1. ACSDA Seminar Next Challenges in Depository, Clearance and Settlement Services - CCP Opportunities - Margarida Baptista November 15, 2002

2. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

3. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

4. Securities Settlement Systems Real Time Gross Settlement System Deferred Net Settlement System DNS x RTGS RISK LIQUIDITY Trade-off: Risk x Liquidity

5. Minimization of liquidity requirements Decreasing of participants exposure to credit risk High reduction of settlement instructions Netting: advantages Cut down on transaction costs Decreasing in operational risk BUT: potential problems ….

6. How to handle a participant’s default : Systemic Risk Netting: potential problems The contamination effect depends on: the defaulter’s debit value the number of its counterparties 1st. alternative Unwinding Procedures In case of a participant’s default: contamination of the debit/credit chain

7. 2nd. alternative Third Party Pays Socialization of losses Moral Hazard How to handle a participant’s default : Netting: potential problems

8. CCP International recommendation for risk mitigation in DNS Systems Allows the benefits of netting without increasing systemic risk CCP: the third alternative Provided that: adequate risk management controls and systems should be adopted.

9. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

10. CPSS-IOSCO: « A central counterparty (CCP) is an entity that interposes itself between the counterparties of trade, acting as a buyer to every seller and a seller to every buyer » BUYERSELLER Trading BUYER SELLER CCP CCP assumes the role of the seller CCP assumes the role of the buyer What is a CCP ?

11. Measure; Manage; and Assume the counterparty risk CCP: main function and advantages CCP RISK A RISK B RISK C RISK D RISK H RISK G RISK F RISK E CCP RISK A B C D E H G F Main advantages: Guarantee of anonymity Supports multilateral netting Absorption of risks between trade and the settlement period Protection of market participants in the event of a participant default Prevents the spillover of securities settlement risks to the payments system Systemic Risk Reduction

12. Barriers to be overcome in order to implement a robust risk management system High initial investments Human resources Risk management systems IT systems (both hardware and software) High ongoing expenses to maintain the system CCP: main disadvantages High fixed costs Minimum Scale Requirements

13. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

14. CBLC: main risks to be managed Principal Risk Credit risk Liquidity risk Principal Risk Replacement cost Risk DELIVERY vs. PAYMENT

15. SFI-DVP model 3 - multilateral netting for both securities and cash legs For cash leg, multilateral netting across different markets and instruments Settlement cycles: Equities: T+3 Corporate Bonds: T+0 and T+1 Same day finality in central bank money (allowed by the Brazilian Payment System implemented in April 2002) STR: Central Bank Money Transfer System (RTGS) CBLC: Transitory settlement account at STR Adequate legal basis: Enforceability of multilateral netting and novation of trades CBLC lien on securities posted as collateral CBLC Model

16. Equities (cash and derivatives) Corporate debt instruments BTC – Securities Lending Service CBLC acts as a CCP: When CBLC becomes a CCP? CBLC Trades are automatically reported to CBLC CBLC CLEARING AGENT A B CLEARING AGENT Information is sent to Brokers and Clearing Agents: CBLC BECOMES CCP ABROKERBBROKER Trading Systems Trading Matching Sell Order Buy Order Trading and matching

17. CBLC credit risk: layers of protection Participants’ requirements Collateralization 95% confidence level under historic scenarios Settlement fund 99% confidence level under stress scenarios Segregated Net worth LAMFALUSSY PLUS Hybrid Loss Sharing model defaulters pay survivors pay

18. 1 st : collaterals posted by the defaulter 2 nd : defaulter’s contribution to the settlement fund 3 rd : settlement fund 4 th : segregated net worth Dealing with payment failures... LIQUIDITY PROVISION Financial credit lines provided by a pool of banks CBLC has only a short time period (3:30 to 3:55 pm) to execute collaterals

19. Dealing with securities delivery failures Fundamental mechanism to prevent delivery failures 1 st : Securities Lending: CBLC acts as principal Full collateralization Risk management tool: CM–TIMS (OCC system) Fully integrated in the settlement process 2 nd : Buy-in procedures: T+4: CBLC releases a buy-in order The buy-in order can be canceled until T+6 should the defaulter delivers the security; Buy-in order execution: the buyer´s broker buys the security in the market Market price difference: covered by the collaterals posted by the defaulter

20. Same day finality in Central Bank Money Participants requirements Collateralization Segregated Net Worth Multilateral netting supported by a CCP SFI – DVP 3 Settlement Fund Securities Lending Summing up...

21. AGENDA NET SETTLEMENT SYSTEMS THE CCP SOLUTION CBLC MODEL CONCLUDING REMARKS

22. Concluding Remarks The choice and design of a suitable model depends on several key variables: International recommendations and best practices Particularities of each country: National Payment Systems Legal environment Profile and characteristics of the financial market Size Regulations Market practices Participant’s size, concentration, profile and business strategies Type and diversity of financial instruments Strong cooperation between the market and the regulators

23. Concluding Remarks That is: it is not wise to support an optimal model, regardless the specific context in which it is going to be put in place Volume and value of financial transactions Trading patterns among counterparties Opportunity costs to implement risk management robust systems RTGS x DNS systems: the choice of adopting one or the other (or a combination of the two of them) has to be addressed, case by case, taking into account: the trade-offs between the RTGS and DNS systems cost x benefit analysis

24. Concluding Remarks CPSS-IOSCO Recommendation n.4: “The benefits and costs of a CCP should be evaluated. Where such a mechanism is introduced, the CCP should rigourously controls the risks it assumes.” If a DNS system should be chosen, it is worth considering the implementation of a CCP in order to capture the benefits of netting without jeopardising the systemic risk reduction goal; otherwise, it can be more suitable to settle in a gross basis Nevertheless: it is possible to outline one general conclusion: