[Federal Register Volume 63, Number 123 (Friday, June 26, 1998)]
[Notices]
[Pages 34888-34895]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16694]
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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: Policy statement.
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SUMMARY: As part of its payment system risk reduction program, the
Board of Governors is adopting a policy statement on Privately Operated
Multilateral Settlement Systems, which integrates its existing policies
on Privately Operated Large-Dollar Multilateral Netting Systems and
Private Small-Dollar Clearing and Settlement Systems into one
comprehensive policy.
EFFECTIVE DATE: January 4, 1999.
FOR FURTHER INFORMATION CONTACT: Jeffrey C. Marquardt, Assistant
Director (202/452-2360) or Paul Bettge, Assistant Director (202/452-
3174); Oliver Ireland, Associate General Counsel (202/452-3625); for
the hearing impaired only, Telecommunications Device for the Deaf,
Diane Jenkins (202/452-3544).
SUPPLEMENTARY INFORMATION:
I. The Proposed Policy Statement
In November, 1997, the Board issued for public comment a proposal
to adopt a policy statement on Privately Operated Multilateral
Settlement Systems (62 FR 60713, Nov. 12, 1997). The proposed policy
statement was designed to integrate several of the Board's existing
policies on payment system risk into a more comprehensive and
consistent framework. The proposed policy statement addressed risks in
multilateral settlement arrangements for both ``small-dollar''
payments, such as clearinghouses for checks and automated clearing
house (ACH) payments and systems for settlement of ``large-dollar''
payments, which are typically used for interbank and financial market
transactions. The proposal was intended to provide a flexible, risk-
based approach to risk management in these systems and not mandate
uniform, rigid requirements for all systems.
The proposed policy statement identified fundamental categories of
risk, including credit, liquidity, operational, legal, and systemic
risk, that may arise in different types of multilateral settlement
arrangements. Systems would be expected to address any material risks
in each category. For each type of risk, the policy statement included
first, a discussion of risk factors designed to identify those
multilateral settlement systems where risks may be heightened relative
to other means of settlement. Second, threshold criteria were intended
to identify more clearly systems in which these risk factors were not
likely to arise. These criteria were intended to simplify
administration of the policy and reduce potential regulatory burden on
systems where the Board's analysis suggests that risks may be minimal.
(An Appendix published with the proposed policy statement also provided
examples of the likely application of the policy statement to specific
types of systems.) Third, the proposed policy statement provided
illustrations of the types 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, these illustrations were intended to provide
flexible guidance rather than an exhaustive or prescriptive set of
requirements, such that systems would be encouraged to implement risk
management measures commensurate with the scale and scope of risks.
For multilateral settlement systems that were considered
sufficiently large to raise potential systemic risk concerns, the
proposed policy statement would have imposed higher risk management
standards. Those larger systems that met proposed systemic risk
criteria would have been expected to demonstrate robust policies and
procedures for addressing settlement failures and disruptions. Certain
of those larger multilateral settlement systems would also have been
required to meet the same requirements of the Board's existing policy
statement on Privately Operated Large-Dollar Multilateral Netting
Systems (Large-Dollar Policy Statement), including meeting the
Lamfalussy Minimum Standards.1
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\1\ Report of the Committee on Interbank Netting Schemes of the
Central Banks of the Group of Ten Countries (Bank for International
Settlements, November 1990) presented a set of minimum standards for
netting schemes (Lamfalussy Minimum Standards).
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The Board also proposed to repeal its existing risk policies for
certain ``small-dollar'' payments clearing and settlement arrangements.
The earlier policies were designed to address specific situations that
arose in the Federal Reserve's provision of net settlement services to
depository institutions. The proposed policy statement would eliminate
the need for such policies.
II. The Final Policy Statement
The Board is adopting a final policy statement that retains the
structure and analytical approach of the original proposal. The policy
statement replaces two existing components of the Board's Policy
Statement on Payments System Risk, namely those for ``Privately
Operated Large-Dollar Multilateral Netting Systems'' and ``Private
Small-Dollar Clearing and Settlement Systems,'' which are being
repealed concurrently with the effective date of this policy statement.
As in the proposal, multilateral settlement systems subject to the
policy would be required to address risk factors using a set of basic
analytical risk categories. The final policy statement reflects
important modifications to the original proposal designed to improve
the clarity and effectiveness of the policy and to address concerns
identified by commenters.
Scope and Administration of the Policy
The final policy statement includes a general threshold for
application of the policy in order to eliminate potential
administrative burden on those smaller
[[Page 34889]]
systems that are not likely to pose systemic risks or other significant
risk concerns. Specifically, the policy will apply to those
multilateral settlement systems that settle payments with an aggregate
gross value of more than $5 billion on any day. The Board believes that
systems with activity below this threshold and their members may
nonetheless find the framework and analysis of the policy statement
helpful in evaluating and managing risks.
Risk Factors and Risk Management Measures
The final policy statement largely retains the discussions of
credit, liquidity, operational, and legal risk factors and risk
management measures in the proposal. Technical modifications have been
made in a number of areas, however, to clarify the policy and address
concerns of commenters, as discussed further below. In conjunction with
the limitation on the scope of the policy discussed above, the final
policy has been simplified by elimination of the proposed separate
Systemic Risk category.
As in the proposed policy statement and the Board's existing Policy
Statement on Payments System Risk, certain systems are required to meet
the Lamfalussy Minimum Standards. However, under the final policy, the
Board will use several factors to determine whether a system should
meet the Lamfalussy Minimum Standards. These factors include the
settlement of predominantly large-value, interbank or other financial
market transactions, such as foreign exchange transactions, or the
existence of credit or liquidity exposures that have the potential to
raise significant systemic risk concerns. These factors should ensure
that the Lamfalussy Minimum Standards will be applied where systemic
risks exist, but allow for more flexible risk management in other
systems. The Board may be required to make infrequent case-by-case
determinations in this regard. In addition, the final policy strongly
encourages systems, in meeting the Lamfalussy Minimum Standards, to
establish real-time risk controls and other specific risk management
measures, as currently described in the Board's existing Large-Dollar
Policy Statement. However, alternative risk management measures that
provide an equivalent level of assurance that the Lamfalussy Minimum
Standards will be met will also be considered. The final policy also
includes modified terminology in restating the Lamfalussy Minimum
Standards to reflect the policy's broader application to ``settlement''
systems rather than to ``netting'' systems only.
III. Summary of Comments
The Board received 26 public comment letters on its proposed policy
statement.2 The commenters included nine commercial banking
organizations, seven clearing organizations and associations, seven
retail payment networks, and three trade associations.
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\2\ This total does not include comment letters from Federal
Reserve Banks.
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General Comments
Commenters generally supported the policy's flexible approach to
addressing risks in multilateral settlement arrangements. Many also
supported the integration of the Board's existing policy statements
within a unified, analytical framework. However, a number of commenters
expressed concerns about the inclusion of clearinghouses for small-
dollar or traditionally retail-oriented payments, such as checks, ACH
payments, and automated teller machine (ATM) and credit card
transactions, within a comprehensive policy on settlement risk. Many of
these commenters focused on the requirements for real-time risk
controls associated with the Lamfalussy Minimum Standards (discussed
further below) and on the implication that small-dollar payments
settlement arrangements may pose systemic risk. Three commenters felt
that there was no rationale for unifying the large-and small-dollar
policies for settlement arrangements.
A number of commenters described risk management measures used in
their system and requested exemptions from the policy based on those
measures. Several commenters requested that particular types of systems
or payments be exempt from the policy altogether, such as credit card
or ATM card settlement arrangements. Several commenters felt that the
policy was too vague and did not provide sufficient guidance regarding
measures that would be adequate for compliance with the policy.
The limitation on the scope of the policy to systems with daily
payment activity above $5 billion should address concerns expressed by
commenters about the potential burden of the policy statement on
smaller, retail-oriented systems. Under the policy, only the largest
systems will need to complete an analysis of credit, liquidity,
operational, and legal risks.
For systems subject to the policy statement, the Board believes
that the flexible approach set out in the policy, while requiring more
careful analysis on the part of the clearinghouses than would a more
rigid set of requirements, is the most likely to lead to appropriate
risk management measures commensurate with the level and nature of
risks in different systems. The Board emphasizes that the policy does
not necessarily imply that any particular system needs to make changes
to its policies or procedures. In particular, for some systems covered
by the policy, the risk factors described in the policy statement may
not be significant. For systems that do exhibit one or more risk
factors, the types of risk management measures described by a number of
commenters are likely to be sufficient to meet the requirements of the
policy statement. Moreover, the new policy is likely to be less
burdensome than the Board's existing payment system risk policies for
small-dollar payments arrangements because it does not contain specific
risk management requirements for these systems. The final policy also
clarifies that, in general, the Board does not believe that retail-
oriented systems need to meet fully the Lamfalussy Minimum Standards
and implement real-time risk controls.
Six commenters requested that the Board reference and endorse other
reports on payment system risk, including one report on settlement risk
issued by a private-sector task force (the NACHA/NOCH Report) and a
General Accounting Office report.3 These reports include
useful background information and insights on certain aspects of
payment system risk. Although many of the findings of the NACHA/NOCH
Report are consistent with those in this policy statement, the Board
does not believe that it would be appropriate to attempt to incorporate
these findings within this policy statement.
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\3\ National Organization of Clearing Houses and National
Automated Clearing House Association, Report of the Settlement Risk
Management Task Force: Findings and Recommendations, 1996; General
Accounting Office, Payments, Clearance, and Settlement: A Guide to
the Systems, Risks, and Issues, June 1997, GAO/GGD-97-73.
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Specific Issues on Which the Board Sought Comment
1. Identification of Material Risks; Threshold Criteria
Most commenters felt that the risk categories and descriptions of
risk factors and risk management measures reasonably captured the
features of multilateral settlement systems likely to lead to greater
settlement risk (with the exception of the Systemic Risk category,
discussed below). Two commenters requested that definitions of major
risks
[[Page 34890]]
be included in the policy. The final policy includes brief definitions
of credit, liquidity, operational, and legal risks in the context of
settlement risk management.
As noted above, the proposed policy statement included ``threshold
criteria'' for each risk category to distinguish systems not likely to
pose material risk factors. Many commenters requested clarification of
the definition of certain of the thresholds. A number of commenters
described certain features of their system and requested that systems
with these features be exempt from the policy. Others noted that
certain risk factors, such as loss-sharing arrangements, would in many
cases not give rise to material risks for participants given the small
size of potential losses. A number of participants felt that the
netting factor was not a useful indication of liquidity risk.
The original intent of the threshold criteria was to provide
simple, de minimis exclusions for systems where risks were not likely
to be material. Questions raised by commenters indicate that these
criteria may not prove to be as simple to implement as originally
intended. The limitation on the scope of the policy to systems with
daily payment activity above $5 billion should address many of the
concerns of commenters. The final policy thus does not include separate
threshold criteria, although it retains the closely related discussion
of risk factors.
Some commenters requested that the Board clarify that not all risk
management measures listed under the discussion of risk management
measures are required to address a particular risk factor. The final
policy clarifies that this is the case.
Some commenters, such as ATM networks, requested greater
specificity on which risk management measures would be required for
their systems in order to be considered in compliance with the policy
statement. Others requested that the Board confirm that certain risk
measures used by their system would be considered sufficient to address
a particular risk factor in all cases. For example, two commenters
requested that the Board confirm that credit card systems do not
exhibit legal risk by virtue of their operating rules; other commenters
requested that use of the Federal Reserve's net settlement service be
considered adequate protection against legal risk. Some commenters
requested clarification on the acceptability of gross versus net
recasts of payments in a settlement failure situation.
As noted above, the limitation on the scope of the policy to the
largest systems should address many of the concerns of commenters. Even
for these larger systems, the Board believes that because different
systems may implement different risk management measures appropriate to
the scale of risks and the nature of their operations, additional
prescriptive requirements would not be appropriate for all systems and
would undermine the flexible approach of the policy. Moreover, the
Board is not in a position to confirm that particular measures adopted
by particular systems, such as specific time frames for settlement,
provisions of system rules, or use of any particular settlement
services, would be sufficient to address particular risk factors
independent of detailed knowledge of the operations and other features
of the particular system on an ongoing basis. However, the final policy
clarifies that a system that exhibits one or more risk factors does not
necessarily need to enhance its risk management policies and procedures
if existing arrangements are adequate to address the particular risk
factor.
2. Systemic Risk Criteria and Risk Management Measures
The proposed policy set out dollar thresholds for identifying
systems that have the potential to pose systemic risk. The Board
requested comment on the thresholds used to identify those systems with
the potential to pose systemic risk, as well as on the risk management
measures specified for such systems. Commenters suggested a range of
different criteria that may be indicative of systemic risk, including
gross and net settlement volumes, settlements relative to individual
participants' capital, and the characteristics of underlying payments.
Some commenters noted that a uniform threshold was inappropriate, as
systemic risk could depend on many factors. Commenters also requested
clarification on risk management measures, including the application of
the Lamfalussy Minimum Standards.
To simplify the analysis and assessment of risks and address
concerns expressed by commenters, the final policy does not include a
separate component for ``Systemic Risk.'' As noted earlier, the overall
scope of the policy has also been limited to systems with aggregate
gross daily payment activity above $5 billion. This threshold is also
consistent with suggestions made by some commenters for identifying
systems that may pose systemic risk. The Board considered other
thresholds, such as those based on settlement exposures relative to the
capital of participants, but concluded that such thresholds would be
overly complex and burdensome as a means of identifying systems that
are subject to the policy statement (as well as those that are not).
The Board continues to believe that the Lamfalussy Minimum
Standards provide important guidance for addressing settlement risk in
multilateral settlement systems where failure to settle net obligations
as and when expected could have systemic consequences. However, the
requirement that a system be capable of settling all positions in the
event of the default of the largest single participant may not be
necessary for certain systems. Although large check, ACH, and credit
card settlement arrangements, for example, should demonstrate sound
risk management measures, the Board does not believe that all of the
requirements of the Lamfalussy Minimum Standards are generally
necessary for these systems. Settlement obligations for individual
participants are not of the same magnitude as in traditional large-
value payment systems, and credit and liquidity exposures are typically
diversified over large numbers of participants. In many cases, there
are reliable and timely alternatives to settlement through the
clearinghouse, particularly for check and ACH clearing and settlement
arrangements.
The Board will, therefore, apply additional factors to determine
whether systems must meet the Lamfalussy Minimum Standards. These
factors include settlement of high volumes of large-value, interbank or
other financial market transactions, such as foreign exchange
transactions, or significant systemic credit or liquidity risks.
The proposed policy enumerated the five implementation measures,
including real-time controls and net debit caps, required of systems
currently subject to the Lamfalussy Minimum Standards. Many commenters
felt that real-time interbank risk controls and bilateral credit limits
were generally not feasible or desirable for retail payment systems.
The modifications to the proposal discussed above should obviate
these concerns. In addition, to provide additional flexibility, the
final policy has been modified to permit alternative risk management
controls that provide an equivalent level of certainty that the
Lamfalussy Minimum Standards can be met. The final policy also
clarifies that, as in the Board's existing policy for large-dollar
multilateral netting systems, centrally managed limits between the
[[Page 34891]]
system and each participant would be considered equivalent to bilateral
limits when the system itself acts as a central counterparty or
otherwise guarantees settlement. This is also consistent with the
Board's approach under Regulation F, where institutions are required to
set bilateral limits on credit and liquidity exposures to
correspondents and other counterparties.
3. Usefulness of an Appendix
Most commenters felt that the Appendix to the proposed policy
containing examples of application of the policy was useful, although
several commenters disagreed. Given the limitation on the scope of the
final policy, the Board does not believe that such examples are
necessary. Thus, the final policy does not include an Appendix.
Other Comments
1. Administration and Enforcement of the Policy Statement
A number of commenters raised questions about the administration
and enforcement of the policy statement. Two commenters stated that the
Board should not apply or enforce the policy through provision of
Federal Reserve net settlement services. Several commenters encouraged
the development of interagency supervisory examination procedures to
provide a consistent, objective approach to enforcement of the policy
statement. A few commenters requested that the legal status of the
policy statement be clarified, and that an appeals process be specified
for actions taken under the policy statement.
Like other components of the Board's Policy Statement on Payments
System Risk, this policy statement is not a regulation, but rather
provides the framework that the Board expects to use when taking action
on matters within its jurisdiction. The Board expects to administer the
policy statement through its existing authority, including its
supervisory jurisdiction over institutions such as state member banks
and bank holding companies, as well as Federal Reserve service
relationships, where appropriate. The assessment of compliance with the
policy statement will not be based on the use of any particular type of
Federal Reserve net settlement service, but rather on systems' risk
factors and risk management policies. The avenues for appealing actions
under the policy would be the same as in the Board's existing
supervisory or service relationships. Given the limited scope of the
final policy, the Board does not believe that interagency examination
procedures are needed at this time.
Two commenters asked that the Board clearly specify any reporting
requirements for gross and net settlement data and position data. The
final policy includes a clarification as to the type of data that may
be requested.
2. Repeal of Existing Small-Dollar Policies
Five commenters objected to the perceived withdrawal of the Board's
approval under the Board's existing payment system risk policies for
small-dollar systems. Some of these commenters requested that a program
of certification of compliance with the policy statement be developed
in lieu of these ``approvals.''
The ``approvals'' referred to by commenters represent previous
determinations by the Board that particular systems may use the
Fedwire-based net settlement services across multiple Federal Reserve
Districts. In 1990, the Board established a set of conditions, embodied
in the current Payments System Risk policy for ``small-dollar''
systems, for the use of this service. Subsequent applications for
cross-District net settlement services have been reviewed under this
policy. The conditions in the policy were designed in large part to
address specific concerns about risk to the Federal Reserve in
providing cross-District net settlement services.
Although the Board is repealing its existing small-dollar policies
concurrently with the issuance of this policy statement, the Board is
not repealing the prior approval of any system to use the Fedwire-
based, cross-District net settlement service in conjunction with
issuance of this policy. In general, such cross-District systems may
continue to use the Fedwire-based net settlement service. As with any
system subject to this policy, regardless of whether it uses the
Fedwire-based net settlement service, another Federal Reserve net
settlement service, or another settlement method, appropriate
enforcement actions will be considered if the system is found to be not
in compliance with the policy. The Board also notes that approval to
use the cross-District net settlement service or any other Federal
Reserve service does not imply Federal Reserve endorsement of a
particular system or of its risk management arrangements, and should
not be used to communicate any such endorsement to participants or
potential participants. Moreover, the Board does not anticipate
formally certifying compliance of systems under the policy, as this
would be likely to reduce the normal incentives for participants to
monitor and manage the risk in systems in which they participate.
Effective Date
The policy statement will be effective January 4, 1999 to permit
systems subject to the policy a six-month period to assess and ensure
their compliance. Although the Board does not expect that compliance
with the policy statement will necessitate operational changes for the
few systems that will fall within its scope, the Board recognizes that
systems may currently have other critical efforts underway, such as
preparation for the century date change. As a result, the Board will
consider extending the effective date on a case-by-case basis for
systems that can demonstrate significant resource demands due to other
critical efforts.
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.4 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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\4\ 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. 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, should reduce
costs and other potential barriers for private check and ACH clearing
and settlement arrangements that compete with the Federal Reserve.
While the Reserve Banks are not subject to this policy statement, the
Board notes that settlement risk exposures arising from services
provided by central banking organizations are inherently different than
for private-sector organizations. In
[[Page 34892]]
addition, the Reserve Banks are subject to Part I of the Policy
Statement on Payments System Risk, which requires them to implement an
extensive program of risk controls, including ongoing monitoring of all
depository institution customers, net debit caps, and fees that are
charged to depository institutions for the use of intraday credit.
Federal Reserve System Policy Statement on Payments System Risk
The Board is amending its ``Federal Reserve System Policy Statement
on Payments System Risk'' (57 FR 40455, September 3, 1992) 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, Federal Reserve
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.18
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\18\ 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 when due could have credit or liquidity effects on
participants that have not dealt with the defaulting participant.
Multilateral settlement may, in some cases, also 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 and limit the
risk exposures to other institutions, as required under Regulation F,
may be reduced. In addition, in some cases, there may be no timely or
feasible 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 certain multilateral settlement systems relative to
other settlement methods. As a result, a number of multilateral
settlement systems and their participants have implemented a variety of
risk management measures to control these risks.
Clearinghouses also may generate systemic risks 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 net debit caps and 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 those multilateral settlement systems that
have the potential to raise systemic risks, particularly in cases where
risks may not be adequately addressed by existing supervisory guidance
on management of exposures to other depository institutions. The Board
recognizes that multilateral settlement systems differ widely in terms
of form, function, scale, and scope of activities. Thus, risk
management measures may be designed differently for different systems.
This policy statement, therefore, is designed to permit market
participants to determine the best means of addressing risks, within
the guidelines provided. As a general rule, risk management measures
should be commensurate with the nature and magnitude of risks involved.
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 any
significant bilateral credit and liquidity exposures to other
institutions as required under Federal Reserve Regulation F.
Scope and Administration of the Policy
This policy statement applies 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
where the aggregate gross value of payments is expected to exceed $5
billion on any day during the next 12 months. 19 Further,
the policy does not apply to clearing and settlement systems for
securities or exchange-traded futures and options, and 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.
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\19\ The gross value of payments settled refers to the total
dollar value of individual payments or transactions that are settled
in the system, which represents the sum of total debits or total
credits to all participants prior to any netting of settlement
obligations. ``On-us'' transactions that do not require interbank
settlement, but may in some cases be processed by the system, may be
excluded for purposes of these calculations. Where a system conducts
multiple settlements per day, these settlements should be aggregated
for purposes of this calculation if they are conducted among the
same group of participants subject to the same rules and procedures.
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[[Page 34893]]
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. 20
Systems subject to this policy may be asked to provide to the Federal
Reserve peak and daily average aggregate gross and net settlement data
for the most recent 12-month period or calendar year, as well as peak
and daily average settlement position data for individual participants.
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\20\ 12 U.S.C. 1861-67.
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Risk Factors and Risk Management Measures
An analysis of settlement risks in any multilateral settlement
system should begin with the identification of key risks and exposures.
For purposes of this policy, the general categories of settlement risk
include credit risk--the risk to participants or to the system that a
participant will be unable to meet fully its settlement obligation;
liquidity risk--the risk that participants or the system will have
insufficient funds available to meet settlement obligations as and when
expected; operational risk--the risk that operational factors in the
settlement process may cause or exacerbate these credit or liquidity
risks or disrupt the settlement of payments; and legal risk--the risk
that legal uncertainties in the settlement process may cause or
exacerbate these credit and liquidity risks.
Systems subject to the policy that exhibit one or more risk factors
should assess whether their policies and procedures adequately address
those specific risks, including consideration of the risk management
measures listed below. In general, risk management controls should be
proportional to the nature and magnitude of risks in the particular
system. The Board does not expect that all of the specific risk
management measures listed below will be necessary or appropriate for
all systems; moreover, there may be other risk management measures that
will address a particular risk factor. Systems that exhibit one or more
risk factors may not need to implement any additional risk controls as
a result of this assessment if existing risk controls adequately
address the particular risk.
If necessary, the Board and its staff 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 adequately
address the risk factor. 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.
To facilitate the analysis under this policy, systems may need to
develop the capability to simulate credit and liquidity effects on
participants and on the system resulting from one or more participant
defaults, or other possible sources of settlement
disruption.21 Systems may also need to test the operational
capability to execute settlement failure procedures, where these differ
from normal settlement procedures. Documentation of any significant
legal analysis or agreements relevant to risk management may also be
appropriate.
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\21\ Such simulations may include, if appropriate, the effects
of changes in market prices, volatilities, or other factors.
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(1) Credit risk. Risk factors: A multilateral settlement system
would give rise to credit risk if its rules or practices significantly
increase or shift the bilateral obligations or credit exposures between
participants in the clearing and settlement process. For example, a
clearinghouse operator or agent that provides an implicit or explicit
guarantee of settlement could shift bilateral exposures. Such a
guarantee might be implemented 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 may
expose participants to credit risk to one another, due for example, to
agreements to mutualize any settlement losses.
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 significant bilateral exposures to one another or to
the system, such as through loss-sharing agreements, may need to
implement mechanisms for participants to control these exposures if
they are significant. 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 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 likely to be 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 other funding channels, and (4) the greater the likelihood
that a settlement failure of the particular system would be accompanied
by abnormal market conditions.
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. For example, many of the
measures described above that are commonly used to mitigate credit risk
may reduce the probability and effect of a participant's inability to
meet its settlement obligations when due. External liquidity resources
available to the system and adequate operational contingency
arrangements may also 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 assess, and where necessary address, the liquidity impact on
participants of such a procedure.22 For example, timely
notification of settlement failure before or during the period of
active money market trading should permit participants readily to
borrow funds to cover any shortfalls due
[[Page 34894]]
to the recast. Individual participants may also take steps to limit
their own liquidity exposures in the system or increase available
liquidity resources.
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\22\ 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, for a
system that anticipates recasting settlement obligations in the event
of a participant default, 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, certain 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.
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 the information to participants in a
timely manner. To the extent that payments would be expected to be
settled outside the system, procedures should be established to notify
participants such that they have adequate time, settlement information,
and operational capabilities to complete such settlements before the
close of critical funds transfer systems. A system that does not
anticipate recasting settlements but plans to settle all positions as
and when expected should ensure that operational procedures to
implement risk management measures are in place, such as means of
access to lines of credit in a timely manner.
(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 of the
underlying transactions in the event of a settlement failure.
Significant legal uncertainty could exacerbate efforts to achieve an
orderly and timely resolution and could expose participants to
significant credit and liquidity risks. For example, 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 significant risk
management measures, netting agreements, or related arrangements, is
not well supported.
Risk management measures: Systems should address legal risk
factors, where significant exposures may arise, by ensuring that
operating rules or other agreements between participants will be
enforceable in the event of a settlement failure. As part of this
process, systems may wish to obtain legal opinions as to the
enforceability of its rules and agreements under applicable legal
regimes. Additionally, when the transactions settled through the system
are not otherwise covered by an established body of law, the system
should ensure that the rights and obligations of the participants are
adequately addressed through the system's rules or participant
agreements.
Application of the Lamfalussy Minimum Standards
Certain multilateral settlement systems are also required to meet
the Lamfalussy Minimum Standards.23 These standards were
designed to address the main risk factors that may be present in
multilateral settlement systems and to provide confidence that such
systems can settle all positions as and when expected in the event that
a participant cannot meet its settlement obligations, thereby reducing
substantially the risk that a default by one participant will cause
defaults by others. To determine whether a system is also required to
meet the Lamfalussy Minimum Standards, the Board will consider
additional factors that include the following: settlement of a high
proportion of large-value, interbank or other financial market
transactions, such as foreign exchange transactions; very large
liquidity exposures that have potentially systemic consequences, such
as by virtue of a high ratio of gross payments to net settlement
obligations; or systemic credit exposures relative to participants'
financial capacity.
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\23\ 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. The text included in this
policy statement includes editorial modifications to the original
standards.
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Lamfalussy Minimum Standards for the Design and Operation of
Privately Operated Large-Dollar Multilateral Settlement Systems: 1.
Multilateral settlement systems should have a well-founded legal basis
under all relevant jurisdictions.
2. Multilateral settlement 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 settlement 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 settlement 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.
[[Page 34895]]
5. Multilateral settlement systems should have objective and
publicly-disclosed criteria for admission which permit fair and open
access.
6. Multilateral settlement systems should ensure the operational
reliability of technical systems and the availability of backup
facilities capable of completing daily processing requirements.
Risk management measures: For systems that the Board has determined
are required to meet the Lamfalussy Minimum Standards, systems and
their participants should consider the following risk management
measures: (1) to the extent that participants have significant credit
and liquidity exposures to other participants, 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.24
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\24\ 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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Alternative risk management measures may provide an equivalent
level of assurance that the Lamfalussy Minimum Standards are met,
depending on the nature and scope of the system. However, the Board
strongly encourages systems to develop real-time risk management
controls where necessary to provide an appropriate level of risk
control. The Board may also encourage or require higher risk management
standards, such as the ability to ensure timely multilateral 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.
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 settlement 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, June 18, 1998.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 98-16694 Filed 6-25-98; 8:45 am]
BILLING CODE 6210-01-P
