Protection of Settlement in Danish Payment Systems

In the two Danish payment and settlement systems, the VP Settlement (securities transactions) and the Sumclearing (retail payments), the principal elements protecting settlement are the flexible access to liquidity, combined with the banking institutions' large holdings of securities that can be pledged as collateral for loans from Danmarks Nationalbank. Analyses based on data for 2005 show that the Danish banking institutions' holdings of eligible assets are large enough for settlement to take place even if a large participant becomes unable to settle its payments. Against this background, Danmarks Nationalbank finds that the present situation does not warrant special measures to ensure settlement in the Danish systems.

INTRODUCTION

The Danish payment and settlement systems are currently being assessed as part of the IMF's Financial Sector Assessment Program, cf. Box 6. The IMF review is based on internationally agreed standards for systemically important systems. The standards e.g. specify that such systems should have appropriate and clearly defined procedures for management of liquidity and credit risks. Furthermore, they stipulate that multilateral net settlement systems, cf. Box 16, should be capable of settlement even in the event that the participant with the largest payment obligation is unable to settle.^[1]

Settlement via multilateral net settlement systems is associated with both credit and liquidity risks. Credit risk is the risk that a participant with a negative net position becomes insolvent before settlement without sufficient liquidity reserves to cover the payment obligation. The participant in question will then be excluded from the settlement and the net positions of the remaining participants will be recalculated. The liquidity risk is the risk that other participants have insufficient cover for their new net positions, so that they also have to be excluded from the settlement.

In Denmark, both the VP Settlement for settlement of securities transactions and the Sumclearing for settlement of retail payments are multilateral net settlement systems. Settlement in the two systems mainly takes place in overnight settlement cycles. The participants reserve money (liquidity) before the settlement, which is executed by transfer between the participants' accounts at Danmarks Nationalbank. The participants in the settlement have access to intra-day credit at Danmarks Nationalbank against securities as collateral.^[2]

This chapter reviews the measures that ensure settlement in Danish payment and settlement systems. Although it focuses on the Sumclearing, the same principles apply to the VP Settlement. Firstly, a number of general measures to protect settlement in retail payment systems with multilateral net settlement are described. This is followed by an account of specific elements in the Sumclearing to ensure settlement execution. Finally, an analysis based on data for 2005 is presented of the Danish banking institutions' contingency measures to counter the liquidity risk in the VP Settlement and the Sumclearing.

The analysis shows that even if a large participant is unable to settle its payments the settlement of securities transactions and retail payments in Denmark is generally well-protected. This is mainly due to the participants' flexible access to liquidity, combined with their substantial holdings of securities that can be pledged as collateral for loans from Danmarks Nationalbank. As a consequence, the current situation is not deemed to warrant any further measures to ensure settlement. Danmarks Nationalbank assesses the need for such measures on an ongoing basis, including the implications of any structural changes, such as cross-border consolidation, in the Danish financial sector.

PROTECTING SETTLEMENT IN MULTILATERAL NETTING SYSTEMS

Protection against credit risk
The factors which in general determine the extent of a credit risk are the counterparty's credit standing, the size and maturity of the exposure and the use of collateral. Multilateral net settlement systems may comprise measures which deal with each of these factors.

Participation in most retail payment systems is subject to access criteria, such as requirements of the participants' credit standing. Furthermore, participation is often restricted to banks that are subject to supervision. This reduces the risk of a participant becoming insolvent, which limits the credit risk in the system.

The size of the exposures in the system can be subject to limits to the participants' negative net positions in a settlement cycle.^[3] Such limits can be stipulated vis-à-vis all other participants in total, or against each individual participant. The participants can also decide to set a ceiling for individual payments in the system, which in practice also limits the participants' net positions.^[4]

In multilateral net settlement systems, the maturity of the exposures can be reduced by increasing the frequency of settlement cycles (i.e. introducing more settlement cycles during the day). This reduces the probability of a participant becoming insolvent in the period from a payment being effected until final settlement. A higher settlement-cycle frequency may also contribute to limiting the participants' net positions.

Finally, the credit risk in multilateral net settlement systems can be countered by requiring collateral for the participants' net positions. This can e.g. be achieved via a scheme based on a collateral pool. The latter normally consists of highly liquid assets, e.g. cash or securities, which can be used at short notice if a participant defaults on its payment obligation.

A collateral pool differs from the other measures in that it normally also protects settlement of the payments of an insolvent participant. Thus, a collateral pool helps to ensure confidence in the payment settlement system among both payers and payees. Box 17 outlines the functioning of a collateral pool, as well as the pros and cons of such a scheme.

Protection against liquidity risk
In many retail payment systems with multilateral netting, the most important measure to counter liquidity risk is proper central-bank credit facilities. If the participants also have ample holdings of securities that can be pledged as collateral for loans from the central bank, they can relatively easily reserve liquidity for settlement. Another important measure is the possibility of extra settlement cycles within the same settlement day, for which the participants can reserve further liquidity.

PROTECTING SETTLEMENT IN THE SUMCLEARING

The Danish retail payment system, the Sumclearing, is normally defined to comprise only the compilation of banking institutions' total net positions with the system operator, PBS (Payment Business Services), and the actual exchange of amounts on accounts at Danmarks Nationalbank. Thus, the two preceding subclearings, the electronic clearing and truncation and the PBS clearing, which provide the data for the Sumclearing, are not formally part of the system.^[5]

Like the VP Settlement, the Sumclearing has been notified to the European Commission as being subject to the Settlement Finality Directive^[6]. This directive stipulates that transfer orders and their netting are legally enforceable and binding in relation to third parties, even in the event of a participant's insolvency, if the transfer orders have entered the system before insolvency proceedings are opened. According to the directive, the system's own rules determine when a transfer order has entered the system.

In the Sumclearing, a payment has entered the system if it is included in the banking institutions' mutual net positions, i.e. the sum data, on expiry of the time limits for delivery of these net positions to the PBS Sumclearing system. If a banking institution is declared insolvent before that time, it is excluded from the Sumclearing. This means that the payments of that banking institution will not be settled, cf. below.^[7]

In the following, "the Sumclearing" denotes the total clearing and settlement cycle for Danish retail payments, including the electronic clearing and truncation and the PBS clearing.

Protection against credit risk in the Sumclearing
A number of measures to counter credit risk have been introduced in the Sumclearing. Firstly, only banking institutions have access to participate in the Sumclearing. Banking institutions are supervised by the Danish Financial Supervisory Authority and must meet a number of requirements of their solvency, liquidity, etc. This reduces the risk of a participant in the Sumclearing becoming insolvent.

In addition, the banking institutions participating in the Sumclearing have set individual limits to the amount that can be drawn on them in a single payment in the electronic clearing and truncation.^[8] The PBS clearing also applies limits to the size of individual payments, i.e. kr. 1 million for any single Dankort payment.

Furthermore, most of the retail payments in Denmark are settled in the Sumclearing during the night following the execution of the payment (e.g. a card payment at a merchant). Consequently, the exposures on the individual payments are of short duration.^[9]

In the Sumclearing there is no collateral pool, and no other collateral is required for the banking institutions' net positions in the system. As mentioned above, this means that there are no measures to ensure the settlement of an insolvent banking institution's retail payments transacted prior to the insolvency order. Box 18 outlines some pros and cons of completing settlement of an insolvent banking institution's retail payments.

Protection against liquidity risk in the Sumclearing
The settlement of payments in the Sumclearing also includes measures to reduce the banking institutions' liquidity risk. The principal element is the banking institutions' easy access to intraday credit at Danmarks Nationalbank against collateral. The banking institutions can provide collateral via traditional pledging of securities or via the automatic collateralisation arrangement. The latter is a highly flexible credit scheme, particularly for settlement of securities, cf. below.^[10]

Eligible securities acceptable to Danmarks Nationalbank include Danish government bonds and mortgage-credit bonds as well as, for intraday credit, certificates of deposit issued by Danmarks Nationalbank. Overall, the banking institutions have ample holdings of securities that are eligible as collateral for credit from Danmarks Nationalbank. This can be attributed to the very large mortgage-credit market in Denmark, even by international standards. This ample supply of eligible securities is illustrated in the following section.

The combination of the banking institutions' flexible access to credit from Danmarks Nationalbank and their ample holdings of eligible securities entails very low costs for reserving liquidity for settlement in the Sumclearing. This is reflected in the fact that the banking institutions typically seek to have substantial excess liquidity cover in the Sumclearing, cf. Chart 55. Consequently, a banking institution's failure to meet its payment obligations very rarely causes other banking institutions' net positions to exceed their liquidity cover.^[11]

In the event that a banking institution's cover for its net position is inadequate so that it has to be excluded from the settlement, the Sumclearing allows for extra settlement cycles during the day. This ensures that the banking institution's payments can still be settled on the required settlement date. At that time, Danmarks Nationalbank's RTGS system, Kronos, is open, so that participants can provide further liquidity for the extra settlement cycle. In addition, extraordinary settlement cycles (i.e. settlement cycles in addition to the predetermined extra settlement cycles) during the day can be agreed until 3.00 p.m.^[12]

THE BANKING INSTITUTIONS' LIQUIDITY RESERVES

This section assesses the extent of the Danish banking institutions' contingency measures to counter liquidity risk in the VP Settlement and the Sumclearing.^[13] In accordance with the usual hypothesis in international standards for payment and settlement systems, a large banking institution is assumed to be unable to meet its payment obligations and, thus, has to be excluded from the settlement. It is then analysed whether the other banking institutions have sufficient liquidity reserves to cover their recalculated net positions.

A banking institution's liquidity reserves for a given settlement day can be calculated as the sum of the following two items:

The balance of the banking institution's current account at Danmarks Nationalbank at the close of the preceding monetary-policy day, i.e. at 3.30 p.m.^[14]

Its holdings of eligible securities that have not already been pledged as collateral for a loan from Danmarks Nationalbank.

This measure expresses how much liquidity a banking institution can reserve for the settlement without borrowing from other parties besides Danmarks Nationalbank. It must be emphasised, however, that this by no means gives the complete picture of the banking institutions' access to provide liquidity for the settlement, since they may also borrow against simultaneously acquired securities as collateral via the automatic collateralisation arrangement.

The methodology of the calculations is described in more detail in Box 19. The analysis is based on all banking days in 2005^[15] and covers the Danish banking institutions participating in the VP Settlement and/or the Sumclearing. For each day in the course of the year it is assumed that the banking institution with the largest net outgoing payment is unable to meet its payment obligation and has to be excluded from the settlement. The other participants' net positions are recalculated on the basis of their estimated bilateral net positions vis-à-vis the excluded participant, and the net positions are then compared with the banking institutions' liquidity reserves.

Table 12 summarises the results of the analysis for all banking institutions. The Table shows the number of days in 2005 when one or more banking institutions had a larger net outgoing payment in the VP Settlement or the Sumclearing than the liquidity reserves. The Table compares the actual pattern in 2005 with the situation where on each day the banking institution with the largest net outgoing payment has been excluded from the settlement.

On four days in 2005, one banking institution's total net outgoing payment exceeded its liquidity reserves.^[16] There were no days when this was the case for several banking institutions. If the banking institution with the largest payment obligation had to be excluded from the settlement on each day, there would be 17 days when the total net outgoing payment of one or more banking institutions exceeded their liquidity reserves. On a few days several banking institutions would be affected, but on most days only one.

In Table 12 especially the small banking institutions have a net outgoing payment that exceeds their liquidity reserves, which to some extent can be attributed to the methodology, cf. Box 19.

Chart 56 shows the 20 largest banking institutions' maximum net outgoing payments as a ratio of their liquidity reserves during 2005, where on each day the banking institution with the largest payment obligation is excluded from the settlement. It appears that only one banking institution, on one day, has a net outgoing payment that exceeds its liquidity reserves. On all days in 2005, the liquidity reserves of most of the other banking institutions considerably exceed their total net outgoing payments in the VP Settlement and the Sumclearing.

As mentioned above, the analysis to some extent underestimates the banking institutions' contingency measures to counter liquidity risk in the VP Settlement and the Sumclearing. Thus, in the VP Settlement the banking institutions may, in addition to the calculated liquidity reserves, pledge acquired securities as collateral for intraday credit already in the settlement cycle in which the securities are received. As a result, the banking institutions' real contingency liquidity is considerably higher than the calculated liquidity reserves. Furthermore, the banking institutions will rarely lack liquidity in the VP Settlement even if no payments are received from a large banking institution.^[17]

The analysis confirms that in overall terms the Danish banking institutions have ample contingency liquidity to counter the liquidity risk in VP Settlement and the Sumclearing. This applies especially to the largest banking institutions whose total net outgoing payments only rarely exceed their liquidity reserves, even when the banking institution with the largest payment obligation has to be excluded from the settlement. In addition, in the VP Settlement the banking institutions can pledge simultaneously acquired securities as collateral for intraday credit via the automatic collateralisation agreement, which in practice significantly increases their real contingency liquidity.

[1] See BIS, Core Principles for Systemically Important Payment Systems, 2001, principles 3 and 5. BIS/IOSCO, Recommendations for Securities Settlement Systems, 2001, contains similar principles for securities settlement systems.

[2] The VP Settlement and the Sumclearing are described in more detail in Danmarks Nationalbank, Payment Systems in Denmark, 2005, Chapters 5 and 6.

[3] I.e. limits to amounts payable by one participant to other participants in the settlement cycle.

[4] Payments above this limit are normally settled in a real-time gross settlement (RTGS) system. Danmarks Nationalbank's payment system, Kronos, is an example of an RTGS system.

[5] The electronic clearing and truncation handles credit transfers, giro and cheque payments, as well as Dankort (debit card) payments using transaction vouchers. The PBS clearing processes payments related to PBS's own products, e.g. Betalingsservice (direct debit) and Dankort payments via payment terminals.

[6] Directive 98/26/EC on settlement finality in payment and securities settlement systems, cf. Danmarks Nationalbank, Payment Systems in Denmark, 2005, Chapter 9.

[7] The handling of an insolvent participant in the Sumclearing is described in detail in Niels C. Andersen, Clearing and Settlement in a Legal Perspective, Danmarks Nationalbank, Working Papers no. 20, 2004.

[8] In electronic clearing and truncation, no single payment may exceed kr. 100 million, but most banking institutions have set their own considerably lower limits.

[9] Some retail payment systems provide for settlement of payments already on the day they are effected, i.e. intraday settlement, implying even shorter exposure durations.

[10] See also the detailed description of the automatic collateralisation arrangement in Danmarks Nationalbank, Payment Systems in Denmark, 2005, Chapter 5.

[11] Danmarks Nationalbank, Financial stability 2002, contains a chapter on payment system risks, including an analysis of the consequences of having to exclude a banking institution from the Sumclearing settlement. The analysis shows that this in only very few cases entails that other banking institutions have inadequate cover for their recalculated net positions.

[12] Furthermore, these measures increase the robustness of settlement in the Sumclearing to operational events (e.g. computer system failure) that may have significant liquidity consequences for the participants.

[13] The analysis also includes banking institutions' payments in the CLS foreign-exchange settlement system. The settlement of payments in CLS is described in more detail in Danmarks Nationalbank, Payment Systems in Denmark, 2005, Chapter 5.

[14] The monetary-policy day in kroner runs from 4.00 p.m. to 3.30 p.m. the next banking day and is the period during which the banking institutions have access to intraday credit at Danmarks Nationalbank.

[15] Data for 20 December 2005 is disregarded, however, cf. Box 19.

[16] Usually, a banking institution is still able to settle its payments even if it has a net outgoing payment that exceeds its liquidity reserve. This is due to the automatic collateralisation arrangement, which allows the participants to pledge securities not yet part of their liquidity reserves as collateral, cf. below.

[17] See Danmarks Nationalbank, Financial stability 2005, Assessment of Settlement Risks in VP Securities Services, for an analysis of the liquidity risk in VP Settlement.