[Federal Register Volume 59, Number 249 (Thursday, December 29, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-32014]


[[Page Unknown]]

[Federal Register: December 29, 1994]


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Part IV





Federal Reserve System





_______________________________________________________________________




Policy Statement on Privately Operated Large-Dollar Multilateral 
Netting Systems; Notice
FEDERAL RESERVE SYSTEM

[Docket No. R-0842]

 
Policy Statement on Privately Operated Large-Dollar Multilateral 
Netting Systems

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Policy Statement.

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SUMMARY: As part of its payment system risk reduction program, the 
Board of Governors is updating its policies on ``Privately Operated 
Large-Dollar Funds Transfer Networks'' and ``Offshore Dollar-Clearing 
and Netting Systems'' and integrating those policies into a single 
policy statement on ``Privately Operated Large-Dollar Multilateral 
Netting Systems.'' The Board is incorporating into the new policy 
statement the minimum standards for the design and operation of 
privately operated large-dollar multilateral netting systems set forth 
in the Report of the Committee on Interbank Netting Schemes of the 
Central Banks of the Group of Ten Countries, which was published in 
November 1990 by the Bank for International Settlements.

EFFECTIVE DATE: December 21, 1994.

FOR FURTHER INFORMATION CONTACT: Jeffrey C. Marquardt, Assistant 
Director (202/452-2360), Paul Bettge, Manager (202/452-3174), Kelly 
Shaw, Project Leader (202/452-3054), Division of Reserve Bank 
Operations and Payment Systems; or Oliver Ireland, Associate General 
Counsel (202/452-3625), Stephanie Martin, Senior Attorney (202/452-
3198), Legal Division, Board of Governors of the Federal Reserve 
System; for the hearing impaired only, Telecommunications Device for 
the Deaf, Dorothea Thompson (202/452-3544).

SUPPLEMENTARY INFORMATION:

I. Background

    On July 18, 1994 the Board issued for public comment a proposal to 
update its existing policies on ``Privately Operated Large-Dollar Funds 
Transfer Networks'' and ``Offshore Dollar-Clearing and Netting 
Systems'' and to integrate those policies into a single policy 
statement on ``Privately Operated Large-Dollar Multilateral Netting 
Systems.'' (59 Fed. Reg. 36438) At the same time, the Board proposed to 
apply to such arrangements the minimum standards for multilateral 
netting systems identified in the Report of the Committee on Interbank 
Netting Schemes of the Central Banks of the Group of Ten Countries 
(Lamfalussy Report).
    The proposed policy statement was developed to apply to such 
arrangements as domestic, privately operated, large-dollar multilateral 
payment netting systems; offshore large-dollar multilateral payment 
netting systems; multilateral foreign exchange clearinghouses involving 
settlements in U.S. dollars; and multicurrency payment netting systems 
involving settlements in U.S. dollars. Application of the policy 
statement to such arrangements would cover more completely the range of 
multilateral netting systems involving settlements in U.S. dollars that 
have the potential to increase systemic risk in the financial markets. 
The inclusion of multilateral foreign exchange clearinghouses and 
multicurrency payment netting systems involving settlements in U.S. 
dollars represented an expansion of the Board's existing PSR policy. 
Neither of these types of arrangements is covered explicitly by the 
Board's current policy, yet both types of arrangements have the 
potential to generate the same kinds of systemic risks as single 
currency netting systems.

II. The Proposed Policy Statement

    The Board requested comment on a policy statement that would apply 
to multilateral netting systems that: (1) Have three or more 
participants that net payments or foreign exchange contracts involving 
the U.S. dollar, whether or not netted amounts are legally binding; and 
either (2) have, or are likely to have, on any day, settlements with a 
system-wide aggregate value of net settlement credits (or debits) 
larger than $500 million (in U.S. dollars and any foreign currencies 
combined); or (3) routinely process individual payments or foreign 
exchange contracts, with a stated dollar value larger than $500,000. 
Further, a multilateral netting system that met the above threshold 
criteria would be subject to the policy if (1) It were a state-
chartered member of the Federal Reserve System, (2) any of its agent(s) 
or participants were state-chartered members of the Federal Reserve 
System, (3) its participants' net positions were settled through a 
Federal Reserve settlement account, (4) its participants settled their 
net positions in the multilateral netting system through their 
individual Federal Reserve accounts or the Federal Reserve account of 
the settlement agent(s), or (5) one or more bank holding companies had 
an investment in the multilateral netting system.
    The Board recognized that in the case of privately operated large-
dollar multilateral netting systems for batch processed paper-based or 
electronic payments, including privately operated Automated Clearing 
House (ACH) systems, certain electronic controls that would be required 
to implement the Lamfalussy Minimum Standards might not be feasible. In 
addition, the characteristics of the instruments cleared in such 
systems, along with the scale of systemic risk, might differ from 
large-dollar electronic systems. Consequently, the Board proposed to 
study further the implications of the Lamfalussy Minimum Standards, and 
various arrangements that might be used to implement the Lamfalussy 
Minimum Standards, for privately operated multilateral netting systems 
for batch processed paper-based or electronic payments.
    The proposed policy statement also contained five risk management 
measures that large-dollar multilateral netting systems would be 
expected to utilize in order to satisfy Lamfalussy Minimum Standards 
III and IV, which deal with risk management and settlement completion. 
The risk management measures were: (1) Require each participant to 
establish bilateral net credit limits vis-a-vis each other participant 
in the system; (2) establish and monitor in real time system-specific 
net debit limits; (3) establish a system to reject or hold any payment 
or foreign exchange contract that would exceed the relevant bilateral 
and net debit limits; (4) establish liquidity resources, such as cash, 
committed lines of credit secured by collateral, or a combination 
thereof, at least equal to the largest single net debit position; and 
(5) establish rules and procedures for the sharing of credit losses 
among the participants in a netting system.
    The Board proposed an eighteen-month transition period for large-
dollar multilateral netting systems operating on the date of any final 
action by the Board, following which such systems would be expected to 
comply fully with the policy statement. Large-dollar multilateral 
netting systems established subsequent to the date of final adoption of 
the policy by the Board would be expected to comply fully with the 
policy statement, without benefit of a transition period.
    Finally, the Board requested comment on the application of a higher 
standard than Lamfalussy Minimum Standard IV for individual large-
dollar multilateral netting systems that present a high degree of 
systemic risk. Lamfalussy Minimum Standard IV states that 
``multilateral netting systems should, at a minimum, be capable of 
ensuring the timely completion of daily settlements in the event of an 
inability to settle by the participant with the largest single net 
debit position.'' The Board requested comment on whether certain 
systems should be expected to ensure settlements in the event, for 
example, that participants with the first, second, and third largest 
net debit positions are simultaneously unable to settle these 
positions. The Board also asked what factors should be considered in 
analyzing the incremental costs and benefits of requiring multilateral 
systems to meet a higher standard, and whether a quantitative threshold 
should be employed to identify systems that might present a high degree 
of systemic risk.

III. The Final Policy Statement

    The final policy statement adopted by the Board, with slight 
modifications, is essentially unchanged from the draft policy statement 
issued last July. The Board has made certain technical modifications to 
the policy statement to clarify both the threshold criteria for 
identifying multilateral netting systems subject to the policy and the 
risk management measures for implementing Lamfalussy Minimum Standards 
III and IV. These modifications are discussed below.

Scope and Application of the Policy

    The Board has retained the threshold criteria, with one 
modification, for identifying multilateral netting systems that are 
subject to the policy. In order to specify more clearly the size of 
transactions that give rise to the application of the policy statement, 
the criterion that systems ``routinely process'' transactions with a 
stated value larger than $500,000 has been changed to ``* * * process 
payments or foreign exchange contracts, with a daily average stated 
dollar value, calculated over the twelve month period corresponding to 
the most recent fiscal year for the netting system, larger than 
$100,000.'' The jurisdictional criteria for applying the policy remain 
unchanged. Taken together, these criteria are designed to limit the 
scope and application of the policy to large-dollar multilateral 
netting systems for payments and foreign exchange contracts that 
involve settlements in U.S. dollars and have the potential to increase 
systemic risk in financial markets.
    The Board believes that the Lamfalussy Minimum Standards may apply 
to all large-dollar multilateral payment netting systems irrespective 
of the type of financial instrument or contractual obligation netted by 
the system. However, the Board recognizes that in the case of privately 
operated large-dollar multilateral netting systems for batch processed 
paper-based or electronic payments, including privately operated 
Automated Clearing House (ACH) systems, certain electronic controls 
that would be required to implement the Lamfalussy Minimum Standards 
may not be feasible. Further, the rights and responsibilities of 
parties within such systems may require further analysis. Thus, the 
Board intends to study further the implications of the Lamfalussy 
Minimum Standards, and various arrangements that might be used to 
implement the Lamfalussy Minimum Standards, for privately operated 
large-dollar multilateral netting systems for batch processed paper-
based or electronic payments. The Board is not, therefore, applying the 
Lamfalussy Minimum Standards to these systems at this time.

Implementation of the Lamfalussy Minimum Standards

    The Board believes that large-dollar multilateral netting systems, 
whether on-shore or off-shore, should meet in full the Lamfalussy 
Minimum Standards, as set forth in the final policy statement. The 
Board's policy statement retains the five risk management measures 
contained in the proposed policy statement that multilateral netting 
systems may utilize to satisfy Lamfalussy Minimum Standards III and IV, 
which deal with risk management and settlement completion. Risk 
management devices that lead to a substantially equivalent degree of 
risk management and control could also be adopted, as approved by the 
Board on a case-by-case basis.
    The Board's final policy statement makes it clear that multilateral 
netting systems utilizing a central counterparty would be expected to 
satisfy the risk management measure relating to bilateral net credit 
limits through the establishment by the central counterparty of net 
credit limits vis-a-vis each participant. In addition, each participant 
would be expected to establish a bilateral net credit limit for the 
central counterparty.
    The Board has clarified its final policy statement to encourage 
large-dollar multilateral netting systems to establish a capability to 
simulate the effect on liquidity resources and risk management controls 
of one or more defaults by existing participants, as well as the 
effects of adding additional participants or products to the system. In 
addition, the Board has further encouraged large-dollar systems for 
contract netting to conduct simulation analyses of forward replacement 
cost risk under different assumptions about changes in market prices, 
volatilities, and other factors.
    The Board has not adopted at this time a specific higher standard 
for multilateral netting systems that may present a high degree of 
systemic risk. Although the Board believes that it might be appropriate 
for such systems to meet additional standards beyond the six Lamfalussy 
Minimum Standards, the costs and benefits of meeting a higher standard 
remain unclear. Public comments, however, appear to indicate a 
consensus that higher standards would be appropriate when the costs are 
justified. Thus, the Federal Reserve will continue to work on a case-
by-case basis with individual large-dollar multilateral netting systems 
it believes present a potentially high degree of systemic risk, by 
virtue of their high volume of large-value transactions or central role 
in the operation of the financial markets, in order to determine 
whether higher risk standards, including the ability to ensure 
settlement in the event of multiple defaults, would be appropriate. In 
no event, would systems be discouraged from adopting higher standards 
based on specific risk assessments. The Board will continue to review 
the experience of netting systems with risk management measures to deal 
with multiple defaults.

Timeframe for Implementation of the Lamfalussy Minimum Standards

    Consistent with its earlier proposal, the Board's final policy 
statement retains an eighteen-month transition period for large-dollar 
multilateral netting systems that are operating on or before December 
21, 1994. Such systems will be expected to comply fully with the policy 
statement within the eighteen-month transition period. Large-dollar 
multilateral netting systems established subsequent to December 21, 
1994 will be expected to comply fully with the policy statement, 
without benefit of a transition period.

IV. Summary of Comments

    The Board received twenty-one public comment letters on its 
proposed policy statement.1 The commenters were distributed as 
follows:
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    \1\ This total does not include comment letters sent by Federal 
Reserve Banks.

------------------------------------------------------------------------
                       Type of institution                        Number
------------------------------------------------------------------------
Clearing Organizations and Associations.........................      10
Commercial Banking Organizations................................       5
Trade Associations..............................................       3
Retail Payment Networks.........................................       2
Regulatory Agencies.............................................       1
                                                                 -------
  Total.........................................................      21
------------------------------------------------------------------------

General Comments

    Twelve commenters did not respond to the application of the 
Lamfalussy Minimum Standards to large-dollar multilateral payment 
netting systems, but instead stated opposition to the application of 
the standards to large-dollar multilateral netting systems for batch 
processed paper-based or electronic payments. Some of these commenters 
provided important insights into the operational characteristics of 
such systems. These commenters noted further that the National 
Organization of Clearing Houses (NOCH) and the National Automated 
Clearing House Association (NACHA) have jointly organized a 
``Settlement Risk Management Task Force,'' the mandate of which is to 
conduct an analysis of ``the systemic and liquidity risks associated 
with the clearing and settlement of batch payment transactions like ACH 
entries and checks.'' One of the twelve commenters proposed that the 
Board exclude batch systems from the minimum standards until it has 
examined further systemic risk in these systems rather than grant a 
temporary exemption. Another commenter proposed that the criteria that 
delimit the application of the policy be designed explicitly to exclude 
large-dollar multilateral netting systems for batch processed paper-
based and electronic payments.
    The Board stated in its request for comment that certain electronic 
controls that would be required to implement the Lamfalussy Minimum 
Standards might not be feasible for large-dollar multilateral netting 
systems for batch processed paper-based and electronic payment systems 
and that the rights and responsibilities of parties within such systems 
might require further analysis. As noted above, the Board is not 
applying the Lamfalussy Minimum Standards to large-dollar multilateral 
netting systems for batch processed paper-based and electronic payments 
at this time. Moreover, the Board intends to monitor closely the 
discussions and analysis of the NOCH/NACHA task force to supplement the 
Board's analysis of appropriate risk management measures for such 
systems.
    The remaining nine commenters generally supported the adoption of 
the Lamfalussy Minimum Standards in the Board's policy statement on 
large-dollar multilateral netting systems. These commenters also stated 
that a specific higher standard for controlling risks in systems with a 
high degree of systemic risk should not be implemented at this time.

Specific Issues on which the Board Sought Comment

1. Proposed criteria for identifying large-dollar multilateral netting 
systems subject to the policy statement
    The commenters generally agreed with the proposed criteria. One 
commenter suggested that the Board clarify whether exchange clearing 
systems for derivatives other than futures and options, such as 
interest rate swaps, would be subject to the proposed policy. The Board 
believes that the Lamfalussy Minimum Standards provide a useful 
starting point for the analysis of large-dollar multilateral netting 
systems irrespective of the type of financial instrument or contractual 
obligation netted by the system. It is premature, however, to determine 
whether the Lamfalussy Minimum Standards provide a sufficient framework 
for the development of clearinghouses for interest rate swaps. The 
Board notes that in its comment letter the Commodity Futures Trading 
Commission (CFTC) stated that ``[i]n general, the Commission agrees 
with the FRB that the minimum standards for netting recommended by the 
Lamfalussy Report (``Lamfalussy Minimum Standards'') represent a core 
of minimum requirements for multilateral netting systems.''
    One commenter proposed that the financial condition of the 
participants as well as the underlying instrument to be settled should 
be considered as criteria. Another commenter proposed that only new 
multicurrency multilateral netting arrangements should be subject to 
the policy and that existing netting systems should be exempt. The 
Board has set forth criteria that it believes are appropriate for 
identifying large-dollar multilateral netting systems with the 
potential to increase systemic risk in financial markets. The Board 
believes that the prospective application of the policy statement would 
ignore the potential for increased systemic risk posed by existing 
multilateral netting systems. Moreover, the application of the 
Lamfalussy Minimum Standards on a prospective basis only would lead to 
competitive inequalities between existing multilateral netting systems 
and those that may become operational in the future.
    Several commenters suggested that the Board clarify the meaning of 
the words ``routinely process'' in the third threshold criterion that 
deals with individual payments or foreign exchange contracts with a 
stated dollar value larger than $500,000. One of these commenters 
proposed that the Board adopt a definite test of transaction size, and 
specifically suggested that systems with payments having an average 
size of $100,000 or more be covered by the policy statement. In support 
of this suggestion, the commenter noted, ``[w]e believe that any funds 
transfer system that has an average payment size of $100,000 would 
``routinely'' process payments of $500,000 or more.''
    The Board agrees that it would be helpful to the financial markets 
for the policy statement to articulate as clearly as possible the 
conditions under which a multilateral netting system would be subject 
to the policy statement. The Board believes that an average transaction 
size threshold would allow the operators of multilateral netting 
systems, and the participants in those systems, to determine more 
easily when they are covered by the policy. Accordingly, the third 
threshold criterion for identifying large-dollar multilateral netting 
systems subject to the policy statement has been modified to take 
account of the daily average transaction size over a twelve month time 
period.
    One commenter proposed that a threshold greater than $500 million 
in daily net settlements should be considered by the Board since large-
dollar multilateral netting systems are more likely to have 
significantly higher aggregate daily net settlements. The Board 
continues to believe that $500 million in daily net settlements is an 
appropriate threshold. It is important to recognize that, in 
multilateral netting systems, the value of net settlements is often 
less than 10 percent, and sometimes less than 5 percent, of the gross 
daily value of transactions. Thus, net settlements of $500,000 may 
represent transactions with a daily aggregate value considerably in 
excess of $5 billion or even $10 billion. Settlement failures of this 
magnitude have the potential to create significant liquidity problems 
for their participants and to generate systemic risks. Moreover, the 
Board is excluding check clearing and ACH systems that might otherwise 
be covered, and which raise separate issues, from the policy statement 
at this time.
2. The five risk management measures for implementation of the 
Lamfalussy Minimum Standard
    The first risk management measure is that each participant 
establish bilateral net credit limits vis-a-vis each other participant 
in the system. Two commenters proposed that the Board clarify this 
measure with regard to netting systems that utilize a central 
counterparty. These commenters suggested that such systems should be 
able to meet the first risk measure by establishing bilateral net 
credit limits between the central counterparty and each participant 
rather than between each participant. The Board concurs with this 
analysis and the final policy statement makes it clear that 
multilateral netting systems utilizing a central counterparty would be 
expected to satisfy the first risk management measure through the 
establishment by the central counterparty of net credit limits vis-a-
vis each participant. In addition, the Board expects that each 
participant will establish a bilateral net credit limit for the central 
counterparty. The Board notes that the establishment of bilateral net 
credit limits between the central counterparty and each participant 
would not necessarily eliminate the need for traditional bilateral 
credit limits between participants, if bilateral exposures are 
incurred, or preclude the establishment of automated bilateral credit 
limits between participants as part of certain overall types of risk 
management designs for a clearinghouse.
    The second and third risk management measures require large-dollar 
multilateral netting systems to establish and monitor in real time 
system-specific net debit limits and reject or hold any payment or 
foreign exchange contract that would exceed the relevant bilateral and 
net debit limits. Two commenters raised issues regarding the 
application of these two measures to forward-value foreign exchange 
contract netting systems. One commenter stated that forward-value 
contract netting systems would typically stop accepting contracts for a 
particular value date at some point prior to the start of settlement 
for that value date. Therefore, except for changes in the forward value 
of contracts as a result of changes in foreign exchange rates, the size 
of any unmargined settlement exposure in excess of a net debit limit 
would be known in advance of the settlement date. The commenter went on 
to argue that real time monitoring of net debit limits would be 
inappropriate for forward-value contract netting systems, since system 
operators could collect additional margin or otherwise cover any 
settlement exposure prior to settlement.
    The Board believes that real-time monitoring is an important device 
for controlling the settlement and forward replacement cost risks 
inherent in multilateral netting systems. The capability to monitor 
these exposures is especially critical for netting systems that accept 
transactions for same day, or even possibly next day, settlement. In 
general, however, the strength of alternatives to real-time monitoring 
must be judged in the context of the risks and risk management systems 
of specific multilateral netting arrangements.
    Two commenters contended that rejecting contracts for trades that 
exceed net debit limits on a contract netting system would be unfair to 
counterparties that did not violate net debit limits and would disrupt 
market liquidity. The Board believes that the ability of a netting 
system to reject, or possibly pend, transactions that violate risk 
management parameters is a critical risk management tool for 
multilateral netting systems, irrespective of whether the system nets 
payment orders or forward-value contracts. Issues relating to impacts 
on market liquidity need to be assessed in relation to the impact on 
market liquidity if a multilateral netting system were to collapse as a 
result of the inability of the system to protect adequately itself and 
its participants. Moreover, in response to the installation of systems 
for rejecting transactions, system participants would normally develop 
contingency plans to deal with rejected items. It should also be noted 
that the Board has the flexibility to approve on a case-by-case basis 
risk management devices that lead to a substantially equivalent degree 
of risk management and control as the five risk management measures 
contained in the policy statement.
    Two commenters suggested that the real-time monitoring requirement 
should be expanded to a twenty-four hour basis. Although the Board does 
not discourage systems from adopting higher standards based on specific 
risk assessments, it believes that twenty-four hour monitoring of 
system specific net debit limits and netted transactions would not be 
necessary for all types of multilateral netting systems. The Board 
expects that multilateral netting systems will adopt risk management 
systems that are appropriate to the scale and nature of the credit, 
liquidity, and settlement risks inherent in the system. For example, 
twenty-four hour monitoring of net debit limits and netted transactions 
would likely be an appropriate risk management measure for any 
multilateral multicurrency netting system with significant foreign 
currency exposures.
    The fourth risk measure requires multilateral netting systems to 
establish liquidity resources such as cash, committed lines of credit 
secured by collateral, or a combination thereof, at least equal to the 
largest single net debit position. One commenter proposed that for 
contract netting systems, the largest single net debit position should 
be defined as the aggregate of all final net settlement payments due 
from a single participant on the relevant value date. The Board 
believes that its definition of the term ``largest single net debit'' 
is sufficiently flexible to accommodate the specific operational 
aspects of contract netting systems.
    Two commenters proposed that U.S. Treasury securities or other 
high-grade collateral should be acceptable as liquidity resources. The 
Board notes that a critical characteristic of liquidity resources that 
support settlement is that they be highly liquid. While it is true that 
high-grade securities are considered highly liquid during most hours of 
the trading day, it is less clear that such securities can be readily 
converted to cash late in the business day when a settlement failure is 
most likely to occur. Consequently, the Board believes that liquidity 
resources in support of settlement should take the form of cash, 
committed lines of credit secured by collateral, or some combination 
thereof. In individual cases, U.S. Treasury securities may provide an 
appropriate source of liquidity. Clearly, U.S. Treasury securities 
would be an important source of collateral for committed lines of 
credit.
    Several commenters agreed with the fifth risk measure that would 
require system participants to establish rules and procedures for the 
sharing of credit losses. Several commenters also endorsed the Board's 
statement that it will consider, on a case-by-case basis, alternative 
risk measures that would lead to a substantially equivalent degree of 
risk management and control as the five risk management measures 
identified in the policy statement.
3. Timeframe for Implementation of the Lamfalussy Minimum Standards
    Most commenters agreed that 18 months is a reasonable time period 
in which to expect existing large-dollar multilateral netting systems 
to meet the Lamfalussy Minimum Standards. One commenter proposed a two 
year timeframe, and two others proposed that flexibility be built into 
the process for systems that are making a good faith effort to comply 
with the standards.
    The Lamfalussy Report was published four years ago by the G-10 
central bank Governors, and it has been clear to the financial markets 
for some time that large-dollar systems would ultimately be expected to 
meet some version of these standards. The Board has adopted an eighteen 
month transition period in order to provide existing multilateral 
netting systems sufficient time, and the incentives associated with a 
clear deadline, to implement any needed changes.
4. Establishment of a higher standard than Lamfalussy Minimum Standard 
IV for systems that present a high degree of systemic risk

    Lamfalussy Minimum Standard IV requires that a netting system be 
capable of ensuring the completion of daily settlement in the event 
that the participant with the largest net debit position is unable to 
settle its obligation to the system. The Board requested comment on 
whether this standard should be enhanced for systems that may present a 
high degree of systemic risk. The Board also requested comment on 
establishing a threshold to define such systems.
    Several commenters expressed concern about the cost of requiring 
additional risk controls. One commenter proposed that simulations be 
conducted of the effects of multiple participant defaults in systems in 
order to analyze the costs and benefits of a higher standard. This 
commenter also suggested that start-up systems should not be held to a 
higher standard as the cost of meeting the standard may be prohibitive.
    Commenters were unanimous in their opinion that quantifying a 
threshold to define high systemic risk would be difficult, although one 
commenter proposed a threshold based on the ratio of uncollateralized 
net debit positions to Tier One capital weighted according to credit 
rating. One commenter proposed that the Board defer action on adopting 
a higher standard, and another proposed that higher risk measures be 
imposed by the Board only on a case-by-case basis. As the Board has 
noted, it is not adopting a higher standard at this time. The Federal 
Reserve will continue to work on a case-by-case basis with individual 
large-dollar multilateral netting systems it believes present a 
potentially high degree of systemic risk, by virtue of their high 
volume of large-value transactions or central role in the operation of 
the financial markets, in order to determine whether higher risk 
standards, including the ability to ensure settlement in the event of 
multiple defaults, would be appropriate. In order to help quantify the 
risks, the Board is also encouraging netting systems to adopt regular 
simulation analyses in order to determine the effects, among other 
risks, of multiple participant defaults.

Competitive Impact Analysis

    The Board has established procedures for assessing the competitive 
impact of rule or policy changes that have a substantial impact on 
payments system participants.2 Under these procedures, the Board 
will assess whether a change would have a direct and material adverse 
effect on the ability of other service providers to compete effectively 
with the Federal Reserve in providing similar services due to differing 
legal powers or constraints, or due to a dominant market position of 
the Federal Reserve deriving from such differences. If no reasonable 
modifications would mitigate the adverse competitive effects, the Board 
will determine whether the anticipated benefits are significant enough 
to proceed with the change despite the adverse effects.
---------------------------------------------------------------------------

    \2\These procedures are described in the Board's policy 
statement ``The Federal Reserve in the Payments System,'' as revised 
in March 1990. (55 FR 11648, March 29, 1990).
---------------------------------------------------------------------------

    The Board does not believe that the Lamfalussy Minimum Standards 
will have a direct and material impact on the ability of other service 
providers to compete effectively with the Reserve Banks' payments 
services. The Board notes that in several cases the payment services 
potentially covered by the policy statement are not offered by the 
Federal Reserve Banks. For example, the Federal Reserve Banks do not 
offer services relating to the electronic clearing and settlement of 
payments or contracts in foreign currencies.
    In the case of domestic large-dollar multilateral netting systems, 
a number of the risk control measures proposed to meet the Lamfalussy 
Minimum Standards as well as certain of the standards themselves have 
grown out of the experience of the private sector in developing robust 
netting arrangements and are currently employed in multilateral netting 
systems. To the extent an incremental burden might be imposed on large-
dollar systems, the need to reduce and control the large potential 
systemic risks of such systems would justify the adoption of prudent 
standards and measures to control risk. The Board does not expect at 
this time, however, that the adoption of the Lamfalussy Minimum 
Standards would have a direct and material impact on the ability of 
other service providers to compete with the Federal Reserve Banks.

Federal Reserve System Policy Statement on Payments System Risk

    The Board is amending its ``Federal Reserve System Policy Statement 
on Payments System Risk'' under the heading ``II. Policies for Private-
Sector Networks'' by replacing in the heading the word ``Networks'' 
with the word ``Systems;'' deleting ``A. Private Large-Dollar Funds 
Transfer Networks'' in its entirety and replacing that part with ``A. 
Privately Operated Large-Dollar Multilateral Netting Systems;'' and 
deleting ``C. Offshore Dollar Clearing and Settlement Systems'' and 
redesignating ``D. Private Small-Dollar Clearing and Settlement 
Systems'' as ``C. Private Small-Dollar Clearing and Settlement 
Systems.''

II. Policies For Private-Sector Systems

A. Privately Operated Large-Dollar Multilateral Netting Systems
    Large-dollar multilateral netting systems can create a significant 
degree of credit and liquidity risk for their participants and also 
expose the U.S. payments system and financial markets to systemic risk. 
In the context of large-dollar multilateral netting systems, systemic 
risk is the risk that the inability of one institution within such a 
system, including a central counterparty if one exists, to meet its 
obligations when due will lead to the illiquidity or failure of other 
institutions, either within the particular system or in the financial 
markets as a whole.
    Large-dollar multilateral netting systems may produce efficiencies 
in the clearance and settlement of payments and financial contracts. At 
the same time, multilateral netting may obscure, concentrate, and 
redistribute the credit and liquidity risks associated with clearance 
and settlement. As the size of netted positions increases, for example, 
so do the potential liquidity effects on such systems and their 
participants, as well as third parties, in the event of a settlement 
failure. In addition, if the high volumes of interrelated large-value 
financial contracts and payments, which reflect money and capital 
market activity, are not settled in a timely manner, there is a 
significant potential for widespread financial market disruption.
    Certain types of netting system rules may also create sizable 
systemic liquidity risks, if employed by systems that process large-
value payments or financial contracts that are central to the operation 
of financial markets. For example, privately operated payment systems 
that permit a system operator to unwind, recast, or otherwise reverse 
same-day funds transfers made by system participants, whether for 
reasons of general financial market stress or because of the inability 
of a system participant to settle its obligations on time, can obscure 
and greatly increase the level of systemic liquidity risk associated 
with the system. As a general matter, the Board does not view a same-
day recast, unwind, or reversal of payments as a satisfactory mechanism 
for managing liquidity and settlement risks in large-dollar 
multilateral netting arrangements.
    The Board also recognizes that the development of offshore 
multilateral netting systems for large-dollar payments and foreign 
exchange contracts may raise concerns about systemic risk that extend 
beyond the potential for disturbances to payment and settlement 
systems, or financial markets, in the United States. For example, the 
offshore clearing of U.S. dollar payments, for subsequent net 
settlement in the United States, may create transactional and other 
efficiencies for participants in such offshore systems. At the same 
time, these arrangements have the potential to concentrate settlement 
risks at clearing organizations and their associated settlement agents 
either in the United States or abroad. If the allocation of credit and 
liquidity risks associated with the netting is not clearly defined, 
understood, and managed, offshore dollar-clearing arrangements may 
obscure, or even increase, the level of systemic risk in U.S. and 
offshore large-dollar payments systems, as well as in the international 
dollar settlement process. Poorly designed and managed systems may, 
therefore, increase risks to the international banking and financial 
system. In addition, offshore arrangements have the potential to 
operate without sufficient official oversight.
    As the Federal Reserve implements fees for daylight overdrafts, 
along with other risk management measures, it also is important that 
risks not simply be shifted from the Federal Reserve's payment services 
to private, inadequately structured multilateral netting arrangements, 
either domestically or in other countries. For example, the Board has 
been concerned that the steps being taken to reduce systemic risk in 
U.S. large-dollar payments systems may induce the further development 
of ``offshore'' large-dollar multilateral netting systems. These 
offshore systems can settle directly through payments on Fedwire or 
indirectly through a private large-dollar clearing system, which in 
turn settles on a net basis using Fedwire.
    In response to potential systemic risks and the possibility that 
efforts to avoid risk controls will lead to inadequately structured and 
managed systems, the Board is adopting minimum standards for the design 
and operation of privately operated large-dollar multilateral netting 
systems. The minimum standards apply whether or not these systems 
operate domestically or in other countries. These minimum standards are 
identical to those set out in the Report of the Committee on Interbank 
Netting Schemes of the Central Banks of the Group of Ten Countries 
(Lamfalussy Report).3 The Board recognizes that from time to time, 
in specific cases, questions of interpretation of these standards, as 
they apply to large-dollar multilateral netting systems, may have to be 
resolved by the Board.
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    \3\In November 1990, the Committee on Interbank Netting Schemes 
of the Central Banks of the Group of Ten Countries produced a report 
on multilateral netting schemes. The Committee was chaired by Mr. 
Alexandre Lamfalussy, General Manager of the Bank for International 
Settlements. That report recognized that netting arrangements for 
interbank payment orders and forward-value contractual commitments, 
such as foreign exchange contracts, have the potential to improve 
the efficiency and the stability of interbank settlements through 
the reduction of costs along with credit and liquidity risks, 
provided certain conditions are met. In this regard, the Lamfalussy 
Report developed and discussed, in some detail, both ``Minimum 
Standards for Netting Schemes'' and ``Principles for Co-operative 
Central Bank Oversight'' of such arrangements.
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    It is important to note that the Board's adoption of the Lamfalussy 
Minimum Standards in no way diminishes the primary responsibilities of 
participants in, and operators of, large-dollar netting systems for 
ensuring that these systems have adequate credit, liquidity, and 
operational safeguards. In adopting this policy statement, it is the 
Board's intent to heighten awareness of the risks associated with 
multilateral netting arrangements and of the need for their prudent 
management. The Board also seeks to provide the financial system with a 
set of minimum criteria, which have been discussed by the G-10 central 
banks, against which structural and risk management features of large-
dollar multilateral netting systems can be evaluated.
    Scope and Application of the Policy. This policy statement is 
directed toward any privately operated, multilateral netting system 
that settles, or seeks to settle, U.S. dollar obligations through 
payments affecting one or more accounts at Federal Reserve Banks, 
either directly or indirectly (``multilateral netting systems''). 
Multilateral netting systems include clearinghouse organizations, with 
or without a central counterparty, for netting payments or foreign 
exchange contracts among financial institutions.
    The scope of the policy statement is limited to multilateral 
netting systems that involve large-dollar settlements or payments. In 
particular, such systems that: (1) Have three or more participants that 
net payments or foreign exchange contracts involving the U.S. dollar, 
whether or not netted amounts are legally binding; and either (2) have, 
or are likely to have, on any day, settlements with a system-wide 
aggregate value of net settlement credits (or debits) larger than $500 
million (in U.S. dollars and any foreign currencies combined); or (3) 
process payments or foreign exchange contracts, with a daily average 
stated dollar value, calculated over a twelve month period 
corresponding to the most recent fiscal year for the netting system, 
larger than $100,000.
    A multilateral netting system that meets the above criteria is 
subject to the policy if (1) it is a state-chartered member of the 
Federal Reserve System, (2) any of its agent(s) or participants are 
state-chartered members of the Federal Reserve System, (3) its 
participants' net positions are settled through a Federal Reserve 
settlement account, (4) its participants settle their net positions in 
the multilateral netting system through their individual Federal 
Reserve accounts or the Federal Reserve account of the settlement 
agent(s), or (5) one or more bank holding companies have an investment 
in the multilateral netting system. The Board also reserves the right 
to apply the elements of this policy to any non-dollar system based, or 
operated, in the United States that engages in the multilateral 
clearing or netting of non-dollar payments among financial institutions 
and that would otherwise be subject to this policy. This policy does 
not apply to systems dealing with exchange-traded futures and options.
    In applying the policy, the Board seeks to distinguish between 
routine banking relationships and arrangements that create a 
multilateral ``system'' for clearing and settling U.S. dollar payment 
and other obligations. This policy statement is not intended to apply 
to routine bilateral relationships between financial institutions, such 
as those involved in correspondent banking. In certain borderline 
cases, for example involving netting systems operated by a single 
financial institution and that combine elements of bilateral and 
multilateral netting, a case-by-case determination that an arrangement 
is a large-dollar multilateral netting system may be necessary for the 
purpose of applying this policy statement.
    In general, the participation in, and operation of, a multilateral 
netting system is governed by rules and procedures designed to 
facilitate multilateral clearance and settlement. Settlement risks are 
typically shared by the participants in some fashion, either implicitly 
or through employment of explicit loss-sharing and liquidity 
arrangements. In contrast, correspondent banking relationships 
generally focus on bilateral relationships and risks; the risk of a 
settlement failure typically falls, at least initially and sometimes 
primarily, on the service provider's or settlement agent's liquidity 
resources and capital.
    The Board believes that the Lamfalussy Minimum Standards may apply 
to all large-dollar multilateral payment netting systems irrespective 
of the type of financial instrument or contractual obligation netted by 
the system. However, the Board recognizes that in the case of privately 
operated large-dollar multilateral netting systems for batch processed 
paper-based or electronic payments, including privately operated 
Automated Clearing House (ACH) systems, certain electronic controls 
that would be required to implement the Lamfalussy Minimum Standards 
may not be feasible. Further, the rights and responsibilities of 
parties within such systems may require further analysis. The Board 
intends to study further the implications of the Lamfalussy Minimum 
Standards, and various arrangements that might be used to implement 
these standards, for privately operated large-dollar multilateral 
netting systems for the batch processing of paper-based as well as 
electronic payments. The Board is not, therefore, applying the 
Lamfalussy Minimum Standards to these systems at this time.
    Lamfalussy Minimum Standards for the Design and Operation of 
Privately Operated Large-Dollar Multilateral Netting Systems. The 
Federal Reserve's policy on privately operated large-dollar 
multilateral netting systems is designed to strike an appropriate 
balance between the requirements of market efficiency and payments 
system stability. A direct means of achieving this balance is to ensure 
that large-dollar multilateral netting systems are designed and 
operated so that the participants and service providers have both the 
incentives and the ability to manage the associated credit and 
liquidity risks. The Board's approach to privately operated large-
dollar multilateral netting systems will be guided by the following 
minimum standards for such systems:4
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    \4\These standards are identical to the minimum standards for 
netting systems in the Lamfalussy Report, with the exception that 
the words ``netting system'' have been substituted for ``netting 
scheme'' in minimum standards one, two, and six, and the words 
``particular system'' have been substituted for ``particular 
scheme'' in standard two.
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    1. Netting systems should have a well-founded legal basis under all 
relevant jurisdictions.
    2. Netting system participants should have a clear understanding of 
the impact of the particular system on each of the financial risks 
affected by the netting process.
    3. Multilateral netting systems should have clearly-defined 
procedures for the management of credit risks and liquidity risks which 
specify the respective responsibilities of the netting provider and the 
participants. These procedures should also ensure that all parties have 
both the incentives and the capabilities to manage and contain each of 
the risks they bear and that limits are placed on the maximum level of 
credit exposure that can be produced by each participant.
    4. Multilateral netting systems should, at a minimum, be capable of 
ensuring the timely completion of daily settlements in the event of an 
inability to settle by the participant with the largest single net 
debit position.
    5. Multilateral netting systems should have objective and publicly-
disclosed criteria for admission which permit fair and open access.
    6. All netting systems should ensure the operational reliability of 
technical systems and the availability of backup facilities capable of 
completing daily processing requirements.
    The Federal Reserve reserves the right to prohibit the use of 
Federal Reserve payment services to support funds transfers that are 
used to settle, directly or indirectly, obligations on large-dollar 
multilateral netting systems that do not meet the Lamfalussy Minimum 
Standards. The Federal Reserve will also take appropriate supervisory 
steps, or refer matters to the appropriate supervisory or regulatory 
authority, in cases of systems not in compliance with the 
aforementioned Lamfalussy Minimum Standards, or their equivalent. 
Moreover, in order for Federal Reserve Banks to monitor the use of 
intraday credit, no future or existing privately operated large-dollar 
multilateral netting system will be permitted to settle on the books of 
a Federal Reserve Bank unless its participants authorize the system to 
provide position data to the Reserve Bank on request.
    Implementation of the Lamfalussy Minimum Standards. The Board 
believes that large-dollar multilateral netting systems, whether 
onshore or offshore, should meet in full the Lamfalussy Minimum 
Standards, as set forth in this policy statement. In order to satisfy 
the Lamfalussy Minimum Standards, the Board expects that individual 
large-dollar multilateral netting systems will utilize the following 
risk management measures, or their equivalent: (1) Require each 
participant to establish bilateral net credit limits vis-a-vis each 
other participant in the system; (2) establish and monitor in real-time 
system-specific net debit limits for each participant; (3) establish 
real-time controls to reject or hold any payment or foreign exchange 
contract that would cause a participant's position to exceed the 
relevant bilateral and net debit limits; (4) establish liquidity 
resources, such as cash, committed lines of credit secured by 
collateral, or a combination thereof, at least equal to the largest 
single net debit position;5 and (5) establish rules and procedures 
for the sharing of credit losses among the participants in the netting 
system. The Board will consider, on a case-by-case basis, alternative 
risk management measures that provide for risk management systems and 
controls that are equivalent to the five measures listed above. The 
Board notes that the Lamfalussy Minimum Standards and the arrangements 
to implement the Lamfalussy Minimum Standards, as discussed above, in 
no way diminish the responsibilities of the participants in, and the 
operator of, a large-dollar multilateral netting system to determine if 
additional safeguards would be appropriate.
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    \5\The term ``largest single net debit position'' means the 
largest intraday net debit position of any individual participant at 
any time during the daily operating hours of the netting system.
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    The Board recognizes that there are differences between 
decentralized and centralized risk management structures for 
multilateral netting systems. Some multilateral netting systems utilize 
a clearinghouse or similar entity as the central counterparty to 
transactions submitted by the system's participants for netting. 
Depending upon the design of a particular system, the central 
counterparty may bear directly both settlement exposures and forward 
replacement cost exposures vis-a-vis participants.6 Consequently, 
multilateral netting systems utilizing a central counterparty would be 
expected to satisfy the first risk management measure through the 
establishment by the central counterparty of net credit limits vis-a-
vis each participant. In addition, each participant would be expected 
to establish a bilateral net credit limit for the central counterparty. 
The establishment of bilateral net credit limits between the central 
counterparty and each participant would not necessarily eliminate the 
need for traditional bilateral credit limits between participants, if 
bilateral exposures are incurred, or preclude the establishment of 
automated bilateral net credit limits between participants as part of 
certain overall types of risk management designs for a clearinghouse.
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    \6\For example, the central counterparty in a foreign exchange 
contract netting system would face forward replacement cost 
exposures as well as settlement exposures.
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    The Board encourages large-dollar multilateral netting systems to 
establish a capability to simulate the effect on liquidity resources 
and risk management controls of one or more defaults by existing 
participants, as well as the effects of adding additional participants 
or products to the system. In view of the complexity of multilateral 
netting and the potential systemic risks of such systems, the Board 
believes the capability to simulate the effects of participant defaults 
as well as adding additional participants and products is a prudent 
risk management device that should be employed by large-dollar 
multilateral netting systems.
    In addition, the Board encourages large-dollar systems for contract 
netting to conduct simulation analyses of forward replacement cost 
risks under different assumptions about changes in market prices, 
volatilities, and other factors. Such analyses will help to determine 
the sensitivity of the netting system to changes in market factors and 
help ensure that a netting system is able to withstand a default by the 
participants with one or more of the largest net debits on the system.
    Timeframe for Implementation of the Lamfalussy Minimum Standards. 
The Board recognizes that not all existing large-dollar multilateral 
netting systems may meet the Lamfalussy Minimum Standards, and the 
associated requirements for implementation of those standards, set 
forth in this policy statement. The Board also recognizes that existing 
large-dollar multilateral netting systems will need a period of time in 
which to make any needed changes to their organization and operations. 
Consequently, the Board believes that an eighteen-month transition 
period would be appropriate for large-dollar multilateral netting 
systems that are operating on December 21, 1994. Such systems will be 
expected to comply fully with the policy statement by June 21, 1996. 
Large-dollar multilateral netting systems established subsequent to 
December 21, 1994 will be expected to comply fully with the policy 
statement, without benefit of a transition period.
    The Board intends to review periodically the scale and nature of 
the credit, liquidity, and settlement risks in privately operated 
large-dollar multilateral netting systems. Operators of such systems 
should ensure that as the scale of risks in their systems increase, 
risk management systems are designed and operated to control the 
increased scale of risk. The Federal Reserve will continue to work on a 
case-by-case basis with individual large-dollar multilateral netting 
systems it believes present a potentially high degree of systemic risk, 
by virtue of their high volume of large-value transactions or central 
role in the operation of the financial markets, in order to determine 
whether higher risk standards, including the ability to ensure 
settlement in the event of multiple defaults, would be appropriate. 
Moreover, the Board expects that over time, whenever systems are 
changed or redesigned, significant attention will be given to the issue 
of risk management in order to ensure that high standards of risk 
control are achieved.
    In addition, offshore, large-dollar multilateral netting systems 
and multicurrency netting systems should at a minimum be subject to 
oversight or supervision, as a system, by the Federal Reserve, or by 
another relevant central bank or supervisory authority. The Board 
recognizes that central banks have common policy objectives with 
respect to large-value netting arrangements. Accordingly, the Board 
expects that it will cooperate, as necessary, with other central banks 
and foreign banking supervisors in the application of the Lamfalussy 
Minimum Standards to offshore and multicurrency systems. In this 
regard, the Principles for Co-operative Central Bank Oversight outlined 
in the Lamfalussy Report provide an important international framework 
for cooperation.

    By order of the Board of Governors of the Federal Reserve 
System, December 21, 1994.
William W. Wiles,
Secretary of the Board.
[FR Doc. 94-32014 Filed 12-28-94; 8:45 am]
BILLING CODE 6210-01-P