Investors do not physically hold their investment securities any more. Securities are held and transferred through a complex, sophisticated, and international network of financial intermediaries, including central securities depositories, investment banks, and brokers-dealers. Investors buy and sell their holdings by having book-entries made to their securities accounts; they provide collateral to secured lenders by book-entries or by control agreements. Because transfers and collateral transactions are critical to the liquidity of the financial markets and to financial stability, market participants and regulators have become increasingly concerned with the legal soundness, the internal consistency, and the international compatibility of national laws regulating the holding and transfer of securities held with an intermediary. This article examines how the international harmonization of key rules of commercial law can contribute to the reduction of legal risk and discusses a draft convention prepared by the International Institute for the Unification of Private Law (UNIDROIT). Rather than addressing the numerous features of that draft, the author focuses on its methodology - the "functional approach" - and finds that it is possible to create effective international treaty provisions, which contracting States may implement without disrupting their property law with respect to the structure and characterization of investors' interests in securities. This article tests the robustness of the functional approach by examining two critical issues: the definition of intermediated securities as the building block of international substantive rules and the choice among four internationally recognized methods for the transfer of intermediated securities and for their use as collateral.
Investment securities are intangible rights against issuers. Transferring intangible rights often requires cumbersome formalities and exposes investors to significant uncertainties regarding the validity of their acquisition and the content of the rights so acquired. One of the critical innovations of modern capital markets was the incorporation of investors' intangible rights into certificates, which could be transferred in accordance with the rules governing negotiable instruments. Transforming intangible rights into tangible property allowed investors to prove their ownership through the possession of certificates and to dispose of their investment by delivering them to purchasers or to secured lenders. By treating certificated securities as negotiable instruments, the law protected innocent subsequent investors against unknown defenses of the issuer (holder in due course doctrine) and against adverse claims (bona fide purchaser doctrine),1 even though residual risks -such as the risk of dealing with forged certificates-still required some degree of caveat emptor. The circulation of certificated securities materialized the capital flowing between investors and issuers through increasingly sophisticated intermediaries and markets.
In the mid-20th century however, these flows of physical certificates outgrew the plumbing through which ever increasing stocks of financial assets were issued, re-sold, and pledged. The sheer volume, number of issues, and turnover speed made the delivery of certificated securities impractical and too costly, and also increased the operational risk associated with the physical handling of certificates to unacceptable levels. The pipes were clogged, the highways were jammed, or, as it was later described, the markets faced a "paper crunch."2 Two innovative approaches were used, alternately or cumulatively, to unclog the pipes: immobilization and dematenalization of securities. Certificated securities do not need to move if they are immobilized in the custody of reliable depositories and represented by entries in securities accounts maintained by financial intermediaries for investors. …