[Federal Register Volume 71, Number 119 (Wednesday, June 21, 2006)]
[Notices]
[Pages 35679-35687]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-5538]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1257]


Consultation Paper on Intraday Liquidity Management and Payment 
System Risk Policy

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice; Request for comments.

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SUMMARY: The Board of Governors of the Federal Reserve System 
(``Board'') is publishing this consultation paper to seek information 
from financial institutions and other interested parties on their 
experience in managing intraday liquidity, credit, and operational 
risks relating to Fedwire funds transfers and associated transactions. 
The Board also seeks views on potential changes in market practices, 
operations, and its Payments System Risk (PSR) Policy that could reduce 
one or more of these risks, while maintaining or improving the 
efficiency of the payments system. This consultation is consistent with 
the Federal Reserve's long-standing practice of working with the 
financial industry to address payments system risk issues and provides 
a framework for discussions about the long-term evolution of the PSR 
Policy.

DATES: Comments must be received on or before December 15, 2006.

ADDRESSES: You may submit comments, identified by Docket No. OP-1257, 
by any of the following methods:
     Agency Web Site: http://www.federalreserve.gov. Follow the 
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
     Federal eRulemaking Portal: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     E-mail: [email protected]. Include the 
docket number in the subject line of the message.
     FAX: 202/452-3819 or 202/452-3102.
     Mail: Jennifer J. Johnson, Secretary, Board of Governors 
of the Federal Reserve System, 20th Street and Constitution Avenue, 
NW., Washington, DC 20551.
    All public comments are available from the Board's Web site at 
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as 
submitted, unless modified 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: Jeffrey Marquardt, Deputy Director 
(202-452-2360), Lisa Hoskins, Assistant Director (202-452-3437), or 
Susan Foley, Manager (202-452-3596), Division of Reserve Bank 
Operations and Payment Systems, Board of Governors of the Federal 
Reserve System; for users of Telecommunications Device for the Deaf 
(``TDD'') only, contact (202) 263-4869.

SUPPLEMENTARY INFORMATION:

I. Executive Summary

    The Federal Reserve's PSR Policy sets out the general public policy 
objectives of safety and efficiency for payments and settlement 
systems.\1\ The Federal Reserve is currently reviewing the long-term 
effects of market, operational, and policy changes by the financial 
industry and the Federal Reserve on intraday liquidity and risks in 
financial markets and the payments system, including account overdrafts 
(daylight overdrafts) at the Federal Reserve Banks (Reserve Banks). In 
connection with this review, the Board is seeking information from 
financial institutions and other interested parties on their experience 
in managing intraday liquidity, credit, and operational risks relating 
to Fedwire funds transfers and associated transactions. The Board is 
also seeking commenters' views on potential changes in market 
practices, operations, and its PSR Policy that could reduce one or

[[Page 35680]]

more of these risks, while maintaining or improving the efficiency of 
the payments system. The body of this paper also includes a list of 
more detailed objectives relating to safety (e.g., low systemic risk, 
low direct credit risk to the Federal Reserve and the private sector, 
and rapid final payments) and efficiency (e.g., low cost of making 
payments, equitable treatment of all payments system participants, 
effective tools for implementing monetary policy, and low transaction 
costs in the Treasury securities market) that the Board has previously 
used to conduct payments system risk analysis. The paper also provides 
broad examples of tradeoffs, particularly risk tradeoffs, among these 
detailed objectives (e.g., efforts to reduce systemic risk may be 
associated with increased levels of daylight overdrafts in Reserve Bank 
accounts, and efforts to reduce daylight overdrafts may be associated 
with delays in making final payments.) An important goal of this 
consultation is to identify opportunities to shift these trade-offs in 
a favorable manner that lowers the overall risks and costs in the 
payments system over the long run.
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    \1\ See the Board of Governors of the Federal Reserve System, 
``Payments System Risk Policy'' at http://www.federalreserve.gov/paymentsystems/psr/policy.pdf.
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    Over the past twenty-five years, significant changes to U.S. 
payments and settlement systems have substantially reduced systemic 
risk. In accord with U.S. and international risk policies and 
standards, a number of these changes have relied increasingly on the 
use of central bank money--in this context, balances that financial 
institutions hold in accounts at Reserve Banks--to strengthen the 
management of credit and liquidity risk in private-sector clearing and 
settlement arrangements. Such changes have had the effect of increasing 
significantly the intraday demand for central bank money and hence the 
demand for daylight overdrafts at the Reserve Banks, which are a major 
source of these funds.
    The long-term growth of payment transactions such as Fedwire funds 
transfers, along with continuing financial market developments, have 
also contributed to greater demand for intraday liquidity and central 
bank money, and to greater daylight overdrafts at the Reserve Banks. 
Following a sharp initial decline in daylight overdrafts in the mid-
1990s when the Board implemented fees for these overdrafts, and 
particularly since about 1997, both average and peak daylight 
overdrafts have been growing slowly but steadily. This growth has 
generated gradually increasing credit exposures of the Reserve Banks. 
Data and additional details are provided in the appendix.
    The Federal Reserve has taken very significant steps over time to 
control the credit exposures of Reserve Banks to daylight overdrafts. 
These steps include establishing an extensive program of both risk 
limits (net debit caps) and daylight overdraft fees, and some limited 
use of collateral. However, given the growing demand for intraday 
central bank money and accompanying daylight overdrafts, significant 
further opportunities may be available to mitigate the growing credit 
exposures of the Reserve Banks, for example through the greater use of 
collateral, while also improving intraday liquidity management for the 
banking system.
    Partly in response to the introduction of daylight overdraft fees, 
a number of depository institutions introduced explicit strategies and 
techniques to manage their intraday liquidity and daylight overdrafts. 
More recently, a combined effect of depository institutions' intraday 
liquidity management strategies, coupled with other factors, has been 
to shift the sending of larger Fedwire payments to later in the day. 
From an operational risk perspective, delaying the sending of large 
payments until late in the day increases the potential magnitude of 
liquidity dislocation and risk in the financial industry if late-in-
the-day operational disruptions should occur. An increase in such risk 
is particularly troublesome in an era of heightened concern about 
operational disruptions from a range of sources. There may be 
significant opportunities to both improve intraday liquidity management 
and reduce late-in-the-day operational risk.
    In July 2006, the Federal Reserve will implement change--announced 
in 2004--to its daylight overdraft rules for government sponsored 
enterprises and certain international organizations. The changes will 
require these organizations to eliminate their daylight overdrafts at 
the Reserve Banks relating to their interest and redemption payments 
and to pay a penalty fee if daylight overdrafts occur in their accounts 
as a result of their general corporate payment activity.\2\ The 
changes, however, may indirectly increase further the demand for 
intraday liquidity by depository institutions, and possibly raise their 
daylight overdrafts. The preparations for this policy change are being 
closely monitored by the Federal Reserve.
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    \2\ The PSR Policy change for government sponsored enterprises 
and certain international organizations is available at http://www.federalreserve.gov/boarddocs/press/other/2004/20040205/default.htm. (See also 69 FR 57917, September 28, 2004.)
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    The subsequent sections of this consultation paper summarize long-
term developments involving intraday liquidity and risks in the context 
of the Federal Reserve's PSR Policy, and provide a brief list of 
possible market, operational, and policy changes that might further 
assist depository institutions, financial markets, and the Reserve 
Banks in managing intraday risks. These ideas should be regarded as 
preliminary and intended for further study. If the Board has specific 
proposals for changes to Federal Reserve operations or policies as a 
result of this consultation process, they would be issued for public 
comment.

II. Background

    The Federal Reserve's Payments System Risk Policy emerged from 
growing concerns in the late 1970s and early 1980s about systemic risk 
in the clearance and settlement functions for key financial markets as 
well as increasing intraday account overdrafts (daylight overdrafts) by 
depository institutions at the Reserve Banks. Over the years, the 
Federal Reserve has engaged in extensive discussions with the financial 
industry on these matters. The outgrowth has been a series of market, 
operational, and policy changes by the industry and the Federal Reserve 
that together have substantially reduced systemic risk, while creating 
a significant, structural intraday demand for central bank money.
    For example, the industry has made important institutional and risk 
management changes that rely on the intraday use of central bank money 
to reduce private-sector risks.\3\ These changes include The Depository 
Trust Company (DTC) making commercial paper eligible for its book-entry 
securities program in 1990 and expanding its Same-Day Funds Settlement 
program to all securities settling through its system in 1996.\4\ In 
2001, the Clearing House Interbank Payment System (CHIPS) introduced a 
system that requires CHIPS participants to use central bank money to 
pre-fund

[[Page 35681]]

CHIPS payments and settlements. This system also uses payment queuing 
techniques and algorithms that allow a participant's incoming funds 
transfers to fund outgoing transfers in order to conserve and manage 
the use of the pre-funded intraday liquidity within the system.\5\ In 
2002, CLS Bank International (CLS) began settling foreign exchange 
transactions using payment-versus-payment techniques, along with the 
(intraday) funding of daily settlements in central bank money for seven 
(now fifteen) currencies, including the U.S. dollar.\6\ In connection 
with their respective settlement processes, these systems accumulate 
significant intraday balances in their Reserve Bank accounts.
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    \3\ These changes are consistent with current standards in the 
Federal Reserve's PSR Policy that are derived from international 
standards established by the G-10 central banks' Committee on 
Payment and Settlement Systems and the Technical Committee of the 
International Organization of Securities Commissions.
    \4\ The Depository Trust Company (DTC) is a limited-purpose 
trust company that provides custody and settlement services for 
corporate, municipal, and other securities. DTC is a member of the 
Federal Reserve System and a clearing agency registered with the 
Securities and Exchange Commission.
    \5\ The Clearing House Interbank Payment System (CHIPS) is a 
real-time final payments system operated by The Clearing House 
Payments Company. In January 2001, The Clearing House implemented 
operational and rule changes to allow all transactions settled in 
CHIPS to be final upon release from CHIPS' central queuing system.
    \6\ CLS Bank International (CLS), an Edge Corporation supervised 
by the Federal Reserve, offers payment-versus-payment settlement of 
foreign exchange trades. Prior to the creation of CLS, many foreign 
exchange trades were subject to foreign exchange settlement risk 
(also known as Herstatt risk), which included significant credit 
risk.
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    These and other changes have substantially reduced systemic risk, 
but have also created a structural intraday demand for central bank 
money--balances at Reserve Banks--currently averaging about $50 billion 
per day to support the settlement and risk management activities of key 
private sector payment and settlement systems. On peak days, this 
demand can exceed $150 billion. The demand, which can ``lock up'' 
significant amounts of liquidity in the aggregate during the day, is 
met largely using Fedwire funds transfers and associated daylight 
overdrafts in the accounts of depository institutions. Other needs for 
intraday funds, including funding for other Fedwire payments used to 
settle transactions in financial and commercial markets, create 
additional intraday demand for central bank money.
    There are two main sources of supply to meet this intraday demand. 
One is overnight balances held at the Reserve Banks and the other is 
daylight overdrafts.\7\ Since the mid-1990s, overnight balances held at 
the Reserve Banks have declined by over one third to $18 billion at the 
end of 2005.\8\ Over the corresponding time period, average total 
daylight overdrafts at the Reserve Banks grew from $23 billion to $42 
billion. (Peak overdrafts averaged about $120 billion at the end of 
2005.) \9\ Thus, to meet the continued growth in intraday demand for 
central bank money the industry has become increasingly reliant on 
daylight overdrafts at the Reserve Banks.
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    \7\ A Fedwire funds transfer funded by a daylight overdraft 
provides an increase in the intraday balance of central bank money 
to the recipient.
    \8\ Balances held at the Reserve Banks are the sum of required 
reserve balances, required clearing balances, and excess balances. 
These balances ranged from $29 to $34 billion in 1994, declined 
gradually to a low of $12 billion in 2000, and ranged from $18 to 
$23 billion in 2005.
    \9\ Historical peak and average daylight overdraft data and 
aggregate fees are available on the Board's Web site at http://www.federalreserve.gov/paymentsystems/psr/data.htm.
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    Considering the growth in payments and financial market activity, 
the Reserve Banks' experience with daylight overdrafts since the early 
1980s is not surprising. Overdrafts grew substantially from 1988 to 
1993 as the value and volume of Fedwire transactions expanded. In 1994, 
the Federal Reserve began charging fees for daylight overdrafts. 
Initially, total daylight overdrafts declined significantly, owing 
primarily to changes in the settlement practices in the government 
securities and repo markets. By 1997, total daylight overdrafts began 
growing again and have grown at approximately 8 percent per year since 
that time. At first, these increases were driven primarily by the 
continuing growth of daylight overdrafts attributable to Fedwire funds 
transfers. Since 2001, overdrafts attributable to Fedwire securities 
transfers have begun growing again, reinforcing the increase in total 
overdrafts (See Appendix, Chart 1). Recently, overdrafts attributable 
to both Fedwire funds and securities transactions have grown roughly in 
line with the value of the underlying transfers, with an upward trend 
in overdrafts attributable to Fedwire funds transfers in 2005 (See 
Appendix, Chart 2).
    The Federal Reserve has undertaken a number of efforts over a long 
period to address the credit risk associated with providing intraday 
central bank money through daylight overdrafts at the Reserve Banks 
without unduly disrupting financial markets. The Federal Reserve has 
established key policies and programs to measure, monitor, and control 
intraday credit risk to the Reserve Banks; these policies and programs 
include introducing limits on account-holders' overdrafts (net debit 
caps), pricing (intraday overdraft fees), and in certain cases, 
permitting collateralization of large overdrafts (max caps). Taken 
together, these initiatives have encouraged the industry to economize 
on the use of daylight overdrafts in their accounts at Reserve Banks 
and have helped limit the Reserve Banks' credit risk exposures.
    In July 2006, the Federal Reserve will implement changes--announced 
in 2004--to its daylight overdraft rules for government sponsored 
enterprises and certain international organizations. The changes will 
require these organizations to eliminate their daylight overdrafts at 
the Reserve Banks relating to their interest and redemption payments 
and to pay a penalty fee if daylight overdrafts occur in their accounts 
as a result of their general corporate payment activity. The changes, 
however, are likely to increase further the demand for intraday 
liquidity by some depository institutions, and possibly raise their 
daylight overdrafts.
    To date, the rise in daylight overdrafts has not necessarily 
resulted in the Reserve Banks assuming significantly greater credit 
risk. The overall growth of commercial bank capital and the continued 
financial strength of depository institutions have supported increasing 
volumes of payments and rising levels of daylight overdrafts. Over the 
long term, however, either the continued growth of uncollateralized 
daylight overdrafts or a reduction in the financial strength of 
depository institutions could increase the direct credit risk to the 
Reserve Banks from daylight overdrafts.
    In recent years, intraday liquidity management strategies of 
depository institutions, coupled with other factors, have increased the 
amount of large Fedwire payments made late in the day. The aggregate 
value of Fedwire funds transfers sent after 5 p.m. Eastern Time (ET) 
has increased from 20 percent of the daily value of Fedwire funds 
transfers in 1998 to over 30 percent in 2005.10, 11 (See 
Appendix, Chart 3) On peak payment volume days, the percentage of 
payments delayed may be even larger. The upcoming changes in policy 
affecting government sponsored enterprises could further affect this 
shift. As noted earlier, the larger the number and value of Fedwire or 
other payments that are made late in the day, the greater the risk to 
financial markets that payments will not be settled in a timely manner 
if significant operational disruptions were to occur late in the day.
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    \10\ All times noted are Eastern Time (ET). Data discussed here 
exclude the value of payments to and from CLS, CHIPS, and DTC.
    \11\ The Fedwire Funds Transfer Service business day begins at 9 
p.m. on the preceding calendar day and closes at 6:30 p.m. The cut-
off time for third-party transfers is 6 p.m.
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    A related long-standing concern of the Federal Reserve has been 
that

[[Page 35682]]

depository institutions' intraday liquidity management strategies may 
lead them to delay sending Fedwire payments until they receive payments 
in order to manage their use of daylight overdrafts at the Reserve 
Banks. If this practice became widespread, it could lead to a form of 
``gridlock'' in the payments system with multiple depository 
institutions waiting for each other to send payments in order to obtain 
intraday funds and limit their daylight overdrafts.
    Over time, Board and Reserve Bank staff has engaged members of the 
financial industry in various discussions about the causes of and 
concerns about late-in-the-day payments and increasing overdraft 
levels, as well as potential actions to address these and other 
concerns. From preliminary information and analysis, the Board 
understands that the growing volume of late-in-the-day Fedwire payments 
may be caused by (1) the late-in-the-day settlement by some private 
systems and the associated late release of intraday funds into the 
market, (2) mismatches of payments sent over CHIPS and Fedwire whereby 
some participants are consistently long (or short) for the CHIPS 
settlement, resulting in large sums of liquidity being consistently 
distributed late in the day to some institutions, (3) the increasingly 
late-in-the-day reconciliation of positions by money market 
participants and corresponding late-in-the-day determination of final 
funding requirements, which results in depository institution customers 
initiating late-in-the-day payments, and (4) the use of general 
liquidity management strategies by depository institutions that rely on 
internal queuing of Fedwire payments, especially large payments, to 
reduce their daylight overdrafts and daylight overdraft fees.

III. Examples of Potential Market, Operational, or Policy Changes

    Looking forward, there may be important trade-offs among PSR Policy 
objectives that need to be analyzed in light of experience and could be 
improved. As noted in the executive summary, the Board's general public 
policy objectives are to foster the safety and efficiency of payments 
and settlement systems.\12\ Additional subsidiary objectives derive 
from these broad objectives. The following detailed objectives were 
published in the Board's study that led to the pricing of daylight 
overdrafts in the 1990s: \13\
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    \12\ See Board of Governors, ``Payment System Risk Policy,'' 
op.cit. See also Committee on Payment and Settlement Systems, ``Core 
Principles for Systemically Important Payment Systems,'' http://www.bis.org/publ/cpss34ep1.pdf.
    \13\ See ``Controlling Risk in the Payment System,'' Report of 
the Task Force on Controlling Payments System Risk to the Payments 
System Policy Committee of the Federal Reserve System, Board of 
Governors of the Federal Reserve System, August 1988.
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Safety

     Low direct credit risk to the Federal Reserve.
     Low direct credit risk to the private sector.
     Low systemic risk.
     Rapid final payments.

Efficiency

     Low operating expense of making payments.
     Equitable treatment of all service providers and users in 
the payments system.\14\
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    \14\ This objective can be viewed as supporting efficient 
financial markets.
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     Effective tools for implementing monetary policy.
     Low transaction costs in the Treasury securities market.
    Among these detailed objectives, some trade-offs are readily 
apparent. For example, lower systemic risk has been achieved by 
strengthening risk controls in private systems, including using central 
bank money as a settlement asset and risk management tool. These 
changes, however, have created the large structural intraday demand for 
central bank money that is satisfied primarily through daylight 
overdrafts at the Reserve Banks, contributing to the growing direct 
credit exposure of the Reserve Banks.
    As noted earlier, charging for overdrafts initially lowered the 
direct risk exposure of the Reserve Banks and encouraged depository 
institutions to economize on their use of daylight credit. The 
resulting increased operating expense of making payments, however, 
provided an incentive to delay sending Fedwire payments leading, other 
things equal, to greater operational risk exposure from the greater 
value of funds transfers processed later in the day. The potential 
trade-off between direct credit risk to the Reserve Banks and 
operational risk exposure to the financial markets from delays in 
sending payments was recognized when the pricing of overdrafts was 
initiated. Early on there was little evidence that payments were being 
shifted to later in the day. In the past five years, however, payments 
have shifted, implying that operational risk exposure has also been 
rising.
    The strategic question for the industry and policy makers is 
whether there are market, operational, or policy changes, that could, 
if taken individually or in combination, significantly reduce one or 
more of these risks, while maintaining or improving the efficiency of 
the payments system. Depository institutions and others have 
highlighted a number of items that could be analyzed further by the 
Federal Reserve and the industry. These ideas should be regarded as 
preliminary and are reported here for further comment and study. These 
include the following:

Possible Market Changes

     Foster an intraday market to exchange liquidity between 
institutions that hold positive balances at the Reserve Banks and those 
that run negative balances.
     Foster a market for the early return of federal funds or 
other money market investments.

Possible Operational Changes

     Enhance private settlement systems to economize further on 
the use of central bank money, for example, by developing multiple 
settlement periods to release liquidity earlier in the day.
     Add liquidity saving mechanisms to the Fedwire funds 
transfer system.
     Establish throughput requirements for the Fedwire funds 
transfer system.

Possible PSR Policy Changes

     Make greater use of voluntary or required collateral to 
cover daylight overdrafts in Reserve Bank accounts.
     Introduce a lower price for collateralized than for 
uncollateralized daylight overdrafts.
     Introduce time-of-day pricing of daylight overdrafts.
Possible Market Changes
    As part of the discussions around the introduction of daylight 
overdraft fees in 1994, some industry participants questioned whether 
these fees would create sufficient incentives to establish an intraday 
funds market. It is not clear whether the cost of setting up an 
intraday funds market, practical problems, or both discouraged industry 
action. Since that time, depository institutions have experienced 
additional liquidity pressures from time-critical payments that may 
provide an incentive to establish more formal market arrangements for 
exchanging intraday liquidity. The policy, operational, and technical 
implications of establishing such a market are not clearly understood.
    In addition, intraday liquidity pressures may encourage growth in 
the market for the early return of Federal funds or other money market

[[Page 35683]]

investments. The return of Federal funds late in the day provides 
borrowers rather than lenders with the use of that liquidity throughout 
the day. Lenders may find an early return option beneficial during 
periods in which they anticipate making large or time-critical 
payments. Terms acceptable to both parties could be negotiated to 
compensate for the early return. Currently, transactions supporting the 
early return of funds appear to be relatively rare. A more active 
market could effectively amount to an implicit market for intraday 
funds. It is not clear whether there is sufficient demand to support a 
larger early-return market. It is also possible that operational 
changes to Fedwire would be needed in order to support such market 
arrangements.
Possible Operational Changes
    As noted earlier, operational changes in private settlement systems 
over the past several years have created a significant, structural 
intraday demand for central bank money. These systems established 
procedures that require participants to transfer funds to them early in 
the day to begin clearing transactions and to transfer additional funds 
during the day if needed for risk management purposes or final 
settlements. While these processes clearly reduce systemic risk, they 
can also ``lock up'' significant amounts of liquidity in the aggregate 
during the day. It may be possible for private settlement systems to 
modify their procedures to release liquidity earlier in the day by 
developing multiple cutoff or settlement periods. There may be other 
operational changes that could enhance private settlement systems in 
order to economize further on the use of intraday liquidity, 
particularly in the form of central bank money.
    The Reserve Banks could also explore establishing a liquidity 
saving mechanism for the Fedwire funds transfer system. For example, a 
liquidity saving mechanism could involve adding new features to Fedwire 
that depository institutions could use to economize on the use of 
intraday central bank money, while retaining the existing (real-time 
gross settlement) functionality of Fedwire. While a depository 
institution could still designate that a Fedwire funds transfer settle 
immediately as it does today, such new features could allow depository 
institutions to designate certain payments to be placed into a central 
queuing system and settled using algorithms that allow the liquidity 
provided by incoming payments to a depository institution to be used to 
settle that institution's outgoing payments. Versions of these features 
are used by CHIPS and the RTGS Plus system in Germany. Such features 
will also be included in the new wire transfer systems in the European 
Union (Target 2), Japan, and other countries. In the typical designs 
for such systems, payments retain their individual identity and are 
settled on a gross basis. Like netting arrangements, however, the 
systems use the liquidity from pairs or groups of payments to fund and 
settle offsetting or nearly offsetting payments, potentially reducing 
the demand for central bank money and daylight overdrafts needed to 
conduct payment activity.\15\
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    \15\ In recent years, both central banks and private-sector 
systems have explored new features for payments systems that help 
coordinate the timing of payments among depository institutions and 
help conserve the amounts of liquidity needed to make payments. For 
a discussion of developments in liquidity saving features and their 
history, see Committee on Payment and Settlement Systems, ``New 
developments in large-value payment systems,'' Bank for 
International Settlements, May 2005. (http://www.bis.org/publ/cpss67.pdf)
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    In theory, the use of liquidity saving mechanisms in the Fedwire 
Funds Service could also help promote the earlier sending of Fedwire 
payments that are held in depository institutions' internal queues. For 
example, suppose a depository institution (Bank X) could enter payments 
into a central queue in the Fedwire system subject to rules that these 
payments would not be sent until sufficient liquidity is available to 
fund these payments, and the liquidity takes the form of payments held 
in the queue on behalf of other depository institutions that are 
destined for Bank X. In this case, payments could be entered into the 
central queue early in the day without incurring daylight overdrafts 
fees since no intraday credit would be used. If a number of depository 
institutions enter payments early, then these payments could also be 
settled earlier in the day, using significantly less daylight credit 
from the Reserve Banks. In essence, technical changes to Fedwire could 
allow depository institutions to better coordinate their payment flows 
and shift some of these flows to earlier in the day.
    In addition to, or in place of, technological changes, the Federal 
Reserve could consider adopting procedural changes that can affect the 
timing of payments, such as establishing Fedwire funds transfer 
throughput requirements. Throughput requirements are used by some other 
systems around the world. For example, participants could be expected 
to submit a certain percentage of their Fedwire payments volume by 10 
a.m., another percentage by noon, and so on. Meeting throughput 
requirements, however, may be difficult for individual participants to 
achieve and also difficult to enforce.
Possible PSR Policy Changes
    In 2001, the Board stated that it might consider several changes to 
its PSR Policy, including the introduction of two-tiered pricing for 
daylight overdrafts, with one rate for uncollateralized overdrafts and 
a second, lower rate, for collateralized overdrafts.\16\ Greater use of 
collateral to cover daylight overdrafts coupled with two-tier pricing 
could lower the cost of daylight overdrafts, reduce direct credit risk 
to the Reserve Banks, and increase the flexibility of the supply of 
intraday central bank money through the daylight overdraft mechanism. 
Concerns about possible adverse effects on depository institutions or 
the payments system as a whole figured importantly in decisions not to 
require the full collateralization of daylight overdrafts when the PSR 
Policy was initially developed. Since 2002, however, the level of 
collateral pledged to Reserve Banks for discount window and PSR 
purposes has increased steadily. In 2005, 64 percent of the 
approximately 270 depository institutions that paid daylight overdraft 
fees had assets pledged to the Reserve Banks for discount window 
purposes. These data imply that the role of collateral in supporting 
daylight overdrafts could be augmented with little to no adverse effect 
on many institutions.
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    \16\ See 66 FR 30208, June 5, 2001. The Board issued a 
subsequent notice in 2002 discussing comments received regarding its 
potential longer term policy direction, including two-tiered 
pricing. (67 FR 54424, August 22, 2002) In this notice, the Board 
stated that it would continue to evaluate the benefits and drawbacks 
of implementing two-tiered pricing. The Board also stated that it 
intended to allow depository institutions with collateral pledged to 
be charged the collateralized price for daylight credit up to the 
level of that collateral before being charged the higher price for 
uncollateralized daylight credit.
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    Potential collateral policies can have different characteristics 
that influence the degree to which they would reduce risk to Reserve 
Banks, affect the intraday supply of central bank money, and influence 
the timing of payments. The terms for providing collateralized intraday 
credit, the availability of eligible collateral and its opportunity 
cost, and the associated charges for daylight overdrafts would be major 
factors in a collateral policy. For example, the collateralization of 
daylight overdrafts might be either required (for all daylight 
overdrafts or some portion thereof) or voluntary (i.e., pledged at the 
depository institution's discretion); the definition of eligible 
collateral might be either narrow or

[[Page 35684]]

broad; the daylight overdraft fee might be either risk-based or not, 
with the fee for uncollateralized credit set above the fee for 
collateralized credit.
    Given the widespread use of collateral in financial markets to 
mitigate risk and the potential for daylight overdrafts to become 
overnight lending by the Reserve Banks, consideration should be given 
to having collateral play a much greater role in managing daylight 
overdrafts. Whereas most other central banks require participants to 
collateralize all intraday overdrafts, the PSR Policy currently 
requires collateral for daylight overdrafts only in limited 
circumstances.\17\ Over the long run, the greater use of collateral 
might provide a more flexible means for the Federal Reserve to deal 
with the impact of future stresses in the financial industry on the 
availability of intraday balances through the daylight overdraft 
mechanism. Incentives to increase the amount of collateral pledged to 
the Reserve Banks could also potentially strengthen further the 
industry's preparedness to draw on the discount window.
---------------------------------------------------------------------------

    \17\ For example, Reserve Banks may require collateral from 
financially-troubled depository institutions or participants that 
are not eligible to borrow from the discount window. In addition, an 
institution that is constrained by its net debit cap may be 
permitted to obtain additional, collateralized daylight overdraft 
capacity.
---------------------------------------------------------------------------

    Regarding collateral eligibility, the Reserve Banks' lending policy 
assumes that if a daylight overdraft is not repaid, it could become a 
discount window loan and appropriate collateral would be needed to 
support that loan. As a result, the types of collateral eligible for 
securing daylight overdrafts currently track the types eligible for 
discount window purposes.\18\ At year-end 2005, collateral pledged to 
the Reserve Banks for discount window and PSR purposes amounted to 
almost $564 billion; 70 percent of this collateral took the form of 
bank loans.
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    \18\ The Reserve Banks accept a wide range of financial assets 
as collateral for discount window loans. The collateral eligibility 
policy is set forth in the Federal Reserve's Regulation A, 
Extensions of Credit by Federal Reserve Banks (12 CFR 201.3). 
Additional terms and conditions relating to collateral are 
established in the Reserve Banks' Operating Circular No. 8, 
Collateral, and Operating Circular No. 10, Lending, which can be 
found at http://frbservices.org/OperatingCirculars/index.html.
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    Regarding fees for collateralized daylight overdrafts, there are 
several options. Today, the Federal Reserve charges the same fee for 
collateralized and uncollateralized overdrafts. In contrast, other 
central banks do not generally charge fees for daylight overdrafts (but 
do require collateral). It would be possible to consider a risk-based 
fee for collateralized overdrafts that was lower than the fee for 
uncollateralized overdrafts. The Board did not specify a price for 
collateralized daylight credit in either its 2002 notice or 2001 
request for comment on potential longer-term policy direction. The 
original request for comment, however, discussed a possible methodology 
for determining a risk differential between collateralized and 
uncollateralized credit. The Board examined loans for federal funds, 
which are uncollateralized, and loans through repurchase agreements, 
which are collateralized, and set forth a possible daylight overdraft 
fee differential of 12 to 15 basis points (per annum) for a 24-hour 
period.
    Finally, the Federal Reserve might have other options to influence 
the timing of payments. For example, the Federal Reserve might be able 
to influence the timing of payments by varying the fee charged for 
daylight overdrafts through the day so that overdrafts incurred earlier 
in the day incur a lower fee than overdrafts incurred late in the day.

IV. Conclusion

    From a public policy perspective, the ideas outlined in Section III 
can be understood as possibilities for improving the trade-offs among 
the Federal Reserve's PSR Policy objectives either by affecting the 
demand for intraday liquidity or by affecting the terms on which 
Reserve Banks supply intraday central bank money via daylight 
overdrafts. At this stage, the Board believes it is important to 
request input from the public on potential changes in market practices, 
operations, or PSR Policy that could further reduce intraday liquidity, 
credit, and operational risks. The Board specifically encourages 
comments on the suggested means to improve trade-offs among safety and 
efficiency objectives and requests information that will help 
strengthen the analysis of these trade-offs. The Board also welcomes 
additional suggestions from financial institutions and other interested 
parties in connection with the long-term evolution of risk policy. 
Section V includes a list of specific questions to help frame 
commenters' analysis and response.

V. Questions

    1. What intraday liquidity conservation strategies and technologies 
does your institution use (such as controlling the timing of payments 
and introducing queuing techniques to conserve on liquidity)? How do 
these affect your institution's timing for sending payments? What, if 
any, changes are you planning with regard to intraday liquidity 
management?
    2. How do the concentrated demands for intraday central bank money 
by private sector systems influence intraday liquidity management by 
depository institutions throughout the day? Are there significant 
concentrated sources of demand for intraday central bank money beyond 
those already mentioned in the text and how does this demand affect 
intraday liquidity management?
    3. Is the concentration of payments late in the day a concern for 
your organization? If so, what is the nature of your concern? Does it 
include operational risk from late-in-the-day payments, and has 
operational risk to your organization from such payments been 
increasing or decreasing? What are the key drivers of late-in-the-day 
payments? How has your organization responded to the late-in-the-day 
concentration of payments?
    4. For the market, operational, and PSR Policy changes discussed in 
this document and listed as follows, how might the timing of payments 
and the demand for daylight overdrafts be affected? What advantages or 
disadvantages do you see for these changes?
     An intraday market to exchange liquidity between 
institutions that hold positive balances at the Reserve Banks and those 
that run negative balances.
     A market for the early return of federal funds or other 
money market investments.
     Enhancements by private settlement systems that further 
economize on the use of central bank money, for example multiple 
settlement periods to release liquidity earlier in the day.
     Liquidity saving mechanisms for the Fedwire funds transfer 
system.
     Throughput requirements for the Fedwire funds transfer 
system.
     Greater use of voluntary or required collateral to cover 
partially or fully daylight overdrafts in depository institution 
accounts at the Reserve Banks.
     Two-tiered pricing for collateralized daylight overdrafts, 
with a fee charged for collateralized daylight overdrafts set lower 
than the rate for uncollateralized overdrafts.
     Time-of-day pricing of daylight overdrafts.
    5. What are other possible approaches to consider to reduce delays 
in payments and to manage efficiently and effectively the Federal 
Reserve's exposure to increasing daylight overdrafts as well as 
depository institutions' exposure to intraday

[[Page 35685]]

liquidity and credit risks? Are there other market or operational 
changes in the private sector that could help reduce intraday liquidity 
and credit risks?
    6. Congress is currently considering legislation that would allow 
the Federal Reserve to pay interest on reserve balances held by 
depository institutions at the Reserve Banks. How would the payment of 
interest on reserves affect depository institutions' intraday liquidity 
management, including the demand for daylight overdrafts at the Reserve 
Banks? Could the payment of interest on reserves be utilized to reduce 
the value or timing of daylight overdrafts?

VI. Appendix

Daylight Overdrafts

    The Federal Reserve introduced the Payment System Risk Policy in 
1986, establishing cross-system net debit caps for Fedwire and CHIPS on 
the use of intraday credit. Over the next two years, cross-system net 
debit caps were reduced twice and eventually replaced in 1991 with caps 
that only applied to overdrafts incurred in Reserve Bank accounts. 
Intraday overdraft fees were formally adopted by the Board in 1992 and 
became effective in 1994. Almost a decade later, the Federal Reserve 
implemented a policy allowing certain institutions to request 
collateralized capacity in excess of the net debit cap.\19\
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    \19\ In 2001, in conjunction with allowing certain institutions 
to request collateralized capacity, the Federal Reserve decided to 
include book-entry securities overdrafts for the purposes of 
determining an institution's compliance with its cap. The Federal 
Reserve eliminated the frequent and material thresholds that 
required a depository institution to collateralize overdrafts 
associated with securities transfers that frequently and materially 
exceeded its net debit cap.
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    Chart 1 provides peak overdraft data adjusted for inflation. 
Average overdraft data show a similar pattern at lower levels. Since 
1986, average and peak daylight overdrafts have steadily increased for 
Fedwire funds transfers. From 1986 to 2005, peak daylight overdrafts 
associated with Fedwire funds transfers (adjusted for inflation) have 
more than doubled from $44 billion to $96 billion, growing at a rate of 
4.2 percent per year. (In 2005, peak overdrafts associated with funds 
transfers averaged $108 billion in nominal dollars.) \20\ In contrast, 
daylight overdrafts related to securities transfers, which had been 
increasing rapidly prior to the implementation of daylight overdraft 
fees, decreased rapidly after 1994 once those fees were implemented. 
Since 2000, however, daylight overdrafts for securities transfers have 
begun increasing again.
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    \20\ Historical peak and average daylight overdraft data and 
aggregate fees in nominal dollars are available on the Board's Web 
site at http://www.federalreserve.gov/paymentsystems/psr/data.htm.
---------------------------------------------------------------------------

Chart 1

Peak Daylight Overdrafts: 1986-2005
(Annual Averages of Daily Data in 2000 Dollars)
[GRAPHIC] [TIFF OMITTED] TN21JN06.001

    Further, as shown in Chart 2, intraday credit usage associated with 
Fedwire funds transfers has grown roughly in line with the value of 
these funds transfers for many years, with an upward trend in 2005. 
Average overdrafts resulting from Fedwire funds transfers and the value 
of Fedwire funds transfers have grown 11 and 9 percent per year, 
respectively, since 1994.

Chart 2

Daylight Overdrafts at Reserve Banks as a Percent of Average Daily 
Value of Fedwire Transfers
(1994-2005: Daily Averages)

[[Page 35686]]

[GRAPHIC] [TIFF OMITTED] TN21JN06.002

    Overall, while total peak system overdrafts are still slightly 
below pre-pricing levels in nominal dollars ($120 billion in 2005; $129 
billion in 1993), total average overdrafts now exceed pre-pricing 
levels ($41 billion in 2005; $33 billion in 1993).

Timing of Fedwire Funds Transfers

    In the early years of the Payments System Risk Policy, there was no 
clear evidence that a substantial value of payments originated on 
Fedwire shifted to late in the day in response to policy changes.\21\ 
More recently, as discussed above, structural changes in the payments 
system, along with technology and market factors, may have contributed 
to market-wide delays in making Fedwire funds transfers.
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    \21\ See Richards, Heidi Willmann, ``Daylight Overdraft Fees and 
the Federal Reserve's Payment System Risk Policy,'' Federal Reserve 
Bulletin, December 1995.
---------------------------------------------------------------------------

    Chart 3 shows that while the percentage of payments slightly 
increased after 3:30 p.m., the percentage dramatically increased after 
5 p.m. The percentage of payments made after 5 p.m. went from 20 
percent of payments in 1998 to over 30 percent in 2005. This 
calculation excludes all payment transactions sent or received by 
CHIPS, DTC, or CLS, including transactions related to important end-of-
day funding and settlement functions.

Chart 3

Timing of Fedwire Payments Excluding Transactions Sent or Received by 
CHIPS, DTC, or CLS
(1998-2005: Percentage of Daily Value--21 Day Moving Average)
[GRAPHIC] [TIFF OMITTED] TN21JN06.003



[[Page 35687]]


    By order of the Board of Governors of the Federal Reserve 
System, June 14, 2006.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 06-5538 Filed 6-20-06; 8:45 am]
BILLING CODE 6210-01-P