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G R O U P O F T H I R T Y 30

ClearingClearingSettlement

A Plan of Action

GLOBALAND

All members of the Steering Committee served in their personal capacities. The views expressed in this report do not necessarily reflect the views or policies of their respective institutions, nor does publication of the report by the Group of Thirty imply an endorsement of the views expressed herein.

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Global Clearing and SettlementA P L A N O F A C T I O N

Group of Thirty©

Washington, DC

2003

iii

CONTENTS

Foreword, by Paul Volcker and Jacob Frenkel ...................................................................................................... v

Chairman’s Message, by Sir Andrew Large ......................................................................................................... vii

Steering Committee Members ............................................................................................................................ ix

Acknowledgments ................................................................................................................................................ x

Executive Summary ............................................................................................................................................... 1

Chapter 1. Clearing and Settlement: What Is at Stake? .....................................................................................13

Chapter 2. The Current State of Affairs ...............................................................................................................21

Chapter 3. Building an Efficient, Interoperable Network .................................................................................... 25

Recommendations 1-8 ................................................................................................................................. 29

Chapter 4. Ensuring Safety and Stability ............................................................................................................ 35

Recommendations 9-16 ...............................................................................................................................40

Chapter 5. Governance: The Key to Reform.......................................................................................................49

Recommendations 17-20 .............................................................................................................................50

Chapter 6. From Recommendation to Implementation ......................................................................................57

APPENDIXES

Appendix 1. Detailed Background on the Recommendations ........................................................................... 67

Apppendix 2. Conduct of the Study .................................................................................................................125

Glossary ............................................................................................................................................................ 133

Group of 30 Publications since 1989 ................................................................................................................ 135

Group of 30 Members ......................................................................................................................................137

FIGURES AND TABLES

Figure 1-1. U.S. Activity in Foreign Securities versus

Foreign Activity in U.S. Securities, 1980–2001 ............................................................................................... 17

Table 6-1. Implementation Targets for the Private and Public Sector ................................................................. 61

Table A2-1. Contributing Organizations ...........................................................................................................126

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Table A2-2. Organizations Interviewed ............................................................................................................. 127

Table A2-3. Related Studies Examined ............................................................................................................. 128

BOXES

1-1. Interoperability .............................................................................................................................................14

2-1. System Components .................................................................................................................................... 22

3-1. Participants in the Clearing and Settlement Process ................................................................................... 28

A2-1. Individual Contributors ............................................................................................................................ 131

v

FOREWORD

v

THE GROUP OF THIRTY COMMISSIONED THIS STUDY

of global securities clearing and settlement arrange-ments out of concern that unevenly developed nationalclearing and settlement infrastructure and inconsistentbusiness practices across markets could be a source ofsignificant systemic risk, and certainly of inefficiency.Given rapid growth of debt, equity, and derivativestrading, both generally and cross-border, the wrongcombination of market shocks and financial disloca-tions might be sufficient to overtax the infrastructureon which the functioning of global markets depends.

With these concerns in mind, the Group of Thirtyrecruited a senior group of private executives and pub-lic officials to serve on the project’s Steering Commit-tee, and Andrew Large agreed to serve as its chair. Elevenmembers of the Group of Thirty itself and a dozenothers joined him on the Committee, which undertookthe substantial challenge to investigate the complex in-stitutional structures and processes that characterize glo-bal clearing and settlement. Their aim was to improveboth the safety and efficiency of these global processes.

The Committee began by assembling a formidablearray of talent to complete the body of work that iscatalogued in this report. Over the course of twoyears, survey teams and working parties analyzed cur-rent industry conditions, evaluated current practiceand latest supervisory guidance, and framed propos-als for making the system safer and more efficient.If the hours of effort devoted to this venture by itsmany contributors were fully valued, it would certainlyconstitute a multi-million dollar enterprise.

The particular focus of the exercise was the set ofchallenges arising from cross-border trading. Tradesare moving across borders without support of com-mon — or even consistent — structures, performancestandards, or operational rules. Achieving consistencywill require far-reaching change, from purely technical

and operational matters to risk management and gov-ernance practices. The Steering Committee devised athree-pronged strategy to accomplish this, including:

� Technical and business practice standardsintended to strengthen the connections acrossborders and systems;

� Stronger risk management, including thestronger legal guarantees necessary to provide asolid legal basis for clearing and settlement; and

� Improved governance by private boards,supported by official supervision and fair andopen access to systems.

The strategy encompasses 20 recommendationsthat constitute an action plan for global clearing andsettlement. The plan is ambitious but it reflects theaspirations of market participants, gives direction towork that is already under way, and provides specificguidance for tackling new areas. Its fundamental logicis that a globally linked marketplace should be sub-ject to global norms.

Like the Group of Thirty itself, the report seeks toachieve a balance of views and interests, incorporat-ing the best thinking of the private and public sectors.This is important because achieving its objectives willrequire significant attention from both quarters, alongwith significant investment by a great many marketparticipants. All of this will take time and it will beimportant to review progress along the way. To ensurethat the issues raised receive the continuing attentionthey deserve, the Group of Thirty will monitorprogress on cross-border reforms going forward.

The Group of Thirty is pleased to have sponsoredthis project and we commend its analysis and recom-mendations to all who are concerned about the safetyand efficiency of global markets.

Paul A. Volcker Jacob A. Frenkel

Chairman of the Trustees Chairman

Group of Thirty Group of Thirty

vii

CHAIRMAN’S MESSAGE

THE GLOBAL FINANCIAL SYSTEM is only as good asthe infrastructure that supports it. And the smoothfunctioning of that system—and the confidence onwhich it depends—will be threatened if the infrastruc-ture is unreliable. Unfortunately attention to the over-all system of global securities clearing and settlementhas been in short supply. Meanwhile the process ofclearing and settlement has become much more in-terdependent globally, increasingly linked to the worldof payments and foreign exchange as well. Such anetwork of interdependent systems can improve ef-ficiency, but a network without a sound basis couldalso create vulnerabilities.

On a domestic basis there is confidence that clear-ing and settlement systems work. It is the cross-border arena that has been neglected because the ar-chitects have tended to stop at their own borders. Andalthough a major failure has so far not struck, recentevents—and not least the U.S. tragedy on September11, 2001—warn us against any complacency.

Against this background, two years ago the Groupof Thirty formulated a project on global clearing andsettlement. They recruited a Steering Committee,which they asked me to chair, to see whether a path-way could be devised to improve the global system.We took as our basic premise that market-led changeshould be the key mechanism.

We have avoided prescribing structures, institu-tional arrangements, or who ought to own what. In-stead we have focused on the need for standards—best-practice standards that conform to public policyneeds. These standards will in practice define the net-work: they will outline its features and help form itsarchitecture. In addition, mechanisms to ensure openaccess to both service providers and users will un-derwrite competition in clearing and settlement ser-vices and functions. In this way institutional arrange-ments will evolve through market-led change.

We also wanted to ensure a practical outcome, onethat conforms to prevailing industry approaches. Sowe asked market participants themselves what is wrong

and what needs to change. We pursued a dialogue withmajor firms, smaller firms, service providers like con-trol securities depositories (CSDs) and centralcounterparties, as well as investors and end-users. Wereviewed the results against public policy requirements,using as a starting point the CPSS/IOSCO recommen-dations of November 2001. We were also informedby other studies—by the Giovannini report in Europe,for example—which articulated so clearly many of thebarriers to improvement in this area.

The net result of this effort is a series of twentyrecommendations, outlined in the Executive Sum-mary that follows. Because the costs of failure in thecross-border area are high, our recommendations gobeyond minimum standards. They target best prac-tice in the major mature markets. They may go fur-ther than needed in emerging markets, although forthe long term we feel that they should be aspirationalfor such markets as well. The recommendations fallinto three groups.

First are those primarily related to efficiency. In anutshell these are standards of best practice aimed atthe private sector. They cover technical features of theclearing and settlement process (messaging, for ex-ample), but also market practices such as operatinghours. Together they provide for a strengthened net-work with the potential for interoperability—a con-cept that we have discussed in some detail on page 14.

Second are recommendations related to mitigatingrisks—an area of mutual concern to the industry andthose who supervise it. Many areas here are familiarand we have focussed on financial and operational in-tegrity of all main participants: users as well as provid-ers. In addition, however, we have taken account ofmuch that has been learned since the September 11outrage, and addressed some significant areas in thelegal arena. Market confidence after all is underpinnedby legal certainty in such basic areas as finality and close-out, so we have addressed both these difficult areas.

Third, there is a series of recommendations onimproving and strengthening governance, aimed at

viii

ensuring implementation of the efficiency and riskmitigation proposals in the report. We have recom-mended ways to strengthen the resolve and forceful-ness of boards of directors as well as ways to ensurefair access and consistent oversight. We have at-tempted to set out clearly the issues in need of atten-tion, how our recommendations address them, andwhat needs to change. And we have looked for realis-tic ways to drive consistent and concerted progress,and to do so on many fronts. We have therefore de-vised a “pathway” in the form of a statement of whoneeds to do what for each of the twenty recommen-dations. Much of the required effort must come fromthe private sector, but some from public authoritiesas well.

To add impetus to this process, we intend to put inplace machinery to coordinate and to catalyze progresson implementation. The Group of Thirty is forming aStanding Committee to oversee this process. We ex-pect that this Committee will work very closely withall interested parties both public—such as CPSS/IOSCO and individual supervisors and central banks—and private—such as ISSA and the Global Documen-tation Steering Committee and individuals firms andclearing and settlement organizations. A substantivereview of progress will be undertaken two years afterpublication of this report that will examine progressand make transparent who has been active and whetherthere are areas in which sufficient progress has notbeen made.

We have, of course, been mindful of the signifi-cant costs involved in implementing our recommen-dations, but we are confident that our approach isrealistic on two grounds. Firstly, while it is the private

sector on whom the costs are likely to fall, it is theywho can see the potential for lower unit costs bymaking the necessary investments. Secondly, timehelps. The system cannot be changed overnight inany case, and the time horizon for realizing the vi-sion in our proposals is consistent with the cycle forobsolescence of software and systems that requiresrenewal over a five-to-seven-year period. So we be-lieve that introducing new standards as part of thatrenewal will be significantly less costly than forcingchange faster.

The final point to be made is that the changes wepropose will not happen without top-level support.Many of us in the corporate boardroom have shiedaway from the clearing and settlement area because ofits sheer complexity, but this report is aimed at strate-gic decisionmakers in both public and private sectors.While those with operational responsibility for clear-ing and settlement will certainly have to understandthese matters in detail, top-level support does not re-quire a detailed knowledge of the mechanics. What itdoes require is that the issues are addressed in an un-derstandable and consistent way, that a sensible courseis set, and that the goals are realistically achievable. Wehope our study inspires confidence that this is so, andwill accordingly enjoy wide support.

If industry leaders and public officials embracethe objectives we have set, the improved infrastruc-ture that results will contribute to enhanced confi-dence in the markets themselves. We hope that thereport proves helpful not only in tackling the specificchallenges of global clearing and settlement but inaddressing vulnerabilities in global financial networksmore generally.

Sir Andrew Large

Chairman, Global Clearing and Settlement Project

ix

Chairman: Andrew Large, Deputy Governor, Bank of EnglandVice Chairman: John Heimann, Senior Advisor, Financial Stability Institute.Vice Chairman: David Walker, Senior Advisor, Morgan Stanley International

Daniel Bouton Chairman, Société GénéraleRolf Breuer Chairman, Supervisory Board of Managing Directors, Deutsche BankMarsh Carter Chairman and CEO (Retired), State Street CorporationJill Considine Chairman and CEO, Depository Trust & Clearing CorporationE. Gerald Corrigan Managing Director, Goldman Sachs & Co.Andrew Crockett* General Manager, Bank for International SettlementsHoward Davies* Chairman, Financial Services AuthorityWilliam Harrison President and CEO, JP Morgan Chase & Co.Gerald Hassell President, The Bank of New YorkGerd Häusler* Director, International Capital Markets Department, International Monetary FundMervyn King* Deputy Governor, Bank of EnglandWilliam McDonough* President, Federal Reserve Bank of New YorkJohn Olds Member of the Board (Retired), DBS Group HoldingsMarcel Ospel Chairman, UBSTommaso Padoa-Schioppa* Member of the Executive Board, European Central BankRobert Pozen Chief of Commerce and Labor, Commonwealth of Massachusetts,

Office of the GovernorAlessandro Profumo Chief Executive Officer, UniCredito ItalianoWilliam Rhodes Senior Vice Chairman, Citigroup, Inc.Andrew Sheng* Chairman, Hong Kong Securities and Futures CommissionJean-Claude Trichet* Governor, Banque de FranceYutaka Yamaguchi* Deputy Governor, Bank of Japan

Project Director: Marc Hollanders, Bank for International SettlementsExecutive Director: John Walsh, Group of Thirty

* Public sector member whose service was in a personal, advisory capacity.

STEERING COMMITTEE MEMBERS

x

ACKNOWLEDGMENTS

THE GROUP OF THIRTY WOULD LIKE TO PAY TRIB-UTE to those whose contribution of time, talent, andenergy over the last two years made this project pos-sible. Thanks is due first and foremost to the Chair-man of the project Steering Committee, AndrewLarge, and the two Vice Chairmen, John Heimannand David Walker, who contributed countless hoursguiding the project from inception to completion.Planning the work and bringing it to fruition also re-lied on the immeasurable support and dedication ofthe G30 Executive Director, John Walsh, and theProject Director, Marc Hollanders.

They were assisted by an Executive Committee thatalso included Steering Committee members JillConsidine of the Depository Trust & Clearing Cor-poration, E. Gerald Corrigan of Goldman Sachs,Gerald Hassell of the Bank of New York, and An-drew Sheng of the Hong Kong Securities and Fu-tures Commission; Michael Patterson of JP MorganChase and Stephan Schuster of Deutsche Bank. Asdiscussed in Appendix 2, the Executive Committeechaired working and advisory groups and provideddetailed input to the identification and drafting ofrecommendations. The full 24-member SteeringCommittee, listed at the front of this report, was re-sponsible for oversight of the work program and forthe resulting report and recommendations.

Analysis, drafting, and coordinating the efforts ofdiverse contributors are key to any successful projectand a particular debt of gratitude is owed in this caseto PricewaterhouseCoopers for serving as profes-sional services partner for the project. Sam Dibb, PhilRivett, Chris Thompson, Jack Pullara, and their col-leagues conducted the industry survey that lies at theheart of this report, analyzed its findings, and workedwith the Executive Committee and industry expertsto identify areas of recommendation. Their assistancein all phases of the project, but especially in prepar-ing the report’s 20 recommendations, was instrumen-tal to the success of the project. Special thanks is alsodue to the Bank for International Settlements for per-

mitting Marc Hollanders to serve as Project Directorand to the Hong Kong Securities and Futures Com-mission, JP Morgan Chase, and the European Cen-tral Bank for permitting Stella Leung, Ed Neeck, andElias Kazarian to serve as working group secretaries.

Although the contributions of these individuals wereprodigious, the total work effort was dominated by thecumulative contributions of the many private and pub-lic institutions that participated in it. The full list of or-ganizations represented on working and advisory groupsand those that took part in the industry survey are listedin tables A2-1 and A2-2 of Appendix 2. Of course, anysuch list is a proxy for the efforts of a great many indi-viduals. Those who made significant personal contribu-tions through their service on working or advisorygroups, drafting documents, or offering technical ad-vice are listed at the end of Appendix 2.

We would also like to thank organizations that pro-vided facilities and hospitality for meetings of projectcommittees and working groups. These includeBarclays plc, the Bank of England, Citigroup,Goldman Sachs, JP Morgan Chase, Merrill Lynch,Morgan Stanley, and PricewaterhouseCoopers.

The overall project was a complex undertaking andthe production, dispatch of drafts, and a very sub-stantial editorial and production process had their lo-gistical center at the G30 offices, and in the office ofthe project Chairman. Although the work took longerthan anyone imagined at the outset, it could neverhave been completed without the efforts of DawnHewitt and Friso van der Oord of the Group ofThirty, Francesca Carter of the Bank of England andBarclays plc, and without the dedicated efforts of oureditors Martha Gottron and Nancy Morrison, andour designer Sarah McPhie.

As the number of firms and individuals cited in-dicates, the G30 global clearing and settlement projectwas a far-flung enterprise. If there are others whoassisted the project in uncharted meetings orunremarked conference calls, we apologize for theoversight and thank them for their contribution.

xi

The final word of recognition is reserved for Gor-don Richardson, honorary chairman of the Groupof Thirty. Lord Richardson was the driving force be-hind the 1989 clearing and settlement study as chair-

man of the Group, and his continuing leadership andinterest in this area were manifest in efforts to launchthis project. For his support as the Group’s seniorstatesman, we are most grateful.

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Executive Summary

EXECUTIVE SUMMARY

CLEARING AND SETTLEMENT OF SECURITIES IS A

CORE FINANCIAL FUNCTION on which fundamentalconfidence in the financial markets depends. It is alsoan area experiencing rapid growth, profound techni-cal and structural change, and infrequent but severemarket shocks. Growth has been tremendous. Forexample, the value of shares traded annually in worldmarkets rose nearly 63 times between 1980 and 2001.Over that same period, U.S. gross activity (both pur-chases and sales) in foreign securities grew nearly ahundred-fold, while foreign gross activity in U.S. se-curities also increased more than a hundred-fold.2 InEurope the institutional setting within which clear-ing and settlement occurs is changing rapidly, whiletechnology is changing the face of the process world-wide. And the events of September 11, 2001, chill-ingly demonstrated that global clearing and settlementarrangements are vulnerable to physical disruptionand threats previously considered improbable.

Any one of these factors—rapid growth, structuralchange, or market shocks—would normally begrounds for a thorough reexamination of market func-tion and each has, on occasion, provided justificationfor significant changes in market practices and super-vision. Mindful of the need for reform, the Group ofThirty commissioned this study fully a year before ter-ror struck Wall Street. Subsequent developments haveonly underscored the importance of the project.

The report recommends wide-ranging reform ofthe clearing and settlement process, including creationand implementation of global standards in techno-

logical and operational areas, improvements in riskmanagement practices, further harmonization of glo-bal legal and regulatory environments, and improvedgovernance for providers of clearing and settlementservices. These changes are embodied in the follow-ing 20 recommendations, which, when implemented,will significantly improve the safety and efficiency ofinternational securities markets. The reforms envis-aged are likely to be attainable within five to sevenyears at modest incremental cost.

THE TWENTY RECOMMENDATIONSCREATING A STRENGTHENED,

INTEROPERABLE GLOBAL NETWORK

1. Eliminate paper and automate communication,data capture, and enrichment.

2. Harmonize messaging standards and communi-cation protocols.

3. Develop and implement reference data standards.4. Synchronize timing between different clearing

and settlement systems and associated paymentand foreign-exchange systems.

5. Automate and standardize institutional tradematching.

6. Expand the use of central counterparties.7. Permit securities lending and borrowing to

expedite settlement.8. Automate and standardize asset servicing processes,

including corporate actions, tax relief arrangements,and restrictions on foreign ownership.

1. Standard and Poor’s, Emerging Stock Markets Factbook 2002, McGraw Hill & Co., New York.2. See footnote of Figure 1-1. p. 17.

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2

Global Clearing and Settlement: A Plan of Action

MITIGATING RISK

9. Ensure the financial integrity of providers ofclearing and settlement services.

10. Reinforce the risk management practices ofusers of clearing and settlement serviceproviders.

11. Ensure final, simultaneous transfer and avail-ability of assets.

12. Ensure effective business continuity anddisaster recovery planning.

13. Address the possibility of failure of a systemi-cally important institution.

14. Strengthen assessment of the enforceability ofcontracts.

15. Advance legal certainty over rights to securities,cash, or collateral.

16. Recognize and support improved valuation andcloseout netting arrangements.

IMPROVING GOVERNANCE

17. Ensure appointment of appropriately experi-enced and senior board members.

18. Promote fair access to securities clearing andsettlement networks.

19. Ensure equitable and effective attention tostakeholder interests.

20. Encourage consistent regulation and oversightof securities clearing and settlement serviceproviders.

These recommendations are further elaborated at theend of this summary and in the first five chapters ofthe accompanying report. Chapter 6 provides a fullerdiscussion of priorities and a plan of action. Appen-dix 1 presents detailed steps toward implementation.This is an ambitious agenda that will require substan-tial action by a wide range of market participants, in-dustry associations, and public sector agencies, and itis important to understand why changes of such sig-nificance must be made at this time.

RISING STAKES AND RISKS IN THE

CLEARING AND SETTLEMENT PROCESS

Clearing and settlement of securities—the processby which the ownership of securities is transferred

finally and irrevocably from one investor to another,typically in exchange for a corresponding transfer offunds—is central to all securities market activity andis thus a linchpin of any financial system. Yet fewpeople, even within financial institutions, understandits complex mechanics in detail. The process, includ-ing the associated costs and risks, is also largely invis-ible to end investors. For the most part this is unre-markable, in the same way that users of telephone orInternet services need not understand the intricaciesof data transmission or digital switching technology.

The reliable performance this implies owes muchto the high level of attention that has been devotedto domestic systems, notably in response to the Groupof Thirty’s 1989 report, “Clearance and SettlementSystems in the World’s Securities Markets.” Recom-mendations published in 2001 by the Committee onPayments and Settlement Systems of the Group ofTen central banks (CPSS) and the International Or-ganization of Securities Commissions (IOSCO) arenow one of the key standards used by public authori-ties to achieve sound financial systems.

At the same time, this is a period of rapid changein technology and market infrastructure, linked to fun-damental changes in the marketplace. These changesare associated with growth in trading volumes andtechnological advances that have been instrumentalin opening up access to markets and providing op-portunities to automate markets’ core processes. Con-tinued consolidation of market players and infrastruc-ture is concentrating both market power and risk. In-vestors and the financial intermediaries that servethem are increasingly focusing on the costs of trad-ing, and the cleaning and settlement of those trades.With securities trading, especially cross-border trad-ing, expanding rapidly, both the stakes and the risksinvolved are rising.

THE CHALLENGE OF CROSS-BORDER

CLEARING AND SETTLEMENT

Cross-border trading is a particular challenge because,at its heart, clearing and settlement of securities is stillan activity that takes place market by market. This“domestic” approach reflects the natural evolution ofsecurities markets in the context of local law, business

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Executive Summary

practice, and regulatory frameworks, and the fact thatsettlement systems have usually grown up in close alli-ance with the markets they support. Indeed in severalcountries, the stock exchange owns the clearing andsettlement system. In some countries, members ofthe exchange are obliged to use these systems.

Any firm that provides investment services to in-ternational investors must participate in myriadsettlement systems and related legal and regulatorysystems. Maintaining the systems and retainingpeople who understand the intricacies of the con-ventions and practices that differ from system to sys-tem and from market to market is costly. That costis ultimately borne by investors in internationallytraded securities, be they individuals or institutions,mutual funds or pension funds.

NETWORK IMPLICATIONS

As well as adding costs, cross-border trading intro-duces an increasing element of risk. The lack ofimplementation of globally recognized technicalstandards, uniform business processes, and consis-tent legal and regulatory underpinnings makes theglobal clearing and settlement network inefficient,unwieldy, and potentially unreliable. Furthermore,this global network links clearing and settlementsystems with payments systems and foreign-exchangemarkets, so that problems in one system and mar-ket are increasingly likely to affect markets andfirms in other parts of the world.

In addition, this imperfect network is vulnerableto shocks, whether through an unexpected surge inmarket volatility, a major technical or institutional fail-ure, or a physical disruption. These shocks tend to beof relatively short duration but are sometimes verylarge in scale. Loss of the clearing and settlement func-tions even briefly can be costly and disruptive of mar-kets. Loss of function over several days, or simply ata critical time in the daily clearing and settlement pro-cess, can have serious systemic implications, especiallyif accompanied by other financial disruptions.

MARKET DYNAMICS AND THE NEED FOR CHANGE

With risks rising and pressures to reduce costs in-creasing, it would be reasonable to expect markets to

respond to these challenges in ways that reduced bothcosts and risk. This report proceeds from the premisethat market-led change is essential. However, thereare two reasons to believe that some external stimu-lus is needed.

First, the legal and regulatory frameworks on whichclearing and settlement systems are founded continueto develop piecemeal and largely on a domestic basis.Thus, the complexities of cross-border clearing andsettlement are likely to grow, evenif best industry practice and offi-cial guidance are strictly followed.Second, incentives within indi-vidual clearing and settlement en-tities tend to support incrementalchange that strengthens the localfranchise, rather than initiatives tofacilitate greater competitivenessat the international level that couldadversely affect the value of thelocal franchise. Indeed, segmenta-tion restricts competition because each system is able toset its own standards for membership and for the ser-vices it provides. These are not incentives likely to pro-duce global standards of best practice appropriate tothe emerging global network.

THE GROUP OF THIRTY INITIATIVE

For all these reasons, the Group of Thirty decidedto initiate an assessment of cross-border clearingand settlement issues. A Steering Committee wasrecruited from senior representatives of the privatesector and leading figures in the public sector (seepage ix). The contribution of the latter, owing to thedemands of public office, was in a personal capacity,drawing on their experience but without committingtheir institutions. The aim of the assessment was toimprove efficiency and reduce risk in the system. Itsprimary focus was major securities markets and thekey institutions that form the backbone of the globalclearing and settlement framework. In the interest ofpromoting meaningful change, its objective was toenunciate technical, legal, and process standardswhere possible, rather than remaining at the level of

Implementing the twenty

recommendations in this

report would significantly

improve the safety and

efficiency of international

securities markets.

4


broad principles. To reflect the realities of the mar-ketplace, Pricewaterhouse Coopers undertook a sur-vey of 40 firms along what this report refers to as theclearing and settlement value chain. Participantsranged from asset managers and broker-dealers tocustodians and providers of clearing and settlementservices, from small firms to the large “bulge bracket”market participants. It included major trade associa-tions and all major regions of the world (for a com-plete list of participants, see Appendix 2). To avoidbias in the result, the survey consisted of open-endedquestions designed to allow the survey participantsto provide their concerns about the current systemand expectations regarding this study.

The survey findings constitute a far-reachingagenda for change, aimed at achieving a truly glo-bal model for clearing and settlement. The recom-mendations contained in this report respond directlyto this research. If acted upon, the result would be awidely interoperable and accessible system operat-ing to standards of best market practice.

RELATIONSHIP TO OTHER KEY INITIATIVES

To ensure that any new recommendations were an-chored in existing standards of best practice and thelatest regulatory guidance, a second element of theassessment was an evaluation of existing principlesand standards. These included recommendations ofthe International Securities Services Association(ISSA), work of the Global Documentation TaskForce, various reports on integrating clearing andsettlement structures in the European Union includ-ing the Giovannini report and work of the Euro-pean Central Securities Depositories Association,and official guidance issued by various supervisorybodies. Most important in this regard were the rec-ommendations issued jointly by CPSS and IOSCOin November 2001, which this report fully endorsesas a foundation for the recommendations that fol-low. It should be noted, however, that this reportmoves beyond these recommendations in several re-spects.

� This report promotes “best practice” thatclearing and settlement systems in the mostadvanced economies should aspire to meetwithin roughly five to seven years, while theCPSS-IOSCO recommendations set forthminimum standards that are expected to bemet at the earliest opportunity by settlementsystems in all economies.

� Although this report and CPSS-IOSCO sharethe broad objectives of safety and efficiency,the agenda set out here is considerably moreambitious regarding efficiency, reflectingindustry aspirations expressed in the survey.

� This report places greater emphasis thanCPSS-IOSCO on cross-border issues, aimingfor creation of an integrated global networkwhich goes beyond applying minimumstandards in individual jurisdictions.

� Overall, this report’s recommendations tend tobe more prescriptive than the CPSS-IOSCOrecommendations and focus more explicitly onthe implementation path to be followed, againreflecting industry aspirations.

Despite these differences in emphasis and intensity,the two sets of recommendations are broadly comple-mentary and entirely consistent. Together, they pro-mote sound infrastructure for global markets.

COSTS AND BENEFITS

The Steering Committee also carefully considered thebenefits and costs of the changes being recommended.The available data clearly support the view that thecurrent system is significantly less efficient than itcould be. No one disputes that the cost of settling atrade varies significantly from market to market, andcross-border settlement is substantially more expen-sive than domestic settlement. Yet, when it comes toquantifying this assertion, analysis and opinion dif-fer. For example, the Center for European PolicyStudies estimated European Union cross-border coststo be between two and eight times U.S. domestic costs,although the basis and assumptions underlying thesecalculations have been challenged by other analysis

5

Executive Summary

that finds much greater differences, notably by theDepository Trust and Clearing Corporation. Mean-while, recent estimates of the cross-border premiumfor trading costs as a whole range from 30 percentfor a wholesale trade to 150 percent for retail. Whilethe quantum differs, the cost differences and the po-tential for savings in all cases are substantial.3

Studies to date have focused on the direct costspaid to infrastructure providers for clearing and settle-ment services. We estimate their operating costs atapproximately $2.5 billion annually. A much greatershare of overall clearing and settlement costs, how-ever, is attributable to internal expenditure among fi-nancial intermediaries, the organizations that facili-tate a financial transaction between end-user issuersand investors. These broker-dealers and custodian-agent banks spend on the order of $10 billion a year—and this estimate ignores the cost of working capitaltied up in the various systems (for analysis of costs,see chapter 1, pp. 15-16). Cross-border trades alsofail far too frequently, and it is estimated that manualintervention to fix these problems can increase trad-ing costs by a factor of nearly four.4 Significant sav-ings are possible by eliminating the poor data, manualprocesses, and weak communications that typicallycause such failures. An improved infrastructure forclearing and settlement would reduce the unit costof international transactions, and expanded compe-tition between service providers resulting from a moreopen and competitive approach to international clear-ing and settlement services would exert further down-ward pressure on these costs. Our analysis suggeststhat these savings will benefit end investors as well asreduce the effective costs to issuers.

The report’s conclusion is that significant cost sav-ings can be realized by implementing its recommen-dations, although the full measure of cost savings andrisk mitigation envisaged in the report will be achievedonly through comprehensive reform and over an ex-tended period. Accurate quantification of anticipated

efficiency gains, however, would require a detailed busi-ness-case analysis that is beyond the scope of even thesignificant resources dedicated to this project.

While substantial cost-savings are to be had overtime from adopting these recommendations, there arealso significant costs to be borne in implementingthem. This will not be a short-term undertaking.Agreement on standards, changes in the organizationof local markets, and changes to operating systemsat many service providers and market participants willall take time to effect. At the same time, software andsystems must be updated and replaced periodically,typically on a replacement cycleof five to seven years. The align-ment between the time requiredto develop standards and thesoftware cycle should permit in-troduction of new standards inthe context of otherwise neces-sary system replacement or up-grade. Thus, the changes envis-aged here are likely to be attain-able within five to seven years atmodest incremental cost. It isalso worth repeating that the im-petus for the most ambitiouschanges comes from the indus-try itself, suggesting that thechanges proposed will be viewedas essential improvements ratherthan unnecessary expenditures.

NEW GROUND COVERED BY THE REPORT

Taking account of the full range of analysis, the Steer-ing Committee concluded that fundamental changeis needed. The current system of predominantly lo-cal provision of clearing and settlement services,based on local or proprietary standards and businesspractices, must be transformed into a widely acces-sible global network that is more fully automated and

3. Karel Lannoo and Mattias Levin, “The Securities Settlement Industry in the EU: Structure, Costs and the Way Forward,”Center for European Policy Studies, December 2001; and Deutsche Börse Group and Clearstream International, “White Paperon Cross-Border Equity Trading Clearing and Settlement in Europe,” April 2002.

4. Based on audits of transcription processing at major financial institutions in Europe and the United States, conducted bySWIFT between 1996 and 1998.

The impetus for the

most ambitious

changes comes from

the industry itself,

suggesting that the

changes proposed will

be viewed as essential

improvements rather

than unnecessary

expenditures.

6


operates to consistently implemented global stan-dards. The report breaks new ground in several im-portant areas, beginning in the cross-border arenawhere it defines interoperability and the steps neces-sary to achieve it, including development of specificstandards. Next is the area of risk management. Thereport sheds new light on risk management for usersand providers of clearing and settlement infrastruc-ture services. The report also raises important issuesof legal risk relating to the enforceability of nettingand collateral agreements, and it incorporates lessonslearned from September 11 into higher standards forbusiness continuity and disaster recovery planning.An important new area addressed is post-settlementasset servicing, including corporate actions, tax re-lief arrangements, and foreign-ownership restrictions.And in the other areas touched by the report, it is fairto say that the standards have been pushed higher.

The result, when these recommendations are fullyimplemented, will be a framework for internationalsettlement and clearing that is quite different from thestatus quo. In some ways it will resemble the frame-work that exists in global telecommunications. The glo-bal telecommunications carriers compete among them-selves but have common standards (both technical andmarket practice) for interface among one another andwith local exchanges and for delivery of transmissionsto the end user. The Steering Committee believes thatan approach of this type—one that establishes globalstandards to which all participants in the clearing and

settlement process adhere—is es-sential to facilitate competitionand indeed to encourage the pro-viders of international clearingand settlement services to com-pete as robustly as possible.

ACHIEVING REFORM

Reform in these three areas con-stitutes the Steering Committee’svision for the future of the clear-

ing and settlement system, a vision that will be real-ized by the 20 recommendations set out in this re-port. It is worth noting that although the cross-bor-der focus is an important factor in this report, only

about one-third of the recommendations are explic-itly directed to the cross-border environment. Theremainder apply to practices within markets. The rea-son is simple. Only when the characteristics of per-formance are consistent will it be possible to createthe cross-system linkages ultimately required to pro-duce a seamless global infrastructure.

Together, the recommendations represent a compre-hensive plan of action for the future development ofglobal clearing and settlement. Provided that action onthese recommendations is systematic, the landscape forclearing and settlement could be very different and muchimproved within five to seven years. The full improve-ment in efficiency and safety described in this reportwill result, however, only from comprehensive adoptionof the recommendations set out here.

The critical requirement for change on this scaleis the motivation to complete it. Seeing these recom-mendations through to full implementation will re-quire individual and collective action by providers andusers of clearing and settlement services, as well asby supervisors, central banks, and governments. Eventhough the matters involved are sometimes highlytechnical, commitment and consensus will be needednot only among technical specialists, but also at thelevel of boards of directors. Collective action will in-volve a range of existing industry organizations al-ready active on these issues, while for some, theappropriate venue for action will have to be decided.Neither the Steering Committee nor the Group ofThirty itself can devise or implement these changes.

Although the agenda is ambitious, it is also sen-sible: responsive to market aspirations for greatersafety and efficiency and focused on practical solu-tions to current problems. It offers an organizing prin-ciple for the substantial body of work that is alreadyunder way by industry groups, supervisors, and cen-tral banks. As new standards and approaches becomeavailable, firms will include them in system and soft-ware upgrades. The question is whether these effortswill proceed piecemeal or will embrace an approachbased on global standards as outlined in this report.

Such an approach can be pursued if those that havethe capacity to carry the work forward have confi-dence that change will come in a reasonable time

The reforms envisaged

are likely to be

attainable within five to

seven years at modest

incremental cost.

7

Executive Summary

frame and at reasonable cost compared to the antici-pated benefits.

To that end, both the Steering Committee andother participants in the study have supported themonitoring of progress against the reform agendaas motivation for action after the report is published.It has been widely suggested that the Group ofThirty should play a continuing role in this process,in collaboration with appropriate public and privatesector entities. Accordingly, the Group has agreedto form a Standing Committee to monitor progressin the period after the report’s release.

THE LONGER TERM

The question of how best to carry the full agenda forchange through to completion remains to be answered.In other areas such as telecommunications (Interna-tional Telecommunication Union), postal services (Uni-versal Postal Union), and air transport (InternationalAir Transport Association), an internationally recog-nized agency has emerged that oversees the creationand maintenance of standards, as well as their adop-tion and enforcement. In the clearing and settlement

area, many organizations are already involved—ISSA,CPSS/IOSCO, the Committee of European Securi-ties Regulators, central banks, supervisors, and vari-ous bodies representative of in-frastructure providers—butnone with both global reach andcomprehensive scope. It will ul-timately be for the organizationsthat collectively comprise the glo-bal clearing and settlement indus-try to decide on a long-term ap-proach.

In the meantime, with theGroup’s agreement to play acontinuing role following releaseof this report, the Steering Committee makes thefollowing recommendations. These are offered in thefirm belief that if implementation of these recom-mendations begins immediately, then its vision of asafer, more efficient global clearing and settlementsystem can be brought to fruition in the proposedfive- to seven-year time frame.

The current system must

be transformed into a

widely accessible global

network that is more fully

automated and operates

to global standards.

8


RECOMMENDATIONSCREATING A STRENGTHENED,


RECOMMENDATION 1. ELIMINATE PAPER AND AUTOMATECOMMUNICATION, DATA CAPTURE, AND ENRICHMENT.Infrastructure providers and relevant public au-thorities should work with issuers and securitiesindustry participants to eliminate the issuance, use,transfer, and retention of paper securities certifi-cates without delay. All market participants shouldseek to automate elements of the process, suchas confirmations and trade allocations, that intro-duce other forms of paper into the securities pro-cessing transaction flow as technology safely al-lows. All market participants should use electroniccommunication to transmit information for all in-struments and transaction types. They should alsoidentify opportunities to streamline processes byavoiding duplicative recording of data and manualaddition of supplementary information at eachstage of the value chain.

RECOMMENDATION 2. HARMONIZE MESSAGING STANDARDS ANDCOMMUNICATION PROTOCOLS.All market participants should adopt ISO15022(the data field dictionary and message catalogue forsecurities information flows) as the global standardfor straight-through securities messaging across theentire securities life cycle.5 Over time, XML (ex-tensible mark-up language) should become the lan-guage to describe standardized messages.6 All mar-ket participants should support and use commu-nication networks that adopt open, standardized,IP-based protocols for securities transactions. 7

RECOMMENDATION 3. DEVELOP AND IMPLEMENT REFERENCEDATA STANDARDS.Market participants should collectively identify, de-velop and adopt universal securities, counterparty

and relevant generic reference data standards thatfully meet the needs of all relevant users. Issuers,exchanges, and other originators and distributorsof data should make all relevant information avail-able to the market in compliance with these stan-dards for a fair price and on a timely basis.

RECOMMENDATION 4. SYNCHRONIZE TIMING BETWEEN DIFFERENTCLEARING AND SETTLEMENT SYSTEMS AND ASSOCIATEDPAYMENT AND FOREIGN EXCHANGE SYSTEMS.Providers of clearing and settlement services andlinked or otherwise associated payment andforeign-exchange systems should collectively en-sure that their design, procedures, operationaltimetables, and funding and cutoff times are suchthat the operation of one system does not mate-rially reduce the efficiency or increase the risk ofsettlement in another. Market participants shouldwork together to develop a comprehensive actionplan to increase the efficiency and safety of cross-border securities transactions where the foreign-exchange settlement cycle is not synchronizedwith the securities settlement cycle.

RECOMMENDATION 5. AUTOMATE AND STANDARDIZE INSTITU-TIONAL TRADE MATCHING.Market participants should collectively developand use fully compatible and industry-acceptedtechnical and market-practice standards for theautomated confirmation and agreement of insti-tutional trade details on the day of the trade.

RECOMMENDATION 6. EXPAND THE USE OF CENTRALCOUNTERPARTIES.Market participants and relevant public institutionsshould collaborate to assess the potentially substan-tial risk reduction and efficiency improvements ofusing a central counterparty. These benefits are ex-pected to outweigh their costs in most markets.Where this is so, market participants should seek

5. ISO, the International Organization for Standardization, is a confederation of national standards institutes that works in part-nership with public and private institutions to develop standards to be used consistently as rules, guidelines, or definitions ofcharacteristics and to ensure that materials, products, processes, and services are fit for their purpose.

6. XML (extensible mark-up language) is the universal language for describing structured documents or data on the Internet.7. IP (Internet protocol) is a suite of protocols developed for and used by the Internet and by private networks as the open, global

standard for electronic communication.

9

Executive Summary

either to use the services of an existing centralcounterparty or to establish one of their own, which-ever has the better risk, cost, and benefit profile.

RECOMMENDATION 7. PERMIT SECURITIES LENDING ANDBORROWING TO EXPEDITE SETTLEMENT.Relevant authorities should permit securities lend-ing and borrowing as a method for expediting thesettlement of securities transactions.

RECOMMENDATION 8. AUTOMATE AND STANDARDIZE ASSETSERVICING PROCESSES, INCLUDING CORPORATE ACTIONS,TAX RELIEF ARRANGEMENTS, AND RESTRICTIONS ONFOREIGN OWNERSHIP.Issuers, providers of clearing and settlement ser-vices, and other relevant market participants shouldadvise investors of all details of corporate eventsthat they require in an automated, timely mannerand in compliance with accepted industry stan-dards, so that each investor can make a timely de-cision on the action to be taken with full knowl-edge of the facts. Market participants and publicauthorities should work together to minimize theadministrative costs to each party involved in taxrelief arrangements through standardization andautomation of procedures and communication ofinformation and through the use and acceptanceof electronic data and documentation. Relevantpublic authorities, infrastructure providers, andmarket participants should work together to har-monize and make transparent the processes, docu-mentation, and communication of information inconnection with foreign-ownership restrictions andreporting requirements.

MITIGATING RISK

RECOMMENDATION 9. ENSURE THE FINANCIAL INTEGRITY OFPROVIDERS OF CLEARING AND SETTLEMENT SERVICES.Providers of clearing and settlement servicesshould manage their risks and set standards andcontrols concerning the use of those services thatallow them to conduct business in a safe, sound,and prudent manner consistent with their businessmodel and all relevant supervisory and regulatory

requirements. The need to operate prudently withinthe risk boundaries inherent within the businessmodel requires risk management processes andstandards, which should be applied objectively andconsistently in determining compliance with riskmeasures, in three broad areas: the counterpartydue diligence process; the procedures and tech-niques used to measure, monitor, and control riskexposure; and the minimum financial and liquidityrequirements. Each organization should publish areport, at least annually, that describes the businessmodel, risk framework, and underlying risk man-agement processes, controls, and standards, to-gether with the results of independent testing ofthose procedures. The report would thereby reas-sure users that the organization had operated ef-fectively, and also would provide greater transpar-ency to the market.

RECOMMENDATION 10. REINFORCE THE RISK MANAGEMENTPRACTICES OF USERS OF CLEARING AND SETTLEMENTSERVICE PROVIDERS.Organizations that use, or are considering using,providers of clearing and settlement servicesshould establish robust due diligence andcounterparty risk management controls and pro-cesses that appropriately evaluate, measure, moni-tor, and control the risks inherent in such activityand in associated customer-related business.

RECOMMENDATION 11. ENSURE FINAL, SIMULTANEOUS TRANSFERAND AVAILABILITY OF ASSETS.Providers of securities settlement services shouldreduce to the lowest possible level the credit riskcreated if securities or cash are delivered with-out receipt of corresponding assets, by linkingsecurities transfers to funds transfers in a way thatachieves effective delivery versus payment (DvP)and by making transparent the point at which fi-nality of transfer is achieved. Once finality oftransfer is fully assured, the rules should enable areceiver to re-use securities and cash without fur-ther delay.

10


RECOMMENDATION 12. ENSURE EFFECTIVE BUSINESS CONTINUITYAND DISASTER RECOVERY PLANNING.All market participants should, and all systemi-cally important institutions must, regularly review,update, and test their business continuity anddisaster recovery plans, including evaluation ofreliance on third parties, to ensure with reason-able certainty that critical operations will continuewith a high level of integrity and sufficient ca-pacity following a disruption or disaster.

RECOMMENDATION 13. ADDRESS THE POSSIBILITY OF FAILURE OFA SYSTEMICALLY IMPORTANT INSTITUTION.Market participants in each financial center shouldwork together to identify those institutions, or partsthereof, that are systemically important to the clear-ing and settlement process. User groups should beestablished to address how they would react if,despite strengthened business continuity and dis-aster recovery plans, there were a failure for what-ever reason at one of these institutions. Ways ofmitigating the risks created should a systemicallyimportant institution fail, such as building a real-time data depository, should be evaluated. Whereit is determined that effective and feasible solutionsmay exist, detailed business cases setting out thecosts and benefits should be built up, and decisionson future actions and investment decisions shouldbe taken accordingly. As well as enforcing suitablyhigh standards of business continuity and disasterrecovery planning in systemically important insti-tutions, regulators and overseers should encour-age this process of industry-wide contingencyevaluation and planning.

RECOMMENDATION 14. STRENGTHEN ASSESSMENT OF THEENFORCEABILITY OF CONTRACTS.Market participants should ensure that due dili-gence procedures examine contract enforceabil-ity, including basic formation and validity, as wellas power and authority to contract.

RECOMMENDATION 15. ADVANCE LEGAL CERTAINTY OVER RIGHTSTO SECURITIES, CASH, OR COLLATERAL.Market participants must be able to determine,with certainty and reasonable cost and effort, whatlaw defines and governs their rights to securities,cash, or collateral in a clearing and settlement sys-tem or other intermediary, what those rights are,and how to perfect and enforce them.

RECOMMENDATION 16. RECOGNIZE AND SUPPORTIMPROVED VALUATION METHODOLOGIES AND CLOSEOUTNETTING ARRANGEMENTS.Market participants should ensure that master agree-ments provide that upon the early termination of atransaction or group of transactions, the determin-ing party will have the flexibility to value such trans-actions by the method that is most likely to producea commercially reasonable valuation at the time oftermination. Market participants should includecloseout netting provisions in their contract docu-mentation. Relevant authorities in each jurisdictionshould ensure that their laws give effect to closeoutnetting for all central counterparties, brokers, endusers, and other market participants, and for all en-tity, transaction, and asset types.


RECOMMENDATION 17. ENSURE APPOINTMENT OF APPROPRIATELYEXPERIENCED AND SENIOR BOARD MEMBERS.Members of the boards of securities clearing andsettlement infrastructure providers should, indi-vidually and collectively, be of a weight in termsof experience and seniority to discharge the en-larged strategic, risk, and operational managementoversight responsibilities described in this report.

RECOMMENDATION 18. PROMOTE FAIR ACCESS TO SECURITIESCLEARING AND SETTLEMENT NETWORKS.Boards of securities clearing and settlement ser-vice providers, other organizations providing simi-lar services, and public authorities should ensure

11

Executive Summary

that rules and other requirements that control orlimit access to securities clearing and settlementservices are accepted only where they are neces-sary and are designed exclusively for the purposeof controlling financial, operational, reputationalor regulatory risks; maintaining the safety of thesystem; or achieving other reasonable public policyobjectives. Networks and services should be ac-cessible to all users that pass risk and safety evalu-ations and enjoy appropriate financial standing, andusers should be free to select the mix of functionsand services that they wish to use on the basis ofstraightforward, transparent, and fair tariff policiesgrounded on the principle of user pays.

RECOMMENDATION 19. ENSURE EQUITABLE AND EFFECTIVEATTENTION TO STAKEHOLDER INTERESTS.Board participation should represent differentstakeholder interests fairly and equitably. Provi-sion should be made for regular review of, andfor changes as necessary in, board compositionto ensure continuing balanced representation ofvarying stakeholder groups, including users.

RECOMMENDATION 20. ENCOURAGE CONSISTENT REGULATIONAND OVERSIGHT OF SECURITIES CLEARING AND SETTLEMENTSERVICE PROVIDERS.Providers of securities clearing and settlement ser-vices should be subject to consistent and trans-parent regulation and oversight, which shouldfocus on the activities undertaken and risks in-curred. Standards of regulation and oversight ofcross-border activity should be complementaryand consistently applied across all relevant juris-dictions. As a long-term goal and where coherentwith other public policy objectives, regulatory andoversight standards should be harmonized.

13

Clearing and Settlement: What Is at Stake?

1. CLEARING AND SETTLEMENT: WHAT IS AT STAKE?

THE SAFETY AND EFFICIENCY OF GLOBAL CAPITAL

MARKETS DEPEND ON EFFECTIVE CLEARING AND

SETTLEMENT of the securities, debt, and derivativetransactions that flow through them. Clearing is theprocess following a trade in which the arrangementsfor transfer of title and funds are agreed. Settlementis the process by which the ownership interest in se-curities is transferred from one investor to another,generally in exchange for a corresponding transferof funds. The goal is to provide the buyer with irre-vocable delivery of a security from the seller at orvery near the precise moment when the seller receivesfinal and irrevocable payment for it from the buyer.Although largely invisible to the end investor, theseprocesses lie at the core of all securities markets. In-deed, modern securities markets could not functionwithout the systems and infrastructure that facilitateclearing and settlement.

In concept, there is nothing mysterious about thismechanism; yet in practice, it is quite complex. Match-ing transaction terms, confirming, and settling the manymillions of trades taking place every day in major mar-kets is complicated enough in a purely domestic con-text. But the mechanics have become even more com-plex with the rapid growth of cross-border trading,which spans many clearing and settlement systems andlegal and regulatory jurisdictions. Meanwhile, the under-lying legal and regulatory frameworks on which thesesystems rely continue to develop in a piecemeal fashionand largely on a domestic basis. In short, the tradingnetwork is ultimately global in coverage; yet the post-trade clearing and settlement environment is highly seg-mented and provides only limited integration or reliableconnectivity. The causes of this fragmentation include

the lack of global technical standards, differing businessprocesses, and inconsistent legal and regulatory under-pinnings. The result is excessive delay, failed trades, andsubstantial duplication of system capabilities. These in-efficiencies are costly to users of clearing and settlementservices, to investors and issuers active in internationalmarkets, and, to the extent that trading activity is dis-couraged, to the economy as a whole.

In addition to the costs involved, this imperfectnetwork is subject to shocks—an unexpected surge inmarket activity, a major technical failure, or an externaldisruption such as the terrorist attack on the WorldTrade Center in New York on September 11, 2001.Although the system has proven very resilient, the costand disruption arising from lossof clearing and settlement func-tions can be profound, especiallyif accompanied by other finan-cial disruptions.

Inefficiencies and risks in theclearing and settlement processwere a concern well beforecross-border trading began itsrapid growth. The 1989 Groupof Thirty study “Clearance andSettlement Systems in the World’s Securities Markets”made nine recommendations for reducing risk andstrengthening national systems, now largely adopted.Authoritative guidance in this area was most recentlyissued in November 2001 by a joint task force of theCommittee on Payments and Settlements Systems ofthe Group of Ten central banks (CPSS) and the In-ternational Organization of Securities Commissions(IOSCO).

Although largely invisible

to the end investor,

clearing and settlement

lie at the core of all

securities markets.

13

14


BOX 1-1. INTEROPERABILITY

As used in this report, interoperability refers to the ability ofparticipants along the clearing and settlement value chainto communicate and work with service providers and otherparticipants without special effort on the part of users.Interoperability involves more than technical compatibilityof systems, although standardized communication, messag-ing, data, and timing are clearly essential. The ability of sys-tems to interoperate also requires like or compatible pro-cesses, business practices, controls, technologies, products,access arrangements, and fee structures. The recommen-dations in this report aim at creating the potential forinteroperability. Its full realization will require implementa-tion and consistent use of technical, market practice, riskcontrol, system access, and other standards within and be-tween connected entities, enforced though economic, regu-latory, or other means.

The benefits of interoperability can be seen in many otherindustries that have evolved to meet the needs of users op-erating across borders or systems.

� National standardization of railway track gauges in theUnited States in the late 19th century eliminated manualswitching between systems, making commercial rail trans-port much faster and cheaper and triggering a major ex-pansion in system use and interstate trade.

� National aviation authorities, through the International CivilAviation Organization, have adopted standards for auto-mation of air traffic control services, protocols for use ofthe global navigation satellite system, and controller-pilotdata link communications that have significantly reducedthe risk of human error and expanded system capacity.

� Through the standard setting of the International Tele-communications Union, almost all telephone calls todayrequire no intervention by anyone other than the caller,whether they are within a particular network or acrossmany networks, and whether they are fixed line or mo-bile. Combined with expanded competition, whichinteroperability has promoted, the cost of cross-networkcalls has fallen dramatically. For example, from 1995 to2000, the average cost of calls from Switzerland to theUnited States fell from 74 cents to 7 cents a minute, whilethe price of Swiss domestic calls dropped only from 5cents to 4 cents a minute.

Source: International Telecommunications Union, “InterconnectionRegulation,” Trends in Telecommunications Reform 2000-2001, 3rd ed.,Geneva. 2000.

Despite the excellent work that hasbeen done in this area, some of themore intractable legal and operationalconcerns identified more than a de-cade ago remain unresolved, whilenew issues continue to arise. TheGroup of Thirty therefore decided tocommission an updated assessmentof clearing and settling arrangementsto address the new challenges. ASteering Committee was recruited toconduct this assessment. Its startingpoint was a survey of participants inall phases of the clearing and settle-ment process to evaluate their levelof concern and determine the scopefor further work. The survey, under-taken by PricewaterhouseCoopers onbehalf of the Group of Thirty, iden-tified five broad areas of concern:

� Access barriers to markets andservices that limit effectivecompetition.

� Lack of interoperability andconnectivity that prevent theseamless flow of transactionsand messages among marketparticipants across differentclearing and settlement systems.

� Continuing deficiencies in thebasic clearing and settlementmodel, including traditionalconcerns over finality oftransfer and reliance on paperand manual processes.

� Concerns about risk manage-ment, including businesscontinuity and disaster recovery(later underscored by the eventsof September 11), and thelimitations of risk mitigationtechniques, such as the effective-ness of collateral in cross-border trades.

15


1. See footnote 3 in the executive summary.2. Major markets for this purpose were taken to include equity and fixed-income securities markets in the United States, Canada,

members of the European Union, Switzerland, Japan, Hong Kong, Singapore, and Australia.3. By using fully loaded costs, aggregation and averaging of the results should help to smooth out variances caused by organiza-

tions at different stages of the system development life cycle. Costs paid to other organizations in the value chain (such asbroker-dealer payments to custodians, central securities depositories, and central counterparties) were excluded to reduce therisk of double counting. It is clear that organizations are managed and structured on differing bases, and so measure costs andmarket share accordingly. Thus, while participants were able to provide estimates of costs and market share, it must be recog-nized that this survey was not intended to be precise. Surveying the costs of large organizations is likely to underestimateoverall industry costs because such firms enjoy economies of scale compared with smaller organizations. Conversely, largeorganizations typically undertake a disproportionate amount of cross-border trading, which is inherently more expensive andso is likely to offset any distortions caused by scale economies.

� The impact of complex asset servicing require-ments on clearing and settlement, includingactivities such as recording dividends andexercising voting rights (known collectively ascorporate actions), tax relief arrangements, andrestrictions on foreign ownership.

The survey indicated a high degree of consensus onthe need for further work in the five priority areasand the benefits available from the Group of Thirty’srenewed attention to these matters.

The areas of recommendation focus on clearingand settlement of debt instruments and equities ratherthan derivatives, although many of the improvementsproposed will benefit derivatives as well. Similarly, therecommendations address the “street” side of clear-ing and settlement: that is, improvements affectingservice providers and intermediaries rather than in-vestor clients. Although the report does not addressthe “client” side of the securities business, develop-ment of comprehensive common standards for elec-tronic processing and messaging in client businesswould greatly reduce internal costs for market par-ticipants by eliminating the use of telephone, fax, anddisparate electronic messaging systems for trade com-parison and confirmation.

WHAT IS THE COST OF INEFFICIENCY?

The current system for settling cross-border trades issignificantly less efficient than it could be. Many com-parisons of costs from system to system have beenmade; although there is much debate over methodol-ogy, numerous studies have indicated that the cost ofsettlement may differ by as much as a factor of eightbetween trades cross-border in the European Union

and the United States, and that cross-border trades areconsiderably more expensive than domestic ones.1 Inaddition, to cope with the range of clearing and settle-ment entities and their unique operating systems, bro-ker-dealers and other financial intermediaries are in-stalling duplicative systems and implementing moreextensive risk management processes, thereby increas-ing their internal costs. A related cost is the use of lo-cal custodians and agents to cope with the specific re-quirements of local markets, an expensive practicesometimes mandated by local lawor regulation. While this varietyis unlikely ever to be eliminated,it is usually asserted that the great-est scope for efficiency gains liesin streamlining these areas ofduplication at financial interme-diaries.

To test these assertions, a lim-ited number of large, interna-tional broker-dealers and custo-dian banks were asked to pro-vide their “fully loaded” annualcosts of clearing and settlementin connection with major mar-kets, including all development and day-to-day run-ning costs, along with relevant market share data.2

PricewaterhouseCoopers collated and extrapolatedfrom this source data to project a total industry cost.Although such an analysis has many inherent limita-tions, it yielded reasonable “order of magnitude” es-timation of overall clearing and settlement costs that,if anything, are likely to err on the conservative side.3

The result very plainly supports the view that inter-nal expenditure at the level of intermediaries makes

The lack of global

technical standards,

differing business

processes, and

inconsistent legal and

regulatory underpinnings

are impeding the

C&S process.

16


up the clear majority of overall clearing and settle-ment costs—on the order of $10 billion a year, com-pared with approximately $2.5 billion in costs incurredby the organizations that provide the actual clearingand settlement infrastructure—and this estimate ig-nores the cost of working capital tied up in the vari-ous systems.

Thus, standardization and streamlining of process-ing could offer considerable savings. An analysis un-dertaken by Oxford Economic Research Associates(OXERA) for this project examined the level of com-petition along the clearing and settlement value chain

and concluded that the majorityof these savings, including re-duced back-office processingcosts at intermediaries, wouldlikely accrue to end investors inand issuers of securities. More-over, high transaction costs andcomplexity in cross-border trad-ing depress the level of tradingactivity and discourage efficientdiversification of portfolio in-vestment (such as pensions)across borders. A more efficient

system with lower costs would encourage growth ofcross-border transactions and related economic ac-tivity, with potentially substantial public benefit.

Of course, it is the overall cost-benefit calculationfor any changes proposed that must be considered. Ad-ditional costs clearly will be involved in developing andadopting new technical standards and business prac-tices, and these one-time costs could be quite substan-tial. These costs represent an investment in a globalnetwork, the ultimate cost of which will depend im-portantly on the speed with which new standards areintroduced. The report argues for phasing in new stan-dards in line with cycles for obsolescence and replace-ment of software and systems—perhaps five to sevenyears—a strategy that should contain additional costs.Once the reforms are in place, the return on invest-ment will be a reduction in the unit cost of transac-tions for a large range of participants, and an increasein trading activity.

HOW GREAT ARE THE RISKS IN THE SYSTEM?

Risk is a significant concern in any analysis of clear-ing and settlement systems because of the interre-lated credit, market, liquidity, operational, and legalrisks that come into play and the fact that, while gen-erally of short duration, the value of transactions in-volved is almost always very large. Moreover, becauseof the highly interdependent movement of cash andsecurities, sometimes including foreign-exchangetransactions, a problem in one part of the clearingand settlement process can have a serious adverseeffect on other parts of the financial system.

In considering the risk proposals in this report, itis important to recognize that providers of clearingand settlement services, users of those services, andthe regulatory community have pursued significantinitiatives to strengthen safety and stability over thelast decade. These efforts have already produced sub-stantial gains in the major markets and the recom-mendations should be viewed as an effort to raise thebar still higher in view of the critical nature of theactivities being undertaken.

Our research indicates widespread belief that therisks involved in clearing and settlement, includingthe risk and associated cost of a systemic disruption,are unacceptably high. And the substantial concernabout risk revealed by our survey did not factor inthe horror of the September 11 terrorist attack andits impact on Wall Street. From long experience, bothmarket practitioners and public officials know thatthings can go very wrong in markets very quickly, anda scenario in which a major shock could lead to criti-cal failure is not difficult to imagine.

There is also every reason to believe that futuredevelopments in international markets will be evenmore challenging. Risk will rise with the increase ofcross-border trading because of the many connec-tions involved, each introducing some level of un-certainty and greatly complicating risk assessment incrisis situations. The contagion risk phenomenon islikely to increase further as the global system becomesmore concentrated, with fewer and larger global firmsand settlement entities.

A more efficient system

with lower costs would

encourage growth of

cross-border transactions

and related economic

activity, with potentially

substantial public benefit.

17


1980 1990 1995 1997 1998 1999 2000 2001 0

5,000

10,000

15,000

20,000

25,000

U.S. gross activity in foreign securities (purchase plus sales)

Foreign gross activities in U.S. securities (purchase plus sales)

WHY FOCUS ON

CROSS-BORDER

CLEARING AND

SETTLEMENT?

The survey results underscoredthe sentiment among members ofthe project Steering Committeethat many of the problems so farunaddressed are concentrated inthe cross-border arena. Cross-border transactions are a particu-lar challenge because of the com-plexity of moving from system tosystem and across legal jurisdic-tions. The legacy of national sys-tems and the reality of nationalborders means that this range ofinteractions tends to be duplicatedfor each country or market. Settling the cash leg of thetransaction brings payment systems and foreign-ex-change markets into play, multiplying the range of in-teractions further. Local agents or custodians are em-ployed to deal with the specific financial, operational,technical, and legal characteristics of the various sys-tems involved. Thus, the clearing and settlement ofcross-border trades can be accomplished only througha technically complex process involving links throughmany and varied institutions and almost certainly fea-turing different business practices, regulatory ap-proaches, and legal concepts, all of which introduceboth cost and risk into the system.

These issues have not been addressed systematically,and there is little authoritative guidance on them.Clearly, no single authority, public or private, can dic-tate the terms of cross-border transactions or the man-ner in which they will be cleared and settled. Nor doesany global authority, even of a cooperative nature, ex-ist to address them comprehensively. In these circum-stances, elaboration of technical standards and bestpractices appears to be the best, and possibly the only,way to make progress in the cross-border arena.

Alongside questions of cost, risk, and oversight isthe issue of scale: cross-border trading has grown

SOURCE: Securities Industry Association, “Key Trends in the Securities Industry,2001” (www.sia.com/publications/html/trends_during_1990s.html).

4. International Monetary Fund, World Economic Outlook, 2001, Washington.

dramatically. As an example, figure 1-1 indicates thatin 20 years U.S. gross activity (both purchases andsales) in foreign securities grew nearly a hundred-fold,from just $53 billion in 1980 to nearly $5.1 trillion in2001. Foreign gross activity in U.S. securities increasedmore than a hundred-fold, from $198 billion in 1980to $20 trillion in 2001.

Data from the International Monetary Fund alsoindicate a significant increase during the 1990s inholdings of foreign equities as a share of householdfinancial assets in other industrial countries.4 Theshare of total household financial assets representedby foreign portfolio equity holdings ranged from un-der 2 percent in Japan to nearly 12 percent in theUnited Kingdom at the end of the period, reflectingan increase of more than 40 percent in Japan, 60 per-cent in France (to 3 percent), and more than 90 per-cent in Germany (to 7 percent). In the United States,nearly 5 percent of total household financial assetswere made up of foreign equities, a 78 percent in-crease over the period.

This trend is expected to continue, particularly inthe Eurozone where securities are now denominatedin a single currency, but also in other markets whereinvestors are seeking global diversification for their

FIGURE 1-1. U.S. ACTIVITY IN FOREIGN SECURITIES VERSUS

FOREIGN ACTIVITY IN U.S. SECURITIES,1980-2001

$U

.S.

BIL

LIO

NS

18


portfolios and issuers are seeking access to wider andlarger pools of capital.

HOW CAN THESE CHALLENGES BE ADDRESSED?

In light of this analysis, the Steering Committee settwin goals for reforming the global system: to pursue

the maximum attainable level ofefficiency in clearance and settle-ment arrangements, consistentwith still higher levels of sys-temic safety and stability. Fromthese goals flow recommenda-tions for a system quite differ-ent from the status quo. Theamount of change needed toachieve consistently safe and ef-ficient performance on a globalbasis is substantial: the problemis extremely complicated, andthere are no simple fixes. Be-cause change in one system ormarket segment will not yield the

promised benefits unless all systems and segmentschange as well, the proposed changes must be pur-sued comprehensively.

The result would be a strengthened and widelyaccessible global network with lower unit-costs oftrading and post-trade processing, greater liquidity,and reduced risk to individual institutions and to theoverall system. Our proposals for reform includetwenty recommendations in three areas of reform.

� Building a strengthened, interoperable global

network by strengthening and streamlining thebasic clearing and settlement model, makingclearance and settlement systems fullyinteroperable, and permitting any qualified useraccess to systems and services on fair andtransparent terms (for more on interoperability,see box 1-1). The justification and detail forthese recommendations are set out in chapter 3.

� Mitigating risk by ensuring that clearing andsettlement systems and their major users havethe financial strength, risk managementexpertise, operational reliability, and supportive

legal and regulatory frameworks to confront therisk management challenges that arise. Giventhe potential for shocks, heavy emphasis is laidon contingency planning for business continuityand disaster recovery. These recommendationsare discussed in chapter 4.

� Improving governance by strengthening privateboards in pursuit of the agenda proposed inthis study and by providing consistent regula-tion and oversight by public authorities. Theserecommendations are discussed in chapter 5.

Although specific governance recommendations arefew in number, it should be recognized that the prin-cipal challenges in this report are aimed at the boardsand management of service providers and their us-ers in certain cases, and at the public authorities thatoversee them. Creating the conditions for intero-perability of systems and ensuring access to systemsand services for all qualified users—both missingfrom existing clearing and settlement arrangements—are fundamental to competitiveness and reform andnew in this report.

In framing the recommendations in each of theseareas, the Steering Committee has borne in mind theaspirations expressed by industry respondents to a sur-vey undertaken by PricewaterhouseCoopers for thisstudy. They called for a report that would offer a clearvision for the future of global clearing and settlementarrangements based on best market practice. Where asound standard already exists in a critical area, theyasked that the report endorse it; but where additionalguidance is provided, they asked that it be articulatedwith sufficient specificity to stipulate best practice with-out ambiguity. All proposals should be practical, butthose that are less than optimal should specify the rea-sons why, while areas in which longer-term changes inlaw or regulation are also required should specify theneeded changes. Finally, to the extent possible, recom-mendations should include guidance on how theyshould be implemented and subsequently enforced.True to this mandate, the recommendations in this re-port are carefully considered and offer a comprehen-sive and demanding agenda for change.

The Steering Committee

set twin goals for

reforming the global

system: to pursue the

maximum attainable

level of efficiency,

consistent with still

higher levels of systemic

safety and stability.

19


The report addresses the challenge first by describ-ing the current state of the system in chapter 2.Chapters 3, 4, and 5 then examine how to build an effi-cient, interoperable global network for clearing and settle-ment; how to strengthen the safety and stability of thatframework; and how to improve governance as the driverfor the changes proposed. The recommendations in

each area are distributed throughout the chapters.Given the complexity of implementing the full rangeof recommendations, the next steps for bringing themto fruition are discussed in chapter 6. Further detailon selected recommendations is provided in appen-dix 1, while the extensive work program associatedwith the study is described in the Appendix 2.

2. THE CURRENT STATE OF AFFAIRS

This chapter benefits from two recent reports on clearing and settlement: M. Guadamilla and R. H. Keppler, “Securities Clearanceand Settlement Systems, A Guide to Best Practices,” World Bank, Washington, 2001; and The Giovannini Group, “Cross-borderClearing and Settlement, Arrangements in the European Union,” European Commission, Brussels, 2001.

THE CLEARING AND SETTLEMENT PROCESS BEGINS

AFTER A TRADE IS EXECUTED; it ends with the finaland irrevocable transfer of value between thecounterparties to the transaction. Clearing, the first halfof the process, encompasses all procedures necessaryto determine the obligations of a direct market par-ticipant, such as a broker-dealer, to deliver securities orfunds once a trade is executed. This part of the pro-cess includes recording the key information related toa trade so that the counterparties can agree on its terms,matching and confirming the trade details and the pro-cedures for completing the transaction, and calculat-ing settlement obligations. The settlement part of theprocess aims to ensure that cash is delivered if andonly if securities are delivered and to do so with fi-nality: that is, when the transfer or pledge is irrevo-cable and unconditional. This overall objective is usu-ally referred to as delivery versus payment, or DvP.

The objective is to complete the overall clearingand settlement process with speed and certainty soas to minimize the credit exposures faced by thecounterparties and service providers while trades arestill unsettled. Speed and certainty also help maximizethe efficiency benefits to be gained from processinglarge volumes at high speeds, while minimizing thenumber of expensive failed trades.

A VARIETY OF SERVICE PROVIDERS

To understand the recommendations for changingclearing and settlement arrangements, it is useful first

to understand the component parts of the system.The clearance function can be performed by a clear-inghouse—usually a central counterparty (CCP), acentral securities depository (CSD), or an interna-tional central securities depository (ICSD). CCPs canprovide not only the clearing function, but they go astep further by legally interposing themselves ascounterparty to both buyers and sellers. This processis called novation; buyer andseller interact with the CCP andremain anonymous to one an-other. CCPs may also providenetting services that reduce riskexposures, thereby also reducinggross margin requirements andliquidity needs of qualifying in-stitutions. A CSD or an ICSD canperform both clearance and settle-ment functions because it not onlycan facilitate the coordination andexchange of trade information be-tween counterparties but also can hold securities andprocess change of ownership by book entry.

In the settlement phase, the movement of securi-ties (such as ownership transfer and bookkeeping) isdone at the CSD or ICSD, while the movement offunds is usually accomplished through the bankingor payments systems. A number of major securitiessettlement systems have “embedded” payment orfunds-transfer systems that accomplish settlement,

The aim is to complete

the overall C&S process

with speed and certainty

so as to minimize credit

exposure for the relevant

parties while trades are

still unsettled.

21

22


whether in central bank or commercial bankmoney. A CSD or ICSD may hold securitiesowned by a party other than a member, thusrequiring these nonmembers to interact withthe CSD through an intermediary such as a cus-todian or a global custodian.

Custodians hold securities on behalf of theirowners and provide asset servicing. Asset ser-

vices may range frommonitoring dividendreceipts and interest pay-ments, to filing informa-tion and claims with therelevant taxation authori-ties, to managing corpo-rate actions such as votingand conversion rights rel-evant to owners of equi-ties, where the provisionsof company law in thecountry concerned mayinclude requirements fortrade reporting, disclosure

of significant holdings, or foreign-ownershiprestrictions. Because custodians can deal withthe specific financial, operational, technical, andlegal characteristics of local systems, foreign in-vestors normally employ local custodian banksas agents in the clearance and settlement pro-cess. Although these matters fall outside thetime frame of clearing and settlement, they canhave important implications for effective trans-fer and exercise of ownership, and lack of stan-dardization and automation of these servicesis a serious efficiency concern.

An emerging trend arising from cross-bor-der trading is development of global custodi-ans. Global custodians are usually members ofmany national CSDs or have access to mem-bership through local subcustodian membersof the relevant CSD. Because custodians are avital intermediary in the provision of clearingand settlement services to end users, they mustbe part of any discussion of functional stan-dards of performance.

BOX 2-1. SYSTEM COMPONENTS

Central counterparty (CCP) — An entity that is thebuyer to every seller and seller to every buyer of aspecified set of contracts, such as those executedon a particular exchange or trading system. CCPslegally interpose themselves as principal to eachside of the transaction; some also offer a nettingfacility, whereby positions, obligations, or levels ofexposure of trade parties are reduced by setting aparticipant’s debits and credits off against eachother, leaving a smaller net obligation.

Central securities depository (CSD) — A facility (oran institution) for holding securities, which en-ables securities transactions to be processed bybook entry. Physical securities may be immobi-lized by the depository, or securities may be de-materialized (so that they exist only as electronicrecords). In addition to safekeeping, a centralsecurities depository may incorporate compari-son, clearing, and settlement functions (withoutacting as a CCP) and provide services related tocorporate actions.

International central securities depository (ICSD) —A central securities depository that clears andsettles international securities or cross-bordertransactions in domestic securities, usuallythrough local agents or direct links to local CSDs.The distinction between ICSDs and local CSDsis blurring as ICSDs merge with local CSDs (forexample, Euroclear and Sicovam; Cedel andDKV into Clearstream) and local CSDs offercross-border settlement.

Custodian — An entity, often a bank, that providessafekeeping and administers securities for itscustomers and that may provide other services,including clearance and settlement, cash man-agement, foreign exchange, securities lending,corporate actions, and tax relief arrangements.

Global custodian — A custodian that provides itscustomers with custody services for securitiestraded and settled not only in the country inwhich the custodian is located but also in nu-merous other countries throughout the world.

Speed and certainty help

maximize the efficiency

benefits to be gained

from processing large

volumes at high speeds,

while minimizing

the number of

expensive failed trades.

Based on CPSS-IOSCO definitions.

23

The Current State of Affairs

The final category of players is the members andusers of the CCPs and CSDs (a category that gener-ally includes custodians) who influence strategicdecisionmaking within these entities, whose own ef-ficiency as users affects overall efficiency, and whoseaccess creates risk exposures in both directions. Thelevel of risk is a function both of the size of theseintermediaries and the extent of their access to theentity on behalf of themselves, their customers, andother indirect participants.

THE CHALLENGE OF

CROSS-BORDER TRADING

Not surprisingly, the complexity of the clearing andsettlement process is directly related to the numberof actors involved. Of necessity, therefore, the levelof complexity rises substantially as the process ex-tends across borders. Although not every country hasa CCP, the typical pattern is a single CCP and a singleCSD in each market so any cross-border trade requiresinteraction with a duplicate set of institutions andactors for each market or country the trade affects.

As securities trading strategies expand on a globalbasis, the complexities of cross-border clearance andsettlement will be further magnified in proportion tothe number of (I)CSDs, global custodians, and soforth introduced into the process. More foreign-ex-change settlement risk, legal risk, and custody riskswill be introduced into the process; operational riskwill rise with mismatches in technology, communica-tion methods, and business practices; and there willbe more opportunities for exposure to credit risk fromparticipants whose financial standing will be difficultto verify.

Clearing and settlement service providers havehad to adapt continuously to the changing demandsof the marketplace—growing volumes, new instru-ments, electronic trading, and improved backup andsecurity arrangements. In all these areas, boards andmanagement of service providers have been veryresponsive to the needs of users. Yet the responseto rapidly expanding cross-border activity has so farbeen limited. With the exception of Euroclear andClearstream in Europe (which were established to

serve and until recently dealt almost exclusively indebt instruments in the Eurobond market), mostclearing and settlement entities were established todeal principally with domestic business, subject tonational regulatory and legal arrangements, and thefocus of their business models and governance re-mains domestic. Even in the European Union, wherea single economic market is an overriding objectiveof public policy, the pan-EU investor must contendwith highly fragmented infrastructure for equities,including nine CSDs and two ICSDs. A number offactors underlie this inertia regarding the cross-bor-der challenges:

� There has been little sensitivity to cost in

pursuing cross-border business. At least untilrecently, the appetite for portfolio diversifica-tion through growing cross-border business hasbeen such that the high cost of clearing,settlement, and custody services has beenabsorbed relatively uncritically. Moreover,relatively little attention has been paid toassociated internal costs.

� International agreement on key operational

and technical standards and consistency of

regulatory and legal approaches required for

building cross-border infrastructure is difficult.

Pursuing solutions to these challenges is costlyand complex and unlikely to be pursuedwithout reasonable assurance of success.

� Infrastructure providers have faced limited

competitive pressure and have few incentives to

support change in the cross-border arena.

Limited competition, relatively high barriers toentry, and some explicit market protectionmeasures, which may be represented as in thenational public interest, have provided littleinducement to pursue costly investment incross-border infrastructure. Because standard-ization risks loss of franchise value whileconsolidation to achieve scale economies riskserosion of autonomy, the fiduciary responsibil-ity of board members to shareholders mayargue against improved cross-border service for

24


their customers. In the EU, the public listing ofexchanges such as in France (Euronext) andGermany (Deutsche Börse), both of whichhave substantial ownership interests in theclearing and settlement process, will sharpenattention to shareholder value.

� Cross-border clearing has worked well enough,

and there has been no crisis to motivate

reform. Despite rapid growth of cross-border

business, market infrastructure has experiencedno serious breakdown.

In the chapters that follow, a program for tacklingthe complex challenges described above is set out.Pursuing it will require that private boards and man-agement, in the first instance, overcome inertia andcarry the program forward.

25

The Current State of Affairs

3. BUILDING AN EFFICIENT,INTEROPERABLE NETWORK

EFFICIENT CLEARING AND SETTLEMENT SYSTEMS

ARE NEEDED, on the one hand, to reduce risks byachieving finality as quickly as possible and on theother hand, to minimize the costs of using and oper-ating systems. In both cases the beneficiaries are thesame: service providers, intermediaries, issuers, inves-tors, and ultimately, the broader economy.

The clearing and settlement infrastructure outlinedin chapter 2 has been shaped by three main factors:the needs and demands of users (which have at timeschanged dramatically and quickly, following stressesor shocks to the financial system); the technology andcommunications capabilities available; and the inno-vation of service providers and intermediaries in uti-lizing those technologies to meet users’ needs.

Perhaps the most persistent factor has been the con-stant evolution of technological capabilities. In the past,most securities markets operated by physically transfer-ring paper securities from one owner to another over arelatively prolonged settlement cycle. In some markets,the paper transfer had to be supplemented by an entryregistering the transfer before the new owner could ex-ercise the full rights of ownership. In other markets, asystem of bearer securities meant that all the ownershiprights were acquired with the physical transfer of thesecurity certificate. As market volumes increased, thelimitations of paper-based and manual processing be-came increasingly clear. User pressure to increase effi-ciency and reduce risk of securities processing has ledthe industry to adopt various technological tools as theyhave become available to create new and more effectiveservices and means of delivery.

The Group of Thirty, in its 1989 report, encour-aged movement toward an automated, paperless en-

vironment, with settlement on a delivery versus pay-ment basis, so that settlement cycles could be short-ened. The result has been DvP settlement effectedon a T+3 basis (within three days after the trade), orshorter in some cases, by electronic book entrythrough CSDs; this has becomethe standard way in which secu-rities transactions are settled inall developed securities markets.This development has largelyeliminated paper stock certifi-cates themselves from the pro-cess (although not many otherpaper-based transaction ele-ments and in many markets re-tail investors are still able to holdpaper stock certificates); it alsohas unquestionably had a dra-matic impact on the efficiency and safety with whichsecurities markets operate. Indeed, given the huge in-creases in the volume of securities traded, anyunautomated alternative to this system of clearing andsettlement would be impractical.

Although technological and communicationsprogress has been made, the increasing demand forcross-border trading has raised new challenges to ef-ficiency. Clearing and settlement infrastructure hasevolved, quite understandably, to meet the needs ofusers focused mainly on domestic markets. That fo-cus cannot attain the full measure of efficiency andeffectiveness for international securities transactionsthat could be achieved if domestic systems in differ-ent countries were effectively linked in a well-func-tioning global network.

Many groups would

benefit from building an

efficient C&S system:

service providers,

intermediaries, issuers,

investors, and ultimately,

the broader economy.

25

26


STRENGTHENING THE GLOBAL NETWORK

An essential element in building an efficient globalinfrastructure is to encourage the emergence of stron-ger providers of clearing and settlement services, in-cluding both CCPs and matching utilities where theydo not now exist.1 These stronger service providerscould take a number of forms: providing functional-ity exclusively for clearing, typically in the form of a

central counterparty; providingfunctionality exclusively forsettlement, with or without asupporting custodial capability;or providing functionality thatcombines clearing and settle-ment. There is no inherent rea-son to favor one structure overanother or to specify the lines ofbusiness in which any entity mayengage as long as risk disciplinesare calibrated to the risks taken

and users have fair access to select the mix of prod-ucts they want at a fair price. Thus, the report andrecommendations focus on strengthened, standard-ized clearing and settlement functions, and the Steer-ing Committee does not advocate any particular or-ganizational model for CCPs, CSDs, or any other pro-vider of centralized services.

The underlying principle in this report is that mar-ket forces should be relied upon to produce the opti-mal organizational solution. This is possible, ofcourse, only if market forces are allowed to operate.The recommendations to improve governance inchapter 5 directly address restrictions in national lawor regulation that can distort competition, act as bar-riers to entry, or encourage anticompetitive practices.Users should not be excluded from or tied into ser-vices through law, regulation, market practices, orother means, other than through objective and con-sistently applied processes solely designed to mitigaterisk or enhance systemic safety.

The analysis that underlies the recommendationscontained in this report is founded on a functional

assessment of the current state of clearing and settle-ment arrangements. Therefore, while the recommen-dations will be implemented through the actions ofspecific organizations (private firms and public insti-tutions, either individually or collectively), the recom-mendations that apply to a particular organizationshould be determined by what it does and the associ-ated risks rather than by its legal, regulatory, or otherstatus. As a general principle, if two organizations pro-vide comparable services—such as the similar ser-vices offered by an (I)CSD and a global custodian—then a recommendation made in connection withthose services should generally apply to both.

The recommendations use collective terms to addresscertain groups of organizations that are invited to takeprimary responsibility for implementation. It is imprac-tical to define precisely and comprehensively each spe-cific organization included within each particular term,as the activities undertaken by individual organizationsand the market structures vary between jurisdictions, butbox 3-1 offers some terms as guidance.

THE CASE FOR INTEROPERABILITY

Promoting competition and innovation is not simplya matter of removing specific barriers, but also ofcreating compatible systems that permit seamlessoperations on a global basis. Despite significantprogress in automating the clearing and settlementprocess over the past 20 years, it remains operation-ally and organizationally complex. Arrangements varysignificantly from market to market, and cross-border processing is particularly convoluted. In somecases, payment involves a different currency from thatin which the underlying security is denominated, afactor that introduces a foreign-exchange dimensioninto the process.

Moreover, securities are subject to a variety of cor-porate actions—including payment of dividends or cou-pons, restructurings, and voting and conversion rights—governed by the provisions of company law in the coun-try concerned. These often require the owner to com-ply with particular rules that relate to trade reporting.

The underlying principle

in this report is that

market forces should

be relied upon to

produce the optimal

organizational solution.

1. Matching utilities are automated systems through which financial intermediaries and agents for institutional investors matchand thereby confirm trade and settlement details.

27

Building an Efficient, Interoperable Network

Such matters can complicate the transfer of ownershiprights to the instruments and hence their clearing andsettlement. Further, tax treatment for different classesof owners of securities may differ from country to coun-try, requiring the filing of information and claims withthe relevant taxation authorities. Likewise, foreign-own-ership restrictions may require special filings or limit cer-tain actions involving an instrument. As a result of thiscomplexity, the degree of overhead and cost associatedwith settling a securities trade is still significantly higherthan, for example, the cost of processing a cash pay-ment or a foreign-exchange transaction.

Furthermore, because of the close link betweenclearing and settlement and the trading of securities,particularly for equities, CSDs and CCPs have typi-cally been established as part of, or closely aligned to,national stock exchanges. Thus, they have been de-signed to comply with the laws, regulations, and mar-ket practices governing securities transactions in theparticular jurisdictions with which they are aligned.As a result, clearing and settlement conventions andstructures differ materially from country to country.A transaction involving securities that settle in differ-ent countries or through more than one CSD or CCPtherefore involve an added layer of cost and com-plexity. By the same token, financial intermediariesthat seek to provide international securities clearingand settlement services to their customers either mustdevelop the capability to transact and settle in eachof the underlying markets and become members ofthe local CSDs and CCPs themselves, or they mustsubcontract the activity to an agent who has that ca-pability and is able to undertake the activity on theirbehalf. The use of local agents, together with the al-ready large number of global intermediaries, createsan elaborate web of relationships among organiza-tions, with no standards to define how they shouldconnect and interact.

The recommendations offered here to address in-efficient and costly market practices and technical andnetwork standards can be divided into two categories.These categories may be broadly defined as measuresnecessary to build a strengthened and interoperableglobal network, and measures to enhance services de-livered across the network.

As discussed in chapter 1, interoperability refers tothe ability of entities along the clearing and settlementprocessing chain to communicate and work with otherentities without special effort on the part of users.Interoperability involves more than technical compat-ibility of systems, although standardized communica-tion, messaging, data, and timing are clearly essential.The ability of systems to interoperate also requires likeor compatible processes, business practices, controls,technologies, products, fee structures, and the like.

With all these elements in place, interoperabilityoffers the potential for processing of transactions with-out human intervention, for simpler and cheaper back-office operations, for greater competition between pro-viders and systems, and for integration and consolida-tion of service providers. The market will determinethe extent of change that occurs, although creating fullcompatibility between entities implies a level of coop-eration not often seen between competing entities.

Achieving interoperability is a critical issue in secu-rities processing because of themultiple paths along which clear-ing and settlement systems havedeveloped and the lack of com-mon standards to bridge their dif-ferences. The resulting “many tomany” relationships are costly, re-flecting maintenance of multipleinterfaces, duplicate system de-velopment, and increased training requirements. Thereare also indirect costs, for example, in connection withfunding (collateral and margin requirements and work-ing capital), with regulatory compliance, and with theinvestigation and resolution of errors. Interoperabilitywould reduce these costs because users would interactwith a number of systems as if they were interactingwith only one.

Creating the potential for interoperability requiresthe development and introduction of a wide-rangingset of standards, covering technical, market practice,risk control, system access, and other commercial andeconomic features. Establishing full interoperabilityrequires implementation and consistent use of thosestandards within and between connected entities, en-forced through economic, regulatory, or other means.

Interoperability is

a significant factor in

the proposed solution

to many issues.

28


Monitoring and governance of the processes fordeveloping and setting standards are clearly criti-cal and must ensure fair representation for all rel-evant stakeholders; this will help build consensusaround practical and workable standards. Thesestandards should be open and able to evolve, sothat they do not inhibit innovation or competition.They should be clear and unambiguous, so thatthey can be used in a consistent manner. And theyshould be both enforceable and enforced.

This report argues for implementation of fullinteroperability across all significant entities overa five-to-seven-year time horizon. Some of thestandards that collectively create the potential forinteroperability can be implemented in a shorterperiod. Standardization of individual elements ofthe process—for example, consistent messagestandards and communication protocols—willbring definable benefits, even if the overall ben-efits of full interoperability will eventually begreater than the sum of these parts. On this ba-sis, development and use of each particular stan-dard should be pursued as quickly as prudentlypossible and should not be delayed by the timeframe of any other standard unless critical de-pendencies exist.

Interoperability is central to meeting the broadareas of concern identified by the PricewaterhouseCoopers survey described in chapter 1. As well asbeing one of the five key areas identified, interoper-ability is a significant factor in the proposed solu-tion to many issues. The costs to users of switch-ing between interoperable service providers wouldbe lower, helping to remove a barrier to access andcompetition. Interoperability would likely facilitatethe standardization and automation of additionalprocesses; asset servicing is an important area inthis regard. The Steering Committee has foundbroad consensus among market participants forstreamlining their internal processes, in particular,by eliminating manual processing and avoiding du-plicative systems and procedures necessary to in-teract with multiple and incompatible clearing andsettlement service providers.

BOX 3-1. PARTICIPANTS IN THE

CLEARING AND SETTLEMENT PROCESS

Several categories of participants figure promi-nently in the recommendations and are impor-tant to their implementation:

� Financial intermediaries are those organiza-tions that facilitate a financial transaction be-tween end-user issuers and investors. Theycan broadly be categorized between broker-dealers (or stockbrokers) and custodian-agent banks. Within these broad categoriesthere is clearly a wide range, from small do-mestically focused operations to very largeglobal organizations.

� Infrastructure providers are the operators ofsecurities clearing and settlement systems ornetworks. They include (I)CSDs, CCPs, and—where relevant to the particular recommen-dation—payment, communications network,or other systems that are integral to the clear-ing and settlement process.

� Providers of clearing and settlement services(“service providers”) include infrastructureproviders as well as those financial interme-diaries that provide clearing and/or settle-ment services to their particular clients, al-though not to the industry collectively.

� The term market participants is used broadlyand collectively and embraces infrastructureproviders and financial intermediaries, to-gether with end-user issuers, investors, andother organizations that undertake securities-transaction–related processes, such as reg-istrars and transfer agents.

� Systemically important institutions are thosemarket participants whose operational or fi-nancial failure has the potential to cause otherorganizations to fail and so to spread conta-gion through the entire financial system. Inany particular market, infrastructure provid-ers and particularly large or strategically im-portant financial intermediaries are likely tobe classed as systemically important.

29


IMPROVING THE EFFECTIVENESS

OF ALL SYSTEMS

Efficient clearing and settlement systems require usersto be able to communicate and interact seamlessly. Indomestic markets, eliminating paper (for example,through the creation of CSDs) and automating com-munication (for example, through dedicated networks)have been a continuing focus. Major markets have elimi-nated use of paper securities certificates themselves,either through immobilization of securities certificatesin depositories so that transfers can take place in elec-tronic form, or by eliminating certificates all togetherthrough dematerialization. Many processes even inthese markets still generate paper records, such as thoserelated to voice and fax communications. The Steer-ing Committee recommends that these be eliminatedand sees no reasonable grounds for delay.

RECOMMENDATION 1. ELIMINATE PAPER AND AUTOMATECOMMUNICATION, DATA CAPTURE, AND ENRICHMENT.Infrastructure providers and relevant public au-thorities should work with issuers and securitiesindustry participants to eliminate the issuance, use,transfer, and retention of paper securities certifi-cates without delay. Such action should be sub-ject to proper investor protection over assets heldin electronic form. There is no greater assuranceof ownership or control from maintaining paper,and it should be possible to overcome the con-trary perceptions of some retail investors througheducation and by ensuring a sound legal basis forall paperless securities in each jurisdiction. De-materialization of securities certificates—convert-ing all paper ownership records into electronic for-mat—is the preferred solution. However, in prac-tice immobilization—where ownership is re-corded through electronic book entry and the un-derlying paper certificate is kept in a central secu-rity depository—realizes many of the benefits ofdematerialization. Therefore, if immobilizationcan be achieved more quickly and efficiently thandematerialization, it is an acceptable step on theway to full dematerialization.

All market participants should seek to automateelements of the process that introduce other

forms of paper, such as confirmations and tradeallocations, into the securities processing trans-action flow as available technology safely allows,from issuance through to asset servicing. Meansof electronic capture, storage, and transmissionof documents should be used to their fullest ex-tent to avoid the need for physical documents toserve as evidence of transactional activities andasset ownership.

All market participants should use electronic com-munication to transmit information for all instru-ments and transactions types. Market participantsshould identify opportunities to streamline pro-cesses by avoiding duplicative recording of dataand manual addition of supplementary informa-tion. This recommendation applies to each stageof the value chain, from issuance through to trad-ing, clearing, settlement, and asset servicing, in-cluding confirmations, allocations, and rights anddecisions related to asset ownership. Electroniccommunication and avoidance of repetitive ormanual recording and enrichment of data amongall participants are essential building blocks inachieving a zero-intervention process. Technol-ogy to address these two aspects of processingshould be fully utilized.

CREATING CONNECTIVITY

AND INTEROPERABILITY

Creating an effective network at a global level requiresconnectivity and interoperability between differentmarkets and systems. Achieving interoperability re-quires standardization of the technical specificationsand market practices that embody the mechanics ofsystems and networks. These recommendations thusfocus on establishing a series of standards in the mostcritical areas of the clearing and settlement network.

RECOMMENDATION 2. HARMONIZE MESSAGING STANDARDS ANDCOMMUNICATION PROTOCOLS.

All market participants should adopt ISO 15022(the data field dictionary and message catalogue forsecurities information flows) as the global standardfor straight-through securities messaging across the

30


entire securities life cycle.2 Over time, XML (ex-tensible mark-up language) should become the lan-guage to describe standardized messages. 3 Marketparticipants should follow the road map set out bythe ISO working group established to advance ISO15022 to a standardized use of XML. This stan-dard should develop to meet the needs of all par-ties to the investment product life cycle and, inparticular, the asset servicing requirements of theindustry. All stakeholders in the securities industryshould be appropriately represented in the stan-dard development process.

All market participants should support and usecommunication networks that adopt open, stan-dardized, IP-based protocols for securities trans-actions. 4 These standard internet protocols mustembrace key attributes critical to the sending ofmessages related to securities transactions. Secu-rity, in particular, should be set at a level that sat-isfies business and regulatory requirements andthat meets the needs of all stakeholders in theindustry. Each network provider should clearlydefine and publish its plans to migrate from pro-prietary communication protocols to the open IP-based protocols.

RECOMMENDATION 3. DEVELOP AND IMPLEMENT REFERENCEDATA STANDARDS.

Market participants should collectively identify,develop, and adopt universal securities, counterparty,and relevant generic reference data standards thatfully meet the needs of all relevant users. Suchstandards should be adopted in connection with:� Asset identification and associated descriptive

data, based upon ISO 6166 (concerning Inter-national Securities Identification Number, ISIN).

� Counterparty identification, exact accountidentification, and standard settlement in-structions, based upon ISO 9362 (concern-ing Bank Identifier Code, BIC).

� Relevant generic data categories, such as fee,tax, and commission rates and other, typicallycountry-specific, data (including currencies,local holidays, and time zones).

Standards should be comprehensive, covering theneeds of all users in the securities value chain.They should also be applicable globally. Particu-lar attention is required to address the concernsof jurisdictions where use of such standards isrestricted for reasons of data confidentiality, se-crecy, or other public policy purposes.

Issuers, exchanges, and other originators and dis-tributors of data should make all relevant infor-mation available to the market in compliance withthese standards for a fair price and on a timelybasis. The development of standards is not in it-self sufficient to avoid the very substantial ineffi-ciencies and costs incurred through inaccurate,incomplete, or incompatible data. In addition, itis critical to enhance the substance and contentof the data.

Extensive work is needed in connection with allthree categories of reference data, and the timeframe for ultimate adoption and use of standardswill vary. As a first step the industry should set upworking groups (or where initiatives are alreadyunder way, build upon or combine existing work-ing groups) representative of all parties to theinvestment product life cycle, to identify the spe-cific areas where standardization is needed. Theseindustry groups should work with the relevantstandard-setting bodies and data suppliers to es-tablish a plan designed to achieve identified ob-jectives in connection with these standards.

2. See footnote 5, page 8.3. See footnote 6, page 8.4. See footnote 7, page 8.

31


RECOMMENDATION 4. SYNCHRONIZE TIMING BETWEEN DIFFERENTCLEARING AND SETTLEMENT SYSTEMS AND ASSOCIATEDPAYMENT AND FOREIGN-EXCHANGE SYSTEMS.

Providers of clearing and settlement services andlinked or otherwise associated payment andforeign-exchange systems should collectively en-sure that their design, procedures, operationaltimetables, and funding and cutoff times are suchthat the operation of one system does not mate-rially reduce the efficiency or increase the risk ofsettlement in another. These organizations shouldcollaborate to identify the specific areas wherestandardization is needed and to develop detailedplans to achieve it. Standardization should beimplemented initially on a regional basis (broadlybased on the Americas, Europe, and Asia-Pacific).Cross–time zone protocols should be establishedsubsequently. Systems should allow transfers toand from securities settlement systems to be madein a timely manner. Periods of peak cash demandin separate systems should be carefully managedso that they do not clash with one another.

Market participants should work together to de-velop a comprehensive action plan to increase theefficiency and safety of cross-border securitiestransactions where the foreign-exchange settle-ment cycle is not synchronized with the securi-ties settlement cycle. As yet, no fully developedsolutions systematically address the costs and risksarising from the mismatch between securities andforeign-exchange settlement cycles in these cir-cumstances. This issue will increase in importanceas securities settlement cycles are shortened.

DELIVERING ENHANCED

SERVICES OVER THE NETWORK

The recommendations outlined so far aim to helpestablish an effective international clearing and settle-ment network that allows infrastructure providers andintermediaries to better provide services that usersrequire. Improvements have already been made at thedomestic level to many stages of the securities pro-cessing value chain, but considerable scope remainsfor further automating and streamlining the system

in certain areas, particularly (but not exclusively) inconnection with cross-border transactions.

One area for improvement is institutional tradematching. Matching is the process whereby the partiesto a trade agree on the details of the trade and therelated settlement instructions. Much of the cost as-sociated with clearing and settlement arises from thefailure of these details to match. Broker-to-brokertrades typically already use automated matching sys-tems, and automated matching is unlikely to be practi-cal for trades involving retail investors. Thus the op-portunity for improvement lies with trades involvinginstitutional investors. Greater use of matching utili-ties would help address this problem. With this facility,parties to a transaction could identify and correct prob-lems with transaction details at an early stage in thesettlement process, thereby reducing the number andcosts associated with unmatched and failed trades.

RECOMMENDATION 5. AUTOMATE ANDSTANDARDIZE INSTITUTIONALTRADE MATCHING.

Market participants shouldcollectively develop and usefully compatible and indus-try-accepted technical andmarket-practice standardsfor the automated confirma-tion and agreement of insti-tutional trade details on theday of the trade. The estab-lishment and use of thematching utilities currentlybeing developed and putinto operation is an important part of this pro-cess, although many of the potential efficiencygains that they offer will not be realized withoutinteroperability among separate systems. If thenumber of organizations providing these servicesgrows, the inefficiencies that fragmentation andlack of standardization can create will increase.

At the clearing level, the key issue that the industryhas to tackle is whether to establish CCPs. These haveundoubted benefits in terms of reducing both cost

Promoting competition

and innovation is not

simply a matter of

removing specific

barriers, but also of

creating compatible

systems that permit

seamless operations

on a global basis.

32


and risk, but they are also costly to establish and main-tain, and the cost-benefit equation will be differentin each market. The Steering Committee expects thatin most markets the benefits of using a CCP are likelyto outweigh the expense, but does not consider it wiseto prejudge the outcome of a full and thorough analy-sis in specific markets.

RECOMMENDATION 6. EXPAND THE USE OF CENTRALCOUNTERPARTIES.

Market participants and relevant public institu-tions should collaborate to assess the potentiallysubstantial risk reduction and efficiency improve-ments of using a central counterparty. These ben-efits are expected to outweigh their costs in mostmarkets. Where this is so, market participantsshould seek either to use the services of an exist-ing central counterparty or establish one of theirown, whichever has the better risk, cost, and ben-efit profile. If more than one organization un-dertakes this function in a particular market ormarkets, each should follow harmonized and rig-orous operational practices and standards, includ-ing those set out elsewhere in this report, so as tobe fully interoperable, and each should follow con-sistent risk management practices as set out inRecommendation 9.

Securities lending and borrowing is a device usedin many markets to expedite settlement where stockwould otherwise be unavailable to meet settlementobligations. It brings considerable efficiency benefits,yet is not permitted in some markets.

RECOMMENDATION 7. PERMIT SECURITIES LENDING ANDBORROWING TO EXPEDITE SETTLEMENT.

Relevant authorities should permit securities lend-ing and borrowing as a method for expediting thesettlement of securities transactions. Each mar-ket should provide tax, legal, regulatory, and ac-counting frameworks to allow the use of stocklending and borrowing to prevent settlement fail-ures. CSDs or other infrastructure providers, whilenot necessarily acting as principal to the transaction,

should seek to develop functionality to allow stocklending and borrowing to be conducted efficientlyby intermediaries and other users. This recom-mendation does not seek to eliminate restrictionsin individual jurisdictions that prohibit stock lend-ing and borrowing undertaken for reasons otherthan expediting settlement, such as transactionsthat facilitate short-selling.

Asset servicing is an often overlooked but criticalpart of the transaction value chain. Corporate actionsremain an area with significant diversity of practicesand widespread use of manual processes and paper,often as a result of legal, regulatory, and taxation re-quirements governing the ownership and of securi-ties and associated rights.

RECOMMENDATION 8. AUTOMATE AND STANDARDIZE ASSETSERVICING PROCESSES, INCLUDING CORPORATE ACTIONS,TAX RELIEF ARRANGEMENTS, AND RESTRICTIONS ONFOREIGN OWNERSHIP.

Issuers, providers of clearing and settlement ser-vices, and other relevant market participants shouldadvise investors of all details of corporate actionsthat they require in an automated, timely mannerand in compliance with accepted industry standardsso that each investor can make a timely decisionon the action to be taken with full knowledge ofthe facts. Each market place should protect therights of the beneficial owner of a security to allcorporate and income events from the point ofexecution of the purchase transaction in the rel-evant security. All corporate actions should be ableto be executed through book entry transfer and/or payment systems, where such systems operatefor the settlement of purchases and sales of secu-rities. All communications through the value chainbetween issuer and beneficial owner should, astechnology allows, be automated as set out in therelevant recommendation.

Market participants and public authorities shouldwork together to minimize the administrativecosts to each party involved in tax relief arrange-ments through standardization and automation

33


of procedures and communication of informa-tion and through the use and acceptance of elec-tronic data and documentation. This recommen-dation exclusively addresses the process of tax rec-lamation. It does not in any way seek to addressthe absolute levels of the taxes themselves.

Relevant public authorities, infrastructure provid-ers, and market participants should work to har-monize and make transparent the processes, docu-mentation, and communication of information

in connection with foreign-ownership restrictionsand reporting requirements. Full informationneeded to assess whether restrictions apply shouldbe available to allow investors and intermediariesto make timely and appropriate decisions. Forexample, investors should be able to determinein advance of trade execution whether the tradewill breach any limits. Reporting and disclosureresponsibilities should also be transparent andshould be able to be discharged through auto-mated electronic communication.

4. ENSURING SAFETY AND STABILITY

35

CLEARING AND SETTLEMENT SYSTEMS INVOLVE AN

INTERRELATED GROUP OF RISKS—credit, market,liquidity, operational, and legal—that are generally ofshort duration but almost always involve transactionvalues that are very large in size. Moreover, becauseof the highly interdependent movement of cash andsecurities (and other assets and instruments) associ-ated with settlement systems, any event that poses athreat to achieving final settlement in one system islikely to have swift and serious implications for othersystems. Contagion risk is likely to increase further asthe systems become more concentrated globally, withfewer and larger settlement entities. In short, clear-ing and settlement systems are akin to the nervoussystem of the global financial system. As such, theypresent the classic policy dilemma of how best tomanage situations that entail disturbances or shocksof relatively low probability but with the potential tocause serious, perhaps systemic, financial damage.

At one level, the role of clearing and settlementsystems is quite straightforward: to ensure that thebuyer of a security receives irrevocable delivery ofthat security from the seller at or near the precise pointin time when the seller of the security receives fromthe buyer final and irrevocable payment for the secu-rity. But that apparent simplicity is deceiving, for theprocess itself is enormously complex and subject tosizable, if often subtle, risks. Achieving finality—andachieving it in the shortest time possible—is partly a

matter of the financial, operational, and technical ar-chitecture of the particular settlement system.1 But itis also a matter of the complex legal and regulatorycharacteristics of both the system and the underlyinginstruments that are being exchanged. While finalityof such transactions is regularly achieved without theslightest hitch, this very regularity can give rise to afalse sense of security, even complacency, about thereliability of all elements of such systems to functioneven under serious stress.

Broadly speaking, there are two modes of securi-ties settlement. The first is the “gross settlement sys-tem,” in which payment for and delivery of securitiesoccurs transaction by transaction and almost simul-taneously. A number of central banks operate real-time gross settlement systems for settling nationalgovernment securities, with the exchange of cash andsecurities occurs virtually simultaneously on the booksof the central bank. The central bank provides a defacto guarantee to the receiving bank that funds com-ing from the paying bank will be final—even if thepaying bank is found to be insolvent minutes later.This, of course, is finality in purest form.

The second mode of securities settlement is the“net settlement” system. In this system, individualtransactions accumulate at the settlement entity forvarying periods of time (usually one business day, butsometimes for shorter intervals). At a specified time,the settlement entity nets the gross transactions

1. Finality is achieved when a transfer or pledge of securities is irrevocable and unconditional.

The treatment of risk issues in this report relies heavily on a risk paper drafted by Gerald Corrigan, Managing Director, GoldmanSachs & Co., and further analysis by a working group of technical experts that he chaired.

36


among its members, with each member becoming anet deliverer or net recipient of cash and/or securi-ties. The net cash settlement payments are madethrough preexisting payment facilities at banks orcentral banks. Although all net settlement systemshave these general characteristics, the specific nettingprocedures may vary. For example, some systems havemultiple net settlements during a single day in lieu oflarger end-of-day net settlements. In other systemssecurities are transferred trade by trade while pay-ments are netted, or both securities and cash are net-ted, with credit risk prior to finality addressed by vari-ous risk mitigation mechanisms.

Although the focus of this report is clearing andsettlement of securities, the financial and operationalintegrity of these systems cannot be viewed indepen-dently of the financial and operational integrity ofsettlement systems more broadly. That is, if a majordisturbance originates in foreign-exchange, commod-ity, over-the-counter derivative, or futures markets—especially if that disturbance is credit-related—thepresence of essentially the same large counterpartiesacross all such markets would likely mean that cashor securities destined for securities clearing systemsmight not get there, throwing into question the sta-tus of the securities systems settlement. In otherwords, even the very best of securities clearing andsettlement systems are not insulated from problemsoriginating elsewhere in the financial system.

This point takes on a special significance when oneconsiders the specific nature of the risks associatedwith clearing and settlement systems. At the dangerof great oversimplification, those risks can be groupedinto four main categories.

� Credit and market risk. The most dangerousrisk inherent in all clearing and settlementsystems is the risk of default by one or moresystem participants unable to complete settle-ment because of liquidity or solvency problems.Such a condition can arise for any number ofspecific reasons, and it is important to recognizethat even the threat of such default will causeother participants and counterparties to takedefensive actions that may have the unintended

effect of aggravating the very problem thatsuch actions are seeking to mitigate. Credit riskand market risk are grouped together herebecause one of the more likely and formidablecauses of default or the threat of default is themarket risks associated with large and rapiddeclines in financial asset prices, such asoccurred in 1987 and 1998.

� Liquidity and market-liquidity risks. Liquidityrisk involves several different but related issues.The first and most straightforward is the riskthat a key institution facing temporary liquidityproblems encounters difficulty in meeting cashor securities obligations to one or moresettlement systems. Alternatively, the settlementsystem itself could have operational problems(see below) that limit or prohibit it fromredelivering cash or liquid securities to systemparticipants. Problems along these lines relate tothe term “liquidity” in its traditional meaning.

A different and more troubling aspect ofliquidity is the concept of market liquidity ofassets. This involves the extent to which variousasset markets have sufficient trading liquidity sothat financial institutions can readily sell orliquidate positions either to limit losses or toraise cash to satisfy obligations. In the worst ofthe financial market disturbances of the past 20years, the de facto evaporation of marketliquidity greatly added to credit and market risk.In some instances, the workability of nettingsystems and closeout procedures that are socentral to clearing and settlement systems werealso called into question. Among other things,such episodes—as rare as they are—raisequestions about the financial and liquiditycushions associated with clearing and settle-ment systems.

� Operational risks. Simply stated, the operationalrisks inherent in clearing and settlement systemsare the danger that for whatever reason, one ormore such systems incur operational problemsthat limit or halt normal activities. The cause ofsuch problems can have many specific origins,ranging from protracted software problems to

37

Ensuring Safety and Stability

natural disasters to catastrophic events such asSeptember 11, 2001. Such problems are likely tobe most acute when they occur during businesshours and extend beyond the close of the normalbusiness day. Ironically, they are also most difficultwhen they affect only one or a few institutions in aparticular locale rather than, for example, a largenumber of institutions in a particular locale—asmight happen in a major natural disaster, such asan earthquake, where there is no question aboutthe cause of the disruption or how to resolve it. Inthe most severe cases, operational failures can giverise to liquidity, market liquidity, and credit andmarket risk.

� Legal risks. The potential legal risks (broadlydefined) inherent in clearing and settlementsystems are many in number, and some canhave serious implications. In essence, legal risksentail the threat that any one factor or a varietyof factors will prohibit or limit one or morecounterparties from discharging their contrac-tual responsibilities—as they understand suchresponsibilities—or from protecting themselvesfrom financial harm in the event that anothercounterparty is unable or unwilling to meet itscontractual responsibilities.

Legal risks can have very simple causes,such as shortcomings in documentation orfailure to confirm trade agreement on a timelybasis. They can also arise from very complexsources, such as uncertainties about legalinterpretations in particular jurisdictions or thepractical workability of closeout provisions intimes of major market stress.

Far more often than not, legal issues havebeen resolved with virtually no so-called“knock-on” effects—even though some ofthese events have proved quite costly toindividual institutions. Legal risks tend not tospread because they rarely carry the directthreat of default that could raise generalizedconcerns about sizable credit losses tocounterparties. In times of very serious marketstress, however, the possibility that legaluncertainties—about the ability to close out

defaulting counterparties, for example—couldadd considerable fuel to the fire of market andcredit risk shocks.

While the categories of risks inherent in clearingand settlement systems are fairly easy to describe inbroad terms, it is impossible to anticipate the precisenature of the future shocks that might move such con-cerns from the realm of risk tothe realm of reality. It is evenmore difficult to anticipate theexact manner in which an initialshock in one area—operationalrisk, for example—might workits way into other areas of con-cern, such as legal and then creditrisk, in the progression of a clas-sic chain reaction. One thing isquite clear, however. When anysuch shock reaches the pointwhere counterparties begin toquestion seriously whether theywill receive payment, delivery of securities, or prom-ised collateral, that is the point when behavior becomesdefensive and the seeds of major problems are sown.It is the potential for such problems to disrupt the glo-bal financial network that requires practitioners andpolicymakers alike to devote considerable resources torisk mitigation efforts in the area of clearing and settle-ment, even if such efforts are admittedly being directedat low-probability contingencies.

RISK MITIGATION IN CLEARING

AND SETTLEMENT SYSTEMS

Risk mitigation in clearing and settlement systems hasmany dimensions. Moreover, it takes place in a com-plex institutional framework that must be understoodin order to place both risk and risk mitigation inproper perspective. The complexity of some of theprocesses and linkages involved places a substantialburden on private boards and management to ensurethat risks are being effectively monitored, measured,and controlled, and that dedicated and contingentresources are sufficient to address losses arising inthe course of business. This burden falls both on pro-

The very regularity of

C&S transactions can

give rise to a false

sense of security, even

complacency, about

the reliability of such

systems to function even

under serious stress.

38


viders of securities clearing and settlement servicesand on their potential users. It applies equally toquestions of the financial strength and risk manage-ment of individual firms and to their ability to copewith the operational challenges of high-speed, high-volume transactions. Due diligence is required bothat the time that decisions are made about acceptingnew members or about joining a system and duringthe normal course of business, when risks must bemonitored and controlled in real time.

It is safe to assume that every financial institutionand service provider devotes substantial time and re-sources to these matters. The fact that this report in-cludes recommendations on financial integrity and aframework for evaluating current performance is notmeant to imply laxity on the part of boards and man-agement or public authorities. The challenge in thisarea is so great, however, and the cost of failure sohigh, that the aim of financial management at majorservice providers must be to ensure continued op-eration in the face of market shocks and to minimizethe potential for default. Thus notwithstanding sub-stantial efforts over a sustained period to strengthenfinancial stability, the purpose of recommendationsin this area is to push the bar a bit higher.

Before turning to specific recommendations, it isworth examining two features of the existing system,neither of which is addressed directly in the recom-mendations.

� Limited liability loss-sharing arrangement.

Among users of clearing and settlementsystems, the legal entity that is the member ofa clearing and settlement system may be alimited liability, lightly capitalized entity.Similarly, settlement systems may have limitedliability provisions in their loss-sharingagreements for members in the event of adefault by another member or members. Theselimited liability features are accepted methodsof risk mitigation. Both providers and users ofsuch facilities must recognize, however, that inrare cases of acute stress, the protectionsprovided by these arrangements may proveillusory; the financial and reputational damage

associated with rigid adherence to the legalletter of such protections could be of sizable,if not systemic, consequence.

In such circumstances, the best risk mitigantmight well be for some, or many, institutions tostep up to the losses, rather than seek theshelter of an imperfect mitigant. That said, thebest way to ensure that such a fateful contin-gency does not arise relates squarely to thequality and effectiveness of risk mitigationefforts more generally.

� Reliance on netting of exposures.

Many of the tools to monitor counterpartyexposures, whether within settlement systemsor more broadly, look at “net” exposures ratherthan at the gross owed-to and due-fromexposures. Securing gross transactions on a netbasis can entail several steps, most notablyaccounting for collateral and/or margin and anybilateral or multilateral netting agreements thatare legally binding.

While measures of net exposures are usefuland relevant for many purposes, they can bemisleading, particularly in times of stress whenthese underlying presumptions may not hold.Moreover, in times of stress, such measuresimplicitly assume that counterparties to adefaulting counterparty can successfully closeout positions with the defaulting counterpartyand do so in a manner that is consistent with thelevel of net exposure. Unfortunately, bothpractical and legal factors may stand in the wayof such an outcome. If that occurs, it is the grossmeasure of exposure, not the net, that will berelevant. Accordingly, where the enforceabilityof netting arrangements is in question, riskmanagement practices and tools must accountfor gross as well as net exposure both betweencounterparties and between counterparties andsettlement entities.

With these issues in mind, and against the back-ground of earlier official and private studies of thissubject, the Steering Committee gave careful consid-eration to the additional steps needed to reduce the

39


risks associated with clearing and settlement systems.These additional steps are seen as particularly impor-tant given the highly likely, perhaps virtually inevi-table, consolidation and concentration in the globaluniverse of clearing and settlement. On the basis ofthese deliberations, three broad sets of recommen-dations have been developed in the areas of enhancedfinancial integrity, enhanced operational integrity, andenhanced legal integrity.

ENHANCING FINANCIAL INTEGRITY

OF SERVICE PROVIDERS AND USERS

The operations of CCPs and CSDs sit at the heart ofthe clearing and settlement process. Because a CCPinterposes itself between the counterparties to eachtransaction, acting as the buyer to the original sellerand the seller to the original buyer, it is by definitionexposed to credit risk of market participants. Theo-retically, a CCP assumes no market risk because themarket values of the long and short unsettled trans-actions it holds must be identical at all times. If amarket participant fails to fulfill its settlement obli-gations, however, the CCP is obligated to completethe settlement of the other side of transactions. Inthat event a CCP is exposed to market risk because itneeds to go into the market to buy or sell securities atmarket prices for settlement purposes. (This risk isoften referred to as replacement cost risk.)

In many markets CSDs also have procedures inplace to help ensure the timely completion of settle-ment and maximize settlement of transactions. Oth-erwise, in extreme cases, the failure of a sizable num-ber of transactions to settle on time could escalate toa gridlock situation whereby a chain of transactionscould not be completed on the settlement date, re-sulting in systemic risk to markets. Banks supportingthe operation of CSDs extend intraday or overnightcredit to participants by allowing overdrafts in theiraccounts to facilitate timely settlement. Participantsthat fail to repay the credit extension create creditlosses and put liquidity pressure on those banks. Thesame applies in those cases where CSDs engage insecurities lending (intraday and overnight): if a par-ticipant fails to deliver the securities within the agreedperiod, the CSD or the bank providing the securities

lending facility has to replace the missing securitiesitself. In addition to credit and market risk, CCPs andCSDs face other types of risks, including operationalrisk and legal risk, in the course of their operations.Although this report addresses these risks specificallyin the recommendations on operational and legal in-tegrity, they also need to be considered when deter-mining the suitable level of financial resources.

CCPs and CSDs put in place risk mitigation mea-sures, which can be broadly categorized as:

� Measures aimed at controlling the probability

of suffering loss through default of a

counterparty. In essence, these measures areembodied in the due diligence process surround-ing the acceptance of new members and reviewof the continued suitability of existing members.

� Measures aimed at minimizing the scale of

loss if a counterparty should default. Thesesteps include marking to market exposures,imposing collateral requirements and variationmargins, setting concentration limits onexposures, and establishing proper internalcontrol and risk management procedures.

No matter how well established and rigorous riskmanagement and mitigation systems and processesare, unexpected losses are inevitable. For example,there could be extreme market moves that are notcaptured by the risk models; unexpected losses couldresult from operational failure, disasters, or other ex-ternal shocks; or losses could arise from legal contin-gencies. CCPs and CSDs must have financial re-sources to meet these losses. Although there are manysources of funding, ultimately financial resources willusually come from a combination of the past, present,and future owners, members, and users of the rel-evant CCP or CSD (the three groups are hereinafterdescribed simply as members).

Because membership in a CCP or CSD creates therisk of having to fund a default, financial intermedi-aries that are—or are contemplating becoming—members typically adopt procedures to mitigate therisk of loss through default of the CCP, CSD, or othermembers. Like the risk mitigation processes used in

40


relation to its members by the CCP or CSD itself,these procedures are a combination of due diligenceover the CCP or CSD, and day-to-day internal con-trol and risk management processes. Due diligenceconsiderations also evaluate operational risk and couldfocus on legal risk such as the clarity of the rules de-scribing finality. As discussed earlier, members oftenjoin through specially established limited liabilityentities whose capital is sufficient to meet member-ship requirements, but little more.

The decision whether to join a CCP or CSD isprimarily a commercial decision, often a necessary

condition of doing business,particularly where the CCP orCSD is effectively a monopolyin a particular market. That said,it is important that the commer-cial decision be made withproper appreciation of the risksand balanced accordingly.

Intermediaries oftentransact business with CCPs andCSDs on behalf of their cus-tomers. In fact, participationrules may differentiate betweenmembers with full execution andclearing rights and non-clearingparticipants, where “third-party”

clearing is considered a risk mitigation technique.Typically, the intermediary has separate contractualarrangements with the CCP or CSD and with the cus-tomer, so customer default does not expose the CCPor CSD directly to loss. Instead, the intermediary mustbear any loss following customer default, with theCCP or CSD affected only if the loss is sizable enoughto threaten the ability of the intermediary to fulfill itsobligations to the CCP or CSD. Intermediaries arethus faced with a similar commercial decision to putin place due diligence assessment and risk control pro-cesses to minimize the risk of loss from dealings withcustomers.

Because CCPs and CSDs play such a central role,minimizing the risk of their failure is an importantobjective. Yet there are several trade-offs in imple-menting the approach to risk outlined above. Increas-

ing the level of capital required for membershipreduces a CCP’s or CSD’s risk exposure—by attract-ing intermediaries that are financially robust and wellmanages—but excludes smaller potential members.At the same time, increasing the hurdle for member-ship may make a CCP or CSD more attractive to in-termediaries that are financially robust and managerisk well. The appropriate balance to be struck willdiffer from market to market, and indeed within thesame market over time, depending on the character-istics of the market, the nature of the products andorganizations involved, and the wider commercialenvironment, including consideration of public policyobjectives. The choices made by an individual serviceprovider or user will depend on the mix of activitiesand supervisory requirements reflected in its busi-ness model. Therefore, the recommendations beloware not a fixed standard, but an analytical frameworkfor best practice against which boards and manage-ment can evaluate their operations and seek consis-tency and high quality in financial risk management.

RECOMMENDATION 9. ENSURE THE FINANCIAL INTEGRITY OFPROVIDERS OF CLEARING AND SETTLEMENT SERVICES.

Providers of clearing and settlement servicesshould manage their risks and set standards andcontrols concerning the use of those services thatallow them to conduct business in a safe, sound,and prudent manner consistent with their busi-ness model and all relevant supervisory and regu-latory requirements. Each organization’s businessmodel should incorporate a risk framework thataddresses all risks connected to its operations.This risk framework should be approved by theboard and expressed through a set of limits andother qualitative and quantitative measures andtests. For systemically important organizations,the business model should minimize the prob-ability and impact of default.

The need to operate prudently within the riskboundaries inherent within the business modelrequires risk management processes and stan-dards, which should be applied objectively andconsistently in determining compliance with riskmeasures, in three broad areas:

The recommendations

are not a fixed standard

but an analytical

framework against which

boards and management

can evaluate their

operations and seek

consistency and quality

in risk management.

41


� The counterparty due diligence process,whereby service providers make ex ante andex post assessments of the suitability of theiractual or potential users, and the basis uponwhich users transact, for example distinguish-ing between those acceptable as clearing andnonclearing members. This process shouldbalance risk control (which inclines toward set-ting high financial and operational thresholds)with other commercial and competition con-siderations (which may incline toward lower-ing barriers to entry of users), while recog-nizing that there will always be minimum riskthresholds that should not be lowered.

� The procedures and techniques used to mea-

sure, monitor, and control risk exposure aris-ing as a result of the activities of the serviceprovider, its users, and its users’ customers.These should seek to avoid moral hazardwhereby users can introduce risk to the sys-tem without providing proportionate finan-cial protection to the service provider andother users.

� The minimum financial and liquidity re-

quirements that should be established by in-frastructure providers (and enforced by su-pervisors, as described in the relevant recom-mendation) in proportion to the risks to whichthey are exposed, so as to ensure their abilityto continue to provide services to markets andminimize the probability and impact of a de-fault on their users and the financial markets.

Each organization should publish a report, at leastannually, that describes the business model, riskframework, and underlying risk management pro-cesses, controls, and standards, together with theresults of independent testing of those procedures.The report would reassure users that the organiza-tion had been operating effectively and would alsoprovide greater transparency to the market.

Coverage of this report may overlap with otherreporting requirements, such as the so-called SAS 70reports, assessments pursuant to CPSS-IOSCO stan-

dards, and financial sector assessments carried outby the International Monetary Fund and World Bank.This report is intended to be complementary to theseother requirements and not to require additional re-porting where the purposes of this recommendationare otherwise met.

RECOMMENDATION 10. REINFORCE THE RISK MANAGEMENTPRACTICES OF USERS OF CLEARING AND SETTLEMENTSERVICE PROVIDERS.

Organizations that use, or are considering using,providers of clearing and settlement servicesshould establish robust due diligence andcounterparty risk management controls and pro-cesses that appropriately evaluate, measure, moni-tor, and control the risks inherent in such activityand in associated customer-related business. Therecommendation does not seek to replace pru-dential standards and supervision that may alreadyapply to financial intermediaries, including risk-related minimum capital requirements set by pru-dential supervisors. However, it is clearly impor-tant that capital resources and risk managementpractices appropriately reflect the range of risksinherent in clearing and settlement. Likewise,nonsupervised users of providers’ services shouldbe able to demonstrate the risk-based adequacyof their capital resources and risk managementprocesses.

ENSURING FINALITY

Because finality is essential to limiting credit risk in theclearing and settlement process, ensuring simultaneous,final, and irrevocable transfer of assets and paymentsis critical. Therefore it is incumbent on providers ofsecurities settlement services to link securities trans-fers to funds transfers in a way that achieves deliveryversus payment (DvP). Pursuit of DvP was a recom-mendation in the 1989 G30 report and has remainedon the list of recommended practices ever since, mostrecently in the 2001 recommendations by CPSS/IOSCO. Despite its vintage and wide endorsement,an industry-wide definition of DvP remains elusiveand DvP is still not universal.

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RECOMMENDATION 11. ENSURE FINAL, SIMULTANEOUS TRANSFERAND AVAILABILITY OF ASSETS.

Providers of securities settlement services shouldreduce to the lowest possible level the credit riskcreated if securities or cash are delivered withoutreceipt of corresponding assets, by linking secu-rities transfers to funds transfers in a way thatachieves effective delivery versus payment (DvP)and by making transparent the point at which fi-nality of transfer is achieved. There are differentsettlement arrangements that can achieve this:

� Real-time (or frequent intraday batch) settle-ment systems can offer the greatest certaintyby providing simultaneous and immediatetransfer for securities and cash at multiplepoints within the working day so long as thereis finality of transfer of securities and cash.

� Systems that offer real time (or frequentintraday batch) transfers of securities followedby net cash payments at the end of each work-ing day (or intraday) offer a lower level ofcertainty, but can substantially reduce costsand demands on liquidity, particularly in high-volume markets. In practice, such systems re-quire additional and enhanced levels of riskmanagement to offset the greater uncertaintybut are acceptable provided that intraday se-curities transfers are final and that risk con-trols ensure that the end-of-day (or intraday)net settlement of cash payments will be com-pleted, even if one or more participants ow-ing the largest end-of-day cash payments failto meet their obligations.

Determining the arrangement appropriate toa particular market will depend on a number offactors, including available technology and com-munication infrastructure, the number and valueof transactions, the systemic importance of themarket to the world financial system, and the busi-ness and operational models of other market par-ticipants and related payments systems. Anyuncertainties within an individual system are mag-nified by the complexity and intersystem depen-

dencies of cross-border transactions; this meansthat the impact of uncertainty on such trades willbe greater than on domestic trades. This is an-other important consideration.

Whichever settlement model is used, each se-curities settlement system should specify the mo-ment of final transfer in its rules or through bind-ing contracts in plain and simple language, as ex-pounded further in the respective legal risk rec-ommendation.

Systems that settle both securities and cashon a net basis and allow intraday transfers thatare conditional or not legally binding, have yetgreater uncertainty, as a participant’s transfers maybe revoked following failure to meet their end-of-day contractual obligations. In these circum-stances the complexities of unwinding conditionaltransfers of securities (and thereby needing torecalculate the delivery obligations of other par-ticipants), and the operational difficulties andliquidity pressures that may result, have the po-tential to create systemic risk. Such arrangementsare therefore considered unacceptable, particularlywhere there is potential cross-border impact.

Once finality of transfer is fully assured, therules should enable a receiver to re-use securitiesand cash without further delay, whether arisingfrom settlement, dividend or interest payments, orcorporate events.

ENHANCING OPERATIONAL INTEGRITY

As discussed earlier, business continuity and recoveryfrom disaster are concerns for clearing and settlementsystems because a technical, terrorist, or natural catas-trophe could restrict or halt normal activity. In the worstcase, operational as well as, liquidity, market-liquidity,and market and credit risk concerns could affect a widerange of other providers of clearing and settlementservices and financial institutions. For this reason, ser-vice providers have always devoted considerable re-sources to planning for business continuity and disas-ter recovery. Even so, several important lessons werelearned from the events of September 11, 2001.

The widespread destruction of the physical infra-structure and telecommunications environment in

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lower Manhattan caused disruptions in the trading ofcertain securities and the subsequent clearing and settle-ment of trades. While the global financial system con-tinued to function in the days following September 11,the level of disruption caused when key institutionswere knocked off-line demonstrated the interdepen-dence of the financial system. Recommendation 12aims to promote immediate action to strengthen busi-ness continuity and disaster recovery plans. Given thediffering nature of organizations to whom the recom-mendation is addressed and the varying circumstancesin which they operate, the recommendation is not in-tended to be prescriptive. It is also important to notethat elements of business continuity and disaster re-covery plans aimed at addressing less catastrophic butnonetheless important scenarios, such as loss of ser-vice from telecom or other key suppliers, remain vital.Similarly, effective contingency planning does not inany way diminish the need for strong preventativemeasures, including physical and IT security.

RECOMMENDATION 12. ENSURE EFFECTIVE BUSINESS CONTINUITYAND DISASTER RECOVERY PLANNING.

All market participants should, and all systemi-cally important institutions must, regularly review,update, and test their business continuity and dis-aster recovery plans, including evaluation of reli-ance on third parties, to ensure with reasonablecertainty that critical operations will continue witha high level of integrity and sufficient capacity fol-lowing a disruption or disaster. The review, updat-ing, and testing of plans should build upon thethorough analysis and good practices that have al-ready been established and that are being devel-oped by public and private institutions. The planshould be based upon revisiting planning assump-tions, revised risk assessment, and scenario plan-ning that encompasses the key lessons learned fromSeptember 11, 2001, and any other relevant inci-dents that may occur. Organizations should assesswhether plans provide satisfactory resilience and

evaluate the costs and benefits of developing so-lutions to the broad range of business continuityand disaster recovery issues. For functions criticalto the market as a whole, a split operations modelshould be considered, whereby one processing siteactively backs up another, with each site having therequisite level of key resources, capabilities, andfunctionality, including appropriately skilled and ex-perienced people. Systemically important institu-tions should undertake tests with member firmsand users as part of their evaluation exercises.

In their review of backup arrangements, organiza-tions should consider whether they have sufficientaccess to dedicated backup facilities to ensure thatoperations can be reconstituted within a suitabletime frame. When major incidents occur, organi-zations should be aware that the pressure on sharedbackup facilities may be such that they are not ableto rely on having access to it.

Full disclosure of plans may increase the risk ofcertain events or attacks, or otherwise compro-mise plans, and is clearly undesirable. However,contingency plans should be sufficiently transpar-ent and effectively communicated to the othermarket participants that depend on the institu-tion to allow them to make reasonable judgmentsabout the operational risks to which they in turnare exposed. In addition, the responsible super-visory body should critically assess the contin-gency plans of the organizations that they super-vise, including an evaluation of the adequacy andfrequency of testing. The nature of these assess-ments should reflect the associated risks, and forhigh-risk organizations should be performed atleast annually.

As already noted, the events of September 11 il-lustrate the vulnerability of financial institutions andthe clearing and settlement infrastructure to physicaldisruption and threats previously thought improbable.

2. “Draft Interagency White Paper on Structural Change in the Settlement of Government Securities: Issues and Options,” issuedjointly by the Board of Governors of the Federal Reserve System and the Securities and Exchange Commission, May 6, 2002.

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The recommendation aimed at ensuring effective busi-ness continuity and disaster recovery planning incor-porates lessons learned from this catastrophe that in-dividual institutions need to consider in their futureplans and operations. But this in itself is not a suffi-cient response. However robust, thorough, and well-tested they are, it is unrealistic to expect business con-tinuity and disaster recovery plans to anticipate andcater to all possible eventualities. The range of poten-tial scenarios is enormous, yet each individually is un-likely to happen. At the same time the chance of acatastrophic event of some sort is clearly real. It wouldtherefore be imprudent not to consider how the mar-ket collectively should address the potential failure ofa systemically important institution. Unsurprisinglysuch considerations are now a high priority for manypublic and private institutions around the world.

Quite naturally, in the aftermath of September 11,the focus of efforts to further increase the operationalintegrity of systemically important clearing and settle-ment entities (and systematically important institutionsmore generally) has been a matter of particular urgencyin the United States. Indeed, in 2002, the U.S. bankingand securities regulatory bodies issued for public com-ment two “white papers” that are relevant to the issueof enhanced operational integrity, although both thesepapers consider a number of broader issues, as well.

At the risk of considerable oversimplification, oneof these papers is directed at structural alternatives thatcould reduce the vulnerabilities of the overall financialsystem to a major failure, arising for any reason, at oneof the two major clearing banks located in New York.2

Although the focus of these structural alternatives wasnot limited to an extended operational failure, it is safeto say that in the post–September 11 environment sucha scenario was of particular concern, both in the draft-ing of the white paper and in the financial community’sresponse to the paper.

The other white paper was much broader, focus-ing, from a largely supervisory point of view, on arange of “sound practices” aimed at substantially in-

creasing the resilience of key U.S. financial institu-tions and financial markets in the face of a “wide-scale regional disruption.”3 Among other things, thispaper requested public comment on an extremelyambitious timetable for substantial and broad-basedenhancements to business and operational recoverycapabilities in the event of such a disaster.

Although the two white papers are directed at U.S.markets and U.S.-based institutions, the issues they raiseare relevant for all systemically important institutionsacross all jurisdictions, and they are clearly relevant tothe report’s goals for enhancing the operational integ-rity of systematically important clearance and settle-ment systems. Indeed, regulators, overseers, and mar-ket participants in many other jurisdictions have alsoundertaken considerable effort to evaluate contingencyplans in the light of September 11 and to update andstrengthen them where necessary.

At this stage, it is not possible to anticipate thespecific actions the U.S. regulatory agencies will takein response to the comments they have received fromthe public on the two white papers. Nevertheless, itseems fairly clear that, under virtually any foresee-able set of circumstances, the system will remain vul-nerable to an extended operational failure at system-atically important clearance and settlement entitiesarising for any reason—including reasons less draco-nian than a wide-scale regional disaster contemplatedby the second white paper.

Neither the structural changes nor sound practicescontemplated in the two white papers would elimi-nate this problem, and it would even exist in a globalclearance and settlement system having the interop-erability and other characteristics contemplated in thisreport, although the risk and adverse impact wouldbe greatly reduced.

Thus, the very difficult question remains whetherthere are meaningful steps that can be taken in therelatively short run to further reduce the risks associ-ated with sustained operational failures at systemi-cally important clearing and settlement entities.

3. “Draft Interagency White Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System,” issued jointlyby the Board of Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and the Securities andExchange Commission, August 30, 2002.

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The nature of the difficulties encountered in seek-ing to identify such short-run measures is best illus-trated by the problems experienced in New York onand for a number of days after September 11. In thattime frame, one of the New York clearing banks hadprotracted operational problems that left a massive vol-ume of transactions (and much of the critical infor-mation relating to those transactions) essentiallygridlocked in the temporarily impaired clearing bank.Moreover, because there was no interoperability, evennew transactions by clients of the clearing bank couldnot be routed through the second clearing bank. How-ever, and this point is critical, even if interoperabilityhad existed so that new transactions could have beenrerouted, market participants believe that it would nothave made much difference unless the gridlocked trans-actions—or at least the information associated withsuch transactions—could also have been recovered andprocessed. In other words, interoperability is a neces-sary condition for materially reducing the risks of cer-tain types of operational failures, but it is not a suffi-cient condition to achieve that result.

Discussions with prominent private sector expertsand the publicly available comments received by theU.S. regulatory authorities on the first of their twowhite papers have brought forth several ideas forpossible solutions to this particular vulnerability thatmight be achievable in the reasonably short run.Moreover, the steps would be consistent with thelonger-term vision for the global network of clear-ance and settlement systems advocated by this study.

One very promising idea is the concept of a real-time data depository by which each of the two NewYork clearing banks could back up the other. Obvi-ously any such real-time data depository would requireat least some degree of interoperability between thetwo clearing banks and most, if not all, of their clientsand possibly with the U.S. Federal Reserve System aswell. Importantly, the real-time data depository wouldsimultaneously capture transactions and informationflows to the two clearing banks. Together, the creationof such a depository and the achievement of the

degree of interoperability that it would require may besufficient to ensure that in the event of a major opera-tional failure at one such institution, the other couldprovide operational backup, including a high level ofassurance that all, or virtually all, transactions directedto the troubled bank could be processed and settled inline with normal time schedules.4

This example demonstrates how it may be possibleto create innovative solutions to the important issueof how the financial market as a whole could deal withthe failure of a systemically important institution. Thesolutions appropriate to systemically important enti-ties other than the two New York clearing banks willdiffer according to the business model and activitiesinvolved, the entity’s position in the processing chain,and the way in which the entity interacts with othermarket participants. Other systemically important en-tities requiring alternative solutions might include(I)CSDs, CCPs, and providers of secure communica-tions, payment services, and, in a rapidly consolidatingmarket, global custodian services. This report recog-nizes the remarkable challenge of finding solutions foreach of these different types of entity, but it is none-theless a critical task deserving of sustained effort.

Accordingly, the Steering Committee fully sup-ports initiatives to explore promptly the costs, feasi-bility, and benefits of approaches that address thefailure of systemically important institutions, alongthe lines of the real-time data depository. Such anapproach will not solve all of the problems associ-ated with systematically important operational fail-ures, but it will, among other things, buy the time andthe experience to forge more comprehensive longer-run solutions.

RECOMMENDATION 13. ADDRESS THE POSSIBILITY OF FAILURE OFA SYSTEMICALLY IMPORTANT INSTITUTION.

Market participants in each financial centershould work together to identify those institu-tions, or parts thereof, that are systemically im-portant to the clearing and settlement process.User groups should be established to address

4. U.S. regulatory agencies have commissioned a private-sector group to explore solutions to the issues addressed in the first whitepaper with a mandate to propose feasible plans for addressing them.

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how they would react if, despite strengthenedbusiness continuity and disaster recovery plans,there were a failure for whatever reason at oneof these institutions. Ways of mitigating the riskscreated should a systemically important institu-tion fail, such as building a real-time data de-pository, should be evaluated. Where it is deter-mined that effective and feasible solutions mayexist, detailed business cases setting out the costsand benefits should be built up, and decisionson future actions and investment decisionsshould be taken accordingly. As well as enforc-ing suitably high standards of business continu-ity and disaster recovery planning in systemicallyimportant institutions, regulators and overseersshould encourage this process of industry-widecontingency evaluation and planning.

ENHANCING LEGAL INTEGRITY

Essential to the management of risk in the clearingand settlement process is an adequate understandingof key legal considerations and the risks that legaluncertainty can introduce to that process. Among thecritical considerations in this regard are contract le-gality and enforceability; legal certainty over rights tosecurities, cash, or collateral; and recognition and sup-port of flexible valuation and closeout netting ar-rangements. These legal considerations are not uniqueto the clearing and settlement of securities and otherinstruments but are relevant for all market partici-pants, including counterparties, intermediaries, agents,brokers, and end users.

Ultimately, legal certainty in cross-border transac-tions will be fully achieved only through enactmentof strong, clear, and consistent national and interna-tional laws. The Steering Committee recognizes thatsuch legal reform is necessary but will require a long-term effort. Meanwhile, much can and should be doneto increase legal certainty and reduce risk throughsound management. First of all, it is important thatthe legal status of transactions and financial relation-ships be determined in advance of trouble. Once afailure occurs, indeterminate legal positions may makeit impossible to determine financial positions with

clarity, and it is too late to remedy the underlying le-gal issues at that point.

Thus, individual entities should further strengthentheir internal process of due diligence to ensure thatlegal risks are identified and effectively managed. Wherelegal principles can be agreed among practitioners andimplemented contractually, standardization of legal ap-proaches by industry participants can yield substantialbenefit in advance of broader law reform. In fact, thisprocess can be very effective in laying the groundworkfor eventual changes in law. The recommendations be-low identify interim measures that can be taken and notewhere the enactment of effective laws is necessary.

While an ongoing business relationship increasesthe likelihood that parties will perform as agreed, it isthe reasonable certainty of legal enforcement that ul-timately must underlie all transactions. Legal recog-nition of the parties’ agreement is a precondition forthe enforcement of rights under any contract. Fun-damental issues include valid formation of the con-tract, the capacity and authority of all the participantsto enter into the contract and to perform their re-spective obligations, and the compliance of the termsof the contract and the obligations of the partiesthereto with applicable law.

RECOMMENDATION 14. STRENGTHEN ASSESSMENT OF THEENFORCEABILITY OF CONTRACTS.

Market participants should ensure that due dili-gence procedures examine contract enforceabil-ity, including basic formation and validity, as wellas power and authority to contract. Where sig-nificant uncertainty exists about the reliability ofthe legal system of relevant jurisdictions, stepsshould be taken where possible to ensure that suchlaws do not govern the transactions and that en-forcement in such jurisdictions will not be re-quired. Collateral posted and held outside such ju-risdictions and letters of credit essentially remov-ing all reliance on enforcement ability in the ques-tionable jurisdiction should be considered. Indus-try groups should enunciate standards of diligence,and together with appropriate regulators, identifydeficiencies in law that could potentially impair

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contract enforceability, such as those related togambling and other public policy areas. Industrygroups should also propose legislative changes toprotect transactions between commercial entities.

While sound contracts are critical, enforceabilityderives fundamentally from legal certainty embodiedin clear operating rules and sound laws. Thus, the pur-suit of legal certainty must address operating rules atindividual CCPs and CSDs, industry agreements onthe formulation of financial contracts, and ultimatelyreform of national laws. While the exact details oflegal reform will depend on national context, achiev-ing the goals of these recommendations may requirefundamental changes in law in some jurisdictions.

RECOMMENDATION 15. ADVANCE LEGAL CERTAINTY OVER RIGHTSTO SECURITIES, CASH, OR COLLATERAL.

Market participants must be able to determine,with certainty and reasonable cost and effort, whatlaw defines and governs their rights to securities,cash, or collateral in a clearing and settlement sys-tem or other intermediary, what those rights are,and how to perfect and enforce them. The appli-cable rules of law should be automatically effec-tive, to the extent possible, and should afford theparties to the transaction ex ante certainty andpredictability for the largest number of transac-tions possible. To the extent possible, clearanceand settlement systems and other intermediariesshould describe to their participants or custom-ers the relevant choice of law that rules in theirhome countries as they relate to what law gov-erns the effectiveness of transfers and pledges ofsecurities held through an account with an inter-mediary. Specifically, the following is recom-mended:

� Choice-of-law rules. Financial supervisors andlegislators should ensure that the Hague Con-vention on the Law Applicable to CertainRights in Respect of Securities Held with anIntermediary, adopted on December 13, 2002,is signed and ratified by their respective nations

as soon as is reasonably possible. The HagueConvention, once ratified by all relevant na-tions, will ensure that there will be a clear andcertain answer to the question in an interna-tional setting as to which law governs in deter-mining whether a collateral taker has receiveda perfected interest in pledged securities.

� Protection against intermediary insolvency

risk. Financial supervisors and central banksshould confirm that the rights of a personholding securities through an account with anintermediary in their jurisdiction are senior tothe claims of the intermediary’s creditors tosuch securities, except where the intermedi-ary affirmatively grants such creditors controlover such securities. If the financial supervi-sor or central bank is unable to provide suchconfirmation, it should take all appropriateaction to ensure that its local commercial andbankruptcy laws are interpreted or amendedto achieve such a result.

� Pledging and realization procedures. Finan-cial supervisors, central banks, and legislatorsshould encourage collateral transactions bysimplifying any legal procedures that imposeconditions on the effectiveness of pledgingarrangements or govern the fairness of real-izing on collateral.

� Finality. The boards of central securities de-positories should specify in plain language themoment when a transfer or pledge of securi-ties becomes “final” (that is, irrevocable andunconditional) in its rules or binding contractswith its account holders. Financial supervisorsand central banks should require this specifi-cation from each central securities depositorysubject to their jurisdiction.

When a financial failure occurs, the availability ofcloseout netting and clear valuation rules are the sur-est way to limit risk. Netting limits overall exposure,and clear, legally recognized valuation procedurespermit speedy closeout of complex portfolios andpositions.

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RECOMMENDATION 16. RECOGNIZE AND SUPPORT IMPROVEDVALUATION METHODOLOGIES AND CLOSEOUT NETTINGARRANGEMENTS.

Market participants should ensure that all masteragreements provide that upon the early termina-tion of a transaction or group of transactions,the determining party will have the flexibility tovalue such transactions by the method that is mostlikely to produce a commercially reasonable valu-ation at the time of termination. Master agree-ments also should provide that in any exercise ofsuch discretion, the determining party should beguided by principles of good faith and commer-cial reasonableness.

Market participants should include closeout net-ting provisions in their contract documentation.Trade associations and other industry bodiesshould work together to harmonize informationon the effectiveness of netting and disseminate itwidely and in accessible form.

Relevant authorities in each jurisdiction shouldensure that their laws give effect to closeout net-ting for all central counterparties, brokers, endusers, and other market participants, and for allentity, transaction and asset types. Market partici-pants and other interested bodies should encour-age legislative reform in those jurisdictions wherelaws do not meet this standard.

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Governance: The Key to Reform

5. GOVERNANCE: THE KEY TO REFORM

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GOVERNANCE IS THE FINAL KEY ELEMENT, AND PRI-MARY DELIVERY MECHANISM, IN STRENGTHENING

CLEARING AND SETTLEMENT SYSTEMS. In fact, theoverarching governance challenge in this report is forboards to implement the recommendations for strength-ening the clearing and settlement model and strength-ening risk management set out in the preceding chap-ters. Governance refers to the mechanisms and proce-dures through which the objectives of a company areset, the means to achieve them are identified, and theperformance of the company is measured. It also refersto the set of relationships among management, theboard, shareholders or owners, users, regulators, andother stakeholders that influence these outcomes.

The specific recommendations under this headingare primarily directed toward the activities and account-ability of the boards and management of these sys-tems and, to the extent applicable, their users. The rec-ommendations also touch on the public policy frame-work for competition and prudential oversight withinwhich these clearance and settlement systems operate.Ensuring the system’s openness to competition is asecond important challenge and key to success in anumber of other areas. The term competition refers tothe ability both of users to shop around for the bestservice provision and for qualified would-be serviceproviders to have access to the market. Providersshould be judged to be qualified according to objec-tive criteria related to the soundness of their businessorganization—not their nationality, location, or otherfactors unrelated to business soundness.

The recommendations outlined below build upon,rather than displace, the substantial governance re-sponsibilities associated with current infrastructurearrangements. The challenge is to raise overall infra-structure capability and performance to a new level.This improvement will takeplace within a framework ofpublic policy requirements andparameters for both competitionand prudential supervision.However, the initiative on sub-stance and timing lies with theboards of entities that are com-pletely or mostly privatelyowned . (Broadly similar initia-tives will be required of clearingand settlement entities owned bycentral banks or other publicbodies.)

The recommendations have implications for gov-ernance in three main areas.

� First, boards and management should ensurethat new or upgraded systems and software arealigned with the technical and operationalstandards recommended in this report forachieving interoperability and improvingclearing and settlement processes.

� Second, boards and managements shouldensure that services and technologies areintroduced on an open and competitive basis.

The overarching

governance challenge

in this report is for boards

to implement the

recommendations set

out in the preceding

chapters.

Analysis of the structure and governance of global clearing and settlement arrangements, as well as the report’s governancerecommendations, are based on a draft paper prepared by David Walker, Senior Advisor, Morgan Stanley International.

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� Third, boards and managements should ensurethat arrangements for the identification, mea-surement, and control of risk, including opera-tional risk, fully comprehend the risks inherent inan increasingly linked global network.

The relevant competition authorities and centralbanks and supervisors responsible for regulation andoversight clearly have important interests in the lat-ter two categories.

GENERAL RESPONSIBILITIES

OF BOARDS AND MANAGEMENT

The responsibilities placed on boards of clearing andsettlement entities by this report are both wider in scopeand more detailed than has been the case to date. Theseboards are being asked to become the main drivers ofchange in support of cross-border business, not leastbecause the principal initiatives can be taken only bythe boards themselves, with the agreement of usersand shareholders. The current state of cross-borderclearing and settlement arrangements demonstrates thechallenge that this responsibility poses. Cross-bordertrading has been one of the fastest-growing segmentsof securities activity around the world over the pastdecade. Nonetheless, clearing and settlement costs andrisks for cross-border trades remain substantially higherthan those for domestic clearing and settlement. De-spite at least a degree of user involvement in gover-nance and, commonly, a significant element of userownership, cost and efficiency improvements for cross-border business have lagged behind.

Given this experience, it is clear that board mem-bers must enjoy sufficient seniority and experienceto provide the strategic vision and authoritative voicenecessary to carry through the expanded mandaterecommended here.

RECOMMENDATION 17. ENSURE APPOINTMENT OF APPROPRIATELYEXPERIENCED AND SENIOR BOARD MEMBERS.

Members of the boards of securities clearing andsettlement infrastructure providers should, indi-vidually and collectively, be of a weight in termsof experience and seniority to discharge the en-larged strategic and management oversight

responsibilities described in this report. Organi-zations that are users of such providers, or other-wise have input into the appointment of boardmembers, should be mindful of the broad rangeof capabilities needed to discharge the diverse,important responsibilities of such a position.

More generally, principles of good corporate gov-ernance require directors to adhere to certain stan-dards of conduct in carrying out their responsibili-ties, including a duty of care. In a user-owned struc-ture where persons appointed to the board are likelyto be employees of users, directors need to be espe-cially vigilant. The duty of that director is to exercisehis or her authority in the interest of the clearing andsettlement entity and all of its users and to discloseconflicts of interest before the board acts. In takingthese initiatives forward, boards will need to strike abalance among, for example, the interests of differ-ent users of the entity’s services or between short-term interest in fee reductions and required invest-ment in capacity and systems enhancement over thelonger term.

THE DEMANDS OF PUBLIC POLICY

Good governance must also recognize public policyinterests. The capacity to exploit a monopoly posi-tion for competitive advantage will necessarily attractinterest by relevant competition authorities. Whereusers have access to alternative infrastructure provid-ers, public policy is likely to focus on harmonizationof standards, much as it does with telecommunica-tions. Where there is a sole provider, competitionconcerns will assume higher priority. Issues includethe need to ensure that systems are open, that cross-subsidy between monopoly services and other ser-vices is avoided, and that any monopoly rents accrue,one way or another, to users.

Public policy interests also arise in the area ofprudential supervision to ensure that clearing andsettlement systems are managed so that they cancontinue to operate in the face of market shocksand so that the risk of default is minimized. To ad-dress risk, boards will need to establish and main-tain levels of capital, risk management standards,

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and market transparency consonant with the scaleand nature of an entity’s operations and potentialexternal shocks. Because such standards could beexploited by incumbent market participants to dis-courage new entrants and inhibit competition, trans-parency must extend to application of the standardsas well. In the event of consolidation, concentra-tion of risk will only increase the importance ofthese board responsibilities. The board and man-agement will carry out these responsibilities subjectto the oversight of the central bank or prudentialsupervisor.

INTEROPERABILITY AND COMPETITION

Beyond the general duty of care and the specific de-mands of public policy, good governance as it is out-lined in this report requires boards of clearing andsettlement entities to work toward the twin goals ofinteroperability and openness of systems. Theinteroperability goal is embodied in specific techni-cal and process recommendations to be implementedas new software and systems are installed. Given therange of actions involved, these recommendationsdemand early attention and proactivity by boards ofmajor service providers.

Appraisal of the cost involved in implementinginternational standards and installing new systems thatembody them may prove an important influence onconsolidation. In particular, boards of smaller enti-ties may find that the more attractive strategic optionis consolidation with another entity so that the costsof adopting standards that create the potential forinteroperability are shared. Thus, the need to adoptstandards associated with interoperability can makethe business case for consolidation.

An apparent paradox arises in this report betweenthe stress laid on achieving interoperability and thatdirected at maintaining or even enhancing competi-tion as a spur to innovation. As discussed above, thedrive for interoperability alongside the pursuit of scaleeconomies will tend to promote consolidation, whichwill reduce competition in numerical terms. But a re-duction in the current universe of service providersneed not be associated with reduced competition, andit could have the opposite effect.

A major reason for the current array of CSDs isthat they often developed, or were granted status, as aform of monopoly within each national jurisdiction.Where such monopoly national systems operate to dif-ferent technical standards and processing rules—thatis, where monopoly national systems are notinteroperable—there can be no effective competitionbetween them. The introduction of interoperabilitywould significantly change thatsituation. The use of commonstandards would create value forusers by increasing the numberof potential users of any singleclearing and settlement system(creating network externalities).Because products would be lessdifferentiated under commonstandards, direct price competi-tion would be more important.Common standards would thusproduce effective competition on the basis of bothprice and service, something that is unlikely to beachieved if the current array of partially interconnectedservice providers operating to different technical andbusiness standards is maintained.

Standardization could reduce the franchise valueof smaller service providers and inevitably in a com-petitive environment, economies of scale and net-work externalities would lead to a more concentratedstructure. In the extreme case, a monopoly entity of-fering low tariffs and dependable service quality couldemerge. The competitive process could thereby wellserve the interest of users—so long as it did not re-sult in anticompetitive behavior, such as creating bar-riers to new entrants. It is that behavior that wouldcreate a concern for competition policy.

The other concern with consolidation is its poten-tial impact on innovation. There seems no particularreason to suppose that boards of entities that haveconsolidated would be less ready to be effectively in-novative in improving efficiency and service qualitythan the boards of fragmented and noninteroperableentities, except perhaps in the case of a true monopoly.Therefore, an important ingredient for sustaining in-novation is open and transparent business models so

Ensuring the system’s

openness to competition

is a second important

challenge and key to

success in a number of

other areas.

52


that even a consolidated entity may be exposed to com-petitive challenge in one or several of its functions.

Key to addressing the competition concern is en-suring that qualified users have access to systems andare free to select the mix of functions and servicesthat they wish to use.

RECOMMENDATION 18. PROMOTE FAIR ACCESS TO SECURITIESCLEARING AND SETTLEMENT NETWORKS AND SERVICES.

Boards of securities clearing and settlement serviceproviders, other organizations providing similar ser-vices, and public authorities should ensure that rulesand other requirements that control or limit accessto securities clearing and settlement services are ac-cepted only where they are necessary and are de-signed exclusively for the purpose of controlling fi-nancial, operational, reputational, or regulatory risks;maintaining the safety of the system; or achieving

other reasonable public policy ob-jectives. Networks and servicesshould be accessible to all usersthat pass risk and safety evalua-tions and enjoy appropriate finan-cial standing, and users should befree to select the mix of functionsand services that they wish to useon the basis of straightforward,transparent, and fair tariff policiesgrounded on the principle of user

pays. Such risk-based rules should be broadlyfounded (encompassing the due diligence processset out in the financial integrity recommendation),and fairly and consistently applied. Moreover, therules and their application should be transparent tothe market. Existing barriers that do not meet thistest should be removed.

OWNERSHIP AND COMPETITION

Competition policy aims to protect the interests ofusers or consumers of products and services. There-fore, where users own a service provider, public in-terest concerns are likely to be limited because in sucha case any quasi-monopoly rents earned would auto-matically accrue to users as a group. Where owner-ship is held substantially by nonuser shareholders,

policy interest in the allocation of economic rents islikely to be heightened. The ownership patterns forclearing and settlement entities (there are exceptions,such as those for government bonds in the UnitedStates and Japan) are by users, by nonuser sharehold-ers, or by a combination of the two. The last caseoccurs where a securities exchange (with its own pub-lic shareholders) is a nonuser shareholder of an en-tity that also has shareholders who are direct users.

The landscape of interlinked and interdependentorganizations described in chapter 2 demonstratesthat the term “user,” when applied to clearing andsettlement services, could be defined in many differ-ent ways. User in this context is taken to refer to anorganization that has a direct relationship with a ser-vice provider. Most users of this type will be inter-mediaries who, in turn, provide additional services,typically for an all-in fee, to meet the overall require-ments of the end users: investors in, or issuers of,securities. Observation of market practice and theOXERA analysis cited earlier together suggest thatcompetition at the intermediary level is such that asignificant proportion of savings accruing to directusers will be passed to end users over time. Thus, ad-dressing competition issues in the interests of inter-mediaries may be generally expected to bring similarbenefit to their clients as end-users.

Where users own the entity, there is likely to be asubstantial convergence of interests about improvingservices. Important choices will still have to be made,however, between short-term and long-term inter-ests—for example, tariff reduction for users versus in-vestment in enhanced systems and capacity,including necessary steps toward interoperability orconsolidation. There will also be questions of fairnessbetween large and small market participants. Two ar-eas in which potential differences could arise are theallocation of cost and benefits and setting service pri-orities among users. In the former case, the incidenceof costs and the extent to which savings flow throughusers to issuers is largely a function of competition.As discussed earlier, the primary beneficiary of sav-ings will be issuers. In any case, all market participantsand users share a broad interest in improving efficiency,so the potential for conflict appears small.

Boards are being

asked to become the

main drivers of change

in support of cross-

border business.

53


As to differing priorities among different usergroups, smaller brokers may have a greater interest inshort-term tariff reduction than do larger brokers,and custodians may see different investment priori-ties for the entity than those seen by broker-dealers(for example, custodians may have less interest thanbroker-dealers in improving the asset-servicing capa-bilities of CSDs, with which they may be in directcompetition). Such differences are likely to be mat-ters of degree, however, and point to the need for anappropriate structuring of the board to ensure a bal-ance among different user interests. A mechanism willbe needed to resolve such differences, perhapsthrough governance arrangements or by-laws. Theinclusion on the board of public interest members isa practical means of ensuring that longer-term pri-orities set by the board are not unduly at risk fromshort-term user interests.

For entities where nonuser ownership is signifi-cant, the board is likely to focus more or less explic-itly on shareholder value objectives, which provide astrong spur to efficiency and cost reduction in a com-petitive environment. As one example, DeutscheBörse has created a vertically integrated structurecombining an exchange, clearing and settlement fa-cilities to provide one-stop services from trading tosettlement. This offers substantial user convenience.As a publicly traded company, it is also an attractivemodel from the standpoint of nonuser shareholders.But two potential limitations of the model have to beaddressed:

� Can a vertically integrated structure offer thesame level of user benefits as an infrastructuremodel featuring competition on price andservice at each level of the value chain andacross trading systems?

� Will value-added services, such as creditfacilities supplied competitively in the market,be offered or added?

These concerns are all but eliminated if the verticalstructure incorporates open access and fair tariffpolicies that allow users of other stock exchanges orelectronic trading platforms into its facility while us-

ers of its trading platform can clear and settle tradesand pursue ancillary services elsewhere. Of course,the commitment to open access has full effect onlyif the main clearing and settlement entities areinteroperable, allowing competition for services.

The difficulty is that open access and interoper-ability may not be consistent with profit maximiza-tion, at least in the short term. Therefore, an appro-priate balance between the interests of users andshareholders may be difficult to achieve in a boardconsisting of nonuser shareholders. These concernswill be less where there is effective competition thanwhere an infrastructure provider is an effective mo-nopoly. Where a monopoly exists, competition policyinterest is likely to arise regarding an array of specificoutcomes such as openness of access and fee trans-parency. A related competition concern is whetheradditional services that could be competitively sup-plied are instead tied to core, monopoly services.

If a monopoly or quasi-monopoly exists, but eco-nomic rents accrue largely or wholly to market users,competition policy oversight may be confined to en-suring that representation on the board is balancedamong different user interests and that board mem-bers are committed to interoperable and open sys-tems. However, where nonuser shareholder interestis significant, oversight may be needed to ensure trans-parency in fee structures and to guarantee that eco-nomic rents reach the users of clearing and settle-ment services. These considerations suggest that forthe majority of situations in which clearing and settle-ment is through private sector entities, the overallbalance of advantage probably lies with a user-own-ership structure. But the report is not prescriptive inthis respect, and other structures may also serve wellas long as competition concerns are addressed.

It is also important to recognize that central bankor other public ownership of a clearing and settle-ment capability does not obviate the need for atten-tion to user interest in monopoly rents. Nor does itremove the need for risk management disciplines simi-lar to those to be applied in privately owned entities.Equally, the boards of publicly owned clearing andsettlement entities should pursue international opera-tional and technical standards and be attentive to

54


opportunities for improvements in efficiency, just likeboards in the private sector.

RECOMMENDATION 19. ENSURE EQUITABLE AND EFFECTIVEATTENTION TO STAKEHOLDER INTERESTS.

Board participation should represent differentstakeholder interests fairly and equitably. Provi-sion should be made for regular review of, andfor changes as necessary in, board compositionto ensure continuing balanced representation ofvarying stakeholder groups, including users.Where a securities clearing and settlement infra-structure provider is user-owned, user-sharehold-ers should make certain that arrangements are inplace to provide equitable and effective represen-tation through appropriate by-laws; the appoint-ment of independent, public interest, or end-userinvestor directors; or other similar measures.Where such a provider is partly or wholly ownedby nonuser shareholders and is also a substan-tially monopoly provider of clearing, settlement,and related services in a particular market, user(and other stakeholder) interests can be adequatelyprotected through appropriate user or other in-dependent, nonshareholder participation in theboard. However, these arrangements may have tobe supplemented by oversight of tariff and otherpolicies by relevant competition authorities. Ineither case, the independent directors should beappropriately involved in the audit and remunera-tion committees.

SAFETY AND SOUNDNESS

Whereas ownership structure will heavily influencethe extent of competition policy oversight, that is notthe case for prudential oversight. Ensuring safety andsoundness is an explicit and core responsibility of theboard of any clearing and settlement entity, regard-less of ownership structure, and the need for engage-ment by central banks or supervisors is clear.

Boards of clearing and settlement entities and thosewho use their services devote considerable effort torisk mitigation, even though the major contingenciesthey face are of relatively low probability. However,the changes proposed in this report may introduce new

configurations of risk that warrant heightened atten-tion. The move to interoperability will in itself neitherincrease nor attenuate the risk management responsi-bilities of boards because whether or not the entity isinteroperable with other similar entities, the board andmanagement are still responsible for maintaining therisk management process.

These matters are discussed in greater detail inchapter 4, along with specific recommendations inthe area of financial, operational, and legal integrity.An important capability in pursuit of these recom-mendations by infrastructure providers is an effec-tive due diligence process for their boards and man-agement regarding clearing members and major us-ers. Where these members and users are supervisedfinancial institutions, reliable and timely sharing ofinformation between the supervisor and infrastruc-ture provider will be essential. Of particular impor-tance is access to filings made with primary supervi-sors. Whether such intelligence-sharing arrangementsare likely to be adequate will depend partly on thepractical working relationships that evolve. But fromthe standpoint of robust system design and the avoid-ance of moral hazard, the board of the infrastruc-ture provider (and its prudential supervisor) must besatisfied as to the independence of its capability toevaluate its clearing members and users. In those situ-ations where the mandate of the primary supervisorof a financial entity such as a broker-dealer is to en-sure continuing capacity to meet obligations to retailclients, official supervision will offer no assurance thatthe firm is able to meet its payment or securities trans-fer obligations to the infrastructure provider. In thosecases, the infrastructure provider will have to have anindependent appraisal capability with the possibilityof on-site inspection, even if such capability is likelyto be used only rarely.

Given the reciprocal nature of the assessment ofcontinuing financial health that is recommendedbetween infrastructure providers and their membersand users, transparency of the entity is a key ingredi-ent in informing the due diligence of users. There-fore, the board should conduct, at least annually, anindependent assessment of the provider’s financialposition, its risk profile, and its risk management sys-

55


tems, together with its operational reliability includ-ing backup and contingency plans. The results of thisassessment should be made promptly available tomembers, users, and the market generally. These as-sessments will also encourage compliance with therecommendations at large.

There is plainly a substantial and evolving role forofficial regulation and oversight in the case of all clear-ing and settlement entities. There may, additionally,be a role for competition policy oversight. Its extentand form will depend in particular on the competi-tive environment in the marketplace, the ownershipand governance structure of a particular clearing andsettlement entity, and the extent to which voluntaryinitiative by the board of the entity mitigates the needfor active public policy intervention.

RECOMMENDATION 20. ENCOURAGE CONSISTENT REGULATIONAND OVERSIGHT OF SECURITIES CLEARING AND SETTLEMENTSERVICE PROVIDERS.

Providers of securities clearing and settlementsystems should be subject to consistent andtransparent regulation and oversight, whichshould focus on the activities undertaken andthe risks incurred. Standards of regulation andoversight of cross-border activity should becomplementary and consistently applied acrossall relevant jurisdictions. As a long-term goal andwhere coherent with other public policy objectives,regulatory and oversight standards should be har-monized. While public authorities have devel-

oped minimum standards for many aspects ofclearing and settlement services, notably as em-bodied in the CPSS-IOSCO recommendations,the oversight and supervision applied to provid-ers of clearing and settlement services variesacross jurisdictions. In addition, organizationsundertaking similar activi-ties can be subject to differ-ent regulatory regimes andstandards based upon theirstatus, such as whether ornot they are a bank.

Supervisory, prudential, andoversight standards shouldrecognize the systemic im-portance of providers ofclearing and settlement ser-vices with a view to minimiz-ing the risk of default or op-erational failure of critical organizations. As notedin Recommendation 9, aimed at ensuring consis-tent financial integrity of service providers, con-sistent supervision is necessary to create uniformrisk standards and ensure consistent minimum fi-nancial and liquidity requirements. But consistentsupervision is also important to help create a levelplaying field between competing organizations.

Regulatory and oversight standards that affect cross-border activity must be undertaken consistently andtransparently across all relevant countries.

Boards should

pursue international

operational and technical

standards and be

attentive to opportunities

for improvements in

efficiency.

57

From Recommendation to Implementation

6. FROM RECOMMENDATION TO IMPLEMENTATION

57

Taken together, the recommendations in this reportrepresent a comprehensive plan of action for the fu-ture development of global clearing and settlement.This is an ambitious agenda but a sound one: respon-sive to market aspirations for greater safety and effi-ciency, and focused on practical solutions to recog-nized problems. The report offers an organized ap-proach to the body of work that is needed, a sub-stantial portion of which is already under way by in-dustry groups, supervisors, and central banks. Thequestion is not whether the issues identified need tobe addressed, but whether the efforts under way, andthe investments that flow from them, will proceedpiecemeal or aim toward global consistency.

An approach based on global standards can resultif those who have the capacity to motivate changehave confidence that it can come in a reasonable timeframe and at reasonable cost. The report sets out thegeneral benefits that can be obtained from compre-hensive reform, yet the decision to support reformmust be made by individual service providers andmarket participants, whose own cost-benefit calcula-tions are less than certain.

Making all service providers fully interoperable withcounterparts in other countries and markets, and withcompeting firms, will create a more competitive envi-ronment, but it could reduce the value of proprietarysystems. Open access to systems and services, basedonly on financial integrity considerations, will enhanceprice competition and limit cross-subsidy of services.System-wide, the outcome of pursuing these goals willbe positive because overall opportunity will increase,but the outcome for individual entities will be uncer-

tain if their former franchise is threatened. At the sametime, implementing the recommendations will requiresubstantial investment and change over time and pos-sibly a basic change in business strategy.

There is no certainty that benefits will be propor-tionate to costs for all organizations, or that eithercosts or benefits will be spread evenly.

EXISTING INCENTIVES

ARE PROPELLING CHANGE

Fortunately, three major influences appear likely toincrease strategic attention to strengthening clearingand settlement systems and to produce substantialconvergence of private and official interests in favorof reform.

� Cost reduction is moving higher on the private

sector agenda. As margins are squeezed, bothduring the current marketdownturn and in thefuture, broker-dealers,investors, and ultimatelyissuers will be seeking toreduce external inefficien-cies and costs, rather thanlimiting themselves tointernal economies. Usersand boards of clearing andsettlement entities face newincentives to reduce systemdevelopment costs, avoidduplicative capital spend-ing, find opportunities for

The report offers an

organized approach

to the body of work

that is needed, a

substantial portion

of which is already

under way by industry

groups, supervisors,

and central banks.

58


fee reduction, and pursue consolidation. Asharper focus on external infrastructure costswill underscore the importance of harmonizingtechnical and operational standards and ofreducing the need for multiple linkages todifferently configured external providers.

� The potential for systemic risk in cross-border

activities is more widely recognized. The addedcomplexity of cross-border business requiresgreater awareness of risks. Concentration of

the business among a relativelysmall group of major globalplayers, together with consoli-dation of infrastructure, meanthat a disturbance affectingone counterparty could rapidlyspread to other markets andthe infrastructure arrange-ments that support them—however robustly these arestructured. This possibilityfocuses attention on theintegrity of payment andsettlement arrangements

generally, a focus that has been further sharp-ened by lessons arising from the events ofSeptember 11.

� Market developments call for the attention of

competition authorities. Consolidation ofservices and changing ownership structures, inparticular where the profit motive has beenintroduced more strongly into the infrastructurearena through the public offering of shares,raise concern over elements of monopoly inclearing and settlement. There are considerableparallels between the clearing and settlementarea and other businesses such as telecommuni-cations and energy supply, where economicderegulation has encouraged the exploitation ofscale economies and network externalities,balanced by substantial competition oversight.

REFORM IS A COMPLEX UNDERTAKING

Incentives for change notwithstanding, achieving theobjectives set out in this report will be a complex

undertaking. The 20 detailed recommendations pre-sented here will require concerted action from mul-tiple parties into the medium-term future. Many ofthe recommendations cover new ground and entailcosts that will have to be carefully considered.

Given the scale of this effort, those asked to adoptthe recommendations must feel confident not onlythat the proposals are of substantive merit, but thatthey will be implemented systematically. Confidencebuilding requires a realistic framework for action thatoffers sensible prioritization and ongoing monitor-ing to ensure sustained attention to performance.Prioritization offers guidance on where work shouldbegin and how it should proceed. Monitoring enablesparticipants to see progress being made and ensurecoordination of efforts.

ESTABLISHING PRIORITIES

Because achieving the risk and efficiency benefitsdescribed earlier depends on pursuing the programcomprehensively, no recommendation can truly beleft for later attention. That said, two sets of propos-als are of overriding importance.

� The risk recommendations address ongoingsafety and stability concerns, stand on their ownmerits, and warrant speedy action.

� The promised efficiency gains can be achievedonly through meeting the conditions forinteroperability, which begins with technical

compatibility, including communicationprotocols, messaging standards, reference datastandards, and synchronized timing.

When these technical capabilities are available, theway will be clear for full implementation of the re-maining recommendations relating to business prac-tice and process. Yet given the interdependenciesamong recommendations, the lead time required fortheir implementation, and the benefits each offer,there is work to be done in all areas, even if prepara-tory in nature, within the next year.

Many of the 20 detailed recommendations involvemultiple stages: formulation of standards; their wideadoption by providers and users of the clearing and

This is an ambitious

agenda but a sound

one: responsive to

market aspirations for

greater safety and

efficiency, and focused

on practical solutions to

recognized problems.

59


settlement services; and subsequent incorporation, overtime, into revised system designs. This process will in-volve multiple actors: a wide range of trade associa-tions and public bodies to formulate standards, withtheir implementation becoming the primary responsi-bility of boards and management of private institu-tions, with support from prudential supervisors andother regulatory institutions. Furthermore, creating afully interoperable network will require contempora-neous introduction of standards to achieve the desiredresult. Finally, a few areas represent new territory forstandard setting, reflecting the project’s focus on hith-erto neglected cross-border activity.

A five-to-seven-year time horizon is proposed,considering the desire for cost minimization and thesoftware obsolescence cycle. That seems quite a longtime to address important systemic concerns, but itis a very aggressive time frame for achieving the scopeof change contemplated here. Meeting that schedulewill require a prompt start on implementation by thoseresponsible for initiating action in each area, so it isimportant to be clear about the locus of first action.

INITIATING ACTION

Overall, the initiative to build a global network re-sides in the private sector. The key players here willbe boards of securities clearing and settlement ser-vice providers, although it is recognized that in a fewjurisdictions they are publicly owned, and major us-ers of these services in some instances. They are calledupon to take the lead on all recommendations relatedto strengthening network connections and most ofthose concerning risk mitigation. There are also sev-eral specific recommendations related to the compo-sition and focus of boards, but the overarching gov-ernance directive is to put into effect the recommen-dations set out in this report.

In pursuit of these objectives, private boards shouldensure that all new systems development and capitalexpenditures comply with relevant international op-erational and technical standards for interoperability.These systems should also be fully capable of identi-fying, measuring, and controlling the risks faced by theentity, including its counterparty risks. Strategies shouldbe formulated and pursued for avoiding duplicative

capital spending and achieving scale economies andnetwork externalities, with due attention to the risksthat may arise from consolidation. In keeping with therisk mitigation recommendations in the report, an in-dependently prepared report on the financial and op-erational condition of the entity should be made avail-able to users and the market more widely on at least anannual basis. Such a report willenable current and potential us-ers to make considered risk andoperational performance assess-ments of their own.

Because an overarching ob-jective of the recommendationsis to advance current practicetoward best practice, private ini-tiatives should be supportive notonly of sound managementpractices, but of sound publicpolicy as well. That said, nothing in the recommen-dations is intended to limit the public sector’s scopeof action, and interaction between the private sectorand public authorities as standards emerge and evolvewill be necessary. Furthermore, there are areas inwhich action by public authorities is either appropri-ate or required.

One area is removing legal and regulatory barri-ers. Although some barriers can be overcome, at leastin part, by adopting industry conventions or uniformcontractual language, specific legal barriers to entryor access can be overcome only by official action.

There are also a number of areas in which publicauthorities must act, either in concert with the pri-vate sector or actually taking the initiative. One ex-ample is providing consistent regulation to providefair competition and equivalent oversight of differ-ent functions. In the area of competition and marketaccess, the degree of involvement of the public au-thorities is likely to evolve over time, depending onthe private sector’s response to monopoly concernsand the speed and scope of consolidation that oc-curs. Where public authorities determine that mo-nopoly conditions exist and governance arrangementsmake it possible that they will be abused, competi-tion authorities may have to intervene.

Meeting the five- to

seven-year timetable will

require a prompt start on

implementation by those

responsible for initiating

action in each area.

60


The first step required in each area of recommen-dation and the party best suited to take it are closelyinterrelated. Where a recommendation calls for adop-tion of already specified standards (such as messag-ing standards or communication protocols), primaryaction will fall to boards and management of infra-structure providers, intermediaries, and custodians,supported as appropriate by relevant industry orga-nizations and public institutions. Where work is on-going, as is true in many areas of recommendation,

existing organizations should berelied upon to the extent pos-sible to continue their work.Where new standards or ap-proaches must be created (suchas reference data or corporateactions), impetus is likely to berequired first by industry orga-nizations or trade associations inconcert with their members. Fi-nally where recommendationscall for further study of specific

areas (such as systemic operational failure), the im-petus for action will have to come from leading pri-vate firms, with support and participation as appro-priate from the public sector. Table 6-1 identifies firststeps to be taken for all 20 areas of recommenda-tions.

It is also important to remember that the initial fo-cus of attention for the recommendations is limited toa set of advanced economies with significant financialmarkets. As defined in chapter 1, major markets aretaken to include equity and fixed-income securitiesmarkets in the United States, Canada, European Union,Switzerland, Japan, Hong Kong, Singapore, and Aus-tralia. Thus, in the first instance, the focus is on theCCPs, CSDs, other infrastructure providers, and ma-jor intermediaries active in those markets.

MONITORING

Given the complexity and extent of the changes pro-posed and the time required to effect them, the con-tinuing strong support of boards and senior man-agement will be essential, and external monitoring willbe required to name and shame laggards. Followingrelease of its 1989 report, the Group of Thirty spon-sored follow-up review of implementation for sev-eral years. Then national committees, formed by theprivate sector, continued monitoring for several moreyears. There is strong support for a continuing moni-toring role for the Group in this case as well. Accord-ingly, the Steering Committee recommended, and theGroup agreed, to a continuing role.

A review is anticipated within two years of thisreport’s release, in consultation with relevant privateand public parties, with a report six months thereaf-ter. It will address the extent to which relevant par-ties are taking each recommended action, the needfor further action, and analysis of the time frame forthe adoption of emerging standards. Given its mis-sions and resources, the Group of Thirty cannot con-tinue this monitoring role for the long run. Users andproviders of various network functions and the or-ganizations associated with those services are in thebest position to evaluate the factors that govern theirlong-term efficiency and safety. It will be for the par-ties themselves to decide the most appropriate mecha-nism for pursuing the recommendations in the re-port over the contemplated five- to seven-year timehorizon for implementation—and beyond. Whetheran organization should be formed to undertake thisrole across the global clearing and settlement land-scape is a decision that will have to be confronted inthe future.

Overall, the initiative

to build a global

network resides in the

private sector. The key

players here will be

infrastructure providers.

61


TABLE 6-1. IMPLEMENTATION TARGETS FOR THE PRIVATE AND PUBLIC SECTOR

Building a Strengthened, Interoperable Global Network

Recommendation 1

Eliminate paper andautomate communi-cation, data capture,and enrichment.

• For each major market, identifyand publish:• Steps necessary to eliminate the

use of paper securities certifi-cates within a set time frame.

• All regulations or laws that leadto a requirement for physicalpaper, along with proposals foreliminating them.

• Enunciate harmonized legalstandards for recognition ofelectronic documents.

Collective action bycountry/marketthrough formation ofindustry workinggroup in each majormarket.

Collective actioninternationally throughinternational legalworking group.

Consultation withnational regulatorsand legislatorsregarding amend-ments of law andregulation.

Recommendation 2

Harmonize messag-ing standards andcommunicationprotocols.

• Targets for ISO 15022 implementa-tion and migration to an XMLversion already in place andcoordinated through SWIFT.

• Any network provider not alreadyoperating an IP-based network topublish plans to do so within adefined time frame.

Individual actionby boards andmanagement.

Individual actionby boards andmanagement.

Recommendation 3

Develop andimplement referencedata standards.

• Establish detailed objectives andterms of reference for coordinatedand coherent formulation of asset,counterparty, and generic refer-ence data standards.

Collective actioninternationally throughformation of fullyrepresentative,industry-wide workinggroup in each area,drawing on existinginitiatives.

Recommendation 4

Synchronize timingbetween differentclearing and settle-ment systems andassociated paymentand foreign-exchange systems.

• Identify all critical timing interde-pendencies and establish detailedobjectives for synchronizing timing,with terms of reference for carryingwork forward, on a country,regional, and/or global basis, asappropriate, to address respectiveinterdependencies.

Collective actionwithin markets/countries and interna-tionally, includingrepresentatives ofsettlement, payment,and foreign-exchangesystem operators.

Consultation withsupervisors, centralbanks and govern-ment-run systems.

Recommendation 5

Automate andstandardize institu-tional trade matching.

• Publish a working paper onglobally applicable technical andmarket practice standards for tradematching and confirmation,building upon work in the U.S.market by the Securities IndustryAssociation.

Collective actioninternationally throughformation of a globalworking group.

Recommendations Initial Goal Private Sector Public Sector

NEXT STEPS

62


Recommendation 7

Permit securitieslending and borrow-ing to expeditesettlement.

• In each market where securitieslending and borrowing is limited orprohibited:• Identify all regulations, laws, or

market practices that serve asimpediments.

• Propose steps to remove themin a defined time frame,including amendments of lawand regulation, as necessary.

Collective actionby country/marketthrough formationof industry workinggroup to identifyimpediments andpropose specificchanges.

National supervisorsand legislators to setout plan to imple-ment proposedchanges.

Recommendation 8

Automate andstandardize assetservicing processes,including corporateactions, tax reliefarrangements, andrestrictions onforeign ownership.

• Develop and publish plan to enablestandardized, automatic transmis-sion of corporate action informa-tion in ISO 15022 format, in eachmarket within a specified timeframe.

• Establish detailed objectives forharmonization of national taxdocumentation and processes, andset terms of reference and timeframe for action.

• In each market, publish clear ruleson foreign ownership restrictionsand reporting requirements, andmake all relevant information freelyavailable to ensure compliance.

Collective actioninternationally—establish industryworking group.

Collective actioninternationally—form tax processingworking groupincluding industryrepresentatives andtax experts.

Consultation withnational supervisorsand legislators.

Consultation withnational supervisorsoverseers, andlegislators.

Participation ofnational legislatorsand tax authorities.

National supervisorsoverseers, andlegislators to clarifylaw and regulations.

Mitigating Risk

Recommendation 9

Ensure the financialintegrity of providersof clearing andsettlement services.

• Each provider to publish outline ofbusiness model, risk framework,and underlying risk managementprocesses and standards.

Individual action byboards andmanagement.

Enforcement bysupervisors.

Recommendation 10

Reinforce the riskmanagementpractices of users ofC&S service providers.

• All organizations to establishappropriate due diligence and riskmanagement controls.

Individual action byboards andmanagement.


Building a Strengthened, Interoperable Global Network (continued)

Participation inindustry workinggroups by nationalsupervisors.

Recommendation 6

Expand the use ofcentralcounterparties.

• In each market without a CCP,publish a paper for commentsetting out the risks, costs, andbenefits of using a CCP, with apreliminary conclusion andproposed course of action.

Collective action bycountry/marketthrough formationof industry workinggroup.


NEXT STEPS

63


Recommendation 12

Ensure effectivebusiness continuityand disaster recoveryplanning.

• Each provider to publish outline ofbusiness continuity plan, includingthe scenarios considered, testingperformed, and the results of thattesting.

Individual actionby boards andmanagement offinancial intermedi-aries and clearingand settlementservice providers.


Recommendation 13

Address thepossibility of failureof a systemicallyimportant institution.

• Identify systemically importantinstitutions and evaluate how therisk of their extended failure couldbe mitigated.

Cooperation withprivate sector inevaluating alternativeapproaches.

Recommendation 14

Strengthen assess-ment of the enforce-ability of contracts

• All organizations to establishappropriate legal due diligenceand risk management controls.

• Enunciate appropriate standardsof legal due diligence and identifydeficiencies in law that couldpotentially impair contractenforceability.

Individual actionby boards andmanagement offinancial intermedi-aries and clearingand settlementservice providers.

Collective action bycountry/market –form industryworking group.

Monitoring bynational supervisorsand overseers.

Recommendation 15

Advance legalcertainty over rightsto securities, cash, orcollateral.

• Complete agreement on PRIMAin the Hague Convention andembody in national laws.

• Confirm seniority ofaccountholder’s rights overcreditor’s and simplify rulesgoverning pledging and realizationof collateral.

• Providers to specify moment offinality in rules and contracts.

N/A

Individual action byboards andmanagement offinancial intermedi-aries and clearingand settlementservice providers.

Collective action bynational supervisors,overseers, andlegislators.

Collective action bynational supervisors,overseers, andlegislators.

Mitigating Risk (continued)

Recommendation 11

Ensure final, simulta-neous transfer andavailability of assets.

Each provider to publish report covering:

• Nations to sign and ratify the HagueConvention.

• How providers will specify themoment of finality specified in rulesand contracts in plain language.

• Rules for transfer and reuse of cashand securities once finality isachieved.

Individual actionby boards andmanagement ofclearing andsettlement serviceproviders.


Collective action bycountry/market—form industryworking group.


NEXT STEPS

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Recommendation 16

Recognize andsupport improvedvaluation andcloseout nettingarrangements.

• Standard master agreements for allsignificant transaction types shouldembody consistent closeoutnetting and valuation provisions.

Collective actioninternationally—appropriateindustry groupsshould coordinateaction and amendmaster agreements,as indicated.


Improving Governance

Recommendation 17

Ensure appointmentof appropriatelyexperienced andsenior boardmembers.

• Develop guidelines by which toevaluate experience and seniorityof board members.

Individual action byboards andmanagement ofclearing andsettlement serviceproviders.

Review by nationalsupervisors, andoverseers.

Recommendation 18

Promote fair accessto securities clearingand settlementnetworks.

• Providers to publish report onaccess rules, detailing inconsisten-cies with recommendation andspecifying plans for remediationwithin a specified time frame.


Review by nationalsupervisors,overseers andcompetitionauthorities.

Recommendation 19

Ensure equitable andeffective attention tostakeholder interests.

• Providers to publish mechanismdesigned to ensure fair userrepresentation and timetable forimplementation of this mechanismif not already in place


Review by nationalsupervisors,overseers, andcompetitionauthorities.

Recommendation 20

Mitigating Risk (continued)

• Clarify regulatory and oversightresponsibilities for each provider.

• Establish supervisory principlesbased on activity and risk-baseddefinitions and analysis.

Collective action bysupervisors andoverseers.

Encourage consistentregulation andoversight of securi-ties clearing andsettlement serviceproviders.


NEXT STEPS

APPENDIX 1. DETAILED BACKGROUNDON THE RECOMMENDATIONS

APPENDIX 1. CONTENTS

Recommendation 1. Eliminate paper and automate communication,data capture, and enrichment ....................................................................................................................... 67

Recommendation 2. Harmonize messaging standards and communication protocols ...................................... 71

Recommendation 3. Develop and implement reference data standards ........................................................... 74

Recommendation 4. Synchronize timing between different clearing andsettlement systems and associated payment and foreign-exchange systems .............................................. 77

Recommendation 5. Automate and standardize institutional trade matching ................................................... 80

Recommendation 6. Expand the use of central counterparties .......................................................................... 83

Recommendation 7. Permit securities lending and borrowing to expedite settlement ..................................... 85

Recommendation 8. Automate and standardize asset servicing processes, includingcorporate actions, tax relief arrangements, and restrictions on foreign ownership ...................................... 87

Recommendation 9. Ensure the financial integrity of providers of clearingand settlement services ................................................................................................................................91

Recommendation 10. Reinforce the risk management practices of users ofclearing and settlement service providers .................................................................................................... 92

Recommendation 11. Ensure final, simultaneous transfer and availability of assets ........................................ 100

Recommendation 12. Ensure effective business continuity and disaster recovery planning ............................ 103

Recommendation 13. Address the possibility of failure of a systemically important institution ....................... 108

Recommendation 14. Strengthen assessment of the enforceability of contracts ............................................. 109

Recommendation 15. Advance legal certainty over rights to securities, cash, or collateral ............................. 111

Recommendation 16. Recognize and support improved valuation methodologiesand closeout netting arrangements ............................................................................................................ 114

Recommendation 17. Ensure appointment of appropriately experiencedand senior board members .........................................................................................................................119

Recommendation 18. Promote fair access to securities clearing andsettlement networks and services ............................................................................................................... 120

Recommendation 19. Ensure equitable and effective attention to stakeholder interests ................................ 121

Recommendation 20. Encourage consistent regulation and oversightof securities clearing and settlement service providers .............................................................................. 122

APPENDIX 1. DETAILED BACKGROUNDON THE RECOMMENDATIONS

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BUILDING A STRENGTHENED,


RECOMMENDATION 1. ELIMINATE PAPER AND AUTOMATECOMMUNICATION, DATA CAPTURE, AND ENRICHMENT.

Infrastructure providers and relevant public au-thorities should work with issuers and securitiesindustry participants to eliminate the issuance, use,transfer, and retention of paper securities certifi-cates without delay. Such action should be sub-ject to proper investor protection over assets heldin electronic form. There is no greater assuranceof ownership or control from maintaining paper,and it should be possible to overcome the con-trary perceptions of some retail investors througheducation and by ensuring a sound legal basis forall paperless securities in each jurisdiction. De-materialization of securities certificates—convert-ing all paper ownership records into electronic for-mat—is the preferred solution. However, in prac-tice immobilization—where ownership is re-corded through electronic book entry and the un-derlying paper certificate is kept in a central secu-rity depository—realizes many of the benefits ofdematerialization. Therefore, if immobilizationcan be achieved more quickly and efficiently thandematerialization, it is an acceptable step on theway to full dematerialization.

All market participants should seek to automateelements of the process that introduce other forms

of paper, such as confirmations and trade alloca-tions, into the securities processing transaction flowas available technology safely allows, from issuancethrough to asset servicing.1 Means of electroniccapture, storage, and transmission of documentsshould be used to their fullest extent to avoid theneed for physical documents evidencing transac-tional activities and asset ownership.

All market participants should use electronic com-munication to transmit information for all instru-ments and transactions types. Market participantsshould identify opportunities to streamline pro-cesses by avoiding duplicative recording of dataand manual addition of supplementary informa-tion. This recommendation applies to each stageof the value chain, from issuance through to trad-ing, clearing, settlement, and asset servicing, in-cluding confirmations, allocations, and rights anddecisions related to asset ownership. Electroniccommunication and avoidance of repetitive ormanual recording and enrichment of data amongall participants are essential building blocks inachieving a zero-intervention process. Technol-ogy to address these two aspects of processingshould be fully utilized.

COMPARISON WITH CPSS-IOSCO

RECOMMENDATIONS

This recommendation advances aspects of CPSS-IOSCO Recommendations 6 (CSDs), 15 (efficiency),

1. The term “market participants” is used as a collective to include, as relevant, providers of securities clearing and settlementservices, financial intermediaries, end-user issuers and investors, and other organizations that undertake processes related tosecurities transactions

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and 2 (trade confirmations). CPSS-IOSCO Recom-mendation 6 calls for immobilization or dematerial-ization of securities to the greatest extent possible.The G30 recommendation advocates complete de-materialization or immobilization on the basis of theoverwhelming balance of benefits over any respec-tive costs or risks. CPSS-IOSCO Recommendation 2describes the benefits of automating trade confirma-tions. G30 Recommendation 1 goes further to ex-plicitly advocate automation of processes, commu-nications, and data processing to the full extent thatavailable technology allows. It is broader in scope,including all aspects of securities processing for whichpaper can be eliminated or communications and dataprocessing can be automated. CPSS-IOSCO Recom-mendation 15 sets the broad principle that securitiessettlement systems should seek to be cost-effectivewithin the constraint of maintaining safe and secureoperations and notes examples of places where effi-ciencies may be sought. G30 Recommendation 1 (andthe seven that follow) identify specific areas whereefficiency could be improved and set out what shouldbe done to realize cost-saving opportunities.

ISSUE

The use of paper, unautomated communication, andmanual recording and use of data in securities pro-cessing is time-consuming, expensive, and prone toclerical error. In addition, the use of paper certifi-cates and other physical documents within the settle-ment and custody environment gives rise to the riskof forgery, theft, or other misappropriation—risksthat are lessened in a secure, electronic environment.The use of paper causes greater problems wheredocuments are voluminous, not standardized, or dif-ficult to prepare, interpret, or process.

Completion of an otherwise efficient transactionis often hampered by the need for paper documentsto be produced before, after, or alongside executionof an underlying transaction, and exchanged or com-municated manually: by fax, for example. Repetitivedata capture (such as re-keying of already agreed andmatched trade details for clearing and settlement pur-poses) and manual addition of supplementary infor-mation along the process chain (such as the manual

addition of standard settlement instructions to acounterparty reference so that securities can be de-livered to the correct account), often referred to asdata enrichment, also hampers timely, efficient, fault-free, end-to-end completion of a transaction. Theever-increasing focus on the efficiency of processingand avoiding errors challenges the securities industryto work toward the ability to process transactionswithout the need for manual intervention at any pointfrom trade execution to final settlement (often re-ferred to as zero-intervention processing or, more ge-nerically, straight-through processing). With theheightened use of automated trade execution plat-forms by both private and institutional investors, thepressure for straight-through processing is increased.Electronic documentation, automated communica-tion, and automated transfer and enrichment of dataamong all participants to a particular transaction areessential building blocks to achieve this goal.

Despite available electronic alternatives, docu-mentation—such as statements, confirmations, al-locations, issuer information, notification of regis-tration details, and certifications as to domicile andtax status of the investor—often relies on paper cer-tificates. Communication and information exchangebetween issuers and investors is rendered less effi-cient by the use of paper documents. A number ofsecurities markets still transfer funds by check, be itbetween the (retail) investor and the broker-dealer,between market infrastructure providers, or betweendividend/interest disbursing agents and the securi-ties holders of record. The use of checks, like otherpaper documents, hampers efficient final settlementand exposes the parties to the risk of loss, theft, orother misappropriation as well as the risk of belatedreceipt and availability of funds. There is also a risk,particularly as settlement cycles are shortened, thatinsistence on paper for some transactions might leadto differences in settlement periods in markets forpaper and paperless settlement. Such differenceswould harm liquidity and disadvantage the holdersof paper certificates or recipients of checks (mainlythe retail sector). Yet many markets still requirephysical documents preceding or accompanyingan underlying securities transaction or as part of

69

associated tasks such as dividend or interest incomepayments. These include:

� Physical documents used to evidence andtransfer ownership, be they securities certifi-cates, accompanying transfer and assignmentdocuments, or checks.

� The exchange of physical trade confirmationsfor the purpose of matching and allocatingsecurities.

� New issues prospectuses, selling memoranda,corporate actions documentation, and subscrip-tion agreements (the latter in particular formutual fund shares and private placementtransactions).

� Beneficial ownership declarations, notarized taxauthority certifications, and omnibus certifica-tions regarding preferential withholding taxtreatments at source.

Centralized securities depositories (CSDs) have beenestablished in many markets to mitigate the need totransfer or use paper securities certificates, a develop-ment strongly influenced by the 1989 G30 report. Inmany countries, however, some investors still hold re-sidual paper certificates. In other areas, some marketshave made an effort to facilitate the use and exchangeof electronic documents among securities industryintermediaries, but physical documents are often stillprevalent. In addition, the insistence by regulators andother authorities on original, paper documents to sup-port and evidence transactions necessitates a flow ofpaper, even among intermediaries.

The main argument usually advanced in supportof maintaining paper is that some, mainly retail, in-vestors like the apparent assurance and tangible evi-dence of ownership that securities certificates andother physical documents give. However, when se-cure electronic documentation has a sound legal ba-sis, it can provide similar, if not better, levels of as-surance. Public authorities should not underestimatethe capacity and flexibility of retail investors to ac-cept and embrace change, as shown, for example, bythe acceptance by U.S. investors of electronic recordsevidencing holdings in mutual funds and the recent

smooth transition to the use of the Euro rather thannational currencies in many European countries. Thelatter in many ways was a change far more fundamen-tal than switching from paper to electronic records.Educating investors, responding to their concerns,and clearly explaining the benefits of eliminating pa-per, many of which should flow through to investorsin the form of lower transaction and custody charges,should be able to overcome any apprehension.

Electronic, real-time transmission of data from ex-changes or other trading platforms to the subsequentclearing and settlement process must be practicedconsistently; otherwise, parties to the trade have toprovide secondary duplicative input of the same data.The increase in cross-border investment activities andin investor choice between various combinations ofservice providers has resulted in a lack of electroniclinkage among parties involved in the trading, match-ing, and settlement of particular trades. In addition,the necessity for various parties at different stagesalong the value chain to add to transaction data byreference to various information and reference datasources, many of them unautomated, and the heavyuse of fax and other manual means of communica-tion in executing, allocating, and settling trade detailsall contribute to the relatively high failure rates pre-vailing in the cross-border arena.

Markets operating book-entry transfer systemsoften require separate, unautomated communicationof registration information among custodian-agentbanks, CSDs, and the relevant securities transferagents. Issuers and their agents communicate upcom-ing entitlements and distributions through the secu-rities industry in an inconsistent manner and througha variety of communication means, such as publica-tion in newspapers, by electronic communication, orthrough securities data vendor services and stock ex-changes. The reclamation of (parts of) withholdingtaxes levied at source by custodian-agent banks is alsoa manually intensive process, particularly for cross-border investment activities.

HOW RECOMMENDATION 1

ADDRESSES THE ISSUE

Elimination of the issuance, use, and transfer of pa-

Recommendation 1

70


per securities certificates can be achieved throughcomprehensive use of CSDs for all records of own-ership. CSDs operate by one of two main mecha-nisms: dematerialization, whereby all records evidenc-ing ownership are electronic and paper securities cer-tificates are not issued; and immobilization, wherebyownership is recorded through electronic book entrybut with the underlying securities certificates still heldby the CSD in physical form. Dematerialization ofsecurities certificates is considered best practice toachieve fast and efficient clearing, settlement, andasset servicing, and to prevent forgery, theft, or othermisappropriation. Where local law or regulation re-quires physical certificates, moving quickly to dema-terialization may be impractical. In these circum-stances, full immobilization of certificates (preferablyaccompanied by the ability to issue global notes ratherthan definitive certificates) achieves many of the ben-efits of dematerialization and is an acceptable stepon the way to full dematerialization. Partial immobi-lization, whereby most transactions are book entrybut investors can still opt to deposit or withdraw pa-per certificates from CSDs, is not considered suffi-ciently efficient or safe.

Eliminating the use of paper significantly facili-tates automated electronic communication and ex-change of information. Technological developmentsprovide an increasingly secure, stable, and efficientmeans of capturing, storing, and transmitting docu-ments, as well as the ability to exchange informationelectronically in an automated fashion. This technol-ogy presents the opportunity to eliminate paper andmanual forms of communication and thereby cap-tures significant improvements in the speed, effi-ciency, and safety of transaction processing.

WHAT NEEDS TO CHANGE

All paper securities certificates should be dematerial-ized or, if this is impractical in the short to mediumterm, immobilized in CSDs as a matter of priority. Overtime, the law in jurisdictions where immobilization isestablished as an interim step should be changed toallow full-fledged dematerialization of securities cer-tificates. For markets where the benefits of immobili-zation have already been achieved and the barriers to

and costs of change are significant, the step to full de-materialization is of lower priority but should still betargeted as a medium- to long-term objective.

Other opportunities to eliminate paper at eachstage of the securities processing transaction flowshould be taken where the risk and efficiency ben-efits outweigh the costs, which they are already ex-pected to do in most circumstances and will increas-ingly do as the capacity and functionality of technol-ogy develops. In many cases national law or regula-tion requires the use of paper, either through an af-firmative rule or through not recognizing the legalstatus or validity of electronic alternatives and equiva-lents. Again, where law or regulation needs to changeto allow paper to be removed from the process, it isrecognized that progress may necessarily be slower,but the process should nevertheless begin.

To facilitate harmonized standards for cross-bor-der transactions, the recognition of electronic sub-stitutes for paper documents should be coordinatedinternationally between the national securities andcommercial law legislators so that relevant and con-sistent changes can be made to their local laws. Al-though not directly part of the clearing and settle-ment process, many root causes of processing ineffi-ciencies originate “upstream” at the time securitiesare issued. Consideration should be given to standard-izing primary issue prospectuses and sales memorandaas a precondition for enabling electronic filing, dis-semination, and re-use of key data elements for fur-ther processes. As discussed further in the recom-mendation on asset servicing, national tax authori-ties should accept and provide electronic confirma-tions of beneficial ownership and taxpayer status asvalid substitutes for the relevant paper documents.

Electronic and real-time communication amongall parties to trading, clearing, settlement, and assetservices activities needs to be established where it doesnot already exist. Where certain parties (such as end-user investors) are unable to communicate in such away and it is uneconomic for them to invest in equip-ment to do so, processes should be designed to mini-mize the impact of necessary manual processes onother parts of the transaction flow.

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RECOMMENDATION 2. HARMONIZE MESSAGING STANDARDS ANDCOMMUNICATION PROTOCOLS.

All market participants should adopt ISO 15022(the data field dictionary and message cataloguefor securities information flows) as the globalstandard for straight-through securities messag-ing across the entire securities life cycle. Over time,XML (extensible mark-up language) should be-come the language to describe standardized mes-sages. 2 Market participants should follow the roadmap set out by the ISO working group establishedto advance ISO 15022 to a standardized use ofXML. This standard should develop to meet theneeds of all parties to the investment product lifecycle and, in particular, the asset servicing require-ments of the industry. All stakeholders in the se-curities industry should be appropriately repre-sented in the standard development process.

All market participants should support and usecommunication networks that adopt open, stan-dardized, IP-based protocols for securities trans-actions. 3 These standard Internet protocols mustembrace key attributes critical to the sending ofmessages related to securities transactions. Secu-rity, in particular, should be set at a level that sat-isfies business and regulatory requirements andthat meets the needs of all stakeholders in theindustry. Each network provider should clearlydefine and publish its plans to migrate from pro-prietary communication protocols to the open IP-based protocols.


RECOMMENDATIONS

This recommendation endorses CPSS-IOSCO Rec-ommendation 16 (communications procedures andstandards), which advocates the use of relevant in-ternational communications procedures and stan-

dards for the settlement of cross-border transactions.G30 Recommendation 2 is more prescriptive in iden-tifying ISO 15022 and IP (Internet protocol) as therespective current messaging standard and commu-nication protocol that the securities industry shoulduse. It is broader in scope in advocating that thesestandards be used for all transactions and be devel-oped and used to meet participant requirementsthroughout the securities life cycle.

ISSUE

Differences in the manner and form by which elec-tronic messages are sent, and in defining and inter-preting what elements of messages mean, inhibit theability of organizations to automate the exchange anduse of information, both between organizations andwithin a particular organization during the process-ing cycle. Even where paper and manual communi-cation has been eliminated from a transaction flow,lack of messaging standards and communication pro-tocols (broadly speaking, a “dictionary” to harmo-nize the meaning of the content of the message, andan electronic “envelope” to harmonize its sending)can mean that organizations still need to intervenemanually to capture, interpret, or use electronic mes-sages, or at best use middleware to translate betweendifferent formats. This issue is significantly magni-fied for cross-border trading, which require use ofmultiple local networks and multiple intermediaries,all of which need to communicate with each other ina “many-to-many” web of connections.

Historically, ISO 7775 aimed to address at leastpart of this issue by defining standardized securitiesmessages; it was endorsed by the 1989 G30 report.Its usefulness was limited, however, because it didnot cover all message types used by market partici-pants. In addition, it allowed discretion by incorpo-rating optional fields, and varying interpretations ap-

2. ISO, the International Organization for Standardization, is a confederation of national standards institutes that works in part-nership with public and private institutions to develop standards to be used consistently as rules, guidelines, or definitions ofcharacteristics and to ensure that materials, products, processes, and services are fit for their purpose. XML (extensible mark-up language) is the universal language for describing structured documents or data on the Internet.

3. IP (Internet protocol) is a suite of protocols developed for and used by the Internet and by private networks as the open, globalstandard for electronic communication.

Recommendation 2

72


plied by different users of the standard critically com-promised its effectiveness. The market is now mov-ing to adopt ISO 15022, which effectively replacesand builds upon ISO 7775, as the global standard forsecurities messaging. ISO 15022 uses a set of definedexpressions, termed “business elements”, which formthe building blocks of and collectively describe secu-rities messages. A business element is a unique com-ponent of a business process that cannot logically befurther subdivided. Each business element must bedefined in a consistent fashion on a global basis tomaximize the benefit of the new standard. This stan-dard must be developed to meet the needs of all par-ties to the investment product life cycle, especiallythe asset servicing requirements of the industry. Inaddition, data quality and consistent use of standardsmust enable all parties to receive messages and usethe message content through their systems and pro-cesses without the need for intervention.

The road map for the migration to ISO 15022 andits further progression to an XML version and be-yond also needs to be defined clearly. Considerationshould be given to whether all stakeholders in thesecurities industry have the appropriate representa-tion in the process of developing, setting, and imple-menting standards. Consideration must also be givento how to balance the need to move and adapt quicklywith the need to achieve consensus. Clearly, develop-ment of standards should not follow a lowest com-mon denominator approach whereby the whole in-dustry moves at the pace of the slowest to change;neither should a limited number of participants “im-prove” upon the standard at the expense of broad-based and consistent use.

Protocols are needed to set rules that govern theoperation and safety of networks (including thoseused in the financial services sector), how the variousdevices connecting the network join up and interact,and the way that dedicated hardware is required tosend, transmit, and receive messages securely. To date,communication networks used for transmitting se-curities messages have generally been based on pro-prietary protocols and fixed, dedicated hardware. Thedrawback with this type of network is that it is ineffi-cient, because it requires specific and therefore costly

infrastructure and specialized maintenance and sup-port. Users that connect to more than one such net-work suffer the costs of building customized systemsthat enable compliance with multiple protocols toconnect to multiple networks. Innovation is also in-hibited because integration and development of soft-ware requires customized tools.


ADDRESSES THE ISSUE

The adoption of a universal messaging standard en-compassing the entire securities transaction flow willfacilitate zero-intervention processing throughout thesecurities life cycle. This in turn will enable faster andmore accurate confirmation, matching, netting (whereused), and settlement, thereby reducing operationaland counterparty risk. Greater levels of straight-through processing will also sharply reduce industrycosts, given the level of human intervention currentlyrequired in executing electronically delivered instruc-tions in forms that are nonstandardized. ISO 15022aims to enable standardization of all these flowsthrough the following key attributes:

� It is based on a data field dictionary thatprovides definitions allowing common usage ofbusiness elements for all messages.

� It offers flexibility and can thus accommodatein standard form messages that in earlierformats used nonstandard, free-form commentor narrative fields that required receivers toread, interpret, and re-input data.

� It allows any community of users to create itsown series of messages, an attribute that hasadvantages (speed to market without the needto gain universal approval) but also disadvantages(multiple de facto standards for users who mayneed to participate in several such communities).Market participants can determine the appropri-ate balance.

The evolution of ISO 15022 to an XML-basedstandard will further improve message quality, scope,and automation, because the XML-based standard—a cross-industry standard that is not restricted to the

73

securities market—will be wider in scope and usagethan that of the first edition of ISO 15022. The ISO15022 XML toolkit will be freely available to any com-munity of users in the financial industry.

A registration authority appointed by ISO is respon-sible for maintaining the standard and provides a gov-ernance framework. The standards development pro-cess is transparent and based on a publicly availablebusiness modeling methodology. The migration ofprograms to XML can be automated, guaranteeing aconsistent use of XML and a fast delivery of defini-tive standards. The migration to XML standards needsto be scheduled against business demand, especiallywhere existing ISO 15022 messages already accom-modate the relevant business need. Compensating useradvantage (such as a reduction in the amount of inter-vention needed in processing high-volume or high-riskmessage types) should always exceed cost of change,and the process needs to ensure continuity and avoidthe need for costly changes from one standard to an-other unless supported by a sound business case.

The development of the Internet presents the op-portunity to use a common network based on open,widely used protocols, with consequent improve-ments to the ease and cost of connectivity and ac-cess to the network, and elimination of the need tomaintain proprietary, dedicated infrastructure. His-torically, however, the level of security offered bycommunications sent over open networks using stan-dard Internet communication protocols has not beensufficiently secure or confidential to meet the needsof the securities industry.

Internet-based protocols can be used in connec-tion with Public Key Infrastructure (PKI) cryptog-raphy and secure communication layer protocols thatsubstantially address these concerns.4 IP-based net-works also offer security benefits that not all exist-ing proprietary networks have. One such benefit is

nonrepudiation of messages, which ensures that themessage is received from an identifiable and autho-rized source and effectively replaces the need forbilateral key exchange. Critically, IP-based networksfully support XML-based messaging standards. IP,like ISO 7775 and ISO 15022, is an open standardand, by advocating a move to IP-based networks,the recommendation is not advocating any one par-ticular network. Indeed, the appropriate networkmay differ between various types of messages. Forexample, secure Internet messages may be accept-able for lower-value transactions, but the greatersecurity of virtual private networks may be appro-priate for higher-value transactions. Where differ-ent IP-based networks connect, it is critical to en-sure that lower-security users are unable to causecontagion in higher-security networks.


The current processes for setting message standardsare still fragmented, but key groups of market par-ticipants are now working together more closely andhave accepted the need to ensure consistency in stan-dards across the market and through the securitiesvalue chain. These groups include FIX, the standardmost commonly used for securities messages at thepre-trade and trade execution stage of the value chain;SWIFT, the inter-bank communications network andcorresponding standard-setter at the settlement andcustody stage; and ISO, the overarching global stan-dards body.5 The successful, wide adoption of stan-dards by the financial community will depend on thewillingness of these and other market groups to par-ticipate in the process and collaborate to define, imple-ment, and consistently use standards that cover thecomplete securities value chain. This process is al-ready under way, and the following key stages havebeen scheduled:

4. PKI is a generic term for a system that uses digital certificates and authorities that verify and authenticate the validity of partiesto an electronic message or transaction.

5. The Financial Information eXchange (FIX) protocol is a messaging standard maintained by FIX Protocol Ltd., a membershiporganization open to all interested firms and developed specifically for the real-time electronic exchange of securities transac-tions. SWIFT is an industry-owned cooperative organized under Belgian law that supplies secure messaging services to finan-cial institutions active in payments, securities, treasury, and trade services.

Recommendation 2

74


� The securities industry and associated applica-tion vendors have started developing businessapplications that take into account and use thebusiness components that are defined in theISO 15022 data dictionary.

� The official ISO approval process has begun forthe ISO 15022 XML standard. This should leadto an officially approved standard in 2003,following which the current and XML versionsof the ISO 15022 will coexist for a period, withthe non-XML version being discontinued at apoint to be determined by its users.

� SWIFT and FIX have agreed in a Memoran-dum of Understanding to develop and registerall future standards in compliance with the ISO15022 XML standard. This agreement ensuresthat there will be no further divergence orduplication of effort and investment betweenthe securities message standards supported byFIX and by SWIFT. The reach of the ISO15022 XML standard needs to be furtherexpanded throughout the financial industrythrough active cooperation with other organiza-tions in the standards field.

Adoption and use of the standard will be facili-tated by the growing industry trend to discount feesfor messages that do not require manual interven-tion, as opposed to those that require further humaninvolvement before they can be processed, so thatthose not complying will be penalized economically.

Many network providers that have previously usedproprietary protocols are moving to develop IP-basedcommunication networks, such as SWIFTNET, onthe basis that it provides appropriate security as wellas substantial improvements in efficiency, connectiv-ity, and access. These developments should be ad-vanced, with all communication networks significantto the securities industry moving toward commonstandards so that providers and users of the networksbenefit fully from the improvements available. Mar-ket participants should work with network providersto ensure that concerns about security and other criti-cal issues are properly and consistently addressed, forexample, through the establishment of common

security standards. The process of transition will needto be carefully managed, acknowledging the need forusers of the networks to develop their own parallelinternal infrastructure, applications, systems, andhardware to work effectively with the new standards.

RECOMMENDATION 3. DEVELOP AND IMPLEMENT REFERENCEDATA STANDARDS.

Market participants should collectively identify,develop, and adopt universal securities, counter-party, and relevant generic reference data stan-dards that fully meet the needs of all relevant us-ers. Such standards should be adopted in connec-tion with:

� Asset identification and associated descriptivedata, based upon ISO 6166 (concerning In-ternational Securities Identification Number,ISIN).

� Counterparty identification, exact accountidentification, and standard settlement in-structions, based upon ISO 9362 (concern-ing Bank Identifier Code, BIC).

� Relevant generic data categories, such as fee,tax, and commission rates and other, typicallycountry-specific, data (including currencies,local holidays, and time zones).

Standards should be comprehensive, covering theneeds of all users in the securities value chain.They should also be applicable globally. Particu-lar attention is required to address the concernsof jurisdictions where use of such standards isrestricted for reasons of data confidentiality, se-crecy, or other public policy purposes.

Issuers, exchanges, and other originators and dis-tributors of data should make all relevant infor-mation available to the market in compliance withthese standards for a fair price and on a timelybasis. The development of standards is not in it-self sufficient to avoid the very substantial ineffi-ciencies and costs incurred through inaccurate,incomplete, or incompatible data. In addition, itis critical to enhance the substance and contentof the data.

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Extensive work is needed in connection with allthree categories of reference data, and the timeframe for ultimate adoption and use of these stan-dards will vary. As a first step the industry shouldset up working groups (or, where initiatives arealready under way, build upon or combine exist-ing working groups) representative of all partiesto the investment product life cycle to identifythe specific areas where standardization is needed.These industry groups should work with the rel-evant standard-setting bodies and data suppliersto establish a plan designed to achieve identifiedobjectives in connection with these standards.

ISSUE

Reference data plays a critical role in securities clear-ance and settlement. Poor quality, incomplete, incom-patible, or inconsistent data can significantly reducethe efficiency and increase the risk of securities pro-cessing. The vital importance of reference data hasnot always been fully appreciated, and the perhapssurprising complexity of the issues involved, fromboth a technological and an organizational standpoint,has hindered the ability of the financial services in-dustry to implement fully effective reforms. This isan area where substantial potential for improvementremains. Although some progress was made duringthe last decade (such as the introduction of ISIN),the continued absence of comprehensive and widelyadopted reference data standards that meet the needsof all users creates major costs and risks for industryparticipants.

There are two main aspects of reference data: thestandards that describe how data content should bedefined, and the information provided in accordancewith those standards. The lack of comprehensivestandardization has wide-ranging facets and ramifi-cations, including:

� Multiple content standards. The existence ofmultiple standards and sources of data meansthat the same asset (such as a traded instru-ment) or entity is often described in manydifferent ways.

� Lack of specificity. Some data are not specificenough to ensure accurate settlement. Forexample, the BIC is not detailed enough toensure that the funds are transferred to thecorrect branch of a specific bank.

� Incomplete scope. Many existing standards areincomplete and do not fully solve the underlyingproblem. For example, ISIN does not accommo-date the various representations of securities thatcan be used for trading purposes (such as themany symbols that may be used for a globalequity instrument) so that these can be refer-enced to the single settlement representation.

Even where standards such as BIC and ISIN ex-ist, data are not always provided consistently or inaccordance with these standards. The originators anddistributors of data are often inconsistent in how theyprovide data to the various market participants whouse the data in their business processes. It is not al-ways clear who has the responsibility, authority, in-centive, or means to provide complete, accurate, andtimely data. Typically, it is a combination of securi-ties issuers, exchanges, data vendors, and various othertypes of organizations that vary from market to mar-ket. The form of data provided also varies, from pub-lication in newspapers to automated electronic mes-sages. As a consequence of these issues, industry par-ticipants have to employ significant numbers ofpeople to set up, maintain, reconcile, and cleanse ref-erence data. In addition, the lack of quality data cre-ates operational risk and causes significant costs inrelation to correction and reworking of transactions,an increased need for manual intervention in tradeprocessing, and increased settlement failure.

While it is generally acknowledged that the lackof common standards adds cost and risk and that allparticipants spend significant money on “cleaning”the same deficient data, the industry has made onlyvery limited progress in this area over many years.The issues are complex and intractable, and the diffi-culties with moving forward have many root causes.Historically, the effort to eliminate manual interven-tion from trade processing has focused on electronic

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connectivity. It is now becoming recognized that com-plete, accurate, and up-to-date data are similarly criti-cal. The costs involved in bringing about change inrelation to data are perceived to be very high, partlybecause of the diversity and complexity of any dataset that would need to be developed, but also becauseof the substantial additional costs associated withintegrating the standards into each organization’s in-dividual systems.

Obtaining funding within organizations to supportimprovements in reference data is difficult for a num-ber of reasons. Many organizations do not link allthe direct and opportunity costs that arise from poordata (such as losses on corporate actions, settlementfailure, and the need to rework transactions) back totheir underlying cause in a transparent manner, so thebusiness case for change is not clear. Establishing abusiness case is made even more difficult in manyorganizations by lack of clarity over ownership ofand responsibility for reference data. Given that manyissues need to be addressed on an industry-widebasis, the complexities even within individual firmsillustrate the difficulties involved in coordinatingaction across many different parties, including bro-ker-dealers, custodian-agent banks, infrastructure pro-viders, issuers, investors, and data vendors.


ADDRESSES THE ISSUE

Establishing a standardized and comprehensive ref-erence data set across all data classes, one that isadopted by the full range of industry participants,would overcome many of the risks and inefficienciesthat currently exist in connection with the need formanual intervention, failure rates, and reworks. Forthese purposes the term “reference data” is broad andall-encompassing, covering a range of data classes thatare diverse in nature and complexity. Three broadclasses have been identified:

� Asset, including asset identification and descrip-tive data associated with asset identification

� Client/counterparty, including counterpartyidentification, account identification, andsettlement instructions.

� Other, including fee, tax, and commission rates,and generic data that is generally country-specific, such as currencies, local holidays, andtime zones.

Establishing widely adopted reference data stan-dards covering these broad areas will be complex andchallenging. The recommendation therefore seeks toidentify and clarify the process required for achievingthe proposed change and the need for pragmatic firststeps to create initial momentum for moving forward.


Delivering effective and substantial change in thiscomplex area requires a significant shift in behavior,both in individual firms and at the industry-wide level:

� Increased industry participation and leadership inthe development and definition of reference datastandards, including collaboration between, ormerging of, the many existing and fragmentedinitiatives in connection with this subject.

� Harmonization of industry participants’ owninternal reference data sets and of the interfacesthat hand off and receive reference data, bothbetween and within industry participants.

� Changes in the way the industry creates andmaintains reference data.

� Willingness of entities, such as stock exchanges,that own data content or proprietary standardsto participate in change that may affect theirfranchise.

In overview, the process for moving forward re-quires relevant industry participants for each data classor their representative bodies to collaborate with dataproviders and the relevant standard-setting bodies todefine, develop, and implement the appropriate stan-dards. The challenge for the industry is to find theappropriate group for each data class and to estab-lish the necessary leadership and commitment to drivechange and complete the process. Each of the threecategories of data class, and even the subcategoriza-tions within, will require a different combination of

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participants and different leadership. However, mostwill require involvement of representatives of usersand providers of data and of standard setters. It isrecognized that several initiatives are under way, andthis recommendation does not propose to add to thatnumber. Instead, existing initiatives should be com-bined and coordinated as appropriate to achieve co-herent and harmonized progress.

The business case for change should be establishedand confirmed and should include the nature and scaleof the costs and benefits that will flow from stan-dardization and better provision of data. The inclu-sion of all types of organizations that will be affectedwill help build consensus and momentum toward re-alizing change.

Definition, development, and implementation ofthe standards requires that several issues be addressed,including:

� Identification of the data elements required topopulate the standards.

� Analysis and design of the proposed commondata content.

� Mechanisms for building consensus andagreement and for resolving disputes.

� Ownership of the standards and the data.� Implementation plan and timetable.� Process for updating the standards to accom-

modate changes and new elements.� Guidelines for the use of data in a live process-

ing environment (such as timeliness of addingnew data elements into production tradingsystems).

� Enforcement mechanisms.

As noted previously, establishing standards is a nec-essary condition for eliminating the inefficiencies andrisks caused by poor reference data, but it is not initself sufficient. In addition, the originators and dis-tributors of data will need to provide all relevant dataconsistently and comprehensively in a form that com-plies with these standards and in a timely fashion. Suchproviders of data should also follow the relevant stan-dards set out in other, relevant recommendations,

particularly those dealing with messaging standardsand communication protocols. Data provision has anassociated cost, and users of data should expect topay an amount that fairly reflects this cost. Ideally,data providers should comply with this recommen-dation for their own commercial benefit, but in someinstances, particularly where there is only one datasource, regulation or other forms of enforcement maybe needed, for example, to compel issuers to providedata to the market as part of listing requirements.

RECOMMENDATION 4. SYNCHRONIZE TIMING BETWEEN DIFFERENTCLEARING AND SETTLEMENT SYSTEMS AND ASSOCIATEDPAYMENT AND FOREIGN-EXCHANGE SYSTEMS.

Providers of clearing and settlement services andlinked or otherwise associated payment and foreign-exchange systems should collectively ensure thattheir design, procedures, operational timetables,and funding and cutoff times are such that theoperation of one system does not materially re-duce the efficiency or increase the risk of settle-ment in another. These organizations should col-laborate to identify the specific areas where stan-dardization is needed and to develop detailedplans to achieve it. Standardization should beimplemented initially on a regional basis (broadlybased on the Americas, Europe, and Asia-Pacific).Cross–time zone protocols should be establishedsubsequently. Systems should allow transfers toand from securities settlement systems to be madein a timely manner. Periods of peak cash demandin separate systems should be carefully managedso that they do not clash with one another.

Market participants should work together to de-velop a comprehensive action plan to increase theefficiency and safety of cross-border securitiestransactions where the foreign-exchange settle-ment cycle is not synchronized with the securi-ties settlement cycle. As yet, no fully developedsolutions systematically address the costs and risksarising from the mismatch between securities andforeign-exchange settlement cycles in these cir-cumstances. This issue will increase in importanceas securities settlement cycles are shortened.

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RECOMMENDATIONS

This recommendation advances aspects of CPSS-IOSCO Recommendation 3 (settlement cycles),which calls for the benefits, costs, and risks of shortersettlement cycles to be assessed while retaining T+3settlement as a minimum standard; and Recommen-dation 19 (risks in cross-border links), which calls forassessment and mitigation of the risks associated withcross-border links between settlement systems. G30Recommendation 4 is broader in scope in identifyingthe critical interdependencies between linked settle-ment, foreign exchange, and payment systems and ismore assertive in describing the proactive steps thatthe industry should take to identify, evaluate, andmitigate associated risks and inefficiencies.

ISSUE

Where connections and interactions exist betweenclearing and settlement organizations and associatedpayment and foreign-exchange systems, differencesin opening hours and in funding and instruction cut-off times can lead to administrative difficulties andrisk for participants.

For transactions involving more than one securi-ties settlement location, the risks to participants re-sult largely from being unable to settle back-to-backtrades as a result of failure to receive from or inabil-ity to deliver to another settlement organization. Theparticipant is then left with an overnight fail, with theassociated funding cost and replacement risk. Wherethis failure arises from differences in public holidays,this risk may be extended over three days or more.As the market moves toward increased connectivityand interoperability, giving participants a greaterchoice of clearinghouse and settlement location, tim-ing differences may also create risk management prob-lems for the service providers.

In current market conditions, interaction betweenproviders of clearing and settlement services isgenerally relatively limited. However, interaction canbe a significant issue where liquidity is split betweenorganizations and a sizable transaction flow betweenthem results, for example, across the Euroclear/Clearstream bridge. As such practices as dual listing

and competition between trading spaces make splitpools of liquidity more commonplace, the need forharmonization between clearing and settlement pro-viders will increase. Even though such organizationsmay be open at the same time, if funding between themis unavailable, participants will still be unable to settle.

Payment systems are used to facilitate the transferof money between banks. A payment system con-sists of the network that links member banks, switchesfor routing messages, and rules and procedures gov-erning the use of the system. In the context of secu-rities settlement, the exchange of money can be in-ternalized (for example, where a CSD is organized asa limited-purpose bank) or externalized (where mul-tiple settlement banks compete to provide paymentservices to participants of a CSD and use a separatepayment system to effect funds transfers). Becausepayments are an integral part of the securities settle-ment process, it follows that a critical interdependenceexists between payment and securities settlement sys-tems. This is true even in the case of internalizedsettlement, because external payment systems are usedto fund settlement accounts.

In recent years the number of links between pay-ment and settlement systems (both at the domesticand international level) has increased to facilitatecross-border settlement, delivery versus payment, andpayment versus payment. Those initiatives havebrought benefits ranging from opening up marketsto new investors to reducing settlement risk. How-ever, when these initiatives are coupled with the emer-gence of time-critical payments and securities settle-ments, interdependencies are created that need to beinvestigated further from a systemic viewpoint.

Because central bank money is frequently thesettlement asset for payments between commercialbanks, demand for cash liquidity that underpins thosetransfers is increasing. This demand means that settle-ment banks hold many different pots of cash liquid-ity around the globe to meet the peak demand in eachunderlying system at any given time on any given day,and further increases in demand will require settle-ment banks to hold higher and higher levels of eli-gible collateral (the assets required to source centralbank money, primarily government debt) purely to

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support and maintain efficient levels of settlement.Fragmentation of cash liquidity between differentsystems is inefficient.

The operating hours of payment and securitiessettlement systems need to allow the timely and au-tomated funding of settlement accounts. The designof securities settlement systems will dictate theamount of money needed to effect settlement, whichin turn could adversely affect the efficiency of pay-ments markets, and vice versa. As a matter of prin-ciple, the design of payment and securities settlementsystems should ensure that both are able to operateefficiently.

Cross-currency trades introduce the need for aforeign-exchange transaction to provide the paymentleg of the securities transaction in the appropriate cur-rency. This creates one or more additional links inthe chain of organizations that need to interact in acoordinated manner. It also requires coherent settle-ment cycles for securities and foreign-exchange trans-actions. Further, certain market practices, such asfunding several securities transactions with one“block” foreign-exchange trade, often lead to the needfor additional manual intervention, such as the sub-sequent allocation of those block trades across theseveral underlying securities transactions.

Currently, the typical foreign-exchange transactionsettles two days after the trade date (T+2). Wheresecurities settle on a T+3 basis (the normal cycle formost equities and corporate bonds), there is clearlyno obvious problem in completing the associatedforeign-exchange trade so that the respective settle-ments coincide. As the securities industry considersfurther reducing settlement cycles, however, propercoordination with the foreign-exchange markets isimperative. Otherwise, participants in cross-bordersecurities trades will suffer increased cost or risk, orboth. In some cases, they may be able to opt for anonstandard foreign-exchange settlement, but thismethod is more expensive. Alternatively, the timingdifference may result in additional funding costs and/or exposure to market risk on the mismatched cur-rency amounts. These issues already exist in someareas where securities settlement systems operate ona T+1 basis, particularly government bond markets.

However, workarounds are available, and althoughthese increase cost and risk and so likely restrict thescale of cross-border activity in these markets, theyhave not yet done so on a scale sufficient to cause themarket to seek and fully evaluate alternatives.


ADDRESSES THE ISSUE

The objectives of the recommendation are to ensurethat:

� The opening hours and funding deadlinesbetween organizations providing clearing andsettlement and associated services, includingconnected payment and foreign-exchangesystems, are properly sequenced.

� The design of payment and securities settle-ment systems enables the systems as a whole tooperate efficiently.

� Movement toward a shortened securitiessettlement cycle recognizes the dependency ofa contemporaneous reduction in the settlementcycle of the spot foreign-exchange market.

The issues involved are extremely complex froma technical viewpoint, and proper analysis also re-quires the involvement of a significant number ofinstitutions drawn from both the public and privatesectors. A holistic approach is critical to ensure thesynchronized and coherent working of payment, se-curities, and foreign-exchange settlement systems sothat all can be effected efficiently from an economi-cally viable supply of cash liquidity.

The recommendation focuses on the need for col-laboration between providers of all types of settle-ment and payment services to ensure that dependen-cies between such systems are understood and thatprocesses and operations develop to allow synchro-nization between interdependent activities. This isclearly the right approach at a general level, butbeyond setting out principles and high-level guidance,the recommendation does not attempt to prescribe aspecific set of answers in an area where highly com-plex and many-faceted issues are apparent but notyet fully understood and where potential solutions

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need to be properly tested and thought through.Rather, it advocates that the above-mentioned orga-nizations undertake further research and investiga-tion and remain mindful of the need to consider thesefactors fully in any future development plans.


Significant work and study are required to analyze fullythe risks and costs involved. Although many of theprinciples and issues are common across all jurisdic-tions, workable solutions in the short to medium termare likely to be much more practical if regionallybased. As a subsequent medium- to long-term objec-tive, cross-regional protocols should also be estab-lished. As functionality is developed, operators ofpayment, foreign-exchange, and securities clearing andsettlement systems should collaborate to ensure thattheir design, working practices, and operational time-tables are such that:

� The operation of one system does not materi-ally reduce the efficiency of settlement inanother.

� Individual funding deadlines recognize theinteraction with other settlement and paymentsystems and banking hours.

� Transfers to and from securities settlementsystems can be made in a timely manner.

� Deadlines, timings, and operational cycles aredesigned to manage periods of peak cashdemand in each system in a coordinated manner.

� Effective contingency arrangements are inplace, particularly to ensure that an outage ofone system has a minimal disruptive effect onthe others.

� All systems follow recognized and agreedmessaging, communication, and data standardsto allow efficient information flow without theneed for manual intervention.

Such considerations should encompass the effectsof interdependencies on both the service providersand their users.

RECOMMENDATION 5. AUTOMATE AND STANDARDIZEINSTITUTIONAL TRADE MATCHING.

Market participants should collectively developand use fully compatible and industry-acceptedtechnical and market-practice standards for theautomated confirmation and agreement of insti-tutional trade details on the day of the trade. Theestablishment and use of the matching utilitiescurrently being developed and put into operationis an important part of this process, althoughmany of the potential efficiency gains that theyoffer will not be realized without interoperabilityamong separate systems. If the number of orga-nizations providing these services grows, the in-efficiencies that fragmentation and lack of stan-dardization can create will increase.


RECOMMENDATIONS

This recommendation endorses and builds uponCPSS-IOSCO Recommendation 2 (trade confirma-tion), which describes the benefits of automatingtrade confirmations. G30 Recommendation 5 goesfurther to emphasize the need for agreed and com-monly used standards, as well as for automation ofprocesses as critical components of an efficient andrisk-reducing, industry-wide solution.

ISSUE

Continued expansion of institutional trading com-bined with an increasing focus on the efficiency ofpost-trade processing makes it imperative to improveand harmonize the current post-trade confirmationand matching model for institutional trades to makeit more robust, efficient, and scalable. Even thoughsome parts of the process are already highly auto-mated, the process as a whole is not seamless, butreplete with potential bottlenecks, the need for manualintervention, and opportunities for trade failure. With-out improvements, the process will come underincreasing strain, with high error rates, increased num-bers of exceptions, excessive trade failures, a higherdegree of operational risk, and higher operationalcost. Nor will it be possible to reach the goal of match-

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ing all institutional trades on the day that the trade isexecuted, which in itself is an important element inreducing risk. These issues are most prevalent in thecross-border environment, but even efficient domes-tic markets will be increasingly affected. Already, forexample, rising volumes have made the daily numberof unaffirmed trades unacceptably high in severalmarkets.

Few standards facilitate a consistent and efficientprocess for institutional trade confirmation andmatching. Without standards that are accepted andwidely practiced throughout the entire post-tradeprocess, further automation of disparate procedureswill not produce the required efficiencies or properlymitigate risk. The current post-trade processing modelis characterized by the following features:6

� Sequential and reactive process. Currently,trades are processed sequentially, with only oneparticipant reviewing and enriching trade data ata time. This practice creates a “windshieldwiper” effect, where the trade swings back andforth between the investment manager, broker-dealer, and other relevant parties, and data isenriched incrementally with each pass. Theprocess is also reactive, as participants wait for a“trigger” before executing the next step in theprocess, causing processing delays and redun-dant flows of nonessential data.

� Lack of participant automation. Lack ofinternal automation on behalf of participants isalso responsible for inefficiencies in the currentprocess. Specifically, trade data are oftenmanually re-keyed into several systems, custodi-ans’ credit and position checks may be manual,and affirmations may be manually reviewed, allleading to an increased chance of error. Manualintervention is necessitated by participants’ useof internally developed proprietary systems orvendor systems that fail to adhere to a commonstandard through the life cycle of a trade.

Furthermore, trade information is often passedbetween parties via phone or fax, again callingfor manual input on the receiver’s end. Forexample, approximately one-third of allallocations are manually or verbally transmitted,resulting in delayed affirmation and greaterpotential for trade failure.

� Lack of standards. Currently, universal usageof messaging standards or protocols is lackingacross the industry, an aspect specificallyaddressed by the relevant recommendation inconnection with the entire processing chain. Inaddition, no codes of practice for settlingtransactions have been universally accepted. Forexample, settlement differences are not cur-rently resolved by agreed-upon tolerance levels,resulting in higher levels of trade “don’t knows”and resubmissions.

� Inefficient use of data.The current processrequires the manual enrichment of missing datafields and standing settlement instructionsthroughout the process, leading to errors andunmatched trades. Where automation isavailable, the potential for discrepanciesbetween systems exists because data on thesystems have not been synchronized, a situationthat also often results in unmatched trades andissues requiring resolution.

Additionally, the current process demands thatall transaction data be included in each step of thetransaction process, as opposed to isolating spe-cific data elements that are required for each par-ticular step. This inclusion requirement slows downtrade processing significantly, particularly in thosecases where trade data are manually entered alongthe cycle.

To tackle these issues and so enable efficient andtimely trade confirmation and matching, commonstandards and practices for trade processing must bedeveloped. Many of these issues are addressed, at least

6. As described by the February 2002 white paper on the Institutional Transaction Processing Model put out by the InstitutionalTrade Processing Committee of the Securities Industry Association. Although written from a U.S. market perspective, thewhite paper identifies issues common to almost all markets.

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in part, by other recommendations in this report.However, the other recommendations do not gener-ally deal with the market practices and ways of work-ing particular to trade confirmation and matching. Thesecurities industry, notably in the United States, butalso increasingly in other markets, has recently focusedon the establishment and use of matching utilities, asa key mechanism for creating and using standardizedand efficient market practices.

Matching utilities are technology platforms thataim to provide an environment of multilateralinterconnectivity for post-trade and presettlementactivities (including trade matching and trade dataenrichment) among investment managers, broker-dealers, custodians, and infrastructure providers. Thematching utilities are expected to use and complywith industry-accepted messaging, communication,and data standards as set out elsewhere in this re-port. By establishing and using common practices,matching utilities should increase efficiency and re-duce risk.

Several issues need to be addressed, however. Thecost of implementation and use is a barrier, espe-cially for investment managers, in particular thosethat are not fully automated. Many may not havethe resources to build platforms for matching util-ity usage or recognize the business benefits. Con-versely, investment managers that are more techno-logically sophisticated may have already invested ininfrastructure to eliminate the need for manual in-tervention in most trades and so be reluctant to in-vest further to gain what may be perceived as onlymarginal additional benefits.

The presence of multiple matching utility vendors,established either as industry-owned utilities or for-profit organizations, has introduced several issues.Currently, investment managers and smaller broker-dealers are undecided about which to choose, withno organization wanting to choose the matching util-ity that becomes the one least used. A single match-ing utility also raises important and adverse conse-quences, both in terms of the subsequent lack ofcompetition, and the concentration of risk and reli-ance on one organization that could become a singlepoint of failure for the industry. The industry needs

to accept that multiple utilities will be used and turnits attention to mitigating the loss of efficiency thatcould potentially result.


ADDRESSES THE ISSUE

The recommendation focuses on the need to automateinstitutional trade matching through establishing fullycompatible and industry-accepted technical and marketpractice standards. The recommendation also recognizesthat with more than one matching utility operating,interoperability is required to ensure that the concernsof users about connectivity costs and the choice of whichmatching utility to use are addressed. Interoperabilityaddresses many of the issues that users face. For ex-ample, by connecting to one matching utility, organiza-tions would be able to match trades with users of oth-ers. Users of one matching utility would also be able,with only marginal additional cost and effort, to con-nect to another, interoperable matching utility. Creat-ing interoperability requires standardization of practicesin many areas, some of which form part of other G30recommendations. These areas include:

� Commercial considerations, such as how accessor trade match fees, or both, are allocated whenmore than one matching utility provides servicesto a trade.

� Consideration of economic or other enforce-ment mechanisms required to ensure fullimplementation and use of standards acrossparticipants in all key markets.

� Standardization of liability across multipleproviders.

� Matching criteria and standards, includingtolerance for small differences.

� Communication protocols and messagingstandards.

� Reference data standards.� Operational timetables and timing of processing.� Operating model, procedural flow, and se-

quencing of different elements of the process.

While matching utilities in themselves will be key

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tools in the quest for efficiency and reduced risk, with-out an environment where the trade matching behav-ior of all its participants is conducted to specific andagreed standards, they will not be fully effective. Thegoal is real-time institutional trade matching, andinteroperable matching utilities are a necessary, butin themselves an insufficient, part of a solution toachieve this goal.


Market participants and infrastructure providersshould collaborate to develop relevant technical andmarket practice standards for trade matching andconfirmation, some of which are expanded upon inother recommendations. The Security IndustryAssociation’s paper on the Institutional TransactionsProcessing Model for the U.S. market is an effectivebase from which to develop a methodology that ad-dresses the needs of other domestic markets and,importantly, cross-border transactions.

Standardization of matching processes, includingthe use of matching utilities, is a global cross-marketand cross-border issue. Indeed, the issue also affectsproducts other than securities; for example, deriva-tives transactions could achieve greatly enhanced ef-ficiency and reduced risk with better and standard-ized matching processes. A universally accepted andwidely applicable model is clearly desirable, but it willtake longer to implement and be more costly toachieve, as harmonization and consensus will beneeded across a greater range of existing practicesand market participants. If improvements can bemade in individual markets more quickly, these shouldnot be delayed, as long as they are compatible withthe long-term objective of a consistent and fully com-patible global model.

Commitment to participate in matching utility de-velopment and use is needed from all market partici-pants and types of organizations. With the adoptionof standards for matching, complete interoperabilitybetween matching utilities needs to be achieved tomaximize the potential efficiency gains and to encour-age adoption and use, particularly on the “buy” sidewhere otherwise there will be continued reluctance touse a matching utility whose model may in time be-

come redundant or not provide access to a full rangeof other market participants. The development of“concentrators” as providers of access to multiplematching utilities through a single interface, either in-dependently or as part of the service offering of glo-bal custodians, is an alternative to full matching utilityconnectivity that may provide an effective and prag-matic interim solution. Adding another intermediarylayer may not be as efficient as achieving fullinteroperability between matching utilities, but thevalue-added services that concentrators could providemay be an added incentive for broader and faster par-ticipation in the use of matching utilities.

Improvements to efficiency and risk will be sig-nificantly greater where there is full implementationand use of standards across the industry. Certain typesof organization may not perceive benefit for them-selves in moving toward standardized practices thatbenefit efficiency and reduce risk for the market as awhole; incentive structures therefore need to be es-tablished to ensure broad participation. Preferablyeconomic incentives will prove sufficient. An examplewould be differential pricing that reflects the addi-tional costs incurred when standardized, automatedpractices are not followed. But if by not adhering toparticular standards certain market participants cre-ate substantial risk or inefficiencies for the market asa whole, then supervisory enforcement of those stan-dards may need to be considered.

RECOMMENDATION 6. EXPAND THE USE OF CENTRALCOUNTERPARTIES.

Market participants and relevant public institu-tions should collaborate to assess the potentiallysubstantial risk reduction and efficiency improve-ments of using a central counterparty. These ben-efits are expected to outweigh their costs in mostmarkets. Where this is so, market participantsshould seek either to use the services of an exist-ing central counterparty or establish one of theirown, whichever has the better risk, cost, and ben-efit profile. If more than one organization under-takes this function in a particular market or mar-kets, each should follow harmonized and rigor-ous operational practices and standards, includ-

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ing those set out elsewhere in this report, so as tobe fully interoperable, and each should follow con-sistent risk management practices as set out inRecommendation 9.


RECOMMENDATIONS

This recommendation endorses CPSS-IOSCO Rec-ommendation 4 (central counterparties), which pro-motes the assessment of the benefits and costs ofCCPs and asserts the need for CCPs to have rigor-ous risk control. G30 Recommendation 6 is moreemphatic, taking the view that CCPs are strongly ex-pected to bring substantial benefits to most markets.The G30 recommendation also emphasizes the needfor harmonized practices and standards and explic-itly encourages the evaluation of using the servicesof an existing CCP as an alternative to building a newsystem. The need for rigorous control of risk notedin the CSPP-IOSCO recommendation is addressedseparately in G30 Recommendation 9: Ensure the fi-nancial integrity of providers of clearing and settle-ment services.

ISSUE

As described in the risk chapter and associated rec-ommendations, organizations undertaking securitiestransactions are exposed to counterparty risk and, asa consequence, put in place risk mitigation processesand controls. Such risk control practices have associ-ated costs, including the costs of operating the pro-cesses and controls and the opportunity cost of col-lateral and margin that may need to be put up. Thehigher the risk and the more counterparties that anorganization has exposure to, the greater these costs.

The need to perform due diligence over each newcounterparty that an organization wishes to do busi-ness with may also delay the speed at which tradescan be executed, as it is clearly undesirable to enter acontractual arrangement before satisfactory due dili-gence has been completed, and this can take time.

Furthermore, where trading mechanisms are used thatprovide anonymity to buyers and sellers, it may be im-possible to determine in advance whether thecounterparty to a trade is one that an organizationwould wish to do business with, or could have excessivecredit exposure to as a result of that trade. In addi-tion, a series of bilateral relationships between dif-ferent counterparties can result in a very significantnumber of settlement transactions, even where net-ting arrangements are applied between each pair.


ADDRESSES THE ISSUE

Central counterparties (CCPs) interpose themselvesbetween the parties to each transaction and therebybecome the buyer to every seller and the seller to everybuyer.7 Through this mechanism the number of rela-tionships is greatly reduced, as each participant thenhas commitments with the CCP, rather than with themany other users of the CCP that it originally dealtwith. An organization can therefore deal with anycounterparty that it knows is eligible to use a CCP with-out the need for extensive due diligence because itknows its contractual relationship and risk exposurewill be to the CCP. The due diligence of thecounterparty will, instead, have been undertaken by theCCP itself, as expanded upon in the recommendationon financial integrity. Similarly, risk mitigation controlssuch as requesting collateral or margin payments areundertaken between the CCP and each market partici-pant, rather than between each combination of sepa-rate market participants. This is plainly more efficient.

Most CCPs use netting, the contractual offsettingof positions or obligations, to further reducecounterparty risk with each user. This multilateralnetting between all market participants that use theCCP is far more effective than bilateral netting at re-ducing both risk exposures and the number of trans-fers of securities and cash subsequently needed toeffect settlement.

CCPs also have a positive role to play in enabling

7. CCPs are generally used only by direct market participants who act as principals to a transaction (such as broker-dealers). Typically,end-user investors are not users of a CCP’s services, mainly because they operate on a nonprincipal basis across multiple funds andcannot aggregate their transactions under netting arrangements that are generally core to a CCP’s operations.

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connectivity through compliance with industry-widestandards. As a critical part of the market infrastruc-ture, CCPs can significantly influence the adoptionand consistent use of standards by their users, as eachof those users can be more certain that their ownprocessing efficiency will be increased by using stan-dards that the CCP itself uses.

Against these benefits the concentration of risk ina single entity needs to be considered. The concentra-tion of risk is as much operational as it is financial, andindeed the ability to withstand financial shocks throughdefault of one or more users is almost certainly easierto plan for and manage than the risk of a significantoperational shock. These issues are discussed more fullyin chapter 4 and the risk management recommenda-tions that outline the key techniques and practices thatshould be used by CCPs to manage and mitigate risk.In addition, the development and maintenance of aCCP clearly has an investment and day-to-day runningcost that market participants collectively will need tobear and to weigh in determining the overall net ben-efits that may accrue.


The risk reduction and efficiency improvements ofusing a CCP are expected to outweigh their costs inmost markets, particularly in all high-volume, devel-oped markets. Over time CCPs may come to beviewed as an expected part of the market infrastruc-ture in almost all markets, much as CSDs have be-come over the past decade.

In markets that currently operate without a CCP,market participants and relevant public authoritiesshould collaborate to assess the benefits and costs ofestablishing and using such an organization. Where asound business case is established, there are broadlytwo alternatives:

� Build and operate a new CCP.� Use the services of a CCP already established in

another center or for another trading market.

Although to date most markets that have decidedto use a CCP have opted for the former option, thelatter should not be dismissed, particularly for smaller

markets or where a CCP is already used for otherproducts, such as exchange-traded or over-the-counter derivatives. Although added concentration ofrisk may result, it can be appropriately managed andin many cases will be outweighed by the economy ofscale benefits that can be gained from use of an ex-isting CCP. The cost of adapting and increasing thecapacity of an existing CCP is likely to be consider-ably lower than the costs of building a new CCP fromscratch. In addition, the operating costs of the oneCCP can then be spread over a greater volume oftransactions, with a consequently lower unit cost.Specific concerns need to be addressed in connec-tion with legal and regulatory jurisdiction, risk man-agement, liquidity and acceptability of collateral, ac-cess, and the connection of the CCP to the existingmarket infrastructure. These concerns are importantbut in many cases would be substantially mitigatedwhere the other recommendations in this report havebeen implemented. These are not straightforward is-sues and should be fully evaluated as part of eachmarket’s assessment. Where developing a new CCPis determined to be the best solution, it should bedesigned to comply fully with all relevant internationaltechnical, risk, and market practice standards.

In many markets, the costs and benefits of a CCPmay not be equally or proportionately shared betweendifferent market participants. Generally, large, activeparticipants will have most to gain from use of a CCP,because they deal with the most counterparties andhave a greater volume of trades in each security thatcan be netted. Business cases should carefully considerhow the costs of development and use of a CCP shouldbe allocated to ensure an equitable outcome for allmarket participants and thereby encourage broad sup-port and participation, for example, through pricingof services based on ad valorem or user-pays principles.

RECOMMENDATION 7. PERMIT SECURITIES LENDING ANDBORROWING TO EXPEDITE SETTLEMENT.

Relevant authorities should permit securities lend-ing and borrowing as a method for expediting thesettlement of securities transactions. Each mar-ket should provide tax, legal, regulatory, and ac-counting frameworks to allow the use of stock lend-

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ing and borrowing to prevent settlement failures.CSDs or other infrastructure providers, while notnecessarily acting as principal to the transaction,should seek to develop functionality to allow stocklending and borrowing to be conducted efficientlyby intermediaries and other users. This recommen-dation does not seek to eliminate restrictions inindividual jurisdictions that prohibit stock lendingand borrowing undertaken for reasons other thanexpediting settlement, such as transactions that fa-cilitate short-selling.


RECOMMENDATIONS

This recommendation endorses CPSS-IOSCO Rec-ommendation 5 (securities lending), which encour-ages the use of securities lending and borrowing as amethod for expediting settlement and the removalof barriers that prevent this use. G30 Recommenda-tion 7 reiterates the need to remove such barriers andidentifies the actions that public authorities shouldtake to create a framework that permits securities lend-ing. It takes the view that it is then a commercial mat-ter for relevant market participants to encouragebroad involvement in such activity.

ISSUE

A significant contributor to the incidence and frequencyof failed settlement is the lack of available securities tomeet a seller’s settlement obligations. In these circum-stances, settlement efficiency is greatly increased if theseller is allowed to borrow temporarily the relevantsecurities from another party to fulfill delivery for settle-ment. The lender is usually an institutional investor thathas securities holdings and, by lending them for a fee,increases the return on those securities; the borrowerprovides sufficient collateral to mitigate the credit riskof the lender. Such transactions are typically facilitatedand processed by the providers of the settlement in-frastructure, such as CSDs, and intermediaries such ascustodian banks, but these institutions are not neces-sarily principal to the transaction.

The recommendation that securities lending andborrowing be encouraged to facilitate timely and ef-ficient settlements was first set forth in the 1989 G30

recommendations and has been reiterated and ex-panded since then, most recently in the report issuedin November 2001 by the Committee on Paymentsand Settlement Systems of the Group of Ten centralbanks (CPSS) and the International Organization ofSecurities Commissions (IOSCO).

Over the past decade significant efforts have beenmade to develop and refine the operational, legal, tax,and accounting aspects of global securities lending,particularly in those markets that had some infrastruc-ture in place before 1990. Indeed, in those countriessecurities lending has become a substantial factor notonly in reducing failed settlements, but in supportingthe more complex hedging, trading, and derivativestructures that have become elements of mature mar-kets worldwide. However, in several countries littleprogress has been made in developing viable securi-ties lending structures accessible to both onshore andoffshore participants. This lack of progress contin-ues to impede settlement efficiency in both local andcross-border environments.

While a number of countries continue to ban se-curities lending outright, other countries have onlypartially developed the requisite legal, tax, and regu-latory framework to permit effective lending. Themost common impediments include uncertaintiesabout transaction definition and tax, regulatory, oraccounting treatment; limitations on the securitieseligible for lending; restrictions that limit eligiblemarket participants; and onerous buy-in requirements.


ADDRESSES THE ISSUE

Establishing a supporting framework and environ-ment that permits securities lending and borrowingas a method for expediting the settlement of secu-rities transactions will increase settlement efficiency.G30 Recommendation 7 endorses the 2001 CPSS-IOSCO recommendation encouraging the use of se-curities lending and borrowing as a method for ex-pediting the settlement of securities transactions.Barriers that inhibit the practice of lending for thispurpose should be removed. By providing the mini-mum tax, legal, regulatory, and accounting elementsto support the utilization of stock lending and bor-

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rowing, markets can substantially reduce settlementfailures. Furthermore, CSDs and other providers ofsecurities clearing and settlement services shouldseek to develop functionality to allow stock lendingand borrowing to be conducted efficiently. In manycases the business model, risk framework, and capi-tal of organizations such as CSDs will make it inap-propriate for them to act as principal to securitieslending and borrowing transactions, but that shouldnot prevent them from developing functionality thatcan be used by intermediaries and other users whoare able to act as principal.

As noted above, securities lending and borrowingis an integral part of the overall trading environmentin most mature markets and supports many complextransactions unrelated to expediting settlement. It isrecognized that in some markets such activity is con-sidered undesirable for various public policy reasons,such as discouraging short-selling. This recommenda-tion does not seek to debate whether such public policyobjectives are desirable or soundly based but is con-cerned only with settlement efficiency. Accordingly, itdoes not in any way advocate that securities lendingand borrowing should be permitted for purposes otherthan expediting settlement of securities transactions.


Taxation. Lending transactions are not sales andshould not be considered as such. Consequently,lending transactions should not have capital gain orloss implications for taxation purposes. Further,rebates paid to cross-border and domestic borrowersshould not be subject to withholding taxes. Taximplications of payments in lieu of dividends made tolenders should be clarified. Stamp and equivalentduties should be waived. The treatment of securitieslending transactions should be explicitly stated toeliminate any uncertainty related to their treatment.

Accounting. Lending transactions (both the transferof the security to the borrower and the receipt ofassociated collateral) should not be considered salesfor accounting purposes. Treating such transactions as

sales would be contrary to the underlying economicimpact and substance.

Legal/bankruptcy. Law should support theenforceability of the terms of a securities lendingagreement, and such agreements should be stan-dardized among market participants. The legal riskrecommendations apply to securities lendingtransactions and discuss further the key legal risksand recommended actions.

Securities lending support by infrastructure

providers. CSDs, CCPs, and other infrastructureproviders should develop functionality and servicesthat support efficient lending and borrowing,whether it be provided directly by themselves asprincipal, by intermediaries, custodians, other marketparticipants, or a combination thereof. Such func-tionality should support both passive transactions(whereby securities are automatically borrowed whena settlement failure would otherwise occur) andborrowing on demand (whereby participants activelymanage their securities positions and decide when itis necessary to borrow).

This framework creates the environment for effi-cient securities lending and borrowing, but holders ofsecurities should not be compelled to participate in suchactivity. Rather, market participants and infrastructureproviders should offer economic incentives and robustrisk management practices that encourage broad par-ticipation in securities lending and borrowing by thoseinstitutions that need to make their portfolios avail-able for the process to succeed fully.

RECOMMENDATION 8. AUTOMATE AND STANDARDIZE ASSETSERVICING PROCESSES, INCLUDING CORPORATE ACTIONS,TAX RELIEF ARRANGEMENTS, AND RESTRICTIONS ONFOREIGN OWNERSHIP.

Issuers, providers of clearing and settlement ser-vices, and other relevant market participantsshould advise investors of all details of corpo-rate actions that they require in an automated,timely manner and in compliance with acceptedindustry standards so that each investor can make

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a timely decision on the action to be taken with fullknowledge of the facts. Each market place shouldprotect the rights of the beneficial owner of a se-curity to all corporate and income events from thepoint of execution of the purchase transaction inthe relevant security. All corporate actions shouldbe able to be executed through book entry trans-fer and/or payment systems where such systemsoperate for the settlement of purchases and salesof securities. All communications through the valuechain between issuer and beneficial owner should,as technology allows, be automated as set out inthe relevant recommendation.

Market participants and public authorities shouldwork together to minimize the administrativecosts to each party involved in tax relief arrange-ments through standardization and automationof procedures and communication of informa-tion and through the use and acceptance of elec-tronic data and documentation. This recommen-dation exclusively addresses the process of tax rec-lamation. It does not in any way seek to addressthe absolute levels of the taxes themselves.

Relevant public authorities, infrastructure provid-ers, and market participants should work togetherto harmonize and make transparent the processes,documentation, and communication of informa-tion in connection with foreign-ownership restric-tions and reporting requirements. Full informa-tion needed to assess whether restrictions applyshould be available to allow investors and inter-mediaries to make timely and appropriate deci-sions. For example, investors should be able todetermine in advance of a trade executionwhether the trade will breach any limits. Report-ing and disclosure responsibilities should also betransparent and should be able to be dischargedthrough automated electronic communication.

ISSUE

Corporate actions and associated asset servicing ac-tivities present particularly significant opportunitiesfor increased efficiency. Technology developments inthis area have not yet been exploited as fully as they

have been in other areas of securities processing, suchas the communication of information among issuers,intermediaries, and investors. Variations exist in mar-ket practice and standards in connection with com-mon definitions of different types of corporate actionor elements of complex transactions, in the tax reliefarrangements process, and in restrictions over foreignownership. These variations frequently demand manualintervention, limit the ability to automate processes,and often require market participants to interpret com-plex documents or rules that may vary from transac-tion to transaction. Where investor choice is introduced(in connection with rights issues, for example), there isrisk as well as inefficiency, as lack of complete, timely,and accurate notifications and other information canlead to losses through inappropriate or ill-informeddecisionmaking or through notification of decisionsthat does not reach issuers by set deadlines.

Many of these concerns are addressed in part byother recommendations that when fully implementedwill lead to automated, standardized, and efficient pro-cessing and communication and produce accurate andcomprehensive reference data. However, the specificnature of many (often arcane) aspects of corporateactions and associated activities demands specific sepa-rate recommendations. For the purposes of this rec-ommendation, a “corporate action” is defined broadly.It includes involuntary events (such as a scrip issue),voluntary events (such as a capital increase, share reor-ganization, takeover event, warrant exercise, conver-sion, or similar act), and various forms of dividends,including those that are paid with scrip options or thatallow dividend reinvestment and similar plans. Corpo-rate actions, across the market, are the major sourceof financial losses attributable to operational failure.The losses arise for two main reasons:

� The inefficient flow of information betweenissuer and investor, particularly where there is along chain of intermediaries and/or paper flow orother nonautomated methods of communication.

� Market failure to protect all the rights of thebeneficial owner of a security at all times,including all connected corporate and incomeevents.

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Apart from the risk that results from the miscom-munication of information, the key risk arises in vol-untary corporate actions that require investors to ad-vise the issuer in order to protect their entitlements orelect between different options. Major losses most fre-quently arise on market transactions that occur closeto the issuer’s deadline for instructions and on stocksout on loan, especially when these are returned justbefore the corporate event instruction deadline. Clearly,in these circumstances the inefficient and slow com-munication of information is put under greatest strain.

Processing tax relief arrangements associated withincome on equity or debt securities is also inefficient.It is standard practice for the full rate of withholdingtax on income to be deducted at source. However,beneficial owners are entitled to reclaim some por-tion of the tax withheld if their country of residencehas a double-taxation treaty with the country in whosejurisdiction the dividend is paid. This tax reclaim pro-cess varies considerably by country and is frequentlymanually intensive, inefficient, and hence costly toadminister. There is no standardization in the type orcontent of documentation required to support thereclaims; nor are electronic reclaims normally ac-cepted, let alone in standardized message form. Thetime taken for fiscal authorities to process such re-claims varies greatly and can in some cases take sev-eral years. Furthermore the deadlines for making re-claims vary considerably, from as little as 18 monthsto as much as 20 years.

Rules surrounding ownership restrictions (such aslimitations on foreign ownership) and the reportingof material interests vary from country to country.As with tax relief arrangements, the documentationand procedures required to comply with rules is of-ten manually intensive and inefficient. Transparentinformation is often unavailable, for example on thecurrent level of foreign ownership or the outstand-ing number of securities in issue against which a limitis measured, making it difficult to determine in ad-vance if an individual trade will cause a limit to bebreached. In some markets, restrictions on foreignownership may lead to other inefficient behavior, suchas causing foreign investors to withdraw previouslyimmobilized stocks from securities depositories so

that they can instead be registered directly with trans-fer agents prior to record dates.


ADDRESSES THE ISSUE

Each of the specific issues described above has twospecific themes. First is the use of paper and lack ofautomation, which with improvements in technology,are increasingly unnecessary and avoidable. Secondis the industry-wide fragmentation and variation be-tween jurisdictions that require industry participantsoperating in more than one country to have multipleinternal people, systems, and processes to deal withthe multiple different requirements and ways of do-ing things. In many ways, this is a microcosm of sev-eral of the issues described in this report that applyto securities processing generally. However, specifi-cally targeted action is required for corporate actionsand related asset servicing, and this recommendationaddresses these issues through advocating the needfor standardization and automation of documenta-tion and processes in three key areas:

� The manner in which corporate actions aredescribed and communicated.

� The documentation and processes for tax reliefarrangements connected with securitiestransactions and income.

� The documentation and processes surroundingrestrictions on securities ownership.

Replacing paper with electronic documents andautomating communication will greatly reduce manyof the inefficiencies described above in each indi-vidual market. By doing this in a way that establishesstandard market and business practices and ways ofoperating, further efficiency benefits will be achievedon a global scale.


All corporate actions should be able to be executedover book entry transfer and/or payment systemswhere such systems operate for the settlement of pur-chases and sales of securities. Issuers should commu-nicate all details relating to corporate actions in elec-

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tronic form and through the appropriate settlementsystems and other relevant information channels.

� The industry should agree on templates forelectronic dissemination of information on allcommonly used corporate action types usingISO 15022 messages. Guidelines should also bewritten on the treatment of complex corporateactions that do not completely fit within the ISO15022 guidelines. If particular types of exceptionoccur frequently, then the ISO 15022 guidelinesshould be updated to accommodate them.

� Exchanges should require issuers to communi-cate in a timely fashion all corporate events thatarise on their securities to all appropriateparties, including the relevant settlementsystems for that security, both in words and inISO 15022 format, and with no discrepancybetween the two. Where issuers release infor-mation on a corporate action in several separateannouncements, they should also releasecollectively all the relevant information both inword and ISO 15022 forms.

� Intermediaries should be able to accept,process, and pass on information that conformswith ISO 15022 messages without the need formanual intervention, so that the beneficialowner receives such information withoutunnecessary delay.

Each market should have rules that minimize thelapsed time between settlement and registration (orequivalent event), and record dates should be as closeas possible to the final date for subscription on anycorporate event. Markets should link transfer agentsto their book entry depository system to enable real-time update of registered records concurrently withthe time of settlement of each market transaction.Each market should ensure that investors receive allentitlements due from the point of execution of thepurchase transaction in the market, and market rulesshould require the seller and the seller’s broker to pro-tect the buyer’s rights where the seller receives anentitlement due to the buyer. Markets rules shouldalso ensure that a lender of a security is able to recall

securities out on loan so as to receive entitlements toall corporate actions, including when the security isreturned just before the last date for subscription.

There is no expectation that governments will har-monize the various tax regimes that affect securitiestransactions and income on those securities. However,the processes and documentation underlying the col-lection of these taxes could be harmonized withoutaffecting the fiscal independence and decisionmakingpowers of each jurisdiction. The objective with taxrelief arrangements is to move toward a mechanismthat minimizes the administrative costs to each partyinvolved in the process: the beneficial owner, the in-vestment manager, the broker-dealer, the custodian,

and the fiscal authority. In the medium to long term, itis expected that the most efficient and transparent so-lution is likely to be a cross-jurisdictional process toself-certify the residency of the beneficial owner toclaim any lower treaty rate available, with this lowertreaty rate then applied at source. It is recognized, how-ever, that such a fundamental change requires carefuland detailed study and that fiscal authorities would haveconcerns about the loss of cash flow and the potentialfor false certification. Thus, while this proposal is ad-vocated as a long-term goal worthy of further study, anumber of principles and working practices could beestablished more quickly and would bring more im-mediate benefit, including:

� Standard deadlines should be set for reclaims tobe submitted and for valid claimants to be paid.

� Global custodians or registrars, as appropriate,should substantiate the positions entitled to taxrelief.

� The procedures for tax relief arrangementsshould be clearly, fully, and unambiguouslystated and made available electronically onappropriate websites, along with electronic taxreclaim forms.

� Tax forms and supporting documentation, proofof identity, and proof of residency should bestandardized and be able to be submitted to fiscalauthorities electronically using digital signaturesand other appropriate electronic securitymeasures to confirm authenticity.

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The process of harmonizing tax practices is a com-plex and difficult challenge, with many important is-sues of national jurisdiction and interest that requiredetailed consideration. As a first step, a global, industry-wide tax harmonization working group should beestablished that includes representatives of invest-ment managers, broker-dealers, and custodians,together with representatives of fiscal and other rel-evant public authorities. This working group shoulddesign, publish for comment, and update as neces-sary detailed best practice guidelines for tax reliefdocumentation and processing that adhere to theabove principles and working practices. Fiscal authori-ties should then be invited to determine and announceimplementation plans detailing how and by when theywill adopt the best practice guidelines.

As with harmonization of the tax relief process,the recommendation does not seek to comment onthe merit or otherwise of foreign-ownership restric-tions and reporting requirements. Rather, it seeks tominimize both the costs and administrative burdenof complying with such restrictions and the incidencewith which limits may be inadvertently or unknow-ingly breached, with losses incurred through conse-quent remedial actions. To achieve this, relevant rulesshould be unambiguous and transparent to the mar-ket, and the documentation and processes requiredto comply with such rules should be automated andfollow communication, messaging, and data standardsas set out in the relevant recommendations in thisreport. Where compliance with rules depends onknowledge of information for the market as a wholerather than that for an individual organization—forexample, where an upper limit is set on the overalllevel of foreign ownership—that information shouldbe regularly updated and freely available to all relevantmarket participants so that appropriate and fully in-formed decisions can be made in advance of tradeexecution.

MITIGATING RISK

In considering the recommendations relating to risk,it is important to recognize the major initiatives tostrengthen safety and stability that have been pursued

during at least the last decade by providers of clear-ing and settlement services, user of those services,and the public agencies charged with regulation andoversight. These efforts, individual and collective,have produced substantial gains in safety and stabil-ity in the major markets and these recommendationsshould be viewed as an effort to raise the bar stillhigher in view of the critical nature of the activitiesbeing undertaken.

RECOMMENDATION 9. ENSURE THE FINANCIAL INTEGRITY OFPROVIDERS OF CLEARING AND SETTLEMENT SERVICES.

Providers of clearing and settlement servicesshould manage their risks and set standards andcontrols around the use of those services that al-low them to conduct business in a safe, sound,and prudent manner consistent with their busi-ness model and all relevant supervisory and regu-latory requirements. Each organization’s businessmodel should incorporate a risk framework thataddresses all risks connected to its operations.This risk framework should be approved by theboard and expressed through a set of limits andother qualitative and quantitative measures andtests. For systemically important organizations thebusiness model should minimize the probabilityand impact of default.

The need to operate prudently within the riskboundaries inherent within the business modelrequires risk management processes and stan-dards, which should be applied objectively andconsistently in determining compliance with riskmeasures, in three broad areas:

� The counterparty due diligence process,whereby service providers make ex ante andex post assessments of the suitability of theiractual or potential users, and the basis uponwhich users transact, for example distinguish-ing between those acceptable as clearing andnonclearing members. This process shouldbalance risk control (which inclines towardsetting high financial and operational thresh-olds) with other commercial and competition

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considerations (which may incline toward low-ering barriers to entry of users), while recog-nizing that there will always be minimum riskthresholds that should not be lowered.

� The procedures and techniques used to mea-

sure, monitor, and control risk exposure aris-ing as a result of the activities of the serviceprovider, its users, and its users’ customers.These should seek to avoid moral hazardwhereby users can introduce risk to the sys-tem without providing proportionate finan-cial protection to the service provider andother users.

� The minimum financial and liquidity re-

quirements that should be established by in-frastructure providers (and enforced by su-pervisors as described in the relevant recom-mendation) in proportion to the risks to whichthey are exposed, so as to ensure their abilityto continue to provide services to markets andminimize the probability and impact of a de-fault on their users and the financial markets.

Each organization should publish a report, at leastannually, that describes the business model, riskframework, and underlying risk management pro-cesses, controls, and standards, together with theresults of independent testing of those procedures.The report would reassure users that the organiza-tion had been operating effectively, and would alsoprovide greater transparency to the market.

Coverage of this report may overlap with otherreporting requirements, such as the so-called SAS 70reports, assessments pursuant to CPSS-IOSCO stan-dards, and financial sector assessments carried outby the International Monetary Fund and World Bank.This report is intended to be complementary to theseother requirements and not to require additional re-porting where the purposes of this recommendationare otherwise met.


RECOMMENDATIONS

This recommendation builds upon aspects of CPSS-IOSCO Recommendations 4 (CCPs), which asserts

the need for CCPs to have rigorous risk control; Rec-ommendation 9 (CSD risk controls), which sets outthe controls that CSDs should establish to mitigatesettlement risk; and Recommendation 14 (access),which advocates that CSDs and CCPs should haveobjective and publicly disclosed criteria for participa-tion that permit fair and open access. G30 Recom-mendation 9 is broader in scope, applying to all pro-viders of clearing and settlement services, and setsout in greater detail elements of the due diligence,risk control, and financial requirements that shouldform part of consistent, objective, and appropriatelyhigh risk-management standards for providers ofclearing and settlement services. The recommenda-tion also stresses the need for transparency in themarket and sets out a mechanism through which thiscan be achieved.

RECOMMENDATION 10. REINFORCE THE RISK MANAGEMENTPRACTICES OF USERS OF CLEARING AND SETTLEMENTSERVICE PROVIDERS.

Organizations that use, or are considering using,providers of clearing and settlement servicesshould establish robust due diligence andcounterparty risk management controls and pro-cesses that appropriately evaluate, measure, moni-tor, and control the risks inherent in such activityand in associated customer-related business. Therecommendation does not seek to replace pru-dential standards and supervision that may alreadyapply to financial intermediaries, including risk-related minimum capital requirements set by pru-dential supervisors. However, it is clearly impor-tant that capital resources and risk managementpractices appropriately reflect the range of risksinherent in clearing and settlement. Likewise,nonsupervised users of providers’ services shouldbe able to demonstrate the risk-based adequacyof their capital resources and risk managementprocesses.

The primary objective of Recommendations 9 and10 is to reach strong risk management standards, con-sistently and comprehensively applied on a global basis.This is a challenging target. The guidance below forms

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a checklist that aims to assist organizations achieve thisgoal, and in so doing, it builds on and embeds much ofthe collective best practice used in the financial servicesindustry today. Although it is recognized that many or-ganizations already have in place several of the prac-tices and procedures outlined, for some organizationsimplementing these recommendations (and being ableto demonstrate this) will require substantial change. Eventhose organizations considered leaders in the field ofrisk management are expected to need to improve theirpractices in certain areas.

The recommendations are directed at two broadgroups: the organizations that provide clearing andsettlement services, and those that directly use theseservices. The business models operated by differentorganizations within these groups are not all the same,and the appropriate risk practices and controls varyaccordingly. 8 However, the overall nature of the riskmanagement practices that these recommendationsseek to establish is broadly similar across all types oforganization and therefore, except where otherwisespecified, the guidance below is commonly applicable.

RISK MANAGEMENT FRAMEWORK

Financial risk management techniques should formpart of a coherent and integrated risk managementframework to help ensure that risks are addressed ina rational and sound manner with appropriate super-vision and guidance at the level of the board of di-rectors. This framework should also encompass non-financial risks, such as the legal and operational riskmatters analyzed in detail as part of separate recom-mendations. The framework should facilitate the su-pervision of the organization’s activities in line withthe business model considered and approved by theboard. The specifics of the appropriate frameworkwill vary from organization to organization, but in allcases the framework is expected to include the fol-lowing features:

� Unambiguous lines of authority and responsi-bility delegated from the board of directors.

� A comprehensive set of documented riskpolicies and processes including an assessmentprogram to proactively identify risks (financialand nonfinancial), conducted as frequently asnecessary to evaluate changing risks but at aminimum on an annual basis.

� A set of systems, procedures, controls, andmanagement information to facilitate appropri-ate and timely monitoring, management, anddecisionmaking.

It is critical that the particular matters discussedbelow are implemented within the boundaries of sucha framework. The absence of such a framework isprima facie evidence of unsafe and unsound busi-ness practice, and one should be established as a mat-ter of priority where it does not exist.

The detailed guidance is grouped consistent withthe areas outlined in the summary recommendations:

� The elements of the risk-based counterpartydue diligence processes, some of which arecommon to all due diligence assessments, withimportant additional factors relevant to usersassessing infrastructure providers.

� The procedures and techniques that should beused to measure, monitor, control, and reducefinancial risk exposure arising as a result ofclearing and settlement activities: practicescommon to both the infrastructure providersand their users.

� The minimum financial and liquidity require-ments that should be established by infrastruc-ture providers. This guidance applies directly tothose organizations but will also critically affectthe risk management decisions and assessmentsof their users.

8. For example, taking on and managing financial risk is core to the purpose and operation of a CCP and so forms a fundamentalpart of its business model. Many CSDs seek to eliminate through their contractual and operational arrangements financial risksto which they may otherwise be exposed. The risk management practices appropriate to each of these models will clearly differ,although they will still encompass due diligence, risk management systems and controls, and the maintenance of adequatefinancial resources.

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1. Counterparty Due Diligence

Initial assessment of counterparties

In the clearing and settlement process, counterpartyrelationships with other institutions—as users of ser-vices, service providers, or customers—are a keysource of risk. Therefore, a critical part of risk man-agement is a comprehensive and objective assessmentof these institutions before accepting them as finan-cial counterparties. This initial assessment is the pri-mary mechanism by which the probability of suffer-ing a subsequent default from these counterpartiescan be prevented.

a. All organizations evaluating other counterparties

should consider a broad range of factors, including:

Legal structure and financial resources

� Legal status (individual or corporate), nature oforganization, and capacity to transact business(see also specific legal risk recommendation)

� Financial resources, capital, and reserves (underboth financial accounting and risk-basedsupervisory rules)

� Availability, transparency, and reliability ofaudited financial accounts and other publiclyavailable financial and nonfinancial information,which should be received and assessed regularly,such as quarterly financial statements, whereavailable

� Scope and quality of external audit� Connection to or association with other existing

or potential counterparties (for example, wherethese counterparties are part of same group orsubject to common control)

� Guarantees from parent or other groupcompanies

� Bank guarantees, lines of credit, or similarbackup arrangements

� Asset and funding liquidity, including assess-ment of trigger events

� Rating agency evaluation

Risk, operational, and financial

control assessments

� Assessment of range and scale of financial andnonfinancial risks

� Appropriate and independent governance, riskframework, and control structure that limits orotherwise controls the organization’s activitiesand ensures compliance with good businesspractice

� Management structure, competence of peoplein critical management positions, and extent ofreliance on key individuals

� Availability, transparency, reliability, andindependence of information on internalcontrol framework, management reports, andother internal financial and nonfinancialinformation that supports the governance andrisk-control structure

� Availability, transparency, and reliability ofinformation on fully documented and regularlytested business continuity and disaster recoveryplans, including an assessment of the relianceon third parties and arrangements to deal withindustry-wide shocks

Supervisory approval

� Identity and role of supervisor(s)� Scope of supervised activity� Penalties, censure, or other sanctions imposed

by supervisors

b. Users evaluating providers of clearing and settle-

ment services should also consider:

Market structure

� Sovereign analysis, including assessment ofcreditworthiness and political and economicstability of country of jurisdiction

� Regulatory framework, including identity androle of supervisor(s) of the service providerand its users, and any regulatory or self-regulatory responsibilities of the infrastructureprovider

� Legal framework, including evaluation of howfinality is defined by the service provider, andassessment of which law governs transactionswhere the service provider operates or handlessecurities issued in more than one country

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� Business model and competitive position of theservice provider, along with ability to innovateand maintain market position

Organizational structure,

governance, and management

� Legal status and structure, ownership, andcontrol

� Governance arrangements, including userrepresentation and mechanisms for balancingconflicting requirements between differentcategories of user

� Existing user and/or membership profile,considering range of activities, domesticversus international split, size, and number ofparticipants

� Relationships, linkages, or alliances between theservice providers and other market participants,including local and international exchanges andother service providers

Operational, risk management,

margining, and default arrangements

� Resources in each type of funding (includingmargin and collateral guarantee fund or loss-sharing arrangements, insurance and guarantees,capital, and reserves) available to meet losses,and the order in which these will be used

� Clarity and transparency of service provider’srules concerning transaction processing, andconsistency with definition of when finality oftransfer is achieved

� Procedures for recording, matching, andregistering transactions

� Transparency and reliability of pricing andcalculation of position-related balances

� Position, activity, risk, concentration, and otherlimits in place and the measures available to theservice provider to ensure compliance withthose limits

� Margin arrangements, including methodologyand basis on which initial and variation marginsare set, the frequency and timing of margin calls,and the payment of interest on balances held

� Type of collateral accepted and “haircuts”applied

� Segregation of assets (cash, securities used asmargin or collateral) and rules surroundingthese in the event of default

� Transparency and clarity of rules concerningdefault arrangements and the methodology andbasis upon which any losses are calculated,allocated, and shared

� History of defaults, settlement failures, or otherevents that have caused the service provider todraw on funds available to meet losses

� Where multiple products are transacted:whether margin is calculated by product line oracross product lines on a portfolio basis;whether collateral is held in separate accountsor aggregated; and the extent of cross-subsidybetween products in the event of default

User/membership requirements

and basis of participation

� Due diligence assessment of potential or existingusers performed by the service provider

� Financial requirements of membership,including minimum capital requirements fordifferent user or membership categories and theneed for guarantees or rating agency evaluation

� Operational requirements of use or member-ship, including the need to have individualbusiness recovery procedures or to participatein collective plans

� Financial, operational, and risk managementand reporting requirements

� Regulatory requirements� User/membership status, representation, and

influence on making of key decisions

The results of such an assessment should in thefirst instance be used in determining whether the or-ganization is one that the institution should do busi-ness with and on what basis. For example, the assess-ment should be used to distinguish between thoseorganizations acceptable as clearing or nonclearingusers of certain service providers.

For infrastructure providers, or organizations thatact effectively as industry utilities, user/membershipcriteria and risk hurdles should not be set so high that

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the detrimental effects of any reduction in competi-tion outweighs the benefits of avoiding risk. Insteadthey should be set equitably and judged consistentlyand objectively with the business model, and the pro-cess by which organizations are assessed should beclearly disclosed to the market. The membership cri-teria and risk hurdles also need to be set in consider-ation of the structure of the market as a whole andthe profile of other market participants, reflecting themutualization of risk and loss-sharing inherent inmany institutional arrangements. There should besymmetry of risk and reward, so that a relatively low-risk organization or group of organizations is notobliged by loss-sharing arrangements to act, withoutequitable compensating benefit, as an effective guar-antor of other, higher-risk organizations.

The impact of changing membership criteria canand should be assessed as part of the risk measure-ment practices to help ensure that the criteria con-tinue to be set at an appropriate level. Raising thethresholds should be considered where the results ofstress tests and other risk modeling techniques indi-cate that an infrastructure provider is exposed to alevel of risk incompatible with its business model andlevel of financial resources.

The due diligence assessment should inform otherimportant processes such as the setting of limits andmonitoring of subsequent activity.

Ongoing assessment of counterparties

Organizations should continuously and proactivelymonitor the key factors evaluated as part of the initialassessment. Processes should be in place to identify,collect, and appraise information relevant tocounterparties and their activities, for example, infor-mation as reported by news agencies, regulators, ex-changes, or other relevant bodies. Periodically, and atleast annually, the continued appropriateness of theinitial due diligence assessment should be positivelyreaffirmed using up-to-date data and information.

An organization concerned about the continuedsuitability of a counterparty should take action to miti-gate the risks introduced by that organization. It is notrealistic to set out here the full range of actions thatmight be appropriate in different circumstances, but

the sanctions and tools available are likely to includetermination of membership or closeout of positions,increased collateral requirements, revision of limits asdiscussed below, and the seeking of adequate assur-ances from the relevant organization or its guarantors.

2. Risk Mitigation Techniques

Setting of limits and master agreements

For counterparties accepted as part of the due dili-gence process, master agreements should be establishedand limits set prior to the commencement of activity.The legal risk recommendations address specific issuesthat are pertinent to master agreements. Limits shouldeffectively control the activities of counterparties andrestrict the risks that they introduce to a level com-mensurate with the organization’s business model, in-formed by the due diligence assessment of thatcounterparty. Limits can be set for a number of fac-tors, including credit exposure, collateral, activity lev-els, credit standing, concentration, open interest, or anycombination thereof. Limits should cover intraday andovernight exposures and, importantly, both net andgross exposures. Setting and monitoring ofcounterparty gross exposure limits should be informedby the legal risk assessment of the enforceability ofnetting arrangements discussed in the relevant recom-mendation. The system of limits established shouldform part of the risk management framework de-scribed above and should include clear delegation ofauthority for approval of or changes to limits. Limitsshould be revised consistent with the ongoing assess-ment cycle outlined above.

Monitoring against limits

Organizations should have a system of controls thatallows intraday monitoring of the limits set for theircounterparties on a timescale corresponding to sig-nificant changes in exposure. Where significantchanges in exposure happen in a short period of time,monitoring may need to be on a real-time or very fre-quent batch basis. Clear procedures should be writ-ten for reporting and escalating usage of limits and inparticular breaches of limits or the crossing of triggeror warning points that may indicate the increased pos-sibility of a future breach.

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Limit excesses should be dealt with on a timelybasis. The appropriate action depends on several fac-tors, including the extent or size of the breach, theperiod over which it has persisted, and the status ofthe counterparty breaching the limit as assessed bythe due diligence process described above.

Margin, collateral, and netting arrangements

Margin, collateral, and netting arrangements are usedto restrict the exposure to counterparties. The con-trols and systems surrounding such functions arefundamental to the ability of an infrastructure provideror financial intermediary to manage risks successfully.These arrangements should be clearly laid out as partof the organization’s risk management procedures, andthey should encompass factors including:

� Acceptable forms of collateral and the fractionof collateral (haircut) not eligible to coveroutstanding exposures, reviewed on a regularbasis against market and liquidity risk criteria.

� Margin calculation and methodology, includingthe process by which margins can be calculatedand collected quickly in rapidly changing marketconditions.

� Frequency, basis, and transparency of the mark-to-market process.

� Frequency and timing of margin and collateralcalls, including intraday and during extrememarket conditions.

� Segregation and protection of assets in theevent of insolvency.

� Contingency arrangements applicable inabnormal or illiquid markets.

Users of providers of clearing and settlement ser-vices who transact business on behalf of customersshould ensure consistency between the marginingarrangements imposed on them by service providersand the margining arrangements that they in turnimpose on customers. However, users should not as-sume that a simple pass-through of margins is theappropriate action in all cases.

Organizations should be mindful of the risk thatthey would be exposed to should netting agree-

ments not be enforceable or the ownership of col-lateral and margin held not be secure; legal risksare discussed in detail in Recommendations 14 to16. Risk managers should specifically include anassessment of the financial impact of failure oflegal arrangements as part of scenario analysis.Except where legal risk is considered insignificant,risk managers should also actively measure andmonitor gross exposures.

Multiple products

A number of providers of clearing and settlement ser-vices handle multiple products, be they different typesof securities or completely different products such asderivatives or commodities. The characteristics of theseproducts vary, and as a result, they affect the risk (andoperational) management of the infrastructure providerand its users or counterparties. For example, derivativesgive rise to counterparty risk over their lifetime, which istypically much greater than the counterparty risk overthe life cycle of a cash securities transaction, which typi-cally follows the settlement period. While the focus ofthis report is on securities clearing and settlement ofdebt instruments and equities, it would be disingenuousto ignore this issue. The rules of the service providerand master agreements with counterparties shouldclearly state how the interaction between different prod-ucts is handled and address issues including:

� Whether margin is calculated for each productline or by using a methodology assessingportfolio risk across products.

� Whether collateral is held in separate accountsor aggregated across products.

� The extent of cross-subsidy betweennondefaulting users operating in differentproduct silos to the defaulting user.

The introduction of new or variant products byservice provider can change the risk profile of thatorganization, either because of the variation in thecharacteristics of the new products from existingproducts or because of their interaction with exist-ing products. For this reason, new product proceduresshould be established and include:

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� Risk-focused definition of what constitutes anew product.

� New product application process, business caseand risk assessment methodology (includinginteraction with existing products and associ-ated impact on risk exposures and financialresources), and approval authorities.

� Implementation guidelines and controls.

Financial risk modeling,

stress, and scenario analysis

Organizations should identify the key risk factors towhich they are exposed, such as market volatility, trad-ing liquidity, the number of simultaneous defaults, andthe correlation of defaults, and then estimate theirpotential losses under different scenarios arising fromthese risk factors. Scenarios should be derived both byrecreating historical events and by forecasting futurepotential shocks, and they should be constructed totest overnight and intraday real and potential exposures.

Stress tests are inherently subjective and based onindividual judgment and experience to determine sce-narios. Organizations should therefore also use otherquantitative evaluation techniques, such as value atrisk (VaR), as a supplement to the stress tests. VaRuses statistical modeling techniques to estimate bothscale and probability of loss. It can be seen as a moreobjective measure than stress testing, but has limita-tions in dealing with the types of low-probability,high-impact risks that are faced in connection withclearing and settlement and should not therefore berelied upon without a full range of other measures.

Providers of clearing and settlement servicesshould make the methodology, procedures, and re-sults of their risk modeling, stress, and scenario analy-sis transparent to the market, so that users and po-tential users can assess the impact on their own riskexposures. This information should include a descrip-tion of the key risks, the scenarios considered, and aquantitative and qualitative summary of the resultsof tests sufficient to allow users to understand theorganization’s risk exposure in the context of its busi-ness model and financial resources.

3. Financial Resources

Providers of clearing and settlement services shouldmaintain capital and other financial resources pro-portionate to the nature and scale of risks inherentin the clearing and settlement process and their ownbusiness model, their exposure to these risks, and thesystems and controls that they have put in place tomitigate these risks. The adequacy of financial re-sources should be assessed by service providers regu-larly, and at least once a day, based on results of stresstests and other quantitative models. Service provid-ers should look at the correlation between partici-pants regarding the nature of their exposures toproject the potential impacts of the failure of oneparticipant on others. They should ensure that theirfinancial resources are sufficiently liquid, preferablyin same day (T+0) liquidity, to support their continu-ous operation in market stress conditions. Financialresources should be drawn from sources that fairlydistribute and mutualize risk between the infrastruc-ture provider and its users.

Forms of funding

Financial safeguards against such default can take sev-eral forms including:

� The initial margin or collateral posted by thecounterparty.

� A guarantee fund (or collateral pool) and loss-sharing arrangements among market participants.

� Financial support by third parties (such asinsurance facilities, guarantees, and committedlines of credit arranged by infrastructureproviders).

� The capital and reserves of infrastructureproviders.

Initial margin or collateral posted by thecounterparty is generally the first source of funds usedin the event of a default. This source reduces the de-gree to which nondefaulting organizations are re-quired to fund the losses. The desire to have mecha-nisms to reduce the exposure of industry participantsto mutualized risk must be balanced against the

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competitive arguments for lowering margin or col-lateral requirements. There is an opportunity cost tousers in providing margin or collateral, with the costin general being proportionately greater for smallerusers. This point is particularly important in marketswhere direct access to or membership in a providerof clearing and settlement services is in practical termspart of an organization’s license to do business, andmargin requirements should not act as an inequitablebarrier to entry. Providers of clearing and settlementservices should set margins that fairly and reasonablyreflect the risk introduced by each counterparty. Thelevel of initial margin or collateral required shouldcorrelate to and be consistent with the due diligenceassessment of each counterparty as described above.

Contributions to a guarantee fund are a commonentry requirement of services providers. With guaran-tee funds, participants are required either to depositsums to form a resource pool to help service provid-ers fulfill their obligations in the case of default or tocommit to make such contributions upon demand.Participants in guarantee funds should have the obli-gations to contribute to the fund on an ongoing basisand to share losses that exceed the fund according to aset of predefined, clear, and unambiguous rules. Con-tributions and replenishment of the fund by marketparticipants should be calculated commensurate withtheir risk exposure and activity levels.

Loss-sharing arrangements are widely establishedto provide funds in the event of low-probability butpotentially significant unforeseen losses. However, thedetails of such arrangements vary materially, most im-portantly in connection with the extent of liability ofindividual users. In some cases, users may be exposedto unlimited liability, and even where limited liabilityarrangements are in place, they may not be preservedin times of acute stress. Service providers should bemindful that users who are exposed to potentially un-limited liability will act to protect their overall capital.Typically, users transact through specially establishedlimited liability entities whose capital meets member-ship requirements, but frequently with little excess, sothat the user’s overall exposure is limited to the capitalof the transacting entity. To create greater certainty forusers, loss-sharing rules should be clearly defined and

made transparent, including the methodology by whichrespective risk exposures and activity levels are calcu-lated, so that users are able to estimate accurately theirexposure and potential liability.

Capital and reserves of providers of clearing andsettlement services are typically used as a last resortafter all other sources of funding have been ex-hausted. The nature of who supplies this risk capitalis clearly different depending on whether the organi-zation is a for-profit enterprise, a user-owned utility,or some in-between hybrid.

In practice, service providers employ a combina-tion of these sources of funding. The characteristicsof each type of funding—and in particular who ulti-mately bears the cost—vary, making the relative pro-portion and order in which resources are used of criti-cal importance. The recommendation does not seekto stipulate an optimal mix, as that will depend onthe business model, circumstances, operation, andrisks of the particular organization and its users/members. However, the benefits and drawbacks ofeach form of funding should be objectively assessedin determining the combination of financial re-sources. The factors considered, options assessed, andconclusions reached should be clearly and unambigu-ously set out and made available to users/members.

Amount of financial resources

No matter which form of financial safeguard isadopted by providers of clearing and settlement ser-vices, financial resources should be sufficient to en-sure, with a high level of certainty, complete andtimely settlement in the case of a default by one ormore participants. The stress, scenario, and financialmodeling analysis described above is a key part ofdetermining the amount of financial resources re-quired. The capital of service providers is crucial notonly to cover default on settlements, but also to ad-dress other business risks such as legal, operational,and fraud errors that are not measurable reliably byquantitative models. Service providers should set asidepart of their capital as a cushion to cover the poten-tial losses arising from business risks other thandefault risks. As described in the relevant recommen-dation, prudential supervisors should apply consistent

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regulatory capital requirements to infrastructure pro-viders (and other organizations that undertake equiva-lent functions) to ensure they hold financial resourcesproportionate to the nature and scale of the risks thatthey pose to participants and the financial system, aswell as to promote a level playing field between suchorganizations.

Liquidity of financial resources

Providers of clearing and settlement services typicallyinvest their financial resources to generate revenues.Noncash investment assets must be liquidated orpledged before they can be used to meet obligations.This process may be lengthy or costly to complete inthe event of a default; for example, insurance under-writers usually cannot make all payments within 24hours, and credit lines may not be able to be drawndown immediately. Service providers should estimatetheir daily liquidity requirements and ensure that acorresponding proportion of their total assets andresources can be converted into cash within the sameday (T+0 liquidity) and the next day (T+1 liquidity)to meet these requirements. In the event of a mar-ket-wide problem, service providers would need touse their financial resources to address the problemwithout delay to restore the confidence in the finan-cial system. Therefore, it is desirable for service pro-viders to maintain the bulk of their assets and re-sources in T+0 liquidity, so that there is a significantbuffer in excess of the calculated liquidity require-ment. For this reason, assets should be in highly liq-uid, short-term securities/bank deposits, and repo-eligible instruments, such as government bonds. Ser-vice providers should also establish contingency plansto obtain additional or replacement funding, for ex-ample, through assured credit lines.

RECOMMENDATION 11. ENSURE FINAL, SIMULTANEOUS TRANSFERAND AVAILABILITY OF ASSETS.

Providers of securities settlement services should re-duce to the lowest possible level the credit risk cre-ated if securities or cash are delivered without receiptof corresponding assets, by linking securities trans-fers to funds transfers in a way that achieves effec-tive delivery versus payment (DvP) and by making

transparent the point at which finality of transferis achieved. There are different settlement ar-rangements that can achieve this:

� Real-time (or frequent intraday batch) settle-ment systems can offer the greatest certaintyby providing simultaneous and immediatetransfer for securities and cash at multiplepoints within the working day so long as thereis finality of transfer of securities and cash.

� Systems that offer real time (or frequentintraday batch) transfers of securities followedby net cash payments at the end of each work-ing day (or intraday) offer a lower level of cer-tainty, but can substantially reduce costs anddemands on liquidity, particularly in high-volume markets. In practice, such systems re-quire additional and enhanced levels of riskmanagement to offset the greater uncertaintybut are acceptable provided that intraday se-curities transfers are final and that risk con-trols ensure that the end-of-day (or intraday)net settlement of cash payments will be com-pleted, even if one or more participants owingthe largest end-of-day cash payments fail tomeet their obligations.

Determining the arrangement appropriate to aparticular market will depend on a number of fac-tors, including available technology and commu-nication infrastructure, the number and value oftransactions, the systemic importance of the mar-ket to the world financial system, and the busi-ness and operational models of other market par-ticipants and related payments systems. Any un-certainties within an individual system are mag-nified by the complexity and intersystem depen-dencies of cross-border transactions; that meansthat the impact of uncertainty on such trades willbe greater than on domestic trades. This is an-other important consideration.

Whichever settlement model is used, each securi-ties settlement system should specify the momentof final transfer in its rules or through bindingcontracts in plain and simple language, as

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expounded further in the respective legal risk rec-ommendation.

Systems that settle both securities and cash on anet basis and allow intraday transfers that are con-ditional or not legally binding, have yet greateruncertainty, as a participant’s transfers may be re-voked following failure to meet their end-of-daycontractual obligations. In these circumstances thecomplexities of unwinding conditional transfersof securities (and thereby needing to recalculatethe delivery obligations of other participants), andthe operational difficulties and liquidity pressuresthat may result, have the potential to create sys-temic risk. Such arrangements are therefore con-sidered unacceptable, particularly where there ispotential cross-border impact.

Once finality of transfer is fully assured, the rulesshould enable a receiver to re-use securities andcash without further delay, whether arising fromsettlement, dividend or interest payments, or cor-porate events.


RECOMMENDATIONS

This recommendation broadly endorses CPSS-IOSCORecommendation 7 (DvP), Recommendation 8 (timingof settlement finality), and Recommendation 9 (CSDrisk controls to address participants’ failures to settle),which set out minimum standards for mitigating creditrisk in settlement systems across all markets. G30 Rec-ommendation 11 aims to build on the CPSS-IOSCOrecommendations. Acknowledging the inherent andcomplex trade-offs that exist between efficiency and riskin this area, it seeks to give guidance on determining theappropriate settlement arrangement and identify ap-proaches that present unacceptable risk, particularlywhere there is potential cross-border impact.

ISSUE

It is critical that participants in securities markets haveconfidence that their assets will be properly protected inthe settlement process and that they then have freedomto use those assets as they wish once the settlementprocess has been completed.

To create confidence, the key attribute that thesettlement process must have is absolute assurancethat a participant will not be obliged to give up own-ership of an asset (cash or security) without receiv-ing the corresponding asset that the participant is dueas part of the contractual obligations that the settle-ment process discharges. To achieve this objective forboth parties, the exchange of assets must be simulta-neous. In addition, both transfers must be final andin no way conditional or capable of being revoked.This final, simultaneous transfer of assets is describedby the term delivery (of securities) versus payment(of cash) and is usually abbreviated to DvP.

DvP was first properly recognized as an essentialrisk-mitigating principle in the mid-1970s, followingthe collapse of Bank Herstatt. Other banks were leftwith very significant exposures as they had paid oneside of foreign exchange transactions to BankHerstatt, but had not yet received the correspondingpayment from it. Although this case was not directlyconnected to securities markets, it dramatically em-phasized the need for simultaneous exchange of as-sets in any linked financial transaction.

The primary issue that the financial markets havebeen grappling with since accepting DvP as an essen-tial characteristic of settlement is that the payment andsettlement systems have not generally been able to sup-port DvP in its literal interpretation. There has usuallybeen some dislocation in the timing of delivery andpayment; this has created uncertainty. At this point,the questions that need answering are how much of agap and what level of uncertainty is acceptable, andwhat mitigating systems, controls, and processes needto be put in place where exchange is not simultaneous.While these basic questions have remained constant,the answers to them have evolved. This evolution re-sults partly from technological advancements that haveallowed progress from typically end-of-day batch pro-cessing toward real-time or frequent intraday batchprocessing, but also from pressure applied by regula-tors, supervisors, and trade groups, and from variabil-ity of the acceptable level of uncertainty from marketto market.. Factors such as the value and volume oftransactions, the systemic importance of the marketto the world’s financial systems, and the business and

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operational models of other market participants andrelated payment systems all need to be evaluated.Broadly speaking, market changes drive the require-ment to develop increasingly certain settlement ar-rangements to meet investor needs, and technologicaladvancements provide the means to get closer to amore literal form of DvP and enhance risk manage-ment processes, and so meet such needs. Because tech-nologies and markets are constantly changing, this is-sue requires frequent review and revision.

A second critical and connected issue is definingthe point at which a delivery of a security or paymentof funds becomes final. The issue of finality is ad-dressed in the respective legal risk recommendation.A critical concern in this regard is that operators ofsettlement and payment systems, in their rules, or inbinding contracts with their members, should definethe moment at which finality is achieved—in plainand unambiguous language. It is central to analysisof the timing of transfers that the terms delivery andpayment refer to the point of final transfer and shouldnot be confused with any conditional transfers thatmay happen beforehand.

In a number of settlement and payment systems,the timing of final transfer or of processing cutoffs issuch that receivers of cash or securities are able to re-use the assets outside those systems only after a fur-ther delay. This situation applies not only to DvP secu-rities transactions, but also to receipt of cash or securi-ties arising from coupons, dividends, and other corpo-rate actions. In other cases, either the deliverer or thereceiver can be obliged to make cash or securities avail-able for processing significantly earlier than the time atwhich settlement processing commences. Where over-night batch processes are operated, the deliverer orreceiver is obliged to immobilize securities before theclose of normal settlement activity on the day beforethe day of settlement. In addition, in some instances,cash arising from sales of securities cannot be appliedto the purchase of another security even within thesame settlement batch. These timing issues are closelyrelated to the need to synchronize securities settlement,payment, and foreign exchange systems, as discussedmore fully in Recommendation 4. It is important thatmultiple settlement systems dealing with either a single

security or a specific denomination of cash operate asa virtual single system, through system linkages orcross-membership arrangements.


ADDRESSES THE ISSUE

The 1989 G30 report reiterated the need for DvPand set as a minimum standard finalization of bothdelivery and payment by the close of business on theday of settlement, at the latest. In its September 1992report “Delivery versus Payment in Securities Settle-ment Systems,” the Bank for International Settle-ments offered a thorough and comprehensive analy-sis of the issues surrounding DvP, which has beenrecently re-endorsed by the 2001 CPSS-IOSCO rec-ommendations. The BIS report described and evalu-ated the various ways that different markets had es-tablished arrangements that, while diverse in nature,were commonly described as DvP.

Recommendation 11 does not aim to revisit thelevel of detailed analysis contained in the 1992 BISreport. Instead the recommendation seeks to augmentthe BIS analysis by defining the key features that settle-ment and payment systems should have in the con-text of today’s system functionality and market needsto create a level of certainty that appropriately dimin-ishes the settlement risk of market participants andhence, in practical terms, can be viewed as accept-able forms of DvP. Without such a structure thecounterparty, liquidity, and operational risks con-nected to the settlement of securities transactions areunacceptably high and have the potential to becomesystemic, in particular where transactions have po-tential cross-border impact.

The recommendation recognizes that achieving si-multaneous and final exchange is not always the mostcost-effective solution, given current technology andmarket practices. Further, the amount of cash and se-curities needed to enable settlement can be limitedthrough netting and other arrangements, and these canimprove further settlement liquidity and efficiency, eventhough netting can have the potential to conceal orobscure the point at which finality is achieved.

By advocating that each securities settlement sys-tem should specify the moment of final transfer in

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its rules or through binding contracts in plain andsimple language, certainty should be increased which-ever operational settlement arrangements are fol-lowed. This point is expounded further in the discus-sion of legal risk in Recommendation 15.

Once finality has been achieved, it is importantthat the proceeds of settlement are available for re-use, both within and across market settlement sys-tems, to optimize settlement liquidity. Therefore:

� Cash or securities should be available for re-use,both within and outside the system in whichthey settle, following completion of thesettlement process.

� Cash or securities required for settlementshould not be immobilized for any lengthyperiod of time, before or after the point ofsettlement, and especially not during marketopening hours.

Adoption of these principles will improve settle-ment liquidity across markets and thus settlement per-formance, will reduce risk, and will ensure that inves-tors are given good value on all flows relating to theirsecurities.


It is critical that users of settlement systems are ableto determine and properly evaluate the settlementarrangements that they are obliged to use. To enablethis, infrastructure providers should, as part of thereport advocated in Recommendation 9, set outclearly the settlement arrangements they have put inplace and all relevant mitigating controls, with an as-sessment against the criteria outlined in this recom-mendation. The report should explicitly address iden-tification of the point at which finality of transfer isachieved, the legal status of the rulebook of thesecurities settlement system, simultaneity of transfer,and protection against insolvency of the intermedi-

ary within a country. Settlement systems that do notcomply with the criteria set out in this recommenda-tion should be encouraged to develop their processesso as to remove the risks that noncompliant struc-tures present (both to individual investors and othermarket participants and to the system). In particular,clear rules on finality should be established in eachsettlement system.

RECOMMENDATION 12. ENSURE EFFECTIVE BUSINESS CONTINUITYAND DISASTER RECOVERY PLANNING.

All market participants should, and all systemi-cally important institutions must, regularly review,update, and test their business continuity and dis-aster recovery plans, including evaluation of reli-ance on third parties, to ensure with reasonablecertainty that critical operations will continue witha high level of integrity and sufficient capacityfollowing a disruption or disaster. 9 The review,updating, and testing of plans should build uponthe thorough analysis and good practices that havealready been established and that are being devel-oped by public and private institutions. The planshould be based upon revisiting planning assump-tions, revised risk assessment, and scenario plan-ning that encompasses the key lessons learnedfrom September 11, 2001, and any other relevantincidents that may occur. Organizations shouldassess whether plans provide satisfactory resil-ience and evaluate the costs and benefits of de-veloping solutions to the broad range of businesscontinuity and disaster recovery issues. For func-tions critical to the market as a whole, a split op-erations model should be considered, wherebyone processing site actively backs up another, witheach site having all key resources, capabilities, andfunctionality, including appropriately skilled andexperienced people. Systemically important insti-tutions should undertake tests with member firmsand users as part of their evaluation exercises.

9. Systemically important institutions are those market participants whose operational or financial failure has the potential to, inturn, cause other organizations to fail and so spread contagion through the financial system as a whole. In any particularmarket, infrastructure providers and particularly large or strategically important financial intermediaries are likely to be classedas systemically important.

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In their review of backup arrangements, organi-zations should consider whether they have suffi-cient access to dedicated backup facilities to en-sure that operations can be reconstituted withina suitable time frame. When major incidents oc-cur, organizations should be aware that the pres-sure on shared backup facilities may be such thatthey are not able to rely on having access to it.

Full disclosure of plans may increase the risk ofcertain events or attacks, or otherwise compro-mise plans, and is clearly undesirable. However,contingency plans should be sufficiently transpar-ent and effectively communicated to the othermarket participants that depend on the institu-tion to allow them to make reasonable judgmentsabout the operational risks to which they in turnare exposed. In addition, the responsible super-visory body should critically assess the contin-gency plans of the organizations that they super-vise, including an evaluation of the adequacy andfrequency of testing. The nature of these assess-ments should reflect the associated risks, and forhigh-risk organizations should be performed atleast annually.


RECOMMENDATIONS

This recommendation builds upon aspects of CPSS-IOSCO Recommendation 11 (operational reliability),which advocates that contingency plans and backupfacilities be established to allow for timely recoveryof operations and completion of the settlement pro-cess. This recommendation sets out in greater detailthe processes and specific factors for considerationthat should form part of sound business continuityand disaster recovery plans. This recommendationalso stresses the need for transparency so that firmsthat are operationally dependent on other organiza-tions can make appropriate and considered judgmentsabout the risks to which they are in turn exposed.

ISSUE

Business continuity and disaster recovery planning hasfor many years been an important part of the opera-tional risk management practices of financial services

companies. These plans have focused on matters suchas the loss of power or telecommunication facilities,and on the impact of terrorist activities in those coun-tries that have suffered attacks or where such attackshave been perceived as a significant threat. However,market participants learned several lessons from theevents of September 11, 2001 regarding businesscontinuity and disaster recovery planning in the con-text of extreme disruptions. The widespread destruc-tion of the physical infrastructure and telecommuni-cations environment in lower Manhattan caused dis-ruptions in the trading of securities and the subse-quent clearing and settlement of trades.

While the global financial system continued tofunction in the days following September 11, the in-dustry witnessed the interdependencies in the finan-cial system and the need to improve its overall opera-tional resiliency. Because they are systemically impor-tant, clearing and settlement organizations, paymentsystems, and other institutions that undertake func-tions that provide an actual or effective industry util-ity need to operate at a high standard of operationalresiliency and may therefore need to take further ac-tion to strengthen and test their business continuityand disaster recovery plans.


ADDRESSES THE ISSUE

Several new efforts are therefore under way in the fi-nancial services industry in both the public and privatesector to provide updated business continuity and di-saster recovery guidance. For example, in the UnitedStates, the Board of Governors of the Federal ReserveSystem, the Office of the Comptroller of the Currency,and the Securities and Exchange Commission jointlyissued a “White Paper on Sound Practices to Strengthenthe Resilience of the U.S. Financial System.” This con-sultative paper will become the basis for future regula-tory guidance in the United States. Given that theseefforts are under way, the differing nature of organiza-tions to which the recommendation is addressed, andthe varying circumstances in which they operate, theG30 recommendation is not intended to be prescrip-tive. Rather, it gives best practice guidance and furtherpoints for consideration, with a focus on dealing with

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extreme events, that may enhance existing policy andpractices and can be applied objectively and consis-tently by market participants to help ensure:

� Timely review, updating, and testing of organi-zations’ business continuity and disasterrecovery plans.

� Continuity of processing following eventsranging from localized processing disruptionsto wide-scale disasters affecting an entiregeographic region.

� Effective communication of the organization’splanning (without compromising confidential-ity) so that market participants that depend onthe institution can make reasonable judgmentsabout the operational risks to which they in turnare exposed.


Organizations to which the recommendation is ad-dressed should review, update, and test their businesscontinuity and disaster recovery plans to ensure thatfollowing a disaster, critical operations will continuewith a high level of integrity and sufficient capacity.These bodies should review their planning assump-tions, their risk assessment, and scenario planning inthe light of the key lessons learned from September11, 2001.

In the event of a disaster, backup facilities shouldallow processing to be switched to a second location(located outside the geographical zone impacted)within the same business day. The distance betweenthe primary and secondary location should be deter-mined by taking into account the trade-offs of risk,cost, and efficiency. For functions critical to the mar-ket as a whole, organizations should also considerwhether developing a split operations model (com-monly referred to as “active/active”), whereby oneprocessing site actively backs up another, is appro-priate, and evaluate the costs and benefits of such asolution.

Organizations should publish, at least annually, anoutline of the business continuity and disaster recov-ery procedures they have in place and the results of

independent testing of those procedures and to giveusers assurance that the procedures have operated ef-fectively. The level of disclosure provided to the mar-ket participants should be sensitive to confidential is-sues that could increase the risk of compromising plans.

The key lessons learned from September 11, 2001,which should be considered in revising or develop-ing business continuity and disaster recovery plans,are summarized below:

1. Revisit planning assumptions and

perform and/or update risk assessments.

Business continuity plans need to consider the rangeof their planning assumptions. Before September 11some organizations focused only on the informationtechnology portions of their disaster recovery plansand made certain assumptions that are no longer re-alistic for all eventualities today (concerning, for ex-ample, availability of key people, regional availabilityof public transportation, and availability of key ven-dors and business partners).

The first stage in developing a business continuityplan typically consists of developing planning as-sumptions and assessing the risks of certain events(scenarios) that could occur and therefore should befactored into the plans. This process should be per-formed on an annual basis at minimum, but it canalso be performed throughout the year as changeoccurs in the organization or as external events oc-cur that affect the organization. As organizationsupdate their business continuity plans, they shouldfactor in several potentially new planning assumptionsin the post-September 11 environment, in additionto scenarios that they already consider, such as thepotential for:

� Wide-scale regional disruption� Loss or unavailability of key personal, critical

vendors, customers, and other business partners� Unavailability of public transportation key

infrastructure such as bridges and tunnels� Cyber-threats such as computer hacking� Unavailability of business locations for periods

of up to six months

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2. Avoid geographic concentration

of primary and alternate facilities.

Just as an investor would diversify the risk in her stockportfolio, the events of September 11 highlighted theneed for organizations to diversify geographic loca-tions that support critical business functions. Inaddition, the advances in information technology maymean that it is no longer essential for employees tobe located in one concentrated location.

For business functions critical to the market as awhole, organizations should assess the costs and ben-efits of developing a split operations model wherebykey personnel, business processes, and technology aredivided between two or more geographic locations,though it is clear that this will not always be appropri-ate or desirable. Determining the appropriate geo-graphic separation is a complex and subjective issuethat requires careful judgment to balance the trade-offsof risk, cost, and efficiency. This recommendation doesnot aim to prescribe a particular solution in recogni-tion of the fact that much effort is currently underway to study this issue by both public and private insti-tution. Rather, it gives good practice guidance that canthen be applied objectively and consistently.

Where a split operations model has been deter-mined as necessary to give sufficient resilience, bestpractice would be for personnel at each location tobe cross-trained and for each location to have suffi-cient “people capacity” to absorb the work if onelocation is unable to process transactions or conductbusiness. The business operations and technology en-vironment at the backup facility should be able toaccommodate sufficient personnel, technology, andprovide timeliness of data backup to ensure process-ing can continue at the second site with sufficientcapacity and processing integrity.

3. Develop/review emergency response,

incident management procedures, and

communication and information flows.

Many organizations have well-developed and testedbusiness continuity and disaster recovery plans but havenot developed emergency and incident response plans.The events of September 11 undoubtedly reinforcedthe need for establishing communications requirements

and decision matrixes for the initial hours of a response,including performing rapid but accurate employee headcounts, responding to the media and family members,interacting with government officials and law enforce-ment personnel, and cross-training the chain of com-mand. The dependencies between service providersemphasize the need for inter-organizational planning,particularly on maintaining the inter-organizationalcommunications and flow of information that formsa critical part of a coherent and coordinated response.Having a detailed and fully tested incident responseplan has now become just as critical as being able torecover business operations.

Roles and responsibilities for the recovery teamsshould be clearly documented and communicated.Each team should be trained and ready to deploy inthe event of a disruptive event that requires the planto be activated. The specific teams that should beconsidered are:

� Senior management team� Crisis management team� Damage assessment team� Alternate site recovery team� Technical (network/telecommunications/

applications/operating systems/server)� Business recovery teams� Security team� Media relations team� Legal affairs team

4. Review disaster declaration

and notification procedures.

Many steps are typically involved during the activa-tion of a disaster recovery plan, many of which oc-cur before the actual declaration of a disaster. An in-formed decision process should be established inadvance to provide an effective framework to allowthose “on the ground” to take critical initial steps in atimely manner to best position the organization for asuccessful recovery. The disaster declaration proce-dures should clearly identify the initial actions to betaken by damage assessment and/or recovery person-nel to implement the recovery plans.

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Notification procedures should be documented inthe plan for many different scenarios. The proceduresshould describe the methods to be used to notify re-covery personnel during business and nonbusinesshours. Notifications can be accomplished through avariety of methods including telephone, pager, workor personal electronic mail, and cell phone. A com-mon notification method is a call tree. This techniqueinvolves assigning notification duties to specific indi-viduals, who are in turn responsible for notifying otherrecovery personnel. A call tree should be establishedfor primary and alternate methods of notification.

5. Implement appropriate data backup technology.

Many data backup plans focus only on critical computersystems. Consideration should be given to backing uppaper-based records, desktop computer systems, andother systems needed to ensure continuity of operations.

Policies and procedures should specify the data thatshould be backed up and the means for doing so (mir-rored/synchronous, replication, tape; daily or weekly;incremental or full) based on data criticality and thefrequency that new information is introduced.

6. Focus on vendor and outsourcing dependencies.

In the past, many organizations did not consider theimpact on their own operations of a disaster affect-ing key vendors or outsourcing dependencies. There-fore, a review of vendor and outsourced service pro-viders should be conducted that includes assessing avendor’s criticality, securing multiple vendors for criti-cal processes, understanding a vendor’s preparednessto deal with disasters, and understanding vendor ca-pacity thresholds and capacity plans. Organizationsneed to understand where they are dependent uponkey vendors (such as telecommunications) and iden-tify single points of failure that these vendors pose.Vendors and outsourced service arrangements shouldbe included in the business continuity planning pro-cess and should provide the organization sufficientevidence as to their operational resiliency.

7. Test all aspects of plans.

Testing of connectivity between all parties (such asparticipants, exchanges, key vendors) should be per-

formed from primary and backup locations. In addi-tion, plans should consider the loss of key customersand key personnel. Scenarios for technical disasterrecovery planning can frequently become routine,ensuring successful tests and the appearance of pre-paredness. Incorporating “B Team” staff, impacts ofdegraded critical vendors (especially networks), in-complete data backups, and other realistic problemswill ensure that the recovery program is realisticallyevaluated for its true capabilities.

Besides technical recovery, one of the critical les-sons learned from the September 11 attack is the criti-cal need to increase end-user involvement within thetesting process. Incomplete procedures and inadequatework area resources can be identified and addressedonly through effective and comprehensive tests.

At a minimum, the following areas should be ad-dressed in testing:

� Systems recovery on an alternate platform� Testing of business process recovery, including

coordination among various recovery teams� Internal and external connectivity� System performance using alternate equipment� Restoration of normal operations

Training for recovery personnel should complementtesting. Training should be provided at least annually;new hires that have plan responsibilities should receivetraining shortly after they have been hired. Recoverypersonnel should be trained in the following:

� Purpose of the plan� Cross-team coordination and communication� Reporting procedures� Security requirements� Team-specific processes (activation/notifica-

tion, recovery, and reconstitution phases)� Individual responsibilities (activation/notifica-

tion, recovery, and reconstitution phases)

8. Develop a strong maintenance

process to keep plans current.

Organizations should have a process in place to en-sure that business continuity and disaster recovery

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plans reflect changes in business, technology, people, andprocesses. Periodic maintenance is necessary to ensurethat the right people can be contacted in the event of adisaster and that a sufficient level of resources is avail-able at alternative processing sites to meet actual needs.Business continuity, disaster recovery, and incidentmanagement plans must be continually updated andtested to remain current and ensure organizations areready. The plan update should be performed at leastannually or whenever significant changes occur for:

� Operational requirements� Security requirements� Technical procedures and requirements� Hardware, software, and other equipment� Names and contact information of team

members, business partners, and vendors� Alternate and offsite facility requirements� Vital records (hard copy or electronic)� External events affecting the organization

RECOMMENDATION 13. ADDRESS THE POSSIBILITY OF FAILURE OFA SYSTEMICALLY IMPORTANT INSTITUTION.

Market participants in each financial centershould work together to identify those institu-tions, or parts thereof, that are systemically im-portant to the clearing and settlement process.User groups should be established to addresshow they would react if, despite strengthenedbusiness continuity and disaster recovery plans,there were a failure for whatever reason at oneof these institutions. Ways of mitigating the riskscreated should a systemically important institu-tion fail, such as building a real-time data de-pository, should be evaluated. Where it is deter-mined that effective and feasible solutions mayexist, detailed business cases setting out the costsand benefits should be built up, and decisionson future actions and investment decisionsshould be taken accordingly. As well as enforc-ing suitably high standards of business continu-ity and disaster recovery planning in systemicallyimportant institutions, regulators and overseersshould encourage this process of industry-widecontingency evaluation and planning.

ISSUE

The recommendation aimed at ensuring effectivebusiness continuity and disaster recovery planning iscritical to strengthening the resilience of financialmarkets infrastructure and providers of clearing andsettlement services. Yet, however robust, thorough,and well-tested, it is unrealistic to expect businesscontinuity and disaster recovery plans to anticipateand cater to all possible eventualities, as this encom-passes an enormous range of potential scenarios, eachindividually unlikely. At the same time, the likelihoodof a catastrophic event of some sort is clearly real.


ADDRESSES THE ISSUE

The recommendation does not seek to prescribe a so-lution to this issue, which is extremely complex andwhich, until the events of September 11, attracted lim-ited attention. The recommendation instead outlinesthe process that the industry should follow to investi-gate, evaluate, and implement potential solutions.


Because the failure of an institution systemically im-portant to clearing and settlement will—by defini-tion—have widespread impact across all users of theirservices, market participants need to act collectively.As a first step, those institutions, or parts thereof, thatare systemically important need to be identified. Us-ers then need to make contingent arrangements as tohow they would react should one of these systemi-cally important institutions fail. Ways of mitigatingsuch risks, such as building a real-time data deposi-tory, need to be carefully considered and evaluated.The benefits of such solutions may well be substan-tial, but so will be the costs. For that reason, detailedbusiness cases will be needed for each potential solu-tion to enable considered and appropriate investmentdecisions to be made.

The recommendation is addressed primarily tomarket participants, and it is foremost the responsi-bility of the boards and management of these orga-nizations to act to address the risks described above.However, the systemic nature of the issue has a verysubstantial public interest. Quite properly, those

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responsible for the regulation and oversight of marketparticipants have paid significant attention to industry-wide contingency planning, particularly in the UnitedStates in the aftermath of September 11, but also else-where. They have already encouraged debate anddiscussion of these matters among the relevant insti-tutions and should ensure that progress continues tobe made with sufficient rigor and momentum.

RECOMMENDATION 14. STRENGTHEN ASSESSMENT OF THEENFORCEABILITY OF CONTRACTS.

Market participants should ensure that due dili-gence procedures examine contract enforceabil-ity, including basic formation and validity, as wellas power and authority to contract. Where sig-nificant uncertainty exists about the reliability ofthe legal system of relevant jurisdictions, stepsshould be taken where possible to ensure thatsuch laws do not govern the transactions andthat enforcement in such jurisdictions will notbe required. Collateral posted and held outsidesuch jurisdictions and letters of credit essentiallyremoving all reliance on enforcement ability inthe questionable jurisdiction should be consid-ered. Industry groups should enunciate stan-dards of diligence and, together with appropri-ate regulators, identify deficiencies in law thatcould potentially impair contract enforceability,such as those related to gambling and other pub-lic policy areas. Industry groups should also pro-pose legislative changes to protect transactionsbetween commercial entities.


RECOMMENDATIONS

This recommendation builds upon aspects of CPSS-IOSCO Recommendation 1 (legal framework), whichsets out the need for securities settlement systems tohave a well-founded, clear, and transparent legal ba-sis. G30 Recommendation 14 identifies specific is-sues in connection with legal enforceability and setsout mitigating measures that should be taken wherelegal uncertainty exists.

ISSUE

While ongoing business relationships offer primaryassurance that parties to a financial transaction willperform as agreed, it is the reasonable certainty oflegal enforcement that ultimately must underlie alltransactions. Contract legality and enforceability arefundamental in this regard, and parties to financialtransactions have long focused on these issues as ba-sic elements of due diligence and risk management.But the increasing complexity of transaction struc-tures, as well as the involvement of an ever-growingnumber of national legal systems, requires reempha-sis of this fundamental consideration. In fact, mar-gining and other collateralization, closeout netting,

and essentially all other considerations addressed inthis report are without significance unless the funda-mentals of legal recognition are assured.

In considering how to address these risks, it mustbe noted that there are many jurisdictions in whichlegal opinions on fundamental issues have not beenobtained, even regarding standard agreements. Theissues of concern fall into four categories.

Formation and validity of contract

The law of the jurisdiction or jurisdictions that gov-erns the contract must respect and enforce agree-ments accomplished and evidenced in the mannerutilized by the parties. Typically it is anticipated thatoral and electronic agreements will be binding andthat confirmations evidencing the terms will be con-clusive, absent manifest error. However, the issue ofthe binding nature of such agreements and themethod of proof, while having been addressed incertain key jurisdictions such as New York, has notbeen the subject of comprehensive evaluation and,where appropriate, legislation. The laws of many ju-risdictions, even if not the laws purportedly govern-ing the contract, may have bearing on validity andenforcement, particularly in the context of a multi-jurisdictional bankruptcy or similar event.

Issues of power and authority

The principles of power and authority have oftenbeen considered. The commitment of both public

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and private entities to enter into contracts requiresstatutory empowerment and formalities that vary byjurisdiction and type of entity. In many cases, authoritymust be traced to the underlying legal powers of theorganization, the approval of the governing board,the delegated authority of the individual expressingthe commitment of the entity and, in some cases, theprecise formality of execution of documentation.Understanding the applicability of the doctrine ofapparent authority, the control exercised bycounterparties over their own employees, in the rel-evant jurisdiction can have far-reaching implicationsfor each party to a transaction.

Issues of public policy

Assuming valid formation and proper exercise ofpower and authority, enforceability generally dependson whether aspects of the agreement violate law orpublic policy and on the effect of the violation in therelevant jurisdiction. While violation of law is to beavoided in any event, it may or may not affect con-tract enforceability. And even if lawful in the juris-diction whose laws govern the contract, offense topublic policy in the jurisdiction in which enforcementis sought may affect enforceability. The typical ex-ample is the gambling laws of a jurisdiction.

Integrity and transparency of the legal system

Regardless of the theoretical validity and enforceabil-ity of a contractual obligation, access to and the reli-ability and transparency of the legal system that maybe called on to enforce the contractual obligation it-self or the judgment of another jurisdiction may bean additional risk to be addressed. These factors mayalso be affected by the stress to the economy repre-sented by the circumstances under which the con-tractual obligation is sought to be enforced, the na-tionality of the parties involved in the litigation, andthe possibility of corruption, among other matters.


ADDRESSES THE ISSUE

Addressing legal risks effectively requires due dili-gence of legal matters in sufficient detail to fully as-sess the complex of issues involved, as well as a clear

understanding of legal rights under relevant legal ju-risdictions. The surest ways to control legal risks is toadopt a high standard of due diligence and to ensure,where possible, that deficient laws do not governtransactions and that enforcement in such jurisdic-tions will not be required. Such steps could includeposting and holding collateral outside such jurisdic-tions and use of letters of credit that essentially re-move all reliance on enforcement ability in the ques-tionable jurisdiction.

Formulation of minimum due diligence standardsin various legal areas by industry groups would pro-vide a firm basis for risk assessment and managementby market participants. Identifying changes in lawnecessary to remove legal uncertainties and recom-mending them to governments and legislatures would,to the extent they are implemented over time, pro-vide the ultimate resolution of the problem. Even inthat event, however, the need to understand and man-age legal risks would remain an essential element ofrisk management and control.


Market participants should ensure that their due dili-gence procedures examine issues of contract legalityand enforceability in sufficient detail to assess fully thecomplex of issues involved in multi-party cross-bor-der transactions. This must include a clear understand-ing of legal rights under all relevant legal jurisdictions.

To support these efforts, industry groups shouldformulate standards of minimum diligence, identifysound legal principles that would minimize legal risk,and recommend changes in national laws that fallshort of these sound principles. Beyond strict legalprinciples, concerns over the reliability of legal sys-tems of relevant jurisdictions should also be enunci-ated in the interest of promoting reform.

Formation and validity of contract

Industry groups should formulate standards of mini-mum diligence regarding conclusions about contractenforceability. With respect to purely domestic trans-actions, where the legal system is well understood,conclusions may be based on a thorough understand-ing of the legislative and case law affecting the issues.

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These conclusions will, of necessity, be subject tovarying levels of uncertainty, but nonetheless, reason-able levels of comfort should be obtainable. The com-plexity of legal opinions relating to the subject mat-ter should also be addressed. Legislation ensure thevalidity of oral and electronic agreement and dealingwith issues of proof should be formulated and pur-sued if it has not already been enacted.

Issues of power and authority

Industry groups should recommend minimum dili-gence standards regarding confirmation of authorityfor each type of transaction and for particular typesof counterparties. This may include schedules forstandard-form agreements recognizing differing stan-dards applicable to certain types of counterparties.The issue of apparent authority should also be con-sidered since applicable legal principles may affectcontract enforceability in ways not fully appreciated.Where principles of apparent authority do not apply,appropriate legislative changes to implement themshould be proposed. In jurisdictions where the doc-trine does apply, legal considerations that could un-dermine its application should be identified and leg-islative changes proposed.

Issues of public policy

Industry groups and appropriate regulators shouldreview issues of public policy concern that couldimpair contract enforceability, such as gambling stat-utes that have sometimes restricted the use of cer-tain types of financial contracts, and propose legisla-tive changes to protect transactions between com-mercial entities.

Integrity and transparency of the legal system

The issue of integrity and transparency of the legalsystem must be considered as it applies to cross-bor-der transactions, particularly those involvingcounterparties in nations experiencing political orsevere economic instability. This is true regardless ofthe law apparently governing the contract if ultimateenforcement is dependent on the application of im-partial legal principles by a court in a jurisdiction un-der stress. Industry groups should seek to heighten

awareness of these issues and encourage the use ofenforceable collateralization outside of such jurisdic-tions so as to avoid the necessity of resort to courtsin such jurisdictions for purposes of enforcement.

RECOMMENDATION 15. ADVANCE LEGAL CERTAINTY OVER RIGHTSTO SECURITIES, CASH, OR COLLATERAL.

Market participants must be able to determine,with certainty and reasonable cost and effort, whatlaw defines and governs their rights to securities,cash, or collateral in a clearing and settlement sys-tem or other intermediary, what those rights are,and how to perfect and enforce them. The appli-cable rules of law should be automatically effec-tive, to the extent possible, and should afford theparties to the transaction ex ante certainty andpredictability for the largest number of transac-tions possible. To the extent possible, clearanceand settlement systems and other intermediariesshould describe to their participants or custom-ers the relevant choice of law rules in their homecountries as they relate to what law governs theeffectiveness of transfers and pledges of securi-ties held through an account with an intermedi-ary. Specifically, the following is recommended:

� Choice-of-law rules. Financial supervisors andlegislators should ensure that the Hague Con-vention on the Law Applicable to CertainRights in Respect of Securities Held with anIntermediary, adopted on December 13, 2002,is signed and ratified by their respective nationsas soon as is reasonably possible. The HagueConvention, once ratified by all relevant na-tions, will ensure that there will be a clear andcertain answer to the question in an interna-tional setting as to which law governs in deter-mining whether a collateral taker has receiveda perfected interest in pledged securities.

� Protection against intermediary insolvencyrisk. Financial supervisors and central banksshould confirm that the rights of a personholding securities through an account with anintermediary in their jurisdiction are senior to

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the claims of the intermediary’s creditors tosuch securities, except where the intermedi-ary affirmatively grants such creditors controlover such securities. If the financial supervi-sor or central bank is unable to provide suchconfirmation, it should take all appropriateaction to ensure that its local commercial andbankruptcy laws are interpreted or amendedto achieve such a result.

� Pledging and realization procedures. Finan-cial supervisors, central banks, and legislatorsshould encourage collateral transactions bysimplifying any legal procedures that imposeconditions on the effectiveness of pledgingarrangements or govern the fairness of real-izing on collateral.

� Finality. The boards of central securities de-positories should specify in plain language themoment when a transfer or pledge of securi-ties becomes “final” (that is, irrevocable andunconditional) in its rules or binding contractswith its account holders. Financial supervisorsand central banks should require this specifi-cation from each central securities depositorysubject to their jurisdiction.


RECOMMENDATIONS

This recommendation develops aspects of CPSS-IOSCCO Recommendations 1 (legal framework),which sets out the need for securities settlement sys-tems to have a well-founded, clear, and transparent le-gal basis; and Recommendation 12 (protection of con-sumers’ securities), which sets out the need for entitiesholding customers’ securities to protect those assetsthrough appropriate safeguarding procedures. G30Recommendation 15 builds upon these sound prin-ciples to identify specific issues in connection with le-gal certainty over rights to securities, cash, or collat-eral, together with how these issues should be resolvedand/or the appropriate measures to be put in place tomitigate risk where such legal uncertainty exists.

ISSUE

Most existing choice-of-law rules (private internationallaw) do not allow market participants to determine, inadvance of any action, with sufficient certainty and onlyreasonable effort, what substantive local law governstheir rights to securities, cash, or collateral in a cross-border transaction involving a clearing and settlementsystem or other intermediary. Even when they do, thegoverning substantive local law may not allow marketparticipants to determine in advance with sufficientcertainty and reasonable effort what those rights areor how to enforce them, provide practical answers tothose questions, or facilitate risk reduction. Local lawsare also far from harmonized in this area.

The problem has arisen because modern devel-opments in systems for holding cash and securities,and the cross-border nature of an increasing volumeof transactions, have not been matched by develop-ments in the underlying legal infrastructure. To in-crease the efficiency of both local and cross-bordertransfers and collateral transactions, the vast quantityof securities and cash is now held, transferred, andpledged by entries to accounts with clearing and settle-ment systems and other intermediaries, rather thandirectly in physical form or directly by issuers. Un-fortunately, most choice-of-law rules and local sub-stantive law continue to reflect assumptions of a by-gone era when securities and cash were held, trans-ferred, and pledged by physical delivery or directlyby issuers and mainly in purely domestic transactions.In fact, most local laws in this area have not changedfundamentally since Roman times. This has created aclassic gap between law and practice—a gap that fos-ters legal uncertainty and undermines the soundnessof the legal infrastructure underlying the moderncash- and securities-holding system. The current le-gal infrastructure can be likened to a rusting bridgethat needs to be strengthened or replaced before itcollapses under the stress of modern activity.

Many other organizations, including the BaselCommittee on Banking Supervision and IOSCO, haverecognized that the modern cash- and securities-hold-ing system needs to have a sound legal framework,

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but they have not defined the standards that shouldcharacterize such a framework nor made specific rec-ommendations for bringing local laws into line withcommercial practices.


ADDRESSES THE ISSUE

This recommendation aims to ensure that the legalinfrastructure underlying the cash- and securities-holding system allows market participants to determinein advance of any action, with certainty, and with onlyreasonable effort, what local substantive law governstheir rights to securities, cash, or collateral in a clearingand settlement system or other intermediary, whatthose rights are, and how to enforce them. The rec-ommendation requests action by a broad range ofmarket participants including financial supervisors,central banks, intermediaries, end users, financial tradeassociations, and legislators. There are few circum-stances where action by intermediaries and end usersalone could achieve this result, but in a number of ar-eas, determinations by the boards of clearing and settle-ment entities, financial supervisors, and central bankscould be effective. In still other cases, and ultimatelyfor the system as a whole, national laws should be har-monized consistent with these objectives and, as amatter of priority, existing choice-of-law rules and na-tional and other local substantive law should be mod-ernized as follows:

� Choice-of-law rules. For securities held throughaccounts with an intermediary, the law of theplace of the relevant intermediary (commonlyreferred to as PRIMA) should determine thelegal nature of the rights arising out of a creditof securities or cash to such accounts; the stepsrequired for a transfer or pledge of securities orcash credited to such accounts to be enforce-able among the parties (including the intermedi-ary) and senior to the rights of third parties;and the steps required to realize a pledge ofsecurities or cash credited to such accounts.

� Protection against intermediary insolvency

risk. Local law should ensure that the rights of

a person holding securities through an interme-diary are generally senior to the claims to suchsecurities by the intermediary’s creditors.

� Pledging and realization procedures. Locallaws that condition the effectiveness ofpledging arrangements or govern the fairnessof realizing on collateral should be simplified tofacilitate and encourage risk reduction byreducing the cost of collateral transactions.

� Finality. Each clearing and settlement systemshould specify in plain and simple language themoment when a transfer or pledge of securitiesbecomes final in its rules or binding contractswith its account holders, and this specificationshould be required by financial regulators andembodied in local law.


The fundamental requirement is to modernize na-tional and local laws to bring them into line withmodern commercial practices, as indicated in the rec-ommendations set forth above. This is a matter ofurgency, but there is strong tendency to ignore evenwell-known defects in the legal infrastructure untilafter a financial crisis occurs. Nevertheless, becausethe legal system underpins the entire clearing andsettlement framework that this report urges shouldbe reformed, legal reform cannot be left for later, notleast because legal reform is often a difficult and slow-moving enterprise.

A broad range of clearing and settlement organi-zations; market participants including banks, brokers,and other intermediaries; industry groups; bankingand securities supervisors and their international bod-ies; central banks; and national and international barassociations will have to provide persistent supportfor reforms, taking such opportunities as arise to of-fer organized support.

One area of recommendation for which unitedsupport can be offered is choice of laws. Nationalauthorities should be encouraged by all interestedparties to sign and ratify the just-adopted Hague Con-vention as soon as is reasonably possible. It is ofcourse critical to its effectiveness that the Hague Con-

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vention be ratified as quickly as possible in as manynations as possible.

As part of the monitoring of performance that willfollow this report, national choice-of-law rules andapplicable substantive law should be monitored andthe extent to which they conform to the specific rec-ommendations set forth above should be specified.

Banking and securities supervisors should considerrecognition of sound legal frameworks by calibrat-ing capital treatment of collateral transactions andother risk mitigation measures based on the sound-ness of the underlying legal framework.

RECOMMENDATION 16. RECOGNIZE AND SUPPORT IMPROVEDVALUATION METHODOLOGIES AND CLOSEOUT NETTINGARRANGEMENTS.

Market participants should ensure that all masteragreements provide that upon the early termina-tion of a transaction or group of transactions,the determining party will have the flexibility tovalue such transactions by the method that is mostlikely to produce a commercially reasonable valu-ation at the time of termination. Master agree-ments also should provide that in any exercise ofsuch discretion, the determining party should beguided by principles of good faith and commer-cial reasonableness.

Market participants should include closeout net-ting provisions in their contract documentation.Trade associations and other industry bodiesshould work together to harmonize informationon the effectiveness of netting and disseminate itwidely and in accessible form.

Relevant authorities in each jurisdiction shouldensure that their laws give effect to closeout net-ting for all central counterparties, brokers, end us-ers, and other market participants, and for all en-tity, transaction, and asset types. Market partici-pants and other interested bodies should encour-age legislative reform in those jurisdictions wherelaws do not meet this standard.


RECOMMENDATIONS

This recommendation builds upon aspects of CPSS-IOSCO Recommendation 1 (legal framework), whichsets out the need for securities settlement systems tohave a well-founded, clear, and transparent legal basis.G30 Recommendation 16 highlights the measures thatneed to be taken to mitigate legal risk in connectionwith closeout netting and valuation arrangements.

ISSUE

Financial agreements, particularly master agreementsfor derivatives transactions, contain provisions autho-rizing the closeout or early termination of outstand-ing transactions under specified circumstances, includ-ing payment or delivery defaults or insolvency. In thesecircumstances, valuation and netting questions becomeimportant to the speedy and accurate resolution ofclaims, and language giving effect to flexible valuationmethods and closeout netting should be part of allcontract documentation and master agreements andshould enjoy the full force of law.

Valuation is an important step in closeout netting,but it is also important in a wider range of financialevents. A broad array of master agreements is in usetoday and many of them require that the value of ter-minated transactions be determined by reference tomarket quotations obtained for the elements of thetransactions at the time of their termination. Experi-ence with these market quotation–based valuationmethodologies has shown that they generally work wellfor transactions for which there are with liquid mar-kets that are functioning in a normal manner.

Questions arise concerning the use of closeout valu-ations that are based on market quotations obtained frommarkets that are illiquid, irregular, or nontransparent.Questions also arise in cases where quotations cannotbe obtained and where quotations are obtained but aclear determination cannot be made as to whether theyproduce a commercially reasonable result. In closeoutnetting, the real problem with unclear valuations is thatthe determining party does not know with any certaintywhether the right amounts are being set off. A court or

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trustee may amend the closeout value at some later dateand effect a potentially significant change to the nettedamount. In addition, some master agreements requirethat a closeout value be calculated for each transactionthat is being terminated. Experience, however, has shownthat, in some circumstances, it can be much more effi-cient to determine closeout valuations for groups of ter-minated transactions, rather than individual terminatedtransactions.

Closeout netting is typically triggered in case ofcloseout or early termination.10 Effective closeoutnetting is an important counterparty risk managementtechnique because it ensures that if a counterpartyfails, the innocent party is required to pay (or receive)only the net sum owing. This is important for all par-ticipants in the markets, whether they are centralcounterparties, brokers, or end users, and is even pro-tection against systemic risk. For closeout netting tobe effective, methods available for valuation of af-fected transactions must be effective and expeditious.In fact, valuation is a critical issue in case of any earlytermination of outstanding transactions.

The effectiveness of credit support techniques maydepend on the effectiveness of closeout netting, par-ticularly if the underlying collateral is provided bymeans of outright transfer. Closeout netting itself isoften used in conjunction with other risk manage-ment techniques, such as the provision of credit sup-port in relation to the net exposure resulting fromthe application of closeout netting. Through capitalrules promulgated by the CPSS, regulatory capitalbenefits accrue from adopting netting, provided thatthe netting schemes have “a well-founded legal basisunder all relevant jurisdictions.” Thus closeout net-ting must be effective under the laws of the jurisdic-tion in which the counterparty is organized, the juris-

diction of the law governing the netting agreementand related transactions, and the jurisdiction ofbranches through which the parties are transacting.Accordingly, much hinges on the effectiveness ofcloseout netting and that effectiveness must extendto a range of jurisdictions.

The closeout netting process comprises fourstages: closeout (or termination) of transactions; valu-ation of the terminated transactions in the underly-ing currency of the transactions; conversion of ter-mination values into a single base currency; and net-ting (or set off) of the individual values to produce asingle amount payable by one party to the other.Closeout netting will occur either automatically orupon notice from one party to the other, as previ-ously agreed by the parties. In some jurisdictionswhere there are doubts as to whether closeout net-ting will be upheld by a local liquidator, the likelihoodof closeout netting being effective may be increasedthrough automatic termination of transactions at atime prior to the appointment of the liquidator.

In the first instance, closeout netting is a techniquegenerally employed in the derivatives markets, be-tween two parties to an over-the-counter derivativestransaction or, in the case of exchange-traded deriva-tives, between brokers and their customers or clear-ing brokers and a central counterparty. In addition,the technique is commonly used between parties inthe foreign exchange and repo markets and in theinterbank deposit markets. Participants in other mar-kets have similar interests in reducing counterpartyrisk, and the principles of closeout netting can beapplied equally within these other markets and, in-deed, across all of these markets.

The benefits of closeout netting are particularlyobvious in transactions that include a lengthy period

10. Closeout netting is to be distinguished from other netting techniques. Payment (or settlement) netting is a technique allowing partiesto settle payment obligations to each other that are payable on the same date, by netting amounts payable in the same currency.Payment netting may apply across all transactions between the parties, or it can be limited to transactions of the same type or even topayments within a single transaction. The obligations remain as gross payment obligations until the time of settlement. Netting bynovation is a technique that also allows netting of payments in the same currency that are due on the same date. It differs frompayment netting in that the conversion of gross obligations to net obligations occurs when each new transaction is entered into, ratherthan at the settlement date. Neither technique provides the protections offered by closeout netting, which is intended to apply to alltransactions subject to the relevant netting agreement, regardless of when payment or delivery is due and regardless of the currencyof the transaction. Although closeout netting does not mitigate settlement risk (which payment netting and novation netting both do),it can be combined with payment netting to gain the combined benefits of both netting techniques.

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between contracting and settlement, and a corre-sponding lengthy period of exposure to thecounterparty. In certain markets (such as the cashequities market) where settlement periods are short,the shorter window of possible counterparty defaulthas traditionally meant that the benefits of closeoutnetting have been less obvious. Entities that partici-pate in more than one market are, however, increas-ingly seeking to implement cross-product (or cross-market) netting agreements (“master netting agree-ments”), pursuant to which counterparty exposuresarising from a range of transactions (cash market aswell as derivatives, for example) will be reduced. Suchmaster netting agreements, if effective, allowcounterparties to calculate exposure on a net basisacross products and also to calculate their credit lim-its and margin requirements on the basis of the re-sulting net figure.

Although acceptance of netting is becoming in-creasingly widespread, a number of uncertainties stillexist. The nature of the uncertainty varies from ju-risdiction to jurisdiction and may render closeout net-ting either partially or entirely ineffective:

� Mandatory insolvency rules. Closeout nettingmay offend principles of local insolvency lawfor several reasons, including the following. Itmay be regarded as a means of preferring onecreditor over another, in breach of principles ofequal treatment of creditors; set-off allows thenondefaulting party to “receive” the benefit ofone hundred cents in the dollar for each dollarthat it owes to the defaulting party. Alternativelya liquidator may be able to “cherry pick” certaintransactions that would otherwise be subject tonetting by disclaiming onerous property(including transactions that are loss-making forthe insolvent estate) and forcing performanceof contracts that are profitable to the insolventestate. A liquidator may additionally be able tochallenge arrangements entered into within acertain period before the onset of insolvency(for example, as unlawful preferences, transac-tions at an undervalue, fraudulent conveyances,

or other transactions depriving the estate ofassets). Insolvency laws may specifically affectthe ability of the parties to terminate transac-tions before the stated maturity date or to netthe resulting termination amounts. Alternatively,mandatory insolvency rules of a particularjurisdiction may require a particular valuationmethodology or require calculations andpayments to be made in a particular currency,which differs from that agreed between theparties, thereby affecting the net result.

� Entity types. Certain entity types may be subjectto special insolvency procedures, whichoverride netting arrangements and produce adifferent net result.

� Contracting parties. Closeout netting is generallynot enforceable where there is no mutuality ofobligations (for example, between two affiliatesand their mutual counterparty). In addition, theapplication of closeout netting becomes com-plex in arrangements involving agents acting forunderlying principals, especially where theidentity of the principal is not disclosed, either atall or until after the transaction has been enteredinto. Furthermore, netting legislation may beconfined to circumstances in which both partiesare of a particular type (see, for example, theUnited States Federal Deposit InsuranceCorporation Improvement Act).

� Cross-border issues. Netting may be effective insome jurisdictions but not in others, where theparties are transacting. A liquidator in a jurisdic-tion that does not recognize closeout nettingmay seek to undermine the global effectivenessof closeout netting by suing for amounts owedbetween a party’s offices in different jurisdic-tions or requiring specific performance oftransactions that are profitable to the estate.Alternatively, an insolvency representative in aparticular jurisdiction may “ringfence” theassets of the insolvent estate in order tomaximize the benefit to local creditors. RecentEuropean Union legislation has promotedcertainty in this area (see the discussion in

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footnote12 on insolvency proceedings) butmore extensive global initiatives are required.

� Central counterparties. To date, the rules ofsome central counterparties contemplate thedefault of the clearing broker but do notprovide any mechanism to deal with the defaultof the central counterparty itself. Clearly thisshould be of concern to clearing brokers whohave an exposure to the central counterparty.Further analysis is required regarding the effectof the potential insolvency of the centralcounterparty.

� Variable application of netting laws. Theapproach to closeout netting varies betweenjurisdictions. In some jurisdictions closeoutnetting is mandatory in bankruptcy, while inothers it is prohibited. Where general bank-ruptcy law may otherwise prohibit closeoutnetting, exceptions to the general rule havebeen implemented (largely influenced by theBasel capital proposals) but are limited to theparticular market circumstances prevailing ineach jurisdiction. In particular, closeout nettinglegislation, if it has been enacted, does notalways cover all entity types or all transactionand asset types.


ADDRESSES THE ISSUE

In the first instance, the recommendation focuses onstrengthening contract documentation and masteragreements within the control of industry. Marketparticipants are charged with including closeout net-ting provisions in their contract documentation. Tradeassociations and other industry bodies are chargedwith harmonizing information on the effectivenessof netting and disseminating it widely and in acces-sible form.

Market participants are further charged with ensur-ing that master agreements provide the determiningparty the flexibility to value such transaction or trans-actions by reference to the valuation method that bestsuits the relevant market conditions for such transac-tion or transactions at the time of termination.

Then there is a legal reform component as authori-

ties in all jurisdictions are charged with ensuring thattheir laws give effect to closeout netting for all mar-ket participants (central counterparties, brokers, endusers, and other market participants) and for all en-tity, transaction, and asset types. Market participantsand other interested parties are directed to encour-age legislative reform in those jurisdictions where lawsdo not meet this standard.


First, uncertainties surrounding valuation must beaddressed. Closeout valuation methodologies shouldgive the determining party discretion to select thevaluation method that is best suited to the market forthe relevant transaction at the time of its terminationand should require the determining party to act ingood faith and in a commercially reasonable mannerin exercising such discretion. In pursuit of such meth-odologies, the following actions should be taken byrelevant industry associations:

� Associations that issue and maintain masteragreements should promptly review theirprovisions for conformity with this standardand conform them as necessary.

� Associations that issue and maintain masternetting agreements that provide closeoutvaluation methodologies for use with alltransactions underlying the master nettingagreement, or for use only with underlyingtransactions that lack such methodologies,should compare their closeout valuationmethodologies to the foregoing standards andmake any necessary changes.

� Where amendments to an agreement are issuedin the form of a new version of the agreement,the relevant industry association should alsoissue a “stand-alone” version of the amend-ment for use with previous versions of therelevant agreements.

� Relevant associations should educate the usersand potential users of agreements about thebenefits of using closeout valuation methodolo-gies that meet the recommended standards.

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To give full effect to the recommendation on close-out netting:

� The legal or contractual framework for all centralcounterparties should include provisionsenabling closeout netting in the event of their ora contracting participant’s insolvency. Locallegislatures should implement any legislativechanges required to effect this recommendation.

� Use of closeout netting provisions in contractsby all parties to financial transactions, includingcentral counterparties, and use of masternetting agreements are already widespread butshould be implemented wherever appropriate.

� Because the legal basis for netting is problematicin many jurisdictions, including the United States,legislation should be adopted to ensure the fulleffectiveness of closeout netting; supervisors andcentral banks should support netting for banksthrough regulatory determinations; and nationalauthorities should pursue global enforceabilitythrough an international closeout nettingconvention or other means, as appropriate. 11

� Further global harmonization of cross-borderbankruptcy legislation is needed, followingupon recent European Union initiatives thathave resolved a number of uncertaintiesrelating to cross-border aspects of closeoutnetting for entities located within the EU. 12

To increase the availability of information to marketparticipants:

� Central counterparties should publish astatement of the legal effectiveness of thecloseout netting provisions of their rules.

� In the interest of harmonizing informationregarding the effectiveness of netting andmaking it widely and easily available to partici-pants, trade associations and other appropriateindustry bodies should pursue cooperativeefforts, possibly including a register of jurisdic-tions, showing the extent to which closeoutnetting is effective for different types ofentities, transactions, and assets.

� In the interest of promoting legal certainty,initiatives that have been undertaken by variousindustry bodies (notably the InternationalSwaps and Derivatives Association, the UKFutures and Options Association, the BondMarket Association, and the British BankersAssociation) to obtain opinions from counselregarding netting in a wide range of jurisdic-tions should be extended to new jurisdictions,entities, transactions, and asset types and shouldbe coordinated among industry bodies andparticipants in order to centralize efforts andminimize the costs of these initiatives.

� Appropriate industry or official bodies shouldundertake a study of central counterpartyinsolvency and the insolvency of clearingsystems through which transactions are settled.

� To encourage adoption of the proposed languageand supportive legislation and judicial approaches,international databases should be maintained andregularly updated. These databases should list

11. The International Swaps and Derivatives Association Inc. (ISDA) has already made legislative proposals (for example, the 1996Model Netting Act and the proposed 2002 Model Netting Act). The proposed language includes an extensive definition of“qualified financial contracts,” which includes commodity contracts, repurchase agreements, and securities transactions. Theproposed act limits the powers of liquidators and any insolvency laws prohibiting set-off.

12. Council Directive 2001/24 on the reorganization and winding up of credit institutions entered into force on May 5, 2001,although EU member states must approve implementing legislation before it becomes effective in those member states. Thisdirective specifies that upon the insolvency of a party to a netting agreement, the only applicable law in relation to that nettingagreement is the law of the contract, irrespective of where the insolvency proceedings are being held. Council Regulation1346/2000 on insolvency proceedings, which applies primarily to corporations and individuals, took effect in all EU memberstates (other than Denmark) on May 31, 2002. This regulation is directly effective and therefore requires no further implement-ing legislation. It provides that insolvency proceedings may be opened in the EU member state where the debtor has the centerof his main interests. Although it does not deal expressly with netting, the regulation specifically states that insolvency proceed-ings shall not affect the rights of creditors to demand the set-off of their claims against the claims of the debtor.

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master agreements and relevant master nettingagreements that contain closeout valuationmethodologies that meet the requirements of therecommendation and those that do not. Theyshould also report judicial and legislative develop-ments relating to closeout valuation methodolo-gies, that would be widely publicized and open foruse by all interested persons.


RECOMMENDATION 17. ENSURE APPOINTMENT OF APPROPRIATELYEXPERIENCED AND SENIOR BOARD MEMBERS.

Members of the boards of securities clearing andsettlement infrastructure providers should, in-dividually and collectively, be of a weight interms of experience and seniority to dischargethe enlarged strategic, risk, and operational man-agement oversight responsibilities described inthis report. Organizations that are users of suchproviders or otherwise have input into the ap-pointment of board members should be mind-ful of the broad range of capabilities needed todischarge the diverse, important responsibilitiesof such a position.


RECOMMENDATIONS

This recommendation builds upon broad principlesarticulated in CPSS-IOSCO Recommendation 13(governance), which advocates that the governancearrangements for securities settlement systems shouldfulfill public interest requirements and promote theobjectives of owners and users. G30 Recommenda-tion 17 gives more detailed guidance on the experi-ence and seniority that board members should haveto allow them to effectively meet such objectives,which place great burden on the capability and judge-ment of board members.

ISSUE

Boards of institutions that form the clearing andsettlement infrastructure face complex challenges anddemands from many sources: the owners of the in-

stitutions, the users of the services the institutionsprovide, and other important stakeholders, includingpublic authorities. Addressing these challenges andmeeting the needs of the varied stakeholders requiresboard members to have an appropriate level of sen-iority and a broad range of capabilities to exercisesound judgments over often opaque and occasion-ally intractable problems.

Many strategic decisions require evaluation andweighing of difficult trade-offs, such as balancing thedesire to achieve short-term cost savings with the needto invest to achieve innovation and greater savings inthe long term, or maintaining a proper balance betweenthe pursuit of potential cost savings and acceptable con-straints of safety and risk management. For most suchdecisions, each of the different stakeholder groups willhave different preferences, further complicating matters.Moreover, the requirement to oversee the commercial,operational, and risk management practices of the or-ganization demands a thorough understanding of themechanics of the business. In aggregate, these challengesgo beyond those typically faced by the boards of simi-larly sized commercial organizations and underscore thestrategic importance of clearing and settlement infra-structure to the securities industry as a whole.

This report focuses on the steps that need to betaken to bring about change that will support saferand more efficient clearing and settlement and in par-ticular bring cross-border costs and risks down to lev-els closer to those currently associated with domesticsystems. This task represents a greater challenge anda broader mandate than now exists for boards. Forthis vision to be realized, the boards of institutionsactive in this area will need directors who can leadand drive such change.


ADDRESSES THE ISSUE

Many countries and markets already have well-devel-oped and well-defined governance frameworks andmechanisms for ensuring appropriately qualified andcompetent boards, and this recommendation (andindeed other governance-related recommendations)is not intended to replace or override such arrange-ments. Rather, it is intended as supplementary guid-

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ance for those organizations that form the infrastruc-ture for securities clearing and settlement to help themaddress the distinctive and important issues that theyface, as described above. Board members of infra-structure providers already have weighty obligationsto varied stakeholder groups, and these duties areexpanded by the mandate created by this report. Todischarge such responsibilities, it is vital that boardmembers enjoy sufficient seniority and experience toprovide appropriate authority and strategic vision.


Individuals or organizations that are responsible for ap-pointing, electing, or otherwise influencing the selectionof board members of clearing and settlement infrastruc-ture providers need to assess carefully the duties associ-ated with such a role and the experience and senioritynecessary to fulfill these duties and proceed accordingly.

RECOMMENDATION 18. PROMOTE FAIR ACCESS TO SECURITIESCLEARING AND SETTLEMENT NETWORKS AND SERVICES.

Boards of securities clearing and settlement ser-vice providers, other organizations providing simi-lar services, and public authorities should ensurethat rules and other requirements that control orlimit access to securities clearing and settlementservices are accepted only where they are neces-sary and are designed exclusively for the purposeof controlling financial, operational, reputational,or regulatory risks; maintaining the safety of thesystem; or achieving other reasonable publicpolicy objectives. Networks and services shouldbe accessible to all users that pass risk and safetyevaluations and enjoy appropriate financial stand-ing, and users should be free to select the mix offunctions and services that they wish to use onthe basis of straightforward, transparent, and fairtariff policies grounded on the principle of userpays. Such risk-based rules should be broadlyfounded (encompassing the due diligence processset out in the financial integrity recommendation),and fairly and consistently applied. Moreover, therules and their application should be transparentto the market. Existing barriers that do not meetthis test should be removed.


RECOMMENDATIONS

This recommendation broadly endorses CPSS-IOSCO Recommendation 14 (access), which advo-cates that CSDs and CCPs should have objective andpublicly disclosed criteria for participation that per-mit fair and open access. G30 Recommendation 18seeks to further clarify the acceptable criteria for par-ticipation, by reference to those designed solely forrisk, systemic safety, or public policy objectives. Allother criteria are thereby deemed unacceptable be-cause they inhibit fair access. This recommendationalso explicitly addresses business practices that ham-per fair access where an effective monopoly exists,such as tying in or cross-subsidy of other services.

ISSUE

Many infrastructure providers operate as effectivemonopolies within the markets they serve, either be-cause they have been granted such status through leg-islation or market convention, or because it would noteconomically be viable for an alternative organizationto attempt to compete within the existing market struc-ture. It is therefore critical that providers that are ef-fective monopolies allow access to users on a fair ba-sis; otherwise some users may be effectively excludedfrom the market or forced to conduct business throughan intermediary that is a direct user of the infrastruc-ture provider. In either case, the level of competitionin the market will be reduced overall, disadvantagingboth actual and potential participants in the market andultimately end-user investors and issuers. For this rea-son, barriers to fair access need to be removed.


ADDRESSES THE ISSUE

The recommendation calls for fair access for all quali-fied organizations to use or provide clearing andsettlement services. This is not a call for full, openaccess, as restrictions on the grounds of risk, systemicsafety, or public policy are clearly for the good ofmarket participants as a whole and in the wider pub-lic interest. Rather, the recommendation seeks toclarify the restrictions to access that are acceptable.In this way all other types of restriction are deemed

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to be unacceptable, a method at the same time sim-pler and more comprehensive than attempting todefine explicitly every unacceptable restriction.


The most important barriers to fair access need to beidentified and plans put in place to remove them.Where unacceptable barriers have been establishedthrough the policies, rules, or operations of providersof clearing and settlement services, there appears nogood reason why they cannot be dismantled immedi-ately. Where the barriers result from legislation orregulation, a longer time frame will be needed. Thedefinition of acceptable barriers contained in the rec-ommendation should be sufficient to ensure that inremoving barriers to fair access, other public policyobjectives are not inadvertently compromised. How-ever, it is recognized that careful attention will beneeded to ensure that this is so and that adverse un-intended consequences are avoided.

RECOMMENDATION 19. ENSURE EQUITABLE AND EFFECTIVEATTENTION TO STAKEHOLDER INTERESTS.

Board participation should represent differentstakeholder interests fairly and equitably. Provi-sion should be made for regular review of, andfor changes as necessary in, board compositionto ensure continuing balanced representation ofvarying stakeholder groups, including users.Where a securities clearing and settlement infra-structure provider is user-owned, user-sharehold-ers should make certain that arrangements are inplace to provide equitable and effective represen-tation through appropriate by-laws; the appoint-ment of independent, public interest, or end-userinvestor directors; or other similar measures.Where such a provider is partly or wholly ownedby nonuser shareholders and is also a substan-tially monopoly provider of clearing, settlement,and related services in a particular market, user(and other stakeholder) interests can be adequatelyprotected through appropriate user or other in-dependent, nonshareholder participation in theboard. However, these arrangements may have tobe supplemented by oversight of tariff and other

policies by relevant competition authorities. Ineither case, the independent directors should beappropriately involved in the audit and remunera-tion committees.


RECOMMENDATIONS

This recommendation builds upon broad principlesarticulated in CPSS-IOSCO Recommendation 13(governance), which advocates that the governance ar-rangements for securities settlement systems shouldfulfill public interest requirements and promote the ob-jectives of owners and users, and Recommendation14 (efficiency), which suggests that securities settle-ment systems should be cost-effective in meeting therequirements of users. G30 Recommendation 19builds upon these broad principles to give more de-tailed guidance on how the varied stakeholder inter-ests should be equitably represented on the boards ofclearing and settlement infrastructure providers.

ISSUE

Efficient and safe operation of clearing and settle-ment infrastructure providers is central to the effec-tive operation of securities markets. Consequently, avariety of stakeholders have a significant and legiti-mate interest in the operation of these institutions.Important stakeholders include the users of theinstitution’s services and bodies that represent thepublic interest. Issues in connection with public au-thorities are addressed primarily through the recom-mendation aimed at encouraging consistent regula-tion and supervisory oversight. This recommenda-tion focuses on the need for representation of otherstakeholders, particularly users.

Users are not a homogeneous group, and differ-ent sets of users are likely to have different objec-tives. For example, users whose business is primarilyfocused on domestic markets are less likely to wantto invest in developments aimed at improving theefficiency and safety of cross-border activity andwould instead prefer rebates or tariff reductions. Al-ternatively, users who compete with the infrastruc-ture provider for the provision of certain services willhave an active interest in restricting the infrastruc-

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ture provider’s development of those services, at apotential cost to other users who may have benefitedfrom the development of the services.

Fair and equitable representation of these variedstakeholder interests on the boards of clearing andsettlement infrastructure providers is critical to helpensure that the different interests and needs of dis-parate groups are considered and addressed, so thatstrategy and allocation of resources is appropriate anddoes not act to distort market dynamics or preventeffective competition. In addition, the appointmentof directors fully independent of management pro-vides an important level of challenge and oversightand is particularly important in the context of issuesconnected to audit and remuneration.


ADDRESSES THE ISSUE

Fair and equitable representation of stakeholder in-terests on the boards of clearing and settlement in-frastructure providers will help to ensure that theneeds of varied stakeholder groups are properly un-derstood and considered in making key decisions andformulating strategy. Although it is unrealistic to ex-pect a strategy that fully meets the wishes of a di-verse set of stakeholders, through proper stakeholderrepresentation a strategy that fairly reflects the as-sorted expectations can be determined.

The recommendation recognizes that the compo-sition and relative importance of different stakehold-ers will change over time and therefore calls explicitlyfor private institutions to have a mechanism to reviewand, where appropriate, change board composition.This helps to overcome the potential concern that incatering solely to the interests of stakeholders at anypoint in time, the infrastructure provider could increasethe resistance to changing participation in the marketas a whole, for example by following policies that actedto prevent new entrants. This issue is also addressed inpart through the recommendations on fair access andconsistent regulation and oversight.


The issue of stakeholder representation needs to beconsidered in the context of the ownership structure

of each institution. Where an institution is user-owned,the interests of shareholders and users are already likelyto be substantially aligned, and representation of otherimportant stakeholders such as end-user investors andissuers and the wider public interest can be achievedthrough appropriate appointments. Where nonusershave an ownership stake in a private institution, thenadditional, strengthened mechanisms may be neededto ensure users have appropriate representation. Thisis vital where users have no or very limited choice ofinstitutions from whom they can procure services, andin such circumstances competition authorities orequivalent public bodies may need to oversee policiesand operational practices pertaining, for example, totariffs or bundling of services.

RECOMMENDATION 20. ENCOURAGE CONSISTENT REGULATIONAND OVERSIGHT OF SECURITIES CLEARING AND SETTLEMENTSERVICE PROVIDERS.

Providers of securities clearing and settlement ser-vices should be subject to consistent and transpar-ent regulation and oversight, which should focuson the activities undertaken and risks incurred.Standards of regulation and oversight of cross-border activity should be complementary and con-sistently applied across all relevant jurisdictions. Asa long-term goal and where coherent with otherpublic policy objectives, regulatory and oversightstandards should be harmonized. While publicauthorities have developed minimum standards formany aspects of clearing and settlement services,notably as embodied in the CPSS-IOSCO recom-mendations, the oversight and supervision appliedto providers of clearing and settlement services var-ies across jurisdictions. In addition, organizationsundertaking similar activities can be subject to dif-ferent regulatory regimes and standards based upontheir status, such as whether or not they are a bank.

Supervisory, prudential, and oversight standardsshould recognize the systemic importance of pro-viders of clearing and settlement services with aview to minimizing the risk of default or opera-tional failure of critical organizations. As notedin Recommendation 9, aimed at ensuring consis-tent financial integrity of service providers, con-

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sistent supervision is necessary to create uniformrisk standards and ensure consistent minimum fi-nancial and liquidity requirements. But consistentsupervision is also important to help create a levelplaying field between competing organizations.

Regulatory and oversight standards that affect cross-border activity must be undertaken consistently andtransparently across all relevant countries.


RECOMMENDATIONS

This recommendation recognizes that the bodies re-sponsible for supervising clearing and settlement ser-vice providers vary between jurisdictions and ofteninclude separate oversight and regulatory authorities.CPSS-IOSCO defines oversight as a “public policyactivity principally intended to promote the safety andefficiency of payment and securities settlement sys-tems and in particular to reduce systemic risk,”whereas regulation typically focuses more on day-to-day supervision and the setting and enforcing of pru-dential standards. G30 Recommendation 20 endorsesand builds upon CPSS-IOSCO Recommendation 18(regulation and oversight), which calls for all securi-ties settlement systems to be subject to regulation andoversight, for regulatory responsibilities and objectivesto be clearly defined and made transparent, and forcooperation between different regulatory and super-visory bodies. G30 Recommendation 20 expands uponthe CPSS-IOSCO work to explicitly advocate build-ing upon cooperation between regulators and overseersto achieve consistent regulation and oversight acrossjurisdictions, in particular for cross-border activity. Inaddition, this recommendation encourages supervisoryand regulatory assessments based on the functions andactivities that supervised or regulated institutions un-dertake, so that similar operations are subject to simi-lar oversight irrespective of their status.

ISSUE

In a purely domestic context, the existing arrange-ments for regulation and oversight of securities clear-ing and settlement are generally sound. In addition,there is cooperation between different regulators and

overseers—certainly in most developed markets—and the 2001 CPSS-IOSCO Recommendations forSecurities Settlement Systems set out minimum stan-dards that operators of such systems should follow.However, differences in the regulation and oversightof clearing and settlement activities remain, becauseof differences in regulatory regimes between juris-dictions and because of differences in the status ofproviders of clearing and settlement services. Forexample, several of the services offered by CSDs andICSDs are similar to, and in some cases compete with,services offered by global custodian banks, but thediffering nature of these organizations may mean thatthey are subject to a different regulatory approach.All institutions providing critical clearing and settle-ment functions must be subject to rigorous and ap-propriate supervision.

The need for consistent regulation and oversightof clearing and settlement service providers is evenmore apparent in the context of cross-border activity,where service providers are connected and interdepen-dent. If there are weaknesses in the procedures or sys-tems at one provider of clearing and settlement ser-vices, then there is potential for risks introduced at thatpoint to extend through to connected organizations.Although service providers carry the primary respon-sibility for preventing contagion through robust andconsistent due diligence and risk management prac-tices, regulation and oversight provides a vital furtherlayer of protection and must be consistent to be fullyeffective. In addition, any inconsistencies in regulationand oversight between jurisdictions traversed by a cross-border trade may lead to ambiguity about which stan-dards should apply and therefore to a greater risk ofnoncompliance. The cost to firms of complying withregulatory standards also needs to be considered: wheresuch standards vary between regimes, the cost of com-pliance for internationally active firms is necessarilyhigher, as different standards create the need for du-plication in the understanding and application of rel-evant policies and rules. Variations in regulation andoversight can also affect the ability to move towardfull interoperability, because the regulatory and over-sight framework in some instances drives market con-ventions and practices.

Recommendation 20

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It is clearly correct that regulation and oversightauthorities should consider the systemic importanceof organizations, and so the regime imposed couldproperly vary depending, for example, on marketshare or the degree to which alternative service pro-viders are available and on risks involved. However,two organizations that provide similar services andattract similar risks in similar markets should be sub-ject to consistent regulation and oversight. Variationin regulation and oversight approaches can affect therisk management and financial and liquidity require-ments of supervised organizations, which can in turnaffect the competitive positions of those organiza-tions, as well as the overall safety of connected sys-tems. Creating a competitive playing field is a crucialpart of realizing efficiencies and encouraging inno-vation among service providers, as expanded uponin the recommendation advocating fair access.


ADDRESSES THE ISSUE

Consistent and transparent regulation and oversightacross jurisdictions reflecting the activities undertaken(rather than the legal form of the organization) shouldhelp ensure that each organization providing clearingand settlement services establishes risk managementpractices and maintains capital appropriate to its busi-ness model, the activities that it undertakes, and therisks to which it is exposed. By focusing on an evalua-tion of activities undertaken, all services that shouldbe subject to regulation and oversight will be, irrespec-tive of the type of organization that provides thoseservices, facilitating fair competition between serviceproviders and a more consistent and appropriate risklevel in the market as a whole. The development ofconsistent regulatory and supervisory conventions forcross-border transactions will offer greater certaintyover the standards that apply to such activity. Consis-tent and transparent regulation and oversight will ad-

dress many of the issues set out above, but harmoni-zation of regulation and oversight among jurisdictionscould present even greater potential benefits. In par-ticular, it would reduce the costs of compliance forinternationally active firms, the benefits of which, aswith other efficiency opportunities identified elsewherein this report, are likely to flow through in large part toend-user investors and issuers.


Ensuring consistent approaches to regulation andoversight is a significant challenge, and differing publicpolicy priorities and concerns of individual jurisdic-tions must be recognized. The challenges in identify-ing and moving to an approach that takes appropri-ate account of the activities undertaken and the risksincurred should not be underestimated, and the de-tailed planning for such a change will need to be care-fully considered to avoid unintended consequencesand unhelpful inflexibility. In particular, formulatingaccurate and workable definitions of activities will becritical, as will the linking of these activities to asso-ciated risks and understanding of the interrelation-ships between different activities and risks.

However valid the difficulties of implementation,such barriers should not prevent developments thatwould help overcome the important issues outlinedabove. Consistent regulation and oversight should bepursued insistently, and harmonization should besought as a long-term goal, particularly as the ben-efits of a step-by-step move to harmonization arelikely to accrue incrementally. Significant progress hasalready been made in this area; in particular the 2001CPSS-IOSCO recommendations create a set of mini-mum standards for securities settlement systems andform a sound basis for the further developmentscalled for in this recommendation.

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The study on global clearance and settlement arrange-ments was commissioned by the Group of Thirty inthe Fall of 2000. Sir Andrew Large, then Deputy Chair-man of Barclays plc, was invited to chair the projectand was joined by John Heimann and David Walkerfrom the ranks of the Group of Thirty as vice chairsfor the project. A Steering Committee was then re-cruited, drawn from the senior ranks of the public andprivate sectors, to oversee progress and approve thefinal report (Committee members, p. ix).

Serious study of global clearing and settlementarrangements requires examination of a wide rangeof complex issues, beginning with an analysis of thecurrent state of the system. Since the goal of thisstudy was to develop specific recommendations forimproving these arrangements, issues had to be ex-amined at a level of significant detail. Working groupsof experts from the public and private sectors wereformed, with leadership drawn from the SteeringCommittee.

The working and advisory groups were led by Steer-ing Committee members Jill Considine, GeraldCorrigan, Gerald Hassell (who replaced Gerd Häusler)and Andrew Sheng; Michael Patterson of JP MorganChase and Stephan Schuster of Deutsche Bank. To-gether with the Chairman, Vice Chairman, ProjectDirector Marc Hollanders, and the G30 ExecutiveDirector, this group constituted an Executive Com-mittee for the project that provided ongoing oversightof the work program.

In the analytical phase of work, Gerald Corriganand Stephan Schuster co-chaired a working group thatexamined the current state of clearing and settlementsystems and practices, based on the industry surveyby PricewaterhouseCoopers discussed below, to iden-tify areas in need of reform. Michael Patterson andAndrew Sheng co-chaired a working group that sur-veyed the current state of industry best practice andofficial guidance on clearing and settlement issues inorder to identify core principles that should be pur-sued in the study. Gerald Hassell led a working groupthat examined governance issues, assuming the chair

from Gerd Häusler who led the initial investigation.Jill Considine organized and chaired a service-pro-viders advisory group.

Following the analytical phase of work, GeraldCorrigan assumed responsibility for a working groupon risk issues and produced the draft chapter and rec-ommendations on that issue. David Walker took thelead in preparing the discussion and recommenda-tions on governance.

The project was able to rely upon the input andparticipation of a wide range of institutions and in-dividuals. A complete list of institutions that contrib-uted to the project is provided in table A2-1, withparticipants in the industry survey listed in table A2-2. Individuals who made significant contributions arerecognized in Box A2-1. Our purpose in listing theseorganizations and individuals is to express our grati-tude for their contributions to the project, not to sug-gest their endorsement of the result. Our hope is thatthe report proves as useful to them as was their inputto the project.

ANALYTICAL PHASE OF WORK

The basic research effort proceeded along two tracks:a “bottom up” analysis of the current state of thesystem based on an industry survey, and a “top down”assessment of existing standards, principles, and otherauthoritative guidance in this area. The first phase ofanalysis, the industry survey, was undertaken byPricewaterhouseCoopers, financial services partnerfor this project.

Interview process

Beginning in early 2001, PricewaterhouseCoopers de-veloped a set of survey questions intended to ascer-tain the key concerns facing participants in clearing andsettlement activities worldwide. It also developed a listof survey targets in North America, Europe, and Asiato whom the questions would be posed. The surveywas conducted through face-to-face interviews ratherthan written questionnaires. Thus, within a commonframework and methodology for recording results,

APPENDIX 2. CONDUCT OF THE STUDY

126


TABLE A2-1. CONTRIBUTING ORGANIZATIONS

ABN Amro NV

Association of Private Client InvestmentsManagers and Stockbrokers

Australian Stock Exchange

Banc of America Securities

Bank One Corporation

Bank of England

Bank for International Settlements

Bank of Japan

The Bank of New York

Banque de France

Barclays

The Bear Stearns Companies

BNP Paribas

Brown Brothers Harriman & Co.

The Canadian Depository for Securities

Chase Manhattan Corporation

Citigroup, Inc.

Clearnet

Clearstream International

Clifford Chance

Companhia Brasileira de Liquidaçâo e Custódia

Council on Foreign Relations

Credit Suisse First Boston Corporation

CRESTCo

David Polk & Wardwell

DBS Group Holdings

Depository Trust & Clearing Corporation

Deutsche Bank

Deutsche Börse

DGZ-Bank Frankfurt

Edward Jones

Eurex

Euroclear

European Brokers Club

European Central Bank

European Securities Forum

Federal Reserve Bank of New York

Fidelity Investments

The Finance Foundation

Financial Services Authority

Financial Stability Institute

FleetBoston Financial Corporation

Global Documentation Steering Committee

Goldman Sachs & Co.

Government of SingaporeInvestment Corporation

Hong Kong Exchanges and Clearing

Hong Kong Securities and Futures Commission

HSBC Holdings

International Monetary Fund

International Securities Services Association (ISSA)

Invesco Asia

Ivy Funds

Janus Capital Corp.

Japan Securities Dealers Association

JASDEC

JP Morgan Chase & Co.

Legg Mason

The London Clearing House Limited

Merrill Lynch & Co.

The Monetary Authority of Singapore

Morgan Stanley Dean Witter & Co.

National Financial Services

Nomura Securities and Nomura Asset Management

Northern Trust Corporation

Options Clearing Corp.

Oxford Economic Research Associates

PricewaterhouseCoopers

Promethee

Prudential Securities

Reuters Group

Robertson Stephens

Singapore Exchange

SIS Sega Intersettle

Société Générale

Soifer Consulting

Standard Chartered

State Street Corporation

The Stern School, New York University

Tokyo Stock Exchange

Tsubasa Securities

UBS

UniCredito Italiano

U.S. Clearing Corporation

U.S. Securities and Exchange Commission

U.S. Securities Industry Association

Wexford Clearing Services

127

Conduct of the Study

TABLE A2-2. ORGANIZATIONS INTERVIEWED

ABN Amro NV

Association of Private Client InvestmentsManagers and Stockbrokers

Banc of America Securities

Bank One Corporation

The Bank of New York

Barclays

The Bear Stearns Companies, Inc.

Brown Brothers Harriman & Co.

BNP Paribas

Citigroup, Inc.

CRESTCo

Depository Trust & Clearing Corporation

Deutsche Bank

Edward Jones

Euroclear

European Brokers Club

Fidelity Investments

Goldman Sachs & Co.

HSBC Holdings

Invesco Asia

Ivy Funds

Janus Capital Corp.

Japan Securities Dealers Association

JASDEC

JP Morgan Chase & Co.

Legg Mason

Merrill Lynch & Co.

Morgan Stanley Dean Witter & Co.

National Financial Services

Nomura Securities

and Nomura Asset Management

Northern Trust Corporation

Prudential Securities

Robertson Stephens

SIS Sega Intersettle

Standard Chartered

State Street Corporation

Tsubasa Securities

UBS

UniCredito Italiano

U.S. Clearing Corporation

U.S. Securities and Exchange Commission

Wexford Clearing Services

interviewers could readily identify issues of greatestconcern to each organization while exploring criticalissues in depth. As is usual for surveys of this kind,participating firms were offered assurance of confi-dentiality to protect proprietary information.

In order to obtain a fair and balanced representationof the issues and concerns facing system participants,PricewaterhouseCoopers conducted interviews with avariety of different stakeholders along the global clear-ing and settlement value chain, including investors, bro-kers, infrastructure providers, and agent banks. Organi-zations whose operations and locations span differentregions and countries were represented, including thosethat offer global products and services and those thatare principally focused on domestic business.

Analysis

Following the initial round of interviews, team mem-bers from PricewaterhouseCoopers distilled the keyproblems and concerns into broad categories, taking

account of their impact on the various stakeholdergroups and on the different phases of the trade lifecycle. Follow-up calls were made to pursue points ofparticular interest or areas of uncertainty. A summaryof the key themes and detailed findings was then dis-tributed to the participants and updated based on theiradditional feedback. Out of this process emerged fivepriority areas for improvement. These priority areasenjoyed a high degree of consensus as to their sub-ject matter and scope across the range of participants:

� Barriers to competition, including the lack ofopen and equal access to separable functionsalong the value chain and lack of price transpar-ency of separable services.

� Interoperability, including the need forconsistently applied and enforced communica-tions protocols, technology, and data standardsand for reliable and comprehensive sources ofcounterparty and securities reference data.

128


� Improvements to the basic clearance and

settlement model, including information on allprocesses and communications and eliminationof paper from the process.

� Optimization of collateral and risk manage-

ment, including a common standard for finality,legal certainty in all securities and collateraltransactions, and better management of riskarising in cross-border transactions.

� Streamlining asset servicing and corporate

actions, including electronic communicationand information flow to investors and easiercompliance with foreign ownership restrictions.

In addition to a broad consensus on substance, thesurvey indicated clear enthusiasm for a Group of Thirtyeffort in this area and wide recognition of the benefitsthat the undertaking could provide. Beyond the obvi-ous evidence of enthusiastic participation in the inter-view process itself, respondents offered the followingsuggestions for achieving the study’s objectives:

� Set out a clear vision for the global clearing andsettlement system toward which all recommen-dations could be seen as advancing.

� Rather than duplicate the work of other studiesin this area, sound recommendations already

TABLE A2-3. RELATED STUDIES EXAMINED

1989 Group of Thirty, Clearance and Settlement Systems in the World’s Securities Markets.

BIS, Report on Netting Schemes (Angell Report).

1990 BIS, Report of the Committee on Interbank Netting Schemes of the Central Banksof the Group of Ten Countries (Lamfalussy Report).

1992 BIS/CPSS, Delivery versus Payment in Securities Settlement Systems.

1995 BIS/CPSS, Cross-border Securities Settlements.

1996 FIBV, Clearing and Settlement Best Practices.*

IOSCO, Report of the Technical Committee, Client Asset Protection.

1997 Joint Report by CPSS and by the Technical Committee of IOSCO, Disclosure Frameworkfor Securities Settlement Systems.

1998 IOSCO, Objectives and Principles of Securities Regulation.

2000 ISSA, 2000 Recommendations.

2001 BIS/CPSS, Core Principles for Systematically Important Payment Systems.

CPSS-IOSCO, Recommendations for Securities Settlement Systems.

The Center for European Policy Studies, The Securities Settlement Industry in the EU,Structure, Costs and the Way Forward.

The Giovannini Group, Cross-Border Clearing and Settlement Arrangements in theEuropean Union.

Final Report of the Committee of Wise Men on the Regulation of European Securities Markets.

2002 Communication from the Commission to the Council and the European Parliament, Clearingand settlement in the European Union — Main policy issues and future challenges.

Board of Governors of the Federal Reserve System and Securities and Exchange Commission,Interagency White Paper on Structural Change in the Settlement of Government Securities:Issues and Options.

* La Federation International de Bourse Valeur (FIBV) is the World Federation of Stock Exchanges, a global trade association for theexchange industry, representing 56 regulated exchanges from all over the world.

129


enunciated by others should be endorsed.Where recommendations go beyond existinginitiatives, arguments and recommendationsshould be articulated at a level of detailsufficient to describe best practice withoutambiguity.

� The focus of the study should be clear state-ments of best market practice. Necessarychanges in law or regulation should be detailedas well, while recognizing their longer imple-mentation horizon.

� In striking a balance between the achievable andthe optimal, recommendations that are less thanoptimal should include the reasons for stoppingshort of an optimal solution, including ananalysis of barriers blocking further progressand benefits forgone by not pursuing theoptimal solution.

� To the extent possible, recommendationsshould include guidance on how and by whomthey should be implemented and subsequentlyenforced.

In recognition of the pledge of confidentiality tosurvey participants, detailed responses to the surveyquestions are not being published. However, moreinformation about the content of the survey may beobtained by contacting the Group of Thirty office inWashington, DC.

ASSESSMENT OF EXISTING

PRINCIPLES AND STANDARDS

While work proceeded on the industry survey, a work-ing group undertook a detailed inventory of existingstandards and principles published by authoritativeindustry bodies and official agencies with respect toclearing and settlement. The goal of this exercise wasto develop a “map” of standards and principles toidentify gaps and vulnerabilities that the G30 studyshould address, whether by expanding upon existingguidance or developing recommendations in areasotherwise unaddressed.

The starting point for the analysis was a bibliogra-phy of authoritative studies, many including specificrecommendations, that had been undertaken since the

1989 G30 study “Clearance and Settlement in WorldSecurities Markets.” Most of these reports were is-sued under the auspices of the Bank for InternationalSettlements (BIS), the Committee on Payments andSettlements Systems of the Group of Ten centralbanks (CPSS), the International Organization of Se-curities Commissions (IOSCO), or the InternationalSecurities Services Association (ISSA) or in the con-text of creating a single capital market in the Euro-pean Union. These studies are listed in table A2-3

Out of this review emerged an elaborate matrix,organized by major theme, and including specific is-sues and actions at the level of trade matching, secu-rities lending, communications protocols, and the like.The review encompassed both questions of substanceand implementation and went into the voluminousmaterial available in considerable detail. In view ofthe emphasis among firms interviewed on endorsingand building upon sound recommendations alreadyenunciated by others, the working party focused inparticular on the 2000 ISSA recommendations andthe recommendations jointly issued by CPSS andIOSCO in late 2001. Where those studies have maderecommendations, this report builds upon that foun-dation, either expanding the reach of the basic rec-ommendation to the global context or exploring thematter addressed in greater detail.

Given the complex and detailed nature of the map-ping exercise, the large volume of material generatedhas not been reproduced in this volume. As with theindustry survey, however, more detailed informationabout the analysis and the resulting matrix itself isavailable through the office of the Group of Thirtyin Washington, DC.

DEFINING RECOMMENDATIONS

The industry survey and analysis of principles pro-duced two “maps” of the system, which were broughttogether to identify priority areas for further work.Where strong interest from industry intersected withan area identified as needing action in the standardsand principles map, the Steering Committee endorsedthe development of specific recommendations. Rec-ommendations take one of several forms:

130


� Endorsement of existing standards, withidentification of additional or broader actionsthan those envisaged under the current stan-dard, where appropriate.

� News standards where none now exist.� In particularly complex areas, identification of

further work that should be pursued, with guid-ance on the purpose and direction of research.

With the areas and format of recommendationthus identified, several additional rounds of workinglevel meetings were organized to develop specific pro-posals. The actual drafting of recommendations wasundertaken by experts in various phases of the clear-ing and settlement process, many of them veteransof the earlier working party process, and small off-site meetings of these experts were then organizedto discuss and refine the proposals. Draft proposalswere vetted more widely and refined before beingincluded in the final report.

131


As previously noted, the total work effort devotedto the project was dominated by the cumulative in-put of many individual contributors. Although thereis a danger of oversight in naming individuals, wewould like to recognize those who made significantpersonal contributions to the project, whether byoffering their time and expertise in working and ad-visory groups, drafting and reviewing documents,or offering advice and counsel during the life of theproject. Although some have changed jobs duringthe last two years, they are listed here with theiraffiliations at the time of their initial participation.

Significant contributions were made by: ABNAmro NV, Hugh Scott-Barret; the Australian StockExchange, Angus Richards; from the Bank of En-gland, Alastair Clark, Victoria Cleland, and JohnTrundle; the Bank of Japan, Iwao Kuroda; from theBank of New York, Tom Perna and Elizabeth Siano;the Banque de France, Yvon Lucas; from Barclays,Simon Chatterton and Tim Shepheard-Walwyn;Bear Stearns, Michael Alix; BNP Paribas, Jacques-Phillipe Marson; Brown Brothers Harriman & Co.,Anthony Enders; the Canadian Depository for Se-curities, Bruce Butterill and Allan Cooper;Companhia Brasiliera Liquidaçâo e Custódia,Amarilis Sardenberg; from Citigroup, Diana Chan,Ranjit Chatterji, Anne Frascarelli, and Ray Parodi;Clearstream International, Mark Gem, AndreRoelants, and Charles Vuylsteke; and from CliffordChance, Mark Harding and Dermot Turing.

Also contributing significantly to the projectwere: from CRESTCo, Iain Saville (now at Com-puter-share) and Paul Symons; on behalf of theCPSS-IOSCO Task Force, Patrick Parkinson of theU.S. Federal Reserve and Shane Tregillis of theMonetary Authority of Singapore; Davis Polk &Wardwell, Randy Guynn; from Deutsche Bank,Mitchel Lenson, Simon Powell, and Swen Werner;from Deutsche Börse: Orlando Chiesa and JochenSeitz; DGZ-Bank Frankfurt, Manfred Zass; DTCC,Peter Axilrod, Mary Ann Callahan, Dennis Dirks,Dennis Earle, Ellen Levine, Richard Nesson andJack Wiener; Eurex, Daniel Gisler; from Euroclear,Pierre Francotte, Martine Dinne, Kristen Geyer andAnso Thire; Euronext, Patrice Renault; from the Eu-ropean Central Bank, Elias Kazarian (working groupsecretary) and Daniela Russo; from the EuropeanCommission, John Berrigan and Elizabeth Wrigley;European Securities Forum, Pen Kent; from the

Federal Reserve Bank of New York, PeterBakstansky and Lawrence Sweet; the FinanceFoundation, Michel Gabrysiak; the Financial Ser-vices Authority, Gay Huey Evans; the GiovanniniGroup, Alberto Giovannini; from Goldman Sachs,Paul Deighton, Tim Cole, Robert Mancini, AlbertoPravettoni, and Mike Sammons; Hong Kong Ex-changes and Clearing Ltd, Walter Reisch; from theHong Kong Securities & Futures Commission, StellaLeung (working group secretary); HSBC, JohnGubert (subcommittee chair); from the IOSCOTechnical Committee, David Brown and DavidKnott; from JP Morgan Chase, Neil Henderson, Ed-ward Neeck (working group secretary), Gillian VanSchaick, and Susannah Truitt; Lehman Brothers,Thomas Russo; London Clearing House, RoryCunningham, David Hardy and Andrew Lamb; andfrom the London Stock Exchange, DonaldCruickshank.

Major contributors also included: the MonetaryAuthority of Singapore, Yeo Lian Sim; from MorganStanley, Jane Carlin, Patrick de Saint-Aignan, MaryeHumphery, David Nicol, Judy Smith, and EileenMurray (now at CSFB); Nomura Securities, HitoshiTonomura; Options Clearing Corporation, WayneLuthringshausen and Michael Walinskas; from Ox-ford Economic Research Associations, Fod Barnes,Dieter Helm, Gunnar Niels, and Reinder van Dijk;Promethee, Albert Bressand; Reuters, Henry Engler;from the U.S. Securities and Exchange Commission,Larry Bergmann, Robert Colby, Jeff Mooney, andAnnette Nazareth; Singapore Exchange, ChristinaAng and Peter Chia; Société Générale, YannickChagnon; State Street Corporation, RobertAlmanas, Mary Fenoglio and Simon Zornoza; fromthe Stern School at New York University, Roy Smithand Ingo Walter; the Tokyo Stock Exchange,Toshitsugu Shimizu; from UBS, Peter Gnepf, JosefLandolt, and Urs Staehli; and from UnicreditoItaliano, Francesco Giordano.

Finally, we are deeply appreciative of the ad-vice and counsel provided in a personal capacityby Wendelin Hartmann, Alexandre Lamfalussy, andby Raphael Soifer. And we appreciate the oppor-tunity afforded to review the project’s progress withRoger Ferguson of the Board of Governors of theFederal Reserve System; Cathy Minehan of theFederal Reserve Bank of Boston; and Mario Montiof the European Commission.

BOX A2-1. INDIVIDUAL CONTRIBUTORS

133

The following terms and acronyms are used in this report as defined in “A Glossary of Terms Used in Paymentsand Settlement Systems,” Bank for International Settlements, January 2001, revised July 2001.

GLOSSARY

batch

beneficial ownership/interest

central counterparty(CCP)

central securitiesdepository (CSD)

clearing/clearance

clearing system

confirmation

cross-border settlement

cross-border trade

custodian

delivery

delivery versus payment(DVP)

dematerialization

the transmission or processing of a group of payment orders and/or securitiestransfer instructions as a set at discrete intervals of time.

the entitlement to receive some or all of the benefits of ownership of a security orother financial instrument (such as income, voting rights, power to transfer). Benefi-cial ownership is usually distinguished from “legal ownership” of a security orfinancial instrument.

an entity that is the buyer to every seller and seller to every buyer of a specified set ofcontracts, such as those executed on a particular exchange or exchanges.

a facility (or an institution) for holding securities, which enables securities transactionsto be processed by book entry. Physical securities may be immobilized by thedepository or securities may be dematerialized (that is, so that they exist only aselectronic records). In addition to safekeeping, a central securities depository mayincorporate comparison, clearing, and settlement functions.

the process of transmitting, reconciling, and, in some cases, confirming paymentorders or security transfer instructions prior to settlement, possibly including thenetting of instructions and the establishment of final positions for settlement.

a set of procedures whereby financial institutions present and exchange data and/ordocuments relating to funds or securities transfers to other financial institutions at asingle location (clearinghouse). The procedures often also include a mechanism forthe calculation of participants’ bilateral and/or multilateral net positions with a viewto facilitating the settlement of their obligations on a net or net net basis.

the process in which the terms of a trade are verified either by market participantsdirectly or by some central entity (typically the marketplace). When direct participantsexecute trades on behalf of indirect market participants, trade confirmation occurson two separate tracks: verification (generally termed confirmation) of the terms ofthe trade between direct participants and verification (sometimes termed affirmation)of the intended terms between each direct participant and the indirect participant forwhom the direct participant is acting.

a settlement that takes place in a country other than the country in which one tradecounterparty or both are located.

a trade between counterparties located in different countries.

an entity, often a bank, that safekeeps and administers securities for its customers andthat may provide various other services, including clearance and settlement, cashmanagement, foreign exchange, and securities lending.

final transfer of a security or financial instrument.

a link between a securities transfer system and a funds transfer system that ensuresthat delivery occurs if, and only if, payment occurs.

the elimination of physical certificates or documents of title that represent ownershipof securities so that securities exist only as accounting records.

134

a failure to settle a securities transaction on the contractual settlement date, usuallybecause of technical or temporary difficulties. Fail is usually distinguished from“default.” Also called failed transaction.

irrevocable and unconditional.

the discharge of an obligation by a transfer of funds and a transfer of securities thathave become irrevocable and unconditional.

a custodian that provides its customers with custody services in respect of securitiestraded and settled not only in the country in which the custodian is located but also innumerous other countries throughout the world.

a transfer system in which the settlement of funds or securities transfer instructionsoccurs individually (on an instruction-by-instruction basis).

placement of certificated securities and financial instruments in a central securitiesdepository to facilitate book-entry transfers.

a central securities depository that clears and settles international securities or cross-border transactions in domestic securities.

recognition in law as the owner of a security or financial instrument. It is usuallyrepresented by holding “legal title” and sometimes distinguished from beneficialownership/interest.

the process for comparing the trade or settlement details provided by counterpartiesto ensure that they agree with respect to the terms of the transaction.

an agreed offsetting of positions or obligations by trading partners or participants.The netting reduces a large number of individual positions or obligations to a smallernumber of obligations or positions. Netting may take several forms that have varyingdegrees of legal enforceability in the event of default of one of the parties.

the payer’s transfer of a monetary claim on a party acceptable to the payee. Typically,claims take the form of banknotes or deposit balances held at a financial institutionor at a central bank.

a payment system consists of a set of instruments, banking procedures, and, typically,interbank funds transfer systems that ensure the circulation of money.

the processing of instructions on an individual basis at the time they are receivedrather than at some later time.

the continuous (real-time) settlement of funds or securities transfers individually onan order-by-order basis (without netting).

the full set of institutional arrangements for confirmation, clearance, and settlementof securities trades and safekeeping of securities.

an act that discharges obligations in respect of funds or securities transfers betweentwo or more parties.

the completion of presettlement and settlement processes based on trade data that ismanually entered only once into an automated system.

a payment system is systemically important where, if the system were insufficientlyprotected against risk, disruption within it could trigger or transmit further disrup-tions among participants or systemic disruptions in the financial area more widely.

fail

final (finality)

final settlement

global custodian

gross settlement system

immobilization

international centralsecurities depository

(ICSD)

legal ownership

matching

netting

payment

payment system

real time

real-time grosssettlement (RTGS)

securities settlementsystem (SSS)

settlement

straight-throughprocessing (STP)

systemically importantpayment system

135

GROUP OF THIRTY PUBLICATIONS SINCE 1989

REPORTS

Key Issues in Sovereign Debt Restructuring

Study Group Report. 2002

Reducing the Risks of International Insolvency

A Compendium of Work in Progress. 2000

Collapse: The Venezuelan Banking Crisis of ‘94

Ruth de Krivoy. 2000

The Evolving Corporation: Global Imperatives and

National Responses


International Insolvencies in the Financial Sector


Global Institutions, National Supervision

and Systemic Risk

Study Group on Supervision and Regulation. 1997

Latin American Capital Flows: Living with Volatility

Latin American Capital Flows Study Group. 1994

Defining the Roles of Accountants, Bankers and

Regulators in the United States

Study Group on Accountants, Bankers and Regulators. 1994

EMU after Maastricht

Peter B. Kenen. 1992

Sea Changes in Latin America

Pedro Aspe, Andres Bianchi and Domingo Cavallo, with

discussion by S.T. Beza and William Rhodes. 1992

The Summit Process and Collective Security: Future

Responsibility Sharing

The Summit Reform Study Group. 1991

Financing Eastern Europe

Richard A. Debs, Harvey Shapiro, and Charles Taylor. 1991

The Risks Facing the World Economy

The Risks Facing the World Economy Study Group. 1991

Perestroika: A Sustainable Process for Change

John P. Hardt and Sheila N. Heslin, with commentary by Oleg

Bogomolov. 1989

THE WILLIAM TAYLOR MEMORIAL LECTURES

Post Crisis Asia: The Way Forward

Lee Hsien Loong. 2001

Licensing Banks: Still Necessary?

Tomasso Padoa-Schioppa. 2000

Banking Supervision and Financial Stability

Andrew Crockett. 1998

Global Risk Management

Ulrich Cartellieri and Alan Greenspan. 1996

The Financial Disruptions of the 1980s:

A Central Banker Looks Back

E. Gerald Corrigan. 1993

SPECIAL REPORTS

Derivatives: Practices and Principles: Follow-up

Surveys of Industry Practice

Global Derivatives Study Group. 1994

Derivatives: Practices and Principles,

Appendix III: Survey of Industry Practice


Derivatives: Practices and Principles, Appendix II:

Legal Enforceability: Survey of Nine Jurisdictions


Derivatives: Practices and Principles,

Appendix I: Working Papers


Derivatives: Practices and Principles


Clearance and Settlement Systems:

Status Reports, Autumn 1992

Various Authors. 1992


Status Reports, Year-End 1990


Conference on Clearance and Settlement Systems;

London, March 1990: Speeches



Status Reports, Spring 1990


Clearance and Settlement Systems

in the World’s Securities Markets

Steering & Working Committees of the Securities Clearance and

Settlement Study. 1989

OCCASIONAL PAPERS

66. Enron et al: Market Forces in Disarray

Jaime Caruana, Andrew Crockett, Douglas Flint, Trevor Harris,

Tom Jones. 2002

65. Venture Capital in the United States and Europe

Guillermo de la Dehesa

64. Explaining the Euro to a Washington Audience

Tomasso Padoa-Schioppa. 2001

63. Exchange Rate Regimes:

Some Lessons from Postwar Europe

Charles Wyplosz. 2000

136

62. Decisionmaking for European Economic and

Monetary Union

Erik Hoffmeyer. 2000

61. Charting a Course for the Multilateral Trading

System: The Seattle Ministerial Meeting and Beyond

Ernest Preeg. 1999

60. Exchange Rate Arrangements for the Emerging

Market Economies

Felipe Larraín and Andrés Velasco. 1999

59. G3 Exchange Rate Relationships: A Recap of the

Record and a Review of Proposals for Change

Richard Clarida. 1999

58. Real Estate Booms and Banking Busts:

An International Perspective

Richard Herring and Susan Wachter. 1999

57. The Future of Global Financial Regulation

Sir Andrew Large. 1998

56. Reinforcing the WTO

Sylvia Ostry. 1998

55. Japan: The Road to Recovery

Akio Mikuni. 1998

54. Financial Services in the Uruguay

Round and the WTO

Sydney J. Key. 1997

53. A New Regime for Foreign Direct Investment

Sylvia Ostry. 1997

52. Derivatives and Monetary Policy

Gerd Hausler. 1996

51. The Reform of Wholesale Payment Systems

and its Impact on Financial Markets

David Folkerts-Landau, Peter Garber, and Dirk Schoenmaker.

1996

50. EMU Prospects

Guillermo de la Dehesa and Peter B. Kenen. 1995

49. New Dimensions of Market Access

Sylvia Ostry. 1995

48. Thirty Years in Central Banking

Erik Hoffmeyer. 1994

47. Capital, Asset Risk and Bank Failure

Linda M. Hooks. 1994

46. In Search of a Level Playing Field: The Implemen-

tation of the Basle Capital Accord in Japan and the

United States

Hal S. Scott and Shinsaku Iwahara. 1994

45. The Impact of Trade on OECD Labor Markets

Robert Z. Lawrence. 1994

44. Global Derivatives: Public Sector Responses

James A. Leach, William J. McDonough, David W. Mullins,

Brian Quinn. 1993

43. The Ten Commandments of Systemic Reform

Vaclav Klaus. 1993

42. Tripolarism: Regional and Global Economic

Cooperation

Tommaso Padoa-Schioppa. 1993

41. The Threat of Managed Trade to Transforming

Economies

Sylvia Ostry. 1993

40. The New Trade Agenda

Geza Feketekuty. 1992

39. EMU and the Regions

Guillermo de la Dehesa and Paul Krugman. 1992

38. Why Now? Change and Turmoil in U.S. Banking

Lawrence J. White. 1992

37. Are Foreign-owned Subsidiaries Good for the

United States?

Raymond Vernon. 1992

36. The Economic Transformation of East Germany:

Some Preliminary Lessons

Gerhard Fels and Claus Schnabel. 1991

35. International Trade in Banking Services: A

Conceptual Framework

Sydney J. Key and Hal S. Scott. 1991

34. Privatization in Eastern and Central Europe

Guillermo de la Dehesa. 1991

33. Foreign Direct Investment:

The Neglected Twin of Trade

DeAnne Julius. 1991

32. Interdependence of Capital Markets and Policy

Implications

Stephen H. Axilrod. 1990

31. Two Views of German Reunification

Hans Tietmeyer and Wilfried Guth. 1990

30. Europe in the Nineties: Problems and Aspirations

Wilfried Guth. 1990

29. Implications of Increasing Corporate Indebtedness

for Monetary Policy

Benjamin M. Friedman. 1990

28. Financial and Monetary Integration in Europe:

1990, 1992 and Beyond

Tommaso Padoa-Schioppa. 1990

27. Reciprocity and the Unification of the European

Banking Market

Douglas Croham. 1989

26. Japan’s Savings and External Surplus in the World

Economy

Masaru Yoshitomi. 1989

25. 1992: The External Dimension

David Henderson. 1989

137

GROUP OF THIRTY MEMBERS

Mr. Paul A. Volcker

Chairman of the Board of Trustees

Group of Thirty

Rt. Hon. Lord Richardson of Duntisbourne, KG

Honorary Chairman, Group of Thirty

Dr. Jacob A. Frenkel

Chairman, Group of Thirty

Chairman, Merrill Lynch International, Inc.

Dr. Josef Ackermann

Spokesman of the Board of Managing Directors

Deutsche Bank AG

Mr. Leszek Balcerowicz

President, National Bank of Poland

Mr. Geoffrey L. Bell

Executive Secretary, Group of Thirty

President, Geoffrey Bell & Company, Inc.

Dr. Domingo Cavallo

Leonard N. Stern School of Business

New York University

Mr. E. Gerald Corrigan

Managing Director, Goldman Sachs & Co.

Mr. Andrew D. Crockett

General Manager, Bank for International Settlements

Mr. Richard A. Debs

Advisory Director, Morgan Stanley & Co.

Sr. Guillermo de la Dehesa

Director and Member of the Executive Committee,

Santander Central Hispano

Mr. Martin Feldstein

President, National Bureau of Economic Research

Professor of Economics, Harvard University

Professor Gerhard Fels

Director, Institut der deutschen Wirtschaft

Mr. Stanley Fischer

President, Citigroup International

Mr. Arminio Fraga Neto

Former Governor, Banco Central do Brasil

Mr. Toyoo Gyohten

President, Institute for International Monetary Affairs

Mr. Gerd Häusler

Counsellor and Director,

International Capital Markets Department

International Monetary Fund

Mr. John G. Heimann

Senior Advisor, Financial Stability Institute

Professor Peter B. Kenen

Walker Professor of Economics & International Finance,

Department of Economics, Princeton University

Mr. Mervyn King

Deputy Governor, Bank of England

Professor Paul Krugman

Professor of Economics, Woodrow Wilson School,

Princeton University

M. Jacques de Larosière

Conseiller, BNP Paribas

Mr. William McDonough

President, Federal Reserve Bank of New York

Mr. Shijuro Ogata

Former Deputy Governor, Bank of Japan

Mr. Guillermo Ortiz Martinez

Governor, Banco de Mexico

Dr. Sylvia Ostry

Distinguished Research Fellow,

Munk Centre for International Studies, Toronto

Dr. Tommaso Padoa-Schioppa

Member of the Executive Board, European Central Bank

Mr. William R. Rhodes

Senior Vice Chairman, Citigroup, Inc.

Mr. Ernest Stern

Former Managing Director, JP Morgan Chase & Co.

Mr. Lawrence Summers

President, Harvard University

M. Jean-Claude Trichet

Governor, Banque de France

Sir David Walker

Treasurer, Group of Thirty

Senior Advisor, Morgan Stanley International Inc.

Dr. Marina v N. Whitman

Professor of Business Administration & Public Policy,

University of Michigan

Mr. Yutaka Yamaguchi

Deputy Governor, Bank of Japan

EMERITUS MEMBERS

Dr. Wilfried Guth

Deutsche Bank AG

Mr. Erik Hoffmeyer

Former Chairman, Danmarks Nationalbank

EXECUTIVE DIRECTOR

John G. Walsh

Group of Thirty

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