Financial Stability Standards for Securities Settlement Facilities – December 2012 Standard 16: Tiered Participation Arrangements

Guidance

Tiered participation arrangements occur when some firms (indirect participants) rely on the services provided by other firms (direct participants) to use the securities settlement facility's settlement facilities.^[41]

The dependencies and risk exposures (including credit, liquidity and operational risks) inherent in these tiered arrangements can present risks to the securities settlement facility and its smooth functioning, as well as to the participants themselves and the broader financial markets. For example, if a securities settlement facility has few direct participants but many indirect participants with large values or volumes of transactions, it is likely that a large proportion of the transactions processed by the securities settlement facility depend on a few direct participants. This will increase the severity of the effect on the securities settlement facility of a default of a direct participant or an operational disruption at a direct participant. The credit exposures in tiered relationships can also affect the securities settlement facility. If the value of an indirect participant's transactions is large relative to the direct participant's capacity to manage the risks, this may increase the direct participant's default risk. There may also be legal or operational risk to the securities settlement facility if there is uncertainty about the liability for indirect participant transactions and how these transactions will be handled in the event of a default (see SSF Standard 1 on legal basis).

The nature of these risks is such that they are most likely to be material where there are indirect participants whose business through the securities settlement facility is a significant proportion of the securities settlement facility's overall business or is large relative to that of the direct participant(s) through which they access the securities settlement facility's services. Typically, the identification, monitoring and management of risks from tiered participation will therefore be focused on the immediate customers of direct participants and depend on the direct participant for access to a securities settlement facility's services. In exceptional cases, however, tiered participation arrangements may require the securities settlement facility to look beyond the direct participant and its immediate customer. An important source of tiering is participants' use of commercial settlement banks to effect money settlements and carry out funding and defunding activities. This source of tiering is not directly addressed in this Standard, but rather is considered in SSF Standard 8.

There are limits on the extent to which a securities settlement facility can, in practice, observe or influence direct participants' commercial relationships with their customers. However, a securities settlement facility will often have access to information on transactions undertaken on behalf of indirect participants and can set direct participation requirements that may include criteria relating to how direct participants manage relationships with their customers insofar as these criteria are relevant for the safe operation of the securities settlement facility. At a minimum, a securities settlement facility should identify the types of risk that could arise from tiered participation and should monitor concentrations of such risk. If a securities settlement facility or its smooth operation is exposed to material risk from tiered participation arrangements, the securities settlement facility should seek to manage and limit such risk.

16.1.1 A securities settlement facility may be able to obtain information relating to tiered participation through its own systems or by collecting it from direct participants. A securities settlement facility should ensure that its procedures, rules and agreements with direct participants allow it to gather basic information about indirect participants in order to identify, monitor and manage any material risks to the securities settlement facility arising from such tiered participation arrangements. This information should enable the securities settlement facility, at a minimum, to identify: the proportion of activity that direct participants conduct on behalf of indirect participants; direct participants that act on behalf of a material number of indirect participants; indirect participants with significant volumes or values of transactions in the system; and indirect participants whose transaction volumes or values are large relative to those of the direct participants through which they access the securities settlement facility.^[42]

16.2.1 A securities settlement facility should identify material dependencies between direct and indirect participants that can affect the securities settlement facility. Indirect participants will often have some degree of dependence on the direct participant through which they access the securities settlement facility. In the case of a securities settlement facility with few direct participants but many indirect participants, it is likely that a large proportion of the transactions processed by the securities settlement facility would depend on the operational performance of those few direct participants. Disruption to the services provided by the direct participants – whether for operational reasons or because of a participant's default – could therefore present a risk to the smooth functioning of the system as a whole. The securities settlement facility should identify and monitor material dependencies of indirect participants on direct participants so that the securities settlement facility has readily available information on which significant indirect participants may be affected by problems at a particular direct participant.

16.2.2 In some cases, issues at an indirect participant could affect the securities settlement facility. This is most likely to occur where a large indirect participant accesses a securities settlement facility's facilities through a relatively small direct participant (see SSF Standard 16.3). Failure of this significant indirect participant to perform as expected, such as by failing to meet its payment obligations, or stress at the indirect participant, such as that which causes others to delay payments to the indirect participant, may affect the direct participant's ability to meet its obligations to the securities settlement facility. Securities settlement facilities should therefore identify and monitor the material dependencies of direct participants on indirect participants so that the securities settlement facility has readily available information on how the securities settlement facility may be affected by problems at an indirect participant, including which direct participants may be affected.

Credit and liquidity risks in tiered participation arrangements

16.3.1 Tiered participation arrangements typically create credit and liquidity exposures between direct and indirect participants. The management of these exposures is the responsibility of the participants and, where appropriate, subject to supervision by their regulators. A securities settlement facility is not expected to manage the credit and liquidity exposures between direct and indirect participants, although the securities settlement facility may have a role in applying credit or position limits in agreement with the direct participant. A securities settlement facility should, however, have access to information on concentrations of risk arising from tiered participation arrangements that may affect the securities settlement facility, allowing it to identify indirect participants responsible for a significant proportion of the securities settlement facility's transactions or whose transaction volumes or values are large relative to those of the direct participants through which they access the securities settlement facility. A securities settlement facility should identify and monitor such risk concentrations.

16.3.2 If a participant default would leave a securities settlement facility with a potential credit exposure related to an indirect participant's positions, the securities settlement facility should ensure it understands and manages the exposure it would face. For example, the securities settlement facility may set participation requirements that require the direct participant, on the securities settlement facility's request, to demonstrate that it is adequately managing relationships with its customers to the extent that they may affect the securities settlement facility. A securities settlement facility should also consider establishing concentration limits on exposures to indirect participants, where appropriate.

Indirect participation and default scenarios

16.3.3 Default scenarios can create uncertainty about whether indirect participants' transactions have been settled or will be settled and whether any settled transactions will be unwound. Default scenarios can also raise legal and operational risks for the securities settlement facility if there is uncertainty about whether the indirect or direct participant is liable for completing the transaction. A securities settlement facility should ensure that a default, whether by a direct participant or by an indirect participant, does not affect the finality of indirect participants' transactions that have been processed and settled by the securities settlement facility. A securities settlement facility should ensure that its rules and procedures are clear regarding the status of indirect participants' transactions at each point in the settlement process (including the point at which they become subject to the rules of the system and the point after which the rules of the system no longer apply) and whether such transactions would be settled in the event of an indirect or direct participant default. A securities settlement facility should also ensure that it adequately understands its direct participants' processes and procedures for managing an indirect participant's default. For example, the securities settlement facility should know whether the indirect participant's queued payments can be removed or future-dated transactions rescinded and whether such processes and procedures would expose the securities settlement facility to operational, reputational or other risks.

Encouraging direct participation

16.3.4 Direct participation in a securities settlement facility usually provides a number of benefits, some of which may not be available to indirect participants, such as real-time gross settlement, exchange-of-value settlement, or settlement in central bank money. Moreover, indirect participants are vulnerable to the risk that their access to a securities settlement facility is withdrawn or disputed. If these indirect participants have large values or volumes of business through the securities settlement facility, this may affect the smooth functioning of the securities settlement facility. For these reasons, where an indirect participant accounts for a material proportion of the transactions processed by a securities settlement facility, it may be appropriate to encourage direct participation. For example, a securities settlement facility may in some cases establish objective thresholds above which direct participation would normally be encouraged (provided that the firm satisfies the securities settlement facility's access criteria). Setting such thresholds and encouraging direct participation should be based on risk considerations rather than commercial advantage.

16.4.1 A securities settlement facility should regularly review risks to which it may be exposed as a result of tiered participation arrangements. If material risks exist, the securities settlement facility should take mitigating action as appropriate. The results of the review process should be reported to the board of directors and updated periodically and after substantial amendments to a securities settlement facility's rules.