Over the last 30 to 40 years, there has been much greater level of intermediation in relation to savings and money markets. Most banks are unable to fund more than half of their lending from deposits. They accordingly need to source monies on money markets from other banks and through other intermediaries by whom monies and money like (highly liquid investments) are held.
A bank’s treasury division manages liquidity and funding requirements. It is exposed to risks in relation to various matters including exchange rate and interest rate exposure. In order to meet the bank’s requirements, it engages in interbank lending, purchase and sale of securities, derivative transactions, foreign exchange, repo transactions and debt issuing.
Wholesale market refers to markets in which bank source their financing. It is critical to the wholesale banking market that counterparty participants are financially stable. Regulators play a key role in solvency of the participants and stability.
The global financial crisis which Ireland particularly hard, had a dramatic and catastrophic effect on bank funding. It has caused fundamental changes in global banking. The crisis followed prolonged stable period of low interest rates. It showed that many of the structures were flawed and highly vulnerable to the events which occurred.
The European Union instituted significant banking reform. Part of the objective was to break the vicious circle between banks and sovereigns. New capital requirements, CRD IV were introduced. Agreement was reached in December 2012 on the single supervisory mechanism and oversight for certain credit institutions.
The European Stability Mechanism has authority to recapitalise banks once all banks are under proper supervisory arrangements. The regulation establishes the European Banking Authority. The Central Bank’s monetary tasks and supervisory task will be separated to avoid conflict of interest.
In November 2014, the European Central Bank assumed prudential supervision of significant credit institutions after a wide-ranging asset quality review and stress tests of Eurozone banks. The Bank Recovery and Resolution Directive was introduced. The European Markets Infrastructure Regulation deals with key financial infrastructural issues.
The payment system is the method by which the money is transferred between wholesale bank market participants. It is critical to its functioning and that is effective, and the participants can have complete confidence in it. The Payment system is supervised by regulators.
It is critical to the payment system that there is prompt and complete settlement, so that there is a minimum time during which parties might have an exposure to the other. Central Banks have sought to achieve real time gross settlement with immediate settlement.
The Irish system is called IRIS and is part of the ECB’s payment system TARGET, Trans-European Automated Real-time Gross Settlement Express Transfer System.
The euro system has a shared technical platform for real-time gross settlement known as TARGET2 which replaced the initial decentralised structure originating from the late 90s.
Clearing and settlement system involves the seller of a security, transferring ownership and receiving payment in return. The clearing and settling of a transaction involve matching the terms of trade entered and confirmation issued. Clearance involves the establishment of the buyer and seller’s obligations. Delivery involves delivery of the security and payment involves the corresponding payment.
Clearstream and Euroclear Bank are international central security depositories in Luxembourg and Brussels. Most European security trades are settled through them. They hold securities in centralised accounts which are recorded and updated by computer entry. They are vital to the infrastructure that allows security settlements.
The transfer of securities is recorded electronically without any physical certificates of transfer. The international central securities depositories link to the national securities depositories. A certain number of securities traded in Euroclear are held by national security depositories that are members of Euroclear.
2014 Central Security Depositories Regulation provides for common rules and uniform licensing for central securities depositories. There is now a harmonised regime for settlement with common authorisation and supervision and regulatory framework.
The TARGET2-Securities project was aimed at addressing fragmentation in security settlement infrastructure. It seeks to achieve greater technical harmonisation in the European security settlement market. TS2 is a single platform for settlement of securities that is applicable where cash instruments are settled in central securities depositories, custodian banks and agent banks. It is to operate in a single technical platform.
Netting is a central feature of settlement of transactions at the wholesale level. Netting is set-off of multiple payment obligations and payment of the net amount due by one party to the other. It considerably reduces the risk of insolvency and so-called settlement risk. It reduces the number of payments required and the risk of errors. It settles obligations as at a certain point in time.
The risks associated with the wholesale banking market are classically described as settlement, systematic credit and market risk and net liquidity risk. Settlement risk is the risk of default in wholesale bank trades if an entity became illiquid at a point in time, it would leave very substantial obligations to counterparties.
Systematic risk is knock-on risk due to failure by one entity to meet its obligations. Because of the speed of transactions and interconnectivity, the failure of one bank could immediately cause contagion and cause multiple banks to fail.
These risks arose loomed large in the financial crisis of 2008-2009. Accordingly, regulators and legislators have focused worldwide on managing and reducing such risks.
Credit risk and market risk. Settlement risk focuses on default at the time the obligation is due to be made. If a party becomes insolvent at that point, it could have severe consequences and very arbitrary consequences and results.
Credit and market risks are risks of inability on the part of counterparty to complete its obligations that it has entered. That is, credit risk and market risk is a risk that changes in market value of financial assets causing a financial loss.
Liquidity risk is risk of having insufficient short-term funds available to meet obligations as they arise. Certain instruments including in particular classes of derivatives which were assumed to be liquid become illiquid during the financial crisis. Regulators focused on liquidity. The committee on bank supervision, Basel Committee on Bank Supervision has established principles for sound liquidity, risk management and supervision.
The Continuous Linked Settlement (CLS) commenced in 2002. It is a global foreign exchange settlement system by which banks seek to reduce settlement risk. Banks may participate in CLS by joining as a settlement bank or third party. Settlement banks maintain currency accounts at CLS Bank and settles eligible financial trades with other members through that account.
CLS settles transactions in 17 currencies including the euro, dollar, sterling and other major currencies. It operates on the basis of payment versus payment to eliminate the risk that one party may have settled first before the other with the risk of an intervening insolvency. CLS does not release bank’s payment until the other counterparty payments has been made payment, so that funds are simultaneously exchanged.
A bank which is a third-party member submits trade through a settlement member which settles the trade with the CLS. The third party’s relationships are with the settlement member, not CLS.
The volume of trades handled by CLS is of the order of several million a day with settlements being of the value of several trillion euro a day. There are nearly 10,000 participants of which 63 are members of CLS.