FEAS Yearbook FEAS Yearbook 2002 | Page 12

FEDERATION OF EURO-ASIAN STOCK EXCHANGES > YEARBOOK 2002/2003 > PAGE 10 HP CAPITAL MARKETS FRAMEWORK CLEARING AND SETTLEMENT CONSIDERATIONS Major markets settlement providers and market participants have been driven by a number of strategic trends in recent years, the ripple effects of which affect smaller market environments in a material way. By “settlement provider” we mean central clearing and settlement institution. This covers clearing houses (clearing and settlement services and links to the money transfer system), Central Securities Depositories (CSDs maintain accounts for market participants and offer delivery versus payment facilities) and Central Counter Parties (CCPs offer centralized settlement guarantees). The trends include: Rapid increases in settlement volumes (in spite of setback caused by the past year’s economic slump); The need to reduce risk; Mergers and rationalization of exchanges and clearing organizations; Voluntary changes in governance and profit objectives; Cross-border settlement; Business and technology standards development. These trends, on the one hand, force and, on the other hand, facilitate the expansion of the business areas of the major exchange and clearing environments: for instance, an increasing number of de-mutualised for-profit institutions need to expand their traditional area of coverage (instrument-wise, as well as geographical) to leverage the investment in large systems, while at the same time, the increasing experience with cross border trading and settlement makes it easier to expand across new borders. We’ll briefly review some of these trends to underscore the investment required (and thus the need to leverage!) and than we’ll make some suggestions as to what the smaller exchange environments can do to ward of the threat of oblivion and establish a solid regional niche. Volume increases The volume of shares traded from 1999 to 2000 increased in most major markets in the world, placing ever-increasing stress on the settlement providers: Hong Kong 69%, Amex 62%, Deutsche Boerse 48%, LSE 42%, Euronext (Paris) 40%, NYSE 29%, Sao Paolo and Buenos Aires both 28%, Tokyo 12%. Although the recent adverse economic conditions have affected volumes quite negatively, these conditions are not expected to last and volume growth will return. Major markets are adopting clearing and settlement structures to alleviate the stress brought on by these growth rates. The need to reduce risk Central counterparties An increasing number of exchanges are adopting Central Counter Party (CCP) structures. A properly constituted CCP defines the assets and liabilities of counterparties to a transaction, offers a guarantee system that protects participants against settlement risk, manages and administers collateral assets and exists as a separate legal entity from the trading organizer and settlement provider. A CCP concentrates settlement risk in one organization built on a strong legal and regulatory foundation. Shorter settlement cycles Although in the US the SIA has dropped it’s ambitious T+1 schedule (2005), the trend towards shorter settlement cycles will continue to place great pressures on clearing and settlement providers to upgrade their infrastructures. T+1 is an initiative that is ahead of the globally recommended standard of a T+3 settlement cycle. Automated clearinghouses and CSDs have achieved a relatively high degree of straight- thru-processing (STP). Market participants, on the other hand, still need to overcome a formidable range of current weaknesses, due to mainly manual, non-integrated processes and lacking data integrity. Continuous net settlement (CNS) CNS systems allow settlement of net securities positions at settlement date. Combined with multilateral settlement of money positions, this allows clearing participants to minimize the movements of both securities and money, greatly increasing the efficiency of use of their asset positions. The National Securities Clearing Corporation (NSCC) in the U.S. market has successfully implemented CNS. Real time settlement and RTGS Real-time settlement systems are the ultimate aim for most settlement providers, subject to business and technological constraints of market participants. In such an environment settlement risk, unsettled exposures, and uncertainty of settlement finality are virtually eliminated. An RTGS system is the most common type of large-value payment system. The aim of RTGS is to allow payments to be settled on a continuous basis throughout the day. Such systems require interconnected applications at the Central Bank (the infrastructure provider), the commercial banks (payments processing), the CSD (if it has a limited banking license) and, in some cases, banking clients. Settlement providers often use an RTGS system to ensure that the money transfers that are associated with end-of-day delivery versus payment processing take place in an efficient manner. Few markets currently use RTGS on a continuous basis throughout the day to settle matched trades in real time, but such usage is likely to increase over the next three to five years. Some settlement providers use RTGS facilities to settle off-market or block trades on a gross basis throughout the day, using either RTGS or SWIFT terminals to complete the money transfer leg. Operational reliability The increasing reliance on single central institutions to clear, settle, and possibly register high volumes of transactions for national or trans- national markets makes their operational reliability of great concern. In some major markets, settlement volumes have increased tenfold in five years. Working papers issued by the BIS (Basel II) outline the recommendations on operational risk for banking institutions. National CSDs will have no alternative but to follow these guidelines and implement appropriate systems and controls. Mergers and rationalization of exchanges and clearing organisations Integration of settlement with securities depository In large markets three different models are being deployed to integrate settlement and depository: Fully integrated clearinghouse and CSD systems (most non-US equities markets) Merged clearinghouse and CSD, but separate systems (all in the US) Separate clearinghouse and CSDs (some equities markets, derivatives) The trend toward a fully integrated clearinghouse and CSD is expected to continue; a recent example is the creation of the Brazilian Clearing and Depository Corporation from numerous separate entities. System integration would normally follow organizational merging. Integration of CSD with central registry The majority of emerging markets that adopted a mass privatization approach have settlement systems that incorporate central registry functionality alongside CSD features. This approach is less common in developed markets owing to different legal structures and business practices. In Europe, CREST is encouraging the creation of a single central registry that will have real-time links with the settlement provider—this exists in all but name for institutionally traded balances. The majority of markets in Scandinavia and Eastern Europe already have a central registry, where a beneficial owner’s name is held on a central record usually within the integrated clearinghouse or depository. Coupling of clearing and settlement with trading Many securities markets operate with an end- of-day, uncoupled processing environment. Coupling an order-driven trading system with a clearing and settlement system is designed to increase operational efficiency and reduce settlement risk, and works at two levels. Many of the larger markets have achieved loose coupling, but tight coupling is more frequent in emerging markets, usually where the exchange and clearinghouse systems are supplied by the same ISV. Loose coupling Matched trades are sent real-time or multi-batch to the clearing and settlement system. Available securities balances may be frozen for future settlement. Net pay amounts for each