1

CONCEPT PAPER FOR AN INTEGRATED CAPITAL MARKETS ARCHITECTURE IN

AZERBAIJAN

Dr. Fred Reinertz

EU Short term expert capital markets architecture

Baku, February 2010

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Table of Contents

1. Introduction.......................................................................................6
2. Definitions.........................................................................................7
3. Information flows and information systems for securities trading.......18
4. Securities trading information flow ...................................................18
4.1. Pre-trade........................................................................................................18
4.2. Trading........................................................................................................... 18
4.3. Post-trade.......................................................................................................18
4.4. Clearing-Settlement-Custody ........................................................................19
5. Categories of capital markets information systems............................19
5.1. Information collection and distribution ..........................................................19
5.2. Trading tools..................................................................................................20
5.3. Order-routing systems ...................................................................................20
5.4. Order-presentation systems ..........................................................................23
5.5. Settlement and custody systems ..................................................................23
5.6. Surveillance systems......................................................................................25
6. The prevailing legal and regulatory framework in the EU....................25
6.1. The main EU Directives on capital markets....................................................25
6.2. The institutional links among capital markets operators................................25
6.3. The role of professional capital markets participants.....................................26
6.4. The role of the Capital Markets Regulators....................................................27
7. The prevailing capital markets architectural models in the EU.............27
7.1. The Euroclear model .....................................................................................27
7.1.1. IT Architecture..........................................................................................27
7.1.2. Organisational links among various capital markets stakeholders...........28
7.1.3. Institutional links among various capital markets stakeholders ..............28
7.2. The Clearstream model .................................................................................30
7.2.1. IT Architecture..........................................................................................30
7.2.2. Organisational links among various capital markets stakeholders...........30
7.2.3. Institutional links among various capital markets stakeholders...............30
7.3. Comparisons between the two.......................................................................32
8. The prevailing capital markets architectural models in emerging
markets...............................................................................................33
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8.1. The Turkish model..........................................................................................33

8.2. The Russian model.........................................................................................34
8.3. Benchmarking vis a vis the EU capital markets architectures........................35
9. The proposed architecture for Azerbaijan..........................................37
9.1. Action plan and time frame for implementation.............................................37
9.1.1 Global Strategy.........................................................................................37
9.1.2 Main general task......................................................................................37
9.1.3 Main actions and priorities........................................................................38
9.1.4 Ancillary tasks...........................................................................................40
9.2. The capital markets operators’ positions........................................................41
9.2.1. The Baku Stock Exchange .......................................................................41
9.2.2. The National Depository Centre...............................................................43
9.3. The Capital Markets Regulator.......................................................................45
9.4. The professional capital markets participants................................................45
9.4.1. The Investment firms...............................................................................46
9.4.2. The Banks licensed to provide investment services.................................46
9.4.3. The Custodian Banks................................................................................46
9.4.4. The professional capital markets associations.........................................47
9.5. Linkages among them....................................................................................47
9.6. The necessary reforms from the legal and regulatory point of view..............47
9.6.1 the operational aspects of the capital market in Azerbaijan.....................47
9.6.2 Important..................................................................................................48
9.7. The necessary organisational and institutional reforms.................................49
10. Conclusions (benefits from the proposed model).............................51
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0. Executive summary

The concept proposal for an architecture of a capital markets structure in Azerbaijan is placed
in the more general frame of the overall objective of the project , that aims at improving the
economic development of Azerbaijan and to reduce the dependence on the oil sector, (cit. the
TOR’s, the terms of reference of the project).

In this context, the mission of the consultant when defining the sketch of an integrated new
capital market design and structure did focus also on analysing and formulating
recommendations to improve the existing domestic Azeri capital market with an end-state
analysis.

This concept paper should also serve the purposes of a later subsequent technology evaluation
and the development of a standard electronic IT platform for the implementation of the structural
proposals as issued.

The capital market architecture presented in this paper is feasible with the current technology, It
is based on the end-to-end functionalities of the in the actual present capital markets
embryonic elements, It takes into account all internal requirements of the market participants.

Various architectural and ethical issues are broached as well and discussed, sketching a
framework for further project work in the matter under review.

The structure itself as proposed is compliant with the actual prevailing EU regulations in matters
of capital markets organizational set-up and the due Regulatory supervision. The consultant did
seek “EU acquis communautaire” adhesion of the present proposal as the necessary foundation
of the architecture. In compliance with the requirements as outlined in the TORs, the projects’
terms of reference the paper will encompass:

An action plan for the Azeri capital markets proposed architecture, with emphasis on the
capacity building and/or strengthening process for its key components as well as a structured
transition action plan for the existing present Azeri capital markets elements.

The action plan will contain recommendations for recommendable capital markets architecture
in Azerbaijan. It puts the emphasis on the role of the Depository House as the pivotal core
element. It also recommends the establishment of custodian banks. It will issue
recommendations on the organizational and operational structure of the NDC with emphasis on
the Risk Management system. It will opine also on the establishment of a reliable Delivery
Versus Payment (DVP) system, and the functioning of the clearing and settlement operators in
the market.

The consultant’s intervention will also address the following issues:

Recommendations on the organisational structure of the capital markets organizations with

emphasis on: a comprehensive diagnosis of current trading, settlement and supervision
infrastructure of Securities market in Azerbaijan on institutional, normative and operational level,
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benchmarking against best practices adopted in developed and other emerging markets, a
significant GAP analysis and elaboration of conceptual recommendations for an optimum
infrastructure.
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1. Introduction

The elaboration of a proposal for a capital market structure requires, in the process, the
examination and evaluation of the basic components such a common structure, this in view to
determine the usefulness of the proposed structure for the beneficiaries and the different stake-
holders of the project. Although the final beneficiaries of the proposed capital market
architecture are the market participants, the project as such was designed for duly perusal by
the Regulator, the State Committee for Securities, SCS; the National Depository Centre, NDC
and the Baku Stock Exchange BSE as the first involved parties.

The functionalities to structure, in a capital markets architecture proposal that wants to take into
account the best practice as prevailing in the EU capital markets, are well known. It must be
outlined that there is no uniform structure or type of capital markets set-up in the European
Unions’ capital markets, the Member State’s diversity is nevertheless always taking into account
the in the “EC acquis communautaire” given rules and requirements.

In Annex 1 the consultant has attached a schematic presentation of the status quo of the
structures as prevailing in the different European capital markets. It was elaborated by a project
team member and is known to the project beneficiaries. It would exceed the scope of this paper
to pass in review in full details the different architectures, as only a comparative study with pros
and cons would be a meaningful tool to opine on that issue.

It could be recommended to be undertaken only if the actual project would require a more
enhanced approach; it would require an allocation of project man days to be performed. The
consultant intends to recommend a more specific and tailor made capital market architecture for
Azerbaijan, by poaching in the different structural set-ups as used in Europe. This will be based
on the respective merits of the in the EU capital markets competing structures.

The first issue to be addressed is how to structure adequately, or to whom to allocate, the
relevant capital market functionalities. Their efficient, safe and sound operation depends on the
three key types of infrastructures – exchanges, central counter-parties and central securities
depositories.

Securities trading are a financial activity involving transactions of property such as stocks,
bonds, commodities, and currency. Needless to say it is the starting point for elaborating a
capital markets structure proposal.

The advent of new technologies, particularly in computers and telecommunications, has brought
about a new era in securities trading. Traditional stock exchanges, while still vitally important in
major cities around the world, now compete with such over-the-countertrading organizations
and other similar systems that allow computerized trading, linking investors with brokers and
dealers both on a domestic and an international level, as the MTF’s; the multilateral trading
facilities (they are mentioned in the MiFID directive. This EU directive also explains the
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whereabouts and set up’s functionalities in more details. They often use a so called “dark pools”
approach in matters of securities trade processing. A Multilateral Trading Facility (or MTF) is a
multilateral system, operated by an investment firm or a market operator, which brings together
multiple third-party buying and selling interests in financial instruments - in the system and in
accordance with non-discretionary rules - in a way that results in a contract in accordance with
the provisions of Title II in MiFID.

The appearance of MTF’s is one of several actions that aim to improve the access of small and
medium sized enterprises to capital through new share, bond and rights issues.

In the EU, there are several MTFs operational now:

POSIT, a pure dark-pool MTF operated by ITG, launched in 1998, Chi-X, launched in March
2007, Turquoise, launched in August 2008, Equiduct-Berliner Börse, NASDAQ OMX Europe,
launched in September 2008, BATS Europe , launched in October 2008, NYSE Arca Europe,
launched in March 2009, QUOTE MTF - launched 4th September 2009, NX MTF - launched in
11th December 2009 by Nomura Securities Ltd.

2. Definitions

This is a list of the most common used terms in the context of capital markets: courtesy from
Euroclear and the consultant’s definition data base, the list is long but the subject is complex,
and the info may be useful in the context.

Account operator

In the context of ESES, a Client that has been authorized by one or more Parties to send
instructions in the name of, and on behalf of, each of such other Parties in relation to the latter's
Securities Account(s) and the Cash Account linked thereto.

Bridge

The 'Bridge' is the name used for the processes established between Euroclear Bank and
Clearstream Banking Luxembourg that permit cross-systems settlement of a trade between a
customer of one ICSD and a customer of the other ICSD.

Cash Account

In the ESES context, a cash account opened by a Settlement Bank with a central bank in
accordance with the Cash Account Documentation, which is operated by the Euroclear CSDs
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on behalf of the relevant Central Bank in connection with the use of the CSD System or a
system operated by another Euroclear CSD; Cash Accounts may also be referred to in the
Euroclear Contractual Documentation as 'cash positions in Central Bank Money (CeBM).

Cash Correspondent

A financial institution that executes cash transfers on behalf of its clients.

Cash position in Central Bank Money

Balance in a central bank money account on a settlement platform operating the integrated
settlement model. Also referred to, in the context, as the Liquidity position.

CBA

Central Bank of Azerbaijan

Central bank money (CeBM)

Settlement is described as being in central-bank money if payment moves directly and

irrevocably between accounts on the books of the central bank.

CCP stands for Central counterparty

An entity that is the buyer to every seller and the seller to every buyer of a specified set of
contracts/obligation (e.g. those executed on a particular exchange). CCPs typically interpose
themselves between the counterparties to trades, acting as the buyer to every seller and the
seller to every buyer (“novation”). In order to be able to settle the novated transactions, Central
CCPS must also have direct or indirect access to the SSS, Securities Settlement Systems
where transactions are ultimately settled and securities held.

Central Securities Depositary (CSD)

An entity which operates a system enabling clients to hold, manage and transfer securities by

CNS

Continuous Net Settlement

CoBM

Commercial Bank Money (CoBM)

Settlement is described as being commercial money if the payment moves between the
accounts of banks (in contrast to central bank money).

Cross-quality payment
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Payment between a Euroclear group customer using central bank money and another Euroclear
group customer using commercial bank money.

CSD

Central Securities Depositary

Dark pool

Dark pools of liquidity (also dark pools or dark liquidity) are crossing networks that provide
liquidity that is not displayed on order books in an MTF context. This is useful for traders who
wish to move large numbers of shares without revealing themselves to the open market. Dark
liquidity pools offer institutional investors many of the efficiencies associated with trading on the
exchanges' public limit order books but without showing their actions to others. Dark liquidity
pools avoid this risk because neither the price nor the identity of the trading company is
displayed. Dark pools are recorded as over-the-counter transactions. Therefore detailed
information about the volumes and types of transactions is left to the crossing network to report
to clients if they desire and are contractually obligated.

Dark Pools in funds to line up and move large blocks of equities without tipping their hands as to
what they are up to. Modern trading platforms and the lack of human interaction has reduced
the time scale on market movements. This increased responsiveness of the price of equity to
market pressures has made it more difficult to move large blocks of stock without affecting the
price.[

Debit party

The party that gives cash or securities. In the payment chain, it may be an agent or the debtor.
Furthermore, for each pair of consecutive parties in the payment chain, one party always plays
the role of the debit party and the other the role of the credit party.

Debtor

The party that owes assets to the creditor, e.g. as a result of receipt of goods or services, gifts,
or charity payments. The debtor may also be the debit account owner.

Default

Failure to complete a funds or securities transfer according to its terms for reasons that are not
technical or temporary, usually as a result of bankruptcy. Default is usually distinguished from a
failed transaction.

DVP model 1

One of the three DVP schemes, as defined by the G10. In model 1, transfer instructions for both
securities and funds are settled on a trade by trade basis, with final transfer of the securities
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from the seller to the buyer (delivery) occurring at the same time as final transfer of the funds
from the buyer to the seller (payment).

ECSDA

European Central Securities Depositories Association

End-of-month settlement (SRD)

End-of-month settlement is the opposite from rolling settlement whereby the settlement date of
a party's securities transaction instruction is deferred until the end of the month. Hence, it is
possible to buy stocks without immediately settling and benefit from an anticipated rise of the
stock or to short sell the stock not yet purchased.

Escrow balance

See 'restricted balance'

ESES

Euroclear Settlement of Euronext-zone Securities

eXtensible Markup Language (XML)

Simple and very flexible text format derived from Standard Generalized Markup Language
(SGML) (ISO 8879). The eXtensible Markup Language (XML) is a W3C-recommended general
purpose mark-up language for creating special-purpose mark-up languages. Its primary purpose
is to facilitate the sharing of data across different systems, particularly systems connected via
the internet.

Final agent

A financial institution of the creditor that receives the payment transaction on behalf of an
account owner or other nominated party, and posts the transaction to the account.

Final party

The party that is the ultimate beneficiary of the cash transfer. The final party is mentioned when
different from the creditor, whose account will be credited by the final agent. See Beneficiary of
money (Securities Industry), Ultimate beneficiary (Payment Industry).

Final settlement

The discharge of an obligation by a transfer of funds and a transfer of securities that have
become irrevocable and unconditional.
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First agent

A financial institution of the debtor that receives the payment transaction from either the account
owner or authorized party, and processes the instruction.

ICSD

International central securities depository

Identifiable bearer security (TPI)

Based on the French legal framework, it is a service in Euroclear France that allows an issuer of
bearer securities to request and obtain a list of, all or part of, securities' holders registered on
the custodians’ books. Certain holders declared by the custodians may have the status of
registered intermediary. (French acronym)

Infrastructure

The party that provides, through common membership, services to create a fair and open
process for the execution of transactions between trading parties, and the creation of settlement
obligations.

Instrument category

The second qualifier in the CFI - ISO 10962 classification of a security.

Instrument family

The first qualifier in the CFI - ISO 10962 classification of a security. Synonym: security family.

International Central Securities Depository (ICSD)

An entity in which securities are held and managed, and which enables transactions to be
processed by book entry. An ICSD also settles trades in international securities and in various
domestic securities, usually through direct or indirect (through local agents) links to local CSDs.
Within Euroclear group, the ICSD offers its services in the Full Service.

Internaliser

In the context of the EU’s basic capital market directive MiFID, see below systematic Internaliser
definition

ISO 15022

International standard which sets the principles necessary to provide the different communities
of users with the tools to design message types to support their specific information flows.
These tools consist of a set of syntax and message design rules, a dictionary of data fields and
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a catalogue for present and future messages built by the industry with the above mentioned
fields and rules.

ISO 20022 Financial Services

It is a Universal Financial Industry message scheme (UNIFI) - newly published standard which
provides the usage of a common platform for the development of messages.

Issuance Account

In the ESES context, any account opened in the name of an issuer in the books of the CSD on
the debit of which all securities of a same issue which are admitted by the CSD are recorded; in
the case of dematerialized securities, all securities of the relevant issue will be recorded on the
debit of the Issuance Account; Issuance Accounts are not considered as Securities Accounts for
the purposes of the Terms and Conditions.

Legacy platform

One of the current input, matching, settlement and/or reporting systems in the Euroclear group’s
(I)CSDs.

Liquidity sweep

Any automated transfer of cash from a Cash Account to the corresponding RTGS Cash Account

Matching

It is the process for comparing the trade or settlement details provided by counterparties to
ensure that they agree with respect to the terms of the transaction.

MiFID

Stands for the EU’s Directive 2004/39/EC of the European Parliament and of the Council of 21
April 2004 on markets in financial instruments, the basic capital market directive

MTF

a Multilateral Trading Facility is a multilateral system, operated by an investment firm or a

market operator, which brings together multiple third-party buying and selling interests in
financial instruments - in the system and in accordance with non-discretionary rules - in a way
that results in a contract in accordance with the provisions of Title II in the EU’s MiFID capital
market basic directive.

Netting
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Stands for an agreed offsetting of positions or obligations between counterparties. The netting
reduces a large number of individual positions or obligations to a smaller number of obligations
or positions. Netting may take several forms.

Nominee

A person or entity named by another to act on his behalf. A nominee is commonly used in a
securities transaction to obtain registration and legal ownership of a security. See 'Trustee'.

Omnibus account

A single Securities Account within which the Securities Account Holder co-mingles the assets of
two or more underlying clients, rather than in separate accounts with designation.

Payment settlement agent

An agent that executes the cash transfer upon the request of either an agreement party, or a
clearing agent.

Post-trade administrator

The party ensuring that all the details of the trade have been collected and reported, as required
to all parties involved in the trade transaction including counterparties, the investor, and
settlement parties.

Purchasing power

A settlement bank's cash position in central bank money and its collateral value of securities
that may be used for auto-collateralization with the central bank (when allowed by the relevant
central bank). Also referred to as a liquidity provision.

Real-time gross settlement system (RTGS / RBTR)

Settlement system in which occurs the continuous (real-time) settlement of funds or securities
transfers individually on a transaction-by-transaction basis (without netting).

Registrar

The party that is responsible for keeping track of the owners of securities. In the context of
investment funds, the party appointed by the fund management company that keeps the
investor registry of the fund, and administers investor accounts and related records. These
records represent the liability accounts of the fund management company. It prepares and
distributes account statements (holdings and transactions) to the investor and/or its
intermediary, on a periodical or upon request basis. It may provide tax information to the
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investor and/or to its intermediary, can be the corporate secretary for the proxy voting, reports to
the regulator on shareholder identity, and can appoint the sub-registrar.

RNC

Continuous Net Settlement

Rolling settlement

A practice in which settlement takes place a standard number of business days after the date of
the trade.

RTGS

Real-time gross settlement system

Securities loan / Securities lending / Securities borrowing

Securities finance mechanism that involves transferring full ownership of securities, with or
without a guarantee, with a contractual agreement that the seller will repurchase the securities
in return for the guarantee, if there is a guarantee, at an agreed price and date. The lending of
securities in an exchange for a fee. Securities lending is mostly facilitated by CSDs, but not
offered directly. (I)CSDs and banks, such as custodians that directly offer securities lending,
possess a banking license and are regulated by existing banking law.

Securities Settlement System (SSS)

A system which permits the holding and transfer of securities, either free of payment (FOP) or
against payment (Delivery Versus Payment-[DVP]).

Settlement

Delivering securities and/or making payments in the performance of obligations between the
counterparties to a transaction.

Settlement account

An account held by a direct participant of a national RTGS system, which is thus registered with
its central bank for the purpose of processing payments.

Settlement agent

The party that provides settlement, custody, and accounting services for its own, or someone
else's, assets.

Settlement Bank
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A Client which is permitted under the Standard Form Agreement it has entered into with a
Euroclear group CSD to make and/or receive payments by means of the (I)CSD Systems as a
bank for the account of itself and/or one or more other Clients in connection with the Domestic
Service.

Settlement Bank Client

A Client who has appointed a Settlement Bank to provide cash services in connection with the
Domestic Service.

Settlement date

Date at which the financial instruments are to be delivered or received.

Settlement Finality Directive

Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on
settlement finality in payments and securities settlement systems.

Settlement liquidity indicator

The liquidity position of a client in the system that uses the services of a settlement bank (i.e.
the liquidity position of a settlement bank’s client, as above). It reflects the liquidity resulting from
the settlement bank client’s activity in the Securities Settlement System (SSS).

Settlement liquidity limit

The amount of liquidity or credit which a settlement bank has notified to the CSD as being
available to a settlement bank client during each Business Day.

Single Platform

The long-term solution, an IT platform shared by all Euroclear group (I)CSDs hosting the (I)CSD
Systems.

Single Settlement Engine (SSE)

The first building block of the Single IT Platform, concentrating on the core settlement (i.e.
positioning and booking of cash and securities transfers).

Single Shared Platform (SSP)

The new platform of European Central Bank, also known as TARGET2, which will be shared by
a number of participating national central banks.

SLAB

Delivery by mutual consent settlement service

SSS
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Securities Settlement System,should be taken to mean all institutions, in particular CSDs,

performing the Pre-settlement, Settlement and custody functions except custodians.

STP

Straight Through Processing

System Paying Agent (SPA)

The party within the CSD that is responsible for distributing resources relating to a specific
distribution to other CSD parties.

Systematic internaliser

It means an investment firm which, on an organised, frequent and systematic basis, deals on
own account by executing client orders outside a regulated market or an MTF; the concept
stems from the EU’s MiFID directive

TARGET2

Trans-European Automated Real- Time Gross settlement Express Transfer 2

TPI

Identifiable bearer security, a service in Euroclear France that allows an issuer of bearer
securities to request a list of beneficial owners registered in the custodians’ books.

Trade date

The date on which a market trade is executed.

Trading party

The party that plays an active role in planning and executing the transactions that create or
liquidate investments of the investors’ assets, or that move the investor's assets from one
investment to another. A trading party is a trade instructor, an investment decision-maker, a
post trade administrator, or a trader. In the context of treasury, it is the party that negotiates and
executes the treasury transaction.

Transaction

In a Euroclear context, it is the result of the matching and execution of either a purchase or sale
order with compatible opposite orders.

Two-leg settlement instruction

Settlement instruction which can be used to settle bilateral repo, securities lending & borrowing,
buy-sell back and sell-buy back transactions.
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UNIFI Standard

See 'ISO 20022 Financial Services'.

Valuation haircut

A risk control measure applied to securities used in reverse transactions, implying that the
central bank calculates the market value of the underlying securities, reduced by a certain
percentage (haircut). The Eurosystem (European Central Bank, ECB) applies valuation haircuts
that also reflect certain characteristics of the securities, notably their residual maturity.

Voting service provider (VSP)

A service provider mandated by the Client to act on its behalf. (I.e. receipt and sending of
meeting notifications, collection of voting instructions, instructing the system agent.
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3. Information flows and information systems for

securities trading

There are several large professional provider of financial information in Europe, and in the US,
who are specialists in the procurement, processing and distribution of international financial
information for investment advisory services, fund administration, portfolio management,
financial analysis, securities trading and securities administration.

They maintain database of structured, encoded securities information based on a global

network of market specialists that procures real-time stock exchange information at source from
the leading financial Centres. These so called Data providers are also a source of financial
information, they provides financial news and data (e.g. facts, statistics and analysis), for
professional and individual investors through various communication channels (e.g. the internet,
magazine).

They very often act also as official numbering agency responsible for allocating security
identification numbers.(NNAs, ISIN,CUSIP etc.) There is an Association of National Numbering
Agencies (ANNA) which leads the way in introducing standards aimed at simplifying trading and
securities administration. NDC is the member in ANNA for Azerbaijan.

4. Securities trading information flow

4.1. Pre-trade
Compliant with the EU requirements in its specific MiFID directive (see below for more details
under 6.1) operators in the market must provide full pre-trade transparency. As outlined later,
all market operators, depending the nature of their systems must provide mandatory the
following data information:

- Continuous order-matching systems, aggregated order information on "liquid shares" available

at the five best price levels on the buy and sell side;

-for quote-driven markets, the best bids and offers of market makers must be made available.

4.2. Trading
MiFID again requires that professional capital market operators take all reasonable steps to
obtain the best possible result in the execution of an order for a client. This best possible result
or best execution as it is called by the operators, is not limited to execution price but also
includes cost, speed, likelihood of execution and likelihood of settlement and any other factors
deemed relevant.

4.3. Post-trade
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MiFID the basic capital market directive in the EU requires from all professional capital market
operators to publish the price, volume and time of all trades executed in listed shares, even if
executed outside of a regulated market, unless certain requirements are met to allow for
deferred publication. But disclosure is required mandatory by the directive.

4.4. Clearing-Settlement-Custody
It can be mentioned that in matters of clearing, settlement and custody the core directive for
capital markets in the EU MiFID remains silent. Also the other directives regarding prospectus,
market abuse, and transparency are only focusing of the trading not the post-trade aspects. It is
up to the member States in the EU to act in the matter.

Between 2002 and 2005, a joint CESR (Committee of European Securities Regulators)/ESCB
(European System of Central Banks) working group developed Standards for Clearing and
Settlement systems in Europe. Following other emerging initiatives in the area of post-trading,
activities of the group were disrupted after that period.

In 2007, the CESR Members decided to establish a group of CESR experts only, the Post-
Trading Expert Group (PTEG). This group does focus on post-trading activities in the EU, where
relevant for CESR and its members. PTEG, given the responsibilities of national securities
regulators for post-trading activities in the respective Member-States, does only focus on a
number of regulatory initiatives going on in the area of post-trading, with the objective to
enhance a level-playing-field and the safety and soundness of post-trading activities within the
EU. The political support for these regulatory initiatives was reflected in the conclusions of the
EU Council on Clearing and Settlement of 9 October 2007. Prior to this, CESR had decided to
create a platform to follow these initiatives more closely, establish a place to share supervisory
experiences and, where appropriate, to respond to these initiatives.

The first major point on the agenda of the PTEG is the Code of Conduct for Clearing and
Settlement, in particular with regard to the envisaged role of regulators in this Code. The Code
of Conduct was developed and signed by the providers of infrastructures for Trading, Clearing
and Settlement, i.e. Stock Exchanges, Central Clearing Parties and Central Securities
Depositories within and outside the EU-area. CESR is a member of the Monitoring Group, the
group established by the European Commission with the mandate to review the compliance with
the Code by the signatories.

The second important initiative followed by the PTEG on behalf of CESR is the ESCB-project
TARGET-2-for-Securities (T2S). This long-term project aims to create a single and central
platform for the cross-border and domestic settlement of Euro-denominated securities against
central bank money, run by the Euro-system.

5. Categories of capital markets information systems

5.1. Information collection and distribution
There are IT systems, like AutoFlow, an automated ISO-based STP interface to exchange
structured data with custodian banks via a CCI, Common communication interface. It is a
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communication interface with the external world that provides users with a single access to a
common integrated trading platform. It enables also clients to send instructions and receive
reports in industry standard formats, using a variety of networks.

All collected data are aggregated in a layer where all quotes and trade data are put in a feed
handler as received from the exchanges, the data providers etc. …to be aggregated in a feed
handling infrastructure for connection with the trading platform for processing. The market data
layer captures the BBO best bid of r offer across markets enabling later by order routing to how
an order is split and routed and how many titles are purchased. They can derive custom
indicators based on the order or trade information. These indicators, that show momentum or
compare executed liquidity versus displayed liquidity over a time window on a per venue basis,
can be easily included in the order routing module later.

5.2. Trading tools

Global electronic trading is technology based. It is strategies, liquidity management tools and
advanced technology to execute trades. Trading tools must have the following capabilities:
direct execution to every major global exchange, control of order flow while maintaining
anonymity, order execution through a suite of global, qualitative algorithms designed to monitor
market changes, dynamically optimize performance and avoid market impact. Sophisticated
liquidity management and advanced DMA products. Tools, access to ConvergEx ATS for block
crossing and aggregating dark liquidity (dark pools) tools. Trading platforms remain the core of
all the central integrated IT system In particular, but there are ancillary systems (AS); these
include retail payment systems, large-value payment systems, foreign exchange settlement
systems, money market systems, clearing houses and securities settlement systems (SSSs).
AS systems do usually settle their net positions either at the end of the day or at several times
during the day through an Ancillary System Interface (ASI), a standardized interface of the
common shared IT platforms which control and distribute the information pertaining to Ancillary
Systems and, in particular, securities settlement systems activity. Continuous Net Settlement
(CNS / RNC) are automated book-entry accounting systems. CNS centralizes the settlement of
matched transactions and is maintaining an efficient flow of security and money balances.
Euroclear Trade Capture and Matching System (ETCMS).

5.3. Order-routing systems

Traders often split orders and route them to different market centres in order to reduce market
impact and achieve best prices for their trades. A key tool in this practice is the in an order
routing system to find the National Best Bid or Offer (NBBO) across markets. Smart order
routing systems decide how an order is split and routed and how many shares are purchased at
particular venues while ensuring the in the EU MiFID required compliance. It continuously scans
different liquidity pools in order to get the best price. In addition a host of other parameters such
as aggression levels, execution quality, speed and costs can also be considered in the routing
logic. An optimized order routing system will slice and route orders with ultra-low latency; it will
have an embedded custom routing logic that takes multiple factors into account; supports
multiple order types, maintains and persists all order states. It uses multiple in and output FIX
connections, leverages low latency market data including custom indicators. It must also ensure
MiFID compliance and run in parallel with the OMS system. Below the consultant provides a
21

sample of an order routing system set-up and the connections with OMS etc... Order Routing
Solution consists always of two main layers – the first layer deals with the order flow and the
second layer deals containing the market data.
22
23

5.4. Order-presentation systems

In this area we find now since recently now EMS, an execution management system (EMS). It is
a software-based platform that facilitates and manages the execution of securities orders,
typically through the Financial Information exchange (FIX) protocol.

EMSs have four key features: a trading blotter, connectivity, multiple destinations and real-time
market data. The trading blotter is composed of an order entry screen where users initiate and
monitor trading activity. Users can access brokers' direct-market-access (DMA) capabilities and
algorithms to carry out electronic trading strategies. The platforms enable both single-stock and
portfolio trading capabilities. An EMS offers multiple destinations to which to route a trade.
Through the EMS platforms, users can connect to major exchanges, electronic communication
networks (ECNs), alternative trading systems (ATSs), crossing networks and multiple brokers.
Real-time market data enters the system from a combination of external feeds from exchanges
and market data providers and, in some cases, internal proprietary data from the EMS provider.

It is worth pointing out that, by definition, DMA platforms either are single- or limited-destination
systems. Although a number of DMA players call their order entry and management portals
EMSs, there should be a differentiation between an EMS and a pure DMA platform.

In comparison, the older traditional order management systems (OMSs) were designed as tools
to allow firms to manage and document their trading activities electronically. With an OMS, firms
easily can look back in order to analyse their orders. Since this modest beginning of OMSs as
trading blotters with FIX engines, they have extended the breadth and depth of their functionality
significantly. Today's OMSs have emerged as portfolio management systems with functionality
that ranges from pre-trade through post-trade support. The new EMSs may follow a path similar
to the one OMSs have followed through their evolution: The EMSs will increase the breadth of
their functionality, adding analytics, portfolio staging capabilities and tighter systems integration.
As a result, they will continue to substitute for OMSs more and more.

There are also automated matching and routing service for over-the-counter transactions with a
Central Counterparty (CCP), which offers netting at both user and security eligibility level. In
practice, the following occurs: • instructions are entered by clients for matching purposes. If the
instruction is deemed to be valid, it will be given a Euroclear reference ID and will enter the
matching process; • once matched, instructions are sent to the CCP for netting; • the CCP then
undertakes a local validation process, whereupon the instruction is either registered when the
trade is novated or rejected when the instruction does not meet all of the validation criteria.

5.5. Settlement and custody systems

Securities Settlement Systems enable the transfer of securities, for instance following trading on
a stock-exchange or over the counter. There are two legs for the settlement of such a trade: the
delivery of the securities and the corresponding payment which takes places in a payment
system, unless the delivery is free of payment. The delivery of securities takes place by book
entries in computerized systems. Both legs must be simultaneous and linked to limit risks.
Moreover, transactions settled in SSSs are considered final and irrevocable (i.e. unconditional)
24

when they meet certain conditions. SSSs either settle on a gross basis or on a net basis.
Integrated settlement model

SSSs settle transactions directly in their own system without the constant involvement of the
payment system. An interface is used at the request of clients when they want to transfer cash
into the SSS or back to the payment system. There are also settlement sub-Systems. These
systems process the settlement of instructions, manage the Securities Accounts balances and
the Purchasing Powers and provide reporting to the Clients.

Interfaced settlement model: transactions are settled using an interface between the payment
system and the SSS. As two systems are involved, they constantly communicate with each
other. The security leg is settled in the SSS while the cash leg is settled in the RTGS in the EU.

In settlement there is an internal transaction category. In a single platform context, in Euroclear

this transaction category includes: Intra-entity settlement transactions when both parties to the
transactions are members of the same (I)CSD; This covers: intra-Domestic transactions when
both parties are using the Domestic Service and transactions settle then on the books of the
primary issuer CSD or the CSD of reference of the security, intra-Full transactions when both
parties are using the Full Service and transactions settle then on the books of the custodian
Bank. Full-Domestic transactions when one party is using the Full Service and the other is using
the Domestic Service (i.e. one party is using a Domestic operational securities account and the
other is using a Full securities account); Domestic inter-CSD transactions when the security is
eligible in several group CSDs and one party is instructing on a depot with the primary issuer
CSD and the other is instructing on a depot with the other eligible CSD.

Securities are held with central securities depositories (CSD), who are notably responsible for
ensuring securities’ integrity. Next to the safekeeping function, CSDs enable securities’ mobility
as they operate securities settlement engines. There is usually at least one CSD and one SSS
in each EU country.

Custody systems are most of the time in-house developed as this kind of service is not provided
by Euroclear given its horizontal structure, Clearstream and other global custody provider have
most of the time their own traditional IT architectures. Deutsche Bank's Securities Custody
System is one of the earliest successful examples of commercial grid computing. This large-
scale financial application demonstrates the substantially lower costs and higher return on
investment possible with only processing software, as compared to the traditional architectures.
Deutsche Bank did add front-office grid applications to support "straight-through processing"
(automated, streamlined workflow) in its custody system. Euroclear Settlement of Euronext-
zone Securities (ESES) Often also custodian banks make use of sub-custodians by means of a
service level agreement

Euroclear Settlement of Euronext-zone Securities (ESES) is an intermediary step towards a

Single Platform that Euroclear want to develop. ESES will provide the Euronext-zone market
CSDs (Euroclear Belgium, Euroclear France and Euroclear Nederland) with an integrated
settlement solution and harmonized custody service for stock exchange and over-the-counter
activities.
25

In the context there is also SBI, a Broker to custodian trade affirmation system that is widely
used in the market.

5.6. Surveillance systems

In order to face the challenge in trading surveillance and the need to detect employee fraud the
market has developed surveillance systems to prevent unauthorized trading and to avoid risks
for Financial Institutions. This kind of transactional risk management software for the financial
services industry developed in the US for surveillance and detection of employee trading fraud
solution for uncovering rogue trading in securities firms. These solutions do combine trading
surveillance and employee fraud detection this requires a proven technology and domain
expertise in the institutional and proprietary trading market. They are mostly based on a core
analytics and profiling engine and a set of flexible enterprise case management and
investigation applications, they are designed to identify trader behaviour and activities that could
be related to fraud or unauthorized activities.

6. The prevailing legal and regulatory framework in the EU

6.1. The main EU Directives on capital markets
The main EU directive governing the capital markets is the Markets in Financial Instruments
Directive (MiFID). It is a European Union law that provides harmonized regulation for investment
services across the 30 member states of the European Economic Area (the 27 Member States
of the European Union plus Iceland, Norway and Liechtenstein).

MiFID is the cornerstone of the European Commission's Financial Services Action Plan whit
some 42 measures that did change significantly how the EU financial service markets do
operate. MiFID is the most significant piece of legislation introduced under the “'Lamfalussy”
procedure designed to accelerate the adopting of legislation based on a four-level approach as
recommended by the Committee of Wise Men chaired by Baron Alexandre Lamfalussy. At the
first level, the EU adopts a piece of legislation, establishing the core values of a law and building
guidelines on its implementation. The law then progresses to the second level, where sector-
specific committees and regulators advise on technical details, then bring it to a vote in front of
member-State representatives. At the third level, national regulators work on coordinating new
regulations with other nations. The fourth level involves compliance and enforcement of the new
rules and laws.

There are three other Directives' in the context of the “Lamfalussy” procedure that the EU did
also needed to issue: the Prospectus Directive, the Market Abuse Directive and the
Transparency Directive.

All these directives compose the legal frame for capital markets in the EU. Under European
law, a Directive has to be transposed into national law: as all the 30 States of the EEA have
done.

6.2. The institutional links among capital markets operators

26

The institutional links among capital market operators are defined in 3 aspects: authorization,
regulation and pass-porting

Firms covered by MiFID will be authorised and regulated in their "home State" (broadly, the
country in which they have their registered office). Once a firm has been authorised, it will be
able to use the MiFID passport to provide services to customers in other EU member States.
These services will be regulated by the member state in their "home State".

To determine which firms are capital market operators under the legal MiFID frame and which
are not, MiFID distinguishes between "investment services and activities" ("core" services) and
"ancillary services" ("non-core" services).

If a professional capital market operator performs investment services and activities, it is subject
to MiFID in respect both of these and also of ancillary services (and it can use the MiFID
passport to provide them to member States other than its home State). However if a firm only
performs ancillary services, it is not subject to MiFID (but cannot benefit from a MiFID passport).

MiFID covers almost all tradable financial products with the exception of certain foreign
exchange trades. This includes therefore commodities and derivatives but also such as freight,
climate and carbon derivatives, which were not covered by the former EU investment services
directive ISD that now is now superseded by MiFID.

That part of an investment firm's (capital market operator) business that is not covered by the
above is not subject to MiFID.

6.3. The role of professional capital markets participants

MiFID requires professional capital markets participants to categorize their clients as "eligible
counterparties", professional clients or retail clients (these have increasing levels of protection).
Clear procedures must be in place to categorize clients and assess their suitability for each type
of investment product. That said, the appropriateness of any investment advice or suggested
financial transaction must still be verified before being given.

Systematic Internaliser. MiFID has introduced the concept of this Systematic Internaliser. This is
a professional capital market participant that executes orders from its clients against its own
book or against orders from other clients. MiFID considers Systematic Internalisers as mini-
exchanges, hence, for example, they are subject to pre-trade and post-trade transparency
requirements as above mentioned.

Comments:

MiFID intended to increase transparency for prices, but caused in fact a fragmentation of trading
venues. Where once a financial institution was able to see information from just one or two
exchanges, they now have the possibility (and in some cases the obligation) to collect
information from a multitude of multilateral trading facilities, Systematic Internalisers and other
exchanges from around the European Economic Area. This did results in an additional amount
of work for the professional capital market operators to comply with the transparency that MiFID
wanted to introduce.
27

The number of additional pricing sources introduced by MiFID means that financial institutions
have now to seek additional data sources to ensure that they capture as many quotes/trades as
possible.

6.4. The role of the Capital Markets Regulators

MiFID retained the principles of the EU 'passport' introduced by the old investment services
directive ISD but innovated by introducing the concept of 'maximum harmonization' which
places more emphasis on home State supervision. This is a change from the prior EU financial
service legislation which featured a 'minimum harmonization and a mutual recognition' concept
in matters of Regulatory supervision.

'Maximum harmonization' does not permit member States to be 'super equivalent' or to 'gold-
plate' EU requirements detrimental to a 'level playing field' as done previously in some member
States when implementing EU directives.

Another regulatory change was the abolition of the 'concentration rule' in which member States
could require investment firms to route client orders through regulated markets. The capital
market Regulators are, as previously mentioned the fourth level in the “Lamfalussy procedure”,
they have to take care of compliance and enforcement of the in national rules and laws
transposed MiFID directive, the Prospectus Directive, the Market Abuse Directive and the
Transparency Directive. Under European law, a Directive has to be transposed into national
law: an EU Regulation, when issued, on the other hand, is automatically binding throughout all
member states.

7. The prevailing capital markets architectural models in

the EU
7.1. The Euroclear model
7.1.1. IT Architecture
Up to now Euroclear uses two platforms: A Single Settlement Engine (SSE) and a Euroclear
Settlement of Euronext-zone Securities (ESES) trading platform. But it intends to integrate all in
the Euroclear group CSDs’ legacy systems in one Single IT Platform. The Single Platform
intends to offer a number of important benefits in terms of additional services and more
automation and consolidation, including:

Enhanced levels of Straight-Through Processing (STP)

More streamlined processing as a result of harmonization agreements on dates and the

classification of corporate actions

Increased efficiency due to real-time credit and reporting of cash proceeds

Clients will connect to the Single Platform using Euroclears’ Common Communication Interface
(CCI), which will replace each CSD’s current client interfaces.
28

7.1.2. Organisational links among various capital markets stakeholders.

Euroclear is a Settlement service provider only. Settlement is only the delivery of securities,
usually against payment, to complete a trade between two parties. Settlement as the final step
in securities transactions is vital for a good functioning of financial markets. At the time of the
settlement, the proprietary ownership becomes effective for the purchaser from a legal point of
view.

Clients of Euroclear submit an instruction telling Euroclear when, how and with whom they want
them to settle their securities transaction. Usually this is done electronically through a fast and
low-cost form of processing known as Straight-Through Processing (STP). The counterparty in
the trade also submits an instruction.

Euroclear match up the two instructions, and make sure the seller has the securities and, if
against payment, the buyer can pay. They then settle the transaction which can take different
forms depending: if it is taking place between two clients of the same Central Securities
Depository (CSD) or an International CSD (ICSD), a simple book-entry transfer is made
enabling the required simultaneous exchange of cash and securities.

Where the trade is between two counterparties in different countries, with accounts in different
ICSD’s, settlement is achieved through local market settlement structures, which vary from
market to market as there is diversity in the EU capital markets.

The settlement process is also largely determined by the type of asset and market. For
example, unlike for bond and equity transactions, order routing is an essential step prior to the
settlement phase for fund orders. Within the Euroclear group, EMXCo is the provider of funds
order routing.

7.1.3. Institutional links among various capital markets stakeholders

As providers of settlement services, the Euroclear group is a horizontal organized structure that
comprises Euroclear Bank in Brussels, an ICSD (International Central Securities Depository)
headquartered also in in Brussels, as well as six other CSD in the Euro currency area:

Euroclear Belgium, the Brussels-based CSD for Belgium

Euroclear Finland, the Helsinki-based CSD for Finland

Euroclear France, the Paris-based CSD for France

Euroclear Nederland, the Amsterdam-based CSD for The Netherlands

Euroclear Sweden, the Stockholm-based CSD for Sweden

Euroclear UK & Ireland, the London-based CSD for the United Kingdom and Irish equities
29

Below a schematic graph to illustrate this capital market organization.

Horizontal structured providers of settlement and custody and horizontal providers of clearing function

Universal Banks

Brokers

Stock Exchange
Stock exchange B
Stock exchange A C
Trading& Settlement
Trading &Settlement Trading &
Settlement
Settlement

Clearing
Clearing LSE
ClearingL CH Clernet
Euronext
30

7.2. The Clearstream model

7.2.1. IT Architecture
Clearstream uses three trading platforms: Eurex, an integrated, fully electronic derivatives
trading and clearing system. The Eurex clearing functionality also supports clearing of equities,
bonds and repos traded on the Frankfurt Stock Exchange. Xetra , the other electronic trading
platform for the cash market allows the trading of stocks on one platform – everywhere in the
world. “Link Up Markets” the third platform is a common IT infrastructure allowing for easy
implementation of links between CSD markets and introducing efficient cross-border processing
capabilities.

Clearstream is developing also a new globalized standard IT platform using open source
components, commercial third parties soft-ware and internally developed software. The design
will be modular base on a shared technical infrastructure which combines extremely low latency
with high volume. This platform will favour algorithmic trading by mitigating towards an Itanium
platform to boost output with new enhances broadcast solutions.

7.2.2. Organisational links among various capital markets stakeholders

Clearstream is a wholly owned subsidiary of the Deutsche Börse. It offers two fundamental
services to the industry:

International central securities depository (ICSD) services and the Central securities depository
services (CSD) for German and Luxembourgish domestic securities. It also operates now the
Link Up Markets, joint venture by nine leading Central Securities Depositories (CSDs) – a
common infrastructure allowing for easy implementation of links between CSD markets,
introducing efficient cross-border processing capabilities.

Clearstream also has an innovative post trade system for investment funds CFF Central Facility
for Investment Funds based on its own proprietary order-routing system Vestima +

7.2.3. Institutional links among various capital markets stakeholders

Clearstream is a vertically integrated supplier of all post-trading services. It provides after
trading and settlement, the clearing and custody functions.

Link Up Markets is the joint venture by nine leading Central Securities Depositories (CSDs) –
Clearstream Banking AG Frankfurt (Germany), Cyprus Stock Exchange (Cyprus), Hellenic
Exchanges S.A. (Greece), IBERCLEAR (Spain), Oesterreichische Kontrollbank AG (Austria),
SIX SIS AG (Switzerland), STRATE (South Africa), VP SECURITIES (Denmark) and VPS
(Norway). Its key objective is to improve efficiency and reduce costs of post-trade processing of
cross-border securities transactions by streamlined interoperability on the CSD layer.

Below a graphical scheme representing this capital market architecture type in Euro
31

Vertical structured single provider of settlement, clearing and global custody.

Universal Banks

Brokers

Stock Stock
exchange A exchange B
Stock
Trading Exchange C Trading

Trading

Clearstream
Clearing

Settlement

Custody

Custody
32

7.3. Comparisons between the two

The fundamental difference is reflected in the structural aspect: Clearstream has a vertical
single provider integrated set -up structure whereas Euroclear has a horizontal approach with
several providers in matters of capital market architecture. The issue is that Clearstream is
owned by a single shareholder Deutsche Börse, while Euroclear is owned by its users the
different stock exchanges, brokers and investment banks. The fee earnings therefore are at the
level of these shareholders who act as “clearers” in the Euroclear structure leaving Euroclear
only the trading and settlement activities to handle and earn less(mostly running the services at
cost). But both architectures compete in the market to provide the lowest global processing
fees, in addition the MTF are now also more and more a competitor capital markets structure.

From this fundamental organizational difference also stems the difference in their respective
functionalities: Euroclears provides settlement only, while clearing and custody is always
mandatory provided by third parties, who in most cases of the time are also its shareholders of
Euroclear. From an economic point of view there may be a conflict of interests, as ,as
shareholders they want the best possible return, while as users they want to pay the lowest
handing fees.

Clearstream does provide the whole range of services from trading to all integrated post trading
services; settlement, clearing and custody; it is owned by the Deutsche Börse Group. In addition
both are Global Custody services providers world-wide and competitors in the European capital
markets post trade value chain services.

There is an electronic bridge between both ICSDs (Clearstream and Euroclear have also both
ICSD statuses) this interoperability has significantly contributed to attract liquidity from new
customers.

But in the last Financial crisis, in September 2009, only Clearstream was able to offer
automated lending and borrowing of securities as well as tripartite collateral management
services. Their Euro GC Pooling facility was particularly successful as a reliable liquidity pool
whereas Euroclear having not the clearing activities and the underlying assets under control
were unable to operate in a similar way.

Due to the credit crunch, many banks did found it difficult to borrow cash, making Clearstream
services valuable in improving liquidity: Eliminating counterparty risk by using the CCP(central
counterparty) service; ascertaining the superior quality of underlying securities by limiting the
assets to those which the ECB (European Central Bank) accepts as collateral. Also the post-
trade CFF Central Facility for (investment) funds in Clearstream did allow cash and securities to
be exchanged synchronously between investment fund distributors and transfer agents despite
the financial crisis.

Clients of the Euroclear architecture were not able to be serviced as the different clearing
institutions in this set-up could not cope with the situation, only Clearsteam with its vertical
structure (enabling them to have control of collateral through all the post-trade cycle, areal
advantage) could offer clearing through collateral management during the Financial crisis 2009.
33

In clear the systemic risk of horizontal capital market architecture was revealed to be higher
than that of the vertical structured capital markets architecture. That major point was for
Clearstream in the competition game on the European capital markets.

During the financial crisis in 2009 clients of Euroclear were obliged to shift therefore their asset
from Euroclear to Clearstream to benefit from the Clearstream clearing facility failing Euroclear
set-ups’ ability to clear their trading transactions.

This may also explain, as mentioned above in 7.2.3, that CSDs from eight leading Central
Securities Depositories (CSDs) – Cyprus Stock Exchange (Cyprus), Hellenic Exchanges S.A.
(Greece), IBERCLEAR (Spain), Oesterreichische Kontrollbank AG (Austria), SIX SIS AG
(Switzerland), STRATE (South Africa), VP SECURITIES (Denmark) and VPS (Norway) did
prefer to join Clearstreams’ Link Up Markets joint venture for leading Central Securities
Depositories (CSDs) instead of pooling up with Euroclear.

Systemic risk considerations do explain the choice in favour of Clearstream in the opinion of the
consultant.

From a strictly operational point of view, the handling of the flux of assets and cash is easier to
process in a vertical structure, so operational risk results to be less than in a horizontal
structured architecture. Therefore a vertical capital market model has a better operability and a
better risk management capacity, compared with the horizontal capital market architecture.
Needless to say the consultant recommends for Azerbaijan the adoption of the vertical
structured capital market architecture as the better choice.

It must also be mentioned that the new MTFs in the capital markets worldwide, as mentioned
previously already by the consultant, are also vertical structures for the same obvious reasons.

8. The prevailing capital markets architectural models in

emerging markets
8.1. The Turkish model
In Turkey, the capital market structure is based on the ISE, Istanbul Stock Exchange for
transferable securities whereas derivatives are dealt on in the Izmir Mercantile Exchange. In this
paper the consultant will broach the Turkish capital market architecture through the ISE.

Trading is taking place at the ISE, whereas clearing and settlement takes place through
TAKASBANK ISE Settlement and Custody Bank Inc. It is the central settlement institution
authorized by the ISE for the finalization of cash and securities transfers of transactions made in
existing markets within the ISE. The Settlement Centre is operating with book entries. Securities
transfer transactions are done either trough:

Real Time Gross (RTG) DVP Settlement

The “RTG DVP Settlement System” provides delivery versus payment for stocks and fixed
income.
34

Free transfer

The Stock Transfer Transactions between members vary in respect of whether the security,
which will be transferred, is dematerialized or not. Dematerialized transfers vary according to
institutions being party to the transfer.

or Electronic Security Transfer (EMKT) Transactions

EMKT is a system established within the framework of CBT Central Bank of Turkey, facilitating
the real-time execution of buy-sell, transfer and other related transactions of dematerialized
securities in an electronic environment and in an integrated manner with EFT. Brokerage
houses, which are members of TETS (Takasbank Electronic Transfer System) can join this
system through Takasbank.

TAKASBANK does also provide custody and banking services. Within the framework of central
custodian services provided all records relating to the stock certificates and investment fund
participation certificates traded in the stock exchange have been transferred to the Central
Registry Agency Inc. in accordance with the regulations of Capital Markets Board regarding
dematerialization of securities.

Physical custodian services towards the members of ISE, issuer companies and corporate
investors is continued to be provided.

In clear a vertical architecture type of an emerging market capital market organisational set-up.

The Regulator in Turkey is the CMB, or Capital Markets Board of Turkey.

8.2. The Russian model

In Russia we have the MICEX Stock Exchange

Within the MICEX Group, the CJSC “MICEX Stock Exchange”, is the largest stock exchange in
the CIS countries, countries of Eastern and Central Europe. The MICEX Group provides
financial market participants with a complete set of trading, clearing, settlement, depositary,
and information services. MICEX covers a stock market, currency market, and derivatives
market.

There is also the well-known RTS, the Russian Trading System. RTS is an integrated trading
and settlement IT platform in a structure consisting of Not-for-profit partnership "Russian
Trading System Stock Exchange", "Open Joint Stock Company "Russian Trading System Stock
Exchange", "RTS Clearing Centre", " RTS Settlement Chamber" and "St. Petersburg Stock
Exchange. It is a regulated market in Russia.

The National Depository Centre (Closed Joint Stock Company) NDC was established as a
central settlement depository for the servicing of state securities, corporate, sub-federal and
municipal securities. NDC functions as a central settlement depository and a centre of technical
support of dealer’s sub-depository in Russia’s federal securities, the circulation of which is
supervised by the Bank of Russia.
35

Currently NDC is Russia’s largest settlement and safekeeping provider.

The Moscow Interbank Currency Exchange Settlement House (MICEX SH) is a credit
organization that provides settlement banking services, including cash settlements on trades
made by financial market participants.

The MICEX Settlement House:

 acting as a settlement bank, offers its clients a full range of settlement services;

 it performs cash settlements in real time. Clients’ payment orders are handled and
executed immediately after their delivery to the MICEX SH;

 it completes cash settlements on participants’ transactions on the day of trading;

 it guarantees timely settlements and the safety of its clients’ funds;

 interacts with clients throughout the entire trading day;

 is one of the main exchanges trading infrastructure. Since January 1, 1997, it provides
reliable and prompt cash settlements on trades made in MICEX financial markets;

 it provides settlement services in all of the MICEX financial markets:

 the government-backed securities market;

 the corporate securities market;

 the currency market;

 the derivatives (standard contracts) market.

The MICEX Settlement House guarantees timely settlements and the safety of its clients’ funds
because active operations are not performed on clients’ funds.

In clear, a horizontal organizational capital market structure type, (whereas RTS is of the
vertical capital market organisational set-up).Both structures competing for market shares in the
Russian market.

The Regulator in the Russian Federation is the Federal Financial Markets Service.

8.3. Benchmarking vis a vis the EU capital markets

architectures
From a structural point of view both capital markets architectures in Turkey and Russia area not
compliant with EU standards and regulations on capital markets, regardless their organisational
structures: horizontal or vertical.

Turkey has applied to join the EU, its’ capital market structure was pre-scrutinized by the
European Commission and would need to introduce the full range of the “acquis communautaire
36

“to meet the adhesion criteria. Deficiencies were detected in the areas of prospectus directive,
market abuse and transparency: the operational aspects of the capital market structure. Actually
the vetting procedure is frozen by the EU and accession talks are suspended because the
unsolved Cyprus issue.

In the case of Russia the actual structure is rather cumbersome (as resulting from the fact that it
is a horizontal structure, except the RTS who is a vertical structured type) with many entities
intervening in the market. In the end both organisational set up do not provide full DVP, which is
an absolute prerequisite requirement in an EU type of capital market structure. Deficiencies do
also exist in matters of prospectus directive, market abuse, transparency and corporate
governance
37

9. The proposed architecture for Azerbaijan

9.1. Action plan and time frame for implementation
9.1.1 Global Strategy
The action plan starts with a day T, to be the day the decision is taken to accept the proposal
and to start the implementation of the proposal as such. We have then to differentiate between
the broader sub-strategies to be followed:

Sub strategy A-Define the structural aspects to achieve the new capital market organisational
set-up in Azerbaijan, indicate the time and means to achieve this recommended structures and
institutional frame, and

Sub strategy B- Define the operational aspects of this new capital market architecture that
must be put in place and indicate the time required, to enable the institutions and all other
capital market participants to operate in the new proposed structure,

Sub strategy C-in addition the proposed set-up capital market structure will need an
appropriated IT-tool/platform. The consultant intends to recommend a modular base on a
shared technical infrastructure to combine extremely low latency with high volume. This platform
should favour algorithmic trading by mitigating towards a Itanium platform to boost output with
new enhances broadcast solutions as developed now by Clearstream, to be ready in the future,
once trading will start for real at the BSE and

Sub strategy D- to conclude the consultant intends to undertake a marketing study/ market
needs analysis to define suitable products to be traded on the capital market that will generate
a kick-off of the stock exchange transactions in the end.

The overall objective of the new proposed capital market structure in Azerbaijan is to create an
integrated financial market, in which investors are effectively protected and the efficiency and
integrity of the overall market are safeguarded, it requires the establishment of specific
regulatory and supervisory requirements relating to investment firms (inclusive banks
operating as brokers) and governing the functioning of regulated markets and other trading
systems so as to prevent opacity or disruption from undermining the efficient operation of the
Azeri financial system as a whole.

9.1.2 Main general task

The main task for the consultant would be to recommend and co-ordinate all the necessary
steps and measures necessary to generate the legal frame for the proposed architecture of the
capital market. As the underlying frame should be compliant with the EU rules and regulations
the consultant recommends adopting the most important EU directives as relevant to capital
markets. Based on the experience as gained in the EU, the implementation time for transposing
voluminous complex EU directive (like MiFID) in national law requires two years in average: 24
project months to elaborate the legal tools and putting in place the recommended global
architecture for the capital market in Azerbaijan.
38

In the case of Azerbaijan to set-up the legal frame the consultant recommends, would require a
simultaneous implementation of all the EU directives mentioned under 9.6 below to have the
required global legal frame duly set-up:

The consultant has drafted a graph showing the time frame for this action to be undertaken to
achieve the implementation of this legal frame, it encompasses also elaboration of supervisory
reporting frame to the Regulator SCS regarding compliance. Capacity building to exercise the
prudential supervision of the market would accompany the consultants’ action. The consultant
has elaborated a graph showing in details the time allocated to achieve the proposed
implementation. (Gantt chart in Annex 2)

Another element of the main task for the consultant is the enabling of the banks to act as
brokers in the stock exchange; this would require also elaboration of regulations and an
appropriated reporting frame to the Regulator. Banks should also be enabled to act as
custodians banks; again this will require elaboration of regulations and an appropriated
reporting frame to the Regulator. The graph illustrates the time necessary to achieve these
objectives as well.

The major work load would be for the consultant to facilitate the required change of status for
NDC towards a CSD status enabled institution. This would require the consultant to elaborate
detailed proposals for rules and regulations to be implemented. Also capacity building for the
institutions involved (SCS, NDC and BSE) should be done in parallel. This is also reflected in
the detailed graph in the graph in Annex 2.

9.1.3 Main actions and priorities

As resulting from the information of the consultant in Azerbaijan, the legal frame for capital
markets transactions is based on some specific articles in the civil code. There is also a draft
law for domestic investment funds under scrutiny. This from a capital market point of view is a
piece meal structure. It does not allow for the development of a coherent capital market.

9.1.3.3 The structural aspects for a capital market architecture in Azerbaijan.

To create a legal coherent frame in Azerbaijan, the first priority recommended by the consultant
would be to create a global integrated legal frame: a capital market law by means of a normative
and legal Azeri act with all EU legislation incorporated. This capital market frame law should
contain all requirements as below stated in more details. It would take the form of a financial
services action plan encompassing all institutions: SCS, DNC, BSE, the brokers, banks,
custodians and all other market participants in the capital market. This will require a time period
of 18-24 months to achieve. The required time: at least 18 months for elaboration and 6 months
for implementation. This is a prudent estimate based on experience as gained with the
elaboration of the latest capital market law in Moldavia, as an example. Such a basic capital
market law must contain rules and regulations addressing the following issues:

1-Access to professional activities in the capital market : Authorization requirement ,

Authorization procedure, The legal form of the institution, Central administration and
infrastructure , Shareholdings, Professional standing and experience , Capital base ,External
auditing, Participation in a deposit guarantee scheme , Participation in an investors’
39

compensation scheme for all professionals such as: Investment firms, Investment advisers,
Brokers in financial instruments, Commission agents, Private portfolio managers , Professionals
acting for their own account, Market makers, Underwriters of financial instruments, Distributors
of units/shares in investment funds, Financial intermediation firms, Investment firms operating
an MTF in Azerbaijan, Miscellaneous firms other than investment firms, Registrar agents,
Professional custodians of financial instruments.

2-Authorization for the establishment of branches and freedom to provide services

3-Professional obligations, prudential rules and rules of conduct in the capital market

4-Provisions applicable to credit institutions when acting as brokers and investment

firms

Organisational requirements, Conflicts of interest, Conduct of business rules when providing

investment services to clients, Provision of services through the medium of another credit
institution or another investment firm , Obligation to execute orders on terms most favourable to
the client, Client order handling rules ,Transactions executed with eligible counterparties ,
Obligations of credit institutions and investment firms when appointing tied agents, Professional
obligations of the financial sector as regards combating money laundering and the financing of
terrorism, Obligation to cooperate with the authorities , Obligation of professional secrecy

5-Prudential supervision of the capital market

-The competent authority responsible for supervision and its tasks, Purpose of
supervision, Professional secrecy of the Regulator, Exchange of information with other
Regulators, Exchange of information with third countries.

-Supervision of investment firms on a consolidated basis: Definitions, Scope and

parameters of supervision on a consolidated basis, Form and extent of consolidation, Content of
supervision on a consolidated basis, Means used to exercise supervision on a consolidated
basis, Parent undertakings having their head office in a third country, Cooperation with the other
authorities responsible for prudential supervision regarding consolidated supervision.

-Supplementary supervision of investment firms in a financial conglomerate:: Definitions,

thresholds for identifying a financial conglomerate, Identifying a financial conglomerate, Scope
of supplementary supervision of investment firms, Financial position, Capital adequacy, Risk
concentration, Intra-group transactions, Internal control mechanisms and risk management
processes, Cooperation and exchange of information between competent authorities,
Verification, Enforcement measures.

-Means used to exercise prudential supervision: Official lists and the protection of titles,
Powers of the Regulator, Relationship between the Regulator and external auditors, accounting
documents, Coefficients, Authorization of holdings, Complaints by clients, Powers of injunction
and suspension.
40

-Reorganization and winding up of certain professionals in the capital market: Definitions,

Scope, Suspension of payments: Provisions governing the opening of proceedings for
suspension of payments, Opening of proceedings for suspension of payments, Competent
jurisdiction and applicable law.

Winding up: Voluntary winding up,: Provisions governing proceedings for the judicial winding
up of establishments ,Winding-up proceedings, Withdrawal of an establishment’s authorization,
Provision of information to known creditors , Lodgement of claims.

-Provisions common to reorganization measures and winding-up proceedings: Effects on

certain contracts and rights , Third parties’ rights, Reservation of title, Set-off, Netting
agreements , Repurchase agreements, Regulated markets, proof of the appointment and
powers of administrators and liquidators, Registration in a public register, Detrimental acts,
Protection of third parties, Lawsuits pending, Professional secrecy.

6-Deposit-guarantee schemes: Compensation schemes for investors in credit institutions

and investment firms

7-Penalties: Administrative fines; Criminal sanctions

9.1.4 Ancillary tasks

The consultant recommends the set-up of an integrated IT platform for the BSE and NDC
(deemed to become a CSD in the proposed architecture. This is the technical component,
corollary to the set-up of the legal and regulatory architecture of capital markets in Azerbaijan.
This requires that part time the consultant should assist the IT developers to design such an
integrated platform until the testing and launch to start after T in parallel. This is also duly
reflected in the graphical scheme in Annex 2. The time frame is 6-12 months for the
development of such a platform, according IT duly consulted.

Another part time task for the consultant would be, simultaneously, assuming the proposed
architecture is accepted, to provide assistance to the project team when elaborating market
analysing and when proposing ways and means to start up the capital market in Azerbaijan.

During his first mission in Azerbaijan the consultant had meetings with market participants
regarding the launch of a capital market in Azerbaijan. He did meet with banks, insurance
companies, brokers, the Central bank and the State Fund. He gained the impression that
actually there is a lack of adequate tradable products in the stock exchange.

Therefore he recommends undertaking a formal capital markets needs analysis and a market
acceptance and absorption evaluation together with the project team. The consultant is of the
vested opinion that the issue is to propose suitable products that would allow the take-off of the
stock exchange and subsequently give impetus to the entire capital market.

In this context it is for instance of importance to mention that OMV has launched a gas
exchange together with the Vienna stock exchange and natural gas company Gazprom in
Baumgarten (Austria). OMV plans to make the Central European Gas Hub CEGH, the leading
gas exchange in Central Europe within the next years. At present the gas flowing through the
41

hub at Baumgarten covers 10% of Europe’s gas requirements. This percentage is expected to
rise further when Nabucco and the South Stream gas pipelines will be connected.

The gas exchange should bring transparency and flexibility in the gas prices that actually are
resulting from long term contracts between European suppliers and Gazprom. This initiative
seems to be an attempt to emulate the actual existing Caspian Oil & Gas Exchange.

The require time for this task for the consultant is also reflected in the graph in Annex 2 and is
scheduled over a period of two years.

9.2. The capital markets operators’ positions

The position of the different operators is shown in the context of the proposed new proposal
architecture of the capital market in Azerbaijan.

9.2.1. The Baku Stock Exchange

The stock exchange should share the common integrated IT platform that need to be put in
place to make the capital market operational in Azerbaijan. The core element of any capital
market; the Baku Stock Exchange must necessarily be endowed exclusively and compulsory
with all securities trading in the Azerbaijan capital market architecture proposal of the
consultant.

It is understood that under securities’ the consultant regroups all eligible items to be traded on a
stock exchange: from plain vanilla securities like stocks and bonds, that are currently on a case
by case dealt in, already sporadically now, to derivatives, commodities and currencies that could
be eligible at a later stage, once the market develops.

This encloses also private deals done on listed equities that should and must be duly notified to
the Baku Stock Exchange compulsory.

The consultant recommends to formulate policy recommendations as mentioned under 9.1 on

products that could be launched in the stock exchange and allow for a take-off of the
transactions that actually are having a low and occasional turn-over only, for lack of adequate
products for the potential investors. (Refer for more details to the consultants’ previously
elaborated preliminary report “Reflection paper on an “ad hoc” capital market architecture in
Azerbaijan” December 2009).

The stock exchange to fulfil its trading duties and obligations needs to have the regulatory frame
in place and it staff trained to perform the duties according the established rules, mainly those
as mentioned in the EU MIFID directive. The execution of these duties must be under the duly
Supervision by the Azerbaijan capital market Regulator, the State Committee for Securities,
SCS.

This will require building up the capacity to handle transaction with EU conform regulatory
requirements, which would require the elaboration of a stock exchange handbook containing the
rules and regulations, a trading manual and implementing the EC recommendations dating July
25, 1977, concerning the European code of conduct relating to transactions in transferable
securities. These tasks are mentioned in the graph of the action plan.
42

The Baku Stock exchange necessarily should also be vested to initiate the clearing and
settlement functions as these post-trade chains technical functionalities are required to be
located under the responsibility of the Stock exchange given the requirements of the EU
regulations.

A stock exchange under EU rules must be regulated, operating regularly (no sporadic trading as
actually in the Baku Stock Exchange ref. “Reflection paper on an “ad hoc” capital market
architecture in Azerbaijan” December 2009) and open to the public. This is defined in more
details as meaning:

The stock exchange must be “regulated”; under EU rules the essential characteristic of a
regulated market is the clearing, which presupposes the existence of a central market
organization for the processing of orders. Such a market may also be distinguished by
multilateral order matching (general matching of bids and offers enabling the setting of a single
price), transparency (maximum information distribution amongst buyers and sellers giving them
the possibility to follow the evolution of the market, so that they may ensure that their orders
have been carried out at current conditions) and the neutrality of its organizer (the organizers’
role must be limited to recording and supervision).

In addition EU rules require a stock exchange to be “recognized”, the stock exchange must be
recognized by a State or by public Authority which has been delegated by that State or by
another Entity which is recognized by the State or by that public Authority, such as a
professional Association.

“Operating regularly” as already previously mentioned securities admitted to this market must be
dealt in at certain fixed frequency and “open to the public” the securities dealt thereon must be
accessible to the public: they must be able to acquire and sell the quoted items.

In that regard an assessment of the fulfilment of the before mentioned requirements must be
undertaken and an action plan devised to comply with these requirements. To ascertain
compliance, training of handling staff must been foreseen as an underlay of the capacity
building exercise when and where necessary.

Trade processing by the Baku Stock Exchange will require a post-trade model, and the
consultant would favour a classical guaranteed model such as the CCP or Central counterparty
model to be exclusively and compulsory put in place.

CCPs require netting of transactions and collateralization. CCPs require collateral for the
settlement of trades with them, therefore the settlement is guaranteed; this function could, but
must not be outsourced to another institution like the National Depository Centre, NDC for
instance(upgraded to a CSD), as the depository of the collateral securities.

The consultant would favour the later, the BSE should initiate the settlement/clearing while the
CDS should finalize it.

But in an integrated IT system/platform encompassing the whole capital market structure that
the consultant intends to recommend to be implemented, this issue is rather irrelevant,
43

technically speaking: as deals/transactions cannot fail, as all transaction elements (cash/

securities) must be present before initiating the dealing in the stock exchange. Therefore this
eliminates any failed trades at the end of the post-trade value chain.

These recommended reforms to be addressed as outlined under NDC by an appropriated

presidential decree approach in matters legal handling. The institution empowered to act under
the decree being the State Committee for Securities.

9.2.2. The National Depository Centre

The National Depository Centre, NDC in the Azerbaijan capital market architecture should have
the pivotal role, as in the EU capital market structural architecture.

In the EU the key participants in any reform of Clearing & Settlement are those, whose roles are
integral to the process, i.e. Central Counterparties (Clearing), Central Securities Depositories
(Settlement & Custody) and Central Banks (cash settlement, collateral etc.).

However, these are generally not retail service providers and access to their services is
provided through wholesale service providers such as Custodians (Global and Domestic) and
Clearing Members (Global and Self Clearing). Investment Managers and Brokers are also
important participants but only as initiators of Clearing & Settlement activity through trading and
investment.

In the case of Azerbaijan a first pre-requisite would be that the NDC would compulsory become
the provider of the custody function in the capital market for all listed securities in Azerbaijan:
the CSD for Azerbaijan. This recommendation is within the scope of actual project aims. It
carries as corollary a compulsory dematerialization to be the standard for those securities
seeking a listing and trading at the Baku Stock Exchange. No CSD, is involved in supervising
custodian banks in the EU/EEA area. All securities traded in Azerbaijan (inclusive State or
Government securities should fall under the jurisdiction of the CSD). The Azerbaijan CSD
should exclusively deal with other CSD abroad and with the ICSD and the Global custodians
when and where appropriated (such as Clearstream, Euroclear etc.) that means in matters of all
Azerbaijan securities. The modus should be DVP mode 1, as recommended by the G10 and
achieved by STP in the integrated common platform that the consultant proposes. The
messaging standard should normally be SWIFT. At record date for the purpose of AGM, the
shares held in the CSD should be blocked allowing attendance. CSD is not concerned by
attendance in person or by proxy as this is at the retail level of the entitlement beneficiaries.

In order not to fall in the pitfall of the retail business as previously mentioned, the operational
working standard should be only the omnibus account procedure for NDC, (aggregation of
same asset type) leaving the retail for the other market participants as mentioned (custodian
banks, and brokers in case of Azerbaijan tentatively) to handle. This is good practice in all
CSD. CSD do not have the status of banks in the EU, they come under the Regulator of capital
markets.

CSD are wholesale transaction processing entities, they are not involved with individual
investors/clients as they deal only with omnibus accounts. This is stemming from an operational
facility point of view shared by other CSD. CSDs do have relations with other ICSD and
44

domestically with brokers and banks. As outlined, OTC transactions must be mandatory under
the jurisdiction of CSD, the same as the other trades.

The National Depository Centre, NDC in the Azerbaijan capital market architecture should have
a pivotal role, as in the EU capital market structural architecture as the central clearing house,
which is an important mandatory attribute of a CSD beside netting, and the settlement. OTC
falls under the jurisdiction of the CSD as well as mandatory these transactions must be reported
to the CSD.

This could be achieved in several steps: the first requirement would be the enactment of the
basic new capital market law draft proposal as made by the consultant. This would require time
to elaborate; time to go through the legislative procedure, Parliament etc. Based on the example
in Romania, that needed to meet the EU criteria in matters capital market organization for not
delaying the EU accession further, all, so called “EU reforms” were simply addressed by issuing
a presidential decree enacting all EU legislation to be applicable in Romania, after a specified
date. Thereby Romania did gain the time to elaborate detailed organic laws, ministerial decrees
and regulations to implement in domestic law all the EU acquis communautaire. To avoid a
difficult transition this kind of approach could be recommended by the consultant: the State
Committee for Securities becoming the institution to issue instructions rules etc…under a
presidential decree pertaining to organize the proposed capital market structure in Azerbaijan.
The SCS would be empowered to issue binding rules and regulations that at a later stage could
be repelled by specific organic law when elaborated, issued and superseding these rules. The
transformation from NDC to CSD status could result from a simple rule issue based on the
presidential decree from the SCS.

CSD should hold securities and enable securities transactions to be processed through book
entry. In Azerbaijan its home country, CSD should provide processing services for trades of
those securities that it holds in final custody, and in this function it is referred to as “the issuer
Central Securities Depository”. A CSD can also process services as an intermediary in cross-
border clearing and settlement, where the primary deposit of securities is in another country. For
instance in Germany, securities which are intended for trading are safe-kept in collective safe
custody (omnibus account principle), as opposed to individual custody. In collective safe
custody, fungible securities of the same type are kept in a single collective holding. The
customer acquires fractional co-ownership in the CSD’s collective holdings and transactions can
be settled by book entry, without physical movement of the securities.

The consultant would like to recommend also the introduction of a Central Registrar for
securities in Azerbaijan, but as a separate entity from the CSD, based on the experience in
other emerging markets with failing company registrars as in Russia, in matters of corporate
governance as experienced by the consultant during an EU project assignment with the Federal
Financial Markets Service. The separation is to avoid conflicts of interests. The setting up of
such an institution would nevertheless exceed the present mission of the consultant as not
enough time and resources could be made available, unless an extension of the present project
with allocation of new resources could be granted.
45

As outlined previously, to reduce the transition time and resulting legal insecurity, the
presidential decree approach could also be used to address the creation of a National Central
Registrar in Azerbaijan, to be formalized at a later stage by the consultants’ elaboration of a
specific basic law for later implementation.

In case all joint stock companies shares should be kept only in dematerialized form at the
Central Registrar as done for instance in France. In this case the Central Registrar deals with
final owners no broker, no custodian bank, no fronting possible, but restricted to the domestic
market in Azerbaijan.

In France this is handled under TPI as an example: (TPI stands for Identifiable bearer security in
French, a service that allows an issuer of bearer securities to request a list of beneficial owners
registered in the custodians’ books.)

The Central Registrar is also the only institution were liens and pledges over securities can be
registered this cannot be done in CSDs as they deal not at retail level.

The main argument is to ascertain the title for shareholders/investors and guarantee corporate
governance in all aspects. A Central Registrar could also extend its registration to bondholders
(public or private), the argument in favour is again corporate governance: bondholders are
entitled to certain rights in an EU context. For instance issuing new bonds that could prejudice
the bearer of older issue are compulsory required to get approval from a bondholder general
meetings in some EU countries.

9.3. The Capital Markets Regulator

The role of the SCS as capital market Regulator in the proposal of the consultant must be
enhanced considerably. It is obvious that the Regulator needs assistance to elaborate the global
legislative implementation plan to create the global capital market frame as mentioned under 9.1
Specifically the Regulator must be endowed with an appropriate structure to cope with the new
tasks in matter of compliance surveillance and reporting The consultant would recommend to
elaborate guidelines on supervisory disclosure based on the CEBS Committee of Banking
Supervision as far as capital markets aspect are concerned stemming from in relation to
information about issuers whose securities are admitted to trading on a regulated market,
Capacity building could be provided by the consultant to put in place based on the Standards for
Clearing and Settlement systems in Europe as elaborated by the CESR, the Committee of
European Securities Regulators in that regard.

It should be noted that if the consultants’ recommendation would be retained in matters legal
tool and means to achieve the new capital market structure in Azerbaijan, this would result in an
enhancement of the SCS role especially when acting as the institution designated under a
presidential decree to achieve the transformation.

9.4. The professional capital markets participants

All recommendations under 9.4 could also be obtained by way and means of the presidential
decree approach as previously already mentioned. The institution in charge of the changes
would be as principal the SCS again.
46

9.4.1. The Investment firms

Brokers should be duly licensed and apply the MiFID criteria in their clients relationship. The
consultant recommends that brokers should keep their holdings with the CSD (the upgraded
NDC) in omnibus accounts as CSD’s work with this concept only. The will have domestic clients
and may as well have direct foreign clients if the MIFID legal frame is duly in place. They are
linked up with the CSD through the market IT platform as professional users. In matters of
domestic investors investing abroad the link is with CSD that is then in connection with the
foreign CSD and/or ICSD, that are foreign CSD acting as global custodians for these assets if
they are in custody with them. All transactions done to be mandatory only through CSD for
domestic operations, OTC transactions must be mandatory reported to the CSD for all domestic
Azerbaijan securities, inclusive Government and State titles. It should be noted that the brokers
have to comply also with the EU capital adequacy directive (the Directive 2006/49/EC on the
capital adequacy of investment firms and credit institutions) and compulsory under reporting
duties to the Azerbaijan capital market Regulator.

9.4.2. The Banks licensed to provide investment services

The consultant recommends that all authorized and licensed banks in Azerbaijan should have
the option to become brokers in the exchange and accordingly as professional users linked up
with the IT platform. This is a request, subject to a formal application with the capital markets
Regulator SCS. It entails reporting duties. The granting of the status is subject to vetting by the
SCS in agreement (maybe under a formal MOU, memorandum of understanding) with the
banking Regulator in Azerbaijan. Banks duly authorized can as well be custodian banks and as
such safe keeping their own assets in deposit but under the omnibus account modus with the
CSD. The CSD is not involved in supervision or in license granting for brokers or for Custodian
banks, as it is not a Regulator. This is at discretion of the capital market Regulator alone.

9.4.3. The Custodian Banks

Custodian banks are mandatory for safe-keeping of assets of the domestic Azerbaijan
investment funds, assuming the draft law is approved and such funds would become
operational then. The requirements to be a custodian bank can be cumulated with a brokerage
license, but always with due consideration of the, from relevant EU directives implementation
resulting, new legal Regulatory frame in Azerbaijan, as recommended by the consultant.

Custodian banks have also specific duties, when acting as investment fund custodian banks as
resulting from the investment fund law. The consultant would recommend seeking inspiration
from the E so called UCITS directive in that regard. (Council Directive 85/611/EEC on the
coordination of laws, regulations and administrative provisions relating to undertakings for
collective investment in transferable securities (UCITS).

Custody of assets is the main duty under EU regulations. It must be understood that the legal
concept is versus supervision of assets, rather than safe-keeping of the deposited assets.
Therefore custodian banks can make use of correspondent banks (sub-custodian banks) to fulfil
this main task, for operational reasons, but the overall responsibility remains with the custodian
bank. Ancillary carrying out all day-to day-administration of assets under custody: corporate
actions, collection of dividends, interests and proceeds of matured securities, exercise of
options etc.
47

Needless to say that although custodian bank status granting is a prerogative enshrined with the
SCS on request, as the duly appointed capital market Regulator; this should be exercised
nevertheless in close co-operation and concert with the Banking Regulator, as done in some EU
countries.(a MOU would be recommendable, in case).

9.4.4. The professional capital markets associations

No professional capital market association is involved directly in the proposed capital market
architecture.

9.5. Linkages among them

The common link of all institutions and market participants will be the integrated common IT
platform allowing all of them to communicate and execute transactions according their assigned
tasks and respective duties under the regulatory supervision of the Regulator SCS.

9.6. The necessary reforms from the legal and regulatory point
of view
The proposed new architecture of the Azeri capital markets will result from the new legal frame
stemming from the implementation of the recommended capital market law as under 9.1 plus
some specific capital market basic organic laws to reflect all other EU capital market directives.

It must be clearly stated that the arguments for the implementation of the EU directive would
require an exhaustive study that would exceed this modest paper by far. It was assumed the
model to follow for Azerbaijan would be an EU conform capital markets structure without
justifications of its relevant merits as opposed to other possible structures. Nevertheless the
consultant will try to give some short arguments why EU directives were from time to time duly
elaborated and subsequently are implemented by the EU member States.

9.6.1 the operational aspects of the capital market in Azerbaijan

It is necessary now to precise and to define, after the structural institutional aspects are given in
the new basic capital market law, how the market will function. Therefore we need to have some
additional basic organic laws that define the rules and the operational modus of the new capital
market set-up.

1-Basic organic law taking into account the Commission Regulation (EC) No 1289/2008 of 12
December 2008, as regards elements related to prospectuses and advertisements,

Safeguards for the protection of the interests of actual and potential investors are required in the
EU States of undertakings offering their securities to the public, either at the time of their offer or
of their admission to official stock exchange listing; such safeguards require the provision of
information which is sufficient and as objective as possible concerning the financial
circumstances of the issuer and particulars of the securities for which admission to official listing
is requested; the form under which this information is required usually consists of the publication
of listing particulars.

2-Basic organic law for a Central Registry in Azerbaijan; appointment of mechanisms for the
central storage of regulated information within the meaning of transparency requirements for
48

issuers of securities whose securities are admitted to trading on a regulated market, on markets
in financial instruments,

3-Basic organic law reflecting Commission regulation (EC) No 1287/2006 of 10 August 2006 as
regards record-keeping obligations for investment firms, transaction reporting, market
transparency, and admission of financial instruments to trading; implementing also the
requirements of Directive 2004/25/EC of 21 April 2004 on takeover bids, and Insider Trading

The basic capital market law under 9.1 setting the institutional structural frame, has in its
elaboration of this frame law to take also into account the rules and regulations as resulting
from older EC capital market regulations as issued in the interest of investor protection such as::

1-Directive 2004/39/EC on markets in financial instruments (MiFID). . And ancillary the Directive
2006/49/EC on the capital adequacy of investment firms and credit institutions (only the
investment firms aspects to be taken into account).

2-Directive 2003/6/EC on insider dealing and market manipulation (MAD) (market abuse).And
ancillary also the Commission Directive 2003/124/EC implementing Directive 2003/6/EC as
regards the definition and public disclosure of inside information and the definition of market
manipulation; as well as the Commission Directive 2003/125/EC implementing Directive
2003/6/EC as regards the fair presentation of investment recommendations and the disclosure
of conflicts of interest.

3-Directive 2003/71/EC on the prospectus to be published when securities are offered to the
public or admitted to trading and amending Directive 2001/34/EC(Prospectus directive). And the
corresponding Commission Regulation (EC) No 809/2004 implementing Directive 2003/71/EC
as regards information contained in prospectuses as well as the format, incorporation by
reference and publication of such prospectuses and dissemination of advertisement.

4-Directive 2004/109/EC on the harmonization of transparency requirements in relation to

information about issuers whose securities are admitted to trading on a regulated market and
amending Directive 2001/34/EC (Transparency directive) especially the in relation to
information about issuers whose securities are admitted to trading on a regulated market,

Institution specific, there should be a basic operational organic law reflecting:

The Council Directive 85/611/EEC on the coordination of laws, regulations and administrative
provisions relating to undertakings for collective investment in transferable securities (UCITS).
This should be merged together with the actual draft law of investment funds in Azerbaijan.

All this changes to be realized in a time frame of 18-24 months after the day T as in the
attached chart in Annex.2.(18 months discussion and elaboration, 6 months implementation
guide line issuing).

9.6.2 Important
Regardless all these specific recommendations, the first step would be to enact all EU
requirements through the issue of a presidential decree appointing the SCS to be the main actor
49

in charge to implement these EU requirements rapidly through immediate transitional

appropriated measures and rules. the basic organic laws to follow later in time.

9.7. The necessary organisational and institutional reforms

The core pivotal institution in the new architecture is the CSD which will result from an
upgrading of the actual NDC as explained above. (means and ways as under 9.6.2 outlined)
The existing banks, duly authorized by the Banking Regulator can apply to the capital markets
Regulator to be authorized/licensed to act as broker in the stock exchange, based on the
universal banking principle e as existing in some of the EU member States (Germany,
Luxembourg just to mention some) as well as custodian banks for investment funds assuming
the legislation id introduced in Azerbaijan. All these professional market participants must have
an electronic link in compliance with the new regulatory frame that will establish a common
integrated IT platform to allow market participants to perform their duties. Below a diagram to
show the relationship and the resulting flows.
50

FDI

FDI buy security x

Bank A
Bank B
A/C securities FDI
A/C cash Investor B
A/C cash Investor A
Invesrtor A Investor B local
local A/C cash FDI
Central
Registrar of
securty X
Sale security X Buy
security X fromInvestor A

/sell securit X to FDI

CSD / Exchange common
Broker A integrated IT pCSD / CSD / Broker B
A/C Exchange common integrated IT A/C
platform
investor A Investor B
Omnibus accounf securties X
security X securty X
Brokers A&B Banks A&B latform

Omnibus accounf securties X

Brokers A&B Banks

CentralA&B
Registrar of
securty X
51

10. Conclusions (benefits from the proposed model)

The proposed architecture of the capital markets in Azerbaijan could set the foundation of a
future development of capital market opportunities for the benefits of international and domestic
investors.

The institutional aspects are as defined in the basic capital market law, whereas the operational
aspects of the new capital market structure are defined in the basic organic law proposals. The
tools to achieve operations in the best professional way are given as an integrated IT platform
that connects all institutions and market participants in the new capital market architecture. The
consultant also intends to give precise hints regarding products to be traded in the new capital
market structure as proposed, and likely may finally generate an effective take-off of the new
capital market architecture.

From an organizational IT point of view, the common platform guarantees STP processing of
transactions, but it I will be an open architecture, enabling it to encompass new products later.
These will result from the study and market analysis the consultant proposes to perform in the
context of this project.

The main argument to choose vertically integrated capital market architecture, the Clearstream
model, stems from the necessity of the CCP.

It is the main argument for the consultant to recommend this solution.

In a horizontal architecture there are different, separate clearing providers as a horizontal

architecture set-up provides only trading and settlement. In the vertical structure the CCP stems
from the integrated clearing structure: assets are under the control from trading through all the
post trade cycle that generates CCP within the system. All horizontal organisational capital
market set-ups need such an entity that is the buyer to every seller and the seller to every buyer
of a specified set of contracts/obligations executed on a particular exchange.

This means another entity handling the post-trade transactions with an additional cost factor and
possibility of errors generating failed trades, without adding any additional value to the
transaction processing. In the vertical organised capital market structure, this is eliminated as no
need for a separate CCP entity, especially in the context of a single market structure as in
Azerbaijan.

One should avoid setting up separate entities for post trade processing and go for the
centralized vertical single entity handling the transactions from trading, settlement, clearing to
custody in the new CSD in STP modus as previously already stated. In the context of a
emerging markets approach the structure the most suitable capital market structure it is
interesting to see that the discussion is on. Bulgaria’s Central Depositary is now seeking to join
forces with an international settlement and clearing institution in line with a long-term
52

development strategy aimed to guarantee free trade by foreign investors on the Bulgarian
market and vice versa.

Before deciding for the options in the market the Bulgarian CSD want to thoroughly discuss the
strategy with all stakeholders including the investment intermediaries’, asset managers’ and
banks’ associations as well as the Bulgarian Stock Exchange (BSE) itself. The discussion is to
either join Clearstream, Euroclear or Link Up Markets (which is again Clearstream).The
Bulgarian CSD suggested that Clearstream could turn out to be the best-suited and possibly the
cheapest option for the Bulgarian market but they reiterated that the choice will be made after
discussions with all stakeholders.

It must be mentioned that Clearstream thanks to its vertical processing is more performing and
has less failed trades as Euroclear in the European capital markets in general. This also
explains that Euroclear will set up a single common IT platform that allows for vertical
processing as much as possible despite its horizontal clearing institution providers. The unique
characteristics of Clearstreams business, on which they expand, implies that their risk profile is
atypical from that of other providers. When discussing the new Basel II capital agreement,
(Clearstream as a bank is subject to this accord) aspects of the new frame did affect
Clearstream more than had perhaps been intended. In reducing settlement risk in the
international and domestic securities markets by “internalizing” (technical term for the vertical
processing structure) Clearstream, by definition, does particularly focused on operational risk
issues for itself and for the global capital markets. It is vital for the post-trade industry as a whole
to ensure that the measures for operational risk are appropriate and achieve their desired goals
of increasing financial safety and soundness in the system. Clearstream can offer some
particular expertise and insight in matters Operational risk managing capacity. In the field of
Credit Risk, and the Second (Supervisory review) and Third pillars(market discipline),
Clearstream International has probably have not so much to contribute beyond that which any
other bank may be expected to make.

In clear in an emerging market the Clearstream approach , “internalizing” (vertical integration)

the entire post-trade processing allows for an optimum operational risk solution that a horizontal
approach (Euroclear model) is unable to guarantee. This is an additional argument in the
opinion of the consultant to strongly recommend this architecture type for the Azerbaijan capital
market. Besides, the structural pattern being pursued throughout the EU is one of increased
vertical integration, allowing for economies of scope, which is pervasive and remains the
industry standard. This is witnessed by the vertical silos throughout the EU such as in Germany
where Deutsche Börse owns Cleartream and Eurex clearing and by Borsa Italiana’s recent
acquisition of control of the Italian settlement service provider Monte Titoli.

As also outlined, systemic risk in case of a crisis, as in 2009, is much higher when using
horizontal capital market structures, this in addition, is also an argument not to neglect. The
consultant did also explain that the processing of transactions and the general operability in
vertical structured capital market architecture is higher, as the assets are always under the
control of one single processing entity. Therefore, the Straight Through Processing ratio for
vertical capital markets structure is so high (98.5% for Clearstream), and they have less failed
53

trades to report then horizontal organized architecture where multiple entities are handling the
post-trade transactions.

In matters cost efficiency there is no data, as the scope of horizontal capital market operators is
to earn most while performing the clearing, and custody fees thereafter; keeping the trading and
settlement functions running at cost.

In the vertical structure the fees are not so transparent, but both structures do compete
successfully in the EU capital markets.

The proposed vertical integrated architecture will enable the Azeri CSD to establish e a working
relationship with other CSD in the EU and worldwide, while keeping its own assets under control
in the post trade area, having less operational risk in this structure as opposed to a horizontal
structure where outsourcing of risk may occur but at the cost of higher systemic risk stemming
from that functionality.

As some non EU CSD in Europe such as Switzerland, Norway did also join the Target 2
securities system it should be possible, that the new Azeri CSD joins as well the system as the
proposed capital market set-up is compliant with all EU regulations, and through the ICSD
Clearstream and/or Euroclear the CSD Azerbaijan (through the bridge) could be connected
internationally as to this new securities settlement system in the Europe. It is clear that this is
not conditional to opt for the horizontal or vertical capital market organisational set-up, as both
are possible and acceptable structures in the EU.

Azerbaijan could be a precursor in the Caucasus and innovate by launching products such as
commodities related investment opportunities for FDI while enabling its domestic investor to
gain a secure and safe access to international investment opportunities world-wide.
54

ANNEX 1 Capital market structures in the EU

 55

ANNEX 2

Area/ Tasks M M M M M M M M M M M M M M M M M M M M M M M M
Details 1 2 3 4 5 6 7 8 9 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2
0 1 2 3 4 5 6 7 8 9 0 1 2 3 4
1- with Ancillary
Main Common part time
TASK CSD/Exchan with
ge IT technical
platform assistance
projects
SCS Coordinati
on
With IT
developers
NDC Coordinati
on with IT
developers
BSE Coordinati
on with IT
developers
3rd Parties Coordinati
market on
participants with IT
developers
2- Capacity Main full
Main building time
TASK /training coordinatio
/coaching n
with
technical
assistance
projects
SCS MiFID &
other EU
Supervisor
56

y&
Regulatory
complianc
e issues
Custodian/
depositary
bank
regulatory
and
supervisor
y
NDC Legal
frame
change to
CSD
Implementa
tion/risk
managemen
t
procedures
EU
complianc
e
assessmen
t
Dematerial
isation
Issues/
omnibus
A/C
National
securities
depositary
issues
OTC
transaction
57

s
Recording
issues
CBA and
Governme
nt
securities
handling
BSE Exchange
rulebook
Trading
manual
Implement
EU code
of conduct
transaction
s
Implement
EU
Code of
conduct
Settlement
/
clearing
Testing/
launch
assistance
OTC
transaction
s
reporting/h
andling
CB Linkage
with
common IT
platform
 58

“brokerage
” enabled
banks/
MOU
Regulatory
requireme
nt/CB
advisory
FDI issue
3rd parties: Awareness
market raising
participants exercise
3- Products Ancillary
Main developmen part time
TASK t with other
for the AZ LT expert
Capital
Market
a- needs
analysis
b- market
acceptanc
e
absorption
assessmen
t
c- products
recommen
d
d. launch
assistance
59