[Federal Register Volume 62, Number 218 (Wednesday, November 12, 1997)]
[Notices]
[Pages 60713-60720]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-29760]


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FEDERAL RESERVE SYSTEM

[Docket No. R-0987]


Policy Statement on Privately Operated Multilateral Settlement 
Systems

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Request for comment.

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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,

[[Page 60714]]

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 
Large-Dollar 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.
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    \1\ 59 FR 67534, December 29, 1994.
    \2\ Bank for International Settlements (Basle, 1990).
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    At the time the Large-Dollar Policy Statement was adopted, the 
Board recognized that in the case of larger multilateral netting 
systems for ``batch-processed'' 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 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 of 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 ``large-dollar'' 
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 small-dollar 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 
settlement-related 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 settlement-related risks individually are 
reduced

[[Page 60715]]

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 requests 
comment on the appropriate level of these thresholds, or whether a 
different measure, such as gross payment value settled, or net 
settlement amounts alone, would be more appropriate proxies for 
systemic risk.
    Under the proposed policy statement, those larger systems that meet 
the systemic risk criteria would be expected to demonstrate robust 
policies and procedures for addressing settlement failures and 
disruptions, but would not necessarily be required to meet all of the 
Lamfalussy Minimum Standards. The Board believes that full application 
of the Lamfalussy Minimum Standards embodied in the existing Large-
Dollar Policy Statement may not be necessary or appropriate for some of 
those arrangements. These standards were designed for those 
multilateral netting systems for which a failure to settle all 
positions on a multilateral net basis as and when expected could pose a 
high degree of systemic risk. As a result, these standards require 
systems, among other things, to have the ability to settle all 
positions on a multilateral net basis even if the participant with the 
largest debit position defaults on its settlement obligations. In 
contrast, the Board recognizes that for many small-dollar multilateral 
settlement systems, such as check clearinghouses, a recast of 
multilateral net settlement positions (to exclude transactions with the 
defaulting participant) or similar procedures may be an effective risk 
management tool. This presumes that settlement for non-defaulting 
participants can be completed in a timely manner and that any liquidity 
effects on participants are manageable.
    For some larger multilateral settlement systems, however, there is 
no feasible or reasonable alternative to settlement of all multilateral 
net positions within the system as and when expected, due primarily to 
potentially systemic credit and liquidity effects. As a result, these 
systems are expected to meet fully the Lamfalussy Minimum Standards. 
For such systems, the proposed policy statement retains the same 
requirements of the Board's existing Large-Dollar Policy Statement. The 
Board expects that these requirements would apply to those multilateral 
netting systems for large-dollar payments and foreign exchange 
contracts that are currently required to meet the Lamfalussy Minimum 
Standards under the Board's existing Large-Dollar Policy Statement. For 
other systems meeting the systemic risk criteria under the new policy 
but for which real-time controls may not be operationally feasible, the 
Board would consider alternative risk management measures that would 
provide an equivalent level of risk management.

Repeal of Existing ``Small-Dollar'' Policies

    The Board is also proposing to repeal its existing policies for 
certain ``small-dollar'' payments clearing and settlement arrangements. 
These policies date from 1984 and 1990, when the Board approved the 
provision of Federal Reserve net settlement services to ATM and 
national ACH clearing arrangements, respectively, subject to certain 
conditions. These conditions were also restated as part of the Board's 
Policy Statement on Payments System Risk (57 FR 40455, September 3, 
1992).
    The earlier policies were designed to address specific situations 
that arose in the Federal Reserve's provision of net settlement 
services to depository institutions and were not intended to represent 
a comprehensive approach to fundamental risks that arise in payments 
clearing and settlement arrangements. In addition, the policies were 
developed before the Federal Reserve had fully implemented its program 
for managing risks in providing payment services to depository 
institutions, as well as other policy developments relevant to the 
management of interbank exposures, such as the issuance of Regulation 
F.
    Furthermore, a policy that links clearinghouse usage of a 
particular Federal Reserve net settlement service to its compliance 
with particular risk management standards (which do not apply to other 
clearinghouse arrangements), may have the unintended effect of 
discouraging the use of settlement services with potentially lower 
risks to financial institutions and their customers, such as those 
providing same-day finality. Moreover, many of the fundamental risks 
that may exist in a clearing arrangement are not linked to a particular 
form of settlement. Consequently, the Board is proposing to repeal 
these policy statements once a revised, unified policy statement on 
risks in multilateral settlement arrangements is finalized.

Specific Questions for Comments

    1. The Board requests comment on whether the policy statement 
adequately identifies settlement arrangements that exhibit material 
settlement-related risks. Please address the usefulness of the base 
criteria. Are there any other such thresholds or criteria that the 
Board should consider?
    2. How should the policy statement distinguish systems that may 
pose systemic risk and are thus subject to

[[Page 60716]]

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.
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    \3\ These procedures are described in the Board's policy 
statement ``The Federal Reserve in the Payments System,'' as revised 
in March 1990. (55 FR 11648, March 29, 1990).
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    The Board does not believe that the adoption of this policy 
statement will have a direct and material adverse impact on the ability 
of other service providers to compete effectively with the Reserve 
Banks' payments services. 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.

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 Systems'' by removing ``A. Privately Operated Large-Dollar 
Multilateral Netting Systems'' in its entirety and adding in its place 
``A. Privately Operated Multilateral Settlement Systems'' and removing 
``C. Private Small-Dollar Clearing and Settlement Systems'' in its 
entirety.

II. Policies for Private-Sector Systems

A. Privately Operated Multilateral Settlement Systems

Introduction
    Multilateral settlement systems, such as clearinghouses and similar 
arrangements, may produce important efficiencies in the clearance and 
settlement of payments and financial contracts. Participants in such 
systems, typically depository institutions, exchange payments for their 
own account or the accounts of their customers in a coordinated fashion 
and settle the resulting obligations on a multilateral, often net, 
basis.
    A variety of credit, liquidity, and other risks can arise in the 
clearing and settlement process that institutions must manage in the 
normal course of business, regardless of the method of clearing and 
settlement. Existing supervisory standards are generally directed at 
ensuring that institutions establish appropriate policies and 
procedures to manage such risks. For example, Regulation F directs 
insured depository institutions to establish policies and procedures to 
avoid excessive exposures to any other depository institutions, 
including exposures that may be generated through the clearing and 
settlement of payments.1
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    \1\ See 12 CFR 206.
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    However, the use of multilateral settlement systems introduces the 
risk that a failure of one participant in the system to settle its 
obligations will have credit or liquidity effects on participants that 
have not dealt with the defaulting participant. Multilateral settlement 
may have the effect of altering the underlying bilateral relationships 
that arise between institutions during the clearing and settlement 
process. As a result, the incentives for, or ability of, institutions 
to manage effectively the risk exposures to other institutions may be 
reduced. In addition, in some cases, there may be no feasible or timely 
alternative to settlement through the multilateral system in the event 
that the system fails to complete settlement, due, for example, to a 
participant default. These factors may create added risks to 
participants in multilateral settlement systems relative to other 
settlement methods.
    Clearinghouses also may generate systemic risk that could threaten 
the financial markets or the economy more broadly. The failure of a 
system to complete settlement as and when expected could generate 
unexpected credit losses or liquidity shortfalls that participants in 
the system are not able to absorb. Thus, the inability of one 
participant to meet its obligations within the system when due could 
lead to the illiquidity or failure of other institutions. Further, the 
disruption of a large number of payments and the resulting uncertainty 
could lead to broader effects on economic activity. In addition, as the 
Federal Reserve has established fees for daylight overdrafts, along 
with other risk management measures for Federal Reserve payment 
services, the potential exists for intraday credit risks to be shifted 
from the Federal Reserve to private, multilateral settlement 
arrangements, either domestically or in other countries, that have 
inadequate risk controls.
    The Board believes that these concerns warrant the application of a 
risk management policy to a limited number of multilateral settlement 
systems that raise material added risks for participants or financial 
markets. The Board recognizes that multilateral settlement systems 
differ widely in terms of form, function, scale, and scope of 
activities. As a general rule, risk management measures should be 
commensurate with the nature and magnitude of risks involved, but risk 
management measures may be designed differently for different types of 
payments or systems. This policy statement, therefore, is designed to 
permit market participants to determine the best means of addressing 
risks, within certain guidelines.
    The Board's adoption of this policy in no way diminishes the 
primary responsibilities of participants in, and operators of, 
multilateral settlement systems to address settlement and other risks 
that may arise in these systems. In addition, the Board encourages all 
multilateral settlement systems to consider periodically cost-effective 
risk management improvements, even if not specifically required under 
this policy. Insured depository institutions participating in 
multilateral settlement systems are also expected to limit their 
bilateral credit and liquidity exposures

[[Page 60717]]

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, large-value 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.
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    \2\ 12 USC 1861-67.
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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 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
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    \3\ The Report of the Committee on Interbank Netting Schemes of 
the Central Banks of the Group of Ten Countries (Bank for 
International Settlements, November 1990), known as the Lamfalussy 
Report, recognized that netting arrangements for interbank payment 
orders and forward-value contractual commitments, such as foreign 
exchange contracts, have the potential to improve the efficiency and 
the stability of interbank settlements through the reduction of 
costs along with credit and liquidity risks, provided certain 
conditions are met. That Report developed and discussed ``Minimum 
Standards for Netting Schemes'' (Lamfalussy Minimum Standards) and 
``Principles for Co-operative Central Bank Oversight'' of such 
arrangements. These standards have been adopted by the central banks 
of the G-10 and European Union countries.
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    (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 
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

[[Page 60718]]

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
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    \4\ The netting factor, calculated as the ratio of gross 
transactions exchanged in a particular period to the resulting 
multilateral net amounts (aggregate net debits or net credits) 
settled, is one indicator of the magnitude of the change in 
positions if all multilateral net settlement obligations had to be 
settled on a gross basis.
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    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.
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    \5\ For example, in a ``recast'' of settlements, some or all 
transactions involving the defaulting participant would be removed 
from the system's settlement process, to be settled or otherwise 
resolved outside the system. A revised multilateral settlement with 
recalculated settlement obligations would then be conducted among 
the remaining participants. In an ``unwind,'' transactions or 
settlement obligations to be settled on the day of the default for 
all participants would be removed from the system.
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    (3) Operational risk. Risk factors: Operational risks, such as 
those relating to the reliability and integrity of electronic data 
processing facilities used in the clearing and settlement process, are 
addressed in standard supervisory guidance for depository institutions 
and their service providers. Operational risk factors for purposes of 
this policy statement include those that could hinder the timely 
completion of settlement or the timely resolution of a settlement 
disruption in a multilateral settlement system. For example, 
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

[[Page 60719]]

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
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    \6\ Such simulations may include, if appropriate, the effects of 
changes in market prices, volatilities, or other factors.
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    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 Systems 7
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    \ 7\ The minimum standards adopted by the Board are identical to 
those set out in the Lamfalussy Report, with minor changes to 
terminology.
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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.
    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.
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    \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.
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Offshore Systems
    The Board has a long-standing concern that steps taken to reduce 
systemic risk in U.S. large-dollar payments systems may induce the 
further development of multilateral systems for settling U.S. dollar 
payments that are operated outside the United States. Such systems, if 
implemented with inadequate attention to risk management, may increase 
risks to the international banking and financial system. In addition, 
offshore arrangements have the potential to operate without sufficient 
official oversight.
    As a result, the Board has determined that offshore, large-dollar 
multilateral 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.
William W. Wiles,
Secretary of the Board.

Appendix

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

[[Page 60720]]

arrangements have a daily average dollar value larger than $100,000, 
so the arrangements would not be considered to give rise to systemic 
risk.

Example #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.

Example #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]
BILLING CODE 6210-01-P