Ontario Securities Commission, Canada Mr. Howard Wetston

Superintendencia de Valores y Seguros, Chile Ms. Vivianne Rodriguez

Comision Nacional de Valores, Argentina Mr. Emilio Ferre

Securities Commission of the Bahamas Ms. Sandra Knowles

Securities Exchange of Barbados Ms. Virginia Mapp

Comissao de Valores Mobiliarios, Brazil Mr. Eduardo Manhaes

Ontario Securities Commission, Canada Mr. Winfield Liu

Superintendencia de Valores y Seguros, Chile Mr. Cristian Villalobos Mr. Nestor Contreras Mr. Patricio Valenzuela

Superintendencia de Valores, El Salvador Mr. Omar Ernesto Rodriguez

United States Securities and Exchange Commission Mr. Ester Saverson, Jr.

Banco Central del Uruguay Mr. Jorge Xavier

Inter-American Development Bank Mr. Kenroy Dowers

World Bank Mr. Mario Guadamillas

1. INTRODUCTION¹

1.1 In 1999 the Council of Securities Regulators of the Americas (COSRA) undertook a Work Program to determine the types of regulatory approaches that regulators in the region used to supervise securities settlement systems². The purpose of the Work Program was to provide information and alternatives for improving oversight of such systems. COSRA members participating in the Work Program conducted self-evaluations to obtain information about the legal and regulatory frameworks for settlement systems, including financial and operational capacity and membership standards.

1.2 COSRA has recognised the importance of a sound and efficient clearance and settlement system to the financial marketplace. To further advance its efforts in implementing the objectives, principles and recommendations developed by the many international organisations it established the Working Party on Clearance and Settlement. The objective of the Working Party is to provide members of COSRA with practical advice intended to facilitate the development of effective and efficient clearing and settlement systems within the region.

1.3 Building upon the 1999 Work Program, and as a complement to the work of the Western Hemisphere Payments and Securities Clearance and Settlement Initiative³, the Working Party chose to examine in greater detail the topics of delivery versus payment (DVP) and settlement assurance. Each member of the Working Group undertook to examine the principal securities settlement system(s) within their country and to prepare Country Reports on the operation of the settlement system(s) in the areas of DVP and settlement assurance. Guidelines were developed to facilitate the preparation of the Country Reports⁴. Information was sought to facilitate an understanding of the DVP model that was used, the steps involved in the clearance and settlement process, the rights and obligations of participants, and the procedures and facilities invoked when there is a settlement failure. The findings of the Working Party are set out in this report. Detailed descriptions of the various settlement systems and how DVP and settlement assurance is achieved are contained in the respective Country Reports that accompany this report⁵.

1.4 A key premise of this work was to recognise that the goal is to help regulators and market participants identify definitive steps that may be taken to improve the existing systems within their countries. Securities markets in the Americas vary considerably in terms of size, volume, securities traded and stage of development. Thus, the Working Party decided against setting benchmarks⁶. Instead it decided to document the various DVP and settlement assurance procedures used among the Working Party Members. It was the view of the Working Party that securities markets may learn how the various securities markets among the Working Party implemented DVP and settlement assurance procedures in hopes that they may be able to identify procedures that may be used to improve market efficiency and reduce risks.

1.5 The size and nature of a securities market may determine not only what realistic short-term goals should be pursued but also the longer term goals. The costs of both developing and implementing a sophisticated settlement system and operating the system may not be an issue in a large market where level of activity would allow participants to reap the benefits of economies of scale, as well as the risk reduction that the system provides. However, other markets may not be able to economically support such a system, which may not be necessary if the type and size of transactions in the market do not create significant levels of systemic risk. The Working Party recognises that there are a variety of alternatives to improving efficiency and reducing risks that can be less costly and more appropriate in certain circumstances.

1.6 This report summarises the findings of the Working Party. It is not intended to be prescriptive but rather to serve as a reference point for COSRA members seeking to enhance the settlement system(s) within their country. The report examines the concepts underlying DVP and settlement assurance, analyses the settlement systems of the Working Party members and illustrates some of the different means by which DVP and settlement assurance have been achieved in the region by looking at the systems currently in operation or under development, within the member countries.

1.7 Guidance on DVP and settlement assurance also is provided in a report entitled: Recommendations for Securities Settlement Systems (Securities Settlement Report). The Securities Settlement Report was developed by a task force of central banks and securities regulators created by the Committee on Payment and Settlement Systems (CPSS)⁷ and the International Organization of Securities Commissions (IOSCO)⁸ (CPSS-IOSCO Task Force). Members of the CPSS-IOSCO Task Force included securities regulators that are also members of the Working Party. Other members of the Working Party submitted comments on the Securities Settlement Report during its consultative stage⁹ .

1.8 The Securities Settlement Report contains 19 recommendations and accompanying explanatory texts that identify minimum standards that securities settlement systems should meet. The recommendations are designed to cover systems for all types of securities, for securities issued in both industrialised and developing countries and for domestic as well as cross-border trades. Specifically, recommendation 7 addresses DVP and recommendations 8 through 12 address "Timing of Settlement Finality," "CSD Risk Controls to Address Participants’ Failures to Settle," "Cash Settlement Assets," "Operational Reliability," and "Protection of Customers’ Securities," respectively.

1.9 National authorities responsible for the regulation and oversight of securities settlement systems are expected to assess whether markets in their jurisdiction have implemented the recommendations and to develop action plans for implementation where necessary. The Securities Settlement Report also includes key questions pertaining to each of the recommendations, answers to which would form the basis for assessments. The CPSS and IOSCO plan to develop an assessment methodology in 2002. The International Monetary Fund and the World Bank will participate in this next stage of the work.

2. RISKS IN CLEARANCE AND SETTLEMENT

2.1 Clearance and settlement involves a variety of risks. These include risks that arise from the possibility that the counterparty to a trade will fail giving rise to principal risk, replacement cost risk and liquidity risk. Operational risk and legal risk may also give rise to principal risk, replacement cost risk and liquidity risk. Operational risks arise from deficiencies in systems, human error and management processes. Legal risk arises when the legal or regulatory regime does not fully support a clearance and settlement system, its rules or the application of those rules designed to enforce the rights of system operators, participants and their customers. Systemic risk is the risk that one participant that fails to meet its settlement obligations can cause other participants to subsequently default on their obligations. It can arise whenever problems in the settlement process, possibly from one or more of the risks noted above, causes losses to a participant or creates liquidity pressures that are transmitted to other participants causing failure among other participants or other institutions, such as settlement banks and custodians.

2.2 DVP is primarily designed to mitigate principal risk. In a system that has effective DVP procedures, settlement assurance schemes are intended to mitigate, replacement cost risk, liquidity risk and systemic risk. However, DVP and settlement assurance schemes may prove ineffective without a legal regime and an effective operating system that fully supports the clearance and settlement system.

Principal Risk

2.3 Principal risk is the risk that a participant, either the buyer or the seller, will lose the full value of its side of the transaction when securities or funds due from it are delivered but it, in turn, does not receive back the funds or securities due to it. That is, the buyer will make payment of funds for the securities but not receive the securities, or, the seller will deliver the securities but not receive payment. In either case the non-defaulting participant is at risk of losing the full principal value of its consideration when it satisfies its obligations but the counterparty defaults. Principal risk is present when there is no mechanism, like DVP, to ensure that a participant’s delivery of securities will happen if, and only if, that participant is guaranteed payment, or that the participant’s payment will be made if, and only if, that participant is guaranteed delivery of the securities.

Replacement Cost Risk

2.4 When a transaction fails to settle the non-defaulting participant may be in a position of having to return to the market to complete the transaction. A buyer that did not receive delivery of securities previously bought may have to re-enter the market and purchase the securities again at the then current market price. Similarly, a seller that did not deliver the securities as a result of default by the buyer will have to attempt to resell the securities at the prevailing market price. In either case the non-defaulting participant is subject to replacement cost risk. The price at which the subsequent transaction is completed may not be as favourable as the original transaction. A buyer attempting to replace the original securities may have to do so at a higher price. A seller attempting to resell securities may have to do so at a lower price. The degree of risk is dependent upon the volatility of the securities in question and the period of time between the original transaction and the subsequent transaction.

Liquidity Risk

2.5 Liquidity risk is the risk that a participant fails to deliver funds or securities to its counterparty at settlement and the counterparty’s ability to take remedial steps to address the lack of funds and securities it needs to meet its other obligations. A seller that does not receive payment of funds may be in a position where is has to borrow money or liquidate other assets in order to have funds that it may be in need of to meet other obligations coming due. Similarly a buyer expecting delivery of securities may find itself in a position of having to borrow those securities if it has a delivery obligation that it has to meet. In either scenario, the non-defaulting participant may find itself having to access a credit facility or borrow the securities in order to meet its obligations that will entail certain costs.

Systemic Risk

2.6 Systemic risk is the risk that the failure of one participant to meet its settlement obligations when due may cause other participants to fail to meet their obligations when due. In the event of a failure, the non-defaulting participant may be subject to liquidity pressures that cause a subsequent default by that participant. This, in turn, has the potential to be transmitted to a broader segment of the market. The failure of the one participant may result in a domino effect, precipitating failures of other participants and creating the potential for significant market disruption. Other market participants aware of the developing problems may be reluctant to make deliveries of securities, or make payments that are due, over concern that the settlement system cannot ensure that delivery of funds and deliveries of securities will occur. Their reluctance to meet their obligations may exacerbate systemic risk.

2.7 It is critically important that a settlement system has the necessary risk management procedures in place to instil confidence in the system. A settlement system not only centralises the processes involved in settlement but also the risks inherent in the settlement process. It should, therefore, monitor and manage those risks in a way that creates confidence among its participants. It also should have the legal regime and the operational capability to support those risk management procedures. The largest source of risk in the settlement process is principal risk where the entire value of a participant’s side of the trade could be lost, which in turn, may place the participant in a position where it is unable to meet its other settlement obligations. Liquidity risk and replacement cost risk, as well as principal risk, are potential sources of systemic risk. 3.DELIVERY VERSUS PAYMENT

Purpose of DVP¹⁰

3.1 There are two main benefits that accrue from DVP: risk reduction and enhanced efficiency. Principal risk is a significant potential source of systemic risk. DVP, if implemented properly, allows a market to eliminate principal risk by ensuring that a seller will give up its securities if, and only if, it receives full payment and a buyer gives up its funds if, and only if, it receives the securities.

3.2 A market's efficiency is determined by many factors. One of these factors is the ease with which market participants can safely exchange securities and funds. Without DVP, a market's ability to move securities and funds can be significantly impaired.

Elements of DVP

3.3 There are three essential elements to achieving a good DVP transaction:

1. good delivery of securities;
2. payment of irrevocable funds; and
3. transfer of securities can occur if, and only if, transfer of funds also occurs.

To achieve DVP there must be a mechanism that ensures that good delivery of securities occurs if, and only if, the transfer of irrevocable funds also occurs, and vice versa.

3.4 The "delivery" part of a DVP transaction refers to the transfer or delivery of securities. In the context of DVP, "delivery" refers to the good delivery of securities. For a "good" delivery of securities to occur the receiver of the securities must know that the value it has received cannot be taken away after receipt. In a physical environment, "delivery" is accomplished by the delivery of a physical certificate in which the owner (seller) signs over the legal title of the securities to the buyer in exchange for physical payment (e.g., cash, check or bank draft)¹¹ . In a depository environment, delivery of securities is usually accomplished by making entries on the books of the central securities depository (CSD). By debiting a security position from the account of the seller and crediting that position to the account of the buyer, a depository makes a "delivery" of securities

3.5 The "payment" part of a DVP transaction refers to the transfer or delivery of funds. The transfer of funds by the buyer to the seller must be final and irrevocable. Thus, the seller of securities must know that the value or funds it has received cannot be taken away after it has given up its securities. In a physical settlement environment, a funds transfer is typically accomplished by the physical exchange of a cheque or bank draft of some kind. The cheque is exchanged for the physical certificates. The quality of the payment depends upon the type of cheque and the issuer or guarantor behind the cheque. In a depository environment, payment is often accomplished by making entries on the books of the settlement bank for the CSD. In most cases the settlement bank is a central bank or one or more commercial banks.

3.6 The third element of DVP is the transfer of securities can occur if, and only if, the transfer of irrevocable funds also occurs. The movement of securities and funds may not, and often does not, occur at the same time. The timing of the movement if securities and funds is often difficult because the movement of securities usually occurs at the CSD and the movement of the funds usually occurs at the settlement bank. The CSD and the settlement bank must have sufficient legal authority, as well as the procedures and safeguards to ensure that the good delivery of securities occurs if, and only if, final payment of irrevocable funds also occurs.

Models of DVP

3.7 In 1992 CPSS published a report on Delivery versus Payment in Securities Settlement Systems (DVP Report). The DVP Report identified three broad structural models to achieve DVP:

1. Model 1 - systems that settle transfer instructions for both securities and funds on a real-time gross settlement basis (RTGS) with final and irrevocable transfer of securities from the seller to the buyer and funds from the buyer to the seller occurring on a trade-for-trade basis;

2. Model 2 - systems that settle securities transfer instructions on a trade-for-trade basis on an interim basis during the settlement cycle but funds are paid on a net basis at the end of the settlement cycle. Buyers may not remove the securities delivered to their account until payment is made. Final and irrevocable transfer of securities and funds occur at the end of the processing cycle; and

3. Model 3 - systems that settle transfer instructions for both securities and funds on a net basis, with final transfer of both securities and funds occurring at the end of the processing cycle. In most Model 3 DVP systems netting typically occurs between the participants and the central counterparty that guarantees the settlement of all netted transactions.

3.8 Model 1 DVP system is an RTGS system that settles each transaction trade-for-trade. There is no novation or substitution of counterparties so identity of the buyer and seller are maintained throughout the process. In the event of a default by one of the parties, the settlement is rejected and the securities or funds are be returned to the non-defaulting party. The structure of a Model 1 DVP system addresses the issue of principal risk on a trade-for-trade basis. The simultaneous and contingent nature of the exchange of value for value does not create any opportunity for the possible loss of the principal value of the securities or payment due to the failure of the counterparty. However, an RTGS system generally does not minimise other types of risk, such as replacement cost risk or liquidity risk.

3.9 Model 2 DVP systems net payment obligations but settle securities obligations on a trade-for-trade basis. During the settlement period, securities are delivered from the sellers’ accounts to the buyers’ accounts on an interim basis. The netting process results in a single payment of all fund obligations, either from a participant to the settlement agency or from the settlement agency to a participant, at the end of the settlement cycle. Once the funds are received and distributed to the sellers, the settlement agency removes the restrictions on the buyers’ accounts. If a participant fails to pay in full the netted amount, the settlement agency must have sufficient liquidity to settle all transactions on settlement date or be able to reverse the related securities transactions from the buyer’s account back to the seller’s account. If a participant does not have the securities for delivery, the settlement agency may borrow the securities, obtain sufficient collateral to debit the seller’s securities account and credit the buyer’s securities account or exclude those trades from the netting of fund obligations. Model 2 DVP not only minimises, if not completely eliminates principal risk, it also reduces the liquidity risk by reducing the amount of funds needed to complete settlement.

3.10 Model 3 DVP systems net both payment and securities obligations. If the netting process is bi-lateral then there will be a single payment and, for each issue of securities, a single delivery obligation to or from each counterparty with whom a participant has conducted a trade. Although this will reduce, to a certain extent, the number of obligations that need to be settled and, likely, the aggregate payment amounts due to or from each counterparty, there will still be, potentially, a large number of obligations that have to be settled for each settlement cycle. To further increase efficiency and reduce liquidity requirements, many large systems employ multilateral netting in which each trade is netted between the participants to the trade and a central counterparty resulting in only a single funds transfer and, for each security, a single delivery. Multilateral netting reduces a participant’s liquidity risk by dramatically reducing the number of securities needed for delivery and the aggregate funds needed for settlement. In addition, most multilateral netting systems carry out the settlement process on a continuous net settlement basis and guarantee the settlement of all netted trades. A Model 3 DVP system with continuous net settlement and a central counterparty guarantee should have risk management systems, including settlement assurance procedures, to not only minimise principal risk but improve efficiency and reduce liquidity risk, replacement cost risk and systemic risk.

3.11 DVP systems that guarantee the settlement of all trades on settlement date effectively shift principal risk, replacement cost risk, liquidity risk and systemic risk from the participants to the central counterparty (such as the settlement agency itself). The central counterparty serves to essentially guarantee that each participant making payment for securities will receive delivery of securities, and each participant making delivery of securities will receive payment, even if the original counterparty were to default. Principal risk and replacement cost risk have been removed from the participants but have not been eliminated - rather those risks have been assumed by the central counterparty and hence should be properly managed so as not to put the central counterparty, or indirectly, all other market participants, at risk should a default occur. The management of these risks is usually addressed through the use of participant funds, collateral pools or other mechanisms designed to absorb the impact of a participant default and insulate the central counterparty and other market participants from a loss sufficient to cause any subsequent failure. Assumption of such risks by the central counterparty also increases its liquidity risk. This is the topic of settlement assurance which is discussed below.

3.12 The choice of DVP Model will be dictated largely by the type of clearance and settlement services demanded by the market and the relative costs of those services. Although consideration of risks of the system are also very important, the overall level of risk is not determined so much by the particular DVP Model which is chosen but rather the risk management policies and procedures that are employed. With adequate safeguards and procedures all three models should virtually eliminate principal risk. In markets with a high number of transactions, DVP Models 2 or 3, which net the obligations of the participants, allow the participants to benefit the most from the cost efficiencies that come with a netting process. Markets that have few transactions may find Model 1 DVP the most beneficial from a cost benefit analysis. This model effectively eliminates principal risk, but it may also impose high settlement cost on participants because of the increased need to have more funds and securities available for settlement. Participants will need to have access to significant levels of financial resources, of their own, or arrange to have access to readily available credit and securities lending facilities. Reliance upon credit facilities may significantly increase financing costs.

Delivery versus Payment in the Americas

3.13 Nine COSRA members are represented on the Working Party and a total of 19 systems are covered in the Country Reports owing to the existence of more than one settlement system in a number of countries. (A summary of the key features found in some of the settlement systems examined is contained in Table A below.) In this report a "settlement system" or "system" refers to a process for the clearance and settlement of a trade in a security as defined by functionality. A system is not defined by the particular entity or entities that may have a role in the clearance and settlement of a trade but rather the process used to clear and settle trades. The process, and the associated rules, will determine the rights and obligations arising among participants and between participants and the settlement agency. This includes the procedures relevant in the event of a default. Although some systems may be designed to handle only one type of security, other systems may accommodate many types of securities without necessarily making any distinction between them. In other situations, a system may have developed, from an historical perspective, to deal with trades originating from a particular market such as a clearance and settlement agency established to handle all trades from a specific stock exchange. Consequently, there may be several settlement systems in a country where each system was developed to service a different exchange. In some countries there is a single settlement agency that offers more than one settlement service or process. Participation in one of the services would impose certain obligations on the user of that service but the participant would not be obligated or otherwise affected by any events that may take place in the other service. In this report each of those services would be considered a distinct system.

Table A: Key Features of Select Settlement Systems

3.14 Of the systems that were reviewed by the Working Party it was found that most, but not all, systems used some form of DVP that could be classified as one or more of the models described in the DVP Report. In total 16 systems (84% of the systems reviewed) achieved DVP, of which 2 (10%) were described as Model 1, 6 (32%) were Model 2 and 8 (42%) were Model 3.

3.15 The proportion of systems that are described as Model 1 DVP is relatively low at only 10%. This finding is similar to that found in the report of the Federation Internationale des Bourse de Valeurs in 1996 where globally only 9% of settlement systems surveyed were Model 1 DVP systems. Presently, only two systems achieve RTGS, the bilateral settlement system in Chile and the FEDWIRE system in the United States. The settlement system for fixed rate bonds and commercial paper in Chile is an RTGS system carried out by the same brokers that are parties to the transaction. When the securities are deposited in the DCV, the central depository in Chile, the delivery of the securities will occur in the DCV with final and irrevocable electronic transfer from the seller’s account to the buyer’s account in DCV. In Chile the buyer will deliver a means of payment to the seller at the same time the seller delivers the securities to the buyer. The means of payment is completely guaranteed by the Chilean Central Bank and is considered to be final and irrevocable payment. The FEDWIRE is owned by the Federal Reserve Banks which are a part of the central bank. FEDWIRE provides safekeeping and book-entry for funds and securities of the US Government, US Government agencies, US Government sponsored enterprises and certain international financial institutions. It settles transfer instructions for both securities and funds on a trade-for-trade real-time gross basis.

3.16 The Debt Clearing Service (DCS) operated by The Canadian Depository for Securities Limited in Canada is example of a Model 2 DVP system that functions for practical purposes like a Model 1 DVP system. DCS transfers securities on a trade-for-trade basis throughout the settlement cycle but settles payment at the end of the day through the Large Value Transfer System operated by the payment system. The unique feature of the system is the guarantee of payment settlement given by the central bank on a trade-for-trade real-time basis. From the perspective of the participants, this would be the equivalent of final and irrevocable payment because of the unconditional claim on the central bank. The risk of default assumed under the guarantee by the central bank is mitigated through collateral pledged to the central bank by the participants in DCS.

3.17 Efforts to improve the markets within a country are often enhanced by parallel efforts of neighbouring countries within the region. Regional harmonisation is encouraged to enhance the attractiveness of a number of markets that may be at a similar stage of development, such as the efforts taking place in Caribbean countries of Barbados, Bahamas, Trinidad & Tobago, Jamaica and the Dominican Republic. In the Bahamas, the changes will significantly alter the clearance and settlement process by moving the current paper-based system to an electronic system which will be implemented in two phases. The first phase will create a Model 2 DVP system whereby securities will be transferred throughout the day on a real-time basis with funds settling on a net basis at the end of the day. In the second phase, the system will look like a Model 1 DVP system. The Bahamas Central Securities Depository will settle each transaction on an RTGS basis. The funds will transfer electronically at the central bank from the account of the participant buying the securities to the account of the participant selling the securities, and the securities will transfer electronically on the books of the CSD from the account of the participant selling the securities to the account of the participant buying the securities.

3.18 The systems that were reviewed show Model 1 DVP systems are associated with debt markets, such as those in the United States and Chile, and smaller equities markets, such as the Bahamas. This would indicate that RTGS models tend to find favour in situations where the size of the market (as measured by the number of transactions) is not large. Debt markets, although large in terms of aggregate value traded, usually have a relatively small number of transactions most of which are of a high value. Most markets with a high volume tended to use a model of DVP that employs netting, at least on the payment side, and in most cases on the securities side as well, in order to benefit from the efficiencies that the netting process offers. NSCC in the United States, which clears and settles virtually all securities traded on U.S. stock exchanges and the Nasdaq Stock Market, is a Model 3 DVP system that nets and guarantees both securities and funds obligations for its participants.
4. SETTLEMENT ASSURANCE

Purpose of Settlement Assurance

4.1 Settlement assurance mechanisms are those procedures that have been established, either by the settlement system or pursuant to regulatory requirements, in order to ensure the settlement of transactions even when a participant in the system fails to meet its obligations. In its most basic form, DVP can be achieved by simply "unwinding" any trade whenever one of the counterparties fails to fully meet its obligations precisely when due. While this would achieve the singular goal of protecting the counterparties from principal risk, the failure to complete the transaction may subject the non-defaulting participant to replacement cost risk and liquidity pressures. Each of these can be a source of systemic risk in itself in that the non-defaulting participant in the first transaction may nonetheless find itself unable to complete other transactions as a result of the initial default. For this reason, unwinding of transactions is not the most desirable way to prevent principal risk. Instead, it would be far better to have a settlement assurance system that provides for the completion of all transactions on settlement day, even if the non-defaulting parties to those trades should ultimately incur the loss.

4.2 Settlement systems around the world employ a variety of schemes to guarantee or ensure the settlement of transactions processed through their services. The extent or quality of the guarantee varies from place to place, as do the mechanisms employed to provide the guarantees. Settlement assurance mechanisms are usually employed by settlement agencies (be they in the securities settlement or payments settlement operations) to guarantee the completion of the transactions that are processed through a given settlement system. The use of settlement assurance mechanisms should not be part of a "business-as-usual" process; they are employed when things "go wrong". In most cases, the thing that "goes wrong" is the default or failure of an organisation that owed funds, or has outstanding transactions with the settlement system.

4.3 Assets held by the settlement system for settlement assurance may be used to cover losses from such risks as replacement cost risk and liquidity risk. Settlement systems that employ RTGS (Model 1 DVP) have no need of settlement assurance schemes to guarantee the payment of net obligations. This is because an RTGS system achieves DVP in real-time and in final funds, when the delivery of securities is made. The use of "final" funds precludes any possibility of a payment problem in the future and therefore eliminates the need for a settlement assurance mechanism to cover payment problems. However, RTGS systems could employ the use of settlement assurance schemes to guarantee the settlement of transactions as they come due. Moreover, systems that do not guarantee the settlement of transactions may use various settlement mechanisms to minimise losses to participants. For example, the DCV in Chile has a Model 1 DVP system for fixed rate bonds and commercial paper. The system does not guarantee delivery of securities or funds, yet it imposes a lien on a participant’s assets held at the DCV.

4.4 The need for settlement assurance mechanisms arises from the centralisation of the settlement process itself and the centralisation of the inherent risks in the settlement process. In a non-centralised settlement environment, each counterparty to a trade enters into the transaction on the faith that the other side of the trade will fulfil its part of the transaction (i.e. either delivery of "good" securities or "final" payment). When there is a failure, the extent of the problem is limited to the organisations that dealt with the failing participant. In a centralised settlement environment, a failure by one participant can put the settlement system, and all of its participants, at risk of failure. The centralisation of processing also implies a centralisation of risks. The need to address this "systemic" risk is usually the reason that settlement assurance schemes are put in place by settlement systems. In addition, in modern settlement systems, there are a myriad of dependencies between settling transactions. The failure of one transaction can have a cascading effect that causes the failure of many other transactions. This too is a systemic risk. In summary, settlement assurance schemes are usually employed for two distinct purposes:

1. to guarantee the payment of net settlement obligations usually in an environment where RTGS is not employed; and





2. to guarantee the settlement of transactions that are due and transactions that are in the clearance and settlement system and are due to settle in the future.

4.5 Typically, settlement assurance mechanisms are used to guarantee the payment obligations of the participants in a centralised settlement system. For example, in a settlement system that has its participants make a single, day-end, payment of their net payment obligations (a Model 2 DVP system), a settlement assurance mechanism is used to guarantee the net payments. For example, Canada uses Model 2 DVP for settlements in its debt market, where the payments are made on a net basis at the end of the settlement cycle. However, the central bank guarantees the funds on a RTGS basis provided that the participant has sufficient collateral pledged to the central bank. The guarantee makes this system function essentially like a Model 1 DVP system.

4.6 In addition, Models 2 and 3 DVP systems generally operate some form of a "zero sum" system. In these systems, the completion of each individual transaction results in an update to a running net payment obligation maintained for the buyer and seller. If the settlement amount of a given transaction is $100, the buyer’s account has $100 deducted from it and the seller’s account has $100 added to it. These are considered to be "zero sum" systems because at any given time, the sum of the payment obligations owed to the settlement system is exactly offset by the payment obligations owed by settlement system. The ability of the settlement system to pay the participants that have a net amount owing to them is totally dependent upon the settlement system receiving the payments from the participants that have a net amount owed by them. If a participant that owes funds to the settlement system does not pay, or cannot pay, the settlement system would have insufficient funds to complete all of the payments. In this situation, a settlement assurance scheme can be used to absorb the missing payment(s) and allow the settlement system to complete its obligations owing to other participants.

Guarantee of Settlement Transactions

4.7 The other typical use of a settlement assurance scheme is to guarantee the settlement of all transactions in the clearance and settlement system. One of the most prominent recommendations of the Group of Thirty, was for securities transactions to be "locked-in and guaranteed for settlement at the close of T+1. By having settlements guaranteed at the close of T+1, the counterparties to the trades can plan their onward settlements and lending/borrowing requirements. The dependencies between transactions in an active securities market are considerable. It is not uncommon, in an active market, for a given security position to be exchanged five to ten times within a single day. In fact, a market’s ability to process such a chain of settlements is one of the measurements of a market’s efficiency.

4.8 Settlement assurance schemes can absorb the failures of a single participant and prevent the transmission of the failure to other participants. In this way, a settlement assurance scheme can mitigate systemic risks and prevent a series of failures amongst other market participants.

4.9 A settlement assurance mechanism is often used to provide the assurance that a group of transactions will settle, no matter what, on their settlement date. For example, on T+1 a settlement assurance scheme might provide participants with a guarantee, for settlements on T+3. In the event that a participant fails to fulfil its settlement obligations (either delivery of securities or payment of funds), the settlement assurance mechanism steps in to complete the transactions. This could involve borrowing or purchasing securities in the open market to complete a delivery, or it could involve making payment and taking receipt of the securities. In both cases, the settlement assurance mechanism provides a means to complete an anticipated settlement. For the counterparty to a trade that would have otherwise failed without the settlement assurance mechanism, this means that its onward settlements remain unaffected by the failure of another market participant.

Considerations in Establishing a Settlement Assurance Scheme

4.10 Settlement assurance schemes deal with two fundamental issues: liquidity and loss allocation. Immediately upon the default of a participant the most pressing issue is to ensure adequate liquidity to the system to enable the completion of the settlement cycle. An effective settlement assurance scheme should have provisions for ready access to funds for this purpose. Common approaches to deal with this matter include the use of: (1) lines of credit arranged with banking institutions; (2) participant funds that must include a minimum amount of cash; and (3) the settlement agency's own retained earnings or paid-in-capital.

4.11 An effective settlement assurance scheme also should address the issue of how the loss occasioned by the default of a participant should be borne by the surviving participants. Inherent in the design of the system is the respective responsibility of each participant to bear a portion of the risk or loss. Usually this will take the form of a participant fund, collateral pool and/or credit ring. Since the purpose of the settlement assurance schemes is to "absorb" a payment default or failure to settle, it is essential that the scheme maintain sufficient assets to cover potential problems. Typically, the scheme will be sized to address the largest potential loss arising from a default that might occur in keeping with the Lamfalussy Standards.

Guarantee of Payment Models

4.12 Schemes that are designed to guarantee the payment of participants’ net payment obligations typically employ a participant fund as one of the primary components of the scheme. Each participant contributes a certain amount of assets to the fund, usually in the form of government (guaranteed) securities, cash and irrevocable bank letters of credit. There are several factors, listed below, that could determine an individual participant’s contribution to the fund:

4.13 Capacity of the Settlement Assurance Scheme: Taken as a whole, the particular settlement assurance scheme should be created or designed to handle a situation of a pre-determined magnitude. At a minimum, settlement agencies should strive to meet the minimum level set in the Lamfalussy Standards; that is, a settlement system should be designed to accommodate the failure of the participant with the single largest net debit position. Settlement agencies have been encouraged to design systems to exceed this minimum by being able to withstand the failure of more than one major participant.

4.14 Gross/Net Settlements: A participant’s contribution to a payment guarantee fund might be based on the participant’s gross settlements (gross buys plus gross sells). For example, a participant might be required to contribute 5% of the gross value of its buys and sells to the participant fund. Alternatively, a participant’s net settlements might be used as the basis for the contributions.

4.15 Defaulter vs. Survivor Pay Models: The settlement system and its participants should decide, up front, which type or blend of models they wish to adopt. A defaulter-pay model attempts to have each participant cover its own risk of default. In a defaulter-pay model, each participant’s contribution to the participant fund is roughly equal to its largest potential payment default. A survivor-pay model "mutualises" the risk coverage by spreading it amongst not only the defaulter itself but also the surviving members of the participant fund. Survivor-pay models have the advantage of reducing the cost (by reducing the contributions) to all members of the participant fund but at the expense of increased risk exposure to all participants.

4.16 Capital Strength: One of the issues that frequently arises in the formation of a participant fund is the "too big to fail" argument. Large participants usually feel that they bring less risk of failure to a participant fund than the smaller participants bring. On the other hand, the default amount of a large participant is larger than that of a smaller participant. Larger participants usually argue for a participant fund contribution formula that recognises their capital strength by reducing, proportionally their contributions and increases, proportionally, the contributions of the smaller participants. However, a settlement agency, in determining the size of any participant fund should make sure the burden does not unduly hinder its members’ liquidity needs. The burden may be minimised by seeking low cost options to meeting liquidity needs (such as lines of credit) and employing other risk reduction methods (such as membership standards and net debit caps).

Guarantee of Settlement Transaction Models

4.17 A guarantee mechanism for future-dated settlements must be able to address either a failure to deliver securities or a failure to pay for securities that result from transactions that are to settle in the future. For example, if a settlement agency guarantees trades on T+1 (for settlement on T+3) and a participant defaults on settlements due on the same day, the settlement agency would be obligated to settle the securities on that day plus securities that were guaranteed but not settled. That means that the settlement agency would have to meet the settlement obligations of the defaulting participant for two additional days to cover all guaranteed trades. A participant fund is the chief mechanism to provide assets to cover future settlement guarantees. The amount of a participant’s contribution is based on a number of factors including the participant’s settlement activity and on the factors outlined above for payment guarantee schemes. In addition, the following factors may also be taken into account in the calculation of a participant’s contribution to a participant fund:

4.18 Size of Outstanding Settlements: The gross size of a participant’s outstanding securities settlements should be taken into account in calculating the participant’s fund contributions.

4.19 Volatility: The price volatility of the securities in a participant’s future securities settlements is an important aspect of a settlement guarantee mechanism. If the securities are highly volatile, the settlement system is at greater risk if it is ever required to step in to complete a participant’s settlements. Higher volatility usually means a participant must make a larger contribution to the participant fund.

Settlement Assurance Mechanisms in the Americas

4.20 A great deal of variability was found among the settlement systems examined by the Working Party in terms of the settlement assurance mechanisms that were used and the degree of "risk-proofing" that was achieved. (A summary of the key features found in some of the settlement systems examined is contained in Table A on page *). Most of the systems that have settlement assurance mechanisms provide a guarantee of the payment obligations. GSCC and NSCC in the United States, are examples of settlement systems that provide guarantee of settlement of all transactions once they are accepted as matched trades in their systems. All matched trades are guaranteed at midnight of T+1 by NSCC for settlement on T+3. The review of the settlement systems by the Working Party revealed a number of mechanisms or techniques that are used to provide the systems with the means to complete all settlement obligations that are due and to protect the integrity of the system and the participants. The different mechanisms are discussed below.

4.21 Participant Funds: One of the more common methods of providing settlement assurance is through the use of participant or guarantee funds that are pools of assets to which participants of the settlement system are required to contribute. Eight of the 19 systems reviewed used participant funds: Argentina (MERVAL), Brazil (CBLC), Canada (CDS- SSS and CDS-DCS), United States (NSCC, DTC, GSCC and OCC). Another three systems (the MAE in Argentina, Bahamas and Barbados) are being significantly upgraded and the use of participant funds is under consideration. Contributions to the fund can occur in a number of different ways:

• In Argentina, legislation requires that stock markets establish a guarantee fund to fulfil settlement obligations. The guarantee fund established by the MERVAL is funded from its profits.

• The participant fund established for the equity settlement system in Canada calculates participant's contribution requirements based on a percentage of daily settlement debits and credits over a specified period of time.

• The equity settlement system operated by NSCC in the United States provides a guarantee of future settlement. The guarantee is provided on T+1 (for matched trades) for trades that are to settle on T+3. In order to manage the exposure to market risk, NSCC imposes "additional margin" requirements that are calculated taking into account daily price movements of the securities, the anticipated closing price that NSCC believes it can purchase the securities to cover the guaranteed position, based on historical patterns.

4.22 Assessment on Members: Most systems that have a participant fund as a primary means to provide liquidity, and to fund any ensuing losses from a participant default, also have the means or right to make further assessments of its participant members for losses that remained outstanding after the participant fund has been exhausted. The right to make further assessments on members is akin to an extension of a participant fund, and the amount of a member's additional liability is usually calculated using the same formula as the contributions required for the participant fund. In total, 7 of the systems include the ability to levy further assessments as one of the mechanisms in the settlement assurance scheme.

4.23 Credit Rings: The CDS-DCS system in Canada uses a variation of the participant fund/assessment on member mechanism. Participants in DCS are designated in one of four classes of participants according to the types of activities they can engage in. Participants in each of the classifications form a "credit ring" whereby each participant guarantees the obligations of the other members in the credit ring. If any participant defaults then the other members of the credit ring must pay a pro-rata share of the outstanding obligation of the defaulting participant.

4.24 Lien on Assets of Defaulting Participant: The most commonly used settlement assurance mechanism is a lien on security interests granted by each participant in favour of the settlement agency or other participants in the system, depending on which party would be responsible for the outstanding obligations of the defaulting participant. The assets of the participant that may be subject to the security interest may include cash in the participant’s account, securities on deposit (including any securities delivered to the participant in the settlement process), any other assets deposited as collateral, and any participant fund contribution.

4.25 Guarantees: Various parties can provide guarantees for the purpose of ensuring the completion of a settlement cycle. These parties could include: the settlement agency itself, all other participants within the settlement service in question, or perhaps a specific financial institution or group of financial institutions that may or may not be themselves participants. In El Salvador, the stock exchange has undertaken to provide liquidity to a defaulting broker to ensure the completion of settlement. Guarantees do not eliminate risk per se but rather shifts the risk to the guarantor(s). It is therefore important that the party that assumes the risk has the financial ability to meet its commitment and appropriate risk management procedures. Failure to ensure this may frustrate the intent of a settlement assurance scheme, which is to enhance the stability of the clearance and settlement process and the financial marketplace, since the guarantor itself becomes a potential source of risk.

4.26 Committed Lines of Credit from Financial Institutions: Even where a participant fund is established with an intent to maintain a specified amount of its assets in cash to provide liquidity, this amount may not be sufficient in the case of a default by a participant with a large net debit position. For this reason, system operators will also establish lines of credit with banks or other major financial institutions to ensure adequate liquidity to handle the largest anticipated failure. Assets of the participant fund may be pledged to the financial institution as security for the credit facility.

4.27 Paid-in Capital and Retained Earnings of the Settlement Agency: The settlement agency's own financial resources may be used as an additional source of liquidity to supplement credit facilities, participants fund or other collateral on deposit.

4.28 Collateralised Exposure: In a number of systems, participants are required to provide collateral for the risk that their activities bring to the system. A collateral requirement poses a cost for the participant in that it ties up the participant’s assets for the purpose of gaining access to clearance and settlement services. However, it is a very effective measure to protect the settlement agency, CSD, financial institutions providing credit to the participant or the system and other participants from the risk of default by a participant. The following are examples of how various settlement systems in the Americas collaterlise their exposure:

• In Brazil the clearance and settlement system operated by CBLC requires that the clearing agent representing a defaulting broker must deposit collateral equal to 30% of the gross value of the outstanding trade. The collateral will only be returned on the first business day after the transaction has been completed without any remuneration for the period it was retained.

• The settlement systems operated by DTC and NSCC in the United States maintain collateralised lines of credit with major banks for liquidity purposes

• In the DCS system in Canada, the participants in each of the credit rings must contribute collateral to a pool which is intended to provide liquidity and security in the event of default by a member of the credit ring.

4.29 Mark-to-Market for Default Positions: The settlement systems operated by NSCC and GSCC in the United States impose mark-to-market margin for each failed delivery of securities. The margin is calculated daily as the difference between the original contract price and the price at the previous day's close. The accounts of the seller and buyer are debited and credited accordingly each day until the securities are delivered. This margin requirement provides a certain degree of protection against the market risk to which the settlement agency (as guarantor of settlement) is exposed.

4.30 Buy-in Procedures: Procedures to compel the delivery of outstanding securities by participants in a net-to-receive position are found primarily in systems dealing with equity trades; CBLC (Brazil), SSS (Canada) and NSCC (United States).
5. OTHER RISK REDUCTION MECHANISMS

5.1 Intimately tied in with the use of DVP and settlement assurance mechanisms are a multitude of other measures or procedures that can be used to provide further risk mitigation. A number of these procedures were noted in the Country Reports describing the various settlement systems that were examined. Although they are not technically what would be considered settlement assurance mechanisms, it is worthwhile to briefly highlight some these measures that are used to further enhance the overall safety and efficiency of a settlement system. Settlement assurance mechanisms are mechanisms that are designed to deal with the consequences of a default. Risk reduction mechanisms referred to in this section are those procedures or requirements that are not dependent upon an event of default. They may include mechanisms to minimise the likelihood of a default, such as imposing membership standards for eligibility to participate in the settlement system, or ensuring that securities lending and borrowing is permitted. Other mechanisms are ones that minimise the magnitude of the potential problem when a default occurs, such as limiting the debit position that a participant may generate, or employing multiple settlement cycles during the day to reduce the size of outstanding obligations.

5.2 Membership Standards: Almost all systems have certain requirements for a market participant to be able to use the services of the settlement system. A basic requirement is that a participant must be registered with a securities regulatory authority, a regulated entity such as a bank or trust company, or a member of a recognised or registered self-regulatory organisation, and that the registration or membership is in good standing. Membership in these capacities usually entails minimum levels of financial capacity (regulatory capital), management experience, and technical and operational capacity. Settlement systems themselves may have additional requirements or higher minimum requirements over and above that required by the participants’ relevant regulatory body. Membership requirements are especially important for systems that guarantee payments or settlement transactions because participants no longer look at the credit of the counterparties to their trades. Instead, participants look to the settlement agency guaranteeing the payment or transaction. Therefore, it is critical that systems that guarantee trades have high membership standards to minimise credit risks.

5.3 Net Debit Caps: Certain settlement systems impose limitations on a participant's level of transactions. Net debit caps help to ensure that the risk created by a participant is within established parameters. Caps can be used in a very complimentary way with participant funds and collateral requirements. Participant funds are often sized based on anticipated needs that are determined on historical patterns of activity by participants. However, a participant may engage in unprecedented levels of activity and a default in this situation may create losses that the fund cannot adequately deal with. Similarly, collateral deposited by a participant to secure its settlement activities may be insufficient if there is no limit on the aggregate value of transactions that the participant can process through the settlement system. Net debit caps ensure that settlement obligations taken on by a participant during a settlement cycle are limited such that existing participant funds and collateral on deposit will be adequate to absorb the losses of a default. Flexibility may be added to the system by allowing participants to exceed their caps by depositing additional collateral or making a higher contribution to the participant fund in an amount equal to the amount of the excess over the cap.

5.4 Multiple or Intra-day Settlement Cycles: Systems that are Model 2 or 3 DVP use a netting process to determine a participant's end of cycle obligation. The amounts owed by participants are greatly reduced through the use of netting. Nonetheless, having multiple cycles during the day is likely to further reduce the amount of outstanding settlement obligations and the associated systemic risk and liquidity risk.

5.5 Securities Borrowing or Lending: The Group of Thirty, the International Securities Services Association and the CPSS-IOSCO Task Force each recommended that securities lending and borrowing be encouraged as a means of expediting the settlement of securities transactions. The larger markets permit this practice. The MERVAL in Argentina operates a securities loan facility.
6. CONCLUSION

6.1 The degree of the risk abatement in settlement systems is dependent, not only on the model of DVP that is chosen but also on the specific risk management mechanisms that are employed. The choice of DVP Models 1, 2 or 3 for a settlement system should be determined by the needs of the particular marketplace. The Working Party members found that settlement systems within their countries achieved DVP using one or more of these three Models and sometimes a combination of more than one Model. The Working Party also found that the particular Model of DVP selected did not necessarily have any bearing on the ultimate quality of risk management that is achieved. Any one of the Models may provide a highly safe and secure environment for the clearance and settlement process if appropriate risk management policies and procedures are incorporated into the system.

6.2 Without DVP, parties to a trade must rely on the credit worthiness of the counterparty and on his honesty to deliver a valid and properly endorsed security or a check drawn on sufficient funds. DVP not only centralises the settlement function but also minimises principal risk and, depending on the DVP Model and the risk management mechanisms used, minimises other risks, including replacement risk, liquidity risk and systemic risk.

6.3 A Model 1 DVP system - an RTGS system - eliminates principal risk by exchanging securities and funds on a trade-for-trade basis. While an RTGS system eliminates principal risk, it does not guarantee that the securities or funds will be available for transfer. It prevents the counterparties from losing their principal but does not reduce other types of settlement risk, such as replacement cost risk and liquidity risk. An RTGS system, if securities and funds are received, will by its nature, eliminate principal risk, which is the greatest source of systemic risk, by ensuring final and irrevocable delivery of securities against final and irrevocable payment of funds where each leg of the transaction will occur if and only if the other leg of the transaction also takes place.

6.4 Model 2 and 3 DVP systems use netting in the settlement process in order to more efficiently settle a large number of transactions. The process of netting itself can mitigate liquidity risk for settlement participants, since the aggregate obligations of participants are dramatically reduced under this process than would be the case if obligations were calculated on a gross basis. Using a central counterparty that guarantees all settlements further reduces the liquidity risk of participants. However, the settlement risks do not go away but are transferred from the original counterparties to the central counterparty.

6.5 The quality of the clearance and settlement process may be further enhanced and other types of risks – liquidity, replacement cost and systemic risks – may be reduced by the use of various settlement assurance mechanisms. Settlement assurance mechanisms are designed to address the risks that DVP fails to cover and any additional risk imposed on the settlement system by centralising the settlement process and imposing a central counterparty between the buy and sell parties to each transaction.

6.6 DVP systems that guarantee settlement of all trades on settlement day are transferring the risks involved in settlement from the counterparties to the trade to the central counterparty guaranteeing the trades. The central counterparty eliminates principal risk and replacement cost risk for participants of the settlement agency from the point at which it interposes itself as the central counterparty. By eliminating these risks from the original counterparties to the trade it also eliminates the liquidity risk for the original counterparties that can arise from a default. The central counterparty should have sufficient liquidity to meet its settlement obligations. Through proper management of the principal risk, replacement cost risk and liquidity risk, the central counterparty can minimise systemic risk to the marketplace.

6.7 The almost universal presence of settlement agencies in securities markets, especially those that are highly developed, is testament to the potential economic benefits that they offer to the marketplace. However, a settlement system that is not cost effective, no matter how effective its risk management program, may find that market participants decide not to use some or all of its services. Instead, participants may seek out other avenues to clear and settle their transactions that may involve much higher levels of risks to each of the participants and the markets in general. Therefore, the benefits of adopting further or additional settlement assurance mechanisms should always be considered against the costs they impose and the effect that this will have on system usage.

6.8 A settlement assurance system should offer efficient, economic and value-added services to the marketplace. In this report a variety of mechanisms are identified as being used within the region’s settlement systems. These mechanisms may be used in conjunction with others as part of a comprehensive risk management program. However, each mechanism can be used on its own to reduce settlement risks even if it is not adopted as part of a larger more extensive program. This incremental approach to improving a settlement system should result in a reduction in the risks associated with the settlement process and should be considered whenever it is practical and cost effective to do so.

6.9 The quality of the risk management program for a settlement system does not depend solely upon the number of different settlement assurance mechanisms that may be in effect but is also determined in large part by the level at which the requirements are established. A system that employs only one or two mechanisms is capable of providing the participants with substantial risk reduction in the settlement process if the requirements of those few mechanisms are set at a high level. Such a system may have less risk overall than a system that employs additional mechanisms but where each of the requirements are set only at minimal levels.

6.10 The topics of DVP and settlement assurance were selected for examination because they were considered key recommendations which if implemented could bring about significant improvements in efficiency and risk reduction in a settlement system. However, they are only two of many recommendations that have been made by international organisations such as IOSCO and CPSS. System operators and regulators should consider implementing all CPSS-IOSCO Task Force recommendations.

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1. In 1989 the Group of Thirty made nine recommendations for securities clearance and settlement systems. These recommendations have become the most frequently cited benchmarks for evaluating a settlement system for its efficiency and risk profile. Recognising that there was a substantial risk in the settlement process, in that one party may deliver securities without the simultaneous receipt of value, one of the key recommendations made was that "Delivery versus payment should be employed as the method for settling all securities transactions". It was the view of the Group of Thirty that one of the more significant deficiencies in clearance and settlement systems was the lack of DVP which was a source of principal risk to market participants.





2. The Group of Thirty also recommended that "Each country should study its market volumes and participation to determine whether a trade netting system would be beneficial in terms of reducing risk and promoting efficiency". Netting of trades for settlement purposes can be highly efficient in markets with high volumes of transactions. While noting that there are three basic options for netting of transactions, in the case of multilateral netting and continuous net settlement, the netting process results in a change in the counterparty. The change of counterparty, either to another counterparty or to the settlement system itself, necessitates the adoption of some sort of risk sharing and trade guarantee system to ensure the completion of the settlement cycle even in the event of the failure of one of the participants in the system.

Committee on Payment and Settlement Systems

3. In 1992 the Committee on Payment and Settlement Systems of the Bank for International Settlements (CPSS) published a report on Delivery versus Payment in Securities Settlement Systems (DVP Report) that remains the most comprehensive review of the topic to date. The review undertaken by the central banks on the subject of securities clearance and settlement was related to their concern that disturbances to settlements in the securities markets have the potential to spread to the payment system and to the financial system generally. The Committee’s view was that the Group of Thirty’s recommendation for DVP to be adopted as a means of settling securities transactions was the recommendation that attracted the most attention. DVP was the mechanism to address principal risk which was seen as the largest potential source of systemic risk.





4. From its review of the securities transfer systems in the Group of Ten countries the CPSS Study Group identified three basic models used to achieve DVP: Model 1 which is a real-time gross settlement model; Model 2 which transfers securities on a gross basis throughout the settlement cycle but transfers funds on a net basis at the end of the settlement cycle; and Model 3 which transfers securities and funds on a net basis at the end of the settlement cycle. Although the use of the models was a convenient tool in understanding the basic structure of a system it was noted that the degree of protection against the various risks found in clearance and settlement, such as principal risk, liquidity risk and replacement cost risk, depended more on the risk management safeguards that were utilised than the particular model employed.





5. In 1998 the CPSS established the Task Force on Payment System Principles and Practices to consider what principles (Core Principles) should govern the design and operation of payment systems in all countries. The objective was to develop international consensus on such Core Principles that would be applied to systemically important payment systems. Although the focus of the Task Force report was on payment systems only, it did note that the Core Principles could apply to other settlement systems such a securities settlement system which could raise financial stability issues in its own right.





6. The Core Principles updated and extended recommendations for minimum standards that were produced by the Committee on Interbank Netting Schemes of the Group of Ten Countries (Lamfalussy Standards). The Lamfalussy Standards have become widely accepted standards for evaluating payment systems. Netting systems inherently defer settlement of participant’s obligations creating the risk of participant’s failure in the intervening time from entering the trade for settlement to the actual settlement of resulting net obligations. The Core Principles carried forward the key recommendations in the Lamfalussy Standards relating to participant failure. It recommended that a system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation.





International Organization of Securities Commissions

7. IOSCO stated that the objectives of securities regulation were (i) the protection of investors, (ii) ensuring that markets are fair, efficient and transparent, and (iii) the reduction of systemic risk. The latter objective of reducing systemic risk is also a key objective of the CPSS. In order to achieve these objectives IOSCO developed 30 principles of securities regulation. In relation to clearance and settlement systems it stated "Systems for clearance and settlement of securities transaction should be subject to regulatory oversight and designed to ensure that they are fair, effective and efficient and that they reduce systemic risk". Regulatory authorities should have direct supervision of settlement systems and their operators. The framework for regulation should ensure accountability of such systems and allow for the identification of potential problems through a review of the system mechanisms and establishment of operating standards.

International Securities Services Association

8. In the more than ten years since the Group of Thirty recommendations were made there have been several efforts to update the recommendations. The International Securities Services Association (ISSA) made revised recommendations in 1995 (G30/ISSA Recommendations). It stated that any settlement systems employing netting procedures should meet the Lamfalussy Standards. It also reiterated that DVP should be used to settle all securities transactions first recommended by the Group of Thirty, but went further to defined DVP to mean "simultaneous, final, irrevocable and immediately available exchange of securities and cash on a continuous basis throughout the day". The ISSA has again updated the G30/ISSA Recommendations. The most recent recommendations continue to call for "real" DVP – that is, simultaneous, final and irrevocable DVP – and clear rules that assure investor protection by safeguarding participants from financial risks of failed settlement.





CPSS-IOSCO Task Force on Securities Settlement Systems

9. Most recently the CPSS-IOSCO Task Force on Securities Settlement Systems published its report – Recommendations for Securities Settlement Systems - which contained recommendations intended to facilitate making settlement arrangements safer and more efficient. The objective of the project was "to promote the implementation by securities settlement systems of measures that can enhance international financial stability, reduce risks, increase efficiency, and provide adequate safeguards for investor by developing recommendations for the design, operation and oversight of such systems". The Task Force made its recommendations with the goal that they should be useful to both emerging markets as well as developed markets. To that end the recommendations identified minimum requirements that settlement systems should meet as well as best practices that they should strive for.





10. Two of the recommendations made by the Task Force relate to DVP and risk controls to address participant defaults. In a settlement system that uses deferred net settlement procedures, risk controls should ensure that timely settlement would take place even in the event of default by the participant with the single largest net-debit (payment) obligation. This threshold was first recommended in the Lamfalussy Standards for payment settlement systems and is increasingly being applied to securities settlement systems as well. It was further recommended that settlement assurance procedures that involved the extension of credit or arranges for securities loans to facilitate settlement, should ensure that any credit exposure is fully collateralised.