🎅 What are Market Infrastructures?

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Market infrastructures are the rails that keep global finance running smoothly. From the moment you tap 'buy' on your trading app, to the final settlement of your trade, these systems and entities work together. Whether you're a market professional or simply curious about how financial markets work, understanding these foundations will give you insights into the machinery of modern finance. Let's begin.

From Coffee Houses To Mainframe Computers

In the late 1600s, London's financial markets operated from coffee houses. Here, traders dealt in shares of early corporations like the East India Company. Each trade involved elaborate paper stock certificates, designed with intricate patterns to prevent forgery. These weren't just beautiful documents - they represented legal ownership of company shares. Settlement happened on fixed days through a sophisticated forward trading system, with clerks carefully recording each transaction in thick ledgers.

This paper-based system worked for centuries until Wall Street hit a paperwork crisis in the 1960s. As trading volumes exploded, back offices couldn't keep up with the paperwork. By 1968, hundreds of millions of dollars in unprocessed trades piled up. Brokerages had to close on Wednesdays and reduce trading hours just to process the backlog.

This crisis prompted major changes: the creation of the Securities Investor Protection Corporation (SIPC) in 1970 and the establishment of the Depository Trust Company (DTC) in 1973. The solution was dematerialization - converting paper certificates into electronic records. Moving these records to mainframe computers solved multiple problems beyond just efficiency - it reduced risks of theft and forgery while creating more robust systems for clearing and settling trades. However, it also set up a legacy technology challenge for the future.

The Lifecycle of a Cash Equities Trade

Let’s explain the lifecycle of a securities trade, using a retail investor's purchase of Tesla shares as an example.

When you buy 100 shares of Tesla through Robinhood on your phone, several market infrastructures work together behind the scenes. Your order is routed to a trading venue like NASDAQ or potentially other venues including dark pools. Once your order matches with a seller's order, the trade is executed. Your Robinhood app will show a projected position, but this is not yet actual ownership of the shares.

After execution, the trade enters post-trade processing. First, the trade details go through comparison or trade confirmation, where the details are matched to ensure accuracy. The trade then flows to the National Securities Clearing Corporation (NSCC), a subsidiary of DTCC. At this point, NSCC becomes the central counterparty through novation - legally becoming the buyer to every seller and the seller to every buyer, thereby taking on and managing counterparty risk.

NSCC performs multilateral netting, a crucial efficiency function. It takes all Tesla trades made by your broker-dealer (Robinhood) that day and nets them down to two figures: a single cash amount representing the net money Robinhood either owes or is owed, and a single securities position showing the net number of Tesla shares Robinhood needs to deliver or receive. This netting process is powerful because your broker-dealer might execute thousands of Tesla trades in a day - some buys, some sells. Rather than settling each trade individually, netting reduces it to one cash movement and one securities movement per security.

The final settlement occurs one business day later (T+1) through the Depository Trust Company (DTC), another DTCC subsidiary. DTC handles the actual exchange of securities for payment using delivery versus payment (DvP), ensuring that securities move only when payment is made. This protects both parties in the transaction.

This process shows how different market infrastructures - trading venues, clearing houses (CCPs), and central securities depositories - work together to ensure the safe and efficient transfer of securities from sellers to buyers. Each infrastructure plays a specific role in the journey from trade execution to final settlement, operating under strict risk management frameworks and regulatory oversight.

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The 5 Types of Markets Infrastructures

Payment Systems

Payment systems form the foundation of modern financial markets through Real-Time Gross Settlement (RTGS) systems. These systems process high-value payments between banks using central bank money, which is money held directly at the central bank. The key feature of RTGS systems is payment finality – once a payment is settled, it cannot be reversed. For instance, in the United States, Fedwire serves as the RTGS system operated by the Federal Reserve.

Central Securities Depositories (CSDs)

Central Securities Depositories function as the source-of-truth databases tracking securities ownership. They manage the dematerialization process, converting physical certificates into electronic records. CSDs handle two distinct types of ownership:

• Legal title, which represents the official owner in the CSD's records

• Beneficial title, belonging to the ultimate owner who receives the economic benefits

Securities can be held in omnibus accounts where multiple customers' assets are pooled together, or in segregated accounts where assets are held separately for each customer. When securities need to move between different CSDs, complex cross-border arrangements come into play.

Securities Settlement Systems (SSS)

Securities Settlement Systems are the infrastructure responsible for the transfer and settlement of securities transactions. They operate on a delivery-versus-payment (DvP) basis, ensuring that securities delivery occurs if and only if the corresponding payment is made. SSS typically work in conjunction with CSDs and payment systems to:

• Process the settlement instructions from trading parties

• Verify the availability of securities and funds

• Execute simultaneous transfer of securities and funds

• Provide settlement finality

• Handle corporate actions and income payments

SSS can operate on different settlement cycles (T+1, T+2, etc.) and may offer features like securities lending and borrowing to prevent settlement failures.

Central Counterparties (CCPs)

Central Counterparties play a crucial role by standing between trading parties, becoming the buyer to every seller and seller to every buyer through a process called novation. They reduce counterparty risk by requiring margin (collateral) from participants and enable multilateral netting, which reduces the total number of settlements needed. CCPs manage risk through:

• Initial margin to cover potential future losses

• Variation margin for daily price adjustments

• Default funds that pool resources to handle member defaults

Trade Repositories

Trade Repositories maintain essential records of derivatives and other financial transactions. They provide transparency to regulators and market participants, helping identify potential systemic risks in the financial system before they become critical issues. Their key functions include:

• Centralized collection of transaction data

• Standardization of reported information

• Provision of data access to relevant authorities

• Support for regulatory oversight and market surveillance

• Facilitation of public price transparency where required

Interconnections and Dependencies

These infrastructure components work together as an integrated system:

• Payment systems settle the cash leg of securities transactions

• CSDs and SSS handle securities custody and settlement

• CCPs reduce counterparty risk and settlement volumes

• Trade repositories provide transparency across markets

The smooth functioning of financial markets depends on the reliable operation and coordination of all these components, with robust risk management and operational resilience at each level.

The PFMI Rules for Market Infrastructures

The Principles for Financial Markets Infrastructures are a product of the Bank of International Settlements (BIS). The BIS is the central bank of central banks. They set up the framework of global financial regulation, and then all the member countries change their laws and regulation so everything lines up.

The better known part of BIS regulation is the Basel Rules. You might have heard of this when it comes to how bank leverage and capital ratios are regulated. The Basel Committee on Banking Supervision is a key part of global financial regulation, but its focus is a bit different from financial market infrastructures.

The BCBS and the Basel Rules have evolved since the early 1990s, in response to the different financial crises and scandals over the past few decades, to become one of the most important parts of financial regulation when it comes to ensuring financial stability.

Financial stability is the idea that, there are a lot of risks in finance, and we can accept some losses here and there, but it’s better for everyone if the ground rules are roughly similar across the world so that in the event of a crisis, central banks and governments can engage in actions that keep depositors funds safe and the cost to taxpayers of bailouts low.

Banking regulations like the Basel rules boil down to a straightforward principle: banks need to keep enough capital and liquid assets on hand to stay safe. While the actual rules are complex, their purpose is to prevent banks from taking excessive risks or lending more than they can safely manage.

If banks break these rules, they face a cascade of consequences. Their supervisors can impose penalties, financial markets may lose confidence in them (affecting their stock price and borrowing costs), and bank leaders could face personal legal repercussions. This creates strong incentives for banks to maintain prudent capital and liquidity levels, even if it means passing up potentially profitable but risky opportunities.

The Principles of Financial Markets Infrastructures are less about the risks from lending too much to the wrong people, but more about making sure that the overall financial system and the different pieces of plumbing that enable value and risk to move throughout it are resilient and risks are managed to protect investors and taxpayers.

Key Takeaways

• Market infrastructures evolved from paper-based systems in coffee houses to today's sophisticated electronic networks, driven by the 1960s Wall Street paperwork crisis that forced major modernization

• Modern trade settlement is highly automated but complex - a simple retail trade involves multiple institutions working together for clearing and settlement, with the DTCC's subsidiaries (NSCC and DTC) playing crucial roles in the US market

• Global standards like the Principles for Financial Market Infrastructures (PFMI) ensure consistency across jurisdictions, helping prevent systemic risks in the financial system

• The regulatory framework is overseen by the Bank for International Settlements (BIS), which coordinates with national regulators and central banks to maintain unified standards for safety and efficiency

• Understanding market infrastructures is essential for grasping the global custody industry, as custodians operate within and connect to these systems in every major market worldwide

• While complex, this infrastructure has evolved to solve real problems in trading, settlement, and risk management across different legal and regulatory regimes

What’s Next

Next Wednesday, we'll dive deeper into market infrastructures and their regulatory frameworks. This foundational knowledge helps explain the value chain of global custody, from trading to final settlement and asset servicing. Once you understand these building blocks, many industry challenges start to make sense.

You'll see why technology upgrades are so complex, and why seemingly strange legal and tax requirements actually exist for good reasons. The global custody industry might appear unnecessarily complicated at first glance, but its complexity stems from decades of solving real-world problems across different markets, legal systems, and regulatory regimes.

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