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Margarida Baptista November 15, 2002

ACSDA Seminar Next Challenges in Depository, Clearance and Settlement Services - CCP Opportunities -. Margarida Baptista November 15, 2002. AGENDA. NET SETTLEMENT SYSTEMS. THE CCP SOLUTION. CBLC MODEL. CONCLUDING REMARKS. AGENDA. NET SETTLEMENT SYSTEMS. THE CCP SOLUTION. CBLC MODEL.

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Margarida Baptista November 15, 2002

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  1. ACSDA SeminarNext Challenges in Depository, Clearance and Settlement Services - CCP Opportunities - Margarida Baptista November 15, 2002

  2. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

  3. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

  4. DNS x RTGS RISK LIQUIDITY Securities Settlement Systems • Real Time Gross Settlement System • Deferred Net Settlement System Trade-off: Risk x Liquidity

  5. Cut down on transaction costs Decreasing in operational risk Netting: advantages • Minimization of liquidity requirements • Decreasing of participants exposure to credit risk • High reduction of settlement instructions BUT: potential problems ….

  6. The contamination effect depends on: • the defaulter’s debit value • the number of its counterparties • In case of a participant’s default: contamination of the debit/credit chain Systemic Risk Netting: potential problems • How to handle a participant’s default : 1st. alternative Unwinding Procedures

  7. Socialization of losses • Moral Hazard Netting: potential problems • How to handle a participant’s default : 2nd. alternative Third Party Pays

  8. International recommendation for risk mitigation in DNS Systems • Allows the benefits of netting without increasing systemic risk CCP: the third alternative CCP Provided that: adequate risk management controls and systems should be adopted.

  9. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

  10. Trading BUYER SELLER CCP assumes the role of the buyer CCP CCP assumes the role of the seller SELLER BUYER What is a CCP ? CPSS-IOSCO: « A central counterparty (CCP) is an entity that interposes itself between the counterparties of trade, acting as a buyer to every seller and a seller to every buyer »

  11. RISK A A RISK H RISK B H B CCP RISK G CCP RISK C G C RISK RISK F RISK D F D RISK E E CCP: main function and advantages • Main advantages: • Guarantee of anonymity • Supports multilateral netting • Absorption of risks between trade and the settlement period • Protection of market participants in the event of a participant default • Prevents the spillover of securities settlement risks to the payments system • Systemic Risk Reduction • Measure; • Manage; and • Assume the counterparty risk

  12. High fixed costs Minimum Scale Requirements CCP: main disadvantages Barriers to be overcome in order to implement a robust risk management system • High initial investments • Human resources • Risk management systems • IT systems (both hardware and software) • High ongoing expenses to maintain the system

  13. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

  14. Principal Risk • Replacement cost Risk • Credit risk • Liquidity risk CBLC: main risks to be managed DELIVERY vs. PAYMENT Principal Risk

  15. CBLC Model • SFI-DVP model 3 - multilateral netting for both securities and cash legs • For cash leg, multilateral netting across different markets and instruments • Settlement cycles: • Equities: T+3 • Corporate Bonds: T+0 and T+1 • Same day finality in central bank money (allowed by the Brazilian Payment System implemented in April 2002) • STR: Central Bank Money Transfer System (RTGS) • CBLC: Transitory settlement account at STR • Adequate legal basis: • Enforceability of multilateral netting and novation of trades • CBLC lien on securities posted as collateral

  16. CBLC acts as a CCP: • Equities (cash and derivatives) • Corporate debt instruments • BTC – Securities Lending Service Trading Systems Trading Matching CBLC CCP CBLC Buy Order Sell Order CLEARING AGENT A B CLEARING AGENT A BROKER B BROKER CBLC • Information is sent to Brokers and Clearing Agents: CBLC BECOMES CCP • Trading and matching • Trades are automatically reported to CBLC CBLC Model • When CBLC becomes a CCP?

  17. Segregated Net worth Settlement fund 99% confidence level under stress scenarios Hybrid Loss Sharing model • defaulters pay • survivors pay Collateralization 95% confidence level under historic scenarios Participants’ requirements LAMFALUSSY PLUS CBLC credit risk: layers of protection

  18. LIQUIDITY PROVISION • Financial credit lines provided by a pool of banks • CBLC has only a short time period (3:30 to 3:55 pm) to execute collaterals Dealing with payment failures... • 1st: collaterals posted by the defaulter • 2nd: defaulter’s contribution to the settlement fund • 3rd: settlement fund • 4th: segregated net worth

  19. Fundamental mechanism to prevent delivery failures Dealing with securities delivery failures • 1st: Securities Lending: • CBLC acts as principal • Full collateralization • Risk management tool: CM–TIMS (OCC system) • Fully integrated in the settlement process • 2nd: Buy-in procedures: • T+4: CBLC releases a buy-in order • The buy-in order can be canceled until T+6 should the defaulter delivers the security; • Buy-in order execution: the buyer´s broker buys the security in the market • Market price difference: covered by the collaterals posted by the defaulter

  20. Summing up ... Multilateral netting supported by a CCP SFI – DVP 3 Same day finality in Central Bank Money Participants requirements Collateralization Settlement Fund Segregated Net Worth Securities Lending

  21. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

  22. Strong cooperation between the market and the regulators Concluding Remarks The choice and design of a suitable model depends on several key variables: International recommendations and best practices Particularities of each country: • National Payment Systems • Legal environment • Profile and characteristics of the financial market • Size • Regulations • Market practices • Participant’s size, concentration, profile and business strategies • Type and diversity of financial instruments

  23. Concluding Remarks • That is:it is not wise to support an optimal model, regardless the specific context in which it is going to be put in place • RTGS x DNS systems: the choice of adopting one or the other (or a combination of the two of them) has to be addressed, case by case, taking into account: • the trade-offs between the RTGS and DNS systems • cost x benefit analysis • Volume and value of financial transactions • Trading patterns among counterparties • Opportunity costs to implement risk management robust systems

  24. Nevertheless: it is possible to outline one general conclusion: If a DNS system should be chosen, it is worth considering the implementation of a CCP in order to capture the benefits of netting without jeopardising the systemic risk reduction goal; otherwise, it can be more suitable to settle in a gross basis CPSS-IOSCO Recommendation n.4: “The benefits and costs of a CCP should be evaluated. Where such a mechanism is introduced, the CCP should rigourously controls the risks it assumes.” Concluding Remarks

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