I. Current account 15,039,000 10,429,000 (222,600) (1,364,200) 1,683,600 6,051,200
1. Foreign trade balance 19,730,000 18,927,000 5,812,400 4,206,300 6,114,500 9,841,400
1.1. Exports 26,476,000 28,259,000 15,586,000 13,210,500 15,152,000 20,793,800
1.1.1. Oil & gas 25,108,000 26,627,000 14,087,800 12,050,400 13,679,000 19,176,000
1.1.2. Other sectors 1,368,000 1,632,000 1,498,200 1,160,100 1,473,000 1,617,800
1.2. Imports (6,746,000) (9,332,000) (9,773,600) (9,004,200) (9,037,500) (10,952,400)
1.2.1. Oil & gas (838,000) (1,438,000) (2,403,000) (2,328,700) (1,342,500) (1,745,400)
1.2.2. Other sectors (5,908,000) (7,894,000) (7,370,600) (6,675,500) (7,695,000) (9,207,000)
2. Service balance (1,733,000) (6,090,000) (4,228,900) (3,154,500) (3,379,300) (2,062,000)
2.1. Oil & gas (1,241,000) (4,058,000) (3,064,500) (2,740,300) (3,102,600) (1,712,000)
2.2. Other sectors (492,000) (2,032,000) (1,164,400) (414,200) (276,700) (350,000) 099 CHAPTER 3. Net income from (3,467,000) (2,582,000) (2,027,800) (2,472,000) (1,759,600) (2,459,600) abroad 02
4. Net current Transfers 509,000 174,000 221,700 56,000 708,000 731,400 Development of Azerbaijan’s FX and Related Derivative Markets
II. Capital account 0 (6,000) (43,900) (40,100) 100,400 1,400
III. Finance account (3,590,000) (3,419,000) (9,025,200) (2,760,200) (200,900) (3,190,800)
1. Net direct investments 329,000 2,205,000 786,000 1,926,000 301,700 (808,000)
2. Bonus from oil 2,000 17,000 2,000 2,000 1,400 450,100
3. Portfolio & other (3,921,000) (5,641,000) (9,813,200) (4,688,200) (504,000) (2,832,900) investments
Changes in reserve assets (10,461,000) (4,194,000) 11,329,000 539,200 (1,971,300) (3,508,100)
Source: Statistics Committee of Azerbaijan Republic.
10-4-4 10-1-4 Central Bank of Azerbaijan, www.investing.com. Central 80 60 40 20 USD per Barrel 160 140 120 100 The Central Bank of Azerbaijan (CBAR) in 2014 recorded a high of about USD 15 billion Bank of Azerbaijan (CBAR) The Central In 2017, Azerbaijan’s exports amounted to USD 14.3 billion and imports USD 8.1 billion, exports amounted to USD 14.3 billion In 2017, Azerbaijan’s the central bank regulated the ability of commercial banks to set a spread on the base the base bank regulated the ability of commercial banks to set a spread on the central bid- the this, of Because devaluation. massive AZN’s the before corridor 8% an within rate before the crisis. In could not exceed 4% of the base rate ask spread of the AZN-USD rate had to allow its currency to depreciate 33.76% against the 2015, however, the CBAR February in FX reserves, but after August 2014, the amount nosedived to USD 500 million due to huge 2014, the amount nosedived to USD 500 million due in FX reserves, but after August with supplemented the CBAR SOFAZ of the devaluation crisis. wake pressure in the market of government corresponding to 103% currency, foreign USD 7.9 billion in an estimated FX policy regulator as well as monetary policymaker, revenue for that year. As the country’s million), and broadcasting equipment (USD 158 million). Oil exports have long dominated dominated long have exports Oil million). 158 (USD equipment broadcasting and million), (when dependence of the exchange rate trends. [Figure 2-3] shows the heavy AZN-USD rate In line). (blue prices oil on USD-AZN) of instead line orange an in AZN-USD as expressed are synchronized. short, oil prices and FX rates with the top export items being crude petroleum (USD 11.7 billion), petroleum gas (USD 1.29 with the top export items being crude raw and million), 57.4 (USD alcohol acyclic million), 323 (USD petroleum refined billion), aluminum (USD 56.2 leading million).The import items were cars (USD 312 million), refined (USD 219 million), packaged medicaments (USD 212 petroleum (USD 245 million), wheat Source: GDP the same year reached USD 40.7 billion, surplus of USD 6.17 billion. resulting in a trade [Figure 2-3] Oil Prices vs. AZN-USD Rate Oil Prices vs. AZN-USD 2-3] [Figure 100 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan USD as the current-account deficit proved too much to bear. Meanwhile, the black market for foreign currency dealings took off. The central bank took administrative and legislative measures to crack down on such illegal trading, but ultimately failed to do so. The CBAR was forced to conduct a second devaluation of the AZN on December 21, 2015. At the time, the AZN had suffered devaluation of 47.62% against the USD, and thus its devaluation for the year reached 98%. In 2015, the central bank also removed the corridor limit of 8% given its inability to fight devaluation pressure. In addition, the CBAR switched to the free-floating exchange rate system to allow market forces to determine FX rates. At the time, trading of the AZN rose to 1.99 per USD. AZN-USD spreads fluctuated from 0-30% due to lack of foreign currency liquidity during the first five months of 2017.
From May 2017, however, an improved trade balance and SOFAZ’s provision of FX reserve aid to the CBAR helped stabilize the AZN to around 1.7 per USD. Another positive factor was apparently cooperation from pro-government banks. Market participants said certain large banks with high FX liquidity have intentionally lowered USD prices on the market in return for getting dollars at low prices through CBAR-sponsored USD auctions. Meanwhile, banks with large demand for USD liquidity such as International Bank of 101
Azerbaijan (IBAR) are known to have been excluded from such auctions despite no official CHAPTER announcement to that effect. Monetary policy also helped the AZN appreciate against the 02
USD on the domestic market. The CBAR raised interest rates for the domestic currency from Development of Azerbaijan’s FX and Related Derivative Markets 3% to 15% for ordinary deposits while minimizing the AZN’s base by around 600 million AZN in the first quarter of 2017 through holding deposit auctions. By doing so, the central bank reduced the volume of AZN in circulation and increased confidence in the currency by ensuring profitability. On the other hand, the CBAR allowed an interest rate of just 2% on USD-denominated deposits. The modest appreciation of the AZN significantly contributed to this discriminatory monetary policy
In 2016, FIMSA shut down money changers in the wake of insufficient foreign currency liquidity. In 2017, the financial watchdog revised a bill to allow such businesses to reopen amid a surge in incoming tourists after the huge AZN devaluation. Though the need for money changers has increased, FIMSA has given no specific instructions on this, thus the money-changing sector cannot resume operations. 1.90 1.70 1.50 1.30 1.10 0.90 0.70 0.50 AZN/USD 5.60 47.40 2018 41.80 5.30 (Unit: Billion USD, AZN/USD) USD, (Unit: Billion 41.10 2017 35.80 4.00 USD/AZN 37.10 2016 33.10 5.00 38.60 2015 33.60 TOTAL 13.80 50.90 2014 37.10 CBAR 14.20 50.10 2013 35.90 11.70 45.80 2012 SOFAZ 34.10 10.50 40.30 2011 29.80 6.40 29.20 2010 22.80 Central Bank of Azerbaijan, State Oil Fund of Azerbaijan Republic. Bank of Azerbaijan, State Oil Fund of Central 0 60 50 40 30 20 10 billion USD 2.1.2. FX Trading Volume 2.1.2. FX Trading No government body in Azerbaijan has released an official announcement or statistical four the size of other currencies excluding the USD in the cash turnover of all currencies (seefour the size of other currencies excluding the USD in the cash turnover of 2-2). Table all foreign currency purchased from the auctions. The volume of FX transactions sold by sold by all foreign currency purchased from the auctions. The volume of FX transactions In interviews CBAR. the to reported data through counted be can settlement cash banks for with banking officials, the KSP team found thattransaction the volume FX of banks was four in all other currencies except for the USD. times what was reported as cash transactions after multiplying by this report estimates the volume of FX cash transactions Accordingly, for computing FX trading volume. The CBAR held 99 currency auctions in 2018 and sold sold and 2018 in auctions currency 99 held CBAR The volume. trading FX computing for them. Information on USD amounts sold to banks an estimated USD 6.285 billion through through these auctions have been confirmedby banking sources or announced as part of USD to the government budget, with a 10% margin of error. Since banks of transfer SOFAZ's have sold almost had the same FX positions in late 2018 as in 2017, they can be assumed to as follows. The first amount is whatthe central bank is known to sell to commercial banks without banks by purchases or sales FX of that is second the auctions, USD its through sold accounts, and the third is that of FX transactions cash settlement through other bank have become basic data sources banks through cash settlement. These three methods by data on FX trading volume, including the CBAR and FIMSA. Yet market experts estimate the experts market Yet FIMSA. and volume, including the CBAR data on FX trading figure in 2018 at AZN 40.6 billion (USD 23.9billion). FX trading volume overall is calculated Source: [Figure 2-4] Azerbaijan’s FX Reserves (2010-18) FX Reserves Azerbaijan’s 2-4] [Figure 102 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan
FX Turnover Volume in Azerbaijan (2018) (Unit: Thousand)Unit: Thousand Cash turnover CBAR to banks Banks non-cash Sum in AZN
USD 7,319,847.78 10,370,000.00 12,444,000.00 30,133,847.78
GBP 124,067.67 496,270.68 620,338.35
EUR 1,520,324.29 6,081,297.16 7,601,621.45
RUB 444,121.44 1,776,485.77 2,220,607.21
Sum in AZN 40,576,414.78
Sum in USD 23,868,479.28
Source: Central Bank of Azerbaijan, interviews with banking officials.
The auction turnover of AZN 40.6 billion in 2018 was larger than in 2017 and 2016, but still lower than in 2015 and 2014. At the time, SOFAZ’s currency sales were not made through CBAR auctions, but the company’s FX amount can be deduced from the government budget. The assumption is that 100% of currency sales were used before the budget was calculated(see Figure 2-5). 103 CHAPTER [Figure 2-5] Trend of FX Turnover Volume of Azerbaijan (2010-18) (Unit: Billion USD) 02 Development of Azerbaijan’s FX and Related Derivative Markets
80
70
60
50
40
30
20
10
0 2010 2011 2012 2013 2014 2015 2016 2017 2018
Source: Central Bank of Azerbaijan, interviews with banking, Ministry of Finance officials. On November 28, 2016, the government changed the direction of foreign currency currency foreign of direction the changed government the 2016, 28, November On Shortly after the second AZN devaluation in 2016, the government banned FX in 2016, the government banned FX Shortly after the second AZN devaluation 2.2. Developments in Azerbaijan's FX Policy in Azerbaijan's 2.2. Developments to regulate the authority transferred government 2016, the Azerbaijani In March were delivered within 270 days after a currency transfer abroad. Failure to do this incurred abroad. Failure after a currency transfer were delivered within 270 days a fine of 20% of the transferred amount for the company CEO and 30% for the corporation. amount FX an of receipt proving documents with non-resident or resident a Moreover, settlements could freely send that sum abroad with no limit. Also, the new law on non-cash operations for residents and non-residents. In December 2016, a law on non-cash settlements for residents and non-residents. In December 2016, a operations limited the in the country was enacted to decrease capital outflows. A new regulation before, residents sending of money abroad to USD 1,000 daily and USD 10,000 per month; amount to their own accounts abroad or those of relatives. The new rule could send any services that to provide custom import or other documents proving a company required significant reduction of illegal FX transactions. In another measure to crack down on illegal exceeding USD 500 and all FX transactions required ID documents for FIMSA FX trading, in cash. records of large amounts of FX trading kept transactions through money exchangers under law. This was the first time for FIMSA to to FIMSA for time first the was This law. under exchangers money through transactions take action as a financial supervisory It authority. also took actions to prevent black market a in resulting operated, previously had changers money 1,000 than more since activities financialinstitutions. It can also supervise all FX operations in and out of the country and if for controlling and blocking operations information has immediate access to operational licenses, and revokes fully monitors risk assessment, regulates needed. In addition, FIMSA and inspects and controls banking operations. FX policy instead of the Ministry of Finance (MOF), in contrast to other countries where where to other countries contrast of the Ministry of Finance (MOF), in FX policy instead the finance ministry normally oversees FX Meanwhile, policy. the CBAR remains the main through its USD foreign currency market intervening in the by rates FX setting for authority auctions and use of FX reserves. As the country’s main financial FIMSA authority, enforces other from applications supervises and modifications, implements regulations, and laws CBAR to a third party, FIMSA, and that the central bank should concentrate on monetary on monetary bank should concentrate the central and that FIMSA, third party, to a CBAR government also regulator for the banking sector, the separate Instead of setting up a policy. companies, securities brokers, other financial institutions like to supervise FIMSA asked depository institutions, and stock and processing companies, central insurers, liquidation for the main authority also became watchdog financial The as well as banks. exchanges financial institutions from the CBAR to FIMSA. The government concluded that day-to- government concluded The FIMSA. to the CBAR institutions from financial from the should be transferred as banking licensing, and regulations such operations day 104 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan of FX significantly tightened cash operations in Azerbaijan. The two goals of this law were to prevent capital outflows and streamline the tracking of FX transactions within the country. The law also allowed companies with simplified tax obligations to spend AZN 15,000 in cash per month and companies paying VAT of AZN 30,000 on monthly FX purchases. To raise market transparency and reduce illegal activity, the statute required payment of taxes, customs, administrative penalties, financial sanctions, interest, loans and leasing, salaries, compensation, and bonuses through bank accounts without cash settlement.
From an FX policymaker’s perspective, the CBAR is nothing more than an information provider as it fully transferred its FX system policy authority to FIMSA in 2016. The central bank, however, retains the right to supervise FX rate policy as it still intervenes in the FX market through its USD auctions with the support of SOFAZ. Every morning, the CBAR sets the AZN-USD exchange rate based on the previous day's weighted average price and sets the rates of other currencies according to the latest market prices. As the FX rate stabilizes, the bank spread fluctuates by around 0.1%. The CBAR collects reports on currency operations, holds currency auctions, intervenes in the market when needed, and publishes market statistics. 105 CHAPTER
On December 21, 2015, the central bank announced a switch to a free-floating exchange 02 rate system after having devalued the AZN twice during the same year. Yet the AZN is Development of Azerbaijan’s FX and Related Derivative Markets clearly not ready for free floating because the country has few sources that earn foreign currency other than oil. As of 2019, the CBAR intervenes twice a week in the FX market and thus the basic exchange rate almost never fluctuates. Thus the Azerbaijani economy has a long way to go before launching a fully free-floating exchange rate, but authorities have begun taking steps toward that end. Measures are being taken for diversifying the economy, attracting tourists, increasing support to sectors with the biggest export potential, implementing reform to make the economy more suitable for foreign investors, shifting to a fully transparent economy, and instituting revisions to the tax and customs systems.
The Azerbaijani government seems to have little desire to implement capital liberalization. FIMSA confirmed that a capital liberalization policy is not within the scope of the country’s strategic roadmap, making it difficult to get related information. Today, the economy remains sensitive to external shocks and its FX market has yet to recover investor trust. Thus a policy of capital liberalization could result in the immediate outflow of a huge amount of capital.
The last thing the KSP team noticed about the Azerbaijani FX market was the problem of data transparency. The central bank only releases reports on cash currency operations With 1 Azerbaijan has four main players on its FX market. The first is thegovernment or public 2.3. FX Market Players 2.3. FX Market SOFAZ sold USD 864.3 million, 15.94% more than predicted in the 2018 government budget. in the 2018 government than predicted sold USD 864.3 million, 15.94% more SOFAZ
1 stable at 1.70 per USD in 2018(see Figure 2-6). auctions organized by the CBAR, with the main buyers being domestic banks. SOFAZ sells sells main buyers being domestic banks. SOFAZ with the the CBAR, auctions organized by 6,285 USD sold which auctions, the through AZN in government the to money transfer to USD only USD 256.3 million FX reserves increased by CBAR’s million in 2018. Considering that the in the first 11 months of 2018, SOFAZ can be presumed to have sold all the currency. did not change throughout the year and remained help from the fund, the AZN-USD rate revenue comes from this transfer. SOFAZ has financed an average 70% of the country’s annual 70% of the country’s has financed an average SOFAZ revenue comes from this transfer. At the start of every year, the Ministry of Finance government budget over the last 9 years. in AZN. sells to supplement the government budget (MOF) announces how much USD SOFAZ is also conducted through currency SOFAZ AZN by The conversion between the USD and player as the country’s largest and sole liquidity provider (because of its size) of USD to the largest and sole liquidity provider (because of as the country’s player and oil revenues the country’s The fund was established in 2001 to save domestic FX market. in Azerbaijan transfer oil companies Foreign increase USD reserves for future generations. 60% of their profits to the State Oil Company of Azerbaijan Republic (SOCAR) under a profit- of SOFAZ and 90% portion of its revenue in SOFAZ, sharing agreement. SOCAR saves a agencies. First, the Central Bank of the Azerbaijan Republic (CBAR), which sets monetary which sets monetary Bank of the Azerbaijan Republic (CBAR), agencies. First, the Central auction the policymaker; FX of role the playing in auctions USD hosts and oversees policy, is a leading FX Fund of Azerbaijan Republic (SOFAZ) process began in 2015. The State Oil but has not built a database or collected data on the banks’ forward positions. Data on the Data on positions. forward on the banks’ or collected data database built a not but has finds it difficult to obtain thus even FIMSA is not centralized, market interbank currency such information. and the currency structure of the banking sector’s balances. Investors and financial financial and Investors balances. sector’s banking the of structure currency and the auctions and of currency data on the volumes access CBAR however, cannot researchers, interbank operations and their components. Furthermore, even FIMSA staff admitted that there is no public data on currency flows in and out of the The country. financial watchdog banks over the past few years spot currency positions of commercial has requested the 106 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan [Figure 2-6] SOFAZ Transfers to Budget and Their Share in Its Revenue
(Unit: Billion USD, %)
Billion USD % 15 150
10 100
5 50
0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 Transfers to budget Revenue/Transfer
Source: SOFAZ website and Ministry of Finance.
The second group comprises banks, which are the main participants in the CBAR’s USD auctions. Any bank with a Bloomberg terminal can participate in the auctions, and every bank has direct access to these auctions without having to use broker. But certain banks 107 with huge liquidity such as International Bank of Azerbaijan Republic (IBAR) have been CHAPTER banned from these auctions for some time.2 Banks mainly sell foreign currency to retail clients, who can also buy such currency to manage their USD positions. Retail clients can 02 Development of Azerbaijan’s FX and Related Derivative Markets exchange foreign currency through branches or ATMs in cash or non-cash form. They can do so through mobile or web apps. Banks also trade derivatives with retail clients, mostly over the counter (OTC) and usually through a full credit line, and no margin is applied to OTC forwards. In that case, banks must carry the credit risk of the client. Also, banks can spot trade foreign currency through their foreign bank accounts.
The third group is investment companies that use the spot market for cross-selling investment products. In other words, when a customer tries to acquire an investment product in another currency, an investment company conducts the exchange using its own rate if one currency is introduced.
The last group comprises export and import companies. Oil is the country’s major export item with overseas shipments in 2017 reaching USD 123.6 billion, or 89.5% of exports overall. Oil exports declined from USD 46.3 billion in 2008 to USD 123.6 billion in 2017 mainly because of the drop in oil prices exceeding 73%. The No. 2 export of Azerbaijan is fruits, nuts, and vegetables. Exports of all remaining items, including the latter, declined from USD 15.9 billion in 2012 to USD 14.5 billion in 2017. Because of huge fluctuations in currency rates,
2 President’s decree on refinancing of IBAR for preparation of privatization, July 15, 2015 (https://president.az/articles/15836). - - 3 Domestic banks also perform this trading using Bloomberg terminals through individual deals Domestic banks also perform this trading 3 1. Spot Market that market and a non-cash spot spot market a cash of spot markets: Azerbaijan has two types The miscellaneous group consists of individuals who trade USD for travel or other needs. or travel USD for group consists of individuals who trade The miscellaneous The CBAR also announced vital details about currency auctions such as volume, demand, and average price. now, it However, only announces the fact that the auction has been Thus provided. Bloomberg also offers no to transparency the market. One conclusion use Bloomberg Banks now utility or test the limits of Bloomberg. is that the Azerbaijani market is not and will not use Bloomberg’s just not them because auctions only to. the but currency bank The CBAR also provides central requires those of its deposits through Bloomberg. tle at the end of an auction, the central bank adopted the t-1 settlement method. Every bank cannot place an order for more than for more adopted the t-1 settlement method. Every bank cannot place an order bank tle at the end of an auction, the central every to participate in these auctions pays a flat fee to Bloomberg bank who wants the amount it has in its CBAR account. Thus every while oth national security, warn of heightened fears over and bankers who criticize this platform monopoly month. Certain experts ers say Bloomberg is stable and reliable enough to serve as a core platform in one of Azerbaijan’s biggest financial markets. Here, the CBAR is mainly on the selling side of the transactions and banks on the buying side. must Banks, conduct however, all currency transactions among them through Bloomberg, so while the market organizer is the CBAR and the platform Bloomberg, these are transactions. not exchange Bloomberg was originally introduced as an ideal tool to boost transparency in the currency market and prevent unexpected results. results. unexpected market and prevent in the currency as an ideal tool to boost transparency was originally introduced Bloomberg (CBAR and FX Bid Auction Market) Until mid-2015, the CBAR was applying t+0 to settlement but because certain banks failed to set with the same rate from the CBAR the next day. the next day. CBAR from the with the same rate is mostly done for fund transfers to foreign companies for import purposes, but companies can for import purposes, but companies can to foreign companies is mostly done for fund transfers for other purposes. Individuals conduct non-cash freely convert their funds into other currencies when shopping abroad or buying via e-commerce from spot conversion mostly through bank cards foreign marketplaces and websites. Sufficient data is lacking on what portion of FX volume is done of low due to the unwillingness to be comparably volume can be assumed the but interbanking, via banks and their expectation of obtaining the currency banks to share their FX positions with other currencies with foreign banks through Bloomberg or a specific determined platform of foreign of foreign platform determined specific a or through Bloomberg banks foreign with currencies Clearing here is also based on agreements between institutions but is banks for currency trading. trading spot Non-cash system. every case, clearing is done through the SWIFT In t+0. in mostly held deposits funds into its are held in accounts. A company between domestic banks and their clients of existing funds in its accounts. The conversion accounts and converts or orders the conversion are both OTC. The country has neither an exchange institution nor exchange transactions for for nor exchange transactions has neither an exchange institution The country are both OTC. bank, and the central is held mostly among banks, spot trading Non-cash currency spot trading. non-cash spot currency but at extremely low volume. Non-cash legal entities. Individuals also trade with are held through a Bloomberg terminal via auctions between banks and the CBAR spot trading t+0. clearing can also be t+1. Domestic banks also trade with t+0; under an agreement between banks,
3 FX Markets in Azerbaijan Continued
Cash spot currency trading is held mainly between banks and individuals. Most of the time, cash exchange is held at bank branches but can also be done through cash machines. Individuals mostly trade currencies in cash for travel purposes and if currency conditions are volatile, they can convert to foreign currency and keep long positions. Azerbaijani travelers can take up to USD 10,000 out of the country per month. Anyone who carries more than USD 1,000 in cash when traveling abroad must declare it to customs.
2. Forward Market
The forward market is relatively new to Azerbaijan. Because of the high margin, however, banks rushed to offer FX forwards to individual customers. In 2014, the volume of the forward market was believed to be worth tens of million USD but no official report on these transactions came out. Officially, the CBAR’s stance on the overall FX position is a maximum 20% of equity at that time.
Because of the required overall position report, official statistics on forward contracts are provided but it is unclear to market participants what portion of this volume is generated by real trades. Banks are also known to frequently manipulate forward contracts in their off-balance sheets to forge their overall currency positions due to the fear of devaluation. During the first devaluation period, banks with forward deals experienced huge losses as the premium skyrocketed to around 109 CHAPTER 30% considering the existing forward rate of around 4%. After this debacle, banks stopped trading forwards for a while. In 2017, however, banks and select investment companies started trading 02
forwards again because the near peg of the AZN-USD rate made forward sales profitable. Lack of Development of Azerbaijan’s FX and Related Derivative Markets liquidity and scarcity of counterparties offering contracts caused forward rates to go way above their theoretical value. Today, the forward premium is known to be 9%-10% but the size of the forward market remains a mystery.
3. Other Derivatives Markets (CFD)
Azerbaijan has no futures market, meaning it also lacks a currency futures market. The nation does have a contract for difference (CFD) market. A CFD is an OTC product brokered by domestic investment companies licensed by FIMSA for margin trading but is manufactured overseas. Since 2016, no license has been required for margin trading. Individuals can open an account with a foreign broker and use its services. As a form of non-delivery forward (NDF) margin trading, a CFD is like betting on the direction of an underlying currency. Furthermore, the volume of CFD trading has no impact on currency rates, and thus CFDs are good hedging instruments. With a 1% margin on the CFD market, traders can hedge their currency positions. The annual market size is around AZN 10 billion and the major player is InvestAZ, which brokers CFD products. The average leverage of a CFD is 1:100. This market is the most improved of any financial market in Azerbaijan. Individuals can get direct access to their trading accounts and trade through a desktop, web, or mobile platform. Trades are purely made on a cash settlement basis without delivery. Around 50 but CFDs are mostly used by speculators speculators are mostly used by but CFDs 4 Azerbaijan also has currency swaps. The CBAR made such swaps with commercial banks to made such swaps with commercial banks to CBAR Azerbaijan also has currency swaps. The The Baku Stock Exchange (BSE) also has its own CFD product and platform. An investment and platform. An investment (BSE) also has its own CFD product The Baku Stock Exchange Related Infrastructure Korean Experience in Developing FX Market and FX Market and in Developing Experience Korean 3.1. Korea’s FX Market 3.1. Korea’s on depending customers and interbanking for those into is classified market The FX This section provides an overview of the Korean government's FX policy, experience in experience in policy, government's FX the Korean This section provides an overview of currency swaps with banks, making such swaps seem inactive. currency swaps with banks, making such swaps FX liquidity comes from a single source, thus most FX prices are more likely to be dictated by that by dictated to be thus most FX prices are more likely source, a single FX liquidity comes from than being formed. source rather was known to be 2016, the currency swap market hedge their currency positions. In 2015 and conducts on if the CBAR however, no data exists As of now, hundred million USD. worth several company can become a market maker and provide liquidity to other investment companies. Here, provide liquidity to other investment and maker can become a market company its and requirement, margin minimum the meet traders making by market the regulates BSE the allows the exchange to create AZN- platform This BSE also increases transparency. monitoring FX available on its spot market but to do this, the exchange quotes the average based FX derivatives FX derivatives in Azerbaijan is that price. Another problem in developing platform as the reference types of CFDs are based on 25-30 underlying currencies are based on 25-30 types of CFDs The in AZN. denominated is CFD No money. fast want to make or simply well market know the who than others. more attractive this market and ease makes usability, liquidity, in market, leverage market has cases in which only forward exchange transactions are made but also more are made but also more exchange transactions has cases in which only forward market between through swaps. The swaps strengthen the link cases in which FX funds are traded a big role also play FX brokerages the FX and foreign currency-denominated funds markets. the transaction subject. This market is also closely related to the lending and borrowing of of borrowing and lending the to related closely also is market This subject. transaction the only can transactions market FX of The stimulation funds. currency-denominated foreign transactions FX market denominated in foreign currency. in funds to transactions be linked as standardized products on the exchange. but traded transactions OTC are usually bilateral The latter is divided into the spot and forward exchange markets. the FX market Finally, transactions will conclude this section. transactions capital liberalization around the 2000s, and efforts toward construction of infrastructure and efforts toward construction of infrastructure around the 2000s, capital liberalization regulation of FX market and supervision supervision. Korea’s and monitoring market FX for 3. Continued 3.1.1. FX Market
The FX market allows the exchange of two currencies through an exchange rate. The FX money market features the borrowing of foreign currencies through interest rates. Though the FX and FX money markets are different, they are hardly exclusive of each other.
The FX market has various entities like individuals, companies, financial and foreign investors, and insurers as well as FX banks that sell or purchase foreign currencies. This market can be divided into the interbank and customer markets according to type of trading partner. The latter is a retail market in which FX transactions are carried out between banks and non-banking counterparts, namely individuals and companies. As a result of customer transactions, the FX position of FX banks often changes and is adjusted through the interbank market, and this connects both markets. The interbank market, meanwhile, is like a wholesale market and divided into a section that trades directly between FX dealer 111 banks and another intermediated by FX brokerages. CHAPTER
FX brokers act as intermediaries between FX banks without holding any positions. FX 02 Development of Azerbaijan’s FX and Related Derivative Markets banks are the main participants in the interbank market to resolve open positions resulting from transactions with other non-financial customers. Most interbank transactions are intermediated by FX brokers. To conduct FX brokering, authorization is required from the Ministry of Economy and Finance (MOEF). Korea has 10 FX brokerages, with the top 3 being Seoul Money Brokerage Services, Ltd., Korea Money Broker Corporation, and ICAP Foreign Exchange Brokerage, Ltd.
[Figure 2-7] Classification of FX Market by Transaction Subject
Interbank Client Market Market
Government Bank of Korea
Foreign Foreign Foreign Business Exchange Exchange Exchange Bank Broker Bank
Foreign Individuals Exchange Bank
Source: Bank of Korea.
FX transactions in form FX transactions Economically speaking, they are (FX swap, CRS) markets Swap currency call market Foreign Short-term loan market ㆍ with interest loan transactions as a parameter rates ㆍ ㆍ ㆍ Foreign currency transactions: currency Foreign is a parameter the exchange rate FX loan transactions ㆍ CRS Spot Option Option Futures FX Swap Forward Currency Currency Currency OTC Exchange (exchange-traded) (over-the-counter) Money Market Bank of Korea. Foreign Currency Foreign FX Market The KRW is not an international currency, thus sales of KRW-denominated spot and spot and thus sales of KRW-denominated is not an international currency, The KRW [Figure 2-8] shows the classification of the FX money market together with the FX market. market. together with the FX of the FX money market [Figure 2-8] shows the classification FX market transactions are divided into those of spot, forward exchange, and currency currency and exchange, forward spot, of those into divided are transactions market FX and into those of OTC are also divided transactions FX market venue, transaction By transactions, such banks must cover the position on the FX money market. As a result, a As a result, a market. such banks must cover the position on the FX money transactions, strong link connects the two markets. forward exchanges are limited to the domestic market. The market has been developed developed been has market The market. to the domestic are limited exchanges forward are banks the of most dealers; as act banks FX which in market" "interbank or dealer a as customer of result a as exposure FX net offset To transactions. FX conduct to designated The former involves foreign currency loans and borrowings conducted with interest rates rates interest with conducted borrowings and loans currency foreign involves former The dealt should be market FX money the why The following explanation covers parameters. as with on the FX market. Source: An FX transaction intermediated by an FX is brokerage also classified as an OTC transaction by FX product in which it. Classification has no authority to settle and ratify as the brokerage this section. is explained will come later in FX transaction an OTC by Product 2-8] Classification of FX Market [Figure option, and foreign exchange and currency swaps. and currency swaps. foreign exchange option, and nature. their of because OTC conducted be to likely more are transactions Such exchange. 112 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Though FX and currency swaps are considered FX market transactions, both contracts imply borrowing different currencies for a certain period of time between traders and are thus deemed transactions on the FX money market. Swaps take the form of FX trading, but are essentially lending and borrowing transactions in which each party borrows one currency it needs from another while providing another currency as collateral for its loan.
3.1.2. FX Money Market
The FX money market has domestic banks borrowing from each other (or foreign bank branches) to overcome a foreign currency shortage. Banks often have temporary long or short positions in foreign currencies due to the results of transactions in import and export payments using corporate FX loans, FX transactions with either banks or individual customers, and issuance and repayment of foreign currency-denominated bonds.
If long-term procurement of foreign currency is infeasible, the shortage may be continuously rolled over through currency procurement from the short-term FX money market. This market also features the FX call market for short-term (usually within 30 days) 113
FX lending transactions. CHAPTER
Domestic banks are primary borrowers of USD but foreign banks, with relatively rich 02 Development of Azerbaijan’s FX and Related Derivative Markets FX liquidity, and foreign bank branches that can easily borrow from their companies’ headquarters abroad, become primary lenders. The two types of transactions on this FX money market are unsecured lender transactions and those of RP in which the bonds are used as collateral.
3.1.3. OTC FX Market vs. Exchange
The FX market can also be divided into a dealer-to-dealer (OTC) market featuring large- scale wholesale trading and an exchange or client-based OTC FX market in which small-scale transactions are made between non-banking customers
Non-banking clients are not FX dealers so they cannot directly participate on the FX market and must use FX dealer banks or FX-traded products on exchanges. On the OTC FX market, the lower a customer's creditworthiness and the smaller the transaction size, the more likely the FX bank will require a high value of collateral. While access to the OTC market remains considerably limited for most individuals or SMEs, the KRX's FX market allows small-scale transactions, low-credit individuals, and transactions conducted horizontally and equally between trading partners. On this FX market, currency futures An FX forward is a contract to buy or sell a certain amount of a foreign currency for a to buy or sell a certain amount of a foreign currency for a An FX forward is a contract 3.1.4.1. FX Forward Transaction 3.1.4.1. FX Forward 3.1.4. Transactions by Product Type (OTC Market) Spot Transaction (OTC Type Product by 3.1.4. Transactions 2 within made KRW and USD of settlement and exchange the has transaction spot A Transparency of the KRX’s FX market is comparatively high compared to the OTC market market high compared to the OTC is comparatively FX market of the KRX’s Transparency Four Four major categories of USD futures (first listed inApril 1999) and options (April 1999), swap forwards. set price for settlement at a specified (from t+3) period in the future. The forward is further buying and selling in which only forward exchange divided into outright forward trading, FX swaps classified as as part of occur, and forward exchange transactions transactions the transaction date. For non-banking customers, who score far lower in creditworthiness lower in creditworthiness non-banking customers, who score far date. For the transaction And this is another reason a for spot transactions. is required even than dealers, collateral a pivotal role. credibly designated FX bank plays business days from the conclusion of the transaction (value date). The spot exchange rate (value date). The spot exchange rate transaction from the conclusion of the business days are divided into of spot transactions The types becomes the base price of the FX market. (t+1), and value spot (t+2), among which the international value tomorrow value today, acquisition of both currencies are involving the Most FX transactions standard is (t +2) days. because the settlement date is the future of to non-settlement (counterparty) risk vulnerable traditionally dominated by dealers. dominated by traditionally because the price and turnover volume of currency futures are released in real time. The are released in real time. The and turnover volume of currency futures because the price system, quotation order electronic an with market, FX KRX's the of mechanism trading basic market a as dealer a for need little requiring market, stock KRX the like auction double a is is are limited as the currency market FX market The role and function of the KRX’s maker. yen futures (May 2006) and euro futures (May 2006) are listed. Currency futures and options 2006) are listed. Currency futures futures (May 2006) and euro yen futures (May underlying but the former’s different from those of stock indexes, are not fundamentally for and receipt than stock indexes. Currency payment currencies rather assets are foreign also occur when holding until maturity. options may currency futures and and options are traded on derivatives. This market is part of an FX market that operates that operates of an FX market is part market This on derivatives. are traded and options capital market with FX currency market and is also an mechanisms to FX market according infrastructure. 114 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan An outright forward transaction is further classified as a non-deliverable forward (NDF) or general forward exchange transaction in which KRW and USD are acquired on the settlement date. An NDF is another outright forward transaction in which each party settles the differential between the contracted NDF price and the prevailing spot price with an agreed notional amount
3.1.4.2. FX Swap
An FX swap is a transaction in which one party borrows a currency from the other party while simultaneously lending another currency to the counterparty. Each party uses its repayment obligation to its counterpart as collateral and the repayment amount is predetermined at the forward rate from the beginning of the contract. Thus FX swaps can be viewed as exchange risk-free collateralized borrowing and lending.
[Figure 2-9] Fund Flows in EUR/USD FX Swap
a. Start b. Maturity 115 A A CHAPTER
X XㆍS X XㆍF (EUR) (USD) (EUR) (USD) 02 Development of Azerbaijan’s FX and Related Derivative Markets B B
FX spot rate(S) FX forward rate(F)
Source: Bank for International Settlements.
FX swaps have been used to raise foreign currency for financial intermediaries and their exporter and importer clients, as well as institutional investors who want to hedge their FX positions. Such swaps are also used in speculative trading and stay liquid for terms shorter than a year.
The swap rate means the difference between the spot and forward rates. In theory, the rate is determined per difference between both currencies according to the theory of interest rate parity.
3.1.4.3. Cross-currency Basis Swap
The cross-currency basis swap (CRS) is a transaction in which one party borrows a currency from another and simultaneously lends the same value (at the current spot rate) of another currency to the counterparty. The parties using a CRS tend to be financial
S ㆍ X (USD) X (EUR) B A c. Maturity USD 3M Libor +α EUR 3M Libor USD 3M Libor B A +α b. During the term EUR 3M Libor S ㆍ X (USD) B A a. Start X FX spot rate(S) Bank for International Settlements. Second, the introduction of commercial FX brokerages enhanced the price function enhanced the price function Second, the introduction of commercial FX brokerages At a time when drastic changes occurred in the domestic and foreign financial foreign financial and domestic in the occurred changes drastic time when At a 3.1.5. FX Brokerages the expectation of raising came in 2000 with in Korea The first FX brokerage Though the CRS structure differs from that of an FX swap, thetwo swap types basically (EUR) mechanism on the FX market. With the introduction of FX brokerages, FX banks could FX banks could With the introduction of FX brokerages, mechanism on the FX market. At the time, price function. thus further enhance the market’s actively offer and bid and banks between transactions direct small-scale through only made were transactions FX bank, dealer a For transactions. large-scale conclude to ability the lacked and generally raise the competitiveness of domestic brokerages ahead of the entry of foreign competitors the competitiveness of domestic brokerages raise to minimize as cultivate multiple commercial FX brokerages as well market, into the Korean on the domestic market. the effect of foreign brokers environments, a free floating FX system was introduced accompaniedby liberalization of of system brokerage the monopoly over whether however, grew, Fears transactions. FX the Korea Financial Telecommunications and Clearings Institute would make it difficultto plan in line management a market In addition, this was efficiently run an FX brokerage. since 1999. The government sought to promoted of the FX market with the liberalization responsiveness to changes in the domestic and foreign financial environments, bolstering and promoting globalization. the efficiency of the FX market, serve the same purpose except for the exchange of rates floating during interest the contract term. Source: institutions institutions that either conduct the swap on their own or on behalf of other non-financial corporations. in USD/EUR Swap of Funds Involved Flow 2-10] [Figure 116 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan determining the best bid price is time-consuming and costly. In addition, FX banks prefer to conduct foreign currency transactions through brokerages for fear of their FX positions being exposed to the other party during trading. Otherwise, a direct deal should present their positions immediately. Furthermore, the concentration of transactions through such brokerages helped derive economies of scale, spurring expectations of new product development and higher quality service.
Third, commercial FX brokerages were seen as helping globalize the Korean FX market. This trend strengthened the international and domestic short- and long-term fund markets and the KRW’s globalization.
In Korea, the FX brokerage system proved successful and today, more than 95% of interbank FX spot transactions are handled by FX brokerages. A representative brokerage announces once per day the basic KRW-USD rate and those of other major currencies.
As of September 2015, FX banks active on the domestic interbank market comprised 17 domestic and 30 foreign banks. On the interbank market, Seoul Money Brokerage Co., 117
Ltd. and Korea Fund Brokerage Co. are the main intermediaries for spot exchange with a CHAPTER combined share of 90%. The country has 10 FX brokerages including four domestic. 02 Development of Azerbaijan’s FX and Related Derivative Markets [Figure 2-11] Flow Chart of FX Brokerages
FX Brokerage FX Banks Customers firms
Export, Import Interbank Bank to Customer Market Market companies Participating Interbank Public Market companies Brokerage FX Transaction FX Transaction Government Services (Buy & Sell) & (Buy & Sell) Entities
Customer Off-shore Reuters FX transaction Reuters Infomax Infomax Individuals
Information Information Etc.. Providers Providers
Source: Seoul Money Brokerage Services. 0.9 0.2 19.6 31.0 10.1 19.8 50.6 2017 (Unit: 100 billion USD) 9.6 0.8 0.2 19.4 29.0 18.4 48.4 2016 8.3 0.8 0.2 20.0 28.5 19.2 48.4 2015 7.6 0.8 0.3 17.5 27.7 19.0 45.3 2014 7.1 0.7 0.4 18.3 27.9 19.6 46.1 2013 6.6 0.7 0.3 27.4 19.8 45.4 18.0 2012 7.5 0.8 0.3 27.7 19.2 46.8 19.1 2011 Total Total Spots FX swaps Bank of Korea. Forwards Forwards Spots are FX sales transactions in which delivery is executed within 2 business days after is executed within 2 business days in which delivery Spots are FX sales transactions The daily average turnover of FX transactions including spots and derivatives on the the on derivatives and spots including transactions FX of turnover average daily The 3.1.6. Korean FX Market and Size 3.1.6. Korean growth and qualitative in both quantitative has made great strides FX market The Korean Currency swaps Derivatives total Currency options USD 19.8 billion in 2017. More recently, FX swaps have been widely used to manage the risk USD 19.8 billion in 2017. More recently, than lower was (39.1%) turnover FX overall in swaps FX of portion the but fluctuations, FX of currency turnover of daily average the 2017, In 2016. April in 46.9% of average world the swaps and options was USD 1.1 billion. to to strong hedging demand since the 2008 global financialcrisis. Alsoin 2017, the average comprising billion, 10.1 was USD transactions NDF including forwards of turnover daily when has increased since April 1999, 20% of FX sales. The volume of forward transactions of were allowed, and now comprise almost 82% of the combined volume NDF transactions for FX swaps was daily turnover forward turnover as a leading hedging tool. The average Source: accounting billion, 19.6 USD was turnover spot daily average the 2017, In day. contract the due increased also derivatives FX of trading The market. sales on the FX overall of 38.7% for to the 2008 global financial crisis, this figure has shown rapid recovery and returned to its of the world’s is roughly 1% market of April 2016, the volume of the FX level before 2008. As Settlements. turnover, according to the Bank for International combined market Banks (Daily Average) as Reported by in Korea 2-3> FX Turnover
Korea’s FX policy is divided into those for FX rate and FX system. The former is about the selection of an FX system and its stable operation, and the latter refers to policy toward current and capital transactions of financial institutions, corporations, and individuals. Changes in FX system policy affect the exchange rate either directly or indirectly through changes in FX supply and demand on the market. Thus both policy types are inseparable. The most recent significant policy action was the reintroduction of the forward FX position limit in July 2010, which effectively alleviated severe volatility in the exchange rate and the concentration of external debt.
[Figure 2-12] FX Policy Framework
Supervisory and Objectives of policy Scope of policy Policy authorities inspection agencies
• Facilitation of foreign • Financial Services transactions • Minister of Strategy and Commission • Maintaining of Finance • Exchange rate policy • Financial Supervisory equilibrium in the • Bank of Korea • FX system policy Service 119
balance of payments • Financial Services CHAPTER • Bank of Korea • Stabilization of the KRWs Commission external values 02
Agencies subject to Development of Azerbaijan’s FX and Related Derivative Markets Related agencies Basic laws Related laws policy
• Foreign Exchange • Bank of Korea Act • FX information • Foreign exchange bank Transactions Act (FETA) • Capital Market and concentration agency • Other foreign exchange • Enforcement decree of Financial Investment (BOK) agencies FETA Business Act • FX information analysis • Foreign exchange • Foreign Exchange • Foreign Investment agency(International brokerage company Transaction Regulations Promotion Act Finance Center) • Money exchangers • FSC's related regulations • External Trade Act
.Source: Bank of Korea
3.2.1. FX Rate Policy
3.2.1.1. Changes in FX Rate System
The Korean exchange rate system has gradually accommodated currency fluctuations in accordance with developments in the economy and financial markets. The country used a fixed exchange rate system until the 1970s and later introduced a multilateral basket system in 1980 to reflect changes in the monetary value of major trading partners. Under this system, the basic KRW-USD exchange rate was decided as the weighted average of a special (Unit: %) e 1997 ± free Dec.16, 1997 ± 10.0 Nov.20, Nov.20, 1995 ± 2.25 Dec.1, ± 1.5 1994 Nov.1, Nov.1, ± 1.0 1993 Oct.1, Trade weighted basket + Policy variabl + Policy weighted basket Trade ㆍ ± 0.8 1992 July1, ± 0.6 1991 Sept.2, SDR basket + β SDR basket ㆍ ± 0.4 1990 March2, * Exchange Rate = α * Exchange Bank of Korea. Bank of Korea. Bandwidth 3.2.1.2. Customer and Basic Exchange Rates 3.2.1.2. Customer and Basic Exchange on the revised based and FX bank each by independently determined are rates Customer In March 1990, the country sought to improve the market function of the FX rate by by function of the FX rate country sought to improve the market In March 1990, the Effective dates transaction volume-weighted average of the rates on the previous business day as reported previous business day on the of the rates volume-weighted average transaction FX brokerages. by Source: is the meanwhile, exchange rate, basic The spot exchange rate. interbank movement of the
Shifts in FX Rate Bandwidths 2,000
1,800
1,600
1,400
1,200
1,000
800 ‘98 ‘99 ‘00 ‘01 ‘02 ‘03 ‘04 ‘05 ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17
Source: Bank of Korea.
The basic KRW rates against other non-USD currencies are derived by arbitrating between the USD rates of other currencies on the international market and the basic KRW- 121
USD rate. These rates are calculated and provided by the designated brokerage, Seoul Money CHAPTER Brokerage Services, once a day. 02 Development of Azerbaijan’s FX and Related Derivative Markets 3.2.2. FX Authorities and Roles of Related Policy Institutions
The Minister of Economy and Finance (MOEF) has the final authority and responsibility for the establishment and management of FX policy and the stability of the FX market. In addition, he or she has authority over the registration of FX businesses, operation and management of FX equilibrium funds, restriction, and permission for conducting FX transactions, and emergency stop orders for such transactions according to the Act on Foreign Exchange Transactions.
The minister may supervise the duties of FX service agencies and place orders necessary for supervision. If necessary for the stability of the FX market and soundness of FX service agencies, restrictions may be imposed on the agencies’ services. The Act on Foreign Exchange Transactions entrusts or delegates several of the minister’s powers to the heads of the Bank of Korea (BOK), Financial Supervisory Service (FSS), Financial Supervisory Commission (FSC), and Korea Customs Service. The FX soundness policy is entrusted to the heads of the BOK and FSC. The central bank performs the function of negotiating FX policy and performs daily tasks for FX management such as market intervention. The FSC and FSS handle the supervision and inspection of FX businesses and follow-up management of related transactions Since 2006, all permissible items of capital transactions have been converted into converted into have been Since 2006, all permissible items of capital transactions In April 2002, Korea announced a three-stage plan on the medium and long-term plan on the medium and long-term announced a three-stage In April 2002, Korea Given fears over the heightened possibility of capital inflows and outflows after the first In June 1998, the government announced a plan to liberalize FX transactions in two in two FX transactions government announced a plan to liberalize In June 1998, the 3.2.3. FX System Policy 3.2.3. FX financial the 1997-98 Asian changed since has significantly FX system policy Korea's Transactions. Additional measures to promote overseas investment have followed, along along measures to promote overseas investment have followed, Additional Transactions. estate acquisition with relaxed regulations on individual foreign direct investment and real The scope of foreign currency securities permitted for individual Koreans. abroad by amount for a non- investors has also been widened. The exemption limit on the foreign debt oversupply of subsequent foreign currencies and encourage Korean companies to expand companies to expand Korean oversupply of subsequent foreign currencies and encourage domestic corporations. abroad through measures promoting investment abroad by Exchange on Foreign reportable ones under the supplementary sunset provision of the Act after the first two stages of liberalization. In July 2002, the first step was lifting limits on July 2002, the first step was lifting limits on In after the first two stages of liberalization. to take companies remittances, allowing securities and insurance transfer an individual’s by In June 2005, buoyed in KRW. and permitting export payments part in the FX market, the to resolve sought the government of payments, surplus in the balance the continued limits were abolished on individual travel expenses, immigration, and overseas deposits of immigration, expenses, travel limits were abolished on individual individual residents. development to further ease FX regulations that had remained direction of the FX market’s was also shifted from a positive to negative system. was also shifted from a positive to negative such as systems for variable deposit reserves safeguards were set up phase of liberalization, that started in January 2001, of liberalization In the second phase and FX concentration. stages. The Act on Foreign Exchange Management was abolished in April 1999 and replaced abolished in April 1999 and replaced Exchange Management was on Foreign stages. The Act by the Act on Foreign Exchange Transactions. In the first phase of liberalization carried out domestic related to overseas business activities of most FX transactions under the new law, non-financial and financial institutionswere liberalized. Regulation of capital transactions from certification to reporting. In July 1998,long-term overseas borrowing and the issuance allowing were liberalized, domestic institutions of more than a year by of debt securities effectively measures These bonds. and stocks Korean unlisted buy to investors foreign investment in domestic securities. most inbound foreign liberalized crisis. In 1998, the government liberalized all direct and indirect foreign investment by by foreign investment direct and indirect all liberalized 1998, the government crisis. In of foreign direct investment such investment and shifting the regulation abolishing limits on 122 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan resident held by residents was raised, while the FX position of FX banks was expanded as part of the streamlining of the FX market.
As such, liberalization measures for FX and capital transactions were stepped up by domestic companies, financial institutions, individuals, and foreign investors. The level of capital market liberalization in Korea is now close to that of developed economies.
3.3. Capital Market Liberalization
Capital market liberalization brings both positive and negative effects on an economy. The pros include procuring foreign capital needed for economic development, economic growth through the opening of the capital market, and advancement of financial markets. Among the cons are the monetary expansion, asset price bubbles, and FX volatility (sharp appreciation) that can result from inflows of foreign “hot money,” leading to problems in macroeconomic policy. Foreign capital outflows can also cause financial market instability through a plunge in stock prices and sharp depreciation of a country’s currency. In addition, the bankruptcy of financial institutions with poor FX liquidity management could spur the 123 collapse of both the domestic financial system and FX market. For this reason, emerging CHAPTER economies have conducted capital liberalization more gradually in line with their respective development stages and the development of financial markets. Capital market liberalization 02 Development of Azerbaijan’s FX and Related Derivative Markets is generally promoted in the order of wider domestic investment by nonresidents and then expanded overseas investment by residents. Foreign investment in a country starts with direct investment and then moves on to stock investment.
The types of regulations on capital flows can be classified as direct (administrative or direct) or indirect (market-based or indirect). First, direct restrictions on capital transactions can include limits on foreign borrowing by residents, prior approval of foreign investment in domestic securities, and restrictions on lending to nonresidents by domestic financial institutions. Indirect regulation methods have the advantage of higher transparency and predictability than direct regulation by imposing taxes or deposit obligations on capital flows and thus absorbing capital gains and losses through differentials between internal and external interest rates. Among indirect controls are the requirements for variable deposit (VDR) and marginal reserves and the financial transaction tax. The VDR is a method of depositing a percentage of a resident's foreign borrowing or currency issuance in the central bank without interest. The policy authority can also adjust the amount of capital movement by flexibly adjusting the deposit target and reserve ratio.
Institutions taking part in FEIS are classified as FX information concentration agencies 3.4.1. Foreign Exchange Information System Exchange 3.4.1. Foreign data on FX The BOK, as a major agency for collecting FX information, gathers key Thus prudential regulations on FX transactions were installed as safeguards. The were installed as safeguards. The transactions Thus prudential regulations on FX Since the 1997-98 Asian financial crisis, the Korean economy has grown increasingly increasingly has grown economy Asian financial crisis, the Korean Since the 1997-98 3.4. Monitoring and Supervision of Korean FX Market and Supervision of Korean 3.4. Monitoring (e.g., the BOK), mandatory reporting entities, and user institutions. All participating All participating (e.g., the BOK), mandatory reporting entities, and user institutions. quickly be can data FX that so network computer BOK a to connected are institutions exchanged. transactions to share with related institutions, thereby strengthening its monitoring of monitoring of strengthening its thereby to share with related institutions, transactions 1999 set up bank in April To this end, the central by all FX authorities. foreign currency flows (FEIS). Exchange Information System the Foreign due to the global financial crisis but rebounded to the level of USD 400 billion in June 2019. due to the global financial crisis but examine such flows and systemize and centralize the collection of information on FX of information on FX the collection and centralize examine such flows and systemize (BOK) has steadily crisis, the Bank of Korea Since the 1997-98 Asian economic transactions. not reserves Such demand. payment for emergency reserves to prepare FX its expanded currency foreign a suffers sector private the if rate to stabilize the FX be used can only reserve amount declined in late 2008 The BOK’s national credibility. shortage but also raise liberalization of such transactions early and effectively. early and effectively. of such transactions liberalization its monitoring of foreign currency flows in and government also decided to strengthen to closely (FEIS) Exchange Information System setting up the Foreign out of the country by sensitive to global financial trends given how fast FX liberalization in the country has has in the country liberalization financial trends given how fast FX sensitive to global due to external in domestic financial markets progressed. The threat of higher volatility decided to build infrastructure these reasons, the government risks has also increased. For from the negative effects to detect any on FX transactions and use data to concentrate equalization tax implemented in the US from 1963-74 are classified as financialtransaction taxes. The marginal reserve requirement is a central bank obligation to prepare payments for for payments prepare to obligation bank a central is requirement reserve marginal The is in parallel cut on the deposits and a rate a certain level, deposits that exceed nonresident common. The financial transaction tax is appliedby the government to a loan from abroad The principal. investment collects or securities domestic in invests who nonresident a to or and an interest James Tobin economist and Nobel laureate American by tax proposed Tobin 124 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan The BOK also acts as an FX information concentration agency to concentrate on, relay, and manage such data. Reporting agencies must also report such data including self- or third-party transactions to the central bank. Specifically, such agencies are FX businesses like FX banks.
User institutions include the Ministry of Economic and Finance (MOEF), the Financial Services Commission, National Tax Service, Korean Customs Service, Korea Financial Intelligence Unit, Financial Supervisory Service, Korea Deposit Insurance Corporation, and Korea Center for International Finance as well as the BOK. The central bank provides information on FX transactions concentrated in the FX network to user agencies such as MOEF. FX policy authorities can use this data to prepare measures to stabilize the FX market, compile major statistics such as those on balance of payments and foreign debt, and crack down on illegal market activity.
As of September 2015, the country had 1,162 institutions participating in FEIS, 103 of which were directly connected to the BOK and 1,059 indirectly connected through intermediary institutions. 125 CHAPTER
[Figure 2-14] Information Flows Among Institutions 02 Development of Azerbaijan’s FX and Related Derivative Markets Reporting FX Information Data Users Institutions Concentration Agency
HOST/PC
ㆍDomestic Banks (18) ㆍBOK ㆍForeign Bank Branches (41) ㆍMOSF ㆍKorea Securities Finance Corp. (1) ㆍFSC ㆍAsset Management Corps (137) ㆍNTS ㆍFutures Companies (5) ㆍBank of Korea ㆍKCS ㆍSecurities Companies (53) ㆍKoFIU ㆍInsurance Companies (52), etc. ㆍFSS ㆍ Total 1,557 institutions KDIC ㆍ (as of August 31, 2017) KCIF
Note: Ministry of Economy and Finance (MOEF), Financial Supervisory Service (FSS), Financial Services Commission (FSC), National Tax Service (NTS), Korea Customs Service (KCS), Korean Financial Intelligence Unit (KoFIU), Korean Deposit Insurance Corporation (KDIC), Korea Center for International Finance (KCIF). Source: Bank of Korea (2016). This regulation has been adjusted depending on the state of the domestic FX market. The market. FX domestic the of state the depending on adjusted been has This regulation 3.4.2.2. Regulation on FX Derivatives Position 3.4.2.2. Regulation on FX Derivatives positions to restrict the positions has regulated FX derivatives Since October 2010, Korea 3.4.2. FX Prudential Regulations 3.4.2. FX Position FX on Overall 3.4.2.1. Regulation Korea- the and domestic banks of positions such keep to seek position FX on Regulations position ratio has been strengthened by lowering the limit when capital volatility is high and lowering the limit when capital volatility is high and has been strengthened by position ratio FX trading continue also can Banks improves. situation market the when limit the raising guards restriction This limit. regulatory the reaches position related the if even derivatives forwards (NDF) within a certain level. At the time of the regulation’s introduction, the ratio introduction, the ratio forwards (NDF) within a certain level. At the time of the regulation’s and subordinated of the FX derivatives position was applied to domestic banks, brokerages, for Korea-based companies at half of their capital at the end of the previous month. The ratio of foreign banks was up to 250% of equity capital at the end of the previous month. branches of FX derivatives such as forwards, futures, FX and currency swaps, and non-deliverable non-deliverable of FX derivatives such as forwards, futures, FX and currency swaps, and process of selling FX spot transactions for a neutral position. Meanwhile, external debt position. Meanwhile, external debt for a neutral process of selling FX spot transactions caused the FX In addition, excessive FX selling on the market increased more than necessary. necessitated additional regulations to appreciate above an appropriate level, which spot rate on forward exchange positions. If an FX bank sells FX spot money equal to an FX forward exchange purchase, it could avoid If an FX bank sells FX spot money equal the forward position. Korea FX position even after increasing the regulation on overall faced strong pressure from foreign currency inflows through the FX forward market due to funds investment overseas of expansion the and 2008 in shipbuilding in boom export the the time, FX banks received FX forward selling in the asset management companies. At by spot exchange position debuted in 1964. That for FX forward exchange position followed exchange position followed debuted in 1964. That for FX forward spot exchange position system in position overall Then came the FX forward transactions. in July 1980, allowing into the position system was abolished and integrated April 1981. In July 1998, the forward FX reinstated in July 2010. Despite the overall FX position system, but the former was overall position is needed because of loopholes. regulation of the forward position system, separate based branches of foreign banks within a set range of equity capital. Overall FX position FX position of equity capital. Overall a set range of foreign banks within based branches spot and futures FX liabilities. of spot and futures FX assets minus refers to the amount prevents the position of a foreign the comprehensive position ceiling The regulation on of end the at capital equity the of 50% exceeding from excess (oversold) purchase currency system, the system for FX FX position During the evolution of Korea’s the previous month. 126 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan against the possibility of trading through counter positions because banks see only the net positions of FX derivatives as regulated. In addition, if a bank is expanding its equity capital, it can increase its FX derivative position. Korean banks have significantly expanded their equity levels since this regulation on FX derivatives position came out.
Korea’s FX Position Management System
When foreign currency assets and liabilities see imbalance, FX banks are exposed to exchange rate risk, which could result in either profit or loss. For an overbought position, a gain occurs when the exchange rate rises and a loss ensues if it falls. In contrast, overselling will see losses when the exchange rate rises and profit when it falls. Furthermore, an FX bank’s risk of insolvency to the point that it drastically disrupts the FX market increases as the FX open position widens. For this reason, the government regulates FX positions by setting limits on excess foreign currency buying or selling positions to maintain sound management of FX banks and prevent disruption on the FX market. Korea manages its foreign currency positions based on overall FX and FX derivatives positions. The total position limit is 50% of equity capital at the end of the previous month. The FX derivatives positions of domestic banks are set at 30%, while those of the domestic branches of foreign banks can reach up to 150% of their capital at the end of the previous month. 127 The overall position is calculated by the simple method (converted from the method of net CHAPTER summation position since January 1999 according to recommendation of the BIS Basel Committee). Under this method, the combined oversold and overbought positions by each currency are 02
computed and then compared; the higher score is set as the target FX position. The target FX Development of Azerbaijan’s FX and Related Derivative Markets position of derivatives is calculated by the net position method, in which the net position is subtracted from the total oversold position minus the overbought position by currency.
Regulation of the FX derivatives position is to improve macroeconomic stability by restraining the growth of foreign debt. The main objective is thus to consider potential increases in foreign debt against the net FX derivative position. For example, if Bank A’s currency position is USD 24 billion in the overbought position and USD 23 billion in the oversold position, USD 24 billion is the FX position under the simple position method, while the target FX position is USD 1 billion, or the difference between the two amounts.
For example:
- Overbought positions: EUR 8 billion, JPY 12 billion, and GBP 4 billion (total USD 24 billion)
- Oversold positions: USD 15 billion, EUR 8 billion (total USD 23 billion; each amount converted into USD)
Source: Bank of Korea, Korea's Foreign Exchange System and Market, 2016, p. 140. 1.0% 1.0% Non-resident, bank 2.0% 7.0% Resident Bank of Korea. 3.4.2.5. Reserve Requirements for Foreign Currency Deposits Currency for Foreign 3.4.2.5. Reserve Requirements up to a predetermined proportion of its FX An FX bank must maintain reserves 3.4.2.4. FX Loan Management (BOK) placed restrictions on foreign currency- 2007, the Bank of Korea In August 3.4.2.3. FX Stability Levy 3.4.2.3. FX imposed on a bank's 2011, is in August introduced levy, exchange stability The foreign Other deposits including demand Time deposit (maturity of more than 1 month); installment savings deposit certificates of deposit (more than 6 months) (more than 30 days); Source:
Reserve Requirements for Foreign Currency Deposits Currency for Foreign Reserve Requirements 2-5> The management of maturity mismatches in FX assets and liabilities was introduced with the so-called gap rate regulation that matches assets and liabilities by maturity. Starting with the debut of the FX liquidity (FX assets-to-liability) ratio during the 1997-98 Asian financial crisis, financial supervisory authorities introduced the asset/liability nonconformity ratio with a maturity of 7 days and a month. In 2001, implementation of the FX liquidity ratio was expanded to cover mid- to long-term foreign currency funds. In 2010, financial authorities gradually strengthened the ratio and proportion of FX liquidity regulations through measures such as a rule on the ratio of FX safe deposit holdings. The 2008 global financial crisis, however, exposed loopholes in the FX liquidity regulatory system and necessitated supplementary measures. The regulation on the management of asset/liability maturity mismatch works well without problems in the normal course of business, but remains limited when a severe credit crunch occurs. At the time of the 2008 global financial crisis, the Korean financial market was ravaged by liquidity depletion though all banks met the three- month FX liquidity ratio. This is because counterparty risk, which grows more evident in a crisis, was not considered. As a result, financial authorities revised FX liquidity regulations 129 in June 2016 to focus on strengthening soundness so that financial institutions could endure CHAPTER the situation in the short term (under a month). To do this, the FX liquidity coverage ratio 02
monitoring system was made a formal regulation based on a recommendation from the Development of Azerbaijan’s FX and Related Derivative Markets Basel Committee on Banking Supervision.
FX Liquidity Coverage RatioTarget Banks
Stock of high-quality liquid assets LCR Total net cash outflow over next 30 calendar days (cash outflows—cash inflows)
Required ratio 40-60% (2017) → 50-70% (2018) → 60-80% (2019)
Source: Bank of Korea. Development Plan FX (Derivatives) Market Development FX (Derivatives) Market (1st stage) Preparation of supervisory system (1st stage) Preparation on FX market. into fully free floating (2nd stage) Transition system and activation of FX exchange rate transaction market (3rd stage) Developing (or fostering) FX derivatives market FX Market Activation FX Market Other thing to keep in mind Other thing to keep Top 3 things to keep in mind 3 things to keep Top Build a pre-monitoring system to prevent another foreign currency crisis system to prevent another foreign Build a pre-monitoring quickly to such a crisis and regulation system that responds Set up a supervision the market Building an (secondary) FX market (FX spot, Building an (secondary) FX market Form an FX market (FX spots and forwards) that freely allows price determination by price determination by spots and forwards) that freely allows (FX an FX market Form
. 1. Construction of pre-monitoring system 2. Building a supervisory and regulatory system 3 forward) which freely determines its price. 1. To reduce the likelihood of currency crisis reduce the likelihood 1. To system to be able to 2. Develop FX Market respond quickly in the event of the currency crisis 3. Necessity to build an roadmap in the process of capital liberalization Policy Recommendations for Developing Developing for Recommendations Policy Market FX Azerbaijan’s ③ FX of distribution and compilation the is roadmap the preparing in task urgent most The ① ② Based on the analyses presented in Section 2 and 3, the KSP team proposes a three-stage presented in Section 2 and 3, the Based on the analyses [Figure 2-15] Policy Recommendation Framework 2-15] Policy Recommendation Framework [Figure of another FX liquidity crisis given Korea's experience in the 1997-98 Asian financial crisis, while acquiring an process of capital liberalization a phased roadmap is required in the properly managing external debt (or capital flows). appropriate level of FX reserves and is market FX derivatives of Azerbaijan’s roadmap for the development The three-stage [Figure 2-15]. summarized by transaction data and setup of a reporting system for FX businesses. To prevent the possibility possibility the prevent To businesses. FX for system reporting a of setup and data transaction roadmap for the development of Azerbaijan’s FX derivatives market, stressing the following FX derivatives market, of Azerbaijan’s roadmap for the development points. 4. 130 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 4.1. Preparation of Initial Supervisory System for FX Market (1st Stage)
4.1.1. Recommendation 1: Establish a regular reporting system for FX transactions and compile and distribute statistical data on such transactions
During the KSP team’s trip to Azerbaijan, members noticed a data transparency problem on the Azerbaijani FX market. The Central Bank of Azerbaijan Republic (CBAR) produces reports on cash currency operations but investors and financial researchers cannot access data on the trading volume of the central bank’s currency auctions, interbank operations, and their components. Even staff from the financial watchdog FIMSA mentioned the lack of public data on currency flows in and out of the country. FIMSA or the CBAR needs to build a database of FX transactions as well as compile data on the FX spot and forward positions of banks. Data on the interbank currency market should be collected in a systematic and centralized way and distributed to all market participants
In the initial stage, an electronic document reporting system linking designated FX 131 banks to FIMSA is needed; the system should be set up periodically at least once a week. CHAPTER Once FIMSA or the CBAR compiles FX transaction data, the subsequent distribution of such information to the public will help restore confidence among market participants. 02 Development of Azerbaijan’s FX and Related Derivative Markets
4.1.2. Recommendation 2: Review the roles of FX policy institutions
The KSP team also noticed that the roles of the CBAR and FIMSA in FX policy had apparently not been fully settled. Shortly after the second major currency devaluation in Azerbaijan in 2016, the government banned by law FX transactions by money changers. At the same time, FIMSA was designated the country’s financial regulatory authority, taking this duty away from the CBAR.
The government concluded that supervision of day-to-day operations such as bank licensing and regulations should be transferred from the CBAR to FIMSA, and that the central bank should focus on monetary policy, which the KSP team believes covers FX rate determination since the CBAR is a regular operator on the USD auction market as an organizer. FIMSA now supervises the operations of non-banking financial institutions like brokers, securities, insurance, and liquidation and processing companies, central depository institutions, and stock exchanges as well as banks. Thus the main government authority on FX policy is FIMSA, which can enforce laws and regulations, offer modifications, and supervise enforcement by other government bodies. The CBAR organizes FX auctions twice a week, mainly for USD, thus the central bank is thus the central auctions twice a week, mainly for USD, organizes FX The CBAR After the second major currency devaluation in Azerbaijan in 2015, the CBAR announced After the second major currency devaluation in Azerbaijan in 2015, the CBAR 4.1.4. Recommendation 4: Review roadmap on adopting floating FX rate on adopting floating FX roadmap 4.1.4. Recommendation 4: Review To To ensure effective monitoring of FX market transactions, the CBAR and FIMSA need to The The FX policy authority needs an effectiveFX market (transaction) monitoring system. 4.1.3. Recommendation 3: Form an FX market (transaction) monitoring system 3: Form an FX market (transaction) 4.1.3. Recommendation Yet FIMSA still has no regular reporting system for the FX transactions and positions and positions for the FX transactions reporting system still has no regular FIMSA Yet mainly on the sell side on behalf of SOFAZ and domestic banks on the buy side. The AZN- mainly on the sell side on behalf of SOFAZ USD rate sees little or no fluctuations at the end of bidding. In addition, no active interbank the launch of a free-floating exchangerate system at year’s end.Yet the domestic currency was obviously ill-prepared for free floating because of little or no fluctuations in the AZN- USD exchange rate. be either a government body (CBAR) or private institution under government control. FIMSA under government control. FIMSA or private institution be either a government body (CBAR) eligibility or number of money changers. must also set its policy direction on the concentrate data on such transactions. concentrate the designation of FX banks (elaboration Most importantly, decide what roles each side plays. The latter can agencies are necessary. concentration of eligibility) and that of FX information stage must build the proper infrastructure to compile and utilize data on FX transactions to and utilize data on FX transactions to compile stage must build the proper infrastructure detect negative effects on the FX market early and In Korea, effectively. FX authorities have strengthened their monitoring of FX flows in and out of the country As part of this drive, the (predecessor up set Korea that (FEIS) System Information Exchange Foreign the of setup early closely examine FX movement in Azerbaijan and of Stage 2 on Page 48) is advised to Because of the rise of globalized finance and multilateral trade, a small open economy is is economy a small open trade, and multilateral Because of the rise of globalized finance of volatility the likelihood financial trends, raising increasingly sensitive to international in domestic financial markets due to external risk. Thus the government in the developing responsibilities and setup of a coordination system connecting FX authorities. An FX An FX system connecting FX authorities. setup of a coordination responsibilities and setup in the is needed similar to and FIMSA system between the CBAR information exchange and MOEF. linking the BOK, FSC, FSS, Korea of FX banks. Furthermore, the FIMSA does not have an information sharing system with system with information sharing does not have an the FIMSA Furthermore, of FX banks. thus The KSP team exchange rate. and the basic auction transactions on the FX the CBAR be and regulation) systems (supervision and FX rates that policy toward recommends of roles and separation Another crucial step is to ensure the as it is in Korea. separated 132 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan trading of USD comes afterwards, as banks buying USD through the auctions merely sell dollars to their retail clients. This is because aside from the oil industry led by SOFAZ, the country has no other major supplier of USD. And since the huge currency devaluation in 2015, USD demand from retail consumers has been unidirectional. The Azerbaijani economy thus has a long way to move before adopting a fully free-floating exchange rate.
Azerbaijan has officially announced taking steps toward its adoption of a free-floating rate. To do so, the government must foster the secondary interbank market for FX spot transactions among banks without regular CBAR intervention. An exchange rate will arise as the result of FX trading among banks and fluctuate according to market supply and demand. For this, the integration of a Bloomberg-match USD auction with the interbank FX secondary market must be considered. The CBAR holds currency auctions twice a week for a predetermined short period of time separately from the interbank FX secondary market. The government also can consider the direct participation of SOFAZ in the interbank FX market.
4.1.5. Recommendation 5: Create a stable base of operations on the FX market 133 CHAPTER
The CBAR needs to secure an adequate level of FX reserves not only to stabilize the FX rate in the event of a foreign currency shortage in the private sector, but also help raise 02 Development of Azerbaijan’s FX and Related Derivative Markets national credibility. The central bank’s FX reserves in late 2018, however, were worth less than a sixth of SOFAZ’s. Azerbaijan ultimately needs to set the appropriate level of foreign reserves for the CBAR. To determine the amount, consideration should go to the patterns of Azerbaijan’s global trade, the extent of capital market opening, and the nation’s import- export structure. What is deemed the appropriate level of FX reserves varies by country, and thus the CBAR must conduct a study to set the proper amount. As a reference, the Bank of Korea’s FX reserves declined due to the global financial crisis in late 2008 but rebounded to the level of USD 400 billion in June 2019.
Azerbaijan can consider the exchange of the issuance of monetary stabilization bonds (MSBs) by CBAR and USD sales by SOFAZ. The central bank can supervise the management of FX reserves after acquiring USD from SOFAZ. Regulations on bank balance sheets, credit expansion limits, and capital inflow restrictions (i.e., variable deposit ratio) can be considered for ensuring prudence on the FX market. - 2014 37,104.1 13,758.3 (Unit: Million USD) (Unit: Million 5016.7 2015 3,574.1 but these CFDs are mostly 4 2016 3,974.4 33,147.0 2017 5,334.6 35,806.5 Stage) nd 2018 5,625.7 38,515.2 Transactions (2 Transactions CBAR SOFAZ SOFAZ, CBAR. SOFAZ, 4.2.1. Recommendation 1: Implement a floating exchange rate system exchange a floating 4.2.1. Recommendation 1: Implement a free floating In the second stage, Azerbaijan needs to move toward the adoption of 4.2. Floating Exchange Rate System and Promotion of FX Market System and Promotion Rate 4.2. Floating Exchange Thus Azerbaijan must develop forwards for hedging purposes. For that, the government for hedging purposes. For Thus Azerbaijan must develop forwards 4.1.6. Recommendation 6: Review plan to develop the forward market market the forward plan to develop 6: Review 4.1.6. Recommendation During Azerbaijan’s first major currency devaluation in 2015, banks with forwarddeals one of the firstretail trading platforms on the FX CFD market. MetaTrader has desktop, web, and mobilement versions.companies Certainlike invest InvestAZ provide user platforms to manage their accounts, deposits, withdrawals, access to and positions is used in transactions of (AZN-USD). MetaTrader transactions of spot currency and exchange accounts, inter-account transfers, trading on both the OTC and exchange market. The Baku Stock Exchange has just one liquidity provider on the FX CFD exchange is an estimated AZN 7 billion. transactions The volume of this market’s market. Individuals or entities who want to a trade CFDs trading platform for developed by Meta currencies mainly Quotes, use MetaTrader, USD (mln) 4 exchange rate along with the installation of systems for FX market monitoring and monitoring and along with the installation of systems for FX market exchange rate for conditions demand and supply market of maturation the and supervision initial the country must promote interbank market adopt the rate, To accommodating such a rate. whose results will eventually lead to the setting of a basic exchange rate. transactions, reduce the speculative property of a CFD by decreasing the leverage ratio (i.e., raising both (i.e., raising ratio leverage the decreasing by CFD a of property speculative the reduce or eligibility for participation) for the protection of the initial and maintenance margins creation of a forward market. financial consumers and inducing the types of CFD contracts exist based on 25-30 underlying currencies exist based on 25-30 underlying types of CFD contracts in AZN. speculators. No CFD product is denominated used by suppliers. It must also USD) vs FX forwards (AZN needs to review a plan for developing experienced huge losses in the wake of skyrocketing premiums, and this caused the banks the banks premiums, and this caused of skyrocketing losses in the wake experienced huge to stop trading forwards for a while. On the other hand, trading of contracts for difference worth (NDF), grew active with an annual market (CFDs), a type of non-delivery forward most saw the of a CFD is 1:100. This market leverage around AZN 10 billion. The average 50 Around market. financial entire the but sector currency the in only not improvement Source:
FX Reserves Held by SOFAZ and CBAR and SOFAZ Held by 2-7> FX Reserves Given the Korean experience and the aftermath of Azerbaijan’s two major devaluations, the KSP team recommends the adoption of MARS. This means that at this stage, Azerbaijan’s floating exchange rate must retain the daily fluctuation limit but with upper and lower limits around the basic exchange rate.
4.2.2. Recommendation 2: Set up FX brokerages
Korea’s first FX brokerage came in2000 amid drastic changes in the domestic and foreign 135 financial environments. As the FX rate system was scrapped in favor of one featuring a free- CHAPTER floating exchange rate and the liberalization of FX transactions saw progress, fears arose over how to efficiently run FX brokering under a monopoly brokerage system of the Korea 02 Development of Azerbaijan’s FX and Related Derivative Markets Financial Telecommunications and Clearings Institute. The government approved the entry of FX brokerages to enhance the price function mechanism, efficiency of the FX market, and globalization of domestic finance. With the introduction of FX brokerages, FX banks could actively offer and bid, and this helped enhance the price function on the market.
For Azerbaijan, the KSP team recommends in the initial stage a form of government ownership with one brokerage to start. The Azerbaijani government should also designate the FX brokerage to also announce an official basic FX rate and secure data on FX transactions.
4.2.3. Recommendation 3: Promote interbank FX and domestic money markets
Fund transactions in Azerbaijani bank mostly support business activities. In other words, fund trading by banks could reflect the capital needs of export and import companies, and demand for funding will occur in both the domestic and foreign currencies. In practice, FX transactions should be closely related to transactions on the FX fund market. The function of the FX market is considered inseparable from that of the FX fund market.
liberalization 4.2.5. Recommendation 5: Devise a roadmap for promoting capital transaction for promoting a roadmap 4.2.5. Recommendation 5: Devise and extent This recommendation focuses on the determination of the basic direction B) Regulation of ratio of FX derivatives position B) Regulation of ratio deposits C) Reserve requirements for foreign currency D) FX stability levy E) Regulation of foreign currency liquidity The country has since scrapped the above measures and replaced them with the the with them replaced and measures above the scrapped since has country The limits on FX spot and forward positions A) Separate 4.2.4. Recommendation 4: Set up FX prudential regulations 4.2.4. Recommendation 4: Set up FX to foreign investment, the capital markets decided to open its In 2000 when Korea Azerbaijan thus must form links between the short-term AZN and FX money markets. and FX money markets. short-term AZN links between the thus must form Azerbaijan businesses must also in export and import real-sector transactions The promotion of positive and negative effects on an economy. The pros include procuring foreign capital The pros include procuring foreign capital positive and negative effects on an economy. and needed for economic development, economic growth through capital liberalization, asset expansion, are monetary cons the Among markets. financial of advancement the of capital transaction liberalization. Capital transaction liberalization is known to bring is known to bring liberalization Capital transaction liberalization. of capital transaction following FX prudential regulations. government considered a slew of potential FX prudential regulation including the variable government considered a slew of potential deposit reserve (VDR) and marginal reserve requirements and the financial transaction tax. of a resident's foreign borrowing or FX issuanceThe VDR requirement refers to a percentage without interest. The policy authority can adjust the bank being deposited in the central ratio. the deposit target and reserve flexibly adjusting capital movement amount by market. be a precondition for boosting the volume of financial transactions.Without support from import industries, FX supply and such as the development of export and real sector demand real the Thus transactions. financial on relying just by unstable grow ultimately demand policy of promoting exports. In that expansion through an industrial sector needs steady to promote the interbank FX policy should be considered sense, an export diversification The promotion of the interbank FX market should be accompanied by that of the short-term that of the be accompanied by should FX market of the interbank The promotion market. AZN money 136 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan price bubbles, and FX rate volatility (sharp appreciation) caused by foreign capital inflows that could create problems in macroeconomic policy. Foreign capital outflows could also contribute to financial market instability through a plunge in stock prices and sharp depreciation of the domestic currency. In addition, the bankruptcy of financial institutions with poor FX liquidity management could collapse the domestic financial system and FX market. For this reason, emerging economies have conducted such capital liberalization gradually based on each nation’s economic development stage and development of financial markets. Such liberalization is generally promoted first by allowing domestic investment by nonresidents and then overseas investment by residents. The former investment form is done in the order of direct and stock investment.
The scope and pace of capital liberalization should thus be determined by considering a country’s economy and stage of financial market development. Regulation of capital flows can be classified as direct (administrative or direct) or indirect (market-based or indirect) regulations. Liberalization can be gradually implemented by sector. Azerbaijan can first mitigate (or abolish) limits on domestic bonds and equity investment for foreign investors, and then ease limits on overseas bonds and stock investment (i.e., purpose, size, 137 and maturity) for domestic investors (in the order of financial institution, non-financial CHAPTER corporation, and individual investor). 02 Development of Azerbaijan’s FX and Related Derivative Markets 4.2.6. Recommendation 6: Devise effective plan to manage FX reserves and foreign debt (or capital flows)
For foreign debt, the size of short-term foreign debt should be kept within a controllable range through prudential regulations like Korea’s Foreign Exchange Stability Levy and a regulation on FX liquidity.
4.2.7. Recommendation 7: Build a foreign exchange information system
Since the 1997-98 Asian financial crisis, the Korean economy has grown increasingly sensitive to international financial trends with the rapid liberalization of FX trading. Volatility fears in the country’s financial markets have also risen due to external risks. Thus the government has set up infrastructure to concentrate and use data on FX transactions to help detect negative effects from FX liberalization early and effectively.
The Bank of Korea (BOK), in addition to supervising monetary policy, is also a major FX information concentration agency that collects related data to be shared with FX institutions, thereby strengthening the monitoring function of FX flow for all FX authorities. To this end, Stage) rd For currency futures, Azerbaijan needs to consider listing FX futures denominated in currency futures, Azerbaijan needs to consider listing FX futures denominated in For 4.3.3. Recommendation 3: Develop currency futures and forwards denominated in AZN and forwards futures currency 4.3.3. Recommendation 3: Develop The cross-currency basis swap (CRS) is a transaction in which one party borrows a in which one party borrows a is a transaction The cross-currency basis swap (CRS) 4.3.2.Recommendation 2: Promote currency swaps currency 4.3.2.Recommendation 2: Promote 4.3.1. Recommendation 1: Foster FX swaps 4.3.1. Recommendation 1: Foster FX and party another from currency a borrows party one which in contract a is swap FX An 4.3. Developing FX Derivatives Market (3 FX Derivatives 4.3. Developing spot FX the between links enhanced requires trading derivatives FX of promotion The AZN versus USD on the Baku Stock Exchange (BSE), after which demand for speculative for speculative AZN versus USD on the Baku Stock Exchange (BSE), after which demand contract. The CRS has a maturity of more than a year and the FX swap up to 12 months. The The CRS has a maturity of more than a year and the FX swap up to 12 months. contract. long-term (i.e., market financial long-term the with connection in develop must thus CRS government bonds) currency from the counterparty and simultaneously lends the same value in another simultaneously lends the same value in another currency from the counterparty and Though the structure of such a swap differs from currency to at the the other spot party. rate the exchange of that of an FX swap, both swaps basically serve the same purpose except for floatingrates during the contract term. The main difference lies in the maturity of the swap forward discount depends on interest rate differential (the bond yield curve is required). differential (the bond yield curve is required). rate forward discount depends on interest of FX swap banks. will prove helpful to the development The promotion of FX brokerages simultaneously lends another currency to the counterparty. Each party uses the repayment Each party uses the repayment to the counterparty. simultaneously lends another currency at predetermined is amount repayment the and as collateral counterpart its to obligation Thus FX swaps can be viewed as FX contract. from the beginning of the the FX forward rate short- with along develop lending and can also and/or borrowing collateralized risk-free bonds) because activity (i.e., CDs, CPs, and short-term government term financial market nonresidents; and meeting new demand for FX trading. meeting new demand for FX trading. nonresidents; and and forward markets and between the FX and AZN money markets. This necessitates the This necessitates the the FX and AZN money markets. and between and forward markets intermediary agencies, fostering participants by of market expansion and diversification of (expectation) trend unidirectional the eliminating and volume, transaction increasing equipping hedging capital liberalization, Other preconditions include expanding FX rates. domestic investment by residents and risk of overseas investment by tools against the FX the BOK in April 1999 created the Foreign Exchange Information System (FEIS). System Information Exchange the Foreign April 1999 created the BOK in 138 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan CFDs will loosen accordingly. Yet the development of forward products should come before that of futures because futures contracts are highly standardized while the terms of forward contracts can be privately negotiated between FX banks and their exporter and importer clients.
A domestic bank taking the opposite position of a retail customer can conduct hedging through a combination of FX spot and FX swap transactions on the interbank market in the early stage. This method is recommended since forward discount carries a heavy burden in an underdeveloped market and fuels fear of default by the counterparty.
4.3.4. Recommendation 4: Consider opening capital markets
At this stage, Azerbaijan can seriously consider fully opening its capital markets. The crucial consideration is how to step up the scope and pace of capital liberalization in line with the country’s economic development stage and development of financial markets. Again, the KSP team recommends that such liberalization is conducted in the order of allowing domestic investment by nonresidents and then overseas investment by residents. 139
The former should also be liberalized in the order of direct and stock investment. CHAPTER 02
5. Conclusion Development of Azerbaijan’s FX and Related Derivative Markets
In recent years, Azerbaijan suffered a large current-account deficit and near depletion of its FX reserves, with the AZN suffering devaluation of 98% from 2015-16. The surge in FX volatility also fueled higher demand for hedging the AZN. Entering 2017, the country’s FX market saw restored confidence due to the recovery of global oil prices.
In 2018, the Financial Market Supervisory Authority (FIMSA) assigned the KSP team to prepare measures promoting the FX derivatives market to alleviate FX jitters. During its visit to Azerbaijan, however, the team learned of the country’s continuous high demand for foreign currency (USD) on the market because of lingering fears of another devaluation debacle. In a sense, this kind of market environment is speculative enough to trigger another devaluation (unidirectional) if the FX derivatives market is set up without FX prudential measures.
This report provided an overview of Azerbaijan’s FX market, explanation of the Korean experience in building and advancing its FX market and relevant infrastructure, and policy suggestions for the development of Azerbaijan’s FX market. The KSP team proposes a three- stage roadmap for the development of the FX derivatives market in Azerbaijan and stresses To research and write this report, the author and the KSP team visited Azerbaijan three research and write this report, the author and the KSP team visited To Azerbaijan will find it extremely helpful to learn from the Korean experience. As a As a experience. the Korean it extremely helpful to learn from Azerbaijan will find to overcoming financial crises. to four meetings with relevant government agencies and experts such as staff from FIMSA, in sincerely hope that FX policy authorities BSE and major Azerbaijani banks. We CBAR, Azerbaijan shun institutional selfishness and instead strive to build a cooperation system to ensure smooth and effective FX market operations. InKorea, cooperation among the central and Finance turned out to be crucial of Economy bank, financial regulators, and the Ministry was thanks to the strategic and ultimately successful policy efforts ofKorean FX authorities and planning. three also held They relevance. and accuracy ensure 2019 to to May 2018 from October times country with trade and capital flows open to all countries,Korea overcame both the 1997-98 Asian financial crisisand the 2008 global financial crisis despite the threat of FX speculation The overcoming of both crises currency. not being a major world KRW stemming from the two recommendations here. The first is to compile and distribute data on FX transactions liquidity crisis prevent another currency To for FX businesses. a reporting system and set up for a phased roadmap is to promote the second suggestion experience, Korea's based on reserves and level of FX acquiring an appropriate process while liberalization the capital outflows). external debt (or capital inflows and properly managing 140 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan References
Ahn, Byungchan, Exchange Rate and Foreign Exchange Rate Policies in Korea, Seoul: Hannarae Publishing, 2013. [in Korean].
Bank of Korea, Financial Institutions in Korea, 2011. [in Korean].
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Bin, Kibeom, and Woncheol Kang, , The Concepts of Foreign Exchange Market and Foreign 141 CHAPTER Currency Money Market and the Role of Capital Market, Issue Paper 09-03, Korea Capital Market Institute, 2009. [in Korean]. 02 Development of Azerbaijan’s FX and Related Derivative Markets Conrad, Jurgen F., Azerbaijan: Financial Sector Assessment,” Asian Development Bank Central and West Asia Working Paper Series No. 3, 2012.
Hasanov, Rashad, Currency Market in Azerbaijan: Challenging Environment for the National Currency, CESD Research Paper, Center for Economic and Social Development, 2016.
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Benchmarking Korea’s Experience Benchmarking Korea’s Policy Recommendations Evaluation of Azerbaijan’s Environment for Stock and Stock-related and Stock-related for Stock Environment Evaluation of Azerbaijan’s Derivatives Markets CHAPTER Keywords Privatization Market Development, Stock, Stock Derivative, Stock Index, 5. Conclusion 3. 4. 2. 1. Introduction Museyyib Mehdiyev (Baku Stock Exchange) Mehdiyev Museyyib Wook Chang (Duksung Women’s University) Chang (Duksung Women’s Wook Stock-related Derivatives Markets Derivatives Stock-related Developing Azerbaijan’s Stock and Azerbaijan’s Developing 03 142 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
Wook Chang (Duksung Women’s University) Museyyib Mehdiyev (Baku Stock Exchange)
Summary
This project is under the 2018/19 Knowledge Sharing Program (KSP) with Azerbaijan has the title “Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan.” The main purpose of this study is to provide the Financial Market Supervisory Authority (FIMSA) with useful and hands-on recommendations to make the 143 CHAPTER country’s capital market more competitive and innovative to support the unstable domestic economy, which fluctuates because of international oil prices. This chapter covers and 03 proposes recommendations to develop the Azerbaijani stock market more efficiently as well Developing Azerbaijan’s Stock and Stock-related Derivatives Markets as introduce a stock-related derivatives market as a vehicle to hedge against investor losses.
This study presents 14 policy recommendations for Azerbaijan’s stock and stock-related derivatives markets. The recommendations for the stock market and those for related derivatives markets are divided because both markets should be developed at the same time and the goals set for each market are different. The recommendations to develop the stock market can also serve as conditions to develop a stock-related derivatives market. The first condition is to increase trading volume of the stock market. Good underlying securities representing the volatility of the stock market are needed for hedging purposes. The second condition is the efficiency of the fast-price discovery function of the stock market. Because volatility is hedged, continuous mark-to-market fair pricing of underlying securities is needed. The third and final condition is the consolidation of confidence in market infrastructure. Market players such as large securities companies are needed to actively participate in the market.
The recommendations are as follows. Recommendation I is to increase market supply and leads to R[1] I-1) privatization of government-owned companies, R[2] I-2) relaxation of listing standards, and R[3] I-3) fostering of the venture ecosystem to satisfy Condition I, The Financial Market Supervisory Supervisory Market The Financial 1 Introduction This study is arranged in the following order. First, analysis of the stock markets of of markets stock the of analysis First, order. following the in arranged is study This Azerbaijan must develop and advance its stock and stock-related derivatives markets. its stock and stock-related derivatives markets. Azerbaijan must develop and advance The following recommendations seek to develop the stock-related derivatives market to develop the stock-related derivatives market The following recommendations seek one company is listed in the premium division (first tier) and five in the standard division (second tier). division (first tier) and five in the standard one company is listed in the premium Azerbaijan has 907 listed companies but 901 are listed in the alternative division (third tier) on the Baku Stock Exchange (BSE). Just and threats of the Azerbaijani market are also covered. Second, the Korean experience and are also covered. Second, the Korean and threats of the Azerbaijani market the stock and global standards as benchmarks are explored covering the legal framework, 1 domestic companies. demand, and supply markets, secondary and primary the including covered is Azerbaijan The strengths and weaknesses and opportunities and the legal and regulatory frameworks. companies is low and trading volume remains small. remains volume and trading low is companies economic against hedge efficiently to markets two the foster to seeks (FIMSA) Authority material prices and foreign exchange(FX) of raw uncertainty due to the high volatility economic development is important, but so is building stock market Azerbaijan, To rates. to prevent another FX crisis and stabilizing the revenue and values of infrastructure 1. listed prime of number the but 2004, in (BSE) Exchange Stock Baku the on debuted Trading organize market infrastructure; R[11] VI-1) incubation of sound and qualified speculators; for investment in stock-related favorable R[12] VI-2) design of tax and fee mechanisms accounting; and R[14] VI-4) design a marking-to- derivatives; [13] VI-3) design risk-aversion mechanism. market Condition III, which is consolidation of confidence in market infrastructure. is consolidation of confidence in market Condition III, which leads and product star potential a on focus to is V Recommendation vehicle. hedging a as to is VI Recommendation start. to products derivative two or one only offer V-1) R[10] to continuous trading environment; R[7] III-2) offering of the market-making process, and R[8] Condition satisfy and market stock the represent to indexes stock various of design III-3) market. stock the of function discovery fast-price the of efficiency ensure is which II, of financial institutions and leads IV is to consolidate the confidence Recommendation on securities companies to satisfy of laws and regulations to R[9] IV-1) reorganization which is raising the (trading) volume of the stock market. Recommendation II is to increase to is II Recommendation market. stock the of volume (trading) the raising is which fund and mutual the asset management II-1) fostering and leads to R[4] demand market satisfy to investors for fees and taxes of exemption or reduction II-2) R[5] and industry Recommendation of the stock market. volume the (trading) increase is to I, which Condition promotion of a mechanisms and leads to R[6] III-1) efficient market III is to promote 144 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan stock-related derivatives markets, and supervision of the securities sector, followed by the recommended direction for development of the Azerbaijani market. Third, the gap between “as is” and “to be” is studied and tasks to fill the gap are suggested. Finally, a roadmap for development and detailed recommendations are put forth.
This chapter comprises five sections. Second 2 evaluates the stock market environment of Azerbaijan. Section 3 introduces the Korean experience in developing the stock and related derivatives markets. Section 4 offers policy recommendations and Section 5 concludes this chapter.
2. Evaluation of Azerbaijan’s Environment for Stock and Stock-related Derivatives Markets2
2.1. Review of Azerbaijan’s Stock Market
2.1.1. Overview of Primary and Secondary Markets 145 CHAPTER 2.1.1.1. History 03
Analysis of the privatization of government properties during 1996-2001 is indispensable Developing Azerbaijan’s Stock and Stock-related Derivatives Markets for gaining a clear understanding of the Azerbaijani stock market, especially of the acquired characteristics of the primary and secondary markets and their development since the 1990s. After the 1991 collapse of the Soviet Union, Azerbaijan conducted economic reform to form a free market and market mechanisms to eventually produce an independent national economy. Privatization of public property was essential during that process and featured three stages. Compared to most former Soviet republics, Azerbaijan needed a longer preparation time for privatization and started quite late in the game, two factors that prevented success in the remaining stages of the process. The preparatory period of 1990-95 is considered the initial stage characterized by the preparation of regulations and normative legal base and establishment of a conceptual framework to manage privatization. 1996 saw the launch of the next stage, the so-called State Program for Privatization of State-owned Property in Azerbaijan, which lasted through 1998. During that period, privatization checks were distributed to all citizens born before January 1, 1996, who owned the right to sell or buy shares in public property. Because this program started late, most government-owned properties remained owner-less or were poorly managed, and this led to the termination of the program’s operations or a huge decline in its capacity. This, in turn, prevented proper
2 Chapter 2’s content mostly references a report prepared by Azerbaijan-based consultant Musyib Mehdiyev. I sincerely thank him for his dedicated work.
(Unit: %) Government Bonds Bonds Corporate Stocks 1 94 5 shows how an undeveloped stock market is reflected by the lowest is reflected shows how an undeveloped stock market
3 The Statistics of the Baku Stock Exchange. The Baku Stock Exchange (BSE) has three market tiers—alternative, standard, and standard, and tiers—alternative, The Baku Stock Exchange (BSE) has three market 2.1.1.2. Overview of Stock Market of Stock 2.1.1.2. Overview are due to stock market the problems and weaknesses of the Azerbaijani Overall, All 2018 statistics cover the period from January through November. January through period from the All 2018 statistics cover premium—and more than 919 companies with a combined capitalization of USD 3.3 3.3 USD of capitalization a combined with companies 919 than more premium—and 3 Source: weak management of the privatization process and improper application of free market process and improper application of free market weak management of the privatization mechanisms. [Figure 3-1] in the stock exchange market. percentage of turnover it takes on Bond and Stock Markets 3-1] Turnover [Figure supply and demand on the BSE. supply and demand an extension of maturity of privatization checks, and a new law on the privatization of state- of privatization checks, and a new an extension of maturity the process slowed and people who enacted. Despite these changes, owned property was As a result, ownership of SMEs preferred to sell them to property owners. had checks mostly privatization unsuccessful the conclusion, In shareholders. few or single to consolidated was and market, segments, secondary market of Azerbaijan’s characteristics process shaped the valuation of most of the properties, and methods used in calculation remained uncertain. uncertain. remained calculation in used methods and properties, the of most of valuation ensued institutional investors and foreign domestic by low participation Correspondingly, small properties, especially of privatized the mismanagement auctions, and in privatization or targets its to reach failed this stage Overall, continued. enterprises (SMEs), and medium produce effective results in economic and social reforms. The final stage started in 1999 with 146 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan billion are ranked according to these tiers. Considering that most listed companies are in the alternative segment, which has no entrance requirements, and just one company is classified as premium and four as standard, listed companies are mostly are SMEs with low levels of performance, transparency, corporate governance, and reporting responsibility. These factors also explain the low trading turnover on the BSE. In addition, the number of companies listed in each segment and their market capitalization have seen no major changes in the last six years, a clear sign of market underdevelopment
. Market Capitalization of Each Segment and No. of Listed CompaniesPanel A: Market Capitalization (Unit: USD)
2013 2014 2015 2016 2017 2018
Alternative 1,423,689,596 1,508,453,329 2,294,487,886 2,348,465,208 1,679,332,214 1,750,420,447
Standard 50,002,466 50,002,466 308,132,606 308,132,606 313,133,610 518,983,610
Premium 21,000,000 21,000,000 21,000,000 21,000,000 1,241,287,248 1,241,287,248
Total 1,494,692,062 1,579,455,795 2,623,620,492 2,677,597,814 3,233,753,072 3,510,691,305 147
Change - 84,763,732 1,044,164,698 53,977,322 556,155,258 276,938,233 CHAPTER
Source: The Statistics of the Baku Stock Exchange. 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets Panel B: No. of Listed Companies (Unit: Number)
2013 2014 2015 2016 2017 2018
Alternative 841 886 912 943 895 914
Standard 1 1 3 3 3 4
Premium 1 1 1 1 1 1
Total 843 888 916 947 899 919
Source: The Statistics of the Baku Stock Exchange.
As seen in the tables above, the number of listed companies in the standard and premium tiers saw no change but their market capitalization rose. This is because after the financial crisis in 2016, banks issued new shares to raise capital and certain small or medium banks were delisted because of bankruptcy. As a result, the number of listed companies has not changed but market capitalization of the premium and standard tiers has increased.
To get listed on a regulated market, an issuer must submit several documents with a prospectus and sign a contract with the BSE on the obligations of both sides. According to laws on the Azerbaijani capital market, if issued or traded shares comprise under 10% of (Unit: %) First type listed companies Second type listed companies 62 38 The Statistics of the Baku Stock Exchange. Source: [Figure 3-2] Market Capitalization Based on Listing Type [Figure share price does not come for a long time. As a result, most companies listed on the BSE lack share price does not come for a long proper corporate governance and financial transparency and show low operating capacity; capitalization, main The shareholders. existing among traded mostly are shares their of such companies’ 3-2], and many [Figure company however, lies with the first type of listed on the secondary market. issues are traded contracts contracts with the BSE as the first type of listedcompanies. The second type is remaining Without no liability. and carrying BSE contracts companies listed without having signed the nominal value of all of those shares is determined depending on performance or status, as AZN 2, which does not reflect realvalue, and in most of them, even a small fluctuation in and contract if a shareholder wants to sell shares on a regulated market and the number number the and market regulated a on shares sell to wants a shareholder if contract and As the result, companies that shares. overall under 10% of a company’s of shares comprise governance, financial requirements for corporate liability like this carry no any list like as normally listed companies do. This study will coverreporting, and publishing information a prospectus with other documents and signed normally listed companies that submitted privatized properties began to gather shares from minor shareholders who bought shares shares bought who shareholders minor from shares gather to began properties privatized minor shareholders go through checks distributed in 1997. Thus when with the privatization investment companies to sell their shares on the regulated market to fulfill sell orders, the The BSE also prospectus or contract. shares of these companies without a BSE lists the whole without requiring a prospectus whole shares in an alternative segment allows the listing of the paid-in capital of a shareholding company, no prospectus is required. Just 16 companies Just 16 companies is required. no prospectus company, capital of a shareholding the paid-in a contract and signing submitted prospectuses having market, on the regulated are listed from 1996-2001, those privatized are mainly companies 898 The remaining the BSE. with real estate value; simply having and others operations of them terminating with some the main shareholders of As mentioned above, low production capacity. most of them show 148 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 2.1.1.3. Primary Market
On the Baku Stock Exchange (BSE), the shares of 16 companies (excluding those delisted) were listed by submitting a prospectus and meeting the requirements set by BSE regulations and signing contracts between the issuers and the exchange. Only two of them are not from the financial sector and one is a non-financial company that is government owned, Azercosmos, a satellite-based telecommunication company. The other is the government- owned non-banking credit union Agrolizing, which lends to the agricultural sector. The remaining companies are banks, insurers, and non-banking credit organizations, most of which were listed before Azerbaijan’s 2016 currency devaluation crisis. As shown in
, the number of companies listed on the premium and standard markets did not change after the crisis and no new companies applied for listing. During the crisis, most banks faced insolvency and nearly 12 of them were closed. During the recovery period of 2017-18, several banks issued new shares to raise their capitalization and decrease the crisis’ effects. This was the main reason for increasing market capitalization on the standard and premium markets (Table 3-1) and boosting primary market turnover during 2017-18 [Figure 3-3]. 149[Figure 3-3] Primary Market Turnover by Year CHAPTER
(Unit: AZN) 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
800,000,000
700,000,000
600,000,000
500,000,000
400,000,000
300,000,000
200,000,000
100,000,000
0 2015 2015.5 2016 2016.5 2017 2017.5 2018
Source: The Statistics of the Baku Stock Exchange.
The 2017 surge in turnover was mainly due to International Bank of Azerbaijan (IBAR), the country’s biggest bank that was facing insolvency, issued new shares worth AZN 600 million to raise its capital and government-backed debt. The number of trade orders in 2016 was 18 and nine in 2017. In 2016, IBAR-issued shares were bought in just two orders. From (Unit: AZN) 2018 Total 2017 Second type listed First type listed 2016 0 5,000,000 10,000,000 15,000,000 35,000,000 25,000,000 20,000,000 45,000,000 30,000,000 40,000,000 The Statistics of the Baku Stock Exchange. 2.1.1.4. Secondary Market 2.1.1.4. Secondary companies that are only investment markets, capital to laws on Azerbaijan’s According Source: which saw growth from 2015-18, however. This study will analyze trading orders based on trading however. This study will analyze which saw growth from 2015-18, and identify the reasons behind the increase the shares of the two types of listed companies of volume on the secondary market. Year by 3-4] Secondary Market Turnover [Figure movements, or analyze markets. So to place trade orders, individuals have to physically go to orders, individuals have to physically So to place trade movements, or analyze markets. fill out, submit,an andinvestment signcompany, a order trade form then have legal entities execution. after the order’s the original copy email and then send submit the order form by and severely limits of the secondary market This poses a major barrier to the development market, as well as ensure low volume on the secondary investor access to capital markets, BSE members can directly access the exchange’s trading platform Centralized Exchange Exchange Centralized platform trading exchange’s the access directly can members BSE these members. can place their orders through and traders of Azerbaijan (CETA), Trading going to the latter’s with investment companies by do this, investors must sign contracts To National Depository Center (NDC). The main drawback offices and opening accounts with the to place orders, observe price for traders application or platform is the lack of a trading study’s supply and demand section. study’s January to November 2018, the number of trade orders on the primary market increased increased market orders on the primary the number of trade November 2018, January to best country’s the Bank, Kapital by stock preferred of issuance the to due mainly 64 to not the crisis are apparently investors since Overall, bank, at 15% interest. performing interested in participating in public offers and mostly bank shareholders have bought newly detail in this will be discussed in more on the primary market orders issued shares. Trade 150 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan In 2016, 373 of 947 listed companies had their stocks traded and 1,849 trade orders were processed based on the issues. The value of these trades reached AZN 2,849,216.95, or AZN 957,038.15 worth from 85 completed orders from the shares of the first type of listed companies and AZN 1,892,178.80 from 1,764 finished orders from the stocks of the second type. Of the 85 orders, 75 were based on IBAR shares and most trading volume (AZN 741,185.64) came from the first type through IBAR-based orders.
2017 saw a huge increase in trading volume with 1,567 orders worth a combined AZN 18,982,578.13. Despite that only 20 orders were conducted based on the shares of the first type of listed company, such issues comprised a whopping 95% of volume (AZN 18,025,893.33). Yet just two orders (Rabite Bank shares) from the 20 were worth AZN 17,080,507.51, or nearly 95% of the volume of normally listed companies. Of this amount, AZN 8,673,001.08 came from private placement. The same situation occurred in 2018 as 1,876 orders combined for AZN 42,854,933.57, of which AZN 41,651,213.79 spanning 19 orders occurred from the shares of the first type of listed company. Again, AZN 41,637,332.19 of this amount came from orders for the stocks of just one company (Rabite), and nearly half of it was done through private placement
. The volume of the remaining 1,857 151 orders was AZN 1,203,719.78 from the stocks of the second type of listed company. Another CHAPTER influential characteristic is the absence of price fluctuations on the secondary market. All 03 stocks from normally listed companies are traded at nominal prices and 350-400 stocks Developing Azerbaijan’s Stock and Stock-related Derivatives Markets from the second type are traded at prices higher than their nominal values. The remaining companies of the second type are traded at the nominal value of AZN 2. In conclusion, Azerbaijan’s trading activity is low and an incredibly disproportionate volume comes from a few orders, nearly half of which are public placement.
[Figure 3-5] 2018 Secondary Market Turnover by Order Type & Listing (Unit: %)
97 51 46 3
First type listed Second type listed Private Placement Continuous Trading
Source: The Statistics of the Baku Stock Exchange. 2018 42,854,933.57 298,791,772.93 2017 18,982,578.13 161,670,801.84 2016 2,849,216.95 1,370,799,836.89 OTC market OTC Regulated market The Statistics of the Baku Stock Exchange. To determine supply and demand on the primary market, this study will analyze will analyze study this market, primary on the supply and demand determine To As covered in the discussion of the secondary market, the stocks of the second type stocks of the second type the secondary market, As covered in the discussion of the 2.1.2. Supply and Demand While comparing the secondary OTC market to the regulated market, turnover in the in the turnover market, to the regulated market OTC the secondary While comparing placed shares through two orders but Unibank sold only 20,265,119 out of 51,355,268 shares. placed shares through two orders but Unibank sold only 20,265,119 out of method in two subscription placement through the conducted Bank 2018, Kapital and AG In AG issued 3,500,000 new shares at a nominal value of AZN 2 and In its first tranche, tranches. from 2,900,000 placed 600,000 shares; in the second placement, 200,000 shares were placed placement results from 2016-18. In 2016, three entities, two of them banks, Parabank and and Parabank placement results from 2016-18. In 2016, three entities, two of them banks, organization, Deka Bank, that went bankrupt in the same year, and one non-banking credit In 2017, two major Finex Kredit, conducted private placement on the primary market. issuing 2,222,222,223 shares at a conducted public placement by and Unibank, banks, IBAR sold all of its IBAR nominal value of AZN 0.27 and 51,355,268 shares at AZN 2.72, respectively. volume occurred with the stocks of the first type of listedwith company, half of them done supply determining unsuitable for is market secondary overall the So placement. private via and demand. of listed company dominate the volume of trade orders and individuals must visit an orders and individuals must visit an of trade dominate the volume of listed company that most orders are cross orders orders. This shows to place trade investment company that comprise 95%-98% of trading Moreover, a few orders conducted through brokers. Source: 0.27). Market & BSE on Secondary OTC 3-2> Turnover
2.2. Review of Stock-related Derivatives Market in Azerbaijan
The Azerbaijani stock market can be summarized as having considerably low trading activity and volume and most orders being either cross orders or done through private placement. Thus no price fluctuations are seen, and few investors or traders participate on either the primary or secondary market. Most turnover stems from a few trade orders based on select stocks that dominate the market, which is dependent on a few shares. Most listed companies are of the second type of listed company that lack proper valuation, corporate governance, and financial reporting, thus traders and investors have insufficient data about them. Moreover, most first-type listed companies are not traded on the secondary market 153 and some are mainly traded on the OTC market. In addition, the lack of trading applications CHAPTER means traders have no direct access to the capital market and must visit an investment 03 company to make trade orders. All of these factors explain the absence of a stock-related Developing Azerbaijan’s Stock and Stock-related Derivatives Markets derivatives market in Azerbaijan. In addition, the country has no detailed regulations on organizing such a market and existing regulations merely form the basic grounds for one. The BSE’s CETA trading platform, however, is suitable for the application of stock-related derivatives and could organize their trading.
2.3. Regulation and Supervision of Stock Market
2.3.1. Regulation of Listing on Baku Stock Exchange
After receiving FIMSA approval of the prospectus, an issuer can apply to get listed on the Baku Stock Exchange (BSE) with the required documents. The listing procedure is regulated by the Law on Listing, Delisting and Issuing of the BSE and normal regulatory acts of FIMSA. As previously mentioned, the country has two types of listed companies and depending on the format of issuance, the number of required documents and listing periods vary. According to the BSE law, shares can be listed through an application from an issuer or shareholder if the shareholder holds less than 10% of all shares. In the first case except in certain cases, the issuer must submit a prospectus or memorandum and sign a contract with the BSE to get listed. In the second case, the issuer has no requirements to meet and no ------application market segment market of securities, charter capital of of securities, charter capital Document confirming ownership Document confirming ownership (2nd type of listed companies) right to securities reflecting volume right to securities reflecting shareholders, & company on date of shareholders, & company Application for listing on alternative Application for listing on Application for shareholder selling for shareholder selling Application - - - - - exchange member Private placement Application questionnaire Copy of contract with NDC & of contract Copy Shareholders’ decision on placement Shareholders’ decision on Copy of gov’t registration of securities of gov’t registration Copy
floating rate floating Public offer issuer’s charter issuer’s submitted data exchange member Statement on accuracy of Statement on accuracy Application questionnaire owners or approval of free The Regulations of the Baku Stock Exchange. in activity requiring license Copy of contract with NDC & of contract Copy Prospectus or memorandum According to BSE regulations, securities are listed under three segments, each of which which of each segments, three under listed are securities regulations, BSE to According After the issuer or investor applies for listing, the BSE’s listing committee must decide on listing listing, the BSE’s After the issuer or investor applies for Declaration of registry of securities of registry Declaration Notarized copy of issuer’s certificate of issuer’s Notarized copy Audited annual financial statements annual financial Audited Copies of licenses if issuer is engaged of gov’t registration of legal entities & of of gov’t registration Copy of gov’t registration of securities of gov’t registration Copy free floatingrate, and creditrating. The sharesof companies cannot be listed partially in different segments, so when a company gets listed, preferred and common shares must be segment had tolisted in the same segment. In 2018, the requirements and obligations of each market, but placement through shareholder application is part of that of the secondary the secondary that of part of application is shareholder but placement through market, market. has its own requirements for financial performance, corporate structure, issuance format, a listing within 10 days, with the average decision coming within four to five days. After the decision is made and announced, a public offer in a primary auction market can start in two after the can start the day but private placement or application of shareholder trading days, effect. Privatedecision andtakes public placements count toward the volume of the primary Source: contract is needed between the issuer and the BSE. the issuer is needed between contract for Listing Application Documents Required 3-3> List of
Requirements of SegmentsRequirements Premium Standard Alternative
During 1-year period preceding submission of application for listing, issuer cannot undergo bankruptcy - - process or face periodic financial Profitability sustainability issues
Issuer must operate at least 3 years & Issuer must operate at least 1 year & at show profit for at least 1 year among least 1 year of last 3 fiscal years must - last 3 fiscal years see profit
Minimum paid-in capital of AZN 2.5 Minimum paid-in capital Capital - mil. of AZN 200,000
Free floating rate of at least 10%; - - if not at least AZN 500,000
Free floating rate Free floating rate must be distributed among 50 shareholders; 155
- - CHAPTER each shareholder cannot own more than 5% 03 Financial reports must meet IFRS
Financial reports must meet IFRS Developing Azerbaijan’s Stock and Stock-related Derivatives Markets requirements; last year’s financial Reporting requirements, last 3 years of audited - report requires auditing by reports needed independent auditor
No significant changes in managerial board or supervisory council within - - last 3 months Corporate structure At least 3 members on supervisory council, with at least 1/3 of members - - independent
Issuer must have website, Issuer must have website - charter must be posted on website Transparency Issue must be followed by prospectus Issue must be followed by prospectus - or memorandum or memorandum
Source: The Regulations of the Baku Stock Exchange.
As seen in
, the alternative segment has no requirements. All issues conducted through private placement, public offers without a prospectus or memorandum, the second type of listing company, and other issues that cannot meet the requirements of the premium and standard segments are listed on the alternative segment market. As segment requirements have been simplified, standard segment requirements are not complex Primary market placement and secondary market trading are regulated by the Securities are regulated by trading and secondary market placement Primary market 2.3.2. FIMSA’s Supervision and Regulation of Stock Market Supervision and Regulation of Stock 2.3.2. FIMSA’s FIMSA regulates Azerbaijan’s stock market in accordance with the financial watchdog’s In conclusion, Azerbaijan’s business environment and capital market requires listing requires listing and capital market business environment In conclusion, Azerbaijan’s In addition, the BSE’s listing fees are considerably low. The premium market’s listing fee listing market’s premium The low. considerably are fees listing BSE’s the addition, In The disclosure requirements cover information on new issues, patents, licenses, new issues, patents, licenses, cover information on The disclosure requirements Market Law for the securities market, rules of subscription, placement of securities, and rules of subscription, placement of securities, and market, Law for the securities Market through of investment securities. Private placement can be done regulations on transactions is determined by FIMSA laws and regulations. If the prospectus and memorandum are are regulations. If the prospectus and memorandum laws and FIMSA is determined by collection, the for system information central the ESID, by announced is this approved, on the issuers whose securities are traded and dissemination of information by storage, website and the BSE. as the issuer’s as well regulated market, offering the securities to more than 50 investors or an unknown number of people through mass media. Another type of offering is considered private placement, which can be done of government-owned or BSE, but except for the privatization market through the OTC Except in certain companies, public offering must be done through the stock exchange. content whose memorandum or prospectus a by followed be must offering public cases, regulatory acts, the Securities Market Law, and Civil Code (Chapter 54, Articles 98-108). 98-108). Articles 54, (Chapter Code Civil and Law, Market Securities the acts, regulatory is defined as a public offer of securities Law, Capital Markets to the country’s According listed companies classified as the first type of company pay an annual listing fee. type of company listed companies classified as the first promoting trust among investors. issuer convenience while regulations that raise high trading volume on the OTC market. Even the shares of listed companies are traded on are traded Even the shares of listed companies market. OTC volume on the high trading on the BSE homepage. as executed orders are posted this market AZN 200. Only segment’s AZN 500, and the alternative is AZN 1,000, the standard segment’s cooperation, changes in charter, and significant changes in the supervisory council and council and and significant changes in the supervisory changes in charter, cooperation, transparent that not is Azerbaijan in environment business the Thus board. management as these requirements can Suchstifle a corporateactivity. business climate also explains the for a medium-size company to meet. On the other hand, disclosure obligations of the of the obligations other hand, disclosure to meet. On the company for a medium-size standard segment can prove unattractive to mid-size companies. Disclosure of financial and extra no has BSE the so requirements, FIMSA under as same the is reporting management a listed company requirements require disclosure In addition, above FIMSA’s. requirements the BSE within five days. its activities and share them with to publicly announce 156 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan the subscription or auction method. The subscription method cannot last more three months and after subscription, placement must be done within five business days and cannot exceed seven. According to BSE rules, auctions must be completed during one trading day. After the end of placement, the issuer must submit the results to FIMSA within 10 business days and the financial watchdog announces its approval decision within 15 business days. After the approval of the primary market’s placement results, the secondary market is opened for trading. Excluding negotiated orders, the listed shares of an issuer with more than 50 shareholders can only be traded on the stock exchange. The NDC regularly provides the BSE with a list of such issuers.All issuers must submit their annual reports no later than six months after the end of the year. Such reports include financial statements and independent audit and management reports. Issuers that made public offers and traded on the regulated market must release their half-year reports to the public no later than two months after the first six months of the fiscal year. FIMSA has set all reporting guidelines through regulatory acts.
In general, the Securities Market Law of Azerbaijan covers the prevention of abuse and 157 insider activity, transparency, and disclosure of information in detailed form. In addition, CHAPTER disclosure of data on the acquisition and alienation of an important part of shares is covered 03 by this law. For example, if the number of common shares owned by a shareholder whose Developing Azerbaijan’s Stock and Stock-related Derivatives Markets shares are traded on the regulated market reaches 5%, 10%, 25%, 50%, or 75% of the issuer’s overall shares, this must be reported within four business days via a declaration. Within three business days after the declaration is released, the issuer has to announce it publicly. In addition, FIMSA supervises market transparency and information disclosure through regulatory acts such as rules on the prevention of abuse, guidelines for the prospectus and memorandum, and issuance of management reports.
3. Benchmarking Korea’s Experience
This section presents the Korean experience as a benchmark for developing the stock and stock-related derivatives market in Azerbaijan. The following is covered in this section: 1) the legal framework to govern Korea’s capital market; 2) development of the stock market; 3) development of the stock-related derivatives market: and 4) supervision of securities companies. In 1993, the securities industry underwent a major overhaul in its legal environment. environment. In 1993, the securities industry underwent a major overhaul in its legal ii) and higher capital of securities companies, Enhanced external audits Introduction of book-entry clearing. iii) 1976 as the and the SSB were established in Commission Securities and Exchange The i) Improved statements for securities registration, i) 3.1.1. Brief History of Legislation 3.1.1. Brief History of 1949 along with the inauguration securities companies appeared in first Korea’s 3.1. Legal Framework to Regulate Korean Capital Market Capital Korean to Regulate Framework 3.1. Legal in the capital market Korea’s governing legal framework the introduces This section Six related laws were comprehensively revised: the Securities and Exchange Act, the Law the Law Act, Six related laws were comprehensively revised: the Securities and Exchange on Investment Trust Business, the Act on Securities the Act the Capital Market, on Fostering facilitate corporate listing. Several focused on helping stabilize the managerial rights of focused on helping stabilize the managerial rights of listing. Several facilitate corporate such shareholders like hazard by major shareholders, while others sought to prevent moral securities companies’ by and stock transactions regulations on disclosure, insider trading, to was launched (KOSCOM) Corporation Securities Computer Korea the 1977, executives. In provide reliable and efficient computer systems for the stock market. principal regulators of the securities industry. Additional measures followed to further measures followed to further Additional principal regulators of the securities industry. formally provided the legal grounds for securities investment trust as a sector. The Securities The sector. a as trust investment securities for grounds legal the provided formally 1973 that resulted in the following changes. underwent major revision in and Exchange Act a relatively short time. To achieve this goal, the act provided newly listed corporations corporations listed newly provided act the goal, this achieve To time. short relatively a Investment facilitate stock issuance, the Korea To with aggressive and extensive tax relief. same year. Set up as a government-owned (KIC) was also established in the Corporation into the Securities Supervisory Board (SSB) and Daehan the KIC was later divided entity, In 1969, the Securities Investment Trust Business Act Investment Trust Co. in the mid-1970s. the Korea Stock Dealers Association (KSDA). An official stock exchange, the Daehan Stock the Daehan Stock An official stock exchange, Stock Dealers Association (KSDA). the Korea the followed by 1956, March in launched was KRX) Exchange or Korea the Exchange (now code the and law the Both 1962. in Code Commercial the and Act Exchange and Securities and industries. The Capital for the domestic securities market formed a legal framework within companies listed of number the bolster to 1968 in enacted was Act Promotion Market investment services; 5) financial supervisors; and 6) other rules and principles. 5) financial supervisors; and 6) other investment services; following order: 1) a brief history of legislation; 2) the Financial Investment Services and and Services Investment Financial the 2) legislation; of history a brief 1) order: following of financial instruments and institutions; 4) providers 3) financial Act; Capital Markets 158 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan External Audit of Stock Companies, and the Act on Certified Public Accountants. Before 2009, the following three laws formed the backbone of securities sector regulation:
1) The Securities and Exchange Act defined the scope of securities issued and circulated on the market and the sector. Measures to crack down on unfair securities trading were also included in this act.
2) The Futures Trading Act formed the basis for the formation of the Futures Exchange in 1998. This law sought to prevent market and price manipulation, defined the futures sector, and specified regulatory requirements for the industry. The exchange was later merged with the Korea Stock Exchange (KSE).
3) The Act on Indirect Investment Asset Management was enacted through the consolidation of the Securities Investment Trust Act and the Securities Investment Companies Act, defining the asset management sector and setting limits on business scope.
In 1997, a fundamental change occurred in the regulatory and supervisory frameworks 159
of the financial sector through the Act on the Establishment, etc. of Financial Supervisory CHAPTER Organizations. This law set the legal basis for integrated supervision of the financial sector as a whole, and in 1998, the Financial Supervisory Commission (FSC) and the Financial 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets Supervisory Service (FSS) were established. In 1999, the financial supervision-related entities Bank Inspection Board, SSB, Insurance Supervisory Board, and Korea Non-Bank Deposit Insurance Corporation were all absorbed by the FSS.
The Securities and Futures Commission (SFC) was established separately under the FSC as the main regulator of the securities industry. In 2008, the FSC was reorganized to handle policy formulation and implementation for the entire financial sector in addition to being the sole supervisory watchdog for all financial industries. The FSS directorship was held by the FSC chief under the old regime but became a separate appointment to ensure the independence of the FSS’ financial supervision from the FSC’s policy considerations.
In 2009, the legal framework for and regulatory structure of the securities industry underwent yet another fundamental change with the Financial Investment Services and Capital Markets Act (FSCMA).
3.1.2. Financial Investment Services and Capital Markets and Act
In February 2009, the Financial Investment Services and Capital Markets Act took effect biz act biz act finance & finance & Consumer Consumer specialized specialized credit financial credit financial act act biz biz Insurance Insurance act Korea Korea & futures exchange securities investment sector Expansion of work scope Expansion of work scope All financial investment industry biz act Regulation by business function Regulation by finance - allowing mutual biz in financial - allowing mutual biz in Application of negative system in Application of negative system act biz Advancement of investment protection system Advancement Trust trade act trade Derivatives Asset mgmt. biz act Scope of financial laws trade act trade Nonstandard Financial Investment Services & Capital Markets Act Financial Investment Services & Capital Markets act trade Futures & asset mgmt. trade act trade protection system Securities under law (positive system) act act Banking Banking having different laws & regulations. having different laws & Lack of advanced & systematic investor Lack of advanced & systematic capital market sectors such as securities sectors such as securities capital market Limited listing of securities & derivatives Limited listing of securities Acknowledgement of financial companies Acknowledgement Korea Financial Investment Association (2009), Capital Market in Korea. Financial Investment Association (2009), Korea Korea Financial Investment Association (2009), Capital Market in Korea. Financial Investment Association (2009), Korea Strict restrictions on cross-ownership between Strict restrictions on cross-ownership The FSCMA comprises 10 parts spanning 41 chapters, and has many subordinate subordinate many has 41 chapters, and spanning 10 parts comprises FSCMA The After Before [Figure 3-7] Scope of Korean Financial Laws 3-7] Scope of Korean [Figure Source: to govern the overall capital market. The main direction of this law is shown below in [Figure law is shown below direction of this The main capital market. the overall to govern 3-6]. of FSCMA Main Direction 3-6] [Figure Source: this law. regulations on implementation. The following table shows the structure of 160 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan
Structure of FSCMAPart Chapter Details
1 General provisions Purposes & definitions
2 Financial License & 1 Conditions & procedure for licensing & registration investment biz registration
Approval of change of major shareholders - Outside directors, standing auditors 2 Governance - Internal control guidelines & compliance officer - Minority shareholder rights
Maintenance of financial soundness Maintenance of - Restriction on trading with major shareholders 3 sound business - Accounting mgmt. - Biz report & disclosure
Maintenance of financial soundness - Restriction on trading with major shareholders 4 Biz conduct rules - Accounting - Biz report and disclosure
3 Issuance & Disclosure of 1 Registration statement circulation issuance of securities Systems related to 2 Public tender offer, 5% rule, others 161
corporate M&As CHAPTER
Biz reports of listed 3 Submission of annual biz & other major reports
corporations 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets Over-the-counter 4 OTC trading, restrictions on OTC trading by foreigners (OTC) trading
4 Regulation on Return of insider’s short-swing profit, insider trading, 1 Insider trading unfair trading others
Market price 2 Ban on market price manipulation manipulation
Restriction of 3 short sale & unfair Comprehensive restrictions on unfair trading, short sale trading
Definition & composition of collective Collective Collective investment systems 5 investment 1-11 investment system - Collective investment securities & related system companies in collective investment system
Financial Korea Financial Investment Ass’n, Financial service 6 service 1-8 Korea Securities Depository, securities finance companies, institutions institutions merchant banks, others
Organization, formation of markets 7 Korea Exchange 1-8 Korea Exchange - Market supervision & dispute resolution
Supervision Order & approval, inspection, & disposition 8 & disciplinary 1-4 FSC’s authority - Audit, penalty surcharge actions Details Definitions Reporting of violations via Reporting of electronic document sentencing rules Penal provisions, fines, Chapter shares in contribution Beneficiary certificates of monetary trust or collective investment trust, & other similar instruments with beneficial interest in trust Instruments with contractual right under which investor is entitled to profits earned or liable for losses sustained, depending on results of joint venture in which investor makes investment jointly with another person who will mainly run it shall be determined or recoverable Instruments with right under which amount payable per predetermined formula tied to fluctuations in price of underlying asset,rates, interest of aforementioned items or similar factors dedicator, unit, or index based on any Instruments issued by person with whom any of five types of securities mentioned above are deposited in country other than one where such underlying securities were issued that retain right in deposited underlying securities Gov’t, municipal, special (referring to bonds issued by legal entity established through legal entity established through by Gov’t, municipal, special (referring to bonds issued CPs, & other similar instruments with right to payment bonds, corporate law), & corporate claim right, investment securities issued by Stock certificates, instruments with preemptive equity shares in contribution to limited partnership or law, legal entity established by equity shares or undisclosed association under Commercial Act, limited liability company & other similar instruments with equity in contribution to association under Civil Act, Part Type Supplementary provisions Supplementary Penal provisions receipts securities securities Korea Financial Investment Association, Capital Market in Korea, 2009. Financial Investment Association, Capital Market in Korea, Korea Korea Financial Investment Association (2009), Capital Market in Korea. Financial Investment Korea Debt securities Equity securities According to the FSCMA, a financial investment instrument is any financial product product financial any is instrument investment financial a FSCMA, the to According 3.1.3. Financial Instruments and Institutions 3.1.3. Financial Instruments Instruments 3.1.3.1. Financial Investment Investment contract Investment contract 9 Securities depository 10 Derivatives-combined Beneficiary certificates Source:
Types & Definitions of Securities 3-6> Types shows the types and definitions of securities as described in the FSCMA. incurring investment risk. Investment risk is formally definedby the law as the possibility the possibility of loss arising from a counterparty’s of losing all or part of the principal; such a risk. The two types of these however, is also considered payments, failure to make Source: Continued Korea has four categories of financial institutions: banks, financial investment service providers (FISPs), insurance companies, and non-banking financial institutions. Banks include commercial and specialized as well as the branches of foreign banks. FISPs conduct securities trading activity defined by the FSCMA. Insurers include life, non-life, and hybrid. Non-banking financial institutions (NBFIs) conduct a variety of business activities like taking in deposits in the manner of traditional microfinance institutions such as mutual savings banks, specialized credit finance companies, and mutual credit cooperatives. Such cooperatives include credit unions and agricultural, fishery, forestry, and community credit cooperatives. NBFIs also include non-depository businesses providing specialized credit products.
Before the FSCMA took effect, financial institutions operating on the securities market were classified as securities, futures, or asset management companies or investment advisers. Many of these institutions still call themselves security or asset management companies, but others have renamed themselves financial investment companies. According 163 to the FSCMA, a FISP may simultaneously conduct several investment-related businesses CHAPTER irrespective of the company name. Other financial institutions such as banks may also 03 engage in FISP business lines under the FSCMA. Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
3.1.4. Financial Investment Service Providers
3.1.4.1. Primary Businesses
The FSCMA classifies financial investment services into six business categories: dealing, brokering, collective investment systems, investment advisory, discretionary investment, and trust. An FISP is a financial institution licensed to engage in any one or more of such services defined by the FSCMA. To do so, a FISP must apply with the FSC and FSS to gain proper authorization, approval, or registration. A FISP may conduct primary, secondary, and concurrent businesses.
Among the six business lines, dealing is the proprietary buying and selling of an investment product through a company’s proprietary account. Activities related to new securities issuance are also included in dealing such as underwriting on an issuer’s behalf, subscribing to or making offers, and accepting bids for the securities. The second sector, brokering, is the non-proprietary buying and selling of investment products through client accounts. Subscribing to, making offers, and accepting bids for an investment product 3.1.4.3. Concurrent Businesses 3.1.4.3. Concurrent payment and agency insurance as such services of range wide a offer can FISP A A negative list approach is used to determine secondary businesses, thus no secondary secondary businesses, thus no secondary A negative list approach is used to determine 3.1.4.2. Secondary Businesses settlement as a concurrent business. Certain activities (classified as Type 1 services) require regulatory authorization or approval, while other types of concurrent businesses (classified advance notification. as Type 2, 3, or 4) require seven-day conduct an activity as a secondary business seven days in advance. seven days conduct an activity as a secondary business business activity is specified by the FSCMA. This means that a FISP may engage in any engage in any may the FSCMA. This means that a FISP business activity is specified by unless license another for need the without business primary its to secondary business however, must report to the FSC or FSS its intention to An FISP, by law. specifically stipulated management company may offer trusts these manage services. assets Finally, for the benefit of designated beneficiaries. Trust service companies, banks, brokerages, insurers, and asset offer these services. management companies may association, or private equity fund. The fourth business line is investment advisory that line is investment advisory that equity fund. The fourth business association, or private securities, and asset advisory, products and decisions. Investment advises on investment management companies may offer such services. The fifth area is discretionary investment and manages decisions on discretionary investment partial or whole to help make or asset service, brokerage, of clients. A discretionary investment investments on behalf for a customer are also considered brokering activities. The third area is the collective collective is the area third The activities. brokering considered are also customer a for investment system (CIS), or pooling funds from investors and putting the money in financial assets for investor for investing pooled responsibility assume CIS operators instruments. benefit. A CIS can take on a legal form as aninvestment trust or limited company, liability investment investment or undisclosed partnership company, investment or limited 164 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 3.1.5. Financial Supervisors
[Figure 3-8] Structure of Financial Supervision in Korea
Prime minister
Reconsideration Legislation
Ministry Financial of Economy Supervisory & Finance Data Commission Data Bank of Korea
Exam. ination Exam. ination Financial Supervisory KDIC Service
Financial Institutions Money Market
Source: Financial Supervisory Service, FSS Handbook 2016.
165
3.1.5.1. Financial Services Commission CHAPTER
The Financial Services Commission (FSC) is a ministry-level public agency whose 03 regulatory authority covers the whole financial sector. The Act on the Establishment of the Developing Azerbaijan’s Stock and Stock-related Derivatives Markets FSC granted the financial watchdog the power to set financial policy, propose legislation to the National Assembly, and make and grant licenses for a range of financial institutions. Nine commissioners jointly make decisions for the FSC: the chairman, vice chairman, and two standing and five non-standing commissioners. Though the Securities and Futures Commission (SFC) is empowered to make its own decisions on matters related to the securities market, such decisions are not necessarily independent of the FSC because the FSC vice chairman is concurrently SFC chairman. Four of the five non-standing FSC commissioners are from other institutions: vice minister of the Ministry of Economy and Finance, FSS governor, deputy governor of the Bank of Korea (BOK), and president of the Korea Deposit Insurance Corporation. The chairman of the Korea Chamber of Commerce and Industry recommends the fifth non-standing commissioner.
3.1.5.2. Securities and Futures Commission
The Securities and Futures Commission (SFC) is a body within the FSC that oversees and supervises the securities and futures markets. The SFC conducts advance review of matters to be deliberated by the FSC and directs the FSS in investigations into alleged misconduct 3.1.5.4. Bank of Korea (BOK) has maintained a close and Bank of Korea Since its establishment in 1950, the Though the Financial Supervisory Service (FSS) was established under the act that set set that act the under established was (FSS) Service Supervisory Financial the Though 3.1.5.3. Financial Supervisory Service Supervisory 3.1.5.3. Financial the FSS. For an FSS-conducted audit per the BOK’s request, the central bank may request request may bank central the request, BOK’s the per audit FSS-conducted an For FSS. the supervisory the FSS to take also request may findings. The BOK the sharing of the FSS’s action based on such findings. Though such cooperative activities are mostly concentrated the BOK in theory can extend the scope of its indirect supervision in the banking industry, authority to securities in the case of a potential threat to the financial system. system was adopted for the sector with the establishment of the FSC and FSS, the BOK also system was adopted for the sector with institutional defined clearly through regulators both with ties working close maintained the arrangements. Accordingly, central bank can ask the FSS to audit a financial institution, an institution with and in certain circumstances, the BOK can initiate a joint probe into such cooperative relationship with government departments responsible for planning economic relationship with government cooperative supervisory financial sector. After an integrated development, and supervision of the ministry shared supervisory responsibilities for the securities and insurance sectors with sectors with for the securities and insurance ministry shared supervisory responsibilities Supervisory Board (ISB), respectively. and Insurance the Securities Supervisory Board (SSB) Other non-banking financial institutions were also jointlysupervised by the ministry and the office. of the entire financial sector; prior to its establishment, such supervision was carried outby authorities assigned to each sector on the financial market. At the time, select supervisory functions for certain financial industries were sharedby multipleFor supervisors. example, the Office of Banking Supervision under the Bank of Korea (BOK) was responsible for the the exercised strong oversight power. Likewise, banking sector, but the Ministry of Finance up its parent organization FSC, the former is not part of the government and thus gets no of the government and thus gets no FSC, the former is not part up its parent organization and regulation the for responsible capital no has FSS The budget. national the from funding institutionsby the financial are funded industries, and its operations supervision of financial supervision conducts integrated supervisory service fees. This watchdog it oversees through and abuse by market participants. The SFC also sets accounting and audit standards. The SFC SFC The standards. audit and accounting sets also SFC The participants. market by abuse and the FSC. ners from commissio three non-standing five members, including consists of 166 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 3.1.5.5. Korea Deposit Insurance Corporation
The Korea Deposit Insurance Corporation (KDIC) insures the deposits and deposit-like funds of individual depositors, insurers, and investors if a financial institution collapses. Funds deposited in securities companies by individual investors to invest later in stocks are protected by the KDIC up to KRW 50 million per person per institution. As a result, the FSS and KDIC constantly share supervisory data to protect insurance funds. In addition, the KDIC if necessary may ask the FSS to audit an insured institution and use the KDIC’s own specialists in the process.
3.1.6. Other Rules and Principles
3.1.6.1. Conflict of Interest
Conflict of interest can arise from information exchanges between units within a financial instrument service provider (FISP) if and when it conducts multiple businesses simultaneously. The FSCMA specifies principles and mechanisms to prevent problems 167
arising from conflicts of interest. First, an FISP must conduct business fairly and honestly CHAPTER and cannot harm investors for its own benefit. Second, it must identify and assess all potential for conflict of interest and appropriately exercise prudent management through 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets internal control procedures. Third, it must set up appropriate information barriers to prevent employees from assuming more than one position in multiple investment service providers.
3.1.6.2. Sales and Investor Solicitation
The FSCMA classifies investors as retail and institutional depending on purpose, expertise, and risk appetite. The following rules and principles for investor protection are specifically designed to protect retail investors.
i) The duty to explain requires a FISP, when it recommends an investment product to a retail investor, to explain product risk and other major characteristics. Deliberate omission or misrepresentation of important information is strictly prohibited, and the FISP must retain records of investor acknowledgement of product guidance.
ii) The duty to disclose investor solicitation practices stipulates the rules, standards, and procedures a FISP is required to express when soliciting an investor. Additional data separate from general information must be announced when a FISP solicits retail promptly inform the investor if a proposed product is inappropriate. promptly inform the investor if a proposed who solicit or allows a FISP to introduce brokers introduction rule broker the Finally, benefit. for the FISP’s offer investment advice to investors experience. that to sell derivatives or other complex says The principles of appropriateness a FISP must evaluate the investor’s investment products to a retail customer, and previous investment experience. It must investment objective, asset holdings, also be kept. The principle of suitability bans a FISP from offering investment recommendations investor- is determined by for individual investors. Suitability considered unsuitable specific factorssuch as investment objective, asset holdings, orprevious investment investors to sell derivatives and other complex investments. and other complex to sell derivatives investors individualized a FISP to obtain process requires (KYC) The know-your-customer and previous objective, asset holdings, as investment retail investor such data on a must acknowledgement and signatures investor of Records experience. investment Fourth, the rule on no abuse of information prohibits brokers and dealers from from dealers and brokers prohibits of information on no abuse rule the Fourth, First, a person processing a customer order to buy or sell an investment product must order to buy or sell an investment product must First, a person processing a customer 3.1.6.3. Requirements for Brokers and Dealers for Brokers 3.1.6.3. Requirements and dealer (broker and/or as broker requirements, a FISP acting In addition to general vi) v) iv) iii) integrity. Finally, the rule on segregation of proprietary and customer assets requires a FISP the rule Finally, integrity. and deposit all securities belonging to customer proprietary assets from a client’s to separate Securities Depository (KSD). assets in the Korea and dealers to provide detailed descriptions of transactions including the price and fees including the price and fees and dealers to provide detailed descriptions of transactions charged when a customer order is executed and settled. market undermining activities in or engaging informational advantage their exploiting declare if he or she is a broker or a dealer. Second, the express customer order says brokers brokers customer order says or a dealer. Second, the express declare if he or she is a broker account without and dealers must not buy or sell investment products through a customer the client’s express instruction. Third, the settled transaction notificationrequires brokers dealer requirements) for the purchase and sale of investment products must comply with and sale of investment products must comply with dealer requirements) for the purchase the following rules on investor protection. 168 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 3.2. Development of Korea’s Stock Market
This section is about the development and advancement of the Korean stock market starting with 1) creating the proper conditions to promote the stock market; 2) maintaining a system for capital market development; 3) encouraging corporate disclosure for the promotion of the capital market; 4) opening and operating the OTC KOSDAQ market; and 5) building and advancing the Korea New Exchange (KONEX).
3.2.1. Creating Conditions to Develop Stock Market
Since May 16, 1961, government measures to develop and boost the domestic stock market can be divided into those for increasing demand for stock investment through improvement of the investment environment and others for expanding stock supply through the sale of government-owned stocks and the issuance of new shares by listed companies. A key breakthrough for this purpose was the enactment of the Securities and Exchange Act, which had been demanded by stockholders since the country’s founding. This was followed by a new commercial law that solidified the stock trading system and a special measure 169 on property reevaluation to supplement the system’s shortcomings for the stock market’s CHAPTER growth. 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets 3.2.1.1. Enactment of Securities and Exchange Act
On January 15, 1962, the Securities and Exchange Act was enacted and its enforcement ensued on April 1 that year. The purpose of this law was to develop the national economy and protect investors through the smooth circulation of securities by issuing stocks and ensuring fair transactions. To that end, the new act sought to streamline stock market operations by rationally reorganizing market order and clarifying the authority, duties, and responsibilities of each securities institution. The act consists of 135 sections in the text and 15 articles in the attachment that led to the following developments. First, organization of the stock exchange was changed from the “yeongdan” system (partially state-owned enterprise with joint contribution by finance, insurance, and securities groups) to the stock exchange system, and the old exchange’s equity investment was made a shareholder on the new exchange. Second, the adoption of a securities declaration system allowed those who wanted to collect or sell securities to protect investors by fairly issuing securities could submit a report to the finance minister and issue them after getting approval. Third, the act strengthened the qualifications of securities companies. Eligibility to enter the stock industry was limited to a corporation with paid-in capital of KRW 50 million or more, and the establishment of a brokerage was granted by the finance minister. Fourth, the exchange’s The Act on Share Dividend Protection was enacted in December 1962 to guarantee a a in December 1962 to guarantee Share Dividend Protection was enacted on The Act 3.2.1.3. Other Laws 3.2.1.2. Enactment of Commercial Business Act Business of Commercial 3.2.1.2. Enactment The Commercial Business enacted Act, in January 1962 and taking effect in January 1963, of stocks along with measures to raise demand for stock investment. Previously, the auction the Previously, investment. stock for demand raise to measures with along stocks of Exchange (KSE) in October 1958 to facilitate the sale Stock the Korea was built within market development led to the sale of of government-owned stocks, yet policy toward stock market As a result, 160,000 shares government shares of major issues through the auction market. percentage of profit dividends to corporations with more than half of the shares ownedby to improve their passive tendency the government, and to require major listed corporations for the sale of toward awarding dividends. In addition, the government actively pushed supply corresponding the expand to institutions public and government the by owned stocks to protect shareholder rights and ensure free share transfers greatly contributed to the greatly contributed to the free share transfers to protect shareholder rights and ensure development of the stock market. These actions sought to facilitate the establishment and growth of companies. Second, the establishment and growth of companies. Second, the These actions sought to facilitate the a decision from the board of directors and possible by issuance of private bonds was made issuing them became smoother through capital and reserve funds. And thefinally, granting books accounting to access gain and lawsuits file to shareholders minority to right the of market with the newly enacted Securities and Exchange Act. The main content is as follows. The main with the newly enacted Securities and Exchange Act. market issued act, in which the number of capital system under the nominal the First, unlike a of shares was changed by association, the payment shares was set under the articles of total number of shares to be issued under the articles shareholder resolution, and only the the board of directors. shares could be issued by The remaining the company. was set up by consolidated the stock trading system and thereby facilitated the development of the stock stock the of development the facilitated thereby and system trading stock the consolidated finally, Regulationsfinally, on the Establishment of the SecuritiesDealers Association were made to maintain business order among of a dispute coordination agency to allow the formation Thus purchases on the stock market. and settle disputes over sales and securities companies government promotion of spurred active Securities and Exchange Act the enactment of the investment mood. as well as created a stable the stock market power to sanction and monitor its members was strengthened to set a fair market order order to set a fair market was strengthened its members sanction and monitor power to staff, trading cancel and register to right the through including investors, protect and of the work and property and report on the with the exchange, transactions suspend trading strengthened. was exchange the over authority oversight government’s Fifth, the exchange. And prescribed. were institutions securities of work and establishment the on items Sixth, 170 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan of Korea Electric Power Corporation (KEPCO), 80,000 of Korea Rice Warehouse, and 990,000 of Korea Shipping Corporation were sold from October 1961 to May 1962. This large number of shares corresponded to 151%, 1,079%, and 65% of the number of market-backed shares of the companies before sale.
Meanwhile, the volume of new share issuance reached only KRW 36.9 million until 1958, when the stock market opened, but with the 1962 enactment of the Act on Property Reassessment Special Measures, new shares were issued in 1963 through capital transfers, including revaluation reserves, with the amount of paid-in capital the same year surging to KRW 3.1 billion. Unlike the previous act on property reassessment, the Act on Special Measures for Reassessment actively promoted management rationalization of businesses by adopting a voluntary execution method, recognizing special revaluation, and lowering the revaluation tax on revaluation reserves. As a result, assets were revalued and the capital of revaluation reserves were actively transferred, thereby expanding stock supply. Since the act’s enforcement, 11 listed companies transferred KRW 10.7 billion into equity from 1963- 64, helping the stock market to become more stock-oriented. 171
Tax breaks were also prepared for investors and listed corporations. In November 1962, CHAPTER the Income Tax Act and the Corporate Tax Act were amended to exempt investors from taxes 03 on dividend income from listed companies and cut corporate taxes on capital increases for Developing Azerbaijan’s Stock and Stock-related Derivatives Markets listed companies. These revisions helped boost stock investment demand by increasing the expected return on equity investments.
To boost the supply of listed stocks, the exchange requested early listing of government- owned companies and distributed sales of listed public stocks, while directly inducing the listing of blue-chip companies. The Enforcement Decree of the Budget Accounting Act was also revised in 1965 to raise the distribution value of listed stocks so that they could be used as bids or contract guarantees. Meanwhile, the Ministry of Finance’s so-called Share Distribution and Internal Automatic Assistance was adopted by the Economic Cabinet to prepare measures for the dispersion of government-owned stocks. Accordingly, the finance minister issued an executive order in January 1966 requiring nine government affiliates including Incheon Heavy Industries to be listed. Of the nine, Incheon Heavy Industries, Korean Air, Korea Machinery, Honam Fertilizer, Daehan Chloride, and the International Tourism Corporation (now the Korea Tourism Organization) went public in March that year and Daehan Steel Development in October, raising the number of listed companies from 17 to 24. The government-owned distributed sales of these new listed stocks continued from August to December 1966 through the auction market on the main exchange, with shares valued at approximately KRW 1 billion being sold. Limiting the auction price to more than Following the enactment of the Act on Capital Market Development, Korea Investment Investment Development, Korea on Capital Market the enactment of the Act Following 3.2.2.2. Founding of KDIC and Strengthening Function of Securities Issuance Market 3.2.2.2. Founding of KDIC and Strengthening This law was a milestone in the Korean stock market as the first to comprehensively as the first to comprehensively stock market This law was a milestone in the Korean 3.2.2.1. Enactment of Act on Capital Market Development 3.2.2.1. Enactment After Korea suffered a stock market crash in May 1962, the market was neither opened 3.2.2. System Maintenance for Capital Market Development 3.2.2. System Maintenance Development Corporation (KIDC) was established in December 1968. The government in December 1968. The government established (KIDC) was Development Corporation 1.5 billion at the time of the KIDC’s 500 million of the paid-in capital of KRW provided KRW received the right to maintain order to prevent “shareholder tyranny.” The establishment of received the right to maintain order to prevent “shareholder tyranny.” was stipulated to (KDIC), a specialized agency, Investment Development Corporation Korea facilitate securities issuance and distribution and spur stock acquisitions. breaks in income taxation. Further, the use of stocks was enhanced by allowing government- use of stocks was enhanced by breaks in income taxation. Further, the disclosure, a public induce corporate To deposits as listed stocks. related companies to pay tax exemption and receive a tax deduction was required to recognize a special corporation meeting of 20% other than ordinary depreciation. The chairman of the shareholders’ by promoting business disclosure and stock dispersion while creating investment conditions promoting business disclosure and stock dispersion by procurement. To capital smooth business and in participation to expand the people’s were given shareholders a listed company’s distribute stocks and induce public investment, received the right to of shares and employees preferential rights through a percentage also received special paid-in capital increase; shareholders assign priority to the company’s legislative efforts, and the Act on Capital Market Development was ultimately enacted in was ultimately enacted in Development Market on Capital legislative efforts, and the Act November 1968. markets Its purpose was to promote sound development of capital legislate securities policy. speculative trading of a handful of stocks, including Han Securities and Securities Finance, Securities and Securities Finance, of a handful of stocks, including Han speculative trading in 1967. 25 to 1962 in from 60 also down was employees trading number of the while was Act a bill on the Stock Investment Guarantee this stagnant market, reinvigorate To in January 1965 but failed to pass due to political submitted to the National Assembly change through continuing content and name underwent turmoil. Afterwards, the bill’s nor accepted new listings until 1965. Transaction payments were also concentrated in in were also concentrated payments listings until 1965. Transaction nor accepted new par value, however, hardly made it easier for general investors to participate and thus thus to participate and investors general made it easier for however, hardly par value, parties monopolized shares because certain in distribution little to the increase contributed managerial control. shares to secure the for-sale 172 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan establishment as a government-run enterprise. The Investment Review Committee was put in charge of deliberating and deciding key tasks. The KIDC’s main business was to take over the sale and collection of securities.
The five tasks of market adjustment assigned were family stability, management analysis and guidance, matters for entities subject to the consignment sale of government-owned and general business shares, and securities acquisition. These tasks were required under a resolution by the Investment Review Board and securities acquisition was approved by the finance minister. In addition, the KIDC registered the securities with an exchange clerk to carry out securities acquisition or arrangement. Other duties included permission to implement operations for financial and securities investment trusts with securities as collateral. Thanks to the KIDC, the once-barren public interest in securities saw the creation of a related system, and the development of the stock issuance market grew more active.
Even before the KIDC’s establishment, stock issuance remained intermittent but insignificant, and in the case of bonds, the issuance market did little to procure industrial capital depending on the method of acquisition by financial institutions or that of addition 173 and digestion, with little exception. Under these circumstances, the stock issuance market CHAPTER was buoyed by the KIDC’s establishment and its full-fledged activities. Twelve companies 03 collaborated to issue KRW 2.21 billion worth of shares in 1969 and nine companies publicly Developing Azerbaijan’s Stock and Stock-related Derivatives Markets issued KRW 2.06 billion worth in 1970. On the bond market, the initial public offering of KRW 250 million in general corporate bonds by Dong-A Pharmaceutical in March 1972 and KRW 300 million in KIDC-guaranteed corporate bonds by Taihan Electric Wire Co. began in 1972, when the bond market became a normal stock market by moving away from the collapse of government bonds. As such, the stock market saw a turning point in its capital procurement role to raise corporate funds through public offerings of stocks and bonds through the enactment of the Act on Capital Market Development and the KIDC’s founding.
3.2.2.3. Reorganization of Securities Relations Act
Following the enactment of the Act on Capital Market Development in November 1968, the Securities and Exchange Act was amended in December of the same year to add the following provisions to improve the stock market and protect investors. The minimum capital of securities companies differed according to their licensed activities through the abolition of such companies’ registration system and enhancing public confidence by switching to a licensing system. In other words, brokerages that solely focused on consignment and self-sales set minimum capital at KRW 30 million and those engaged in acquisition work raised the bar to KRW 50 million won. The net operating capital of 3.2.3. Promoting Corporate Openness for Capital Market Development Openness for Capital Corporate 3.2.3. Promoting enacted in 1968, a more active government Development on Capital Market With the Act The most crucial tax incentive for public corporations was a tax rate up to 20 percentage was a tax rate corporations The most crucial tax incentive for public In November 1967, tax code revisions sought to develop the domestic stock market. A A market. stock domestic the develop to sought revisions code tax 1967, November In In August 1969, the Act on Securities Investment Trust Business debuted to promote stock Trust Business debuted to on Securities Investment the Act 1969, In August policy toward the corporate sector came on January 5, 1973, through the Act on the on the the Act sector came on January 5, 1973, through policy toward the corporate tax rate was lowered across the board regardless of whether a company conducted conducted a company was lowered across the board regardless of whether tax rate details to promote internal accumulation disclosure, with the aim of mitigating an entity’s from gap between public and private entities was also reduced and investment. The tax rate 20 to 13 percentage points. effectively requiring a public corporation to be listed. to be effectively requiring a public corporation on Capital Market in late 1968, when the Act points lower than that of ordinary corporations Development was enacted as a corporate tax benefit. In late 1971, however, the corporate 1971 raised the required ratio of the largest shareholder’s equity to 51%, that of minority equity to 51%, that of minority shareholder’s of the largest the required ratio 1971 raised of minority shareholders to 200. In addition, the shareholders to 30%, and the number recruitment or capital with tax exemption to a corporation a corporate amended act granted increase in public offering but must that listthe its company shares on the exchange in June, leading measure to this end after the revision was to divide the tax liability between public leading measure to this end after the or their shareholders’ corporations benefits to public and grant and private corporations income if they met certain requirements. After stipulating such requirements for the first revision in December in late 1967, the Act Tax time through an amendment to the Corporate of stocks, and contribute to national economic development by setting up a specialized up a specialized setting by to national economic development of stocks, and contribute knowhow. securities no with investors or investors small for agent an as act to institution sector, the KIDC started the allowance of the securities investment trust Through this law’s 1970. 100 million in May first such trust with paid-in capital of KRW country’s market stability and facilitate internal automation by stimulating demand for securities securities for demand stimulating by automation internal facilitate and stability market the raising enable stock price stability, ensure purpose was to law’s investment. The new idle funds, expand the volume funds through the gathering of small of large industrial securities companies was subject to change in accordance with the increase in assets. The The the increase in assets. accordance with to change in companies was subject securities setting aside of securities and required the debt ratio set new a and Exchange Act Securities 2.6 billion to KRW from KRW exchange was raised capital of the main reserves. The trading Hanbo Securities, brokerages—Hanshin large three the creation of also saw 1969 billion. 3 Insurance. Securities, and Life 174 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Promotion of Public Openness of Enterprise on December 30, 1972, while revising the Act on Capital Market Development. This was the first adjustment to develop the stock market from the implementation of a new market system, including the conversion of the ordinary trading system centered on credit transactions under the June 3 Act of 1971.
3.2.3.1. Enactment of Act on Promotion of Public Openness of Enterprise
The Act on the Promotion of the Public Openness of Enterprise sought to improve a company’s financial structure through corporate disclosure, induce a corporate financing system biased toward indirect financing to favor direct financing, and promote sound economic development through the people’s participation. This law was combined with the Act on Capital Market Development and its legislative purpose. Corporate disclosure, however, proved less than expected after 1971 since tax breaks for public corporations in general had been passive in the economic recession of 1971, lack of acquisition capacity by stock acquisition institutions, management rights violations due to corporate disclosure, and pressure on public corporations to pay dividends. Accordingly, the government’s policy toward corporate disclosure shifted from its previous approach of passive inducement that 175 gave tax benefits for disclosure to one requiring more active disclosure. In other words, the CHAPTER government was empowered to limit financial support as well as offer tax advantages to 03 companies subject to disclosure and ordered them to conduct it. Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
The procedures for corporate disclosure designation had the finance minister select an open qualified corporation from those subject to public disclosure and order the implementation of corporate disclosure to a publicly qualified company after a decision reached in a corporate public review meeting. The corporation subject to disclosure stipulated that the amount of cash loans or capital goods introduced under the Foreign Capital Act was equal to the capital amount of the corporation, the August 3 Measures with a loan adjustment of more than KRW 100 million, three financial institutions with more than KRW 1 billion in loans, four companies with credit of more than KRW 1 billion, a corporation deemed necessary for national economic development, and a publicly qualified corporation with more than double the annual profit of more than 10% after an investment of KRW 50 million. In addition, the Corporate Public Deliberation Council, which selected a public corporation from among those publicly qualified, comprised five or fewer members appointed by the ministers of economic planning, finance, and commerce, BOK governor, president of Korea Investment Corp., chairman of the Korea Stock Exchange, and other financial leaders led by the prime minister. In addition, when the finance minister ordered the disclosure of an entity, he was required to specify the disclosure method of 1) public share count; 2) an ownership ratio other than the largest shareholder; 3) condition; and 4) Voluntary corporate disclosure was scarce even after the enactment of the Act on on disclosure was scarce even after the enactment of the Act corporate Voluntary 3.2.3.3. Active Promotion of Corporate Disclosure of Corporate 3.2.3.3. Active Promotion 3.2.3.2. Revision of Act on Capital Market Development of Act 3.2.3.2. Revision of public offerings after the enactment of the Act In order to enhance the efficiency Disciplinary measures were taken against a corporation that failed to fulfill the disclosure that failed to fulfill against a corporation were taken Disciplinary measures In addition to exemptions in corporate and income taxes, a public corporation was was corporation taxes, a public and income in corporate to exemptions In addition Corporate Open Market to promote private investment activity while improving the the while improving activity investment private promote to Market Open Corporate Thus the financial structure and expanding long-term stabilization funds. corporate of the KIDC was changed to Korea Investment Corporation (KIC), its capital was increased to increased was capital its (KIC), Corporation Investment Korea to changed was KIDC the of KRW 10 billion, and its duties were expanded to prepare for a large-scale public offering in Disclosure. on Promotion of Corporate line with the purpose of the Act fourth of all issued shares under the Commercial Act). Third, for the convenience of listed Third, for the convenience of listed Commercial Act). fourth of all issued shares under the of sovereign rights and the proxy system of name companies, the non-issuance system the requirements for a chairman of the shareholders’ recognition were adopted. In addition, name The strengthened. were accounts shareholder check and order to maintain meeting on Promotion of Corporate Disclosure, the related Act on Capital Market Development Development on Capital Market Act Disclosure, the related on Promotion of Corporate was extended to 10% to establish warrants was amended. First, the scope of employee was capital of an open corporation holding system. Second, the authorized an employee the under capital paid-in of amount the (twice capital paid-in the times four to expanded to one-half (one- was expanded shares and the issuance of non-conformity Commercial Act) tax secretary. aggregate income amount of shareholders’ income tax, including dividend income from a a from income dividend including tax, income shareholders’ of amount income aggregate of interest the loss allow not does which income, taxable as such corporation, default public on limit deduction the reduces but executives, and shareholders from borrowed debts on 20 collects additionally and corporations general of that of half to expenses entertainment amount, as taxable income taxable income tax percent of the government-decided corporate amount of dividend income received by the shareholders was added to the aggregate income the shareholders was added to the aggregate income received by amount of dividend law applied. evasion or non-payment amount, and the tax income tax was included in the income amount of shareholders’ order. If the aggregate share distribution method and investor protection. method and share distribution subject to a one-time asset reassessment for non-business land for the benefitof its founder. the less than 30%, a 50% reduction in was ratio largest shareholders whose share the For 176 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan government decided to stimulate the practice of disclosure more aggressively. In March 1973, the first meeting on corporate open review was held to designate 110 companies for public disclosure. Of 26 companies that could be publicly designated, 12 were first encouraged to conduct disclosure; if not, they were ordered to do so. In July 1973, a second meeting lowered the criteria for selecting a corporation for public disclosure, and 350 companies were ordered to submit financial statements and other data.
In the first half of 1973, voluntary initial public offerings appeared before public designation was made, especially as disclosure was boosted by an unprecedented economic boom. In that year, 47 companies raised KRW 21.5 billion through issuing new shares or selling existing ones, 13 times more than that of the 34 publicly traded companies from 1968-72; the amount of public offerings also more than tripled. As such, the number of listed companies surged due to the rise in public disclosure that began in 1973, but things started to cool down due to the global economic slowdown in the second half of 1973 and the stock slump caused by the oil crisis in October that year.
3.2.4. Opening and Operation of KOSDAQ Market 177 CHAPTER
3.2.4.1. Debut of Korea Stock Exchange 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets Public policy promoted since the late 1970s had favored large companies and economic growth but this caused an imbalance between regions, social classes, and industries. Around this time, the government sought a new economic paradigm as Taiwan, which was a developing economy like Korea and a strong competitor, achieved high economic growth through a growth model favoring small and medium enterprises (SMEs). As part of an initiative to nurture smaller companies, Seoul launched projects to foster venture and small businesses by simplifying the process of launching startups and strengthening tax and financial support for promising ones. Despite this, such companies found it almost impossible to obtain direct financing through the capital market because of their inability to meet the listing criteria of the Korea Stock Exchange (KSE) due to their small capital. In response, the government in December 1986 announced a plan to promote a stock exchange for SMEs and pushed to open this market separately from the previous trading market under the auspices of the Korea Securities Dealers Association (KSDA). This was the first step toward the opening of the stock market in April 1987.
When it opened in 1987, the stock market started with three companies including Aero System and finished the year with 21 companies registered. The number of KSE-registered companies surged every year, reaching 340 in 1995, the year just before the launch of For transactions on the KOSDAQ, a company wanting to register first had to select a wanting to register first had to select a a company on the KOSDAQ, transactions For 3.2.4.2. Setup and Operation of KOSDAQ Market and Committee of KOSDAQ 3.2.4.2. Setup and Operation on March 26, development, the government announced Under a plan for stock market a decision on the sale price was made through individual competition based on multiple multiple on based competition individual through made was price sale the on decision a notified prices. The results of sales concluded under this principle were immediately The system. through the computer network of securities companies connected to the trading from the sale date (T+2 days) settlement was made through the depository on the third day the registered company’s shares (343 companies at the time of opening) distributed through shares (343 the registered company’s and 09:30 to 11:30 on such bidding procedures were from 09:30 to 15:00 on weekdays unit without as a single at that time, it was operated market the trading Unlike Saturdays. The signing method was the and the afternoon market. the morning market separating based on the principle of price and time preferences, and contract conclusion of a trade securities company to take charge of registration after meeting certain requirements. In after meeting certain requirements. In charge of registration to take securities company was required to select a company a registered corporation case of bidding for registration, winning bid was adopted as a conventional method to substitute for the bidding, and the hours of The trading to bid from the highest price to the total number of bids sequentially. for the acquisition of KOSDAQ shares with a capital of KRW 5 billion and established 5 billion and established shares with a capital of KRW for the acquisition of KOSDAQ Stock for the KOSDAQ 17, 1996. On June 12, the main permit Securities on May KOSDAQ 1. on July began operations market the finance minister and the by Exchange was granted 1996, that it would establish an OTC brokerage to introduce a competitive trading method to to introduce a competitive trading brokerage 1996, that it would establish an OTC and securities companies completed their applications As a result, the KSDA market. the OTC called improvement of the stock exchange-related system. The system expanded the function of the stock exchange-related system. called improvement more sound, to become registered corporations encouraged market, of the stock exclusion so that the latter could emerge on the stock market and digitize buying and selling methods for promising SMEs and venture businesses. as a financing market 953.5 billion in 1995, emerging as a new market for corporate financing. InJuly 1992, the listed on the KSE to register on the small businesses wishing to be government required in the number of newly registered in a spike for more than a year, resulting market OTC market for the setup of the OTC Meanwhile, the foundation market. OTC companies on the 10, 1994, of the so- announcement on December set through the government’s was KOSDAQ the over-the-counter (OTC) stock market KOSDAQ (Korean Securities Dealers Automated Dealers Automated Securities (Korean KOSDAQ market stock (OTC) the over-the-counter 1.3 billion KRW volume was merely of stock transactions, In the first year Quotations). Bank got Exchange Korea such as grow as large companies to steadily but continued first KSE’s the In billion. 332 KRW hit transactions of volume the saw 1994 1992. in listed 4.5 billion but ballooned to KRW reached just KRW funding performance year, corporate 178 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan (T+2 days) and a commission of 0.4% of the transaction amount was paid to the securities company. Registered corporations by law had to report disclosure details in writing or through fax, and regular disclosure was required to investors through the KOSDAQ and the stock market network. The regular disclosure of settlement details for each business year had to be submitted within 100 days after the end of a business year, including settlement and audit reports, company reform statements, and shareholder lists, and a half-year report was due within 60 days of the end of a business year.
Despite its commitment to nurturing promising small and medium venture companies as a funding market, the KOSDAQ remained sluggish more than a year after its opening. In late October 1997, this market had just 45% of the number of KSE-listed companies but the annual transaction volume was only a fraction of the KSE’s (one to two days). The KOSDAQ’s identity was not secure as it merely remained an audition-type market for listing on the KSE and with low confidence from the general public. And as registration methods of old stock sales were used more often due to lack of system devices, only capital gains such those by as former startup shareholders could be realized, and the KOSDAQ’s functions were not smooth as a direct financing market for promising small and venture businesses. Unlike on 179 the KSE, investors were still unable to invest in the KOSDAQ due to the practice of collecting CHAPTER 100% consignment securities when trading stocks on it and the lack of a simultaneous 03
interest system. Investment by institutional investors such as investment trust companies Developing Azerbaijan’s Stock and Stock-related Derivatives Markets and pension funds were also sluggish. To boost the KOSDAQ, the government in November 1997 decided to restructure and nurture the market. The main direction of the reform was to significantly ease KOSDAQ entry requirements, apply strict conditions for market maintenance, improve the disclosure system to further strengthen investor protection, and enhance the independence of KOSDAQ market operations and the public nature of market supervision by separating market management and supervision. In addition, a decision was made to promote three separate markets for venture businesses on the KOSDAQ: the Stock Exchange Market for blue-chip conglomerates, the KOSDAQ Business Market for SMEs, and the KOSDAQ Venture Market for companies based on size and characteristics. In addition, a government five-year plan for launching and promoting venture businesses was released in December 1998. This key policy tool sought to support prospective and early startups through tax support such as a 50% reduction in corporate taxes for venture businesses and preferential treatment in the review of KOSDAQ registration. The result greatly contributed to fostering new industries, especially those featuring information and communications technology (ICT).
The KSDA opened and operated the KOSDAQ under the Securities and Exchange Act. Yet this organization was supposedly limited in its capacity to maintain the public nature of the This raised the need to form a virtuous circle of an ecosystem for small and medium medium and small for ecosystem an of circle virtuous a form to need the raised This The KOSDAQ is the capital market for small and medium venture businesses, but it was for small and medium is the capital market The KOSDAQ 3.2.5. Opening and Growth of KONEX of KONEX 3.2.5. Opening and Growth in Opening and Progress of 3.2.5.1. Background Judging that the launch of the committee could no longer be delayed, however, however, delayed, be longer no could committee the of launch the that Judging such as bank loans. revitalizing the collection and reinvestment of investment funds from venture funds by practically impossible for startups in the market’s early stage to enter. This was because early stage to enter. This was because impossible for startups in the market’s practically obligations were regulations including those on entry standards and public disclosure than that of listed applied to protect investors. Thus the burden of interest costs was heavier companies as most financing for small and medium startups depended on indirect financing the number of representatives from the securities industry, attracting the participation of of the participation attracting the securities industry, the number of representatives from the proportion of experts in venture technology and institutional investors, and expanding the committee and prevent unfair trading, protect investors on the KOSDAQ accounting. To investor in September 2000 to enhance (KOSS) Surveillance System established the KOSDAQ functions. monitoring and sales psychology by strengthening market confidence market operations, began to consider strengthening its autonomy by further expanding expanding further by autonomy its strengthening consider to began operations, market healthy a of plan for the development a released authority and responsibilities. It its independence and expertise committee’s the 1999, to increase December 20, on KOSDAQ chairman dedicated to business affairs, reducing introducing one full-time committee by conditions. policymakers finally opened it on Oct. 12, 1998, to bolster public confidence in the KOSDAQ. and management of with the supervision tasked In line with this action, the committee, as planned, including supervision of tasks delegated to the KOSDAQ Stock Market. Due to Due to Stock Market. the KOSDAQ to tasks delegated supervision of including as planned, of the establishment for preparation crisis that erupted in late 1997, the foreign exchange continued to stagnate. On October and the KOSDAQ Committee was delayed, the KOSDAQ index adjusting the KOSDAQ index reached 60.7 (the index before 7, 1998, the KOSDAQ unstable by was plagued the market to 1000 on January 26, 2004) and base value from 100 KOSDAQ as a special corporation aimed at enhancing the rights and interests of its member interests of its member the rights and aimed at enhancing corporation as a special KOSDAQ authority established order. Thus the policy business companies and maintaining securities Committee the in KOSDAQ December 1997 to enhance the public confidence in theKOSDAQ, approval the with Along market. the registering as well as system its revising and drafting supervise and manage the KOSDAQ government failed to the cancellation, of registration 180 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan the start of business through the capital market. Because of the need to improve the listing conditions of such venture companies, which had technical knowhow but lacked the funds to commercialize it, to overcome difficulties in the early stage of startups by raising funds through listed companies, the government and the Korea Exchange began to prepare improvement measures in the second half of 2011. The launch of the Park Geun-hye administration in 2013 led to the “creative economy” campaign, with improving conditions for small and medium venture businesses proposed as a way to support this campaign.
To support SMEs and venture companies in the early stages of growth, easing their requirements to enter the KOSDAQ was proposed. Yet in this case, individual investors with relatively poor investment and risk-loss management expertise were feared to suffer damage. At the time, the market functions of the free board (now the K-OTC market) was reduced since it was recognized as a bad corporate market including for companies that were exiting the exchange.
Accordingly, the KOSDAQ decided to open a “tailored market” for small and medium venture businesses in the early stages of growth rather than utilizing the previous market. 181
The Korea Capital Market Institute in January 2012 was commissioned to research support CHAPTER for SMEs in the initial growth stage through the capital market and formed and operated 03 a task force for deliberation among working-level experts in March of the same year. In Developing Azerbaijan’s Stock and Stock-related Derivatives Markets April, the Financial Services Commission (FSC) jointly announced a plan to establish a stock market exclusively for small businesses, holding a workshop and a public hearing for reporters in May to gather opinions from market participants. In February 2013, exchange regulations were revised to open the Korea New Exchange (KONEX), which was dedicated to small and medium-size startups, after undergoing infrastructure maintenance including system construction.
3.2.5.2. Characteristics of KONEX in Early Stage of Opening
As Korea’s next-generation stock market, the KONEX was initially designed to cater exclusively to SMEs. Accordingly, only small businesses classified by the Framework Act on Small and Medium Businesses were allowed to get listed on the KONEX. Thus listing methods other than public offering were recognized, while listing requirements were minimized to support such companies in the initial stage of technical expertise.
Second, the KONEX was required to focus on professional investors. This limited the scope of market participants to those with a designated level of risk-reduction capability, as the market had high investment risk for ordinary investors since it catered to SMEs The KONEX also waived its external audit obligations to designated auditors and its its also waived its external audit obligations to designated auditors and The KONEX Unlike the KSE and KOSDAQ, the diversifiedUnlike the KONEX itsKSE listingand methodsKOSDAQ, to public offering, When the KONEX was opened on July 1, 2013, it had 21 companies including five in the 3.2.5.3. Initial Market Operations 3.2.5.3. Initial Market Operations Fourth, the KONEX was geared to support restructuring through methods such as M&As was geared to support restructuring through methods the KONEX Fourth, Third, the designated person-to-person system was adopted early after the KONEX’s early after the KONEX’s person-to-person system was adopted Third, the designated startups without KOSDAQ-type listing requirements. startups without KOSDAQ-type reduce to (K-IFRS) Standards Reporting Financial International Korean apply to obligation submission the exempt to eased also were disclosure public on Regulations costs. entry (22.5%). and direct listing. This lowered entry requirements so that SMEs or venture private equity, of the early days companies with promising technology and growth prospects could enter in bio sector, four in semiconductor equipment, three in software, and two in auto parts. The bio sector, four in semiconductor equipment, 22 billion, or 42.3% of the was KRW on the market assets of each listed company average average, while sales KOSDAQ’s were KRW 28.6 billion (55.3%) and net profit KRW 1.4 billion to support active M&As through the KONEX. A system of mass selling and auction sales was A to support active M&As through the KONEX. also introduced. receive advice and sponsorship. early the in important was this As competitiveness. and growth corporate strengthen to merger requirements (including listing) were mitigated growth stage of such businesses, the companies, writing a report on their status, and guiding them to comply with the rules. them to comply with the rules. a report on their status, and guiding companies, writing (after the government by 11 securities companies designated Exchange selected The Korea in late March 2013 after conducting a comprehensive selecting another five such companies) for acquisition work. The exchange was then review of securities companies authorized as an adviser to it designated company with the securities required to conclude a contract founding to make it easier for small businesses to use the market and protect investors. The to use the market it easier for small businesses founding to make and reviewing their eligibility was in charge of discovering companies designated adviser listed publicizing in guardian facto de as a served or she he afterwards, and listing, for initially. Thus professional investors, venture capitalists, and professional angel investors investors angel capitalists, and professional investors, venture professional Thus initially. deposits from basic were exempted and investment expertise risk-taking with sufficient those who investors, only Among general market. institutional investor-centric to form an were allowed to proxy securities) (including cash and 300 million more than KRW deposited participate. 182 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan of quarterly and semi-annual reports, and only 29 items were required to comply with disclosure requirements, lower than the KOSDAQ’s 51.
The sales method adopted a “single-price competitive trading method” that accepts an asking price on a 30-minute basis, enters a transaction at a single price, and requires transactions to be made on a 100-share basis.
In June 2013 just before the KONEX’s opening, five securities-related institutions—the Korea Exchange, Korea Deposit Insurance Corp., Korea Securities Finance, KOSCOM, and the Korea Financial Investment Association—decided to create a joint fund of KRW 100 billion to invest in listed companies on the KONEX. In addition, support measures were implemented to ease list maintenance by exempting KONEX-listed companies from listing and annual fees on a trial basis through June 2015.
3.2.5.4. Drive to Stimulate KONEX
In April 2014, the Korea Exchange and the Financial Services Commission jointly 183
announced a measure to promote the listing of companies to repair the fast track system CHAPTER (June 30, 2014) so that KONEX-listed companies could be transferred to the KOSDAQ at an early date. Accordingly, if certain requirements such as company size were met by KONEX- 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets listed companies for more than a year, this activated the KOSDAQ relocation listing, which exempted such companies from requirements for corporate continuity screening and shortened the listing period from 45 business days to 30. In addition, the trading method was changed from single- to multiple-price access selling (June 20, 2014) to raise efficiency in market operations. On the KONEX’s first anniversary in June of the same year, the company announced an additional plan to promote the market while improving the system of selling and selling off-hours and other items in November.
The improvements implemented by the KONEX Market Act (April 23, 2014), among policy initiatives for reforming the capital market announced by the government in 2015, greatly contributed to the KONEX’s revitalization by significantly boosting transaction volume. First, the basic deposit regulation was lowered from KRW 300 million to KRW 100 million to ease restrictions on entry by individual investors, small investment accounts in the KONEX were allowed up to KRW 30 million in investment per year regardless of basic deposit amount, and the basic deposit regulation was abolished for indirect investment (rap account) through securities companies. To expand securities supply, financial (external) requirements were abolished, the number of designated advisers was expanded from 16 companies to 51, and a listing system was adopted for companies meeting certain requirements such as technicality 3.3.1. Launching Futures Trading and Legislating Futures Market Legislating Futures and Trading 3.3.1. Launching Futures Market Opening of Korean before Trading 3.3.1.1. Futures This section covers the development of Korea’s stock-related derivatives market in the in the market derivatives stock-related Korea’s of development the covers section This 3.3. Development of Korea’s Stock-related Derivatives Market Stock-related Korea’s of 3.3. Development Corporate defections from the KONEX to the KOSDAQ also increased in number. Starting also increased in number. Starting to the KOSDAQ defections from the KONEX Corporate The KONEX showed remarkable growth in just a short period of time due to government growth in just a short period of time showed remarkable The KONEX following order: 1) Launch of futures trading and legislating the futures market; 2) opening and legislating the futures market; following order: 1) Launch of futures trading 3) setup of a domestic futures exchange; and 4) a futures and options market; and operating and diversifying its products. consolidating the futures market market using Pure Cell’s technological prowess, and Fantagio merged with the KOSDAQ- prowess, and Fantagio technological using Pure Cell’s market listed Edu Company. with Azin XTec in July 2014, 14 companies moved up to the KOSDAQ by late 2015, not to 2015, not to late by in July 2014, 14 companies moved up to the KOSDAQ with Azin XTec example, Pure Cell Power merged through M&As. For to higher markets mention transfers cell fuel the to enter wanted that market price oil the on company a listed Doosan, with listed companies raised KRW 170.1 billion in 74 cases since the KONEX’s opening, far more 170.1 billion in 74 cases since the KONEX’s KRW listed companies raised than the KRW 13.6 billion raised in the year’s first six months. The amount later surged to the through raised funds the and 2015, in billion 88.6 KRW and 2014 in billion 67.9 KRW of factories. went toward boosting growth engines such through construction market year to 108, with 74 ICT and bio companies accounting for 58 percent of the total (based on for 58 percent of the total (based on ICT and bio companies accounting year to 108, with 74 exploded capitalization Market 20 listed and delisted companies). 128 companies including over the period, and 3.6 trillion won 470 billion to KRW more than seven times from KRW 2014, to 2013 July from million 400 KRW around remained average transaction daily the 39 1.8 billion in 2015. A combined opened, but increased 4.6 times to KRW when the market efforts tostimulate the marketfrom theoutset. The marketappeared tosettle as a supply to fast growth and the steady rise of for early venture capital thanks and recovery channel its financing and transfer listing on theKOSDAQ. In late 2015, two and a half years after its opening, the KONEX saw its number of listed companies jump fivefoldfrom 21 in its first assessment by a technical credit rating agency and recommendation from a designated from a designated and recommendation agency rating a technical credit by assessment In addition, the KOSDAQ’s consultant. without a designated investor for listing institutional transfer review in case of part of the listing mitigating promoted by list was further transfer (SPAC)_. company acquisition special purpose a KOSDAQ-listed a merger with listing through 184 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Prior to the opening of the Korean futures market, futures trading was available only abroad. Futures trading by Koreans overseas began in 1973 after the oil crisis hit the Korean economy given the nation’s heavy dependence on the import of energy and other raw materials. Recognizing the need to stably secure and stock raw materials due to the first oil shock, the Regulations on the Management of Overseas Futures Trading of Major Goods took effect in December 1974 to allow overseas commodity exchanges only for the misreporting of raw materials by the Public Procurement Service (PPS) and businesses. After the revision of the Regulations on Foreign Exchange Management in December 1987 allowed only foreign exchange banks to make mistakes, the error requirement was abolished in April 1998 to allow speculative trading by individuals. Early futures trading abroad was monopolized by the Seoul office of Merrill Lynch and later dominated by the PPS. Participation in overseas futures by ordinary manufacturers and others, a mistake factor for items subject to futures trading, was launched in 1984 after a domestic futures brokerage was established. On April 13, 1984, Daehan was designated the country’s first futures trading broker by the PPS. Shindongbang, Cheil Jedang, Samyang Maintenance Materials, and LG Metal also participated in overseas futures trading at the time, in addition to three home appliance makers—Goldstar (later LG Electronics and LG Cable), Samsung Electronics, and Daewoo 185 Electronics—and precious metal wholesalers. CHAPTER 03
The foreign financial futures system was introduced to Korea in January 1988, more Developing Azerbaijan’s Stock and Stock-related Derivatives Markets than 10 years after the introduction of the overseas trading of commodity futures. In December 1987, the Regulations on Foreign Exchange Control were amended to allow overseas financial transactions with the Bank of Korea (BOK) as the regulator in January 1988. Brokerage operations of foreign financial futures were the exclusive domain of foreign exchange (FX) banks, while transaction performance of foreign financial futures was minimal due to lower marketing and investor awareness since overseas commodity futures grabbed most of the market’s attention. Among foreign financial futures, interest rate futures saw relatively brisk trading, mostly through in-house transactions by FX banks.
3.3.1.2. Laws on Opening Futures Market
The Act on the Opening of the Domestic Futures Exchange provided the basis for adding the opening of the futures trading market to the KSE’s work after the seventh amendment to the Securities and Exchange Act came in November 1987, and for setting business regulations for the futures trading market. The 10th revision to the act in December 1991 allowed the designation of derivatives related to the securities index as securities by easing the designation criteria under presidential decree. This amendment alone, however, made it difficult to introduce futures trading that targeted the securities rights index, with legal In the process of effectuating the act, a heated debate erupted over who would handle In the first half of 1995, the Futures Trading Act was enacted and promulgated on promulgated on was enacted and Act In the first half of 1995, the Futures Trading In April 1994, a bill on the Financial Transactions Act was submitted to the National was submitted to the National Act Transactions In April 1994, a bill on the Financial In response to this move, the Ministry of Finance formed the Financial Futures of Finance formed the Financial Futures In response to this move, the Ministry In July 1986, the PPS under the Economic Planning Board (EPB) proposed the creation creation the proposed (EPB) Board Planning Economic the under PPS the 1986, July In stock index futures or options, the KSE or the newly established futures exchange. These These exchange. futures established newly the or KSE the options, or futures index stock and the theory of arguments were largely divided into the existing system of good faith of the past and present. separation Transportation Act was enacted to cover goods, water, and financial products. Act Transportation December 29 of the same year after a public hearing was held in July. Assembly, and the Act on Commodity Futures Trading was enacted as the Ministry of of Ministry the as enacted was Trading Futures Commodity on Act the and Assembly, of the same year under a government was established in December Finance and Economy and the reorganization. Individual legislative promotion of the two parties was suspended Association in February 1993 that included banks and merchant banks, and short-term and 1993 that included banks and merchant Association in February general financial, insurance, and leasing companies to promoting the establishment of the approval. minister’s Financial Futures Exchange with the finance Korea this time, the Korea Futures Trading Council, which focused on companies participating in in participating on companies focused which Council, Trading Futures the Korea time, this the 1992, PPS. In the for vehicle the main as established was overseas futures exchanges, bill that included the setup of a futures transaction procurement agency prepared a futures exchange after consulting with the EPB. listing the options as securities under the act. listing the options as structural for compensate to gifts financial and goods covering exchange futures a of of finance. At or that markets and livestock on the domestic agricultural vulnerabilities act in January 1994 set a new regulation that included the designation of futures trading of the designation of futures trading set a new regulation that included act in January 1994 securities indexes as securities, trading of such indexes as that of securities, and the figures legal disputes and allowing the stock as securities prices, thus resolving of securities indexes the act’s And on March 22, 1997, Article 2-3 of to be opened on the KSE. index futures market and stock options on the KSE, was added to list the securities index Enforcement Decree ure with no real propertyfigure with no a computational index was simply needed. The supplementation Moreover, securities. with traditional could not avoid confusion and this rights in securities, the to due trade a constitute not could it securities, as designated was index the if even to of the act related net, under the provisions was settled which futures trading, nature of to the the 11th amendment of securities. Accordingly, such as the sale and consignment trade 186 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan The existing system’s premise was that transactions of stock index futures and options should be handled by the KSE under the Securities and Exchange Act since such transactions were not only based on stock prices determined by the market, but are closely related to transactions in kind such as hedge and profit trading. Thus both markets had to be managed comprehensively for the healthy development of the domestic spot and futures markets.
Another argument, however, proposed that all futures including stock index futures and option trading would be more efficiently traded on the futures exchange through the system under the Transfer Act. This was because futures and spot transactions were different in nature, with only the types of underlying assets being different while functions and trading methods remained the same.
This controversy was eventually settled after futures trading vis-à-vis the securities index and the index itself was removed from Article 2 of the Securities and Exchange Act, which limited the sale of securities, and from Article 6 of the Act on the Enforcement of the Futures Exchange, which handled all futures transactions. The period of implementation, however, was postponed until the date stipulated by presidential decree, and until then, the KSE was 187 required to deal with it per the Securities and Exchange Act. CHAPTER
3.3.2. Opening of and Operation of Futures and Options Markets 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
3.3.2.1. Opening of and Progress in Stock Price Index Futures Market
The Korea Stock Exchange (KSE) in the mid-1980s pushed for the opening of the futures market, adding the market’s opening to the KSE’s duties when the Securities and Exchange Act was revised in 1987. The opening of the futures market was delayed, however, due to problems such as the overall legislative system for futures trading or questions over jurisdiction on who should open and manage the market. From July to December 1990, the KSE studied the feasibility of introducing new products and announced the results as measures to introduce main stock futures to prepare for a phased market opening.
The opening of futures trading on the KSE occurred in 1993 under a five-year government economic plan that included opening the main market to stock index futures as part of financial reform. Accordingly, the 11th amendment to the Securities and Exchange Act in January 1994 completed the necessary legislation for the market’s opening, including the securities index on the agenda. Starting from June 15, 1994, the KSE calculated and announced the Korea Composite Stock Price Index 200 (KOSPI 200). 3.3.3. Setup of Korea Futures Exchange Futures 3.3.3. Setup of Korea of Ministry new the after came Exchange Futures Korea the of establishment The The opening of Korea’s main market for stock options futures following that of the main main market The opening of Korea’s To open the stock index options market, the KSE formed a task force in March 1994 1994 March in force a task formed KSE the market, options index stock the open To Following the opening of the main market for stock index futures, the KSE opened the index futures, the KSE opened the for stock market the opening of the main Following 3.3.2.2. Opening and Development of Stock Price Index Options Market Options Price Index of Stock Development 3.3.2.2. Opening and The KOSPI 200 is a stock index used as a trading target for stock futures and index and index for stock futures target used as a trading 200 is a stock index The KOSPI in April 1995 test market the KSE opened a futures years of preparation, After several Finance and Economy was formed in December 1994 following government reorganization. was formed in December 1994 following government reorganization. Finance and Economy The Futures Trading Act, which combined commodity and financial futures, was enacted in December 1995. investors with new investment opportunities. introduction of stock index options trading in Korea. in Korea. introduction of stock index options trading market for stock index futures not only improved the efficiency of the domestic exchange providing investors with the means to manage stock investment risk, but also provided by to study the feasibility of opening the options trading system and market in major in major and market system the options trading to study the feasibility of opening was fully index options market and in September that year, the stock international markets, situation except for was developed to suit Korea’s prepared to open. The computer system In other countries, the introduction of stock index futures and systems. payment several which led to the early stock index options within two years was common, of general trading public sentiment said the stock index options market needed early opening to promote needed early opening to promote options market public sentiment said the stock index Thus the stock index option domestic stock market. globalization and development of the work. preparatory was opened early thanks to the KSE’s market main market for stock index options on July 7, 1997, through the KOSPI 200 as a trading 200 as a trading through the KOSPI for stock index options on July 7, 1997, main market demand 1996, trading in May index futures market target. Since the opening of the stock stock index options. In addition, linking stock index futures with increased by has gradually and studied possible scenarios; the country’s first futures market was opened on May 3, 3, May on opened was market futures first country’s the scenarios; possible studied and 1996. This milestone opened the era of full-fledged derivatives trading inKorea and freed from reliance on overseas futures. the market options. Among all stocks listed on the main exchange, the top 200 are selected based on based on selected the top 200 are exchange, on the main all stocks listed options. Among and liquidity. representation and industry market 188 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan After two years of preparation, the Korea Futures Exchange (KOFEX) was founded after its inaugural general meeting was held on January 8, 1999 and registration was completed on February 6 of the same year. KOFEX was designated a not-for-profit corporation using the membership system with a paid-in capital of KRW 33 billion; 11 members invested KRW 3 billion each.
A computerized transaction method was adopted to computerize all processes ranging from ordering, signing, and settlement of futures transactions. To stabilize the computer system and master the activities of market participants, the KOFEX operated a mock market in three stages in 1999 from February to March and opened a futures market on April 23 of that year. At the time of opening, the four trading targets were CD rate, USD dollar and options, and gold futures.
3.3.4. Unifying Futures Market and Diversifying Products
By late 2003, the domestic futures market was divided into the stock price index and stock-related futures market opened by the KSE and the futures market opened by the 189
KOFEX. The markets for stock index futures and stock options opened by the KSE were CHAPTER governed by the Securities and Exchange Act, while the line water market opened by KOFEX had different laws for its two markets per the temporary Transfer Act, which was scheduled 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets to unify the futures-related regulatory law.
In other words, Article 1 of the Act on the Exhibit of Futures Trading enacted in December 1995 stipulated the deletion of the relevant provisions of the Securities and Exchange Act on the stock index or individual stock options from the date prescribed by presidential decree, and the provisions of the Securities and Exchange Act on stock index and individual stock options were also in effect until the day stipulated in the first amendment to the Securities and Exchange Act on March 22, 1999. As a result, KSE-listed stock futures and options and stock index options were subject to the Transfer Act from January 2004. Research and discussion on the transfer of KOSPI 200 futures, options and futures exchange and a plan to revamp the stock and futures markets were carried out.
The transfer of KOSPI 200 futures and options to the KOFEX was plagued by a debate over the lack of recognition for the KSE, which had been developing goods and fostering them as global products, and the view that unifying the futures market under the Transfer Act was desirable for the development of the futures market. The transfer of KOSPI 200 futures and other issues was closely related to the reorganization of the stock and futures markets, but on May 16, 2003, a solution was found after the government announced a basic The trading volume on the domestic derivatives market grew at record rates of 180% of 180% rates grew at record market volume on the domestic derivatives The trading 3.3.5. Rapid Development of Korean Derivatives Market of Korean 3.3.5. Rapid Development On September 8, 2003, an agreement was signed between the KSE and KOFEX on the the on KOFEX and KSE the between signed was agreement an 2003, 8, September On In accordance with the government’s plan to restructure the stock and futures markets, futures markets, the stock and plan to restructure with the government’s In accordance derivatives trading and exemption from the capital gains tax also played a major role in the and exemption from the capital gains tax also played derivatives trading success. derivatives market’s level was the active participation of individual investors. Based on initial annual trading trading annual initial on Based investors. individual of participation active the was level Another factor behind players. volume, such investors formed the majority of this market’s was the development and dissemination of growth of the derivatives market the initial rapid the entry system (HTS). The ease of access of the HTS further accelerated the home trading from taxes on stock trading The lifting of transaction of individual investors into the market. institutional changes seen on the derivatives market, the reduction of basic reserves greatly the reduction market, institutional changes seen on the derivatives affected early growth. Thebasic deposit system required an investor to open an account or A tolerance. investors with low risk access by an amount for an order to curb market prepay to the global volume on the derivatives market transaction to raising factor contributing key in 2000, 289% in 2001, and 123% in 2002. High stock fluctuations were a major factor in 2002. High stock fluctuations were a major factor in in 2000, 289% in 2001, and 123% in because the greater the volatility of an underlying trading growth of derivatives the rapid the hedging. Among for demand greater the nature, the derivative’s the to due price asset’s January 2004, such as KOSPI 200 futures and options and stock options, but the agreement 200 futures January 2004, such as KOSPI designated the KOFEX to do so. To that end, 24 staffers from the KSE andKorea Securities in Busan. dispatched to the KOFEX specializing in listed stock futures were Company stipulated the basic content of the transfer of KOSPI 200 futures and options to the futures options and 200 futures of KOSPI content of the transfer stipulated the basic 2004. exchange from January since KSE the by handled been had futures Such futures. stock listed of transfer detailed agreement on the transfer of KOSPI 200 futures and options. On June 12, the three entities options. On June 12, the three entities 200 futures and of KOSPI transfer agreement on the stock listed of transfer and the exchange of consolidation the on agreement an signed to set up a single exchange said the government would cooperate futures. The agreement of the Advancement on the the Act possible since the amendment to in the shortest time into a unified exchange, of markets including the integration Markets, Stock and Futures plan to reform both markets that included their consolidation for the sake of efficiency and smooth decentralization. 3, 2003, prepared an on June and Finance, KSE, and KOFEX the Ministry of Economic 190 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan
Key Factors behind Early Success of Korean Derivatives MarketFactor Description
The greater the price volatility of an underlying asset due to the derivative’s High fluctuations on stock market nature, the greater the hedging demand.
A lower basic deposit eased market access by investors with low risk Reduction of basic deposit tolerance.
Active participation of individual Individual investors accounted for more than a majority of all investors investors based on initial annual trading volume.
Development & dissemination of Easier market access accelerated the entry of individual investors to the HTS market.
The exemption of transaction taxes normally levied on stock trading and the Tax exemption lifting of the capital gains tax both played a major role in the development of the Korean derivatives market.
Source: Korea Capital Market Institute, Korean Derivatives Market: Diagnosis and Road Ahead, 2015.
3.4. Supervision of Securities Companies in Korea
This section explores the regulation and supervision of securities companies in Korea, 191 with five business lines of the industry defined by the law on capital markets. A company CHAPTER can engage in as many of these lines as permitted by the Financial Supervisory Service (FSS).
The section covers 1) evaluation and rating; 2) off-site monitoring and on-site examination; 3) 03 disclosure rules; 4) unfair trading and enforcement; and 5) accounting supervision. Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
3.4.1. Evaluation and Rating
3.4.1.1. Supervisory Evaluation
The FSS conducts supervisory evaluation of financial institutions, assessing the business operations and health of each institution. Several business characteristics of an institution are separately evaluated and later aggregated, resulting in the assignment of an overall rating. This supervisory rating was introduced for banks in 1996 and securities companies in 1999. With the introduction of the Financial Investment Services and Capital Markets Act (FSCMA), a revised system of common supervisory rating for financial instrument providers (FISPs) was established in 2009. The revised system divided the evaluation criteria into common and business specific. The first accounted for 60% of the rating and considered capital adequacy, earnings, and internal controls of individual companies. Components of the business-specific criteria vary by the business types a FISP engages in. For brokers and dealers, such components are liquidity and stability, while providers of real estate trust services are rated on liquidity and asset soundness. For a FISP dealing in multiple businesses, the weight of each business is computed and assigned based on earnings. It must also set aside on a quarterly basis allowances for credit losses according to losses according to quarterly basis allowances for credit a It must also set aside on classification. Asset classification is usually a major concern for a banking institution but also equally important for a FISP with assets exposed to credit risk. in five categories: normal, substandard, precautionary, doubtful, and presumed loss. Asset soundness: A FISP must classify its assets exposed to credit risk and impairment Asset soundness: A FISP must classify its assets exposed to credit risk and i) 3.4.1.3. Prudential Standards institutions. A The FSC and FSS have prudential guidance standards for financial Prompt corrective action (PCA) for financial institutions is enforced based mainly on financial institutions is enforced based mainly on Prompt corrective action (PCA) for At the time of the MCR’s introduction, FISPs were classified into three tiers for for tiers three into classified were FISPs introduction, MCR’s the of time the At In Korea, minimum capital requirements (MCR) were introduced for securities for securities (MCR) were introduced minimum capital requirements In Korea, 3.4.1.2. Minimum Capital Requirements 3.4.1.2. Minimum is capital adequacy financial institution for a most common requirements One of the FISP must comply with these standards specified for each business line including capital including capital FISP must comply with these standards specified for each business line asset soundness, risk management, and foreign currency assets and liabilities. adequacy, below zero are subject to MIO. the MCR. PCA has three categories: management improvement recommendation (MIR), management improvement recommendation (MIR), the MCR. PCA has three categories: and management improvement order (MIO). Themanagement improvement demand (MID), are 50%-100% from NCR an with companies 1 Tier 100%. is FISPs 1 for Tier NCR minimum and those with an NCR an NCR from 0%-50% are MID, subject to MIR. Tier 1 companies with assigned to Tier 2. And those providing investment advisory, discretionary investment, and discretionary investment, investment advisory, assigned to Tier 2. And those providing Upon their introduction, the NCR requirements were trust services were placed in Tier 3. FISPs belonging to the other two tiers remained subject applied only to Tier 1 and until 2016, to the NOCR requirement. superior indicator that gauges loss-absorbing capacity relative to a FISP’s risk exposure. risk exposure. to a FISP’s that gauges loss-absorbing capacity relative superior indicator and dealers were put in Those licensed as brokers implementing the new requirements. were services investment collective for licenses with FISPs companies. of group 1 Tier the operating in securities markets vary by country. vary by in securities markets operating was figure This (NOCR). ratio capital operating net the of form the in 1997 in companies is a 2014 under the view that the NCR (NCR) in April capital ratio the net replaced by expressed as a minimum level of capital. Though most countries have adopted BIS capital capital have adopted BIS most countries of capital. Though as a minimum level expressed applied to financial institutions banking sector, specific requirements for the ratios 192 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan ii) Risk management: A FISP must operate with a robust system of risk management. Under such a system, the FISP must properly identify, evaluate, monitor, and control inherent or associated risks with the financial investment services it provides. The FSS must periodically supervise the FISP’s risk management practices, internal guidelines, and practices.
iii) Soundness of foreign currency-denominated assets and liabilities: A FISP authorized to conduct foreign currency transactions faces limits on its overall foreign currency position and must also comply with the liquidity and maturity mismatch requirements for foreign currency. Prudential guideline standards also include restrictions on transactions with large shareholders. A FISP bound by such rules cannot extend credit to a large shareholder unless there is sufficient reason to believe that the action poses no material risk to the FISP’s safety and soundness. In addition, it is prohibited from acquiring securities issued by a large shareholder or equity and debt securities or notes issued by a subsidiary in excess of 8% of the FISP’s capital; conducting a non-arm’s length transaction with a large shareholder or any related party; or any activity or arrangement designed to circumvent the three 193
abovementioned restrictions. CHAPTER 03 The FSC and FSS implement corresponding supervisory actions if and when a FISP fails Developing Azerbaijan’s Stock and Stock-related Derivatives Markets to satisfy such standards. Supervisory actions triggered by the violation of the standards range from recapitalization to restrictions on dividend payouts.
3.4.2. Off-site Monitoring and On-site Examination
3.4.2.1. Off-site Monitoring
The FSS assigns a relationship manager to each financial institution subject to periodic onsite examinations. The manager participates in offsite monitoring and collects reports provided by the assigned institution. The main purpose of such monitoring is to complement onsite examinations. FSS examiners analyze reports and information collected from the institution to look for financial and operational weaknesses and risks to evaluate the institution’s safety and soundness. Findings from off-site monitoring comprise important input for the planning of a formal on-site examination.
3.4.2.2. Pre-assessment Preparation
An annual schedule for comprehensive assessment of financial institutions is made
3.4.2.4. Post-assessment Action detailing After a full-scope assessment is completed, the lead examiner prepares a report 3.4.2.3. On-Site Examination safety and soundness standards at an institution An onsite examination seeks to enforce additional review and decide what actions to take. The audited institution and individuals to additional review and decide what actions to take. decisions. be sanctioned can also file an objection to the FSC’s the findings and any corrective actions needed. Such actions are recommended for serious review violations of laws and regulations. The supervisory department and the enforcement office of the FSC jointly review the assessment report and recommendations. The audited institution and individuals to be sanctioned have the right to file objections to the decisions conduct an the FSC may the enforcement review committee. If deemed necessary, made by specific supervisory matters and concerns. other institutions if necessary. Upon completion of a full-scope inspection, the lead examiner Upon completion of a full-scope inspection, the lead examiner other institutions if necessary. speaks to the institution’s management and notifies it of weaknesses and other supervisory concerns identified during the process. In contrast, a targeted inspection is usually limited to specific incidents of irregularity and unsound business activities in which FSS staff target and ensure compliance with laws and regulations. The FSS conducts both full-scope and regulations. The FSS conducts both full-scope and and ensure compliance with laws and targeted audits of financial institutions. In theformer, the institution’s overall performance can examiner lead The assessed. is compliance and operations, management, finance, in and employees managers from the institution’s obtain statements and documentation and assessment to additional branches expand the scope of the during the audit, and may the assessment. FSS annual assessment plan includes the institutions targeted, types of inspections to be be to inspections of types targeted, institutions the includes plan assessment annual FSS of examiners to be assigned for the tentative launch dates, the number carried out, their supervisory plan is based on scope of assessment activities. A quarterly institutions, and the the annual plan, and the finalized plan is shared with theBank ofKorea andKorea Deposit ahead of ten days sent to the target institution at least Prior notice is Corporation. Insurance through an inspection planning process. Supervisory evaluation and ratings from previous and ratings evaluation process. Supervisory inspection planning through an input in the important comprise off-site monitoring from findings as well as audits size, The sources. various from collected also is information additional process; planning and complexity, risk profile of the institution under assessment are important factors, and the institution. The financial and business status of the overall the examiners determine 194 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 3.4.3. Disclosure Rules
Rules and regulations that promote fair and transparent corporate disclosure are necessary to protect retail investors and ensure an efficient and well-functioning securities market. The FSCMA stipulates three types of such disclosure: new securities issuance, listed companies, and significant events.
3.4.3.1. Disclosure for New Securities Issuance
The issuer of new securities offered for public sale must file a registration statement with both the FSC and FSS containing key information on the new issues. A prospectus, or a document prepared by the issuer to help investors make informed decisions, must also be filed with the statement. In addition, a waiting period is required before the issuer can solicit investors. The issuer must also submit a report on the final securities offering to the FSC and FSS after the offering and settlement procedures are completed. The securities must be issued to investors or registered with the Korea Securities Depository (KSD) before being listed and traded publicly. 195 CHAPTER 3.4.3.2. Disclosure for Listed Companies 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets Two disclosure types are required for listed companies. First, periodic disclosure is what a company must file to inform the FSS of its business operations and financial conditions on a quarterly, semiannual, and annual basis during each accounting period. Companies must file annual business reports within 90 days after such periods, with the quarterly and semiannual reports due within 45 days. Those subject to periodic disclosure include (a) those whose shares are listed on the Korea Exchange (KRX); (b) those with issued shares and other equity rights or claims, unsecured or convertible bonds, bonds with warrants, participating or exchangeable bonds, preemptive rights, depositary receipts, or structured financial instruments on the KRX, KOSDAQ, or KONEX; and (c) those subject to designation as independent external auditors by the FSC and FSS under Article 2 of the Act on the External Audit of Stock Companies. Information to be disclosed in business reports includes business objectives, nature of operations and activities, financial statements and auditor opinions, the names of directors and officers, compensation for officers, status of the board of directors, subsidiaries and affiliates, other governance and organizational matters, shareholder composition and other data on shareholders, transactions with related parties, and other information relevant to investor protection.
Second, material disclosure requires the release of material information as needed insiders of a listed company include directors, officers, and major shareholders. The report must show the legal person’s and beneficial equity ownership in the company. equity ownership must also be reported. Subsequent changes in the insider’s also be filed if such a shareholder enters or amends an agreement that materially materially also be filed if such a shareholder enters or amends an agreement that affect the ownership structure of a listed company. Corporate time. first the for insider corporate a becoming after days five within securities issued (aka the “5% shareholder”). In addition to filing an initial acquisition report, such a shareholder must file reports on subsequent and material changes.A report must be filed when araises 5% or shareholder reduces itsby equity ownership must report A ownership. equity of purpose the alters or more or point percentage a the FSC, FSS, and KRX if the acquired equity exceeds 5% of the company’s equity equity equity exceeds 5% of the company’s the FSC, FSS, and KRX if the acquired Corporate Corporate insider: A person must file a disclosure report with the FSC, FSS, and KRX Large share ownership: A shareholder of a listed company must file a report with must file a report with of a listed company Large share ownership: A shareholder
ii) i) 3.4.3.3. Disclosure of Significant Event of Significant 3.4.3.3. Disclosure for significant events when its business must file a disclosure A listed company In addition, the KRX enforces its own disclosure rules to ensure smooth and orderly disclosure rules to ensure smooth and orderly In addition, the KRX enforces its own large share ownership, a shareholder becoming a corporate insider, tender offer, and short- swing profit. operations or financial conditions experience major changes. Such events include changes in or financial conditions experience major operations exercising a put-back option to give the beneficiary the right to execute a major asset a major asset execute the right to put-back option to give the beneficiary exercising a disposition or transfer. inquired, and fair disclosure. of listed securities including material business, trading or accelerated court receivership; (d) legally recognized cause for business dissolution; (e) cause for business dissolution; (e) receivership; (d) legally recognized court or accelerated debt; (f)to raise the board of directors reduction and a decision by capital increase and filing of a securities class-action suit; (g) issuance of convertible bonds, bonds with warrants, or disposition of treasury stocks; bonds; (h) resolution of the acquisition and exchangeable merger; and (j) division and split share exchange or transfer, (i) decision on a merger, or appropriate in addition to periodic disclosure. Material disclosure must be filed for for filed be must disclosure Material disclosure. periodic to addition in appropriate or one decisions within investment or their investors affect materially event that could any to material changes subject and developments, Activities, occurrence. of the event’s day and/or accounts banking of suspension (b) notes; redeem to failure (a) include disclosure of application for court receivership (partial or whole); (c) submission business operations 196 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan iii) Tender offer: A person and a related party must make a tender offer when the party attempts to acquire more than 5% of a listed company’s shares from more than ten shareholders. The party must file a tender offer statement and announce the offer in major newspapers. Information such as the offer’s purpose, the number and type of securities sought, the offer’s terms and conditions, and the method to be used to acquire the desired shares must be included in the announcement. The tender offer period is usually six months, but the prospective acquirer may amend the terms and conditions and submit a corrected statement before the period expires. Changes considered disadvantageous to existing shareholders are prohibited.
iv) Short-swing profit is any profit a corporate insider earns from trading specific securities within a six-month period. Securities held by a corporate insider with the issuing company are called specific securities, which include equity and equity- convertible securities such as voting and preferred non-voting stock, convertible bonds, bonds with warrants, participating bonds, and investment contracts. Depositary receipts and exchangeable bonds linked to such securities are also specific securities as well as derivatives and investment products whose underlying assets 197
are specific securities. A corporate insider must disclose and return any and all short- CHAPTER swing profit irrespective of the use of any insider information. Corporate insiders 03
prohibited from taking short-swing profit include directors, officers, and others Developing Azerbaijan’s Stock and Stock-related Derivatives Markets covered under Article 401-2(1) of the Commercial Act. Employees with privileged non- public information and major shareholders are also subject to short-swing disclosure.
3.4.4. Unfair Trading and Enforcement
The FSCMA prohibits three classifications of unfair trading activities: First, corporate insiders of a publicly traded company are strictly prohibited from buying and selling specific securities using material nonpublic information. The same rule applies to corporate insiders of a company whose shares will be publicly traded within six months, as well as to quasi- insiders including directors, officers, employees, agents, and major shareholders and their agents of a company and company affiliates or subsidiaries. Other related information users and persons with regulatory or licensing authority over the company and their agents are also deemed quasi-insiders. Persons or insiders of a company undergoing negotiations with the company also cannot conduct trading with material nonpublic information.
Second, market manipulation is a deliberate attempt to alter the prices of publicly traded securities. This illegal act includes the intent to create a misleading or false trading impression in others by orchestrating the purchase and sale of securities on the spot and 3.4.5.2. Audit Review and Quality Control Inspection Control and Quality 3.4.5.2. Audit Review The primary objective of accounting supervision is to ensure that a financial company’s 3.4.5.1. Legal Framework the Korea: in accounting of supervision for framework legal the form laws Three 3.4.5. Supervision of Accounting Third, the FSCMA bans deception and market abuses including the comprehensive including the comprehensive abuses bans deception and market Third, the FSCMA general, general, preparation of a listed company’s financial statements is the responsibility of the then be independently must the statements of and reliability accuracy The CEO. company’s must also deliver an explicit audit opinion in the internal auditor audited. The company’s business report. statements and an auditor’s report are prepared using the proper standards. Another Another report are prepared using the proper standards. statements and an auditor’s important objective is to assess the effectiveness of the auditor’s quality control systems. In accountants (CPAs) accountants and (CPAs) accounting firms to register with the FSC and FSS. Listed companies must submit to an external auditor financial statements that follow established accounting company’s audited the of evaluation an prepare must auditor external The standards. system of internal accounting management. financial reportingby listed companies, as well as continuous operation of internal controls auditors. The AEASC stipulates that a companies and evaluation of internal and external by be dismissed three-year term; he or she may must appoint an auditor for a listed company and committee audit company’s the of approval express the with only ends term the before requires certified public Commission (SFC). The CPAA reporting to the Securities and Futures FSCMA, the Act on the External Audit of Stock Companies (AEASC), and the Certified Public audited requires and measures disclosure provides FSCMA The (CPAA). Act Accountant illegal activity resembling that of market manipulation but deemed less serious. Such abuse Such serious. deemed less but manipulation that of market resembling activity illegal manipulation. market insider and outsider information or includes the use of buying and selling of securities through unfair means, schemes, or techniques. It also schemes, or techniques. It also of securities through unfair means, buying and selling of dissemination and information material of omission misrepresentation or prohibits the or threat to facilitate the buying or to the use of deception, violence, rumors, in addition an abuse market prices. The FSCMA defines as or manipulate market selling of securities futures markets. Other forms of market manipulation include (a) multiple parties conspiring parties conspiring include (a) multiple manipulation market Other forms of futures markets. other; prices with each at prearranged number of securities sell a prearranged to buy and legal without transferring buying or selling fictitious parties conducting and (b) multiple prohibited. activities are strictly of securities. These ownership 198 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 3.4.5.3. Companies Subject to Audit
Audited financial statements from listed companies and unlisted financial service providers are subject to FSS review. Such statements from companies not covered by the FSS are reviewed by the Korean Institute of Certified Public Accountants (KICPA). The FSS conducts a sample audit review employing quantitative analysis methods. When requested by the FSC, SFC, or a law enforcement authority, the FSS may conduct a targeted audit review. It can also conduct a targeted audit review if the SFC receives a request from a corporate insider, audit participant, or another source with credible charges of accounting misconduct.
3.4.5.4. Audit Supervision
The FSS inspects auditors for quality control purposes. Targeted auditors include those who audit 1% or more of listed companies or listed companies with assets of KRW 1 trillion or more. Auditors who employ 30 or more CPAs are also inspected by the FSS. The KICPA performs quality control inspections on auditors who fall under none of the aforementioned 199 categories. CHAPTER
3.4.5.5. Accounting and Auditing Standards 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets
The Korea Accounting Institute (KAI) sets accounting standards through delegation of authority by the FSC under the SFC’s oversight. Companies must prepare financial statements in accordance with the proper accounting standards. Auditors assess financial statements prepared by corporations following KICPA auditing standards.
4. Policy Recommendations
This section features policy recommendations to develop the stock and related derivatives markets in Azerbaijan. The recommendations are divided by market because both markets should be developed at the same time and the goals for each market are different. This section is organized as 1) setting strategic goals; 2) devising action plans; 3) recommending measures for the stock market; and 4) suggesting actions for the stock- related derivatives markets.
4.1. Setting Strategic Goals
The recommendations presented here to develop the Azerbaijani stock market also serve companies Investment Stock market FIMSA Investors Companies (BSE) Baku Stock Exchange Stock Baku Stock market derivatives market Regulated FX exchange FX Since the derivatives market must be promoted through links to the underlying securities must be promoted through links to the underlying Since the derivatives market The following are principles that should be applied to the recommendations. First, the First, the recommendations. to the be applied should that principles are The following sub-market sub-market structures instead of excessive details such as information on specific products structures. and unknown market years), and long term (within five years), and the axis ofrange is considered to be both the Because the main target is to promote the derivatives market, stock and derivatives markets. as a prerequisite for of recommendations scope narrow the needs to the stock market also require Recommendations for the promotion of each market boosting the other market. and demand, and basic and ground-based components such as laws and regulations, supply market, a development roadmap must consider the axis of time and range. The axis of time roadmap must consider the axis of time and range. a development market, two (within term medium year), one (within term short phases: three into divided be should [Figure 3-9] The To-Be Structure of BSE Structure 3-9] The To-Be [Figure of the stock market should also form the conditions needed to develop the stock-related stock-related the develop to needed conditions the form also should market stock the of as a hedging vehicle. should also serve Third, the latter market derivatives market. a of building sake for the global standards must comply with design market’s the Fourth, the priority of need and design of the system must consider Finally, more open economy. should come in stages. complementary measures as the conditions to develop the stock-related derivatives market. Development of the latter of the latter Development derivatives market. the stock-related to develop as the conditions suggested. vehicle is also as a hedging market development development stage. Second, should be based on the market recommendations 200 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan [Figure 3-10] Entire Framework of Recommendations
Stock-related derivatives Stock market market
Conditions Development plan C1 : Increase (trading) volume on R5 : Focus on potential star product stock market R6 : Organization of market C2 : Efficiency of stock market's fast infrastructure price discovery. C3 : Consolidation of confidence of market infrastructure
Development plan
R1 : Increase supply R2 : Increase demand R3 : Promotion of efficient market mechanism R4 : Consolidation of confidence of financial institutions
4.1.1. Recommendations for Stock Market 201 CHAPTER The recommendations presented here to develop the Azerbaijani stock market should also serve as the conditions to develop the country’s stock-related derivatives market. The 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets first condition is to raise the trading volume on the stock market. Good underlying securities representing the exchange’s volatility are needed for hedging. The second condition is the efficiency of the market’s fast price discovery function. Because volatility is hedged, continuous mark-to-market fair pricing of underlying securities is a must. The third and final condition is consolidation of the confidence of market infrastructure. Large securities companies and other players are needed to actively participate in the market.
Recommendation I is to increase supply and leads to R[1] I-1) privatization of government-owned companies; R[2] I-2) relaxation of listing standards; and R[3] I-3) promotion of the venture ecosystem to satisfy Condition I, which is raising the trading volume of the stock market. Recommendation II is to bolster demand and leads to R[4] II-1) foster the asset management and mutual fund industry and R[5] II-2) reduction or exemption of taxes and fees for investors to satisfy Condition I, which is to bolster the trading volume of the stock market.
Recommendation III is promotion of efficient market mechanisms and leads to R[6] III- 1) promotion of a continuous trade environment; R[7] III-2) offering the market-making process; and R[8] III-3) design of various stock indexes to represent the stock market and Recommendation VI is the organization of market infrastructure leading to R[11] VI-1) to R[11] VI-1) leading infrastructure Recommendation VI is the organization of market R[9] IV-1: reorganization of laws and regulations on securities companies R[9] IV-1: reorganization of laws and Derivatives Market 4.1.2. Recommendations for Stock-related Recommendation V is emphasis on a potential star product leading to R[10] V-1) offering R[7] III-2: offering of market-making process R[7] III-2: offering of market-making to represent stock market R[8] III-3: design of various stock indexes infrastructure of market Condition III: consolidation of confidence confidence of financial institutions Recommendation IV: consolidation of R[5] II-2: reduction or exemption of taxes and fees for investors R[5] fast price discovery function Condition II: efficiency of stock market’s mechanism market Recommendation III: promotion of efficient environment R[6] III-1: promotion of continuous trade R[2] I-2: relaxation of listing standards I-2: relaxation R[2] I-3: fostering of venture ecosystem R[3] II: increase demand Recommendation II-1: fostering of asset management and mutual fund industry R[4] Condition I: boost trading volume on stock market trading I: boost Condition I: increase supply Recommendation of government-owned companies I-1: privatization R[1] Recommendation Recommendation IV is consolidation of the confidence of financial institutions, leading accounting; and R[14] VI-4) design of the marking-to-market mechanism. accounting; and R[14] VI-4) design of the marking-to-market only one or two derivatives products in the beginning. incubation of sound and qualified speculators; R[12] VI-2) design of tax and fee mechanisms of risk aversion for investment in stock-related derivatives; [13] VI-3) design favorable Condition III, which is consolidation of the confidence of market infrastructure. of market is consolidation of the confidence Condition III, which ck market’s fast price discovery fast of the stock market’s ensuring the efficiency II, which is satisfy Condition function. to satisfy and regulations on securities companies IV-1) reorganization of laws to R[9] 202 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Recommendation V: focus on potential star product
R[10]V-1: offer only one or two derivative products to start with
Recommendation VI: organization of market infrastructure
R[11] VI-1: incubation of sound and qualified speculators
R[12] VI-2: design of tax and fee mechanisms favorable for derivatives investment
R[13] VI-3: design of risk aversion accounting
R[14] VI-4: design of marking-to-market mechanism
4.2. Devising Action Plans
The following recommendations seek the development of the stock market as an underlying vehicle and that of the derivatives market as a hedging vehicle.
The first step is to build the foundation for the development of both markets. Measures should first improve the supply and demand of stock market infrastructure, ease listing standards (R[2]), foster the asset management and mutual fund industry (R[3]), reduce taxes 203 and fees for investors, and amend laws and regulations on securities companies (R[8]). CHAPTER Other actions include fostering sound and skilled speculators qualified to build derivative infrastructure (R[10]), design of tax and fee mechanisms suitable for investment in stock- 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets related derivatives (R[11]), and risk-averse accounting design (R[12]).
The second step is to promote the stock and derivatives markets. The designs of stock indexes leading the exchange are needed, including the revitalization of a continuous trading environment (R[5]), provision of the market-building process (R[6]), and R[7]. When launching efforts to promote derivatives R[9], a decision is needed on whether to foster one or two star derivatives.
The third step involves improving supply and demand and creating infrastructure, but this is difficult to do in a single step. Thus a two-stage reinforcement plan is advised to further bolster the first stage. Additional measures to improve supply and demand on the stock market and amend laws and regulations on securities companies should be implemented, such as a public-private firm plan (R[1]); deregulation of listing standards R[2]; promotion of the asset management and mutual fund industry (R[3]), reduction of taxes and fees for investors (R[4]); and reform of securities companies (R[8]). Additional measures are also needed to foster sound and qualified speculators to build derivatives infrastructure. In addition, the range of goods should be continuously expanded to stimulate the derivatives market. General incentives like giving benefits to corporations going public and disciplinary going public and disciplinary corporations giving benefits to incentives like General Extreme measures like corporate disclosure designation were used to bolster the designation were used to bolster the disclosure corporate Extreme measures like Adolf A. Berle and Gardner C. Means (1932, 1967) presented the best classical model for A. Berle and Gardner C. Means (1932, 1967) Adolf Recommendation IV is consolidation of the confidence of financial institutions leading Companies 4.3.1. R[1] I-1: Privatization of Government-owned Recommendation III is promotion of efficient market mechanisms, leading to R[6] III- R[6] to leading mechanisms, market efficient of promotion is III Recommendation 4.3. Recommendations for Stock Market 4.3. Recommendations government- privatization of leading to R[1] I-1) supply, I is to increase Recommendation process. Though Section 3.2.3 explains and recommends these measures, a point of emphasisprocess. Though Section 3.2.3 explains and recommends these measures, a of amendments. is that they were not done in a single legislative session but through a series rounds of trial and error are needed. Thus several such moves also helped dramatically reduce the time spent on privatization of government- such moves also helped dramatically also not advised. owned enterprises. Strong measures to shorten the privatization period are actions against non-compliance with open orders were used in this regulatory measures like owned companies. act. This was spinning off of government-owned companies under the 1972 enterprise But today. is it than powerful more was time the at government Korean the because possible modern corporate governance: diversified ownership and the separation of ownership and on (1968) and the Act Development on Capital Market enacted the Act management. Korea (1972) to boost the privatization of government- Promotion of Public Openness of Enterprise to R[9] IV-1) reorganization of laws and regulations on securities companies to satisfy and regulations on securities companies to satisfy to R[9] IV-1) reorganization of laws infrastructure. the confidence of market Condition III, which is consolidation of 1) promotion of a continuous trade environment; R[7] III-2) offering the market-making R[7] III-2) offering the market-making environment; continuous trade 1) promotion of a and satisfy indexes to represent the stock market process; and R[8] III-3) design of stock of the fast price discovery function of the stock market. Condition II, which is the efficiency market. Recommendation II is to raise demand, leading to R[4] II-1) promotion of the asset to R[4] II-1) promotion of the demand, leading Recommendation II is to raise market. and taxes of exemption or reduction II-2) R[5] and industry fund mutual and management volume of the stock the trading to satisfy Condition I, which is raising fees for investors market. owned companies; R[2] I-2) relaxation of listing standards; and R[3] I-3) promotion of the of the R[3] I-3) promotion standards; and relaxation of listing R[2] I-2) owned companies; of the stock volume the trade to satisfy Condition I, which is raising venture ecosystem 204 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 4.3.2. R[2] I-2: Relaxation of Listing Standards
The primary market is the gateway to the capital market and the best alternative to bank loans to access venture capital. The Act on Capital Market Development (1968) and the Act on Promotion of Public Openness of Enterprise (1972) were also related to this recommendation in the Korean experience. Azerbaijan is advised to not only relax listing standards but also incubate companies to rapidly grow at the same time.
The securities company’s role is also important here. Even in Korea, no reliable securities companies existed in the 1970s. The government at the time formed the public securities company Korea Investment Development Corporation (KIDC) to perform the functions of securities companies such as 1) underwriting; 2) sales; 3) trading; 4) market adjustment for stock collection and sale of securities; 5) selling of government-owned and general enterprise shares; and 6) management analysis and consulting of target companies for securities acquisition (See Section 3.2.2.2. on KIDC). This can serve as a reference.
4.3.3. R[3] I-3: Promotion of Venture Ecosystem 205 CHAPTER Azerbaijan should foster its venture ecosystem to reduce its heavy dependence on oil and diversify its economic base. First, the country should foster R&D of startups. Korea 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets legislated the Act on Support for SME Startups (1986) and the Act on Special Measures for the Promotion of Venture Businesses (1996). The most crucial task is to foster the venture funding mechanism. Korea legislated the Credit Guarantee Fund Act for SMEs in 1967, introduced a private equity fund in 2004, and formed the Korea Fund of Funds in 2005. The next mission is to develop financial market infrastructure to fund the venture. Korea set up the KOSDAQ in 1996 and KONEX in 2013. The nominated adviser (nomad) system is tasked with selecting promising startups and providing them with the data and assistance necessary to get listed on the stock market. Public Market Offerings Secondary IPO Mezzanine Corporate Bond Later Stage 3rd TIME 2nd Strategic Alliances VC loan 1st VCs, Acquisitions/MergersVCs, & EarlyStage Equity Crowdfunding & Crowdlending Break even Angels, FFF Angels, Seed Capital Seed Valley of Death Credit Guarantee Loan Debt Equity Korea’s securities transaction tax on the stock market does not conform to international stock market tax on the securities transaction Korea’s 4.3.5. R[5] II-2: Reduction of or Exemption from Investor Taxes and Fees Investor Taxes from 4.3.5. R[5] II-2: Reduction of or Exemption investors, the capital gain tax is the most pressing concern. If they see small and For Unless Azerbaijan can produce qualified (wealthy and neutral) personal investors, personal investors, and neutral) (wealthy can produce qualified Unless Azerbaijan 4.3.4. R[4] II-1: Promotion of Asset Management and Mutual Fund Sector 4.3.4. R[4] II-1: Promotion standards. Azerbaijan has the capital gain tax but the problem is declaration. In this case, In this case, standards. Azerbaijan has the capital gain tax but the problem is declaration. another paying a tax withholding system is recommended. Under this system, the person medium gains, they could qualify for separate taxation, but for large gains, they must pay pay they must large gains, taxation, but for medium gains, they could qualify for separate should be minimized to promote active trading. tax based on total income. Fees into the Financial Investment Services and Capital Market Act (2009), or FSCMA. Investment (2009), Act and Capital Market into the Financial Investment Services and the funds’ investment assets have been in Korea trusts and mutual funds are available derivatives. This as gold and real estate as well as OTC expanded to include real assets such financial products. of range has allowed investors to access a wider indirect investment is recommended as another option. Korea has had the Act on Securities has had the Act as another option. Korea indirect investment is recommended both of which Investment Company, Securities on Investment Trust Business and the Act Asset Management (2003) and again on Indirect Investment were consolidated into the Act Source : Korea Capital Market Institute, Entrepreneurial Capital Markets in Korea: Current Status and Future Directions, 2017. Directions, Status and Future Current Capital Markets in Korea: Entrepreneurial Capital Market Institute, : Korea Source [Figure 3-11] Financing Cycle for Startups Financing Cycle for 3-11] [Figure 206 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan person’s income or the amount of income collects taxes on the government’s behalf and pays it to the government.
4.3.6. R[6] III-1: Promotion of Continuous Trade Environment
Azerbaijan has a small number of shares ready for trade under a non-diversified ownership structure, and this is a fundamental cause of trading discontinuity. This problem should be resolved through diversification of stock ownership and raising stock demand in the long run.
For market infrastructure, an electronic trading system is crucial for expediting continuous trading, and the home trading system is the future. A Korean financial expert compared this to the case of the payment markets in China and Korea. The rapid development of wireless or mobile payment markets in China is due to the lack of broadband infrastructure there, and the slow transfer of magnet cards to wireless or mobile payment markets in Korea due to the country’s world-class broadband infrastructure.
207
4.3.7. R[7] III-2: Offering Market-making Process CHAPTER
The designation of several major financial institutions as market makers is needed on 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets the Baku Stock Exchange (BSE). Azerbaijan should foster large securities companies with economies of scale and scope. Enlargement into a large and complex financial conglomerate is a modern trend in the global financial industry.
Korea has large and complex financial conglomerates that have a bank, securities company, and insurer as subsidiaries through the Financial Holding Companies Act (2000); such conglomerates are major player in Korean finance.
4.3.8. R[8] III-3: Use of Stock Indexes to Represent Stock Market
Diversification and portfolio investment are proven to be the most efficient types of investment on the stock market as shown by Markowitz (1952) and Sharpe, Lintner and Mossin (1962). The exchange traded fund (ETF), a diversified stock fund tracing index, is a common investment type on the stock market, and stock index futures and options are the stars of the Korean stock derivatives market. The country has more than 10 indexes and 600 ETFs that trace indexes on the stock market, in line with similar trends on global stock markets. But this is possible in Azerbaijan probably after the number of listed companies is increased on the BSE. Recommendation VI is organization of market infrastructure leading to R[11]VI-1) leading to R[11]VI-1) infrastructure market is organization of VI Recommendation 4.4. Recommendations for Stock-related Derivatives Market Stock-related 4.4. Recommendations for RecommendationV is emphasis on a potential star product leading to R[10]V-1) offering The regulation of the supervision of securities companies is made and managed by the the securities companies is made and managed by The regulation of the supervision of A better option is to legislate an integrated law to regulate the stock market because it because it the stock market law to regulate to legislate an integrated A better option is 4.3.9. R[9] IV-1: Reorganization of Laws and Regulations on Securities Companies of Laws and Regulations 4.3.9. R[9] IV-1: Reorganization Azerbaijan must start discussing the minimum number of incorporated stocks and how stocks number of incorporated the minimum must start discussing Azerbaijan incubation of sound and qualified speculators; R[12]VI-2) design of tax and fee mechanisms aversion risk of design R[13]VI-3) investment; derivatives stock-related for favorable mechanism. accounting; and R[14]VI-4) design of the marking-to-market only one or two derivative products to start with. FSC and FSS in Korea and comprises 1) evaluation and rating; 2) off-site monitoring and on- and enforcement; and 5) accounting 4) unfair trading site examination; 3) disclosure rules; supervision. country’s capital market. The regulation on entry and exit, reinforcement of FIMSA’s role role on entry and exit, reinforcement of FIMSA’s The regulation capital market. country’s (with the CBAR being a last resort) to support financial institutions, and strengthening the law comprise the major objectives of the integrated regulation on investor protection should investor confidence. help raise to govern securities companies. This will is easier to regulate by function, not institution, under the framework of comprehensive of comprehensive under the framework function, not institution, by is easier to regulate is a special law to promote or foster (negativism) legislation. Another recommendation the market in a specific environment because amendments are easy to make in a rapidly the governs laws, seven of combination a (2009), FSCMA Korea’s environment. changing and premium boards to this level and create a composite index with a weighted average of index with a weighted average to this level and create a composite and premium boards capitalization. market they will be formed to build the underlying stock index. Typically, a minimum of 10-15 items of 10-15 a minimum Typically, stock index. the underlying build to formed be they will the index and the market, a stock index representing required to create are of incorporation capitalization. The of market weighted average or a price-weighted as a calculated should be of listed companies on standard should also be to expand the number primary requirement 208 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 4.4.1. R[10] V-1: Offering Only One or Two Derivative Products to Start With
For price discovery and liquidity, Azerbaijan has the option of introducing single equity derivatives or cross products (using foreign exchange indexes as underlying securities). Because most BSE-listed companies are banks and special companies, cross products are recommended in the beginning. The KRX has Eurostock 50 futures subject to the EURO STOXX 50 index for 50 securities listed in the eurozone’s 12 countries since December 1991.
The study of cross-hedging using cross derivatives has mainly focused on commodities markets such as those for gold, gas, and crude oil. Analyses of the volatility transmission and commonality with global key stock indexes can help select indexes and markets with strong relationships in information transfers for the Azerbaijani economy. This product can test the market for hedging performance and potential speculation.
4.4.2. R[11] VI-1: Incubation of Sound and Qualified Speculators
Both hedgers and speculators are the two pillars of the derivatives market. Institutions 209
that can be defined as institutional investors such as banks, insurers, financial institutions, CHAPTER listed companies, and local governments are classified as professional investors. Individual investors, in principle, are general investors but if they meet certain requirements, they are 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets recognized as individual professional investors. Entry barriers and investor protection are also important.
4.4.3. R[12] VI-2: Design of Tax and Fee Mechanisms Favorable for Stock-related Derivatives Investment
Fundamentally and theoretically, hedging should not be taxed but speculation must have a relatively heavy tax. Fees should be minimized for dynamic hedging and even for easy speculation. Korea has the capital gains tax on its derivatives market but also a transaction tax on its underlying stock market, which is asymmetric. This measure sought to suppress the entry of personal investors into the derivatives market amid an overheating market that occurred around 2010.
Taxation is recommended on capital gains from income earned on the stock and stock- related derivatives markets. Hedging should incur no tax but a relatively heavy tax is needed for speculation. Fees should be minimized for dynamic hedging and even for easy speculation. Conclusion This study proposes 14 policy recommendations for the stock and stock-related stock-related This study proposes 14 policy recommendations for the stock and The Azerbaijani government needs to aggressively develop its capital market and and to aggressively develop its capital market The Azerbaijani government needs The main purpose of this study is to provide FIMSA with useful and hands-on hands-on and useful with FIMSA provide to is study this of purpose main The Design of the marking-to-market mechanism requires a strong clearance and settlement and settlement requires a strong clearance mechanism Design of the marking-to-market 4.4.5. R[14] VI-4: Design of Marking-to-market Mechanism 4.4.5. R[14] VI-4: Design 4.4.4. R[13] VI-3: Design of Risk Aversion Accounting VI-3: Design of 4.4.4. R[13] If financial institutionsand large export and import companies actively (or frequently) derivatives markets. The recommendations for both markets are split into two because are split into two because recommendations for both markets The derivatives markets. are different. they must be developed at the same time and the goals for each market should also be considered conditions Such recommendations to develop the stock market which should also serve as a hedging vehicle. Since to develop the derivatives market, investors. The government should thus understand that the harmonization of interest and and interest of harmonization the that understand thus should government The investors. inflationrates and stock returns is a precondition to put the stock market on the right track. It must immediately exercise an aggressive policy for this situation. prepare policy measures and mid- to long-term plans to achieve this. In addition, the timely the addition, In this. achieve to plans long-term to mid- and measures policy prepare introduction of actions will make the stock market more efficient and led to the adoption vehicle. When the interest rates to provide a hedging of a stock-related derivatives market has much difficulty are relatively high, the government of bank deposits or the market to unattractive are returns market stock because market capital direct the fostering in prices. Given the study author’s experience with the Azerbaijani stock market, the following Azerbaijani stock market, experience with the prices. Given the study author’s a stock-related introduce and efficient more market the make to seek recommendations to hedge against potential investor losses. derivatives market recommendations to make Azerbaijan’s capital market more competitive and innovative; more competitive and innovative; capital market Azerbaijan’s recommendations to make this will help the unstable domestic economy that fluctuates according to international oil system, and the recommendation is the so-called to-be system of Korea Securities Depository. Securities Korea of system to-be so-called the is recommendation the and system, 5. a computer system and market infrastructure such as credit rating and pricing agencies. So as credit rating such infrastructure and market a computer system time. this will take conduct hedging, risk aversion accounting can help. Adoption of international financial financial of international help. Adoption accounting can risk aversion conduct hedging, requires however, This, recommended. also is assessment value fair and standards reporting 210 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Azerbaijan has few listed companies and low trading volume on the stock market, time is needed to develop both markets to a satisfactory level. The experience of and lessons from Korea’s capital market development offer many key benchmarks that could obtain positive results faster than thought. Thus I sincerely hope that such benchmarks will serve Azerbaijan well in this project.
211 CHAPTER 03 Developing Azerbaijan’s Stock and Stock-related Derivatives Markets 1999- 1999- 2015. 2019. Capital Market Focus, Focus, Capital Market 2011. , 2017. 2017. 1956-2016, 2016. [in Korean]. 1956-2016, 2016. [in Korean]. 2015. [in Korean]. 2015. [in Korean]. Korea Development Institute and Ministry of Economy Development Institute and Ministry of Economy Korea 10-year History of the Financial Supervisory Service: Supervisory Financial of the History 10-year SS Handbook 2016, Entrepreneurial Capital Markets in Korea: Current Status and Current Korea: in Capital Markets Entrepreneurial Korean Derivatives Market: Diagnosis and Road Ahead, Diagnosis Derivatives Market: Korean FSS Annual Report 2016 FSS Annual Report On-site Examination Manual, Financial Investment 2017/18 KSP with Myanmar (III): Capacity Building for Capital 2017/18 KSP with Myanmar (III): Capacity KDI Journal of Economic Policy, 2017. ONEX Listing Guide, Korea Exchange 60-year History: Exchange Korea Future Directions, Future in Myanmar, Development Market and Finance, 2018. Policy Experiences,” September 19, 2017. 2008, 2009. [in Korean]. 2008, 2009. [in Korean]. Korea Exchange, K Korea Exchange, Korea 2009. in Korea, Financial Investment Association, Capital Market Korea Korea Development Institute, Korea Kim, Woo Chan, “Korea’s Capital Market Promotion Policies: IPOs and Other Supplementary Promotion Policies: Capital Market Chan, “Korea’s Kim, Woo Institute, Capital Market Korea Institute, Capital Market Korea Financial Supervisory Service, Financial Supervisory Outcomes and Evaluations,” of KONEX: Years “Four Kang, Sohyun, Financial Supervisory Service, Service, Supervisory Financial Service, F Financial Supervisory Service, Financial Supervisory References 212 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan
Recommendation: New Post-trade Infrastructure Model for Infrastructure Post-trade Recommendation: New Capital Markets Azerbaijan's Implementation Plan Analysis of Azerbaijan’s Post-trade Infrastructure Post-trade Analysis of Azerbaijan’s and Market Benchmarks Analyses of Global Standards CHAPTER Capital market, Clearing, Settlement, Post-trade, Risk management, Capital market, Clearing, Settlement, Post-trade, DvP (Delivery versus Payment), PFMI (Principles for Financial Market Infrastructures), line Credit Clearing fund, SLB (Securities Lending and Borrowing), Keywords 5. 4. 2. 3. 1. Introduction Heung Seok Ko (Korea Securities Depository) Heung Seok Ko (Korea (formerly with the National Depository Center) Elchin Mammadov Seung Kwon Lee (Korea Securities Depository) Seung Kwon Lee (Korea Securities Depository) (Korea Kim Soo Yung Settlement System for Azerbaijan’s Settlement System Capital Markets Formation of Effective Clearing and Formation of Effective 04 214 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Formation of Effective Clearing and Settlement System for Azerbaijan’s Capital Markets
Seung Kwon Lee (Korea Securities Depository) Soo Yung Kim (Korea Securities Depository) Heung Seok Ko (Korea Securities Depository) Elchin Mammadov (formerly with the National Depository Center)
Summary
Azerbaijan’s capital markets are suffering from low growth and depressed transactions. This study identifies critical problems in the post-trade infrastructure of such capital markets that impede transactions and then suggests solutions. The post-trade system is a fundamental part of capital market operations directly related to transaction costs. Thus 215 CHAPTER the system’s efficiency must be maximized because high transaction costs lower stock investment profitability, which drives investors out of the market and discourage new 04 players to enter. Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
The Knowledge Sharing Program (KSP), in its detailed analysis of the diverse aspects of Azerbaijan’s clearing and settlement system, found that the system incurs high transaction costs mainly because of excessive stability in requirements and lack of stability in the system. To trade securities on Azerbaijan’s capital markets, investors must deposit in the National Depository Center (NDC) of Azerbaijan before placing orders money or securities that are blocked until settlement is completed. This pre-funding requirement not only makes securities trading rigid and costly by raising opportunity cost but also deprives investment companies and the NDC of the chance to develop, operate, and enhance risk management techniques to boost the efficiency of post-trade activities. And though the legal, institutional, and technical foundations for post-trade infrastructure have been formed through two rounds of major reform, they fail to reflect market practices on a practical level and are thus insufficient.
The post-trade industry is one of the most standardized of its kind in the world. This is because financial market infrastructures (FMIs) such as clearing houses, central securities depositories, and central banks share the goal of minimizing transaction costs while maximizing settlement stability not only for the domestic market but also for cross-border Considering market maturity and the capacity of market participants and FMIs on on FMIs and participants market of capacity the and maturity market Considering To develop post-trade infrastructure on Azerbaijani capital markets for meeting meeting for markets capital Azerbaijani on infrastructure post-trade develop To is highly recommended to reach the final goal, and the tasks for each milestone must be must be is highly recommended to reach the final goal, and the tasks for each milestone performed in phases. This research suggests three development stages. The first stage has investment and NDC (BSE), Exchange Stock Baku the FIMSA, including stakeholders all systems, and companies focusing on performing the tasks needed to reorganize institutions, Azerbaijani capital markets, however, it seems not only impossible but also unnecessary however, it seems not only impossible but also unnecessary Azerbaijani capital markets, the general, In recommendations. aforementioned the of all implement immediately to Thus costs. indirect and direct significant system requires post-trade a of development in transaction this endeavor can be justified only when the expected benefit—reduction milestones multiple of implementation the that sense, In it. of cost the greater than costs—is (CBAR) must jointly promote higher settlement stability by allowing the CBAR to perform to perform the CBAR allowing must jointly promote higher settlement stability by (CBAR) collectively should participants market all And money. bank central using settlement cash the capital markets. environment in (STP) processing strive to install a full straight-through payment (DvP) model payment should be differentiated for each security type totrading better reflect the requirements for clearing membership, develop features. Fifth, the NDC must strengthen in securities lending and borrowing, credit lines with measures to prevent settlement failure reserves, and clarify procedures to minimize damage banks, clearing funds, and settlement Bank of Azerbaijan Republic NDC and the Central Sixth, the failure occurs. when settlement NDC must develop and run an advanced risk management system for the market as a central as a central risk management system for the market NDC must develop and run an advanced form a user-oriented governance structure. Third, the clearing and and counterparty (CCP) for clearly assume responsibility members and CCPs settlement process should have clearing including those for the settlement cycle and delivery versus settlement methods it. Fourth, PFMI requirements and supporting market growth, this study suggests six policy this study suggests six policy growth, and supporting market PFMI requirements investment First, the roles and responsibilities of recommendations requiring top priority. eliminating pre-funding requirements and by companies should be strengthened the Second, each other in risk management capacity. empowering them to compete against PFMI requirements. The principles also require FMIs to maintain a relevant legal basis, basis, legal relevant a maintain to FMIs require also principles The requirements. PFMI institutions, facilities, and financial and/or non-financial capabilities to effectively manage needs an The entire system also on the capital market. trading the risks of securities conflict or confusion. market structure to prevent elaborate transactions. The Principles for Financial Market Infrastructures (PFMI) announced by by announced (PFMI) Infrastructures Market Financial for Principles The transactions. Organization of Securities the International Settlements and for International the Bank and settlement bible of the clearing 2012 serve as the in (BIS-IOSCO) Commissions institutional the PFMI since major to follow worldwide are required All FMIs industry. meet FMIs which in markets in only invest to allowed are markets advanced in investors 216 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan legal and regulatory frameworks. The second stage can begin when the number of daily transactions exceeds 1,000, and partial advanced measures including margin and intraday trading, CCP, and clearing membership are recommended in this stage. When the number of daily transactions exceeds 100,000, the switch to full-scale development is said to be turned on. In this stage, post-trade infrastructure needs upgrading to support domestic mutual funds and foreign investors by initiating advanced measures such as a full-functioning CCP and clearing members, covered short sales, securities lending and borrowing, cross-border issuance and settlement, and a centralized information and communications technology (ICT) platform for the fund industry.
1. Introduction
1.1. Background
Financial markets in Azerbaijan are unfavorable for businesses, especially small and medium enterprises (SMEs), because of the lack of mid- to long-term financing. Banks 217 CHAPTER dominate such markets by controlling more than 95% of combined assets, and their core services are limited to short-term or secured loans. Few banks are capable of providing long- 04 term credit to companies because of weak financial stability and the capital markets are still Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets underdeveloped.
To promote corporate financing, the government implemented two major projects. The first was the State Program on the Development of the Securities Market of the Republic of Azerbaijan in 2011-20, which was initiated in 2011. The second was the Capital Market Modernization Program (CMMP) conducted from 2012-16 under the sponsorship of the World Bank.
Both the state program and the CMMP brought significant benefits to capital markets including stronger legal and regulatory frameworks, automated market infrastructure, and the creation of an independent watchdog for financial transactions, namely the Financial Market Supervisory Authority (FIMSA). These actions help set the foundation for market infrastructure and meet minimum requirements to nurture capital markets.
Yet the country still suffers from marginal interest from both corporations and investors and thus is hardly an attractive opportunity to raise funds or invest money. To change this situation and invigorate the market, Azerbaijan must review its market status, identify the problems that hinder market growth, and devise solutions. - Bulletin Board, etc. OTC Market OTC ATS/MTF Secondary Market given its fundamental importance in importance fundamental its given 1 Stock Clearing House (CCP) (SSS)/ Payment System (PS) Exchange Regulated Market Securities System Settlement Capital Market Primary Market Financial Market Financial Money Market Author. A comprehensive study on Azerbaijan’s clearing and settlement system was conducted conducted was system settlement and clearing Azerbaijan’s on study comprehensive A This study has two tasks. The first is to accurately examine and analyze the clearing and 1.2. Scope and Objectives of Research and Objectives 1.2. Scope this For are numerous. markets growth of capital and low of depressed trade The causes Post-trade Post-trade infrastructure refers to legal and regulatory frameworks, institutions, business processes and procedures, and ICT sys clearing and settlement on the secondary market; those for the primary to transaction or related tems and networks governing not included. market are
trading with a timetable for each step), and institutional facilities (i.e., settlement finality and with a timetable for each step), and institutional facilities (i.e., trading risk management program). 1 including analyses of market structure (i.e., participants in the clearing and settlement (i.e., participants in the clearing and settlement structure including analyses of market framework legal responsibilities), and roles group’s participant each and trading stock of and post-trade (i.e., laws, decrees, and rules and regulations governing the capital market securities of cycle entire the in steps (e.g., procedures and processes business industry), The second is to provide feasible recommendations to resolve such problems and enhance enhance and problems such resolve to recommendations feasible provide to is second The the adoption of global standards for the considering the clearing and settlement system by including a case of other markets, industry and learning from the experiences post-trade markets. of its capital infrastructure improved the post-trade study on how Korea Source: development. to identify factors impeding capital markets settlement system of Azerbaijan's [Figure 4-1] Topic Scope: Post-trade Infrastructure for Capital Markets Infrastructure Post-trade Scope: 4-1] Topic [Figure topic, this study will focus on post-trade infrastructure post-trade on focus will study this topic, operations. market 218 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan In addition, recommendations seek to improve the stability of the clearing and settlement system of Azerbaijan's capital markets, efficiency of the system’s operations, and capacity of the clearing house and central securities depository (CSD) to manage risks arising from the clearing and settlement of securities trading.
1.3. Research Framework
This study consists of the following stages: analysis, “to-be” model design, and implementation planning.
Analysis will be conducted in two parts. The first is analysis of Azerbaijani capital markets (Section 2) and the second will review global standards for clearing and settlement industry and other markets following such standards, including Korea (Section 3). These analyses will define both the strengths and weaknesses of the post-trade infrastructure of capital markets and the direction of development.
Based on the analyses' results, a new model for a clearing and settlement system for 219
capital markets is suggested in the next stage (Section 4). The new model envisions a highly CHAPTER advanced post-trade infrastructure with more sophisticated functionality and stability.
Also included are new roles and responsibilities of each participant group, new business 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets processes and procedures for clearing and settlement, and the upgrading (or addition if necessary) of institutional facilities including a risk management system.
Finally, the implementation planning stage in Section 5 will explain the required tasks to fill the gap between the existing and To-be models. Such tasks will be selected and prioritized based on feasibility, acceptability, necessity, and effectiveness. An implementation roadmap for all of the tasks will be also provided. Analysis of Other Markets Define the direction of development • Global Standards • Korean Experience • Similar Economies List up the tasks to fill the gap Set up the roadmap for the tasks Finalization recommendation of • Market Structure • Process and Procedure of Clearing and Settlement • Institutional Facilities Analysis of the gap between As-Is and To-Be Creation of new model for post-trade system of Azerbaijan Market Analysis of Azerbaijan Market Diagnose strength & weakness
• Market Structure and Legal Framework • Process and Procedure of Clearing & Settlement • Institutional Facilities
Planning
To-Be Design To-Be Analysis Implementation of regulatory enhancement and regulatory frameworks and legal Strengthening of Improvement of capital market infrastructure and underlying trading architecture and underlying trading infrastructure Improvement of capital market instruments and services of capital market Stimulation of supply to enhance range education and public awareness outreach Promotion of demand through corporate body’s capacity body’s
Author. Analysis of Azerbaijan’s Post-trade Infrastructure Post-trade Analysis of Azerbaijan’s In particular, the rule on improvement of capital market infrastructure and underlying infrastructure In particular, the rule on improvement of capital market a) b) c) d) As previously mentioned, the infrastructure of Azerbaijani capital markets has has capital markets of Azerbaijani As previously mentioned, the infrastructure 2.1. Overview trading architecture had four actions specified: trading undergone significant change since the implementation of the state program and the CMMP. plan required the following actions: strategic The former program’s 2. Source: [Figure 4-2] Research Framework Research 4-2] [Figure 220 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan i) Simplification of procedures for registration and transfer of stock ownership rights;
ii) Setup of central securities depository for both corporate and government securities;
iii) Easing of procedures for securities encumbrance; and
iv) Simplification and optimization of processes for both trading and post-trade activities through straight-through processing (STP) on integrated electronic platform.
All of these measures have seen varying degrees of success in implementation, and the status of post-trade infrastructure in Azerbaijan reflects such outcomes.
2.2. Capital Market Structure
[Figure 4-3] Capital Market Structure in Azerbaijan
FIMSA
Regulated Market OTC Market
Investors 221 CHAPTER Baku Stock Investment Notaries Exchange (BSE) Companies 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets National Depository Center (NDC)
Central Bank of Commercial Banks Azerbaijan (CBAR)
Source: Author.
[Figure 4-3] shows the core elements that form key infrastructure of Azerbaijan's capital markets as the following institutions:
a) FIMSA (supervisory and regulatory authority);
b) BSE (stock exchange);
c) NDC (clearing house and CSD);
d) CBAR (central bank);
e) Investment companies (broker and dealer); and
f) Notaries (broker for OTC secondary market trading).
A detailed description of each entity is presented below. In 2013, an electronic link was formed connecting the BSE’s trading platform to the NDC’s platform to the NDC’s trading In 2013, an electronic link was formed connecting the BSE’s Before 2013, no electronic link connected the BSE, NDC, and brokers and dealers, and it Before 2013, no electronic link connected the BSE, NDC, and brokers The Baku Stock Exchange (BSE) offers an electronic trading platform for members platform for members an electronic trading The Baku Stock Exchange (BSE) offers 2.2.2. Baku Stock Exchange (BSE) 2.2.2. Baku Stock Exchange The financial watchdog is closely workingwith market participants including the NDC FIMSA takes measures necessary for the development of capital and derivatives markets and derivatives markets for the development of capital measures necessary takes FIMSA 2.2.1. Financial Market Supervisory Authority (FIMSA) Authority Market Supervisory 2.2.1. Financial and supervisory is the country’s (FIMSA) Supervisory Authority Market The Financial post-trading system. Furthermore, the exchange’s clearing and depository functions were were functions depository and clearing exchange’s the Furthermore, system. post-trading to the NDC the same year. transferred used to take several days to settle stock exchange-traded securities and cash. The BSE also securities and cash. The BSE also to settle stock exchange-traded days several used to take conducted performed two other important functions at the time: clearing of transactions government securities like platform and depository services for government on its trading notes. bonds and CBAR to provide an organized market platform for the trading of newly created shares of public created shares of public of newly platform for the trading to provide an organized market of government public placement (auctions) and arrange companies on the secondary market bonds. (investment companies) as well as a myriad of other services. The BSE was established in other services. The BSE was established in of myriad (investment companies) as well as a shares are whose stock company in the form of a closed joint 1999 as a private company including investment companies and commercial banks; it participants market owned by purpose is mainly the same year. The BSE’s operations obtained a license for stock exchange guarantee fund, modernized risk-management system, and CCP for the capital and and capital the for CCP and system, risk-management modernized fund, guarantee derivatives market. Services and SME Sector approved by presidential decree in 2016. FIMSA was designed to to designed was FIMSA 2016. in decree presidential by approved Sector SME and Services handle these tasks. system in Azerbaijan and develop a settlement and BSE to set up an efficient settlement approves and issues licenses to financial companies. approves and issues to contribute to the efficient allocation of financial resources. Plans to improve bothmarkets of the Financial Roadmaps for Development outlined in the Strategic in Azerbaijan are also regulatory authority for financial markets. Founded in February 2016, FIMSA regulates regulates 2016, FIMSA in February Founded markets. authority for financial regulatory systems and payment and capital, mutual funds, insurance, sectors such as banking, 222 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 2.2.3. National Depository Center (NDC)
The National Depository Center (NDC) is the country’s sole central securities depository (CSD) and registrar and clearing house. This non-for-profit entity (which was until 2015 a closed joint stock company) was founded by FIMSA under the Law on the Securities Market of the Republic of Azerbaijan. The NDC's earnings go toward the development of the depository system and the center's services include:
a) Securities deposit (safe storage of securities for settlement purposes);
b) Safekeeping of securities (for non-settlement purposes);
c) Registry for equities and fixed incomes;
d) Corporate actions (except shareholder voting rights in general shareholders meeting);
e) Clearing services for stock and OTC trades;
f) Securities and cash settlement for stock trades (securities settlement only for OTC trades);
g) Management of securities data; 223 h) Tax withholding; CHAPTER
i) Intermediary role in repo transactions. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
The NDC was established in 1997 to provide depository and registrar services for domestic securities issuers and investors. Back then, the shares of newly privatized companies represented a significant portion of issues and were the only instruments actively traded on the secondary market. Since all shares were issued in dematerialized form at the time of privatization, the NDC’s depository service for its participants was thus relatively simple.
In 2013, the NDC was also assigned the role of clearing house for both stock exchange and OTC transactions. To provide clearing and settlement services for BSE transactions, the NDC opened two cash accounts at the CBAR; one for settlement in the domestic currency (AZN) and the other in foreign currency including the USD. The clearing and settlement model for stock exchange transactions was designed and implemented in the same year, and has largely remained unchanged.
As shown in
below, the overall volume and value of securities deposited in the NDC have continuously grown over the past five years, while the average volume of daily settlement keeps fluctuating in a downward trajectory. This shows the growth imbalance of the country’s primary and secondary markets.47 3.6 23.4 38.2 2018 (Jan.-Sept.) 34 6.3 2017 23.5 39.3 48 2.0 2016 18.8 34.5 have accounts with the CBAR and access have accounts with the CBAR 47 2 8.3 2015 10.7 20.1 58 6.3 5.5 2014 15.9
Statistic (Billion AZN) (Million AZN) No. of new issues Avg. volume of daily settlement volume of Avg. AZIPS, a real-time gross settlement (RTGS)-type system for large transactions, AZIPS, a real-time gross settlement (RTGS)-type payment AZN of netting bilateral with settlement delayed allows which CSSP, and obligations. No. of deposited securities (Billion) No. of deposited securities National Depository Center (2018). National Depository Center Combined value of deposited securities Combined value of deposited From 2013, the NDC started to clear and settle BSE trading and managed its accounts with From 2013, the NDC started to clear and settle BSE trading a) b) Most domestic banks and non-banking entities The two cash settlement systems the CBAR owns and operates are: owns and operates The two cash settlement systems the CBAR For the purpose of monetary policy, the CBAR issues and buys back central bank notes bank notes issues and buys back central the CBAR the purpose of monetary policy, For 2.2.4. Central Bank of Azerbaijan Republic (CBAR) Bank of Azerbaijan 2.2.4. Central sole financial had been the country’s Bank of Azerbaijan Republic (CBAR) The Central Government treasury, NDC, several other publicly owned financial institutions other publicly owned NDC, several treasury, Government
the CBAR through the electronic messaging system Temenos until April 2017. The system The system until April 2017. messaging system Temenos through the electronic the CBAR Since manually. instructions had to be entered had a user interface only and all payment 2 to these settlement systems. Members of either of the two systems can connect to the central to the central to these settlement systems. Members of either of the two systems can connect their own platforms with the settlement bank through an electronic link and integrate system. securities market law allows the CBAR to perform dealer operations without an investment without an investment to perform dealer operations law allows the CBAR securities market license. company rates. essentially short-term bills are notes banks. Such available only to domestic commercial The a yield meant to match the monetary policy rate. with maturity of up to 12 months and supervisory authority until early 2016, when FIMSA was established. The CBAR has since has since CBAR was established. The when FIMSA supervisory authority until early 2016, monetary policy and maintaining stable exchange focused on setting and implementing Source:
Data on Securities Deposited in NDC Securities Deposited 4-1> Data on 2.2.5. Investment Companies
Investment companies act as brokers and dealers for both exchange and OTC trades and perform other functions as specified by their licenses. The first licensed investment company in Azerbaijan appeared in the early 2000s, and the number of investment companies was 14 in 2013. The number in late 2018, however, dropped to just eight.
After obtaining a license, a domestic investment company usually applies for membership in the BSE and NDC.3 To gain BSE membership, an investment company must have at least two staff who obtain the exchange's trading license and pay a membership fee of AZN 60,000. To join the NDC, a company must sign a multilateral agreement with the NDC and its other members and pay an annual fee of about AZN 2,000.
The BSE and NDC also provide members with access to each one's platform, and 225
investment companies can freely trade and settle their obligations on behalf of clients and CHAPTER their own assets. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets Until 2016, all investors had to directly apply to the NDC to open trading accounts, but the center changed its internal rules on this. Investors can now ask investment companies to open trading accounts with the NDC on the investors’ behalf, and this has significantly simplified the process and reduced the time required for account opening. According to the NDC’s internal regulations on securities transfer, an investment company that opens an investor account with the NDC on an investor's behalf is called an account operator.
2.2.6. Notaries
A notary is a legal entity eligible to act only as a broker for transactions on the secondary OTC market under domestic law. In essence, the notary is limited to notarizing (certifying) deals on the purchase and sale of securities between two parties. The cash part of a notary transaction is settled through a notary's account opened with a commercial bank, and the securities settlement is processed through the NDC.
The securities market law requires an electronic link connecting the information systems of notaries and the NDC so that the former can check the availability of securities
3 Not only investment companies but also commercial banks can be clearing members of the NDC, but no bank has gained member- ship because the BSE does not allow banks to become members. Description AZIPS: RTGS-type system for large transactions AZIPS: RTGS-type netting with bilateral settlement CSSSP: Delayed Securities market, investment funds, insurance, credit organizations (banks, non-banking credit insurance, investment funds, Securities market, credit entities) systems operation Payment for equities & fixed-income instruments, corporate registry Securities deposit & safekeeping, securities & cash settlement for stock trading, actions, clearing services for exchange/OTC exchange trades - - - - - Non-for-profit organization (100% gov’t owned) stability of exchange rates Implements monetary policy as dealer & maintains Runs 2 cash settlement systems: - - gov’t owned by Non-capital special corporation providing additional services based on trading and dealers for exchange and OTC Brokers license for client investors operator Account (majority are bank subsidiaries) Joint stock company between two parties certifying deals on securities transactions for OTC Brokers Private company Duties of improving, licensing, regulating, & supervising: Duties of improving, licensing, - - Gov’t organization e-platform among investment companies, platform (organized Provides electronic trading BSE, & NDC) surveillance, member mgmt. Listing/delisting, market Stock investment companies, banks, & Turkey (CJSC) owned by Closed joint stock company Exchange house services as CSD & clearing registrar, Provides depository, - • • • • • • • • • • • • • • • BSE NDC CBAR Regulations adopted by FIMSA; and FIMSA; Regulations adopted by having legal force only for NDC members. internal regulations NDC’s Civil code and securities market law; Civil code and securities market FIMSA Notaries Author. Investment b) c) The legal and regulatory frameworks for trading and post-trading infrastructure in in infrastructure and post-trading for trading The legal and regulatory frameworks a) 2.3. Legal and Regulatory Frameworks A summary of descriptions for each participant group is presented in
below. 4-2> in Summary of Each Participant Group 4-2> Summary of Each The civil code of Azerbaijan has an entire chapter on securities trading and related transactions that stipulates the principles of regulation of stocks, securities markets, issuance and circulation, professional participants, regulations, and investor protection. Because of its principle-based approach, the code is limited to providing basic concepts for the functioning of market infrastructure.
In contrast, the securities market law's section on the post-trade system defines the latter's main components, their roles and functions, and minimum requirements for the risk management system. For example, the law stipulates that to minimize risks arising from the clearing and settlement of securities trades, a clearing house should implement at least one of the following risk management techniques:
i) Pre-funding;
ii) Insurance against settlement failure;
iii) Guarantee provided by third-party bank against settlement obligations; 227 CHAPTER iv) Pledging assets;
v) Setup of clearing fund. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
The law also allows only investment companies and banks to join a clearing house and requires the latter to adopt internal regulations on clearing activities and operations, membership, management of the clearing fund's assets, and other issues related to its functions.
2.3.2. Regulations Adopted by FIMSA
FIMSA has adopted regulations that partially cover issues related to securities trading and post-trade infrastructure.
The only regulation wholly devoted to operations of post-trade infrastructure is the Rules for Post-trade System and Clearing Activities (RPSCA) adopted by FIMSA in December 2015. The main provisions of the rules are:
i) A clearing house, stock exchange, central securities depository, investment fund depositories, and members of the clearing house (banks and investment companies) should conclude a multilateral agreement that defines their rights and responsibilities in the settlement of securities, derivatives and cash. The agreement Central counterparty (CCP) functions can be performed only by entities that have a be performed only by functions can counterparty (CCP) Central clearing house license. The clearing house should suspend all of operations a member that fails to fulfill its clearing obligations. for clearing and settlement procedures Communication and business processes should be conducted electronically. to cash settlement systems. The clearing house should have access companies and their clients opened with banks, namely members of the clearing members of the clearing clients opened with banks, namely companies and their house. must obligations clearing its all of goes bankrupt, the clearing house member of a If effect. be settled before bankruptcy rules take management outlined in the securities market law (details mentioned above). in the securities market management outlined from an investment should calculate open positions arising The clearing house of clients conducted on behalf and trading proprietary trading company's separately. investment of accounts cash the through out carried be should settlement Cash should also include a DvP provision and time schedule for final settlement. and time schedule include a DvP provision should also obligations arising settling securities netting when house should apply The clearing trading. and derivatives from securities for settlement risk should adopt one or more mechanisms The clearing house On transfer of securities. On transfer Organization of post-trade activity and clearing operations; activity and clearing operations; Organization of post-trade x) vii) viii) ix) vi) iv) v) ii) iii) ii) and clearing performing for procedure step-by-step a includes regulation first The The NDC can perform clearing house functions without obtaining a clearing house house The NDC can perform clearing house functions without obtaining a clearing i) 2.3.3. NDC’s Internal Regulations Internal 2.3.3. NDC’s Though most FIMSA regulations are not directly related to market infrastructure, many many infrastructure, market to related directly not are regulations FIMSA most Though license. The two internal regulations applicable to NDC members on the clearing and and clearing on the members NDC to applicable regulations two internal The license. are: settlement of securities trading on Subscription and Placement of Securities has a provision describing the entire procedure on Subscription and Placement of Securities subscription. of public offering of securities through have provisions on the trading and settlement of transactions. For example, the Regulation example, For of transactions. and settlement have provisions on the trading 228 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan settlement of stock exchange trades and risk management techniques for operational and settlement risks arising from those trades. This rule's main advantage is its simplicity and applicability to the domestic market but its scope is limited to trades of stocks and bonds in the exchange. It provides no guidance on the clearing and settlement of OTC trades.
2.4. Clearing and Settlement Process and Procedures
2.4.1. Regulated Market
Azerbaijan has just one regulated market, the BSE, which is divided by securities type. The types of securities tradable on the exchange are:
i) Corporate equities;
ii) Government securities (treasury bonds and CBAR notes);
iii) Mortgage bonds;
iv) Corporate bonds. 229 Though the time schedule of clearing and settlement for each type of security differs, the CHAPTER process and procedures are basically identical for all types of securities traded on the BSE. 04
This study will thus closely examine the process and procedure of clearing and settlement Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets for equity trades and describe the difference between each type of securities when necessary.
2.4.1.1. Pre-funding and Bank Guarantee
Before beginning a trade, an investor who intends to purchase fixed-income securities (e.g., government securities and mortgage or corporate bonds) on the BSE must transfer the money (100% of the purchase amount) to the NDC’s account with the CBAR. The NDC checks its own cash account with the CBAR and reflects this transfer by crediting the investor’s cash account with the NDC.
For equity trading, investors need not transfer the money before placing an order. Investment companies, however, should obtain a payment guarantee from a bank beforehand and submit it to the NDC. Based on the bank guarantee, the NDC sets a buying order ceiling for each investment company that acts like a debit cap, and investors can place buy orders through the investment company within the limit. If the combined sum of the buying amounts exceeds the limit, investment companies must submit extra bank guarantees to the NDC or investors should transfer money to the NDC before placing an order. matching. If the NDC rejects it, the BSE rejects the order, which remains unmatched. on the specified amount until settlement is complete. If the investor is on the sell side, the NDC checks whether he or she has a sufficient amount of securities in his or her related account and places a hold on the specified amount until settlement is completed. If the NDC confirms the BSE's the inquiry, latter accepts the order and proceeds to amount of money in his or her cash account and puts a hold on the specified account and puts a hold on the specified amount of money in his or her cash amount until settlement is complete. checks for sufficient room in the debit capIf the investor is buying equities, the NDC hold that placed the order for the investor and puts a of the investment company If the investor is buying fixed-income securities, the NDC checks for sufficient securities, the NDC checks for sufficient If the investor is buying fixed-income After the orders are accepted and matched, information on all matched trades is sent is trades matched all on information matched, and accepted are After the orders to the NDC electronically for clearing and settlement purposes. • • • When an order is placed on the BSE's platform, it is automatically redirected to the the to redirected automatically is it platform, BSE's the on placed is order an When NDC's system. The NDC's system checks the order's details and verifies the securities or cash balance of the ordering investor. • clients). in ordering keys manually company Based on the instruction, the investment system (FOS), a user interface for investment information on the BSE's front office platform. companies to input data into the trading An investor instructs an investment company to place an order on the BSE's trading to place an order on the BSE's trading company An investor instructs an investment Azerbaijan has no investment written document or phone call (currently platform by system [MTS] to or mobile trading [HTS] companies that offer the home trading v) iii) iv) ii) i) 2.4.1.2. Placing Orders and Matching 2.4.1.2. Placing Orders place can investor an met, is requirement guarantee bank or pre-funding the When Since short selling is not allowed in Azerbaijan, an individual or institutional investor investor institutional or individual an Azerbaijan, in allowed not is selling short Since investors. The procedure for placing and matching orders follows the steps below. follows the steps below. for placing and matching orders investors. The procedure an order. Investors cannot directly access the BSE's trading platform and must place an must place an platform and cannot directly access the BSE's trading an order. Investors for and account operator that is both a BSE member company order through an investment who intends to sell the securities on the BSE needs the relevant balance of securities on his balance of securities the relevant on the BSE needs to sell the securities who intends or her accounts with the NDC before placing sell orders. This rule is applied to both fixed- and equities. income securities 230 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 2.4.1.3. Clearing
When the NDC receives trade details from the BSE after trading hours (4 p.m.) on all matched orders, the NDC calculates each investor's obligations and claims based on them.
The NDC applies the delivery versus placement (DvP) model 2 to all BSE transactions. Thus when calculating obligations and claims, only the cash side is netted while the securities side is not. Cash side obligations and claims are also netted across transactions for a range of securities types. Because of no CCP system in Azerbaijan and the application of netting only bilaterally, the effectiveness of netting is significantly lessened due to lack of transactions on the secondary market.
After calculation is complete, settlement data is created and delivered to each member via the information system.
2.4.1.4. Settlement
231 At 4:15 p.m. on settlement day, the NDC performs securities deliveries and cash payments CHAPTER based on the settlement data created through the clearing process. The settlement cycle differs by securities type: T+1 for all equities and T+0 for all fixed-income instruments (e.g., 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets government bonds, central bank notes, and corporate bonds).
Investors who purchased equities on the BSE must transfer the purchasing amounts to the NDC before 4 p.m. on settlement day.
The settlement is carried out through credit and debit book entry in the securities and cash accounts of each investor opened with the NDC. Since the DvP 2 model is applied, the securities are delivered first followed by the transfer of the netted cash amount. Under the settlement system, however, no transfer of money occurs since the money is credited and debited only between the cash accounts opened with the NDC, not the CBAR. Even after settlement is complete, the money remains in the NDC account until the seller requests the NDC to withdraw the money to his or her personal account with a commercial bank.
Because 100% of cash and securities for settlement purposes are secured and put on hold at the time of order placement, there is no risk of settlement failure.
The entire process of trading, clearing, and settlement of stock exchange trades is presented in diagram format in [Figure 4-4] and [Figure 4-5]. 7 (Buyer) Investor D + 6,000 order - 10,000 order (T) Input Buy 1 AZN 6,000 AZN 30,000 BB Money transfer (~T, AZN(~T, 10,000) 2 22 Company Investment 7 Investor D’s Acc. Settlement Settlement Investor C’s Acc. Commercial Bank Y order (T) Input Sell Bal. Bal. (T/ T+1, 16:15~) (Seller) 17 Investor C 6,000) • Equity : T+1, Bonds:T • Securities delivery on gross basis (credit/debit bookentry on end securities investor's opened account at NDC) • Cash payment on net basis (credit/debit bookentry on end cash investor's opened account at NDC) 14 13 3 Money transfer 21 order(T/T+1~, AZN Money Settlement Money 8 transfer transfer order (~T) instruction (T) result notice Settlement information (T) Input Buy/Sell orders (T) AZN 0 - 6,000 + 7,000 - 10,000 + 10,000 + 6,000 - 10,000 $36,000 AZN 1,000 14 18 6 14 Cash Acc. Cash Acc. Clearing 4 (T, 16:00~) 20 Bank Y’s Acc. Bal. • Right after trading hours, NDC calculates the obligations and the claims for matched trades. • Bilateral DVP 2 is applied for the calculation. - 7,000 10,000 +11,000 Perform Clearing (T, 16:00~) Investor C - Client of BB Investor D - Client of BB Trades matching (T) 15 12 Money Transfer order Securities Acc. Securities Securities Acc. Securities 10 T-Bill T-Note 19 + 7,000 + 10,000 - 15,000 - 6,000 15 Trades details (T) AZN 13,000 11 4 4 20 20 BSE TRS Trade NDC’s Account (T, ~16:00) Matching NDC (CSDR) - 7,000 Bal. + 7,000 - 15,000 + 10,000 AZN 2,000 6 AZN 10,000 16 Front Office System 16 18 Cash Acc. Cash Acc. • Only those orders that been have successfully verified and confirmed by NDC are matched. • Unconfirmed remain orders unmatched. Central Bank of Azerbaijan - 7,000 + 15,000 Balance Check AZN 20,500 1. Seller : A, Buyer : D, T-Bill AZN 11,000, Price : AZN 10,0002 Seller : C, Buyer : B,T-Note AZN 7,500,Price : AZN 7,000 Money Transfer Notification 20,000 9 30,000 + 7,500 - 11,000 4 20 Investor A - Client of AA 5 Investor B - Client of AA 15 Bank X’s Acc. 1. A : Deliver T-Bill AZN 11,000, Receive AZN 10,000 2. B : Pay AZN 7,000, Receive T-Note AZN 7,500 3. C : Deliver T-Note AZN 7,500, Receive AZN 7,000 3. D : Pay AZN 10,000, Receive T-Bill AZN 11,000 Securities Acc. Securities Securities Acc. Securities Bal. T-Bill SOCAR T-Note Order 15 Placing (T, ~16:00) 3 8 21 14 13 Money Money Settlement transfer transfer order (~T) Settlement result notice • Investment companies input the orders on behalf of the investors to BSE trading platform. • All orders are redirected to NDC tobe verified (securities/cash bank and balance guarantee limit). information (T) instruction (T) Input Buy/Sell orders (T) order 7 (Buyer) 1 Investor B - 7,000 order (T) Input Buy (~T, AZN(~T, 7,000) Money transfer + 15,000 AZN 500 AZN 20,000 AA 2 22 Company Investment (~T) 7 17 Investor B’s Acc. Investor Acc. A’s Commercial Bank X Bal. Bal. 15,000) order (T) Input Sell (Seller) Money transfer Investor A Pre-funding / Pre-funding order(T/T+1~, AZN (Fixed-income) Buyers must transfer the moneyin advance to NDC opened account at CABR. (Equity) Buyers do not need to pre-fund, but investment mustcompanies obtain a bank guarantee for payment. Sellers must have enough balance of selling securities on their account opened at NDC. Author. Author. Bank Guarantee Bank • • • Source: Source: [Figure Clearing and Settlement 4-5] of Securities Trading, Process Example of Entire [Figure 4-4] Securities Trading, Clearing and Settlement Process (Stock Exchange Trades) Exchange (Stock Process Clearing and Settlement Securities Trading, 4-4] [Figure 232 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 2.4.2. OTC Market
2.4.2.1. Matching
For over-the-counter (OTC) market trading, Azerbaijan has no electronic trading platform such as the alternative trading system (ATS) or OTC boards. Investment companies as intermediaries for OTC trading can connect buyers and sellers, but it is uncertain whether they actively provide such a service.
Basically, all OTC deals are done in an analog environment and the buyer and seller must produce a document on the agreement of securities sales and purchases. After the document is signed by both parties, it must be submitted to an investment company or notary to certify the deal.
2.4.2.2. Settlement
To fulfill the securities settlement obligation derived from OTC trading, both the buyer 233 and seller must send a settlement instruction to the NDC with the agreement certified by an CHAPTER investment company or notary. The instruction must be submitted in paper form and signed by both parties. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
When the agreement and instruction are delivered, the NDC carries out securities settlement if a sufficient amount of securities exists in the seller's securities account. Cash settlement of OTC deals certified by a notary is done through a notary's bank account per FIMSA regulations. It is unclear who is directly responsible for cash settlement of OTC deals completed by investment companies. Sometimes cash settlement is done in a similar manner to a BSE trade, but in most cases, cash settlement is conducted by a direct money transfer from the buyer's bank account to the seller's.
2.5. Institutional Facilities
2.5.1. Risk Management System
As described earlier, Azerbaijani capital markets have the five measures shown below to prevent settlement failure or minimize settlement risk according to the securities market law.
i) Pre-funding
ii) Insurance for settlement failure Use clearing fund assets to settle the defaulting member’s settlement obligations; Use clearing fund assets to settle the defaulting member’s filing an appeal with a court. legal action against the defaulting member by Take Use the funds deposited by the member in the NDC to pay the member's obligations; the member in the NDC to pay Use the funds deposited by that provided a guarantee/ company Require funds from the bank and/or insurance against settlement failure for the member; insurance the member to fulfill its settlement provided by Seize and sell financial collateral obligation; Guarantee from third-party bank against settlement obligations against settlement third-party bank from Guarantee Pledging assets of clearing fund Establishment iv) v) i) ii) iii) According to the NDC's internal rules on clearing and settlement, if a member fails to and settlement, if a member fails to to the NDC's internal rules on clearing According The regulation also defines the share of asset classes the clearing fund can have. Up to For clearing funds, the clearing house must set up and manage clearing funds under both clearing funds, the clearing house For iii) iv) v) and system management risk the dominates requirement pre-funding the reality, In fulfill its settlement obligations for cash, the NDC must immediately notify the regulator of the following actions: and take operations, this, suspend all of the member’s 100% of the fund can be deposited in the CBAR or invested in central bank notes. Deposits in central or invested in the CBAR 100% of the fund can be deposited in private entities are not restricted, securities issued by commercial banks or investment in a in investment or bank commercial single a in deposit the of share maximum the but issuer cannot exceed 20% of total assets. by a single private financial instrument issued clearing fund and the Rules on Post-trade System and Clearing Activities (RPSCA) cover the Activities and Clearing System clearing fund and the Rules on Post-trade composition. The person responsible for managing fund's establishment, management, and the clearing house must adopt rules on the the regulator and the fund must be appointed by clearing fund's management. pre-funding requirement for cash with a bank guarantee or insurance, yet this practice is is yet this practice or insurance, for cash with a bank guarantee pre-funding requirement pre-funded. are 100% basis, and the majority of trades and applied on a limited arbitrary a establish clearing house that the law stipulates The securities market and regulations. law because of its effectiveness in settlement failure prevention, no settlement risk can be said to prevention, no settlement risk can failure in settlement because of its effectiveness be placed the requirement, an order cannot even Under capital markets. exist on Azerbaijani money deposited sufficient securities or platform unless an investor has on the trading NDC allows the replacement of the and holds are put on them. The with the NDC in advance 234 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 2.5.2. Settlement Finality
The settlement finality provision is stipulated in both the securities market law and the RPSCA.
Article 56 on transfer orders of the securities market law guarantees settlement protection by saying the transfer orders of a clearing member must be executed if they were entered into the post-trade system before the member went bankrupt. Even if such orders were entered on the day of or after bankruptcy, they may be executed if the clearing house or CCP can prove that it was unaware or in no position to know about it. The article also protects the results of netting from suspension of transactions caused by bankruptcy proceedings.
The RPSCA says that if a member of the clearing house goes bankrupt, all of the member's settlement obligations must be settled before bankruptcy rules take effect and that the clearing house should suspend all operations of a member that reneges on such obligations.
235
2.6. ICT Infrastructure and Automation Level CHAPTER
The core information and communications technology (ICT) system that supports trading 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets and post-trading activities on Azerbaijani capital markets is Centralized Exchange Trading in Azerbaijan (CETA), an integrated capital market platform developed by the Korea Exchange (KRX) in 2016 as a subproject of the Capital Markets Modernization Program (CMMP). CETA's three modules are trading, back office, and surveillance. The trading module consists of the front office (FOS) and trading systems (TRS), both of which are used and managed by the BSE. FOS is simply a web screen in which investment companies can input trading orders. TRS is the system to execute and match orders confirmed by the NDC. The back office module is called CSDR, which means clearing, settlement, depository, and registry and is used and managed by the NDC. And the surveillance module is used by FIMSA to monitor market transactions. Since CETA is an integrated system with its modules independently operated, data exchange within the system is fully automated.
Investment companies run their own ICT systems to manage customer information and process internal businesses; some are preparing to provide HTS and/or MTS in the near future. Yet none of them have established a host-to-host link with the BSE or NDC. As a result, when investment companies need to exchange data with either organization, an analog operation using a separate interface is unavoidable. Notaries Commercial Banks OTC Market OTC Investors Companies Investment Center (NDC)Center Central Bank of Azerbaijan (CBAR) National Depository Regulated Market Baku Stock Exchange (BSE) Fully automated Using User-Interface Automation ongoing Base Paper Author. As seen in [Figure 4-7], overall transaction volume on the primary market has has primary market the on volume transaction overall 4-7], seen in [Figure As 2.7. Capital Market Statistics volume and the number both transaction Since 1999, when the BSE started operations, The status of data exchange automation on Azerbaijan capital markets is shown in [Figure on Azerbaijan capital markets The status of data exchange automation Notaries use the exclusive platform E-Notary, and per a FIMSA regulation, an electronic regulation, an FIMSA and per a E-Notary, the exclusive platform Notaries use (CSDR) settlement system of the NDC of data exchange between the securities Automation continuously exceeded that of the secondary market except in 2015, when no government except in 2015, when no government continuously exceeded that of the secondary market of transactions on the secondary market grew slowly with high volatility. Based on data, Based on data, slowly with high volatility. grew on the secondary market of transactions can be summarized as two things: centered on the however, Azerbaijani capital markets toward fixed income. and oriented primary market Source: [Figure 4-6] Status of Data Exchange Automation on Azerbaijani Capital Markets 4-6] Status of Data Exchange [Figure and AZIPS. 4-6]. and the payment system of the CBAR (AZIPS) was achieved in 2017, when the NDC acquired in 2017, when the NDC acquired (AZIPS) was achieved CBAR system of the and the payment to messaging system Temenos NDC previously had to use the electronic access to AZIPS. The input a user interface that required manual had Temenos in the CBAR; manage its account accounts and NDC to of money transfers notifications Today, instructions. payment of all in real time between CSDR from the NDC are delivered electronically related instructions link between E-Notary and the NDC system is under construction for electronic data data for electronic is under construction the NDC system E-Notary and link between trades. to settle OTC exchange 236 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan securities were newly issued. The gap between the primary and secondary markets in transaction volume took a big leap from 2017 due to the surge in new issues of central bank notes and government bonds.
[Figure 4-7] Transaction Volume on Primary and Secondary Markets (Unit: Million AZN)
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 237 CHAPTER Primary market Secondary Market 04 Source: Baku Stock Exchange (2019). Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
The number of transactions on the secondary market was also smaller than that on the primary market until 2010. Yet with a surge in the number of equity transactions from 602 in 2008 to 2,937 in 2009 and continuous decline in the number of fixed-income transactions on the secondary market, the secondary market since 2011 has outperformed the primary market in the number of transactions. The number of secondary market transactions peaked at 5,239 in 2014, but the average number of daily transactions remains between 4 and 20. The latter figure on the secondary market over the last decade (2008-18) is just 12. 2018 2018 (Unit: Number) (Unit: Number) 2017 2017 2016 2016 2015 2015 2014 2014 Secondary Market 2013 2013 Debt Securities other than Govemment Securities 2012 2012 Equities 2011 2011 Primary Market 2010 2010 2009 2009 Government Securities 2008 2008 0 0 1,000 5,000 3,000 6,000 1,000 5,000 4,000 3,000 2,000 6,000 4,000 2,000 Baku Stock Exchange (2019). Baku Stock Exchange Baku Stock Exchange (2019). Baku Stock Exchange Looking deeper into secondary market transactions, the disparity between the volume volume the between disparity the transactions, market secondary into deeper Looking Source: NumberNumber) overall. In transaction volume, however, the monetary volume of equity transactions transactions equity of volume monetary the however, volume, transaction In overall. as on the secondary market only 3.5% of the amount traded of comprises an average presented in [Figure 4-10]. Securities Type on Secondary Market by 4-9] No. of Transactions [Figure Source: obvious. As seen in [Figure 4-9], securities type grows more by and number of transactions for most transactions accounts market on the secondary the number of equity transactions [Figure 4-8] No. of Transactions on Primary and Secondary Markets on Primary and No. of Transactions 4-8] [Figure 238 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan [Figure 4-10] Value of Transactions on Secondary Market by Securities Type (Unit: Million AZN)
2,500
2,000
1,500
1,000
500
0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Government Securities Equities Debt Securities other than Govemment Securities
Source: Baku Stock Exchange (2019).
239
As of 2018, the number of investor accounts opened with the NDC was 110,423; 109,533 CHAPTER for individual investors and 890 for legal entities. Among them, only about 200 accounts had records of at least one or more monthly transactions on the secondary market. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
2.8. Stakeholder Opinions of Capital Market Development
2.8.1. Government and FIMSA
In 2017, the Azerbaijani government devised the Strategic Roadmap on Development of Finance Service in the Republic of Azerbaijan (Strategic Roadmap) to implement the duties specified by the Decree of the President of the Republic of Azerbaijan on Approval of Main Directions of Strategic Roadmap for National Economy and Main Sectors of Economy and issues arising out of this (No. 1897) dated March 16, 2016 (Center for Analysis of Economic Reforms and Communication, 2017).
FIMSA devised an action plan to pursue the second strategic goal of financial market development under the strategic roadmap, the main points of which are:
i) Offer incentives for listing and securitization;
ii) Eliminate obstacles in listing process;
iii) Incentivize investment in securities; Collect and establish clearing funds ; foreign investors; and to attract for cross-border investment Build infrastructure limited banking license to NDC. Grant Raise the number of marketable instruments; Raise the number of marketable system; maker primary dealer or market Adopt Raise access by foreign investors; and foreign by Raise access transparency. Boost market In addition, the NDC hopes to acquire a limited banking license for two reasons. First, reasons. First, In addition, the NDC hopes to acquire a limited banking license for two Among the five items, the NDC stressed the need for clearing funds and a banking license. license. banking a and funds clearing for need the stressed NDC the items, five the Among stipulate that the NDC can perform the role of CCP Though relevant laws and regulations iii) iv) v) i) ii) 2.8.2. NDC Center activities, the National Depository for post-trade responsible As the main body iv) v) government the from development market capital in priority the above, shown As settlements. Second, the NDC's legal status is simply a custodian who safely stores the money settlements. Second, the NDC's legal status is simply a custodian who safely investors. This means the by deposited in NDC accounts and not requested to be withdrawn license, the NDC NDC cannot use the money for other purposes. Thus if it acquires a banking to credit short-term as such money such utilizing services value-added provide can it says management. as well as cash collateral and other investors players market This is because the NDC’s financial stability is insufficient to cover damages if settlement settlement if damages cover to insufficient is stability financial NDC’s the because is This to work as a CCP. risks from cleared trades failure occurs, while it must assume all cash among cash accounts opened in the NDC as valid it wants to legalize money transfers without a license, NDC insists that it cannot do so without clearing funds. The NDC says that says NDC The do so without clearing funds. cannot that it insists NDC license, a without to set up clearing funds should be a prerequisite. collecting money from clearing members (NDC) expects many advances in its pursuit of capital market development. On what needs development. On what needs its pursuit of capital market advances in (NDC) expects many following five suggestions: such development, the NDC gave the to be done to spur supply and demand and raising the market's reliability and credibility. reliability the market's and raising supply and demand perspective seems more toward augmenting market transactions by strengthening both strengthening both by transactions more toward augmenting market perspective seems 240 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 2.8.3. Market Participants
Through interviews with market participants and a review of reports issued by the Azerbaijan Capital Market Participants Association (AFBiA), players on Azerbaijani capital markets expressed dissatisfaction with the market's situation. They also said many problems need immediate attention to promote transactions on the secondary market. The problems cited are summarized below.
i) Pre-funding requirement.
ii) High fees for both settlement and money transfer (deposit and withdrawal).
iii) No solution to problem of ICT system integration between investment companies and BSE and NDC.
iv) Limit on trading below nominal value.
v) No electronic trading platform for OTC trades.
vi) Lack of rules on OTC trades.
vii) Strict listing requirements. 241 CHAPTER
Market players emphasized that the pre-funding requirement needs lifting or easing since it seriously limits the efficiency of securities trading. Because pre-funding is mandated, 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets market participants must deposit securities or cash in the NDC before placing orders, and as the money and securities for matched trades are put on hold until settlement is completed, investors must keep them there instead of investing them elsewhere. Banks and other financial institutions facing liquidity pressure often find it difficult and costly to transfer and keep large amounts of cash in NDC accounts. Sometimes they even refrain from trading due to the pre-funding requirement.
In addition, many market players complained of high fees for money transfers when depositing or withdrawing their money from NDC accounts. The cost doubles if the orders placed by investors fail to match. Before they place buy orders, they must transfer money to their NDC accounts because of the pre-funding requirement, which incurs a transfer fee. If the orders are not matched, they have to pay the fee again to withdraw money from the NDC. This problem is the biggest headache for market players and reduces their interest in securities trading.
Another problem is the low level of automation in market infrastructure systems. Fully automated exchange of information built in electronic platforms exists only between systems of the BSE and NDC. Both organizations have also devised no solutions for host-to- The risk management system relies too much on the pre-funding requirement, and and requirement, pre-funding the on much too relies system management risk The are thus sophisticated systems for risk monitoring, measuring, and management sorely needed. The NDC, which acts as the central securities depository and clearing house, is owned owned is house, clearing and depository securities central the as acts which NDC, The by government. Thus its governance structure is insufficient to advocate the interest system. post-trade or users of the players of market and settlement. The pre-funding requirement is too harsh and rigid for both trading Certain laws, rules, and regulations are too strict or impractical and reduce and reduce Certain laws, rules, and regulations are too strict or impractical effectiveness. The NDC is the country's sole securities registrar and depository for all securities and depository for all securities registrar The NDC is the country's sole securities types. model. settlement is carried out based on the DvP Trade established well been have failure settlement handle to procedures and on rules The in advance. The systems for securities settlement and payment are electronically linked to allow are electronically linked and payment The systems for securities settlement automatic data exchange. without immobilized perfectly and form dematerialized in issued are securities All certificates. the issuance and/or circulation of paper The legal and regulatory frameworks for post-trade infrastructure are well are well infrastructure for post-trade frameworks The legal and regulatory established hierarchically. are stipulated in legislation, but this does not Measures to minimize settlement risk mean that all measures are being implemented. iv) ii) iii) 2.9.2. Cons i) v) vi) vii) iii) iv) i) ii) Based on the above analysis of the post-trade system in Azerbaijan, the pros and cons can can cons and pros the Azerbaijan, in system post-trade the of analysis above the on Based 2.9.1. Pros 2.9. Pros and Cons of Post-trade Infrastructure and Cons of Post-trade 2.9. Pros be summarized as follows. be summarized as host links to investment companies. As a result, investment companies have to manually key key have to manually investment companies As a result, to investment companies. host links and securities trading or CSDR, which exposes to FOS or settlement instructions in all orders risk. operational process to high the settlement 242 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan v) The roles and responsibilities of the NDC and clearing members are unclear in the settlement process.
vi) No active CCP exists in practice.
vii) The level of operational risk is high due to substandard automation in overall market operations.
2.10. Conclusion: Core Problems in Azerbaijan's Post-trade Infrastructure
The goal of the post-trade system is to minimize transaction costs for market players to make their participation in securities trading easier and instill a high level of trust so that they will purchase or sell securities as agreed. Unless securities trading (i.e., entering an agreement to buy or sell securities at specific prices) and settlement are carried out simultaneously, the risk remains that one party will renege on its obligations for any reason. Thus the post-trade system needs to guarantee trade settlement at lower costs.
The core problems of the post-trade infrastructure of Azerbaijan's capital markets can 243 be defined as high transaction costs for market players caused by excessive stability in CHAPTER requirements and inadequate stability in systems. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets 2.10.1. Excessive Stability in Requirements
In settlement stability, the post-trade system in Azerbaijan is excellent because of no risk of settlement failure. Thanks to the pre-funding requirement, an investor must offer a 100% guarantee to be fulfilled from the start of trading. Yet this system is far from perfect because the requirement substantially raises transaction costs. Settlement stability is important but only meaningful only if market transactions are not damaged. As expressed by market participants in interviews, market players in Azerbaijan must bear huge opportunity cost because of the pre-funding requirement, which seriously impedes market trading.
2.10.2. Inadequate Stability in Systems
While the requirements for market players make the market excessively stable, the lack of completeness in the overall system of post-trade infrastructure makes it less stable.
A host of requirements, conditions, and measures are stipulated in the legal and regulatory frameworks for risk management and clearing and settlement. In practice, however, many of them have not been realized. For example, clearing members and the CCP Financial Market Infrastructures Benchmarks In line with this trend, the Committee of Payment and Settlement Systems (CPSS) of (CPSS) of Settlement Systems and In line with this trend, the Committee of Payment 3.1.1. Overview of and Need for PFMI of and 3.1.1. Overview regulators worldwide to grow more many The global financial crisis of 2008 caused 3.1. Global Standards for Post-trade Infrastructure Principles for Infrastructure for Post-trade 3.1. Global Standards With the identification of core problems in Azerbaijan's post-trade system, the next system, the next post-trade in Azerbaijan's With the identification of core problems Another factor reducing stability in the system is substandard automation of ICT systems ICT of automation substandard is system the in stability reducing factor Another for Systemically Important Settlement Systems (CPSIPS), Recommendations for Securities Securities for Recommendations (CPSIPS), Systems Settlement Important Systemically for In (RCCP). Counterparties (RSSS), and Recommendations for Central Settlement Systems (PFMI) were released. Infrastructures April 2012, the Principles for Financial Market the Bank for International Settlements (BIS) and International Organization of Securities of Securities the Bank for International Settlements (BIS) and International Organization for years to strengthen, reconstitute, and harmonize collaborated Commissions (IOSCO) Core Principles recommendations including widely accepted global standards such as the aware of the importance of financial (FMIs) infrastructures market and initiated discussions on introducing standardized principles to regulate FMIs. section will focus on global financial standards and the experiences of other markets in in of other markets and the experiences standards section will focus on global financial resolving such problems. and Market 3. Analyses of Global Standards electronic connection between investors and investment companies and between such companies and between such between investors and investment electronic connection companies and the BSE and NDC causes significant operational risks thatraise transaction participants. costs for market in post-trade infrastructure. In a modern capital market, automated information exchange information exchange automated market, In a modern capital infrastructure. in post-trade or cost for market could cause an enormous loss transaction delayed is essential since a of the exists only between the systems In Azerbaijan, however, such automation players. The absence of a fully automated between those of the NDC and CBAR. BSE and NDC and are supposed to provide clearing and settlement services for market trades, but the state of but the trades, services for market and settlement to provide clearing are supposed their roles and and playing activity any them from conducting prevents related procedures collect to is supposed addition, the NDC In and CCPs. members as clearing responsibilities such a fund. have yet to create markets but the capital as a CCP a clearing fund and manage 244 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan The PFMI aims to minimize system risk and enhance the stability of financial markets by accelerating the efficiency and safety of securities clearing and settlement, deposit, registration, and payment conducted by FMIs and through introducing risk management for individual FMIs.
FMIs in advanced financial markets strive to comply with every principle of the PFMI and regularly perform self-assessment. In particular, many regulators in top markets require investment banks originated in their sovereign to invest only in the markets where FMIs meet the principles. Thus FMIs in any market must comply with the principles if they wish to attract foreign investors and advance to globalized markets. In that context, Azerbaijan must identify the requirements its financial markets must meet and seek solutions.
3.1.2. PFMI at Glance
The PFMI comprises 24 principles in the nine categories of general organization, credit and liquidity risk management, settlement, central securities depository and exchange- of-value settlement system, default management, general business and operational risk 245 management, access, efficiency, and transparency. CHAPTER
A brief explanation of the principles is presented in
below. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets Principles for Financial Market Infrastructure DescriptionsCategory Principle Description
An FMI should have a well-founded, clear, transparent, and enforceable Legal basis legal basis for each material aspect of its activities in all relevant jurisdictions.
An FMI should have governance arrangements that are clear and General transparent, promote the safety and efficiency of the FMI, and support the Governance organization stability of the broader financial system, other relevant considerations of public interest, and the objectives of relevant stakeholders.
Framework for An FMI should have a sound framework for risk management for comprehensive risk comprehensively managing legal, credit, liquidity, operational, and other mgmt. risks. Description An FMI must clearly state its obligations in the delivery of physical An FMI must clearly state its obligations in the delivery of physical monitor, and manage the risks instruments or commodities and identify, deliveries. associated with such physical A CSD should utilize the proper rules and procedures to help ensure the integrity of securities issues and minimize and manage the risks associated of securities. It should also maintain and transfer with the safekeeping by for their transfer securities in an immobilized or dematerialized form book entry. involving the settlement of two linked If an FMI settles transactions it should obligations (i.e., securities or foreign exchange transactions), conditioning the final settlement of one eliminate principal risk by obligation on that of the other. An FMI should effectively measure, monitor, and manage its liquidity risk. ItAn FMI should effectively measure, monitor, and should also maintain sufficient liquid resources in all relevant currencies to effect same-day and,where appropriate, intraday andmultiday settlement range obligations with a high degree of confidence under a wide of payment be limited to, the default of of stress scenarios that should include, but not the participant and its affiliates that could generate the largest aggregate conditions. market liquidity obligation for the FMI in extreme but plausible final settlement at a An FMI should provide a clear and definitively an preferable, or necessary When date. value the of end the by minimum or in real time. FMI should provide final settlement intraday bank notes when in central An FMI should conduct its money settlements If such money is not used, an FMI should minimize and available. practical arising from the use of and strictly control credit and liquidity risk commercial bank money. and their affiliates that could potentially cause the largest aggregate credit other All conditions. plausible market but in extreme CCP the to exposure resources to sufficiently cover should maintain additional financial CCPs to, limited be not but include, should that scenarios stress of range wide a the default of the participant and its affiliates that could cause the largest market plausible but extreme in CCP the to exposure credit aggregate conditions. to manage its or its participants' credit An FMI that requires collateral and market with low credit, liquidity, exposure should accept collateral haircuts and concentration risks. It should also set and enforce conservative limits. products via should cover its credit exposure to its participants for all A CCP regularly reviewed. an effective margin system that is risk-based and An FMI should effectively measure, monitor, and manage its credit exposuremonitor, and manage its effectively measure, An FMI should and settlement clearing, its payment, and those arising from to participants sufficient financial resources to fully cover processes. It should maintain its credit exposure to each participant with a high degree of confidence. In addition, a CCP involved in activities with a more complex risk profile or additional in multiple jurisdictions must keep that is systemically important scenarios stress of range a wide cover to sufficient resources financial not be limited to, the default of two participants that should include, but Margin Collateral Principle Credit risk depository Liquidity risk Physical delivery Physical Central securities Central Money settlement Settlement finality Exchange-of-value settlement systems Continued Category settlement system Central Central securities depository & exchange- of-value Settlement Credit & liquidity risk Management
ContinuedCategory Principle Description
An FMI should have effective and clearly defined rules and procedures to Rules on & manage participant default designed to ensure that the FMI can take timely procedures for action to contain losses and liquidity pressure and continue to meet its participant default Default obligations. Management A CCP should have rules and procedures enabling the segregation and Segregation & portability of positions of a participant's customers and the collateral portability provided to the CCP for those positions.
An FMI should identify, monitor, and manage its general business risk and hold a sufficient amount of liquid net assets funded by equity in case of General business general business losses to continue operations and services if such losses risk materialize. Furthermore, liquid net assets should always be sufficient to ensure recovery or orderly wind down critical operations and services.
General An FMI should safeguard its own and its participants' assets and minimize Custody & business & the risk of loss on and delay in access to these assets. An FMI's investments investment risks operational should be in instruments with minimal credit, market, and liquidity risks. risk Management An FMI should identify the plausible sources of operational risk, both internal and external, and mitigate their impact through the use of appropriate systems, policies, procedures, and controls. Systems should be Operational risk designed to ensure a high degree of security and operational reliability and adequate, scalable capacity. Business continuity management should aim 247
for timely recovery of operations and fulfillment of the FMI’s obligations, CHAPTER including in the event of a wide-scale or major disruption.
Access & 04 An FMI should have objective, risk-based, and publicly disclosed criteria for participation Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets participation that permit fair and open access. requirements
Access Tiered participation An FMI should identify, monitor, and manage material risks to the FMI arrangements arising from tiered participation arrangements.
An FMI that establishes a link with one or more FMIs should identify, FMI links monitor, and manage link-related risks.
Efficiency & An FMI should be efficient and effective in meeting the requirements of its effectiveness participants and the markets it serves.
Efficiency Communication An FMI should use, or at least accommodate, relevant internationally procedures & accepted communication procedures and standards to facilitate efficient standards payment, clearing, settlement, and recording.
An FMI should have clear and comprehensive rules and procedures and Disclosure of rules, provide sufficient information to enable accurate understanding of the key procedures, & risks, fees, and other material costs players can incur through participating market data in FMI. All relevant rules and key procedures should be publicly announced. Transparency
Disclosure of A trade repository should provide timely and accurate data to relevant market data by authorities and the public in line with their respective needs. trade repository
Source: BIS & OICU-IOSCO (2012). No margin system is in operation. The government owns the CSD and clearing house (NDC). Credit risk is hedged pre-funding by requirements. and a system to A CCP measure, monitor, and control credit risk in complex situations are nonexistent. No financial resource is reserved for settlement failure. Practice in Azerbaijan Practice Description their affiliates that could cause the largest aggregate in extreme but plausible credit exposure to the CCP should maintain CCPs conditions. All other market additional financial resources sufficient to cover a of stress scenarios that should include, wide range participant the of default the to, limited be not but and its affiliates that could cause the largest in extreme but CCP to the credit exposure aggregate conditions. plausible market its to exposure credit its cover should CCP A effective an under products all for participants margin system that is risk based and regularly reviewed. the broader financial system other relevant public the broader financial system other relevant public and the objectives of relevant interest considerations, stakeholders. and An FMI should effectively measure, monitor, those manage its credit exposure to participants and settlement clearing, and from its payment, arising processes. It should also maintain sufficient financial each resources to fully cover its credit exposure to In confidence. of degree high a with participant more a with activities in involved CCP a addition, complex risk profile or that is systemically important in multiple jurisdictions should maintain additional financial resources sufficient to cover a wide range not of stress scenarios that should include, but be and participants two the of default the to, limited An FMI should have governance arrangements An FMI should have governance arrangements FMI's the promote transparent, and clear are that of stability the support and efficiency, and safety Margin Principle Credit risk Governance Though such an assessment went beyond the scope of this study, comparison of of comparison of this study, assessment went beyond the scope Though such an 3.2. Comparison of Principles with Azerbaijani Market Situation Azerbaijani Market with of Principles 3.2. Comparison meet the market from a particular if the FMIs assessment to confirm A precise Category Management of credit & liquidity risk General General organization discovered that Azerbaijani FMIs hardly meet eight principles in five categories and require below. 4-4> in
Comparison of Market Practices ContinuedCategory Principle Description Practice in Azerbaijan
An FMI should effectively measure, monitor, and manage its liquidity risk. It should also maintain sufficient liquid resources in all relevant currencies to effect same-day and, where appropriate, intraday The NDC takes no and multiday settlement of payment obligations responsibility for Liquidity risk with a high degree of confidence under a wide range settlement failure of stress scenarios that should include, but not be and has no system to limited to, the default of the participant and its manage liquidity risk. affiliates that would generate the largest aggregate liquidity obligation for the FMI in extreme but plausible market conditions.
An FMI should conduct monetary settlement in central bank notes when practical and available. If Money settlement is Money Settlement such notes are not used, the FMI should minimize performed using money settlement and strictly control credit and liquidity risk arising deposited in the NDC. from the use of commercial bank notes.
An FMI should identify, monitor, and manage its general business risk and hold sufficient liquid net assets funded by equity to cover potential losses from The NDC is a non-for- General general business to continue operations and services profit institution that business risk if such losses materialize. Furthermore, its liquid net has no liquid net assets assets should always be sufficient to ensure recovery funded by equity. 249 or an orderly winding down of critical operations CHAPTER Mgmt. of and services. general 04 business & An FMI should identify the plausible sources of Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets operational operational risk, both internal and external, and risk mitigate their impact by using appropriate systems, Many jobs require policies, procedures, and controls. Systems should human intervention Operational be designed to ensure a high degree of security and analog operation. risk and operational reliability and have adequate and It is unclear if the NDC scalable capacity. Business continuity management has back-up systems for should aim for timely recovery of operations and BCP purposes. fulfillment of the FMI’s obligations, including during a wide-scale or major disruption.
The channel to hear An FMI should be efficient and effective in meeting Efficiency & user requests and Efficiency the requirements of its participants and the markets effectiveness reflect them in the NDC it serves. operation is limited.
Source: Bank for International Settlements & OICU-IOSCO (2012).
3.3. Experiences of Korea and Other Markets as Lessons for Azerbaijan
To devise solutions for the eight problems plaguing Azerbaijan's capital markets stemming from the latter's failure to meet PFMI requirements, this section examines the experiences of other markets worldwide with an emphasis on Korea. The stock exchange-owned model could have an effect similar to that of the user- the of that to similar effect an have could model exchange-owned stock The In several countries, however, the stock exchange fully owns the CSD, usually in nations in usually fully owns the CSD, stock exchange the countries, however, several In For that reason, the development of the CSD ownership and governance structure in structure in the CSD ownership and governance that reason, the development of For 3.3.1. Governance Structure of CSD Structure 3.3.1. Governance infrastructure, (CSD) and settlement securities depository the central operate properly To participating in the capital markets. Yet the former model is inferior to the latter in in latter the to inferior is model former the Yet markets. capital the in participating benefiting market participants and the public interest because stock exchange members are of participants in the CSD system is more dealers, while the range and often mostly brokers wide and diverse. over the past few decades, the number of KSD owners has varied accordingly and was 59 as over the past few decades, the number of KSD owners has varied accordingly of 2018. institutions financial are who members by owned fully is exchange the if model owned more user-friendly. more As user-friendly. a result, 108 financial institutions including commercial banks and KSD in the new owners of became trust companies investment and securities, insurance, including the KRX. participants to market 1994. Ownership of KSD has been distributed Through multiple rounds of capital market reform and M&As among financial institutions book-entry settlement and securities immobilization surged, resulting in the setup of Korea immobilization surged, resulting in the setup of Korea book-entry settlement and securities This corporation a precursor of KSD. (KSBSC) Securities Book-entry Settlement Corporation of the KRX and maintained this ownership was founded a wholly owned subsidiary Securities Depository (KSD) its name to Korea structure until 1994, when KSBSC changed become to structure ownership its changed also KSD entity. non-for-profit a became and where the CSD function has historically been part of a stock exchange’s business lines business lines a stock exchange’s of been part where the CSD function has historically and the CSD was independently created by spinning off such a business.For example, the 1974 settled stock trades Exchange (KRX), the country's main stock exchange, until Korea through the physical exchange of securities certificates andcash. With therapid growth in however, demand for transactions, volume of market the number of listed companies and advanced markets has emphasized user-friendliness. Such CSDs are set up in the form of a Such CSDs are set up in has emphasized user-friendliness. advanced markets rata pro CSD of participants or users the to distributed are equities and company stock joint of the clearing and settlement system. usage rate in each entity’s structure has stockholders, the board of directors, and high-level management come from high-level management come from the board of directors, and structure has stockholders, diverse backgrounds so that they can toward simultaneously benefiting stakeholders on the 2018). Depository, Securities and the public interest (Korea capital market a CSD needs the appropriate ownership and governance structure because it significantly The most desirable but also investors. players of not only market affects the interests 250 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan The government-owned model is found only in emerging markets and developing economies such as Azerbaijan, Uzbekistan, Belarus, and Mongolia. These countries all used to have a communist economy, and the CSD was established at the same time as or even earlier than the stock exchange to register the ownership of companies formerly owned by the government that went public after the introduction of capitalism. Considering this historical background, it is understandable why the CSDs in those countries were established and remained government owned. But as described earlier, this model cannot reflect the requirements of market participants as effectively as the user-owned model and is thus inconducive for stimulating growth.
3.3.2. Credit Risk Management
The definition of credit risk per the PFMI is as follows:
“FMIs and their participants may face various types of credit risk, which is the risk that a counterparty, whether a participant or other entity, will be unable to meet fully its financial obligations when due, or at any time in the future. FMIs and their participants may face 251 replacement-cost risk (often associated with pre-settlement risk) and principal risk (often CHAPTER associated with settlement risk). Replacement-cost risk is the risk of loss of unrealized gains on unsettled transactions with a counter party (for example, the unsettled transactions of 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets a CCP). The resulting exposure is the cost of replacing the original transaction at current market prices. Principal risk is the risk that a counter party will lose the full value involved in a transaction, for example, the risk that a seller of a financial asset will irrevocably deliver the asset but not receive payment. Credit risk can also arise from other sources, such as the failure of settlement banks, custodians, or linked FMIs to meet their financial obligations (BIS & OICU-IOSCO, 2012).”
As seen above, credit risk consists of principal and replacement-cost risk, both of which stem from the possibility that one party in the trade fails to fulfill its financial obligations for settlement. The core element of settlement risk, as well as a fundamental component of the risk management system, is coverage of credit risk.
To manage credit risk in securities trading, most advanced economies have adopted complementary measures from three perspectives: minimizing the size of credit risk, preventing settlement failure, and guaranteeing settlement finality even if a party goes bankrupt. The experiences of other global markets vis-à-vis these three objectives are presented below. T+2 T+0 T+2 T+1 T+2 T+0, T+2 T+0~T+40 T+0, T+1 (FICC) T+0, T+1 (JGBCC) Gov't securities T+2 (stock exchange), T+0~40 (OTC) T+2 T+2 T+2 T+2 T+2 T+2 T+2 T+2 Equities T+3 (B share) T+1 (A share), T+2 (from July 2019) US UK Italy Japan China France Canada Country Germany Hong Kong Switzerland Shorten settlement cycle (time between trade and settlement); cycle (time between trade Shorten settlement netting; obligation by Reduce settlement lag between securities (DvP) model to remove time Apply delivery-versus-payment delivery and cash payment. Shortening the settlement cycle is the best way to reduce an unsettled balance. In that balance. In that unsettled to reduce an best way is the cycle the settlement Shortening i) ii) iii) 3.3.2.1. Minimizing Size of Credit Risk Credit Size of 3.3.2.1. Minimizing and the and settlement trade the time between rata risk increases pro credit Overall, amid a huge number of trades (e.g., equity trades), a longer settlement cycle is generally a longer settlement cycle is generally (e.g., equity trades), amid a huge number of trades are shown below in
. 4-5> Settlement Cycles of Leading Economies ContinuedCountry Equities Gov't securities
Singapore T+2 T+1
Korea T+2 T+1 (stock exchange), T+1-30 (OTC)
Source: Korea Securities Depository (2018a) and Bank for International Settlements (2017).
Netting is a technique to reduce the settlement amount by calculating only the obligation's net position (deducting receivables from payables). This technique lowers credit risk as the number of transactions grows between the same parties. Thus to maximize netting's effect, the adoption of a CCP and centralized multilateral netting by novation is crucial (KSD, 2018). A list of CCPs in major economies is presented below in
. CCPs in Leading EconomiesFinancial instrument Countries CCP Stock Bond Derivatives
FICC × ○ (gov't, MBS) × US NSCC ○ ○ (corporate) × 253 CHAPTER Canada CDS ○ ○ ×
UK LCH.Clearnet Ltd ○ ○ ○ 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets France LCH.Clearnet SA ○ ○ ○
Germany Eurex Clearing ○ ○ ○
Italy CC&C ○ ○ ○
Sweden Euroclear Sweden ○ ○ ×
Denmark VP ○ ○ ×
Finland Euroclear Finland ○ ○ ×
Turkey Takasbank ○ ○ ×
JGBCC × ○ (OTC Gov.) ×
Japan JSCC ○ (OTC) ○ (Market) ○
JDCC ○ (OTC) × ×
China SD&C ○ ○ ×
Hong Kong KSCC ○ ○ ○
Singapore CDP ○ × ×
Australia ASX Clear ○ × × × ○ Derivatives DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 DvP 1 Gov't securities DvP 2(TTF), DvP 1 × (Market) Bond ○ Financial instrument (OTC) (Market) Stock ○ ○ DvP 3 DvP 2 DvP 1 DvP 1 DvP 2 DvP 3 DvP 1 Equities DvP 2 (OTC), DvP 2 (OTC), DvP 2 (OTC), DvP 2 (OTC), DvP 2 (A class) DvP 1 (B class), DvP 3 (Stock Exchange) DvP 3 (Stock Exchange) DvP 2 (TTF), DvP 3 (CNS) DvP 2 (OTC), DvP 3 (Stock Exchange) DvP 2 (OTC), KSD KRX CCP Continued US UK Italy Japan China Korea France Canada Country Germany Singapore Korea Hong Kong Switzerland Korea Securities Depository (2018a). Korea Countries Credit risk, especially principal risk, rises if a time lag exists between securities delivery securities between exists lag time principal risk, rises if a Credit risk, especially 3.3.2.2. Measures to Prevent Settlement Failure to Prevent 3.3.2.2. Measures gross directly settle the obligations with each other (no matter If the parties in a trade or net base), no third party to intervene or settlement guarantee is required since the since the is required or net base), no third party to intervene or settlement guarantee Source: 2018). In most global markets, this model is accepted as the norm by the securities settlement the as the norm by this model is accepted markets, 2018). In most global is shown DvP's application in major economies trades. systems for both exchange and OTC 4-7>. below in
DvP Application in Major Economies First, most FMIs in advanced markets have systems to regulate clearing and settlement members financially and non-financially to prevent settlement failure. For example, the KRX, the CCP for exchange trading on the Korean market, requires clearing members to regularly submit financial statements to prove financial soundness. The KRX also requires its members to meet and maintain a certain level of credit rating acquired from major credit rating agencies. If a clearing member fails to meet these conditions, the KRX can terminate its membership. To limit the scale of risk exposure of a clearing member, the KRX sets a net debit cap for each member and adjusts it based on historical settlement performance and credit VaR (KRX, 2016). A similar mechanism is operated by KSD, which is the CCP for OTC 255 trading. CHAPTER 04 Second, the need for smooth settlement necessitates a system to secure extra liquidity for Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets both securities and cash for settlement purposes. For this, most advanced markets use the automatic securities lending and borrowing (SLB) system and credit lines from commercial banks. In Korea, KSD and Korea Securities Finance Corporation (KSFC) operate the SLB intermediary system, and the KRX and KSD have credit lines with multiple commercial banks to prepare for the event of a fund shortage in settlement, KRW 2.6 trillion for the KRX (KRX, 2016) and KRW 200 billion for KSD (KSD, 2019).
Third, a CCP that guarantees fulfillment of settlement obligations is required to prevent settlement failure. For this purpose, most global markets allow CCPs to collect and/or accumulate funds specifically for settlement failure, and the CCP is ultimately responsible if the damage cannot be covered by such funds. When setting up such funds, advanced markets create multi-layered funds to better guarantee settlement. For instance, the KRX maintains three layers of resources for settlement guarantee fund: KRW 77 billion in joint clearing funds, KRW 1 million per member of fidelity guarantee money, and KRW 80 billion in settlement reserves. The first two funds are collected from clearing members while the third is accumulated with the KRX's own assets (KRX, 2016). KSD also manages two-layered resources separately, KRW 50 billion in default funds and KRW 300 billion in settlement reserves. The default funds are collected from clearing members participating in OTC Scope of application Payment & securities settlement systems Payment law assigned by Specific trades (swap, option, repo, currency (swap, Specific trades futures) Clearing & settlement systems assigned by bank Canadian central assigned by settlement systems Payment financial supervisory authority & Bank of England clearing securities settlement,& Payment, law systems assigned by Recognized settlement systems & multilateral netted settlement agreements settlement systems All recognized payment settled in gross/netted via settlement All trades bank central systems assigned by Already established Legislation of new law Legislation of new law Legislation of new law Legislation of new law Legislation of new law Implementation method Amendment to existing law Amendment to existing law Amendment to existing law - 1998 2003 2002 2003 1996 1999 1999 2001 Year US UK Italy Korea Securities Depository (2018a). Korea Korea Canada The key points in settlement stability are exception to the zero-hour rule in bankruptcy points in settlement stability are exception to the zero-hour The key 3.3.2.3. Guaranteeing Settlement Finality Settlement 3.3.2.3. Guaranteeing regulated officially an by performed settlements the that means finality Settlement Australia Country Germany Singapore New Zealand Source:
Settlement Finality Cases among Leading Economies 4-8> Settlement Finality Cases among Leading Margin is a monetary amount to cover losses from the volatility of an underlying asset’s price during the time gap between trade and settlement. For this reason, relevant parties (from investors to clearing member and from the latter to CCP) generally must pay margin before or right after placing a buy order for securities.
Most advanced capital markets allow margin trading by individual investors to promote investment in securities by lowering entry barriers. Under a margin trading system combined with secured loans from investment companies (or clearing members), investors need not readily secure the entire sum required to buy securities; rather, a small portion of the total purchasing amount (margin) should be prepaid. As a result, they can purchase far more securities relative to the money on hand, maximizing leverage effect.
While margin is used mainly to encourage investment in the relationship between investors and investment companies (clearing members), it is also necessary for the CCP in case a clearing member fails to fulfill its settlement obligation because of crash in the price 257 of the underlying securities. In the past, however, few CCPs collected margin from clearing CHAPTER members because risk management methods (such as clearing funds) were considered sufficient to cover credit risk derived from price fluctuations of the underlying assets. Since 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets PFMI requires CCPs to collect and manage margin to better guarantee settlement stability, CCPs in select countries have recently started to charge margin on clearing members.
In Korea, the KRX, the CCP for exchange trading, started collecting margin from clearing members from September 2017; such members must pay 6%-7.5% of their net settlement position to the KRX by 3 p.m. on T+1. Investment companies collect margin from individual investors at the rate of 40%-100% when placing buy orders depending on the liquidity of the underlying securities and the credit rate of the individual investor. Investment companies do not collect margin from institutional or foreign investors.
3.3.4. Liquidity Risk Management
The PFMI definition of liquidity risk is:
“FMIs and their participants may face liquidity risk, which is the risk that a counterparty, whether a participant or other entity, will have insufficient funds to meet its financial obligations as and when expected, although it may be able to do so in the future. Liquidity risk includes the risk that a seller of an asset will not receive payment when due, and the seller may have to borrow or liquidate assets to complete other payments. It also includes
” (BIS & OICU-IOSCO, 2012). (BIS & OICU-IOSCO, “ The best method for cash settlement using central bank money is allowing the CCP and bank money is allowing the CCP The best method for cash settlement using central 3.3.5. Money Settlement 3.3.5. Money requires cash side settlement to be carried the PFMI settlement finality, guarantee To As explained in 3.3.2.2 , KSD and Korea Securities Finance Corporation (KSFC) are (KSFC) are Finance Corporation Securities As explained in 3.3.2.2 , KSD and Korea In general, liquidity risk is caused by a temporary shortage of securities or money in a shortage of securities or money in a a temporary caused by liquidity risk is In general, financial stability sufficient for directly joining a central bank's payment system. Yet clearing payment system. bank's financial stability sufficient for directly joining a central members active on the capital markets of most other countries are not financially as stable is conducted cash settlement for securities trading as commercial banks. On these markets, agents of clearing members (who are commercial banks under among the payment 2018). bank. This model the central by system operated clearing members to join the payment of level certain a maintain members clearing where markets advanced most by used is out using central bank money because only the transfer of money deposited in the central central in the money deposited of transfer the only because money bank out using central bank is bank Central considered moneyvalid issettlement thusfinality. considered superior finality to the money deposited in other institutions and settlement liquidity, in stability, exposed to bankruptcy risk (KSD, including commercial banks because they are always 2.6 trillion for the KRX (KRX, 2016) and KRW 200 billion for KSD (KSD, 2019). 200 billion for KSD (KSD, KRW 2.6 trillion for the KRX (KRX, 2016) and fails to fulfill its obligation. and KSD have credit lines with the SLB intermediary system, and both the KRX operating purposes in case of money shortage, namely KRW multiple commercial banks for settlement clearing member or the CCP in settlement even if sound financial stability is maintained. maintained. is stability financial if sound even settlement in CCP the or member clearing in CCPs most problem, this tackle To money. and securities both in occur can risk Such borrowing (SLB) system and have adopted the securities lending and advanced markets to have these facilities More important is for the CCP credit lines with commercial banks. for settlement completion even if a clearing member since it bears ultimate responsibility they create concerns about solvency. Liquidity risk can also arise from other sources, such such risk can also arise from other sources, Liquidity about solvency. they create concerns agents, custodian banks, liquidity inability of settlement banks, nostro as the failure or the expected FMIs to perform as providers, and linked the risk that a buyer of an asset will not receive delivery when due, and the buyer may may due, and the buyer delivery when asset will not receive a buyer of an the risk that parties Thus, both its own delivery obligation. order to complete the asset in have to borrow date. risk on the settlement exposed to liquidity are potentially transaction to a financial if they particularly systemic problems, potential to create problems have the Liquidity or if are changing rapidly, closed or illiquid or when asset prices are occur when markets 258 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan contracts between them and clearing members) using central bank money or carried out using a designated commercial bank.
Theoretically, a CSD can process cash settlements if it has a banking license and operates as a bank. This model, however, is rare among CSDs worldwide except international CSDs (ICSDs) such as Euroclear Bank or Clearstream. ICSDs are CSDs that provide settlement and deposit services for cross-border securities investment and cannot work for a domestic market. By nature, they cannot assign the central bank of a specific country for cash settlement purpose and instead, process cash settlement by themselves with a banking license.
In Korea, KSD (as the CCP for OTC trading and the securities settlement system in acting as the CCP's agent for exchange trading) settles cash obligations of clearing members using money deposited in the Bank of Korea (BOK). Except select foreign brokers, most clearing members directly participate in BOK-Wire, a system for paying large amounts. Membership among clearing members in BOK-Wire is limited to securities settlement, however.
259
3.3.6. General Business Risk Management CHAPTER
The PFMI requires FMIs to maintain the appropriate capacity and systems to manage 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets risk from general business operations as explained below.
“An FMI should identify, monitor, and manage its general business risk and hold sufficient liquid net assets funded by equity to cover potential general business losses so that it can continue operations and services as a going concern if those losses materialize. Further, liquid net assets should at all times be sufficient to ensure a recovery or orderly wind-down of critical operations and services” (BIS & OICU-IOSCO, 2012)
As described in 3.3.1, CCPs and CSDs in most advanced countries are operated as joint stock companies owned by financial institutions that are members of both groups. The benefits of running a CCP or CSD as a joint stock company is not limited to the ease of ownership distribution only. Such a company is more advantageous than other organizational forms in operational flexibility and fundraising. So though FMIs are generally not-for-profit entities, they are better operated as joint stock companies rather than governmental bodies or non-capitalized special purpose corporations.
In Korea, both the KRX and KSD run as joint-stock companies under commercial law and maintain sufficient liquid net assets to cover operational damages as presented in
below. (Unit : Billion KRW) (Unit : Billion 53 KSD 2,515 1,911 1,016 121 300 KRX 2,730 1,884 Current assets Paid-in capital Classification Current liabilities Retained earnings Korea Exchange (2018) and Korea Securities Depository (2018). Securities Depository (2018) and Korea Exchange Korea In Korea, KSD classifies risk source into the following categories in accordance with the To guard against damage from external events such as force majeure, many FMIs have FMIs have guard against damage from external events such as force majeure, many To Even as an automated system gets rid of risk from analog operation, greater risk can greater risk can of risk from analog operation, Even as an automated system gets rid Global capital markets have as much as possible full automation of the entire cycle full automation of the entire cycle have as much as possible Global capital markets Operational risk measures the possibility of business failure or suspension caused by not caused by or suspension of business failure possibility measures the risk Operational 3.3.7. Operational Risk Management 3.3.7. Operational Regulation on Internal Risk Management: personnel, system, process and external events. external events. Regulation on Internal Risk Management: personnel, system, process and risk and KSD conducts daily monitoring and weekly and quarterly checks of operational standing auditor, and chairman of the Risk Management reports the results to its CEO, backup ICT centers at several locations. This need was driven home after the 9/11 terror 9/11 terror locations. This need was driven home after the backup ICT centers at several markets financial institutions in advanced in 2001. As a result, many attacks on the U.S. each other. including FMIs have at least one or two such centers located far apart from ensue due to malfunction of ICT systems due to causes such as errors in application software ensue due to malfunction of ICT systems maintenance, required perform to failure system, the of capacity limited hardware, or huge spend markets advanced in FMIs Thus outages. power and attacks, hacking external and cyber security. sums annually on ICT system maintenance data to avoid mistakes or incorrect operations that could cause significant damage. Since Since damage. significant cause could that operations incorrect or mistakes avoid to data is done in an analog process trading job in the securities if any inevitable risk is operational is advised. environment, full automation of the process of securities trading, from order placement to settlement completion, using computers to settlement completion, using computers from order placement of securities trading, human intervention in processing the required and information networks to minimize only an operator's mistakes or system anomalies but also force majeure including a natural including a natural or system anomalies but also force majeure mistakes only an operator's To tackle these issues, FMIs need a business continuity plan disaster such as fire, riot, or war. circumstance. under any to sustain operations Source: Major Values of KRX & KSD Balance Sheets of KRX & KSD Values 4-9> Major 3.3.8. Efficiency and Effectiveness
The PFMI requires FMIs to efficiently and effectively meet the requirements of its members and the market. The best and most fundamental way to ensure this is to make the FMI governance structure user- and market-friendly as mentioned in 3.3.1. Additionally, FMIs must also have communication channels to continuously hear the opinion of market participants. For that reason, FMIs in many advanced markets run multiple committees or councils, regularly hold conferences or meetings, and set up task forces to resolve issues 261 cooperatively with market players. CHAPTER
For example, KSD operates councils whose members are representatives from regulators, 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets market participants, academics and other stakeholders to gather opinions on improving operations and business lines. Such councils include the Securities Settlement Council, Depositor Council, Deposit and Settlement Development Consultation Council, and those for securities settlement, depositors, and the development of consultations on deposits and settlement. In addition, introduction of a new regulation or system, or making a change in an existing one, is thoroughly scrutinized via public consultation and discussion with supervisory authorities including the Financial Services Commission. In 2012, KSD, the KRX, and the Bank of Korea jointly devised a plan for advancing the securities settlement system and built a new system through collaboration with the market.
3.4. Conclusion: Developmental Direction of Azerbaijan's Capital Market
The post-trade industry is one of the world's most globally standardized sectors because it is directly connected to the availability of free capital movement within the domestic market and across countries. Though a well-established post-trade infrastructure is no reason to immediately attract domestic or overseas investments, infrastructure that is poorly set up can hinder market entry not only by domestic investors but also foreign ones or drive As seen in Section 2, the legal and regulatory frameworks of the Azerbaijani capital of the Azerbaijani capital As seen in Section 2, the legal and regulatory frameworks The PFMI requires elaborate legal and regulatory frameworks for every aspect of post- legal and regulatory frameworks The PFMI requires elaborate 3.4.2. Alignment of Overall System 3.4.2. Alignment of Overall To promote transactional activity on the Azerbaijani capital market, post-trade post-trade activity on the Azerbaijani capital market, promote transactional To As seen in the PFMI and the experiences of other markets, risk from securities trading securities trading risk from and the experiences of other markets, As seen in the PFMI 3.4.1. Centralization of Risk Control of Risk 3.4.1. Centralization Considering the items discussed and the Azerbaijani market's situation, the situation, the Azerbaijani market's and the the items discussed Considering market are incongruous with practical business operations and market practices. To make make To practices. market and operations business practical incongruous with are market refine to are requirements the functioning, better and trustworthy, reliable, more market the system meet global standards as much as possible, system, have the post-trade the overall together with market regulators and legislators, need to continuously examine the legal and legal the continuously examine to legislators, need and regulators with market together system to detect and resolve disparity between them and post-trade regulatory frameworks trends and practices. to adopt the best market trade activities because conflicts between laws and/or regulations, mismatches between and/or regulations, mismatches between activities because conflicts between laws trade and poor legal basis business operations, misguided practices, and market both frameworks avoid this danger, FMIs, To of FMI businesses can severely damage the financial market. infrastructure needs to develop a centralized risk management system to allow investors to investors allow to management system risk centralized a develop to needs infrastructure FMIs, without all ensuing risk managed by based on credit, with conduct securities trading advanced markets. in many losing settlement stability just like failure. However, since investors must bear high transaction costs to secure financial costs to secure financial bear high transaction failure. However, since investors must through settlement completion, this requirement resources from the beginning of trading investment. in capital market profitability and lowers interest harms trading needs central control and management by FMIs rather than investors. Because of no of no than investors. Because FMIs rather and management by control needs central are forced to hedge risk management, investors in Azerbaijan for centralized framework is pre-funding If the number of investors is low, settlement risk themselves pre-funding. the most efficient (or the only available) risk management technique to prevent settlement of post-trade infrastructure first requires centralization of risk control and then alignment system. of the overall players out of the market. A market must thus develop its post-trade infrastructure to meet infrastructure develop its post-trade must thus A market out of the market. players in the industry worldwide. standardization that lead to high-level practices globally accepted development is obvious. In conclusion, the development of market recommended direction 262 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan clearly stipulate these requirements in the legal and regulatory frameworks, and implement them in business operations.
Based on the knowledge presented by the analyses so far of the Azerbaijani capital markets, global standards, and the experiences of other markets abroad, the next section proposes a new model of post-trade infrastructure for Azerbaijan.
4. Recommendation: New Post-trade Infrastructure Model for Azerbaijan's Capital Markets
4.1. Principles for To-Be Model Design
4.1.1. Create Optimized System Based on Market Size, Institutions, and Practices
When settling the obligations derived from securities trades, many methods can be considered and applied such as gross (DvP 1) vs. netted (DvP 2 or 3), daily vs. continuous netting, and T+0 vs. T+n. Each method has pros and cons, and no method universally fits 263 CHAPTER any circumstance. The settlement method commonly varies depending on the attributes
of trades even on the same market. For example, government bonds traded on the stock 04 exchange can be settled under the T+0 by DvP model 1 (gross delivery and payment) while Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets equities traded on the OTC market can be settled under the T+3 by the DvP model 2. In other words, the optimal settlement method can be determined by factors such as type of securities traded, who the main traders are, trading frequency, where the trades are made, the volume of securities and money traded, which legislation or regulations govern trading, and what market practices to use in trades. If the post-trade system fails to reflect the characteristics of each trading type, the resulting inefficiency shall produce additional costs for certain entities on the market. So to optimize the post-trade system of a market, the pros and cons of each settlement method must be weighed considering market size, legal and regulatory systems, and market practices for all types of securities traded, then suitable methods should be appropriately combined.
4.1.2. Design System that Boosts Market Growth without Damaging Settlement Stability
Stability in the securities settlement system and efficiency in market trading requires a tradeoff. As a result, sacrificing something to improve another is both inevitable and unavoidable. Such a tradeoff is found in the overall system for securities settlement including settlement methods and scope of and requirements for clearing members and Economy 4.1.4. Design System that Complies with Global Standards and Promotes Open and Promotes with Global Standards 4.1.4. Design System that Complies With the rapid development of information and communications technology (ICT), and communications technology (ICT), development of information With the rapid Since post-trade infrastructure is the fundamental ground of market transactions, any any transactions, of market is the fundamental ground infrastructure Since post-trade 4.1.3. Design System that Minimizes Additional Costs for Overall Development for Overall that Minimizes Additional Costs 4.1.3. Design System recommendation pursues alignment of capital market infrastructure to comply with global infrastructure recommendation pursues alignment of capital market in advanced economies are financial investment companies that many practices market capital markets. familiar with to ease their approach to Azerbaijan's and ICT eliminated time gaps and geographical constraints. As a result, securities settlement constraints. and ICT eliminated time gaps and geographical goals of reducing countries are getting more similar and share the systems in many to costs and minimizing settlement risk. The Azerbaijani government hopes transaction sectors its economic structure from heavy oil dependence to a model diversifying transform investors. The for sustainable growth, and this requires active investment from foreign the transaction volumes of the domestic capital market and that for cross-border trading trading cross-border for that and market capital domestic of the volumes transaction the is continue. The global capital market growing, a trend that is expected to are rapidly has increased the thanks to globalization, which into one single market seeing integration similarity in capital market operation and financial instruments among different markets, familiar with it. Given this situation, more extensive changes to the post-trade system could more extensive changes to the post-trade familiar with it. Given this situation, if even players hurt will changes market frequent and consequences unfavorable produce The design of a new model development. market such actions are recommended for capital changes, and should thus seek to avoid drastic in Azerbaijan infrastructure for post-trade absolutely necessary factors. the amendments should focus solely on amendment to it generally requires or induces significant cost to the overall market. In In market. cost to the overall requires or induces significant amendment to it generally bear indirect costs to participants must market addition to the direct costs of amendment, Azerbaijani capital markets for the infrastructure adapt to a new environment. Post-trade are still getting participants reform, and market was set up in 2016 through large-scale settlement system that seriously hinder market trading and introduce effective mechanisms lower settlement stability. to compensate for investors. The basic goal of the post-trade system is inarguably to stabilize settlement but but stabilize settlement is inarguably to system the post-trade The basic goal of investors. trading If market trading. market constrain only if it does not is meaningful such stability organized to which is strictly system, in the post-trade because of problems is hampered no ensuring despite recommended is not such a system stability, settlement guarantee eliminate factors in the clearing and Thus a critical task is to identify and settlement failure. 264 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 4.1.5. Design System Stressing Need and Taking Complementary Measures by Stage
When the direction of the development of post-trade infrastructure is determined, many tasks will be defined to achieve this goal. Since the effectiveness and feasibility of each task differ amid limited resources to carry out the tasks, conducting them all simultaneously is both impossible and inefficient. Thus the tasks should be placed in order according to the priority set based on the correlation among them, as well as their impact and cost. This research aims to suggest multi-tiered stages for development based on a market's maturity level so that recommended tasks can be more easily and smoothly implemented by all stakeholders in Azerbaijan's capital markets.
4.2. Recommendations for To-Be Market Structure
4.2.1. Strengthen Roles and Responsibilities of Investment Companies
The investment company is the main player on capital markets because of its key role of connecting issuers and investors on the primary market and sellers and buyers on the 265
secondary market. Competition among investment companies is essential to provide better CHAPTER services for issuers and investors and make capital markets more vigorous. Encouragement of such competition requires ample room for investment companies to develop specialized 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets and unique services. In Azerbaijan, however, opportunity for investment companies to creatively generate competitive services for clients is low because of strict regulatory requirements and rigid business processes. As explored in Section 2, investment companies in Azerbaijan can hardly participate in the clearing and settlement process because settlement risk is hedged by investors due to the pre-funding requirement. As risk management is performed by investors, investment companies cannot provide differentiated services because risk management forms the core ground on which investment companies can compete with each other and presents a critical opportunity for them to earn revenue. So strengthening the roles and responsibilities of investment companies is critical. The next section explores what needs to be done in this area.
4.2.1.1. Introduce Credit Concept to Market Transactions and Empower Investment Companies to Manage Ensuing Risk
All trading of fixed-income instruments in Azerbaijan must be pre-funded before orders are placed. Even if equity trades require no pre-funding and investors who buy equities on the secondary market can place orders without depositing the entire purchase amount in advance, equity trading volume accounts for only 3%~5% of trading volume overall. Intraday trading. Intraday Margin trading; Margin trading; Covered short sale; To get investment companies to develop better services and accelerate trading on the on the trading get investment companies to develop better services and accelerate To A key point that investment companies need to consider is that any risk management management risk any point that investment companies need to consider is that A key iii) risk of settlement failure as no investors are incur the Such credit-based transactions i) ii) especially if the company provides credit with its Given own the property. financial stability own their with job the do to them expecting Azerbaijan, in companies investment of most investment companies are subsidiaries of assets or credit is difficult. Alternatively, agent who is is to let each of them assign a payment move commercial banks, so a practical capital market, investment companies should be allowed (or even encouraged) to provide to provide should be allowed (or even encouraged) investment companies capital market, collateralization through lending securities or loans secured through to investors credit an investment Basically, popular in most advanced markets. of investor assets, a practice to customers, needs financial stability and ample liquidity to provide credit company the burden of risk evasion. For example, institutional investors can receive more credit and example, institutional investors the burden of risk evasion. For than individual investors since the former generally be subject to fewer strict requirements among institutional investors, those with than the latter. Even have better credit ratings those with lower ratings. deserve better services than higher credit ratings to set up a risk management system to ensure their risk management capacity up to a a to up capacity management risk their ensure to system management risk a up set to certain level. of clients to optimally allocate on the credit ratings system that they develop should be based risks stemming from client orders. Yet certain investment companies might neglect setting certain investment companies might neglect setting risks stemming from client orders. Yet In that case, such because of budget constraints). up a risk management system (mainly placed through them and competitiveness, and the orders companies will lose market entire the impacting negatively net, no safety with risk face will market the on executed companies investment all requiring regulation a devise to suggested thus is FIMSA market. required to retain securities or money when placing orders. Each investment company when placing orders. Each investment company required to retain securities or money control efficiently and effectively system to must thus develop its own risk management others. This means the pre-funding requirement dominates the overall market with 95%-97% of of with 95%-97% market the overall requirement dominates the pre-funding This means not a major factor that requirement is in Section 2, the As explained trading. combined to companies capacity of investment also hampers the but securities trading only hinders and the needs to be lifted, Thus this rule for risk management. services develop competitive be introduced to Azerbaijan, among types relying on credit should following transaction 266 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan the parent company (if not subsidiary of a commercial bank, any commercial bank) through a bilateral contract and let the payment agent provide a credit line to the investment company to provide credit to investors. In the early stage, what credit investment companies provide to customers should be limited to a certain portion of the purchasing amount over a set time. When such credit is stabilized, the scope of credit (both portion and time) can be extended. In addition, once credit provision for the money side has been firmly rooted without problems and investment companies grow capable of smoothly procuring securities, credit can also be extended to the securities side, namely securities lending from investment companies to investors for covered short sales.
4.2.1.2. Allow Investment Companies, not NDC, to Check Clients' Securities and Money Balance Before Placing Orders
The order placement process requires orders input into the trading system by investment companies to be transferred to the NDC's system (CSDR) to check the balance. In other words, the NDC has the authority to confirm order validity, and without such confirmation, the orders remain invalid even if they are in the trading system. Investment companies are 267 unaware if investors have sufficient securities or money until the NDC returns the results of CHAPTER the balance check to the trading system. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets The process is plagued by two major problems. First, implementation and matching of the orders in the trading system takes longer since they have to undergo the balance check process only after being entered into the system. Though delivering the orders to CSDR and returning the balance check results to the trading system can be completed in a second thanks to the electronic link between the TRS and CSDR, the risk arises of the orders not being matched as expected because of a delay in information delivery between two systems due to technical problems. Considering the daily average number of orders placed in the trading system on the Azerbaijani market, this might seem less important. Yet if the number of orders increases and the competition to buy or sell securities intensifies, even a millisecond delay in order fulfillment could result in enormous investor losses. Second, the process relieves investment companies of the responsibility of orders they input into the trading system, simply rendering them as simple deliverers of orders because they cannot check order validity.
To resolve these problems, investment companies must be empowered to check the balance of securities and money before orders are entered into the trading system. Such companies need to screen orders before trading. The existing practice is for the NDC to open and manage the accounts of all investors, individual or not, under a one-tier account Clearing Member To help investment companies recover damages from client settlement failure more recover damages from client settlement failure more help investment companies To 4.2.1.3. Grant Full Power to Investment Companies of Clearing and Settlement as of Clearing and Settlement to Investment Companies Full Power 4.2.1.3. Grant and the balance check before order placement If the pre-funding requirement is lifted Over the longer term, consideration is needed of shifting the account management account management is needed of shifting the consideration Over the longer term, shares that it unnecessarily obtained but if the price drops to AZN 8 per share at the point of point the at share per 8 AZN to drops price the if but obtained unnecessarily it that shares 5 for shall request reimbursement of AZN 20 for capital losses plus AZN selling, the company financing cost. The losses that investment companies can charge to the defaulting investor should have might not equal the loss, and a penalty can be added. Investment companies shares of SOCAR equity at AZN 10 each but failed to settle by the deadline. The investment the deadline. The investment shares of SOCAR equity at AZN 10 each but failed to settle by AZN 100 to the NDC to who placed the order on behalf of him or her must pay company complete settlement using its own If money. the company had to pay extra to finance AZN investor 100 for the settlement and if the cost was AZN 5, it shall request the defaulting immediately sell those 10 SOCAR may AZN 105 in reimbursement. Or the company to pay easily, they must be authorized to liquidate the securities or money they had to acquire acquire had to they money or securities the liquidate to authorized be must they easily, liquidates the assets, the reimbursement company because of such failure. If an investment investor should be limited to the loss the amount to be requested from the defaulting example, suppose an investor tried to buy 10 took to complete settlement. For company it using its own assets. After settlement is completed, the company should request from the is completed, the company it using its own assets. After settlement for the obligation amount plus losses incurred from defaulting investor reimbursement settlement failure. settlement of orders placed, executed, and matched on the trading system since they will will they since system trading the on matched and executed, placed, orders of settlement obligation settlement the means This orders. the approved and verified, screened, have the investment to and assumed by be transferred of investors for matched orders should to fails investor an if example, For them. of behalf on orders the placed that companies fulfill his or her settlement obligation, the investment company should immediately fulfill is carried out by investment companies, they assume full responsibility for the clearing and investment companies, they assume is carried out by structure from the one-tier to multi-tier model. This would allow authorized investment allow authorized investment one-tier to multi-tier model. This would structure from the (or individual only), and the and manage accounts for all investors companies to open only (or such companies and accounts for investment companies NDC to open and manage institutional investors). management structure. Thus investment companies should receive the right to see the see the the right to should receive investment companies structure. Thus management amounts purchase collect directly and investors placement sell-order of balance securities placing investors. from buy-order 268 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan the right to set rules on penalties for defaulting customers (monetary or non-monetary) to prevent settlement failure and moral hazard but FIMSA should review and approve such rules.
4.2.2. Clarify NDC's Roles and Responsibilities
The National Depository Center (NDC) is the sole central securities depository (CSD) and securities settlement institution in Azerbaijan. The NDC can perform clearing house functions as well under the rules but is technically not a central counterparty (CCP). As the clearing house, the NDC conducts limited technical operations only; it calculates the settlement obligations of each investor and performs crediting and debiting on the end investor's accounts. The major reason the NDC does not engage in clearing and settlement lies in the pre-funding requirement. If and when the requirement is removed from the market, the NDC needs to play a bigger role and take on greater responsibility. To this end, the following measures are recommended.
4.2.2.1. Play CCP Role and Develop New Risk Management System to Guarantee 269
Settlement Stability CHAPTER
When credit-based trading is allowed on the market, settlement risk naturally increases. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets Under this circumstance, the entities entrusted with the responsibility of risk control on the front line should be investment companies. Yet the answer is not so simple because small investment companies who lack financial capacity are always vulnerable to settlement failure, plus trading cannot be executed only by large investment companies whose credit risk is low. The CCP should thus guarantee settlement stability and lower costs to find credible counterparties in securities trading. The CCP can be established as a separate independent institution but considering the size of the Azerbaijani market, establishing a clearing house as a separate entity is not cost effective and thus not recommended. Instead, allowing the NDC to play a CCP role as stipulated in rules is the better option. To do that, four actions are needed to provide the proper foundation.
First, FIMSA needs to clearly stipulate the CCP’s responsibility in detail to guarantee settlement fulfillment by amending rules and authorizing the NDC as a self-regulatory body that sets regulations needed to control its members in clearing and settlement operations.
Second, the NDC must change its clearing and settlement procedures to clearly reflect the roles of the CCP and clearing members in them. Serve Market Needs More Effectively More Serve Market Needs Overall transaction cost including NDC's fee schedule. transaction Overall infrastructure. Large-scale investment in development of post-trade Under the securities trading and settlement process of Azerbaijan, the NDC directly and settlement process of Azerbaijan, the NDC directly Under the securities trading i) ii) Role in Handling Individual Investors' money 4.2.2.3. Redefine NDC's The NDC is 100% owned by FIMSA and the top decision-making board comprises five five comprises board decision-making top the and FIMSA by owned 100% is NDC The 4.2.2.2. Change NDC’s Ownership and Governance Structure to Be User-oriented to to Be User-oriented Structure Governance Ownership and 4.2.2.2. Change NDC’s and CSDs in most governance structure of CCPs As seen in Section 3, the ownership and Third, the NDC shall set new membership requirements for clearing and settlement to to settlement and clearing for requirements membership new set shall NDC the Third, own not only for its management system a new risk the NDC must develop And fourth, collects money from buyers. When settlement is completed, sellers can withdraw the money the collects money from buyers. When settlement is completed, sellers can withdraw money their to withdraw tend investors Institutional account. bank to their from the NDC to serve as NDC shareholders and members of the board of directors according to the use of the board of directors according to the use to serve as NDC shareholders and members should form a system. In the short term, FIMSA proportion of the clearing and settlement to players consists of representatives from market committee whose majority of members decide on the following two major topics for clearing and settlement. members: two from FIMSA, two from investment companies, and one independent member. two from investment companies, members: two from FIMSA, representatives, but the number is still insufficient Two members are on the board as user to properly reflect the demands of all market participants. FIMSA is thus advised to reorganize players to allow all market ownership and governance structure in the long term the NDC’s CCP CCP and CSD are owned by a specific organization and top-level decision-making is carried entity), a single is dominated by this entity (or if the decision-making organization out by such an organization will find it tough to reflect market participant demands for setting the settlement. rules and regulations on clearing and advanced markets advanced are markets set up to be user-oriented Ifto the serve client needs more effectively. should be based on a newly designed process of risk management that can calculate, management that can calculate, a newly designed process of risk should be based on and those of credit, liquidity, and manage a host of risks including monitor, give alerts, operations. The NDC is highly recommended to develop an ICT system to efficiently conduct in financial risk management. hire professionals with expertise risk management and include credit rating, financial soundness, personnel, and ICT facilities of clearing members. ICT facilities of clearing personnel, and financial soundness, rating, include credit institution. The system and settlement as the CCP market of the overall risk but also that 270 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan from the NDC right after settlement is completed, as they need the money for use in other transactions. Yet most individual investors simply leave their money in the NDC for their next trades on the market. The NDC thus always holds a sum that is not part of its assets. Since it is not a bank, the money it holds cannot be utilized for other purposes and its legal status is unclear. Better solutions are thus needed to manage the money in a safer and more efficient way. Direct collection of investor money by investment companies rather than the NDC was recommended in 4.2.1.2, but a solution to this problem is still required because while money collection is one thing, management of it is another. FIMSA should consider the following three options on this matter.
i) Allow investment companies to keep and manage individual investors' money.
ii) Let NDC keep and manage such money.
iii) Create or authorize third-party institution to manage such money.
Many advanced markets allow investment companies the right to safely keep the investors’ money and use it for credit provision purposes. This model is the best for strengthening the competitiveness of market players. To do that, however, investment 271 CHAPTER companies must maintain a high level of fidelity, credit rating, and financial soundness, and penalties for misuse of money or failure to repay investors must be strongly stipulated in 04 legal and regulatory frameworks. Considering the status of the Azerbaijani market, however, Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets immediate adoption of this model seems non-viable. FIMSA should thus designate this model for achieving long-term goals and select other options for short-term remedies.
Of the available options except i), the NDC should be allowed to keep and manage individual investors’ money for two reasons. First, this is far more cost-efficient than creating or authorizing a third-party institution. Second, this is identical to existing market practice so that the process of handling money needs neither establishment nor amendment. Achieving this goal to better protect investors and raise money handling efficiency can be simply accomplished by licensing the NDC to perform limited banking operations. With the license, the legal status of the investors’ money deposited in the NDC can enjoy the same level of protection as commercial bank deposits. In addition, the NDC can provide extra liquidity to market participants or other investors through secured loans by utilizing the money. Investors and Clearing Members The first is settlement between clearing members, who need to guarantee settlement settlement The first is settlement between clearing members, who need to guarantee 4.3.1.1. Split Settlement Process into That Among Clearing Members and Between 4.3.1.1. Split Settlement Process members, clearing and investors between responsibilities and roles the divide clearly To A clearing member is an organization that takes responsibility for fulfilling settlement 4.3. Recommendations for To-Be Process and Procedures Process for To-Be 4.3. Recommendations Settlement in Clearing and to Participate Clearing Members and CCP 4.3.1. Allow NDC in the accounts investor for end performed is cash and securities both of Settlement management and that of the orders placed by investors who placed orders through clearing investors who placed orders through management and that of the orders placed by investment members (if a clearing member assumed an obligation from an unqualified is whether netting on as well). Depending obligation assumed the amount for the company, the settlement process should be split into two separate steps. the settlement process should be split into two separate executed and matched on the stock exchange. So the volume that a clearing of all trades asset own its for itself by placed orders the of amount the of sum the is settle should member party clearing member. With the emergence of clearing members on the market, a formal a formal of clearing members on the market, party clearing member. With the emergence an investor's account to that of the clearing securities and money from procedure to transfer member is required, as well as a process to track securities and money flows to detect who and efficient most the offer following recommendations The obligation. the fulfill to fails to implement these tasks. stable ways obligations on behalf of the person who originally placed the order(s). In general, an an who originally placed the order(s). In general, obligations on behalf of the person as works also (investors) clients for broker of role the plays who company investment to meet the requirements to be one. In that case, the the clearing member unless it fails ineligible to the investment company orders placed by settlement obligations derived from a third- to and assumed by can be transferred become a clearing member and its customers of securities at the moment of order placement. It is impossible to expect all investors to to expect all investors to moment of order placement. It is impossible of securities at the always provide securities or cash on settlement day to fulfill settlement, thus creating the need for a clearing member. since all the securities and money are deposited in the NDC before placing orders and put on before placing orders and put on and money are deposited in the NDC since all the securities members have no room to engage is completed. In this case, clearing hold until settlement is If the pre-funding requirement responsibility for clearing and settlement. in and take depositing 100% of the amount a buyer can place buy orders without eliminated, however, if he or she lacks the full volume and a seller can place sell orders even in his or her account, 272 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan applied to finalize the settlement obligation, the amount might fall short of the exact sum of such obligations. Once settlement is completed by clearing members, the market trades should be deemed finished.
Second is settlement between investors (or unqualified investment companies) and a clearing member. In this case, the securities and money for trades need to be exchanged between investors and a clearing member. Like settlement among clearing members, the amount to be settled can be netted if netting is applied to the calculation of the obligation between them.
As a principle, the NDC should serve as the CCP in the middle to guarantee settlement and facilitate quick delivery of securities and money to the corresponding party for both settlements. The CCP for settlement between investors and a clearing member, however, can be optional and selectively applied depending on necessity.
4.3.1.2. Create Settlement Purpose Account of CCP and Clearing Member for Both Securities and Cash (Securities Account at NDC and Cash Account at CBAR) 273 CHAPTER The NDC opens and manages not only securities accounts but also cash accounts for all investors and performs both securities and cash settlement by using those accounts. But 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets transferring the money via book entry in the NDC's cash accounts holds no legal validity and fails to meet global standards requiring the money to be transferred on the central bank’s payment system using central bank money for settlement finality. In addition, investment companies hold accounts for their own assets only and no exclusive accounts for settlement purposes. The NDC only has its account opened with the central bank to collect money from investors and lacks securities accounts under its own system.
Once the settlement process is separated and both clearing members and the CCP take part in the process, each clearing member and the CCP must have its own settlement accounts to perform settlement and clearly track the flow of securities and cash. Opening securities accounts with the NDC is easy for both the CCP and clearing members but the problem lies in opening cash accounts for clearing members with the central bank because in many countries, only banks can participate in the payment system. This is also the case in Azerbaijan.
To comply with global standards, money transfers for cash settlement using central bank money are needed, which entails book entry in the clearing members' and CCP's cash accounts opened with and managed by the central bank. Yet allowing financial institutions Accounts Opened with NDC and CBAR The dioramic concept of the so-called to-be settlement process is presented in [Figure 4-11]. concept of the so-called to-be settlement The dioramic 4.3.1.3. Perform Stock-exchange Trades Settlement via Settlement Purpose Settlement via Settlement Trades 4.3.1.3. Perform Stock-exchange the and NDC the with CCP the and member clearing each of account securities the Once The first option is superior in many ways but seems infeasible in the short term term short the in infeasible seems but ways many in is superior option first The The The firstis to let the CBAR separatethe payment system for capitalmarket settlement cash account of each clearing member (i.e., a clearing member’s payment agent) and the agent) and the payment (i.e., a clearing member’s cash account of each clearing member must be completed by the settlement of stock exchange trades are ready, with the CBAR CCP These accounts for settlement purposes are not credit or debit book entry on those accounts. the name holder, and thus their balance must remain records of assets owned by for keeping empty after settlement. considering the financial status of investment companies in Azerbaijan and the relationship the best is option second the Thus institutions. market capital and other CBAR the between of number the when for pushed be could suggestion first The future. near the in choice investment companies with financial soundness is equivalentto that ofcommercial banks approval. reaches a certain level with CBAR from the interbank payment system and allow clearing members to participate. The second system and allow clearing members payment from the interbank agent to allow the as a payment member designate a commercial bank is to let each clearing settlement on behalf of it. bank to perform cash with low credit to participate in the banking payment system is a bad idea since their credit is a bad idea system in the banking payment credit to participate with low Two the entire system. and endanger to other participants risk could spread and liquidity this problem. could solve recommendations 274 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan [Figure 4-11] Concept of To-be Settlement Process
NDC's Securities Settlement System
Settlement of Stock Exchange Trades
Clearing Clearing Investor CCP Member CCP Member CCP Investor (Sell Position) (NDC) (Investment (NDC) (Investment (NDC) (Buy Position) Company) Company) Securities Securities Securities Securities Securities Securities Securities
Host-to-Host Connection
Clearing Clearing Investor's Investor's Member's Member's Bank CCP CCP CCP Bank payment agent payment agent (Commercial (NDC) (NDC) (NDC) (Commercial (Commercial (Commercial Bank) Bank) Bank) Bank) Money Money Money Money Money Money Money
CBAR's Payment System Settlement between investor and clearing member for stock exchange trades settlement
Source: Author.
275 4.3.1.4. Allow NDC to Conduct Clearing and Settlement for OTC Trades CHAPTER
Under Azerbaijan's clearing and settlement process for OTC trades, the NDC's role is to 04 simply deliver securities as requested by the seller and buyer with notary certification. The Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets NDC is not involved in cash settlement for OTC trades, a task carried out by a notary. This process is not problematic when the number and scale of OTC trades are not huge.
As a market grows, far more trading will ensue on the OTC market, especially between those who want to avoid affecting the market prices of underlying securities. In addition, many other markets see large-scale trading of government bonds not at a regulated venue but via agreement between two parties using instant messenger, phone call or other communication method. To better handle such trades and allow them to settle in a safer environment, the NDC should develop a system to provide clearing and settlement for OTC trades. The NDC shall also play the role of a CCP if necessary, and the roles of investment companies and notaries in OTC trades need to be limited to brokerages.
4.3.2. Differentiate Settlement Cycle and DvP Model to Meet Global Standards
Based on securities type, trading characteristics can significantly vary. For example, the main investors of government bonds are financial institutions who usually set the investment plan for government bonds in advance based on long-term forecasts for price stability. Trading volume per transaction is huge and the number of government bonds Government bonds: T+0, DvP 1 after 16:00. after 16:00. bonds: T+0, DvP 1 (or DvP 2 if applicable) Corporate Equities: T+2, DvP 2 (or DvP 3 if applicable) from 9:00 (or after 16:00). The rationale for changing the settlement cycle for equities from T+1 to T+2 is to T+2 is T+1 from for changing the settlement cycle for equities The rationale i) ii) iii) First, the settlement obligation of each participant should be separately calculated for for calculated participant should be separately First, the settlement obligation of each The NDC applies the DvP 2 model to all securities types, and the settlement day for fixed- or sell equities on the trading day as explained above, not like fixed-income instruments for steps are needed which they can set up investment plans before placing orders. Since many purposes among administrative are executed on the stock exchange for after the trades a designated banks, and fund administrators, investment managers, custodian brokers, attracting foreign investment. Foreign investors will probably be mutual funds (or other other (or funds mutual be probably will investors Foreign investment. foreign attracting in cross-border collective investment vehicles) from abroad as they are the main investors decisions to buy equities, foreign mutual funds tend to make When they trade transactions. shown below. problems. The following recommendations could prevent this. problems. The following recommendations among settlement exchange stock for Second, risk. systemic reduce to type securities each changing the settlement cycle and DvP model as clearing members, the NDC should consider 20 per day), and iii) foreign investors do not participate, the settlement cycle and DvP model and iii) foreign investors do not participate, 20 per day), the and lifted is requirement pre-funding the when But problems. serious cause not might mention the entry of foreign investors increase, not to number and volume of transactions critical create will likely model of the existing retention into the Azerbaijani market, the trading day (T+1) for stock exchange trades. Because of no CCP, netting is done bilaterally is done bilaterally netting Because of no CCP, trades. (T+1) for stock exchange day the trading a participant of obligation cash the is that point important An obligations. cash for only this case, risk In repo transactions. of all securities types including is netted across trades Given that i) the pre- and spread to other transactions. types and sizes are mingled together extremely small (under is trades ii) the number of market funding requirement is mandatory, affect the clearing and settlementmethod. So when designing the settlement cycle and DvP be considered. securities types, such features must model for specific after the day (T), while equities are settled day the same as the trading income securities is traded during a day is comparatively small. Yet thousands or millions of individual investors individual investors millions of thousands or Yet small. is comparatively during a day traded target a of price the monitoring usually markets, on many trading equity in daily participate shares company’s to find the best time tobuy or sellsince price fluctuations could see wild small while the is relatively volume per transaction Trading trading. intraday swings in number of transactions is the highest among other securities types. These differences also 276 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan period (usually one business day) is inevitably required. If the NDC maintains the settlement cycle for equities as T+1, this will pose a hurdle for foreign mutual funds to invest their assets in Azerbaijani equities. The prudential move is thus securing sufficient time for settlement preparation by extending the settlement cycle to the global standard of T+2.
Third, as the new settlement process between investors and clearing members for settlement of stock exchange trades awaits introduction, formation of the related settlement cycle is recommended below.
i) Settlement between investors and clearing members for government bonds: T+0, DvP 1 after 16:00.
ii) Settlement between investors and clearing members for corporate bonds: T+0, DvP 1 (or DvP 2 if applicable) after 16:00.
iii) Settlement between investors and clearing members for equities: T+2, DvP 2 (or DvP 3 if applicable) from 9:00 (or after 16:00).
A point of emphasis is that the settlement cycle and time between investors and clearing 277 member must be identical to those among clearing members since these two processes CHAPTER combined constitute the entire settlement process for stock exchange trades. The DvP model, 04
however, can be adopted differently. Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
To help understand the so-called to-be settlement process, an example of equity trading on the stock exchange is shown in [Figure 4-12]. 1 14 order amount- margin) settlement (~T, malgin)(~T, order (~T+2, Money transfer Money transfer (Seller) (Seller) Investor C Investor D $ 0 7 $ 6,000 7 - $2,800 - $4,200 - $ 30,000 + $2,800 + $4,200 + - $10,000 + $10,000 order (T) Input Sell order (T) Input Buy 2 6 19 31 37 15 26 8 Bank Y (T+2) Agent of BB) Commercial Commercial Investor C’s ACC. Investor D’s ACC. Settlement Instruction Bank Q (Paying Clearing Member BB Bal. Bal. Bal. 20 BB (T+2) Settlement Instruction 3 Company 16 18 36 (~T) (~T) 32 (T+2) (T+2) (T+2) (T+2) Investment order order order Notice Notice Notice Money Money Money Balance check Balance transfer transfer transfer 5 70 + 500 1000 - $2,800 24 - $4,200 - 9 $ 36,000 - + $10,000 (T+1) orders (T) 4 Investor D Investor C 17 35 21 Securities Acc. Securities Securities Acc. Securities SEC Input Buy/Sell Apple Bank Y’s Acc. Bal. Settlement information 70 70 500 500 13 - - + + - $4,200 - + $3,000 $ 36,000 - $10,000 - $28,000 21 22 23 24 4 Trade comparison and Clearing (T+1) 17 33 30 Securities Acc. Securities SEC Apple Clearing Member BB Bank Q’s Acc. 12 Bal. Trades matching (T) Calculation & finalization of payment position 10 70 70 500 500 $ 0 Trades details (T) 25 2. B : Pay $10,000, Receive 500 SEC shares 4. D : Pay $7,000, Receive Apple 70 shares - - - $7,000 + + - $3,000 11 + $7,000 + $3,000 - $10,000 + $10,000 NDC 22 22 23 23 RSE TRS 35 33 30 29 35 33 Securities Acc. Securities NDC’s Account Bal. SEC Apple Apple SEC NDC (CDRS) Money transfer order $ 0 70 70 34 500 500 Front Office System (AA) Buyer : D,(BB) shares 70 of Apple, $100/share - $7,000 - $3,000 (BB)Buyer : B(AA), 500 shares of SEC, $20/share + $6,000 + $4,000 30 - - + + 4 17 29 33 Central Bank of Azerbaijan 21 22 23 24 Bank P’s Acc. Securities Acc. Securities Bal. 1. Seller : A, 2 Seller : C, Apple SEC Clearing member AA (T+1) 70 500 100 200 - $6,000 - $4,000 + $7,000 $ 20,500 + 9 BB $3,000, 2. AA → A $7,000 3. BB → C S $10,000 4 - 17 35 21 3. BB : Deliver 500 SEC shares, Receive Apple 70 shares, Receive $3,000 1. A : Deliver1. Apple 70 shares, Receive $7,000 3. C : Deliver 500 SEC shares, Receive $10,000 AA1. : Deliver Apple 70 shares, Receive 500 SEC shares, Pay $3,000 orders (T) A : → Settlement information Investor A Investor B 21 Input Buy/Sell 1. A Bank X’s Acc. Securities Acc. Securities Apple Acc. Securities Google SEC Bal. 13 32 3 16 18 36 (~T) (~T) 28 (T+2) (T+2) (T+2) (T+2) order order order Notice Notice Money Money Notice Money transfer transfer transfer 20 5 AA (T+2) $ 0 Balance check Balance $ 500 Company Settlement Instruction Investment - $7,000 - $3,000 - $6,000 - $4,000 + $7,000 + $6,000 $ 20,000 + $4,000 8 26 (T+2) 6 2 19 27 31 37 15 Bank X Settlement Instruction 7 Commercial Commercial Agent of AA) 7 Investor B’s ACC. Investor ACC. A’s Bank P (Paying order (T) Bal. Bal. Clearing Member AA Bal. Input Buy order (T) Input Sell (Seller) (Seller) Investor B Investor A 1 14 order margin) amount- settlement Author. (~T, margin)(~T, order (~T+2, Money transfer Money transfer 4.4.1.1. Preemptive Measures 4.4.1.1. Preemptive to require maintenance Preemptive measures form the NDC's regulatory framework When the pre-funding requirement is removed, clearing members and the CCP must must is removed, clearing members and the CCP When the pre-funding requirement 4.4. Recommendations for To-Be Institutional Facilities To-Be 4.4. Recommendations for Risk Management System for Settlement New 4.4.1. Develop of a designated capacity among clearing members to prevent credit, liquidity, and and liquidity, credit, prevent to members clearing among capacity designated a of define risk. The NDC should amend internal regulations or pass new ones to operational monitor whether the requirements for clearing members and form a system to regularly clearing members are meeting the following requirements. failure. control and manage settlement risk. The NDC—as the CCP of the overall market—thus needs market—thus of the overall NDC—as the CCP control and manage settlement risk. The of risk management to effectively handle risk that to design and develop a new system items: of such a system requires three key Azerbaijan is unfamiliar with. The development of settlement facilities, and solutions in case preemptive measures, settlement guarantee Source: [Figure 4-12] Example of To-be Settlement Process for Equity Trading Settlement Process Example of To-be 4-12] [Figure 278 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan i) Credit rating
ii) Financial stability
iii) Stress test
iv) Credit value at risk (VaR)
The NDC should also calculate and apply the net debit cap for each clearing member so that credit risk stemming from transactions of a clearing member does not exceed its capacity to fulfill settlement obligations. The cap should be based on a clearing member’s history of settlement volume and stay extendable if and when the clearing member temporarily demands it and provides collateral for such an extension.
The penalties for settlement failure should also be clearly stipulated in the regulation on ensuring that clearing members are aware of and follow the rules. Such penalties can be both monetary (i.e., fines) and non-monetary (i.e., lowering of net debit cap or suspension and/or revocation of clearing membership) depending on the severity of the damage caused by the violating clearing member. 279 CHAPTER 4.4.1.2. Settlement Guarantee Facilities 04
Settlement guarantee facilities comprise a system or assets either pre-established or Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets prepared to strengthen settlement stability when clearing members are short of securities or money in fulfilling settlement obligations. Such facilities can be divided into two categories. The first is a facility to provide additional liquidity for clearing members and the CCP and the second is assets reserved for settlement failure.
The most effective facilities for providing additional liquidity for smoother settlement and minimizing credit and liquidity risk of clearing members and the CCP are the securities lending and borrowing (SLB) system and credit lines from commercial banks. To secure liquidity sufficient for SLB purposes, the NDC should operate a securities pool by collecting securities from long-term investors such as pension funds or insurance companies. Monetary incentives should go to such contributors and can be financed from fees paid by entities that borrow securities from the pool. A credit line is an agreement between a clearing member and/or the CCP and a commercial bank requiring the latter to provide cash when the former is short of cash for settlement. For this to work, a credit line must guarantee immediate cash provision when requested. Basically, the payment agent bank of a clearing member should work as the credit line provider as well. To better assure the CCP's capacity to perform settlement, the CCP should form credit lines with multiple banks. Investors Credit Margin (SLB/Loan) SLB Credit Line Bank Member Clearing Commercial Measures Preventive Contribution SLB Credit Line NDC Banks Funds Reserve Clearing Settlement Commercial Long-term Investors Long-term Measures Preventive Contribution Securities Pool for Lending Purpose To-Be Risk Management System SLB Credit Line Bank Member Clearing Commercial Credit Margin (SLB/Loan) for cash for Liquidity Liquidity settlement settlement Author. Investors for securitiesfor In the short term, however, setting up clearing funds and settlement reserves might up clearing funds and settlement reserves might In the short term, however, setting For the case when the obligation of a clearing member cannot be fully fulfilled even be fully fulfilled even member cannot of a clearing when the obligation the case For Source: settlement stability. Management System Risk 4-13] To-be [Figure profitability. In that case, the loss-sharing rule could be an effective alternative. This is a alternative. This is a rule could be an effective In that case, the loss-sharing profitability. to collectively assume in advance members and the CCP clearing principle agreed on by settlement failure occurs. The rule must also be the burden of damage recovery when funds and settlement reserves to better protect maintained even after the setup of clearing clearing members or the CCP. If clearing funds or settlement reserves are paid in securities, or settlement reserves are paid in If clearing funds or the CCP. clearing members securities. to evaluate, monitor, and manage collateralized a system is required low from suffer NDC the as well as companies investment most because difficult prove each clearing member pro rata based on the size of risk exposure. In addition to clearing exposure. In addition to clearing based on the size of risk pro rata each clearing member to is considered the last resort CCP reserves are also required since the funds, settlement the amount countries, In many on the market. full responsibility for settlement failure take of settlement reserves is raised from the CCP's net profit Both annually. clearing funds and securities owned by be replaced by need not be paid in cash and can settlement reserves after the credit line has been used, two types of funds need to be secured in advance. First, secured in advance. of funds need to be used, two types credit line has been after the reserves second, settlement members and clearing by must be contributed clearing funds up the targeted amount should set The CCP with its own assets. the CCP built up by should be and collect contributions from its history of settlement volume of clearing funds considering 280 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 4.4.1.3. Solutions for Settlement Failure
When a clearing member experiences settlement failure, the impact can be enormous if a rule to handle it and minimize the damage has not been clearly defined. The NDC as a CCP must set a rule to prioritize order to cover damage from settlement failure using assets specifically reserved for that purpose and the procedures to resolve the problem. For example, a default downfall set by the European Market Infrastructure Regulation (EMIR), is shown below.
i) All assets and receivables of defaulting member (including credit line)
ii) Clearing funds contributed by defaulting member
iii) 50% of settlement reserves
iv) Clearing funds contributed by clearing members other than defaulting member
v) Remaining half of settlement reserves
4.4.2. Strengthen Settlement Finality and Straight-through Processing 281 CHAPTER 4.4.2.1. Perform Cash Settlement via Central Bank on the CCP's Account and
Clearing Member's Payment Agent’s Account under DvP System 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
Settlement finality comprises settlement protection and perfection. The first dictates that settled transactions (or transactions input into the clearing and settlement system and confirmed as settled per the settlement schedule) shall never be revoked under any circumstance, including the bankruptcy of a clearing member. This is clearly stipulated by Azerbaijani law as shown in Section 2.
Meanwhile, Azerbaijan has yet to implement settlement perfection, or the simultaneous exchange of securities and cash with no possibility of revocation. Under the existing settlement process, the NDC collects the money directly from investors and manages cash accounts for them to perform cash settlement by crediting or debiting the accounts. Since the legal status of deposited money in the NDC is unclear, it is skeptical whether money transfers between cash accounts opened with the NDC can be considered legally valid transfers of ownership. To avoid this problem, cash settlement should be carried out through the accounts of the CCP and the clearing member's payment agent in the CBAR using central bank money. Since the host-to-host link between the CBAR and NDC systems allows real- time messaging between them, this problem could be easily solved by simply adjusting the 4 Second, the BSE and NDC should provide ICT solutions to investment companies and ICT solutions to investment companies and Second, the BSE and NDC should provide First, FIMSA should encourage investment companies to install with relevant ICT ICT companies to install with relevant investment encourage should FIMSA First, Since communication channels not automated by electronic link connect investors and electronic link connect investors and by Since communication channels not automated 4.4.2.2. Remove Analog Operations from Start of Trading via Settlement Completion via Settlement Start of Trading from Analog Operations 4.4.2.2. Remove among capital market 2, the level of automated communication As covered in Section The NDC's role in implementing this recommendation, namely adopting the DvP model using central bank money, is derived from is derived from bank money, namely adopting the DvP model using central in implementing this recommendation, role The NDC's Securing settlement finality is the duty of this system. as the securities settlement system, not the CCP. legal status the NDC's
4 large institutional investors to enable electronic exchange of information required for electronic exchange of information required for large institutional investors to enable application an providing term, short the In settlement. and clearing, trading, securities program interface (API) might be sufficient but in the long term, the BSE and NDC needto link) to consider connecting their ICT systems to those of investment companies (host-to-host protect data from cyber hacking. Another suggestion is for each company to manage the account information of its customers to manage Another suggestion is for each company and deposited money amount so that investors can including securities holding status time. inquire faster about such data in real investment companies as well as such companies and the BSE and NDC, the drive to create a investment companies as well as such two actions. environment requires the following processing (STP) full straight-through system (MTS) for investors. a mobile trading (HTS) and/or systems to provide a home trading the market, and this will definitely lower their interest in stock investment. Thus capital in stock investment. Thus capital lower their interest definitely and this will the market, and create an environment to accurately participants must and market authorities market and settlement. real time for securities trading automatically deliver information in participants in Azerbaijan remains low. Certain processes heavily rely on analog operations heavily rely on analog operations Certain processes remains low. participants in Azerbaijan settlement. Thanks to mobile and clearing, and information on trading, to send or receive financial technology (fintech), even individual investors have grown tech-savvy and familiar Disaster financial transactions. delivery and prompt feedback on other with instant data or sell securities on minutes (or even hours) to buy need several will ensue if investors business process. 282 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 5. Implementation Plan
Section 4 proposed a model for the setup of to-be post-trade infrastructure in Azerbaijan. Section 5 defines and lists the required tasks to build such infrastructure through the gap analysis between "as-is" and "to-be" with the evaluation of cost (difficulty level) and effect (impact or necessity) for each task.
5.1. Gap Analysis
5.1.1. Roles and Responsibilities of Investment Company
From the clearing and settlement perspective, investment companies are simply intermediaries who deliver investor orders and settlement instructions to the BSE or NDC. Eventually, they need to serve as clearing members who take full responsibility for securities trading on the market. To fill the gap, the following 12 tasks should be implemented.
12 Required Duties of Investment Company 283 CHAPTER Required tasks Main performer Effect CostDevelop own risk mgmt. system Investment companies High Moderate 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets Form credit rating agencies in Azerbaijan FIMSA Moderate High
Construct SLB intermediary system NDC High High
NDC/commercial banks/ Assign payment agent for cash settlement Moderate Low investment companies
Commercial banks/ Establish credit lines with commercial banks High Low investment companies
Develop SLB/secured loan services for Investment companies High High investors
FIMSA/NDC/investment Introduce margin trading High High companies
FIMSA/NDC/investment Introduce intraday trading High High companies
FIMSA/NDC/ Introduce covered short sales High High investment companies
Construct balance checking system Investment companies/ NDC Moderate High
Build host-to-host link with BSE and NDC BSE/NDC/investment companies High High
Legislate clearing member's rights, FIMSA High Low responsibilities, & penalties
Source: Author. Low Low Low Low Low Cost High Moderate Moderate Moderate High High High High High High High High High Effect Moderate Main performer FIMSA NDC FIMSA/NDC/ investment companies Commercial banks/NDC FIMSA/NDC FIMSA/NDC FIMSA/NDC FIMSA/NDC/ investment FIMSA/NDC/ companies NDC NDC Required tasks Author. 5.1.3. Clearing and Settlement Procedures per investor In the clearing and settlement process, a settlement obligation is calculated 5.1.2. Roles and Responsibilities of NDC and Responsibilities 5.1.2. Roles securities the For depository. and registrar a securities as is role main NDC's The Start limited banking business to manage investor money Legislate rights, responsibilities, & penalties of CCP Establish credit lines with multiple commercial banks Build up settlement reserves Set loss sharing rule Set new requirements for clearing membership & Develop system to monitor credit, liquidity, risk operational Collect & manage clearing funds Establish user-oriented decision-making Establish user-oriented decision-making system Reform clearing & settlement procedure to in it adopt roles of clearing members & CCP obligation is calculated per investor, clearing member, and the CCP for varying types of for varying types of obligation is calculated per investor, clearing member, and the CCP shall intervene in the settlement process and securities. Clearing members and the CCP and among between investors and a clearing member settlement must be done separately and settled directly among end investors using each investor's securities and cash accounts and settled directly among end investors using each investor's securities a settlement in the NDC system. In the to-be process of clearing and settlement, however, Source: however, the NDC shall also serve as the CCP, securities settlement institution, and provider securities settlement institution, and shall also serve as the CCP, however, the NDC capital markets. settlement stability for the Azerbaijani to guarantee of value-added services 10 tasks are recommended. this end, the following To for NDC Tasks 4-11> 10 Recommended
7 Tasks Needed for Clearing and SettlementRequired tasks Main performer Effect Cost
Open settlement purpose account for each NDC/ investment companies Moderate Low clearing member & CCP in NDC system
Reform clearing & settlement process for NDC High Moderate exchange trades to reflect recommendations
NDC/commercial banks/ Assign payment agent for cash settlement Moderate Low investment companies
Amend ICT modules for clearing & settlement NDC High Moderate
Set new internal regulations for clearing & NDC Moderate Low settlement 285 Lower money transfer fee of CBAR for
CBAR / FIMSA Moderate Low CHAPTER settlement of capital market transactions
Set up business process for OTC trades NDC Moderate Moderate 04 clearing & settlement Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
Source: Author.
5.1.4. Risk Management System
The pre-funding requirement is the dominant (and the only) risk hedging tool on Azerbaijan's capital markets and thus a sophisticated and centralized risk management system is absent. Eventually, this requirement will be lifted and the duty to control risk from securities trading will fall on clearing members and the CCP, who will collaborate to guarantee settlement stability under an environment of centralized risk management. The following 11 tasks listed below are recommended to that end.
11 Required Tasks for Risk ManagementRequired task Main Performer Effect Cost
Set up new requirements for clearing NDC High Moderate membership
Develop credit, liquidity, & operational risk NDC High High monitoring system
FIMSA/NDC/ Investment Collect & manage clearing funds High High companies Low Low Low Low Low Low Low Low Cost Cost High High Moderate Moderate Moderate High High High High High High High Effect Effect Moderate Moderate Moderate Moderate Moderate Moderate Main performer Main Performer Investment companies NDC NDC / FIMSA CBAR NDC NDC / NDC FIMSA Investment companies FIMSA Commercial banks/NDC/ Commercial Investment companies FIMSA/NDC FIMSA/NDC FIMSA/NDC Required task Required task Continued Author. 5.1.5. Settlement Finality and Straight-through Processing 5.1.5. Settlement Finality and Straight-through settlement for law ensures settlement protection and Though the securities market Set new internal regulations for clearing & settlement fee money transfer Lower CBAR's Reform clearing & settlement procedure to adopt in it roles of clearing members and CCP agent for cash settlement Assign payment clearing & trades Set up business process for OTC settlement Develop own risk mgmt. system Develop own risk mgmt. Designate under law rights, responsibilities, & penalties of clearing members & CCP Set loss sharing rule damage from Clarify priority to cover settlement failure system Build SLB intermediary in Azerbaijan agencies Establish credit rating Establish credit lines with multiple Establish credit banks commercial Build up settlement reserves must be fully automated from the moment an investor places an order until settlement is an investor places an order until settlement is must be fully automated from the moment are recommended to achieve these goals. completed. The following eight tasks and STP for Settlement Finality 4-14> 8 Recommended Tasks
ContinuedRequired task Main performer Effect Cost
BSE / NDC / Investment Build host-to-host link with BSE & NDC High High companies
Provide HTS/MTS Investment companies High Moderate
Develop ICT system to manage account data of Investment companies High Moderate own clients
Source: Author.
5.2. Roadmap for Implementation
This study recommends the adoption of the so-called to-be model for post-trade infrastructure of Azerbaijani capital markets, and the required tasks to this end are based on close analyses of the domestic capital market, global standards, and the experiences of other markets.
As seen in the analysis of the Azerbaijani capital markets, the country's post-trade 287 infrastructure has problems that raise transaction costs for market players. Considering the CHAPTER market's maturity level, however, not all of the steps needed to achieve the to-be model must
be adopted immediately. As explained in Section 4.1, developing a market’s post-trade system 04 incurs significant costs directly and indirectly, thus it can be justified only if the expected Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets benefit, namely reduction in overall transaction costs, is greater than the cost.
In that sense, the suggestion is not to implement all tasks at once but to set multiple milestones on the way to the final goal and sort tasks for each milestone to be performed step by step. Here, this study proposes three development stages for the Azerbaijani capital markets for that purpose: system reorganization, growth ignition, and spring toward globalization.
In the system reorganization stage, all stakeholders including FIMSA, BSE, NDC, and investment companies must focus on implementing the least costly solutions. This stage seeks to reorganize institutions, systems, and legal and regulatory frameworks for the next step, and the tasks should be limited to those that can be immediately implemented through strong government action.
The second stage begins when the market has outgrown its status. In general, market capitalization and turnover are frequently used as statistics to measure the growth of a capital market. In post-trade infrastructure responsible for managing risk from Spring for Globalization 3 • Full adoption of advanced remedies • When the number of daily transactions goes over 100,000 Growth Ignition 2 • Partial adoption of advanced remedies • When the number of daily transactions goes over 1,000 System ReorganizationSystem Settlement cycle for equities: change from T+1 to T+2 types, conduct settlement on gross Cash side netting: no netting across all transaction basis DvP model: Apply DvP model 1 to all transactions Author. 1 • Least cost remedies • Immediately executable with the strong will of government ii) iii) i) 5.2.1. Stage 1: System Reorganization 5.2.1.1. Change of Settlement Model including This stage precedes the introduction of the advanced risk management system When the number of daily transactions exceeds 100,000, this can be interpreted as as exceeds 100,000, this can be interpreted of daily transactions When the number the setup of clearing funds or settlement reserves. Adjustment of the settlement model is is of the settlement model the setup of clearing funds or settlement reserves. Adjustment thus required through the following three suggestions. Source: [Figure 4-14] Roadmap for Implementation [Figure the passing of a threshold that signals the start of full-scale development. When this full-scale development. When this that signals the start of the passing of a threshold thus post-trade capital markets, investors will eye the Azerbaijani foreign happens, many to enable their investment and settle obligations without needs upgrading infrastructure from this Thus all of this study's proposals must be fully adopted and implemented difficulty. stage. of daily transactions, which is the most fundamental indicator for designing a clearing and is the most fundamental indicator for which of daily transactions, is between 10 and 20, but in Azerbaijan The number of daily transactions settlement model. is recommended. partial adoption of advanced measures when it exceeds 1,000, market transactions, other indicators such as the number of clearing members and and of clearing members number such as the other indicators transactions, market volume of and maximum average and transactions, volume of daily daily transactions, it is tough turnover. Obviously, capitalization and critical than market are more transactions to select specific indicators and their numbers to precisely judge whether the environment judgment the number this research recommends for been formed. Yet for the next stage has 288 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 5.2.1.2. Restructuring of Decision-making System
The long-term goal is to establish a user-oriented ownership and governance structure for capital market infrastructure. In the short term, however, a committee is needed in this stage for collective discussion by all stakeholders including FIMSA, BSE, NDC, CBAR, and market players on deciding transaction costs in capital markets (including the fee schedule of the NDC and BSE) and large-scale investment in ICT system development.
5.2.1.3. Strengthening Competitiveness of Investment Companies
Investment companies have little opportunity to compete in risk management (especially that of credit and liquidity risk) for clearing and settlement in this stage since the pre- funding requirement is the main tool of risk management. Instead, such companies should focus on minimizing operational risk in the delivery of information for trading and settlement.
For that purpose, FIMSA needs to encourage investment companies to develop HTS/MTS 289
for clients and build host-to-host connections between them and the BSE and NDC. Such CHAPTER connections require more than the efforts of investment companies, thus the BSE and NDC should support them by providing appropriate solutions. 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets
To promote individual investment by nationals in capital markets and expand the business scope of investment companies, FIMSA could consider allowing such companies to provide credit to domestic individual investors through commercial banks at lower interest rates. To this end, a policy is needed to require banks to provide credit to such companies at a specified rate or set up a government fund so that such companies can borrow money from the fund for credit provision purposes.
5.2.1.4. Limited Banking License for NDC
As discussed in Section 4.2.2.3, investor deposits in the NDC must be protected and used to raise market efficiency. The best solution for this is to allow the NDC to obtain a limited banking license. Since the money is already sitting in NDC accounts, adoption of this policy is recommended as soon as possible to better protect investors’ money.
The purpose of this solution is to simply protect investor deposits in the NDC by granting the money the same legal status as commercial bank deposits; it does not mean the NDC can conduct cash settlement using the cash accounts there. Since it is impossible to predict when the market will have the proper conditions to adopt Since it is impossible to predict when the market During During the first stage, FIMSA needs to complete new legaland regulatory frameworks 5.2.1.6. Legislation for Next Step 5.2.1.6. Legislation for Next Aligned with the task described in Section 5.2.1.3, a lower huddle is needed for domestic Aligned with the task described in Section Also, FIMSA and the country's tax authority must jointly decide what tax benefits to decide what tax benefits to country's tax authority must jointly and the Also, FIMSA The fees charged by Azerbaijan's central bank CBAR for conducting money transfers for conducting money transfers CBAR bank central Azerbaijan's by The fees charged In addition, the NDC must open and manage a separate account to keep and manage such account to keep separate and manage a the NDC must open In addition, Transactions of Capital Market 5.2.1.5. Benefits regulations to align them with new legislation set by FIMSA. FIMSA. regulations to align them with new legislation set by timing the such advanced measures stipulated in the new legal and regulatory frameworks, of implementation should not be specified and remain open for the time being. for advanced clearing and settlement operations. Under such frameworks, the rights and the rights and such frameworks, Under operations. for advanced clearing and settlement and clearing members must be clearly defined as well as the responsibilities of the CCP amend internalpenalties for violation of such rules. Also, the NDC, as a self-regulator, should this makes it almost impossible to attract more investors. Since commercial banks will not not will banks commercial Since investors. more attract to impossible almost it makes this to is necessary policy government for loans to investors, rates interest lower voluntarily of a recommended 2%-3%. at low interest rates require banks to provide loans for investment banks. far are (15%-20%) loans bank for rates interest the As markets. capital enter to investors in securities (i.e., 6%-10% for government bonds),higher than the profit margin for investing offer investors. Tax breaks are the most powerful and common weapon of a government powerful and common weapon of a government breaks are the most offer investors. Tax interest and dividends, gains, capital on exemptions Tax transactions. market stimulate to should be considered to make stock investment more profitable than depositing money in in CBAR's payment system is a major cost burden for market players. Even if it the CBAR Even if it the CBAR players. is a major cost burden for market system payment in CBAR's more will attract suspension lift such fees, a reduction or temporary cannot permanently markets. capital investors and invigorate money independently from its own assets or those transferred from investment companies from investment transferred its own assets or those from money independently purposes. for settlement 290 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 5.2.2. Stage 2: Growth Ignition
5.2.2.1. Introduction of Margin and Intraday Trading
As the number of investors and volume of market transactions increase, investor demand for greater efficiency in trading and settlement will rise in tandem. To support further growth, the entry of credit-based transactions is critical in this stage. Margin trading allows investors to place buy orders by depositing only the margin to cover the price fluctuation risk until settlement is carried out, while not depositing the full purchasing amount. Intraday trading means investors can immediately sell the securities purchased on the same day or buy securities with the money that they are set to receive for selling other securities on the same day despite settlement of earlier transactions remaining incomplete.
Two prerequisites are required here. First, investment companies need a system to check the securities and cash balances of investors in real time before placing orders on behalf of investors. Second, such companies should develop a system to keep a record of an investor's daily transactions and manage risk derived from the transactions. 291 CHAPTER When determining the margin rate, differentiation is required based on the liquidity of underlying securities and the credit ratings of investors. Margin rate does not necessarily 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets equal the exact amount of expected price fluctuation of target securities. Since investment companies in Azerbaijan will incur credit risk if the margin rate is set too low from initial adoption, the recommendation is to initially set it high (70%~80%) and gradually reduce it to more appropriate levels.
5.2.2.2. Partial Introduction of CCP and Clearing Member Function
When the market allows credit-based transactions (which would signify the lifting of the pre-funding requirement), effective control of the risk from such transactions is crucial. In this stage, the NDC and investment companies should initiate their respective roles as the CCP and clearing member.
The first order of business is to change the clearing and settlement procedures to get the CCP and clearing members involved as recommended by the to-be model. Steps implemented in this stage are assigning a payment agent for clearing members, opening an account for the payment agent and CCP in the CBAR to perform cash settlement as well as the account of a clearing member and CCP in the NDC to perform securities settlement, and reforming the settlement process to separate settlement among clearing members and that between investors and clearing members. 5.2.2.5. NDC's Clearing and Settlement of OTC Trades Clearing and Settlement of OTC 5.2.2.5. NDC's transactions increase, the need for OTC Once the volume of stock exchange transactions 5.2.2.4. Change of Settlement Model risk. credit reduces netting centralized of availability the action, into comes CCP the As 5.2.2.3. Accumulation of Clearing Funds and Settlement Reserves of Clearing Funds and Settlement 5.2.2.3. Accumulation on the use of preemptive and system relies mainly While the risk management The risk management tool in this stage shall be limited to preventive and promissory and promissory be limited to preventive in this stage shall management tool The risk electronic trading platform for them. Additionally, the NDC should reorganize its internal internal reorganize its should the NDC them. Additionally, platform for trading electronic under trades OTC regulations and business processes to conduct clearing and settlement for its electronic by the DvP system. The development of such a platform should be followed processing (STP). system for straight-through connection to the NDC's post-trade will rise accordingly. To protect OTC trades and process their settlement in a safer manner, trades protect OTC To will rise accordingly. and pursue the development of an trades OTC needs to enact regulations to govern FIMSA settlement model for equities is needed from DvP 1 to DvP 2 using centralized netting; for netting; for from DvP 1 to DvP 2 using centralized settlement model for equities is needed fixed-income instruments, the application of DvP 2 is suggested asYet well. if the number of transactions remains insufficient to expect enhancedefficiency fromnetting, maintaining fixed-income securities. the DvP 1 method is recommended for To raise settlement efficiency, the settlement model needs to be replaced as well. As the the settlement model needs to be replaced as well. As the settlement efficiency, raise To changing the in this stage, will come from equities trading transactions majority of market clearing funds shall be determined based on a member's settlement volume history, and and settlement volume history, be determined based on a member's clearing funds shall the settlement reserve will be saved from the NDC's net profit at a pre-determined annual and settlement reserves should not be used until they reach the both clearing funds Yet rate. target amounts. promissory solutions, it must also start collecting clearing funds from clearing members funds from clearing members it must also start collecting clearing promissory solutions, to contribution member's clearing each of share The reserves. settlement up building and solutions due to the lack of preparation of practical assets to cover settlement failure. Such settlement failure. assets to cover of practical preparation due to the lack of solutions of and the introduction for clearing members requirements shall include stronger remedies rule. and loss sharing cap, credit lines, the net debit 292 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan 5.2.2.6. Restructuring of Decision-making System
As capital markets in Azerbaijan grow, the number of market players is anticipated to surge and fuel the need for diversification of demand for post-trade infrastructure. This requires consideration of restructuring the NDC's ownership and governance structure to reflect such demand for developing new services more effectively. The best way is to let market players own NDC shares and allow them to participate in top-level decision making. The ownership structure can include market players according to the system usage ratio.
However, as long as a channel allows market players to participate in decision making on important issues in post-trade infrastructure, such as the committee supposed to have been established in the former stage, this task needs no implementation in the second stage. It can be delayed until market participants voluntarily request it or FIMSA considers the market sufficiently mature to allow market players to run the clearing and settlement system without direct government intervention.
5.2.3. Stage 3: Spring toward Globalization 293 CHAPTER 5.2.3.1. Full Functioning CCP and Clearing Members 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets In this stage, the market has sufficiently grown to adopt advanced functions for risk management. The NDC may launch a new risk management system that includes use of clearing funds and settlement reserves, a real-time risk monitoring system, and strengthened requirements for clearing members.
5.2.3.2. Introduction of Covered Short Sales
To allow investors to diversify investment strategies for asset management, the Azerbaijan capital markets must allow short sales in this stage. Yet if such sales are allowed without limits, credit risk could skyrocket and market prices could plummet (i.e., a bear market could see the acceleration of market price drops). Thus only covered short sales should be permitted and the level of permission must be differentiated between individual and institutional investors.
5.2.3.3. Introduction of Securities Lending and Borrowing
When short sales are allowed, the securities lending and borrowing (SLB) service is also needed for settlement stability. Though the role of the SBL intermediary that connects The goal of this stage is to get foreign investors interested in Azerbaijan's capital markets. capital markets. The goal of this stage is to get foreign investors interested in Azerbaijan's 5.2.3.5. Construction of Infrastructure for Cross-border Trading for Cross-border 5.2.3.5. Construction of Infrastructure If the number of transactions skyrockets, the CSD will find it inefficient and burdensome 5.2.3.4. Change of Securities Model and Reform of Account Structure 5.2.3.4. Change of Securities Model obligations the settle to need the market, the on increases transactions of number the As SLB transactions can be executed by searching for counterparties case by case. A better case. A better for counterparties case by searching by can be executed SLB transactions lenders more securities SLB system could depend on attracting The success of the review business processes and innovate them to meet global standards and cover the time review business processes and innovate them to meet global standards and gap. To do this, the clearing and settlement system needs upgrading to smoothly support cross- support smoothly to upgrading needs system settlement and clearing the this, do To extra could consider offering woo more global investors, FIMSA To border transactions. must NDC The trading. securities for requirements eased or breaks tax as such incentives keep records on each investor's securities holding status, and the NDC manages only the manages only the records on each investor's securities holding status, and the NDC keep each of name the under investors individual of balance securities the of sum combined investment company. to process settlements for all individual investors. In this situation, FIMSA and the NDC need investors. In this situation, FIMSA to process settlements for all individual management structure from one to multi-tier. This to consider reorganizing the account to investors individual for accounts manage and open to companies investment allow will more efficiently will also grow. Based on market performance, the NDC should consider the NDC should consider performance, Based on market more efficiently will also grow. to fixed-income instruments. applying DvP 3 to equities and DvP 2 than borrowers since demand for borrowing will be greater when covered short sales are are sales short covered when greater be will borrowing for demand since borrowers than lenders to secure a certain level of are a must to motivate securities allowed. So incentives that borrowed management system as well to ensure the collateral liquidity and operate securities are returned safely as agreed. option, however, is to generate in advance a securities pool at least for settlement purposes in advance a securities pool at least to generate option, however, is a pool does not exist. of finding no relevant lenders if such because of the risk securities lenders and borrowers does not exclusively fall on the central securities securities central fall on the does not exclusively and borrowers lenders securities the latter can depository, most efficiently provide the service since it can easily identify who the to develop and operate NDC is advised In that sense, the of lending securities. is capable well. system as SLB intermediary 294 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan As cross-border transactions expand and grow more common, many issuers in Azerbaijan will hope to raise funds from abroad. Likewise, if Azerbaijan capital markets are brisk, many issuers abroad will try to raise funds in Azerbaijan. To support such needs, the NDC should also develop the infrastructure for cross-border securities issuance and settlement in this stage.
5.2.3.6. Construction of Infrastructure to Support Investment Funds
The collective investment system plays a key role in capital market development. Because it requires engagement of many entities to conduct business, communication among them is commonly carried out by unstandardized methods such as phone, email, and instant messenger. By the time Azerbaijan's capital markets reach this stage, the fund industry is also assumed to have grown. This means the need to develop a centralized and standardized platform to more efficiently deal with fund businesses will grow strong. If this occurs, the NDC is strongly recommended to develop an ICT platform for the fund industry to advance to the next level. Such a system will provide an automated environment for processing both the subscription and redemption of fund certificates and delivery of instructions for fund 295 asset allocation and management among participants. CHAPTER
One point of emphasis is that the development and operation of an efficient clearing 04 Formation of Effective Clearing and Settlement System for Azerba ijan’s Capital Markets and settlement system is not simply a matter of policy and legislation, but one of a well- structured system and competent personnel with proper knowledge and expertise in designing, operating, and supervising the system. So in addition to the aforementioned policy recommendations for each stage, this study has two more recommendations for all stages. First, all stakeholders on the capital market should jointly establish an educational system to produce highly skilled experts for each profession, and second, investment companies and the NDC must develop their own internal compliance systems for effective implementation of the clearing and settlement system. - - 2018a, pp. 270-294. 2012, pp. 21-125. 2017. 2018b, pp. 34-36. Statistics on Payment, Clearing and Settlement Sys Clearing and Statistics on Payment, 2018, pp. 24-28. Securities Deposit & Settlement System, Annual Report 2017, Principles for Financial Market Infrastructures, Market Principles for Financial 2017 Annual Report, May 1, 2019. May tems in the CPMI Countries—Figures for 2016, tems in the CPMI Countries—Figures accessed May 1, 2019. accessed May of Securities Commis Committee of the International Organization (CPSS), and Technical sions (IOSCO), Korea Securities Depository, Securities Depository, Korea Securities Depository, Korea National Depository Center, Qeydiyyata alınmış ǝqdlǝrin sayı, https://mdm.az/site, accessed Bank for International Settlements (BIS), Bank for International Exchange, Korea Baku Stock Exchange, Market-meyker kotirovkaları, https://bfb.az/eqdler-ve-kotirovkalar/, Systems and Settlement Payment Settlements (BIS), Committee on Bank for International References 296 Improvement of Operation and Regulation of Capital and Financial Derivatives Markets in Azerbaijan Ministry of Economy and Finance (MOEF) Sejong Government Complex, 477, Galmae-ro, Sejong-si 30109, Republic of Korea Tel. 82-44-215-7741 www.moef.go.kr
Korea Development Institute (KDI) Namsejong-ro, 263, Sejong-si 30149, Republic of Korea Tel. 82-44-550-4114 www.kdi.re.kr
Knowledge Sharing Program (KSP) www.ksp.go.kr
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