A modern, efficient securities settlement system is a principal component of the infrastructure necessary for development of securities markets in general and the government securities market in particular. The settlement system (including depository facilities) affects the degree of confidence investors have in the market infrastructure, determines whether trading in the primary and secondary markets flows smoothly, and influences the capacity a market has to expand. The condition of the securities settlement and depository arrangements is a major direct determinant of systemic risk. The structure of the settlement system will vary with country circumstances. In developing markets for government securities, authorities should place a high priority on establishing a securities settlement infrastructure suited to country and market circumstances.

A modern, efficient securities settlement system is a principal component of the infrastructure necessary for development of securities markets in general and the government securities market in particular. The settlement system (including depository facilities) affects the degree of confidence investors have in the market infrastructure, determines whether trading in the primary and secondary markets flows smoothly, and influences the capacity a market has to expand. The condition of the securities settlement and depository arrangements is a major direct determinant of systemic risk. The structure of the settlement system will vary with country circumstances. In developing markets for government securities, authorities should place a high priority on establishing a securities settlement infrastructure suited to country and market circumstances.

8.1 Introduction

Adequate depository and settlement procedures for cash and securities are basic policy initiatives supporting government securities market development. A well-functioning securities settlement infrastructure will include automated (dematerialized) accounts for securities, reliable custody arrangements for the recording of securities ownership, and a settlement system with delivery versus payment allowing for same-day settlement.

Without an adequate securities settlement infrastructure, there can be considerable systemic risks. Failure of one party to a large securities transaction can lead to a series of subsequent failures. International organizations, study groups, and others have directed considerable attention on the potential dangers for financial markets in general of inadequate securities settlement arrangements. Studies by these bodies include recommendations for strengthening and harmonizing settlement arrangements and procedures to minimize risk.123 The International Organization of Securities Commissions (IOSCO) and the Committee on Payment and Settlement Systems (CPSS) have published several studies, including in 1997, Disclosure Framework for Securities Settlement Systems,124 as a tool for risk management, and are currently preparing for comment a set of core principles for securities settlement.

These studies draw heavily on the needs, operational and policy issues, and experiences of highly developed markets in the securities settlement area. While this chapter draws on the experience in more advanced markets, it also focuses on the needs of emerging national markets, noting recent successful and unsuccessful country experiences.

Policymakers will need to address the development of a government securities infrastructure from a variety of perspectives. The economic perspective will be on efficient and low-risk settlement facilities. From a market supervision perspective, the focus will be on information, since any trading development, and notably anomalous ones, will be known by the depository system before any other authority. The market information perspective will be on comprehensive, timely, and reliable information on holders of government securities and on trading developments (volume, participants, conditions,) in OTC markets. The legal perspective will be mainly registration of ownership and changes thereto, while the regulatory perspective will be on the framework for trading in government securities.

Improvements in settlement systems have been based, without exception, on replacing paper certificates with paperless securities, variously known as dematerialized securities, book-entry securities, or securities accounts. The technically more accurate term of securities accounts will be used in this chapter. Securities accounts require an institutional infrastructure to handle their administration, known as the depository system. The main economic function of a depository system is the provision of settlement services. Securities accounts, depository systems, and settlement arrangements are closely intertwined.

The major policy issues involved in developing a government securities settlement system to particular country circumstances concern the central depository, subdepositories, and settlement procedures. Central depository questions include use of automated securities accounts; whether the central depository should be placed in the central bank and, if so, what independence within this structure it should enjoy; and whether membership should be wide or narrow. Subdepository issues include why subdepositories may be necessary, how transactions in subdepositories may be linked to settlement in the central depository, and the need for proper supervision of subdepositories. Settlement procedure questions include what kinds of transactions need to be registered, how to progress toward prompt DVP and allowing same-day settlement, and what other steps must be taken to minimize settlement risk in a range of market environments. Finally, there is a question about using information in depository facilities for price discovery in what may be an otherwise opaque OTC market for securities. Related to all these issues is the use of electronic technology.

It is not possible to give a good answer at once to all these questions. The first step must be central depository accounts, organization, membership, and procedures. If these are in good order, questions about subdepositories can be more easily faced.

8.2 Securities Accounts

8.2.1 Need for Securities Accounts

Authorities worldwide have moved away from securities issued in the form of paper certificates to securities issued as securities accounts, kept with a special depository institutions. Important reasons favoring securities accounts over paper certificates include lower costs, elimination of delays in admission to trading, administrative simplicity, and protection against destruction, loss, theft or forgery. However, the main contribution of securities accounts has been to open the way to affordable and efficient settlement procedures, both in the primary and the secondary markets for government securities.

8.2.2 Legal Features of Securities Accounts

For a settlement system to be effective, a number of legal questions concerning the holding of securities must be answered. Almost every country has long had a set of specific legal rules concerning paper securities, and there are entrenched legal views based on this tradition. The basic elements of such rules and views can be easily transferred to securities accounts, but they are seldom directly applicable. There has usually been an intermediate stage, based on the immobilization of paper certificates in depositories, which started to recognize ownership rights through some equivalent of a security account.

Transfers of ownership started to take place by registration of the ownership of the accounts, skipping any attendant delivery or movement of paper certificates. In some cases, complex identification of the accounts mimicked the numbering of paper certificates. In others, securities accounts implied just a generic entitlement to a fungible amount of securities. As securities started to remain immobilized for their whole life, issuing few certificates for very large amounts started to take place, reaching in extreme cases a jumbo certificate for a whole issue. These systems all worked under legal systems based on the principle that physical possession of paper certificates was a requirement for proof of title and delivery of certificates a proof of changes in ownership. In practice, they functioned because most investors, for convenience reasons, accepted the alternative solution provided by the depositories and because investors’ need for paper certificates, always envisaged as a last resort, was exceptional.

Given the movement away from securities issued in the form of paper certificates to securities accounts, the legal backing for securities accounts should support ownership based on inscription in the appropriate register and changes in ownership or pledges based on the corresponding transfer or blocking entries in the register. The legal backing should also cover electronic payment orders or other binding instructions. The traditional distinction between bearer and registered securities becomes inapplicable to securities accounts, which are registered by definition. At the same time, securities accounts can, if supported by law and administrative provisions, open the way for an alternative distinction between explicit registration of the beneficial owner and registration of a nominee representing the beneficial owner. Although a small set of articles in the appropriate legal code may be the only modification needed to deal with these legal questions, in many countries the paperless system is characterized by a lack of adequate legal coverage for securities accounts. (See Chapter 9, Legal and Regulatory Framework.)

8.2.3 Transition Issues

Beyond legal or administrative difficulties, policymakers may find that the introduction of securities accounts may meet the reluctance of investors accustomed to paper certificates, particularly to bearer certificates. The transition to securities accounts may be facilitated by previous familiarity with the custody of paper securities by banks,125 by a centralized registration of paper securities,126 or by systems in which a significant volume of non-negotiable securities owned by small investors are distributed and managed by banks.127

Authorities in some countries have used a gradual approach to the introduction of securities accounts. Such accounts have been used for some new type of securities (Treasury bills in many countries) or only for newly issued securities, while paper certificates have been retained for others, in some case for only a transition period. Alternatively, securities accounts may be offered on an optional basis, at least temporarily or for certain types of securities, with the expectation that as investors recognize the advantages of securities accounts they will select that option. Another option is to allow the conversion of paper certificates into securities accounts or the reverse.128 Finally, a complementary approach has sometimes been used, where securities accounts are paperless, but paper notification of transactions (the equivalent of bank statements) may be offered or required.129

There are also transitory operational reasons for the concurrent use of paper certificates and securities accounts. Policymakers in countries lacking a valid legal foundation for securities accounts may resort temporarily to some scheme of voluntary immobilization on which to base securities accounts. Modest scale schemes for Treasury bills associated with the interbank money market may be particularly feasible and have proved to be a fitting starting point.130

8.3 Depository System for Securities Accounts

8.3.1 Registration Function of the Depository System

Owing to the inseparable legal and economic functions of the depository system, requests for registration will be, with few exceptions, requests for settlement. To simplify, registration instructions and settlement orders will be treated as equivalent in the discussion that follows.

The main policy issue concerning the registration of transactions is defining the different categories of transactions to be recorded by the system. Government securities can change hands due to many reasons and under various legal forms. Keeping track of all potential transactions in government securities would involve unwarranted costs and would create administrative complexities. All depository systems for government securities have, therefore, opted for a simplified categorization of recorded transactions.

Transactions in the primary market must be separately identified, because they all involve the Treasury as a counterpart. There are three major transactions types: the issue of new securities, by which they are initially registered with the depository system; the redemption of outstanding securities, by which they are removed from the depository system; and explicit interest payments.131

Concerning secondary market transactions, the depository system should be able to register the transfer of securities without payment. Since there is no settlement complication, newly developed depository systems have often started by being able to do little more than register the transfer of securities, while taking time to add or expand the necessary settlement facilities. The transfer of securities without payment takes explicit care of transactions, including donations, inheritance, and execution of collateral, which do not fit easily into any of the general categories enumerated below. The depository system does not take care of a counterpart payment, which must be made through channels external to the regular settlement facilities of the depository system. Additional transfers without payment include transfers for the management of subdepositories’ accounts with the central depository, transfers among subdepositories, and transfers to engage in securities lending. Temporary transfers, to be reversed on a predetermined date and based on a single initial instruction, should also be envisaged.

Blocking securities from trading is another essential feature of a depository system.132 This is essential in order to facilitate the numerous possibilities for using government securities as collateral for other transactions. By immobilizing securities held as collateral under a repurchase agreement, when such blocking is agreed by the trading partners or mandated by the authorities, the depository can help ensure that these will be available should the party that provided the collateral default. The depository system will not keep track of all the reasons for blocking securities, and would normally only distinguish between decisions mandated by judicial or administrative authorities and those authorized by the owner of the securities.133

Spot trading, implying an immediate exchange of securities against a cash payment, is the cornerstone of a depository system. In fact, a depository system capable of settling spot trading would be an almost fully functional final settlement system. (Final settlement may be “real time” or at the end of the day, depending on the settlement system. See below.) The same facility would serve to settle any forward trading (introduced on the settlement due date and unidentified to the depository system as a forward deal), as well as repurchase agreements (introduced as two successive spot deals, and again unidentified to the depository system as a repurchase agreement). This situation has sometimes emerged in depository systems that did not envisage an explicit treatment of forward transactions and repurchase agreements.134

Dealing with forward trading involves registering on any date standing instructions for execution on some specified future date. Trading for same-day settlement should ideally qualify as spot and other trading as forward. In practice, regulations on trading may take a different approach, influenced by historic precedents stemming from longer settlement delays used to define spot trading transactions.135 The same facility can be used to register advance trading in securities due to be issued on a known date (when-issued trading), which may become relevant as the market develops.

Similar to forward trading, special procedures to register repurchase agreements should be an additional essential feature of a well-functioning depository system. This should take notice, as of the time the initial spot transaction is registered, of the standing instructions to carry out, on the agreed date, the reverse forward leg of the transaction. This will be useful to cover the possibility of forward repurchase agreements, agreements in which the two legs are forward transactions, a transaction practice that may become relevant in a developed market for government securities.136

Although securities lending is an important activity in developed markets for government securities where short selling is an essential instrument for dealers in government securities, special procedures to register loans of securities may not be necessary. Repurchase agreements offer an ideal and frequently used channel for collateralized lending of securities, and temporary transfers of securities without payment can be used to this effect.

Swaps of securities may be an occasionally relevant trading technique. This can be recorded by allowing for the possibility of registering simultaneous and opposite transfers of securities.

Futures and options are increasingly common transactions in developed markets. They can take many forms, traded and netted through a special exchange. The central depository will not be involved in such trading until a future involving a security becomes due or an option is exercised. At this point, ordinary spot transactions will take place to cancel the claims stemming from the trading in derivatives. The central depository can also become involved in the recording of securities held as margin collateral and changes thereto.

8.3.2 Organization of the Depository System 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 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 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 Depositories 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. 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. 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. 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 Settlement Procedures

In developed economies, the settlement of transactions in the primary and secondary markets for government securities may be the largest single component of the payment system, and by far more important than nonfinancial payments.

Settlement of transactions in the OTC market for government securities involves balancing efficiency, implying speed of execution, low cost and risk, including credit risk, liquidity risk, operational risk, and systemic risk. Settlement procedures will be identical in both wholesale and retail markets, and usually stricter and more regulated at the central depository level than at the subdepository level. All transactions in securities involving cash payments should in principle follow DVP, implying that delivery of securities must be simultaneous with payment, although this may not be possible at the retail level. Settlement orders must be possible for execution on any desired date, including future dates and on the same day, the latter being especially important for repurchase agreements.155

8.4.1 Settlement in the Central Depository

Transactions to be settled through the central depository include primary market and secondary market transactions. The former includes the first round of transactions associated with an issue, redemption, and financial servicing of government securities. The latter includes transactions of participants in the central depository acting on their own account. 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. 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. 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 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. 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.

8.4.2 Settlement in Subdepositories

Settlement of transactions through subdepositories is far more complex than that for the primary market. Transactions settled through subdepositories may be numerous, with small transactions typical of a true retail market, or may include a large volume of transactions typical of a wholesale market, which for some reason are not settled at the central depository level.166 Two separate settlement processes must be distinguished: direct settlement between the trading partners, and a counterpart settlement at the central depository where the securities accounts are represented through global correspondent accounts.

Transactions between two parties holding securities with the same sub-depository do not imply any change in the subdepository’s accounts with the central depository. Transactions in which one of the parties is a subdepository, acting against its own portfolio, and some customer of the same institution, will require transfer of securities within the subdepository’s account at the central depository, but will have no payment implications for the central depository. Besides secondary market transactions, all transactions resulting from issues and redemptions in the primary market would fall under this category. For each type of security, the subdepository must order a transfer to/from its own portfolio account from/to its correspondent accounts. Since many transactions of opposite sign may be involved, the usual approach is to require subdepositories to report daily to the central depository the net movements for each type of security. There is then a daily reconciliation of correspondent accounts at the central depository and client accounts at subdepositories. For transfers resulting from repurchase agreements, standing instructions for reversal on maturity are normally allowed or required. Since the central depository may have no alternative means to identify erroneous reporting, on-site inspections may be required to ensure adequate compliance.167

Transactions involving two subdepositories, covering both transactions between customers of different subdepositories or between customers of one subdepository and another subdepository acting on its own account, require a movement of securities in the central depository between the accounts of two subdepositories. Such a movement also has a payment counterpart. Since many underlying transactions may be involved, but only global net amounts are relevant for the central depository, subdepositories may be encouraged or required to lump transactions together, even to net them bilaterally, to bring only the net cash and securities balances to the central depository. This may require time, and subdepositories may be in a difficult position to offer same-day settlement to their customers. A procedure may be allowed to register exceptional transactions individually, on the same ongoing basis applied to wholesale market transactions.168

In the first stage of settlement, directly between subdepositories and customers, general good-practice regulations may be the rule. Same-day settlement in secondary market transactions may be difficult as a rule, but some maximum settlement delay should be established.169 For primary market transactions, however, same-day settlement should not be a problem and should be mandatory. DVP is unlikely to prevail in trades between partners of unequal standing. Financial institutions will often not deliver securities without advance payment, and will not pay without earlier delivery of securities. This will not normally imply a relevant risk to the affected customers, and the cost implications may be contained through the timing rules noted above. Depending on the size, solvency, and reputation of the customer, as well as on the size and overall volume of transactions, settlement will increasingly approach DVP.

8.4.3 Settlement of Stock Exchange Transactions of Government Securities

Stock exchange trading in government securities plays an insignificant role in many developed markets for government securities, with trading taking place in the over-the-counter markets.170 Policymakers in many emerging markets, on the other hand, may find a more active niche for stock exchange trading in government securities because of failures to set up conditions for development of OTC markets. Over time, it is unlikely that stock exchange trading will remain important relative to OTC trading (as OTC markets in these countries take hold), given some inherent weaknesses involved in stock exchange trading of government securities (e.g., inferior settlement facilities, inadequacy for trading repurchase agreements, and higher intermediation costs).

The potential advantages of centralized stock exchange trading of government securities are offset by inherent disadvantages from a settlement perspective. In developing countries in particular, stock exchange membership has been limited to a restricted set of individuals or to small, poorly capitalized institutions that do not hold to any significant extent clients’ deposit accounts nor custody of clients’ securities. Consequently, complex transfers of money and securities are required for settlement. The ideal solution is to allow stock exchange members to run a subdepository holding account with the central depository system. The stock exchange would take care of trading, as well as matching and netting any resulting settlement obligations, and then communicate such net settlement obligations to the central depository. Unfortunately, this solution often faces the difficulty that many stock exchange members fail to meet the solvency and technical eligibility criteria required from subdepositories or other direct members of the central depository.

8.5 The Depository System as Source of Data

Although there may be no substitute for real-time price transparency, a depository system and its settlement facilities offer an excellent basis for compiling frequent, detailed, and reliable ex-post trade reporting information, as well as data on outstanding claims. Such data can also provide an audit trail for market investigation and indicate potential problems for market surveillance. With one exception, all the potentially relevant information on trading would be contained in the coded data included in settlement orders. For the central depository, no other data would indeed be necessary. For subdepositories, irrespective of the forms they might use for client settlement orders, it should be required that they should keep a register of transactions based on the same codes used in the settlement orders of the central depository. In fact, this may be advisable on supervisory grounds alone. In addition, and this is the exception mentioned above, sub-depositories should be required to apply some simple coded classification of the intervening parties (e.g., different types of financial institutions, if relevant, nonresidents, government agencies, enterprises, and households), based, where available, on identification codes already in place (e.g., tax ID numbers). This would allow the compilation of relevant statistics on holdings of government securities and on outstanding repo agreements or other future commitments.

8.6 Conclusion

A well-structured securities settlement system contributes to the development of an active and liquid secondary government securities market. In addition, an effective securities settlement system provides a reliable record of securities holdings and minimizes risk by allowing for DVP and same-day settlement.

A securities settlement system can take varying forms. In an emerging-market country, a single, centralized depository, without subdepositories, located at the central bank may be sufficient. Wide membership of financial institutions in the centralized authority should be encouraged, although care must be taken by the central bank to limit its exposure. As the market expands and becomes more sophisticated, subdepositories may become necessary. Authorities should establish a frame of reference for subdepositories that minimizes risk and encourages competition.

Settlement procedures will depend on country circumstances and the degree of automation. A wide range of technology is possible. At one extreme, a simple PC at the central bank automating securities accounts and connections with account holders by telephone or fax may suffice. At the other extreme, the central depository and subdepositories may be interconnected electronically so that RTGS is possible. In between, there are many possibilities. Whatever approach is suitable at a given time, authorities should strive to minimize potential risks in the system and to improve it.


  • CPSS (Committee on Payment and Settlement Systems). 1992. Delivery Versus Payment in Securities Settlement Systems. Bank for International Settlements, Basel, Switzerland. Available at www.bis.org/publ.index.htm.

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  • CPSS and IOSCO (International Organization of Securities Commissions). 1997. Disclosure Framework for Securities Settlement Systems. Bank for International Settlements, Basel, Switzerland. Available at www.bis.org/publ.index.htm.

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  • ECB (European Central Bank). 1998. Assessment of EU Securities Settlement Systems against the Standards for Their Use in ESCB Credit Operations. Frankfurt, Germany. Available at www.ecb.int.

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Spain is a notable example, where bank custody of paper certificates was a generalized practice, in contrast to the tradition in other countries (e.g., the United Kingdom).


Bangladesh and Kenya, for example, in recent years have employed this method.


Bangladesh and China are examples of countries that follow this procedure.


Spain, during 1987–91, offered this option, and hardly any use was made of it.


Some countries have required a standard format notice for transactions involving a transfer of ownership to nonfinancial investors, with features more akin to a paper security than to a normal bank statement, to be sent to a new owner of a security. Such notices have very limited legal value (at most proof of an initial acquisition) and, being nontransferable, are definitely not a proxy paper security. Statements, however, can be important for the credibility of the depository and are reassuring for investors.


The early precedents of the Spanish depository system (1973–82) involved such a scheme, based on central bank securities and on some special short-term Treasury paper. Similar schemes have recently been implemented for Treasury bills in Bangladesh and Kenya.


A number of complexities could be associated with the three types of transactions. These include disbursement in several installments, payment with other securities due to mature, redemptions through quarterly or annual quotas, optional redemptions under specific circumstances, frequent interest payments, or special premia attached to particular conditions, even lottery features. Modern debt management has given up most of these practices, both to increase the transparency of securities management and to simplify their administration.


Nearly all countries with advanced depository systems have procedures to block securities from trading. Mexico, among countries with developed depository systems, does not offer this possibility.


Some depository systems envisage the possibility of issuing special certificates as proof of ownership, with standing validity until explicit cancellation. This also implies the blocking of securities until cancellation of the certificate.


This situation emerged in Slovenia in 1999. This was also the case, and recently modified, for repurchase agreements in Poland. This is a typical situation in many markets based on paper certificates and traditional settlement facilities.


Under currently accepted accounting standards, participants in any forward transaction are required to record explicitly in their accounting statements (either above or below the line) any forward commitments as of the date they are entered. Such commitments entail several risks, and ignoring them may distort the assessment of the true financial situation of the trading partners. Registration by the depository system of forward trades as of the date they are entered (based on irrevocable settlement orders) is an added guarantee to the trading partners. It leaves with a third party a useful record of the contractual agreement between the trading partners, thus converting the depository system into some sort of informal notary. Advance issue of standing irrevocable settlement orders is a safeguard usually welcomed by trading partners.


The justification for the explicit recording of repurchase agreements, unnecessary on strictly settlement grounds, is similar to that for forward agreements. Internationally accepted accounting standards require that repurchase agreements be recorded as lending operations rather than as two independent, outright transactions. Advance recording of the forward leg offers added guarantees to the trading parties. Furthermore, only one initial set of instructions is sufficient to carry out the two-stage settlement of the spot and forward legs of the transaction. Lacking an explicit registration by the depository system, it would be extremely difficult to gather reliable statistics on repo trading.


Among countries with efficient settlement facilities, Sweden approaches the single depository model. Any investor is entitled (but not obliged) to hold individualized accounts with the central depository, and many of them do, though management of such accounts requires using some bank as an agent. Denmark has a similar model, and Finland is planning to add such a possibility to its two-layer depository system. Other countries with a single depository include mainly small countries with an emerging primary market for a limited set of securities and a narrow secondary market. Lithuania and Slovenia, for example, fall in this category. Argentina has had a large single depository, with millions of accounts, but it does not provide settlement services, except indirectly, for stock exchange trading. The situation in Argentina is in the process of changing.


The United States offers the most significant example of a multi-tiered depository structure.


Mexico offers this possibility to some financial institutions not allowed as direct participants.


The depository systems of Denmark, Slovenia, and Sweden operate under this principie.


Single central depositories for government securities are common in most countries. As exceptions, France formerly maintained, and Poland still maintains, separate central depositories for Treasury bills and for bonds.


Systems born as specialized include Brazil, Canada, Colombia, Mexico, and the United States in the Americas; Japan in Asia; and Belgium, Bulgaria, France, Greece, Italy, the Netherlands, Poland (one of the facilities available), Portugal, Russia, and Spain in Europe. Germany, Switzerland, and the Scandinavian countries have tended to an integrated system.


In the U.S. depository system, municipal bonds and bonds issued by some financial public agencies are included. The same is true for China’s central depository. In the Spanish system, regional governments are eligible, and most of them have taken advantage of this option. There is, however, no known case in which nonfinancial public enterprises are included.


A move toward an integrated depository system for all securities has recently emerged among members of the European Monetary Union. Only Belgium and Spain still retain a separate arrangement for government securities. Those EU countries that have moved toward a single unified depository system, however, still have a way to go beyond the formal institutional shell. Mexico is an example of a country outside Europe where the move toward an integrated depository system has also recently taken place.


The experiences of Argentina, Ecuador, Hungary, Panama, Poland, and Slovenia illustrate the difficulties that countries have encountered in integrating government securities with other securities or in developing efficient settlement procedures.


There are rather generalized conventions, often incorporated in laws concerning the central bank, which limit the type of financial institutions entitled to hold deposit accounts with the central bank to those considered as “monetary institutions,” namely banks and other deposit-taking institutions (savings banks, credit unions and credit cooperatives). These institutions are usually subject to reserve requirements and provide general payment services. Normally, these are the only financial institutions with access to central bank lending facilities. Nonbank financial institutions, such as insurance companies, pension funds, securities firms, or managing companies of investment funds, which may all be significant participants in the wholesale market for government securities, may be deprived of direct access to deposits with the central bank.


China offers a remarkable example. With a central depository in place since 1996, it has not yet finalized subdepository arrangements. As a result, nonfinancial investors are excluded from the market for government securities in book-entry form, which comprise by now all marketable securities. Similar situations prevail in many small emerging economies.


For instance, a subdepository may sell and retain under custody securities that do not really exist (i.e., the subdepository may “create” government securities without holding the corresponding counterpart account with the central depository). Such fraud may be perpetrated by a subdepository cheating its clients by pretending to sell and maintain under custody government securities while, in fact, diverting the client’s proceeds to other purposes. The subdepository might also dispose of securities entrusted to its custody without the investors’ knowledge.


In Spain, immediate supervision of subdepositories is performed by the central depository, which has a small team of inspectors. Action on observed inadequacies may be shared between the central bank (for deposit-taking institutions) and the securities commission (for securities firms).


The U.S. Treasury and the central banks of Hungary and Spain manage such facilities.


The case of international financial organizations is one example.


Spain offers a good example of this development, with some domestic subdepositories having specialized in providing services to nonresident financial institutions. As a result, direct links of nonresidents with domestic subdepositories have tended to become more important than links channeled through Clearstream and EURO-CLEAR, whereas prior to doing so the links of nonresidents were channeled through these settlement systems.


International depositories are not always keen to accept the possibilities offered by the central depository. Spain is an example where both Clearstream and EUROCLEAR are linked to the depository system through two important, separate domestic subdepositories (see previous footnote). A paradoxical reverse situation exists in Mexico. For Mexican Brady bonds, Clearstream is acting as the central depository and the domestic central depository as a subdepository.


Mexico offers such possibility, but with limited settlement facilities.


Same-day settlement is indispensable for overnight repurchase agreements and is highly desirable for spot trading.


Matching of transactions exists in most modem central depositories for government securities. Surprisingly, an exception is the U.S. central depository. In the U.S. case, transactions are settled on a real-time basis upon a single order issued by the seller of securities, but the counterparty is entitled to order the cancellation of such entries any time before the daily close of settlement hours.


This is a point worth emphasizing, as there have been examples of countries setting up otherwise efficient settlement facilities that have ignored this fact. Besides the inconvenience of having to handle a duplicate number of payment orders, the advantages of advance registration were lost, including any knowledge about developments in the markets for repurchase agreements, since each of these was handled as two independent outright transactions belonging to the spot market.


Where online communication facilities exist, there is a more efficient alternative to the procedures so far described. Only one party (say the seller of securities) is required to submit the necessary settlement data to the central depository, which takes cate of relaying the data to the other party, asking for confirmation. The positive or negative result is reported back to the initiating party. Thus communication of payment orders, matching, and confirmation of matching become a single process. Among newly developed markets, Mexico is an example of a country that has adopted this system.


In some cases, the central bank may even be authorized, failing other arrangements, to seize securities in the central depository belonging to the failing institution and to sell them in the market.


A central depository should not “create” securities. Some stock exchanges or their attendant settlement facilities have been notorious for facilitating settlement procedures by delivering securities they have not yet received, thus “creating” securities. The counterpart cash balances received but not delivered have been a non-negligible source of income for the agents of such settlement arrangements.


This was the case in France, which resorted to this system in its recent transition to a full RTGS system. It now remains, with little change, part of their RTGS system.


This conclusion on RTGS for securities need not apply to RTGS for other large payments. In fact, if the European experience can be generalized, introducing an RTGS system for other payments may be a prerequisite or at least the normal way to proceed later to RTGS for securities. Some countries have implemented (e.g., Slovenia) or are in the process of implementing (e.g., China) some RTGS facility for interbank or other large payments. However, caution may also be required here. Central banks in some countries with very narrow financial markets maintain, paradoxically, some large-value interbank payment facility working on an RTGS basis, even based on the physical delivery of paper payment orders (e.g., Bangladesh and Kenya). Given the very small number of daily transactions involved, these are hardly relevant precedents.


This is how MNS securities settlement worked in the Spanish central depository, run by the central bank, until the recent introduction of RTGS, which was in fact facilitated by that practice.


These difficulties explain the delays experienced by some European countries involved in the parallel move from the central bank to a self-standing agency and from MNS to RTGS systems.


Spain offers a relevant example of the second possibility, with transactions settled through subdepositories exceeding the volume of transactions settled through the central depository. This results from a significant direct market participation of nonresidents and a large number of nonbank financial institutions holding securities with sub-depositories (in some cases, despite the possibility of using the central depository).


On-site inspections also include cross-checking subdepository data with a sample of investors.


Such a procedure is available in Spain for transactions exceeding some large, but not exceptional, amount. Mexico follows an alternative approach, where such a procedure is available for any transaction, though subdepositories are allowed to group homogeneous transactions as they wish.


Who sets the rules and who takes the decisions (the government, the minister of finance, the central bank, or the central depository) depends on local factors, and it would not be meaningful to prescribe a common procedure.


Spain and the United States are two countries that do have stock exchange trading of government securities, but their activity in this area is insignificant.