2.1 The process of clearing and settling a securities trade includes a number of key steps, including the matching of the terms of the trade, the calculation of the obligations of the counterparties as a consequence of matched trades (clearance), the discharge of those obligations (settlement) through the final transfer of securities (delivery) and the final transfer of funds (payment). Although a number of these steps may not directly involve the securities settlement system, which is the focus of interest of this study, an understanding of each of the steps is essential to an understanding of the nature and sources of risk that are faced by the operator of the settlement system or by other participants in the system.

2.2 The process begins with the execution of the trade. A variety of trade execution systems are in use in the G-10 countries, ranging from the "open outcry" systems that have traditionally been used on stock exchanges, to the networks of telecommunications links that have traditionally been used in the over-the-counter markets, to automated trade execution systems based on links between computers.⁷ Once a trade is executed, the next step is to ensure that the counterparties to the trade (the buyer and the seller) agree on the terms of the transaction - the security involved, the price, the amount to be exchanged, the settlement date and the counterparty. This step is referred to in some markets as trade matching and in others as trade comparison or checking. In automated trade execution systems, counterparties often agree that trades will settle as recorded at the time of execution unless both agree to a cancellation; such trades are referred to as "locked-in" trades. In other trade execution systems matching is typically performed by an exchange, a clearing corporation or trade association, or by the settlement system. Direct market participants may execute trades not only for their own accounts but also for the accounts of customers, including institutional investors and retail investors. In this case, the direct market participant may be required to notify its customer (or its agent) of the details of the trade and allow the customer to positively affirm the details, a process referred to as trade confirmation or affirmation. As part of its overall strategy to reduce delays between the execution of a trade and its settlement, the Group of Thirty recommended that by 1990 trade matching should be accomplished by trade date plus one day (T + 1) and that by 1992 institutional investors should be members of a trade confirmation system.

2.3 Trade matching and confirmation set the stage for trade clearance, that is, for the computation of the obligations of the counterparties to make deliveries or payments on the settlement date.⁸ The obligations arising from securities trades are sometimes subject to netting. As in the payments and foreign exchange areas, netting arrangements in the securities markets take a variety of forms that have varying degrees of legal enforceability in the event of bankruptcy of one of the counterparties. Multilateral netting arrangements, for example, include position netting schemes as well as systems that involve substitution of a central counterparty and novation of trades with that central counterparty. In the majority of markets, however, no multilateral trade netting occurs and bilateral netting, if practiced at all, is not widespread. The Group of Thirty recommended that the potential benefits of a trade netting system should be studied and, if appropriate, implemented. In many securities markets, however, participants have questioned whether the volume of trading (in the market as a whole and in particular issues) is large enough for netting to produce benefits that are sufficient to justify the costs of setting up such arrangements.

2.4 Once the obligations of the market participants have been calculated, whether on a gross basis, a bilateral net basis or a multilateral net basis, the instructions to transfer the securities and funds (money) necessary to discharge the obligations must be transmitted to the entity or entities that operate the settlement system. These instructions may be prepared by the counterparties themselves or by an exchange or clearing system (which may perform trade matching and perhaps netting as well). If trades have not previously been matched, the settlement system would typically perform this function before initiating processing of the transfer instructions. Other action may be required of participants before settlement can proceed, such as the prepositioning of securities, funds or collateral. The time required to complete these and previous steps currently varies greatly from market to market. The Group of Thirty recommended that settlement occur no later than T +3.

2.5 Settlement of a securities trade involves the transfer of the securities from the seller to the buyer and the transfer of funds from the buyer to the seller. Historically, securities transfers involved the physical movement of certificates. However, in recent years securities transfers have increasingly occurred by book-entry. This trend has been supported by the Group of Thirty, which recommended the establishment of, and broadest possible participation in, central securities depositories that provide a facility for holding securities in either a certificated or an uncertificated (dematerialised) form and permit the transfer of these holdings through book entry. A central securities depository may also offer funds accounts and permit funds transfers as a means of payment, or funds transfers may occur on the books of another institution, such as a commercial bank or central bank. In some cases (most often for government securities), the central bank operates the central securities depository, while in other cases it is operated by a private entity.

2.6 The processing of transfer instructions by a securities transfer system and a funds transfer system often involves several stages during which the rights and obligations of the buyer and the seller are significantly different. Therefore, the status of transfer instructions during the various stages must be carefully distinguished. Often a transfer that has been executed by such systems, in the sense that books have been debited and credited, is a provisional transfer, that is, a conditional transfer in which one or more parties retain the right by law or agreement to rescind the transfer. ⁹ If the transfer can be rescinded by the sender of the instruction (the seller of the security or the payer of money), the transfer is said to be revocable. Even if the transfer is an irrevocable transfer, some other party (often the system operator) may have authority to rescind it, in which case it would still be considered provisional. Not until a later stage does the transfer become a final transfer, that is, an irrevocable and unconditional transfer that effects a discharge of the obligation to make the transfer. Only the final transfer of a security by the seller to the buyer constitutes delivery, while only final transfer of funds from the buyer to the seller constitutes payment .When delivery and payment have occurred, the settlement process is completed.

Types and Sources of Risk

2.7 The types and sources of risk to counterparties to securities trades are essentially the same as those faced by counterparties to foreign exchange trades. Consequently, the definitions and analysis of credit and liquidity risks in foreign exchange trades that were developed in the Angell Report and the Lamfalussy Report are directly applicable in the present context. As in those earlier reports, credit risk is defined in this report as the risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. Credit risks in the event of a counterparty default include both the risk of loss of unrealised gains on unsettled contracts with the defaulting participant and the risk of the loss of securities delivered or payments made to the defaulting counterparty prior to detection of the default.

2.8 The risk of loss of unrealised gains is termed replacement cost risk. The unrealised gain, if any, on a contract is determined by comparing the market price of the security at the time of default with the contract price; the seller of a security is exposed to a replacement cost loss if the market price is below the contract price, while the buyer of the security is exposed to such a loss if the market price is above the contract price. Because future securities price movements are uncertain at the time a trade is initiated, both counterparties face replacement cost risk. The magnitude of this risk is an increasing function of the price volatility of the security and the interval between trade and settlement. Even on cash market (as opposed to forward settling) securities trades, replacement cost risk can be considerable. During the 1987 stock market crashes, for example, equity price declines of 25% to 35% between trade date and settlement date were not uncommon.

2.9 By far the largest credit risks, however, arise in connection with contracts scheduled to settle on the date (and possibly just prior to the date) on which a counterparty default may occur. On such contracts the non-defaulting counterparty may be exposed to principal risk, that is, the risk of loss of the full value of securities or funds that it has transferred to the defaulting counterparty. Both the buyer and the seller of a security may be exposed to principal risk; the buyer is at risk if it is possible to complete payment but not receive delivery, and the seller is at risk if it is possible to complete delivery but not receive payment. Principal risk in securities settlements is readily seen to be analogous to cross-currency settlement risk (Herstatt risk) in foreign exchange settlements.

2.10 Both counterparties to a securities trade are also exposed to liquidity risk on the settlement date. Liquidity risk is defined as the risk that a counterparty will not settle an obligation for full value when due, but on some unspecified date thereafter. The reason that a counterparty fails to settle may be technical or temporary, in which case the event would be termed a failed transaction rather than a default. If so, the counterparty might settle for full value at a later date and no credit loss would be involved. At the time a settlement failure is detected, however, the counterparty generally cannot determine with certainty whether the event is a default or a failed transaction. As a result, a technical failure may result in a loss of confidence in the counterparty that failed to settle, which could cause its counterparties to withhold settlement of other transactions. Counterparties may be especially likely to take such action if the technical failure occurs during a period when securities prices are changing rapidly and thereby creating doubts about the solvency of securities market participants generally. Also, a failure to settle an obligation to transfer funds is much more likely to result in a loss of confidence than a failure to settle an obligation to transfer securities. Market participants recognise that securities and securities lending markets are relatively illiquid and, therefore, that a financially sound counterparty may be unable to buy or borrow the securities needed to complete settlement.

2.11 Even without a loss of confidence, liquidity risks are a matter of concern. For the seller of a security, liquidity risk is the risk that payment will not be received from the buyer, possibly forcing the seller to borrow funds or to liquidate assets to avoid failing to discharge its own payment obligations on other transactions. For the buyer of securities it is the risk that delivery will not be received from the seller, possibly forcing the buyer to borrow the security to complete an obligation to deliver it to a third party. The costs associated with such liquidity pressures depend on the liquidity of the markets in which the affected party must make its adjustments; the more liquid the markets, the less costly the adjustments.

2.12 In addition to counterparty risks, participants in a securities settlement system may face the risk of a settlement bank failure, that is, the failure of the entity that holds the funds accounts used to make payments for securities. This risk can be eliminated by the use of central bank accounts for funds transfers. But in many countries non-bank participants in the securities markets do not have access to central bank accounts, either because it is prohibited by statute or because of a policy decision by the central bank, which may be reluctant to compete with private commercial banks for non-bank customers. If central bank accounts are not available, funds accounts must be provided either by the securities transfer system itself or by a commercial bank. In these cases, in the event of the settlement bank's failure, participants are exposed to the loss of the value of payments received if the balances involved have not been retransferred to another bank prior to the failure.

2.13 Of particular concern to central banks is the possibility of systemic risk in securities settlement arrangements. Systemic risk is defined in this report as the risk that the inability of one institution to meet its obligations when due will cause other institutions to fad] to meet their obligations when due. This is a very broad definition of systemic risk that covers some events that are unlikely to be of serious concern to central banks. In particular, under this definition, technical failures in securities settlements are quite likely to entail systemic risk; because the liquidity of markets for securities loans in many cases is quite limited or non-existent, the failure of the seller of a security to complete delivery quite often causes the buyer to fail to discharge its obligation to redeliver the security to a third party. Market participants have developed contractual and banking arrangements that allow them to manage routine liquidity pressures arising from limited numbers of technical failures quite successfully. Central banks are concerned primarily with the possibility that defaults or widespread technical failures might result in losses or liquidity pressures that cannot be managed and contained with existing arrangements and that, as a result, the stability of payment systems and financial markets might be jeopardised.

The Delivery Versus Payment Principle

2.14 As noted earlier, by far the largest source of credit risk in securities settlement and, therefore, the most likely source of systemic risk is the principal risk that may arise on the settlement date. Such principal risk can be eliminated if the securities settlement system adheres to the principle of delivery versus payment (DVP), that is, if it creates a mechanism that ensures that delivery occurs if and only if payment occurs. Furthermore, by eliminating concerns about principal risk, DVP reduces the likelihood that participants will withhold deliveries or payments when financial markets are under stress, thereby reducing liquidity risk. However, not all securities settlement arrangements currently achieve DVP. In some cases the linkage that exists between delivery and payment is, nonetheless, suff iciently strong to make a loss of principal by a participant seem a remote possibility. But in other cases book-entry securities transfer systems have been created that neither provide, nor are linked to, a money transfer system. The Group of Thirty recommended that by 1992 settlement systems for corporate securities should be delivery versus payment systems.

2.15 Achievement of DVP eliminates principal risk (and contributes to the reduction of liquidity risk), but it does not eliminate replacement cost risk or liquidity risk. Liquidity risk and, to a lesser extent, replacement cost risk also have the potential to create systemic risk. Thus, while the achievement of DVP (or, at a minimum, of a very strong linkage between delivery and payment) is necessary to contain systemic risk, it is not sufficient. An analysis of risks in securities settlement systems must not only determine the strength of the linkage between delivery and payment but must also assess whether the systems adequately control counterparty replacement cost and liquidity risks. Also, unless central bank money is employed in settlements, it must examine the likelihood and potential consequences of a settlement bank failure. In part because of concerns about the potential consequences of a settlement bank failure, the Group of Thirty recommended that the money balances transferred to complete payments be same-day funds, that is, balances that may be used (retransferred) on the day of receipt. In addition, if settlement obligations of participants are guaranteed by some third party (a bank or perhaps the securities settlement system itself), the likelihood and potential consequences of failure of a guarantor must be considered. Finally, those systems that hold securities through third parties (custodians) must consider the risks that could result from failure of one of the custodians.

Footnotes

6. The terms that appear in the text in bold face are included in the glossary. Not all of the bold face terms are defined in the body of the paper, and some that are defined are given more precise definitions in the glossary.

7. The design of the trade execution system may have implications for risk management. For example, many automated trade execution systems do not allow traders to discriminate among counterparties on the basis of creditworthiness.

8. As noted in the glossary, the term "clearance" is sometimes also used as a synonym for delivery, that is, the final transfer of securities on the settlement date.

9. Alternatively, no actual entries may be made on the books. Rather, running balances of debits and credits are calculated, which are only later posted to securities or funds accounts. In those cases, the running balances indicate provisional transfers until the books are actually debited or credited.

10. As noted earlier, the funds transferred may be central bank balances or balances on deposit at private commercial banks. What is critical for payment to be completed is that the transfer of funds is irrevocable and unconditional, not the form of funds. Nonetheless, as discussed below, if commercial bank balances rather than central bank balances are transferred, the terms on which the funds can be retransferred take on added importance in assessing the degree of credit risk in the settlement process.

11. Replacement cost risks can be reduced by >marking-to-market unsettled trades, that is, by revaluing securities at the current market price and requiring the counterparty with an as yet unrealised loss to transfer funds or collateral equal to the value of the loss to the other counterparty, the clearing system or the settlement system.

12. Although the term "settlement date" is used for expositional convenience, the settlement process may take more than one day. In general, a party may be exposed to principal risk from the time it initiates a securities or funds transfer instruction until the time settlement is completed.