W O R K I N G PA P E R S E R I E S
N O. 3 8 7 / A U G U S T 2 0 0 4
HORIZONTAL
AND VERTICAL
INTEGRATION
IN SECURITIES
TRADING AND
SETTLEMENT
by Jens Tapking
and Jing Yang

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W O R K I N G PA P E R S E R I E S
N O. 3 8 7 / A U G U S T 2 0 0 4
HORIZONTAL
AND VERTICAL
INTEGRATION
IN SECURITIES
TRADING AND
SETTLEMENT 1
by Jens Tapking 2
and Jing Yang 3
In 2004 all
publications
This paper can be downloaded without charge from
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1 The views expressed in this paper are the views of the authors and do not necessarily reflect the views of the European Central
Bank or the Bank of England.We thank Charles Goodhart, Andy Haldane, Harry Huizinga, John Jackson, Kevin James, Charles
Kahn, Elias Kazarian,Will Kerry, Stephen Millard, Alistair Milne, Daniela Russo,Victoria Saporta, Hyun Song Shin, Elizabeth
Wrigley, participants at the Bank of Englandís Financial Stability Seminar, members of the Securities Working Group of the
Eurosystem and two anonymous referees for helpful comments and discussions.
2 European Central Bank, jens.tapking@ecb.int.
3 Bank of England, Jing.Yang@bankofengland.co.uk.

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Working Paper Series is available from the
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ISSN 1561-0810 (print)
ISSN 1725-2806 (online)

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C O N T E N T S
Abstract
4
Non-technical summary
5
1
Introduction
7
2
The model
12
3
Stock market equilibrium
15
4
Transaction price equilibrium
17
4.1 Payoff functions
17
4.2 Complete separation
18
4.3 Vertical integration
20
4.4 Horizontal integration of CSDs
21
5. Welfare analysis
23
5.1 Net social benefit function and welfare
maximum
23
5.2 Comparison of social benefit for different
industry structures
24
6
Concluding remarks
26
7
Appendix A
27
8
Appendix B
31
References
40
European Central Bank working paper series
42
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Working Paper Series No. 387
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Abstract
This paper addresses a very European issue, the consolida-
tion of securities trading and settlement infrastructures. In a
two-country model, we analyze welfare implications of different
types of consolidation. We Þnd that horizontal integration of set-
tlement systems is better than vertical integration of exchanges
and settlement systems, but vertical integration is still better
than no consolidation. These Þndings have clear policy implica-
tions with regards to the highly fragmented European securities
infrastructure.
Keywords: Securities trading and settlement, vertical and
horizontal integration, substitutes and complements.
JEL ClassiÞcations: G21, G15, L13.
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Working Paper Series No. 387
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Non-technical summary
Securities trading and securities settlement are essential parts of any
securities transaction. Trading is the process that results in an agree-
ment between a seller and a buyer to exchange securities for funds.
Settlement refers to the actual transfer of securities from the seller to
the buyer and the transfer of the funds from the buyer to the seller.
Trading is often carried out on securities exchanges while settlement of
on-exchange trades takes place in entities called central securities depos-
itories (CSDs).
In the European Union, the securities trading and settlement in-
frastructure is highly fragmented. There are over 20 national exchanges
and about as many central securities depositories (CSDs) in the EU.
Market participants, central banks and regulators agree that consolida-
tion is desirable. However, there is little agreement on what kind of
consolidation would be optimal. Some people prefer vertical integra-
tion, i.e. mergers of exchanges with CSDs. Others favour horizontal
integration of different exchanges or different CSDs.
In this paper, we try to shed light on the pros and cons of the dif-
ferent types of consolidation in a theoretical two-country model. There
is an exchange and a CSD in each country. Investors can buy and sell
securities on both exchanges. All trades executed on a given exchange
are settled in the CSD of the same country. This reßects the current
practice in all major markets. Hence, before a security held in the CSD
of country 1 can be offered on the exchange of country 2, it has to be
transferred to the CSD in country 2. This transfer is carried out through
a so-called link, technologically a communication line between the two
CSDs. A link transfer requires the services of both CSDs. One CSD
has to release the securities and the other CSD has to take them under
custody.
We start from a general observation that has been well established in
industrial economics. From an economic welfare perspective, two goods
that are substitutes should be supplied by different decision makers while
two complements should be supplied by a single decision maker. On the
basis of this observation, we argue as follows. The link services of the
two CSDs are complements since each securities transfer from one to
the other CSD requires both services. Furthermore, the link service of
one CSD and the settlement service of the other CSD are complements
since transferring securities from one to the other country makes sense
only if these securities are afterwards traded and thus settled in the
other country. The two CSDs should therefore be operated by the same
decision maker (horizontal integration of CSDs).
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However, this argumentation is valid only if the operating costs of
the link are low enough to allow the cross-border transfer of securities
at reasonable costs. If the link is too expensive, a horizontal integration
of the CSDs is desirable only if it reduces these link operating costs
signiÞcantly. If it does not reduce these costs, a vertical integration of
the exchange and the CSD in each country is preferable. This is because
trading and settlement in a given country are also complements.
Furthermore, if there is no demand for foreign securities, there is also
no demand for link transfers regardless of whether the link operating
costs are high or low. In this case, the link has no signiÞcance and
the above argument in favour of horizontal integration of the CSDs is
again not valid. Instead we again Þnd that a vertical integration of
the exchange and the CSD in each country is preferable as trading and
settlement in a given country are complements.
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1
Introduction
The European securities trading and settlement infrastructure is highly
fragmented. There are over 20 national exchanges and about as many
central securities depositories (CSDs) in the EU. Market participants,
central banks and regulators agree that consolidation is desirable. How-
ever, there is little agreement on what kind of consolidation would be op-
timal. Some people prefer vertical integration, i.e. mergers of exchanges
with CSDs (and clearing houses). Others favour horizontal integration
of different exchanges or different CSDs. In this paper, we try to shed
some light on the pros and cons of the different types of consolidation in
a theoretical model.
In practice, all kinds of integration have been taking place in recent
years. In Italy and in a similar way in Germany, the exchange and the
CSD have been merged to form a so-called vertical silo. The merger of
the exchanges of France, the Netherlands, Belgium and Portugal have
created Euronext. The CSDs of France, the Netherlands, the UK and
Belgium have been merged into Euroclear Group.
Securities exchanges and CSDs play essential roles in all major secu-
rities markets. Exchanges help to match buyers and sellers of securities.
CSDs are central store houses for securities. In most countries, there
is only one CSD and almost all securities issued under the country’s
legislation are stored there for their entire life - as physical papers or
increasingly often electronically. Furthermore, CSDs maintain records
establishing ownership of securities. Major Þnancial institutions have
securities accounts with the CSD and the account balances indicate the
securities owned by the respective Þnancial institution (or its direct or in-
direct clients). Finally, CSDs act as major settlement service providers:
they organize the transfer of securities from a seller to a buyer. If one
Þnancial institution sells securities to another, the transaction is settled
by book entries in the book of the CSD: The seller’s securities account
with the CSD is debited and the buyer’s securities account is credited.
Exchanges and CSDs cooperate closely. Most exchanges use for rea-
sons of costs or for legal reasons only one CSD to settle all trades ex-
ecuted on the exchange. All members of the exchange have to have
(directly or via an intermediary) securities accounts with that CSD.
Whenever two exchange members - a seller and a buyer - are matched
on the exchange, the CSD receives automatically from the exchange the
instructions to debit the seller’s and to credit the buyer’s securities ac-
count. This process is called straight through processing (STP).
Special problems arise in case of cross-listed securities if the two
exchanges on which the securities are listed use different CSDs for set-
tlement. Assume that an exchange A uses only CSD A and another
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exchange B uses only CSD B. An investor may wish to sell on exchange
B securities held on his account with CSD A. Before he can do that,
the securities have to be transferred from CSD A to CSD B. For this
purpose, CSDs maintain so-called (direct or indirect) links. Only after
the securities have been credited to an account with CSD B, they can
be sold on exchange B.
In this paper, we analyze the interactions between exchanges and
CSDs in a two-country model. There is an exchange and a CSD in both
countries. There are two types of securities, country A securities and
country B securities. There are two types of investors, country A and
country B investors. Initially, all country A securities are held by country
A investors on accounts with CSD A and all country B securities are held
by country B investors with CSD B. Initially, all investors are members
of their home exchange and CSD, but not of the foreign exchange and
CSD. All securities are listed on both exchanges. All trades executed
on exchange A must be settled in CSD A and all trades executed on
exchange B must be settled in CSD B. The two CSDs maintain a link
so that securities can be transferred from one CSD to the other. Country
A investors want to buy B securities and country B investors want to
buy A securities, i.e. due to investors’ preferences, only trades between
investors from different countries are possible.1
There are two ways to initiate transactions for example between a
country A investor who wants to sell security A and a country B in-
vestor who wants to buy security A. Firstly, the A investor offers the
securities on exchange A and the B investor orders them on exchange
A. Settlement takes place in CSD A and the link is not used. This is
relatively costly for the B investor who needs to become a (directly or
indirectly through an intermediary) member of exchange A and CSD A.
Secondly, the A investor transfers the securities through the link from
CSD A to CSD B and then offers them on exchange B while the B
investor orders them on exchange B. This is costly for the A investor
who needs to transfer his securities through the link and must become
a (direct or indirect) member of exchange B and CSD B.
Link transfers must be carried out jointly by the two CSDs. A crucial
exogenous parameter of the model is the operating costs of the CSDs for
providing the link service. Each CSD sets a price the investor has to
pay for this service. Furthermore, each exchange sets a price for the
execution of trades and each CSD sets a price for the settlement of
1 This is a strong assumption. However, in section 6, we note the effects of includ-
ing investors’ demand for home securities.
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on-exchange trades. All four service providers are operated by proÞt
maximizing Þrms.2
We analyze four different industry structures: (1) Under complete
separation (CS), all four service providers are operated by different in-
dependent Þrms and set their prices independently. (2) Under vertical
integration (VI), the exchange and the CSD in both countries are op-
erated by the same Þrm and thus coordinate their price setting. (3)
Under horizontal integration of the CSDs, both CSDs are operated by
the same Þrm. The exchanges are operated independently. We distin-
guish two stages of horizontal integration: (a) Purely legal integrations
(LHI): Though the CSDs are operated by the same Þrm, they are tech-
nologically still different systems. The transfer of securities through the
link entails the same operating costs for the CSDs as under CS and VI.
But the CSDs set their prices for the link transfer as well as for the
settlement of on-exchange trades in a coordinated way. (b) Technical in-
tegration (THI): Both CSDs are technologically merged into one system
so that a transfer of securities from one to another CSD does not entail
any operating costs so that the operating costs of the link are zero.
Horizontal integration of CSDs may indeed always lead eventually
to THI. However, analyzing LHI is still not redundant since it helps
to distinguish two effects of the transition from CS to THI. This is a
pure competition effect illustrated by the transition from CS to LHI.
And a cost reduction effect illustrated by the transition from LHI to
THI. Any kind of merger may have these two effects. This positive cost
reduction effect may however be outweighed by a negative competition
effect. Analyzing LHI as an intermediate step in the transition from CS
to THI helps to distinguish these two effects of horizontal integration of
CSDs.
A welfare comparison of the four industry structures is the center of
our attention. The results of this comparison are strikingly simple: VI
and LHI entail a (weakly) higher welfare then CS. That is, the compe-
tition effects of the transition from CS to LHI and from CS to VI are
positive. If the link operating costs under CS, VI and LHI exceed a
certain threshold, then VI entails a higher welfare then LHI so that the
competition effect is greater in the transition to VI than in the transi-
tion to LHI. If the operating costs of the link under CS, VI and LHI are
small than this threshold, then LHI entails a higher welfare then VI, i.e.
the competition effect is greater in a transition to LHI. However, THI
always entails the highest economic welfare of all four structures. In
other words, even if the competition effect of a transition from CS to VI
2 Some CSDs and exchanges are user owned. In these cases, one may argue that
the assumption of proÞt maximization is not realistic. However, many CSDs and
exchanges are organised as proÞt maximising entities.
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Document Outline

• Horizontal and vertical integration and securities trading and settlement
• Contents
• Abstract
• Non-technical summary
• 1 Introduction
• 2 The model
• 3 Stock market equilibrium
• 4 Transaction price equilibrium
  • 4.1 Payoff functions
  • 4.2 Complete separation
  • 4.3 Vertical integration
  • 4.4 Horizontal integration of CSDs
• 5 Welfare analysis
  • 5.1 Net social benefit function and welfare maximum
  • 5.2 Comparison of social benefits for different industry structures
• 6 Concluding remarks
• 7 Appendix A
• 8 Appendix B
• References
• European Central Bank working paper series

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