Financial Stability Standards for Central Counterparties Standard 11: Exchange-of-value Settlements

Guidance

The settlement of a financial transaction may involve the settlement of two linked obligations, such as the delivery of securities against payment of cash or securities or the delivery of one currency against delivery of another currency.^[1] In this context, principal risk may be created when one obligation is settled, but the other obligation is not (for example, the securities are delivered but no cash payment is received). Because this principal risk involves the full value of the transaction, substantial credit losses as well as substantial liquidity pressures may result from the default of a counterparty or, more generally, the failure to complete the settlement of both linked obligations. Further, a settlement default could result in high replacement costs (that is, the unrealised gain on the unsettled contract or the cost of replacing the original contract at market prices that may be changing rapidly during periods of stress). A central counterparty should eliminate or mitigate these risks by ensuring that it uses an appropriate DvP, DvD or PvP settlement mechanism.^[2]

11.1.1 A central counterparty should ensure that it employs a DvP, DvD or PvP settlement mechanism, which eliminates principal risk by ensuring that the final settlement of one obligation occurs if and only if the final settlement of the linked obligation occurs (see also CCP Standard 4 on credit risk, CCP Standard 7 on liquidity risk and CCP Standard 8 on settlement finality). In the securities market, for example, a DvP settlement mechanism is a mechanism that links a securities transfer and a funds transfer in such a way as to ensure that delivery occurs if and only if the corresponding payment occurs. Similarly, a PvP settlement mechanism is a mechanism which ensures that the final transfer of a payment in one currency occurs if and only if the final transfer of a payment in another currency or currencies takes place, and a DvD settlement mechanism is a securities settlement mechanism which links two or more securities transfers in such a way as to ensure that delivery of one security occurs if and only if the corresponding delivery of the other security or securities occurs.

11.1.2 DvP (or PvP or DvD) should be achieved for all linked obligations cleared by a central counterparty. The settlement of two obligations can be achieved in several ways and varies by how trades or obligations are settled, either on a gross basis (trade-by-trade or line-by-line) or on a net basis, and the timing of when finality occurs.

11.2.1 In meeting the requirements of CCP Standard 11.1, the final settlement of two linked obligations can be achieved either on a gross basis or on a net basis. The choice of settlement model employed by a central counterparty will depend on the nature of obligations that it settles. Typically, exchange-of-value settlement can be achieved in one of three ways:

• where the final transfers of payment and/or securities between trade counterparties required to extinguish linked obligations occur contemporaneously and on a trade-by-trade (or line-by-line) basis in real time (i.e. DvP model 1)
• where final securities transfers are settled on a trade-by-trade (or line-by-line) basis in real time, with final payment transfers settled on a multilateral net basis at the end of the processing cycle (i.e. DvP model 2)^[3]
• where both final securities transfers and/or final payment transfers required to extinguish linked obligations occur contemporaneously on a multilateral net basis at the end of the processing cycle (i.e. DvP model 3).

Regardless of whether a central counterparty employs a payment system or securities settlement facility that settles on a gross or net basis, the facility's legal, contractual, technical and risk management framework should ensure that the settlement of an obligation is final if and only if the settlement of the corresponding obligation is final.

11.2.2 The timing of exchange-of-value settlement of trades is important. Where the final contemporaneous transfers of securities and/or payment required to extinguish linked obligations occur either in real time throughout the day, or on a multilateral net basis at the end of the processing cycle, principal risk is eliminated. On the other hand, where final transfer of securities occurs in real time, but final payment is deferred until some later time, sellers of securities remain exposed to principal risk, which must therefore be managed.

11.2.3 Where settlement involves the exchange of a security for payment (a DvP transaction), the settlement of obligations requires up to three steps:

• the security (or title over the security) needs to be transferred from seller to buyer
• payment must be transferred from the buyer to the seller, either across accounts with the securities settlement facility's money settlement agent (which may be the central bank of issue), or using the services of a commercial settlement bank
• where the buyer and seller use a different commercial settlement bank, funds must be transferred from the account of the buyer's settlement bank to the account of the seller's settlement bank with the money settlement agent (see CCP Standard 9 on money settlements).

11.2.4 Contemporaneous performance of the three steps involved in a DvP transaction requires that:

• the transfer of money settlement assets is irrevocably linked with the settlement of securities and payment obligations, such that one cannot occur without the other
• where netting is used, securities blocked prior to transfer are not subject to claims by third parties
• final and irrevocable settlement of all obligations arising from a securities trade occurs either simultaneously or within such a very small period of time that the benefits of DvP are achieved.

11.2.5 Notwithstanding that contemporaneous multilateral net settlement of securities and/or final payment transfers eliminates principal risk, a participant default that triggered recalculation of obligations within the net settlement batch could, if obligations were sufficiently large, cause either, or both, the central counterparty and survivors to face significant liquidity pressures on a short horizon. Furthermore, even where a participant default did not give rise to sizeable swings in liquidity requirements for participants, the dependencies between participants in a net batch settlement model are such that problems with a single participant could nevertheless cause delays and uncertainty for all participants.

11.2.6 Where individual trade values are large, in the sense that dealing with a defaulting participant's obligations within a multilateral net batch could cause significant delays, uncertainty or liquidity pressures a central counterparty would be expected to settle linked obligations via a payment system or securities settlement facility that provides for trade-by-trade (or line-by-line) settlement on a real-time basis. Only where trade values are not large in this sense would it be acceptable for the payment transfers and/or final securities transfers required to extinguish linked obligations to occur on a multilateral net basis. Even where trade values are small, linked settlements should occur contemporaneously unless this is precluded by operational requirements. Where netting is involved, the central counterparty should ensure that it has taken steps to ensure the certainty of netting arrangements (see CCP Standard 1 on legal basis). The central counterparty should, at a minimum, ensure that the final and irrevocable settlement of obligations is completed by the end of the settlement day.

11.2.7 Operational requirements that may necessitate non-contemporaneous settlement of linked obligations refer to practical matters arising out of the nature of the security and payment being exchanged that preclude contemporaneous settlement. This may occur, for example, where title must be exchanged by individual physical delivery and, as a practical matter, payment is by other than electronic transfer.