GENERAL APPLICATION PRINCIPLES OF COLLATERAL, GUARANTEE AND CREDIT MECHANISM THAT CAN BE USED IN PAYMENT AND SECURITIES SETTLEMENT SYSTEMS

CENTRAL BANK OF THE REPUBLIC OF TURKEY

Payment Systems General Directorate
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Regulation and Supervision Directorate
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04.05.2017

GENERAL APPLICATION PRINCIPLES OF COLLATERAL, GUARANTEE AND CREDIT MECHANISM

The smooth functioning of payment and securities settlement systems (systems) is of critical importance for the stability of the financial system, the monetary policy practices of central banks and the development of the economy. The possibility of any problem that may arise from the systems spreading to other parts of the financial system increases the vital importance of the systems for financial stability. In this context, it is of great importance that the risks arising from the systems are managed effectively and at a sufficient level.

Although the establishment of a collateral, credit or guarantee mechanism is not made mandatory by regulations, especially credit and liquidity risk being at the forefront, such mechanisms stand out as extremely important tools for system operators to effectively manage the risks they will be exposed to. When it comes to the use of the aforementioned mechanisms, the procedures and principles that system operators must comply with are regulated in detail in Article 23 of the Regulation on the Activities of Payment and Securities Settlement Systems (Activity Regulation) published in the Official Gazette dated 28.06.2014 and numbered 29044 and entered into force.

Furthermore, among our Bank's Objectives and Policies Regarding Payment and Securities Settlement Systems, there is the objective of "ensuring that the systems operate in compliance with the 'Principles for Financial Market Infrastructures (Principles)' prepared by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO)", and among the said principles, the fifth Principle titled "Collateral" contains various application principles on the subject.

In this framework, system operators are required to comply with the following principles if they establish collateral, credit or guarantee mechanisms.

1. Collateral Mechanism

The collateral mechanism is defined as the structure consisting of the assets with the required qualifications being given as collateral to the system operator by the system participants in order to ensure the smooth operation of the system, to be used in cases where obligations cannot be fulfilled due to reasons arising from the participants within the system, the management of the collateral given, the conditions of use and the rules and procedures related thereto.

2. Guarantee Mechanism

The guarantee mechanism is defined as the structure that is created specific to the system to be used in cases where the transactions in the system cannot be terminated for any reason and that includes assets suitable for the qualifications determined by the system operator.

3. Credit Mechanism

Another method that can be used to manage liquidity risks that may cause the settlement of transactions realized in the system not to occur or to occur late is the establishment of a special credit mechanism by the system operator to be used in cases where the system participant experiences liquidity tightness.

In cases where a credit mechanism is established by system operators, special attention is paid to ensuring that the credit facilities to be provided to participants are collateralized.

4. Purpose and General Considerations

The main purpose of the mechanisms mentioned above is to minimize the risks that may arise regarding the smooth fulfillment of the settlement of transactions realized in the system.

In this context, it is expected that the aforementioned mechanisms are established in normal periods, the assets to be taken within the scope of these mechanisms are taken "while everything is going well", and when problems begin to be experienced, the aforementioned mechanisms and the assets taken within the scope of these mechanisms come into play. Accordingly, although it is possible to request assets of different sizes by taking into consideration the financial situations of the participants, the system operator not including a participant in the scope of these mechanisms and not requesting any assets just because that participant is not currently experiencing a problem does not comply with the spirit of the aforementioned mechanisms and is not applicable.

Within the scope of the collateral mechanism, assets are generally taken in relation to the participant's own transactions realized in the system and are used in cases where the participant cannot fulfill its obligation related to the aforementioned transaction.

In the guarantee mechanism, on the other hand, generally a pool is created by collecting assets from all participants at fixed or variable rates determined depending on certain conditions, and the assets in the said pool are used in cases where the transactions in the system cannot be terminated for any reason. In this context, especially in systems operating according to the netting method, the use of the guarantee mechanism to manage the risks that may arise due to the participants' failure to fulfill their obligations is accepted as a generally accepted practice.

Within the scope of the credit mechanism, the system operator provides liquidity specific to the system by directly using its own assets or with the support of a third party. Within the scope of the said mechanism, liquidity is provided to system participants against collateral, and the main purpose is to help participants resolve their temporary liquidity tightnesses.

System operators may operate in different fields and the systems they operate may have different characteristics. In this context, the decision on whether to establish mechanisms of the type mentioned above, and if established, the characteristics and design of the collateral mechanism and/or guarantee mechanism to be established must be set forth by taking into consideration matters such as the characteristics of the system, the participant structure and the size of the financial obligations that may arise in the system.

The matter of the procedures and principles regarding collateral, credit and guarantee mechanisms being clearly determined by the system operator within the system rules and entering into force with the approval of our Bank is an obligation regulated in Article 23 of the Activity Regulation.

4.1. Determination of the Amount of Assets to be Received

While determining the amount of assets that participants must provide within the scope of collateral, credit and guarantee mechanisms, the system operator must take into consideration matters such as the size and probability of realization of potential financial risks in the system (arising from participants or other reasons), the financial condition of participants and their history of fulfilling their obligations in the system, as well as the operating principles and settlement cycle of the system.

4.2. Type and Valuation of Assets to be Accepted

With respect to the mechanisms mentioned above, it is essential that the credit, liquidity and market risks of the assets to be received from participants be low. In this context, within the scope of the above-mentioned mechanisms, assets such as TL, foreign currency and government debt securities that contain the aforementioned types of risks at a minimum level or not at all must be accepted.

The assets to be accepted from system participants within this scope are clearly determined in the system rules (in the relevant rules and procedures).

The system operator must diligently investigate the legal, administrative and other risks that may restrict or adversely affect the use of the assets it will accept within the scope of the above-mentioned mechanisms and must not accept unsuitable collateral assets.

The methods to be used in calculating the value of non-cash assets to be accepted by the system operator pursuant to the above-mentioned mechanisms must be clearly determined in the system rules. In this context, in order to determine the current value of the assets provided by system participants in relation to the collateral, credit or guarantee mechanism, prudent valuation practices must be established by the system operator, these practices must be tested regularly, and discount rates (haircuts) that also take into account stressed market conditions must be used.

In this context, while determining the discount rate (haircut) for each type of non-cash asset to be accepted, the system operator must take into consideration, on the basis of the principle of prudence and in order to reduce the need for cyclical adjustments, developments in the relevant markets and value losses that may occur under unusually stressed market conditions.

The system operator must monitor and evaluate whether there is concentration on the basis of asset type with respect to the assets it will accept in relation to the collateral, credit or guarantee mechanism.

4.3. Use and Management of Assets

It is essential that the assets provided by system participants in relation to the collateral, credit or guarantee mechanism not be used for purposes other than the main purpose of use determined in the system rules.

In this context, the assets provided by system participants must be used to cover losses when a risk arises in the finalization of the settlement of transactions carried out in the system.

As stated above, within the scope of the collateral mechanism, assets are generally received in relation to the participant's own transactions carried out in the system and are used in cases where the participant fails to fulfill its obligation related to the said transaction. However, provided that various conditions have been met pursuant to the Activity Regulation, it is possible for a system participant, by assuming the amount determined by the system operator of the obligation of another participant who failed to fulfill its obligation, to use the collateral it holds in the system to cover the additional obligation assumed. In this context, the amount of the additional obligation to be assumed is limited to the amount of assets held by the participant that will assume the additional obligation in the collateral mechanism pursuant to the system rules.

Furthermore, in the event that the assets provided by system participants within the scope of the collateral mechanism are used to cover the obligation that another participant failed to fulfill, the financial condition of the participants must be taken into consideration by the system operator in determining the additional obligation to be assumed.

In cases where the system operator accepts different types of assets from participants within the scope of the above-mentioned mechanisms, when the mechanism needs to be used due to any problem experienced in the system, it is expected that the assets provided by the participant to the system operator within the scope of the same mechanism be used in order from the most liquid to the less liquid asset, and the said matter must be clearly determined in the system rules.

In the event that a collateral mechanism, credit mechanism and/or guarantee mechanism are present in the system at the same time, the system operator must also clearly determine in the system rules by which method and in which order the existing mechanisms will be used.

On the other hand, the collateral management infrastructure must be structured in such a way as to provide redundancy and recovery capability in extraordinary circumstances.

4.4. Reuse of assets

In cases where the system operator has obtained a liquidity facility from our Bank or a financial institution due to a liquidity squeeze that may arise because obligations in the system cannot be met, and where it must provide collateral in order for the said liquidity facility to be used, it is possible for the system operator to provide the assets given by participants within the scope of the collateral, credit or guarantee mechanism as collateral to the institution providing the liquidity facility.

In order for such a practice to be carried out, the necessary legal permission regarding the transfer of the relevant assets to the institution providing liquidity must have been obtained by the system operator from the relevant parties.

4.5. Earning interest on assets

It is possible to earn interest on the cash assets provided by system participants in relation to the collateral, credit or guarantee mechanism.

In this case, the assets in question must be invested in investment instruments with low risk and high liquidity.

The investment instruments that may be used in earning interest on the assets must be clearly specified in the system rules and submitted to our Bank for approval.

4.6. Segregation of assets

The system operator must monitor the assets provided by participants within the scope of the collateral, credit or guarantee mechanism separately from both its own assets and the other assets of the participants held in the system.

Furthermore, an effective system must be established for the monitoring and management of all cash and non-cash assets.

4.7. Replenishment

The system operator must establish the rules and procedures regarding the replenishment of depleted assets in the event that the assets provided by participants are used in whole or in part.

In replenishing the depleted assets, market conditions and the financial situations of the participants must be taken into consideration.

Accordingly, in the event that a collateral, credit or guarantee mechanism exists or is intended to be established with system operators, the examinations to be carried out by our Bank shall be conducted within the framework of the matters set out above and, but not limited to, the legislation.