The second example based on asymmetric information is moral hazard. While adverse selection stands in the way of the closure of deals, moral hazard occurs after a contract was concluded. If these contracts are insufficiently structured counterparties have an incentive to adopt a behaviour which is undesirable to their partners. Moral hazard thus refers to the negative effects of the behaviour of the contract-taker on the contract-issuer. The textbook example here is the one where the holder of a fire insurance contract does not take enough precautions to prevent the outbreak of a fire since he trusts in the insurer’s cover. Only by introducing a certain degree of co-insurance in the contract can these negative effects on the contracting partners behaviour be mitigated. In the field of securities clearing and settlement systems, the design and implementation of various mechanisms may contribute to overcome the problem of moral hazard. Let me give you some examples. An obvious mechanism is to forbid uncovered (or unpriced) overdrafts since such overdrafts might encourage exaggerated risk taking. Some form of collateralisation usually provides the correct incentives. Another means to create the right incentives to avoid moral hazard is for CCPs to set up margining mechanisms to collateralise participants’ open positions. Lastly, market utilities  2  BIS Review 28/2003  may design and implement default funds to which both the defaulting and the surviving participants have to contribute, thereby reducing the occurrence of moral-hazard-like behaviour among them. The second imperfection that typically affects a financial system are externalities.

Such a model based on the Lamfalussy standards (1990) has already been put in place among central bankers and has proven to be effective in the context of the Continuous Linked Settlement system (CLS). A second challenge that the authorities face lies in the risk of cross-border financial transactions. Indeed, whereas the nature of the risks remains basically the same, both the probability of occurrence of an adverse event and the risk exposures themselves have clearly increased. The added dimension of cross-border activities lies in potential spillover effects due to the interlinking of systems. Credit, liquidity and operational risk events occurring in one jurisdiction may indeed trigger a systemic crisis by spilling over to foreign financial markets. Not only systems of the same nature, i.e. payment systems, but also different systems such as payment, clearing and settlement systems have been linked at an international level. A promising outcome would be a cross-border delivery-versus-payment mechanism that relies on central bank money. All in all, the current and, if feasible, future linkages explain why regulatory and oversight authorities have to widen the focus of their responsibilities further. A third challenge relates to in-house clearing, payment and settlement mechanisms at large custodians. This commercial function has undergone a remarkable process of concentration in the last few years. Some of these service providers have become very significant for the stability of the financial system as witnessed by the events of September 11, 2001.