[Federal Register Volume 62, Number 218 (Wednesday, November 12, 1997)]
[Notices]
[Pages 60713-60720]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-29760]
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FEDERAL RESERVE SYSTEM
[Docket No. R-0987]
Policy Statement on Privately Operated Multilateral Settlement
Systems
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Request for comment.
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SUMMARY: As part of its payment system risk reduction program, the
Board of Governors is requesting comment on a proposal to integrate its
policies on ``Privately Operated Large-Dollar Multilateral Netting
Systems'' and ``Private Small-Dollar Clearing and Settlement Systems''
into a single, comprehensive policy statement on ``Privately Operated
Multilateral Settlement Systems.''
DATES: Comments must be received by February 10, 1998.
ADDRESSES: Comments should refer to Docket No. R-0987 and may be mailed
to Mr. William W. Wiles, Secretary, Board of Governors of the Federal
Reserve System, 20th Street and Constitution Avenue, N.W., Washington,
D.C. 20551. Comments may also be delivered to the Board's mail room
between 8:45 a.m. and 5:15 p.m. on weekdays, and to the security
control room at all other times. The mail room and the security control
room are accessible from the courtyard entrance on 20th Street between
Constitution Avenue and C Street, N.W. Comments will be available for
inspection and copying by members of the public in the Freedom of
Information Office, Room MP-500, between 9:00 a.m. and 5:00 p.m.
weekdays, except as provided in Section 261.8 of the Board's Rules
Regarding Availability of Information.
FOR FURTHER INFORMATION CONTACT: Jeffrey C. Marquardt, Assistant
Director (202/452-2360), Paul Bettge, Assistant Director (202/452-
3174), or Heidi Richards, Senior Financial Services Analyst (202/452-
2598), Division of Reserve Bank Operations and Payment Systems; or
Oliver Ireland, Associate General Counsel (202/452-3625); for the
hearing impaired only,
[[Page 60714]]
Telecommunications Device for the Deaf, Diane Jenkins (202/452-3544).
SUPPLEMENTARY INFORMATION:
I. Background
In 1994, the Board adopted a policy statement on Privately Operated
Large-Dollar Multilateral Netting Systems (Large-Dollar Policy
Statement).1 The Large-Dollar Policy Statement, which
replaced earlier policy statements on large-dollar funds transfer
networks and offshore dollar clearing and netting systems, contains
minimum standards for multilateral netting systems (Lamfalussy Minimum
Standards) set forth in The Report of the Committee on Interbank
Netting Schemes of the Central Banks of the Group of Ten Countries
(Lamfalussy Report).2 The criteria for identifying
arrangements subject to the policy were designed to limit the scope and
application of the policy to large-dollar multilateral netting systems
for payments and foreign exchange contracts that involve settlements in
U.S. dollars and have the potential to increase systemic risk in
financial markets.
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\1\ 59 FR 67534, December 29, 1994.
\2\ Bank for International Settlements (Basle, 1990).
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At the time the Large-Dollar Policy Statement was adopted, the
Board recognized that in the case of larger multilateral netting
systems for ``batch-processed'' payments, such as checks or automated
clearing house (ACH) payments, certain electronic controls that would
be required to implement the Lamfalussy Minimum Standards might not be
feasible. In addition, the characteristics of the instruments cleared
in such systems, along with the scale of systemic risk, might differ
from large-dollar systems. Consequently, the Board stated its intent to
study further the implications of the Lamfalussy Minimum Standards for
privately operated multilateral netting systems for batch-processed
payments and did not apply the Large-Dollar Policy Statement to those
systems at that time.
In addition, in 1995, the Board began a comprehensive evaluation of
its policies regarding Federal Reserve net settlement services, which
are typically used by privately operated clearinghouses for batch-
processed and other small-dollar payments, including checks, ACH
payments, and in some cases, automated teller machine (ATM) and credit
card transactions. The Board's review addressed both the need to
enhance the Federal Reserve's net settlement services and risk-
reduction policies toward small-dollar payments clearinghouses more
generally, including, potentially, the Lamfalussy Minimum Standards. As
a result of this review, the Board issued for public comment a proposal
for enhancing the Federal Reserve's net settlement services (62 FR
32118, June 12, 1997).
The proposed modifications to the Policy Statement on Payments
System Risk issued in this notice also stem from this comprehensive
evaluation of net settlement services and policies. This proposal would
repeal the existing Large-Dollar Policy Statement and replace it with a
unified policy statement on risks in multilateral settlement
arrangements. The proposal is not intended to alter the Board's current
policy as applied to those existing privately operated large-dollar
multilateral netting systems that are currently subject to the Large-
Dollar Policy Statement, but to integrate that policy within a broader
and more consistent policy framework.
II. The Proposed Policy Statement
Rationale for and Scope of the Policy
The proposed policy statement is designed to address risks in
multilateral settlement arrangements for both ``small-dollar''
payments, such as checks and ACH transfers, and ``large-dollar''
payments, which are typically used to settle interbank and other
financial market transactions. The policy statement recognizes that
settlement of payments through a multilateral clearinghouse arrangement
may not necessarily pose material additional risks for participants
relative to other methods of settlement, such as bilateral or
correspondent settlement. For example, in smaller arrangements used
primarily to settle customer or third-party payments, such as check
clearinghouses, participants generally are not exposed to significant
credit risk with respect to the underlying payments. Payments are
supported by a well established body of law and operational practice
that would help determine the resolution of a participant default or
clearinghouse settlement failure. In other arrangements, however, such
as those for some types of electronic payments, the characteristics of
the underlying payments in the event of a settlement disruption or
failure and the operational options for resolving such a situation may
be much less clear.
The proposed policy statement, therefore, is directed only at those
multilateral settlement arrangements that heighten existing risks
inherent in the settlement process or that create new risks to their
participants or to financial markets. For these systems, the Board
believes that policy guidance on settlement risk concerns at the
clearinghouse or system level is warranted. For other systems, which
are likely to include the vast majority of clearinghouse arrangements
for small-dollar payments, reliance on existing supervisory approaches
aimed at promoting the safe and sound operation of financial
institutions, including the Bank Service Company Act, is appropriate.
Fundamental categories of risk, including credit, liquidity,
operational, legal, and systemic risk, are common to many different
types of multilateral settlement arrangements. The magnitude and
specific manifestation of these settlement-related risks, as well as
the most cost-effective means of managing them, differ across systems.
Therefore, the proposed policy statement provides a flexible, risk-
based approach to risk management, rather than imposing uniform, rigid
requirements on all systems. While the flexible approach may lead to
some initial uncertainties in the implementation of the policy
statement, the Board expects that the costs of such uncertainty would
be significantly lower than the costs of an alternative policy that
mandated uniform risk management standards for all systems. Further,
such a uniform, rigid policy would likely not adequately address risks
in some systems and would impose unnecessary costs on the majority of
systems that pose limited or no additional risks relative to other
forms of settlement.
Risk Factors and Risk Management Measures
The proposed policy statement identifies five categories of
settlement-related risks--credit, liquidity, operational, legal, and
systemic--that may arise in multilateral settlement systems. For each
type of risk, the policy statement includes (1) a discussion of risk
factors that give rise to concerns, (2) threshold criteria for each
risk category that are intended to serve as ``safe harbors'' for
purposes of compliance with the policy statement, and (3) common
examples of risk management or mitigating controls that can be used to
address these risk factors. Systems would be expected to address any
material risks in each category.
First, the discussion of risk factors for each category is intended
to identify multilateral systems where such risks are heightened
relative to other means of settlement. In general, risks may be
heightened in multilateral settlement arrangements if the ability of
participants to manage settlement-related risks individually are
reduced
[[Page 60715]]
for operational or other reasons, or because risk management incentives
are reduced as a result of shifts in bilateral obligations and risk
exposures between participants. Risks could also be increased if no
alternative to multilateral settlement in a particular system is
available, such that settlements could not reasonably be expected to be
completed by participants in a timely manner outside the system in the
event that settlement could not be completed within the system.
Second, for each risk category the policy statement specifies
qualitative and quantitative thresholds and other criteria intended to
identify more clearly systems in which these risks are not likely to
arise. These criteria are intended to simplify administration of the
policy. Many clearinghouse arrangements will fall below the thresholds
or not meet specified criteria and therefore will not be required to
assess their compliance with the policy statement. The Board requests
comment on the appropriateness of these threshold criteria. The Board
expects that smaller check clearinghouses, for example, will not need
to modify their operations at all in order to comply with the policy;
others should only have to make minimal changes, for example, changes
in settlement timing or settlement failure notification policies. To
provide further guidance on application of the policy, the Appendix to
the policy statement also contains specific illustrative examples.
Third, the risk management discussion in the proposed policy
statement provides illustrations of the type of risk management
measures that may be appropriate given the particular risk factors
identified. Particularly for multilateral settlement systems that are
not likely to raise systemic risk concerns, this policy is intended to
provide flexible guidance on means to address risks. In general, the
Board believes that risk management measures should be commensurate
with the scale and scope of risks. In some cases, the Board recognizes
that systems may need to consult with Board staff regarding approaches
to addressing identified risk factors.
For multilateral settlement systems that are sufficiently large to
raise potential systemic risk concerns, the proposed policy statement
imposes higher risk management standards. The Board is proposing to
retain the threshold criteria for application of the Large-Dollar
Policy Statement, including $500 million in daily net settlement
amounts or an average payment size of $100,000. The Board requests
comment on the appropriate level of these thresholds, or whether a
different measure, such as gross payment value settled, or net
settlement amounts alone, would be more appropriate proxies for
systemic risk.
Under the proposed policy statement, those larger systems that meet
the systemic risk criteria would be expected to demonstrate robust
policies and procedures for addressing settlement failures and
disruptions, but would not necessarily be required to meet all of the
Lamfalussy Minimum Standards. The Board believes that full application
of the Lamfalussy Minimum Standards embodied in the existing Large-
Dollar Policy Statement may not be necessary or appropriate for some of
those arrangements. These standards were designed for those
multilateral netting systems for which a failure to settle all
positions on a multilateral net basis as and when expected could pose a
high degree of systemic risk. As a result, these standards require
systems, among other things, to have the ability to settle all
positions on a multilateral net basis even if the participant with the
largest debit position defaults on its settlement obligations. In
contrast, the Board recognizes that for many small-dollar multilateral
settlement systems, such as check clearinghouses, a recast of
multilateral net settlement positions (to exclude transactions with the
defaulting participant) or similar procedures may be an effective risk
management tool. This presumes that settlement for non-defaulting
participants can be completed in a timely manner and that any liquidity
effects on participants are manageable.
For some larger multilateral settlement systems, however, there is
no feasible or reasonable alternative to settlement of all multilateral
net positions within the system as and when expected, due primarily to
potentially systemic credit and liquidity effects. As a result, these
systems are expected to meet fully the Lamfalussy Minimum Standards.
For such systems, the proposed policy statement retains the same
requirements of the Board's existing Large-Dollar Policy Statement. The
Board expects that these requirements would apply to those multilateral
netting systems for large-dollar payments and foreign exchange
contracts that are currently required to meet the Lamfalussy Minimum
Standards under the Board's existing Large-Dollar Policy Statement. For
other systems meeting the systemic risk criteria under the new policy
but for which real-time controls may not be operationally feasible, the
Board would consider alternative risk management measures that would
provide an equivalent level of risk management.
Repeal of Existing ``Small-Dollar'' Policies
The Board is also proposing to repeal its existing policies for
certain ``small-dollar'' payments clearing and settlement arrangements.
These policies date from 1984 and 1990, when the Board approved the
provision of Federal Reserve net settlement services to ATM and
national ACH clearing arrangements, respectively, subject to certain
conditions. These conditions were also restated as part of the Board's
Policy Statement on Payments System Risk (57 FR 40455, September 3,
1992).
The earlier policies were designed to address specific situations
that arose in the Federal Reserve's provision of net settlement
services to depository institutions and were not intended to represent
a comprehensive approach to fundamental risks that arise in payments
clearing and settlement arrangements. In addition, the policies were
developed before the Federal Reserve had fully implemented its program
for managing risks in providing payment services to depository
institutions, as well as other policy developments relevant to the
management of interbank exposures, such as the issuance of Regulation
F.
Furthermore, a policy that links clearinghouse usage of a
particular Federal Reserve net settlement service to its compliance
with particular risk management standards (which do not apply to other
clearinghouse arrangements), may have the unintended effect of
discouraging the use of settlement services with potentially lower
risks to financial institutions and their customers, such as those
providing same-day finality. Moreover, many of the fundamental risks
that may exist in a clearing arrangement are not linked to a particular
form of settlement. Consequently, the Board is proposing to repeal
these policy statements once a revised, unified policy statement on
risks in multilateral settlement arrangements is finalized.
Specific Questions for Comments
1. The Board requests comment on whether the policy statement
adequately identifies settlement arrangements that exhibit material
settlement-related risks. Please address the usefulness of the base
criteria. Are there any other such thresholds or criteria that the
Board should consider?
2. How should the policy statement distinguish systems that may
pose systemic risk and are thus subject to
[[Page 60716]]
higher risk management standards from those that do not? Should the
thresholds be based on net settlement amounts, gross settlement
amounts, average payment size, or some other measure?
3. Should the policy statement include an Appendix with
illustrative examples of application of the policy in different
circumstances?
Regulatory Flexibility Act Analysis
The Board has determined that this proposed policy statement would
not have a significant economic impact on a substantial number of small
entities. The proposal would require multilateral settlement
arrangements to address material risks in their systems. The proposal
is designed to minimize regulatory burden on smaller arrangements that
do not raise material risks.
Competitive Impact Analysis
The Board has established procedures for assessing the competitive
impact of rule or policy changes that have a substantial impact on
payments system participants.3 Under these procedures, the
Board will assess whether a change would have a direct and material
adverse effect on the ability of other service providers to compete
effectively with the Federal Reserve in providing similar services due
to differing legal powers or constraints, or due to a dominant market
position of the Federal Reserve deriving from such differences. If no
reasonable modifications would mitigate the adverse competitive
effects, the Board will determine whether the anticipated benefits are
significant enough to proceed with the change despite the adverse
effects.
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\3\ These procedures are described in the Board's policy
statement ``The Federal Reserve in the Payments System,'' as revised
in March 1990. (55 FR 11648, March 29, 1990).
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The Board does not believe that the adoption of this policy
statement will have a direct and material adverse impact on the ability
of other service providers to compete effectively with the Reserve
Banks' payments services. A number of the payment services potentially
covered by the proposed policy statement are not offered by the Federal
Reserve Banks. In addition, the revised policy statement may have the
effect of encouraging competition with the Federal Reserve in areas
such as national check and ACH clearing and settlement. The repeal of
the Board's existing policies for small-dollar payments clearing
arrangements, together with the Board's proposal for an enhanced net
settlement service, may reduce barriers to establishing such
arrangements.
Federal Reserve System Policy Statement on Payments System Risk
The Board is amending its ``Federal Reserve System Policy Statement
on Payments System Risk'' under the heading ``II. Policies for Private-
Sector Systems'' by removing ``A. Privately Operated Large-Dollar
Multilateral Netting Systems'' in its entirety and adding in its place
``A. Privately Operated Multilateral Settlement Systems'' and removing
``C. Private Small-Dollar Clearing and Settlement Systems'' in its
entirety.
II. Policies for Private-Sector Systems
A. Privately Operated Multilateral Settlement Systems
Introduction
Multilateral settlement systems, such as clearinghouses and similar
arrangements, may produce important efficiencies in the clearance and
settlement of payments and financial contracts. Participants in such
systems, typically depository institutions, exchange payments for their
own account or the accounts of their customers in a coordinated fashion
and settle the resulting obligations on a multilateral, often net,
basis.
A variety of credit, liquidity, and other risks can arise in the
clearing and settlement process that institutions must manage in the
normal course of business, regardless of the method of clearing and
settlement. Existing supervisory standards are generally directed at
ensuring that institutions establish appropriate policies and
procedures to manage such risks. For example, Regulation F directs
insured depository institutions to establish policies and procedures to
avoid excessive exposures to any other depository institutions,
including exposures that may be generated through the clearing and
settlement of payments.1
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\1\ See 12 CFR 206.
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However, the use of multilateral settlement systems introduces the
risk that a failure of one participant in the system to settle its
obligations will have credit or liquidity effects on participants that
have not dealt with the defaulting participant. Multilateral settlement
may have the effect of altering the underlying bilateral relationships
that arise between institutions during the clearing and settlement
process. As a result, the incentives for, or ability of, institutions
to manage effectively the risk exposures to other institutions may be
reduced. In addition, in some cases, there may be no feasible or timely
alternative to settlement through the multilateral system in the event
that the system fails to complete settlement, due, for example, to a
participant default. These factors may create added risks to
participants in multilateral settlement systems relative to other
settlement methods.
Clearinghouses also may generate systemic risk that could threaten
the financial markets or the economy more broadly. The failure of a
system to complete settlement as and when expected could generate
unexpected credit losses or liquidity shortfalls that participants in
the system are not able to absorb. Thus, the inability of one
participant to meet its obligations within the system when due could
lead to the illiquidity or failure of other institutions. Further, the
disruption of a large number of payments and the resulting uncertainty
could lead to broader effects on economic activity. In addition, as the
Federal Reserve has established fees for daylight overdrafts, along
with other risk management measures for Federal Reserve payment
services, the potential exists for intraday credit risks to be shifted
from the Federal Reserve to private, multilateral settlement
arrangements, either domestically or in other countries, that have
inadequate risk controls.
The Board believes that these concerns warrant the application of a
risk management policy to a limited number of multilateral settlement
systems that raise material added risks for participants or financial
markets. The Board recognizes that multilateral settlement systems
differ widely in terms of form, function, scale, and scope of
activities. As a general rule, risk management measures should be
commensurate with the nature and magnitude of risks involved, but risk
management measures may be designed differently for different types of
payments or systems. This policy statement, therefore, is designed to
permit market participants to determine the best means of addressing
risks, within certain guidelines.
The Board's adoption of this policy in no way diminishes the
primary responsibilities of participants in, and operators of,
multilateral settlement systems to address settlement and other risks
that may arise in these systems. In addition, the Board encourages all
multilateral settlement systems to consider periodically cost-effective
risk management improvements, even if not specifically required under
this policy. Insured depository institutions participating in
multilateral settlement systems are also expected to limit their
bilateral credit and liquidity exposures
[[Page 60717]]
as required under Federal Reserve Regulation F.
Scope and Administration of the Policy
This policy statement will be applied to privately operated
multilateral settlement systems or arrangements with three or more
participants that settle U.S. dollar payments, including but not
limited to systems for the settlement of checks, automated
clearinghouse (ACH) transfers, credit, debit, and other card
transactions, large-value interbank transfers, or foreign exchange
contracts involving the U.S. dollar. It does not apply to clearing and
settlement systems for securities or exchange-traded futures and
options. This policy statement is not intended to apply to bilateral
relationships between financial institutions, such as those involved in
traditional correspondent banking. The Board may also apply this policy
to any non-U.S. dollar system based, or operated, in the United States
that engages in the multilateral settlement of non-dollar payments
among financial institutions and that would otherwise be subject to
this policy.
The Board expects to be guided by this policy statement in taking
action in its supervisory and operational relationships with state
member banks, bank holding companies, and clearinghouse arrangements,
including, for example, the provision of net settlement services and
the implementation of the Bank Service Company Act.2 Systems
subject to this policy may be asked to provide gross and net settlement
data, as well as intraday position data, if applicable, to the Federal
Reserve.
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\2\ 12 USC 1861-67.
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Risk Factors and Risk Management Measures
The risk factors described below are intended to identify those
multilateral settlement systems that may pose material added risks
relative to conventional bilateral means of settlement, and which
therefore must address these risks under this policy statement. The
Board believes that the vast majority of multilateral settlement
systems, including most clearinghouses for checks and other small-value
payments, do not raise the risks identified below to a material degree.
Threshold criteria for each risk category exclude many such systems
from the need to assess risk factors under the policy. The Appendix to
this policy statement also provides several illustrative examples of
the likely application of the requirements of the policy statement.
Systems that exhibit one or more risk factors should take steps to
address those specific risks, including consideration of the risk
management measures listed below. If necessary, the Board will work
with systems to determine whether changes in their policies or
operations are required and, if so, whether steps proposed by the
system would satisfy the requirements of the policy. In some cases, an
operational change may mitigate a particular risk factor. In other
cases, systems may need to develop or modify written rules, policies,
and procedures that specify the rights and obligations of participants,
as well as other relevant parties, such as settlement agents for the
system, in the event that a settlement cannot be completed as and when
expected. Such rules and procedures should be disclosed to all
participants and their primary regulatory authorities.
In general, risk management controls should be proportional to the
nature and magnitude of risks in the particular system. For larger
systems that have the potential to create systemic risk, the Board
expects systems to demonstrate commensurately robust procedures for
addressing settlement disruptions, including, in some cases, meeting
the Lamfalussy Minimum Standards for multilateral netting systems,
discussed below under Systemic risk.3
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\3\ The Report of the Committee on Interbank Netting Schemes of
the Central Banks of the Group of Ten Countries (Bank for
International Settlements, November 1990), known as the Lamfalussy
Report, recognized that netting arrangements for interbank payment
orders and forward-value contractual commitments, such as foreign
exchange contracts, have the potential to improve the efficiency and
the stability of interbank settlements through the reduction of
costs along with credit and liquidity risks, provided certain
conditions are met. That Report developed and discussed ``Minimum
Standards for Netting Schemes'' (Lamfalussy Minimum Standards) and
``Principles for Co-operative Central Bank Oversight'' of such
arrangements. These standards have been adopted by the central banks
of the G-10 and European Union countries.
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(1) Credit risk. Risk factors: A multilateral settlement system
would give rise to material credit risk if its rules or practices
materially increase or shift the bilateral obligations or credit
exposures between participants in the clearing and settlement process.
One example is a clearinghouse operator or agent that provides a
guarantee of settlement. Such a guarantee might be implemented
explicitly through the establishment of a central counterparty for all
transactions, or through other provisions in the system's rules, such
as a guarantee of members' settlement obligations, third-party credit
arrangements, or the system's ability to recover settlement-related
losses from participants. Additionally, a system in which participants
are exposed to material credit risk to one another by virtue of their
participation in the system, due for example, to agreements to
mutualize any settlement losses, would be considered to give rise to
material credit risk if participants have no means to control these
exposures.
Threshold criteria: Multilateral settlement systems in which
underlying bilateral obligations between participants are not altered,
such as those that do not employ settlement guarantees, loss-sharing,
or other techniques, would not give rise to additional material credit
risk. Thus, most traditional check clearinghouses would not be
considered to give rise to credit risk under this policy statement.
Risk management measures: Measures that are commonly used to
mitigate credit risk in a multilateral settlement system and provide
support for settlement guarantees include monitoring of participants'
financial condition, caps or limits on some or all participants'
positions in the system, and requirements for collateral, margin, or
other security from some or all participants. Systems in which
participants have material bilateral exposures to one another or to the
system, such as through loss-sharing agreements, may implement
mechanisms for participants to control these exposures. Use of
settlement methods with same-day finality may also shorten the duration
of credit risk exposure in a system.
(2) Liquidity risk. Risk factors: A multilateral settlement system
would give rise to significant liquidity risk for its participants if a
delay, failure, or reversal of settlement would be likely to cause a
significant change in settlement amounts to be paid or received by
participants on the settlement date. The degree of liquidity risk in a
particular system is greater (1) the larger are gross payment flows
relative to netted amounts to be settled; (2) the larger are
participants' settlement positions relative to their available funding
resources; (3) the later that participants would be notified of a
settlement disruption relative to the timing of activity in the money
markets and through other funding channels, and (4) the greater the
likelihood that a settlement failure of the particular system would be
accompanied by abnormal market conditions.
Threshold criteria: The Board expects that participants in
multilateral net settlement systems ordinarily would be able to fund
their bilateral obligations in
[[Page 60718]]
the event of a delayed or failed settlement where the netting factor
for the system is 10 or less, provided settlement activity does not
reach levels likely to raise systemic risk, as discussed under Systemic
risk, below.4
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\4\ The netting factor, calculated as the ratio of gross
transactions exchanged in a particular period to the resulting
multilateral net amounts (aggregate net debits or net credits)
settled, is one indicator of the magnitude of the change in
positions if all multilateral net settlement obligations had to be
settled on a gross basis.
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Risk management measures: One approach to mitigating liquidity risk
is to implement measures to reduce significantly both the probability
and the effect of a settlement disruption. Measures that are often used
to support a settlement guarantee, as described under Credit risk,
above, as well as establishing external liquidity resources and
adequate operational contingency arrangements may mitigate liquidity
risk.
Some systems anticipate performing a recast of settlements in the
event of a participant default by recalculating multilateral net
settlement obligations among participants. These systems are expected
to address the liquidity impact of such a procedure.5 For
example, timely notification of settlement failure before or during the
period of active money market trading would permit participants readily
to borrow funds to cover any shortfalls due to the recast. Individual
participants may also take steps to limit their own liquidity exposures
or increase available liquidity resources. The system itself may
utilize committed lines of credit or other external liquidity resources
that can be drawn upon to complete settlements in the event of a
temporary settlement disruption.
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\5\ For example, in a ``recast'' of settlements, some or all
transactions involving the defaulting participant would be removed
from the system's settlement process, to be settled or otherwise
resolved outside the system. A revised multilateral settlement with
recalculated settlement obligations would then be conducted among
the remaining participants. In an ``unwind,'' transactions or
settlement obligations to be settled on the day of the default for
all participants would be removed from the system.
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(3) Operational risk. Risk factors: Operational risks, such as
those relating to the reliability and integrity of electronic data
processing facilities used in the clearing and settlement process, are
addressed in standard supervisory guidance for depository institutions
and their service providers. Operational risk factors for purposes of
this policy statement include those that could hinder the timely
completion of settlement or the timely resolution of a settlement
disruption in a multilateral settlement system. For example,
operational obstacles could make it difficult or impossible for
participants to arrange settlement outside the system on a timely basis
in the event of a settlement failure. As a result, those participants
expecting to receive funds could face significant liquidity risk. In
addition, in some cases, failure to complete settlement on a timely
basis could change the rights of participants with respect to the
underlying payments, creating potential credit or liquidity risks. For
example, institutions that are unable either to return or to settle for
checks presented to them on the same day may lose the right to return
the checks for insufficient funds. Further, risk control procedures
implemented by a particular system may themselves entail operational
risks. The ability of a system to execute a recast of settlements,
implement guarantee provisions, or access lines of credit may depend on
the operational reliability of the system's facilities.
Threshold criteria: In smaller multilateral settlement systems, it
is less likely that operational complexities or constraints would
prevent the resolution of a participant default or other settlement
disruption, provided that participants receive notice of a settlement
failure with adequate time to make alternative arrangements before the
closing of funds transfer systems. Thus, the Board does not consider
systems with less than one hundred participants that normally settle
sufficiently early in the day to raise material operational risks.
Risk management measures: Multilateral settlement systems and their
participants typically mitigate the risk of operational failure in
their daily processing activities through standard techniques, such as
contingency plans, redundant systems, and backup facilities. For
purposes of this policy statement, systems should ensure the reliable
operational capability to execute procedures used to resolve a
participant default or other settlement disruption as well as to
implement other risk management measures. For example, if a system
anticipates recasting settlements by excluding transactions of a
defaulting participant, it should ensure that the system can perform
any required processing, generate the necessary information, and
provide it to participants in a timely manner. To the extent that
payments would be expected to be settled outside the system,
participants should have adequate time, settlement information, and
operational capabilities to complete such settlements before the close
of critical funds transfer systems.
(4) Legal risk. Risk factors: Legal risk may exist in a
multilateral settlement system if there is significant uncertainty
regarding the legal status of settlement obligations or the underlying
transactions in the event of a settlement failure. This legal
uncertainty would greatly exacerbate efforts to achieve an orderly and
timely resolution and could expose participants to credit and liquidity
risks. If the obligations of participants with respect to underlying
transactions exchanged in the system have no enforceable legal status
in the event of a system settlement failure, the ability of the
participants to revert to other methods of settlement on a timely basis
may be in doubt. Legal risk would also arise if the legal
enforceability of any risk management measures, netting agreements, or
related arrangements, is questionable.
Threshold criteria: Systems that clear and settle payments that are
supported by a well established legal framework that is independent of
the particular settlement system are unlikely to give rise to
significant legal risk.
Risk management measures: Systems may be able to address legal risk
factors through changes to operating rules or other agreements between
participants. Rules and related agreements may provide an adequate
legal basis for enforceable netting of obligations or for other
arrangements that would be invoked in the event of a settlement
failure, such as unwind or reversal provisions.
(5) Systemic risk. Risk factors: For some multilateral settlement
systems, settlement risk factors could have systemic implications. The
failure of a multilateral settlement system to complete settlement as
and when expected could generate unexpected credit losses or liquidity
shortfalls that participants in the system are not able to absorb, or
disrupt a large number of payments. In general, the larger the size of
settlement activity in a multilateral settlement system, the greater
the potential for systemic risk.
Threshold criteria: The Board considers as posing systemic risk
multilateral settlement systems that have, or that expect to have, on
any day, settlements with a system-wide aggregate value of net
settlement credits (or debits) larger than $500 million (in U.S.
dollars and any foreign currencies combined), or that clear and settle
payments or foreign exchange contracts with a daily average stated
dollar value larger than $100,000 (calculated over a twelve month
period corresponding to the most recent fiscal year for the netting
system). Multilateral settlement systems of any size that serve core
[[Page 60719]]
financial markets may also be considered to pose systemic risk.
Risk management measures: Systems posing systemic risk as defined
above are expected to adopt more robust risk management policies and
procedures addressing participant defaults and other settlement
disruptions and to demonstrate that they are able to execute these
procedures. In order to determine the adequacy of risk management
controls, systems may need to establish a capability to simulate or
test the effects of one or more participant defaults or other possible
sources of settlement disruption on the system and its
participants.6
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\6\ Such simulations may include, if appropriate, the effects of
changes in market prices, volatilities, or other factors.
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Systems with activity exceeding the systemic risk thresholds, and
for which there is no feasible or reasonable alternative to settlement
of all positions within the system as and when expected due to credit,
liquidity, or operational risks, are expected to meet the six
Lamfalussy Minimum Standards, below. These standards are designed to
address the main risk factors that may be present in multilateral
clearing and settlement systems and to provide confidence that such
systems can settle all positions as and when expected, thereby reducing
substantially the risk that a default by one participant will cause
defaults by others.
Lamfalussy Minimum Standards for the Design and Operation of Privately
Operated Large-Dollar Multilateral Netting Systems 7
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\ 7\ The minimum standards adopted by the Board are identical to
those set out in the Lamfalussy Report, with minor changes to
terminology.
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1. Netting systems should have a well-founded legal basis under all
relevant jurisdictions.
2. Netting system participants should have a clear understanding of
the impact of the particular system on each of the financial risks
affected by the netting process.
3. Multilateral netting systems should have clearly-defined
procedures for the management of credit risks and liquidity risks which
specify the respective responsibilities of the netting provider and the
participants. These procedures should also ensure that all parties have
both the incentives and the capabilities to manage and contain each of
the risks they bear and that limits are placed on the maximum level of
credit exposure that can be produced by each participant.
4. Multilateral netting systems 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 net
debit position.
5. Multilateral netting systems should have objective and publicly-
disclosed criteria for admission which permit fair and open access.
6. All netting systems should ensure the operational reliability of
technical systems and the availability of backup facilities capable of
completing daily processing requirements.
In meeting these standards, the Board expects that systems will
utilize the following risk management measures, or their equivalent:
(1) To the extent that participants are exposed to credit and liquidity
risks from other participants, require each participant to establish
bilateral net credit limits vis-a-vis each other participant in the
system; (2) establish and monitor in real-time system-specific net
debit limits for each participant; (3) establish real-time controls to
reject or hold any payment or foreign exchange contract that would
cause a participant's position to exceed the relevant bilateral and net
debit limits; (4) establish liquidity resources, such as cash,
committed lines of credit secured by collateral, or a combination
thereof, at least equal to the largest single net debit position; and
(5) establish rules and procedures for the sharing of credit losses
among the participants in the netting system.8 The Board
will consider, on a case-by-case basis, alternative risk management
measures that provide for an equivalent level of risk management
controls for systems in which real-time risk controls are not
operationally feasible. However, the Board strongly encourages systems
that perform sequential processing of payments or other obligations to
develop real-time risk management controls. The Board may also
encourage or require higher risk standards, such as the ability to
ensure timely multilateral net settlement in the event of multiple
defaults, of individual systems that present a potentially high degree
of systemic risk, by virtue of their high volume of large-value
transactions or central role in the operation of the financial markets.
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\8\ The term ``largest single net debit position'' means the
largest intraday net debit position of any individual participant at
any time during the daily operating hours of the netting system.
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Offshore Systems
The Board has a long-standing concern that steps taken to reduce
systemic risk in U.S. large-dollar payments systems may induce the
further development of multilateral systems for settling U.S. dollar
payments that are operated outside the United States. Such systems, if
implemented with inadequate attention to risk management, may increase
risks to the international banking and financial system. In addition,
offshore arrangements have the potential to operate without sufficient
official oversight.
As a result, the Board has determined that offshore, large-dollar
multilateral netting systems and multicurrency clearing and settlement
systems should at a minimum be subject to oversight or supervision, as
a system, by the Federal Reserve, or by another relevant central bank
or supervisory authority. The Board recognizes that central banks have
common policy objectives with respect to large-value clearing and
settlement arrangements. Accordingly, the Board expects that it will
cooperate, as necessary, with other central banks and foreign banking
supervisors in the application of the Lamfalussy Minimum Standards to
offshore and multicurrency systems. In this regard, the Principles for
Co-operative Central Bank Oversight outlined in the Lamfalussy Report
provide an important international framework for cooperation.
By order of the Board of Governors of the Federal Reserve
System, November 6, 1997.
William W. Wiles,
Secretary of the Board.
Appendix
Example #1
A local or regional check clearinghouse with less than 100
members that settles sufficiently early in the day to allow
settlement disruptions to be resolved on a timely basis would
typically not give rise to risks addressed under this policy
statement. Generally, such arrangements do not guarantee settlement,
mutualize losses, or involve a central counterparty to all
transactions, and therefore the settlement arrangement itself does
not give rise to added or shifted credit risk for participants. In
addition, the liquidity risks of such arrangements generally are
low, with netting factors of less than 10, so that liquidity
shortfalls due to a disruption in settlement are likely to be within
the funding capabilities of participants. From an operational
standpoint, these arrangements usually exchange checks in the
morning. If prompt notice is given of a recast of settlements at
that time, participants should be able to meet their recast
settlement obligations, settle any payments excluded from the system
bilaterally as necessary, and manage any liquidity shortfalls.
Similarly, the existence of established check law would satisfy any
legal concerns. Finally, such check clearing arrangements generally
do not have aggregate net settlement credits (or debits) larger than
$500 million per day, nor do the checks cleared through such
[[Page 60720]]
arrangements have a daily average dollar value larger than $100,000,
so the arrangements would not be considered to give rise to systemic
risk.
Example #2
An ACH clearinghouse with more than 100 members, net settlement
debits averaging less than $500 million per day, and a netting
factor of five would not be considered to raise significant credit,
liquidity, or systemic risks. Such a system would likely not involve
settlement guarantees or mutualization of losses, and without high
netting factors or similar concerns, it would not be likely to lead
to significant liquidity risks. Given the large number of
participants, it is unlikely that participants would be able to
resolve a settlement failure among themselves without prior
coordinated procedures. The system would need to have reliable
operational procedures to resolve a settlement failure in a timely
manner on the settlement date, such as through a recast of
settlements. The rules of the system would need to specify
settlement failure procedures, including those for identifying and
reversing non-settled entries under applicable rules.
Example #3
A foreign exchange clearinghouse that clears and settles
contracts that average more than $100,000 through a central
counterparty arrangement would be required to address potential
credit, liquidity, and legal risks, as well as systemic risks.
Netting and novation of transactions, for example, would shift
credit risk to the central counterparty. Legal risk could exist if
the arrangements to implement the netting of underlying foreign
exchange contracts could be invalidated or ineffective in the event
of bankruptcy of the central counterparty. Given that the
arrangement exceeds or plans to exceed the base criteria for
potential systemic risk, and serves a key financial market, it would
be required to implement robust risk controls and fully meet the
Lamfalussy Minimum Standards.
[FR Doc. 97-29760 Filed 11-10-97; 8:45 am]
BILLING CODE 6210-01-P
