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Updated: November 2002
Table of Contents
Under the Payment Clearing and Settlement Act (the Act) which became law on 31 July 1996, the Bank of Canada is responsible for the regulatory oversight of clearing and settlement systems with a view to controlling systemic risk. This Act is designed to contribute to the development of sound clearing and settlement systems in Canada.
Clearing and settlement systems have the potential to improve the efficiency of the clearing and settlement of Canadian dollar payment obligations by reducing credit and liquidity risks, and lowering operational costs. At the same time, because these systems concentrate these transactions at a single point in the financial system, they can present significant settlement and operational risks to the participants of a particular system, and a disruption in one system can have serious repercussions on participants in other parts of the financial system (often referred to as systemic risk), particularly if these systems process large-value payments. Since these systems are key components in the Canadian financial system, it is important that they be well-designed so that they can serve to strengthen the efficiency, soundness and stability of the Canadian financial system.
This Guideline is issued pursuant to Section 17 of the Act. The purpose of this Guideline is to indicate the principles and procedures that the Bank of Canada intends to follow in:
In addition, this Guideline briefly outlines the implications for a clearing and settlement system of being designated. The Guideline also indicates the minimum standards that designated systems will be expected to meet in order to adequately control systemic risk.
(a) Identifying eligible clearing and settlement systems
The Bank must determine whether a system is a "clearing and settlement system" as defined in the Act (referred to in this Guideline as an "eligible system"). To be within the definition, a clearing and settlement system must:
The definition of a clearing and settlement system includes systems or arrangements for the clearing or settlement of payment obligations, as well as systems or arrangements for the clearing and settlement of securities transactions, foreign exchange transactions, or other transactions, where the system or arrangement also clears or settles payment obligations arising from those transactions (Section 2 of the Act).
Clearing and settlement systems that are not eligible under the Act will be asked to supply information from time to time to monitor their status.
(b) Designation of eligible clearing and settlement systems
Section 4 of the Act provides that where the Governor of the Bank of Canada is of the opinion that a clearing and settlement system may be operated in such a manner as to pose systemic risk, and the Minister of Finance is of the opinion that it is in the public interest to do so, the Governor may designate the clearing and settlement system under the Act. (Designated systems will be informed in writing by the Governor of the Bank of Canada and a copy of the designation will be published in the Canada Gazette).
Systemic risk is defined by the Act as situations where the inability of a participant to meet its obligations in a clearing and settlement system could cause:
To determine if an eligible system may be designated under Part I of the Act, the Bank will gather information that will permit a judgement to be made as to whether it may be operated in such a manner as to pose systemic risk. In making this judgement, clearing and settlement systems which display any of the following characteristics will receive close attention when considering whether to designate a system under the Act:
These characteristics are intended to identify clearing and settlement systems that process significant volumes of large-value payments such that the failure of a participant could have substantial implications for the system or the financial markets. These characteristics are not necessarily the only factors that will be considered when deciding whether to designate a system. In addition, the Bank would expect to discuss with the clearing house of any eligible clearing and settlement system the characteristics of its system and the possible application of the Act to its system.
If the Governor of the Bank concludes that an eligible system is unlikely to be operated in such a manner as to pose systemic risk, the system will not be designated. However, the Bank will continue to monitor these systems by requesting information from time to time to determine whether conditions have changed that would warrant a re-consideration of this decision.
Implications of Being Designated
(a) Advance notice of significant changes
Clearing houses that operate a designated system are required to provide the Bank of Canada with reasonable advance notice of any significant changes to operations, arrangements, rules, procedures, or other documentation in relation to the system. In addition, clearing houses are required to provide the Bank with any other information that the Bank may request in writing. The requirement to provide the Bank with advance notice of changes is a separate and distinct regulatory requirement which applies notwithstanding any knowledge of such changes which the Bank or its employees may acquire as a participant or service provider in the designated system or as a member of the clearing house's management.
(b) Agreements
Once a clearing and settlement system has been designated, the Bank of Canada may wish to enter into an agreement with the clearing house or participants (or both) covering:
(c) Directives
Where the Governor of the Bank is of the opinion that a clearing house of a designated system, a participant of a designated system, or the system itself is operating or is about to operate or engage in an action that results or is likely to result in systemic risk being inadequately controlled, the Governor may issue a directive in writing to the clearing house (or the participants if the clearing house fails to comply or the clearing house is not located in Canada):
within a timeframe set by the Governor.
(d) Audits and inspections
To carry out its responsibilities under the Act, the Bank of Canada may conduct audits and inspections of a clearing house. Designated systems will be required to undergo annual examinations regarding their internal controls and any other matters considered necessary by the Bank to carry out its oversight responsibilities.
(e) Cost of regulation
The Bank of Canada may impose an annual fee on a clearing house covering the cost to the Bank of the administration of the Act in respect of the clearing and settlement system. In the event that the Bank imposes a fee, an explanation of the basis for the calculation of this fee will be provided to the clearing house.
(f) Settlement rules
The settlement rules of a clearing and settlement system are those rules that provide the basis on which payment obligations are calculated, netted, or settled and include rules for the taking of action in the event that a participant is unable or likely to become unable to meet its obligations to the clearing house, a central counter-party or the other participants. When a system is designated, the operation of these rules will have certain protections from legal challenges based on other statutes or laws of Canada or a province.
(g) Day-to-day operations of designated systems
Primary responsibility for the reliable day-to-day functioning of a designated clearing and settlement system lies with the system's clearing house and participants. The Bank, in carrying out its oversight activities, does not get involved in the daily operations of designated payments systems. The Bank does not ordinarily get involved in the resolution of day-to-day operational issues or minor design issues which do not have risk implications, except to the extent that the Bank is itself operationally involved as a participant or as a provider of a particular service to the designated system, in which case its involvement will be as a participant or service provider. If the operational or design issue has the potential of system consequences, the Bank may become involved from a regulatory oversight standpoint.
The Bank does not oversee relations between the participants in a designated system and their customers.
Minimum Standards for Designated Clearing and Settlement Systems
The Bank of Canada has been actively involved with other central banks in initiatives to improve the standards for clearing and settlement systems. This work is being carried out, in particular, by the G-10 central banks' Committee on Payment and Settlement Systems (CPSS), as well as other international bodies such as the International Organization of Securities Commissions (IOSCO). The Bank of Canada is supportive of the principles and recommendations that have emerged from these international initiatives.
This Guideline sets out the general risk-control framework for designated systems. In addition, it indicates the minimum standards that designated systems will be expected to meet in order to adequately control systemic risk. The minimum standards incorporate the principles and recommendations contained in the following two reports(1):
(a) General risk-control framework for designated systems
The following general principles will apply to all designated clearing and settlement systems.
Well-designed clearing and settlement systems that handle large-value payments will be able to provide to participants the assurance that once a transaction has been accepted by the system, that transaction has settled or that it will settle. To achieve this objective, the risks present in large-value clearing and settlement systems must be properly controlled. Appropriate mechanisms must be established that will allow credit and liquidity risks facing participants to be monitored and managed by participants or the clearing house in the system.
The Bank of Canada will want to be satisfied that designated clearing and settlement systems have addressed these risks and that the participants in these systems have the incentives and the ability to manage these risks. Rules and procedures covering the system's operations and the nature and robustness of any loss sharing arrangements are important in this regard. Appropriate mechanisms to control risk could include, for example, limits to exposures that individual participants can create vis-a-vis the system, real-time processing to ensure that limits are not violated, putting in place liquidity arrangements that will support timely settlement in the case of participant failure, and netting of rights and obligations.
Clearing and settlement systems that process large-value payment obligations and that permit the reversal or unwinding of transactions after they have been settled will be unable to meet this objective. Unwinding can be very disruptive to the financial system, does not deal with systemic risk concerns, prevents end-users of systems from receiving irrevocable funds and poses significant risks to participants of systems which employ this technique. Thus, the use of this technique by designated clearing and settlement systems as a means of dealing with the inability of a system participant to settle its obligations in a timely fashion, or to deal with general market or financial difficulties, is not considered acceptable.
Designated clearing and settlement systems that settle financial assets such as securities or foreign exchange should be designed and operated to achieve simultaneous exchange of value, so that there is no period during which one party has obtained value and the other has not. In securities markets, this is known as delivery versus payment (DvP) and in foreign exchange markets this is known as payment versus payment (PvP).
(b) CPSS core principles for systemically important payments systems
In addition to the above general principles, the Bank of Canada will apply to all designated payments systems the more specific "Core Principles for Systemically Important Payment Systems" established by the CPSS. The core principles are intended to encourage the design and operation of safer and more efficient systemically important payment systems. The core principles are set out below.
Note that the standards set out in principles (iv) and (v) are minimum standards only. Designated systems should seek to exceed these minimum standards and the Bank may require a system to exceed the standards.
Although the most direct application of these core principles is for systems which involve the transfer of funds only, the principles can also apply to the payments aspects of systemically important systems in which transfers of other financial assets, such as securities, and related transfers of funds are both settled.
(c) CPSS-IOSCO recommendations for securities settlement systems
In November 2001, a CPSS-IOSCO Joint Task Force issued a report entitled "Recommendations for Securities Settlement Systems". The Bank of Canada endorses the recommendations of the Task Force and intends to apply those recommendations which would pertain to a securities settlement system designated under the Payments Clearing and Settlement Act. Especially relevant to designated securities settlement systems are those recommendations that could have implications for systemic risk. In addition, the Bank will co-operate and work with provincial authorities and agencies, as well as the relevant self-regulatory organizations, in promoting the CPSS-IOSCO recommendations.
The CPSS-IOSCO recommendations are presented below. Recommendations which are particularly relevant to designated securities settlement systems are noted with an asterisk.
Legal risk
Pre-settlement risk
Settlement risk
Operational risk
Custody risk
Other issues
(d) Other considerations
The application by the Bank of Canada of minimum standards for designated clearing and settlement systems does not relieve the system's participants or the clearing house from the primary responsibility of designing and building adequate mechanisms to deal with potential liquidity, credit, and operational risks. In certain cases, for reasons of public policy or best practice, the Bank of Canada might expect a designated system to exceed a minimum standard.
At the same time, the Bank of Canada is aware that clearing and settlement systems are also designed to improve the efficiency of large-value payment processes. In reaching a judgement about the appropriate balance between the objectives of efficiency and safety, the minimum standards laid out above will serve as a major source of guidance.
Application of the Minimum Standards
Clearing and settlement systems that are already in existence at the time they are designated may not have adequate mechanisms for controlling systemic risk. Some time may be needed to make the necessary changes to their systems, rules and procedures to reflect the adoption of appropriate risk containment mechanisms. These periods will be determined on a case-by-case basis. Systems established subsequent to December 1997 which may be operated in such a manner as to pose systemic risk and are thus likely to be designated upon the commencement of operations, are expected to have adequate arrangements to control systemic risk prior to the start of operations. For these latter systems, the Bank of Canada is prepared to consult with the sponsors or developers of such systems regarding the likelihood of their being designated and on the nature of risk controls required to cope with systemic risk concerns. As indicated earlier, before the Governor may designate a system, the Minister of Finance must be of the opinion that it is in the public interest to do so.
Where a clearing and settlement system does not have a clearing house located in Canada (for example, a multicurrency clearing and settlement system), but is an eligible system, such a system may be designated, if appropriate. The Canadian participants in such a designated system would have all the rights available to a clearing house under the Act conferred upon them. In addition, the Canadian participants in such a system would be required to comply with the obligations imposed under the Act on the clearing house in respect of a clearing and settlement system as if the Canadian participants were the clearing house, including, for example, the provision of the information required by section 9 of the Act.
The Bank expects to work closely with the central bank in the country where such a foreign clearing and settlement system (and its associated clearing house) is located, using the framework set out in the Lamfalussy Report (the Principles for Co-operative Central Bank Oversight of Cross-border and Multicurrency Netting and Settlement Schemes). Of particular note in these principles are:
Thus, where an eligible clearing and settlement system does not have a clearing house located in Canada, the focus of the Bank of Canada's oversight activities will be on the Canadian aspects of the clearing and settlement system's operations (particularly the arrangements for clearing and settling Canadian dollar payment obligations) and any action taken by the Bank pursuant to the Act in respect of such a clearing house may be taken only in respect of the Canadian participants. As noted earlier, only clearing and settlement systems that meet certain criteria are subject to the Act. Canadian participants in clearing and settlement arrangements that do not, for example, clear or settle Canadian dollar payment obligations would not be subject to the Act, regardless of where the clearing house was located.
Conversely, oversight by the Bank of Canada of an eligible clearing and settlement system having a clearing house located in Canada may be shared with central banks in other countries should the system have certain cross-border characteristics (for example, a multicurrency clearing and settlement system, or a cross-border securities clearing and settlement system). As in the situation where an eligible clearing and settlement system has a clearing house located outside of Canada, the Bank of Canada will be guided by the Principles for Co-operative Central Bank Oversight of Cross-border and Multicurrency Netting and Settlement Schemes contained in the Lamfalussy Report.
Foreign Participants in Designated Clearing and Settlement Systems
In 1999, section 22.1 was added to the Act, empowering the Governor of the Bank of Canada to assess whether the participation of an authorized foreign bank (i.e. a foreign bank which has obtained a ministerial order under the Bank Act to carry on business in Canada through a branch) in a designated clearing and settlement system could pose systemic risk or an unacceptable risk to the Bank in guaranteeing the settlement of obligations in the system. If the Governor is of the opinion that the foreign bank's participation could pose such a risk, he may prohibit it from participating or impose conditions on its participation. This power is in addition to other powers which the Act confers on the Governor and the Bank.
To enable the Governor to make this assessment, an authorized foreign bank which intends to participate in a designated clearing and settlement system is required to provide the Bank with a satisfactory legal opinion from its home jurisdiction as to the applicability of foreign laws to the bank's participation in the system. The opinion should address, among other things, the enforceability of collateral security and netting (if the system is a netting system) under the home jurisdiction's laws. The opinion should be prepared in consultation with the Bank and submitted to the Bank well in advance of the time that the authorized foreign bank wishes to start participating in the clearing and settlement system, in order to provide the sufficient time for the Bank to assess the systemic risk implications and make a decision as to the foreign bank's participation. Model forms of legal opinions for participation in specific clearing and settlement systems are available from the Bank upon request from foreign banks wishing to participate in a designated clearing and settlement system as an authorized foreign bank.
In the event that a foreign financial institution other than an authorized foreign bank wishes to participate directly in a designated clearing and settlement system (as opposed to participating through a Canadian subsidiary or a correspondent institution), the Bank may conduct a similar assessment of foreign laws. The Bank has the power under section 6 of the Act to require the clearing house to prohibit the foreign institution from participating directly or to place conditions on its participation if the Bank is concerned that the potential application of foreign laws could pose a systemic risk or risk to the Bank.
Further information regarding this Guideline can be obtained from:
Clyde Goodlet1 These reports are available on the Bank for International Settlements web site. (go back)