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FINANCIAL INDUSTRY
FEDERAL RESERVE BANK OF DALLAS
SEPTEMBER 1998
How Might Financial Institutions React
to Glass-Steagall Repeal?
Evidence from the Stock Market
David P. Ely and Kenneth J. Robinson
Managing Cross-Border Settlement Risk:
The Case of Mexican ADRs
Sujit "Bob" Chakravorti
This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
Financial Industry Studies
Federal Reserve Bank of Dallas
Robert D. McTeer, Jr.
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Economists
Jeffery W. Gunther
Robert R. Moore
Kenneth J. Robinson
Thomas F. Siems
Sujit "Bob" Chakravorti
Financial Analysts
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Robert F. Mahalik
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Kenneth J. Robinson
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Contents
How Might Financial
Institutions React to
Glass-Steagall Repeal?
Evidence from the
Stock Market
David P. Ely and Kenneth J. Robinson
Page 1
Managing Cross-Border
Settlement Risk:
The Case of
Mexican ADRs
Sujit "Bob" Chakravorti
Page 12
Passage of the Glass-Steagall Act in 1933 separated commercial and investment banking activities in U.S. financial markets. After several unsuccessful attempts in Congress to repeal
Glass-Steagall, the Federal Reserve Board more than doubled the
revenue commercial banking organizations may earn from certain
securities activities. David Ely and Kenneth Robinson use this
increase as a proxy for how repeal of Glass-Steagall might affect
financial institutions. The authors' results show that the stock market reacted favorably to the revenue-limit increase for banking
organizations already active in securities activities. The stock price
of investment banks, as a group, did not seem to be significantly
affected. However, the authors find some evidence that smaller,
more profitable investment banks' stock prices reacted positively
to commercial banks' greater securities powers. This result is consistent with these investment banks' greater attractiveness as
takeover targets.
The Mexican securities clearance and settlement system is
ahead of many markets in terms of having one of the shortest
settlement periods. However, cross-border transactions—such as
those involving American Depositary Receipts—have tended to
be associated with a greater number of settlement fails than purely
domestic transactions because U.S. and other foreign markets have
longer settlement periods. This article investigates reforms to the
Mexican securities clearance and settlement system that are aimed
at improving liquidity and efficiency while maintaining safety and
reducing both general and cross-border settlement fails. These
reforms include penalties for late settlement and the establishment
of an electronic lending facility. In addition, a proposed clearinghouse would bilaterally net securities transactions that involve the
same type of security.
How Might Financial
Institutions React
to Glass-Steagall
Repeal?
Evidence from the
Stock Market
Since the passage of the Glass-Steagall
Act in 1933, commercial banks have generally
been prohibited from engaging in investment
banking activities. These activities include
underwriting and dealing in corporate debt and
equity securities, as well as acting as brokers
and dealers in securities markets. Over time,
however, these restrictions have been relaxed
somewhat. Currently, the Federal Reserve
authorizes individual bank holding companies,
on a case-by-case basis, to establish securities
subsidiaries. These subsidiaries, though, are limited in the amount of revenue they may derive
from investment banking.
After unsuccessful attempts to repeal
Glass-Steagall restrictions, in June 1996 Rep.
James Leach, chairman of the House Banking
Committee, urged the Federal Reserve to
increase the amount of revenue commercial
banking organizations could earn from certain
securities activities. After seeking comments on
this proposal, in December 1996 the Federal
Reserve Board raised the limit on subsidiary revI his article examines several
enue from "ineligible" securities activities from
10 percent to 25 percent of total subsidiary revhypotheses about how banking
enue, effective March 1997.
How this expansion of banks' securities
organizations and investment
activities affected shareholders of financial institutions is the focus of this article. Repeal of
banks' stock prices reacted to
Glass-Steagall would eliminate restrictions
banking organizations face in their securities
the recent expansion in
activities. The more than doubling in 1997 of
the allowable revenue for banking companies
banks' securities activities.
from certain securities activities, then, can serve
as a useful proxy for investigating the possible
effects of repealing the act.
Of particular interest is how share prices
of investment banks, commercial banks' main
competitor in securities markets, reacted to this
change. Did investment bank shareholders view
this expansion negatively, perhaps reflecting
concerns about increased competition from
commercial banks? Or did these shareholders
react favorably, perhaps because their firms
would be viewed as attractive merger partners
for commercial banks eager to expand their
presence in securities markets? If so, this expansion in commercial banking powers might have
been welcomed by the shareholders of these
competitors.
This article also investigates the stock market response of two other categories of firms
affected by the Federal Reserve's actions: (1)
David P. Ely is a professor at San Diego banking organizations engaged in securities
State University. Kenneth J. Robinson is a activities and (2) banking organizations that
senior economist and policy advisor
could be expected to petition for a securities
at the Federal Reserve Bank of Dallas. subsidiary. For banking organizations a positive
David P. Ely and Kenneth J. Robinson
FEDERAL RESERVE BANK OF DALLAS
1
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
panded the permissible activities of U.S. banks.
The Leach bill was more narrow, focusing
mostly on repealing Glass-Steagall restrictions
on banks' securities activities. D'Amato's bill
proposed a more comprehensive overhaul of
the U.S. banking system by advocating an end
to the long-standing separation of banking and
commerce. The Clinton administration also introduced a package that permitted expanded
activities similar to the Leach proposal but did
not require that those activities be carried out in
separate subsidiaries within a holding company
structure.
response would indicate that the stock market
viewed the expansion in allowable revenue
from securities activities as favorable to their
earnings potential. Furthermore, the size of any
market reaction represents an estimate of the
change in the economic value of the various
firms affected.
To investigate these issues, we use an
event-study methodology to examine the stock
market reaction of these different financial institutions to the various events leading up to
the revenue limit increase. Because stock prices
incorporate future-profit expectations, they signal how financial market participants view the
effects of the revenLie limit increase. Our results
indicate a positive stock price response by
banking organizations already engaged in
securities activities and a neutral effect for the
other category of banking organizations. While
a large number of investment banks exhibit a
positive stock price reaction, the response of a
portfolio of investment banks is not statistically
significant.
Indeed, a number of securities companies merged with commercial banks in
1997. These include Bankers Trust New
York Corp.'s merger with Alex. Brown
Inc., NationsBank Corp.'s acquisition of
Montgomery Securities, Fleet Financial
Initially, given the widespread agreement
on the antiquated nature of the restrictions,
prospects for financial reform legislation
seemed favorable. Hearings were held on the
Leach proposal, and several variations were
introduced in Congress. In June 1995 the House
Banking Committee recommended a bill that
would substantially reduce regulatory burdens
on banks. This bill would have made it easier
for banks to comply with rules in such areas as
lender liability, deposit and loan rate advertising, and application procedures to open
branches or make acquisitions. It would also
have reduced the examination requirements of
the Community Reinvestment Act (CRA) and
blocked regulators from allowing national
banks into the insurance business (Wilke 1995,
Domis 1995).
The favorable stock price reaction for
banking companies probably reflects the
increased earnings potential associated with
expanded securities activities. The failure to find
a statistically significant negative stock price
reaction for investment banks may reflect the
counterbalancing effects of an increase in the
competitive environment for investment banks
versus their greater attractiveness as takeover
targets.1 That is, any negative response from
potential competitive effects may have been
offset by the positive response due to potential
mergers.
We explore in more detail what factors
may lie behind the stock price reaction of individual investment banks. Our evidence indicates that smaller, more profitable investment
banks were more likely to exhibit a positive
stock market response to the easing of the revenue cap, possibly reflecting concerns about
regulatory approval involving mergers of larger
firms.
In October 1995 the Banking Committee's
proposals were merged into Chairman Leach's
bill in an effort to move reform efforts forward.
This compromise pleased almost no one. Both
the American Bankers Association and the
Securities Industry Association opposed the insurance restrictions, while the Treasury Department opposed loosening the CRA requirements
(McConnell 1995, Wells 1995).
Continued disputes over the extent of
insurance activities by commercial banks and
the proper organizational framework for banks
to conduct any expanded activities ultimately
scuttled reform legislation. Consequently, on
June 11, 1996, Leach publicly urged the Federal
Reserve to increase the revenue limit applicable
to section 20 subsidiaries (described in the box
entitled "Banks' Securities Activities: A Brief
Overview"), citing the Fed's "clear and unquestionable" authority to do so.2
Group's acquisition of Quick & Reilly
Group Inc., and U.S. Bankcorp's acquisition of Piper Jaffray Co.
See McConnell (1996, 2). Leach introduced financial modernization legislation again in 1997; see the Financial
Services Competition Act of 1997, H.R.
10, introduced January 7,1997. Other
financial modernization bills were introduced by Rep. Marge Roukema on
January 7,1997, H.R. 268, and by Rep.
Richard Baker on February 22,1997,
H.R. 669. In May 1998 the House
passed by a single vote a financial
reform bill based largely on H.R. 10.
CONGRESSIONAL ATTEMPTS AT
FINANCIAL MODERNIZATION
Banking organizations argue that restrictions on their financial activities limit their ability to diversity their balance sheets and compete
in an increasingly integrated marketplace. Recognizing these concerns, financial modernization legislation was introduced in Congress in
January 1995. Both Rep. Leach and Sen. Alfonse
DAmato put forth bills that would have ex-
FEDERAL RESERVE ACTION ON
FINANCIAL MODERNIZATION
In a press release dated July 31, 1996, the
Federal Reserve Board formally requested com-
2
Banks' Securities Activities: A Brief Overview
Even before the passage of the Glass-Steagall Act in 1933, securities activities were restricted for national
banks. Several court cases in the late 1800s held that the National Bank Act of 1864 prohibited national banks
from underwriting, trading, and holding equities for either their own accounts or those of their customers. The
Federal Reserve Act also restricted member banks from these activities (Benston 1990, 3 1 - 6 9 ) . State-chartered
banks, however, did not operate under these restrictions. As a result, national banks began to create state-chartered affiliates that could underwrite and deal in corporate securities.
Securities activities of national banks increased greatly during World War I as banks played an important
role in the marketing of government bonds. This enabled banks to develop an effective distribution system for
securities and accustomed individuals to the idea of buying open market securities. The McFadden Act of 1927
reaffirmed national banks' authority to underwrite certain investment securities. Initially, the comptroller of the currency allowed only bond underwriting but later approved underwriting of certain equity securities as well (Kelly
1985, 4 2 - 4 3 ; Flannery 1985, 6 7 - 6 8 ) .
The stock market crash of 1929 and the subsequent bank failures led Congress to begin a series of investigations into alleged securities market abuses by banks. Of concern were the following possibilities: (1) that banks'
securities affiliates were involved in speculative and fraudulent activities at the expense of depositors or shareholders; (2) that large banks' investment activities may have endangered smaller banks with correspondent relationships; and (3) that banks' securities activities may have threatened financial safety and soundness. While isolated
instances of fraud and abuse were uncovered, recent evidence generally does not support this view of commercial
banks' involvement in securities. 1 Nevertheless, on June 16, 1933, the Glass-Steagall Act was signed into law.
Glass-Steagall was enacted within the Banking Act of 1933. 2 In addition to restricting banks' securities
activities, the Banking Act also introduced federal deposit insurance, prohibited the payment of interest on demand
deposits, placed ceilings on rates banks could pay on time deposits, and imposed margin requirements on stock
purchases. Section 20 of Glass-Steagall prohibits Federal Reserve member banks from being affiliated with any
entity "engaged principally in the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or
through syndicate participation of stocks, bonds, debentures, notes, or other securities...." 3
By the 1980s, mainly in response to competitive pressures, banks had begun to pursue more active involvement in securities activities. While they were able to underwrite and deal in U.S. government securities and municipal general obligation bonds, as well as engage in private placements, banks increasingly sought the ability to
extend these operations to other types of securities. Beginning in 1987, the Federal Reserve Board issued a
series of orders authorizing individual bank holding companies, on a case-by-case basis, to establish section 20
subsidiaries. These subsidiaries would be allowed to engage in underwriting and dealing in securities within the
limits of Glass-Steagall.
The Board established a revenue test under section 20 to determine whether a company is "engaged principally" in underwriting and dealing in bank-ineligible securities. Initially, this revenue limit was set at 5 percent of the
gross revenue of the subsidiary. In 1989 the Federal Reserve Board raised this limit to 10 percent. 4 For more than
ten years now, commercial banking organizations have been allowed to pursue limited securities activities. At the
end of 1997, a total of forty-five banking organizations were authorized to establish section 20 subsidiaries. 5 These
are mostly large institutions, accounting for almost 48 percent of all U.S. banking assets at the end of 1997.
In addition to the establishment of limited securities activities, calls for further financial modernization
increased in light of the banking problems of the late 1980s. A 1991 Treasury proposal recommended the following:
The current bank holding company structure would be replaced with the new financial services holding company [FSHCs], Well-capitalized banks that form FSHCs would be rewarded with the ability to
engage in a broad new range of financial activities through separate holding company affiliates.
These new financial affiliates could engage in any financial activity, including full-service securities,
insurance, and mutual fund activities (U.S. Treasury 1991, 56).
These recommendations, however, were not included in the FDIC Improvement Act, which Congress
passed in late 1991. Continued recognition of the harmful effects of Glass-Steagall restrictions led in early 1995
to the introduction of legislation in both the House and Senate to expand the permissible activities of banking
organizations.
1
See Kelly (1985) for individual bank abuses before 1933. For evidence that banks' securities activities were not excessively risky, see Ang and
Richardson (1994), Kroszner and Rajan (1994), White (1986), Benston (1990, 1996), and Puri (1994, 1996).
2
3
Only four sections (16, 20, 21, and 32) of the Banking Act of 1933 are technically designated as the Glass-Steagall Act.
See Kelly (1985, 41). Other sections of Glass-Steagall also deal with banks' securities activities. Section 16 prohibits national banks from underwriting
corporate securities. Section 21 makes it unlawful for any person or organization engaged in the activities defined in section 20 to engage in the business of deposit banking. Section 32 prohibits officer, director, or employee interlocks between member banks and entities "primarily engaged" in activities described in Section 20.
4
In its initial 1987 order, the Federal Reserve Board authorized bank holding companies to underwrite and deal in commercial paper, municipal revenue
bonds, mortgage-backed securities, and securities related to consumer receivables. In 1989 the Board authorized underwriting and dealing in all types
of corporate debt and equity securities. The Board also included several firewalls to prevent the transfer of risk from section 20 activities to the insured
commercial bank. See Mester (1996, 17-18).
5
All of these section 20 subsidiaries are authorized to underwrite and deal in certain municipal revenue bonds, mortgage-related securities, commercial
paper, and asset-backed securities. In addition, twenty-eight of these subsidiaries are authorized to underwrite and deal in corporate debt and equity.
FEDERAL RESERVE BANK OF DALLAS
3
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
Table 1
Hypotheses on the Effect of Revenue Limit
Increase on Stock Prices
Firm
Earnings/competitive
Takeover
hypotheses
hypothesis
+
+/-
+
+/-
-
+
Board lacked the authority to increase the revenue limit. Industry commenters also argued
securities firms would be at a competitive disadvantage with banks (Lackritz 1996). The
Board, however, concluded that increasing the
revenue limit would extend the benefits of
"increased competition, greater convenience to
customers, increased efficiency and maintenance of domestic and international competitiveness" ( F e d e r a l Register 1996, 68, 755).
Of interest for this article is how this
expansion in the revenue limit was greeted by
financial market participants. We investigate
several hypotheses about what may lie behind
the stock market's reaction to the expansion in
the securities activities of commercial banks.
Banking organizations with
securities subsidiaries
Banking organizations without
securities subsidiaries
Investment banks
+ indicates a positive effect on stock prices is hypothesized.
- indicates a negative effect on stock prices is hypothesized.
+/- indicates either a positive or negative stock price reaction could occur.
ment on a proposal to raise the limit on section
20 subsidiary revenue from underwriting and
dealing in bank-ineligible securities from 10
percent of total subsidiary revenue to 25 percent. Bank-ineligible securities are those that
member banks may not underwrite or deal in
and include municipal revenue bonds, one- to
four-family mortgage-related securities, securities related to consumer receivables, certain
types of commercial paper, and debt securities.
The same press release also requested comment
on proposals to amend or eliminate three of the
prudential limitations, or firewalls, imposed on
the operations of section 20 subsidiaries.
EFFECTS OF FINANCIAL MODERNIZATION:
ALTERNATIVE HYPOTHESES
This article examines several hypotheses
about how banking organizations and investment banks' stock prices would react to the
revenue-limit increase. We would expect the
stock prices of bank holding companies with
section 20 subsidiaries to react favorably to an
increase in the revenue limit because of the
expanded profit opportunities this represents.
We refer to this as the "earnings hypothesis." In
a similar vein, we wrould expect the stock prices
for banking companies without section 20 subsidiaries to react favorably, consistent with the
earnings hypothesis. This would accord with
the comments the Federal Reserve Board received about the expanded opportunity for creation of new section 20 subsidiaries. In addition,
American
Banker cited a prediction by the
chairman of the American Bar Association's subcommittee on bank securities activities that the
revenue increase could result in 25 percent
more banks developing section 20 subsidiaries
(Dunaief 1996a).
The comment period ended on September
30, and on December 20 the Board announced
an increase in the revenue limit, effective March
6, 1997. A press release stated that "based on its
experience supervising these subsidiaries and
developments in the securities markets since the
revenue limitation was adopted in 1987, the
Federal Reserve Board concluded that a company
earning 25 percent or less of its revenue from
underwriting and dealing would not be engaged principally in that activity for purposes of
section 20" (Federal Reserve Board 1996).
The Board reported that it received fortytwo public comments on the proposed revenue
increase—thirty-four favorable (mostly from
banks) and eight opposed (mostly from the
securities industry) ( F e d e r a l Register 1996).
Several banking industry comments asked for a
revenue limit as high as 49 percent. Some comments predicted the higher, 25 percent revenue
limit would facilitate the creation of new section
20 subsidiaries, thereby increasing competition
in financial markets. The Securities Industry
Association opposed raising the limit because it
would undermine comprehensive financial
reform, achievable only through legislation. The
association also argued that the Federal Reserve
The competitors of bank holding companies in the securities business, however, can be
expected to exhibit a different response. A negative stock price reaction for investment banks
could be expected if the increased revenue limit
results in more competition for investment
banks, with a concomitant decline in expected
profits. We label this the "competitive hypothesis." Under this hypothesis, banking organizations would be expected to exhibit a positive
stock price reaction.
Finally, in what we label the "takeover
hypothesis," if investment banks are seen as
attractive takeover targets in light of commercial banks' greater securities powers, then a
4
Table 2
Events Associated with Federal Reserve Approval for
Increasing the Revenue Limit for Section 20 Subsidiaries
positive stock price reaction would be expected, to the extent that investment banks
are expected to share in benefits arising from
synergies or receive generous premiums from
the acquiring commercial bank. As an article
in Business Week pointed out, "Except for a
handful of the largest, strongest brokerages,
which could stay independent or even buy
banks, the brokerage industry with all of its
regional diversity could dwindle sharply. Commercial banks, on the other hand, could use
broker acquisitions to regain lost market share
and bolster their range of services" (Rea, Spiro,
and Galuszka 1996). A Wall Street
Journal
article also described how the securities industry viewed the proposed revenue increase.
"The securities industry, which stands to see
its market share trimmed by the proposal, was
understandably less enthusiastic." Regarding
the prospects for commercial banks' purchase
of investment banks in light of the revenue
increase, a financial analyst was quoted in
the same article saying, "It should make it more
economic for acquisitions across a whole spectrum of size ranges" (Taylor and Frank 1996).
Banking organizations' stock prices can react
either positively or negatively under the
takeover hypothesis. (Table 1 summarizes the
expected effect on the stock prices of each
group of firms under each of these hypotheses.)
Event
Dt
Description
Rep. James Leach abandons attempts to pass
financial modernization legislation and urges the
Federal Reserve Board to increase the revenue
limit on banking organizations' securities subsidiaries.
July 31, 1996
Federal Reserve Board formally requests comment on raising the section 20 revenue limit and
on amending or eliminating three prudential limitations, or firewalls, on the operations of section
20 subsidiaries.
December 20, 1996
Federal Reserve Board press release announces
an increase in the revenue limit from 10 percent
to 25 percent, effective March 6, 1997.
CHRONOLOGY
Leach's action, the first event in Table 2,
seems to have been unexpected. On June 12,
1996, American Banker characterized Leach's
abandonment of his efforts to pass financial
modernization as a "dramatic move." The article
describes how Leach canceled a planned committee vote on his bill (McConnell 1996, 1).
Regarding the second event, we found no news
stories that anticipated the Federal Reserve's
July 31 press release requesting comment on
the proposal. However, there is evidence that
financial markets anticipated the Fed's approval
of the revenue increase in December. Articles
in both the Wall Street Journal and American
Banker on December 16 stated that the Federal
Reserve was expected to announce approval of
the revenue increase on December 20. The Wall
Street Journal reaffirmed this in a December 19
article, noting that the Federal Reserve Board
was scheduled to discuss section 20 subsidiaries
at an open meeting the following day. It is not
surprising that this Board action was anticipated, especially since the Federal Reserve supported expanded powers for banks (Greenspan
1997).
To test these hypotheses, and to estimate
the economic impact of the revenue limit
increase, an event-study methodology is used to
determine how the stock market viewed the
events leading up to the revenue increase. A
variation on the market model is estimated.
Expected stock returns are assumed to be
linearly related to overall market conditions, but
the level of stock returns may deviate from the
norm on individual event dates. (The box entitled "Event-Study Methodology" summarizes the
procedure used.)
Three events corresponding to different
periods leading up to the revenue increase are
examined for any abnormal stock price reaction
by banking companies with and without securities subsidiaries and for a sample of investment
banks. Table 2 identifies these events. To estimate the economic impact of the increase in the
revenue limit, the events identified must have
been unanticipated by financial markets. A
search of articles in American Banker and the
Wall Street Journal
indicates that around the
days preceding each of these events, there was
little, if any, reporting that indicated financial
markets anticipated the congressional or regulatory actions identified in Table 2.
FEDERAL RESERVE BANK OF DALLAS
Date
June 11, 1996
However, articles in the financial press
leading up to the December approval did not
express certainty over the final outcome. On
June 12, the day after Leach proposed raising
the revenue limit, the Wall Street Journal reported that "some analysts think the Feci won't
go all the way to 25 percent, or might even
keep the 10 percent limit but adjust the way it
is calculated to give banks more breathing
room" (Wilke and Frank 1996). Two weeks later
American Banker reported that "legal observers
5
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
Event-Study Methodology
The event-study methodology this article uses is similar to that employed by
Schipper and T h o m p s o n (1983); Binder (1985); Smith, Bradley, and Jarrell (1986);
and Millon-Cornett and Tehranian (1989, 1990). These studies estimate the economic
impact of regulatory changes in several industries. Specifically, the economic impact
of regulatory changes, or events, can be measured using the market-model regression, whereby the stock return of an individual firm, or of a portfolio of firms, is
assumed to be a function of the returns generated on a marketwide index of stocks.
A system of seemingly unrelated regression equations using Zellner's technique is
estimated, where the return-generating process is also conditioned on the occurrence or nonoccurrence of an event or, in our case, an announcement of a change
in the regulatory environment. 1 This estimation is accomplished by augmenting the
market model with d u m m y variables to capture the different events of interest. We
estimate the following model:
reported that "some analysts guessed that the
board may act on the proposal in November,
depending on the comments that will be received" (.American Banker 1996). At the end of
October, American Banker reported that "the
Fed is expected to act on that proposal [raising
the revenue limit] within a few months" (Seiberg
1996b). From these comments, it appears that
the extent to which the Federal Reserve Board
would raise the revenue limit was unclear before its December 20 press release. Our empirical
results attempt to account for any market expectations or anticipations associated with the
different events.
3
= asec20
+ Psec20 * ^mt + X lsec20,k * &k,t + esec20,t •
k=1
(B- "0
^sec20,f
(B.2)
Rnon20,t
(B-3)
Rinvest,! ~ ainvest + $ invest * Rmt + H1 invest,k * &k.t + e invest,t •
3
= anon20
+ Pnon20 * Rmt + X1 non2Q,k * ®k,t + Enon20,t •
k=1
3
EMPIRICAL RESULTS
k=1
Portfolio Approach
In this model, Rsec2Q,t is the return on an equally weighted portfolio of banking companies with section 20 subsidiaries on day t, Rnon2o,tis t h e return on an equally
weighted portfolio of a sample of banking companies without section 20 subsidiaries
on day t, Rinvestit is the return on an equally weighted portfolio of a sample of investment banks on day f, and Rmt is the equally weighted return on a marketwide index
of stocks. The Dk variables represent d u m m y variables that equal one during the
period of the k ,h event and zero otherwise. Our event window, or the period covered
by the event date, is two d a y s — t h e day before the announcement (to allow for
market anticipations cited in this article) and the day of the announcement itself.
The ex's represent the intercept terms in each regression, the (3's are the coefficients
on the market return, and the y s are the effects of the k different events on each
respective portfolio, or the abnormal returns generated by the event. This approach
allows us to test several hypotheses, including whether the abnormal returns for
each portfolio equal zero for each event and whether the economic impact of an
event differs significantly across the portfolios of the different firms.
Table 3 shows the results of estimating
Equations B.1 through B.3 from the box entitled
"Event-Study Methodology." For all three portfolios, the coefficients on the overall market
return, Rmt, are highly significant, indicating that
movements in the stock market affect our individual portfolios. Regarding the stock market's
response to the events leading up to the
increase in the revenue limit, we find significant
positive abnormal returns only for the third
event, Di—when
the Federal Reserve announced an increase in the limit. In particular,
consistent with the earnings hypothesis, banking organizations with a section 20 subsidiary
show a fairly high (1.25 percent) daily excess, or
abnormal, return over the two-day window
when approval was announced. However, holding companies without a section 20 subsidiary
and our sample of investment banks show positive but no statistically significant abnormal
returns for any of the events listed in Table 2.
These results for the latter two groups do not
support the earnings hypothesis or the competitive hypothesis.
In estimating Equations B.1 through B.3, we use daily return data from the
Center for Research in Security Prices (CRSP) on firms that trade on the New York
Stock Exchange or the American Stock Exchange. Our period runs from January
through December 1996. W e have stock price data for twenty-four banking companies with a section 20 subsidiary, forty-one banking organizations with no section 20
subsidiary, and twenty investment banks. 2
1
T h e use of Zellner's seemingly unrelated regression technique does not affect the coefficient estimates.
Statistical inferences, however, are affected by improving the efficiency of the parameter estimates by modifying
the v a r i a n c e - c o v a r i a n c e matrix.
2
T h e n a m e s of the bank holding c o m p a n i e s with section 20 subsidiaries were obtained from the Board of
Governors of the Federal Reserve System. The sample of bank holding c o m p a n i e s without section 2 0 subsidiaries w a s obtained from the C R S P tapes by retrieving data o n all publicly traded firms with Standard
Industrial Classifications (SIC) of 6021 (national commercial bank) a n d 6022 (state commercial bank). T h e
sample of investment banks used is based on data from the C R S P tapes using SIC classification 6211
(security brokers, dealers, a n d flotation companies). This last group of firms consists of "establishments primarily e n g a g e d in the purchase, sale, a n d brokerage of securities; a n d those, generally known as investment
banks, primarily e n g a g e d in originating, underwriting, and distributing issues of securities" (Standard
Classification
Manual
We also estimate a model using December
16, 1996, as an event date in place of December
20 and a model that includes dummy variables
for both the December 16 and December 20
event dates, given the reports in the financial press anticipating the Federal Reserve's
approval. We then include a five-day window to
encompass the December 16-20 period. The
December 16 date alone produces no significant
abnormal return, while significant abnormal
returns are indicated for these other models for
the section 20 portfolio. We also estimate the
model including October 31, 1996, as an event
date (along with those events listed in Table 2)
to estimate the impact of the American
Banker
Industrial
1987, 341).
expect the Fed to raise the cap" (Seiberg 1996a).
However, in that same issue, an op-ed piece reflected some uncertainty about the final outcome
when it stated that "hopefully, the board will be
equally deferential in complying with this latest
congressional mandate to remove the artificial
regulatory burden on bank holding company
securities activities" (Fein 1996). Finally, in late
September (at the end of the comment period
for raising the revenue limit) American
Banker
6
Table 3
Estimates of Abnormal Portfolio Returns
article stating that the Fed was expected to act
on the revenue limit in a few months. This
October event date produces no significant abnormal returns. Next, we reestimate the model
using separate dummy variables for each day in
the event window, rather than assuming the
same response across the two-day window. This
specification does not affect our conclusions.
To judge the robustness of our results we
also estimate several variations of the model
used in Table 3. In place of the CRSP market
return, we use Standard & Poor's 500-stock
index. This model gives a slightly smaller
abnormal return of 0.74 percent for banking
organizations with a section 20 subsidiary. We
try estimating the model excluding foreignowned banking organizations with a section 20
subsidiary and using only U.S.-based banking
organizations with a section 20 subsidiary. Our
conclusions remain unchanged, with these
domestic organizations also showing a fairly
high (1.4 percent) abnormal return associated
with £>3. We also augment the model in
Equations B.l through B.3 by adding the
change in the daily three-month Treasury bill
rate. This does not affect our conclusions.
Finally, we begin our estimation period in
March, rather than January, because of a change
in the discount rate on January 31 and a change
in the prime rate on February 1. Our results are
qualitatively the same using this period.
Coefficient estimates
.0003
(.0004)
Sec20
Non20
Invest
Rmt
1.2729***
(.0999)
Du
D2t
Dzt
(.0050)
(.0050)
.0125*
(.0052)
-.0000
.0001
.0003
(.0002)
(.0453)
.0009
(.0024)
.0025
(.0024)
.0037
(.0023)
.0000
(.0004)
1.5981***
(.0867)
.0005
(.0044)
.0025
(.0044)
.0035
(.0043)
.8323***
NOTES: The models are estimated using daily data over the period January-December 1996.
Numbers in parentheses are standard errors. Sec20 represents an equally weighted
portfolio of banking organizations with a securities subsidiary; Non20 represents an
equally weighted portfolio of a sample of banking organizations with no securities subsidiary; and Invest represents an equally weighted portfolio of a sample of investment
banks. Rmt is the return on the CRSP equally weighted market index. Du, D2t, and D3t
are two-day dummy variables for the three events listed in Table 2.
*** = significant at the 1 percent level.
** = significant at the 5 percent level.
of investment banks is rejected at the 5 percent
level. These test results imply that section 20
bank holding companies experience significantly different excess returns around the
December 20 event than do banking organizations without section 20 subsidiaries and investment banks. Finally, there appears to be no
statistical difference between the abnormal
returns associated with non-section-20 firms and
those for investment banks.
Firm-Level Estimates
Generally, our results are not sensitive to
the length of the event window. The qualitative
results do not change when the event window
is expanded to cover three days—the day
before the event, the day of the event, and the
day following the event. But we find no statistically significant abnormal returns when the
event window is narrowed to only the event
date itself.3
Table 4 provides statistical evidence about
whether the economic impact of the December
20 event differs across the three portfolios.
These are Wald test statistics. The Wald test is
asymptotically equivalent to both the Lagrange
multiplier test and the likelihood ratio test
(Greene 1993, Chapters 4 and 13). The hypothesis that the abnormal returns associated with
the December 20 event for our section 20 portfolio of banking organizations are the same as
the abnormal returns for our non-section-20
banking companies produces a test statistic of
2.71 that is rejected at the 10 percent level of
significance. Similarly, a test statistic of 4.91
indicates that the hypothesis that there is no
difference between the abnormal returns for
section 20 banking companies and our sample
FEDERAL RESERVE BANK O F DALLAS
Intercept
Portfolio
To determine if our results are sensitive to
the averaging across individual firms undertak-
Table 4
Tests of Coefficient Restrictions
on Abnormal Returns for
December 20,1996, Event
Hypothesis
Ysec2O,03 =
lnon20,D3
Wald test
statistics
2.71 *
Ysec20,D3 =
Yinvest,D3
4.91"
Ynon20,D3 =
Yinvest, D3
.001
NOTES: Ysec2o,D j ' s t h e abnormal return for the
portfolio of section 20 firms for event D 3 .
i s ^ e abnormal return for the
ynon2o,D3
portfolio of non-section-20 firms for event
d 3.
with the Federal Reserve's request for
comment on its proposal to raise the
revenue limit (which we identify as 0 2 ).
These authors find no significant wealth
effects for banking organizations with
section 20 subsidiaries, other banking
organizations, or investment banks.
Bhargava and Fraser do find a significant positive stock market response for
banking organizations granted section
20 subsidiaries around the time the
the abnormal return for the
portfolio of investment banks for event D 3 .
yinvest,dz
Bhargava and Fraser (1998) also fail to
find significant wealth effects associated
is
** = significant at the 5 percent level.
* = significant at the 10 percent level.
Federal Reserve initially approved the
creation of these subsidiaries. However,
when the Fed doubled the revenue limit
in September 1989, negative wealth
effects were found for banking organizations with section 20 subsidiaries and
for a sample of investment banks.
7
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
Table 5
Hypotheses Tests Based on Individual Firm Estimates
mial tests, we have indications that the portfolio
approach may obscure some important firmlevel results. For banking organizations with no
section 20 subsidiary, we now have evidence
of a statistically significant abnormal return
associated with Z)3.5
Moreover, for investment banks, evidence
from both the binomial test and tests of the joint
significance of individual firm abnormal returns
suggests a closer examination of firm-level
results. While most investment banks experience positive excess returns for Di, two individual investment banks exhibit very large,
statistically significant negative daily abnormal
returns of - 2 . 1 percent and - 2 . 7 percent over
the two-day window. As shown in Table 3, our
results indicate that the impact averaged across
all firms is close to zero for investment banks
when considering Dy A closer look at the individual results for the sample of investment
banks might shed more light on the various
hypotheses being tested.
Test statistics for:
Positive
and
negative
returns
Event dates
D2
Individual
firm type
Sec20
Non20
Invest
73
Yi = 0 for
all firms
y2 = 0 for
y3 = 0 for
all firms
all firms
11.04
23.25
46.51***
(22/2)***
18.33
43.35
47.33
(27/14)**
7.79
9.81
36.96**
(No. +/No. - )
(15/5)**
NOTES: Sec20 represents individual banking organizations with a securities subsidiary. Non20
represents a sample of those individual banking organizations with no securities subsidiary. Invest represents a sample of individual investment banks. The Wald test statistics under each event date test the hypothesis that the individual firm-level abnormal
returns are jointly equal to zero in each portfolio, y, is the excess return associated with
event D v y2 is the excess return associated with event D z , and y3 is the excess return
associated with event D 3 . The last column gives the number of positive abnormal
returns relative to the number of negative abnormal returns for event D 3 . The significance level in the last column is based on a binomial test that positive and negative
abnormal returns associated with D 3 have equal probability of occurring.
*** = significant at the 1 percent level.
** = significant at the 5 percent level.
Individual Investment Banks' Abnormal Returns
Assuming a 95 percent significance
level, sixteen section 20 firms, twentysix non-section-20 firms, and fourteen
investment banks with positive (negative) abnormal returns are required to
reject the null hypothesis.
Of the twenty-seven banking organizations without a section 20 subsidiary
that record positive excess returns,
three have statistically significant abnormal returns of more than 2 percent,
which would be consistent with the
earnings hypothesis, while the average
abnormal return across these firms is
0.36 percent. One possible explanation
for this result is that some, but not all,
banking organizations in this group are
likely to create section 20 subsidiaries.
The profit margin is defined as income
before extraordinary items divided by
net sales; return on equity is defined as
income before extraordinary items
divided by common equity; and the
market-to-book-value ratio is defined as
the share price divided by the book
value of common equity on a per-share
basis. Common equity, share price, and
total assets are as of the company's
fiscal year end closest to January 1,
1997. Income and sales are for the four
quarters ending closest to January 1,
1997. These data are from Compustat.
en to construct the portfolio returns, hypotheses
tests are also conducted based on a system of
individual firm-level equations. Table 5 reports
various test statistics derived from individual
firm estimates of the augmented market models
given in Equations B.l through B.3 in the box
entitled "Event-Study Methodology." The numbers under each event provide test statistics for
the hypothesis that the individual estimates of
the yj (the excess returns associated with each
event for each firm in the portfolio) are jointly
equal to zero.
Similar to the portfolio results, the hypothesis that the excess returns for each firm are
jointly equal to zero is rejected for event number three, D}, for banking organizations with
section 20 subsidiaries. Interestingly, as shown
in the third column of numbers in Table 5, the
hypothesis that the excess returns are jointly
equal to zero is also rejected for our sample of
investment banks when considering D}.
The last column of Table 5 shows the
number of positive coefficient estimates (positive abnormal returns) associated with D} relative to the number of negative coefficient
estimates. For example, out of our sample of
twenty-four section 20 banking organizations,
twenty-two firms have positive excess returns
associated with D}. Using a binomial test statistic, we can reject the null hypothesis that positive and negative returns have an equal
probability of occurrence when considering
for all three groups of firms.4 From these bino-
Based on the results in Table 5, threefourths of the investment banks in our sample
exhibit positive excess returns. This would be
consistent with the takeover hypothesis in that
investment banks that would be attractive merger
candidates might be expected to exhibit positive
excess returns. In fact, three investment banks
in our sample were acquired by commercial
banking organizations in 1997. Bankers Trust
acquired Alex. Brown, Fleet Financial Group
acquired Quick & Reilly, and U.S. Bankcorp
merged with Piper Jaffray. Two of these investment banks exhibit fairly high daily excess
returns over the two-day window for the December 20 date of 1.58 percent (Alex. Brown)
and 1.1 percent (Piper Jaffray), although only
the former's return is statistically significant.
To explain the pattern of excess returns
our sample of investment banks exhibits for the
December 20 event date, we regress those
excess or abnormal returns on a number of individual firm-level characteristics that attempt to
capture size and profitability. These include
each investment bank's log of total assets (LTA),
profit margin (PM), return on equity (ROE),
market capitalization (MC), and market-to-bookvalue ratio (MKBK). 6 Table 6 shows the results
of these estimations. In considering each firm
characteristic individually, only the profit margin
is statistically significant, indicating that greater
individual excess returns are associated with
investment banks that are more profitable.
When a regression is estimated using all of
8
Table 6
Determinants of Investment Banks' Excess Returns
these characteristics, both firm size and profitability—as measured by the profit margin—
are statistically significant.
Greater profitability would likely invite
increased investor interest by potential merger
partners, thereby increasing excess returns.
Larger firms, though, may not tend to be as
attractive as takeover targets, given the existence of the revenue limit and possible concerns
about regulatory approval of large mergers. If
so, the excess return for investment banks will
tend to diminish as firm size increases, which
would be consistent with the negative coefficient for LTA.
Dependent variable: Individual excess return
.9620**
(.3766)
.1657
LTA
PM
ROE
MC
MKBK
-.0740
(.0483)
.0441**
(.0184)
(.1650)
.13
.0010
.4413***
(.0008)
(.1295)
.3701**
-.0001
(.0001)
(.1481)
.6860***
-.1826
(.1107)
(.1839)
2.2451***
-.2842***
(.0568)
(.4561)
.0523**
(.0241)
.0002
.0000
(.0010)
(.0012)
-.0259
(.1284)
NOTES: LTA is the log of each investment bank's total assets; PM is each firm's profit margin;
ROE represents the return on equity; MC is each firm's market capitalization; and
MKBK is the market-to-book-value ratio. All data are for year-end 1996 and are from
Compustat. Numbers in parentheses are standard errors. The estimation procedure
uses a heteroscedasticity correction described in Karafiath, Mynatt, and Smith (1991,
Appendix A).
REVIEW OF RESULTS
The stock market response to recent regulatory actions can be taken as a proxy for the
possible effects on publicly traded financial
institutions that may occur if Glass-Steagall is
repealed. Overall, the empirical evidence indicates that the stock market viewed the approval
of the increase in the revenue limit for securities
operations as favorable for banking organizations, especially those already possessing a
securities subsidiary. The positive response for
these banking organizations' stock prices probably reflects the increased earnings potential
associated with expanded securities activities.
The evidence is weaker that shareholders of
banking organizations without a security subsidiary, as a group, viewed the revenue increase
positively.
*** = significant at the 1 percent level.
** = significant at the 5 percent level.
banks potential targets." The same article quoted
a financial market analyst predicting that commercial banks would begin buying brokerage
firms six to twenty-four months after the
approval of the revenue limit increase (Dunaief
1996b). Foreign banking organizations, which
currently make up two-fifths of those with a
section 20 subsidiary, were said to have been
particularly interested in expanding their securities operations in the United States (Frank,
Raghavan, and Deogun 1996). If so, the attractiveness of investment banks as takeover targets
may have offset any negative effect from the
greater competition brought about by increasing
the revenue limit.
Our conclusions about raising the revenue
limit to 25 percent differ from Bhargava and
Fraser's (1998) findings that commercial banks
and investment banks experienced negative
wealth effects around the Federal Reserve's
decision to raise the revenue limit from 5 percent to 10 percent in September 1989- Further,
Bhargava and Fraser find no wealth effects in
their investigations of the increase in the revenue limit from 10 percent to 25 percent.
However, these authors only use the date of the
Fed's request for comments as an event date.
Our analysis indicates that accounting for stock
price movements at the time the Federal
Reserve approved the 25 percent revenue limit
produces a very different conclusion from that
found by Bhargava and Fraser.
The Federal Reserve has supported financial modernization of the type Leach proposed
in his original, 1995 legislation. Steps need to be
taken, though, to limit any transfers to these
new activities of the subsidy created by deposit
insurance and other features of the federal safety
net. This is best accomplished by utilizing the
holding company framework. Permitting the
affiliation of banks and securities firms would
then improve the earnings potential of financial
services firms and result in greater choice for
consumers.
Finally, an explanation for the positive response exhibited by most of the stocks of individual investment banks may lie in their
potential as takeover targets. An
American
Banker article noted that "experts said that
raising the revenue limit makes all investment
FEDERAL RESERVE BANK OF DALLAS
R2
Independent variables:
Constant
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9
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FEDERAL RESERVE BANK OF DALLAS
11
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
Managing CrossBorder Settlement
Risk: The Case of
Mexican ADRs
Technological advances and a global securities market enable individuals to buy shares of
foreign companies with a click of the computer
mouse. Such investors rarely ponder the underlying intricacies involved because these crossborder transactions usually occur without
problems. This article analyzes the international
transfer of funds and securities and one financial market's commitment to improving the
process.
Deregulation of financial markets around
the world, together with new technology, has
led to rapid increases in the value and volume
of cross-border transactions and capital flows,
especially to emerging markets. Daily foreign
exchange turnover rose from $717 billion in
1989 to $1,572 billion in 1995 (Bank for
International Settlements 1996a). From 1990 to
1996, annual private capital flows to emerging
markets increased dramatically, rising from
$45.7 billion to $235.2 billion (Folkerts-Landau,
Mathieson, and Schinasi 1997).
With the increase in cross-border transactions, risks in financial markets have also
increased (Federal Reserve Bank of Kansas City
1997; Group of Thirty 1997). In the global marketplace, the failure of a participant in one part
of the world may have dire consequences for
participants elsewhere. Such a crisis occurred in
the foreign exchange market when the authorities closed Bankhaus Herstatt in 1974. At the
time it was closed, the German bank was
involved in foreign exchange transactions that
had not been completely settled. The bank had
received Deutsche mark payments from foreign
exchange transactions but was closed before it
could deliver U.S. dollars to its counterparties.
The Herstatt case highlighted the potential for
problems caused by different parts of foreign
exchange transactions settling at different times
in different countries. This type of risk has
become known as Herstatt risk, or foreign
exchange settlement risk.1
Sujit "Bob" Chakravorti
D
I I ecent and proposed changes
to the clearance and settlement
process for Mexican securities
should ease considerably the
difficulties associated with
cross-border transactions,
including those involving
American Depositary Receipts.
This article is based on interviews and
correspondence with market participants, financial market regulators, and
clearinghouse operators. I would like to
thank Jorge Familiar, Alfonso de Lara,
Hector Perez Galindo, Rhys Jones,
Gerardo Orendain, Jose Quijano, Alicia
Rodriguez, Ruben Shiftman, Francisco
Soils, Lilia Sumiko, and the staffs of
various banks and brokerage houses for
providing details on the workings of the
Mexican securities market.
For a discussion of foreign exchange
settlement risk, see Chakravorti (1995)
and Bank for International Settlements
(1996b).
In this article, I focus on the clearance
and settlement of equity transactions.
Differences in settlement times are also
common in the settlement of cross-border securities transactions. Various components of a transaction may settle in different coLintries on different days. This article focuses on the difference
in the Mexican and U.S. settlement periods. In
Mexico, securities transactions are settled two
business days after a trade, whereas in the
United States these transactions are settled three
business days after a trade.2 This difference in
settlement periods can increase the risk of settlement fails in Mexico.
Sujit "Bob" Chakravorti is a senior economist
This article analyzes steps taken by Bolsa
at the Federal Reserve Bank of Dallas. Mexicana de Valores (BMV)—the Mexican stock
12
exchange—and S.D. Indeval to reduce settlement fails resulting from cross-border securities
transactions. Indeval is responsible for clearing
and settling securities transactions. It does so by
operating Sistema Interactivo para el Deposito
de Valores (SIDV), the Mexican securities transfer system, and is the central securities depository. The BMV and Indeval impose penalties on
participants that do not settle on time, and they
have created an electronic securities lending
facility. To further improve the efficiency and
liquidity of the settlement process, Indeval has
proposed that a clearinghouse be established.
These initiatives help ensure the timely settlement of securities in Mexico and reduce both
general and cross-border settlement risk. (See
the glossary on page 22 for a definition of this
and other terms in this article.)
recommended improvements that have since
become standards for securities clearance and
settlement systems. (See the box entitled "Group
of Thirty Recommendations for Securities Clearing and Settlement" for a complete list.) One of
the nine recommendations was that securities
markets reduce their settlement period to T + 3,
where settlement occurs three business clays
after the trade date, T.
In June 1995 the U.S. securities market
moved to T + 3 settlement from T+ 5, the trade
date plus five business days. When the move to
T + 3 was proposed, individual investors were
concerned that because of the time required to
send checks and securities by mail, the shorter
period would limit their participation in the
securities market. Another obstacle to moving to
T + 3 settlement was the How of information
between the various participants in a transaction
during the clearing process. Greater coordination between investment managers (firms that
order a trade), broker-dealers (firms that execute a trade), and securities custodians (firms
responsible for the safekeeping of securities)
would be necessary to settle at T + 3 than at
T + 5. (For a description of these interactions,
see Weiss 1993, chapter 12.)
SECURITIES CLEARANCE AND SETTLEMENT
The severe downturn in global stock markets in 1987 led to the recognition that securities
clearance and settlement systems worldwide
needed strengthening. In October 1987, substantially increased volume and price volatility
increased the financial risks to clearinghouses
and their members (U.S. Securities and Exchange
Commission 1988). The Brady Report, the product of a presidential task force created to study
the October 1987 stock market downturn, suggested that problems with securities clearance
and settlement systems resulted in less liquid
markets, leading to increased investor uncertainty (Presidential Task Force on Market
Mechanisms 1988).' Gerald Corrigan, then president of the Federal Reserve Bank of New York,
later said that "the greatest threat to the stability
of the financial system as a whole in that period
[October 19-26, 19871 was the danger of a
major default in one of these clearing and settlement systems" (Corrigan 1990, 129).4
These obstacles were overcome, and the
subsequent move to T + 3 resulted in safer
clearance and settlement systems. The report
issued by the Bachmann Task Force (1992) calculated that the move could reduce by up to 58
percent the risk faced by National Securities
Clearing Corporation (NSCC), the primary provider of centralized clearance, settlement, and
information services to the U.S. securities market. The implementation of T + 3 settlement
resulted in a decrease in settlement fails, and
today financial analysts agree that the move
benefited all participants by reducing settlement
and systemic risk (Levitt 1996, Grasso 1996,
Lindsey and Pecora 1997).
The 1987 incident also highlighted the
strong international linkages of national securities markets. As a result, central banks and other
financial regulators started coordinating their
efforts to strengthen domestic clearing and settlement systems (Bank for International Settlements
1992, Group of Thirty 1989, Organization for
Economic Cooperation and Development 1991,
U.S. Securities and Exchange Commission 1988,
Stehm 1996). The need for coordination continues to be a major issue in the international
financial community.
In 1989 the Group of Thirty, a privatesector nonprofit organization concerned with
the workings of international financial markets,
FEDERAL RESERVE BANK OF DALLAS
Although the Group of Thirty recommended T + 3 settlement, an even shorter
period may be preferable. Grasso (1996), Levitt
(1996), and Litan (1997) argue that a shorter
period could further reduce risk because it
would reduce participants' credit exposure to
their counterparties. However, Levitt identifies
potential impediments to adopting same-day
settlement. First, individual investors who
choose to hold the physical securities or who
are registered shareholders instead of holding stocks in "street name" might be unable to
participate fully because sufficient time might
not be available to deliver the securities.5 The
Bachmann Task Force (1992) suggested that
13
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
3
Improvements to the clearance and
settlement of securities in the United
States were implemented as a result of
the 1987 stock market downturn. For
details, see Lindsey and Pecora (1997).
4
Although clearance and settlement
problems did not cause extended stoppages to U.S. securities markets, the
Hong Kong Futures Exchange experienced problems that led to its closure
for four days in October 1987. See
Folkerts-Landau etal. (1995).
5
When securities are registered in street
name, they are registered in the name
of a brokerage house, bank, or depositary. Such securities are easier to process
since they are ready for delivery.
Group of Thirty Recommendations for
Securities Clearing and Settlement
Mexico. Furthermore, tax incentives ensure that
almost all equity trades are made via the
exchanges. Because, for the most part, the physical securities are stored with Indeval, bookentry transfers are possible for almost all transactions, allowing shorter settlement periods.
Mexican participants are concerned about
settlement delays in their market resulting from
cross-border transactions involving foreign markets where the settlement period is longer. The
longer U.S. settlement period, for example,
complicates timely settlement of cross-border
transactions because one part of the transaction
is settled at T + 2 in Mexico while the other part
is settled at T + 3 in the United States. However,
financial market participants, exchanges, and
clearinghouses have increased the likelihood of
timely settlement in Mexico by imposing penalties for late settlement, increasing the efficiency
of the settlement process, and improving the
liquidity of the underlying securities.
1. Trade Comparison
By 1990, all comparisons of trades between direct market participants (that is,
brokers, broker/dealers, a n d other exchange members) should be accomplished
by T + 1.
2. Trade Affirmation
Indirect market participants (such as institutional investors, or any trading counterparties which are not broker/dealers) should, by 1992, be m e m b e r s of a trade
c o m p a r i s o n system which achieves positive affirmation of trade details.
3. Central Securities Depository
Each country should have an effective a n d fully developed central securities
depository, organized and m a n a g e d to encourage the broadest possible industry
participation (directly a n d indirectly), in place by 1992.
4. Trade Netting System
Each country should study its market volumes and participation to determine
whether a trade netting system would be beneficial in terms of reducing risk and
promoting efficiency. If a netting system would be appropriate, it should be implemented by 1992.
5. Delivery Versus Payment
Delivery versus payment (DVP) should be employed as the method for settling all
securities transactions. A DVP system should be in place by 1992.
6. Same Day Funds
Payments associated with the settlement of securities transactions a n d the
servicing of securities portfolios should be made consistent across all instruments
and markets by adopting the "same day" funds convention.
American Depositary Receipts
A description of the trading, clearing, and
settling of an American Depositary Receipt
(ADR), a popular instrument U.S. investors use
to participate in foreign markets, provides a
framework for discussing cross-border settlement risk in the Mexican context. (For a discussion of the benefits and types of ADRs, see the
box entitled "American Depositary Receipts" on
page 17.) What have become known as depositary banks began issuing ADRs in 1927. After
receiving the underlying shares in the home
country of the firm that issued them, the deposi-
7. T + 3 Settlement
A "Rolling Settlement" system should be adopted by all markets. Final settlement
should occur on T + 3 by 1992. As an interim target, final settlement should
occur on T + 5 by 1990 at the latest, except where it hinders the achievement
o f T + 3 by 1992.
8. Securities Lending
Securities lending a n d borrowing should be encouraged as a method of expediting
the settlement of securities transactions. Existing regulatory and taxation barriers
that inhibit the practice of lending securities should be removed by 1990.
9. Common Message Standard
Each country should adopt the standard for securities messages developed by the
International Organisation for Standardisation [ISO Standard 7775]. In particular,
countries should adopt the ISIN [International Securities Identification Number]
numbering system for securities issues as defined in the ISO Standard 6166, at
least for cross-border transactions. T h e s e standards should be universally applied
by 1992.
Chart 1
SOURCE: Group of Thirty (1989).
Trading in Listed Depositary Receipts
Billions of U.S. dollars
550 -i
According to Levitt (1996), in November 1995 less than 10 percent of the
institutional trades submitted to Depository Trust Company, the main securities
depository in the United States, had
settlement instructions at T.
In Mexico government and bank securities settle at T.
individual investors be charged a fee for the
issuance of securities in paper form and be
required to deliver the securities to their brokers
before selling them. Second, as described above,
various parties may be involved in a securities
transaction. Changes in current business practices, such as when trades between the different
parties involved are confirmed, would be necessary before the settlement period could be
reduced further.6
Securities in Mexico are settled two business days after the trade date.7 The short settlement period is possible because all exchangetraded securities must be deposited with
Indeval, the only central securities depository in
'90
'91
'92
'93
'94
'95
'96
'97
NOTES: Trading volume data is for Depositary Receipts (ADRs
and GDRs) listed on U.S. exchanges only. In 1997, listed
programs accounted for 457 of the 1,358 programs.
SOURCE: Bank of New York (1998).
14
In 1997 Mexico did not rank among the
world leaders in the number of ADR and GDR
programs. But in terms of ADR and GDR share
volume on U.S. exchanges, Mexico trailed only
the United Kingdom and the Netherlands with
15.2 percent {Charts 2 and3). Nearly 100 Mexican companies have ADR programs. However,
the majority of the trading occurs in thirty companies (Riley 1998).
Chart 2
Distribution of Depositary Receipt
Programs, 1997
Netherlands
2.7%
South Africa
Mexico
5%
ADR Purchase
When U.S. investors place a buy order
for Mexican ADRs with U.S. brokers, the brokers have two means of purchasing the ADRs:
(1) the brokers can purchase existing ADRs in
the U.S. market, making what is known as an
intramarket trade, or (2) they can purchase the
underlying shares in Mexico and have a depositary bank issue ADRs.10 Most ADR transactions
are intramarket trades. However, if the U.S.
market lacks sufficient liquidity, brokers access
the Mexican market. The creation of each ADR
usually starts with the purchase of the underlying shares in Mexico.
In the first case—intramarket trades—
existing ADRs trade, clear, and settle like any
U.S. security. These securities usually clear and
settle through the Depository Trust Company
(DTC) and settle at T+ 3 (see Chart 4a).H ADRs
can be held in physical form, but most are held
in book-entry form. In the second case, U.S.
brokers purchase the underlying shares, either
through their Mexican offices or a Mexican
United Kingdom
16.9%
N O T E : In 1 9 9 7 t h e r e w e r e 1 , 3 5 8 D e p o s i t a r y R e c e i p t p r o g r a m s ,
2 9 2 of t h e m u n s p o n s o r e d .
S O U R C E : B a n k of N e w Y o r k ( 1 9 9 8 ) .
tary bank in the United States issues ADRs that
are dollar-denominated negotiable instruments.
(For details on ADRs, see Coyle 1995, Deutsche
Morgan Grenfell 1996, Riley 1998.) ADRs can be
traded over the counter or on exchanges.
ADR programs can be either sponsored
and unsponsored. To start a sponsored program, foreign firms can approach depositary
banks directly or use broker-dealers to set up
depositary contracts. All exchange-traded ADRs
must belong to a sponsored program, in which
a depositary contract exists between the depositary bank and the foreign firm issuing the
shares.8 To start an unsponsored program, broker-dealers set up programs with depositary
banks without informing the foreign firm that
issued the underlying shares. Regardless of the
type of program chosen, the U.S. Securities and
Exchange Commission (SEC) must be notified.
existed before the Securities Exchange
Acts of 1933 and 1934 are exempt from
this rule.
Chart 3
Global Depositary Receipts are deposi-
Depositary Receipt Dollar
Trading Volume, 1997
tary receipts that trade in more than one
country. The GDRs included in these
figures trade in the United States and at
least one other country. However, GDRs
Spain
need not trade in the United States,
although most do.
2.3%
1
United Kingdom
28.3%
According to a study commissioned by
Citibank, 51 percent of U.S. portfolio managers
prefer making foreign investments through
ADRs to directly purchasing shares in the local
market (Citibank 1996). Some U.S. market participants that otherwise restrict themselves to
investments in domestic securities participate in
ADRs because they are treated as U.S. securities,
even though they are fully backed by foreign
shares. During the 1990s, the trading volume in
these instruments has increased dramatically.
Dollar volume for exchange-listed ADRs and
Global Depositary Receipts (GDRs) rose from
$75 billion in 1990 to $503 billion in 1997 (Chart
This article uses the terms brokers and
broker-dealers
interchangeably.
In addition to being a central securities
depository, the DTC is a clearinghouse
for securities transactions for member
banks and broker-dealers. Both the DTC
and the NSCC are involved in the clearance and settlement of securities in the
United States. After netting securities
transactions among its members, the
NSCC settles the net securities positions on the books of the DTC. For
more on the DTC's role, see Depository
Trust Company (1996) and Citibank
(1998).
For simplicity, I have not included the
N O T E : T r a d i n g v o l u m e d a t a is o n l y f o r D e p o s i t a r y R e c e i p t s
( A D R s a n d G D R s ) listed o n U.S. e x c h a n g e s , a c c o u n t i n g
f o r 4 5 7 of t h e 1 , 3 5 8 D e p o s i t a r y R e c e i p t p r o g r a m s in 1 9 9 7 .
I).9
S O U R C E : B a n k of N e w York ( 1 9 9 8 ) .
FEDERAL RESERVE BANK OF DALLAS
Some unsponsored ADR programs that
15
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
NSCC's possible role in netting these
transactions. By using the NSCC, participants reduce their cost of transacting
due to the multilateral netting of a given
type of security and the netting of funds.
Chart 4 a
U.S. Broker Buys ADR in U.S. Market
Trade at 7
Buys ADR
Buyers
broker
^
_ „ ,
Sellers
broker
•
Sells ADR
Settlement at 7 + 3 in the United States
Buyer
Funds
^
Rnwor'c
•
Funds ^
•
Buyers
broker
ADR
^
Funds
D J C
m
ADR
Qpiipr'c
beiiers
broker
•
ADR
Funds
^
•
Se||er
ADR
Chart 4b
U.S. Broker Buys Underlying Shares in Mexican Market
Trade at T
Buys underlying shares
Buyer's
U.S. broker
4
^
Mexican
counterparty
Sells underlying shares
At T+ 2 in Mexico
Delivery
Depositary
bank's
custodian
in Mexico
Shares
of Shares
Delivery
U.S.
broker
Mexican
of Funds
Mexican
SIDV
pesos
Mexican
counterparty's
custodian
Shares
SIDV
Mexican
counterparty
pesos
At 7 + 3 in the United States
U.S.
buyer
**
ADR
U.S.
broker
ADR
Delivery
U.S.
buyer
12
„ „
D T C
^
ADR
US"
depositary
bank
of Funds
U.S. dollars
U.S.
broker
The risk faced by the broker is the
potential price decrease between when
the security was purchased and the
price at T+ 3 if the U.S. investor does
not deliver funds. Furthermore, the
broker faces the risk that the peso will
depreciate vis-a-vis the dollar if the
broker has to liquidate its position because the U.S. investor fails to deliver
dollars at f + 3.
13
For SIDV transactions, participants settle the net funds position at the end of
the day. Netting the funds side for all
transactions in a given day generally
reduces a participant's liquidity needs.
See Chakravorti (1997a).
Mexico before receiving funds in the United
States.12 To reduce or eliminate this exposure,
the broker could extend a line of credit—which
may be collateralized—to the customer or
could collect funds from the customer at T+ 2,
the settlement date in Mexico. In any case,
acquiring funds is easier than acquiring the
underlying securities since Mexican money markets are very liquid, whereas a given security
may be considerably less liquid.13 Although the
agent. Such transactions are cleared and settled
via the SIDV. (For a diagram of these transactions, see Chart 4b.) At T+ 2, settlement day in
Mexico, the U.S. broker delivers Mexican pesos
to a Mexican agent that in turn delivers these
funds to the SIDV. However, in most cases the
U.S. buyer only delivers U.S. dollars to a broker
at T + 3 in the United States. This asymmetry in
timing exposes the U.S. broker to credit risk
because the broker could deliver funds in
16
American Depositary Receipts
By using American Depositary Receipts, foreign companies are able to increase their investor base and visibility and, with certain types of ADR programs,
raise capital. For U.S. investors that are not active traders in the home country of the
ADR, the cost of investing in these instruments is considerably less than the cost of
directly accessing the home country's securities market.
U.S. broker may be exposed to credit risk, the
risk of settlement fail caused by the inability to
deliver funds is minimal.
On the securities side of the transaction,
the Mexican counterparty instructs its custodian
to deliver the underlying shares to the depositary bank's custodian in Mexico at T + 2. These
transactions are settled using delivery versus
payment, whereby the funds are only delivered
to the seller if the securities are delivered to the
buyer. After receipt of the underlying shares in
Mexico, the depositary bank issues the ADR and
delivers it to the broker via the DTC in the
United States at T + 3. u Also at T + 3, the U.S.
buyer delivers dollars to the U.S. broker in exchange for the ADR.
ADRs are issued by depositary banks, whose functions for their clients include disseminating financial and shareholder meeting information about the foreign
companies and making dividend payments in U.S. dollars. The price of the ADR
should be close to the price of the underlying shares because if arbitrage opportunities existed investors would buy from the market offering the lower price and sell in
the one with a higher price until the profit opportunity disappeared. In globally linked
financial markets these opportunities should not last long, if they do exist. However,
investors do face foreign exchange rate risk because the dollar price may change
due to exchange rate fluctuations. The number of ADR programs has grown from
fewer than 800 in 1991 to about 1,800 today (Riley 1998).
There are five main types of ADR programs—unsponsored, sponsored-level
1, sponsored-level 2, sponsored-level 3, and restricted. An unsponsored program is
initiated by a U.S. bank or broker and may not involve the foreign corporation that
issued the shares. Unsponsored programs face less stringent requirements than
sponsored programs. With sponsored programs, formal agreements—called deposit
agreements—exist between the foreign issuer and the depositary bank. S p o n s o r e d level 1 programs trade over the counter and are not subject to as rigorous regulation
by the SEC as the two other sponsored programs. Sponsored-level 2 programs
allow shares to be listed on a U.S. exchange if exchange rules and more stringent
SEC requirements are met. However, these ADR programs cannot be used for public
offerings. In other words, firms may not use this type of program to raise capital.
Sponsored-level 3 ADR programs allow public offerings, and most meet full SEC
disclosure in addition to the requirements for sponsored-level 2 ADR programs.
Restricted ADRs, or Rule 144A ADR programs, are private placements with qualified
institutional buyers as defined by SEC Rule 144A, introduced in April 1990 to stimulate capital raising by foreign corporations.
ADR Sale
When an investor wants to sell an ADR
through a U.S. broker, the broker can either
make an intramarket trade or sell the underlying
shares in Mexico.15 If the trade is an intramarket
one, the transaction usually settles via the DTC
at T+ 3 (see Chart 5a).
A U.S. broker that decides to access the
Mexican market searches for a buyer for the
underlying shares (see Chart 5b). The U.S.
broker may use a Mexican agent to sell the
underlying shares. At T + 2, in most cases, the
depositary bank does not instruct its custodian
to release the underlying Mexican shares.16
Thus, for settlement to occur the U.S. broker
must obti lin the shares elsewhere. If the U.S.
broker has the needed shares in its own portfolio, the broker could use those shares. If the
U.S. broker does not own the shares needed for
settlement, the broker or its agent would borrow the shares from the securities lending
market. If this market lacks sufficient liquidity, a
settlement fail would occur.
would net securities transactions involving the
same type of security, resulting in the need for
fewer securities to settle a day's transactions. All
these reforms should help foreign participants
meet their settlement obligations when a depositary bank does not release the underlying
shares at T+ 2.
MEXICAN REFORMS
In the Mexican securities market, a significant portion of settlement fails results from
cross-border transactions. To reduce these fails,
the BMV, Indeval, and financial authorities have
embarked on a series of reforms. Not only do
these improvements reduce cross-border settlement risk, but they also improve efficiency and
reduce settlement risk in all transactions. The
greater liquidity and safer clearance and settlement process resulting from the reforms should
make the Mexican securities market more attractive to foreign investors.
On the funds side, the Mexican counterparty delivers funds via the SIDV to the U.S.
broker at T + 2. After receiving the funds in
pesos, the seller's broker converts it into dollars
and credits the seller's account at T + 3. However, as mentioned above, all SIDV transactions
are settled using delivery versus payment. Thus,
if the underlying securities are not delivered, the
seller does not receive the corresponding
amount of funds. If the transaction fails at T+ 2,
it will most likely be settled at T + 3 when the
depositary bank releases the underlying shares.
In the next section, I discuss recently
established penalties for late settlement and a
new securities lending facility that allows brokers to borrow securities to make settlement. I
also discuss a proposed clearinghouse that
FEDERAL RESERVE BANK OF DALLAS
" In foreign markets where the settlement
period is longer than T+ 3, the depositary bank usually waits to issue the ADR
until it has received the foreign shares.
The depositary bank may release the
ADR before having custody of the
shares, but cash collateral and proof
of ownership are usually required for
the issuance of the ADR.
15
Usually, the U.S. broker accesses the
Mexican market if unable to sell the
ADR in the U.S. market or to offset a
transaction that it was part of in
Mexico.
16
If the depositary bank releases the
underlying shares without possession
Timely Settlement
To promote timely settlement, institutions
responsible for clearance and settlement must
establish clear rules and impose penalties on
participants when needed. Otherwise, market
17
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
of the corresponding ADRs. it assumes
the default risk up to the full value of
the underlying shares. In other words,
if the ADRs are not delivered to the
depositary bank, it would still have outstanding ADRs that would need to be
backed by shares of the foreign firm.
Chart 5 a
U.S. Broker Sells ADR in U.S. Market
Trade at 7
r, .. ,
Sellers
broker
Sells ADR
^
•
Buyers
broker
Buys ADR
Settlement at 7 + 3 in the United States
Seller
A D R
^
•
Funds
Qoiior-c
ADR
Sellers
broker
^
•
ADR
DTC
m
Funds
Riiwor'c
•
Buy®rs
broker
Funds
^
ADR _
•
Buyer
Funds
Chart 5b
U.S. Broker Sells Underlying Shares in Mexican Market
Trade at 7
Sells underlying shares
Seller's
U.S. broker
Mexican
counterparty
Buys underlying shares
At 7 + 2 in Mexico
Delivery
of
Shares
U.S. Broker Uses Its Shares to Settle
U.S.
broker
U.S.
broker's
custodian
Transfer
order
Shares
Delivery
U.S.
broker
Mexican
of
Mexican
counterparty's
custodian
Funds
Mexican
SIDV
pesos
Shares
SIDV
pesos
Mexican
counterparty
At 7 + 3
Delivery
of
Shares
Cancellation of ADR in the United States
U.S.
seller
ADR
U.S.
broker
ADR
DTC
ADR
U.S.
depositary
bank
Shares
U.S.
broker's
custodian
Depositary Bank Releases Shares in Mexico
U.S.
depositary
bank
Transfer
order
Depositary
bank's
custodian
in Mexico
Delivery
U.S.
seller
^
Shares
of Funds
in the United
U.S. dollars
18
SIDV
States
U.S.
broker
participants may lack the incentive to settle on
time. Market participants in Mexico point to
the difference in U.S. and Mexican settlement
periods as the cause of the majority of settlement fails. As shown in Chart 5b, the delivery of
an ADR to a depositary bank occurs at T+ 3, but
the settlement of underlying shares occurs at
T + 2. If the depositary bank is unwilling to
release the shares before receiving the ADR in
the United States, and if the U.S. broker or its
Mexican agent is unable to acquire shares from
another source to make settlement, the crossborder transaction results in a settlement fail.
Between April 1997 and February 1998,
the average monthly percentage of trades that
failed—that is, trades in which one party could
not make settlement—was 0.16 percent. Of
these fails, almost 77 percent were settled at
T + 3, 22 percent were settled at T + 4, and
less than 1 percent went into a buy-in procedure. The sellout procedure was never initiated. In other words, in none of the settlement
fails was the buyer unable to deliver funds
eventually.18
To provide an incentive to settle on time,
in April 1997 the BMV established penalties for
late settlement, along with buy-in and sellout
procedures for transactions not settled by T + 5.
Currently, the BMV calculates price differentials
and imposes the appropriate penalties on participants unable to make timely settlement. If
settlement does not occur at T+ 2, the penalty
is based on when settlement does occur. If settlement occurs at T + 3, the penalty is the
amount of the position of the party unable to
settle multiplied by THE (Tasa de Interes
Interbancario de Equilibrio), the domestic interbank rate. Whether or not settlement is
achieved at T + 3, the party unable to settle
must deliver the penalty amount to the counterparty at T + 3- If settlement occurs at T+ 4, the
penalty is twice the TIIE multiplied by the value
of the transaction and must be delivered by the
party unable to make settlement to the counterparty. If settlement has not occurred by T + 5,
the party unable to settle must pay three times
the TIIE multiplied by the value of the transaction at T+ 5.
The imposition of penalties for settlement
fails may raise the cost of transacting in the
Mexican market for brokers that sell shares
underlying ADR sales in the United States. This
is because the delivery of the underlying shares
usually occurs at T+ 3. These brokers have two
options for avoiding the penalty. First, they can
carry reserves of the underlying securities and
use them for settlement; however, the cost of
holding these securities for the purposes of
making settlement may outweigh the benefits of
holding the reserves. Second, the brokers can
borrow the securities until the depositary bank
releases the underlying shares.
Increasing Liquidity at Settlement
The Group of Thirty (1989, 16) recommended that "securities lending and borrowing
should be encouraged as a method of expediting the settlement of securities transactions.
Existing regulatory and taxation barriers that
inhibit the practice of lending securities should
be removed by 1990." The group stressed that
securities lending should be fully collateralized
and the lender should be compensated for temporary use of its securities. The group also cautioned financial markets not to interpret this
recommendation as promoting the sale of securities without owning them and that explicit
safeguards are needed to ensure operations are
conducted smoothly and at minimal risk. The
International Organization of Securities Commissions (1992) echoed the need for securities
lending to promote the timely settlement of
transactions but cautioned against its use for
speculative purposes.
In addition, if the trade remains unsettled
at T + 5, the party able to make settlement
invokes a buy-in or sellout.17 If the party unable
to settle is the seller, then a buy-in procedure is
conducted. In a buy-in, the security is bought
on the market by the buyer, and the seller must
pay the difference between the market price
and the agreed selling price, plus the penalty. If
the agreed selling price is above the market
price at T + 5, no price differential is collected
from the seller and the buyer acquires the
securities at the lower price. If the party unable
to settle is the buyer, a sellout procedure is
used. In a sellout, the security is sold and the
buyer must pay the difference between the
agreed trade price and the market price, plus
the penalty. If the market price is higher than
the agreed trade price, the buyer does not pay
the price difference and the seller receives the
higher market price from the sale at T + 5.
FEDERAL RESERVE BANK OF DALLAS
In 1992 the Mexican National Securities
Commission began allowing brokerage firms
to lend securities to clients unable to deliver
securities because of differences in settlement
periods, time zones, and business days among
different markets (Group of Thirty 1992). At that
time, Indeval did not participate in securities
lending.
To promote market liquidity and help participants meet their settlement obligations, in
19
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
17
However, if a participant fails before
7"+ 5, a buy-in or sellout procedure
occurs before f + 5.
18
The fact that the buy-in procedure was
sometimes necessary while the sellout
procedure was never used is consistent
with the argument that settlement fails
more often reflect the difficulty obtaining
securities than the difficulty obtaining
funds.
tions may be offset by other transactions in the
Mexican market.
An important feature of clearinghouses is
their ability to net transactions and allow their
participants to settle the net amounts.22 The netting could occur bilaterally, as described above,
or multilaterally, whereby netting occurs with
more than two participants.23
January 1997 Indeval started operating an electronic securities lending facility, called Valores
en Prestamo (VALPRE). For a fee, participants
owning securities lend them to participants
lacking those securities.19 In addition, if a participant is unable to acquire the underlying
security to make settlement, the BMV can access
VALPRE to complete settlement if the underlying
security is available. So far, only one loan transaction has been conducted in such a manner. In
most cases, participants without the securities
access VALPRE directly. Consistent with the Group
of Thirty's recommendations, all securities transactions are collateralized. All securities pledged
for collateral are discounted from their market
value, based on the type of security used.
19
In the case of funds, the central bank
has various options to increase the supply of funds in the financial market. For
a description of some of these options,
see Chakravorti (1997b).
20
2'
All these transactions involved equities.
One firm may issue more than one type
of share. For netting to occur, the type
Mexico's Proposed Clearinghouse
To increase liquidity and efficiency in the
clearance and settlement of securities, Indeval
has proposed the formation of a clearinghouse—Camara de Compensacion y Liquidacion (CCV)—that would begin operating in
February 1999.24 The primary benefit of this
clearinghouse would be to reduce the cost of
delivering securities for each transaction by
allowing the participants to bilaterally net securities of the same type. Both foreign and
domestic participants would benefit from its
establishment. The clearinghouse would be the
counterparty in every transaction and guarantee
settlement of all transactions. In the first phase
the CCV would only clear and settle BMV transactions; in the second phase the CCV would add
OTC transactions. (As before, here I focus only
on the clearing and settling of equities.)25
Although quantifying VALPRE s effect on
the frequency of cross-border settlement fails is
difficult, the ability to borrow securities does
help participants involved in both cross-border
and domestic transactions make timely settlement. In February 1998 VALPRE handled 622
transactions, valued at 633-63 million pesos.20
VALPRE transactions accounted for 0.64 percent
of all equity transactions. The average time
securities were borrowed was 1.6 days.
of share must be the same.
22
By centralizing the clearance and settlement of trades and risk management
services for their members and associated exchanges, clearinghouses can
take advantage of economies of scale,
thereby improving the efficiency of the
financial market as a whole.
23
The Bank for International Settlements
(1990) recommended minimum international standards, known as the
Lamfalussy standards, for netting
schemes. Hanley, McCann, and Moser
(1995) provide possible extensions to
these standards that may be more
appropriate for securities markets.
24
The regulatory authorities have not given
final approval to the establishment of
this clearinghouse. The description of
CCV is based on communication with
Indeval.
25
The CCV will eventually clear the following securities traded on the BMV: equities and Certificados de Participation
Ordinario (CPO) (ordinary certificates),
fixed income securities, bonds, promissory notes, Certificados de Participation
Inmobiliario (construction certificates),
and commercial paper. In addition, the
CCV will clear the following OTC securities: bank notes and bonds, Pagare con
Rendimiento Liquidable al Vencimeinto
(promissory notes with yields payable
at maturity date), CPO guaranteed by
NAFIN, certificados de las tesorerie de
la federation, bondes, ajustabonos,
Udibonos, United Mexican States
(sovereign securities issued by the
Mexican government in foreign markets), and Bradys.
Benefits of Netting and the
Role of a Securities Clearinghouse
With the establishment of the CCV,
Indeval's role in securities clearing and settlement would change. Upon full implementation
of the CCV's proposed functions, Indeval would
be responsible for securities safekeeping, cash
and securities transfers, management of securities, issuer services, and collateral management.
The CCV would be responsible for clearing,
cash and securities settlement, and collateral
management.
The CCV would have two types of members: indirect and direct. Indirect participants
would include mutual fund firms, insurance and
pension fund firms, other domestic investors,
and foreign financial institutions and investors.
Direct participants would be institutions that
currently settle transactions through the SIDV—
brokerage houses, commercial and development
banks, and the Bank of Mexico. A subset of
direct participants would be settling members,
which would settle trades for themselves and all
other members. CCV organizers hope custodial
banks will participate as settling members to
help in the timely settlement of cross-border
transactions. Clearance and settlement would be
a three-day process, or T + 2 settlement. Each
settling member would have two clearing
accounts at Indeval, one for funds and the other
for securities. In addition, the CCV would have
Another way brokers in ADR transactions
can avoid late-settlement penalties is to net
securities of the same type. By doing so, on
average a broker has to deliver fewer securities.
For example, suppose a broker engaged in ten
transactions, each involving ten shares of the
same security with the same counterparty.21 In
five of these transactions the broker sold the
shares, and in the other five it bought the shares.
Without netting, the broker might not be
able to offset securities to be delivered against
securities to be received. The broker would
then have three options: maintain a reserve of at
least fifty shares in its portfolio and send them
to the counterparty on settlement day; borrow
the underlying securities and make delivery; or
wait for the counterparty to send shares and
then send them back to make settlement. In the
first two options, the broker would incur additional costs. In the third option, if both participants wait for the other to deliver, the result
could be that no settlement occurs.
With netting there would be no transfer of
securities because the net position for each of
the two participants is zero. If fewer securities
are required to settle, fewer securities need to
be borrowed, and in some cases the number of
shares required for settlement of ADR transac-
20
Chart 6
Proposed CCV System
Trade at T
Buyer's
broker
—
Buys ADR
Seller's
broker
Sells ADR
At T+ 1
Buyer's
broker
Advises of net cash
Advises of net securities
CCV
position
position
Seller's
broker
At T+ 2 on indeval's Books
Buyer's
broker
funds
Buyer's
broker
shares
Net
Net
CCV account
at Indeval
shares
CCV account
at Indeval
funds
similar accounts at Indeval. Transactions would
be cleared on a bilateral net basis, security by
security for each settling member. In other
words, transactions involving the same security
between two participants would be netted.
Chart 6 shows an example of a transaction
that would be cleared and settled via the CCV.
On the trade date, the CCV would receive confirmation of the trade from the BMV, an electronic trading system, or Indeval. The CCV would
separate trades by settling members and nonsettling members. At T + 1, the CCV would inform settling members of their net cash positions
and their net positions in each security with
every other participant.26 For transactions involving a foreign participant that would deliver
securities at T + 2, confirmation from the custodian of the foreign participant would be
required.
Net
Seller's
broker
Seller's
broker
receiving funds from the buyer, the CCV would
release the corresponding securities to the participant that delivered funds and the funds to
the participant that delivered securities. If the
participant delivering securities chooses another
settlement cycle, the corresponding participant
delivering funds would have to deliver funds
during that cycle.
If unsettled transactions remain at the end
of T + 2, the CCV would take the following
actions. If cash were not delivered at the specified time, the participant's margin would be
used. There would be no grace period. If the
margin were insufficient to cover the position,
the settling member's previous contribution to a
clearing fund would be accessed. If a shortfall
still existed, explicitly stated loss-sharing procedures would be imposed on the remaining
members. Additional safeguards are still under
consideration, such as a reserve account that
would be funded by Indeval.
For nondelivery of securities, the CCV
would attempt to fill the position by borrowing
the underlying securities via VALPRE on behalf
of the participant unable to deliver them. The
CCV would administer the collection of price
differentials, penalties, and additional margin
requirements. If the participant were unable
to deliver the securities, a buy-in procedure
similar to the one described above would be
used. If a buy-in procedure were not feasible,
the position would be settled with cash, and
if the participant were unable to meet this
cash obligation, the safeguards described above
would be used.
At 7' + 2, settlement day, there would be
three settlement cycles—night (around 2 a.m.),
midday (around noon), and afternoon (around
3 p.m.). For the night settlement cycle, Indeval
would debit the accounts of participants and
credit the CCV's account. Later that morning
(around 10 a.m.), the CCV would collect funds
from the participant that would be receiving the
securities. Participants would be required to
deliver funds to one of three places—the CCV's
cash account at Indeval; the CCV's account at
Sistema de Atencion a Cuentahabientes de
Banco de Mexico—the large-value gross settlement system that transfers funds between
reserve accounts at the Bank of Mexico; or
CCV's account at a commercial bank. Upon
FEDERAL RESERVE BANK OF DALLAS
Net
21
FINANCIAL INDUSTRY STUDIES SEPTEMBER 1998
26
The role of the CCV would be similar to
that of the NSCC in the United States,
except securities are multilaterally netted
per security in the NSCC and would be
only bilaterally netted in the CCV.
Glossary of Terms
A m e r i c a n D e p o s i t a r y Receipt An ADR is a U.S.-dollar-denominated negotiable instrument, issued by U.S. depositary banks and fully backed by foreign shares.
CONCLUSION
B o l s a Mexicana de Valores The BMV is the Mexican stock exchange.
Although a country's financial market benefits greatly from linkages to global securities
markets, such linkages may carry cross-border
settlement risk resulting from differences in settlement periods. In the case of Mexico, securities transactions settle two days after a trade, a
shorter period than in most other countries.
Although shorter settlement periods are preferred, unilaterally implementing such periods
may pose settlement problems for cross-border
transactions. As a result, the BMV, Indeval, and
Mexican financial authorities have implemented
policies that could ease the burden associated
with the clearance and settlement of international transactions.
Camara Mexicana de Compensacion y Liquidacion The CCV is the proposed
clearinghouse that would clear and settle securities transactions in Mexico.
C o m i s i o n Nacional Bancaria y de Valores The CNBV is an autonomous agency of
the Mexican Ministry of Finance and Public Credit, with executive powers established
by the National Banking and Securities Commission Act.
Clearing Clearing is the processing of payment or security transfer instructions,
including the netting of obligations to pay or deliver securities for establishing final
settlement positions.
C r o s s - b o r d e r s e t t l e m e n t risk This is the risk that cross-border transactions associated with different settlement periods will lead to settlement fails.
D e p o s i t o r y Trust C o m p a n y The DTC is a U.S. clearinghouse involved in the clearance and settlement of securities transactions for member banks and broker-dealers.
Global Depositary Receipt A GDR is similar to an ADR. GDRs are depositary
receipts that can trade in two or more countries outside of the underlying firm's home
country.
These policies have resulted in penalties
for late settlement and an electronic lending
facility that improves the liquidity of securities.
A proposed clearinghouse could potentially reduce the quantity of securities required to
settle transactions. With netting systems, the
inability of a participant to settle may affect the
settlement of other participants. To reduce such
risk, Mexico's proposed clearinghouse would
establish safety measures that include margin
requirements, a clearing fund, and other, related
provisions. Taken together, these recent and
proposed reforms could go a long way toward
alleviating the complications for cross-border
transactions resulting from the longer settlement
periods that exist in most other countries.
National Securities Clearing C o r p o r a t i o n The NSCC is the primary provider of
centralized clearance, settlement, and information services to the U.S. securities
market.
S.D. Indeval Indeval is the private institution responsible for the custody, administration, clearing, settlement, and transfer of securities in Mexico. It is also the only institution in Mexico authorized to operate as a central securities depository.
S e t t l e m e n t This is "an act that discharges obligations in respect of funds or securities transfers between two or more parties" (Bank for International Settlements 1993).
Settlement risk This is the risk that one party to a transaction is unable to make
settlement.
Sistema Interactivo para el D e p o s i t o de Valores The SIDV is the Mexican largevalue securities transfer system.
S y s t e m i c risk In the payments system context, this is the risk that a participant's
inability to settle will result in the inability of one or more other participants to settle.
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