1.7 By far the largest financial risks in securities clearance and settlement occur during the settlement process, that is, the process through which the transaction is completed by final (unconditional) transfer of securities from the seller to the buyer (delivery) and final transfer of funds from the buyer to the seller (payment). In some markets no mechanism exists to ensure that delivery occurs if and only if payment occurs. Without such a mechanism (delivery versus payment) counterparties are exposed to principal risk, that is, the risk that the seller of a security could deliver but not receive payment or that the buyer of a security could make payment but not receive delivery.² Principal risk in securities settlements is readily seen to be analogous to what is termed cross-currency settlement risk (Herstatt risk) in foreign exchange settlements.

1.8 Because principal risk involves the full value of the securities transferred, a default by a participant in a securities settlement system that permits such risk may well entail credit losses so sizable as to create systemic problems. For this reason, it is critical for a securities settlement system to create the strongest possible linkage between delivery and payment. Even if principal risk is eliminated through the achievement of DVP, however, participants are still exposed to replacement cost risk and liquidity risk. Liquidity risk includes the risk that the seller of a security that does not receive payment when due may have to borrow or liquidate assets to complete other payments. It also includes the risk that the buyer of the security does not receive delivery when due and may have to borrow the security in order to complete its own delivery obligation. Liquidity problems have the potential to create systemic problems, particularly if they occur at a time when securities prices are changing rapidly and failures to meet obligations when due are more likely to create concerns about the solvency of counterparties. In the absence of a strong linkage between delivery and payment, the emergence of systemic liquidity problems at such times is especially likely, as the fear of a loss of the full principal value of securities or funds is likely to induce some participants to withhold deliveries and payments, which, in turn, may prevent other participants from meeting their obligations. But even the achievement of DVP does not by itself ensure that systemic liquidity or credit problems cannot develop. An analysis of systemic risks in securities settlement systems must not only determine whether DVP is achieved (and, thus, whether principal risk is eliminated) but must also assess the degree of protection provided against replacement cost risk and liquidity risk.

1.9 The Study Group has thoroughly reviewed most of the securities transfer systems in use or under development in the G-10 countries. On the basis of this review, the Study Group has identified three broad structural approaches to achieving DVP (or more generally, to creating a strong linkage between delivery and payment in a securities settlement system):

Model 1: systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment);

Model 2: systems that settle securities transfer instructions on a gross basis with final transfer of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a net basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle;

Model 3: systems that settle transfer instructions for both securities and funds on a net basis, with final transfers of both securities and funds occurring at the end of the processing cycle.

1.10 Although the Study Group at first attached considerable significance to the structural differences among these models, further analysis has led it to conclude that the degree of protection provided against principal risk and especially against replacement cost risk and liquidity risk depends more on the specific risk management safeguards a system utilises than on which model is employed. Model 1 systems can eliminate principal risk by ensuring that securities are transferred from the seller to the buyer if and only if funds are transferred from the buyer to the seller. However, the completion of settlements in such systems may require participants to maintain substantial money balances, especially if participants are unable to adjust their money balances during the processing cycle. If sufficient money balances are not available, high "fail" rates may result, implying substantial liquidity risk and replacement cost risk to participants and possibly adversely affecting the liquidity of the securities markets. To minimise the need for participants to maintain substantial money balances while avoiding high fail rates, most model 1 systems extend credit to their participants, in some cases substantial amounts of credit. While the extension of credit (either intraday or overnight) to participants limits the risks associated with fails, it creates another source of risks - the failure of a participant to repay a credit extension. Such a failure would clearly entail both credit and liquidity risks. Indeed, if such credit extensions are not collateralised (either by securities received during the processing cycle or by other assets), credit risk of the same magnitude as principal risk can be created.³

1.11 The fact that final securities transfers precede final funds transfers in model 2 clearly has the potential to expose sellers of securities to substantial principal risk. Operators of the model 2 systems that the Study Group has reviewed have recognised this potential problem, and these systems are designed to provide strong assurances that sellers will receive payment for securities delivered. In most cases, this involves the creation of an assured payment system in which the seller delivers securities in exchange for an irrevocable commitment by the buyer's bank to make payment to the seller's bank at the end of the processing cycle. To protect itself, the guarantor typically seeks a lien on securities held by the buyer. Nonetheless, the guarantor may be exposed to credit risk of the same magnitude as principal risk as a result of securities purchases on behalf of customers, pledges of securities to other creditors or, if securities are certificated, withdrawals of securities from the system. Even if these problems are avoided, the guarantor is exposed to credit risk from declines in the value of the securities (analogous to replacement cost risk) and to liquidity risk if a participant fails to cover a net funds debit position. From the perspective of system participants, the failure of a guarantor bank is the major potential source of credit and liquidity risks, including principal risk. If the buyer's bank is of sufficiently high credit standing, however, the seller may regard its principal risk as negligible, if not eliminated.

1.12 Like model 1 systems, model 3 systems can eliminate principal risk by ensuring that final transfers of securities (on a net basis) are made if and only if final transfers of funds (on a net basis) are made. However, some model 3 systems inadvertently allow credit risk of the same magnitude as principal risk to arise for the same reasons that guarantors may face such credit risk in model 2 systems. Even if such large exposures are avoided, failure of a participant to cover a net funds debit position exposes the system operator or its participants to replacement cost risk and to liquidity risk. In the extreme, the system might fail to settle, probably resulting in serious systemic liquidity problems.

1.13 The key to developing a framework for the analysis of the implications of DVP systems for credit and liquidity risks is to recognise that nearly all of the systems that the Study Group has reviewed extend credit to their participants, either explicitly by allowing funds account overdrafts (model 1) or tacitly by allowing funds transfer instructions to be settled on a net basis (models 2 and 3). The primary question to be addressed is how well the system could cope with the failure of one or more participants (or guarantor banks) to repay such credit extensions. As noted above, in most cases such settlement failures would not create principal risk, but substantial replacement cost risk and liquidity risk may be involved.⁴

1.14 In many systems the completion of settlement is guaranteed, either by the system operator (which may be a central bank or a private entity) or by one or more third parties (often commercial banks). In systems that provide such a guaranty, a variety of risk controls are imposed by the guarantor to protect it from losses and liquidity pressures and, in cases where the guarantor's solvency might be questioned, to make the guaranty credible to participants. At a minimum, such systems establish membership requirements. Additional credit risk safeguards that may be employed are requirements that credit extensions be collateralised and, less frequently, the creation of collateral pools to cover any residual losses (analogous to replacement costs). Safeguards that directly limit liquidity risk, such as caps on credit extensions and third-party liquidity facilities, are utilised much less often. In several cases, a collateral requirement is the only factor limiting the size of potential credit extensions to participants. The effectiveness of such risk controls is critical; should the controls prove inadequate and the guarantor's financial condition become impaired, serious systemic problems would be likely to result.

1.15 Some model 3 systems, by contrast, do not guarantee settlement; rather, they would respond to a failed payment by a participant by unwinding (deleting) some or all of the transfers involving that participant and then recalculating the settlement obligations of the other participants. Reliance on this procedure has the potential to create significant systemic risk. The key issue raised is whether the participants can be expected to cope with the potential liquidity pressures that might arise from an unwind. This would depend on the magnitude of the pressures and the liquidity resources available to the other participants. The magnitude of the pressures would depend on the size of the net positions of the participant that fails to settle and on how widely the underlying transfer activity is divided among the other participants.⁵ The liquidity resources available to other participants would depend, among other things, on the liquidity of the relevant money and securities lending markets at the time a settlement failure became apparent and on the size and availability of their credit facilities (either from the central bank or from commercial banks). In markets in which the numbers and values of transfers are small, money markets are liquid (or all participants have direct or indirect access to central bank credit facilities) and securities lending markets are liquid (or automatic securities lending facilities are available), such an approach may not entail unacceptable systemic risks. But if these conditions are not all met, some type of risk controls would appear necessary to prevent the emergence of serious systemic liquidity problems.

1.16 Another important issue is the vulnerability of the system to insolvency or liquidity problems on the part of the settlement bank (the entity that holds the funds accounts used for payments in the settlement system). One obvious solution is to use central bank accounts and funds transfers, and such arrangements are in fact used in many of the securities settlement systems that the Study Group has reviewed. However, this solution is not always available, either because of statutory limits on access to central bank accounts (particularly for nonbank participants in securities settlement systems) or because central banks have made policy decisions to limit access, most often because of concerns about competition with the private banking system. If central bank accounts are not available, the vulnerability of the system can nonetheless be greatly reduced by requiring the entity whose liabilities are used as the settlement medium to allow such balances to be retransferred to a third party on the same day The use of "same-day funds" in settlements, it should be noted, is another of the recommendations of the Group of Thirty. Still another issue arises in those securities settlement systems that do not themselves dematerialise securities or immobilise certificates but instead rely on the custody services of third parties (custodians). In such cases, the failure of a custodian may temporarily impair the ability of participants to transfer securities (at least to non-participants), and a loss of some portion of the value of the securities held in custody may also be possible in certain circumstances.

1.17 The Study Group's work suggests that a variety of approaches to the design and operation of a securities settlement system are consistent with central bank policy objectives relating to stability and the containment of systemic risk and to the efficiency of financial markets. Whether a given system provides adequate protection against systemic risk depends on the particular risk controls that it adopts. These vary from system to system because of differences in the structure of securities markets, money markets and national payment systems. No single set of controls can be expected to strike the most favourable balance between risk and efficiency in all circumstances. Nonetheless, securities settlement systems must address a common set of risk management issues.

1.18 In attempting to develop a framework for evaluating the implications of the design and operation of securities settlement systems for the central bank policy objectives identified above, the Study Group decided to explore the feasibility of building on the earlier work on payment and settlement systems contained in the Angell Report and the Lamfalussy Report. In particular, the Lamfalussy Report contained a framework for evaluating the implications for central bank policy objectives of cross-border and multi-currency netting and settlement schemes for payment orders and foreign exchange contracts. This framework took the form of a set of minimum standards for such schemes (see Annex 4), along with a lengthy set of explanations and analysis.

1.19 The Study Group has concluded that the issues addressed by the Lamfalussy Report are also relevant to securities settlement systems and that the Lamfalussy standards provide an effective means of highlighting issues regarding the design and operation of such systems that are relevant to central bank concerns about stability and the containment of systemic risk. However, the standards do not address all of the important risk management issues that arise in securities settlement systems. Moreover, because the potential for systemic risk to arise in securities settlement systems may not in some cases be as great as the potential systemic risks in the multi-currency and cross-border schemes addressed by the Lamfalussy Report, certain safeguards that the Report concluded were essential may not always be necessary for securities settlement systems. Thus, while the Lamfalussy standards provide a valuable framework for the analysis of securities settlement systems, they should not be characterised as minimum standards that such systems must in all cases meet to address central bank concerns about systemic risks.

Additional Issues Relating to Cross-Border Securities Transactions

1.20 During the 1980s cross-border securities transactions grew extremely rapidly, reflecting not only the general trend towards higher turnover in securities markets, but also the liberalisation of restraints on capital flows in many countries and a growing appreciation by investors of the potential benefits of international divers)fication of portfolios. The Study Group's analysis has focused on the settlement of transactions between two direct participants in a single securities settlement system, but in cross-border trades one of the counterparties typically is not a direct participant in the home country settlement system (generally the system in the country in which the issuer of the security is located). Cross-border transactions can be settled through a variety of channels and numerous cross-border linkages between securities settlement systems have been developed in recent years, including both linkages between national systems and linkages between national systems and international systems.

1.21 The Study Group has done some preliminary work analysing the implications of such linkages for credit and liquidity risks in cross-border transactions, including whether DVP can be achieved for such transactions and, if so, by what means. On the basis of this preliminary work, it is clear that a number of additional issues arise in a cross-border context. In particular, while DVP can be achieved, this usually requires exchanges of information between the settlement systems involved on whether their respective participants have the necessary securities and funds. As a result, the settlement process can take longer to complete, especially when the settlement systems operate in different time zones (but even when different processing cycles are employed in the same time zone). In the interim, the settlement systems may face credit and liquidity risks vis-a-vis each other or vis-a-vis their respective participants. To protect against exposures to the participants, the settlement systems often require the participants to preposition securities or funds in advance of the settlement date or delay the availability of securities and funds until after the settlement date, thereby adding to liquidity demands on, and credit exposures of, participants. These inefficiencies and the relatively high costs they impose on counterparties in cross-border securities transactions appear to be inherent in cross-border settlements. Nonetheless, opportunities may exist to develop models for cross-border linkages that improve upon existing arrangements.

Fottnotes:

1 The general conclusions of the Angell and Lamfalussy Reports regarding the potential benefits of netting of foreign exchange contracts appear directly applicable to the netting of securities trades.

2. This report focuses on transfers of securities and funds between direct participants in securities settlement systems. Even if a DVP mechanism is available for such transfers, transfers between direct participants and third parties (their customers) may not receive the protection of the DVP mechanism. A discussion of the various safeguards utilised to protect customers in securities transactions is beyond the scope of this report.

3. As will be discussed below, the effectiveness of collateral as a means of limiting credit risks depends on the enforceability of the lien and the quality of the collateral (including the volatility of collateral values).

4. As will be discussed more thoroughly below, some model 3 systems do not guarantee the completion of settlement in the event that a participant fails to settle a net funds debit position. It could be argued that such systems do not extend credit to their participants. As a practical matter, however, the system operators have typically sought to avoid the potential consequences of a failure to settle by arranging an ad hoc extension of credit to a participant that encounters difficulty settling. And, in any event, such systems must address the same risk management issues as systems that do, in fact, extend credit.

5. The netting of funds transfers and securities transfers in a model 3 system without a guaranty is what the Angell and Lamfalussy Reports termed multilateral position netting. The distribution of pressures from an unwind among the other participants would depend on their bilateral net positions with the participant that failed to settle. Participants that traded actively with the failed participant could be called upon to raise large amounts of funds or to borrow sizable amounts of securities.