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Liquidity Risk in Securities Settlement

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  • Devriese, Johan
  • Mitchell, Janet

Abstract

This paper studies the potential impact on securities settlement systems (SSSs) of a major market disruption, caused by the default of the largest player. A multi-period, multi-security model with intraday credit is used to simulate direct and second round settlement failures triggered by the default, as well as the dynamics of settlement failures, arising from a lag in settlement relative to the date of trades. The effects of the defaulter's net trade position, the numbers of securities and participants in the market, and participants' trading behaviour are also analysed. We show that in SSSs – contrary to payment systems – large and persistent settlement failures are possible even when ample liquidity is provided. Central bank liquidity support to SSSs thus cannot eliminate settlement failures due to major market disruptions. This is due to the fact that securities transactions involve a cash leg and a securities leg, and liquidity can affect only the cash side of a transaction. Whereas a broad program of securities borrowing and lending might help, it is precisely during periods of market disruption that participants will be least willing to lend securities. Interestingly, settlement failures continue to occur beyond the period corresponding to the lag in settlement. This is due to the fact that, upon observation of a default, market participants must form expectations about the impact of the default, and these expectations affect current trading behaviour. If, ex post, fewer of the previous trades settle than expected, new settlement failures will occur. This result has interesting implications for financial stability. On the one hand, conservative reactions by market participants to a default - for example by limiting the volume of trades – can result in a more rapid return of the settlement system to a normal level of efficiency. On the other hand, limitation of trading by market participants can reduce market liquidity, which may have a negative impact on financial stability.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 5123.

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Date of creation: Jul 2005
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Handle: RePEc:cpr:ceprdp:5123

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Keywords: contagion; liquidity risk; securities clearing and settlement; systemic risk;

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References

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Citations

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Cited by:
  1. Galbiati, Marco & Soramäki, Kimmo, 2011. "An agent-based model of payment systems," Journal of Economic Dynamics and Control, Elsevier, vol. 35(6), pages 859-875, June.
  2. Iori, G. & Deissenberg, C., 2008. "An Analysis of Settlement Risk Contagion in Alternative Securities Settlement Architecture," Working Papers 08/03, Department of Economics, City University London.
  3. Van Beveren, Ilke & Bernard, Andrew B & Blanchard, Emily J & Vandenbussche, Hylke, 2011. "Carry-along trade," Open Access publications from Katholieke Universiteit Leuven urn:hdl:123456789/387875, Katholieke Universiteit Leuven.
  4. Joachim Keller, 2008. "Agency problems in structured finance – a case study of European CLOs," Working Paper Document 137, National Bank of Belgium.
  5. Bernard, Andrew B & Van Beveren, Ilke & Vandenbussche, Hylke, 2010. "Multi-product exporters, carry-along trade and the margins of trade," Open Access publications from Katholieke Universiteit Leuven urn:hdl:123456789/386402, Katholieke Universiteit Leuven.
  6. John P Jackson & Mark J Manning, 2007. "Comparing the pre-settlement risk implications of alternative clearing arrangements," Bank of England working papers 321, Bank of England.
  7. Olivier Blanchard & Jordi Gali, 2006. "A new Keynesian model with unemployment," Working Paper Research 92, National Bank of Belgium.
  8. Joseph Plasmans & Tomasz Michalak & Jorge Fornero, 2006. "Simulation, estimation and welfare implications of monetary policies in a 3-country NOEM model," Working Paper Research 94, National Bank of Belgium.
  9. Abraham, Filip & Van Hove, Jan, 2010. "Can Belgian firms cope with the Chinese dragon and Asian tigers? The export performance of multi-product firms on foreign markets," Open Access publications from Katholieke Universiteit Leuven urn:hdl:123456789/330214, Katholieke Universiteit Leuven.
  10. Serge Jeanneau & Camilo E Tovar, 2008. "Financial stability implications of local currency bond markets: an overview of the risks," BIS Papers chapters, in: Bank for International Settlements (ed.), New financing trends in Latin America: a bumpy road towards stability, volume 36, pages 65-87 Bank for International Settlements.
  11. François Coppens & David Vivet, 2006. "The single European electricity market: A long road to convergence," Working Paper Document 84, National Bank of Belgium.

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