Danmarks Nationalbank's Oversight of the Financial Infrastructure in Denmark

Like an increasing number of other central banks, Danmarks Nationalbank has decided to issue an annual report on oversight of the financial infrastructure. The purpose is to describe the developments and risks in core infrastructure systems and to give an account of the activities and measures that make up Danmarks Nationalbank's oversight, cf. Box 7. This is followed by a progress report on Danmarks Nationalbank's response to the recommendations made by the IMF in connection with its assessment of the Danish systems in 2005-06.

On the basis of the oversight, Danmarks Nationalbank finds the risks in the core systems of the Danish financial infrastructure to be moderate and subject to adequate risk management. In the current situation, credit risk and legal risk are not assessed to constitute a major problem for system participants (credit institutions, etc.). Likewise, the systems seem to be able to handle operational risks and ensure a high degree of stability in the settlement of payments, securities transactions, etc. This also applies to Danmarks Nationalbank's own payment system, Kronos, which saw a substantial improvement of operational stability from 2006 to 2007. Finally, there are no indications that settlement in the systems is threatened by shortage of liquidity among participants. Thus, participants have not generally experienced problems in procuring the liquidity required for smooth and efficient settlement in the systems, even if a few credit institutions in Denmark may experience a liquidity squeeze.

The Danish payment and settlement systems do not seem to have been affected by the current financial turmoil, whereas the number of reported transactions in CLS, the international system for settlement of foreign-exchange transactions, reached a record-high level in August 2007 in connection with the turmoil. The extraordinarily high number of reported transactions led to temporary capacity problems in CLS in August. This also affected Danish CLS participants.

KRONOS

The volume of interbank payments settled in Kronos has been rising for several years, but fell by just over 7 per cent in 2007, cf. Table 4. This is attributable to a 22 per cent decrease in payments by the largest 10 participants. Payments by other Kronos participants increased by more than 100 per cent, but since there is a high degree of concentration on the largest participants, the fall seen for this group dominates the overall result.^[1]

Improved operational stability in Kronos
Following a somewhat unsatisfactory operational stability in 2006^[2], Danmarks Nationalbank's payment system, Kronos, operated satisfactorily in 2007. The improvement is the result of a number of stability-enhancing measures in connection with the processing of the SWIFT messages sent between Kronos (Danmarks Nationalbank) and the participants, which are a prerequisite for settling payments.

In view of the very large daily traffic in Kronos, it is important to financial stability in Denmark that system disruptions are kept at a very low level.^[3] In the event of interruptions in the settlement of payments, recipients' claims on remitters are prolonged, which may result in unforeseen credit and liquidity exposures.

Considerable liquidity reserved for payments in Kronos
Kronos is an RTGS system, which means that immediately after receipt of the payment instructions payments are settled individually as transfers between the participants' accounts at Danmarks Nationalbank. Under normal circumstances, the system does not entail any credit risk to participants.

On the other hand, the participants' liquidity requirements are higher than in net settlement systems such as the Sumclearing (see below) since they must take into account situations where incoming payments are received later in the day than outgoing payments. In order to address this issue and support a smooth flow of payments, Danmarks Nationalbank provides intraday credit to participants against liquid securities, primarily government and mortgage-credit bonds and covered bonds, as collateral. Statements of participants' payments in relation to their disposable amounts^[4] at Danmarks Nationalbank show that in 2007, as in previous years, participants had reserved considerable liquidity for payments, cf. Chart 42. Since 2005, however, there has been a tendency for payments settled to constitute a slightly larger share of the disposable amounts.

In addition, an important reason for the smooth functioning of Kronos is that over the years participants have developed payment patterns that entail a very stable time profile for daily payments, cf. Chart 43. This means that participants typically remit and receive approximately 95 per cent of the daily payments before noon. Consequently, participants seldom find themselves in a situation with long delays while outgoing payments are awaiting incoming payments or where they must rely heavily on their credit lines at Danmarks Nationalbank.

Internationally, central-bank RTGS systems are increasingly being upgraded to include functions to facilitate liquidity management by participants and to minimise liquidity requirements in connection with use of the systems. Since participants have traditionally held large bond portfolios that can be pledged as collateral to Danmarks Nationalbank, and on account of the payment patterns observed among participants, there has not been any pronounced need for such functionalities in the Danish financial system so far.

THE SUMCLEARING

In 2007, payment transactions settled in the Sumclearing increased by 7.5 per cent to a total of kr. 5,750 billion. A breakdown by major payment instruments is shown in Chart 44. Except for cheques, the value of transactions has been rising. Foreign payment cards accounted for the largest increase in 2007 (15 per cent), but use of such cards by Danes is still relatively modest compared with use of the Dankort.

Liquidity and credit risks in the Sumclearing are modest
The Sumclearing is a multilateral net settlement system in which retail payments on behalf of participants' customers are settled during the night. Net settlement of payments entails a credit risk since a participant with a net debit position vis-à-vis the other participants may fail before the payments from the previous day are settled. However, Danmarks Nationalbank has on several occasions assessed that the credit risk in connection with net settlement in the Sumclearing is modest.^[5]

Liquidity risk in the system is also found to be limited. The netting of payments between participants that takes place in the Sumclearing thus reduces the liquidity requirement for system participants. In 2007 this meant that cash settlement between Sumclearing participants constituted only 23 per cent of the underlying gross payments.

However, there is the risk that participants do not know exactly how much liquidity they need to reserve for settlement during the night because they have not received information about all payments initiated by their customers before settlement takes place. From time to time – particularly on large settlement days – a participant in a net debit position during a settlement cycle therefore fails to reserve sufficient liquidity for settlement. In that case, the relevant participant is postponed (removed from the settlement), and the net positions of the remaining participants are recalculated. This may trigger a "domino effect", whereby other participants who were net creditors of the postponed participant must also be postponed.

Payments relating to postponed participants are subsequently settled in the morning when the participants have had an opportunity to procure and reserve the liquidity at Danmarks Nationalbank that is required in order to settle the outstanding net positions. In 2007, net positions that could not be settled during the night in the Sumclearing as planned accounted for 1.1 per cent of the total net positions. This is in line with the 2006 level. Delayed settlement of net positions is primarily attributable to one-off handling errors by participants, cf. below.

High operational stability in the Sumclearing
In 2007, the systems for compilation and clearing of retail payments with a view to calculating the net positions to be settled between participants functioned satisfactorily. In general, there were few delays in these systems, and on all days except three the calculation of net positions was completed within the normal settlement cycles. The delays experienced were only small, and compilation and clearing of retail payments was completed during the night.

One incident experienced by a participant in 2007 did, however, mean that a very considerable number of transactions were not settled on time. Since Danmarks Nationalbank does not grant uncollateralised credit, it was not possible to implement a solution in time, and the participant was removed from the settlement cycle. The delay resulted in extensive clean-up efforts at PBS and among participants in order to ensure correct entry of transactions to customer accounts.

Together with PBS and the Danish Bankers Association, Danmarks Nationalbank has therefore implemented measures to prevent such incidents in future. This has led to the introduction of a new contingency procedure. In addition, PBS and the participants are enhancing their system controls. Finally, an analysis will be performed of whether the Sumclearing settlement procedure should be changed from one settlement cycle during the night to a more flexible clearing and settlement of retail payments over a 24-hour period. The IMF, too, has recommended such an analysis, cf. Box 8.

Participants' handling of Sumclearing settlement should be improved
In spite of high operational stability, settlement in the Sumclearing could not be completed as planned during the night on 21 days in 2007 (compared with 19 days in 2006) as participants had not reserved sufficient liquidity. In addition, on 13 days in 2007 (compared with 4 days in 2006) extraordinary settlement cycles were required before settlement could be completed. This is attributable to a combination of the following:

• operational factors such as non-observance of settlement procedures by certain participants, e.g. during the summer holiday period, and
• too little attention to large payment days when participants should reserve extra liquidity for settlement, e.g. on days when mortgages and taxes are paid and around the turn of the month.

As stated above, the risk that a participant has reserved too little liquidity cannot completely be eliminated. Reservations are based on estimates of the payments that are unknown to the participants prior to settlement, e.g. payments by cards issued by the participant in shops banking with other participants.

Danmarks Nationalbank has not found any indications that settlement delays in the Sumclearing are caused by a liquidity squeeze in the Danish financial system. Even on large settlement days, participants had generally reserved far more liquidity than they needed.

In 2007, the Danish Bankers Association emphasised to members participating in the Sumclearing the terms and conditions for participation in the system with a view to limiting the number of days on which settlement cannot be completed until Kronos has opened in the morning.

VP-SETTLEMENT

The value of trading transactions in the VP settlement fell by 1.3 per cent in 2007, to a total of kr. 23,467 billion, cf. Chart 45. This is attributable to lower trade in bonds. The value of equity transactions settled in VP rose by 26 per cent in 2007, but this could not offset the decline in bond trading. The strong rise in the transaction volume in VP, driven by equity trading, contributed to VP's decision in 2007 to lower the fee per trading transaction from kr. 6 to kr. 4.

High operational stability in VP Settlement
Settlement of securities transactions, etc. in VP Securities Services has been very stable for many years with few major disruptions. That was also the case in 2007, when only one such incident was observed. It lasted for approximately two hours, but did not entail substantial settlement problems.

Handling risk on large settlement days
In terms of financial stability, a safe and efficient settlement procedure is particularly important on large settlement days. Consequently, Danmarks Nationalbank has analysed VP Settlement at the beginning of January. In recent years this has been a time when securities trading and corporate actions for very large amounts have been settled due to refinancing of the mortgage-credit institutes' adjustable-rate mortgages. The analysis showed that the existing settlement procedure does not give rise to excessive liquidity risks for participants. This can be attributed to three factors:

• The overall liquidity position of the participants has largely been unaffected by the refinancing of adjustable-rate mortgages since the underlying mortgage-credit bonds are eligible as collateral to Danmarks Nationalbank.
• The need to redistribute liquidity among participants accounts for only a small proportion of the gross value of trades and corporate actions settled. On 2 January 2008, the gross value of trades settled was kr. 562 billion, but after offsetting of opposite payments, the net positions to be exchanged between participants amounted to only kr. 70 billion. Likewise, the respective gross and net values of periodic payments on 2 January 2008 were kr. 404 billion and kr. 72 billion.
• For virtually all participants, net positions concerning trade settlement and corporate actions, respectively, at the beginning of January are opposite, i.e. net creditors in the trading blocks are net debtors in terms of corporate actions.

Nevertheless, the analysis confirmed certain weaknesses in the block for settlement of corporate actions (VP35). This issue will be resolved when VP35 is upgraded to include procedures for removing individual ISIN codes where a participant does not have sufficient cover. This is not possible today and consequently VP35 can only be run if all participants' payment obligations in this block are sufficiently covered by liquidity on the settlement accounts. A new block will also be introduced in VP Settlement, whereby corporate actions for ISIN codes removed from VP35 can subsequently be settled when the relevant participants have procured sufficient liquidity. The work to upgrade VP35 will be resumed when the migration to TARGET2 has been completed in May 2008.

Participants' handling of securities settlement should be improved
Settlement in VP comprises several settlement blocks, in which trades and corporate actions (e.g. interest, repayments and dividend) are settled. The settlement schedule entails that even if a transaction is not settled in the first block – e.g. because the seller does not have the securities, or because the buyer has not reserved sufficient liquidity to pay for the securities purchased – it is possible to settle it in a later block. VP is thus entitled to check the reported transactions with a view to selecting and completing those for which cover can be found. This means that it is not necessary to remove all of a participant's transactions from a block, but only enough to ensure cover for both securities and cash. In 2007, just over 90 per cent of all trading transactions were settled in the first block (VP10). This is more or less the same as in 2006.

In recent years, the percentage of securities transactions settled in a timely manner (i.e. the settlement rate) has been falling marginally, primarily for equities, cf. Chart 46.

VP Securities Services has carefully monitored the development and will therefore, effective from mid-2008, adapt its sanctions policy with the aim of reversing the trend. Consequently, the existing sanctions for monetary overdrafts will also apply to securities shortfalls. At the same time, the sanctions policy will apply to more VP Settlement participants. The aim is to achieve a minimum settlement rate of 98 per cent on an annual basis, which is equivalent to the EU benchmark.

TARGET

Settlement of payments in euro by Danish credit institutions via the trans-European payment system, TARGET, through accounts at Danmarks Nationalbank, increased by 29 per cent in 2007, to a total of 4,080 billion euro (kr. 30,398 billion).

The majority by far of these payments were made to and received from euro area participants. The fact that Danish credit institutions have been able to participate in Target since 1999 has thus, all other things being equal, reduced the exposure of the Danish credit institutions (and thereby their credit risk) to commercial correspondent banks in the euro area.

TARGET2
The migration of TARGET to a new, single shared platform, TARGET2, began in November 2007. The new single platform replaces the current decentralised system in which the payment systems of the participating central banks, including Danmarks Nationalbank, are connected via an interlinking module. The third and final stage of the migration to TARGET2, which includes the Danish participants, will take place on 19 May 2008.

The transition from interlinked platforms to a single shared platform with operations in two regions (Germany and Italy, both places with real-time mirroring of data between two data centres) observes international best practice for settlement of payments, including the requirement that operations can be resumed within two hours after a major failure.

CLS

The value of foreign-exchange transactions in kroner in CLS rose by 6 per cent to kr. 50,446 billion in 2007. Among other things, this increase is attributable to a higher number of indirect participants in the CLS settlement in Denmark.

The onset of the financial turmoil in August 2007 affected the number of transactions settled in CLS, whereas no effect can be registered on the total gross value of the transactions settled. The average number of daily transactions in CLS rose by approximately 35 per cent from July to August 2007, while the average daily gross value of transactions increased by only around 5 per cent. The financial turmoil is not deemed to have had any impact on the settlement of Danish kroner in CLS. However, a very large number of reported foreign-exchange transactions for settlement in CLS caused temporary capacity problems on 16-21 August. This also affected Danish system participants since there were periods when foreign-exchange transactions could not be reported for settlement. Following an appeal from the participating central banks, including Danmarks Nationalbank, CLS has expanded its capacity to a level assessed to be sufficient. In addition, measures have been taken to ensure settlement in CLS in the event of e.g. financial problems among CLS participants.

Netting opposite payments in CLS reduces liquidity requirements
CLS settlement is characterised by substantial netting of opposite payments by participants (e.g. Danish kroner bought and sold on the same value date) before they effect pay-ins to CLS. Using CLS to settle foreign-exchange transactions thus entails a far lower liquidity requirement for participants when compared with gross settlement via correspondent banks. In 2007, netting of opposite krone payments meant that pay-ins to CLS amounted to only 4 per cent of the gross value of krone transactions settled in the system. This is the lowest level since 2003 when the Danish krone joined CLS.

Calendar days and CLS settlement
Most of the foreign-exchange transactions settled in CLS have one leg in USD. Consequently, a very large number of transactions with a high gross value, equivalent to two days' trading, are settled on the first banking day after a US public holiday, cf. Chart 47. Financial calendar days are also important to CLS settlement. For example, in the months of March, June, September and December the third Wednesday is an IMM (International Monetary Market) day, on which e.g. futures contracts are settled. The gross value of foreign-exchange transactions settled on 19 September and 19 December 2007 was therefore exceptionally large.

Credit derivatives in CLS settlement
In November 2007, the CLS system was extended to include settlement of payments related to OTC credit derivatives registered by the US Depository Trust & Clearing Corporation (DTCC). Initially, settlement of OTC credit derivatives will include payments in the major currencies (USD, EUR, JPY, GBP and CHF). Thus an infrastructure is established for settlement in a market where the volume of outstanding contracts has grown substantially in recent years, so that it has been difficult for market participants to ensure satisfactory administration of the contracts after trading.

The establishment of the CLS settlement has required considerable investments in IT systems, etc., and therefore it is generally an advantage for participants that the system is used for settlement of as many instruments as possible with a view to reducing unit costs.

DANMARKS NATIONALBANK'S RESPONSE TO THE IMF RECOMMENDATIONS

Although the Danish systems meet the international standards, it is necessary to consider potential improvements on an ongoing basis. At present the main focus is on following up on the recommendations made by the IMF in connection with its review of the Danish financial infrastructure. This review was completed in the autumn of 2006, cf. Box 8. The aim is to comply with all IMF recommendations, or to initiate projects to address outstanding issues, by the end of 2008.