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gy increases the familiarity of foreign corporations and their operations. This spread of information reduces one of the traditional obstaclesto foreign investment and opens up both savingsand investment opportunities for firms and individuals. The payoff is a more efficient allocation of capital and, thus, a stimulus to productionand real output.Likewise, the advent of almost immediatetransfer of information around the globe reducesthe informational discrepancies between marketparticipants. Arbitrageurs, of course, attempt toprofit from price discrepancies. The more peoplehave access to the same information, however,the more likely price discrepancies will be spotted and acted upon. The divergence of pricesfrom their no-arbitrage relationship (which provides profit potentials), will be quickly arbitragedaway as both the quantity and speed of information transfer is enhanced! Another benefit of internationalization is access to markets otherwise inaccessible. As mentioned earlier, the Chicago Mercantile Exchangewill be accessible after regular trading hoursthrough Globex. Not only will U.S. traders nowbe able to operate after U.S. trading hours, butforeign traders can also use Globex to operateduring their own regular trading hours. Newmarkets enable investors to introduce diversityinto their portfolios in both the type of instrument and the country from which it is issued.Just as computerized systems, such as Globex,facilitate diversification and accessibility, so toocan other methods, such as cross-exchange listings and cross-memberships.Trading in financial assets, whether donedomestically or across national boundaries, involves risk. Some of these risks are more important in an international setting than a strictlydomestic setting. They occur primarily at various stages of the clearing and settlementprocess. Unlike risks commonly associated withprice uncertainty, the risks in clearing and settlement procedures involve uncertainty aboutthe timely payment of funds and the transfer ofassets in financial trades.t0An example of a no-arbitrage condition is that the difference between the cash and futures price of a storablecommodity, at any point in time, should reflect carryingcosts of storing the commodity until maturity. If the pricedifferential exceeds carrying costs, then there exists an in-An example of a typical securities transactioncan provide a clear illustration. Once a securitiestrade is executed, the member firms involvedsubmit the trade information for confirmationto the clearing agent. The trade is then compared and matched by computer for accuracyand the information on the trade is sent to therelevant members on either the day of thetrade or the day after. If both parties concurwith the conditions of the trade, the trade isready for settlement. At present, settlement insecurities occurs five days after the trade in theUnited States.Using this example, the next section will brieflydiscuss the concepts and institutions in clearingand settlement procedures before introducingthe specific risks of globalization. ,J ‘ ,C )C , .C“Clearing” a trade involves the confirmation ofthe type and quantity of the financial instrument being traded, the transaction date andprice, and the identification of the buyer andseller. “Settlement” means the fulfillment of theobligations of the transaction. In equities andbonds, for example, settlement means paymentto the seller and delivery of the security certificate or transfer of ownership to the buyer.The clearing and settlement process dependson the institutions that facilitate transactions.Commodities and securities exchanges providethe facilities for traders to conduct their business, establish and enforce trading rules, collectand distribute market and economic informationabout prices, and provide an institutional framework for arbitrating and settling disputes.Another institution—the clearinghouse—compares trades between parties and can remove risk from the settlement process.2’ Aclearinghouse places itself between the buyerand seller, ensuring that the buyer receives theinstrument purchased and the seller receivespayment. That is, by becoming the counterpartyto all trades, the clearinghouse guarantees everytrade. Each participant has a net obligation withthe clearinghouse to buy or sell the securitycentive to enter the market, that is, to buy today and sellat the higher futures price.21Trade comparison involves confirming and matching theterms of the trade to ensure accuracy.

Table 1Automated Trading SystemstSystem R9nsorPurposeInstrumentsAccessNew York MercantiteExchange (NYMEX)Computerized screen traoingsystem to automatically matchtrade on a first-in-first-outbasis. Allows traders loselect a standtng bid or offer(but are blind to thecounterparty chosen).Energy futures and futuresoptions for crude oil. heat-ngoil, gasoline, propane aridnatural gasAutomated Pu TradingCAPT)London InternationalFinancial FuturesExcnange (LIFFE)Intenoed to extend tradunghours to cover Europeantrading day Its aim is tocopy the life o’ the tradingfloor on to a computer screenFT-SE 100 index futures andmost of LIFFE’s maincontractsEJV (Electronic JointVenture)Gollaooration betweenF:rst Boston. GoldmanSachs. Morgan Stanley.Salomon Brotners.Shearson Lehman andCitbankTrading system that allowsdealers to buy and sellsecurIties electronicallyusing voice-activated computertecnnology. Also providesprice and analytic servicesCurrently restricted toTreasury bills and notes withmaturity of less than threeyears Once established, itexpects to extend cove’ageto all maturit.esEuroquoteEuropean Community (E national stock exonangesA European-wsde share tradingsystem Wit combine prco information from 12 EC exchangesinto an electronic feed f r sub0scribers Eventually. may oecome a full trading system andintegrate Euroquote wth a settlement system to decrease thecost and difficulties of settlingcross-country transactions. (Thisproposal has since been abandoned by the chairmen of Europes national stockEC stocksexchanges)GlobexChicago MercantileExchange (CME). Reutersand Chicago Board ofTrade CBOT)An automated t’ading systemw:tt, anonymous buy and sellorders that are matched Dyprice and t-me (See textfor detailsiTraded instruments will be:ntroduced in three separatewaves 1) financial futuresand options e.g - Eurodoltarfutures, futures and optionson Eurodollar currenciesDeutschemark. yen poundsterling. Canadian and A’ust’alan dollars Swiss francLIBOR. and US Treasurybond aid note futures aidoptions. 2) equity-relatedprooucts: ano 3) aq’iculturerelated futures.

23Table 1 (continued)Automated Trading SystemstSystem.J! L.Purpose— jnst p ftts—Quotron System IncCurrent testing of theprototype nvolves TneBank ot America. BarclaysBarnc. Chase ManhattanBank. Cnemical Bank.Citibank. red’t Suisse.Lloyds Banic. Midland Bank.Morgan Guaranty NationalWestminster. Swiss Bankcorp. and Union Bank ofSwrtzertand.Joint protect to develop acomputer system tiatautomatically matches anoexecutes ioreign exchar-getraoes.Trades n foreign excnangeSwss Options andE nancialFuturesExchange SOFFEX Owned by Switzerlandsthree leading stockexcnanges and tvelargest banksFully automated trading andclearung system. wherequotes and orcers arerecorded sorted andmatcned automaticallyThe computer screen is composed of five segments. eachw.th oifterent types ot unformaton and automatically updateothroughout the oay.Futures and options on the 13undertytng stocks and theSwiss Market Index tSMll abasket of Swtzerlands 24leading stockstOf these systems. only LiFFE’s APT system ano SOFFEX are currently .n operationNOTE For a more extensive survey ot automated systems. see Peter A. Abken Glooatizat.on of Stock Futures. andOptions Markets. Federal Reserve Bank of Atlanta Economic Review July/August1 91lbased on her net position with other participantsin the clearinghouse.A third institution—the depository—is an organization (not necessarily part of an exchange)that holds stocks and bonds for safekeeping onbehalf of their owners. It has a computerizedaccounting system to record and transfer ownership of securities between participants by integrating a book-entry system with a moneytransfer system.22The procedures for clearing and settlementvary across countries. At present, there arethree common methods of clearing and settlement. Each involves various combinations of thethree central institutions involved in futures andsecurities markets.book-entry system means a credit or debit to a customer’s account will transfer securities between buyer andseller. A money transfer system transfers the funds between the parties to the trade, such as a wire transfer22AThe first model is exemplified by the UnitedKingdom’s equities market. In this model, thereis neither a central depository nor a separateclearinghouse. Instead, the stock exchange itselfis responsible for trade matching and confirmation as well as providing a location for the delivery and receipt of securities and payments between traders. The second model, exemplified by Germany’sDeutscher Kassenverein depository system, hasno independent clearinghouse, but does have acentralized depository and a stock exchange thatprovides the matching and confirmation oftransactions. Once matched and confirmed, thetrade information is sent to the depository forsettlement. 23U.S. Congress, Office of Technology Assessment (1990),p. 5B.24lbidCA CCC CA AVC CC,QC’,AflViAAC

The third model, as seen in the U.S. equitiesmarket, contains all three institutions: a stockmarket, a central depository and an independent clearinghouse. For example, the NationalSecurities Clearing Corporation (NSCC), whichprocesses 95 percent of all equities trades in theUnited States, is jointly owned by the New YorkStock Exchange, the American Stock Exchange,and NASD.25 The majority of the securities forNSCC members, in turn, are held by the Depository Trust Company. The stock market and clearinghouse together match and confirm transactions. The clearinghouse also places itself between counterparties to trades, then passestrade information to the depository.28 I Iisk,s’ in (.Je.a ring a in.! SettiernentCredit (or counterparty) risk occurs when oneside of the transaction does not settle in full,either when due or on a later date. The existence of counterparty risk, which is of minimalsignificance in many U.S. markets because of aclearinghouse, can be critical in an internationaltransaction. The clearinghouse, generally wellcapitalized, guarantees that all trades will be honnored. In many international transactions, however, no clearinghouse exists. Thus, a traderlacks information about the counterparty’s reliability. Varying regulations on foreign tradingmay make it even more difficult to ascertain thesafeguards available to a trader in that market.Closely related to credit risk is liquidity risk,which is the risk that trades will not be settledat the appointed time, but at some undeterminedtime thereafter.27 At settlement, counterpartiesare exposed to both credit and liquidity risks.Liquidity risk occurs because settlement maynot occur on the specified date; credit risk occursbecause the other party may not deliver at all.Thus, at settlement, the parties may not knowwhether the problem will be one of liquidity orcredit. The settlement of international trades25U.S. Congress, Office of Technology Assessment (1990),p. 81.tmmFor related readings on clearance and settlement systems,see the monographs prepared by the Payment SystemStudies Staff of the Federal Reserve Bank of New York inthe references to this paper.27A temporary inability to convert assets into cash is oftenassociated with liquidity risk while bankruptcy of a counterparty is associated with credit risk. For a more detaileddescription, see Federal Reserve Bank of New York(February 1989).2mFor further reading on market risks, see Baer and Evanoff(1990).can exacerbate the problem of simultaneouslyexchanging securities for payment because oftime zone differences.28Another risk, replacement cost risk, occurswhen the price of the security changes betweentrade and settlement. When one party has defaulted and the price of the instrument changes,then one of the parties involved would be adversely affected by the price change and suffer’a loss in replacing the transaction. In foreignmarkets, the potential for adverse changes inthe exchange rate can exacerbate this risk.Operational risk occurs because of the possiblefailure of computer systems, telecommunicationsor institutionalized procedures during trading.Given the heavy reliance on technology in accessing financial markets abroad, this issue is extremely important in determining the success orfailure of new trading systems. The precautionstaken by the CME for its Globex system—an important part of its initial proposal to the Commodity Futures Trading Commission, a government regulator of futures exchanges—are a goodexample of this.29Yet another risk, especially worrisome to regulators, is systemic risk. Systemic risk occurswhen credit risks stemming from operational orfinancial problems result in agents exiting themarket, which, in turn, threatens the industry.The inability of one financial institution to makeits payments can cause other participants to beunable to meet their financial obligations in atimely manner. In the banking sector, this istypified as a run from deposits to currency. Infutures and options, it occurs when agents nolonger trade through standard channels like anexchange. For example, if members of an exchange begin trading elsewhere, the financialstability of the exchange is threatened as members withdraw their financial collateral.’ 29Examples of CME precautions include measures to prevent unauthorized individuals from accessing the system,such as four different identification codes; termination of acomputer operator’s session if nonstandard instructionsare entered; and, in the failure of the central computer,recovery would involve automatic switchover to a back-upmainframe, taking approximately 60-90 seconds. SeeCFTC (1989), pp. 125-32.3mFor further reading on systemic risks, see OECD (1991).

i i1C:C.,C Cit)t IiftCliI S: iiC:c. it itSThe October 1987 stock market crash, withworldwide repercussions, revealed weaknessesin the clearing and settlement system. Manyfeared that the default of a major market playercould threaten the financial systems of manycountries. This prompted world financial leaders to work toward global coordination. Theclearing and settlement of trades was considered one of the most crucial aspects of thiscoordination.In 1989, the Group of Thirty issued a report,Clearing and Settlement Systems in the World’sSecurities Markets.31 Based on its examination,five critical deficiencies in the clearing and settlement systems across countries were identified:[1] Absence of compatible trade confirmationand matching systems for both domestic andinternational trades;[2] Varying settlement periods across the different markets;[31 Absence of delivery versus payment in somemarkets;[4] Absence of standardized trade guarantees;[5] Absence of book entry processing for settlement of securities transactions in severalmarkets. t.:nnjnwnannr nnd .litriliij.gTrade confirmation and matching, also knownas trade comparison, is the process of confirming and matching the terms of a trade to ensureaccuracy (for example, the issue, price, quantityand counterparties) and is usually done by aclearinghouse (although sometimes by an exchange or by the parties themselves, in the forward foreign exchange market). If not confirmedand matched, a chain reaction of failed trades ispossible as subsequent trades are made on theassumption that earlier trades will be successfully completed.Rapid trade comparison shortens the amountof time between when the trade is made andwhen it is successfully matched. This reducescredit risk by reducing the amount of time an31The Group of Thirty is a private sector organization thattakes its membership from financial sectors such as exchanges, banks and investment houses.32Setttement risk encompasses both liquidity risk and creditagent has to opt for defaulting on a trade. Inthe international context, delays of hours in adomestic market may result in a delay of daysfor international trades. Requiring all investorsto obtain membership in a trade comparisonsystem and achieving a compatible system acrossinternational markets can reduce the delays andcredit risks involved in diverse systems.The second deficiency is unequal settlementperiods, which can increase settlement risk andpotential default. Settlement t1sk occurs whenthere are gaps in the timing of payments andreceipts on settlement date.32 The harm of different settlement periods is that, as mentionedearlier, traders or investors who are active participants in the market make later trades contingent on the assumption of the successful settlement of earlier trades. Hence, the harm is twofold—the default of an earlier counterparty andthe dependence on this trade that couldjeopardize subsequent trades. As with manytrade issues that require timeliness, delays insettlement can be exacerbated if spread acrossdifferent trading hours and time zones.While this is costly in a domestic market, theinvestment of a U.S. agent dealing in international markets can be even more costly becauseit is also subject to the economic conditions offoreign countries and exchange rates. Adversechanges in the exchange rate can turn a minorloss into a significant one in the presence ofcurrency risk. i’hus, for agents moving betweeninternational markets, an uncertain settlementperiod combined with an uncertain exchangerate can increase financial losses.The gro

of foreign securities, trading approximately 6 billion in foreign securities as of 1991, up from the 2.6 billion in 1985.' Thus, Nasdaq provides the cross-listingof securities, together with the rapid trade execution of an automated system. The growth of international trading has also affected futures and options exchanges in the United States.