PART ONE
Background Information and Analyses
CHAPTER ONE
Definitions
TO MANY PEOPLE it is clear what are the âinfrastructure institutionsâ in financial markets. They are the exchanges, CCPs, and CSDs that provide the trading, clearing, settlement, and sometimes other, core functions for cash and derivative markets.1 These institutions are indeed the focus of attention here. There are, however, also many reasons why the definitions of an infrastructure, an exchange, a CCP, and a CSD are all quite opaque. This is important, as the identification of a particular organization as one of these types of institutions can have significant commercial, regulatory, and policy consequences. This chapter aims to provide some basic insights into the definitions and nature of an infrastructure, an exchange, a CCP, and a CSD; and to explore the reasons why these concepts are sometimes ambiguous and controversial. A comprehensive examination of each of these different concepts would require a series of complex and broad analyses, and is not undertaken here.2
The chapter is composed of three sections. In the first, the meaning and nature of what is an infrastructure is explored. Some comments on the definitions and nature of exchanges, CCPs, and CSDs, and on the functions they deliver, are provided in the second section. Brief conclusions are offered in the last section.
INFRASTRUCTURE
Understanding how the term âinfrastructureâ has generally been employed and the key factors relevant for determining whether an institution is an infrastructure illuminates how the term may be used regarding institutions in financial markets, and the implications of doing so.
Meaning and Use of the Term
An examination of a broad range of definitions and uses of the term âinfrastructureâ highlights eight key nonexclusive factors and attributes that contribute towards identifying an institution as an infrastructure:
1. An infrastructure may be, or provide, the basic equipment, facility, foundation, framework, installation, system, or services that support or underly some form of structure, system, or activity, defined quite broadly. Such a structure, system, or activity may include a corporation, an organization, a productive process, a community, a city, an economy, a society, a nation, or a group of nations.3 The goods or services provided by an infrastructure are often both consumed directly and also used as inputs for a wide range of goods or services produced by users of the infrastructure institution. In this context, an infrastructure is often referred to as a âutilityââalthough this term, itself, is not easy to define.4
2. An infrastructure may be critical, essential, or necessary, to support commerce, economic activity and development, or whatever other activities are facilitated by the system it operates.5 Given the critical nature of the basic goods or services that an infrastructure provides, there are frequently concerns about access to these goods or services.6
3. An infrastructure may be, or provide, a network.7 In the economic sphere, such a network typically facilitates the delivery of goods and services, or links together the participants in a market, and is thus part of the structure underlying a market. The relationship between relevant producers and consumers takes place on, or via, the shared facilities or single medium provided by the infrastructure. A network is typically composed of both the physical structure linking market participants, and the associated commercial arrangements and rules for using this structure.
4. An infrastructure may exhibit economies of scale.8
5. An infrastructure may require large, long-term, immobile, and sunk investments.9
6. An infrastructure may be, or operate, a natural monopoly.10
7. An infrastructure may provide beneficial public goods or services, in addition to the specific goods and services it delivers directly.11 There are two key attributes of a pure public good or service: it is nonrivalrous, so that its consumption by one person does not prevent other people from consuming it; and it is nonexcludable, so that it is not possible to stop somebody from consuming it. An often-cited example of a public good is good health, as facilitated by water and sanitation infrastructures.
8. An infrastructure may have some form of government or public sector involvement, defined very broadly.12 For this reason, the term âpublic worksâ is sometimes used interchangeably for the term âinfrastructure.â The role of government or public sector involvement in infrastructures has been quite diverse. As Waller and Frischmann (2007, 12) note:
The government has played and continues to play a significant and widely-accepted role in ensuring the provision of many infrastructure resources. While private parties and markets play an increasingly important role in providing many types of traditional infrastructure due to a wave of privatization as well as cooperative ventures between industry and government, the governmentâs position as provider, coordinator, subsidizer, and/or regulator of traditional infrastructure provision remains intact in most communities throughout the world.
Several implications and aspects of this list of factors and attributes that contribute towards identifying an institution as being an infrastructure are noteworthy:
1. There are close links between many of them. For example, the presence of economies of scale is often associated both with a natural monopoly and with a network industry.
2. The presence of any one of the identified factors and attributes is not sufficient to determine that an institution is an infrastructure.
3. None of them are exclusive to infrastructure institutions.
4. The term âinfrastructureâ has been used in different contexts for different reasons. Unsurprisingly, therefore, different meanings have been assigned to the term.
5. A central aspect of an infrastructure is its importance, however this quality is defined. This importance may arise, in legal terms, because it is, or runs, an essential facility; in economic terms, because it is a monopoly; or its importance may lie in other directions, affecting social, political, or other factors.
6. The classification of an institution as an infrastructure, or not, may change. For example, technological changes and market developments may mean that an institution that was historically thought to be, and defined as, an infrastructure, given its importance, may no longer be so considered, if it becomes subject to competition.
7. It may be difficult to define an institution as an infrastructure if it undertakes multiple functions. In particular, if a single institution undertakes some functions that are recognized as infrastructure functions, and some others that are not, perhaps because they are provided in competitive markets, then it may be unclear how to characterize the institution. Should it be classified as an infrastructure institution, even though some of its functions are typically provided by non-infrastructure institutions? Or is it more useful to define activities as being associated with infrastructure provision rather than institutions?
8. The presence of these factors and attributes may have important policy implications.
A range of assets, services, organizations, and industries have typically been identified as infrastructure.13 They include the basic physical systems of a nation, particularly its transport (airports, air traffic control, bridges, buses, rail, roads, ports, and public transit), communications (post, telephone, and sometimes the Internet), energy (electricity and gas supply and distribution facilities, and sometimes oil), and water and sanitation systems. In addition, infrastructure may include public and social facilities, such as police, fire, and emergency services, schools, hospitals, recreation facilities, prisons, and government systems, such as courts, ministries, and parliaments.
In financial markets, the term âinfrastructureâ has been widely used to refer to exchanges, CCPs, and CSDs as providers of trading, clearing, and settlement services,14 and also to payment systems.15 It has also infrequently been used to refer to other providers of trading, clearing, and settlement services.
A range of examples illustrate how the term has been used. The UKâs Financial Services Authority (FSA) defined âinfrastructure providersâ to be
entities whose business is organising and supporting the functioning of markets. Infrastructure providers include exchanges, non-exchange (or âalternativeâ) trading systems, clearing houses and market service providers generally.16
More informally, Oleg Vyugin, a Russian regulator from the Federal Service for Financial Markets, noted that âdouble the infrastructure is madness,â when discussing why Russiaâs two major exchanges should consider merging to improve their competitiveness against overseas exchanges.17
The Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) and the Technical Committee of IOSCO have jointly developed recommendations for Securities Settlement Systems (SSS), the first sentence of which notes that such entities âare a critical component of the infrastructure of global financial markets.â18 The committees have also developed recommendations for CCPs, and in doing so noted,
Although a CCP has the potential to reduce risks to market participants significantly, it also concentrates risks and responsibilities for risk management. Therefore, the effectiveness of a CCPâs risk control and the adequacy of its financial resources are critical aspects of the infrastructure of the markets it serves.19
Similarly, a paper prepared for the International Monetary Fund (IMF) noted that
the smooth functioning of and confidence in the securities market depend on the efficiency and reliability of its infrastructure. In particular, it is crucial that the transfer of ownership from the seller to the buyer in exchange for payment takes place in a safe and efficient manner.20
The European Centrol Bank (ECB) has established a Contact Group on Euro Securities Infrastructures, which âaddresses issues and developments which are relevant for the euro securities settlement industry and which are of common interest for the Eurosystem, market infrastructures and market participants.â21
When describing clearing and settlement as the infrastructure underpinning financial markets, one metaphor that is very commonly used is that of plumbing.22 The European Commission, for example, used this metaphor in explaining that such institutions are âvital, but unglamorous and forgotten until something goes wrong.â23 A report from the European Parliament used the same metaphor, similarly noting that clearing and settlement is âlargely invisible, seldom understood and frequently overlooked but causes really unpleasant problems for everyone if it goes wrong.â24 As well as equating clearing and settlement systems with sanitation systems, which are typically themselves accepted as infrastructure, the metaphor also implies that clearing and settlement systems provide a public good in preventing things from âgoing wrong.â
Key Attributes of an Infrastructure Institution
Five of the key factors relevant for determining whether an institution is an âinfrastructureâ are briefly examined here.
ESSENTIAL FACILITY DOCTRINE
A commonly accepted attribute of infrastructure institutions is that the goods or services they produce are essential in some manner. This characteristic has in some contexts brought them within the purview of a legal doctrine, initially developed under US antitrust law, called the âessential facilityâ doctrine.25 The key thrust of the doctrine is that a monopolistic operator of an essential facility may be obliged to provide access to it to a competitor. In the past, four main criteria have needed to be satisfied under US law for such a possibility to arise:26 (1) the monopolist must control access to an essential facility, (2) the facility cannot practically or reasonably be duplicated by the competitor, (3) the monopolist must deny access to the competitor, and (4) it is feasible for the monopolist to grant access to the competitor.
The essential facility doctrine has been applied by US courts to secure the access of competitors to various institutions that could be considered infrastructures, including a terminal railroad,27 an information network for the press,28 an electricity network,29 a telecommunications network,30 and ski facilities.31
As discussed by Waller and Frischmann (2006), however, the continued applicability of the essential facility doctrine has come into question and been subject to criticism from a range of different sources. In 2004 the US Supreme Court expressed a strong reservation as to the pertinence of the doctrine due to its drawbacks on competition policy, noting,
Compelling such firms [i.e., with an essential facility] to share their advantage is in some tension with the underlying principles of antitrust law, sin...