Opinion of the European Monetary Institute on a consultation from the Dutch Ministry of Finance under Article 109f (6) of the Treaty establishing the European Community and Article 5.3 of the Statute of the EMI on a draft law containing an amendment to the Bankruptcy Act and the Act on the supervision of credit institutions 1992 with a view to the smooth functioning of payment systems and securities settlement systems (the “draft law”) (CON/97/11)
Date: 1997-11-11
Institutions: European Monetary Institute
Subjects: European System of Central Banks, Netherlands, bankruptcy, credit institution, financial stability, financial supervision, payment system, securities

OPINION OF THE EUROPEAN MONETARY INSTITUTE

on a consultation from the Dutch Ministry of Finance under Article 109f (6) of the Treaty

establishing the European Community and Article 5.3 of the Statute of the EMI on a draft

law containing an amendment to the Bankruptcy Act and the Act on the supervision of credit

institutions 1992 with a view to the smooth functioning of payment systems and securities

settlement systems (the “draft law”)

CON/97/11

1.

The present opinion was requested by the Dutch Ministry of Finance, which submitted the above

draft law and an explanatory memorandum of 26 October 1996 to the EMI for consultation.

2.

The  EMI 

is  competent 

to  deal  with 

this  request  for  consultation  under  Council

Decision  93/717/EC,  Article  1.1,  fourth  and  fifth  indents,  as  the  draft  law  concerns  payments

systems  and  securities  settlement  systems  as  well  as  the  stability  of  the  financial  markets  and

institutions.

3.

The draft law is intended to amend the operation of the so-called zero hour rule (as laid down in

the  Dutch  Bankruptcy  Act  and  the  Act  on  the  supervision  of  credit  institutions  1992)  for

participants  in  those  payment  systems  and  securities  settlement  systems  which  have  been

designated  by  the  Dutch  Minister  of  Finance.  The  zero  hour  rule  (a  general  rule  under  Dutch

bankruptcy law) implies, inter alia, that insolvencies of such participants have retro-active effect

to  0:00  hour  on  the  day  of  the  declaration  of  insolvency.  The  liquidator  may  reclaim  funds

transfers which have been executed after that time. The zero hour rule is generally considered to

be a threat to the smooth and efficient functioning of payment systems and securities settlement

systems  (which  was  already  signalled  in  the  G10  Report  on  Interbank  Netting  Schemes  of

November  1990)  and  the  draft  law  therefore  provides  that  vis-à-vis  such  systems,  transfer

orders issued by a participant and executed during the day of its insolvency cannot be annulled

by  its  liquidating  authority.  However,  it  would  appear  that  under  the  draft  law,  the  liquidating

authority  would  nevertheless  be  able  to  reclaim  the  payments  and  securities  (or  rather  the

“amount of the value of that which was the subject of the order” in the terminology of the draft

law) from the participant having received such transfer order in a payments system or securities

settlement system “outside of the system”, and without leading to an unwinding of the settlement

process “within the system”. In this manner, the Dutch authorities attempt to accommodate the

above  concern  with  regard  to  their  current  zero  hour  rule  and  at  the  same  time  seem  to

anticipate the adoption of the EU Directive on settlement finality (the “draft Directive”), which is

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presently in the process of being adopted by the EU Council and the European Parliament and

which  contains  provisions  on  the  retro-active  effects  of  insolvency  proceedings.  Against  this

background,  it  is  therefore  necessary  to  consider  the  practical  effects  of  the  draft  law  and  to

assess whether they are indeed beneficial or otherwise appropriate. This issue will be addressed

in this opinion from various perspectives. As explained further in the paragraphs below, the EMI

feels  that  the  draft  law  is  too  restrictive  both  from  a  legal  point  of  view  as  well  as  from  a

payment and securities settlement systems point of view. The legal perspective will be dealt with

in  paragraph  4,  the  systems’  perspective  in  paragraph  5.  For  reasons  of  brevity  and  for  the

purpose  of  this  opinion,  payment  systems  and  securities  settlement  systems  will  collectively  be

referred  to  as  “systems”,  the  amount  of  any  payments  and  securities  will  be  referred  to  as

“funds”,  whilst  transfer  orders  for  payments  and  securities  will  be  collectively  referred  to  as

“transfer orders”. “Receiving participant” will mean a participant in a system, either directly or

indirectly, who first receives the funds and any subsequent participant, if any, in that or any other

system which receives the funds.

4.

The  EMI  feels  that  the  draft  law  is  too  restrictive  from  a  legal  point  of  view.  If  the  EMI

understands  the  draft  law  correctly,  a  liquidator  would  be  able  to  reclaim  funds  from  the

receiving  participant  in  a  system,  irrespective  of  whether  he  is  the  final  beneficiary  of  the

transfer  order  or  only  an  intermediary.  This  application  of  the  zero-hour  rule  outside  of  the

system seems to give the receiving participant only conditional finality for funds received during

the day of the opening of insolvency proceedings, whereas such a participant should actually be

in the position to rely on the definitive character of the funds transfer, particularly in view of its

other  operations  (see  point  5  below).  This  right  of  the  liquidator  is  based  on  the  fact  that  the

“zero-hour rule” will remain applicable “outside the system”, which would allow to challenge all

funds transfers on the day of the opening of insolvency proceedings for the sole reason that they

have been made between 0:00 hour and the opening of the insolvency proceedings on that day in

infringement  of  the  retro-active  dispossession  of  the  insolvent  party.  This  ignores  the  fact  that

the  receiving  participant  may  only  be  an  intermediary  instructed  to  forward  funds  to  other

parties. The avoidance of systemic risks requires that finality and irrevocability of transfer orders

should  not  only  apply  to  the  original  transfer  order,  but  also  to  any  other  subsequent  transfer

orders which are issued as a means of carrying out or pursuant to the first transfer order, and to

any  funds  transfers  made  thereunder.  This  means  that,  where  a  participant  in  a  system  enters

transfer orders into a system and forwards funds to other parties, such funds transfers should not

retro-actively  be  affected  by  an  insolvency  of  the  originator  of  the  transfer.  To  the  extent  that

the  draft  law  appears  to  provide  a  liquidator  with  the  possibility  to  reclaim  funds  from  the

receiving  participant  in  a  system  which  have  already  been  transferred  to  a  subsequent

beneficiary, this would raise numerous legal uncertainties, particularly in a cross-border context.

For  example,  should  the  receiving  participant  delay  the  execution  of  a  funds  transfer  until  the

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moment that certainty exists with regard to the finality of this transfer (i.e. the next day?). This

would  obstruct  the  smooth  and  efficient  functioning  of  systems  and  contradict  the  very  aims

which RTGS systems attempt to achieve. Should the receiving participant retain a right vis-à-vis

a  subsequent  receiving  participants  to  revoke  any  transfer  order?  This  is  difficult  to  construe

from  a  legal  point  of  view  and,  again,  contradicts  the  smooth  and  efficient  functioning  of

systems. Or should the receiving participant bear any losses resulting from a successful claim for

restitution itself? This is unreasonable, particularly if the receiving participant is only the channel

through which funds are transferred to other beneficiaries. In addition to these observations of a

legal nature, it would also be unlikely that the draft Directive intends to allow for a continued, but

delayed, application of the zero-hour rule as envisaged in the draft Dutch law, particularly since

Article 7 of the draft Directive on the non-retroactive effect of insolvency proceedings seems to

be specifically included with a view to the abolition of the zero-hour rule. In this connection, the

EMI recalls that in other countries a zero-hour rule either has never existed or has recently been

abolished (at least for all participants in their respective systems).

5.

The EMI notes that the above analysis is indicative of a more general debate on the appropriate

level  of  finality  in  order  to  avoid  systemic  risks  for  systems  in  particular  and  threats  to  the

stability of financial markets and institutions in general. There are strong arguments in favour of

beneficiary finality (except, of course, in cases of imperfections in the underlying transactions or

funds transfers resulting from fraud or error as decided by courts on a case-by-case basis) for

the purpose of achieving the smooth and efficient functioning of systems and the stability of the

financial markets. The EMI believes that systemic risk concerns are only adequately addressed

if, at least, finality (subject to the foregoing exceptions) for receiving participants is ensured.

Funds  transfers  between  participants  in  the  financial  markets  cannot  be  seen  in  isolation  from

each other. Such participants tend to operate on the basic assumption that funds transfers, when

due  and  indeed  made,  are  irrevocable,  final  and  cannot  successfully  be  challenged  whether

through  court  proceedings  or  otherwise  and  they  anticipate  these  consequences  in  their

transactions  with  other  parties.  Thus,  the  continued  exposure  of  a  receiving  participant  to  the

originator of a transfer order after the purported settlement of that transfer order, as a result of

the delayed application of the zero-hour rule, could still lead to a domino effect causing systemic

risk and instability of financial markets and institutions.

The  above  argument  applies  even  more  strongly  in  an  environment  where  market  participants

are global players, where credit institutions participate in different systems operating in different

time  zones  and  where  links  between  such  systems  are  established.  In  this  connection,  the

magnitude of the transactions involved is also important. Whereas, for individual transactions, or

specific types of transactions, risks such as market risk, replacement risk or operational risks are

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relevant, such risks are multiplied for systems due to the fact that the full amount of the funds
transferred is at stake.1

The  above  considerations  were,  inter  alia,  a  reason  for  EU  central  banks  to  urge  the

implementation of Real-Time Gross Settlement systems (RTGS systems), on the basis that these

systems,  at  least  from  a  technical  point  of  view,  can  guarantee  intra-day  finality  of  individual

transfers  as  they  occur.  Thus,  RTGS  systems  provide  a  tool  for  banks  to  manage  credit  and

liquidity risks inherent in their banking business; but this tool is of course only effective if funds

transfers are also final from a legal point of view. As far as the TARGET system is concerned,

which  the  EU  central  banks  have  been  developing  over  the  past  few  years,  this  system  is

designed on the basic assumption of intra-day finality. If such finality cannot be achieved due to

legal  obstacles  in  a  Member  State,  this  may  have  implications  for  all  participants  in  the  system

and for all credit institutions incorporated in that Member State. The latter may face difficulties if

they wish to participate in or connect to RTGS systems on a remote basis or through branches

abroad.  Furthermore,  the  NCB  in  a  Member  State  with  such  legal  obstacles  may  have  to

guarantee  that  TARGET  payments  channelled  through  it  to  receiving  participants  in  other

Member  States  are  indeed  final,  irrespective  of  the  legal  situation  in  the  Member  State

concerned.  This  would  suggest  that  the  draft  law  does  not  achieve  one  of  its  most  important

aims:  the  removal  of  legal  obstacles  for  the  participation  of  Dutch  credit  institutions  in  RTGS

systems outside the Netherlands.

Furthermore, the absence of finality in systems may make it difficult  to  implement  mechanisms

such  as  payment-versus-payment  and  delivery-versus-payment  or  to  build  bridges  between

systems.  This  is  an  obstacle  to  attempts  to  make  financial  markets  as  efficient  and  sound  as

possible.

For the reasons set out above, the  EMI  regrets  that,  although  the  explanatory  memorandum  to

the draft law acknowledges many of the above considerations, the draft law itself nevertheless

takes  such  a  restrictive  stance  towards  finality.  This  is  from  the  EMI’s  point  of  view  also

particularly  important  as  the  smooth  and  efficient  functioning  of  payment  systems  is

indispensable for the achievement of the ESCB’s objectives in Stage Three and, in particular, the

implementation and execution of the single monetary policy.

1  For example, the scale of potential problems can be demonstrated by reference to the daily turnover in the FX
market alone, which was estimated in April 1995 at 1.26 trillion USD and where daily settlement flows are likely
to amount, in aggregate, to a multiple of this figure. See a report prepared by the Committee on Payment and
Settlement Systems of the central banks of the Group of Ten countries on settlement risk in foreign exchange
transactions which was published by the Bank for International Settlements in March 1996.

                                                
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6.

In summary, the EMI  is  of  the  opinion  that  the  draft  law  is  too  restrictive.  Firstly,  it  does  not

seem to protect transfer orders issued to, and funds transfers made by, the receiving participant.

This  means  that  the  draft  law  does  not  sufficiently  accommodate  the  need  to  avoid  systemic

risks.  Secondly,  the  draft  law  appears  to  run  contrary  to  an  increasing  trend  in  the  financial

markets  to  achieve  receiving  participant  or  even  beneficiary  finality  (except  for  cases  of

imperfections in  underlying transactions or funds transfers resulting from fraud or error) for the

purpose of achieving the smooth and efficient functioning of systems as well as the stability of

financial  markets  and  institutions.  The  EMI  therefore  recommends  to  the  Dutch  legislative

authorities to reconsider the draft law in the light of the above considerations.

7.

The EMI has no objections to this opinion being made public.

11 November 1997