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Federal Reserve Bank
of Dallas

DALLAS, TEXAS
75265-5906

May 23, 2002
Notice 02-23

TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District

SUBJECT
Request for Comments on an Interagency White Paper
Regarding Structural Change in the Settlement
of Government Securities: Issues and Options
DETAILS
The Board of Governors of the Federal Reserve System and the Securities and Exchange Commission are seeking comment on an interagency white paper titled Structural
Change in the Settlement of Government Securities: Issues and Options. The white paper is
designed to facilitate the discussion of possible structural changes in the settlement of government securities transactions. The paper is not intended to suggest that any of the approaches
represent an improvement over current arrangements or that structural change is necessary. The
goal of the paper is to provide a framework for discussion by identifying issues and questions
that need to be further explored.
The Board must receive comments by August 12, 2002. Please address comments to
Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street
and Constitution Avenue, N.W., Washington, DC 20551. Also, you may mail comments electronically to regs.comments@federalreserve.gov. All comments should refer to Docket
No. R-1122.
ATTACHMENT
A copy of the agencies’ paper as it appears on pages 32043–49, Vol. 67, No. 92 of the
Federal Register dated May 13, 2002, is attached.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

-2-

MORE INFORMATION
For more information, please contact Patrick Parkinson, Associate Director, (202)
452-3526; Patricia White, Assistant Director, (202) 452-3620, Division of Research and Statistics; or Jeff Stehm, Assistant Director, (202) 452-2217, Division of Reserve Bank Operations and
Payment Systems, Board of Governors. Telecommunications Device for the Deaf (TDD) users
may call (202) 263-4869.
Paper copies of this notice or previous Federal Reserve Bank notices can be printed
from our web site at http://www.dallasfed.org/banking/notices/index.html.
Sincerely,

Federal Register / Vol. 67, No. 92 / Monday, May 13, 2002 / Notices

FEDERAL RESERVE SYSTEM
SECURITIES AND EXCHANGE
COMMISSION
[Docket No. R–1122; Release No. 34–45879;
File No. S7–15–02]
RIN 3235–AI48

Interagency White Paper on Structural
Change in the Settlement of
Government Securities: Issues and
Options
AGENCIES: Board of Governors of the
Federal Reserve System and Securities
and Exchange Commission.
ACTION: Concept release; request for
comment.
SUMMARY: The Board of Governors of the
Federal Reserve System (‘‘Board’’) and
the Securities and Exchange
Commission (‘‘Commission’’)
(collectively, the ‘‘agencies’’) are
publishing for comment an interagency
White Paper titled: Structural Change in
the Settlement of Government
Securities: Issues and Options (‘‘White
Paper’’). The White Paper is designed to
facilitate the discussion of possible
structural changes in the settlement of
government securities transactions. The
White Paper is not intended to suggest
that any of the approaches represent an
improvement over current arrangements
or that structural change is necessary.
The goal of the White Paper is to
provide a framework for discussion by
identifying issues and questions that
need to be further explored.
DATES: Comments should be received on
or before August 12, 2002.
ADDRESSES: Comments should be sent to
both agencies at the addresses listed
below.
Board: Comments should refer to
Docket No. R–1122 and should be
submitted in triplicate to Ms. Jennifer J.
Johnson, Secretary, Board of Governors
of the Federal Reserve System, 20th
Street and Constitution Avenue, NW.,
Washington, DC 20551, or mailed
electronically to
regs.comments@federalreserve.gov.
Comments addressed to Ms. Johnson
may also be delivered to the Board’s
mail facility in the West Courtyard
between 8:45 a.m. and 5:15 p.m.,
located on 21st Street between
Constitution Avenue and C Street, NW.

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Members of the public may inspect
comments in Room MP–500 of the
Martin Building between 9:00 a.m. and
5:00 p.m. on weekdays pursuant to
§ 261.12, except as provided in § 261.14,
of the Board’s Rules Regarding
Availability of Information, 12 CFR
261.12 and 261.14.
SEC: All comments concerning the
White Paper should be submitted in
triplicate to Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 5th Street, NW., Washington, DC
20549–0609. Comments can be
submitted electronically at the following
e-mail address: rule-comments@sec.gov.
All comment letters should refer to File
No. S7–15–02; this file number should
be included on the subject line if e-mail
is used. All comments received will be
available for public inspection and
copying in the Commission’s Public
Reference Room, 450 5th Street, NW.,
Washington, DC 20549. Electronically
submitted comment letters will be
posted on the Commission’s Internet
Web site (http://www.sec.gov).1
FOR FURTHER INFORMATION CONTACT:
Board: Patrick Parkinson, Associate
Director, (202) 452–3526, and Patricia
White, Assistant Director, (202) 452–
3620, Division of Research and
Statistics; and Jeff Stehm, Assistant
Director, (202) 452–2217, Division of
Reserve Bank Operations and Payment
Systems, Board of Governors of the
Federal Reserve System, 20th and C
Streets, NW., Washington, DC 20551.
Telecommunications Device for the Deaf
(TDD) users may contact (202) 263–
4869.
SEC: Robert L.D. Colby, Deputy
Director, at (202) 942–0094; Larry
Bergmann, Senior Associate Director, at
(202) 942–0770; Jerry Carpenter,
Assistant Director, at (202) 942–4187;
Jeffrey Mooney, Senior Special Counsel,
at (202) 942–4174, and Jennifer Lucier,
Attorney, at (202) 942–0173, Division of
Market Regulation, Securities and
Exchange Commission, 450 Fifth Street,
NW., Washington, DC 20549–1001.
SUPPLEMENTARY INFORMATION:
After the September 11, 2001, terrorist
attacks, discussions were held with
market participants to learn their
perspectives on vulnerabilities in
settlements of government securities.
Three options for addressing
vulnerabilities were explored: (1) The
clearing banks and key market
participants implementing more robust
contingency arrangements; (2) each
1 The Commission does not edit personal,
identifying information, such as names or electronic
mail addresses, from electronic submissions.
Submit only information you wish to make publicly
available.

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Federal Register / Vol. 67, No. 92 / Monday, May 13, 2002 / Notices

primary dealer establishing a backup
clearing arrangement at a bank other
than its existing clearing bank; and (3)
implementing structural change such as
by establishing a utility to conduct
settlement. The discussions revealed
consensus on two points—contingency
planning should be enhanced but
market participants felt that a backup
clearing account would be of little
value. Market participants were
interested in exploring structural
changes in the provision of settlement
services for government securities,
including the concept of creating a
utility, but the discussion was
unfocused because of the absence of
specific proposals.
The purpose of this White Paper is to
facilitate discussion of issues relating to
the settlement of government securities
transactions by describing more
concretely ways in which a utility might
be organized. The staffs of the agencies
believe that further discussion of a
utility is warranted because enhanced
contingency planning alone does not
eliminate the vulnerabilities that have
been identified in the settlement process
for the government securities market.
The White Paper identifies possible
structural approaches for a utility and
possible evaluation criteria for assessing
the approaches. The White Paper also
offers a preliminary assessment of the
various approaches. The agencies
request the views of market participants
on the analysis in the White Paper and
the next steps to be taken in evaluating
structural change further.
The White Paper in its entirety is set
forth below.
Interagency White Paper 2 Structural
Change in the Settlement of
Government Securities: Issues and
Options
Introduction
Payment and securities settlement
systems have been marked by increasing
consolidation of the institutions
providing those services. During the
1980s and early 1990s, for example,
mergers and exits reduced the number
of banks providing settlement services
for government securities trades, and
today only two banks—JPMorgan Chase
(Chase) and The Bank of New York
(BONY)—provide the full range of
services required by major market
participants. Though these changes in
2 Prepared by staff of the Federal Reserve Board,
the Federal Reserve Bank of New York, and the
Securities and Exchange Commission. Staff at the
U.S. Treasury Department were consulted and
provided comments.
The agencies whose staff contributed to the
drafting of this paper have not concluded that
structural change is necessary.

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the settlement of government securities
are only one aspect of broader
developments in financial markets, they
are of particular interest to makers of
public policy because of the key role
that government securities play in the
monetary policy process and as
collateral in a wide array of financial
market transactions.3
The business of settling trades in
government securities involves the
provision of a range of services: the
transfer of government securities against
funds (settlement), the provision of
intraday credit to facilitate these
settlements, position management
services for primary dealers (including
the matching of settlement instructions
with incoming securities, automated
options for handling mismatches, and
the real-time reporting of transactions),
and overnight and term financing
through triparty repurchase agreements
(repos). Settling trades, providing
intraday credit, and providing tools
(software) for position management are
sometimes referred to as ‘‘core
clearing.’’ 4 The financing provided
through triparty repos also is critical to
the functioning of the government
securities market. Triparty services for
government securities currently are
provided by the same banks that
provide core clearing, but different
entities may be able to offer the two
types of services, as is the case for other
types of securities.5
All the primary dealers depend
critically on either Chase or BONY for
core clearing services and triparty repo
arrangements, which are integral to the
dealers’ financing, and institutional
investors rely on these clearing banks to
place large volumes of funds in the
highly secure and liquid triparty repos.
The Federal Reserve also is dependent
upon the clearing banks’ records for
open market transactions conducted
through triparty arrangements, and the
U.S. Treasury relies on the clearing
banks for the settlement of a major
portion of its securities at issuance.

This concentration in the provision of
clearing services gives rise to
operational, financial, and structural
vulnerabilities.
(1) Operational problems at either of
the two clearing banks can significantly
impede the settlement of dealers’ trades
and the reconciliation of their positions.
Market participants settling through a
clearing bank with operational problems
could not easily move to another service
provider because of differences in the
technology used by the clearing banks.
Even if a switch in banks were
technologically feasible, firms would be
hampered because they would not know
their securities and funds positions or
have access to them at the clearing bank
with operational problems.
(2) Financial vulnerabilities arise from
the potential for a clearing bank’s
financial condition to become impaired,
perhaps because of losses from activities
unrelated to the clearing business.
Involuntary exit because of financial
problems could force regulators to
transfer the clearing operations to a
bridge bank.6 Moreover, market
participants might be uncomfortable
with the uncertainty associated with a
bridge bank, particularly because the
ability to fashion a permanent solution
(through, for example, the sale of the
business) may be limited.
(3) The current concentration in
clearing has resulted in part from
voluntary decisions by banks to exit the
clearing business. A business decision
to exit by either clearing bank would
concentrate risk and market power in a
single, full-purpose, commercial bank.
This concentration of risk would likely
be unacceptable to market participants
and public policy makers and might be
unacceptable to the remaining clearing
bank.
As part of the stocktaking after
September 11, staff from the Federal
Reserve, the Commission, and the
Treasury held discussions with market
participants to learn their perspective
on the vulnerabilities of the government

3 The Group of Ten, ‘‘Report on Consolidation in
the Financial Sector,’’ January 2001, provides a
detailed look at the ongoing consolidation of
financial institutions and the potential effects on
the contours of the financial system.
4 Some view the use of the term ‘‘clearing’’ for
these activities as a misnomer. The Government
Securities Clearing Corporation (GSCC) serves as
the clearing utility and central counterparty for
trade comparison and netting in the U.S.
government securities market. Trade comparison
and trade netting services are also traditionally
referred to as ‘‘clearing.’’ Because of the prevalence
of the use of the term ‘‘clearing’’ for settling trades
in government securities, however, its use is
continued here.
5 Triparty programs cover various securities for
which core clearing is provided by the Depository
Trust Company (DTC) or Euroclear Bank.

6 The use of a bridge bank might be consistent
with a least-cost resolution; but if it were not,
authorities would need to consider a systemic-risk
exception to least-cost resolution, with the
attendant increased costs in terms of moral hazard
and diminished market discipline on large complex
banks. The Federal Deposit Insurance Corporation
generally must resolve failed institutions using the
least costly method that meets its obligations to
insured depositors. It can employ a method that is
not least cost only if the Federal Reserve Board and
the board of the FDIC recommend that step and if
the Secretary of the Treasury (in consultation with
the President) makes an explicit determination that
a least-cost resolution would have adverse effects
on economic conditions or financial stability and
that the more costly method for resolution would
avoid or mitigate those adverse effects. This is
known as the ‘‘systemic-risk exception.’’

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Federal Register / Vol. 67, No. 92 / Monday, May 13, 2002 / Notices
securities market. The discussants
explored three options for addressing
vulnerabilities: improving the
operational resiliency of clearing banks,
establishing backup securities accounts
with the second clearing bank, and
instituting structural change, for
example, by creating an industry utility
to conduct settlement.
These discussions indicated
consensus on two points. First, clearing
banks as well as other market
participants needed to improve their
contingency backup arrangements.7
Second, backup securities accounts
would be difficult to arrange and likely
would be of little value. The technology
used by the two clearing banks is
sufficiently different to make it difficult
and costly to establish and maintain
such accounts. More important, quickly
moving activity to another account
would likely be difficult because of the
need to determine positions at the bank
with problems, transfer these positions
to the backup account, and alter
standing settlement instructions with
counterparties to direct new
transactions to the backup account.
Market participants were interested in
exploring structural change, including
the concept of an industry utility.
Discussions of such a utility were
hampered, however, by different
conceptions of how it might be
organized and lack of systematic
consideration of the concept on the part
of most market participants.
This paper facilitates exploration of
structural change in settlements of
government securities by describing
more concretely some approaches to
organizing an industry utility. The
agencies believe further discussion of
structural change is warranted because
enhanced contingency backup
arrangements alone do not eliminate the
financial and structural vulnerabilities
that the market faces. Indeed, the cost of
improved contingency arrangements
could exacerbate structural vulnerability
by reducing the profitability of core
clearing. This paper also identifies
possible criteria for assessing the
approaches and, to encourage further
discussion, offers a preliminary
evaluation of the various approaches
using the assessment criteria.
The agencies whose staff have
contributed to the drafting of this paper
have not concluded that any of the
7 A complementary interagency group is working
with private-sector firms and utilities to improve
the resiliency of financial market participants’
backup arrangements. Goals of the group include
developing guidance on business continuity issues,
organizing industry testing, and addressing
telecommunications issues, particularly switching
and routing diversity.

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approaches described below represents
an improvement over current
arrangements. Nor is this paper
intended to resolve that issue. Rather,
the agencies believe that a broad
industry discussion of these issues is
timely and that such a discussion would
benefit from a document that furnishes
it with a framework. This paper,
therefore, provides that framework and
identifies issues and questions that need
to be explored further.
Approaches
One of the difficulties in discussing
the establishment of a utility is the wide
variety of forms that such an entity
could take. The structure of the utility
determines how risks will be shared and
costs will be borne. An important
dimension along which utilities often
differ is their ownership and
governance. A utility can be organized
as a private-sector entity, perhaps
owned and governed by market
participants but subject to oversight by
a public-sector body. Alternatively,
clearing and settlement functions might
be performed by a governmental entity.
Other important characteristics of a
utility include how credit is supplied in
the clearing process (by individual
banks, by the utility itself, by the central
bank) and how the operational
infrastructure is supplied (by competing
service providers, by a single private
utility, by the central bank). To focus
discussion on the specific
characteristics that meet market needs
and address market vulnerabilities, this
analysis is limited to only three of the
many ways in which a utility might be
structured.
Old Euroclear Model
A utility can be structured as an
industry-owned depository and
settlement entity that contracts with a
commercial bank for the provision of
most services.8 This model for a utility
is similar to the original Euroclear
model in which, until 2001, an
industry-owned company contracted
with Morgan Guaranty Trust Company
for operational and credit services.
Shareholders of a utility organized along
these lines would largely be securities
and banking industry participants. The
governing body typically would be
elected by shareholders, and it would
establish membership criteria, prices,
operating budgets, and investment
priorities. The utility would contract
with a bank (or banks or other service
providers) for the operation of the
settlement and depository services.
8 Contracting

with multiple banks for these
services may be possible.

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Settlements would take place on the
books of this bank, which would furnish
securities and cash accounts to dealers.
It would also furnish intraday financing,
subject to risk controls it would
establish. Overnight financing,
including triparty repo services, would
be provided either by the bank
supplying the operational support or
perhaps by other banks.
A Private Limited-Purpose Bank
A private limited-purpose bank (like
the Depository Trust Company [DTC] or
the new Euroclear Bank) is an
alternative type of industry-owned
depository and settlement mechanism.9
Key features distinguishing this model
from the old Euroclear model are the
means of providing depository and
settlement services and the sources of
liquidity support. Rather than
contracting with a commercial bank, the
utility itself would furnish the
operational support. Settlements of
government securities currently require
aggregate extensions of hundreds of
billions of dollars of intraday credit to
dealers, and a private limited-purpose
bank would need to arrange a backup
liquidity facility to ensure final
settlement in the event one of its
participants failed to cover an overdraft.
Based on the experience of other
utilities in arranging facilities a fraction
of that size, a private limited-purpose
bank might find arranging sufficient
backup liquidity support difficult, other
than possibly from the Federal Reserve.
Overnight funding, including triparty
repo services, could be provided by the
limited-purpose bank or perhaps by
other commercial banks.
Enhancement of Federal Reserve
Services
A third alternative is a public utility
in which the Federal Reserve provides
depository and settlement services. The
Federal Reserve and the Commission
generally prefer private-sector solutions
to policy problems unless a market
failure suggests a clear need for
government intervention. In evaluating
potential structural changes, however, it
is important to discuss the widest
possible set of ways to address the
vulnerabilities for the government
securities market, which includes
enhancing Federal Reserve services.
In a simple version of this model, the
Federal Reserve would need to provide
nonbank securities dealers, as well as
the GSCC (and possibly interdealer
brokers), direct access to securities
9 This option could be implemented by
expanding an existing depository such as DTC or
by creating an organization de novo.

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accounts, funds accounts, and secured
credit. As noted earlier, dealers
routinely use substantial intraday credit,
which would need to be supplied by the
Federal Reserve. A dealer also might
find itself unable to fund its holdings of
government securities in a financial
crisis, and in that event, the Federal
Reserve would need to provide liquidity
support in the form of overnight credit.
For this model to be effective, the
Federal Reserve would have to furnish
operational support by developing
products that replicate at least some of
the position management and
information services currently provided
to the dealers by the clearing banks.
Dealers would continue to need the
overnight funding supplied by triparty
repo services. These services might be
provided by commercial banks.
Alternatively, the Federal Reserve could
develop the product. In this case, the
Federal Reserve would need to consider
how triparty services might be offered
without also extending accounts to
nonbank institutional investors, perhaps
by using these investors’ accounts at
their custodian banks.
Variants on this simple model of
enhanced Federal Reserve services also
might be explored. For example, the
Federal Reserve could provide direct
operational interfaces with the dealers,
but the dealers’ transactions could settle
through accounts held at depository
institutions. In this way, depository
institutions would intermediate the
intraday credit used in the settlement
process.
Evaluation Criteria
Operational, Financial, and Structural
Vulnerabilities
Any proposal to restructure
government securities settlements must
address the operational, financial, and
structural vulnerabilities that are
inherent in the current arrangements.
Arguably, no utility could be designed
to eliminate all these vulnerabilities.
Rather, the relevant criteria for
evaluating options are the extent to
which the utility can reduce existing
vulnerabilities. Proposals thus should
be evaluated on their ability to improve
the operational resiliency of government
securities clearing, to better insulate the
clearing process from the risks of
financial problems at a key service
provider, and to reduce the
vulnerability of the clearing process to
voluntary exit by firms that provide
critical services. In the addressing of
these vulnerabilities, however, it is
equally important that new ones not be
introduced, and evaluations of

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structural change should take this
concern into account.
Efficiency and Innovation
Other criteria that are critical for
evaluating any restructuring proposal
are the proposal’s implications for the
efficiency and innovativeness of the
settlement process and related financing
transactions. Existing arrangements in
which the clearing banks compete in the
provision of services to dealers create a
mechanism both for holding down costs
and for fostering innovation. The
development of triparty repo services
illustrates how clearing banks, in
responding innovatively to market
demands, have reduced dealers’
financing costs and benefited investors.
Proposals for structural change,
therefore, should be evaluated on their
ability to replicate the strengths of the
existing system, encourage ongoing
innovation, and deliver services in a
cost-effective manner.
Fully evaluating proposals may be
difficult because the evaluations will
depend on the governance structures
adopted, which will determine pricing
and investment decisions. In general,
various proposals’ governance
structures (and the transparency of
those structures) will have implications
for a range of important issues, from the
robustness of the risk-management
system to the fairness (particularly with
respect to access) of the system.
Furthermore, assumptions about the
initial investment required and the
potential for savings on operating costs
over time are necessary for making
judgments about the efficiency of
proposals.
Implications for Federal Reserve
Policies
Proposals to restructure the settlement
process will have implications for
Federal Reserve services and policies.
The implementation of some proposals
would require the Federal Reserve to
broaden dramatically the scope of
services that it provides market
participants and, most important,
change policies with respect to the types
of firms that are granted access to
accounts and to credit. Consideration of
these proposals should entail an
assessment of the Federal Reserve’s
legal and operational ability to deliver
the required services. Proposals also
should be evaluated to determine
whether broader access and the
provision of credit to nondepositories
poses significant risk to the Federal
Reserve or entails significant moral
hazard. Other proposals raise the
possibility that the Federal Reserve
would greatly reduce its role in settling

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secondary market transactions for
government securities, and the
implications of that possible outcome
also should be assessed.
Evaluations of Approaches
Old Euroclear Model
This model’s ability to address the
vulnerabilities in the current system is
mixed; though operational
vulnerabilities could be addressed,
financial vulnerabilities would not, and
the effects on structural vulnerabilities
would be unclear. Operationally, the
utility would contract with one or more
entities to provide support for
depository and settlement activities, and
its resiliency would depend upon the
standards it set for firms providing the
services. There is no reason to believe
that the operational resiliency of this
model would not be on par with that of
the current system, and it might be
possible to hold the banks providing
services to higher standards because the
costs would be more transparent and,
therefore, dealers might be more willing
to bear them.
The ability of this model to address
financial and structural vulnerabilities
is much more limited, however. The
utility would be exposed to the risk that
a bank providing operational and credit
services could involuntarily exit the
business because of financial difficulties
unrelated to clearing activities. This risk
would be diversified if more than one
firm provided these services. However,
given the economies of scale and scope
in clearing, the willingness of multiple
banks to provide the critical services
and, therefore, the potential for
diversifying the risks may be limited.
The extent to which the structural
vulnerabilities are addressed depends
on the ability of the utility to negotiate
long-term contracts with suppliers of
critical services at terms that the
supplier will find sufficiently attractive
to remain in the business.
Because of the critical role of triparty
activity in the financing of dealers, the
market would be vulnerable to
operational, financial, or structural
problems if triparty services continued
to be concentrated among only a few
providers. Dealers might be able to
manage these risks by requiring
standardization of software that would
enable them to move their accounts
more easily in the event of operational
problems or exit, but the challenges of
reconciling positions in such events
would remain.
The ability of this model to deliver
innovative services cost effectively will
depend critically on the governance
structure of the utility and the standards

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it sets for banks supplying services. The
utility may be able to foster competition
similar to that of the current system by
contracting with multiple banks for
services. Product innovation would be
dependent upon the utility’s policies as
well. The management and board of the
utility clearly would have to be mindful
of these issues if this model of utility
were to retain these features of the
current system.
This model would not require any
changes in Federal Reserve policies. The
model continues to rely on private
banks to provide operational and credit
support for settlements; the utility itself
would be a vehicle for administration
and governance rather than a provider
of services.
A Private Limited-Purpose Bank
The creation of a limited-purpose
bank to function as the utility would
concentrate depository and settlement
activity within one entity, thereby
concentrating operational risk. The
ability of this model of utility to
improve the operational resiliency of
government securities settlements thus
will depend upon the resources it
devotes to backup facilities. The current
system requires each clearing bank to
incur these costs; so conceivably, a
limited-purpose bank could devote
more resources to backup facilities than
an individual clearing bank but would
still offer a cost savings. A limitedpurpose bank is, by construction, less
exposed to financial problems from
unrelated activities than a full-service
bank because of limits on the scope of
its activities. Similarly, it is unlikely to
voluntarily exit the business of clearing,
having been created solely for that
purpose.
The assessment of the ability of a
limited-purpose bank to address
financial and structural vulnerabilities
in the government securities market is
less sanguine if the utility does not
provide triparty services and these
services remain concentrated among a
few banks. Triparty services are so
integral to the financing of dealers in
government securities markets that
these markets will be operationally,
financially, and structurally vulnerable
to the banks that provide such services.
These banks, which have broader
business lines than a limited-purpose
bank, will be vulnerable to losses in
activities unrelated to clearing and
triparty services. They are also free to
make the business decision to
voluntarily exit the triparty business. If
the separation of core clearing from
triparty services lowers the barriers to
entry and attracts entrants to the triparty
business, however, structural

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vulnerabilities would be ameliorated
with a reduction in concentration.
The ability of this model to deliver
services efficiently and innovatively
will depend upon the governance
structure of the limited-purpose bank.
Assuming that users own the bank and
control the governance structure, these
users will have incentives to monitor
costs and to create mechanisms for
developing new products. In recent
years, triparty repo services have been
the area of most innovation in the
clearing of government securities.
Undoubtedly, the competition between
the clearing banks has spurred the
innovation. Some of this pressure to
innovate thus might be lost if triparty
services were provided exclusively by
the utility. Over time, a failure to
innovate in the triparty area could have
adverse implications for dealer
financing.
This model has several important
implications for Federal Reserve policy.
As was noted in the description of the
limited-purpose bank, the Federal
Reserve may be the only feasible entity
to provide a backup liquidity facility of
large enough size. Providing this facility
to a limited-purpose bank would entail
a change in policy with respect to
discount window access for limitedpurpose banks or trust companies. But
it is not clear whether risk to the Federal
Reserve or moral hazard would increase.
With the current arrangements, the
Federal Reserve effectively provides
back-stop liquidity to the clearing
banks. Providing the same liquidity to a
utility might, in fact, entail less risk and
moral hazard because of the restrictions
on the utility’s activities, more intense
supervision of the utility, and greater
transparency. The creation of this type
of utility would also reduce (and might
eliminate) the Federal Reserve’s role in
settling secondary market transactions
for government securities. The vast
majority of transactions would be
settled on the books of the limitedpurpose bank, particularly if it were
providing triparty repo services as well
as core clearing.
Enhancement of Federal Reserve
Services
If the Federal Reserve provides
accounts, credit, and services directly to
dealers, the existing vulnerabilities in
the government securities market would
be reduced. Under this model, the
Federal Reserve would be providing the
operational support for the settlement
process, and these enhanced products
would be integrated into the existing
backup contingency arrangements for
the Fedwire system. The Federal
Reserve’s arrangements have been more

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robust than those of private-sector firms
and other market utilities, and the
Federal Reserve has spent appropriate
amounts to meet contingency
requirements. Federal Reserve services
are not vulnerable to disruption because
of financial difficulties.
To address vulnerabilities fully, the
Federal Reserve may need to develop
triparty repo as well as core clearing
services. Alternatively, if the Federal
Reserve limits its enhanced services to
core clearing, there may be
opportunities for a wider set of firms to
offer triparty services, reducing
structural vulnerability in the triparty
market. A separation between core
clearing and triparty repos, however,
would require an additional transfer of
securities from the dealer to the triparty
provider, as in the current process with
DTC-eligible securities used for triparty
repos. The number of additional
transfers could be reduced through the
creation of a facility to transfer
securities in blocks (bulk transfers)
rather than security by security.
It is not clear whether this model
could deliver services as cost effectively
as the current system or how product
innovation would be affected. Although
the Federal Reserve is required to price
services to cover its costs over the long
run, the benefits of competition would
be lost. Perhaps more significant in the
long run, innovation would no longer be
spurred by competition. Because the
Federal Reserve is not subject to the
same profitability constraints that a
private-sector business is, some industry
participants may view its assumption of
the role of service provider for
settlement services negatively.
Providing direct access to dealers
would be a marked departure from
existing Federal Reserve policy. The
Federal Reserve would need to provide
accounts and hundreds of billions of
dollars of credit to nondepository
institutions routinely during the day
and, in a crisis, overnight. From a riskmanagement perspective, however,
credit extensions presumably would be
collateralized with highly liquid
securities, and government securities
brokers and dealers would be subject to
federal regulation by the Commission or
the Treasury.
Direct access to dealers could be
perceived as providing dealers with
broad access to liquidity support from
the Federal Reserve. Any adverse effects
on market discipline would be mitigated
by federal regulation of the dealers,
collateralization of the credit
extensions, fees for intraday and
overnight credit, and the potential for
the Federal Reserve to impose quantity
constraints on the amount of intraday

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Federal Register / Vol. 67, No. 92 / Monday, May 13, 2002 / Notices

credit extensions. Still, expansion of
access could raise concerns about moral
hazard. Perception of a safety net
extension might be further attenuated
through some variant of this model that
leaves the dealers’ accounts in a
depository institution. In addition, if the
Federal Reserve were to provide triparty
repo services, the issue of accounts for
a broad set of institutional investors
might arise unless market practices
changed.
Questions for Further Discussion
1. Have the vulnerabilities in the
government securities market been
identified correctly? Are there other
vulnerabilities that should be
considered in evaluating the need for
structural change?
2. Are there other structural
approaches to a utility that should be
given serious consideration besides the
three basic options described in this
paper? If so, what are they?
3. Are the evaluation criteria set out
in this paper the relevant ones for
assessing the merits of an industry
utility? If not, what other criteria are
relevant?
4. Can concerns about efficiency,
innovation, and competition be
addressed through governance? If so,
how?
5. Is it feasible to separate the
provision of core clearing from the
provision of triparty repo services?
Would the separation of core clearing
from triparty repo enable other banks to
compete more effectively in the
provision of triparty services? Can
triparty repo services be provided by a
utility?
6. How much intraday credit would a
utility need to provide in the settlement
of government securities trades? Would
a utility likely be able to arrange backup
liquidity through committed lines of
credit at commercial banks of the
magnitude necessary to ensure timely
settlement in the event a participant
failed to cover an intraday credit
extension?
7. What is the likely size of the initial
investment to create an industry utility?
What factors determine the effects of a
utility on costs generally? On costs to
dealers of core clearing services? On
financing costs to dealers?
8. Who should own a private utility?
How should its board of directors be
chosen? What legal form should it take
(for example, a bank, registered clearing
agency, an Edge Act corporation)?
9. What should be the next steps in
evaluating alternative structures? What
type of decisionmaking framework
should be created, and which groups
should be represented in that process?

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through transfers on the books of a
depository institution or, if settlement
Clearing and Settlement Arrangements
must occur between two depository
for Government Securities
institutions, on the books of the Federal
1. Within the universe of about 1,700
Reserve through the Fedwire securities
dealers, the trading of U.S. government
transfer system. Repo transactions
securities is concentrated largely among generally settle on a same-day (T) basis.
22 primary dealers and a handful of
• More than $800 billion in securities
interdealer brokers (IDBs).
is transferred through the Fedwire
• Interdealer brokers collect dealer
securities transfer system each day.
quotes, post them to electronic screen
• The two banks, Chase and The Bank
services, and execute trades between
of New York (BONY), that provide
dealers, thereby facilitating price
settlement services to primary dealers
discovery, liquid markets, and
account for more than three-quarters of
anonymity in the interdealer market;
the value of Fedwire settlement activity.
about one-third of dealer-to-dealer
On a typical day, these two banks settle
trades are executed through an IDB.
more than $600 billion in government
• Among the primary dealers, most
trading activity is concentrated in five to securities transactions through Fedwire.
The clearing banks apparently settle
ten dealers.
another $200 billion to $300 billion per
• Trading activity includes dealer
day internally, excluding triparty repo
financing (repo) transactions and
transactions.
outright purchases and sales on behalf
• GSCC settles net obligations valued
of customers and for the dealer’s own
at about $415 billion per day through its
account.
accounts at the two clearing banks.
2. After a trade is executed,
counterparties to the trade must
• Chase’s and BONY’s client bases
compare trade details and determine
consist of the primary dealers, other
settlement obligations (clearance).
dealers and banks, and GSCC.
• The Government Securities Clearing
4. The settlement of financing (repo)
Corporation (GSCC) serves as the
transactions occurs either through
clearing utility and central counterparty bilateral exchanges (delivery-versusfor trade comparison and netting in the
payment or DVP repos) of securities and
U.S. government securities market.
funds between a dealer (borrower) and
• GSCC is registered with and
an investor (lender) or through the use
supervised by the Commission.
of triparty repos on the books of the
• Through trade comparison, netting, clearing banks.
and central counterparty guarantees,
• DVP repos are generally settled over
GSCC decreases its participants’
Fedwire between 8:30 a.m. and 12:00
counterparty settlement risk and helps
p.m., Eastern time.
ensure orderly settlement in the
• Triparty repos are settled after the
marketplace.
close of the Fedwire securities transfer
• Each day, GSCC compares trades
valued at more than $1.3 trillion. About system, generally between 5:00 p.m. and
one-third of these trades are for outright 7:00 p.m., Eastern time. The two
clearing banks estimate that together
purchases and sales, and the remaining
they settle on their books between $600
two-thirds are repo transactions.
billion and $1 trillion in triparty repos
• GSCC has 122 direct participants—
each day.
consisting of dealers, interdealer
brokers, investment managers, and
Appendix 2
banks—one-quarter of which use trade
Triparty Repo
comparison services only.
• GSCC participants also clear trades
The Market
for another 468 dealers, banks, and
Understanding the role of the clearing
investment managers, through
banks in the clearance of U.S.
correspondent relationships. Generally,
government securities requires an
these correspondent relationships are
appreciation of the triparty repo market
for trade comparison services only.
and the critical role that such banks
3. Following the clearance process,
play in facilitating triparty repo
securities must be exchanged for funds
transactions. Essentially, these
(settlement) on either a gross or a net
transactions involve the secured
basis.
financing of broker-dealer securities
• Government securities are
inventories by a large number of cash
transferred against funds (settled)
through depository institutions acting as investors, with settlement occurring on
the books of the clearing banks. Over the
agents for nonbank dealers. Interbank
last decade, the importance of the
settlement occurs through the Fedwire
triparty repo market grew significantly,
securities transfer system.
so that now it is integral to the financing
• Settlement typically occurs one
business day after the trade (T+1), either methods of all major broker-dealers and
Appendix 1

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Federal Register / Vol. 67, No. 92 / Monday, May 13, 2002 / Notices
involves nearly $1 trillion per day in
transactions.
The success of the triparty repo
market is due to its ability to meet the
needs of both the broker-dealers who
need secured financing and the cash
investor community, who desire highly
secure and liquid outlets for the
investment of cash on a short-term
basis. The cash investors in triparty repo
consist of money market mutual funds
and other institutional money managers
such as pension funds. Both the pool of
funds that such institutional investors
need to invest and the size of the brokerdealer securities inventories have grown
significantly in recent years, with no
signs of a slowdown yet apparent. The
clearing banks also benefit from
providing triparty repo services as a
profitable line of business and as an
opportunity to cross-sell other custody
and banking services to cash investors.
Settlement: The Critical Role of the
Clearing Banks
In a typical triparty repo transaction,
a broker-dealer contracts with a cash
investor to provide a certain amount of
securities in exchange for cash at the
outset of the transaction, with the
transaction to be unwound at the end of
its term. All movements of cash and
securities are to take place on the books
of the broker-dealer’s clearing bank.
That is, both the broker-dealer and the
cash investor will use cash and
securities accounts at the clearing bank,
and the clearing bank will play a critical
role in settling the transaction. It is
typical for the broker-dealer to pay for
the setting up of accounts at its clearing
bank on behalf of all its cash investors.
Triparty transactions are typically
arranged early in the morning so that
dealers can be assured of meeting their
financing requirements. Importantly,
however, these transactions typically do
not specify the individual securities that
the broker-dealer will provide as
collateral. Rather the transactions are
based on broad categories of collateral,
such as U.S. government or agency
securities. Different qualities of
collateral engender different financing
rates, and the triparty market has been
steadily expanding beyond U.S.
government securities to encompass a
wide range of mortgage-backed
securities, corporate bonds, and nonU.S. securities. However, U.S.
government and agency securities
remain the dominant form of triparty
collateral, accounting for more than
two-thirds of the total market.
The fact that triparty transactions do
not uniquely specify individual
securities is central to their appeal for
the broker-dealer community. This

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flexibility allows the broker-dealers to
trade their securities inventory during
the normal business day, settling
whatever transactions come due,
without significant concern regarding
their financing arrangements. For
example, settlement of cash-market U.S.
government and agency securities
continues until 3:30 p.m. on a normal
day, the time when the Fedwire bookentry transfer system closes. Soon after
this point, the clearing banks begin to
process the broker-dealer’s triparty repo
transactions. This processing involves
comparing the generic triparty
transactions that the broker-dealers have
submitted with the specific securities
that now reside in their accounts at the
clearing bank. The clearing banks have
developed routines for optimizing the
allocation of specific collateral to
individual triparty transactions to
minimize the financing costs for the
broker-dealers.
The collateral optimization and
allocation routines run in the late
afternoon, with settlement of the
triparty transactions on the books of the
clearing bank typically occurring in the
early evening. The efficiency of these
procedures, together with the familiarity
of the broker-dealers with them, means
that the need for residual financing (that
is, securities to finance that cannot be
financed through triparty repos) is
generally only very small, on the order
of 1 percent or less of their total eligible
inventory.
Benefits to Investors and Dealers
Triparty arrangements between a
broker-dealer and a cash investor may
be either on an overnight or on a term
basis. Importantly, however, even if the
transactions are done on a term basis, all
collateral is typically unwound on a
daily basis (early in the morning). This
daily unwinding has two implications.
First, the cash investors get access to
their funds on the books of the clearing
bank on an intraday basis. Second, the
broker-dealers get access to their
securities inventory and thus can
effectively ‘‘substitute’’ other collateral
into the agreements as their inventory
shifts over the term of the agreement.
From the cash investors’ perspective,
the triparty repo market provides a great
deal of liquidity and safety for their cash
holdings. During the day, the cash
resides in deposit accounts at their
clearing bank (or elsewhere if they
choose to wire it back and forth,
although most do not). Overnight, they
are exposed to the credit risk of their
broker-dealer counterparties but are
protected by the presence of collateral
held in their accounts at the relevant
clearing bank. Moreover, the flexibility

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of the triparty arrangement allows them
to frequently adjust the size of their cash
investments as their pool of available
funds fluctuates. For the broker-dealer,
the triparty repo market obviously
provides a highly flexible mechanism to
minimize the costs of financing.
Triparty Repo an Important Source of
Intraday Overdrafts
For the clearing banks, the triparty
repo mechanism is an important
complementary service to their core
clearance activities in the underlying
securities. However, a major implication
of the triparty mechanism as currently
designed is the presence of extremely
large intraday overdrafts in the deposit
accounts of the broker-dealers at the
clearing banks. That is, because all the
cash is returned to the cash investors
daily, the entirety of a dealer’s inventory
is effectively financed by the clearing
bank on an intraday basis. Still, the
clearing bank is secured to the extent
that the broker-dealer’s securities
remain at the bank. These figures can
approach $100 billion for the largest
individual dealers on peak days.
By order of the Board of Governors of the
Federal Reserve System, May 7, 2002.
Jennifer J. Johnson,
Secretary of the Board.
By the Securities and Exchange
Commission.
Dated: May 6, 2002.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02–11785 Filed 5–10–02; 8:45 am]
BILLING CODE 6210–01–P, 8010–01–P

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