, the day before
settlement date). The settlement process would be calculated as follows:
1 April 30 April = 30
1 May 31 May = 30
1 June 30 June = 30
1 July = 1
91 days
number of days in year is: 12 x 30 = 360.
Accrued interest = nominal x interest x no. of days in period (assuming 30 days in month)
100 360
Actual/Actual
The calculation for actual/actual is the same as above, except that the number of days would be:
1 April 30 April = 30
1 May 31 May = 31
1 June 30 June = 30
1 July = 1
92 days
This convention assumes the number of days in the year is equal to the calendar days in the interest
period, multiplied by the number of interest periods in the year.
Accrued interest =
calendar days in period
nominal value x annual coupon (%) x
(calendar days in period) x (number of interest periods in year)
Actual/360-Day Convention
This case assumes and bases the calculation on a 360-day year.
actual days in period

Accrued interest = nominal value x annual coupon (%) x
360
Actual/365-Day Convention
This case assumes and bases the calculation on a 365-day year.
actual days in period

Accrued interest = nominal value x annual coupon (%) x
365

Securities
Example
Question
Investor X holds 1 million corporate bonds of ABC Ltd with a coupon of 6%. Interest is paid quarterly
and the interest periods are:
U 1 January to 31 March;
U 1 April to 30 June;
U 1 July to 30 September;
U 1 October to 31 December.
Calculate the amount received by the investor per period and in total for each of the four interest rate
conventions.
Answer
The interest rate periods are 90 days, 91 days, 92 days and 92 days respectively.
Actual/360-Day Convention:
U Q1:Interest paid = 1m x 0.06 x 90/360 = 15,000
U Q2:Interest paid = 1m x 0.06 x 91/360 = 15,166.67
Total interest received = 60,833.33
Actual/365-Day Convention:
30/360-Day Convention:
U Q1:
Interest paid = 1m x 0.06 x (3x30)/360 = 15,000
U Q2:
U Q3:
U Q4:
Actual/Actual Convention:
U Q1: Interest paid = 1m x 0.06 x 90/(90x4) = 15,000

Chapter One
Example Exercise 3
On 22 July, purchaser X buys 100,000 bonds 100,000 7% bonds are traded ex-interest.
at 98.125% from seller Y. These bonds have a Interest is calculated on actual/360-day
coupon of 6%, which is paid semi-annually on convention basis. How much interest will the
1 April and 1 October. Interest is calculated on seller pay to the buyer if there are 175 days of
Actual/365-day convention basis. accrued interest and the coupon period is 180
days?
What is the total amount payable to seller Y,
assuming that the trade settles on a T+3 basis The answer can be found in the Appendix at the
and that accrued interest is calculated up to the end of this chapter.
day prior to settlement date?
Price = 98.125%, therefore the principal

amount is 98,125.00
4. Warrants
On settlement date minus one (24 July) the
bonds have accrued 115 days interest since the Learning Objective 1.1.4
last payment date of 1 April.
Understand the characteristics of warrants
Accrued interest = 100,000 x 6% x 115/365 = and covered warrants: what are warrants
1,890.41 and covered warrants; how they are valued;
effect on price of maturity and the underlying
Total amount payable = 98,125.00 + security; purpose; detachability; exercise and
1,890.41 = 100,015.41 expiry; benefit to the issuing company and
purpose; issue by a third party; right to
subscribe for capital
Exercise 1
A warrant gives the holder the right, but not the
100,000 7% bonds are purchased for
obligation, to subscribe to an ordinary share
settlement on 1 April and sold for settlement
or a bond at a specified price on or before a
date 28 June. If the investor receives all the
specified date. In other words, they give the
interest accrued during this period, calculate
holder the right to purchase the underlying
accrued interest using:
share or bond:
i. 30/360 convention;
U at a point in the future (up to the expiry date
ii. actual/365 convention.
of the warrant);
The answer can be found in the Appendix at the U at a predetermined price (the strike price).
end of this chapter.
Warrants are bought and sold on exchanges in
the same way as equities and bonds. however,
they pay no income to the warrant-holder.
Exercise 2 Thus, the warrant-holder will not be eligible for
dividends paid on the underlying shares.
200,000 8% bonds are traded cum-interest.
Interest is calculated on actual/365-day The amount that the investor pays for
convention basis. How much interest will the the warrant is called the premium. This
buyer pay to the seller if there are 100 days of is commonly a fraction of the price of the
accrued interest? underlying asset.
The answer can be found in the Appendix at the See opposite for an example.

Securities
Example
An investor buys a warrant at a strike price of 1. He pays a premium of 20p per warrant.
U If the warrant expires without the underlying share price going above 1, the investor will make
a loss of 20p (the premium). A warrant is said to be out-of-the-money if the underlying share price
is lower than the strike price.
U If the underlying share price rises above 1, the investor has the right to buy the shares at 1,
sell them on the market at the higher price and keep the difference. A warrant is said to be in-the-
money if the underlying share price is higher than the strike price.
Plotting profit/loss against share price gives:
Profit/loss on expiry Breakeven point

or when trading out (1.20)
Strike price
(1)
1.60
Warrant premium
Price of
(20p)
underlying share
If the price of the shares goes up as far as 1.20, he will break even. He can buy the shares at 1
as per his warrant, and then sell them to the market at 1.20. He will make 20p on this transaction,
which will offset the 20p he paid for the warrant. Any further increase in the price of the share is profit.
If the price rises as far as 1.60:
Profit per warrant = Price of underlying share strike price warrant premium
= 1.60 1 20p
= 40p
The investor, therefore, has a limited loss the 20p he paid but potentially an unlimited profit.
hence, we note that the warrant provides a share. On this basis, the premium is made up
degree of gearing to the investor. A 20p initial of the intrinsic value of the warrant and its time
investment in the warrant has translated into value. The time value will erode as it moves
a 40p profit (ie, a 200% profit). This profit will towards expiry.
increase further if the share price continues to
A covered warrant has similar behavioural
rise.
characteristics to those outlined for a warrant
The price that the warrant trades at in the above. however, a warrant is issued by a
market will be related to the current share company over its own underlying shares. When
price, but also to the expectation of what the the warrant expires, the company will deliver
share price will do before the warrant expires. the requisite quantity of shares to the warrant-
A range of variables can shape how the price of holder. In contrast, a covered warrant is a
a warrant will move, including the price of the synthetic product structured by an investment
underlying instrument, the exercise price of the bank or another financial institution over a
warrant, time left to expiry date, the volatility range of possible underlying assets, which
of the underlying instrument, interest rates may be a share in a company, a share price
and dividend expectations for the underlying

Chapter One
index, a commodity, a currency or a basket of Further characteristics of warrants and covered

currencies. warrants are summarised in the following table:
All uK covered warrants are cash-settled

Traditional Covered warrants
rather than stock-settled. This means that
warrants
the issuer pays a cash sum for the intrinsic
value of the warrants at the expiry date, or on Issued by Issued by an investment
exercise. In other words, although the terms a company bank or institution over
of warrants are usually expressed as a right over its own other assets, which may
to purchase the underlying share(s), a covered company be a share in a company,
warrant is more accurately a right to receive shares a share price index, a
a cash payment equivalent to the difference commodity, a currency or a
between the exercise price and the value of the basket of currencies.
underlying asset at expiry.
new shares no new shares issued on
issued upon exercise; an equivalent
Example exercise value payment is made to
the warrant holder in cash.
An investor holds 5,000 covered warrants with
the right to buy one share at 100p. At final Maturities Shorter maturities
maturity date, shares close at 140p. typically typically one or two years.
several years
Cash settlement = (share price exercise price)
x number of covered warrants. Source: London Stock Exchange
Cash settlement = (140 100) x 5,000 = Warrants are sometimes used to improve the
2,000. appeal of loan stock to potential investors.
In times of rising inflation, investors may be
cautious about taking on fixed-interest loans.
The terms European-style and American-
In these circumstances, subscribers to a bond
style are sometimes used to describe the
issue may be offered one warrant for each
exercise of covered warrants. The distinction
3.00 of loan, eg, as an equity sweetener that
is:
makes the offer more attractive to the investor.
U American-style means the warrants can
If the share price of the company rises above
be exercised at any time on or before their
the warrant strike price, this will enhance
expiry date.
the returns accruing to the investor. When
U European-style exercise means the
warrants are issued in this manner, they are
warrants may only be exercised on the expiry
commonly traded separately from the loan and
date of the warrant.
are said to be detachable.
In the uK, an attraction of cash-settled covered

warrants is that they are exempt from the
0.5% stamp duty levied on share trading.
Exercise 4
An investor buys 50 warrants for a premium
of 0.20 each and a strike price of 1.25. To
what level will the share price need to rise if the
investor is to make a profit of 30.00?
The answer can be found in the Appendix at the


Securities
5. Depositary Receipts 5.1 American Depositary

(DRs) Receipts (ADRs)
A common type of dR is an American depositary
Learning Objective 1.1.3 Receipt. AdRs are issued in the uS in uS dollars
Understand the characteristics of depositary and provide a mechanism through which uS
receipts: American Depositary Receipt; investors can reduce the costs and risks
Global Depositary Receipt; Depositary associated with investing in non-uS companies
Interest; transferability/ registration/ (see the example below).
transfer to underlying; how created/ AdRs must comply with various Securities and
pre-release facility; rights; stamp duty and Exchange Commission (SEC) rules, including
conversion fees the full registration and reporting requirements
of the SECs Exchange Act.
depositary receipts (dRs) are financial
instruments that mirror the shares of a foreign Example
company. For example, an investor may buy
a dR in a Russian company that is traded on A US investment bank, NYC, purchases ten
the German market. The dR represents the million shares in UK company BHM on the LSE.
underlying shares in the Russian company, but NYC then registers the shares with the US
it is denominated in euros and can be bought Securities and Exchange Commission, the US
and sold on the German market, trading either regulator, in order to issue and market ADRs
OTC or, if it has satisfied exchange listing in BHM. When approval has been granted, NYC
requirements, on exchange. Any dividends or applies to the New York Stock Exchange to list
other entitlements due on the underlying share and trade BHM ADRs on the exchange.
will be paid in euros on the dR.
In essence, the BHM ADR is a repackaged BHM
There are several steps to creating a dR. share, backed by BHM shares that are owned
Consider, for example, that a foreign company by NYC. The ADRs are valued in US dollars and
registered and listed in Country A will create trade like any other share on the NYSE.
a dR in Country b. Typically, a broker from NYC will set up an arrangement with a custodian
Country b will buy a quantity of shares in the bank for the latter to act as the depository bank
company in its home market (A). These shares for the ADRs (the Bank of New York Mellon,
will be deposited with a depository bank in Citi and J.P. Morgan Investor Services hold the
Market A. The depository bank will then create largest market share for this service in the US).
dRs in Market b. The depository bank will set
the ratio of dRs per underlying share. The dR The underlying shares will be deposited with the
can be freely traded in the secondary market depository bank in the UK market (or with the
in Country b and will be subject to Country bs depository banks local agent, or sub-custodian,
market regulations and tax requirements. The in the UK market; see Chapter 2, Section 2.1).
price of the dR denominated in currency b
Dividends paid by BHM are received by the
will mirror the price of the underlying shares
depository bank and distributed to BHM ADR-
(denominated in Country As currency) held by
holders in US dollars in direct proportion to their
the depository bank.
ADR holding. If BHM withholds tax on dividends
dR holders have a right to convert their dRs before this distribution, then the depository
into underlying shares. In some instances, a bank will withhold a proportional amount before
dR programme may be terminated, potentially distributing the dividend to ADR holders.
at the request of the issuer company or the Subsequently, holders of the BHM ADR may trade
depository bank. dR holders will typically be the ADR in the secondary market, either via an
notified in advance and will have the right to exchange transaction or OTC, just like any other
exchange their dRs for underlying shares. US-listed security. The ADR holder is entitled to

Chapter One
Issue Holding Foreign Shares Holding an ADR
Foreign Some countries do not allow foreign As a uS security, the AdR is not subject to
ownership ownership of local companies. local ownership restrictions.
restrictions
Settlement Ordinary shares traded in the local AdRs settle according to a T+3 settlement
procedures market may be subject to extended cycle, just like any other uS-listed share.
settlement cycles and inefficient
settlement procedures.
Foreign Shares have to be paid for in the AdRs settle in uS dollars.

exchange foreign currency, requiring a foreign
exchange (FX) transaction.
dividend dividends are paid in foreign AdRs pay dividends in uS dollars.

payments currency, requiring periodic FX
transactions.
Rights Shareholders have the right to vote AdRs typically provide the holder with the
and to participate in rights issues. right to vote, but not to participate in rights
issues. Shareholders receive the proceeds
of the sale of the rights (if any). however,
this may vary according to the terms of the
depository agreement.
Liquidity There may be a lack of liquidity in AdRs trade on uS stock exchanges and
the foreign market. OTC. Consequently, they can be more liquid
than underlying shares.
Legal The legal framework in the foreign AdRs comply with uS securities legislation
framework country may offer limited protection and accounting principles.
to the investor. Local legal
procedures may be difficult to
interpret in the case of a dispute.
instruct NYC to cancel the BHM ADR at any point pre-release of dRs. The underlying shares
and to convert this back into the underlying must be delivered within a specified time
BHM share. period, usually three months.
NYC, as investment bank, will typically receive a Typically the depository will only pre-release
commission or management fee for overseeing dRs when:
the ADR issuance and marketing process.
1. the dR issuer verifies in writing to the
depository that it owns the underlying
To summarise, dRs overcome a number of equity shares to be deposited;
problems facing investors wishing to hold a 2. the pre-release is fully collateralised with
foreign companys shares. The table above cash or other acceptable collateral;
uses AdRs as an example. 3. the depository is able to close out the pre-
release within a specified notice period;
4. other indemnities required by the depository
5.2 Pre-Release Facility are provided.
In certain circumstances, a depository may
The dR pre-release can be closed out by
issue depositary receipts before the underlying
presenting either the underlying equities or the
shares have been deposited. This is called the
pre-released dRs to the depository.

Securities
5.3 Global Depositary into depositary receipts. This is higher than

the 0.5% rate levied in the uK on the transfer
Receipts (GDRs)
of uK shares. however, SdRT is not charged
GdRs allow issuers to raise capital in two or on depositary receipt transactions in the
more markets simultaneously, thus broadening secondary market. Gilts and loan capital are
their shareholder base. They can be settled exempt from SdRT.
outside their market of issue. Many GdRs settle
in Euroclear or Clearstream.
6. Collective
GdRs may be widely used by companies in
emerging and frontier markets to extend their Investment
reach to global investors. Acer, a Taiwanese Vehicles
computer company, has a GdR quoted in euros
and dollars, for example.
Companies are also increasingly attempting Know the uses of: exchange-traded funds;
to achieve this goal by listing their shares mutual funds; hedge funds; investment trusts;
on multiple exchanges. The GdR offers the real estate funds; private equity
advantage that requirements to list a GdR
are often much less demanding than those for
listing an ordinary share on an exchange. In addition to investing directly in the financial
instruments outlined above, investors
5.4 Depositary Interest (DI) can invest money in a range of collective
investment vehicles. A collective investment
A depositary interest is a depositary receipt is an investment fund that takes money
issued against foreign securities. from a number of investors and pools it
together. A professional fund manager will
When shares in a company are traded in a
then use his or her skill to make investments
foreign market, a depositary interest (rather
designed to increase the value of the funds
than the underlying share) may be settled
under management. unit trusts, open-ended
and held at the local CSd. A dI issuer will
investment companies (OEICs) and investment
issue depositary interests in respect of the
trusts are examples of collective investment
underlying shares. These dIs may then typically
vehicles.
be held electronically at the local CSd and
transferred via its real-time settlement system. Actively managed funds are a category
For example, transactions in the shares of of collective investment funds whereby the
companies that are incorporated outside the fund manager attempts to outperform their
uK but traded in London are normally settled in peer group (ie, other funds of the same type)
the form of a depositary interest held in CREST through the excellence of their research, stock-
(the electronic settlement system operated by picking skills and market timing (ie, predicting
Euroclear uK & Ireland, the central securities when to buy and sell assets in order to optimise
depository for uK and Irish equities). levels of return). The selling point for actively
In the uK, transfers of dIs are subject to stamp managed funds is that the fund managers skill
duty reserve tax (SdRT) at the rate of 0.5%. can generate a higher level of returns than an
investor could secure by investing in a passive
fund that tracks an index in that sector.
5.5 Stamp Duty Reserve Tax however, actively managed funds generally
in the UK involve higher charges (typically an initial
charge when the investor first buys units or
hM Revenue & Customs (hMRC) charges stamp
shares in the fund and an annual management
duty reserve tax (SdRT) at a rate of 1.5% of
fee) than passive funds.
the share value when shares are converted

Chapter One
Index-tracking funds (also known as passive
S
funds) attempt to track the performance of
an index (eg, FTSE 100) by investing in
all the shares in that index or in an index-
based financial instrument in their relevant
C I T
U ROVED
proportions.
APP
6.1 Mutual Funds/Unit
Trusts Like unit trusts, the price per share in an OEIC
is calculated on the basis of assets that the
A unit trust is a trust formed to manage
OEIC owns. however, the OEIC quotes a single
securities on behalf of investors that offers
price for buying and selling shares, rather than
the combined benefits of diversification and
a separate bid and offer price as is the case for
sufficient weight of assets to ensure cost-
a unit trust.
effectiveness.
The term open-ended means that, as
U A fund will use its investors money to buy investor money flows into or out of the
shares or other financial instruments. The fund, the fund manager can create new
fund will then issue units in this underlying shares or cancel existing shares in order
portfolio. to meet investor demand. In contrast, in a
U A unit trust is open-ended; this means that closed-ended fund such as investment trust
the manager can create new units when new (see Section 6.4), only a finite number of
investors subscribe, and can cancel units shares or units are issued in the fund.
when investors cash in their holdings. units
can be sold back to the fund at any point. Open-ended investment companies or mutual
U The daily price of the units will vary depending funds registered in France, belgium or
on how the underlying portfolio is performing, Luxembourg are commonly known as SICAVs
ie, is based on the net asset value of the (Socits dInvestissement Capital Variable).
underlying constituents.
uCITS are harmonised fund products that can be
U The fund managers will either sell the units
established in all Eu member states, providing
on to other investors, or, if no other investors
a robust and consistent level of investor
are willing to buy, they will sell shares and
protection independent of where the uCITS
use the cash to meet the cost of redemptions.
product is manufactured. Since the launch
U The fund managers will charge a commission
of the original undertakings for Collective
on units sold. hence, the price at which a
Investments in Transferable Securities
fund manager sells a unit to a retail investor
(uCITS) directive in 1985, uCITS have
(the offer price) will typically be higher than
provided an important tool through which
the price at which a fund manager will buy a
asset management companies can market
unit from a retail investor (the bid price).
fund products internationally to eligible retail
and institutional investors.
6.2 Open-Ended Investment
Companies (OEICs) 6.3 Exchange-Traded Funds
Open-ended investment companies are another
(ETFs)
type of collective investment vehicle, and these Exchange-traded funds, commonly known as
have many similar characteristics to unit trusts. ETFs, allow an investor to buy an entire basket
however, OEICs are companies, not trusts, and of stocks through a single security that tracks
consequently they issue shares rather than the returns of a stock market index. Investors
units. can buy an ETF, for example, that will track
global indices such as the FTSE 100 or S&P 500.

Securities
ETFs are a special type of index mutual fund, enables fund managers to plan ahead. unit
but they are listed on an exchange and trade trusts and OEICs, in contrast, are open-
and settle like a stock. As such, they are ended: they expand or contract as people
designed to combine the diversification benefits invest in or leave the fund.
offered by mutual funds with the simplicity of U Pricing methodology the price of shares
holding shares. ETFs typically have lower costs in an investment trust is established by the
than conventional mutual funds or unit trusts stock market. hence, the price of investment
and are often more tax-efficient. trust shares may be above or below the
value of the underlying assets, expressed as
ETFs also differ from mutual funds in the
the net asset value (NAV) per share. In
following ways:
contrast, the prices of OEICs and unit trusts
U ETFs trade on a major exchange throughout are calculated on the basis of the value of
the day, just like ordinary stocks, and are their underlying assets (ie, by dividing the
priced intra-day. In contrast, transactions in value of the investment assets held by the
OEICs and unit trusts only occur once per day fund by the number of issued shares/units in
at the markets close and units are repriced the fund).
daily. U Different share classes some investment
U because ETFs trade on an exchange, their trusts issue different classes of shares to
prices are determined by market demand meet different investors needs. These are
for the ETF shares. hence, ETF shares may called split capital investment trusts
be bought at a discount or a premium to (splits). different classes of share have
the value of the underlying assets if trading varying rights and entitlements within the
conditions push their price up or down. In trust. Some split shares aim to pay regular
contrast, mutual funds (unit trusts) take their dividends for investors who want an income.
price from the net value of assets owned by Others aim to pay out only a capital amount
the fund. at the end of the trusts life.
U Independent boards of directors
investment trusts are companies listed on
6.4 Investment Trusts the stock market. This dictates that they
must have independent boards of directors
An investment trust, despite its name, is not whose duty it is to look after the interests of
a trust but a company whose business is to the shareholders. The directors are directly
invest in the shares of other companies. Like answerable to the shareholder. hence,
unit trusts and OEICs, investment trusts pool the latter may challenge the actions of
investors money and employ a professional the directors, call for changes in company
fund manager to invest in the shares of a wider strategy, and vote for or against issues at
range of companies than most retail investors the AGM and any other special shareholder
could practically invest in themselves. meeting called during the year.
U Gearing investment trusts, being
Investment trusts have a number of features
companies, can borrow to purchase addi-
that differentiate them from unit trusts and
tional investments. This is called gearing or
OEICs:
leverage. This allows an investment trust to
U Closed-ended investment trusts raise increase the risk that it takes in its investment
money for investing by issuing shares. strategy in search of additional return.
Generally, this happens just once, at the
launch of the fund. This makes investment
trusts closed-ended: the number of shares
the trust issues and, therefore, the amount
of money it raises to invest, is fixed at the
start. Knowing this amount of money is fixed

Chapter One
6.5 Hedge Funds short selling, and to impose disclosure

requirements on trading parties, applied by
hedge funds come in many shapes and sizes. securities regulators in Eu member states.
The precise definition of what is, or is not, a
hedge fund is widely debated. Other investment strategies employed by
hedge funds include the following:
Like the other fund types described above,
hedge funds pool investors money and U Distressed securities a hedge fund
employ a professional hedge fund manager to manager buys equity or debt at big
invest this money through a diverse range of discounts in companies facing bankruptcy
strategies and instruments. or restructuring. The hedge fund manager
aims to profit from the markets limited
hedge funds may employ a range of investment appreciation of the true value of the deeply
strategies to make money in rising or falling discounted securities and to take advantage
market conditions. In this respect, they differ of the fact that many institutional investors
from conventional equity or mutual funds (unit cannot own securities with a credit rating
trusts), which are generally 100% exposed to below investment grade, or go short. Conse-
market risk (ie, investors make money when quently, this will create a wave of forced
markets rise and lose money when markets selling by institutional investors that will push
fall). One strategy widely employed by hedge the price of the asset downwards.
fund managers is short selling. In simple U Special situations a hedge fund manager
terms, short selling can be explained as the invests in event-driven situations such as
mirror-image of a conventional securities trade. mergers, hostile takeovers, reorganisations or
leveraged buy-outs. he may simultaneously
U In a conventional long trade, the investor buys
purchase stock in companies being acquired
an investment in the anticipation that its price
and sell stock in the acquiring company,
will rise. If it does so, the investor will sell the
hoping to profit from the spread between
instrument at the higher price to realise a profit
the current market price and the ultimate
(ie, the difference between the lower purchase
purchase price of the company. As in many
price and the higher sale price).
other styles of hedge fund, he may also use
U In a short position, an investor sells an
derivatives to leverage returns and to hedge
instrument on the premise that it is over-
out interest rate, currency and/or market
valued or bad news is expected and its
risk.
price will fall. If the price goes down, the
U Arbitrage the hedge fund manager seeks
investor can then buy the security back at the
to exploit specific inefficiencies in the market,
lower price to realise a profit (ie, the
taking advantage of pricing discrepancies
difference between the higher sale price and
and/or anticipated price volatility by trading a
the lower purchase price).
hedged portfolio of offsetting long and short
Short selling is a practice that has been positions. It is by carefully pairing individual
employed by hedge funds in anticipation that long positions with related short positions
market valuations might fall, and as a means of that the hedge fund manager seeks to
hedging risk in long-only portfolios. however, significantly reduce, if not remove, market-
financial regulators in some countries have level risk. Arbitrage strategies employed
introduced rules that forbid short selling include:
without the trader first borrowing or owning Convertible arbitrage buying
the security concerned so-called naked and selling different securities of the
short selling. Some regulatory authorities same issuer (eg, the ordinary shares
have also introduced disclosure requirements, and convertible bonds). by buying the
demanding that firms report net short positions security that is deemed undervalued and
to the appropriate supervisory body. The selling the security that is overvalued, the
European Securities and Markets Authority hedge fund manager seeks to profit from
(ESMA) is co-ordinating measures to regulate the anticipated correction in the spread
between the instruments.

Securities
Fixed income arbitrage exploiting hong Kong, Japan, Taiwan, the netherlands
interest rate opportunities by taking and a range of other jurisdictions. REITs have
offsetting positions in fixed income also been available in the uK market since 1
securities and their derivatives. January 2007. Prior to this, investors had the
Statistical arbitrage by using quanti- opportunity for a number of years to invest in
tative criteria, the hedge fund manager property through property unit trusts (PuTs).
selects a long portfolio of temporarily These unlisted collective investment vehicles
undervalued stocks and a roughly equal- have often been registered in offshore tax
sized short portfolio of temporarily domiciles such as Jersey and Guernsey,
overvalued stocks. This is also sometimes Luxembourg (as a self-managed investment
referred to as pairs trading. company with variable capital, SICAV) or the
Cayman Islands.
In recent years we have also witnessed a
dramatic rise in investment in Funds of hedge The unlisted property fund market has attracted
Funds (FohFs). FohF managers attempt to strong investment flows in the uS market for
select and invest in a range of individual many years. Luxembourg also continues to
hedge funds that will offer positive returns to attract strong investment flows into real estate
investors, while providing the diversification investment funds (REIFs) closed-ended or
needed to ensure that investors are not over- open-ended investment funds that invest in
exposed to the risks associated with any property.
individual hedge fund or investment strategy.
note that REITs and PuTs bear the
Many hedge fund strategies, particularly characteristics of investment trusts and unit
arbitrage strategies, are limited as to how much trusts outlined above. As unlisted vehicles,
capital they can successfully employ before PuTs trade in parallel with their underlying
returns diminish. These are often termed value. As a listed share, REITs may trade at a
capacity constraints. As more investment premium or discount to underlying valuations,
money flows into the fund, the opportunities to depending on demand for the share within the
profit from that investment idea progressively stock market.
become exhausted. As a result, many successful
hedge fund managers limit the amount of
capital they will accept into their funds.
6.7 Private Equity Funds
Private equity firms invest in unlisted assets
that are not publicly traded on a stock exchange
6.6 Real Estate Funds
or MTF, or in some instances they may purchase
Real estate investment trusts (REITs) are publicly traded assets with the intention of
listed investment trusts (see Section 6.4) taking these private.
through which investors purchase exposure to
Typically, a private equity firm will raise funds
investments in the real estate sector. A pool
from a group of investors. These pooled funds
of investors money will thus be invested in
will be used to purchase assets that it believes
property assets and shares issued to underlying
will rise in value (this may be a distressed
investors.
company, for example, when it believes through
Tax will typically not be levied on rental or improved management and a more favourable
capital gains earned within a REIT, provided business climate may have the opportunity to
that at least 90% of its income is distributed to return to strong profitability in the future).
investors via dividends.
Also, these funds may be invested in ventures
Listed real estate trusts have been available that it believes will generate attractive cash
on the Australian Stock Exchange since the flow (this might be, for instance, investment
1970s. REITs have also attracted strong money in public-private partnerships to build schools,
flows in recent years in the uS (in parallel hospitals, airports, or other infrastructure
with the unlisted property fund marketplace), projects).

Chapter One
usually, the private equity firm, as general An International Securities Identification

partner, will be responsible for management Number (ISIN) is a unique international code
decisions relating to the investment of these issued to identify a security. This numbering
pooled funds and for management of the convention was introduced by the International
assets that it purchases (eg, by changing the Standards Organisation (ISO) to harmonise
management structure in a company that it has the array of country-specific numbering
acquired). The investors, as limited partners, systems that had grown up at the domestic
will provide start-up and operating funds but level (see below). The Association of national
will not be responsible directly for day-to-day numbering Agencies (AnnA), acting on behalf
management of the fund, or the assets that of ISO, is responsible for appointing a national
it purchases. Moreover, typically, they will numbering Agency in each country that bears
only be responsible for any losses sustained responsibility for allocating a unique security
by the partnership up to the amount of their identification number to each security.
investment.
The ISIn consists of a total of 12 characters.
Like other types of asset management The first two characters represent the ISO two-
company, private equity groups may specialise letter country code. The next nine characters
in specific types of investment strategy that represent the local number of the security
they employ to optimise return for themselves concerned, with a final check digit so that
and for their investment partners. A buy-out systems can validate the number.
fund, for example, may specialise in purchasing
privately owned companies, improving their In the case of depositary receipts such as AdRs,
profitability and then realising a financial return the instrument takes its country code from the
through their exit strategy the point when it organisation that issued the receipt, rather than
elects to sell the firm to other private investors, the one that issued the underlying security. For
or to float the company through an Initial Public example, the Acer Taiwan stock mentioned
Offering (IPO). earlier has an ISIn of TW0002306008 for the
Taiwanese share and Gb0057226440 for the
A venture capital fund may finance the GdR.
development of promising emergent
companies, whether by taking an equity stake The Local Securities Identifier number
in the business (which it expects to rise in value allocated to a security is based on numbering
as the company grows and its profitability conventions that have evolved within individual
increases), or by committing loan capital, markets. For example:
thereby generating interest income on its loan U A CUSIP (or Committee on uniform Security
commitment. Identification Procedures) number is used
to identify securities issued in the uS and
Canada. The CuSIP number is allocated
7. Securities by the CuSIP Service bureau. The CuSIP
Identification Service bureau is operated by Standard &
Poors on behalf of the American bankers
Numbers Association (AbA). The code is a nine-digit
alphanumerical code.
Learning Objective 1.1.7 U A SEDOL (or Stock Exchange daily Official
Know how securities are identified: ISIN; List) number is a securities identifier issued
CUSIP; SEDOL; tickers by the London Stock Exchange and Irish Stock
Exchange to provide unique identification of
instruments traded in the uK and Ireland and
To enable securities to be clearly identified
on a global basis. This code forms the basis of
during transaction-processing and asset-
the ISIn code for uK securities and consists
servicing procedures, each security is given its
of a seven-digit alphanumeric code allocated
own unique identification code number.

Securities
by the master file service of the London Stock Legal Entity Identifiers (LEIs)
Exchange. until 5 January 2004, SEdOL
The LEI programme for financial contracts will
codes had a seven-digit numeric format.
establish a universal standard for identifying
however, given the number of requests for
any organisation involved in a financial
new SEdOL codes, and concerns that the
transaction worldwide. by establishing a
seven-digit numeric format was reaching its
distinct identifier for each legal entity, this
capacity, a decision was taken to move to the
will help financial regulators to improve their
new seven-character alphanumeric code.
supervision of financial institutions and the
Other national conventions include: transactions these institutions conduct with
their financial counterparties across products
U SVM code, employed in belgium. and markets.
U WKn code, employed in Germany.
U Valoren code, employed in Switzerland. The importance of creating such a system of
U ASX code, employed in Australia. legal entity identifiers has been highlighted in
statements from (among others) the Financial
Once a local identifier has been allocated, it Stability board, the International Organization
is possible to derive the global ISIn identifier, of Securities Commissions (IOSCO) and the
using the convention outlined above. (For a G-20 finance ministers. In the uS, the dodd-
SEdOL code, which is only seven digits, the Frank Act has established a requirement for
ISIn consists of the prefix Gb00, followed by each financial entity to have its own standard
the SEdOL, followed by a single check digit.) LEI, and the uS Treasurys Office of Financial
Research will drive the implementation of this
A stock ticker is an identifier code used to initiative. In Europe, a parallel commitment
identify a security when it trades on a stock has been established under the supervision of
market or in the OTC market. For example, the the European Securities and Markets Authority
stock ticker for uK-listed telecoms Vodafone (ESMA).
Group plc is VOd, the ticker for StatPro Group
plc is SOG, and the ticker for the iShares dJ The International Organization for
Euro STOXX MidCap Exchange-Traded Fund is Standardization has created a new draft
dJMC. standard, ISO 17442, that will provide a
template for the LEI. SWIFT will serve as LEI
note: ticker can also refer to a running feed registration authority, co-ordinating allocation
of current pricing and trading volume for a of LEIs to financial companies according to
given security, alerting the investor to the sale this draft standard. The depository Trust
price and quantity of recent transactions in a and Clearing Corporation (dTCC) has been
specified instrument. appointed facilities manager, collecting requests
for LEIs, storing reference data associated with
A Market Identifier Code (MIC) is a unique
each LEI, and maintaining and updating the LEI
identification code used to identify securities
reference database.
trading exchanges, regulated trading venues
and non-regulated trading venues. The MIC Consultation is still ongoing regarding which
is a four alpha character code defined by the LEIs must be included when submitting trade
International Organization for Standardization and settlement instructions associated with
under ISO Standard 10383. For example, a financial transaction. For a securities trade,
trades that are executed on the uS nASdAQ for example, this is likely to include LEIs for
market are identified by the MIC XNAS. Trades buyer and seller, associated brokers, execution
identified on bATS Europe are identified using venue, clearing facility and potentially other
the MIC BATE. Trades executed on Chi-X systemically important infrastructure entities
Europe are identified by the MIC CHIX. (CSd, ICSds for example) associated with
trading or post-trade functions during the
lifecycle of the trade.

Chapter One
In January 2013, the Regulatory Oversight Trading Record

Committee (ROC) of the Global Legal Entity
In general, a company applying to list on a
Identifier System was established, taking over
registered exchange must have an established
responsibility for leadership of the Global LEI
trading record. On nySE Euronext or the
project from the Financial Stability board (FSb),
London Stock Exchange (LSE), for example, a
which has been at the forefront in pushing for
company must have published annual financial
the introduction of an LEI standard since initial
statements for the preceding three financial
discussions around this initiative.
years. The Australian Stock Exchange (ASX)
by creating a unique Id associated with each specifies that companies must meet minimum
legal entity, the ROC is confident that LEIs will standards of quality, size, operations and
allow more consistent procedures to be set disclosure.
in place for identifying parties to a financial
Some types of company, such as scientific
transaction. In turn, this will help financial
research-based companies and fast-growing
supervisors to maintain a consistent and
innovative technology businesses, may be
integrated view of any firms exposures and to
allowed to list with a shorter trading record
identify at an early point any risk concentrations
provided that they meet specified additional
that may present grounds for concern.
criteria.
8. Issue Methods in Sponsor
the UK In the uK, every company applying for a listing

must be represented by a sponsor, which will
usually be an investment bank, stockbroker,
Learning Objective 1.1.8 law firm or accountancy practice. The sponsor,
Understand how securities are issued: which must itself meet certain qualifications,
equities (offers for subscription; offers for provides the link between the company and
sale; introductions; placing; offer to tender); the uK Listing Authority (uKLA a division of
government bonds (auction; tap; tranche); the uK Financial Conduct Authority, FCA, that
eurobonds (lead manager; syndicate; oversees listings in London), and guides the
underwriting) company through the listing process.
Shares in Public Hands

8.1 Equities: Listing A specified minimum percentage of shares
A private company may reach a stage in its should be distributed to the public. On nySE
development where it feels that, in order to Euronext or the LSE, for example, at least
raise the capital that it needs to carry its 25% of outstanding shares must be made
business forward, it may be beneficial to obtain available to persons not connected with the
a stock exchange quotation in order to make a company. The exchange may also require that
public issue of shares. the companys market capitalisation exceeds a
specified minimum (on the LSE this is currently
Companies wishing to list on a registered 700,000).
stock exchange will typically be subject to
detailed investigation designed to safeguard Prospectus
the integrity of the exchange and offer a degree
of security to investors that they are buying The company and its advisers must publish
shares in a bona fide registered company. a prospectus that complies with the listing
authoritys rules. The prospectus provides
To list shares on a registered exchange, a potential investors with the information that
company must fulfil listings criteria which they need to make an informed decision on
typically include: the company and its shares. It will typically

Securities
include independently audited financial figures, Offer for Sale

details of directors salaries and contracts, and
The issuing company offers a specified number
information on major shareholders.
of shares for sale to the public at a specified
price. These shares may be sold to the public
Continuing Obligations directly, or via an investment bank or other
Once the companys shares have been listed body that agrees to sponsor the share issue.
and admitted to trading, the company must The steps are as follows:
fulfil a number of obligations on a continuing
1. The company sells this specified number of
basis. These include producing half-year
shares to the sponsor (the issuing house).
and independently audited full-year financial
2. The issuing house will then sell the shares
reports within a set timeframe, and notifying
to the public and will end up holding any
the market of any new price-sensitive
shares that the public does not buy.
information. Typically, these financial reports
3. hence, the issuing house underwrites the
must be compliant with recognised IFRS
share issue. The company has received the
accounting standards.
capital it set out to raise directly from the
issuing house. The latter bears the cost of
8.2 Procedure for a Public any shares that do not sell.
Issue of Shares 4. The issuing house will, typically, (a) charge
a fee to the issuer to provide this sponsor/
A public company seeking to raise capital by underwriting service and/or (b) extract a
issuing shares will circulate a prospectus, commission on shares sold (by purchasing
inviting potential investors to apply for shares. shares from the company at a discount to
The successful applicants will be granted the price it sells them to the public).
shares in return for payment, which may either
be in full or in instalments, depending on the If the issue of new shares is oversubscribed,
conditions of the share issue. the issuing house will determine how the
shares are to be allotted. This may be done via
If demand for shares exceeds the number a ballot, or by allocating a quota of shares to
of shares available, then application money each applicant up to a specified ceiling.
will be refunded to unsuccessful applicants.
Oversubscription can also lead to scaling down Offer to Tender
and partial refunds of application monies (see
below). In a variation on the above procedure for an
offer for sale at fixed price, the issuing house
The share issue may proceed through a number may specify a minimum price for the share
of methods, as follows: offer and invite offers (tenders) from investors
at prices of their own choosing. When the
Offer for Subscription application deadline has passed, the sponsor
will fix a sale price (the strike price). All
The issuing company invites applications
investors that have offered the strike price or
from, and sells shares directly to, the public.
above are likely to receive shares, which will be
The share offer is not underwritten by an
sold to them at the strike price.
investment bank or other sponsor. In some
circumstances, the offer for subscription will
only proceed if a minimum number of shares is
Placing (or Private Placements)
purchased. If there are insufficient applications, Like offers for sale, the issuing company will
all applications may be rejected and application typically sell shares direct to an investment
money returned. bank or another sponsor. The latter will then
sell shares to its preferred clients (commonly
institutional investors and investment
managers), but there will be no general

Chapter One
sale to the public. For the issuing company, Any unsold bonds will be retained by the
private placements can yield substantial cost issuing authority and may be offered for resale
savings when compared to the public offers at a later date. This is known as tap stock. In
described above, since it will eliminate a layer exceptional circumstances, if it considers bids
of administration and publicity costs demanded to be unacceptably low, the issuing authority
when a company, via an issuing house, sells may opt not to allot all of the stock on offer at a
shares to retail investors. conventional or index-linked auction.
Some government issues are structured such

Introductions
that the full quota of bonds is not made
An introduction is typically employed when available to investors in a single sale, but is
a company already has a broad spread of sold in blocks (commonly known as tranches
shareholders and seeks authorisation to list or tranchettes) at times when the issuing
shares on the exchange. Introductions do not authority (ie, the debt Management Office
involve the immediate raising of capital or in the uK or the bureau of Public debt in
issue of shares, but are designed to meet the the uS) feels appropriate. Like tap stocks,
conditions required to allow a company to do tranches offer the issuing authority a means of
so in the future. As per the requirements for a fine-tuning market liquidity and raising public
full listing detailed above, at least 25% of the funds in smaller quantities than is practical
companys shares should normally be owned by through tender or auction.
people unconnected to the business.
In some markets, competitive bids are typically
Introductions are used, for example, when: placed by registered agents (eg, gilt-edged
market makers (GEMMs) in the uK, primary
U a company wishes to move from the government dealers in the uS) on behalf of
Alternative Investment Market (AIM), the smaller institutional investors and individual
London Stock Exchanges international investors.
market for smaller companies (see Section
Individuals may be permitted to make
9.1.1), to the main market;
non-competitive bids at auction.
U a company that is already listed on the
In a non-competitive bid, no bid price is
exchange wants to divide into two or more
specified and the bids are allotted at the
separate companies the new companies
weighted average price of successful
may obtain a quotation via an introduction;
competitive bids.
U an overseas company is already listed in
another market but wishes to establish a uK To provide some illustration of the above,
stock exchange listing as well. uS Treasury securities (T-bills, notes, bonds,
Treasury inflation-protected securities or TIPS)
are sold by the uS governments bureau of
8.3 Government Bond Issues Public debt by auction in the primary market.
For government bonds issued by auction, Investors may place competitive or non-
competitive bids (where the bidder specifies competitive bids, with a minimum purchase
a price and quantity of issue for purchase) amount of uS$1,000 specified for all Treasury
will be ranked in descending order of price securities. In a single auction, an investor may
and bonds will be sold to applicants whose bid non-competitively for up to uS$5 million in
competitive bids are at, or above, a minimum any particular security.
price (the lowest accepted price) established
The uS Treasury (Treasury or department)
by the issuing authority. Successful bids above
also maintains a legacy Treasury direct system
the minimum price will be satisfied in full at the
designed for investors that buy Treasury
bid price. bids made at the minimum price may
securities when they are issued and plan to hold
be satisfied in full or only in part.
them until they mature. The investor purchases

Securities
securities directly from the uS government and 8.4 Eurobonds

holds these in an account with the government,
rather than with a bank or broker. As explained in Section 3.1.4, a eurobond
is an international bond issued in markets
In Japan, the Japanese governments Ministry of outside the domestic market of the issuer. Key
Finance issues ten-year Japanese government participants in supporting a eurobond issue
bonds (JGbs) through syndicate underwriting. include the following:
The government will purchase any JGbs that
remain unsold by syndicate members. 60% of
Lead Manager and Syndicate
the issue is determined by competitive auction
bidding and non-competitive tender by the The lead manager is a financial institution
syndicate. The remaining 40% is allocated (commonly an investment bank) that assumes
in fixed share to each syndicate member at responsibility for managing the entire issue
the average price of the auction. JGbs with process. The lead manager will advise the
maturities of 2, 4, 5, 6, 15, 20 and 30 years are issuer on the structure and timing of the issue,
issued by public auction. Successful bidders, and it will appoint the syndicate, a group of
and the terms of issuance, are determined by investment banks that will market, sell and
multiple price auction, where bids are accepted underwrite the issue.
from the highest price downwards until the
issue is fully subscribed. Underwriter, Advisers, Trustees and
Paying Agents
In France, government bonds (OATs and bTAns)
and Treasury bills (bTFs) are issued primarily The underwriter to an issue typically
through competitive auction (where bids are agrees to purchase any unsold securities at
accepted from the highest price downwards a specified price (see Section 8.2). Typically
until the issue is fully subscribed), but partly the underwriter will be paid a commission for
by tap. providing this service, ensuring that the issuer
raises the quantity of capital intended through
In the uK, government bonds (or gilts) market the eurobond issue. however, the underwriter
liquidity is preserved by GEMMs, serving will bear the risk of covering the cost of
as competing market makers that have a securities that remain unsold.
commitment to make, on demand and in all
market conditions, effective two-way prices Legal advisers are responsible for conducting
on gilts that they are contracted to deal in. due diligence on the issue process and the
This arrangement is designed to encourage parties involved, as well as drafting and
investor demand for uK government bonds and, validating the listing details and accompanying
consequently, to minimise the governments documentation posted to investors, the stock
borrowing costs. exchange and regulatory authorities.
GEMMs are the only institutions eligible to Trustees act on behalf of the investors,
submit a competitive bid by telephone directly ensuring that the issuer adheres to conditions
to the debt Management Office (dMO). All set out in the bond sale and ensuring that the
other market participants wishing to bid at a rights and entitlements of bondholders are
gilt auction must route their orders through a protected and met in full.
GEMM. GEMM firms are entitled to submit non-
The paying agent is responsible for receiving
competitive bids for a 10% share of the total
coupon payments from the issuer and
amount of stock on offer at a gilt auction. In
distributing this income to the bondholders.
conventional auctions, this 10% allowance is
split evenly amongst all GEMM firms, whereas
in index-linked auctions each firms individual
allowance will be determined by its successful
purchases at the three previous auctions.

Chapter One
Issuance Methods London Stock Exchange or the Frankfurt

Stock Exchange, operated by deutsche brse.
While methods for eurobond issuance vary from
U Multilateral trading facilities (MTFs)
market to market, typical methods include:
sometimes referred to as alternative
U Bought offer the lead manager purchases trading systems, MTFs are registered
the full quantity of bonds issued at a non-exchange trading venues which bring
predetermined price and then places these together purchasers and sellers of securities.
securities with its own clients. Subscribers can post orders into the system
U Fixed price reoffer the lead manager and these will be communicated (typically,
distributes the bonds to the syndicate. This electronically via an electronic communication
group of investment banks then places the network, ECn) for other subscribers to
securities with their own clients at a fixed view. Matched orders will then proceed to
price. They may only sell at below this price execution.
when the syndicate has been disbanded by
the lead manager. This will generally not 9.1.1 Regulated Markets
occur until most of the bonds have been
placed. The regulated markets and their equity-trading
systems in the selected markets are as follows.
9. Principles of United Kingdom
Trading SETS (the Stock Exchange Electronic Trading

System) is the London Stock Exchanges
flagship electronic order book, trading FTSE
100, FTSE 250 and the FTSE Small Cap
Know the characteristics of the regulated Index constituents, as well as some other
markets and multilateral trading facilities liquid securities. The Exchange also operates
(MTFs) a modified version of SETS for the trading
of covered warrants and other structured
products.
9.1 Regulated Markets and
The LSEs Main Market is its flagship market
Multilateral Trading for the listing and trading of equity, debt and
Facilities other securities. The Alternative Investment
Market (AIM) is a share trading market
The Markets in Financial Instruments
established principally for small companies; it is
Directive (MiFID) was implemented in
regulated by the LSE, but it has less demanding
november 2007 and represents a central
listing rules.
component of the European Parliaments
ambition to create a single market in financial SETSqx (Stock Exchange Electronic Trading
services for the European Economic Area Service quotes and crosses) is a trading
(EEA). under MiFId, investment firms are platform for securities that are less liquid than
required to take all reasonable steps to deliver those traded on SETS. This service is based
best execution to their customers, taking into on SETS, with the added support of liquidity
account factors including speed, cost and provision from registered market makers.
certainty of execution and settlement. The Since 8 October 2007, all main market equity
directive aims to promote competition between securities not traded on a full order book are
trading venues based on market transparency traded on SETSqx.
and a regulatory level playing field. under
MiFId, key execution venues include: SEAQ is the LSEs trading platform for the
fixed-interest market and AIM securities that
U Regulated markets, referring to regulated are not traded on either SETS or SETSqx.
stock exchanges such as Euronext, the

Securities
United States Germany

The largest securities exchanges are: FWB, the Frankfurt Stock Exchange, is the
largest of the eight German stock exchanges.
U New York Stock Exchange (NYSE) the FWb is managed by Deutsche Brse AG,
NYSE Hybrid Market is an order-driven which provides the Xetra electronic trading
market model that attempts to integrate system and which also owns and manages
the best aspects of the auction market with Clearstream and Eurex, the German
automated trading. In April 2007, nySE derivatives exchange. Some of the other
formalised a merger with Euronext (see regional stock exchanges also use deutsche
below) to form NYSE Euronext. brses systems.
U NASDAQ OMX (national Association of
Securities dealers Automated Quotation)
Spain
nASdAQ is the worlds largest exchange
company. It delivers a hybrid model where Equities trading in the Spanish market is
market makers compete with the order- conducted on the barcelona, bilbao, Madrid
driven system. and Valencia stock exchanges, which form part
U In October 2008, nySE Euronext acquired the of the Bolsas y Mercados Espaoles (BME)
American Stock Exchange (Amex), renaming holding group.
the exchange NYSE Amex Equities.
Hong Kong
Japan
Equities trading on the Hong Kong Stock
The Tokyo Stock Exchange is the main Exchange (HKEx) is via the HKEx trading
exchange for equities trading. Its equities system.
trading system is known simply as the TSE
trading system. Singapore
Equities trading on the Singapore Exchange
Europe
(SGX) is via the SGX trading system.
Euronext, the integrated exchange for trading
equities on the French, belgian, dutch and India
Portuguese markets, has merged with nySE to
form NYSE Euronext. Equities are traded on the Bombay (Mumbai)
Stock Exchange and the National Stock
Equities trading on nySE Euronext is via the Exchange (located in Mumbai), along with 23
Nouveau Systme de Cotation (NSC), the smaller regional exchanges.
exchanges integrated electronic cash market
trading platform. It is an order-driven market. Brazil
Equities are traded on Bovespa, the So
Paolo-based exchange for cash equities and
derivatives trading.
South Korea
Equities are traded on the Korea Stock
Exchange (KSE).
China
Equities are traded on the Shanghai Stock
Exchange and Shenzhen Stock Exchange.

Chapter One
9.1.2 Multilateral Trading as counterparty to the trade and a global

Facilities (MTFs) settlement agent employed to provide trade
settlement. Examples of dark pool MTFs
With the implementation of MiFId, we have include Chi-Delta (owned by Chi-X Europe),
witnessed the emergence of two principal Smartpool (a collaboration between nySE
categories of MTF, namely: Euronext, hSbC and bnP Paribas which
began live trading in February 2009) and
U Open-order-book-type venues that provide
LiquidNet.
publicly displayed liquidity. These open-
order-book-type MTFs handle predominantly
small-ticket, high-volume trading with trading
typically cleared via a central counterparty. 10. Exchange-
For example, Chi-X Europe has been live
Traded and OTC
since April 2007. Turquoise, a pan-European
equity trading MTF with initial backing from Transactions
nine leading investment banks, went live in
August 2008 and was acquired by the LSE in Learning Objective 1.2.2
december 2009. BATS Europe has offered
Understand the differences between: on-
trading in leading European equities markets
exchange/MTF and over-the-counter
since October 2008.
U Dark liquidity pools that provide
anonymous trading. These execution venues Although many financial instruments are
do not display order details publicly, thereby traded on-exchange, there are times when a
preserving the anonymity of trading parties complex and highly structured instrument may
and minimising the degree to which their be created specifically to meet the specialised
trading activity can impact the market. These investment needs of an individual client. In this
dark pool MTFs typically support large case, it will typically be traded off-exchange
ticket size trades at lower trading volume or over-the-counter (OTC). Some derivatives
and in many cases they will not employ products are widely traded OTC.
a CCP structure, with the broker standing
See the table below.
Exchange-traded OTC
Instruments generally have Instruments are often tailored to the specialised needs of a
high liquidity and can be specific buyer. This may include when an order is large and needs
traded on to other buyers. to be negotiated to meet the buyers specific requirements.
The exchange regulations and Any legal agreements that are set in place around an OTC
governing body specify trading trade must typically be negotiated directly between the trade
procedures and detail actions counterparties involved. Master legal agreements between
to follow in case of dispute. trade counterparties may specify basic terms that will apply to
all transactions. In case of dispute, trading parties may need to
seek resolution through the law courts subject to the contractual
terms that they have set in place.
Participants dealing on a Trades made with an OTC counterparty may have a higher risk
recognised exchange normally as there is no central clearing counterparty and exposure is
benefit from clearing through directly related to the OTC counterparty chosen.
a central counterparty.

Securities
Exchange provides a price Pricing is more complex. When the OTC market for an instrument
discovery mechanism. hence, is still immature, investment banks can often make large profits
pricing of exchange trades is by exploiting the lack of an effective price-finding mechanism
typically relatively transparent. and the resultant difficulties faced by counterparties in pricing
instruments accurately (to help them, trading parties may
employ the services of an independent valuation agent that
specialises in providing mark-to-market pricing for OTC traded
instruments). As the market develops, and price-discovery
mechanisms become more mature, spreads tend to narrow. As
trading activity in the instrument grows, there may be benefits
to bringing the instrument on-exchange.
Trading participants are In some jurisdictions, OTC trades may be subject to more lenient
typically required to publish post-trade reporting requirements than those conducted on
the price, volume and time a recognised stock exchange. however, under MiFId, trading
of securities traded on a participants are required to report price, volume and time of
recognised stock exchange trades in listed shares, even if executed outside a regulated
within a specified timeframe market (for EEA countries). note that in some jurisdictions (for
after a transaction. example, the uK and Ireland) OTC trades in local instruments
are conducted subject to the rules of the stock exchange.
11. Order-Driven and This matching might take place either on

the floor of an exchange, via a compu-
Quote-Driven terised system or both.
Markets The broker makes a profit by charging his
clients commission for arranging the deal.
The movement in price on an exchange
is governed by the demand for a share
Understand the main characteristics of: and the availability of supply. The
order-driven markets; quote-driven markets; disadvantage of an order-driven market
principal trading; agent trading; agency crosses for large orders is that the order itself may
(systemic internalisers); multilateral trading move the price. Computerised trading
facilities; dark pools (eg, the LSEs SETS system) can reduce
this effect by making anonymous the
buyer or seller and allowing the order to
Know the roles of: market makers/liquidity be placed in small amounts.
providers; sales traders; proprietary traders A market needs to have good liquidity if
it is to become order-driven, otherwise
The price discovery mechanisms provided by there are problems with filling orders and
a stock exchange will differ slightly depending pricing.
on whether a market is order-driven or quote-
U Quote-driven
driven. The main characteristics of order-driven
Liquidity is provided by a market maker,
and quote-driven trading are outlined below.
whose role is to quote prices at which
U Order-driven they will buy and sell securities above a
The buyer and the seller of shares each specified minimum volume. In the uK,
have a broker acting on their behalf as an this minimum volume is known commonly
agent. as the normal market size (nMS) and is
The brokers job is to find a matching based on 2.5% of the securitys average
buyer for his sellers shares, or vice versa. daily turnover during the preceding year.

Chapter One
Market makers always quote a price for are delivering best execution (ie, executing
buying and a price for selling (known as trades on the most favourable terms, taking
the spread) and they make their profits into account price, costs, speed, likelihood
through such dealing. of execution and settlement, size and other
buyers and sellers may still have brokers considerations relevant to the execution of the
acting on their behalf, but, instead of order) for all clients that they service.
trying to find a matching counterparty,
MiFId classifies trading venues into three
the broker arranges the transaction with
explicit categories:
a market maker. As in the order-driven
market, the broker makes a profit by 1. Regulated markets referring to
charging a commission to their client. regulated stock exchanges such as nySE
Euronext, the London Stock Exchange or
When a securities house deals in the market it
Frankfurt Stock Exchange.
is acting either as principal or as an agent.
2. Multilateral trading facilities (MTFs)
Principal trading is when an instrument sometimes referred to as alternative
is bought and held on a firms own account trading systems, MTFs are registered
(rather than on behalf of a client), with the non-exchange trading venues which
view that the price will move up or down and bring together purchasers and sellers of
the instrument can later be sold for profit. securities. Subscribers can post orders into
The price does not always have to move up for the system and these will be communicated
the firm to make a profit. A falling share price (typically, electronically via an electronic
can create a profit if the firm has invested in communication network, ECn) for other
an appropriate derivatives-based instrument subscribers to view. Matched orders will
(refer back, for example, to comments on then proceed for execution.
short-selling earlier in this chapter). 3. Systematic internalisers an investment
firm that, on an organised, frequent and
Agency trading is when a firm acts as an systematic basis, deals on its own trading
intermediary, or agent, on behalf of a client. account by executing clients orders outside
This arrangement is commonly employed when a regulated market or a MTF. This practice
the client does not have its own trading is broadly synonymous with agency crossing
capability, or does not have direct access to (above), whereby a crossing network
a market (ie, it may not be an member of the electronically matches orders for execution
local stock exchange). without routing these to an exchange or
A crossing network is an electronic network MTF.
(eg, MTF) that matches orders for execution Market makers are firms that maintain a
without routing the order to a registered firm bid and offer price in a given security,
exchange. making themselves available to buy or sell a
In an agency cross, a broker matches an specified list of securities at publicly quoted
order between two of its own clients on prices within a specified quoted trade size.
its own books, rather than going via the The bid price is the price at which the market
market. Although the broker will typically maker is prepared to purchase a security from
charge a commission to both clients, this another investor. The offer price is the price
arrangement will save clients the need to pay at which the market maker is prepared to sell
all of the spread charged by market makers. that security to the counterparty. by providing
Agency cross-trades are tightly regulated to such a service, market makers promote a liquid
ensure that brokers do not give preferential market in the trading of specified securities
treatment to favoured customers. under the (thereby serving as liquidity providers),
Eu Markets in Financial Instruments directive ensuring that a buyer is available when a firm
(MiFId), implemented on 1 november 2007, all wishes to sell and a seller is available when a
brokers are required to demonstrate that they firm wishes to buy. Examples of quote-driven

Securities
markets, where market makers publish quoted In some smaller firms, agency trading and
prices on computer screens, are nASdAQ in proprietary trading may be conducted off the
the uS, SEAQ in the uK, and the eurobond same trading desk.
market. Trade execution may be electronic, or
by manual media such as fax or telephone. For MTFs and dark pools, see Section 9.1.2.
Stock exchanges and/or regulators commonly

impose strict rules that firms must adhere to 12. Programme and
in order to act as a market maker within the
exchange. This may include the times each
Algorithmic Trading
day at which the firm must publish the bid/
offer prices for securities in which they trade, Learning Objective 1.2.5
and the means through which these prices Know the principles of programme trades,
should be published. They may also require, algorithmic trading and high-frequency trading
for example, that a specified number of market
makers are active in each stock listed in the
system. 12.1 Programme Trades
Sales traders are broadly responsible for Fund managers that offer index-linked funds
managing the agency trading relationship with will typically need to purchase blocks of shares
a client, offering market advice, providing that mirror the composition of the index they
analysis and taking and placing orders for are tracking. Rather than purchasing shares
instruments. Given the importance of stock in each of the companies that make up the
picking to an investor in optimising the balance index on a trade-by-trade basis, it is commonly
of return and risk through investments, advice more efficient to buy or sell the whole block or
provided to the investor regarding which stocks basket of shares through what is known as a
are likely to move up or down may be an programme trade.
important element of the sales relationship. For
highly structured and complex OTC products, Programme trades are communicated
developed on a bespoke basis for individual electronically through an order generated by
clients, sales traders may play a key role the fund manager or trader. This will place a
in communicating with clients regarding the buy or sell order for a block of trades that, for
specific needs and specifications that such an example:
instrument must fulfil.
U mirrors a financial market index such as the
Proprietary traders are responsible for buying FTSE 100, S&P500, the nikkei 225;
and selling securities for a firms own account U represents a specific basket of shares put
(see principal trading, above). Additionally, together by the fund manager to track, for
proprietary traders may receive orders from example, ethical stocks.
the agency sales team and execute these in
the market, commonly using electronic order
placement facilities, but still in some instances
communicating by telephone, especially for
OTC trading. Sophisticated order routing
systems are employed to ensure that purchase
orders are relayed to the trader promptly, and
once the order is filled the agency sales team
can inform the client of the price obtained
without delay.

Chapter One
Settlement procedures will be similar to those to identify trading opportunities and to execute
for single shares, but note the following points: multiple orders in a short time-frame in order
to take advantage of these opportunities.
U It may be difficult to obtain or dispose of all
shares in the market on the same day.
U Trade confirmation typically occurs after the 13. Multi-Listed Shares
complete order has been filled. Therefore, the
time from execution in the market to trade
confirmation may be longer for some shares
in a programme trade than it would be had Understand the principles of multiple listed
they been executed individually. shares
The choice of a counterparty for programme

A share has historically been listed on only one
trading is typically based on its credit rating
exchange. however, increasingly, companies
and its ability to provide access to all markets
that are active in more than one market may
and sectors covered by the trade. This is
list their shares in a number of exchanges. One
important in large trades. The choice will also
name for these shares is Globally Registered
be influenced by price, likelihood of execution,
Shares (GRSs). here are some of the main
cost of execution and settlement efficiency.
features:
Some programme trades may be sufficiently
large to have an impact on the price of the
U An investment bank may list on the Swiss
Exchange and in new york.
securities that the investor is trying to buy
or sell. For example, when a large buy order
U Most of the trading takes place on the Swiss
Exchange, and so this generally sets the price
arrives for a particular security (or basket of
for the day. At the time when both exchanges
securities), it may have the effect of pushing up
are open, the price will adjust to be the same
the price. Consequently, much effort has been
on both exchanges.
dedicated to developing trading procedures and
systems that ensure, as fully as possible, that
U Any price differences are reduced to zero by
firms using arbitrage. Arbitrage is possible
the block trade remains invisible to the market.
when a share (or any tradeable instrument)
These are sometimes known as iceberg
is quoted in more than one market. It will be
trades.
cheaper in one market than another, even
if only fractionally and temporarily. A firm
12.2 Algorithmic Trading can therefore make money by buying in one
market and selling in the other. normally,
Algorithmic trading involves using computer-
the price differences are so small that a large
based mathematical models, or algorithms,
volume of shares has to be traded to make
to support decision-making around how a
it worthwhile. Specialist firms tend to do this
trade, or blocks of trades, should be executed.
and fulfil the function of equalising the price
Typically, this may involve splitting a trade into
between the markets.
multiple small orders to minimise its market
U Arbitrage also eliminates differences in price
impact (ie, the impact on the share price
due to any foreign exchange movements.
of placing a sizeable trade) and its visibility
U Liquidity is typically higher as the share
to others trading in the market. The trade
is available in more than one market. The
may subsequently be executed automatically
issuer benefits as it has access to a larger
(hence this practice is commonly labelled
investment community than would be the
black box trading) according to a set of
case for a single listed share. Investors have
pre-set rules which, when satisfied, trigger the
the option of buying in one market and selling
order placement.
in another.
Similarly, high frequency trading (HFT) U Traders involved in arbitrage trading will
employs powerful computers, high-speed con- need to maintain stock in multiple locations
nections and sophisticated trading algorithms and conduct regular stock realignment to

Securities
ensure that working stock is available, when The listing requirements for a dR on a
required, for trades to proceed to settlement. particular exchange are typically less
Some organisations (eg, SIS SegaInterSettle, stringent than for a share.
the Swiss central securities depository) have A dR does not necessarily require the
established a third-party service that allows co-operation of the underlying company.
traders to hold stock in a single securities Increases the size of the potential investor
account and for the intermediary to realign community.
the stock on the traders behalf.
U Globally Registered Share
With increasing consolidation of, and Llisted on multiple exchanges in multiple
co-operation between, exchanges, companies currencies.
are exploring the opportunity of listing Can be transferred across markets.
their shares on multiple exchanges rather has to meet the listing requirements of
than issuing AdRs. This is particularly true each exchange on which it is listed.
of multinational companies whose revenue Creation is driven by the issuing company.
streams are received in multiple currencies. Increases the size of the potential investor
however, companies that are looking to multi- community. Extends the global reach and
list shares must assess the costs involved global reputation of the issuing company.
against the potential benefits offered by this
strategy. The significant costs involved have
caused some companies to cancel multi-listings 14. Settlement Periods
in recent times. For example, the company
will typically incur listing fees on each stock
for Equities and
exchange on which it wishes to list its stock. Bonds in the
Also, multiple listing can add cost and complexity
Selected Markets
to the task of disseminating shareholder
information, scheduling shareholder meetings
and processing voting entitlement, or in Learning Objective 1.2.7
managing income distribution, rights issues or Know the settlement periods for equities and
other corporate events across shareholders in bonds in the selected markets
multiple jurisdictions.
Country Trade Type: Settlement
More broadly, multiple listing can have a
Cycle: Settlement System
negative impact on the liquidity of the issuers
stock in its home market. If an issuers primary Australia Equities: T+3 (ChESS)
listing is in a developing market (eg, Latvia, bonds: T+3 (Austraclear)
Czech Republic), a decision to dual-list its stock
on a large international stock exchange (eg, brazil Equities: T+3 (CbLC)
nySE Euronext, London Stock Exchange) may Corporate debt: T+1 (CETIP)
cause the stocks liquidity to decline on the Government debt: T+0 (SELIC)
domestic exchange. France Equities and bonds: T+3
(Euroclear ESES)
These are some of the key characteristics of
dRs and GRSs: Germany* Equities and bonds: T+2 or T+3
(Clearstream banking Frankfurt)
U Depositary Receipt
Shares are listed on a single exchange in a hong Equities: T+2 (hKSCC)
single currency, but dRs can be listed on Kong debt: T+2 (CMu)
multiple exchanges in multiple currencies. India Equities and debt: T+2
dRs are generally not transferable (CdSL or nSdL)
across markets (although they can be Government debt: T+2
converted). (Reserve bank of India)

Chapter One
Country Trade Type: Settlement

Cycle: Settlement System
South Equities: T+2 (KSd)

Korea debt: T+0 (KSd)
Japan Equities: T+3 (JASdEC)

Government debt: T+3
(bank of Japan)
uK Equities and corporate debt:
T+3 (CREST)
Gilts: T+1 (CREST)
uS Equities and corporate debt:
T+3 (dTC)
Government debt: T+1
(Federal Reserve)
* note: The settlement cycle for equities and

bonds in Germany is T+3 if one party is nOT
German. If both parties are German, the
settlement cycle is T+2.

Securities
Answers to Exercises
Exercise 1
(i) Number of days of accrued interest under 30/360 convention for period 1 April (settlement date for
purchase) to 27 June (settlement date 1 for sale):
1 April30 April = 30
1 May31 May = 30
1 June27 June = 27
= 87 days
Accrued interest = nominal x interest/100 x no of days of accrued interest (assuming 30 days in

month)/360
= 100,000 x 7/100 x 87/360

= 1,691.67
The investor would receive 1,691.67 in accrued interest under 30/360 convention.
(ii) Number of days of accrued interest under Actual/365 convention
1 April30 April = 30
1 May31 May = 31
1 June27 June = 27
= 88 days
Accrued interest = nominal x annual coupon/100 x no of days of accrued interest/365
= 100,000 x 7/100 x 88/365

= 1,687.67
The investor would receive 1,687.67 in accrued interest under Actual/365 convention.
Exercise 2
Days of accrued interest due to seller = 100
Accrued interest = nominal value x annual coupon rate / annual divisor x days of accrual
Accrued interest = 200,000 x 8/100 x 1/365 x 100 = 4,383.56
Buyer would pay to seller 4,383.56 in accrued interest.
Exercise 3
Days of accrued interest due to seller = 175
Days of accrued interest due to buyer = 5
Accrued interest = nominal value x annual coupon rate / annual divisor x days of accrual
Accrued interest due to buyer = 100,000 x 7/100 x 1/360 x 5 = 97.22
Seller would pay to buyer 97.22 in accrued interest.

Chapter One
Exercise 4
Profit per warrant = price of underlying share strike price warrant premium (1)
Rearranging this equation:
Profit per warrant + strike price + warrant premium = price of underlying share (P) (2)
To make an overall profit of 30.00, the buyer will make a profit of 30.00/50 = 0.60 per warrant.
Thus, from (2):
0.60 + 1.25 + 0.20 = P
2.05 = P
Therefore the buyer will make a profit of 30.00 if the share price rises to 2.05.

Securities
End of Chapter Questions
Think of an answer for each question and refer to the appropriate section for confirmation.
1. What is equity?
Answer Reference: Section 2.1
2. What are the rights held by ordinary shareholders?
3. What are the advantages and disadvantages to an investor of holding preference shares
relative to ordinary shares?
4. List the order in which obligations will be paid out if a company goes into liquidation or is
wound up.
5. What are the advantages to a company of issuing a bond over issuing shares?
Answer Reference: Section 3

Chapter One
6. What is the nominal value of a bond?
7. What are the characteristics of a eurobond?
Answer Reference: Section 3.1.4
8. What is the clean price and dirty price of a debt security?
9. What is a warrant? What are the characteristics of covered warrants?
10. What is a depositary receipt? how are depositary receipts issued? What are the benefits of
holding depositary receipts rather than the underlying shares?
11. What is a unit trust? What is bid price and offer price? Why are these different prices quoted?

Securities
12. What are the characteristics of an ETF?
13. What is an ISIn and what purpose does it serve?
14. What is:
i. a CuSIP?
ii. a SEdOL?
15. List the qualification criteria that a company must typically satisfy to list its shares on a
registered stock exchange.
16. Who are the main parties involved in the issuance of a eurobond?

Chapter One
17. What are the differences between on-exchange and OTC transactions? What are the
advantages and disadvantages of each type of trading?
18. What are the characteristics of an order-driven and quote-driven market? Give two examples
of each.
19. What are the functions performed by:

i. a market maker;
ii. a proprietary trader;
iii. an agency trader?
20. What is a programme trade?
21. What are the advantages to a company of issuing multi-listed shares?

2
Main Industry Participants
1. Participants 51
2. Investment Administration and

Operations: Custody 54
3. Central Securities Depositories and

International Central Securities Depositories 62
4. Straight-Through Processing (STP) 71
5. Society for Worldwide Interbank

Telecommunications (SWIFT) 74

Chapter Two

1. Participants increase in value. They invest on their

own account, rather than on behalf of a
company or institution. Individual investors
Learning Objective 2.1.1 may decide on their investment strategy,
Know the characteristics of the following types of or may draw on the services of a financial
participant: individual; institutional; investment adviser to finalise how their money is
manager; prime broker; broker; inter-dealer allocated (the asset allocation process)
broker; investment bank; central bank across different investment types. having
decided on which asset classes to invest
in, they will commonly employ one or
1.1 Investors more investment management companies
to manage the money invested in these
As we noted in Chapter 1, a range of different investment vehicles.
types of investors buy and sell securities in
A professional investor (sometimes
search of optimal returns at an appropriate
known as a sophisticated investor) is one
level of risk.
that is deemed sufficiently knowledgeable
Investors fall into a number of categories: to have a sound understanding of the risks
and potential returns associated with the
1. Individual investors put their own
instruments in which they invest. In the uK,
money at risk in the hope that this will

Chapter Two
Certified Sophisticated Investors are any investment performance. Rather, its

persons holding a certificate issued in function will be to serve as a transparent
the past three years by an FCA-approved vehicle through which other investors may
authority confirming that they have this channel their investments in order to spread
required level of investment knowledge. investment risk and to achieve economies
of scale.
A wider body of investors with recent
professional experience may register them- 3. Investment managers are people or
selves as Self-Certified Sophisticated organisations that manage the investment
Investors (for example, a person who in assets of any individual or institutional
investor. This will involve buying and selling
the past two years:
investments, stock-picking and, in some
has been a director of a company with
instances, directly aiding the client with
annual turnover of at least 1 million; or
asset allocation decisions. An investment
has been employed in the private equity
management company may also invest its
sector or has provided finance for small
own companys money, acting as principal
and medium-sized enterprises; or
with regard to assets under its management.
has made at least one investment in an
unlisted company during this period). When managing investments on behalf of
investor clients, the investment manager
The term high net worth individual
may offer a discretionary service through
(HNWI) is used to refer to individual
which the investor will delegate day-to-day
investors with substantial sums to invest.
management of its portfolio (or specific
In the uK, Certified High Net Worth
sections of its portfolio) to the investment
Investors are persons who, during the
manager. The latter will make investment
preceding 12 months, have had an annual
decisions on the investors behalf, managing
net income of at least 100,000 or net
holdings in line with the investors objectives
assets valued at 250,000 or more (not
and risk tolerance, while providing reporting
including the value of the persons primary
on investment performance and levels of
residence).
risk exposure.
2. Institutional investors are institutions Often, investment management companies

(rather than individuals) that invest in have specialist expertise in managing
financial markets, channelling the invest- specific categories of investment (eg, uK
ments of a number of smaller investors or equities, corporate bonds, technology funds,
themselves, so that there is a pooling of the emerging markets, absolute return funds).
investments of these individual members. Consequently, an investor may employ a
Institutional investor is a generic term number of investment managers to optimise
that broadly includes pension funds, the investment performance delivered by
insurance and life assurance companies different sections of its investment portfolio.
and pooled funds/collective investment
schemes. Endowments and hedge funds are 4. Brokers execute trades on an agency
sometimes also classified as institutional basis on behalf of their clients (which may
investors. be institutional or retail investors), finding
buyers for securities that their clients wish
Institutional investors may manage their to sell and vice versa. A broker-dealer firm
portfolio of investments internally, or is licensed to trade on an agency basis for
may employ the services of one or more its clients (as above), or on a proprietary
investment managers to manage these basis (ie, on its own behalf).
assets on their behalf. 5. Inter-dealer brokers act as intermediaries
An institutional investor would not between market-maker firms, meeting
commonly be the principal beneficiary of the latters need for the securities that

they require to support their trading 1.2 Central Banks

requirements. Inter-dealer brokers provide
a liquid source of a wide range of securities A central bank is a banking institution that
that may be difficult to access in quantity, sits at the heart of a countrys financial
and at competitive prices, in public and monetary system, playing a key role in
exchanges. They also enable dealer firms promoting monetary and financial stability
to buy and sell securities without revealing and in encouraging stable economic growth.
their identities reducing the risk that The functions of the central bank may include
they transmit key information about their controlling monetary policy and overseeing
trading strategies to competitors and trigger money market operations, managing the
price movement of the securities concerned national currency, exchange and gold reserves,
within the market. serving as lender of last resort to commercial
banks, and providing banking services to
6. Investment banks are financial institutions
government. In some countries, the central
that serve as intermediaries between
bank may serve as regulatory authority,
securities issuer and investor, offering a
supervising the functioning of the financial
wide range of investment services which
system and the activities of institutions and
might include organising and underwriting
individuals operating within this system. In
the issuance of securities (see Chapter
some countries also, the central bank may
1, Section 8), providing market making
deliver specific market infrastructure functions,
and agency brokerage services, eurobond
eg, operation of the payments system, design
dealing, provision of foreign exchange
of the TARGET2-Securities platform for
services and other functions. An investment
centralised settlement of euro-denominated
bank may assist companies in managing
(and some non-euro) securities in the Eu (see
mergers and acquisitions, and in raising
Section 3.5). Typically the central bank will
capital to finance a range of possible
be state-controlled, but increasingly central
development activities.
banks are being accorded independent status
Some investment banks may also employ in order to separate key central bank functions
prime brokerage arms, typically pro- from political influence and day-to-day party
viding execution services for securities politics. In an economic and political union such
and derivatives, clearing and settlement, as the Eu, a supranational central bank (eg,
securities lending, credit services, research the European Central bank) may co-ordinate
and other functions, predominantly to hedge the monetary policy and financial operations of
fund customers. national central banks within that union.
Investment banks may employ specialist

financial analysts that provide investment 1.3 Client Categories
research to investors. This research may
MiFId (see Chapter 1, Section 9.1) identifies
be purchased as a standalone service, or as two main categories of client (retail clients
part of a bundled package that may include and professional clients), and a distinct third
a selection of the other functions outlined category (known as eligible counterparties)
above. that is applicable to a limited range of
Investment banks traditionally service a businesses. different levels of regulatory
predominantly institutional customer base protection apply to clients within each these
and tend not, specifically within their invest- categories:
ment banking divisions, to specialise in U Retail clients are afforded the most
administering retail deposits/current regulatory protection.
accounts, nor in providing a wider array of U Professional clients are considered to
investment services targeted specifically at be more experienced, knowledgeable and
a retail public. sophisticated and are able to assess their

Chapter Two
own risk. Thus, they are afforded fewer may have the wrong level of taxation applied
regulatory protections. to their income;
U Eligible counterparties (ECPs) are U inefficiencies in transaction-processing and
investment firms, credit institutions, asset servicing may generate high costs or
insurance companies, asset management losses that compromise the returns generated
companies and other regulated financial on invested assets;
institutions. MiFId provides a light-touch U the investor may be subject to penalties/
regulatory regime when investment firms fines and face potential disqualification from
engage in transactions with ECPs. investing in the market if they fail to comply
with regulatory requirements and legal
obligations.
2. Investment
Administration With these points in mind, the risks and costs
involved with holding and servicing securities
and Operations: can be substantial, even when an investor is
Custody holding assets in just one market. Given that

institutional investors, and some hnWIs, invest
When an investor invests in an asset, it may across a wide range of instruments in many
employ a custodian to keep the assets secure different markets, it frequently makes sense
and to administer the assets on its behalf. Why for them to appoint a specialist custodian to
does it do so? because the investor feels that provide safekeeping and asset servicing duties
its resources and time are best dedicated to for their global portfolio of assets.
what it specialises in: namely selecting, buying
and selling investment assets. Its primary goal
2.1 Custody Services
is to optimise the investment returns and risk
on these invested assets (acting either for
itself or for investor clients that it represents). Learning Objective 2.1.2
The investor may not have the systems and Understand the advantages, disadvantages and
expertise internally to provide custody for its purposes of the following types of custodian:
assets. global; sub-custodian
however, when the investor buys investment

assets (this may be equities, bonds or a range of When an institutional investor invests in
the other instruments described in Chapter 1), securities it will commonly employ the services
it must ensure that the assets are secure; that of a custodian to administer these securities
its transactions, and any rights and benefits to by:
which the investor is entitled, are processed
U providing safekeeping of the investors assets
effectively; that correct tax is paid; and that
in the local market;
regulatory reporting requirements, and a
U making appropriate arrangements for delivery
host of other responsibilities, are discharged
and receipt of cash and securities to support
effectively. In short, the investment process
settlement of the investors trading activities
does not just involve picking stocks and waiting
in that market;
for the investment returns to roll in. holding
U providing market information to the investor
assets generates a host of administrative
on developments and reforms within that
obligations that must be handled safely and
market;
effectively. If the investor fails to do so:
U collecting dividend income, interest paid on
U its assets may be under threat due to loss, debt securities and other income payments in
theft, fraud or counterfeit; the local market;
U the investor may miss out on income (ie, U more broadly, managing the clients cash
dividends, interest payments) and other flows;
benefits that they are entitled to, and they U monitoring and managing entitlements

through corporate actions and voting rights 2.1.1 Global Custodians

held by the investor in the local market;
U managing tax reclaims and other tax services A global custodian provides investment
in the local market; administration for investor clients, including
U ensuring that securities are registered and processing cross-border securities trades and
that transfer of legal or beneficial title on keeping financial assets secure (ie, providing
securities transactions proceeds effectively; safe custody) outside the country where the
U efficient reconciliation of assets according to investor is located.
best practice and regulatory standards;
The term global custody came into common
U maximising portfolio return by engaging in
usage in the financial services world in the mid-
stock lending programmes;
1970s, when the Employee Retirement Income
U ensuring that reporting obligations to the
Security Act (ERISA) was passed in the uS.
regulatory authorities, and to other relevant
This legislation was designed to increase the
bodies, are discharged effectively.
protection given to uS pension fund members.
The Act specified that uS pension funds could
The primary responsibility of the custodian
not act as custodians of the assets held in their
is to ensure that the clients assets are fully
own funds. Instead, these assets had to be held
protected at all times. hence, it must provide
in the safekeeping of another bank. ERISA went
robust safekeeping facilities for all valuables
further to specify that only a uS bank could
and documentation, ensuring that investments
provide custody services for a uS pension fund.
are only released from the custodians care in
accordance with authorised instructions from Subsequently, use of the term global custody
the client. has evolved to refer to a broader set of
responsibilities, encompassing settlement,
Importantly, the clients assets must be properly
safekeeping, cash management, record-
segregated from those of the custodian and
keeping and asset servicing (eg, collecting
appropriate legal arrangements must be in
dividend payments on shares and interest on
place to ensure that financial or external shock
bonds, reclaiming withholding tax, advising
to the custodian does not expose the clients
investor clients on their electing on corporate
assets to claims from creditors or any other
actions entitlements), and providing market
party.
information.
The investor may manage its custody
Some investors may also use their global
arrangements in foreign markets in which it
custodians to provide a wider suite of services,
invests by:
including investment accounting, treasury
U appointing its own local custodian in each and FX, securities lending and borrowing,
market in which it invests (often referred to collateral management, and performance and
as direct custody arrangements); risk analysis on the investors portfolio.
U appointing a global custodian to manage
Some global custodians maintain an extensive
custody arrangements across the full range
network of branches globally and can meet the
of foreign markets in which it has invested
local custody needs of their investor clients
assets; or
by employing their own branches as local
U making arrangements to settle trades and
custody providers. Citi, for example, maintains
hold securities and cash with CSDs within
a proprietary branch network covering 57
each market, or to go via an International
markets. Consequently, Citi, acting as global
Central Securities Depository (ICSD, see
custodian for an investor client, may opt to use
Section 3).
its own branch to provide local custody in many
locations where the investor holds assets.

Chapter Two
2.1.2 Subcustodians In selecting a subcustodian, a global custodian

may:
In locations where a global custodian does not
have its own branch, or in situations where it U appoint one of its own branches, in cases
may find advantage by looking outside of its where this option is available;
proprietary branch network, a global custodian U appoint a local agent bank that specialises
may appoint an external agent bank to provide in providing subcustody in the market
local custody services. concerned;
U appoint a regional provider that can offer
Similarly, investment banks and global broker/ subcustody to the global custodian across a
dealers (for example, Morgan Stanley, Goldman range of markets in a region or globally.
Sachs and ubS) will also typically employ a
network of agent banks to meet their needs
for clearing, settlement, asset servicing and Single Market Providers
cash management in markets around the world Agent banks that specialise in providing
where they have investment activities. subcustody in their home market are some-
times known as single market providers.
A subcustodian effectively serves as the
Stiff competition from larger regional or global
eyes and ears of the global custodian in the
competitors has meant that these are becoming
local market, providing a range of clearing,
a dying breed. however, some continue to
settlement and asset servicing duties.
win business in their local markets, often
combining this service with offering global
It will also typically provide market information
custody or master custody for institutional
relating to developments in the local market,
investors (eg, local pension and insurance
and will lobby the market authorities for reforms
funds) in their home markets. Examples
that will make the market more appealing and
include bank of Tokyo-Mitsubishi uFJ, Mizuho
an efficient target for foreign investment.
Institutional Market A Market b

investors
in Market A
use bank A
Global Custodian A
as a global Global
employs bank b Subcustodian b
custodian to
Custodian A as subcustodian in
administer
Market b
their global
investments
bank b
bank A
Institutional
investors
Global Custodian b Global in Market b
Subcustodian A employs bank A use bank b
as subcustodian in Custodian b
as a global
Market A custodian to
administer
their global
investments

Corporate bank and Sumitomo Mitsui banking A local custody bank may be perceived to have
Corporation in Japan, Maybank in Malaysia and the following disadvantages when compared
united Overseas bank in Singapore, Fondaco in with a regional custodian:
Luxembourg, Sanpaolo IMI in Italy and CACEIS
in France. U Its credit rating may not match up to
requirements laid down by some global
A principal selling point is that they are local custodians or global broker/dealers.
market specialists and that is what they do U It cannot apply developments in its
hence, they can remain focused on their local technology and client service across multiple
business without spreading their attentions markets (unlike a regional custodian)
broadly across a wide range of markets. A hence, product and technology development
local specialist bank may be attractive in a may lag behind the regional custodians which
market in which local practices tend to differ it competes.
markedly from global standards, or where a U It may not be able to offer the price discounts
providers long-standing relationship with the that can be extended by regional custodians
local regulatory authorities and/or political offering custody services across multiple
lite leaves it particularly well placed to lobby markets.
for reforms on behalf of its cross-border U For the global custodian or global broker/
clients. dealer client, it will be necessary to conduct
due diligence, performance and risk reviews
Reciprocal arrangements may be influential in
across a host of single-market custodians
shaping the appointment of a local provider in
within its global network. As we see
some instances. under such an arrangement,
below, appointing a regional custodian can
a global custodian (A) may appoint the local
sometimes reduce the administrative burden
provider (b) to deliver subcustody in its local
that this involves.
market (market b). In return, the custodian (A)
may offer subcustody in its own home market
(market A) for pension and insurance funds in Regional Providers
market b that use provider b as their global A regional custodian is able to provide agent
custodian. See the diagram, left. bank services across multiple markets in a
region.
In summary, the advantages of a local
provider may include: For example, Standard Chartered bank and
hSbC have both been offering regional custody
U They are country specialists (especially on
and clearing in the Asia-Pacific and South
taxation).
Asian region for many years, competing with
U They act as the eyes and ears of global
Citi, deutsche bank and some strong single-
custodian or global broker/dealer in local
market providers for business in this region.
market.
In Central and Eastern Europe, bank Austria
U They will have regular dealings with financial
Creditanstalt/unicredit Group, deutsche bank,
authorities and local politicians, and may
InG Group, Raiffeisen Zentralbank Osterreich
be well placed to lobby for reforms that will
and Citi each offer a regional clearing and
improve the efficiency of the local market.
custody service.
U They will have expert knowledge of local
market practice, language and culture; they In Central and South America, Citi and bank
often have a long track record in the local Itau (the brazilian bank that purchased bank
market. bostons established regional custody service)
U They may offer opportunities for reciprocal offer regional custody, in competition in
business. selected markets with hSbC, banco Santander
and deutsche bank.

Chapter Two
Employing a regional custodian may offer a range U Some regional custodians may lack the long
of advantages to global custodian or global track record, customer base and goodwill
broker/dealer clients: held by some local custodians in their own
market.
U Its credit rating may be higher than for a
single market custodian.
U It can cross-fertilise good practice across 2.2 Custody and Subcustody
multiple markets lessons learned in one Agreements
market may be applied, where appropriate,
across other markets in its regional offering.
U It can leverage innovation in technology,
Understand the purpose and provisions of
product development and client service across
custody and subcustody agreements
multiple markets delivering economies of
scale benefits. Learning Objective 2.1.5
U It can offer standardised reporting, manage-
Understand the requirements of a Service
ment information systems and market
Level Agreement between an investor and its
information across multiple markets in its
custodian
regional offering.
U Economies of scale may support delivery
of some or all product lines from a regional
processing centre offering potential cost 2.2.1 Custody Agreement
savings and efficiency benefits. To formalise the custody arrangements outlined
U Its size and regional importance, plus the above, it is standard for the institutional
strength of its global client base, may allow investor and the global custodian to sign a
a regional custodian to exert considerable custody agreement that details:
pressure on local regulators, political
authorities and infrastructure providers. This U the legal conditions under which the investors
may be important in lobbying for reforms that assets are held by the global custodian, and
support greater efficiency and security for are protected and segregated from the assets
foreign investors in that market. of the global custodian;
U using a regional custodian may help in U the responsibilities and obligations required
resolving language barriers for individual of the global custodian under the custody
countries as they are likely to be multilingual. relationship;
U The global client may be able to secure price U the authority for the custodian to accept
discounts by using a regional custodian instructions from fund managers, in instances
across multiple markets. where an institutional investor employs
investment managers to manage assets on
In some situations, a regional provider may its behalf.
be perceived to have certain disadvantages
when compared with a local custody bank: The global custodian will negotiate a separate
custody agreement with each institutional
U A regional custodians product offering may investor with which it conducts business. Given
be less well attuned to local market practice, that these institutions may have markedly
service culture and investor needs than that different investment strategies, allocating their
of a well-established local provider. assets across a different range of markets
U A regional custodian may spread its focus and investment instruments, the structure
across a wider range of clients and a wider and content of the legal agreement may differ
range of markets than a single market significantly from client to client. however,
provider. hence, a cross-border client may each custody agreement is likely to address the
not receive the same level of attention, and following:
the same degree of individualised service as
may be extended by a local custodian.

U the method through which the clients assets U the legal conditions under which client
are received and held by the global custodian; assets are held by the subcustodian, and are
U reporting obligations and deadlines; protected and segregated from the assets of
U guidelines for use of CSds and other relevant the subcustodian;
use of financial infrastructure; U the responsibilities and obligations required
U business contingency plans to cope with of the subcustodian by the global custodian
systemic malfunction or disaster; under the custody relationship.
U liability in contract and claims for damages;
U standards of service and care required under A subcustodian, global custodian and its
the custody relationship; foreign investor clients are bound by the
U a list of persons authorised to give legal regulations prevailing in the overseas
instructions; market. hence, while many provisions of the
U actions to be taken in response to instructions; subcustodian agreement will resemble those
U actions to be taken without instructions; appearing in the investor-global custodian
U default options for corporate action elections; agreement outlined above, these provisions
U specification of contractual settlement date will be amended in certain instances to comply
accounting (CSdA) or actual settlement with local regulatory requirements and legal
date accounting (ASdA) where relevant (see practice.
further in Chapter 3, Section 3.5).
Institutional investors and global custodians

are required to adhere to the legal framework
prevailing in the countries in which assets are
invested.
The custody agreement will typically include

provision on the part of the investor to conduct
periodic reviews of the custodians internal
control environment in order to ensure that it
has effective procedures in place to monitor 2.2.3 Service Level Agreement
and manage risk. These controls should ensure (SLA)
that the investors assets are held securely and
that procedures for accepting and acting on detailed specifications pertaining to the
authorised instructions are in place. standards of service required by an investor
from its custodian are spelled out in a service
The custody agreement will commonly detail level agreement (SLA). This lays down required
the level of indemnity that the global custodian standards for service areas, including:
will provide to the client in instances of error
or negligence on its own part, or on the part U record-keeping, and maintenance of accurate
of subcustodians that it employs. It will also and up-to-date documentation;
define the level of indemnity, if at all, that it U settlement (exchange, MTF and OTC);
will provide to clients against catastrophic U communication and reporting;
events, default by a CSd or clearing house or U corporate actions processing;
counterparty, theft or fraud, and a wide range U income processing;
of other contingencies. U tax services;
U cash management;
U management information systems;
2.2.2 Subcustody Agreement U stock lending and borrowing;
When the global custodian employs a U market information and market knowledge;
subcustodian to provide custody on its behalf in U standards of service expected from account
a foreign market, it will sign a legal agreement officers and relationship managers that
with the subcustody provider that will detail: represent primary points of contact with the
investor.

Chapter Two
2.3 Selecting a Custodian An RFP is a tendering process for buyers of

global financial services. Although the size and
scope of the RFP will vary slightly from client
to client, this will generally represent a lengthy
Understand the purpose of a Request For questionnaire that will request background
Proposal (RFP) in the selection of a global information on the custodians staffing and IT
custodian by an investor capacity, its track record and experience in
the custody area, the strength of its existing
client base and assets under custody, its
Understand how legislation can affect the
creditworthiness and its record of recent losses.
appointment of custodians
The RFP should be viewed as an early stage in
the selection process, rather than a selection
When selecting a global custodian, an
process in its own right. Typically, it will be
institutional investor will typically invite
used to screen out candidates that do not
statements of interest from suitable candidates.
meet the clients selection criteria, and then to
The investor may ask for further detail of
provide a springboard for further investigation
services offered by applicants via a Request
at the site visit and/or interview stage.
for Information (RFI). Eligible candidates will
typically then be asked to complete a detailed The core elements typically addressed in an
Request for Proposal (RFP) submission as a RFP are mapped out in the table below.
preliminary stage in the appointment process.
Service element Information Typically Required in RFP

background of Including the number of years the custodian has been in the business, number/
custodian type of existing clients, assets under custody held on behalf of these clients,
clients won and lost in three years, credit rating.
Service capacity Including name and biographical details of persons responsible for managing
the custody account, their level of experience and total account load, level of
back-up support available, strategy for servicing the clients account.
Account, Including details of the custodians accounting and reporting system:
reporting and report formats, electronic reporting capacity, frequency of reports,
settlement quality checks to ensure reporting accuracy, deadlines for settlement
processing instructions, mechanisms for dealing with exceptions and failed trades.
Safekeeping Including procedures for segregating assets and ensuring security of
assets, reconciliation procedures, procedures for income collection,
procedures for processing mandatory and voluntary corporate actions,
tax services.
Cash Requiring details on account overdraft policy, instruction deadlines for cash
management and movements, policy for maintaining single currency and multi-currency
FX accounts, overnight sweeping of cash balances.
Subcustodian List of subcustodians in network and length of relationship, procedures for
network appointing subcustodians, review procedures, content and structure of service
level agreement, indemnities in place in case of subcustodian failure/error or
failure on part of a third party used by the subcustodian, frequency and format
for providing market information, messaging procedures.
Pricing structure Including the range of service provided in the custodians core package,
pricing schedule for services incurring additional charges, billing
frequency and format.
Value added Including stock lending, fund accounting and performance measurement.
services

U They must demonstrate that they have the

necessary familiarity with the structure and
aims of their pension scheme and have an
appropriate level of training and skill to carry
out their responsibilities to scheme members
effectively.
U Fiduciaries have a responsibility to monitor
and review the tasks that they delegate
to third parties (including custodians and
investment management companies) in order
Given the weight of RFPs that custodians to ensure that these tasks are discharged
are required to complete in bidding for new effectively.
mandates, investors are advised to be clear U The duty of loyalty demands that trustees
about their objectives before finalising and administer their pension scheme solely in the
sending the RFPs to interested parties. best interests of the scheme members.
U Trustees must avoid undue risk in the way
The RFP process should draw attention that scheme assets are managed and appoint
to issues that will be key for the investor intermediaries to manage or administer
client in formulating its choice of custodian. scheme assets, on the schemes behalf.
Importantly, these selection priorities should be
communicated clearly to the candidates. This Also, legislation guiding safekeeping of client
will help prospective custodians to structure assets requires that a firm that holds safe
their responses in such a way that will simplify custody investments with a custodian must
the selection process for the investor. have effective and transparent procedures in
place for custodian selection and for monitoring
Legislation governing the responsibilities held
performance. The frequency of these risk
by pension fund trustees and other fiduciaries
reviews should be dependent on the nature of
can be important in shaping the procedures
the market and the types of services that the
through which custodians are appointed and
custodian delivers to the client.
standards of service monitored. For example,
standards of fiduciary conduct laid down in the
uS in Section 404 of the Employment Retirement
Income Security Act of 1974 (ERISA) or the
1995 uK Pensions Act require pension fund
trustees to be directly responsible for the
appointment of custodians. This makes trustees
liable for civil penalties if they rely on the skill
or judgement of any person who is appointed
(other than by the trustees) to exercise a
prescribed function. To put it simply, this
requires that pension fund trustees should have
a direct legal relationship with their custodian,
not an indirect one via the investment manager
or any other appointed intermediary. Trustees
must take full responsibility for appointing and
monitoring the actions of custodians acting on
behalf of their fund.
In their capacity as fiduciaries, pension fund

trustees are generally required to uphold the
following prudential standards:

Chapter Two
3. Central Securities 3.2 Certificated, Immobilised

Depositories and and Dematerialised
Securities
International
Central Securities Learning Objective 2.2.2
Depositories Understand the concepts of certificated,
immobilised and dematerialised securities
3.1 The Role of Depositories

Securities can be held in a range of formats:
Learning Objective 2.2.1 U Certificated securities holdings a

Understand the roles of ICSDs and CSDs certificate may be registered or bearer.
generally for the selected markets: depositories For registered securities, the register will
available; participation requirements represent a full list of holders of the securities
concerned. The registrar is responsible for
Learning Objective 2.2.4 recording change of ownership following sale
Know how securities and cash are held by or transfer. For bearer securities, there is no
ICSDs and CSDs share register. The issuer prints certificates
(hence a certificated security) and these are
sent to the investor in accordance with their
The main functions of a depository are typically:
holding. The holders name does not appear
1. to enable members to hold book-entry on the security. Securities may also be held
accounts for dematerialised securities; as a global or jumbo certificate, where a
2. to settle transactions between members on a single consolidated certificate representing
delivery versus Payment (dvP) basis, often in the entire issue of the security is held
central bank funds; with an independent agency (known as a
3. to provide basic custody services. common depository). Jumbo certificates are
often held in bearer form (see Chapter 3,
The types of instruments typically eligible Section 3.3). In some instances, smaller-
to be deposited in a CSd or ICSd include denomination securities certificates may be
equities, government bonds, corporate bonds consolidated into a single, jumbo certificate
and money market instruments. that is registered.
CSd systems can be classified as direct U Dematerialised (or uncertificated)
holding systems or indirect holding systems, securities holdings registered holders
or a combination of the two. In some CSds, in many CSds hold securities electronically
securities may be held in book-entry form in via a method known as book entry. The
the name of an intermediary (or nominee) progressive transition in the securities
acting on behalf of the investor (indirect industry from physical (ie, certificated)
holding systems). In other CSds, the investor holdings to book-entry format has been
is listed in the records of the depository system important in reducing the costs and risks
(direct holding systems). associated with clearing, settlement and
asset servicing across the industry. It
In the uK, for example, firms that wish to settle also speeds up settlement and improves
their securities transactions and hold their settlement performance and efficiency.
stock in CREST (operated by Euroclear uK and
Ireland, the CSd that was formerly known as When a depository accepts certificated
CRESTCo) typically have two options: securities, these may be immobilised
such that the depository holds the
U to become a user (ie, a direct member); or underlying certificate in secure storage
U to become a sponsored member, operating and transfer of ownership takes place via
via another CREST user (sponsor).

book-entry movement between participants each member, which shows the net balance
accounts at the CSd. note that Euroclear uK of payments made and received at any time
& Ireland provides depository services for during the course of a settlement day. however,
dematerialised uK and Irish securities (see uS dollar settlements are excluded from real-
below) and, thus, certificated securities are time gross settlement in CREST.
never immobilised within this CSd.
As mentioned earlier, firms that wish to settle
their securities transactions and hold their stock
3.3 Depository in CREST have two main options: to become
Arrangements in the a user (ie, direct member) or to become a
sponsored member operating through another
Selected Markets
CREST user (a sponsor). users are firms that
have the hardware and software to connect
Learning Objective 2.2.1 directly to CREST. A user can be a direct
Understand the roles of ICSDs and CSDs member of CREST and/or can act as a sponsor
generally for the selected markets: depositories for other members that do not have a direct
available; participation requirements connection to CREST. A member (whether
direct or sponsored) has securities and cash
depository arrangements in the selected functionality in CREST and is the legal owner of
markets are summarised below: the securities held in its account in CREST.
In the uK, CREST records its members

UK and Ireland securities balances and these represent the
Euroclear UK & Ireland provides depository legal record of title throughout the day. CREST
services for dematerialised uK and Irish confirms the electronic transfer of title
securities and some foreign securities, (ETT) for all uncertificated stock at the point
facilitated by the CREST system. This CSd was of settlement. The legal register is made up of
previously operated by CRESTCo, which and two parts: the issuer register (the certificated
was merged with Euroclear Group in September holdings held with the issuer or its registrar)
2002. CRESTCo was renamed Euroclear uK & and the operator register (the electronic
Ireland in early 2007. holdings in CREST). The issuer has real-time
access to all movements on the operator
U All equities are registered, as are the majority register and, in order to make up the issuers
of bonds. record, adds a copy of the operator register
U The majority of uK and Irish securities are to the issuer register. The issuers record is
available to settle in Euroclear uK & Ireland, used to calculate shareholder entitlements for
or can be rematerialised. corporate actions, dividends, voting and other
U Transfer of title is by book-entry transfer ownership benefit rights.
in CREST, since the CREST system is fully
dematerialised. Physical certificates do exist, United States
but have to be dematerialised in order to be
settled through CREST. The Depository Trust Company (DTC)
provides depository services for corporate
The CREST electronic settlement system stocks and bonds, municipal bonds, money
provides real-time settlement (on trade date if market instruments (eg, commercial paper),
required) and provides real-time direct access AdRs, and some mutual funds.
to live data in the CREST system. Members
contract with one of the CREST payment The Federal Reserve Bank (FED) provides
banks that provide credit and liquidity to depository services for most uS government
facilitate the settlement of transactions on a bonds and securities issued by federal agents
delivery versus Payment (dvP) basis. CREST and mortgage-backed securities.
maintains a cash memorandum account for

Chapter Two
Transfer of securities held by dTC is by book Germany

entry. however, dTC will safekeep some physical
Clearstream Banking Frankfurt (CBF) acts
securities on customers behalf through its dTC
as the central securities depository. Shares
Custody Service.
exist in both registered and bearer form. The
Settlement at dTC offers net end-of-day majority of securities are immobilised at CbF.
transfer of funds via the Federal Reserve
Transfer is by book entry via one of two
Funds Transfer system. In the case of
settlement processes:
some physical certificates, there needs to
be a re-registration at a transfer agent. uS U The CASCADE system (Central Application
government debt securities cleared by the for Settlement, Clearing And depository
Fixed Income Clearing Corporation (FICC) Expansion) operates within deutsche brse
are settled by J.P. Morgan Chase and the for German domestic business. It runs via
bank of new york. Mortgage-backed securities a combination of batch and real-time pro-
trades are currently settled bilaterally between cessing.
the two counterparties, after FICC MbS division U Clearstreams CREATION settlement com-
nets the trading bilaterally. however, moves munication platform operates for international
are under way to have the FICC MbS division users through Clearstream International.
serve as a central counterparty for clearing and It uses both overnight batch and several
settlement of MbS trades in the future. daytime batches.
Europe Physical transfer of shares is possible, but this

must be done outside of CbF and shares cannot
Euroclear France acts as the central securities
be sold while being reregistered.
depository and primary settlement system for
trading on nySE Euronext Paris, supporting CbF is a wholly owned subsidiary of Clearstream
securities settlement on the ESES platform International, which itself is owned by deutsche
(see below). All securities are dematerialised at brse AG.
Euroclear France.
The nySE Euronext-zone CSds (namely Spain

Euroclear belgium, Euroclear France and IBERCLEAR is the Spanish CSd, bearing
Euroclear nederland) are supported by an responsibility for registration of securities held
integrated settlement solution and harmonised in book-entry form, and clearing and settlement
custody service for stock exchange and over- of all trades on the Spanish stock exchanges,
the-counter activities. This system, known the public debt market, the AIAF fixed income
as Euroclear Settlement of Euronext- market, and Latibex the Latin American stock
zone Securities (ESES), was introduced via exchange denominated in euros.
a phased roll-out during 2007 and 2008,
and replaces the legacy systems previously IbERCLEAR is a member of the Bolsas y
operated independently by these three CSds. Mercados Espaoles (BME) group that
embraces the Spanish equity market, AIAF
Interbolsa, a wholly owned subsidiary of fixed income market and derivatives markets
nySE Euronext Lisbon, is the CSd for the and their clearing and settlement systems. The
Portuguese market and primary settlement bME Group is formed by the barcelona, bilbao,
system for trading at nySE Euronext Lisbon. Madrid and Valencia stock exchanges, MF
LCH.Clearnet SA provides central Mercados Financieros and IbERCLEAR.
counterparty (CCP) services for all the nySE
Euronext European markets. IbERCLEAR manages two technical platforms
for the registration, clearing and settlement
of securities:

1. SCLV is the platform for securities traded on settlement (RTGS) system and lies at the
the Spanish equities exchanges and Latibex. heart of the Australian payments clearing
2. CADE is the platform for the securities and settlement system. RITS also provides
traded on the AIAF fixed income and public cash settlement facilities for other interbank
debt markets. obligations (ie, low-value transactions and those
arising from Australian equity transactions in
The securities register system is structured at
ChESS) on a netted basis.
two levels:
between 1991 and February 2002, RITS
1. IbERCLEARs central register records
provided depository and settlement services
aggregate securities holdings held by CSd
for government securities (known as
participants.
Commonwealth Government Securities, or
2. CSd participants maintain a detailed
CGS). These services are now provided by the
record of their beneficial clients holdings.
Austraclear system, which is operated by the
IbERCLEAR also maintains a historical
ASX Settlement Corporation. Austraclear also
record of operations and account entries.
provides settlement and depository services
When a securities transaction results in
for corporate debt, semi-government debt
change of ownership, IbERCLEAR attaches
(debt issued by state governments) and a
a register reference (RR) to the transaction.
range of other instruments.
This will result in cancellation of original
ownership and transfer on the register to ASX Group was established in July 2006 out of
the new legal owner. The intention of the RR the merger of the Australian Stock Exchange
identifier is to ensure that: (ASX) Ltd and the Sydney Futures Exchange
IbERCLEARs central register remains Corporation (SFE).
synchronised at all times with individual
registers maintained by CSd participants; Japan
and
Japan Securities Depository Centre
the relevant security and original owner
(JASDEC) acts as the CSd for equities,
can be clearly identified throughout the
along with corporate and municipal bonds.
trade life cycle.
Settlement within JASdEC is by book-entry
transfer. dematerialisation of stock certificates
Australia
in JASdEC became mandatory in January
All securities traded on the Australian Stock 2009. JASdECs book entry transfer system for
Exchange (ASX) are cleared and settled corporate bonds was launched in January 2006.
through the ASXs Clearing House Electronic
Bank of Japan (BOJ) provides the central
Sub-register System (CHESS). ChESS is
clearing system and depository for Japanese
owned and operated by the ASX Settlement
government bonds (JGbs) and Treasury bills.
Corporation, a wholly owned subsidiary of the
ASX Group.
Hong Kong
Share certificates are dematerialised in ChESS.
The Hong Kong Securities Clearing
Investors can choose to have their holdings
Company (HKSCC) is the central depository
registered electronically in one of two ways:
for equities, and share certificates are
U on an Issuer-Sponsored Subregister; or immobilised at the hong Kong and Shanghai
U on the ChESS Subregister. banking Corporation Ltd. All shares, and most
warrants, must be registered. depository
Final settlement of payments system obligations shares are registered to the CCASS nominee,
occurs through transactions on accounts at the hKSCC nominees Ltd.
Reserve Bank of Australia (RBA). The RbAs
The depository for corporate and government
Reserve Bank Information and Transfer
debt securities is the Central Moneymarkets
System (RITS) is Australias real-time gross

Chapter Two
Unit (CMU) operated by the hKMA (hong Kong and 95% of bonds are dematerialised within
Monetary Authority). the KSd.
Settlement within KSd is by book entry transfer

Singapore
on a multilateral netting basis. Transfer of
CDP, a wholly owned subsidiary of the ownership in KSd is immediate upon settlement.
Singapore Exchange (SGX), provides integrated Partial settlement is not allowed.
clearing, settlement and depository services
in the Singaporean market. With CdP acting Brazil
as CCP to all CdP clearing members, trades The CBLC (Companhia Brasileira de
are novated to CdP, providing guarantee of Liquidao e Custdia) is the clearing house
settlement. and central securities depository for trades
in equities and corporate bonds listed and
As the central securities depository in
traded through bOVESPA and SOMA. Shares
Singapore, CdP acts as a central nominee
are dematerialised and issued in book-entry
for its account holders. The depository
form. Similarly fixed income instruments are
has two categories of participants, namely
held dematerialised at SELIC and CETIP (see
direct account holders and depository
below).
agents (dAs). Investors can opt to hold their
securities in custody via a direct account with SELIC (Sistema Especial de Liquidao
CdP, or in sub-accounts with the dAs. e Custdia) is the depository and clearing
system for government debt issued by bACEn
dAs are given access to CdPs sub-accounting
(banco Central do brasil the central bank)
system, enabling them to maintain securities
and the brazilian national Treasury. SELIC is
accounts on behalf of their private or institutional
operated by bACEn.
clients. The identities of these sub-account
holders are known only to the respective dAs, CETIP (Central de Custdia e Liquidao
ensuring the confidentiality and anonymity of Financeira de Ttulos Privados) is the
their clients. depository and clearing house for corporate
debt and OTC derivatives.
India
India has two depositories, the National 3.3.1 Link Up Markets
Securities Depository Limited (NSDL) and
the Central Securities Depository Limited Learning Objective 2.2.7
(CSDL). These hold and transfer securities
Know the structure and functions of Link Up
electronically and support electronic transfer of
Markets
securities between the two depositories.
dematerialised settlement accounts for Link up Markets is a multi-market connectivity

over 99% of turnover settled by delivery. To hub that links together ten CSds:
prevent physical certificates from sneaking into
circulation, it has become mandatory that all 1. Clearstream banking Frankfurt (Germany);
new securities must be issued and traded in 2. Cyprus Stock Exchange (Cyprus);
dematerialised form. Transfer of ownership of 3. hellenic Exchanges (Greece);
securities takes place electronically by book 4. IbERCLEAR (Spain);
entry at nSdL and CSdL. 5. MCdR (Egypt);
6. OeKb (Austria);
South Korea 7. SIS SegaInterSettle (Switzerland);
The Korea Central Securities Depository 8. STRATE (South Africa);
(KSD) acts as the central depository, clearing 9. VP Securities Services (denmark); and
and settlement agent for equities and fixed 10. VPS (norway).
income securities. More than 80% of shares

Link up Markets draws on the service The facilities provided by Euroclear bank and
capabilities offered by the participating CSds, Clearstream are summarised below. you will
enabling each CSd to connect to any other note that there is significant overlap between
CSd within the Link up Markets network via the services provided by these two ICSds.
a central communication link. The project
aims to build a central infrastructure that will
3.4.1 Euroclear Bank
enable CSds to narrow the gap between the
costs of processing domestic and cross-border The Euroclear System was founded in december
securities transactions. 1968 by Morgan Guaranty Trust Company of
new york, and is headquartered in brussels.
3.4 International Central Sold to the market in 1972, Euroclear is

Securities Depositories now owned by Euroclears clients through
(ICSDs) Euroclear plc. Morgan Guaranty relinquished its
banking and operating roles to Euroclear bank,
which was created in 2000 for this purpose.
Euroclear bank has become the worlds largest
Know the range of custody and settlement international central securities depository
services offered by the ICSDs (ICSd).

Background The Euroclear Group
Understand the roles played by Euroclear and
Clearstream, including the Bridge In July 2002, the Euroclear board announced a
merger with CRESTCo, the owner of the CSd of
Learning Objective 2.3.4 the uK and Ireland, which in Q1 2007 became
Know the communication methods used with Euroclear uK & Ireland. Following shareholder
Euroclear and Clearstream approval, and confirmation from the uKs
Office of Fair Trading that the deal would not be
referred to the Competition Commission, the
The development of the eurobond market in
merger went ahead in September 2002.
the 1960s created a deregulated international
market for issuers and investors, considerably In 2002, Euroclear announced a plan to provide
increasing the amount of cross-border bond book-entry settlement on a single platform for
trading. equities and bonds in its five core markets,
namely belgium, France, the netherlands, the
ICSds came into being initially to meet the
uK and Ireland, and for Euroclear bank. With full
need for integrated clearing, settlement and
implementation of this Single Platform project,
custody services for eurobonds, a market
Euroclear intended that its five Euroclear
that was certificate-based and, thus, paper-
CSds and Euroclear bank would use the
intensive. Subsequently, the ICSds have now
Single Platform for transaction management,
expanded the range of services that they offer
corporate actions messaging and other
and overlap in many areas with the custodian
asset servicing functions including collateral
community.
management. The first phase of this project
This has created competition among service the launch of a Single Settlement Engine (SSE)
providers in some instances, with custodians focused on transaction settlement only. This
using the services of ICSds as providers was introduced for Euroclear France in May
of depository facilities, but also competing 2006, CREST in August 2006, and at Euroclear
with ICSds in the provision of value-added bank in February 2007.
services (including custody, asset servicing,
Euroclear completed the launch of Stream
cash and collateral management, foreign
1 of the Euroclear Settlement of Euronext-
exchange, proxy voting and securities lending
zone Securities (ESES) at Euroclear France in
and borrowing).
november 2007. This marked an important

Chapter Two
first step towards the delivery of the Euronext and investing institutions. Euroclear currently
Single Order book and the delivery of the holds securities valued at approximately 21.9
Single Platform. trillion euros in custody on behalf of its clients.
ESES Stream 2 was completed in February

Methods of Holding Stock and Cash at
2008, connecting the ESES platform to the
Euroclear Bank
TARGET2 payments system.
Each Euroclear bank client has a set of accounts
ESES Stream 3, the final phase of the ESES
which represents a consolidated logical view of
project, was implemented in november 2008.
the assets, and the currencies in which they are
Euroclear belgium and Euroclear nederland
held, regardless of where they are physically
migrated their client business onto the ESES
deposited.
platform and decommissioned their existing
systems. Euroclear bank holds approximately 330,000
securities, issued from 33 countries, in
Additionally, in Q4 2008 Euroclear completed
dematerialised form. Eligible securities include
the acquisition of APK, the Finnish CSd, and
equities, eurobonds, funds and various other
VPC, the Swedish CSd, and it will gradually
forms of debt instrument, including government
extend parallel benefits in these nordic
bonds, corporate bonds and money market
markets.
instruments.
In 2010, Euroclear announced that, owing
Also, securities may be held in immobilised
to changing circumstances in European
form via one of Euroclear banks network of
securities-processing markets including
depository banks. Participants hold a depot
the development of the TARGET2-Securities
account with Euroclear bank which records the
platform for centralised settlement of euro-
securities they hold. Settlement is by book-
denominated and some non-euro securities
entry transfer across these accounts.
(see Section 3.5) it would no longer deliver its
Single Platform project according to its original Each of the 330,000 instruments that are
design and schedule. however, Euroclear will eligible for processing in Euroclear bank has
continue to pursue many of the core objectives a specialised depository in which they are
of its Single Platform agenda, including the ultimately held. This is particularly significant
harmonisation of asset servicing across its five for bearer securities, as the specialised
core markets. depository has to verify the authenticity of any
certificates deposited.
The Chief Executive Officer of Euroclear states
that: When the Single Platform project was Cash is held in a cash account with Euroclear
first proposed, the intention was to deliver bank in one or more of the 35 currencies in
benefits to users via a big bang release. which Euroclear bank is active.
However, in the current financial climate and
with client priorities changing, the big bang Settlement Services
approach is not viable. The process needs to be
Euroclear bank provides delivery versus
amended; delivering the service enhancements
Payment (dvP) settlement with simultaneous
to Euroclears users that they believe will
and irrevocable transfer of securities and cash
provide the most benefit to them at the current
proceeds. This can be achieved via batch or
time. Euroclear will then focus, at a later point,
real-time settlement functionality:
on improvements that customers deem to be of
lower priority. U Batch process runs overnight, and is
completed early in the morning of the business
The Euroclear Group currently services
day for which settlement is intended.
thousands of institutional clients across 80
markets worldwide, and retail investors in
U Real-time process runs between 04:00
and 18:00 (Central European time) on each
some domestic markets. This client base is
business day, for settlement that same day.
composed principally of banks, brokers/dealers

Settlement instructions will be received Euroclear bank also provides a comprehensive

via Euclid (Euroclear banks proprietary suite of order management, settlement and
communication network), SWIFT or (very asset-servicing for investment funds via its
rarely) telex tested. Low-volume users will FundSettle platform.
use a standalone Euclid PC system, whereas a
Euclid server is required for high-volume users
3.4.2 Clearstream
wishing to integrate Euroclear communications
with their own systems. Clearstream International was formed in 1999
by the merger of Cedel International and
There are three ways that settlement can take
deutsche brse Clearing. It has banking status
place within Euroclear bank.
and operates from offices in Luxembourg,
U Internal settlement is the simplest, as Frankfurt, London, new york, hong Kong and
it only involves a debit and credit within dubai. Cedel Group was created in September
participants accounts. 1970, its shareholders consisting of more than
U Bridge settlement involves an exchange 90 of the worlds major financial institutions,
of messages with Clearstream across an principally banks. There was a holding company,
electronic bridge. The first phase of an Cedel International, with subsidiary companies,
automated daytime bridge was introduced in including Cedel bank, which contained the core
June 2004, with the second phase completed clearing and settlement business. Cedel bank
successfully in november 2004. The was based in Luxembourg, an operating centre
automated daytime bridge is a reflection of that Clearstream banking Luxembourg retains
growing acceptance in the market that Europe today.
needs to be more integrated, representing an
Clearstream operates settlement and custodian
important step towards interoperability of
services on behalf of approximately 2,500
markets in Europe. This facility has enhanced
customers across 40 markets and in 94 global
settlement efficiency and given clients more
locations. It settles over 250,000 transactions
opportunity to settle bridge transactions
per day across 150,000 securities. The
that failed during the overnight settlement
businesses at Clearstreams chief operational
process.
centres are known as Clearstream banking
U External settlement involves the exchange Luxembourg (CbL) and Clearstream banking
of messages with CSds that are not part of
Frankfurt (CbF).
the Euroclear group. Receipt of bearer bonds
for settlement is also possible, but the bonds Customers can access Clearstreams clearing,
may be frozen until they are authenticated by settlement and custody services through a range
the specialised depository. of avenues:
U CreationConnect which provides a real-

Custody Services
time suite of connectivity channels for users
Euroclear bank provides a range of asset to link to Clearstream. The transition to
servicing facilities, which include: CreationConnect was completed in July
2005, and CEdCOM, Clearstreams legacy
U safekeeping;
proprietary communication system, was
U administration of interest, dividend and
decommissioned at that time;
redemption payments;
U Creation via SWIFT, offering a message-
U assistance with recovery of tax withheld;
based solution using ISO 15022;
U exercise of warrants and other options;
U Standalone access via CreationOnline.
U assistance with corporate actions;
U treasury and FX services; Communication with Clearstream via telex
U proxy voting services; is possible, but this method is rarely used.
U securities lending and borrowing services; Via these communication gateways, clients
and can access a range of transaction processing
U triparty collateral management.

Chapter Two
and custody services offered through the Clearstream also provides a comprehensive
CreationOnline package, including the following: suite of order management and settlement
services to investment funds via its Vestima+
Settlement and Central Facility for Funds (CFF).
Fully automated overnight and daytime dvP

settlement processing is via Clearstreams 3.5 TARGET2-Securities
CreationOnline settlement engine. This single
system offers a central point of entry for Learning Objective 2.2.6
settlement on a range of markets. bridge
Know the proposed intentions of Target2-
settlement supports the exchange of settlement
Securities
messages with Euroclear across the electronic
bridge.
In 2006, the European Central bank (ECb)
In March 2008, Clearstream launched a new- announced a plan to launch a centralised
generation post-trade infrastructure processing settlement platform, known as TARGET2-
environment for its ICSd activities, extending Securities (T2S), for the settlement of euro-
real-time processing across the full instruction denominated securities transactions (equities,
life cycle throughout the daytime settlement fixed income, investment funds) and some
period. With this development, Clearstream non-euro-denominated securities transactions
handles all steps for the transaction in central bank money. In March 2009, 27
lifecycle that impact market efficiency CSds signed a Memorandum of understanding
within this processing environment on a confirming that subject to appropriate
real-time basis. This includes instruction contractual arrangements being arranged with
validation, matching, domestic market the Eurosystem (the ECb and national central
instruction handling and confirmations, banks of countries that have adopted the euro)
instruction sequencing, collateral management as owner and operator of the platform they
and customer reporting. would outsource securities settlement to the
T2S platform. CSds outside the eurozone will
This creates a framework through which users
also have freedom to outsource settlement of
can optimise movement of securities and
securities transactions to the T2S operator,
collateral across a daytime processing window
providing that their central bank agrees to
extending from 22.00 on the business day
make its currency available to settle securities
preceding settlement (Sd-1) to 18.00 CET.
transactions via the platform. The Eurosystem
The system runs on Clearstreams Creation
proposes that the T2S platform will provide a
settlement engine.
mechanism to reduce post-trade costs and to
encourage further harmonisation in European
Custody Services securities settlement.
Clearstream provides a range of asset-servicing
An important landmark for the project was
facilities, which include:
set for June 2012, by which time CSds were
U safekeeping; required to confirm whether they would make
U administration of interest, dividend and a legally binding commitment to the T2S
redemption payments; project according to terms laid down in the
U assistance with recovery of tax withheld; T2S Framework Agreement. This Framework
U exercise of warrants and other options; Agreement details the project governance and
U assistance with corporate actions; the legal conditions under which CSds will
U proxy voting services; outsource settlement of securities transactions
U securities lending and borrowing services; to T2S. In a public announcement on 8 May
U triparty collateral management; 2012, the ECb confirmed that nine CSds had
U treasury and FX services; and signed the Framework Agreement collectively
U issues handling. accounting for approximately two-thirds of the

securities transactions settled in euros. These support settlement of securities transactions in

were: T2S. To date, just one central bank outside of
the euro area, namely the danish Central bank,
U bank of Greece Securities Settlement System has signed the T2S Currency Participation
(Greece); Agreement. danmarks nationalbank will make
U Clearstream banking (Germany); the danish krone available in T2S in 2018. In
U depozitarul Central (Romania); the uK, the bank of Englands position not to
U Iberclear (Spain); commit has been apparent for some time.
U LuxCSd (Luxembourg);
U Monte Titoli (Italy); The ECb Governing Council has assigned the
U national bank of belgium Securities development and operation of T2S to four
Settlement System (belgium); European central banks, namely deutsche
U VP LuX Srl (Luxembourg); and bundesbank, banco de Espaa, banque de
U VP Securities A/S (denmark). France and banca dItalia, commonly known
collectively as 4Cb.
A further 15 CSds signed the Framework
Agreement prior to the 30 June deadline. The According to the proposed schedule, T2S will
additional signatories were: be ready for testing by CSds in October 2014.
The first group of CSds will migrate settlement
U Eesti Vrtpaberikeskus (Estonia); activity to the T2S platform in June 2015,
U Central depository (bulgaria); with remaining CSds migrating by January
U Centrlny depozitr cennch papierov 2017 in three further migration waves (plus
(Slovakia); a contingency wave in case of unforeseen
U Cyprus Stock Exchange; events).
U Euroclear belgium;
U Euroclear Finland;
U Euroclear France; 4. Straight-Through
U Euroclear nederland;
U Interbolsa Sociedade Gestora de Sistemas Processing (STP)
de Liquidao e de Sistemas Centralizados de
Valores Mobilirios (Portugal); Learning Objective 2.3.1
U Understand the advantages of straight-through
d.d. (Slovenia); processing
U KELER Kzponti Elszmolhz s rtktr
Zrt. (hungary);
U Straight-through processing (STP) is the
oriumas (Lithuania); automated passage of a financial transaction
U Malta Stock Exchange; from execution to settlement without manual
U Oesterreichische Kontrollbank Aktiengesell- intervention.
schaft (Austria); and
This process involves the seamless passage of
U SIX SIS (Switzerland).
information from the first placement and capture
The 24 CSds that signed up before the 30 June of a trade order through to final settlement.
deadline have had their joining fees waived, Information should pass electronically to all
equivalent to 25% of the total fee paid by the parties involved in the transaction process
CSd in its first year after joining. The nine that (including investment managers, broker/
signed up before 30 April also have their first dealers, custodians, exchanges, depositories,
three months of fees waived. registrars and third-party information vendors),
employing standard information flows, and
Also, central banks outside the euro area technology and processes that are compatible
were asked under the terms of the Currency with each other.
Participation Agreement to confirm whether
they will make their currency available to

Chapter Two
4.1 Why is STP Necessary? 4.2 Barriers to Promoting

There is clear recognition that human
STP
intervention in trade processing and asset- different jurisdictions maintain their own
servicing procedures is one of the principal procedures and legal requirements. Tax
sources of error, and therefore of risk and cost, regulations, for example, differ significantly
in the financial services industry. across European jurisdictions. Similarly, some
types of corporate actions follow markedly
Key concerns include the following:
different procedures in different markets. This
U In the current financial services environment, lack of standardisation presents a barrier to
some participants still conduct their trade handling tax reclaims and corporate actions in
reporting by telephone and fax. This type a seamless, automated manner.
of reporting requires participants to re-key
In a challenging economic climate, participants
information, resulting in processing errors,
in the transaction cycle often demand a quick
reporting and confirmation delays, and
return on investment if they are to commit
increased potential for settlement failure
development resources to automating their
when compared with automated systems.
systems and promoting an STP culture.
U In some companies, front office trading
systems and back-office operations When development money is limited, a small
have evolved independently, with weak investment manager, for example, may feel
connectivity between these systems. This that its firm may profit more from updating its
limits potential to establish automated end- front office stock-selection technology rather
to-end communication from front to back than in automating process flows through its
office without manual intervention. operations department. unless STP is seen to
U Some companies retain their own proprietary deliver immediate cost benefits, it may remain
systems and procedures for holding data and low in the list of development priorities for
communicating messages between process some investment companies.
areas. Lack of standardisation impedes
interconnectivity between participants and new standards (eg, ISO 15022 and ISO 20022,
ultimately impairs the timely and accurate FIX protocol, see Section 4.4) have been
free flow of information. introduced that facilitate the automation
U This concern is exacerbated because of trade processing and asset servicing
consolidations in the industry have brought procedures. however, these will only deliver
multiple legacy systems under one roof. STP if used in the correct way.
Often there is poor connectivity between
For example, some companies have failed to
these disparate systems.
make best use of the structured message types
available under ISO 15022, with appropriate
In summary, the full benefits of developments
fields in the structured message not completed
in technology and communications cannot be
in the correct way. It is still possible to send
realised without a shift to STP.
typed instructions using free-format message
types (eg, MT 599) available in ISO 15022,
effectively sending instructions as an electronic
fax. This demands that the instruction is read
manually by the recipient and that information
is re-keyed into its own system.

4.3 The STP/T+1 Initiative and increase risk and cost (through higher fail
rates and repair costs) on the other.
One of the key drivers that has given momentum
to efforts to promote STP has been the STP/T+1 In Europe, moves towards a standardised
initiative, a project conceived by the Securities T+2 settlement cycle are again on the table,
Industry Association (SIA) and the Canadian with the European Commission publishing a
Capital Markets Association (CCMA) to address proposal in early 2012 to harmonise settlement
rising trading volumes in the uS and Canadian periods across Eu member states as part of
securities markets. The original goal of the wider initiatives to strength Europes post-trade
STP/T+1 programme was to move from T+3 to infrastructure. According to existing plans, a
T+1 settlement in the uS and Canada by 2005. T+2 cycle for securities settlement is expected
In practice, the challenge of moving to a next- in Europe from January 2015.
day settlement cycle (ie, T+1) was abandoned
In line with many participants within the
in October 2002, but the SIA and CCMA have
securities industry, the SIA adjudged that,
continued with their efforts to promote STP in
while T+1 settlement may be a realistic goal for
their respective markets.
the industry in the future, it is not currently an
Why was the T+1 goal put on hold? because, appropriate time to be trying to put next-day
ultimately, the SIA and CCMA felt that the 2005 settlement into practice. Rather, the industry
deadline, which had initially been important in must make further progress in its transition
galvanising market participants, had gradually towards universal STP before a T+1 business
become an obstacle to the real job in hand, case can be considered to be a realistic
namely to improve levels of STP within the objective.
industry.
A T+3 settlement cycle offers counterparties 4.4 FIX Protocol Messaging

time to ensure that their settlement instructions
are correct and sent on time, that instructions Learning Objectives 2.3.3
are matched, and that cash and securities are Know the features and benefits of FIX protocol
in position to ensure effective settlement on messaging
settlement date. however, in a T+1 settlement
cycle the time window that exists for ensuring
The Financial Information Exchange (FIX)
these prerequisites are in place is much
protocol provides a standardised format for
narrower. Fund managers and broker/dealers
the electronic communication of pre-trade
must agree terms of settlement and dispatch
and trade execution messages. Established
settlement instructions to custodians on trade
originally in 1992 as a bilateral communications
date. Moreover, efforts to shorten the T+3
framework between Fidelity Investments and
settlement cycle may be impractical in markets
Salomon brothers for equities trading, the FIX
where certificates need to be dematerialised to
protocol has been developed at the industry
support electronic settlement (see Chapter 3).
level through collaboration between investment
A reduced settlement cycle has the advantage managers, broker/dealers, exchanges,
that it reduces counterparty risk, since credit IT vendors and other key participants to
exposure to the counterparty is shorter in a provide a standard for communication of trade
T+1 cycle. however, on the negative side, this information between buy-side investment
may increase the likelihood that trades may companies and sell-side broker/dealer firms.
fail because the timely dispatch of instructions,
Although the use of FIX is not universal across
affirmation/matching of instructions and
the industry, FIX is integral to many order
positioning of cash and securities may not be
management and trading systems, and efforts
completed effectively in the shorter cycle. In
continue to encourage firms to use FIX to
short, you may reduce risk and cost on the one
communicate their trade information.
hand (through lower counterparty/credit risk)

Chapter Two
Since its inception as a protocol designed To address these inefficiencies, 239 banks from
to promote standardised communication 15 countries formed a co-operative to, as they
and straight-through processing for equities termed it, automate the telex. This co-operative
trading, FIX protocol is gathering momentum was named the Society for Worldwide
as it continues to expand across the foreign Interbank Financial Telecommunication,
exchange, fixed income and derivative markets. or SWIFT. Registered in brussels, this became
operational in May 1977. The goal was to
develop a series of standardised financial
5. Society for messages that could be employed to transmit
Worldwide transaction instructions and data between

participants securely and efficiently.
Interbank Financial
In the early days, SWIFT hoped that ultimately
Telecommunication business use might grow to 300,000 messages
(SWIFT) per day. In reality, daily messages now regularly
exceed nine million, with SWIFT serving 7,600
members and participants in 200 countries.
SWIFTs business objectives include:
Know the features and benefits of SWIFT and
SWIFT messaging U to work in partnership with its members
to provide low-cost, competitive financial
processing and communications services of
SWIFT has played a central role in promoting
the highest security and reliability;
the use of standardised and secure messaging
U to contribute to the commercial success of its
services and interface software within the
members through greater automation of the
financial services industry since its inception
end-to-end financial transaction process, based
in 1973.
on its expertise in message-processing and
setting financial standards;
U to capitalise on its position as an international
open forum for the worlds financial
institutions to address industry-level threats,
issues and opportunities.
SWIFTs worldwide community includes banks,

broker/dealers and investment managers,
as well as their market infrastructures in
The 1960s saw rapid growth in international
payments, securities, treasury and trade.
banking business brought about by the
SWIFT operates around the clock, 24 hours
expansion of international trade. until that
a day, seven days a week. Its main areas of
time, administration and control systems
activity are:
were paper-based and the growth in business
volumes put increasing pressure on these U Payments the systems to support bank
systems. To improve business efficiency, banks instructions, customer instructions, advice,
started to install computer systems. Each bank statements, clearing and settlement. SWIFT
had its own system, which improved internal provides the network infrastructure for
efficiency, but a lack of common standards systems in several countries and interlinks
meant that one banks system could not the participating banks in TARGET2 (see
communicate seamlessly with the proprietary Chapter 3, Section 3.2). Almost 60% of
system developed by another bank. Therefore, message volume in its core FIn message
interbank payments and transfers commonly type relates to payments.
relied on telex, mail or physical delivery.

U Securities providing messaging communi-

cation to support trade confirmation, clearing Category Message Group
and settlement, and custodial operations.
SWIFT provides network services to CREST. 0 General Information
Just over 30% of FIn message volume Customer Transfers and
1
relates to securities. Charges
U Foreign exchange, money markets, 2 Financial Institution Transfers
treasury services providing the systems
Financial Trading (FX, Loans,
to support confirmation messaging, matching, 3
SWAPs, etc)
bilateral or multilateral netting and reporting
of treasury and FX trades. 4 Collections and Cash Letters
5 Financial Trading (Securities)

SWIFT, along with bT, employs standardised
message formats suitable for automated Precious Metals and
6
data-handling that are designed to minimise Syndications
language and interpretation problems. SWIFT
documentary Credits and
messages present data in a structured manner, 7
Guarantees
facilitating straight-through processing.
8 Travellers Cheques
balance Reporting, Rate

9 Changes, nostro Statements
and Status Enquiries
Category 5 Securities Messages

Securities messages can be classified into eight
categories, as follows:
SWIFT has been heavily involved in the
1. Trade instructions and confirmations.
implementation of the ISO 15022 messaging
2. Settlement instructions and confirmations.
standards, introduced in november 2002, which
3. Corporate actions and event notices.
established a common format for securities-
4. Capital and income advice.
related messages. Subsequently, it has also
5. Statements.
been active in promoting the adoption of the
6. Securities lending and borrowing.
newer and more flexible ISO 20022 standard
7. Inter-depository clearing systems.
messaging over its network, which ultimately
8. General.
is likely to be the successor to ISO 15022
standard financial services messaging.
SWIFT supports ten categories of message

types grouped by business use. This are listed
below for informational purposes. (You are not
required to learn these for your examination.)

Chapter Two
1. What is:
i. an investment manager?
ii. an institutional investor?
iii. an individual investor?
2. What is a custodian? Why does an investor appoint a custodian to administer and safekeep its
assets?
3. What is a global custodian? Summarise the range of services offered by a global custodian to an
investor client.
4. What is a subcustodian? In which circumstances will a subcustodian be employed and what

services does it provide?

5. Summarise the relative advantages and disadvantages of appointing a local or a regional

custody provider.
Answer Reference: Sections 2.1.2, 2.1.3
6. What is the purpose of a custody agreement signed between a custodian and an investor client?
Summarise the main elements that a custody agreement is likely to address.
7. What is the purpose of a service level agreement between a global custodian and a subcustodian?
What are the key service elements addressed by the SLA?
8. What is the purpose of an RFP in the selection of a global custodian by an investor? What are the
key elements addressed in an RFP?
9. What is:
i. an immobilised security; and
ii. a dematerialised security?

Chapter Two
10. List the CSds and settlement systems employed in each of the core markets addressed in this
course.
11. List three mechanisms through which settlement can take place within Euroclear.
12. List three communication gateways through which customers may access Clearstreams
CREATIOn system.
13. What function is served by the electronic bridge between Clearstream and Euroclear?
14. Why is STP a requirement for improving efficiency, and reducing risk and cost, in the securities
industry?
15. What is SWIFT and what are its main areas of activity?

3
Settlement Characteristics
1. The Trade Cycle 82
2. Pre-Settlement 82
3. Settlement 86
4. Failed Settlement 103

Chapter Three

If an investor decides to invest in securities, It is common for both institutional investors

they will take a decision about how they wish to and private investors to employ specialist fund
allocate its investment money across different managers to manage investments on their
types of security. This is known as asset behalf. however, some large pensions and
allocation. They must decide, for example, life insurance firms do manage investments
how they wish to divide their investment pool in-house, and some own fund management
across equities (domestic and international), companies.
government bonds, corporate bonds, and other
categories of security. They may also invest in having outlined the process through which
asset classes such as property, commodities, an investor allocates their pool of investment
hedge funds and private equity. money across different asset classes, we
will now examine the mechanisms through
having decided how they wish to allocate their which assets are bought and sold and held in
money, the investor must decide whether they safekeeping, and how legal title to the security
wish to: is registered and transferred between owners.
1. manage these investments themselves; or

2. appoint investment managers who specialise
in investing in asset types and investment
styles required by the investor.

Chapter Three
1. The Trade Cycle The matching of the buyers and sellers trade
data is typically conducted at two levels:
The process of investing money in securities
1. Trading counterparties compare trade
(eg, equities, government bonds, corporate
details. This may take place bilaterally,
bonds) will involve a number of steps:
via matching facilities extended by the
U Trading mechanisms have been described in securities settlement system (at the CSd
Chapter 1. The process of buying or selling an for example), or via a third-party central
instrument is generally termed execution, matching facility (such as Omgeo CTM, see
representing the procedure through which Section 2.5) that will compare trade details
counterparties agree to conduct a financial electronically and issue a report on matching
transaction on specified terms. status (ie, whether matched or unmatched).
U Pre-settlement. As soon as a trade has For centrally cleared transactions, matched
been executed, a number of procedures and instructions may be forwarded to the CCP
checks must be conducted before actual for clearing (see below).
settlement can be completed. These will 2. Custodians acting on behalf of buyer and
include matching the trade instructions seller will compare settlement instructions
supplied by each counterparty to ensure that in order to identify potential mismatches
the details they have supplied for the trade prior to settlement date.
correspond. It will also involve conducting
Generally the following data is required for the
checks to ensure that the seller has sufficient
matching of settlement instructions:
securities to deliver and that the buyer has
sufficient funds to cover the purchase cost. U Title of security.
U Settlement is the process through which U Security identification code.
legal title (ie, ownership) of a security is U Counterparty details and account numbers
transferred from seller to buyer in exchange (ie, custodian depot/nostro account details).
for the equivalent value in cash. Ideally, these U Trade date.
two transfers should occur simultaneously. U Trade price.
U Post-settlement entails the management U Whether a purchase or sale of securities.
of failed transactions and the subsequent U Quantity of security.
accounting of trades. U Settlement currency.
U net settlement value (the cash value to be
paid or received).
2. Pre-Settlement U Trading conditions (eg, ex-dividend,
ex-rights, etc).
2.1 Matching Settlement U The number of days and the amount of
accrued interest, if a fixed-income security.
Instructions
U Settlement date.
U Settlement method (ie, dvP, FOP).
Understand the data required for matching of
2.2 Clearing
settlement instructions

When a trade has been executed, a key step in
Understand the process of clearing (matching
the management of risk in the post-execution,
and the assumption of risk trade for trade
pre-settlement stage is for the two sides to the
versus central counterparty)
trade to compare trade details and to eliminate
any mismatches, prior to the exchange of cash
and securities. Clearing (or clearance) is the process through
which the obligations held by buyer and seller
to a trade are defined and legally formalised. In

simple terms, this procedure establishes what provides a central counterparty service for
each of the counterparties expects to receive exchange-traded equities executed on Xetra
when the trade is settled. It also defines that are denominated in euro and listed on
the obligations each must fulfil, in terms of Xetra. Also, ISE Xetra is the electronic trading
delivering securities or funds, for the trade to system for the Irish Stock Exchange, and
settle successfully. Eurex Clearing provides clearing services for
trades conducted via this system. In its role
Specifically, the clearing process includes:
as clearing house, Eurex Clearing additionally
U recording key trade information so that assures the fulfilment and clearing of trades on
counterparties can agree on its terms; the Eurex derivatives exchange, Eurex bonds
U formalising the legal obligation between and Eurex Repo.
counterparties; Since MiFId implementation, a number of new
U matching and confirming trade details; CCP facilities have been established in Europe,
U agreeing procedures for settling the predominantly to clear trade flow from MTF
transaction; platforms. These CCPs include the European
U calculating settlement obligations and Multilateral Clearing Facility (EMCF), SIS x-clear
sending out settlement instructions to the and EuroCCP.
brokers, custodians and CSd;
U managing margin and making margin calls.
This relates to collateral paid to the clearing 2.3 Clearing via a Central
agent by counterparties to guarantee their Counterparty (CCP)
positions against default up to settlement.
A CCP interposes itself between the
Trades may be cleared bilaterally between counterparties to a trade, becoming the buyer
the trading counterparties or via a central to every seller and the seller to every buyer.
counterparty that interposes itself between As a result, buyer and seller interact with the
buyer and seller. When trades are cleared CCP and remain anonymous to each other. This
bilaterally, each trading party bears a direct process is known as novation.
credit risk against each counterparty that
The introduction of a CCP can offer a number of
it trades with. hence, it will typically bear
benefits for its members:
direct liability for any losses incurred through
counterparty default (see below and Chapter 6). 1. The credit risk that market participants
previously held against each counterparty
Central counterparty services are available in
that they trade with is substituted by a
a range of markets in order to mitigate this
single credit risk held against the CCP.
risk. For example, LCh.Clearnet provides CCP
2. hence, clearing relationships are streamlined
services in the uK and nySE Euronext European
and counterparty risk is significantly reduced.
markets for trading in equity, derivatives and
Each market participant communicates only
energy products, for platforms trading the
with the CCP in managing risk mitigation
majority of euro-denominated and sterling
measures (eg, requesting collateral or
bond and repo products, along with commodity
margin payments), rather than managing
and energy derivatives and the bilaterally
a series of bilateral relationships with each
traded interbank interest rate swaps market.
counterparty that it deals with.
In the uS, clearing of broker-to-broker trades 3. The risk of default by the CCP is, typically,
in equities, corporate bonds, municipal bonds, significantly lower than that of individual
unit investment trusts (uITs) and exchange- counterparties. A CCP is expected by
traded funds (ETFs) takes place through regulatory authorities to maintain effective
the national Securities Clearing Corporation risk management controls that are sufficient
(nSCC), a subsidiary of the depository Trust to withstand severe shocks, including
& Clearing Corporation (dTCC). Eurex Clearing defaults by one or more of its participants.
AG, which is part of deutsche brse Group,

Chapter Three
The risk controls extended by a CCP effectively

provide an early warning system to financial
regulators of impending risks and are an
important tool in efforts to contain these risks
within manageable limits.
2.4 Netting

Understand netting in pre-settlement
4. Since the CCP assumes the obligations,

and acquires the rights, of settlement, it netting occurs when trading partners agree to
is obliged to finalise settlement between offset their positions or obligations. by doing
participants, even if a participant fails to so, they reduce a large number of individual
meet its settlement obligations. In these positions to a smaller number of positions (or
situations, CCPs will typically provide a even a single position), and it is on this netted
settlement guarantee scheme through position that the two trading partners settle
which: (a) the loss is compensated with the their outstanding obligations to transfer cash
defaulting participants property, such as its or securities.
clearing fund deposited with the CCP; and
besides reducing transaction costs and
(b) if this amount is insufficient, the loss
communication expenses, netting is important
may be met through mutual guarantee by
because it reduces credit and liquidity risks
the other participants.
(refer to Chapter 6 for further explanation of
All trades cleared at the CCP must be different types of risk).
cleared via a registered clearing member.
A direct clearing member is a firm by netting the settlement obligations held
that is eligible to clear only its own trade by its members, a CCP may improve the
obligations. A general clearing member efficiency of securities and funds transfer,
(GCM) is eligible to clear its own obligations and may boost liquidity within the system.
and/or to clear trades on behalf of other trading This may also reduce the credit risk exposure
firms. by appointing a GCM to clear trades on its and collateralisation requirements borne by
behalf, a trading firm will be able to focus on its its members. Rather than market participants
core trading activities and this will eliminate having to settle securities and cash on a
the need to meet the capital requirements trade-by-trade (gross) basis with each of the
and technical investment necessary to counterparties that it conducts business with
clear its own trades at the CCP. In these during the trading day, the CCP will net off each
circumstances the trading firm will assume participants respective sales and purchases
non-Clearing Member (nCM) status, allowing it to a single transfer of securities and a single
to trade in its own name while employing the transfer of cash (see below).
services of a GCM to clear its trades at the CCP.
From a liquidity risk standpoint, netting reduces
With systemic risk uppermost in the minds requirements for a particular stock. Imagine
of the financial authorities, regulators are a similar scenario where uS$1 million and
increasingly keen to promote the use of CCPs uS$900,000 worth of shares in a company
across a wide range of financial products. While were to be exchanged. under trade-by-trade
this does not eliminate the risk of institutions arrangements, each counterparty would need
going into default, it does spread this risk to have access to this gross quantity of stock,
across all participants, and makes these risks when in practice only uS$100,000 of stock
progressively easier to monitor and regulate. would actually be exchanged between the

counterparties. netting will allow counterparties The Omgeo solution consists of:
to offset their mutual obligations, and this will
be particularly advantageous when the stock U a central matching system (eg, the Omgeo
is illiquid and may be difficult and expensive to Central Trade Manager) that notifies each
secure. entity of settlement from the same source;
U a central static database of settlement
While we have outlined the benefits extended instructions (Alert) which are applied
by CCPs in this section, the introduction of a automatically to transactions.
CCP may not always be welcomed by all market
participants. The costs of developing a CCP Standard Settlement Instructions (SSIs) should
can be substantial and will typically need to be now appear on the ETC confirmation as they
borne, at least in part, by clearing members. are attached with Alert.
Trading parties will need to bear the cost of
Settlement instructions will only pass to a
CCP fees and the associated cost of putting up
subcustodian/agent bank if the Omgeo
collateral at the CCP. Furthermore, netting of
participant has a direct custody relationship
trades will reduce volumes passing through to
with that party. Otherwise, settlement
settlement, thereby reducing the transaction-
instructions will go via the global custodian who
based income that accrues to settlement
will, in turn, instruct the subcustodian/agent
agents, unless they raise their settlement
bank. This arrangement will ensure that the
fees to adjust for this drop in volume. CCPs
global custodians records remain aligned with
typically bring added surety and efficiency, but
those of the subcustodian.
the benefits that ensue need to be carefully
weighed up against the costs involved. With the launch of the Omgeo Connect facility,
buy-side customers can monitor trades from
2.5 Automating the point of execution through to settlement in
Omgeo, and in third-party systems, providing
Functions Between
a single point of entry for equity and fixed
Execution and income trades matched via Omgeo CTM and
Settlement Omgeo Oasys Tradematch.
TRAX, the matching system developed by the

International Capital Market Association (ICMA)
Understand the role of third-party service and acquired by Euroclear in 2008 (when
providers in the pre-settlement process, eg, Euroclear purchased Xtracker, the operating
OMGEO company that delivers the TRAX service),
was launched in 1989 to provide a one-
While some firms do continue to match trades stop trade matching and regulatory reporting
locally, the use of central trade-matching system. It was designed to eliminate the
facilities has become increasingly widespread. costs and risks associated with paper-based
trade confirmation. Catering particularly for
Several firms have introduced facilities designed OTC bonds trading, TRAX offers an electronic
to centralise and automate trade processing in alternative, enabling counterparties to identify
the post-execution, pre-settlement arena. potential mismatches and problem trades early
in the settlement cycle. The TRAX2 system
Omgeo, a joint venture between Thomson
performs post-trade matching for a range
Reuters and the depository Trust and Clearing
of OTC-traded instruments, including bonds,
Corporation (dTCC), introduced its Omgeo
equities, derivatives and repo trades.
Central Trade Manager (CTM) and Omgeo Oasys
Tradematch facilities in 2001 in order to support Automation improves processing times
centralised matching and communication by eliminating the requirement to send
between buy-side and sell-side customers and information back and forth manually between
their respective settlement agents. parties and by reducing the errors inherent in

Chapter Three
manual processing. At its most sophisticated,

automation allows manual intervention to
3. Settlement
be eliminated from post-trade processing, Settlement is the process through which legal
enabling trade data to be entered only once, title (ie, ownership) of a security is transferred
and for this data to be employed at each stage from seller to buyer in exchange for the
that it is required in the STP process flow from equivalent value in cash. Ideally, these two
execution through to trade settlement. transfers should occur simultaneously.
Efforts to promote automation in the post-

execution, pre-settlement space have been 3.1 Financial Institutions in
supported by key advances in messaging and the Settlement Process
communication.
The Financial Information Exchange (FIX) Learning Objective 3.2.1

protocol provides a standardised format for Know the role of the following types of
the electronic communication of pre-trade financial institutions in the settlement process:
and trade execution messages (see Chapter 2, brokers; investment banks; investment
Section 4.4). managers; custodians; sub-custodians; Central
Counterparty Clearing Houses (CCPs) and
SWIFT offers a suite of standardised electronic
clearing members; ICSDs and CSDs
trade confirmation messages, extending
ETC to an expanding number of investment
management companies, global broker/ To understand the roles played by key financial
dealers and banks. This allows firms that institutions in the settlement process, it may be
have already invested in connecting to SWIFT, useful to break the settlement life cycle down
typically for cash and securities settlement into its component parts. For a cross-border
and reconciliation, for example, to build on the trade, the key elements would commonly be:
SWIFT-compatible infrastructure that they have
Order Placement
in place in order to extend straight-through
processing (STP) in the trade confirmation 1. The investment manager places an order
area. See Chapter 2, Section 5. with its broker.
A number of technology vendors, including

Trade Execution
Smartstream, Sungard, Trace and City
networks, have developed ETC technology 2. The broker executes the clients order,
designed to support, and interface with, ETC either via a stock exchange or MTF, via a
initiatives outlined above. systematic internaliser, or OTC with another
counterparty. If it is a cross-border trade,
this global market maker may use a local
market maker to execute the trade.
3. The broker notifies the investment mana-
ger of the trade using electronic trade
confirmation (ETC) or manual communi-
cation such as fax or telephone.
Confirmation/Affirmation
4. If the trade is a block trade, the investment

manager notifies the broker of how the
purchased securities are to be allocated
across different accounts. On receipt of this
information, the broker will issue a trade
confirmation.

Investigation and Repair of Trade Fails
12. Failed trades are investigated and resolved.
Given that trade confirmation, affirmation and

settlement instructions pass through a large
number of hands before final settlement, there
is a need to exercise considerable vigilance to
ensure that settlement details are correct and
5. The investment manager will check the sent to the appropriate parties.
trade details and, if these are correct, it will
Indeed, the settlement instructions have to
send an affirmation message to the broker.
be correct between a large number of parties.
The investor must instruct its global custodian
Settlement Instructions
correctly. For a cross-border trade, the global
6. The investment manager sends a settlement custodian will send settlement instructions
instruction to the global custodian notifying to its subcustodian, which will, in turn, send
the custodian of the settlement details. settlement instructions to the CSd (or ICSd, if
7. The global custodian will instruct its settling at Clearstream or Euroclear bank).
subcustodian to settle the trade, or it
On the broker side, the broker must correctly
may settle the trade itself if it acts as its
instruct its settlement agent, which must, in
own settlement agent in that market. The
turn, correctly instruct the CSd (or ICSd as
trade will settle at a local CSd, or, rarely,
appropriate). The large number of links in the
physically, depending on the form in which
chain dictates that great care must be taken
the instrument is held.
to ensure that instructions are accurate and
aligned across each of these participants.
Positioning of Cash and Securities
This situation is complicated further by the
8. For CSd-eligible trades, the settlement fact that settlement instruction formats can
agent sends settlement instructions to differ across markets, brokerage entities and
the CSd. These are generally matched at types of investment instrument (eg, equities,
the CSd against settlement instructions bonds). This lack of harmonisation can generate
submitted by the counterparty. mismatches if market participants employ non-
9. The CSd will send notification of those that standard settlement instruction formats.
match, and any trades that fail to match.
The requirement to submit settlement
Any mismatches must be investigated and
instructions is designed to ensure that CSd
resolved.
(or ICSd) members have control over delivery
10. If a successful match is found, the trade
of securities held in their accounts at the CSd
will be queued and will go forward for
(or ICSd) and over delivery of cash payments.
settlement. For trade settlement to be
This arrangement is designed to ensure that
completed successfully, the necessary cash
securities are not delivered from settlement
and securities must be in position on the
members securities accounts, and cash
settlement date to discharge the settlement
payments are not raised, without instructions
obligations of the respective counterparties.
being actively issued by the member concerned
This process is known as positioning.
and delivered to the CSd (or ICSd) via an
11. The settlement agent will receive notification
approved means of communication.
from the CSd of whether successful settle-
ment has taken place. This settlement We noted in Chapter 2 that many investment
notification is communicated by the sub- managers opt to focus on their core competency,
custodian to the global custodian and then namely, the task of fund management, and
back to the investment manager. outsource their investment administration to

Chapter Three
a third party. For example, some investment Interbank Payments System (ChIPS), a private
managers have chosen to outsource their back sector funds transfer network specialising
office responsibilities to a global custodian. in international payments, and through the
Federal Reserve banks Fedwire Funds Transfer
Many hedge funds employ an investment bank Service.
(such as Goldman Sachs, Morgan Stanley) to
manage their execution, clearing and settlement
functions globally, as well as to provide them 3.2.1 The Clearing House
with access to credit lines, extend securities Interbank Payments
lending and borrowing facilities, and provide System (CHIPS)
collateral management, cash management,
The Clearing house Interbank Payments
market information and reporting, and a range
System (ChIPS) is a computerised network for
of other services.
the transfer of uS dollar payments. This was
This bundled function extended to hedge funds originally launched in 1970 by the new york
is generically known as prime brokerage, and Clearing house Association, a group of the
has represented a major growth area for a largest new york City commercial banks, for
number of leading investment banks in recent eight of its members that held Federal Reserve
times. system membership. ChIPS operates on a
multilateral netting basis and enables banks to
by employing a third-party clearing agent in settle dollar payments by electronic transfer.
this way, the investor eliminates the need to Messages are transmitted by SWIFT.
become a member of the clearing house itself.
In Europe, for example, the clearing agent is until 1981, final settlement (ie, the transfer
typically a clearing member (either directly or of funds at the Federal Reserve) took place
via a local agent acting on its behalf) of each the morning after a transfer. however, this
of the major clearing houses and is able to arrangement exposed funds to overnight (or
provide a pan-European clearing function via over-weekend) risk. Consequently, the Federal
a single point of entry, managing the clients Reserve extended same-day settlement finality
collateral, extending credit lines, and covering to ChIPS participants though Fedwire, the
the requirement (via its agent network) to Feds electronic funds and securities transfer
settle trades. network, in August 1981.
A number of leading international investment ChIPS now provides intraday payment finality
banks provide this style of service package on through a real-time system. ChIPS settles
a global or regional basis. small payments, which can be met by the
banks available balances, on an RTGS basis.
Other payments are netted bilaterally or
3.2 Payment Systems multilaterally.
Learning Objective 3.2.2 Each participant in the intraday netting system

is required to pre-fund its ChIPS account by
Know the characteristics of the following cash
depositing a quantity of funds sufficient to
systems: CHIPS; CHAPS; TARGET2; Fedwire;
cover its intra-day exposures. The level of pre-
CLS
funding that each participant must advance is
assessed by ChIPS on the basis of the number
A range of domestic and international payments and size of its recent ChIPS transactions. At
systems offer finality of payment in central the end of the day, ChIPS uses these deposits
bank money. In the uK, the Clearing house to settle any still-unsettled transactions.
Automated Payments System (ChAPS) extends
real-time gross settlement (RTGS) payments banks that have positive closing positions
functionality for sterling inter-bank payments. at the end of the day are credited with the
In the uS, the bulk of large dollar transfers cash balance through the Fedwire payments
are conducted through the Clearing house

system (see below). The vast majority of ChIPS The ChAPS RTGS payments infrastructure is
members are Fedwire participants. extended to ChAPS members by the bank of
England and the ChAPS Clearing Company.
3.2.2 Fedwire
3.2.4 Faster Payments
Fedwire is the Federal Reserves electronic
funds transfer system. It is a real-time gross Faster Payments Service was launched in May
settlement system in which more than 11,000 2008 to handle the processing of internet,
depository institutions initiate funds transfers telephone and standing order payments in the
that are immediate, final, and irrevocable when uK market. This service runs alongside existing
processed. It allows member banks to transfer uK payment schemes bACS (for direct debits
funds on their own behalf, or on behalf of their and direct credits) and ChAPS, and represents
customers. Participants that maintain a reserve the first new payments service to be introduced
or clearing account with a Federal Reserve bank to the uK market for more than 20 years.
may use Fedwire to send payments to, or receive
payments from, other account-holders directly. Although it was initially operated by ChAPS
Participants use Fedwire to handle large-value, Co, responsibility for operation of the Faster
time-critical payments, such as payments for Payments system was transferred to Faster
the settlement of interbank purchases and Payments Schemes Ltd when the latter
sales of federal funds, the purchase, sale, company was formed in november 2011.
and financing of securities transactions, the Faster Payments Service membership is open
disbursement or repayment of loans and the to credit institutions with a settlement account
settlement of real estate transactions. at the bank of England that can connect to
All Fedwire transfers are completed on the the central payments infrastructure. Since the
day they are initiated, generally in a matter of beginning of 2012, all internet and telephone
minutes. They are guaranteed to be final by payments in the uK have been processed via
the Fed as soon as the receiving institution is Faster Payments. All payments must reach the
notified of the credit to its account. recipients account by the next working day
after the customer has initiated the transaction.
The Fedwire Funds Transfer Service operates In practice, telephone or internet payments
from 00:30 to 18:30 new york time. These sent using Faster Payments will typically be
hours of operation overlap with both the available for withdrawal from the beneficiarys
European and Asia/Pacific time zones. The account on the same day that the payment is
Fedwire Securities Transfer Service operates sent.
from 08:30 to 15:30 new york time, Monday to
Friday.
3.2.5 TARGET
3.2.3 The Clearing House Trans-European Automated Real-time Gross

Settlement Express Transfer (TARGET) is the
Automated Payments
real-time gross settlement system for the
System (CHAPS)
euro. As its name states, TARGET is a real-time
The Clearing house Automated Payments gross settlement system and ensures same-
System (ChAPS) is the uKs high-value day payment finality in central bank money.
payments system, providing real-time gross This went live in January 1999 to support the
settlement (RTGS) for credit transfers. creation of a unified money market in the
This provides RTGS settlement for sterling eurozone and the delivery of a single monetary
payments via ChAPS Sterling. ChAPS Euro, policy.
the settlement service for euro payments that
TARGET2, the more recent European real-time
utilised the same settlement systems as ChAPS
gross settlement (RTGS) system, went live in
Sterling, was decommissioned in May 2008
november 2007, replacing the decentralised
after nine years of service.

Chapter Three
The system initially supported seven eligible

currencies: the Australian, Canadian and uS
dollars, the euro, the Japanese yen, the Swiss
franc and the uK pound sterling. Four additional
currencies were added in September 2003:
the danish krone, the norwegian krone, the
Swedish krona, and the Singapore dollar. A
further four currencies were added to the CLS
community in late 2004: the South African
rand, the Korean won, the hong Kong dollar
TARGET system with a single technical platform
and the new Zealand dollar. The Israeli shekel
developed by banca dItalia, banque de France,
and Mexican peso were added in May 2008.
and deutsche bundesbank. These three banks
operate the TARGET2 system on behalf of the With the average daily turnover in global FX
Eurosystem (ie, the European Central bank transactions at almost uS$2 trillion, the FX
and the central banks of Eu states that have market has long needed an effective cross-
adopted the euro currency), thereby providing currency settlement process. While transaction
users with a homogenous payment service volumes have increased, the methods by which
throughout the eurozone. they are settled have stayed virtually the
same for 300 years. before CLS, each side
Migration from TARGET onto the TARGET2
of a trade was paid separately. Taking time-
platform took place in three phases. The initial
zone differences into account, this heightened
launch of TARGET2 on 19 november 2007 saw
the risk of one party defaulting. CLS was
the connection of the first migration group,
implemented to combat herstatt risk (see
composed of the national central banks and
Section 3.3.7) by providing real-time Payment
the respective TARGET user communities in
versus Payment (PvP) settlement between
Austria, Cyprus, Germany, Latvia, Lithuania,
participating currencies.
Luxemburg, Malta and Slovenia.
CLS bank is owned by more than 70 of the
This was followed on 18 February 2008 by the
worlds largest financial groups throughout the
connection of Migration Group 2, consisting of
uS, Europe and Asia Pacific. between them CLS
belgium, Finland, France, Ireland, netherlands,
banks shareholders are responsible for more
Portugal and Spain.
than half the value transferred in the worlds FX
The implementation of TARGET2 was completed market. Five CLS shareholders alone represent
with the connection of national central over 44% of this market.
banks and payments user communities from
banks wishing to make use of CLS to settle
denmark, Estonia, Greece, Italy, Poland and
FX transactions will either take out direct
the ECb on 19 May 2008.TARGET2 is open from
membership at CLS bank, or will go via a
07:00 to 18:00 Central European Time, with a
settlement member or user member which can
deadline of 17:00 for customer payments.
introduce CLS trades on their behalf.
3.2.6 CLS Bank A settlement member must be a CLS

shareholder and must demonstrate that it
CLS refers to Continuous Linked Settlement. has the necessary financial and operational
capability, and sufficient liquidity, to support its
The CLS bank is a private initiative that began
financial commitments to CLS. Each settlement
in 1996, supported by the largest foreign
member has a multi-currency account with
exchange banks the Group of 20 (G20) to
CLS bank. Settlement members have direct
eliminate settlement risk and to reduce the
access and, consequently, can send settlement
systemic liquidity risk in the foreign exchange
instructions direct to CLS on their own behalf
market. CLS was launched commercially in
and on behalf of their customers. They can also
2002.
provide a branded CLS service to their third-

party customers as part of their agreement settlement would have been completed by
with CLS bank. physical delivery of certificates from buyer to
seller in return for cash. however, we have
user members can submit settlement noted that many securities markets are now
instructions for themselves and their dematerialised or immobilised and transfer
customers. however, user members do not takes place electronically by book entry rather
have an account with CLS bank. Instead they than physical movement of certificates.
are sponsored by a settlement member, acting
on their behalf. Each instruction submitted To minimise the principal risk incurred in
by a user member must be authorised by a the case of default by either counterparty, a
designated settlement member. The instruction working group of the worlds leading securities
is then eligible for settlement through the regulators and central banks recommended
sponsoring settlement members account. that settlement providers should reduce to a
minimum the credit risk created if securities or
cash are delivered without receipt of assets of
3.3 Key Concepts in the corresponding value by the counterparty.
Settlement Process
3.3.1 Free of Payment (FoP)
Settlement
Understand the following settlement concepts:
trade for trade; netting bilateral and Free of payment settlement refers to the
multilateral; trade date netting, continuous separate, non-simultaneous exchange of cash
net settlement; fixed date settlement; rolling and securities between counterparties (see dvP
settlement; free of payment transactions; arrangements below). In FoP settlement, one
delivery vs payment; book entry settlement; or both parties to the trade will be forced to
physical settlement; foreign exchange deliver securities or pay cash before they have
settlement taken delivery of the corresponding asset from
the other counterparty. Owing to the higher
risks of FoP settlement when compared with
Settlement of a securities transaction refers
dvP, regulatory authorities are encouraging
to the process of exchanging securities and
companies to employ dvP whenever possible.
cash between the buyer and seller in order to
discharge their respective obligations. delivery
of securities commonly takes place at a CSd 3.3.2 Delivery versus Payment
(or ICSd). Funds transfer (ie, delivery of cash) (DvP)
commonly takes place through a banking or
dvP is a procedure whereby appropriate
payments system.
technical, legal and contractual arrangements
A trade cannot be deemed to be settled until are in place to ensure that a transfer of securities
both the securities transfer and cash transfer is final if, and only if, the corresponding
are final and irrevocable (ie, neither of the transfer of funds is final. More simply, dvP
transfers can be rescinded). Traditionally, trade involves simultaneous exchange of securities
and cash between buyer and seller (in practice,
this commonly takes place via their respective
custodians on the books of the CSd and central
payments system). hence, both parties are
protected against risk of counterparty default.
dvP can be achieved in several ways:
U Via a real-time gross settlement (RTGS)

system that provides simultaneous and
immediate transfer of securities and cash

Chapter Three
throughout the working day. RTGS is the Bilateral

continuous settlement of funds and securities
U Trades between the same two counterparties
transfers individually on an order-by-order
in the same security are offset (ie, netted
basis.
off) so that there is only one transfer.
U Via netting systems that offer finality of cash
U This can be in respect of cash and securities.
and securities transfer by the end of the
U In respect of cash only there is only one
working day. hence, necessary procedures
cash transfer, but each securities transfer is
must be in place to ensure that intra-
carried out separately.
day transfers are final and that end-of-day
U Separate netting agreements must be in
net settlements of cash payments will be
place with each counterparty.
realised, even if one or more participants fail
to meet their obligations.
U On the books of a CSd that operates a Multilateral
combined clearing and depository service U Extends bilateral netting to cover all trades
and is linked to a final payments system in the same security by any number of
(eg, settlement takes place in central bank counterparties.
money). U For each security traded this will result in each
U When securities are delivered against a counterparty making only one transfer of cash
guaranteed cheque that provides the party or securities, either to another counterparty
concerned with cleared funds. or to the central clearing system.
U Requires the use of a central clearing
In the uK, for example, Euroclear uK & Ireland system to establish the cash and securities
(EuI) provides delivery versus payment in obligations of each counterparty and to
central bank money, with simultaneous and instruct respective settlement obligations to
irrevocable transfer of cash and securities (this settlement agents and CSd.
arrangement is known as dvP model 1) for
all sterling and euro payments. Full legal title See the example opposite.
is also transferred at the point of settlement
In trade date netting, each trading company
for all uK-registered shares and government
will settle a single netted cash balance and a
bonds.
single netted securities balance calculated at
At the point of settlement in EuI, the EuI close of business on trade date. This settlement
payment, which discharges the buyers of cash and securities relates only to trades
obligation to the seller, is accompanied by flagged for netting on the trading day, and will
a simultaneous payment from the buyers not include failed trades from previous days
settlement bank to the sellers settlement bank that have been brought forward.
across the books of the central bank (the bank In continuous net settlement (CNS), failed
of England for sterling settlement, the Central trades from previous days may be re-presented
bank of Ireland for euros). This removes the for netting in a later multilateral netting cycle.
theoretical risk to an investor arising from the
failure of its counterpartys settlement bank. The following rules and steps are applied by the
CnS process:
3.3.3 Netted Settlement U For securities the CnS algorithm will

attempt to net positions against other posi-
netting can be bilateral (between two
tions with opposite-signed quantities, with
counterparties only) or multilateral (involving
the oldest positions being netted first. So it
many counterparties, as in a CCP). The following
will try to net POS1 against POS2. If POS1
compares the two:
cannot net to zero against POS2, it will try
against POS3, POS4 POSn (see example
overleaf). The netted security quantity is
always kept on the position having the bigger

Example Multilateral Netting

Consider, for example, that trading company BCD conducts trades in a specified share with three
counterparties, DEF, LMN and TUV, as follows:
Settled on a trade-for-trade basis, BCD would need to settle each trade individually with these
three respective counterparties. By netting multilaterally via the CCP, each trading company settles
just a single cash balance and a single securities balance with the CCP. This can be represented
diagrammatically:
BCD DEF
Receive 800 shares Deliver 7,000 shares
Pay 3,180.00 cash Receive 28,000.00 cash
CCP
LMN TUV
Receive 2,000 shares Receive 4,200 shares
Pay 7,600.00 cash Pay 17,220.00 cash
security quantity irrespective of the intended settlement finality and in limiting systemic
settlement date. risk. Gross settlement systems have been
U For cash the CnS algorithm will attempt widely employed to mitigate the risks in large-
to net opposite-signed cash amounts, with value funds transfer systems where the main
the oldest positions netted first. The net cash participants have access to intra-day liquidity
amount is always kept on the position having extended by the central bank.
the bigger cash amount in absolute value,
irrespective of the intended settlement date. however, trade-for-trade settlement can place
substantial demands on liquidity, requiring that
cash and securities obligations are met in full
3.3.4 Finality of Transfer
for each trade (ie, without being netted against
Whichever settlement model is employed, the other positions). This can create gridlock within
settlement system must specify the moment of the system, when delivery of funds or securities
finality of transfer in its rules through binding does not move sufficiently quickly to release
contracts on the parties involved. Once finality the liquidity needed to allow subsequent trades
of transfer has been assured, these rules must to settle.
allow the buyer to use the securities, and the
We have seen above that netting systems can
seller to use the cash, without further delay
ease these liquidity pressures, since positions
in the safe knowledge that the transaction will
are offset and settled at the end of the settle-
not at that stage fail and the trade have to be
ment batch. by reducing the overall value of
unwound.
money that market participants must transfer
to deliver their obligations at the end of
We have noted above that RTGS systems have
a settlement batch, the efficiency of cash
an important role to play in ensuring real-time

Chapter Three
Example Continuous Net Settlement

At close of business on trade date, D, we have: three failed trade positions in a specified security
(POS1 to POS3) linked to the same customer account, along with a new position (POS4) traded on the
current business day D:
Intended settlement date (ISD) for these securities is, respectively, D3 for POS1, D2 for POS2, D1
for POS3 and D+1 for POS4. The oldest position will be forwarded for netting first.
Positions ISD Quantity Value (EUR)

POS1 fail d3 40 +300
POS2 fail d2 5 +10
POS3 fail d1 100 +1,000
POS4 new d+1 +90 1,200
Securities Quantity Pre-netting CASH Amount Pre-netting

Positions ISD Quantity Positions ISD Value (EUR)
POS1 d3 0 POS1 d3 0
POS2 d2 5 POS2 d2 +10
POS3 d1 100 POS3 d1 +1,000
POS4 d+1 +50 POS4 d+1 900

POS1 d3 0 POS1 d3 0
POS2 d2 0 POS2 d2 0
POS3 d1 100 POS3 d1 +1,000
POS4 d+1 +45 POS4 d+1 890

POS1 d3 0 POS1 d3 0
POS2 d2 0 POS2 d2 0
POS3 d1 55 POS3 d1 +110
POS4 d+1 0 POS4 d+1 0
Final result at end of CNS process:
Positions ISD Quantity Value (EUR)

POS3 d+1 55 +110
Source: LCH.Clearnet
payments and securities transfer mechanisms counterparties with which it has conducted
can be improved. transactions during the settlement batch. If
adequate cover is not in place (eg, requiring
On the downside, a participants true exposure participants to put up collateral in advance to
may only be revealed at the end of the cover their intra-day credit exposure), then
settlement batch. If a market participant default by a counterparty may dictate that
defaults on its settlement obligations at this whole series of trades may need to be
this point, this could impact on a series of unwound.

3.3.5 From Physical Settlement As such, the Group of Thirty (G30), a global
to Book-Entry Transfer industry working group represented by senior
figures from financial services companies,
Many trading and settlement systems have regulators, central banks, academics and a
advanced from the days when securities were range of other industry bodies, has issued
held and traded in physical form, with paper recommendations indicating that infrastructure
certificates exchanged between counterparties providers (eg, exchanges, clearing houses,
against transfer of funds in order to conduct CSds and payments systems) and regulatory
a trade a process known as physical authorities should work with issuers and
settlement. securities industry participants to phase out
physical securities without delay. Some private
When a depository does accept certificated
investors in certain markets continue to have
securities, these will typically be immobilised,
a preference for holding physical certificates
such that they no longer need to be delivered
and debate continues on how best to promote
physically from one counterparty to another.
cultural change within this community in order
In practice, the certificated security remains
to secure more widespread acceptance of
in the vaults of the CSd throughout the
dematerialisation.
transaction (hence it is immobilised), with the
security being debited from the account of the
seller and credited to the account of the buyer. 3.3.6 Fixed Date Settlement and
Rolling Settlement
Many markets now employ computer-based
mechanisms for transferring ownership, with Most countries have now adopted rolling
records of ownership being held in electronic settlement, including each of the core markets
book-entry format. The security ceases to highlighted in Chapter 2. Settlement occurs on
exist in paper form, with the certificate being a specific number of business days after the
replaced by computer records. This transition trade date. In the uK, for example, settlement
from physical to electronic format is known as occurs three days after trade date, which is
dematerialisation. ESES, for example, holds commonly denoted as T+3.
securities in dematerialised form.
Some smaller markets continue to operate a
The shift to a dematerialised securities fixed settlement period (sometimes known as
environment has: account settlement), whereby trades executed
within a specified period (known as an account
U improved processing efficiency by allowing period) would settle on a specified date. For
trading, clearance, settlement and asset example, all trades executed during the week
servicing procedures to be increasingly beginning Monday 9 May would settle on
automated; Monday 16 May; all trades conducted during
U enabled shorter settlement timing; the week beginning Monday 16 May would
U improved security by reducing the possibility settle on Monday 23 May, and so on.
that a physical security may be lost, stolen or
fraudulently copied. Fixed date settlement has the following
disadvantages:
The transition to book-entry settlement and
dematerialised trading commonly demands a
U There can be a lengthy delay between trade
execution and trade settlement, dictating
corresponding change in the markets legal
that sellers may not receive prompt payment
framework in order to ensure that ownership
for their securities and resulting in extended
rights are fully protected through electronic
credit exposure to the counterparty.
records. necessary business continuity
procedures must also be put in place to ensure
U Failed trades cannot be re-presented for
settlement until settlement date at the end
effective back-up of electronic records and
of the next account period. hence, failed
systems in the instance of any systemic shock
trades may remain unsettled for an extended
or crisis.
period.

Chapter Three
U The market value of the security may move When a price is quoted on a trading screen or a
significantly during this period, creating a website it will look something like this:
sizeable replacement risk (the risk that non-
defaulting parties will incur a loss when GbP/uSd 1.742630
replacing unsettled contracts) in instances of U The three-letter acronyms denote the
trade failure. currencies. The first currency is the base
U Fixed date settlement creates peaks and currency and the second is the quoted
troughs of settlement activity, with trades currency. Many currencies are quoted
being queued to settle on a specified date against the uS dollar as the base currency
at the end of the account period; this puts a (ie, the reverse of the rate shown above).
strain on operations at these peak times. Sterling and the euro are exceptions to this
generalisation. both Aud and nZd are also
The longer the period from trade execution to quoted as the base against the uS dollar.
settlement, the greater the risk that one of the U One unit of the base currency will buy the
parties may become insolvent or default on amount shown in the quoted currency. In
the trade, the larger the number of trades that the example quoted, one pound sterling will
will be awaiting settlement, and the greater purchase uS$1.7426.
the opportunity for the prices of the securities U The first price is the bid price, which is what
to move away from the contract prices. These an investor would obtain if buying the second
factors collectively accentuate the risk that currency with the first.
non-defaulting parties will incur a loss when U The second price is the offer price, which is
replacing the unsettled contracts. the amount of the second currency that one
In contrast, under a rolling settlement cycle, would need to pay to buy one unit of the
trades settle a specified number of business first, in this case uS$1.7430 will buy 1.00.
days after the trade date, rather than at the note that the second price is not quoted in
end of an account period, thereby limiting the full, only the last two digits; this is because
number of outstanding trades and reducing the spread is normally less than 1% and the
aggregate market exposure. whole amount does not need to be quoted.
U The spread is the difference between the
In 1989, the G30 recommended that final bid and offer prices and is the traders profit
settlement of cash transactions should occur margin on the transaction.
on T+3, that is, three business days after U The mid-price is the average of the bid and
the trade date. however, in reviewing its offer prices. It is normally not quoted for
recommendations in 2003, the G30 specified trading, but it is reported in the financial
that, in order to minimise counterparty risk press, for example, to illustrate how
and market exposure associated with securities currencies are moving relative to one other.
transactions, the goal should be ultimately to
further shorten the securities settlement cycle. FX is not traded on-exchange. Instead,
FX traders deal directly with each other,
informed by screen-based pricing systems
3.3.7 Foreign Exchange and transacting by phone or electronically.
Settlement banks are the main players. Settlement of FX
transactions (the actual movement of cash)
Foreign exchange (FX) transactions are used
may take place immediately (spot, ie, on a T+2
for three main purposes:
basis, see below) or in the future (forward),
U to obtain currency to settle immediate either as outright forwards or as foreign
payment commitments; exchange swaps. In addition, currency futures
U to hedge against future exchange rate contracts can be traded on many derivatives
movements; and exchanges.
U to speculate, or trade, in currencies in order
to make profits from changes in exchange
rates.

Average daily turnover on the global foreign

exchange market is roughly uS$4 trillion per
day according to a Triennial Central bank
survey of foreign exchange markets published
in September 2010. Approximately 37% of this
daily turnover is in spot forex transactions,
with currency swap transactions accounting
for 44%, and outright forwards a further 12%.
Options on interbank FX transactions represent
a further 5% of average daily turnover. date the quoted currency is not exchanged.
Instead, the rate is compared against the
U Spot transactions a spot transaction is prevailing spot rate. The profit or loss is
a single outright transaction involving the calculated as if a reverse transaction had
exchange of two currencies at a rate agreed been completed. This is the amount that is
at the time of the contract. Settlement takes settled. An investor would enter into a non-
place within two business days. deliverable forward if:
U Outright forwards a forward transaction they wish to speculate in the currency,
is one for settlement more than two days in but do not wish to execute the reverse
the future. There are no standard settlement transaction;
dates as there are with futures contracts: there are liquidity or dealing restrictions
a forward outright can be for a few days, that would prevent (or make it difficult
months or years. The exchange rate is fixed for) the investor from executing the
at the time that the transaction is agreed, reverse transaction. For example, in
but there is no exchange of money until brazil, FX transactions above bRL10,000
settlement date. must be registered and, if considered to
U Foreign exchange swaps a foreign be an international transfer (to a foreign
exchange swap is the simultaneous purchase bank), they will be subject to a 2%
and sale of a specified amount of foreign finance tax.
currency for two different settlement dates. U FX options these provide a right, but
A single transaction combines two deals, not an obligation, for the option-holder to
one spot and one forward. enter into a foreign exchange transaction,
For example, bank X may sell 20 usually at some date in the future, at a
million for spot dollars to bank y and predetermined exchange rate with the issuer
simultaneously buys 20 million forward of the option. This option will be exercised
for dollars for, say, seven-day settlement. (or closed out at a profit) if the rate at which
The spot deal takes place at the spot rate the deal can be struck is preferential to the
and the forward deal at the forward rate. prevailing market rate. For example, an
A foreign currency swap allows each party option written in June that would allow the
to use a currency for a period in exchange holder to exchange JPy100 million for uS$ at
for another currency that is not needed a rate of JPy100 per uS$ in december would
during that time. be exercised if the uS$ market rate were
The foreign exchange swap is arranged greater than JPy100 per uS$. The purchaser
as a single transaction with a single of an option pays a premium to the seller (or
counterparty. The majority of forward writer) of the option.
transactions are undertaken as swaps.
The next sections will examine factors which
When a forward transaction is mentioned,
cause the spot FX rate to move up or down and
it usually means a swap.
will describe how cross rates and forward rates
U Non-deliverable forwards in a non-
are calculated.
deliverable forward, the exchange rate is
set for some date in the future, but at that

Chapter Three
Note: the following text is for information only the uS dollar will depreciate against uK sterling
and will not be examined. by 1.5% annually.
Purchasing power parity is not a perfect guide

Spot Rate Determination
to how currencies will behave, but it provides
Spot FX rates are driven up and down by forces a basis for understanding the long-term
of supply and demand and are likely to be relationship between currencies.
influenced by a range of economic and political
considerations that will shape the positions that Cross Rate Calculation
FX traders will take on particular currency pairs
(eg, how the uS dollar will move against the Increasingly, rates between most currencies
Japanese yen). This will include: are calculated and are publicly available to
investors wishing to conduct an FX transaction.
U Economic factors, for example: however, in some instances, an investor
balance of payments; wishing to exchange between two less-quoted
government budget surplus or deficit; currencies may need to go through the dollar.
inflation; The cross-rate can be calculated from the two
economic growth; dollar exchange rates.
interest rates; and
purchasing power parity (see below). Forward Rate Determination
U Political factors, for example:
The determination of the forward rate does not
government policies;
involve any guess or estimate of what exchange
political stability;
rates will be in the future. The forward rate
central bank intervention; and
reflects the interest rate differentials between
regulation and control by the government
the currencies at the time the deal is done. In
and central bank.
theory, the forward rate could be the same as
U Market sentiment.
the spot rate, but this will only occur if interest
rates in the two countries are the same. In
Purchasing Power Parity
practice, the forward price is normally higher or
Purchasing power parity (PPP) is a theory lower than the spot rate.
that states that identical goods should cost
For example, if uK interest rates are 5% and
the same in two countries. For example, if a
uS rates are 4%, an investor may be tempted
basket of goods costs 100 in London, and the
to:
same basket of goods costs uS$150 in new
york, then the exchange rate should be 1 = U borrow dollars and pay interest at 4% on the
uS$1.50. loan;
If, after a number of years, the same basket of U convert the dollars into sterling at the spot
goods costs 125 in London and yet it remains rate, put the pounds on deposit and earn
at uS$150 in new york, then one might expect interest at 5%;
the exchange rate to be 1.00 = uS$1.20; this U agree a forward rate of exchange for
would demonstrate a decline in the value of converting the pounds back into dollars to
sterling. repay the loan.
This Law of One Price describes the principle The forward rate will be calculated such that the
of Absolute PPP. investor will not profit from this arrangement.
In this example, it means that forward dollars
The principle of Relative PPP tells us that the will have to be more expensive than spot
rate of appreciation of a currency (ie, currency A dollars (ie, forward dollars will be at a premium
relative to currency b) is equal to the difference to the spot rate). If uS interest rates were
in inflation rates between the two countries. higher than uK rates, forward dollars would be
For example, if the uK has an inflation rate of cheaper than spot (thus, forward dollars would
2.0% and the uS has an inflation rate of 3.5%, be quoted at a discount to the spot rate).

The principle that allows us to calculate forward

RGbP = uK interest rates = 5% (in the example)
rates from spot rates and interest rates is
R$ = uS interest rates = 4%
called interest rate parity and is explained
Xspot = the spot rate = 1.6
below.
Xfor = the forward rate = 1.6 (same as spot in
Forward rates are not quoted outright but at the example)
a premium, or discount, to the spot rate. For
To make equations (1) and (2) the same, the
example, if the spot rate is 1.00 = uS$1.60
forward rate in equation (1) must be less than
and the three-month forward is 0.25 cents
the spot rate. The left hand side of (1) must
discount, the three-month forward rate is thus
amount to the uS$1,040,000 in (2):
uS$1.6000 uS$0.0025 = uS$1.5975. note
that the discount is deducted from the spot 656,250 x Xfor = uS$1,040,000
rate, thus making dollars more expensive for
three-month delivery. uS$1,040,000
Xfor =
656,250
The reason for quoting the premium is that
swaps are based on the interest rate differential. = 1.5848uS$/
A second benefit is that premiums and discounts
The example will be worked again, but
are subject to much less fluctuation than spot
substituting symbols for amounts. The investor
rates, so quoting differentials requires fewer
would convert its loan to sterling using the spot
amendments to published prices.
rate, Xspot :
Forward Rate Calculation uS$1m uS$1m

=
Xspot Xspot
Taking the previous scenario, imagine that an
investment company were to borrow uS$1 The investor then places this on deposit at RGbP
million in the uS at 4%, and agrees to repay for one year and receives:
the loan in a year. It enters into a forward
transaction at the spot price. uS$1m x (1 + RGbP)
Xspot
Firstly, it would convert it to sterling using the
spot rate. It would receive: The investor converts this back to dollars at the
forward rate:
uS$1,000,000
= 625,000
1.60 uS$1m x (1 + RGbP) x Xfor
Xspot
It then places this on deposit at 5% for one
year and receives: This will be equal to the original loan, plus the
R$ interest:
625,000 x 1.05 = 656,250 (principal plus
interest) $1m x (1 + RGbP) x X for
= $1m x (1 + R$)
It converts this back to dollars: Rearranging gives:
656,250 x 1.60 = uS$1,050,000 (1) Xfor (1 + R$)

=
X spot (1 + RGbP)
The original loan has to be paid off, plus the 4%
interest:
Or:
uS$1,000,000 x 1.04 = uS$1,040,000 (2)
(1 + R$)
Forward rate = x spot rate
Leaving it with a profit of uS$10,000. (1 + RGbP)
To calculate the forward rate, we set (1) and (2)

This is known as interest rate parity.
to be equal, so no profit is generated.
Note: this is the end of the non-examinable
To generate a general formula for this:
text.

Chapter Three
Settlement Risk in FX Transactions 3.4 Transfer of Title

Given that there is no central dealing exchange
for FX transactions in the same way as exists for Learning Objective 3.2.4
securities, settlement has traditionally involved Understand the transfer of legal title: bearer;
payments between both counterparties banks. registered
When conducting FX transactions under these
arrangements there is a finite risk that one
party to the trade may default before both When securities are sold or transferred to a
counterparties have met their settlement new owner, the method for transferring legal
obligations. This may result in a situation title will depend on whether the security is in
where one leg is paid, but the counterparty bearer, certificated or dematerialised form and
goes into liquidation before the second leg is whether there is a requirement to re-register
paid out. the security. See the table below.
This is known as Herstatt risk, named after 3.4.1 Bearer Securities

bankhaus herstatt, a German bank active in
the FX market. In June 1974, the bank had its Investors typically hold bearer securities in
banking licence withdrawn after the interbank secure storage at the local CSd, or sometimes
payment system in Germany had closed. It with their custodian. The CSd or custodian
had received deutschmark payments from its will maintain records of the total quantity
counterparties. however, its correspondent of a specific security that it holds, and the
bank in new york, which had just opened quantity held by each investor. however,
when the news broke, would not make the uS$ the CSd or custodian will not usually record
payments that herstatt was due to pay. the identification numbers of the individual
certificates deposited by each investor.
We noted earlier that CLS was implemented
to eliminate herstatt risk by providing Like bank notes, bearer securities are said
real-time Payment versus Payment (PvP) to be fungible, meaning that the certificate
settlement between participating currencies. deposited by the investor may not be the exact
It intermediates between the two sides of an certificate that it receives on return, should it
FX transaction, requiring both counterparties opt to withdraw the security from safe storage.
to pay the funds due for delivery to the other Like bank notes, holders of bearer securities
directly into accounts with CLS bank. bear the risk of theft or loss of the certificate.
Only after these funds have been fully paid into If both buyer and seller have securities accounts
CLS will the latter pay out the funds owed to at the CSd (or with the same custodian), transfer
each party. hence, if either counterparty fails of legal title can take place electronically by
to meet its obligations to pay in funds, it will book-entry transfer, without the immobilised
not receive its payout; rather, the funds will certificates leaving the vaults of the CSd (or
be returned to the party that had originally the vaults of the custodian concerned).
remitted them.
Registered
Bearer Registered (dematerialised)
(certificated)
Typical method of Certificate and Register and certificate Register and book entry
holding securities book entry
Typical method for book-entry Transfer and book entry and

securities transfer transfer re-registration reregistration
holders name no yes yes

appears on register

3.4.2 Registered Securities in sellers account, and the costs of a securities

Certificated Form purchase are debited from the buyers account,
on the date that a trade actually settles.
If an investor sells or transfers registered
securities that are in certificated (ie, physical) If trade settlement is delayed, this dictates
form, the seller is typically required to complete that the seller will not receive due funds
a securities transfer form, confirming that the until after the proposed settlement date. For
seller authorises transfer of legal title to the example, if a trade is scheduled to settle on
buying counterparty. Transfer of title will be T+3, but does not actually settle until T+6,
effected on the securities register. the seller will not receive funds until three
days after the proposed settlement date. As
Subsequently, the registrar will cancel the a result, the seller is disadvantaged by losing
sellers certificate, as it is now void. The the opportunity to utilise these funds, or earn
registrar will then issue a new certificate in the interest on this money, for three days.
buyers name. This method of transferring legal
title is called transfer and re-registration, after Conversely, ASdA works to the advantage of the
accounting for any transfer tax liability. buyer, who will not need to pay cash to settle
the transaction until three days after the
originally scheduled T+3 settlement date.
3.4.3 Registered Securities in
Dematerialised Form To provide clients with greater certainty
over their cash flows, some custodians have
Transfer of title takes place via book entry with introduced Contractual Settlement Date
re-registration in instances when the registered Accounting (CSDA) arrangements, whereby,
security is held in dematerialised form, or the subject to certain conditions, funds will be
buyer wishes to hold in dematerialised form credited or debited on settlement date (or an
(when available) a registered security that was otherwise pre-agreed value date), even if trade
previously held as a physical certificate. settlement is not yet final and irrevocable on
under this method, the CSd will send an that date. Contractual settlement will typically
electronic notification to the registrar only be offered in well-structured and liquid
confirming details of the change in holding markets, and custodians will specify in their
from seller to buyer. The register will then SLA where this applies.
be updated electronically, confirming transfer Contractual settlement arrangements imply
of legal title by book entry transfer. This a risk to the custodian, since it is absorbing
arrangement offers the advantage that the liquidity pressures from the client by extending
security can be traded as soon as the stock provisional credit to the clients account.
settles. With certificated securities, there may
be a longer time delay while transfer of title is In some circumstances, CSdA arrangements
processed by the registrar and a new certificate may not apply, or may be withdrawn eg, if
is sent to the buying investor. the sellers stock was not available to complete
settlement successfully.
3.5 Contractual Settlement To control the risk that it takes on through

these arrangements, the custodian should have
Learning Objective 3.2.5 procedures in place to monitor late settlements
and, if appropriate, to reverse any provisional
Understand Contractual Settlement Date
credits made to the clients account.
Accounting (CSDA) and Actual Settlement Date
Accounting (ASDA) The terms under which provisional credits are
extended to the client under CSdA arrangements
Actual Settlement Date Accounting (ASDA) must be clearly established between custodian
refers to accounting procedures by which the and client. If the client is unaware that credits
proceeds of a securities sale are credited to the are provisional in certain circumstances, it

Chapter Three
may, for example, underestimate its overall barriers are classified as technical or market-
credit exposure, or be faced with an account practice barriers, legal barriers, and barriers
overdraft in circumstances where a provisional related to tax procedures:
credit is reversed.
In response to these barriers, the European
Commission outlines a set of proposals
3.6 The Giovannini Barriers designed to promote a safe and efficient
to the Creation of a European clearing environment and a level
playing field across providers of clearing and
Harmonised Securities
settlement services. To achieve this objective,
Market for Europe the Commission plans:
Learning Objective 3.2.6 U to liberalise and integrate existing securities

clearing and settlement systems, particularly
Know the main Giovannini Barriers to the
by providing access rights at all levels and
creation of a harmonised market for Europe
removing barriers to cross-border clearing
and settlement;
The Giovannini Group (a consultative group of U to remove restrictive market practices and to
market participants formed in 1996 to advise monitor industry consolidation in accordance
the European Commission on issues relating with the requirements of competition policy;
to Eu financial integration and the efficiency U to adopt a common regulatory and supervisory
of euro-denominated financial markets) framework that ensures financial stability and
produced two reports that analyse barriers to investor protection, leading to the mutual
efficient and secure clearing and settlement recognition of systems;
in the Eu, the first in november 2001 and the U to implement appropriate governance
second in April 2003. The 2001 Giovannini arrangements so as to address national
Report highlighted 15 factors preventing the authorities concerns regarding the way in
efficient provision of cross-border clearing which clearing and settlement infrastructures
and settlement services within the Eu. These operate.
Barrier 1 There is need to eliminate connectivity problems resulting from national differences
in information technology and interfaces used by clearing and settlement providers.
This includes encouraging the use of standardised communication based on ISO
standard electronic messaging.
Barrier 2 national restrictions on the location of clearing and settlement should be removed
as an essential pre-condition for a market-led integration of Eu clearing and
settlement arrangements. barrier 2 is to be treated jointly with barrier 9, as they
both address location restrictions. unlike barrier 9, however, barrier 2 is more
of a market structure issue, since it refers to the linkage between exchange and
settlement systems.
Barrier 3 national rules relating to corporate actions processing should be harmonised, as

well as the timing of transfer of ownership.
Barrier 4 Intra-day settlement finality in all links between settlement systems within the Eu
should be guaranteed.
Barrier 5 national governments should draw up a set of conditions that will enable remote
access to national clearing and settlement mechanisms to be guaranteed across
the Eu. The Giovannini report stresses the need to tackle barrier 5 with action from
public authorities, so as to ensure remote access on a strictly non-discriminatory
basis.

Barrier 6 Settlement periods for all equity markets within the Eu should be harmonised.
barrier 6 is linked to barrier 1, as both aim to render the settlement process more
efficient by standardising operational procedures across Eu states.
Barrier 7 Operating hours for national clearing and systems should be standardised across
the Eu.
Barrier 8 Securities issuance practices across European markets should be harmonised.
Barrier 9 national restrictions on the location of securities must be removed.
Barrier 10 Restrictions on the activity of primary dealers and market makers should be
removed.
Barrier 11 All financial intermediaries established within the Eu should be allowed to offer
withholding agent services in each of the Eu member states.
Barrier 12 Any provisions requiring that taxes on securities transactions be collected via local
systems should be removed.
Barrier 13 There is need to establish an Eu-wide framework for the treatment of ownership
of securities.
Barrier 14 There is need to address inconsistencies across Eu states in the legal treatment of
netting procedures.
Barrier 15 There is need to address inconsistencies in conflict of law rules applicable across Eu
states. The current framework addressing conflicts of laws (the Settlement Finality
directive and Financial Collateral directive) is incomplete, and could potentially be
improved through the approval of the hague Securities Convention.
4. Failed Settlement 4.1 Failure Reasons and

Penalties
Understand the risks associated with: buy-ins; Learning Objective 3.3.1
sell-outs; interest claims; settlement fines; Understand the main reasons for failed
matching fines; suspension of trading; short settlement: failure to match; insufficient
sale fines stock; insufficient cash; counterparty default;
corporate event
If a trade fails to settle then a firm has several
options. This section will cover why trades fail, Settlement failure may be caused by a number
buying in or selling out, and interest claims. of factors:
U Non-matching settlement instructions

trade instructions are unmatched because,
for example, one of the counterparties has
entered incorrect or incomplete trade details,
or the counterparties may be in dispute, or
no instruction might have been submitted.
U Insufficient securities the seller has
insufficient securities to deliver and has been
unable or unwilling to borrow securities to
meet its shortfall. The shortfall may result,
for example, because the seller is awaiting

Chapter Three
delivery of a purchase of securities, or

because securities are out on loan and the
seller has been unable to recall them to meet
its settlement obligations.
U Insufficient funds the purchaser may
have insufficient cash to settle the cash leg of
the trade because, for example, it is awaiting
the proceeds of a sale or is experiencing a
cash funding problem.
U Corporate actions securities are not
available for delivery because the clearing
organisation has blocked delivery in respect
of some corporate action or event. For If the seller has failed to deliver securities
example, if shareholders (or proxies acting by the specified deadline, the buyer will
on their behalf) are invited to vote on a purchase the securities from a third party at the
motion at a company meeting, then shares current market price. Any additional costs (the
may be blocked for a number of days in the difference between the price paid on the buy-in
lead-up to the meeting. and the price agreed with the original seller) are
U Counterparty default a counterparty may passed on to the offending seller.
have gone into default (liquidation) and been
unable to honour its trading commitments. If the selling counterparty is in a position to
deliver securities, but the buying counterparty
If a buyer of securities fails to provide sufficient is unable to deliver cash payment to enable the
funds to meet its settlement obligations, they trade to settle, the seller may opt to sell-out
are likely to be charged penalty interest for the securities involved. The procedure involved
the period that the trade is unsettled. The broadly mirrors that described above for buy-
exchange (or the other counterparty) may ins: the seller will notify the buyer that, unless
initiate a buy-in of securities (see below). necessary funds are delivered by a specified
deadline, then the selling party will initiate a
Other penalties for failure vary from market to sell-out procedure. The sale proceeds raised
market, but may include: by the sell-out are used to cover the cash leg
of the trade settlement. Additional costs of
U interest claims;
raising these funds at market rates through the
U various fines;
sell-out procedure are passed on to the original
U suspension of trading;
buyer.
U fines for short selling;
U damage to a brokers image and reputation. U Buying in the purchaser buys in from an
alternative source and any additional costs
(the difference between the price paid on the
4.2 Buy-Ins and Sell-Outs buy-in and the price agreed with the original
If the seller fails to deliver securities by seller) are passed on to the offending seller,
the value date, the buyer (or potentially the along with associated fees.
central counterparty or exchange) may initiate U Selling out the seller sells out to an
a buy-in of securities to allow trade settlement alternative purchaser, with any additional
to be completed. Commonly, the buyer (or costs being passed on to the offending
potentially the CCP or exchange) will issue purchaser.
notification to the seller indicating that unless
both procedures may be instigated by the firm
delivery of the requisite securities takes place
and/or the market authorities in accordance
by a specified deadline, then a buy-in will be
with local market conventions and rules. In
initiated. depending on market regulations, this
some markets, buying-in and selling-out are
communication may be copied to the exchange
triggered automatically if a trade fails. For
and/or market authorities.

example, in Singapore trades not settled on that the non-failing party should submit a claim
Sd+1 are posted on a buy-in board. for fails penalty charges to the failing party. This
is also the case for trades in agency mortgage-
backed securities that do not settle within
4.3 Fines two business days following the contractual
A firm may be fined by the exchange or CSd if settlement date. The recommended threshold
it fails to match or settle trades within a defined for claims is uS$500; claims below this amount
period. For example, in the uK, Euroclear uK will not be raised or honoured.
& Ireland (EuI) applies fines to a firm that
has failed to match a given percentage of its
4.4 Interest Claims
overall trades on T+1 and T+2. For transactions
involving market or CCP matching, for example,
a firm will be fined if it has failed to match Learning Objective 3.3.3
98% of its overall trades during the preceding Understand interest claims (ICMA rules on fixed
two-month period by close of business (COb) income and ISITC for equities)
on T+1, and 100% of trades by COb on T+2
(figures accurate at november 2011).
Be able to calculate interest claims based on
For trade settlement, EuI will impose a fine if a the above rules
firm fails to meet the following targets for trade
settlement during the two-month period:
If a buyer or its clearing agent has caused a
U 85% must settle on Sd; trade settlement to fail, the seller will normally
U 90% must settle by Sd+1; make an interest claim for the loss of interest
U 95% must settle by each of Sd+2 to Sd+9; on the net amount that they would have
U 98% must settle by each of Sd+10 to received had settlement happened on time.
Sd+15;
The International Capital Market
U 99% must settle by each of Sd+16 to Sd+20.
Association (ICMA) has rules and
recommendations relating to these claims for
A trading firm will often use stock borrowing
fixed-income products. If both counterparties
arrangements as a means to cover a shortfall
are members of ICMA, then they are bound by
of securities in a securities transaction, in order
these rules. For equities, the International
to prevent the exchange initiating a buy-in or to
Securities Association for Institutional
prevent a fine.
Trade Communication (ISITC) has advanced
In the uS, the Federal Reserve bank of new a comparable set of guidelines relating to
yorks Treasury Market Practice Group (TMPG) claims for interest. The worked example is for
advises that financial penalties be imposed on a fixed-income product and the differences
parties failing to meet their obligation to deliver under ISITC are noted at the end. The amount
securities required to settle a trade in uS is calculated according to the following formula:
Treasury securities, agency debt securities (ie,
Claim amount =
debentures issued by Fannie Mae, Freddie Mac
or the Federal home Loan bank) and agency overdraft rate no. calendar days
mortgage-backed securities. net amount x x
100 360 or 365/366
For inter-dealer trades in uS Treasury securities
The overdraft rate is the one applicable to the
and agency debt securities, the Fixed Income
seller at its agent bank.
Clearing Corporation (FICC) will calculate any
outstanding fines automatically and these will The number of days in the third term (360 or
be applied to FICC members monthly bills. 365/366) is that used for cash overdrafts in the
cash market of the settlement currency. For
When the trade involves one or more parties
example, for GbP it is 365/366, but many other
that are not FICC members, the TPMG advises
currencies use 360.

Chapter Three
Example 4.4.1 ISITC Differences
A buyer was due to pay 219,000 for a number The claims threshold is uS$500. netting and
of bonds. bulking of claims under uS$500 are at the
counterparties discretion. The timetable for
Settlement was delayed by five days because response by each entity involved is shown
the buyer instructed its agent bank incorrectly below:
and then took several days to recognise and
correct the error. The seller pays 4% on its Time Cumulative
Action
overdraft: (Days) Time
Initial claim issuance
Claim amount =
(to investment 60 60
4 5 manager)
219,000 x x = 120
100 365 Initial claim
acknowledgement
The buyer has 15 days to dispute the claim or 07
issuance (by
30 days to pay it. A buyer would dispute the investment manager)
claim if, for example, it disagreed about the
Onward claim
number of days that a transaction remained
transmission to third 10 70
unsettled, or it believed that the overdraft rate
party
used in the calculation was significantly above
the published borrowing rate. To ensure that Claim
the claims process is not excessively onerous, acknowledgement by 07
there are two recommendations: third party
Claim investigation/
1. That any claim under USD500 (or the 20 90
rejection
equivalent in another currency) is written
Claim settlement/
off. This is to prevent more money being 30 120
rejection acceptance
spent on the administration (checking and
payment) of a claim than the claim is worth. Source: ISITC, International Interest Claims
Best Practices & Market Guidelines
2. That a claim is not paid if 30 calendar days
have lapsed since the actual settlement
date. For claims beyond this period, it may
be difficult or exceptionally time consuming
to investigate.
This takes into account that the investment

manager who transacted the trade may not be
the third party who is responsible for the failed
or delayed settlement. The guidelines indicate
that the actual overdraft rate incurred should
be used for the calculation. They also prohibit
claiming any additional administration costs for
the time and effort of calculating and chasing
the claims.

1. define the following processes involved when an investor decides to buy securities:
i. trading;
ii. pre-settlement;
iii. settlement.
2. What data is required for the matching of a settlement instruction?
3. What is clearing and what purpose does it serve?
4. What is novation?

Chapter Three
5. What functions are performed by a central counterparty? how can use of a central counterparty
reduce credit risk for its members?
Answer Reference: Sections 2.2, 2.3, 2.4
6. What is the purpose of a settlement instruction?
7. What is positioning?
8. Give four examples of secure payment systems and summarise their main features.
9. What is TARGET and TARGET2 and what function does it serve?

10. What is FoP settlement?
11. What is delivery versus payment? List four mechanisms through which dvP may be
achieved.
12. What benefits are offered by:
i. bilateral netting;
ii. multilateral netting?
13. What advantages does book-entry transfer offer over physical transfer of securities?

Chapter Three
14. What is:
i. an immobilised security?
ii. a dematerialised security?
15. What is rolling settlement?
16. describe the bid price, the offer price and the spread. Why are these different prices quoted for
FX transactions?
17. What is:
i. a spot transaction
ii. a foreign exchange swap
iii. an outright forward transaction, and
iv. an FX option?

18. how does CLS reduce herstatt risk?
Answer Reference: Section Section 3.3.7
19. What is registered ownership?
20. What are the principal differences between ASdA and CSdA?
21. List four reasons why a trade may fail.
22. List two reasons why a counterparty may have insufficient securities to meet its settlement
obligations.

Chapter Three
23. What is buying-in and selling-out?
24. What system of fines does EuI have in place to penalise firms that fail to meet its targets for
matching and trade settlement?
25. What is the formula used to calculate interest claims?
26. What are the ISITC interest claim thresholds?

4
Other Investor Services
1. Safekeeping 115
2. Substantial Shareholder Reporting 118
3. The Nominee Concept 118
4. Custodian Fee Schedules 120
5. Corporate Actions 122
6. Cash Management 132
7. Securities Lending 134

Chapter Four

1. Safekeeping 1.1 Requirements for

Safeguarding Assets
Firms must ensure that they have effective
Understand the principles of safekeeping client arrangements in place to protect client assets
assets: to safeguard assets; to segregate safe held in their care. These must prevent the
custody investments; to reconcile safe custody co-mingling of assets owned by the client and
investments; to maintain records and controls the firm to minimise the risk that the clients
in respect of the use of mandates safe custody investments might be:
U used by the firm without the clients

Regulatory authorities in each of the selected
agreement or knowledge; or
markets lay down guidelines and requirements
U treated as the firms assets in the event of its
for firms holding client assets and client money.
insolvency.
These regulations typically uphold the following
general principles.

Chapter Four
1.2 Segregation of Safe

Custody Assets
In keeping with the above, a clear distinction
must be maintained between safe custody
investments held on behalf of clients and the
firms own designated investments.
In practice, this implies that:
1. As provider of custody services, a firm must

ensure that, if it holds client assets, the title This reconciliation process must be supported
of the account must make it clear that the by appropriate statements obtained from
safe custody investment belongs to a client, custodians detailing client assets held in their
and is segregated from the firms own safekeeping. Similarly, for any dematerialised
designated investments. This requirement is investments that are not held through
necessary to ensure the clients assets are a custodian (eg, assets held at a CSd),
fully protected in instances of the liquidation appropriate statements must be obtained from
or insolvency of either the custodian or third the body that maintains the record of legal
parties it relies on for custody services. entitlement.
2. When employing the services of a custodian,
a firm must ensure that it is made clear in A firm must periodically (in the uK at least once
the title of the account that it holds assets every six months, or twice in a period of 12
belonging to a client of the firm. before a months but at least five months apart) conduct
firm holds a custody asset with a custodian a count of all safe custody investments it
that is in the same group as the firm, it physically holds on behalf of clients, and
must typically inform the client in writing reconcile this with its records of assets held in
that it intends to do so. safe custody.
3. When using nominee arrangements, a firm
U Nominee and other safe custody holdings
must ensure that the same standards of
this reconciliation process must include all
care are delivered to the client by any
safe custody investments recorded in the
nominee company (see Section 3) that is
firms books and records, and those of any
controlled by the firm.
nominee company controlled by the firm that
A firm must ensure that arrangements for it uses for providing safe custody services.
holding any document of title to a safe custody U Correcting discrepancies a firm must
investment are appropriate to the value and promptly correct any discrepancies that are
risk of loss of the safe custody investments revealed through the reconciliation process,
concerned. It must also ensure that adequate and make good any unreconciled shortfall
controls are in place to safeguard these for which there are reasonable grounds for
documents from damage, misappropriation or concluding that the firm is responsible.
other loss. U Record-keeping a firm must ensure that
proper records of the custody assets that
it holds on behalf of clients are kept and
1.3 Reconciliation of Safe retained for a period of three years after they
Custody Investments are made.
U Stock lending and borrowing a firm
Firms are required, at periodic intervals (in
that uses a safe custody investment in
the uK this is at least every 25 business days),
stock lending activity must ensure that its
to perform a reconciliation of that record of
records identify clearly which safe custody
safe custody investments for which they are
investments are available to be lent, and
accountable, but which they do not physically
which are currently out on loan.
hold themselves.

U Non-compliance a firm must inform U whether the custodian is regulated, and by

the regulator in writing without delay if it whom;
is unable to comply with any element of U the capital or financial resources of the custo-
the reconciliation requirements specified by dian; and
Client Asset Safekeeping (CASS) rules. U any other activities undertaken by the
custodian and, where relevant, any affiliated
note that a designated investment need
company.
not typically be treated as a safe custody
investment in respect of a delivery versus
Payment transaction through a commercial 1.5 Records and Controls
settlement system if it is intended that the
Relating to the Use of
designated investment is to be:
Mandates
U due to the client within one business day
(though a different time window may apply The mandate rules apply to a firm that has been
in some jurisdictions) following the clients granted written authority by a client to control
fulfilment of a payment obligation; or the clients assets and/or to create liabilities in
U in respect of a clients sale, due to the the clients name. These rules require that the
firm within one business day following the firm maintain appropriate records and internal
fulfilment of a payment obligation. controls to prevent the misuse of this authority
granted by the client. This must include:
U an up-to-date list of these written authorities

1.4 Custodian Appraisal and any conditions placed by the client, or
A firm that holds safe custody investments the firms management, on how these may
with a custodian, or recommends custodians to be used;
private customers, must have an effective and U a record of all transactions conducted using
transparent process in place for evaluating the this mandated authority, and details of
performance of its custodians. The frequency internal controls that are in place to ensure
of these risk reviews should be dependent that these transactions are within the scope
on the nature of the market and the types of the authority;
of services that the custodian delivers to the U details of the procedures covering how
client. The firm should maintain clear records instructions should be sent to and from the
detailing the criteria and rationale employed to custodian under this authority;
appoint and reappoint custodians. U where the firm holds a passbook or similar
documents belonging to the client, details
In conducting a risk assessment of the of the internal controls that are in place
custodian, a firm should give due consideration to safeguard (against loss, unauthorised
to the following criteria: destruction, theft, fraud or misuse) any
passbook or similar document belonging to
U the expertise and market reputation of the
the client.
custodian;
U the arrangements for holding and safe-
guarding an investment;
U an appropriate legal opinion regarding the
level of protection afforded to custody assets
in the event of the liquidation or insolvency of
the custodian or a subcustodian it employs;
U procedures for disaster recovery and to
ensure technology resilience;
U current industry standard reports (eg, an AAF
01/06 report (see Chapter 6, Section 4) or its
equivalent);

Chapter Four
2. Substantial 3. The Nominee

Shareholder Concept
Reporting
Learning Objective 4.1.2 Understand the functions of nominee

companies and the following concepts: legal
Understand the requirements of substantial
title; beneficial ownership; pooled nominee
shareholding reporting
holdings; designated nominee holdings;
nominee as bare trustee; omnibus accounts;
Substantial shareholder reporting regulations segregated accounts
require shareholders to inform a company
when their ownership moves above, or below,
When institutional investors or investment
a specified percentage of the overall issued
managers hold significant volumes of overseas
capital in that company. The initial disclosure
assets in multiple locations, it is sometimes
threshold in the uK is 3% of the listed
logistically impractical or impossible for them to
companys voting shares. Elsewhere in the
hold these assets in their own name (known as
world it might be 5% (as in hong Kong and
name on register) and much more convenient
the uS) or 10% (as in Taiwan or Sri Lanka).
to register these in the name of the custodian
Shareholders may then be required to disclose
that is providing safekeeping and investment
further increases or reductions in their holding
administration services for these cross-border
relative to this threshold (ie, for each 1%
assets. This is known as the nominee concept.
increase or decrease in its holding, as in hong
Kong, or when their holding crosses other nominee companies have long been established
specified thresholds). as the mechanism by which custodians (or
another intermediary authorised by the
Typically, substantial shareholder reporting
investor) can process transactions on behalf
rules also empower companies to enquire
of their clients. Given that many investment
into the ownership of their shares. To do so,
management firms outsource some or all
a company must send a written notice to any
of their investment administration activities
investor or company that it has reasonable
to a specialist custodian, the vast majority
cause to believe has owned or had rights over
of institutional shareholdings, and those
its share capital (under Section 793 of the uK
of wealthy private investors, now reside in
Companies Act 2006, for example, this is any
nominee accounts overseen by specialist
investor that has owned, controlled or had
custodians.
rights over its shares during the last three
years). under company law, the nominee name
appearing on its share register holds legal
The recipient of the notice is required to
title to the share and is thus the legal owner
inform the company (typically, within three
of the shares for the purposes of benefits and
or five business days, although this will vary
for voting. however, beneficial ownership
from market to market) of its interest in the
continues to reside with the underlying client.
company. If it fails to do so, the company may
approach the court to apply restrictions on because the nominees name appears on the
the rights attached to the shares in question. share register, all shareholder communication
In practice, this may involve disenfranchising will be addressed to the nominee and can be
the shares by, for example, prohibiting their processed promptly by the nominee according to
sale or transfer, and by suspending dividend instructions that it receives from the beneficial
payments, voting rights and other corporate owner.
ownership benefits attached to the shares.

nominees can be classified into three types: U Transfers of securities between clients of the
custodian do not need to be reregistered.
U Pooled nominee holdings, whereby indi- Legal title to the securities remains in
vidual clients assets are grouped together in the name of the custodian, as nominee,
a single nominee registration (also called an before and after the transaction. hence, the
omnibus account). transaction is recorded purely as a transfer of
U Designated nominee holdings can also securities against cash from Client A to Client
provide anonymity, where each clients b on the books of the custodian. however,
asset holding is registered separately next custodians will typically be required to report
to the nominee companys name. hence, the the transaction to the relevant authorities
nominee name includes a unique account and to account for any transfer taxes or other
identifier for each individual client, eg, XyZ obligations that may be due.
nominees Account 1, XyZ nominees Account
2, XyZ nominees Account 3 When deciding whether it is happy to allow
U Sole nominee holdings, where a single, an intermediary (eg, its custodian) to use a
dedicated nominee name is used for each nominee account structure to administer its
specific client, eg, LMn Pension Fund assets, an investor should take into account
nominees Ltd. how it will affect the following:
Appropriate regulations need to be in place U receipt of annual report and accounts;
to ensure that the firm properly accounts for U voting rights on shares;
such nominee holdings and to safeguard the U timing of dividend receipts;
investors position. Regulations governing firms U impact on other corporate ownership
holding client assets (see Section 1) typically privileges and benefits;
require that the custodian has a separate U cost structure applied by the nominee;
nominee company to hold clients investments, U legal status of the nominee concept in the
thus ensuring that a clients investments are jurisdiction concerned;
segregated from those owned by the firm U security and segregation of assets;
itself. The money that is attributable to clients U corporate action instructions.
must also be held in a designated client money
account that is beyond the reach of creditors, Indeed, the type of registration structure
should the firm go into liquidation. employed has an important bearing on the
rights held by beneficial owners when it comes
For a large custodian providing safekeeping to voting shares. Clients pooled together with
services for a large number of cross-border others in an omnibus account structure are
clients, using an omnibus account structure typically not visible to the company: the
can reduce the complexity and costs involved nominee is recognised by the company as
in servicing clients assets in a number of ways: legal owner of the clients assets. Thus, from a
U Entitlements due to the custodians investor voting perspective, it is only the nominee that
clients will be paid directly by the issuing is entitled to vote. no separate entitlement is
company into the custodians nominee extended by the registrar to each individual
account as an aggregated payment, rather client making up the total omnibus holding. In
than as many individualised payments for practice the nominee may canvass the voting
each beneficial owner. preferences of the underlying clients, but it
U The custodian has only to reconcile one may not hold a formal obligation to do so unless
holding on receipt of each issue, rather than this is spelt out in the custody agreement.
multiple beneficiary-level accounts. Given the growing importance attached to
U Only the nominees name appears on the corporate governance, some investors may
records of the registrar, providing anonymity wish to maintain their visibility on the share
to beneficial shareholders. register and to ensure that their voting rights

Chapter Four
are protected and exercised directly. In these

instances, they may require that their custodian
4. Custodian Fee
registers their holding via a designated nominee Schedules
structure, or as a segregated (ie, sole) nominee
holding. This will protect their voting rights Learning Objective 4.1.4
before the company registrar.
Understand how a custodian charges for the
From the nominees perspective, there may services it provides to its clients
be advantages, in certain circumstances, in
registering the client via a designated nominee
Be able to calculate the cost of custody for a
structure. This approach will ensure that the
given portfolio given a value of assets held and
custodian receives a separate set of company
the basis point price
reports and documentation for each beneficial
owner. This can then be forwarded to the
client as required. Of greater importance, The methods employed by global custodians to
however, is the fact that a unique nominee charge for their services will be arranged on a
registration or designation will generate an case-by-case basis and will be dependent on the
individual, identifiable voting entitlement for volume of business that the client puts through
each company meeting, thereby enabling the custodian, the length and strength of the
voting instructions to be carried out cleanly and relationship, the reputational benefits that the
with a clear audit trail. custodian may experience by having that client
on board, and a range of broader factors.
Summary: Characteristics of Pooled
Prestigious clients can sometimes negotiate
Nominee and Designated Nominee
preferential terms, given the size of their
Holdings business and the valuable endorsement that
their custom may bring to the custodians
Pooled Designated
reputation in the marketplace.
The company Each beneficial
In general terms, investor clients will pay their
registrar maintains owners holding
custodian on the basis of:
just one registration is registered
for any particular separately. U a basis point fee charged against the
company. value of assets that the investor holds with
Still in the nominee
The nominee retains companys name. the custodian (known as an ad valorem
records of each fee);
With an additional
clients holdings. U a transaction fee, which will be charged
identifying code.
according to the number of settlement
transactions that the custodian processes
If the nominee is asked by the client to serve on the clients behalf.
as bare trustee, then the custodian carries
no discretionary powers and will be required The ad valorem fee represents a payment for
to act only on the basis of instructions from the the asset-servicing duties that the custodian
beneficial owner. As bare trustee, the custodian performs on the investors behalf. The
must only act when it is instructed to act, and transaction fee represents a charge for clearing
must act only as instructed. and settlement services.
In both areas, the precise fee paid by the

investor client will vary according to volume,
and according to where its assets are held
and/or its transactions settled. Ad valorem
and transaction fees in complex and high-risk
emerging markets will, typically, be higher

than in mature and efficient markets in which

Example
market practices comply closely with global
standards. An investment manager has a portfolio of
assets with market value US$500 million held
Within this package of core services, investor
in a major market such as the US, UK, France
clients would commonly expect to receive the
or Germany. As a medium-sized portfolio to a
following suite of services:
long-established client, the custodian charges
U safe custody; the investor a 1 basis point (ie, 0.01%) ad
U income collection; valorem fee to provide core custody services
U tax services; for this portfolio. The annual fee paid by the
U processing of corporate actions; investment manager will be:
U cash management; and
0.01
U supply of market information. 500,000,000 x = 50,000
100
For additional services (often referred to as
The client will pay the custodian US$50,000 per
value-added services) such as securities
annum to provide custody for this portfolio.
lending, performance and risk analysis and
proxy voting services, supplementary charges
are likely be added by the custodian. The
custodian would also expect to generate Example
significant revenue by handling clients foreign
An investment manager has invested assets
exchange and treasury requirements.
with a market value of US$2 million held in an
The custodian may typically offer reduced emerging market such as Brazil. The custodian
custody tariffs to customers that buy a charges a 20 basis point fee (ie, 0.20%) to
bundled package of services. As a general rule provide custody for this portfolio.
of thumb, the more services the client buys
The annual fee paid by the investment manager
from the custodian, the greater the number
will be:
of markets in which it buys them and the
larger the volume of business that it brings to
0.20
the custodian, the greater the client is likely 2,000,000 x = 4,000
100
to benefit from fee discounts as a result of
economies of scale. The client will pay the custodian US$4,000 to
provide custody for this portfolio of assets for
Pricing schedules can become a point of dispute
the year.
when a custodian charges separately for a
service that the client feels should be covered The extra basis point fee charged by the
by the core custody fee. Consequently, both custodian in an emerging market reflects:
parties must be specific, when drawing up
their custody contract, about exactly which 1. the additional risks that the custodian will
suite of services is included in the core custody bear in providing custody for assets held in
package, for which services the custodian will this location (when compared with holding
charge separately, and how much the client assets in a more mature market as in the
will be required to pay for these value-added previous example);
services. 2. a lower scale discount offered on the
transaction fee (since the clients trade
volumes in emerging markets will often
be lower than in larger, more mature
markets); and
3. the higher costs borne by the custodian
in servicing assets in a less developed
market.

Chapter Four
A further reason why the fee might be larger in 5.1 Risks for the Custodian
an emerging market is that there might be less
competition, ie, not as many viable providers as
there might be in a developed market.
Understand the importance of receiving timely
and accurate corporate action data and the
While most custodians will offer clients the risks involved
option of paying for their clearing, settlement
and custody services as part of a bundled Corporate actions involve a high level of risk
package, some providers are attempting to for the custodian. If the custodian fails to
differentiate themselves from their competitors inform its investor client of an upcoming
by offering to price their services on an corporate event, or fails to process the clients
unbundled pay-as-you-use basis. instructions accurately or in a timely fashion,
This option is designed to provide freedom of then the custodian will typically be required to
choice to the user, allowing the user, if they make good any financial loss that results.
so wish, to purchase clearing services from When an error is made in processing a corporate
one clearing agent, to settle their trades with action, then there is a high possibility that this
a different settlement agent, and to buy their will result in a capital loss for the investor. The
custody/asset servicing from somebody else. size of this loss can be difficult to quantify until
the custodian has closed that exposure down
by buying shares for the client to which it was
5. Corporate Actions entitled (or selling unsolicited shares issued
The term corporate action refers to events through a corporate action that the client had
that arise when an issuer opts to change the not wanted). until this point, the custodian is
structure of its companys securities, or to at the mercy of the market, and the more the
issue benefits to shareholders, commonly in market moves against the custodian, the larger
the form of cash dividends, shares, or the right the financial loss it is likely to incur.
to buy newly issued shares. Given these considerations, receipt of timely
Corporate actions may be initiated by and accurate corporate actions data is crucial
a company, for example when it makes a to effective risk management.
dividend or interest payment, or when it puts The principal challenge in processing corporate
a motion to a shareholder vote at a company actions is to ensure that the entitlements owing
meeting. Corporate actions may also result to the beneficial owner of the securities are
from action on the part of the shareholder, for collected in full and at the earliest possible
example when a shareholder opts to exercise a point. Custodians bear a primary responsibility
warrant, to take up a rights issue, or to convert for alerting their investor clients to forthcoming
a convertible bond. corporate events, ensuring that they have
Any benefit arising from a corporate action comprehensive information on the structure
is due to the beneficial owner. however, the of the corporate event and, in the case of
benefit will actually accrue to the registered voluntary corporate actions, that clients
holder (this may be a nominee acting on behalf instructions are conveyed to the company
of the beneficial owner) on ex-date (see Section registrar before the deadline in order for its
5.5). Given that shares may have been bought entitlement to be upheld. The custodian will
or sold in the lead-up to this event, this may also need to be aware of the regulations in
give rise to claims in the market if the buyer is different juridictions, as there may be local
not registered in time for the corporate action. rules that stipulate that residents should not be
sent the documentation (eg, in Japan, Canada
and South Africa).

U this consolidated and verified information is

sent to the investor in good time, enabling a
timely response from the investor before the
instruction deadline.
5.2 Mandatory Corporate

Events
To ensure that client instructions can be
processed efficiently before this deadline, the Learning Objective 4.2.1
custodian will typically specify a cut-off point, Know the characteristics of the following
which is the latest time that instructions may mandatory events: dividends (cash and scrip);
be received from the client to guarantee that interest and coupon payments; capitalisation
they are filed before the event deadline. issues; splits and consolidations; capital
repayments/redemptions
If instructions are sent by the client before
this cut-off point, and the custodian fails to Learning Objective 4.2.5
communicate these instructions before the Be able to calculate corporate actions related
event deadline, the custodian will likely to be data on capitalisations, scrip and rights issues
required to cover any resulting losses. Client and the effect on the underlying share price
instructions received after this cut-off point will
typically be processed on a best efforts basis
Corporate actions can be mandatory or
only, and the custodian will typically not cover
voluntary.
resulting losses that may occur if the event
deadline is missed. Mandatory corporate events involve
entitlements that accrue to a shareholder
Global custodians, and the subcustodians that
without the shareholder needing to take a
they employ across their global agent bank
decision about whether to participate. Cash
networks, will draw on a range of data sources
dividend payments, bonus issues, splits and
that provide information on forthcoming
consolidations, for example, will result from
corporate events. This will include information
decisions taken by the companys directors and
which is:
will be applied to all shares for all shareholders.
U supplied directly by the company or its
registrar; 5.2.1 Dividends
U supplied through data feeds purchased from
data vendors, such as FT Interactive data A dividend payment reflects a decision by
and Reuters; a companys board of directors, subject to
U supplied via stock exchanges or CSds; shareholder approval, to distribute a percentage
U published in the local and international press; of its profits to shareholders by paying a fixed
U collected through the subcustodians network dividend per share. Most commonly, a dividend
of contacts in the local market. is paid in cash (a cash dividend) in the issue
currency. however, dividends are sometimes
To ensure the validity of this information, it is paid in the form of shares (a scrip dividend)
important that: instead of cash, or reinvested.
U it can be cross-checked against a number of In some instances, the shareholder may be

independent sources; given the option of selecting the format in which
U data from these multiple sources is consoli- the dividend is paid, whether cash or shares.
dated into a single, accurate source of The global custodian must ensure that the
validated information (any inconsistencies client receives timely and accurate information
must be followed up and clarified); regarding the structure of the upcoming

Chapter Four
5.2.3 Capitalisation Issues

A capitalisation (or bonus) issue is a release
of new shares to existing shareholders, given
free of cost from the issuing companys capital
reserves. A company may elect to issue bonus
shares in this way as an alternative to returning
accumulated reserves to shareholders as
dividend. The company will typically transfer
funds from its profit and loss account to a
capital redemption reserve fund and will use
this to issue bonus shares to shareholders in
corporate event, and that its instructions are proportion to the size of their existing holdings.
received and recorded in timely fashion.
The aggregate market value of the existing
U If the investor is recorded by the custodian as and bonus shares will remain the same before
requesting a dividend payment in cash, when and after the bonus issue. hence, the issue of
it wanted a payment in shares, the custodian bonus shares will prompt a change in the share
may expose itself to significant loss if the price.
market moves in the wrong direction before
the error is rectified. The global custodian will Example
typically be required to make good this loss
to its investor clients. An investor holds 3,000 shares in a stock that
U More broadly, if a custodian fails to inform is priced at 1.00 per share. The company
its investor clients of a corporate event, it subsequently makes a 1:3 bonus issue, such
is again likely it will be required to make that each ordinary shareholder receives one
good any resultant loss of entitlement to the new share for every three existing shares in
investor. its holding. As such, the investor receives an
additional 1,000 shares through the bonus
Some types of fund (eg, income funds) will issue, giving it 4,000 shares in total.
have standing instructions in place with their Since the aggregate market value of the
custodian specifying that cash should always shareholders holding will remain unchanged
be taken rather than scrip. at 3,000 before and after the bonus issue,
the price of each share will fall to 0.75. The
5.2.2 Interest and Coupon reduced price will make the shares more
Payments marketable and thereby improve their liquidity.
An interest payment is a cash entitlement

paid to the holders of debt securities, Why do bonus issues occur? Rather than pay
including government bonds, corporate bonds, a cash dividend, a company may choose to
eurobonds, foreign bonds and convertible issue new shares to existing shareholders to
bonds. Interest payments are an example of reflect an increase in the companys capital
predictable benefits, in that the size of the reserves. Since this allocation is made from the
interest payment (the coupon rate) and the companys capital reserves, it may not be liable
timing of the payment (the coupon payment for taxation.
date) are announced in advance, namely at
the time that the debt security was issued. An
exception would be floating rate bonds, where 5.2.4 Splits
the coupon rate would not be announced in
A stock split or subdivision reflects a decision
advance since this will vary with the benchmark
by a companys directors to convert a single
interest rate.

share in the company into a larger number of

Example
shares, without any change taking place in the
aggregate market value of the shares of the An investor owns 4,000 shares in a company,
company. each priced at US$0.25. The company then
decides to consolidate its shares four-for-one.
Example This will reduce the number of issued ordinary
shares in the company fourfold, but without
An investor owns 1,000 shares with a nominal affecting the overall shareholder equity (ie, the
value of 0.20 in a company priced at 100 per aggregate market value of authorised shares).
share. The company then decides to split its Subsequent to the split, the shareholder will
shares one-for-two. As a result, the investor will own 1,000 shares, each priced at US$1.00.
subsequently hold 2,000 shares with a nominal
value of 0.10 after the split, and the price of
each share will fall to 50. Why do companies opt to consolidate their
shares? This may reduce the complexity
In contrast, if the company had decided to split of administering shares in the company by
its share one-for-four, the same investor would lowering the number of issued shares in
subsequently hold 4,000 shares with a nominal circulation. As we see above, this may also
value of 0.05, each priced at 25. be designed to establish a market value for
The dividend per share distributed by the shares that the board of directors feel will
company will generally fall in direct proportion be more appealing to existing and potential
to the increased number of authorised shares shareholders. This may particularly be the case
issued in the company. when the share price of the authorised shares
has fallen sharply as a result of tough economic
conditions and/or loss of investor confidence in
Why do share splits occur? Generally, because the companys performance.
company directors wish to reduce the share
price of the shares in the company to make 5.2.6 Capital Repayments
them more attractive to investors, while
simultaneously increasing the number of shares A capital repayment reflects a decision by
issued, thereby leaving the market value of the a companys directors to repay a portion of
company unchanged. In the above example, the companys issued capital to shareholders.
the board of directors may feel that, when The number of issued shares will remain the
the share price rises above 100 per share, same, but the nominal value of the shares will
investors (especially retail investors) may be fall by the amount of the capital repayment
less eager to buy the share. reimbursed per share. A capital repayment
in full is when the company repays all of the
To encourage more individual investors to issued capital in specified categories of shares
purchase the stock, it may therefore engage in to the registered shareholders.
a one-for-two split that reduces the price per
share to 50. Capital repayments are typically arranged
when company directors wish to return some
or all of the issued capital in a particular class
5.2.5 Consolidations
of shares to shareholders.
Conversely, a stock consolidation reflects
a decision by a companys directors to 5.2.7 Redemptions
amalgamate multiple shares in a company into
a single share. The issuer of a fixed income security will repay
(or redeem) the principal and any outstanding
coupon on maturity (ie, on redemption date) to
the legal owner of the security.

Chapter Four
5.3 Voluntary Corporate be paid to shareholders that did not sell

or take up their rights. If no premium was
Events
generated during this sale, then no lapsed
rights proceeds will be distributed. Lapsed
Learning Objectives 4.2.2 rights are paid minus commission and fees.
Know the characteristics of the following
voluntary events: rights issue subscription; note from bullet point two that shareholder
conversions; takeovers; exchanges; initial entitlements under many rights issues are
public offers; proxy voting; exercise of warrants tradeable. Shareholders have the option of
selling nil paid rights (ie, rights that have not
Learning Objective 4.2.5 been exercised) to a counterparty up to a
Be able to calculate corporate actions related specified cut-off point before the call payment
data on capitalisations, scrip and rights issues date (in cases where rights are not transferable,
and the effect on the underlying share price these are known as non-renounceable rights).
The aggregate market value of the existing and

Voluntary corporate events demand that the newly issued shares will remain the same before
shareholder communicate a response to the and after the rights issue. hence, the rights
company regarding whether it wishes to accept issue will prompt a change in the share price.
the terms of the corporate action or to reject The calculation methodology is comparable to
it. A response will be required to exercise that described for bonus issues in the previous
certain forms of entitlement available to the section.
shareholder (eg, to exercise a put option or a
rights issue). Example
An investor holds 3,000 shares in a stock that
5.3.1 Rights Issues and
is priced at 2.00 per share. The company
Subscriptions
subsequently makes a 2:3 rights issue at 1.50,
Rights issues give existing shareholders the such that each ordinary shareholder has a
right to subscribe to an issue of new shares, right, but not an obligation, to purchase two
usually at a discount to the market price. The new shares at this price for every three existing
issuance of rights is a mandatory corporate shares that it holds.
event. however, shareholders are entitled to
The investor decides to subscribe to the rights
elect on whether they subscribe to the offer of
issue. Consequently, it acquires a further 2,000
new shares and this element is, therefore, a
shares through the rights issue at 1.50, to
voluntary event. The shareholders entitlement
supplement its existing holding of 3,000 shares
to purchase new shares will be in proportion to
each worth 2.00.
the number of shares already owned.
Hence, the total value of the investors shares
The main stages in a rights issue are:
will be:
U distribution of the rights entitlement by the
(3,000 x 2.00) + (2,000 x 1.50)
issuer to the existing shareholders;
U shareholders elect or decline to subscribe = 6,000 + 3,000
to the offer of new common shares, or may = 9,000
trade their entitlement with another investor;
U non-subscribed rights will expire at the The investor now holds 5,000 shares in total:
subscription deadline. Typically, the company
9,000
will sell off lapsed rights (ie, rights that have Price per share = = 1.80
5,000
not been exercised) subsequent to the issue
process. Any premium (ie, positive difference Hence, the price per share after the rights issue
between the price attained through this sale would be expected to adjust to 1.80 (the
of shares and the take-up price) will then adjusted ex-rights price). Note that this is a

theoretical price. Stock market conditions and

level of investor demand will dictate that the
share price will be constantly fluctuating for
tradeable securities, so the price may rapidly
move away from this predicted level.
To estimate the capital gain that the investor

may secure by selling the rights, an approximate
value may be calculated as follows: an offer of cash or securities or both to
existing shareholders of the target company.
Nil paid rights = adjusted ex-rights price The takeover commonly advances through the
rights issue price following procedure:
= 1.80 1.50 1. The takeover is announced by the board of
= 0.30 directors of the bidding company.
So we would expect the nil paid rights to be 2. Subsequently, shareholders in the target
worth 0.30 per share. company will be given a specified period
in which to vote on whether to accept
the offer. In some jurisdictions, if the
percentage of shareholders in the target
5.3.2 Conversions
company that accept the offer reaches a
Investors holding convertible bonds may elect specified threshold (this may be 50.01%
to convert these debt securities into shares. The of shareholders for example), then the
conditions for this conversion are outlined at bidding company gains control of the target
the time that the convertible bonds are initially company.
issued. Typically, these allow the investor to 3. The proceeds of the takeover offer, in the
change the convertible bonds into shares at form of cash or securities or both, will be
pre-established rates and at pre-established distributed to shareholders whose shares
times fixed by the issuing company. have been acquired.
When the time period for a conversion expires,

bondholders are required either to redeem the
5.3.4 Debt Tenders and
bonds for cash, or they will be converted into Exchanges
equity according to the terms specified when
A company can offer bondholders the right to
the convertible bond was issued.
exchange their debt securities for a specified
amount of cash or shares during a specified
5.3.3 Takeovers time period. This process may happen during
an acquisition deal, for example when the
A takeover is an attempt by a company acquiring company offers bondholders in the
to acquire all or a portion of the issued target company the right to exchange these
share capital of another company. A friendly debt securities for cash or shares in the
takeover describes a takeover bid where merged entity.
the bidding company has the support of
the management of the target company. A
hostile takeover refers to a bid where the 5.3.5 Exercise of Warrants
management of the target company opposes
A warrant provides the right for the holder to
the takeover and may attempt to obstruct
subscribe to shares in a company at a specified
the takeover process. The bidding company is
price (the strike price) at a specified date
often referred to as a predator.
or dates in the future. When the warrant is
The objective of the bidding company is exercised, the company will issue the specified
to secure a majority holding in the target number of shares to the warrant holder, as
company. Typically, the process will involve described more fully in Chapter 1.

Chapter Four
A covered warrant is a synthetic product

structured by an investment bank or another
financial institution over a range of possible
underlying assets, which may be a share in a
company, a share price index, a commodity,
a currency or a basket of currencies. The
issuer pays a cash sum for the intrinsic value
of the warrants at the expiry date, or on
exercise. In other words, although the terms
of warrants are usually expressed as a right
to purchase the underlying share(s), a covered
warrant is more accurately a right to receive
a cash payment equivalent to the difference With institutional investors and investment
between the exercise price and the value of the managers owning large holdings in some
underlying asset at expiry. companies, investors are taking increasing
interest in the way that their votes can
impact on company policy, thereby having
5.3.6 Initial Public Offerings a direct influence on the returns that these
(IPOs) investors receive on their holdings. This
IPOs refer to the mechanism through which interest has been reinforced by bodies such
a company first floats its shares on the stock as the International Corporate Governance
market. In the uK, they have traditionally network, an association represented by leading
been known as launches or new issues, figures from global corporations and financial
but the uS term IPO is now widely used. institutions, which campaign for improved
The issue methods involved (offers for sale, standards of transparency and accountability
private placements, introductions) have been to shareholders.
described in more detail in Chapter 1.
5.4.1 Why Does Voting Make a
5.4 Voting Difference?
The importance attached to shareholder voting
Shareholders are periodically given the right
has been progressively rising over the last five
to vote on resolutions brought before them
years. Listed companies play a significant role
at company meetings (commonly an annual
in the economic and financial system of the uK
general meeting, AGM, or extraordinary general
and it is in the public interest that company
meeting, EGM). This may include votes on:
directors are accountable to shareholders,
U election of directors; who are the owners of the company. As such,
U directors remuneration; it is important that accountability is exercised
U plans to issue new equity capital; through the voting rights that come with
U stock repurchase plans; owning company shares.
U takeover bids;
In the uK, efforts to formalise these concerns
U plans to appoint a new auditor;
have led to the commissioning of a number of
U specific resolutions brought before the
influential reports on corporate governance
meeting by shareholders themselves;
and voting practice. building on an important
U approval of a dividend.
consultation paper by Sir Adrian Cadbury
A shareholder may opt to exercise this voting published in 1992, the substance of these
right in person by attending the meeting, or by reports is now reflected in the Combined Code
voting by post or electronically. Alternatively, on Corporate Governance (the Combined
the shareholder may exercise its voting rights Code), published by the Financial Reporting
through a legally approved third party. This Council, which is annexed to the FCAs listing
process is known as proxy voting. rules. These rules require listed companies to

make a statement on their level of compliance In the uS, the Securities and Exchange
with the Combined Code. A companys directors Commission (SEC) initiated a ruling in 2003
are not legally required to apply all elements that now requires uS-registered mutual funds
of the Code, but, if they do not do so, they to provide details of their voting policy, and
should explain why not. This is known as the their records of voting, to the SEC. This dove-
comply or explain principle. A similar principle tailed with broader legislation introduced under
operates in the netherlands and a number of the Sarbanes-Oxley Act of 2002, designed to
other jurisdictions. protect investors by enhancing the reliability
and accuracy of corporate disclosure. The
overarching principles are:
5.4.2 How the Voting Process
Works U Mutual funds must demonstrate that they
have a clear chain of responsibility for voting
When a general meeting is convened, the
shares and their voting policies must be
company registrar will issue voting papers and
transparent to their members and other con-
details of the agenda to the shareholders and/or
cerned members of the public.
custodians acting on behalf of investor clients.
U Mutual funds must be clearly accountable
These could be:
to those on whose behalf they act and they
U an institutional investor; should be required to explain periodically how
U a fund manager investing on its own account; they have discharged their voting obligations.
or
Similarly, in his high-profile report on proxy
U a fund manager investing on behalf ofan
voting to the uK Shareholder Voting Working
institutional investor. In this case, the institu-
Group in February 2004, Paul Myners indicated
tional investor may vote itself, or may dele-
that beneficial owners should be responsible
gate this responsibility to the fund manager.
for ensuring that there is a clear chain of
Many global custodians now employ the responsibility for voting their shares in the
services of proxy voting specialists such as companies in which they own holdings. In this
broadridge (formerly AdP Investor Services) report, Myners pointed to a range of obstacles
or ISS Governance Services (formerly to transparency in the uK voting process:
Institutional Shareholder Services, but now
U The voting process involves many participants
a part of RiskMetrics Group) to manage the
and the chain of responsibilities between
voting process on their behalf. under this
these parties is not always clear.
arrangement, the custodian will pass voting
U The system is not fully automated, in that
papers to the proxy voting agent, along with
some participants still rely on faxes and paper
details of all holdings in the company, broken
proxy cards.
down by client. The proxy voting agent will then
U Legal title to the shares often rests with
pass details on the resolutions to be voted, and
the custodian as nominee and, with indi-
the relevant holding details, to each investor
vidual holdings pooled into an omnibus
client.
account, the beneficial owner is effectively
The investor will subsequently instruct the disenfranchised. This can create difficulties in
custodian (or the proxy voting agency acting tracing information from and to the registrar.
on the custodians behalf) how the votes should U The beneficial owners that own the shares
be cast. The latter will communicate the vote to often delegate voting to their fund managers
the company registrar. The company registrar the fund manager can only issue voting
will compare the votes received against its instructions indirectly, given that it is not the
record of owners and will tally the votes cast. legal owner. Automatic confirmation of receipt
In the uK, the Combined Code recommends of voting instructions is usually only possible
that issuers should publish a breakdown of when the votes are cast electronically.
votes cast.

Chapter Four
5.4.3 The Problem of Lost Votes to be paid, the amount to be paid per share,
the payable date (ie, the value date) and the
As a result of these inefficiencies, Myners record date. The ex-dividend date (ex-date)
reported instances where pension funds had is the date that determines the eligibility of a
cast votes and these votes had not been shareholder to receive the declared benefit.
recorded by the company registrar. This he The registrar will inspect the share register on
termed the problem of lost votes. record date, and will pay the declared dividend
per share to all shareholders whose names
To address these problems, Myners recom-
appear on the register at that point. This
mended that:
entitlement will be paid to these shareholders
U beneficial owners should publish, and adhere on pay date (also known as payment date, or
to, a clear voting policy, detailing the chain of payable date).
responsibilities involved in voting shares.
The same principle applies for rights issues.
U Levels of automation throughout the proxy
Companies raising additional money may do
voting chain should be extended, with more
so by offering their shareholders the right to
extensive use made of electronic voting.
subscribe to new or additional stock, usually at
U The use of designated nominee holdings
a discount to the prevailing market price. The
should be employed to make the voting pro-
buyer of a stock selling ex-rights is not entitled
cess more transparent and to make it easier
to the rights.
to trace votes from shareholder through to
registrar. When considering claims on rights issues, note
that in some markets the ex-date will precede
Many of these principles are enshrined in the
the record date (often known as record date-
International Corporate Governance networks
driven markets). In other markets, the ex-date
best practice guidance, providing a foundation
will be after the record date (typically labelled
for global efforts to encourage active and
ex-date-driven markets).
efficient shareholder voting and to raise
standards of corporate governance worldwide.
Example
Custodians and investment managers can make
it easier for their institutional clients to be Consider a situation where Investor A purchases
confident that votes are being cast by reporting 1,000 shares from Investor B in a market that is
on their systems and internal controls through record-date-driven, operating a T+3 settlement
a FRAG 21 or SSAE 16 report (see Chapter cycle for equities.
6), which will normally include details of their
The ex-date for a rights issue event is 3
voting process. beneficial owners should
November. The record date is 5 November.
ensure that they receive copies of such reports.
Investor A purchases shares on 1 November
(ie, two days before ex-date) and thus will be
5.5 Ex-Benefit vs entitled to the rights. This transaction will settle
Cum-Benefit on T+3 (ie, 4 November). The registrar will
examine who is the owner of the shares at close
of business on record date (5 November) and
will pay the rights to Investor A, who is legal
Understand the following terms: record date; owner of the shares at this time.
ex-date; pay date; effective date; cum-benefit;
ex-benefit; special-ex and special-cum Now consider a situation where Investor A
purchases 1,000 shares from Investor B in a
market that is ex-date-driven, operating a T+3
If a companys board of directors votes to
settlement cycle for equities.
pay a dividend (quarterly, semi-annually or
annually), it will announce the type of dividend

The ex-date for a rights issue event is 4 The date on which entitlement is accredited to
November. The record date is 3 November. the legal owner of the security is commonly
Investor A purchases shares on 2 November known as the effective date. After a stock split,
(ie, two days before ex-date) and thus will for example, the owner would receive their
be entitled to the rights. The registrar will converted shares on the effective date.
examine who is legal owner of the shares at
close of business on record date and will pay When shares are traded, you should be aware
the rights to Investor B (who is still legal owner whether they are traded with the entitlement to
since the transaction will settle on T+3, ie, the next dividend (cum-dividend) or without
5 November). that entitlement (ex-dividend).
Consequently, Investor A will need to claim While we have used dividend payments
these rights from Investor B. as an example, the same logic will apply
when considering interest payments on debt
securities, and some other entitlements due
If the security has been purchased before to shareholders by virtue of their corporate
the ex-date, the purchaser is entitled to the ownership rights.
dividend or rights (this is called the cum-
benefit), given that they will be the beneficial 5.5.2 Special Ex and Special Cum
owner of the security on record date.
In some markets, counterparties conducting
If the security has been purchased on or a trade during the cum-benefit period have
after the ex-date, the seller is entitled to the the right to agree that the security is being
dividend or rights (this is called the ex-benefit). sold ex-benefit. This is known as special ex.
Consequently, after the ex-date, the stock Similarly, in some markets, counterparties
begins to trade in the market at a lower price conducting a trade during the ex-benefit
because it assumes no dividend or rights. period may agree to trade the security
cum-benefit. This is known as special cum.
5.5.1 Ex-Benefit and
When these special conditions are applied, the
Cum-Benefit Periods for trade price agreed between buyer and seller
Dividend Payments will reflect whether the security is traded
See the diagram below. ex-benefit or cum-benefit.
dividend payment Ex-dividend date Record date Payment date

is announced
5 APRIL 10 APRIL 14 APRIL 1 MAy
6 7 8 9 11 12 13
Cum-dividend period Ex-dividend period
Entitlement paid to buyer Entitlement not paid to buyer
Seller does not receive entitlement Seller receives entitlement

Chapter Four
6. Cash Management 3. Sophisticated cash forecasting tools to

predict a clients cash flows on a short-
term (covering one day to two weeks) and
Learning Objective 4.3.1 medium-term (covering a few weeks up to
Understand the importance and use of cash one or two years) basis. This is necessary
management to ensure that funding requirements are
met as cheaply as possible and that cash
balances are utilised efficiently to generate
Understand the advantages and disadvantages optimum return. The goal is to predict in
of operating single and multi-currency accounts advance the amount of credit balance (or
overdraft) that is expected at the custodian
at a forthcoming date (eg, over the next
Know what is meant by the terms sweeping two business days) and then to act on
and pooling as they relate to base currency and this prediction. When a trade is settled
settlement currency on behalf of the client, for example, the
Learning Objective 4.3.4 resultant credit (or debit) should be offset
by a corresponding cash movement to or
Understand the importance of cash forecasting
from the client, so that there is a zero cash
tools
balance at the custodian and no debit or
credit interest is incurred at the custodian.
Cash management refers to the set of strategic 4. Appropriate designated client money bank
policies that an organisation will employ accounts to ensure that the clients cash
to optimise the use of its cash resources. holdings are protected, should the custodian
Specifically, this includes collecting payments, go into liquidation.
controlling disbursements, covering shortfalls,
forecasting cash needs, investing uninvested
cash and managing liquidity.
6.1 Sweep Accounts
To avoid clients having funds sit overnight in
The goal is to ensure that cash holdings are
non-interest-bearing accounts, custodians will
employed in the most effective way possible,
often offer the use of sweep accounts which
either covering payments or generating income
allow clients to transfer (or sweep) uninvested
for the company concerned. Leading global
cash into overnight investments (or an interest-
custodians commonly offer a wide range
bearing deposit account) at the end of the
of treasury and FX services to institutional
business day.
investors and corporate clients. These are
designed to provide integrated multi-currency These may be used in parallel with zero-balance
banking and payments facilities through their accounts, which allow clients to make payments
global networks that are tailored to the needs from an account where the balance is held
of individual clients. This demands: at zero without penalty. Cash is drawn from
a central account whenever cash obligations
1. A detailed knowledge of the clients business
arise that require payment.
in order to understand where cash needs
to be at a particular time (eg, to settle
a pending transaction) in order to meet 6.2 Pooling
payment obligations and avoid penalties.
2. A detailed understanding of the cash flows Global custodians hold single-currency or multi-
into the clients business and when these currency accounts for their clients. For interest
are likely to arrive. For securities investment calculations, custodians may pool balances by
companies, key cash flows will be through currency into one larger balance in order to
profit and loss on their portfolio trading, and attract a higher rate of interest or reduce the
through income paid (dividends, coupon) on penalties incurred by some accounts being
their investments. overdrawn. Clear provisions must be in place

to ensure clients cash holdings remain legally large global corporation with high-volume
separated from those of the custodian and cross-border business in multiple locations.
other clients. U The potentially smaller amounts being
converted may result in a wider spread on
the FX rates offered, or the custodian may
6.3 Single-Currency use a conversion rate that benefits itself.
Accounts
With single-currency accounts, cash manage- 6.4 Multi-Currency Accounts
ment is conducted in the investors base
currency. Credits paid to the investor in a Multi-currency accounts are commonly
foreign currency (eg, income generated from employed by companies that need to process
dividend and interest payments, proceeds regular and sizeable payments and credits in a
realised from trading in securities) will be foreign currency.
converted through an FX transaction back
The benefits of multi-currency account
into the investors base currency and held in a
structures include:
cash account maintained in the base currency.
Similarly, debits paid by the investor (eg, the U Securities can be settled on a dvP basis in
cost of settling the cash leg of a securities foreign currency.
purchase) will be drawn from this single cash U These reduce the costs and risks incurred in
account maintained in the base currency and maintaining multiple FX transactions required
converted through an FX transaction into the by a single-currency account structure.
required foreign currency. U A global custodian may offer integrated custody
and banking services, providing a one-stop
The benefits of maintaining a single-currency
shop for investors cross-border service needs.
account structure include:
Potential disadvantages of a multi-currency
U Cash reconciliation, audit and accounting arrangement include:
processes are conducted in a single currency,
aiding simplicity and control. U The use of multi-currency accounts adds to
U Risk exposure to foreign currency volatility is the complexity of reconciliation and control
mitigated by using a single-currency account. processes as a result of maintaining accounts
Transactions that yield payment in a foreign in multiple currencies, especially because of
currency are converted immediately back into dividends received in different currencies.
the base currency. U A bundled package bought from a global
U The client can shop for the best FX rates custodian may not always be cheaper for
for each transaction, which may be more a sizeable investment manager client than
competitive than FX rates offered by its managing its own FX trading internally, or via
global custodian. If the client wishes to do a third-party FX desk.
so, it will need to maintain bank accounts U not every market in which an investor client
in currencies other than the base currency is active will require a centralised cash
in order to effect FX settlement (ie, bank management function, such as that provided
accounts in the settlement currency). by a multi-currency account structure offered
by a custodian.
Potential disadvantages of employing a
single-currency account structure include: The client must evaluate how a market-by-
market approach compares to the economies of
U Multiple FX transactions engender settlement scale offered by a centralised cash management
risk and counterparty risk associated with facility.
each individual FX trade.
U Single account structures may lack the
sophistication and flexibility necessary to
process the cash management needs of a

Chapter Four
7. Securities Lending 7.2 Why is Securities

Lending and Borrowing
In simple terms, securities lending is when
an owner of securities lends them to a third
Employed?
party with an agreement to buy them back at
a future date. Learning Objective 4.4.3
Understand the reasons for securities lending
7.1 Legal Ownership Learning Objective 4.4.4

Implications of Understand the reasons why loans might be
Securities Lending and delayed or prevented
Borrowing (SLB)
For the lender, the main benefit of lending out
Learning Objective 4.4.2 securities is to generate income. Lending out
Know the definition, legal ownership implications securities will generate cash that will boost the
and the advantages and disadvantages to the overall returns that the investor generates on
market that segment of its portfolio.
Learning Objective 4.4.6 Indeed, there are sizeable returns to be made

through securities lending on the expansive
Understand the lenders and borrowers rights
securities portfolios held by large institutional
(including manufactured dividends and voting
investors (particularly the largest pension and
rights)
insurance funds).
Consequently, securities lending has become big
Understand the reasons why a loan might be business for global custodians and third-party
recalled securities-lending agents that have cornered the
market for providing securities-lending services
Legal title to on-loan securities passes from the to this investor community.
lender to the borrower for the duration of the
For the borrower, it may wish or need to
loan. The lenders entitlements to income pay-
borrow securities because:
ments and other benefits from corporate actions
will typically be protected during the loan U it needs to access securities to cover a
period, with the borrower paying any benefits settlement fail (ie, the borrower does not have
to the lender, either directly or via the lending sufficient securities to meet its settlement
agent. For dividend payments, the payment obligations);
pass-through is known as a manufactured U it may be short selling the security concerned
dividend, and often has taxation implications. and needs to borrow securities to close its
position. The rapid growth of the hedge fund
Since the legal ownership of the shares changes
industry has created a surge in demand
hands during this period, the lender will lose
for borrowed securities in order to cover
voting rights on the shares while they are
short positions. hedge funds have commonly
out on loan. This fact has discouraged some
satisfied this need for securities borrowing
institutional investors from allowing securities
through their prime brokers;
under their management to be placed on loan.
U a market maker may be short of a security
however, under standard securities-lending
owing to strong demand for that security
agreements, shares can often be recalled for
from its customers. Thus, the market maker
voting purposes. With this in mind, institutional
may need to borrow the security in order
investors are increasingly taking steps when
to fulfil its obligation to promote a liquid
entering into securities-lending agreements to
market by buying and selling a specified list
ensure that on-loan securities can be recalled
of securities at publicly quoted prices (see
so that voting rights can be exercised.
Chapter 1, Section 11).

The existence of liquid markets for securities U marking exposures and collateral to market
lending reduces the risks of failed settlements. (ie, ensuring that exposures and collateral
Market participants with an obligation to deliver are valued at current market prices) on a
securities that they have failed to receive, and daily basis and making margin calls to bring
do not hold in inventory, can borrow these collateral and exposure into line;
securities to complete delivery. U employing master legal agreements that
set out clear legal parameters that dictate
Securities that are on loan cannot typically be
the structure and process of the lending
voted by the lender in case of, for example,
arrangements, and how the lender will be
an annual or extraordinary general meeting.
compensated in the event of default or
Should the lender wish to exercise voting
systemic crisis.
rights on the stock, they will need to recall the
stock before the requisite deadline (ie, before When collateral is taken in securities-lending
effective date). arrangements, the value of collateral taken
will typically exceed the market value of the
7.3 Risks Involved and borrowed assets by an agreed percentage,
known as a haircut. This protects the lender
Precautionary Measures
from adverse price movements of the collateral
held.
Understand the role of a custodian in securities
lending and the risks and rewards to those
involved

Understand collateral and marking to market
While securities lending may be a useful tool, it

presents associated risks to both the borrower
and the lender. The securities on loan, or the
collateral, may not be returned on the agreed
date, whether because of settlement delays and 7.4 Strategic Approaches to
liquidity problems in the market concerned, or
Securities Lending and
the more intimidating prospect of counterparty
default or legal challenge. Those securities
Borrowing
would then need to be acquired in the market,
potentially at high cost. Learning Objective 4.4.8
Know the role of a stock borrowing and lending
In order to mitigate the risk of such failures,
intermediary
lenders are advised to employ a range of
precautions to ensure the safe return of the
securities and to ensure that the loss is fully
compensated in the event that securities are 7.4.1 Managing Securities
not returned. These include: Lending and Borrowing
In-House
U employing detailed credit evaluations on the
borrower; Some large institutional investors have the scale
U setting limits on the lenders credit exposure and in-house expertise necessary to manage
to any individual borrower; their securities-lending activities internally.
U collateralising loan exposures against cash or They will employ specialist staff whose function
securities (the lender will decide what quality is to identify opportunities for lending out
of collateral it will accept); elements of the overall portfolio, securing an

Chapter Four
optimal balance between the income generated 7.5 Repurchase Agreements

by these securities-lending and -borrowing
activities and the risks incurred.
Understand the use of repo agreements
7.4.2 Use of a Securities
Lending and Borrowing Learning Objective 4.4.7
Intermediary Understand collateral and marking to market
In contrast, many institutional investors prefer

to outsource their securities lending and A repurchase agreement, or repo, is a method
borrowing activities to a third-party securities- of secured lending, whereby securities are
lending agent. Given that the investors global sold to a counterparty against payment of
custodian may already be providing safe custody cash, and then repurchased at a later date,
and asset servicing for its securities portfolio, with interest or a fee being paid to the cash
typically, investors will find it convenient and lender. A repo may be employed, for example,
cost-effective to draw these services from their to raise the funds necessary to cover the cash
global custodian (or sometimes an ICSd/CSd). leg of a securities transaction. This mode of
financing will typically be cheaper than seeking
however, given the potential returns that unsecured funding and may be particularly
securities lending can offer to a large well suited for trading companies that hold a
institutional investor, some may tender for this large inventory of stock that may otherwise be
service separately from their core custody unutilised.
mandate. This will allow the investor to appoint
a specialised securities lending agent, alongside For the cash borrower, a key feature of
their main global custodian, which offers a repo is that a repo transaction provides a
bespoke range of services and expertise method of funding that is significantly cheaper
particularly well attuned to the investors than borrowing on an unsecured basis. The
securities-lending requirements. A small cash lender receives securities as collateral
number of independent securities lending throughout the loan period and is free to utilise
bureaux (eSecLending, for example) have these securities if the cash borrower fails to
established themselves in this niche to meet repay cash plus interest (or cash plus fee) to
the specialised needs of lender and borrower the lender.
clients.
For the cash lender, repo provides an avenue
Some ICSds/CSds have established auto- through which it can generate income on its
lending programmes as a settlement fail cash balance. Although it could potentially
coverage facility, designed to ensure that earn more income by lending this cash on
adequate securities are available to trading an unsecured basis, repo affords additional
counterparties to ensure timely and efficient security to the lender by ensuring that it holds
trade settlement. Typically, if a seller of collateral that it will inherit if the borrowing
securities has insufficient securities to meet its counterparty defaults on its obligations.
settlement obligation, these securities may be
The collateral will be marked-to-market
accessed at a cost through the auto-lending
on a daily basis throughout the repo period
facility to ensure timely settlement. Lenders of
to reflect current market rates. If the value
securities to the auto-lending pool will receive
of the collateral rises or falls outside of a pre-
income against their stock loans into the pool.
agreed band (known as the variation margin),
a margin call will be made (ie, collateral is
requested from, or returned to, the lender) to
ensure that the value of the collateral remains
aligned to the cash sum borrowed through the
repo agreement.

Repo transactions can be arranged directly As such, some counterparties may accept
between counterparties on a bilateral basis. This asset-backed securities, high-grade corporate
is commonly known as direct repo. however, debt and, in some instances, equities as
use of a tri-party collateral agent (known collateral.
as tri-party repo) has become increasingly
Lenders can specify their eligibility criteria
widespread, particularly in the wake of some
for collateral that they are willing to accept.
high-profile defaults in bilateral repo markets
Tri-party agents have become increasingly
that have prompted counterparties to look
sophisticated in their ability to use their
to the extra security afforded by using a tri-
powerful collateralisation engines to provide
party repo agent. use of tri-party repo also
a mix of different grades of collateral that
offers benefits to clients that do not have
meet the collateral takers eligibility criteria,
the operational capacity to take in collateral
while making optimal use of assets in the
themselves, or that do not wish to dedicate
collateral-givers portfolio that might otherwise
staff and resources to managing their own repo
be unutilised.
operations.
The tri-party repo agent will serve as service

partner to the cash borrower and cash lender,
managing the transfer of cash and securities
between these two parties, and ensuring that
neither counterparty is uncollateralised or
misses margin calls.
The types of securities that will be acceptable

as collateral will typically be dependent on
the risk appetite of the collateral taker (ie,
the cash lender). Government debt securities
(German bunds, uK gilts, uS Treasuries and
selected other G10 government bonds) typically
represent premium-quality collateral. however,
each collateral taker will apply its own collateral
eligibility criteria when specifying the types of
collateral that it will accept in repo transactions
and other forms of secured lending. These
criteria may include asset type, credit rating
of issuer, currency, duration and average daily
traded volume (ie, a measure of the securitys
liquidity).
Some collateral-takers will be willing to accept

lower-quality collateral in repo arrangements.
The motivation for doing so is twofold:
1. Accepting lower-quality collateral will typi-

cally yield a better return for the collateral-
taker (the lender).
2. Top-grade collateral (eg, high quality
government debt such as German bunds)
is often in short supply and may be
expensive to borrow.

Chapter Four
1. What requirements do the client asset rules (CASS) impose regarding how safe custody
investments must be held by a firm?
2. Who holds legal title to securities registered in a nominee name?
3. name three types of nominee holding. What are the main differences between these types of
nominee arrangement?
4. List five factors that an investor should take into account when deciding whether to allow an
intermediary (eg, its custodian) to use a nominee account structure.

5. Which two types of fee arrangement are typically employed by custodians when charging an
investor client for its services?
6. What steps can custodians take to ensure that they collect timely and accurate information on
corporate actions?
7. Why do corporate actions typically involve a substantial level of risk for custodians?
8. Why do companies engage in:
i. stock splits?
ii. stock consolidations?
9. What is a mandatory corporate action? What is a voluntary corporate action?
Answer Reference: Sections 5.2, 5.3

Chapter Four
10. What is proxy voting?
11. Which obstacles to transparency did Paul Myners identify in the uK proxy voting system? What
recommendations did he make to address the problem of lost votes?
12. What is a record date?
13. define the following: ex-dividend, cum-dividend, special-ex, special-cum.
14. What is a sweep account?

15. What are the advantages and disadvantages of:
i. single currency cash accounts?

ii. multi currency accounts?
Answer Reference: Sections 6.3, 6.4
16. What is securities lending?
17. What is a manufactured dividend?
18. Who holds legal title to on-loan securities? Who will hold voting rights on the shares that are on
loan?
19. Why is securities lending and borrowing (SLb) employed by:
i. the lender of securities?

ii. the borrower of securities?

Chapter Four
20. What benefits can SLb bring to market efficiency?
21. What is a repurchase agreement (or repo)? What benefits do repo arrangements offer to lender
and borrower?
22. What is:
i. direct repo?
ii. tri-party repo?
23. What is:
i. marking to market?
ii. a margin call?

5
Aspects of Taxation
1. Tax Credit on Dividends 145
2. Tax Treatment of Bond Interest 146
3. Calculating Capital Gains and Losses 147
4. Tax Treatment of Discount Securities 149
5. Withholding Tax and Double Taxation Treaties 149
6. Transaction Taxes 151

Chapter Five

Aspects of Taxation
Aspects of Taxation
1. Tax Credit on a dividend of 90, they are deemed to have

been entitled to a gross amount of 100 and to
Dividends have suffered tax in the form of a tax credit of
10.
Learning Objectives 5.1.1
When the investor receives a dividend payment,
Understand the tax treatment of dividends they will also receive a voucher that indicates:
U the dividend paid out; and

U the amount of tax credit related to that
1.1 UK Personal Tax
dividend.
Treatment of Dividend
Income If a retail investor is resident in the uK and
pays tax at the basic rate (ie, their taxable
Companies pay some dividends to shareholders
income falls within the basic tax rate threshold
out of profits on which they have already paid
of 32,011 for the 2013/14 tax year), they will
tax. For this reason, dividends carry what
have to pay no further tax on this dividend
is known as a tax credit to prevent double
income because the tax liability is 10%, the
taxation.
same amount as the tax credit.
For tax purposes, dividend income on uK shares
non-taxpayers are not eligible to reclaim the
is the aggregate of the dividend received and
10% tax credit on dividends from shares.
the tax credit. hence, if a uK investor receives

Chapter Five
If the investors income, including dividends, back from hM Revenue & Customs (hMRC).
means that they pay tax at a higher rate, they Since this dividend tax credit was removed,
will have to pay more tax on their dividend pension funds no longer receive concessionary
income. The dividend tax rate on income above status and are treated in the same way as
the basic tax rate threshold of 32,011 but other investors. It does not make a difference
below the higher rate tax threshold of 150,000 whether the investor receives dividends from
in the 2013/14 tax year is 32.5%. Given that a company, a unit trust or an open-ended
the first 10% of the tax due on this dividend investment company. All dividends are taxed in
income is already covered by the tax credit, in the same way.
practice the investor will pay 22.5% tax on the
gross amount of dividend income falling into
this tax band. 2. Tax Treatment of
In the 2013/14 tax year, investors will pay a Bond Interest
total of 37.5% tax on dividend income that
exceeds the higher rate income tax limit Learning Objective 5.1.2
(currently 150,000). but because the first Understand the tax treatment of bond interest
10% of the tax due on this dividend income is
already covered by the tax credit, in practice
the investor will pay 27.5% tax on the gross
amount of dividend income falling into this
2.1 Conventional and
higher rate tax band. Index-Linked Gilts
If the dividend income comes from foreign uK individual investors are liable for
shares, there is no automatic tax credit. income tax on interest receivable on
dividend income from foreign companies falling gilts (including the interest uplift on
below the basic rate threshold is liable for tax at index-linked gilts when an interest rate is
10%. Income which exceeds the basic rate limit revised upwards). Interest is normally paid
is taxed at 32.5%. The taxpayer is usually able gross, but investors may opt for net payment
to claim a credit for any foreign withholding tax (ie, payment made after deduction of tax or
paid, up to the amount of the uK tax. other adjustments) on application to the gilts
registrar, Computershare. however:
1.2 UK Corporate Tax U individuals are not liable to capital gains tax
Treatment of Dividend (CGT) or income tax on the sale of gilts;
U no stamp duty or stamp duty reserve tax is
Income
payable on purchases or sales of gilts;
Generally, a uK company is not taxed on U uK individual investors may be liable for tax
dividends received from another uK company. on accrued interest on the purchase and
however, if it receives dividend income from transfer of gilts (see Chapter 1).
a foreign company, it is taxed at the uK
corporation tax rate applicable to the company,
Example
which is typically 30%. The taxpayer is able to
claim a credit for foreign tax deducted (see the Investor A invested 50,000 in a fixed-term
sections on withholding tax and double taxation bond on 1 June 2012 which lasts one year and
treaties later in this chapter). matures on its first anniversary, 1 June 2013.
On this date, interest of 1,500 is paid to the
The dividend tax credit that was previously
investor. The interest will be taxable in the
available to pension funds was abolished in
tax year 2013/14 because this is the tax year
July 1997. Prior to this date, pension funds
in which this income is paid. Investor A would
were entitled to a 20% tax credit on dividend
not need to pay tax on this income if her total
income. This meant that an 0.80 dividend paid
income for the tax year 2013/14 was below her
to a pension fund was actually worth 1.00
personal allowance of 9,440.
when a 0.20 tax credit had been claimed

Aspects of Taxation
All gains and losses on gilt strips held by

Example
individuals are taxed as income on an annual
Investor B invests 250,000 in a fixed-term basis. At the end of the tax year, individuals are
bond on 1 June 2011 which lasts two years and deemed for tax purposes to have disposed of,
matures on its second anniversary, 1 June 2013. and reacquired, their holdings of gilt strips at
No interest was to be paid or credited on the the prevailing market value. Any gain (or loss)
bond until maturity. On 1 June 2013, Investor arising during the year on the holding should
B is paid interest of 10,000. This interest is be added to the gain (or loss) on any strips
taxable in the tax year 2012/13, because this actually maturing in the tax year. The overall
was the tax year in which the income was paid. gain (or loss) is taxed as income.
Investor B is liable to tax because the 10,000
received in interest was more than the personal
2.4 Overseas Investors
allowance of 9,440.
Gilts held on FOTRA (Free of Tax to Residents
Abroad) terms, and the interest on these
bonds, are typically exempt from tax when held
2.2 Corporate Bonds by persons who are not ordinarily resident in
uK individual investors are liable for income the uK. The precise tax arrangements depend
tax on interest received on corporate bonds. on the terms under which the gilts were issued.
Just as for gilts, interest payments on most under current arrangements, which have been
corporate bonds is payable gross (ie without in place since 1996, income on FOTRA gilts is
tax deducted), so investors must declare this exempt from tax if the holder is non-resident,
income on their income tax return unless they unless the income is received as part of a trade
have made specific arrangements with the conducted in the uK.
registrar to receive this income net.
Individuals are not liable to capital gains tax 3. Calculating Capital

on profits made on corporate bonds which are
classified by hMRC to be Qualifying Corporate
Gains and Losses
bonds (typically this applies to most uK
corporate bonds that are sterling-denominated Learning Objective 5.1.3
and do not offer rights of conversion into shares Understand capital gains tax as it applies to
or other securities, or the right to subscribe for equities and bonds
other shares or other securities).
no stamp duty or stamp duty reserve tax is Capital gains tax (CGT) is payable on profits
payable on purchases or sales of uK corporate generated on the sale of most assets, including
bonds. equities. however, private investors in the
uK are exempt from paying CGT on profits
generated from the sale of gilts and qualifying
2.3 Gilt Strips corporate bonds (although gilt strips are
taxable, see above). Investors are entitled to
Cash flows resulting from ownership of fixed
tax relief on any capital losses.
income securities may be stripped into their
components (the right to receive principal The capital gain generated on an equities
on redemption, the right to receive periodic transaction can be calculated as the difference
interest payments) and sold separately as between the sale price and purchase price of
zero-coupon securities. When a gilt is stripped, the quantity of shares concerned.
the principal element (or corpus) is known as
a gilt strip and is traded independently from the
coupons.

Chapter Five
gilts and qualifying corporate bonds (ie, those

Example
which are non-convertible debt instruments
An investor purchases 1,000 shares in a denominated in sterling) are exempt.
company at 1.70 per share, selling all 1,000
With the market volatility seen over the last few
shares several months later for 2.00 each.
years, students will be aware that individuals
The capital gain generated on his investment may suffer losses, as well as make gains,
would be: from their share transactions. In the event
of a net loss in a fiscal year, individuals may
(1,000 x 2.00) (1,000 x 1.70) carry forward such losses to be offset against
gains in future fiscal years. There is no limit to
= 2,000 1,700 = 300
the number of years that such losses may be
The investor has made a capital gain of 300 on carried forward.
the transaction.
To calculate the amount of gain that may
The investor would be permitted to offset any be subject to CGT, an individual will need to
costs (eg, trading costs) against this profit for ascertain the purchase price of the shares that
tax purposes. For example, if the investor had have been sold. If the shares have been bought
incurred 25.00 cost in trading charges and in one tranche then that would be simple, but
other overheads, the gain potentially subject to shares may have been accumulated over a
CGT would be 275.00. period of time or may be repurchased after the
sale.
If fixed-income securities are sold before In the uK, hM Revenue & Customs (hMRC) has
maturity, the investor may realise a capital gain a set of rules that must be followed to identify
or loss on the transaction. The amount of gain which acquisitions should be allocated to a sale.
(or loss) will equal the difference between the These are known as the Matching Rules. They
amount realised from the sale and the adjusted are applied in the following order:
tax basis (see example below).
U Acquisitions on the same day as the sale.
U Acquisitions during the 30 days following the
Example sale on a first-in, first-out basis.
U Shares bought at any other time. All shares
Purchase price: 20.00
acquired prior to the day of the sale, of the
Sale proceeds: 21.60 (including 0.30 same share class in the same company, are
in accrued income) pooled together. This is called a Section 104
holding.
Adjusted tax basis: (20.30) (purchase price
+ 0.30 accrued income in The cost of any given share in a Section 104
sale price) holding is calculated by dividing the total
amount paid for shares in the Section 104
Capital gain: 1.30
holding by the number of shares.
Taxable income: 0.30 (the accrued income
received on sale) Example
An investor buys 5,000 shares in March 2006
Although a gain or loss on a sale of a security for 4000. In August 2007, the investor buys
is generally considered to be capital, special another 7000 shares of the same type in the
rules apply to securities purchased at market same company for 6,000.
discount, ie, for an amount less than par value
This will create a Section 104 holding of 12,000
(see Section 4). Subject to the exemption
shares at a cost of 10,000 (ie, price per share
mentioned below, gains on the sales of equities
= 0.83)
are subject to capital gains tax (CGT). Gains on

Aspects of Taxation
In May 2011, the investor chooses to sell 4,000

shares from this Section 104 holding. Thus, the
4. Tax Treatment of
proportion of the Section 104 holding that is Discount Securities
being sold is 4,000/12,000.
Now multiply this by the total cost of the
Section 104 holding: 10,000 * 4,000/12,000 = Understand the tax treatment of discount
3,333.33. The cost of the 4,000 shares that securities
the investor chooses to sell from its Section 104
holding is 3,333.33. Discount securities are securities that are
purchased for a price below their par value. An
original issue discount (OID) exists when a
The exception to the above is shares held on 31 bond is issued at a price below its redemption
March 1982, which are valued at the price on price. Market discount exists when a bond
that day and not at the original cost. falls in value after it has been issued. An OID
For capital gains made during the period bond may be subject to the market discount
6 April 2010 to 22 June 2010, capital gains rules if purchased after original issue at a time
tax is charged at a flat rate of 18% and when the price of the bond reflects a market
Entrepreneurs Relief (see Glossary) is given by discount, ie, if the bond is purchased at a price
reducing the amount of gains liable to CGT by below its issue price.
four-ninths up to a maximum lifetime limit of
Market discount must be declared, on an
2 million. From 23 June 2010 onwards, capital
accreted basis, as ordinary taxable income in
gains are taxed as follows:
the year a bond is sold or redeemed.
U 18% and 28% tax rates for individuals (the
In some jurisdictions, if the market discount is
rate depends on the total amount of taxable
below a certain threshold (sometimes known as
income);
the de minimis amount) the market discount is
U 28% for trustees or for personal represen-
considered to be zero for tax purposes and the
tatives of someone who has died;
difference between purchase price and sales/
U 10% for gains qualifying for Entrepreneurs
redemption price is treated as a capital gain
Relief.
when the bond is redeemed or sold.
Henceforward, Entrepreneurs Relief is subject
to an increased maximum lifetime limit of 10
million. 5. Withholding
Individuals are entitled to an exemption of Tax and Double
10,900 in the fiscal year 2013/14 and therefore Taxation Treaties
this amount is deducted from the individuals
net gain before calculating the amount liable
to CGT.
Understand the advantages, disadvantages
and uses of: withholding tax; double taxation
Exercise 1
treaties; relief at source; tax reclamation;
An investor purchases 500 shares in a company being an authorised US-approved Qualifying
at 1.00 per share, selling the same 500 shares Intermediary; FATCA rules
several months later at 1.40 per share.The
investor has incurred 30 in trading charges
against this transaction. Calculate the taxable 5.1 Withholding Tax (WHT)
capital gain on this transaction.
Tax regulations in many countries dictate that
The answer can be found in the Appendix at the income payments accruing to non-residents are
end of this chapter. liable to be taxed at source in the jurisdiction in

Chapter Five
which the investments are incorporated. This is network of treaties, covering more than
known as withholding tax (WhT). 100 countries. hM Revenue & Customs has
established dTTs to:
Income that is paid to investors on their
securities portfolio, via stock dividends and U protect against the risk of double taxation
coupon payments, for example, is typically where the same income is taxable in two
subject to WhT in the country in which the states;
issuing company is incorporated. U provide certainty of treatment for cross-
border trade;
Investors may be eligible to reclaim WhT (in full
U prevent tax discrimination against uK
or part) in instances where the governments
business interests abroad;
of the two countries involved have signed a
U protect the uK governments taxing rights
double taxation treaty (see below).
and protect against attempts to avoid or
WhT is typically deducted at source (ie, evade uK liability (dTTs typically contain
deducted by the issuer or paying agent and provisions for the exchange of information
paid directly to the local tax authorities) and between the taxation authorities of states).
must be reclaimed by the investor from the
local tax authorities. This is typically done If there is no dTT in place, a foreign investor
on the investors behalf by its custodian. may be able to secure unilateral relief against
To support this process, global custodians double taxation in their country of residency.
must maintain clear and up-to-date records For example, an investor resident in the uK may
of their clients tax status, with supporting offset against their uK tax liability any WhT
documentation (including signed declarations) already paid on investment income overseas.
available to present to the local tax authorities Tax administration remains a challenging area
as required. for custodians holding assets on behalf of
In some jurisdictions, eg, in the uS, tax relief foreign investors. The following obstacles exist
may be applied at source, removing the need to efforts to automate and streamline tax
for the custodian to reclaim WhT on behalf of processing:
its investor clients. U There is a distinct lack of harmonisation
of tax procedures, with many jurisdictions
5.2 Double Taxation Treaties clinging firmly to the tax frameworks that
have evolved historically within their own
(DTTs)
borders.
To address investor concerns over double U different instruments may attract different
taxation (ie, being taxed on income in both WhT rates within the same jurisdiction,
the country where the income is paid, and reinforcing the degree to which tax reclaims
the country where the investor is resident must be processed on a case-by-case basis.
or registered), many governments have U Lack of harmonisation obstructs efforts by
established bilateral double taxation treaties custodians to standardise and automate
(dTTs) with governments in other jurisdictions. tax processing; this adds to costs and
accentuates risks that tax reclaims may be
non-resident companies or individuals may be missed or processed incorrectly.
eligible for a refund of WhT levied on income U Tax-reporting obligations can be highly
payments in instances when their country of demanding in some jurisdictions. A number of
domicile has a dTT in place with the country custodians report, for example, that meeting
where the payment is made. Tax relief at IRS nRA 1441 obligations in the uS has
source may be possible on application to the placed heavy demands on them in terms of
relevant tax authorities. staffing costs and workflow pressures.
U The fees may make smaller tax reclaims not
There are more than 1,300 double taxation
worthwhile.
treaties worldwide. The uK has the largest

Aspects of Taxation
5.2.1 US-Approved Qualified 6. Transaction Taxes

Intermediary Status
The Internal Revenue Service, the uS tax Learning Objective 5.1.6
authority, established a Qualified Intermediary
Understand transaction-based taxes
(QI) Program in 2001 in an attempt to encourage
foreign investment into the uS and to simplify
A transaction tax is triggered by trading in
procedures for tax collection and tax reporting.
specified assets (eg, trading shares, or the sale of
Foreign institutions granted QI status have a a property) and is imposed either as a percentage
commitment to report to the IRS a list of their of a transactions full value, but sometimes
non-uS clients with investment interests in uS as a flat fee. For example, in the uK stamp
securities. There is also an obligation to report duty land tax (SDLT) is usually payable on
income on uS securities for any uS residents. purchasing or leasing land or property and is
This obligation also applies to sale proceeds of sometimes payable on transfers of ownership
share sales of uS assets. Subsequently, QIs of property or land. Stamp duty reserve tax
will withhold taxes due on uS securities held (SDRT) is a tax applied to trading in securities.
in these investors accounts and will advance The SdRT rate in the uK is 0.5%.
these tax obligations owed to the IRS.
As margins on trading costs have fallen
over time, some jurisdictions have opted to
5.2.2 FATCA Rules remove securities transfer taxes, owing to
the disincentive these may provide to trading
The uS Foreign Account Tax Compliance Act
activity. For example, Japan removed a 0.3%
(FATCA), which took effect in January 2013,
Securities Transaction Tax (STT) in 1999 in
requires uS taxpayers holding foreign financial
the face of the Asian financial crisis as a result
assets that exceed given thresholds to report
of fears that transaction taxes and turnover
those assets to the Internal Revenue Service
fees might drive trading activity offshore. For
(IRS). This information must be reported on a
similar reasons, a 2% STT was abolished in the
form (Form 8938) which is submitted with the
Swedish market in 1991, when the Stockholm
taxpayers annual tax return.
Exchange lost a sizeable percentage of its share
Additionally, FATCA requires foreign financial trading activity to the London Stock Exchange.
institutions to report to the IRS information
The French government has introduced a
about financial accounts held by uS taxpayers
transaction-based tax on trading in some listed
or by foreign entities in which uS taxpayers
equities. This French Financial Transaction
hold a substantial ownership interest. To
Tax (FTT) came into force on 1 August 2012.
comply with these reporting requirements, a
designed to curb market speculation, a 0.2%
foreign financial institution (FFI) is required
levy is applicable to transactions in French
to enter into an agreement with the IRS by 30
listed equities with a market capitalisation of
June 2013, under which it will:
more than 1 billion on 1 January in the tax
a. fulfil specified due diligence and identification year concerned, irrespective of where the buyer
procedures on its account holders; and seller are based. The tax is payable on the
b. provide annual reporting to the IRS on first day of the month after the transaction
account holders that are uS citizens or has settled. The legal taxpayer will be the
foreign entities with substantial uS owner- broker executing the purchase order or, where
ship. no broker is involved, the bank providing
custody of the buyers account. The FTT will
FFIs and their account holders that do not be applicable to purchases of dRs and AdRs
comply with these FATCA requirements will be for the French equities concerned. A number
subject to a 30% withholding tax on a range of Eu member states have proposed that
of income payments sourced from the uS, an FTT should be introduced across the Eu.
including gross proceeds resulting from the The European Commission has initiated public
sale of securities in the uS. consultation relating to this proposal.

Chapter Five
Answers to Exercises
Exercise 1
The capital gain generated on the investment in these 500 shares would be:
(500 x 1.40) (500 x 1.00 ) = 200
The investor is permitted to offset associated costs against this capital gain for CGT calculation. Thus
the capital gain subject to CGT would be:
200 30 = 170

Aspects of Taxation
1. What is a dividend tax credit?
2. how is tax applied to capital gains and interest on uK government and corporate bonds?
3. What is an original issue discount?
4. What is withholding tax? In which circumstances may WhT be reclaimed?

Chapter Five
5. What is a double taxation treaty? Why do governments enter into dTTs?
6. Why might a country remove a securities transfer tax?

6
Risk
1. What is Risk? 157
2. Risk Reviews of Market Infrastructure

and Custodian Sub-Networks 160
3. Global Custody Risks 163
4. Reporting on Internal Control Environments 166
5. Shareholder Limits and Restrictions on Foreign

Investment 168
6. Mitigating Risk Through Reconciliation 170

Chapter Six

Risk
Risk
1. What is Risk? the bankruptcy of a major counterparty (for

example, Lehman brothers filing for Chapter
11 bankruptcy protection in September 2008),
Learning Objective 6.1.1 the collapse of a sub-custodian or central
Know the following major categories of risk: securities depository, the danger of missing a
market; counterparty; issuer; settlement; large corporate action, a terrorist attack, or a
operational; political; regulatory large trading loss such as that experienced by
barings bank in Singapore in 1995, provide just
four among many possible examples.
Risk in the securities industry both presents an
opportunity to make sizeable profits and is a From a financial perspective, risk may be
potential source of major loss. Many investment defined as the quantifiable likelihood of loss or
banks, for example, make a significant share underperformance of invested assets.
of their overall profits through the successful
management of market risk namely, in the The Bank for International Settlements,
form of proprietary trading. a basel-based international organisation that
serves as a bank for central banks and a
On the downside, a securities firm repeatedly forum for international monetary and financial
comes into contact with events and processes co-operation, identifies three main categories
that could result in huge financial losses of risk in the financial services industry. These
if appropriate controls are not in place to are:
prevent or manage these risks effectively

Chapter Six
U Credit risk the risk of loss caused by standards introduced in 1988 had become
the failure of a counterparty to settle its outdated and no longer reflected the advances
obligations. in business practice and developments in
U Market risk the risk of loss of earnings risk assessment methodologies that had been
or capital arising as a result of movements introduced during the subsequent period.
in market prices, including interest rates,
Consequently, in June 1999, the Committee
exchange rates and equity values.
issued a proposal for a New Capital Adequacy
U Operational risk the risk of loss resulting
Framework to replace the 1988 Accord. The
from inadequate or failed internal processes,
proposed capital framework consists of three
people and systems or from external events.
pillars:
A prime mover in identifying sources of risk in the
1. Efforts to establish new minimum capital
banking industry, and in formulating strategies
requirements, which are more sympathetic
for protecting against risk, has been the Basel
to the actual risks that firms face and the
Committee on Banking Supervision. This
risk controls they have put in place to
was established by the central bank governors
mitigate these risks.
of the Group of Ten countries at the end of 1974.
2. A supervisory review of an institutions
The Committees members now come from
internal assessment process and capital
Argentina, Australia, belgium, brazil, Canada,
adequacy in order to give banks the
China, France, Germany, hong Kong SAR, India,
opportunity to develop their own advanced
Indonesia, Italy, Japan, Korea, Luxembourg,
methodologies for measuring their internal
Mexico, the netherlands, Russia, Saudi Arabia,
and external risks.
Singapore, South Africa, Spain, Sweden,
3. Effective use of disclosure in order to
Switzerland, Turkey, the united Kingdom and
strengthen market discipline by enhancing
the united States. The Committee meets four
transparency in banks financial reporting.
times a year. It has around 25 technical working
This will complement the supervisory efforts
groups and task forces that also meet regularly.
described in 1 and 2.
The basel Committee sets out to formulate
Following extensive consultation with banks
broad supervisory standards and best practice
and industry groups, a revised framework,
guidelines, which national financial authorities
commonly known as Basel II, was approved by
can refine as necessary to suit the circumstances
the basel Committee on 26 June 2004. This text
of their own national systems. In this way, the
served as a foundation for: (i) reforms at the
Committee encourages convergence towards
level of individual firms, designed to enhance
common approaches and common standards
their own internal controls; and (ii) legal reforms
without attempting to enforce harmonisation of
at the national level designed to strengthen the
member countries supervisory techniques.
overarching risk control framework. basel II
In 1988, the Committee introduced a risk came into effect in the European union on 1
evaluation system commonly known as the January 2007 under the Capital Requirements
Basel Capital Accord. This system requires Directive (CRD). Lenders covered by the CRd
securities firms to set aside a percentage of were required to implement its provisions from
their overall capital to protect against the the beginning of 2008.
risks that they face in their business. broadly
Following the global financial crisis, banks have
speaking, the greater a firms exposure to risk,
been required by financial regulators to raise
the higher the capital charge that it will be
the level of capital that they must hold against
required to bear. Since 1988, this framework
the lending, trading and operational activities.
has been progressively introduced not only in
Reforms proposed under the Basel III Accord
member countries, but also in virtually all other
will be implemented by member countries from
countries with active international banks.
1 January 2013. Among other requirements,
by the late 1990s, however, many in the banks will be expected under basel III to hold
banking world felt that the capital adequacy specified minimum capital levels against their

Risk
risk-weighted assets (the value of an asset 1.2 Market Risk

multiplied by a scaling factor that reflects the
level of risk associated with the asset). Market risk is the risk of loss of earnings or
capital arising from changes in the value of
The three primary areas of risk identified by financial instruments.
the basel Committee are addressed in more
detail in the next section. Financial institutions have always faced the
risk of losses on- and off-balance sheet arising
from undesirable market movements. however,
1.1 Credit Risk the sharp increase of proprietary trading in
Credit risk is most simply defined as the potential many banks has heightened the need among
that a counterparty will fail to meet its obligations regulators to ensure that these institutions
in accordance with agreed terms. The objective have the management systems to control,
of credit risk management is to maximise a banks and the capital to absorb, the risks posed by
risk-adjusted rate of return by maintaining market-related exposures.
credit risk exposure within acceptable limits. This said, the primary focus in the 1988 basel
Securities firms need to manage the credit Accord was on credit risk, and market risk
risk inherent in their entire portfolio, as well only gained a high profile when the basel
as the risk inherent in individual credits or Committee on banking Supervision published a
transactions. For most banks, loans are the policy document on the supervisory treatment
largest and most obvious source of credit risk. of market risk in April 1993. This proposed
however, other sources of credit risk extend that firms should set aside capital to cover the
throughout the activities of a bank, including price risks inherent in their trading activities.
in the banking book and trading book, and This document put forward a standardised
both on and off the balance sheet. banks measurement framework to calculate market
are increasingly facing credit risk in various risk for interest rates, equities and currencies.
business lines other than lending, including Market risk can become an issue in securities
trade financing, foreign exchange transactions, operations in several ways:
financial futures and options, and settling
transactions. U If a settlement is delayed or a trade fails, there
is potential that the value of the instrument will
The term credit risk may embrace a range of fall during this period until settlement has
risk elements: been finally achieved.
U Issuer risk is the risk that an issuer may U If the custodian misses a corporate action
default on its obligations. In the case of a (eg, a rights issue), it may be required to
debt instrument, for example, this will be compensate the investor for lost entitlements.
the risk that the issuer fails to meet interest If the price of the securities moves against
payments and to redeem principal on the the custodian before this exposure is closed
instrument on redemption date. down, this can result in major financial losses
U Counterparty risk is the risk that an for the custodian concerned.
institution defaults on obligations outstanding U If a trade confirmation remains unmatched
to a trade counterparty prior to trade settle- and it is discovered, for example, that both
ment. parties have reported a sale, instead of one a
U Settlement risk is the risk that the sale and the other a purchase, one may have
completion or settlement of a transaction to reverse the transaction in the market and
will fail to take place as expected, ie, that incur a loss because the market price has
an expected payment of an asset/security changed.
or cash will not be made on time or at all. It U Late or failed transactions, or a missed rights
is most likely to occur when there is a non- issue, in illiquid markets can be difficult to
simultaneous exchange of value (eg, cash rectify as additional stock may not be
and securities) (see Chapter 3). available to borrow or buy.

Chapter Six
1.3 Operational Risk 1.4 Political Risk

Operational risk (OR) is defined by the basel This is the risk of loss to an investor triggered by
Committee as the risk of loss resulting from change in political regime or political policy. This
inadequate or failed internal processes, people might result through changes in regulation or
and systems, or from external events. through existing legal contracts being amended
or rendered null and void. It may include
Factors that may contribute to operational risk changes in economic strategy, in tax policy,
include: or in the legal protection afforded to private
U internal and external frauds; property (eg, protecting against expropriation
U theft; of the assets of a foreign company or investor).
U total or partial interruption of systems or It may pertain to currency convertibility and
processes; freedom to repatriate profits, and it may relate
U unauthorised access to a companys computer to shifts in a markets geopolitical vulnerability
systems and/or physical records; through threat of war, political takeover or civil
U lack of robust business continuity planning unrest.
(bCP) to ensure continuity in response to
shock events (eg, fire, earthquake, terrorist 1.5 Regulatory Risk
attack);
U incorrect execution of certain processes, Regulatory risk typically refers to the risk of
whether internal or external to the bank, material loss, liability or reputational damage
such as a transaction that is executed in the resulting from failure to comply with the
wrong direction; requirements of financial services regulators
U problems deriving from poor management or related codes of best practice that guide the
supervision of administrative staff and activities of regulated businesses in a particular
inadequate procedures for delegating jurisdiction or industry sector.
authority; and
U problems associated with personnel employ-
ment contracts. 2. Risk Reviews
Events have shown that a firm can be forced of Market
into liquidation by fraud, environment disasters, Infrastructure
or legal action initiated by a disaffected group
of clients or former employees. There is a day-
and Custodian
to-day cost to the firm as operational risk is Sub-Networks
realised across its respective business lines,
but there is also an overarching risk that a
catastrophic event may trigger a loss from
Understand the factors that should be taken
which the firm is unable to recover.
into account when conducting risk reviews
There are a large number of sub-categories of of market infrastructures and sub-custodian
operational risk, including: networks
U Transaction-processing risk the risk that

an error in the processing of a transaction will A global custodians network management group
cause a direct or indirect loss to the firm. represents the first line of risk management
U Legal risk the risk that a contract is within the bank in terms of managing cross-
unenforceable, resulting in a loss. border settlement and providing custody for
U Reputational risk the risk that an act overseas assets. In consultation with the banks
conducted by a firm or one of its employees legal department, the network management
damages the reputation of the firm, resulting team will hold primary responsibility within the
in a direct or indirect loss. bank for conducting risk assessments of:

Risk
1. market infrastructure that may process or U Market information and data flows does
hold clients assets; and the agent have the contacts and experience
2. the subcustodians that it employs to service needed to provide timely notification of
these assets in the local market. key developments within the market? In
high-risk areas, such as corporate actions,
Relating to the first of these areas, it is
does the agent have access to multiple,
standard practice among global custodians
reliable sources of event information and the
that client assets should not be held in any
ability to provide a cleansed, consolidated
overseas market until a thorough risk review
notification of forthcoming events?
has been conducted on clearing and settlement
U Staff expertise and succession issues
infrastructure, the local CSd and national
does the agent have the required level
payments system (these points are discussed
of staff expertise and experience, and
more fully when we discuss uS SEC Regulations
effective provision in place if key staff leave
17f-5 and 17f-7 in Section 2.1).
or are unable to work? does the market
Factors that must be taken into account when have sufficient depth of talent to ensure
conducting risk reviews on subcustodian effective replacements? What procedures
networks include the following (note that these does the bank have in place to address these
factors apply to agents in all markets, but may succession issues?
assume special importance when appointing U Transparency and integrity does the
agents in low-volume, emerging markets): agent, or do its employees, have any history of
financial misconduct or negligence? does the
U A banks credit rating and strength of its legal framework applicable in the jurisdiction
balance sheet if using a small local bank concerned provide effective recourse in
as agent in a low-volume market, does it instance of loss, threat to business continuity
provide an appropriate level of credit comfort? or damage to reputation?
And are clients assets fully protected in case
of insolvency either of the agent or an entity Global custodians will typically insulate investor
(eg, depository, registrar) holding assets on clients from fraud, gross negligence or wilful
its behalf? misconduct within their own organisation, or
U Contingency planning are necessary on the part of agents (eg, subcustodians) that
business continuity provisions in place to they employ.
protect against natural hazards (earthquake,
hurricane, flooding), political instability or Most global custodians will not indemnify
terrorist threat? investor clients against losses sustained
U Track record and commitment to the through systemic shocks to infrastructure,
business can the agent provide assurance such as a CSd, clearing house or payments
of its long-term commitment to the local system. This is deemed to be part of the
custody business? What provisions are market risk borne by the investor. however,
in place, should client assets need to be custodians will make every reasonable effort to
migrated to another agent? ensure that investor clients are informed about
U Technological capability are the agents prevailing risks associated with investing in a
technology platforms sufficiently robust to particular market.
cope with predicted daily business volumes This said, there is nothing currently to stop
and peaks in activity? What commitment has a global custodian providing indemnity to an
the agent made to support IT upgrades and investor client against this category of risk,
technical enhancements? should it choose to do so. The custodian must
U Communication and reporting does the balance the potential for winning new business
agent employ communication media (eg, by offering this level of indemnity to the client
SWIFT ISO 15022 messaging) that conform against the sizeable additional risks that it will
to global industry standards? be taking on.

Chapter Six
2.1 SEC Rules 17f-5 and U It must be a national or transnational centre

for handling securities that is regulated by a
17f-7
foreign financial regulatory authority.
In the uS market, the Securities and U It must be subject to periodic audits by the
Exchange Commission (SEC) has laid down regulatory authorities or by independent
strict rules governing the conditions under accountants.
which a uS-based investment company U It must provide regular and comprehensive
can hold its assets overseas. under reports to all depository participants.
SEC Rule 17f-5, which was introduced in 1984, U The CSd must apply equal safekeeping
uS investment companies can hold securities treatment to each depository participant.
with any custodian that meets the SECs U It must maintain a register that details the
eligible foreign custodian criteria, dictating assets held on behalf of each depository
that rigorous due diligence is conducted on any participant.
custodian before it can be appointed.
Given that many global custodians have been
required to collect similar information from a
similar set of depositories, the Association
of Global Custodians (AGC) has attempted
to reduce duplication of effort by centralising
this information-gathering process. It asks
depositories to submit a single annual
response to a comprehensive questionnaire
Indeed, prior to holding assets with a foreign (over 120 questions) detailing their internal
custodian, a uS investor must consider: control environment and providing a broad
range of data demanded under Rule 17f-7
1. Access to books and records whether reporting requirements. As well as simplifying
foreign laws applying within the jurisdiction the due diligence process for AGC member
concerned will restrict the access of custodians, this has eased the reporting burden
independent public auditors and/or the on depositories themselves, allowing each to
investors accountants to books and records submit one consolidated risk report to the AGC.
maintained by the eligible foreign custodian.
2. Recovery of assets whether local laws Within this risk report, CSds are required to
will limit the clients ability to recover its provide information on a broad body of issues:
assets in the event that the eligible foreign
U Structure and Organisation of CSD
custodian goes into liquidation, or if assets
Legal status and ownership structure of
are lost while under the custodians control.
the depository.
3. Currency convertibility whether
The regulatory authority that oversees
currency restrictions will prevent the client
the depositorys activities.
from repatriating cash holdings or income
how frequently its activities are subject
from the market concerned and converting
to a financial and operational audit by a
these back into uS dollars.
regulator or external auditor.
4. Expropriation of assets the probability
that investors assets may be confiscated, U CSD Participants
frozen or taken under state control while in number of CSd participants, types of
the care of the eligible foreign custodian. participant, criteria that must be satisfied
to be a CSd participant.
under Rule 17f-7, introduced in 2001, the SEC
specified that any depository that is employed U Method of Holding Assets
by a uS investment company (or its custodian) Controls for ensuring segregation of
to hold its assets must be an eligible foreign participants assets, method of recording
depository. This requires that it meets the those assets.
following criteria:

Risk
Whether nominee arrangements are in Although SEC 17f-5 and 17f-7 regulations
place. apply specifically to uS-based firms, the
Procedure for transfer of legal ownership principles enshrined in these regulations have
(ie, when is finality of transfer estab- been widely adopted in other jurisdictions as
lished?). a foundation for conducting risk reviews of
market infrastructures and custodial networks.
U Settlement and Asset Servicing
Settlement options provided by the
depository (eg, availability of dvP, real- 3. Global Custody
time settlement, batch settlement).
What broader range of services does Risks
the depository provide (eg, collection
of dividends and interest, collection of Learning Objective 6.1.3
corporate actions entitlements, supply Understand the areas of global custody risk and
of information on issues and corporate appropriate countermeasures
events, tax services, securities lending
and borrowing, collateral handling)?
Links that the depository has with other Firms providing global custody services can
CSds or ICSds. What protection is be exposed to a wide range of risks. These
afforded against the collapse of an ICSd/ may be linked to the nature of the business,
CSd with which it maintains a link? the counterparties involved, credit, liquidity,
market conditions, operational hazards,
U Protection against Losses settlement, systemic and transfer risks.
The degree to which local law protects
participants assets from claims and
liabilities of the depository.
Whether the depository imposes a lien
on participants accounts (allowing the
depository to hold or sell a participants
securities in payment of a debt).
Whether the depository delegates any
responsibilities to third-party service
providers. does it accept responsibility
for any losses or error resulting from the
actions of these third parties? up to what These risks can be managed effectively,
limit? providing that appropriate controls are set in
Whether the depository accepts liability place. however, special care may be required
for loss in instances of theft, fraud, force in emerging markets, where the technological
majeure... infrastructure, the market systems or the
Insurance policies that the CSd has in regulatory framework may still be weak.
place to cover CSd default, systemic
threat, etc. Is there a guarantee fund 3.1 Settlement Risk
independent of stock exchange or other
market guarantees? In this Global Securities Operations workbook,
Any business continuity provisions that we have identified a range of possible sources
are in place to address such contingencies. of trade and settlement risk. Also, we have
identified a range of countermeasures that
U Record of Losses might be employed to mitigate these risks. A
Any default by a depository participant selection of key risks and countermeasures are
that may have resulted in a significant summarised overleaf:
loss over the last three years.

Chapter Six
Cause Countermeasures
Late receipt of trade Maintain agreed operating procedures.

data and/or trade
Employ electronic communication link between investment manager
instructions
and custodian.
Inability to verify Ensure timely pre-matching of settlement instructions, preferably

instructions from through a clearing organisation or a CSd.
investment manager
Employ standardised, automated electronic data flow between
parties involved in the trade.
Inaccurate or outdated Periodically check prices against a range for information sources/
pricing feeds for listed vendors supplying pricing data. Ensure regular (in many cases daily)
and unlisted securities interaction with market vendors to ensure the integrity of a firms
market data.
Acting on an no instructions should be acted upon unless they carry valid

unauthorised instruction signatures, or other authorised security procedures.
Accurate and up-to-date documentation must be maintained by the
custodian regarding who is authorised to give client instructions.
Transaction with a use a clearing organisation that assumes counterparty risk through
failing counterparty novation.
Clients history of failed trades should be closely monitored, with
periodic analysis of settlement failures sent to the client.
dvP settlement Secure dvP on books of a creditworthy settlement bank.

infrastructure Employ actual settlement date accounting. If contractual settlement
unavailable date accounting is to be employed, positions should be collateralised so
that they can be reversed if necessary.
Late delivery of Prompt follow up shortfall with counterparty.

securities and/or cash Initiate compensation claim against defaulting counterparty.
Failure of trading Industry associations and market practice groups to promote use of
parties to adhere to industry standards and global best practice.
market standards and Potential use of price discounts for settlement messages communicated
codes of practice (eg, by ISO standard, rather than by fax or proprietary message formats.
use of ISO standard
electronic messaging)
Poor cash management, Set intra-day credit limits and ensure these are not exceeded.
failure to ensure money
transfers in local or
foreign currency occur
on time
Lack of reliable and use multiple information sources, including local press, to collect
timely dividend and information on forthcoming corporate events. Subcustodians should be
corporate actions responsible for providing timely information of client entitlements.
information

Risk
Cause Countermeasures
delayed income collection dividend, interest and redeemable principal should only be credited
on due date if timely payment is expected from issuer. Provision
should be made in the custody contract to allow credit to be
reversed if funds are not actually received from the issuer.
Inaccurate or late reporting need to implement improvements in reporting system.

to client need regular reconciliation of predicted with actual positions.
Clients instructions Four eyes principle involving checking of instructions by another

not implemented, or person.
implemented incorrectly Forward value payment or delivery instructions to be held in a diary
system, which is to be reviewed daily.
debit and credit balances in a clients account to be validated daily.
3.2 Safekeeping Risk must verify that there is a complete and

unambiguous custody agreement in place.
This section summarises a range of possible U Custodians are required to maintain accurate
sources of safekeeping risk and possible and up-to-date client documentation to meet
countermeasures through which these risks know your customer requirements.
may be mitigated. These include those in the U In dealing with an investment manager
table above. acting as principal on assets held with the
custodian, a custody contract must be signed
between the custodian and the investment
3.3 Other Operational Risks
manager.
Custodians must have effective measures in U In dealing with an investment manager that
place to protect against a broader set of is managing assets as an agent on behalf
operational risks, which include theft and of an institutional investor or some other
fraudulent acts by personnel, loss of securities beneficial owner, the custody relationship will
in transportation, power cuts and system be between the custodian and the beneficial
downtime, money laundering, unauthorised owner. Consequently, appropriate legal
persons (eg, hackers) gaining access to contracts must be in place between these
computer systems, and effective safeguards parties. In these:
against system faults such as a breakdown at the beneficial owner must provide clear
the central securities depository. instructions to the custodian specifying
which instructions should be accepted
directly from the investment manager(s)
3.4 Risks Associated appointed by the client;
with Contractual credit limits for foreign exchange
Relationships transactions and overdrafts must be made
explicit in the custody relationship;
In delivering custody services, global custodians
may enter into legally binding contractual
arrangements with institutional investors,
investment managers and subcustodians. They
must pay particular attention to the following
set of issues:
U In managing their relationships with

institutional investor clients, custodians

Chapter Six
the custodian should maintain a regular, this reporting process, a standardised audit
ongoing review process with investment methodology has been developed in the uK,
managers and investor clients to identify entitled AAF 01/06, and in the uS, entitled
whether or not agreed investment SSAE 16 and ISAE 3402.
standards are being met and whether
instructions are being received on a timely
basis.
4.1 AAF 01/06
Financial services companies must be able to
3.4.1 Relationship with demonstrate that their internal control proce-
Subcustodians dures are robust and efficient. In line with this
requirement, the Audit and Assurance Faculty
In managing its relationship with subcustodians, of the Institute of Chartered Accountants in
the global custodian must ensure that each England and Wales (ICAEW) issued reporting
subcustodian is selected on the basis of guidelines to assist directors needing to
effective research and due diligence. The global verify that their organisations have strong
custodian must maintain a regular and ongoing internal controls in place. This guidance, AAF
review of subcustodian performance to ensure 01/06, replaces FRAG 21, and provides an
that required service standards are being independently audited record of the internal
met. This will include periodic site visits to the controls employed by investment services
market concerned. companies, including investment custodians.
Although not yet a statutory requirement, the
AAF 01/06 is a widely used report designed
to make it easier for investment custodians
(and other service organisations) to respond
to requests for information from auditors and
investor clients wishing to review the internal
risk controls the organisation has in place.
The uK Pensions Act 1995 highlights the

responsibilities of the management and
Investor clients will typically demand protection
trustees of pension funds to review the risk
against any risk to their assets caused by
controls in place within their pension funds and
default or failure by a subcustodian. This
to share this information regularly with their
issue must be addressed by the custodian in
stakeholders. Where control of assets has been
the custody contract signed with the investor
outsourced to a custodian, management and
client.
trustees must ensure that the control systems
employed by the custodian complement those
within their own organisation, and that assets
4. Reporting on (whether in physical or dematerialised form) are
Internal Control protected effectively while in the custodians
care.
Environments
Importantly, the 1995 Pensions Act makes it
Learning Objective 6.1.4 explicit that using an external custodian does
not diminish the fiduciary responsibility held by
Know the purpose of an ISAE 3402 report
management and trustees to ensure that the
overall integrity of data and safeguarding of
Investors and regulators are increasingly assets is maintained.
requiring more sophisticated reporting from
custodians relating to the internal controls Although primarily intended for the reporting
that they have in place to monitor and mitigate accountants of custodians, the AAF 01/06
the set of risks outlined above. To facilitate framework is also used selectively by

Risk
investment managers, pensions administration been taken to address these areas of reported
companies and other providers of financial weakness.
services to establish an independently audited
review of their own internal control environment by reporting, accountants will include an
that can be presented to regulators and to their audit of the physical controls and reconciliation
own clients. procedures maintained by the custodian to
ensure that:
The AAF 01/06 reporting package should
include: U physical securities are released only on
receipt of a customer-authorised validated
1. a report on the custodians internal risk controls instruction;
prepared by the custodians board of directors U all customers are contacted annually to verify
(ie, an internal risk evaluation from within the accuracy of the authorised signatory list;
the company); and U six-monthly physical counts of all securities
2. a report on the custodians internal controls are undertaken by staff not responsible for
prepared by the reporting auditors (ie, an recording and authenticating transactions;
independent external risk evaluation). U reconciliation is conducted, on a six-monthly
basis, of physical securities held against the
The directors report should contain a review count recorded in the custodians books and
of the main control procedures employed by the records. This reconciliation is to be conducted
custodian, and an analysis of how these engage by persons not responsible on a day-to-
with the internal control objectives employed day basis for providing physical custody of
by its customers. These main features should these assets, or for recording and verifying
include: customer instructions;
U the securities compliance department,
U a general description of the custodians independent of custody operations,
activities and its dependence (if any) on
reviews and scrutinises the results of the
fellow group members;
securities counts and stock reconciliations.
U the overall control objectives that the These reconciliations must be reviewed by
directors have established;
management on a timely basis to ensure that
U a review of specific procedures designed to any anomalies are promptly resolved.
control custodial functions in accordance
with the control objectives. These may Reporting accountants will also test the
include arrangements for the segregation of procedures employed by the custodian for
customer assets, reconciliation procedures, appointing and monitoring its network of
procedures for selecting and monitoring subcustodians to ensure that:
subcustodians, procedures for monitoring IT
systems and communications networks, and U arrangements with independent sub-
level of compliance with investor mandates; custodians are documented and subject to
U other relevant information that the directors review by the compliance department;
may wish to provide (eg, controls that should U subcustodians provide written confirmation
be employed by the client when sending that customer assets are held in segregated
or receiving information to or from the accounts in order to afford maximum
custodian). protection in the event of any default;
U monthly reconciliations of securities held with
For the statement by directors to be fairly the subcustodian are conducted against the
described, the directors should include in custodians records. These reconciliations are
their report a description of any material to be reviewed by management on a timely
weaknesses that they feel may compromise the basis to ensure that any differences are
effectiveness of the internal control procedures adequately resolved.
that the custodian has in place. directors
should also detail any corrective action that has

Chapter Six
4.2 SSAE 16 and ISAE 3402 Without a current service auditors report, a
custodian may need to respond to multiple
Statement on Standards for Attestation audit requests from its customers and their
Engagements (SSAE) no. 16 and International respective auditors. Multiple visits from
Standard on Assurance Engagements user auditors can place a strain on the
(ISAE) 3402 are internationally recognised service organisations resources. A service
audit standards developed respectively by auditors report, which provides evidence of
the American Institute of Certified Public effectively designed control objectives and
Accountants (AICPA, which created SSAE) control activities, can be valuable in helping
and the International Auditing and Assurance organisations and their auditors to ensure that
Standards board (IAASb) of the International they have the information necessary to meet
Federation of Accountants (IFAC), which their compliance and reporting requirements.
created ISAE 3402.
Like an AAF 01/06 report in the uK, the

SSAE 16 and ISAE 3402 reports in the uS
5. Shareholder Limits
verify that a service organisation has had its and Restrictions on
control activities reviewed by an independent
auditing firm. This audit of control processes
Foreign Investment
will generally include controls over information
technology and related processes. Learning Objective 6.1.5
Understand the concept of shareholder limits
SSAE 16 and ISAE 3402 replace SAS 70 as and restrictions
the authoritative guidance for auditing and
reporting on service organisations.
Share ownership may be restricted in some
under SAS 70, there were two types of service companies or sectors. In certain markets,
auditors reports: Type 1 and Type II. A Type investment restrictions dictate that no non-
I report described the service organisations resident shareholder may own more than a
control procedures at a specific point in time specified percentage of total issued shares in
(eg, 30 June 2011). A Type II report not only any one company.
contained the service organisations description
of controls, but also included detailed testing of Limits may also exist on the aggregate
these controls over at least a six-month period percentage of total issued shares in any
(eg, 1 January 2011 to 30 June 2011). company that may be held by foreign investors.
disclosure requirements, typically, require that
SSAE 16 and ISAE 3402 both make a distinction foreign investors (or their custodian acting
between Type 1 and Type 2 reports, but they on their behalf) report their holdings in the
add a requirement for the auditor to obtain company when specific disclosure thresholds
a written assertion from the management of are exceeded.
the service provider about the fairness of the
description of their controls, the suitability of Prior to investment, foreign investors may
the controls design and, in respect of a Type be required to provide official documentation
2 report, the operating effectiveness of these confirming the investors nationality along with
controls. proof that it has necessary investment licences
and tax registration. Examples are provided
Though there are technical differences between from selected markets in the table opposite.
the the SSAE 16 and ISAE 3402 standards,
their structure and focus is in many ways
similar. It is unclear at this stage which of these
two standards will become most widely used.

Risk
Ownership Restrictions for Non-Resident Investors in Selected Markets
Country Ownership restrictions for non-resident investors
Foreign investment is highly regulated in brazil. There are upper aggregate limits
on the foreign ownership of investments in air transportation 20%, cable television
companies 49%, highway cargo transportation 20% and media 30%. In order to
obtain a 30% share of the voting capital of a media company, a foreign investor
must first create a corporation in brazil governed by brazilian law.
Foreign ownership is prohibited with respect to some industries: cabotage (domestic

transportation by water, port to port), lottery services, medical assistance or
health plans, nuclear mining and production, the transportation of valuables, oil
prospecting and refining.
Brazil
Prior government authorisation is needed for purchases of stock in the mineral
exploration, mining and hydroelectric, agriculture and forestry, maritime, river and
transport, and insurance sectors.
Foreign investor shareholding in financial institutions is restricted to the levels they

held at 5 October 1988. Additional purchase of stock must be deemed to be in the
interests of the brazilian government and, hence, requires the formal approval of
the central bank. International investment in non-voting shares of brazilian financial
institutions was authorised without restriction in 1997.
Foreign investors must secure government authorisation to invest in some sectors

(eg, defence, healthcare).
France A non-Eu residents stake in a company listed on the Premier, Second or nouveau
March may not exceed 20% without previous authorisation from the French
Finance Ministry.
There are some restrictions on foreign ownership. For example, foreigners can own
no more than 49.99% of Lufthansa registered shares. The Federal Cartel Office
must authorise transactions if a foreign owner is gaining a dominant market position
in a particular sector.
Germany
Federal Savings bonds (Bundesschatzbriefe) cannot be acquired by foreign
institutional investors, and Federal Finance bonds (Finanzierungsschatze) cannot be
acquired by foreign banks. Issuing companies may also reject purchases by foreign
institutional investors.
There are some restrictions on foreign investment. no single investor may hold
more than 5% of hKExs shares without approval from the Securities and Futures
Commission (SFC). Furthermore, no single non-resident investor may hold more
Hong
than 10% of a television broadcasting company. Aggregate foreign ownership in
Kong
the latter case is capped at 49% of a companys voting shares. If a foreign investor
wishes to own 2% or more of the companys voting rights, it must obtain prior
written approval from the broadcasting Authority.
Limits on overseas investments are set on airline, broadcasting, energy and

Japan telecommunications companies. Specific companies within these sectors may be
restricted.

Chapter Six
Country Ownership restrictions for non-resident investors
Foreign investors must obtain an Investment Registration Card (IRC) prior to

investing in South Korea. IRC holders at both individual and aggregate levels may
own 100% of the outstanding shares of most listed and unlisted Korean companies,
as well as short-term debt instruments.
The exceptions are in a small number of companies deemed to be of national impor-

tance, or in industries such as aviation, communications and broadcasting. Korea
South Electric Power is deemed of national importance and has aggregate limits of 40%
Korea and individual limits of 3%.
South Korea petroleum companies, airlines and mining stocks have foreign
ownership limits of 50%.
The aggregate limit for Korean telecommunication companies is 49%.
The individual limits for banks vary, depending on whether they are large national
city banks (4%) or regional banks (15%).
There are some restrictions on overseas investors. Some voting shares in industries
UK
of national importance have limits on foreign ownership.
Overseas investors are barred from direct investments in certain industries, eg,
US
communications, aviation, mining on federal land, energy and banking.
The author would like to thank Thomas Murray for their assistance in collating information contained
in this table.
6. Mitigating as per client asset rules, outlined in Chapter 5),

and any risks which may be generated through
Risk Through fraud or through a handling error, for example,
Reconciliation are identified and acted upon at an early stage.
A firm will reconcile on a trade-by-trade basis

Learning Objective 6.2.1 to ensure that trades placed, and entered in
Understand the risks associated with a failure the trading book, have been entered accurately
to reconcile the following: open trades; into the settlement system and comply with the
counterparty cash; corporate actions; cash records therein.
accounts; custodian holdings; client assets;
Once a trade has settled, and settlement
entitlements
confirmation has been received from
the custodian (or from the CSd/ICSd, as
Cash and securities reconciliation the process appropriate), it is necessary for the firm to
of matching internal balances, transactions, update internal records immediately with the
and holdings with those held at the custodian, details of securities and cash movements. For
prime broker or other external provider is example, if the firm has purchased securities,
key to the process of identifying and managing it must update and reconcile records to
risk outlined in this chapter and throughout the demonstrate that:
workbook.
1. the transaction is no longer shown as
Accurate and timely reconciliation is required outstanding in internal records (ie, it is no
to ensure that a firm is fully in control of assets longer recorded as an open trade) when
that it owns, or that are in its safe custody (ie, the trade has been settled;

Risk
2. securities are recorded as having been how exposure to the counterparty changes
received and added to the inventory of with time. time. Among other problems,
securities held in the relevant custodian failure to do so may tie up a companys
depot account; capital and liquidity unncessarily.
3. cash is recorded as having been paid and 6. Its cash account may fall overdrawn if a
has been deducted from the relevant cash securities transaction has settled but this
account (nostro account) at the custodian. has not been recorded accurately in the
companys internal records. Alternatively,
The objective of open trade reconciliation is to
an open trade reconciliation failure may
prove that trades recorded as open (ie, not yet
dictate that the seller fails to make available
settled) on the firms internal trading book are
securities required to complete trade
in reality open at the relevant custodian, and
settlement.
vice versa, and that they correspond with the
settlement instructions that the custodian is
holding. 6.1 Assets and Entitlements
Failure to do so may leave the firm susceptible In the context of the above, a firm must
to the following risks: maintain an accurate and up-to-date record of
its asset holdings and must reconcile its own
1. Its contractual commitment with its trading
internal records regularly with custodian depot
counterparties is not represented accurately;
accounts in order to identify:
2. It fails to make optimal use of its operational
resources: timely and effective reconciliation 1. unauthorised removal of securities from one
is vital to ensure that operations staff focus of the firms accounts at the custodian;
on the settlement of genuinely open trades 2. unexpected receipt of securities within one
and dedicate their time to investigating of the firms accounts at the custodian (eg,
genuine errors and exceptions; as a result of a corporate action, or an FoP
3. Its traders may trade off incorrect book transfer from another account that has not
positions or may open new positions when been recorded correctly);
previous trading positions are not complete. 3. errors in updating ownership records
Given restrictions on short selling in some subsequent to a completed transaction
markets, a firm may be subject to penalty if settlement.
a trader sells a stock that it does not legally
own; This process is crucial to support efficient
4. Its stock-lending department may lend out processing of dividends and interest payments.
securities that the firm does not legally own, An accurate record of ownership and location
or, alternatively, borrows securities to meet is required to ensure that income paid on
shortfalls that do not actually exist. Similarly, a security has been credited to the correct
repo trading requires accurate and current client cash account and that non-delivery of
information regarding open trades and entitlement can be investigated. Given that
settled securities and cash at each custodian. entitlement is contingent on who was the legal
The firm must ensure that securities listed owner of the security on record date, this
on internal records as being available for use demands an up-to-date picture of open trades
as collateral are genuinely available at the and settled securities.
custodian;
Similarly, accurate reconciliation is required to
5. Its credit risk department is unable to evaluate
support efficient processing of mandatory and
counterparty risk accurately. In doing so, it
voluntary corporate actions ensuring timely
must be able to view trades listed as open
delivery of entitlements and, in the case of
on internal records, confident that data is
voluntary corporate actions, that instructions
complete, timely and accurate. This demands
are conveyed to the company registrar before
an accurate record of counterparty cash
the deadline in order for the entitlement to
payments and collateral position to monitor

Chapter Six
be upheld; there is a risk of huge losses if a This process is also important to enable the
corporate action deadline is missed. accounting department to calculate profit
and loss information accurately; and, as we
As we noted in Chapter 4, in the uK a firm is
have noted, for the credit risk department
periodically required (usually at least every 25
to monitor counterparty cash payments and
business days) to perform a reconciliation of its
collateral positions in order to calculate its
record of safe custody investments for which it
credit exposure to each of its counterparties.
is accountable, but which it does not physically
hold itself. This reconciliation process must
be supported by appropriate statements or
electronic equivalent obtained from custodians
detailing client assets held in their safekeeping.
Similarly, for any dematerialised investments
that are not held through a custodian (eg, assets
held at a CSd), appropriate statements must
be obtained from the person who maintains the
record of legal entitlement.
Particular vigilance must be placed on

monitoring assets held overseas, which may be
held in safe custody by a subcustodian (acting
on behalf of a global custodian or prime broker)
or at the local CSd.
6.2 Cash Reconciliation

A firm will perform a comparable cash
reconciliation process for custodian nostro
accounts the cash equivalent of the
custodian depot position reconciliation. This
is to ensure that cash balances (reconciled
by nostro account, by currency) held on the
firms internal books and records agree with
equivalent balances held at each custodian.
This process is key to ensuring efficient cash

management. This (as we saw in Chapter
5) allows cash management staff to chase
up instances of fraud or mishandling at an
early stage. It is also necessary to ensure
that unanticipated debits do not cause an
account to fall overdrawn (thereby incurring
penalty charges) or for unanticipated cash
deliveries (including cash entitlements due
from corporate actions, for example) to be
sitting unnecessarily in accounts that do not
yield interest.

Risk
1. What is the bank for International Settlements and what functions does it serve?
2. What are the three pillars of the basel II Capital Accord?
3. What are the three categories of risk addressed by the basel Committee?
4. Identify three types of credit risk and why they occur.

Chapter Six
5. define operational risk and identify six factors that contribute to operational risk.
6. name seven elements that a global custodian will give attention to when conducting a risk
review on a subcustodian.
7. What is SEC Rule 17f-7 and what actions must be taken in order to comply with this rule?
8. What is a depository risk report and what does it contain?
9. What countermeasures are recommended in order to protect against safekeeping risk?

Risk
10. What is relationship risk? What are the principal sources of relationship risk experienced by a
global custodian?
11. What is an ISAE 3402 report?
12. What are the risks associated with failure to implement open trade reconciliation?

Chapter Six

Glossary
Glossary

Glossary
Glossary
The following is an alphabetical listing of terms Agency Trading

used in this workbook and in the industry Trading on behalf of clients in the capacity of
generally. an agent. Agency traders will typically not hold
securities positions on their own behalf (see
30/360 Proprietary Trading).
Calculation of accrued interest on bonds,
assuming that the year comprises 12 months of American Depositary Receipt (ADR)
30 days each used in the Eurobond market. A negotiable receipt issued by a uS bank or
trust company certifying that shares of a non-
AAF 01/06 uS company are held on deposit. The usual way
An independently audited record of the internal for the shares of non-uS companies to trade in
controls employed by investment services the uS.
companies, including investment custodians.
The AAF 01/06 reporting guidelines, issued by AMS
the Audit and Assurance Faculty of the Institute dealing system for the Stock Exchange of hong
of Chartered Accountants in England and Wales Kong (Automatic Order Matching and Execution
(ICAEW), replace FRAG 21 reporting guidelines. System).
Accrued Interest AMS/3

The amount of interest on a bond that has The hong Kong trading system.
accrued since the most recent interest payment.
Can be calculated using the 30/360 convention
Arbitrage
or the actual/actual convention.
The process of buying the same or similar assets
in one market and selling in another and then
Actively Managed Fund
profiting from the difference in price.
A fund whose composition is managed actively
by an investment manager in contrast to Index
Asset-Backed Security
Tracking Funds.
A security issued against a pool of loans
which may be credit card debt, student loans,
Actual Settlement Date Accounting
automobile loans, property loans or other types
Accounting procedures by which the proceeds of loan contract which is underpinned by cash
of a securities sale are credited to the sellers flows from the pool of underlying loans. These
account, and the costs of a securities purchase securities can be bought and sold by investors
debited from the buyers account, on the date just like any other tradeable securities.
that a trade actually settles (see Contractual
Settlement date Accounting).
Bearer Security
A security that has no facility for the issuer to
Agency Cross
register ownership of the security, such that the
An agency trade where the broker matches holder of the physical certificate (the bearer)
an order between two of its clients on its own is deemed to be legal owner. Income is typically
books. payable upon presentation of the coupon, which
may have been detached from the certificate.

Glossary
Beneficial Owner Broker-Dealer

The true owner of securities; the person entitled broker-dealers are licensed to trade on an
to the benefits of ownership. The beneficial agency basis on behalf of their investor clients
owner may or may not be the registered owner (see Agency Trading, broker), or on a proprietary
(see nominee). basis on their own behalf.
Bid Price Buying In

The price at which a dealer will buy securities. If the selling counterparty fails to deliver the
securities necessary to fulfil its settlement
Bilateral Netting obligations, the buyer (or sometimes the
exchange) may purchase the necessary
Offsetting trades between two counterparties
securities from an alternative source and pass
in the same security such that there is only one
any costs incurred onto the defaulting seller.
transfer of cash and securities. See netting.
This process is known as a buying in.
BOJ
Cash Funding
bank of Japan, which also runs bOJ-nET a yen
Process whereby the buyer ensures that there
payment system.
will be sufficient cash in place to pay for the
purchase of securities. Also called Positioning.
Bond
A marketable debt instrument issued by a
CASCADE
company or a government or government
Central Application for Settlement, Clearing
agency.
and depository Expansion. German securities
settlement system maintained by Clearstream.
Bonus Issue (Capitalisation)
The issuance of additional shares by a company
Central Clearing and Settlement System
to its shareholders, free of cost, at a fixed ratio
(CCASS)
to the original shares held by the shareholder.
Clearing system for the Stock Exchange of hong
Kong.
Book Entry Transfer
A system of transfer of ownership which
Central Securities Depository (CSD)
entails only a change in the computer record of
ownership. There is no movement of certificates An organisation that holds securities in either
and no new certificates are issued. immobilised or dematerialised form, thereby
enabling transactions to be processed by
book entry transfer. Also provides securities
Bridge
administration services.
An electronic link between Clearstream and
Euroclear bank, across which settlement of
Central Trade Manager (CTM)
trades is effected between the two ICSds.
An STP (straight-through processing) solution
provided by Omgeo.
Broker
brokers execute trades on an agency basis
Certificate
on behalf of their clients, finding buyers for
securities that investors wish to sell and vice See Share Certificate.
versa.
CLC
Clearing organisation and CSd for the Rio de
Janeiro Stock Exchange.

Glossary
Clean Price Continuous Net Settlement

Price of a bond excluding accrued interest. Extends multilateral netting to handle failed
trades brought forward see Multilateral
Clearing House netting, Trade date netting.
An organisation operating a clearing system.

Some exchanges act as their own clearing Contractual Settlement Date Accounting
house, some depositories act as clearing houses Accounting procedures by which the proceeds
and some clearing houses are entities separate of a securities sale are credited to the sellers
from exchanges or depositories. account, and the costs of a securities purchase
are debited from the buyers account for value
Clearing House Automated Payment System on settlement date (or an otherwise pre-agreed
(CHAPS) value date), even if trade settlement is not yet
final and irrevocable on that date (see Actual
Clearing system for sterling and euro payments
Settlement date Accounting).
between banks.
Convertible (Bond)
Clearing House Electronic Sub-Register
A bond that can be converted into shares of
System (CHESS)
the issuing company on terms specified at the
Equities settlement system maintained by the
time of issue. Called a convertible bond (Cb) or
Australian Stock Exchange.
Convertible unsecured Loan Stock (CuLS).
Clearing House Interbank Payments System

Corporate Action
(CHIPS)
Any action by an issuer of investments, or by
Clearing system for uS dollar payments between another party in relation to the issuer, affecting
banks in new york. an investors entitlement to investments or
benefits relating to those investments. This
Clearstream includes, but is not restricted to, takeovers,
CSd and clearing house for Eurobonds and rights issues, stock conversions, scrip dividends
German stock based in Luxembourg and and redemptions.
Frankfurt.
Counterparty
Client Money One of the parties to a transaction either the
Money received from or for a client in the course buyer or the seller.
of carrying on investment business.
Coupon
CLS The physical coupon detached from a bearer
Continuous Linked Settlement real-time global certificate in order to claim a dividend or interest
settlement system for the foreign exchange payments. The annual interest rate paid on
market. a bond. The coupon rate is expressed as a
percentage of the nominal (par) value.
Common Shares
Creation
See Equities.
Communications system operated by
Clearstream.
Confirmation
See Trade Confirmation.
CREST
The electronic settlement system operated by
Consolidation
Euroclear uK & Ireland, the central securities
The amalgamation of multiple shares in a
depository for uK and Irish securities.
company into a single share.

Glossary
Cumulative Preference Share Derivatives

If a company fails to pay a preference dividend, A financial contract between a buyer and a
the entitlement to the dividend will accumulate seller, which is derived from the future value of
and the arrears of the preference dividend must an underlying instrument. derivatives include
be paid before any ordinary dividend. There futures, options, forwards, swaps and CFds.
is no accumulation where a non-cumulative
preference share misses a dividend it is simply Deutsche Brse
lost.
The group that owns the Frankfurt Stock
Exchange and many other entities.
Custodian
An organisation that holds clients assets in safe Dirty Price
custody, ensures that they are not released
Price of a bond including accrued interest.
without proper authorisation, and ensures the
timely and accurate collection of dividends and
Distributable Profits
other benefits.
The profits available for payment to the
shareholders as a dividend. Will comprise
Debenture
realised profits.
Another name for a corporate bond usually
secured on assets of the company.
Dividend
A distribution of profits to the shareholders of a
Default Risk
company.
The risk that the issuer of a bond will be
unable to meet the payments of interest or the
Domestic Bond
repayment of the capital.
A bond issued in the domestic market by a
domestic issuer in the domestic currency.
Deferred Share
A class of share where the holder is only entitled
Double Tax Treaty
to a dividend if the ordinary shareholders have
been paid a specified minimum dividend. An arrangement between two countries, whereby
residents of one country who invest in securities
issued by issuers in another country will have
Delivery versus Payment (DVP)
withholding tax deducted at a lower rate than
Settlement where transfer of the security and
the standard rate payable by investors.
payment for that security occur simultaneously.
Entrepreneurs Relief
Dematerialised Shares
Relief granted under uK capital gains tax against
Shares that are recorded in a central computer
business assets. This allows individuals and
system and for which no certificates exist.
some trustees to claim relief on gains made
Transfer is by book Entry Transfer.
through the disposal of a company (or part of a
company) or the assets of a company after it has
Depository Trust and Clearing Corporation stopped trading. This relief applies for the years
(DTCC) 200809 onwards.
A clearing, settlement, CSd and information
service for uS securities. Exchange-Traded Fund
An instrument that tracks an index or a basket
Depository Trust Company (DTC) of assets, but is traded like a share on a stock
depository for uS equities. The uS CSd that is a exchange or Multilateral Trading Fund (MTF),
subsidiary of dTCC. thus experiencing price changes throughout the
day as it is bought and sold.

Glossary
Equities Federal Home Loan Mortgage Corporation

Shares in a company that are entitled to the (Freddie Mac)
balance of profits and assets after all prior A government-sponsored organisation in the uS
charges. Also called Ordinary Shares or Common that purchases eligible residential mortgages
Shares. from mortgage lenders, packages these into new
securities and sells these to investors in the open
EUCLID market. The funds generated through the sale of
Communications system operated by Euroclear. these securities is utilised to support further
mortgage lending. Fannie Mae and Freddie
Mac have similar charters, regulatory structure
EUREX
and Congressional mandate, competing with
German-Swiss derivatives exchange created by each other in buying residential loans in the
the merger of the German (dTb) and Swiss secondary mortgage market.
(SOFFEX) exchanges. The parent of Eurex
Clearing, the CCP.
Federal Reserve Book Entry System
CSd for uS government securities.
Eurobond
A generic name for bonds issued outside of
Foreign Account Tax Compliance Act
the country of the issuer and denominated in a
(FATCA)
foreign currency.
A uS act requiring uS taxpayers holding foreign
financial assets that exceed given thresholds
Euroclear Bank
to report those assets to the IRS. Also, FATCA
International central securities depository (ICSd) requires foreign financial institutions to report
owned by Euroclear group, based in brussels. to the IRS information about financial accounts
held by uS taxpayers or by foreign entities in
Euroclear France which uS taxpayers hold a substantial ownership
CSd for French corporate securities and OATs. interest.
Euroclear UK & Ireland Limited Fixed Interest Securities

Formally CRESTCo, the CSd within the Euroclear A general name for bonds paying a fixed rate of
group that operates the CREST electronic interest.
settlement system for uK and Irish securities.
Fixed Settlement
Euronext All trades within a specified period, called a
See nySE Euronext. dealing period or period, are settled on one fixed
day, a specified number of days after the end of
Faster Payments the account.
A cash payments system to handle processing of

internet, telephone and standing order payments Flat Yield
in the uK market. The yield of a bond, calculated as
Annual coupon
x 100%
Federal National Mortgage Association Current market price
(Fannie Mae)
Also called the Income yield.
A government-sponsored organisation in the uS
that purchases eligible mortgages from lenders,
Floating-Rate Note (FRN)
packages these into new securities and sells
these to investors, using the proceeds to provide A bond whose coupon is re-fixed periodically in
further funding for home mortgages. line with a benchmark interest rate.

Glossary
Foreign Bond Globally Registered Share

A bond issued in the domestic market by a A share thats quoted on more than one exchange.
foreign issuer in the domestic currency.
Government Securities Clearing Corporation
Forward Contract (GSCC)
A bilateral contract where one counterparty Clearing organisation for uS Treasury securities.
agrees to buy a specified quantity of a financial
instrument or commodity from the other Gross Income
counterparty at a specified price, with delivery to
Total income before adjustments, deductions, or
take place on a specified date in the future. The
exemptions.
counterparties cannot close out their positions
by trading on an exchange.
Gross Redemption Yield
Forward Rate (FX) The yield on a bond that combines the income
together with any profit or loss arising on
A foreign exchange rate for delivery at an agreed
maturity, expressed as a percentage of the
future date.
market price of the bond. Also called yield to
Maturity.
Gilt-Edged Security
uK government bond. Gross Settlement
Each trade is settled separately from any other.
Gilt Strip There is no netting. Also called trade-for-trade
An entitlement to a stream of income payments settlement.
from a gilt security, without owning or having
exposure to fluctuations in price of the underlying Group of 30
gilt. Gilt strips originated from the practice of
Private international organisation aiming to
separating coupons from the underlying bond
deepen understanding of international economic
and trading them separately. hence, the holder
and financial issues.
could own the coupon (or strip) and be entitled
to the coupon payment, without owning the
underlying security. Hedging
The use of securities and derivatives to protect a
Giovannini Barriers portfolio against an adverse movement in value.
Also can be applied to one or more securities.
Fifteen barriers identified by the Giovannini
Group in its 2001 Giovannini Report to the
efficient provision of cross-border clearing and Herstatt Risk
settlement services within the Eu. The risk on an FX transaction where there is
a non-simultaneous exchange of the different
Global Depositary Receipt (GDR) currencies.
A negotiable receipt issued by a depository bank

certifying that shares of a foreign company that High Frequency Trading
are listed and traded on a foreign exchange Programme trading strategies that utilise
(or a number of foreign exchanges) are held powerful computers and high-speed fibre optic
on deposit. The GdR mirrors the shares of connections to trade multiple orders in a short
a foreign company, but can be traded in an timeframe.
investors domestic market, in the investors
domestic currency, and according to the financial High Yield Bond
regulations operating in the investors domestic
bond with a low credit rating and a high yield.
market. See also American depositary Receipt.

Glossary
Hong Kong Clearing International Securities Identification

The clearing organisation for hong Kong Number (ISIN)
operates CCASS. A system of unique code numbers developed by
the International Standards Organisation (ISO,
Immobilised Shares see below) for use worldwide for identifying
Securities held by a central depository, which securities.
records changes of ownership by book entry
transfer. International Standards Organisation (ISO)
ISO promotes consistency of standards around
Income Yield the globe relating to goods and services,
See Flat yield. including the financial services industry.
Index-Linked Bond International Swaps and Derivatives

Association (ISDA)
bond whose interest payments and redemption
value are linked to an index such as the retail The global trade association for OTC derivatives.
price index. See also Master Agreements.
Index-Tracking Fund In-the-Money (ITM)
A fund that is run by a computer algorithm to An option or warrant with intrinsic value.
track a particular set of stocks.
ISAE 3402
Initial Public Offering (IPO) An internationally recognised auditing standard
This first issue that makes shares available for developed by the International Auditing and
trading. Assurance Standards board (IAASb) of the
International Federation of Accountants (IFAC)
that succeeds the earlier SAS 70 standard. Like
Institutional Investor
a AAF 01/06 (which succeeds FRAG21) report
An institution that is usually investing money on in the uK, a ISAE 3402 report in the uS verifies
behalf of others. Examples are mutual funds and that a service organisation has had its control
pension funds. activities reviewed by an independent auditing
firm.
Inter-Dealer Broker
A firm that acts as an intermediary between Japan Securities Clearing Corporation
market-maker firms, meeting the latters needs (JSCC)
for securities that they need to support their
Clearing organisation in Japan. CSd and clearing
own trading requirements. An Idb also provides
organisation for the Korean Stock Exchange.
anonymity.
Key Performance Indicators (KPIs)

Interim Dividend
A set of indicators employed by a firm to
dividend paid part-way through a year in advance
measure its level of progress towards specified
of the final dividend.
organisational goals (eg, level of assets under
management, return on investment, percentage
International Foreign Exchange Master of trades settled on settlement date, percentage
Agreement (IFEMA) of customer queries resolved within one hour).
A legal agreement used to define key terms and KPIs are typically used to establish quantifiable
obligations in a foreign exchange transaction. strategic goals to drive improvements in
Master agreements are designed to ensure performance.
that parties to a foreign exchange transaction
specify key transaction information in a full and
standardised way.

Glossary
Key Risk Indicators (KRIs) Market Identifier Code (MIC)

A set of indicators that provide early warning of A unique identification code used to identify
how well or badly a firm is managing potential securities trading exchanges, regulated and
operational hazards such as technology and non-regulated trading markets.
systems failure, legal risk, trade settlement
errors, fraud or labour militancy. Market Maker
A securities trading firm that will buy and sell
Liquidation specified securities at published bid and offer
The formal process of winding down a company. prices and sizes.
The assets are sold, the liabilities and preference
shares are repaid, and any balance of assets is Mark to Market
paid to the ordinary shareholders.
Revaluation of a financial instrument to reflect
the current market price or an estimate of the
Liquidity current market price if the market is illiquid. This
The ease with which shares can be converted is used, for example, for recalculating the value
into cash at close to fair value, or market value of collateral at current market valuations.
ie, the ease with which they can be sold,
or cashed in, and the speed with which the Master Agreement
proceeds are received.
The ISdA Master Agreement is a legal agreement
used to define key terms and obligations in
Listed Company an over-the-counter derivative transaction.
Company which has been admitted to listing on These ISdA Masters are designed to ensure
a stock exchange and whose shares can then be that parties to an OTC derivative transaction
traded on that exchange. specify key transaction information in a full and
standardised way.
Loan Stock
The IFEMA (International Foreign Exchange
Another name for a corporate bond usually Master Agreement) is a legal agreement used
unsecured. to define key terms and obligations in a foreign
exchange transaction. These master agreements
Margin are designed to ensure that parties to a foreign
Collateral paid to the clearing house or General exchange transaction specify key transaction
Clearing Member (GCM) by the counterparties information in a full and standardised way.
to a transaction to guarantee their positions
against loss. Can also be paid over bilaterally Master Custody
between counterparties. A comprehensive custody service offered to
investor clients holding assets with multiple
Initial margin is paid when a position is first
investment managers and across multiple
opened.
locations. This service combines the benefits of
Variation margin is paid or withdrawn daily as, global custody and domestic custody, offering
respectively, daily losses and profits are made. the investor consolidated reporting for their
worldwide investments.
Market Capitalisation
The market capitalisation of a company is the Maturity
market price per share multiplied by the number date upon which the principal of a bond or
of shares in issue. The market capitalisation other securities instrument becomes due and
of a stock market is the sum of the market repayable.
capitalisations of all the companies quoted on
the exchange.

Glossary
MiFID Nominal Value of a Share

The Markets in Financial Instruments directive The minimum price at which a share can be
is the Eu directive that governs investment issued. Also called Par Value.
business within the European Economic Area.
Nominee
Money Markets A person registered as the holder of a security
The market in debt instruments with a maturity who is holding it in safe custody on behalf of
of less than one year. another person, usually a limited company that
is a non-trading subsidiary of a parent company.
Mortgage-Backed Security
A type of asset-backed security that uses a Non-Cumulative Preference Share
single mortgage, or a pool of mortgage loans, as If the company fails to pay a preference dividend,
collateral. Investors receive payments derived the entitlement to the dividend is simply lost.
from the interest and principal of the underlying There is no accumulation.
mortgage loans.
Nostro Account
Multilateral Netting One banks foreign currency account with
Trades between several counterparties in another bank.
the same security are netted such that each
counterparty makes only one transfer of cash NYSE Euronext
or securities to another party or to a central
Exchange created from the merger of the Paris,
clearing system. handles only transactions due
Amsterdam, brussels and Lisbon exchanges.
for settlement on the same day.
now owned by the nySE Euronext group.
Multilateral Trading Facility (MTF)

OASYS
Registered non-exchange trading venues
Trade confirmation system for uS brokers
which bring together purchasers and sellers
operated by Thomson Financial Services.
of securities. Subscribers can post orders into
the system and these will be communicated
Offer Price
anonymously (typically electronically, via an
electronic communication network, ECn) for The price at which a dealer will sell securities
other subscribers to view. also called the ask price.
National Securities Clearing Corporation OMGEO

(NSCC) Joint venture between Thomson Financial
Clearing organisation for uS shares maintained Services and the dTCC providing trade
by the dTCC. confirmation services.
Netting One-Sided Confirmation
Trading partners offset their positions, thereby Only one party to the transaction, usually the
reducing the number of positions for settlement. broker or dealer, submits trade details to a
netting can be bilateral, Multilateral or centralised trade confirmation system. The other
Continuous net Settlement. counterparty merely affirms or rejects the trade.
Nominal Value of a Bond On-Exchange
The value at which the capital, or principal, of a dealing of securities through a regulated
bond will be redeemed by the issuer. Also called investment exchange.
Par Value.

Glossary
Open Outcry Market Premium

Method of dealing face-to-face using verbal bids The amount paid for a rights issue, or a warrant
and offers on the floor of an exchange. or other option.
Option Pre-Settlement
A contract that gives the holder the right but The term for the checks and procedures
not the obligation to buy (or to sell) a specified undertaken immediately after execution of a
quantity of a specified financial instrument at trade prior to settlement.
a specified price called the exercise price
during or at the end of a specified period. A call Primary Market
option is an option providing the holder with a
The issuance of new securities to raise funds.
right but not an obligation to buy the underlying
asset at a specified price within a specified time
Prime Broker
period A put option is an option providing a right
but not an obligation to sell the underlying asset A one-stop clearing and custody service,
for a specified price on or before a specified commonly used by hedge funds.
date.
Private Investor
Order-Driven Market An individual who holds securities to realise
A stock market where brokers acting on behalf investment returns for his or her own benefit.
of clients match trades with each other either on
the trading floor of the exchange or through a Proprietary Trading
central computer system. A trader that buys, sells and holds securities to
make profit on its own account, not acting as an
Ordinary Shares agent for investors.
See Equity Shares.
Quote-Driven Market
Out-of-the-Money A stock market where dealing is carried out with
An option or warrant with no intrinsic value. market-makers.
Over-the-Counter (OTC) Real-Time Gross Settlement (RTGS)

The dealing of securities outside of an organised Gross settlement system where trades are
exchange or MTF. settled continuously through the processing day.
Par Value Reconciliation

See nominal Value. The comparison of a persons records of cash and
securities positions with records held by another
party and the investigation and resolution of any
Perpetual Bond
discrepancies between the two sets of records.
A bond that has no redemption date.
Record Date
Positioning
For equities, the date at which shareholders
Positioning assets for settlement see Cash
on the issuers register are identified for the
Funding.
purpose of distributing dividends and other
shareholder entitlements.
Preference Shares
Shares that are entitled to profits and assets For fixed income securities, the date at which
in priority to the ordinary shares. Also called the owner of the security is identified for receipt
preferred stock. of income payments or redemption monies.

Glossary
Redemption Selling Out

The repayment of the capital of a bond. Process whereby, on failure by the purchaser
to pay for securities, the seller sells to an
Registered Security alternative purchaser and any additional costs
are passed on to the defaulting purchaser.
A security where ownership is recorded on a
register maintained by the issuer or registrar.
Settlement
Registrar The process whereby cash and legal ownership

of a security are exchanged in order to fulfil
The official with responsibility for maintaining
the contractual obligations of buying and selling
the share register of a company.
counterparties.
Repo
Share
Repurchase agreements are collateralised
The unit of ownership of a company.
lending transactions whereby securities are sold
with the agreement to buy them back. These
represent a means of borrowing stock with cash Share Capital
provided as collateral, or a means of borrowing The figure in the balance sheet representing
money with stock provided as collateral. the nominal value of the shares that have been
issued.
Rights Issue
A new issue of shares offered to the existing Share Certificate
shareholders in proportion to their existing A certificate issued by a company to a
holdings. shareholder stating either that a named person
is the registered owner or that the bearer is the
Rolling Settlement owner.
A trade is settled a specified number of days

after the date of the trade. usually denoted as Shareholder
T+n, where n is the number of business days. The owner of a share in a company the part-
Thus T+3 means settlement three business days owner of a company.
after the trade day.
Shareholders Rights
Secondary Market The legal rights of shareholders, such as the
The trading of existing securities on an exchange right to vote at meetings.
or MTF.
Short Selling
Secured Bond Selling of securities not owned by the seller.
A bond where the company has pledged assets
to back the bond. In default, the assets are then Single Settlement Engine (SSE)
available to repay the bond.
Euroclears project to consolidate securities
and cash positioning functions, and the booking
Securities Lending sub-systems, of all Euroclear Group entities,
Process by which a shareholder or bondholder embracing belgium, France, Ireland, the
lends securities to a borrower in return for a fee, netherlands and the uK markets, along with
in order to enhance the lenders return on its Euroclear bank.
investment.
SMARTS
dealing system for the Korea Stock Exchange.

Glossary
Society for Worldwide Interbank Financial Stock Split

Telecommunications (SWIFT) A split of a share into a number of shares with a
Secure electronic communications network smaller nominal value.
between financial service providers.
Straight-Through Processing
Spot Rate (FX) The automated passage of a financial transaction
A foreign exchange rate for delivery in two from execution to settlement without manual
business days. intervention.
Spread Subordinated Loan Stock

The difference between the bid and offer prices. A special type of loan stock that ranks after
unsecured creditors but before shareholders.
SSAE 16
An internationally recognised auditing standard Subscription
developed by the American Institute of Certified The process of an investor paying for, and taking
Public Accountants (AICPA) that succeeds the up, a new issue of shares.
earlier SAS 70 standard. Like an AAF 01/06
report in the uK, an SSAE 16 report in the uS Substantial Shareholder Reporting Rules
verifies that a service organisation has had its Rules that empower companies to inquire into
control activities reviewed by an independent ownership of their shares and that require
auditing firm. shareholders to inform the company when their
ownership moves above, or below, a specified
Stock Exchange percentage of the overall issued share capital in
An organisation that provides facilities for that company.
companies and governments to issue securities
and for those securities to be traded among Systematic Internaliser (SI)
investors. An investment firm that, on an organised,
frequent and systematic basis, deals on its own
Stock Exchange Automated Trading System trading account by executing clients orders
(SEATS) outside a regulated market or a multilateral
The equities trading platform of the Australian trading facility.
Stock Exchange.
Systemic Risk
Stock Exchange Daily Official List (SEDOL) The risk that failure of a participant in a financial
A daily published list of values for uK shares, unit market to meet its obligations will cause other
trusts, investment trusts and insurance-linked participants or financial institutions to fail to
investment products traded on the London meet their respective obligations when required.
Stock Exchange. A SEdOL number is a securities Such a failure may lead to liquidity constraints or
identifier issued by the London Stock Exchange credit difficulties that may threaten the overall
or Irish Stock Exchange to provide unique stability of the financial market.
identification of instruments traded in the uK,
Ireland and on a global basis. TARGET2
TARGET2 is the RTGS system for the euro,
Stock Exchange Trading Service (SETS) offered by the Eurosystem. It is used for the
Stock Exchange Trading Service for the London settlement of central bank operations, large-
Stock Exchange. value euro interbank transfers as well as other
euro payments.

Glossary
TARGET2-Securities (T2S) Warrant

A proposed centralised settlement platform An instrument issued by a company that gives
for the settlement of euro-denominated and the holder the right but not the obligation to
some non-euro securities. built and operated subscribe for a specific number of shares in the
by the Eurosystem, CSds will have the option of company at a specific price (called the exercise
outsourcing their securities settlement activity price) during a specific period.
to the T2S platform. This is currently scheduled
to be released for the first wave of CSds in Winding Up
September 2014, with all participating CSds due
See Liquidation.
to migrate their settlement activity by 2016; this
may be subject to change.
Withholding Tax
Tax withheld by the payer of interest or a
Trade Date Netting
dividend and paid over to the Revenue Authority
Multilateral netting, resulting in settlement of
for the country of residence of the payer on
a single netted cash balance and a single
behalf of the recipient.
netted securities balance calculated at close
of business on trade date. This settlement
Xetra
of cash and securities relates only to trades
presented for netting on that day, and will not dealing system of the deutsche brse, Austria,
include failed trades from previous days that bulgaria and Ireland (ISE Xetra).
have been brought forward (see Continuous net
Settlement). Trade Confirmation
Formal agreement of the details of a trade by the
Trade for Trade Settlement two counterparties prior to instructions being
See Gross Settlement. given for settlement.
Trade Matching Yield to Maturity

The matching by a clearing house of the trade See Gross Redemption yield.
details submitted by the two counterparties to a
trade. Often combined with trade confirmation. Zero Coupon Bond
A bond which pays no coupon but which will be
Traded Option redeemed at a premium to the issue price.
A standardised option that is traded on an
organised exchange.
TRAX
Trade confirmation system for the Euro-markets
operated by ICMA.
Treasury Bill
Money market instrument issued with a life of
less than one year issued by, for example, the
uS and uK governments.
Underwriter
Investment bank or other financial institution
that will guarantee to buy unsold shares following
an IPO or rights issue.

Glossary
Abbreviations
AbS Asset-backed security dVP delivery versus Payment
AdR American depositary Receipt ESES Euroclear Settlement of Euronext-

zone Securities the settlement
AMEX American Stock Exchange system employed to provide
AMS Automatic Order Matching and delivery-versus-payment book
Execution System entry for a wide range of securities
in the belgian, French and dutch
ASdA Actual Settlement date Accounting markets
ASX Australian Stock Exchange ETF Exchange-traded fund
bIS bank for International Settlements ETT Electronic transfer of title
bOJ bank of Japan EuRIbOR Europe Interbank Offered Rate
bOVESPA So Paulo Stock Exchange FEd Federal Reserve bank
bRL brazilian Real FICC Fixed Income Clearing Corporation
bTAn bon Taux Annuel normalis FRn Floating-rate note

French government Treasury notes,
typically with two- or five-year FX Foreign exchange
maturity GdR Global depositary Receipt
CASCAdE Central Application for Settlement, ICMA International Capital Market
Clearing and depository Expansion Association
CCASS Central Clearing and Settlement IFEMA International Foreign Exchange
System Master Agreement
CdS Canadian depository for Securities IFRS International Financial Reporting
ChAPS Clearing house Automated Payment Standards
System IPO Initial public offering
ChESS Clearing house Electronic Sub- IOSCO International Organization of
Register System Securities Commissions
ChIPS Clearing house Interbank Payments ISdA International Swaps and
System derivatives Association
CLS Continuous Linked Settlement ISITC International Securities
CSd Central Securities depository Association for Institutional Trade
Communication
CSdA Contractual Settlement date
Accounting ISd Intended Settlement date
CTM Central Trade Manager ISIn International Securities

Identification number
dTCC depository Trust and Clearing
Corporation ISO International Standards
Organisation
dTC depository Trust Company

Glossary
ISSA International Securities Services

Association
JASdEC Japan Securities depository Centre

the CSd for Japan
JSCC Japan Securities Clearing

Corporation
JGb Japanese government bond
KPIs Key performance indicators
KSE Korea Securities depository
LIbOR London Interbank Offered Rate
MbS Mortgage-backed security
MiFId Markets in Financial Instruments

directive
nASdAQ national Association of Securities

dealers Automated Quotation
system
nSCC national Securities Clearing

Corporation
OTC Over-the-Counter
REIT Real Estate Investment Trust
RITS Reserve bank Transfer System

CSd for Australian Government
bonds
RTGS Real-time gross settlement
SdRT Stamp duty Reserve Tax
SEATS Stock Exchange Automated Trading

System
SEdOL Stock Exchange daily Official List
SEhK Stock Exchange of hong Kong
SETS Stock Exchange Electronic Trading

Service
SSE Single settlement engine
STP Straight-through processing
T2S TARGET2-Securities
TSE Tokyo Stock Exchange or Toronto

Stock Exchange

Glossary

Multiple Choice Questions

The following questions have been compiled to reflect as closely as possible the standard you will
experience in your examination. Please note, however, they are not the CISI examination questions
themselves.
Tick one answer for each question. When you have completed all questions, refer to the end of this
section for the answers.
1. deferred shares normally differ from conventional ordinary shares in which key area?
A. Voting rights
b. dividend payments
C. Tax treatment
d. Shareholder perks
2. What would an American depositary Receipt (AdR) holder expect to receive when the issuing
company makes a rights issue?
A. Shares in the underlying security

b. nothing
C. Proceeds of the sale of the rights
d. Revaluation of the AdR
3. An investor buys 100 call warrants for a premium of 0.40 each and a strike price of 1.00.
What will the share price have to reach for the investor to make a profit of 50?
A. 50.40
b. 1.90
C. 1.40
d. 0.90
4. A buyer was due to pay 650,000 for shares on 1 July. due to a computer processing error his
payment arrived four days late. The seller incurred a 6% overdraft and discovered this on 28
July. The seller submitted a claim for interest on 2 August. under ISITC guidelines, what is the
likely amount of settlement of the sterling interest claim?
A. nil
b. 254.82
C. 427.40
d. 433.33

5. What is short selling?
A. A transaction where a broker delivers insufficient securities to settle a trade

b. A situation where an investor delivers insufficient cash to settle a trade
C. A strategy employed by an investor in anticipation that the market price might fall
d. A term that describes all trading in covered warrants
6. Which OnE of the following activities is nOT regarded as a custody service?
A. Tax reclamation
b. dividend collection reporting
C. Safekeeping services
d. Funds transference on trade settlement
7. Which of the following bEST describes the role of an agency trader?
A. The lead client when creating an initial public offering of shares

b. The supervisor of a group of junior traders
C. buys and sells shares on behalf of a client
d. buys and sells shares on behalf of his firm
8. A foreign exchange rate between currencies which is determined via the two currencies
respective dollar exchange rates is known as a:
A. bridge rate
b. Cross rate
C. Spot rate
d. Split rate
9. What role does the CMu play regarding hong Kong securities?
A. It acts as a clearing house

b. It acts as depository for corporate and government bonds
C. It acts as CSd for equities and corporate bonds
d. It acts as registrar for equities and warrants
10. One of the generally recognised advantages of rolling settlement, compared to fixed date
settlement, is:
A. A reduction in settlement costs

b. A smoothing of settlement activities
C. An increase in regulatory protection
d. An improvement in the tax treatment

11. A eurobond is:
A. A floating-rate note denominated in euros

b. A government bond issued by the European Central bank
C. A local bond issued in a European country
d. An international bond issued in markets outside the issuers domestic market
12. What is the main purpose of a Request for Proposal in the context of an institutional
investors custodianship needs?
A. It serves as a draft agreement between the custodian and the institution

b. It provides an initial indication of a potential custodians capabilities
C. It enables a consortium of custodians to be established
d. It operates as a back-up should the chosen custodian default
13. Which of the following pairs correctly matches a country and its central securities depository
for equities?
A. uK and SETS
b. France and LCh.Clearnet
C. Germany and Euroclear
d. Japan and JASdEC
14. Typically an ICSd is established for what purpose?
A. As a recognised clearning house for CCP-related activity

b. To provide settlement and custody facilities over a range of security types and currencies
C. As a clearing agent for the derivatives markets
d. As an inter-dealer agent for the securities financing industry
15. Which OnE of the following is the best description of the Electronic Transfer of Title (ETT)
facility offered by the CREST system?
A. The facility whereby all CREST eligible securities trades are instantly registered at the point of
settlement following the acknowledgment of an actioned RuR
b. The function of the positioning of securities post-matching but pre-settlement
C. The instant legal registration of uK securities upon settlement
d. The system that ensures full intra-bank cash settlement happens at the point of trade
settlement
16. What is the settlement period for uK Gilts?
A. T+0
b. T+1
C. T+2
d. T+3

17. TARGET2 is a payments system for which currency?
A. GbP
b. uSd
C. ChF
d. EuR
18. What is the claims threshold under ISITC guidelines?
A. uS$100
b. uS$300
C. uS$500
d. uS$1,000
19. The primary difference between bilateral netting and multilateral netting relates to:
A. Whether fixed date settlement or rolling settlement is used

b. Whether the trades are on-exchange or off-exchange
C. The number of counterparties involved
d. The number of trades involved
20. A firm has chosen a new custodian to hold its safe custody investments. To comply with the
regulations, how often must it carry out a risk assessment on this custodian?
E. A minimum of once every six months

F. A minimum of once every year
G. A minimum of once every two years
h. no prescribed minimum; it depends on circumstances
21. under the Substantial Shareholder Reporting rules, a company is empowered to:
A. List its shares on a recognised exchange

b. Initiate an investigation into ownership of its shares
C. List its shares on exchanges outside of the uK
d. Enter into a merger with another uK-registered company
22. If a broking firm is managing a private investors portfolio and registers the clients shares
into a nominee company name, the beneficial owner and the legal owner of the shares will be:
A. The nominee company in both cases

b. The client in both cases
C. The nominee company and the client respectively
d. The client and the nominee company respectively

23. An investment manager has a portfolio of invested assets with a market value of uS$50
million. If the custodian charges an annual custody fee at 20 basis points, the annual charge
will be:
A. uS$10,000
b. uS$20,000
C. u$100,000
d. uS$1,000,000
24. A sweep account allows investors to:
A. Transfer uninvested funds into overnight investments

b. Secure special protection against money laundering
C. Meet compliance requirements under Sarbanes-Oxley legislation
d. Minimise foreign exchange transaction costs on cross-border investments
25. What is the electronic method by which Euroclear bank communicates with Clearstream
banking?
A. bridge settlement
b. ESES
C. CreationOnline
d. Link up Markets
26. What is marking to market?
A. Prioritising a block of trades for immediate execution by a broker

b. Processing individual trades for prompt settlement
C. Fixing the price of a security at a pre-agreed level
d. Revaluing a securities position to its current market price
27. If a net dividend of 10p per share is paid by a uK company, what would be the value of the
dividend after all tax liabilities for a uK basic rate taxpayer?
A. 7.5p
b. 7.8p
C. 9p
d. 10p

28. Withholding tax is tax deducted:
A. Against revenues from safekeeping activities conducted by custodians on behalf of foreign

investor clients
b. In respect of capital gains generated by investors on their investment activity
C. As a deposit by a jurisdictions tax authorities against potential non-payment of tax by a
foreign investor
d. In the issuers country of residence on income paid by issuers to investors
29. Operational risk is bEST defined as the risk:
A. That an issuer may default on its obligation to meet interest payments and to redeem
principal on redemption date
b. Of loss resulting from inadequate or failed internal processes, people and systems, or from
external events
C. Of loss of earnings or capital arising from changes in the value of financial instruments
d. Of material loss, liability or reputational damage resulting from failure to comply with the
requirements of financial services regulators
30. An investor buys a gilt for 8,200 and sells it for 9,600. If this investor is a higher rate
taxpayer who has exhausted his annual capital gains tax allowance, how much capital gains
tax (if any) will be charged on this gain?
A. nothing
b. 140
C. 280
d. 560
31. If the holder of a convertible preference share takes up the conversion option, what type of
share will it usually become?
A. deferred share
b. A share
C. b share
d. Ordinary share
32. Which of the following correctly describes a benefit extended by the process of listing
securities?
A. The issuing house will specify a minimum price for the share offer and invite offers from
investors at prices of their own choosing
b. Companies will be subject to detailed scrutiny designed to ensure that investors are buying
securities in a bona fide company
C. unsold stock will be retained by the debt Management Office and may be offered for sale at
a later date
d. The issuing company will sell shares directly to an investment bank or another sponsor,
which will then sell shares to its preferred clients

33. The first two characters in an ISIn represent:
A. year of issuance
b. Check code: confirming validity
C. Country code
d. Securities type: whether an equity, bond, mutual fund, ETF
34. A covered warrant is issued:
A. by a company over its own underlying shares

b. by a third party over a single asset or a range of possible underlying assets
C. At a specified minimum price and investors are invited to submit offers at prices of their own
choosing
d. by government to applicants whose competitive bids are at or above a specified minimum
price
35. A multilateral trading facility is:
A. A regulated stock exchange that supports trading from broker members from multiple
jurisdictions
b. A registered non-exchange trading venue that brings together buyers and sellers of securities
C. A share trading facility for the sole purpose of supporting trading of small cap equities
d. An order-driven market where investors can route orders to the platform electronically or
via a floor broker
36. Which of the following statements is TRuE regarding the execution of programme trades?
A. It may be difficult to obtain all the required shares on the same day
b. The operational risk and credit risk on programme trades will typically be lower than for
single-security transactions
C. Time from trade execution to trade confirmation will typically be shorter than for trades
executed individually
d. The trades must be settled at an ICSd
37. In their capacity as fiduciaries, pension fund trustees are required to:
A. Manage sub-custodian selection for pension fund assets held in overseas markets
b. Ensure that withholding tax agreements are in place with tax authorities in markets in which
the pension fund invests
C. Ensure that pension fund assets are at all times sufficient to cover scheme liabilities
d. Monitor and review the tasks that they delegate to custodians to ensure that these are
discharged effectively

38. Which OnE of the following systems operates on a multilateral netting basis for the transfer of
uS dollar payments?
A. ChAPS
b. ChIPS
C. Fedwire
d. TARGET
39. Contractual settlement date accounting works to the advantage of the seller because:
A. The seller will receive funds on the original settlement date, even if settlement is delayed
b. The seller will receive due funds three days after the proposed settlement date
C. delivery of requisite securities on settlement date is guaranteed
d. Settlement will take place free of payment
40. due to internal problems, a firm is unable to carry out its periodic reconciliation of safe
custody investments held with a nominee company within the required period. What action
therefore must it urgently take?
A. Obtain a written mandate from all the affected clients

b. Obtain a written mandate from the nominee company
C. notify hMRC
d. notify the financial regulator
41. When securities are placed on loan, legal title to the securities lies with:
A. The lender
b. The borrower
C. The securities lending agent
d. The local central securities depository
42. Why might a cash lender enter into a repo agreement, rather than lending on an unsecured
basis?
A. It will typically earn a higher premium through repo agreements than through unsecured
lending
b. unsecured lending is illegal in many European jurisdictions
C. There is no possibility that the cash borrower may default on its obligations when a repo
agreement is in place
d. Repo agreements afford security by ensuring that the lender will inherit collateral if the
borrowing counterparty defaults on its obligations

43. An investor buys 2,500 shares in a company at 9.00 per share. She sells the same number
of shares later in the tax year for 10.25 per share. She incurs brokerage costs of 20.00
on buying the shares, and a further 20.00 on their sale. The amount potentially subject to
capital gains tax will therefore be:
A. 3,085
b. 3,105
C. 3,185
d. 25,625
44. Which OnE of the following is considered to be a prime benefit of using a multi-currency cash
account?
A. Faster dividend processing for multi-jurisdictional portfolios

b. More advantageous deposit rates
C. A reduction in the number of FX transactions
d. A bundled package of multi-currency accounting saves costs
45. A bonus issue is:
A. A release of new shares to existing shareholders provided free of cost

b. A cash dividend paid to a companys ordinary shareholders
C. A cash dividend paid to a companys preference shareholders
d. A decision to convert a single company share into a larger number of shares
46. An investor holds 5,000 shares in a company priced at 8.50 per share. The company
subsequently makes a one for five share rights issue at 6.50. nil paid rights on the share
issue will therefore be worth:
A. 1.67
b. 2.00
C. 6.50
d. 8.17
47. One of the main reasons why custodians sometimes adopt a pooling approach to client
accounts is to:
A. Reduce taxation liabilities

b. Offset the credit risk
C. benefit from arbitrage opportunities
d. Obtain more advantageous deposit rates

48. Credit risk is the risk:
A. Of loss of earnings or capital arising from changes in the value of financial instrument
b. Of loss resulting from inadequate or failed internal processes, people and systems, or from
external events
C. That a counterparty will fail to meet its obligations in accordance with agreed terms
d. That an act conducted by a firm or one of its employees damages the reputation of the firm
49. Which OnE of the following is not a reason for failed settlement?
A. A counterparty may have gone into liquidation

b. The purchaser may have insufficient cash
C. The purchaser may have initiated a buy-in of securities
d. A corporate action may be in motion
50. Corporate actions typically present a high level of risk to the custodian because:
A. It is not possible to automate processing of mandatory corporate events

b. Operational errors in the corporate actions department at the custodian bank tend to rise
sharply under conditions of high market volatility
C. If the custodian fails to inform investors of an upcoming corporate event it may be required
to cover any financial loss
d. Liquidity risk evaluation procedures for corporate events perform poorly in conditions of high
market volatility

Answers to Questions
Q1. Answer: B Ref: Chapter 1, Section 2.1

deferred shares offer holders the same rights as ordinary shares with the exception that they do not
rank for a dividend until specified conditions are met.
Q2. Answer: C Ref: Chapter 1, Section 5.1

AdR shareholders receive the proceeds of the sale of any rights.
Q3. Answer: B Ref: Chapter 1, Section 4

(1.90 1.00 0.40) x 100 = 50.00.
Q4. Answer: A Ref: Chapter 3, Section 4.4

nil, as the claim was submitted after 30 days had elapsed.

Short selling is a practice widely employed by hedge funds in anticipation that market valuations
might fall.
Q6. Answer: D Ref: Chapter 2, Section 2.1

Transference of funds is part of the main function of clearing and settlement operations.
Q7. Answer: C Ref: Chapter 1, Section 11

Agency trading is when a firm acts as an intermediary, or agent, on behalf of a client.
Q8. Answer: B Ref: Chapter 3, Section 3.3.7

The cross rate can be calculated from the two dollar exchange rates.

CMu (Central Moneymarkets Unit) operated by the hKMA (hong Kong Monetary Authority) is the
depository for corporate and government debt securities. The Hong Kong Securities Clearing
Company (HKSCC) is the central depository for equities, and share certificates are immobilised
at the hong Kong and Shanghai banking Corporation Ltd. All shares, and most warrants, must be
registered.

Fixed date settlement creates peaks and troughs of settlement activity.

Q11. Answer: D Ref: Chapter 1, Sections 3.1.4, 8.4

Eurobonds are issued in markets outside the domestic market of the issuer.

RFPs are submitted by potential custodians as part of the early stages of the selection process.
Q13. Answer: D Ref: Chapter 2, Sections 3.3, 3.4

Euroclear is the depository for the uK and France and Clearstream/deutsche brse is the depository
for Germany. SETS is not a CSd.

International Central Securities depositories (ICSds) came into being initially to meet the need for
integrated clearing, settlement and custody services for international eurobonds. Subsequently, the
ICSds have now expanded the range of services that they offer and overlap in many areas with the
custodian community. ICSds can hold equities, eurobonds, government bonds, corporate bonds and
many other types of financial instrument.

For uK securities, the CREST record of its members holdings is the legal record of title. When a
transaction settles in CREST, transfer of title will happen electronically and simultaneously with
settlement. CREST will notify the registrar of the transfer by issuing a register update request (RuR)
so that the registrar can update its records. under the Electronic Transfer of Title regulations, legal
title passes at the point of settlement even though the register may not reflect the change until later
in the day.

The settlement period for uK gilts is T+1.
Q17. Answer: D Ref: Chapter 3, Section 3.2.4

Trans-European Automated Real-time Gross Settlement Express Transfer (TARGET) is the real-time
gross settlement system for the euro.
Q18. Answer: C Ref: Chapter 3, Section 4.4.1

netting and bulking of claims under uS$500 are at the counterparties discretion.

bilateral netting covers trades between the same two counterparties whereas multilateral netting
covers trades by any number of counterparties.

The frequency of the risk review should be dependent on the nature of the market and the type of
services that the custodian delivers to the client.


The rules give companies the power, following certain procedures, to investigate share ownership.
Q22. Answer: D Ref: Chapter 4, Section 3

The nominee company holds legal title whereas beneficial ownership continues to remain with the
underlying client.

20 basis points means 0.20%. hence the charge uS$50m x 0.20% = uS$100,000.

Sweep accounts avoid clients having funds sitting idle overnight in non-interest bearing accounts.

Bridge settlement involves an exchange of messages between Euroclear bank and Clearstream
banking across an electronic bridge.

Marking to market means ensuring that exposures are valued at current market prices.

dividends are normally paid net of 10% tax and no further liability exists for basic rate taxpayers.

Tax regulations in many countries dictate that income payments accruing to non-residents are liable
to be taxed at source in the jurisdiction in which the investments are incorporated. This is known as
withholding tax.

Operational risk covers the four main areas of process, people, systems and external events.
Q30. Answer: A Ref: Chapter 5, Section 3

Profits generated from the sale of gilts are free of capital gains tax.

If the preference share is convertible, the shareholder has the option, at some stage, of converting it
into an ordinary share.


Companies wishing to be listed will typically be subject to a detailed investigation to safeguard the
integrity of the exchange and to offer a degree of protection to investors.

The ISIn consists of 12 characters, the first two of which represent the country code.

A covered warrant is structured by a bank or other financial institution over a range of possible
underlying assets.

MTFs are alternative trading systems which enable securities to be bought and sold.

It may not be possible to complete the programme trade for the desired amount of shares on the day
the order is raised.

Legislation requires the trustees to take full responsibility for the appointment and monitoring of
custodian actions.

The Clearing house Interbank Payments System (ChIPS) is a computerised network for the transfer
of uS dollar payments and operates on a multilateral netting basis. ChAPS is an electronic credit
transfer system for sterling payments; Fedwire is the electronic transfer of funds system for the
Federal Reserve; and TARGET is a real-time gross settlement system for the euro.

CSdA means that the seller does not suffer as a result of a settlement delay.

A firm must inform the regulator in writing without delay if it is unable to comply with any element of
the reconciliation requirements specified by CASS.

Legal title to on-loan securities passes from the lender to the borrower for the duration of the loan.

The cash lender under a repo agreement receives securities as collateral throughout the loan period.

Q43. Answer: A Ref: Chapter 5, Section 3

The net gain = 2,500 x (10.25 9.00) 20 20 = 3,085.

Multi-currency accounts are commonly employed by companies that need to process regular and
sizeable payments and credits in a foreign currency. The benefits of multi-currency account
structures include: securities can be settled on a dvP basis in foreign currency; these reduce the
costs and risks incurred in maintaining multiple FX transactions required by a single-currency
account structure; a global custodian may offer integrated custody and banking services, providing a
one-stop shop for investors cross-border service needs.
Q45. Answer: A Ref: Chapter 4, Section 5.2.3

bonus issues involve existing shareholders acquiring new shares free of charge.
Q46. Answer: A Ref: Chapter 4, Section 5.3.1

Total value of investors shares prior to the corporate event: 5,000 x 8.50 = 42,500.
Subsequent to taking up the issue, the investor will have 6,000 shares in total.
Adjusted price per share: (42,500 + (1,000 x 6.50)) 6,000 = 8.17.
nil paid rights will be worth = 8.17 6.50 = 1.67 per share.

Pooling is done in order to attract a higher rate of interest or to reduce the penalties incurred by some
accounts being overdrawn.

A is market risk, b is operational risk, C is credit risk and d is reputational risk
Q49. Answer: C Ref: Chapter 3, Sections 4.1, 4.2

Settlement failure may be caused by a number of factors, including non-matching settlement
instructions; insufficient securities; insufficient funds; corporate actions and counterparty
default. If a trade fails to settle on time, the exchange (or the other counterparty) may impose
penalties, or may also seek remedial action by initiating a buy-in of securities. Therefore a buy-in is
part of the solution to failed settlement, not a cause of it.

The custodian will be responsible for losses resulting from failure to communicate in good time.


Syllabus Learning Map

Syllabus Unit/ Chapter/

Element Section
ELEMENT 1 SECURITIES Chapter 1

1.1 Securities
On completion, the candidate should:
1.1.1 understand the characteristics of ordinary shares: Section 2.1
U ranking in liquidation
U dividends
U voting rights/non-voting shares
U deferred shares
U registration
U bearer/unlisted securities
U transfer restrictions
1.1.2 understand the characteristics of preference shares: Section 2.2
U ranking in liquidation
U dividends
U voting rights/non-voting shares
U cumulative/non-cumulative
U participating
U redeemable
U convertible
1.1.3 understand the characteristics of depositary Receipts: Section 5
U American depositary Receipt
U Global depositary Receipt
U depositary Interest
U transferability/registration / transfer to underlying
U how created/pre-release facility
U rights
U stamp duty and conversion fees
1.1.4 understand the characteristics of warrants and covered warrants: Section 4
U what are warrants and covered warrants
U how they are valued
U effect on price of maturity and the underlying security
U purpose
U detachability
U exercise and expiry
U benefit to the issuing company and purpose
U issue by a third party
U right to subscribe for capital
1.1.5 understand the characteristics of fixed income instruments: Section 3
U corporate bonds
U eurobonds Section 3.1
U convertible bonds Section 3.1
U government bonds Section 3.1
U discount securities Section 3.1
U floating rate notes Section 3.1
U coupon payment intervals Section 3


Element Section
U coupon calculations (may be tested by the use of simple calculations) Section 3

U accrued interest calculations (may be tested by the use of simple Section 3.3
calculations):
actual/actual
30/360
U clean and dirty prices Section 3.2
U mortgage-backed securities Section 3.1
U asset-backed securities Section 3.1
U index-linked bonds Section 3.1
1.1.6 know the characteristics of: Section 6
U exchange-traded funds
U mutual funds
U hedge funds
U investment trusts
U real estate funds
U private equity
1.1.7 know how securities are identified: Section 7
U ISIn
U CuSIP
U SEdOL
U tickers
1.1.8 understand how securities are issued: Section 8
U equities: Sections 8.1,
8.2
offers for subscription
offers for sale
introductions
placing
offer to tender
U government bonds: Section 8.3
auction
tap
tranche
U eurobonds: Section 8.4
lead manager
syndicate
underwriting
1.2 Principles of Trading
1.2.1 know the characteristics of the Regulated Markets and Multilateral Section 9
Trading Facilities (MTFs)
1.2.2 understand the differences between: Section 10
U on exchange/MTF
U over-the-counter
1.2.3 understand the main characteristics of: Section 11
U order-driven markets


Element Section
U quote-driven markets
U principal trading
U agent trading
U agency crosses (systematic internalisers)
U multilateral trading facilities
U dark pools
1.2.4 know the roles of: Section 11
U market makers/liquidity providers
U sales traders
U proprietary traders
1.2.5 know the principles of programme trades, algorithmic trading and Section 12
high frequency trading
1.2.6 understand the principles of multiple listed shares Section 13
1.2.7 know the settlement periods for equities and bonds in the selected Section 14
markets
ELEMENT 2 MAIN INDUSTRY PARTICIPANTS Chapter 2

2.1 Investors and Custody Service Suppliers
2.1.1 know the characteristics of the following types of participant: Section 1
U individual
U institutional
U investment manager
U prime broker
U broker
U inter-dealer broker
U investment bank
U central bank
2.1.2 understand the advantages, disadvantages and purposes of the Section 2.1
following types of custodian:
U global
U sub-custodian
2.1.3 understand the purpose and provisions of custody and sub-custody Section 2.2
agreements
2.1.4 understand the purpose of a Request For Proposal (RFP) in the Section 2.3
selection of a global custodian by an investor
2.1.5 understand the requirements of a Service Level Agreement between Section 2.2
an investor and its custodian
2.1.6 understand how legislation can affect the appointment of Section 2.3
custodians


Element Section
2.2 International Central Securities Depositories and Central

Securities Depositories
2.2.1 understand the roles of ICSds and CSds generally for the selected Sections 3.1,
markets: 3.3
U depositories available
U participation requirements
2.2.2 understand the concepts of certificated, immobilised and Section 3.2
dematerialised securities
2.2.3 understand the roles played by Euroclear and Clearstream including Section 3.4
the bridge
2.2.4 know how securities and cash are held by ICSds and CSds Section 3.1
2.2.5 know the range of custody and settlement services offered by the Section 3.4
ICSds
2.2.6 know the proposed intentions of TARGET2-Securities Section 3.5
2.2.7 know the structure and functions of Link-up Markets Section 3.3.1
2.3 Communications and Technology
2.3.1 understand the advantages of straight-through processing Section 4
2.3.2 know the features and benefits of SWIFT and SWIFT messaging Section 5
2.3.3 know the features and benefits of FIX Protocol messaging Section 4.4
2.3.4 know the communication methods used with Euroclear and Section 3.4
Clearstream
ELEMENT 3 SETTLEMENT CHARACTERISTICS Chapter 3

3.1 Pre-settlement
3.1.1 understand the data required for matching of settlement instructions Section 2.1
3.1.2 understand the process of clearing (matching and the assumption of Section 2.2
risk trade for trade versus central counterparty)
3.1.3 understand the role of third party service providers in the pre- Section 2.5
settlement process, eg, OMGEO
3.1.4 understand netting in pre-settlement Section 2.4
3.2 Settlement
3.2.1 know the role of the following types of financial institutions in the Section 3.1
settlement process:
U brokers
U investment banks
U investment managers
U custodians
U sub-custodians
U Central Counterparty Clearing houses (CCPs) and clearing members
U ICSds and CSds


Element Section
3.2.2 know the characteristics of the following cash systems: Section 3.2
U ChIPS
U ChAPS
U TARGET 2
U Fedwire
U CLS
3.2.3 understand the following settlement concepts: Section 3.3
U trade for trade
U netting bilateral and multilateral
U trade date netting, continuous net settlement
U fixed date settlement
U rolling settlement
U free of payment transactions
U delivery vs. payment
U book entry settlement
U physical settlement
U foreign exchange settlement
3.2.4 understand the transfer of legal title: Section 3.4
U bearer
U registered
3.2.5 understand Contractual Settlement date Accounting (CSdA) and Section 3.5
Actual Settlement date Accounting (ASdA)
3.2.6 know the main Giovannini barriers to the creation of a harmonised Section 3.6
market for Europe
3.3 Failed Settlement
3.3.1 understand the main reasons for failed settlement: Section 4.1
U failure to match
U insufficient stock
U insufficient cash
U counterparty default
U corporate event
3.3.2 understand the risks associated with: Section 4
U buy-ins
U sell-outs
U interest claims
U settlement fines
U matching fines
U suspension of trading
U short sale fines
3.3.3 understand interest claims (ICMA rules on fixed income and ISITC for Section 4.4
equities)
3.3.4 be able to calculate interest claims based on the above rules Section 4.4


Element Section
ELEMENT 4 OTHER INVESTOR SERVICES Chapter 4

4.1 Safekeeping
4.1.1 understand the principles of safekeeping client assets: Section 1
U to safeguard assets
U to segregate safe custody investments
U to reconcile safe custody investments
U to maintain records and controls in respect of the use of mandates
4.1.2 understand the requirements of substantial shareholding reporting Section 2
4.1.3 understand the functions of nominee companies and the following Section 3
concepts:
U legal title
U beneficial ownership
U pooled nominee holdings
U designated nominee holdings
U nominee as bare trustee
U omnibus accounts
U segregated accounts
4.1.4 understand how a custodian charges for the services it provides to Section 4
its clients
4.1.5 be able to calculate the cost of custody for a given portfolio given a Section 4
value of assets held and the basis point price
4.2 Corporate Actions
4.2.1 know the characteristics of the following mandatory events: Section 5.2
U dividends (cash and scrip)
U interest and coupon payments
U capitalisation issues
U splits and consolidations
U capital repayments / redemptions
4.2.2 know the characteristics of the following voluntary events: Section 5.3
U rights issue subscription
U conversions
U takeovers
U exchanges
U initial public offers
U proxy voting
U exercise of warrants
4.2.3 understand the importance of receiving timely and accurate corporate Section 5.1
action data and the risks involved
4.2.4 understand the following terms: record date; ex date; pay date; Section 5.5
effective date; cum benefit; ex benefit and special ex and special
cum
4.2.5 be able to calculate corporate actions related data on capitalisations, Sections 5.2,
scrip and rights issues and the effect on the underlying share price 5.3


Element Section
4.3 Cash Management

4.3.1 understand the importance and use of cash management Section 6
4.3.2 understand the advantages and disadvantages of operating single Section 6
and multi-currency accounts
4.3.3 know what is meant by the terms sweeping and pooling as they relate Section 6
to base currency and settlement currency
4.3.4 understand the importance of cash forecasting tools Section 6
4.4 Securities Lending
4.4.1 understand the role of a custodian in securities lending and the risks Section 7.3
and rewards to those involved
4.4.2 know the definition, legal ownership implications and the advantages Section 7.1
and disadvantages to the market
4.4.3 understand the reasons for securities lending Section 7.2
4.4.4 understand the reasons why loans might be delayed or prevented Section 7.2
4.4.5 understand the use of repo agreements Section 7.5
4.4.6 understand the lenders and borrowers rights (including manufactured Section 7.1
dividends and voting rights)
4.4.7 understand collateral and marking to market Sections 7.3,
7.5
4.4.8 know the role of a Stock borrowing and Lending Intermediary Section 7.4
4.4.9 understand the reasons why a loan might be recalled Section 7.1
ELEMENT 5 ASPECTS OF TAXATION Chapter 5

5.1 General
5.1.1 understand the tax treatment of dividends Section 1
5.1.2 understand the tax treatment of bond interest Section 2
5.1.3 understand capital gains tax as it applies to equities and bonds Section 3
5.1.4 understand the tax treatment of discount securities Section 4
5.1.5 understand the advantages, disadvantages and uses of: Section 5
U withholding tax
U double taxation treaties
U relief at source
U tax reclamation
U being an authorised uS approved Qualifying Intermediary
U FATCA rules
5.1.6 understand transaction-based taxes Section 6
ELEMENT 6 RISK Chapter 6

6.1 Identifying and Managing Risk
6.1.1 know the following major categories of risk: Section 1
U market
U counterparty


Element Section
U issuer
U settlement
U operational
U political
U regulatory
6.1.2 understand the factors that should be taken into account when Section 2
conducting risk reviews of market infrastructures and sub-custodian
networks
6.1.3 understand the areas of global custody risk and appropriate Section 3
countermeasures
6.1.4 know the purpose of an ISAE 3402 report Section 4
6.1.5 understand the concept of shareholder limits and restrictions Section 5
6.2 Mitigating Risk through Reconciliation
6.2.1 understand the risks associated with a failure to reconcile the Section 6
following:
U open trades
U counterparty cash
U corporate actions
U cash accounts
U custodian holdings
U client assets
U entitlements
Examination Specification
Each examination paper is constructed from a specification that determines the weightings that will be
given to each element. The specification is given below.
It is important to note that the numbers quoted may vary slightly from examination to examination as
there is some flexibility to ensure that each examination has a consistent level of difficulty. however,
the number of questions tested in each element should not change by more than plus or minus 2.
Element Number Element Questions

1 Securities 10
2 Main Industry Participants 10
3 Settlement Characteristics 10
4 Other Investor Services 14
5 Aspects of Taxation 3
6 Risk 3
Total 50

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The Official Learning and Reference Manual

This workbook relates to syllabus version 8.0 and will cover

PROFESSIONALISM INTEGRITY EXCELLENCE

TEChnICAL REVIEW by:

SEnIOR REVIEW by:

Workbook version: 9.1 (April 2013)

Learning and Professional Development with the CISI

With best wishes for your studies.

Chapter 2: Main Industry Participants 49

Chapter 3: Settlement Characteristics 79

Chapter 4: Other Investor Services 113

Chapter 5: Aspects of Taxation 143

Chapter 6: Risk 155

Multiple Choice Questions 195

Syllabus Learning Map 213

5. Depositary Receipts (DRs) 21

6. Collective Investment Vehicles 23

7. Securities Identification Numbers 28

8. Issue Methods in the UK 30

10. Exchange-Traded and OTC Transactions 36

11. Order-Driven and Quote-Driven Markets 37

12. Programme and Algorithmic Trading 39

13. Multi-Listed Shares 40

14. Settlement Periods for Equities and Bonds in the

This syllabus area will provide approximately 10 of the 50 examination questions

2 Global Securities Operations

1. Securities money to finance research, to buy new

Global Securities Operations 3

(commonly known as over-the-counter (OTC) 1.1 Why Do Investors Buy

4 Global Securities Operations

Global Securities Operations 5

In some instances, a company may issue ordinary

6 Global Securities Operations

U The security is traded in a regulated and

Global Securities Operations 7

1. In some instances, securities may not be

This is a preference share with a nominal value

8 Global Securities Operations

This indicates that the 0.40 per share

If a preference share is a participating

Preference shares may be cumulative or

3% cumulative preference share Corporate bondholders (ie, holders of debt

Global Securities Operations 9

The two main promises are:

Graphically, the cash flows would be as follows:

10 Global Securities Operations

Global Securities Operations 11

3.1.1 Government Bonds 3.1.4 Eurobonds

uS Treasury bonds or Treasury notes 3.1.5 Convertible Bonds

12 Global Securities Operations

3.1.7 Floating Rate Notes (FRNs) 3.1.10 Index-Linked Bonds

In creating an AbS, the originator of the loan

Global Securities Operations 13

under uK tax law, for example, the clean price

Example: Cum-Interest Transaction

15 January Trade date 3 March