One of the most significant risks that has plagued markets since the beginning of time has been that a seller would deliver their securities (equities, bonds, money market instruments), but would not receive payment in return, or that the buyer would make payment and will not receive what they had paid for. This is referred to as Principal Risk.
The Knock-on Effects of Principal Risk
Today, the financial markets are certainly not immune to Principal Risk. In many ways, developments have made things more complex - with buyers and sellers of securities located further apart. Trading practices have changed and the electronic systems that are used have become more sophisticated, as the markets have sought to address other risks or issues faced. In many instances, one has no idea who the counterparty is or where they are situated, let alone whether they are even in a position to fulfil their obligations in terms of the transaction. As a result, onus has been placed on a variety of intermediaries to manage these risks and provide others with assurance. The integration of systems across the intermediary chain means that the effective mitigation of Principal Risk (at an individual transaction level) is essential. The consequences of hypothetically having a small percentage of transactions fail due to Principal Risk could have profound implications on the financial system. Should one financial institution be unable to meet its obligations, it will impact another institution’s ability to meet its own obligations as well…creating greater financial market contagion or systemic risk.
Delivery versus Payment (DvP): Designed to mitigate Principal Risk
Those challenges have resulted in the introduction of the concept of Delivery versus Payment (DvP), which is specifically designed to mitigate Principal Risk and protect against widespread contagion. DvP can be achieved in a number of ways, but even in this area, markets have evolved to allow for the efficient delivery of securities in exchange for cash.
For as long as we can remember, banks have provided us with a trusted service in respect of our money – and it is only when we physically require actual bank notes that we draw them out. If not, we rely on our ability to instruct our bank to transfer money safely and efficiently through the banking system to an appointed recipient.
Similarly, the first Central Securities Depository (CSD) was created just over 40 years ago and was designed to provide a trusted service in respect of securities, using its independent, secure environment in which the ownership (and transfer of ownership) of securities is recorded and maintained. The creation of a CSD to perform this function has become a critical component of the financial markets around the world, and South Africa is no different.
The Golden Triangle
The challenge for markets, however, is just how do the banks and the CSD interface with each other to ensure an effective DvP process. Regulators and practitioners around the world have long recognised that the ultimate DvP process also embodies the legal certainty that the final settlement of one obligation (say the cash movement) is contingent upon the final settlement of the other (the securities) and that these are both irrevocable at a point in time. This process (often referred to as the Golden Triangle) is essentially:
- For the CSD to reserve (or block) the securities that have been sold in its system;
- For the CSD to then instruct the bank (appointed by the buyer) to transfer the funds to the sellers’ account; and finally
- For the reservation on the securities to be lifted and the securities moved from the transferring party to the recipient party, thereby transferring ownership of the securities to the recipient.
Additional protection for investors - SFIDvP
One of South Africa’s Financial Market Infrastructures is the Central Securities Depository, Strate. In conjunction with the other financial market stakeholders, Strate chose at the outset to develop the most secure method of DvP possible - simultaneous, final and irrevocable Delivery versus Payment (SFIDvP) using the Central Bank, i.e. the South African Reserve Bank (SARB).
Why the Central Bank?
Commercial banks perform multiple roles in the market (such as taking deposits and granting credit to their clients) and this exposes them to credit and liquidity risks. The Central Bank, on the other hand, has the lowest possible credit risk exposure in any given market.
By Strate interfacing directly with the South African Multiple Options System (SAMOS) operated by the SARB, SFIDvP has become one of the cornerstones of our market.Both credit and liquidity risks are significantly reduced because of the risk profile of both the SARB and Strate as the CSD. Not only does the SARB have the lowest possible credit risk exposure in any given market, every transaction that is processed through its South African Multiple Options System (SAMOS) is collateralised, adding additional layers of security. In addition, Strate only deals with operational risk and is not exposed to counterparty credit risk. This provides both local and foreign investors with a measure of comfort in the settlement process that has been rated at one of the best in the world.
With the value of securities settlements exceeding R2 trillion on a monthly basis, a large portion of which can be attributed to the bond / debt market where liquidity is essential, it clearly highlights the important role that Strate plays in the mitigation of Principal Risk and the promotion of financial market stability.
Alignment to International Standards
The settlement model implemented by Strate has been affirmed time and again, as international standards (such as the CPSS-IOSCO Principles for Financial Market Infrastructures) clearly favour the use of central bank money in securities settlement models. Principle 9 of the Principles for Financial Market Infrastructures states that a “Financial Market Infrastructure should conduct its money settlements in central bank money where practical and available.”
Many markets around the world have not yet achieved this particular standard and are now having to earnestly re-assess their settlement models to establish just how they can achieve something that is fast becoming a ‘not negotiable’ requirement designed to protect the investor.
South Africa’s markets have provided SFIDvP through Strate and the SARB for over 17 years. Both parties provide integral elements in the processes that seek to ensure the stability of our financial markets. Given the efficiencies created and the mitigation of risk achieved, one shouldn’t even need to ask of the importance of settlement using SFIDvP in central bank funds.