Running the World's Markets: The Governance of Financial Infrastructure - Hardcover

Lee, Ruben

Hardcover

ISBN 10: 0691133530 ISBN 13: 9780691133539

Publisher: Princeton University Press, 2011

Synopsis

The efficiency, safety, and soundness of financial markets depend on the operation of core infrastructure--exchanges, central counter-parties, and central securities depositories. How these institutions are governed critically affects their performance. Yet, despite their importance, there is little certainty, still less a global consensus, about their governance. Running the World's Markets examines how markets are, and should be, run.


Utilizing a wide variety of arguments and examples from throughout the world, Ruben Lee identifies and evaluates the similarities and differences between exchanges, central counter-parties, and central securities depositories. Drawing on knowledge and experience from various disciplines, including business, economics, finance, law, politics, and regulation, Lee employs a range of methodologies to tackle different goals. Conceptual analysis is used to examine theoretical issues, survey evidence to describe key aspects of how market infrastructure institutions are governed and regulated globally, and case studies to detail the particular situations and decisions at specific institutions. The combination of these approaches provides a unique and rich foundation for evaluating the complex issues raised.


Lee analyzes efficient forms of governance, how regulatory powers should be allocated, and whether regulatory intervention in governance is desirable. He presents guidelines for identifying the optimal governance model for any market infrastructure institution within the context of its specific environment.



Running the World's Markets provides a definitive and peerless reference for how to govern and regulate financial markets.

About this title

About the Author

Ruben Lee is CEO of Oxford Finance Group. He was a fellow of Nuffield College, University of Oxford, and worked for Salomon Brothers International. He is the author of What is an Exchange?

From the Back Cover

"How should the infrastructure underpinning today's volatile, rapidly evolving, and complex markets be run? Ruben Lee's extensive knowledge, superlative analysis, and practical guidance help answer this fundamental question."--Donald F. Donahue, chairman and CEO, The Depository Trust & Clearing Corporation

"Ruben Lee has used his deep understanding of the markets to produce a comprehensive analysis of governance issues. A must for every policymaker's bookshelf."--Ravi Narain, CEO, National Stock Exchange of India

"Ruben Lee has written the essential guide to the ownership, structure, and governance of the exchanges, clearing houses, and depositories constituting the essential infrastructure of financial markets throughout the world. Nobody understands or explains these vital, complex, and constantly evolving institutions better than Lee."--Henry B. Hansmann, Yale Law School

"Market infrastructures are based on an unusually strong combination of contradictory forces. In this complicated setting, Ruben Lee's book constitutes a major contribution, laying bare these complexities and offering perspectives for their efficient organization."--Eddy Wymeersch, chairman, Committee of European Securities Regulators

"While one may disagree with some of its conclusions, this book is an important contribution to the debate about the role and function of regulation and regulators, and the governance of financial market infrastructure."--Jane Diplock AO, chairman, New Zealand Securities Commission and chairperson, Executive Committee, International Organization of Securities Commissions

"Lee offers important policy analysis for governing the institutions that provide the basic infrastructure of the world's financial markets. He looks at crucial but underanalyzed organizations that sustain the critical trading, clearing, and settlement platforms for the world's massive cash and derivative markets. The well-developed policy proposals contained here would, if implemented, make the financial markets significantly safer and more efficient."--Jonathan Macey, Yale Law School

From the Inside Flap

"How should the infrastructure underpinning today's volatile, rapidly evolving, and complex markets be run? Ruben Lee's extensive knowledge, superlative analysis, and practical guidance help answer this fundamental question."--Donald F. Donahue, chairman and CEO, The Depository Trust & Clearing Corporation

"Ruben Lee has used his deep understanding of the markets to produce a comprehensive analysis of governance issues. A must for every policymaker's bookshelf."--Ravi Narain, CEO, National Stock Exchange of India

"Ruben Lee has written the essential guide to the ownership, structure, and governance of the exchanges, clearing houses, and depositories constituting the essential infrastructure of financial markets throughout the world. Nobody understands or explains these vital, complex, and constantly evolving institutions better than Lee."--Henry B. Hansmann, Yale Law School

"Market infrastructures are based on an unusually strong combination of contradictory forces. In this complicated setting, Ruben Lee's book constitutes a major contribution, laying bare these complexities and offering perspectives for their efficient organization."--Eddy Wymeersch, chairman, Committee of European Securities Regulators

"While one may disagree with some of its conclusions, this book is an important contribution to the debate about the role and function of regulation and regulators, and the governance of financial market infrastructure."--Jane Diplock AO, chairman, New Zealand Securities Commission and chairperson, Executive Committee, International Organization of Securities Commissions

"Lee offers important policy analysis for governing the institutions that provide the basic infrastructure of the world's financial markets. He looks at crucial but underanalyzed organizations that sustain the critical trading, clearing, and settlement platforms for the world's massive cash and derivative markets. The well-developed policy proposals contained here would, if implemented, make the financial markets significantly safer and more efficient."--Jonathan Macey, Yale Law School

Excerpt. © Reprinted by permission. All rights reserved.

Running the World's Markets

The Governance of Financial InfrastructureBy Ruben Lee

PRINCETON UNIVERSITY PRESS

Copyright © 2011 Ruben Lee
All right reserved.
ISBN: 978-0-691-13353-9

Contents

Foreword and Acknowledgments.........................................................................................xiList of Acronyms.....................................................................................................xiiiIntroduction.........................................................................................................1Part One: Background Information and Analysis........................................................................7Chapter One Definitions..............................................................................................9Chapter Two Market Power.............................................................................................40Part Two: Survey Evidence............................................................................................83Chapter Three The Allocation of Regulatory Powers over Securities Markets............................................85Chapter Four Regulation and Governance of Market Infrastructure Institutions: Global Perspective.....................117Chapter Five Governance of Market Infrastructure Institutions: A Snapshot............................................145Part Three: Case Studies.............................................................................................167Chapter Six Exchanges................................................................................................169Chapter Seven CCPs and CSDs..........................................................................................201Part Four: Policy Analysis and Recommendations.......................................................................245Chapter Eight What Is the Most Efficient Governance Structure?.......................................................247Chapter Nine Who Should Regulate What?...............................................................................301Chapter Ten How Should Market Infrastructure Institution Governance Be Regulated?....................................339Authorities..........................................................................................................363Cases and Decisions..................................................................................................365Notes................................................................................................................367References...........................................................................................................395List of Contributors.................................................................................................433Index................................................................................................................437

Chapter One

Definitions

To many people it is clear what are the "infrastructure institutions" in financial markets. They are the exchanges, CCPs, and CSDs that provide the trading, clearing, settlement, and sometimes other, core functions for cash and derivative markets. These institutions are indeed the focus of attention here. There are, however, also many reasons why the definitions of an infrastructure, an exchange, a CCP, and a CSD are all quite opaque. This is important, as the identification of a particular organization as one of these types of institutions can have significant commercial, regulatory, and policy consequences. This chapter aims to provide some basic insights into the definitions and nature of an infrastructure, an exchange, a CCP, and a CSD; and to explore the reasons why these concepts are sometimes ambiguous and controversial. A comprehensive examination of each of these different concepts would require a series of complex and broad analyses, and is not undertaken here.

The chapter is composed of three sections. In the first, the meaning and nature of what is an infrastructure is explored. Some comments on the definitions and nature of exchanges, CCPs, and CSDs, and on the functions they deliver, are provided in the second section. Brief conclusions are offered in the last section.

Infrastructure

Understanding how the term "infrastructure" has generally been employed and the key factors relevant for determining whether an institution is an infrastructure illuminates how the term may be used regarding institutions in financial markets, and the implications of doing so.

Meaning and Use of the Term

An examination of a broad range of definitions and uses of the term "infrastructure" highlights eight key nonexclusive factors and attributes that contribute towards identifying an institution as an infrastructure:

1. An infrastructure may be, or provide, the basic equipment, facility, foundation, framework, installation, system, or services that support or underly some form of structure, system, or activity, defined quite broadly. Such a structure, system, or activity may include a corporation, an organization, a productive process, a community, a city, an economy, a society, a nation, or a group of nations. The goods or services provided by an infrastructure are often both consumed directly and also used as inputs for a wide range of goods or services produced by users of the infrastructure institution. In this context, an infrastructure is often referred to as a "utility"—although this term, itself, is not easy to define.

2. An infrastructure may be critical, essential, or necessary, to support commerce, economic activity and development, or whatever other activities are facilitated by the system it operates. Given the critical nature of the basic goods or services that an infrastructure provides, there are frequently concerns about access to these goods or services.

3. An infrastructure may be, or provide, a network. In the economic sphere, such a network typically facilitates the delivery of goods and services, or links together the participants in a market, and is thus part of the structure underlying a market. The relationship between relevant producers and consumers takes place on, or via, the shared facilities or single medium provided by the infrastructure. A network is typically composed of both the physical structure linking market participants, and the associated commercial arrangements and rules for using this structure.

4. An infrastructure may exhibit economies of scale.

5. An infrastructure may require large, long-term, immobile, and sunk investments.

6. An infrastructure may be, or operate, a natural monopoly.

7. An infrastructure may provide beneficial public goods or services, in addition to the specific goods and services it delivers directly. There are two key attributes of a pure public good or service: it is nonrivalrous, so that its consumption by one person does not prevent other people from consuming it; and it is nonexcludable, so that it is not possible to stop somebody from consuming it. An often-cited example of a public good is good health, as facilitated by water and sanitation infrastructures.

8. An infrastructure may have some form of government or public sector involvement, defined very broadly. For this reason, the term "public works" is sometimes used interchangeably for the term "infrastructure." The role of government or public sector involvement in infrastructures has been quite diverse. As Waller and Frischmann (2007, 12) note:

The government has played and continues to play a significant and widely-accepted role in ensuring the provision of many infrastructure resources. While private parties and markets play an increasingly important role in providing many types of traditional infrastructure due to a wave of privatization as well as cooperative ventures between industry and government, the government's position as provider, coordinator, subsidizer, and/or regulator of traditional infrastructure provision remains intact in most communities throughout the world.

Several implications and aspects of this list of factors and attributes that contribute towards identifying an institution as being an infrastructure are noteworthy:

1. There are close links between many of them. For example, the presence of economies of scale is often associated both with a natural monopoly and with a network industry.

2. The presence of any one of the identified factors and attributes is not sufficient to determine that an institution is an infrastructure.

3. None of them are exclusive to infrastructure institutions.

4. The term "infrastructure" has been used in different contexts for different reasons. Unsurprisingly, therefore, different meanings have been assigned to the term.

5. A central aspect of an infrastructure is its importance, however this quality is defined. This importance may arise, in legal terms, because it is, or runs, an essential facility; in economic terms, because it is a monopoly; or its importance may lie in other directions, affecting social, political, or other factors.

6. The classification of an institution as an infrastructure, or not, may change. For example, technological changes and market developments may mean that an institution that was historically thought to be, and defined as, an infrastructure, given its importance, may no longer be so considered, if it becomes subject to competition.

7. It may be difficult to define an institution as an infrastructure if it undertakes multiple functions. In particular, if a single institution undertakes some functions that are recognized as infrastructure functions, and some others that are not, perhaps because they are provided in competitive markets, then it may be unclear how to characterize the institution. Should it be classified as an infrastructure institution, even though some of its functions are typically provided by non-infrastructure institutions? Or is it more useful to define activities as being associated with infrastructure provision rather than institutions?

8. The presence of these factors and attributes may have important policy implications.

A range of assets, services, organizations, and industries have typically been identified as infrastructure. They include the basic physical systems of a nation, particularly its transport (airports, air traffic control, bridges, buses, rail, roads, ports, and public transit), communications (post, telephone, and sometimes the Internet), energy (electricity and gas supply and distribution facilities, and sometimes oil), and water and sanitation systems. In addition, infrastructure may include public and social facilities, such as police, fire, and emergency services, schools, hospitals, recreation facilities, prisons, and government systems, such as courts, ministries, and parliaments.

In financial markets, the term "infrastructure" has been widely used to refer to exchanges, CCPs, and CSDs as providers of trading, clearing, and settlement services, and also to payment systems. It has also infrequently been used to refer to other providers of trading, clearing, and settlement services.

A range of examples illustrate how the term has been used. The UK's Financial Services Authority (FSA) defined "infrastructure providers" to be

entities whose business is organising and supporting the functioning of markets. Infrastructure providers include exchanges, non-exchange (or "alternative") trading systems, clearing houses and market service providers generally.

More informally, Oleg Vyugin, a Russian regulator from the Federal Service for Financial Markets, noted that "double the infrastructure is madness," when discussing why Russia's two major exchanges should consider merging to improve their competitiveness against overseas exchanges.

The Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) and the Technical Committee of IOSCO have jointly developed recommendations for Securities Settlement Systems (SSS), the first sentence of which notes that such entities "are a critical component of the infrastructure of global financial markets." The committees have also developed recommendations for CCPs, and in doing so noted,

Although a CCP has the potential to reduce risks to market participants significantly, it also concentrates risks and responsibilities for risk management. Therefore, the effectiveness of a CCP's risk control and the adequacy of its financial resources are critical aspects of the infrastructure of the markets it serves.

Similarly, a paper prepared for the International Monetary Fund (IMF) noted that

the smooth functioning of and confidence in the securities market depend on the efficiency and reliability of its infrastructure. In particular, it is crucial that the transfer of ownership from the seller to the buyer in exchange for payment takes place in a safe and efficient manner.

The European Centrol Bank (ECB) has established a Contact Group on Euro Securities Infrastructures, which "addresses issues and developments which are relevant for the euro securities settlement industry and which are of common interest for the Eurosystem, market infrastructures and market participants."

When describing clearing and settlement as the infrastructure underpinning financial markets, one metaphor that is very commonly used is that of plumbing. The European Commission, for example, used this metaphor in explaining that such institutions are "vital, but unglamorous and forgotten until something goes wrong." A report from the European Parliament used the same metaphor, similarly noting that clearing and settlement is "largely invisible, seldom understood and frequently overlooked but causes really unpleasant problems for everyone if it goes wrong." As well as equating clearing and settlement systems with sanitation systems, which are typically themselves accepted as infrastructure, the metaphor also implies that clearing and settlement systems provide a public good in preventing things from "going wrong."

Key Attributes of an Infrastructure Institution

Five of the key factors relevant for determining whether an institution is an "infrastructure" are briefly examined here.

ESSENTIAL FACILITY DOCTRINE

A commonly accepted attribute of infrastructure institutions is that the goods or services they produce are essential in some manner. This characteristic has in some contexts brought them within the purview of a legal doctrine, initially developed under US antitrust law, called the "essential facility" doctrine. The key thrust of the doctrine is that a monopolistic operator of an essential facility may be obliged to provide access to it to a competitor. In the past, four main criteria have needed to be satisfied under US law for such a possibility to arise: (1) the monopolist must control access to an essential facility, (2) the facility cannot practically or reasonably be duplicated by the competitor, (3) the monopolist must deny access to the competitor, and (4) it is feasible for the monopolist to grant access to the competitor.

The essential facility doctrine has been applied by US courts to secure the access of competitors to various institutions that could be considered infrastructures, including a terminal railroad, an information network for the press, an electricity network, a telecommunications network, and ski facilities.

As discussed by Waller and Frischmann (2006), however, the continued applicability of the essential facility doctrine has come into question and been subject to criticism from a range of different sources. In 2004 the US Supreme Court expressed a strong reservation as to the pertinence of the doctrine due to its drawbacks on competition policy, noting,

Compelling such firms [i.e., with an essential facility] to share their advantage is in some tension with the underlying principles of antitrust law, since it may lessen the incentive for the monopolist, the rival or both to invest in those economically beneficial facilities. Enforced sharing also requires antitrust courts to act as a central planner identifying the proper price, quantity and other terms of dealings—a role for which they are ill-suited. Moreover, compelling negotiations between competitors may facilitate the supreme evil of antitrust: collusion.

The Supreme Court stressed that "we have never recognized such a doctrine [i.e., the essential facility doctrine], and we find no need either to recognize it or to repudiate it here." A range of US commissions and enquiries, and analyses by antitrust enforcement agencies from the United States and other countries, and by academic scholars, have also found fault with the essential facility doctrine.

Though not formally recognized under EU law, the essential facility doctrine has influenced the creation, implementation, and enforcement of EU law. EU competition law does not forbid the creation or the maintenance of monopolies per se, but does regulate the actions of companies in dominant positions that abuse such positions, under Article 82 of the Treaty of Rome. One type of behavior that may constitute an abuse is the unfair denial of access. The European Commission has referred to the essential facility doctrine in order to demonstrate the existence of an infringement against Article 82 in cases where

[an] undertaking, which occupies a dominant position in the provision of an essential facility and itself uses that facility, refuses other companies access to that facility without objective justification or grants access to competitors only on terms less favourable than those which it gives its own services.

The Commission has also specifically defined an essential facility on its website as a

facility or infrastructure which is necessary for reaching customers and/ or enabling competitors to carry on their business. A facility is essential if its duplication is impossible or extremely difficult due to physical, geographical, legal or economic constraints. Take for example a national electricity power grid used by various electricity producers to reach the final consumers: Since it would not be viable for these producers to build their own distribution network, they depend on access to the existing infrastructure. Denying access to an essential facility may be considered an abuse of a dominant position by the entity controlling it, in particular where it prevents competition in a downstream market.

In addition, the European Commission has adopted several items of sector-specific legislation regarding the nondiscriminatory access of competitors to what could be considered essential facilities, such as in the electricity and telecommunication sectors.

Under the Merger Control Regulation, the European Commission has ruled on several occasions that entering into an agreement or a merger could create the equivalent of an essential facility, access to which by competitors should be granted as a preventative measure in order to avoid the possibility that the newly integrated business become the source of an undue restriction of competition.

(Continues...)

Excerpted from Running the World's Marketsby Ruben Lee Copyright © 2011 by Ruben Lee. Excerpted by permission of PRINCETON UNIVERSITY PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Edition details

• Publisher: Princeton University Press
• Publication date: 2011
• Language: English
• ISBN 10: 0691133530
• ISBN 13: 9780691133539
• Binding: Hardcover
• Number of pages: 472