**3.2. Risks in clearing and settlement systems**

342 Risk Management – Current Issues and Challenges

*3.1.1. Clearing and settlement stages* 

The settlement itself, which is composed of:

particular security;

respect to financial funds.

between parties are to be performed safely and with little cost.

instruments is closed and goes through the following main steps:

and settlement take into account that transfers of financial instruments and financial funds

To prevent and to reduce the risks specific to the settlement of financial instruments transactions, direct access to clearing and settlement system is limited to those participants who meet a set of capitalization criteria, operational capacity and professional experience, which means that the settlement of an exchange transaction involves a given number of financial intermediaries. The more financial intermediaries are involved in the settlement of

Clearing and settlement process begins immediately after a transaction with financial

 **Confirming** the terms in which the deal was closed between the buyer and seller. Confirmation of transactions can be conducted directly between parties or using a system that generates such an acknowledgment. In the latter case, the terms of the transaction can be transmitted to the central system or automatically by the trading system, or separately by each party. Although apparently it is just a formality, confirmation of transactions is a significant milestone in the process of completing a stock transaction, since it can identify

 **Compensation** is an algorithm of obligations and / or rights accrued to the participant, after transactions were inserted in the system and confirmed. Usually, the calculation of obligations and rights of a participant can be made on a gross basis for the settlement of transactions, based on a bilateral net or multilateral net basis. Therefore, the calculation algorithm can result in one or more instructions to participants in the system that have to be respected. Only in the case of net multilateral compensation, the calculation algorithm results for each participant in only one instruction, that expresses (cash

in due time differences that may affect the proper functioning of the system.

settlement level) either the obligation/ write to pay/ receive a certain amount.

 **obligation to deliver securities:** falls to the seller that is part of a transaction or to the participant in the settlement that is in the position of a net debtor for a

 **obligation to pay an equivalent amount:** falls to the buyer that is part of transaction or to the participant in the settlement with a debtor net quality in

The last stages of the settlement imply the highest financial risk throughout the process of finalizing exchange transactions, one of the main criteria that measures the performance of a clearing system and securities settlement transactions refers to the method the connection between the mechanism of transfer of securities (obligation to deliver) and transfer mechanism of funds (payment required) is made. The systems within which the permanent transfer of securities are to take place, subject to an exchange transaction, only if the final and irrevocable payment of amounts is made, fulfilling one of the main conditions to measure performance:

financial instruments transactions, the more complex is the settlement process.

As presented before, between the moment a transaction with financial instruments is closed and the ownership transfer certain stages are to be completed in a given time frame. The following risks are present and occur:

**CREDIT RISK**, implies the possibility that one side of a transaction might not honor its obligations, or after maturity, in whole or in part. Types of credit risk:


**LIQUIDITY RISK** refers to the situation where the seller of certain financial securities does not receive on the settlement date the amount from the buyer and thus he finds himself in a position to borrow or sell other financial assets to honor at its turn various other obligations assumed in view of collecting amounts from the original sale of securities. Liquidity risk arises in the case of the buyer as well if upon settlement it does not receive the securities purchased that were possibly involved in a transaction following the initial sale. The size of

the liquidity risk is inversely proportional to market liquidity: the more liquid the market is, the lower the liquidity risk costs are. Liquidity problems have a high potential to have negative influences on the entire settlement system, especially when occurring amid high volatility of shares market and any delay in completion of the settlement by a participant thus raising concerns about solvency.

Risk Management on the Romanian Capital Market 345

 Confirmation of all transactions must be achieved by all direct participants in the market (for example: brokers/ brokers/dealers and other members) in T+0. Details of all

Indirect market participants (e.g. institutional investors) should be informed on the

 Every country should have an operational central securities depository, organized and managed so as to encourage activity of the direct and indirect market participants. The range of financial instruments eligible to be registered in the central depository must be broad. Preserving or dematerializing financial instruments should be as extensive as possible. If on the same market there are several depositors, they should operate on the basis of compatible rules and practices, in order to reduce settlement risk and to allow use of funds and make available any financial securities pledged as collateral in an

 Each market should be encouraged to reduce settlement risk by introducing "gross settlement in real time" mechanisms (Real Time Gross Settlement - RTGS) or by using

 Payments related to settlement of securities transactions and using a financial instrument portfolio should target all markets and financial instruments, the adoption

A single cycle of implementation of the settlement should be adopted for all markets.

 Loans of financial instruments should be encouraged as a method of developing financial instruments transactions settlement. Barriers and taxes that limit loan of

Each country should develop a standard for messages related to financial instruments based on ISO Standard 7775. In particular, each country should adopt the ISIN coding system for

CPSS (Committee on Payment and Settlement Systems) - IOSCO (International Organization of Securities Commissions) recommendations, completed in 2001, take and develop provisions of G30 recommendations, adapting them to the important changes occurring in

1. The legal system: the settlement of transactions with financial instruments must have a

2. Confirming transactions: Confirming transactions between direct market participants should be completed as soon as possible after the time transactions are executed, but not later than the end of the trading day (T +0). When it is necessary to confirm the

Final settlement for all transactions should be made no later than T +3.

compensation based on transactions that meet Lamfalussy recommendations. DVP system should be used as a method of settlement for all transactions. DVP is defined as "simultaneous dismissal, final, irrevocable and immediate securities and

confirmed transactions must be transmitted to clearing – settlement system.

implementation details of transactions in T +1.

funds continuously throughout the day."

financial instruments should be removed.

the securities industry in recent years, but adding new ones.

solid legal framework, clear and transparent.

securities, as specified in ISO Standard 6166.

*3.3.2. CPSS – IOSCO recommendations* 

of the "Same day fund" Convention.

efficient manner.

**SYSTEMIC RISK** refers to cascade spreading of a situation when settlement is impossible, from one participant to the clearing - settlement system to other members in the system (or all participants in the system). Institutions that operate clearing and settlement of exchange transactions are required to provide mechanisms and procedures to prevent expansion of liquidity or solvency problems from one participant to the whole system. Investor confidence in post-transaction systems is essential for liquidity growth of the stock market and is a prerequisite to entering a virtuous circle: a more liquid market significantly reduces the impact of risks that may arise in clearing and settlement system, which is reflected in increased market liquidity.

**OPERATIONAL RISK** implies that defective processing of transactions by participants in a settlement system, failure of transactions, fraud, disruption of communications or any other operating problems turn into financial losses.

Depending on the structure of clearing - settlement systems and transaction type, there might also be other risk categories, such as bankruptcy risks of the settlement bank, legal risk or custody risk. The probability that one or other of the above risks could materialize depends substantially on the following two main factors:


### **3.3. Recommendations on the clearing and settlement systems to reduce risks**

Materialization of risks in clearing and settlement operations may have significant negative influences on a country's entire financial system [13].

Moreover, given the internationalization of financial flows, where some of the affected participants in a clearing and settlement system operate simultaneously in multiple markets or operational links exist between two or more national clearing and settlement systems, this may cause contamination and spread of local problems internationally. Thus a set of recommendations was elaborated by specialized international institutions.

#### *3.3.1. G30 recommendations*

"G30 Recommendations" consists of a set of nine recommendations that should be implemented by all settlement systems:


Each country should develop a standard for messages related to financial instruments based on ISO Standard 7775. In particular, each country should adopt the ISIN coding system for securities, as specified in ISO Standard 6166.
