Review of Settlement Practices for Australian Equities – May 2008
5.1 The settlement model
Settling novated and non-novated transactions separately
Given that the settlement delays in late January arose from difficulties in settling off-market transactions, one possible response would be to split the current batch and settle novated and non-novated trades separately.
In the Bank’s view, the case for such a change is weak. It would undermine the efficiency of the current batch settlement process, and would not necessarily improve the resilience of the system. As discussed previously, many of the non-novated transactions are related to the settlement of novated trades. A common batch allows these non-novated transactions to net off against securities being delivered in respect of on-market transactions. If these non-novated transactions were not settled in the same batch, alternative arrangements would need to be developed to ensure that securities were in place to allow settlement of the novated transactions. One possibility is that participants might choose to settle the off-market transactions on a nondelivery- versus-payment basis, thereby introducing principal risk to the system.
A second alternative would be to move away from the current net batch model for equities settlement to a model whereby both securities and funds transfers are settled on a trade-by-trade basis.10 Such a model is currently adopted for fixed-interest securities and most high-value payments, and often also for equities in overseas securities settlement systems (Table 1). In the payments context, systems settling on this basis are known as real-time gross settlement (RTGS) systems; in the securities context, they are known as DvP Model 1 systems.11
|High-value payments||Fixed income||Equities|
RTGS: Real-time gross settlement
of payments – transfer instructions are
settled individually with finality.
DvP Model 1: Delivery-versus-payment Model 1 – transfer instructions for both securities and funds are settled with finality on a trade-by-trade basis.
DvP Model 2: Delivery-versus-payment Model 2 – transfer instructions for securities are settled with finality on a trade-bytrade basis, with funds transfer instructions settling on a net basis with finality only at the end of the funds processing cycle.
DvP Model 3: Delivery-versus-payment Model 3 – transfer instructions for both securities and funds are settled on a net basis with finality at the end of the processing cycle.
* Refers to TARGET 2; high-value payments can also be settled in Euro-1, which is a deferred net settlement system.
+ Refers to Fedwire Funds Transfer System; high-value payments can also be settled in CHIPS, which is a continuous net settlement system.
|Australia||RTGS||DvP Model 1||DvP Model 3|
|Canada||RTGS equivalent||DvP Model 2||DvP Model 2|
|France||RTGS *||DvP Model 1||DvP Model 1|
|Germany||RTGS *||DvP Model 1||DvP Model 1|
|Japan||RTGS||DvP Model 1||DvP Model 3|
|Switzerland||RTGS||DvP Model 1||DvP Model 1|
|UK||RTGS||DvP Model 1||DvP Model 1|
|US||RTGS +||DvP Model 1||DvP Model 2|
In systems settling on a trade-by-trade basis the ordering of settlements is important to the efficiency of recycling in both cash and securities liquidity. Reflecting this, overseas systems that settle securities in this way typically offer some type of queue-management or ‘offset’ functionality. In some systems, securities transfers are executed during multiple ‘batch-processing cycles’ in which sophisticated chaining procedures manipulate the order in which transfer instructions are settled to maximise the volume or value of securities transferred. In other cases, systems incorporate algorithms to identify offsetting opportunities.
The introduction of such a model in Australia for all (or most) equity settlements would reduce some of the risks inherent in the current system. In particular, trade-by-trade settlement, implemented with appropriate queue-management functionality, would reduce the potential for market-wide delays in settlement due to problems with a single participant, while preserving the links between dependent settlements. It could also relax the constraints imposed by the pre-batch settlement cut-off, potentially allowing settlement priming activity to take place over a longer intraday time-frame. Furthermore, it would eliminate the need for settlement banks to accommodate potentially sizeable swings in net payment obligations arising from such concentrated settlement priming activities, or indeed from batch recalculation.
A trade-by-trade settlement alternative has in fact existed within CHESS since late 2000, running in parallel with batch settlement. In particular, this option (CHESS RTGS) allows participants to settle individual transactions in real time outside of the batch, with the securities transfer in CHESS occurring simultaneously with an interbank funds transfer across Exchange Settlement accounts at the Reserve Bank. To date, however, this trade-by-trade alternative has never been used, with participants favouring the liquidity efficiency of batch settlement. Upfront connectivity and other system and messaging costs may also have been a disincentive.
In the Bank’s view, the use of DvP Model 1 for equities settlement represents the first-best outcome from a pure risk perspective, especially as it would reduce the probability that problems with one participant affect the broader market. At the same time, the Bank recognises that there would be transition costs from introducing a new settlement system. With values settled in CHESS around one-tenth of those in the high-value payments system, the case for moving to trade-by-trade settlement for equities is less clear-cut than it was for moving to RTGS for high-value payments in 1998, especially as principal risk is already addressed through delivery-versus-payment. However, as revealed by recent events, the concentration of settlement activity in the batch process and the possibility of system-wide settlement delays have the potential to undermine confidence in the Australian equity market, which could ultimately have systemic implications beyond any direct financial loss associated with settlement problems.
On balance, the Bank sees a strong case to move to trade-by-trade settlement over the medium term. In this context, one option worth considering is the introduction of a single system for all securities settlement, as is increasingly common overseas. The Austraclear securities settlement system, which also sits within the ASX Group, currently provides DvP Model 1 settlement for the over-the-counter fixed-income market and could eventually be an option for equities settlement. In the interim, a number of changes could be made to existing arrangements to improve their functioning.12
- There is a third model under which securities are settled on a trade-by-trade basis with finality, but funds are settled net at the end of the processing cycle (DvP Model 2). Given the separation of securities and funds transfers in such a system, intraday finality of securities settlement can only be achieved if securities transfers are collateralised or otherwise guaranteed. For this reason, this alternative has not been considered in this analysis.
- Where equity trades have been novated, this can involve net settlement of obligations vis-à-vis the central counterparty by line of stock.
- In the interim, there may also be merit in industry participants re-examining the existing real-time trade-by-trade alternative within CHESS, at least in respect of non-novated settlements which have not been instructed before the cut-off. These transactions are currently often settled on a non-delivery-versus-payment basis: the securities pass free-of-payment in CHESS and the associated funds pass separately through Austraclear.