ACSDA SeminarNext Challenges in Depository, Clearance

and Settlement Services

- CCP Opportunities -

ACSDA SeminarNext Challenges in Depository, Clearance

and Settlement Services

- CCP Opportunities -

Margarida BaptistaNovember 15, 2002

AGENDA

NET SETTLEMENT SYSTEMSNET SETTLEMENT SYSTEMS

THE CCP SOLUTIONTHE CCP SOLUTION

CBLC MODELCBLC MODEL

CONCLUDING REMARKSCONCLUDING REMARKS

AGENDA

NET SETTLEMENT SYSTEMSNET SETTLEMENT SYSTEMS

THE CCP SOLUTIONTHE CCP SOLUTION

CBLC MODELCBLC MODEL

CONCLUDING REMARKSCONCLUDING REMARKS

Securities Settlement SystemsSecurities Settlement Systems

Real Time Gross Settlement System

Deferred Net Settlement System

DNS x RTGS

RISK

LIQUIDITY

Trade-off: Risk x Liquidity

Minimization of liquidity requirements

Decreasing of participants exposure to credit risk

High reduction of settlement instructions

Netting: advantagesNetting: advantages

Cut down on transaction costs

Decreasing in operational risk

BUT: potential problems ….BUT: potential problems ….

How to handle a participant’s default :

Systemic Risk

Netting: potential problemsNetting: potential problems

The contamination effect depends

on:

the defaulter’s debit value

the number of its counterparties

1st. alternative

Unwinding Procedures

In case of a participant’s

default: contamination of

the debit/credit chain

2nd. alternative

Third Party

Pays

Socialization of losses

Moral Hazard

How to handle a participant’s default :

Netting: potential problemsNetting: potential problems

CCPCCP

International recommendation for risk mitigation in DNS Systems

Allows the benefits of netting without increasing systemic risk

CCP: the third alternativeCCP: the third alternative

Provided that: adequate risk management controls and

systems should be adopted.

AGENDA

NET SETTLEMENT SYSTEMSNET SETTLEMENT SYSTEMS

THE CCP SOLUTIONTHE CCP SOLUTION

CBLC MODELCBLC MODEL

CONCLUDING REMARKSCONCLUDING REMARKS

CPSS-IOSCO: « A central counterparty (CCP) is an entity that interposes itself between the counterparties of trade, acting as a buyer to every seller and a seller to every buyer »

BUYERBUYER SELLERSELLER

Trading

BUYERBUYER SELLERSELLER

CCPCCPCCP assumes the role of the

seller

CCP assumes the role of the

seller

CCP assumes the role of the

buyer

CCP assumes the role of the

buyer

What is a CCP ?What is a CCP ?

Measure;

Manage; and Assume the

counterparty risk

CCP: main function and advantagesCCP: main function and advantages

CCP

RISK ARISK A

RISK BRISK B

RISK CRISK C

RISK DRISK D

RISK HRISK H

RISK GRISK G

RISK FRISK F

RISK ERISK E

CCPRISK

AA

BB

CC

DD

EE

HH

GG

FF

Main advantages:

Guarantee of anonymity

Supports multilateral netting

Absorption of risks between trade and the settlement period

Protection of market participants in the event of a participant default

Prevents the spillover of securities settlement risks to the payments system

Systemic Risk Reduction

Barriers to be overcome in order to implement a robust risk management system

High initial investments

Human resources

Risk management systems

IT systems (both hardware and software)

High ongoing expenses to maintain the system

CCP: main disadvantagesCCP: main disadvantages

High fixed costs Minimum Scale Requirements

AGENDA

NET SETTLEMENT SYSTEMSNET SETTLEMENT SYSTEMS

THE CCP SOLUTIONTHE CCP SOLUTION

CBLC MODELCBLC MODEL

CONCLUDING REMARKSCONCLUDING REMARKS

CBLC: main risks to be managedCBLC: main risks to be managed

Principal Risk

Credit risk

Liquidity risk

Principal Risk

Replacement cost Risk

DELIVERY vs. PAYMENT

SFI-DVP model 3 - multilateral netting for both securities and cash legs

For cash leg, multilateral netting across different markets and instruments

Settlement cycles:

Equities: T+3

Corporate Bonds: T+0 and T+1 Same day finality in central bank money (allowed by the Brazilian Payment System implemented in April 2002)

STR: Central Bank Money Transfer System (RTGS)CBLC: Transitory settlement account at STR

Adequate legal basis: Enforceability of multilateral netting and novation of tradesCBLC lien on securities posted as collateral

CBLC ModelCBLC Model

CBLC ModelCBLC Model

Equities (cash and derivatives)

Corporate debt instruments

BTC – Securities Lending Service

CBLC acts as a CCP: When CBLC becomes a CCP?

CBLC

Trades are automatically reported to CBLC

CBLCCBLC

CCPCCPCLEARING AGENTCLEARING AGENT A A B B CLEARING AGENTCLEARING AGENT

Information is sent to Brokers and Clearing Agents: CBLC BECOMES CCP

AABROKERBROKER

BBBROKERBROKER

Trading Systems Trading

MatchingSell

Order

Buy

Order

Trading and matching

CBLC credit risk: layers of protectionCBLC credit risk: layers of protection

Participants’ requirements

Collateralization

95% confidence level under historic scenarios

Settlement fund 99% confidence level under

stress scenarios

Segregated Net worth

LAMFALUSSY PLUS

Hybrid Loss Sharing model

• defaulters pay

•survivors pay

1st: collaterals posted by the defaulter2nd: defaulter’s contribution to the settlement fund 3rd: settlement fund 4th: segregated net worth

Dealing with payment failures...Dealing with payment failures...

LIQUIDITY PROVISIONLIQUIDITY PROVISION

Financial credit lines provided by a pool of banks

CBLC has only a short time period (3:30 to 3:55 pm) to execute collaterals

Dealing with securities delivery failures

Fundamental mechanism to prevent delivery failures

1st: Securities Lending:

CBLC acts as principal

Full collateralization

Risk management tool: CM–TIMS (OCC system)

Fully integrated in the settlement process

2nd: Buy-in procedures:

T+4: CBLC releases a buy-in order

The buy-in order can be canceled until T+6 should the defaulter delivers the security;

Buy-in order execution: the buyer´s broker buys the security in the market

Market price difference: covered by the collaterals posted by the defaulter

Same day finality in Central Bank Money

Participants requirements

Collateralization

Segregated Net Worth

Multilateral netting supported by a CCP

SFI – DVP 3

Settlement Fund

Securities Lending

Summing up ...

AGENDA

NET SETTLEMENT SYSTEMSNET SETTLEMENT SYSTEMS

THE CCP SOLUTIONTHE CCP SOLUTION

CBLC MODELCBLC MODEL

CONCLUDING REMARKSCONCLUDING REMARKS

Concluding RemarksConcluding Remarks

The choice and design of a suitable model depends on several key variables:

International recommendations and best practices Particularities of each country:

National Payment Systems Legal environment Profile and characteristics of the financial market

Size Regulations Market practices Participant’s size, concentration, profile and business strategies Type and diversity of financial instruments

Strong cooperation between the market and the regulators

Concluding RemarksConcluding Remarks

That is: it is not wise to support an optimal model, regardless the specific context in which it is going to be put in place

Volume and value of financial transactions

Trading patterns among counterparties

Opportunity costs to implement risk management robust systems

RTGS x DNS systems: the choice of adopting one or the other (or a combination of the two of them) has to be addressed, case by case, taking into account:

the trade-offs between the RTGS and DNS systems

cost x benefit analysis

Concluding RemarksConcluding Remarks

CPSS-IOSCO Recommendation n.4:

“The benefits and costs of a CCP should be evaluated. Where such a mechanism is introduced, the CCP should rigourously controls the risks it assumes.”

If a DNS system should be chosen, it is worth considering the implementation of a CCP in order to capture the benefits of netting without jeopardising the systemic risk reduction goal; otherwise, it can be more suitable to settle in a gross basis

Nevertheless: it is possible to outline one general conclusion: