the links between securities settlement systems: an olihopoly theoretic approach

International Review of Financial Analysis

13 (2004) 585–600

The links between securities settlement

systems: An olihopoly theoretic approach

Karlo Kauko

Bank of Finland, (Suomen Pankki) PO Box 160, 00101 Helsinki, Finland

Abstract

A duopoly model of the securities settlement industry is presented. Because pooling payments

can help in using liquidity efficiently, issuers prefer systems where a large number of securities are

issued. If the central securities depositories (CSDs) establish a mutual link that enables investors to

make transactions with foreign securities, cost savings can be achieved. However, these links may

have unexpected effects on CSDs’ pricing, and the issuers’ share of the fee burden can increase

substantially. It is not advisable to ban additional fees for using the link, as the CSDs might simply

increase the fee for domestic transactions.

D 2004 Published by Elsevier Inc.

JEL classification: L13; G20

Keywords: Securities settlement systems; Oligopolies

1. Introduction

Modern securities settlement systems (SSSs) are often highly centralised. The core of

the system is a central institution that runs the system, for example, the national central

securities depository (CSD). A relatively small number of institutions participate directly

in the process. These participants (members) are financial institutions such as banks and

investment firms (IFs). Government treasuries and central banks may also be members. A

typical investor uses services provided by a member of the settlement system. There are

many nonintegrated national systems, and most of the securities traded are issued by

domestic entities. Although remote access from abroad to trading has become common-

place, remote participation in SSSs is still exceptional. The report of Giovannini et al.

1057-5219/$ - see front matter D 2004 Published by Elsevier Inc.

doi:10.1016/j.irfa.2004.02.014

E-mail address: [email protected] (K. Kauko).

K. Kauko / International Review of Financial Analysis 13 (2004) 585–600586

(2001) discusses the practical problems related to cross-border clearing and settlement in

the EU.

It is increasingly appreciated that the European securities market infrastructure is going

through a period of profound change. Several mergers have taken place between securities

market institutions. Although much of the consolidation has taken place at the national

level, some international mergers have occurred between EU member countries, and more

are expected to occur over time, bringing historically exceptional change to the increas-

ingly integrated securities market infrastructure. Links between CSDs are a relatively new

arrangement, aimed at improving the possibilities to settle cross-border transactions. These

links are established by bilateral agreements between SSSs. Customers of an SSS can hold

securities in another system via the domestic service provider. The domestic service

provider opens an omnibus account in a foreign book-entry system, and the holdings of its

customers are pooled in this account. The domestic CSD keeps individual records on

investors’ holdings.

This paper analyses the competition between two SSSs in a fragmented market,

where the focus is on pricing and interlinking. The systems operate in a platform

industry, as defined by Rochet and Tirole (2001), and must attract both issuers and

investors. Although there are earlier analyses on network effects and oligopolistic

competition between stock exchanges (Di Noia, 1999; Shy & Tarkka, 2001), these

focus on trading activities rather than on SSSs. The basic model is presented in Sections

2 and 3. Competition for issuers is fierce because trades must be settled in the CSD,

chosen by the issuer. The whole fee burden is borne by the investors. In Section 4 it is

assumed that the two CSDs are linked. Significant cost savings can be achieved in the

use of liquidity and in operating costs. Competition for issuers is relaxed, and their

relative fee burden increases. In Section 5, we demonstrate that it is not advisable to ban

additional fees for using the link because this may simply lead to higher prices for

domestic services. The main conclusions and a few suggestions for further research are

presented in the final section.

2. The basic model

A large number of bond issuers, each of whom issues I bonds in the primary market, are

numbered 0,1,2,. . .,M. The bonds are in book-entry form. The issuers maximise the

difference between the value of bonds in the primary market and the cost of registering and

issuing them. The bonds are sold to investors at a price equal to the difference between a

constant and the expected value of secondary market settlement costs paid by purchasers

in the primary market. The issuer pays all fees related to issuance. Investors live in two

countries, denoted 1 and 2. In each country, they are divided into two groups, A and B.

These groups might be households and institutional investors.

There is a profit maximising CSD in each country. Each CSD operates as a platform

industry because it needs two types of customers that interact—issuers and investors. The

CSD is the registrar of the book-entry system, and it runs the SSS. Running the settlement

process generates costs, whereas registering new issues does not. The unit cost—per

transaction, sale, or purchase—of the centre for country j is denoted zj.

K. Kauko / International Review of Financial Analysis 13 (2004) 585–600 587

Bonds are distributed in the primary market so that the proportion of issuer i’s investors

living in Country 1 is (M�i)/M. Each issuer knows beforehand where its investors live. All

the original buyers of any issue belong to the same investor group. Half of the issues are

subscribed by A investors and half by B investors. Issue number is not related to investor

group. In most cases, not all investors live in the same country, but the two groups exist in

both countries. There is also a secondary market for bonds in which trades are settled in

systems operated by the CSDs. Investors must use IFs to settle transactions in the CSDs. In

each country, there are two IFs competing for the A investors and two competing for the B

investors. IFs cannot become members of the foreign SSS. Investors must use a foreign IF

when they trade in foreign securities. Using a foreign IF is more complicated than using a

domestic one and entails an extra cost h. The IFs achieve turnover via pricing of their

services to investors. The price charged by an IF (v) is the same for a sale or a purchase.

The IFs have simple cost functions. For any IF, the cost of processing a transaction is y,

which is an exogenous constant. One trade, consisting of a sale and corresponding

purchase, is now defined as two transactions. The IFs Bertrand compete with identical

services.

Only two of the randomly determined (equally likely) bond issues are traded. The two

bonds are originally held by the investors of each group. The two issuers’ bondholders

exchange securities. Each investor is simultaneously a seller and a buyer. Price formation

and trading are ignored. The price of every security in the secondary market is the same

and does not depend on settlement costs. High settlement costs reduce both supply and

demand, and the total impact on price is consequently unclear (see Barclay, Kandel, &

Marx, 1998 for empirical analysis). Because each investor is simultaneously a seller and a

buyer, his/her incoming and outgoing monetary payments sum to zero, except for the IF

fees.

Monetary payments between the SSSs and IFs are based on netting.1 The IFs prefer

situations in which they intermediate both sales and purchases and need not make gross

payments to the CSDs. If gross payments are made, the IFs may need large and costly

cash balances. An IF might be unable to acquire liquidity to cover its net payment

obligations, which could result in sanctions. Clearing parties with net obligations may

have to post some assets as collateral, forcing the clearing parties to hold larger

portfolios (e.g., of government securities) than they would otherwise prefer. Moreover,

by pledging an important part of its assets, a clearing party weakens its own

creditworthiness in noncollateralised borrowing because collateral assets cannot be freely

liquidated to cover the debts in case of bankruptcy. This probably affects the cost of

external funding.

The expected total cost and disutility of being a clearing party with a gross payment

obligation is a per security purchase to be intermediated. The analysis is restricted to

cases where 2h>a. It will be seen in due course that there is no meaningful equilibrium

1 This is a satisfactory approximation for many gross settlement systems. In a typical gross settlement

system, no settlement counterparty is obliged to make all the outgoing payments during a day before receiving

any incoming payments. Instead, automatic chaining procedures applied in many systems guarantee that

incoming payments can be used efficiently as a source of funding for outgoing payments.


with two participating CSDs if this condition is not satisfied. Events happen in the

following order.

1. Profit-maximising CSDs set their prices, including those to be paid by issuers ( pi for

the CSD based in the country i), and a unit price per bond to be paid by clearing parties

(bi),

2. Issuers choose their CSDs, and bonds are issued,

3. Profit maximising IFs simultaneously set their fees (vs),

4. The two bond issues to be traded are determined,

5. Investors choose IFs and try to minimise settlement costs, and

6. The trades are settled, net payments are made, and securities are transferred.

All agents are assumed to be risk neutral and to be able to immediately observe every

decision and random outcome. Steps 4, 5, and 6 could describe a day. These three steps are

repeated hundreds of times every year. The CSDs and IFs make no decisions at these

stages. Expected values analysed in the following sections are simply multiplied by the

number of repetitions and have no fundamental impact on their optimal decisions.

3. Solving the model

3.1. Competition between IFs

Because of Bertrand competition with identical services, the fee charged by an IF (vi)

must equal the marginal cost, which equals the sum of the unit fee charged by the CSD

(bj), the marginal processing cost for the IF ( y), and the expected value of the per-

transaction cost of gross payments (Fi).

vi ¼ Fi þ bj þ y ð1Þ

Gross payment costs are the only complicated component of the marginal cost. If two

bond issues, i and j, are traded, the cost of gross payments (a) materialises as a part of

Country 1’s IF cost in two possible cases. (Terms in parentheses are respective

probabilities.) Bond i is registered in the domestic country (C1) and bond j in the foreign

country (C2). The IF represents half of the buyers. Hence, the expected value of the total

gross payment cost is

aC1C2

2þ C2C1

2

� �¼ aC1C2 ð2Þ

A part of the fee corresponds to this expected value. According to Eq. (1), the expected

value of this cost factor must equal the expected value of the corresponding fee revenue.

The expected value of the number of transactions is the sum of two components. First, the

IF collects fees if one of the two securities to be traded is registered in its home country.

Each customer must pay the fee at once to the IF. The probability of this equals 2C1C2.

Second, if the IF charges fees if both issues to be traded are registered domestically. The


probability that both bond issues to be settled are registered in Country 1 is C12. In this

case, each customer has to pay the same fee twice because he presents two settlement

orders to the same IF.

The expected value of the part of the fee revenue that corresponds to gross payment

costs is thus:

F1ð2C2C1 þ 2C21Þ ð3Þ

The expected value of fee revenue related to gross payment costs (Eq. (3)) must equal

the expected cost of making gross payments (Eq. (2))

aCjCi ¼ Fð2CjCi þ 2C21Þ

ZFi ¼aCj

2ð4Þ

This result is quite intuitive. If the market share of domestic CSD 1 is marginal (C1c0),

it is almost certain that if a domestically registered bond is traded, the other bond to be

traded is registered abroad and netting cannot be used. The IF has a 50% chance of

representing a buyer. The larger the domestic CSD’s market share, the more likely it is that

the IFs will benefit from netting. Therefore, Eq. (1) can be rewritten as

vi ¼aCj

2þ bi þ y ð5Þ

3.2. Pricing decisions by the CSDs

The CSDs maximise the expected value of their profits. Their decision variables are

the price paid by issuers ( pi) and the price per transaction paid by settlement counter-

parties (bi). Issuers minimise the sum of fees paid by themselves and the settlement costs

to their bondholders. Investors’ costs are relevant because they affect security prices in

the primary market. If 100j% of the bondholders live in Country 2, the cost of using

CSD 1 is p1+I(2/M){v1+jh}, where 2/M is the probability that the issuer will be one of

the two issuers whose securities are traded and v1 the price charged by all the IFs of

Country 1. The cost of using CSD 2 is p2+I(2/M){v2+(1�j)h}. Because v1=aC2/2+b1+y

and v2=aC1/2+b2+y, the condition for using CSD 1 can be written as

p1 þ2I

M

� �aC1

2þ b2 þ yþ jh

� �< p2 þ

2I

M

� �að1� C1Þ

2þ b2 þ yþ ð1� jÞh

� �

Zj <f2hI � aI � 2Ib1 þ 2Ib2 þ 2aC1I �Mp1 þMp2g

f4hIg ð6Þ

This condition implies a network externality. The market share of CSD 1 (C1) has a

direct impact on its competitiveness. If most companies are registered at CSD 1, it

becomes more likely that IFs operating in Country 1 need not make gross payments in the


settlement system. This, in turn, has a direct impact on the fee paid by the investors (v1).

This network externality implies that market forces are, at least, weakly inclined to

integrate securities settlement by centralising the process in one centre.

In equilibrium, the relative share of issuers preferring CSD 1 must equal the market

share C1. Because issuers’ bondholder structures are evenly distributed along the

continuum from j=0 to 100, it follows that Eq. (6) implies

C1 ¼ 1=2þ2b2 � 2b1 þ M

I

� �ðp2 � p1Þ

� �½4h� 2a ð7Þ

The CSD has two decision variables, b and p. As determinants of market shares, these

two variables are perfect substitutes; any combination of p and b that satisfies the

condition 2Ib1+Mp1=D (D being any constant) leads to the same market share. The

CSD can decide these prices in the following way. CSD 1 decides first on a suitable value

of D, then, on the value of p1. These decisions determine the value of b1. Using this

notation, the expected profit of CSD 1 can be written as

P1¼C1 Mp1þ4IðD�Mp1Þ

ð2IÞ

� �� z1

¼ C1½2D�Mp1 � z1Z

BP1

Bp1¼ �C1M < 0

It follows that the optimal price paid by issuers is 0, so the entire fee burden is borne by

IFs and the investors [ p1=p2=0, b1=D/(2I)]. When choosing a CSD, an issuer pays no

attention to the fees paid by future bondholders. However, these fees are a valuable source

of revenue for CSDs.

There are two issues of I bonds to be traded. For each of them, the probability of being

registered in CSD 1 equals its market share (C1), implying that the expected value of the

number of processed securities equals 2IC1. Each traded issue registered in CSD 1 yields

two service fees (b1) per processed security, one for selling and another for buying. The

cost per processed security equals 2z1. Therefore, CSD i’s expected profit is

Pi ¼ 2I ½bi � zi½�a þ 2bj � 2bi þ 2h

½2h� a ð8Þ

The first-order optimisation condition of a CSD is

BPi

Bbi¼ �2I

½a þ 4bi � 2ðbj þ hþ zi½2h� a ¼ 0 ð9Þ

This condition is satisfied for both CSDs iff (i= 1,2)

bi ¼ð�3a þ 6hþ 4zi þ 2zjÞ

6ð10Þ

The second order condition is B2P1/Bb12=�8I/(2h�a). This is negative, and the extreme

values are maxima iff a<2h. If this condition were not satisfied, Eq. (7) would imply that

BCi/Bpi>0 and BCi/Bbi>0, which is not a meaningful result. The result in Eq. (10) is easy


to understand intuitively. First, being cost inefficient means a high optimal price. A cost-

inefficient competitor improves the possibility to charge high prices. If the cost of making

cross-border transactions (h) is high, the CSD’s pricing decisions are made in a less

competitive environment because the issuer’s decisions are determined by bondholders’

home countries rather than the CSD’s prices.

The most interesting finding might be the impact of netting possibilities on price

competition. If almost nothing can be gained by netting (ac0), price competition is

moderate. If the potential cost savings are substantial aH0, price competition is fierce. By

attracting an issuer with aggressive pricing, the CSD can easily attract another issuer

because its bondholders value the possibility to benefit from netting should they exchange

bond issues with the bondholders of the first issuer. This outcome is somewhat analogous

with that of Katz and Shapiro (1986), but it differs in terms of the equilibrium price

externality from the analysis of Economides and Siow (1988).

These pricing decisions imply the following market shares:

Ci ¼½�3a þ 6h� 2zi þ 2zj

½12h� 6a ð11Þ

The profits of the country i CSD can be calculated by combining the results Eqs. (10)

and (11).

Pi ¼½�3a þ 6h� 2zi þ 2zj2

½9ð2h� aÞ ð12Þ

Because the cost of cross-border transactions is the CSD’s only source of market power,

it is not surprising that high costs increase the likelihood that both CSDs will earn positive

profits. In contrast to this, a high cost of gross payments (a) intensifies price competition,

making it increasingly difficult, especially for the smaller CSD, to charge prices that

exceed costs. The empirical prediction of this model is that the issuers are loss leaders, as

defined by Rochet and Tirole (2001), whereas investors are the profit-making segment for

CSDs. It is surprisingly difficult to find suitable data on different sources of CSD revenue,

but casual observation indicates that revenue from secondary market trading has

traditionally exceeded revenue from issuance.

4. Linking the securities centres

Every IF can participate in the SSS of the neighbouring country via the domestic CSD

and the link between CSDs. The domestic CSD has an omnibus account with the foreign

CSD, in which the customers’ securities are held. The operating costs of a transaction are

borne by the CSD of the investor’s home country. From the viewpoint of registration

country processes, there is only one large net transaction on a particular customer account,

whereas the CSD based in the investors’ home country must administer thousands of small

transactions on a large number of accounts. CSD i sets three different prices: first, a price

paid by each issuer ( piz0), second, a basic unit fee paid by IFs for each settlement

transaction involving any security (biz0), and third, an additional fee paid by IFs for each


transaction with foreign securities (riz0). When trading in foreign securities, the investor

can use either a domestic IF connected to the domestic CSD and the link, or he/she can

participate via a foreign IF. If the investor uses the foreign IF, there is an extra cost, h, as in

the basic model. Events happen in the following order.

1. CSDs set prices for issuers ( ps) and for IFs (bs and rs),

2. IFs set their prices,

3. Issuers choose CSDs, and

4. Investors choose IFs. Trades are agreed, cleared, and settled.

Establishing the link is pointless unless the CSDs know that investors are going to use

it. The following analysis can be restricted to cases where the link is in use. As we will see,

however, investors’ possibilities to use foreign IFs are not completely irrelevant when

CSDs set their prices.

4.1. Competition between IFs

If a cross-border transaction is processed via the link, every investor deals through one

IF. Because no investor has to make a gross payment, the monetary payment between the

IF and the investor is always zero. Consequently, even the monetary payments between the

IF and the CSD can always be netted. Interestingly, even the net payment between the two

CSDs will always be zero because of complete netting at all the levels. If the CSDs offer

no cross-border payment facilities, the IFs in different countries will use an existing

international payment system in which payments can be netted. Hence, the cost component

a vanishes. This reduced need for liquidity argues in favour of consolidation and linking in

the securities settlement industry. Eq. (2) implies that the prices paid by customers in

country i are

vid ¼ bi þ y and vif ¼ bi þ ri þ y ð13Þ

where vid is the price paid by country i investors for domestic transactions and vif is the

price paid for cross-border transactions.

4.2. Market shares

Issuer i, with 100(i/M)% of bondholders in Country 2, prefers to use CSD 1 iff

p1 þ b1I 1� i

M

� �þ ðb2 þ r2ÞI

i

M< p2 þ ðb1 þ r1ÞI 1� i

M

� �þ I

i

Mb2

Zi < MðIr1 � p1 þ p2ÞðIr1 þ Ir2Þ

The CSD’s market share does not enter this expression. The network externality

that prevailed in the previous version of the model no longer exists because all


payments can be netted. The formulas for market shares can be derived easily from

the above condition

Ci ¼ðIri � pi þ pjÞ½Iðri þ rjÞ

ð14Þ

Interestingly, the basic transaction fee (bi) is irrelevant for market share. Possibly even

more surprising is that high extra fees charged for cross-border transactions raise the

market share because CSD 1 can make the rival CSD 2 unattractive for Country 1

customers.

BC1

Br1¼ ½Ir2 � p2 þ p1

½Iðr1 þ r2Þ2> 0

4.3. CSDs’ profits

The relative share of securities originally issued in a CSD has no direct impact on the

number of secondary market transactions processed by it. Investors’ home countries

determine where the securities are settled, irrespective of the original country of issuance.

CSD 1 can earn revenue in three different ways. First, when securities are issued, the CSD

collects fees related to securities registration and primary market transactions. This

revenue equals the fee revenue from each issue ( p) times the number of issuers (M)

times the market share of the CSD (C).

p1MC1 ð15Þ

Second, it earns revenue by selling services to buyers. The number of securities to be

bought equals 2I. In expected value terms, half of the buyers live in the home country of

the CSD. A certain percentage of securities is registered abroad, implying that there is an

extra fee revenue worth I(1–C1)r1. Therefore, the total net revenue from buyers equals

Iðb1 � z1Þ þ Ið1� C1Þr1 ð16Þ

Calculating the fee revenue collected from investors that sell securities is more

complicated. The country of registration aligns with the original bondholders’ home

countries. The expected value of net revenue earned by providing services to sellers of

domestically registered security i equals

2

M

� �Iðb1 � z1Þ 1� i

M

� �

Here, (2/M) is the likelihood that the issue is traded, I the number of securities per issue,

(b1�z1) the net revenue per transaction, and (1– i/M) the relative share of bondholders

living in Country 1 and thus using the services of CSD 1.


As regards securities registered in the foreign country, the net revenue for selling is

determined in a similar way, the difference being the extra fee, r1

2

M

� �Iðb1 þ r1 � z1Þ 1� i

M

� �

The number of domestically registered bond issues is MC1 and the total number of

issuers is M. It follows that the net income from providing services to sellers is

Z MC1

0

2

M

� �Iðb1 � z1Þ 1� i

M

� �diþ

Z M

MC1

2

M

� �Iðb1 þ r1 � z1Þ 1� i

M

� �di ð17Þ

The profit can be calculated as the sum of these three components (Eqs. (15), (16), and

(17)).

Pi ¼ 2biI þ CiMpi þ 2Iri � 3IriCi þ C2i Iri � 2Izi ð18Þ

4.4. Prices and profits

When Eq. (14) is substituted for market shares, optimal prices in the primary market are

determined by the conditions

BP1

Bp1¼ 0

BP2

Bp2¼ 0

There is one combination of ps that satisfies both conditions, namely,

pi ¼ If�8rirj þM 2ðr2j þ 3rirj þ 2r2i Þ þMðr2j þ 5rirj þ 2r2i Þg

½Mð3M � 2Þðri þ rjÞð19Þ

The second-order condition (B2P1/Bp12=�2{(M�1)r1+Mr2}/{I(r1+r2)

2}<0) is satisfied.

Because MH0, both p1 and p2> 0 whenever r1>0 or r2>0, or both.

Differentiation of Eq. (18) yields

BP1

Bb1¼ 2I > 0 ð20Þ

It will always be optimal to charge a higher fee if pricing is not constrained. The upper

limit for this fee is determined by the condition that the total fee paid by cross-border

investors cannot exceed the cost of using foreign IFs. It follows that if a CSD wants to

intermediate settlement orders through the link, the highest feasible price satisfies the

condition

bi þ ri ¼ bj þ hZ bi ¼ bj þ h� ri ð21Þ

Hence, both the fee paid by issuers ( pi) and the basic fee paid by investors (bi)

can be expressed as functions of ri, bj, and h. By substituting Eq. (21) for b1,

substituting the optimal price presented in Eq. (19) for p1, substituting Eq. (14) for


market shares, and taking into account the assumption that MH0, differentiation of

Eq. (18) yields

LimM!l

BP1

Br1

¼ Lim

M!lM

f3p2r2 þ 2Ir1ðr1 þ 2r2Þg½9ðr1 þ r2Þ2

ð22Þ

Whenever r1>0, r2>0, or both, this equals +l. It follows that irrespective of rival

prices, the additional fee for cross-border transactions (r1) is the highest fee that still

satisfies Eq. (21), and the optimal combination of b1 and r1 is

r1 ¼ hþ b2; b1 ¼ 0 ð23Þ

Analogously r2=h+b1 and b2=0. It follows that (r1=r2=h). This outcome does not

necessarily depend on the assumption of zero price elasticity of demand.

The pricing decision of the CSD is constrained by the fact that domestic customers

will use foreign IFs whenever the additional fee (r) is higher than the investors’ cost of

using foreign IFs (h). If this condition is binding, it holds irrespective of whether there is

a higher but finite optimal monopoly price. In real life, a CSD’s fees for cross-border

transactions are higher than its fees for domestic transactions (Lannoo & Levin, 2001).

Interestingly, the link does not promote the integration of securities markets. In the

absence of the link, the cost differential between domestic and cross-border transactions

is an exogenous constant h, at least, if both CSDs are equally cost efficient. Now, in the

presence of the link, the difference still equals h, although it consists of CSDs fees. This

result has a clear policy implication. Even when the link has been established,

governments could try to promote the integration of financial markets by making it

easier and cheaper for investors to use services offered by foreign IFs. This would limit

CSD’s possibilities to exploit the monopoly position. Removing the causes of a high

value of h would enhance integration more efficiently than pressing CSDs to establish

mutual links.

When r1=r2=h and b1=b2=0, Eq. (19) implies that the fee paid by issuers equals

pi ¼Ið2þMÞh

Mð24Þ

Applying Eqs. (14), (18), (23), and (24) yields

Pi ¼I ½hð7þ 2MÞ � 8zi

4ð25Þ

This model predicts that in the presence of the link, CSDs will charge issuers rather

than investors will. In the basic model, issuers can make CSDs compete, whereas investors

cannot. If there is a link between the two CSDs, issuers no longer determine where the

secondary market investors have to operate, which makes it less essential to attract them.

The empirical prediction is clear, but it is surprisingly difficult to find reliable data on

different sources of CSD revenue. Securities issuance is even more cyclical than secondary

market trading, which would make meaningful comparisons difficult even if the data were

readily available. This outcome is analogous to a result of Laffont, Rey, and Tirole (1998),

who concluded that if telecommunications operators can charge additional fees for calls


between networks, there can be positive externalities between customers of the same

operator that might intensify price competition. Because telecommunications networks are

not two-sided markets, however, the fee burden cannot be shifted to another customer

group.

4.5. Will the link be established?

Profit-maximising CSDs will establish the link if they can earn higher profits with it

than without it. This situation can be analysed by comparing the expressions for profits

under the two alternative arrangements (Eqs. (12) and (15)). CSD i would prefer to

establish the link if

I ½�3a þ 6h� 2zi þ 2zj2

½9ð2h� aÞ <I ½hð7þ 2MÞ � 8zi

4ð26Þ

If z1=z2=z, either both or neither of the CSDs will prefer to establish the link. Thus, Eq.

(26) can be rewritten as

M > 1=2þ 4z� 2ah

ð27Þ

If there are no operating costs (z=0), the CSDs always prefer to establish the link.

Nonlinked CSDs can pass the cost z to investors, whereas linked CSDs cannot.

Whether coincidental or not, ICT has improved SSS’s efficiency, while at the same

time, links between CSDs have become more commonplace. A large number of

issuers (M) makes it more certain that the CSDs will want to establish the link

because issuers become the profit-making sector, and if there is a large number of

them, opening the link is a lucrative strategy. High costs of gross payments (a)encourage CSDs to establish the link; these costs intensify price competition in the

absence of the link.

From the viewpoint of social welfare, the link is particularly useful if using foreign IFs

is expensive for investors (hH0). By opening the link, the two CSDs can transform

investors’ costs of making cross-border transactions into fee revenue. In this sense, their

incentives are ‘‘correct;’’ they want to establish the link when the costs that can be avoided

by using it are high.

5. Regulation of cross-border fees

The EU has issued a regulation saying that fees for cross-border retail payments are not

to differ from those for domestic transactions. This section presents an analysis of the

possible impact of a comparable regulation on SSSs. CSDs are obliged to form a link and

not to charge additional fees for cross-border transactions (r=0). Investors trading in

foreign securities can use domestic IFs and the link, or they can use foreign IFs. As in the


previous sections, they incur a fixed cost (h) if they use foreign IFs. If issuers are

indifferent between the two CSDs, they randomise between them. If there is no Nash

equilibrium in the Bertrand game between CSDs, they end up in an undercut-proof

equilibrium, as defined by Shy (2002).

5.1. The undercut-proof equilibrium

The situation presented in this section is highly analogous to the one presented by Shy

(2002). Shy assumes two Bertrand competing firms. Every consumer has an established

relationship with one of the two companies. Buying from the competitor would cause

switching costs. Each consumer buys one unit of good. It turns out that there is no Nash

equilibrium in pure strategies. The optimal price for each firm is that charged by the

competitor plus the switching cost. It is obviously impossible to find any equilibrium in

which both companies charge more than the competitor does. A firm could also undercut

by pricing low enough to get all the customers. The firm whose price is undercut would

find it profitable to charge a fee that exceeds the price of the rival by the transaction cost.

Firms might eventually end up in an undercut-proof equilibrium, both charging the

highest price that the rival cannot profitably undercut, if the alternative is to charge the

price that prevails in the undercut-proof equilibrium. This equilibrium is not a Nash

equilibrium.

When r1=r2=r, Eq. (19) reduces to pi=I(2+M)r/M. When no additional fees for cross-

border services are allowed (r=0), the optimal fee to be paid by issuers equals zero. The

CSDs end up in Bertrand competition, with identical services and zero marginal costs, and

the price ( p) converges to zero. Therefore, issuers randomise between the two CSDs, and

there will be no correlation between the country of registration of a security and the

investors’ home country. Because issuers pay no fees, and because there are no fees for

cross-border transactions, both CSDs are completely dependent on the basic fees paid by

domestic investors. The expression for profits reduces to

Pi ¼ 2Iðbi � ziÞ ð28Þ

According to this expression, it is always profitable to increase the price (dPi/dbi>0).

However, investors have the option to use foreign IFs. The highest price the CSD i can

charge and still get all the transactions of domestic customers is

bi ¼ bj þ h� e ð29Þ

where e is an arbitrarily small positive constant. The profit would equal 2I(bj+h�zi). All

payments can be netted, there are no costs related to gross payments, and the cost

component a vanishes.

A CSD can also capture all the customers by undercutting. The highest price the CSD

can charge and get all the customers is

bi ¼ bj � h� e ð30Þ


With this price, CSD i would also get all the issuers because the undercutting CSD

would be a cheaper alternative for all the investors. The expected value of its profit is

4Iðbj � h� e � ziÞ ð31Þ

Undercutting, that is, charging price in Eq. (30) instead of the price in Eq. (29), is

profitable for CSD i iff

4Iðbj � h� e � ziÞ > 2Iðbj þ h� ziÞZbj > 3hþ 2zi þ e ð32Þ

With sufficiently high rival prices (bj), Eq. (32) implies that it becomes profitable to

undercut. When firms decide the basic fees (b’s), the situation is analogous to Shy’s model,

and there is no Nash equilibrium in pure strategies. If a customer living in Country 2 deals

with foreign securities, the cost of a transaction via a domestic IF and domestic CSD 2

equals b2+y. If the customer uses foreign IFs, the cost equals b1+y+h. If CSD 1 undercuts,

the price (b1V) will satisfy the condition b2+y�e=b1V+y+hZ b1V=b2�h�e, where b1V is the

price that CSD 1 uses for undercutting, if it decides to undercut.

The highest price that can be used for profitable undercutting (b1V) satisfies the condition

2Iðb1 � z1Þ þ e ¼ 4Iðb1V� z1Þ and; analogously; 2Iðb2 � z2Þ þ e ¼ 4Iðb2V� z2Þ

Combining these conditions with Eq. (32) and letting e=0 yields

b1 ¼ð6hþ z1 þ 2z2Þ

3b2 ¼

ð6hþ z2 þ 2z1Þ3

b1V¼ð3hþ z1 þ 2z2Þ

3b2V¼

ð3hþ z2 þ 2z1Þ3

If there is no link between the CSDs, the cost of cross-border transactions for investors

living in Country 2 is determined by Eqs. (5), (7), and (10), and the extra cost h:

hþ v1 ¼ aC2=2þ ð�3a þ 6hþ 4z1 þ 2z2Þ=6þ yþ h

¼ �ð1� C2Þa=2þ f6hþ z2 þ 2z1g=3

This is less than the transaction fee charged by CSD 2 (b2) in the undercut-proof

equilibrium. Hence, in the undercut-proof equilibrium, the fee for transactions is higher

than the total cost of cross-border transactions that prevails without a link. Thus, the

regulation does not make it cheaper to trade in foreign securities. Instead, it becomes more

expensive to process transactions with domestic bonds.

In the basic model the two CSDs had to compete for issuers by being attractive

locations for investors. In Section 4, the CSDs competed for issuers even more directly.

Now, the country of registration is no longer relevant to the costs for investors in the

secondary market. Hence, the main source of competitive pressure has been largely

eliminated and it is not surprising that the average price for settlement services increases.

Somewhat similar results have been presented in the earlier literature. Banning price

differentials between domestic and export prices may enhance tacit collusion between

oligopolistic firms (see Martin, 2001, pp. 203–204). If competing telecommunication


operators are not allowed to charge different prices for calls between networks, they might

increase the price for all calls (Laffont et al., 1998).

6. Conclusions

This paper has presented an oligopoly model of the securities settlement industry. The

main focus has been on competition between two national CSDs and on the impact of a

securities link on this competition. It was assumed that the need for securities settlement

services is exogenous. Each CSD runs both a book-entry register and a settlement system.

Secondary market transactions must be settled in the system in which the security was

issued. It follows that CSDs compete fiercely for issuers in the primary market because

issuers’ choices determine market shares. Consequently, CSDs collect all the revenue from

IFs and investors, while issuers get services for nothing.

Section 4 analysed the situation where the two CSDs are linked. Investors can settle

transactions with foreign securities via either domestic IFs and the domestic CSD, or they

can use services offered by foreign IFs. Transactions do not have to be settled in the CSD

chosen by the issuer, and it is no longer essential for CSDs to attract as many issuers as

possible. Consequently, issuers become the profit-making segment, whereas investors can

get domestic services free of charge and cross-border services at reasonable prices. In

Section 5, we analysed what might happen if the CSDs of the two countries are obliged to

establish the link and not to charge fees beyond the basic fee for domestic transactions for

cross-border transactions through it. It may be unclear how the CSDs would price

secondary market settlement orders, but they might simply increase the price for all the

transactions to a level that is higher than the costs of cross-border transactions in the

absence of a link.

The paper has one major policy implication. If policy makers want to enhance the

integration of financial markets, they should focus on eliminating the fundamental causes

of obstacles to cross-border settlement. Encouraging the private sector to develop new

ways to bypass barriers that remain basically unchanged may be much less useful. It is

always possible that access to a detour is controlled by an institution with monopoly

power. The institution could easily benefit from its monopoly position and capture all the

benefits from the detour.

In real life, many securities market infrastructure institutions are joint-venture under-

takings of financial institutions. If the two CSDs maximise the sum of their own profits

and the profits of the shareholder IFs, it is possible that basically nothing will change. IFs’

pure profits in their own operations are zero in any case, and it would be in their common

interest to instruct the CSD to maximise its own profits (see Park & Ahn, 1999 for a

detailed analysis on jointly owned upstream suppliers). Future work could profitably

continue along the following lines. First, by taking the price elasticity of demand into

account, we could analyse consumer surplus and issuer profits. Price elasticities could be

highly important determinants of platform industries’ pricing (Rochet & Tirole, 2001).

Fortunately, however, the intuition behind the results is not greatly affected by the absence

of price elasticity. Second, there are many kinds of ownership connections and co-

operative agreements between securities market institutions. The analysis could be


expanded by taking into account several alternative structures. The settlement system and

the book-entry register are often operated by different institutions. Moreover, the market

place could also be explicitly modelled. In many cases, stock exchanges operate their own

settlement systems. One might also include international SSSs. Third, the impact of

institutional problems that issuers face in issuing securities in a foreign system could also

be modelled. In the case of equities, there are largely unresolved legal problems. Finally,

there are more than two CSDs in the real world. Fortunately, the intuition behind the main

results is not dependent on the assumption of two CSDs. For instance, investors must use

the CSD chosen by issuers, irrespective of the number of CSDs. Establishing the link

would weaken this effect, making it possible and necessary to compete for investors,

irrespective of the number of CSDs.

Acknowledgements

Thanks are due to Juha Tarkka, Tuomas Takalo, Esa Jokivuolle, Kari Korhonen,

Daniela Russo and seminar participants at the Bank of Finland research department for

several insightful comments.

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the links between securities settlement systems: an olihopoly theoretic approach

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