Assessment of Settlement Risks in VP Securities Services
In connection with the settlement of securities transactions, participants may incur various types of risk.[1] A number of elements in VP Securities Services (VP) contribute to reducing the risks. These include simultaneous exchange of securities and cash, which eliminates the principal risk. Likewise, VP's rules and procedures are designed to ensure that transactions are settled on the designated day, so that the participants' liquidity risk is reduced.
Participants in the VP System usually incur a replacement risk on securities transactions that have been concluded but not settled. This is the case when participants choose to settle transactions in VP's normal settlement process, whereby settlement typically takes place three days after the conclusion of the transactions. However, an analysis based on data for a single settlement day shows that the replacement risk may only entail relatively small losses for the participants.
RISKS RELATED TO SETTLEMENT OF SECURITIES TRANSACTIONS
Settlement of securities transactions involves a number of risks that can be grouped under the headings of credit risk, liquidity risk, legal risk and operational risk. The definition of the various types of risk is basically the same as for other types of financial business. Box 13 further explains the implications of the risks related to settlement of securities transactions.
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Box 13
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Risks related to settlement of securities transactions can be grouped under the headings of credit risk, liquidity risk, legal risk and operational risk.1 Credit risk on settlement of securities transactions comprises a principal risk, a replacement risk and other credit risks. The principal risk occurs if the buyer and seller do not execute their legs of the transaction simultaneously. The party executing its leg first incurs a credit risk on the counterparty equivalent to the agreed value of the principal. The principal risk increases with the time lapse between the parties' planned deliveries. The replacement risk is the risk of suffering a loss because the counterparty fails in the period from the conclusion to the settlement of a securities transaction, so that the transaction cannot be executed. A buyer thus loses an unrealised gain if the market price of the securities has gone up in the meantime. Correspondingly, the seller suffers a loss if the price has gone down. The replacement risk increases with the time lapse from the conclusion to the settlement of the transaction, and with fluctuations in market prices. Other credit risks related to settlement of securities transactions include the participants' credit risk on the settlement bank. Credit risks may also arise between direct and indirect participants in cash settlement. A securities settlement system may also incur a credit risk on participants if it lends securities or extends other credits in order to facilitate settlement. Liquidity risk is the risk of incurring a loss because liquidity or securities are not received at the expected time. This loss may occur if the liquidity or securities have been disposed of in advance. In that case the seller of securities may have to borrow liquidity or sell assets at short notice, which often involves certain costs. Correspondingly, the buyer of securities may have to borrow equivalent securities in the market to meet any resale obligations for settlement on the same day. Legal risk is the risk of suffering a loss as a result of an unexpected interpretation of the basis of agreement or the legislation on which settlement of securities transactions is based. A special type of legal risk pertains to uncertainty as to the ownership of securities deposited with a custodian bank that fails. This type of risk is often referred to as the custody risk. Operational risk is the risk of loss resulting from inadequate internal processes, system failure, or external events. In modern securities settlement systems, operational risk mainly relates to IT systems. Like legal risk, operational risk amplifies credit and liquidity risks. For instance, operational errors may delay the settlement of securities transactions, which may in turn cause liquidity problems. |
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| 1 See BIS, Recommendations for securities settlement systems, 2001. | |
Problems experienced by one participant as a consequence of these risks may potentially spread to other participants and affect the entire financial system. This risk is amplified since securities transactions often involve the exchange of large amounts.
SETTLEMENT OF SECURITIES TRANSACTIONS IN VP[2]
Participants in the settlement of securities transactions in VP (the VP Settlement System) mainly comprise banking institutions in Denmark. The banking institutions perform a number of tasks in relation to the VP System. In their capacity as account controllers, they handle administration of VP's securities accounts and may report transactions to VP on behalf of themselves or others. The banking institutions also make liquidity available for cash settlement, which takes place via accounts at Danmarks Nationalbank. Some banking institutions do not participate directly in cash settlement, but choose to provide liquidity for settlement via a direct participant.
The VP System is a multilateral net settlement system, which means that at fixed times during the day, VP calculates and settles the individual participants' total net positions in securities and cash. Settlement mainly takes place in a number of settlement blocks between 6.00 p.m. (when VP's settlement day begins) and 10.30 a.m. on the following day. An overview of VP's settlement blocks for securities transactions in Danish kroner is provided in Chart 48.[3]
| VP'S SETTLEMENT BLOCKS FOR SECURITIES TRANSACTIONS IN KRONER |
Chart 48
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| Note: Kronos is Danmarks Nationalbank's real-time gross settlement system for settlement of payments between account holders. Kronos is open for krone-denominated payments from 7.00 a.m. to 3.30 p.m. Between 4.00 and 4.30 p.m., Kronos is open for transfer of funds from current accounts to settlement accounts for settlement during the night. | |
Prior to the commencement of VP's settlement day, the banking institutions provide liquidity for settlement during the night. They can do this by transferring an amount from their current account with Danmarks Nationalbank to a VP settlement account, after which Danmarks Nationalbank informs VP of the amount. In addition, the banking institutions may provide liquidity for settlement under the automatic collateralisation agreement, cf. Box 14.
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Box 14
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Automatic collateralisation enables banking institutions to obtain intraday credit from Danmarks Nationalbank for settlement of securities transactions in VP1. Under the automatic collateralisation agreement, the banking institutions pledge securities deposited in one or several securities accounts with VP, typically their trading accounts, as collateral. In some ways, automatic collateralisation is a more flexible borrowing arrangement than traditional pledging of collateral for loans granted by Danmarks Nationalbank. Under the automatic collateralisation agreement it is thus possible to pledge securities as collateral for credit in the settlement block in which they are received, rather than in subsequent settlement blocks only as for traditional pledging of collateral. This means that fewer securities are tied as collateral for settlement of securities transactions compared to traditional pledging arrangements. |
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| 1 Automatic collateralisation may also be used for settlement of payments in the Danish retail payment system (the Sumclearing), the VP Settlement System for periodic payments and the CLS settlement system for currency trades. See Danmarks Nationalbank, Payment Systems in Denmark, 2005 (published in the summer of 2005) for a more detailed description of the automatic collateralisation agreement. | |
Before running a settlement block, VP checks that the buyer and seller have sufficient liquidity/securities to cover the transactions concluded. If that is the case, settlement takes place by exchanging securities in securities accounts with VP for cash in accounts (settlement accounts or automatic collateralisation accounts) with Danmarks Nationalbank. Positions in securities and cash are exchanged simultaneously, i.e. Delivery versus Payment (DvP). A securities transaction has been finally settled when the settlement block has been completed.
VP also offers settlement of securities transactions as real-time transactions outside the fixed settlement blocks. In real-time transactions, securities in securities accounts with VP and money in current accounts with Danmarks Nationalbank are exchanged immediately and simultaneously. In practice, relatively few VP transactions are settled in real time.
MANAGEMENT OF SETTLEMENT RISKS IN VP
A number of elements in the VP Settlement System contribute to reducing the risks involved. This section contains an assessment of the relevance of the various types of settlement risk in VP.
Credit risk
The principal risk is the exposure incurred by one party to a securities transaction vis-à-vis the other party if money is provided before the securities are received or vice versa, cf. Box 14. In the VP System, this risk is eliminated in that positions in securities and money are exchanged simultaneously. As described, both multilateral net settlement and real-time settlement in VP take place according to the DvP principle.
Another type of credit risk is replacement risk, i.e. the risk of suffering a loss because a securities transaction must be cancelled due to the failure of the counterparty. In the VP System this risk can be eliminated by settling the transaction in real time. In the multilateral net settlement, where the major part of the transactions are settled three days after the contract date, both parties incur a replacement risk, however. Below, the significance of this risk is assessed on the basis of data for a specific day.
Other potential credit risks on settlement of securities transactions are of minimum relevance to VP. Any credit risk on the settlement bank is eliminated by effecting payment via accounts with Danmarks Nationalbank. VP does not itself incur any credit risk since it does not engage in securities lending or otherwise extend credit to participants. A banking institution that participates indirectly in cash settlement may, however, incur a credit risk on a direct participant in the form of a cash account balance.[4]
Liquidity risk
Liquidity risk is the risk of incurring a loss because the securities transaction is not settled at the expected time. A loss may occur if the buyer or seller has already disposed of the securities or cash that is not received, which must then be procured elsewhere.
In the VP Settlement System, liquidity risk is reduced via rules and procedures aimed at ensuring that transactions are settled on the agreed day. For instance, the last settlement block (VP40) is placed within the opening hours of Danmarks Nationalbank's payments system, Kronos, cf. Chart 48. This enables participants to provide extra liquidity for the transactions not settled during the night. Furthermore, unsettled transactions remaining after the last block can be settled as real-time transactions.
Another example is the agreed code of conduct for settlement in VP, encouraging participants to conclude the transactions as early as possible in the settlement run, preferably in the first settlement block. Among other things, the code of conduct requires that participants operate with an excess margin when calculating their liquidity requirements. A participant that does not adhere to this requirement and fails to cover its net positions in cash or securities will be fined.
A third example is VP's procedure for handling transactions that fail the check for adequate cover. If a participant in a settlement block has insufficient securities or cash, VP is entitled to remove transactions from the block until there is adequate cover for the remaining transactions. Transactions are removed in accordance with specific criteria designed to optimise the remaining settlement. When a transaction has been removed from one settlement block, it is automatically rescheduled for the next block.
According to international standards, the robustness of a settlement system can be assessed by its ability to settle transactions in the event that the participant with the largest payment obligation is unable to settle.[5] Box 15 outlines the results of such a stress test of the VP System on a specific day. The results show that the VP System can withstand an incident of this nature since most of the transactions can still be settled even if the largest participant is removed. This is, to a great extent, attributable to the automatic collateralisation agreement, which helps to ensure that participants can still provide the necessary liquidity even though no money is received from the largest participant.
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Box 15
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The robustness of the VP System has been analysed by measuring the impact on the settlement ratio if the largest participant is removed on a selected day (2 January 2004). Only the impact on the first settlement block (VP10), in which most transactions are settled, is considered.1 Any transactions removed from this settlement block may be settled in a later settlement block on the same day. The result of the stress test is shown in the Chart below. Initially, i.e. before any participants are removed, approximately 88 per cent of all bond transactions and almost 99 per cent of all equity transactions are settled.2 Most of the transactions that are not settled are filtered out in the securities check (i.e. the sellers do not have the securities in question), while only few do not pass the monetary check. This shows that, as prescribed by the code of conduct, participants operate with an excess margin when providing liquidity for settlement. If the participant with the largest payment obligation is removed, almost 79 per cent of the remaining bond transactions and approximately 92 per cent of the remaining equity transactions are settled.3 A small proportion of the unsettled bond transactions are filtered out in the monetary check, while the remaining transactions are caught in the securities check. The overall settlement rate thus remains high even though the largest participant is removed. Consequently, the VP System can be said to be robust to incidents of this kind. A major contributing factor is the automatic collateralisation agreement, which enables participants to provide the necessary liquidity even if they do not receive money from sale of securities to the largest participant. |
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| SETTLEMENT IN THE VP SYSTEM WITH AND WITHOUT THE LARGEST PARTICIPANT | |
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| Note: Based on data from 2 January 2004. Only the impact on the first settlement block (VP10) is considered. | |
| 1 In 2004, more than 96 per cent of all stock and bond transactions in VP were settled in VP10. 2 The first settlement block does not include securities from Euroclear Bank, which has a link to VP. Most of the remaining 12 per cent of the bond transactions were settled in later blocks the same night, which also included deliveries from Euroclear Bank. 3 Settlement rates before and after removal of the participant with the largest payment obligation are not directly comparable since the initial settlement rate for the largest participant is not known. |
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Operational risk
Operational risk is the risk of loss resulting from system failure, external events, etc. The settlement process in VP is carefully coordinated with a number of other key systems, and even brief system failures that delay settlement in VP may have major consequences. It is therefore important for VP to prevent system failures that have an impact on settlement.
VP has introduced a number of measures to minimise operational risk. These include internal controls, procedures for reporting and follow-up in connection with system failures, and back-up facilities at a second site. VP's track record shows a high degree of operational stability (uptime) and only few system failures.[6]
THE SIGNIFICANCE OF THE REPLACEMENT RISK TO THE VP SYSTEM
The replacement risk may result in a reduced profit to the buyer or a loss to the seller, cf. Box 13. In relation to financial stability it is primarily relevant to assess the possible loss to the seller.
The impact of the replacement risk in VP is analysed on the basis of data for the participants' bilateral transactions on a selected settlement day. It is assumed that a participant fails immediately prior to the start of VP's settlement day and that a given fall in market prices is seen. For each of the other participants, the ratio of the loss on the cancelled sales to the participant's capital buffer is then calculated[7].
The analysis is based on a number of extreme conditions. Firstly, the data relates to 2 January 2004, when VP experienced the largest securities settlement volume on any date in 2004[8]. The replacement risk normally increases with the transaction volume.
Secondly, the participant that fails is assumed to be the largest participant. In addition, the analysis includes the potential failure of the second, third and fourth largest participants, which may have a greater impact on individual participants than the failure of the largest participant.
Thirdly, the fall in market prices is assumed to correspond to the largest decline, in percentages, over a period of three days seen since 1990. As mentioned, three days is the duration of the replacement risk for most securities transactions settled in VP. In the KFX index, the largest drop in stock prices in this period was by 13.1 per cent (April 2000), while the largest fall in bond prices, measured by the benchmark 30-year mortgage-credit bond, was 4.9 per cent (August 1994).
Even in this extreme scenario, participants suffer only modest losses. Chart 49 shows the reduction of the capital buffer for the banking institutions bearing the greatest losses. When the participant purchasing the greatest volume of securities fails, the banking institution suffering the greatest loss as a result of the replacement risk loses only approximately 8 per cent of its capital buffer. No other banking institution loses more than 2 per cent of its capital buffer. Likewise, the failures of the second, third or fourth largest buyers only entail small losses to the individual banking institutions.
| BANKING INSTITUTIONS' REMAINING CAPITAL BUFFER IF A PARTICIPANT IN THE VP SYSTEM FAILS |
Chart 49
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| Note: Based on data from 2 January 2004. In each case, the Chart shows only the five banking institutions suffering the greatest losses as a percentage of their capital buffers. | |
CONCLUSION
Overall, the risks on settlement of securities transactions in VP are assessed to be relatively limited. This is due to a number of risk-reducing elements in the VP settlement procedure. Examples include the Delivery versus Payment principle, the automatic collateralisation agreement and the code of conduct for settlement via VP.
Participants in the VP System incur a replacement risk when they opt for settlement of securities transactions via VP's multilateral net settlements. However, calculations show that, even in extreme scenarios, losses stemming from this risk will not threaten the solvency of the participants.
The potentially most significant type of risk in relation to the VP System is operational risk. VP system failures and similar incidents that delay settlement will affect many participants and may have a serious impact on the financial system. Consequently, it is important for VP to maintain a high degree of operational security.
[1] In 2004, Danmarks Nationalbank and the Danish Financial Supervisory Authority performed a joint assessment of VP Securities Services A/S (VP) in relation to international recommendations, cf. the chapter on framework conditions for the financial system. In the course of this work, the risks on settlement of securities transactions in VP were analysed. This chapter outlines the main results of the analysis
[2] Danmarks Nationalbank, Payment Systems in Denmark, 2005 (published in the summer of 2005), includes a more detailed description of the settlement process in VP.
[3] In addition to the settlement blocks illustrated in Chart 48, VP runs a block for securities transactions in euro (VP50) at 1.35 p.m. and a number of settlement blocks for periodic payments in kroner and euro. A new settlement block in kroner (VP60) will also be introduced soon. It is expected to be placed at noon. In this connection, the settlement times for a few of the other blocks will be adjusted slightly.
[4] A direct participant providing liquidity for settlement on behalf of an indirect participant may lay down a maximum drawing right for the indirect participant. In this way the direct participant can limit its credit risk on the indirect participant.
[5] See e.g. Recommendation 9 of BIS, Recommendations for securities settlement systems, 2001.
[6] For an elaboration of the measures taken by VP to limit operational risk, see the Danish Financial Supervisory Authority and Danmarks Nationalbank, Review of VP Securities Services in relation to Recommendation for Securities Settlement Systems, 2004.The report can be found at Danmarks Nationalbank's website, www.nationalbanken.dk.
[7] The capital buffer is measured as the part of the base capital that exceeds the statutory solvency requirement of 8 per cent of risk-weighted assets, calculated at end-2004.
[8] The large volume is primarily attributable to the annual refinancing of adjustable-rate mortgage-credit loans with 2 January as the value date.