Evaluation of the Securities Settlement System

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1 of the Securities Settlement System September 2007 Introduction This note presents an evaluation of the securities settlement system managed by S.D. Indeval S.A. de C.V., Mexico s central securities depository, according to the Recommendations for Securities Settlement Systems 1 (BIS 2001). The evaluation only includes recommendations related to Indeval s services and responsibilities. An evaluation of aspects related to securities trading in Mexico, which is not directly related to Indeval (Recommendations 2, 3, 4, 5, 12 and 18), is presented in the appendix. The evaluation used the Methodology for the of Recommendations for Securities Settlement Systems 2 (BIS 2002), and each recommendation is assigned one of the following categories: complies, complies overall, complies partially, does not comply, does not apply or not evaluated. The table below shows an executive summary of the evaluation results. results by category Summary Category Recommendations Complies 6, 7, 8, 10, 13, 14, 16, 19 Complied overall 1, 17 Complied partially 15 Does not comply 11 Does not apply, not evaluated

2 System evaluation Legal risk R1. Legal framework Securities settlement systems must have a solid legal base that is clear and transparent in all jurisdictions. Complies overall. The laws, regulations, standards and procedures and contractual provisions governing securities settlement system transactions are available to the public, and system participants can easily access them through the Internet. The laws are clear. Indeval is updating standards and procedures and is using this review to make them clearer and more precise. Laws governing securities settlement systems establish clear legal bases and a high degree of legal protection for each aspect of the settlement process. In the event of insolvency by one of the system s participants, standards and contracts can be enforced. Furthermore, the settlement system does not provide credit. Cross-border transactions within the system are relatively low. International operations accounted for 0.27% of the total number of transactions in February 2007, representing 0.28% of the total. The securities balance through custodian banks abroad or in international deposits was 2.78% of the total amount Indeval held in custody at the end of the same month. The Securities Market Act (SMA), the Payment Systems Law (PSL, for its acronym in Spanish), and Indeval s internal regulations and operating manual govern and provide certainty to securities transactions. In particular, the immediacy with which securities transactions are settled through Indeval is rooted in the PSL. Settlement risk R6. Central securities depositories (CSDs) Securities should be immobilized or dematerialized and transferred by book entry in CSDs to the greatest extent possible. 2

3 Documents covering securities issued in Mexico must be issued. However, it is possible to cover the entire issuance in one document (immobilization). Indeval is the physical depository for most of the securities it trades with the exception of securities issued by the Federal Government and securities held in external vaults (securities issued abroad). Custody (securities entry) and transfer of securities in Indeval takes place through electronic entries only. R7. Delivery against payment (DAP) CSD must eliminate the main risk linking securities transfers to fund transfers so that delivery is against payment. Indeval system procedures and the legal and contractual framework ensure DAP in all buy/sell transactions participants instruct as such. More than 98% of transactions which take place between participants in the Indeval system are settled via DAP. The other 2% consists of free payment transfers at the instruction of participants. These numbers do not include inter-account transactions by a single participant or transactions between Banco de México and participants. R8. Settlement completion time Settlement must be completed no later than by the end of the settlement day. In order to reduce risks, settlement must be immediate, intraday or in real time. Indeval system settlement completion occurs when the system credits and debits the corresponding securities and cash accounts. This takes place through different settlement processes that are executed at least four times each hour during normal trading times. 3

4 R9. CSD risk controls for dealing with participants non-compliance with settlement CSDs that provide intraday credit to participants, including CSDs which operate net settlement systems, must establish risk controls which at a minimum ensure timely settlement in the event of the participant with the biggest payment obligation being unable to settle. The most reliable set of controls consists of a combination of guarantees and limits. Does not apply. The Indeval system does not allow for debtor securities balances. The system does not grant credit. Settlement is restricted to a series of transactions which leave all participants balances higher than or equal to zero. R10. Assets for cash settlement Assets used to settle final payment obligations arising from securities transactions should involve little or no credit or liquidity risk. If the central bank s money is not used, measures should be taken to protect CSD members from possible losses and liquidity pressures arising from the insolvency of the cash settlement agent whose assets are used. Indeval performs settlement using money deposited in a Banco de México account. Operating risk R11. Operating reliability Sources of operating risk that arise during the clearing and settlement process must be identified and minimized through the development of systems, controls and adequate procedures. Systems must be reliable and secure and have sufficient capacity to process a higher transaction volume. There must be contingency plans and backup systems for the timely recovery of transactions and completion of the settlement process. Does not comply. 4

5 Indeval has policies for controlling the operating risks of its computer system (Interactive System for Securities Deposit, SIDV for its acronym in Spanish) and published them on the Internet site. These policies have not proven sufficient to fully mitigate risks owing to system limitations as well as a low level of automation. The SIDV is not easily able to process a relatively high number of transactions. Indeval is developing a new system to fulfill this recommendation. Indeval has contingency plans that are updated and reviewed by a security committee. Other aspects R13. Corporate governance Agreements related to the corporate governance of CSD and central counterparty entities (CCE) must be designed so as to meet public interest requirements and achieve owner and user objectives. Corporate governance risks are clearly specified and information about them is available to the public. The most relevant objectives and decisions are at the disposal of owners, users and public authorities. Senior management has the incentives and capacity required to achieve such objectives and is responsible for its performance. Indeval s board of directors has the necessary knowledge and understands the interests at stake. Indeval is a private company and all information related to its corporate structure is public. Banco de México has a permanent place on Indeval s board with a voting right at board meetings. Indeval users influence the operation through the board, executive committees and professional committees. R14. Access CSDs and CCEs must have objective participation criteria available to the public, which allow for fair and open access. 5

6 Access criteria are objective, clearly defined and available to the general public. Indeval does not preclude the direct participation of institutions which under the SMA may be its depositors, as long as they comply with established legal and systems requirements. R15. Efficiency Besides undertaking secure and protected transactions, securities settlement systems must be cost effective by complying with their users requirements. Partially complies. Indeval reviews its costs and fees and undertakes service satisfaction surveys among its clients. However, Indeval has not established that these reviews and studies must take place regularly. Recent studies performed by independent consultants concluded that the costs and fees of the Indeval system are relatively low. 3 However, the system needs to upgrade its technology and automate many processes in order to make the operation more secure and reliable. R16. Communication procedures and standards Securities settlement systems must use or adopt adequate international communication procedures and standards for facilitating efficient settlement of cross-border transactions. The system uses communication procedures that adhere to the ISO15022 standard. 3 The costs survey concluded that in 2005 Indeval s total annual cost was less than half a basis point of the total value of assets held, which is the average for the industry. As for its fees, the survey concluded that Indeval s were similar or even lower in the case of some services than other deposit fees such as Clearstream (Germany), Euroclear (Belgium), DTC (United States), CDS (Canada), and Keler (Hungary). 6

7 R17. Transparency CSDs and CCEs must provide market participants with enough information for them to precisely identify and evaluate the risks and costs associated with the use of their services. Complies overall. Market participants have information about their rights and obligations, the cost of participating in the Indeval system, the rules, regulations and laws that govern it and the related risks. The information is available on the Internet in Spanish, and some of it is available in English. Indeval publishes a draft of responses to key questions about these recommendations on its website. R19. Cross border link risks CSDs that establish links for settling crossborder transactions must design and operate them in order to lower risks associated with cross-border settlements. Indeval has custody links with US and EU international custodian and deposit banks. Credit risks associated with these links are controlled, as the system does not allow transfer to take place between local security custody accounts in central depositories it maintains a link with until the securities have effectively been credited in the respective system. However, operating risks are not controlled in the same way, as the transactions require Indeval to perform manual processes. 7

8 Appendix Pre-settlement risk R2. Negotiation confirmation The confirmation of negotiations between direct market participants must take place as soon as possible as of when the negotiation has taken place, but no later than the negotiation date (T+0). When confirmation of indirect transactions by market participants is required (such as institutional investors), it must take place as soon as possible after the negotiation has taken place, preferably on T+0 but no later than T+1. Complies overall. Banco de México requires participants to confirm all of their debt security transactions on the date they are entered into. A central counterparty called Contraparte Central de Valores de México (CCV) settles stock market transactions entered into through the Mexican Stock Exchange. The CCV and its participants are Indeval system depositors. The CCV settles its transactions by transferring securities and cash in the SIDV. The central depository is not responsible for negotiations between depositors. Direct participants comply with this provision by confirming the negotiations they undertake on their behalf in SIDV. As there are no automated mechanisms for indirect participants to confirm their negotiations in the SIDV, the direct participant may not record transactions the day they are entered into. R3. Settlement cycles All securities markets must adopt rolling settlement. Settlement must be completed no later than after T+3. The costs and benefits of a settlement cycle of less than T+3 must be evaluated. Parties can instruct the Indeval system to settle the transaction the same day as the negotiation (T). Settlement is complete as soon as Indeval records the transaction as settled and makes the information available to depositors. 8

9 R4. Central Counterparty Entities (CCEs) The costs and benefits of a CCE must be evaluated. When this mechanism is introduced, the CCE must rigorously control the risks it assumes. Not evaluated. The CCV is a central counterparty that settles Mexican Stock Market transactions. An evaluation of the costs and benefits of the CCV has not been published. Banco de México will publish an evaluation of the CCV in accordance with the Recommendations for Central Counterparties published by the BIS in R5. Securities lending Securities lending and borrowing (or repos and other equivalent economic transactions) should be encouraged as measures for facilitating the settlement of securities transactions. Barriers to securities lending must therefore be eliminated. There are no obstacles to the development and function of securities lending (or repos and other equivalent economic transactions). There are at least two systems for negotiating securities lending and their use is encouraged so that transactions are settled in a timely manner. Banco de México and the National Banking and Securities Commission (CNBV) have securities lending policies and procedures and analyze practices for ensuring the oversight of associated risks and their adequate control. Securities lending is not subject to any legal barriers. Securities lending is provided for in art. 98 of the SMA as well as other general provisions issued by Banco de México and the CNBV. Indeval offers a securities lending negotiation service. Furthermore, Banco de México lends government securities to financial intermediaries that act as market makers in order to develop the market for such securities. 9

10 Custody risk R12. Protection of clients securities Entities with securities in custody must use custodian accounting practices and procedures in order to fully protect clients securities. Clients securities must be protected from custodian creditors claims. Not evaluated. CNBV must evaluate this recommendation. Other aspects R18. Regulation and oversight Securities settlement systems must be subject to transparent and effective regulation and oversight. Central banks and securities regulators must cooperate with each other as well as with the competent authorities. Indeval is governed by the SMA and the PSL. Indeval regulators are the CNBV and Banco de México. The SMA and PSL establish clear responsibilities for each regulator. Banco de México and CNBV have different oversight responsibilities and cooperate with each other when subjects coincide. Banco de México has the capacity and resources to effectively undertake its regulatory and oversight policies. 10

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