Financial Issues Discussions May 30, 2002

1. Financial Issues DiscussionsMay 30, 2002 Payments & Securities Clearance and Settlement SystemsCompliance with International Principles Robert H. Keppler Financial Sector Development Department

2. The role of the World Bank in the transformation process in payment systems Developing the Core Principles for Systemically Important Payment Systems Applying the Core Principles International Standards for SSS Compliance with International Principles

3. Provide the foundation for improved banking products and services, and geographical coverage Ensure greater efficiency and liquidity in the banking system Reduce risk and establish a sound risk management process Optimize the costs of funds transfer transactions Provide support for international funds transfer Enhance the financial performance of the commercial sector Lay the technical and procedural foundation for future developments, such as Electronic Commerce The World Bank Role in the Transformation Process What we do … Typical modernization objectives

4. The World Bank Role in the Transformation Process • Comprehensive initiatives: • China, Vietnam, Algeria, Angola, Azerbaijan, BCEAO, BEAC, Libya, etc. • Undertaking initial diagnostics and developing reform strategies: • Costa Rica, Ecuador, Haiti, India, Indonesia, Madagascar, Morocco, Poland, Thailand, Tunisia, Venezuela, etc. • Providing specific technical advice: • Estonia, Hong Kong, Russia, Ukraine, Iran, Moldova, Barbados, etc.

5. The World Bank Role in the Transformation Process • Coordinating and managing regional initiatives • BCEAO, Central Bank of West Africa and BEAC • Southern African Development Community (SADC) • Western Hemisphere Initiative • Commercial bank operational procedural improvements - MIS, Decision Support, and Products & Services Modernization (India, Vietnam)

6. The Importance of PSS Systems • Payment systems and securities settlement (PSSS) systems are essential parts of the financial sector infrastructure • PSSS are essential components of the monetary policy transmission mechanism and the value transfer mechanisms • The soundness and, especially the efficiency of PSSS is a fundamental factor in sustaining economic activity and economic development

7. The Importance of PSS Systems • Robust, efficient and comprehensive PSSS are essential for the stability of financial markets – as Financial market crises are likely to show their first signs in the value transfer systems

8. Internationally Accepted Principles & Standards • Recognizing this Importance the Financial Stability Forum, the Standard Setters (E.G. BIS and IOSCO) and the International Financial Institutions (including the IMF and the WB) have pushed for the update and/or release of common international principles, standards and best practices for payments and securities settlement systems - for use in the development and the assessment of such systems

9. Developing the Core Principles • The Committee on Payment and Settlement Systems (CPSS, Bank for International Settlements) has traditionally been the forum to discuss and develop international standards and best practices in the payments arena • In May 1998, the CPSS established a Task Force on Payment System Principles and Practices

10. Developing the Core Principles • The TF comprised representatives not only from G10 CBs and the ECB but also from 11 other CBs of countries in different stages of development, the IMF and the WB • The BIS published a draft of Part I of the report in December 1999 and a draft of Part II in July 2000, for public comments. Final publication of the entire Report occurred in January 2001

11. Developing the Core Principles • The TF identified: • Two Public Policy objectives (safety and efficiency) in systemically important payment systems (SIPS) • Ten core principles for SIPS • Four central bank’s responsibilities in applying the core principles

12. Developing the Core Principles • A PS is Systemically Important if disruption within it could trigger or transmit further disruptions amongst participants and ultimately in the entire financial arena • It is likely that a system is a SIPS if at least one of the following is true: • It is the only or the main system in the country • It handles payments of high individual value • It is used for settlement of financial market transactions or of other important interbank payment systems

13. Developing the Core Principles • Principle I: The system should have a well founded legal basis under all relevant jurisdictions • completeness and reliability of the legal and regulatory framework • enforceability of laws and contracts • clarity of timing of final settlement • legal recognition of netting arrangements • relevant provisions of banking and CB laws

14. Developing the Core Principles • Principle II: The system’s rules and procedures should enable participants to have a clear understanding of the system’s impact on each of the financial risks they incur through participation in it. • System’s rules and procedures should: • be clear, comprehensive and up-to-date • explain the system’s design, risk management procedures, legal basis and role of the parties • set out procedures and timetables for abnormal situations

15. Developing the Core Principles • Principle III: The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain these risks • The system must have: • Tools for managing credit risks • Tools for managing liquidity risks • General Tools • Incentives to manage these risks

16. Developing the Core Principles • Principle IV: The system should provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day • Promptness of final settlement entails: • Clarity in the rules and procedures about the revocability of the payment • A defined and legally effective moment of final settlement • Ensuring that operating hours and the settlement processes are strictly enforced

17. Developing the Core Principles • Principle V: A system in which multilateral netting takes place should, at a minimum,be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation • Additional financial resources must be available to meet this contingency • The amount of these resources must be determined appropriately • Alternatively, other system designs (e.g. RTGS) must be explored

18. Developing the Core Principles • Principle VI: Assets used for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk and little or no liquidity risk • If assets other than a CB’s claim are used, it should be checked: • the creditworthiness of the issuer • how readily the asset can be transferred into others • size and duration of exposures of the issuer • risk controls, if any

19. Developing the Core Principles • Principle VII: The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing • The following issues should be considered: • Security • Operational reliability • Business continuity

20. Developing the Core Principles • Principle VIII: The system should provide a means of making payments which is practical for its users and efficient for the economy • The following issues should be considered: • General: Define objectives; Identify user needs and constraints; Identify system choices and benefits; Determine social and private costs; Develop decision choices • Analytical Framework: Identify efficiency and safety requirements; Evaluate costs; Identify resources; Determine practical and safety constraints

21. Developing the Core Principles • Principle VIII: The system should provide a means of making payments which is practical for its users and efficient for the economy • The following issues should be considered: • Methods: Cost-Benefits or other structured analysis; involvement of participants and/or users in discussions; Methodology for data collection and analysis; Identify data sources

22. Developing the Core Principles • Principle IX: The system should have objective and publicly disclosed criteria for participation, which permit fair and open access • The following issues should be considered: • Access criteria should be justified in terms of both safety and efficiency • Exit criteria

23. Developing the Core Principles • Principle X: The system’s governance arrangements should be effective, accountable and transparent • Major decisions should be made after consultation with interested parties • The systems consistently attains projected financial results • The system delivers payment services that satisfy customer needs • The system complies with the other 9 principles

24. Developing the Core Principles • The Central Bank’s Responsibilities in Applying the Core principles: • A: The Central Bank should define clearly its payment system objectives and should disclose publicly its role and major policies with respect to systemically important payment systems • B: The Central Bank should ensure that the systems it operates comply with the core principles

25. Developing the Core Principles • The Central Bank’s Responsibilities in Applying the Core principles: • C: The Central Bank should oversee compliance with the Core Principles by systems it does not operate and it should have the ability to carry out this oversight • D: The Central Bank, in promoting payment system safety and efficiency through the Core Principles, should cooperate with other central banks and with any other relevant domestic and foreign authorities

26. The World Bank Role in the Implementation of the Core Principles The Importance of International Standards and Best Practices • We have always used international standards and best practices (e.g., Lamfalussy, other BIS reports, G-30 recommendations) in our assessments and payments system design activities • We consistently supported the need for internationally recognized principles for payment systems

27. The World Bank Role in the Implementation of the Core Principles The Importance of International Standards and Best Practices • We were pleased with the methodology used to develop the CPSS core principles, namely the involvement of the IMF/WB and of representatives from emerging markets • We participated enthusiastically in the works of the Task Force

28. The World Bank Role in the Implementation of the Core Principles Applying the core principles • In the payment system component of the Financial Sector Assessment Program (FSAP): • The IMF/WB joint effort to assess the vulnerability of the financial sector. • The FSAP normally includes a formal assessment of the standards and codes indicated by the Financial Stability Forum (ROSC).

29. The World Bank Role in the Implementation of the Core Principles Applying the core principles • We have teamed up with Fund Colleagues and consulted the CPSS to prepare a uniform approach in assessing the CPSIPS in the context of the FSAP. • The Guidance Note, Questionnaire and Assessment Templates are now available and are being used since August 2001.

30. The World Bank Role in the Implementation of the Core Principles Applying the core principles • We conducted a comprehensive evaluation of past FSAP experience to draw lessons for the future and improve the process (Paris Outreach in November 2001 and possible joint Outreach with the CPSS in late 2002).

31. The World Bank Role in the Implementation of the Core Principles Applying the core principles • In our technical assistance missions • In our technical loans (we encourage our borrowers to use the principles) • In Regional Initiatives

32. Definition of SSS • The SSS include the full set of institutional arrangements for confirmation, clearance and settlement of securities trades and safekeeping of securities • Weaknesses in SSSs can be a source of inefficiency: • Impede capital formation due to higher costs

33. Definition of SSS • Weaknesses in SSSs can be a source of systemic disturbances due to: • Creation of liquidity pressures • Potential relevant credit losses • Potential spillover effects to payment systems • Uncertainty on who bears risks

34. International Standards for SSS Evolution of Standards for SSS • 1989: G30 Recommendations • 1990: IOSCO C&S Blueprint • 1991: OECD Systemic Risks in Sec. Mkts • 1992: BIS - CPSS DVP Report • 1992: IOSCO Blueprint for Emerging Mkts • 1995: BIS Cross Border Sec. Settlements • 1996: FIBV Best Practices • 1996: COSRA Principles • 1997: CPSS/IOSCO Disclosure Framework

35. International Standards for SSS Evolution of Standards for SSS • 1997: IOSCO Legal Framework for SSS • 1998: IOSCO Principles of Securities Regulation • 1999: FIBV Best Practices • 2000: ISSA Recommendations • 2000: ACSDA Identification of Risks • 2001: CPSS/IOSCO Recommendations • 2001-02: New G-30 Projects

36. International Standards for SSS Evolution of Standards for SSS (other references) • 1998-99: ESCB requisites for the use of securities as collateral in TARGET • 2001: World Bank Guide to Best Practices • 2001: Evolution of Securities Markets and Infrastructure in Europe (Committee of Wise Men, Giovannini Group, etc.)

37. International Standards for SSS • In December 1999 CPSS and IOSCO established a Joint Task Force to set up recommendations for sound and efficient securities settlement systems. • The recommendations were released for public comments in January 2001 and in their final version in November 2001

38. International Standards for SSS • The CPSS and IOSCO have directed the Task Force to complete by the end of 2002 a methodology for assessing the implementation of the recommendations • The World Bank and the IMF are participating actively in this work

39. International Standards for SSS • Key Public Policy Objectives for SSS • Reduction of Systemic Risks • Protection of Investor Assets • Efficiency • To Guarantee Well Functioning Financial Markets and Efficient Capital Formation

40. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS I Securities settlement systems should have a well-founded, clear, and transparent legal basis in the relevant jurisdictions. II Confirmation of trades between direct market participants should occur as soon as possible after trade execution, but no later than trade date (T+0). Where confirmation of trades by indirect market participants (such as institutional investors) is required, it should occur as soon as possible after trade execution, preferably on T+0, but no later than T+1.

41. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS III Rolling settlement should be adopted in all securities markets. Final settlement should occur no later than T+3. The benefits and costs of a settlement cycle shorter than T+3 should be evaluated. IV The benefits and costs of a Central CounterParty should be evaluated. Where such a mechanism is introduced, the Central CounterParty should rigorously control the risks it assumes.

42. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS V Securities lending and borrowing (or repurchase agreements and other economically equivalent transactions) should be encouraged as a method for expediting the settlement of securities transactions. Barriers that inhibit the practice of lending securities for this purpose should be removed. VI Securities should be immobilized or dematerialized and transferred by book-entry in CSDs to the greatest extent possible.

43. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS VII CSDs should eliminate principal risk by linking securities transfers to funds transfers in a way that achieves delivery-versus-payment (DvP). VIII Final settlement should occur no later than the end of the settlement day. Intraday or real-time finality should be provided where necessary to reduce risks.

44. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS IX CSDs that extend intraday credit to participants, including CSDs that operate net settlement systems, should institute risk controls that, at a minimum, ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle. The most reliable set of controls is a combination of collateral requirements and limits.

45. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS X Assets used to settle the ultimate payment obligation arising from securities transactions should should carry little or no credit or liquidity risk. If central bank money is not used, steps must be taken to protect CSD members from potential losses and liquidity pressures arising from the failure of the cash settlement agent whose assets are used for that purpose.

46. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS XISources of operational risk arising in the clearing and settlement process should be identified and minimized through the development of appropriate systems, controls, and procedures. Systems should be reliable and secure, and have adequate, scaleable capacity. Contingency plans and backup facilities should be established to allow for timely recovery of operations and completion of the settlement process.

47. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS XII Entities holding securities in custody should employ accounting practices and safekeeping procedures that fully protect customers’ securities. It is essential that customers’ securities be protected against the claims of a custodian’s creditors. XIII Governance arrangements for CSDs and Central CounterParties should be designed to fulfil public interest requirements and to promote the objectives of owners and users.

48. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS XIVCSDs and central CounterParties should have objective and publicly disclosed criteria for participation that permit fair and open access. XV While maintaining safe and secure operations, securities settlement systems should be cost effective in meeting the requirements of users. XVI Securities settlement systems should use or accommodate the relevant international communication procedures and standards in order to facilitate efficient settlement of cross-border transactions.

49. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS XIVXVII CSDs and Central CounterParties should provide market participants with sufficient information for them to identify and evaluate accurately the risks and costs associated with using the CSD or Central CounterParties services. XVIII Securities settlement systems should be subject to transparent and effective regulation and oversight. Central banks and securities regulators should cooperate with each other and with other relevant authorities.

50. International Standards for SSS CPSS-IOSCO Recommendations for Safe and Efficient SSS XIX CSDs that establish links to settle cross border trades should design and operate such links to reduce effectively the risks associated with cross-border trades.