Management of Risk in CSDs
- presentation to AMEDA members
John Woodhouse25 October 2007
Agenda
• Risk Management – Importance for CSDs• TM CSD Association – Post Trade Risk Assessment• TM Risk Rating Methodology• Six Risk Types
Risk Factors– Definition– Criteria– Graphs
• Key Risk Factors for each Risk Type• Situation for AMEDA
– AMEDA Risk Profiles– TM Assessments– Comparative analysis
• END
Risk Management – Importance for CSDs
• Regulatory requirements – SEC17F7, FSA,G30, IOSCO
• Investor requirements – FIIs often impose own criteria eg Calpers
• CSDs offer competitive services and need to manage risk similar to
custodians:– Custody of ineligible securities.– Asset Servicing.– Information services.– Expanded corporate actions servicing.– Provision of back office services.– Collateral management.
• Increased focus on transparency– IOSCO recommendation 17– Market trend for consolidation and demutualisation– Attention to improved governance arrangements and more director
liability
Thomas Murray CSD Association
• Worked with Gobal Custodians and CSDs for 10 years
• Risk assessments of CSDs from 2001
• Risk ratings of CSDs from 2006
• Market surveillance
• Risk analysis
Risk Rating Methodology
• Assesses risk for investors in post-trade capital market infrastructure
• Settlement, safekeeping and asset servicing risks• Six primary risks assessed• Agreed key criteria or factors assessed against each
primary risk• Assessment against the familiar international rating scale
‘AAA’ – ‘C’• Criteria (factors) weighted by relative importance in the
individual market • Overall rating derived from rating of six primary risks
Six Risk Types
1. Asset Commitment Risk (ACR)
2. Liquidity Risk (LR)
3. Counterparty Risk (CPR)
4. Asset Servicing Risk (ASR)
5. Financial Risk (FR)
6. Operational Risk (OR)
CSD Risk Diagram
A3 A4
A1
A2
A3
A4
A6
A5
CSD Risk Rating
A2
A5A1
A6
Less Important Important Critical
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
CSD RatingsRisk ProfileAsset Commitment Risk
Liquidity Risk
Counterparty Risk
Financial risk
Operational Risk
Asset Servicing Risk
Asset Commitment Risk
Asset Commitment Risk - The period of time from when control of securities or cash is given up until receipt of countervalue.
This risk concerns the time period during which a participant’s assets, either cash or stock, are committed within the CSD and payment system pending final settlement of the underlying transaction(s). Following settlement, the risk period is extended until the transfer of funds and stock becomes irrevocable. It excludes any periods when assets, cash or stock, are committed to a market participant including brokers, banks and custodians, not caused by CSD processing.
Asset Commitment Risk - Criteria
• Minimising processing times maximises the availability of assets, particularly for transfer of assets off-shore (e.g. cross-border collateral movement, repatriation of funds)
• Processing speed (real-time, intraday batches, overnight batches)
• Market deadline for securities / funds positioning
• Finality in settlement system (with legal basis)
• Pre-funding markets (e.g. Russia), or long blocking periods
CSD ‘old’
CSD ‘new’
CSD Ratings
Rating
AC4
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
Asset Commitment Risk
Less important Important Critical
AC1
AC2
AC3
AC4
AC3
AC1
AC2
Inter-broker - Sales
Inter-broker - Purchases
Broker-custodian – (Selling Broker)
Broker-custodian – (Buying Broker)
Broker-custodian – (Custodian)
Free of payment
AC5
AC6
AC5
AC6
Liquidity Risk
Liquidity Risk - The risk that insufficient securities and or funds are available to meet commitments; the obligation will be covered some time later.
This is where for certain technical reasons (e.g., stock out on loan, stock in course of registration, turn round of recently deposited stock is not possible) one or both parties to the trade has a shortfall in the amount of funds (credit line) or unencumbered stock available to meet settlement obligations when due. These shortfalls may lead to settlement ‘fails’ but do not normally lead to a default.
Liquidity Risk - Criteria
• Optimising asset liquidity now paramount in large markets. Managing late settlements effectively and quickly reduces ‘indirect’ losses
• Netting (with legal basis) / optimisation• Multiple processing cycles• Stock lending• Credit facilities• Fails management (fines, buy-ins)• High levels of immobilisation / dematerialisation• Fast registration / central registrar
Rating
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
CSD RisksLiquidity Risk
CSD ‘old’
Less important Important Critical
Processing Model 2 – on exchange
Processing Model 1 – off exchange
Credit Facilities
Stock lending and Borrowing
Fails management
Registration
Deposited securities
Matching
Processing Model 1 - Same Day
Trading
CSD Ratings
CSD ‘new’
L1
L2
L3
L4
L5
L6
L7
L8
L6
L3
L1
L8
L2
L5
L4
L7
L9
L9
Counterparty Risk
Counterparty Risk - The risk that a counterparty (i.e., a participant) will not settle its obligations for full value at any time.
This is simply the total default of a direct participant of the CSD. This is the event when a participant is unable to meet its financial liability to the CSD and possibly other creditors. This risk only goes as far as direct participants of the CSD and excludes clients of direct participants that default on liabilities to such participants, even if such a default should systemically cause the direct participant to subsequently default.
Counterparty Risk - Criteria
• Managing defaults is critical to reducing direct loss of Principal and Systemic risks through participant interdependence.
• DVP (market AND client-side)• Central Bank, same-day funds• Settlement assurance (CCP, collateral, guarantee fund)• Strict participation criteria• Participant concentration• Surveillance of participant volumes / risk modelling
Rating
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
Counterparty Risk
CSD ‘old’
Less important Important Critical
Participation Criteria
Participant concentration
Surveillance
DVP – Inter-Broker
DVP - Broker-custodian
Settlement Assurance
CSD Ratings
CSD ‘new’
C1
C2
C3
C4
C5
C6
C3 C4
C5
C1
C6
C2
Asset Servicing Risk
Asset Servicing Risk - The risk that a participant may incur a loss arising from missed or inaccurate information provided by the depository, or from incorrectly executed instructions, in respect of corporate actions and proxy voting.
This risk arises when a participant places reliance on the information a depository provides or when the participant instructs the depository to carry out an economic transaction on its behalf. If the depository fails either to provide the information or to carry out the instruction correctly then the participant may suffer a loss for which the depository may not accept liability. The depository may provide these services on a commercial basis, without statutory immunity, or it may provide the service as part of its statutory role, possibly with some level of protection from liability. This risk is likely to become much higher when international securities are included in the service.
Asset Servicing Risk - Criteria
• Managing corporate actions effectively perhaps the biggest potential risk exposure.
• Reliable ‘official’ source• Multiple information sources allowing for
verification/’data scrubbing’• Timely, accurate and comprehensive event notification• Timely, accurate and comprehensive event processing• Pro-active client servicing• Straight-Through-Processing• Clear statement of liability
Rating
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
Asset Servicing Risk
CSD ‘old’
Less important Important Critical
Info Collection
Info Dissemination
Receipt of Instructions
Execution of Instructions
Proxy Voting
Other Services
CSD Ratings
CSD ‘new’
AS1
AS2
AS3
AS4
AS3
AS4
AS1AS2
AS6
AS6 AS5
AS5
Financial Risk
Financial Risk - The ability of the CSD to operate as a financially viable company.
This risk concerns the financial strength of the depository and if its capital is sufficient to meet the on-going operation of the organisation.
Financial Risk - Criteria
Ongoing financial stability of the CSD as a business. Net capital Operationally profitable Comprehensive insurance Any principal activity fully collateralised/ managed Limited commercial activity Limited liability (exclude indirect losses)
CSD ‘new’
Rating
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
Financial Risk
CSD ‘old’
Less important Important Critical
Capital Structure
Earnings performance
Ownership
Access to Credit
Insurance Coverage
Operational claims
Investment in infrastructure
CSD Ratings
F1
F2
F3
F4
F5
F6
F7
F6 F5
F7F3
F4
F2
F1
Operational Risk
Operational Risk - The risk that deficiencies in information systems or internal controls, human errors or management failures will result in losses.
The risk of loss due to breakdowns or weaknesses in internal controls and procedures. Internal factors to be considered in the assessment include ensuring the CSD has formalised procedures established for its main services. The CSD should have identified control objectives and related key controls to ensure operation and proper control of established procedures. Systems and procedures should be tested periodically. There should be external audit processes in place to provide third-party audit evidence of the adequacy of the controls.
Operational Risk - Criteria
• Internal controls and procedures should be adequate to control operational risk exposures
• Comprehensive controls and procedures• Extent of Internal and External operational
audits• Limit manual processing / internal STP• Secure and efficient interfaces – external STP• DRP/BCP procedures
CSD ‘new’
Rating
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
Operational Risk
CSD ‘old’
Less important Important Critical
Established procedures
Identification of key controls
Operational Audit
Processing
Reporting
Disaster Recovery procedures
Business Continuity Plan
Staff training
CSD Ratings
O2
O1
O2
O3
O4
O5
O6
O8
O4 O6
O1
O5
O7
O8
O7
O3
Situation for AMEDA
- AMEDA Website- AMEDA risk profiles- TM Assessments- Regional Comparison
AMEDA Website
AMEDA Documentation Screen
AMEDA Depository Risk Profiles
TM Assessments – Reports – Depository Service
Depository Assessment - example
Rating
AAA
AA+
AA
AA-
A+
A
A-
BBB
BB
B
CCC
CC
C
Regional Comparison – Overall Risk Rating
Less important Important Critical
Americas
Africa
Asia Pacific
Middle East
Eastern Europe
Western Europe
CSD Average Regional Ratings
TM Organisation Chart
Main Group Responsibilities
TM Group
Simon Thomas
Group Client RelationshipManagement
& Business Development
Group Technology
Ross Whitehill
Mark Crocker
Group Finance, Company Secretary
and Administration
Peter Sturdy
Canadian &Australian
offices
Ross Whitehill
Capital Market Ratings&
Overseas Advisory
Custody Ratings& Investor Services
Custody Ratings
Investor Services
consulting toInstitutions
Roger Fishwick
Joanne Parker
OverseasAdvisory
Custodian Monitoring
Nick Bradley
Tim Reucroft
Capital Market Ratings
John Woodhouse
Data Services
Data Services
Derek Duggan