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Page last updated
February 16, 2003




The need to assess and evaluate CSDs

Pressure has been building for some years for the investment industry to analyse and better understand central securities depsitories (CSDs) and the risks associated with the local market transactions settlement and custody. This trend is being driven partially by regulatory pressure to minimise risk, and partly through the desire of many groups to improve transactions processing efficiency.

Investments held in most markets are directly exposed to CSDs, whose use is often obligatory for legal or local market practice reasons. Responsibility for CSD risk has traditionally been regarded as an investment risk assumed by the global investor. It is therefore the investors responsibility to assess and evaluate these entities and determine whether they are satisfied that their assets are secure.

The obvious difficulty with this situation is that the investor is often in a poor position to gather information on CSDs and analyse their strengths and weaknesses. Global custodians through their local sub-agents are better able to analyse and monitor Depositories, but do not wish to evaluate associated risks or accept responsibility for the selection or ongoing use of these entities. This has resulted in a lack of detailed analysis by the industry of these groups to date.

CSDs play an increasingly important role in the development and maintenance of domestic capital markets, and increasingly in cross-border investment. The design, ownership and structure of CSDs has a major impact on the asset safety of investments held in domestic markets. This has been highlighted by recent regional difficulties particularly as the strength of many local commercial banks has weakened.

Progress continues to be made by domestic markets to improve efficiency and reduce the risk of investment through the creation of local CSDs. CSDs continue to proliferate, rising from 13 in 1980 to 102 operational CSDs and 20 planned CSDs across 96 countries today. In 28 countries, single CSDs currently cover the three main instrument types - equities, fixed income and money market instruments. In the remaining countries, separate CSDs currently handle only one or two of the instrument types, although some are planning to cover all instrument types in the future. Globally, CSDs currently employ in the region of 9,700 people directly.

Increasing Regulatory Pressures to Formally Assess CSDs
The increasing use of CSDs as centralised settlement and safekeeping entities has led the U.S. Securities and Exchange Commission (SEC) to reconsider the relevance of the original rule 17f-5 criteria, governing the custody of assets of registered management investment companies, with custodians outside the U.S.

The fact that many CSDs now performing core settlement and safekeeping functions are not banks and cannot meet the rule 17f-5 criteria, has resulted in the SEC proposed amendments to rule 17f-5 governing eligible foreign (i.e., non-U.S.) custodians and a new rule 17f-7, which relates to CSDs. Together these two rules would permit assets to be maintained in CSDs, subject to certain standards and conditions being met.

The proposed new rule would require global custodians to evaluate each CSD and provide investors with CSD information, and then, continuously monitor the risks associated with the use of each CSD. There is an ongoing requirement to report material changes. The SEC sees the proposed rule 17f-7 as a form of partnership between global custodians and investment advisors. Information on the CSDs and related risks would be made available to investors by the global custodians, who in turn would evaluate the risks as part of their overall assessment of investment risk in local markets. Responsibility for maintaining securities with a CSD will remain with the investor.

Under the proposed rule, custodian banks will continue to play a crucial role. Global custodians would agree to exercise reasonable care with respect to their proposed duties under the new rule. The management of agents, counterparties and the provision of information on these entities is, after all, one of the central functions of custodian banks. However, the banks are increasingly looking to third parties for relevant expertise and support.

Use of CSDs
One of the main advantages of investing in markets with fully operational CSDs is that they reduce safekeeping risks. This is achieved by immobilising or dematerialising securities, thereby minimising the inefficiencies and risk of physical settlement, typically by use of book entry transfers. Most CSDs operate net clearing systems among their participants and have either direct or indirect links to payment systems in order to move cash in parallel to the securities. Finally, the development of CSDs can facilitate the implementation of true delivery versus payment (DVP) in local markets, by reducing the timing difference, (and intra-day credit exposure) between local payment systems and settlement systems.

However, the diverse characteristics of CSDs and the development of cross exchange settlement links raise very real concerns for global investors in terms of asset safety and operational risk. Much less attention has been given by investors to problems arising out of the complexity and diversity of central depositories around the world, and their growing role as custodian of institutional assets. Most notably, there is a danger that investors could become more exposed to the risks inherent in asset safety and administration, if their assets sit outside the banking system. These risks and how they impact cross-border investment and settlement need to be better understood, and regulatory pressure is forcing this process.

A number of issues facing investors and their custodians in using CSDs are outlined and supported by global statistical findings from the Thomas Murray CSD Guide 1999.

Is the use of CSDs compulsory?

Of the existing operational depositories 66% are compulsory to use and 34% optional.

The decision to use a local CSD will invariably be determined by local market practice. If the use of a CSD is optional then very careful consideration must be given to the benefits/shortfalls of use.

Where use is compulsory, due consideration must be given to the best means of accessing the CSD.

Investor access to the CSDs
The most common form of access is via a local custodian bank (85% domestic investors, 89% foreign investors). Selecting the best method of access may be determined by the functionality contained within each local CSD. Even if local membership rules permit direct investor access it may not be cost effective. Also it could be beneficial to access the CSD via a local agent who is already a member, as direct participants are normally affected by obligations to the CSD for risk minimisation and loss sharing arrangements in the event of default.

Number of CSDs that have immobilised/dematerialised securities
As described above, the immobilisation or dematerialisation of securities reduces safekeeping risks, which is one of the main advantages of using a CSD. Overall, 41% of CSDs have eliminated the need for physical documents to represent the ownership of securities. Securities and ownership records exist only as data (dematerialisation). 31% of CSDs remain immobilised, i.e., where physical securities are deposited and retained in a CSD so that transactions may be effected by book-entry rather than physical movement. A further 16% currently hold securities in both immobilised and dematerialised form.

CSD settlement models
Using the three types of settlement model developed by the Bank for International Settlements (BIS) allows one to examine the role of CSDs in the settlement process. The most common settlement process operated by CSDs is Model 2 (21% overall) - the gross simultaneous settlement of securities followed by net settlement of funds. Under this model CSDs operate an assured payment system whereby the seller delivers securities against an irrevocable commitment from the buyer’s bank to make payment to the seller’s bank at the end of the processing cycle.

Model 3 - simultaneous net settlement of securities and funds transfer is used by 19% of depositories. 17% of CSDs use Model 1 - gross simultaneous settlement of securities and funds transfer. Users of this model would also include the ICSDs (i.e., Euroclear and Cedelbank).

The legal entities of the CSDs
The majority of CSDs (50%) are part of the Central Bank or Stock Exchange and, as such, do not have separate legal status. 15% of depositories are independent, non-profit-making organisations and 15% are privately owned.

It is important to ask whether conflicts of interest exist between the owners of the CSD and other local market participants. There are several examples where commercial banks and brokers have jointly created a local CSD to serve their collective needs only to find that commercial conflicts have interfered with the development of the CSD. What is the significance of failure? Can the owners allow the CSD to fail or would there be too many repercussions? Does the CSD link to the national payments system? Is there proper matching of responsibility and accountability.

Cross-border services

41% of CSDs offer cross-border securities deposit and settlement services. Where CSDs have established direct or indirect participant linkages with other local market CSDs, this has nearly always been done on a geographical proximity basis, such as in the planned links by ECSDA (Euro-zone) and a number of Central and Eastern European depositories.

Internal risk safety measures
In managing risks, investors need to look below their immediate custodial bank suppliers, and ask whether the CSD itself is guaranteed, and if so, who is the ultimate guarantor(s)? This in turn raises a number of related issues. What sort of guarantee(s) exist to support the members and their settlement through the CSD? Is the guarantee meaningful? If called upon, would the guarantee be sufficient to cover normal intraday/ overnight settlement exposures? What is the guarantee in place to support: settlement default, liquidity shortages, intraday chaining? If guaranteed by a Central Bank is the sovereign risk of the country satisfactory?

The following list summarises the internal risk management programmes currently in effect among CSDs. These internal safety measures must be looked at in the context of external factors, which will greatly influence the ability of a CSD to maximise asset safety.

64% of CSDs have insurance to cover the loss or theft of securities held in safe custody, and damage from fire.

Compensation fund:
43% of CSDs have a compensation fund to cover losses which might take place during the business operation.

Participants eligibility:
71% of CSDs evaluate and monitor the financial status, securities and transactions of new and existing participants.

Internal controls:

87% of CSDs keep records of the conveyance, location and number of securities that are deposited or withdrawn, to reconcile problems that may occur during service processing.

55% of CSDs have vaults. The majority of vaults are secured by closed circuit television (CCTV) and are guarded full time.

Off-site back-up:
87% of CSDs have office back-up facilities for its EDP centre(s). 80% have back-up power generators and 92% UPS (uninterruptible power supply).

Overall, 66% of CSDs have implemented anti-forgery measures, with 17% implementing optical card readers, 21% image scanners and 52% storing information about lost, stolen and counterfeit securities.

Disaster recovery:
83% of CSDs have disaster recovery plans, including computer back-up and locations, support and recovery systems. Many of the plans ensure that every single component in the system (gateway, system, communication method) are replicated and operational.

Legal safety measures:
45% of CSDs are legally required to compensate for the loss of missing deposited securities. In most cases the depository is responsible for the replacement and direct additional cost which its clients have incurred due to the loss.

In addition to the many CSDs which have an internal auditing department, 89% use external auditors to carry out at least an annual audit. 52% allow third parties to audit their internal controls and procedures. In most cases, third party audits are restricted to local market regulatory and supervisory bodies.

Understanding the structure, procedures, services and functionality offered by each CSD is critical for investors and custodian banks in determining how best to structure their local market securities services support. The need to formally assess and evaluate CSDs is also being increasingly driven by both regulatory and investor pressures, in order to reduce securities and cash exposure. The investment community is on notice to better understand local market infrastructure, conditions and related risks.

Prepared by Derek Duggan
Director, Thomas Murray



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