Even if the settlement interval conforms to the local market convention, in some other respects the risks faced by a non-resident settling through a local agent differ from the risks faced by a direct participant in the local CSD. As was noted above and as is discussed in more detail in Annex 3, the involvement of intermediaries in the holding of securities and the settling of trades necessarily creates new legal relationships and new risks. Perhaps the most basic difference in risks is that the non-resident faces custody risk - the potential loss of the securities held in custody in the event that the local agent becomes insolvent, acts negligently or commits fraud.

In addition to custody risk, a non-resident counterparty that utilises a local agent may face greater cash deposit risks. As noted earlier, CSDs typically extend substantial amounts of intraday credit to their participants, thereby enabling them to settle trades with smaller cash balances than would otherwise be necessary. Unless local agents are equally willing to extend intraday credit to non-resident counterparties, such counterparties would be compelled to hold larger balances than direct participants to effect their trades, implying higher opportunity costs and greater cash deposit risks.

The amounts of intraday credit required to obviate the need for the cash balances and mitigate the associated risks depend on the number and timing of processing cycles in the local funds and securities transfer systems and the timing of finality in those systems. In a model 1 DVP system, a non-resident buyer would need to prefund on S-1 if confirmation of payments for value S occurs only after the CSD's deadline for crediting cash balances for use during the processing cycle for S. In DVP models 2 or 3, a non-resident seller would be forced to accept delayed availability if funds transfers resulting from the securities processing cycle are not final until after the deadline for inputting funds transfer instructions for value S.

To reduce the need for balances and the associated risks, in a model 1 DVP system the local agent would need to allow non-resident buyers to overdraw their funds accounts. In model 2 or model 3 systems, the local agent would need to accept instructions to wire out funds prior to, and in anticipation of, settlement. In either case, the local agent is exposed to credit risk and liquidity risk in the event that the non-resident fails to repay the credit extension, and would need to develop internal controls to manage those risks.

Non-resident securities dealers that settle through local agents may also need considerable volumes of intraday securities loans if they are to avoid substantial opportunity costs and liquidity risks. The need for such securities loans can arise in the settlement of back-to-back trades, which, as noted earlier, has become increasingly important as trading of European government securities and related derivative products has grown and as dealers have come to rely more heavily on repos and reverse repos in their financing and position-taking.

The settlement of back-to-back trades by non-residents and other trade counterparties that are not direct participants often poses a dilemma for local agents when local CSDs: (1) process securities transfer instructions in a single processing cycle; and (2) provide local agents with a single omnibus securities account for their customers rather than with individual sub-accounts. With only a single processing cycle, the local agent must input the instruction to deliver out the securities prior to the processing cycle and, therefore, prior to receipt of the security. If its customer fails to receive the security, its instruction to deliver the security may nonetheless be executed, using securities held for other customers of the local agent.

In such systems, if the local agent inputs a customer's instruction to deliver out the securities in anticipation of the customer's receipt of the securities during the same processing cycle, it is, in effect, extending an intraday securities loan to the customer. If the securities are not received as anticipated, the intraday loan becomes an overnight loan. In such circumstances, if the local agent does not own the securities itself, it would need to borrow them, either externally (often via a reverse repo) or internally (from another of its customers). If it fails to do so, it creates a shortfall in its custodial holdings, which may give rise to significant custody risks for other holders of those securities. Local agents attempt to minimise the need to borrow securities, and the risk of shortfalls if they are unable to do so, by prematching settlement instructions with the local agents employed by their customers' counterparties. Usually, they attempt to prematch the instructions to receive securities before prematching instructions to deliver out securities. Even when instructions are prematched, however, some instructions inevitably fail to settle as anticipated.

An alternative solution to problems in settling back-to-back trades through omnibus accounts at CSDs is for a local agent to settle both trades on its own books. Such a local agent is effectively operating a securities transfer system. This is possible only if all counterparties involved in the back-to-back trades use the same local agent. However, custody and settlement are highly concentrated businesses in many local markets, and in some markets local agents have reportedly encouraged further concentration by introducing lower fees for trades that can be settled internally, that is, on the local agent's own books. However, while settling trades internally reduces the costs and risks described earlier, it does not eliminate them. A local agent's customers expect it to settle their trades with counterparties that are direct participants in the CSD and with counterparties that use other local agents, including back-to-back trades in which the customer is receiving securities from such counterparties for redelivery internally.

Finally, in some local markets (for example, the United States), the need for back-to-back settlements is reduced significantly by the operation of multilateral trade netting systems. However, these netting systems typically do not include all trade counterparties or all transactions. In particular, membership tends to be restricted largely to securities dealers, and financing transactions (for example repos) may be excluded. Consequently, even with a multilateral trade netting system the settlement of back-to-back trades could remain a significant issue in markets in which the local CSD employs a single batch processing cycle and dealers' trades are settled through omnibus accounts at the CSD. In any event, the design and operation of multilateral trade netting systems for securities raise significant public policy issues, similar to those raised by proposals to create multilateral netting systems for foreign exchange contracts.