_SECURITIES CLEARANCE AND SETTLEMENT SYSTEMS_

# ExPOSURE TO RISK **WITHN** THE SYSTEM

Clearing and settlement procedures expose participants to a number of risks. Maintaining acceptable levels of safety and soundness is a primary regulatory objective. More recently the regulatory role has been expanded to include system efficiency as an equally important objective. Risks<sup>23</sup> stem from weaknesses in system design and can have their origin in any of the following: (a) rules and procedures, (b) institutional arrangements, (c) participants, (d) technical mechanisms, and (e) the need for implicit and/or explicit extension of credit. The specific major risks are discussed in the following paragraphs.

_Credit risk_ is the risk that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. It involves both the _replacement cost risk and principal risk._ Replacement cost risk is the loss of unrealized gains on unsettled contracts due to changes in securities market prices between the time a trade is executed and the time that it is settled. The exposure depends on the market price volatility and the time gap between trade date and settlement date. Principal risk is the risk that the full value of securities or funds will be lost by either the seller or buyer, when the respective counterparty fails to settle. This risk can be eliminated by introducing an acceptable form of DvP.<sup>24</sup> _Third party credit risk_ arises when settlement participants are permnitted or required to use banks or intermediaries to guarantee or provide settlement funds and fail to perform, whether or not the settlement participant has perforned its obligations.

**_Liquidity_** _risk_ is defined as the risk that a counterparty will not settle an obligation for full value when due, but on some unspecific date thereafter. If a counterparty fails to settle, it does not always mean that it is insolvent. The reason could be a failure in the technology being used (a computer failure), a transitory liquidity problem or a "cascading" effect from other failed transactions. However, it is very difficult to determine ex-ante if the counterparty is having a liquidity or solvency problem. Moreover, in some situations, an unresolved liquidity problem could result in subsequent insolvency. In any case, the implication for the non-defaulting counterparty might well be the need to liquidate assets, borrow funds or borrow securities.

_Operational risk_ stems from breakdowns in internal controls, failure to follow procedures or inability to follow procedures. Operational weaknesses or failures can result in specific problems such as credit or liquidity problems and indeed can create the potential for fraud. Sufficient attention should be given to the need for appropriate logical and physical security arrangements, especially those relating to data integrity including the use of rigorous encryption and message authentication/non-repudiation procedures as well as strong system access controls.

_Legal risk_ stems from ambiguity or uncertainty in the rules governing the clearance and settlement process. In an environment with widespread legal uncertainty, participants may view the systems as being unreliable, and unfair. Legal risks can also impede the ability of paymnent system operators to manage credit and liquidity risks (unenforceability of netting arrangements, bankruptcy laws may force payments to be revoked, no validity of interests in pledged collateral). In general, legal risks can arise from three different sources. First, rules may not clearly allocate responsibilities (liabilities or losses)

- **_23_** _See Payne, Myriam, May 1999,_ Risks in Payments Systems, _presented in the Thomas Murray Global Custody Conference on Minimizing Risk in Clearing, Payment and Settlement Systems held at New York May 24-25 1999._

- **_24_** _Note that this risk is non existent when there is simultaneity in the transfer of securities and funds. However, it could be that even in the absence of this simultaneity, DvP is accomplished, provided that there is delivery if and only if there is payment and vice versa._

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