Reports on Observance of Standards and Codes Canada and the IMF Canada ROSC I.  Banking Supervision II.  Securities Supervision III.  Insurance Supervision IV.  Payment System V.  Transparency of Monetary and Financial Policies SURVEY What do you think of Reports on the Observance of Standards and Codes?

REPORT ON THE OBSERVANCE OF STANDARDS AND CODES (ROSC) Canada   Queries/Comments      should be directed to:    Director    Western Hemishere Department    700 19th Street, NW    Washington, DC 20431    202-623-7000    http://www.imf.org    scu-comment@imf.org IV.  Payment Systems   Prepared by a staff team from the International Monetary Fund in the context of a Financial Sector Assessment Program (FSAP), on the basis of information provided by the Canadian Authorities. June 2000 Canada: Observance of the CPSS Core Principles for Systemically Important Payment Systems1 1. This report provides an assessment of Canada's observance of and consistency with relevant international standards and core principles in the financial sector, as part of a broader assessment of the stability of the financial system. This assessment work by the IMF was undertaken under the auspices of the IMF-World Bank Financial Sector Assessment Program (FSAP) based on information up to October 1999. This has helped to place the standards assessments in a broader institutional and macroprudential context, and identify the extent to which the supervisory and regulatory framework has been adequate to address the potential risks in the financial system. The assessment has also provided a source of good practices in financial regulation and supervision in various areas.

2. The assessment covered (i) the Basel Core Principles for Effective Banking Supervision; (ii) the International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation; (iii) the International Association of Insurance Supervisors' (IAIS) Supervisory Principles; (iv) the Committee on Payment and Settlement Systems' (CPSS) Core Principles for Systemically Important Payment Systems; and (v) the IMF's Code of Good Practices on Transparency in Monetary and Financial Policies. Such a comprehensive coverage of standards was needed as part of the financial system stability assessment for Canada in view of the increasing convergence in the activities of banking, insurance, and securities firms, and the integrated nature of the markets in which they operate. It should be noted that some of the standards are still in draft form, and some do not yet have a complete methodology to systematically assess compliance or consistency.2 This module was prepared in consultation with the Canadian authorities in the context of the IMF FSAP mission that visited Canada in October 1999, and constitutes a summary of the detailed assessments prepared by the mission. The summary was part of the Financial System Stability Assessment (FSSA) report that was considered by the IMF Executive Board on February 2, 2000, in the context of the IMF's Article IV consultation discussions with Canada. 3. The assessment of standards and codes draws on the self-assessments of the Canadian authorities, and on the field work undertaken October 11-22, 1999, based on a peer review process by Kai Barvll (Payment Systems, Sveriges Riksbank), Karl Driessen and Charles Siegman (Transparency Code, IMF), Alvir Hoffmann (Banking Supervision, Banco Central do Brasil), Rodney Lester (Insurance, World Bank), Michael Martinson (Banking Supervision, Board of Governors of the Federal Reserve System), Stefan Spamer (Banking Supervision, Deutsche Bundesbank), and Shane Tregillis (Securities, Australian Securities and Investments Commission). The expert team was coordinated by the IMF FSAP mission, led by V. Sundararajan, and comprised R. Barry Johnston, Karl Driessen, Haizhou Huang and Martin Cerisola. The assessment has been communicated to the authorities. 4. Overall, the assessment found a high degree of compliance that had contributed to a stable financial system. Minor deviations from Basel Core Principles of Effective Supervision were detected, which are addressed by the proposals contained in the Policy paper. 3 Full compliance with the Core Principles for Systemically Important Payment Systems was noted for the Large Value Transfer System. Canada is broadly compliant with all principles of insurance regulation, and is broadly consistent with IOSCO Objectives and Principles of Securities Regulation. The complexity of federal/provincial regulatory arrangements, oversight of mutual funds, and resource limitations on the enforcement capacity of some securities commissions are areas of concern that are being addressed. There is a high degree of consistency with the Code of Good Practices on Transparency in Monetary and Financial Policies. The more specific findings in the area of payment system design and supervision are discussed below. A. Background and Overview 5. The major payment and clearing systems in Canada are the Large Value Transfer System (LVTS) for large value payments, the Debt Clearing System (DCS) for transactions involving federal government treasury bill and bonds and private sector money market securities (both system being overseen by the Bank of Canada, under the Payment Clearing and Settlement Act of 1996) and the Automated Clearing Settlement System (ACSS) primarily for retail payments. The LVTS and ACSS are operated by a private organization, the Canadian Payments Association (CPA), in accordance with the Canadian Payments Association Act, which came into force in 1980. As of July 28, 1999, the CPA membership consisted of 143 member institutions; the Bank of Canada, 59 chartered banks, 26 credit union centrals and federations, 39 trust, mortgage and loan companies and eighteen other deposit-taking institutions. The retail payments are primarily based on checks even though card-payments are increasing, and some 10 percent of large value payments continues to be paper-based. 6. The risk control systems in LVTS are well developed and include the use of caps and collateral pledged by the private sector participants. In the unlikely event that two or more participants fail on the same day, during the operating hours of LVTS, with an aggregate net debit position in the survivors' payment stream that exceeds the total value of collateral pledged to the system by the participants, the Bank of Canada has guaranteed that the system will settle. In other cases of multiple failures, the system would settle using collateral pledged by the participants, without a need for the Bank of Canada guarantee. 7. There exists a substantial regulatory framework for the clearing and settlement systems as well as for their oversight. The LVTS has been designated for oversight-for reasons of systemic importance—under the Payment Clearing and Settlement Act, and complies with all 10 draft core principles for systemically important payment systems (Table 1). However, the review noted that although the value of large-value payments through the ACSS has declined substantially, and now accounts for a very small percentage of total ACSS transactions, the ACSS will need to be formally assessed for its capacity to pose systemic risk. This assessment will occur at the end of the transition phase during which large-value payments are migrating to the LVTS. 4 If the ACSS were to be judged capable of posing systemic risk, then the Core Principles would be applied to this system. B. Assessment of CPSS Principles Principle I Well-founded legal basis in all relevant jurisdictions. 8. There are well-developed laws in Canada governing contracts, insolvency, anti-competitive behavior, etc. that have general application to individuals, institutions and markets in the economy. In addition, there are laws that are specifically applicable to the payments system. The Canadian Payments Association (CPA), the operator of LVTS, is a body incorporated by an Act of Parliament, with the authority to operate payment systems and to create rules governing the operation of such systems. The arrangements that govern the relationships among direct participants in LVTS are in the form of a by-law or rules. The provisions of the by-laws are reinforced by the fact that the LVTS is designated for oversight under the Payment Clearing and Settlement Act (PCSA). The PCSA provides immunity to the LVTS by preventing creditors of failed LVTS participants from challenging any of the LVTS rules and any outcome resulting from the application of those rules. Table 1. Canada: Compliance with the CPSS Draft Core Principles for Payment Systems CP Principle FC 1/ BC 2/ Comments and Corrective Actions 1 The system should have a well-founded legal basis in all relevant jurisdictions. X   Some of the recent legislative changes supporting the operation of the LVTS have not been "tested" in court, in circumstances involving a participant failure, but expert legal opinion is that the legislative changes are sound and robust.. 2 The system's rules and procedures should enable participants to have a clear understanding of the system's impact on each of the financial risks they incur through participating in it. X     3 The system should have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and participants, and which provide appropriate incentives to manage and contain risk. X     4 The system should provide prompt final settlement on the day of value, preferably during the day, and at a minimum at the end of the day. X   Intra-day finality is obtained through the risk control mechanism in combination with the guarantee for settlement given by the Bank of Canada. 5 A system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation. X   Risk control arrangements including collateral pledged by the private sector participants ensure that the minimum principle is met. In the unlikely event that two or more participants fail on the same day, during the operating hours of LVTS with an aggregate net debit position in Tranche II that exceeds the total value of collateral pledged to the system by the participants, the Bank of Canada guarantee would be necessary for the system to settle. 6 Assets for settlement should preferably be a claim on the central bank; where other assets are used, they should carry little or no credit risk. X     7 The system should ensure a high degree of security and operational reliability and should have contingency arrangements for timely completion of daily processing. X     8 The system should provide a means of making payments which is practical for the markets it serves and efficient for the economy. X   The system has only been in use for nine months, and so far there are no signs of system inefficiencies. The system has been designed to economize on the use of collateral. 9 The system should have objective and publicly disclosed criteria for participation, which permit fair and open access. X     10 Governance of the system should be effective, transparent, and accountable. X   The mission recommends that the forthcoming legislation should codify the primary responsibility of the Bank of Canada for systemic risk issues, and that the governance structure of the CPA is reviewed to diminish the prospect of conflict of interest for the Bank of Canada. 1/ FC: Fully compliant 2/ BC: Broadly compliant 9. While no gaps in the domestic legal environment vis-à-vis LVTS were identified, some of the recent legislative changes supporting the operation of the LVTS have not been tested in court in circumstances involving a participant failure. Nevertheless, based on an informed legal analysis and expert opinion, the legal environment appears robust. 10. Assessment: Full compliance. Principles II-III Understanding of the system's impact on risks; and procedures for the management of risks and liquidity risks. 11. The LVTS by-laws and associated rules give participants a clear understanding of the risks incurred by participating in the system. The system design and procedures provide incentives for the participants to manage and contain these risks: (i) the system operates in real time, and payment messages have to pass real-time risk control tests before being accepted by the system; (ii) participants can decide whether they wish to grant intraday credit to other participants or not; and if they grant a credit they have an incentive to manage this exposure carefully; (iii) collateral to support the use of Tranche I or Tranche II payments is pledged directly to the BoC, ensuring immediate access to liquidity; 5 (iv) the CPA determines whether prospective participants are technically capable of meeting LVTS requirements. The by-laws and CPA rules cover participant withdrawal both in normal and abnormal situations. 12. Assessment: Full compliance. Principles IV-VI Final settlement; inability to settle by the participant with the largest single settlement obligation; and assets for settlement. 13. The LVTS meets Principles IV and V although the actual settlement does not take place until the evening. There exists a risk-control mechanism, which ensures that settlement will take place even if the largest participant defaults. Limits, both bilateral and multilateral, control the exposures that any one participant can create in the LVTS. The guarantee of the BoC will, if necessary, be used in the unlikely circumstance of default by at least two participants on the same day, during the operating hours of LVTS, and whose aggregate net debit position in Tranche II exceeds the total value of collateral pledged to the system. Regarding Principle VI, the LVTS uses claims on the central bank to settle net payment obligations among the participants. 14. Assessment: Full compliance. Principle VII Security and operational reliability; and contingency arrangements. 15. LVTS uses SWIFT for the transmission of payment instructions, which provides a highly secure and reliable means of sending payment instructions. Controls are in place to ensure that only authorized users access the LVTS system. LVTS has a secondary operation site, in a geographically separate part of the country relative to its primary site. Back-up processing is tested regularly. There exist emergency committees to deal with problems in LVTS or in other systems critical to the functioning of LVTS, mainly the DCS, which is used by LVTS participants to pledge securities to the BoC to support the use of intra-day credit in the two payment streams in the LVTS. The recovery time in DCS to bring the systems back to full operations following a disaster at the primary site has been shortened to two hours, the same as in LVTS. Contingency plans have been developed, and an independent auditing firm carries out an annual audit of the LVTS arrangements for controlling a variety of operational risks. 16. Assessment: Full compliance. Principle VIII Practical for the markets and efficient for the economy. 17. The LVTS was developed by private sector financial institutions under the auspices of the CPA. It fully addresses the central bank's concerns about systemic risk. The private sector participants were very intensely focussed on creating the least cost arrangement for processing large-value and time-sensitive payments. The system minimizes the amount of collateral necessary to support the use of intra-day credit, while delivering real-time processing of payment messages, certainty of settlement, and intra-day receiver finality. There do not appear to be any signs of system inefficiencies. 18. The BoC guarantees that settlement will take place at the end of the day. An explicit central bank guarantee of a payment system is unusual in developed economies most of which use real-time gross settlement systems (RGTS), and even if the risk is very small, a guarantee of the payment system still involves risk. However, the BoC has concluded that the relative cost of the risk that the guarantee would ever be used, is smaller than the cost to the participants of pledging a larger amount of collateral to cover the possibilities of multiple participant failures, however remote, and that the guarantee thus is to be seen as a "public good". 19. Assessment: Full compliance. Principle IX Objective and publicly disclosed criteria for participation. 20. The criteria for becoming a participant in the LVTS are stated in its by-laws and allow all members of the CPA, at present 143, to become a member in LVTS. There are no other criteria for becoming a member. In order to be able to make Tranche I payments, the participant must have funds in their account at the BoC or collateral pledged to the BoC; or it must have received a bilateral credit line from the other participants in regard to a Tranche II payment. 21. Assessment: Full compliance. Principle X Governance of the system should be effective, transparent and accountable. 22. The governance of the LVTS seems to be effective, transparent, and accountable. The LVTS is owned and operated by the CPA. The BoC has designated the LVTS under the PCSA, which means that the Central Bank is the overseer of the system. The CPA operates under an Act of Parliament, which specifies membership criteria, the composition of the board of directors, public disclosure, and other requirements. The CPA has a board of directors responsible for the operation of the LVTS, and the BoC is responsible for appointing the chairperson. The cabinet of the federal government must approve all by-laws, and thus provides a form of external oversight. 23. Assessment: Full compliance. 1 The work of the mission was coordinated by an FSAP team led by Mr. V. Sundararajan (IMF). Mr. Kai Barvell (Central Bank of Sweden) was the principal contributor to this module. 2 The Basel Core Principles were issued in September 1997; a Core Principles Methodology was released in October 1999 by the Basel Committee on Banking Supervision. The Code of Good Practices on Transparency was adopted by the Interim Committee in September 1999; work on a supporting document is in progress. The IOSCO Objectives and Principles were issued in September 1998, and a detailed self-assessment methodology is being developed. A draft of the Core Principles for Systemically Important Payment Systems was issued for public comment in December 1999. The IAIS Insurance Supervisory Principles were issued in September 1997; a self-assessment program has been developed to assist member countries in evaluating compliance. 3 Department of Finance, Canada (1999), "Reforming Canada's Financial Services Sector: A Framework for the Future," June 25. 4 A CPA committee is examining ways in which remaining large-value payments can be migrated from the ACSS to the LVTS and the BoC is encouraging the timely migration of these payments. 5 In payments made using Tranche I, a participant can move into a net debit position as long as the position is no greater than the amount of collateral the participant has pledged specifically for this type of activity. While in payments made using Tranche II, bilateral net credit lines are set daily by each participant on each of the other participants.