22 Years since Lamfalussy: Infrastructure Issues

The Committee on Payment and Settlement Systems and the International Organization for Securities Commissions have jointly published a report, “Principles for Financial Market Infrastructures.” FMI, for these organizations, refers to the sum of the systems that facilitate the clearing, settlement, and recording of financial transactions. The CPSS-IOSCO report warns that if the systems involved are not up to their tasks, they could “pose significant risks,” and that FMI may prove a “source of contagion” in periods of great market stress.

Along with this report, IOSCO and CPSS have published two consultation papers on how best to strengthen that infrastructure.

These organizations hope specifically to advance consistency in the oversight and regulation of such systems around the world. CPSS and IOSCO have worked on such issues for more than a decade.  It was in January 2001 that CPSS published “Core Principles for Systemically Important Payment Systems,” which in turn drew upon the G10’s Lamfalussy Report of November 1990. These issues, it seems, we have always with us.

Payment Systems

Payment systems remain a big part of FMI and thus of the latest report. In broad conceptual terms, as the report explains, all payment systems have four stages of processing: submission; validation; conditionality; settlement.

The submission of a payment to the payment system is in a sense the most intuitive. (Thus, in CPSS-IOSCO’s Box, shown below, used to illustrate these four stages, there isn’t much to be said in that column.) Validation requires that the submission satisfy “key data elements.” If it doesn’t, the submission is rejected. If it does, the processing proceeds to the conditionality stage. This stage, too, can end in rejection – or the submission might move smoothly on to settlement.

It is at the stage of settlement that a critical distinction becomes evident. Some retail systems are real-time gross settlement, others are deferred net settlement. Central banks typically use a Large-Value Payment System, which use an RTGS “or equivalent mechanism.”

Though all this may seem straightforward, it can lead to tangles. For example, questions often arise as to whether transactions entered into by an insolvent party will be treated as final, or whether and at what stage(s) in the process they may be treated as “void or voidable by liquidators and relevant authorities.” Some jurisdictions have “zero-hour rules,” that may have the effect especially within RTGS systems, of reversing a payment that appeared to have been settled.

The conjunction of a zero-hour rule and a DNS system is probably less annoying for the counter-parties than such reversals, but it can entail a recalculation of net positions, with significant impacts of participant balances.

From: CPSS-IOSCO – Principles for Financial Market Infrastructures

Either way, awkward and unexpected results from insolvency are among the legal risks to which inadequate FMI can lead. There are also credit risks (such as the risk “that counterparty will irrevocably deliver the asset but not receive payment”), liquidity risks, etc.

Principles Set Out

The way to address such risks is by adherence to a set of 24 principles which the CPSS and IOSCO have helpfully set out. Principle 1, for example, is: “An FMI should have a well-founded, clear, transparent, and enforceable legal basis for each material aspect of its activities in all relevant jurisdictions.”

Principle 23 is especially worth quoting here. It requires that an FMI “should have clear and comprehensive rules and procedures and should provide sufficient information to enable participants to have an accurate understanding of the risks, fees, and other material costs they incur by participating in the FMI. All relevant rules and key procedures should be publicly disclosed.” That sounds like there are two distinct but of course interrelated disclosure standards, one for the benefits of system “participants” and the other for the “public.”

One of the related CPs concerns “assessment methodology.” That is: how might observers tell whether the principles set out in the report are being observed?

The other CP is about the “disclosure framework,” that is how can FMIs best communicate to the public, given that a comprehensive level of disclosure that expected of them under Principle 23 of the report.

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