It is not an exaggeration to say that (International) Central Securities Depositories ((I)CSDs) are at the heart of financial market transactions. They ensure the smooth provision of finance to the global economy. Despite their centrality, (I)CSDs are not widely known or understood. In our chapter forthcoming in The Law and Regulation of Financial Market Infrastructure (edited by Paolo Saguato and Jens-Hinrich Binder), we explain the critical role (I)CSDs play in financial markets. Following this, a look at the European (I)CSDs reveals substantial variations in ownership and structure that raise questions about corresponding variations in governance. These variations are then considered in the context of the risks (I)CSDs pose to financial stability and compared to those posed by Central Counterparties.
The key role of an (I)CSD is to provide a settlement service for the delivery and payment of securities. Additionally, they must also provide a notary service to record securities ownership and/or the provision and maintenance of securities accounts. ICSDs provide this service across borders, allowing cross-border investment without the necessity of a local presence. ICSDs enable market participants to source, mobilise and segregate collateral across borders and time zones. An important difference between CSDs and ICSDs is that ICSDs can advance credit where necessary to keep transactions flowing. To do this requires a banking licence. Consequently, ICSDs must comply with an array of prudential and resolution regulations that are in addition to the regulations to which CSDs are subject.
There are two ICSDs in Europe; Euroclear Bank and Clearstream, both of which are considered systemically important institutions. Euroclear Bank is owned by Euroclear Holdings, a private company with just 100 shareholders, whose group also contains five CSDs. Clearsteam is owned by Deutsche Börse, a public company traded on the Frankfurt Stock Exchange with around 52,000 shareholders, whose group contains exchanges, central counterparties and other institutions ancillary to the financial markets. This divergence in ownership and structure create potentially distinct agency costs and systemic risk concerns.
Taking a broader perspective, since the financial crisis of 2007/08, the ownership and governance of financial institutions has faced intense regulatory scrutiny. Predating this, corporate governance theories relating to the impact of ownership forms were already numerous. Links have been made between concentrated ownership and reduced managerial agency costs. Contrasting studies have suggested that fewer shareholders, holding more substantial investments, can result in conflict and dysfunction. (I)CSDs have been flying under the radar of this scrutiny. This is something we seek to address on the basis that (I)CSDs present unique concerns, not least because of the centrality of their role and the divergence in ownership structures but also because, in terms of core CSD services, competition amongst (I)CSDs remains limited. This is the case despite increasing competition for services that extend beyond those core to the CSD role.
Understanding effective governance necessitates an understanding of the specific institutional risks. By their nature (I)CSD risks are largely operational. For example, they rely heavily on technology and the risk of tech failure cannot be wholly guarded against. This has been shown by a variety of recent FMI failures. But compared to central counterparty risks there are some important differences.
The role of a central counterparty is to interpose itself between sellers and buyers in financial market transactions. Like (I)CSDs, central counterparties face operational risks but they are particularly exposed to the risk of default from the parties in whose shoes they are standing. This is one of the reasons central counterparties have been described as 'super systemic'. There has been much debate about the allocation of losses in the event of central counterparty failure. Some argued the shareholders have insufficient skin-in-the-game whilst others argued that to increase potential shareholder liability would be to dangerously foist the role of 'under-writer-of-last-resort' onto central counterparties. Regulation published in January 2021 has drawn a line under this debate by, amongst other measures, increasing central counterparty skin in the game.
We argue that the misalignment of control rights and economic risks that may be present in the central counterparty context is not found in the (I)CSD context. As such the regulatory solution found for central counterparties does not fit (I)CSDs. Nevertheless, the risks posed by (I)CSDs do warrant further investigation. Badly run ICSDs could generate significant negative externalities for the entire financial system. Their centrality, combined with their duopoly and the limited competition in the provision of core CSD services, presents a market failure problem. Different solutions for uncovered losses in the event of (I)CSD failure may be needed. Although the Central Securities Depositories Regulation is under consultation, its impact is likely to be limited in respect of these issues.
What our chapter shows is that (I)CSDs present some underexplored corporate governance concerns. However, it is not at all clear that the standard solutions to corporate governance issues that apply to corporations more generally are fit for purpose in the complicated world of the (I)CSD. This lack of clarity needs to be addressed in order to create context specific solutions that will better serve the unique securities market regulatory goals of fairness and efficiency, systemic safety and the protection of the investor.
Eilís Ferran is Professor of Company and Securities Law and Pro-Vice-Chancellor for Institutional and International Relations at the University of Cambridge Faculty of Law.
Eleanore Hickman is a Research Associate and Modern Law Review Early Career Research Fellow at the University of Cambridge Faculty of Law.