Forthcoming Journal of Money, CrForthcoming Journal of Money, Credit and Bankingedit and Banking

11

Wine glass, hourglass, or bottomless glass Wine glass, hourglass, or bottomless glass - integration in securities trading and - integration in securities trading and

settlementsettlement

Jens Tapking (ECB)Jens Tapking (ECB)Jing YangJing Yang (BOE) (BOE)

Prepared for Taiwan _ EFMACI 2005

22

Euroclear Group

EQUITIES

EXCHANGES

Clearstream Frankfurt

(DE)

Virt-x

ISE (IE)

LSE (UK)

SWX (CH)

VPS (NOR)

VPC (SWE)

VP (DEN)

Norex

OSE (NOR)

ISEX2

(ICE) CSE

(DEN) OM HEX 3, 6

(FI/SWE)

CLEARING HOUSES

SETTLEMENT SYSTEMS

CREST (UK) SIS

(CH)

London Clearing

House (UK)

Euroclear NL

Euroclear Bank (BE)

Euronext3

Amsterdam (NL)

Brussels (BE)

Paris (FR)

Deutsche Börse (DE)

Euroclear France

(FR)

The Settlement

Network

Clearnet (FR) LCH.Clearnet

AMEX JSE

Eurex Clearing

Clearstream Luxembourg

(LU)

Lisbon (PT)

Interbolsa (PT)

LSX3

(LU)

WSE3

(PO)

Borsa Italiana (IT)

CC&G (IT)

Monte Titoli (IT)

KEY Link Alliance Merger

Clearstream International

As of January 2004

BUSE4 (HU)

CIK5 (BE)

Nasdaq (US)

Global Equity

Market1

NSCC (US)

DTC (US)

NYSE (US)

DTCC

APK7 (FI)

LuxClear8 (LU)

1. The Global Equity Market consists of the NYSE, Euronext, Tokyo SE, Toronto SE, Australian SE, Hong Kong SE, Mexican SE and Sao Paulo SE. 2. The Iceland Stock Exchange does not currently use a depository as shares are still physically traded. 3. The Warsaw, Helsinki and Luxembourg Stock Exchanges have a cross membership and cross trading agreement with Euronext. 4. The Budapest Stock Exchange has signed a co-operation pact with Deutsche Boerse which gives them access to Deutsche Börse’s Xetra platform. 5. CIK is managed by Euroclear Bank. 6. OM merged with HEX in Q4 2003. OMHex will use a common trading platform Saxess. 7. APK offers both clearing and settlement. 8. LuxClear is operated by Clearstream Luxembourg.

33

Current Industry Structure in EuropeCurrent Industry Structure in Europe

DeutscheBourse

Clearstream Frankfurt

LSE

CREST

Euronext

Paris BSE AEX

Euroclear Group

Euroclear France

Euroclear Bank (BE)

EuroclearNL

BVLP

44

Aim of the paperAim of the paper

55

Aim of the paper Aim of the paper

To identify the competition and welfare implications of To identify the competition and welfare implications of horizontalhorizontal

and vertical integration of securities trading and and vertical integration of securities trading and settlement service settlement service

providers (exchanges and CSDs). providers (exchanges and CSDs).

It is often said that consolidation hasIt is often said that consolidation has > a positive effect because it reduces operating costs> a positive effect because it reduces operating costs > a negative effect because it reduces competition > a negative effect because it reduces competition However, we show that the latter is not necessarily However, we show that the latter is not necessarily

true!true!

66

Road MapRoad Map

1.1. Structure of the modelStructure of the model

2.2. Securities markets equilibriumSecurities markets equilibrium

3.3. Overall equilibriumOverall equilibrium

4.4. Welfare analysisWelfare analysis

77

Structure of the modelStructure of the model

88

2) Structure of the model

Country B

Ex A

CSD BCSD A

Ex B

Country A

B investorsA investors

Bilateral link

STP STP

99

AssumptionsAssumptions

Every trade executed on Ex A has to be settled in CSD Every trade executed on Ex A has to be settled in CSD A and every trade executed on Ex B has to be settled in A and every trade executed on Ex B has to be settled in CSD B.CSD B.

The two CSDs maintain a bilateral (direct) link.The two CSDs maintain a bilateral (direct) link.

Initially, all A investors are members of Ex A and CSD Initially, all A investors are members of Ex A and CSD A, but not of Ex B and CSD B. But each A investor can A, but not of Ex B and CSD B. But each A investor can become member of Ex B and CSD B at a cost of become member of Ex B and CSD B at a cost of tt (to be (to be borne by the investor). The same holds for B investors.borne by the investor). The same holds for B investors.

1010

Preference of investorsPreference of investors

BenefitBenefit

0 1Name of investors

y = i

y = 1-i

Benefit of holding home stocks

Benefit of holding foreign stocks

y

1111

Two-stage modelTwo-stage model

Stage 1 Stage 2

Each investors chooses the demand and supply by maximising his benefit.Security markets

},{ T

B

T

APP

Exchanges set transaction fees

CSDs set prices for settlement of trades executed on exchange and for transfers of securities through the link

},{A

S

AqP },{

B

S

BqP

1212

Structure of the model

Each investor decides whether or not to trade one or both securities and where to trade. The decision depends on (1) the transaction prices pA

T, pBT , pA

S , pBS, qA, qB

(2) the cost parameter t (3) the securities prices rAA, rAB , rBB , rBA (4) the investor’s preferences. The securities prices rAA, rAB , rBB , rBA are determined such that demand equals supply on all securities markets (general equilibrium). When the exchanges and CSDs set the transaction prices in Stage 1, they take into account what the investors do in Stage 2. Both exchanges and both CSDs maximise profits.

1313

Substitutes and complements

A few (theoretical) considerations about substitutes and complements: Perfect substitutes: The services provided by two airlines that both fly e.g. from London non-stop to the same destination. If one supplier increases its price, the profit of the other increases! If the two suppliers merge, the prices increase and the social welfare

decreases! (Perfect) complements: Services provided by (1) an airline that flies from London to the Canary Islands and (2) hotels on the Canary Islands. If one supplier increases its price, the profit of the other decreases! If the two suppliers merge, the prices decrease and the social welfare

increases!

1414

Substitutes and complements

In our model: Substitutes: - (1) Trading and settlement in country A and (2) trading and

settlement in country B. Complements: - (1) Trading in A and (2) settlement in A. - (1) Trading in B and (2) settlement in B. - (1) Link services provided by CSD A and (2) link services provided by

CSD B. Institutions that offer complements should merge?!

1515

Securities market equilibriumSecurities market equilibrium

1616

Securities market equilibrium

Assume the transaction prices pA

T, pBT , pA

S , pBS, qA, qB have been fixed

already. Which trading volumes xAA, xAB , xBB , xBA are obtained? (1) In principle the higher the transaction prices, the lower the trading

volumes. (2) If qA+qB>t (and the difference between pA

T+pAS and pB

T+pBS is

moderate), the link is not used at all (xAB=xBA =0). A investors become members of Ex B and CSD B to buy security B; B investors become members of Ex A and CSD A to buy security A.

Trading a security in A and trading the same security in B are no

substitutes.

1717

Securities market equilibrium

(3) If qA+qB<t, as little investors as possible become members of the foreign exchange and CSD.

If pA

T+pAS <pB

T+pBS all trades take place in country A. I.e. B

investors become members of Ex A and CSD A and use the link to transfer security B from CSD B into CSD A. A investors neither become members of Ex B and CSD A nor use the link.

If pAT+pA

S <pBT+pB

S all trades take place in country B. If pA

T+pAS =pB

T+pBS both securities are traded in both countries.

Trading a security in A and trading the same security in B are

perfect substitutes.

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Overall equilibriumOverall equilibrium

1919

Overall equilibrium

We now look at how the exchanges and CSDs set transaction prices in equilibrium. We consider three different industry structures: (1) Complete separation (CS): Ex A, CSD A, Ex B and CSD B are all

independent companies, i.e. they all set prices independently. (2) Vertical integration (VI): Ex A and CSD A are owned by the same

company and Ex B and CSD B are owned by the same company (two vertical silos).

(3) Horizontal integration of the two CSDs (HI): CSD A and CSD B are

owned by the same company. To begin with, we assume that the cost parameters are the same for all industry structures.

2020

Vertical integration and complete separationVertical integration and complete separation

½ t-τ cL

qA+qB >t VI pA

S=pBS=α> ½cS

pAT=pB

T=β> ½cT

qA+qB >t CS pA

S=pBS=γ>α

pAT=pB

T=δ>β

2121

½ t-τ cL qA+qB = ε<t qA+qB >t VI pA

S=pBS=½cS pA

S=pBS=α>½cS

pAT=pB

T=½cT pAT=pB

T=β>½cT qA+qB=ε<t qA+qB >t CS pA

S=pBS=½cS pA

S=pBS=γ>α

pAT=pB

T=½cT pAT=pB

T=δ>β

Vertical integration and complete separationVertical integration and complete separation

2222

½ t-τ ½ t cL

qA+qB=ε<t qA+qB >t VI pA

S=pBS=½cS pA

S =pBS= α> ½cS

pAT=pB

T=½cT pAT =pB

T= β> ½cT

qA+qB=ε<t qA+qB >t CS pA

S=pBS=½cS pA

S=pBS= γ >α

pAT=pB

T=½cT pAT=pB

T= δ >β

qA+qB<ε qA+qB >t HI pA

S=pBS>½cS pA

S=pBS=γ>α

pAT=pB

T=½cT pAT=pB

T=δ>β

2323

Welfare analysisWelfare analysis

2424

Welfare analysis Welfare: Defined as the sum of the benefits of all investors plus the profits of both exchanges and both CSDs. We consider two settings: Welfare I: We assume that the cost parameters are the same for all industry structures. Welfare II: We assume that HI leads to cL=0.

2525

½ t-τ ½ t cL qA+qB=ε<t qA+qB >t VI pA

S=pBS=½cS pA

S=pBS=α>½cS

pAT=pB

T=½cT pAT=pB

T=β>½cT qA+qB=ε<t qA+qB >t CS pA

S=pBS=½cS pA

S=pBS=γ>α

pAT=pB

T=½cT pAT=pB

T=δ>β

qA+qB<ε qA+qB >t HI pA

S=pBS>½cS pA

S=pBS=γ>α

pAT=pB

T=½cT pAT=pB

T=δ>β Welfare I HI>CS=VI HI>CS=VI HI>VI>CS VI>HI=CS ½ t-8τ ½ t-τ ½ t cL

2626

½ t-τ ½ t cL qA+qB=ε<t qA+qB >t VI pA

S=pBS=½cS pA

S=pBS=α>½cS

pAT=pB

T=½cT pAT=pB

T=β>½cT qA+qB=ε<t qA+qB >t CS pA

S=pBS=½cS pA

S=pBS=γ>α

pAT=pB

T=½cT pAT=pB

T=δ>β

qA+qB<ε qA+qB >t HI pA

S=pBS>½cS pA

S=pBS=γ>α

pAT=pB

T=½cT pAT=pB

T=δ>β Wel- fare I HI> VI =CS HI>VI>CS VI>HI=CS Wel- fare II HI>VI=CS HI>VI>CS ½ t-8τ ½ t-τ ½ t cL

2727

ConclusionConclusion

1.1. A full technical integration of CSDs is always the best A full technical integration of CSDs is always the best no matter whether there is an additional vertical no matter whether there is an additional vertical integration or not. integration or not.

2.2. If the cost for transferring is low, then a legal If the cost for transferring is low, then a legal integration of two CSDs is the second best.integration of two CSDs is the second best.

3.3. If the cost for transferring is high, then a vertical If the cost for transferring is high, then a vertical integration of a stock exchange and a CSD in both integration of a stock exchange and a CSD in both countries is second best. countries is second best.

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Order of preferenceOrder of preference

2929

Thank YouThank You

Jing.yang@bankofengland.co.ukJing.yang@bankofengland.co.uk