10. Oversight
During the last 20 years, many countries have developed a payments infrastructure with relatively few systems, in which very large volumes of payments as well as foreign-exchange and securities transactions are settled. This development can be viewed as a result of the rapid advances in the IT area, which have enabled significant streamlining of payment systems. However, the concentration of payments and settlements on few systems also means that problems within the systems may threaten financial stability. This is clearly illustrated by the three incidents outlined in Chapter 1.
It is the responsibility of central banks worldwide to oversee systemically important payment and settlement systems. The oversight function is primarily aimed at supporting the smooth functioning of the systems by contributing to their security and efficiency. Oversight relates to the overall system complex, taking into account that the participants are usually subject to financial supervision too. Since the late 1980s a number of international standards for systemically important payment and securities settlement systems have been developed. Compliance with these standards is the starting-point for the central banks' oversight of existing and new systems.
This Chapter initially describes the role of central banks as overseers of systemically important payment and settlement systems. Next, the main principles of Danmarks Nationalbank's oversight and the international standards for systemically important payment and settlement systems are outlined, followed by the main conclusions of the most recent assessments of systemically important systems in Denmark, i.e. the Sumclearing, Kronos and the VP settlement system, in relation to the international standards. Finally, the Chapter discusses the reflections which the events in the USA on 11 September 2001 gave rise to, including in Denmark.
The international standards for, respectively, payment and securities settlement systems are further described in the Annexes to this Chapter. The Memorandum of Understanding between Danmarks Nationalbank and the Danish Financial Supervisory Authority concerning Payment Systems and Clearing Centres is also included as an Annex.
10.1 CENTRAL BANKS AS OVERSEERS
As international standards have been laid down, central banks have worked to develop the framework for oversight, in order to ensure that payment and settlement systems comply with these standards.
The central banks' oversight of payment and settlement systems is linked to their responsibility for financial stability. In this connection it is important that the systems are designed to significantly reduce systemic risk, i.e. the risk that problems experienced by one participant may spread to other participants, cf. Chapter 4.
Payment and settlement systems handling retail payments and transactions are often owned and operated by private enterprises on commercial terms, with a focus on developing facilities to meet the participants' requirements in the most cost-effective manner, cf. Chapter 1. However, it is important that the systems are regularly compared with best practice internationally so that they do not pose a threat to financial stability.
Oversight involves tasks extending beyond financial supervision and audit. Unlike supervisory authorities and auditors, the central bank in its capacity as overseer also considers how a system functions in relation to alternative options. Consequently, proposals may be made that are not purely based on a risk assessment, but can also be aimed at creating a payment system with added value to society.
As opposed to the operator, the overseer does not actually check day-to-day operations. However, the results of the operator's system checks constitute valuable input in connection with the oversight of a system.
10.1.1 MAIN PRINCIPLES FOR OVERSIGHT
BIS has laid down four general principles for oversight of systemically important payment systems by central banks, cf. Box 10.1.[1] One of the objectives of these principles is for other stakeholders in the payment systems to become aware of and understand the central bank's oversight function. Consequently, the principles stipulate that central banks should publicly disclose their major policies with respect to payment systems (and the payments infrastructure as such). This allows other stakeholders to take initiatives to improve system compliance with these policies.
| OVERSIGHT OF PAYMENT SYSTEMS BY CENTRAL BANKS |
Box 10.1
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| Source: BIS (2001) and Thygesen (2001). | |
Oversight of payment systems by central banks takes place in cooperation with other relevant authorities. Otherwise different authorities could potentially order system operators to comply with contradictory objectives. This problem becomes particularly evident if the authorities do not attach the same importance to, respectively, efficiency and security. In some situations, efficiency can only be improved at the expense of security and vice versa. Besides the system owners, the participants, the central bank and the national competition authorities and supervisory authorities are important stakeholders. Where a system has foreign participants, foreign central banks and authorities are also stakeholders – to the extent that the foreign participation can cause systemic problems to be channelled to and from other countries.
Besides ensuring compliance with international standards, central banks may – as part of their policies for payment systems – determine national objectives for oversight of payment systems. In many cases the international standards are minimum standards that should preferably be exceeded by the national payment systems.
Initially, oversight by central banks was to a large extent based on "moral suasion", i.e. the central bank sought to exert influence without having any formal legal backing. Since the central banks acted as settlement banks for systemically important systems, they were usually able to impose requirements on systems and participants via settlement agreements and terms and conditions for accounts, cf. Chapter 9. However, the trend is for the oversight function of central banks to be regulated by law. In the EU this development is based on, inter alia, the Maastricht Treaty from 1992, which defined oversight as a basic task of the ESCB.[2]
At the global level, the IMF and the World Bank also play an important role in the oversight of payment systems, in that assessment of payment systems forms part of their Financial Sector Assessment Programs, cf. Box 10.2.
| PAYMENT SYSTEMS AND FINANCIAL SECTOR ASSESSMENT PROGRAMS |
Box 10.2
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Since the major financial crises in Asia in 1997-98, the International Monetary Fund, IMF, and the World Bank have conducted Financial Sector Assessment Programs (FSAP) in their member countries. An FSAP often includes an assessment of whether the systemically important payment systems comply with the BIS Core Principles, as well as an assessment of securities settlement systems' compliance with the BIS/IOSCO Recommendations. An FSAP is often based on the system assessment reports prepared by the national central banks, cf. section 10.5. In addition, the central bank and other relevant authorities must answer a number of questions and provide an account of a country's systems. In relation to payment systems the FSAPs performed show considerable differences between countries in respect of compliance with international standards; generally less developed countries tend to be less compliant. The greatest problems typically concern the systems' liquidity and credit risk management. This is particularly true in relation to the possibility of effecting fast and final settlement, and it is often assessed that multilateral netting systems will have difficulty in ensuring timely settlement if the participant with the largest single settlement obligation is removed. Few problems are observed in terms of the quality of the settlement asset, which is usually central-bank money. Some problems have been identified in relation to rules and procedures. The recommendations concerning operational stability and efficiency have proved to be the easiest to observe, although a relatively large number of systems have problems with corporate governance. |
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| Source: IMF (2002). | |
10.1.2 WHICH SYSTEMS ARE SUBJECT TO OVERSIGHT?
Oversight by central banks comprises only systemically important systems. To provide guidance on how to identify systemically important systems, BIS suggests that at least one of the following criteria should be met:
- It is the only payment system in a country, or the principal payment system in terms of the aggregate value of payments.
- It handles mainly payments of high individual value.
- It is used for the settlement of financial market transactions or for the settlement of other payment systems.[3]
Consequently, real-time gross settlement (RTGS) systems are typically viewed as systemically important owing to the value of payments settled. Net settlement systems, which settle retail payments of a significantly lower value, are, however, also systemically important if there are no suitable alternatives.
Likewise, the national securities settlement systems are often systemically important. Even where there are several securities settlement systems in a country, each system tends to have a dominant position in relation to settlement of one or several groups of securities, e.g. equities, government bonds, etc.
10.1.3 IMPLEMENTATION OF OVERSIGHT
The overall objective of oversight is to contribute to the efficiency and security of payment and settlement systems and thus to prevent problems within these systems from threatening financial stability.[4] In order to assess whether this objective is met, it is necessary to develop specific targets and benchmarks. Chart 10.1 provides an example of how the oversight task may be structured.
| OVERSIGHT BY CENTRAL BANKS | Chart 10.1 |
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The first step is to specify the overall objective of a well-functioning payment system in more detail. This is done by identifying the criteria to be applied when assessing the system. In the example, assessment is performed on the basis of two efficiency criteria, while risks are assumed to fall within four categories, cf. Chapter 4.
Step two is to determine standards to be met by a well-functioning system. International standards are e.g. the BIS Core Principles and the BIS/IOSCO Recommendations, which are described in sections 10.3 and 10.4 and elaborated on in Annexes 10.A and 10.B. National standards are typically further specification or tightening of the international standards. Subsequently the standards must be incorporated in guidelines describing the sources and methods to be used for assessing system compliance with the standards.
Step three is the actual review of the system on the basis of the assessment guidelines. The list in the Chart is not necessarily exhaustive, and often an assessment focuses on a limited number of issues. For example, an assessment of the impact of a regulatory amendment on a system could be based on a legal expert opinion and a review of relevant parts of the system's legal and contractual basis, often supplemented with discussions with the system owner and operator as well as any other relevant stakeholders.
The central bank's assessment may result in various recommendations, and the fourth and final step is to suggest changes with a view to enhancing the system.
10.2 OVERSIGHT BY DANMARKS NATIONALBANK
The primary objective of Danmarks Nationalbank's oversight is to ensure the efficiency and stability of the Danish payment and settlement systems so that they do not pose a threat to financial stability. This is enshrined in section 1 of the Danmarks Nationalbank Act, stating that Danmarks Nationalbank shall "maintain a safe and secure currency system in this country, and [...] facilitate and regulate the traffic in money and the extension of credit".
Danmarks Nationalbank's oversight of the Danish payment and settlement systems is based on international standards and recommendations, first and foremost the BIS' Core Principles for Systemically Important Payment Systems and the BIS/IOSCO Recommendations for Securities Settlement Systems. The three systemically important systems in Denmark – Kronos, the Sumclearing and the VP settlement system – have been assessed in relation to these standards.
Danmarks Nationalbank ensures that different units handle system operation and oversight, in that Accounting is responsible for day-to-day operations while Payment Systems is responsible for system oversight and development. This applies in relation to Kronos, where Danmarks Nationalbank handles all operator functions, but also in relation to the other two systems, in which Danmarks Nationalbank only acts as settlement bank.
Oversight takes place on an ongoing basis, and Payment Systems must regularly report to the governors of Danmarks Nationalbank on operations, including any system failures or other incidents that have caused problems. The regular oversight is supplemented by more extensive system reviews from time to time, aimed at assessing whether the systems comply with international and national standards.
Where required, oversight takes place in cooperation with other national and international authorities. Danmarks Nationalbank and the Danish Financial Supervisory Authority have concluded a Memorandum of Understanding concerning Payment Systems and Clearing Centres , cf. Annex 10.C.
10.3 INTERNATIONAL STANDARDS FOR PAYMENT SYSTEMS
The work to develop international standards for payment and settlement systems commenced in the late 1980s prompted by the substantial volume of payment and trading transactions settled via the systems. The need for international standards was highlighted by several serious incidents threatening the settlement of payments and trading transactions, cf. Chapter 1. In a few cases the problems were of a nature and scope that made it necessary for central banks to provide considerable extra liquidity to participants in order to prevent problems from spreading to other participants, thereby threatening financial stability.
10.3.1 THE LAMFALUSSY STANDARDS
BIS' publication of the Lamfalussy Report[5], named after the chairman of the Committee, in 1990 was a milestone in the development of international standards for payment systems. The Report listed six minimum standards for net settlement systems, all of which have also been found in subsequent reports in this area.
The main objective of the Lamfalussy Report was for participants to understand and manage the risks involved when settling payments via net settlement systems. The systems should rest on a well-founded legal basis in all relevant areas, and procedures should encourage participants to manage and limit all significant risks on payment settlement. This was to ensure timely daily settlement even if the participant with the largest net settlement obligation was unable to settle. Finally, access criteria should be objective and publicly disclosed in order to ensure fair and open access for participants. The Lamfalussy standards also led to the adoption of the Settlement Finality Directive in 1998, cf. the description in Chapter 9.
In 1993 the central banks of the EU member states agreed on a number of standards for national payment systems, cf. Box 10.3, including that netting systems should comply with the Lamfalussy standards.
| MINIMUM COMMON FEATURES FOR DOMESTIC PAYMENT SYSTEMS IN EMU | Box 10.3 |
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As part of the preparation of Economic and Monetary Union (EMU) and the new single currency, the euro, the central banks of the EU member states in 1993 under the auspices of the EMI (the precursor of the ECB) prepared a report, Minimum Common Features for Domestic Payment Systems. Among other things, the relevant central banks were to encourage compliance with the Lamfalussy standards by their domestic payment systems. Another primary aim of the EMI report was to harmonise the rules of the payment systems that were to constitute a coherent system for payment transfers between the EU member states, in particularly those that had opted to substitute the euro for their national currencies. Common general criteria for system participation were to limit the risk that less stringent access criteria in one national system would attract cross-border participants from other member states, thereby increasing the overall risk in the euro payment system. The access criteria stipulated that, subject to a few exceptions, direct system participants should be credit institutions only. More specifically, national access criteria could include requirements as to financial strength, minimum payment transaction volume, and participation fees. The criteria laid down should be publicly disclosed and objective, e.g. to counteract discrimination by nationality. With a view to limiting credit risk on payment settlement, the EMI report recommended that member states without any RTGS system should develop one, and that the central bank should limit access to uncollateralised credit. When the report was issued, Denmark already had an RTGS system (DN Inquiry and Transfer System), cf. Chapter 6. However, extension of credit was to a relatively large degree based on uncollateralised intraday credit. This option was phased out from 1995 and completely abolished in 1998. The report placed the responsibility for oversight with the central bank of the system's home country. As regards cross-border participants from other EU member states, the Second Banking Coordination Directive provides for authorities in the home countries of, respectively, the payment systems and the foreign participants to exchange the necessary information, under normal conditions as well as in crises. |
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| Source: EMI (1993) and Berg (1994). | |
10.3.2 BIS CORE PRINCIPLES FOR SYSTEMICALLY IMPORTANT PAYMENT SYSTEMS[6]
The Core Principles for Systemically Important Payment Systems issued by BIS in 2001, cf. Box 10.4, attached more importance to system efficiency than previous standards had done since it had become clear that the introduction of security measures could take place at the expense of system efficiency or at an excessive cost. The development of very secure, but inefficient payment systems could therefore entail a risk that the participants would not use the systems to a sufficient degree. Instead, they might be tempted to settle payments outside the systems, so that the systems would not have the desired risk-reducing impact on payment settlement. The Core Principles also take account of the more widespread use of RTGS systems since the publication of the Lamfalussy Report in 1990.
| BIS' 10 CORE PRINCIPLES FOR SYSTEMICALLY IMPORTANT PAYMENT SYSTEMS | Box 10.4 |
Core Principles IV and V are minimum standards, and payment systems should preferably aim higher. |
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| Source: BIS (2001) and Thygesen (2001). | |
Today most important payment systems are assessed in relation to the 10 Core Principles, which can be broken down on three main groups according to their target areas:
- rules and procedures
- risk management
- efficiency
The Core Principles are described in more detail in Annex 10.A.
10.4 INTERNATIONAL REQUIREMENTS FOR SECURITIES SETTLEMENT SYSTEMS
As regards securities settlement systems, a major contribution to the development of international standards was made in 1989, when the Group of Thirty (G30) published a report, Clearance and Settlement Systems in the World's Securities Markets.[7] The report included nine recommendations which subsequently set the standard for securities settlement worldwide.
The background to the report was increasing awareness that many securities markets, including some in OECD countries, were inefficient and exposed participants to unnecessary risks. At the time of the publication of the report, there was a specific need to shorten the settlement cycle for securities transactions. Trade confirmation should be received the day after the trade is concluded, at the latest, while settlement should take place within three days. In addition, the report encouraged settlement via simultaneous exchange of securities and cash (Delivery versus Payment, DvP). Finally, the report recommended the establishment of central securities depositories (CSDs) so that transactions could be settled without physical transfer of securities, but solely by book entry.
The establishment of VP Securities Services in 1983 meant that Denmark complied with the G30 recommendations from day one, cf. Chapter 6.
10.4.1 BIS/IOSCO RECOMMENDATIONS
In 2001, BIS and IOSCO, the International Organization of Securities Commissions, issued a joint report containing 19 Recommendations for Securities Settlement Systems, cf. Box 10.5.[8] Like the Core Principles, the Recommendations were intended to contribute to increased security and efficiency in securities settlement systems. Compared with the G30 report from 1989, recommendations pertaining to risk management, as well as rules and procedures, had been added.
| BIS/IOSCO'S 19 RECOMMENDATIONS FOR SECURITIES SETTLEMENT SYSTEMS | Box 10.5 |
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The Recommendations can be broken down on five main groups according to their target areas:
- rules and procedures
- risk management prior to securities settlement
- risk management during securities settlement
- risk management when providing custody services, etc. in relation to securities
- efficiency
The Recommendations are described in more detail in Annex 10.B.
10.4.2 ESCB/CESR STANDARDS
In October 2004, CESR (the Committee of European Securities Regulators) and the ECB published a report aimed at ensuring uniform, harmonised European implementation of the BIS/IOSCO Recommendations for Securities Settlement Systems.[9]
The BIS/IOSCO Recommendations are aimed at securities settlement systems worldwide, i.e. a relatively broad and heterogeneous target group, while the ESCB/CESR Standards are aimed at the EU and are more stringent in a number of areas. For instance, the ESCB/CESR Standards have tightened the requirements for operational reliability by prescribing a recovery time not exceeding two hours after large system disruptions. In practice this means that central securities depositories must have a "hot" backup centre. To further protect the investors, all records of entities holding securities in custody should, at least once a day, be reconciled with the entity administering the ultimate record of holdings of particular securities issues.
The ESCB/CESR report also established a set of standards comprising other standards and recommendations in this field. To a large extent the report can therefore replace the ESCB's user requirements for central securities depositories used in the ESCB's open-market operations.
When the report was adopted, certain issues were deferred for treatment in a separate Methodology Report, which is due at the end of 2005. In particular, the regulation of CSD functions handled by large custodian banks was deferred for later decision. Other issues included regulation of credit risk, particularly in credit institutions, which is also comprised by the new Basel II solvency requirements.[10] The new standards will not take effect until the Methodology Report has been published.
10.5 ASSESSMENT OF DANISH PAYMENT AND SETTLEMENT SYSTEMS
This section describes the results of the most recent assessments of the Danish payment and settlement systems in relation to international standards. Danmarks Nationalbank assessed Kronos and the Sumclearing, while the assessment of the VP settlement system took place in cooperation with the Danish Financial Supervisory Authority.[11]
The assessments are updated from time to time so as to reflect changes in both international and Danish system requirements. In addition, the systems must be reassessed after implementation of major changes.
10.5.1 ASSESSMENT OF KRONOSs
Danmarks Nationalbank has reviewed whether its RTGS system, Kronos, complies with the 10 BIS Core Principles. In the most recent review of Kronos, in 2002, all Core Principles were assessed to have been observed without any real shortcomings, except for Core Principle V, which does not apply to RTGS systems.
Rules and procedures
The legal basis for Kronos is assessed to be adequate and well-documented, which limits the legal risk pertaining to Kronos. Procedures, price structure, guidelines, etc. for Kronos are accessible at Danmarks Nationalbank's website. Kronos participants have been through training sessions, and for new participants a series of mandatory tests must be performed to ensure that the participants meet the technical requirements and can use Kronos in practice.
Risk management
Kronos' structure, rules and procedures, the use of central-bank money for settlement, and the access to intraday liquidity ensure that participants do not incur any credit risk on settlement of payments in Kronos, and that the liquidity risk is limited. Since Kronos is an RTGS system, cf. Chapters 4 and 6, the period from a payment is ready for settlement until it has been finally settled has been minimised. Operational risk is limited thanks to Kronos' structure and general security policy. System operations can be reestablished within four hours, and continuous data mirroring ensures that transactions can still be settled by Danmarks Nationalbank after a Kronos system failure.
Since the review in 2002, Danmarks Nationalbank has performed stress tests of Kronos with a view to assessing the risk of gridlock and deadlock, which could have a negative impact on system performance and thus on financial stability.[12]
Efficiency
Kronos incorporates state-of-the-art technology and is regularly updated to match technological advances and user requirements. The modular structure enables a pricing policy under which participants' costs reflect their use of the system. Virtually all monetary financial institutions in Denmark have access to Kronos, provided that they meet certain system requirements and know how Kronos functions. As mentioned above, Kronos' rules and procedures are publicly disclosed.
10.5.2 ASSESSMENT OF THE SUMCLEARING
In cooperation with the Danish Bankers Association, which owns the Sumclearing net settlement system, Danmarks Nationalbank has reviewed whether the Sumclearing complies with the 10 BIS Core Principles.
In the 2002 review of the Sumclearing, all Core Principles were assessed to be observed, except for Core Principles III and VII, which were broadly observed, i.e. minor shortcomings were found but did not give rise to major concerns. The results of the Sumclearing review are outlined below.
Rules and procedures
The legal basis for the Sumclearing is assessed to be adequate, which limits the legal risk in the Sumclearing. The structure, rules, procedures and agreements of the Sumclearing are available to members of the Danish Bankers Association, who also have access to a general information system. The Danish Bankers Association conducts regular training sessions and information meetings for Sumclearing participants.
Risk management
The Sumclearing operates with a number of procedures for limiting the participants' liquidity risk. The risk that payments are not settled on time is limited via the number and scheduling of settlement cycles in the Sumclearing. The use of central-bank money limits the credit and liquidity risks on the settlement bank.
Stress tests show that if the participant with the largest single settlement obligation is removed, other participants will not experience problems since the excess liquidity in the Sumclearing is considerable.[13]
Operational risk is limited via the security policy. Operations can be reestablished within 24 hours after system failure, which is deemed to be a little on the slow side.
Another shortcoming is the lack of adequate procedures to counter the credit risk incurred by participants who choose to credit recipient accounts on the basis of bookkeeping data received one day before the funds are actually received from the remitter's bank. The latter issue is only relevant for payments included in PBS settlement, cf. Chapter 6.
Efficiency
The Sumclearing is owned by the Danish Bankers Association and thus by the participants. Major decisions are made by the Board of the Danish Bankers Association. The Sumclearing is based on the common payments infrastructure, which limits the costs and increases efficiency in payments settlement.
Access to the Sumclearing requires, inter alia, access to accounts at Danmarks Nationalbank and thus observance of the Kronos access criteria. The participation costs are low and not linked to system use.
10.5.3 ASSESSMENT OF THE VP SETTLEMENT SYSTEM
In 2004, Danmarks Nationalbank and the Danish Financial Supervisory Authority conducted a review of the VP settlement system's compliance with the BIS/IOSCO Recommendations. 17 of the 19 Recommendations were assessed to be observed, i.e. all criteria were met with no real shortcomings. The exceptions were Recommendation 5, which does not apply to the system, and Recommendation 17 on sufficient information for identification and evaluation of risks, which was broadly observed, i.e. minor shortcomings were found but did not give rise to major concerns. The results of the review are outlined below.
Rules and procedures
The statutory basis for VP settlement is assessed to be adequate, which limits the legal risk. Information on VP's statutes and rules, including procedures and guidelines for participation in clearing and settlement, etc., and descriptions of the risks related to the VP settlement are available at VP's website. However, only parts of the information are available in English, which is why Recommendation 17 is assessed to be only broadly observed.
Risk management prior to securities settlement
A number of procedures minimise the risk that securities transactions are not ready for settlement on the value date. It is an established practice that trades are confirmed for VP settlement immediately after their conclusion, and normally with three days' value, T+3. In addition, securities can be borrowed in the market, and certain government and mortgage-credit bonds can be borrowed from Danmarks Nationalbank.
Risk management during securities settlement
The credit risk in VP settlement is limited by using the DvP principle, by settling in central-bank money and by VP not extending credit to participants. The settlement procedure for net settlement of securities transactions and the possibility of real-time gross settlement minimise the risk that securities transactions are not settled on time. The excess liquidity requirement and VP's automatic collateralisation, cf. Chapter 5, limit the risk that other participants are affected if a participant is removed from settlement owing to insufficient cover in cash or securities. The use of lines reduces the risk to primary cash providers related to unexpectedly large liquidity withdrawals by indirect payment participants. Operational risk is limited via VP's security policy. Operations can be resumed at a second operating centre within an hour, and at a third operating centre within a few days. VP's links to other central securities depositories are also assessed in the regular risk analyses.
Risk management when providing custody services, etc. in relation to securities
All securities issued by VP are dematerialised, and registration, custody and settlement of securities take place electronically in VP. This minimises the risk of handling errors and supports fast clearing and settlement of securities transactions. Efficient segregation of titles to securities in VP is e.g. ensured by using single-investor accounts. In addition, legislation ensures the investors' rights, including the title to securities deposited in omnibus accounts, in the event that an account controller becomes subject to insolvency proceedings.
Efficiency
Participation in VP is chiefly limited to securities dealers, major customers and foreign central securities depositories. Legislation ensures that access requirements are objective and non-discriminatory. Via system ownership, VP users are represented on the Board of VP, and the interests of the public are safeguarded via legislation. VP is subject to supervision by the Danish Financial Supervisory Authority and oversight by Danmarks Nationalbank. VP's access criteria, rules, objectives, etc. are published at VP's website. The structure of the VP settlement system, which e.g. support STP (Straight-Through Processing) and international communication standards, enables a high degree of automation in securities settlement, thereby reducing costs.
10.6 OVERSIGHT OF THE RISK OF MAJOR OPERATIONAL DISRUPTIONS
The terrorist attacks on New York on 11 September 2001 clearly demonstrated the vulnerability of payment and settlement systems, cf. Chapter 1, Box 1.1. Oversight of systemically important payment and settlement systems has therefore increasingly focused on the risk of extreme events causing major disruptions of systems for settlement of payments, securities transactions, etc. since the potential negative impact can be so large that a contingency plan should be in place even though the risk is very small. Examples of extreme events are provided in Box 10.6.
| EVENTS THAT COULD THREATEN PAYMENT AND SETTLEMENT SYSTEMS |
Box 10.6
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A number of events in recent years have demonstrated that the global flow of payments is subject to risks that cannot be handled via ordinary financial and operational risk management. Several of the events do not require special contingency measures on the part of the financial institutions if they occur on a small scale. On a large scale, however, they can have serious consequences if the necessary measures have not been taken. This also applies to settlement of payments and trading transactions, since these are often concentrated on a few key systems and enterprises. Examples of events that could lead to major disruptions to payment and settlement systems include:
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Major operational disruptions to payment and settlement systems are characterised by having either:
- systemic consequences,i.e. a participant's inability to meet its payment or delivery obligations triggers a chain reaction, whereby other participants are also unable to meet their obligations, cf. Chapter 4, or
- wide-ranging consequences to society, i.e. a wide-scale disruption of the execution of payments and transactions (falling short of having a systemic effect) that cannot immediately be handled in alternative ways.[14]
The consequences are, however, not purely a result of the actual events. In relation to payment systems, the impact may be amplified if participants already have serious doubts as to the creditworthiness of one or several participants.
10.6.1 THE OBJECTIVES OF CONTINGENCY PLANS
The overall purpose of establishing contingency plans for payment and settlement systems is to prevent systemic consequences or other wide-ranging consequences to society as a result of extreme events. After the terrorist attacks on 11 September 2001, the US authorities have, in consultation with thesectorsinquestion,preparedrecommendationsfor all relevantpartiestodrawup contingency plans, so that the overall financial system will still function in the event of any wide-scale disruption.[15] In relation to payment and settlement systems, the contingency plans should provide for:
- Rapid recovery and timely resumption of critical operations following a wide-scale disruption, e.g. within two hours after the event.
- Rapid recovery and timely resumption of critical operations following theloss orinaccessibilityofstaffinatleast one major operating location.
- A high level of confidence, through ongoing use or robust testing, that critical internal and external continuity arrangements are effective and compatible.
On resumption of operations it should be ensured that new settlement orders can be placed in the systems and that the settlement transactions that were interrupted are completed. In this context it is important that the contingency measures are aimed at reestablishing the business activities in question, not merely on IT system recovery.
Contingency plans must also be drawn up for those parts of the payments infrastructure that are not directly controlled by the financial sector, e.g. telephone networks used for transmission of payment instructions, etc. Generally, contingency plans should also be prepared for outsourced parts of the payments infrastructure. The payment system provider is responsible for ensuring that the subcontractors' contingency plans also comply with the above objectives.[16]
10.6.2 SOUND PRACTICES FOR COUNTERACTING MAJOR OPERATIONAL DISRUPTIONS
Sound practices for counteracting major operational disruptions comprise four elements:
- Identification of payment and settlement systems used by business segments of major significance to society.
- Establishment of relevant targets for resumption of payments and settlements that were interrupted.
- Establishment of backup facilities at sufficiently geographically dispersed locations.
- Regular use and testing of resumption arrangements.
Identification of the critical parts of the payments infrastructure is the task of the individual enterprise. Critical parts comprise not only the enterprises operating key payment and settlement systems[17], but also parts of systems and installations in enterprises with a substantial market share of payments, etc., e.g. large banks.
Establishment of targets for resumption of payments and settlements affected by system disruption is primarily a question of the acceptable time lapse before payment and settlement can be resumed. In large-value payment systems the time factor is particularly critical since non-settlement of payments is more likely to have a systemic impact. In such systems, operations should preferably be resumed or transferred to alternative systems within a few hours.
Separate backup facilities have already been established to a large extent. Mergers in the financial sector have often been taken as an opportunity to establish IT backup facilities. When the business operations of the merging banks have been integrated on a single platform, the IT system of one of the parties has been reclassified as a backup system. However, this does not provide full security since the backup system often applies the same software as the primary system, and consequently software bugs can potentially disrupt both systems at the same time.
The efficiency of the resumption arrangements can only be ensured if they are tested and applied on a regular basis. The above example, viz. a software bug in both the primary system and the backup system, illustrates the need to test new software thoroughly before releasing it.
Implementation of contingency plans to make payment and settlement systems more resilient to extreme events often requires extensive resources. It is therefore important that the enterprises operating critical parts of the payments infrastructure integrate contingency measures in their long-term planning. This allows them to develop the contingency measures to match initiatives in the business segments. In addition, this is often less expensive than to implement the contingency plans subsequently.
10.6.3 INTERVENTION BY PUBLIC AUTHORITIES
The authorities must acknowledge that the contingency plans of business enterprises cannot envisage all situations. Where payments using critical parts of the payments infrastructure cannot be resumed in a timely manner, special precautions may have to be taken. One option could be to declare a normal working day a "bank holiday" as the US authorities did on 11 September 2001. This gives the participants in the payments infrastructure more time to reestablish their systems or put alternative systems into operation.
Finally, central banks may have to supply participants with substantial extra liquidity, as was also the case in the USA following 11 September 2001. Such liquidity may have to be provided on extraordinary terms, e.g. by relaxing the collateral requirements.
LITERATURE
Bank of England, 2003. Do we need new statutory powers?, Report of the Task Force on Major Operational Disruptions in the Financial System.
Bech, Morten L., Bo Madsen and Lone Natorp, 2002. Systemic Risk in the Danish Interbank Netting System, Danmarks Nationalbank, Working Paper no. 8.
Berg, Jesper, 1994. International Observations concerning Payment Systems, Monetary Review, August 1994.
Biltoft, Karsten, 2002. The Objectives of oversight – what are they?, E-money and Payment Systems Review, Pringle, Robert et al. (eds.), Central banking Publications.
BIS, 1990. Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy Report).
BIS, 2001. Core principles for Systemically Important Payment Systems, January 2001.
BIS/IOSCO, 2001. Recommendations for Securities Settlement Systems, Report on the CPSS-IOSCO Joint Task Force on Securities Settlement System, CPSS publication No. 46, November 2001.
Board of Governors et al., 2003. Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System, recommendations published by the Board of the Governors of the Federal Reserve System, Office of the Comptroller of the Currency, and the Securities and Exchange Commission.
Borup, Lisbeth and Morten Lykke, 2003. New Capital-Adequacy Rules for Credit Institutions, Danmarks Nationalbank, Monetary Review, 3rd Quarter.
Danmarks Nationalbank, 2002a. Financial stability.
Danmarks Nationalbank, 2002b. Second assessment of KRONOS in relation to the Core Principles for Systemically Important Payment Systems.
Danmarks Nationalbank, 2002c. Review of the Sumclearing in relation to Core Principles for Systemically Important Payment Systems.
Danmarks Nationalbank and the Danish Financial Supervisory Authority, 2004. Review of VP Securities Services in relation to Recommendations for Securities Settlement Systems.
Danmarks Nationalbank and the Danish Financial Supervisory Authority, 2001. Memorandum of Understanding between Danmarks Nationalbank and the Danish Financial Supervisory Authority Concerning Payment Systems and Clearing Centres, published in Danmarks Nationalbank, Monetary Review, 2nd Quarter.
ESCB-CESR, 2004. Standards for Securities Clearing and Settlement in the European Union.
EMI, 1993. Minimum Common Features for Domestic Payment Systems.
Swedish Financial Supervisory Authority, 2004. Från elavbrott till 11 september (From power outage to 11 September) (in Swedish only).
Group of Thirty, 1989. Clearance and Settlement Systems in the World's Securities Markets.
IMF, 2002. Financial Sector Assessment Program – Experience with the Assessment of Systemically Important Payment Systems.
Rosenoer, Jonathan, 2004. Outsourcing and operational risk management, Financial Regulation International, Issue 7.10.
Thygesen, Tobias, 2001. International Standards for Payment Systems, Danmarks Nationalbank, Monetary Review, 1st Quarter.
ANNEX 10.A
BIS' CORE PRINCIPLES FOR SYSTEMICALLY IMPORTANT PAYMENT SYSTEMS
This Annex presents a brief overview of the BIS Core Principles for Systemically Important Payment System. A more detailed review can be found in BIS (2001) at the BIS website, www.bis.org, under Publications.
Rules and procedures
Core Principles I and II specify requirements for payment system rules and procedures. The legal basis must be clear and unambiguous in order to limit legal risk, i.e. the risk of loss as a result of unforeseen interpretations of the systems' contractual basis or the legislation regulating the contracts, which is ultimately the basis for the mutual claims of the participants in the systems.
The legal basis must be applicable to all participants, irrespective of their geographical location.
The rules and procedures of a payment system must also be concise and easy to understand, so as to avoid any doubt about the risks involved in participating in the payment settlement procedure. Clear rules and procedures thus facilitate adequate risk management on the part of the participants.
Risk management
Core Principles III to VII specify requirements for payment systems, with a view to limiting the risks that may arise during settlement of payments.
Payment systems should have clearly defined procedures and facilities for management and limitation of the credit and liquidity risks incurred by participants during settlement. Examples include access to intraday credit, extension of credit against collateral only, loss-sharing agreements and use of optimisation routines and other queue facilities.
To limit the systemic risk, net settlement systems should, as a minimum, be capable of settlement in the event that the participant with the largest single settlement obligation is unable to settle.
To limit credit and liquidity risks, the period from a payment is ready for settlement until it has been finally settled should also be minimised. As a minimum, a payment that is ready for settlement should be settled on the value day, inter alia in order to limit the types of credit and liquidity risk that might otherwise arise, e.g. if insolvency proceedings are initiated between settlement days.
If the volume of payments settled is large, it should be possible to settle via RTGS systems.
The use of central-bank money in payment systems eliminates the credit and liquidity risks on the settlement bank. Where payment systems use other assets than central-bank money, the credit and liquidity risks on the settlement bank should be limited.
In order to limit operational risk, the structure of payment systems and their rules, procedures, etc. should be designed and updated to match technological advances.
Efficiency
Core Principles VIII-X concern the efficiency of payment systems, since a payment system should not only be secure, but also efficient. All other things being equal, participants will feel more inclined to use a secure payment system if it also meets user requirements in terms of functionality, is fast and practical to use, provides access to adequate liquidity and is cost-effective.
Open access criteria for a payment system, with due consideration of security aspects, will enhance competition and thereby efficiency among system participants. Transparency regarding payment-system objectives and decisions supports effective governance and makes it easier for participants and other stakeholders to exert influence on the system.
ANNEX 10.B
BIS/IOSCO RECOMMENDATIONS FOR SECURITIES SETTLEMENT SYSTEMS
This Annex presents a brief overview of the BIS/IOSCO Recommendations for Securities Settlement Systems. A more detailed review can be found in BIS/IOSCO (2001) at the BIS website, www.bis.org.
Rules and procedures
Recommendations 1 and 17 concern the rules and procedures of securities settlement systems. The legal basis should be adequate and transparent in order to limit the legal risk arising from uncertainty as to e.g. the consequences to other participants if a participant is subject to insolvency proceedings.
The legal basis should be applicable to all participants, irrespective of their geographical location. Securities settlement systems should also ensure that participants have a clear understanding of and are fully aware of the system rules and procedures and thus the risks involved in securities settlement. This supports efficient risk management by participants.
Risk management prior to securities settlement
Recommendations 2-5 concern measures to limit the risks prior to settlement of a securities transaction.
Minimising the period from conclusion to settlement of a securities transaction reduces the replacement risk, since it limits the risk that the counterparty is unable to meet its financial obligations on the value date. To ensure that a securities transaction is ready for settlement on the value date, reporting, matching and confirmation should take place as soon as possible after the conclusion of the agreement.
The use of central counterparties is encouraged, whereby the credit risk is transferred to a known counterparty, and anonymous securities trading is enabled. However, the central counterparty should rigorously control the risks assumed in order to limit the systemic risk related to the concentration of transactions on a central counterparty.
Securities lending is also encouraged. This limits the risk that a securities transaction cannot be settled on the value date, as well as the consequences if timely settlement cannot be effected.
Risk management during securities settlement
Recommendations 7-11 and 19 are aimed at limiting risks during settlement of securities transactions.
The use of central-bank money limits the risk on the settlement bank. If other means of payment are used for settlement, the risk on the settlement bank should be minimised.
If the parties to a transaction exchange cash and securities simultaneously (Delivery versus Payment, DvP), the principal risk is eliminated.
Final settlement of securities transactions should, as a minimum, take place at the end of the value date. Final settlement several times during the settlement day or in real time offers several advantages, e.g. by enabling cross-border settlement of securities transactions back-to-back. In addition, several settlement cycles and the option to settle in real time limit the liquidity risks that might occur at the end of the day, just before the system closes.
To limit the systemic risk, securities settlement systems applying netting or extending credit to their participants, should, as a minimum, ensure timely settlement in the event that the participant with the largest single settlement obligation is unable to settle.
Operational risk should be limited through ongoing development of the systems and updating of security policies to match technological advances. Cross-border links between securities settlement systems generally reduce the risk on settlement of transactions across national borders, but entail special risks. The risks relating to cross-border links should be handled via procedures incorporated in the risk-management policies.
Risk management when providing custody services, etc. in relation to securities
Recommendations 6 and 12 concern registration and custody services, etc. in relation to securities.
Electronic registration, safekeeping and settlement of securities offers a number of advantages, including cost and efficiency gains, and supports rapid settlement, securities lending and DvP settlement.
The rights of investors should be protected when securities are held by custodian banks or central securities depositories. In particular, investors should not lose their title to the securities in the event of insolvency proceedings.
Efficient securities settlement systems
Recommendations 13-16 and 18 relate to the efficiency of securities settlement systems.
A securities settlement system should be secure to use, as cost-effective as possible and take the users' functionality requirements into account.
Fair and open access to securities settlement systems and central counterparties, with due consideration for system security, enhances competition between participants, as well as efficient and inexpensive clearing and settlement. Transparency concerning rules and decisions supports efficient and responsible management and makes it easier for participants and other stakeholders to exert influence on management decisions in relation to the settlement system. The use of internationally recognised procedures and standards for communication also facilitates efficient cross-border securities settlement.
Central banks and supervisory authorities must have the necessary resources to ensure efficient oversight and supervision. The objectives and key elements of their policies in these areas should be clear and publicly disclosed, and the central banks and supervisory authorities should cooperate with relevant authorities at home and abroad. Securities settlement systems operated by central banks must naturally also observe the above international recommendations for securities settlement systems.
ANNEX 10.C
MEMORANDUM OF UNDERSTANDING BETWEEN DANMARKS NATIONALBANK AND THE DANISH FINANCIAL SUPERVISORY AUTHORITY CONCERNING PAYMENT SYSTEMS AND CLEARING CENTRES
OBJECTIVE AND DELINEATION
- Well-functioning payment systems and clearing centres are vital to financial stability. Systemically important systems have the potential to trigger financial disruptions or to spread financial problems to the financial system in a broader perspective, thereby threatening financial stability. The objective of the Memorandum of Understanding is to contribute to efficient and stable payment systems and clearing centres in Denmark. One aspect is to ensure that systemically important systems adhere to internationally recognised standards. The Memorandum of Understanding concerns functions which interface between the Danish Financial Supervisory Authority and Danmarks Nationalbank in this respect. The Memorandum of Understanding does not reduce the system owners' responsibility to ensure that their systems fulfil their relevant obligations.
- The tasks and responsibilities of the Danish Financial Supervisory Authority in connection with payment systems and clearing centres are set out in the Danish Securities Trading Act etc. The Act stipulates the obligations and rights of the Financial Supervisory Authority in connection with establishment, registration and supervision.
- Pursuant to the Danmarks Nationalbank Act the task of Danmarks Nationalbank as the central bank of Denmark is to maintain a safe and secure currency system and to facilitate and regulate the traffic in money. Danmarks Nationalbank considers this to entail contributing to the efficiency and stability of payment systems and clearing centres.
DEFINITIONS
The following definitions shall apply in this Memorandum of Understanding:
- Payment system: A system of which the sole purpose is clearing and settlement of money transactions.
- Clearing centre: A securities clearing enterprise which clears and settles transactions in securities and derivatives thereof, including related payments.
- Internationally recognised standards: Standards and recommendations adopted by international organisations and forums directed at payment systems and clearing centres.
- Supervision: The statutory obligations of the Danish Financial Supervisory Authority vis-à-vis payment systems and clearing centres, including supervision of whether the systems and the participants therein fulfil their statutory obligations.
- Oversight: Danmarks Nationalbank's task of contributing to the efficiency and stability of payment systems and clearing centres.
PAYMENT SYSTEMS AND CLEARING CENTRES COMPRISED BY THE MEMORANDUM OF UNDERSTANDING
- This Memorandum of Understanding comprises all systemically important payment systems and clearing centres which at the same time are approved or registered by the Danish Financial Supervisory Authority and which use Danmarks Nationalbank as settlement bank, cf. Annex 1. The Memorandum of Understanding does not include Danmarks Nationalbank's own payment systems.
- The Danish Financial Supervisory Authority and Danmarks Nationalbank may decide to add other systemically important payment systems and clearing centres to the scope of the Memorandum of Understanding.
- Under this Memorandum of Understanding, a payment system or clearing centre shall be considered systemically important if this is agreed between the Financial Supervisory Authority and Danmarks Nationalbank.
COORDINATION OF TASKS AND CONSULTATION
- To the greatest possible degree, the Financial Supervisory Authority and Danmarks Nationalbank shall coordinate their joint tasks concerning verification of the compliance of payment systems and clearing centres with the internationally recognised standards stated in Annex 2.
- To the greatest possible degree, the Financial Supervisory Authority and Danmarks Nationalbank shall consult each other prior to any ruling or decision of vital importance to the payment systems or clearing centres covered by the Memorandum of Understanding.
COLLECTION AND EXCHANGE OF INFORMATION
- To the greatest possible degree, the Financial Supervisory Authority and Danmarks Nationalbank shall coordinate the collection of information in connection with supervision or oversight of the payment systems and clearing centres covered by the Memorandum of Understanding.
- To the greatest possible degree, the Financial Supervisory Authority and Danmarks Nationalbank shall exchange information of significance to the supervision or oversight of payment systems and clearing centres covered by the Memorandum of Understanding. The information shall be exchanged with due regard for current provisions on confidentiality, etc.
AMENDMENT AND TERMINATION OF THE MEMORANDUM OF UNDERSTANDING
- Either party may at any time propose amendments to the Memorandum of Understanding or its annexes. On amendment of an annex to this Memorandum of Understanding, the date of the annex shall be amended, while the date of the Memorandum of Understanding shall remain unchanged. Adoption of amendments to the Memorandum of Understanding or its annexes shall be subject to the consent of the other party.
- Either the Danish Financial Supervisory Authority or Danmarks Nationalbank may at any time terminate this Memorandum of Understanding in its entirety at 30 days' notice.
ANNEX 1: PAYMENT SYSTEMS AND CLEARING CENTRES COVERED BY THE MEMORANDUM OF UNDERSTANDING
The following payment systems and clearing centres are covered by the Memorandum of Understanding between Danmarks Nationalbank and the Danish Financial Supervisory Authority concerning Payment Systems and Clearing Centres:
Sumclearing
c/o the Danish Bankers Association
Finansrådets Hus
Amaliegade 7
DK-1256 Copenhagen K
VP Securities Services
Helgeshøj Allé 61
DK-2630 Taastrup
ANNEX 2: INTERNATIONALLY RECOGNISED STANDARDS COVERED BY THE MEMORANDUM OF UNDERSTANDING
The following internationally recognised standards are covered by the Memorandum of Understanding between Danmarks Nationalbank and the Danish Financial Supervisory Authority concerning Payment Systems and Clearing Centres:
- Core Principles for Systemically Important Payment Systems
The standards are reproduced in the report of 15 January 2001 from the Committee on Payment and Settlement Systems of the G-10 central banks. - Recommendations for Securities Settlement Systems
The recommendations are presented in the draft report of January 2001 from the Committee on Payment and Settlement Systems of the G-10 central banks in cooperation with IOSCO (International Organization of Securities Commissions).
[1] The role of central banks in the oversight of securities settlement systems is described in BIS/IOSCO Recommendation no. 18, cf. Box 10.5.
[2] According to the Treaty Establishing the European Community, Article 105(2) one of the basic tasks of the ESCB is "to promote the smooth operation of payment systems". Furthermore, the Statute of the ESCB and of the ECB in Article 22 on Clearing and payment systems states that "the ECB and national central banks may provide facilities, and the ECB may make regulations, to ensure efficient and sound clearing and payment systems within the Community and with other countries.". These provisions only apply to euro area member states.
[3] Cf. BIS (2001).
[4] Cf. Biltoft (2002).
[5] Cf. BIS (1990).
[6] For a more detailed review of the BIS Core Principles, see Annex 10.A.
[7] Cf. Group of Thirty (1989).
[8] Cf. BIS/IOSCO (2001).
[9] Cf. ECB-CESR (2004).
[10] Cf. Borup and Lykke (2003).
[11] The assessments can be found at www.nationalbanken.dk (under Tasks/Payment systems/Oversight).
[12] Cf. Chapter 6, section 6.1, Appendix C and Danmarks Nationalbank (2002a).
[13] Cf. Danmarks Nationalbank (2002a) and Appendix D.
[14] Cf. Bank of England (2003).
[15] Cf. Board of Governors et al. (2003).
[16] Cf. for example Rosenoer (2004).
[17] In Denmark these are PBS, VP Securities Services and Danmarks Nationalbank.