Management of Risk in CSDs - presentation to AMEDA members

1. Management of Risk in CSDs- presentation to AMEDA members John Woodhouse 25 October 2007

2. Agenda • Risk Management – Importance for CSDs • TM CSD Association – Post Trade Risk Assessment • TM Risk Rating Methodology • Six Risk Types Risk Factors • Definition • Criteria • Graphs • Key Risk Factors for each Risk Type • Situation for AMEDA • AMEDA Risk Profiles • TM Assessments • Comparative analysis • END

3. Risk Management – Importance for CSDs • Regulatory requirements – SEC17F7, FSA,G30, IOSCO • Investor requirements – FIIs often impose own criteria eg Calpers • CSDs offer competitive services and need to manage risk similar to custodians: • Custody of ineligible securities. • Asset Servicing. • Information services. • Expanded corporate actions servicing. • Provision of back office services. • Collateral management. • Increased focus on transparency • IOSCO recommendation 17 • Market trend for consolidation and demutualisation • Attention to improved governance arrangements and more director liability

4. Thomas Murray CSD Association • Worked with Gobal Custodians and CSDs for 10 years • Risk assessments of CSDs from 2001 • Risk ratings of CSDs from 2006 • Market surveillance • Risk analysis

5. Risk Rating Methodology • Assesses risk for investors in post-trade capital market infrastructure • Settlement, safekeeping and asset servicing risks • Six primary risks assessed • Agreed key criteria or factors assessed against each primary risk • Assessment against the familiar international rating scale ‘AAA’ – ‘C’ • Criteria (factors) weighted by relative importance in the individual market • Overall rating derived from rating of six primary risks

6. 1. Asset Commitment Risk (ACR) 2. Liquidity Risk (LR) 3. Counterparty Risk (CPR) 4. Asset Servicing Risk (ASR) 5. Financial Risk (FR) 6. Operational Risk (OR) Six Risk Types

7. CSD Risk Diagram CSD Ratings Risk Profile Asset Commitment Risk Liquidity Risk Counterparty Risk Financial risk Operational Risk Asset Servicing Risk AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C A1 A2 A3 A4 A2 A5 CSD Risk Rating A1 A3 A6 A4 A5 A6 Less Important Important Critical

8. Asset Commitment Risk Asset Commitment Risk -The period of time from when control of securities or cash is given up until receipt of countervalue. This risk concerns the time period during which a participant’s assets, either cash or stock, are committed within the CSD and payment system pending final settlement of the underlying transaction(s). Following settlement, the risk period is extended until the transfer of funds and stock becomes irrevocable. It excludes any periods when assets, cash or stock, are committed to a market participant including brokers, banks and custodians, not caused by CSD processing.

9. Asset Commitment Risk - Criteria • Minimising processing times maximises the availability of assets, particularly for transfer of assets off-shore (e.g. cross-border collateral movement, repatriation of funds) • Processing speed (real-time, intraday batches, overnight batches) • Market deadline for securities / funds positioning • Finality in settlement system (with legal basis) • Pre-funding markets (e.g. Russia), or long blocking periods

10. Asset Commitment Risk CSD Ratings Rating AC5 AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Inter-broker - Sales Inter-broker - Purchases Broker-custodian – (Selling Broker) Broker-custodian– (Buying Broker) Broker-custodian– (Custodian) Free of payment AC1 AC3 AC4 AC2 AC3 CSD ‘new’ AC4 AC5 CSD ‘old’ AC6 AC1 AC2 AC6 Less important Important Critical

11. Liquidity Risk Liquidity Risk -The risk that insufficient securities and or funds are available to meet commitments; the obligation will be covered some time later. This is where for certain technical reasons (e.g., stock out on loan, stock in course of registration, turn round of recently deposited stock is not possible) one or both parties to the trade has a shortfall in the amount of funds (credit line) or unencumbered stock available to meet settlement obligations when due. These shortfalls may lead to settlement ‘fails’ but do not normally lead to a default.

12. Liquidity Risk - Criteria • Optimising asset liquidity now paramount in large markets. Managing late settlements effectively and quickly reduces ‘indirect’ losses • Netting (with legal basis) / optimisation • Multiple processing cycles • Stock lending • Credit facilities • Fails management (fines, buy-ins) • High levels of immobilisation / dematerialisation • Fast registration / central registrar

13. CSD Risks Liquidity Risk Rating CSD Ratings Processing Model 2 – on exchange Processing Model 1 – off exchange Credit Facilities Stock lending and Borrowing Fails management Registration Deposited securities Matching Processing Model 1 - Same Day Trading L6 AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C L1 L2 L3 L7 L9 L3 L5 L4 L1 CSD ‘new’ L5 CSD ‘old’ L8 L6 L4 L2 L7 L8 L9 Less important Important Critical

14. Counterparty Risk Counterparty Risk -The risk that a counterparty (i.e., a participant) will not settle its obligations for full value at any time. This is simply the total default of a direct participant of the CSD. This is the event when a participant is unable to meet its financial liability to the CSD and possibly other creditors. This risk only goes as far as direct participants of the CSD and excludes clients of direct participants that default on liabilities to such participants, even if such a default should systemically cause the direct participant to subsequently default.

15. Counterparty Risk - Criteria • Managing defaults is critical to reducing direct loss of Principal and Systemic risks through participant interdependence. • DVP (market AND client-side) • Central Bank, same-day funds • Settlement assurance (CCP, collateral, guarantee fund) • Strict participation criteria • Participant concentration • Surveillance of participant volumes / risk modelling

16. Counterparty Risk CSD Ratings Rating Participation Criteria Participant concentration Surveillance DVP – Inter-Broker DVP - Broker-custodian Settlement Assurance C1 AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C C2 C2 C3 C4 C3 C1 C4 CSD ‘new’ C6 C5 C6 CSD ‘old’ C5 Less important Important Critical

17. Asset Servicing Risk Asset Servicing Risk -The risk that a participant may incur a loss arising from missed or inaccurate information provided by the depository, or from incorrectly executed instructions, in respect of corporate actions and proxy voting. This risk arises when a participant places reliance on the information a depository provides or when the participant instructs the depository to carry out an economic transaction on its behalf. If the depository fails either to provide the information or to carry out the instruction correctly then the participant may suffer a loss for which the depository may not accept liability. The depository may provide these services on a commercial basis, without statutory immunity, or it may provide the service as part of its statutory role, possibly with some level of protection from liability. This risk is likely to become much higher when international securities are included in the service.

18. Asset Servicing Risk - Criteria • Managing corporate actions effectively perhaps the biggest potential risk exposure. • Reliable ‘official’ source • Multiple information sources allowing for verification/’data scrubbing’ • Timely, accurate and comprehensive event notification • Timely, accurate and comprehensive event processing • Pro-active client servicing • Straight-Through-Processing • Clear statement of liability

19. Asset Servicing Risk CSD Ratings Rating Info Collection Info Dissemination Receipt of Instructions Execution of Instructions Proxy Voting Other Services AS1 AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C AS2 AS3 AS4 AS4 AS6 AS3 AS5 CSD ‘new’ AS5 CSD ‘old’ AS6 AS2 AS1 Less important Important Critical

20. Financial Risk Financial Risk- The ability of the CSD to operate as a financially viable company. This risk concerns the financial strength of the depository and if its capital is sufficient to meet the on-going operation of the organisation.

21. Financial Risk - Criteria • Ongoing financial stability of the CSD as a business. • Net capital • Operationally profitable • Comprehensive insurance • Any principal activity fully collateralised/ managed • Limited commercial activity • Limited liability (exclude indirect losses)

22. Financial Risk CSD Ratings Rating AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C F1 Capital Structure Earnings performance Ownership Access to Credit Insurance Coverage Operational claims Investment in infrastructure F2 F3 F2 F4 F1 F7 F3 CSD ‘old’ F4 F5 CSD ‘new’ F6 F6 F5 F7 Less important Important Critical

23. Operational Risk Operational Risk - The risk that deficiencies in information systems or internal controls, human errors or management failures will result in losses. The risk of loss due to breakdowns or weaknesses in internal controls and procedures. Internal factors to be considered in the assessment include ensuring the CSD has formalised procedures established for its main services. The CSD should have identified control objectives and related key controls to ensure operation and proper control of established procedures. Systems and procedures should be tested periodically. There should be external audit processes in place to provide third-party audit evidence of the adequacy of the controls.

24. Operational Risk - Criteria • Internal controls and procedures should be adequate to control operational risk exposures • Comprehensive controls and procedures • Extent of Internal and External operational audits • Limit manual processing / internal STP • Secure and efficient interfaces – external STP • DRP/BCP procedures

25. Operational Risk CSD Ratings Rating Established procedures Identification of key controls Operational Audit Processing Reporting Disaster Recovery procedures Business Continuity Plan Staff training O1 AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C O2 O3 O1 O2 O8 O4 O5 O5 O6 O7 O4 O6 CSD ‘new’ O8 CSD ‘old’ O3 O7 Less important Important Critical

26. Situation for AMEDA AMEDA Website AMEDA risk profiles TM Assessments Regional Comparison

27. AMEDA Website

28. AMEDA Documentation Screen

29. AMEDA Depository Risk Profiles

30. TM Assessments – Reports – Depository Service

31. Depository Assessment - example

32. Regional Comparison – Overall Risk Rating CSD Average Regional Ratings Rating Americas Africa Asia Pacific Middle East Eastern Europe Western Europe AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Less important Important Critical

33. TM Organisation Chart