[Federal Register Volume 79, Number 14 (Wednesday, January 22, 2014)]
[Proposed Rules]
[Pages 3666-3693]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-00682]
[[Page 3665]]
Vol. 79
Wednesday,
No. 14
January 22, 2014
Part II
Federal Reserve System
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12 CFR Part 234
Financial Market Utilities; Proposed Rule
Federal Register / Vol. 79 , No. 14 / Wednesday, January 22, 2014 /
Proposed Rules
[[Page 3666]]
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FEDERAL RESERVE SYSTEM
12 CFR Part 234
[Regulation HH; Docket No. R-1477]
RIN AD-7100 AE-09
Financial Market Utilities
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Notice of proposed rulemaking.
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SUMMARY: Under the Dodd-Frank Wall Street Reform and Consumer
Protection Act (``Dodd-Frank Act'' or ``Act''), the Board of Governors
of the Federal Reserve System (Board) is required to prescribe risk-
management standards governing the operations related to the payment,
clearing, and settlement activities of certain financial market
utilities that are designated as systemically important (designated
FMUs) by the Financial Stability Oversight Council (Council). The Board
is proposing to amend the risk-management standards currently in the
Board's Regulation HH by replacing the current risk-management
standards with a common set of risk-management standards applicable to
all types of designated FMUs. These new risk-management standards are
based on the Principles for Financial Market Infrastructures (PFMI),
which were developed by the Committee on Payment and Settlement Systems
(CPSS) and the Technical Committee of the International Organization of
Securities Commissions (IOSCO) and published in April 2012.
DATES: Comments on this notice of proposed rulemaking must be received
by March 31, 2014.
ADDRESSES: You may submit comments, identified by Docket No. R-1477 and
RIN No. 7100 AE-09, 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.
Email: [email protected]. Include the
docket number in the subject line of message.
Facsimile: (202) 452-3819 or (202) 452-3102.
Mail: Robert deV. Frierson, 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 form 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: Jennifer A. Lucier, Deputy Associate
Director (202) 872-7581, Kathy C. Wang, Senior Financial Services
Analyst (202) 872-4991, or Emily A. Caron, Senior Financial Services
Analyst (202) 452-5261, Division of Reserve Bank Operations and Payment
Systems; Christopher W. Clubb, Special Counsel (202) 452-3904 or Kara
L. Handzlik, Counsel (202) 452-3852, Legal Division; for users of
Telecommunications Device for the Deaf (TDD) only, contact (202) 263-
4869.
SUPPLEMENTARY INFORMATION:
I. Background
A. Title VIII of the Dodd-Frank Act
Title VIII of the Dodd-Frank Act, titled the ``Payment, Clearing,
and Settlement Supervision Act of 2010,'' was enacted to mitigate
systemic risk in the financial system and to promote financial
stability, in part, through an enhanced supervisory framework for
designated FMUs.\1\ Section 803(6) of the Act defines an FMU as a
``person that manages or operates a multilateral system for the
purposes of transferring, clearing, or settling payments, securities,
or other financial transactions among financial institutions or between
financial institutions and the person.'' Pursuant to section 804 of the
Act, the Council is required to designate those FMUs that the Council
determines are, or are likely to become, systemically important.\2\
Such a designation by the Council makes an FMU subject to the
supervisory framework set out in Title VIII of the Act.
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\1\ The Dodd-Frank Act, Public Law 111-203, 124 Stat. 1376, was
signed into law on July 21, 2010.
\2\ For these purposes, section 803(9) of the Dodd-Frank Act
defines ``systemically important'' and ``systemic importance'' as a
situation in which the failure of or disruption to the functioning
of an FMU could create, or increase, the risk of significant
liquidity or credit problems spreading among financial institutions
or markets and thereby threaten the stability of the financial
system of the United States. 12 U.S.C. 5462(9).
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The supervisory framework established under Title VIII includes
risk-management standards for designated FMUs that take into
consideration relevant international standards and existing prudential
requirements. Section 805(a)(1)(A) of the Act requires the Board to
prescribe risk-management standards governing the operations related to
the payment, clearing, and settlement activities of certain designated
FMUs.\3\ In addition, section 805(a)(2) of the Act grants the U.S.
Commodity Futures Trading Commission (CFTC) and the U.S. Securities and
Exchange Commission (SEC) the authority to prescribe regulations
containing risk-management standards for a designated FMU that is,
respectively, a derivatives clearing organization (DCO) registered
under section 5b of the Commodity Exchange Act or a clearing agency
registered under section 17A of the Securities Exchange Act of 1934.
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\3\ Currently, two of the eight FMUs that have been designated
by the Council are subject to the risk-management standards
promulgated by the Board under section 805(a)(1)(A)--The Clearing
House Payments Company, L.L.C., on the basis of its role as operator
of the Clearing House Interbank Payments System, and CLS Bank
International.
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As set out in section 805(b) of the Act, the applicable risk-
management standards must (1) promote robust risk management, (2)
promote safety and soundness, (3) reduce systemic risks, and (4)
support the stability of the broader financial system. Further, under
section 805(c), the risk-management standards may address areas such as
(1) risk-management policies and procedures, (2) margin and collateral
requirements, (3) participant or counterparty default policies, (4) the
ability to complete timely clearing and settlement of financial
transactions, (5) capital and financial resource requirements for
designated FMUs, and (6) other areas that are necessary to achieve the
objectives and principles for risk-management standards in section
805(b). Designated FMUs are required to conduct their operations in
compliance with the applicable risk-management standards. Compliance is
examined by the federal agency that has primary jurisdiction over a
designated FMU under federal banking, securities, or commodity futures
laws (the ``Supervisory Agency'').\4\
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\4\ The Act's definition of ``Supervisory Agency'' is codified
at 12 U.S.C. 5462(8).
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B. Risk-Management Standards for Designated Financial Market Utilities
On July 30, 2012, the Board adopted Regulation HH to implement,
among other things, the statutory provisions under section 805(a)(1)(A)
of the Dodd-Frank Act.\5\ Regulation HH established two sets of risk-
management standards for certain designated FMUs: One set of
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risk-management standards for designated FMUs that operate a payment
system (Sec. 234.3(a)) and another set for designated FMUs that
operate a central securities depository or a central counterparty
(Sec. 234.4(a)).\6\ The Regulation HH standards do not apply to
designated FMUs for which the CFTC or the SEC is the Supervisory
Agency.\7\ In adopting Regulation HH, the Board considered relevant
international standards as well as the Board's Federal Reserve Policy
on Payment System Risk (PSR policy).\8\
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\5\ 12 CFR part 234.
\6\ At the time of the rulemaking, the Board acknowledged that
most designated FMUs that operate as central securities depositories
or central counterparties would be subject to the risk-management
standards promulgated by the CFTC or SEC. The Board, however,
adopted standards for designated FMUs that operate as central
securities depositories, central counterparties, or both, to address
the event that a designated FMU operates as one of the two types of
FMUs and is not required to register as derivatives clearing
organization or a clearing agency with the CFTC or SEC,
respectively.
\7\ 12 CFR 234.1.
\8\ The relevant international standards were the 2001 Committee
on Payment and Settlement Systems (CPSS) report on the Core
Principles for Systemically Important Payment Systems, the 2001 CPSS
and the Technical Committee of the International Organization of
Securities Commissions (IOSCO) report on the Recommendations for
Securities Settlement Systems, and the 2004 CPSS-IOSCO report on the
Recommendations for Central Counterparties. The Board previously
incorporated these international standards into its PSR policy.
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As noted in the preamble to the final rule for Regulation HH, the
CPSS and IOSCO finalized the PFMI in April 2012. The Board also noted
in the preamble that it anticipated reviewing the PFMI, consulting with
other appropriate agencies and the Council, and seeking public comment
on the adoption of revised standards for designated FMUs based on the
PFMI.
The PFMI updated, harmonized, strengthened, and replaced the
previous international risk-management standards for payment systems
that are systemically important, central securities depositories,
securities settlement systems, and central counterparties.\9\ The PFMI
addresses areas such as legal risk, governance, credit and liquidity
risks, operational risk, and general business risk.\10\ It sets forth
24 principles, each with (1) a headline standard that frames the
overall risk-management objective of the principle, (2) a list of key
considerations that elaborate on the headline standard, and (3)
accompanying explanatory notes that discuss the objective and rationale
of the principle and provide additional guidance on how the principle
may be implemented.
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\9\ The PFMI also establishes minimum requirements for trade
repositories, which have emerged internationally as an important
category of financial market infrastructure. The term ``financial
market utility'' as defined in Title VIII of the Dodd-Frank Act
excludes trade repositories.
\10\ The PFMI reflects broad market input from FMUs, their
participants, authorities, and others. A consultative version of the
PFMI was published in March 2011. CPSS and IOSCO received 120
comment letters on the consultative version. All designated FMUs, as
well as many of their major participants, provided comments on the
consultative report.
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The Board believes that the risk-management standards in Regulation
HH should be revised in consideration of the PFMI. The PFMI establishes
an important framework for promoting sound risk management in payment,
clearing, and settlement systems and financial stability more broadly.
The report reflects more than a decade of experience with international
risk-management standards for these types of systems, important lessons
learned from the financial crisis, and other relevant policy work by
the international standard-setting bodies. As described in more detail
below, risk-management standards based on the PFMI may improve upon the
standards currently in Regulation HH and will further promote the
objectives of the risk-management standards for designated FMUs set out
in section 805(b) of the Dodd-Frank Act.
In addition, the PFMI is widely recognized as the most relevant set
of international risk-management standards for payment, clearing, and
settlement systems. The Financial Stability Board (FSB), which includes
U.S. authorities, has endorsed the PFMI and has replaced the previous
sets of risk-management standards with the PFMI in its Key Standards
for Sound Financial Systems.\11\ In addition, the Basel Committee on
Banking Supervision considers the application of the PFMI as an
important factor in determining capital charges for bank exposures to
central counterparties related to over-the-counter derivatives,
exchange-trade derivatives, and securities financing transactions.\12\
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\11\ The FSB is an international forum that was established to
develop and promote the implementation of effective regulatory,
supervisory, and other financial sector policies. The FSB includes
the U.S. Department of the Treasury, the Board, and the SEC. For the
FSB's Key Standards for Sound Financial Systems, see http://www.financialstabilityboard.org/cos/key_standards.htm.
\12\ See Basel Committee on Banking Supervision (BCBS), interim
rules on Capital Requirements for Bank Exposures to Central
Counterparties, July 2012, http://www.bis.org/publ/bcbs227.pdf and
BCBS, Capital Treatment of Bank Exposures to Central Counterparties,
consultative document, June 2013 http://www.bis.org/publ/bcbs253.pdf.
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The Board believes that the implementation of risk-management
standards based on the PFMI by the relevant payment, clearing, and
settlement systems and their regulators, both domestically and
internationally, can help promote the safety and efficiency of these
systems and financial stability more broadly. Implementation also
supports the initiatives of the Group of Twenty Finance Ministers and
Central Bank Governors (G20) and the FSB to strengthen core financial
infrastructures and markets around the world.\13\ Widespread
implementation also reduces potential conflicts among domestic and
foreign authorities regarding prudential requirements for FMUs, and
provides a more consistent framework among relevant domestic and
foreign authorities for assessing the risks and risk management of FMUs
with cross-market, cross-border, or cross-currency operations. Since
April 2012, many central banks and market regulators have taken steps
to incorporate the PFMI into their respective legal and regulatory
frameworks that apply to systemically important financial market
infrastructures.\14\
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\13\ See, G20 Declaration on Strengthening the Financial System
(April 2009), http://www.treasury.gov/resource-center/international/
g7-g20/Documents/London%20April%202009%20Fin_Deps_Fin_Reg_
Annex_020409__-1615_final.pdf.
\14\ For an overview of how the PFMI is being implemented by
different authorities around the world, see CPSS-IOSCO,
Implementation Monitoring of PFMIs--Level 1 Assessment Report,
August 2013.
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II. Explanation of Proposed Rules
The Board proposes to amend Regulation HH by replacing the existing
risk-management standards with a set of standards based on the PFMI and
making conforming changes to the definitions. In developing the
proposal, the Board has considered the PFMI as the relevant
international standards applicable to payment, clearing, and settlement
systems. In implementing the proposed revisions to Regulation HH, the
Board anticipates using the PFMI as a reference as it establishes its
supervisory planning and analysis tools for each designated FMU for
which it is the Supervisory Agency.
The Board requests comment on all aspects of the proposed rules. In
addition, the Board requests comment on specific questions set out with
respect to certain of the risk-management standards as discussed below.
Where possible, commenters should provide both quantitative data and
detailed analysis in their comments, particularly with respect to
suggested alternatives to the proposed standards. Commenters should
also explain the rationale for their suggestions.
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A. Proposed Sec. 234.2--Definitions
The Board proposes to amend Regulation HH Sec. 234.2 by revising
three definitions, adding six definitions, and deleting one definition.
These proposed amendments constitute conforming changes or provide
clarity with respect to the proposed revisions to the risk-management
standards.
Central counterparty. The Board proposes to revise the definition
of ``central counterparty'' to describe more accurately the nature of
the relationship between the central counterparty and the original
counterparties with respect to a particular trade. The existing
definition, ``an entity that interposes itself between the
counterparties to trades, acting as the buyer to every seller and the
seller to every buyer,'' is being revised to read, ``an entity that
interposes itself between the counterparties to contracts traded in one
or more financial markets, becoming the buyer to every seller and the
seller to every buyer.''
Designated financial market utility. The Board proposes to revise
the definition of ``designated financial market utility'' for clarity
regarding designation rescission. The existing definition, ``a
financial market utility that the [Council] has designated under
section 804 of the Dodd-Frank Act'' is being revised to read, ``a
financial market utility that is currently designated by the [Council]
under section 804 of the Dodd-Frank Act.'' Under section 804(b) of the
Act, a designated FMU may have its designation rescinded if the Council
determines the designated FMU no longer meets the standards for
systemic importance. The proposed revision is intended to clarify that
Regulation HH applies only to FMUs with designations that are currently
effective. If the Council rescinds a designation of an FMU, the FMU is
no longer subject to the provisions of Title VIII of the Act or any
rules or orders prescribed under Title VIII, including the risk-
management standards set out in Regulation HH.
Central securities depository. The Board proposes to revise the
definition of ``central securities depository.'' The existing
definition, ``an entity that holds securities in custody to enable
securities transactions to be processed by means of book entries or an
entity that enables securities to be transferred and settled by book
entry either free of or against payment,'' is being revised to read,
``an entity that provides securities accounts and central safekeeping
services.'' This revision reflects a narrower set of functions that a
central securities depository can provide and better distinguishes this
type of FMU from a ``securities settlement system,'' which will be
covered by a new term as described below.
Securities settlement system. The Board proposes to add the term
``securities settlement system,'' which means ``an entity that enables
securities to be transferred by book entry and allows transfers of
securities free of or against payment.'' The term ``securities
settlement system'' was previously embedded in the Regulation HH
definition for ``central securities depository'' because a central
securities depository typically also performs the securities settlement
function. The Board proposes this separation of the two functions--
central securities depositories and securities settlement systems--in
order to accommodate any systems in which the central securities
depository does not also operate a securities settlement system.
Nonetheless, the Board recognizes that one entity can perform both
functions and satisfy both definitions.
Backtest and stress test. The Board proposes to add the terms
``backtest'' as used in proposed Sec. 234.3(a)(6) (Margin) and
``stress test'' as used in proposed Sec. 234.3(a)(4) (Credit risk) and
proposed Sec. 234.3(a)(7) (Liquidity risk). Under the proposal,
``backtest'' is defined as ``the ex post comparison of realized
outcomes with margin model forecasts to analyze and monitor model
performance and overall margin coverage.'' ``Stress test'' is defined
as ``the estimation of credit or liquidity exposures that would result
from the realization of potential stress scenarios, such as extreme
price changes, multiple defaults, and changes in other valuation inputs
and assumptions.'' These proposed definitions provide further clarity
to designated FMUs with regard to compliance with the above standards.
Recovery and wind-down. The Board proposes to add the terms
``recovery'' and ``wind-down,'' used in proposed Sec. 234.3(a)(3)
(Framework for the comprehensive management of risks) and Sec.
234.3(a)(15) (General business risk). Under the proposal, ``recovery''
is defined as ``the actions of a designated financial market utility
consistent with its rules, procedures, and other ex ante contractual
arrangements, to address any uncovered credit loss, liquidity
shortfall, capital inadequacy, or business, operational or other
structural weakness, including the replenishment of any depleted
prefunded financial resources and liquidity arrangements, as necessary
to maintain the designated financial market utility's viability as a
going concern.'' The proposed definition of ``recovery'' is for
purposes of proposed Sec. 234.3(a)(3) and (15) only and not in the
context of business continuity management under proposed Sec.
234.3(a)(17). The Board proposes to define ``wind-down'' as ``the
actions of a designated financial market utility to effect the
permanent cessation, sale, or transfer of one or more of its critical
operations or services.''
Links. The Board proposes to add the term ``link'' as used in
proposed Sec. 234.3(a)(20) (Links to other financial market
utilities). For the purposes of Sec. 234.3(a)(20), ``link'' is defined
as ``a set of contractual and operational arrangements between two or
more central counterparties, central securities depositories, or
securities settlement systems that connect them directly or indirectly,
such as for the purposes of participating in settlement, cross
margining, or expanding their services to additional instruments and
participants.''
Payment system. The Board proposes to remove the definition of
``payment system'' from Regulation HH because the term is neither used
in the proposed rule nor used in any other section of Regulation HH.
The term ``payment system'' is currently included in Regulation HH
because there is list of risk-management standards for payment systems
in Sec. 234.3 that is separate from the list of standards for central
securities depositories and central counterparties in Sec. 234.4.
Under the proposed rule, there would be only one list of standards for
all types of designated FMUs, so the separate term is no longer
necessary.
The Board specifically requests comment on whether the proposed
definitions are clear and sufficiently detailed and whether additional
definitions are needed to implement the proposed rules.
B. Proposed Sec. 234.3--Standards for Designated Financial Market
Utilities
As noted above, the Board proposes to replace the two current sets
of standards under Sec. Sec. 234.3(a) and 234.4(a) with one set of
standards for all types of designated FMUs under revised Sec.
234.3(a). In certain cases where proposed standards would only apply to
a particular type of designated FMU, the type of designated FMU is
specified in the proposed standard.
The Board believes the proposed revisions, which reflect the new
international standards in the PFMI, improve the current risk-
management standards under Regulation HH and further the objectives in
section 805(b) of the Dodd-Frank Act. Additionally, in considering the
PFMI, the proposed
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revisions reflect the most recent and relevant views on comprehensive
risk management by FMUs. Furthermore, adopting a common set of
standards across all types of designated FMUs will help remove any
confusion that can be caused by perceived inconsistencies in the
wording in two similar sets of requirements set out in the same
regulation.
The Board, however, recognizes that certain proposed revisions
represent new or heightened requirements relative to the baseline
requirements established under the current set of risk-management
standards. The Board also understands the need to weigh the risk-
reduction benefits of and any burden that may be imposed by a
particular rulemaking. Among other things, the Board has compared the
proposed standards with the baseline standards under current Regulation
HH to identify and analyze potential incremental burden, and is
considering establishing different effective dates for certain proposed
standards that may require additional time for a designated FMU to
implement.
Comparison to baseline requirements under current Regulation HH.
Consistent with current Regulation HH and the Board's longstanding
approach in its supervision and oversight of FMUs, the proposed
standards generally employ a flexible, principles-based approach to
permit a designated FMU to employ a cost-effective method for
compliance, so long as the method chosen achieves the risk-mitigation
goals of the standard. In addition, the standards are intended to
permit the risk-management goals to be pursued in light of evolving
market conditions, technology, and risk-management techniques and
systems. In several cases, however, the Board proposes explicit minimum
requirements, including minimum frequencies for testing requirements
and methods of calculating a minimum level of financial resources,
which are drawn from PFMI key considerations and explanatory notes. The
Board selected explicit minimum requirements that the Board believes a
designated FMU must be able to meet in order to achieve the overall
objective of a particular standard. Although some of these additions
constitute new or heightened requirements relative to the current
requirements in Regulation HH, many of the additions represent the
Board's existing supervisory practice with respect to designated FMUs
for which the Board is the Supervisory Agency.
In comparing the proposed revised risk-management standards to the
current standards in Regulation HH, the Board has identified three
broad types of revisions: (1) Those that essentially carry over a
current standard under Regulation HH; (2) those that establish a
standard that is new to Regulation HH, but represent an expectation
that is a prudential objective of the Board's current supervisory
process or a specific Board-imposed requirement for a particular
designated FMU; and (3) those that establish a standard that is new or
heightened to both Regulation HH as well as either the current
supervisory process or a specific Board-imposed requirement for a
particular designated FMU.\15\ The Board recognizes that the
incremental burden associated with each type of proposed revision may
vary by designated FMU.
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\15\ The Board may have additional statutory authority over a
particular designated FMU that is subject to Regulation HH, which
would allow the Board to apply other requirements or conditions on
the FMU in those contexts. For example, the Board may set conditions
on an FMU's membership in the Federal Reserve System under the
Federal Reserve Act.
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A majority of the proposed revisions to Sec. 234.3(a) are similar
in content and application to existing Regulation HH standards. In
these cases, differences between the current standard and the proposed
standard generally result from conforming edits to harmonize the
originally separate standards into one set of standards. These proposed
standards include proposed Sec. 234.3(a)(1) on legal basis, proposed
Sec. 234.3(a)(4)(i) on credit risk, proposed Sec. 234.3(a)(8) on
settlement finality, proposed Sec. 234.3(a)(9) on money settlements,
and proposed Sec. 234.3(a)(18) on access and participation
requirements. The Board does not anticipate that minor differences in
wording of the rule text will impose any significant incremental burden
on designated FMUs that are already in compliance with Regulation HH.
With respect to some other proposed revisions to Sec. 234.3(a),
although they establish a standard or parts thereof that is new to
Regulation HH, the designated FMU may already meet the standard through
the Board's current supervisory process or as a part of a specific
Board-imposed requirement. These proposed revisions include paragraphs
(a)(3)(i) and (ii) on the comprehensive management of risks, (a)(4)(ii)
on credit risk, and (a)(7)(i)-(v) on liquidity risk. There may be
minimal costs associated with demonstrating compliance with the
proposed revision and incorporating it into any formal compliance
documentation. The Board, however, does not anticipate this type of
revision to impose significant burden.
Other proposed revisions to Sec. 234.3(a) establish a standard or
parts thereof that is new or heightened to both Regulation HH and the
current supervisory process. These proposed revisions, depending on the
designated FMU, may include proposed Sec. 234.3(a)(3)(iii) on plans
for recovery or orderly wind-down, proposed Sec. 234.3(a)(15)(i) and
(ii) on maintaining sufficient liquid net assets funded by equity and a
viable capital plan, and proposed Sec. 234.3(a)(19) on tiered
participation arrangements, which the Board recognizes may impose costs
on designated FMUs to implement. The costs can be viewed as a
designated FMU's incremental expenses in establishing and maintaining
the systems and procedures necessary to meet the standards over and
above the risk-management measures it has currently in place to comply
with the current Regulation HH standards or would have otherwise
adopted for business reasons. If these costs are passed on to a
designated FMU's participants, they can take the form of higher
transaction costs and margin or collateral costs. These costs should be
weighed against the societal benefit of stability in the financial
system and the economy more broadly.
These new standards are meant to help achieve the financial
stability and systemic risk-reduction objectives of Title VIII of the
Act. As such, the key benefits of these proposed standards are in
minimizing the probability of recurrent financial crises and avoiding
events in which firm-level distress leads to a market-wide disruption
or even an economic recession. Such benefits are difficult to quantify,
because it would require the computation of the probability of a crisis
with and without regulatory change. Such computations generally cannot
produce credible figures. To the extent possible, the Board provides
instead its qualitative reasons for proposing requirements that may
impose an incremental cost, including its explanation of the importance
of these requirements to risk management and systemic-risk reduction.
The Board provides this explanation in the discussion for each standard
below.
Effective and compliance dates. The Board recognizes that certain
new or heightened requirements may require more time for designated
FMUs to implement and achieve compliance. Any delay in implementation,
however, must be balanced against the risks presented to the financial
system during the period that a designated FMU is not required to
comply with an applicable risk-management standard. As discussed below,
the Board therefore is
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considering different compliance dates to provide sufficient lead time
for certain new or heightened requirements.
The Board is proposing that the requirements proposed in Sec.
234.3(a) become effective and require compliance 30 days from the date
the final rule is published in the Federal Register, with the exception
of establishing plans for recovery or orderly wind-down, set forth in
proposed Sec. 234.3(a)(3)(iii); addressing uncovered credit losses,
set forth in proposed Sec. 234.3(a)(4)(vi); addressing liquidity
shortfalls, set forth in proposed Sec. 234.3(a)(7)(viii); maintaining
sufficient liquid net assets funded by equity and a viable capital
plan, set forth in proposed Sec. 234.3(a)(15)(i) and (ii); managing
risks arising in tiered participation arrangements, set forth in
proposed Sec. 234.3(a)(19); and providing comprehensive public
disclosure, set forth in proposed Sec. 234.3(a)(23)(iv). The Board is
proposing that compliance with these proposed requirements be required
six months from publication of the final rule.
The Board believes the revised risk-management standards as
proposed, including any that may impose incremental burden to
designated FMUs, achieve an appropriate balance between reducing
systemic risk through enhanced risk management of designated FMUs and
minimizing incremental burden associated with implementing any new or
heightened requirements. With respect to the set of the risk-management
standards set out in the proposed rule, the Board is specifically
requesting comment on the following questions:
Q.0.1. Are the proposed standards reasonable risk-mitigation tools?
Q.0.2. Is six months from publication of the final rules
appropriate for designated FMUs to comply with the proposed
requirements identified above (that is, proposed Sec. Sec.
234.3(a)(3)(iii), (a)(4)(vi), (a)(7)(viii), (a)(15)(i) and (ii),
(a)(19), and (a)(23)(iv))? Should the Board propose alternative
compliance dates for these or any other proposed requirements?
Q.0.3. What are the costs that are imposed by the proposed
standards? Are there ways to meet the proposed standards other than
those identified as examples in the discussion on each standard below?
Q.0.4. What are other benefits that are achieved by the proposed
standards?
1. Legal Basis
Proposed Sec. 234.3(a)(1) requires the designated FMU to have a
well-founded, clear, transparent, and enforceable legal basis for each
material aspect of its activities in all relevant jurisdictions.\16\ A
designated FMU's legal basis consists of its rules, procedures, and
contracts as well as the legal framework (that is, applicable laws and
regulations) under which it operates. The legal basis defines, or
provides the foundation for relevant parties to define, the rights and
obligations of the designated FMU, its participants, and other relevant
stakeholders (such as customers of participants, custodian banks,
settlement banks, and service providers). Most risk-management tools
rely on assumptions regarding the manner and time at which these rights
and obligations arise through the designated FMU's operations. Sound
and effective risk management, therefore, is dependent on the
enforceability of these rights and obligations. If the legal basis for
a designated FMU's activities and operations is inadequate or
uncertain, the designated FMU, its participants, and their customers
may face unexpected or unmanageable credit or liquidity risks, which
may also create or amplify systemic risks.
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\16\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(1) for payment systems and Sec.
234.4(a)(1) for central securities depositories and central
counterparties.
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While the Board acknowledges that an FMU cannot control or dictate
its governing laws or regulations, a designated FMU must take steps to
manage its legal risk within this environment, such as by conducting
legal due diligence to ensure that its rules, procedures, and
contractual provisions are consistent with and enforceable under the
legal framework in each applicable jurisdiction. In particular, these
rules, procedures, and contracts should be clear regarding material
aspects of the designated FMU's activities, such as settlement
finality, netting arrangements, and default procedures. If a designated
FMU operates across multiple jurisdictions, it must confirm the legal
basis for all material aspects of its activities in all relevant
jurisdictions to mitigate legal risks.
A designated FMU must be able to articulate, in a clear and
understandable manner, its compliance with applicable laws and
regulations and the enforceability of its rules, procedures, or
contracts under those law and regulations. When appropriate, a
designated FMU may need to obtain well-reasoned and independent legal
opinions or analyses on the material aspects of its activities.
Further, when evaluating the enforceability of its rules and
procedures, a designated FMU may need to consider different scenarios,
such as implementation of its plans for recovery or orderly wind-down,
the insolvency or resolution of a participant, and the potential for
conflict-of-laws issues, and must take steps to mitigate any identified
legal risks.
2. Governance
Proposed Sec. 234.3(a)(2) sets out the requirements that apply to
a designated FMU's governance arrangements.\17\ Governance is the set
of relationships among the designated FMU's stakeholders, including its
owners, board of directors (or an equivalent body), management,
participants, and other relevant parties (such as customers of
participants, other interdependent FMUs, and the broader market).
Governance arrangements define the structure under which the designated
FMU's board of directors and management operate.
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\17\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(10) for payment systems and Sec.
234.4(a)(8) for central securities depositories and central
counterparties.
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Sound governance is essential to achieving comprehensive and
effective risk management at a designated FMU. The way in which a
designated FMU's governance arrangements are structured, including the
definition of its lines of authority, responsibility, and
accountability, affects the fundamental decisionmaking within the
designated FMU, including decisionmaking involving risk management.
Furthermore, governance arrangements that promote sound risk-management
decisions and practices, in turn, help provide a basis for compliance
with the other risk-management standards in Regulation HH. For these
reasons, effective, accountable, and transparent governance
arrangements are critical to the effective risk management of a
designated FMU.
Under proposed Sec. 234.3(a)(2)(i), a designated FMU must
establish and document clear and transparent governance arrangements.
Clarity and transparency in a designated FMU's governance arrangements
promote accountability by providing relevant stakeholders with the
information necessary to understand how decisions are made and what the
chosen course of action is intended to accomplish. Key components of an
FMU's governance arrangements that must be clear and transparent
include the (a) role and composition of the board and any board
committees, (b) senior management structure, (c) reporting lines
between management and the board, (d)
[[Page 3671]]
ownership structure, (e) internal governance policy, (f) design of
risk-management and internal controls, (g) procedures for the
appointment of board members and senior management, and (h) processes
for ensuring performance accountability.
Under proposed Sec. 234.3(a)(2)(ii) and (iii), a designated FMU
must develop governance arrangements that promote the safety and
efficiency of its operations and support the stability of the broader
financial system and other relevant public interest considerations. The
stability of the financial system is an important public interest
consideration for all designated FMUs. Certain designated FMUs may have
other relevant public interest considerations, such as fostering fair
and efficient markets, market transparency, and investor protection.
The Board can provide guidance as needed, through ongoing dialogue
during the supervisory process, to assist a designated FMU in
identifying other public interests that are relevant to its operations.
Further, proposed Sec. 234.3(a)(2)(iii) requires a designated FMU
to develop governance arrangements that support the legitimate
interests of relevant stakeholders. These stakeholders include the
owners of the FMU, participants of the FMU, and participants'
customers. Although the mechanisms for involving stakeholders may
depend on the type of stakeholder and the particular designated FMU, in
general, the involvement of relevant stakeholders in the designated
FMU's governance processes, particularly in the determination of the
FMU's risk tolerance, the formal objective-setting process, the design
of its risk-management framework, and the strategic decisionmaking
process may enhance the effectiveness of the FMU's overall risk
management.
In addition, proposed Sec. 234.3(a)(2)(iv)(A) and (B) require the
designated FMU to define the structure under which its board and
management operate by setting out their responsibilities and defining
how they will interact. Proposed Sec. 234.3(a)(2)(iv)(A) requires a
designated FMU to ensure that its governance arrangements provide clear
and direct lines of responsibility and accountability, and proposed
Sec. 234.3(a)(2)(iv)(B) requires that the board of directors and
senior management have roles and responsibilities that are clearly
specified. These elements must be clear, because the board of directors
and senior management are ultimately responsible for managing a
designated FMU's business and operations.
Proposed Sec. 234.3(a)(2)(iv)(C) and (D) address the composition
of the board of directors. Proposed Sec. 234.3(a)(2)(iv)(C) requires
that the designated FMU's governance arrangements be designed to ensure
its board consists of suitable individuals with appropriate skills to
fulfill its multiple roles identified under proposed Sec.
234.3(a)(2)(iv)(B). For example, such arrangements may include a
process to identify and regularly review the desired set of skills and
experience for the board as a whole and for individual board members.
Such arrangements may also include processes and procedures for
recruiting board members. Proposed Sec. 234.3(a)(2)(iv)(D) requires
that the board include a majority of individuals who are not
executives, officers, or employees of the designated FMU or an
affiliate of the designated FMU; such individuals may offer different
perspectives and can help strengthen the board's decisionmaking
process.18 19
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\18\ For these purposes, ``affiliate'' means a company that
controls, or is controlled by, or is under common control with the
designated FMU. Control of a company means (a) ownership, control,
or holding with power to vote 20 percent or more of a class of
voting securities of the company; or (b) consolidation of the
company for financial report purposes.
\19\ The Board recognizes that the language on the composition
of the board of directors under Principle 2 of the PFMI is phrased
differently. Principle 2 states that the board of directors
typically requires the inclusion of non-executive board member(s).
The Board believes the intended effect of having non-executive board
members (that is, the ability to make objective decisions), is
better achieved when they represent the majority on the board of
directors.
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Proposed Sec. 234.3(a)(2)(iv)(E) requires the board to establish
policies and procedures to identify, address, and manage board member
conflicts of interest and to review the performance of the board as a
whole and of the individual members on a regular basis. Proposed Sec.
234.3(a)(2)(iv)(F) requires the board to establish a clear, documented
risk-management framework that includes the designated FMU's risk-
tolerance policy, assigns responsibilities and accountability for risk
decisions, and addresses decisionmaking in crises and emergencies.
Under proposed Sec. 234.3(a)(2)(iv)(G), governance arrangements
must be designed to ensure that the designated FMU's senior management
has the appropriate experience, skills, and integrity necessary to
discharge operational and risk-management responsibilities. For
example, the arrangements may include a process to identify and
regularly review the desired set of skills and experience for the
individual senior management positions. With respect to ensuring the
integrity of senior management, a designated FMU may establish rules of
conduct, provide ethics guides and training, and conduct background
checks.
Proposed Sec. 234.3(a)(2)(iv)(H) and (I) address the important
role that the risk-management and internal audit functions serve in a
designated FMU. A designated FMU must have governance arrangements
designed to ensure that its risk-management and internal audit
functions have sufficient authority, resources, independence, and
access to the board of directors to achieve risk-management objectives.
In addition, the reporting lines for risk management must be clear and
separate from those for other operations of the designated FMU and
there must be an additional direct reporting line to a non-executive
director on the board via a chief risk officer (or equivalent).
Further, the risk-management and internal audit functions must each be
overseen by a committee, although not necessarily the same committee,
of the board of directors. The committee responsible for advising the
board with respect to the designated FMU's risk management or for
overseeing the audit function must be chaired by a sufficiently
knowledgeable individual who is independent of the designated FMU's
senior management and be composed of a majority of members who are non-
executive members.
Finally, proposed Sec. 234.3(a)(2)(iv)(J) requires that the
designated FMU's governance arrangements be designed to ensure that
major decisions of the board of directors are clearly disclosed to
relevant stakeholders, including the designated FMU's owners,
participants, and participants' customers, and, where there is a broad
market impact, the public. Major decisions include those that would
affect the nature or overall level of risk that the designated FMU
presents to the relevant stakeholders. Information should be disclosed
to the extent that it would not risk prejudicing the security and
integrity of the FMU or its participants or divulge commercially
sensitive information, such as trade secrets or other intellectual
property.
With respect to proposed Sec. 234.3(a)(2), the Board requests
comment on the following specific questions:
Q.2.1 Should the Board specify in the rule text ``other relevant
public interest considerations'' for a specific type of or even for a
particular designated FMU?
[[Page 3672]]
Q.2.2 Should the Board set a specific minimum percentage of
individuals on the board of directors that may not be executives,
officers, or employees of the designated FMU or an affiliate of the
designated FMU? Alternatively, should the standard set any requirements
for the participation of outside directors (that is, directors who are
not participants in or management of the designated FMU)?
Q.2.3 Should the Board require specifically that the chairman of
the board of directors be (a) an individual who is not an executive,
officer, or employee of the designated FMU or an affiliate of the
designated FMU or (b) a different individual than the designated FMU's
chief executive officer?
Q.2.4 Should there be a requirement for the regular reviews of the
performance of the board of directors and its individual board members
to include periodic independent assessments?
Q.2.5 Should the designated FMU's board of directors be required to
have a committee of the board of directors that only has audit
responsibilities to which the audit function reports and a risk
committee of the board of directors that only has risk-management
responsibilities to which the risk-management function reports?
Alternatively, should the designated FMU's audit and risk-management
functions be required to report directly to the entire board of
directors?
Q.2.6 What additional guidance should the Board provide to a
designated FMU's board of directors in order to identify a ``major
decision'' that must be disclosed to relevant stakeholders under the
rule?
3. Framework for the Comprehensive Management of Risks
Proposed Sec. 234.3(a)(3) requires the designated FMU to have a
sound risk-management framework for comprehensively managing legal,
credit, liquidity, operational, general business, custody, investment,
and other risks that arise in or are borne by the designated FMU. A
comprehensive risk-management framework is a set of objectives,
policies, procedures, and systems that supports the designated FMU in
identifying risks, determining a risk-tolerance level, and managing
risks. The framework provides an overall mechanism for the designated
FMU to address the manner in which the risks, addressed individually by
the other proposed standards, relate to and interact with each other.
For example, attempts to reduce or limit one type of risk could lead to
the concentration or creation of different risks, and, although some
risks do not appear to be significant in isolation, they can become
material when combined with others. Therefore, robust risk management
involves taking an integrated and comprehensive approach to risk in
order to understand and manage effectively this interplay among
individual risks.
Proposed Sec. 234.3(a)(3)(i) requires a designated FMU to have
risk-management policies, procedures, and systems that enable it to
identify, measure, monitor, and manage risk. These policies,
procedures, and systems must address the full range of risks and, in
particular, interactions among these risks that can arise in or are
borne by the designated FMU, including those posed by other entities as
a result of interdependencies. Proposed Sec. 234.3(a)(3)(ii) requires
a designated FMU to have risk-management policies, procedures, and
systems that enable the designated FMU to identify, measure, monitor,
and manage the material risks that it poses to other entities as the
result of interdependencies. Such entities include other FMUs,
settlement banks, liquidity providers, and services providers.
Policies, procedures, and systems must also be designed for a dynamic
environment, which includes taking into account the possibility of
various economic and financial shocks that may affect the risks
presented to or arising in the designated FMU. The entire risk-
management framework, including the assumptions used and the component
frameworks established for individual risks, must be reviewed and
updated periodically to reflect changes in market conditions or the
designated FMU's operations.
Even with comprehensive risk management, however, a designated FMU
may face extreme scenarios that require extraordinary actions by the
FMU so that it can continue to provide its critical operations and
services as a going concern. The designated FMU's management of these
extreme events requires comprehensive, thoughtful planning to avoid
disrupting the markets it serves. Therefore, proposed Sec.
234.3(a)(3)(iii) requires a designated FMU to develop and maintain
recovery or orderly wind-down plans that identify the designated FMU's
critical operations and services related to payment, clearing, or
settlement; scenarios that may potentially prevent it from being able
to provide its critical operations and services as a going concern,
including scenarios involving uncovered credit losses (as described in
proposed Sec. 234.3(a)(4)(vi)(A)), uncovered liquidity shortfalls (as
described in proposed Sec. 234.3(a)(7)(viii)), and general business
losses (as described in proposed Sec. 234.3(a)(15)); and criteria that
could trigger the implementation of the recovery or orderly wind-down
plans. Proposed Sec. 234.3(a)(3)(iii) further requires the recovery or
orderly wind-down plans to include rules, procedures, policies, and any
other tools the designated FMU would use in a recovery or wind-down to
address the scenarios identified by the designated FMU; procedures to
ensure timely implementation of the plans in the scenarios identified
by the designated FMU; and procedures for informing the Board, as soon
as practicable, if the designated FMU is considering initiating the
recovery or orderly wind-down plan.
Effective plans not only address the specific actions or measures a
designated FMU would take during a recovery or orderly wind-down, but
also the ex ante determination of key individuals who are responsible
for the plan (including responsibilities for overseeing the
development, maintenance, and implementation of the plans), the
incentives that the plan creates for the designated FMU's participants
and the participants' customers, and identification of key areas of the
designated FMU that may affect (for example, organization structure,
interconnectedness and interdependencies of existing processes or
resources) or be affected by (for example, funding, liquidity, or
capital needs and resources available) the strategies planned.\20\ As
mentioned in the discussion on legal basis in proposed Sec.
234.3(a)(1), one way for the designated FMU to ensure the soundness of
its recovery and orderly wind-down strategies is to include in its
plans an analysis of the legal implications and risks involved. The
plans should be reviewed and tested, for example by carrying out
periodic simulation and scenario exercises, at least annually or
following material changes to the designated FMU's operations or risk
profile, and the designated FMU should update these
[[Page 3673]]
plans as needed following the completion of each test and review.
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\20\ See CPSS-IOSCO Recovery of Financial Market Infrastructures
consultative report at http://www.bis.org/publ/cpss109.pdf. See also
Financial Stability Board, Key Attributes of Effective Resolution
Regimes for Financial Institutions report at http://www.financialstabilityboard.org/publications/r_111104cc.pdf, and
the Board's Regulation QQ (joint rule with the FDIC) for a similar
requirement for resolution plans with respect to nonbank financial
companies supervised by the Board and bank holding companies with
consolidated assets of $50 billion or more. http://www.federalreserve.gov/bankinforeg/reglisting.htm#QQ.
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Proposed Sec. 234.3(a)(3)(iii) is a new requirement and may impose
a cost on a designated FMU with respect to the analysis, development,
and maintenance of plans for recovery or orderly wind-down. The
proposed rule, however, is intended to help a designated FMU respond to
extreme scenarios on a timely basis and may help the designated FMU
develop early indicators for these types of scenarios so they can be
avoided. Ex ante identification of, and planning for, scenarios that
could lead to failure, as well as dissemination of such information to
participants, also can increase market certainty. Ultimately, this
requirement is intended to prevent a disorderly wind-down of a
designated FMU and the resulting liquidity or credit problems to other
financial institutions or markets.
With respect to proposed Sec. 234.3(a)(3), the Board requests
comment on the following specific questions:
Q.3.1 Should an annual or longer minimum frequency be established
for the proposed ``periodic review'' of the designated FMU's
comprehensive risk-management framework? Commenters should discuss the
anticipated costs or benefits of any suggested minimum frequency.
Alternatively, should individual minimum frequencies be established for
each particular designated FMU, given the design or type of designated
FMU?
4. Credit Risk
Proposed Sec. 234.3(a)(4) requires a designated FMU to measure,
monitor, and manage effectively its credit risk to its participants and
those arising from its payment, clearing, and settlement processes.
Credit risk arises when a counterparty such as a participant,
settlement bank, custodian, or other FMU, is unable to meet fully its
financial obligations when due or at any time in the future.\21\ A
default by one or more of a designated FMU's participants could prevent
the designated FMU from meeting financial obligations to its other
participants, consequently causing the other participants to fail to
meet their other financial obligations when due. The failure of a
designated FMU to manage appropriately its credit risks, therefore, has
the potential to increase systemic risk throughout the broader
financial system and thus threaten financial stability. To mitigate the
risk of such a systemic impact, a designated FMU must manage its credit
exposures to its participants and the credit risks arising from its
payment, clearing, and settlement processes.
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\21\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(3) and (5) for payment systems,
Sec. 234.4(a)(15) for central securities depositories, and Sec.
234.4(a)(16) and (18) for central counterparties. The current
standards bundle the management of credit and liquidity risks.
Separating credit risk and liquidity risk recognizes that there are
different tools that could be used to identify, monitor, and manage
these two distinct risks.
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Under proposed Sec. 234.3(a)(4), a designated FMU must establish a
comprehensive framework to manage its credit exposures to its
participants and any other exposures arising from its payment,
clearing, and settlement processes. This framework should allow the
designated FMU to identify sources of credit risk, measure and monitor
its credit exposures, and use appropriate risk-management tools to
control the risks generated by such exposures. Credit exposure can be
separated into two measurable components: Current exposure and
potential future exposure.\22\ Current exposure is relatively
straightforward to measure and monitor, while potential future exposure
typically requires modeling and estimation. For example, a designated
FMU that operates a payment system would face current exposure when it
extends intraday credit to its participants and potential future
exposure if the value of any collateral that participants provide to
secure the intraday credit falls below the amount of the credit
extended.\23\
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\22\ Current exposure is the larger of zero or the market value
(replacement cost) of a transaction or portfolio of transactions
within a netting set with a counterparty that would be lost upon the
default of the counterparty. Potential future exposure is the
maximum exposure estimated to occur at a future point in time at a
high level of statistical confidence.
\23\ Proposed Sec. 234.3(a)(5) provides additional requirements
relating to collateral.
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Under proposed Sec. 234.3(a)(4), a designated FMU also must
maintain sufficient financial resources to cover its credit exposure to
each participant fully with a high degree of confidence.\24\ The Board
acknowledges that a designated FMU cannot be completely certain that it
is covering its credit exposure to each participant fully, because
measuring potential future exposure likely requires modeling and
estimation. Therefore, although the designated FMU's current exposures
must be covered fully, its potential future exposures must be covered
fully with a high degree of confidence. In the case of a designated FMU
that operates as a central counterparty, ``high degree of confidence''
means establishing initial margin requirements that, at a minimum, meet
a single-tailed confidence level of at least 99 percent of the
estimated distribution of future exposure.
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\24\ In a case in which a designated FMU operates a payment
system or a securities settlement system, financial resources would
include collateral and other equivalent financial resources, as
described in proposed Sec. 234.3(a)(5) on collateral. In the case
where a designated FMU operates as a central counterparty, financial
resources would include margin and other prefunded financial
resources, as described in proposed Sec. 234.3(a)(5) and (6) on
collateral and margin, respectively.
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Additional prefunded financial resources. Proposed Sec.
234.3(a)(4)(i) and (ii) require a designated FMU that operates as a
central counterparty to maintain additional prefunded financial
resources to cover a portion of the residual risk (or tail risk) of
disruptions that could occur in extreme but plausible market
conditions, which could cause a central counterparty's losses to exceed
the margin posted if a participant defaulted.\25\ Specifically,
proposed Sec. 234.3(a)(4)(i) requires a designated FMU that operates
as a central counterparty to maintain additional prefunded resources
sufficient to cover its credit exposure under a wide range of
significantly different stress scenarios, including the default of the
participant and its affiliates that would potentially cause the largest
aggregate credit exposure net of any applicable margin to the central
counterparty in extreme but plausible market conditions (a ``Cover
One'' requirement).
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\25\ Proposed Sec. 234.3(a)(4)(iv) prohibits a designated FMU
that is a central counterparty from counting assessment powers for
additional default or guaranty fund contributions (i.e., default or
guaranty fund contributions that are not prefunded) in its
calculation of financial resources available to meet the total
financial resource requirement to cover its credit exposures.
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Alternatively, under proposed Sec. 234.3(a)(4)(ii), the central
counterparty may instead be directed by the Board to maintain
additional prefunded financial resources that are sufficient to cover
its credit exposure under a wide range of significantly different
stress scenarios, including the default of the two participants and
their affiliates that would potentially cause the largest aggregate
credit exposure net of any applicable margin to the central
counterparty in extreme but plausible market conditions (a ``Cover
Two'' requirement). Under the proposal, the Board may require a central
counterparty to meet the Cover Two requirement when that central
counterparty is involved in activities with a more-complex risk profile
(such as clearing products with discrete jump-to-default risks or that
are highly correlated with potential participant defaults) or is
determined by another
[[Page 3674]]
jurisdiction to be systemically important in that jurisdiction.
Stress testing. Stress testing is a critical component of a
designated FMU's financial risk-management framework. Under proposed
Sec. 234.3(a)(4)(iii), a designated FMU that is a central counterparty
must determine the amount and regularly test the sufficiency of its
total financial resources in the event of a participant default or
multiple participant defaults in extreme but plausible market
conditions through stress testing. Under the proposal, a designated FMU
must, (A) on a daily basis, conduct a stress test of its total
financial resources using standard and predetermined stress scenarios,
parameters, and assumptions; (B) on at least a monthly basis, and more
frequently when the products cleared or markets served experience high
volatility or become less liquid, or when the size or concentration of
positions held by the central counterparty's participants increases
significantly, conduct a comprehensive and thorough analysis of the
existing stress scenarios, models, and underlying parameters and
assumptions such that the designated FMU meets its required level of
default protection in light of current and evolving market conditions;
and (C) have clear procedures to report the results of its stress tests
to decisionmakers at the central counterparty and use these results to
evaluate the adequacy of and adjust, if necessary, its total financial
resources.
Stress testing helps ensure that the designated FMU has sufficient
total financial resources under current and evolving market conditions.
When conducting stress tests, a designated FMU should use a wide range
of significantly different stress scenarios in terms of both
defaulters' positions and possible price changes in liquidation
periods, including, at a minimum, relevant peak historic price
volatilities, shifts in other market factors, such as price
determinants and yield curves, multiple defaults over various time
horizons, simultaneous pressures in funding and asset markets, and a
range of forward-looking stress scenarios in a variety of extreme but
plausible market conditions. The results of these stress tests inform
the decisionmakers such as the board of directors or the appropriate
committee of the board within the organization, who must use the
results to evaluate the adequacy of and adjust its total financial
resources. Clearly established and documented procedures allow for
these results to be reported to the appropriate parties for prompt
action and contribute to the overall effectiveness of using stress
testing as a risk-management tool.
Model validation. Under proposed Sec. 234.3(a)(4)(v), a designated
FMU must validate its risk-management models used to determine the
sufficiency of its total financial resources at least annually.\26\ A
validation should be comprehensive, addressing the justification of the
approach and assumptions underlying the model, the calibration of
critical parameters and other model settings, and the reliability of
the model and programming. Model validation can either be undertaken by
outside experts or by internal staff with the necessary expertise. In
either case, the validator must be a qualified person who does not
perform functions associated with the model (except as part of the
annual model validation), does not report to such a person, and does
not have a financial interest in whether the model is determined to be
valid.
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\26\ This validation must include validation of models the
designated FMU uses to comply with the collateral provisions under
proposed Sec. 234.3(a)(5) and to determine initial margin under
proposed Sec. 234.3(a)(6). It should also include validation of
models the designated FMU uses to size its total financial resources
and to conduct any other material risk-management functions.
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Proposed Sec. 234.3(a)(4)(iii) through (v) contain two new
requirements to Regulation HH related to the frequency of stress
testing conducted by designated FMUs that are central counterparties
and to model validation by all designated FMUs that face credit risk.
Broadly, stress testing and validation of credit risk management models
are consistent with past Board supervisory practice. The proposed rule,
however, establishes minimum frequencies for such stress testing and
model validation. The daily and monthly stress testing requirements
help to promote robust management of credit risk by increasing the
availability of stress testing data available to a central counterparty
to assess its financial resources and the performance of its models.
The annual model validation requirement also promotes robust credit
risk management by ensuring the designated FMU's risk-management models
continue to reflect current economic and financial conditions, in part
by allowing the FMU to both uncover and track any limitations to its
models.
Rules and procedures to address uncovered credit losses. In certain
extreme circumstances, the post-liquidation value of the collateral and
other financial resources held by a designated FMU to fulfill its
credit-risk requirement may not be sufficient to cover fully realized
credit losses. A designated FMU must make plans for responding to such
a shortfall. Proposed Sec. 234.3(a)(4)(vi) requires the designated FMU
to establish rules and procedures that explicitly address how
potentially uncovered credit losses would be allocated, including how
the designated FMU would repay any funds it may borrow from liquidity
providers. This proposed provision represents an enhancement of
existing expectations. The proposed rule also requires the designated
FMU to establish rules and procedures that explicitly describe how the
designated FMU plans to replenish any financial resources it may use
during a stress event, including a participant default, so that it may
continue to operate in a safe and sound manner. This proposed provision
represents a new requirement.
Proposed Sec. 234.3(a)(4)(vi) contains an enhanced requirement
that designated FMUs have rules and procedures that explicitly address
how potentially uncovered credit losses would be allocated, including
repayment of any funds a designated FMU might borrow from liquidity
providers, and a new requirement that designated FMUs have rules and
procedures that address the FMU's process to replenish any financial
resources that the FMU might employ in a stress event. This requires a
designated FMU to plan for and be transparent with respect to its
procedures for extreme credit events. It is also a critical step in the
designated FMU's process for developing its recovery or orderly wind-
down plans, as described in proposed Sec. 234.3(a)(3)(iii).
The process of planning for extreme events such as uncovered credit
losses helps prepare the designated FMU for managing these events,
thereby reducing the likelihood that the designated FMU will fail to
settle its obligations. Planning for replenishment of financial
resources increases the likelihood that the designated FMU will be able
to continue to operate after an extreme credit event occurs. The
transparency of the designated FMU's rules and procedures will also
help participants plan and prepare for such an event.
With respect to proposed Sec. 234.3(a)(4), the Board requests
comment on the following specific question:
Q.4.1 In considering whether to apply a Cover Two requirement for a
central counterparty, should the Board consider factors other than
whether the central counterparty is involved in activities with a more-
complex risk profile and whether the central counterparty is determined
by another jurisdiction to be systemically important
[[Page 3675]]
in that jurisdiction? Should the approach used to make the
determination by another jurisdiction that a designated FMU is
systemically important in that jurisdiction be similar to the approach
used by the Council in order for the determination to be a factor in
the Board's consideration of whether to impose a Cover Two requirement?
5. Collateral
Proposed Sec. 234.3(a)(5) requires a designated FMU that uses
collateral to manage its or its participants' credit exposure to accept
collateral with low credit, liquidity, and market risks and set and
enforce appropriately conservative haircuts and concentration limits,
in order to achieve a high degree of confidence in the adequacy of the
value of the collateral in the event of liquidation and that the
collateral can be used in a timely manner.\27\ Collateralizing credit
exposures protects an FMU against potential losses in the event of a
participant default because the FMU can liquidate the defaulting
participant's collateral to cover the losses. A designated FMU
requiring its participants to post collateral may also encourage these
participants to manage the risks that they may pose to the FMU and
other participants to avoid losing their collateral.
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\27\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(5) for payment systems, Sec.
234.4(a)(15) for central securities depositories, and Sec.
234.4(a)(17) for central counterparties.
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Collateral with low credit, liquidity, and market risks protects
the FMU during stressed market conditions, when both a default may
become more likely and collateral quality may deteriorate. A designated
FMU must generally limit the assets it routinely accepts as collateral
to those with low credit, liquidity, and market risks, such as currency
and government securities issued by the United States, or other highly
marketable collateral, including high quality, liquid, general
obligations of another sovereign nation, in order to be confident of
the collateral's value and the FMU's ability to access and use that
collateral in the event of a participant default, especially during
stressed market conditions.
A designated FMU applies haircuts to collateral it collects in
order to protect itself from losses resulting from declines in the
market value of the asset posted in the event that the collateral taker
needs to liquidate that collateral. Haircuts represent a risk control
measure and are estimated to be the possible percentage decrease in
liquidation value from the current market value until the designated
FMU can liquidate the collateral. A precursor to ensuring the haircuts
applied are appropriate, therefore, includes assigning an accurate
current value to the collateral accepted, which depends on prudent
practices for valuation, including marking collateral to market on a
daily basis.
Proposed Sec. 234.3(a)(5)(i) through (iii) establish requirements
related to a designated FMU's collateral practices and specifically, on
haircut procedures. Proposed Sec. 234.3(a)(5)(i) requires a designated
FMU that accepts collateral to establish prudent valuation practices
and develop haircuts that are tested regularly and take into account
stressed market conditions. Further, proposed Sec. 234.3(a)(5)(ii)
requires the designated FMU to establish stable and conservative
haircuts that reflect relevant periods of stressed market conditions to
reduce the need for procyclical adjustments. In a stressed market, a
designated FMU may require the posting of additional collateral both
because of the decline of asset prices and because of an increase in
haircut levels. Such actions could exacerbate market stress and
contribute to driving asset prices down further and result in
additional collateral requirements. This cycle could exert further
downward pressure on asset prices. Calibrating haircuts to incorporate
stressed market conditions is, therefore, essential to help mitigate
the need for a designated FMU either to require large amounts of
additional collateral, or to significantly increase the size of the
haircut to address declining asset prices. Proposed Sec.
234.3(a)(5)(iii) requires a designated FMU to validate annually its
haircut procedures, as part of its risk-management model validation
under proposed Sec. 234.3(a)(4)(v).
Proposed Sec. 234.3(a)(5)(iv) requires a designated FMU to avoid
concentrated holdings of certain assets where it could significantly
impair the ability to liquidate such assets quickly without significant
adverse price effects. One way of avoiding concentrated holdings is
through the establishment of concentration limits that restrict
participants' ability to provide more than a specified amount or
percentage of a specific asset as collateral. Imposing concentration
charges on participants that maintain holdings beyond this limit may
help the designated FMU create disincentives for such concentrations.
Whether concentration limits are needed will depend, in part, on the
assets accepted as collateral.
Proposed Sec. 234.3(a)(5)(v) requires that a designated FMU use a
collateral management system that is well-designed and operationally
flexible. Among other things, the collateral management system must
accommodate changes in the ongoing monitoring and management of
collateral. It should also allow for the timely valuation of collateral
and execution of any collateral or margin calls. The designated FMU
should allocate sufficient resources to its collateral management
system to ensure an appropriate level of operational performance,
efficiency, and effectiveness.
6. Margin
Proposed Sec. 234.3(a)(6) requires a designated FMU that operates
as a central counterparty to cover its credit exposures to its
participants for all products by establishing a risk-based margin
system.\28\ Margin is the collateral that a central counterparty
collects in order to help manage and mitigate the credit exposures
posed by its participants' open positions. It is one of the core tools
a central counterparty uses to manage its credit exposures. Margin
systems typically differentiate between initial margin, which covers
potential future exposure over the appropriate close-out period in the
event of a default, and variation margin, which a central counterparty
collects and pays out to reflect changes in current exposures resulting
from realized changes in market prices.
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\28\ The proposed standard replaces and builds on Sec.
234.4(a)(17) under current Regulation HH.
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Collecting sufficient margin protects the central counterparty and
its non-defaulting participants against potential losses in the event
of a participant default because the central counterparty can apply the
defaulting participant's margin to cover the defaulter's obligations
and any resulting losses. To promote robust risk management, therefore,
a designated FMU that operates as a central counterparty must establish
a margin system that is risk-based and reviewed regularly to ensure
sufficient margin is collected. When designing and establishing an
effective margin system, a designated FMU should consider the
underlying concept and methodology; the attributes of each product,
portfolio, and market the designated FMU serves; the availability and
use of price data; the calculation of variation and initial margin; the
operational capacity to make margin calls; and appropriate parameters
and assumptions. The Board proposes the following provisions to address
these aspects of margin systems.
Under proposed Sec. 234.3(a)(6)(i), a designated FMU that operates
as a central counterparty is required to
[[Page 3676]]
establish a risk-based margin system that is conceptually and
methodologically sound for the risks and particular attributes of each
product, portfolio, and markets it serves, as demonstrated by
documented and empirical evidence supporting the margin model's design
choices, methods used, variables selected, theoretical bases, key
assumptions, and limitations. These elements are important for
demonstrating the quality of the model, including showing whether
judgment exercised in its design and construction is well-informed and
carefully considered. Under proposed Sec. 234.3(a)(6)(ii), the margin
levels applied by the central counterparty must be commensurate with
the risks and particular attributes of each product, portfolio, and
markets it serves, including taking into account the complexity of the
underlying instruments.
Proposed Sec. 234.3(a)(6)(iii) and (iv) establish requirements
related to a central counterparty's price data for purposes of its
margin system. First, a central counterparty's margin system must be
based on a reliable source of timely price data for the central
counterparty to cover sufficiently its credit exposures to its
participants. A central counterparty must use high-quality price data
from continuous, transparent, and liquid markets where available. When
such high-quality price data is unavailable, a central counterparty
must acquire pricing data from other sources. A central counterparty
should evaluate developing its own pricing process and obtaining third-
party pricing services. In either case, the designated FMU must
continually evaluate the data's reliability and accuracy.
Under proposed Sec. 234.3(a)(6)(v), a central counterparty's
margin system must mark participant positions to market and collect
variation margin at least daily and have the operational capacity to
make intraday margin calls and payouts, both scheduled and unscheduled,
to participants. A central counterparty must collect variation margin
at least daily (and, when appropriate, intraday) to prevent the
accumulation of current exposures and mitigate potential future
exposures.
Proposed Sec. 234.3(a)(6)(vi), a central counterparty's system
must also be able to generate initial margin requirements sufficient to
cover potential changes in the value of future exposure to each
participant's position during the interval between the last variation
margin collection and the close out of positions following a
participant default. In particular, the margin system must (A) ensure
that initial margin meets an established single-tailed confidence level
of at least 99 percent with respect to the estimated distribution of
future exposure; and (B) use a conservative estimate of the time
horizons for the effective hedging or close out of the particular types
of products cleared by the central counterparty, including in stressed
market conditions.
A key assumption of effective margin models is the close-out
period, which is an estimate of how long it would take the designated
FMU to liquidate or completely hedge the market risk of one or more
participants' portfolios. For purposes of the proposed rule, an
appropriate close-out period conservatively reflects market liquidity
under stressed market conditions for each product that the central
counterparty clears. A central counterparty must document the close-out
periods and related analysis for each product type that it clears.
A designated FMU's margin model is also dependent on a number of
other model parameters and assumptions, which may include the selection
of an appropriate sample period of historical data to use in
establishing its initial margin model for each product that it clears.
For these purposes, an appropriate sample period is long enough to
provide an accurate representation of historical price movements, while
also being sensitive to recent price and volatility levels.
Additionally, an effective margin system eliminates the potential for
specific wrong-way risk, which occurs when the default of a participant
is highly correlated with a decrease in value of the participant's
cleared portfolio. An example of specific wrong-way risk is when a
participant sells single-name credit-default swap protection on debt
issued in its own name or on the names of any affiliates.
A central counterparty must also seek to avoid application of its
margin arrangement in a manner that could exacerbate or cause financial
instability. For example, in a period of rising credit risk, if the
central counterparty requires initial margin in excess of the amount
determined by the margin model, it may add to the market stress and
volatility. In general, margin requirements should be, to the extent
possible, designed to be forward-looking, stable, and conservative that
are specifically designed to limit the need for destabilizing,
procyclical changes. To support this objective, a central counterparty
could consider increasing the size of its prefunded default
arrangements to limit the need and likelihood of large or unexpected
margin calls in times of market stress.
Under proposed Sec. 234.3(a)(6)(vii), the designated FMU must
monitor on an ongoing basis and regularly review, test, and verify its
margin system. Specifically, the designated FMU must conduct daily
backtests and monthly sensitivity analyses, performed more frequently
during stressed market conditions or significant fluctuations in
participant positions. Further, the central counterparty must also
provide for annual validation of its margin models and related
parameters and assumptions, as part of its risk-management model
validation under proposed Sec. 234.3(a)(4)(v).
The Board expects backtests to incorporate only the portions of the
margin model that are reflected in the available historical data. For
example, a central counterparty might add an additional concentration
charge to reflect the difficulty in unwinding a large position, but
because historical price data may not incorporate large concentrated
positions, the charge should not be included in the backtesting
analysis. Separate analyses would need to be conducted to determine the
adequacy of concentration charges. For systems whose initial margin
covers multiple days, the worst observed price move within the period
should be used in backtesting. Backtesting, however, only evaluates the
performance of the margin model on the historical sample chosen, it
does not guarantee that a model will perform well going forward.
Sensitivity analyses study how variability in the output of the
margin model can be influenced by the variability and other aspects of
its inputs. It tests the robustness of the margin model and potentially
uncovers errors or limits of the model. Sensitivity analysis should
incorporate a wide range of input parameters and, where feasible, vary
assumptions to reflect various possible market conditions, including
the most-volatile periods that have been experienced by the markets
served and extreme changes in the correlations between prices and other
factors.
Effective backtesting and sensitivity analysis may use both
historical data from realized stressed market conditions and
hypothetical data for unrealized stressed market conditions. Further,
the Board expects the sensitivity analysis to be performed on both
actual and simulated positions and portfolios. The analysis would help
a central counterparty understand how the level of margin coverage
might be affected by highly stressed market conditions.
[[Page 3677]]
Sensitivity analysis can also be used to determine the impact of
varying important model parameters, such as the sample period, the
close-out period, and a confidence interval.
Proposed Sec. 234.3(a)(6) includes three enhanced requirements
relative to the current corresponding standard under Regulation HH.
First, the proposal increases frequency of backtesting from quarterly
to daily. Second, the proposed provision includes an express
requirement to perform sensitivity analysis. Third, the proposal
increases the frequency of the analysis from quarterly to at least
monthly. The Board believes these enhanced requirements will help to
ensure that the designated FMU has sufficient financial resources to
cover its credit exposures to its participants with a high degree of
confidence in current and stressed market conditions. Effective
management of credit risk will allow the designated FMU to continue
operating normally during periods of market stress and prevent the
spread of credit losses to its participants, the market it serves, and
the financial system more broadly.
7. Liquidity Risk
Proposed Sec. 234.3(a)(7) requires a designated FMU to effectively
measure, monitor, and manage the liquidity risk that arises in or is
borne by the designated FMU.\29\ Liquidity risk is intended to be a
broad concept covering different designs for payment and settlement
arrangements. Liquidity risk arises in a designated FMU when it, its
participants, or other entities (such as settlement banks, nostro
agents, and liquidity providers) cannot settle their payment
obligations when due as part of the clearing or settlement process. It
is important for a designated FMU to manage carefully its liquidity
risk so that it can meet its payment obligations and complete
settlement when due. If the designated FMU has insufficient liquid
resources to meet its payment obligations and complete settlement when
due, the other participants may not receive funds they are relying upon
to meet their own obligations. As a consequence, the liquidity
shortfalls and pressure could be transmitted to these participants and
quickly give rise to broad liquidity dislocations and systemic risk.
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\29\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(3) and (5) for payment systems,
Sec. 234.4(a)(15) for central securities depositories, and Sec.
234.4(a)(18) for central counterparties. The current standards
bundle the management of credit and liquidity risks. Separating
credit risk and liquidity risk recognizes that there are different
tools that could be used to identify, monitor, and manage these two
distinct risks.
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Under proposed Sec. 234.3(a)(7)(i), a designated FMU must have
effective operational and analytical tools to identify, measure, and
monitor its settlement and funding flows on an ongoing and timely
basis, including its use of intraday liquidity. Effective measuring and
monitoring of liquidity risk involves understanding and assessing the
value and concentration of a designated FMU's daily settlement and
funding flows through its settlement banks, nostro agents, and other
intermediaries. Further, a designated FMU must be able to monitor on a
daily basis the level of any liquid assets that it holds and determine
the value of liquid assets that is available for use. If a designated
FMU maintains committed funding arrangements, it must similarly
identify, measure, and monitor its liquidity risk from the liquidity
providers of the arrangements.
Sufficient liquid resources. Under proposed Sec. 234.3(a)(7)(ii),
a designated FMU must maintain sufficient liquid resources in all
relevant currencies to effect same-day and, as applicable, intraday and
multiday settlement of payment obligations with a high degree of
confidence under a wide range of significantly different potential
stress scenarios. These scenarios must include the default of the
participant and its affiliates that would generate the largest
aggregate liquidity obligation for the designated FMU in extreme but
plausible market conditions. A designated FMU that operates as a
central counterparty and that is subject to proposed Sec.
234.3(a)(4)(ii) should consider scenarios that include the default of
the two participants and their affiliates that would generate the
largest aggregate liquidity obligation for the designated FMU in
extreme but plausible market conditions.
For purposes of meeting this liquid resource requirement, proposed
Sec. 234.3(a)(7)(iii) requires the designated FMU to maintain these
liquid resources in cash in each relevant currency at the central bank
of issue or at creditworthy commercial banks, or in assets that are
readily available and convertible into cash through committed
arrangements without material adverse change conditions. These
committed arrangements include, but are not limited to, collateralized
lines of credit, foreign exchange swaps, and repurchase agreements.
Proposed Sec. 234.3(a)(7)(iii) requires these arrangements to be
committed in order to ensure that the resources are highly reliable
even in extreme but plausible market conditions.\30\
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\30\ The Board recognizes that the language on qualifying liquid
resources under Principle 7 of PFMI is phrased differently.
Principle 7 requires qualifying liquid resources to be, among other
things, highly marketable collateral held in custody and investments
that are readily available and convertible into cash with
``prearranged and highly reliable'' funding arrangements. For many
years, the Board has expected FMUs under its authority to maintain
cash or committed arrangements for converting non-cash assets into
cash to meet the minimum liquidity resource requirement. The Board
believes that, in order for arrangements to be ``highly reliable,''
they must be ``prearranged and committed.'' The legal enforceability
of committed arrangements helps to ensure obligations are fulfilled
even in extreme but plausible market conditions. Supplemental
resources beyond amounts needed to meet proposed the minimum liquid
source requirement in Sec. 234.3(a)(7) may not need to be obtained
on a committed basis.
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Proposed Sec. 234.3(a)(7)(iv) and (v) require a designated FMU to
evaluate and confirm, at least annually, whether each provider of the
committed arrangements as described in proposed Sec. 234.3(a)(7)(iii)
has sufficient information to understand and manage that provider's
associated liquidity risks, and that the provider has the capacity to
perform as required under this commitment. Effective liquidity risk
management involves ensuring that the designated FMU is operationally
ready to handle liquidity pressures caused by participants' or other
entities' financial or operational problems. For example, the
designated FMU should have the operational capacity to reroute payments
on a timely basis in case problems arise with a correspondent bank. A
designated FMU therefore must conduct rigorous due diligence to ensure
that each of its liquidity providers has the understanding and capacity
to perform as expected. As part of rigorous due diligence, a designated
FMU also must test at least annually its procedures and operational
capacity for accessing each type of liquid resource required under this
standard. A designated FMU may also employ other risk-management tools
to manage its or its participants' liquidity risk, which can vary
depending on the source of liquidity risk (such as a participant
default, the late-day submission of payments or other transactions, or
the use of a service provider or a linked FMU).
Stress testing of liquid resources. Under proposed Sec.
234.3(a)(7)(vi), a designated FMU must determine the amount and
regularly test the sufficiency of its potential liquidity needs and the
value of its liquid resources by, (A) on a daily basis, conducting a
stress test of its liquid resources using standard and predetermined
stress scenarios,
[[Page 3678]]
parameters, and assumptions; (B) on at least a monthly basis, and more
frequently when products cleared or markets served experience high
volatility or become less liquid, or when the size or concentration of
positions held by the designated FMU's participants increases
significantly, conducting a comprehensive and thorough analysis of the
existing stress-testing scenarios, models, and underlying parameters
and assumptions such that the designated FMU meets its identified level
of liquidity needs and resources in light of current and evolving
market conditions; and (C) having clear procedures to report the
results of its stress tests to decisionmakers at the designated FMU and
using these results to evaluate the sufficiency of and to adjust its
liquidity risk-management framework.
In conducting stress testing, the designated FMU must consider a
wide range of significantly different potential scenarios. These
scenarios include relevant peak historic price volatilities, shifts in
other market factors such as price determinants and yield curves,
multiple defaults over various time horizons, simultaneous pressures in
funding and asset markets, and a spectrum of forward-looking stress
scenarios in a variety of extreme but plausible market conditions.
Scenarios also include disruptions to the design and operation of the
designated FMU, including disruptions caused by all entities that might
present material liquidity risks to the FMU, and where appropriate,
cover a multiday period. A designated FMU also must consider any strong
inter-linkages or similar exposures among its participants, as well as
the multiple roles that participants may play with respect to risk
management of the designated FMU. Also, liquidity stress test scenarios
must consider the probability of multiple failures and the contagion
effect among its participants that such failures may cause.
Model validation. Under proposed Sec. 234.3(a)(7)(vii), a
designated FMU must validate any models used in its liquidity risk-
management at least annually. The validation should be comprehensive,
addressing the justification of the approach and assumptions underlying
the model, the calibration of critical parameters and other model
settings, and the reliability of the model and programming. Model
validation can either be undertaken by outside experts or by using
internal staff with the necessary expertise. In either case, the
validator must be a qualified person who does not perform functions
associated with the model (except as part of the annual model
valuation), does not report to such a person, and does not have a
financial interest in whether the model is determined to be valid. An
annual validation of the model is important to provide a high degree of
confidence that the designated FMU is using an appropriate liquidity
risk-management framework to determine the amount and test the
sufficiency of the designated FMU's liquid resources.
Rules and procedures to address shortfalls. In certain extreme
circumstances, a designated FMU may not have sufficient liquid
resources to cover its obligations. A designated FMU must analyze the
possibility of these circumstances and plan for steps it would take in
response to such a liquidity shortfall. Under proposed Sec.
234.3(a)(7)(viii), a designated FMU must establish explicit rules and
procedures that address potential liquidity shortfalls that would not
be covered by the designated FMU's liquid resources and avoid
unwinding, revoking, or delaying the same-day settlement of payment
obligations, including in the event of one or more participant
defaults. Proposed Sec. 234.3(a)(7)(viii) also requires a designated
FMU to describe in its rules and procedures its process to replenish
any liquid resources that the designated FMU may employ during a stress
event, including a participant default, so that it can continue to
operate in a safe and sound manner.
The proposed standard contains two new requirements for designated
FMUs. First, proposed Sec. 234.3(a)(7)(vi) and (vii) with respect to
liquidity stress testing and model validation are new. These
requirements are necessary to ensure that the appropriate data
regarding liquidity flows and potential liquidity pressures is
available to the designated FMU. Increased availability of data will
allow an FMU to identify and respond more quickly to liquidity
pressures and prevent them from disrupting the operations of the FMU
and possibly spreading to the FMU's participants and the financial
markets more broadly.
Second, proposed Sec. 234.3(a)(7)(viii) includes a new requirement
above the existing standards that requires rules and procedures that
explicitly address unforeseen and potentially uncovered liquidity
shortfalls and that describe the designated FMU's process to replenish
any liquid resources it may employ during a stress event. The process
of planning for uncovered liquidity shortfalls helps prepare the FMU to
manage such an event, thereby reducing the likelihood that the FMU and
its participants will fail to meet payment and settlement obligations
as expected. The process of preparing for replenishment of resources
increases the likelihood that an FMU will be able to continue to
operate after an extreme liquidity event occurs and continue to provide
its critical operations and services to the markets it serves. The
transparency of the FMU's rules and procedures will also help the FMU's
participants plan and prepare for such an event.
With respect to proposed Sec. 234.3(a)(7), the Board requests
comment on the following specific question:
Q.7.1 Should the Board establish a requirement for designated FMUs
that are subject to the Cover Two credit exposure requirement under
proposed Sec. 234.3(a)(4)(ii) to also undertake an analysis at least
once a year to evaluate the feasibility of maintaining sufficient
liquid resources for the default of the two participants and their
affiliates that would generate the largest aggregate liquidity
obligation for the designated FMUs in extreme but plausible market
conditions?
8. Settlement Finality
Proposed Sec. 234.3(a)(8) requires a designated FMU to provide
clear and certain final settlement intraday or in real time, as
appropriate, and at a minimum, by the end of the value date.\31\ The
proposed rule addresses settlement risk, which is the risk that
settlement will not take place as expected. For these purposes, final
settlement is the moment when the transfer of an asset or financial
instrument or discharge of an obligation by a designated FMU or its
participants becomes legally irrevocable and unconditional. Final
settlement by the end of the value date (that is, the day on which the
payment, transfer instruction, or other obligation is due and the
associated funds and securities are typically available to the
receiving participant) is important because deferring settlement can
create credit and liquidity risks for the FMU and its participants. The
potential for these additional risks to arise increases the likelihood
that a deferred or revocable settlement at a single designated FMU can
cause systemic risk and threaten the stability of the broader financial
system. Clear and certain final settlement by the end of the value date
is therefore necessary for robust risk management and helps to promote
the safety and
[[Page 3679]]
soundness of the designated FMU, reduce systemic risk, and support the
stability of the broader financial system.
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\31\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(4) for payment systems, Sec.
234.4(a)(11) for central securities depositories and central
counterparties.
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Under the proposed rule, a designated FMU's payment, clearing, and
settlement processes must provide final settlement no later than the
end of the value date. Where appropriate, a designated FMU must provide
intraday or real-time settlement to reduce settlement risk. Intraday or
real-time finality may be appropriate, for example, for payments
operations, settlement of back-to-back transactions, intraday margin
calls by central counterparties, or safe and efficient cross-border
links between central securities depositories that perform settlement
functions. The proposed rule also requires a designated FMU to clearly
define in its rules and procedures a cutoff point, after which settled
payments, transfer instructions, or other settlement instructions may
not be revoked by a participant. A clearly defined cutoff point
contributes to the overall certainty that a payment will be settled and
helps participants manage their liquidity risks.\32\
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\32\ Ensuring the consistency and enforceability of a designated
FMU's settlement finality rules consistent with relevant laws and
regulations is a component of the broader requirement to have a
well-founded and enforceable legal basis for each material aspect of
the designated FMU's activities under proposed Sec. 234.3(a)(1).
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9. Money Settlements
Proposed Sec. 234.3(a)(9) requires a designated FMU to address the
settlement risk that arises when it conducts its money settlements.\33\
A designated FMU conducts money settlements for a variety of purposes,
such as the settlement of various financial instruments or contracts,
funding and defunding activities, and the distribution and collection
of margin payments. Money settlements may be conducted in one or more
currencies. In general, a designated FMU can conduct settlements in
central bank money or in commercial bank money. Central bank money is a
liability of a central bank, in the form of deposits held at the
central bank that can be used for money settlement purposes. Commercial
bank money is a liability of a commercial bank in the form of deposits
held at the commercial bank.
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\33\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(6) for payment systems, Sec.
234.4(a)(5) for central securities depositories and central
counterparties.
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A designated FMU and its participants may face credit and liquidity
risks from money settlements. Credit risk may arise when a settlement
bank has the potential to default on its obligations. Liquidity risk
may arise if, after a payment obligation has been settled, participants
or the designated FMU are unable to transfer readily their assets at
the settlement bank to obtain other liquid assets, such as claims on a
central bank. These potential credit and liquidity risks that arise
from the money settlement process increase the chances that a single
designated FMU would create systemic risk, which may threaten the
stability of the broader financial system. To promote risk management,
therefore, a designated FMU should manage and mitigate, to the greatest
extent practicable, the risks that arise in conducting money
settlements.
Under the proposed rule, a designated FMU must conduct its money
settlements in central bank money, where available and practical, in
order to mitigate the credit and liquidity risks that arise from money
settlements. Central bank money, however, may not always be available
for use. For example, a designated FMU or its participants may not have
direct access to relevant central bank accounts and payment services.
In addition, in some cases, settlement in central bank money may not
always be practical. For example, an FMU that has access to the
relevant central bank accounts and services may find that a central
bank's payment services may not operate or provide the necessary
finality at the times when it needs to conduct money settlements. In
such cases, a designated FMU may conduct money settlements at a
commercial bank or on its own books and would need to minimize and
strictly control the credit and liquidity risks arising from the money
settlement arrangement used.
Proposed Sec. 234.3(a)(9)(i) through (iii) apply specifically to
designated FMUs that conduct money settlements at a commercial bank.
Under proposed Sec. 234.3(a)(9)(i), such a designated FMU must
establish and monitor adherence to criteria based on high standards for
its settlement banks that take account of, among other things, the
commercial bank's applicable regulatory and supervisory frameworks,
creditworthiness, capitalization, access to liquidity, and operational
reliability. Further steps to limit credit and liquidity exposures
include using multiple commercial settlement banks to diversify the
risk of a commercial settlement bank failure. Under proposed Sec.
234.3(a)(9)(ii), a designated FMU using multiple commercial settlement
banks must monitor and manage the concentration of credit and liquidity
exposures to its commercial settlement banks and assess its potential
losses and liquidity exposures as well as those of its participants in
the event that the commercial settlement bank with the largest share of
activity were to fail. Finally, under proposed Sec. 234.3(a)(9)(iii),
a designated FMU must ensure that its legal agreements with its
settlement banks state clearly when transfers on the books of
individual settlement banks are expected to occur, that transfers are
final when funds are credited to the recipient's account, and that
funds credited to the recipient are available immediately for
withdrawal.
10. Physical Deliveries
Proposed Sec. 234.3(a)(10) requires a designated FMU that operates
as a central counterparty, securities settlement system, or central
securities depository to clearly state its obligations with respect to
the delivery of physical instruments or commodities and identify,
monitor, and manage the risks associated with such physical
deliveries.\34\ A designated FMU may settle transactions using physical
delivery, which is the delivery of an asset, such as a financial
instrument or a commodity, in physical form. Physical instruments
include securities, commercial paper, and other debt instruments that
are issued in paper form. Commodities include tangible assets.
Settlement risk arises in both the storage and delivery of the
underlying instrument or commodity because of, for example, risk of
theft, loss, counterfeiting, or deterioration. Settlement risk
associated with credit, liquidity, or other risks involving money
settlements in U.S. or foreign currencies are addressed broadly in the
other proposed standards.
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\34\ The proposed standard replaces Sec. 234.4(a)(13) under
current Regulation HH.
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Under the proposed rule, a designated FMU that provides physical
settlement must have rules that clearly state its obligations with
respect to physical deliveries. Clear rules on physical deliveries
enable the designated FMU and its participants to take the appropriate
steps to mitigate the risks posed by such physical deliveries. For
example, clear rules would include definitions for acceptable physical
instruments or commodities, permissible alternative delivery locations
or assets (if any), rules for warehouse operations, and the timing of
delivery, where relevant. The designated FMU must also identify,
monitor, and manage the risks associated with the storage and delivery
of physical instruments and commodities. The designated FMU must ensure
that its record of physical assets
[[Page 3680]]
reflects accurately the assets in its possession. It would be prudent
for a designated FMU to have appropriate employment policies and
procedures for personnel that handle physical assets, including proper
background checks and training. Additional risk-management methods a
designated FMU may consider include insurance coverage and random
storage facility audits.
11. Central Securities Depositories
Proposed Sec. 234.3(a)(11) requires a designated FMU that operates
as a central securities depository to minimize and manage the unique
risks associated with its function and design.\35\ A central securities
depository provides securities accounts, central safekeeping, and asset
services; helps to ensure the integrity of securities issues; and
usually operates a securities settlement system to transfer securities.
As a result, a central securities depository may present custody risk
to their participants. Custody risk is the risk of loss on assets held
in custody in the event of the central securities depository's
insolvency, negligence, fraud, poor administration, or inadequate
recordkeeping. For example, safekeeping and transferring securities in
physical form can pose risk of loss or destruction of the securities
due to such causes as fire, flood, or theft of the security.
---------------------------------------------------------------------------
\35\ The proposed standard replaces and builds on Sec.
234.4(a)(14) under current Regulation HH.
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Under the proposed rule, a central securities depository must have
appropriate rules and procedures to help ensure the integrity of
securities issues. The preservation of the rights of issuers and
holders of securities is essential for the orderly functioning of a
securities market. Failure by the central securities depository to
protect customers' assets from loss or destruction, to safeguard the
rights of securities issuers or holders, or to keep accurate records of
a securities issuance can have severe effects on the confidence of the
participants in the safety and soundness of the central securities
depository and on the safety and stability of the markets for these
securities. To protect the integrity of the securities issue, the rules
and procedures must provide for reconciliation of the securities issues
that it maintains at least daily, and ensure that the total number of
securities recorded in the central securities depository for a
particular issue is equal to the amount of securities of that issue
held on the central securities depository's books. One important way
for a designated FMU to avoid credit risk and reduce the potential for
the unauthorized creation of securities is to have the rules and
procedures that prohibit overdrafts and debit balances in securities
accounts.
Further, the central securities depository must minimize and manage
the risks associated with the safekeeping and transfer of securities.
With respect to safekeeping, the central securities depository must
employ a system that ensures the segregation of assets belonging to the
central securities depository from those belonging to its participants.
In addition, the central securities depository must segregate
participants' securities from those of other participants. With respect
to the transfer of securities, although a central securities depository
may transfer securities held in physical form via physical delivery, it
can reduce the risks associated with such form of delivery by
immobilizing the securities and providing electronic transfer via a
book-entry system. It can further eliminate the risks associated with
holding securities in physical form through dematerialization.
Therefore, a central securities depository must maintain securities in
immobilized or dematerialized form so that they can be transferred via
book entry to the greatest extent possible.
12. Exchange-of-Value Settlement Systems
The settlement of a financial transaction by a designated FMU may
involve the settlement of two linked transactions, such as the delivery
of securities against payment of cash (i.e., DvP), delivery of
securities against delivery of other securities (i.e., DvD), or the
delivery of a payment in one currency against delivery of a payment in
another currency (i.e., PvP). Substantial credit losses and liquidity
pressures may result from the failure to complete the settlement of
both sides of the linked obligations. Accordingly, under proposed Sec.
234.3(a)(12), a designated FMU that settles transactions that involve
the settlement of two linked obligations, such as a transfer of
securities against payment or the exchange of one currency for another,
must condition the final settlement of one obligation upon the final
settlement of the other.\36\ In this context, the designated FMU
eliminates principal risk, which is the risk that a counterparty will
lose the full value involved in a transaction when one leg of the
obligation is settled, but the other is not (for example, the
securities are delivered but no cash payment is received). The
appropriate mechanisms to achieve such final settlement to eliminate
principal risk are DvP, DvD, or PvP settlement. These mechanisms can
settle obligations on either a gross basis or on a net basis and the
obligations need not be settled simultaneously. However, the mechanism
must ensure that the settlement of one obligation is final if and only
if the settlement of the corresponding obligation is final.
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\36\ The proposed standard replaces Sec. 234.4(a)(12) under
current Regulation HH for central securities depositories and
central counterparties and extends the requirement explicitly by
regulation to payment systems.
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13. Participant-Default Rules and Procedures
Proposed Sec. 234.3(a)(13) requires the designated FMU to have
effective and clearly defined participant-default rules and procedures
that are designed to ensure that the designated FMU can take timely
action to contain losses and liquidity pressures and continue to meet
its obligations.\37\ If participant defaults are handled ineffectively,
losses and liquidity pressures can lead to the failure of the
designated FMU and can spread to the designated FMU's other
participants and to the markets it serves.
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\37\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(2) and (5) for payment systems and
Sec. 234.4(a)(10) for central securities depositories and central
counterparties.
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Participant-default rules and procedures must describe the
circumstances, both financial and operational, that constitute a
participant default and that would trigger the established default
procedures. Other key aspects to be considered in designing the rules
and procedures include the actions that a designated FMU can take when
a default is declared; the extent to which such actions are automatic
or discretionary; potential changes to the normal settlement practices
to ensure timely settlement should these changes be necessary in
extreme circumstances; the management of transactions at different
stages of processing; the expected treatment of proprietary and
customer transactions and accounts; the probable sequencing of actions;
the roles, obligations, and responsibilities of the various parties,
including non-defaulting participants; and the existence of other
mechanisms that may be activated to contain the impact of a default.
The proposed rule requires that a designated FMU's rules and
procedures regarding participant defaults enable it to take timely
action to contain losses and liquidity pressures resulting from a
[[Page 3681]]
default. Its rules must clearly describe the use and sequence of use of
the financial resources at its disposal and the obligations of the non-
defaulting participants to replenish the financial resources used
during a default. Further, the public disclosure of key aspects of the
designated FMU's participant default rules and procedures will help to
provide predictability regarding the measures that the designated FMU
will take during a default (see also proposed Sec. 234.3(a)(23)).
The proposed rule also requires a designated FMU to test and review
its default procedures, including any close-out procedures, at least
annually or following any material changes to the rules and procedures.
These tests and reviews are most effective when they involve the
designated FMU's participants and other stakeholders because the
objective of the testing is to ensure that the parties affected by a
default understand and are able to carry out their responsibilities as
expected during a default event.
14. Segregation and Portability
Proposed Sec. 234.3(a)(14) requires a designated FMU that operates
as a central counterparty to have rules and procedures that enable the
segregation and portability of positions of a participant's customers
and the collateral provided to the designated FMU with respect to those
positions. Segregation refers to a method of holding or accounting for
a participant's customer collateral and contractual positions
separately from those of the participant in order to protect the
customer's collateral from becoming part of the participant's estate in
insolvency. Portability refers to the operational aspects of the
transfer of contractual positions, funds, or securities from one party
to another.
It is important for a central counterparty to have segregation and
portability arrangements, or alternate means, that protect the assets
of a participant's customers in the event of that participant's default
or insolvency. Effective segregation arrangements also provide for
clear and reliable identification of the participant's customers'
positions and related collateral. Effective portability arrangements
lessen the need for closing out positions, even during times of market
stress. Portability thus reduces the costs and potential market
disruption associated with closing out positions and reduces the
possible impact on customers' ability to continue to obtain access to
central clearing.
Effective segregation and portability not only depends on the
operational capabilities of the designated FMU, but also on the
applicable legal framework. A cash-market central counterparty, for
example, may operate in a legal regime that offers the same degree of
protection for a participant's customers as the segregation and
portability approaches under proposed Sec. 234.3(a)(14). In such
cases, the Board will take into consideration a central counterparty's
assessment of whether the applicable legal or regulatory framework
achieves the same degree of protection and efficiency for customers
that would otherwise be achieved by segregation and portability
arrangements at the central counterparty level described in the
proposed standard. The Board believes segregation and portability
arrangements may differ depending on the design of a central
counterparty and would work with any applicable designated FMU through
the supervisory process to determine how best to set specific
requirements.
Proposed Sec. 234.3(a)(14) is a new standard with respect to
Regulation HH. These arrangements help to minimize credit and liquidity
risks to participants' customers, reduce the potential for systemic
risk that could result from credit and liquidity exposures on a
defaulting participant's customers, and thereby support the stability
of the broader financial system.
15. General Business Risk
Proposed Sec. 234.3(a)(15) requires the designated FMU to
identify, monitor, and manage its general business risk, which is the
risk of losses that may arise from its administration and operation as
a business enterprise that are neither related to participant default
nor separately covered by financial resources maintained for credit or
liquidity risk under proposed Sec. 234.3(a)(4) and (7). General
business risk includes any potential impairment of the designated FMU's
financial position as a consequence of a decline in its revenues or an
increase in its expenses, where such expenses exceed revenues and
result in a loss that must be charged against capital. Such impairment
can be caused by a variety of business factors, including a poor
business strategy, ineffective operations, negative cash flows, and
unexpected and excessively large operating expenses. General business
risks may also arise from other risks, such as legal risk (in the case
of legal actions challenging the designated FMU's custody arrangements
or other business activities), investment risk affecting the designated
FMU's resources, and operational risk (in the case of fraud, theft, or
loss). Losses associated with general business risk may result in an
extraordinary one-time loss or recurring losses.
General business risk may threaten the designated FMU's ability to
continue to operate as a going concern. The abrupt or disorderly
failure of a designated FMU would cause significant uncertainty and
confusion in the markets it serves. In such a scenario, the designated
FMU's participants may be unable to clear or settle their financial
transactions as expected.
Under the proposed rule, a designated FMU must identify, monitor,
and manage its general business risk, in part by identifying and
assessing its sources of general business risk and their potential
impact on its operations and services. For example, a designated FMU
must conduct scenario analysis to examine how specific adverse business
scenarios would affect it. The designated FMU must also conduct
sensitivity analysis to test how a particular source of business risk,
such as the loss of a key customer, may affect its financial standing
(for example, its cash flows, liquidity, and capital positions). A
designated FMU also must have internal processes, controls, and
information systems to measure and monitor on an ongoing basis the
general business risks that it identifies.
Proposed Sec. 234.3(a)(15)(i) requires a designated FMU to
maintain, at a minimum, sufficient liquid net assets funded by equity
to cover the greater of: (1) The cost to implement its recovery or
orderly wind-down plan to address general business losses and (2) six
months of current operating expenses. This requirement is intended to
ensure that the designated FMU has both the liquidity and the capital
to absorb unexpected losses, permitting it to weather adverse
conditions, and promote public confidence in the designated FMU's
ability to continue operations and services as a going concern. Should
it become necessary for a designated FMU to wind down its operations
and services to its participants, the liquid resources and capital it
holds may also help to fund the wind-down so that it can be conducted
in an orderly manner.
Under proposed Sec. 234.3(a)(15)(i), liquid net assets funded by
equity are composed of two components, unencumbered liquid financial
assets and equity, both of which must be sufficient to cover the
greater of (1) the cost to implement the recovery or orderly wind-down
plan and (2) six months of operating expenses, as described above.
Proposed Sec. 234.3(a)(15)(i)(A) requires the designated FMU to hold
liquid financial
[[Page 3682]]
assets, such as cash and highly liquid securities, sufficient to cover
the greater of the two calculated costs described above.\38\ The liquid
financial assets must also be unencumbered by creditor claims or liens.
In addition, proposed Sec. 234.3(a)(15)(i)(B) requires the designated
FMU to hold equity in the form of common stock, disclosed reserves, and
other retained earnings, that is at all times greater than or equal to
the amount of unencumbered liquid financial assets held under paragraph
(A).
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\38\ If the designated FMU does not hold cash or cash
equivalents, the assets held should be sufficiently liquid so that
they can be liquidated to match the cash outflows projected under
the recovery or wind-down plans.
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For cases in which a designated FMU is subject to international
risk-based capital standards or other relevant Board-imposed capital
requirements, the Board, at its discretion, may allow a designated FMU
to use the equity held for this purpose towards the designated FMU's
equity requirement in proposed Sec. 234.3(a)(15)(i)(B) to avoid
duplicate capital requirements. Further, the Board, at its discretion,
may allow a designated FMU that is part of a larger legal entity with
multiple business lines that do not each have a separate balance sheet
to meet the requirement by using unencumbered liquid financial assets
and equity held at the legal entity level.
Calculating recovery or orderly wind-down costs. Costs to implement
the recovery or orderly wind-down plan are those direct, support, and
overhead costs that the designated FMU would incur in a recovery or
wind-down scenario. In determining these costs, the designated FMU
should first consider reasonable scenarios where general business
losses could cause it to need to recover or wind down. The appropriate
scenarios will depend on the designated FMU's organizational structure
and market environment. The designated FMU should then determine the
appropriate time period for a recovery or orderly wind-down when faced
with these scenarios and calculate the costs that would be incurred. A
designated FMU should also include in its analysis the possibility that
the designated FMU may have to wind-down after an initial attempt to
recover. In calculating its recovery or orderly wind-down costs, the
designated FMU should consider additional, extraordinary costs related
to a recovery or wind-down, such as additional legal expenses and costs
associated with retaining staff (such as retention bonuses). The
designated FMU may also remove from its calculation those normal
business operating expenses that would not be incurred in a recovery or
wind-down scenario, such as certain marketing costs.
Calculating six months of current operating expenses. At a minimum,
a designated FMU must hold six months of current operating expenses.
This is a minimum requirement for all designated FMUs, irrespective of
their organizational and ownership structure, as well as charter type,
that creates a level playing field among different types of FMUs. When
calculating its current operating expenses, the designated FMU is
expected to consider its normal business operating expenses. These
expenses are those that are typically categorized as either ``cost of
sales'' or ``selling, general, and administrative expenses'' on the
designated FMU's income statement. Therefore, these costs may exclude,
among other items, depreciation and amortization expenses, taxes, and
interest on debt.
Further, proposed Sec. 234.3(a)(15)(ii) requires a designated FMU
to develop and maintain a viable capital plan for raising additional
equity before its equity falls below the amount required. In developing
this plan, the designated FMU should consider its ownership structure
and any insured business risks. Given the contingent nature of
insurance, a designated FMU should use conservative assumptions when
taking insurance into account for its capital plan, and these resources
may not be taken into account when assessing the designated FMU's
capital adequacy. A designated FMU's capital plan must be approved by
the board of directors and updated at least annually.
Proposed Sec. 234.3(a)(15) is a new standard in Regulation HH. The
proposed standard reflects existing Board supervisory expectations for
a financial institution to manage appropriately its general business
risk, including through the use of financial and internal controls. The
proposed capital requirement to maintain liquid net assets funded by
equity equal to at least six months of current operating expenses is
also generally consistent with past and current Board supervisory
practice. Before the passage of the Dodd-Frank Act, the Board required
certain FMUs under its jurisdiction to hold sufficient resources to
ensure a recovery or orderly wind-down of critical operations and
services. In determining the appropriate level of capital for an FMU,
the Board considered three factors: (1) Initial capital should be
sufficient to absorb any projected start-up operating losses and
limited business losses in its early operation; (2) capital should be
sufficient to cover costs of continued operations during an orderly
wind-down; and (3) capital should be sufficient at all times to meet
any minimum regulatory requirements. Therefore, although the proposed
standard is new to Regulation HH, its objectives are consistent with
the prudential objectives of the Board's supervisory process that
existed prior to the Act. The Board recognizes that the incremental
burden may vary by designated FMU.
With respect to proposed Sec. 234.3(a)(15), the Board requests
comment on the following specific questions:
Q.15.1 Should the Board set a minimum amount of liquid net assets
funded by equity that is different from the six-month minimum
international standard, such as three or nine months of current
operating expenses? Should the Board set the requirement based on the
risk profile of the designated FMU? If so, what factors should the
Board consider and what would be the effects of such an approach?
Q.15.2 Should the Board require a designated FMU that is part of a
larger legal entity to take into account, when calculating the cost to
implement its recovery or orderly wind-down plans, recovery or wind-
down scenarios in which other business lines in the legal entity or the
legal entity itself may also face an adverse business environment? To
prepare for such scenarios, should the designated FMU include in its
calculation of recovery or wind-down costs more than its normal
business share of any shared support and overhead costs?
Q.15.3 For designated FMUs that are part of a larger legal entity,
the Board considered the alternative of requiring the designated FMU to
hold liquid net assets funded by equity that are specific to the FMU
itself to meet the requirement, but believes that it would likely be
difficult to implement in practice. Are there any reasonable
methodologies for determining which of the liquid net assets and equity
held at the legal entity level belong to a particular business line?
16. Custody and Investment Risks
Proposed Sec. 234.3(a)(16) requires the designated FMU to minimize
and manage the custody and investment risks associated with its own and
its participants' assets.\39\ Custody risk is the risk of loss on
assets held in custody in the event of a custodian's (or
subcustodian's) insolvency, negligence, fraud, poor administration, or
[[Page 3683]]
inadequate recordkeeping. Investment risk is the risk of loss faced by
an FMU when it invests its own or its participants' assets. Situations
that create custody and investment risks may prevent a designated FMU
from having prompt access to its own assets or its participants' assets
at the expected value when needed. Problems with access could result in
financial losses incurred by the FMU, participants, and other parties
and damage the designated FMU's reputation or perceived reliability.
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\39\ The proposed standard replaces Sec. 234.4(a)(3) under
current Regulation HH for central securities depositories and
central counterparties and extends the requirement explicitly by
regulation to payment systems.
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Proposed Sec. 234.3(a)(16)(i) requires a designated FMU to
safeguard its own and its participants' assets and minimize the risk of
loss on and delay in access to these assets by holding its own and its
participants' assets at supervised and regulated entities that have
robust accounting practices, safekeeping procedures, and internal
controls that fully protect the assets. A designated FMU must also
evaluate and consider the full scope of its relationship with and
exposures to its custodian banks. For example, a custodian bank may
also be a participant in the designated FMU, as well as the designated
FMU's settlement bank or liquidity provider. Understanding these
different relationships is necessary to avoid excessive concentration
or exposure to an individual financial institution.
Under proposed Sec. 234.3(a)(16)(ii), if a designated FMU invests
its own and its participants' assets, it is required to invest the
assets in instruments with minimal credit, market, and liquidity risks,
such as investments that are secured by, or are claims on, high-quality
obligors and investments that allow for quick liquidation with little,
if any, adverse price effect. A designated FMU must use an investment
strategy that is consistent with its overall risk-management strategy
and fully disclosed to its participants. The alignment of investment
and risk-management strategies and the disclosure of the investment
strategies can help ensure that investment choices do not allow the
pursuit of profit to compromise the designated FMU's financial
soundness and liquidity management. A designated FMU must also consider
its overall credit risk exposures to individual obligors, including
relationships with the obligor that create additional exposures, such
as when the obligor is also a participant or an affiliate of a
participant in the designated FMU.
17. Operational Risk
Proposed Sec. 234.3(a)(17) requires the designated FMU to manage
its operational risk by establishing a robust operational risk-
management framework that is approved by the board of directors.\40\
Operational risk is the risk that deficiencies in information systems,
internal processes, and personnel or disruptions from external events
will result in the deterioration or breakdown of services provided by
an FMU. Vulnerabilities to and threats against the designated FMU's
physical security or information security, including cyber security,
also present operational risk.
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\40\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(7) for payment systems and Sec.
234.4(a)(4) for central securities depositories and central
counterparties. The proposed standard is also consistent with the
requirements in the Federal Financial Institutions Examination
Council (FFIEC) IT Handbook, Board Supervision and Regulation (SR)
Letter 03-9 on the Interagency Paper on Sound Practices for the
Resilience of the U.S. Financial System, SR Letter 07-18 on Pandemic
Planning, and SR Letter 05-23 on Interagency Guidance on Response
Programs for Unauthorized Access to Customer Information and
Customer Notice.
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Under the proposed rule, a designated FMU must establish a
framework to manage its operational risk. Proposed Sec.
234.3(a)(17)(i) requires the designated FMU to identify the plausible
sources of operational risk, both internal and external, and mitigate
their impact through the use of appropriate systems, policies,
procedures, and controls that are reviewed, audited, and tested
periodically, as well as after major changes that could affect the
source or level of operational risk that is present in the designated
FMU. In addition, proposed Sec. 234.3(a)(17)(ii) requires the
designated FMU to identify, monitor, and manage the risks its
operations might pose to other FMUs.
Proposed 234.3(a)(17)(iii) requires the designated FMU to have
policies and systems that are designed to achieve clearly defined
objectives to ensure a high degree of security and operational
reliability. Proposed 234.3(a)(17)(iv) requires the designated FMU to
have systems that have adequate, scalable capacity to handle increasing
stress volumes and achieve the designated FMU's service-level
objectives. Proposed 234.3(a)(17)(v) requires the designated FMU to
have comprehensive physical, information, and cyber security policies,
procedures, and controls that address potential and evolving
vulnerabilities and threats.
Proposed Sec. 234.3(a)(17)(vi) and (vii) address the designated
FMU's business continuity management. The designated FMU must have
business continuity management that aims for rapid recovery and timely
resumption of critical operations and fulfillment of the designated
FMU's obligations, under a range of scenarios, including a wide-scale
or major disruption. Specifically, a designated FMU must have a
business continuity plan that incorporates the use of a secondary site
located at a sufficient geographical distance from the primary site to
have a distinct risk profile, such that, for example the sites are not
located in the same hurricane zone or on the same fault line. Further,
the business continuity plan must be designed to ensure that critical
information technology systems can recover and resume operations within
two hours after the disruptive events and to enable the designated FMU
to complete settlement by the end of the day of the disruption, even in
case of extreme circumstances. Further, the business continuity plan
must be tested at least annually and more frequently where appropriate.
Sources of operational risk change over time and with advancements
in technology. Although the operational risk standard has historically
been applied through the lens of a disruption that causes physical
damage to infrastructure or equipment (that is, physical threats or
attacks), the Board believes, in general, that a designated FMU should
take into account cyberattacks and threats when establishing its
business continuity plans. The PFMI also makes explicit references to
cyberattacks, which suggests that the traditional view on operational
risk has evolved internationally. Cyberattacks can reach far beyond the
geographical distance that any physical attack can reach. While
cyberattacks may present different challenges than physical attacks,
the need for rapid recovery and timely resumption in response to
cyberattacks is equally necessary.
The Board recognizes, however, that there is ongoing work and
discussion domestically and internationally on developing operational
risk-management standards and planning for business continuity with
respect to cyber security and responses to cyberattacks. Further,
certain standards or responses originally intended to address physical
attacks may not be appropriate for certain types of cyberattacks. For
example, the proposed two-hour recovery time objective (a longstanding
industry objective and Board requirement) may present challenges in the
near term for extreme cyberattacks that could corrupt data or software
from not just the designated FMU's primary site but also its
geographically distance backup site(s). The Board anticipates
addressing with designated FMUs through the supervisory process
reasonable
[[Page 3684]]
approaches to cyberattacks in the context of the evolving risk and
technological environment.
The requirement to consider cyberattack scenarios in a designated
FMU's business continuity planning may, in some respects, constitute a
heightened requirement. In an environment where cyberattacks have
become increasingly sophisticated and far-reaching, a designated FMU
must plan for recovery and resumption of operations in these scenarios.
The inability of a designated FMU to respond in a timely manner to
cyberattacks could compromise the integrity of the financial markets.
In addition, planning for such scenarios also would be in accordance
with national policies aimed at improving the cybersecurity posture of
U.S. critical infrastructures. The Board recognizes that there may be
additional costs associated with development of business continuity
plans and establishment of any systems and controls to accommodate
different scenarios of cyberattacks.
With respect to proposed Sec. 234.3(a)(17), the Board requests
comment on the following specific questions related to cyberattacks:
Q.17.1 What types of changes to a designated FMU's current systems,
policies, procedures, and controls will be necessary to reasonably
ensure that its critical information technology systems can recover and
resume operations no later than two hours following disruptive events
caused by cyberattacks?
Q.17.2 What are reasonable estimates of the costs and other
challenges associated with these changes?
18. Access and Participation Requirements
Proposed Sec. 234.3(a)(18) requires the designated FMU to have
objective, risk-based, and publicly disclosed criteria for
participation, which permit fair and open access.\41\ Access refers to
the ability to use a designated FMU's services by direct participants
and, where relevant, indirect participants and service providers. These
participation requirements should not be subjective or overly
restrictive because fair and open access to a designated FMU helps
support the stability of the financial system. Fair and open access may
help avoid the concentration of financial activity (and therefore risk)
into a few large participants. Broad participation in a designated FMU
can also increase the effectiveness of multilateral netting
arrangements, facilitate crisis management by applying a consistent set
of rules and procedures (for example, default management and loss
mutualization), encourage competition among participants, promote
efficiency, and improve overall market transparency.
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\41\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(7) for payment systems and Sec.
234.4(a)(2) for central securities depositories and central
counterparties.
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Unlimited access to an FMU, however, can pose a wide variety of
risks to the FMU. A designated FMU can control these risks by setting
reasonable risk-based participation requirements to ensure that
participants have the requisite operational capacity, financial
resources, legal powers, and risk-management expertise to prevent
unacceptable risk exposure for the designated FMU and its other
participants. Therefore, balancing fair and open access with reasonable
risk-based participation requirements can promote robust risk
management, promote the safety and soundness of the designated FMU,
reduce systemic risk, and support the stability of the broader
financial system.
Under proposed Sec. 234.3(a)(18), a designated FMU is required to
control the risks to which it is exposed from its participants by
setting objective, risk-based, and publicly disclosed requirements for
participants in its services, including designing the criteria to
ensure that participants meet appropriate operational, financial, and
legal requirements that allow them to meet their obligations to the FMU
or other participants on a timely basis. Although a designated FMU may
use risk-based measures in determining access, the requirements should
be objective and should not unnecessarily discriminate against
particular classes of participants or introduce competitive
distortions. Participation requirements must be justified in terms of
the safety and efficiency of the designated FMU and the markets it
serves, and tailored to and commensurate with the designated FMU's
specific risks. Overall, risk-based, as well as other participation
requirements, should aim to have the least restrictive impact on access
needed to achieve their objectives.
Under proposed Sec. 234.3(a)(18)(i), a designated FMU must monitor
compliance with its access and participation criteria on an ongoing
basis. Further, it must have the authority to impose more-stringent
requirements and other risk controls on a participant in situations
where the designated FMU determines that the participant poses
heightened risk to the FMU. The proposed rule allows the designated FMU
to require participants to report any developments that may affect
their ability to comply with the designated FMU's requirements. If a
participant's creditworthiness declines, the designated FMU can then
require the participant to provide additional collateral or reduce the
participant's credit limit. Under proposed Sec. 234.3(a)(18)(ii), the
designated FMU must clearly define and publicly disclose its procedures
for facilitating the suspension and orderly exit of a participant that
fails to meet the designated FMU's access and participation criteria.
19. Tiered Participation Arrangements
Proposed Sec. 234.3(a)(19) requires the designated FMU to
identify, monitor, and manage the material risks to the designated FMU
arising from tiered participation arrangements. Tiered participation
arrangements occur when other firms (indirect participants) rely on the
services provided by direct participants to use the designated FMU's
central payment, clearing, or settlement facilities. Indirect
participants are not bound by the rules of the designated FMU, but
their transactions are cleared or settled through the FMU by way of a
direct participant that has a contractual relationship with the FMU. As
a result, the transactions of indirect participants may pose credit,
liquidity, operational, and other risks to the FMU. If these risks are
not managed effectively by the direct participants of the FMU or the
FMU itself, these risks can affect the safety and soundness of the FMU
and pose systemic risk to other market participants and FMUs.
Under the proposed rule, a designated FMU is required to identify
the types of risk that could arise from tiered participation
arrangements and monitor concentrations of such risk. If a designated
FMU is exposed to material financial or operational risk from tiered
participation arrangements, the FMU should seek to manage and limit the
risk. The Board recognizes that there are limits to the extent to which
a designated FMU can influence direct participants' commercial
relationships with their customers. Nonetheless, the FMU should not
ignore risks that can significantly affect its operations. A designated
FMU may have access to information on transactions undertaken on behalf
of indirect participants that would allow it to evaluate and take steps
to manage any risks posed by the indirect participants. For example, a
designated FMU can set expectations in
[[Page 3685]]
its membership agreements with its direct participants regarding
information on transactions undertaken on behalf of their customers in
order to evaluate the proportion of customer business relative to the
direct participant's proprietary business. A regular review of the
risks to which the designated FMU may be exposed as a result of tiered
participation arrangements may also be beneficial to determining
whether any mitigating actions are necessary.
In order to determine whether it faces material risks arising from
tiered participation, a designated FMU could gather basic information
on indirect participants in order to identify (a) the proportion of
activity that direct participants conduct on behalf of indirect
participants, (b) direct participants that act on behalf of a material
number of indirect participants, (c) indirect participants with
significant volumes or values of transactions in the system, and (d)
indirect participants whose transaction volumes or values are large
relative to those of the direct participants through which they access
the FMU. A designated FMU's analysis would also benefit from
identifying material dependencies between direct and indirect
participants that might affect the FMU. For example, the FMU could
determine whether a large proportion of the transactions processed by
the designated FMU originates from indirect participants and, as a
result, creates a material dependency on the operational or financial
performance of a few direct participants.
Proposed Sec. 234.3(a)(19) is a new rule and may impose an
additional cost or burden on designated FMUs. The Board believes this
requirement is necessary because the dependencies and risk exposures
inherent in tiered participation arrangements can present risks to the
designated FMU and its smooth functioning and the broader financial
markets. If a designated FMU has few direct participants, but many
indirect participants, the disruption to the services of one or more of
these few direct participants could present risk to the smooth
functioning of the market the designated FMU serves. In addition, if
the value of an indirect participant's transactions is large relative
to the direct participant's ability to manage risks, the direct
participant's default risk may be greater.
With respect to proposed Sec. 234.3(a)(19), the Board requests
comment on the following specific questions:
Q.19.1 What, if any, risks do tiered participation arrangements
pose to a payment system? How would a payment system assess these
risks?
Q.19.2 What types of information would be helpful to assess the
risks posed by indirect participants to a designated FMU? Is it
feasible for a payment system to collect this information?
Q.19.3 How, if at all, should the Board define the threshold for
identifying indirect participants responsible for a significant
proportion of transactions processed by the designated FMU?
Q.19.4 How, if at all, should the Board define the threshold for
identifying indirect participants whose transaction volumes or values
are large relative to the capacity of the direct participants through
which the indirect participants access the designated FMU?
Q.19.5 How often should a designated FMU review the potential risks
from tiered participation arrangements?
20. Links to Other Financial Market Utilities
Proposed Sec. 234.3(a)(20) requires a designated FMU that operates
as a central counterparty, securities settlement system, or central
securities depository and that establishes a link with one or more of
these types of FMU to identify, monitor, and manage link-related
risks.\42\ FMU links, as defined in proposed Sec. 234.2(f), can reduce
transaction costs and increase market efficiency, but they may also
serve as an avenue for contagion of market stress between FMUs and
markets. Links can expose a designated FMU to legal risk, where the
laws and rules governing the linked FMUs differ; operational risk,
where operational failures in one FMU may have implications for other
linked FMUs; and financial risk, where the failure or default of a
participant in one FMU may impact a linked FMU. Any of these risks
individually or in combination could pose systemic risk and threaten
the stability of the broader financial system. Therefore, a designated
FMU should manage and mitigate to the greatest extent practicable the
risks that arise from its link arrangements.
---------------------------------------------------------------------------
\42\ The proposed standard replaces Sec. 234.4(a)(7) under
current Regulation HH for central securities depositories and
central counterparties. Links to payment systems are addressed in
proposed Sec. 234.3(a)(9) and are not covered under this standard.
---------------------------------------------------------------------------
Under the proposed rule, a designated FMU that establishes a link
is required to identify, monitor, and manage the risks related to the
link, which may include legal, operational, credit, and liquidity
risks. The identification, monitoring, and management of link-related
risks begin before the designated FMU enters into the arrangement in
order to identify, monitor, and manage all potential sources of risk
arising from the link arrangement. A link must have a well-founded
legal basis in all relevant jurisdictions. Further, a designated FMU
must measure, monitor, and manage the credit and liquidity risks
arising from a link to another FMU. Credit extensions between linked
FMUs must be covered fully with a high degree of confidence with high-
quality collateral. In particular, a designated FMU that operates as a
central counterparty in a link arrangement with another central
counterparty must cover, at least on a daily basis, its current and
potential future exposures to the linked central counterparty and its
participants, if any, fully with a high degree of confidence without
reducing the designated FMU's ability to fulfill its obligations to its
own participants. A designated FMU that establishes a link with another
FMU must also ensure that the arrangement provides a high level of
protection for the rights of its participants. Furthermore, a
designated FMU that establishes multiple links must ensure that the
risks generated in one link do not affect the soundness of the other
links and linked FMUs. Links must be designed so that the designated
FMU can comply with the other standards proposed in this regulation.
21. Efficiency and Effectiveness
Proposed Sec. 234.3(a)(21) requires a designated FMU to be
efficient and effective in meeting the requirements of its participants
and the markets it serves.\43\ Efficiency generally encompasses what an
FMU chooses to do, how it does it, and the resources required by the
designated FMU to perform its functions. Effectiveness refers to
whether the designated FMU is meeting its goals and objectives, which
include the requirements of its participants and the markets it serves.
A designated FMU that is designed or managed inefficiently or
ineffectively may ultimately distort financial activity and market
structure, increasing not only the credit, liquidity, and other risks
of the FMU's participants, but also the risks of their customers and
other end users.
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\43\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(8) for payment systems and Sec.
234.4(a)(6) for central securities depositories and central
counterparties.
---------------------------------------------------------------------------
There is an inherent tradeoff between safety (that is, risk
management) and efficiency (that is, direct and indirect costs) in the
design and management of
[[Page 3686]]
a designated FMU. A designated FMU's design; operating structure; scope
of payment, clearing, and settlement activities; and use of technology
can influence its efficiency and can ultimately provide incentives for
market participants to use, or not use, the designated FMU's services.
In certain cases, inefficiently designed systems may increase
operational costs to the point at which it would be cost prohibitive
for participants to use the designated FMU. As a result, the
inefficiency could drive market participants toward less-safe
alternatives, such as bilateral clearing or settlement on the books of
the participants. In such cases, risks to the market participants
increase as they seek less-safe opportunities to lower direct costs;
this behavior may reintroduce risk into the market that the designated
FMU was intended to mitigate. Therefore, designated FMUs should be
efficient and effective in their design and operations.
Under proposed Sec. 234.3(a)(21)(i), a designated FMU must be
efficient and effective with regard to (A) its clearing and settlement
arrangement (for example, gross, net, or hybrid settlement; real time
or batch processing; and novation or guarantee scheme); (B) risk-
management policies, procedures, and systems; (C) scope of products
cleared or settled; and (D) the use of technology and communication
procedures. To help maintain system efficiency, the designated FMU's
system design must be sufficiently flexible to respond to changing
demand and new technologies.
Under proposed Sec. 234.3(a)(21)(ii), a designated FMU must have
clearly defined goals and objectives that are measureable and
achievable, such as minimum service levels (for example, the time it
takes to process a transaction), risk-management expectations (for
example, the level of financial resources it should hold), and business
priorities (for example, the development of new services). Under
proposed Sec. 234.3(a)(21)(iii), a designated FMU must have policies
and procedures for the regular review of its efficiency and
effectiveness. To be ``effective,'' a designated FMU must reliably meet
its obligations in a timely manner, including service and security
requirements, and achieve the public policy goals of safety and
efficiency for participants and the markets it serves.
22. Communication Procedures and Standards
Proposed Sec. 234.3(a)(22) requires the designated FMU to use, or
at a minimum accommodate, relevant internationally accepted
communication procedures and standards in order to facilitate efficient
payment, clearing, and settlement. The use of internationally accepted
communication procedures and standards can reduce the number of errors,
avoid information losses, and reduce transaction and processing costs,
which helps reduce operational risk faced by a designated FMU, its
participants, and the broader markets. Further, lower transaction costs
associated with the use or accommodation of internationally accepted
communication procedures and standards can promote participation in the
designated FMU by a broad set of financial institutions in various
locations. Therefore, the use or accommodation of internationally
accepted communication procedures and standards supports robust risk
management, promotes the safety and soundness of designated FMUs, and
supports the stability of the broader financial system.
Under the proposed rule, a designated FMU must use or accommodate
internationally accepted communication procedures, messaging standards,
and reference data standards that provide a common set of rules across
systems for exchanging messages and allow a broad set of systems and
institutions in various locations to communicate efficiently and
effectively. A designated FMU, alternatively or additionally, may
communicate with other systems by supporting systems that translate or
convert internationally accepted procedures and standards into those
used by the designated FMU.
Proposed Sec. 234.3(a)(22), although new to Regulation HH as an
explicit requirement, codifies the Board's existing supervisory
requirements for the payment, clearing, or settlement systems under its
authority.\44\ Designated FMUs subject to the Board's authority already
use, or at minimum accommodate, the relevant internationally accepted
communications procedures.
---------------------------------------------------------------------------
\44\ For example, this standard is consistent with the existing
supervisory expectations for systemically important central
securities depositories and central counterparties in section
C.2.a.xvi of part I of the PSR policy.
---------------------------------------------------------------------------
23. Disclosure of Rules, Key Procedures, and Market Data
Proposed Sec. 234.3(a)(23) requires the designated FMU to disclose
relevant information about its operations and risk management to its
participants and to the public.\45\ Such transparency allows a
designated FMU's participants, relevant authorities, and the broader
public to understand better the activities and structure of the
designated FMU, its risk profile, and its risk-management practices and
to compare such characteristics across similar types of FMUs.
Disclosure of relevant information by a designated FMU can thus support
sound decisionmaking by these stakeholders. Participants can use this
information to assess and manage more effectively any risks posed to
them by the designated FMU. Relevant authorities can use this
information to better assess the designated FMU's observance of the
risk-management standards, help identify possible risks, and inform
their cooperative or coordination efforts with the Board. Relevant
authorities can include those supervising the participants of the
designated FMU. These authorities can use the information disclosed by
the FMU to better assess the risks posed to the financial institutions
they supervise. Disclosure to the public helps potential participants
make informed decisions on whether to become members of the designated
FMU and promotes confidence in the markets served by the FMU. Thus,
transparency by a designated FMU promotes robust risk management,
reduces systemic risk, and supports the stability of the broader
financial system.
---------------------------------------------------------------------------
\45\ For similar corresponding standards under current
Regulation HH, see Sec. 234.3(a)(2) for payment systems and Sec.
234.4(a)(9) for central securities depositories and central
counterparties.
---------------------------------------------------------------------------
Under proposed Sec. 234.3(a)(23)(i) and (ii), a designated FMU
must have clear and comprehensive rules and procedures and disclose
publicly all rules and key procedures, including key aspects of its
default rules and procedures. An FMU's rules and procedures are
typically the foundation of the FMU and provide the basis for
participants' and potential participants' understanding of the risks
they incur by participating in the FMU. Rules and procedures should
include clear descriptions of the system's design and operations as
well as the participants' and the FMU's rights and obligations. In
addition to disclosing all relevant rules and key procedures, the FMU
should have a clear and fully disclosed process for proposing and
implementing changes to its rules and procedures and for informing
participants and relevant authorities of these changes.
Under proposed Sec. 234.3(a)(23)(iii), the designated FMU must
provide sufficient information to enable participants to have an
accurate understanding of the risks, fees, and other material costs
they incur by participating in the designated FMU. An FMU should
provide all
[[Page 3687]]
documentation, training, and information necessary to facilitate
participants' understanding of the rules and procedures and the risk
they face from participating in the FMU. For example, an FMU should
disclose to each individual participant the stress test scenarios used,
the individual participant's stress-test results, aggregate stress-test
results, and other data to help each participant understand and manage
the potential financial risks stemming from its participation in the
FMU. An FMU should also disclose to its participants the key highlights
of its business continuity arrangements, without revealing information
that can create vulnerabilities for the FMU or undermine its safety and
soundness.
Under proposed Sec. 234.3(a)(23)(iv), the designated FMU must
provide a comprehensive public disclosure on its legal, governance,
risk management, and operating framework. The public disclosure must
include (A) an executive summary, (B) a summary of major changes since
the last update of the disclosure, (C) general background information
on the designated FMU, (D) a narrative for each standard that
summarizes the designated FMU's approach to complying with the
standard, and (E) a list of publicly available resources that provide
further information on the designated FMU. The general background
information required under proposed Sec. 234.3(a)(23)(iv)(C) must
include (I) the designated FMU's function and the markets it serves,
(II) basic data and performance statistics on its services and
operations, such as basic volume and value statistics by product type,
average aggregate intraday exposures to its participants, and
statistics on the designated FMU's operational reliability, and (III) a
description of the designated FMU's general organization, legal and
regulatory framework, and system design and operations. Data provided
should be accompanied by robust explanatory documentation that enables
readers to understand and interpret the data correctly.
Under proposed Sec. 234.3(a)(23)(iv)(D), the designated FMU's
disclosure framework must include a standard-by-standard summary
narrative. This section must provide a narrative for each applicable
principle with sufficient detail and context to enable a reader to
understand the FMU's approach to observing the principle. A designated
FMU may look to the guiding questions in the CPSS-IOSCO Principles for
Financial Market Infrastructures: Disclosure Framework and Assessment
Methodology as background to understand the level and type of detail
that the Board expects to be included in the disclosure. Further,
cross-references to publicly available documents should be included,
where relevant, to supplement the narrative.
Under proposed Sec. 234.3(a)(23)(v), a designated FMU must update
the public disclosure under (iv) of this part every two years, or more
frequently following changes to its system or the environment in which
it operates, which would significantly change the accuracy of the
statements provided the public disclosure.
The proposed standard contains two requirements that may be new for
at least one designated FMU subject to Regulation HH. The proposed
standard makes more explicit that a designated FMU should disclose
relevant rules and key procedures and provide a comprehensive
disclosure to the public. The Board does not expect that disclosure of
rules and key procedures will impose a significant burden on designated
FMUs because they already have these rules available; the cost of
posting them on their Web sites should be minimal. An FMU's initial
comprehensive disclosure may be more costly to produce, but the Board
expects that a designated FMU will leverage, where possible, the
narratives from the self-assessment against the previous sets of
international standards that it currently prepares under the PSR
policy. Further, future updates to the comprehensive disclosure should
impose a minimal burden unless there are significant changes to the
designated FMU's governance, operations, or risk-management framework.
The Board believes that such transparency is essential to promoting
robust risk management, reducing systemic risk, and enhancing financial
stability because it allows the public, including market participants,
to understand an FMU's operations and better predict its actions in a
crisis. This, in turn, allows participants to manage any risks posed to
them from the FMU's actions and thereby limit systemic risk and enhance
financial stability.
With respect to proposed Sec. 234.3(a)(23), the Board requests
comment on the following specific question:
Q.23.1 Should the Board require information about fees and discount
policies to be part of the designated FMU's public disclosure
framework? Why should the Board not require disclosure of fees and
discount policies?
III. Administrative Law Matters
A. Regulatory Flexibility Act Analysis
Congress enacted the Regulatory Flexibility Act (RFA) (5 U.S.C. 601
et seq.) to address concerns related to the effects of agency rules on
small entities, and the Board is sensitive to the impact its rules may
impose on small entities. The RFA requires agencies either to provide
an initial regulatory flexibility analysis with a proposed rule or to
certify that the proposed rule will not have a significant economic
impact on a substantial number of small entities. In accordance with
section 3(a) of the RFA, the Board has reviewed the proposed
regulation. In this case, the proposed rule would apply to FMUs that
are designated by the Council under Title VIII of the Dodd-Frank Act as
systemically important to the U.S. financial system. In July 2012, the
Council designated eight FMUs as systemically important. Based on
current information, none of the designated FMUs are ``small entities''
for purposes of the RFA, and so, the proposed rule likely would not
have a significant economic impact on a substantial number of small
entities (5 U.S.C. 605(b)). The following Initial Regulatory
Flexibility Analysis, however, has been prepared in accordance with 5
U.S.C. 603, based on current information. The Board will, if necessary,
conduct a final regulatory flexibility analysis after consideration of
comments received during the public comment period. The Board requests
public comment on all aspects of this analysis.
1. Statement of the need for, objectives of, and legal basis for,
the proposed rule. The Board is proposing these revisions to Regulation
HH to implement certain provisions of Title VIII of the Dodd-Frank Act.
Section 805(a)(1)(A) of the Dodd-Frank Act requires the Board to
prescribe risk-management standards governing the operations related to
the payment, clearing, and settlement activities of certain designated
FMUs. In prescribing the risk-management standards, section 805(a)(1)
of the Act requires the Board to take into consideration, among other
things, the relevant international standards. As noted above, the CPSS
and IOSCO finalized the PFMI in April 2012. The Board believes that the
PFMI is now widely recognized as the most relevant set of international
risk-management standards for payment, clearing, and settlement systems
and the risk-management standards in Regulation HH should be updated in
consideration of the PFMI. As described above, risk-management
standards
[[Page 3688]]
based on the PFMI may improve upon the standards currently in
Regulation HH and will further promote the objectives of the risk-
management standards for designated FMUs set out in section 805(b) of
the Dodd-Frank Act. The Board believes that the implementation of risk-
management standards based on the PFMI by the relevant payment,
clearing, and settlement systems and their regulators, both
domestically and internationally, can help promote the safety and
efficiency of these systems and financial stability more broadly.
Widespread implementation also reduces potential conflicts among
domestic and foreign authorities regarding prudential requirements for
FMUs, and provides a more consistent framework among relevant domestic
and foreign authorities for assessing the risks and risk management of
FMUs with cross-market, cross-border, or cross-currency operations.
2. Small entities affected by the proposed rule. Pursuant to
regulations issued by the Small Business Administration (SBA) (13 CFR
121.201), a ``small entity'' includes an establishment engaged in (i)
financial transaction processing, reserve and liquidity services, and/
or clearinghouse services with an average annual revenue of $35.5
million or less (NAICS code 522320); (ii) securities and/or commodity
exchange activities with an average annual revenue of $35.5 million or
less (NAICS code 523210); and (iii) trust, fiduciary, and/or custody
activities with an average annual revenue of $35.5 million or less
(NAICS code 523991). Based on current information, the Board does not
believe that any of the FMUs that have been designated by the Council,
and in particular the two designated FMUs for which the Board is the
Supervisory Agency under Title VIII of the Dodd-Frank Act, would be
``small entities'' pursuant to the SBA regulation.
3. Projected reporting, recordkeeping, and other compliance
requirements. The proposed rule imposes certain reporting and
recordkeeping requirements for a designated FMU, such as proposed Sec.
234.3(a)(3) that requires a designated FMU to have policies and
procedures to identify, measure, monitor, and manage relevant risk and
to develop recovery or orderly wind-down plans. The proposed rule also
contains a number of compliance requirements that the designated FMU
must meet, such as the designated FMU having a well-founded, clear,
transparent, and enforceable legal basis for each material aspect of
its activities in all relevant jurisdictions (proposed Sec.
234.3(a)(1)). In addition, the proposed rule contains requirements for
the maintenance of sufficient financial resources to address its credit
risk (proposed Sec. 234.3(a)(4)), liquidity risk (proposed Sec.
234.3(a)(7)), and general business risk (proposed Sec. 234.3(a)(15)).
Professionals that the designated FMU needs to employ to comply with
these standards may include experts skilled in the legal, risk
management, finance, payments operations, and accounting areas.
4. Identification of duplicative, overlapping, or conflicting
Federal rules. The Board does not believe that any Federal rules
conflict with these proposed revisions to Regulation HH.
5. Significant alternatives to the proposed rule. The Board is not
aware of any significant alternatives to the proposed rule that
accomplish the stated objectives of the Dodd-Frank Act and that
minimize any significant economic impact of the proposed rule on small
entities. As noted above, the PFMI is now widely recognized as the most
relevant set of international risk-management standards for payment,
clearing, and settlement systems. The Board is proposing to revise the
risk-management standards in Regulation HH in consideration of the
current international standards. FMUs that are designated as
systemically important by the Council and present similar risk profiles
should be held to consistent standards, including compliance and
reporting requirements, regardless of size, because they can present
similar risk to the U.S. financial system. In addition, except as noted
above, the proposed standards generally employ a flexible, principles-
based approach to permit a designated FMU to employ a cost-effective
method for compliance, so long as the method chosen achieves the risk-
mitigation goals of the standard. Where necessary or appropriate, the
proposed rule includes specific testing frequencies or other
requirements. The Board included such detail in each proposed standard
as it deemed necessary to provide the designated FMUs with sufficient
guidance for compliance with the standard.
B. Competitive Impact Analysis
As a matter of policy, the Board subjects all operational and legal
changes that could have a substantial effect on payment system
participants to a competitive impact analysis, even if competitive
effects are not apparent on the face of the proposal. Pursuant to this
policy, the Board assesses whether proposed changes ``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'' and whether any such adverse effect ``was due to
legal differences or due to a dominant market position deriving from
such legal differences.'' If, as a result of this analysis, the Board
identifies an adverse effect on the ability to compete, the Board then
assesses whether the associated benefits--such as improvements to
payment system efficiency or integrity--can be achieved while
minimizing the adverse effect on competition.
Designated FMUs are subject to the supervisory framework
established under Title VIII of the Dodd-Frank Act. This proposed rule
promulgates revised Regulation HH risk-management standards for certain
designated FMUs as required by Title VIII. At least one currently
designated FMU that is subject to Regulation HH competes with a similar
service provided by the Reserve Banks. Under the Federal Reserve Act,
the Board has general supervisory authority over the Reserve Banks,
including the Reserve Banks' provision of payment and settlement
services (``Federal Reserve priced services''). This general
supervisory authority is much more extensive in scope than the
authority provided under Title VIII over designated FMUs. In practice,
Board oversight of the Reserve Banks goes well beyond the typical
supervisory framework for private-sector entities, including the
framework provided by Title VIII.
The Board is committed to applying risk-management standards to the
Reserve Banks' Fedwire Funds Service and Fedwire Securities Service
that are at least as stringent as the applicable Regulation HH
standards applied to designated FMUs that provide similar services. In
a separate, related Federal Register notice, the Board proposes to
revise concurrently part I of its PSR policy, which applies to the
Federal Reserve priced services, in consideration of the PFMI. The
proposed revisions to the risk-management and transparency expectations
in part I of the PSR policy are consistent with those proposed for
Regulation HH. Therefore, the Board does not believe the proposed rule
promulgating risk-management standards for designated FMUs under Title
VIII will have any direct and material adverse effect on the ability of
other service providers to compete with the Reserve Banks.
C. Paperwork Reduction Act Analysis
In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3506; 5 CFR part 1320, Appendix A.1), the
[[Page 3689]]
Board reviewed the proposed rule under the authority delegated to the
Board by the Office of Management and Budget. For purposes of
calculating burden under the Paperwork Reduction Act, a ``collection of
information'' involves 10 or more respondents. Any collection of
information addressed to all or a substantial majority of an industry
is presumed to involve 10 or more respondents (5 CFR 1320.3(c),
1320.3(c)(4)(ii)). The Board estimates there are fewer than 10
respondents and these respondents do not represent all or a substantial
majority of the participants in payment, clearing, and settlement
systems. Therefore, no collections of information pursuant to the
Paperwork Reduction Act are contained in the proposed rule.
IV. Text of Proposed Rule
List of Subjects in 12 CFR 234
Banks, Banking, Credit, Electronic funds transfers, Financial
market utilities, Securities.
Authority and Issuance
For the reasons set forth in the preamble, the Board proposes to
amend 12 CFR, Chapter II as set forth below.
PART 234--DESIGNATED FINANCIAL MARKET UTILITIES (REGULATION HH)
0
1. The authority citation for part 234 continues to read as follows:
Authority: 12 U.S.C. 5461 et seq.
0
2. Revise Sec. 234.2 as follows:
Sec. 234.2 Definitions.
(a) Backtest means the ex post comparison of realized outcomes with
margin model forecasts to analyze and monitor model performance and
overall margin coverage.
(b) Central counterparty means an entity that interposes itself
between counterparties to contracts traded in one or more financial
markets, becoming the buyer to every seller and the seller to every
buyer.
(c) Central securities depository means an entity that provides
securities accounts and central safekeeping services.
(d) Designated financial market utility means a financial market
utility that is currently designated by the Financial Stability
Oversight Council under section 804 of the Dodd-Frank Act (12 U.S.C.
5463).
(e) Financial market utility has the same meaning as the term is
defined in section 803(6) of the Dodd-Frank Act (12 U.S.C. 5462(6)).
(f) Link means, for purposes of Sec. 234.3(a)(20), a set of
contractual and operational arrangements between two or more central
counterparties, central securities depositories, or securities
settlement systems that connect them directly or indirectly, such as
for the purposes of participating in settlement, cross margining, or
expanding their services to additional instruments and participants.
(g) Recovery means, for purposes of Sec. 234.3(a)(3) and Sec.
234.3(a)(15), the actions of a designated financial market utility,
consistent with its rules, procedures, and other ex ante contractual
arrangements, to address any uncovered credit loss, liquidity
shortfall, capital inadequacy, or business, operational, or other
structural weakness, including the replenishment of any depleted
prefunded financial resources and liquidity arrangements, as necessary
to maintain the designated financial market utility's viability as a
going concern.
(h) Securities settlement system means an entity that enables
securities to be transferred and settled by book entry and allows
transfers of securities free of or against payment.
(i) Stress test means the estimation of credit or liquidity
exposures that would result from the realization of potential stress
scenarios, such as extreme price changes, multiple defaults, and
changes in other valuation inputs and assumptions.
(j) Supervisory Agency has the same meaning as the term is defined
in section 803(8) of the Dodd-Frank Act (12 U.S.C. 5462(8)).
(k) Wind-down means the actions of a designated financial market
utility to effect the permanent cessation, sale, or transfer of one or
more of its critical operations or services.
0
3. In Sec. 234.3, revise paragraph (a) to read as follows:
Sec. 234.3 Standards for designated financial market utilities.
(a) A designated financial market utility must implement rules,
procedures, or operations designed to ensure that it meets or exceeds
the following risk-management standards with respect to its payment,
clearing, and settlement activities.
(1) Legal basis. The designated financial market utility has a
well-founded, clear, transparent, and enforceable legal basis for each
material aspect of its activities in all relevant jurisdictions.
(2) Governance. The designated financial market utility has
governance arrangements that--
(i) Are clear, transparent, and documented;
(ii) Promote the safety and efficiency of the designated financial
market utility;
(iii) Support the stability of the broader financial system, other
relevant public interest considerations such as fostering fair and
efficient markets, and the legitimate interests of relevant
stakeholders, including the designated financial market utility's
owners, participants, and participants' customers; and
(iv) Are designed to ensure--
(A) Lines of responsibility and accountability are clear and
direct;
(B) The roles and responsibilities of the board of directors and
senior management are clearly specified;
(C) The board of directors consists of suitable individuals having
appropriate skills to fulfill its multiple roles;
(D) The board of directors includes a majority of individuals who
are not executives, officers, or employees of the designated financial
market utility or an affiliate of the designated financial market
utility;
(E) The board of directors establishes policies and procedures to
identify, address, and manage potential conflicts of interest of board
members and to review its performance and the performance of individual
board members on a regular basis;
(F) The board of directors establishes a clear, documented risk-
management framework that includes the designated financial market
utility's risk-tolerance policy, assigns responsibilities and
accountability for risk decisions, and addresses decisionmaking in
crises and emergencies;
(G) Senior management has the appropriate experience, skills, and
integrity necessary to discharge operational and risk-management
responsibilities;
(H) The risk-management function has sufficient authority,
resources, and independence from other operations of the designated
financial market utility, and has a direct reporting line to and is
overseen by a committee of the board of directors;
(I) The internal audit function has sufficient authority,
resources, and independence from management, and has a direct reporting
line to and is overseen by a committee of the board of directors; and
(J) Major decisions of the board of directors are clearly disclosed
to relevant stakeholders, including the designated financial market
utility's owners, participants, and participants' customers, and, where
there is a broad market impact, the public.
(3) Framework for the comprehensive management of risks. The
designated
[[Page 3690]]
financial market utility has a sound risk-management framework for
comprehensively managing legal, credit, liquidity, operational, general
business, custody, investment, and other risks that arise in or are
borne by the designated financial market utility. This framework is
subject to periodic review and includes--
(i) Risk-management policies, procedures, and systems that enable
the designated financial market utility to identify, measure, monitor,
and manage the risks that arise in or are borne by the designated
financial market utility, including those posed by other entities as a
result of interdependencies;
(ii) Risk-management policies, procedures, and systems that enable
the designated financial market utility to identify, measure, monitor,
and manage the material risks that it poses to other entities, such as
other financial market utilities, settlement banks, liquidity
providers, or service providers, as a result of interdependencies; and
(iii) Plans for the designated financial market utility's recovery
or orderly wind-down that--
(A) Identify the designated financial market utility's critical
operations and services related to payment, clearing, and settlement;
(B) Identify scenarios that may potentially prevent it from being
able to provide its critical operations and services as a going
concern, including uncovered credit losses (as described in paragraph
(a)(4)(vi)(A) of this section), uncovered liquidity shortfalls (as
described in paragraph (a)(7)(viii)(A) of this section), and general
business losses (as described in paragraph (a)(15) of this section);
(C) Identify criteria that could trigger the implementation of the
recovery or orderly wind-down plans;
(D) Include rules, procedures, policies, and any other tools the
designated financial market utility would use in a recovery or wind-
down to address the scenarios identified under paragraph (a)(3)(ii)(B)
of this section;
(E) Include procedures to ensure timely implementation of recovery
or orderly wind-down plans in the scenarios identified under paragraph
(a)(3)(ii)(B) of this section; and
(F) Include procedures for informing the Board, as soon as
practicable, if the designated financial market utility is considering
initiating the recovery or orderly wind-down plan.
(4) Credit risk. The designated financial market utility
effectively measures, monitors, and manages its credit exposures to
participants and those arising from its payment, clearing, and
settlement processes. In this regard, the designated financial market
utility maintains sufficient financial resources to cover its credit
exposure to each participant fully with a high degree of confidence. In
addition, the designated financial market utility--
(i) If it operates as a central counterparty, maintains additional
prefunded financial resources that are sufficient to cover its credit
exposure under a wide range of significantly different stress scenarios
that includes the default of the participant and its affiliates that
would potentially cause the largest aggregate credit exposure to the
designated financial market utility in extreme but plausible market
conditions;
(ii) If it operates as a central counterparty, may be directed by
the Board to maintain additional prefunded financial resources that are
sufficient to cover its credit exposure under a wide range of
significantly different stress scenarios that includes the default of
the two participants and their affiliates that would potentially cause
the largest aggregate credit exposure to the designated financial
market utility in extreme but plausible market conditions, if it--
(A) Is involved in activities with a more-complex risk profile,
such as clearing financial instruments characterized by discrete jump-
to-default price changes or that are highly correlated with potential
participant defaults, or
(B) Has been determined by another jurisdiction to be systemically
important in that jurisdiction;
(iii) If it operates as a central counterparty, determines the
amount and regularly tests the sufficiency of the total financial
resources available to meet the requirements of this paragraph by--
(A) On a daily basis, conducting a stress test of its total
financial resources using standard and predetermined stress scenarios,
parameters, and assumptions;
(B) On at least a monthly basis, and more frequently when the
products cleared or markets served experience high volatility or become
less liquid, or when the size or concentration of positions held by the
central counterparty's participants increases significantly, conducting
a comprehensive and thorough analysis of the existing stress scenarios,
models, and underlying parameters and assumptions such that the
designated financial market utility meets its required level of default
protection in light of current and evolving market conditions; and
(C) Having clear procedures to report the results of its stress
tests to decisionmakers at the central counterparty and using these
results to evaluate the adequacy of and adjust its total financial
resources;
(iv) If it operates as a central counterparty, excludes assessments
for additional default or guaranty fund contributions (i.e., default or
guaranty fund contributions that are not prefunded) in its calculation
of financial resources available to meet the total financial resource
requirement under this paragraph;
(v) At least annually, provides for a validation of the designated
financial market utility's risk-management models used to determine the
sufficiency of its total financial resources that--
(A) Includes the designated financial market utility's models used
to comply with the collateral provisions under paragraph (a)(5) of this
section and models used to determine initial margin under paragraph
(a)(6) of this section; and
(B) Is performed by a qualified person who does not perform
functions associated with the model (except as part of the annual model
validation), does not report to such a person, and does not have a
financial interest in whether the model is determined to be valid; and
(vi) Establishes rules and procedures that explicitly--
(A) Address allocation of credit losses the designated financial
market utility may face if its collateral and other financial resources
are insufficient to fully cover its credit exposures, including the
repayment of any funds a designated financial market utility may borrow
from liquidity providers; and
(B) Describe the designated financial market utility's process to
replenish any financial resources that the designated financial market
utility may employ during a stress event, including a participant
default.
(5) Collateral. If it requires collateral to manage its or its
participants' credit exposure, the designated financial market utility
accepts collateral with low credit, liquidity, and market risks and
sets and enforces conservative haircuts and concentration limits, in
order to ensure the value of the collateral in the event of liquidation
and that the collateral can be used in a timely manner. In this regard,
the designated financial market utility--
(i) Establishes prudent valuation practices and develops haircuts
that are tested regularly and take into account stressed market
conditions;
[[Page 3691]]
(ii) Establishes haircuts that are calibrated to include relevant
periods of stressed market conditions to reduce the need for
procyclical adjustments;
(iii) Provides for annual validation of its haircut procedures, as
part of its risk-management model validation under paragraph (a)(4)(vi)
of this section;
(iv) Avoids concentrated holdings of any particular type of asset
where the concentration could significantly impair the ability to
liquidate such assets quickly without significant adverse price
effects;
(v) Uses a collateral management system that is well-designed and
operationally flexible such that it, among other things,--
(A) Accommodates changes in the ongoing monitoring and management
of collateral; and
(B) Allows for the timely valuation of collateral and execution of
any collateral or margin calls.
(6) Margin. If it operates as a central counterparty, the
designated financial market utility covers its credit exposures to its
participants for all products by establishing a risk-based margin
system that--
(i) Is conceptually and methodologically sound for the risks and
particular attributes of each product, portfolio, and markets it
serves, as demonstrated by documented and empirical evidence supporting
design choices, methods used, variables selected, theoretical bases,
key assumptions, and limitations;
(ii) Establishes margin levels commensurate with the risks and
particular attributes of each product, portfolio, and markets it
serves;
(iii) Has a reliable source of timely price data;
(iv) Has procedures and sound valuation models for addressing
circumstances in which pricing data are not readily available or
reliable;
(v) Marks participant positions to market and collects variation
margin at least daily and has the operational capacity to make intraday
margin calls and payments, both scheduled and unscheduled, to
participants;
(vi) Generates initial margin requirements sufficient to cover
potential changes in the value of each participant's position during
the interval between the last margin collection and the close out of
positions following a participant default by--
(A) Ensuring that initial margin meets an established single-tailed
confidence level of at least 99 percent with respect to the estimated
distribution of future exposure; and
(B) Using a conservative estimate of the time horizons for the
effective hedging or close out of the particular types of products
cleared, including in stressed market conditions; and
(vii) Is monitored on an ongoing basis and regularly reviewed,
tested, and verified through--
(A) Daily backtests;
(B) Monthly sensitivity analyses, performed more frequently during
stressed market conditions or significant fluctuations in participant
positions, with this analysis taking into account a wide range of
parameters and assumptions that reflect possible market conditions that
captures a variety of historical and hypothetical conditions, including
the most volatile periods that have been experienced by the markets the
designated financial market utility serves; and
(C) Annual model validations of the designated financial market
utility's margin models and related parameters and assumptions, as part
of its risk-management model validation under paragraph (a)(4)(v) of
this section.
(7) Liquidity risk. The designated financial market utility
effectively measures, monitors, and manages the liquidity risk that
arises in or is borne by the designated financial market utility. In
this regard, the designated financial market utility--
(i) Has effective operational and analytical tools to identify,
measure, and monitor its settlement and funding flows on an ongoing and
timely basis, including its use of intraday liquidity;
(ii) Maintains sufficient liquid resources in all relevant
currencies to effect same-day and, where applicable, intraday and
multiday settlement of payment obligations with a high degree of
confidence under a wide range of significantly different potential
stress scenarios that includes the default of the participant and its
affiliates that would generate the largest aggregate liquidity
obligation for the designated financial market utility in extreme but
plausible market conditions;
(iii) Holds, for purposes of meeting the minimum liquid resource
requirement under paragraph (a)(7)(ii) of this section, cash in each
relevant currency at the central bank of issue or creditworthy
commercial banks or assets that are readily available and convertible
into cash, through committed arrangements without material adverse
change conditions such as--
(A) collateralized lines of credit;
(B) foreign exchange swaps; and
(C) repurchase agreements;
(iv) Evaluates and confirms, at least annually, whether each
provider of the committed arrangements as described in paragraph
(a)(7)(iii) of this section has sufficient information to understand
and manage that provider's associated liquidity risks, and that the
provider has the capacity to perform as required under this commitment;
(v) Maintains and tests its procedures and operational capacity for
accessing each type of liquid resource required under this paragraph at
least annually;
(vi) Determines the amount and regularly tests the sufficiency of
the liquid resources necessary to meet the minimum liquid resource
requirement under this paragraph by--
(A) On a daily basis, conducting a stress test of its liquid
resources using standard and predetermined stress scenarios,
parameters, and assumptions;
(B) On at least a monthly basis, and more frequently when products
cleared or markets served experience high volatility or become less
liquid, or when the size or concentration of positions held by the
designated financial market utility's participants increases
significantly, conducting a comprehensive and thorough analysis of the
existing stress scenarios, models, and underlying parameters and
assumptions such that the designated financial market utility meets its
identified liquidity needs and resources in light of current and
evolving market conditions; and
(C) Having clear procedures to report the results of its stress
tests to decisionmakers at the designated financial market utility and
using these results to evaluate the adequacy of and make adjustments to
its liquidity risk-management framework;
(vii) At least annually, provides for a validation of its liquidity
risk-management model by a qualified person who does not perform
functions associated with the model (except as part of the annual model
validation), does not report to such a person, and does not have a
financial interest in whether the model is determined to be valid; and
(viii) Establishes rules and procedures that explicitly--
(A) Address potential liquidity shortfalls that would not be
covered by the designated financial market utility's liquid resources
and avoid unwinding, revoking, or delaying the same-day settlement of
payment obligations; and
(B) Describe the designated financial market utility's process to
replenish any liquid resources that it may employ during a stress
event, including a participant default.
(8) Settlement finality. The designated financial market utility
provides clear and certain final settlement intraday or in real time as
appropriate, and at a minimum, by the end of the value date.
[[Page 3692]]
The designated financial market utility clearly defines the point at
which settlement is final and the point after which unsettled payments,
transfer instructions, or other settlement instructions may not be
revoked by a participant.
(9) Money settlements. The designated financial market utility
conducts its money settlements in central bank money where practical
and available. If central bank money is not used, the designated
financial market utility minimizes and strictly controls the credit and
liquidity risks arising from conducting its money settlements in
commercial bank money, including settlement on its own books. If it
conducts its money settlements at a commercial bank, the designated
financial market utility--
(i) Establishes and monitors adherence to criteria based on high
standards for its settlement banks that take account of, among other
things, their applicable regulatory and supervisory frameworks,
creditworthiness, capitalization, access to liquidity, and operational
reliability;
(ii) Monitors and manages the concentration of credit and liquidity
exposures to its commercial settlement banks; and
(iii) Ensures that its legal agreements with its settlement banks
state clearly--
(A) When transfers on the books of individual settlement banks are
expected to occur;
(B) That transfers are final when funds are credited to the
recipient's account; and
(C) That the funds credited to the recipient are available
immediately for retransfer or withdrawal.
(10) Physical deliveries. A designated financial market utility
that operates as a central counterparty, securities settlement system,
or central securities depository clearly states its obligations with
respect to the delivery of physical instruments or commodities and
identifies, monitors, and manages the risks associated with such
physical deliveries.
(11) Central securities depositories. A designated financial market
utility that operates as a central securities depository has
appropriate rules and procedures to help ensure the integrity of
securities issues and minimizes and manages the risks associated with
the safekeeping and transfer of securities. In this regard, the
designated financial market utility maintains securities in an
immobilized or dematerialized form for their transfer by book entry.
(12) Exchange-of-value settlement systems. If it settles
transactions that involve the settlement of two linked obligations,
such as a transfer of securities against payment or the exchange of one
currency for another, the designated financial market utility
eliminates principal risk by conditioning the final settlement of one
obligation upon the final settlement of the other.
(13) Participant-default rules and procedures. The designated
financial market utility has effective and clearly defined rules and
procedures to manage a participant default that are designed to ensure
that the designated financial market utility can take timely action to
contain losses and liquidity pressures so that it can continue to meet
its obligations. In this regard, the designated financial market
utility tests and reviews its default procedures, including any close-
out procedures, at least annually or following material changes to
these rules and procedures.
(14) Segregation and portability. A designated financial market
utility that operates as a central counterparty has rules and
procedures that enable the segregation and portability of positions of
a participant's customers and the collateral provided to the designated
financial market utility with respect to those positions.
(15) General business risk. The designated financial market utility
identifies, monitors, and manages its general business risk, which is
the risk of losses that may arise from its administration and operation
as a business enterprise (including losses from execution of business
strategy, negative cash flows, or unexpected and excessively large
operating expenses) that are neither related to participant default nor
separately covered by financial resources maintained for credit or
liquidity risk. In this regard, in addition to holding financial
resources required to manage credit risk (paragraph (a)(4) of this
section) and liquidity risk (paragraph (a)(7) of this section), the
designated financial market utility--
(i) Maintains liquid net assets funded by equity that are at all
times sufficient to ensure a recovery or orderly wind-down of critical
operations and services such that it--
(A) Holds unencumbered liquid financial assets, such as cash or
highly liquid securities, that are sufficient to cover the greater of--
(1) The cost to implement the recovery or wind down plan to address
general business losses as required under Sec. 234.3(a)(3)(iii) and
(2) Six months of current operating expenses or as otherwise
determined by the Board; and
(B) Holds equity, such as common stock, disclosed reserves, and
other retained earnings, that is at all times greater than or equal to
the amount of unencumbered liquid financial assets that are required to
be held under paragraph (a)(15)(i)(A) of this section; and
(ii) Maintains a viable plan, approved by the board of directors
and updated at least annually, for raising additional equity before the
designated financial market utility's equity falls below the amount
required under paragraph (a)(15)(i) of this section.
(16) Custody and investment risks. The designated financial market
utility--
(i) Safeguards its own and its participants' assets and minimizes
the risk of loss on and delay in access to these assets by--
(A) Holding its own and its participants' assets at supervised and
regulated entities that have accounting practices, safekeeping
procedures, and internal controls that fully protect these assets; and
(B) Evaluating its exposures to its custodian banks, taking into
account the full scope of its relationships with each; and
(ii) Invests its own and its participants' assets--
(A) In instruments with minimal credit, market, and liquidity
risks, such as investments that are secured by, or are claims on, high-
quality obligors and investments that allow for timely liquidation with
little, if any, adverse price effect; and
(B) Using an investment strategy that is consistent with its
overall risk-management strategy and fully disclosed to its
participants.
(17) Operational risk. The designated financial market utility
manages its operational risks by establishing a robust operational
risk-management framework that is approved by the board of directors.
In this regard, the designated financial market utility--
(i) Identifies the plausible sources of operational risk, both
internal and external, and mitigates their impact through the use of
appropriate systems, policies, procedures, and controls that are
reviewed, audited, and tested periodically and after major changes;
(ii) Identifies, monitors, and manages the risks its operations
might pose to other financial market utilities;
(iii) Has policies and systems that are designed to achieve clearly
defined objectives to ensure a high degree of security and operational
reliability;
(iv) Has systems that have adequate, scalable capacity to handle
increasing stress volumes and achieve the
[[Page 3693]]
designated financial market utility's service-level objectives;
(v) Has comprehensive physical, information, and cyber security
policies, procedures, and controls that address potential and evolving
vulnerabilities and threats;
(vi) Has business continuity management that provides for rapid
recovery and timely resumption of critical operations and fulfillment
of its obligations, including in the event of a wide-scale disruption
or a major disruption; and
(vii) Has a business continuity plan that--
(A) Incorporates the use of a secondary site that is located at a
sufficient geographical distance from the primary site to have a
distinct risk profile;
(B) Is designed to ensure that critical information technology
systems can recover and resume operations no later than two hours
following disruptive events;
(C) Is designed to enable it to complete settlement by the end of
the day of the disruption, even in case of extreme circumstances; and
(D) Is tested at least annually.
(18) Access and participation requirements. The designated
financial market utility has objective, risk-based, and publicly
disclosed criteria for participation, which permit fair and open
access. The designated financial market utility--
(i) Monitors compliance with its participation requirements on an
ongoing basis and has the authority to impose more-stringent
restrictions or other risk controls on a participant in situations
where the designated FMU determines the participant poses heightened
risk to the designated FMU; and
(ii) Has clearly defined and publicly disclosed procedures for
facilitating the suspension and orderly exit of a participant that
fails to meet the participation requirements.
(19) Tiered participation arrangements. The designated financial
market utility identifies, monitors, and manages the material risks to
the designated financial market utility arising from arrangements in
which firms that are not members in the designated financial market
utility rely on the services provided by direct participants to access
the designated financial market utility's payment, clearing, or
settlement facilities.
(20) Links to other financial market utilities. If it operates as a
central counterparty, securities settlement system, or central
securities depository and establishes a link with one or more of these
types of financial market utilities, the designated financial market
utility identifies, monitors, and manages risks related to this link.
In this regard, each central counterparty in a link arrangement with
another central counterparty covers, at least on a daily basis, its
current and potential future exposures to the linked central
counterparty and its participants, if any, fully with a high degree of
confidence without reducing the central counterparty's ability to
fulfill its obligations to its own participants.
(21) Efficiency and effectiveness. The designated financial market
utility--
(i) Is efficient and effective in meeting the requirements of its
participants and the markets it serves, in particular, with regard to
its--
(A) Clearing and settlement arrangement;
(B) Risk-management policies, procedures, and systems;
(C) Scope of products cleared and settled; and
(D) Use of technology and communication procedures;
(ii) Has clearly defined goals and objectives that are measurable
and achievable, such as minimum service levels, risk-management
expectations, and business priorities; and
(iii) Has policies and procedures for the regular review of its
efficiency and effectiveness.
(22) Communication procedures and standards. The designated
financial market utility uses, or at a minimum accommodates, relevant
internationally accepted communication procedures and standards in
order to facilitate efficient payment, clearing, and settlement.
(23) Disclosure of rules, key procedures, and market data. The
designated financial market utility--
(i) Has clear and comprehensive rules and procedures;
(ii) Publicly discloses all rules and key procedures, including key
aspects of its default rules and procedures;
(iii) Provides sufficient information to enable participants to
have an accurate understanding of the risks, fees, and other material
costs they incur by participating in the designated financial market
utility;
(iv) Provides a comprehensive public disclosure of its legal,
governance, risk management, and operating framework, that includes--
(A) Executive summary. An executive summary of the key points from
paragraphs (a)(23)(iv)(B) through (D) of this section;
(B) Summary of major changes since the last update of the
disclosure. A summary of the major changes since the last update of
paragraph (a)(23)(iv) (C), (D), or (E) of this section;
(C) General background on the designated financial market utility.
A description of--
(1) The designated financial market utility's function and the
markets it serves,
(2) Basic data and performance statistics on its services and
operations, such as basic volume and value statistics by product type,
average aggregate intraday exposures to its participants, and
statistics on the designated financial market utility's operational
reliability, and
(3) The designated financial market utility's general organization,
legal and regulatory framework, and system design and operations;
(D) Standard-by-standard summary narrative. A comprehensive
narrative disclosure for each applicable standard set forth in this
paragraph (a) with sufficient detail and context to enable a reader to
understand the designated financial market utility's approach to
controlling the risks and addressing the requirements in each standard;
and
(E) List of publicly available resources. A list of publicly
available resources, including those referenced in the disclosure, that
may help a reader understand how the designated financial market
utility controls its risks and addresses the requirements set forth in
this paragraph (a); and
(v) Updates the public disclosure under paragraph (a)(23)(iv) of
this section every two years, or more frequently following changes to
its system or the environment in which it operates that would
significantly change the accuracy of the statements provided under
paragraph (a)(23)(iv) of this section.
* * * * *
Sec. 234.4 [Removed]
0
4. Remove Sec. 234.4.
Sec. 234.5 [Redesignated as Sec. 234.4]
0
5. Redesignate Sec. 234.5 as Sec. 234.4.
Sec. 234.5 [Added and Reserved]
0
6. A new Sec. 234.5 is added and reserved.
Sec. 234.6 [Removed and Reserved]
0
7. Remove and reserve Sec. 234.6.
By order of the Board of Governors of the Federal Reserve
System, January 10, 2014.
Robert deV. Frierson,
Secretary of the Board.
[FR Doc. 2014-00682 Filed 1-21-14; 8:45 am]
BILLING CODE P