T2S PROGRAMME OFFICE ECB-PUBLIC. Page 1 of 12

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1 T2S PROGRAMME OFFICE ECB-PUBLIC T2S CLARIFICATION NOTE CLIENT COLLATERAL REUSE FOR CENTRAL BANK AUTO-COLLATERALISATION Page 1 of 12

2 Introduction Auto-collateralisation in T2S is an automatic process which aims to facilitate smooth DvP settlement in central bank money. It is a credit operation that is or can be triggered when a buyer does not have sufficient funds to settle a securities transaction. In T2S, the auto-collateralisation functionality applies to two types of credit: 1. credit from a central bank to a payment bank, also called central bank auto-collateralisation, as the central bank is the credit provider and the payment bank the credit consumer; 2. credit from a payment bank to one of its clients (CSD participant), also called client collateralisation, in which case the payment bank is the credit provider and its client the credit consumer. T2S automatically selects the collateral to be used in each auto/client-collateralisation credit operation, thereby relying both on collateral on flow (i.e. securities involved in the purchase) and collateral on stock. Auto- and client-collateralisation have been discussed in several T2S forums such as information sessions, workshops and meetings. Recently a specific question arose in some of these forums, whether and under which conditions it is possible to automatically re-use collateral, which was selected during a client-collateralisation operation between a Payment Bank and its Client, for fulfilling a subsequent central bank auto-collateralisation operation between that Payment Bank and the Central Bank. The aim of this technical note is to detail the technical features and conditions under which the collateral in a client-collateralisation operation can be re-used in a subsequent auto-collateralisation operation. Furthermore, the re-use of collateral is illustrated by examples and explanations of the conditions and technical features. The explanation of the illustration has been documented on a similar level of detail and approach as followed in the User Detailed Functional Description (UDFS), in order to provide the reader with a familiar reading and level of understanding of this specific business case. This note describes the specific business case of re-using collateral between the client and autocollateralisation operations and does not elaborate on auto/client-collateralisation itself. For more information on the features, benefits and processing of auto and client-collateralisation that will be available via T2S please refer to the following: T2S Special Series, Issue 2, published in October 2012 and available on the ECB web site at: T2S Special Series on auto-collateralisation T2S Information Session on client-collateralisation: T2S Technical Dialogue "Implementing the relationship between Payment Banks and their clients in T2S Auto-collateralisation: an ECB tutorial T2S Key Technical/Functional Documentation Page 2 of 12

3 Executive Summary The "reuse of collateral" from client-collateralisation onward to Central Bank auto-collateralisation is possible on-flow and on-stock and will be performed automatically by T2S. As the client-collateralisation in T2S is based on repo collateralisation technique 1, the Payment Bank becomes the legal owner of the collateral obtained as a result of this transaction and it can use these securities for auto-collateralisation, provided that certain conditions are met: The security (ISIN) is defined as an eligible security for client-collateralisation (by the Payment Bank) as well as for auto-collateralisation (by the Central Bank) No close link exists between the security (ISIN) and credit receiver as the Payment Bank in Central Bank auto-collateralisation or ISIN and the credit receiver as the client of Payment Bank in client collateralisation. The collateral providing securities account of the Payment Bank for the auto-collateralisation with the Central Bank is the same account that is configured as the collateral receiving account for clientcollateralisation. Diagram - T2S Auto-collateralisation Framework: Central Bank auto-collateralisation and client collateralisation set-up T2S selects collateral on-flow first and if required, complements it by other available collateral (collateral on-stock) in both Central Bank auto-collateralisation and client collateralisation. For client collateral re- 1 In a repo, the buyer becomes the owner of the collateral at the start of the transaction and can freely dispose of the collateral. His right of re-use is an automatic right arising from property ownership. In case of an alternative technique, i.e. pledge, the title to collateral remains with the collateral-giver. Page 3 of 12

4 use, only when all of the above mentioned conditions are met, then the security/isin (collateral on-flow) in client collateralisation is reused for auto-collateralisation. T2S shall select any other available securities (collateral on-stock) from the Payment Bank for Central Bank auto-collateralisation in case any one of the conditions is not satisfied. The selection of collateral by T2S in case of Central Bank auto-collateralisation depends on many factors for e.g. amount of cash needed, available and eligible collateral, maximum credit percentage etc. and for client collateral re-use, overlap of collateral eligible securities between client collateralisation and autocollateralisation. Therefore, the securities selected for collateral by T2S cannot be exactly determined in advance. Page 4 of 12

5 Illustration of collateral re-use from client collateralisation to auto-collateralisation High level description The following example (assuming all conditions stated above are met) illustrates a client collateralisation operation between the client (Party C) and its Payment Bank (Party PB1) and then onward re-use of collateral for the auto-collateralisation operation between that Payment Bank and the Central Bank (Party CB1). Party B is the counterparty of Party C in the original instruction. We assume that client-collateralisation is triggered between Party C and its Payment Bank PB1, because of insufficient external guarantee identified during the provision check process of the settlement between Party B and C. Furthermore the assumption is that Central Bank CB1 follows the Repo procedure and also that there is a lack of cash on the DCA of the Payment Bank PB1, so that a subsequent auto-collateralisation operation will be triggered with the Central Bank. Below, a detailed description of the numbered movements illustrated in the example: 1a, 1b DvP Settlement Instruction (Party B delivering to Party C and Party C delivering cash to Party B) 2a, 2b Client collateralisation Instruction (collateral movement from Party C to Payment Bank PB1 and cash provision from Payment Bank PB1 to client Party C) 3a, 3b Central Bank auto-collateralisation Instruction (collateral movement from Payment Bank PB1 to Central Bank CB1 and intra-day cash provision from Central Bank CB1 to Payment Bank PB1) Page 5 of 12

6 Detailed technical description For ease of understanding in line with the technical details, subsequent section follows the structure of the UDFS. Trigger for client collateralisation The original settlement attempt concerns the following matched Settlement Instructions (RvP instruction SI1 from Party C (client of Payment Bank PB1) and DvP instruction SI2 from the counterparty Party B) received by T2S: OPE ID SECURITIES ACCOUNT ISIN CODE IMPACTED BALANCE SEC MVT TYPE QTY T2S DEDICATED CASH ACCOUNT CUR. CRED DEB INDIC AMOUNT SI1 SA5 EEUR RECE 110 DCA1 EUR DBIT SI2 SA2 AWAS DELI 110 DCA2 CRDT SI1 is instructed by Party C, client allowed by the payment bank PB1 to use its T2S dedicated cash account DCA1 for the settlement of its Settlement Instructions. The capacity of Party C to use this T2S dedicated cash account is capped by limits set on the CMB. During the provision check process, the following provision net flows and provision check execution are calculated for each involved securities position (SecPos1 and SecPos2), cash balance (CashBal1 and CashBal2) and credit memorandum balance (CMB): SECURITY SIDE CASH SIDE OPERATION SecPos1 SecPos2 CashBal1 CMB CashBal2 SA5 EEUR SA2 AWAS DCA1 DCA2 SI , , SI , Provision net flow , , , Availability N/A +10, External guarantee N/A 0.00 N/A Provision check execution , LACK -9, Insufficiency +19, Central bank collateralisation Client collateralisation Unsecured credit 50, N/A 0.00 N/A 10, N/A N/A 4, N/A Page 6 of 12

7 Since the provision check execution is negative and client collateralisation limit is not zero, the initial conditions to resort to the client collateralisation process are checked: CONDITIONS CHECK RESULT REASONS Existence of a missing resource CMB presents an insufficient external guarantee (- 9,000.00) due to the buying Settlement Instruction SI1. Eligible credit consumer Party C using the T2S dedicated cash account DCA1 is set as eligible to the client collateralisation by the payment bank PB1 owning this account. Sufficient limit capacity At the moment of the need of intraday credit, the sum of client collateralisation (10,000.00) and the unsecured credit (4,000.00) is higher (14,000.00) than the missing amount necessary for the settlement (9,000,00). Once triggered, T2S calculates the intraday credit capacity allowed by the potential collateral identified to guarantee the provision of intraday credit through client collateralisation for CMB. Since the impacted balance indicated in SI1 (EEUR) is related to the Earmarking for autocollateralisation processing type for the currency of the needed intraday credit (EUR), the use of collateral on flow to guarantee the intraday credit is possible (assuming the is set as eligible for collateral by PB1 as credit provider). Using collateral on flow before any collateral on stock, T2S calculates the intraday credit capacity related to SI1 by multiplying the received quantity (110) by the most recent collateral price (90.00) set by the payment bank PB1 for. The potential intraday credit capacity from the collateral flow (9,900.00) is sufficient to cover the insufficient external guarantee (-9,000.00). T2S selects the collateral on flow (100 of the purchased securities for a collateral valuation of EUR 9,000.00) and checks the ultimate conditions to resort a client collateralisation process: CONDITIONS CHECK RESULT REASONS Limit fulfilled The client collateralisation remains positive (+1,000.00) after the processed client collateralisation operation. Missing resource coverage The identified insufficient external guarantee (-9,000.00) is covered by the provided intraday credit (9,000.00). Since all the ultimate conditions are fulfilled, T2S generates the following collateral Settlement Instructions based on the parameters previously configured in the static data by PB1 in a way to transfer the received securities to the securities account of PB1: OPE ID SECURITIES ACCOUNT ISIN CODE IMPACTED BALANCE SEC MVT TYPE QTY T2S DEDICATED CASH ACCOUNT CUR. CRED DEB INDIC AMOUNT SI3 PB1CCO SA EXXX RECE 100 DCA1 EUR DBIT 9, SI4 SA5 EEUR DELI 100 DCA1 CRDT 9, Page 7 of 12

8 For the client collateralisation, the securities are delivered on a position type Earmarking for auto-collateralisation for all currencies earmarked by the payment bank. Considering the new collateral Settlement Instructions (SI3 and SI4), a new provision net flows calculations followed by a new provision check execution are executed: OPERATION SECURITY SIDE CASH SIDE SecPos1 SecPos2 SecPos33 CashBal1 CMB CashBal2 SA5 EEUR SA2 AWAS PB1 CCO SA EXXX DCA1 DCA2 SI , , SI , SI3 (collateral) , SI4 (collateral) , , Provision net flow , , Availability N/A +10, External guarantee N/A 0.00 N/A Provision execution check , LACK 0 +19, Central bank collat. 50, N/A 0.00 Client collat. N/A 1, N/A Unsecured credit N/A 4, N/A The following reverse collateral Settlement Instructions SI5 SI6 2 are generated for future reimbursement during the settlement day: OPE ID SECURITIES ACCOUNT ISIN CODE IMPACTED BALANCE SEC MVT TYPE QTY T2S DEDICATED CASH ACCOUNT CUR. CRED DEB INDIC AMOUNT T2S PARTY HOLD INDICATOR SI5 PB1CCO SA EXXX DELI 100 DCA1 EUR CRDT 9, YES SI6 SA5 EEUR RECE 100 DCA1 DBIT 9, NO The Settlement Instruction SI5 of the payment bank PB1 is set on hold waiting for a release in order to trigger the reimbursement of intraday credit. Trigger of Central Bank auto-collateralisation 2 If the underlying (used as collateral) is needed by the client of the PB1 for the settlement of a DVP transaction, T2S will automatically release any client reverse collateral instruction which can provide the missing securities and automatic substitution is triggered to replace this initial collateral. Page 8 of 12

9 The new provision check execution is still negative with a lack of cash on DCA1. The initial conditions to resort to Central Bank auto-collateralisation process are now checked: CONDITIONS CHECK RESULT REASONS Existence of a missing resource The cash balance CashBal1 presents a lack of cash (-9,000.00) due the buying Settlement Instruction SI1. Eligible credit consumer Participant A owning the T2S dedicated cash account DCA1 is set as eligible to the central bank collateralisation by the central bank CB1 managing this account. Sufficient limit capacity At the moment of the need of intraday credit, the central bank collateralisation is higher (50,000.00) than the needed intraday credit (9,000.00). Once triggered, T2S calculates the intraday credit capacity allowed by the collateral available to guarantee the provision of intraday credit on the T2S dedicated cash account DCA1. For the client collateralisation, the securities are delivered on a position type Earmarking for autocollateralisation for all currencies earmarked by the payment bank, the use of collateral on flow to subsequently guarantee the intraday credit via the Central Bank auto-collateralisation is therefore possible (assuming the is set as eligible for collateral by CB1 as credit provider). However, if the collateral on flow is insufficient to cover the lack, T2S will try to first utilise the collateral on flow and subsequently collateral on stock available in one or more collateral providing accounts linked to the DCA. Note that in addition to the eligibility conditions for the collateral, the maximum credit percentage as defined by the CB would also be considered during the selection of collateral 3. Using collateral on flow before any collateral on stock, T2S calculates the intraday credit capacity related to SI3 by multiplying the received quantity (100) by the most recent collateral price (90.00) set by the Central Bank CB1 for. T2S selects the collateral on flow (100 of the purchased securities for a collateral valuation of EUR 9,000.00) for the exact amount of the needed intraday credit (EUR 9,000.00) Based on the selected collateral, the ultimate conditions for a central bank collateralisation process are checked again: CONDITIONS CHECK RESULT REASONS Limit fulfilled The central bank collateralisation remains positive (+EUR 41,000.00) after the central bank collateralisation operation. Missing resource coverage The identified lack of cash (-9,000.00) is covered by the provided intraday credit (9,000.00). Maximum credit percentage fulfilled Since the intraday credit provided is equal to the lack of cash to be covered, the central bank collateralisation operation fulfils any maximum credit percentage defined by central bank CB1. 3 It is possible that in case the collateral on flow does not meet the requirements, T2S may select securities collateral on stock for CB auto-collateralisation (let us say, 2 shares of ISIN worth 55 each were collateralised for client-collateralisation to cover a lack of 100. The lack on the DCA being 40 and maximum credit percentage of 105% (which means the upper limit of intraday credit for the transaction can be 42, the received in client-collateralisation on flow cannot be used for CB auto-collateralisation. T2S may select another select another security that meets the upper and lower limits of the credit thresholds. Page 9 of 12

10 Since all the ultimate conditions are fulfilled, T2S generates the following collateral Settlement Instructions based on the parameters previously configured in the static data by CB1 and according to the collateral management procedure (Repo): OPE ID SECURITIES ACCOUNT ISIN CODE IMPACTED BALANCE SEC MVT TYPE QTY T2S DEDICATED CASH ACCOUNT CUR. CRED DEB INDIC AMOUNT SI7 CB1 ACO SA AWAS RECE 100 CB1 CBCA EUR DBIT 9, SI8 SA1 EXXX DELI 100 DCA1 CRDT 9, Considering the new collateral Settlement Instructions (SI7 and SI8), a new provision net flows calculations followed by a new provision check execution are computed: OPERATION SECURITY SIDE CASH SIDE SecPos1 SecPos2 SecPos33 SecPos99 CashBal1 CashBal2 CashBal99 SA5 EEUR SA2 AWAS PB1 CCO SA EXXX CB1 ACO SA AWAS DCA1 DCA2 CB1 CBCA SI , SI , SI3 (collateral) , SI4 (collateral) , SI7 (collateral) , SI8 (collateral) , Provision flow net , , Availability , Provision execution check Central bank collateralisation , , , N/A Since the central bank cash account CB1 CBCA used by central bank CB1 for the intraday credit provision is allowed to be negative, the new provision check execution is successful. The matched Settlement Instructions and the generated Settlement Instructions are submitted for settlement on allor-none basis and subsequent booking process. Once the settlement of SI1 SI2, SI3 SI4 (collateral Settlement Instructions corresponding to PB1 as credit provider and to Party C as credit consumer) and SI7 SI8 (collateral Settlement Instructions corresponding to central bank CB1 as credit provider and to the payment bank PB1 as credit consumer) is irrevocable, T2S updates the involved securities positions and cash balances. Page 10 of 12

11 The following reverse collateral Settlement Instructions for Central Bank auto-collateralisation SI9 SI10 are generated for future reimbursement during the settlement day: OPE ID SECURITIES ACCOUNT ISIN CODE IMPACTED BALANCE SEC MVT QTY T2S DEDICATED CUR. CRED DEB AMOUNT T2S PARTY HOLD TYPE CASH INDIC INDICATOR ACCOUNT SI9 CB1 ACO SA AWAS DELI 100 CB1 CBCA EUR CRDT 9, NO SI10 SA1 EXXX RECE 100 DCA1 DBIT 9, YES The Settlement Instruction SI10 of the payment bank PB1 is set on hold waiting to be released to trigger the reimbursement of intraday credit. The reporting corresponding of all the generations is then sent to Central Bank CB1, Payment Bank PB1 and the Party C. Page 11 of 12

12 Conclusion The illustration in this note is a simple example on re-use of collateral wherein the full collateral on-flow received in client collateralisation (due to lack of external guarantee ) is propagated to Central Bank auto-collateralisation (due to lack of cash on T2S DCA) where the security is valuated at same price 4 in both the process. The selection of collateral by T2S in case of Central Bank auto-collateralisation depends on many factors for e.g. amount of cash needed, available and eligible collateral, maximum credit percentage etc. and for client collateral re-use, overlap of collateral eligible securities between client collateralisation and autocollateralisation. Therefore, even more complex cases resulting in such propagation could occur, for example (non-exhaustive): Collateral on-flow could be complemented by collateral on-stock wherein securities received in client collateralisation could be used partially or is not sufficient to cover the lack of cash. The collateral valuation or collateral eligibility in Central Bank auto-collateralisation is different to that of client collateralisation. In this case collateral on-stock is only used for Central Bank autocollateralisation 4 If the security is not valued at the same price for the auto/client collateralisation, T2S may select a different security (on stock) or more than one security as collateral, based on the collateral valuation that is needed to fulfil the exact lack of cash on the T2S DCA. Page 12 of 12