Management of Risk in CSDs

- presentation to AMEDA members

John Woodhouse25 October 2007

Agenda

• Risk Management – Importance for CSDs• TM CSD Association – Post Trade Risk Assessment• TM Risk Rating Methodology• Six Risk Types

Risk Factors– Definition– Criteria– Graphs

• Key Risk Factors for each Risk Type• Situation for AMEDA

– AMEDA Risk Profiles– TM Assessments– Comparative analysis

• END

Risk Management – Importance for CSDs

• Regulatory requirements – SEC17F7, FSA,G30, IOSCO

• Investor requirements – FIIs often impose own criteria eg Calpers

• CSDs offer competitive services and need to manage risk similar to

custodians:– Custody of ineligible securities.– Asset Servicing.– Information services.– Expanded corporate actions servicing.– Provision of back office services.– Collateral management.

• Increased focus on transparency– IOSCO recommendation 17– Market trend for consolidation and demutualisation– Attention to improved governance arrangements and more director

liability

Thomas Murray CSD Association

• Worked with Gobal Custodians and CSDs for 10 years

• Risk assessments of CSDs from 2001

• Risk ratings of CSDs from 2006

• Market surveillance

• Risk analysis

Risk Rating Methodology

• Assesses risk for investors in post-trade capital market infrastructure

• Settlement, safekeeping and asset servicing risks• Six primary risks assessed• Agreed key criteria or factors assessed against each

primary risk• Assessment against the familiar international rating scale

‘AAA’ – ‘C’• Criteria (factors) weighted by relative importance in the

individual market • Overall rating derived from rating of six primary risks

Six Risk Types

1. Asset Commitment Risk (ACR)

2. Liquidity Risk (LR)

3. Counterparty Risk (CPR)

4. Asset Servicing Risk (ASR)

5. Financial Risk (FR)

6. Operational Risk (OR)

CSD Risk Diagram

A3 A4

A1

A2

A3

A4

A6

A5

CSD Risk Rating

A2

A5A1

A6

Less Important Important Critical

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

CSD RatingsRisk ProfileAsset Commitment Risk

Liquidity Risk

Counterparty Risk

Financial risk

Operational Risk

Asset Servicing Risk

Asset Commitment Risk

Asset Commitment Risk - The period of time from when control of securities or cash is given up until receipt of countervalue.

This risk concerns the time period during which a participant’s assets, either cash or stock, are committed within the CSD and payment system pending final settlement of the underlying transaction(s). Following settlement, the risk period is extended until the transfer of funds and stock becomes irrevocable. It excludes any periods when assets, cash or stock, are committed to a market participant including brokers, banks and custodians, not caused by CSD processing.

Asset Commitment Risk - Criteria

• Minimising processing times maximises the availability of assets, particularly for transfer of assets off-shore (e.g. cross-border collateral movement, repatriation of funds)

• Processing speed (real-time, intraday batches, overnight batches)

• Market deadline for securities / funds positioning

• Finality in settlement system (with legal basis)

• Pre-funding markets (e.g. Russia), or long blocking periods

CSD ‘old’

CSD ‘new’

CSD Ratings

Rating

AC4

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

Asset Commitment Risk

Less important Important Critical

AC1

AC2

AC3

AC4

AC3

AC1

AC2

Inter-broker - Sales

Inter-broker - Purchases

Broker-custodian – (Selling Broker)

Broker-custodian – (Buying Broker)

Broker-custodian – (Custodian)

Free of payment

AC5

AC6

AC5

AC6

Liquidity Risk

Liquidity Risk - The risk that insufficient securities and or funds are available to meet commitments; the obligation will be covered some time later.

This is where for certain technical reasons (e.g., stock out on loan, stock in course of registration, turn round of recently deposited stock is not possible) one or both parties to the trade has a shortfall in the amount of funds (credit line) or unencumbered stock available to meet settlement obligations when due. These shortfalls may lead to settlement ‘fails’ but do not normally lead to a default.

Liquidity Risk - Criteria

• Optimising asset liquidity now paramount in large markets. Managing late settlements effectively and quickly reduces ‘indirect’ losses

• Netting (with legal basis) / optimisation• Multiple processing cycles• Stock lending• Credit facilities• Fails management (fines, buy-ins)• High levels of immobilisation / dematerialisation• Fast registration / central registrar

Rating

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

CSD RisksLiquidity Risk

CSD ‘old’

Less important Important Critical

Processing Model 2 – on exchange

Processing Model 1 – off exchange

Credit Facilities

Stock lending and Borrowing

Fails management

Registration

Deposited securities

Matching

Processing Model 1 - Same Day

Trading

CSD Ratings

CSD ‘new’

L1

L2

L3

L4

L5

L6

L7

L8

L6

L3

L1

L8

L2

L5

L4

L7

L9

L9

Counterparty Risk

Counterparty Risk - The risk that a counterparty (i.e., a participant) will not settle its obligations for full value at any time.

This is simply the total default of a direct participant of the CSD. This is the event when a participant is unable to meet its financial liability to the CSD and possibly other creditors. This risk only goes as far as direct participants of the CSD and excludes clients of direct participants that default on liabilities to such participants, even if such a default should systemically cause the direct participant to subsequently default.

Counterparty Risk - Criteria

• Managing defaults is critical to reducing direct loss of Principal and Systemic risks through participant interdependence.

• DVP (market AND client-side)• Central Bank, same-day funds• Settlement assurance (CCP, collateral, guarantee fund)• Strict participation criteria• Participant concentration• Surveillance of participant volumes / risk modelling

Rating

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

Counterparty Risk

CSD ‘old’

Less important Important Critical

Participation Criteria

Participant concentration

Surveillance

DVP – Inter-Broker

DVP - Broker-custodian

Settlement Assurance

CSD Ratings

CSD ‘new’

C1

C2

C3

C4

C5

C6

C3 C4

C5

C1

C6

C2

Asset Servicing Risk

Asset Servicing Risk - The risk that a participant may incur a loss arising from missed or inaccurate information provided by the depository, or from incorrectly executed instructions, in respect of corporate actions and proxy voting.

This risk arises when a participant places reliance on the information a depository provides or when the participant instructs the depository to carry out an economic transaction on its behalf. If the depository fails either to provide the information or to carry out the instruction correctly then the participant may suffer a loss for which the depository may not accept liability. The depository may provide these services on a commercial basis, without statutory immunity, or it may provide the service as part of its statutory role, possibly with some level of protection from liability. This risk is likely to become much higher when international securities are included in the service.

Asset Servicing Risk - Criteria

• Managing corporate actions effectively perhaps the biggest potential risk exposure.

• Reliable ‘official’ source• Multiple information sources allowing for

verification/’data scrubbing’• Timely, accurate and comprehensive event notification• Timely, accurate and comprehensive event processing• Pro-active client servicing• Straight-Through-Processing• Clear statement of liability

Rating

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

Asset Servicing Risk

CSD ‘old’

Less important Important Critical

Info Collection

Info Dissemination

Receipt of Instructions

Execution of Instructions

Proxy Voting

Other Services

CSD Ratings

CSD ‘new’

AS1

AS2

AS3

AS4

AS3

AS4

AS1AS2

AS6

AS6 AS5

AS5

Financial Risk

Financial Risk - The ability of the CSD to operate as a financially viable company.

This risk concerns the financial strength of the depository and if its capital is sufficient to meet the on-going operation of the organisation.

Financial Risk - Criteria

Ongoing financial stability of the CSD as a business. Net capital Operationally profitable Comprehensive insurance Any principal activity fully collateralised/ managed Limited commercial activity Limited liability (exclude indirect losses)

CSD ‘new’

Rating

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

Financial Risk

CSD ‘old’

Less important Important Critical

Capital Structure

Earnings performance

Ownership

Access to Credit

Insurance Coverage

Operational claims

Investment in infrastructure

CSD Ratings

F1

F2

F3

F4

F5

F6

F7

F6 F5

F7F3

F4

F2

F1

Operational Risk

Operational Risk - The risk that deficiencies in information systems or internal controls, human errors or management failures will result in losses.

The risk of loss due to breakdowns or weaknesses in internal controls and procedures. Internal factors to be considered in the assessment include ensuring the CSD has formalised procedures established for its main services. The CSD should have identified control objectives and related key controls to ensure operation and proper control of established procedures. Systems and procedures should be tested periodically. There should be external audit processes in place to provide third-party audit evidence of the adequacy of the controls.

Operational Risk - Criteria

• Internal controls and procedures should be adequate to control operational risk exposures

• Comprehensive controls and procedures• Extent of Internal and External operational

audits• Limit manual processing / internal STP• Secure and efficient interfaces – external STP• DRP/BCP procedures

CSD ‘new’

Rating

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

Operational Risk

CSD ‘old’

Less important Important Critical

Established procedures

Identification of key controls

Operational Audit

Processing

Reporting

Disaster Recovery procedures

Business Continuity Plan

Staff training

CSD Ratings

O2

O1

O2

O3

O4

O5

O6

O8

O4 O6

O1

O5

O7

O8

O7

O3

Situation for AMEDA

- AMEDA Website- AMEDA risk profiles- TM Assessments- Regional Comparison

AMEDA Website

AMEDA Documentation Screen

AMEDA Depository Risk Profiles

TM Assessments – Reports – Depository Service

Depository Assessment - example

Rating

AAA

AA+

AA

AA-

A+

A

A-

BBB

BB

B

CCC

CC

C

Regional Comparison – Overall Risk Rating

Less important Important Critical

Americas

Africa

Asia Pacific

Middle East

Eastern Europe

Western Europe

CSD Average Regional Ratings

TM Organisation Chart

Main Group Responsibilities

TM Group

Simon Thomas

Group Client RelationshipManagement

& Business Development

Group Technology

Ross Whitehill

Mark Crocker

Group Finance, Company Secretary

and Administration

Peter Sturdy

Canadian &Australian

offices

Ross Whitehill

Capital Market Ratings&

Overseas Advisory

Custody Ratings& Investor Services

Custody Ratings

Investor Services

consulting toInstitutions

Roger Fishwick

Joanne Parker

OverseasAdvisory

Custodian Monitoring

Nick Bradley

Tim Reucroft

Capital Market Ratings

John Woodhouse

Data Services

Data Services

Derek Duggan