The costs and risks incurred in an internal settlement through an ICSD can differ significantly from the costs and risks involved in settling in the local market. Economies of scale and a high degree of automation allow the ICSDs to charge fees for internal settlements that are often much lower than settlement fees charged by local agents. The risks associated with internal settlements are determined by the ICSD's rules and procedures and by the services that it provides, which can differ significantly from the rules and procedures in the local market and the services provided by local agents. The ICSDs are best thought of as model 1 DVP systems; although transfer instructions are processed in a series of batches during the night before the settlement date rather than on a real-time basis, within each batch processing cycle individual transfer instructions are settled on a gross rather than a net basis. Because DVP is achieved, internal settlements do not involve principal risk, even if principal risks arise in the local market. On the other hand, replacement cost risks may currently be higher than in the local market because the interval between trade and settlement is longer. ICSD participants often choose to settle according to the rules established by the International Securities Market Association (ISMA), which, as noted earlier, currently provide for a longer settlement interval than most local markets. When ISMA implements T+3 settlement in mid-1995 this difference in replacement cost risks will disappear for most securities.

Internal settlements of trades by the ICSDs can often be effected with smaller securities balances and cash balances than would be required if a local agent were employed, implying lower opportunity costs, liquidity risks and cash deposit risks. On the securities side, same-day turnaround of internal receipts for internal delivery is always possible, whereas, as already discussed, in some local markets securities dealers that are not direct participants in the CSD may be required to pre-position securities or borrow securities to meet their delivery obligations.

On the cash side, extensions of credit by the ICSDs, combined with the timing of their processing cycles and their reporting of processing results, greatly facilitate their participants' efforts to economise on their holdings of cash balances. Credit is extended by allowing pre-advices of funds to be received on S to be used during night-time processing on S-1 and by permitting overdrafts on funds accounts. Because funds positions are reported early in the European business day, for most currencies participants can cover overdrafts or wire out excess funds on S, without incurring overdraft charges or losing opportunities for the investment of funds received. Lower cash balances imply lower opportunity costs and smaller cash deposit risks. In addition, the reporting of results early in the day reduces liquidity risks by reducing uncertainty about funding requirements and by allowing more time to meet the requirements.

Of course, extensions of credit to participants expose the ICSDs to credit and liquidity risks. They seek to minimise these risks by imposing credit limits and collateralisation requirements on their participants and by maintaining credit lines with their cash correspondents in the various local markets. Nonetheless, the risks associated with these credit extensions may be greater than the risks associated with credit extensions by local CSDs or local agents because the duration of the exposures is generally longer. The exposure is created during the night of S-1 and is not extinguished until payment is received from the participant. Given the hours of operation of the various national payment systems, funds transfers from participants are often not final until quite late on S. The collateralisation of such credit exposures diminishes the risks, but the benefits of collateralisation may in some cases be limited by choice of law and conflict of laws issues, which can create ambiguities about the effectiveness of the liens on securities.

In contrast to internal settlements, the costs and risks involved in cross-system settlements of trades between ICSD participants and local market participants are heavily influenced by local market practices. DVP is achieved only if the local CSD achieves DVP, and the settlement interval typically follows the local market convention. Moreover, the design and operation of many of the links to the local markets require ICSD participants to maintain higher balances of cash or securities than are necessary to settle trades in the local market, or require the ICSDs to extend substantial amounts of credit to obviate the need for the higher balances.

The basic source of these inefficiencies in cross-system settlements is that a settlement can be completed only if the seller has sufficient securities (or access to a securities loan) and if the buyer has sufficient funds (or access to credit). In a cross-system settlement, determining that both conditions are satisfied requires an exchange of information between the two systems. Depending on the number and timing of settlement cycles, this exchange of information can take one or even two days to complete. In such circumstances, the seller may be required to pre-position (or borrow) securities and the buyer may be required to pre-position (or borrow) funds one or two days before the settlement date. Such requirements imply substantial opportunity costs for participants, especially for securities dealers that engage in back-to-back trades. In some cases, however, the ICSDs have loaned funds or securities on a subsidised (or even uncompensated) basis to mitigate the costs and risks to their participants. Of course, such facilities simply shift the costs and risks to the ICSDs rather than reducing them.

These same inefficiencies until recently added significantly to the costs and risks involved in cross-system settlements between participants in the two ICSDs effected via the bridge between the two systems. However, enhancements introduced in September 1993 largely eliminated the inefficiencies and the associated costs and risks. A full description and analysis of the bridge, including the recent enhancements, are provided in Annex 4. In summary, under the old bridge arrangement, both Cedel and Euroclear performed a single batch processing of delivery instructions for any settlement date S. Consequently, the necessary exchange of information about the availability of funds and securities balances could not be completed in a single day. This created inefficiencies, especially for Cedel and its participants. In particular, if a Cedel participant sought to complete delivery of securities to a Euroclear participant for settlement on S, it needed to pre-position the securities in its account on S-1. If it did not have the securities, however, Cedel would attempt to arrange a securities loan and would subsidise its participant by waiving the usual borrowing fee. Cedel would then block the securities and transmit the settlement instructions to Euroclear for processing during Euroclear's night-time cycle. If the Euroclear participant had sufficient cash (or credit), the delivery would become final on S and be reported back to Cedel and (by Cedel) to the Cedel participant. If the Cedel participant did not have the securities available until S, it would not receive the funds until S+1. To remain competitive with Euroclear, however, Cedel subsidised its participants by backvaluing cash receipts from securities deliveries. Still, under the old bridge arrangement it was not possible for a Cedel participant to receive a security from a Euroclear participant for value S and turn around the security for on-delivery to a Euroclear participant for the same value date (to settle back-to-back trades of that pattern).

Under the new bridge arrangement, both Cedel and Euroclear transfer files containing proposed deliveries and feedbacks of accepted and rejected deliveries several times each night and run several batch processing cycles in order to release securities for delivery from one run to the next. With this agreement in place, the necessary exchange of information about the availability of securities and funds (proposed deliveries and feedbacks) can be completed during the same night. Consequently, a Cedel participant that has received a security on S can redeliver that security to a Euroclear participant on S, even if it was received from a Euroclear participant. Thus, the costs to Cedel participants of pre-positioning securities (and the costs to Cedel of providing subsidies) have largely been eliminated, and Cedel participants can settle back-to-back trades with Euroclear participants.

Settlements of trades between ICSD participants and local market participants continue to pose difficulties. Specifically, as illustrated in Chart 4, the processing cycles for the local settlement systems typically occur during the local business day and, therefore, after the ICSDs' processing and settlement cycles have been completed. In such cases, an ICSD participant cannot settle back-to-back trades in which it receives securities in the local market and seeks to deliver the same securities to another ICSD participant or back to the local market. Instead, it must pre-position the securities on S-1 and incur added financing costs and liquidity pressures, or it must borrow the securities during the ICSD's night-time processing cycle. The ICSDs have developed programmes that provide what are effectively intraday securities loans in anticipation of local market receipts. Such intraday loans are usually provided free of charge or at a fraction of the cost of overnight securities loans. In some cases, however, the effectiveness of these intraday lending programmes is significantly limited by the size of the pools of lendable securities held by the ICSDs.

The ability to settle efficiently back-to-back trades involving local market participants has become increasingly important because of the growing use of repos in trading and financing European government securities. Some of the most active ICSD participants tend to trade securities with other dealers that settle through the ICSDs, while they tend to engage in repos with local market participants. In some cases, the inefficiencies associated with cross-system settlements have prompted dealers to employ both an ICSD and a local agent in settling trades. All trades with other ICSD participants are settled in the ICSDs, while all trades with local market participants are settled through the local agent. The link between the dealer's ICSD and its agent in the local market is used only when necessary to rebalance securities holdings in the two locations. In other cases, the high costs of cross-system settlements have prompted some dealers to settle all of their trades, including trades with other ICSD participants, through a local agent.

The risks involved in extending credit to facilitate cross-system settlements and the actual and potential movement of settlement activity to local markets have motivated the ICSDs to attempt to improve the efficiency of their local market links. To this end, the ICSDs have supported the introduction by local CSDs of multiple processing cycles - at a minimum, one cycle before the night-time processing cycles at the ICSDs and one cycle after. For example, as described in Annex 5, in 1993 the German CSD introduced a same-day processing cycle (after the ICSDs' night-time processing cycles), while maintaining its standard processing cycle (before the ICSDs' processing cycles). This allows ICSD participants to complete same-day turnarounds of securities, regardless of from whom they are received (the local market or an ICSD participant) or to whom they are delivered.

As discussed earlier, a serious weakness of some of these links to local markets is that the transfers from the local market resulting from the evening processing cycle are not final until money settlement occurs the next day. If a local market participant were to fail to meet its money settlement obligations, provisional transfers of securities from that participant to ICSD participants might be unwound. Thus, these links create significant credit and liquidity interdependencies between the systems - disruptions from a settlement failure in the local market would promptly be transmitted to the ICSDs and their participants, possibly including participants that did not trade with the defaulting local market participant.

Even if CSD-to-CSD links (including those involving the ICSDs) are not vulnerable to unwinds of provisional transfers, they create significant operational interdependencies between settlement systems and can also create credit and liquidity interdependencies. An operational problem at one CSD would result in a failure to complete deliveries between their participants, which could affect the completion of deliveries at other CSDs, including CSDs not directly linked to the CSD with the operational problem. Furthermore, the provision of settlement services by linked CSDs has the potential to create credit and liquidity interdependencies. Such exposures arise when one CSD provides another CSD with a cash account and settles trades between its own participants and participants in the other CSD by debiting or crediting the other CSD's cash account. In effect, the second CSD is a participant in the first CSD and, like other participants, it may request and be granted substantial extensions of credit to enable it to avoid the opportunity costs associated with the need to prefund payments or to accept delayed availability of receipts.

Credit demands are likely to be especially large in links that allow settlements in multiple currencies. While prepayment or delayed availability may not be a problem in the case of the local currency or the currencies of countries in the same time zone as the first CSD, without such credit extensions currencies of countries in later time zones would need to be prepaid, and currencies in earlier time zones would not be available for investment. CSD-to-CSD credit extensions eliminate the opportunity costs of such cash requirements, but only by creating CSD-to-CSD credit exposures. As with credit exposures to participants, the duration of such exposures depends on the hours of operation of national payment systems.