THE WORLD BANK AND THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM TRAINING COURSE REFORMING PAYMENT AND SECURITIES SETTLEMENT SYSTEMS Washington, D.C., November 3-7, 2003

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THE WORLD BANK AND THE BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM TRAINING COURSEREFORMING
PAYMENT AND SECURITIES SETTLEMENT SYSTEMS
Washington, D.C., November 3-7, 2003

• IMPROVING SECURITIES SETTLEMENT SYSTEMS
• Mario Guadamillas, World Bank

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Content

• International standards as a guide for the reform
• A.1 Evolution of international (regional)
  standards
• A.2 Main factors identified
• Main challenges for SSSs
• B.1 Special consideration of CCPs
• C. Interrelations between payments and
  securities settlement systems
• D. Conclusions

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• The international standards provide a very
  helpful framework to systematize and address the
  main factors to be considered for a reform
• Despite the process of consolidation and
  generalization of accepted standards worldwide,
  some focus on minimum standards while others seek
  best practices
• There is closer attention by international
  standards to the interaction between payments and
  securities settlement systems

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• Group of Thirty Recommendations Regarding
  Securities Clearance and Settlement, 1990
• Objective reducing risk, improving efficiency
  and promoting greater standardization in
  international settlement
• - Trade comparison,Trade confirmation/affirmation
  , CSDs, Netting Schemes, DvP, Same day funds,
  Rolling settlement cycle, Securities lending,
  Common message standard
• Lamfalussy Minimum Standards, 1990
• Objective cross-border and multi-currency
  netting and settlement schemes
• - Legal basis, Financial risks, Management of
  credit and liquidity risks, Admission criteria,
  Operational reliability of netting schemes

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• Technical Committee of IOSCO, 1990
• Objective contribute to the process of
  creating an efficient central securities
  depository from a national regulatory point of
  view and, at the international level, offering
  views on how to create links in accordance to the
  recommendations issued on the subject
• - Regulatory aspects (including SRO role)
• - Liquidity risk
• - Industry organizational arrangements
• - Operational reliability
• - Endorses G30 recommendations

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• ISSA, 1995
• Objective amendment of G30 recommendations
• - Trade comparison in T0 instead of T1
• - Positive affirmation of trade details by
  indirect market participants by T1
• - Explicit reference to immobilization/demateria
  lization
• - Rules when several CSDs operate in a country
  in
• order to allow for use of funds and
  cross-collateral
• - Choice between a RTGS or Lamfalussy
• Recommendations compliant netting system for
  funds settlement

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• Emerging Markets Committe of IOSCO, 1997
• Objective study on the legal and regulatory
  framework for clearing and settlement in emerging
  markets
• - Legal and custody issues
• IOSCO, Objectives and Principles of Securities
  Regulation, 1998
• Objectives The principles are based upon three
  main objectives of securities regulation
  protection of investors ensure that markets are
  fair, efficient and transparent reduction of
  systemic risk
• - SSSs should be subject to regulatory
  oversight and designed to ensure that they are
  fair, effective and efficient and that thay
  reduce systemic risk

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• FIVB, Clearing and Settlement Best Practices
  Report, 1999
• Objective to enable FIBV members and their
  respective clearing and settlement organizations
  to score their performance against benchmarks and
  best practices, and to identify areas in their
  processes where improvements should be
  considered
• - Trade confirmation, Settlement cycles,
  Securities lending, CSDs and risk controls, DvP,
  Operational reliability, Efficiency, Netting
  schemes, Systems integration

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• ISSA, New Recommendations, 2000
• Objective to tackle key risks in todays world
  of settlement and clearance
• - Governance of infrastructure
• - Technology core processing
• - Technology messaging and standards
• - Uniform market practice
• - Reduction of settlement risk
• - Market linkages
• - Investor protection
• - Securities lending
• - Legal infrastructure

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• CPSS, Core Principles for Systemically Important
  Payment Systems, 2001
• Public Policy Objectives safety and
  efficiency
• Introduction of the SIPS concept
• - Ten principles legal foundation (CPI),
  understanding and management of risks (CP II and
  III), settlement (CPs IV-VI), security,
  operational reliability and contingency
  arrangements (CP VII), efficiency and
  practicality (CP VIII), criteria for
  participation (CP IX) and governance (CP X)
• - Four central banks responsibilities
  objectives and policy (A), observance of CPs (B
  and C), cooperation (D)
• - Not specific for SSSs but relevant

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• CPSS-IOSCO, Recommendations for SSSs, 2001
• Objective to promote implementation by SSSs of
  measures that can enhance international financial
  stability, reduce risks, increase efficiency and
  provide safeguards for investors by developing
  recommendations for the design, operation and
  oversight of such systems
• 19 Recommendations
• - Legal risk
• - Pre-settlement risk (including CCPs)
• - Settlement risk
• - Operational risk
• - Custody risk
• - Other issues (governance, access, efficiency,
  communication procedures and standards,
  transparecy, regulation and oversight, risks in
  cross-border links)

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS

• G30, New Recommendations, 2003
• Objective to establish a set of new
  recommendations focused on the cross-border and
  international context that go beyond minimum
  standards and try to identify best practices
• - Building a strengthened interoperable global
  network
• - Strengthening network safety and stability
• - Improving governance
• CPSS-IOSCO Task Force, Risk Management Standards
  for Central Counterparties, work in progress

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A.1 EVOLUTION OF REGIONAL STANDARDS

• EMI, Standards for the use of EU Securities
  Settlement Systems in ESCB Credit Operations,
  1998
• Objective assessing the soundness of SSSs
  seeking to qualify for involvement in monetary
  policy and intraday credit operations
• - Legal soundness
• - Settlement in central bank money
• - No undue custody risks
• - Regulation and/or control by competent
  authorities
• - Transparency of risks and conditions for
  participation in a system
• - Risk management procedures
• - Intraday finality of settlement
• - Operating hours and days
• - Operational reliability of technical systems
  and availability of adequate back-up facilities

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A.1 EVOLUTION OF REGIONAL STANDARDS

• Giovannini Group 1st Report, 15 Barriers to the
  EU CS Integration, 2002
• Giovannini Group 2nd Report, Action proposals for
  removing barriers, 2003
• Objective conduct a comprehensive analysis of
  clearing and settlement arrangements for
  equities, fixed-income securities and
  derivatives
• 15 Barriers to efficient cross-border
  settlement
• - Technical requirements/market practice
• - Differences in tax procedures
• - Issues related to legal certainty

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A.1 EVOLUTION OF REGIONAL STANDARDS

• ESCB-CESR Standards for Securities Clearing and
  Settlement Systems in the European Union
  (consultative report), 2003
• Objective to increase the safety, soundness
  and efficiency of securities clearing and
  settlement systems in the European Union
• - Based on CPSS-IOSCO recommendations
• - Beyond recommendations (standards) to be
  used as a regulatory tool
• - Identifying systemically important
  institutions
• - Standards to major custodian banks

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A.1 EVOLUTION OF INTERNATIONAL STANDARDS (SUMMARY)
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A.2 MAIN FACTORS IDENTIFIED

• Legal custody
• CS processes trade confirmation, settlement
  cycles, systems integration, securities lending,
  communication procedures standards and securities
  identification
• Settlement risk CSDs, DvP, timing of settlement
  finality, risk management mechanisms, cash
  settlement assets,netting versus gross schemes,
  liquidity risk
• CCPs
• Operational reliability
• RegulatoryOversight (including SRO role)
• Organizational arrangements participation
  requirements, governance, transparency
• Cross-border
• Cost-efficiency

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A.2 MAIN FACTORS IDENTIFIED
LEGALCUSTODY
CS PROCESSES
SETTLEMENT RISK
CCP
OPERATIONAL
REG.OVERSIGHT
ORG.
ARRANGEMENTS
CROSS-BORDER
COST-EFFICIENCY
G30
IOSCO
G30/ISSA
IOSCO
IOSCO
FIBV
ISSA
CPSS IOSCO
NEWG30
1989
1990
1995
1997
1998
1999
2000
2002
2001
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B. MAIN CHALLENGES FOR SSSs

• Legal Framework and Custody Risk
• - Trading takes place global while underlying
  legal systems continue to be domestic
• Absence of a unique framework for the treatment
  of security interests
• Problems with legal certainty in collateralized
  transactions
• Uneven application of national conflict of law
  rules
• - Finality importance to adapt financial
  institutions bankruptcy legislation to protect
  SSSs
• - Enforceability of security interests provided
  under collateral arrangements, legal basis for
  netting, electronic documents and signatures
  (for developing systems)

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B. MAIN CHALLENGES FOR SSSs

• Clearing and settlement processes
• - Standardization of messaging standards and
  communication protocols
• - Synchronization of timing among systems
• - National differences in settlement cycles
• - Tax and other impediments to securities lending
  and borrowing
• - Mix of securities and money markets settlement
  procedures creates problems for market
  development (different settlement needs)
• - Diversity of trading and settlement mechanims
  and procedures even for similar type of
  securities
• - Eliminate paper processing (for developing
  systems)

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B. MAIN CHALLENGES FOR SSSs

• Settlement risk
• - CCPs risk reduction but higher risk
  concentration
• - Increasing need to ensure financial integrity.
  Delicate balance between access and competition
• - Reduction of the settlement cycle not always
  accompanied by reduction of settlement risk
• - Systemically important systems must have
  adequate risk management mechanisms
• - Settlement assurance procedures (for developing
  systems)

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B. MAIN CHALLENGES FOR SSSs

• Operational issues
• Interoperability of global network (more than
  technical compability of systems)
• - Global identification methodology to facilitate
  STP
• - National differences in IT and interfaces
• - Practical impediments to remote access
• Need to accommodate increasing volume of traffic
  and volatility in markets
• Adequate contingency procedures and back- up
  systems (for developing systems)

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B. MAIN CHALLENGES FOR SSSs

• Regulation oversight
• Increasing importance of settlement issues for
  securities regulators and role of SROs
• - No role in operating systems
• - More attention to regulation and oversight.
  Dual roles public policy framework for
  competition and prudential oversight
• - Increasing need to coordinate with other
  regulators/supervisors, specially central bank,
  both domestically and internationally
• - Interaction with private sector through SROs.
  Importance of overlaps/gaps in regulation and
  supervision

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B. MAIN CHALLENGES FOR SSSs

• Organizational arrangements
• Governance of infrastructure is a key issue for
  markets integration
• - Transparency full disclosure to system users
• - Non discrimination fair access to SSSs
• - No single group or single interest group with
  majority control
• - Effective attention to users interests
• Access to liquidity can be an important obstacle
  (interaction with funds transfer system)

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B. MAIN CHALLENGES FOR SSSs

• Cross-border settlement
• - Inconsistent legal and regulatory
  underpinnings
• - Lack of globally recognized technical
  standards
• - Differing business processes
• - Differences in tax procedures
• These problems lead to higher costs due to
• - Direct costs from higher fees of the services
  provided
• - Indirect costs from extra back-office
  facilities
• - Opportunity costs from inefficient use of
  collateral and higher incidence of failed trades

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B. MAIN CHALLENGES FOR SSSs

• Cost-efficiency issues
• - Level of market competition on clearing and
  settlement organizations is low (lack of direct
  competitors to use as a benchmark), thus,
  alternatively in-house unit costing techniques
  need to be developed.
• - Composition on costs is changing rapidly with
  diminishing IT costs. Increasing use of
  outsourcing
• - Considerable variation around the world in
  SSSs charging arrangements (standard, ad valorem)
• - Small value transactions normally subsidized by
  imposing higher charges on large value
  transactions.
• - Many systems may be under-recovering their
  operating costs

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B.1. SPECIAL CONSIDERATION OF CCPs

• Benefits
• Attributed to multilateral netting
• - Reduction in the number of settlements
• - Reduction in individual contractual obligations
• - May help reduce the margins required to
  collateralize current and potential future
  credit exposures
• - May help to reduce the capital required to
  support participants trading activity
• - Helps to sustain anonymity where trade
  execution process itself is anonymous

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B.1. SPECIAL CONSIDERATION OF CCPs

• Benefits
• Provides risk management services
• - Replaces exposures to multiple counterparties
  with a single exposure to a single counterparty
• - No worry about the creditworthiness to a single
  counterparty
• - Does not eliminate counterparty credit risk,
  but redistribute it much more efficiently than
  market participants could do in isolation

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B.1. SPECIAL CONSIDERATION OF CCPs

• Risks
• Legal and technical risks (not specific to CCPs
  but higher potential systemic impact)
• Principal risk (reduction but concentration)
• Replacement cost risks (not specific to CCPs but
  higher potential systemic impact)
• Risk management tools
• Financial and operational requirements (to
  minimize probability of failure of a market
  participant)
• Margins (to minimize the loss if a participants
  fails)
• Limit build-up of exposures by means of periodic
  settlement of positions (normally used in
  derivative markets)

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B.1. SPECIAL CONSIDERATION OF CCPs

• Main concerns
• Concentration of risk
• Moral hazard (too big to fail)
• Information asymmetry is reduced but only if CCP
  is perceived to be solvent
• Competition between CCPs could negatively affect
  risk management standards
• A single CCP would maximize externalities and
  economies of scale but could produce potential
  inefficiencies (lack of innovation). Need of
  appropriate governance rules
• Contagion effects (cross-process, cross-products,
  cross currencies)

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B.1. SPECIAL CONSIDERATION OF CCPs

• Main issues to be considered
• Legal Framework
• Participation Requirements
• Understanding Risks
• Novation
• Settlement
• Default Procedures
• Risk Controls
• Margins/Guarantee fund/Loss Sharing
• Governance
• Operational Risk
• Regulatory Reporting

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C. INTERRELATIONS BETWEEN PAYMENTS AND SECURITIES
SETTLEMENT SYSTEMS

• Timing of settlement finality
• Careful analysis of design, procedures,
  operational timetables and funding cut-off times
• SSSs settlement end-of-day, intra-day,
  real-time?
• Cash settlement asset and settlement agent risks
• Is central bank money used?
• Credit, liquidity, and operational risks
• Management of a settlement agents failure
• Concentration of settlement flows
• Who has access to the funds transfer system
• Participants ability to choose a settlement
  agent
• Range of services provided by agent
• Participants views on agents competitive
  neutrality
• Arrangements for funding/defunding accounts

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C. INTERRELATIONS BETWEEN PAYMENTS AND SECURITIES
SETTLEMENT SYSTEMS

• Higher potential contagion effects in the
  financial system from the use of CCPs
• Impact of SSSs on the implementation of monetary
  policy
• Impact of SSSs on the liquidity management of the
  system (increasingly important with the
  generalized use of RTGS systems)
• Impact of SSSs on the fiscal policy (especially
  for development markets)
• Need of coordination between central bank and
  securities regulator

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D. MAIN CONCLUSIONS

• New approach for SSSs
• Integration of payments and securities settlement
• SSSs recognized as incurring same inherent risks
  as those associated with SIPS
• Consolidation of SSSs functions (efficiency
  gains, risk reduction, higher concentration of
  risk)
• Cross-border settlement main obstacles
  differences in legal regulatory frameworks,
  lack of enough technical and processes
  standardization, differences in tax procedures
• Domestic settlement main challenges legal issues
  (finality, collateral), adequate risk management
  procedures (beyond DvP), adequate coordination
  with other regulators and cooperation with the
  private sector
• SSSs reform an on-going process