Complying with the international regulatory standards stipulated by the G30, CPMI-IOSCO, FTSE Russell and MSCI has become the default method for developing markets to attract foreign investors. But Bruce Lawrence, founder of the HBL financial market infrastructure consultancy, warns that an undue obsession with international standards can also lead to complacency, a failure to take account of local market conditions, and even increase risk rather than reduce it. He advises CSDs to focus on asset safety and engage not only with other parts of their local market eco-system, but with the worldwide community of CSDs.
“Every developing market wants more foreign investors,” says Bruce Lawrence, founder of HBL Consultancy Services. “They do not have enough domestic capital to grow, so they need foreign capital, and market infrastructure is an important enabler in attracting it.” Nobody understands this better than Lawrence, who invested five years in helping Russia develop its securities market infrastructure between 1992 and 1997 and [two years] on a similar project in Mongolia.
In the 22 years that have passed since he set up HBL in 1997, Bruce Lawrence has advised a dozen other frontier and emerging markets throughout Europe, Asia, Central Asia, the Middle East and Africa on how to set up and operate a central securities depository (CSD), and ensure that it interacts efficiently with the stock exchange, the central counterparty clearing house (CCP) and the global custodians and their sub-custodians in the local marketplace.
So it matters when he says that he is worried that the Principles for Financial Market Infrastructures, published in 2012 by the Committee on Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO), have become the benchmark every CSD aspires to reach but not every CSD wishes to rise above.
Copycat compliance with international standards is leading to complacency
“There is a cut-and-paste mentality, but there are limitations on the value of doing that,” explains Lawrence. “Compliance with CPMI-IOSCO has got to the point where the industry is using regulation as a benchmark. You cross-check what you are doing against the CPMI-IOSCO principles and ask, `What do we need to do to comply?’ Once you achieve compliance, there is a degree of comfort. Complacency sets in.”
CSDs have of course been here before. After the Group of Thirty (G30) published its nine recommendations in Clearance and Settlement Systems in the World’s Securities Markets in March 1989, they and the subsequent status reports of 1990-1992 and updates of 2003 and 2006 became the pattern for both established CSDs and the new CSDs established through the 1990s and the Noughties.
But Lawrence points to a new force at work which is also moulding the behaviour of CSDs in emerging and frontier markets: the emerging and frontier market indices published by FTSE Russell and MSCI. To be included in one of these indices is highly prized, since it guarantees the attention of indexed pools of money. But inclusion hinges on liquidity (hence the enthusiasm of developing markets for new listings, free float and stock borrowing) and investability (which includes the clearing and settlement infrastructure as well the absence of quantitative constraints such as foreign ownership limits).
The indices are an unforgiving test of the readiness of a market for foreign investors. A market can find it is removed from the emerging to the frontier market index, or assigned to a single country index, or even dropped altogether, if it falls short of requirements. Two years ago, for example, Mongolia was dropped from the FTSE Russell frontier market index because it lacked delivery-versus-payment on T+3 and custodian banks to safekeep assets.
International standards can fail to take account of local market needs
“The overlapping recommendations of the index manufacturers are having a huge influence over the evolution of market infrastructures,” says Lawrence. “But applying homogeneous standards irrespective of local market conditions creates problems.” In Mongolia, for example, the stock exchange abandoned the goal of settling trades on T+3 because local brokers did not want to wait that long to get paid.
Switching to settlement on T+1, however, deterred foreign investors because they could not fund their trades that quickly. “T+3 was too slow for Mongolian brokers, but it was too fast for international investors,” notes Lawrence. “It is a case of the tail wagging the dog. Investment opportunities get missed because the market infrastructure does not match international standards, even if local standards are more demanding.”
This is regrettable, since one of the benefits of being an emerging or frontier market is that the financial market infrastructure can actually be more advanced than a developed market. Settling on T+1 or even T+0 is already common in developing markets without the legacy technologies or conservative market participants to hold progress back. Stocks also tend to be fully dematerialised, and proxy voting digitised.
Convergence on international standards is increasing risk, not reducing it
Lawrence notes that rapid infrastructural advance can be associated with convergence on international standards. “In the early days in Russia, banks were using SWIFT message templates long before SWIFT arrived,” says Lawrence. “Using SWIFT made it much easier to bring in industry standard IT applications, because all the main custody systems offered by vendors were built to operate with SWIFT messages.” But he also concedes that the opposite can happen.
“I recommended SWIFT in Russia because it was what I had been exposed to,” he says. “If a Japanese consultant had gone to Russia, he would probably have recommended following JASDAQ message standards.” Any area of post-trade operations not fully covered by the chosen standard – corporate actions notifications and instructions are a classic example – also remains open to freelance local solutions, in order to meet the immediate need.
As Lawrence points out, heterogeneity of this kind is by no means a bad idea. If every CSD in every frontier and emerging market met the demands of CPMI-IOSCO, FTSE Russell and MSCI, it would lead to a regulatory variant of concentration risk. Lawrence cites Pakistan as an example. The National Clearing Company of Pakistan Limited inherited a CCP from the Pakistan Stock Exchange (PSX) in 2016 largely in order to maximise its degree of alignment with international standards in financial market infrastructure – and to emulate its Indian neighbour.
“If you have an efficient market that works well to manage risk, why do you need a CCP?” asks Lawrence. “The authorities in Pakistan have since 2012 worked hard to comply with the CPMI-IOSCO standards to a pretty aggressive timetable. I would argue that an excessive zeal for compliance with international standards actually increases risk in the system overall, because you have too much homogeneity.”
Asset safety is the best guarantees of investability for foreign investors
International standards are however, the preference of the largest financial institutions. Though they are not always the most important participants in a developing market, their decisions can entice or deter smaller institutions. “If the global custodians are not prepared to support buy-side clients in a market that is invariably because of the risk, and that ensures that small and medium-sized banks will not enter the market either,” explains Lawrence. “We need to build a market infrastructure that satisfies global financial institutions in order to make it safe for smaller institutions to go there.”
He has a clear idea of what that means in practical terms. “As an investor, I am more protected if my assets are held by the CSD, because the CSD is a systemically important institution,” explains Lawrence. “If my custodian falls over, I am merely a creditor. CSDs are guarantee of asset safety, especially if the assets are held in a segregated account.”
CSDs are a component of an investable market and not a complete answer
But he warns developing markets not to treat the CSD as the only key to unlocking foreign portfolio investment. “You can get so focused on the CSD that you lose sight of other important items, such as links from the CSD to the payments system and putting in place proper asset servicing functions,” warns Lawrence. “A market infrastructure is a bit like a beehive. The CSD is the queen at the centre of the hive. But you have to work from the periphery to the centre, not the centre to the periphery. Some of the projects I have worked on are so singular in their approach that they do not look at the overall infrastructure, and vital elements get left out.”
Taking a regional view helps maintain a broad perspective. “You need to see what other initiatives there are in the region,” says Lawrence. “CSDs should work together to eradicate the barriers to cross-border transactions in their region.” He points to the East African Community (EAC) regional trade zone agreed between Burundi, Kenya, Rwanda, South Sudan, Tanzania and Kenya as a case in point.
“The EAC is working in the sense that you can trade Rwandan securities on the Nairobi Securities Exchange (NSE) but in all those markets there is simply not enough business being done,” explains Lawrence. “They need to collaborate to get volumes up.” An obvious starting point, he thinks, is to eliminate the contradictions between the securities laws of the six member-states.
“They need an acceptable common legal framework before much securities trading can be done across borders,” says Lawrence. “Foreign investors can get access through the Mauritius hub of a big custodian bank such as Standard Chartered or Société Générale, but they have to pay more. It would be cheaper if they could go direct. There is no operational problem at the broker-to-broker level, but the market infrastructure to settle and record cross-border transactions has still got gaps. The CSDs in the EAC markets could solve that.”
Co-ordination and collaboration accelerate progress
One reason they cannot solve it quickly is lack of resources to make the necessary investment. Funding is available from bodies such as the World Bank, the European Bank for Reconstruction and Development (EBRD), the regional development banks and USAID, and Bruce Lawrence has worked with them all. But, he says, their investment decisions are not co-ordinated, and are often led by one country (which naturally favours exporters from that country).
“In Mongolia I had the EBRD funding the CSD and the stock exchange, but led by Japan, which funded the purchase of technology from Nomura,” recalls Lawrence. “Luxemburgers and the Japanese were helping to set up the securities market regulator, while the London Stock Exchange was advising the Mongolian stock exchange, and the Koreans were competing with everybody. All the different countries had their own way of doing things. There was no commonality between them.”
So one person who welcomes the call at WFC 2019 for closer collaboration and greater co-ordination between CSDs across regions and the globe is Bruce Lawrence. “Building securities market infrastructures in frontier and emerging markets requires collaboration between policymakers, government officials and international bureaucracies,” he says. “And success depends on exchanges, CCPs, CSDs, banks and technology vendors co-ordinating their efforts.”
Cross-border regulatory challenges in different jurisdictions
Thursday 11 April
Moderator: Bruce Lawrence, Founder, HBL Consultancy Services
Paul Wong, Member of the secretariat, Bank for International Settlements (BIS)
Brigitte Daurelle, CEO, Euroclear Belgium, France and the Netherlands
Timothy Oliver Bennett, AIX CSD, Kazakhstan
Sung-Kwon Lee, Vice chair, Cross-Border Settlement Infrastructure Forum Asia#
Indars Ascuks, CEO Nasdaq CSD, Baltics region