US treasuries make up the largest, most liquid class of securities. Apart from providing investors with dollar exposure, they are widely accepted as collateral and are used by US broker-dealers for financing. Their only drawback is that trades have to be settled in the US, via Fedwire, and all custody has to be through book-entry accounts at Fedwire, which is operated by the Federal Reserve.
Not surprisingly, custodians, particularly international central securities depositories (ICSDs) such as Cedel Bank and Euroclear, have sought ways to obtain the right to settle such trades themselves. Being able to settle trades in US treasuries outside the US would open up their use as global collateral, particularly in repurchase agreements denominated in illiquid currencies or where, as in some emerging markets, there is no domestic market at all. In this way, US treasuries would help oil the international capital markets machine.
Now, thanks to the pioneering work of Cedel Bank, offshore settlement of US treasuries is possible. Under section 17A of the Securities Exchange Act of 1934, anyone wishing to transfer an interest in US securities must obtain registration or exemption. At the end of February, the US Securities and Exchange Commission (SEC) granted Cedel an exemption from registration as a US clearing agency. Euroclear has applied for a similar exemption.
What has swayed the SEC over the last decade is a succession of moves at supranational level to promote international settlement. Pressure has come from the G30, the International Federation of Stock Exchanges, the International Securities Markets Association and, most recently, the Bank for International Settlements. The latter published a report in March 1995 approving the role of ICSDs in reducing the risk and cost of cross-border settlement by settling such trades internally through their own books. ICSDs smooth settlement by achieving delivery versus payment, providing margining and offering securities lending and cash facilities to cover short positions.
However, that is only part of the story. For US treasuries to be used freely, they have to be capable of falling outside the application of US law. Under the traditional US conflicts of law doctrine, securities have their situs (ie, are located) where they are issued (if in book-entry form) or where physically held (if certificated). “Situs is important to establishing the finality of settlement and perfection of a security interest such as a pledge or charge, and also may be quite important to the allocation of assets to creditors in an insolvency,” says Kathleen Tyson-Quah, the former senior corporate counsel to Cedel Bank who, with Seth Weinberger of Mayer, Brown & Platt, negotiated the terms of Cedel’s exemption with the SEC.
The Uniform Commercial Code (which attempts to harmonize contractual and commercial law between US states) originally provided that dematerialized securities were held where issued. Article 8 of the UCC was changed in February 1995 to provide that securities in book-entry form are deemed to have situs in the jurisdiction where the holding depository is located. Article 9, which deals with the creation and perfection of security interests, was also revised to provide that perfection of a security interest (ie, for the benefit of the chargee against third parties) is governed by the laws of the jurisdiction where the security in question has its situs.
The changes to Articles 8 and 9 have been enacted in most US states, but are still pending in New York, a critical omission given that New York law is often chosen to govern international financial agreements. To prevent any confusion, the US Department of the Treasury independently enacted the changes in the form of regulations that became effective from January 1 this year, regardless of state law, for US treasury securities.
The change in situs rules also clears the way for the use of treasuries in multi-currency repo. The PSA/Isma global master repurchase agreement (the standard form repo documentation provided by the Public Securities Association and the International Securities Markets Association) provides that it should not be used with US treasuries. This is because the PSA/Isma agreement allows for set-off under English law which would not necessarily be recognized in the US. By contrast, the standard US repo agreement creates an Article 9 security interest. However, by holding US treasuries in an ICSD (settled under Luxembourgeois or Belgian law) and subject to the laws of a foreign jurisdiction that recognizes set-off (such as English law), this concern falls away.
Apart from the wider benefits of offshore treasuries settlement, ICSDs are bound to claim that they provide a better system than Fedwire. But in some respects this may be true. “Settlement in ICSDs requires matching messages from seller and buyer, while Fedwire requires just one,” says Tyson-Quah, “so matching settlement messages should ensure fewer settlements being unwound or contested. Settlement will only occur if sufficient cash or securities are available in participant accounts or if securities borrowing or cash financing facilities are available.”
By contrast, Fedwire extends cash overdrafts automatically if insufficient cash is available. This can cause problems when clearing bank systems fail. In 1986, the Bank of New York’s (BoNY’S) systems for using Fedwire failed during the settlement day. Fedwire continued to deliver securities into the BoNY account even though BoNY could not send them out again. This resulted in a $23 billion overnight overdraft for BoNY and tighter back-up systems for Fedwire member banks.
The biggest change to risk management from overseas custody of US treasuries may have nothing to do with settlement at all. Under US insolvency law, all assets of an insolvent foreign company in the US are seized with a “ring fence” to settle US claims, including punitive fines imposed by regulators. The ring fence is often unfair to a failed company’s home country and international creditors, given large international holdings of US treasuries as reserve assets. If holdings of US treasuries in ICSDs have their situs outside the US, in Luxembourg or Belgium, then they should be free of the US ring fence in the event of an insolvency. Regulators may be interested in this rather simple means of improving the protection of bank depositors and investors, particularly given the poor recovery-rate of non-US creditors’ claims on failed bank BCCI.
