Risks in the payment systems
The payment and settlement systems are an essential part of the country’s financial infrastructures, and their efficient operation contributes to the country’s entire economic performance and stability. However, if the payment and settlement systems do not operate properly, they may expose their participants and the other payment and settlement systems to various risks in a way that could impair their stability and efficiency. For instance, the systems may be exposed to a systemic risk, a legal risk, a credit risk, a liquidity risk, an operational risk, a general business risk, or a custody and investment risk. The type and level of risk inherent in a payment and settlement system and/or in its participants will be dependent on the type and structure of the system.
The BIS Principles for Financial Market Infrastructure (PFMI) set out recommendations for supervising these infrastructures in order to identify the existing risks in their operations and take steps to mitigate those risks.
Stable and efficient financial market infrastructures mitigate systemic risk. However, they may themselves be exposed to system risk, since the inability of one or more participants to do what is expected of them may lead to the inability of other participants to meet their obligations on time. Under such circumstances, there may be a variety of “domino” effects, and the financial market infrastructure’s inability to complete settlement may have significant negative effects on the markets that it serves and on the economy as a whole. These adverse effects may, for instance, be due to the annulling or cancellation of payments and deliveries; a delay of settlement or the close-out of transactions with guarantors; or the immediate exercise of collateral or other assets at clearance prices. If a financial market infrastructure takes such measures, its participants may suddenly face significant and unexpected credit or liquidity exposures that it would be very difficult to manage when they occur. This may lead to additional interruptions in the financial system and to impaired public trust in the collateral, suitability, or reliability of the financial infrastructure.
Financial market infrastructures should be interlinked or interdependent. They may have common users, and they may serve institutions and markets that are interconnected. Complex interdependencies may be a normal part of the structure and operation of a financial market infrastructure. In many cases, these interdependencies have helped inject significant improvements in the safety and efficiency of the financial market infrastructure’s operations and processes. However, interdependencies may also be an important source of systemic risk. For instance, they may increase the potential for the rapid and broad spread of interruptions in various markets. If one financial market infrastructure is dependent on the proper functioning of one or more other financial market infrastructure(s) with regard to the payment, settlement, clearance or recording processes, then interruptions in one financial market infrastructure may concurrently interfere with another. These interdependencies may “infect” more than one financial market infrastructure and their participants, and harm the entire economy.
Financial market infrastructures and their participants may be exposed to legal risk. This is the risk of an unexpected application of a law or regulation, which generally leads to a loss. Legal risk may be created even if the application of the relevant laws or regulations is not a certainty. For instance, legal risk includes the risk faced by a counterparty due to unexpected application of a law that makes certain contracts illegal or unenforceable. Legal risk also includes the risk of loss due to a delay in recovery of financial assets or the freezing of a position due to legal proceedings, in cross-border or domestic contexts. Various laws may apply to individual transactions, individual activities, or individual participants. Such cases may lead to losses for financial market infrastructures or their participants due to the court’s unexpected application of a certain law or application of a law in a different way than defined in the contract, in the relevant jurisdiction.
Financial market infrastructures and their participants may face different types of credit risk: the risk that a counterparty—participant or other entity—may not be able to meet its monetary obligations in full at the repayment date or at any point in the future. Financial market infrastructures and their participants may face a risk of replacement costs (generally relevant to presettlement risk), or fund risk (generally relevant to clearance risk). Replacement cost risk is the risk of a loss of profits prior to realization in respect of transactions with a counterparty that have not been settled. The accepted risk is the cost of replacing the initial transaction at current market prices. Fund risk means that the counterparty will lose the full value of the transaction—for instance, the risk that the seller of a financial asset will deliver the asset in a way that cannot be cancelled, but will not receive payment for it. Credit risk is also derived from other sources, such as a failure of an interconnected settlement bank, trust, or financial market infrastructure, or their inability to pay off their financial debts.
Financial market infrastructures and their participants may face liquidity risk. This is a risk that a counterparty—a system participant or another entity—may not have sufficient cash to cover its monetary liabilities in the expected way or timing, even though it may be able to do so in the future.
Liquidity risk includes the risk that the seller of an asset may not receive payment at the payment date and may need to borrow or realize assets for liquid cash in order to make other payments. it also includes the risk that the purchaser of an asset may not receive the product that it purchased at the designated time, and may need to borrow that asset in order to meet its delivery obligation. Therefore, the two parties to a financial transaction both have a potential exposure to liquidity risk on the settlement date.
Liquidity problems have the potential to create systemic problems, particularly if the liquidity problems are created when the markets are closed or illiquid, or when asset prices change rapidly or arouse suspicion regarding repayment capability.
Liquidity risk may also arise from other sources, such as the failure of a settlement bank, nostro agents, trust banks, liquidity suppliers, or interconnected financial market infrastructures, or the inability of such entities to do what is expected of them.
All financial market infrastructures face operational risks, which occur when deficiencies in information systems or internal processes, human error, management failures, or interruptions due to external events lead to the reduction, deterioration, or collapse of the services provided by the financial market infrastructure. Such operational failures may lead to delays, losses, liquidity problems, and in some cases systemic risks. Operational deficiencies may also reduce the effectiveness of the risk management measures that the financial market infrastructures may take, for instance by impairing their ability to complete settlement or by preventing them from monitoring and managing their credit exposures. In the case of trading systems, operational deficiencies may limit the usability of the transaction data held by the system. Potential operational failures include errors or delays in processing, system shut-downs, insufficient capacity, fraud, and data loss or leakage. Operational risk may be due to internal or external sources. For instance, participants may create operational risk to financial market infrastructures and other participants, and this risk may lead to liquidity or operational problems in the broad financial system.
General business risk
Financial market infrastructures face general business risks. These risks have to do with the management and operation of the financial market infrastructure as a business organization, with the exception of risks that involve the failure of a participant or of another entity, such as a settlement bank, a global trust, or another financial market infrastructure.
General business risk relates to a potential worsening of the monetary situation of a financial market infrastructure (as a business organization), due to a decline in income or an increase in expenses, due to which expenses are higher than income, and which causes a loss that is absorbed by the organization’s capital. Such a worsening may be caused by the effects of negative publicity, the failure of a business strategy, an ineffective response to competition, losses in other business units of the financial market infrastructure or of its parent company, or by other business factors. Business losses may also be due to other risks, such as legal or operational risk. Failure in managing general business risk may lead to interruptions in the financial market infrastructure’s business activity.
Custody and investment risk
Financial market infrastructures may also face custody and investment risks in respect of assets they own or assets they hold on behalf of their participants.
Custody risk is the risk of losses on assets held in custodianship. Such losses may be caused in a case where a trust (or secondary trust) defaults, is negligent, is fraudulent, fails in its management, or keeps improper records.
Investment risk is a risk that a financial market infrastructure will absorb losses when it invests its resources or those of its participants, such as collateral. These risks may be relevant not only for the costs of holding and investing the resources, but also for the safety and reliability of the financial market infrastructure’s risk management systems. The failure of a financial market infrastructure to protect its assets may lead to credit problems, liquidity problems, or harm to its reputation.