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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.
Regulatory Pressures to Formally Assess CSDs
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.
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.
access to the CSDs
of CSDs that have immobilised/dematerialised securities
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).
legal entities of the CSDs
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.
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.
risk safety measures
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.
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.
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