[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  

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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

[[Page 3667]]

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

[[Page 3670]]

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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \34\ The proposed standard replaces Sec.  234.4(a)(13) under 
current Regulation HH.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \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]
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