Cross-border securities settlement and risk analysis framework for ...

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Box 4 – CPSS-IOSCO Recommendation and Key Issues for Cross-Border LinksRecommendation 19 : Risks in cross-border linksCSDs that establish links to settle cross-border trades should design and operate such links to reduce effectivelythe risks associated with cross-border settlements.Key issues :1. CSDs should design links to ensure that settlement risks are minimised or contained. A CSD should evaluate thefinancial integrity and operational reliability of any CSD with which it intends to establish a link.2. DVP should be achieved and provisional transfers across the link should be prohibited, or, at a minimum, theirretransfer prohibited, until the first transfer is final.3. Any credit extensions between CSDs should be fully secured and subject to limits. Liquidity managementarrangements should be implemented to address operational inefficiencies and potential defaults.Source : CPSS-IOSCO (2002), Assessment Methodology for Securities Settlement Systems.When the investor (I)CSD has a direct securities accountin the issuer (I)CSD and conducts a cross-system transferon behalf of its participants, the investor (I)CSD is subjectto the same inherent securities settlement risks as thoseconfronting other participants in the issuer (I)CSD fordomestic trades. The use of intermediaries in cross-borderlinks, however, has an impact on the risks borne by theinvestor (I)CSD. From an operational point of view, theextension of the settlement chain through intermediationcould theoretically increase risks for the investor (I)CSD.At the same time, subject to contractual arrangementsbetween the intermediary and the investor (I)CSD, theinvestor (I)CSD would primarily have a risk exposure onthe intermediary instead of on the issuer (I)CSD. Thiswould be the case for cross-system transfers via indirector relayed links as well as for internalised settlement in thebooks of the intermediary. Internalisation of settlementat the level of the investor (I)CSD may have an impact oncertain risks that arise in cross-system transfers or intermediationin links.Below, the article identifies risks in cross-border settlementrelated to the (1) legal, (2) settlement, (3) financial,(4) control and (5) operational environment in which the(I)CSD link operates. Specifications according to the typeof cross-border settlement and its impact on the relevantrisks are made if deemed necessary.2.2.1 Legal risk (1)By definition, cross-border settlement of foreign securitiesthrough links involves multiple legal jurisdictions. Legalrisks in cross-border settlement include the choice of lawgoverning the relationship between the parties involvedand problems related to conflicts of laws. These risks haveto be addressed by the legal and contractual frameworkof the link between the investor (I)CSD and the local issuer(I)CSD, or the intermediaries involved (in the case of indirector relayed links, the investor (I)CSD does not have anydirect contractual arrangements with the issuer (I)CSD.Local regulation should also be taken into account toassess the eligibility of foreign securities for internal settlementwith the investor (I)CSD (e.g. whether foreign securitiesare required to be settled through an agent locatedin the country of issue). Local asset protection rules needto ensure that, in the case of bankruptcy or insolvency,the securities held by the investor (I)CSD on behalf of itsparticipants are protected against the claims on the issuer(I)CSD or intermediary’s creditors. Other reasons than(1) Legal risk is the risk that a party will suffer a loss because laws or regulations donot support the rules of the securities settlement system, the performance ofrelated settlement arrangements, or the property rights and other interests heldthrough the settlement system. Legal risk also arises if the application of lawsand regulations is unclear (BIS (2003), “Glossary of terms used in payments andsettlement“).130
CROSS-BORDER SECURITIES SETTLEMENT ANDRISK ANALYSIS FRAMEWORK FOR CROSS-BORDER LINKSbankruptcy or insolvency for blocking foreign securities(i.e. attachment by the issuer (I)CSD or intermediary’screditors, freeze or blocking instructions from local courtsor regulators) need to be assessed. Legal risk also includescustody risk which is defined as the risk of loss of securitiesheld in custody occasioned by the insolvency, negligenceor fraudulent action of the custodian or of a subcustodian. Investor (I)CSDs typically use intermediaries incross-border links, who may again subdeposit securitieswith other intermediaries (i.e. typically the issuer (I)CSD).The involvement of multiple agents (i.e. tiering of holdings)has an impact on custody risk.At the level of the investor (I)CSD, the effectiveness ofclient recovery rules should also be assessed in the case ofbankruptcy or insolvency of the investor (I)CSD. Possiblelegal or practical uncertainties in the home jurisdictionmight have an impact on the speed with which foreignassets held through links are recovered by the liquidator.In the European context, some of the legislation relatingto securities settlement has been harmonised. TheSettlement Finality Directive, for example, aims at reducingthe systemic risk associated with participation in paymentand securities settlement systems, and in particularthe risks caused by the insolvency of a participant in thesesystems (1) . Settlement of a transaction is to be consideredirrevocable and unconditional in accordance withlocal market finality rules. If the investor (I)CSD receivesprovisional transfers of funds and securities via a crosssystemsettlement, an unwinding of such transactionsdue to an insolvency or failure of a local participant in theissuer (I)CSD could create credit and liquidity problems forparticipants in the investor (I)CSD. Moreover, settlementcould also be reversed due to existing claw-back rules inthe local market (2) .2.2.2 Settlement modelCross-system transfers with the issuer (I)CSD are executedin accordance with the applicable settlement model ofthe local issuer (I)CSD. The settlement cycle has an impacton replacement cost risk (or pre-settlement risk) which isthe risk that a counterparty to an outstanding transactionfor completion at a future date will fail to perform on thecontract or agreement during the life of the transaction.The resulting exposure is the cost of replacing the originaltransaction at current market prices.When cross-system transfers are executed with a counterpartyin the issuer (I)CSD, the investor (I)CSD runs asettlement risk on that local counterparty. Settlement riskis a general term designating the risk that settlement ina transfer system will not take place as expected. Whenthe issuer (I)CSD has a DVP mechanism in place, principalrisk for the investor (I)CSD will be eliminated, i.e. therisk that the seller of a security delivers a security butdoes not receive payment, or that the buyer of a securitymakes payment but does not receive delivery. The DVPmodel applied by the issuer (I)CSD will have an impact onreplacement cost risk, as well as on liquidity risk (i.e. therisk that a counterparty in a settlement system will notsettle an obligation on time). In gross settlement systems(DVP Model 1), replacement cost and liquidity risks couldmaterialise throughout the batch / day on an operationby-operationbasis. In net systems (DVP Model 2 & 3),however, replacement cost and liquidity risks are typicallybuilt up during the batch / day and could materialise on anet basis at the end of the batch / day.The settlement model is also defined by the cash settlementassets used, i.e. central or commercial bank money.As a rule, the investor (I)CSD will settle transactions in thelocal market through cash correspondents, as it has nodirect access to central bank liquidity or credit. By holdingcash balances with cash correspondents it bears cashdeposit risk.In the case of internalisation (i.e. at the level of the investor(I)CSD or intermediary), cross-border settlement isexecuted outside the local issuer (I)CSD and is thereforesubject to other rules than those of the issuer (I)CSD. TheDVP settlement model, for example, applied in the investor(I)CSD might be different from the one in the issuer(I)CSD, whereas internalising settlement at the level ofintermediaries, such as local agents or global custodians,might make DVP rules less transparent. Moreover, forinternal cross-border settlement at the level of the investor(I)CSD, securities and cash transfers are settled in onlyone system, as no settlement occurs in the books of theissuer (I)CSD or an intermediary. Consequently, settlementrules applicable in the local market do not have an impacton the settlement process in the books of the investor(I)CSD.2.2.3 Financial strengthBy making use of intermediaries in the case of indirect andrelayed links, the investor (I)CSD has to check the solvencyand financial resilience of its intermediary service provider.Since the issuer (I)CSD is part of the settlement chainingprocess, either active or passive depending on the typeof link and cross-border settlement, the analysis has to(1) The Settlement Finality Directive, adopted in May 1998, contains provisionsregarding (1) transfer orders and netting, (2) insolvenly proceedings and(3) collateral security.(2) Claw-back rules are provisions defining circumstances that lead to the reversalof transactions which occurred previously. Whenever claw-back rules exist,by definition, claw-back risk cannot be mitigated within the local jurisdiction.131
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