extend to the financial strength of the issuer (I)CSD toprovide com<strong>for</strong>t regarding the continuity of its business.Moreover, issuer (I)CSDs can grant credit (fully collateralisedor not) to their participant ; that requires adequatecredit <strong>and</strong> liquidity <strong>risk</strong> controls to address participants’failures to settle or operational deficiencies. An <strong>analysis</strong>should also be conducted to find out whether the investor(I)CSD bears any credit or liquidity <strong>risk</strong> by settling transactionsthrough the link, <strong>and</strong> to see how these <strong>risk</strong>s aremanaged at its own level. In accordance with CPSS-IOSCORecommendation 19, any credit extensions between(I)CSDs should be fully secured <strong>and</strong> subject to limits (1) .Default procedures to mutualise <strong>risk</strong> among the participantsmight be in place in the issuer (I)CSD whereby participantsthat fail to meet their obligations can settle, thusavoiding further disruption in the system (i.e. guaranteefund). Loss-sharing arrangements can also be applied<strong>for</strong> the allocation of losses arising from the default of aparticipant in the local system. When the investor (I)CSDholds a <strong>securities</strong> account directly in the issuer (I)CSD, itruns the <strong>risk</strong> of having to participate to the loss-sharingarrangement if such an arrangement has been put inplace by the issuer (I)CSD.2.2.5 Operational <strong>risk</strong> (2)For cross-system <strong>settlement</strong>, (I)CSD systems need to beconnected – through an intermediary in the case of indirect<strong>and</strong> relayed links – to exchange in<strong>for</strong>mation (3) <strong>and</strong><strong>settlement</strong> confirmations between systems across the link.Inefficiencies may occur due to differences in communicationmeans, <strong>settlement</strong> windows or time zones, creatingfurther replacement cost <strong>and</strong> liquidity <strong>risk</strong>s. The interoperability<strong>and</strong> efficiency of a cross-system transfer across alink is of particular importance <strong>for</strong> broker / dealers as theyintend to buy <strong>and</strong> sell the same security <strong>for</strong> the samevalue date by back-to-back trades (4) . Inefficient links couldaffect liquidity needs <strong>for</strong> broker / dealers, as they may haveto block <strong>securities</strong> be<strong>for</strong>eh<strong>and</strong> or borrow <strong>securities</strong> <strong>and</strong>funds to realise same day turnaround of <strong>securities</strong>.This type of operational <strong>risk</strong> would, in theory, increase withthe number of intermediaries involved. As an operational<strong>risk</strong> in a linked system may affect or delay <strong>settlement</strong> <strong>for</strong>the investor (I)CSD, business continuity arrangements inplace with the issuer (I)CSD <strong>and</strong> intermediaries (incl. businesscontinuity plans, back-up sites <strong>and</strong> testing) need tobe addressed in the investor (I)CSD’s <strong>analysis</strong> of the link.2.2.4 Control environmentThe investor (I)CSD needs to be confident that the issuer(I)CSD <strong>and</strong> the intermediaries involved in cross-<strong>border</strong><strong>settlement</strong> through links are subject to effective controlsby internal <strong>and</strong> external audit. The regulation <strong>and</strong> oversightof <strong>securities</strong> <strong>settlement</strong> systems <strong>and</strong> the divisionof responsibilities among public authorities varies fromcountry to country, depending on the legal <strong>and</strong> institutional<strong>framework</strong>. There<strong>for</strong>e, the investor (I)CSD has to bein<strong>for</strong>med whether the issuer (I)CSD <strong>and</strong> the intermediary(if applicable) are subject to regulation, supervision oroversight by regulatory bodies, <strong>and</strong> by whom. In accordancewith the CPSS-IOSCO Recommendations, the objectives<strong>and</strong> responsibilities, as well as the roles <strong>and</strong> majorpolicies of the <strong>securities</strong> regulator <strong>and</strong> the central bankhave to be clearly defined <strong>and</strong> disclosed. In that regard,some authorities have published <strong>for</strong> their domestic systemsa report on the observance of the CPSS-IOSCORecommendations.(1) This applies typically to the Bridge between Euroclear <strong>and</strong> Clearstream.(2) Operational <strong>risk</strong> can be defined as the <strong>risk</strong> of deficiencies in internal controls orthe <strong>risk</strong> of human error or a breakdown of some component of the hardware,software or communications systems that are crucial to <strong>settlement</strong> (BIS (2003),“Glossary of terms used in payments <strong>and</strong> <strong>settlement</strong>”).(3) I.e. in<strong>for</strong>mation required to complete <strong>settlement</strong> ; in particular to confirm thatcounterparties have sufficient positions in <strong>securities</strong> <strong>and</strong> funds (or access tocredit).(4) Back-to-back trades are pairs of transactions that require a counterparty toreceive <strong>and</strong> redeliver the security on the same day.On the other h<strong>and</strong>, internalisation of cross-<strong>border</strong> <strong>settlement</strong>through an (I)CSD link can neutralise some operational<strong>risk</strong>s due to a shorter <strong>settlement</strong> chain. When thereis an internal <strong>settlement</strong> at the level of the investor (I)CSD,the link is a pure custody arrangement without the needto exchange <strong>settlement</strong> related in<strong>for</strong>mation across thelink. Operational problems with the issuer (I)CSD mightnot necessarily have an impact on the internal <strong>settlement</strong>of <strong>for</strong>eign <strong>securities</strong> in the investor (I)CSD, limitingoperational <strong>and</strong> systemic <strong>risk</strong>s. Where <strong>settlement</strong> is internalisedat the level of the intermediary, in<strong>for</strong>mation is stillexchanged between the investor (I)CSD <strong>and</strong> the intermediary,not with the issuer (I)CSD.Chart 3 below gives, per category of <strong>risk</strong>s, an overviewof the possible impact of <strong>risk</strong>s on the investor (I)CSD settling<strong>for</strong>eign <strong>securities</strong> via cross-system transfers acrossthe link or via internalisation in its own books. There isno differentiation according to the type of link in the caseof cross-system <strong>settlement</strong> since, <strong>for</strong> indirect <strong>and</strong> relayedlinks, the relevant <strong>risk</strong> exposures on the issuer (I)CSD arelargely shifted to the intermediary. By internalising <strong>settlement</strong>at the investor (I)CSD, some <strong>risk</strong>s that are typical <strong>for</strong>cross-system transfers through a link can be neutralised.The <strong>settlement</strong> model applicable in the issuer (I)CSD aswell as the interoperability of the link would not have animpact on the <strong>settlement</strong> process in the investor (I)CSD.However, the investor (I)CSD would still bear legal <strong>risk</strong> (inparticular custody <strong>risk</strong>) <strong>for</strong> the holding of <strong>securities</strong> in the132
CROSS-BORDER SECURITIES SETTLEMENT ANDRISK ANALYSIS FRAMEWORK FOR CROSS-BORDER LINKSCHART 3IMPACT OF RISKS FOR THE INVESTOR (I)CSD PER TYPE OF CROSS-BORDER SETTLEMENTRisks in <strong>Cross</strong>-BorderSettlement related toType of <strong>Cross</strong>-BorderSettlement<strong>Cross</strong>-SystemSettlementInternalSettlement atInvestor (I)CSDLegal <strong>risk</strong> (1)Settlement modelFinancial strengthControl environmentOperational <strong>risk</strong>Large impactSmall impact(1) Including custody <strong>risk</strong>issuer (I)CSD. The quality of the control environment, aswell as the financial strength of the intermediary <strong>and</strong> / orthe issuer (I)CSD, also remain relevant <strong>for</strong> the investor(I)CSD.3. Risk <strong>analysis</strong> <strong>framework</strong> <strong>for</strong>cross-<strong>border</strong> (I)CSD linksCPSS-IOSCO Recommendation 19 requires (I)CSDs toconduct a <strong>risk</strong> <strong>analysis</strong> of the design of the link as well asof the financial integrity <strong>and</strong> operational reliability of thelinked issuer (I)CSD. The latter may per<strong>for</strong>m different setsof functions (i.e. provision of depository, credit, <strong>securities</strong>lending, collateral management, custodian <strong>and</strong> <strong>settlement</strong>services) which may also be provided through the link. Thedesign of the link is there<strong>for</strong>e determined by the choice offunctions, as well as by the structure of the issuer (I)CSDsthemselves <strong>and</strong> the legal <strong>framework</strong> applicable in therespective jurisdictions (1) . Recommendation 19 does not,however, provide detailed “tools” that specify how this<strong>analysis</strong> should be done in practice.In the assessment process of the links of investor (I)CSDslocated in Belgium, the NBB has set up, as overseer of<strong>securities</strong> <strong>settlement</strong> systems, a Risk Analysis Framework(“the Framework”) that provides guidance on the interpretationof CPSS-IOSCO Recommendation 19 relatingto cross-<strong>border</strong> links. It allows both the NBB, as overseer,<strong>and</strong> the investor (I)CSD to conduct a comprehensiveassessment of the relevant <strong>risk</strong>s in cross-<strong>border</strong> (I)CSDlinks set up by the investor (I)CSD, <strong>and</strong> to verify whetherthe investor (I)CSD, subject to the oversight by the NBB,meets CPSS-IOSCO Recommendation 19. The Frameworkis detailed in Annex 1.In accordance with CPSS-IOSCO Recommendation 19, theFramework is based on the principle that it is the investor(I)CSD (<strong>and</strong> not the issuer (I)CSD) that needs to conducta <strong>risk</strong> <strong>analysis</strong> of the link. In the case of indirect links, <strong>for</strong>example, the issuer (I)CSD might even be unaware thatit is linked with an investor (I)CSD as an intermediary willact on behalf of the investor (I)CSD by holding a <strong>securities</strong>account in its system. As a consequence, (I)CSDs locatedin Belgium operating as issuer (I)CSDs in links will not haveto meet the requirements of the Framework.In accordance with the Framework, the investor (I)CSDshould assess the <strong>risk</strong>s relating to cross-<strong>border</strong> <strong>settlement</strong>at the level of the issuer (I)CSD <strong>and</strong> all other intermediaries(i.e. local agent, global custodian, (I)CSDs) engaged in aparticular cross-<strong>border</strong> link (2) , regardless of the type of linkor cross-<strong>border</strong> <strong>settlement</strong>. When a security deposited by(1) For legal <strong>and</strong> custody <strong>risk</strong>s, CPSS-IOSCO refers to Recommendation 1 (“Legal”)<strong>and</strong> 12 (“Protection of customers’ <strong>securities</strong>”).(2) Since <strong>for</strong> a particular link, the intermediary may not function as cashcorrespondent, the latter should also be covered by some aspects of theFramework.133
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