United States of America: The Depository Trust Company’s Observance of the CPSS-IOSCO Recommendations for Securities Settlement Systems

The report gives a summary of the detailed assessment report on the implementation of the Basel Core Principles for Effective Banking in the United States and its recommendations, securities and futures market regulatory, insurance regulation, Fixed Income Clearing Corporation -Government Securities Division (FICC-GSD) system, and other recommendations such as Depository Trust Company (DTC) against the Recommendations for Securities Settlement Systems (RSSS), the National Securities Clearing Corporation (NSCC) against the Recommendation for Central Counterparties (RCCP), the Fedwire Securities Service (FSS) against the Committee on Payment and Settlement Systems -International Organization of Securities Commission (CPSS-IOSCO) RSSSs as well. The U.S. authorities welcomed the Financial Sector Assessment Program (FSAP) and independent reviews, and appreciated significant undertaking associated with reviews in the wake of the crisis.

Abstract

The report gives a summary of the detailed assessment report on the implementation of the Basel Core Principles for Effective Banking in the United States and its recommendations, securities and futures market regulatory, insurance regulation, Fixed Income Clearing Corporation -Government Securities Division (FICC-GSD) system, and other recommendations such as Depository Trust Company (DTC) against the Recommendations for Securities Settlement Systems (RSSS), the National Securities Clearing Corporation (NSCC) against the Recommendation for Central Counterparties (RCCP), the Fedwire Securities Service (FSS) against the Committee on Payment and Settlement Systems -International Organization of Securities Commission (CPSS-IOSCO) RSSSs as well. The U.S. authorities welcomed the Financial Sector Assessment Program (FSAP) and independent reviews, and appreciated significant undertaking associated with reviews in the wake of the crisis.

I. Introduction, and Methodology

1. The assessment of the Depository Trust Company (DTC) against the CPSS-IOSCO Recommendations for Securities Settlement Systems (RSSSs)1 reveals that the system observes the recommendations, although some enhancements would allow DTC to increase its compliance level with all the recommendations. More precisely, actions need to be undertaken to improve its risk resilience by strengthening the stress testing, DTC’s financial and liquidity resources, in particular, to address the problem that could arise when money market does not work smoothly and equities repo cannot be used to raise equities or cash. Additional improvements would be to enhance governance arrangements, develop procedure for intraday finality for cash settlement.

2. The assessment of DTC was undertaken in the context of the IMF Financial Sector Assessment Program (FSAP).2 Prior to the mission, DTC conducted a self-assessment following the methodology of the RSSSs published in 2002 by the CPSS-IOSCO. The assessors3 also benefited from discussion with the Securities and exchange Commission (SEC), the Federal Reserve Board and Federal Reserve Bank of New York representatives (supervision and oversight), as well as with the operator of DTC and some major participants in the system. Relevant authorities and the operator of the system have been very co-operative in providing additional confidential information and organizing additional meetings, when required.

3. Given the organization of the Depository Trust & Clearing Corporation (DTCC), the assessment of the three entities belonging to the group (The Depository Trust Company – DTC, the National Securities Clearing Corporation – NSCC and the Fixed Income Clearing Corporation – FICC) resulted in almost identical recommendations concerning legal risk (RSSS1 and CCP1), operational risk (RSSS11 and RCCP8) governance (RSSS13 and RCCP 13) and efficiency (RSSS 15 and RCCP14).

II. Institutional AND Market Structure—Overview

4. DTC is a limited purpose trust company under the New York Banking Law, a clearing agency registered under the Securities Exchange Act, a clearing organization as defined by the Federal Deposit Insurance Corporation Improvement Act, a clearing corporation as defined in the Uniform Commercial Code, and a member bank of the Federal Reserve System. It is a depository and settlement system that effects issuance, transfer, and pledge by computerized book-entry system. DTC, the National Securities Clearing Corporation (NSCC), and the Government Securities Division of the Fixed Income Clearing Corporation (FICC-GSD), assessed in the context of the U.S. FSAP, are all wholly owned subsidiaries of the Depository Trust and Clearing Corporation (DTCC). The key statistics of DTC are provided in Table 1.

Table 1.

Key Statistics of Depository Trust Company (DTC), 2007–09

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Source: DTCC.1 Value of end of day committed credit facility for USD settlements. The facility was not drawn on for any of the days noted. The current facility is 364 day facility that expires in May of the following year.

Value of the Participant Fund (all cash).

5. DTC provides its participants with various settlement services to facilitate the end-of-day settlement of obligations resulting from their trading activity in various markets. Besides the main settlement services, DTC provides a range of settlement, custody, and tax-related services for its members. DTC serves three different markets, namely (i) money market instruments, (ii) equities, and (iii) corporate and municipal bonds (Table 1).

6. The oversight, regulation, and supervision of DTC is conducted by different authorities owing to the organizational structure of DTC: (i) the Federal Reserve Board that derives its supervisory authority from DTC’s membership in the Federal Reserve System as a State member bank, (ii) the SEC whose authority stems from DTC’s operations as a clearing agency; (iii) the New York Banking State Department (NYSBD) whose supervisory authority derives from DTC’s charter as a limited purpose trust company under the New York banking law.

III. Main Findings

Legal Framework (Rec. 1)

7. DTC’s activities are governed by a consistent set of laws, regulations, and contractual arrangements that form a sound legal foundation for clearing, settlement and custody activities, which are publicly available and readily accessible to system participants.

Pre-settlement Risk (Rec. 2–5)

8. DTC does not fully offer trade confirmation services, as it is performed at the broker level provided to the NSCC on a “locked-in basis”. OTC equity product and fixed income transactions are not matched at the market place of execution. DTC does not match settlement instructions prior to settlement. DTC does not monitor settlement fails. For trades cleared by NSCC, the CCP monitors settlement fails, the figures of which are available on the SEC’s website, and has put in place incentives to settle in time. The settlement cycle for trades is generally T+3. Cost-benefit analysis for a shorter settlement fail have been conducted under the aegis of SEC. Not all transactions settled by DTC are cleared by NSCC or another CCP. For those transactions not cleared by a CCP, neither market participants nor U.S. regulators conducted a cost-benefit analysis.

Settlement Risk (Rec. 6–10)

9. The majority of securities settled in DTC are represented by physical certificates immobilized in the depository, although the trend is towards dematerialization. The vast majority of municipal and corporate debt issues distributed through DTC are in book-entry only form. Transfer of ownership occurs when securities are transferred between participants within the system. DTC relies on a DVP model 2 with securities settled on an intraday gross basis and associated funds on a net basis at the end of the day. All valued transactions in DTC are settled on a DVP basis. Finality of settlement occurs intraday for securities deliveries but at the end of the day for cash transfers outside DTC. To facilitate settlement through the day, DTC provides liquidity to participants, based on rigorous risk management procedures. DVP transactions are processed by debiting the securities from the account of the delivering participant and at the same time crediting the delivering participant the corresponding payment amount. DTC then reflects a payment debit and securities credit in the account of the receiving participant, treating the securities credit as an incomplete transaction. Should a participant default, DTC will be exposed to financial risks depending on its ability to timely liquidate the collateral of the defaulting participant. However, full collateralization of any intraday net debit money positions assures that, should several major participants fail to pay for their net debit money obligations at the end of the day, DTC would have sufficient collateral value (inclusive of haircuts) to cover the participants’ unpaid obligation. For cash settlement, DTC relies on settling banks—settling for their own and other participants—making the payments from and to DTC’s account at the FRBNY. There is a high concentration of payment flows at the top five settling banks in DTC. This concentration is currently not monitored by DTC.

Operational Risk (Rec. 11)

10. DTCC has developed business continuity arrangements at the level of the holding company, covering all sites; networks control centres and business sites as a unified complex. In doing so, DTCC has taken into account the requirements of the “Interagency paper on sound practices to strengthen the resiliency of the U.S. financial system”.4 DTCC has in place adequate procedures to identify and minimize the sources of operational risk that may arise in the clearing and settlement process. Contingency plans and back-up facilities are regularly tested and maintained to ensure the resilience of DTC. A risk-based review of the IT system supporting DTCC functioning is performed by independent external auditors. Senior management regularly reviews operational reliability issues.

Custody Risk (Rec. 12)

11. DTC operates an indirect holding system where securities (or interest in securities) are registered in the name of the direct participants through nominee accounts rather than in the name of the end beneficiary. Physical and technical controls as well as periodic audits are performed by DTC’s regulators and Internal Audit Department.

Other Issues (Rec. 13–19)

12. There is a single governance structure for all the subsidiaries of DTCC. Currently, DTCC’s Board is composed of 18 members. Members of the Board are elected by the shareholders annually. Although DTCC’s governance arrangements are made public on its website, not all the relevant information is publicly available. DTC’s access and exit criteria are publicly disclosed and the same eligibility rules apply to all participants depending on the scope of the service used regardless of the type, identity and location of the participant. DTC reviews in the annual budget process its pricing levels which are cost-based. The cost allocation methodology is part of a regular review by both internal and external auditors. DTCC ensured that each service of the DTCC group does not cross-subsidise the cost and expenses of the others. DTC uses international standards for its cross-border linkages with foreign central securities depositories (CSDs). The laws, regulations, rules and procedures governing DTC are publicly available. Moreover, following the Federal Reserve Payment System Risk Policy, DTC has completed a self assessment following the RSSSs assessment methodology.

13. The responsibilities and objectives of relevant public authorities with regard to DTC activities are clearly defined and publicly disclosed. DTC is regulated and overseen by the SEC, the Federal Reserve and the NYSBD. The SEC has entered into memoranda of understanding with foreign regulators to facilitate the exchange of information with authorities of all the countries with which DTC has developed links, except for Peru.

14. DTC maintains links with 13 foreign CSDs, of which two are bilateral, i.e., both inbound link (foreign CSD opened accounts at DTC) and outbound link (DTC opened accounts with a foreign CSD). For inbound links, linked CSDs are treated as other participants in DTC, while for outbound links DTC conducts an assessment of the risks associated with the establishment of the link before allowing its participants to process transactions with a foreign CSD’s participants.

Table 2.

Summary of Observance with the CPSS-IOSCO Recommendations

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Table 3.

Actions to Improve Compliance

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IV. Authorities’ Response to the Assessment

15. The U.S. authorities welcome the IMF’s assessment of DTC against the RSSSs. We appreciate the significant undertaking associated with an FSAP review of the biggest financial sector in the world, as well as the challenges that accompany the first assessment of a large advanced country in the wake of the crisis. The authorities are pleased to note that the IMF’s assessment reflects the high degree of compliance of DTC with the RSSSs, and are largely in agreement with the assessment’s comments and recommendations, which the authorities will share with DTC.

16. Again, the authorities appreciate the significant undertaking associated with the assessment of DTC and the contribution that the assessment process makes to the stability and effective regulation and oversight of systemically important payment, clearing and settlement systems.

1

The underlying Detailed Assessment Report was published in May 2010 and is available at http://www.imf.org/external/pubs/cat/longres.cfm?sk=23870.0.

2

For further discussion see the accompanying Financial System Stability Assessment (FSSA), (www.imf.org).

3

This assessment was carried out by Daniela Russo (external expert) and overseen by Elias Kazarian (IMF).

4

“Interagency paper on sound practices to strengthen the resiliency of the U.S. financial system”, Federal Reserve Board, Securities and Exchange Commission, Office of the Comptroller of the Currency, 2003.