[Federal Register Volume 69, Number 80 (Monday, April 26, 2004)]
[Notices]
[Pages 22512-22519]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-9413]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1191]


Policy Statement on Payments System Risk

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Policy Statement; request for comment.

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SUMMARY: The Board requests comments on proposed changes to part II of 
its Policy Statement on Payments System Risk (PSR policy) addressing 
risk management in payments and securities settlement systems. The 
purpose of these revisions is to update the policy in light of current 
industry and supervisory risk-management approaches and new 
international risk-management standards for payments and securities 
settlement systems. The key changes include an expansion of the 
policy's scope to include the Federal Reserve Banks' (Reserve Banks) 
payments and securities settlement services, revised general risk-
management expectations for all systems subject to the policy, and the 
incorporation of new international risk-management standards for 
systemically important systems. The Board is also proposing to 
reorganize the PSR Policy, reversing the current order of parts I and 
II to provide a more coherent framework for the overall policy and 
better communicate the Board's objectives with regard to payments 
system risk. No changes, however, are proposed to the current part I, 
Federal Reserve Daylight Credit Policies.

DATES: Comments must be received by July 26, 2004.

ADDRESSES: Comments should refer to Docket No. OP-1191 and may be 
mailed to Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, NW., 
Washington, DC 20551. Please consider submitting your comments through 
the Board's Web site at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm, by e-mail to [email protected], or by 
fax to the Office of the Secretary at (202) 452-3819 or (202) 452-3102. 
Policies proposed by the Board and other federal agencies may also be 
viewed and commented on at http://www.regulations.gov. All public 
comments are available from the Board's Web site at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, 
except as necessary for technical reasons. Accordingly, your comments 
will not be edited to remove any identifying or contact information. 
Public comments may also be viewed electronically or in paper in Room 
MP-500 of the Board's Martin Building (20th and C Streets, NW.) between 
9 a.m. and 5 p.m. on weekdays.

FOR FURTHER INFORMATION CONTACT: Jeff Stehm, Assistant Director ((202) 
452-2217), or Doug Conover, Senior Analyst ((202) 452-2887), Division 
of Reserve Bank Operations and Payment Systems; for the hearing 
impaired only: Telecommunications Device for the Deaf, (202) 263-4869.

SUPPLEMENTARY INFORMATION:

I. Background

    Since the early 1980s the Board has published and periodically 
revised a series of policies encouraging the reduction and management 
of risks in payments and securities settlement systems.\1\ In 1992, the 
Board issued its ``Policy Statement on Payments System Risk,'' which 
provided a comprehensive statement of its previously adopted policies 
regarding payments system risk reduction.\2\ Part I of that policy 
statement covered the provision of intraday credit to Federal Reserve 
accountholders and Part II of that policy statement covered previous 
policies on risk management in private large-dollar funds transfer 
networks, private delivery-against-payment securities systems, offshore 
dollar clearing and netting systems, and private small-dollar clearing 
and settlement systems.
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    \1\ See 50 FR 21120, May 22, 1985; 52 FR 29255, August 6, 1987; 
and 54 FR 26104 and 26092, June 21, 1989.
    \2\ 57 FR 40455, September 3, 1992.
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    In this same period, the Federal Reserve also worked with other 
central banks and securities regulators to develop standards to 
strengthen payments and securities settlement infrastructures and to 
promote financial stability. These efforts initially produced the 
Lamfalussy Minimum Standards, which were incorporated into the Board's 
PSR policy in 1994.\3\ More recently, this work resulted in the 
publication of the Core Principles for Systemically Important Payment 
Systems (Core Principles), as well as the Recommendations for 
Securities Settlement Systems (Recommendations).\4\ The Core

[[Page 22513]]

Principles extend and replace the Lamfalussy Minimum Standards, while 
the Recommendations provide, for the first time, explicit standards for 
securities settlement systems.\5\
    In addition to establishing specific standards, the Core Principles 
and Recommendations call for central banks to state clearly their roles 
and policies regarding payments and securities settlement systems, 
assess compliance with the Core Principles and the Recommendations when 
overseeing relevant systems, and coordinate with other authorities in 
overseeing systems. Moreover, the Core Principles and Recommendations 
are intended to apply both to systems operated by central banks and the 
private sector.
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    \3\ 59 FR 67534, December 29, 1994. The Lamfalussy Minimum 
Standards were set out in the ``Report of the Committee on Interbank 
Netting Schemes of the Central Banks of the Group of Ten 
Countries,'' published by the Bank for International Settlements in 
November 1990.
    \4\ The Core Principles were developed by the Committee on 
Payment and Settlement Systems (CPSS) of the central banks of the 
Group of Ten countries, and the Recommendations were developed by 
the CPSS in conjunction with the Technical Committee of the 
International Organization of Securities Commissions (IOSCO). The 
full reports on the Core Principles and the Recommendations are 
available at http://www.bis.org.
    \5\ Both sets of standards are part of the Financial Stability 
Forum's Compendium of Standards that have been widely recognized and 
endorsed by U.S. authorities as integral to strengthening global 
financial stability. Both sets of standards were published by the 
relevant committees for public comment before being adopted in their 
final form.
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II. Discussion of Planned Policy Changes

    The policy changes proposed by the Board include changes to the 
scope of the policy to include payments and securities settlement 
systems operated by the Reserve Banks, establishment of clearer risk-
management expectations for all systems subject to the policy based on 
current industry and supervisory risk-management concepts, and 
incorporation of the Core Principles and Recommendations as the Board's 
risk-management standards for systemically important payments and 
securities settlement systems, respectively. The Board is also 
proposing a new introduction to and reordering of the current parts of 
the PSR policy in order to provide a more coherent framework for the 
overall policy and better communicate the Board's concerns and 
objectives regarding payments system risk. The proposed changes do not 
affect the current Part I of the PSR Policy that concerns Federal 
Reserve daylight credit policies except to renumber this part of the 
policy as the new Part II.
    The Board believes that these proposed structural and substantive 
changes more clearly ground the PSR policy in the Board's high-level 
objectives, provide a more coherent structure for the overall policy, 
and better communicate the Board's concerns about risks in the nation's 
payments and securities settlement system and the implications of these 
risks for the Federal Reserve. In particular, the introduction to the 
overall policy was revised to include a clear statement of the Board's 
public policy objectives and provide a general discussion of the types 
of risks encountered in settling payments and securities transactions, 
how those risks arise, and why the Board believes they must be 
controlled.

A. Changes to the Policy's Scope, Definitions, and Application

    The proposed policy extends its scope to include payments and 
securities settlement systems operated by the Reserve Banks, which is 
consistent with the Core Principles and the Recommendations. The scope 
continues to cover those private-sector payments systems that expect to 
settle an aggregate gross value exceeding $5 billion on any day during 
the next twelve-month period and extends the same threshold to private-
sector securities settlement systems and Reserve Bank payments and 
securities settlement systems. While the direct application of the 
policy will be limited to those systems above the threshold, the Board 
encourages all payments and securities settlement systems to consider 
the risk-management approach set out in the policy.
    The proposed policy also clarifies the definition of a ``system'' 
for purposes of applying the policy, defining a system to be a 
``multilateral arrangement (three or more participants) among financial 
institutions for the purposes of clearing, netting, and/or settling 
funds or securities transactions among themselves or between each of 
them and a central party.'' This definition also identifies three key 
characteristics of systems, which would be used individually or in 
combination, to determine if an arrangement qualifies as a system for 
purposes of the policy: (1) A set of rules and procedures, common to 
all participants, that govern the clearing (comparison and/or netting) 
and settlement of payments or securities transactions, (2) a common 
technical infrastructure for conducting the clearing or settlement 
process, and (3) a risk-management or capital structure in which credit 
losses are ultimately borne by system participants rather than by the 
system operator, a central counterparty or guarantor, or the system's 
shareholders. Futures and options clearing organizations and 
correspondent banking services continue to be excluded from the 
coverage of the policy.
    Finally, new language clarifies how the policy will be applied by 
the Board, both when the Board exercises its existing authority and, if 
it does not have direct or exclusive authority, when it works with 
other authorities to promote the aims of the policy.

B. Changes to the General Policy Expectations

    The proposed policy sets out revised risk-management expectations 
for all systems covered by the policy, including those deemed as 
systemically important. Under the current policy, systems are asked to 
identify the risk factors present in their systems, assess whether the 
system's policies and procedures adequately address the identified 
risks, and, if necessary, improve their policies and procedures such 
that risk-management controls are proportional to the nature and 
magnitude of the risks in the system. The current policy provides 
limited illustrative examples of risk-management controls that a system 
might employ to address various risks (for example, credit, liquidity, 
operational, and legal risks), but does not provide guidance for 
addressing risk management in an integrated manner. The current 
policy's general approach was intended to provide flexibility, with an 
expectation that systems would implement a risk-management framework 
appropriate for the risks the system poses to the system operator, 
system participants, and the financial system more broadly. In 
practice, however, the Board has found that the current policy's 
approach lacks sufficient structure to provide useful guidance to 
systems. The proposed revisions continue to provide flexibility but set 
out four key elements of a sound risk-management framework that the 
Board believes will provide systems with more structured guidance. 
These elements are based on a review of current industry and 
supervisory concepts of sound risk management: (1) Clearly identify 
risks and set sound risk-management objectives; (2) establish sound 
governance arrangements; (3) establish clear and appropriate rules and 
procedures; and, (4) ensure the employment of the resources necessary 
to implement the system's risk-management objectives and implement 
effectively its rules and procedures.

C. Incorporation of the Core Principles and Recommendations

    The proposed policy adopts the Core Principles and the 
Recommendations with no modifications and presents them as the Board's 
standards for systemically important systems. Private-

[[Page 22514]]

sector systems currently expected to meet the Lamfalussy Minimum 
Standards would, under the proposed policy, be expected to comply with 
the Core Principles. Similarly, private-sector systems currently 
subject to the Board's policy requirements for delivery-against-payment 
systems would be expected to comply with the relevant portions of the 
Recommendations. As noted below, the Core Principles and the 
Recommendations would apply to Reserve Banks' payments and securities 
settlement systems that meet the relevant policy criteria.
    The proposed policy introduces six characteristics that would be 
used by the Board, on a case-by-case basis, to identify systems, 
including Federal Reserve systems, that would be considered 
systemically important. In applying the standards to systemically 
important systems, the policy seeks to be flexible, recognizing that 
systems differ in the specific instruments they settle, the markets and 
institutions they serve, and the legal and regulatory constraints under 
which they operate. The policy states that these factors will be 
considered when assessing the way in which a systemically important 
system addresses any particular standard.

III. Request for Comment

    The Board requests comment on the proposed revisions to its Policy 
on Payments System Risk. In particular, the Board requests comment on 
whether the scope and application of the revised policy is sufficiently 
clear and provides the appropriate coverage to achieve the policy's 
intended objectives. The Board also requests comment on the following 
specific questions:
    1. Do the benefits of a bright line quantitative threshold based on 
a system's daily gross settlement value outweigh the costs of using 
more complex factors to determine whether a system is covered by the 
policy? Should more qualitative or judgmental criteria be used instead? 
If a quantitative threshold is appropriate, does a threshold of $5 
billion a day continue to be reasonable? Should other quantitative 
criteria be considered?
    2. Is the definition of what constitutes a system, and explicit 
exemptions from this definition, reasonable and appropriate?
    3. Do the general policy expectations of a sound risk-management 
framework, laid out in part B of the revised policy, give more 
structure and specific guidance to system operators and participants 
than the current policy's primary focus on types of risks and the 
general need to manage these risks?
    4. In applying the Core Principles and the Recommendations, do the 
six criteria presented in the proposed policy appear reasonable for 
determining if a system is systemically important? Are there other 
factors that the Board should consider when determining whether a 
system is systemically important?

IV. 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 payments and securities settlement 
systems to address material risks in their systems. The policy would 
apply to relatively large systems, i.e., those that expect to settle an 
aggregate gross value exceeding $5 billion on any day during the next 
twelve month period. Thus, the proposal is designed to minimize 
regulatory burden on smaller systems that do not raise material risks. 
Although small financial institutions may participate in payments or 
securities settlement systems that are subject to the proposed policy, 
the compliance burden largely falls on system operators and not on 
individual participants.

V. 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.\6\ 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 expected benefits are sufficient to warrant 
proceeding with the change despite the adverse effects. The proposed 
policy revisions provide that Reserve Bank systems will be treated 
similarly to private-sector systems and thus will have no material 
adverse effect on the ability of other service providers to compete 
effectively with the Federal Reserve Banks in providing payments and 
securities settlement services.
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    \6\ 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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VI. Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
ch. 3506; 5 CFR 1320 Appendix A.1), the Board has reviewed the policy 
statement under the authority delegated to the Board by the Office of 
Management and Budget. No collections of information pursuant to the 
Paperwork Reduction Act are contained in the policy statement.

VII. Federal Reserve Policy on Payments System Risk

Introduction [Revised]
Risks in Payments and Securities Settlement Sytems [New]
I. Risk Management in Payments and Securities Settlement Systems 
[Revised]
    A. Scope
    B. General Policy Expectations
    C. Systemically Important Systems
    1. Standards for Systemically Important Payments Systems
    2. Standards for Systemically Important Securities Settlement 
Systems
II. Federal Reserve Daylight Credit Policies [No Change]
    A. Daylight Overdraft Definition and Measurement
    B. Pricing
    C. Net Debit Caps
    D. Collateral
    E. Special Situations
    F. Monitoring
    G. Transfer-size Limit on Book-Entry Securities
III. Other Policies [No Change]
    A. Rollovers and Continuing Contracts

Introduction

    Payments and securities settlement systems are critical components 
of the nation's financial system. The smooth functioning of these 
systems is vital to the financial stability of the U.S. economy. Given 
the importance of these systems, the Board has developed this policy to 
address the risks that payments and securities settlement systems 
present to the financial system and to the Federal Reserve Banks 
(Reserve Banks).
    In adopting this policy, the Board's objectives are to foster the 
safety and efficiency of payments and securities settlement systems. 
These policy objectives are consistent with (1) the Board's long-
standing objectives to promote the integrity, efficiency, and 
accessibility of the payments mechanism; (2) industry and supervisory 
methods for risk management; and (3) internationally accepted risk-
management standards and practices for systemically important

[[Page 22515]]

payments and securities settlement systems.\7\
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    \7\ For the Board's long-standing objectives in the payments 
system, see ``The Federal Reserve in the Payments System,'' 
September 2001, FRRS 9-1550, available at http://www.federalreserve.gov/paymentsystems/pricing/frpaysys.htm.
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    Part I of this policy sets out the key risk-management expectations 
of the Board that public- and private-sector payments and securities 
settlement systems should meet in designing and operating such systems. 
Under the policy, all payments and securities settlement systems that 
expect to settle an aggregate gross value exceeding $5 billion on any 
day during the next twelve months are expected to implement a risk-
management framework that is appropriate for the risks they pose to the 
system operator, system participants, and the financial system more 
broadly. Systemically important payments and securities settlement 
systems are also expected to meet more specific standards based upon 
the Core Principles for Systemically Important Payments Systems (Core 
Principles) and the Recommendations for Securities Settlement Systems 
(Recommendations), respectively.\8\
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    \8\ The Core Principles were developed by the Committee on 
Payment and Settlement Systems of the central banks of the Group of 
Ten countries (CPSS) and the Recommendations were developed by the 
CPSS in conjunction with the Technical Committee of the 
International Organization of Securities Commissions (IOSCO). The 
full reports on the Core Principles and the Recommendations are 
available at http://www.bis.org.
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    Part II of this policy governs the provision of intraday or 
``daylight'' overdrafts in accounts at the Reserve Banks and sets out 
the general methods used by the Reserve Banks to control their intraday 
credit exposures.\9\ Under this part, the Board expects depository 
institutions to manage their Federal Reserve accounts effectively and 
minimize their use of Federal Reserve daylight credit.\10\ Although 
some intraday credit may be necessary, the Board expects that, as a 
result of this policy, relatively few institutions will consistently 
rely on intraday credit supplied by the Federal Reserve to conduct 
their business.
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    \9\ To assist depository institutions in implementing this part 
of the Board's payments system risk policy, the Federal Reserve has 
prepared two documents, the ``Overview of the Federal Reserve's 
Payments System Risk Policy'' and the ``Guide to the Federal 
Reserve's Payments System Risk Policy,'' which are available on line 
at http://www.federalreserve.gov/paymentsystems/PSR or from any 
Reserve Bank. The ``Overview of the Federal Reserve's Payments 
System Risk Policy'' summarizes the Board's policy on the provision 
of daylight credit, including net debit caps and daylight overdraft 
fees. The overview is intended for use by institutions that incur 
only small and infrequent daylight overdrafts. The ``Guide to the 
Federal Reserve's Payments System Risk Policy'' explains in detail 
how these policies apply to different institutions and includes 
procedures for completing a self-assessment and filing a cap 
resolution, as well as information on other aspects of the policy.
    \10\ The term ``depository institution,'' as used in this 
policy, refers not only to institutions defined as ``depository 
institutions'' in 12 U.S.C. 461(b)(1)(A), but also to U.S. branches 
and agencies of foreign banking organizations, Edge and agreement 
corporations, trust companies, and bankers' banks, unless the 
context indicates a different reading.
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Risks in Payments and Securities Settlement Systems

    The basic risks in payments and securities settlement systems are 
credit risk, liquidity risk, operational risk, and legal risk. In the 
context of this policy, these risks are defined as 
follows.11 12
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    \11\ The term ``financial institution,'' as used in this policy, 
includes a broad array of types of organizations that engage in 
financial activity, including depository institutions and securities 
dealers.
    \12\ These definitions of credit risk, liquidity risk, and legal 
risk are based upon those presented in the Core Principles and the 
Recommendations. The definition of operational risk is based on the 
Basel Committee on Banking Supervision's ``Sound Practices for the 
Management and Supervision of Operational Risk.'' See these 
publications at http://www.bis.org for a fuller discussion of these 
risks.
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    Credit Risk. The risk that a counterparty will not settle an 
obligation for full value either when due or anytime thereafter.
    Liquidity Risk. The risk that a counterparty will not settle an 
obligation for full value when due.
    Operational Risk. The risk of loss resulting from inadequate or 
failed internal processes, people, and systems, or from external 
events. This type of risk includes various physical and information 
security risks.
    Legal Risk. The risk of loss because of the unexpected application 
of a law or regulation or because a contract cannot be enforced.
    These risks arise between financial institutions as they settle 
payments and securities transactions and must be managed by 
institutions, both individually and collectively.\13\ Multilateral 
payments and securities settlement systems, in particular, may 
increase, shift, concentrate, or otherwise transform risks in 
unanticipated ways. These systems also may pose systemic risk to the 
financial system where the inability of a system participant to meet 
its obligations when due may cause other participants to be unable to 
meet their obligations when due. The failure of one or more 
participants to settle their payments or securities transactions, in 
turn, could create credit or liquidity problems for other participants, 
the system operator, or depository institutions. Systemic risk might 
lead ultimately to a disruption in the financial system more broadly or 
undermine public confidence in the nation's financial infrastructure.
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    \13\ Several existing regulatory and bank supervision guidelines 
and policies also are directed at institutions' management of the 
risks posed by interbank payments and settlement activity. For 
example, Federal Reserve Regulation F (12 CFR 206) 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.
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    These risks stem, in part, from the multilateral and time-sensitive 
credit and liquidity interdependencies among financial institutions. 
These interdependencies often create complex transaction flows that, in 
combination with a system's design, can lead to significant demands for 
intraday credit, either on a regular or on an extraordinary basis. Some 
level of intraday credit is appropriate to ensure the smooth 
functioning of payments and securities settlement systems. To the 
extent that financial institutions or the Reserve Banks are the direct 
or indirect source of such intraday credit, they may face a direct risk 
of loss if daylight credit is not extinguished as planned. In addition, 
measures taken by Reserve Banks to limit their intraday credit 
exposures may shift some or all of the associated risks to private-
sector systems.
    The smooth functioning of payments and securities settlement 
systems is also critical to certain public policy objectives in the 
areas of monetary policy and banking supervision. The effective 
implementation of monetary policy, for example, depends on both the 
orderly settlement of open market operations and the efficient 
distribution of reserve balances throughout the banking system via the 
money market and payments system. Likewise, supervisory objectives 
regarding the safety and soundness of depository institutions must take 
into account the risks payments and securities settlement systems pose 
to depository institutions that participate directly or indirectly in, 
or provide settlement, custody, or credit services to, such systems.
    Through this policy, the Board expects financial system 
participants, including the Reserve Banks, to reduce and control 
settlement and systemic risks arising in payments and securities 
settlement systems, consistent with the smooth operation of the 
financial system. This policy is designed to fulfill that aim by (1) 
making financial system participants and system operators aware of the 
types of basic risks that arise in the settlement process and the 
Board's expectations with regard to risk

[[Page 22516]]

management, (2) providing explicit risk-management standards for 
systemically important systems, and (3) establishing the policy 
conditions governing the provision of Federal Reserve intraday credit 
to account holders. The Board's adoption of this policy in no way 
diminishes the primary responsibilities of financial system 
participants generally and settlement system operators, participants, 
and Federal Reserve accountholders more specifically, to address the 
risks that may arise through their operation of, or participation in, 
payments and securities settlement systems.

I. Risk Management in Payments and Securities Settlement Systems

    This part sets out the Board's expectations regarding the 
management of risk in payments and securities settlement systems, 
including those operated by the Reserve Banks. The Board will be guided 
by this part, in conjunction with relevant laws and other Federal 
Reserve policies, when exercising its existing authority in (1) 
supervising state member banks, bank holding companies, and 
clearinghouse arrangements, including the exercise of authority under 
the Bank Service Company Act, where applicable,\14\ (2) setting the 
terms and conditions for the use of Federal Reserve payments and 
settlement services by system operators and participants, (3) 
developing and applying policies for the provision of intraday 
liquidity to Reserve Bank account holders, and (4) interacting with 
other domestic and foreign financial system authorities on payments and 
settlement risk-management issues. The Board's adoption of this policy 
is not intended to exert or create new supervisory or regulatory 
authority over any particular class of institutions or arrangements for 
which the Board does not currently have such authority.
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    \14\ 12 U.S.C. 1861 et seq.
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    Where the Board does not have direct or exclusive supervisory or 
regulatory authority over systems covered by this policy, it will work 
with other domestic and foreign financial system authorities to promote 
effective risk management in payments and securities settlement 
systems. The Board encourages other relevant authorities to consider 
the principles embodied in this policy when evaluating the payments and 
securities settlement risks posed by and to the systems and individual 
system participants that they oversee, supervise, or regulate. In 
working with foreign financial system authorities, the Board will be 
guided by Responsibility D of the Core Principles, Recommendation 18 of 
the Recommendations, and the ``Principles for Cooperative Central Bank 
Oversight of Cross-border and Multi-currency Netting and Settlement 
Schemes.'' \15\ The Board believes these international principles 
provide an appropriate framework for cooperating with foreign 
authorities to address risks in cross-border, multicurrency, and, where 
appropriate, offshore payments and securities settlement systems.
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    \15\ The ``Principles for Cooperative Central Bank Oversight and 
Multi-currency Netting and Settlement Schemes' are set out in the 
``Report of the Committee on Interbank Netting Schemes of the 
central banks of the Group of Ten countries'' (Lamfalussy Report). 
The Lamfalussy Report is available at http://www.bis.org/cpss/cpsspubl.htm.
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A. Scope
    This policy applies to public- and private-sector payments and 
securities settlement systems that expect to settle a daily aggregate 
gross value of U.S. dollar-denominated transactions exceeding $5 
billion on any day during the next twelve months.\16\ For purposes of 
this policy, a payments or securities settlement system is considered 
to be a multilateral arrangement (three or more participants) among 
financial institutions for the purposes of clearing, netting, and/or 
settling payments or securities transactions among themselves or 
between each of them and a central party, such as a system operator or 
central counterparty.17 18 A system generally embodies one 
or more of the following characteristics: (1) A set of rules and 
procedures, common to all participants, that govern the clearing 
(comparison and/or netting) and settlement of payments or securities 
transactions, (2) a common technical infrastructure for conducting the 
clearing or settlement process, and (3) a risk-management or capital 
structure in which any credit losses are ultimately borne by system 
participants rather than the system operator, a central counterparty or 
guarantor, or the system's shareholders.
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    \16\ The ``next'' twelve-month period is determined by reference 
to the date a determination is being made as to whether the policy 
applies to a particular system. Aggregate gross value of U.S dollar-
denominated transactions refers to the total dollar value of 
individual U.S. dollar transactions settled in the system which also 
represents the sum of total U.S. dollar debits (or credits) to all 
participants prior to or in absence of any netting of transactions.
    \17\ A system includes all of the governance, management, legal 
and operational arrangements used to effect settlement as well as 
the relevant parties to such arrangements, such as the system 
operator, system participants, and system owners.
    \18\ The types of systems that may fall within the scope of this 
policy include, but are not limited to, large-value funds transfer 
systems, automated clearinghouse (ACH) systems, check 
clearinghouses, and credit and debit card settlement systems, as 
well as central counterparties, clearing corporations, and central 
depositories for securities transactions. For purposes of this 
policy, the system operator is the entity that manages and oversees 
the operations of the system.
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    These systems may be organized, located, or operated within the 
United States (domestic systems), outside the United States (offshore 
systems), or both (cross-border systems) and may involve other 
currencies in addition to the U.S. dollar (multicurrency systems). The 
policy also applies to any system based or operated in the United 
States that engages in the settlement of non-U.S. dollar transactions 
if that system would otherwise be subject to the policy.\19\
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    \19\ The daily gross value threshold will be calculated on a 
U.S. dollar equivalent basis.
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    This policy does not apply to bilateral relationships between 
financial institutions and their customers, such as traditional 
correspondent banking, including traditional government securities 
clearing services. The Board believes that these relationships do not 
constitute ``a system'' for purposes of this policy and that relevant 
safety and soundness issues associated with these relationships are 
more appropriately addressed through the banking supervisory process. 
This policy also does not apply to clearance or settlement systems for 
exchange-traded futures and options that fall under the oversight of 
the Commodities and Futures Trading Commission or the Securities and 
Exchange Commission.
B. General Policy Expectations
    The Board expects payments and securities settlement systems within 
the scope of this policy to implement a risk-management framework 
appropriate to the risks the system poses to the system operator, 
system participants, and other relevant parties as well as the 
financial system more broadly. A risk-management framework is the set 
of objectives, policies, arrangements, procedures, and resources that a 
system employs to limit and manage risk. While there are a number of 
ways to structure a sound risk-management framework, all frameworks 
should perform certain functions:
     Clearly identify risks and set sound risk-
management objectives
     Establish sound governance arrangements
     Establish clear and appropriate rules and 
procedures
     Employ the resources necessary to achieve the 
system's risk-management objectives and implement effectively its rules 
and procedures.
    In addition to establishing a risk-management framework that 
includes

[[Page 22517]]

these key elements, the Board expects systems it deems systemically 
important to comply with the more detailed standards set out in Section 
C.
    Identify Risks and Set Sound Risk-Management Objectives. The first 
element of a sound risk-management framework is the clear 
identification of all risks that have the potential to arise in or 
result from the system's settlement process and the development of 
clear and transparent objectives regarding the system's tolerance for 
and management of such risks.
    System operators should identify the forms of risk present in their 
system's settlement process as well as the parties posing and bearing 
each risk. In particular, system operators should identify the risks 
posed to and borne by them, the system participants, and other key 
parties such as a system's settlement banks, custody banks, and third-
party service providers. System operators should also analyze whether 
risks might be imposed on other external parties and the financial 
system more broadly.
    In addition, system operators should analyze how risk is 
transformed or concentrated by the settlement process. System operators 
should also consider the possibility that attempts to limit one type of 
risk could lead to an increase in another type of risk. Moreover, 
system operators should be aware of risks that might be unique to 
certain instruments, participants, or market practices. System 
operators should also analyze how risks are correlated among 
instruments or participants.\20\
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    \20\ Where systems have inter-relationships with or dependencies 
on other systems (e.g., cross-guarantees, cross-collateralization, 
cross-margining, common operating platforms), system operators 
should also analyze whether and to what extent any cross-system 
risks arise and who bears them.
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    Based upon its clear identification of risks, a system should 
establish its risk tolerance, including the levels of risk exposure 
that are acceptable to the system operator, system participants, and 
other relevant parties. The system operator should then set risk-
management objectives that clearly allocate acceptable risks among the 
relevant parties and set out strategies to manage this risk. Risk-
management objectives should be consistent with the objectives of this 
policy, the system's business purposes, and the type of instruments and 
markets for which the system clears and settles. Risk-management 
objectives should also be communicated to and understood by both the 
system operator's staff and system participants.
    System operators should re-evaluate their risks in conjunction with 
any major changes in the settlement process or operations, the 
instruments or transactions settled, a system's rules or procedures, or 
the relevant legal and market environments. Systems should revisit 
their risk-management objectives regularly to ensure that they are 
appropriate for the risks posed by the system, continue to be aligned 
with the system's purposes, remain consistent with this policy, and are 
being effectively adhered to by the system operator and participants.
    Sound Governance Arrangements. Systems should have sound governance 
arrangements to implement and oversee their risk-management frameworks. 
The responsibility for sound governance rests with a system operator's 
board of directors or similar body and with the system operator's 
senior management. Governance structures and processes should be 
transparent, enable the establishment of clear risk-management 
objectives, set and enforce clear lines of responsibility and 
accountability for achieving these objectives, ensure that there is 
appropriate oversight of the risk-management process, and enable the 
effective use of information reported by the system operator's 
management, internal auditors, and external auditors to monitor the 
performance of the risk-management process.\21\ Individuals responsible 
for governance should be qualified for their positions, understand 
their responsibilities, and understand their system's risk-management 
framework. Governance arrangements should also ensure that risk-
management information is shared in forms, and at times, that allow 
individuals responsible for governance to fulfill their duties 
effectively.
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    \21\ The risk management and internal audit functions should 
also be independent of those responsible for day-to-day functions.
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    Clear and Appropriate Rules and Procedures. Systems should 
implement rules and procedures that are appropriate and sufficient to 
carry out the system's risk-management objectives and that have a well-
founded legal basis. Such rules and procedures should specify the 
respective responsibilities of the system operator, system 
participants, and other relevant parties. Rules and procedures should 
establish the key features of a system's settlement and risk-management 
design and specify clear and transparent crisis management procedures 
and settlement-failure procedures, if applicable.\22\
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    \22\ Examples of key features that might be specified in a 
system's rules and procedures are controls to limit participant-
based risks, such as membership criteria based on participants' 
financial and operational health, limits on settlement exposures, 
and the procedures and resources to hedge, margin, or collateralize 
settlement exposures. Other examples of key features might be 
business continuity requirements, and loss allocation procedures.
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    Employ Necessary Resources. Systems should ensure that the 
appropriate resources and processes are in place to allow them to 
achieve their risk-management objectives and effectively implement 
their rules and procedures. In particular, the system operator's staff 
should have the appropriate skills, information, and tools to apply the 
system's rules and procedures and achieve the system's risk-management 
objectives. System operators should also ensure that their facilities 
and contingency arrangements, including any information system 
resources, are sufficient to meet their risk-management objectives.
    The Board recognizes that payments and securities settlement 
systems differ widely in terms of form, function, scale, and scope of 
activities and that these characteristics result in differing 
combinations and levels of risks. Thus, the exact features of a 
system's risk-management framework should be tailored to the risks of 
that system. The Board also recognizes that the specific features of a 
risk-management framework may entail tradeoffs between efficiency and 
risk reduction. Payments and securities settlement systems will need to 
consider these tradeoffs when designing appropriate rules and 
procedures. In considering such tradeoffs, however, it is critically 
important that systems take into account the costs and risks that may 
be imposed on all relevant parties, including parties with no direct 
role in the system. Furthermore, in light of rapidly evolving 
technologies and risk-management practices, the Board encourages all 
systems to consider periodically making cost-effective risk-management 
improvements.
    To determine whether a system's current or proposed risk-management 
framework is consistent with this policy, the Board will seek to 
understand how a system achieves the four elements of a sound risk-
management framework set out above. In this context, it may be 
necessary for the Board to obtain information from system operators 
regarding their risk-management framework, risk-management objectives, 
rules and procedures, significant legal analyses, general risk 
analyses, analyses of the credit and liquidity effects of settlement 
disruptions, business continuity plans, crisis management procedures, 
and other relevant documentation.\23\ It may

[[Page 22518]]

also be necessary for the Board to obtain data or statistics on system 
activity on an ad-hoc or ongoing basis. All information provided to the 
Federal Reserve for the purposes of this policy will be handled in 
accordance with all applicable Federal Reserve policies on information 
security, confidentiality, and conflicts of interest.
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    \23\ To facilitate analysis of settlement disruptions, systems 
may need to develop the capability to simulate credit and liquidity 
effects on participants and on the system resulting from one or more 
participant defaults, or other possible sources of settlement 
disruption. Such simulations may need to include, if appropriate, 
the effects of changes in market prices, volatilities, or other 
factors.
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C. Systemically Important Systems
    In addition to establishing a risk-management framework that 
includes the key elements described above, the Board expects 
systemically important payments and securities settlement systems to 
comply with the detailed standards set out in this section. To 
determine whether a system is systemically important for purposes of 
this policy, the Board may consider, but will not be limited to, one or 
more of the following factors:
     Whether the system has the potential to create 
significant liquidity disruptions or dislocations should it fail to 
perform or settle as expected
     Whether the system has the potential to create 
large credit or liquidity exposures relative to participants' financial 
capacity
     Whether the system settles a high proportion of 
large-value or interbank transactions
     Whether the system settles transactions for 
critical financial markets.\24\
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    \24\ The ``Interagency Paper on Sound Practices to Strengthen 
the Resilience of the U.S. Financial System.'' (Interagency Paper) 
(68 FR 17809 April 11, 2003) currently defines critical financial 
markets as the markets for federal funds, foreign exchange, and 
commercial paper; U.S. government and agency securities; and 
corporate debt and equity securities.
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     Whether the system provides settlement for other 
systems
     Whether the system is the only system or one of 
a very few systems for settlement of a given financial instrument.
    Systemically important systems are expected to meet specific risk-
management standards because of their potential to cause major 
disruptions in the financial system. The Board, therefore, expects 
systemically important payments systems to comply with the standards 
listed in Section C.1. Securities settlement systems of systemic 
importance are expected to comply with the standards listed in Section 
C.2. Some systemically important systems, however, may present an 
especially high degree of systemic risk, by virtue of their high volume 
of large-value transactions or central role in the operation of 
critical financial markets. Because all systems are expected to employ 
a risk-management framework that is appropriate for their risks, the 
Board may expect these systems to exceed the standards set out below.
    The Board acknowledges that payments and securities settlement 
systems vary in terms of the scope of instruments they settle and 
markets they serve. It also recognizes that systems may operate under 
different legal and regulatory constraints and within particular market 
infrastructures or institutional frameworks. The Board will consider 
these factors when assessing how a systemically important system 
addresses a particular standard.
    The Board's standards for systemically important payments and 
securities settlement systems are based, respectively, on the Core 
Principles and the Recommendations. The Core Principles and the 
Recommendations are two examples of recent initiatives pursued by the 
international financial community to strengthen the global financial 
infrastructure.\25\ The Federal Reserve worked closely with other 
central banks to draft the Core Principles and with other central banks 
and securities regulators to draft the Recommendations. These standards 
are part of the Financial Stability Forum's Compendium of Standards 
that have been widely recognized, supported, and endorsed by U.S. 
authorities as integral to strengthening the stability of the financial 
system.
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    \25\ The Core Principles draw extensively on the previous work 
of the CPSS, most importantly the Report of the Committee on 
Interbank Netting Schemes of the Central Banks of the Group of Ten 
Countries (the Lamfalussy Minimum Standards). The Core Principles 
extend the Lamfalussy Minimum Standards by adding several principles 
and broadening the coverage to include systemically important 
payments systems of all types, including gross settlement systems 
and hybrid systems, operated by either the public or private sector. 
The Core Principles also address the responsibilities of central 
banks in applying the Core Principles.
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1. Standards for Systemically Important Payments Systems
    1. The system should have a well-founded legal basis under all 
relevant jurisdictions.
    2. The system's rules and procedures should enable participants to 
have a clear understanding of the system's impact on each of the 
financial risks they incur through participation in it.
    3. The system should have clearly defined procedures for the 
management of credit risks and liquidity risks, which specify the 
respective responsibilities of the system operator and the participants 
and which provide appropriate incentives to manage and contain those 
risks.
    4. The system should provide prompt final settlement on the day of 
value, preferably during the day and at a minimum at the end of the 
day.
    5. A system in which multilateral netting takes place 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 settlement obligation.
    6. Assets used for settlement should preferably be a claim on the 
central bank; where other assets are used, they should carry little or 
no credit risk and little or no liquidity risk.
    7. The system should ensure a high degree of security and 
operational reliability and should have contingency arrangements for 
timely completion of daily processing.
    8. The system should provide a means of making payments which is 
practical for its users and efficient for the economy.
    9. The system should have objective and publicly disclosed criteria 
for participation, which permit fair and open access.
    10. The system's governance arrangements should be effective, 
accountable and transparent.
2. Standards for Systemically Important Securities Settlement Systems
    The CPSS-IOSCO Recommendations apply to the full set of 
institutional arrangements for confirmation, clearance, and settlement 
of securities transactions, including those related to market 
convention and pre-settlement activities. As such, not all of these 
standards apply to all systems. Moreover, the standards applicable to a 
particular system also will vary based on the structure of the market 
and the system's design.
    While the Board endorses the CPSS-IOSCO Recommendations in their 
entirety, its primary interest for purposes of this policy is in those 
standards related to the settlement aspects of securities transactions, 
including the role of central counterparties and central depositories, 
the delivery of securities against payment, and related risks. The 
Board expects that systems engaged in the management or conduct of 
settling securities transactions and their participants to comply with 
the expectations set forth in the applicable Recommendations. 
Securities settlement

[[Page 22519]]

systems also may wish to consult the Assessment Methodology for 
``Recommendations for Securities Settlement Systems'' for further 
guidance on each standard.\26\
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    \26\ Bank for International Settlements (November 2002). 
Available at http://www.bis.org.
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    1. Securities settlement systems should have a well-founded, clear 
and transparent legal basis in the relevant jurisdictions.
    2. Confirmation of trades between direct market participants should 
occur as soon as possible after the trade execution, but no later than 
the trade date (T+0). Where confirmation of trades by indirect market 
participants (such as institutional investors) is required, it should 
occur as soon as possible after the trade execution, preferably on T+0, 
but no later than T+1.
    3. Rolling settlement should be adopted in all securities markets. 
Final settlement should occur no later than T+3. The benefits and costs 
of a settlement cycle shorter than T+3 should be evaluated.
    4. The benefits and costs of a central counterparty should be 
evaluated. Where such a mechanism is introduced, the central 
counterparty should rigorously control the risks it assumes.
    5. Securities lending and borrowing (or repurchase agreements and 
other economically equivalent transactions) should be encouraged as a 
method for expediting the settlement of securities transactions. 
Barriers that inhibit the practice of lending securities for this 
purpose should be removed.
    6. Securities should be immobilized or dematerialized and 
transferred by book entry in central securities depository to the 
greatest extent possible.
    7. Central securities depositories should eliminate principal risk 
linking securities transfers to funds transfers in a way that achieves 
delivery versus payment.
    8. Final settlement should occur no later than the end of the 
settlement day. Intraday or real time finality should be provided where 
necessary to reduce risks.
    9. Central securities depositories that extend intraday credit to 
participants, including central securities depositories that operate 
net settlement systems, should institute risk controls that, at a 
minimum, ensure timely settlement in the event that the participant 
with the largest payment obligation is unable to settle. The most 
reliable set of controls is a combination of collateral requirements 
and limits.
    10. Assets used to settle the ultimate payment obligations arising 
from securities transaction should carry little or no credit or 
liquidity risk. If central bank money is not used, steps must be taken 
to protect central securities depository members from potential losses 
and liquidity pressures arising from the failure of the cash settlement 
agent whose assets are used for that purpose.
    11. Sources of operational risk arising in the clearing and 
settlement process should be identified and minimized through the 
development of appropriate systems, controls and procedures. Systems 
should be reliable and secure, and have adequate, scalable capacity. 
Contingency plans and backup facilities should be established to allow 
for the timely recovery of operations and completion of the settlement 
process.
    12. Entities holding securities in custody should employ accounting 
practices and safekeeping procedures that fully protect customers' 
securities. It is essential that customers' securities be protected 
against the claims of a custodian's creditors.
    13. Governance arrangements for central securities depositories and 
central counterparties should be designed to fulfill public interest 
requirement and to promote the objectives of owners and users.
    14. Central securities depositories and central counterparties 
should have objective and publicly disclosed criteria for participation 
that permit fair and open access.
    15. While maintaining safe and secure operations, securities 
settlement systems should be cost-effective in meeting the requirements 
of users.
    16. Securities settlement systems should use or accommodate the 
relevant international communication procedures and standards in order 
to facilitate efficient settlement of cross-border transactions.
    17. Central securities depositories and central counterparties 
should provide market participants with sufficient information for them 
to identify and evaluate accurately the risks and costs associated with 
using the central securities depository or central counterparty 
services.
    18. Securities settlement systems should be subject to transparent 
and effective regulation and oversight. Central banks and securities 
regulators should cooperate with each other and with other relevant 
authorities.
    19. Central securities depositories that establish links to settle 
cross-border trades should design and operate such links to reduce 
effectively the risks associated with cross-border settlement.

    By order of the Board of Governors of the Federal Reserve 
System, April 21, 2004.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 04-9413 Filed 4-23-04; 8:45 am]
BILLING CODE 6210-01-P