Entire DVPS Process
Picked From http://www.financialstabilityboard.org/cos/cos_920901.htm
By far the largest financial risks in securities clearance and settlement occur during the settlement process, that is, the process through which the transaction is completed by final (unconditional) transfer of securities from the seller to the buyer (delivery) and final transfer of funds from the buyer to the seller (payment). In some markets no mechanism exists to ensure that delivery occurs if and only if payment occurs. Without such a mechanism (delivery versus payment) counterparties are exposed to principal risk, that is, the risk that the seller of a security could deliver but not receive payment or that the buyer of a security could make payment but not receive delivery. Principal risk in securities settlements is readily seen to be analogous to what is termed cross-currency settlement risk (Herstatt risk) in foreign exchange settlements. Because principal risk involves the full value of the securities transferred, a default by a participant in a securities settlement system that permits such risk may well entail credit losses so sizable as to create systemic problems. For this reason, it is critical for a securities settlement system to create the strongest possible linkage between delivery and payment. Even if principal risk is eliminated through the achievement of DVP, however, participants are still exposed to replacement cost risk and liquidity risk. Liquidity risk includes the risk that the seller of a security that does not receive payment when due may have to borrow or liquidate assets to complete other payments. It also includes the risk that the buyer of the security does not receive delivery when due and may have to borrow the security in order to complete its own delivery obligation. Liquidity problems have the potential to create systemic problems, particularly if they occur at a time when securities prices are changing rapidly and failures to meet obligations when due are more likely to create concerns about the solvency of counterparties. In the absence of a strong linkage between delivery and payment, the emergence of systemic liquidity problems at such times is especially likely, as the fear of a loss of the full principal value of securities or funds is likely to induce some participants to withhold deliveries and payments, which, in turn, may prevent other participants from meeting their obligations. But even the achievement of DVP does not by itself ensure that systemic liquidity or credit problems cannot develop. An analysis of systemic risks in securities settlement systems must not only determine whether DVP is achieved (and, thus, whether principal risk is eliminated) but must also assess the degree of protection provided against replacement cost risk and liquidity risk.
The Study Group has thoroughly reviewed most of the securities transfer systems in use or under development in the G-10 countries. On the basis of this review, the Study Group has identified three broad structural approaches to achieving DVP (or more generally, to creating a strong linkage between delivery and payment in a securities settlement system):
* Model 1: systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment).
* Model 2: systems that settle securities transfer instructions on a gross basis with final transfer of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a net basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle.
* Model 3: systems that settle transfer instructions for both securities and funds on a net basis, with final transfers of both securities and funds occurring at the end of the processing cycle.
Although the Study Group at first attached considerable significance to the structural differences among these models, further analysis has led it to conclude that the degree of protection provided against principal risk and especially against replacement cost risk and liquidity risk depends more on the specific risk management safeguards a system utilises than on which model is employed.
The key to developing a framework for the analysis of the implications of DVP systems for credit and liquidity risks is to recognise that nearly all of the systems that the Study Group has reviewed extend credit to their participants, either explicitly by allowing funds account overdrafts (model 1) or tacitly by allowing funds transfer instructions to be settled on a net basis (models 2 and 3). The primary question to be addressed is how well the system could cope with the failure of one or more participants (or guarantor banks) to repay such credit extensions. As noted above, in most cases such settlement failures would not create principal risk, but substantial replacement cost risk and liquidity risk may be involved.
Another important issue is the vulnerability of the system to insolvency or liquidity problems on the part of the settlement bank (the entity that holds the funds accounts used for payments in the settlement system). One obvious solution is to use central bank accounts and funds transfers, and such arrangements are in fact used in many of the securities settlement systems that the Study Group has reviewed. However, this solution is not always available, either because of statutory limits on access to central bank accounts (particularly for non-bank participants in securities settlement systems) or because central banks have made policy decisions to limit access, most often because of concerns about competition with the private banking system. If central bank accounts are not available, the vulnerability of the system can nonetheless be greatly reduced by requiring the entity whose liabilities are used as the settlement medium to allow such balances to be retransferred to a third party on the same day. The use of "same-day funds" in settlements, it should be noted, is another of the recommendations of the Group of Thirty. Still another issue arises in those securities settlement systems that do not themselves dematerialise securities or immobilise certificates but instead rely on the custody services of third parties (custodians). In such cases, the failure of a custodian may temporarily impair the ability of participants to transfer securities (at least to non-participants), and a loss of some portion of the value of the securities held in custody may also be possible in certain circumstances.
The Study Group's work suggests that a variety of approaches to the design and operation of a securities settlement system are consistent with central bank policy objectives relating to stability and the containment of systemic risk and to the efficiency of financial markets. Whether a given system provides adequate protection against systemic risk depends on the particular risk controls that it adopts. These vary from system to system because of differences in the structure of securities markets, money markets and national payment systems. No single set of controls can be expected to strike the most favourable balance between risk and efficiency in all circumstances. Nonetheless, securities settlement systems must address a common set of risk management issues.
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