Management of Risk in CSDs presentation to AMEDA

Management of Risk in CSDs - presentation to AMEDA members John Woodhouse 25 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 – SEC 17 F 7, FSA, G 30, 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 CSD Ratings AA A Risk Profile AA + A 1 A 2 AA A 3 A 4 Asset Commitment Risk A 2 Liquidity Risk A 3 Counterparty Risk A A 4 Financial risk A- A 5 Operational Risk BB B A 6 Asset Servicing Risk AA- A 1 CSD Risk Rating. A 5 A+ A 6 BB B CC C Less Important Critical

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

Asset Commitment Risk CSD Ratings Rating AC 5 AAA AA+ AC 1 Inter-broker - Sales AC 2 Inter-broker - Purchases AC 3 Broker-custodian – (Selling Broker) AC 3 AC 4 AA AA- CSD ‘new’ AC 4 A+ Broker-custodian – (Buying Broker) A CSD ‘old’ AC 5 A- AC 6 BBB AC 1 BB AC 2 Broker-custodian – (Custodian) Free of payment B CCC CC C AC 6 Less important Important Critical

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

CSD Risks Liquidity Risk CSD Ratings Rating L 6 AAA L 1 Processing Model 2 – on exchange AA+ L 2 L 3 AA AA- Processing Model 1 – off exchange L 7 L 9 L 3 A+ L 5 L 4 A Credit Facilities CSD ‘new’ L 1 L 5 A- Stock lending and Borrowing CSD ‘old’ BBB L 8 BB L 2 L 6 L 4 L 7 B L 8 Fails management Registration Deposited securities CCC Matching CC L 9 Processing Model 1 - Same C Less important Day Trading Important Critical

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

Counterparty Risk CSD Ratings Rating AAA C 1 Participation Criteria AA+ C 2 Participant concentration C 3 Surveillance C 4 DVP – Inter-Broker AA C 2 C 3 AA- C 4 C 1 CSD ‘new’ A+ C 6 A CSD ‘old’ ABBB C 5 BB B CCC CC C Less important Important Critical C 5 DVP - Broker-custodian C 6 Settlement Assurance

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

Asset Servicing Risk CSD Ratings Rating AAA AA+ AS 1 Info Collection AS 2 Info Dissemination AS 3 Receipt of Instructions AS 4 Execution of Instructions AA AA- AS 4 A+ A AS 6 AS 5 CSD ‘new’ CSD ‘old’ AS 3 AS 5 AAS 6 AS 2 BBB AS 1 BB B CCC CC C Less important Important Critical Proxy Voting Other Services

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. m Net capital m Operationally profitable m Comprehensive insurance m Any principal activity fully collateralised/ managed m Limited commercial activity m Limited liability (exclude indirect losses) m

Financial Risk CSD Ratings Rating AAA F 1 AA+ F 2 AA F 3 AAF 7 CSD ‘old’ F 3 F 4 F 1 F 4 A- F 5 CSD ‘new’ BBB F 6 Ownership F 7 B CCC CC Less important Important Access to Credit Insurance Coverage Operational claims F 5 BB C Earnings performance F 2 A+ A Capital Structure Critical Investment in infrastructure

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

Operational Risk CSD Ratings Rating AAA AA+ O 1 AA AA- O 5 A CSD ‘new’ A- O 4 O 6 CSD ‘old’ BBB O 3 BB O 7 B CCC CC C Less important Important Established procedures O 2 Identification of key controls O 3 Operational Audit O 4 Processing O 5 Reporting O 6 Disaster Recovery procedures O 2 O 8 A+ O 1 Critical O 7 Business Continuity Plan O 8 Staff training

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

Regional Comparison – Overall Risk Rating CSD Average Regional Ratings Rating Americas AAA Africa AA+ Asia Pacific AA Middle East AA- Eastern Europe A+ Western Europe A ABBB BB B CCC CC C Less important Important Critical

TM Organisation Chart