The Securities Settlement System: Without Regulation, Contagion?
After the 2008 financial crisis, the demand for regulatory reform gained momentum on an international scale, expressing the belief among regulators that loose oversight had contributed to the catastrophe.
Regulating financial market infrastructures (FMI) has been among the most important aspects of this post-crisis agenda. Payment systems, securities settlement systems, and central counterparty clearinghouses are the primary components of FMIs. Before the meltdown, payment systems and securities settlement were regulated separately. Payment was recognized as the main channel that connects money markets to the “real economy.” Securities settlement systems, on the other hand, was considered a key part of the capital markets infrastructure with no direct impact on the real economy. The latter market thus received less regulatory attention.
The events of 2008, however, painfully demonstrated that capital markets and money markets are more intertwined than regulators had assumed. Post-crisis regulatory architecture acknowledges their inseparable linkage, with officials putting both markets at the heart of the new legislation. Yet in practice, capital markets remain underregulated compared to money markets and the banking sector, which have received a great deal of attention in recent years.
FMI is an area where this regulatory imbalance is pertinent. After the crisis, central bankers and securities regulators joined together in an effort to harmonize their recommendations for payment and securities settlement systems based on their recognition that the two markets are closely interconnected. Again, though, efforts to secure banks’ payment systems have overshadowed the safety of security settlements in practice.
In the European Union, for instance, the regulation of payment systems, which are largely owned by the banks, is in a more advanced stage than the regulation of securities settlements. The Directive on Payment Services provides the legal foundation for the creation of an EU-wide market for payments. The agreed final rule was published in 2015 and entered into force in 2016. The Central Securities Depositories Regulation (CSDR), on the other hand, is not effectively regulating the market yet. Despite CSDR becoming law in 2014, the adoption of the settlement system’s technical standards has been delayed.
Before the crisis, “financial Intermediation” was assumed to be the essence of banking, with banks acting as intermediary transferring loanable funds from non-bank savers to non-bank borrowers. Payment systems, as a result, stood alone as the key element of financial infrastructure. But the crisis marked that view as an illusion. In modern finance, credit creation is at the heart of banking. Banks are significant players in both money markets and capital markets, as they finance most of their lending by borrowing in the capital markets. It is repurchase agreement market, “repo” for short, and not necessarily bank deposits, that ultimately finances bank customers. As a result, receiving and settling securities in the repo market helps to smooth lending to the real economy.
Bank lending has other impacts on the securities market too. Interest rate changes significantly affect movements in securities. By creating new monetary purchasing power, banks affect the price of money, i.e., interest rates, which influence the valuations of capital assets such as derivatives. For one thing, the rate on risk-free assets such as bank deposits is a key determinant of the value of risky assets, such as securities. Also, a substantial category of derivatives, including futures, are “marked to market,” which pegs their value to that assigned by investors rather than book value.
As cash and securities circulate among buyers and sellers, the prices of assets will fluctuate, sometimes wildly, creating risk that one or more of the parties to a transaction will not be able to fulfill these obligations. The primary role of securities settlement systems is to reduce this liquidity risk and prevent it from becoming credit risk and potentially a systemic peril.
Bank lending stirs a series of cascade effects that ultimately involve settlement systems. The financial crisis was the devastating manifestation of this interconnectedness. In the capital markets, securities settlement is crucial in managing risk and preserving liquidity, and it should be secured with as much robustness and sophistication as payment settlement in the banking system. We will be in a much better position to prevent another crisis if we ensure the protection of both.
 The International Organization of Securities Commissions developed the Objectives and Principles of Securities Regulation (IOSCO, 1998), and the Committee on Payment and Settlement Systems of the Group of Ten countries’ central banks created the Core Principles for Systemically Important Payment Systems (BIS, 2001).