Cross-Border Transactions in Intermediated Securities: Switzerland Maintains its Lead (Part 1/2)

On 1 April 2017, the Hague Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary entered into force. The entry into force of the Convention coincides with renewed efforts by the European Commission at modernising the conflicts rules for the third-party effects of transactions in book-entry securities and financial claims in the overall context of the Capital Markets Union action plan.

By Thomas Werlen / Matthias Wühler (Reference: CapLaw-2017-43)


“The business is so constant and incessant that hardly a definite place can be named where it goes on.”

Joseph de la Vega, Confusion de confusiones [1688]: Portions descriptive of the Amsterdam Stock Exchange (Baker Library, 1957), as quoted in Corzo et al., 15 The Journal of Behavorial Finance 341, 343 (2014)


On 1 April 2017, the Hague Convention on the Law Applicable to Certain Rights in Respect of Securities held with an Intermediary (Hague Securities Convention, the Convention) entered into force. The entry into force of the Convention coincides with renewed efforts by the European Commission (COM(2015) 468 final, p. 23 et seq.) at modernising the conflicts rules for the third-party effects of transactions in book-entry securities and financial claims in the overall context of the Capital Markets Union action plan (on the CMU, see Sester, CapLaw-2015-56).

Nearly eight years have passed since the promulgation of the Swiss Federal Act on Intermediated Securities (FISA). This year’s entry into force of the Hague Convention again puts a spotlight on the Swiss legislation in the domain of intermediated / book-entry securities. Without a doubt, this will serve to strengthen Switzerland’s reputation as a global benchmark for high-quality legislation. We wish to take this opportunity to place the Swiss legal framework for intermediated securities in the broader international context.

In this, the first of our two-part contribution, we have taken a high-level view. We set out, after a brief introduction (1.), the basic structure of the prevailing intransparent securities holding systems (2.). We then provide an overview of the various ways in which the American legal system reflects these market realities (3.).

In the second part of our contribution, we will briefly review FISA, the Swiss equivalent to Article 8 of the Uniform Commercial Code, before focusing on conflicts issues in the cross-border trade in intermediated securities. In particular, we will discuss the Hague Securities Convention and the ongoing attempts by the EU to arrive at, if not harmonised substantive laws, a coherent private international law framework for intermediated securities.

1) Introduction

The days of individual investors holding physical security certificates are long gone, but one still encounters vestiges of the past in the terminology of financial markets. Market participants may speak of physical delivery or physical settlement of transactions referencing book-entry securities. Investors may be overheard discussing the coupon or coupon rate of a fixed-income security, even though bonds no longer materialise as certificated bearer securities with coupons.

Much as the chirographs on early bearer securities, the doctrine and language of a particular jurisdiction may hark back to ancient practices. In the case of intermediated securities, some jurisdictions continue to conceive of the interest an investor holds in an intermediated security in the traditional categories of property law or the law of obligations. Other jurisdictions have introduced new, openly hybrid, legal institutions specifically for the trade in intermediated securities (for an overview of the Swiss legislation, we refer to Reutter, CapLaw-2010-2; Sulzer, CapLaw-2010-1 and Costantini, CapLaw-2009-55).

Nowadays, where an investor acquires a unit of a share or part of a bond issuance, that investor enters a (frequently international) web of legal relationships mainly characterised by contract. Various jurisdictions differ in the extent to which they reflect this contractual foundation of modern securities intermediation. The different doctrinal perspectives may in part explain the difficulty in arriving at uniform international solutions.

As words have taken on new meanings and novel infrastructures have opened up new linguistic dimensions (Trans-European Automated Real-time Gross Settlement Express Transfer System), the fast-paced securities markets have brought about new legal concepts and continue to test the flexibility of traditional rules. This makes the cross-border trade in intermediated securities and their cross-border custody a fascinating area of law.

2) Modern Systems of Securities Intermediation

The current, indirect and intransparent systems of securities intermediation prevailing in the United States, Switzerland and most of the EU (we do not address transparent systems) are based on contractual relationships. The terms and conditions of these contracts are of enormous importance to the position of investors seeking exposure to financial assets traded as intermediated securities, in particular in a cross-border context.

a) Book Entries in Securities Accounts as the Basis of Modern Systems

In these indirect systems, asking whether or not an investor owns securities may be misleading. The investor is first and foremost an accountholder at a custodian that acts as that investor’s contractual counterparty. This is crucial. The custodian is not merely incidental to the investor’s securities holdings, somehow facilitating them and serving as a repository for ancillary services. The custodian is the investor’s only direct point of contact with the system, the gatekeeper to the securities infrastructure. For most investors, it is impossible to hold securities in the absence of a custody agreement. The agreements between the investors and their custodians constitute the bottom of the securities holding pyramid. From the perspective of the investor, the account with the custodian is the decisive element.

This is not a new insight. On 2 March 1976, the Swiss Federal Supreme Court explained, in the context of an enforcement proceeding between two Julius Bär clients (BGE 102 III 94 pp. 105 et seq., authors’ translation):

The client generally does not know which correspondent bank holds the securities in custody. In the present case, it appears not even the petitioner would know the country of custody for all the securities. The custodian bank in turn does not know the name of the client, it only knows the name of the Swiss bank for which it holds a number of securities. We must also take into account that in certain countries, certain kinds of securities are increasingly on deposit with central securities depositories. Only banks and brokers may transact with these central depositories. We deem it extremely unlikely that the foreign laws governing these relationships would allow for direct attachment at the level of the central securities depository. (…) The prevailing view is that a portfolio of shares is located with the bank providing the securities account, wherever the physical securities certificates may be located. Generally speaking, the client can only access his securities via the custodian bank. (…) A client who owns securities on deposit at a Swiss bank will deem his patrimony to be located in Switzerland. He does not normally know where these securities are actually located. As long as the client can freely instruct the bank providing the securities account to dispose of the securities, he may be indifferent to this question.

b) Immobilisation of Securities at Central Securities Depositories

At the top of the securities holding pyramid is the central securities depository (CSD). Each jurisdiction has at least one CSD. The CSD provides collective custody of securities, custody of a global securities certificate (a physical certificate representing an entire issuance) or a non-certificated security (i.e. a book-entry security that is fully dematerialised). By keeping the securities in custody at the CSD, securities are immobilised. This enables their transfer by way of book entry.

c) Sub-custodians

If all investors held an account at the CSD, transactions between them could be settled by crediting and debiting their accounts at the CSD. In reality, the system is much more intermediated. The CSD enters into contracts with qualifying members and thereby establishes the first layer of intermediation: the CSD holds the securities for the benefit of the qualifying members which are the first-layer custodians. Each qualifying member has an account at the CSD and the CSD credits each such account. The CSD can transfer securities between these accounts. This is only necessary where transactions between investors at the bottom of the pyramid (and the transactions between the intermediaries) do not net out at the intermediate layers of the system. The ability to net out transfer instructions at lower levels of the system provides rationalisation and is seen as a key benefit of this system.

Each first-layer custodian is bound by its own custody agreements with custodians further down the chain of intermediation, obliging the first-layer custodian to hold the position it is credited for the benefit of the custodian at the next layer. This process may repeat itself through a number of layers, with each sub-custodian holding the legal position (variable, depending on the applicable law) it enjoys vis-à-vis the higher-ranking custodian for the lower-ranking layer. The structure branches out ever further until the investor is reached. A chain of custody relationships thus connects the investor at the bottom of the “pyramid” to the CSD at the top.

In this web of contractual relationships, one frequently encounters the notion of account segregation. Here, the basic distinction is between account segregation (or not) at the CSD level on the one hand, and on the level of the (sub-)custodians on the other. There is a considerable overlay of regulation dealing with account segregation. Many of those rules came into effect as a result of the experience of the recent financial crisis (for a detailed exposition, we refer to Costantini, CapLaw-2012-40).

d) Cross-Border Securities Custody

The structure is more complicated when it comes to the cross-border settlement of securities transactions or the custody of securities across jurisdictions.

Clearstream Banking S.A. in Luxembourg (Clearstream) and Euroclear Bank in Belgium (Euroclear) are the two prominent cross-border service providers. They are referred to as international central securities depositaries (ICSDs). Clearstream and Euroclear do not hold securities directly in the same manner as CSDs. From the perspective of market participants, however, they perform a similar function. ICSDs enable the settlement of cross-border securities transactions by way of book-entry in their own accounts. ICSDs are therefore a specific type of sub-custodian facilitating the cross-border settlement of securities transactions by internalising these transactions (for an illustration involving US securities held for the benefit of the Central Bank of Iran, see the Factual Statement in the settlement agreement between the US Treasury Department’s Office of Foreign Assets Control and Clearstream Banking S.A. of 22 January 2014). ICSDs can internalise large numbers of cross-border transactions in view of the large number of participants connected to them.

A CSD does not stand in isolation. There are numerous so-called CSD links. These CSD links also facilitate the settlement of transactions and the custody of securities in a cross-border context. Article 2 (29) Regulation (EU) No 909/2014 (CSDR) defines a CSD link as:

an arrangement between CSDs whereby one CSD becomes a participant in the securities settlement system of another CSD in order to facilitate the transfer of securities from the participants of the latter CSD to the participants of the former CSD or an arrangement whereby a CSD accesses another CSD indirectly via an intermediary.

Another important category of undertakings involved in the cross-border safekeeping of securities is that of the global custodian. Where an investor holds a large, internationally diversified portfolio of securities, it may be impracticable for the investor to arrange for custody relationships to cover every market. From the perspective of such an investor, the global custodian acts as a single interface to these diverse systems of settlement and safekeeping. Global custodians operate proprietary and third-party custody networks spanning many jurisdictions.

The facts in two recent cases in the courts of England and Wales provide interesting illustrations of cross-border custody chains. In Eckerle v Wickeder Westfalenstahl GmbH: [2013] EWHC 68 (Ch), the custody chain linking the German investors to the shares in DNick Holding plc involved Bank of New York Depository (Nominees) Limited as the registered shareholder and as sub-custodian for Clearstream AG. The rest of the German side of the custody chain was not fully reported. In Secure Capital SA v Credit Suisse AG, the chain involved RBS Global Banking (Luxembourg) SA as the investor’s custodian, Clearstream as the sub-custodian and the settlement system, and Bank of New York Mellon holding the securities for Clearstream as a so-called common depository.

e) Basic Functional Requirements

Regardless of how national laws and legal doctrine translate this infrastructure into legal categories, there are a few universally acknowledged necessities, namely:

  • the number of “shares in circulation” must match the number of shares on deposit at the central securities depository;
  • the rules must provide legal certainty for the acquisition, disposal and hypothecation of securities and securities portfolios;
  • an investor’s assets must be insulated from the insolvency of the custodian;
  • creditors should not be permitted to interfere with book-entries in securities accounts at higher levels of the securities intermediation pyramid; for an investor’s general (attachment) creditors, the only object of attachment should be the investor’s account at their custodian.

i. No Increase in Number of Shares (Phantom Shares)

In any given securities settlement and safekeeping system, the transactions between market participants and the activities of intermediaries must not result in an increase in the number of shares. Suppose that Corporation A has issued 10 million shares. At all times material, the number of shares “in circulation” in the system must be 10 million.

As we have outlined above, the shares issued by A are on deposit with a central securities depository. Strictly speaking, the number of A shares outstanding therefore cannot increase. What can theoretically increase beyond 10 million is the number of A shares credited by custodians to securities accounts at lower levels of the securities holding “pyramid”: there is nothing to stop a custodian (if only accidentally) from crediting securities to a client’s account.

This leads to an interesting contrast with money creation by banks. Most money in circulation is created by commercial banks. As is well known, commercial banks create money by crediting funds to their customers, e.g. when agreeing to lend them a certain sum of money. Whereas this is very much a socially desired outcome, the opposite is true in the securities markets. To preserve the integrity of the system, it is essential that custodians do not credit more securities to their customers than are held for them at the central securities depository, or than are credited to their account at the sub-custodian. One of the main causes for the crediting of phantom shares has been so-called naked short-selling, a practice dating back to the time of Joseph de la Vega and the Dutch Golden Age. In a naked short sale, the seller enters into the sale, but fails to avail himself of the means to deliver the share to the buyer. If the custodian of the buyer has already credited the buyer’s account with the corresponding number of securities, a settlement fail may arise.

The notion of phantom shares is important in the context of our contribution, because it has been reported especially in the US securities markets and because it has been used as an argument in criticizing the US laws on intermediated securities founded on the concept of the security entitlement. It has on occasion been argued that phantom shares are the result of the legal foundation of the US post-trade infrastructure. In this system, investors no longer hold any title to the securities on custody, but instead acquire security entitlements only vis-à-vis their custodians. This kind of criticism insinuates that phantom shares cannot arise in systems which continue to attribute full legal title over the securities to the investor.

This claim is unfounded. Settlement fails (the technical events underlying the creation of phantom shares) are possible in all book-entry securities systems, regardless of the whether the applicable law conceives of the book entry in the investors’ account as a security entitlement, another type of hybrid entitlement, or as “pure” property.

ii. Legal Certainty regarding Acquisition, Disposal and Hypothecation

Because securities are immobilised at a central securities depository, securities are acquired and disposed by way of book entry. For a plain vanilla sale, a credit to the buyer’s account will have a matching debit in the sellers’ securities account. The legal infrastructure must provide specifically for this practice. Alternatively, the existing rules must be sufficiently general in order to accurately capture the transfer of securities by way of book entry.

Of equal if not greater importance, the law must enable the creation of security interests in individual securities and entire portfolios of securities at acceptable cost. Hypothecation occurs at all layers of the highly dynamic modern securities systems, e.g. in the form of lombard facilities provided by banks to wealthy clients, where prime brokers provide leverage to their hedge fund clients against the hedge fund’s portfolio, in the form of security interests taken by custodian banks over investors’ assets etc. Transactions are large and frequent especially between intermediaries with no direct links to investors. They engage in large numbers of institutionalised and ad hoc-transactions which require the posting of collateral. All these practices require a legal infrastructure that enables the transfer and hypothecation not only of individual securities, but of entire securities portfolios, clear rules on the attachment and perfection of security title, and legal certainty with respect to finality of settlement.

iii. Insolvency Protection

The essential requirement in preserving confidence in the modern book-entry securities systems is to insulate the assets held for investors from the insolvency of their custodians and sub-custodians.

vi. No Upper-Tier Attachment

Turning from the custodian’s general creditors to the attachment creditors of an investor, an important question is whether the latter should be allowed only to attach at the level of the investor’s custodian, or whether they may initiate enforcement at higher levels of the securities holding pyramid (upper-tier attachment). There is broad international consensus that at each layer of the securities intermediation pyramid, the answer is no.

As we noted in our introduction, the systems of securities intermediation prevailing in the United States, Switzerland and most of the EU are intransparent systems. In such systems, a custodian at a higher level of the securities holding pyramid does not know whether a custodian at a lower level of the pyramid holds the securities for its own purposes or for another custodian at the bottom of the pyramid/an investor. Allowing for upper-tier attachment could result in the blocking of omnibus accounts by higher-level custodians and cause disruption in the system (settlement fails etc.).

3) Substantive Laws: The UCC Model

A fundamental distinction to be made in the US system is between the legal owner of securities on the one hand, and the beneficial owner on the other. The separation between legal and beneficial/equitable title is said to be alien to civil law jurisdictions, but commonplace in common law jurisdictions such as the laws of England and Wales and US laws. Crucially, there is no fixed notion of beneficial ownership that would apply across the board in all situations where the holder of legal title is different from the ultimate beneficiary.

Where securities must be registered (all US corporate laws mandate the issuance of registered shares), the entity recorded in the register and therefore the legal owner is Cede & Co., a nominee for the Depository Trust Company (DTC), the American central securities depository.

a) Security Entitlement

In the US context, to say that an investor is the beneficial owner of the securities should not lead one to think that the general property laws of the States apply. It was precisely to avoid this outcome that the UCC was drawn up. The position of the investor with respect to the securities is exhaustively covered by each State’s legislation on investment securities mirroring or modelled on the UCC.

Under the UCC model, the investor is fully severed from the securities. The investor has no direct interest in the securities. The only legal position that an investor holds is a security entitlement vis-à-vis their custodian. As evidenced in the definition (U.C.C. § 8-102(a)(17)), the security entitlement is a hybrid concept incorporating contractual rights and a property interest:

“Security entitlement” means the rights and property interest of an entitlement holder with respect to a financial asset specified in Part 5.

Pursuant to U.C.C. § 8-501(b), the investor (in U.C.C. parlance, the entitlement holder, cf. § 8-102(a)(7) acquires such security entitlement the moment a book entry is made to their securities account (U.C.C. § 8-501(a)) at a securities intermediary (U.C.C. § 8-102(a)(14)).

The security entitlement relates to a financial asset. The definition of a financial asset in U.C.C. § 8-102(a)(9) encompasses securities but extends to anything the entitlement holder and the securities intermediary agree to treat as a financial asset. The UCC model is radically functional (and, as we shall see, ideally suited to cross-border custody chains). Any asset the entitlement holder and the securities intermediary wish to deal with under the UCC model is thereby elevated to the status of a financial asset. In the words of the legendary James S. Rogers ((2007), 45 Can. Bus. L. J. 49, 55):

This provision captures a thought that only became apparent after considerable work on the UCC Article 8 revision project – that the rules of the indirect holding system were rules about how property is held, not what property is. In the quip that became part of the folklore of the UCC Article 8 revision project, the indirect holding system rules could just as well apply to a banana as to a bond. If a clearing corporation or other intermediary wishes to hold bananas for its customers as having the same package of rights with respect to those bananas as with respect to traditional securities held in the account, so be it.

b) No Increase in the Number of Security Entitlements

The separation of the investor from the financial asset reflects the reality of the highly intermediated securities infrastructure. Since it is the securities intermediary that creates a security entitlement by way of book entry, safeguards need to be put in place to ensure that the number of security entitlements generated by the intermediaries will not exceed the number of financial assets. In the tradition of fruit analogies one might say that the security entitlements must not turn out to be lemons. U.C.C. § 8-504(a) reflects this concern, its wording again accounting for the reality of a multi-tiered chain of custody:

A securities intermediary shall promptly obtain and thereafter maintain a financial asset in a quantity corresponding to the aggregate of all security entitlements it has established in favor of its entitlement holders with respect to that financial asset. The securities intermediary may maintain those financial assets directly or through one or more other securities intermediaries.

c) Insolvency Protection

What distinguishes the entitlement holder from a general creditor/depositor of the securities intermediary is that the entitlement holder enjoys a first priority claim to all interests in the financial asset that the securities intermediary acquires. This situation very much resembles a trust where the entitlement holder is the beneficiary and the securities intermediary act as the trustee. U.C.C. § 8-503(a) stipulates that:

To the extent necessary for a securities intermediary to satisfy all security entitlements with respect to a particular financial asset, all interests in that financial asset held by the securities intermediary are held by the securities intermediary for the entitlement holders, are not property of the securities intermediary, and are not subject to claims of creditors of the securities intermediary, (…)

A crucial element not directly evident from the wording of this provision is that of timing: Even where a securities intermediary acquires the interests in the financial asset after having credited the entitlement holder’s account, the interests will still be reserved for the entitlement holder. § 8-503(a) is a clear statutory allocation of risk for the benefit of the entitlement holder and to the detriment of general creditors.

As always, the wording of the U.C.C. model provisions allows for an infinite number of steps in the custody chain. The interest in that financial asset which the custodian or sub-custodian acquires may well be and frequently is a security entitlement vis-à-vis a sub-custodian.

d) Custodian as Sole Point of Contact

The investor’s sole point of contact with the securities safekeeping infrastructure is the investor’s custodian. All rights that the investor enjoys they may exercise only via the custodian. U.C.C § 8-503(c) stipulates that

An entitlement holder’s property interest with respect to a particular financial asset under subsection (a) may be enforced against the securities intermediary only by exercise of the entitlement holder’s rights under Sections 8-505 through 8-508.

e) No Upper-Tier Attachment

In reality, there are several custodians between the investor and the security to which the investor’s security entitlement relates. Under the UCC model, the custodian holds a security entitlement vis-à-vis the first sub-custodian, the first sub-custodian holds a security entitlement vis-à-vis the second sub-custodian, and so on. In this structure, upper-tier attachment is impossible. U.C.C. § 8-112(c) clarifies this for all levels of the securities holding pyramid:

The interest of a debtor in a security entitlement may be reached by a creditor only by legal process upon the securities intermediary with whom the debtor’s securities account is maintained…

f) Transfer

Given that the investor only holds a security entitlement with their custodian, it is not legally possible for the investor to transfer title to a security to another investor. Instead, the investor can only give an entitlement order to their custodian, which U.C.C. § 8-102(a)(8) defines as

a notification communicated to a securities intermediary directing transfer or redemption of a financial asset to which the entitlement holder has a security entitlement.

As we have seen, the financial asset held by each (sub-)custodian (in UCC parlance, each securities intermediary) in the multi-tiered custody chain is itself a security entitlement. The only securities intermediary that holds actual title to the security and not merely a security entitlement is the securities intermediary at the top of the custody chain. That is the central securities depository. U.C.C. § 8-102(a)(14)(i) includes a clearing corporation in the definition of securities intermediary. The Depository Trust Corporation (DTC), the central securities depository in the United States, is a clearing corporation within the meaning of U.C.C. § 8-102(a)(14)(i).

Turning again to the bottom of the securities holding pyramid, an entitlement order originating from an investor results in an additional entitlement order by the investor’s custodian to the first sub-custodian, a further entitlement order by the first sub-custodian to the second sub-custodian and so on. Such entitlement orders may net out at lower levels of the securities holding pyramid before reaching the level of the central securities depository.

As between an investor A disposing of their security and investor an B acquiring it, there is no transfer of title. This differentiates the UCC model from those jurisdictions which continue to ascribe title to the securities to the investor (French and German law in particular). U.C.C. § 8-104(a)(2) provides that, in the intermediated system, a security is acquired by a person when

the person acquires a security entitlement to the security pursuant to Section 8-501.

It follows from U.C.C. § 8-501(b)(1) and U.C.C. § 8-501(b)(c) that investor B acquires a security entitlement by the simple fact of their custodian crediting their account, and irrespective of whether the transaction has settled.

This is at odds with the terminology generally used in the financial markets, including contractual documentation (delivery, transfer etc.). To avoid any problems of interpretation, the UCC provides a so-called translation rule. U.C.C. § 8-104(d) stipulates:

Unless the context shows that a different meaning is intended, a person who is required by law, regulation, rule or agreement to transfer, deliver, present, surrender, exchange, or otherwise put in the possession of another person a security or financial asset satisfies that requirement by causing the other person to acquire an interest in the security or financial asset pursuant to subsection (a) or (b).

g) Hypothecation

The rules for establishing security interests over security entitlements are contained in U.C.C. Article 9 – Secured Transactions. There are various ways in which security interests over security entitlements can be perfected. Of these, automatic perfection of security interests created by brokers and securities intermediaries pursuant to U.C.C. §§ 9-310(b)(2), 9-309(10) and perfection by control of security entitlement pursuant to U.C.C. §§ 9-310(b)(8), 9-314(a), 9-106(a) and 8-106(d) are particularly important for the intermediated securities system and wholesale collateral management.

h) Cross-Border Holdings

To illustrate the advantage of the UCC model in a cross-border context, consider the situation of a German investor wanting to acquire shares in an American company through their overseas custodian. In a domestic setting, German law would treat the investor as legal owner, assigning a special type of joint title to a pool of securities on deposit at the central securities depository. In a cross-border setting with the US, that is not possible. The legal owner of the shares is Cede & Co, the DTC’s nominee. The entity linking the German securities infrastructure to the US securities infrastructure cannot have itself registered as the shareholder. Something has to give. Unsurprisingly, German law provides specific rules for the custody of foreign securities.

Under the UCC model, there is no need to differentiate the statutory provisions even further. An American investor seeking exposure to overseas securities through a domestic custodian will acquire, by way of book entry to their account at that custodian, a security entitlement. In all likelihood, their security entitlement will be covered by another security entitlement that their custodian holds at its sub-custodian, and so on. At each layer, the financial asset reveals itself to be another security entitlement. The only entity that holds a financial asset that is not a security entitlement is the entity linking the US securities infrastructure to the overseas securities infrastructure. Regardless of the legal nature of the interest that entity holds, the domestic situation remains unchanged. From the investor’s point of view, the situation is only marginally different where the link to the foreign securities infrastructure is established via American Depository Receipts (ADRs).

Thomas Werlen (
Matthias Wühler (