GLOBAL Clearing Settlementand a Plan of Action

GLOBAL Clearing SettlementAND A Plan of Action

G ROUP OF T HIR TY 30 All members of the Steering Committee served in their personal capacities. The views expressed in this report do not necessarily reflect the views or policies of their respective institutions, nor does publication of the report by the Group of Thirty imply an endorsement of the views expressed herein.

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Group of Thirty 1990 M Street, N.W., Suite 450 Washington, DC 20036 Tel: (202) 331-2472 · Fax: (202) 785-9423

WWW – http://www.group30.org E-mail – [email protected] Global Clearing and Settlement A PLAN OF ACTION

Group of Thirty© Washington, DC 2003 CONTENTS

Foreword, by Paul Volcker and Jacob Frenkel ...... v

Chairman’s Message, by Sir Andrew Large ...... vii

Steering Committee Members ...... ix

Acknowledgments ...... x

Executive Summary ...... 1

Chapter 1. Clearing and Settlement: What Is at Stake? ...... 13

Chapter 2. The Current State of Affairs...... 21

Chapter 3. Building an Efficient, Interoperable Network ...... 25 Recommendations 1-8 ...... 29

Chapter 4. Ensuring Safety and Stability ...... 35 Recommendations 9-16 ...... 40

Chapter 5. Governance: The Key to Reform...... 49 Recommendations 17-20 ...... 50

Chapter 6. From Recommendation to Implementation ...... 57

APPENDIXES

Appendix 1. Detailed Background on the Recommendations ...... 67

Apppendix 2. Conduct of the Study ...... 125

Glossary ...... 133

Group of 30 Publications since 1989 ...... 135

Group of 30 Members ...... 137

FIGURES AND TABLES Figure 1-1. U.S. Activity in Foreign Securities versus Foreign Activity in U.S. Securities, 1980–2001 ...... 17

Table 6-1. Implementation Targets for the Private and Public Sector ...... 61

Table A2-1. Contributing Organizations ...... 126

iii Table A2-2. Organizations Interviewed ...... 127

Table A2-3. Related Studies Examined ...... 128

BOXES 1-1. Interoperability...... 14

2-1. System Components...... 22

3-1. Participants in the Clearing and Settlement Process ...... 28

A2-1. Individual Contributors ...... 131

iv FOREWORD

THE GROUP OF THIRTY COMMISSIONED THIS STUDY and operational matters to risk management and gov- of global securities clearing and settlement arrange- ernance practices. The Steering Committee devised a ments out of concern that unevenly developed national three-pronged strategy to accomplish this, including: clearing and settlement infrastructure and inconsistent business practices across markets could be a source of ½ Technical and business practice standards significant systemic risk, and certainly of inefficiency. intended to strengthen the connections across Given rapid growth of debt, equity, and derivatives borders and systems; trading, both generally and cross-border, the wrong ½ Stronger risk management, including the combination of market shocks and financial disloca- stronger legal guarantees necessary to provide a tions might be sufficient to overtax the infrastructure solid legal basis for clearing and settlement; and on which the functioning of global markets depends. ½ Improved governance by private boards, With these concerns in mind, the Group of Thirty supported by official supervision and fair and recruited a senior group of private executives and pub- open access to systems. lic officials to serve on the project’s Steering Commit- tee, and Andrew Large agreed to serve as its chair. Eleven The strategy encompasses 20 recommendations members of the Group of Thirty itself and a dozen that constitute an action plan for global clearing and others joined him on the Committee, which undertook settlement. The plan is ambitious but it reflects the the substantial challenge to investigate the complex in- aspirations of market participants, gives direction to stitutional structures and processes that characterize glo- work that is already under way, and provides specific bal clearing and settlement. Their aim was to improve guidance for tackling new areas. Its fundamental logic both the safety and efficiency of these global processes. is that a globally linked marketplace should be sub- The Committee began by assembling a formidable ject to global norms. array of talent to complete the body of work that is Like the Group of Thirty itself, the report seeks to catalogued in this report. Over the course of two achieve a balance of views and interests, incorporat- years, survey teams and working parties analyzed cur- ing the best thinking of the private and public sectors. rent industry conditions, evaluated current practice This is important because achieving its objectives will and latest supervisory guidance, and framed propos- require significant attention from both quarters, along als for making the system safer and more efficient. with significant investment by a great many market If the hours of effort devoted to this venture by its participants. All of this will take time and it will be many contributors were fully valued, it would certainly important to review progress along the way. To ensure constitute a multi-million dollar enterprise. that the issues raised receive the continuing attention The particular focus of the exercise was the set of they deserve, the Group of Thirty will monitor challenges arising from cross-border trading. Trades progress on cross-border reforms going forward. are moving across borders without support of com- The Group of Thirty is pleased to have sponsored mon — or even consistent — structures, performance this project and we commend its analysis and recom- standards, or operational rules. Achieving consistency mendations to all who are concerned about the safety will require far-reaching change, from purely technical and efficiency of global markets.

Paul A. Volcker Jacob A. Frenkel Chairman of the Trustees Chairman Group of Thirty Group of Thirty

v CHAIRMAN’S MESSAGE

THE GLOBAL FINANCIAL SYSTEM is only as good as and what needs to change. We pursued a dialogue with the infrastructure that supports it. And the smooth major firms, smaller firms, service providers like con- functioning of that system—and the confidence on trol securities depositories (CSDs) and central which it depends—will be threatened if the infrastruc- counterparties, as well as investors and end-users. We ture is unreliable. Unfortunately attention to the over- reviewed the results against public policy requirements, all system of global securities clearing and settlement using as a starting point the CPSS/IOSCO recommen- has been in short supply. Meanwhile the process of dations of November 2001. We were also informed clearing and settlement has become much more in- by other studies—by the Giovannini report in Europe, terdependent globally, increasingly linked to the world for example—which articulated so clearly many of the of payments and foreign exchange as well. Such a barriers to improvement in this area. network of interdependent systems can improve ef- The net result of this effort is a series of twenty ficiency, but a network without a sound basis could recommendations, outlined in the Executive Sum- also create vulnerabilities. mary that follows. Because the costs of failure in the On a domestic basis there is confidence that clear- cross-border area are high, our recommendations go ing and settlement systems work. It is the cross- beyond minimum standards. They target best prac- border arena that has been neglected because the ar- tice in the major mature markets. They may go fur- chitects have tended to stop at their own borders. And ther than needed in emerging markets, although for although a major failure has so far not struck, recent the long term we feel that they should be aspirational events—and not least the U.S. tragedy on September for such markets as well. The recommendations fall 11, 2001—warn us against any complacency. into three groups. Against this background, two years ago the Group First are those primarily related to efficiency. In a of Thirty formulated a project on global clearing and nutshell these are standards of best practice aimed at settlement. They recruited a Steering Committee, the private sector. They cover technical features of the which they asked me to chair, to see whether a path- clearing and settlement process (messaging, for ex- way could be devised to improve the global system. ample), but also market practices such as operating We took as our basic premise that market-led change hours. Together they provide for a strengthened net- should be the key mechanism. work with the potential for interoperability—a con- We have avoided prescribing structures, institu- cept that we have discussed in some detail on page 14. tional arrangements, or who ought to own what. In- Second are recommendations related to mitigating stead we have focused on the need for standards— risks—an area of mutual concern to the industry and best-practice standards that conform to public policy those who supervise it. Many areas here are familiar needs. These standards will in practice define the net- and we have focussed on financial and operational in- work: they will outline its features and help form its tegrity of all main participants: users as well as provid- architecture. In addition, mechanisms to ensure open ers. In addition, however, we have taken account of access to both service providers and users will un- much that has been learned since the September 11 derwrite competition in clearing and settlement ser- outrage, and addressed some significant areas in the vices and functions. In this way institutional arrange- legal arena. Market confidence after all is underpinned ments will evolve through market-led change. by legal certainty in such basic areas as finality and close- We also wanted to ensure a practical outcome, one out, so we have addressed both these difficult areas. that conforms to prevailing industry approaches. So Third, there is a series of recommendations on we asked market participants themselves what is wrong improving and strengthening governance, aimed at

vii ensuring implementation of the efficiency and risk sector on whom the costs are likely to fall, it is they mitigation proposals in the report. We have recom- who can see the potential for lower unit costs by mended ways to strengthen the resolve and forceful- making the necessary investments. Secondly, time ness of boards of directors as well as ways to ensure helps. The system cannot be changed overnight in fair access and consistent oversight. We have at- any case, and the time horizon for realizing the vi- tempted to set out clearly the issues in need of atten- sion in our proposals is consistent with the cycle for tion, how our recommendations address them, and obsolescence of software and systems that requires what needs to change. And we have looked for realis- renewal over a five-to-seven-year period. So we be- tic ways to drive consistent and concerted progress, lieve that introducing new standards as part of that and to do so on many fronts. We have therefore de- renewal will be significantly less costly than forcing vised a “pathway” in the form of a statement of who change faster. needs to do what for each of the twenty recommen- The final point to be made is that the changes we dations. Much of the required effort must come from propose will not happen without top-level support. the private sector, but some from public authorities Many of us in the corporate boardroom have shied as well. away from the clearing and settlement area because of To add impetus to this process, we intend to put in its sheer complexity, but this report is aimed at strate- place machinery to coordinate and to catalyze progress gic decisionmakers in both public and private sectors. on implementation. The Group of Thirty is forming a While those with operational responsibility for clear- Standing Committee to oversee this process. We ex- ing and settlement will certainly have to understand pect that this Committee will work very closely with these matters in detail, top-level support does not re- all interested parties both public—such as CPSS/ quire a detailed knowledge of the mechanics. What it IOSCO and individual supervisors and central banks— does require is that the issues are addressed in an un- and private—such as ISSA and the Global Documen- derstandable and consistent way, that a sensible course tation Steering Committee and individuals firms and is set, and that the goals are realistically achievable. We clearing and settlement organizations. A substantive hope our study inspires confidence that this is so, and review of progress will be undertaken two years after will accordingly enjoy wide support. publication of this report that will examine progress If industry leaders and public officials embrace and make transparent who has been active and whether the objectives we have set, the improved infrastruc- there are areas in which sufficient progress has not ture that results will contribute to enhanced confi- been made. dence in the markets themselves. We hope that the We have, of course, been mindful of the signifi- report proves helpful not only in tackling the specific cant costs involved in implementing our recommen- challenges of global clearing and settlement but in dations, but we are confident that our approach is addressing vulnerabilities in global financial networks realistic on two grounds. Firstly, while it is the private more generally.

Sir Andrew Large Chairman, Global Clearing and Settlement Project

viii STEERING COMMITTEE MEMBERS

Chairman: Andrew Large, Deputy Governor, Bank of England Vice Chairman: John Heimann, Senior Advisor, Financial Stability Institute. Vice Chairman: David Walker, Senior Advisor, Morgan Stanley International

Daniel Bouton Chairman, Société Générale Rolf Breuer Chairman, Supervisory Board of Managing Directors, Deutsche Bank Marsh Carter Chairman and CEO (Retired), State Street Corporation Jill Considine Chairman and CEO, Depository Trust & Clearing Corporation E. Gerald Corrigan Managing Director, Goldman Sachs & Co. Andrew Crockett* General Manager, Bank for International Settlements Howard Davies* Chairman, Financial Services Authority William Harrison President and CEO, JP Morgan Chase & Co. Gerald Hassell President, The Bank of New York Gerd Häusler* Director, International Capital Markets Department, International Monetary Fund Mervyn King* Deputy Governor, Bank of England William McDonough* President, Federal Reserve Bank of New York John Olds Member of the Board (Retired), DBS Group Holdings Marcel Ospel Chairman, UBS Tommaso Padoa-Schioppa* Member of the Executive Board, European Central Bank Robert Pozen Chief of Commerce and Labor, Commonwealth of Massachusetts, Office of the Governor Alessandro Profumo Chief Executive Officer, UniCredito Italiano William Rhodes Senior Vice Chairman, Citigroup, Inc. Andrew Sheng* Chairman, Hong Kong Securities and Futures Commission Jean-Claude Trichet* Governor, Banque de France Yutaka Yamaguchi* Deputy Governor, Bank of Japan

Project Director: Marc Hollanders, Bank for International Settlements Executive Director: John Walsh, Group of Thirty

* Public sector member whose service was in a personal, advisory capacity.

ix ACKNOWLEDGMENTS

THE GROUP OF THIRTY WOULD LIKE TO PAY TRIB- mitting Marc Hollanders to serve as Project Director UTE to those whose contribution of time, talent, and and to the Hong Kong Securities and Futures Com- energy over the last two years made this project pos- mission, JP Morgan Chase, and the European Cen- sible. Thanks is due first and foremost to the Chair- tral Bank for permitting Stella Leung, Ed Neeck, and man of the project Steering Committee, Andrew Elias Kazarian to serve as working group secretaries. Large, and the two Vice Chairmen, John Heimann Although the contributions of these individuals were and David Walker, who contributed countless hours prodigious, the total work effort was dominated by the guiding the project from inception to completion. cumulative contributions of the many private and pub- Planning the work and bringing it to fruition also re- lic institutions that participated in it. The full list of or- lied on the immeasurable support and dedication of ganizations represented on working and advisory groups the G30 Executive Director, John Walsh, and the and those that took part in the industry survey are listed Project Director, Marc Hollanders. in tables A2-1 and A2-2 of Appendix 2. Of course, any They were assisted by an Executive Committee that such list is a proxy for the efforts of a great many indi- also included Steering Committee members Jill viduals. Those who made significant personal contribu- Considine of the Depository Trust & Clearing Cor- tions through their service on working or advisory poration, E. Gerald Corrigan of Goldman Sachs, groups, drafting documents, or offering technical ad- Gerald Hassell of the Bank of New York, and An- vice are listed at the end of Appendix 2. drew Sheng of the Hong Kong Securities and Fu- We would also like to thank organizations that pro- tures Commission; Michael Patterson of JP Morgan vided facilities and hospitality for meetings of project Chase and Stephan Schuster of Deutsche Bank. As committees and working groups. These include discussed in Appendix 2, the Executive Committee Barclays plc, the Bank of England, Citigroup, chaired working and advisory groups and provided Goldman Sachs, JP Morgan Chase, Merrill Lynch, detailed input to the identification and drafting of Morgan Stanley, and PricewaterhouseCoopers. recommendations. The full 24-member Steering The overall project was a complex undertaking and Committee, listed at the front of this report, was re- the production, dispatch of drafts, and a very sub- sponsible for oversight of the work program and for stantial editorial and production process had their lo- the resulting report and recommendations. gistical center at the G30 offices, and in the office of Analysis, drafting, and coordinating the efforts of the project Chairman. Although the work took longer diverse contributors are key to any successful project than anyone imagined at the outset, it could never and a particular debt of gratitude is owed in this case have been completed without the efforts of Dawn to PricewaterhouseCoopers for serving as profes- Hewitt and Friso van der Oord of the Group of sional services partner for the project. Sam Dibb, Phil Thirty, Francesca Carter of the Bank of England and Rivett, Chris Thompson, Jack Pullara, and their col- Barclays plc, and without the dedicated efforts of our leagues conducted the industry survey that lies at the editors Martha Gottron and Nancy Morrison, and heart of this report, analyzed its findings, and worked our designer Sarah McPhie. with the Executive Committee and industry experts As the number of firms and individuals cited in- to identify areas of recommendation. Their assistance dicates, the G30 global clearing and settlement project in all phases of the project, but especially in prepar- was a far-flung enterprise. If there are others who ing the report’s 20 recommendations, was instrumen- assisted the project in uncharted meetings or tal to the success of the project. Special thanks is also unremarked conference calls, we apologize for the due to the Bank for International Settlements for per- oversight and thank them for their contribution.

x The final word of recognition is reserved for Gor- man of the Group, and his continuing leadership and don Richardson, honorary chairman of the Group interest in this area were manifest in efforts to launch of Thirty. Lord Richardson was the driving force be- this project. For his support as the Group’s senior hind the 1989 clearing and settlement study as chair- statesman, we are most grateful.

xi Executive Summary

EXECUTIVE SUMMARY

CLEARING AND SETTLEMENT OF SECURITIES IS A logical and operational areas, improvements in risk CORE FINANCIAL FUNCTION on which fundamental management practices, further harmonization of glo- confidence in the financial markets depends. It is also bal legal and regulatory environments, and improved an area experiencing rapid growth, profound techni- governance for providers of clearing and settlement cal and structural change, and infrequent but severe services. These changes are embodied in the follow- market shocks. Growth has been tremendous. For ing 20 recommendations, which, when implemented, example, the value of shares traded annually in world will significantly improve the safety and efficiency of markets rose nearly 63 times between 1980 and 2001. international securities markets. The reforms envis- Over that same period, U.S. gross activity (both pur- aged are likely to be attainable within five to seven chases and sales) in foreign securities grew nearly a years at modest incremental cost. hundred-fold, while foreign gross activity in U.S. securities also increased more than a hundred-fold.2 In Europe the institutional setting within which clear- THE TWENTY RECOMMENDATIONS ing and settlement occurs is changing rapidly, while CREATING A STRENGTHENED, technology is changing the face of the process world- INTEROPERABLE GLOBAL NETWORK wide. And the events of September 11, 2001, chill- 1. Eliminate paper and automate communication, ingly demonstrated that global clearing and settlement data capture, and enrichment. arrangements are vulnerable to physical disruption 2. Harmonize messaging standards and communi- and threats previously considered improbable. cation protocols. Any one of these factors—rapid growth, structural 3. Develop and implement reference data standards. change, or market shocks—would normally be 4. Synchronize timing between different clearing grounds for a thorough reexamination of market func- and settlement systems and associated payment tion and each has, on occasion, provided justification and foreign-exchange systems. for significant changes in market practices and super- 5. Automate and standardize institutional trade vision. Mindful of the need for reform, the Group of matching. Thirty commissioned this study fully a year before ter- 6. Expand the use of central counterparties. ror struck Wall Street. Subsequent developments have 7. Permit securities lending and borrowing to only underscored the importance of the project. expedite settlement. The report recommends wide-ranging reform of 8. Automate and standardize asset servicing processes, the clearing and settlement process, including creation including corporate actions, tax relief arrangements, and implementation of global standards in techno- and restrictions on foreign ownership.

1. Standard and Poor’s, Emerging Stock Markets Factbook 2002, McGraw Hill & Co., New York. 2. See footnote of Figure 1-1. p. 17.

1 Global Clearing and Settlement: A Plan of Action

MITIGATING RISK finally and irrevocably from one investor to another, 9. Ensure the financial integrity of providers of typically in exchange for a corresponding transfer of clearing and settlement services. funds—is central to all securities market activity and 10. Reinforce the risk management practices of is thus a linchpin of any financial system. Yet few users of clearing and settlement service people, even within financial institutions, understand providers. its complex mechanics in detail. The process, includ- 11. Ensure final, simultaneous transfer and avail- ing the associated costs and risks, is also largely invis- ability of assets. ible to end investors. For the most part this is unre- 12. Ensure effective business continuity and markable, in the same way that users of telephone or disaster recovery planning. Internet services need not understand the intricacies 13. Address the possibility of failure of a systemi- of data transmission or digital switching technology. cally important institution. The reliable performance this implies owes much 14. Strengthen assessment of the enforceability of to the high level of attention that has been devoted contracts. to domestic systems, notably in response to the Group 15. Advance legal certainty over rights to securities, of Thirty’s 1989 report, “Clearance and Settlement cash, or collateral. Systems in the World’s Securities Markets.” Recom- 16. Recognize and support improved valuation and mendations published in 2001 by the Committee on closeout netting arrangements. Payments and Settlement Systems of the Group of Ten central banks (CPSS) and the International Or- IMPROVING GOVERNANCE ganization of Securities Commissions (IOSCO) are 17. Ensure appointment of appropriately experi- now one of the key standards used by public authori- enced and senior board members. ties to achieve sound financial systems. 18. Promote fair access to securities clearing and At the same time, this is a period of rapid change settlement networks. in technology and market infrastructure, linked to fun- 19. Ensure equitable and effective attention to damental changes in the marketplace. These changes stakeholder interests. are associated with growth in trading volumes and 20. Encourage consistent regulation and oversight technological advances that have been instrumental of securities clearing and settlement service in opening up access to markets and providing op- providers. portunities to automate markets’ core processes. Con- tinued consolidation of market players and infrastruc- These recommendations are further elaborated at the ture is concentrating both market power and risk. In- end of this summary and in the first five chapters of vestors and the financial intermediaries that serve the accompanying report. Chapter 6 provides a fuller them are increasingly focusing on the costs of trad- discussion of priorities and a plan of action. Appen- ing, and the cleaning and settlement of those trades. dix 1 presents detailed steps toward implementation. With securities trading, especially cross-border trad- This is an ambitious agenda that will require substan- ing, expanding rapidly, both the stakes and the risks tial action by a wide range of market participants, in- involved are rising. dustry associations, and public sector agencies, and it is important to understand why changes of such sig- THE CHALLENGE OF CROSS-BORDER nificance must be made at this time. CLEARING AND SETTLEMENT Cross-border trading is a particular challenge because, RISING STAKES AND RISKS IN THE at its heart, clearing and settlement of securities is still CLEARING AND SETTLEMENT PROCESS an activity that takes place market by market. This Clearing and settlement of securities—the process “domestic” approach reflects the natural evolution of by which the ownership of securities is transferred securities markets in the context of local law, business

2 Executive Summary

practice, and regulatory frameworks, and the fact that respond to these challenges in ways that reduced both settlement systems have usually grown up in close alli- costs and risk. This report proceeds from the premise ance with the markets they support. Indeed in several that market-led change is essential. However, there countries, the stock exchange owns the clearing and are two reasons to believe that some external stimu- settlement system. In some countries, members of lus is needed. the exchange are obliged to use these systems. First, the legal and regulatory frameworks on which Any firm that provides investment services to in- clearing and settlement systems are founded continue ternational investors must participate in myriad to develop piecemeal and largely on a domestic basis. settlement systems and related legal and regulatory Thus, the complexities of cross-border clearing and systems. Maintaining the systems and retaining settlement are likely to grow, even people who understand the intricacies of the con- if best industry practice and offi- ventions and practices that differ from system to sys- cial guidance are strictly followed. Implementing the twenty tem and from market to market is costly. That cost Second, incentives within indi- recommendations in this is ultimately borne by investors in internationally vidual clearing and settlement en- traded securities, be they individuals or institutions, tities tend to support incremental report would significantly mutual funds or pension funds. change that strengthens the local improve the safety and franchise, rather than initiatives to efficiency of international NETWORK IMPLICATIONS facilitate greater competitiveness As well as adding costs, cross-border trading intro- at the international level that could securities markets. duces an increasing element of risk. The lack of adversely affect the value of the implementation of globally recognized technical local franchise. Indeed, segmenta- standards, uniform business processes, and consis- tion restricts competition because each system is able to tent legal and regulatory underpinnings makes the set its own standards for membership and for the ser- global clearing and settlement network inefficient, vices it provides. These are not incentives likely to pro- unwieldy, and potentially unreliable. Furthermore, duce global standards of best practice appropriate to this global network links clearing and settlement the emerging global network. systems with payments systems and foreign-exchange markets, so that problems in one system and mar- THE GROUP OF THIRTY INITIATIVE ket are increasingly likely to affect markets and For all these reasons, the Group of Thirty decided firms in other parts of the world. to initiate an assessment of cross-border clearing In addition, this imperfect network is vulnerable and settlement issues. A Steering Committee was to shocks, whether through an unexpected surge in recruited from senior representatives of the private market volatility, a major technical or institutional fail- sector and leading figures in the public sector (see ure, or a physical disruption. These shocks tend to be page ix). The contribution of the latter, owing to the of relatively short duration but are sometimes very demands of public office, was in a personal capacity, large in scale. Loss of the clearing and settlement func- drawing on their experience but without committing tions even briefly can be costly and disruptive of mar- their institutions. The aim of the assessment was to kets. Loss of function over several days, or simply at improve efficiency and reduce risk in the system. Its a critical time in the daily clearing and settlement pro- primary focus was major securities markets and the cess, can have serious systemic implications, especially key institutions that form the backbone of the global if accompanied by other financial disruptions. clearing and settlement framework. In the interest of promoting meaningful change, its objective was to MARKET DYNAMICS AND THE NEED FOR CHANGE enunciate technical, legal, and process standards With risks rising and pressures to reduce costs in- where possible, rather than remaining at the level of creasing, it would be reasonable to expect markets to

3 Global Clearing and Settlement: A Plan of Action

broad principles. To reflect the realities of the mar- ½ This report promotes “best practice” that ketplace, Pricewaterhouse Coopers undertook a sur- clearing and settlement systems in the most vey of 40 firms along what this report refers to as the advanced economies should aspire to meet clearing and settlement value chain. Participants within roughly five to seven years, while the ranged from asset managers and broker-dealers to CPSS-IOSCO recommendations set forth custodians and providers of clearing and settlement minimum standards that are expected to be services, from small firms to the large “bulge bracket” met at the earliest opportunity by settlement market participants. It included major trade associa- systems in all economies. tions and all major regions of the world (for a com- ½ Although this report and CPSS-IOSCO share plete list of participants, see Appendix 2). To avoid the broad objectives of safety and efficiency, bias in the result, the survey consisted of open-ended the agenda set out here is considerably more questions designed to allow the survey participants ambitious regarding efficiency, reflecting to provide their concerns about the current system industry aspirations expressed in the survey. and expectations regarding this study. ½ This report places greater emphasis than The survey findings constitute a far-reaching CPSS-IOSCO on cross-border issues, aiming agenda for change, aimed at achieving a truly glo- for creation of an integrated global network bal model for clearing and settlement. The recom- which goes beyond applying minimum mendations contained in this report respond directly standards in individual jurisdictions. to this research. If acted upon, the result would be a ½ Overall, this report’s recommendations tend to widely interoperable and accessible system operat- be more prescriptive than the CPSS-IOSCO ing to standards of best market practice. recommendations and focus more explicitly on the implementation path to be followed, again RELATIONSHIP TO OTHER KEY INITIATIVES reflecting industry aspirations. To ensure that any new recommendations were an- chored in existing standards of best practice and the Despite these differences in emphasis and intensity, latest regulatory guidance, a second element of the the two sets of recommendations are broadly comple- assessment was an evaluation of existing principles mentary and entirely consistent. Together, they pro- and standards. These included recommendations of mote sound infrastructure for global markets. the International Securities Services Association (ISSA), work of the Global Documentation Task COSTS AND BENEFITS Force, various reports on integrating clearing and The Steering Committee also carefully considered the settlement structures in the European Union includ- benefits and costs of the changes being recommended. ing the Giovannini report and work of the Euro- The available data clearly support the view that the pean Central Securities Depositories Association, current system is significantly less efficient than it and official guidance issued by various supervisory could be. No one disputes that the cost of settling a bodies. Most important in this regard were the rec- trade varies significantly from market to market, and ommendations issued jointly by CPSS and IOSCO cross-border settlement is substantially more expen- in November 2001, which this report fully endorses sive than domestic settlement. Yet, when it comes to as a foundation for the recommendations that fol- quantifying this assertion, analysis and opinion dif- low. It should be noted, however, that this report fer. For example, the Center for European Policy moves beyond these recommendations in several re- Studies estimated European Union cross-border costs spects. to be between two and eight times U.S. domestic costs, although the basis and assumptions underlying these calculations have been challenged by other analysis

4 Executive Summary

that finds much greater differences, notably by the efficiency gains, however, would require a detailed busi- Depository Trust and Clearing Corporation. Mean- ness-case analysis that is beyond the scope of even the while, recent estimates of the cross-border premium significant resources dedicated to this project. for trading costs as a whole range from 30 percent While substantial cost-savings are to be had over for a wholesale trade to 150 percent for retail. While time from adopting these recommendations, there are the quantum differs, the cost differences and the po- also significant costs to be borne in implementing tential for savings in all cases are substantial.3 them. This will not be a short-term undertaking. Studies to date have focused on the direct costs Agreement on standards, changes in the organization paid to infrastructure providers for clearing and settle- of local markets, and changes to operating systems ment services. We estimate their operating costs at at many service providers and market participants will approximately $2.5 billion annually. A much greater all take time to effect. At the same time, software and share of overall clearing and settlement costs, how- systems must be updated and replaced periodically, ever, is attributable to internal expenditure among fi- typically on a replacement cycle nancial intermediaries, the organizations that facili- of five to seven years. The align- tate a financial transaction between end-user issuers ment between the time required and investors. These broker-dealers and custodian- to develop standards and the The impetus for the agent banks spend on the order of $10 billion a year— software cycle should permit in- most ambitious and this estimate ignores the cost of working capital troduction of new standards in changes comes from tied up in the various systems (for analysis of costs, the context of otherwise neces- the industry itself, see chapter 1, pp. 15-16). Cross-border trades also sary system replacement or up- fail far too frequently, and it is estimated that manual grade. Thus, the changes envis- suggesting that the intervention to fix these problems can increase trad- aged here are likely to be attain- changes proposed will ing costs by a factor of nearly four.4 Significant sav- able within five to seven years at be viewed as essential ings are possible by eliminating the poor data, manual modest incremental cost. It is processes, and weak communications that typically also worth repeating that the im- improvements rather cause such failures. An improved infrastructure for petus for the most ambitious than unnecessary clearing and settlement would reduce the unit cost changes comes from the indus- expenditures. of international transactions, and expanded compe- try itself, suggesting that the tition between service providers resulting from a more changes proposed will be viewed open and competitive approach to international clear- as essential improvements rather ing and settlement services would exert further down- than unnecessary expenditures. ward pressure on these costs. Our analysis suggests that these savings will benefit end investors as well as NEW GROUND COVERED BY THE REPORT reduce the effective costs to issuers. Taking account of the full range of analysis, the Steer- The report’s conclusion is that significant cost saving Committee concluded that fundamental change ings can be realized by implementing its recommen- is needed. The current system of predominantly lo- dations, although the full measure of cost savings and cal provision of clearing and settlement services, risk mitigation envisaged in the report will be achieved based on local or proprietary standards and business only through comprehensive reform and over an ex- practices, must be transformed into a widely acces- tended period. Accurate quantification of anticipated sible global network that is more fully automated and

3. Karel Lannoo and Mattias Levin, “The Securities Settlement Industry in the EU: Structure, Costs and the Way Forward,” Center for European Policy Studies, December 2001; and Deutsche Börse Group and Clearstream International, “White Paper on Cross-Border Equity Trading Clearing and Settlement in Europe,” April 2002. 4. Based on audits of transcription processing at major financial institutions in Europe and the United States, conducted by SWIFT between 1996 and 1998.

5 Global Clearing and Settlement: A Plan of Action

operates to consistently implemented global stan- about one-third of the recommendations are explic- dards. The report breaks new ground in several im- itly directed to the cross-border environment. The portant areas, beginning in the cross-border arena remainder apply to practices within markets. The rea- where it defines interoperability and the steps neces- son is simple. Only when the characteristics of per- sary to achieve it, including development of specific formance are consistent will it be possible to create standards. Next is the area of risk management. The the cross-system linkages ultimately required to pro- report sheds new light on risk management for users duce a seamless global infrastructure. and providers of clearing and settlement infrastruc- Together, the recommendations represent a compre- ture services. The report also raises important issues hensive plan of action for the future development of of legal risk relating to the enforceability of netting global clearing and settlement. Provided that action on and collateral agreements, and it incorporates lessons these recommendations is systematic, the landscape for learned from September 11 into higher standards for clearing and settlement could be very different and much business continuity and disaster recovery planning. improved within five to seven years. The full improve- An important new area addressed is post-settlement ment in efficiency and safety described in this report asset servicing, including corporate actions, tax re- will result, however, only from comprehensive adoption lief arrangements, and foreign-ownership restrictions. of the recommendations set out here. And in the other areas touched by the report, it is fair The critical requirement for change on this scale to say that the standards have been pushed higher. is the motivation to complete it. Seeing these recom- The result, when these recommendations are fully mendations through to full implementation will re- implemented, will be a framework for international quire individual and collective action by providers and settlement and clearing that is quite different from the users of clearing and settlement services, as well as status quo. In some ways it will resemble the frame- by supervisors, central banks, and governments. Even work that exists in global telecommunications. The glo- though the matters involved are sometimes highly bal telecommunications carriers compete among them- technical, commitment and consensus will be needed selves but have common standards (both technical and not only among technical specialists, but also at the market practice) for interface among one another and level of boards of directors. Collective action will in- with local exchanges and for delivery of transmissions volve a range of existing industry organizations al- to the end user. The Steering Committee believes that ready active on these issues, while for some, the an approach of this type—one that establishes global appropriate venue for action will have to be decided. standards to which all participants in the clearing and Neither the Steering Committee nor the Group of settlement process adhere—is es- Thirty itself can devise or implement these changes. sential to facilitate competition Although the agenda is ambitious, it is also sen- and indeed to encourage the pro- sible: responsive to market aspirations for greater The reforms envisaged viders of international clearing safety and efficiency and focused on practical solu- are likely to be and settlement services to com- tions to current problems. It offers an organizing prin- attainable within five to pete as robustly as possible. ciple for the substantial body of work that is already under way by industry groups, supervisors, and cen- seven years at modest ACHIEVING REFORM tral banks. As new standards and approaches become incremental cost. Reform in these three areas con- available, firms will include them in system and soft- stitutes the Steering Committee’s ware upgrades. The question is whether these efforts vision for the future of the clear- will proceed piecemeal or will embrace an approach ing and settlement system, a vision that will be real- based on global standards as outlined in this report. ized by the 20 recommendations set out in this re- Such an approach can be pursued if those that have port. It is worth noting that although the cross-bor- the capacity to carry the work forward have confi- der focus is an important factor in this report, only dence that change will come in a reasonable time

6 Executive Summary

frame and at reasonable cost compared to the antici- area, many organizations are already involved—ISSA, pated benefits. CPSS/IOSCO, the Committee of European Securi- To that end, both the Steering Committee and ties Regulators, central banks, supervisors, and vari- other participants in the study have supported the ous bodies representative of in- monitoring of progress against the reform agenda frastructure providers—but as motivation for action after the report is published. none with both global reach and The current system must It has been widely suggested that the Group of comprehensive scope. It will ul- Thirty should play a continuing role in this process, timately be for the organizations be transformed into a in collaboration with appropriate public and private that collectively comprise the glo- widely accessible global sector entities. Accordingly, the Group has agreed bal clearing and settlement indus- network that is more fully to form a Standing Committee to monitor progress try to decide on a long-term ap- automated and operates in the period after the report’s release. proach. In the meantime, with the to global standards. THE LONGER TERM Group’s agreement to play a The question of how best to carry the full agenda for continuing role following release change through to completion remains to be answered. of this report, the Steering Committee makes the In other areas such as telecommunications (Interna- following recommendations. These are offered in the tional Telecommunication Union), postal services (Uni- firm belief that if implementation of these recom- versal Postal Union), and air transport (International mendations begins immediately, then its vision of a Air Transport Association), an internationally recog- safer, more efficient global clearing and settlement nized agency has emerged that oversees the creation system can be brought to fruition in the proposed and maintenance of standards, as well as their adop- five- to seven-year time frame. tion and enforcement. In the clearing and settlement

7 Global Clearing and Settlement: A Plan of Action

RECOMMENDATIONS and relevant generic reference data standards that fully meet the needs of all relevant users. Issuers, CREATING A STRENGTHENED, INTEROPERABLE GLOBAL NETWORK exchanges, and other originators and distributors of data should make all relevant information avail- RECOMMENDATION 1. ELIMINATE PAPER AND AUTOMATE able to the market in compliance with these stan- COMMUNICATION, DATA CAPTURE, AND ENRICHMENT. dards for a fair price and on a timely basis. Infrastructure providers and relevant public authorities should work with issuers and securities RECOMMENDATION 4. SYNCHRONIZE TIMING BETWEEN DIFFERENT industry participants to eliminate the issuance, use, CLEARING AND SETTLEMENT SYSTEMS AND ASSOCIATED transfer, and retention of paper securities certifi- PAYMENT AND FOREIGN EXCHANGE SYSTEMS. cates without delay. All market participants should Providers of clearing and settlement services and seek to automate elements of the process, such linked or otherwise associated payment and as confirmations and trade allocations, that intro- foreign-exchange systems should collectively en- duce other forms of paper into the securities pro- sure that their design, procedures, operational cessing transaction flow as technology safely al- timetables, and funding and cutoff times are such lows. All market participants should use electronic that the operation of one system does not mate- communication to transmit information for all in- rially reduce the efficiency or increase the risk of struments and transaction types. They should also settlement in another. Market participants should identify opportunities to streamline processes by work together to develop a comprehensive action avoiding duplicative recording of data and manual plan to increase the efficiency and safety of cross- addition of supplementary information at each border securities transactions where the foreign- stage of the value chain. exchange settlement cycle is not synchronized with the securities settlement cycle. RECOMMENDATION 2. HARMONIZE MESSAGING STANDARDS AND COMMUNICATION PROTOCOLS. RECOMMENDATION 5. AUTOMATE AND STANDARDIZE INSTITU- All market participants should adopt ISO15022 TIONAL TRADE MATCHING. (the data field dictionary and message catalogue for Market participants should collectively develop securities information flows) as the global standard and use fully compatible and industry-accepted for straight-through securities messaging across the technical and market-practice standards for the entire securities life cycle.5 Over time, XML (ex- automated confirmation and agreement of insti- tensible mark-up language) should become the lan- tutional trade details on the day of the trade. guage to describe standardized messages.6 All market participants should support and use commu- RECOMMENDATION 6. EXPAND THE USE OF CENTRAL nication networks that adopt open, standardized, COUNTERPARTIES. IP-based protocols for securities transactions. 7 Market participants and relevant public institutions should collaborate to assess the potentially substan- RECOMMENDATION 3. DEVELOP AND IMPLEMENT REFERENCE tial risk reduction and efficiency improvements of DATA STANDARDS. using a central counterparty. These benefits are ex- Market participants should collectively identify, de- pected to outweigh their costs in most markets. velop and adopt universal securities, counterparty Where this is so, market participants should seek

5. ISO, the International Organization for Standardization, is a confederation of national standards institutes that works in part- nership with public and private institutions to develop standards to be used consistently as rules, guidelines, or definitions of characteristics and to ensure that materials, products, processes, and services are fit for their purpose. 6. XML (extensible mark-up language) is the universal language for describing structured documents or data on the Internet. 7. IP (Internet protocol) is a suite of protocols developed for and used by the Internet and by private networks as the open, global standard for electronic communication.

8 Executive Summary

either to use the services of an existing central requirements. The need to operate prudently within counterparty or to establish one of their own, which- the risk boundaries inherent within the business ever has the better risk, cost, and benefit profile. model requires risk management processes and standards, which should be applied objectively and RECOMMENDATION 7. PERMIT SECURITIES LENDING AND consistently in determining compliance with risk BORROWING TO EXPEDITE SETTLEMENT. measures, in three broad areas: the counterparty Relevant authorities should permit securities lend- due diligence process; the procedures and tech- ing and borrowing as a method for expediting the niques used to measure, monitor, and control risk settlement of securities transactions. exposure; and the minimum financial and liquidity requirements. Each organization should publish a RECOMMENDATION 8. AUTOMATE AND STANDARDIZE ASSET report, at least annually, that describes the business SERVICING PROCESSES, INCLUDING CORPORATE ACTIONS, TAX RELIEF ARRANGEMENTS, AND RESTRICTIONS ON model, risk framework, and underlying risk man- FOREIGN OWNERSHIP. agement processes, controls, and standards, to- Issuers, providers of clearing and settlement ser- gether with the results of independent testing of vices, and other relevant market participants should those procedures. The report would thereby reas- advise investors of all details of corporate events sure users that the organization had operated ef- that they require in an automated, timely manner fectively, and also would provide greater transpar- and in compliance with accepted industry stan- ency to the market. dards, so that each investor can make a timely decision on the action to be taken with full knowl- RECOMMENDATION 10. REINFORCE THE RISK MANAGEMENT PRACTICES OF USERS OF CLEARING AND SETTLEMENT edge of the facts. Market participants and public SERVICE PROVIDERS. authorities should work together to minimize the Organizations that use, or are considering using, administrative costs to each party involved in tax providers of clearing and settlement services relief arrangements through standardization and should establish robust due diligence and automation of procedures and communication of counterparty risk management controls and pro- information and through the use and acceptance cesses that appropriately evaluate, measure, moni- of electronic data and documentation. Relevant tor, and control the risks inherent in such activity public authorities, infrastructure providers, and and in associated customer-related business. market participants should work together to harmonize and make transparent the processes, docu- RECOMMENDATION 11. ENSURE FINAL, SIMULTANEOUS TRANSFER mentation, and communication of information in AND AVAILABILITY OF ASSETS. connection with foreign-ownership restrictions and Providers of securities settlement services should reporting requirements. reduce to the lowest possible level the credit risk created if securities or cash are delivered with- MITIGATING RISK out receipt of corresponding assets, by linking RECOMMENDATION 9. ENSURE THE FINANCIAL INTEGRITY OF securities transfers to funds transfers in a way that PROVIDERS OF CLEARING AND SETTLEMENT SERVICES. achieves effective delivery versus payment (DvP) Providers of clearing and settlement services and by making transparent the point at which fi- should manage their risks and set standards and nality of transfer is achieved. Once finality of controls concerning the use of those services that transfer is fully assured, the rules should enable a allow them to conduct business in a safe, sound, receiver to re-use securities and cash without fur- and prudent manner consistent with their business ther delay. model and all relevant supervisory and regulatory

9 Global Clearing and Settlement: A Plan of Action

RECOMMENDATION 12. ENSURE EFFECTIVE BUSINESS CONTINUITY RECOMMENDATION 15. ADVANCE LEGAL CERTAINTY OVER RIGHTS AND DISASTER RECOVERY PLANNING. TO SECURITIES, CASH, OR COLLATERAL. All market participants should, and all systemi- Market participants must be able to determine, cally important institutions must, regularly review, with certainty and reasonable cost and effort, what update, and test their business continuity and law defines and governs their rights to securities, disaster recovery plans, including evaluation of cash, or collateral in a clearing and settlement sys- reliance on third parties, to ensure with reason- tem or other intermediary, what those rights are, able certainty that critical operations will continue and how to perfect and enforce them. with a high level of integrity and sufficient capacity following a disruption or disaster. RECOMMENDATION 16. RECOGNIZE AND SUPPORT IMPROVED VALUATION METHODOLOGIES AND CLOSEOUT RECOMMENDATION 13. ADDRESS THE POSSIBILITY OF FAILURE OF NETTING ARRANGEMENTS. A SYSTEMICALLY IMPORTANT INSTITUTION. Market participants should ensure that master agree- Market participants in each financial center should ments provide that upon the early termination of a work together to identify those institutions, or parts transaction or group of transactions, the determin- thereof, that are systemically important to the clearing party will have the flexibility to value such trans- ing and settlement process. User groups should be actions by the method that is most likely to produce established to address how they would react if, a commercially reasonable valuation at the time of despite strengthened business continuity and dis- termination. Market participants should include aster recovery plans, there were a failure for what- closeout netting provisions in their contract docu- ever reason at one of these institutions. Ways of mentation. Relevant authorities in each jurisdiction mitigating the risks created should a systemically should ensure that their laws give effect to closeout important institution fail, such as building a real- netting for all central counterparties, brokers, end time data depository, should be evaluated. Where users, and other market participants, and for all en- it is determined that effective and feasible solutions tity, transaction, and asset types. may exist, detailed business cases setting out the costs and benefits should be built up, and decisions IMPROVING GOVERNANCE on future actions and investment decisions should RECOMMENDATION 17. ENSURE APPOINTMENT OF APPROPRIATELY be taken accordingly. As well as enforcing suitably EXPERIENCED AND SENIOR BOARD MEMBERS. high standards of business continuity and disaster Members of the boards of securities clearing and recovery planning in systemically important insti- settlement infrastructure providers should, indi- tutions, regulators and overseers should encour- vidually and collectively, be of a weight in terms age this process of industry-wide contingency of experience and seniority to discharge the en- evaluation and planning. larged strategic, risk, and operational management oversight responsibilities described in this report. RECOMMENDATION 14. STRENGTHEN ASSESSMENT OF THE ENFORCEABILITY OF CONTRACTS. RECOMMENDATION 18. PROMOTE FAIR ACCESS TO SECURITIES Market participants should ensure that due dili- CLEARING AND SETTLEMENT NETWORKS. gence procedures examine contract enforceabil- Boards of securities clearing and settlement ser- ity, including basic formation and validity, as well vice providers, other organizations providing simi- as power and authority to contract. lar services, and public authorities should ensure

10 Executive Summary

that rules and other requirements that control or RECOMMENDATION 20. ENCOURAGE CONSISTENT REGULATION limit access to securities clearing and settlement AND OVERSIGHT OF SECURITIES CLEARING AND SETTLEMENT SERVICE PROVIDERS. services are accepted only where they are neces- Providers of securities clearing and settlement ser- sary and are designed exclusively for the purpose vices should be subject to consistent and trans- of controlling financial, operational, reputational parent regulation and oversight, which should or regulatory risks; maintaining the safety of the focus on the activities undertaken and risks in- system; or achieving other reasonable public policy curred. Standards of regulation and oversight of objectives. Networks and services should be ac- cross-border activity should be complementary cessible to all users that pass risk and safety evalu- and consistently applied across all relevant juris- ations and enjoy appropriate financial standing, and dictions. As a long-term goal and where coherent users should be free to select the mix of functions with other public policy objectives, regulatory and and services that they wish to use on the basis of oversight standards should be harmonized. straightforward, transparent, and fair tariff policies grounded on the principle of user pays.

RECOMMENDATION 19. ENSURE EQUITABLE AND EFFECTIVE ATTENTION TO STAKEHOLDER INTERESTS. Board participation should represent different stakeholder interests fairly and equitably. Provi- sion should be made for regular review of, and for changes as necessary in, board composition to ensure continuing balanced representation of varying stakeholder groups, including users.

11 Clearing and Settlement: What Is at Stake?

1. CLEARING AND SETTLEMENT: WHAT IS AT STAKE?

THE SAFETY AND EFFICIENCY OF GLOBAL CAPITAL the lack of global technical standards, differing business MARKETS DEPEND ON EFFECTIVE CLEARING AND processes, and inconsistent legal and regulatory under- SETTLEMENT of the securities, debt, and derivative pinnings. The result is excessive delay, failed trades, and transactions that flow through them. Clearing is the substantial duplication of system capabilities. These in- process following a trade in which the arrangements efficiencies are costly to users of clearing and settlement for transfer of title and funds are agreed. Settlement services, to investors and issuers active in international is the process by which the ownership interest in se- markets, and, to the extent that trading activity is dis- curities is transferred from one investor to another, couraged, to the economy as a whole. generally in exchange for a corresponding transfer In addition to the costs involved, this imperfect of funds. The goal is to provide the buyer with irre- network is subject to shocks—an unexpected surge in vocable delivery of a security from the seller at or market activity, a major technical failure, or an external very near the precise moment when the seller receives disruption such as the terrorist attack on the World final and irrevocable payment for it from the buyer. Trade Center in New York on September 11, 2001. Although largely invisible to the end investor, these Although the system has proven very resilient, the cost processes lie at the core of all securities markets. In- and disruption arising from loss deed, modern securities markets could not function of clearing and settlement func- without the systems and infrastructure that facilitate tions can be profound, especially Although largely invisible clearing and settlement. if accompanied by other finan- In concept, there is nothing mysterious about this cial disruptions. to the end investor, mechanism; yet in practice, it is quite complex. Match- Inefficiencies and risks in the clearing and settlement ing transaction terms, confirming, and settling the many clearing and settlement process lie at the core of all millions of trades taking place every day in major mar- were a concern well before kets is complicated enough in a purely domestic con- cross-border trading began its securities markets. text. But the mechanics have become even more com- rapid growth. The 1989 Group plex with the rapid growth of cross-border trading, of Thirty study “Clearance and which spans many clearing and settlement systems and Settlement Systems in the World’s Securities Markets” legal and regulatory jurisdictions. Meanwhile, the under- made nine recommendations for reducing risk and lying legal and regulatory frameworks on which these strengthening national systems, now largely adopted. systems rely continue to develop in a piecemeal fashion Authoritative guidance in this area was most recently and largely on a domestic basis. In short, the trading issued in November 2001 by a joint task force of the network is ultimately global in coverage; yet the post- Committee on Payments and Settlements Systems of trade clearing and settlement environment is highly seg- the Group of Ten central banks (CPSS) and the In- mented and provides only limited integration or reliable ternational Organization of Securities Commissions connectivity. The causes of this fragmentation include (IOSCO).

13 Global Clearing and Settlement: A Plan of Action

BOX 1-1. INTEROPERABILITY Despite the excellent work that has been done in this area, some of the As used in this report, interoperability refers to the ability of more intractable legal and operational participants along the clearing and settlement value chain concerns identified more than a de- to communicate and work with service providers and other cade ago remain unresolved, while participants without special effort on the part of users. new issues continue to arise. The Interoperability involves more than technical compatibility Group of Thirty therefore decided to of systems, although standardized communication, messag- commission an updated assessment ing, data, and timing are clearly essential. The ability of sys- of clearing and settling arrangements tems to interoperate also requires like or compatible pro- to address the new challenges. A cesses, business practices, controls, technologies, products, Steering Committee was recruited to access arrangements, and fee structures. The recommen- conduct this assessment. Its starting dations in this report aim at creating the potential for point was a survey of participants in interoperability. Its full realization will require implementation and consistent use of technical, market practice, risk all phases of the clearing and settle- control, system access, and other standards within and be- ment process to evaluate their level tween connected entities, enforced though economic, regu- of concern and determine the scope latory, or other means. for further work. The survey, under- The benefits of interoperability can be seen in many other taken by PricewaterhouseCoopers on industries that have evolved to meet the needs of users op- behalf of the Group of Thirty, iden- erating across borders or systems. tified five broad areas of concern: ½ National standardization of railway track gauges in the United States in the late 19th century eliminated manual ½ Access barriers to markets and switching between systems, making commercial rail trans- services that limit effective port much faster and cheaper and triggering a major ex- competition. pansion in system use and interstate trade. ½ Lack of interoperability and ½ National aviation authorities, through the International Civil connectivity that prevent the Aviation Organization, have adopted standards for auto- seamless flow of transactions mation of air traffic control services, protocols for use of and messages among market the global navigation satellite system, and controller-pilot participants across different data link communications that have significantly reduced clearing and settlement systems. the risk of human error and expanded system capacity. ½ Continuing deficiencies in the ½ Through the standard setting of the International Tele- basic clearing and settlement communications Union, almost all telephone calls today require no intervention by anyone other than the caller, model, including traditional whether they are within a particular network or across concerns over finality of many networks, and whether they are fixed line or mo- transfer and reliance on paper bile. Combined with expanded competition, which and manual processes. interoperability has promoted, the cost of cross-network ½ Concerns about risk manage- calls has fallen dramatically. For example, from 1995 to ment, including business 2000, the average cost of calls from Switzerland to the continuity and disaster recovery United States fell from 74 cents to 7 cents a minute, while (later underscored by the events the price of Swiss domestic calls dropped only from 5 of September 11), and the cents to 4 cents a minute. limitations of risk mitigation Source: International Telecommunications Union, “Interconnection Regulation,” Trends in Telecommunications Reform 2000-2001, 3rd ed., techniques, such as the effective- Geneva. 2000. ness of collateral in cross- border trades.

14 Clearing and Settlement: What Is at Stake?

½ The impact of complex asset servicing require- and the United States, and that cross-border trades are ments on clearing and settlement, including considerably more expensive than domestic ones.1 In activities such as recording dividends and addition, to cope with the range of clearing and settle- exercising voting rights (known collectively as ment entities and their unique operating systems, bro- corporate actions), tax relief arrangements, and ker-dealers and other financial intermediaries are in- restrictions on foreign ownership. stalling duplicative systems and implementing more extensive risk management processes, thereby increas- The survey indicated a high degree of consensus on ing their internal costs. A related cost is the use of lo- the need for further work in the five priority areas cal custodians and agents to cope with the specific re- and the benefits available from the Group of Thirty’s quirements of local markets, an expensive practice renewed attention to these matters. sometimes mandated by local law The areas of recommendation focus on clearing or regulation. While this variety and settlement of debt instruments and equities rather is unlikely ever to be eliminated, The lack of global than derivatives, although many of the improvements it is usually asserted that the great- proposed will benefit derivatives as well. Similarly, the est scope for efficiency gains lies technical standards, recommendations address the “street” side of clear- in streamlining these areas of differing business ing and settlement: that is, improvements affecting duplication at financial interme- processes, and service providers and intermediaries rather than in- diaries. vestor clients. Although the report does not address To test these assertions, a lim- inconsistent legal and the “client” side of the securities business, develop- ited number of large, interna- regulatory underpinnings ment of comprehensive common standards for elec- tional broker-dealers and custo- are impeding the tronic processing and messaging in client business dian banks were asked to pro- C&S process. would greatly reduce internal costs for market par- vide their “fully loaded” annual ticipants by eliminating the use of telephone, fax, and costs of clearing and settlement disparate electronic messaging systems for trade com- in connection with major mar- parison and confirmation. kets, including all development and day-to-day running costs, along with relevant market share data.2 WHAT IS THE COST OF INEFFICIENCY? PricewaterhouseCoopers collated and extrapolated The current system for settling cross-border trades is from this source data to project a total industry cost. significantly less efficient than it could be. Many com- Although such an analysis has many inherent limita- parisons of costs from system to system have been tions, it yielded reasonable “order of magnitude” es- made; although there is much debate over methodol- timation of overall clearing and settlement costs that, ogy, numerous studies have indicated that the cost of if anything, are likely to err on the conservative side.3 settlement may differ by as much as a factor of eight The result very plainly supports the view that inter- between trades cross-border in the European Union nal expenditure at the level of intermediaries makes

1. See footnote 3 in the executive summary. 2. Major markets for this purpose were taken to include equity and fixed-income securities markets in the United States, Canada, members of the European Union, Switzerland, Japan, Hong Kong, Singapore, and Australia. 3. By using fully loaded costs, aggregation and averaging of the results should help to smooth out variances caused by organizations at different stages of the system development life cycle. Costs paid to other organizations in the value chain (such as broker-dealer payments to custodians, central securities depositories, and central counterparties) were excluded to reduce the risk of double counting. It is clear that organizations are managed and structured on differing bases, and so measure costs and market share accordingly. Thus, while participants were able to provide estimates of costs and market share, it must be recognized that this survey was not intended to be precise. Surveying the costs of large organizations is likely to underestimate overall industry costs because such firms enjoy economies of scale compared with smaller organizations. Conversely, large organizations typically undertake a disproportionate amount of cross-border trading, which is inherently more expensive and so is likely to offset any distortions caused by scale economies.

15 Global Clearing and Settlement: A Plan of Action

up the clear majority of overall clearing and settle- HOW GREAT ARE THE RISKS IN THE SYSTEM? ment costs—on the order of $10 billion a year, com- Risk is a significant concern in any analysis of clear- pared with approximately $2.5 billion in costs incurred ing and settlement systems because of the interre- by the organizations that provide the actual clearing lated credit, market, liquidity, operational, and legal and settlement infrastructure—and this estimate ig- risks that come into play and the fact that, while gen- nores the cost of working capital tied up in the vari- erally of short duration, the value of transactions in- ous systems. volved is almost always very large. Moreover, because Thus, standardization and streamlining of process- of the highly interdependent movement of cash and ing could offer considerable savings. An analysis un- securities, sometimes including foreign-exchange dertaken by Oxford Economic Research Associates transactions, a problem in one part of the clearing (OXERA) for this project examined the level of com- and settlement process can have a serious adverse petition along the clearing and settlement value chain effect on other parts of the financial system. and concluded that the majority In considering the risk proposals in this report, it of these savings, including re- is important to recognize that providers of clearing A more efficient system duced back-office processing and settlement services, users of those services, and costs at intermediaries, would the regulatory community have pursued significant with lower costs would likely accrue to end investors in initiatives to strengthen safety and stability over the encourage growth of and issuers of securities. More- last decade. These efforts have already produced sub- cross-border transactions over, high transaction costs and stantial gains in the major markets and the recom- complexity in cross-border trad- mendations should be viewed as an effort to raise the and related economic ing depress the level of trading bar still higher in view of the critical nature of the activity, with potentially activity and discourage efficient activities being undertaken. substantial public benefit. diversification of portfolio in- Our research indicates widespread belief that the vestment (such as pensions) risks involved in clearing and settlement, including across borders. A more efficient the risk and associated cost of a systemic disruption, system with lower costs would encourage growth of are unacceptably high. And the substantial concern cross-border transactions and related economic ac- about risk revealed by our survey did not factor in tivity, with potentially substantial public benefit. the horror of the September 11 terrorist attack and Of course, it is the overall cost-benefit calculation its impact on Wall Street. From long experience, both for any changes proposed that must be considered. Ad- market practitioners and public officials know that ditional costs clearly will be involved in developing and things can go very wrong in markets very quickly, and adopting new technical standards and business prac- a scenario in which a major shock could lead to criti- tices, and these one-time costs could be quite substan- cal failure is not difficult to imagine. tial. These costs represent an investment in a global There is also every reason to believe that future network, the ultimate cost of which will depend im- developments in international markets will be even portantly on the speed with which new standards are more challenging. Risk will rise with the increase of introduced. The report argues for phasing in new stan- cross-border trading because of the many connec- dards in line with cycles for obsolescence and replace- tions involved, each introducing some level of un- ment of software and systems—perhaps five to seven certainty and greatly complicating risk assessment in years—a strategy that should contain additional costs. crisis situations. The contagion risk phenomenon is Once the reforms are in place, the return on invest- likely to increase further as the global system becomes ment will be a reduction in the unit cost of transac- more concentrated, with fewer and larger global firms tions for a large range of participants, and an increase and settlement entities. in trading activity.

16 Clearing and Settlement: What Is at Stake?

WHY FOCUS ON FIGURE 1-1. U.S. ACTIVITY IN FOREIGN SECURITIES VERSUS CROSS-BORDER FOREIGN ACTIVITY IN U.S. SECURITIES,1980-2001 CLEARING AND

SETTLEMENT? 25,000 The survey results underscored Foreign gross activities in U.S. securities the sentiment among members of 20,000 U.S. gross activity (purchase plus sales) the project Steering Committee in foreign securities (purchase plus sales) that many of the problems so far 15,000 unaddressed are concentrated in the cross-border arena. Cross- $U.S. BILLIONS 10,000 border transactions are a particular challenge because of the com- 5,000 plexity of moving from system to system and across legal jurisdic- 0 tions. The legacy of national sys- 1980 1990 1995 1997 1998 1999 2000 2001 tems and the reality of national SOURCE: Securities Industry Association, “Key Trends in the Securities Industry, borders means that this range of 2001” (www.sia.com/publications/html/trends_during_1990s.html). interactions tends to be duplicated for each country or market. Settling the cash leg of the dramatically. As an example, figure 1-1 indicates that transaction brings payment systems and foreign-ex- in 20 years U.S. gross activity (both purchases and change markets into play, multiplying the range of in- sales) in foreign securities grew nearly a hundred-fold, teractions further. Local agents or custodians are em- from just $53 billion in 1980 to nearly $5.1 trillion in ployed to deal with the specific financial, operational, 2001. Foreign gross activity in U.S. securities increased technical, and legal characteristics of the various sys- more than a hundred-fold, from $198 billion in 1980 tems involved. Thus, the clearing and settlement of to $20 trillion in 2001. cross-border trades can be accomplished only through Data from the International Monetary Fund also a technically complex process involving links through indicate a significant increase during the 1990s in many and varied institutions and almost certainly fea- holdings of foreign equities as a share of household turing different business practices, regulatory ap- financial assets in other industrial countries.4 The proaches, and legal concepts, all of which introduce share of total household financial assets represented both cost and risk into the system. by foreign portfolio equity holdings ranged from un- These issues have not been addressed systematically, der 2 percent in Japan to nearly 12 percent in the and there is little authoritative guidance on them. United Kingdom at the end of the period, reflecting Clearly, no single authority, public or private, can dic- an increase of more than 40 percent in Japan, 60 per- tate the terms of cross-border transactions or the man- cent in France (to 3 percent), and more than 90 per- ner in which they will be cleared and settled. Nor does cent in Germany (to 7 percent). In the United States, any global authority, even of a cooperative nature, ex- nearly 5 percent of total household financial assets ist to address them comprehensively. In these circum- were made up of foreign equities, a 78 percent instances, elaboration of technical standards and best crease over the period. practices appears to be the best, and possibly the only, This trend is expected to continue, particularly in way to make progress in the cross-border arena. the Eurozone where securities are now denominated Alongside questions of cost, risk, and oversight is in a single currency, but also in other markets where the issue of scale: cross-border trading has grown investors are seeking global diversification for their

4. International Monetary Fund, World Economic Outlook, 2001, Washington.

17 Global Clearing and Settlement: A Plan of Action

portfolios and issuers are seeking access to wider and legal and regulatory frameworks to confront the larger pools of capital. risk management challenges that arise. Given the potential for shocks, heavy emphasis is laid HOW CAN THESE CHALLENGES BE ADDRESSED? on contingency planning for business continuity In light of this analysis, the Steering Committee set and disaster recovery. These recommendations twin goals for reforming the global system: to pursue are discussed in chapter 4. the maximum attainable level of ½ Improving governance by strengthening private efficiency in clearance and settle- boards in pursuit of the agenda proposed in ment arrangements, consistent this study and by providing consistent regula- The Steering Committee with still higher levels of sys- tion and oversight by public authorities. These set twin goals for temic safety and stability. From recommendations are discussed in chapter 5. these goals flow recommenda- reforming the global tions for a system quite differ- Although specific governance recommendations are system: to pursue the ent from the status quo. The few in number, it should be recognized that the prin- maximum attainable amount of change needed to cipal challenges in this report are aimed at the boards level of efficiency, achieve consistently safe and ef- and management of service providers and their us- ficient performance on a global ers in certain cases, and at the public authorities that consistent with still basis is substantial: the problem oversee them. Creating the conditions for intero- higher levels of systemic is extremely complicated, and perability of systems and ensuring access to systems safety and stability. there are no simple fixes. Be- and services for all qualified users—both missing cause change in one system or from existing clearing and settlement arrangements— market segment will not yield the are fundamental to competitiveness and reform and promised benefits unless all systems and segments new in this report. change as well, the proposed changes must be pur- In framing the recommendations in each of these sued comprehensively. areas, the Steering Committee has borne in mind the The result would be a strengthened and widely aspirations expressed by industry respondents to a sur- accessible global network with lower unit-costs of vey undertaken by PricewaterhouseCoopers for this trading and post-trade processing, greater liquidity, study. They called for a report that would offer a clear and reduced risk to individual institutions and to the vision for the future of global clearing and settlement overall system. Our proposals for reform include arrangements based on best market practice. Where a twenty recommendations in three areas of reform. sound standard already exists in a critical area, they asked that the report endorse it; but where additional ½ Building a strengthened, interoperable global guidance is provided, they asked that it be articulated network by strengthening and streamlining the with sufficient specificity to stipulate best practice with- basic clearing and settlement model, making out ambiguity. All proposals should be practical, but clearance and settlement systems fully those that are less than optimal should specify the rea- interoperable, and permitting any qualified user sons why, while areas in which longer-term changes in access to systems and services on fair and law or regulation are also required should specify the transparent terms (for more on interoperability, needed changes. Finally, to the extent possible, recom- see box 1-1). The justification and detail for mendations should include guidance on how they these recommendations are set out in chapter 3. should be implemented and subsequently enforced. ½ Mitigating risk by ensuring that clearing and True to this mandate, the recommendations in this re- settlement systems and their major users have port are carefully considered and offer a comprehen- the financial strength, risk management sive and demanding agenda for change. expertise, operational reliability, and supportive

18 Clearing and Settlement: What Is at Stake?

The report addresses the challenge first by describ- each area are distributed throughout the chapters. ing the current state of the system in chapter 2. Given the complexity of implementing the full range Chapters 3, 4, and 5 then examine how to build an effi- of recommendations, the next steps for bringing them cient, interoperable global network for clearing and settle- to fruition are discussed in chapter 6. Further detail ment; how to strengthen the safety and stability of that on selected recommendations is provided in appen- framework; and how to improve governance as the driver dix 1, while the extensive work program associated for the changes proposed. The recommendations in with the study is described in the Appendix 2.

19 2. THE CURRENT STATE OF AFFAIRS

THE CLEARING AND SETTLEMENT PROCESS BEGINS to understand the component parts of the system. AFTER A TRADE IS EXECUTED; it ends with the final The clearance function can be performed by a clear- and irrevocable transfer of value between the inghouse—usually a central counterparty (CCP), a counterparties to the transaction. Clearing, the first half central securities depository (CSD), or an interna- of the process, encompasses all procedures necessary tional central securities depository (ICSD). CCPs can to determine the obligations of a direct market par- provide not only the clearing function, but they go a ticipant, such as a broker-dealer, to deliver securities or step further by legally interposing themselves as funds once a trade is executed. This part of the pro- counterparty to both buyers and sellers. This process cess includes recording the key information related to is called novation; buyer and a trade so that the counterparties can agree on its terms, seller interact with the CCP and matching and confirming the trade details and the pro- remain anonymous to one an- The aim is to complete cedures for completing the transaction, and calculat- other. CCPs may also provide the overall C&S process ing settlement obligations. The settlement part of the netting services that reduce risk process aims to ensure that cash is delivered if and exposures, thereby also reducing with speed and certainty only if securities are delivered and to do so with fi- gross margin requirements and so as to minimize credit nality: that is, when the transfer or pledge is irrevo- liquidity needs of qualifying in- exposure for the relevant cable and unconditional. This overall objective is usu- stitutions. A CSD or an ICSD can ally referred to as delivery versus payment, or DvP. perform both clearance and settle- parties while trades are The objective is to complete the overall clearing ment functions because it not only still unsettled. and settlement process with speed and certainty so can facilitate the coordination and as to minimize the credit exposures faced by the exchange of trade information be- counterparties and service providers while trades are tween counterparties but also can hold securities and still unsettled. Speed and certainty also help maximize process change of ownership by book entry. the efficiency benefits to be gained from processing In the settlement phase, the movement of securi- large volumes at high speeds, while minimizing the ties (such as ownership transfer and bookkeeping) is number of expensive failed trades. done at the CSD or ICSD, while the movement of funds is usually accomplished through the banking A VARIETY OF SERVICE PROVIDERS or payments systems. A number of major securities To understand the recommendations for changing settlement systems have “embedded” payment or clearing and settlement arrangements, it is useful first funds-transfer systems that accomplish settlement,

This chapter benefits from two recent reports on clearing and settlement: M. Guadamilla and R. H. Keppler, “Securities Clearance and Settlement Systems, A Guide to Best Practices,” World Bank, Washington, 2001; and The Giovannini Group, “Cross-border Clearing and Settlement, Arrangements in the European Union,” European Commission, Brussels, 2001.

21 Global Clearing and Settlement: A Plan of Action

whether in central bank or commercial bank BOX 2-1. SYSTEM COMPONENTS money. A CSD or ICSD may hold securities

owned by a party other than a member, thus Central counterparty (CCP) — An entity that is the requiring these nonmembers to interact with buyer to every seller and seller to every buyer of a the CSD through an intermediary such as a cus- specified set of contracts, such as those executed todian or a global custodian. on a particular exchange or trading system. CCPs Custodians hold securities on behalf of their legally interpose themselves as principal to each owners and provide asset servicing. Asset ser- side of the transaction; some also offer a netting vices may range from facility, whereby positions, obligations, or levels of monitoring dividend exposure of trade parties are reduced by setting a receipts and interest pay- participant’s debits and credits off against each Speed and certainty help ments, to filing informa- other, leaving a smaller net obligation. Central securities depository (CSD) — A facility (or maximize the efficiency tion and claims with the an institution) for holding securities, which en- relevant taxation authori- benefits to be gained ables securities transactions to be processed by ties, to managing corpo- from processing large book entry. Physical securities may be immobi- rate actions such as voting lized by the depository, or securities may be de- volumes at high speeds, and conversion rights rel- materialized (so that they exist only as electronic while minimizing evant to owners of equi- records). In addition to safekeeping, a central ties, where the provisions securities depository may incorporate compari- the number of of company law in the son, clearing, and settlement functions (without expensive failed trades. country concerned may acting as a CCP) and provide services related to include requirements for corporate actions. trade reporting, disclosure International central securities depository (ICSD) — of significant holdings, or foreign-ownership A central securities depository that clears and restrictions. Because custodians can deal with settles international securities or cross-border transactions in domestic securities, usually the specific financial, operational, technical, and through local agents or direct links to local CSDs. legal characteristics of local systems, foreign in- The distinction between ICSDs and local CSDs vestors normally employ local custodian banks is blurring as ICSDs merge with local CSDs (for as agents in the clearance and settlement pro- example, Euroclear and Sicovam; Cedel and cess. Although these matters fall outside the DKV into Clearstream) and local CSDs offer time frame of clearing and settlement, they can cross-border settlement. have important implications for effective trans- Custodian — An entity, often a bank, that provides fer and exercise of ownership, and lack of stan- safekeeping and administers securities for its dardization and automation of these services customers and that may provide other services, is a serious efficiency concern. including clearance and settlement, cash man- An emerging trend arising from cross-bor- agement, foreign exchange, securities lending, der trading is development of global custodi- corporate actions, and tax relief arrangements. ans. Global custodians are usually members of Global custodian — A custodian that provides its customers with custody services for securities many national CSDs or have access to mem- traded and settled not only in the country in bership through local subcustodian members which the custodian is located but also in nu- of the relevant CSD. Because custodians are a merous other countries throughout the world. vital intermediary in the provision of clearing and settlement services to end users, they must Based on CPSS-IOSCO definitions. be part of any discussion of functional standards of performance.

22 The Current State of Affairs

The final category of players is the members and serve and until recently dealt almost exclusively in users of the CCPs and CSDs (a category that gener- debt instruments in the Eurobond market), most ally includes custodians) who influence strategic clearing and settlement entities were established to decisionmaking within these entities, whose own ef- deal principally with domestic business, subject to ficiency as users affects overall efficiency, and whose national regulatory and legal arrangements, and the access creates risk exposures in both directions. The focus of their business models and governance re- level of risk is a function both of the size of these mains domestic. Even in the European Union, where intermediaries and the extent of their access to the a single economic market is an overriding objective entity on behalf of themselves, their customers, and of public policy, the pan-EU investor must contend other indirect participants. with highly fragmented infrastructure for equities, including nine CSDs and two ICSDs. A number of THE CHALLENGE OF factors underlie this inertia regarding the cross-bor- CROSS-BORDER TRADING der challenges: Not surprisingly, the complexity of the clearing and settlement process is directly related to the number ½ There has been little sensitivity to cost in of actors involved. Of necessity, therefore, the level pursuing cross-border business. At least until of complexity rises substantially as the process ex- recently, the appetite for portfolio diversifica- tends across borders. Although not every country has tion through growing cross-border business has a CCP, the typical pattern is a single CCP and a single been such that the high cost of clearing, CSD in each market so any cross-border trade requires settlement, and custody services has been interaction with a duplicate set of institutions and absorbed relatively uncritically. Moreover, actors for each market or country the trade affects. relatively little attention has been paid to As securities trading strategies expand on a global associated internal costs. basis, the complexities of cross-border clearance and ½ International agreement on key operational settlement will be further magnified in proportion to and technical standards and consistency of the number of (I)CSDs, global custodians, and so regulatory and legal approaches required for forth introduced into the process. More foreign-ex- building cross-border infrastructure is difficult. change settlement risk, legal risk, and custody risks Pursuing solutions to these challenges is costly will be introduced into the process; operational risk and complex and unlikely to be pursued will rise with mismatches in technology, communica- without reasonable assurance of success. tion methods, and business practices; and there will ½ Infrastructure providers have faced limited be more opportunities for exposure to credit risk from competitive pressure and have few incentives to participants whose financial standing will be difficult support change in the cross-border arena. to verify. Limited competition, relatively high barriers to Clearing and settlement service providers have entry, and some explicit market protection had to adapt continuously to the changing demands measures, which may be represented as in the of the marketplace—growing volumes, new instru- national public interest, have provided little ments, electronic trading, and improved backup and inducement to pursue costly investment in security arrangements. In all these areas, boards and cross-border infrastructure. Because standard- management of service providers have been very ization risks loss of franchise value while responsive to the needs of users. Yet the response consolidation to achieve scale economies risks to rapidly expanding cross-border activity has so far erosion of autonomy, the fiduciary responsibil- been limited. With the exception of Euroclear and ity of board members to shareholders may Clearstream in Europe (which were established to argue against improved cross-border service for

23 Global Clearing and Settlement: A Plan of Action

their customers. In the EU, the public listing of business, market infrastructure has experienced exchanges such as in France (Euronext) and no serious breakdown. Germany (Deutsche Börse), both of which have substantial ownership interests in the In the chapters that follow, a program for tackling clearing and settlement process, will sharpen the complex challenges described above is set out. attention to shareholder value. Pursuing it will require that private boards and man- ½ Cross-border clearing has worked well enough, agement, in the first instance, overcome inertia and and there has been no crisis to motivate carry the program forward. reform. Despite rapid growth of cross-border

24 The Current State of Affairs 3. BUILDING AN EFFICIENT, INTEROPERABLE NETWORK

EFFICIENT CLEARING AND SETTLEMENT SYSTEMS vironment, with settlement on a delivery versus pay- ARE NEEDED, on the one hand, to reduce risks by ment basis, so that settlement cycles could be short- achieving finality as quickly as possible and on the ened. The result has been DvP settlement effected other hand, to minimize the costs of using and oper- on a T+3 basis (within three days after the trade), or ating systems. In both cases the beneficiaries are the shorter in some cases, by electronic book entry same: service providers, intermediaries, issuers, inves- through CSDs; this has become tors, and ultimately, the broader economy. the standard way in which secu- The clearing and settlement infrastructure outlined rities transactions are settled in Many groups would in chapter 2 has been shaped by three main factors: all developed securities markets. benefit from building an the needs and demands of users (which have at times This development has largely changed dramatically and quickly, following stresses eliminated paper stock certifi- efficient C&S system: or shocks to the financial system); the technology and cates themselves from the pro- service providers, communications capabilities available; and the inno- cess (although not many other intermediaries, issuers, vation of service providers and intermediaries in uti- paper-based transaction ele- lizing those technologies to meet users’ needs. ments and in many markets re- investors, and ultimately, Perhaps the most persistent factor has been the con- tail investors are still able to hold the broader economy. stant evolution of technological capabilities. In the past, paper stock certificates); it also most securities markets operated by physically transfer- has unquestionably had a dra- ring paper securities from one owner to another over a matic impact on the efficiency and safety with which relatively prolonged settlement cycle. In some markets, securities markets operate. Indeed, given the huge in- the paper transfer had to be supplemented by an entry creases in the volume of securities traded, any registering the transfer before the new owner could ex- unautomated alternative to this system of clearing and ercise the full rights of ownership. In other markets, a settlement would be impractical. system of bearer securities meant that all the ownership Although technological and communications rights were acquired with the physical transfer of the progress has been made, the increasing demand for security certificate. As market volumes increased, the cross-border trading has raised new challenges to ef- limitations of paper-based and manual processing be- ficiency. Clearing and settlement infrastructure has came increasingly clear. User pressure to increase effi- evolved, quite understandably, to meet the needs of ciency and reduce risk of securities processing has led users focused mainly on domestic markets. That fo- the industry to adopt various technological tools as they cus cannot attain the full measure of efficiency and have become available to create new and more effective effectiveness for international securities transactions services and means of delivery. that could be achieved if domestic systems in differ- The Group of Thirty, in its 1989 report, encour- ent countries were effectively linked in a well-func- aged movement toward an automated, paperless en- tioning global network.

25 Global Clearing and Settlement: A Plan of Action

STRENGTHENING THE GLOBAL NETWORK assessment of the current state of clearing and settle- An essential element in building an efficient global ment arrangements. Therefore, while the recommen- infrastructure is to encourage the emergence of stron- dations will be implemented through the actions of ger providers of clearing and settlement services, in- specific organizations (private firms and public insti- cluding both CCPs and matching utilities where they tutions, either individually or collectively), the recom- do not now exist.1 These stronger service providers mendations that apply to a particular organization could take a number of forms: providing functional- should be determined by what it does and the associ- ity exclusively for clearing, typically in the form of a ated risks rather than by its legal, regulatory, or other central counterparty; providing status. As a general principle, if two organizations pro- functionality exclusively for vide comparable services—such as the similar ser- settlement, with or without a vices offered by an (I)CSD and a global custodian— The underlying principle supporting custodial capability; then a recommendation made in connection with in this report is that or providing functionality that those services should generally apply to both. market forces should combines clearing and settle- The recommendations use collective terms to address be relied upon to ment. There is no inherent rea- certain groups of organizations that are invited to take son to favor one structure over primary responsibility for implementation. It is imprac- produce the optimal another or to specify the lines of tical to define precisely and comprehensively each spe- organizational solution. business in which any entity may cific organization included within each particular term, engage as long as risk disciplines as the activities undertaken by individual organizations are calibrated to the risks taken and the market structures vary between jurisdictions, but and users have fair access to select the mix of prod- box 3-1 offers some terms as guidance. ucts they want at a fair price. Thus, the report and recommendations focus on strengthened, standard- THE CASE FOR INTEROPERABILITY ized clearing and settlement functions, and the Steer- Promoting competition and innovation is not simply ing Committee does not advocate any particular or- a matter of removing specific barriers, but also of ganizational model for CCPs, CSDs, or any other pro- creating compatible systems that permit seamless vider of centralized services. operations on a global basis. Despite significant The underlying principle in this report is that mar- progress in automating the clearing and settlement ket forces should be relied upon to produce the opti- process over the past 20 years, it remains operation- mal organizational solution. This is possible, of ally and organizationally complex. Arrangements vary course, only if market forces are allowed to operate. significantly from market to market, and cross- The recommendations to improve governance in border processing is particularly convoluted. In some chapter 5 directly address restrictions in national law cases, payment involves a different currency from that or regulation that can distort competition, act as bar- in which the underlying security is denominated, a riers to entry, or encourage anticompetitive practices. factor that introduces a foreign-exchange dimension Users should not be excluded from or tied into ser- into the process. vices through law, regulation, market practices, or Moreover, securities are subject to a variety of cor- other means, other than through objective and con- porate actions—including payment of dividends or cou- sistently applied processes solely designed to mitigate pons, restructurings, and voting and conversion rights— risk or enhance systemic safety. governed by the provisions of company law in the coun- The analysis that underlies the recommendations try concerned. These often require the owner to com- contained in this report is founded on a functional ply with particular rules that relate to trade reporting.

1. Matching utilities are automated systems through which financial intermediaries and agents for institutional investors match and thereby confirm trade and settlement details.

26 Building an Efficient, Interoperable Network

Such matters can complicate the transfer of ownership As discussed in chapter 1, interoperability refers to rights to the instruments and hence their clearing and the ability of entities along the clearing and settlement settlement. Further, tax treatment for different classes processing chain to communicate and work with other of owners of securities may differ from country to coun- entities without special effort on the part of users. try, requiring the filing of information and claims with Interoperability involves more than technical compat- the relevant taxation authorities. Likewise, foreign-own- ibility of systems, although standardized communica- ership restrictions may require special filings or limit cer- tion, messaging, data, and timing are clearly essential. tain actions involving an instrument. As a result of this The ability of systems to interoperate also requires like complexity, the degree of overhead and cost associated or compatible processes, business practices, controls, with settling a securities trade is still significantly higher technologies, products, fee structures, and the like. than, for example, the cost of processing a cash pay- With all these elements in place, interoperability ment or a foreign-exchange transaction. offers the potential for processing of transactions with- Furthermore, because of the close link between out human intervention, for simpler and cheaper back- clearing and settlement and the trading of securities, office operations, for greater competition between pro- particularly for equities, CSDs and CCPs have typi- viders and systems, and for integration and consolida- cally been established as part of, or closely aligned to, tion of service providers. The market will determine national stock exchanges. Thus, they have been de- the extent of change that occurs, although creating full signed to comply with the laws, regulations, and mar- compatibility between entities implies a level of coop- ket practices governing securities transactions in the eration not often seen between competing entities. particular jurisdictions with which they are aligned. Achieving interoperability is a critical issue in secu- As a result, clearing and settlement conventions and rities processing because of the structures differ materially from country to country. multiple paths along which clear- A transaction involving securities that settle in differing and settlement systems have Interoperability is ent countries or through more than one CSD or CCP developed and the lack of com- a significant factor in therefore involve an added layer of cost and common standards to bridge their dif- plexity. By the same token, financial intermediaries ferences. The resulting “many to the proposed solution that seek to provide international securities clearing many” relationships are costly, re- to many issues. and settlement services to their customers either must flecting maintenance of multiple develop the capability to transact and settle in each interfaces, duplicate system de- of the underlying markets and become members of velopment, and increased training requirements. There the local CSDs and CCPs themselves, or they must are also indirect costs, for example, in connection with subcontract the activity to an agent who has that ca- funding (collateral and margin requirements and work- pability and is able to undertake the activity on their ing capital), with regulatory compliance, and with the behalf. The use of local agents, together with the al- investigation and resolution of errors. Interoperability ready large number of global intermediaries, creates would reduce these costs because users would interact an elaborate web of relationships among organiza- with a number of systems as if they were interacting tions, with no standards to define how they should with only one. connect and interact. Creating the potential for interoperability requires The recommendations offered here to address in- the development and introduction of a wide-ranging efficient and costly market practices and technical and set of standards, covering technical, market practice, network standards can be divided into two categories. risk control, system access, and other commercial and These categories may be broadly defined as measures economic features. Establishing full interoperability necessary to build a strengthened and interoperable requires implementation and consistent use of those global network, and measures to enhance services de- standards within and between connected entities, en- livered across the network. forced through economic, regulatory, or other means.

27 Global Clearing and Settlement: A Plan of Action

BOX 3-1. PARTICIPANTS IN THE Monitoring and governance of the processes for CLEARING AND SETTLEMENT PROCESS developing and setting standards are clearly critical and must ensure fair representation for all rel- Several categories of participants figure promi- evant stakeholders; this will help build consensus nently in the recommendations and are impor- around practical and workable standards. These tant to their implementation: standards should be open and able to evolve, so that they do not inhibit innovation or competition. ½ Financial intermediaries are those organiza- They should be clear and unambiguous, so that tions that facilitate a financial transaction be- they can be used in a consistent manner. And they tween end-user issuers and investors. They should be both enforceable and enforced. can broadly be categorized between broker- This report argues for implementation of full dealers (or stockbrokers) and custodian- interoperability across all significant entities over agent banks. Within these broad categories a five-to-seven-year time horizon. Some of the there is clearly a wide range, from small do- standards that collectively create the potential for mestically focused operations to very large interoperability can be implemented in a shorter global organizations. period. Standardization of individual elements of ½ Infrastructure providers are the operators of securities clearing and settlement systems or the process—for example, consistent message networks. They include (I)CSDs, CCPs, and— standards and communication protocols—will where relevant to the particular recommen- bring definable benefits, even if the overall ben- dation—payment, communications network, efits of full interoperability will eventually be or other systems that are integral to the clear- greater than the sum of these parts. On this ba- ing and settlement process. sis, development and use of each particular stan- ½ Providers of clearing and settlement services dard should be pursued as quickly as prudently (“service providers”) include infrastructure possible and should not be delayed by the time providers as well as those financial interme- frame of any other standard unless critical de- diaries that provide clearing and/or settle- pendencies exist. ment services to their particular clients, al- Interoperability is central to meeting the broad though not to the industry collectively. areas of concern identified by the Pricewaterhouse ½ The term market participants is used broadly and collectively and embraces infrastructure Coopers survey described in chapter 1. As well as providers and financial intermediaries, to- being one of the five key areas identified, interoper- gether with end-user issuers, investors, and ability is a significant factor in the proposed solu- other organizations that undertake securities- tion to many issues. The costs to users of switch- transaction–related processes, such as reg- ing between interoperable service providers would istrars and transfer agents. be lower, helping to remove a barrier to access and ½ Systemically important institutions are those competition. Interoperability would likely facilitate market participants whose operational or fi- the standardization and automation of additional nancial failure has the potential to cause other processes; asset servicing is an important area in organizations to fail and so to spread conta- this regard. The Steering Committee has found gion through the entire financial system. In broad consensus among market participants for any particular market, infrastructure provid- streamlining their internal processes, in particular, ers and particularly large or strategically im- by eliminating manual processing and avoiding du- portant financial intermediaries are likely to be classed as systemically important. plicative systems and procedures necessary to interact with multiple and incompatible clearing and settlement service providers.

28 Building an Efficient, Interoperable Network

IMPROVING THE EFFECTIVENESS forms of paper, such as confirmations and trade OF ALL SYSTEMS allocations, into the securities processing trans- Efficient clearing and settlement systems require users action flow as available technology safely allows, to be able to communicate and interact seamlessly. In from issuance through to asset servicing. Means domestic markets, eliminating paper (for example, of electronic capture, storage, and transmission through the creation of CSDs) and automating com- of documents should be used to their fullest ex- munication (for example, through dedicated networks) tent to avoid the need for physical documents to have been a continuing focus. Major markets have elimi- serve as evidence of transactional activities and nated use of paper securities certificates themselves, asset ownership. either through immobilization of securities certificates All market participants should use electronic com- in depositories so that transfers can take place in elec- munication to transmit information for all instru- tronic form, or by eliminating certificates all together ments and transactions types. Market participants through dematerialization. Many processes even in should identify opportunities to streamline pro- these markets still generate paper records, such as those cesses by avoiding duplicative recording of data related to voice and fax communications. The Steer- and manual addition of supplementary informa- ing Committee recommends that these be eliminated tion. This recommendation applies to each stage and sees no reasonable grounds for delay. of the value chain, from issuance through to trad- RECOMMENDATION 1. ELIMINATE PAPER AND AUTOMATE ing, clearing, settlement, and asset servicing, in- COMMUNICATION, DATA CAPTURE, AND ENRICHMENT. cluding confirmations, allocations, and rights and Infrastructure providers and relevant public au- decisions related to asset ownership. Electronic thorities should work with issuers and securities communication and avoidance of repetitive or industry participants to eliminate the issuance, use, manual recording and enrichment of data among transfer, and retention of paper securities certifi- all participants are essential building blocks in cates without delay. Such action should be sub- achieving a zero-intervention process. Technol- ject to proper investor protection over assets held ogy to address these two aspects of processing in electronic form. There is no greater assurance should be fully utilized. of ownership or control from maintaining paper, and it should be possible to overcome the con- CREATING CONNECTIVITY trary perceptions of some retail investors through AND INTEROPERABILITY education and by ensuring a sound legal basis for Creating an effective network at a global level requires all paperless securities in each jurisdiction. De- connectivity and interoperability between different materialization of securities certificates—convert- markets and systems. Achieving interoperability re- ing all paper ownership records into electronic for- quires standardization of the technical specifications mat—is the preferred solution. However, in prac- and market practices that embody the mechanics of tice immobilization—where ownership is re- systems and networks. These recommendations thus corded through electronic book entry and the un- focus on establishing a series of standards in the most derlying paper certificate is kept in a central secu- critical areas of the clearing and settlement network. rity depository—realizes many of the benefits of RECOMMENDATION 2. HARMONIZE MESSAGING STANDARDS AND dematerialization. Therefore, if immobilization COMMUNICATION PROTOCOLS. can be achieved more quickly and efficiently than dematerialization, it is an acceptable step on the All market participants should adopt ISO 15022 way to full dematerialization. (the data field dictionary and message catalogue for securities information flows) as the global standard All market participants should seek to automate for straight-through securities messaging across the elements of the process that introduce other

29 Global Clearing and Settlement: A Plan of Action

entire securities life cycle.2 Over time, XML (ex- ½ Relevant generic data categories, such as fee, tensible mark-up language) should become the lan- tax, and commission rates and other, typically guage to describe standardized messages. 3 Market country-specific, data (including currencies, participants should follow the road map set out by local holidays, and time zones). the ISO working group established to advance ISO 15022 to a standardized use of XML. This stan- Standards should be comprehensive, covering the dard should develop to meet the needs of all par- needs of all users in the securities value chain. ties to the investment product life cycle and, in They should also be applicable globally. Particu- particular, the asset servicing requirements of the lar attention is required to address the concerns industry. All stakeholders in the securities industry of jurisdictions where use of such standards is should be appropriately represented in the stan- restricted for reasons of data confidentiality, se- dard development process. crecy, or other public policy purposes. All market participants should support and use Issuers, exchanges, and other originators and dis- communication networks that adopt open, stan- tributors of data should make all relevant infor- dardized, IP-based protocols for securities trans- mation available to the market in compliance with actions. 4 These standard internet protocols must these standards for a fair price and on a timely embrace key attributes critical to the sending of basis. The development of standards is not in it- messages related to securities transactions. Secu- self sufficient to avoid the very substantial ineffi- rity, in particular, should be set at a level that sat- ciencies and costs incurred through inaccurate, isfies business and regulatory requirements and incomplete, or incompatible data. In addition, it that meets the needs of all stakeholders in the is critical to enhance the substance and content industry. Each network provider should clearly of the data. define and publish its plans to migrate from pro- Extensive work is needed in connection with all prietary communication protocols to the open IP- three categories of reference data, and the time based protocols. frame for ultimate adoption and use of standards will vary. As a first step the industry should set up RECOMMENDATION 3. DEVELOP AND IMPLEMENT REFERENCE DATA STANDARDS. working groups (or where initiatives are already under way, build upon or combine existing work- Market participants should collectively identify, ing groups) representative of all parties to the develop, and adopt universal securities, counterparty, investment product life cycle, to identify the spe- and relevant generic reference data standards that cific areas where standardization is needed. These fully meet the needs of all relevant users. Such industry groups should work with the relevant standards should be adopted in connection with: standard-setting bodies and data suppliers to es- ½ Asset identification and associated descriptive tablish a plan designed to achieve identified ob- data, based upon ISO 6166 (concerning Inter- jectives in connection with these standards. national Securities Identification Number, ISIN). ½ Counterparty identification, exact account identification, and standard settlement instructions, based upon ISO 9362 (concerning Bank Identifier Code, BIC).

2. See footnote 5, page 8. 3. See footnote 6, page 8. 4. See footnote 7, page 8.

30 Building an Efficient, Interoperable Network

RECOMMENDATION 4. SYNCHRONIZE TIMING BETWEEN DIFFERENT in certain areas, particularly (but not exclusively) in CLEARING AND SETTLEMENT SYSTEMS AND ASSOCIATED connection with cross-border transactions. PAYMENT AND FOREIGN-EXCHANGE SYSTEMS. One area for improvement is institutional trade Providers of clearing and settlement services and matching. Matching is the process whereby the parties linked or otherwise associated payment and to a trade agree on the details of the trade and the foreign-exchange systems should collectively en- related settlement instructions. Much of the cost as- sure that their design, procedures, operational sociated with clearing and settlement arises from the timetables, and funding and cutoff times are such failure of these details to match. Broker-to-broker that the operation of one system does not mate- trades typically already use automated matching sys- rially reduce the efficiency or increase the risk of tems, and automated matching is unlikely to be practi- settlement in another. These organizations should cal for trades involving retail investors. Thus the op- collaborate to identify the specific areas where portunity for improvement lies with trades involving standardization is needed and to develop detailed institutional investors. Greater use of matching utili- plans to achieve it. Standardization should be ties would help address this problem. With this facility, implemented initially on a regional basis (broadly parties to a transaction could identify and correct prob- based on the Americas, Europe, and Asia-Pacific). lems with transaction details at an early stage in the Cross–time zone protocols should be established settlement process, thereby reducing the number and subsequently. Systems should allow transfers to costs associated with unmatched and failed trades. and from securities settlement systems to be made in a timely manner. Periods of peak cash demand RECOMMENDATION 5. AUTOMATE AND in separate systems should be carefully managed STANDARDIZE INSTITUTIONAL TRADE MATCHING. Promoting competition so that they do not clash with one another. Market participants should and innovation is not Market participants should work together to de- collectively develop and use velop a comprehensive action plan to increase the simply a matter of fully compatible and indus- efficiency and safety of cross-border securities removing specific try-accepted technical and transactions where the foreign-exchange settle- market-practice standards barriers, but also of ment cycle is not synchronized with the securi- for the automated confirma- creating compatible ties settlement cycle. As yet, no fully developed tion and agreement of insti- solutions systematically address the costs and risks systems that permit tutional trade details on the arising from the mismatch between securities and seamless operations day of the trade. The estab- foreign-exchange settlement cycles in these cir- lishment and use of the on a global basis. cumstances. This issue will increase in importance matching utilities currently as securities settlement cycles are shortened. being developed and put into operation is an important part of this pro- DELIVERING ENHANCED SERVICES OVER THE NETWORK cess, although many of the potential efficiency The recommendations outlined so far aim to help gains that they offer will not be realized without establish an effective international clearing and settle- interoperability among separate systems. If the ment network that allows infrastructure providers and number of organizations providing these services intermediaries to better provide services that users grows, the inefficiencies that fragmentation and require. Improvements have already been made at the lack of standardization can create will increase. domestic level to many stages of the securities processing value chain, but considerable scope remains At the clearing level, the key issue that the industry for further automating and streamlining the system has to tackle is whether to establish CCPs. These have undoubted benefits in terms of reducing both cost

31 Global Clearing and Settlement: A Plan of Action

and risk, but they are also costly to establish and main- should seek to develop functionality to allow stock tain, and the cost-benefit equation will be different lending and borrowing to be conducted efficiently in each market. The Steering Committee expects that by intermediaries and other users. This recom- in most markets the benefits of using a CCP are likely mendation does not seek to eliminate restrictions to outweigh the expense, but does not consider it wise in individual jurisdictions that prohibit stock lend- to prejudge the outcome of a full and thorough analy- ing and borrowing undertaken for reasons other sis in specific markets. than expediting settlement, such as transactions that facilitate short-selling. RECOMMENDATION 6. EXPAND THE USE OF CENTRAL COUNTERPARTIES. Asset servicing is an often overlooked but critical Market participants and relevant public institu- part of the transaction value chain. Corporate actions tions should collaborate to assess the potentially remain an area with significant diversity of practices substantial risk reduction and efficiency improve- and widespread use of manual processes and paper, ments of using a central counterparty. These ben- often as a result of legal, regulatory, and taxation re- efits are expected to outweigh their costs in most quirements governing the ownership and of securi- markets. Where this is so, market participants ties and associated rights. should seek either to use the services of an existing central counterparty or establish one of their RECOMMENDATION 8. AUTOMATE AND STANDARDIZE ASSET SERVICING PROCESSES, INCLUDING CORPORATE ACTIONS, own, whichever has the better risk, cost, and ben- TAX RELIEF ARRANGEMENTS, AND RESTRICTIONS ON efit profile. If more than one organization un- FOREIGN OWNERSHIP. dertakes this function in a particular market or markets, each should follow harmonized and rig- Issuers, providers of clearing and settlement ser- orous operational practices and standards, includ- vices, and other relevant market participants should ing those set out elsewhere in this report, so as to advise investors of all details of corporate actions be fully interoperable, and each should follow con- that they require in an automated, timely manner sistent risk management practices as set out in and in compliance with accepted industry standards Recommendation 9. so that each investor can make a timely decision on the action to be taken with full knowledge of Securities lending and borrowing is a device used the facts. Each market place should protect the in many markets to expedite settlement where stock rights of the beneficial owner of a security to all would otherwise be unavailable to meet settlement corporate and income events from the point of obligations. It brings considerable efficiency benefits, execution of the purchase transaction in the rel- yet is not permitted in some markets. evant security. All corporate actions should be able to be executed through book entry transfer and/ RECOMMENDATION 7. PERMIT SECURITIES LENDING AND or payment systems, where such systems operate BORROWING TO EXPEDITE SETTLEMENT. for the settlement of purchases and sales of securities. All communications through the value chain Relevant authorities should permit securities lend- between issuer and beneficial owner should, as ing and borrowing as a method for expediting the technology allows, be automated as set out in the settlement of securities transactions. Each mar- relevant recommendation. ket should provide tax, legal, regulatory, and accounting frameworks to allow the use of stock Market participants and public authorities should lending and borrowing to prevent settlement fail- work together to minimize the administrative ures. CSDs or other infrastructure providers, while costs to each party involved in tax relief arrange- not necessarily acting as principal to the transaction, ments through standardization and automation

32 Building an Efficient, Interoperable Network

of procedures and communication of informa- in connection with foreign-ownership restrictions tion and through the use and acceptance of elec- and reporting requirements. Full information tronic data and documentation. This recommen- needed to assess whether restrictions apply should dation exclusively addresses the process of tax rec- be available to allow investors and intermediaries lamation. It does not in any way seek to address to make timely and appropriate decisions. For the absolute levels of the taxes themselves. example, investors should be able to determine in advance of trade execution whether the trade Relevant public authorities, infrastructure provid- will breach any limits. Reporting and disclosure ers, and market participants should work to har- responsibilities should also be transparent and monize and make transparent the processes, docu- should be able to be discharged through auto- mentation, and communication of information mated electronic communication.

33 4. ENSURING SAFETY AND STABILITY

CLEARING AND SETTLEMENT SYSTEMS INVOLVE AN matter of the financial, operational, and technical ar- INTERRELATED GROUP OF RISKS—credit, market, chitecture of the particular settlement system.1 But it liquidity, operational, and legal—that are generally of is also a matter of the complex legal and regulatory short duration but almost always involve transaction characteristics of both the system and the underlying values that are very large in size. Moreover, because instruments that are being exchanged. While finality of the highly interdependent movement of cash and of such transactions is regularly achieved without the securities (and other assets and instruments) associ- slightest hitch, this very regularity can give rise to a ated with settlement systems, any event that poses a false sense of security, even complacency, about the threat to achieving final settlement in one system is reliability of all elements of such systems to function likely to have swift and serious implications for other even under serious stress. systems. Contagion risk is likely to increase further as Broadly speaking, there are two modes of securi- the systems become more concentrated globally, with ties settlement. The first is the “gross settlement sys- fewer and larger settlement entities. In short, clear- tem,” in which payment for and delivery of securities ing and settlement systems are akin to the nervous occurs transaction by transaction and almost simul- system of the global financial system. As such, they taneously. A number of central banks operate real- present the classic policy dilemma of how best to time gross settlement systems for settling national manage situations that entail disturbances or shocks government securities, with the exchange of cash and of relatively low probability but with the potential to securities occurs virtually simultaneously on the books cause serious, perhaps systemic, financial damage. of the central bank. The central bank provides a de At one level, the role of clearing and settlement facto guarantee to the receiving bank that funds com- systems is quite straightforward: to ensure that the ing from the paying bank will be final—even if the buyer of a security receives irrevocable delivery of paying bank is found to be insolvent minutes later. that security from the seller at or near the precise point This, of course, is finality in purest form. in time when the seller of the security receives from The second mode of securities settlement is the the buyer final and irrevocable payment for the secu- “net settlement” system. In this system, individual rity. But that apparent simplicity is deceiving, for the transactions accumulate at the settlement entity for process itself is enormously complex and subject to varying periods of time (usually one business day, but sizable, if often subtle, risks. Achieving finality—and sometimes for shorter intervals). At a specified time, achieving it in the shortest time possible—is partly a the settlement entity nets the gross transactions

The treatment of risk issues in this report relies heavily on a risk paper drafted by Gerald Corrigan, Managing Director, Goldman Sachs & Co., and further analysis by a working group of technical experts that he chaired. 1. Finality is achieved when a transfer or pledge of securities is irrevocable and unconditional.

35 Global Clearing and Settlement: A Plan of Action

among its members, with each member becoming a effect of aggravating the very problem that net deliverer or net recipient of cash and/or securi- such actions are seeking to mitigate. Credit risk ties. The net cash settlement payments are made and market risk are grouped together here through preexisting payment facilities at banks or because one of the more likely and formidable central banks. Although all net settlement systems causes of default or the threat of default is the have these general characteristics, the specific netting market risks associated with large and rapid procedures may vary. For example, some systems have declines in financial asset prices, such as multiple net settlements during a single day in lieu of occurred in 1987 and 1998. larger end-of-day net settlements. In other systems ½ Liquidity and market-liquidity risks. Liquidity securities are transferred trade by trade while pay- risk involves several different but related issues. ments are netted, or both securities and cash are net- The first and most straightforward is the risk ted, with credit risk prior to finality addressed by vari- that a key institution facing temporary liquidity ous risk mitigation mechanisms. problems encounters difficulty in meeting cash Although the focus of this report is clearing and or securities obligations to one or more settlement of securities, the financial and operational settlement systems. Alternatively, the settlement integrity of these systems cannot be viewed indepen- system itself could have operational problems dently of the financial and operational integrity of (see below) that limit or prohibit it from settlement systems more broadly. That is, if a major redelivering cash or liquid securities to system disturbance originates in foreign-exchange, commod- participants. Problems along these lines relate to ity, over-the-counter derivative, or futures markets— the term “liquidity” in its traditional meaning. especially if that disturbance is credit-related—the A different and more troubling aspect of presence of essentially the same large counterparties liquidity is the concept of market liquidity of across all such markets would likely mean that cash assets. This involves the extent to which various or securities destined for securities clearing systems asset markets have sufficient trading liquidity so might not get there, throwing into question the sta- that financial institutions can readily sell or tus of the securities systems settlement. In other liquidate positions either to limit losses or to words, even the very best of securities clearing and raise cash to satisfy obligations. In the worst of settlement systems are not insulated from problems the financial market disturbances of the past 20 originating elsewhere in the financial system. years, the de facto evaporation of market This point takes on a special significance when one liquidity greatly added to credit and market risk. considers the specific nature of the risks associated In some instances, the workability of netting with clearing and settlement systems. At the danger systems and closeout procedures that are so of great oversimplification, those risks can be grouped central to clearing and settlement systems were into four main categories. also called into question. Among other things, such episodes—as rare as they are—raise ½ Credit and market risk. The most dangerous questions about the financial and liquidity risk inherent in all clearing and settlement cushions associated with clearing and settle- systems is the risk of default by one or more ment systems. system participants unable to complete settle- ½ Operational risks. Simply stated, the operational ment because of liquidity or solvency problems. risks inherent in clearing and settlement systems Such a condition can arise for any number of are the danger that for whatever reason, one or specific reasons, and it is important to recognize more such systems incur operational problems that even the threat of such default will cause that limit or halt normal activities. The cause of other participants and counterparties to take such problems can have many specific origins, defensive actions that may have the unintended ranging from protracted software problems to

36 Ensuring Safety and Stability

natural disasters to catastrophic events such as defaulting counterparties, for example—could September 11, 2001. Such problems are likely to add considerable fuel to the fire of market and be most acute when they occur during business credit risk shocks. hours and extend beyond the close of the normal business day. Ironically, they are also most difficult While the categories of risks inherent in clearing when they affect only one or a few institutions in a and settlement systems are fairly easy to describe in particular locale rather than, for example, a large broad terms, it is impossible to anticipate the precise number of institutions in a particular locale—as nature of the future shocks that might move such con- might happen in a major natural disaster, such as cerns from the realm of risk to an earthquake, where there is no question about the realm of reality. It is even the cause of the disruption or how to resolve it. In more difficult to anticipate the The very regularity of the most severe cases, operational failures can give exact manner in which an initial C&S transactions can rise to liquidity, market liquidity, and credit and shock in one area—operational market risk. risk, for example—might work give rise to a false ½ Legal risks. The potential legal risks (broadly its way into other areas of con- sense of security, even defined) inherent in clearing and settlement cern, such as legal and then credit complacency, about systems are many in number, and some can risk, in the progression of a clas- the reliability of such have serious implications. In essence, legal risks sic chain reaction. One thing is entail the threat that any one factor or a variety quite clear, however. When any systems to function even of factors will prohibit or limit one or more such shock reaches the point under serious stress. counterparties from discharging their contrac- where counterparties begin to tual responsibilities—as they understand such question seriously whether they responsibilities—or from protecting themselves will receive payment, delivery of securities, or prom- from financial harm in the event that another ised collateral, that is the point when behavior becomes counterparty is unable or unwilling to meet its defensive and the seeds of major problems are sown. contractual responsibilities. It is the potential for such problems to disrupt the glo- Legal risks can have very simple causes, bal financial network that requires practitioners and such as shortcomings in documentation or policymakers alike to devote considerable resources to failure to confirm trade agreement on a timely risk mitigation efforts in the area of clearing and settle- basis. They can also arise from very complex ment, even if such efforts are admittedly being directed sources, such as uncertainties about legal at low-probability contingencies. interpretations in particular jurisdictions or the practical workability of closeout provisions in RISK MITIGATION IN CLEARING times of major market stress. AND SETTLEMENT SYSTEMS Far more often than not, legal issues have Risk mitigation in clearing and settlement systems has been resolved with virtually no so-called many dimensions. Moreover, it takes place in a com- “knock-on” effects—even though some of plex institutional framework that must be understood these events have proved quite costly to in order to place both risk and risk mitigation in individual institutions. Legal risks tend not to proper perspective. The complexity of some of the spread because they rarely carry the direct processes and linkages involved places a substantial threat of default that could raise generalized burden on private boards and management to ensure concerns about sizable credit losses to that risks are being effectively monitored, measured, counterparties. In times of very serious market and controlled, and that dedicated and contingent stress, however, the possibility that legal resources are sufficient to address losses arising in uncertainties—about the ability to close out the course of business. This burden falls both on pro-

37 Global Clearing and Settlement: A Plan of Action

viders of securities clearing and settlement services associated with rigid adherence to the legal and on their potential users. It applies equally to letter of such protections could be of sizable, questions of the financial strength and risk manage- if not systemic, consequence. ment of individual firms and to their ability to cope In such circumstances, the best risk mitigant with the operational challenges of high-speed, high- might well be for some, or many, institutions to volume transactions. Due diligence is required both step up to the losses, rather than seek the at the time that decisions are made about accepting shelter of an imperfect mitigant. That said, the new members or about joining a system and during best way to ensure that such a fateful contin- the normal course of business, when risks must be gency does not arise relates squarely to the monitored and controlled in real time. quality and effectiveness of risk mitigation It is safe to assume that every financial institution efforts more generally. and service provider devotes substantial time and re- ½ Reliance on netting of exposures. sources to these matters. The fact that this report in- Many of the tools to monitor counterparty cludes recommendations on financial integrity and a exposures, whether within settlement systems framework for evaluating current performance is not or more broadly, look at “net” exposures rather meant to imply laxity on the part of boards and man- than at the gross owed-to and due-from agement or public authorities. The challenge in this exposures. Securing gross transactions on a net area is so great, however, and the cost of failure so basis can entail several steps, most notably high, that the aim of financial management at major accounting for collateral and/or margin and any service providers must be to ensure continued op- bilateral or multilateral netting agreements that eration in the face of market shocks and to minimize are legally binding. the potential for default. Thus notwithstanding sub- While measures of net exposures are useful stantial efforts over a sustained period to strengthen and relevant for many purposes, they can be financial stability, the purpose of recommendations misleading, particularly in times of stress when in this area is to push the bar a bit higher. these underlying presumptions may not hold. Before turning to specific recommendations, it is Moreover, in times of stress, such measures worth examining two features of the existing system, implicitly assume that counterparties to a neither of which is addressed directly in the recom- defaulting counterparty can successfully close mendations. out positions with the defaulting counterparty and do so in a manner that is consistent with the ½ Limited liability loss-sharing arrangement. level of net exposure. Unfortunately, both Among users of clearing and settlement practical and legal factors may stand in the way systems, the legal entity that is the member of of such an outcome. If that occurs, it is the gross a clearing and settlement system may be a measure of exposure, not the net, that will be limited liability, lightly capitalized entity. relevant. Accordingly, where the enforceability Similarly, settlement systems may have limited of netting arrangements is in question, risk liability provisions in their loss-sharing management practices and tools must account agreements for members in the event of a for gross as well as net exposure both between default by another member or members. These counterparties and between counterparties and limited liability features are accepted methods settlement entities. of risk mitigation. Both providers and users of such facilities must recognize, however, that in With these issues in mind, and against the back- rare cases of acute stress, the protections ground of earlier official and private studies of this provided by these arrangements may prove subject, the Steering Committee gave careful consid- illusory; the financial and reputational damage eration to the additional steps needed to reduce the

38 Ensuring Safety and Stability

risks associated with clearing and settlement systems. lending facility has to replace the missing securities These additional steps are seen as particularly impor- itself. In addition to credit and market risk, CCPs and tant given the highly likely, perhaps virtually inevi- CSDs face other types of risks, including operational table, consolidation and concentration in the global risk and legal risk, in the course of their operations. universe of clearing and settlement. On the basis of Although this report addresses these risks specifically these deliberations, three broad sets of recommen- in the recommendations on operational and legal in- dations have been developed in the areas of enhanced tegrity, they also need to be considered when deter- financial integrity, enhanced operational integrity, and mining the suitable level of financial resources. enhanced legal integrity. CCPs and CSDs put in place risk mitigation measures, which can be broadly categorized as: ENHANCING FINANCIAL INTEGRITY OF SERVICE PROVIDERS AND USERS ½ Measures aimed at controlling the probability The operations of CCPs and CSDs sit at the heart of of suffering loss through default of a the clearing and settlement process. Because a CCP counterparty. In essence, these measures are interposes itself between the counterparties to each embodied in the due diligence process surround- transaction, acting as the buyer to the original seller ing the acceptance of new members and review and the seller to the original buyer, it is by definition of the continued suitability of existing members. exposed to credit risk of market participants. Theo- ½ Measures aimed at minimizing the scale of retically, a CCP assumes no market risk because the loss if a counterparty should default. These market values of the long and short unsettled trans- steps include marking to market exposures, actions it holds must be identical at all times. If a imposing collateral requirements and variation market participant fails to fulfill its settlement obli- margins, setting concentration limits on gations, however, the CCP is obligated to complete exposures, and establishing proper internal the settlement of the other side of transactions. In control and risk management procedures. that event a CCP is exposed to market risk because it needs to go into the market to buy or sell securities at No matter how well established and rigorous risk market prices for settlement purposes. (This risk is management and mitigation systems and processes often referred to as replacement cost risk.) are, unexpected losses are inevitable. For example, In many markets CSDs also have procedures in there could be extreme market moves that are not place to help ensure the timely completion of settle- captured by the risk models; unexpected losses could ment and maximize settlement of transactions. Oth- result from operational failure, disasters, or other ex- erwise, in extreme cases, the failure of a sizable num- ternal shocks; or losses could arise from legal contin- ber of transactions to settle on time could escalate to gencies. CCPs and CSDs must have financial re- a gridlock situation whereby a chain of transactions sources to meet these losses. Although there are many could not be completed on the settlement date, resources of funding, ultimately financial resources will sulting in systemic risk to markets. Banks supporting usually come from a combination of the past, present, the operation of CSDs extend intraday or overnight and future owners, members, and users of the rel- credit to participants by allowing overdrafts in their evant CCP or CSD (the three groups are hereinafter accounts to facilitate timely settlement. Participants described simply as members). that fail to repay the credit extension create credit Because membership in a CCP or CSD creates the losses and put liquidity pressure on those banks. The risk of having to fund a default, financial intermedi- same applies in those cases where CSDs engage in aries that are—or are contemplating becoming— securities lending (intraday and overnight): if a par- members typically adopt procedures to mitigate the ticipant fails to deliver the securities within the agreed risk of loss through default of the CCP, CSD, or other period, the CSD or the bank providing the securities members. Like the risk mitigation processes used in

39 Global Clearing and Settlement: A Plan of Action

relation to its members by the CCP or CSD itself, ing the level of capital required for membership these procedures are a combination of due diligence reduces a CCP’s or CSD’s risk exposure—by attract- over the CCP or CSD, and day-to-day internal con- ing intermediaries that are financially robust and well trol and risk management processes. Due diligence manages—but excludes smaller potential members. considerations also evaluate operational risk and could At the same time, increasing the hurdle for member- focus on legal risk such as the clarity of the rules de- ship may make a CCP or CSD more attractive to in- scribing finality. As discussed earlier, members often termediaries that are financially robust and manage join through specially established limited liability risk well. The appropriate balance to be struck will entities whose capital is sufficient to meet member- differ from market to market, and indeed within the ship requirements, but little more. same market over time, depending on the character- The decision whether to join a CCP or CSD is istics of the market, the nature of the products and primarily a commercial decision, often a necessary organizations involved, and the wider commercial condition of doing business, environment, including consideration of public policy particularly where the CCP or objectives. The choices made by an individual service CSD is effectively a monopoly provider or user will depend on the mix of activities The recommendations in a particular market. That said, and supervisory requirements reflected in its busi- are not a fixed standard it is important that the commer- ness model. Therefore, the recommendations below but an analytical cial decision be made with are not a fixed standard, but an analytical framework framework against which proper appreciation of the risks for best practice against which boards and manage- and balanced accordingly. ment can evaluate their operations and seek consis- boards and management Intermediaries often tency and high quality in financial risk management. can evaluate their transact business with CCPs and operations and seek CSDs on behalf of their cus- RECOMMENDATION 9. ENSURE THE FINANCIAL INTEGRITY OF tomers. In fact, participation PROVIDERS OF CLEARING AND SETTLEMENT SERVICES. consistency and quality rules may differentiate between Providers of clearing and settlement services in risk management. members with full execution and should manage their risks and set standards and clearing rights and non-clearing controls concerning the use of those services that participants, where “third-party” allow them to conduct business in a safe, sound, clearing is considered a risk mitigation technique. and prudent manner consistent with their busi- Typically, the intermediary has separate contractual ness model and all relevant supervisory and regu- arrangements with the CCP or CSD and with the cus- latory requirements. Each organization’s business tomer, so customer default does not expose the CCP model should incorporate a risk framework that or CSD directly to loss. Instead, the intermediary must addresses all risks connected to its operations. bear any loss following customer default, with the This risk framework should be approved by the CCP or CSD affected only if the loss is sizable enough board and expressed through a set of limits and to threaten the ability of the intermediary to fulfill its other qualitative and quantitative measures and obligations to the CCP or CSD. Intermediaries are tests. For systemically important organizations, thus faced with a similar commercial decision to put the business model should minimize the prob- in place due diligence assessment and risk control pro- ability and impact of default. cesses to minimize the risk of loss from dealings with The need to operate prudently within the risk customers. boundaries inherent within the business model Because CCPs and CSDs play such a central role, requires risk management processes and stan- minimizing the risk of their failure is an important dards, which should be applied objectively and objective. Yet there are several trade-offs in imple- consistently in determining compliance with risk menting the approach to risk outlined above. Increas- measures, in three broad areas:

40 Ensuring Safety and Stability

½ The counterparty due diligence process, dards, and financial sector assessments carried out whereby service providers make ex ante and by the International Monetary Fund and World Bank. ex post assessments of the suitability of their This report is intended to be complementary to these actual or potential users, and the basis upon other requirements and not to require additional re- which users transact, for example distinguish- porting where the purposes of this recommendation ing between those acceptable as clearing and are otherwise met. nonclearing members. This process should balance risk control (which inclines toward set- RECOMMENDATION 10. REINFORCE THE RISK MANAGEMENT ting high financial and operational thresholds) PRACTICES OF USERS OF CLEARING AND SETTLEMENT SERVICE PROVIDERS. with other commercial and competition considerations (which may incline toward lower- Organizations that use, or are considering using, ing barriers to entry of users), while recog- providers of clearing and settlement services nizing that there will always be minimum risk should establish robust due diligence and thresholds that should not be lowered. counterparty risk management controls and pro- ½ The procedures and techniques used to mea- cesses that appropriately evaluate, measure, moni- sure, monitor, and control risk exposure aris- tor, and control the risks inherent in such activity ing as a result of the activities of the service and in associated customer-related business. The provider, its users, and its users’ customers. recommendation does not seek to replace pru- These should seek to avoid moral hazard dential standards and supervision that may already whereby users can introduce risk to the sys- apply to financial intermediaries, including risk- tem without providing proportionate finan- related minimum capital requirements set by pru- cial protection to the service provider and dential supervisors. However, it is clearly impor- other users. tant that capital resources and risk management ½ The minimum financial and liquidity re- practices appropriately reflect the range of risks quirements that should be established by in- inherent in clearing and settlement. Likewise, frastructure providers (and enforced by su- nonsupervised users of providers’ services should pervisors, as described in the relevant recom- be able to demonstrate the risk-based adequacy mendation) in proportion to the risks to which of their capital resources and risk management they are exposed, so as to ensure their ability processes. to continue to provide services to markets and minimize the probability and impact of a de- ENSURING FINALITY fault on their users and the financial markets. Because finality is essential to limiting credit risk in the clearing and settlement process, ensuring simultaneous, Each organization should publish a report, at least final, and irrevocable transfer of assets and payments annually, that describes the business model, risk is critical. Therefore it is incumbent on providers of framework, and underlying risk management pro- securities settlement services to link securities trans- cesses, controls, and standards, together with the fers to funds transfers in a way that achieves delivery results of independent testing of those procedures. versus payment (DvP). Pursuit of DvP was a recom- The report would reassure users that the organiza- mendation in the 1989 G30 report and has remained tion had been operating effectively and would also on the list of recommended practices ever since, most provide greater transparency to the market. recently in the 2001 recommendations by CPSS/ IOSCO. Despite its vintage and wide endorsement, Coverage of this report may overlap with other an industry-wide definition of DvP remains elusive reporting requirements, such as the so-called SAS 70 and DvP is still not universal. reports, assessments pursuant to CPSS-IOSCO stan-

41 Global Clearing and Settlement: A Plan of Action

RECOMMENDATION 11. ENSURE FINAL, SIMULTANEOUS TRANSFER dencies of cross-border transactions; this means AND AVAILABILITY OF ASSETS. that the impact of uncertainty on such trades will Providers of securities settlement services should be greater than on domestic trades. This is an- reduce to the lowest possible level the credit risk other important consideration. created if securities or cash are delivered without Whichever settlement model is used, each se- receipt of corresponding assets, by linking secu- curities settlement system should specify the mo- rities transfers to funds transfers in a way that ment of final transfer in its rules or through bind- achieves effective delivery versus payment (DvP) ing contracts in plain and simple language, as ex- and by making transparent the point at which fi- pounded further in the respective legal risk rec- nality of transfer is achieved. There are different ommendation. settlement arrangements that can achieve this: Systems that settle both securities and cash on a net basis and allow intraday transfers that ½ Real-time (or frequent intraday batch) settle- are conditional or not legally binding, have yet ment systems can offer the greatest certainty greater uncertainty, as a participant’s transfers may by providing simultaneous and immediate be revoked following failure to meet their end- transfer for securities and cash at multiple of-day contractual obligations. In these circum- points within the working day so long as there stances the complexities of unwinding conditional is finality of transfer of securities and cash. transfers of securities (and thereby needing to ½ Systems that offer real time (or frequent recalculate the delivery obligations of other par- intraday batch) transfers of securities followed ticipants), and the operational difficulties and by net cash payments at the end of each work- liquidity pressures that may result, have the po- ing day (or intraday) offer a lower level of tential to create systemic risk. Such arrangements certainty, but can substantially reduce costs are therefore considered unacceptable, particularly and demands on liquidity, particularly in high- where there is potential cross-border impact. volume markets. In practice, such systems re- Once finality of transfer is fully assured, the quire additional and enhanced levels of risk rules should enable a receiver to re-use securities management to offset the greater uncertainty and cash without further delay, whether arising but are acceptable provided that intraday se- from settlement, dividend or interest payments, or curities transfers are final and that risk con- corporate events. trols ensure that the end-of-day (or intraday) net settlement of cash payments will be com- ENHANCING OPERATIONAL INTEGRITY pleted, even if one or more participants ow- As discussed earlier, business continuity and recovery ing the largest end-of-day cash payments fail from disaster are concerns for clearing and settlement to meet their obligations. systems because a technical, terrorist, or natural catastrophe could restrict or halt normal activity. In the worst Determining the arrangement appropriate to case, operational as well as, liquidity, market-liquidity, a particular market will depend on a number of and market and credit risk concerns could affect a wide factors, including available technology and com- range of other providers of clearing and settlement munication infrastructure, the number and value services and financial institutions. For this reason, ser- of transactions, the systemic importance of the vice providers have always devoted considerable re- market to the world financial system, and the busi- sources to planning for business continuity and disas- ness and operational models of other market par- ter recovery. Even so, several important lessons were ticipants and related payments systems. Any learned from the events of September 11, 2001. uncertainties within an individual system are mag- The widespread destruction of the physical infra- nified by the complexity and intersystem depen- structure and telecommunications environment in

42 Ensuring Safety and Stability

lower Manhattan caused disruptions in the trading of evaluate the costs and benefits of developing so- certain securities and the subsequent clearing and settle- lutions to the broad range of business continuity ment of trades. While the global financial system con- and disaster recovery issues. For functions critical tinued to function in the days following September 11, to the market as a whole, a split operations model the level of disruption caused when key institutions should be considered, whereby one processing site were knocked off-line demonstrated the interdepen- actively backs up another, with each site having the dence of the financial system. Recommendation 12 requisite level of key resources, capabilities, and aims to promote immediate action to strengthen busi- functionality, including appropriately skilled and ex- ness continuity and disaster recovery plans. Given the perienced people. Systemically important institu- differing nature of organizations to whom the recom- tions should undertake tests with member firms mendation is addressed and the varying circumstances and users as part of their evaluation exercises. in which they operate, the recommendation is not in- In their review of backup arrangements, organiza- tended to be prescriptive. It is also important to note tions should consider whether they have sufficient that elements of business continuity and disaster re- access to dedicated backup facilities to ensure that covery plans aimed at addressing less catastrophic but operations can be reconstituted within a suitable nonetheless important scenarios, such as loss of ser- time frame. When major incidents occur, organi- vice from telecom or other key suppliers, remain vital. zations should be aware that the pressure on shared Similarly, effective contingency planning does not in backup facilities may be such that they are not able any way diminish the need for strong preventative to rely on having access to it. measures, including physical and IT security. Full disclosure of plans may increase the risk of RECOMMENDATION 12. ENSURE EFFECTIVE BUSINESS CONTINUITY certain events or attacks, or otherwise compro- AND DISASTER RECOVERY PLANNING. mise plans, and is clearly undesirable. However, All market participants should, and all systemi- contingency plans should be sufficiently transpar- cally important institutions must, regularly review, ent and effectively communicated to the other update, and test their business continuity and dis- market participants that depend on the institu- aster recovery plans, including evaluation of reli- tion to allow them to make reasonable judgments ance on third parties, to ensure with reasonable about the operational risks to which they in turn certainty that critical operations will continue with are exposed. In addition, the responsible super- a high level of integrity and sufficient capacity fol- visory body should critically assess the contin- lowing a disruption or disaster. The review, updat- gency plans of the organizations that they super- ing, and testing of plans should build upon the vise, including an evaluation of the adequacy and thorough analysis and good practices that have al- frequency of testing. The nature of these assess- ready been established and that are being devel- ments should reflect the associated risks, and for oped by public and private institutions. The plan high-risk organizations should be performed at should be based upon revisiting planning assump- least annually. tions, revised risk assessment, and scenario planning that encompasses the key lessons learned from As already noted, the events of September 11 il- September 11, 2001, and any other relevant inci- lustrate the vulnerability of financial institutions and dents that may occur. Organizations should assess the clearing and settlement infrastructure to physical whether plans provide satisfactory resilience and disruption and threats previously thought improbable.

2. “Draft Interagency White Paper on Structural Change in the Settlement of Government Securities: Issues and Options,” issued jointly by the Board of Governors of the Federal Reserve System and the Securities and Exchange Commission, May 6, 2002.

43 Global Clearing and Settlement: A Plan of Action

The recommendation aimed at ensuring effective busi- creasing the resilience of key U.S. financial institu- ness continuity and disaster recovery planning incor- tions and financial markets in the face of a “wide- porates lessons learned from this catastrophe that in- scale regional disruption.”3 Among other things, this dividual institutions need to consider in their future paper requested public comment on an extremely plans and operations. But this in itself is not a suffi- ambitious timetable for substantial and broad-based cient response. However robust, thorough, and well- enhancements to business and operational recovery tested they are, it is unrealistic to expect business con- capabilities in the event of such a disaster. tinuity and disaster recovery plans to anticipate and Although the two white papers are directed at U.S. cater to all possible eventualities. The range of poten- markets and U.S.-based institutions, the issues they raise tial scenarios is enormous, yet each individually is un- are relevant for all systemically important institutions likely to happen. At the same time the chance of a across all jurisdictions, and they are clearly relevant to catastrophic event of some sort is clearly real. It would the report’s goals for enhancing the operational integ- therefore be imprudent not to consider how the mar- rity of systematically important clearance and settle- ket collectively should address the potential failure of ment systems. Indeed, regulators, overseers, and mar- a systemically important institution. Unsurprisingly ket participants in many other jurisdictions have also such considerations are now a high priority for many undertaken considerable effort to evaluate contingency public and private institutions around the world. plans in the light of September 11 and to update and Quite naturally, in the aftermath of September 11, strengthen them where necessary. the focus of efforts to further increase the operational At this stage, it is not possible to anticipate the integrity of systemically important clearing and settle- specific actions the U.S. regulatory agencies will take ment entities (and systematically important institutions in response to the comments they have received from more generally) has been a matter of particular urgency the public on the two white papers. Nevertheless, it in the United States. Indeed, in 2002, the U.S. banking seems fairly clear that, under virtually any foresee- and securities regulatory bodies issued for public com- able set of circumstances, the system will remain vul- ment two “white papers” that are relevant to the issue nerable to an extended operational failure at system- of enhanced operational integrity, although both these atically important clearance and settlement entities papers consider a number of broader issues, as well. arising for any reason—including reasons less draco- At the risk of considerable oversimplification, one nian than a wide-scale regional disaster contemplated of these papers is directed at structural alternatives that by the second white paper. could reduce the vulnerabilities of the overall financial Neither the structural changes nor sound practices system to a major failure, arising for any reason, at one contemplated in the two white papers would elimi- of the two major clearing banks located in New York.2 nate this problem, and it would even exist in a global Although the focus of these structural alternatives was clearance and settlement system having the interop- not limited to an extended operational failure, it is safe erability and other characteristics contemplated in this to say that in the post–September 11 environment such report, although the risk and adverse impact would a scenario was of particular concern, both in the draft- be greatly reduced. ing of the white paper and in the financial community’s Thus, the very difficult question remains whether response to the paper. there are meaningful steps that can be taken in the The other white paper was much broader, focus- relatively short run to further reduce the risks associ- ing, from a largely supervisory point of view, on a ated with sustained operational failures at systemi- range of “sound practices” aimed at substantially in- cally important clearing and settlement entities.

3. “Draft Interagency White Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System,” issued jointly by the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and the Securities and Exchange Commission, August 30, 2002.

44 Ensuring Safety and Stability

The nature of the difficulties encountered in seek- degree of interoperability that it would require may be ing to identify such short-run measures is best illus- sufficient to ensure that in the event of a major opera- trated by the problems experienced in New York on tional failure at one such institution, the other could and for a number of days after September 11. In that provide operational backup, including a high level of time frame, one of the New York clearing banks had assurance that all, or virtually all, transactions directed protracted operational problems that left a massive vol- to the troubled bank could be processed and settled in ume of transactions (and much of the critical infor- line with normal time schedules.4 mation relating to those transactions) essentially This example demonstrates how it may be possible gridlocked in the temporarily impaired clearing bank. to create innovative solutions to the important issue Moreover, because there was no interoperability, even of how the financial market as a whole could deal with new transactions by clients of the clearing bank could the failure of a systemically important institution. The not be routed through the second clearing bank. How- solutions appropriate to systemically important enti- ever, and this point is critical, even if interoperability ties other than the two New York clearing banks will had existed so that new transactions could have been differ according to the business model and activities rerouted, market participants believe that it would not involved, the entity’s position in the processing chain, have made much difference unless the gridlocked trans- and the way in which the entity interacts with other actions—or at least the information associated with market participants. Other systemically important en- such transactions—could also have been recovered and tities requiring alternative solutions might include processed. In other words, interoperability is a neces- (I)CSDs, CCPs, and providers of secure communica- sary condition for materially reducing the risks of cer- tions, payment services, and, in a rapidly consolidating tain types of operational failures, but it is not a suffi- market, global custodian services. This report recog- cient condition to achieve that result. nizes the remarkable challenge of finding solutions for Discussions with prominent private sector experts each of these different types of entity, but it is none- and the publicly available comments received by the theless a critical task deserving of sustained effort. U.S. regulatory authorities on the first of their two Accordingly, the Steering Committee fully sup- white papers have brought forth several ideas for ports initiatives to explore promptly the costs, feasi- possible solutions to this particular vulnerability that bility, and benefits of approaches that address the might be achievable in the reasonably short run. failure of systemically important institutions, along Moreover, the steps would be consistent with the the lines of the real-time data depository. Such an longer-term vision for the global network of clear- approach will not solve all of the problems associ- ance and settlement systems advocated by this study. ated with systematically important operational fail- One very promising idea is the concept of a real- ures, but it will, among other things, buy the time and time data depository by which each of the two New the experience to forge more comprehensive longer- York clearing banks could back up the other. Obvi- run solutions. ously any such real-time data depository would require at least some degree of interoperability between the RECOMMENDATION 13. ADDRESS THE POSSIBILITY OF FAILURE OF two clearing banks and most, if not all, of their clients A SYSTEMICALLY IMPORTANT INSTITUTION. and possibly with the U.S. Federal Reserve System as Market participants in each financial center well. Importantly, the real-time data depository would should work together to identify those institu- simultaneously capture transactions and information tions, or parts thereof, that are systemically im- flows to the two clearing banks. Together, the creation portant to the clearing and settlement process. of such a depository and the achievement of the User groups should be established to address

4. U.S. regulatory agencies have commissioned a private-sector group to explore solutions to the issues addressed in the first white paper with a mandate to propose feasible plans for addressing them.

45 Global Clearing and Settlement: A Plan of Action

how they would react if, despite strengthened clarity, and it is too late to remedy the underlying le- business continuity and disaster recovery plans, gal issues at that point. there were a failure for whatever reason at one Thus, individual entities should further strengthen of these institutions. Ways of mitigating the risks their internal process of due diligence to ensure that created should a systemically important institu- legal risks are identified and effectively managed. Where tion fail, such as building a real-time data de- legal principles can be agreed among practitioners and pository, should be evaluated. Where it is deter- implemented contractually, standardization of legal ap- mined that effective and feasible solutions may proaches by industry participants can yield substantial exist, detailed business cases setting out the costs benefit in advance of broader law reform. In fact, this and benefits should be built up, and decisions process can be very effective in laying the groundwork on future actions and investment decisions for eventual changes in law. The recommendations be- should be taken accordingly. As well as enforc- low identify interim measures that can be taken and note ing suitably high standards of business continu- where the enactment of effective laws is necessary. ity and disaster recovery planning in systemically While an ongoing business relationship increases important institutions, regulators and overseers the likelihood that parties will perform as agreed, it is should encourage this process of industry-wide the reasonable certainty of legal enforcement that ul- contingency evaluation and planning. timately must underlie all transactions. Legal recognition of the parties’ agreement is a precondition for ENHANCING LEGAL INTEGRITY the enforcement of rights under any contract. Fun- Essential to the management of risk in the clearing damental issues include valid formation of the con- and settlement process is an adequate understanding tract, the capacity and authority of all the participants of key legal considerations and the risks that legal to enter into the contract and to perform their re- uncertainty can introduce to that process. Among the spective obligations, and the compliance of the terms critical considerations in this regard are contract le- of the contract and the obligations of the parties gality and enforceability; legal certainty over rights to thereto with applicable law. securities, cash, or collateral; and recognition and support of flexible valuation and closeout netting ar- RECOMMENDATION 14. STRENGTHEN ASSESSMENT OF THE rangements. These legal considerations are not unique ENFORCEABILITY OF CONTRACTS. to the clearing and settlement of securities and other Market participants should ensure that due dili- instruments but are relevant for all market partici- gence procedures examine contract enforceabil- pants, including counterparties, intermediaries, agents, ity, including basic formation and validity, as well brokers, and end users. as power and authority to contract. Where sig- Ultimately, legal certainty in cross-border transac- nificant uncertainty exists about the reliability of tions will be fully achieved only through enactment the legal system of relevant jurisdictions, steps of strong, clear, and consistent national and interna- should be taken where possible to ensure that such tional laws. The Steering Committee recognizes that laws do not govern the transactions and that en- such legal reform is necessary but will require a long- forcement in such jurisdictions will not be re- term effort. Meanwhile, much can and should be done quired. Collateral posted and held outside such ju- to increase legal certainty and reduce risk through risdictions and letters of credit essentially remov- sound management. First of all, it is important that ing all reliance on enforcement ability in the ques- the legal status of transactions and financial relation- tionable jurisdiction should be considered. Indus- ships be determined in advance of trouble. Once a try groups should enunciate standards of diligence, failure occurs, indeterminate legal positions may make and together with appropriate regulators, identify it impossible to determine financial positions with deficiencies in law that could potentially impair

46 Ensuring Safety and Stability

contract enforceability, such as those related to as soon as is reasonably possible. The Hague gambling and other public policy areas. Industry Convention, once ratified by all relevant na- groups should also propose legislative changes to tions, will ensure that there will be a clear and protect transactions between commercial entities. certain answer to the question in an international setting as to which law governs in deter- While sound contracts are critical, enforceability mining whether a collateral taker has received derives fundamentally from legal certainty embodied a perfected interest in pledged securities. in clear operating rules and sound laws. Thus, the pur- ½ Protection against intermediary insolvency suit of legal certainty must address operating rules at risk. Financial supervisors and central banks individual CCPs and CSDs, industry agreements on should confirm that the rights of a person the formulation of financial contracts, and ultimately holding securities through an account with an reform of national laws. While the exact details of intermediary in their jurisdiction are senior to legal reform will depend on national context, achiev- the claims of the intermediary’s creditors to ing the goals of these recommendations may require such securities, except where the intermedi- fundamental changes in law in some jurisdictions. ary affirmatively grants such creditors control over such securities. If the financial supervi- RECOMMENDATION 15. ADVANCE LEGAL CERTAINTY OVER RIGHTS sor or central bank is unable to provide such TO SECURITIES, CASH, OR COLLATERAL. confirmation, it should take all appropriate Market participants must be able to determine, action to ensure that its local commercial and with certainty and reasonable cost and effort, what bankruptcy laws are interpreted or amended law defines and governs their rights to securities, to achieve such a result. cash, or collateral in a clearing and settlement sys- ½ Pledging and realization procedures. Finan- tem or other intermediary, what those rights are, cial supervisors, central banks, and legislators and how to perfect and enforce them. The appli- should encourage collateral transactions by cable rules of law should be automatically effec- simplifying any legal procedures that impose tive, to the extent possible, and should afford the conditions on the effectiveness of pledging parties to the transaction ex ante certainty and arrangements or govern the fairness of real- predictability for the largest number of transac- izing on collateral. tions possible. To the extent possible, clearance ½ Finality. The boards of central securities de- and settlement systems and other intermediaries positories should specify in plain language the should describe to their participants or custom- moment when a transfer or pledge of securi- ers the relevant choice of law that rules in their ties becomes “final” (that is, irrevocable and home countries as they relate to what law gov- unconditional) in its rules or binding contracts erns the effectiveness of transfers and pledges of with its account holders. Financial supervisors securities held through an account with an inter- and central banks should require this specifi- mediary. Specifically, the following is recom- cation from each central securities depository mended: subject to their jurisdiction.

½ Choice-of-law rules. Financial supervisors and When a financial failure occurs, the availability of legislators should ensure that the Hague Con- closeout netting and clear valuation rules are the sur- vention on the Law Applicable to Certain est way to limit risk. Netting limits overall exposure, Rights in Respect of Securities Held with an and clear, legally recognized valuation procedures Intermediary, adopted on December 13, 2002, permit speedy closeout of complex portfolios and is signed and ratified by their respective nations positions.

47 Global Clearing and Settlement: A Plan of Action

RECOMMENDATION 16. RECOGNIZE AND SUPPORT IMPROVED Market participants should include closeout net- VALUATION METHODOLOGIES AND CLOSEOUT NETTING ting provisions in their contract documentation. ARRANGEMENTS. Trade associations and other industry bodies Market participants should ensure that all master should work together to harmonize information agreements provide that upon the early termina- on the effectiveness of netting and disseminate it tion of a transaction or group of transactions, widely and in accessible form. the determining party will have the flexibility to Relevant authorities in each jurisdiction should value such transactions by the method that is most ensure that their laws give effect to closeout net- likely to produce a commercially reasonable valu- ting for all central counterparties, brokers, end ation at the time of termination. Master agree- users, and other market participants, and for all ments also should provide that in any exercise of entity, transaction and asset types. Market partici- such discretion, the determining party should be pants and other interested bodies should encour- guided by principles of good faith and commer- age legislative reform in those jurisdictions where cial reasonableness. laws do not meet this standard.

48 Governance: The Key to Reform

5. GOVERNANCE: THE KEY TO REFORM

GOVERNANCE IS THE FINAL KEY ELEMENT, AND PRI- The recommendations outlined below build upon, MARY DELIVERY MECHANISM, IN STRENGTHENING rather than displace, the substantial governance re- CLEARING AND SETTLEMENT SYSTEMS. In fact, the sponsibilities associated with current infrastructure overarching governance challenge in this report is for arrangements. The challenge is to raise overall infra- boards to implement the recommendations for strength- structure capability and performance to a new level. ening the clearing and settlement model and strength- This improvement will take ening risk management set out in the preceding chap- place within a framework of ters. Governance refers to the mechanisms and proce- public policy requirements and dures through which the objectives of a company are parameters for both competition The overarching set, the means to achieve them are identified, and the and prudential supervision. governance challenge performance of the company is measured. It also refers However, the initiative on sub- in this report is for boards to the set of relationships among management, the stance and timing lies with the board, shareholders or owners, users, regulators, and boards of entities that are com- to implement the other stakeholders that influence these outcomes. pletely or mostly privately recommendations set The specific recommendations under this heading owned . (Broadly similar initia- out in the preceding are primarily directed toward the activities and account- tives will be required of clearing chapters. ability of the boards and management of these sys- and settlement entities owned by tems and, to the extent applicable, their users. The rec- central banks or other public ommendations also touch on the public policy frame- bodies.) work for competition and prudential oversight within The recommendations have implications for gov- which these clearance and settlement systems operate. ernance in three main areas. Ensuring the system’s openness to competition is a second important challenge and key to success in a ½ First, boards and management should ensure number of other areas. The term competition refers to that new or upgraded systems and software are the ability both of users to shop around for the best aligned with the technical and operational service provision and for qualified would-be service standards recommended in this report for providers to have access to the market. Providers achieving interoperability and improving should be judged to be qualified according to objec- clearing and settlement processes. tive criteria related to the soundness of their business ½ Second, boards and managements should organization—not their nationality, location, or other ensure that services and technologies are factors unrelated to business soundness. introduced on an open and competitive basis.

Analysis of the structure and governance of global clearing and settlement arrangements, as well as the report’s governance recommendations, are based on a draft paper prepared by David Walker, Senior Advisor, Morgan Stanley International.

49 Global Clearing and Settlement: A Plan of Action

½ Third, boards and managements should ensure responsibilities described in this report. Organi- that arrangements for the identification, mea- zations that are users of such providers, or other- surement, and control of risk, including opera- wise have input into the appointment of board tional risk, fully comprehend the risks inherent in members, should be mindful of the broad range an increasingly linked global network. of capabilities needed to discharge the diverse, important responsibilities of such a position. The relevant competition authorities and central banks and supervisors responsible for regulation and More generally, principles of good corporate gov- oversight clearly have important interests in the lat- ernance require directors to adhere to certain stan- ter two categories. dards of conduct in carrying out their responsibilities, including a duty of care. In a user-owned struc- GENERAL RESPONSIBILITIES ture where persons appointed to the board are likely OF BOARDS AND MANAGEMENT to be employees of users, directors need to be espe- The responsibilities placed on boards of clearing and cially vigilant. The duty of that director is to exercise settlement entities by this report are both wider in scope his or her authority in the interest of the clearing and and more detailed than has been the case to date. These settlement entity and all of its users and to disclose boards are being asked to become the main drivers of conflicts of interest before the board acts. In taking change in support of cross-border business, not least these initiatives forward, boards will need to strike a because the principal initiatives can be taken only by balance among, for example, the interests of differ- the boards themselves, with the agreement of users ent users of the entity’s services or between short- and shareholders. The current state of cross-border term interest in fee reductions and required invest- clearing and settlement arrangements demonstrates the ment in capacity and systems enhancement over the challenge that this responsibility poses. Cross-border longer term. trading has been one of the fastest-growing segments of securities activity around the world over the past THE DEMANDS OF PUBLIC POLICY decade. Nonetheless, clearing and settlement costs and Good governance must also recognize public policy risks for cross-border trades remain substantially higher interests. The capacity to exploit a monopoly posi- than those for domestic clearing and settlement. De- tion for competitive advantage will necessarily attract spite at least a degree of user involvement in gover- interest by relevant competition authorities. Where nance and, commonly, a significant element of user users have access to alternative infrastructure provid- ownership, cost and efficiency improvements for cross- ers, public policy is likely to focus on harmonization border business have lagged behind. of standards, much as it does with telecommunica- Given this experience, it is clear that board mem- tions. Where there is a sole provider, competition bers must enjoy sufficient seniority and experience concerns will assume higher priority. Issues include to provide the strategic vision and authoritative voice the need to ensure that systems are open, that cross- necessary to carry through the expanded mandate subsidy between monopoly services and other ser- recommended here. vices is avoided, and that any monopoly rents accrue, one way or another, to users. RECOMMENDATION 17. ENSURE APPOINTMENT OF APPROPRIATELY Public policy interests also arise in the area of EXPERIENCED AND SENIOR BOARD MEMBERS. prudential supervision to ensure that clearing and Members of the boards of securities clearing and settlement systems are managed so that they can settlement infrastructure providers should, indi- continue to operate in the face of market shocks vidually and collectively, be of a weight in terms and so that the risk of default is minimized. To ad- of experience and seniority to discharge the en- dress risk, boards will need to establish and main- larged strategic and management oversight tain levels of capital, risk management standards,

50 Governance: The Key to Reform

and market transparency consonant with the scale A major reason for the current array of CSDs is and nature of an entity’s operations and potential that they often developed, or were granted status, as a external shocks. Because such standards could be form of monopoly within each national jurisdiction. exploited by incumbent market participants to dis- Where such monopoly national systems operate to dif- courage new entrants and inhibit competition, trans- ferent technical standards and processing rules—that parency must extend to application of the standards is, where monopoly national systems are not as well. In the event of consolidation, concentra- interoperable—there can be no effective competition tion of risk will only increase the importance of between them. The introduction of interoperability these board responsibilities. The board and man- would significantly change that agement will carry out these responsibilities subject situation. The use of common to the oversight of the central bank or prudential standards would create value for Ensuring the system’s supervisor. users by increasing the number openness to competition of potential users of any single INTEROPERABILITY AND COMPETITION clearing and settlement system is a second important Beyond the general duty of care and the specific de- (creating network externalities). challenge and key to mands of public policy, good governance as it is out- Because products would be less success in a number of lined in this report requires boards of clearing and differentiated under common settlement entities to work toward the twin goals of standards, direct price competi- other areas. interoperability and openness of systems. The tion would be more important. interoperability goal is embodied in specific techni- Common standards would thus cal and process recommendations to be implemented produce effective competition on the basis of both as new software and systems are installed. Given the price and service, something that is unlikely to be range of actions involved, these recommendations achieved if the current array of partially interconnected demand early attention and proactivity by boards of service providers operating to different technical and major service providers. business standards is maintained. Appraisal of the cost involved in implementing Standardization could reduce the franchise value international standards and installing new systems that of smaller service providers and inevitably in a com- embody them may prove an important influence on petitive environment, economies of scale and net- consolidation. In particular, boards of smaller enti- work externalities would lead to a more concentrated ties may find that the more attractive strategic option structure. In the extreme case, a monopoly entity of- is consolidation with another entity so that the costs fering low tariffs and dependable service quality could of adopting standards that create the potential for emerge. The competitive process could thereby well interoperability are shared. Thus, the need to adopt serve the interest of users—so long as it did not re- standards associated with interoperability can make sult in anticompetitive behavior, such as creating bar- the business case for consolidation. riers to new entrants. It is that behavior that would An apparent paradox arises in this report between create a concern for competition policy. the stress laid on achieving interoperability and that The other concern with consolidation is its poten- directed at maintaining or even enhancing competi- tial impact on innovation. There seems no particular tion as a spur to innovation. As discussed above, the reason to suppose that boards of entities that have drive for interoperability alongside the pursuit of scale consolidated would be less ready to be effectively in- economies will tend to promote consolidation, which novative in improving efficiency and service quality will reduce competition in numerical terms. But a re- than the boards of fragmented and noninteroperable duction in the current universe of service providers entities, except perhaps in the case of a true monopoly. need not be associated with reduced competition, and Therefore, an important ingredient for sustaining in- it could have the opposite effect. novation is open and transparent business models so

51 Global Clearing and Settlement: A Plan of Action

that even a consolidated entity may be exposed to com- policy interest in the allocation of economic rents is petitive challenge in one or several of its functions. likely to be heightened. The ownership patterns for Key to addressing the competition concern is en- clearing and settlement entities (there are exceptions, suring that qualified users have access to systems and such as those for government bonds in the United are free to select the mix of functions and services States and Japan) are by users, by nonuser sharehold- that they wish to use. ers, or by a combination of the two. The last case occurs where a securities exchange (with its own pub- RECOMMENDATION 18. PROMOTE FAIR ACCESS TO SECURITIES lic shareholders) is a nonuser shareholder of an en- CLEARING AND SETTLEMENT NETWORKS AND SERVICES. tity that also has shareholders who are direct users. Boards of securities clearing and settlement service The landscape of interlinked and interdependent providers, other organizations providing similar ser- organizations described in chapter 2 demonstrates vices, and public authorities should ensure that rules that the term “user,” when applied to clearing and and other requirements that control or limit access settlement services, could be defined in many differ- to securities clearing and settlement services are ac- ent ways. User in this context is taken to refer to an cepted only where they are necessary and are de- organization that has a direct relationship with a ser- signed exclusively for the purpose of controlling fi- vice provider. Most users of this type will be inter- nancial, operational, reputational, or regulatory risks; mediaries who, in turn, provide additional services, maintaining the safety of the system; or achieving typically for an all-in fee, to meet the overall require- other reasonable public policy ob- ments of the end users: investors in, or issuers of, jectives. Networks and services securities. Observation of market practice and the should be accessible to all users OXERA analysis cited earlier together suggest that Boards are being that pass risk and safety evalua- competition at the intermediary level is such that a asked to become the tions and enjoy appropriate finan- significant proportion of savings accruing to direct main drivers of change cial standing, and users should be users will be passed to end users over time. Thus, ad- free to select the mix of functions dressing competition issues in the interests of inter- in support of cross- and services that they wish to use mediaries may be generally expected to bring similar border business. on the basis of straightforward, benefit to their clients as end-users. transparent, and fair tariff policies Where users own the entity, there is likely to be a grounded on the principle of user substantial convergence of interests about improving pays. Such risk-based rules should be broadly services. Important choices will still have to be made, founded (encompassing the due diligence process however, between short-term and long-term inter- set out in the financial integrity recommendation), ests—for example, tariff reduction for users versus in- and fairly and consistently applied. Moreover, the vestment in enhanced systems and capacity, rules and their application should be transparent to including necessary steps toward interoperability or the market. Existing barriers that do not meet this consolidation. There will also be questions of fairness test should be removed. between large and small market participants. Two areas in which potential differences could arise are the OWNERSHIP AND COMPETITION allocation of cost and benefits and setting service pri- Competition policy aims to protect the interests of orities among users. In the former case, the incidence users or consumers of products and services. There- of costs and the extent to which savings flow through fore, where users own a service provider, public in- users to issuers is largely a function of competition. terest concerns are likely to be limited because in such As discussed earlier, the primary beneficiary of sav- a case any quasi-monopoly rents earned would auto- ings will be issuers. In any case, all market participants matically accrue to users as a group. Where owner- and users share a broad interest in improving efficiency, ship is held substantially by nonuser shareholders, so the potential for conflict appears small.

52 Governance: The Key to Reform

As to differing priorities among different user ers of its trading platform can clear and settle trades groups, smaller brokers may have a greater interest in and pursue ancillary services elsewhere. Of course, short-term tariff reduction than do larger brokers, the commitment to open access has full effect only and custodians may see different investment priori- if the main clearing and settlement entities are ties for the entity than those seen by broker-dealers interoperable, allowing competition for services. (for example, custodians may have less interest than The difficulty is that open access and interoper- broker-dealers in improving the asset-servicing capa- ability may not be consistent with profit maximiza- bilities of CSDs, with which they may be in direct tion, at least in the short term. Therefore, an appro- competition). Such differences are likely to be mat- priate balance between the interests of users and ters of degree, however, and point to the need for an shareholders may be difficult to achieve in a board appropriate structuring of the board to ensure a bal- consisting of nonuser shareholders. These concerns ance among different user interests. A mechanism will will be less where there is effective competition than be needed to resolve such differences, perhaps where an infrastructure provider is an effective mo- through governance arrangements or by-laws. The nopoly. Where a monopoly exists, competition policy inclusion on the board of public interest members is interest is likely to arise regarding an array of specific a practical means of ensuring that longer-term pri- outcomes such as openness of access and fee trans- orities set by the board are not unduly at risk from parency. A related competition concern is whether short-term user interests. additional services that could be competitively sup- For entities where nonuser ownership is signifi- plied are instead tied to core, monopoly services. cant, the board is likely to focus more or less explic- If a monopoly or quasi-monopoly exists, but eco- itly on shareholder value objectives, which provide a nomic rents accrue largely or wholly to market users, strong spur to efficiency and cost reduction in a com- competition policy oversight may be confined to en- petitive environment. As one example, Deutsche suring that representation on the board is balanced Börse has created a vertically integrated structure among different user interests and that board mem- combining an exchange, clearing and settlement fa- bers are committed to interoperable and open sys- cilities to provide one-stop services from trading to tems. However, where nonuser shareholder interest settlement. This offers substantial user convenience. is significant, oversight may be needed to ensure trans- As a publicly traded company, it is also an attractive parency in fee structures and to guarantee that eco- model from the standpoint of nonuser shareholders. nomic rents reach the users of clearing and settle- But two potential limitations of the model have to be ment services. These considerations suggest that for addressed: the majority of situations in which clearing and settlement is through private sector entities, the overall ½ Can a vertically integrated structure offer the balance of advantage probably lies with a user-own- same level of user benefits as an infrastructure ership structure. But the report is not prescriptive in model featuring competition on price and this respect, and other structures may also serve well service at each level of the value chain and as long as competition concerns are addressed. across trading systems? It is also important to recognize that central bank ½ Will value-added services, such as credit or other public ownership of a clearing and settle- facilities supplied competitively in the market, ment capability does not obviate the need for atten- be offered or added? tion to user interest in monopoly rents. Nor does it remove the need for risk management disciplines simi- These concerns are all but eliminated if the vertical lar to those to be applied in privately owned entities. structure incorporates open access and fair tariff Equally, the boards of publicly owned clearing and policies that allow users of other stock exchanges or settlement entities should pursue international opera- electronic trading platforms into its facility while us- tional and technical standards and be attentive to

53 Global Clearing and Settlement: A Plan of Action

opportunities for improvements in efficiency, just like configurations of risk that warrant heightened atten- boards in the private sector. tion. The move to interoperability will in itself neither increase nor attenuate the risk management responsi- RECOMMENDATION 19. ENSURE EQUITABLE AND EFFECTIVE bilities of boards because whether or not the entity is ATTENTION TO STAKEHOLDER INTERESTS. interoperable with other similar entities, the board and Board participation should represent different management are still responsible for maintaining the stakeholder interests fairly and equitably. Provi- risk management process. sion should be made for regular review of, and These matters are discussed in greater detail in for changes as necessary in, board composition chapter 4, along with specific recommendations in to ensure continuing balanced representation of the area of financial, operational, and legal integrity. varying stakeholder groups, including users. An important capability in pursuit of these recom- Where a securities clearing and settlement infra- mendations by infrastructure providers is an effec- structure provider is user-owned, user-sharehold- tive due diligence process for their boards and man- ers should make certain that arrangements are in agement regarding clearing members and major us- place to provide equitable and effective represen- ers. Where these members and users are supervised tation through appropriate by-laws; the appoint- financial institutions, reliable and timely sharing of ment of independent, public interest, or end-user information between the supervisor and infrastruc- investor directors; or other similar measures. ture provider will be essential. Of particular impor- Where such a provider is partly or wholly owned tance is access to filings made with primary supervi- by nonuser shareholders and is also a substan- sors. Whether such intelligence-sharing arrangements tially monopoly provider of clearing, settlement, are likely to be adequate will depend partly on the and related services in a particular market, user practical working relationships that evolve. But from (and other stakeholder) interests can be adequately the standpoint of robust system design and the avoid- protected through appropriate user or other in- ance of moral hazard, the board of the infrastruc- dependent, nonshareholder participation in the ture provider (and its prudential supervisor) must be board. However, these arrangements may have to satisfied as to the independence of its capability to be supplemented by oversight of tariff and other evaluate its clearing members and users. In those situ- policies by relevant competition authorities. In ations where the mandate of the primary supervisor either case, the independent directors should be of a financial entity such as a broker-dealer is to en- appropriately involved in the audit and remunera- sure continuing capacity to meet obligations to retail tion committees. clients, official supervision will offer no assurance that the firm is able to meet its payment or securities trans- SAFETY AND SOUNDNESS fer obligations to the infrastructure provider. In those Whereas ownership structure will heavily influence cases, the infrastructure provider will have to have an the extent of competition policy oversight, that is not independent appraisal capability with the possibility the case for prudential oversight. Ensuring safety and of on-site inspection, even if such capability is likely soundness is an explicit and core responsibility of the to be used only rarely. board of any clearing and settlement entity, regard- Given the reciprocal nature of the assessment of less of ownership structure, and the need for engage- continuing financial health that is recommended ment by central banks or supervisors is clear. between infrastructure providers and their members Boards of clearing and settlement entities and those and users, transparency of the entity is a key ingredi- who use their services devote considerable effort to ent in informing the due diligence of users. There- risk mitigation, even though the major contingencies fore, the board should conduct, at least annually, an they face are of relatively low probability. However, independent assessment of the provider’s financial the changes proposed in this report may introduce new position, its risk profile, and its risk management sys-

54 Governance: The Key to Reform

tems, together with its operational reliability includ- oped minimum standards for many aspects of ing backup and contingency plans. The results of this clearing and settlement services, notably as em- assessment should be made promptly available to bodied in the CPSS-IOSCO recommendations, members, users, and the market generally. These as- the oversight and supervision applied to provid- sessments will also encourage compliance with the ers of clearing and settlement services varies recommendations at large. across jurisdictions. In addition, organizations There is plainly a substantial and evolving role for undertaking similar activi- official regulation and oversight in the case of all clear- ties can be subject to differing and settlement entities. There may, additionally, ent regulatory regimes and Boards should be a role for competition policy oversight. Its extent standards based upon their pursue international and form will depend in particular on the competi- status, such as whether or tive environment in the marketplace, the ownership not they are a bank. operational and technical and governance structure of a particular clearing and Supervisory, prudential, and standards and be settlement entity, and the extent to which voluntary oversight standards should attentive to opportunities initiative by the board of the entity mitigates the need recognize the systemic im- for active public policy intervention. for improvements in portance of providers of efficiency. clearing and settlement ser- RECOMMENDATION 20. ENCOURAGE CONSISTENT REGULATION AND OVERSIGHT OF SECURITIES CLEARING AND SETTLEMENT vices with a view to minimiz- SERVICE PROVIDERS. ing the risk of default or operational failure of critical organizations. As noted Providers of securities clearing and settlement in Recommendation 9, aimed at ensuring consis- systems should be subject to consistent and tent financial integrity of service providers, con- transparent regulation and oversight, which sistent supervision is necessary to create uniform should focus on the activities undertaken and risk standards and ensure consistent minimum fi- the risks incurred. Standards of regulation and nancial and liquidity requirements. But consistent oversight of cross-border activity should be supervision is also important to help create a level complementary and consistently applied across playing field between competing organizations. all relevant jurisdictions. As a long-term goal and where coherent with other public policy objectives, Regulatory and oversight standards that affect cross- regulatory and oversight standards should be har- border activity must be undertaken consistently and monized. While public authorities have devel- transparently across all relevant countries.

55 From Recommendation to Implementation

6. FROM RECOMMENDATION TO IMPLEMENTATION

Taken together, the recommendations in this report tain if their former franchise is threatened. At the same represent a comprehensive plan of action for the fu- time, implementing the recommendations will require ture development of global clearing and settlement. substantial investment and change over time and pos- This is an ambitious agenda but a sound one: respon- sibly a basic change in business strategy. sive to market aspirations for greater safety and effi- There is no certainty that benefits will be propor- ciency, and focused on practical solutions to recog- tionate to costs for all organizations, or that either nized problems. The report offers an organized ap- costs or benefits will be spread evenly. proach to the body of work that is needed, a substantial portion of which is already under way by in- EXISTING INCENTIVES dustry groups, supervisors, and central banks. The ARE PROPELLING CHANGE question is not whether the issues identified need to Fortunately, three major influences appear likely to be addressed, but whether the efforts under way, and increase strategic attention to strengthening clearing the investments that flow from them, will proceed and settlement systems and to produce substantial piecemeal or aim toward global consistency. convergence of private and official interests in favor An approach based on global standards can result of reform. if those who have the capacity to motivate change have confidence that it can come in a reasonable time ½ Cost reduction is moving higher on the private frame and at reasonable cost. The report sets out the sector agenda. As margins are squeezed, both general benefits that can be obtained from compre- during the current market hensive reform, yet the decision to support reform downturn and in the must be made by individual service providers and future, broker-dealers, The report offers an market participants, whose own cost-benefit calcula- investors, and ultimately organized approach tions are less than certain. issuers will be seeking to Making all service providers fully interoperable with reduce external inefficien- to the body of work counterparts in other countries and markets, and with cies and costs, rather than that is needed, a competing firms, will create a more competitive envi- limiting themselves to substantial portion ronment, but it could reduce the value of proprietary internal economies. Users systems. Open access to systems and services, based and boards of clearing and of which is already only on financial integrity considerations, will enhance settlement entities face new under way by industry price competition and limit cross-subsidy of services. incentives to reduce system groups, supervisors, System-wide, the outcome of pursuing these goals will development costs, avoid and central banks. be positive because overall opportunity will increase, duplicative capital spend- but the outcome for individual entities will be uncer- ing, find opportunities for

57 Global Clearing and Settlement: A Plan of Action

fee reduction, and pursue consolidation. A undertaking. The 20 detailed recommendations pre- sharper focus on external infrastructure costs sented here will require concerted action from mul- will underscore the importance of harmonizing tiple parties into the medium-term future. Many of technical and operational standards and of the recommendations cover new ground and entail reducing the need for multiple linkages to costs that will have to be carefully considered. differently configured external providers. Given the scale of this effort, those asked to adopt ½ The potential for systemic risk in cross-border the recommendations must feel confident not only activities is more widely recognized. The added that the proposals are of substantive merit, but that complexity of cross-border business requires they will be implemented systematically. Confidence greater awareness of risks. Concentration of building requires a realistic framework for action that the business among a relatively offers sensible prioritization and ongoing monitor- small group of major global ing to ensure sustained attention to performance. This is an ambitious players, together with consoli- Prioritization offers guidance on where work should dation of infrastructure, mean begin and how it should proceed. Monitoring enables agenda but a sound that a disturbance affecting participants to see progress being made and ensure one: responsive to one counterparty could rapidly coordination of efforts. market aspirations for spread to other markets and greater safety and the infrastructure arrange- ESTABLISHING PRIORITIES ments that support them— Because achieving the risk and efficiency benefits efficiency, and focused however robustly these are described earlier depends on pursuing the program on practical solutions to structured. This possibility comprehensively, no recommendation can truly be recognized problems. focuses attention on the left for later attention. That said, two sets of propos- integrity of payment and als are of overriding importance. settlement arrangements generally, a focus that has been further sharp- ½ The risk recommendations address ongoing ened by lessons arising from the events of safety and stability concerns, stand on their own September 11. merits, and warrant speedy action. ½ Market developments call for the attention of ½ The promised efficiency gains can be achieved competition authorities. Consolidation of only through meeting the conditions for services and changing ownership structures, in interoperability, which begins with technical particular where the profit motive has been compatibility, including communication introduced more strongly into the infrastructure protocols, messaging standards, reference data arena through the public offering of shares, standards, and synchronized timing. raise concern over elements of monopoly in clearing and settlement. There are considerable When these technical capabilities are available, the parallels between the clearing and settlement way will be clear for full implementation of the re- area and other businesses such as telecommuni- maining recommendations relating to business prac- cations and energy supply, where economic tice and process. Yet given the interdependencies deregulation has encouraged the exploitation of among recommendations, the lead time required for scale economies and network externalities, their implementation, and the benefits each offer, balanced by substantial competition oversight. there is work to be done in all areas, even if prepara- tory in nature, within the next year. REFORM IS A COMPLEX UNDERTAKING Many of the 20 detailed recommendations involve Incentives for change notwithstanding, achieving the multiple stages: formulation of standards; their wide objectives set out in this report will be a complex adoption by providers and users of the clearing and

58 From Recommendation to Implementation

settlement services; and subsequent incorporation, over capital spending and achieving scale economies and time, into revised system designs. This process will in- network externalities, with due attention to the risks volve multiple actors: a wide range of trade associa- that may arise from consolidation. In keeping with the tions and public bodies to formulate standards, with risk mitigation recommendations in the report, an in- their implementation becoming the primary responsi- dependently prepared report on the financial and op- bility of boards and management of private institu- erational condition of the entity should be made avail- tions, with support from prudential supervisors and able to users and the market more widely on at least an other regulatory institutions. Furthermore, creating a annual basis. Such a report will fully interoperable network will require contempora- enable current and potential us- neous introduction of standards to achieve the desired ers to make considered risk and Meeting the five- to result. Finally, a few areas represent new territory for operational performance assess- standard setting, reflecting the project’s focus on hith- ments of their own. seven-year timetable will erto neglected cross-border activity. Because an overarching ob- require a prompt start on A five-to-seven-year time horizon is proposed, jective of the recommendations implementation by those considering the desire for cost minimization and the is to advance current practice responsible for initiating software obsolescence cycle. That seems quite a long toward best practice, private ini- time to address important systemic concerns, but it tiatives should be supportive not action in each area. is a very aggressive time frame for achieving the scope only of sound management of change contemplated here. Meeting that schedule practices, but of sound public will require a prompt start on implementation by those policy as well. That said, nothing in the recommen- responsible for initiating action in each area, so it is dations is intended to limit the public sector’s scope important to be clear about the locus of first action. of action, and interaction between the private sector and public authorities as standards emerge and evolve INITIATING ACTION will be necessary. Furthermore, there are areas in Overall, the initiative to build a global network re- which action by public authorities is either appropri- sides in the private sector. The key players here will ate or required. be boards of securities clearing and settlement ser- One area is removing legal and regulatory barri- vice providers, although it is recognized that in a few ers. Although some barriers can be overcome, at least jurisdictions they are publicly owned, and major us- in part, by adopting industry conventions or uniform ers of these services in some instances. They are called contractual language, specific legal barriers to entry upon to take the lead on all recommendations related or access can be overcome only by official action. to strengthening network connections and most of There are also a number of areas in which public those concerning risk mitigation. There are also sev- authorities must act, either in concert with the pri- eral specific recommendations related to the compo- vate sector or actually taking the initiative. One ex- sition and focus of boards, but the overarching gov- ample is providing consistent regulation to provide ernance directive is to put into effect the recommen- fair competition and equivalent oversight of differ- dations set out in this report. ent functions. In the area of competition and market In pursuit of these objectives, private boards should access, the degree of involvement of the public au- ensure that all new systems development and capital thorities is likely to evolve over time, depending on expenditures comply with relevant international op- the private sector’s response to monopoly concerns erational and technical standards for interoperability. and the speed and scope of consolidation that oc- These systems should also be fully capable of identi- curs. Where public authorities determine that mo- fying, measuring, and controlling the risks faced by the nopoly conditions exist and governance arrangements entity, including its counterparty risks. Strategies should make it possible that they will be abused, competi- be formulated and pursued for avoiding duplicative tion authorities may have to intervene.

59 Global Clearing and Settlement: A Plan of Action

The first step required in each area of recommen- MONITORING dation and the party best suited to take it are closely Given the complexity and extent of the changes pro- interrelated. Where a recommendation calls for adop- posed and the time required to effect them, the con- tion of already specified standards (such as messag- tinuing strong support of boards and senior man- ing standards or communication protocols), primary agement will be essential, and external monitoring will action will fall to boards and management of infra- be required to name and shame laggards. Following structure providers, intermediaries, and custodians, release of its 1989 report, the Group of Thirty spon- supported as appropriate by relevant industry orga- sored follow-up review of implementation for sev- nizations and public institutions. Where work is on- eral years. Then national committees, formed by the going, as is true in many areas of recommendation, private sector, continued monitoring for several more existing organizations should be years. There is strong support for a continuing moni- relied upon to the extent pos- toring role for the Group in this case as well. Accord- Overall, the initiative sible to continue their work. ingly, the Steering Committee recommended, and the Where new standards or ap- Group agreed, to a continuing role. to build a global proaches must be created (such A review is anticipated within two years of this network resides in the as reference data or corporate report’s release, in consultation with relevant private private sector. The key actions), impetus is likely to be and public parties, with a report six months thereaf- required first by industry orga- ter. It will address the extent to which relevant par- players here will be nizations or trade associations in ties are taking each recommended action, the need infrastructure providers. concert with their members. Fi- for further action, and analysis of the time frame for nally where recommendations the adoption of emerging standards. Given its mis- call for further study of specific sions and resources, the Group of Thirty cannot con- areas (such as systemic operational failure), the im- tinue this monitoring role for the long run. Users and petus for action will have to come from leading pri- providers of various network functions and the or- vate firms, with support and participation as appro- ganizations associated with those services are in the priate from the public sector. Table 6-1 identifies first best position to evaluate the factors that govern their steps to be taken for all 20 areas of recommenda- long-term efficiency and safety. It will be for the par- tions. ties themselves to decide the most appropriate mecha- It is also important to remember that the initial fo- nism for pursuing the recommendations in the re- cus of attention for the recommendations is limited to port over the contemplated five- to seven-year time a set of advanced economies with significant financial horizon for implementation—and beyond. Whether markets. As defined in chapter 1, major markets are an organization should be formed to undertake this taken to include equity and fixed-income securities role across the global clearing and settlement land- markets in the United States, Canada, European Union, scape is a decision that will have to be confronted in Switzerland, Japan, Hong Kong, Singapore, and Aus- the future. tralia. Thus, in the first instance, the focus is on the CCPs, CSDs, other infrastructure providers, and major intermediaries active in those markets.

60 From Recommendation to Implementation

TABLE 6-1. IMPLEMENTATION TARGETS FOR THE PRIVATE AND PUBLIC SECTOR

NEXT STEPS

Recommendations Initial Goal Private Sector Public Sector Building a Strengthened, Interoperable Global Network

Recommendation 1 • For each major market, identify Collective action by Consultation with and publish: country/market national regulators Eliminate paper and • Steps necessary to eliminate the through formation of and legislators automate communi- use of paper securities certifi- industry working regarding amend- cation, data capture, cates within a set time frame. group in each major ments of law and and enrichment. • All regulations or laws that lead market. regulation. to a requirement for physical paper, along with proposals for eliminating them. • Enunciate harmonized legal Collective action standards for recognition of internationally through electronic documents. international legal working group.

Recommendation 2 • Targets for ISO 15022 implementa- Individual action tion and migration to an XML by boards and Harmonize messag- version already in place and management. ing standards and coordinated through SWIFT. communication protocols. • Any network provider not already Individual action operating an IP-based network to by boards and publish plans to do so within a management. defined time frame.

Recommendation 3 • Establish detailed objectives and Collective action terms of reference for coordinated internationally through Develop and and coherent formulation of asset, formation of fully implement reference counterparty, and generic refer- representative, data standards. ence data standards. industry-wide working group in each area, drawing on existing initiatives.

Recommendation 4 • Identify all critical timing interde- Collective action Consultation with pendencies and establish detailed within markets/ supervisors, central Synchronize timing objectives for synchronizing timing, countries and interna- banks and govern- between different with terms of reference for carrying tionally, including ment-run systems. clearing and settle- work forward, on a country, representatives of ment systems and regional, and/or global basis, as settlement, payment, associated payment appropriate, to address respective and foreign-exchange and foreign- interdependencies. system operators. exchange systems.

Recommendation 5 • Publish a working paper on Collective action globally applicable technical and internationally through Automate and market practice standards for trade formation of a global standardize institu- matching and confirmation, working group. tional trade matching. building upon work in the U.S. market by the Securities Industry Association.

61 Global Clearing and Settlement: A Plan of Action

NEXT STEPS

Recommendations Initial Goal Private Sector Public Sector Building a Strengthened, Interoperable Global Network (continued)

Recommendation 6 • In each market without a CCP, Collective action by Participation in publish a paper for comment country/market industry working Expand the use of setting out the risks, costs, and through formation groups by national central benefits of using a CCP, with a of industry working supervisors. counterparties. preliminary conclusion and group. proposed course of action.

Recommendation 7 • In each market where securities Collective action National supervisors lending and borrowing is limited or by country/market and legislators to set Permit securities prohibited: through formation out plan to imple- lending and borrow- • Identify all regulations, laws, or of industry working ment proposed ing to expedite market practices that serve as group to identify changes. settlement. impediments. impediments and • Propose steps to remove them propose specific in a defined time frame, changes. including amendments of law and regulation, as necessary.

Recommendation 8 • Develop and publish plan to enable Collective action Consultation with standardized, automatic transmis- internationally— national supervisors Automate and sion of corporate action informa- establish industry overseers, and standardize asset tion in ISO 15022 format, in each working group. legislators. servicing processes, market within a specified time including corporate frame. actions, tax relief arrangements, and • Establish detailed objectives for Collective action Participation of restrictions on harmonization of national tax internationally— national legislators foreign ownership. documentation and processes, and form tax processing and tax authorities. set terms of reference and time working group frame for action. including industry representatives and tax experts. • In each market, publish clear rules Consultation with National supervisors on foreign ownership restrictions national supervisors overseers, and and reporting requirements, and and legislators. legislators to clarify make all relevant information freely law and regulations. available to ensure compliance.

Mitigating Risk

Recommendation 9 • Each provider to publish outline of Individual action by Enforcement by business model, risk framework, boards and supervisors. Ensure the financial and underlying risk management management. integrity of providers processes and standards. of clearing and settlement services.

Recommendation 10 • All organizations to establish Individual action by Enforcement by appropriate due diligence and risk boards and supervisors. Reinforce the risk management controls. management. management practices of users of C&S service providers.

62 From Recommendation to Implementation

NEXT STEPS

Recommendations Initial Goal Private Sector Public Sector Mitigating Risk (continued)

Recommendation 11 Each provider to publish report covering: Individual action Monitoring by by boards and national supervisors Ensure final, simulta- • Nations to sign and ratify the Hague management of and overseers. neous transfer and Convention. clearing and availability of assets. • How providers will specify the settlement service moment of finality specified in rules providers. and contracts in plain language. • Rules for transfer and reuse of cash and securities once finality is achieved.

Recommendation 12 • Each provider to publish outline of Individual action Enforcement by business continuity plan, including by boards and supervisors. Ensure effective the scenarios considered, testing management of business continuity performed, and the results of that financial intermedi- and disaster recovery testing. aries and clearing planning. and settlement service providers.

Recommendation 13 • Identify systemically important Collective action by Cooperation with institutions and evaluate how the country/market— private sector in Address the risk of their extended failure could form industry evaluating alternative possibility of failure be mitigated. working group. approaches. of a systemically important institution.

Recommendation 14 • All organizations to establish Individual action Monitoring by appropriate legal due diligence by boards and national supervisors Strengthen assess- and risk management controls. management of and overseers. ment of the enforce- financial intermedi- ability of contracts aries and clearing and settlement service providers. • Enunciate appropriate standards Collective action by of legal due diligence and identify country/market – deficiencies in law that could form industry potentially impair contract working group. enforceability.

Recommendation 15 • Complete agreement on PRIMA N/A Collective action by in the Hague Convention and national supervisors, Advance legal embody in national laws. overseers, and certainty over rights legislators. to securities, cash, or collateral. • Confirm seniority of Individual action by Collective action by accountholder’s rights over boards and national supervisors, creditor’s and simplify rules management of overseers, and governing pledging and realization financial intermedi- legislators. of collateral. aries and clearing and settlement • Providers to specify moment of service providers. finality in rules and contracts.

63 Global Clearing and Settlement: A Plan of Action

NEXT STEPS

Recommendations Initial Goal Private Sector Public Sector Mitigating Risk (continued)

Recommendation 16 • Standard master agreements for all Collective action Monitoring by significant transaction types should internationally— national supervisors Recognize and embody consistent closeout appropriate and overseers. support improved netting and valuation provisions. industry groups valuation and should coordinate closeout netting action and amend arrangements. master agreements, as indicated.

Improving Governance

Recommendation 17 • Develop guidelines by which to Individual action by Review by national evaluate experience and seniority boards and supervisors, and Ensure appointment of board members. management of overseers. of appropriately clearing and experienced and settlement service senior board providers. members.

Recommendation 18 • Providers to publish report on Individual action by Review by national access rules, detailing inconsisten- boards and supervisors, Promote fair access cies with recommendation and management of overseers and to securities clearing specifying plans for remediation clearing and competition and settlement within a specified time frame. settlement service authorities. networks. providers.

Recommendation 19 • Providers to publish mechanism Individual action by Review by national designed to ensure fair user boards and supervisors, Ensure equitable and representation and timetable for management of overseers, and effective attention to implementation of this mechanism clearing and competition stakeholder interests. if not already in place settlement service authorities. providers.

Recommendation 20 • Clarify regulatory and oversight Collective action by responsibilities for each provider. supervisors and Encourage consistent overseers. regulation and • Establish supervisory principles oversight of securi- based on activity and risk-based ties clearing and definitions and analysis. settlement service providers.

64 APPENDIX 1. DETAILED BACKGROUND ON THE RECOMMENDATIONS APPENDIX 1. CONTENTS

Recommendation 1. Eliminate paper and automate communication, data capture, and enrichment ...... 67 Recommendation 2. Harmonize messaging standards and communication protocols ...... 71 Recommendation 3. Develop and implement reference data standards ...... 74 Recommendation 4. Synchronize timing between different clearing and settlement systems and associated payment and foreign-exchange systems ...... 77 Recommendation 5. Automate and standardize institutional trade matching ...... 80 Recommendation 6. Expand the use of central counterparties ...... 83 Recommendation 7. Permit securities lending and borrowing to expedite settlement ...... 85 Recommendation 8. Automate and standardize asset servicing processes, including corporate actions, tax relief arrangements, and restrictions on foreign ownership ...... 87 Recommendation 9. Ensure the financial integrity of providers of clearing and settlement services ...... 91 Recommendation 10. Reinforce the risk management practices of users of clearing and settlement service providers ...... 92 Recommendation 11. Ensure final, simultaneous transfer and availability of assets ...... 100 Recommendation 12. Ensure effective business continuity and disaster recovery planning ...... 103 Recommendation 13. Address the possibility of failure of a systemically important institution ...... 108 Recommendation 14. Strengthen assessment of the enforceability of contracts ...... 109 Recommendation 15. Advance legal certainty over rights to securities, cash, or collateral ...... 111 Recommendation 16. Recognize and support improved valuation methodologies and closeout netting arrangements ...... 114 Recommendation 17. Ensure appointment of appropriately experienced and senior board members ...... 119

Recommendation 18. Promote fair access to securities clearing and settlement networks and services ...... 120 Recommendation 19. Ensure equitable and effective attention to stakeholder interests ...... 121 Recommendation 20. Encourage consistent regulation and oversight of securities clearing and settlement service providers ...... 122 APPENDIX 1. DETAILED BACKGROUND ON THE RECOMMENDATIONS

BUILDING A STRENGTHENED, of paper, such as confirmations and trade alloca- INTEROPERABLE GLOBAL NETWORK tions, into the securities processing transaction flow as available technology safely allows, from issuance RECOMMENDATION 1. ELIMINATE PAPER AND AUTOMATE through to asset servicing.1 Means of electronic COMMUNICATION, DATA CAPTURE, AND ENRICHMENT. capture, storage, and transmission of documents Infrastructure providers and relevant public au- should be used to their fullest extent to avoid the thorities should work with issuers and securities need for physical documents evidencing transac- industry participants to eliminate the issuance, use, tional activities and asset ownership. transfer, and retention of paper securities certifi- All market participants should use electronic com- cates without delay. Such action should be sub- munication to transmit information for all instru- ject to proper investor protection over assets held ments and transactions types. Market participants in electronic form. There is no greater assurance should identify opportunities to streamline proof ownership or control from maintaining paper, cesses by avoiding duplicative recording of data and it should be possible to overcome the con- and manual addition of supplementary informa- trary perceptions of some retail investors through tion. This recommendation applies to each stage education and by ensuring a sound legal basis for of the value chain, from issuance through to trad- all paperless securities in each jurisdiction. De- ing, clearing, settlement, and asset servicing, in- materialization of securities certificates—convert- cluding confirmations, allocations, and rights and ing all paper ownership records into electronic for- decisions related to asset ownership. Electronic mat—is the preferred solution. However, in prac- communication and avoidance of repetitive or tice immobilization—where ownership is re- manual recording and enrichment of data among corded through electronic book entry and the un- all participants are essential building blocks in derlying paper certificate is kept in a central secu- achieving a zero-intervention process. Technol- rity depository—realizes many of the benefits of ogy to address these two aspects of processing dematerialization. Therefore, if immobilization should be fully utilized. can be achieved more quickly and efficiently than

dematerialization, it is an acceptable step on the COMPARISON WITH CPSS-IOSCO way to full dematerialization. RECOMMENDATIONS All market participants should seek to automate This recommendation advances aspects of CPSS- elements of the process that introduce other forms IOSCO Recommendations 6 (CSDs), 15 (efficiency),

1. The term “market participants” is used as a collective to include, as relevant, providers of securities clearing and settlement services, financial intermediaries, end-user issuers and investors, and other organizations that undertake processes related to securities transactions

67 Global Clearing and Settlement: A Plan of Action

and 2 (trade confirmations). CPSS-IOSCO Recom- addition of standard settlement instructions to a mendation 6 calls for immobilization or dematerial- counterparty reference so that securities can be de- ization of securities to the greatest extent possible. livered to the correct account), often referred to as The G30 recommendation advocates complete de- data enrichment, also hampers timely, efficient, fault- materialization or immobilization on the basis of the free, end-to-end completion of a transaction. The overwhelming balance of benefits over any respec- ever-increasing focus on the efficiency of processing tive costs or risks. CPSS-IOSCO Recommendation 2 and avoiding errors challenges the securities industry describes the benefits of automating trade confirma- to work toward the ability to process transactions tions. G30 Recommendation 1 goes further to ex- without the need for manual intervention at any point plicitly advocate automation of processes, commu- from trade execution to final settlement (often re- nications, and data processing to the full extent that ferred to as zero-intervention processing or, more ge- available technology allows. It is broader in scope, nerically, straight-through processing). With the including all aspects of securities processing for which heightened use of automated trade execution plat- paper can be eliminated or communications and data forms by both private and institutional investors, the processing can be automated. CPSS-IOSCO Recom- pressure for straight-through processing is increased. mendation 15 sets the broad principle that securities Electronic documentation, automated communica- settlement systems should seek to be cost-effective tion, and automated transfer and enrichment of data within the constraint of maintaining safe and secure among all participants to a particular transaction are operations and notes examples of places where effi- essential building blocks to achieve this goal. ciencies may be sought. G30 Recommendation 1 (and Despite available electronic alternatives, docu- the seven that follow) identify specific areas where mentation—such as statements, confirmations, al- efficiency could be improved and set out what should locations, issuer information, notification of regis- be done to realize cost-saving opportunities. tration details, and certifications as to domicile and tax status of the investor—often relies on paper cer- ISSUE tificates. Communication and information exchange The use of paper, unautomated communication, and between issuers and investors is rendered less effi- manual recording and use of data in securities pro- cient by the use of paper documents. A number of cessing is time-consuming, expensive, and prone to securities markets still transfer funds by check, be it clerical error. In addition, the use of paper certifi- between the (retail) investor and the broker-dealer, cates and other physical documents within the settle- between market infrastructure providers, or between ment and custody environment gives rise to the risk dividend/interest disbursing agents and the securi- of forgery, theft, or other misappropriation—risks ties holders of record. The use of checks, like other that are lessened in a secure, electronic environment. paper documents, hampers efficient final settlement The use of paper causes greater problems where and exposes the parties to the risk of loss, theft, or documents are voluminous, not standardized, or dif- other misappropriation as well as the risk of belated ficult to prepare, interpret, or process. receipt and availability of funds. There is also a risk, Completion of an otherwise efficient transaction particularly as settlement cycles are shortened, that is often hampered by the need for paper documents insistence on paper for some transactions might lead to be produced before, after, or alongside execution to differences in settlement periods in markets for of an underlying transaction, and exchanged or com- paper and paperless settlement. Such differences municated manually: by fax, for example. Repetitive would harm liquidity and disadvantage the holders data capture (such as re-keying of already agreed and of paper certificates or recipients of checks (mainly matched trade details for clearing and settlement pur- the retail sector). Yet many markets still require poses) and manual addition of supplementary infor- physical documents preceding or accompanying mation along the process chain (such as the manual an underlying securities transaction or as part of

68 Recommendation 1

associated tasks such as dividend or interest income smooth transition to the use of the Euro rather than payments. These include: national currencies in many European countries. The latter in many ways was a change far more fundamen- ½ Physical documents used to evidence and tal than switching from paper to electronic records. transfer ownership, be they securities certifi- Educating investors, responding to their concerns, cates, accompanying transfer and assignment and clearly explaining the benefits of eliminating pa- documents, or checks. per, many of which should flow through to investors ½ The exchange of physical trade confirmations in the form of lower transaction and custody charges, for the purpose of matching and allocating should be able to overcome any apprehension. securities. Electronic, real-time transmission of data from ex- ½ New issues prospectuses, selling memoranda, changes or other trading platforms to the subsequent corporate actions documentation, and subscrip- clearing and settlement process must be practiced tion agreements (the latter in particular for consistently; otherwise, parties to the trade have to mutual fund shares and private placement provide secondary duplicative input of the same data. transactions). The increase in cross-border investment activities and ½ Beneficial ownership declarations, notarized tax in investor choice between various combinations of authority certifications, and omnibus certifica- service providers has resulted in a lack of electronic tions regarding preferential withholding tax linkage among parties involved in the trading, match- treatments at source. ing, and settlement of particular trades. In addition, the necessity for various parties at different stages Centralized securities depositories (CSDs) have been along the value chain to add to transaction data by established in many markets to mitigate the need to reference to various information and reference data transfer or use paper securities certificates, a develop- sources, many of them unautomated, and the heavy ment strongly influenced by the 1989 G30 report. In use of fax and other manual means of communica- many countries, however, some investors still hold re- tion in executing, allocating, and settling trade details sidual paper certificates. In other areas, some markets all contribute to the relatively high failure rates pre- have made an effort to facilitate the use and exchange vailing in the cross-border arena. of electronic documents among securities industry Markets operating book-entry transfer systems intermediaries, but physical documents are often still often require separate, unautomated communication prevalent. In addition, the insistence by regulators and of registration information among custodian-agent other authorities on original, paper documents to sup- banks, CSDs, and the relevant securities transfer port and evidence transactions necessitates a flow of agents. Issuers and their agents communicate upcom- paper, even among intermediaries. ing entitlements and distributions through the secu- The main argument usually advanced in support rities industry in an inconsistent manner and through of maintaining paper is that some, mainly retail, in- a variety of communication means, such as publica- vestors like the apparent assurance and tangible evi- tion in newspapers, by electronic communication, or dence of ownership that securities certificates and through securities data vendor services and stock ex- other physical documents give. However, when se- changes. The reclamation of (parts of) withholding cure electronic documentation has a sound legal ba- taxes levied at source by custodian-agent banks is also sis, it can provide similar, if not better, levels of as- a manually intensive process, particularly for cross- surance. Public authorities should not underestimate border investment activities. the capacity and flexibility of retail investors to accept and embrace change, as shown, for example, by HOW RECOMMENDATION 1 the acceptance by U.S. investors of electronic records ADDRESSES THE ISSUE evidencing holdings in mutual funds and the recent Elimination of the issuance, use, and transfer of pa-

69 Global Clearing and Settlement: A Plan of Action

per securities certificates can be achieved through and costs of change are significant, the step to full de- comprehensive use of CSDs for all records of own- materialization is of lower priority but should still be ership. CSDs operate by one of two main mecha- targeted as a medium- to long-term objective. nisms: dematerialization, whereby all records evidenc- Other opportunities to eliminate paper at each ing ownership are electronic and paper securities cer- stage of the securities processing transaction flow tificates are not issued; and immobilization, whereby should be taken where the risk and efficiency ben- ownership is recorded through electronic book entry efits outweigh the costs, which they are already ex- but with the underlying securities certificates still held pected to do in most circumstances and will increas- by the CSD in physical form. Dematerialization of ingly do as the capacity and functionality of technol- securities certificates is considered best practice to ogy develops. In many cases national law or regula- achieve fast and efficient clearing, settlement, and tion requires the use of paper, either through an af- asset servicing, and to prevent forgery, theft, or other firmative rule or through not recognizing the legal misappropriation. Where local law or regulation re- status or validity of electronic alternatives and equiva- quires physical certificates, moving quickly to dema- lents. Again, where law or regulation needs to change terialization may be impractical. In these circum- to allow paper to be removed from the process, it is stances, full immobilization of certificates (preferably recognized that progress may necessarily be slower, accompanied by the ability to issue global notes rather but the process should nevertheless begin. than definitive certificates) achieves many of the ben- To facilitate harmonized standards for cross-bor- efits of dematerialization and is an acceptable step der transactions, the recognition of electronic sub- on the way to full dematerialization. Partial immobi- stitutes for paper documents should be coordinated lization, whereby most transactions are book entry internationally between the national securities and but investors can still opt to deposit or withdraw pa- commercial law legislators so that relevant and con- per certificates from CSDs, is not considered suffi- sistent changes can be made to their local laws. Al- ciently efficient or safe. though not directly part of the clearing and settle- Eliminating the use of paper significantly facili- ment process, many root causes of processing ineffi- tates automated electronic communication and ex- ciencies originate “upstream” at the time securities change of information. Technological developments are issued. Consideration should be given to standard- provide an increasingly secure, stable, and efficient izing primary issue prospectuses and sales memoranda means of capturing, storing, and transmitting docu- as a precondition for enabling electronic filing, dis- ments, as well as the ability to exchange information semination, and re-use of key data elements for fur- electronically in an automated fashion. This technol- ther processes. As discussed further in the recom- ogy presents the opportunity to eliminate paper and mendation on asset servicing, national tax authori- manual forms of communication and thereby cap- ties should accept and provide electronic confirma- tures significant improvements in the speed, effi- tions of beneficial ownership and taxpayer status as ciency, and safety of transaction processing. valid substitutes for the relevant paper documents. Electronic and real-time communication among WHAT NEEDS TO CHANGE all parties to trading, clearing, settlement, and asset All paper securities certificates should be dematerial- services activities needs to be established where it does ized or, if this is impractical in the short to medium not already exist. Where certain parties (such as end- term, immobilized in CSDs as a matter of priority. Over user investors) are unable to communicate in such a time, the law in jurisdictions where immobilization is way and it is uneconomic for them to invest in equip- established as an interim step should be changed to ment to do so, processes should be designed to mini- allow full-fledged dematerialization of securities cer- mize the impact of necessary manual processes on tificates. For markets where the benefits of immobili- other parts of the transaction flow. zation have already been achieved and the barriers to

70 Recommendation 2

RECOMMENDATION 2. HARMONIZE MESSAGING STANDARDS AND dards for the settlement of cross-border transactions. COMMUNICATION PROTOCOLS. G30 Recommendation 2 is more prescriptive in iden- All market participants should adopt ISO 15022 tifying ISO 15022 and IP (Internet protocol) as the (the data field dictionary and message catalogue respective current messaging standard and commu- for securities information flows) as the global nication protocol that the securities industry should standard for straight-through securities messag- use. It is broader in scope in advocating that these ing across the entire securities life cycle. Over time, standards be used for all transactions and be devel- XML (extensible mark-up language) should be- oped and used to meet participant requirements come the language to describe standardized mes- throughout the securities life cycle. sages. 2 Market participants should follow the road map set out by the ISO working group established ISSUE to advance ISO 15022 to a standardized use of Differences in the manner and form by which elec- XML. This standard should develop to meet the tronic messages are sent, and in defining and inter- needs of all parties to the investment product life preting what elements of messages mean, inhibit the cycle and, in particular, the asset servicing require- ability of organizations to automate the exchange and ments of the industry. All stakeholders in the se- use of information, both between organizations and curities industry should be appropriately repre- within a particular organization during the process- sented in the standard development process. ing cycle. Even where paper and manual communication has been eliminated from a transaction flow, All market participants should support and use lack of messaging standards and communication pro- communication networks that adopt open, stan- tocols (broadly speaking, a “dictionary” to harmo- dardized, IP-based protocols for securities trans- nize the meaning of the content of the message, and actions. 3 These standard Internet protocols must an electronic “envelope” to harmonize its sending) embrace key attributes critical to the sending of can mean that organizations still need to intervene messages related to securities transactions. Secu- manually to capture, interpret, or use electronic mes- rity, in particular, should be set at a level that sat- sages, or at best use middleware to translate between isfies business and regulatory requirements and different formats. This issue is significantly magni- that meets the needs of all stakeholders in the fied for cross-border trading, which require use of industry. Each network provider should clearly multiple local networks and multiple intermediaries, define and publish its plans to migrate from pro- all of which need to communicate with each other in prietary communication protocols to the open IP- a “many-to-many” web of connections. based protocols. Historically, ISO 7775 aimed to address at least part of this issue by defining standardized securities COMPARISON WITH CPSS-IOSCO messages; it was endorsed by the 1989 G30 report. RECOMMENDATIONS Its usefulness was limited, however, because it did This recommendation endorses CPSS-IOSCO Rec- not cover all message types used by market partici- ommendation 16 (communications procedures and pants. In addition, it allowed discretion by incorpo- standards), which advocates the use of relevant in- rating optional fields, and varying interpretations ap- ternational communications procedures and stan-

2. ISO, the International Organization for Standardization, is a confederation of national standards institutes that works in part- nership with public and private institutions to develop standards to be used consistently as rules, guidelines, or definitions of characteristics and to ensure that materials, products, processes, and services are fit for their purpose. XML (extensible mark- up language) is the universal language for describing structured documents or data on the Internet. 3. IP (Internet protocol) is a suite of protocols developed for and used by the Internet and by private networks as the open, global standard for electronic communication.

71 Global Clearing and Settlement: A Plan of Action

plied by different users of the standard critically com- infrastructure and specialized maintenance and sup- promised its effectiveness. The market is now mov- port. Users that connect to more than one such net- ing to adopt ISO 15022, which effectively replaces work suffer the costs of building customized systems and builds upon ISO 7775, as the global standard for that enable compliance with multiple protocols to securities messaging. ISO 15022 uses a set of defined connect to multiple networks. Innovation is also in- expressions, termed “business elements”, which form hibited because integration and development of soft- the building blocks of and collectively describe secu- ware requires customized tools. rities messages. A business element is a unique component of a business process that cannot logically be HOW RECOMMENDATION 2 further subdivided. Each business element must be ADDRESSES THE ISSUE defined in a consistent fashion on a global basis to The adoption of a universal messaging standard en- maximize the benefit of the new standard. This stan- compassing the entire securities transaction flow will dard must be developed to meet the needs of all par- facilitate zero-intervention processing throughout the ties to the investment product life cycle, especially securities life cycle. This in turn will enable faster and the asset servicing requirements of the industry. In more accurate confirmation, matching, netting (where addition, data quality and consistent use of standards used), and settlement, thereby reducing operational must enable all parties to receive messages and use and counterparty risk. Greater levels of straight- the message content through their systems and pro- through processing will also sharply reduce industry cesses without the need for intervention. costs, given the level of human intervention currently The road map for the migration to ISO 15022 and required in executing electronically delivered instruc- its further progression to an XML version and be- tions in forms that are nonstandardized. ISO 15022 yond also needs to be defined clearly. Consideration aims to enable standardization of all these flows should be given to whether all stakeholders in the through the following key attributes: securities industry have the appropriate representation in the process of developing, setting, and imple- ½ It is based on a data field dictionary that menting standards. Consideration must also be given provides definitions allowing common usage of to how to balance the need to move and adapt quickly business elements for all messages. with the need to achieve consensus. Clearly, develop- ½ It offers flexibility and can thus accommodate ment of standards should not follow a lowest com- in standard form messages that in earlier mon denominator approach whereby the whole in- formats used nonstandard, free-form comment dustry moves at the pace of the slowest to change; or narrative fields that required receivers to neither should a limited number of participants “im- read, interpret, and re-input data. prove” upon the standard at the expense of broad- ½ It allows any community of users to create its based and consistent use. own series of messages, an attribute that has Protocols are needed to set rules that govern the advantages (speed to market without the need operation and safety of networks (including those to gain universal approval) but also disadvantages used in the financial services sector), how the various (multiple de facto standards for users who may devices connecting the network join up and interact, need to participate in several such communities). and the way that dedicated hardware is required to Market participants can determine the appropri- send, transmit, and receive messages securely. To date, ate balance. communication networks used for transmitting securities messages have generally been based on pro- The evolution of ISO 15022 to an XML-based prietary protocols and fixed, dedicated hardware. The standard will further improve message quality, scope, drawback with this type of network is that it is ineffi- and automation, because the XML-based standard— cient, because it requires specific and therefore costly a cross-industry standard that is not restricted to the

72 Recommendation 2

securities market—will be wider in scope and usage nonrepudiation of messages, which ensures that the than that of the first edition of ISO 15022. The ISO message is received from an identifiable and autho- 15022 XML toolkit will be freely available to any com- rized source and effectively replaces the need for munity of users in the financial industry. bilateral key exchange. Critically, IP-based networks A registration authority appointed by ISO is respon- fully support XML-based messaging standards. IP, sible for maintaining the standard and provides a gov- like ISO 7775 and ISO 15022, is an open standard ernance framework. The standards development pro- and, by advocating a move to IP-based networks, cess is transparent and based on a publicly available the recommendation is not advocating any one par- business modeling methodology. The migration of ticular network. Indeed, the appropriate network programs to XML can be automated, guaranteeing a may differ between various types of messages. For consistent use of XML and a fast delivery of defini- example, secure Internet messages may be accept- tive standards. The migration to XML standards needs able for lower-value transactions, but the greater to be scheduled against business demand, especially security of virtual private networks may be appro- where existing ISO 15022 messages already accom- priate for higher-value transactions. Where differ- modate the relevant business need. Compensating user ent IP-based networks connect, it is critical to en- advantage (such as a reduction in the amount of inter- sure that lower-security users are unable to cause vention needed in processing high-volume or high-risk contagion in higher-security networks. message types) should always exceed cost of change, and the process needs to ensure continuity and avoid WHAT NEEDS TO CHANGE the need for costly changes from one standard to an- The current processes for setting message standards other unless supported by a sound business case. are still fragmented, but key groups of market par- The development of the Internet presents the op- ticipants are now working together more closely and portunity to use a common network based on open, have accepted the need to ensure consistency in stan- widely used protocols, with consequent improve- dards across the market and through the securities ments to the ease and cost of connectivity and ac- value chain. These groups include FIX, the standard cess to the network, and elimination of the need to most commonly used for securities messages at the maintain proprietary, dedicated infrastructure. His- pre-trade and trade execution stage of the value chain; torically, however, the level of security offered by SWIFT, the inter-bank communications network and communications sent over open networks using stan- corresponding standard-setter at the settlement and dard Internet communication protocols has not been custody stage; and ISO, the overarching global stan- sufficiently secure or confidential to meet the needs dards body.5 The successful, wide adoption of stan- of the securities industry. dards by the financial community will depend on the Internet-based protocols can be used in connec- willingness of these and other market groups to par- tion with Public Key Infrastructure (PKI) cryptog- ticipate in the process and collaborate to define, imple- raphy and secure communication layer protocols that ment, and consistently use standards that cover the substantially address these concerns.4 IP-based net- complete securities value chain. This process is al- works also offer security benefits that not all exist- ready under way, and the following key stages have ing proprietary networks have. One such benefit is been scheduled:

4. PKI is a generic term for a system that uses digital certificates and authorities that verify and authenticate the validity of parties to an electronic message or transaction. 5. The Financial Information eXchange (FIX) protocol is a messaging standard maintained by FIX Protocol Ltd., a membership organization open to all interested firms and developed specifically for the real-time electronic exchange of securities transactions. SWIFT is an industry-owned cooperative organized under Belgian law that supplies secure messaging services to financial institutions active in payments, securities, treasury, and trade services.

73 Global Clearing and Settlement: A Plan of Action

½ The securities industry and associated applica- security standards. The process of transition will need tion vendors have started developing business to be carefully managed, acknowledging the need for applications that take into account and use the users of the networks to develop their own parallel business components that are defined in the internal infrastructure, applications, systems, and ISO 15022 data dictionary. hardware to work effectively with the new standards. ½ The official ISO approval process has begun for the ISO 15022 XML standard. This should lead RECOMMENDATION 3. DEVELOP AND IMPLEMENT REFERENCE to an officially approved standard in 2003, DATA STANDARDS. following which the current and XML versions Market participants should collectively identify, of the ISO 15022 will coexist for a period, with develop, and adopt universal securities, counter- the non-XML version being discontinued at a party, and relevant generic reference data stan- point to be determined by its users. dards that fully meet the needs of all relevant us- ½ SWIFT and FIX have agreed in a Memoran- ers. Such standards should be adopted in connec- dum of Understanding to develop and register tion with: all future standards in compliance with the ISO 15022 XML standard. This agreement ensures ½ Asset identification and associated descriptive that there will be no further divergence or data, based upon ISO 6166 (concerning In- duplication of effort and investment between ternational Securities Identification Number, the securities message standards supported by ISIN). FIX and by SWIFT. The reach of the ISO ½ Counterparty identification, exact account 15022 XML standard needs to be further identification, and standard settlement in- expanded throughout the financial industry structions, based upon ISO 9362 (concern- through active cooperation with other organiza- ing Bank Identifier Code, BIC). tions in the standards field. ½ Relevant generic data categories, such as fee, tax, and commission rates and other, typically Adoption and use of the standard will be facili- country-specific, data (including currencies, tated by the growing industry trend to discount fees local holidays, and time zones). for messages that do not require manual interven- Standards should be comprehensive, covering the tion, as opposed to those that require further human needs of all users in the securities value chain. involvement before they can be processed, so that They should also be applicable globally. Particu- those not complying will be penalized economically. lar attention is required to address the concerns Many network providers that have previously used of jurisdictions where use of such standards is proprietary protocols are moving to develop IP-based restricted for reasons of data confidentiality, se- communication networks, such as SWIFTNET, on crecy, or other public policy purposes. the basis that it provides appropriate security as well as substantial improvements in efficiency, connectiv- Issuers, exchanges, and other originators and dis- ity, and access. These developments should be ad- tributors of data should make all relevant infor- vanced, with all communication networks significant mation available to the market in compliance with to the securities industry moving toward common these standards for a fair price and on a timely standards so that providers and users of the networks basis. The development of standards is not in it- benefit fully from the improvements available. Mar- self sufficient to avoid the very substantial ineffi- ket participants should work with network providers ciencies and costs incurred through inaccurate, to ensure that concerns about security and other criti- incomplete, or incompatible data. In addition, it cal issues are properly and consistently addressed, for is critical to enhance the substance and content example, through the establishment of common of the data.

74 Recommendation 3

Extensive work is needed in connection with all ½ Lack of specificity. Some data are not specific three categories of reference data, and the time enough to ensure accurate settlement. For frame for ultimate adoption and use of these stan- example, the BIC is not detailed enough to dards will vary. As a first step the industry should ensure that the funds are transferred to the set up working groups (or, where initiatives are correct branch of a specific bank. already under way, build upon or combine exist- ½ Incomplete scope. Many existing standards are ing working groups) representative of all parties incomplete and do not fully solve the underlying to the investment product life cycle to identify problem. For example, ISIN does not accommo- the specific areas where standardization is needed. date the various representations of securities that These industry groups should work with the rel- can be used for trading purposes (such as the evant standard-setting bodies and data suppliers many symbols that may be used for a global to establish a plan designed to achieve identified equity instrument) so that these can be refer- objectives in connection with these standards. enced to the single settlement representation.

ISSUE Even where standards such as BIC and ISIN ex- Reference data plays a critical role in securities clear- ist, data are not always provided consistently or in ance and settlement. Poor quality, incomplete, incom- accordance with these standards. The originators and patible, or inconsistent data can significantly reduce distributors of data are often inconsistent in how they the efficiency and increase the risk of securities pro- provide data to the various market participants who cessing. The vital importance of reference data has use the data in their business processes. It is not al- not always been fully appreciated, and the perhaps ways clear who has the responsibility, authority, in- surprising complexity of the issues involved, from centive, or means to provide complete, accurate, and both a technological and an organizational standpoint, timely data. Typically, it is a combination of securi- has hindered the ability of the financial services in- ties issuers, exchanges, data vendors, and various other dustry to implement fully effective reforms. This is types of organizations that vary from market to mar- an area where substantial potential for improvement ket. The form of data provided also varies, from pub- remains. Although some progress was made during lication in newspapers to automated electronic mes- the last decade (such as the introduction of ISIN), sages. As a consequence of these issues, industry par- the continued absence of comprehensive and widely ticipants have to employ significant numbers of adopted reference data standards that meet the needs people to set up, maintain, reconcile, and cleanse ref- of all users creates major costs and risks for industry erence data. In addition, the lack of quality data cre- participants. ates operational risk and causes significant costs in There are two main aspects of reference data: the relation to correction and reworking of transactions, standards that describe how data content should be an increased need for manual intervention in trade defined, and the information provided in accordance processing, and increased settlement failure. with those standards. The lack of comprehensive While it is generally acknowledged that the lack standardization has wide-ranging facets and ramifi- of common standards adds cost and risk and that all cations, including: participants spend significant money on “cleaning” the same deficient data, the industry has made only ½ Multiple content standards. The existence of very limited progress in this area over many years. multiple standards and sources of data means The issues are complex and intractable, and the diffi- that the same asset (such as a traded instru- culties with moving forward have many root causes. ment) or entity is often described in many Historically, the effort to eliminate manual interven- different ways. tion from trade processing has focused on electronic

75 Global Clearing and Settlement: A Plan of Action

connectivity. It is now becoming recognized that com- ½ Other, including fee, tax, and commission rates, plete, accurate, and up-to-date data are similarly criti- and generic data that is generally country- cal. The costs involved in bringing about change in specific, such as currencies, local holidays, and relation to data are perceived to be very high, partly time zones. because of the diversity and complexity of any data set that would need to be developed, but also because Establishing widely adopted reference data stan- of the substantial additional costs associated with dards covering these broad areas will be complex and integrating the standards into each organization’s in- challenging. The recommendation therefore seeks to dividual systems. identify and clarify the process required for achieving Obtaining funding within organizations to support the proposed change and the need for pragmatic first improvements in reference data is difficult for a num- steps to create initial momentum for moving forward. ber of reasons. Many organizations do not link all the direct and opportunity costs that arise from poor WHAT NEEDS TO CHANGE data (such as losses on corporate actions, settlement Delivering effective and substantial change in this failure, and the need to rework transactions) back to complex area requires a significant shift in behavior, their underlying cause in a transparent manner, so the both in individual firms and at the industry-wide level: business case for change is not clear. Establishing a business case is made even more difficult in many ½ Increased industry participation and leadership in organizations by lack of clarity over ownership of the development and definition of reference data and responsibility for reference data. Given that many standards, including collaboration between, or issues need to be addressed on an industry-wide merging of, the many existing and fragmented basis, the complexities even within individual firms initiatives in connection with this subject. illustrate the difficulties involved in coordinating ½ Harmonization of industry participants’ own action across many different parties, including bro- internal reference data sets and of the interfaces ker-dealers, custodian-agent banks, infrastructure pro- that hand off and receive reference data, both viders, issuers, investors, and data vendors. between and within industry participants. ½ Changes in the way the industry creates and HOW RECOMMENDATION 3 maintains reference data. ADDRESSES THE ISSUE ½ Willingness of entities, such as stock exchanges, Establishing a standardized and comprehensive ref- that own data content or proprietary standards erence data set across all data classes, one that is to participate in change that may affect their adopted by the full range of industry participants, franchise. would overcome many of the risks and inefficiencies that currently exist in connection with the need for In overview, the process for moving forward re- manual intervention, failure rates, and reworks. For quires relevant industry participants for each data class these purposes the term “reference data” is broad and or their representative bodies to collaborate with data all-encompassing, covering a range of data classes that providers and the relevant standard-setting bodies to are diverse in nature and complexity. Three broad define, develop, and implement the appropriate stan- classes have been identified: dards. The challenge for the industry is to find the appropriate group for each data class and to estab- ½ Asset, including asset identification and descrip- lish the necessary leadership and commitment to drive tive data associated with asset identification change and complete the process. Each of the three ½ Client/counterparty, including counterparty categories of data class, and even the subcategoriza- identification, account identification, and tions within, will require a different combination of settlement instructions.

76 Recommendation 4

participants and different leadership. However, most particularly those dealing with messaging standards will require involvement of representatives of users and communication protocols. Data provision has an and providers of data and of standard setters. It is associated cost, and users of data should expect to recognized that several initiatives are under way, and pay an amount that fairly reflects this cost. Ideally, this recommendation does not propose to add to that data providers should comply with this recommen- number. Instead, existing initiatives should be com- dation for their own commercial benefit, but in some bined and coordinated as appropriate to achieve co- instances, particularly where there is only one data herent and harmonized progress. source, regulation or other forms of enforcement may The business case for change should be established be needed, for example, to compel issuers to provide and confirmed and should include the nature and scale data to the market as part of listing requirements. of the costs and benefits that will flow from standardization and better provision of data. The inclu- RECOMMENDATION 4. SYNCHRONIZE TIMING BETWEEN DIFFERENT sion of all types of organizations that will be affected CLEARING AND SETTLEMENT SYSTEMS AND ASSOCIATED PAYMENT AND FOREIGN-EXCHANGE SYSTEMS. will help build consensus and momentum toward realizing change. Providers of clearing and settlement services and Definition, development, and implementation of linked or otherwise associated payment and foreign- the standards requires that several issues be addressed, exchange systems should collectively ensure that including: their design, procedures, operational timetables, and funding and cutoff times are such that the ½ Identification of the data elements required to operation of one system does not materially re- populate the standards. duce the efficiency or increase the risk of settle- ½ Analysis and design of the proposed common ment in another. These organizations should col- data content. laborate to identify the specific areas where stan- ½ Mechanisms for building consensus and dardization is needed and to develop detailed agreement and for resolving disputes. plans to achieve it. Standardization should be ½ Ownership of the standards and the data. implemented initially on a regional basis (broadly ½ Implementation plan and timetable. based on the Americas, Europe, and Asia-Pacific). ½ Process for updating the standards to accom- Cross–time zone protocols should be established modate changes and new elements. subsequently. Systems should allow transfers to ½ Guidelines for the use of data in a live process- and from securities settlement systems to be made ing environment (such as timeliness of adding in a timely manner. Periods of peak cash demand new data elements into production trading in separate systems should be carefully managed systems). so that they do not clash with one another. ½ Enforcement mechanisms. Market participants should work together to develop a comprehensive action plan to increase the As noted previously, establishing standards is a nec- efficiency and safety of cross-border securities essary condition for eliminating the inefficiencies and transactions where the foreign-exchange settle- risks caused by poor reference data, but it is not in ment cycle is not synchronized with the securi- itself sufficient. In addition, the originators and dis- ties settlement cycle. As yet, no fully developed tributors of data will need to provide all relevant data solutions systematically address the costs and risks consistently and comprehensively in a form that com- arising from the mismatch between securities and plies with these standards and in a timely fashion. Such foreign-exchange settlement cycles in these cir- providers of data should also follow the relevant stan- cumstances. This issue will increase in importance dards set out in other, relevant recommendations, as securities settlement cycles are shortened.

77 Global Clearing and Settlement: A Plan of Action

COMPARISON WITH CPSS-IOSCO and competition between trading spaces make split RECOMMENDATIONS pools of liquidity more commonplace, the need for This recommendation advances aspects of CPSS- harmonization between clearing and settlement pro- IOSCO Recommendation 3 (settlement cycles), viders will increase. Even though such organizations which calls for the benefits, costs, and risks of shorter may be open at the same time, if funding between them settlement cycles to be assessed while retaining T+3 is unavailable, participants will still be unable to settle. settlement as a minimum standard; and Recommen- Payment systems are used to facilitate the transfer dation 19 (risks in cross-border links), which calls for of money between banks. A payment system con- assessment and mitigation of the risks associated with sists of the network that links member banks, switches cross-border links between settlement systems. G30 for routing messages, and rules and procedures gov- Recommendation 4 is broader in scope in identifying erning the use of the system. In the context of secu- the critical interdependencies between linked settle- rities settlement, the exchange of money can be in- ment, foreign exchange, and payment systems and is ternalized (for example, where a CSD is organized as more assertive in describing the proactive steps that a limited-purpose bank) or externalized (where mul- the industry should take to identify, evaluate, and tiple settlement banks compete to provide payment mitigate associated risks and inefficiencies. services to participants of a CSD and use a separate payment system to effect funds transfers). Because ISSUE payments are an integral part of the securities settle- Where connections and interactions exist between ment process, it follows that a critical interdependence clearing and settlement organizations and associated exists between payment and securities settlement sys- payment and foreign-exchange systems, differences tems. This is true even in the case of internalized in opening hours and in funding and instruction cut- settlement, because external payment systems are used off times can lead to administrative difficulties and to fund settlement accounts. risk for participants. In recent years the number of links between pay- For transactions involving more than one securi- ment and settlement systems (both at the domestic ties settlement location, the risks to participants re- and international level) has increased to facilitate sult largely from being unable to settle back-to-back cross-border settlement, delivery versus payment, and trades as a result of failure to receive from or inabil- payment versus payment. Those initiatives have ity to deliver to another settlement organization. The brought benefits ranging from opening up markets participant is then left with an overnight fail, with the to new investors to reducing settlement risk. How- associated funding cost and replacement risk. Where ever, when these initiatives are coupled with the emer- this failure arises from differences in public holidays, gence of time-critical payments and securities settle- this risk may be extended over three days or more. ments, interdependencies are created that need to be As the market moves toward increased connectivity investigated further from a systemic viewpoint. and interoperability, giving participants a greater Because central bank money is frequently the choice of clearinghouse and settlement location, tim- settlement asset for payments between commercial ing differences may also create risk management prob- banks, demand for cash liquidity that underpins those lems for the service providers. transfers is increasing. This demand means that settle- In current market conditions, interaction between ment banks hold many different pots of cash liquid- providers of clearing and settlement services is ity around the globe to meet the peak demand in each generally relatively limited. However, interaction can underlying system at any given time on any given day, be a significant issue where liquidity is split between and further increases in demand will require settle- organizations and a sizable transaction flow between ment banks to hold higher and higher levels of eli- them results, for example, across the Euroclear/ gible collateral (the assets required to source central Clearstream bridge. As such practices as dual listing bank money, primarily government debt) purely to

78 Recommendation 4

support and maintain efficient levels of settlement. However, workarounds are available, and although Fragmentation of cash liquidity between different these increase cost and risk and so likely restrict the systems is inefficient. scale of cross-border activity in these markets, they The operating hours of payment and securities have not yet done so on a scale sufficient to cause the settlement systems need to allow the timely and au- market to seek and fully evaluate alternatives. tomated funding of settlement accounts. The design of securities settlement systems will dictate the HOW RECOMMENDATION 4 amount of money needed to effect settlement, which ADDRESSES THE ISSUE in turn could adversely affect the efficiency of pay- The objectives of the recommendation are to ensure ments markets, and vice versa. As a matter of prin- that: ciple, the design of payment and securities settlement systems should ensure that both are able to operate ½ The opening hours and funding deadlines efficiently. between organizations providing clearing and Cross-currency trades introduce the need for a settlement and associated services, including foreign-exchange transaction to provide the payment connected payment and foreign-exchange leg of the securities transaction in the appropriate cur- systems, are properly sequenced. rency. This creates one or more additional links in ½ The design of payment and securities settle- the chain of organizations that need to interact in a ment systems enables the systems as a whole to coordinated manner. It also requires coherent settle- operate efficiently. ment cycles for securities and foreign-exchange trans- ½ Movement toward a shortened securities actions. Further, certain market practices, such as settlement cycle recognizes the dependency of funding several securities transactions with one a contemporaneous reduction in the settlement “block” foreign-exchange trade, often lead to the need cycle of the spot foreign-exchange market. for additional manual intervention, such as the subsequent allocation of those block trades across the The issues involved are extremely complex from several underlying securities transactions. a technical viewpoint, and proper analysis also re- Currently, the typical foreign-exchange transaction quires the involvement of a significant number of settles two days after the trade date (T+2). Where institutions drawn from both the public and private securities settle on a T+3 basis (the normal cycle for sectors. A holistic approach is critical to ensure the most equities and corporate bonds), there is clearly synchronized and coherent working of payment, se- no obvious problem in completing the associated curities, and foreign-exchange settlement systems so foreign-exchange trade so that the respective settle- that all can be effected efficiently from an economi- ments coincide. As the securities industry considers cally viable supply of cash liquidity. further reducing settlement cycles, however, proper The recommendation focuses on the need for col- coordination with the foreign-exchange markets is laboration between providers of all types of settle- imperative. Otherwise, participants in cross-border ment and payment services to ensure that dependen- securities trades will suffer increased cost or risk, or cies between such systems are understood and that both. In some cases, they may be able to opt for a processes and operations develop to allow synchro- nonstandard foreign-exchange settlement, but this nization between interdependent activities. This is method is more expensive. Alternatively, the timing clearly the right approach at a general level, but difference may result in additional funding costs and/ beyond setting out principles and high-level guidance, or exposure to market risk on the mismatched cur- the recommendation does not attempt to prescribe a rency amounts. These issues already exist in some specific set of answers in an area where highly com- areas where securities settlement systems operate on plex and many-faceted issues are apparent but not a T+1 basis, particularly government bond markets. yet fully understood and where potential solutions

79 Global Clearing and Settlement: A Plan of Action

need to be properly tested and thought through. RECOMMENDATION 5. AUTOMATE AND STANDARDIZE Rather, it advocates that the above-mentioned orga- INSTITUTIONAL TRADE MATCHING. nizations undertake further research and investiga- Market participants should collectively develop tion and remain mindful of the need to consider these and use fully compatible and industry-accepted factors fully in any future development plans. technical and market-practice standards for the automated confirmation and agreement of insti- WHAT NEEDS TO CHANGE tutional trade details on the day of the trade. The Significant work and study are required to analyze fully establishment and use of the matching utilities the risks and costs involved. Although many of the currently being developed and put into operation principles and issues are common across all jurisdic- is an important part of this process, although tions, workable solutions in the short to medium term many of the potential efficiency gains that they are likely to be much more practical if regionally offer will not be realized without interoperability based. As a subsequent medium- to long-term objec- among separate systems. If the number of orga- tive, cross-regional protocols should also be estab- nizations providing these services grows, the in- lished. As functionality is developed, operators of efficiencies that fragmentation and lack of stan- payment, foreign-exchange, and securities clearing and dardization can create will increase. settlement systems should collaborate to ensure that their design, working practices, and operational time- COMPARISON WITH CPSS-IOSCO tables are such that: RECOMMENDATIONS This recommendation endorses and builds upon ½ The operation of one system does not materi- CPSS-IOSCO Recommendation 2 (trade confirma- ally reduce the efficiency of settlement in tion), which describes the benefits of automating another. trade confirmations. G30 Recommendation 5 goes ½ Individual funding deadlines recognize the further to emphasize the need for agreed and com- interaction with other settlement and payment monly used standards, as well as for automation of systems and banking hours. processes as critical components of an efficient and ½ Transfers to and from securities settlement risk-reducing, industry-wide solution. systems can be made in a timely manner. ½ Deadlines, timings, and operational cycles are ISSUE designed to manage periods of peak cash Continued expansion of institutional trading com- demand in each system in a coordinated manner. bined with an increasing focus on the efficiency of ½ Effective contingency arrangements are in post-trade processing makes it imperative to improve place, particularly to ensure that an outage of and harmonize the current post-trade confirmation one system has a minimal disruptive effect on and matching model for institutional trades to make the others. it more robust, efficient, and scalable. Even though ½ All systems follow recognized and agreed some parts of the process are already highly auto- messaging, communication, and data standards mated, the process as a whole is not seamless, but to allow efficient information flow without the replete with potential bottlenecks, the need for manual need for manual intervention. intervention, and opportunities for trade failure. With- out improvements, the process will come under Such considerations should encompass the effects increasing strain, with high error rates, increased num- of interdependencies on both the service providers bers of exceptions, excessive trade failures, a higher and their users. degree of operational risk, and higher operational cost. Nor will it be possible to reach the goal of match-

80 Recommendation 5

ing all institutional trades on the day that the trade is Furthermore, trade information is often passed executed, which in itself is an important element in between parties via phone or fax, again calling reducing risk. These issues are most prevalent in the for manual input on the receiver’s end. For cross-border environment, but even efficient domes- example, approximately one-third of all tic markets will be increasingly affected. Already, for allocations are manually or verbally transmitted, example, rising volumes have made the daily number resulting in delayed affirmation and greater of unaffirmed trades unacceptably high in several potential for trade failure. markets. ½ Lack of standards. Currently, universal usage Few standards facilitate a consistent and efficient of messaging standards or protocols is lacking process for institutional trade confirmation and across the industry, an aspect specifically matching. Without standards that are accepted and addressed by the relevant recommendation in widely practiced throughout the entire post-trade connection with the entire processing chain. In process, further automation of disparate procedures addition, no codes of practice for settling will not produce the required efficiencies or properly transactions have been universally accepted. For mitigate risk. The current post-trade processing model example, settlement differences are not cur- is characterized by the following features:6 rently resolved by agreed-upon tolerance levels, resulting in higher levels of trade “don’t knows” ½ Sequential and reactive process. Currently, and resubmissions. trades are processed sequentially, with only one ½ Inefficient use of data.The current process participant reviewing and enriching trade data at requires the manual enrichment of missing data a time. This practice creates a “windshield fields and standing settlement instructions wiper” effect, where the trade swings back and throughout the process, leading to errors and forth between the investment manager, broker- unmatched trades. Where automation is dealer, and other relevant parties, and data is available, the potential for discrepancies enriched incrementally with each pass. The between systems exists because data on the process is also reactive, as participants wait for a systems have not been synchronized, a situation “trigger” before executing the next step in the that also often results in unmatched trades and process, causing processing delays and redun- issues requiring resolution. dant flows of nonessential data. ½ Lack of participant automation. Lack of Additionally, the current process demands that internal automation on behalf of participants is all transaction data be included in each step of the also responsible for inefficiencies in the current transaction process, as opposed to isolating spe- process. Specifically, trade data are often cific data elements that are required for each par- manually re-keyed into several systems, custodi- ticular step. This inclusion requirement slows down ans’ credit and position checks may be manual, trade processing significantly, particularly in those and affirmations may be manually reviewed, all cases where trade data are manually entered along leading to an increased chance of error. Manual the cycle. intervention is necessitated by participants’ use To tackle these issues and so enable efficient and of internally developed proprietary systems or timely trade confirmation and matching, common vendor systems that fail to adhere to a common standards and practices for trade processing must be standard through the life cycle of a trade. developed. Many of these issues are addressed, at least

6. As described by the February 2002 white paper on the Institutional Transaction Processing Model put out by the Institutional Trade Processing Committee of the Securities Industry Association. Although written from a U.S. market perspective, the white paper identifies issues common to almost all markets.

81 Global Clearing and Settlement: A Plan of Action

in part, by other recommendations in this report. to accept that multiple utilities will be used and turn However, the other recommendations do not gener- its attention to mitigating the loss of efficiency that ally deal with the market practices and ways of work- could potentially result. ing particular to trade confirmation and matching. The securities industry, notably in the United States, but HOW RECOMMENDATION 5 also increasingly in other markets, has recently focused ADDRESSES THE ISSUE on the establishment and use of matching utilities, as The recommendation focuses on the need to automate a key mechanism for creating and using standardized institutional trade matching through establishing fully and efficient market practices. compatible and industry-accepted technical and market Matching utilities are technology platforms that practice standards. The recommendation also recognizes aim to provide an environment of multilateral that with more than one matching utility operating, interconnectivity for post-trade and presettlement interoperability is required to ensure that the concerns activities (including trade matching and trade data of users about connectivity costs and the choice of which enrichment) among investment managers, broker- matching utility to use are addressed. Interoperability dealers, custodians, and infrastructure providers. The addresses many of the issues that users face. For ex- matching utilities are expected to use and comply ample, by connecting to one matching utility, organiza- with industry-accepted messaging, communication, tions would be able to match trades with users of oth- and data standards as set out elsewhere in this re- ers. Users of one matching utility would also be able, port. By establishing and using common practices, with only marginal additional cost and effort, to con- matching utilities should increase efficiency and re- nect to another, interoperable matching utility. Creat- duce risk. ing interoperability requires standardization of practices Several issues need to be addressed, however. The in many areas, some of which form part of other G30 cost of implementation and use is a barrier, espe- recommendations. These areas include: cially for investment managers, in particular those that are not fully automated. Many may not have ½ Commercial considerations, such as how access the resources to build platforms for matching util- or trade match fees, or both, are allocated when ity usage or recognize the business benefits. Con- more than one matching utility provides services versely, investment managers that are more techno- to a trade. logically sophisticated may have already invested in ½ Consideration of economic or other enforce- infrastructure to eliminate the need for manual in- ment mechanisms required to ensure full tervention in most trades and so be reluctant to in- implementation and use of standards across vest further to gain what may be perceived as only participants in all key markets. marginal additional benefits. ½ Standardization of liability across multiple The presence of multiple matching utility vendors, providers. established either as industry-owned utilities or for- ½ Matching criteria and standards, including profit organizations, has introduced several issues. tolerance for small differences. Currently, investment managers and smaller broker- ½ Communication protocols and messaging dealers are undecided about which to choose, with standards. no organization wanting to choose the matching util- ½ Reference data standards. ity that becomes the one least used. A single match- ½ Operational timetables and timing of processing. ing utility also raises important and adverse conse- ½ Operating model, procedural flow, and se- quences, both in terms of the subsequent lack of quencing of different elements of the process. competition, and the concentration of risk and reliance on one organization that could become a single While matching utilities in themselves will be key point of failure for the industry. The industry needs

82 Recommendation 6

tools in the quest for efficiency and reduced risk, with- come redundant or not provide access to a full range out an environment where the trade matching behav- of other market participants. The development of ior of all its participants is conducted to specific and “concentrators” as providers of access to multiple agreed standards, they will not be fully effective. The matching utilities through a single interface, either in- goal is real-time institutional trade matching, and dependently or as part of the service offering of glo- interoperable matching utilities are a necessary, but bal custodians, is an alternative to full matching utility in themselves an insufficient, part of a solution to connectivity that may provide an effective and prag- achieve this goal. matic interim solution. Adding another intermediary layer may not be as efficient as achieving full WHAT NEEDS TO CHANGE interoperability between matching utilities, but the Market participants and infrastructure providers value-added services that concentrators could provide should collaborate to develop relevant technical and may be an added incentive for broader and faster par- market practice standards for trade matching and ticipation in the use of matching utilities. confirmation, some of which are expanded upon in Improvements to efficiency and risk will be sig- other recommendations. The Security Industry nificantly greater where there is full implementation Association’s paper on the Institutional Transactions and use of standards across the industry. Certain types Processing Model for the U.S. market is an effective of organization may not perceive benefit for them- base from which to develop a methodology that ad- selves in moving toward standardized practices that dresses the needs of other domestic markets and, benefit efficiency and reduce risk for the market as a importantly, cross-border transactions. whole; incentive structures therefore need to be es- Standardization of matching processes, including tablished to ensure broad participation. Preferably the use of matching utilities, is a global cross-market economic incentives will prove sufficient. An example and cross-border issue. Indeed, the issue also affects would be differential pricing that reflects the addi- products other than securities; for example, deriva- tional costs incurred when standardized, automated tives transactions could achieve greatly enhanced ef- practices are not followed. But if by not adhering to ficiency and reduced risk with better and standard- particular standards certain market participants cre- ized matching processes. A universally accepted and ate substantial risk or inefficiencies for the market as widely applicable model is clearly desirable, but it will a whole, then supervisory enforcement of those stan- take longer to implement and be more costly to dards may need to be considered. achieve, as harmonization and consensus will be needed across a greater range of existing practices RECOMMENDATION 6. EXPAND THE USE OF CENTRAL and market participants. If improvements can be COUNTERPARTIES. made in individual markets more quickly, these should Market participants and relevant public institu- not be delayed, as long as they are compatible with tions should collaborate to assess the potentially the long-term objective of a consistent and fully com- substantial risk reduction and efficiency improve- patible global model. ments of using a central counterparty. These ben- Commitment to participate in matching utility de- efits are expected to outweigh their costs in most velopment and use is needed from all market partici- markets. Where this is so, market participants pants and types of organizations. With the adoption should seek either to use the services of an exist- of standards for matching, complete interoperability ing central counterparty or establish one of their between matching utilities needs to be achieved to own, whichever has the better risk, cost, and ben- maximize the potential efficiency gains and to encour- efit profile. If more than one organization under- age adoption and use, particularly on the “buy” side takes this function in a particular market or mar- where otherwise there will be continued reluctance to kets, each should follow harmonized and rigor- use a matching utility whose model may in time be- ous operational practices and standards, includ-

83 Global Clearing and Settlement: A Plan of Action

ing those set out elsewhere in this report, so as to Furthermore, where trading mechanisms are used that be fully interoperable, and each should follow con- provide anonymity to buyers and sellers, it may be im- sistent risk management practices as set out in possible to determine in advance whether the Recommendation 9. counterparty to a trade is one that an organization would wish to do business with, or could have excessive COMPARISON WITH CPSS-IOSCO credit exposure to as a result of that trade. In addi- RECOMMENDATIONS tion, a series of bilateral relationships between dif- This recommendation endorses CPSS-IOSCO Rec- ferent counterparties can result in a very significant ommendation 4 (central counterparties), which pro- number of settlement transactions, even where net- motes the assessment of the benefits and costs of ting arrangements are applied between each pair. CCPs and asserts the need for CCPs to have rigorous risk control. G30 Recommendation 6 is more HOW RECOMMENDATION 6 emphatic, taking the view that CCPs are strongly ex- ADDRESSES THE ISSUE pected to bring substantial benefits to most markets. Central counterparties (CCPs) interpose themselves The G30 recommendation also emphasizes the need between the parties to each transaction and thereby for harmonized practices and standards and explic- become the buyer to every seller and the seller to every itly encourages the evaluation of using the services buyer.7 Through this mechanism the number of rela- of an existing CCP as an alternative to building a new tionships is greatly reduced, as each participant then system. The need for rigorous control of risk noted has commitments with the CCP, rather than with the in the CSPP-IOSCO recommendation is addressed many other users of the CCP that it originally dealt separately in G30 Recommendation 9: Ensure the fi- with. An organization can therefore deal with any nancial integrity of providers of clearing and settle- counterparty that it knows is eligible to use a CCP with- ment services. out the need for extensive due diligence because it knows its contractual relationship and risk exposure ISSUE will be to the CCP. The due diligence of the As described in the risk chapter and associated rec- counterparty will, instead, have been undertaken by the ommendations, organizations undertaking securities CCP itself, as expanded upon in the recommendation transactions are exposed to counterparty risk and, as on financial integrity. Similarly, risk mitigation controls a consequence, put in place risk mitigation processes such as requesting collateral or margin payments are and controls. Such risk control practices have associ- undertaken between the CCP and each market partici- ated costs, including the costs of operating the pro- pant, rather than between each combination of sepa- cesses and controls and the opportunity cost of col- rate market participants. This is plainly more efficient. lateral and margin that may need to be put up. The Most CCPs use netting, the contractual offsetting higher the risk and the more counterparties that an of positions or obligations, to further reduce organization has exposure to, the greater these costs. counterparty risk with each user. This multilateral The need to perform due diligence over each new netting between all market participants that use the counterparty that an organization wishes to do busi- CCP is far more effective than bilateral netting at re- ness with may also delay the speed at which trades ducing both risk exposures and the number of trans- can be executed, as it is clearly undesirable to enter a fers of securities and cash subsequently needed to contractual arrangement before satisfactory due dili- effect settlement. gence has been completed, and this can take time. CCPs also have a positive role to play in enabling

7. CCPs are generally used only by direct market participants who act as principals to a transaction (such as broker-dealers). Typically, end-user investors are not users of a CCP’s services, mainly because they operate on a nonprincipal basis across multiple funds and cannot aggregate their transactions under netting arrangements that are generally core to a CCP’s operations.

84 Recommendation 7

connectivity through compliance with industry-wide markets or where a CCP is already used for other standards. As a critical part of the market infrastruc- products, such as exchange-traded or over-the- ture, CCPs can significantly influence the adoption counter derivatives. Although added concentration of and consistent use of standards by their users, as each risk may result, it can be appropriately managed and of those users can be more certain that their own in many cases will be outweighed by the economy of processing efficiency will be increased by using stan- scale benefits that can be gained from use of an ex- dards that the CCP itself uses. isting CCP. The cost of adapting and increasing the Against these benefits the concentration of risk in capacity of an existing CCP is likely to be consider- a single entity needs to be considered. The concentra- ably lower than the costs of building a new CCP from tion of risk is as much operational as it is financial, and scratch. In addition, the operating costs of the one indeed the ability to withstand financial shocks through CCP can then be spread over a greater volume of default of one or more users is almost certainly easier transactions, with a consequently lower unit cost. to plan for and manage than the risk of a significant Specific concerns need to be addressed in connec- operational shock. These issues are discussed more fully tion with legal and regulatory jurisdiction, risk man- in chapter 4 and the risk management recommenda- agement, liquidity and acceptability of collateral, actions that outline the key techniques and practices that cess, and the connection of the CCP to the existing should be used by CCPs to manage and mitigate risk. market infrastructure. These concerns are important In addition, the development and maintenance of a but in many cases would be substantially mitigated CCP clearly has an investment and day-to-day running where the other recommendations in this report have cost that market participants collectively will need to been implemented. These are not straightforward is- bear and to weigh in determining the overall net ben- sues and should be fully evaluated as part of each efits that may accrue. market’s assessment. Where developing a new CCP is determined to be the best solution, it should be WHAT NEEDS TO CHANGE designed to comply fully with all relevant international The risk reduction and efficiency improvements of technical, risk, and market practice standards. using a CCP are expected to outweigh their costs in In many markets, the costs and benefits of a CCP most markets, particularly in all high-volume, devel- may not be equally or proportionately shared between oped markets. Over time CCPs may come to be different market participants. Generally, large, active viewed as an expected part of the market infrastruc- participants will have most to gain from use of a CCP, ture in almost all markets, much as CSDs have be- because they deal with the most counterparties and come over the past decade. have a greater volume of trades in each security that In markets that currently operate without a CCP, can be netted. Business cases should carefully consider market participants and relevant public authorities how the costs of development and use of a CCP should should collaborate to assess the benefits and costs of be allocated to ensure an equitable outcome for all establishing and using such an organization. Where a market participants and thereby encourage broad sup- sound business case is established, there are broadly port and participation, for example, through pricing two alternatives: of services based on ad valorem or user-pays principles.

½ Build and operate a new CCP. RECOMMENDATION 7. PERMIT SECURITIES LENDING AND ½ Use the services of a CCP already established in BORROWING TO EXPEDITE SETTLEMENT. another center or for another trading market. Relevant authorities should permit securities lending and borrowing as a method for expediting the Although to date most markets that have decided settlement of securities transactions. Each mar- to use a CCP have opted for the former option, the ket should provide tax, legal, regulatory, and ac- latter should not be dismissed, particularly for smaller counting frameworks to allow the use of stock lend-

85 Global Clearing and Settlement: A Plan of Action

ing and borrowing to prevent settlement failures. recommendations and has been reiterated and ex- CSDs or other infrastructure providers, while not panded since then, most recently in the report issued necessarily acting as principal to the transaction, in November 2001 by the Committee on Payments should seek to develop functionality to allow stock and Settlement Systems of the Group of Ten central lending and borrowing to be conducted efficiently banks (CPSS) and the International Organization of by intermediaries and other users. This recommen- Securities Commissions (IOSCO). dation does not seek to eliminate restrictions in Over the past decade significant efforts have been individual jurisdictions that prohibit stock lending made to develop and refine the operational, legal, tax, and borrowing undertaken for reasons other than and accounting aspects of global securities lending, expediting settlement, such as transactions that fa- particularly in those markets that had some infrastruc- cilitate short-selling. ture in place before 1990. Indeed, in those countries securities lending has become a substantial factor not COMPARISON WITH CPSS-IOSCO only in reducing failed settlements, but in supporting RECOMMENDATIONS the more complex hedging, trading, and derivative This recommendation endorses CPSS-IOSCO Rec- structures that have become elements of mature mar- ommendation 5 (securities lending), which encour- kets worldwide. However, in several countries little ages the use of securities lending and borrowing as a progress has been made in developing viable securi- method for expediting settlement and the removal ties lending structures accessible to both onshore and of barriers that prevent this use. G30 Recommenda- offshore participants. This lack of progress contin- tion 7 reiterates the need to remove such barriers and ues to impede settlement efficiency in both local and identifies the actions that public authorities should cross-border environments. take to create a framework that permits securities lend- While a number of countries continue to ban se- ing. It takes the view that it is then a commercial mat- curities lending outright, other countries have only ter for relevant market participants to encourage partially developed the requisite legal, tax, and regu- broad involvement in such activity. latory framework to permit effective lending. The most common impediments include uncertainties ISSUE about transaction definition and tax, regulatory, or A significant contributor to the incidence and frequency accounting treatment; limitations on the securities of failed settlement is the lack of available securities to eligible for lending; restrictions that limit eligible meet a seller’s settlement obligations. In these circum- market participants; and onerous buy-in requirements. stances, settlement efficiency is greatly increased if the seller is allowed to borrow temporarily the relevant HOW RECOMMENDATION 7 securities from another party to fulfill delivery for settle- ADDRESSES THE ISSUE ment. The lender is usually an institutional investor that Establishing a supporting framework and environ- has securities holdings and, by lending them for a fee, ment that permits securities lending and borrowing increases the return on those securities; the borrower as a method for expediting the settlement of secu- provides sufficient collateral to mitigate the credit risk rities transactions will increase settlement efficiency. of the lender. Such transactions are typically facilitated G30 Recommendation 7 endorses the 2001 CPSS- and processed by the providers of the settlement in- IOSCO recommendation encouraging the use of se- frastructure, such as CSDs, and intermediaries such as curities lending and borrowing as a method for ex- custodian banks, but these institutions are not neces- pediting the settlement of securities transactions. sarily principal to the transaction. Barriers that inhibit the practice of lending for this The recommendation that securities lending and purpose should be removed. By providing the mini- borrowing be encouraged to facilitate timely and ef- mum tax, legal, regulatory, and accounting elements ficient settlements was first set forth in the 1989 G30 to support the utilization of stock lending and bor-

86 Recommendation 8

rowing, markets can substantially reduce settlement sales would be contrary to the underlying economic failures. Furthermore, CSDs and other providers of impact and substance. securities clearing and settlement services should seek to develop functionality to allow stock lending Legal/bankruptcy. Law should support the and borrowing to be conducted efficiently. In many enforceability of the terms of a securities lending cases the business model, risk framework, and capi- agreement, and such agreements should be stan- tal of organizations such as CSDs will make it inap- dardized among market participants. The legal risk propriate for them to act as principal to securities recommendations apply to securities lending lending and borrowing transactions, but that should transactions and discuss further the key legal risks not prevent them from developing functionality that and recommended actions. can be used by intermediaries and other users who are able to act as principal. Securities lending support by infrastructure As noted above, securities lending and borrowing providers. CSDs, CCPs, and other infrastructure is an integral part of the overall trading environment providers should develop functionality and services in most mature markets and supports many complex that support efficient lending and borrowing, transactions unrelated to expediting settlement. It is whether it be provided directly by themselves as recognized that in some markets such activity is con- principal, by intermediaries, custodians, other market sidered undesirable for various public policy reasons, participants, or a combination thereof. Such func- such as discouraging short-selling. This recommenda- tionality should support both passive transactions tion does not seek to debate whether such public policy (whereby securities are automatically borrowed when objectives are desirable or soundly based but is con- a settlement failure would otherwise occur) and cerned only with settlement efficiency. Accordingly, it borrowing on demand (whereby participants actively does not in any way advocate that securities lending manage their securities positions and decide when it and borrowing should be permitted for purposes other is necessary to borrow). than expediting settlement of securities transactions. This framework creates the environment for efficient securities lending and borrowing, but holders of WHAT NEEDS TO CHANGE securities should not be compelled to participate in such activity. Rather, market participants and infrastructure Taxation. Lending transactions are not sales and providers should offer economic incentives and robust should not be considered as such. Consequently, risk management practices that encourage broad par- lending transactions should not have capital gain or ticipation in securities lending and borrowing by those loss implications for taxation purposes. Further, institutions that need to make their portfolios avail- rebates paid to cross-border and domestic borrowers able for the process to succeed fully. should not be subject to withholding taxes. Tax implications of payments in lieu of dividends made to RECOMMENDATION 8. AUTOMATE AND STANDARDIZE ASSET lenders should be clarified. Stamp and equivalent SERVICING PROCESSES, INCLUDING CORPORATE ACTIONS, duties should be waived. The treatment of securities TAX RELIEF ARRANGEMENTS, AND RESTRICTIONS ON lending transactions should be explicitly stated to FOREIGN OWNERSHIP. eliminate any uncertainty related to their treatment. Issuers, providers of clearing and settlement services, and other relevant market participants Accounting. Lending transactions (both the transfer should advise investors of all details of corpo- of the security to the borrower and the receipt of rate actions that they require in an automated, associated collateral) should not be considered sales timely manner and in compliance with accepted for accounting purposes. Treating such transactions as industry standards so that each investor can make

87 Global Clearing and Settlement: A Plan of Action

a timely decision on the action to be taken with full have been in other areas of securities processing, such knowledge of the facts. Each market place should as the communication of information among issuers, protect the rights of the beneficial owner of a se- intermediaries, and investors. Variations exist in mar- curity to all corporate and income events from the ket practice and standards in connection with com- point of execution of the purchase transaction in mon definitions of different types of corporate action the relevant security. All corporate actions should or elements of complex transactions, in the tax relief be able to be executed through book entry trans- arrangements process, and in restrictions over foreign fer and/or payment systems where such systems ownership. These variations frequently demand manual operate for the settlement of purchases and sales intervention, limit the ability to automate processes, of securities. All communications through the value and often require market participants to interpret com- chain between issuer and beneficial owner should, plex documents or rules that may vary from transac- as technology allows, be automated as set out in tion to transaction. Where investor choice is introduced the relevant recommendation. (in connection with rights issues, for example), there is risk as well as inefficiency, as lack of complete, timely, Market participants and public authorities should and accurate notifications and other information can work together to minimize the administrative lead to losses through inappropriate or ill-informed costs to each party involved in tax relief arrange- decisionmaking or through notification of decisions ments through standardization and automation that does not reach issuers by set deadlines. of procedures and communication of informa- Many of these concerns are addressed in part by tion and through the use and acceptance of elec- other recommendations that when fully implemented tronic data and documentation. This recommen- will lead to automated, standardized, and efficient pro- dation exclusively addresses the process of tax rec- cessing and communication and produce accurate and lamation. It does not in any way seek to address comprehensive reference data. However, the specific the absolute levels of the taxes themselves. nature of many (often arcane) aspects of corporate Relevant public authorities, infrastructure provid- actions and associated activities demands specific sepa- ers, and market participants should work together rate recommendations. For the purposes of this rec- to harmonize and make transparent the processes, ommendation, a “corporate action” is defined broadly. documentation, and communication of informa- It includes involuntary events (such as a scrip issue), tion in connection with foreign-ownership restric- voluntary events (such as a capital increase, share reor- tions and reporting requirements. Full informa- ganization, takeover event, warrant exercise, conver- tion needed to assess whether restrictions apply sion, or similar act), and various forms of dividends, should be available to allow investors and inter- including those that are paid with scrip options or that mediaries to make timely and appropriate deci- allow dividend reinvestment and similar plans. Corpo- sions. For example, investors should be able to rate actions, across the market, are the major source determine in advance of a trade execution of financial losses attributable to operational failure. whether the trade will breach any limits. Report- The losses arise for two main reasons: ing and disclosure responsibilities should also be transparent and should be able to be discharged ½ The inefficient flow of information between through automated electronic communication. issuer and investor, particularly where there is a long chain of intermediaries and/or paper flow or ISSUE other nonautomated methods of communication. Corporate actions and associated asset servicing ac- ½ Market failure to protect all the rights of the tivities present particularly significant opportunities beneficial owner of a security at all times, for increased efficiency. Technology developments in including all connected corporate and income this area have not yet been exploited as fully as they events.

88 Recommendation 8

Apart from the risk that results from the miscom- that they can instead be registered directly with trans- munication of information, the key risk arises in vol- fer agents prior to record dates. untary corporate actions that require investors to advise the issuer in order to protect their entitlements or HOW RECOMMENDATION 8 elect between different options. Major losses most fre- ADDRESSES THE ISSUE quently arise on market transactions that occur close Each of the specific issues described above has two to the issuer’s deadline for instructions and on stocks specific themes. First is the use of paper and lack of out on loan, especially when these are returned just automation, which with improvements in technology, before the corporate event instruction deadline. Clearly, are increasingly unnecessary and avoidable. Second in these circumstances the inefficient and slow com- is the industry-wide fragmentation and variation be- munication of information is put under greatest strain. tween jurisdictions that require industry participants Processing tax relief arrangements associated with operating in more than one country to have multiple income on equity or debt securities is also inefficient. internal people, systems, and processes to deal with It is standard practice for the full rate of withholding the multiple different requirements and ways of do- tax on income to be deducted at source. However, ing things. In many ways, this is a microcosm of sev- beneficial owners are entitled to reclaim some por- eral of the issues described in this report that apply tion of the tax withheld if their country of residence to securities processing generally. However, specifi- has a double-taxation treaty with the country in whose cally targeted action is required for corporate actions jurisdiction the dividend is paid. This tax reclaim pro- and related asset servicing, and this recommendation cess varies considerably by country and is frequently addresses these issues through advocating the need manually intensive, inefficient, and hence costly to for standardization and automation of documenta- administer. There is no standardization in the type or tion and processes in three key areas: content of documentation required to support the reclaims; nor are electronic reclaims normally ac- ½ The manner in which corporate actions are cepted, let alone in standardized message form. The described and communicated. time taken for fiscal authorities to process such re- ½ The documentation and processes for tax relief claims varies greatly and can in some cases take sev- arrangements connected with securities eral years. Furthermore the deadlines for making re- transactions and income. claims vary considerably, from as little as 18 months ½ The documentation and processes surrounding to as much as 20 years. restrictions on securities ownership. Rules surrounding ownership restrictions (such as limitations on foreign ownership) and the reporting Replacing paper with electronic documents and of material interests vary from country to country. automating communication will greatly reduce many As with tax relief arrangements, the documentation of the inefficiencies described above in each indi- and procedures required to comply with rules is of- vidual market. By doing this in a way that establishes ten manually intensive and inefficient. Transparent standard market and business practices and ways of information is often unavailable, for example on the operating, further efficiency benefits will be achieved current level of foreign ownership or the outstand- on a global scale. ing number of securities in issue against which a limit is measured, making it difficult to determine in ad- WHAT NEEDS TO CHANGE vance if an individual trade will cause a limit to be All corporate actions should be able to be executed breached. In some markets, restrictions on foreign over book entry transfer and/or payment systems ownership may lead to other inefficient behavior, such where such systems operate for the settlement of pur- as causing foreign investors to withdraw previously chases and sales of securities. Issuers should commu- immobilized stocks from securities depositories so nicate all details relating to corporate actions in elec-

89 Global Clearing and Settlement: A Plan of Action

tronic form and through the appropriate settlement securities out on loan so as to receive entitlements to systems and other relevant information channels. all corporate actions, including when the security is returned just before the last date for subscription. ½ The industry should agree on templates for There is no expectation that governments will har- electronic dissemination of information on all monize the various tax regimes that affect securities commonly used corporate action types using transactions and income on those securities. However, ISO 15022 messages. Guidelines should also be the processes and documentation underlying the col- written on the treatment of complex corporate lection of these taxes could be harmonized without actions that do not completely fit within the ISO affecting the fiscal independence and decisionmaking 15022 guidelines. If particular types of exception powers of each jurisdiction. The objective with tax occur frequently, then the ISO 15022 guidelines relief arrangements is to move toward a mechanism should be updated to accommodate them. that minimizes the administrative costs to each party ½ Exchanges should require issuers to communi- involved in the process: the beneficial owner, the in- cate in a timely fashion all corporate events that vestment manager, the broker-dealer, the custodian, arise on their securities to all appropriate and the fiscal authority. In the medium to long term, it parties, including the relevant settlement is expected that the most efficient and transparent so- systems for that security, both in words and in lution is likely to be a cross-jurisdictional process to ISO 15022 format, and with no discrepancy self-certify the residency of the beneficial owner to between the two. Where issuers release infor- claim any lower treaty rate available, with this lower mation on a corporate action in several separate treaty rate then applied at source. It is recognized, how- announcements, they should also release ever, that such a fundamental change requires careful collectively all the relevant information both in and detailed study and that fiscal authorities would have word and ISO 15022 forms. concerns about the loss of cash flow and the potential ½ Intermediaries should be able to accept, for false certification. Thus, while this proposal is ad- process, and pass on information that conforms vocated as a long-term goal worthy of further study, a with ISO 15022 messages without the need for number of principles and working practices could be manual intervention, so that the beneficial established more quickly and would bring more im- owner receives such information without mediate benefit, including: unnecessary delay. ½ Standard deadlines should be set for reclaims to Each market should have rules that minimize the be submitted and for valid claimants to be paid. lapsed time between settlement and registration (or ½ Global custodians or registrars, as appropriate, equivalent event), and record dates should be as close should substantiate the positions entitled to tax as possible to the final date for subscription on any relief. corporate event. Markets should link transfer agents ½ The procedures for tax relief arrangements to their book entry depository system to enable real- should be clearly, fully, and unambiguously time update of registered records concurrently with stated and made available electronically on the time of settlement of each market transaction. appropriate websites, along with electronic tax Each market should ensure that investors receive all reclaim forms. entitlements due from the point of execution of the ½ Tax forms and supporting documentation, proof purchase transaction in the market, and market rules of identity, and proof of residency should be should require the seller and the seller’s broker to pro- standardized and be able to be submitted to fiscal tect the buyer’s rights where the seller receives an authorities electronically using digital signatures entitlement due to the buyer. Markets rules should and other appropriate electronic security also ensure that a lender of a security is able to recall measures to confirm authenticity.

90 Recommendation 9

The process of harmonizing tax practices is a com- during at least the last decade by providers of clear- plex and difficult challenge, with many important is- ing and settlement services, user of those services, sues of national jurisdiction and interest that require and the public agencies charged with regulation and detailed consideration. As a first step, a global, industry- oversight. These efforts, individual and collective, wide tax harmonization working group should be have produced substantial gains in safety and stabil- established that includes representatives of invest- ity in the major markets and these recommendations ment managers, broker-dealers, and custodians, should be viewed as an effort to raise the bar still together with representatives of fiscal and other rel- higher in view of the critical nature of the activities evant public authorities. This working group should being undertaken. design, publish for comment, and update as necessary detailed best practice guidelines for tax relief RECOMMENDATION 9. ENSURE THE FINANCIAL INTEGRITY OF documentation and processing that adhere to the PROVIDERS OF CLEARING AND SETTLEMENT SERVICES. above principles and working practices. Fiscal authori- Providers of clearing and settlement services ties should then be invited to determine and announce should manage their risks and set standards and implementation plans detailing how and by when they controls around the use of those services that al- will adopt the best practice guidelines. low them to conduct business in a safe, sound, As with harmonization of the tax relief process, and prudent manner consistent with their busi- the recommendation does not seek to comment on ness model and all relevant supervisory and regu- the merit or otherwise of foreign-ownership restric- latory requirements. Each organization’s business tions and reporting requirements. Rather, it seeks to model should incorporate a risk framework that minimize both the costs and administrative burden addresses all risks connected to its operations. of complying with such restrictions and the incidence This risk framework should be approved by the with which limits may be inadvertently or unknow- board and expressed through a set of limits and ingly breached, with losses incurred through conse- other qualitative and quantitative measures and quent remedial actions. To achieve this, relevant rules tests. For systemically important organizations the should be unambiguous and transparent to the mar- business model should minimize the probability ket, and the documentation and processes required and impact of default. to comply with such rules should be automated and The need to operate prudently within the risk follow communication, messaging, and data standards boundaries inherent within the business model as set out in the relevant recommendations in this requires risk management processes and stan- report. Where compliance with rules depends on dards, which should be applied objectively and knowledge of information for the market as a whole consistently in determining compliance with risk rather than that for an individual organization—for measures, in three broad areas: example, where an upper limit is set on the overall level of foreign ownership—that information should ½ The counterparty due diligence process, be regularly updated and freely available to all relevant whereby service providers make ex ante and market participants so that appropriate and fully in- ex post assessments of the suitability of their formed decisions can be made in advance of trade actual or potential users, and the basis upon execution. which users transact, for example distinguish- ing between those acceptable as clearing and nonclearing members. This process should MITIGATING RISK balance risk control (which inclines toward In considering the recommendations relating to risk, setting high financial and operational thresh- it is important to recognize the major initiatives to olds) with other commercial and competition strengthen safety and stability that have been pursued

91 Global Clearing and Settlement: A Plan of Action

considerations (which may incline toward low- the need for CCPs to have rigorous risk control; Rec- ering barriers to entry of users), while recog- ommendation 9 (CSD risk controls), which sets out nizing that there will always be minimum risk the controls that CSDs should establish to mitigate thresholds that should not be lowered. settlement risk; and Recommendation 14 (access), ½ The procedures and techniques used to mea- which advocates that CSDs and CCPs should have sure, monitor, and control risk exposure aris- objective and publicly disclosed criteria for participa- ing as a result of the activities of the service tion that permit fair and open access. G30 Recom- provider, its users, and its users’ customers. mendation 9 is broader in scope, applying to all pro- These should seek to avoid moral hazard viders of clearing and settlement services, and sets whereby users can introduce risk to the sys- out in greater detail elements of the due diligence, tem without providing proportionate finan- risk control, and financial requirements that should cial protection to the service provider and form part of consistent, objective, and appropriately other users. high risk-management standards for providers of ½ The minimum financial and liquidity re- clearing and settlement services. The recommenda- quirements that should be established by in- tion also stresses the need for transparency in the frastructure providers (and enforced by su- market and sets out a mechanism through which this pervisors as described in the relevant recom- can be achieved. mendation) in proportion to the risks to which they are exposed, so as to ensure their ability RECOMMENDATION 10. REINFORCE THE RISK MANAGEMENT to continue to provide services to markets and PRACTICES OF USERS OF CLEARING AND SETTLEMENT SERVICE PROVIDERS. minimize the probability and impact of a default on their users and the financial markets. Organizations that use, or are considering using, providers of clearing and settlement services Each organization should publish a report, at least should establish robust due diligence and annually, that describes the business model, risk counterparty risk management controls and pro- framework, and underlying risk management processes that appropriately evaluate, measure, moni- cesses, controls, and standards, together with the tor, and control the risks inherent in such activity results of independent testing of those procedures. and in associated customer-related business. The The report would reassure users that the organiza- recommendation does not seek to replace pru- tion had been operating effectively, and would also dential standards and supervision that may already provide greater transparency to the market. apply to financial intermediaries, including risk- related minimum capital requirements set by pru- Coverage of this report may overlap with other dential supervisors. However, it is clearly impor- reporting requirements, such as the so-called SAS 70 tant that capital resources and risk management reports, assessments pursuant to CPSS-IOSCO stan- practices appropriately reflect the range of risks dards, and financial sector assessments carried out inherent in clearing and settlement. Likewise, by the International Monetary Fund and World Bank. nonsupervised users of providers’ services should This report is intended to be complementary to these be able to demonstrate the risk-based adequacy other requirements and not to require additional re- of their capital resources and risk management porting where the purposes of this recommendation processes. are otherwise met.

The primary objective of Recommendations 9 and COMPARISON WITH CPSS-IOSCO RECOMMENDATIONS 10 is to reach strong risk management standards, con- This recommendation builds upon aspects of CPSS- sistently and comprehensively applied on a global basis. IOSCO Recommendations 4 (CCPs), which asserts This is a challenging target. The guidance below forms

92 Recommendation 10

a checklist that aims to assist organizations achieve this ½ Unambiguous lines of authority and responsi- goal, and in so doing, it builds on and embeds much of bility delegated from the board of directors. the collective best practice used in the financial services ½ A comprehensive set of documented risk industry today. Although it is recognized that many or- policies and processes including an assessment ganizations already have in place several of the prac- program to proactively identify risks (financial tices and procedures outlined, for some organizations and nonfinancial), conducted as frequently as implementing these recommendations (and being able necessary to evaluate changing risks but at a to demonstrate this) will require substantial change. Even minimum on an annual basis. those organizations considered leaders in the field of ½ A set of systems, procedures, controls, and risk management are expected to need to improve their management information to facilitate appropri- practices in certain areas. ate and timely monitoring, management, and The recommendations are directed at two broad decisionmaking. groups: the organizations that provide clearing and settlement services, and those that directly use these It is critical that the particular matters discussed services. The business models operated by different below are implemented within the boundaries of such organizations within these groups are not all the same, a framework. The absence of such a framework is and the appropriate risk practices and controls vary prima facie evidence of unsafe and unsound busi- accordingly. 8 However, the overall nature of the risk ness practice, and one should be established as a mat- management practices that these recommendations ter of priority where it does not exist. seek to establish is broadly similar across all types of The detailed guidance is grouped consistent with organization and therefore, except where otherwise the areas outlined in the summary recommendations: specified, the guidance below is commonly applicable. ½ The elements of the risk-based counterparty due diligence processes, some of which are RISK MANAGEMENT FRAMEWORK common to all due diligence assessments, with Financial risk management techniques should form important additional factors relevant to users part of a coherent and integrated risk management assessing infrastructure providers. framework to help ensure that risks are addressed in ½ The procedures and techniques that should be a rational and sound manner with appropriate super- used to measure, monitor, control, and reduce vision and guidance at the level of the board of di- financial risk exposure arising as a result of rectors. This framework should also encompass nonclearing and settlement activities: practices financial risks, such as the legal and operational risk common to both the infrastructure providers matters analyzed in detail as part of separate recom- and their users. mendations. The framework should facilitate the su- ½ The minimum financial and liquidity require- pervision of the organization’s activities in line with ments that should be established by infrastruc- the business model considered and approved by the ture providers. This guidance applies directly to board. The specifics of the appropriate framework those organizations but will also critically affect will vary from organization to organization, but in all the risk management decisions and assessments cases the framework is expected to include the fol- of their users. lowing features:

8. For example, taking on and managing financial risk is core to the purpose and operation of a CCP and so forms a fundamental part of its business model. Many CSDs seek to eliminate through their contractual and operational arrangements financial risks to which they may otherwise be exposed. The risk management practices appropriate to each of these models will clearly differ, although they will still encompass due diligence, risk management systems and controls, and the maintenance of adequate financial resources.

93 Global Clearing and Settlement: A Plan of Action

1. Counterparty Due Diligence ½ Appropriate and independent governance, risk Initial assessment of counterparties framework, and control structure that limits or In the clearing and settlement process, counterparty otherwise controls the organization’s activities relationships with other institutions—as users of ser- and ensures compliance with good business vices, service providers, or customers—are a key practice source of risk. Therefore, a critical part of risk man- ½ Management structure, competence of people agement is a comprehensive and objective assessment in critical management positions, and extent of of these institutions before accepting them as finan- reliance on key individuals cial counterparties. This initial assessment is the pri- ½ Availability, transparency, reliability, and mary mechanism by which the probability of suffer- independence of information on internal ing a subsequent default from these counterparties control framework, management reports, and can be prevented. other internal financial and nonfinancial information that supports the governance and a. All organizations evaluating other counterparties risk-control structure should consider a broad range of factors, including: ½ Availability, transparency, and reliability of information on fully documented and regularly Legal structure and financial resources tested business continuity and disaster recovery ½ Legal status (individual or corporate), nature of plans, including an assessment of the reliance organization, and capacity to transact business on third parties and arrangements to deal with (see also specific legal risk recommendation) industry-wide shocks ½ Financial resources, capital, and reserves (under both financial accounting and risk-based Supervisory approval supervisory rules) ½ Identity and role of supervisor(s) ½ Availability, transparency, and reliability of ½ Scope of supervised activity audited financial accounts and other publicly ½ Penalties, censure, or other sanctions imposed available financial and nonfinancial information, by supervisors which should be received and assessed regularly, such as quarterly financial statements, where b. Users evaluating providers of clearing and settle- available ment services should also consider: ½ Scope and quality of external audit ½ Connection to or association with other existing Market structure or potential counterparties (for example, where ½ Sovereign analysis, including assessment of these counterparties are part of same group or creditworthiness and political and economic subject to common control) stability of country of jurisdiction ½ Guarantees from parent or other group ½ Regulatory framework, including identity and companies role of supervisor(s) of the service provider ½ Bank guarantees, lines of credit, or similar and its users, and any regulatory or self- backup arrangements regulatory responsibilities of the infrastructure ½ Asset and funding liquidity, including assess- provider ment of trigger events ½ Legal framework, including evaluation of how ½ Rating agency evaluation finality is defined by the service provider, and assessment of which law governs transactions Risk, operational, and financial where the service provider operates or handles control assessments securities issued in more than one country ½ Assessment of range and scale of financial and nonfinancial risks

94 Recommendation 10

½ Business model and competitive position of the ½ Segregation of assets (cash, securities used as service provider, along with ability to innovate margin or collateral) and rules surrounding and maintain market position these in the event of default ½ Transparency and clarity of rules concerning Organizational structure, default arrangements and the methodology and governance, and management basis upon which any losses are calculated, ½ Legal status and structure, ownership, and allocated, and shared control ½ History of defaults, settlement failures, or other ½ Governance arrangements, including user events that have caused the service provider to representation and mechanisms for balancing draw on funds available to meet losses conflicting requirements between different ½ Where multiple products are transacted: categories of user whether margin is calculated by product line or ½ Existing user and/or membership profile, across product lines on a portfolio basis; considering range of activities, domestic whether collateral is held in separate accounts versus international split, size, and number of or aggregated; and the extent of cross-subsidy participants between products in the event of default ½ Relationships, linkages, or alliances between the service providers and other market participants, User/membership requirements including local and international exchanges and and basis of participation other service providers ½ Due diligence assessment of potential or existing users performed by the service provider Operational, risk management, ½ Financial requirements of membership, margining, and default arrangements including minimum capital requirements for ½ Resources in each type of funding (including different user or membership categories and the margin and collateral guarantee fund or loss- need for guarantees or rating agency evaluation sharing arrangements, insurance and guarantees, ½ Operational requirements of use or member- capital, and reserves) available to meet losses, ship, including the need to have individual and the order in which these will be used business recovery procedures or to participate ½ Clarity and transparency of service provider’s in collective plans rules concerning transaction processing, and ½ Financial, operational, and risk management consistency with definition of when finality of and reporting requirements transfer is achieved ½ Regulatory requirements ½ Procedures for recording, matching, and ½ User/membership status, representation, and registering transactions influence on making of key decisions ½ Transparency and reliability of pricing and calculation of position-related balances The results of such an assessment should in the ½ Position, activity, risk, concentration, and other first instance be used in determining whether the or- limits in place and the measures available to the ganization is one that the institution should do busi- service provider to ensure compliance with ness with and on what basis. For example, the assess- those limits ment should be used to distinguish between those ½ Margin arrangements, including methodology organizations acceptable as clearing or nonclearing and basis on which initial and variation margins users of certain service providers. are set, the frequency and timing of margin calls, For infrastructure providers, or organizations that and the payment of interest on balances held act effectively as industry utilities, user/membership ½ Type of collateral accepted and “haircuts” criteria and risk hurdles should not be set so high that applied

95 Global Clearing and Settlement: A Plan of Action

the detrimental effects of any reduction in competi- the sanctions and tools available are likely to include tion outweighs the benefits of avoiding risk. Instead termination of membership or closeout of positions, they should be set equitably and judged consistently increased collateral requirements, revision of limits as and objectively with the business model, and the pro- discussed below, and the seeking of adequate assur- cess by which organizations are assessed should be ances from the relevant organization or its guarantors. clearly disclosed to the market. The membership criteria and risk hurdles also need to be set in consider- 2. Risk Mitigation Techniques ation of the structure of the market as a whole and Setting of limits and master agreements the profile of other market participants, reflecting the For counterparties accepted as part of the due dili- mutualization of risk and loss-sharing inherent in gence process, master agreements should be established many institutional arrangements. There should be and limits set prior to the commencement of activity. symmetry of risk and reward, so that a relatively low- The legal risk recommendations address specific issues risk organization or group of organizations is not that are pertinent to master agreements. Limits should obliged by loss-sharing arrangements to act, without effectively control the activities of counterparties and equitable compensating benefit, as an effective guar- restrict the risks that they introduce to a level com- antor of other, higher-risk organizations. mensurate with the organization’s business model, in- The impact of changing membership criteria can formed by the due diligence assessment of that and should be assessed as part of the risk measure- counterparty. Limits can be set for a number of fac- ment practices to help ensure that the criteria con- tors, including credit exposure, collateral, activity lev- tinue to be set at an appropriate level. Raising the els, credit standing, concentration, open interest, or any thresholds should be considered where the results of combination thereof. Limits should cover intraday and stress tests and other risk modeling techniques indi- overnight exposures and, importantly, both net and cate that an infrastructure provider is exposed to a gross exposures. Setting and monitoring of level of risk incompatible with its business model and counterparty gross exposure limits should be informed level of financial resources. by the legal risk assessment of the enforceability of The due diligence assessment should inform other netting arrangements discussed in the relevant recom- important processes such as the setting of limits and mendation. The system of limits established should monitoring of subsequent activity. form part of the risk management framework described above and should include clear delegation of Ongoing assessment of counterparties authority for approval of or changes to limits. Limits Organizations should continuously and proactively should be revised consistent with the ongoing assess- monitor the key factors evaluated as part of the initial ment cycle outlined above. assessment. Processes should be in place to identify, collect, and appraise information relevant to Monitoring against limits counterparties and their activities, for example, infor- Organizations should have a system of controls that mation as reported by news agencies, regulators, ex- allows intraday monitoring of the limits set for their changes, or other relevant bodies. Periodically, and at counterparties on a timescale corresponding to sig- least annually, the continued appropriateness of the nificant changes in exposure. Where significant initial due diligence assessment should be positively changes in exposure happen in a short period of time, reaffirmed using up-to-date data and information. monitoring may need to be on a real-time or very fre- An organization concerned about the continued quent batch basis. Clear procedures should be writ- suitability of a counterparty should take action to miti- ten for reporting and escalating usage of limits and in gate the risks introduced by that organization. It is not particular breaches of limits or the crossing of trigger realistic to set out here the full range of actions that or warning points that may indicate the increased pos- might be appropriate in different circumstances, but sibility of a future breach.

96 Recommendation 10

Limit excesses should be dealt with on a timely ments not be enforceable or the ownership of col- basis. The appropriate action depends on several fac- lateral and margin held not be secure; legal risks tors, including the extent or size of the breach, the are discussed in detail in Recommendations 14 to period over which it has persisted, and the status of 16. Risk managers should specifically include an the counterparty breaching the limit as assessed by assessment of the financial impact of failure of the due diligence process described above. legal arrangements as part of scenario analysis. Except where legal risk is considered insignificant, Margin, collateral, and netting arrangements risk managers should also actively measure and Margin, collateral, and netting arrangements are used monitor gross exposures. to restrict the exposure to counterparties. The controls and systems surrounding such functions are Multiple products fundamental to the ability of an infrastructure provider A number of providers of clearing and settlement ser- or financial intermediary to manage risks successfully. vices handle multiple products, be they different types These arrangements should be clearly laid out as part of securities or completely different products such as of the organization’s risk management procedures, and derivatives or commodities. The characteristics of these they should encompass factors including: products vary, and as a result, they affect the risk (and operational) management of the infrastructure provider ½ Acceptable forms of collateral and the fraction and its users or counterparties. For example, derivatives of collateral (haircut) not eligible to cover give rise to counterparty risk over their lifetime, which is outstanding exposures, reviewed on a regular typically much greater than the counterparty risk over basis against market and liquidity risk criteria. the life cycle of a cash securities transaction, which typi- ½ Margin calculation and methodology, including cally follows the settlement period. While the focus of the process by which margins can be calculated this report is on securities clearing and settlement of and collected quickly in rapidly changing market debt instruments and equities, it would be disingenuous conditions. to ignore this issue. The rules of the service provider ½ Frequency, basis, and transparency of the mark- and master agreements with counterparties should to-market process. clearly state how the interaction between different prod- ½ Frequency and timing of margin and collateral ucts is handled and address issues including: calls, including intraday and during extreme market conditions. ½ Whether margin is calculated for each product ½ Segregation and protection of assets in the line or by using a methodology assessing event of insolvency. portfolio risk across products. ½ Contingency arrangements applicable in ½ Whether collateral is held in separate accounts abnormal or illiquid markets. or aggregated across products. ½ The extent of cross-subsidy between Users of providers of clearing and settlement ser- nondefaulting users operating in different vices who transact business on behalf of customers product silos to the defaulting user. should ensure consistency between the margining arrangements imposed on them by service providers The introduction of new or variant products by and the margining arrangements that they in turn service provider can change the risk profile of that impose on customers. However, users should not as- organization, either because of the variation in the sume that a simple pass-through of margins is the characteristics of the new products from existing appropriate action in all cases. products or because of their interaction with exist- Organizations should be mindful of the risk that ing products. For this reason, new product procedures they would be exposed to should netting agree- should be established and include:

97 Global Clearing and Settlement: A Plan of Action

½ Risk-focused definition of what constitutes a 3. Financial Resources new product. Providers of clearing and settlement services should ½ New product application process, business case maintain capital and other financial resources pro- and risk assessment methodology (including portionate to the nature and scale of risks inherent interaction with existing products and associ- in the clearing and settlement process and their own ated impact on risk exposures and financial business model, their exposure to these risks, and the resources), and approval authorities. systems and controls that they have put in place to ½ Implementation guidelines and controls. mitigate these risks. The adequacy of financial resources should be assessed by service providers regu- Financial risk modeling, larly, and at least once a day, based on results of stress stress, and scenario analysis tests and other quantitative models. Service provid- Organizations should identify the key risk factors to ers should look at the correlation between partici- which they are exposed, such as market volatility, trad- pants regarding the nature of their exposures to ing liquidity, the number of simultaneous defaults, and project the potential impacts of the failure of one the correlation of defaults, and then estimate their participant on others. They should ensure that their potential losses under different scenarios arising from financial resources are sufficiently liquid, preferably these risk factors. Scenarios should be derived both by in same day (T+0) liquidity, to support their continu- recreating historical events and by forecasting future ous operation in market stress conditions. Financial potential shocks, and they should be constructed to resources should be drawn from sources that fairly test overnight and intraday real and potential exposures. distribute and mutualize risk between the infrastruc- Stress tests are inherently subjective and based on ture provider and its users. individual judgment and experience to determine scenarios. Organizations should therefore also use other Forms of funding quantitative evaluation techniques, such as value at Financial safeguards against such default can take sev- risk (VaR), as a supplement to the stress tests. VaR eral forms including: uses statistical modeling techniques to estimate both scale and probability of loss. It can be seen as a more ½ The initial margin or collateral posted by the objective measure than stress testing, but has limita- counterparty. tions in dealing with the types of low-probability, ½ A guarantee fund (or collateral pool) and loss- high-impact risks that are faced in connection with sharing arrangements among market participants. clearing and settlement and should not therefore be ½ Financial support by third parties (such as relied upon without a full range of other measures. insurance facilities, guarantees, and committed Providers of clearing and settlement services lines of credit arranged by infrastructure should make the methodology, procedures, and re- providers). sults of their risk modeling, stress, and scenario analy- ½ The capital and reserves of infrastructure sis transparent to the market, so that users and po- providers. tential users can assess the impact on their own risk exposures. This information should include a descrip- Initial margin or collateral posted by the tion of the key risks, the scenarios considered, and a counterparty is generally the first source of funds used quantitative and qualitative summary of the results in the event of a default. This source reduces the de- of tests sufficient to allow users to understand the gree to which nondefaulting organizations are reorganization’s risk exposure in the context of its busi- quired to fund the losses. The desire to have mecha- ness model and financial resources. nisms to reduce the exposure of industry participants to mutualized risk must be balanced against the

98 Recommendation 10

competitive arguments for lowering margin or col- made transparent, including the methodology by which lateral requirements. There is an opportunity cost to respective risk exposures and activity levels are calcu- users in providing margin or collateral, with the cost lated, so that users are able to estimate accurately their in general being proportionately greater for smaller exposure and potential liability. users. This point is particularly important in markets Capital and reserves of providers of clearing and where direct access to or membership in a provider settlement services are typically used as a last resort of clearing and settlement services is in practical terms after all other sources of funding have been ex- part of an organization’s license to do business, and hausted. The nature of who supplies this risk capital margin requirements should not act as an inequitable is clearly different depending on whether the organi- barrier to entry. Providers of clearing and settlement zation is a for-profit enterprise, a user-owned utility, services should set margins that fairly and reasonably or some in-between hybrid. reflect the risk introduced by each counterparty. The In practice, service providers employ a combina- level of initial margin or collateral required should tion of these sources of funding. The characteristics correlate to and be consistent with the due diligence of each type of funding—and in particular who ulti- assessment of each counterparty as described above. mately bears the cost—vary, making the relative pro- Contributions to a guarantee fund are a common portion and order in which resources are used of criti- entry requirement of services providers. With guaran- cal importance. The recommendation does not seek tee funds, participants are required either to deposit to stipulate an optimal mix, as that will depend on sums to form a resource pool to help service provid- the business model, circumstances, operation, and ers fulfill their obligations in the case of default or to risks of the particular organization and its users/ commit to make such contributions upon demand. members. However, the benefits and drawbacks of Participants in guarantee funds should have the obli- each form of funding should be objectively assessed gations to contribute to the fund on an ongoing basis in determining the combination of financial re- and to share losses that exceed the fund according to a sources. The factors considered, options assessed, and set of predefined, clear, and unambiguous rules. Con- conclusions reached should be clearly and unambigu- tributions and replenishment of the fund by market ously set out and made available to users/members. participants should be calculated commensurate with their risk exposure and activity levels. Amount of financial resources Loss-sharing arrangements are widely established No matter which form of financial safeguard is to provide funds in the event of low-probability but adopted by providers of clearing and settlement ser- potentially significant unforeseen losses. However, the vices, financial resources should be sufficient to en- details of such arrangements vary materially, most im- sure, with a high level of certainty, complete and portantly in connection with the extent of liability of timely settlement in the case of a default by one or individual users. In some cases, users may be exposed more participants. The stress, scenario, and financial to unlimited liability, and even where limited liability modeling analysis described above is a key part of arrangements are in place, they may not be preserved determining the amount of financial resources re- in times of acute stress. Service providers should be quired. The capital of service providers is crucial not mindful that users who are exposed to potentially un- only to cover default on settlements, but also to ad- limited liability will act to protect their overall capital. dress other business risks such as legal, operational, Typically, users transact through specially established and fraud errors that are not measurable reliably by limited liability entities whose capital meets member- quantitative models. Service providers should set aside ship requirements, but frequently with little excess, so part of their capital as a cushion to cover the poten- that the user’s overall exposure is limited to the capital tial losses arising from business risks other than of the transacting entity. To create greater certainty for default risks. As described in the relevant recommen- users, loss-sharing rules should be clearly defined and dation, prudential supervisors should apply consistent

99 Global Clearing and Settlement: A Plan of Action

regulatory capital requirements to infrastructure pro- transparent the point at which finality of transfer viders (and other organizations that undertake equiva- is achieved. There are different settlement ar- lent functions) to ensure they hold financial resources rangements that can achieve this: proportionate to the nature and scale of the risks that they pose to participants and the financial system, as ½ Real-time (or frequent intraday batch) settle- well as to promote a level playing field between such ment systems can offer the greatest certainty organizations. by providing simultaneous and immediate transfer for securities and cash at multiple Liquidity of financial resources points within the working day so long as there Providers of clearing and settlement services typically is finality of transfer of securities and cash. invest their financial resources to generate revenues. ½ Systems that offer real time (or frequent Noncash investment assets must be liquidated or intraday batch) transfers of securities followed pledged before they can be used to meet obligations. by net cash payments at the end of each work- This process may be lengthy or costly to complete in ing day (or intraday) offer a lower level of cer- the event of a default; for example, insurance under- tainty, but can substantially reduce costs and writers usually cannot make all payments within 24 demands on liquidity, particularly in high- hours, and credit lines may not be able to be drawn volume markets. In practice, such systems re- down immediately. Service providers should estimate quire additional and enhanced levels of risk their daily liquidity requirements and ensure that a management to offset the greater uncertainty corresponding proportion of their total assets and but are acceptable provided that intraday se- resources can be converted into cash within the same curities transfers are final and that risk con- day (T+0 liquidity) and the next day (T+1 liquidity) trols ensure that the end-of-day (or intraday) to meet these requirements. In the event of a mar- net settlement of cash payments will be com- ket-wide problem, service providers would need to pleted, even if one or more participants owing use their financial resources to address the problem the largest end-of-day cash payments fail to without delay to restore the confidence in the finan- meet their obligations. cial system. Therefore, it is desirable for service pro- Determining the arrangement appropriate to a viders to maintain the bulk of their assets and re- particular market will depend on a number of fac- sources in T+0 liquidity, so that there is a significant tors, including available technology and commu- buffer in excess of the calculated liquidity require- nication infrastructure, the number and value of ment. For this reason, assets should be in highly liq- transactions, the systemic importance of the mar- uid, short-term securities/bank deposits, and repo- ket to the world financial system, and the busi- eligible instruments, such as government bonds. Ser- ness and operational models of other market par- vice providers should also establish contingency plans ticipants and related payments systems. Any un- to obtain additional or replacement funding, for ex- certainties within an individual system are mag- ample, through assured credit lines. nified by the complexity and intersystem depen- RECOMMENDATION 11. ENSURE FINAL, SIMULTANEOUS TRANSFER dencies of cross-border transactions; that means AND AVAILABILITY OF ASSETS. that the impact of uncertainty on such trades will be greater than on domestic trades. This is an- Providers of securities settlement services should re- other important consideration. duce to the lowest possible level the credit risk created if securities or cash are delivered without receipt Whichever settlement model is used, each securi- of corresponding assets, by linking securities trans- ties settlement system should specify the moment fers to funds transfers in a way that achieves effec- of final transfer in its rules or through binding tive delivery versus payment (DvP) and by making contracts in plain and simple language, as

100 Recommendation 11

expounded further in the respective legal risk rec- To create confidence, the key attribute that the ommendation. settlement process must have is absolute assurance that a participant will not be obliged to give up own- Systems that settle both securities and cash on a ership of an asset (cash or security) without receiv- net basis and allow intraday transfers that are con- ing the corresponding asset that the participant is due ditional or not legally binding, have yet greater as part of the contractual obligations that the settle- uncertainty, as a participant’s transfers may be re- ment process discharges. To achieve this objective for voked following failure to meet their end-of-day both parties, the exchange of assets must be simulta- contractual obligations. In these circumstances the neous. In addition, both transfers must be final and complexities of unwinding conditional transfers in no way conditional or capable of being revoked. of securities (and thereby needing to recalculate This final, simultaneous transfer of assets is described the delivery obligations of other participants), and by the term delivery (of securities) versus payment the operational difficulties and liquidity pressures (of cash) and is usually abbreviated to DvP. that may result, have the potential to create sys- DvP was first properly recognized as an essential temic risk. Such arrangements are therefore con- risk-mitigating principle in the mid-1970s, following sidered unacceptable, particularly where there is the collapse of Bank Herstatt. Other banks were left potential cross-border impact. with very significant exposures as they had paid one Once finality of transfer is fully assured, the rules side of foreign exchange transactions to Bank should enable a receiver to re-use securities and Herstatt, but had not yet received the corresponding cash without further delay, whether arising from payment from it. Although this case was not directly settlement, dividend or interest payments, or cor- connected to securities markets, it dramatically em- porate events. phasized the need for simultaneous exchange of assets in any linked financial transaction. COMPARISON WITH CPSS-IOSCO The primary issue that the financial markets have RECOMMENDATIONS been grappling with since accepting DvP as an essen- This recommendation broadly endorses CPSS-IOSCO tial characteristic of settlement is that the payment and Recommendation 7 (DvP), Recommendation 8 (timing settlement systems have not generally been able to sup- of settlement finality), and Recommendation 9 (CSD port DvP in its literal interpretation. There has usually risk controls to address participants’ failures to settle), been some dislocation in the timing of delivery and which set out minimum standards for mitigating credit payment; this has created uncertainty. At this point, risk in settlement systems across all markets. G30 Rec- the questions that need answering are how much of a ommendation 11 aims to build on the CPSS-IOSCO gap and what level of uncertainty is acceptable, and recommendations. Acknowledging the inherent and what mitigating systems, controls, and processes need complex trade-offs that exist between efficiency and risk to be put in place where exchange is not simultaneous. in this area, it seeks to give guidance on determining the While these basic questions have remained constant, appropriate settlement arrangement and identify ap- the answers to them have evolved. This evolution re- proaches that present unacceptable risk, particularly sults partly from technological advancements that have where there is potential cross-border impact. allowed progress from typically end-of-day batch processing toward real-time or frequent intraday batch ISSUE processing, but also from pressure applied by regula- It is critical that participants in securities markets have tors, supervisors, and trade groups, and from variabil- confidence that their assets will be properly protected in ity of the acceptable level of uncertainty from market the settlement process and that they then have freedom to market.. Factors such as the value and volume of to use those assets as they wish once the settlement transactions, the systemic importance of the market process has been completed. to the world’s financial systems, and the business and

101 Global Clearing and Settlement: A Plan of Action

operational models of other market participants and security or a specific denomination of cash operate as related payment systems all need to be evaluated. a virtual single system, through system linkages or Broadly speaking, market changes drive the require- cross-membership arrangements. ment to develop increasingly certain settlement arrangements to meet investor needs, and technological HOW RECOMMENDATION 11 advancements provide the means to get closer to a ADDRESSES THE ISSUE more literal form of DvP and enhance risk manage- The 1989 G30 report reiterated the need for DvP ment processes, and so meet such needs. Because tech- and set as a minimum standard finalization of both nologies and markets are constantly changing, this is- delivery and payment by the close of business on the sue requires frequent review and revision. day of settlement, at the latest. In its September 1992 A second critical and connected issue is defining report “Delivery versus Payment in Securities Settle- the point at which a delivery of a security or payment ment Systems,” the Bank for International Settle- of funds becomes final. The issue of finality is ad- ments offered a thorough and comprehensive analy- dressed in the respective legal risk recommendation. sis of the issues surrounding DvP, which has been A critical concern in this regard is that operators of recently re-endorsed by the 2001 CPSS-IOSCO rec- settlement and payment systems, in their rules, or in ommendations. The BIS report described and evalu- binding contracts with their members, should define ated the various ways that different markets had es- the moment at which finality is achieved—in plain tablished arrangements that, while diverse in nature, and unambiguous language. It is central to analysis were commonly described as DvP. of the timing of transfers that the terms delivery and Recommendation 11 does not aim to revisit the payment refer to the point of final transfer and should level of detailed analysis contained in the 1992 BIS not be confused with any conditional transfers that report. Instead the recommendation seeks to augment may happen beforehand. the BIS analysis by defining the key features that settle- In a number of settlement and payment systems, ment and payment systems should have in the con- the timing of final transfer or of processing cutoffs is text of today’s system functionality and market needs such that receivers of cash or securities are able to re- to create a level of certainty that appropriately dimin- use the assets outside those systems only after a fur- ishes the settlement risk of market participants and ther delay. This situation applies not only to DvP secu- hence, in practical terms, can be viewed as accept- rities transactions, but also to receipt of cash or securi- able forms of DvP. Without such a structure the ties arising from coupons, dividends, and other corpo- counterparty, liquidity, and operational risks con- rate actions. In other cases, either the deliverer or the nected to the settlement of securities transactions are receiver can be obliged to make cash or securities avail- unacceptably high and have the potential to become able for processing significantly earlier than the time at systemic, in particular where transactions have po- which settlement processing commences. Where over- tential cross-border impact. night batch processes are operated, the deliverer or The recommendation recognizes that achieving si- receiver is obliged to immobilize securities before the multaneous and final exchange is not always the most close of normal settlement activity on the day before cost-effective solution, given current technology and the day of settlement. In addition, in some instances, market practices. Further, the amount of cash and se- cash arising from sales of securities cannot be applied curities needed to enable settlement can be limited to the purchase of another security even within the through netting and other arrangements, and these can same settlement batch. These timing issues are closely improve further settlement liquidity and efficiency, even related to the need to synchronize securities settlement, though netting can have the potential to conceal or payment, and foreign exchange systems, as discussed obscure the point at which finality is achieved. more fully in Recommendation 4. It is important that By advocating that each securities settlement sys- multiple settlement systems dealing with either a single tem should specify the moment of final transfer in

102 Recommendation 12

its rules or through binding contracts in plain and ary within a country. Settlement systems that do not simple language, certainty should be increased which- comply with the criteria set out in this recommenda- ever operational settlement arrangements are fol- tion should be encouraged to develop their processes lowed. This point is expounded further in the discus- so as to remove the risks that noncompliant struc- sion of legal risk in Recommendation 15. tures present (both to individual investors and other Once finality has been achieved, it is important market participants and to the system). In particular, that the proceeds of settlement are available for re- clear rules on finality should be established in each use, both within and across market settlement sys- settlement system. tems, to optimize settlement liquidity. Therefore: RECOMMENDATION 12. ENSURE EFFECTIVE BUSINESS CONTINUITY AND DISASTER RECOVERY PLANNING. ½ Cash or securities should be available for re-use, both within and outside the system in which All market participants should, and all systemi- they settle, following completion of the cally important institutions must, regularly review, settlement process. update, and test their business continuity and dis- ½ Cash or securities required for settlement aster recovery plans, including evaluation of reli- should not be immobilized for any lengthy ance on third parties, to ensure with reasonable period of time, before or after the point of certainty that critical operations will continue with settlement, and especially not during market a high level of integrity and sufficient capacity opening hours. following a disruption or disaster. 9 The review, updating, and testing of plans should build upon Adoption of these principles will improve settle- the thorough analysis and good practices that have ment liquidity across markets and thus settlement per- already been established and that are being devel- formance, will reduce risk, and will ensure that inves- oped by public and private institutions. The plan tors are given good value on all flows relating to their should be based upon revisiting planning assump- securities. tions, revised risk assessment, and scenario planning that encompasses the key lessons learned WHAT NEEDS TO CHANGE from September 11, 2001, and any other relevant It is critical that users of settlement systems are able incidents that may occur. Organizations should to determine and properly evaluate the settlement assess whether plans provide satisfactory resil- arrangements that they are obliged to use. To enable ience and evaluate the costs and benefits of de- this, infrastructure providers should, as part of the veloping solutions to the broad range of business report advocated in Recommendation 9, set out continuity and disaster recovery issues. For func- clearly the settlement arrangements they have put in tions critical to the market as a whole, a split op- place and all relevant mitigating controls, with an as- erations model should be considered, whereby sessment against the criteria outlined in this recom- one processing site actively backs up another, with mendation. The report should explicitly address iden- each site having all key resources, capabilities, and tification of the point at which finality of transfer is functionality, including appropriately skilled and achieved, the legal status of the rulebook of the experienced people. Systemically important insti- securities settlement system, simultaneity of transfer, tutions should undertake tests with member firms and protection against insolvency of the intermedi- and users as part of their evaluation exercises.

9. Systemically important institutions are those market participants whose operational or financial failure has the potential to, in turn, cause other organizations to fail and so spread contagion through the financial system as a whole. In any particular market, infrastructure providers and particularly large or strategically important financial intermediaries are likely to be classed as systemically important.

103 Global Clearing and Settlement: A Plan of Action

In their review of backup arrangements, organi- companies. These plans have focused on matters such zations should consider whether they have suffi- as the loss of power or telecommunication facilities, cient access to dedicated backup facilities to en- and on the impact of terrorist activities in those coun- sure that operations can be reconstituted within tries that have suffered attacks or where such attacks a suitable time frame. When major incidents oc- have been perceived as a significant threat. However, cur, organizations should be aware that the pres- market participants learned several lessons from the sure on shared backup facilities may be such that events of September 11, 2001 regarding business they are not able to rely on having access to it. continuity and disaster recovery planning in the context of extreme disruptions. The widespread destruc- Full disclosure of plans may increase the risk of tion of the physical infrastructure and telecommuni- certain events or attacks, or otherwise compro- cations environment in lower Manhattan caused dis- mise plans, and is clearly undesirable. However, ruptions in the trading of securities and the subse- contingency plans should be sufficiently transpar- quent clearing and settlement of trades. ent and effectively communicated to the other While the global financial system continued to market participants that depend on the institu- function in the days following September 11, the in- tion to allow them to make reasonable judgments dustry witnessed the interdependencies in the finan- about the operational risks to which they in turn cial system and the need to improve its overall opera- are exposed. In addition, the responsible super- tional resiliency. Because they are systemically impor- visory body should critically assess the contin- tant, clearing and settlement organizations, payment gency plans of the organizations that they super- systems, and other institutions that undertake func- vise, including an evaluation of the adequacy and tions that provide an actual or effective industry util- frequency of testing. The nature of these assess- ity need to operate at a high standard of operational ments should reflect the associated risks, and for resiliency and may therefore need to take further ac- high-risk organizations should be performed at tion to strengthen and test their business continuity least annually. and disaster recovery plans.

COMPARISON WITH CPSS-IOSCO HOW RECOMMENDATION 12 RECOMMENDATIONS ADDRESSES THE ISSUE This recommendation builds upon aspects of CPSS- Several new efforts are therefore under way in the fi- IOSCO Recommendation 11 (operational reliability), nancial services industry in both the public and private which advocates that contingency plans and backup sector to provide updated business continuity and di- facilities be established to allow for timely recovery saster recovery guidance. For example, in the United of operations and completion of the settlement pro- States, the Board of Governors of the Federal Reserve cess. This recommendation sets out in greater detail System, the Office of the Comptroller of the Currency, the processes and specific factors for consideration and the Securities and Exchange Commission jointly that should form part of sound business continuity issued a “White Paper on Sound Practices to Strengthen and disaster recovery plans. This recommendation the Resilience of the U.S. Financial System.” This con- also stresses the need for transparency so that firms sultative paper will become the basis for future regula- that are operationally dependent on other organiza- tory guidance in the United States. Given that these tions can make appropriate and considered judgments efforts are under way, the differing nature of organiza- about the risks to which they are in turn exposed. tions to which the recommendation is addressed, and the varying circumstances in which they operate, the ISSUE G30 recommendation is not intended to be prescrip- Business continuity and disaster recovery planning has tive. Rather, it gives best practice guidance and further for many years been an important part of the opera- points for consideration, with a focus on dealing with tional risk management practices of financial services

104 Recommendation 12

extreme events, that may enhance existing policy and independent testing of those procedures and to give practices and can be applied objectively and consis- users assurance that the procedures have operated ef- tently by market participants to help ensure: fectively. The level of disclosure provided to the market participants should be sensitive to confidential is- ½ Timely review, updating, and testing of organi- sues that could increase the risk of compromising plans. zations’ business continuity and disaster The key lessons learned from September 11, 2001, recovery plans. which should be considered in revising or develop- ½ Continuity of processing following events ing business continuity and disaster recovery plans, ranging from localized processing disruptions are summarized below: to wide-scale disasters affecting an entire geographic region. 1. Revisit planning assumptions and ½ Effective communication of the organization’s perform and/or update risk assessments. planning (without compromising confidential- Business continuity plans need to consider the range ity) so that market participants that depend on of their planning assumptions. Before September 11 the institution can make reasonable judgments some organizations focused only on the information about the operational risks to which they in turn technology portions of their disaster recovery plans are exposed. and made certain assumptions that are no longer realistic for all eventualities today (concerning, for ex- WHAT NEEDS TO CHANGE ample, availability of key people, regional availability Organizations to which the recommendation is ad- of public transportation, and availability of key ven- dressed should review, update, and test their business dors and business partners). continuity and disaster recovery plans to ensure that The first stage in developing a business continuity following a disaster, critical operations will continue plan typically consists of developing planning as- with a high level of integrity and sufficient capacity. sumptions and assessing the risks of certain events These bodies should review their planning assump- (scenarios) that could occur and therefore should be tions, their risk assessment, and scenario planning in factored into the plans. This process should be per- the light of the key lessons learned from September formed on an annual basis at minimum, but it can 11, 2001. also be performed throughout the year as change In the event of a disaster, backup facilities should occurs in the organization or as external events oc- allow processing to be switched to a second location cur that affect the organization. As organizations (located outside the geographical zone impacted) update their business continuity plans, they should within the same business day. The distance between factor in several potentially new planning assumptions the primary and secondary location should be deter- in the post-September 11 environment, in addition mined by taking into account the trade-offs of risk, to scenarios that they already consider, such as the cost, and efficiency. For functions critical to the mar- potential for: ket as a whole, organizations should also consider ½ whether developing a split operations model (com- Wide-scale regional disruption ½ monly referred to as “active/active”), whereby one Loss or unavailability of key personal, critical processing site actively backs up another, is appro- vendors, customers, and other business partners ½ priate, and evaluate the costs and benefits of such a Unavailability of public transportation key solution. infrastructure such as bridges and tunnels ½ Organizations should publish, at least annually, an Cyber-threats such as computer hacking ½ outline of the business continuity and disaster recov- Unavailability of business locations for periods ery procedures they have in place and the results of of up to six months

105 Global Clearing and Settlement: A Plan of Action

2. Avoid geographic concentration and decision matrixes for the initial hours of a response, of primary and alternate facilities. including performing rapid but accurate employee head Just as an investor would diversify the risk in her stock counts, responding to the media and family members, portfolio, the events of September 11 highlighted the interacting with government officials and law enforce- need for organizations to diversify geographic loca- ment personnel, and cross-training the chain of com- tions that support critical business functions. In mand. The dependencies between service providers addition, the advances in information technology may emphasize the need for inter-organizational planning, mean that it is no longer essential for employees to particularly on maintaining the inter-organizational be located in one concentrated location. communications and flow of information that forms For business functions critical to the market as a a critical part of a coherent and coordinated response. whole, organizations should assess the costs and ben- Having a detailed and fully tested incident response efits of developing a split operations model whereby plan has now become just as critical as being able to key personnel, business processes, and technology are recover business operations. divided between two or more geographic locations, Roles and responsibilities for the recovery teams though it is clear that this will not always be appropri- should be clearly documented and communicated. ate or desirable. Determining the appropriate geo- Each team should be trained and ready to deploy in graphic separation is a complex and subjective issue the event of a disruptive event that requires the plan that requires careful judgment to balance the trade-offs to be activated. The specific teams that should be of risk, cost, and efficiency. This recommendation does considered are: not aim to prescribe a particular solution in recognition of the fact that much effort is currently under ½ Senior management team way to study this issue by both public and private insti- ½ Crisis management team tution. Rather, it gives good practice guidance that can ½ Damage assessment team then be applied objectively and consistently. ½ Alternate site recovery team Where a split operations model has been deter- ½ Technical (network/telecommunications/ mined as necessary to give sufficient resilience, best applications/operating systems/server) practice would be for personnel at each location to ½ Business recovery teams be cross-trained and for each location to have suffi- ½ Security team cient “people capacity” to absorb the work if one ½ Media relations team location is unable to process transactions or conduct ½ Legal affairs team business. The business operations and technology environment at the backup facility should be able to 4. Review disaster declaration accommodate sufficient personnel, technology, and and notification procedures. provide timeliness of data backup to ensure process- Many steps are typically involved during the activa- ing can continue at the second site with sufficient tion of a disaster recovery plan, many of which oc- capacity and processing integrity. cur before the actual declaration of a disaster. An informed decision process should be established in 3. Develop/review emergency response, advance to provide an effective framework to allow incident management procedures, and those “on the ground” to take critical initial steps in a communication and information flows. timely manner to best position the organization for a Many organizations have well-developed and tested successful recovery. The disaster declaration proce- business continuity and disaster recovery plans but have dures should clearly identify the initial actions to be not developed emergency and incident response plans. taken by damage assessment and/or recovery person- The events of September 11 undoubtedly reinforced nel to implement the recovery plans. the need for establishing communications requirements

106 Recommendation 12

Notification procedures should be documented in formed from primary and backup locations. In addi- the plan for many different scenarios. The procedures tion, plans should consider the loss of key customers should describe the methods to be used to notify re- and key personnel. Scenarios for technical disaster covery personnel during business and nonbusiness recovery planning can frequently become routine, hours. Notifications can be accomplished through a ensuring successful tests and the appearance of pre- variety of methods including telephone, pager, work paredness. Incorporating “B Team” staff, impacts of or personal electronic mail, and cell phone. A com- degraded critical vendors (especially networks), in- mon notification method is a call tree. This technique complete data backups, and other realistic problems involves assigning notification duties to specific indi- will ensure that the recovery program is realistically viduals, who are in turn responsible for notifying other evaluated for its true capabilities. recovery personnel. A call tree should be established Besides technical recovery, one of the critical les- for primary and alternate methods of notification. sons learned from the September 11 attack is the critical need to increase end-user involvement within the 5. Implement appropriate data backup technology. testing process. Incomplete procedures and inadequate Many data backup plans focus only on critical computer work area resources can be identified and addressed systems. Consideration should be given to backing up only through effective and comprehensive tests. paper-based records, desktop computer systems, and At a minimum, the following areas should be ad- other systems needed to ensure continuity of operations. dressed in testing: Policies and procedures should specify the data that should be backed up and the means for doing so (mir- ½ Systems recovery on an alternate platform rored/synchronous, replication, tape; daily or weekly; ½ Testing of business process recovery, including incremental or full) based on data criticality and the coordination among various recovery teams frequency that new information is introduced. ½ Internal and external connectivity ½ System performance using alternate equipment 6. Focus on vendor and outsourcing dependencies. ½ Restoration of normal operations In the past, many organizations did not consider the impact on their own operations of a disaster affect- Training for recovery personnel should complement ing key vendors or outsourcing dependencies. There- testing. Training should be provided at least annually; fore, a review of vendor and outsourced service pro- new hires that have plan responsibilities should receive viders should be conducted that includes assessing a training shortly after they have been hired. Recovery vendor’s criticality, securing multiple vendors for criti- personnel should be trained in the following: cal processes, understanding a vendor’s preparedness to deal with disasters, and understanding vendor ca- ½ Purpose of the plan pacity thresholds and capacity plans. Organizations ½ Cross-team coordination and communication need to understand where they are dependent upon ½ Reporting procedures key vendors (such as telecommunications) and iden- ½ Security requirements tify single points of failure that these vendors pose. ½ Team-specific processes (activation/notifica- Vendors and outsourced service arrangements should tion, recovery, and reconstitution phases) be included in the business continuity planning pro- ½ Individual responsibilities (activation/notifica- cess and should provide the organization sufficient tion, recovery, and reconstitution phases) evidence as to their operational resiliency. 8. Develop a strong maintenance 7. Test all aspects of plans. process to keep plans current. Testing of connectivity between all parties (such as Organizations should have a process in place to en- participants, exchanges, key vendors) should be per- sure that business continuity and disaster recovery

107 Global Clearing and Settlement: A Plan of Action

plans reflect changes in business, technology, people, and ISSUE processes. Periodic maintenance is necessary to ensure The recommendation aimed at ensuring effective that the right people can be contacted in the event of a business continuity and disaster recovery planning is disaster and that a sufficient level of resources is avail- critical to strengthening the resilience of financial able at alternative processing sites to meet actual needs. markets infrastructure and providers of clearing and Business continuity, disaster recovery, and incident settlement services. Yet, however robust, thorough, management plans must be continually updated and and well-tested, it is unrealistic to expect business tested to remain current and ensure organizations are continuity and disaster recovery plans to anticipate ready. The plan update should be performed at least and cater to all possible eventualities, as this encom- annually or whenever significant changes occur for: passes an enormous range of potential scenarios, each individually unlikely. At the same time, the likelihood ½ Operational requirements of a catastrophic event of some sort is clearly real. ½ Security requirements ½ Technical procedures and requirements HOW RECOMMENDATION 13 ½ Hardware, software, and other equipment ADDRESSES THE ISSUE ½ Names and contact information of team The recommendation does not seek to prescribe a so- members, business partners, and vendors lution to this issue, which is extremely complex and ½ Alternate and offsite facility requirements which, until the events of September 11, attracted lim- ½ Vital records (hard copy or electronic) ited attention. The recommendation instead outlines ½ External events affecting the organization the process that the industry should follow to investigate, evaluate, and implement potential solutions. RECOMMENDATION 13. ADDRESS THE POSSIBILITY OF FAILURE OF A SYSTEMICALLY IMPORTANT INSTITUTION. WHAT NEEDS TO CHANGE Market participants in each financial center Because the failure of an institution systemically im- should work together to identify those institu- portant to clearing and settlement will—by definitions, or parts thereof, that are systemically im- tion—have widespread impact across all users of their portant to the clearing and settlement process. services, market participants need to act collectively. User groups should be established to address As a first step, those institutions, or parts thereof, that how they would react if, despite strengthened are systemically important need to be identified. Us- business continuity and disaster recovery plans, ers then need to make contingent arrangements as to there were a failure for whatever reason at one how they would react should one of these systemi- of these institutions. Ways of mitigating the risks cally important institutions fail. Ways of mitigating created should a systemically important institu- such risks, such as building a real-time data deposi- tion fail, such as building a real-time data de- tory, need to be carefully considered and evaluated. pository, should be evaluated. Where it is deter- The benefits of such solutions may well be substan- mined that effective and feasible solutions may tial, but so will be the costs. For that reason, detailed exist, detailed business cases setting out the costs business cases will be needed for each potential solu- and benefits should be built up, and decisions tion to enable considered and appropriate investment on future actions and investment decisions decisions to be made. should be taken accordingly. As well as enforc- The recommendation is addressed primarily to ing suitably high standards of business continu- market participants, and it is foremost the responsi- ity and disaster recovery planning in systemically bility of the boards and management of these orga- important institutions, regulators and overseers nizations to act to address the risks described above. should encourage this process of industry-wide However, the systemic nature of the issue has a very contingency evaluation and planning. substantial public interest. Quite properly, those

108 Recommendation 14

responsible for the regulation and oversight of market ISSUE participants have paid significant attention to industry- While ongoing business relationships offer primary wide contingency planning, particularly in the United assurance that parties to a financial transaction will States in the aftermath of September 11, but also else- perform as agreed, it is the reasonable certainty of where. They have already encouraged debate and legal enforcement that ultimately must underlie all discussion of these matters among the relevant insti- transactions. Contract legality and enforceability are tutions and should ensure that progress continues to fundamental in this regard, and parties to financial be made with sufficient rigor and momentum. transactions have long focused on these issues as basic elements of due diligence and risk management. RECOMMENDATION 14. STRENGTHEN ASSESSMENT OF THE But the increasing complexity of transaction struc- ENFORCEABILITY OF CONTRACTS. tures, as well as the involvement of an ever-growing Market participants should ensure that due dili- number of national legal systems, requires reempha- gence procedures examine contract enforceabil- sis of this fundamental consideration. In fact, mar- ity, including basic formation and validity, as well gining and other collateralization, closeout netting, as power and authority to contract. Where sig- and essentially all other considerations addressed in nificant uncertainty exists about the reliability of this report are without significance unless the funda- the legal system of relevant jurisdictions, steps mentals of legal recognition are assured. should be taken where possible to ensure that In considering how to address these risks, it must such laws do not govern the transactions and be noted that there are many jurisdictions in which that enforcement in such jurisdictions will not legal opinions on fundamental issues have not been be required. Collateral posted and held outside obtained, even regarding standard agreements. The such jurisdictions and letters of credit essentially issues of concern fall into four categories. removing all reliance on enforcement ability in the questionable jurisdiction should be consid- Formation and validity of contract ered. Industry groups should enunciate stan- The law of the jurisdiction or jurisdictions that gov- dards of diligence and, together with appropri- erns the contract must respect and enforce agree- ate regulators, identify deficiencies in law that ments accomplished and evidenced in the manner could potentially impair contract enforceability, utilized by the parties. Typically it is anticipated that such as those related to gambling and other pub- oral and electronic agreements will be binding and lic policy areas. Industry groups should also pro- that confirmations evidencing the terms will be con- pose legislative changes to protect transactions clusive, absent manifest error. However, the issue of between commercial entities. the binding nature of such agreements and the method of proof, while having been addressed in COMPARISON WITH CPSS-IOSCO certain key jurisdictions such as New York, has not RECOMMENDATIONS been the subject of comprehensive evaluation and, This recommendation builds upon aspects of CPSS- where appropriate, legislation. The laws of many ju- IOSCO Recommendation 1 (legal framework), which risdictions, even if not the laws purportedly govern- sets out the need for securities settlement systems to ing the contract, may have bearing on validity and have a well-founded, clear, and transparent legal ba- enforcement, particularly in the context of a multi- sis. G30 Recommendation 14 identifies specific is- jurisdictional bankruptcy or similar event. sues in connection with legal enforceability and sets out mitigating measures that should be taken where Issues of power and authority The principles of power and authority have often legal uncertainty exists. been considered. The commitment of both public

109 Global Clearing and Settlement: A Plan of Action

and private entities to enter into contracts requires understanding of legal rights under relevant legal ju- statutory empowerment and formalities that vary by risdictions. The surest ways to control legal risks is to jurisdiction and type of entity. In many cases, authority adopt a high standard of due diligence and to ensure, must be traced to the underlying legal powers of the where possible, that deficient laws do not govern organization, the approval of the governing board, transactions and that enforcement in such jurisdic- the delegated authority of the individual expressing tions will not be required. Such steps could include the commitment of the entity and, in some cases, the posting and holding collateral outside such jurisdic- precise formality of execution of documentation. tions and use of letters of credit that essentially re- Understanding the applicability of the doctrine of move all reliance on enforcement ability in the ques- apparent authority, the control exercised by tionable jurisdiction. counterparties over their own employees, in the rel- Formulation of minimum due diligence standards evant jurisdiction can have far-reaching implications in various legal areas by industry groups would pro- for each party to a transaction. vide a firm basis for risk assessment and management by market participants. Identifying changes in law Issues of public policy necessary to remove legal uncertainties and recom- Assuming valid formation and proper exercise of mending them to governments and legislatures would, power and authority, enforceability generally depends to the extent they are implemented over time, pro- on whether aspects of the agreement violate law or vide the ultimate resolution of the problem. Even in public policy and on the effect of the violation in the that event, however, the need to understand and man- relevant jurisdiction. While violation of law is to be age legal risks would remain an essential element of avoided in any event, it may or may not affect con- risk management and control. tract enforceability. And even if lawful in the jurisdiction whose laws govern the contract, offense to WHAT NEEDS TO CHANGE public policy in the jurisdiction in which enforcement Market participants should ensure that their due dili- is sought may affect enforceability. The typical ex- gence procedures examine issues of contract legality ample is the gambling laws of a jurisdiction. and enforceability in sufficient detail to assess fully the complex of issues involved in multi-party cross-bor- Integrity and transparency of the legal system der transactions. This must include a clear understand- Regardless of the theoretical validity and enforceabil- ing of legal rights under all relevant legal jurisdictions. ity of a contractual obligation, access to and the reli- To support these efforts, industry groups should ability and transparency of the legal system that may formulate standards of minimum diligence, identify be called on to enforce the contractual obligation it- sound legal principles that would minimize legal risk, self or the judgment of another jurisdiction may be and recommend changes in national laws that fall an additional risk to be addressed. These factors may short of these sound principles. Beyond strict legal also be affected by the stress to the economy repre- principles, concerns over the reliability of legal sys- sented by the circumstances under which the con- tems of relevant jurisdictions should also be enunci- tractual obligation is sought to be enforced, the na- ated in the interest of promoting reform. tionality of the parties involved in the litigation, and the possibility of corruption, among other matters. Formation and validity of contract Industry groups should formulate standards of mini- HOW RECOMMENDATION 14 mum diligence regarding conclusions about contract ADDRESSES THE ISSUE enforceability. With respect to purely domestic trans- Addressing legal risks effectively requires due dili- actions, where the legal system is well understood, gence of legal matters in sufficient detail to fully as- conclusions may be based on a thorough understand- sess the complex of issues involved, as well as a clear ing of the legislative and case law affecting the issues.

110 Recommendation 15

These conclusions will, of necessity, be subject to awareness of these issues and encourage the use of varying levels of uncertainty, but nonetheless, reason- enforceable collateralization outside of such jurisdic- able levels of comfort should be obtainable. The com- tions so as to avoid the necessity of resort to courts plexity of legal opinions relating to the subject mat- in such jurisdictions for purposes of enforcement. ter should also be addressed. Legislation ensure the validity of oral and electronic agreement and dealing RECOMMENDATION 15. ADVANCE LEGAL CERTAINTY OVER RIGHTS with issues of proof should be formulated and pur- TO SECURITIES, CASH, OR COLLATERAL. sued if it has not already been enacted. Market participants must be able to determine, with certainty and reasonable cost and effort, what Issues of power and authority law defines and governs their rights to securities, Industry groups should recommend minimum dili- cash, or collateral in a clearing and settlement sys- gence standards regarding confirmation of authority tem or other intermediary, what those rights are, for each type of transaction and for particular types and how to perfect and enforce them. The appli- of counterparties. This may include schedules for cable rules of law should be automatically effec- standard-form agreements recognizing differing stantive, to the extent possible, and should afford the dards applicable to certain types of counterparties. parties to the transaction ex ante certainty and The issue of apparent authority should also be con- predictability for the largest number of transac- sidered since applicable legal principles may affect tions possible. To the extent possible, clearance contract enforceability in ways not fully appreciated. and settlement systems and other intermediaries Where principles of apparent authority do not apply, should describe to their participants or custom- appropriate legislative changes to implement them ers the relevant choice of law rules in their home should be proposed. In jurisdictions where the doc- countries as they relate to what law governs the trine does apply, legal considerations that could un- effectiveness of transfers and pledges of securi- dermine its application should be identified and leg- ties held through an account with an intermedi- islative changes proposed. ary. Specifically, the following is recommended:

Issues of public policy ½ Choice-of-law rules. Financial supervisors and Industry groups and appropriate regulators should legislators should ensure that the Hague Con- review issues of public policy concern that could vention on the Law Applicable to Certain impair contract enforceability, such as gambling stat- Rights in Respect of Securities Held with an utes that have sometimes restricted the use of cer- Intermediary, adopted on December 13, 2002, tain types of financial contracts, and propose legisla- is signed and ratified by their respective nations tive changes to protect transactions between com- as soon as is reasonably possible. The Hague mercial entities. Convention, once ratified by all relevant nations, will ensure that there will be a clear and Integrity and transparency of the legal system certain answer to the question in an interna- The issue of integrity and transparency of the legal tional setting as to which law governs in deter- system must be considered as it applies to cross-bor- mining whether a collateral taker has received der transactions, particularly those involving a perfected interest in pledged securities. counterparties in nations experiencing political or ½ Protection against intermediary insolvency severe economic instability. This is true regardless of risk. Financial supervisors and central banks the law apparently governing the contract if ultimate should confirm that the rights of a person enforcement is dependent on the application of im- holding securities through an account with an partial legal principles by a court in a jurisdiction un- intermediary in their jurisdiction are senior to der stress. Industry groups should seek to heighten

111 Global Clearing and Settlement: A Plan of Action

the claims of the intermediary’s creditors to ISSUE such securities, except where the intermedi- Most existing choice-of-law rules (private international ary affirmatively grants such creditors control law) do not allow market participants to determine, in over such securities. If the financial supervi- advance of any action, with sufficient certainty and only sor or central bank is unable to provide such reasonable effort, what substantive local law governs confirmation, it should take all appropriate their rights to securities, cash, or collateral in a cross- action to ensure that its local commercial and border transaction involving a clearing and settlement bankruptcy laws are interpreted or amended system or other intermediary. Even when they do, the to achieve such a result. governing substantive local law may not allow market ½ Pledging and realization procedures. Finan- participants to determine in advance with sufficient cial supervisors, central banks, and legislators certainty and reasonable effort what those rights are should encourage collateral transactions by or how to enforce them, provide practical answers to simplifying any legal procedures that impose those questions, or facilitate risk reduction. Local laws conditions on the effectiveness of pledging are also far from harmonized in this area. arrangements or govern the fairness of real- The problem has arisen because modern devel- izing on collateral. opments in systems for holding cash and securities, ½ Finality. The boards of central securities de- and the cross-border nature of an increasing volume positories should specify in plain language the of transactions, have not been matched by develop- moment when a transfer or pledge of securi- ments in the underlying legal infrastructure. To in- ties becomes “final” (that is, irrevocable and crease the efficiency of both local and cross-border unconditional) in its rules or binding contracts transfers and collateral transactions, the vast quantity with its account holders. Financial supervisors of securities and cash is now held, transferred, and and central banks should require this specifi- pledged by entries to accounts with clearing and settle- cation from each central securities depository ment systems and other intermediaries, rather than subject to their jurisdiction. directly in physical form or directly by issuers. Un- fortunately, most choice-of-law rules and local sub- COMPARISON WITH CPSS-IOSCO stantive law continue to reflect assumptions of a by- RECOMMENDATIONS gone era when securities and cash were held, trans- This recommendation develops aspects of CPSS- ferred, and pledged by physical delivery or directly IOSCCO Recommendations 1 (legal framework), by issuers and mainly in purely domestic transactions. which sets out the need for securities settlement sys- In fact, most local laws in this area have not changed tems to have a well-founded, clear, and transparent le- fundamentally since Roman times. This has created a gal basis; and Recommendation 12 (protection of con- classic gap between law and practice—a gap that fos- sumers’ securities), which sets out the need for entities ters legal uncertainty and undermines the soundness holding customers’ securities to protect those assets of the legal infrastructure underlying the modern through appropriate safeguarding procedures. G30 cash- and securities-holding system. The current le- Recommendation 15 builds upon these sound prin- gal infrastructure can be likened to a rusting bridge ciples to identify specific issues in connection with le- that needs to be strengthened or replaced before it gal certainty over rights to securities, cash, or collat- collapses under the stress of modern activity. eral, together with how these issues should be resolved Many other organizations, including the Basel and/or the appropriate measures to be put in place to Committee on Banking Supervision and IOSCO, have mitigate risk where such legal uncertainty exists. recognized that the modern cash- and securities-holding system needs to have a sound legal framework,

112 Recommendation 15

but they have not defined the standards that should a person holding securities through an interme- characterize such a framework nor made specific rec- diary are generally senior to the claims to such ommendations for bringing local laws into line with securities by the intermediary’s creditors. commercial practices. ½ Pledging and realization procedures. Local laws that condition the effectiveness of HOW RECOMMENDATION 15 pledging arrangements or govern the fairness ADDRESSES THE ISSUE of realizing on collateral should be simplified to This recommendation aims to ensure that the legal facilitate and encourage risk reduction by infrastructure underlying the cash- and securities- reducing the cost of collateral transactions. holding system allows market participants to determine ½ Finality. Each clearing and settlement system in advance of any action, with certainty, and with only should specify in plain and simple language the reasonable effort, what local substantive law governs moment when a transfer or pledge of securities their rights to securities, cash, or collateral in a clearing becomes final in its rules or binding contracts and settlement system or other intermediary, what with its account holders, and this specification those rights are, and how to enforce them. The rec- should be required by financial regulators and ommendation requests action by a broad range of embodied in local law. market participants including financial supervisors, central banks, intermediaries, end users, financial trade WHAT NEEDS TO CHANGE associations, and legislators. There are few circum- The fundamental requirement is to modernize na- stances where action by intermediaries and end users tional and local laws to bring them into line with alone could achieve this result, but in a number of ar- modern commercial practices, as indicated in the rec- eas, determinations by the boards of clearing and settle- ommendations set forth above. This is a matter of ment entities, financial supervisors, and central banks urgency, but there is strong tendency to ignore even could be effective. In still other cases, and ultimately well-known defects in the legal infrastructure until for the system as a whole, national laws should be har- after a financial crisis occurs. Nevertheless, because monized consistent with these objectives and, as a the legal system underpins the entire clearing and matter of priority, existing choice-of-law rules and na- settlement framework that this report urges should tional and other local substantive law should be mod- be reformed, legal reform cannot be left for later, not ernized as follows: least because legal reform is often a difficult and slow- moving enterprise. ½ Choice-of-law rules. For securities held through A broad range of clearing and settlement organi- accounts with an intermediary, the law of the zations; market participants including banks, brokers, place of the relevant intermediary (commonly and other intermediaries; industry groups; banking referred to as PRIMA) should determine the and securities supervisors and their international bod- legal nature of the rights arising out of a credit ies; central banks; and national and international bar of securities or cash to such accounts; the steps associations will have to provide persistent support required for a transfer or pledge of securities or for reforms, taking such opportunities as arise to of- cash credited to such accounts to be enforce- fer organized support. able among the parties (including the intermedi- One area of recommendation for which united ary) and senior to the rights of third parties; support can be offered is choice of laws. National and the steps required to realize a pledge of authorities should be encouraged by all interested securities or cash credited to such accounts. parties to sign and ratify the just-adopted Hague Con- ½ Protection against intermediary insolvency vention as soon as is reasonably possible. It is of risk. Local law should ensure that the rights of course critical to its effectiveness that the Hague Con-

113 Global Clearing and Settlement: A Plan of Action

vention be ratified as quickly as possible in as many COMPARISON WITH CPSS-IOSCO nations as possible. RECOMMENDATIONS As part of the monitoring of performance that will This recommendation builds upon aspects of CPSS- follow this report, national choice-of-law rules and IOSCO Recommendation 1 (legal framework), which applicable substantive law should be monitored and sets out the need for securities settlement systems to the extent to which they conform to the specific rec- have a well-founded, clear, and transparent legal basis. ommendations set forth above should be specified. G30 Recommendation 16 highlights the measures that Banking and securities supervisors should consider need to be taken to mitigate legal risk in connection recognition of sound legal frameworks by calibrat- with closeout netting and valuation arrangements. ing capital treatment of collateral transactions and other risk mitigation measures based on the sound- ISSUE ness of the underlying legal framework. Financial agreements, particularly master agreements for derivatives transactions, contain provisions autho- RECOMMENDATION 16. RECOGNIZE AND SUPPORT IMPROVED rizing the closeout or early termination of outstand- VALUATION METHODOLOGIES AND CLOSEOUT NETTING ing transactions under specified circumstances, includ- ARRANGEMENTS. ing payment or delivery defaults or insolvency. In these Market participants should ensure that all master circumstances, valuation and netting questions become agreements provide that upon the early termina- important to the speedy and accurate resolution of tion of a transaction or group of transactions, claims, and language giving effect to flexible valuation the determining party will have the flexibility to methods and closeout netting should be part of all value such transactions by the method that is most contract documentation and master agreements and likely to produce a commercially reasonable valu- should enjoy the full force of law. ation at the time of termination. Master agree- Valuation is an important step in closeout netting, ments also should provide that in any exercise of but it is also important in a wider range of financial such discretion, the determining party should be events. A broad array of master agreements is in use guided by principles of good faith and commer- today and many of them require that the value of ter- cial reasonableness. minated transactions be determined by reference to market quotations obtained for the elements of the Market participants should include closeout net- transactions at the time of their termination. Experi- ting provisions in their contract documentation. ence with these market quotation–based valuation Trade associations and other industry bodies methodologies has shown that they generally work well should work together to harmonize information for transactions for which there are with liquid mar- on the effectiveness of netting and disseminate it kets that are functioning in a normal manner. widely and in accessible form. Questions arise concerning the use of closeout valu- Relevant authorities in each jurisdiction should ations that are based on market quotations obtained from ensure that their laws give effect to closeout net- markets that are illiquid, irregular, or nontransparent. ting for all central counterparties, brokers, end us- Questions also arise in cases where quotations cannot ers, and other market participants, and for all en- be obtained and where quotations are obtained but a tity, transaction, and asset types. Market partici- clear determination cannot be made as to whether they pants and other interested bodies should encour- produce a commercially reasonable result. In closeout age legislative reform in those jurisdictions where netting, the real problem with unclear valuations is that laws do not meet this standard. the determining party does not know with any certainty whether the right amounts are being set off. A court or

114 Recommendation 16

trustee may amend the closeout value at some later date diction of the law governing the netting agreement and effect a potentially significant change to the netted and related transactions, and the jurisdiction of amount. In addition, some master agreements require branches through which the parties are transacting. that a closeout value be calculated for each transaction Accordingly, much hinges on the effectiveness of that is being terminated. Experience, however, has shown closeout netting and that effectiveness must extend that, in some circumstances, it can be much more effi- to a range of jurisdictions. cient to determine closeout valuations for groups of ter- The closeout netting process comprises four minated transactions, rather than individual terminated stages: closeout (or termination) of transactions; valu- transactions. ation of the terminated transactions in the underly- Closeout netting is typically triggered in case of ing currency of the transactions; conversion of ter- closeout or early termination.10 Effective closeout mination values into a single base currency; and net- netting is an important counterparty risk management ting (or set off) of the individual values to produce a technique because it ensures that if a counterparty single amount payable by one party to the other. fails, the innocent party is required to pay (or receive) Closeout netting will occur either automatically or only the net sum owing. This is important for all par- upon notice from one party to the other, as previ- ticipants in the markets, whether they are central ously agreed by the parties. In some jurisdictions counterparties, brokers, or end users, and is even pro- where there are doubts as to whether closeout net- tection against systemic risk. For closeout netting to ting will be upheld by a local liquidator, the likelihood be effective, methods available for valuation of af- of closeout netting being effective may be increased fected transactions must be effective and expeditious. through automatic termination of transactions at a In fact, valuation is a critical issue in case of any early time prior to the appointment of the liquidator. termination of outstanding transactions. In the first instance, closeout netting is a technique The effectiveness of credit support techniques may generally employed in the derivatives markets, be- depend on the effectiveness of closeout netting, par- tween two parties to an over-the-counter derivatives ticularly if the underlying collateral is provided by transaction or, in the case of exchange-traded deriva- means of outright transfer. Closeout netting itself is tives, between brokers and their customers or clear- often used in conjunction with other risk manage- ing brokers and a central counterparty. In addition, ment techniques, such as the provision of credit sup- the technique is commonly used between parties in port in relation to the net exposure resulting from the foreign exchange and repo markets and in the the application of closeout netting. Through capital interbank deposit markets. Participants in other mar- rules promulgated by the CPSS, regulatory capital kets have similar interests in reducing counterparty benefits accrue from adopting netting, provided that risk, and the principles of closeout netting can be the netting schemes have “a well-founded legal basis applied equally within these other markets and, in- under all relevant jurisdictions.” Thus closeout net- deed, across all of these markets. ting must be effective under the laws of the jurisdic- The benefits of closeout netting are particularly tion in which the counterparty is organized, the juris- obvious in transactions that include a lengthy period

10. Closeout netting is to be distinguished from other netting techniques. Payment (or settlement) netting is a technique allowing parties to settle payment obligations to each other that are payable on the same date, by netting amounts payable in the same currency. Payment netting may apply across all transactions between the parties, or it can be limited to transactions of the same type or even to payments within a single transaction. The obligations remain as gross payment obligations until the time of settlement. Netting by novation is a technique that also allows netting of payments in the same currency that are due on the same date. It differs from payment netting in that the conversion of gross obligations to net obligations occurs when each new transaction is entered into, rather than at the settlement date. Neither technique provides the protections offered by closeout netting, which is intended to apply to all transactions subject to the relevant netting agreement, regardless of when payment or delivery is due and regardless of the currency of the transaction. Although closeout netting does not mitigate settlement risk (which payment netting and novation netting both do), it can be combined with payment netting to gain the combined benefits of both netting techniques.

115 Global Clearing and Settlement: A Plan of Action

between contracting and settlement, and a corre- or other transactions depriving the estate of sponding lengthy period of exposure to the assets). Insolvency laws may specifically affect counterparty. In certain markets (such as the cash the ability of the parties to terminate transac- equities market) where settlement periods are short, tions before the stated maturity date or to net the shorter window of possible counterparty default the resulting termination amounts. Alternatively, has traditionally meant that the benefits of closeout mandatory insolvency rules of a particular netting have been less obvious. Entities that partici- jurisdiction may require a particular valuation pate in more than one market are, however, increas- methodology or require calculations and ingly seeking to implement cross-product (or cross- payments to be made in a particular currency, market) netting agreements (“master netting agree- which differs from that agreed between the ments”), pursuant to which counterparty exposures parties, thereby affecting the net result. arising from a range of transactions (cash market as ½ Entity types. Certain entity types may be subject well as derivatives, for example) will be reduced. Such to special insolvency procedures, which master netting agreements, if effective, allow override netting arrangements and produce a counterparties to calculate exposure on a net basis different net result. across products and also to calculate their credit lim- ½ Contracting parties. Closeout netting is generally its and margin requirements on the basis of the re- not enforceable where there is no mutuality of sulting net figure. obligations (for example, between two affiliates Although acceptance of netting is becoming in- and their mutual counterparty). In addition, the creasingly widespread, a number of uncertainties still application of closeout netting becomes com- exist. The nature of the uncertainty varies from ju- plex in arrangements involving agents acting for risdiction to jurisdiction and may render closeout net- underlying principals, especially where the ting either partially or entirely ineffective: identity of the principal is not disclosed, either at all or until after the transaction has been entered ½ Mandatory insolvency rules. Closeout netting into. Furthermore, netting legislation may be may offend principles of local insolvency law confined to circumstances in which both parties for several reasons, including the following. It are of a particular type (see, for example, the may be regarded as a means of preferring one United States Federal Deposit Insurance creditor over another, in breach of principles of Corporation Improvement Act). equal treatment of creditors; set-off allows the ½ Cross-border issues. Netting may be effective in nondefaulting party to “receive” the benefit of some jurisdictions but not in others, where the one hundred cents in the dollar for each dollar parties are transacting. A liquidator in a jurisdic- that it owes to the defaulting party. Alternatively tion that does not recognize closeout netting a liquidator may be able to “cherry pick” certain may seek to undermine the global effectiveness transactions that would otherwise be subject to of closeout netting by suing for amounts owed netting by disclaiming onerous property between a party’s offices in different jurisdic- (including transactions that are loss-making for tions or requiring specific performance of the insolvent estate) and forcing performance transactions that are profitable to the estate. of contracts that are profitable to the insolvent Alternatively, an insolvency representative in a estate. A liquidator may additionally be able to particular jurisdiction may “ringfence” the challenge arrangements entered into within a assets of the insolvent estate in order to certain period before the onset of insolvency maximize the benefit to local creditors. Recent (for example, as unlawful preferences, transac- European Union legislation has promoted tions at an undervalue, fraudulent conveyances, certainty in this area (see the discussion in

116 Recommendation 16

footnote12 on insolvency proceedings) but ties in all jurisdictions are charged with ensuring that more extensive global initiatives are required. their laws give effect to closeout netting for all mar- ½ Central counterparties. To date, the rules of ket participants (central counterparties, brokers, end some central counterparties contemplate the users, and other market participants) and for all en- default of the clearing broker but do not tity, transaction, and asset types. Market participants provide any mechanism to deal with the default and other interested parties are directed to encour- of the central counterparty itself. Clearly this age legislative reform in those jurisdictions where laws should be of concern to clearing brokers who do not meet this standard. have an exposure to the central counterparty. Further analysis is required regarding the effect WHAT NEEDS TO CHANGE of the potential insolvency of the central First, uncertainties surrounding valuation must be counterparty. addressed. Closeout valuation methodologies should ½ Variable application of netting laws. The give the determining party discretion to select the approach to closeout netting varies between valuation method that is best suited to the market for jurisdictions. In some jurisdictions closeout the relevant transaction at the time of its termination netting is mandatory in bankruptcy, while in and should require the determining party to act in others it is prohibited. Where general bank- good faith and in a commercially reasonable manner ruptcy law may otherwise prohibit closeout in exercising such discretion. In pursuit of such meth- netting, exceptions to the general rule have odologies, the following actions should be taken by been implemented (largely influenced by the relevant industry associations: Basel capital proposals) but are limited to the particular market circumstances prevailing in ½ Associations that issue and maintain master each jurisdiction. In particular, closeout netting agreements should promptly review their legislation, if it has been enacted, does not provisions for conformity with this standard always cover all entity types or all transaction and conform them as necessary. and asset types. ½ Associations that issue and maintain master netting agreements that provide closeout HOW RECOMMENDATION 16 valuation methodologies for use with all ADDRESSES THE ISSUE transactions underlying the master netting In the first instance, the recommendation focuses on agreement, or for use only with underlying strengthening contract documentation and master transactions that lack such methodologies, agreements within the control of industry. Market should compare their closeout valuation participants are charged with including closeout net- methodologies to the foregoing standards and ting provisions in their contract documentation. Trade make any necessary changes. associations and other industry bodies are charged ½ Where amendments to an agreement are issued with harmonizing information on the effectiveness in the form of a new version of the agreement, of netting and disseminating it widely and in acces- the relevant industry association should also sible form. issue a “stand-alone” version of the amend- Market participants are further charged with ensur- ment for use with previous versions of the ing that master agreements provide the determining relevant agreements. party the flexibility to value such transaction or trans- ½ Relevant associations should educate the users actions by reference to the valuation method that best and potential users of agreements about the suits the relevant market conditions for such transac- benefits of using closeout valuation methodolo- tion or transactions at the time of termination. gies that meet the recommended standards. Then there is a legal reform component as authori-

117 Global Clearing and Settlement: A Plan of Action

To give full effect to the recommendation on close- ½ Central counterparties should publish a out netting: statement of the legal effectiveness of the closeout netting provisions of their rules. ½ The legal or contractual framework for all central ½ In the interest of harmonizing information counterparties should include provisions regarding the effectiveness of netting and enabling closeout netting in the event of their or making it widely and easily available to partici- a contracting participant’s insolvency. Local pants, trade associations and other appropriate legislatures should implement any legislative industry bodies should pursue cooperative changes required to effect this recommendation. efforts, possibly including a register of jurisdic- ½ Use of closeout netting provisions in contracts tions, showing the extent to which closeout by all parties to financial transactions, including netting is effective for different types of central counterparties, and use of master entities, transactions, and assets. netting agreements are already widespread but ½ In the interest of promoting legal certainty, should be implemented wherever appropriate. initiatives that have been undertaken by various ½ Because the legal basis for netting is problematic industry bodies (notably the International in many jurisdictions, including the United States, Swaps and Derivatives Association, the UK legislation should be adopted to ensure the full Futures and Options Association, the Bond effectiveness of closeout netting; supervisors and Market Association, and the British Bankers central banks should support netting for banks Association) to obtain opinions from counsel through regulatory determinations; and national regarding netting in a wide range of jurisdic- authorities should pursue global enforceability tions should be extended to new jurisdictions, through an international closeout netting entities, transactions, and asset types and should convention or other means, as appropriate. 11 be coordinated among industry bodies and ½ Further global harmonization of cross-border participants in order to centralize efforts and bankruptcy legislation is needed, following minimize the costs of these initiatives. upon recent European Union initiatives that ½ Appropriate industry or official bodies should have resolved a number of uncertainties undertake a study of central counterparty relating to cross-border aspects of closeout insolvency and the insolvency of clearing netting for entities located within the EU. 12 systems through which transactions are settled. ½ To encourage adoption of the proposed language To increase the availability of information to market and supportive legislation and judicial approaches, participants: international databases should be maintained and regularly updated. These databases should list

11. The International Swaps and Derivatives Association Inc. (ISDA) has already made legislative proposals (for example, the 1996 Model Netting Act and the proposed 2002 Model Netting Act). The proposed language includes an extensive definition of “qualified financial contracts,” which includes commodity contracts, repurchase agreements, and securities transactions. The proposed act limits the powers of liquidators and any insolvency laws prohibiting set-off. 12. Council Directive 2001/24 on the reorganization and winding up of credit institutions entered into force on May 5, 2001, although EU member states must approve implementing legislation before it becomes effective in those member states. This directive specifies that upon the insolvency of a party to a netting agreement, the only applicable law in relation to that netting agreement is the law of the contract, irrespective of where the insolvency proceedings are being held. Council Regulation 1346/2000 on insolvency proceedings, which applies primarily to corporations and individuals, took effect in all EU member states (other than Denmark) on May 31, 2002. This regulation is directly effective and therefore requires no further implementing legislation. It provides that insolvency proceedings may be opened in the EU member state where the debtor has the center of his main interests. Although it does not deal expressly with netting, the regulation specifically states that insolvency proceedings shall not affect the rights of creditors to demand the set-off of their claims against the claims of the debtor.

118 Recommendation 17

master agreements and relevant master netting stitutions, the users of the services the institutions agreements that contain closeout valuation provide, and other important stakeholders, including methodologies that meet the requirements of the public authorities. Addressing these challenges and recommendation and those that do not. They meeting the needs of the varied stakeholders requires should also report judicial and legislative develop- board members to have an appropriate level of sen- ments relating to closeout valuation methodolo- iority and a broad range of capabilities to exercise gies, that would be widely publicized and open for sound judgments over often opaque and occasion- use by all interested persons. ally intractable problems. Many strategic decisions require evaluation and weighing of difficult trade-offs, such as balancing the IMPROVING GOVERNANCE desire to achieve short-term cost savings with the need to invest to achieve innovation and greater savings in RECOMMENDATION 17. ENSURE APPOINTMENT OF APPROPRIATELY the long term, or maintaining a proper balance between EXPERIENCED AND SENIOR BOARD MEMBERS. the pursuit of potential cost savings and acceptable con- Members of the boards of securities clearing and straints of safety and risk management. For most such settlement infrastructure providers should, in- decisions, each of the different stakeholder groups will dividually and collectively, be of a weight in have different preferences, further complicating matters. terms of experience and seniority to discharge Moreover, the requirement to oversee the commercial, the enlarged strategic, risk, and operational man- operational, and risk management practices of the or- agement oversight responsibilities described in ganization demands a thorough understanding of the this report. Organizations that are users of such mechanics of the business. In aggregate, these challenges providers or otherwise have input into the ap- go beyond those typically faced by the boards of simi- pointment of board members should be mind- larly sized commercial organizations and underscore the ful of the broad range of capabilities needed to strategic importance of clearing and settlement infra- discharge the diverse, important responsibilities structure to the securities industry as a whole. of such a position. This report focuses on the steps that need to be taken to bring about change that will support safer COMPARISON WITH CPSS-IOSCO and more efficient clearing and settlement and in par- RECOMMENDATIONS ticular bring cross-border costs and risks down to lev- This recommendation builds upon broad principles els closer to those currently associated with domestic articulated in CPSS-IOSCO Recommendation 13 systems. This task represents a greater challenge and (governance), which advocates that the governance a broader mandate than now exists for boards. For arrangements for securities settlement systems should this vision to be realized, the boards of institutions fulfill public interest requirements and promote the active in this area will need directors who can lead objectives of owners and users. G30 Recommenda- and drive such change. tion 17 gives more detailed guidance on the experience and seniority that board members should have HOW RECOMMENDATION 17 to allow them to effectively meet such objectives, ADDRESSES THE ISSUE which place great burden on the capability and judge- Many countries and markets already have well-devel- ment of board members. oped and well-defined governance frameworks and mechanisms for ensuring appropriately qualified and ISSUE competent boards, and this recommendation (and Boards of institutions that form the clearing and indeed other governance-related recommendations) settlement infrastructure face complex challenges and is not intended to replace or override such arrange- demands from many sources: the owners of the in- ments. Rather, it is intended as supplementary guid-

119 Global Clearing and Settlement: A Plan of Action

ance for those organizations that form the infrastruc- COMPARISON WITH CPSS-IOSCO ture for securities clearing and settlement to help them RECOMMENDATIONS address the distinctive and important issues that they This recommendation broadly endorses CPSS- face, as described above. Board members of infra- IOSCO Recommendation 14 (access), which advo- structure providers already have weighty obligations cates that CSDs and CCPs should have objective and to varied stakeholder groups, and these duties are publicly disclosed criteria for participation that per- expanded by the mandate created by this report. To mit fair and open access. G30 Recommendation 18 discharge such responsibilities, it is vital that board seeks to further clarify the acceptable criteria for par- members enjoy sufficient seniority and experience to ticipation, by reference to those designed solely for provide appropriate authority and strategic vision. risk, systemic safety, or public policy objectives. All other criteria are thereby deemed unacceptable be- WHAT NEEDS TO CHANGE cause they inhibit fair access. This recommendation Individuals or organizations that are responsible for ap- also explicitly addresses business practices that ham- pointing, electing, or otherwise influencing the selection per fair access where an effective monopoly exists, of board members of clearing and settlement infrastruc- such as tying in or cross-subsidy of other services. ture providers need to assess carefully the duties associated with such a role and the experience and seniority ISSUE necessary to fulfill these duties and proceed accordingly. Many infrastructure providers operate as effective monopolies within the markets they serve, either be- RECOMMENDATION 18. PROMOTE FAIR ACCESS TO SECURITIES cause they have been granted such status through leg- CLEARING AND SETTLEMENT NETWORKS AND SERVICES. islation or market convention, or because it would not Boards of securities clearing and settlement ser- economically be viable for an alternative organization vice providers, other organizations providing simi- to attempt to compete within the existing market struc- lar services, and public authorities should ensure ture. It is therefore critical that providers that are ef- that rules and other requirements that control or fective monopolies allow access to users on a fair ba- limit access to securities clearing and settlement sis; otherwise some users may be effectively excluded services are accepted only where they are neces- from the market or forced to conduct business through sary and are designed exclusively for the purpose an intermediary that is a direct user of the infrastruc- of controlling financial, operational, reputational, ture provider. In either case, the level of competition or regulatory risks; maintaining the safety of the in the market will be reduced overall, disadvantaging system; or achieving other reasonable public both actual and potential participants in the market and policy objectives. Networks and services should ultimately end-user investors and issuers. For this rea- be accessible to all users that pass risk and safety son, barriers to fair access need to be removed. evaluations and enjoy appropriate financial standing, and users should be free to select the mix of HOW RECOMMENDATION 18 functions and services that they wish to use on ADDRESSES THE ISSUE the basis of straightforward, transparent, and fair The recommendation calls for fair access for all quali- tariff policies grounded on the principle of user fied organizations to use or provide clearing and pays. Such risk-based rules should be broadly settlement services. This is not a call for full, open founded (encompassing the due diligence process access, as restrictions on the grounds of risk, systemic set out in the financial integrity recommendation), safety, or public policy are clearly for the good of and fairly and consistently applied. Moreover, the market participants as a whole and in the wider pub- rules and their application should be transparent lic interest. Rather, the recommendation seeks to to the market. Existing barriers that do not meet clarify the restrictions to access that are acceptable. this test should be removed. In this way all other types of restriction are deemed

120 Recommendation 19

to be unacceptable, a method at the same time sim- policies by relevant competition authorities. In pler and more comprehensive than attempting to either case, the independent directors should be define explicitly every unacceptable restriction. appropriately involved in the audit and remuneration committees. WHAT NEEDS TO CHANGE The most important barriers to fair access need to be COMPARISON WITH CPSS-IOSCO identified and plans put in place to remove them. RECOMMENDATIONS Where unacceptable barriers have been established This recommendation builds upon broad principles through the policies, rules, or operations of providers articulated in CPSS-IOSCO Recommendation 13 of clearing and settlement services, there appears no (governance), which advocates that the governance ar- good reason why they cannot be dismantled immedi- rangements for securities settlement systems should ately. Where the barriers result from legislation or fulfill public interest requirements and promote the ob- regulation, a longer time frame will be needed. The jectives of owners and users, and Recommendation definition of acceptable barriers contained in the rec- 14 (efficiency), which suggests that securities settle- ommendation should be sufficient to ensure that in ment systems should be cost-effective in meeting the removing barriers to fair access, other public policy requirements of users. G30 Recommendation 19 objectives are not inadvertently compromised. How- builds upon these broad principles to give more de- ever, it is recognized that careful attention will be tailed guidance on how the varied stakeholder inter- needed to ensure that this is so and that adverse un- ests should be equitably represented on the boards of intended consequences are avoided. clearing and settlement infrastructure providers.

RECOMMENDATION 19. ENSURE EQUITABLE AND EFFECTIVE ISSUE ATTENTION TO STAKEHOLDER INTERESTS. Efficient and safe operation of clearing and settle- Board participation should represent different ment infrastructure providers is central to the effec- stakeholder interests fairly and equitably. Provi- tive operation of securities markets. Consequently, a sion should be made for regular review of, and variety of stakeholders have a significant and legiti- for changes as necessary in, board composition mate interest in the operation of these institutions. to ensure continuing balanced representation of Important stakeholders include the users of the varying stakeholder groups, including users. institution’s services and bodies that represent the Where a securities clearing and settlement infra- public interest. Issues in connection with public au- structure provider is user-owned, user-sharehold- thorities are addressed primarily through the recom- ers should make certain that arrangements are in mendation aimed at encouraging consistent regula- place to provide equitable and effective represen- tion and supervisory oversight. This recommenda- tation through appropriate by-laws; the appoint- tion focuses on the need for representation of other ment of independent, public interest, or end-user stakeholders, particularly users. investor directors; or other similar measures. Users are not a homogeneous group, and differ- Where such a provider is partly or wholly owned ent sets of users are likely to have different objec- by nonuser shareholders and is also a substan- tives. For example, users whose business is primarily tially monopoly provider of clearing, settlement, focused on domestic markets are less likely to want and related services in a particular market, user to invest in developments aimed at improving the (and other stakeholder) interests can be adequately efficiency and safety of cross-border activity and protected through appropriate user or other in- would instead prefer rebates or tariff reductions. Al- dependent, nonshareholder participation in the ternatively, users who compete with the infrastruc- board. However, these arrangements may have to ture provider for the provision of certain services will be supplemented by oversight of tariff and other have an active interest in restricting the infrastruc-

121 Global Clearing and Settlement: A Plan of Action

ture provider’s development of those services, at a of each institution. Where an institution is user-owned, potential cost to other users who may have benefited the interests of shareholders and users are already likely from the development of the services. to be substantially aligned, and representation of other Fair and equitable representation of these varied important stakeholders such as end-user investors and stakeholder interests on the boards of clearing and issuers and the wider public interest can be achieved settlement infrastructure providers is critical to help through appropriate appointments. Where nonusers ensure that the different interests and needs of dis- have an ownership stake in a private institution, then parate groups are considered and addressed, so that additional, strengthened mechanisms may be needed strategy and allocation of resources is appropriate and to ensure users have appropriate representation. This does not act to distort market dynamics or prevent is vital where users have no or very limited choice of effective competition. In addition, the appointment institutions from whom they can procure services, and of directors fully independent of management pro- in such circumstances competition authorities or vides an important level of challenge and oversight equivalent public bodies may need to oversee policies and is particularly important in the context of issues and operational practices pertaining, for example, to connected to audit and remuneration. tariffs or bundling of services.

HOW RECOMMENDATION 19 RECOMMENDATION 20. ENCOURAGE CONSISTENT REGULATION ADDRESSES THE ISSUE AND OVERSIGHT OF SECURITIES CLEARING AND SETTLEMENT Fair and equitable representation of stakeholder in- SERVICE PROVIDERS. terests on the boards of clearing and settlement in- Providers of securities clearing and settlement ser- frastructure providers will help to ensure that the vices should be subject to consistent and transpar- needs of varied stakeholder groups are properly un- ent regulation and oversight, which should focus derstood and considered in making key decisions and on the activities undertaken and risks incurred. formulating strategy. Although it is unrealistic to ex- Standards of regulation and oversight of cross- pect a strategy that fully meets the wishes of a di- border activity should be complementary and con- verse set of stakeholders, through proper stakeholder sistently applied across all relevant jurisdictions. As representation a strategy that fairly reflects the as- a long-term goal and where coherent with other sorted expectations can be determined. public policy objectives, regulatory and oversight The recommendation recognizes that the compo- standards should be harmonized. While public sition and relative importance of different stakehold- authorities have developed minimum standards for ers will change over time and therefore calls explicitly many aspects of clearing and settlement services, for private institutions to have a mechanism to review notably as embodied in the CPSS-IOSCO recom- and, where appropriate, change board composition. mendations, the oversight and supervision applied This helps to overcome the potential concern that in to providers of clearing and settlement services var- catering solely to the interests of stakeholders at any ies across jurisdictions. In addition, organizations point in time, the infrastructure provider could increase undertaking similar activities can be subject to dif- the resistance to changing participation in the market ferent regulatory regimes and standards based upon as a whole, for example by following policies that acted their status, such as whether or not they are a bank. to prevent new entrants. This issue is also addressed in Supervisory, prudential, and oversight standards part through the recommendations on fair access and should recognize the systemic importance of pro- consistent regulation and oversight. viders of clearing and settlement services with a view to minimizing the risk of default or opera- WHAT NEEDS TO CHANGE tional failure of critical organizations. As noted The issue of stakeholder representation needs to be in Recommendation 9, aimed at ensuring consis- considered in the context of the ownership structure tent financial integrity of service providers, con-

122 Recommendation 20

sistent supervision is necessary to create uniform overseers—certainly in most developed markets— risk standards and ensure consistent minimum fi- and the 2001 CPSS-IOSCO Recommendations for nancial and liquidity requirements. But consistent Securities Settlement Systems set out minimum stan- supervision is also important to help create a level dards that operators of such systems should follow. playing field between competing organizations. However, differences in the regulation and oversight of clearing and settlement activities remain, because Regulatory and oversight standards that affect cross- of differences in regulatory regimes between juris- border activity must be undertaken consistently and dictions and because of differences in the status of transparently across all relevant countries. providers of clearing and settlement services. For example, several of the services offered by CSDs and COMPARISON WITH CPSS-IOSCO RECOMMENDATIONS ICSDs are similar to, and in some cases compete with, This recommendation recognizes that the bodies re- services offered by global custodian banks, but the sponsible for supervising clearing and settlement ser- differing nature of these organizations may mean that vice providers vary between jurisdictions and often they are subject to a different regulatory approach. include separate oversight and regulatory authorities. All institutions providing critical clearing and settle- CPSS-IOSCO defines oversight as a “public policy ment functions must be subject to rigorous and ap- activity principally intended to promote the safety and propriate supervision. efficiency of payment and securities settlement sys- The need for consistent regulation and oversight tems and in particular to reduce systemic risk,” of clearing and settlement service providers is even whereas regulation typically focuses more on day-to- more apparent in the context of cross-border activity, day supervision and the setting and enforcing of pru- where service providers are connected and interdepen- dential standards. G30 Recommendation 20 endorses dent. If there are weaknesses in the procedures or sys- and builds upon CPSS-IOSCO Recommendation 18 tems at one provider of clearing and settlement ser- (regulation and oversight), which calls for all securi- vices, then there is potential for risks introduced at that ties settlement systems to be subject to regulation and point to extend through to connected organizations. oversight, for regulatory responsibilities and objectives Although service providers carry the primary respon- to be clearly defined and made transparent, and for sibility for preventing contagion through robust and cooperation between different regulatory and super- consistent due diligence and risk management prac- visory bodies. G30 Recommendation 20 expands upon tices, regulation and oversight provides a vital further the CPSS-IOSCO work to explicitly advocate build- layer of protection and must be consistent to be fully ing upon cooperation between regulators and overseers effective. In addition, any inconsistencies in regulation to achieve consistent regulation and oversight across and oversight between jurisdictions traversed by a cross- jurisdictions, in particular for cross-border activity. In border trade may lead to ambiguity about which stan- addition, this recommendation encourages supervisory dards should apply and therefore to a greater risk of and regulatory assessments based on the functions and noncompliance. The cost to firms of complying with activities that supervised or regulated institutions un- regulatory standards also needs to be considered: where dertake, so that similar operations are subject to simi- such standards vary between regimes, the cost of com- lar oversight irrespective of their status. pliance for internationally active firms is necessarily higher, as different standards create the need for du-

ISSUE plication in the understanding and application of rel- In a purely domestic context, the existing arrange- evant policies and rules. Variations in regulation and ments for regulation and oversight of securities clear- oversight can also affect the ability to move toward ing and settlement are generally sound. In addition, full interoperability, because the regulatory and over- there is cooperation between different regulators and sight framework in some instances drives market conventions and practices.

123 Global Clearing and Settlement: A Plan of Action

It is clearly correct that regulation and oversight dress many of the issues set out above, but harmoni- authorities should consider the systemic importance zation of regulation and oversight among jurisdictions of organizations, and so the regime imposed could could present even greater potential benefits. In par- properly vary depending, for example, on market ticular, it would reduce the costs of compliance for share or the degree to which alternative service pro- internationally active firms, the benefits of which, as viders are available and on risks involved. However, with other efficiency opportunities identified elsewhere two organizations that provide similar services and in this report, are likely to flow through in large part to attract similar risks in similar markets should be sub- end-user investors and issuers. ject to consistent regulation and oversight. Variation in regulation and oversight approaches can affect the WHAT NEEDS TO CHANGE risk management and financial and liquidity require- Ensuring consistent approaches to regulation and ments of supervised organizations, which can in turn oversight is a significant challenge, and differing public affect the competitive positions of those organiza- policy priorities and concerns of individual jurisdictions, as well as the overall safety of connected sys- tions must be recognized. The challenges in identify- tems. Creating a competitive playing field is a crucial ing and moving to an approach that takes appropri- part of realizing efficiencies and encouraging inno- ate account of the activities undertaken and the risks vation among service providers, as expanded upon incurred should not be underestimated, and the de- in the recommendation advocating fair access. tailed planning for such a change will need to be carefully considered to avoid unintended consequences HOW RECOMMENDATION 20 and unhelpful inflexibility. In particular, formulating ADDRESSES THE ISSUE accurate and workable definitions of activities will be Consistent and transparent regulation and oversight critical, as will the linking of these activities to asso- across jurisdictions reflecting the activities undertaken ciated risks and understanding of the interrelation- (rather than the legal form of the organization) should ships between different activities and risks. help ensure that each organization providing clearing However valid the difficulties of implementation, and settlement services establishes risk management such barriers should not prevent developments that practices and maintains capital appropriate to its busi- would help overcome the important issues outlined ness model, the activities that it undertakes, and the above. Consistent regulation and oversight should be risks to which it is exposed. By focusing on an evalua- pursued insistently, and harmonization should be tion of activities undertaken, all services that should sought as a long-term goal, particularly as the ben- be subject to regulation and oversight will be, irrespec- efits of a step-by-step move to harmonization are tive of the type of organization that provides those likely to accrue incrementally. Significant progress has services, facilitating fair competition between service already been made in this area; in particular the 2001 providers and a more consistent and appropriate risk CPSS-IOSCO recommendations create a set of mini- level in the market as a whole. The development of mum standards for securities settlement systems and consistent regulatory and supervisory conventions for form a sound basis for the further developments cross-border transactions will offer greater certainty called for in this recommendation. over the standards that apply to such activity. Consis- tent and transparent regulation and oversight will ad-

124 APPENDIX 2. CONDUCT OF THE STUDY

The study on global clearance and settlement arrange- from Gerd Häusler who led the initial investigation. ments was commissioned by the Group of Thirty in Jill Considine organized and chaired a service-pro- the Fall of 2000. Sir Andrew Large, then Deputy Chair- viders advisory group. man of Barclays plc, was invited to chair the project Following the analytical phase of work, Gerald and was joined by John Heimann and David Walker Corrigan assumed responsibility for a working group from the ranks of the Group of Thirty as vice chairs on risk issues and produced the draft chapter and rec- for the project. A Steering Committee was then re- ommendations on that issue. David Walker took the cruited, drawn from the senior ranks of the public and lead in preparing the discussion and recommenda- private sectors, to oversee progress and approve the tions on governance. final report (Committee members, p. ix). The project was able to rely upon the input and Serious study of global clearing and settlement participation of a wide range of institutions and in- arrangements requires examination of a wide range dividuals. A complete list of institutions that contrib- of complex issues, beginning with an analysis of the uted to the project is provided in table A2-1, with current state of the system. Since the goal of this participants in the industry survey listed in table A2- study was to develop specific recommendations for 2. Individuals who made significant contributions are improving these arrangements, issues had to be ex- recognized in Box A2-1. Our purpose in listing these amined at a level of significant detail. Working groups organizations and individuals is to express our grati- of experts from the public and private sectors were tude for their contributions to the project, not to sug- formed, with leadership drawn from the Steering gest their endorsement of the result. Our hope is that Committee. the report proves as useful to them as was their input The working and advisory groups were led by Steer- to the project. ing Committee members Jill Considine, Gerald Corrigan, Gerald Hassell (who replaced Gerd Häusler) ANALYTICAL PHASE OF WORK and Andrew Sheng; Michael Patterson of JP Morgan The basic research effort proceeded along two tracks: Chase and Stephan Schuster of Deutsche Bank. To- a “bottom up” analysis of the current state of the gether with the Chairman, Vice Chairman, Project system based on an industry survey, and a “top down” Director Marc Hollanders, and the G30 Executive assessment of existing standards, principles, and other Director, this group constituted an Executive Com- authoritative guidance in this area. The first phase of mittee for the project that provided ongoing oversight analysis, the industry survey, was undertaken by of the work program. PricewaterhouseCoopers, financial services partner In the analytical phase of work, Gerald Corrigan for this project. and Stephan Schuster co-chaired a working group that examined the current state of clearing and settlement Interview process systems and practices, based on the industry survey Beginning in early 2001, PricewaterhouseCoopers de- by PricewaterhouseCoopers discussed below, to iden- veloped a set of survey questions intended to ascer- tify areas in need of reform. Michael Patterson and tain the key concerns facing participants in clearing and Andrew Sheng co-chaired a working group that sur- settlement activities worldwide. It also developed a list veyed the current state of industry best practice and of survey targets in North America, Europe, and Asia official guidance on clearing and settlement issues in to whom the questions would be posed. The survey order to identify core principles that should be pur- was conducted through face-to-face interviews rather sued in the study. Gerald Hassell led a working group than written questionnaires. Thus, within a common that examined governance issues, assuming the chair framework and methodology for recording results,

125 Global Clearing and Settlement: A Plan of Action

TABLE A2-1. CONTRIBUTING ORGANIZATIONS

ABN Amro NV Goldman Sachs & Co. Association of Private Client Investments Government of Singapore Managers and Stockbrokers Investment Corporation Australian Stock Exchange Hong Kong Exchanges and Clearing Banc of America Securities Hong Kong Securities and Futures Commission Bank One Corporation HSBC Holdings Bank of England International Monetary Fund Bank for International Settlements International Securities Services Association (ISSA) Bank of Japan Invesco Asia The Bank of New York Ivy Funds Banque de France Janus Capital Corp. Barclays Japan Securities Dealers Association The Bear Stearns Companies JASDEC BNP Paribas JP Morgan Chase & Co. Brown Brothers Harriman & Co. Legg Mason The Canadian Depository for Securities The London Clearing House Limited Chase Manhattan Corporation Merrill Lynch & Co. Citigroup, Inc. The Monetary Authority of Singapore Clearnet Morgan Stanley Dean Witter & Co. Clearstream International National Financial Services Clifford Chance Nomura Securities and Nomura Asset Management Companhia Brasileira de Liquidaçâo e Custódia Northern Trust Corporation Council on Foreign Relations Options Clearing Corp. Credit Suisse First Boston Corporation Oxford Economic Research Associates CRESTCo PricewaterhouseCoopers David Polk & Wardwell Promethee DBS Group Holdings Prudential Securities Depository Trust & Clearing Corporation Reuters Group Deutsche Bank Robertson Stephens Deutsche Börse Singapore Exchange DGZ-Bank Frankfurt SIS Sega Intersettle Edward Jones Société Générale Eurex Soifer Consulting Euroclear Standard Chartered European Brokers Club State Street Corporation European Central Bank The Stern School, New York University European Securities Forum Tokyo Stock Exchange Federal Reserve Bank of New York Tsubasa Securities Fidelity Investments UBS The Finance Foundation UniCredito Italiano Financial Services Authority U.S. Clearing Corporation Financial Stability Institute U.S. Securities and Exchange Commission FleetBoston Financial Corporation U.S. Securities Industry Association Global Documentation Steering Committee Wexford Clearing Services

126 Conduct of the Study

TABLE A2-2. ORGANIZATIONS INTERVIEWED

ABN Amro NV Janus Capital Corp. Association of Private Client Investments Japan Securities Dealers Association Managers and Stockbrokers JASDEC Banc of America Securities JP Morgan Chase & Co. Bank One Corporation Legg Mason The Bank of New York Merrill Lynch & Co. Barclays Morgan Stanley Dean Witter & Co. The Bear Stearns Companies, Inc. National Financial Services Brown Brothers Harriman & Co. Nomura Securities BNP Paribas and Nomura Asset Management Citigroup, Inc. Northern Trust Corporation CRESTCo Prudential Securities Depository Trust & Clearing Corporation Robertson Stephens Deutsche Bank SIS Sega Intersettle Edward Jones Standard Chartered Euroclear State Street Corporation European Brokers Club Tsubasa Securities Fidelity Investments UBS Goldman Sachs & Co. UniCredito Italiano HSBC Holdings U.S. Clearing Corporation Invesco Asia U.S. Securities and Exchange Commission Ivy Funds Wexford Clearing Services

interviewers could readily identify issues of greatest account of their impact on the various stakeholder concern to each organization while exploring critical groups and on the different phases of the trade life issues in depth. As is usual for surveys of this kind, cycle. Follow-up calls were made to pursue points of participating firms were offered assurance of confi- particular interest or areas of uncertainty. A summary dentiality to protect proprietary information. of the key themes and detailed findings was then dis- In order to obtain a fair and balanced representation tributed to the participants and updated based on their of the issues and concerns facing system participants, additional feedback. Out of this process emerged five PricewaterhouseCoopers conducted interviews with a priority areas for improvement. These priority areas variety of different stakeholders along the global clear- enjoyed a high degree of consensus as to their sub- ing and settlement value chain, including investors, bro- ject matter and scope across the range of participants: kers, infrastructure providers, and agent banks. Organi- zations whose operations and locations span different ½ Barriers to competition, including the lack of regions and countries were represented, including those open and equal access to separable functions that offer global products and services and those that along the value chain and lack of price transpar- are principally focused on domestic business. ency of separable services. ½ Interoperability, including the need for Analysis consistently applied and enforced communica- Following the initial round of interviews, team mem- tions protocols, technology, and data standards bers from PricewaterhouseCoopers distilled the key and for reliable and comprehensive sources of problems and concerns into broad categories, taking counterparty and securities reference data.

127 Global Clearing and Settlement: A Plan of Action

TABLE A2-3. RELATED STUDIES EXAMINED

1989 Group of Thirty, Clearance and Settlement Systems in the World’s Securities Markets. BIS, Report on Netting Schemes (Angell Report). 1990 BIS, Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy Report). 1992 BIS/CPSS, Delivery versus Payment in Securities Settlement Systems. 1995 BIS/CPSS, Cross-border Securities Settlements. 1996 FIBV, Clearing and Settlement Best Practices.* IOSCO, Report of the Technical Committee, Client Asset Protection. 1997 Joint Report by CPSS and by the Technical Committee of IOSCO, Disclosure Framework for Securities Settlement Systems. 1998 IOSCO, Objectives and Principles of Securities Regulation. 2000 ISSA, 2000 Recommendations. 2001 BIS/CPSS, Core Principles for Systematically Important Payment Systems. CPSS-IOSCO, Recommendations for Securities Settlement Systems. The Center for European Policy Studies, The Securities Settlement Industry in the EU, Structure, Costs and the Way Forward. The Giovannini Group, Cross-Border Clearing and Settlement Arrangements in the European Union. Final Report of the Committee of Wise Men on the Regulation of European Securities Markets. 2002 Communication from the Commission to the Council and the European Parliament, Clearing and settlement in the European Union — Main policy issues and future challenges. Board of Governors of the Federal Reserve System and Securities and Exchange Commission, Interagency White Paper on Structural Change in the Settlement of Government Securities: Issues and Options.

* La Federation International de Bourse Valeur (FIBV) is the World Federation of Stock Exchanges, a global trade association for the exchange industry, representing 56 regulated exchanges from all over the world.

½ Improvements to the basic clearance and In addition to a broad consensus on substance, the settlement model, including information on all survey indicated clear enthusiasm for a Group of Thirty processes and communications and elimination effort in this area and wide recognition of the benefits of paper from the process. that the undertaking could provide. Beyond the obvi- ½ Optimization of collateral and risk manage- ous evidence of enthusiastic participation in the inter- ment, including a common standard for finality, view process itself, respondents offered the following legal certainty in all securities and collateral suggestions for achieving the study’s objectives: transactions, and better management of risk arising in cross-border transactions. ½ Set out a clear vision for the global clearing and ½ Streamlining asset servicing and corporate settlement system toward which all recommen- actions, including electronic communication dations could be seen as advancing. and information flow to investors and easier ½ Rather than duplicate the work of other studies compliance with foreign ownership restrictions. in this area, sound recommendations already

128 Conduct of the Study

enunciated by others should be endorsed. 1989 G30 study “Clearance and Settlement in World Where recommendations go beyond existing Securities Markets.” Most of these reports were is- initiatives, arguments and recommendations sued under the auspices of the Bank for International should be articulated at a level of detail Settlements (BIS), the Committee on Payments and sufficient to describe best practice without Settlements Systems of the Group of Ten central ambiguity. banks (CPSS), the International Organization of Se- ½ The focus of the study should be clear state- curities Commissions (IOSCO), or the International ments of best market practice. Necessary Securities Services Association (ISSA) or in the con- changes in law or regulation should be detailed text of creating a single capital market in the Euro- as well, while recognizing their longer imple- pean Union. These studies are listed in table A2-3 mentation horizon. Out of this review emerged an elaborate matrix, ½ In striking a balance between the achievable and organized by major theme, and including specific is- the optimal, recommendations that are less than sues and actions at the level of trade matching, secu- optimal should include the reasons for stopping rities lending, communications protocols, and the like. short of an optimal solution, including an The review encompassed both questions of substance analysis of barriers blocking further progress and implementation and went into the voluminous and benefits forgone by not pursuing the material available in considerable detail. In view of optimal solution. the emphasis among firms interviewed on endorsing ½ To the extent possible, recommendations and building upon sound recommendations already should include guidance on how and by whom enunciated by others, the working party focused in they should be implemented and subsequently particular on the 2000 ISSA recommendations and enforced. the recommendations jointly issued by CPSS and IOSCO in late 2001. Where those studies have made In recognition of the pledge of confidentiality to recommendations, this report builds upon that foun- survey participants, detailed responses to the survey dation, either expanding the reach of the basic rec- questions are not being published. However, more ommendation to the global context or exploring the information about the content of the survey may be matter addressed in greater detail. obtained by contacting the Group of Thirty office in Given the complex and detailed nature of the map- Washington, DC. ping exercise, the large volume of material generated has not been reproduced in this volume. As with the ASSESSMENT OF EXISTING industry survey, however, more detailed information PRINCIPLES AND STANDARDS about the analysis and the resulting matrix itself is While work proceeded on the industry survey, a work- available through the office of the Group of Thirty ing group undertook a detailed inventory of existing in Washington, DC. standards and principles published by authoritative industry bodies and official agencies with respect to DEFINING RECOMMENDATIONS clearing and settlement. The goal of this exercise was The industry survey and analysis of principles pro- to develop a “map” of standards and principles to duced two “maps” of the system, which were brought identify gaps and vulnerabilities that the G30 study together to identify priority areas for further work. should address, whether by expanding upon existing Where strong interest from industry intersected with guidance or developing recommendations in areas an area identified as needing action in the standards otherwise unaddressed. and principles map, the Steering Committee endorsed The starting point for the analysis was a bibliogra- the development of specific recommendations. Rec- phy of authoritative studies, many including specific ommendations take one of several forms: recommendations, that had been undertaken since the

129 Global Clearing and Settlement: A Plan of Action

½ Endorsement of existing standards, with With the areas and format of recommendation identification of additional or broader actions thus identified, several additional rounds of working than those envisaged under the current stan- level meetings were organized to develop specific pro- dard, where appropriate. posals. The actual drafting of recommendations was ½ News standards where none now exist. undertaken by experts in various phases of the clear- ½ In particularly complex areas, identification of ing and settlement process, many of them veterans further work that should be pursued, with guid- of the earlier working party process, and small off- ance on the purpose and direction of research. site meetings of these experts were then organized to discuss and refine the proposals. Draft proposals were vetted more widely and refined before being included in the final report.

130 Conduct of the Study

BOX A2-1. INDIVIDUAL CONTRIBUTORS

As previously noted, the total work effort devoted Federal Reserve Bank of New York, Peter to the project was dominated by the cumulative in- Bakstansky and Lawrence Sweet; the Finance put of many individual contributors. Although there Foundation, Michel Gabrysiak; the Financial Ser- is a danger of oversight in naming individuals, we vices Authority, Gay Huey Evans; the Giovannini would like to recognize those who made significant Group, Alberto Giovannini; from Goldman Sachs, personal contributions to the project, whether by Paul Deighton, Tim Cole, Robert Mancini, Alberto offering their time and expertise in working and ad- Pravettoni, and Mike Sammons; Hong Kong Ex- visory groups, drafting and reviewing documents, changes and Clearing Ltd, Walter Reisch; from the or offering advice and counsel during the life of the Hong Kong Securities & Futures Commission, Stella project. Although some have changed jobs during Leung (working group secretary); HSBC, John the last two years, they are listed here with their Gubert (subcommittee chair); from the IOSCO affiliations at the time of their initial participation. Technical Committee, David Brown and David Significant contributions were made by: ABN Knott; from JP Morgan Chase, Neil Henderson, Ed- Amro NV, Hugh Scott-Barret; the Australian Stock ward Neeck (working group secretary), Gillian Van Exchange, Angus Richards; from the Bank of En- Schaick, and Susannah Truitt; Lehman Brothers, gland, Alastair Clark, Victoria Cleland, and John Thomas Russo; London Clearing House, Rory Trundle; the Bank of Japan, Iwao Kuroda; from the Cunningham, David Hardy and Andrew Lamb; and Bank of New York, Tom Perna and Elizabeth Siano; from the London Stock Exchange, Donald the Banque de France, Yvon Lucas; from Barclays, Cruickshank. Simon Chatterton and Tim Shepheard-Walwyn; Major contributors also included: the Monetary Bear Stearns, Michael Alix; BNP Paribas, Jacques- Authority of Singapore, Yeo Lian Sim; from Morgan Phillipe Marson; Brown Brothers Harriman & Co., Stanley, Jane Carlin, Patrick de Saint-Aignan, Marye Anthony Enders; the Canadian Depository for Se- Humphery, David Nicol, Judy Smith, and Eileen curities, Bruce Butterill and Allan Cooper; Murray (now at CSFB); Nomura Securities, Hitoshi Companhia Brasiliera Liquidaçâo e Custódia, Tonomura; Options Clearing Corporation, Wayne Amarilis Sardenberg; from Citigroup, Diana Chan, Luthringshausen and Michael Walinskas; from Ox- Ranjit Chatterji, Anne Frascarelli, and Ray Parodi; ford Economic Research Associations, Fod Barnes, Clearstream International, Mark Gem, Andre Dieter Helm, Gunnar Niels, and Reinder van Dijk; Roelants, and Charles Vuylsteke; and from Clifford Promethee, Albert Bressand; Reuters, Henry Engler; Chance, Mark Harding and Dermot Turing. from the U.S. Securities and Exchange Commission, Also contributing significantly to the project Larry Bergmann, Robert Colby, Jeff Mooney, and were: from CRESTCo, Iain Saville (now at Com- Annette Nazareth; Singapore Exchange, Christina puter-share) and Paul Symons; on behalf of the Ang and Peter Chia; Société Générale, Yannick CPSS-IOSCO Task Force, Patrick Parkinson of the Chagnon; State Street Corporation, Robert U.S. Federal Reserve and Shane Tregillis of the Almanas, Mary Fenoglio and Simon Zornoza; from Monetary Authority of Singapore; Davis Polk & the Stern School at New York University, Roy Smith Wardwell, Randy Guynn; from Deutsche Bank, and Ingo Walter; the Tokyo Stock Exchange, Mitchel Lenson, Simon Powell, and Swen Werner; Toshitsugu Shimizu; from UBS, Peter Gnepf, Josef from Deutsche Börse: Orlando Chiesa and Jochen Landolt, and Urs Staehli; and from Unicredito Seitz; DGZ-Bank Frankfurt, Manfred Zass; DTCC, Italiano, Francesco Giordano. Peter Axilrod, Mary Ann Callahan, Dennis Dirks, Finally, we are deeply appreciative of the ad- Dennis Earle, Ellen Levine, Richard Nesson and vice and counsel provided in a personal capacity Jack Wiener; Eurex, Daniel Gisler; from Euroclear, by Wendelin Hartmann, Alexandre Lamfalussy, and Pierre Francotte, Martine Dinne, Kristen Geyer and by Raphael Soifer. And we appreciate the oppor- Anso Thire; Euronext, Patrice Renault; from the Eu- tunity afforded to review the project’s progress with ropean Central Bank, Elias Kazarian (working group Roger Ferguson of the Board of Governors of the secretary) and Daniela Russo; from the European Federal Reserve System; Cathy Minehan of the Commission, John Berrigan and Elizabeth Wrigley; Federal Reserve Bank of Boston; and Mario Monti European Securities Forum, Pen Kent; from the of the European Commission.

131 GLOSSARY

The following terms and acronyms are used in this report as defined in “A Glossary of Terms Used in Payments and Settlement Systems,” Bank for International Settlements, January 2001, revised July 2001.

batch the transmission or processing of a group of payment orders and/or securities transfer instructions as a set at discrete intervals of time. beneficial ownership/ the entitlement to receive some or all of the benefits of ownership of a security or interest other financial instrument (such as income, voting rights, power to transfer). Benefi- cial ownership is usually distinguished from “legal ownership” of a security or financial instrument. central counterparty an entity that is the buyer to every seller and seller to every buyer of a specified set of (CCP) contracts, such as those executed on a particular exchange or exchanges. central securities a facility (or an institution) for holding securities, which enables securities transactions depository (CSD) to be processed by book entry. Physical securities may be immobilized by the depository or securities may be dematerialized (that is, so that they exist only as electronic records). In addition to safekeeping, a central securities depository may incorporate comparison, clearing, and settlement functions. clearing/clearance the process of transmitting, reconciling, and, in some cases, confirming payment orders or security transfer instructions prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement. clearing system a set of procedures whereby financial institutions present and exchange data and/or documents relating to funds or securities transfers to other financial institutions at a single location (clearinghouse). The procedures often also include a mechanism for the calculation of participants’ bilateral and/or multilateral net positions with a view to facilitating the settlement of their obligations on a net or net net basis. confirmation the process in which the terms of a trade are verified either by market participants directly or by some central entity (typically the marketplace). When direct participants execute trades on behalf of indirect market participants, trade confirmation occurs on two separate tracks: verification (generally termed confirmation) of the terms of the trade between direct participants and verification (sometimes termed affirmation) of the intended terms between each direct participant and the indirect participant for whom the direct participant is acting. cross-border settlement a settlement that takes place in a country other than the country in which one trade counterparty or both are located. cross-border trade a trade between counterparties located in different countries. custodian an entity, often a bank, that safekeeps and administers securities for its customers and that may provide various other services, including clearance and settlement, cash management, foreign exchange, and securities lending. delivery final transfer of a security or financial instrument. delivery versus payment a link between a securities transfer system and a funds transfer system that ensures (DVP) that delivery occurs if, and only if, payment occurs. dematerialization the elimination of physical certificates or documents of title that represent ownership of securities so that securities exist only as accounting records.

133 fail a failure to settle a securities transaction on the contractual settlement date, usually because of technical or temporary difficulties. Fail is usually distinguished from “default.” Also called failed transaction. final (finality) irrevocable and unconditional. final settlement the discharge of an obligation by a transfer of funds and a transfer of securities that have become irrevocable and unconditional. global custodian a custodian that provides its customers with custody services in respect of securities traded and settled not only in the country in which the custodian is located but also in numerous other countries throughout the world. gross settlement system a transfer system in which the settlement of funds or securities transfer instructions occurs individually (on an instruction-by-instruction basis). immobilization placement of certificated securities and financial instruments in a central securities depository to facilitate book-entry transfers. international central a central securities depository that clears and settles international securities or cross- securities depository border transactions in domestic securities. (ICSD) legal ownership recognition in law as the owner of a security or financial instrument. It is usually represented by holding “legal title” and sometimes distinguished from beneficial ownership/interest. matching the process for comparing the trade or settlement details provided by counterparties to ensure that they agree with respect to the terms of the transaction. netting an agreed offsetting of positions or obligations by trading partners or participants. The netting reduces a large number of individual positions or obligations to a smaller number of obligations or positions. Netting may take several forms that have varying degrees of legal enforceability in the event of default of one of the parties. payment the payer’s transfer of a monetary claim on a party acceptable to the payee. Typically, claims take the form of banknotes or deposit balances held at a financial institution or at a central bank. payment system a payment system consists of a set of instruments, banking procedures, and, typically, interbank funds transfer systems that ensure the circulation of money. real time the processing of instructions on an individual basis at the time they are received rather than at some later time. real-time gross the continuous (real-time) settlement of funds or securities transfers individually on settlement (RTGS) an order-by-order basis (without netting). securities settlement the full set of institutional arrangements for confirmation, clearance, and settlement system (SSS) of securities trades and safekeeping of securities. settlement an act that discharges obligations in respect of funds or securities transfers between two or more parties. straight-through the completion of presettlement and settlement processes based on trade data that is processing (STP) manually entered only once into an automated system. systemically important a payment system is systemically important where, if the system were insufficiently payment system protected against risk, disruption within it could trigger or transmit further disruptions among participants or systemic disruptions in the financial area more widely.

134 GROUP OF THIRTY PUBLICATIONS SINCE 1989

REPORTS The Financial Disruptions of the 1980s: A Central Banker Looks Back Key Issues in Sovereign Debt Restructuring E. Gerald Corrigan. 1993 Study Group Report. 2002

Reducing the Risks of International Insolvency SPECIAL REPORTS A Compendium of Work in Progress. 2000 Derivatives: Practices and Principles: Follow-up Collapse: The Venezuelan Banking Crisis of ‘94 Surveys of Industry Practice Ruth de Krivoy. 2000 Global Derivatives Study Group. 1994 The Evolving Corporation: Global Imperatives and Derivatives: Practices and Principles, National Responses Appendix III: Survey of Industry Practice Study Group Report. 1999 Global Derivatives Study Group. 1994 International Insolvencies in the Financial Sector Derivatives: Practices and Principles, Appendix II: Study Group Report. 1998 Legal Enforceability: Survey of Nine Jurisdictions Global Institutions, National Supervision Global Derivatives Study Group. 1993 and Systemic Risk Derivatives: Practices and Principles, Study Group on Supervision and Regulation. 1997 Appendix I: Working Papers Latin American Capital Flows: Living with Volatility Global Derivatives Study Group. 1993 Latin American Capital Flows Study Group. 1994 Derivatives: Practices and Principles Defining the Roles of Accountants, Bankers and Global Derivatives Study Group. 1993 Regulators in the United States Clearance and Settlement Systems: Study Group on Accountants, Bankers and Regulators. 1994 Status Reports, Autumn 1992 EMU after Maastricht Various Authors. 1992 Peter B. Kenen. 1992 Clearance and Settlement Systems: Sea Changes in Latin America Status Reports, Year-End 1990 Pedro Aspe, Andres Bianchi and Domingo Cavallo, with Various Authors. 1991 discussion by S.T. Beza and William Rhodes. 1992 Conference on Clearance and Settlement Systems; The Summit Process and Collective Security: Future London, March 1990: Speeches Responsibility Sharing Various Authors. 1990 The Summit Reform Study Group. 1991 Clearance and Settlement Systems: Financing Eastern Europe Status Reports, Spring 1990 Richard A. Debs, Harvey Shapiro, and Charles Taylor. 1991 Various Authors. 1990 The Risks Facing the World Economy Clearance and Settlement Systems The Risks Facing the World Economy Study Group. 1991 in the World’s Securities Markets Steering & Working Committees of the Securities Clearance and Perestroika: A Sustainable Process for Change Settlement Study. 1989 John P. Hardt and Sheila N. Heslin, with commentary by Oleg Bogomolov. 1989 OCCASIONAL PAPERS THE WILLIAM TAYLOR MEMORIAL LECTURES 66. Enron et al: Market Forces in Disarray Jaime Caruana, Andrew Crockett, Douglas Flint, Trevor Harris, Post Crisis Asia: The Way Forward Tom Jones. 2002 Lee Hsien Loong. 2001 65. Venture Capital in the United States and Europe Licensing Banks: Still Necessary? Guillermo de la Dehesa Tomasso Padoa-Schioppa. 2000 64. Explaining the Euro to a Washington Audience Banking Supervision and Financial Stability Tomasso Padoa-Schioppa. 2001 Andrew Crockett. 1998 63. Exchange Rate Regimes: Global Risk Management Some Lessons from Postwar Europe Ulrich Cartellieri and Alan Greenspan. 1996 Charles Wyplosz. 2000

135 62. Decisionmaking for European Economic and 43. The Ten Commandments of Systemic Reform Monetary Union Vaclav Klaus. 1993 Erik Hoffmeyer. 2000 42. Tripolarism: Regional and Global Economic 61. Charting a Course for the Multilateral Trading Cooperation System: The Seattle Ministerial Meeting and Beyond Tommaso Padoa-Schioppa. 1993 Ernest Preeg. 1999 41. The Threat of Managed Trade to Transforming 60. Exchange Rate Arrangements for the Emerging Economies Market Economies Sylvia Ostry. 1993 Felipe Larraín and Andrés Velasco. 1999 40. The New Trade Agenda 59. G3 Exchange Rate Relationships: A Recap of the Geza Feketekuty. 1992 Record and a Review of Proposals for Change 39. EMU and the Regions Richard Clarida. 1999 Guillermo de la Dehesa and Paul Krugman. 1992 58. Real Estate Booms and Banking Busts: 38. Why Now? Change and Turmoil in U.S. Banking An International Perspective Lawrence J. White. 1992 Richard Herring and Susan Wachter. 1999 37. Are Foreign-owned Subsidiaries Good for the 57. The Future of Global Financial Regulation United States? Sir Andrew Large. 1998 Raymond Vernon. 1992 56. Reinforcing the WTO 36. The Economic Transformation of East Germany: Sylvia Ostry. 1998 Some Preliminary Lessons 55. Japan: The Road to Recovery Gerhard Fels and Claus Schnabel. 1991 Akio Mikuni. 1998 35. International Trade in Banking Services: A 54. Financial Services in the Uruguay Conceptual Framework Round and the WTO Sydney J. Key and Hal S. Scott. 1991 Sydney J. Key. 1997 34. Privatization in Eastern and Central Europe 53. A New Regime for Foreign Direct Investment Guillermo de la Dehesa. 1991 Sylvia Ostry. 1997 33. Foreign Direct Investment: 52. Derivatives and Monetary Policy The Neglected Twin of Trade Gerd Hausler. 1996 DeAnne Julius. 1991 51. The Reform of Wholesale Payment Systems 32. Interdependence of Capital Markets and Policy and its Impact on Financial Markets Implications David Folkerts-Landau, Peter Garber, and Dirk Schoenmaker. Stephen H. Axilrod. 1990 1996 31. Two Views of German Reunification 50. EMU Prospects Hans Tietmeyer and Wilfried Guth. 1990 Guillermo de la Dehesa and Peter B. Kenen. 1995 30. Europe in the Nineties: Problems and Aspirations 49. New Dimensions of Market Access Wilfried Guth. 1990 Sylvia Ostry. 1995 29. Implications of Increasing Corporate Indebtedness 48. Thirty Years in Central Banking for Monetary Policy Erik Hoffmeyer. 1994 Benjamin M. Friedman. 1990 47. Capital, Asset Risk and Bank Failure 28. Financial and Monetary Integration in Europe: Linda M. Hooks. 1994 1990, 1992 and Beyond 46. In Search of a Level Playing Field: The Implemen- Tommaso Padoa-Schioppa. 1990 tation of the Basle Capital Accord in Japan and the 27. Reciprocity and the Unification of the European United States Banking Market Hal S. Scott and Shinsaku Iwahara. 1994 Douglas Croham. 1989 45. The Impact of Trade on OECD Labor Markets 26. Japan’s Savings and External Surplus in the World Robert Z. Lawrence. 1994 Economy 44. Global Derivatives: Public Sector Responses Masaru Yoshitomi. 1989 James A. Leach, William J. McDonough, David W. Mullins, 25. 1992: The External Dimension Brian Quinn. 1993 David Henderson. 1989

136 GROUP OF THIRTY MEMBERS

Mr. Paul A. Volcker Professor Peter B. Kenen Chairman of the Board of Trustees Walker Professor of Economics & International Finance, Group of Thirty Department of Economics, Princeton University Rt. Hon. Lord Richardson of Duntisbourne, KG Mr. Mervyn King Honorary Chairman, Group of Thirty Deputy Governor, Bank of England Dr. Jacob A. Frenkel Professor Paul Krugman Chairman, Group of Thirty Professor of Economics, Woodrow Wilson School, Chairman, Merrill Lynch International, Inc. Princeton University Dr. Josef Ackermann M. Jacques de Larosière Spokesman of the Board of Managing Directors Conseiller, BNP Paribas Deutsche Bank AG Mr. William McDonough Mr. Leszek Balcerowicz President, Federal Reserve Bank of New York President, National Bank of Poland Mr. Shijuro Ogata Mr. Geoffrey L. Bell Former Deputy Governor, Bank of Japan Executive Secretary, Group of Thirty Mr. Guillermo Ortiz Martinez President, Geoffrey Bell & Company, Inc. Governor, Banco de Mexico Dr. Domingo Cavallo Dr. Sylvia Ostry Leonard N. Stern School of Business Distinguished Research Fellow, New York University Munk Centre for International Studies, Toronto Mr. E. Gerald Corrigan Dr. Tommaso Padoa-Schioppa Managing Director, Goldman Sachs & Co. Member of the Executive Board, European Central Bank Mr. Andrew D. Crockett Mr. William R. Rhodes General Manager, Bank for International Settlements Senior Vice Chairman, Citigroup, Inc. Mr. Richard A. Debs Mr. Ernest Stern Advisory Director, Morgan Stanley & Co. Former Managing Director, JP Morgan Chase & Co. Sr. Guillermo de la Dehesa Mr. Lawrence Summers Director and Member of the Executive Committee, President, Harvard University Santander Central Hispano M. Jean-Claude Trichet Mr. Martin Feldstein Governor, Banque de France President, National Bureau of Economic Research Professor of Economics, Harvard University Sir David Walker Treasurer, Group of Thirty Professor Gerhard Fels Senior Advisor, Morgan Stanley International Inc. Director, Institut der deutschen Wirtschaft Dr. Marina v N. Whitman Mr. Stanley Fischer Professor of Business Administration & Public Policy, President, Citigroup International University of Michigan Mr. Arminio Fraga Neto Mr. Yutaka Yamaguchi Former Governor, Banco Central do Brasil Deputy Governor, Bank of Japan Mr. Toyoo Gyohten President, Institute for International Monetary Affairs EMERITUS MEMBERS Mr. Gerd Häusler Dr. Wilfried Guth Counsellor and Director, Deutsche Bank AG International Capital Markets Department Mr. Erik Hoffmeyer International Monetary Fund Former Chairman, Danmarks Nationalbank Mr. John G. Heimann Senior Advisor, Financial Stability Institute EXECUTIVE DIRECTOR John G. Walsh Group of Thirty

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