Legal Regulation Of Risk Control Of The Financial Market Infrastructures

The post-trade processing of securities,which includes securities registration,custody,clearing and settlement,has been given the title of “plumbing system” by the financial industry for a long time because of its repetitiveness and tediousness.As for the financial market infrastructure(referred to as FMI)that provides these post-trade processing,including the central securities custodian,the central counterparty clearing house,the settlement system,and the data transaction database,it has been hidden behind the scene from the public due to the high-tech and strong professional characteristics of the business.The 2008 subprime mortgage crisis became a turning point in the attention of post-trade processing of securities.At the time when Lehman Brothers' bankruptcy triggered the spread of the global financial crisis,the FMI that provided post-trade processing successfully responded to the bankruptcy of important financial institutions,successive defaults by counterparties,large-scale market panic,and instantaneous and huge volume of securities trading.Since then,the importance of FMI has received unprecedented attention,and its function of stability and risk mitigation for the financial market have begun to be noticed by market participants,market regulators and policy makers.In order to further promote the establishment of FMI in various countries and promote standardised post-trade processing of securities,the Committee on Payment and Settlement Settlement Systems(CPSS)and the International Organization of Securities Commissions(IOSCO)jointly issued the Principles for Financial Market Infrastructures(hereinafter referred to as PFMI)in2012.The introduction of 24 guiding principles has become an important guide for countries to promote the construction of FMI.Countries comply with the relevant provisions of the PFMI and gradually incorporate its guiding principles into their existing legal systems in order to systematically regulate the FMI that provides post-trade processing of securities.The securities market in China has developed rapidly,and the transaction volume of the spot market has been at the forefront of the world for many years.However,in contrast of the fast development of the securities market,the construction of FMI that provides post-trade processing of securities has only just begun.The late start has brought the "late-comer advantage" in institutional setup and practical operation,but it also has brought the "late-comer disadvantage" to the timely supply of the policies and system.From macro perspective,the legislation for FMI in China is scattered and lagging,and there are serious problems with the lack of upper-level laws and the fragmentation of lower-level laws.Without outlining and prescribing upper-level laws,relevant legislations are generally low in rank,and those laws that closely related to daily operations are only scattered in various administrative regulations,departmental rules and internal rules of institutions.The problems at the micro level are numerous,for example: the status of FMI has not yet been clearly positioned;the priority and finality of the internal rules of institutions have not been clearly recognized;The regulation to avoid “intermediary risk " under the indirect holding mode is lacking;the isolation of accounts at all levels in the phases of the securities custody has not been fully implemented;the disposal of pledges in the phases of securities settlement conflicts with the traditional principle of " prohibition of fluidity contract”;the bankruptcy and orderly liquidation mechanism of the FMI,the mechanism of the central bank's emergency loan assistance,and the restoration and disposal mechanism of institutions is still lacking;there is no suitable basis for the extraterritorial application of Chinese laws and regulations when institutions are interconnected across borders,etc.In the context of this era,this article conforms to the trend of the times,taking the FMI that provides post-trade processing of securities as the research object,taking three “phases” and two "special issues" as logical clues,elaborates registration risk,custody risk,settlement risk,systematic risk,and cross-border interconnection risk chapter by chapter in sequence.It comprehensively analyses risks in different phases and overall situation that may occur in the FMI as the provider of post-trade processing of securities.Guided by the PFMI,each chapter compares with the legislation and practical experience of various countries,combines with current situation and legislation in China,and provides recommendations on improvements of the legal regulation of risk control of FMI in China.This article is divided into six chapters besides the introduction and conclusion:The first chapter is “The Basic Theory of Legal Regulation of Risk Control of FMI".This chapter is the basis of the full text to clarify the connotation and extension of key concepts,clarify the basic theories on which the research is based,and clarify the objectives of risk control of FMI.The key concepts that being defined are: FMI,post-trade processing,securities registration,custody and clearing institutions,and securities registration,custody and settlement systems,and risks of post-trade processing.In the concept of “post-trade processing of securities”,it is clear that this concept encompasses the entire process from securities transaction confirmation to securities delivery,covering five phases: transaction confirmation,securities registration,securities custody,securities clearing and securities settlement.In the“PFMI” which is the leading global authority standard,FMI is a fixed expression that cannot be splited and divided.Most countries adopt the "three elements of systemic importance" standard or the "four characteristics of practical operation" standard as the core certified standard of FMI.The former assesses the scale,substitutability and relevancy,while the latter focuses on whether the relevant institution has functional foundation,system criticality,network connectivity and natural monopoly.The relationship between FMI and post-trade processing,and other important concepts is summarized as the following: FMI is the undertaker of post-trade processing(service provider),but not all financial institutions that provide post-trade processing are FMI;FMI intersects with the concepts of “securities registration,custody and clearing institutions” and “securities registration,custody and settlement systems”,but they do not completely overlap.Some other financial institutions at the intermediary level or in an auxiliary position are classified as "securities registration,custody and clearing institutions" and "securities registration,custody and settlement systems",but they are not FMI.In terms of the fundamental theory,four economic theories are closely related to this article,namely institutional economics theory,club theory,network economic theory,and institutional innovation theory,which is the leads of the basis of the article,to study the essential issues of securities post-trade processing.In the theoretical section of institutional economics,the post-trade processing not only conforms to the logical recursion of institutional economics,but also the focus of attention is very consistent with the research of institutional economics in all aspects.The post-trade processing cover the entire process from security transaction confirmation to settlement,which is very consistent with the holism in post-institutional economics,that is,the effect of a whole is far beyond the sum of all parts and each part complements each other.Adjusting the various levels of legislation for the post-trade processing is not static and solidified,but are constantly evolving and developing according to the development of the financial markets of various countries,the needs of national conditions and the existing legal system,which coincides with the evolutionary viewpoint of institutional economics.The continuously specialised and refined design of post-trade processing system also reflects a clear tendency of instrumental rationalism.In addition,the basic organizational form of the relevant FMI,the types of contracts with various types of participants,the design details of the risk regulation system,etc.,all take "transaction costs" into consideration as an important factor,which is in line with the concerns of new institutional economics.In the club theory section,it analyzes how the club theory,which researches the allocation efficiency of impure public goods,the supply and demand of impure public goods and the quantity equilibrium,provides the theoretical support to the post-trade processing.All relevant FMIs that provide post-trade processing are restricted by their service capabilities.When the system's processing capacity reaches the upper limit,each time a new participant is added,the quality of services provided by the institution to the original participant will decrease accordingly.With its capacity and processing capacity,there is an objective optimal service scale for participants,which is fully in line with the characteristics of the club's products.For various FMIs,club theory not only provides theoretical support for the membership threshold of club members(participant qualifications),but also provides important theoretical basis for members' rewards and punishments(relief in case of settlement default)and other issues.In the network economic theory section,the essence of the theory of "positive network effect" and "negative network effect" was emphatically sorted out,and the analysis was carried out respectively corresponding to the securities post-trade processing.Whether in the era of materialized or dematerialized securities,post-trade processing has obvious positive network effects,that is,the value and utility of the network is directly proportional to the number of users of the network.But at the same time,there are also significant negative network effects in post-trade processing,which are manifested as barriers to competition and natural monopoly on the one hand,and on the other hand as systematic risk caused by the “cascade” of risks due to network effects.In the analysis of institutional innovation theory,it benefits the securities post-trade processing in the sense that it may bring higher efficiency,lower costs and more controllable risks.Induced changes(spontaneous market competition)and mandatory changes(national corporations)can promote institutional innovation.The theory of institutional innovation is a guide to how the FMI formulate reasonable system to effectively and fully utilize the existing financial resources,and promote the vigorous and sustainable development of the financial market without systematic risk.Taking the goal of risk regulation of FMI as the core of the research,the articles summarizes the evolution of the goals in different historical stages and the logic behind them,and proposes four goals suitable for current national conditions and legislation in China.The first goal is to improve the legal framework and solve the basic legal risks in all phases.It is required to build a systematic legal and regulatory framework for FMI,establish clear,unified and rigorous regulatory standards,and remedy loopholes of basic legal risk in all phases.As the basis for risk management by relevant institutions,this goal needs to be ranked first among the goals of risk regulation of FMI.The second goal is to remove barriers to integration and optimize industry competition mechanisms.For the securities post-trade processing business which has the tendency of natural monopoly,the relevant competent authority should play a leading role,remove barriers to market integration,establish uniform industry standards,and appropriately introduce competition mechanisms.Under the situation that not to affect the scale effect of natural monopoly businesses,the authority should reduce the negative market risks brought about by natural monopoly.The third goal is to refine risk management and prevent systemic risks.The securities post-trade processing faces legal risks,principal risks,replacement risks,operational risks and liquidity risks,etc.,involving securities issuers,registration agencies,custodian agencies,settlement agencies,participants,exchanges,supervision and management agencies,etc.Different entities need to refine risk management,and implement corresponding prevention and control strategies on the basis of clarifying the risks that each phase may face.In addition,due to the theoretical “paradox” of systemic risk in FMI and the “cascading effect” of risk transmission in practice,compared with the clear and controllable risks of each phase,it is utterly important to prevent systemic risk.The fourth goal is to fill gaps in differences and promote cross-border interconnection and international cooperation.Various countries are currently adopting different methods to fill the differences from legal,technical,and operational perspective that may arise in the cross-border interconnection of FMI.From international level,there has also been various recommendations and coordinated guidelines to help countries' FMIs to enter the interconnection.It is worth noting that although cross-border interconnection can provide a win-win situation,risk events will no longer only affect single institution in the country,but rapidly spread to related financial institutions of other countries by the cross-border interconnection system,and consequently affect the stability of the entire financial market.Thus one of the important goals to be considered in the financial market in China in the medium and long term is how to enjoy the positive network effects brought by cross-border interconnection while preventing and controlling the potential global risks.The second chapter is "Legal Regulations of Risks of Securities Registration in FMI".This chapter takes the CSD,one of the FMIs,that provides securities registration services as the object of research object,focusing on the intermediary risks and business operation risks faced by the securities registration process.There are three major modes of securities registration in the global financial market: direct holding mode,indirect holding mode,and parallel mode of direct holding and indirect holding,and discusses the legal basis behind each mode and the current state of the country.It is clear that the difference of the securities holding mode will lead to the difference of the securities registration risks.For the securities registration process,the most likely risks are the intermediary risk and the business operation risk.The former is more likely to occur in the countries indirect securities holding mode is used,the latter may occur in all countries regardless of mode of securities registration.This article clarifies the legal roots of the intermediary risk,and summarizes the various mechanisms for dealing with intermediary risks in foreign countries.In terms of coping strategies,using Article 8-503 of the Uniform Commercial Code of the United States as an entry point,we study the existing legislation and rules specifically formulated to deal with the intermediary risk in domestic laws of countries and international multilateral treaties/guidance documents,and summarized the response principle of "taking investor protection as the primary purpose,taking into account the interests of intermediaries in a balanced manner,and ensuring the compatibility between the system and the existing legal basis".In the part of business operation risk,it summarizes the multiple internal and external factors that may trigger this risk.Based on Principle 17 of the PFMI,we analyze in detail the seven different strategies in regulating current business operational risks in various countries: establishing a comprehensive prevention and control mechanism for the business operational risk,clearly defining the responsibilities of the board of directors and various departments,establishing internal control and regular review mechanisms,clearly defining goal of operational reliability,and formulating appropriate capacity plans,pay attention to the information security of the organization and the physical security of the site,develop business continuity plans,and identify,prevent and control internal and external risks at the same time.On the basis of previous elaborations,this chapter lastly focuses on the three CSDs that undertake the securities registration function in China: China Securities Depository and Clearing Company Limited(CSDCC),China Government Securities Depository Trust & Clearing Co.Ltd.(CDC),and Shanghai Clearing House(SHCH).The existing mechanisms of intermediary risks and business operation risks are sorted out and analyzed,and recommendations are made for the improvement of related mechanisms based on the current situation.Due to characteristics of the direct holding mode of securities in China,the occurrence of intermediary risks is avoided to a certain extent.However,with the gradual increase in market participation of overseas channels,the prevention and control of intermediary risks requires precautions.Although the existing Article 150 of the Securities Law and Article 8 of the “Notice on Issues Concerning the Implementation of the QFII Management Measures”basically established the account isolation system,the regulations are too general and the legal level is low,and the protection of investors is still weak.Considering current national conditions and system supply in China,it is not suitable for China to directly adapt the US Uniform Commercial Code 8-503 model and the EU's model that trust property is not subject to creditor recourse.It is recommended to learn from the relevant provisions of the "Convention on the Applicable Law of Certain Rights and Interests in Securities Held by Intermediaries",formulate corresponding rules from the perspective of functionalism and facts,and achieve better compatibility with existing domestic laws at all levels.As for business operational risks,through a horizontal comparison and comprehensive analysis of the existing disclosure reports of various institutions,it can be found that the corresponding institutions in various countries have fully implemented the "PFMI" to prevent and control business operational risks,and established the business continuity plan and emergency response plan from perspectives of institutions,systems and procedures.Next step,we can refer to the experience of parallel institutions in foreign countries,to further optimize from the following three aspects: fill the talent reserve resources to avoid human resource risks;strengthen the cross-system and cross-border crisis management,and establish a coordinated emergency response mechanism;and refine plan and precautious measures for the outsourcing business risk.The third chapter is "Legal Regulations of Risks of Securities Custody in FMI".This chapter takes the CSD that provides securities custody services in the FMI as the research object,and focuses on the double tests faced by CSD: the security of its own assets and the security of participants' assets.By studying the difference between the securities single-level custody model and the securities multi-level custody model and the legal basis behind it,the article compares one by one the practical operations of the representative countries of each model.Generally speaking,countries that adopt the direct securities holding model use securities single-level custody,while those that adopt the indirect securities holding model adopt multi-level securities custody.Under single-level custody model,investors set up accounts in the CSD,where the former can independently control the account and enjoy completely independent ownership of the account,while the latter has the information of underlying investors of the account,the types of securities held,and the quantify of securities held.The most outstanding feature of the multi-level custody model lies in the multi-level intermediary holding level between the securities issuer and the actual investor.The actual investor opens a securities account with a securities custodian and becomes the equity holder of the securities.The custodian institution holds securities on behalf of the nominal holder,and then deposits its own and investors' securities to the CSD for centralized custody.In practical operation,multi-level custody can be further subdivided into two branches,typical and atypical,according to whether intermediary agencies strictly separate their own securities and investor securities during centralized custody.Subsequently,this section takes the dispute and arbitration of a treasury bond custody agreement in 2004 as an example,to analyze the securities custody risks that occurred in practice: under the premise that the bond exchange market implements a membership system,the securities company had not strictly distinguished own accounts and investors' accounts,which resulted in the relevant CSD being able to transfer all the securities under the account names opened by the securities company,and consequently the securities company was not able to return the investors' securities assets on schedule.From this case,it can be found that the securities company's incomplete implementation of the account isolation system between their own account and investors' account is one of the important sources of possible risks in securities custody,and this leads to the risk of securities custody in essence is a double test of the security of the organization's own assets and the security of the participants' assets.After that,the article takes the relevant provisions of Principle 16 "Custody Risk" of the "PFMI" as an entry point,and analyzes in detail the general and special measures that countries are currently taking to deal with custody risks.General measures refer to the measures that countries generally decide to take in response to securities custody risks,including account segregation systems,independent evaluation and audit systems,insurance systems,and data backup systems.Special measures are based on the specific operating conditions of the CSD in the country,and the characteristics of the development of the domestic financial market,such as the day-end and month-end double reconciliation system in the United States,the overall coordination system in the United Kingdom,the third-party outsourcing co-responsibility system in Germany,and the "fire drill" testing system in Singapore.With above analysis,based on the general measures and special measures adopted by various countries,the article turns the focus back to domestic securities custody system and custody risk response mechanism in China,analyzes the existing custody risk response mechanisms of related institutions,and make suggestions to improve the relevant mechanisms.For the existing general measures such as account isolation,independent audit,insurance and data backup,it is necessary to continue the reform of the system,for example,a more reasonable regular reconciliation and evaluation system,and a more adequate insurance system,and better data backup system.As for the special measures that reflect the characteristics of the development of the financial market in the country,China needs to be aware of the existence of current legal loopholes such as the identification of the CSD,the legal status of the institution and its participants,boundaries of rights and obligations of related entities,and arrangements of legal responsibilities,etc.,have not yet been clearly stipulated within the existing legal framework.China should put filling the legal loopholes and improving the legalization as the basic goal,and on this basis,reduce the existing separation of custodial business as much as possible.That means to unblock the communication channels among CSDCC,CDC and SHCH so as to make investment participants fully freely choose and switch in different markets and different types of securities,which results in the reduction of transaction costs,improvement of transaction efficiency,and promotion of the integration process of securities custody system in China.The fourth chapter is "Legal Regulations of Risks of Securities Settlement in FMI",studies the risks faced by the FMI of securities clearing(including CSD and general clearing house)and securities settlement(including central settlement and non-central settlement)in the securities settlement process and their response mechanisms.At the level of legal risk,there are two main risks faced by settlement institutions:first,whether the internal rules of the institution have priority and whether the settlement is final;second,for those institutions in countries where exist the principle of "prohibition of fluidity contract”,whether the disposal of the defaulting participants is compatible with the existing legal principles.Regarding the issues concerning the effectiveness and priority of the internal rules of the organization,most countries regard the internal rules of settlement institutions as the agreement between the institution and the participants,which have the similar effect of contracts.When the effectiveness of the “finality of settlement” is challenged by the bankruptcy law,legal principles such as the “safe harbor of contracts”(the United States),“the finality of securities settlement and the non-traceability of bankruptcy procedures”(EU)and the “handling procedures of clearing house overrules the bankruptcy law”(Hong Kong-China)are adopted,to ensure the adverse effects of participants entering the bankruptcy process are minimized and the finality of settlement is guaranteed.Regarding the second legal risk,all civil law countries that follow the principle of “prohibition of fluidity contract” have adopted a “relaxation” mechanism,which is to selectively allow commercial liquidity under the basis of “prohibited of fluidity contract”.Aiming to balance the legislative logic and practical needs,it designs special system,which is worth for China to learn in dealing with the same problem.At the level of default risk,the article takes the relevant provisions of Principle13 "default risk" from “PFMI” as the entry point,analyzes its core requirements based on rules and procedures,enforcement,transparency and participation.It also considers the reasons of default,decision-making institutions,and consequences of default in real practice in various countries,and systematically analyzes how these countries deal with default risks,which are the root causes of credit and liquidity risks.Other than that,it sorts out and summarizes the pre-,during and post-event response mechanisms for default risks in various countries,including the participant review system,the clearing/settlement fund system and the margin system at the pre-event period,the coupon payment system and “mark-to-market” during the event,as well as the penalty system and “waterfall” relief at the post-event period.It leads to the study of how FMI that undertakes the securities liquidation and settlement functions can prevent the occurrence of default risks,and how to relieve the pressure on liquidity in a timely manner after the occurrence of risks to order to maintain the normal operation of the institution.Lastly this chapter takes the existing legal risks and default risk response mechanisms of FMI that undertakes the functions of securities clearing and settlement in China as the object of analysis,and makes suggestions for improvement based on the legislation and practical experience of various foreign countries.At the level of legal risk,in response to the first legal risk,it is recommended that FMIs,established in accordance with specific administrative examination and approval procedure with business scope covering securities registration,custody,clearing and settlement,should be defined as “self-regulatory organizations”.These "self-regulatory organizations" should be given the power to formulate internal rules in accordance with the procedures approved by the competent authority,and use this as a basis to establish the binding effect of relevant internal rules on various participants in the financial market;alternatively,lower the legal level expectations,and issue administrative regulations by the State Council such as the "Financial Market Infrastructure Regulations" or "Registration,Clearing and Settlement Regulations" to uniformly confirm the legal status of FMI,and at the same time endow the internal and external final effects of the internal rules formulated by various institutions.Regarding the finality of settlement,it is recommended to choose the best and appropriate option from the following two options: one is to establish the principle of "contract safe harbor" in the bankruptcy law based on the US model;the other is to follow the EU or Asian country model which confirms the finality of settlement directly at a higher legal position,and coordinates its relationship with the bankruptcy law.The two schemes have their own characteristics,and both need to pay attention to the localized system design and the convergence with the existing rules.As for the second legal risk,it is recommended that China,on the basis of acknowledging the particularity of commercial guarantees,allows clearing institutions and their participants to make their own agreement on how to assume transaction risks.In considerations of practices,we can consider embedding in the new law or promulgation of a special law to regulate relevant issues,authorizing securities clearing institution to quickly dispose the pledges of participants in accordance with its internal rules.At the level of default risk,it has sorted out and summarized the status quo of the regulatory mechanisms for default risks adopted by CSDCC and SHCH which undertakes clearing and settlement guarantees of the central counterparty,and by CDC which does not undertake the clearing of the central counterparty.It provides three levels of suggestions: 1.Strengthen the systematic analysis of the determination of default.Objective and subjective reasons should be classified instead of being limited to a list of rules,and thus “settlement failure” situations are sorted out in a more systematic way,in order to strengthen the logical connection among the situations.In addition,we suggest the introduction of reasons with “preventive nature”for the determination of breach of contract as early warning signs of possible“settlement failure” and pay attention for it;2.Establish diversified remedy channels for liquidity losses.Learning from overseas “waterfall” self-relief measures,signing mutual assistance agreements,increasing information sharing among relevant institutions,a more diversified channel could be created for the backfill of liquidity losses;3.focus on the continuous optimization of existing self-relief mechanisms.FMI in China should reserve certain level of discretion when dealing with default events,strengthen cooperation with various relevant departments,reduce losses,and improve the speed and accuracy when handling default incidents.In addition,we can learn from the retrial system of default response mechanisms in foreign countries,and increase the number of annual re-examination according to the national condition of China in order to establish a relatively comprehensive self-relief mechanism in a relatively short period of time.After that,the number of annual re-examinations of the mechanism can be gradually reduced to ensure the predictability and stability of the relevant mechanisms.The fifth chapter is "Legal Regulation of Systematic Risks in FMI".Based on the previous chapters focusing on the risks of various phases in the securities post-trade processing,this chapter uses the "cascading effect" of network economics as a guide to study the systematic risks faced by FMI and the corresponding legal regulations from a holistic perspective.Conducted empirical research on historical risk cases of FMI,including the palm oil settlement default event of Kuala Lumpur Commodity Clearing House in Malaysia in 1983,the event of overdue deposits of participants of the Hong Kong Futures Exchange in 1987,and the series of illegal events in the Commodity Spot Exchange market in India in 2013,the article illustrates that defaults can occur if the FMI is not well managed.The Kuala Lumpur Clearing House in Malaysia eventually led to bankruptcy due to the breach of contract.It shows that in the absence of a reasonable and adequate resolution mechanism,t...