[Federal Register Volume 59, Number 249 (Thursday, December 29, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-32014]
[[Page Unknown]]
[Federal Register: December 29, 1994]
_______________________________________________________________________
Part IV
Federal Reserve System
_______________________________________________________________________
Policy Statement on Privately Operated Large-Dollar Multilateral
Netting Systems; Notice
FEDERAL RESERVE SYSTEM
[Docket No. R-0842]
Policy Statement on Privately Operated Large-Dollar Multilateral
Netting Systems
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Policy Statement.
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SUMMARY: As part of its payment system risk reduction program, the
Board of Governors is updating its policies on ``Privately Operated
Large-Dollar Funds Transfer Networks'' and ``Offshore Dollar-Clearing
and Netting Systems'' and integrating those policies into a single
policy statement on ``Privately Operated Large-Dollar Multilateral
Netting Systems.'' The Board is incorporating into the new policy
statement the minimum standards for the design and operation of
privately operated large-dollar multilateral netting systems set forth
in the Report of the Committee on Interbank Netting Schemes of the
Central Banks of the Group of Ten Countries, which was published in
November 1990 by the Bank for International Settlements.
EFFECTIVE DATE: December 21, 1994.
FOR FURTHER INFORMATION CONTACT: Jeffrey C. Marquardt, Assistant
Director (202/452-2360), Paul Bettge, Manager (202/452-3174), Kelly
Shaw, Project Leader (202/452-3054), Division of Reserve Bank
Operations and Payment Systems; or Oliver Ireland, Associate General
Counsel (202/452-3625), Stephanie Martin, Senior Attorney (202/452-
3198), Legal Division, Board of Governors of the Federal Reserve
System; for the hearing impaired only, Telecommunications Device for
the Deaf, Dorothea Thompson (202/452-3544).
SUPPLEMENTARY INFORMATION:
I. Background
On July 18, 1994 the Board issued for public comment a proposal to
update its existing policies on ``Privately Operated Large-Dollar Funds
Transfer Networks'' and ``Offshore Dollar-Clearing and Netting
Systems'' and to integrate those policies into a single policy
statement on ``Privately Operated Large-Dollar Multilateral Netting
Systems.'' (59 Fed. Reg. 36438) At the same time, the Board proposed to
apply to such arrangements the minimum standards for multilateral
netting systems identified in the Report of the Committee on Interbank
Netting Schemes of the Central Banks of the Group of Ten Countries
(Lamfalussy Report).
The proposed policy statement was developed to apply to such
arrangements as domestic, privately operated, large-dollar multilateral
payment netting systems; offshore large-dollar multilateral payment
netting systems; multilateral foreign exchange clearinghouses involving
settlements in U.S. dollars; and multicurrency payment netting systems
involving settlements in U.S. dollars. Application of the policy
statement to such arrangements would cover more completely the range of
multilateral netting systems involving settlements in U.S. dollars that
have the potential to increase systemic risk in the financial markets.
The inclusion of multilateral foreign exchange clearinghouses and
multicurrency payment netting systems involving settlements in U.S.
dollars represented an expansion of the Board's existing PSR policy.
Neither of these types of arrangements is covered explicitly by the
Board's current policy, yet both types of arrangements have the
potential to generate the same kinds of systemic risks as single
currency netting systems.
II. The Proposed Policy Statement
The Board requested comment on a policy statement that would apply
to multilateral netting systems that: (1) Have three or more
participants that net payments or foreign exchange contracts involving
the U.S. dollar, whether or not netted amounts are legally binding; and
either (2) have, or are likely 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 (3) routinely process individual payments or foreign
exchange contracts, with a stated dollar value larger than $500,000.
Further, a multilateral netting system that met the above threshold
criteria would be subject to the policy if (1) It were a state-
chartered member of the Federal Reserve System, (2) any of its agent(s)
or participants were state-chartered members of the Federal Reserve
System, (3) its participants' net positions were settled through a
Federal Reserve settlement account, (4) its participants settled their
net positions in the multilateral netting system through their
individual Federal Reserve accounts or the Federal Reserve account of
the settlement agent(s), or (5) one or more bank holding companies had
an investment in the multilateral netting system.
The Board recognized that in the case of privately operated large-
dollar multilateral netting systems for batch processed paper-based or
electronic payments, including privately operated Automated Clearing
House (ACH) systems, 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 electronic systems. Consequently, the Board proposed to
study further the implications of the Lamfalussy Minimum Standards, and
various arrangements that might be used to implement the Lamfalussy
Minimum Standards, for privately operated multilateral netting systems
for batch processed paper-based or electronic payments.
The proposed policy statement also contained five risk management
measures that large-dollar multilateral netting systems would be
expected to utilize in order to satisfy Lamfalussy Minimum Standards
III and IV, which deal with risk management and settlement completion.
The risk management measures were: (1) 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; (3) establish a system to reject or hold any payment
or foreign exchange contract that would 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 a netting system.
The Board proposed an eighteen-month transition period for large-
dollar multilateral netting systems operating on the date of any final
action by the Board, following which such systems would be expected to
comply fully with the policy statement. Large-dollar multilateral
netting systems established subsequent to the date of final adoption of
the policy by the Board would be expected to comply fully with the
policy statement, without benefit of a transition period.
Finally, the Board requested comment on the application of a higher
standard than Lamfalussy Minimum Standard IV for individual large-
dollar multilateral netting systems that present a high degree of
systemic risk. Lamfalussy Minimum Standard IV states that
``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.'' The Board requested comment on whether certain
systems should be expected to ensure settlements in the event, for
example, that participants with the first, second, and third largest
net debit positions are simultaneously unable to settle these
positions. The Board also asked what factors should be considered in
analyzing the incremental costs and benefits of requiring multilateral
systems to meet a higher standard, and whether a quantitative threshold
should be employed to identify systems that might present a high degree
of systemic risk.
III. The Final Policy Statement
The final policy statement adopted by the Board, with slight
modifications, is essentially unchanged from the draft policy statement
issued last July. The Board has made certain technical modifications to
the policy statement to clarify both the threshold criteria for
identifying multilateral netting systems subject to the policy and the
risk management measures for implementing Lamfalussy Minimum Standards
III and IV. These modifications are discussed below.
Scope and Application of the Policy
The Board has retained the threshold criteria, with one
modification, for identifying multilateral netting systems that are
subject to the policy. In order to specify more clearly the size of
transactions that give rise to the application of the policy statement,
the criterion that systems ``routinely process'' transactions with a
stated value larger than $500,000 has been changed to ``* * * process
payments or foreign exchange contracts, with a daily average stated
dollar value, calculated over the twelve month period corresponding to
the most recent fiscal year for the netting system, larger than
$100,000.'' The jurisdictional criteria for applying the policy remain
unchanged. Taken together, these criteria are 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.
The Board believes that the Lamfalussy Minimum Standards may apply
to all large-dollar multilateral payment netting systems irrespective
of the type of financial instrument or contractual obligation netted by
the system. However, the Board recognizes that in the case of privately
operated large-dollar multilateral netting systems for batch processed
paper-based or electronic payments, including privately operated
Automated Clearing House (ACH) systems, certain electronic controls
that would be required to implement the Lamfalussy Minimum Standards
may not be feasible. Further, the rights and responsibilities of
parties within such systems may require further analysis. Thus, the
Board intends to study further the implications of the Lamfalussy
Minimum Standards, and various arrangements that might be used to
implement the Lamfalussy Minimum Standards, for privately operated
large-dollar multilateral netting systems for batch processed paper-
based or electronic payments. The Board is not, therefore, applying the
Lamfalussy Minimum Standards to these systems at this time.
Implementation of the Lamfalussy Minimum Standards
The Board believes that large-dollar multilateral netting systems,
whether on-shore or off-shore, should meet in full the Lamfalussy
Minimum Standards, as set forth in the final policy statement. The
Board's policy statement retains the five risk management measures
contained in the proposed policy statement that multilateral netting
systems may utilize to satisfy Lamfalussy Minimum Standards III and IV,
which deal with risk management and settlement completion. Risk
management devices that lead to a substantially equivalent degree of
risk management and control could also be adopted, as approved by the
Board on a case-by-case basis.
The Board's final policy statement makes it clear that multilateral
netting systems utilizing a central counterparty would be expected to
satisfy the risk management measure relating to bilateral net credit
limits through the establishment by the central counterparty of net
credit limits vis-a-vis each participant. In addition, each participant
would be expected to establish a bilateral net credit limit for the
central counterparty.
The Board has clarified its final policy statement to encourage
large-dollar multilateral netting systems to establish a capability to
simulate the effect on liquidity resources and risk management controls
of one or more defaults by existing participants, as well as the
effects of adding additional participants or products to the system. In
addition, the Board has further encouraged large-dollar systems for
contract netting to conduct simulation analyses of forward replacement
cost risk under different assumptions about changes in market prices,
volatilities, and other factors.
The Board has not adopted at this time a specific higher standard
for multilateral netting systems that may present a high degree of
systemic risk. Although the Board believes that it might be appropriate
for such systems to meet additional standards beyond the six Lamfalussy
Minimum Standards, the costs and benefits of meeting a higher standard
remain unclear. Public comments, however, appear to indicate a
consensus that higher standards would be appropriate when the costs are
justified. Thus, the Federal Reserve will continue to work on a case-
by-case basis with individual large-dollar multilateral netting systems
it believes 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, in order to determine
whether higher risk standards, including the ability to ensure
settlement in the event of multiple defaults, would be appropriate. In
no event, would systems be discouraged from adopting higher standards
based on specific risk assessments. The Board will continue to review
the experience of netting systems with risk management measures to deal
with multiple defaults.
Timeframe for Implementation of the Lamfalussy Minimum Standards
Consistent with its earlier proposal, the Board's final policy
statement retains an eighteen-month transition period for large-dollar
multilateral netting systems that are operating on or before December
21, 1994. Such systems will be expected to comply fully with the policy
statement within the eighteen-month transition period. Large-dollar
multilateral netting systems established subsequent to December 21,
1994 will be expected to comply fully with the policy statement,
without benefit of a transition period.
IV. Summary of Comments
The Board received twenty-one public comment letters on its
proposed policy statement.1 The commenters were distributed as
follows:
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\1\ This total does not include comment letters sent by Federal
Reserve Banks.
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Type of institution Number
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Clearing Organizations and Associations......................... 10
Commercial Banking Organizations................................ 5
Trade Associations.............................................. 3
Retail Payment Networks......................................... 2
Regulatory Agencies............................................. 1
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Total......................................................... 21
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General Comments
Twelve commenters did not respond to the application of the
Lamfalussy Minimum Standards to large-dollar multilateral payment
netting systems, but instead stated opposition to the application of
the standards to large-dollar multilateral netting systems for batch
processed paper-based or electronic payments. Some of these commenters
provided important insights into the operational characteristics of
such systems. These commenters noted further that the National
Organization of Clearing Houses (NOCH) and the National Automated
Clearing House Association (NACHA) have jointly organized a
``Settlement Risk Management Task Force,'' the mandate of which is to
conduct an analysis of ``the systemic and liquidity risks associated
with the clearing and settlement of batch payment transactions like ACH
entries and checks.'' One of the twelve commenters proposed that the
Board exclude batch systems from the minimum standards until it has
examined further systemic risk in these systems rather than grant a
temporary exemption. Another commenter proposed that the criteria that
delimit the application of the policy be designed explicitly to exclude
large-dollar multilateral netting systems for batch processed paper-
based and electronic payments.
The Board stated in its request for comment that certain electronic
controls that would be required to implement the Lamfalussy Minimum
Standards might not be feasible for large-dollar multilateral netting
systems for batch processed paper-based and electronic payment systems
and that the rights and responsibilities of parties within such systems
might require further analysis. As noted above, the Board is not
applying the Lamfalussy Minimum Standards to large-dollar multilateral
netting systems for batch processed paper-based and electronic payments
at this time. Moreover, the Board intends to monitor closely the
discussions and analysis of the NOCH/NACHA task force to supplement the
Board's analysis of appropriate risk management measures for such
systems.
The remaining nine commenters generally supported the adoption of
the Lamfalussy Minimum Standards in the Board's policy statement on
large-dollar multilateral netting systems. These commenters also stated
that a specific higher standard for controlling risks in systems with a
high degree of systemic risk should not be implemented at this time.
Specific Issues on which the Board Sought Comment
1. Proposed criteria for identifying large-dollar multilateral netting
systems subject to the policy statement
The commenters generally agreed with the proposed criteria. One
commenter suggested that the Board clarify whether exchange clearing
systems for derivatives other than futures and options, such as
interest rate swaps, would be subject to the proposed policy. The Board
believes that the Lamfalussy Minimum Standards provide a useful
starting point for the analysis of large-dollar multilateral netting
systems irrespective of the type of financial instrument or contractual
obligation netted by the system. It is premature, however, to determine
whether the Lamfalussy Minimum Standards provide a sufficient framework
for the development of clearinghouses for interest rate swaps. The
Board notes that in its comment letter the Commodity Futures Trading
Commission (CFTC) stated that ``[i]n general, the Commission agrees
with the FRB that the minimum standards for netting recommended by the
Lamfalussy Report (``Lamfalussy Minimum Standards'') represent a core
of minimum requirements for multilateral netting systems.''
One commenter proposed that the financial condition of the
participants as well as the underlying instrument to be settled should
be considered as criteria. Another commenter proposed that only new
multicurrency multilateral netting arrangements should be subject to
the policy and that existing netting systems should be exempt. The
Board has set forth criteria that it believes are appropriate for
identifying large-dollar multilateral netting systems with the
potential to increase systemic risk in financial markets. The Board
believes that the prospective application of the policy statement would
ignore the potential for increased systemic risk posed by existing
multilateral netting systems. Moreover, the application of the
Lamfalussy Minimum Standards on a prospective basis only would lead to
competitive inequalities between existing multilateral netting systems
and those that may become operational in the future.
Several commenters suggested that the Board clarify the meaning of
the words ``routinely process'' in the third threshold criterion that
deals with individual payments or foreign exchange contracts with a
stated dollar value larger than $500,000. One of these commenters
proposed that the Board adopt a definite test of transaction size, and
specifically suggested that systems with payments having an average
size of $100,000 or more be covered by the policy statement. In support
of this suggestion, the commenter noted, ``[w]e believe that any funds
transfer system that has an average payment size of $100,000 would
``routinely'' process payments of $500,000 or more.''
The Board agrees that it would be helpful to the financial markets
for the policy statement to articulate as clearly as possible the
conditions under which a multilateral netting system would be subject
to the policy statement. The Board believes that an average transaction
size threshold would allow the operators of multilateral netting
systems, and the participants in those systems, to determine more
easily when they are covered by the policy. Accordingly, the third
threshold criterion for identifying large-dollar multilateral netting
systems subject to the policy statement has been modified to take
account of the daily average transaction size over a twelve month time
period.
One commenter proposed that a threshold greater than $500 million
in daily net settlements should be considered by the Board since large-
dollar multilateral netting systems are more likely to have
significantly higher aggregate daily net settlements. The Board
continues to believe that $500 million in daily net settlements is an
appropriate threshold. It is important to recognize that, in
multilateral netting systems, the value of net settlements is often
less than 10 percent, and sometimes less than 5 percent, of the gross
daily value of transactions. Thus, net settlements of $500,000 may
represent transactions with a daily aggregate value considerably in
excess of $5 billion or even $10 billion. Settlement failures of this
magnitude have the potential to create significant liquidity problems
for their participants and to generate systemic risks. Moreover, the
Board is excluding check clearing and ACH systems that might otherwise
be covered, and which raise separate issues, from the policy statement
at this time.
2. The five risk management measures for implementation of the
Lamfalussy Minimum Standard
The first risk management measure is that each participant
establish bilateral net credit limits vis-a-vis each other participant
in the system. Two commenters proposed that the Board clarify this
measure with regard to netting systems that utilize a central
counterparty. These commenters suggested that such systems should be
able to meet the first risk measure by establishing bilateral net
credit limits between the central counterparty and each participant
rather than between each participant. The Board concurs with this
analysis and the final policy statement makes it clear that
multilateral netting systems utilizing a central counterparty would be
expected to satisfy the first risk management measure through the
establishment by the central counterparty of net credit limits vis-a-
vis each participant. In addition, the Board expects that each
participant will establish a bilateral net credit limit for the central
counterparty. The Board notes that the establishment of bilateral net
credit limits between the central counterparty and each participant
would not necessarily eliminate the need for traditional bilateral
credit limits between participants, if bilateral exposures are
incurred, or preclude the establishment of automated bilateral credit
limits between participants as part of certain overall types of risk
management designs for a clearinghouse.
The second and third risk management measures require large-dollar
multilateral netting systems to establish and monitor in real time
system-specific net debit limits and reject or hold any payment or
foreign exchange contract that would exceed the relevant bilateral and
net debit limits. Two commenters raised issues regarding the
application of these two measures to forward-value foreign exchange
contract netting systems. One commenter stated that forward-value
contract netting systems would typically stop accepting contracts for a
particular value date at some point prior to the start of settlement
for that value date. Therefore, except for changes in the forward value
of contracts as a result of changes in foreign exchange rates, the size
of any unmargined settlement exposure in excess of a net debit limit
would be known in advance of the settlement date. The commenter went on
to argue that real time monitoring of net debit limits would be
inappropriate for forward-value contract netting systems, since system
operators could collect additional margin or otherwise cover any
settlement exposure prior to settlement.
The Board believes that real-time monitoring is an important device
for controlling the settlement and forward replacement cost risks
inherent in multilateral netting systems. The capability to monitor
these exposures is especially critical for netting systems that accept
transactions for same day, or even possibly next day, settlement. In
general, however, the strength of alternatives to real-time monitoring
must be judged in the context of the risks and risk management systems
of specific multilateral netting arrangements.
Two commenters contended that rejecting contracts for trades that
exceed net debit limits on a contract netting system would be unfair to
counterparties that did not violate net debit limits and would disrupt
market liquidity. The Board believes that the ability of a netting
system to reject, or possibly pend, transactions that violate risk
management parameters is a critical risk management tool for
multilateral netting systems, irrespective of whether the system nets
payment orders or forward-value contracts. Issues relating to impacts
on market liquidity need to be assessed in relation to the impact on
market liquidity if a multilateral netting system were to collapse as a
result of the inability of the system to protect adequately itself and
its participants. Moreover, in response to the installation of systems
for rejecting transactions, system participants would normally develop
contingency plans to deal with rejected items. It should also be noted
that the Board has the flexibility to approve on a case-by-case basis
risk management devices that lead to a substantially equivalent degree
of risk management and control as the five risk management measures
contained in the policy statement.
Two commenters suggested that the real-time monitoring requirement
should be expanded to a twenty-four hour basis. Although the Board does
not discourage systems from adopting higher standards based on specific
risk assessments, it believes that twenty-four hour monitoring of
system specific net debit limits and netted transactions would not be
necessary for all types of multilateral netting systems. The Board
expects that multilateral netting systems will adopt risk management
systems that are appropriate to the scale and nature of the credit,
liquidity, and settlement risks inherent in the system. For example,
twenty-four hour monitoring of net debit limits and netted transactions
would likely be an appropriate risk management measure for any
multilateral multicurrency netting system with significant foreign
currency exposures.
The fourth risk measure requires multilateral netting systems to
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. One commenter proposed that for
contract netting systems, the largest single net debit position should
be defined as the aggregate of all final net settlement payments due
from a single participant on the relevant value date. The Board
believes that its definition of the term ``largest single net debit''
is sufficiently flexible to accommodate the specific operational
aspects of contract netting systems.
Two commenters proposed that U.S. Treasury securities or other
high-grade collateral should be acceptable as liquidity resources. The
Board notes that a critical characteristic of liquidity resources that
support settlement is that they be highly liquid. While it is true that
high-grade securities are considered highly liquid during most hours of
the trading day, it is less clear that such securities can be readily
converted to cash late in the business day when a settlement failure is
most likely to occur. Consequently, the Board believes that liquidity
resources in support of settlement should take the form of cash,
committed lines of credit secured by collateral, or some combination
thereof. In individual cases, U.S. Treasury securities may provide an
appropriate source of liquidity. Clearly, U.S. Treasury securities
would be an important source of collateral for committed lines of
credit.
Several commenters agreed with the fifth risk measure that would
require system participants to establish rules and procedures for the
sharing of credit losses. Several commenters also endorsed the Board's
statement that it will consider, on a case-by-case basis, alternative
risk measures that would lead to a substantially equivalent degree of
risk management and control as the five risk management measures
identified in the policy statement.
3. Timeframe for Implementation of the Lamfalussy Minimum Standards
Most commenters agreed that 18 months is a reasonable time period
in which to expect existing large-dollar multilateral netting systems
to meet the Lamfalussy Minimum Standards. One commenter proposed a two
year timeframe, and two others proposed that flexibility be built into
the process for systems that are making a good faith effort to comply
with the standards.
The Lamfalussy Report was published four years ago by the G-10
central bank Governors, and it has been clear to the financial markets
for some time that large-dollar systems would ultimately be expected to
meet some version of these standards. The Board has adopted an eighteen
month transition period in order to provide existing multilateral
netting systems sufficient time, and the incentives associated with a
clear deadline, to implement any needed changes.
4. Establishment of a higher standard than Lamfalussy Minimum Standard
IV for systems that present a high degree of systemic risk
Lamfalussy Minimum Standard IV requires that a netting system be
capable of ensuring the completion of daily settlement in the event
that the participant with the largest net debit position is unable to
settle its obligation to the system. The Board requested comment on
whether this standard should be enhanced for systems that may present a
high degree of systemic risk. The Board also requested comment on
establishing a threshold to define such systems.
Several commenters expressed concern about the cost of requiring
additional risk controls. One commenter proposed that simulations be
conducted of the effects of multiple participant defaults in systems in
order to analyze the costs and benefits of a higher standard. This
commenter also suggested that start-up systems should not be held to a
higher standard as the cost of meeting the standard may be prohibitive.
Commenters were unanimous in their opinion that quantifying a
threshold to define high systemic risk would be difficult, although one
commenter proposed a threshold based on the ratio of uncollateralized
net debit positions to Tier One capital weighted according to credit
rating. One commenter proposed that the Board defer action on adopting
a higher standard, and another proposed that higher risk measures be
imposed by the Board only on a case-by-case basis. As the Board has
noted, it is not adopting a higher standard at this time. The Federal
Reserve will continue to work on a case-by-case basis with individual
large-dollar multilateral netting systems it believes 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, in order to determine whether higher risk
standards, including the ability to ensure settlement in the event of
multiple defaults, would be appropriate. In order to help quantify the
risks, the Board is also encouraging netting systems to adopt regular
simulation analyses in order to determine the effects, among other
risks, of multiple participant defaults.
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.2 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.
---------------------------------------------------------------------------
\2\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 Lamfalussy Minimum Standards
will have a direct and material impact on the ability of other service
providers to compete effectively with the Reserve Banks' payments
services. The Board notes that in several cases the payment services
potentially covered by the policy statement are not offered by the
Federal Reserve Banks. For example, the Federal Reserve Banks do not
offer services relating to the electronic clearing and settlement of
payments or contracts in foreign currencies.
In the case of domestic large-dollar multilateral netting systems,
a number of the risk control measures proposed to meet the Lamfalussy
Minimum Standards as well as certain of the standards themselves have
grown out of the experience of the private sector in developing robust
netting arrangements and are currently employed in multilateral netting
systems. To the extent an incremental burden might be imposed on large-
dollar systems, the need to reduce and control the large potential
systemic risks of such systems would justify the adoption of prudent
standards and measures to control risk. The Board does not expect at
this time, however, that the adoption of the Lamfalussy Minimum
Standards would have a direct and material impact on the ability of
other service providers to compete with the Federal Reserve Banks.
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 Networks'' by replacing in the heading the word ``Networks''
with the word ``Systems;'' deleting ``A. Private Large-Dollar Funds
Transfer Networks'' in its entirety and replacing that part with ``A.
Privately Operated Large-Dollar Multilateral Netting Systems;'' and
deleting ``C. Offshore Dollar Clearing and Settlement Systems'' and
redesignating ``D. Private Small-Dollar Clearing and Settlement
Systems'' as ``C. Private Small-Dollar Clearing and Settlement
Systems.''
II. Policies For Private-Sector Systems
A. Privately Operated Large-Dollar Multilateral Netting Systems
Large-dollar multilateral netting systems can create a significant
degree of credit and liquidity risk for their participants and also
expose the U.S. payments system and financial markets to systemic risk.
In the context of large-dollar multilateral netting systems, systemic
risk is the risk that the inability of one institution within such a
system, including a central counterparty if one exists, to meet its
obligations when due will lead to the illiquidity or failure of other
institutions, either within the particular system or in the financial
markets as a whole.
Large-dollar multilateral netting systems may produce efficiencies
in the clearance and settlement of payments and financial contracts. At
the same time, multilateral netting may obscure, concentrate, and
redistribute the credit and liquidity risks associated with clearance
and settlement. As the size of netted positions increases, for example,
so do the potential liquidity effects on such systems and their
participants, as well as third parties, in the event of a settlement
failure. In addition, if the high volumes of interrelated large-value
financial contracts and payments, which reflect money and capital
market activity, are not settled in a timely manner, there is a
significant potential for widespread financial market disruption.
Certain types of netting system rules may also create sizable
systemic liquidity risks, if employed by systems that process large-
value payments or financial contracts that are central to the operation
of financial markets. For example, privately operated payment systems
that permit a system operator to unwind, recast, or otherwise reverse
same-day funds transfers made by system participants, whether for
reasons of general financial market stress or because of the inability
of a system participant to settle its obligations on time, can obscure
and greatly increase the level of systemic liquidity risk associated
with the system. As a general matter, the Board does not view a same-
day recast, unwind, or reversal of payments as a satisfactory mechanism
for managing liquidity and settlement risks in large-dollar
multilateral netting arrangements.
The Board also recognizes that the development of offshore
multilateral netting systems for large-dollar payments and foreign
exchange contracts may raise concerns about systemic risk that extend
beyond the potential for disturbances to payment and settlement
systems, or financial markets, in the United States. For example, the
offshore clearing of U.S. dollar payments, for subsequent net
settlement in the United States, may create transactional and other
efficiencies for participants in such offshore systems. At the same
time, these arrangements have the potential to concentrate settlement
risks at clearing organizations and their associated settlement agents
either in the United States or abroad. If the allocation of credit and
liquidity risks associated with the netting is not clearly defined,
understood, and managed, offshore dollar-clearing arrangements may
obscure, or even increase, the level of systemic risk in U.S. and
offshore large-dollar payments systems, as well as in the international
dollar settlement process. Poorly designed and managed systems may,
therefore, increase risks to the international banking and financial
system. In addition, offshore arrangements have the potential to
operate without sufficient official oversight.
As the Federal Reserve implements fees for daylight overdrafts,
along with other risk management measures, it also is important that
risks not simply be shifted from the Federal Reserve's payment services
to private, inadequately structured multilateral netting arrangements,
either domestically or in other countries. For example, the Board has
been concerned that the steps being taken to reduce systemic risk in
U.S. large-dollar payments systems may induce the further development
of ``offshore'' large-dollar multilateral netting systems. These
offshore systems can settle directly through payments on Fedwire or
indirectly through a private large-dollar clearing system, which in
turn settles on a net basis using Fedwire.
In response to potential systemic risks and the possibility that
efforts to avoid risk controls will lead to inadequately structured and
managed systems, the Board is adopting minimum standards for the design
and operation of privately operated large-dollar multilateral netting
systems. The minimum standards apply whether or not these systems
operate domestically or in other countries. These minimum standards are
identical to those set out in the Report of the Committee on Interbank
Netting Schemes of the Central Banks of the Group of Ten Countries
(Lamfalussy Report).3 The Board recognizes that from time to time,
in specific cases, questions of interpretation of these standards, as
they apply to large-dollar multilateral netting systems, may have to be
resolved by the Board.
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\3\In November 1990, the Committee on Interbank Netting Schemes
of the Central Banks of the Group of Ten Countries produced a report
on multilateral netting schemes. The Committee was chaired by Mr.
Alexandre Lamfalussy, General Manager of the Bank for International
Settlements. That 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. In this regard, the Lamfalussy
Report developed and discussed, in some detail, both ``Minimum
Standards for Netting Schemes'' and ``Principles for Co-operative
Central Bank Oversight'' of such arrangements.
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It is important to note that the Board's adoption of the Lamfalussy
Minimum Standards in no way diminishes the primary responsibilities of
participants in, and operators of, large-dollar netting systems for
ensuring that these systems have adequate credit, liquidity, and
operational safeguards. In adopting this policy statement, it is the
Board's intent to heighten awareness of the risks associated with
multilateral netting arrangements and of the need for their prudent
management. The Board also seeks to provide the financial system with a
set of minimum criteria, which have been discussed by the G-10 central
banks, against which structural and risk management features of large-
dollar multilateral netting systems can be evaluated.
Scope and Application of the Policy. This policy statement is
directed toward any privately operated, multilateral netting system
that settles, or seeks to settle, U.S. dollar obligations through
payments affecting one or more accounts at Federal Reserve Banks,
either directly or indirectly (``multilateral netting systems'').
Multilateral netting systems include clearinghouse organizations, with
or without a central counterparty, for netting payments or foreign
exchange contracts among financial institutions.
The scope of the policy statement is limited to multilateral
netting systems that involve large-dollar settlements or payments. In
particular, such systems that: (1) Have three or more participants that
net payments or foreign exchange contracts involving the U.S. dollar,
whether or not netted amounts are legally binding; and either (2) have,
or are likely 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 (3)
process payments or foreign exchange contracts, with a daily average
stated dollar value, calculated over a twelve month period
corresponding to the most recent fiscal year for the netting system,
larger than $100,000.
A multilateral netting system that meets the above criteria is
subject to the policy if (1) it is a state-chartered member of the
Federal Reserve System, (2) any of its agent(s) or participants are
state-chartered members of the Federal Reserve System, (3) its
participants' net positions are settled through a Federal Reserve
settlement account, (4) its participants settle their net positions in
the multilateral netting system through their individual Federal
Reserve accounts or the Federal Reserve account of the settlement
agent(s), or (5) one or more bank holding companies have an investment
in the multilateral netting system. The Board also reserves the right
to apply the elements of this policy to any non-dollar system based, or
operated, in the United States that engages in the multilateral
clearing or netting of non-dollar payments among financial institutions
and that would otherwise be subject to this policy. This policy does
not apply to systems dealing with exchange-traded futures and options.
In applying the policy, the Board seeks to distinguish between
routine banking relationships and arrangements that create a
multilateral ``system'' for clearing and settling U.S. dollar payment
and other obligations. This policy statement is not intended to apply
to routine bilateral relationships between financial institutions, such
as those involved in correspondent banking. In certain borderline
cases, for example involving netting systems operated by a single
financial institution and that combine elements of bilateral and
multilateral netting, a case-by-case determination that an arrangement
is a large-dollar multilateral netting system may be necessary for the
purpose of applying this policy statement.
In general, the participation in, and operation of, a multilateral
netting system is governed by rules and procedures designed to
facilitate multilateral clearance and settlement. Settlement risks are
typically shared by the participants in some fashion, either implicitly
or through employment of explicit loss-sharing and liquidity
arrangements. In contrast, correspondent banking relationships
generally focus on bilateral relationships and risks; the risk of a
settlement failure typically falls, at least initially and sometimes
primarily, on the service provider's or settlement agent's liquidity
resources and capital.
The Board believes that the Lamfalussy Minimum Standards may apply
to all large-dollar multilateral payment netting systems irrespective
of the type of financial instrument or contractual obligation netted by
the system. However, the Board recognizes that in the case of privately
operated large-dollar multilateral netting systems for batch processed
paper-based or electronic payments, including privately operated
Automated Clearing House (ACH) systems, certain electronic controls
that would be required to implement the Lamfalussy Minimum Standards
may not be feasible. Further, the rights and responsibilities of
parties within such systems may require further analysis. The Board
intends to study further the implications of the Lamfalussy Minimum
Standards, and various arrangements that might be used to implement
these standards, for privately operated large-dollar multilateral
netting systems for the batch processing of paper-based as well as
electronic payments. The Board is not, therefore, applying the
Lamfalussy Minimum Standards to these systems at this time.
Lamfalussy Minimum Standards for the Design and Operation of
Privately Operated Large-Dollar Multilateral Netting Systems. The
Federal Reserve's policy on privately operated large-dollar
multilateral netting systems is designed to strike an appropriate
balance between the requirements of market efficiency and payments
system stability. A direct means of achieving this balance is to ensure
that large-dollar multilateral netting systems are designed and
operated so that the participants and service providers have both the
incentives and the ability to manage the associated credit and
liquidity risks. The Board's approach to privately operated large-
dollar multilateral netting systems will be guided by the following
minimum standards for such systems:4
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\4\These standards are identical to the minimum standards for
netting systems in the Lamfalussy Report, with the exception that
the words ``netting system'' have been substituted for ``netting
scheme'' in minimum standards one, two, and six, and the words
``particular system'' have been substituted for ``particular
scheme'' in standard two.
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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.
The Federal Reserve reserves the right to prohibit the use of
Federal Reserve payment services to support funds transfers that are
used to settle, directly or indirectly, obligations on large-dollar
multilateral netting systems that do not meet the Lamfalussy Minimum
Standards. The Federal Reserve will also take appropriate supervisory
steps, or refer matters to the appropriate supervisory or regulatory
authority, in cases of systems not in compliance with the
aforementioned Lamfalussy Minimum Standards, or their equivalent.
Moreover, in order for Federal Reserve Banks to monitor the use of
intraday credit, no future or existing privately operated large-dollar
multilateral netting system will be permitted to settle on the books of
a Federal Reserve Bank unless its participants authorize the system to
provide position data to the Reserve Bank on request.
Implementation of the Lamfalussy Minimum Standards. The Board
believes that large-dollar multilateral netting systems, whether
onshore or offshore, should meet in full the Lamfalussy Minimum
Standards, as set forth in this policy statement. In order to satisfy
the Lamfalussy Minimum Standards, the Board expects that individual
large-dollar multilateral netting systems will utilize the following
risk management measures, or their equivalent: (1) 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;5 and (5) establish rules and procedures
for the sharing of credit losses among the participants in the netting
system. The Board will consider, on a case-by-case basis, alternative
risk management measures that provide for risk management systems and
controls that are equivalent to the five measures listed above. The
Board notes that the Lamfalussy Minimum Standards and the arrangements
to implement the Lamfalussy Minimum Standards, as discussed above, in
no way diminish the responsibilities of the participants in, and the
operator of, a large-dollar multilateral netting system to determine if
additional safeguards would be appropriate.
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\5\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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The Board recognizes that there are differences between
decentralized and centralized risk management structures for
multilateral netting systems. Some multilateral netting systems utilize
a clearinghouse or similar entity as the central counterparty to
transactions submitted by the system's participants for netting.
Depending upon the design of a particular system, the central
counterparty may bear directly both settlement exposures and forward
replacement cost exposures vis-a-vis participants.6 Consequently,
multilateral netting systems utilizing a central counterparty would be
expected to satisfy the first risk management measure through the
establishment by the central counterparty of net credit limits vis-a-
vis each participant. In addition, each participant would be expected
to establish a bilateral net credit limit for the central counterparty.
The establishment of bilateral net credit limits between the central
counterparty and each participant would not necessarily eliminate the
need for traditional bilateral credit limits between participants, if
bilateral exposures are incurred, or preclude the establishment of
automated bilateral net credit limits between participants as part of
certain overall types of risk management designs for a clearinghouse.
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\6\For example, the central counterparty in a foreign exchange
contract netting system would face forward replacement cost
exposures as well as settlement exposures.
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The Board encourages large-dollar multilateral netting systems to
establish a capability to simulate the effect on liquidity resources
and risk management controls of one or more defaults by existing
participants, as well as the effects of adding additional participants
or products to the system. In view of the complexity of multilateral
netting and the potential systemic risks of such systems, the Board
believes the capability to simulate the effects of participant defaults
as well as adding additional participants and products is a prudent
risk management device that should be employed by large-dollar
multilateral netting systems.
In addition, the Board encourages large-dollar systems for contract
netting to conduct simulation analyses of forward replacement cost
risks under different assumptions about changes in market prices,
volatilities, and other factors. Such analyses will help to determine
the sensitivity of the netting system to changes in market factors and
help ensure that a netting system is able to withstand a default by the
participants with one or more of the largest net debits on the system.
Timeframe for Implementation of the Lamfalussy Minimum Standards.
The Board recognizes that not all existing large-dollar multilateral
netting systems may meet the Lamfalussy Minimum Standards, and the
associated requirements for implementation of those standards, set
forth in this policy statement. The Board also recognizes that existing
large-dollar multilateral netting systems will need a period of time in
which to make any needed changes to their organization and operations.
Consequently, the Board believes that an eighteen-month transition
period would be appropriate for large-dollar multilateral netting
systems that are operating on December 21, 1994. Such systems will be
expected to comply fully with the policy statement by June 21, 1996.
Large-dollar multilateral netting systems established subsequent to
December 21, 1994 will be expected to comply fully with the policy
statement, without benefit of a transition period.
The Board intends to review periodically the scale and nature of
the credit, liquidity, and settlement risks in privately operated
large-dollar multilateral netting systems. Operators of such systems
should ensure that as the scale of risks in their systems increase,
risk management systems are designed and operated to control the
increased scale of risk. The Federal Reserve will continue to work on a
case-by-case basis with individual large-dollar multilateral netting
systems it believes 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, in order to determine
whether higher risk standards, including the ability to ensure
settlement in the event of multiple defaults, would be appropriate.
Moreover, the Board expects that over time, whenever systems are
changed or redesigned, significant attention will be given to the issue
of risk management in order to ensure that high standards of risk
control are achieved.
In addition, offshore, large-dollar multilateral netting systems
and multicurrency netting 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 netting 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, December 21, 1994.
William W. Wiles,
Secretary of the Board.
[FR Doc. 94-32014 Filed 12-28-94; 8:45 am]
BILLING CODE 6210-01-P
