Investors are exposed to risk from local market infrastructure. It is not sensible for them to assume that just because their investments are being settled and held within a developed market infrastructure, which appears to include a sound and robust depository and clearing environment, they are safe. Recent cases have seen a depository mislaying some bearer documents in its care and others having to admit very publicly to significantly overstating the value of the securities held in custody. However, this level of visibility is very much the exception to the rule and it is clear that in many markets much remains unreported. Investors are exposed to the vagaries of the local market infrastructure and the risk intermediation mechanisms the local market has in place to support their structures.
Doesn't my custodian bank take this risk?
During contract negotiations investors can agree and specify what level of risk a global custodian is prepared to accept in each market. These risks are almost exclusively linked to the level of cover the global custodian receives from its local sub-custodian. In turn, the local custodian must rely on the cover he receives from the local market infrastructure. Generally a custodian cannot accept liabilities if they cannot be offset in the local market through the standard of care provided by the local central securities depository (CSD) and the protection it affords through its insurance, guarantee funds etc. The standard of care provided by CSDs and clearing houses is generally not negotiable (Figure 1).
Figure 1: Investor risk exposures
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Source: Thomas Murray Ltd
But to what extent is this risk real? Perhaps a good starting point to look at this is the United States, which is without doubt one of the safest markets in which to settle transactions in its domestic securities and to hold such assets in custody. But even here there are concerns, although fortunately on the depository infrastructure side some key issues have been recognised by The Depository Trust & Clearing Corporation (DTCC), the USA depository and the largest in the world. In January 2002, DTCC issued a paper entitled Straight-Through Processing: A new Model for Settlement, setting out its vision for the future of settlement in the USA. The paper includes a discussion of the current method of settling transactions between brokers (who generally use one of the US custodian banks for this purpose). Under this settlement process, which in a typical day involves 250,000 deliveries, some 10,000 get rejected (known locally as reclaims). This equates to approximately 1 delivery in 25 with a value in the region of USD7bn to USD10bn . When you take into consideration that some of these rejections are likely to occur on the day after the intended settlement date, if not later, the number of failing deliveries should concern any investor.
If this is the situation in an advanced market such as the USA, investors should have greater settlement concerns in some of the world's smaller and emerging markets where, while the numbers of failing deliveries and their values are far less, the financial stability and regulation of the market and its participants may well not be up to the standards applied in the USA.
Research carried out by Thomas Murray on the local capital market infrastructures of 104 markets globally has identified instances of high risk in 63% of markets (Figure 2). The findings show that Asia Pacific has the fewest instances with 47%, with Americas and Western Europe the most with 71%. Each market infrastructure was assessed against six different risk criteria:
- Asset commitment risk -- The period of time from when control of securities or cash is given up until receipt of countervalue.
- Liquidity risk -- The risk that insufficient securities and or funds are available to meet commitments; the obligation is covered sometime later.
- Counterparty risk -- The risk that a counterparty (i.e., an entity) will not settle its obligations for full value at any time.
- Financial risk -- The ability of the CSD to operate as a financially viable company.
- Operational risk -- The risk that deficiencies in information systems or internal controls, human errors or management failures will result in unexpected losses.
- CSD on CSD (credit) risk -- The credit risk that a CSD is taking when linking to another CSD.
Figure 2: Instances of high risk in local capital market infrastructures, by region
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Of these six risks, CSD on CSD (credit) risk is the newest area of investigation, as CSDs establish cross-border links. However, the creation of these links compounds investor risk as a result of one market infrastructure running potential risk to another. We consider that in many cases the full risk analysis has not been completed, with parties to the links brushing many of the potential problems aside in a rush to establish these links. Certainly, it is extremely difficult to acquire an analysis of this work, even if one was ever conducted. An example of potential exposure is CDS, the Canadian depository, which has recognised the exposure it has in the area of stock situations through its link with DTCC. In common with all DTCC participants, it must ensure that it tracks the corporate action activity on all the holdings it has placed with DTCC on behalf of its participants. Should an event get missed CDS would be liable and not DTCC, requiring the Canadian depository to expend considerable resources ensuring that this does not occur.
One of the problems in assessing how reliable, and hence safe, a market settlement system is concerns obtaining reliable data on such matters as failing transactions -- let alone ascertaining exactly where liabilities lie during the settlement and subsequent on-going custody of the assets. In the more advanced markets, such as those in the UK and the US, the local regulators have ensured that reliable transaction data is readily available in a very transparent manner. In these markets, when the depository advises that they have a fail rate of approximately 5% (in the case of DTCC) or approaching 1% in the case of CRESTCo in the UK, one can rely on such figures. This is not always the case in some of the less transparent markets, and this includes some markets which are generally considered to be 'developed'. While independently produced benchmarking reports are available, these reports normally rely on data supplied by only a sub-set of the users of the local system, generally the custodians. But overall market percentages can be misleading. Thomas Murray's research has confirmed that in the majority of markets where separate systems exist, the settlement procedures used for market-side (broker-to-broker) settlements is more efficient that that adopted for broker-to-client settlements. This research is supported by the DTCC white paper, which reports that 6% of institutional transactions being settled on an average day are expected to fail, while the fail rate on the market-side is lower at 4.4%.
For many years Thomas Murray has considered that it is essential that, before making an investment in a new market, a comprehensive analysis is undertaken of the local infrastructure. We are now in good company. Oversight of national and international securities depositories has assumed a new importance as a result of new regulation in the US and UK and discussion papers in the area from many respected supra-national and other international groups.
This was led by the introduction of rule 17f-7, part of the 1940 Investment Company Act of the US. The new rule, while permitting a mutual fund to maintain assets with an eligible securities depository, requires the fund's 'primary custodian' to provide the fund, or its advisor, with an analysis of the custodial risks of using the depository, monitor the depository on a continuing basis, and notify the fund of any material changes in risks associated with using the depository. This was followed by the UK Financial Services Authority (FSA) and the introduction in November 2001 of the latest conduct of business regulations, which require investors to assess risks associated with the use of both custodians and CSDs.
The CPSS--IOSCO Joint Task Force on Securities Settlement Systems, set up by many of the major central banks and the global association of regulators (IOSCO), issued a recent report containing a number of significant recommendations. One of these (Recommendation 17 -- Transparency) states that CSDs and central counterparties should provide market participants with sufficient information for them to accurately identify and evaluate the risks and costs associated with using a CSD or a central counterparty service. Recommendation 19, which concerns risks in cross-border links, looks to ensure that CSDs that establish links to settle cross-border trades should design and operate such links to reduce effectively the risks associated with cross-border settlements. Many do not comply with these important recommendations.
Inevitably, both clearing houses and depositories now face much closer scrutiny from regulators and lawmakers worldwide. This is particularly evident with the introduction of the single European capital market. A indication of the European Commission's thinking has already been given in the Giovanni Report on cross-border clearing and settlement, which recommended changes that would enable greater interoperability between national trading, clearing and settlement systems. The European Commission wants healthy competition and a level playing field, and there is little doubt that it will introduce regulation to achieve those aims if necessary. To date, local regulators have applied a very light touch with clearing and settlement houses, but that seems likely to change as the regulators tighten their grip on the infrastructure.
Local market infrastructure risk assessment
It is the general view that all depositories and clearing systems are undoubted organisations. If one should get into difficulties the local central bank, or even government, would step in and resolve the problem. However, this is not a financially prudent assumption to make when considering the value of investments that may be entrusted to them. While some are departments of the central bank, this number is reducing with their consolidation into the local equity and other depositories in several markets. Outside of the central bank operated depositories, there is no known independent depository which has a formal binding guarantee from its domestic central bank or government.
Many market participants are astounded to find out that the CSDs, which they have unwaveringly trusted and which hold much of their assets, have varying levels of support, capital and insurance (see Figure 3). And there is no firm evidence to indicate that this problem is diminishing, as minimum standards for depositories have proved difficult to define, and CSDs start to demutualise into commercial entities.
Figure 3: Examples of financial risk criteria
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Market-led response
The exposure to local capital market infrastructure risk suffered by institutional investors is an increasingly significant issue as market volatility increases. As we have seen, regulatory and commercial pressures to assess these risks have already started, with the new regulatory requirement under 17f-7 being very prescriptive in outlining the necessity for a first class analysis of CSD risk exposures. Naturally, many investors are turning to their custodians for this information, who themselves are looking at ways to meet these obligations on a subject not considered to be an area of differentiation where they want to compete against each. In addition, the cost of carrying out individual proprietary research to the level of detail required, together with full surveillance, would be prohibitive for most custodial groups. The Thomas Murray Depository Service emerged as the catalyst for co-operation between different interested parties to collectively meet the demands from custodians, broker/dealers and mutual fund boards for independent risk assessments, including on-going surveillance of CSDs globally.
Through the Depository Service, Thomas Murray has brought together many leading global custodians and other entities to provide an inclusive cross-industry solution. The Service is available to any group wishing to participate. One key aspect of the Depository Service is that it is based on renewable, validated, global information. This is provided through a wide range of banks (and CSDs) keen to co-operate in global analysis and risk assessments where there is no obvious differentiation available through the provision of proprietary products and assessments. Each market is typically supported by at least two support banks and when you include the CSDs (who are invited to confirm the findings), and Thomas Murray, this ensures the assessments have been reviewed and agreed by four individual sources. The output from this service, which includes daily surveillance of CSDs through flash reports highlighting changes, is vital to meeting the regulatory obligations of market participants.
Market infrastructure
It must be borne in mind that, as good as a depository or clearing house may be, their effectiveness is constrained by the market and legal infrastructure in which they operate. It is most important that there is a reliable same-day, preferably real-time, payment system in the market, which they can use to effect funds transfer, ideally through the central bank. Real-time payment systems are now commonplace in major markets but are rarely linked to real-time securities movements. Reverting yet again to the DTCC white paper, it states that, even in the advanced US market, changes in payments arrangements are not expected to occur quickly. Clearly, it would be very beneficial to the completion of the safely executed trade if the securities settlement system of a country was directly or closely linked to a real-time payments system -- in the case of the US, the DTCC system to the FedWire system. It is also very desirable that the depository receives an automated flow of matched and agreed transactions directly from the stock exchange, as this ensures all trades are correct at the point of entry and aids settlement in the desired short timeframe.
So what should investors exposed to local market infrastructures be concerned with, and what should be considered as part of an appropriate risk assessment? Thomas Murray believes that a minimum analysis at should include an examination of: delivery versus payment (DVP); net versus gross payment; if settlement is in central bank or commercial bank money; if stock lending is available for failed trades; counterparty risk exposure; settlement cycles; forms of securities; registration of transfer of title; cash/FX restrictions; financial backing of the CSD; the existence of a central counter party (CCP); the local market asset servicing environment; tax reclaims procedures; and the legal issues regarding segregation of assets and retrievability of securities in the event of default.
Identifying the risk and actually assessing the risk, initially and on an on-gong basis, are very different issues. Taking DVP as the most common example, the problem is that even 11 years after the publication of the ubiquitous Group of Thirty recommendations there are still markets, some major, which do not even have a truly effective DVP procedure let alone true DVP. The central factor in the assessment of any settlement system should be a careful analysis of the claimed DVP mechanism. In fact, notwithstanding local claims to the contrary, most markets do not achieve a simultaneous exchange of securities and cash; many use a model which moves cash at a later stage during the settlement day. A good test is to look at the Asset Commitment Period within the system. This is the period of time during which use of securities or cash is lost before receipt of countervalue. Even in major markets in Western Europe and North America (or just America and Europe) it is not uncommon to see these periods, under some circumstances, being considerably longer than 24 hours. While there are often built-in compensating factors, such as guarantee funds, these add additional costs into the process.
Another area of major concern, which has been known to lead to large financial losses, is the manner in which the local market services assets, i.e. corporate events, proxy voting and AGM/EGMs. While it is common practice for the depository to notify its participants of all stock events that are taking place in its eligible securities, it is frequently up to the participant to ensure that they obtain the resulting considerations. Particularly in markets where bearer stock is prevalent, the depository often does not guarantee that it will advise users of every stock event or advise users of their likely entitlements. Investors should check clauses in the contracts they have with their global custodians to ensure they will be made good if the local custodian, or depository, misses a stock event; otherwise a close examination of how the depository operates is critical, as there can be significant risk for the unwary from missed stock events.
Thomas Murray's work in assessing and monitoring local market infrastructures globally, as demonstrated in Table 1, shows the level of risks identified across six key risk areas. What is immediately obvious is the large number of market infrastructures that involve a high level of at least one risk in their use. In many cases, it is effectively compulsory either by regulation or market practice to use the local administrative organisation such as the CSDs, which can expose the investor to risks when things go wrong. Investors should no longer ignore their risk exposures to local market infrastructures, including depositories, when assessing which markets to invest in.
