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Chapter 3
Market Infrastructure
44. Market infrastructure broadly covers the systems, including the institutional arrangements, that are necessary for the smooth functioning of a debt market. It includes the trade execution system and the systems used in clearing, making payments and settling the securities trades. Some of these areas, especially payments systems, have been the subject of extensive analysis by the BIS, culminating in the publication of a set of core principles by which individual systems can be assessed. These principles are not reproduced in detail here, though the practices discussed below draw heavily upon the material in these publications. Specific features of the types of trade-execution systems are covered in more detail in Chapter Four.
Clarity of Rules and Procedures
45. There should be clear and unambiguous rules and procedures that govern all major aspects of each system's operations. Both the system operator and the participants must clearly understand their respective roles within the system, with well-defined procedures specifying where the responsibility for action rests. Rules that are clear and unambiguous allow participants to undertake transactions with confidence when the system is operating smoothly, and, more importantly, allow them to form clear expectations about the operation of the system in times of stress. Events of default are amongst the most stressful occurrences and ensuring that default procedures are transparent provide the wherewithal for the effective operation of critical market mechanisms.
46. The rules and procedures should give participants a clear understanding of the system's impact on the financial risks that they incur through participation in it. They should clearly define the rights and obligations that participants acquire through participation and they should specify where the responsibility lies for mitigating or managing financial risks. The system operator should provide sufficient information to enable participants and institutions wishing to participate to understand and assess the impact of these obligations on risks they bear. For instance, it may be the responsibility of participants to manage their throughput of payments and their exposures and the responsibility of the system operator to provide them with relevant information on a timely basis.
47. The system's rules and procedures should be set out clearly in a written form available to the public. This ensures that participants or potential participants have a clear understanding of their obligations and minimises any potential misunderstanding or conflicting interpretations of the applicable rules. Access to the systems should also be fair and open and in accordance with objective criteria as set out in the rules.
Element 16: There should be clear and unambiguous rules and procedures that govern all aspects of the operations of a market infrastructure system. These rules should be made freely available to all interested parties with fair and open access to a system based on objective criteria.
Legal Enforceability
48. The rules and procedures should be drawn up so that they are enforceable and that their consequences are predictable. A system which is not legally robust could endanger its participants by giving them a false sense of security, for example, by leading them to underestimate their exposures. A well-founded legal basis is achievable only if the relevant legal environment permits such enforceability and predictability of the rules.
49. There are some specific aspects of payments systems which need special attention in determining whether the legal basis is well founded. These include the legal enforceability of any provisions relating to:
- the irrevocability of payments;
- finality of settlement;
- taking of securities as collateral for providing credit;
- the netting of obligations between participants; and
- the allocation of liabilities among participants, e.g. as part of a loss-sharing arrangement.
50. For example, intermediaries may simply agree to net payments obligations in order to reduce their liquidity requirements. While such a system may function smoothly in normal circumstances, problems are likely to occur if an institution is unable to meet its obligations (either because it is insolvent or it is suffering some temporary liquidity shortfall). Without adequate legal backing for netting, participants may seek to unwind transactions that have already been undertaken, choosing to honour only those transactions that are profitable whilst ignoring transactions that are not in their favour. This selective honouring of transactions is likely to put all system participants under great pressure, potentially creating systemic problems. In contrast, a netting system established under legally enforceable statutes ensures that such unwinding of transactions cannot occur. Liquidity pressures on those institutions remaining in the system will still occur, but with adequate loss sharing arrangements in place, the system will be capable of enhancing timely completion of the transactions.
51. In addition, some aspects of a system may be subject to the law of more than one jurisdiction. The system, for example, may include foreign participants, custodians or settlement banks or could involve issues of securities in foreign markets.
Element 17: The legal enforceability of the system's rules and procedures in all relevant jurisdictions should be established.
Effective regulation
52. While markets tend to promote efficiency, they are not always adequate to ensure the overall systemic safety and stability. An effective regulatory regime should be established, with, where appropriate, one or more institutions explicitly identified to ensure sound risk management procedures are adopted. This oversight function may vary from economy to economy in both scope and procedure. Some economies have a statute-based system of oversight with specific tasks, responsibilities and powers assigned to the central bank and/or to other agencies. Other regimes are based on custom and practice and rely on non-statutory approaches. Each approach can work in its own setting. What is important is that the regulatory environment meets current needs effectively and is capable of accommodating foreseeable changes in these needs.
Element 18: An effective regulatory regime should be established with one or more institutions as appropriate, explicitly identified to ensure sound risk management and efficient operation of the systems.
Management of Risks
Principal risk
53. The largest financial risk faced by market participants occurs during the process of settlement, that is, the process through which the transaction is completed by the final transfer of securities from the seller to the buyer and the final transfer of funds from the buyer to the seller. A mechanism must exist that ensures that delivery of securities occurs only if payment occurs. Without such a mechanism, market participants are exposed to principal risk; this is the risk that the seller of the security could deliver the security but not receive payment, or the buyer of the security could make the payment but not receive delivery of the security. Because the full value of the security being transferred is at risk, a securities system that does not eliminate principal risk can entail very large losses to a counterparty and may even create systemic problems. As a consequence, it is critical for a securities system to create the strongest possible link between delivery and payment.
Delivery-versus-payment
54. A delivery-versus-payment (DVP) system ensures that delivery of securities occurs, if and only if, the cash payment occurs. There are a number ways to achieving DVP in the securities settlement system. An example is some version of real-time gross settlement (RTGS) which is being increasingly adopted by many economies. Such a system settles transfer instructions for both securities and funds on a trade-by-trade (gross) basis with final transfer of securities from the seller to the buyer occurring at the same time as final transfer of any inter-bank obligations arising from a securities settlement. In this case, all parts of the securities settlement are final, with no further transfers of securities, cash or interbank settlement funds being required to give effect to the securities settlement. Because settling all parts of the transaction in real time puts a heavy burden on the liquidity of a system, however, some versions of RTGS systems may use netting to reduce this heavy call on liquidity. Securities transfers may be settled on a gross basis throughout the day, for instance, but the interbank obligations that the securities transfers give rise to are settled on a net basis at the end of the processing cycle. In this case, the system operator may provide a commitment that the buyer’s bank will make payment to the seller’s bank at the end of the processing cycle.
55. Analysis of the risks in securities settlement systems must not only determine whether DVP is achieved, but must also assess the degree of protection provided against liquidity risk. This is the risk that a counterparty will not settle an obligation for full value when it is due, but at some later time. In the case of a system providing final settlement at the end of the day, for instance, the inability of a participant to settle may upset the funding plans of other participants and expose them to liquidity risk unless appropriate contingent facilities are in place. In some systems the completion of settlement may be guaranteed, either by the system operator (which may be a central bank or a private entity) or by another third party (such as a group of commercial banks). In systems that provide such a guarantee, a variety of risk controls are imposed by the guarantor to protect it from losses, and, in cases where the guarantor's solvency is open to question, to make the guarantee credible to participants. The effectiveness of such risk controls is critical - should the controls prove inadequate and the guarantor's financial condition become impaired, serious systemic problems may result.
Element 19: The risk management procedures should address the various categories of risks, including principal and liquidity risks. The introduction of delivery-versus-payment procedures substantially addresses the principal risk. Systems should ensure that suitable contingency arrangements are in place in the event that a counterparty is unable to settle an obligation when it becomes due.
Settling in central bank funds
56. In addition to the risk of counterparty failure, participants in securities settlement systems may face the risk of a settlement bank failure, that is, the failure of the entity that holds the funds accounts used to make payments for securities. This risk can be eliminated by the use of central bank accounts for undertaking the funds transfers.
Element 20: Assets used for final settlement should preferably not present the holder with credit risk, and where possible should take the form of a claim on the central bank.
Shortening the settlement lag
57. Counterparties to securities trades are also exposed to replacement cost risk. This represents the cost of replacing an outstanding transaction in the event that the counterparty will fail on the settlement date. Because future securities prices movements are uncertain when the trade is initiated, both counterparties face replacement cost risk. The size of this risk depends on the price volatility of the security and the interval between trade and settlement. Replacement cost risks can be reduced by marking-to-market unsettled trades and requiring the counterparty with an unrealised loss to transfer funds or collateral equal to the value of the loss to the other counterparty, the clearing system or the settlement system. A simpler alternative is to shorten the interval between trade and settlement. A common benchmark is to ensure that settlement lags are kept to T+3 days or shorter.
Element 21: In order to reduce replacement cost risks, it is preferable for the settlement of trades to take place as soon as possible after the trade has been confirmed. A common benchmark is to ensure that settlement lags are kept to T+3 days or shorter.
Effectiveness of risk controls
58. A key factor influencing the effectiveness of risk controls is the promptness with which relevant information is available. A payments system that operates in real time, for example, should provide participants with real-time information on their settlement balances, and where applicable, their positions against risk management limits. A system that does not operate in real time should provide relevant information as frequently and as promptly as necessary for good decision-making.
Element 22: For effective risk control, systems need to provide relevant information to participants on a timely basis.
Suitable Contingency Arrangements
59. The breakdown of a critical operational component of a securities system can create serious liquidity difficulties, and by delaying settlement, can increase replacement cost and credit exposures. The rules of the system should set standards for the reliability of individual participants' operational performance as this affects the operations of the system itself. In addition, the systems should ensure that all hardware, software and communications facilities that support their operations have a high degree of reliability and integrity. Contingency plans should be established for the potential failure of each critical component, including the identification of back-up facilities capable of completing the settlement process on the settlement day and performing the accounting and processing work necessary to prepare for the next settlement day.
60. Plans should be developed to meet a wide range of plausible contingencies. The plans should cover not only the failure of technical components within the system, but also possible failure of external connections and systems, such as the telecommunications infrastructure. They should also cover contingencies that do not stem from technical failure, such as industrial disputes or natural disasters.
Element 23: There should be suitable contingency arrangements to handle system problems caused by internal operations or external service providers.
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