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 – SEC17F7, FSA,G30, 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 A3A4 A1 A2 A3 A4 A6 A5 CSD Risk Rating A2 A5 A1 A6 Less ImportantImportantCritical AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C CSD Ratings Risk Profile Asset Commitment Risk Liquidity Risk Counterparty Risk Financial risk Operational Risk Asset Servicing Risk

Asset Commitment Risk 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 participants 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

CSD old CSD new CSD Ratings Rating AC4 AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Asset Commitment Risk Less importantImportantCritical AC1 AC2 AC3 AC4 AC3 AC1 AC2 Inter-broker - Sales Inter-broker - Purchases Broker-custodian – (Selling Broker) Broker-custodian – (Buying Broker) Broker-custodian – (Custodian) Free of payment AC5 AC6 AC5 AC6

Liquidity Risk 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

Rating AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C CSD Risks Liquidity Risk CSD old Less importantImportantCritical Processing Model 2 – on exchange Processing Model 1 – off exchange Credit Facilities Stock lending and Borrowing Fails management Registration Deposited securities Matching Processing Model 1 - Same Day Trading CSD Ratings CSD new L1 L2 L3 L4 L5 L6 L7 L8 L6 L3 L1 L8 L2 L5 L4 L7 L9

Counterparty Risk 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

Rating AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Counterparty Risk CSD old Less importantImportantCritical Participation Criteria Participant concentration Surveillance DVP – Inter-Broker DVP - Broker-custodian Settlement Assurance CSD Ratings CSD new C1 C2 C3 C4 C5 C6 C3 C4 C5 C1 C6 C2

Asset Servicing Risk 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

Rating AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Asset Servicing Risk CSD old Less importantImportantCritical Info Collection Info Dissemination Receipt of Instructions Execution of Instructions Proxy Voting Other Services CSD Ratings CSD new AS1 AS2 AS3 AS4 AS3 AS4 AS1AS2 AS6 AS5

Financial Risk 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 m 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)

CSD new Rating AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Financial Risk CSD old Less importantImportantCritical Capital Structure Earnings performance Ownership Access to Credit Insurance Coverage Operational claims Investment in infrastructure CSD Ratings F1 F2 F3 F4 F5 F6 F7 F6 F5 F7 F3 F4 F2 F1

Operational Risk 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

CSD new Rating AAA AA+ AA AA- A+ A A- BBB BB B CCC CC C Operational Risk CSD old Less importantImportantCritical Established procedures Identification of key controls Operational Audit Processing Reporting Disaster Recovery procedures Business Continuity Plan Staff training CSD Ratings O2 O1 O2 O3 O4 O5 O6 O8 O4O6 O1 O5 O7 O8 O7 O3

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

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

TM Organisation Chart