Conversion to the New JGB Book-entry System Based on the New Legal Framework
July 18, 2002
Bank of Japan
On June 5, 2002, the Law concerning the Establishment of Relevant Laws to Improve Securities Markets through the Reform of the Securities Settlement System (hereafter the "Securities Settlement System Reform Law") was enacted in the 154th Diet session. With the enactment of this law, the Law concerning Book-Entry Transfer of Corporate Debt Securities (hereafter the "Transfer of Corporate Debt Securities Law") will come into effect on January 6, 2003.1 The Transfer of Corporate Debt Securities Law provides for full dematerialization of corporate bonds, Japanese government bonds and bills (JGBs), and other securities, and enables these securities to be transferred by book entries on the accounts at settlement institutions.
Following the above changes in the legal framework, the Bank of Japan (hereafter the "Bank") decided on June 21, 2002 its plan to convert from the JGB Book-entry System it currently operates (hereafter the "current system") to a new system based on the Transfer of Corporate Debt Securities Law (hereafter the "new system"). Specifically, the Bank has decided to (1) abolish the current system and start the new system based on the Transfer of Corporate Debt Securities Law around January 27, 2003, provided that certain conditions have been met; and (2) initiate preparations for the conversion.
The sections below explain the background to the Bank's decision, the reasons for the conversion to the new system, the main changes from the current system, and how the Bank will proceed with the preparations for the conversion. An outline of operational procedures and transaction processing in the new system is available in a document sent to direct participants, indirect participants, and foreign indirect participants in the current system (hereafter all three types of participants are referred to collectively as "participants").2
With the enactment of the Securities Settlement System Reform Law, the Law concerning Book-Entry Transfer of Short-Term Corporate Debt Securities was amended and renamed the Law concerning Book-Entry Transfer of Corporate Debt Securities. For details, see information available in Japanese on the Financial Services Agency's Web site at http://www.fsa.go.jp/.
|2||"Conversion to the New JGB Book-entry System" prepared in Japanese by the Operations Department of the Bank of Japan and sent to participants on June 21, 2002.|
The Bank established the JGB Book-entry System in 1980, and has managed it for over 20 years.3 It was established with the aim of achieving smooth and efficient trading and safekeeping of JGBs, thereby improving and fostering the secondary market for JGBs. This was because at the time the system was established, the volume of processing for registered JGBs (JGBs held under the JGB Registration System), such as changing the names of JGB holders, had increased markedly as their issuance and trading volume surged.
Even after the establishment of the JGB Book-entry System, the Bank has continued its efforts and taken a number of steps to improve the safety and efficiency of JGB settlement, given that settlement of JGBs is very closely connected with that of funds between financial institutions. For example, in 1990 the Bank started operating the Bank of Japan Financial Network System (BOJ-NET), an online network system for transmitting transfer instructions. In 1994, the Bank introduced the delivery-versus-payment (DVP) mechanism, which ensures that transfer of securities occurs if and only if the corresponding transfer of funds occurs. In 2001, the Bank further improved the BOJ-NET and made real-time gross settlement (RTGS) the only settlement mode for JGBs.
Today, as a result of these measures taken by the Bank, Japan's settlement system for JGBs meets international standards for the most part, and it is the safest and most efficient mechanism for securities settlement in Japan.4 The Bank will continue its efforts to maintain and ensure the safe and efficient operation of the settlement system for JGBs, and will respond to the needs of market participants and other relevant parties.
Looking at the current state of securities settlement in Japan, including settlement systems for securities other than JGBs, there are still points that need to be improved. In recent years, there has been an increasing awareness of the need to deal with these points with the aim of strengthening the international competitiveness of Japanese securities markets, as the importance of securities markets as a financial intermediary channel is growing and the global competition among securities markets is intensifying.
Given this awareness of the need for improvement in securities settlement, the working group on securities settlement system reform under the First Subcommittee of the Financial System Council published a report titled "Reform of the Securities Settlement System for the 21st Century."5
The report pointed out that one of the problems of Japan's securities settlement system was that there were separate settlement arrangements for different types of securities. To deal with this problem, the report called for the establishment of a uniform legal framework for securities settlement that will provide a basis for common rules governing settlement of marketable securities, regardless of the type of security or settlement institution.6 Following this proposal, the establishment of a uniform legal framework became a pillar of the reform of Japan's securities settlement system.
The Law concerning Book-Entry Transfer of Short-Term Corporate Debt Securities was enacted by the Diet in June 2001, enabling commercial paper (CP) to be fully dematerialized. The law was amended as the Transfer of Corporate Debt Securities Law in the 154th Diet session in 2002, and now applies to a wider range of securities, including corporate bonds, JGBs, and investment trust beneficiary certificates, as well as short-term corporate bonds (i.e., CP). The amended law enables all of these securities to be fully dematerialized and to be governed by the same rules, according to which they are created, transferred, and extinguished by means of record on the books of settlement institutions.
The Transfer of Corporate Debt Securities Law marked a great advance in the establishment of a uniform legal framework for securities settlement, and this law will be the core of the future legal framework governing securities settlement.
In addition, the Transfer of Corporate Debt Securities Law defines and governs handling of the bonds eligible for STRIPS (Separate Trading of Registered Interest and Principal of Securities) in special clauses concerning JGBs. These bonds are interest-bearing JGBs which can be separated into two components, the coupon and the principal, which are traded separately in the market.
Having considered the above background, the Bank became aware of the need to address the change in the legal framework of the JGB Book-entry System that will follow after the Transfer of Corporate Debt Securities Law comes into effect.7
Japan's settlement system for JGBs is explained in detail in Chapter 10, Section 1 of "Functions and Business Operations of the Bank of Japan," available in Japanese at http://www.imes.boj.or.jp/japanese/pf/chapter10.pdf.
See "Recommendations for Securities Settlement Systems," published in November 2001 by the Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries and the Technical Committee of the International Organization of Securities Commissions (available at http://www.bis.org and http://www.iosco.org) and "Clearance and Settlement Systems in the World's Securities Markets," published in 1989 by the Group of Thirty.
See http://www.fsa.go.jp/p_mof/singikai/kinyusin/tosin/kin20000705-2.pdf for the original report in Japanese.
The report pointed to several specific problems in the current securities settlement system: (1) separate settlement arrangements for different types of security; (2) delay in dematerialization of securities, which is necessary to achieve efficient settlement; (3) delay in online processing of securities transactions; and (4) absence of a DVP mechanism. To address these problems, the report proposed the following: (1) establishment of a uniform legal framework for securities settlement; (2) implementation of straight-through processing (STP) (automated processing of transactions from trade to settlement without the need for reentering settlement instructions manually); (3) introduction of a DVP mechanism; and (4) realization of smooth settlement of cross-border transactions.
|7||Following the amendment of the Law concerning Government Bonds, which became effective with the enactment of the Securities Settlement System Reform Law, the government plans to introduce JGBs designed for individual investors, which are to be held by and can be transferred only among individuals.|
III. Reasons for the Conversion to the New System
The Bank has deliberated on the future structure of the JGB Book-entry System, considering the issues discussed above. As a result of these deliberations, the Bank has decided that it should convert the current JGB Book-entry System to the new system around January 27, 2003. The reasons for this decision are explained in detail below.
A. To Achieve Greater Efficiency of Safekeeping and Settlement of JGBs
The conversion will fully dematerialize JGBs -- it will eliminate JGB certificates (physical certificates) from the JGB Book-entry System -- thus achieving greater efficiency of safekeeping and settlement of JGBs.
Under the Transfer of Corporate Debt Securities Law, no physical certificate will be used during the life of a security, at issuance, in trading, or at redemption. Under the current system, in contrast, book-entry JGBs are converted to JGB certificates and vice versa at the request of JGB holders. Maintaining operational arrangements for handling and safekeeping JGB certificates to respond to such requests involves costs both for the operator of the JGB Book-entry System and its participants. The Bank also maintained operational arrangements to handle and destroy JGB certificates as part of its provision of services related to JGBs as the fiscal agent of the government. These arrangements, however, are rarely used, as 99 percent of the amount outstanding of JGBs in bearer form is currently held under the JGB Book-entry System, and only 0.3 percent is held in the form of physical certificates.
It is expected, therefore, that dematerialization of JGBs held under the JGB Book-entry System will contribute to the reduction of costs associated with the issuance, trading, and safekeeping of JGBs, and thereby to greater efficiency of JGB settlement.
B. To Make the Legal Structure of Book-Entry Transfer Easier to Understand
The conversion will make the legal structure of book-entry transfer of JGBs more straightforward.
The current legal structure of JGB Book-entry System is based on the existence of physical certificates. Book-entry transfer of JGBs is structured as follows: the seller, who has deposited JGB certificates with the Bank, instructs the Bank, which has possession of the JGBs on the seller's behalf, to transfer the possession of the JGBs and to hold them on behalf of the buyer; and the buyer obtains the possession of the JGB certificates and holds them through the Bank. Book-entry transfer is governed by provisions in general private law, such as the Civil Code and the Commercial Code, and the contracts between the Bank and the participants.
The current legal structure of book-entry transfer of JGBs has functioned adequately in practice, but may not be straightforward for foreign participants and investors, compared with the legal structure that is based directly on the special law governing the book-entry transfer of securities.
The conversion to the new system based on the Transfer of Corporate Debt Securities Law will make the legal structure of JGB settlement easier to understand than at present. In addition, the legal framework of Japan's securities settlement system will be better understood abroad as the legal structure of book-entry transfer of securities, such as JGBs and corporate bonds, will be the same.
C. To Achieve Smooth Conversion to the New System
It will be possible to start the new system in a relatively short time and without imposing an undue burden on participants and other relevant parties by making full use of the existing computer network and systems. The current system and the new system have many features in common, including that they are both mechanisms for book-entry transfer of JGBs. In addition, most of the system infrastructure of the current system will continue to be used in the new system. Because the current system will be used as the base of the new system, it will be possible to start the new system early next year, even with the change in the legal framework.
IV. Main Changes from the Current System
The new system and the current system have many features in common: (1) JGBs are managed as a balance recorded in the accounts on the books of settlement institutions; (2) transfer of these securities is represented by book entries; and (3) both systems have a tiered structure, with intermediaries such as banks and securities companies interposing themselves between the central securities depository and JGB holders. Thus, the fundamental framework of the new system as a book-entry system will not change as a result of the conversion.8 In addition, the BOJ-NET will continue to serve as the system infrastructure of the new system. Various services and facilities offered in the current system through the BOJ-NET, such as online processing of transfer instructions and DVP, will also be available under the new system.
The sections that follow explain the main changes which will take place as a result of the conversion to the new system.
A. Change in the Legal Structure of the Book-Entry Transfer of JGBs
The legal structure in the new system will differ from that in the current system in regard to what determines who owns JGBs and how these securities are transferred.
The difference is that the new system, unlike the current one, is not based on the existence of physical certificates.
In both systems, amounts of JGBs are recorded in the accounts on the books of settlement institutions and JGBs are transferred between these accounts by book entries, but the legal significance of the record or book-entry transfer is different. In the current system, balances of JGB accounts on the books of settlement institutions or book-entry transfers have no legal effect in and of themselves. Ownership of JGBs is conferred and transfer is effected by possession and delivery of JGB certificates, which are represented by the balances and transfers recorded on the books. In the new system, on the other hand, transfer of JGBs will be effected by book entries (credit and debit to accounts).
Due to the changes in the legal structure, a JGB certificate will no longer be required at any stage during the life of a JGB, from issuance to redemption. The relationship between the JGB Book-entry System and the JGB Registration System will also change. Registered JGBs (JGBs held under the JGB Registration System) and JGB certificates will remain mutually convertible, but book-entry JGBs held under the new JGB Book-entry System will not be able to be converted to JGB certificates, and thus not to registered JGBs either.9 In addition, JGB certificates redeposited with the Bank by participants in the current JGB Book-entry System are registered in the JGB Registration System under the name of the Bank (package registration), but in the new JGB Book-entry System package registration will not be made.
B. Changes in the Obligations of the Transfer Institution (Furikae Kikan) and Account-Keeping Institutions (Kouza Kanri Kikan)
In the new system, the obligations of the transfer institution (the central securities depository in the current system) and account-keeping institutions (the participants, who maintain customer accounts in the current system) will change.10
The transfer institution and account-keeping institutions must fulfill the following obligations in the new system.
1. The obligation to resolve "overbooking" of JGBs
If the transfer institution or an account-keeping institution records, for some reason, an amount larger than the correct amount in a JGB account on its books, and if JGBs corresponding to that excess balance are transferred to a bona fide purchaser, this will result in the total amount of JGBs held in the JGB Book-entry System exceeding the total amount outstanding of book-entry JGBs. Such recording of an excess balance is called "overbooking."
If overbooking occurs, the transfer institution or the account-keeping institution responsible for overbooking (hereafter "overbooking institution") is required, pursuant to the Transfer of Corporate Debt Securities Law, to resolve the overbooking, so that the total JGBs recorded in the system match the actual amount outstanding of book-entry JGBs issued.11
2. The obligation to conclude a contract in which responsibility is assumed jointly and severally in relation to customers
In relation to the problem of overbooking explained above, there could be a case where the dates for interest and principal payments arrive before the overbooking institution fulfills its obligation to resolve overbooking. In such cases, the overbooking institution has an obligation to pay interest and principal in place of the issuer and compensate for any loss or damage.
The Transfer of Corporate Debt Securities Law requires each settlement institution in the tiers below the overbooking institution to guarantee jointly and severally the obligation of the overbooking institution to pay interest and principal and compensate for any loss or damage to the settlement institution's own customers.
Specifically, each account-keeping institution will be required to include a clause in its contract with its customers stating that it will guarantee jointly and severally the obligation of overbooking institutions in the tiers above it to make interest and principal payments or pay compensation to "general investors," i.e., investors other than institutional investors, the government, regional public bodies, and the like.
However, this obligation will not apply when the account-keeping institution is a foreign financial institution providing custody services in foreign countries for JGBs and equivalent securities, and is designated by the competent ministers.
3. The obligation to contribute to the investor protection trust
The investor protection trust is a scheme to compensate for any loss or damage to general investors up to a certain amount, in the event an account-keeping institution becomes insolvent before fulfilling its obligations to make interest or principal payments and compensate for any loss or damage as explained in 2. above.
The transfer institution and account-keeping institutions are required to make contributions to the investor protection trust calculated according to the method determined by the transfer institution based on the criteria stipulated in the ordinance of the competent ministries.
The relevant parties will shortly start examining specific issues related to the details of contributions.
C. Other Changes
In addition to these changes, the following new services will be offered upon conversion to the new system. A document outlining the new services has been sent to participants.12
1. Handling of STRIPS
The Ministry of Finance plans to introduce STRIPS for some issues of JGBs upon conversion to the new system.
The bonds eligible for STRIPS will be book-entry JGBs designated by the Minister of Finance. For these securities, it will be possible to separate and consolidate the coupon and the principal, and transfer the principal and the coupon separately. Only incorporated entities will be eligible to hold the principal and coupon components created by STRIPS. The Bank plans to enable online processing of instructions for separation and consolidation of the interest and principal components of JGBs.
2. Handling of JGBs designed for individual investors
The Ministry of Finance plans to issue a new type of JGBs designed for individual investors. Such JGBs will be issued with floating interest rates, and can only be held by and transferred between individuals in principle. The minimum trading lot will be 10,000 yen, smaller than the 50,000 yen for ordinary JGBs. These JGBs will be issued only as book-entry JGBs and will be repayable before maturity under certain conditions.
3. Deposit (kyoutaku) of book-entry JGBs with public deposit offices
Currently, JGB certificates are used when JGBs are deposited with public deposit offices, but under the new system it will not be possible to convert book-entry JGBs into physical certificates. Thus, under the provisions of the Transfer of Corporate Debt Securities Law regarding deposit of book-entry JGBs, financial institutions which provide services to public deposit offices and are agents of the Bank will handle bookkeeping for book-entry JGBs deposited with public deposit offices.
A book-entry system is an accounting system that permits the electronic transfer of claims without the movement of paper documents or certificates.
JGB certificates and registered JGBs can be converted to book-entry JGBs at the request of the holder under the new system, provided that they are (1) issued on and before a date within five years after the Transfer of Corporate Debt Securities Law comes into effect, which date will be specified by a Cabinet Order; and (2) designated by the Minister of Finance.
In the current system, the obligations of the central securities depository (the Bank) and the participants are stipulated in the contracts between the Bank and the participants and the "Regulations concerning the JGB Book-entry System." In the new system, the obligations of the transfer institution and account-keeping institutions will be governed by the Transfer of Corporate Debt Securities Law, the related Cabinet Order and ministerial ordinance, and regulations and rules set by the transfer institution.
When the total amount of a certain issue of JGBs on the book of the overbooking institution exceeds the total amount of the issue recorded in the customer account on the books of the account-keeping institution or the transfer institution with which the overbooking institution holds accounts (hereafter the "settlement institution directly above"), the overbooking institution is required to balance out the excess amount by obtaining JGBs of the same issue, in an amount equivalent to the overbooking, to increase JGBs held with the settlement institution directly above.
In the current system, when overbooking occurs and the amount overbooked is transferred to a bona fide purchaser, it is deemed that the participant responsible for overbooking has an obligation to compensate customers who suffer any loss or damage due to overbooking.
|12||"Conversion to the New JGB Book-entry System" prepared in Japanese by the Operations Department of the Bank of Japan and sent to participants on June 21, 2002.|
V. Steps toward the Conversion
A. The Bank's Preparations
The Bank plans to abolish the current JGB Book-entry System and start the new system around January 27, 2003. The Bank will take necessary measures in preparation for the conversion.
In order to abolish the current system and start the new system, the following three conditions must be met. First, that cabinet orders and ministerial ordinances necessary to enforce the Transfer of Corporate Debt Securities Law are promulgated and put into effect, and that it is confirmed that the Bank can operate the new system based on these orders and rules. Second, that the Bank fulfills requirements under the Transfer of Corporate Debt Securities Law and the Bank of Japan Law, including designation by the competent ministries as an institution providing securities settlement services pursuant to the Transfer of Corporate Debt Securities Law. And third, that sufficient progress has been made with preparations by the Bank and financial institutions participating in the new system.
The Bank will carry forward its own preparations for the conversion to the new system, at the same time keeping in close communication with participants in the current system to support their preparations. The Bank plans to inform relevant parties about the start of the new system in early 2003.
B. Confirmation of JGB Holders' Approval for the Conversion of Their JGBs
Before the conversion to the new system, the Bank will require participants to confirm with JGB holders in the current system whether they approve the conversion of their JGBs.
Once these procedures are complete, the Bank will, at the time of the system conversion, convert JGBs held in the current system by JGB holders whose approval has been confirmed to JGBs in the new system. The Bank plans to return JGBs to (1) JGB holders who have withheld approval, in the form of either JGB certificates or registered JGBs as requested by the JGB holder; and (2) participants who maintain JGB accounts for JGB holders whose intent could not be confirmed before the conversion, in the form of JGB certificates.
The Bank is determined to achieve a smooth conversion to the new system, and will continue its efforts to enhance the safety and efficiency of JGB settlement. The Bank hopes that JGB holders and other relevant parties will understand the purpose of the conversion, and that they will cooperate with the Bank in the process of preparations.