8.3.2.1 Layered Structure

The degree of centralization of the settlement system will depend in part on country circumstances. For an emerging-market country, a single register, where all individual holdings are listed, may be sufficient. This could include all individual holdings, including those of retail customers. Alternatively, it could include only financial institution participants that would distinguish their holdings at the single register between their own account and the account of their customers. These institutions would, in effect, be acting as implicit subdepositories for their clients. With modern communication and computer facilities, a single register should be technically feasible.¹³⁷ As the number of investors and their transactions in government securities rise and a variety of privately issued securities become tradable, a fully centralized depository may become unwieldy, justifying the introduction of subdepositories.

Most countries end up adopting a two-tier structure, consisting of a central depository complemented by a number of financial institutions acting as subdepositories. Only a select set of financial institutions is allowed to hold securities with the central depository, while nonfinancial investors and even some financial investors are allowed to hold securities only with sub-depositories. Subdepositories, in turn, hold global nominee accounts with the central depository. These global nominee accounts must be a precise counterpart of the accounts they have opened to their clients.

This two-tier basic structure may have some variants, based on special factors or country-specific arrangements. International depositories (e.g., Clearstream, EUROCLEAR) may be linked to the system, either at the central depository or the subdepository level, thus introducing an additional layer. In some countries, authorities may allow subdepository institutions to hold the counterpart of their clients’ accounts with another subdepository. This may lead to a three- or more-tiered structure.¹³⁸ Sometimes, despite the tiered framework, some investors holding securities with a subdepository are allowed, under specific circumstances, to have their holdings also identified separately at the central depository.¹³⁹ This rather atypical solution is apparently to reduce investor fear about the trustworthiness of subdepositories. The reverse situation may also emerge. There may be a single depository, but direct access to it is only permitted to select financial institutions, while other investors have to link with the central depository through these institutions.¹⁴⁰

8.3.2.2 General Versus Specialized Depository Systems

Regardless of its actual layering, a depository system for government securities is usually a fully integrated structure with a single central depository.¹⁴¹ Policymakers must decide whether such a system should be specialized for government securities or should encompass many types of securities, with government securities as a specific segment.

Almost all successful depository systems for government securities were initially set up as independent systems devoted only to government securities.¹⁴² There are precedents for depositories specialized in government securities that have expanded their activity to cover bonds issued by regional or local governments, local issues by international financial organizations, and nongovernment bond issues, many of which may correspond to large public financial intermediaries.¹⁴³ There are also examples of initially separate systems that have tended to become single depositories, mainly in countries with well-developed financial institutions.¹⁴⁴Attempts to start with a single unified depository system in countries where a range of securities is traded have usually encountered difficulty in integrating government securities with other securities or in developing efficient settlement procedures.¹⁴⁵

8.3.2.3 Automation

An adequate depository system for government securities accounts becomes feasible with automation, both at the central depository and the subdepository levels. In some cases, central depository automation has begun with a simple personal computer application and software developed in-house or by the International Monetary Fund. An important requirement in software development is central depository interface with secondary market transactions. Complications may arise from development by each subdepository of its own software and with the subdepository’s interface with the central depository.

Good communication facilities are essential for an effective government securities depository system. Sophisticated computer-to-computer communications are being introduced in many countries, which may be unwarranted for some emerging-market countries. There are many examples of depository systems for government securities that have managed to function efficiently with rudimentary communications facilities (telephone, fax), provided necessary equipment and staff were assigned to cover communication needs.

8.3.3.1 Central Depository Organization and Membership

Many central banks have found it desirable to play an important role in setting up and running central depositories for government securities. Central banks have encouraged development of a market for government securities as a means to eliminate the need for central bank lending to the government, as an important vehicle for the conduct of their own monetary policy operations, and as a way to improve the monetary policy transmission mechanism. Setting up and managing efficient settlement arrangements for government securities is relatively easy and inexpensive when the securities accounts and the deposit accounts of the main market participants are held with the same institution, i.e., the central bank. The central bank may already have a depository system in place for its own instruments, the required expertise and resources for expanding this facility, and a reputation for professional competence and honesty. Another significant advantage of central depositories associated with the central bank is the ability of central banks to resist the pressure of vested interests and to draw on their supervisory capabilities.

While it is desirable for the central bank to play an active role in establishing and managing a central government securities depository, the depository function need not be a direct central bank responsibility. Organizing the central depository as a separate public agency, even if located within the central bank, allows a more transparent delineation of functions and responsibilities and more easily allows for independent official oversight than if the facility were a direct central bank responsibility. A related policy question is oversight of the central depository. The central bank itself, the Treasury, and the supervisory authority for securities markets might be included on the central depository board of management. There must also be a mechanism for close interaction with market participants. Inclusion of market participants on the board is debatable. On the one hand, their participation would provide practical market perspectives to the design and operation of the depository arrangements. On the other hand, their participation could lead to a conflict of interest since they may represent their personal pecuniary interests rather than those of the public at large. If market participants are not included on the depository management board, procedures, formal or informal, for regular consultation with market participants are essential.

An alternative to a central depository associated with the central bank is a self-standing institution that could perform the same depository functions and provide similar settlement efficiency, although it would not have the above-cited advantages of the central bank. Needed for a self-standing institution are excellent electronic communications with the central bank, where the deposit accounts that will finally support settlement are held, and efficient procedures to coordinate transfers of securities accounts in the depository and transfers of money at the central bank, so as to ensure DVP. Reasonable communications of the central depository with market participants would also be necessary. Some countries that have recently transferred the depository function for government securities to a general depository for all securities have proved the feasibility of this approach. The recent attempt to do so and the limited number of countries involved indicate, however, that this route is not easy to pursue. In most cases, the depository for government securities started at the central bank and was moved at a later stage to a separate agency.

A central depository must determine the type and number of institutions allowed to hold government securities accounts with it. In a two-tier depository system, all subdepositories would be account holders at the central depository for securities belonging both to their own and to their clients’ accounts. From a market development perspective, many other financial institutions actively engaged in the market for government securities might also find it desirable to hold accounts with the central depository.

Restricted participation in the central depository leads to an enlarged role for subdepositories. The difficulties associated with setting up a reliable and efficient subdepository system may be an additional reason to favor direct participation of financial intermediaries in the central depository.

Whether or not a financial institution allowed to hold securities accounts with the central depository should be entitled to hold money accounts with the central bank opens a host of related issues, from an efficiency and risk standpoint. Widening central bank account holders beyond banks to private financial institutions raises questions of central bank exposure to a greatly enlarged safety net and of enlarging central bank facilities providing liquidity to the market.¹⁴⁶ Limiting central bank exposure to the market through real-time gross settlement or other procedures (see below) and netting outside the central bank makes opening central bank accounts to institutions other than banks more feasible. This may well be desirable from a market development standpoint.

While holding deposit accounts with the central bank need not necessarily mean that these institutions should have access to the central bank lending facilities available to banking institutions, excluding institutions that conduct similar business from such access raises questions of equitable treatment and fair competition. Institutions excluded from the central depository would settle their transactions at the subdepository level. Exclusion may or may not have adverse implications for market development. Some markets, notably in the United States, have thrived despite the exclusion of nonbank financial institutions from accounts at Federal Reserve Banks. One reason for widespread bank participation in the securities markets in the United States was, for years, a large, implicit intraday overdraft allowed on banks’ deposits with Federal Reserve Banks. The overdraft facility enabled a bank to authorize deductions from its Federal Reserve account before expected receipts were transferred to the account. The bank, in turn, had lower administrative costs and could offer its customers money transfer facilities at reasonable prices. The Federal Reserve recognized this exposure as unwarranted and has since greatly restricted it, but U.S. banks have continued to offer competitive payment services to clients.

In addition to private financial institution participants in the central depository, there are other potential participants in the central depository. First is the central bank itself, which will normally trade in government securities as part of its monetary policy functions. The Treasury may be an additional likely candidate, to the extent that it may engage in trading activity. It may also be appropriate to open Treasury accounts to handle the issue and redemption of securities. Some subnational government agencies might also be considered, if they issue securities or are significant holders of government securities and are entitled to hold deposit accounts with the central bank, (See Chapter 11, Development of Subnational Bond Markets.) International depositories are another category of potential participants.

Policymakers will need to set explicit and transparent rules for membership in the central depository and establish clear criteria and procedures for application and decision. All decisions concerning membership should be published immediately, and a public register of members of the central depository should be available. A standard regulatory measure to limit settlement risks in the central depository is an on-going screening of the creditworthiness of participants. Restrictions based on prudential grounds are always difficult to formulate. Obviously, any financial institution not subject to an effective (rather than simply formal) control by some supervisory authority should not be admitted to the central depository. Effective compliance with capital adequacy rules should be required, as well as with other objective and transparent criteria formulated in each particular context. Who sets the rules and who takes the decisions regarding membership in the central depository (the government, the minister of finance, the central bank, or the central depository) depends on many local factors, and it would not be meaningful to generalize.

8.3.3.2 Subdepositories

Setting up an efficient and reliable system of subdepositories has proved to be, in many countries, a more difficult task than introducing a central depository. The presence of subdepositories has strong implications for market development, as the government’s capacity to place securities with any investor lacking access to the central depository will otherwise be limited.¹⁴⁷

The authorization of subdepositories should be subject to formal conditions stricter than those for selecting other members of the central depository, since subdepositories can introduce new risks, including fraud.¹⁴⁸Complex technical interactions with the central depository will be required to ensure the integrity and coherence of the whole depository system, based on the matching of clients’ accounts with the subdepository and the subdepositories’ nominee accounts with the central depository. Authorities in some countries starting a new depository system have preferred a relatively regulated approach to subdepository activity, contrary to the rather loose rules prevailing in other countries. This allows scope for subsequent relaxation of the system, as the depository gains experience and expertise.

Dealing with a limited number of subdepositories simplifies the administrative and regulatory tasks of the central depository. Opting for too small a number of subdepositories, however, can lead to complaints of unequal treatment, and may run contrary to the development of a competitive market for government securities.

Where the number of subdepository accounts is limited, those excluded may have to avail themselves of depository account facilities through other institutions that provide that service. The larger commercial banks often manage such subsidiary accounts for smaller institutions.

Basic rules and regulations should be set on the status of securities accounts held with a subdepository to ensure segregation from the subdepository’s own accounts, to establish the status of accounts in case of subdepository bankruptcy, and to fix the status and responsibilities of sub-depositories as account holders with the central depository. Regulations for subdepositories should also include principles of good practice, freedom to transfer securities from one subdepository to a different one in order to encourage competition, operating relations with the central depository, firewalls that separate a bank’s subdepository business from its other activities, and statistical reporting requirements. The regulations should envisage sanctions for noncompliance. These should include, for extreme cases, the cancellation of the privilege to offer sub-depository services.

Similar to other financial activities, the provision of subdepository services and the attendant settlement obligations should be subject to supervision. The responsible authority may be closely linked to the authority responsible for overall market supervision, though it may be argued that the tasks are far from comparable. In any case, supervision should include reporting requirements and on-site inspections,¹⁴⁹ as well as an easily accessible service to which customers may address complaints.

Policymakers will find little scope to plan for gradual implementation of a subdepository system. Regulations, both on substantive and procedural matters, should be in place, even if the subdepository system is small. It is unlikely that satisfactory regulation will be reached from the start, and experience with the system will be extremely valuable in improving the initial rules. Special efforts should be made to achieve a careful and detailed drafting of regulations to facilitate development by the institutions concerned of the software necessary to run their subdepository business. Changing the rules may imply a need to change the software, which, in addition to being costly, will be a source of delay. In countries where candidates for providing subdepository services may lack the minimum technical standards and skills required to coordinate with the central depository, it might be necessary to implement a subdepository system gradually and introduce such a system selectively. For example, involving only headquarters offices in the financial center might be a viable interim solution for some countries.

Some alternative mechanisms are no direct substitutes for subdepositories, but may contribute to reducing the need for them. One is, of course, a more comprehensive central depository. This can be the most economic and practical approach in countries where the frequency of transactions, the number of securities account holders, and the number and variety of securities issued are not yet large. In addition, the Treasury or central bank in some countries has offered limited subdepository facilities to nonfinancial investors.¹⁵⁰ Almost invariably, these services have been set up as mechanisms to facilitate the participation of small investors in the government securities market. In some cases, these facilities offer only the possibility of buying newly issued securities, to be kept until redemption or to be transferred elsewhere for sale. In others, the agency involved may also be selling and repurchasing outstanding securities. Such arrangements normally face the constraint that the number of physical outlets the Treasury and central bank are able to provide may be limited.

Mutual (open-end) investment funds specializing in government securities or just holding a significant volume of government securities in their portfolio provide a useful alternative to retail investment and trading in government securities (and, in the process, an enhanced scope for the wholesale market). They also offer an alternative to the custody and settlement problems at the subdepository level, assuming, of course, that they hold their portfolio with the central depository and rely on its settlement facilities.

8.3.3.3 Integration in Depository System of Nonresident Participants

Countries allowing nonresidents to invest in domestic government securities have to provide the means to integrate nonresidents in their depository system and to give them access, to the extent possible, to the same settlement facilities as domestic investors. There are only rare and atypical precedents of a country allowing direct holdings of final nonresident investors with the central depository.¹⁵¹ Most nonresident participants in government securities markets rely on some intermediate subdepository.

Domestic subdepositories should be allowed, in any case, to hold securities accounts belonging to nonresidents. Local branches of well-established foreign financial institutions may be in a particularly favorable situation to offer such a service.¹⁵² For such an arrangement to be successful, however, excellent trading and settlement facilities should be in place. It is, thus, unlikely that this will be a promising arrangement in emerging markets. Domestic subdepositories do not normally provide services to all final nonresident investors, but rather to a limited set of well-known international dealers in government securities (including the parent house of local branches of such institutions). These international dealers have accounts for final foreign investors and thus act as an ad hoc third layer of the depository system.

More direct involvement of the central depository with nonresident investors may also be considered. A convenient solution would be to allow well-established international depositories like EUROCLEAR or Clearstream (formerly CEDEL) to become participants in the central depository. These agencies would thus reach a status similar to that of domestic subdepositories, except that the rules under which they would operate would be special bilaterally agreed rules.¹⁵³ As an alternative, some international dealers in government securities might be accepted as ad hoc subdepositories linked to the central depository. For obvious reasons, only a select set of well-known institutions should be granted this right.¹⁵⁴In either case, the issue of allowing these institutions to hold deposit accounts with the central bank for settlement purposes would need to be addressed.

8.3.3.4 Fees of Depositories and Subdepositories

Policymakers may need to set parameters for central depository fees. Ideally, a central depository should be a nonprofit venture, though, to the extent possible, the costs of maintaining it should be identified and recovered through fees, either on transactions or a periodic fee.

Fees on transactions should be low per transaction, irrespective of volume. This approach, typical of modern payment systems, departs from the historical tradition, still ingrained in many countries, of fees proportional to the size of transactions. Fees on transactions have to be paid, inevitably, by the trading parties. As most transactions involve two parties (one paying, the other delivering securities), the fee should be split between them. This refers to secondary market transactions (including those in which the central bank is a party), since transactions linked to the primary market are usually free for investors, though not necessarily for the Treasury. It has become a general practice to charge the fee only once for transactions involving two successive opposite flows, such as in repurchase agreements and securities loans.

Periodic fees could conceivably be applied to the number of accounts maintained, though it is usual to base them on the volume of securities. In the latter case, the fee may be charged to the holders of the securities, to the issuer of the securities (the Treasury), or both. The frequent combination of fees on transactions and fees on holdings is justified, since the former reflect variable costs and the latter fixed costs.

In any case, it is essential that fees for use of the central depository and its settlement services should be kept low so that they do not have a significant impact on the yield for the securities transacted. This is consistent with cost recovery if the number of transactions or the volume of securities is large. Many emerging markets may not meet this condition. Consequently, the Treasury or the central bank may have to incur costs that significantly exceed the price for the services provided to them by the depository. The implicit subsidy by the Treasury or the central bank to other beneficiaries of the depository services would most likely be transitory, and can be justified as a way to develop the market for government securities.

Policymakers should leave subdepositories free to determine their fees or price differentials in response to market forces. Markets with low activity levels, however, do not favor price transparency, and limited competition may be prevalent in highly concentrated banking systems. The best medium-term solution in this case may be the adoption of general policies to enhance competition and price transparency. Subdepositories should, in any case, be required to be explicit and transparent toward their customers concerning prices and fees. Any temptation by the government to regulate the pricing of securities traded through subdepositories should be resisted as contrary to market-oriented financial policy.

8.4.1.1 Settlement Orders and Matching

Secondary market transactions to be settled by the central depository will be unknown to the central depository until the trading partners deliver the settlement orders to the central depository for processing. Since there are always two parties to every transaction, the standard procedure is that each party issues a settlement order, one corresponding to the payment of cash, the other to the delivery of the securities. The central depository matches them before proceeding to later settlement stages.

Matching transactions before proceeding to final settlement, real-time or at the end of the day depending on the system, is a standard requirement in an efficient settlement system. Matching validates the authenticity of settlement orders, detects errors, determines the point when settlement orders must become irrevocable, provides trading partners with additional proof of the contractual agreement they have entered, and, most importantly is an absolute requirement for controlling implementation of the DVP principle and for keeping track of pending settlement claims. These features are relevant for any transactions to be settled, but they become particularly important when settlement flows on future dates are involved.¹⁵⁶

To facilitate matching, settlement orders must be complementary, highly standardized, and as simple as possible. Both orders should contain the same basic elements identifying the transaction, though one will be an order for a cash payment and the other an order for the delivery of securities. Data included should only be limited to full identification of the transaction to be settled, using predefined codes for most items to facilitate automated processing. In cases involving future reverse flows (notably repurchase agreements, but also other securities lending or transitory transfers without payment), the initial settlement order should include all the necessary data for settlement of the reverse flow. It should be considered as a standing and irrevocable order issued in advance to carry out the transaction.¹⁵⁷ As a by-product, a well-designed settlement order would contain all the necessary data to produce relevant statistics on trading.

For central depositories associated with the central bank, the collection of settlement orders will normally be based on whatever general communications facilities and procedures are already available for other large-value payments facilities (central bank transactions, interbank unsecured loans, interbranch transfers, or other general interbank payments). The facilities need not be particularly sophisticated. Online electronic communications may be highly desirable, but it must be stressed that quite efficient settlement systems have been based on rather rudimentary communications facilities. Even the physical delivery of paper orders could suffice at an early stage, though normally telephone, telex, fax, or Internet could be used, as has been the case in the past in most countries that now rely on more advanced technology. Appropriate security procedures (validation rules, encryption, and authentication of messages) should be introduced. Matching itself provides a security check. Since orders will always be for transfers among a limited set of known participants, the affected party should be able to detect unilateral fraud. Protecting the secrecy of the parties involved in individual transactions may be a more important issue in countries with a record of administrative corruption.

Settlement orders should reach the central depository as soon as possible after trade execution, to speed up further processing. This need is more obvious in real-time settlement systems, but is also important for those relying on settlement at some end-of-day point to allow for same-day settlement and avoid any workload accumulation at the close of business. Poor back-office arrangements of trading parties are the usual cause of delay.

The working hours of the central depository must be tailored to the pattern of prevailing banking hours. Settlement hours set limits to normal trading hours for same-day settlement. Too short a time schedule for settlement may unjustifiably constrain the hours available for such trading. The strong interaction between the market for government securities, the interbank money market, the foreign exchange market, and the intervention operations of the central bank call for coordination of the trading and settlement schedules in each market. Settlement facilities should be available for necessary late-hour adjustment.

In order to simplify the workload, some central depositories require a minimum size for settlement orders to be processed through the normal communications channels. Small transactions do not play a significant role in the market, and flat settlement fees per transaction discourage the possibility of breaking a single underlying transaction into various settlement orders.

The matching of received settlement orders by the central depository should be recorded on a computer to expedite matters and eliminate further sources of error. Suitable backup facilities should always be in place. Matching should take place on an on-going basis, immediately following the receipt of settlement orders. A record should be kept of the exact time at which each pair of settlement orders is matched. The trading parties should also be informed, as soon as possible, of successfully matched transactions.¹⁵⁸ Some end-of-day batch communication should in any case be envisaged for transactions due for settlement on future dates. Matched settlement orders should be integrated in a database (including separate records for the second leg of repurchase transactions and similar two-sided transactions) of transactions pending settlement, which will be the basis on which settlement decisions will rest. A procedure is needed to cancel unmatched orders and to inform as soon as possible the involved parties so that they may submit revised orders. Only fully matched orders would go for further processing by the central depository. With a proper matching procedure in place, transactions could be handled on a DVP basis.

8.4.1.2 Net Versus Gross Settlement

Most payment systems with a predefined set of participants, including those involving securities settlement, have traditionally operated on a multilateral net basis. On this basis, payment obligations are accumulated over some period (normally one day), and at some point (normally the end of the day), the net balance of payments to be made or received by each participant against the whole set of other participants is calculated. These net balances, adding by definition to zero for the whole system, are actually paid to/by the agent in charge of running the system. Payments are, therefore, pending until they reach what is known as “finality,” namely, the legal assurance that the payment obligations/rights have been legally satisfied. For ease of reference, such systems will be referred to as multilateral net settlement (MNS).

As participants usually have both in- and out-payments, netting reduces the amounts finally due for settlement and allows participants to operate with comparatively small balances (both money and securities) in a securities settlement system. MNS, however, raises some difficult issues, since at the end of the day some participant may not have the necessary cash or securities balances to satisfy obligations. All MNSs envisage the possibility that, in such case, all or part of the transactions involving such a participant will be excluded from settlement, and a new set of multilateral net balances will be calculated. After excluding some participant, however, it is likely that other participants will suffer the effects of not being credited the payments due to them by the initial defaulting participant and will also fall into default, thus requiring further rounds of readjustment. More importantly, when default is partial, only some transactions of the defaulting participant need to be excluded. Which ones are excluded and which ones are settled may be hotly debated by the affected parties. If the defaulting party is an institution that is on the verge of bankruptcy, the implications of such discretionary decisions may become very unpleasant. Therefore, unwinding of trades due for settlement takes place, in fact, very rarely in MNS. Several alternative solutions, based on covering imbalances through lending, are normally followed.

Because of MNSs’ potential problems, a consensus has emerged in recent years favoring a different approach to settlement. This is the so-called real-time gross settlement system (RTGS). This approach is based on very good, online communications. Under it, transactions are settled bilaterally, on an on-going basis and as soon as possible. Transactions that cannot be settled for lack of funds or securities are queued, to be settled as soon as this deficiency is resolved. After some pre-established time without execution, transactions may under some systems be canceled. In case of several pending transactions, priority rules (established in advance by the parties or the system) may be applicable. Participants are kept continuously informed of their settled and pending claims.

Intermediate solutions exist as well. MNS systems may operate with more than one daily settlement cycle. A frequent formula—used by some countries in their transition to an RTGS system—involves just two cycles: one at the end of the day, and one at the opening of business, the latter for settlement of orders introduced at earlier dates for value this date.

8.4.1.3 Risk Management Provisions of Settlement

Given the potential systemic risks involved in the settlement process, policymakers should be especially attentive to various sorts of risks that require minimization. Careful screening of participants in the settlement facilities should be a major consideration in the initial selection of members of the central depository. Supervisory authorities should monitor settlement performance and be ready to exclude any institution failing to maintain a satisfactory record. Risk avoidance would also include application of the DVP principle, an active money market including, for the settlement of government securities, a market for very short-term repurchase agreements (see Chapter 2, Money Markets and Monetary Policy Operations), and allowance of a short time (normally not more than half an hour) between provisional closure of the netting procedures and final closure of the settlement cycle. Participants with deficient balances are individually informed and requested to go to the market and try to close some special transaction with other market participants to cover the cash or securities balance shortfall. Risk avoidance may also include reserve requirements allowing averaging of daily balances, thereby allowing banks to temporarily draw on these reserve balances for settlement if needed.

Most MNS arrangements rely, one way or another, on some end-of-day, last resort cash-lending facility by the central bank. It may be discretionary or automatic, with the latter possibly subject to limits. Usually, central bank lending for this purpose is based on overnight, secured loans (mainly repurchase agreements), for which a penalty rate is charged and which may incorporate other restrictive conditions to discourage frequent use.¹⁵⁹ The purpose of a cash-lending facility by the central bank is to avoid the need for unwinding transactions due for settlement, while strongly encouraging participants to use alternative means, including the recourse to other participants through money market transactions, in order to avoid or deal with settlement difficulties.

The central bank can create unlimited amounts of cash by granting credit, but the central depository cannot create securities.¹⁶⁰ A standard method is to create a voluntary pool of securities, contributed by participants, but also sometimes the central bank, which can be lent automatically (normally through overnight repurchase agreements for which a penalty rate is charged) to any party that has not otherwise been able to obtain them.

Special risk management considerations are also involved in an MNS system allowing for more than one settlement cycle. Taking as a reference systems that allow for one additional settlement event at the opening of business, the possibility that some member may not be able to meet its obligations at this point must be faced. Contrary to arrangements for end-of-day settlement, in this case the usual procedure is to resort to gross bilateral settlement. Settlement of transactions for which there is a lack of securities is postponed to the end-of-day cycle. To settle transactions for which there is a lack of money, the seller receives payment based on central bank intraday credit to the purchaser, the central bank retaining a pledge on the securities as collateral, or, alternatively, the operation can be done through the use of repos. This combination of very transitory unwinding of some transactions and settlement of others based on collateralized intraday credit is usually a smooth operation, and it may provide, in some countries, early finality to a large volume of transactions.¹⁶¹

As regards RTGS, many of the above risk management considerations for MNS systems may also be applicable. However, the main problem is to minimize the need for excessive balances of settlement means. This is usually done through intraday credit provided by the central bank. This raises, in turn, complex technical and policy issues that are too complex to be covered here.¹⁶²

The choice between MNS or RTGS systems must consider market demand, technical requirements, and relevant risk management provisions. Market demand for RTGS in securities markets has been associated with highly developed financial markets, such as the special needs of monetary and financial integration in the EU. Technical and cost considerations do not favor RTGS systems for emerging markets, and the same applies to their risk management requirements. Despite the superiority of the RTGS system, most emerging-market countries are not in a position to implement RTGS. For these countries, the MNS system seems likely to remain the best choice in most instances, with the possibility of expanding it later with some additional daily settlement cycle.¹⁶³

8.4.1.4 Linking Delivery of Securities with Payment

Processing settlement orders with DVP implies (irrespective of the MNS or RTGS character of the settlement system) checking the availability of securities in the central depository and the availability of funds, wherever they may be maintained, to ensure that matching changes in the funds and securities take place nearly simultaneously. The standard approach (ignoring for simplicity any settlement difficulty) consists in executing first the transfer of securities on a provisional basis, then the transfer of money, and finally lifting of the transitional condition to the transfer of securities. This may involve simple or complex procedures, depending on the depository arrangements.

For a central depository run by the central bank, the linking of delivery of securities with payment is an internal affair, and there may be no significant difference between running an MNS or an RTGS system. In fact, an MNS system may in practice be managed like an RTGS system if transactions are immediately entered in the corresponding accounts, on the assumption that only rarely will there be a need to undo them at the end of the day. This would be a different matter from considering them final from a legal perspective.¹⁶⁴ This approach may facilitate the monitoring of settlement developments, and be helpful in avoiding the risk of misjudging developments in securities settlement that may result from considering it isolated from other segments of the payment system.

For a separate depository, this may instead be a complex issue. With ideal online computer links between the central depository and the central bank and maximum compatibility of computer systems, the procedures might be equivalent to any system fully managed by the central bank. Without a good communication system, an external depository might have difficulties in running an RTGS system.¹⁶⁵ Difficulties should be smaller, however, for an MNS system, since such a system might require linking with the central bank only at the end of the day.

8.4.1.5 Settlement of Primary Market Transactions

Settlement of transactions associated with the primary market is a comparatively simple task. The first round of any such transactions must take place in the central depository, where the total outstanding amount of any security must appear, either under the own or correspondent accounts of direct members or of subdepositories.

Redemption of securities is equally straightforward. Without any need for intervention of the involved account holders, the Treasury should issue an order, for value on the redemption date, to cancel the outstanding securities and to pay the corresponding amount (including, in many cases, implicit interest) into the deposit accounts of the securities accounts holders. The central depository knows the cash amounts to pay to the direct members and the global amounts of securities to take out of their own or correspondent securities accounts. Subdepositories would, in turn, make the detailed allocation of redemptions to their own clients, following a similar procedure. Interest payments would imply a similar, but even simpler, procedure, since only cash payments would be involved.

Settlement of newly issued securities should also be a simple matter, if placement procedures are adjusted to facilitate settlement. For auction and syndicated placements in which the participants are institutions holding securities accounts with the central depository and acting either on their own account or on account of a third party, the solution should be simple. The Treasury would deliver the securities to the central depository and would simultaneously issue a debit payment order to obtain the counterpart funds. The Treasury could do this for the whole amount to be issued, leaving to the central depository any allocation of securities and funds to the involved agents, or could itself make this allocation (usually involving only a limited number of institutions). Securities might be fully allocated to the own accounts of subdepositories, leaving to them the task of transferring the necessary amounts to their correspondent accounts.

Since DVP should prevail, if funds are not available the standard procedure is to postpone the issue of the corresponding securities and settle the disbursement at the next feasible opportunity. Cancellation of such claims (as happens in some countries) should never be envisaged. Most countries have complementary measures (managed by the Treasury rather than the central depository) to penalize, economically or otherwise, such disbursement failures.