Cross-border Equity Trading Clearing & Settlement in Europe (by Deutsche Borse)

8/4/2019 Cross-border Equity Trading Clearing & Settlement in Europe (by Deutsche Borse)

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Cross-Border Equity Trading,

Clearing & Settlement in Europe

White Paper


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Cross-Border Equity Trading,Clearing & Settlement in Europe

White Paper


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3CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE

Contents

Contents

Executive summary 5

Introduction 6

1 Status quo of European equity markets 7

1.1 Characteristics 7

1.2 Level of efficiency and innovation in domestic European equity markets 7

1.3 Engines of efficiency and innovation 9

1.4 Summary 14

2 Incremental costs 15

2.1 Total incremental costs of cross-border equity trading in Europe 15

2.2 Potential scenarios of cross-border trades 16

2.3 Cost comparison of domestic and cross-border trades 18

2.4 Summary 25

3 Improvement of efficiency 26

3.1 Possible measures by European Commission and national governments,

legislators and regulators 26

3.2 Possible measures driven by market participants 28

List of figures 33

Glossary 34

References 36


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6 CROSS-BORDER EQUITY TRADING, CLEARING & SETTLEMENT IN EUROPE

Introduction

Introduction

The introduction of the euro as a physical currency on 1 January 2002, was only the latest andmost visible sign of the accelerating efforts to integrate the European capital markets. Much more

important for industry participants are the ongoing initiatives by the European Commission and

other public as well as private institutions to further this integration and to reduce costs for cross-

border trading, clearing and settlement in Europe. Other measures aimed at integrating the

European capital markets should be pursued in parallel, however. These should be predominantly

targeted at increasing the diversification of portfolios of European investors as a shift from a

domestic toward a European or even global orientation promises to result in significantly improved

risk/return trade-offs.

Deutsche Brse and Clearstream International welcome the European Unions determination to

integrate the capital markets. We support this initiative and would like to contribute to the discus-sion of how to improve the efficiency of the European securities market infrastructure. This paper

presents our view on the state of the European trading, clearing and settlement industry (chapter 1),

analyses the incremental costs of cross-border trading, clearing and settlement (chapter 2) and dis-

cusses ways how these costs can be reduced (chapter 3). This paper concentrates on secondary

cash equity markets, as these are at the centre of the ongoing discussions about cross-border trad-

ing, clearing and settlement. A glossary is provided in the appendix to this White Paper to define

some of the technical terms used in the trading, clearing and settlement industries.


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Status quo of European equity markets

1 Status quo of European equity markets

An analysis of how to improve the integration of the European equity markets must be based onan understanding of their main characteristics. This chapter will show that given their high extent

of fragmentation, European equity markets are actually operating at a high level of efficiency.

An understanding of the reasons for this efficiency will be necessary to ensure that proposals for

improvement and thus change will not jeopardize well-functioning existing structures.

1.1 Characteristics

Compared to their US counterparts, European secondary equity markets are characterized by sever-

al structural disadvantages, most of which are very difficult to influence and will change only grad-

ually over the coming years. The most important of such characteristics is the high degree of frag-

mentation: the largest European market, London, generates only about 23 percent of the transac-tion volume in the largest US market. 2)

Even though the European Union works toward integration between its member states, Europe

remains segmented into 15 different cultural, legal, taxation and regulatory environments. While

some barriers to true integration, like differences in market practices which developed historically,

can be gradually overcome through concerted and ambitious initiatives, other barriers like 11 dif-

ferent languages will persist. Because of these many differences, small players concentrate on their

local markets; by our estimate, approximately 60 percent of all equity trading is still purely domestic.

Another disadvantage of European equity markets compared with their US counterparts is the less

developed equity culture. Total market capitalization relative to GDP in Europe is on average 16 per-cent lower than US levels and in many smaller European countries significantly below that level.

This also contributes to the limited size of national markets.

1.2 Level of efficiency and innovation in domestic European equity markets

Given these disadvantages compared with the United States, one may be surprised that the

European cash equity markets are generally characterized by a high level of efficiency.

Transaction and liquidity costs are an adequate measure of a markets efficiency. Transaction fees

can be directly influenced by exchanges, clearing houses and CSDs. Additionally, through its mar-

ket model and technology, an exchange organization can also have significant impact on investorsliquidity costs. Both transaction fees and liquidity costs are compared internationally by the US

consultancy Elkins/McSherry. A recent analysis conducted in 2001 shows that the most efficient

European markets like Euronext and Deutsche Brse are actually more efficient than the New York

Stock Exchange (NYSE) although the latter has a 5-6 times higher trading volume and a corre-

sponding potential for economies of scale (cf. figure 1).

2) A trading volume of4.8 trillion in London in 2000 compares with 22.2 trillion for the largest US market,

i.e. Nasdaq (FIBV data, including OTC transaction figures).


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The reason for the low liquidity costs of Euronext and Deutsche Brse expressed in the

Elkins/McSherry study as the difference between execution price for sample transactions to the

average of a days open, high, low and closing price 3) lies with efficient trading systems with

widely used electronic open limit order books. London Stock Exchanges liquidity costs are also

below NYSEs levels, but total transaction costs on its domestic market are skewed by the UK

stamp duty. In summary, the low overall transaction costs on the most efficient European ex-

changes are due to relatively low fees and efficient market models and trading platforms.

The higher transaction volume in the US is of particular importance for the level of settlement

costs, as this is a largely fixed cost-driven business with very large economies of scale. Given thehigh level of fragmentation in Europe, it is therefore surprising that the difference between US and

European costs is relatively small.

9.0 1.2 10.2

9.5 1.3 10.8

14.9 0.6 15.5

15.3 1.5 16.8

17.8 1.4 19.2

12.3 25.0 37.3

Deutsche Brse

Euronext**

NYSE***

Madrid

Milan

LSE****

MilanMadrid

NYSE *****

Euronext

Deutsche Brse

25

20

15

10

5

0 2 4 6 8 10 12 14

Basis points Basis points

Trading volume trillion

Liquidity costs

Trading, Clearing & Settlement and other fees

* Country data taken as proxy for a countrys dominant stock exchange

** Weighted average of Paris (60 percent), Amsterdam (38 percent) and Brussels (2 percent) stock exchanges

*** Different trading system leads to low fees, but higher liquidity costs

**** Average of UK sell orders and UK buy orders; high cost of trading mainly due to stamp duty

***** Given high volume in New York, relatively high transaction costs in US

Source: Elkins /McSherry, Global Universe Market Cost Report: Quarter 1, 2001; FIBV (US$1= 1.12).

Figure 1: Exchange-influenced transaction costs for equity trading*

3) This proxy for liquidity costs used by Elkins/McSherry is only a very rough approximation to the actual liquidity costs consisting of the average

bid-ask spread and the market impact (i.e. adverse move in price) of a trade. Elkins/McSherry data is used because currently no better inde-

pendent global comparison of total trading costs is available. Due to Elkins/McSherrys methodology, very liquid markets are difficult to com-

pare with rather illiquid (e.g. emerging) markets.


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After netting 4), costs at some European CSDs are even lower than in the United States, as figure 2

shows. Comparing operating income per transaction between the EU and the US, a recent CEPSreport 5) found that domestic settlement costs after netting in the EU are on average only 8 percent

higher than in the US.6)

1.3 Engines of efficiency and innovation

A number of engines of efficiency and innovation can be identified within European equity mar-

kets. The most important of these are advanced technology and high innovation, demutualization,

and strong competition of industry participants.

Advanced technology and high innovation

The most efficient European equity markets are characterized by advanced technology and a high

degree of innovation across all levels of the transaction processing chain, contributing to a high

rate of straight-through processing.

Most noteworthy is the early introduction of electronic trading systems in all major European mar-

kets. Disintermediation efforts to reduce automation and commission costs were significantly ad-

vanced by the launch of the NSC system in Paris in 1995 and the introduction of similar electronic

trading platforms in London (SETS) and Frankfurt (Xetra) in 1997.

CBF (Germany)** 2.15 2.15 125

CREST (UK) 2.44 2.44 59

DTCC (US) 2.77 0.40 1,586

Euroclear (France) 6.60 2.00 135

Operating income

per transactionafter netting

Operating income

per transactionbefore netting

Settlement transactions

before nettingmillion

Figure 2: Settlement costs according to the Giovannini report *

* Method of relating operating income (includes custody and other income, thus only rough proxy for settlement costs)

to transaction number understates pre-netting costs and overstates post-netting costs

** Giovannini: The number of [CBF] is for stock-exchange trades only, therefore operating income per transaction overstated

Source: Giovannini report commissioned by the European Commission, NSCC (only for DTCC costs per settlement transaction)

4) Netting refers to settlement netting.5) Cf. CEPS 2001, p. ii; domestic after-netting costs: Operating income of European CSDs without ICSDs to exclude distortions from the higher

costs of cross-border settlement which will be analysed in the following chapter.6) A comparison based on after-netting costs is appropriate if the focus lies on the efficiency of settlement organizations, which usually receive

netted transactions. A pre-netting analysis includes the efficiency of clearing houses in the analysis. A number of major European market

places do not yet offer settlement netting but plan to introduce it soon (e.g. Deutsche Brse with its announced Equity Central Counterparty).


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These systems helped Europe to establish an early lead over the United States with fully electronicopen limit order books.

Following the success of the Nasdaq exchange in the US, growth stock markets were introduced

around Europe during the 1990s (e.g. AIM in the UK, Neuer Markt in Germany, and Nouveau

March in France) and have started to compete in the new issues market of European technology

and other growth stocks.

Through innovation and customer orientation, Eurex and Liffe managed to establish a significant

lead over their US competitors in the fast growing segment of derivatives markets.

While not all European markets offer a central counterparty for equity trading (ECCP) yet, this effi-cient clearing solution is quickly evolving as a new industry standard in Europe, with up to eight

markets expected to have developed an ECCP by 2003.

As the cost comparison has shown, Europes processes for the settlement of domestic securities are

highly automated and sophisticated. Similarly efficient systems exist for international bond settle-

ment through the two ICSDs Euroclear and Clearstream International, while cross-system equity

settlement still involves significant costs which are discussed in detail in chapter 2.

Demutualization

The trend toward demutualization started with the Paris, Madrid and Frankfurt stock exchanges in1988, 1989 and 1991 respectively, and continued with the Stockholm exchange in 1993, the

Amsterdam and Milan stock exchanges in 1997, the Brussels and Lisbon stock exchanges in

1999, and finally the London Stock Exchange (LSE) in 2000. The trend is further supported by

the listing of some of the demutualized organizations which started in 1998 with the acquisition of

the Stockholm stock exchange by the listed OM Group, and was accelerated as figure 3 illus-

trates in 2001 by the listings of the three largest European exchanges: Deutsche Brse went

public in February, and Euronext and LSE followed in July of that year.

The principal effect of demutualization was that exchange organizations shifted to the governance

model of private companies with professional management, clear responsibilities and control, and

transparent accounting. They also took a for-profit-orientation.

Although their shareholder structure remained almost unchanged with intermediaries dominating,

European exchange organizations quickly improved their offerings, expanded in non-traditional

areas such as information products or the organization of markets in non-financial instruments, as

discussed in further detail below.


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Horizontal cross-border competition among exchanges, clearing houses and (I)CSDs

Horizontal competition is a powerful engine of efficiency and innovation in Europe. Cross-border

competition can be found across the entire securities industry value chain, a conclusion supportedby CEPS in its recent report 7).

In the cash equity markets, international competition for new issues has grown strongly over the

past years. Through remote membership, foreign investors receive efficient access to local capital

markets. Deutsche Brse, for example, currently offers remote access to around 650 international

members from Europe, the United States and the Far East. As a result, London members, for

example, trade about as many contracts on Eurex as on Londons Liffe (cf. figure 4). Deutsche

Brses internationalization and therefore competition drive is further supported by its Global

Markets Concept, under which selected European and US blue-chip stocks are traded on Xetra

using hybrid market models. Furthermore, German retail investors have access to 10,015 foreign

stocks traded on the Frankfurt floor of Deutsche Brse and independent regional exchanges wherebrokers provide liquidity for retail investors.

1988 1990

Paris

Demutualization

IPOs

1992 1994 1996 1998 1999 2000 2001 2002

Frankfurt AmsterdamMilan

LSE

Madrid StockholmBrusselsLisbon

Zurich(planned)

1998 1999 2000 2001 2002

Stockholm* EuronextLSE

DeutscheBrse

Madrid (planned)Milan (planned)

Lisbon (Euronext)

Europes largest exchanges

Figure 3: Migration from mutual structures to public companies

7) Since the early 1990s, the EUs banking, insurance and security markets have been open to cross-border competition. (CEPS 2001, 1)

* Acquired by OM (public since 1987)


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15 16 14 13 17 17 14 15 15 16 15 18 14 15

Eurex

Liffe

Xetra/ Eurex

Members outside GermanyAccess pointsLocation of business unit

Access to US market forEuropean exchangesrestricted by SEC and CFTC

650 members

TokyoHong Kong

2001

Eurex: contracts traded by London membersvs. Liffe total turnovermillion contracts

30

15

0

20012000

Xetra: percentage of volume traded by foreign members

Figure 4: Remote access the example of Deutsche Brse

Similar pan-European initiatives are also pursued by the LSE with the internationalization cam-

paign of its AIM growth market and its SEAQ system to support the large OTC market for interna-

tional stocks in London.

Cross-border competition in equity trading is increased further by new market entrants like virt-x,

which offers trading in 629 European blue chips; new alliances like Nasdaq Europes partnership

with the Berlin Stock Exchange, who jointly aspire to capture European cross-border flows; or

mergers as in the case of Euronext, which is the combination of several European exchanges

including those of France, Belgium and the Netherlands.

Competition in derivatives trading is even stronger, as the fierce battle between Eurex and Liffe for

capital market derivatives in the late 1990s has shown. As a result, prices for the trading of deriv-

atives have dropped significantly. Recently, the competition has shifted emphasis from prices to the

most innovative product offering and improved remote access networks.

Cash bond trading is the most international of the three businesses mentioned here. Thus, the

degree of competition is high among Eurex Bonds, BrokerTec, EuroMTS and others competing

within existing or planned product offerings for domestic, European and international bond trading.

International competition in clearing and settlement is relatively strong. Eurex Clearing, Clearnet

and LCH are either already competing for existing domestic and international clearing businesses,or have ambitious expansion strategies. European central securities depositories (CSDs) are

increasingly interlinked, which results in efficiency gains for market participants and requires CSDs


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to keep innovating and updating their systems. Clearstream, for example, has already three Deliveryversus Payment (DvP) and seven Free of Payment (FoP) links with other (I)CSDs, which also con-

tinue to build bilateral links to each other.

Another aspect which is often overlooked is the existing competition between CSDs and custodi-

ans. They have an overlapping service offering. CSD links allow CSDs to compete with custodians

for the international settlement agent and custody business.

Increased competition between market organizers and intermediaries

Demutualization, innovation and new entrants (virt-x, Jiway) resulted in horizontal competition

between exchanges. However, competition between exchanges and intermediaries (brokers, custo-dians, etc.) remained low before exchanges went public, because demutualized exchanges were

still owned by intermediaries.

Market organizers (like exchanges, but also CSDs and clearing houses) provide the framework for

securities transactions and can significantly impact the demand of end customers for intermediary

services. The larger the scope of services that market organizers are directly or indirectly offering to

investors and issuers, the smaller the intermediary fees that can be charged by banks and brokers.

The benefits from increased competition are already evident. Exchange organizations have intro-

duced or are planning to offer retail and foreign brokers direct access to their infrastructure, there-

by disintermediating intermediaries such as local wholesale brokers. They offer information sys-tems to end-investors (e.g. Deutsche Brses range of information on its web site) or organize mar-

kets (e.g. for exchange traded funds) which substitute higher-margin products of intermediaries to

the benefit of end-investors. Likewise, they are subject to competition from intermediaries. For

example, wholesale brokers are already internalizing a portion of their order flow (i.e. matching

customer order flow against their own market making) taking volumes off exchanges. Today, retail

order flow is fully internalized in the UK through five retail service providers, and many brokers are

planning to also internalize continental retail order flow. These measures reduce the transparency

of the trading process as well as the liquidity on the public market, leading to higher costs for

investors in the long run, because the possible savings in transaction fees are very small compared

with the adverse effect of increases in liquidity costs (see figure 7 below for a comparison of the

relative importance of transaction fees versus liquidity costs).

Therefore, for-profit-oriented exchange organizations have no room to abuse their position as mar-

ket organizers due to the increased competition, but are critically important as independent propo-

nents of maximum liquidity and efficient direct access solutions for market participants.


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1.4 Summary

Figure 5 summarizes our analysis of the status of the European capital markets. It shows that

there have been substantial improvements during recent years. As a result, transaction fees on

European exchanges decreased by almost 50 percent, while trading volumes tripled. This highly

positive track record promises fur ther market-driven improvements in the European capital markets

in the years ahead.

4

3

2

1

0

1998 20001996

Domestic transaction fees on European exchanges*,1996 2000Average, basis points

47%

12

9

6

3

0

1998 20001996

Trading volume on European exchanges*,1996 2000US$ trillion

203%

* Nine of Europes largest exchanges; London excluded from transaction fee analysis because of the distorting effect of stamp duty.

Source: Elkins /McSherry data as reported in Institutional Investor, McKinsey analysis

Figure 5: Transaction fee and trading volume development in Europe


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Incremental costs

2 Incremental costs

While it could be demonstrated in the preceding chapter that Europes domestic trading systemsfunction highly efficiently, cross-border trading does incur higher costs. A detailed analysis of these

costs is necessary to understand which reduction measures would be most effective.

2.1 Total incremental costs of cross-border equity trading in Europe

We estimate the total incremental costs of cross-border equity cash trading and cross-border equity

holdings in Europe at approximately 4.3 billion per year, excluding liquidity costs. These consist

of about 2.3 billion in higher commissions, 1 billion in cross-border settlement fees, and 1 bil-

lion in higher cross-border custody fees. 8) For comparison, it should be noted that the UK govern-

ment raises a significantly larger sum through its stamp duty on share purchases of UK stocks. 9)

Thus, one albeit major distortion of a domestic equity market exceeds the overall incremental

costs of cross-border equity trading in Europe.

We estimate that approximately 40 percent or 1.7 billion per year results from cost drivers that

can only be influenced by the European Commission, national governments, legislators and regula-

tors. Roughly 20 percent (less than 1 billion) are due to cost drivers that intermediaries, exchange

organizations, clearing houses and CSDs can influence. The remainder (another 40 percent) can-

not be influenced by any of these institutions and industry players (cf. figure 6).

Percent Who can influence cost drivers?

Higher broker commission

Higher CSD and settlement agent costs

Higher custody costs

Total

EU, member states

Different laws, taxes, and regulatory environments

Different corporate actions

Different currencies (,)

Low degree of automation caused by need for

regulatory translation

Intermediaries, exchanges, CSDsDifferent market practices

Fragmented trading, CSD industr y

Others/ not influenceable

Low volumes (home bias)

Different languages

2.3

1

1

4.3

1.7 0.9 1.7

30 15 55

30 50 20

70 10 20

~ 40 ~ 20 ~ 40

Figure 6: Incremental cross-border equity trading costs in Europe

8) The estimate is based on adjusted McKinsey / JP Morgan estimates for equity turnover and equity holdings in Europe in 2001 and the analysis

from chapter 2.3. Incremental trading commission is calculated by multiplying the estimated non-proprietary equity trading volume in the

European Union (~ 13 trillion; double-counted) with the estimated percentage of cross-border trading (~35 percent; excluding intra-system

transactions for which cross-border commission and settlement costs are similar to domestic ones) and the estimated incremental commission

of 5 basis points. Incremental settlement costs are calculated with an estimated average transaction size of 150,000 and an average cost of

25 per transaction settled cross-border (adjusted for ~20 percent proprietary trading volume in Europe). Finally, incremental custody costs

are calculated by multiplying the estimated total cross-border equity holdings in the European Union (~3.7 trillion) with the estimated incre-

mental custody fee of ~2.8 basis points.9) The UK governments forecasts for stamp duty revenues from the sale of shares for the 2000-2001 tax year are 4.5 billion (~7.3 billion)

according to a survey of the UK tax system by the Institute for Fiscal Studies.

bn.

2001

(estimates)


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Incremental costs

The European Commission, national governments, legislators and regulators have power over themost important cost drivers. These are different legal and tax systems and different regulatory envi-

ronments. E.g. complex and different legal requirements for transfer of title in securities result in

different processes in different countries. Corporate actions (e.g. stock splits, dividend payments,

etc.) differ in the various countries, which leads to higher costs, especially in the cross-border cus-

tody area. Different tax treatment and the handling of country-specific taxes (in particular stamp

duty) result in complex translation processes and costs. The existence of two major currencies

(euro, Sterling) is another cost driver. The need for this regulatory translation leads to a low

degree of automation. Furthermore, there is no uniform language for the processing and reporting

of transactions in different countries. We estimate that these drivers account for roughly 30 percent

of the incremental cross-border commissions and settlement fees respectively and for 70 percent of

the higher custody costs. 10)

Intermediaries, exchanges and CSDs are mainly responsible for the coexistence of different market

practices on different market places. Costs are also driven by scale disadvantages of a fragmented

trading, clearing and settlement industry. This is, on the other hand, a prerequisite for competition,

and a catalyst for innovation and efficiency. The factors discussed here account for about 15 per-

cent of the higher commission costs, 50 percent of the higher settlement costs and 10 percent of

the higher custody costs, in our opinion.

The main factor that cannot be influenced in the short nor medium term is the low (but increasing-

ly growing) cross-border trading volume due to the home bias of European investors, i.e. the ten-

dency to over-invest in domestic stocks at the expense of international diversification. 11) As trading,clearing and settlement are industries with strong economies of scale, low volumes result in higher

costs. Thus, if Europeans invested a larger share of their portfolios in foreign stocks, cross-border

trading costs would automatically decrease. At the same time, European investors would come

closer to an optimally diversified portfolio, thus improving their portfolios risk / return profile.

Other barriers that cannot be influenced but increase cross-border costs are different languages

and cultures. Together, these drivers can explain approximately 55 percent of the broker commis-

sion increase and 20 percent of the incremental settlement and custody costs, respectively.

In the following section, we give a more detailed analysis of these cost drivers, their relative impor-

tance compared with purely domestic costs, and the impact on investors and issuers economics.

2.2 Potential scenarios of cross-border trades

Depending on the countries and types of stocks involved, a relatively large number of alternatives

exists to trade foreign stocks. The two most important factors influencing the total costs per trade

are liquidity costs and settlement location. Liquidity costs depend on the market where the trade

takes place. In a stocks home market, liquidity is usually highest, which reduces bid-ask spreads,

as well as market impact. Thus, liquidity costs will usually be lowest there.

10) These and the following percentage figures: rough estimates by McKinsey industry experts11) See, for example, Schiereck /Weber, 2000.


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Incremental costs

Settlement can take place in two ways: intra-system or cross-system. In the case of intra-systemsettlement, settlement takes place at a CSD to which the seller and buyer or their broker are direct-

ly connected. In case of cross-system settlement, stocks are typically traded on the issuers home

market exchange and settlement takes place at the issuers home market CSD, to which the inves-

tor or his broker is not directly connected. Settlement access to this foreign CSD is an important

cost driver in cross-border stock transactions.

If, for example, a German investor wants to buy a French blue-chip stock through a German broker

with an account at the German CSD Clearstream Banking Frankfurt (CBF), he has several options

for purchasing this foreign stock. Firstly, he can decide to buy the stock through the electronic

trading platform Xetra, the Frankfurt floor, or any regional exchange which lists the stock. In all of

these cases, settlement would take place at CBF. If the seller also holds his stock in CBF, CBFwould only need to transfer the stock from one of its accounts to another. This intra-system trans-

action would not be different from a domestic intra-system transaction and would therefore gener-

ally incur similar costs as a domestic transaction.12)

Secondly, the investor may also decide to trade the stock on the issuers home market in France.

He can do so either by trading on the French trading platform Euronext Paris or by completing an

OTC trade. In both cases, the settlement location would be Euroclear France, the French CSD.

Assuming that the German investor or his brokers are not connected to Euroclear France, a cross-

system settlement would need to take place, either through a direct link between the two CSDs

Euroclear France and CBF or through custodians who could transfer the stock because of their own

or their partners connections to both CSDs.

A third possibility would be to use alternative trading systems like virt-x, Jiway, Nasdaq Europe, or

any other platform where the stock is traded. Such platforms usually have their own specific settle-

ment systems.

Finally, trading could also be done internally within the brokers proprietary platform, which would

result in easy settlement within the brokers systems, but might have a substantial impact on li-

quidity costs as was discussed in chapter 1.13)

In the aforementioned example, the trades on German platforms with intra-system settlement

would incur low direct transaction fees but relatively high liquidity costs, because the volume ofFrench stocks traded on German platforms is limited. This would tend to increase bid-ask spreads

as well as market impact 14). This trading method is therefore best suited for retail investors who

want to trade small order sizes where direct transaction fees are more important, as they are usu-

ally levied on a per-transaction, not on a per-volume basis. Liquidity costs are less relevant here,

as market impact is minimal and the higher bid-ask spread is a percentage of the transaction vol-

ume rather than an absolute sum. Additionally, convenience considerations will make retail

investors favor trading on the local market with subsequent intra-system settlement. In contrast to

Germany, where an adequate market-making model for retail orders of foreign stocks exists, retail

12) In the case of Deutsche Brses Xetra system, exchange and settlement fees for domestic and foreign stocks are the same.

Because of the lower volume in foreign stock transactions, Clearstream charges a higher fee for intra-system settlement for most foreign stocks

compared to most domestic stocks. This fee, however, is still significantly cheaper than any form of cross-system settlement.13) These cases will not be analysed here in depth because of their relatively low volumes.14) Market impact is the effect an order has on the price of the security. The higher the trading volume, i.e. the more liquidity, the easier large

orders will be absorbed by the market and the smaller adverse price movements will be.


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Incremental costs

investors in many other European markets might be forced to trade foreign stocks abroad, thushaving to face the higher costs of cross-system settlement.

For wholesale investors with large trading sizes, liquidity costs are the dominant cost factor. They

will therefore tend to trade in the market with the highest liquidity, which is usually the issuers

home market. The additional costs for cross-system settlement are less relevant, as their percent-

age effect is minimal. An exception are stocks that are heavily traded, and therefore very liquid, on

the investors home market. This can often be the case for the shares of companies that come

from a relatively small home market, and that are consequently traded in high volumes on the

major global exchanges (e.g. Nokia in New York, London and Frankfurt).

2.3 Cost comparison of domestic and cross-border trades

Figures 7 and 8 show the difference between the total transaction costs of a domestic and a cross-

border wholesale and retail trade respectively. The result of the analysis is that the total cost of

wholesale trades is about 30 percent higher for foreign trades compared with a respective domestic

trade and typically 150 percent higher for retail trades. However, those foreign stocks that have

high trading volumes on the investors home market can be traded at substantially lower costs.

This is shown in figure 7. The results of this bottom-up analysis are supported by a recent UBS

study which estimated that cross-border trading in Europe is about twice as expensive as domestic

trading.

A typical wholesale trade

Figure 7 shows that the wholesale investors will typically trade stocks on the market with the high-

est liquidity, which would usually require cross-system settlement. On average, total transaction

costs in this scenario are only about 30 percent of what they would be if the same stock was trad-

ed intra-system (24 to 33 basis points compared to 86 to 96).

The following four cost components are considered in calculating the total transaction costs: com-

mission payments to brokers and other intermediaries, exchange related fees, custodian fees for

cross-system settlement, and liquidity costs. Commissions tends to be somewhat higher for deal-

ings on a foreign exchange. According to an LSE study on trading costs on the London StockExchange, the difference is typically some 5 basis points.15) Interestingly, for wholesale investors,

these 5 basis points can be up to 90 percent of the incremental charges for the trade in the for-

eign security. Recently, cross-border commissions came under increasing pressure; however, this

remains the largest driver for cross-border wholesale transactions. Exchange-related fees, on the

other hand, can be assumed to be the same on the domestic as well as the foreign platform. 16) In

the case of trading on the most liquid marketplace (which would require cross-system settlement),

liquidity costs 17) would also be the same as for domestic trades.

15) No recent comparable study for commission costs in Germany is available.16) For clarity of analysis and comparability, all examples are calculated using Deutsche Brses Xetra Premium 1 all-inclusive fee for trading,

clearing and settlement.17) The liquidity cost estimate is based on the daily closing bid-ask spread relative to the closing price of the five most liquid domestic stocks

and the three most liquid foreign stocks on Xetra, LSE and Euronext, using Bloomberg data from Q2 to Q3, 2001. The liquidity costs are

assumed to be 50 percent of the spread. The domestic (foreign) spread assumptions are (in basis points): 18 (142) on Xetra, 20 on LSE,

5 (157) on Euronext. The LSE foreign spreads could not be estimated as volume was too low on the exchange itself (most foreign stocks are

traded over-the-counter in London). Thus, the average liquidity costs were estimated at 3 to 10 basis points on domestic exchanges and

70 to 80 basis points on foreign exchanges, as liquidity costs are 50 percent of a stocks bid-ask spread.


20/38


Incremental costs

The remaining 2 to 10 percent of the total cost difference to domestic trades are per-transaction

custodian fees for the cross-system settlement process. These fees typically range between 10

and 50 per transaction (i.e. between 0.5 and 2.5 basis points for a 200,000 transaction). The

fees will be at the lower end of the range if transaction turnover between the two different markets

is high and therefore efficient links between the relevant CSDs have been built to satisfy this

demand (see chapter 3 for a closer analysis of the economic viability of building links).

Annual custody costs for holding foreign stocks may or may not be higher than for holding domesticstocks. If the foreign stocks are listed on a domestic exchange, custody costs can be as low as those

for domestic stocks. If not, custody costs can go up to 5 basis points and in some cases even higher.18)

15 0.6

15 0.6

86967080

20 0.6*

2433310

0.5 2.5**

3 10 19 26Domestic stock(benchmark)

Foreign stock

cross-system

Foreign stock

intra-system

Commission Exchange-related fees

Custodianfees pertransaction

Liquiditycosts***

Totaltransactioncosts

Annualcustodycosts****

negligible

negligible

11.5

1 5

3 5

+30%

Total costsbasis points (estimates)

Figure 7: Total costs of a typical wholesale trade of about 200,000

* Some exchanges with higher charges for foreign shares (e.g. LSE)

** Including cross-system settlement fees

*** Spread as proxy for liquidity costs; market impact and opportunity costs not quantified

**** Corporate measures and similar core custody services paid annually

Source: LSE survey, industry experts estimates, McKinsey analysis

18) Industry specialists estimates for domestic (1 to 1.5 basis points) and cross-border custody (3 to 5 basis points).

Preferred option


21/38


Incremental costs

This analysis does not explicitly consider additional costs, e.g. for back-office, that are hard toquantify. Back-office costs are mainly driven by the level of automation and straight-through pro-

cessing. They will be substantially higher for cross-border trades due to different accounting stan-

dards, laws, tax systems, languages, IT systems, etc.

In summary the current settlement solutions are relatively efficient for wholesale investors and

should not significantly deter trading in foreign stocks. To reduce costs, it seems most promising to

negotiate commission levels, given their substantial impact on total transaction costs.

Typical retail trade

Figure 8 shows the example of a German retail investor trading for 5,000 through an online bro-ker. For the benchmark case, a purely domestic trade, total costs would amount to around 23 to 67

basis points. As in the case of wholesale investors the largest of these cost components would be

commission costs.

For retail investors, broker commissions are substantially higher than in the wholesale case. For a

5,000 order, online brokers charge between 10 and 25 which translates into 20 to 50 basis

points. This does not change if foreign stocks are traded on the local exchange, but for trades on

foreign exchanges, commissions are usually higher and can go up to 86 basis points. 19)

Liquidity costs are the same for retail investors as for wholesale investors. However, because of the

higher relative importance of the other cost components, liquidity costs are less relevant here. Ad-ditional third party charges are exchange and settlement fees that brokers may or may not pass on

to their clients in addition to their commissions. For intra-system trades, such fees are seldom

passed on, but this is different when substantial cross-system settlement fees are levied. The

amount of the additional fees passed on to the investor will vary dependent on the brokers addi-

tional margin, but will typically start at 17 (US$ 15) for transactions in US stocks and can reach

100 or more for trades of stocks from less important markets.

19) McKinsey survey amongst 14 German online banks, 2001


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Incremental costs

Expressed in basis points, the charges for cross-system settlement (included in the bar named

additional third-party charges in figure 8) make trading on foreign exchanges expensive for retail

investors. Consequently, retail investors will tend to prefer intra-system trades in foreign stocks

even though they face higher liquidity costs of 70 to 80 basis points. In total, transaction charges

for intra-system foreign equity trading are about 150 percent above those for transactions in

domestic stocks.

Domestic stock

(benchmark)

Foreign stockintra-system

Foreign stockcross-system

Commissionsof onlinebrokers

Additionalthird-partycharges**

Liquiditycosts***

Totaltransaction

costs

Annualaccount

costs****

0 1 5

0 1 5

0 1 5

+150%

Figure 8: Total costs of a typical online broker retail trade of about 5,000

* Some exchanges with higher charges for foreign shares (e.g. LSE)

** Levied by brokers for trading, clearing, and settlement (including cross-system settlement fees)*** Spread as proxy for liquidity costs; in some markets liquidity costs expressed by broker commission rather than spreads;

market impact and opportunity costs not quantified

**** Most online brokers without charge; very few with higher costs for foreign equities

Source: Industry experts estimates, McKinsey analysis and survey, FMH-Finanzberatung survey

2050

3 1 0 2367

0 7

2050

70 80 90 137

0 7 *

2086

3 10 58 296

35200

Total costsbasis points (estimates) Preferred option


23/38


24/38


Incremental costs

The analysis shows that for Nokia, liquidity costs, the major exchange-influenced cost factor, areonly slightly higher on Xetra than in Helsinki. They are 13.5 basis points in Nokias home market,

a relatively high number compared to the more typical average of 3 to 10 basis points for home

markets in Europe. This can be attributed to the high volatility of technology stocks in general. The

liquidity costs on Xetra (17 basis points) are only slightly higher, due to high trading volume on an

efficient trading platform.

The commission for domestic and cross-border transactions is the same as in the standard cases.

The fees for the trade on Xetra are 0.6 basis points, including all clearing and settlement fees. The

exchange fees in Helsinki are assumed to be the same, and the costs of cross-border settlement

between Germany and Finland amount to 3.8 basis points.

In the example, the total costs of trading on the wholesale investors home platform Xetra is lower

than on the issuers home market. The incremental cost of trading this foreign stock is caused

exclusively by slightly higher liquidity costs and amounts to only around 10 percent of the cost of

trading in a purely domestic context.

Special case: Trading of selected foreign stocks with hybrid market models

For most blue chips whose liquidity is mainly concentrated on the home issuer market, trading on

the investors home market can be attractive if lacking liquidity is compensated by a hybrid mar-

ket model, i.e. an order driven market which is supported by market makers if sufficient liquidity is

otherwise not available. One such initiative is the Xetra Stars segment, which was launched inSeptember 2001 with 200 US stocks and which has since been expanded to include European

stocks as well. While all hybrid market models have their limitations for large wholesale trades,

they can give in particular retail investors access to foreign stocks at total trading costs reasonably

close to those available in the domestic market (cf. figure 10).


25/38


Incremental costs

Intel traded on Nasdaq(benchmark)

Intel traded on Xetra(US Stars)

Intel traded cross-system

on Nasdaq

Commissionsof onlinebrokers

Additionalthird-partycharges

Liquiditycosts

Total

transactioncosts

+ 50%

Figure 10: Total costs of a retail trade of about 5,000 in Intel stock*

* For the Nasdaq figure, the liquidity cost estimate is based on the daily closing bid-ask spread relative to the closing

price using Bloomberg data for January and February 2002. As Bloomberg does not provide Xetra data only, Deutsche

Brses own Xetra transaction data was used to calculate the bid-ask spreads for all trades during February 2002.

Liquidity costs are assumed to be 50 percent of the spread.** Additional third-par ty charges for US transactions tend to be on the lower end of the range given in figure 8.

The analysis in figure 10 shows that while liquidity costs are still much lower in the stocks home

market (Nasdaq in this example) than abroad, the hybrid market model allows retail investors to

purchase this stock at prices close to those normally paid by wholesale investors (cf. figure 7).

Through Deutsche Brses hybrid market model of Xetra US Stars, the incremental costs of cross-

border trading, clearing and settlement could thus be cut by roughly two thirds from an incremen-

tal cost of around 150 percent (cf. figure 8) to an incremental cost of only around 50 percent (cf.

figure 10).

0 72050

~2 2259

0 72050

~24 44 81

3570**

2086

~2 57 158

Total costsbasis points (estimates) Preferred option


26/38


Incremental costs

2.4 Summary

On an all-inclusive cost basis, cross-border transactions are less expensive than often alleged. For

a typical wholesale trade, costs are about 30 percent higher than domestic trading costs; for a typ-

ical retail trade, costs are about 150 percent higher than domestic costs. The cost disadvantage is

less pronounced for foreign stocks that are traded in high volumes on the investors home market

(like Nokia on Xetra) or for foreign stocks which are traded under hybrid market models. Even less

significant than the total incremental costs is the percentage of the cost increase that is driven by

inefficiencies in the settlement system. For wholesale investors, these are not more than 2 to 8

percent of total trading costs in foreign stocks.

However, in absolute terms, the costs for translation services, estimated at about 4.3 billion peryear, are still significant. It is therefore necessary to reduce such translation costs, the most impor-

tant drivers of which are different legal, tax, and regulatory environments. Some ideas on how to

approach these issues are presented in the following chapter.


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Improvement of efficiency

3 Improvement of efficiency

The European Commission, national governments, legislators and regulators, as well as industryparticipants like intermediaries, exchanges, clearing houses and settlement organizations, pursue

a common goal: the reduction of the costs of capital in Europe. Lower cross-border transaction and

custody costs are one key lever to achieving this goal. In the preceding chapter, we estimated the

total incremental cross-border transaction and custody costs to be 4.3 billion per year. In the fol-

lowing chapter, we want to discuss measures to reduce these costs and possible actions to be

taken by the different entities and industry players mentioned above.

While our analysis of necessary measures differentiates between authorities like the European Com-

mission or national governments and industry players, it should be noted that a close co-operation

between those two groups is most promising. Such co-operation is already happening on various

areas and should be strengthened even further in future.

A successful process should ultimately result in a reduction of European cross-border costs of up to

2.6 billion, or around 60 percent. A significant residual cost basis will remain, as lower transac-

tion volumes as well as language and cultural barriers will persist into the foreseeable future.

3.1 Possible measures by European Commission and national governments,

legislators and regulators

As discussed in the previous chapter, the harmonization of laws, tax systems and regulations to

reduce the need for regulatory translation services is the most important lever for decreasing cross-border trading and custody costs.

The principal issues to be addressed by the European Commission, national governments, legisla-

tors and regulators relate to three areas. The substantial differences between national legal systems

which still lack harmonization lead to high costs as well as to uncertainty and risks. The tax re-

gimes of the member states are unfavorable to cross-border trading and settlement, subjecting mar-

ket participants to high transaction costs. Finally, there are also some legal restrictions that hinder

players to act freely in a competitive market.

The legal treatment of securities is regulated differently across Europe. Firstly, there are differing

national rules for corporate actions in the member states of the Union. Special problems in cross-border transactions arise when a corporate action has to be executed while the transaction is still

in progress, because the diverging legal systems differ on when beneficial ownership of a stock is

transferred. Harmonization in this area has been described as essential for the integration of the

equity markets in the Giovannini report. With respect to the actual transaction, the availability of

bilateral netting for different situations varies across legal systems and has therefore to be assessed

for the actual case in hand at substantial cost.

Secondly, uncertainty about the legal treatment of a transaction is caused more generally by the

fact that interests in securities are far from being treated equally in all member states. This is

especially important in the context of collateralization, where different techniques required by the

various laws for creating pledges or the transfer of full ownership make cross-border transactionsmuch more complicated than domestic ones. The resulting uncertainty increases costs of transac-

tions in two ways. It requires knowledge about the legal systems of all relevant countries, which is

expensive to maintain. But even if this knowledge is provided, a residual legal risk remains, which


28/38



is much higher in the complex international context than for comparatively simple domestic transac-tions. The existence of this residual risk has to be factored into the costs of cross-border transactions.

A further level of complexity and consequently another increase in transaction costs due to higher

direct costs of legal services and higher risks is caused by the existence of different rules for con-

flicts of law in the various member states.

Another major area that can naturally only be addressed by the European Union and national gov-

ernments and legislators is taxation. Not only can securities transactions, dividend payments, etc.,

have tax consequences in many ways, but these differ for all countries. On the one hand, this

inhibits cross-border securities transactions for similar reasons as those which stem from more

general legal differences, i.e. there are high costs due to unfamiliarity with all those foreign taxsystems that may potentially be involved in cross-border transactions. A risk of unfavorable or even

double taxation results. As tax law and taxation procedures are notoriously complicated, only har-

monization of the applicable areas can reduce the consequential costs.

On the other hand, the national tax requirements, e.g. for withholding taxes and for capital gains

taxes, often come at a high cost to foreign and international intermediaries and subsequently to

their customers. First, the majority of member states restricts the ability to provide at-source relief

from withholding taxes to entities established within their jurisdiction. Foreign intermediaries incur

a high extra cost to provide this service to their clients. Furthermore, reporting requirements im-

posed on intermediaries that frequently require substantial manual intervention impose an even

higher cost burden on foreign players as they often do not have the potential to exploit economiesof scale. More generally, access to national tax authorities is typically significantly more difficult

and subsequently more expensive for foreigners who have to struggle with the requirement to file

taxes in the local language along with an administration that is principally oriented to serving the

needs of national taxpayers.

Beyond the general lack of harmonization of both the legal bases for securities transactions and the

relevant taxation, there are also some restrictions that apply to the international securities markets.

These restrictions reduce the potential of competing providers and market models to make interna-

tional securities trading, clearing, and settlement more efficient. Primary dealers and market makers

are constrained in their cross-border activities. Settlement on the primary-market must often occur

locally. Equally, some member states require securities to be deposited in the local settlement sys-tem only.

The UK is a good example of a country where taxes and other regulations directly increase transac-

tion costs in addition to significantly restricting international competition. The stamp duty charged

from sales of stocks is highly complex in its administration which makes it very difficult and ex-

pensive to build efficient links with CRESTCo, the UK CSD. In addition, the complex process of

levying this tax and a number of other particularities, like nominee account requirements, distort

competition between CRESTCo and foreign CSDs in favor of the UK institution. This results in

higher costs to investors through reduced international co-operation and a protected monopoly

position on the part of the UK CSD.


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The importance of harmonization efforts has been prominently underlined by recent reports of in-dustry experts, such as the Wise Men and the Giovannini group reports. The authors concluded

respectively: [The main factors slowing down market integration] are differences in legal systems

and taxation 20) and [] tax regimes and legal systems act as effective barriers to the efficient

delivery of clearing and settlement services. 21)

The removal of regulatory barriers will allow market forces to create an integrated European capital

market. While new legislation is important to foster harmonization, it should not interfere with the

ongoing, market-driven innovation and consolidation process to avoid further unnecessary ineffi-

ciencies.

3.2 Possible measures driven by market participants

Our analysis has shown that market participants like intermediaries, exchanges, clearing houses

and CSDs can reduce cross-border transaction and custody costs by up to 1 billion per year. Most

of these costs are due to the involvement of a large number of banks and brokers acting as custo-

dians and sub-custodians for the settlement of many cross-border transactions. A reduction of

these costs will be the result of an ongoing development of efficient solutions, which has been

apparent already over the past couple of years.

The three main measures that market participants can influence are closer co-operation with one

another, e.g. in the form of building mutual CSD links, international consolidation along or acrossthe industry value chain, and agreement on common industry standards insofar as local laws and

regulations permit such harmonization efforts.

European CSDs have set up links with one another whenever they are the best means to reduce

costs for customers. Clearstream Banking Frankfurt (CBF), for example, has a total of ten bilateral

links to other CSDs. Through these ten links, about 76 percent of all foreign securities traded on

Deutsche Brses cash markets are being settled.

This analysis shows that more than three-quarters of all cross-border trades on Deutsche Brse are

with countries to which links already exist. The only two major trading partners without links are

the UK and Canada, each with a trading volume of about 4 percent 22). Due to a high dispersion oftrading flows, coverage of all trades through links would require the establishment of links to 66

countries. Because of the high fixed costs associated with setting up such links, this would be a

highly inefficient project. The example shows that market demand is sufficient to ensure that links

are established wherever needed leading to cost savings for participants. Where trading volumes

are low, custodian networks offer an alternative solution to links. Figure 11 shows that settlement

costs per transaction through the custodian network decrease significantly as the number of trans-

actions with that country increases. However, not all links are fully utilized. The reason for these

persistent inefficiencies are cross-border barriers like laws, tax systems, etc., but also business

practices of banks and brokers, who prefer the service of global custodians a typical example of

effective competition.

20) Wise Men Report, February 200121) Giovannini Report, November 200123) The complex treatment of the UK stamp duty is the biggest obstacle to building a link to this country


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An example for a particularly efficient solution is the US link. The United States is the highestturnover country; therefore, settlement costs per transaction (equities) are by far the lowest at only

5. One should note that this low price is only possible because of the large market demand for

such transaction processing. If links were enforced for less liquid markets (in one of the other three

groups in figure 15 for example), total costs might even increase to compensate for the high initial

investment and operating costs for such a link.

As CBF is currently the only German CSD 23), settlement of equities has to take place there. This

does not apply to the more international bond business, however, where a highly efficient link with

Euroclear allows the clients of Eurex Bonds, a subsidiary of Deutsche Brse, to settle their trades

in Clearstreams main European rival.

Average of 10 low liquidity countries

Average of 8 lowest liquidity European Union countries

Average of 9 highest liquidity countries other US

US stocks

500,0003,000

44,000

184,000 1,000,000 1,500,000 2,000,000

60

50

40

30

20

10

0

Number of transactions per month on German exchanges

Figure 11: Clearstream settlement costs per transaction through custodian network*

* Clearstream price list (March 2002) is taken as an example. The transaction number is as of October 2001 for all German exchanges.

23) The fact that trades in stocks which are subject to collective safe custody on German exchanges must be settled exclusively in Clearstream is

due to legal requirements: securities subject to collective safe custody (Wertpapiere in Girosammelverwahrung) must be held in a Wertpapier-

sammelbank ( 5 Depotgesetz). Only Clearstream Banking Frankfurt is currently a Wertpapiersammelbank according to German law ( 1 (3)

Depotgesetz) although any other bank could apply for a licence as a Wertpapiersammelbank. The Exchange Rules of the Frankfurt Stock

Exchange merely refer to this legal situation.

Apart from setting up links, institutional consolidation is another important field which is likely tohelp reduce cross-border costs in the future.

Groups of large intermediaries, e.g. the European Securities Forum (ESF), have argued that one

organizational structure (horizontal integration) might be preferable to another (vertical integration)

and that regulators should exert pressure for consolidation to run along these lines. However, this

would be highly counterproductive. Market forces have worked very well so far in producing effi-

cient results.

Horizontally consolidated institutions tend to be better at avoiding duplication of systems and achiev-

ing economies of scale. These benefits must be weighed against the dangers generally associated


31/38


32/38



Brse Clearing and Cedel International to form Clearstream) and is currently in the process of com-pleting a vertical transaction (Deutsche Brse and Clearstream).

However, some competitors fear that vertical integration will lead to nontransparent prices at the

expense of market participants. This view cannot be substantiated. In contrast to the pricing systems

of most major competitors, Deutsche Brses Xetra pricing system, for example, is transparent with-

out hidden costs or extra charges, e.g. for partial trade execution. Members are charged an all-in

price including Clearstream settlement fees that are passed on to Clearstream by Deutsche Brse.

Additionally, the pricing system offers attractive prices for retail and wholesale traders through its

floor and cap system. Finally, total costs of trading, clearing and settlement on Deutsche Brse are

lower than its competitors prices in almost all cases (cf. figure 13).

It was also alleged that excessive clearing and settlement prices might be employed to cross-subsi-

dize the trading platform which is exposed to more competition than settlement organizations.

This allegation is also unfounded, as Deutsche Brses subsidiary Clearstream is among the CSDs

with the lowest settlement fees in Europe (cf. figure 14). Additionally, members do not pay higher

settlement fees on the Frankfurt trading floor and regional exchanges than Deutsche Brse does for

settlement of Xetra trading to Clearstream within the framework of the all-in pricing described above.

LSE***

Euronext

Deutsche Brse (Xetra)

LSE***

Euronext

Deutsche Brse (Xetra)

Trade on Order size

1,500 25,000 100,000 1,500,000

1.68 2.63

3.70

1.50

2.351.40

1.50

2.53

1.14

1.50

2.31

1.50

6.91

7.45

6.00

6.50

6.06

6.00

30.33

20.48

17.50

26.72

19.09

17.50

Small firm*

Large firm**

Figure 13: Price comparison (trading, clearing and settlement)

* 100,000 orders p.a.; proprietary trading in domestic equities only

** 3,000,000 orders p.a.; proprietary trading in domestic equities only*** Assuming even share of LSE-Originator and LSE-Aggressor trades during continuous trading;

auctions and crossing assumed to be 20 percent of all trades; partial executions considered

Source: Price lists, industry experts interviews, Deutsche Brse, all data as of mid-2001


33/38



Agreement on common industry standards is another area where market participants will continue

to cooperate to reduce the costs of cross-border trading, clearing and settlement. This will involve

highly ambitious programs like the move toward a T+1 settlement model, as well as goals within

easier reach like the standardization of opening hours and convergence in technical requirements.

These efforts will be pursued by the European Commission and national governments in line with

the standardization measures which are often required as a basis for adapting systems and proce-dures within the industry. With the growing importance of cross-border trading, it will become in-

creasingly important to offer low costs to international investors. The desire to keep ahead of their

competitors will be a powerful incentive for industry participants to keep driving down the costs of

cross-border trading, clearing and settlement. They will do so ideally in a market environment

where regulators ensure fair competition between industry participants so that the most efficient

systems, organizational forms, and product and service offerings will prevail.

Germany (Clearstream) 0.40

Italy 0.72

UK 0.90

France 1.13

Denmark 2.28

Figure 14: Domestic equity settlement costs

per transaction in major EU countries according to

Giovannini report

Source: Giovannini report 2001


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List of figures

List of figures

Figure 1 Exchange-influenced transaction costs for equity trading 8

Figure 2 Settlement costs according to the Giovannini report 9

Figure 3 Migration from mutual structures to public companies 11

Figure 4 Remote access the example of Deutsche Brse 12

Figure 5 Transaction fee and trading volume development in Europe 14

Figure 6 Incremental cross-border equity trading costs in Europe 15

Figure 7 Total costs of a typical wholesale trade of about 200,000 19

Figure 8 Total costs of a typical online broker retail trade of about 5,000 21

Figure 9 Total costs of a wholesale trade of about 200,000 in Nokia stock 22

Figure 10 Total costs of a retail trade of about 5,000 in Intel stock 24

Figure 11 Clearstream settlement costs per transaction through custodian network 29

Figure 12 Most important cross-border consolidation in Europe since 1997 30

Figure 13 Price comparison (trading, clearing and settlement) 31

Figure 14 Domestic equity settlement costs per transaction in major EU countries

according to Giovannini report 32


35/38


Glossary

Glossary

AIM (Alternative Investment Market) The London Stock Exchanges market for shares of smallercompanies (established in 1995).

Central counterparty (CCP) In cash market trading, the central counterparty enables exchange

and OTC transactions to be executed anonymously because it acts as an intermediary between the

parties to the trade, thereby assuming the risk of non-performance on the part of the buyer or sell-

er. In the context of clearing procedures for derivatives transactions, it enables participants to han-

dle all aspects of trading via a single system.

Central Securities Depository (CSD) An organization that records holdings of securities and pro-

vides mechanisms for their transfer.

Clearing The netting and settlement of claims and liabilities arising from securities and derivatives

transactions; the determination of the bilateral net debt of buyers and sellers involved in exchange

transactions. Clearing is typically performed by a central institution known as a clearing house.

Clearing house An organization that provides central counterparty services, e.g. London

Clearinghouse, Eurex Clearing, Clearnet.

Delivery versus Payment Link (DvP link) In the settlement process, a type of link between CSDs

for the transfer of traded securities and funds. It ensures that delivery occurs simultaneously with

payment. In comparison to an FoP link, a DvP link reduces settlement risk.

Custody In the securities trading context, the service of holding securities in a CSD account for

account of another person. International custodians enable beneficial ownership of a security to be

maintained and transferred without having an account with the CSD where this type of security

must be held.

Equity Central Counterparty (ECCP) A central counterparty for equity trading.

Eurex (European Exchange Organization) European futures and options exchange organization; a

joint subsidiary of Deutsche Brse AG and the SWX Swiss Exchange. Eurex is also the name of the

corresponding trading and settlement system.

Euronext Exchange resulting from the merger of the Paris, Brussels, Amsterdam and Lisbon stock

exchanges.

Free of Payment Link (FoP-link) In the settlement process, a type of link between CSDs where

the transfer of securities occurs independently of payment.

International Central Securities Depository (ICSD) A CSD that settles trades in international

securities and in various domestic securities, usually through direct or indirect (through local

agents) links to local CSDs. There are two ICSDs in the EU: Clearstream International and

Euroclear.

Liffe (London International Financial Futures and Options Exchange) A market for exchange-

traded derivatives.


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Glossary

Link A technical and contractual connection between CSDs that allows cross-system settlement.

Liquidity costs The costs that a buyer or seller of a security has to incur to create liquidity. A proxy

is the spread between buy and sell quotes or orders. The more liquid the market for a security is,

the lower the cost to create the liquidity needed for the intended transaction, i.e. the lower the li-

quidity costs.

Market impact The effect a single order has on the price of the security. The higher the trading

volume, i.e. the more liquidity, the easier large orders will be absorbed by the market and the

smaller adverse price movements will be.

Netting Procedure for determining net positions In this procedure, long and short positions areoffset against one another. The resulting net position forms the basis for risk management and

serves as the starting point for determining margin requirements.

Neuer Markt The market segment for high growth and technology companies at Deutsche Brse.

Nouveau March The market segment for high growth and technology companies at the Paris

stock exchange (now Euronext).

Open limit order book An order book, i.e. a list of (not yet matched) offers to buy and sell a secu-

rity at various prices, which is transparent for participants before they enter their orders.

Retail trade A small trade with a typical transaction size of about 5,000, initiated by private

investors for their own portfolios.

Settlement Completion and fulfillment of a financial transaction i.e. the delivery of the security or

commodity in exchange for the equivalent in cash.

Straight-through processing (STP) The fully automated and therefore swift, safe and efficient

processing of a securities transaction, from order placement, to delivery vs. payment, to the subse-

quent safe custody of the security.

Wholesale trade A large trade with a typical transaction size of about 200,000, initiated byinstitutional investors like investment or pension funds.

Xetra Deutsche Brses electronic trading system, which is the leading platform for blue-chips.


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References

References

Centre for European Policy Studies (CEPS), The Securities Settlement Industry in the EU -Structure, Costs and the Way Forward, December 2001.

Elkins/McSherry, Global Universe Market Cost Report, Quarter 1, 2001.

European Commission, DG Internal Market, Final Report of the Committee of Wise Men on the

Regulation of European Securities Markets, February 2001.

European Commission, DG Internal Market, Overview of Proposed Adjustments to the Investment

Services Directive, September 2001.

London Stock Exchange (LSE), Survey of London Stock Exchange transactions 2000, 2001.

McKinsey & Company, JP Morgan Securities Ltd., The Future of Equity Trading in Europe -

Balancing Scale, Scope and Segmentation, February 2002.

National Securities Clearing Corporation (NSCC), Rules & Procedures, October 2001.

Schiereck, Dirk /Weber, Martin, Bleibe im Land und rentiere dich klglich: Der Home Bias,

Forschung fr die Praxis, Band 9, Working paper, Behavioral Finance Group, University of

Mannheim, 2000.

The Giovannini Group, Cross-Border Clearing and Settlement Arrangements in the EuropeanUnion, November 2001.

The Institute for Fiscal Studies (IFS), A Survey of the U.K. Tax System, Briefing Note No. 9

prepared by Stuart Adam and Chris Frayne, November 2001.

UBS Financial Services Group, Equity Trading in Europe, presentation at the JP Morgan Banks

Conference, February 2002.

World Federation of Exchanges (FIBV), Table 1.4.A Value of Share Trading 2000, August 2001.


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Cross-border Equity Trading Clearing & Settlement in Europe (by Deutsche Borse)

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