The DVP Report defined systemic risk in a securities settlement system as the risk that the inability of one institution to meet its obligations when due will cause other institutions to fail to meet their obligations when due. The Report noted, however, that this is a very broad definition that covers some events that are unlikely to be of serious concern to central banks. For example, the failure of one institution to deliver a security often causes the institution that had anticipated receipt of the security to fail to meet its obligation to redeliver the security. Central banks are primarily concerned with potential credit losses or liquidity pressures that are on such a scale that they cannot be managed and contained within existing contractual and banking arrangements. Such losses or pressures could threaten the stability of payment systems and financial markets if spillover effects caused widespread difficulties at other firms, in other market segments or in the financial system as a whole. The evolution of a systemic crisis generally involves an initial shock that causes the failure of one or more major financial institutions, which, in turn, impairs the financial system in at least one of three key areas: settlement, credit allocation or the holding or pricing of financial assets.

As discussed earlier, the DVP Report focused heavily on the management by individual CSDs of their credit and liquidity exposures to their direct participants. By its nature, a CSD concentrates settlement activity and related credit and liquidity risks. In particular, the Report emphasised that nearly all CSDs extend substantial amounts of intraday credit to their participants and that the failure of a major participant to repay such credit extensions could create liquidity pressures or losses of sufficient magnitude to create systemic problems. Thus, an important determinant of the degree of systemic risk in a securities settlement system is the effectiveness of the risk controls that a CSD imposes to limit potential liquidity pressures and credit losses from the failure of one or more of its direct participants.

Perhaps the single most important conclusion of this study is that, in analysing risks in securities settlements, greater attention must be paid to other intermediaries in the settlement process. Even in domestic securities trades, multiple intermediaries (in addition to CSDs) are often involved in the custody of securities or the settlement of securities trades. These intermediaries may include banks acting as custodians or money settlement agents, clearing corporations that compare and net trades, money managers and securities brokers and dealers. The performance of these intermediaries is a critical factor in the timely completion of settlement and access by participants and their customers to final settlement proceeds and securities. The failure of any intermediary in the settlement process to meet its obligations could create systemic credit and liquidity problems, especially if settlement activity were centralised in the intermediary, as it is in CSDs, clearing corporations (where one exists), money settlement agents, and often custodians. As has been noted repeatedly, the use of additional settlement intermediaries is pervasive in cross-border settlement arrangements. As a result, risks in cross-border settlements tend to be concentrated in such intermediaries, especially in the ICSDs and in certain local agents, to a greater degree than is typically the case in domestic settlements.

The potential for financial or operational problems at one of these intermediaries to cause systemic problems is most clearly evident in the case of the ICSDs. The ICSDs are now involved in a significant portion of total settlement activity for certain European government securities. To facilitate such settlements, especially cross-system settlements, the ICSDs extend substantial amounts of credit to their participants and to one another. Moreover, because of differences in the hours of operation and the timing of finality between the ICSDs and the various national securities and funds transfer systems, the duration of these exposures is often considerably longer than that of the exposures faced by local CSDs. The risk controls imposed by the ICSDs - binding credit limits and collateral requirements - are far more stringent than those usually imposed by local CSDs. Nonetheless, the risks involved are quite substantial and have been growing rapidly. The ICSDs have attempted to strengthen their local market linkages in ways that would reduce the credit demands of their participants and the associated risks, but, as has been discussed, the lack of intraday finality in many local systems has limited the effectiveness of these efforts and created new sources of risk. If, despite its efforts, an ICSD were to experience a significant financial or operational problem, the effects would be transmitted rapidly to numerous local markets through the linkages that have been established.

Although the operations of the ICSDs and their implications need to be understood more clearly, a significant conclusion of this report is that the potential for other intermediaries involved in cross-border settlements to be a source of systemic disturbances also needs to be carefully examined. As discussed in the previous section, local agents in some markets have reportedly attracted the critical mass of customers necessary to settle significant volumes of trades internally. Such agents are a critical component of the local market infrastructure, and systemic problems could well emerge if their financial or operational integrity were impaired. Moreover, the rules and procedures under which trades are settled on the books of such intermediaries and the risk controls that they impose are typically far less transparent than the rules, procedures and controls of the ICSDs. Bankruptcy or fraud at a major custodian could also have systemic implications, even if the intermediary does not settle trades on its own books. The consequences of a significant shortfall in the securities needed to meet the claims of custody customers could be quickly transmitted throughout the financial system. The direct custody customers could experience a sharp decline in their net worth and might lack the assets needed to obtain secured financing. If the custodian maintains accounts for other custodians, the financial integrity of the other custodians and their customers could be undermined.

In general, the potential for disruptions to cross-border settlement arrangements (whether they involved the ICSDs, other key non-resident intermediaries or large non-resident traders) to cause systemic problems is heightened by the difficulties that central banks and other national authorities would be likely to encounter in containing a disturbance. Such containment difficulties might arise because of choice of law and conflict of laws problems, because non-residents had limited access to liquidity, or because of limitations on national authorities' ability to intervene effectively.

Choice of law and conflict of laws problems might create uncertainty regarding the finality of transfer, ownership interests or collateral rights. In particular, such problems might complicate the use of collateral to mitigate credit exposures arising in cross-border transactions. In addition, differences in bankruptcy law could result in uncertain or conflicting outcomes regarding the disposition of securities in the event of a counterparty's or intermediary's insolvency. Predictability of outcome is essential in efforts to contain financial problems, but widely divergent legal frameworks make predictability hard to achieve in a cross-border context.

Disturbances might also be difficult to contain because of difficulties in obtaining liquidity. Non-resident counterparties to cross-border securities trades, and also key non-resident intermediaries involved in settling such trades, might encounter difficulties in obtaining adequate liquidity in order to complete settlement in a timely manner, particularly during periods of market stress. Access by non-resident counterparties or intermediaries to local money markets, credit lines and repos or securities loans might be severely limited, either because their creditworthiness is more difficult for local lenders to ascertain or because of legal concerns or limitations on participation in local money markets. Time zone differences could complicate efforts by non-residents to meet funding requirements by tapping liquidity sources in their home country and exchanging the proceeds for balances in the local currency.

Relevant national authorities (central banks and securities supervisors) might also face difficulties because of coordination problems, limitations on existing supervisory tools and limited access to lender-of-last-resort facilities by non-residents. Unresolved questions of extraterritoriality and allocation of transnational oversight responsibilities could further constrain a national authority's flexibility and effectiveness in responding in a timely manner to a cross-border systemic crisis. Addressing cross-border systemic disruptions would generally require coordinated action by the authorities affected in several countries.

5.3 Implications for central bank oversight

The critical role in cross-border settlement arrangements played by intermediaries other than the local CSD poses challenges to central bank oversight of domestic money markets and payment and settlement systems. The most basic challenge stems from the lack of transparency in cross-border settlement arrangements. The use of multiple channels for settling cross-border trades and the involvement of multiple intermediaries entail considerable complexity. Even after publication and dissemination of this study, central banks are unlikely to have as clear an understanding of cross-border arrangements as they do of their domestic systems, in which settlement procedures tend to be more uniform and more information tends to be available about the activities and financial condition of key intermediaries.

Another basic challenge stems from the concentration of settlement activity in home country securities in foreign intermediaries, including global custodians and especially ICSDs. If foreign investors and securities dealers play an important role in the markets for home country securities, such foreign settlement intermediaries can constitute an integral part of the settlement system for those securities. For example, the ICSDs have unquestionably come to be an integral part of the settlement systems for certain European government securities. In such circumstances, the rules and procedures of these foreign intermediaries are a potential source of systemic disturbances to the settlement process for home country securities and, thereby, to domestic money markets and payment systems. A central bank and other domestic authorities may find, however, that they have only limited influence over the relevant rules and procedures.

If a systemic disturbance were to arise from a cross-border settlement arrangement, the home country central bank might face special challenges in containing it, for the reasons noted earlier. To begin with, the home country central bank may learn of the disturbance more slowly. Containing the disturbance would probably require the cooperation of central banks, banking supervisors and securities supervisors in several jurisdictions. And the complexity of the arrangements, their lack of transparency and the need to deal with multiple legal jurisdictions could hinder their efforts.