Clearance and Settlement for Government Securities June 17-19, 2003 Johannesburg, South Africa Noritaka Akamatsu Financial Sector Operations and Policy The World Bank
Agenda • Why efficient C&S is important for GS market • Criticality of Delivery versus Payments (DVP) for GS market • RTGS versus net settlement • Alternative institutional setups of C&S bodies and optimal use of government securities as collateral • Functions and services to be provided by C&S systems. • Central counter-party (CCP): Is it needed? • Conflicts of interest in governance of C&S institutions
After Trade Execution ….. • Comparison (of terms of the trade): • affirmation by the client to the agent • confirmation by the counterparties • Communication of settlement instructions to central depositories / custodians. • Computation of the obligations of the counterparties resulting from the comparison • gross settlement • net settlement • Settlement: • Final delivery of securities and final payments. • C&S can also involve other complex processes such as repo clearing, collateral management, securities lending, etc.
Business Functions of CSD • Securities registration • Netting and clearing • Securities settlement / transfer • Safekeeping • Collateral management • Credit lines and risk management • Securities lending and borrowing • Cash management • Corporate event services
“International Standards” CPSS-IOSCO Recommendations addresses • Legal framework • Trade confirmation / affirmation • Settlement cycles • Central counterparties (CCP) & guarantee mechanisms • DVP, settlement finality and same day funds • Operational reliability & business continuity • Custody risk mitigation • Governance • Open access • Efficiency • Communication procedures and standards
Why C&S is particularly important for GS market • GSs are traded frequently in large value, thus posing significant systemic risks to the financial system. • Fixed income trading activities are very sensitive to cost and risk of transaction, and efficient C&S is very importantly in reducing those. • Funds and securities tied up in C&S process necessarily and unnecessarily; • Investment and operating cost of C&S systems • Effectiveness in organizing the trading market depends heavily on the integrity of C&S • Anonymity and DVP
Criticality of DVP • Lack of DVP and resulting principal risk make anonymous trading very difficult. • Telephone OTC trading prevails. • The secondary market remains fragmented and non-transparent, i.e., big banks and institutions deal only among themselves worrying about counter-party risk. Therefore, The secondary market would fail to develop beyond a small group of large banks/institutions.
RTGS vs. Net Settlement • There is tradeoff between cost and risk in C&S, but unnecessary cost and risk should be eliminated. • In choosing optimal tradeoff, utility functions of Central Bank and the market participants are often different. • RTGS eliminates systemic risks and, therefore, often preferred by Central Bank. • Net settlement saves funds and securities needed for settlement attaining higher cost efficiency and often preferred by market participants especially if Central Bank acts as CCP. Q. Which is better and why?
Costs and Risks in RTGS and Net Settlement • Funds (and securities) needed for RTGS need to be provided by Central Bank against collateral. • Funds needed tend to increase proportionally to the volume of trading. • Thus, collateral required tends to increase proportionally to the volume. • Risks in net settlement should be backed up by collateral. • Risks in net settlement tend to increase exponentially with the volume of trading. • Thus, collateral required should also increase exponentially. • Collateral tied up has opportunity cost.
C&S Institutions and integration Types of institutions • (Trading system) • Clearing House • Depository • Registrar Q. Which institution plays what C&S functions? • Integration across Functions / Instruments • Economies of “Scope” • Consolidation across Institutions • Economies of “Scale”
Integration across Functions • The functions can be combined to create a variety of different institutions: • Clearing House • Depository • Registrar • Clearing / Depository • Clearing / Depository / Registrar • Trading / Clearing • Trading / Clearing / Depository / Registrar • Which is the most efficient combination? • C&S process should be as “STP” as possible regardless of the combination.
Integration across Instruments • Equity • Corporate debt • Government securities • Derivatives Examples of CSDs having government securities • Sweden: VPC (all), • France: Sicovam (all), • UK: Crest (all), • New Zealand: NZ CSD • etc.
Consolidation in Europe Exchanges Clearing Houses London iX (failed to materialize) Clearstream Crest Monte Titoli SCLV European Clearing House Frankfurt Milan Madrid Nasdaq Europe Euroclear Sicovam Necigef CIK Brussels Euronext Amsterdam Paris Tradepoint Virt-X SIS Zurich Oslo Norex VPC Stockholm Copenhagen
Account Holding Structure • Multi-tier account holding (central depository/ registrar and sub-depositories/registrars or custodians) • Recognition of transfer of ownership at multi-level with duplication of beneficiary accounts at CSD for ownership transparency and supervisory effectiveness. Important basics: • Dematerialized (book-entry) GSs • Electronic payment / transfer instructions (e.g., SWIFT messaging standards
Why Consolidate? • Avoid duplication of the systems and investments • Reduce fragmentation of exposures of market participants and associated duplication of capital, liquidity, collateral/margin requirements. • To minimize system and liquidity cost while ensuring risk management. • To take advantage of economies of scale. • Natural monopoly?
Cost Items • System investment, maintenance and upgrading. • An obvious advantage if duplication can be avoided. • Operating cost including human resources required. • An advantage but a politically difficult issue to address. • Prudential requirements (capital, collateral, liquidity) for risk management. • Less obvious but a potentially very significant efficiency gain if these could be minimized without increasing liquidity, solvency or systemic risks. • To do so, GSs should be used efficiently through cross margining, etc. since they can be high quality collateral.
Outsourcing • A good idea to avoid duplication of system investments and operating expenses. • A great idea if it can facilitate minimization of prudential requirements without increasing risks. • A terrific idea if role sharing can be arranged to take advantage of different strengths of every provider of C&S services to create best of all possible world.
Commercial Services by CSD SLB, repo clearing, collateral management and cross margining. • Necessary for dealing / market making. • Efficient “CSD lending” requires efficient system architecture and competitive pricing based on contracts with participants. • Collateral and risk management for safekeeping • Clearing of tri-party repo is a “complex commercial service”. Q. Consistent / relevant with the fundamental mission of the Central Bank? A. Partially “Yes” (e.g., management of systemic risk) and partially “No”.
Central Bank asCommercial Service Provider? Advantages: • Competent institution • Have resources • Surest going-concern Disadvantages: • Not central to its mission as Monetary Authority • Absence of governance by participants
Central Counter-party Q. What value would CCP add over and beyond what is already achieved by DVP? Issues: • Need of post-trade anonymity; • Need of safer settlement? Proper risk management is needed (e.g., a loss sharing arrangement among participants to avoid moral hazard); • Convenience, i.e., no need to assess risk of individual counterparties, thus facilitating active trading; • Need of sure settlement for fund liquidity management (e.g., repos); • Need of net settlement in addition to RTGS (repos).
Governance, Access …. • Appropriate governance is a “key” to successful implementation of all institutional reforms of C&S. • Who owns, governs and/or controls CSD / Clearing House / CCP? • Who uses (has access to) them and, therefore, pays for their services? • Whose interest do they represent? • How are custodians represented on the board of CSD???
Relationship with Custodians • A delicate relationship because custodians are important members / users of a clearing house / central depository while at the same time they are providers of similar services. • A need to manage conflict of interest. • Standardized service for “core clearing” by a central depository/clearing house while more tailor-made services for individual institutional clients by custodians. • What if custodians do not have “proper” representation on the Board of the central depository?? • A concern about the “monopoly”.