Legislative Principle 9: The Convention requires intermediaries to prevent shortfalls, notably by holding or having available sufficient securities to cover credits to securities accounts that these intermediaries maintain. The law should regulate the method, manner, and time frame for compliance.
The Convention also requires intermediaries to allocate securities to account holders’ rights. The law may establish a specific form of segregation as a method of allocation.
1. Core Convention principles and rules
The core principles and rules are the following:
An intermediary should hold or have available sufficient securities to cover credits made to securities accounts it maintains. Article 24.
An intermediary should allocate securities to account holders’ rights. A common way to do this is segregation.
Article 25.
It is crucial for the integrity of an intermediated securities holding system to prevent shortfalls as much as possible, to provide for correction mechanisms when they occur, and to have rules in place for the distribution of losses due to shortfalls in insolvency. The Convention addresses these issues in Articles 24-26. Lawmakers should ensure that intermediaries hold or have available sufficient securities (Article 24) and that securities are allocated to account holders, notably by way of segregation (Article 25). The Convention rule regarding the distribution of losses in insolvency (Article 26) and alternative solutions are dealt with in paragraphs 264-265 and 268 below.
a. Sufficient securities
Lawmakers should ensure that an intermediary holds or has available sufficient securities to cover credits to securities accounts it maintains or, in technical and more precise terms,
“hold[s] or [has] available securities and intermediated securities of an aggregate number or amount equal to the aggregate number or amount of securities of that description credited to: (a) securities accounts that it maintains for its account holders other than itself; and (b) if applicable, securities accounts that it maintains for itself”. Article 24(1).
b. Allocation
In addition to ensuring that intermediaries hold or have available sufficient securities and intermediated securities (Article 24), lawmakers should also make sure that these
securities are allocated to the rights of the account holders of the intermediary concerned (Article 25). This allocation is an important tool in determining which assets belong to whom. The allocation should take place to account holders other than the intermediary itself. The default policy set out in the Convention is that securities are deemed to be allocated to such account holders up to the aggregate number or amount of their credits, and that these securities are not available to the intermediary’s other creditors in case of its insolvency. States may, however, deviate from this policy by making a declaration.
The Convention does not determine exactly how allocation takes place, which is thus left to domestic lawmakers.
Article 25(3). However, the Convention does mention the commonly applied method of segregation. Article 25(4). Two different types of segregation can be distinguished in the context of holding through upper-tier securities accounts. In the first case of pooled “omnibus accounts”, the securities of a certain description that an intermediary holds for itself are distinguished from those of all its account holders, whose securities of that description are pooled in an omnibus account. In the second case of so-called “individual segregation”, a distinction is made between an intermediary’s own securities and those of particular account holders or groups of account holders individually. It should be noted that these different methods of segregation can also be combined: an intermediary may hold securities of a certain description for (a) itself, (b) one or more account holders individually, and (c) remaining account holders in an omnibus account.
Diagram 213-1: Omnibus account
In diagram 213-1, Intermediary 4 holds 10000 securities X in two accounts with Intermediary 3. An omnibus account contains 5000 securities X held for Account Holders 1, 2, and 3; another account contains 5000 securities X that Intermediary 4 intends to hold for itself. Intermediary 3 only knows Intermediary 4, not the identity of Account Holders 1, 2, and 3.
Diagram 213-2: Individual segregation
In diagram 213-2, Intermediary 4 holds accounts with Intermediary 3 for each of its account holders individually, as well as for securities it holds for itself. Intermediary 3 knows the identity of Intermediary 4 and of its account holders. In order for the individual segregation to be effective throughout the chain, it must also be ensured at upper-tiers (Intermediary 2, etc.).
2. Choices to be made by declaration a. Sufficient securities
The Convention neither requires nor permits declarations in respect of the requirement to hold or have available sufficient securities.
b. Allocation
The default rule of the Convention is that securities that are available under Article 24 are ex Conventione allocated to account holders and are not available to the intermediary’s other creditors in its insolvency. However, a State may decide to protect the intermediary’s other creditors instead of the intermediary’s account holders by giving “proprietary effect” to the segregation by an intermediary of securities that it holds for its own account.
If the non-Convention law of a State so provides and if a declaration is made to this end, only the securities allocated to the intermediary’s account holders will be available to these account holders, whereas all other “own account” securities are available to the intermediary’s other creditors. For more information on the optional declaration under Article 25(5), see the Declarations Memorandum, Section 4.G and accompanying Form No. 7 and Official Commentary, paragraph 25-20 and ex. 25-6.
3. Matters to be addressed or clarified
a. Sufficient securities: Available methods, time frame for action, and allocation of costs and other
consequences
Lawmakers should decide on the different methods that are made available for complying with the requirement to hold or have available sufficient securities. Different methods are listed in Article 24(2) and include registration in the issuer’s register (either in the name or for the account of account holders or in the intermediary’s own name), possession of certificates or other documents of title, holding intermediated securities with another intermediary, or any other appropriate method. The suitability of these methods depends on the set-up of a given intermediated system.
Lawmakers should also consider the time frame within which corrective action should be undertaken in case the requirement to hold or have available sufficient securities is not complied with at any given moment. Article 24(3). Such corrective action – to make up the difference – could include an intermediary purchasing securities or intermediated securities from the market or from one or more of its account holders, or using a securities lending arrangement to borrow securities or intermediated securities from the market or from its account holders. Again, the policy decision on the time frame to be provided depends on the set-up of a given system. Some systems envisage an inseparable link between credits and debits (the so-called “no credit without debit” rule) and any mismatch within
the system is therefore conceptually impossible. Other systems envisage some leeway as long as there is a form of financial backup to protect account holders.
Another matter that is left to domestic lawmakers is the allocation of cost and any other consequences of non-compliance with the requirement to hold or have available sufficient securities. Article 24(4).
b. Allocation and segregation
Lawmakers should decide on the available methods of allocation, including by way of segregation. See paragraphs 212-213 above.