Securities Settlement Systems
The term securities settlement systems is defined to include the full set of institutional arrangement for confirmation, clearance, and settlement of securities trades and safekeeping of securities.
11.1.2.1 Recommendations for Securities Settlement Systems
In November 2001, the CPSS and the Technical Committee of the International Organization of Securities Commissions (IOSCO) issued Recommendations for Securities Settlement Systems (RSSS) as a benchmark to assess the soundness and effectiveness of securities settlement systems (see CPSS and Technical Committee of the IOSCO 2002). The 19 recommendations are considered to be minimum standards intended to reduce risks, increase efficiency, provide adequate safeguards for investors, and enhance international financial stability (see box 11.3). Those recommendations recognize the importance of securities settlement systems for the infrastructure of the global financial markets, and they note that weaknesses in securities settlement systems can be a source of systemic risks to securities markets and to other payments and settlements systems.
The recommendations are designed to cover securities settlement systems for all securities, including equities, corporate and government bonds, and money market instruments. They provide detailed descriptions of the institutional arrangements for confirmation, clearance, settlement, and safekeeping of securities. They also address specific topics and issues, including the legal framework for securities settlements, risk management, access, governance, efficiency, transparency, and regulation and oversight. Ensuring safe and reliable securities clearing and settlement systems requires a clear understanding of the various risks involved in the process of securities transactions. The recommendations describe those risks and provide a wide range of measures to address them. The main risk related to settlement activities is credit risk, which is the possibility that a counterparty to a trade may fail to settle its obligations when due or at any time thereafter. Liquidity risk—which is the possibility that a counterparty may not be able to meet its obligations when due but may settle at a later stage—is another relevant risk. Other risks involved in settlement activities are legal risk, custody risk, operational risk, and the risk of a settlement bank’s failure.
The reduction of pre-settlement risks is considered crucial to ensure the timely settlement of securities transactions. In this context, the recommendations define some rules for trade confirmation, settlement cycles, central counterparties, and securities lending. In particular, the recommendations require that trade confirmation take place on the same trade date and that settlement cycles—the time of exchanging securities against cash—be no more than three days after trade execution. To reduce settlement failure, the recommendations advocate cost-benefit analysis for the introduction of a central counterparty (CCP) and encourage securities lending and borrowing.
The recommendations discuss the sources of settlement risks and provide several measures to address them. For instance, a recommendation on central securities depository (CSD) requests that securities be immobilized or dematerialized and then transferred by book entry in a CSD. By centralizing the procedures of issuance and safekeeping,
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recalculating the outstanding positions—as a risk control tool is discouraged. The CSDs should instead use a combination of limits and collateral requirements.
The operational risk is defined as the risk that deficiencies in information systems or internal controls, human errors, or management failures will result in expected and unexpected losses. To reduce operation risk, the recommendations require CSDs to identify and minimize the source of operational risk through the development of appropriate systems, controls, and procedures. Furthermore, the system should be reliable and secure and should have adequate scalable capacity. Moreover, contingency plans and backup facilities should be established to allow for timely recovery of operations and completion of the assessment with a high degree of integrity.
The recommendation on assets protection requires the entities holding securities in custody (custodians) to put in place measures that fully protect customers’ securities. In particular, custodians should use adequate accounting practices and safekeeping procedures. Investors’ securities should be protected against the claims of custodians’ creditors.
Cross-border settlement arrangements also pose special challenges for regulation and oversight. For those reasons, cross-border links established by settlement systems should observe all relevant recommendations. In addition, a specific recommendation addresses the risks in cross-border links between CSDs.
The recommendations identify the key mechanisms to promote market efficiency. They consider competition as an important mechanism to achieve efficiency. However, because of the particular features of securities settlement industry such as economies of scale and economies of scope, the recommendations emphasize other mechanisms for ensuring efficiency such as fair and objective access criteria, appropriate governance arrangements, and regulation and oversight.
A specific recommendation addresses the regulation and oversight of securities settlement systems. It calls for transparent and effective regulation and oversight to ensure the safety and efficiency of such systems, and for cooperation between central banks and securities regulators to avoid unnecessary cost and to promote adequate information sharing. Furthermore, the central banks that operate the systems should ensure that those systems are compliant with the recommendations.
The recommendations recognize that some functions critical to the settlement of securities transactions are performed by institutions other than securities settlement systems. For instance, the confirmation of trades can be performed by a stock exchange or trade association, or bilaterally by counterparties. Thus, securities regulators and central bank overseers need to cover the relevant aspects of stock exchanges when assessing compliance with the recommendations.
