Current Legal Issues Affecting Central Banks, Volume IV.

26A. Delivery Against Payment

Robert Effros
Published Date:
April 1997
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If a person is going to give up something of value, what is to ensure that something of value will be received in return? This exchange occurs familiarly in trade transactions. A person giving up goods for money wants to make sure that the money will be received. A letter of credit, with documents attached, can be used to accomplish the transaction. In the past, the seller1 in a securities transaction would give the securities with a demand draft attached to a messenger. The messenger would walk to the buyer’s firm and present the demand draft with the attached securities for payment. The buyer would try to ascertain whether the securities were genuine; if they were, the buyer paid with a certified check (a check that had been stamped as certified by a bank, resulting in the debiting of the buyer’s account by the bank). Consequently, the seller had the bank’s obligation, not the buyer’s. If the buyer could not pay for the securities, the messenger would return with them. In those transactions, therefore, there would only be delivery against payment (that is, the certified check).

Frequently, when the buyer would go to the bank and ask for the check to be certified, there would be insufficient funds in the buyer’s account. The bank would make a day loan to the buyer. The interest rate paid on the day loan was really more in the nature of a transaction fee, because the bank felt that the loan backed by the securities had a fairly low risk and was confident that it would be paid off later in the day. The transaction was booked as a loan and not handled as an overdraft in the account because an archaic U.S. law made it a crime for a bank to certify a check when there were insufficient funds in the customer’s account. With the overdraft programs that exist today, however, the situation is quite different.

This procedure worked fairly well until the securities market in the United States took off in the 1960s. The back rooms of the securities firms were unable to process the securities transactions in a timely fashion. This inability created “fails,” that is, failures to deliver and failures to receive. It also created risk. If customers of a buyer’s firm paid their funds to the buyer but the securities were not delivered to the buyer and the buyer went bankrupt, the customers became unsecured creditors of a failed securities firm. The customers had made their payments but did not have delivery against payment. In the 1960s, a number of small firms that were unable or unwilling to make the investments in their backroom systems needed to keep current with the times did fail, and others were merged out of existence.

This process is analogous to what is occurring today. The concern now, however, is not with the backroom processing of trades; it is with risk management. Today, the issue is derivatives. Are funds being put into systems that manage risk? Those firms that do not invest in risk-management controls will go the same way as those firms that did not invest in their back rooms in the 1960s.

The problem that arose in the 1960s was addressed by changing from the old system of delivery against payment via messengers to delivery versus payment (DVP) systems. Also, the concepts of immobilized security (the security does not move; it stays in one place) and true book-entry security (the uncertificated security) were introduced. In the United States, a large number of people invest in mutual funds, which, in turn, invest in stocks and bonds. In contrast, people in the 1960s more often invested directly in stocks. Investors in mutual funds send their payments to those funds and receive in return advices in the mail. They do not get share certificates representing units in the mutual funds. (A number of these mutual funds are corporations.) The fact that there are no pieces of paper that investors can redeem by having the mutual funds, in effect, buy back their shares does not bother investors. Therefore, the question of whether individuals will be willing to forgo a physical piece of paper is answered by the broad acceptance today of this form of book-entry interest. This acceptance should help the transition to a full book-entry system.

Types of Delivery Against Payment

There are different types of DVP systems. A report on DVP in securities settlement systems prepared by the Committee on Payment and Settlement Systems of the Central Banks of the Group of Ten Countries concluded that the securities transfer systems in use or under development in the Group of Ten countries could be classified as follows:

Model 1:systems that settle transfer instructions for both securities and funds on a trade-by-trade (gross) basis, with final (unconditional) transfer of securities from the seller to the buyer (delivery) occurring at the same time as final transfer of funds from the buyer to the seller (payment);
Model 2:systems that settle securities transfer instructions on a gross basis with final transfer of securities from the seller to the buyer (delivery) occurring throughout the processing cycle, but settle funds transfer instructions on a net basis, with final transfer of funds from the buyer to the seller (payment) occurring at the end of the processing cycle;
Model 3:systems that settle transfer instructions for both securities and funds on a net basis, with final transfers of both securities and funds occurring at the end of the processing cycle.2

However, I would like to suggest a more colloquial classification of DVP systems based on systems that are actually in use.

First DVP System: Dummy Entry System

The first system in my classification is the eo instanti or dummy entry system. In this system, messages requesting the transfer of securities against payment go back and forth over the telecommunications system between all the participants during the day. The central facility is a computer that holds the securities in the funds accounts of the parties. The entries during the day are not real entries representing debits and credits to accounts. Although the entries may result at the end of the processing cycle in debits and credits to accounts, rights and obligations do not change hands between those parties during the day as the messages go back and forth. In the United States, the system of The Depository Trust Company handles the bulk of the equity securities transfers in this way. In Europe, sellers of Eurobonds may use Euroclear to transfer the securities to the buyer; although the Euroclear computer appears to be debiting and crediting, the actual debiting and crediting of accounts happens only after Euroclear closes for the day. A fail in these systems (which can occur if someone is unable to transfer securities or if there are insufficient funds) does not constitute a revocation of the transfer. There is thus no concern about parties having rights that may need to be revoked.

A dummy entry system can, however, have other features built into it. Such a system can decide if the seller is short (that is, does not have) the security. It may arrange to have the security lent to the seller, so that the seller will be able to transfer the security upon final settlement. Similarly, if its calculations suggest that the buyer will not have sufficient funds, the system can arrange a loan for the buyer, perhaps secured by the security to be delivered. Again, however, rights and duties are recorded only after the close of the cycle.

Second DVP System

Operationally, the second DVP system looks almost the same as the first. The seller sends the security against payment across the system. The seller’s securities account is debited; the seller’s funds account is credited. There is a question, however, of whether the buyer’s funds account is debited. An intermediary (typically, a trust company in the United States, although it could also be an ordinary corporation) may hold the securities and funds accounts. However, in this second system (in contrast to the first system described above), the funds credits and securities debits to the seller, or transferor, are real credits and debits. The transferor no longer legally has the security, as of the moment that the security is sent against payment across the system. These debits and credits go back and forth in the system during the day. There may be a net settlement at the end of the cycle, which implies that the system is constantly netting the positions in funds and securities accounts. At the end of the day, parties come up as net debtors or net creditors.

These two DVP systems are closed with respect to securities. In other words, securities overdrafts should not occur. Securities should be immobilized, and book-entry security should be in place. The only overdrafts that ought to occur are in respect of funds. However, when both of these systems settle, some parties are net debtors, and some are net creditors. In these systems, how are payments made by net debtors to net creditors? In the United States, these payments are typically made through Fedwire transfers by the net debtors to the system’s account at the Federal Reserve Bank of New York. Payments are then made back out to the net creditors. One concern in this respect is that making settlement payments through a system that is itself a net settlement system could pose too much of a systemic risk. Should a system, such as the same-day settlement system of The Depository Trust Company or the Participants Trust Company system, be allowed to settle by having the funds transferred through a settlement system that is provisional? The simplistic answer is no, of course not; there are just too much provisionality and too much risk in these systems. Of course, the matter is not that simple.

The Federal Reserve has some concerns about this second type of DVP system that are similar to the concerns that it expressed about the Clearing House Interbank Payments System (CHIPS). Arguably, the system must have arrangements in place to ensure settlement at the end of the day, in order to limit the systemic risk. If a large seller of securities (and a large net creditor) is told at 6 p.m. U.S. eastern standard time that the system is not working well, its counterparty has collapsed, and it will not get its $1 billion, what will the seller do? Does the seller have an interest in the securities? Can the seller pledge the securities? Can the seller raise $1 billion? If the seller is going to be $1 billion short someplace, will that start the falling domino effect that can give rise to systemic risk? It is thus the inability of participants to get liquidity in the market late in the day that generates the greatest concern.

Consequently, the Federal Reserve insists that these systems have their own liquidity facilities. Sometimes the securities cannot be delivered because a party cannot pay. This outcome does not always result from a major failure; it may merely be a mistake—for example, if a party cannot get its funds in on time or the transfer is sent to the wrong place. A system like that of the Participants Trust Company has the capability of taking the securities that it cannot deliver, pledging them overnight to a bank, and obtaining the necessary funds to allow settlement. If a participant were to fail, arrangements would be made the next day to unwind or liquidate the securities or otherwise deal with the problem.

The Federal Reserve insists on the establishment of liquidity facilities partly because the world does not stop turning. If problems in the United States cannot be cured by nightfall, the situation could start to affect the markets in the Far East, as the same group of parties deal and settle with each other all over the world. The cost to these systems is that of setting up the necessary controls and financing arrangements to ensure settlement.

Third DVP System: Central Gilts Office Net Settlement System

The third type of DVP system is the net settlement system of the Central Gilts Office in the United Kingdom. This system seems to be based on the assumption that U.K. clearing banks never fail. The seller delivers the securities to the buyer, but the funds for every delivery are really owed by the buyer’s bank. The buyer’s bank takes a security interest in the securities, just as if the securities were delivered to the buyer’s bank and held there in safekeeping during the day as collateral for the loan. There is an assured means of settlement in this system because the bank will always settle. When the buyer pays the bank by the end of the day, the bank gives up the interest in the securities.

Fedwire: A Real-Time Gross Settlement System

In the United States, the real-time gross settlement system is also used as a DVP system. Fedwire provides for securities against payment for federal government securities issued by the Treasury Department, as well as for Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association securities. Today, the Federal Reserve has as customers only depository institutions, the Federal Government, international organizations, and foreign central banks and governments, but perhaps someday securities dealers will be added. In a transaction, the Federal Reserve Bank of New York, following the seller’s instructions, debits its book-entry securities account and credits its funds account. The reverse is done to the buyer’s accounts: a debit is made to the buyer’s funds account and a credit is made to the securities account. These entries typically take about one second to accomplish.

As many as $500 billion transfers are recorded each day on the books of the Federal Reserve Bank of New York. The U.S. government securities market is the largest securities market in the world, dwarfing the New York Stock Exchange in terms of volume of financing activity. The debits and credits that are made by Fedwire transactions are final. Accordingly, the transfer is not revoked if the right security is sent to the wrong bank or the wrong security sent to the right bank, resulting in the return of the security. Corrections are made by separate transfers.

Much credit is extended through daylight overdrafts in the working of the real-time gross settlement system. The Federal Reserve Bank does not insist that the buyer have funds in its account before the Reserve Bank delivers the security. Therefore, it is not uncommon for banks, especially the larger clearing banks, to have overdrafts with the Federal Reserve of $1 billion–$12 billion during the day. The banks’ positions are supposed to be adjusted to zero by the end of the day because the system is intended to afford a daylight overdraft facility. Typically, peaks in buyers’ overdrafts during the day will be reduced as the securities are retransferred to other buyers.

Originally, the Federal Reserve Bank did not have a daylight overdraft program. However, the Bank of New York, one of the largest clearing banks, had a software problem one day. Participants could send securities to the Bank of New York, but it could not send the securities out. When the system was shut down that night, the Bank of New York owed $23.4 million to the Federal Reserve Bank of New York. A security agreement was prepared, in which the Bank of New York repledged those securities, plus the rest of its domestic bank assets (everything that the bank owned in the United States), to the Federal Reserve Bank of New York. The Bank of New York repaid the Federal Reserve Bank of New York the loan the next day with interest.

This incident provided an impetus to the development of the daylight overdraft program. Changing its ways of operation, the Federal Reserve Bank of New York has entered into security agreements with the major clearing banks that typically occasion large daylight overdrafts. In accordance with such agreements, the Federal Reserve Bank of New York takes a security interest when government securities are delivered against an inadequate balance. If the financial condition of the bank involved is sufficiently weak to arouse the concern of the Federal Reserve Bank of New York, it may reject a transaction that would otherwise give rise to a daylight overdraft, and there will be no delivery. However, this happens only very rarely.

Other DVP Systems: Trade Confirmation and Trade Netting Systems

Two other DVP systems are also noteworthy. The first is the trade confirmation system. One way of ensuring that the right security is delivered to the right party in a DVP is for the buyer and the seller each to send confirmations to a central computer that will match the terms and the securities. The parties will then know they have dealt with the right security. This system helps eliminate the number of “don’t know” transactions, in which the wrong security is delivered to the right person or the right security to the wrong person.

The second system, which can be a part of the trade matching system, is the trade netting system. This system can accommodate a market such as the government mortgage-backed security market, in which all trades in one security over a number of days may settle on the same forward date. If the bank keeps only the gross number of trades, it will look as if it has a huge exposure in its books; however, if the bank can set up a system in which those trades are netted with its counterparties, its exposure will to be reduced to the net amount.

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