Academic journal article Duke Journal of Comparative & International Law

Intermediary Risk in the Indirect Holding System for Securities

Academic journal article Duke Journal of Comparative & International Law

Intermediary Risk in the Indirect Holding System for Securities

Article excerpt


In a wide range of international commercial and financial transactions, intermediaries hold assets in which they, as well as investors, share rights that entitle them to some direct beneficial or equitable interest in these assets. (1) The sharing of rights raises concerns that if an intermediary fails, creditors of the failed intermediary can claim against assets held by the intermediary for the benefit of investors; this is referred to as "intermediary risk." (2)

Intermediary risk is important not only because it affects individual investors but also because it can be systemic. The failure of an intermediary can cause a chain reaction of failures of institutions that have invested in assets held by the intermediary. Indeed, because of the international tiering of intermediaries, such a chain reaction, if it involved an intermediary holding a large enough quantity of assets, could threaten the very stability of the global financial system. (3) Intermediary risk is most prevalent in the indirect holding system for securities. In that context, it affects investors and their secured creditors.


Under the traditional system for direct holding of securities, individual securities were issued to investors who in turn had the right to trade those securities to other investors. An indirect holding system has since evolved, in which intermediary entities--"securities intermediaries" (4)--not only hold the securities on behalf of investors but also frequently own beneficial rights in those securities. (5)

In an indirect holding system, an issuer of securities generally records ownership of its securities as belonging to one or more depository intermediaries. (6) Although physical certificates exist for most securities held through a depository intermediary, these certificates remain in that intermediary's possession and are never delivered to third parties. (7) The depository intermediary records the identities of other intermediaries, such as brokerage firms or banks, that purchase interests in these securities. (8) Those other intermediaries in turn record the identities of investors that purchase interests in the intermediaries' interests. (9)

For example, consider an investor wishing to invest in 500 shares of ABC Corporation's stock. In theory, that investor could purchase 500 individual shares of ABC stock from a brokerage firm. For reasons discussed below, the broker, however, may not directly hold individual shares. Companies often issue securities in very large blocks. For purposes of this example, assume that ABC issued a certificate for 1,000,000 shares of its stock to a depository. If a broker then wishes to purchase 50,000 shares of ABC stock, some perhaps for its own account and some for customers, it would pay the depository the market price for those shares. (10) In return, the broker would effectively receive a 5% undivided, or pro rata, interest in the 1,000,000 share certificate. (11) If the investor then seeks to purchase 500 shares of ABC stock from that broker, the investor would pay the broker the market price for those shares and, in return, effectively would receive a 1% undivided interest in the broker's 5% undivided interest. (12)

The indirect holding system is "widely used in global trading" of securities, (13) and is decisively replacing direct holding because it both reduces the overall costs and complexities of record-keeping and lowers the risk of loss occasioned by physically transferring securities. (14) In addition to facilitating settlement (i.e., delivery), the use of intermediaries assists cross-border investment, (15) as well as the repackaging of securities in securitization, depositary receipt, investment fund, and other structures. (16)

Sometimes the securities intermediaries are transnational organizations. For example, securities settled through Euroclear, the world's largest securities intermediary for internationally-traded securities, (17) are held by local depositories that are members of the Euroclear depository network. …

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