Financial Sector Assessment:A Handbook Box 11.2 Responsibilities of Central Banks in Applying the CPSS Core Principles A and ithoud have the ability to ral bank,in B. The() emtcnt foreign authorities. Source:CPSS(01) value,or (c)is used for the settlement of financial market transactions or for the settle- ment of other payments in the same currency.Although retail payment systems are nor mally not seen as systemically important be ause they settle in large-value systems tha fulfill the criteria for systemic importance,they can influence the function of the latter systems. The responsibilities of central banks with respect to payment systems center on the ayment systems,focusing on the liance of the SIPSs with the 11 CPSSCore nd on mnagment (e box 11.foraiing cet bank responsibilities).Crisis management deals with major problems in the systems- instance,the bankruptcy of a participant,the technical problems in the systems itself or in the system of a larger participant,or the major liquidity problems.Crisis management often requires coordn en different uthor or instance,between the pa ment system overseer an d the banking supervisor and b etween the payment overseer and the securities regulator.Coordination with monetary policy departments is also necessary because the payment system is the main channel for the transmission of monetary policy and the decisions on liquidity support in the payment system will also influence monetary volved,how decisions should be made,how information is organized forth should be in place.Preferably narios should be developed in advance for dealing with specific problems.Cooperation coordination,and exchange of information among the different supervisory authorities in the country,as well as with relevant foreign authorities.are often worked out in a memo. randum of understanding(MOU). In addition to an oversight role,a central bank might have other roles in the pay ment area such as a developmental role (designer of the strategy with respect to the development and international positioning of markets and infrastructure)and an operat- ing role (system provider or owner of payment systems or securities settlement systems). Sometime conflicts of interest might arise between the different roles.One way to make ct clear is to enh nce transparency of the different roles and the goals and objectives of a central bank in the payment area. 294
294 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 value, or (c) is used for the settlement of financial market transactions or for the settlement of other payments in the same currency.4 Although retail payment systems are normally not seen as systemically important because they settle in large-value systems that fulfill the criteria for systemic importance, they can influence the function of the latter systems. The responsibilities of central banks with respect to payment systems center on the effective oversight of payment systems, focusing on the compliance of the SIPSs with the 10 CPSS Core Principles and on crisis management (see box 11.2 for a listing central bank responsibilities). Crisis management deals with major problems in the systems—for instance, the bankruptcy of a participant, the technical problems in the systems itself or in the system of a larger participant, or the major liquidity problems. Crisis management often requires coordination between different authorities—for instance, between the payment system overseer and the banking supervisor and between the payment overseer and the securities regulator. Coordination with monetary policy departments is also necessary, because the payment system is the main channel for the transmission of monetary policy, and the decisions on liquidity support in the payment system will also influence monetary policy. Clear procedures for who should be involved, how decisions should be made, how the exchange of information is organized, and so forth should be in place. Preferably, scenarios should be developed in advance for dealing with specific problems. Cooperation, coordination, and exchange of information among the different supervisory authorities in the country, as well as with relevant foreign authorities, are often worked out in a memorandum of understanding (MOU). In addition to an oversight role, a central bank might have other roles in the payment area such as a developmental role (designer of the strategy with respect to the development and international positioning of markets and infrastructure) and an operating role (system provider or owner of payment systems or securities settlement systems). Sometimes conflicts of interest might arise between the different roles. One way to make this potential for conflict clear is to enhance transparency of the different roles and the goals and objectives of a central bank in the payment area. Box 11.2 Responsibilities of Central Banks in Applying the CPSS Core Principles A. The central bank should clearly define its payment system objectives and should publicly disclose its role and major policies with respect to systemically important payment systems (SIPS). B. The central bank should ensure that the system it operates complies with the CPSS Core Principles. C. The central bank should oversee compliance with the CPSS Core Principles by systems it does not operate, and it should have the ability to carry out this oversight. D. The central bank, in promoting payment system safety and efficiency through the CPSS Core Principles, should cooperate with other central banks and with any other relevant domestic or foreign authorities. Source: CPSS (2001)
Chapter 11:Assessing Systemic Liquidity Infrastncture Oversight of payment systems is a core task of a central bank,and often a paymen system department is charged with the function.If it is to avoid conflicts of interest with respect to the compliance of the systems operated by the central bank itself,the oversight unit,at a minimum,should be separated from the operational section. The payment system oversight policy should comply with the International Monetary Fund (IMF)Code of Good Practices on Transparency in Monetary and Financial Policies Transparency practices relate to (a)the roles.responsibilities.and obiectives of a centra hank or fins ability of informa ncy:(b)financial policy formulation andr ting;(c)public on; d (d)a nd a ssuranc bank good transparency practices. 11.1.1.3 The Assessment Methodology and Assessment Experience A CPSS assessment of core principles seeks to identify the strengths and weaknesses of the SIPS,including its potential to transmit shocks (also originating in other countries),as well as risks to the monetary system or financial markets or across the economy more gen erally.The methodology for the assessment and the structure and scope of the assessment report are explained in detail in the guidance note prepared by the IMF and the World eindPSS (IMF and World Bank 2001).It contains guidelines fo Bank in cons the s of the dividual。 iples by providing a shor criteria,as wella pects tha sho this cor deally,before an ssessment takes place,the central ban of the country first provides 11 list of systems in the country that are deemed systemically important and then conducts self-assessments of those systems.The self-assessments are reviewed by the assessor,and they provide a basis for the discussions with the stakeholders in the payment system such as the central bank,system provider(s)in case systems that are privately operated,and any relevant governmental and private sector entities (including bankers associations.carc ompanies,clearinghouses,and securities market ope rators) Exper e pr ciples of the CPSS has shown that the prin eful and r ity and efficiency o suaussasse ayL (ZOOZ WI aas)suonepuawuooal Aonod Bune obust framewe k for as n gest that there are substantial weaknesses in many payment systems.Payment systems in advanced economies and,to a large extent,in transition economies observe most of the core principles.In developing countries,a significant maiority of the systems suffers shortcomings of varying importance in design and operation that may expose the systems to risks in the events of a problem. In many systems.the awareness of risk and the possibilities for the particinants to manage and majority of the ne settle- o adequat egu i pla to ensure timely complei ent of all systems give evidenc of an uncertain legal basis,mainly from the absence of legal recognition of netting and finality,and from unclear rules and regulations governing the systems.The effectiveness of the governance structure could be improved in more than 60 percent of the systems In around half of the systems,the operation reliability is not addressed in full and may 295
295 Chapter 11: Assessing Systemic Liquidity Infrastructure 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 Oversight of payment systems is a core task of a central bank, and often a payment system department is charged with the function. If it is to avoid conflicts of interest with respect to the compliance of the systems operated by the central bank itself, the oversight unit, at a minimum, should be separated from the operational section. The payment system oversight policy should comply with the International Monetary Fund (IMF) Code of Good Practices on Transparency in Monetary and Financial Policies. Transparency practices relate to (a) the roles, responsibilities, and objectives of a central bank or financial agency; (b) financial policy formulation and reporting; (c) public availability of information; and (d) accountability and assurances of integrity. The central bank responsibilities in the CPSS Core Principles document (CPSS 2001) include those good transparency practices. 11.1.1.3 The Assessment Methodology and Assessment Experience A CPSS assessment of core principles seeks to identify the strengths and weaknesses of the SIPS, including its potential to transmit shocks (also originating in other countries), as well as risks to the monetary system or financial markets or across the economy more generally. The methodology for the assessment and the structure and scope of the assessment report are explained in detail in the guidance note prepared by the IMF and the World Bank in consultation with CPSS (IMF and World Bank 2001). It contains guidelines for the assessment of the individual core principles by providing a short explanation and the assessment criteria, as well as additional aspects that should be evaluated in this context. Ideally, before an assessment takes place, the central bank of the country first provides a list of systems in the country that are deemed systemically important and then conducts self-assessments of those systems. The self-assessments are reviewed by the assessor, and they provide a basis for the discussions with the stakeholders in the payment system such as the central bank, system provider(s) in case systems that are privately operated, and any relevant governmental and private sector entities (including bankers associations, card companies, clearinghouses, and securities market operators).5 Experience with assessing the core principles of the CPSS has shown that the principles provide a useful and robust framework for assessing the reliability and efficiency of SIPSs and formulating policy recommendations (see IMF 2002). The assessments suggest that there are substantial weaknesses in many payment systems. Payment systems in advanced economies and, to a large extent, in transition economies observe most of the core principles. In developing countries, a significant majority of the systems suffers shortcomings of varying importance in design and operation that may expose the systems to risks in the events of a problem. In many systems, the awareness of risk and the possibilities for the participants to manage and control those risks are insufficient. A significant majority of the net settlement systems have no adequate safeguards in place to ensure the timely completion of daily settlements in the event of a default. Nearly 70 percent of all systems give evidence of an uncertain legal basis, mainly from the absence of legal recognition of netting and finality, and from unclear rules and regulations governing the systems. The effectiveness of the governance structure could be improved in more than 60 percent of the systems. In around half of the systems, the operation reliability is not addressed in full and may
Financial Sector Assessment a Handbook be vunerable to failures that can prevent the daily settlement from being completed in time.Ass essment of transparency of central banks'policy on payments shows that the objectives and institutional framework for oversight are not always transparent and that some central banks do not disclose the general policy principles for the oversight of pay- ment systems. The assessments,as appropri ate,recommend changesor reforms to the SIPS.They also help make the authorities aware of thos aspects of their SIPS that should be kept unde review as the economy and financial markets develop.In practice,some assessments have used the core principles as a basis for more widely assessing the whole payment infrastruc. ture of a country and the risks arising from interrelation between various payment systems (IMF.Paragrap 1).While such may be helpful,peally in developed fin y5 ems where there a e links h ystems domestically and sometimes abroad,a decision to assess the whole system must take into account the resource intensity of also assessing systems that are not systemically important. The level of observance of the CPSIPS in the countries assessed highlights some key nt sustems The reaui CPSS Core Prine ments to ensure iple IV) nd the need to setlement system even if the largest single obligor fails (CPSCore Principle V)were not fully observed in many countries that were assessed.This weakness was com- pounded by legal uncertainty,weak governance,and insufficient operational reliability in a significant number of countries.In light of this,policy recommendations have focused 11 on the following .Reviewing procedures to deal with settlement problems,including loss-sharing and risk control systems,information to system participants,and provision of intraday liquidity .Strengthening bankruptcy law (including the laws on bilateral and multilateral net. g finality of payments,and clarifying laws on pledges and collateral 。Establishingb s and te tingency procedure s,including procedures against potential liquidity problems through cross-sectoral and cross border exposures .Establishing transparent access criteria and reviewing cost structures and pricing policies,including full cost recovery,to improve efficiency ssments have also highlighted factors that could have potential negative impact on the liquidity situation in payment systems in different countries.This negative impac is the result of (a)arrangements for resolution of troubled banks,(b)nontransparent systemic liquidity arrangements provided by the central bank,(c)liquidity that is concen- trated among only a few of the banks in a country in which there is currently no intraday liquidity available from the central bank, nd (d)settlem isks in the securities and the foreign exchange markets caused by the lack of DVP and PVP facilities,respectively.I many countries,it is implicitly assumed by most participants that the central bank would in practice,cover liquidity shortages,even failures,to avoid any systemic effects(IMF 2002,p.4,paragraph 4). 296
296 Financial Sector Assessment: A Handbook 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 be vulnerable to failures that can prevent the daily settlement from being completed in time. Assessment of transparency of central banks’ policy on payments shows that the objectives and institutional framework for oversight are not always transparent and that some central banks do not disclose the general policy principles for the oversight of payment systems. The assessments, as appropriate, recommend changes or reforms to the SIPS. They also help make the authorities aware of those aspects of their SIPS that should be kept under review as the economy and financial markets develop. In practice, some assessments have used the core principles as a basis for more widely assessing the whole payment infrastructure of a country and the risks arising from interrelation between various payment systems (IMF 2002, p. 7, paragraph 12). While such wider assessment may be helpful, especially in developed financial systems where there are links between several systems domestically and sometimes abroad, a decision to assess the whole system must take into account the resource intensity of also assessing systems that are not systemically important. The level of observance of the CPSIPS in the countries assessed highlights some key policy areas that require attention in many payment systems. The requirements to ensure prompt final settlement on the day of value (CPSS Core Principle IV) and the need to settle a net settlement system even if the largest single obligor fails (CPSS Core Principle V) were not fully observed in many countries that were assessed. This weakness was compounded by legal uncertainty, weak governance, and insufficient operational reliability in a significant number of countries. In light of this, policy recommendations have focused on the following: • Reviewing procedures to deal with settlement problems, including loss-sharing and risk control systems, information to system participants, and provision of intraday liquidity • Strengthening bankruptcy law (including the laws on bilateral and multilateral netting), ensuring finality of payments, and clarifying laws on pledges and collateral • Establishing backup processing sites and testing contingency procedures, including procedures against potential liquidity problems through cross-sectoral and crossborder exposures • Establishing transparent access criteria and reviewing cost structures and pricing policies, including full cost recovery, to improve efficiency Assessments have also highlighted factors that could have potential negative impacts on the liquidity situation in payment systems in different countries. This negative impact is the result of (a) arrangements for resolution of troubled banks, (b) nontransparent systemic liquidity arrangements provided by the central bank, (c) liquidity that is concentrated among only a few of the banks in a country in which there is currently no intraday liquidity available from the central bank, and (d) settlement risks in the securities and the foreign exchange markets caused by the lack of DVP and PVP facilities, respectively. In many countries, it is implicitly assumed by most participants that the central bank would, in practice, cover liquidity shortages, even failures, to avoid any systemic effects (IMF 2002, p. 4, paragraph 4)
Chapter 11:Assessing Systemic Liquidity Infrastcture 11.1.2 Securities Settlement Systems The term secrities settlement systems is defined to include the full set of institutional arrangement for confirmation,clearance,and settlement of securities trades and safekeep. ing of securities. 11.1.2.1 Recommendations for Securities Settlement Systems In November 2001,the CPSS and the Technical Committee of the International Organization of Securities Commissions(IOSCO)issued Recommendations for Securities Settlement systems (RsSs)as a benchmark to assess the soundness and effectiveness of ecurities settlem systems(see CPSS and Techr nical committee of the losco 2002) 19 recomme endations are considered to b min um standards intended to reduc risks,increase effi national financial stability (see box 11.3).Those recommendations recognize the impor tance of securities settlement systems for the infrastructure of the global financial markets, and they note that weaknesses in securities settlement systems can be a source of systemic risks to securities markets and to other payments and settlements systems. The recommendations are designed to cover securities settlement systems for all and go tbonds,and money market instru .They provi detailed d criptions o the ange ents for ,clearance settlement,and s afekeeping of securities.They also ad 1 ss specific topic 11 access,governance,efficiency,transparency,and regulation and oversight.Ensuring safe and reliable securities clearing and settlement systems requires a clear understanding of the various risks involved in the process of securities transactions.The recommendations describe those risks and provide a wide range of measures to address them.The main risk settlement ac itiesis credit risk,which is the po trad tle its obligations whe n due or a tim reafter. which is the possibility that a counterparty may not be able to meet its obligations when due but may settle at a later stage-is another relevant risk.Other risks involved i settlement activities are legal risk,custody risk,operational risk,and the risk of a settle. ment bank's failure. The reduction of pre-settlement risks is considered crucial to ensure the timely settle. ment of securities transactions.In this context,the recommendations define some rules for trade confirmation,settlement cycles,central counterparties,and securities lending In par the re ndation req ade tion take place on the RaEhheeaaoea that settlement cycles ne time of exchanging securi agains recommendations advocate cost-benefit analysis for the introduction of a central coun terparty (CCP)and encourage securities lending and borrowing. The recommendations discuss the sources of settlement risks and provide several measures to address them.For instance,a recommendation on central securities deposi- tory (CSD)requests that securities be immobilized or dematerialized and then transferred by book entry in a CSD.By centraliz ing the e procedure of iss ance and safekeeping 297
297 Chapter 11: Assessing Systemic Liquidity Infrastructure 1 I H G F E D C B A 12 11 10 9 8 7 6 5 4 3 2 11.1.2 Securities Settlement Systems The term securities settlement systems is defined to include the full set of institutional arrangement for confirmation, clearance, and settlement of securities trades and safekeeping of securities. 11.1.2.1 Recommendations for Securities Settlement Systems In November 2001, the CPSS and the Technical Committee of the International Organization of Securities Commissions (IOSCO) issued Recommendations for Securities Settlement Systems (RSSS) as a benchmark to assess the soundness and effectiveness of securities settlement systems (see CPSS and Technical Committee of the IOSCO 2002). The 19 recommendations are considered to be minimum standards intended to reduce risks, increase efficiency, provide adequate safeguards for investors, and enhance international financial stability (see box 11.3). Those recommendations recognize the importance of securities settlement systems for the infrastructure of the global financial markets, and they note that weaknesses in securities settlement systems can be a source of systemic risks to securities markets and to other payments and settlements systems. The recommendations are designed to cover securities settlement systems for all securities, including equities, corporate and government bonds, and money market instruments. They provide detailed descriptions of the institutional arrangements for confirmation, clearance, settlement, and safekeeping of securities. They also address specific topics and issues, including the legal framework for securities settlements, risk management, access, governance, efficiency, transparency, and regulation and oversight. Ensuring safe and reliable securities clearing and settlement systems requires a clear understanding of the various risks involved in the process of securities transactions. The recommendations describe those risks and provide a wide range of measures to address them. The main risk related to settlement activities is credit risk, which is the possibility that a counterparty to a trade may fail to settle its obligations when due or at any time thereafter. Liquidity risk—which is the possibility that a counterparty may not be able to meet its obligations when due but may settle at a later stage—is another relevant risk. Other risks involved in settlement activities are legal risk, custody risk, operational risk, and the risk of a settlement bank’s failure. The reduction of pre-settlement risks is considered crucial to ensure the timely settlement of securities transactions. In this context, the recommendations define some rules for trade confirmation, settlement cycles, central counterparties, and securities lending. In particular, the recommendations require that trade confirmation take place on the same trade date and that settlement cycles—the time of exchanging securities against cash—be no more than three days after trade execution. To reduce settlement failure, the recommendations advocate cost-benefit analysis for the introduction of a central counterparty (CCP) and encourage securities lending and borrowing. The recommendations discuss the sources of settlement risks and provide several measures to address them. For instance, a recommendation on central securities depository (CSD) requests that securities be immobilized or dematerialized and then transferred by book entry in a CSD. By centralizing the procedures of issuance and safekeeping