After the financial crisis in 2008, governments and regulators from different countries have been reflecting the formation and development of the crisis with the hope to avoid such disasters in the future. The bankruptcy of two biggest Wall Street investment banks, Bear Stern and Lehman Brothers also drew people’s attention to the more complicated securities holding practices involving Subprime Mortgage and Asset Backed Asset. Meanwhile, CHINALCO was then purchasing the stock of Rio Tinto from Alcoa and the underlying stocks were under Lehman Brothers’custodian. People were suspicious if the stocks would be in trouble when Lehman Brothers were declaring its bankruptcy.
Professor Wu Zhipan, in his paper, pointed that indirect holding will happen if securities were traded cross board via agent and if such agent goes to bankruptcy or use the underlying securities as collaterals for loan, there will be conflicts between the third party debtor and the beneficial holders of the underlying securities. Resolution of those conflicts will have impact on the development of the global trading of securities and the e-securities.
I.Current Securities Holding System in China
(A)Two types of securities holding system
Before the Paperwork Crisis in 1968 in the U.S., clearing and settlement of securities were done manually and such painful work has been largely removed with the establishment of the Central Securities Depository (hereby CSD) of the U.S.: Depository Trust Company (DTC). Since then, many countries followed the U.S. practice and established their own CSD.
Though most of the countries have their own CSD, the securities holding system varies. Generally speaking, the securities holding system can be divided into two types according to the relationship between the issuers and beneficial investors: direct holding and indirect holding system. Nevertheless, relationship between the account holder and issuer is not taken into consideration in such classification and only the status of CSD in the whole system matters.
Under direct holding system, the interest of the account holder is directly reflected by the CSD. The securities interest of the securities holder is complete and traceable. Investors’ interest will not be harmed in the case of the bankruptcy of securities brokers or agents. And it is easy for the holders to mortgage such securities. Furthermore, investors’ name can be directly registered with the issuers or the agent acting for the issuers and thus the investors can conveniently exercise its relevant rights or vote via the agent’s system. CSD undertakes the responsibilities and duties of managing the system and maintaining accounts. Any change made to the investors’ accounts shall be directly reflected on their securities account. The A-share holding system is a typical direct holding example.
Under indirect holding system, account holders shall exercise their securities interest through agent (for example, securities companies or investment banks) according to the agent’s books. CSD does not necessarily record the securities holding status of the actual investors. The securities holding system in the U.S. and Germany are typical indirect holding system.
(B)Current Securities Holding System in China
Currently, direct holding system is the dominant holding system in China while there are few kinds of securities being held under the indirect holding system.
The following securities are held under direct holding system: A-shares, B-shares held by domestic investors and most of other securities, such as, treasury bond, corporate bond, enterprise bond issued after 2007, closed-ended fund, ETF, LOF, warrants, securitization products and securities held by inter-bank market investors for proprietary trading purpose.
However, there are still several types of securities which are held under the indirect holding system: enterprise bond issued before 2007, B-share held by foreign investors and bond over banks’ counter.
II. Analysis on the current securities holding system
(A)Pros
There are several advantages for the direct holding system:
a)Convenient to identify the investors and provide relevant services. Under the direct holding system, investors shall disclose their identity and their securities interests are directly reflected by the CSD. Therefore, CSD can easily provide communication services, dividend distribution, voting and other services to the investors. It is easy for the CSD or the issuer to count the number of investors and to register relevant details.
b)Clear and cut legal relationship which provides the investors with strong protection. Under the direct holding system, the investors have absolute independent and direct property right over the securities. No matter they are under the custodian of brokers, banks or CSD, such property right are properly recorded under the CSD. Therefore, it is easy to solve the property title conflicts, streamline the mortgage procedure of underlying securities and to execute securities frozen and deduction. Investors’ interest will not be affected when the brokers or other agents bankrupt.
Because the investors are holding the securities under their real name and thus the possibility that a broker or other agent to manipulate the investor’s fund or securities can largely be reduced.
c)It is also very natural that it will be helpful for the financial institutions to carry out the anti-money laundering investigation since the beneficial holders are directly reflected at the CSD.
(B)Cons
a)Inadequate legislation and lack of supporting system. Currently, the property right law, securities law, guarantee law, bankruptcy law, trust law and other legal areas are in lack of completeness, rationality and consistency. For example, Property Right Law and Securities Law do not clarify the transfer point of securities property title during various trading stages, e.g. title of the securities shall be transferred when the transfer order is placed by the investor via the securities company or only after the clearing and settlement have been done between the securities company and the CSD.
b)Restrain the innovation in financial products. Direct holding system is very transparent which will, to some extent, restrain the innovation on the financial products. On the contrary, indirect holding system provides the nominee holders with more room for financial innovation. It is observed that the room for innovation in financial sector was limited because the direct holding system is the dominant holding system in our securities market.
c)Limit the development of securities companies. Under the direct holding system,
investors open account with CSD and all securities are under CSD’s custodian. Securities company only provides technical platform for the transaction and making calculation according to the trading result from CSD. Furthermore, the registration from CSD is the only public documents to act against the third party. Practically, securities company has no power to execute any frozen or deduction of securities. Therefore, securities company has very limited role during the securities trading which largely restrain the securities company from developing more business.
(C)As previously discussed, direct holding is the dominant holding system we are adopting in China.
We shall, at the same time, see the fact that other countries are developing their securities market by improving the centralized registration, custodian and settlement system and it seems that indirect holding system is going to replace the direct holding system. Under such big picture, foreign investors, though they might be very interested in entering China’s capital market, may feel hesitant or reluctant when they find that the local market is unfamiliar to them. It is highly possible that they will turn to a market with more familiarities, say, the market in which indirect holding system taking the dominant position.
The newly appointed Chairman of China Securities Regulation Commission, Mr. Guo Shuqing, also pointed that the pretty low professional level and inadequate innovation capacity are holding Chinese securities companies from developing rapidly. It is obvious that the two holding system each has its pros and cons. While we are trying to improve the current direct holding system, we shall also pay enough attention to the indirect holding system. We shall perfect our holding system by thoroughly study at the two holding systems by taking the current market practice into consideration. Securities company shall responsible for more duties of the market to improve their professional level, innovation capacity and the function of the intermediary.
International Institute for the Unification of Private Law (UNIDROIT) has passed Convention on Substantive Rules for Intermediated Securities (hereby the Convention) since 2009 and the Convention is one of the most important documents we shall carefully study when we are perfecting the securities holding system.
III.About the Convention
(A)Convention on Substantive Rules for Intermediated Securities
The UNIDROIT is an independent intergovernmental organization with its seat in Rome. Its purpose is to study needs and methods for modernizing, harmonizing and coordinating private and in particular commercial law as between states and groups of states and to formulate uniform law instruments, principles and rules to achieve those objectives.
In 2001, the Governing Council of UNIDROIT approved and the General Assembly adopted the triennial Work Program including a multi-item project “Transactions on Transnational and Connected Capital Markets”. The Convention has been finalized in Geneva on October 9, 2009 for the ratification of the members.
(B)Shall China ratify the Convention
The Convention is a very important international treaty to address the substantive law in cross-border securities transactions. To China, there are pros and cons to ratify the Convention:
a)Pros
First of all, articles in the Convention will have major impact on the Property Right Law, Securities Law, Guarantee Law, Bankruptcy Law even the Trust Law and securities settlement and clearing system as well as improvement of those legal areas. It will also provide a solid foundation to China’s capital market development and integration with international capital markets.
Secondly, one of the principles of the Convention is to extend the application of the Convention. According to Article 3 of the Convention, Applicability of declarations: If the law of the forum State is not the applicable law, the forum State shall apply the Convention and the declarations, if any, made by the Contracting State the law of which applies, and without regard to the declarations, if any, made by the forum State. It is obvious to see the Convention will be applied widely in the future.
Thirdly, countries and areas with mature capital markets, e.g. U.S. and Europe have been very supportive during the draft of the Convention. And they are all major players on the international financial market and it will not be surprising if those countries take lead to ratify the Convention. The cross-border of securities transaction in China has been increasing during the past few years and QFII and QDII business will largely involve in the business with firms from those countries. Access to the Convention will give the participants of the securities transaction more opportunities to be familiar with the international rules, practices and experience. Moreover, though the International Board has not been officially opened in China, thorough discussion on this topic will give the international giants which are familiar with indirect holding system more confidence to get prepared to be listed in China.
b)Cons
Pros of entry into the Convention are plenty and obvious, we shall not ignore the cons, among which, inadequate preparation is the biggest concern.
In terms of legislation, the articles of the Convention are largely in line with our current legislation. But there are still a lot of conflicts between the Convention and current legislation, especially, in guarantee and bankruptcy system. For example, we do not have laws regulating indirect holding system. Such inadequacy makes it is impossible to determine the beneficial holders’ interest in the scenario of foreign investors holding B-shares and the investment made by QFII.
Practically, the book-keeping system of our CSD is not able to record the securities interest held by brokers/agents for the benefit of the cross-border investors and therefore, all securities interest are seen as the asset of the brokers/ agents as long as they recorded under the name of the brokers/agents. Therefore, any loss or risks arising from bankruptcy or any misconduct of the brokers/agents may be passed to the beneficial holders of the underlying securities.
It has been only two years since the finalization of the Convention, securities market participants do not have enough time to familiarize themselves with the rules of the Convention and the practice are not supportive enough for a lot of concepts in the Convention, i.e., relationship between CSD and securities company has not be clarified Given the plenty pros of entry into the Convention, we still have to seriously consider the cons to avoid possible hidden dangers.
c)Factors need to be considered before entry into the Convention
As a member of the international community, China should adopt a positive way to participate in international rule-making, implementation and enforcement. Therefore, from a strategic sense, entry into Convention is necessary, which is the inevitable direction of the securities holding system of China. However, taking into account the abovementioned cons, it is believed that there is no urgency for China to ratify the Convention in the near future.
However, besides the necessity and urgency of entry into the Convention, we shall also look at the following issues carefully beforehand.
First of all, how to adopt the international treaties domestically? In China, there are various practices. First, according to Article 236 of the Civil Procedure Law: If an international treaty concluded or acceded to by the People’s Republic of China contains provisions differing from those found in this Law, the provisions of the international treaty shall apply, unless the provisions are the ones on which China has announced reservations; secondly, the practice we adopted when we entered into WTO. The WTO rules are transferred to the domestic rules in the form of domestic legislation automatically right after signing; thirdly, the way China entered into International Covenant on Civil and Political Rights. The entry did not take effect right upon the signature but only after the approval from the State Council has been obtained. However, this practice is the unique and may not applicable to the commercial treaties.
The second and third practices are unique and not applicable for the entry of the Convention. Therefore, the most possible way is that China signs the Convention and it will be applicable in China immediately. Therefore, adequate preparation shall be made before signing the Convention.
IV.Conclusion
The hardware of the securities registration is easy to copy while the experience and rules are hard to duplicate within short period. Meanwhile, we shall note that there are not an absolute answer on how to choose between the two holding system. We shall make the best use of them as long as it will work well along with our capital market. The experience from advanced capital market, especially, the concept and practice behind the Convention shall be carefully studied at the same time.