REFORMING SECURITIES SETTLEMENT SYSTEMS Mario Guadamillas, World Bank

1. THE WORLD BANK IN COLLABORATION WITH THE ARAB MONETARY FUND AND THE BAHRAIN MONETARY AGENCYREFORMING PAYMENT AND SECURITIES SETTLEMENT SYSTEMS Manama, Bahrein, March 15-17, 2005 REFORMING SECURITIES SETTLEMENT SYSTEMS Mario Guadamillas, World Bank

2. Content • Importance of market infrastructure • International standards as a guide for the reform • B.1 Evolution of international (regional) standards • B.2 Main factors identified • Main challenges for SSSs • C.1 Special consideration of CCPs • D. Interrelations between payments and securities settlement systems • E. Conclusions

3. IMPORTANCE OF MARKET INFRAESTRUCTURE • Transaction value chain: • Clearing and Settlement key element to determine the infraestructure quality of capital markets • Trading systems, intermediaries, custodians and asset managers can be easily changed if the inverstor perceives an inadequate level of servce or risk • Not the case of Clearing and Settlement

4. IMPORTANCE OF MARKET INFRAESTRUCTURE • Important changes in the supply and demand for capital, • Demographics: evolution in the population ratio between prime savers (40-59) and dissavers, (60+) could imply a surplus/deficit in capital supply • Economics: GDP per capita growth in emerging markets will increase capital demand • will drive to changes in investors’ behavior • Asset reallocation: the investors and their intermediaries will reallocate assets in the search of increased predictability of returns • Higher specialization: need to respond to a more differentiated demand

5. IMPORTANCE OF MARKET INFRAESTRUCTURE In the cases of Italy and Japan the trend is even more severe with a ratio “prime savers” vs. “dissavers” of 2:1 In the cases of India and China the trend is an increase of “prime savers” as a percentage of the population

6. IMPORTANCE OF MARKET INFRAESTRUCTURE • Changes in the investment strategy • More attention to best execution and low fees • Outperformance in emerging markets • Differentiated needs from investors • Increased speed and expandable capacity • “Functional flexibility” in the securitized and structured products area • Despite the specialized need, there is still a very large investor segment interested in “one size fits all” solution • Market segments interested in enhanced market transparency and investor protection

7. IMPORTANCE OF MARKET INFRAESTRUCTURE • How to provide more efficient and secure Clearing and Settlement services? • Lower cost • Reduced operational risk • Straight through Processing (STP) • Fully interoperable markets • Harmonized regulations • Fair market access • Adequate oversight of the systems • Uniform, consistent supervision of market participants • Etc.

8. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • The international standards provide a very helpful framework to systematize and address the main factors to be considered for a reform • Despite the process of consolidation and generalization of accepted standards worldwide, some focus on minimum standards while others seek best practices • There is closer attention by international standards to the interaction between payments and securities settlement systems

9. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • Group of Thirty Recommendations Regarding Securities Clearance and Settlement, 1990 Objective: “reducing risk, improving efficiency and promoting greater standardization in international settlement” - Trade comparison,Trade confirmation/affirmation, CSDs, Netting Schemes, DvP, Same day funds, Rolling settlement cycle, Securities lending, Common message standard • Lamfalussy Minimum Standards, 1990 Objective: “cross-border and multi-currency netting and settlement schemes” - Legal basis, Financial risks, Management of credit and liquidity risks, Admission criteria, Operational reliability of netting schemes

10. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • Technical Committee of IOSCO, 1990 Objective: “contribute to the process of creating an efficient central securities depository from a national regulatory point of view and, at the international level, offering views on how to create links in accordance to the recommendations issued on the subject” - Regulatory aspects (including SRO role) - Liquidity risk - Industry organizational arrangements - Operational reliability - Endorses G30 recommendations

11. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • ISSA, 1995 Objective: “amendment of G30 recommendations” - Trade comparison in T+0 instead of T+1 - Positive affirmation of trade details by indirect market participants by T+1 - Explicit reference to immobilization/dematerialization - Rules when several CSDs operate in a country in order to allow for use of funds and cross-collateral - Choice between a RTGS or “Lamfalussy Recommendations” compliant netting system for funds settlement

12. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • Emerging Markets Committe of IOSCO, 1997 Objective: “study on the legal and regulatory framework for clearing and settlement in emerging markets” - Legal and custody issues • IOSCO, Objectives and Principles of Securities Regulation, 1998 Objectives: “The principles are based upon three main objectives of securities regulation: protection of investors; ensure that markets are fair, efficient and transparent; reduction of systemic risk” - SSSs should be subject to regulatory oversight and designed to ensure that they are fair, effective and efficient and that thay reduce systemic risk

13. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • FIVB, Clearing and Settlement Best Practices Report, 1999 Objective: “to enable FIBV members and their respective clearing and settlement organizations to score their performance against benchmarks and best practices, and to identify areas in their processes where improvements should be considered” - Trade confirmation, Settlement cycles, Securities lending, CSDs and risk controls, DvP, Operational reliability, Efficiency, Netting schemes, Systems integration

14. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • ISSA, New Recommendations, 2000 Objective: “to tackle key risks in today’s world of settlement and clearance” - Governance of infrastructure - Technology: core processing - Technology: messaging and standards - Uniform market practice - Reduction of settlement risk - Market linkages - Investor protection - Securities lending - Legal infrastructure

15. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • CPSS, Core Principles for Systemically Important Payment Systems, 2001 Public Policy Objectives: “safety and efficiency” Introduction of the SIPS concept - Ten principles: legal foundation (CPI), understanding and management of risks (CP II and III), settlement (CPs IV-VI), security, operational reliability and contingency arrangements (CP VII), efficiency and practicality (CP VIII), criteria for participation (CP IX) and governance (CP X) - Four central bank’s responsibilities: objectives and policy (A), observance of CPs (B and C), cooperation (D) - Not specific for SSSs but relevant

16. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • CPSS-IOSCO, Recommendations for SSSs, 2001 Objective: “to promote implementation by SSSs of measures that can enhance international financial stability, reduce risks, increase efficiency and provide safeguards for investors by developing recommendations for the design, operation and oversight of such systems” 19 Recommendations - Legal risk - Pre-settlement risk (including CCPs) - Settlement risk - Operational risk - Custody risk - Other issues (governance, access, efficiency, communication procedures and standards, transparecy, regulation and oversight, risks in cross-border links)

17. B.1 EVOLUTION OF INTERNATIONAL STANDARDS • G30, New Recommendations, 2003 Objective: “to establish a set of new recommendations focused on the cross-border and international context that go beyond minimum standards and try to identify best practices” - Building a strengthened interoperable global network - Strengthening network safety and stability - Improving governance • CPSS-IOSCO Task Force, Risk Management Standards for Central Counterparties, November 2004

18. B.1 EVOLUTION OF REGIONAL STANDARDS • EMI, Standards for the use of EU Securities Settlement Systems in ESCB Credit Operations”, 1998 Objective: “assessing the soundness of SSSs seeking to qualify for involvement in monetary policy and intraday credit operations” - Legal soundness - Settlement in central bank money - No undue custody risks - Regulation and/or control by competent authorities - Transparency of risks and conditions for participation in a system - Risk management procedures - Intraday finality of settlement - Operating hours and days - Operational reliability of technical systems and availability of adequate back-up facilities

19. B.1 EVOLUTION OF REGIONAL STANDARDS • Giovannini Group 1st Report, 15 Barriers to the EU C&S Integration, 2002 • Giovannini Group 2nd Report, Action proposals for removing barriers, 2003 Objective: “conduct a comprehensive analysis of clearing and settlement arrangements for equities, fixed-income securities and derivatives” 15 Barriers to efficient cross-border settlement: - Technical requirements/market practice - Differences in tax procedures - Issues related to legal certainty

20. B.1 EVOLUTION OF REGIONAL STANDARDS • ESCB-CESR Standards for Securities Clearing and Settlement Systems in the European Union (consultative report), 2003 Objective: “to increase the safety, soundness and efficiency of securities clearing and settlement systems in the European Union” - Based on CPSS-IOSCO recommendations - Beyond recommendations (standards) to be used as a regulatory tool - Identifying “systemically important institutions” - Standards to major custodian banks

21. B.1 EVOLUTION OF INTERNATIONAL STANDARDS (SUMMARY)

22. B.2 MAIN FACTORS IDENTIFIED • Legal & custody • C&S processes: trade confirmation, settlement cycles, systems integration, securities lending, communication procedures standards and securities identification • Settlement risk: CSDs, DvP, timing of settlement finality, risk management mechanisms, cash settlement assets,netting versus gross schemes, liquidity risk • CCPs • Operational reliability • Regulatory&Oversight (including SRO role) • Organizational arrangements: participation requirements, governance, transparency • Cross-border • Cost-efficiency

23. B.2 MAIN FACTORS IDENTIFIED LEGAL&CUSTODY C&S PROCESSES SETTLEMENT RISK CCP OPERATIONAL REG.&OVERSIGHT ORG. ARRANGEMENTS CROSS-BORDER COST-EFFICIENCY G30 IOSCO G30/ISSA IOSCO IOSCO FIBV ISSA CPSS IOSCO NEWG30 1989 1990 1995 1997 1998 1999 2000 2002 2001

24. C. MAIN CHALLENGES FOR SSSs • Legal Framework and Custody Risk • - Trading takes place global while underlying legal systems continue to be domestic • * Absence of a unique framework for the treatment of security interests • * Problems with legal certainty in collateralized transactions • * Uneven application of national conflict of law rules • - Finality: importance to adapt financial institutions bankruptcy legislation to protect SSSs • - Enforceability of security interests provided under collateral arrangements, legal basis for netting, electronic documents and signatures (for developing systems)

25. C. MAIN CHALLENGES FOR SSSs • Legal Framework and Custody Risk • - The Hague Securities Convention. Unique legal framework for: • * Transfer of the collateral to the pledgee • * Power of disposal over collateral • * The order in which creditors have rights to the collateral • * The duties of the intermadiary actually holding the pledged securities in custody • * The correct procedure for realizing the collateral • * Rules regarding claims to dividends and the rights associated to securities while they are pledged. • - Not yet applicable. Incorporation to national legal frameworks expected by the end of 2006

26. C. MAIN CHALLENGES FOR SSSs • Clearing and settlement processes • - Standardization of messaging standards and communication protocols • - Synchronization of timing among systems • - National differences in settlement cycles • - Tax and other impediments to securities lending and borrowing • - Mix of securities and money markets settlement procedures creates problems for market development (different settlement needs) • - Diversity of trading and settlement mechanims and procedures even for similar type of securities • - Eliminate paper processing (for developing systems)

27. C. MAIN CHALLENGES FOR SSSs • Settlement risk • - CCPs: risk reduction but higher risk concentration • - Increasing need to ensure financial integrity. Delicate balance between access and competition • - Reduction of the settlement cycle not always accompanied by reduction of settlement risk • - Systemically important systems must have adequate risk management mechanisms • - Settlement assurance procedures (for developing systems)

28. C. MAIN CHALLENGES FOR SSSs • Operational issues • Interoperability of global network (more than technical compability of systems) • - Global identification methodology to facilitate STP • - National differences in IT and interfaces • - Practical impediments to remote access • Need to accommodate increasing volume of traffic and volatility in markets • Adequate contingency procedures and back- up systems (for developing systems)

29. C. MAIN CHALLENGES FOR SSSs • Regulation & oversight • Increasing importance of settlement issues for securities regulators and role of SROs - No role in operating systems • - More attention to regulation and oversight. Dual roles: public policy framework for competition and prudential oversight • - Increasing need to coordinate with other regulators/supervisors, specially central bank, both domestically and internationally • - Interaction with private sector through SROs. Importance of overlaps/gaps in regulation and supervision

30. C. MAIN CHALLENGES FOR SSSs • Organizational arrangements • Governance of infrastructure is a key issue for markets integration • - Transparency: full disclosure to system users • - Non discrimination: fair access to SSSs • - No single group or single interest group with majority control • - Effective attention to users interests • Access to liquidity can be an important obstacle (interaction with funds transfer system)

31. C. MAIN CHALLENGES FOR SSSs • Cross-border settlement • - Inconsistent legal and regulatory underpinnings • - Lack of globally recognized technical standards • - Differing business processes • - Differences in tax procedures • These problems lead to higher costs due to • - Direct costs from higher fees of the services provided • - Indirect costs from extra back-office facilities • - Opportunity costs from inefficient use of collateral and higher incidence of failed trades

32. C. MAIN CHALLENGES FOR SSSs • Cost-efficiency issues • - Level of market competition on clearing and settlement organizations is low (lack of direct competitors to use as a benchmark), thus, alternatively in-house unit costing techniques need to be developed. • - Composition on costs is changing rapidly with diminishing IT costs. Increasing use of outsourcing • - Small value transactions normally subsidized by imposing higher charges on large value transactions. • - Many systems may be under-recovering their operating costs

33. C.1. SPECIAL CONSIDERATION OF CCPs • Benefits • Attributed to multilateral netting • - Reduction in the number of settlements • - Reduction in individual contractual obligations • - May help reduce the margins required to collateralize current and potential future credit exposures • - May help to reduce the capital required to support participant’s trading activity • - Helps to sustain anonymity where trade execution process itself is anonymous

34. C.1. SPECIAL CONSIDERATION OF CCPs • Benefits • Provides risk management services • - Replaces exposures to multiple counterparties with a single exposure to a single counterparty • - No worry about the creditworthiness to a single counterparty • - Does not eliminate counterparty credit risk, but redistribute it much more efficiently than market participants could do in isolation

35. C.1. SPECIAL CONSIDERATION OF CCPs • Risks • Legal and technical risks (not specific to CCPs but higher potential systemic impact) • Principal risk (reduction but concentration) • Replacement cost risks (not specific to CCPs but higher potential systemic impact) • Risk management tools • Financial and operational requirements (to minimize probability of failure of a market participant) • Margins (to minimize the loss if a participants fails) • Limit build-up of exposures by means of periodic settlement of positions (normally used in derivative markets)

36. C.1. SPECIAL CONSIDERATION OF CCPs • Main concerns • Concentration of risk • Moral hazard (too big to fail) • Information asymmetry is reduced but only if CCP is perceived to be solvent • Competition between CCPs could negatively affect risk management standards • A single CCP would maximize externalities and economies of scale but could produce potential inefficiencies (lack of innovation). Need of appropriate governance rules • Contagion effects (cross-process, cross-products, cross currencies)

37. C.1. SPECIAL CONSIDERATION OF CCPs • Main issues to be considered • Legal Framework • Participation Requirements • Understanding Risks • Novation • Settlement • Default Procedures • Risk Controls • Margins/Guarantee fund/Loss Sharing • Governance • Operational Risk • Regulatory Reporting

38. D. INTERRELATIONS BETWEEN PAYMENTS AND SECURITIES SETTLEMENT SYSTEMS • Timing of settlement finality • Careful analysis of design, procedures, operational timetables and funding cut-off times • SSSs settlement end-of-day, intra-day, real-time? • Cash settlement asset and settlement agent risks • Is central bank money used? • Credit, liquidity, and operational risks • Management of a settlement agent’s failure • Concentration of settlement flows • Who has access to the funds transfer system • Participants ability to choose a settlement agent • Range of services provided by agent • Participants’ views on agent’s competitive neutrality • Arrangements for funding/defunding accounts

39. D. INTERRELATIONS BETWEEN PAYMENTS AND SECURITIES SETTLEMENT SYSTEMS • Higher potential contagion effects in the financial system from the use of CCPs • Impact of SSSs on the implementation of monetary policy • Impact of SSSs on the liquidity management of the system (increasingly important with the generalized use of RTGS systems) • Impact of SSSs on the fiscal policy (especially for development markets) • Need of coordination between central bank and securities regulator

40. E. MAIN CONCLUSIONS • Integrated approach for SSSs • Integration of payments and securities settlement • SSSs recognized as incurring same inherent risks as those associated with SIPS • Consolidation of SSSs functions (efficiency gains, risk reduction, higher concentration of risk) • Cross-border settlement main obstacles: differences in legal & regulatory frameworks, lack of enough technical and processes standardization, differences in tax procedures • Domestic settlement main challenges: legal issues (finality, collateral), adequate risk management procedures (beyond DvP), adequate coordination with other regulators and cooperation with the private sector • SSSs reform an on-going process