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Federal Reserve Bank of Dallas HELEN E. HOLCOMB DALLAS, TEXAS F IR ST VICE P R E S ID E N T AND c h ie f o p e r a t in g o f f ic e r January 12, 1998 75265-5906 Notice 98-03 TO : The Chief Operating Officer of each financial institution and others concerned in the Eleventh Federal Reserve District SUBJECT Request for Public Comment on Policy Statement on Privately Operated Multilateral Settlement Systems DETAILS The Board of Governors of the Federal Reserve System is requesting public comment on a proposal to integrate its policies on “Privately Operated Large-Dollar Multilateral Netting Systems” and “Private Small-Dollar Clearing and Settlement Systems” into a single comprehensive policy statement on “Privately Operated Multilateral Settlement Systems.” The Board’s proposal is part of its payments system risk reduction program. The Board must receive comments by February 10, 1998. Please address comments to William W. Wiles, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W., Washington, DC 20551. All comments should refer to Docket No. R-0987. ATTACHMENT A copy of the Board’s notice as it appears on pages 60713-20, Vol. 62, No. 218 of the Federal Register dated November 12, 1997, is attached. MORE INFORMATION For more information, please contact Mike Turner at (214) 922-5573. For additional copies of this Bank’s notice, contact the Public Affairs Department at (214) 922-5254. Sincerely, 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. This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) Federal Register / Vol. 62, No. 218 / Wednesday, November 12, 1997 / Notices 60713 FEDERAL RESERVE SYSTEM [Docket No. R-0987] Policy Statement on Privately Operated Multilateral Settlement Systems Board of Governors of the Federal Reserve System. ACTION: Request for comment. AGENCY: SUMMARY: As part of its payment system risk reduction program, the Board of Governors is requesting comment on a proposal to integrate its policies on “Privately Operated Large-Dollar Multilateral Netting Systems” and “Private Small-Dollar Clearing and Settlement Systems” into a single, comprehensive policy statement on “Privately Operated Multilateral Settlement Systems.” DATES: Comments must be received by February 10, 1998. ADDRESSES: Comments should refer to Docket No. R-0987 and may be mailed to Mr. William W. Wiles, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W., Washington, D.C. 20551. Comments may also be delivered to the Board’s mail room between 8:45 a.m. and 5:15 p.m. on weekdays, and to the security control room at all other times. The mail room and the security control room are accessible from the courtyard entrance on 20th Street between Constitution Avenue and C Street, N.W. Comments will be available for inspection and copying by members of the public in the Freedom of Information Office, Room MP-500, between 9:00 a.m. and 5:00 p.m. weekdays, except as provided in Section 261.8 of the Board’s Rules Regarding Availability of Information. FOR FURTHER INFORMATION CONTACT: Jeffrey C. Marquardt, Assistant Director (202/452-2360), Paul Bettge, Assistant Director (202/452-3174), or Heidi Richards, Senior Financial Services Analyst (202/452-2598), Division of Reserve Bank Operations and Payment Systems; or Oliver Ireland, Associate General Counsel (202/452-3625); for the hearing impaired only, 60714 Federal Register / Vol. 62, No. 218 / Wednesday, November 12, 1997 / Notices Telecommunications Device for the Deaf, Diane Jenkins (202/452-3544). SUPPLEMENTARY INFORMATION: I. Background In 1994, the Board adopted a policy statement on Privately Operated LargeDollar Multilateral Netting Systems (Large-Dollar Policy Statement).1 The Large-Dollar Policy Statement, which replaced earlier policy statements on large-dollar funds transfer networks and offshore dollar clearing and netting systems, contains minimum standards for multilateral netting systems (Lamfalussy Minimum Standards) set forth in The Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Lamfalussy Report).2 The criteria for identifying arrangements subject to the policy were designed to limit the scope and application of the policy to large-dollar multilateral netting systems for payments and foreign exchange contracts that involve settlements in U.S. dollars and have the potential to increase systemic risk in financial markets. At the time the Large-Dollar Policy Statement was adopted, the Board recognized that in the case of larger multilateral netting systems for “batchprocessed” payments, such as checks or automated clearing house (ACH) payments, certain electronic controls that would be required to implement the Lamfalussy Minimum Standards might not be feasible. In addition, the characteristics of the instruments cleared in such systems, along with the scale of systemic risk, might differ from large-dollar systems. Consequently, the Board stated its intent to study further the implications of the Lamfalussy Minimum Standards for privately operated multilateral netting systems for batch-processed payments and did not apply the Large-Dollar Policy Statement to those systems at that time. In addition, in 1995, the Board began a comprehensive evaluation of its policies regarding Federal Reserve net settlement services, which are typically used by privately operated clearinghouses for batch-processed and other small-dollar payments, including checks, ACH payments, and in some cases, automated teller machine (ATM) and credit card transactions. The Board’s review addressed both the need to enhance the Federal Reserve’s net settlement services and risk-reduction policies toward small-dollar payments clearinghouses more generally, including, potentially, the Lamfalussy ' 59 FR 67534, December 29, 1994. 2 Bank for International Settlem ents (Basle, 1990). Minimum Standards. As a result of this review, the Board issued for public comment a proposal for enhancing the Federal Reserve’s net settlement services (62 FR 32118, June 12, 1997). The proposed modifications to the Policy Statement on Payments System Risk issued in this notice also stem from this comprehensive evaluation of net settlement services and policies. This proposal would repeal the existing Large-Dollar Policy Statement and replace it with a unified policy statement on risks in multilateral settlement arrangements. The proposal is not intended to alter the Board’s current policy as applied to those existing privately operated large-dollar multilateral netting systems that are currently subject to the Large-Dollar Policy Statement, but to integrate that policy within a broader and more consistent policy framework. II. The Proposed Policy Statement Rationale for and Scope o f the Policy The proposed policy statement is designed to address risks in multilateral settlement arrangements for both “small-dollar” payments, such as checks and ACH transfers, and “largedollar” payments, which are typically used to settle interbank and other financial market transactions. The policy statement recognizes that settlement of payments through a multilateral clearinghouse arrangement may not necessarily pose material additional risks for participants relative to other methods of settlement, such as bilateral or correspondent settlement. For example, in smaller arrangements used primarily to settle customer or third-party payments, such as check clearinghouses, participants generally are not exposed to significant credit risk with respect to the underlying payments. Payments are supported by a well established body of law and operational practice that would help determine the resolution of a participant default or clearinghouse settlement failure. In other arrangements, however, such as those for some types of electronic payments, the characteristics of the underlying payments in the event of a settlement disruption or failure and the operational options for resolving such a situation may be much less clear. The proposed policy statement, therefore, is directed only at those multilateral settlement arrangements that heighten existing risks inherent in the settlement process or that create new risks to their participants or to financial markets. For these systems, the Board believes that policy guidance on settlement risk concerns at the clearinghouse or system level is warranted. For other systems, which are likely to include the vast majority of clearinghouse arrangements for smalldollar payments, reliance on existing supervisory approaches aimed at promoting the safe and sound operation of financial institutions, including the Bank Service Company Act, is appropriate. Fundamental categories of risk, including credit, liquidity, operational, legal, and systemic risk, are common to many different types of multilateral settlement arrangements. The magnitude and specific manifestation of these settlement-related risks, as well as the most cost-effective means of managing them, differ across systems. Therefore, the proposed policy statement provides a flexible, risk-based approach to risk management, rather than imposing uniform, rigid requirements on all systems. While the flexible approach may lead to some initial uncertainties in the implementation of the policy statement, the Board expects that the costs of such uncertainty would be significantly lower than the costs of an alternative policy that mandated uniform risk management standards for all systems. Further, such a uniform, rigid policy would likely not adequately address risks in some systems and would impose unnecessary costs on the majority of systems that pose limited or no additional risks relative to other forms of settlement. Risk Factors and Risk Management Measures The proposed policy statement identifies five categories of settlementrelated risks—credit, liquidity, operational, legal, and systemic—that may arise in multilateral settlement systems. For each type of risk, the policy statement includes (1) a discussion of risk factors that give rise to concerns, (2) threshold criteria for each risk category that are intended to serve as “safe harbors” for purposes of compliance with the policy statement, and (3) common examples of risk management or mitigating controls that can be used to address these risk factors. Systems would be expected to address any material risks in each category. First, the discussion of risk factors for each category is intended to identify multilateral systems where such risks are heightened relative to other means of settlement. In general, risks may be heightened in multilateral settlement arrangements if the ability of participants to manage settlementrelated risks individually are reduced Federal Register / Vol. 62, No. 218 / Wednesday, November 12, 1997 / Notices for operational or other reasons, or because risk management incentives are reduced as a result of shifts in bilateral obligations and risk exposures between participants. Risks could also be increased if no alternative to multilateral settlement in a particular system is available, such that settlements could not reasonably be expected to be completed by participants in a timely manner outside the system in the event that settlement could not be completed within the system. Second, for each risk category the policy statement specifies qualitative and quantitative thresholds and other criteria intended to identify more clearly systems in which these risks are not likely to arise. These criteria are intended to simplify administration of the policy. Many clearinghouse arrangements will fall below the thresholds or not meet specified criteria and therefore will not be required to assess their compliance with the policy statement. The Board requests comment on the appropriateness of these threshold criteria. The Board expects that smaller check clearinghouses, for example, will not need to modify their operations at all in order to comply with the policy; others should only have to make minimal changes, for example, changes in settlement timing or settlement failure notification policies. To provide further guidance on application of the policy, the Appendix to the policy statement also contains specific illustrative examples. Third, the risk management discussion in the proposed policy statement provides illustrations of the type of risk management measures that may be appropriate given the particular risk factors identified. Particularly for multilateral settlement systems that are not likely to raise systemic risk concerns, this policy is intended to provide flexible guidance on means to address risks. In general, the Board believes that risk management measures should be commensurate with the scale and scope of risks. In some cases, the Board recognizes that systems may need to consult with Board staff regarding approaches to addressing identified risk factors. For multilateral settlement systems that are sufficiently large to raise potential systemic risk concerns, the proposed policy statement imposes higher risk management standards. The Board is proposing to retain the threshold criteria for application of the Large-Dollar Policy Statement, including $500 million in daily net settlement amounts or an average payment size of $100,000. The Board 60715 measures that would provide an requests comment on the appropriate equivalent level of risk management. level of these thresholds, or whether a different measure, such as gross Repeal o f Existing ",Small-Dollar ” payment value settled, or net settlement Policies amounts alone, would be more The Board is also proposing to repeal appropriate proxies for systemic risk. Under the proposed policy statement, its existing policies for certain “smalldollar” payments clearing and those larger systems that meet the systemic risk criteria would be expected settlement arrangements. These policies date from 1984 and 1990, when the to demonstrate robust policies and Board approved the provision of Federal procedures for addressing settlement Reserve net settlement services to ATM failures and disruptions, but would not necessarily be required to meet all of the and national ACH clearing arrangements, respectively, subject to Lamfalussy Minimum Standards. The certain conditions. These conditions Board believes that full application of were also restated as part of the Board’s the Lamfalussy Minimum Standards Policy Statement on Payments System embodied in the existing Large-Dollar Risk (57 FR 40455, September 3, 1992). Policy Statement may not be necessary The earlier policies were designed to or appropriate for some of those address specific situations that arose in arrangements. These standards were the Federal Reserve’s provision of net designed for those multilateral netting settlement services to depository systems for which a failure to settle all institutions and were not intended to positions on a multilateral net basis as represent a comprehensive approach to and when expected could pose a high fundamental risks that arise in degree of systemic risk. As a result, payments clearing and settlement these standards require systems, among other things, to have the ability to settle arrangements. In addition, the policies were developed before the Federal all positions on a multilateral net basis Reserve had fully implemented its even if the participant with the largest debit position defaults on its settlement program for managing risks in providing payment services to depository obligations. In contrast, the Board institutions, as well as other policy recognizes that for many small-dollar multilateral settlement systems, such as developments relevant to the management of interbank exposures, check clearinghouses, a recast of multilateral net settlement positions (to such as the issuance of Regulation F. Furthermore, a policy that links exclude transactions with the defaulting clearinghouse usage of a particular participant) or similar procedures may Federal Reserve net settlement service be an effective risk management tool. to its compliance with particular risk This presumes that settlement for non management standards (which do not defaulting participants can be apply to other clearinghouse completed in a timely manner and that arrangements), may have the any liquidity effects on participants are unintended effect of discouraging the manageable. For some larger multilateral use of settlement services with settlement systems, however, there is no potentially lower risks to financial feasible or reasonable alternative to institutions and their customers, such as settlement of all multilateral net those providing same-day finality. positions within the system as and Moreover, many of the fundamental when expected, due primarily to risks that may exist in a clearing potentially systemic credit and liquidity arrangement are not linked to a effects. As a result, these systems are particular form of settlement. expected to meet fully the Lamfalussy Consequently, the Board is proposing to Minimum Standards. For such systems, repeal these policy statements once a the proposed policy statement retains revised, unified policy statement on the same requirements of the Board’s risks in multilateral settlement existing Large-Dollar Policy Statement. arrangements is finalized. The Board expects that these Specific Questions for Comments requirements would apply to those 1. The Board requests comment on multilateral netting systems for largewhether the policy statement adequately dollar payments and foreign exchange identifies settlement arrangements that contracts that are currently required to meet the Lamfalussy Minimum exhibit material settlement-related risks. Standards under the Board’s existing Please address the usefulness of the base Large-Dollar Policy Statement. For other criteria. Are there any other such systems meeting the systemic risk thresholds or criteria that the Board criteria under the new policy but for should consider? 2. How should the policy statement which real-time controls may not be distinguish systems that may pose operationally feasible, the Board would consider alternative risk management systemic risk and are thus subject to 60716 Federal Register / Vol. 62, No. 218 / Wednesday, November 12, 1997 / Notices higher risk management standards from those that do not? Should the thresholds be based on net settlement amounts, gross settlement amounts, average payment size, or some other measure? 3. Should the policy statement include an Appendix with illustrative examples of application of the policy in different circumstances? Regulatory Flexibility Act Analysis The Board has determined that this proposed policy statement would not have a significant economic impact on a substantial number of small entities. The proposal would require multilateral settlement arrangements to address material risks in their systems. The proposal is designed to minimize regulatory burden on smaller arrangements that do not raise material risks. Competitive Impact Analysis The Board has established procedures for assessing the competitive impact of rule or policy changes that have a substantial impact on payments system participants.3 Under these procedures, the Board will assess whether a change would have a direct and material adverse effect on the ability of other service providers to compete effectively with the Federal Reserve in providing similar services due to differing legal powers or constraints, or due to a dominant market position of the Federal Reserve deriving from such differences. If no reasonable modifications would mitigate the adverse competitive effects, the Board will determine whether the anticipated benefits are significant enough to proceed with the change despite the adverse effects. The Board does not believe that the adoption of this policy statement will have a direct and material adverse impact on the ability of other service providers to compete effectively with the Reserve Banks’ payments services. A number of the payment services potentially covered by the proposed policy statement are not offered by the Federal Reserve Banks. In addition, the revised policy statement may have the effect of encouraging competition with the Federal Reserve in areas such as national check and ACH clearing and settlement. The repeal of the Board’s existing policies for small-dollar payments clearing arrangements, together with the Board’s proposal for an enhanced net settlement service, may reduce barriers to establishing such arrangements. 3These procedures are described in the Board’s policy statem ent “The Federal Reserve in the Paym ents System ,” as revised in March 1990. (55 FR 11648, March 29, 1990). settlement through the multilateral system in the event that the system fails to complete settlement, due, for The Board is amending its “Federal example, to a participant default. These Reserve System Policy Statement on factors may create added risks to Payments System Risk” under the participants in multilateral settlement heading “II. Policies for Private-Sector systems relative to other settlement Systems” by removing “A. Privately methods. Operated Large-Dollar Multilateral Clearinghouses also may generate Netting Systems” in its entirety and systemic risk that could threaten the adding in its place “A. Privately financial markets or the economy more Operated Multilateral Settlement broadly. The failure of a system to Systems” and removing “C. Private complete settlement as and when Small-Dollar Clearing and Settlement expected could generate unexpected Systems” in its entirety. credit losses or liquidity shortfalls that participants in the system are not able II. Policies for Private-Sector Systems to absorb. Thus, the inability of one A. Privately Operated Multilateral participant to meet its obligations Settlement Systems within the system when due could lead to the illiquidity or failure of other Introduction institutions. Further, the disruption of a Multilateral settlement systems, such large number of payments and the as clearinghouses and similar resulting uncertainty could lead to arrangements, may produce important broader effects on economic activity. In efficiencies in the clearance and addition, as the Federal Reserve has settlement of payments and financial established fees for daylight overdrafts, contracts. Participants in such systems, along with other risk management typically depository institutions, measures for Federal Reserve payment exchange payments for their own services, the potential exists for intraday account or the accounts of their credit risks to be shifted from the customers in a coordinated fashion and Federal Reserve to private, multilateral settle the resulting obligations on a settlement arrangements, either multilateral, often net, basis. domestically or in other countries, that A variety of credit, liquidity, and have inadequate risk controls. other risks can arise in the clearing and The Board believes that these settlement process that institutions must concerns warrant the application of a manage in the normal course of risk management policy to a limited business, regardless of the method of number of multilateral settlement clearing and settlement. Existing systems that raise material added risks supervisory standards are generally for participants or financial markets. directed at ensuring that institutions The Board recognizes that multilateral establish appropriate policies and settlement systems differ widely in procedures to manage such risks. For terms of form, function, scale, and scope example, Regulation F directs insured of activities. As a general rule, risk depository institutions to establish management measures should be policies and procedures to avoid commensurate with the nature and excessive exposures to any other magnitude of risks involved, but risk depository institutions, including management measures may be designed exposures that may be generated differently for different types of through the clearing and settlement of payments or systems. This policy payments.1 statement, therefore, is designed to permit market participants to determine However, the use of multilateral the best means of addressing risks, settlement systems introduces the risk within certain guidelines. that a failure of one participant in the The Board’s adoption of this policy in system to settle its obligations will have credit or liquidity effects on participants no way diminishes the primary responsibilities of participants in, and that have not dealt with the defaulting participant. Multilateral settlement may operators of, multilateral settlement have the effect of altering the underlying systems to address settlement and other bilateral relationships that arise between risks that may arise in these systems. In addition, the Board encourages all institutions during the clearing and multilateral settlement systems to settlement process. As a result, the consider periodically cost-effective risk incentives for, or ability of, institutions to manage effectively the risk exposures management improvements, even if not specifically required under this policy. to other institutions may be reduced. In addition, in some cases, there may be no Insured depository institutions participating in multilateral settlement feasible or timely alternative to systems are also expected to limit their bilateral credit and liquidity exposures 1See 12 CFR 206. Federal Reserve System Policy Statement on Payments System Risk Federal Register / Vol. 62, No. 218 / Wednesday, November 12, 1997 / Notices as required under Federal Reserve Regulation F. Scope and Administration of the Policy This policy statement will be applied to privately operated multilateral settlement systems or arrangements with three or more participants that settle U.S. dollar payments, including but not limited to systems for the settlement of checks, automated clearinghouse (ACH) transfers, credit, debit, and other card transactions, largevalue interbank transfers, or foreign exchange contracts involving the U.S. dollar. It does not apply to clearing and settlement systems for securities or exchange-traded futures and options. This policy statement is not intended to apply to bilateral relationships between financial institutions, such as those involved in traditional correspondent banking. The Board may also apply this policy to any non-U.S. dollar system based, or operated, in the United States that engages in the multilateral settlement of non-dollar payments among financial institutions and that would otherwise be subject to this policy. The Board expects to be guided by this policy statement in taking action in its supervisory and operational relationships with state member banks, bank holding companies, and clearinghouse arrangements, including, for example, the provision of net settlement services and the implementation of the Bank Service Company Act.2 Systems subject to this policy may be asked to provide gross and net settlement data, as well as intraday position data, if applicable, to the Federal Reserve. Risk Factors and Risk Management Measures The risk factors described below are intended to identify those multilateral settlement systems that may pose material added risks relative to conventional bilateral means of settlement, and which therefore must address these risks under this policy statement. The Board believes that the vast majority of multilateral settlement systems, including most clearinghouses for checks and other small-value payments, do not raise the risks identified below to a material degree. Threshold criteria for each risk category exclude many such systems from the need to assess risk factors under the policy. The Appendix to this policy statement also provides several illustrative examples of the likely 212 USC 1861-67. application of the requirements of the policy statement. Systems that exhibit one or more risk factors should take steps to address those specific risks, including consideration of the risk management measures listed below. If necessary, the Board will work with systems to determine whether changes in their policies or operations are required and, if so, whether steps proposed by the system would satisfy the requirements of the policy. In some cases, an operational change may mitigate a particular risk factor. In other cases, systems may need to develop or modify written rules, policies, and procedures that specify the rights and obligations of participants, as well as other relevant parties, such as settlement agents for the system, in the event that a settlement cannot be completed as and when expected. Such rules and procedures should be disclosed to all participants and their primary regulatory authorities. In general, risk management controls should be proportional to the nature and magnitude of risks in the particular system. For larger systems that have the potential to create systemic risk, the Board expects systems to demonstrate commensurately robust procedures for addressing settlement disruptions, including, in some cases, meeting the Lamfalussy Minimum Standards for multilateral netting systems, discussed below under Systemic risk.3 (1) Credit risk. Risk factors: A multilateral settlement system would give rise to material credit risk if its rules or practices materially increase or shift the bilateral obligations or credit exposures between participants in the clearing and settlement process. One example is a clearinghouse operator or agent that provides a guarantee of settlement. Such a guarantee might be implemented explicitly through the establishment of a central counterparty for all transactions, or through other provisions in the system’s rules, such as a guarantee of members’ settlement obligations, third-party credit 3 The Report o f the Com m ittee on Interbank N etting Schem es o f the Central Banks o f the Group o f Ten Countries (Bank for International Settlem ents, Novem ber 1990), know n as the Lamfalussy Report, recognized that netting arrangem ents for interbank paym ent orders and forward-value contractual com m itm ents, such as foreign exchange contracts, have the potential to im prove the efficiency and the stability of interbank settlements through the reduction of costs along w ith credit and liquidity risks, provided certain conditions are met. That Report developed and discussed “ M inim um Standards for Netting Schem es” (Lamfalussy M inim um 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. 60717 arrangements, or the system’s ability to recover settlement-related losses from participants. Additionally, a system in which participants are exposed to material credit risk to one another by virtue of their participation in the system, due for example, to agreements to mutualize any settlement losses, would be considered to give rise to material credit risk if participants have no means to control these exposures. Threshold criteria: Multilateral settlement systems in which underlying bilateral obligations between participants are not altered, such as those that do not employ settlement guarantees, loss-sharing, or other techniques, would not give rise to additional material credit risk. Thus, most traditional check clearinghouses would not be considered to give rise to credit risk under this policy statement. Risk management measures: Measures that are commonly used to mitigate credit risk in a multilateral settlement system and provide support for settlement guarantees include monitoring of participants’ financial condition, caps or limits on some or all participants’ positions in the system, and requirements for collateral, margin, or other security from some or all participants. Systems in which participants have material bilateral exposures to one another or to the system, such as through loss-sharing agreements, may implement mechanisms for participants to control these exposures. Use of settlement methods with same-day finality may also shorten the duration of credit risk exposure in a system. (2) Liquidity risk. Risk factors: A multilateral settlement system would give rise to significant liquidity risk for its participants if a delay, failure, or reversal of settlement would be likely to cause a significant change in settlement amounts to be paid or received by participants on the settlement date. The degree of liquidity risk in a particular system is greater (1) the larger are gross payment flows relative to netted amounts to be settled; (2) the larger are participants’ settlement positions relative to their available funding resources; (3) the later that participants would be notified of a settlement disruption relative to the timing of activity in the money markets and through other funding channels, and (4) the greater the likelihood that a settlement failure of the particular system would be accompanied by abnormal market conditions. Threshold criteria: The Board expects that participants in multilateral net settlement systems ordinarily would be able to fund their bilateral obligations in 60718 Federal Register / Vol. 62, No. 218 / Wednesday, November 12, 1997 / Notices the event of a delayed or failed settlement where the netting factor for the system is 10 or less, provided settlement activity does not reach levels likely to raise systemic risk, as discussed under Systemic risk, below.4 Risk management measures: One approach to mitigating liquidity risk is to implement measures to reduce significantly both the probability and the effect of a settlement disruption. Measures that are often used to support a settlement guarantee, as described under Credit risk, above, as well as establishing external liquidity resources and adequate operational contingency arrangements may mitigate liquidity risk. Some systems anticipate performing a recast of settlements in the event of a participant default by recalculating multilateral net settlement obligations among participants. These systems are expected to address the liquidity impact of such a procedure.5 For example, timely notification of settlement failure before or during the period of active money market trading would permit participants readily to borrow funds to cover any shortfalls due to the recast. Individual participants may also take steps to limit their own liquidity exposures or increase available liquidity resources. The system itself may utilize committed lines of credit or other external liquidity resources that can be drawn upon to complete settlements in the event of a temporary settlement disruption. (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, 4 The netting factor, calculated as the ratio of gross transactions exchanged in a p articular period to the resulting m ultilateral n et am ounts (aggregate n et debits or n et credits) settled, is one indicator of the m agnitude of the change in positions if all m ultilateral n et settlem ent obligations had to be settled on a gross basis. 5 For example, in a “recast” of settlem ents, some or all transactions involving the defaulting participant w ould be rem oved from the system ’s settlem ent process, to be settled or otherwise resolved outside the system. A revised m ultilateral settlem ent w ith recalculated settlem ent obligations w ould then be conducted among the rem aining participants. In an “u nw in d ,” transactions or settlem ent obligations to be settled on the day of the default for all participants w ould be rem oved from the system. operational obstacles could make it difficult or impossible for participants to arrange settlement outside the system on a timely basis in the event of a settlement failure. As a result, those participants expecting to receive funds could face significant liquidity risk. In addition, in some cases, failure to complete settlement on a timely basis could change the rights of participants with respect to the underlying payments, creating potential credit or liquidity risks. For example, institutions that are unable either to return or to settle for checks presented to them on the same day may lose the right to return the checks for insufficient funds. Further, risk control procedures implemented by a particular system may themselves entail operational risks. The ability of a system to execute a recast of settlements, implement guarantee provisions, or access lines of credit may depend on the operational reliability of the system’s facilities. Threshold criteria: In smaller multilateral settlement systems, it is less likely that operational complexities or constraints would prevent the resolution of a participant default or other settlement disruption, provided that participants receive notice of a settlement failure with adequate time to make alternative arrangements before the closing of funds transfer systems. Thus, the Board does not consider systems with less than one hundred participants that normally settle sufficiently early in the day to raise material operational risks. Risk management measures: Multilateral settlement systems and their participants typically mitigate the risk of operational failure in their daily processing activities through standard techniques, such as contingency plans, redundant systems, and backup facilities. For purposes of this policy statement, systems should ensure the reliable operational capability to execute procedures used to resolve a participant default or other settlement disruption as well as to implement other risk management measures. For example, if a system anticipates recasting settlements by excluding transactions of a defaulting participant, it should ensure that the system can perform any required processing, generate the necessary information, and provide it to participants in a timely manner. To the extent that payments would be expected to be settled outside the system, participants should have adequate time, settlement information, and operational capabilities to complete such settlements before the close of critical funds transfer systems. (4) Legal risk. Risk factors: Legal risk may exist in a multilateral settlement system if there is significant uncertainty regarding the legal status of settlement obligations or the underlying transactions in the event of a settlement failure. This legal uncertainty would greatly exacerbate efforts to achieve an orderly and timely resolution and could expose participants to credit and liquidity risks. If the obligations of participants with respect to underlying transactions exchanged in the system have no enforceable legal status in the event of a system settlement failure, the ability of the participants to revert to other methods of settlement on a timely basis may be in doubt. Legal risk would also arise if the legal enforceability of any risk management measures, netting agreements, or related arrangements, is questionable. Threshold criteria: Systems that clear and settle payments that are supported by a well established legal framework that is independent of the particular settlement system are unlikely to give rise to significant legal risk. Risk management measures: Systems may be able to address legal risk factors through changes to operating rules or other agreements between participants. Rules and related agreements may provide an adequate legal basis for enforceable netting of obligations or for other arrangements that would be invoked in the event of a settlement failure, such as unwind or reversal provisions. (5) Systemic risk. Risk factors: For some multilateral settlement systems, settlement risk factors could have systemic implications. The failure of a multilateral settlement system to complete settlement as and when expected could generate unexpected credit losses or liquidity shortfalls that participants in the system are not able to absorb, or disrupt a large number of payments. In general, the larger the size of settlement activity in a multilateral settlement system, the greater the potential for systemic risk. Threshold criteria: The Board considers as posing systemic risk multilateral settlement systems that have, or that expect to have, on any day, settlements with a system-wide aggregate value of net settlement credits (or debits) larger than $500 million (in U.S. dollars and any foreign currencies combined), or that clear and settle payments or foreign exchange contracts with a daily average stated dollar value larger than $100,000 (calculated over a twelve month period corresponding to the most recent fiscal year for the netting system). Multilateral settlement systems of any size that serve core Federal Register / Vol. 62, No. 218 / W ednesday, November 12, 1997 / Notices financial markets may also be considered to pose systemic risk. Risk management measures: Systems posing systemic risk as defined above are expected to adopt more robust risk management policies and procedures addressing participant defaults and other settlement disruptions and to demonstrate that they are able to execute these procedures. In order to determine the adequacy of risk management controls, systems may need to establish a capability to simulate or test the effects of one or more participant defaults or other possible sources of settlement disruption on the system and its participants.6 Systems with activity exceeding the systemic risk thresholds, and for which there is no feasible or reasonable alternative to settlement of all positions within the system as and when expected due to credit, liquidity, or operational risks, are expected to meet the six Lamfalussy Minimum Standards, below. These standards are designed to address the main risk factors that may be present in multilateral clearing and settlement systems and to provide confidence that such systems can settle all positions as and when expected, thereby reducing substantially the risk that a default by one participant will cause defaults by others. Lamfalussy Minimum Standards for the Design and Operation of Privately Operated Large-Dollar Multilateral Netting Systems7 1. Netting systems should have a wellfounded legal basis under all relevant jurisdictions. 2. Netting system participants should have a clear understanding of the impact of the particular system on each of the financial risks affected by the netting process. 3. Multilateral netting systems should have clearly-defined procedures for the management of credit risks and liquidity risks which specify the respective responsibilities of the netting provider and the participants. These procedures should also ensure that all parties have both the incentives and the capabilities to manage and contain each of the risks they bear and that limits are placed on the maximum level of credit exposure that can be produced by each participant. 4. Multilateral netting systems should, at a minimum, be capable of ensuring 6 Such simulations may include, if appropriate, the effects of changes in market prices, volatilities, or other factors. 7The minimum standards adopted by the Board are identical to those set out in the Lamfalussy Report, with minor changes to terminology. the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single net debit position. 5. Multilateral netting systems should have objective and publicly-disclosed criteria for admission which permit fair and open access. 6. All netting systems should ensure the operational reliability of technical systems and the availability of backup facilities capable of completing daily processing requirements. In meeting these standards, the Board expects that systems will utilize the following risk management measures, or their equivalent: (1) To the extent that participants are exposed to credit and liquidity risks from other participants, require each participant to establish bilateral net credit limits vis-a-vis each other participant in the system; (2) establish and monitor in real-time system-specific net debit limits for each participant; (3) establish real-time controls to reject or hold any payment or foreign exchange contract that would cause a participant’s position to exceed the relevant bilateral and net debit limits; (4) establish liquidity resources, such as cash, committed lines of credit secured by collateral, or a combination thereof, at least equal to the largest single net debit position; and (5) establish rules and procedures for the sharing of credit losses among the participants in the netting system.8 The Board will consider, on a case-by-case basis, alternative risk management measures that provide for an equivalent level of risk management controls for systems in which real-time risk controls are not operationally feasible. However, the Board strongly encourages systems that perform sequential processing of payments or other obligations to develop real-time risk management controls. The Board may also encourage or require higher risk standards, such as the ability to ensure timely multilateral net settlement in the event of multiple defaults, of individual systems that present a potentially high degree of systemic risk, by virtue of their high volume of large-value transactions or central role in the operation of the financial markets. 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 8 The term “largest single net debit position” means the largest intraday net debit position of any individual participant at any time during the daily operating hours of the netting system. 60719 systems for settling U.S. dollar payments that are operated outside the United States. Such systems, if implemented with inadequate attention to risk management, may increase risks to the international banking and financial system. In addition, offshore arrangements have the potential to operate without sufficient official oversight. As a result, the Board has determined that offshore, large-dollar multilateral netting systems and multicurrency clearing and settlement systems should at a minimum be subject to oversight or supervision, as a system, by the Federal Reserve, or by another relevant central bank or supervisory authority. The Board recognizes that central banks have common policy objectives with respect to large-value clearing and settlement arrangements. Accordingly, the Board expects that it will cooperate, as necessary, with other central banks and foreign banking supervisors in the application of the Lamfalussy Minimum Standards to offshore and multicurrency systems. In this regard, the Principles for Co-operative Central Bank Oversight outlined in the Lamfalussy Report provide an important international framework for cooperation. By order of the Board of Governors of the Federal Reserve System, November 6,1997. W illiam W. W iles, Secretary o f the Board. A ppendix Example #1 A local or regional check clearinghouse with less than 100 members that settles sufficiently early in the day to allow settlement disruptions to be resolved on a timely basis would typically not give rise to risks addressed under this policy statement. Generally, such arrangements do not guarantee settlement, mutualize losses, or involve a central counterparty to all transactions, and therefore the settlement arrangement itself does not give rise to added or shifted credit risk for participants. In addition, the liquidity risks of such arrangements generally are low, with netting factors of less than 10, so that liquidity shortfalls due to a disruption in settlement are likely to be within the funding capabilities of participants. From an operational standpoint, these arrangements usually exchange checks in the morning. If prompt notice is given of a recast of settlements at that time, participants should be able to meet their recast settlement obligations, settle any payments excluded from the system bilaterally as necessary, and manage any liquidity shortfalls. Similarly, the existence of established check law would satisfy any legal concerns. Finally, such check clearing arrangements generally do not have aggregate net settlement credits (or debits) larger than $500 million per day, nor do the checks cleared through such 60720 Federal Register / Vol. 62, No. 218 / W ednesday, November 12, 1997 / Notices arrangements have a daily average dollar value larger than $100,000, so the arrangements would not be considered to give rise to systemic risk. Exam ple #2 An ACH clearinghouse with more than 100 members, net settlement debits averaging less than $500 million per day, and a netting factor of five would not be considered to raise significant credit, liquidity, or systemic risks. Such a system would likely not involve settlement guarantees or mutualization of losses, and without high netting factors or similar concerns, it would not be likely to lead to significant liquidity risks. Given the large number of participants, it is unlikely that participants would be able to resolve a settlement failure among themselves without prior coordinated procedures. The system would need to have reliable operational procedures to resolve a settlement failure in a timely manner on the settlement date, such as through a recast of settlements. The rules of the system would need to specify settlement failure procedures, including those for identifying and reversing non settled entries under applicable rules. Exam ple #3 A foreign exchange clearinghouse that clears and settles contracts that average more than $100,000 through a central counterparty arrangement would be required to address potential credit, liquidity, and legal risks, as well as systemic risks. Netting and novation of transactions, for example, would shift credit risk to the central counterparty. Legal risk could exist if the arrangements to implement the netting of underlying foreign exchange contracts could be invalidated or ineffective in the event of bankruptcy of the central counterparty. Given that the arrangement exceeds or plans to exceed the base criteria for potential systemic risk, and serves a key financial market, it would be required to implement robust risk controls and fully meet the Lamfalussy Minimum Standards. [FR Doc. 97-29760 Filed 11-10-97; 8:45 am] BILLI NG C O D E 6 2 1 0 - 0 1 - P
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