One of the core operational processes that underlies a securities market is the process of clearance and settlement. The clearance and settlement process determines, to a large extent, the efficiency and effectiveness of a securities market.

Progress in technology has driven the development of centralised and computerized book entry systems for custody, as well as clearing and settlement. These developments have contributed significantly to the integrity of the markets where they have occurred, and served to reduce risk and costs.

However, the legal framework of many countries is still based on concepts of physical securities, and settlement based on delivery of physical securities. These concepts are not in keeping with modern day practices, and fail to adequately support the operations of a modern central depository system (CDS).

There is a need for ongoing review of the laws and regulations governing clearance and settlement systems to ensure that these are in keeping with the clearance and settlement systems and processes.

Aim of Report

At the meeting of the Emerging Markets Committee ("EMC") in Montreal in September1996, Working Group2 ("WG2") was given the mandate to conduct a study on the legal and regulatory framework for clearing and settlement in emerging markets.

The aim of the report is to:

1. Conduct a comparative study of the legal and regulatory frameworks of participating countries by identifying and discussing similarities and differences of the respective jurisdictions.

2. Identify and discuss similarities and differences in problems encountered by the participating countries in developing their respective central depository systems.

3. Provide guidelines for the development of policies in relation to the legal and regulatory framework supporting clearing and settlement in emerging market systems.

Methodology

As a method for collation of information for discussion, a questionnaire entitled "Towards a Legal Framework for Clearing and Settlement" was circulated to participating countries. The questionnaire was developed using as source material, inter alia, "Clearing and Settlement in Emerging Markets-A Blueprint", IOSCO, 1992; "Modernizing Securities Ownership, Transfer and Pledging Laws", International Bar Association, 1996 and "Disclosure Framework for Securities Settlement Systems", CPSS/IOSCOjoint project.

Through the questionnaire, it was hoped to obtain information from the different countries in order to analyze and compare the different legal/regulatory arrangements supporting custody, clearing and settlement for listed equities traded on a country's principal stock exchange. The participating countries were also invited to send copies of relevant laws, regulations and standard agreements of central institutions for clearing and settlement, any operating manuals for participants, legislation for the purpose of setting-up a central depository system and any other relevant literature.

Fundamental Principles

The thrust of the study has been based on the four fundamental principles. These principles have been widely recognised , including by the International Bar Association, as fundamental to providing a regulatory framework for the efficiency and efficacy of clearance and settlement in securities markets. The principles are as follows:

1. Interests in securities held through a financial intermediary should be defined by legislation or otherwise interpreted as a type of interest in a pro-rata portion of the pool of securities or interests in securities held by the intermediary with whom the interest holder has a direct contractual relationship evidenced solely by the interest holder's account with the intermediary, and not as a traceable property right in individual securities or a mere contractual claim.

   The first principle suggests that interests in securities should not be defined as a traceable property right in individual securities, but rather as an interest in a pro-rata portion of the pool of securities held by a depository.

2. The pool of securities or interests in securities held by a financial intermediary to satisfy the interest of its interest holders should be protected against the claims of the intermediary's general creditors, either by defining the interest as a type of property or co-property right or by amending existing insolvency laws for financial intermediaries to give explicit effect to this policy.

   The second principle suggests that the pool of securities held in a depository should be protected against the claims of the depository's and brokers' general creditors. This is achievable if the investor's interest in the securities is defined as a property right in a pro-rata portion of the pool of deposited securities or interests in securities.

3. Conflicts of laws rules should be interpreted or modernised to reflect the development of the system for holding, transferring and pledging interests in securities by book-entry to accounts with financial intermediaries so that the selection of the law governing the characterisation, transfer and pledge of interests in securities represented or effected by book entry to accounts with a financial intermediary is determined by agreement among the relevant parties or, in the absence of such agreement, by reference to where the office of the financial intermediary maintaining such accounts is located or otherwise by reference to the intermediary's jurisdiction.

   The third principle suggests that conflict of laws should be interpreted to reflect development of a central depository system so that validity of any transfer or transaction or pledge is determined by agreement among the relevant parties.

4. Procedures for creating and enforcing a pledge of interests in securities credited to accounts with intermediaries should be simplified.

   This last principle suggests that procedures for creating and enforcing a pledge of interests in securities deposited should be simplified in order to encourage the collateralization of credit exposure.