[Federal Register Volume 63, Number 123 (Friday, June 26, 1998)]
[Notices]
[Pages 34888-34895]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-16694]


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FEDERAL RESERVE SYSTEM

[Docket No. R-0987]


Policy Statement on Privately Operated Multilateral Settlement 
Systems

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Policy statement.

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SUMMARY: As part of its payment system risk reduction program, the 
Board of Governors is adopting a policy statement on Privately Operated 
Multilateral Settlement Systems, which integrates its existing policies 
on Privately Operated Large-Dollar Multilateral Netting Systems and 
Private Small-Dollar Clearing and Settlement Systems into one 
comprehensive policy.

EFFECTIVE DATE: January 4, 1999.

FOR FURTHER INFORMATION CONTACT: Jeffrey C. Marquardt, Assistant 
Director (202/452-2360) or Paul Bettge, Assistant Director (202/452-
3174); Oliver Ireland, Associate General Counsel (202/452-3625); for 
the hearing impaired only, Telecommunications Device for the Deaf, 
Diane Jenkins (202/452-3544).

SUPPLEMENTARY INFORMATION:

I. The Proposed Policy Statement

    In November, 1997, the Board issued for public comment a proposal 
to adopt a policy statement on Privately Operated Multilateral 
Settlement Systems (62 FR 60713, Nov. 12, 1997). The proposed policy 
statement was designed to integrate several of the Board's existing 
policies on payment system risk into a more comprehensive and 
consistent framework. The proposed policy statement addressed risks in 
multilateral settlement arrangements for both ``small-dollar'' 
payments, such as clearinghouses for checks and automated clearing 
house (ACH) payments and systems for settlement of ``large-dollar'' 
payments, which are typically used for interbank and financial market 
transactions. The proposal was intended to provide a flexible, risk-
based approach to risk management in these systems and not mandate 
uniform, rigid requirements for all systems.
    The proposed policy statement identified fundamental categories of 
risk, including credit, liquidity, operational, legal, and systemic 
risk, that may arise in different types of multilateral settlement 
arrangements. Systems would be expected to address any material risks 
in each category. For each type of risk, the policy statement included 
first, a discussion of risk factors designed to identify those 
multilateral settlement systems where risks may be heightened relative 
to other means of settlement. Second, threshold criteria were intended 
to identify more clearly systems in which these risk factors were not 
likely to arise. These criteria were intended to simplify 
administration of the policy and reduce potential regulatory burden on 
systems where the Board's analysis suggests that risks may be minimal. 
(An Appendix published with the proposed policy statement also provided 
examples of the likely application of the policy statement to specific 
types of systems.) Third, the proposed policy statement provided 
illustrations of the types of risk management measures that may be 
appropriate given the particular risk factors identified. Particularly 
for multilateral settlement systems that are not likely to raise 
systemic risk concerns, these illustrations were intended to provide 
flexible guidance rather than an exhaustive or prescriptive set of 
requirements, such that systems would be encouraged to implement risk 
management measures commensurate with the scale and scope of risks.
    For multilateral settlement systems that were considered 
sufficiently large to raise potential systemic risk concerns, the 
proposed policy statement would have imposed higher risk management 
standards. Those larger systems that met proposed systemic risk 
criteria would have been expected to demonstrate robust policies and 
procedures for addressing settlement failures and disruptions. Certain 
of those larger multilateral settlement systems would also have been 
required to meet the same requirements of the Board's existing policy 
statement on Privately Operated Large-Dollar Multilateral Netting 
Systems (Large-Dollar Policy Statement), including meeting the 
Lamfalussy Minimum Standards.<SUP>1</SUP>
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    \1\ Report of the Committee on Interbank Netting Schemes of the 
Central Banks of the Group of Ten Countries (Bank for International 
Settlements, November 1990) presented a set of minimum standards for 
netting schemes (Lamfalussy Minimum Standards).
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    The Board also proposed to repeal its existing risk policies for 
certain ``small-dollar'' payments clearing and settlement arrangements. 
The earlier policies were designed to address specific situations that 
arose in the Federal Reserve's provision of net settlement services to 
depository institutions. The proposed policy statement would eliminate 
the need for such policies.

II. The Final Policy Statement

    The Board is adopting a final policy statement that retains the 
structure and analytical approach of the original proposal. The policy 
statement replaces two existing components of the Board's Policy 
Statement on Payments System Risk, namely those for ``Privately 
Operated Large-Dollar Multilateral Netting Systems'' and ``Private 
Small-Dollar Clearing and Settlement Systems,'' which are being 
repealed concurrently with the effective date of this policy statement. 
As in the proposal, multilateral settlement systems subject to the 
policy would be required to address risk factors using a set of basic 
analytical risk categories. The final policy statement reflects 
important modifications to the original proposal designed to improve 
the clarity and effectiveness of the policy and to address concerns 
identified by commenters.

Scope and Administration of the Policy

    The final policy statement includes a general threshold for 
application of the policy in order to eliminate potential 
administrative burden on those smaller

[[Page 34889]]

systems that are not likely to pose systemic risks or other significant 
risk concerns. Specifically, the policy will apply to those 
multilateral settlement systems that settle payments with an aggregate 
gross value of more than $5 billion on any day. The Board believes that 
systems with activity below this threshold and their members may 
nonetheless find the framework and analysis of the policy statement 
helpful in evaluating and managing risks.

Risk Factors and Risk Management Measures

    The final policy statement largely retains the discussions of 
credit, liquidity, operational, and legal risk factors and risk 
management measures in the proposal. Technical modifications have been 
made in a number of areas, however, to clarify the policy and address 
concerns of commenters, as discussed further below. In conjunction with 
the limitation on the scope of the policy discussed above, the final 
policy has been simplified by elimination of the proposed separate 
Systemic Risk category.
    As in the proposed policy statement and the Board's existing Policy 
Statement on Payments System Risk, certain systems are required to meet 
the Lamfalussy Minimum Standards. However, under the final policy, the 
Board will use several factors to determine whether a system should 
meet the Lamfalussy Minimum Standards. These factors include the 
settlement of predominantly large-value, interbank or other financial 
market transactions, such as foreign exchange transactions, or the 
existence of credit or liquidity exposures that have the potential to 
raise significant systemic risk concerns. These factors should ensure 
that the Lamfalussy Minimum Standards will be applied where systemic 
risks exist, but allow for more flexible risk management in other 
systems. The Board may be required to make infrequent case-by-case 
determinations in this regard. In addition, the final policy strongly 
encourages systems, in meeting the Lamfalussy Minimum Standards, to 
establish real-time risk controls and other specific risk management 
measures, as currently described in the Board's existing Large-Dollar 
Policy Statement. However, alternative risk management measures that 
provide an equivalent level of assurance that the Lamfalussy Minimum 
Standards will be met will also be considered. The final policy also 
includes modified terminology in restating the Lamfalussy Minimum 
Standards to reflect the policy's broader application to ``settlement'' 
systems rather than to ``netting'' systems only.

III. Summary of Comments

    The Board received 26 public comment letters on its proposed policy 
statement.<SUP>2</SUP> The commenters included nine commercial banking 
organizations, seven clearing organizations and associations, seven 
retail payment networks, and three trade associations.
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    \2\ This total does not include comment letters from Federal 
Reserve Banks.
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General Comments

    Commenters generally supported the policy's flexible approach to 
addressing risks in multilateral settlement arrangements. Many also 
supported the integration of the Board's existing policy statements 
within a unified, analytical framework. However, a number of commenters 
expressed concerns about the inclusion of clearinghouses for small-
dollar or traditionally retail-oriented payments, such as checks, ACH 
payments, and automated teller machine (ATM) and credit card 
transactions, within a comprehensive policy on settlement risk. Many of 
these commenters focused on the requirements for real-time risk 
controls associated with the Lamfalussy Minimum Standards (discussed 
further below) and on the implication that small-dollar payments 
settlement arrangements may pose systemic risk. Three commenters felt 
that there was no rationale for unifying the large-and small-dollar 
policies for settlement arrangements.
    A number of commenters described risk management measures used in 
their system and requested exemptions from the policy based on those 
measures. Several commenters requested that particular types of systems 
or payments be exempt from the policy altogether, such as credit card 
or ATM card settlement arrangements. Several commenters felt that the 
policy was too vague and did not provide sufficient guidance regarding 
measures that would be adequate for compliance with the policy.
    The limitation on the scope of the policy to systems with daily 
payment activity above $5 billion should address concerns expressed by 
commenters about the potential burden of the policy statement on 
smaller, retail-oriented systems. Under the policy, only the largest 
systems will need to complete an analysis of credit, liquidity, 
operational, and legal risks.
    For systems subject to the policy statement, the Board believes 
that the flexible approach set out in the policy, while requiring more 
careful analysis on the part of the clearinghouses than would a more 
rigid set of requirements, is the most likely to lead to appropriate 
risk management measures commensurate with the level and nature of 
risks in different systems. The Board emphasizes that the policy does 
not necessarily imply that any particular system needs to make changes 
to its policies or procedures. In particular, for some systems covered 
by the policy, the risk factors described in the policy statement may 
not be significant. For systems that do exhibit one or more risk 
factors, the types of risk management measures described by a number of 
commenters are likely to be sufficient to meet the requirements of the 
policy statement. Moreover, the new policy is likely to be less 
burdensome than the Board's existing payment system risk policies for 
small-dollar payments arrangements because it does not contain specific 
risk management requirements for these systems. The final policy also 
clarifies that, in general, the Board does not believe that retail-
oriented systems need to meet fully the Lamfalussy Minimum Standards 
and implement real-time risk controls.
    Six commenters requested that the Board reference and endorse other 
reports on payment system risk, including one report on settlement risk 
issued by a private-sector task force (the NACHA/NOCH Report) and a 
General Accounting Office report.<SUP>3</SUP> These reports include 
useful background information and insights on certain aspects of 
payment system risk. Although many of the findings of the NACHA/NOCH 
Report are consistent with those in this policy statement, the Board 
does not believe that it would be appropriate to attempt to incorporate 
these findings within this policy statement.
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    \3\ National Organization of Clearing Houses and National 
Automated Clearing House Association, Report of the Settlement Risk 
Management Task Force: Findings and Recommendations, 1996; General 
Accounting Office, Payments, Clearance, and Settlement: A Guide to 
the Systems, Risks, and Issues, June 1997, GAO/GGD-97-73.
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Specific Issues on Which the Board Sought Comment

1. Identification of Material Risks; Threshold Criteria
    Most commenters felt that the risk categories and descriptions of 
risk factors and risk management measures reasonably captured the 
features of multilateral settlement systems likely to lead to greater 
settlement risk (with the exception of the Systemic Risk category, 
discussed below). Two commenters requested that definitions of major 
risks

[[Page 34890]]

be included in the policy. The final policy includes brief definitions 
of credit, liquidity, operational, and legal risks in the context of 
settlement risk management.
    As noted above, the proposed policy statement included ``threshold 
criteria'' for each risk category to distinguish systems not likely to 
pose material risk factors. Many commenters requested clarification of 
the definition of certain of the thresholds. A number of commenters 
described certain features of their system and requested that systems 
with these features be exempt from the policy. Others noted that 
certain risk factors, such as loss-sharing arrangements, would in many 
cases not give rise to material risks for participants given the small 
size of potential losses. A number of participants felt that the 
netting factor was not a useful indication of liquidity risk.
    The original intent of the threshold criteria was to provide 
simple, de minimis exclusions for systems where risks were not likely 
to be material. Questions raised by commenters indicate that these 
criteria may not prove to be as simple to implement as originally 
intended. The limitation on the scope of the policy to systems with 
daily payment activity above $5 billion should address many of the 
concerns of commenters. The final policy thus does not include separate 
threshold criteria, although it retains the closely related discussion 
of risk factors.
    Some commenters requested that the Board clarify that not all risk 
management measures listed under the discussion of risk management 
measures are required to address a particular risk factor. The final 
policy clarifies that this is the case.
    Some commenters, such as ATM networks, requested greater 
specificity on which risk management measures would be required for 
their systems in order to be considered in compliance with the policy 
statement. Others requested that the Board confirm that certain risk 
measures used by their system would be considered sufficient to address 
a particular risk factor in all cases. For example, two commenters 
requested that the Board confirm that credit card systems do not 
exhibit legal risk by virtue of their operating rules; other commenters 
requested that use of the Federal Reserve's net settlement service be 
considered adequate protection against legal risk. Some commenters 
requested clarification on the acceptability of gross versus net 
recasts of payments in a settlement failure situation.
    As noted above, the limitation on the scope of the policy to the 
largest systems should address many of the concerns of commenters. Even 
for these larger systems, the Board believes that because different 
systems may implement different risk management measures appropriate to 
the scale of risks and the nature of their operations, additional 
prescriptive requirements would not be appropriate for all systems and 
would undermine the flexible approach of the policy. Moreover, the 
Board is not in a position to confirm that particular measures adopted 
by particular systems, such as specific time frames for settlement, 
provisions of system rules, or use of any particular settlement 
services, would be sufficient to address particular risk factors 
independent of detailed knowledge of the operations and other features 
of the particular system on an ongoing basis. However, the final policy 
clarifies that a system that exhibits one or more risk factors does not 
necessarily need to enhance its risk management policies and procedures 
if existing arrangements are adequate to address the particular risk 
factor.
2. Systemic Risk Criteria and Risk Management Measures
    The proposed policy set out dollar thresholds for identifying 
systems that have the potential to pose systemic risk. The Board 
requested comment on the thresholds used to identify those systems with 
the potential to pose systemic risk, as well as on the risk management 
measures specified for such systems. Commenters suggested a range of 
different criteria that may be indicative of systemic risk, including 
gross and net settlement volumes, settlements relative to individual 
participants' capital, and the characteristics of underlying payments. 
Some commenters noted that a uniform threshold was inappropriate, as 
systemic risk could depend on many factors. Commenters also requested 
clarification on risk management measures, including the application of 
the Lamfalussy Minimum Standards.
    To simplify the analysis and assessment of risks and address 
concerns expressed by commenters, the final policy does not include a 
separate component for ``Systemic Risk.'' As noted earlier, the overall 
scope of the policy has also been limited to systems with aggregate 
gross daily payment activity above $5 billion. This threshold is also 
consistent with suggestions made by some commenters for identifying 
systems that may pose systemic risk. The Board considered other 
thresholds, such as those based on settlement exposures relative to the 
capital of participants, but concluded that such thresholds would be 
overly complex and burdensome as a means of identifying systems that 
are subject to the policy statement (as well as those that are not).
    The Board continues to believe that the Lamfalussy Minimum 
Standards provide important guidance for addressing settlement risk in 
multilateral settlement systems where failure to settle net obligations 
as and when expected could have systemic consequences. However, the 
requirement that a system be capable of settling all positions in the 
event of the default of the largest single participant may not be 
necessary for certain systems. Although large check, ACH, and credit 
card settlement arrangements, for example, should demonstrate sound 
risk management measures, the Board does not believe that all of the 
requirements of the Lamfalussy Minimum Standards are generally 
necessary for these systems. Settlement obligations for individual 
participants are not of the same magnitude as in traditional large-
value payment systems, and credit and liquidity exposures are typically 
diversified over large numbers of participants. In many cases, there 
are reliable and timely alternatives to settlement through the 
clearinghouse, particularly for check and ACH clearing and settlement 
arrangements.
    The Board will, therefore, apply additional factors to determine 
whether systems must meet the Lamfalussy Minimum Standards. These 
factors include settlement of high volumes of large-value, interbank or 
other financial market transactions, such as foreign exchange 
transactions, or significant systemic credit or liquidity risks.
    The proposed policy enumerated the five implementation measures, 
including real-time controls and net debit caps, required of systems 
currently subject to the Lamfalussy Minimum Standards. Many commenters 
felt that real-time interbank risk controls and bilateral credit limits 
were generally not feasible or desirable for retail payment systems.
    The modifications to the proposal discussed above should obviate 
these concerns. In addition, to provide additional flexibility, the 
final policy has been modified to permit alternative risk management 
controls that provide an equivalent level of certainty that the 
Lamfalussy Minimum Standards can be met. The final policy also 
clarifies that, as in the Board's existing policy for large-dollar 
multilateral netting systems, centrally managed limits between the

[[Page 34891]]

system and each participant would be considered equivalent to bilateral 
limits when the system itself acts as a central counterparty or 
otherwise guarantees settlement. This is also consistent with the 
Board's approach under Regulation F, where institutions are required to 
set bilateral limits on credit and liquidity exposures to 
correspondents and other counterparties.
3. Usefulness of an Appendix
    Most commenters felt that the Appendix to the proposed policy 
containing examples of application of the policy was useful, although 
several commenters disagreed. Given the limitation on the scope of the 
final policy, the Board does not believe that such examples are 
necessary. Thus, the final policy does not include an Appendix.

Other Comments

1. Administration and Enforcement of the Policy Statement
    A number of commenters raised questions about the administration 
and enforcement of the policy statement. Two commenters stated that the 
Board should not apply or enforce the policy through provision of 
Federal Reserve net settlement services. Several commenters encouraged 
the development of interagency supervisory examination procedures to 
provide a consistent, objective approach to enforcement of the policy 
statement. A few commenters requested that the legal status of the 
policy statement be clarified, and that an appeals process be specified 
for actions taken under the policy statement.
    Like other components of the Board's Policy Statement on Payments 
System Risk, this policy statement is not a regulation, but rather 
provides the framework that the Board expects to use when taking action 
on matters within its jurisdiction. The Board expects to administer the 
policy statement through its existing authority, including its 
supervisory jurisdiction over institutions such as state member banks 
and bank holding companies, as well as Federal Reserve service 
relationships, where appropriate. The assessment of compliance with the 
policy statement will not be based on the use of any particular type of 
Federal Reserve net settlement service, but rather on systems' risk 
factors and risk management policies. The avenues for appealing actions 
under the policy would be the same as in the Board's existing 
supervisory or service relationships. Given the limited scope of the 
final policy, the Board does not believe that interagency examination 
procedures are needed at this time.
    Two commenters asked that the Board clearly specify any reporting 
requirements for gross and net settlement data and position data. The 
final policy includes a clarification as to the type of data that may 
be requested.
2. Repeal of Existing Small-Dollar Policies
    Five commenters objected to the perceived withdrawal of the Board's 
approval under the Board's existing payment system risk policies for 
small-dollar systems. Some of these commenters requested that a program 
of certification of compliance with the policy statement be developed 
in lieu of these ``approvals.''
    The ``approvals'' referred to by commenters represent previous 
determinations by the Board that particular systems may use the 
Fedwire-based net settlement services across multiple Federal Reserve 
Districts. In 1990, the Board established a set of conditions, embodied 
in the current Payments System Risk policy for ``small-dollar'' 
systems, for the use of this service. Subsequent applications for 
cross-District net settlement services have been reviewed under this 
policy. The conditions in the policy were designed in large part to 
address specific concerns about risk to the Federal Reserve in 
providing cross-District net settlement services.
    Although the Board is repealing its existing small-dollar policies 
concurrently with the issuance of this policy statement, the Board is 
not repealing the prior approval of any system to use the Fedwire-
based, cross-District net settlement service in conjunction with 
issuance of this policy. In general, such cross-District systems may 
continue to use the Fedwire-based net settlement service. As with any 
system subject to this policy, regardless of whether it uses the 
Fedwire-based net settlement service, another Federal Reserve net 
settlement service, or another settlement method, appropriate 
enforcement actions will be considered if the system is found to be not 
in compliance with the policy. The Board also notes that approval to 
use the cross-District net settlement service or any other Federal 
Reserve service does not imply Federal Reserve endorsement of a 
particular system or of its risk management arrangements, and should 
not be used to communicate any such endorsement to participants or 
potential participants. Moreover, the Board does not anticipate 
formally certifying compliance of systems under the policy, as this 
would be likely to reduce the normal incentives for participants to 
monitor and manage the risk in systems in which they participate.

Effective Date

    The policy statement will be effective January 4, 1999 to permit 
systems subject to the policy a six-month period to assess and ensure 
their compliance. Although the Board does not expect that compliance 
with the policy statement will necessitate operational changes for the 
few systems that will fall within its scope, the Board recognizes that 
systems may currently have other critical efforts underway, such as 
preparation for the century date change. As a result, the Board will 
consider extending the effective date on a case-by-case basis for 
systems that can demonstrate significant resource demands due to other 
critical efforts.

Competitive Impact Analysis

    The Board has established procedures for assessing the competitive 
impact of rule or policy changes that have a substantial impact on 
payments system participants.<SUP>4</SUP> Under these procedures, the 
Board will assess whether a change would have a direct and material 
adverse effect on the ability of other service providers to compete 
effectively with the Federal Reserve in providing similar services due 
to differing legal powers or constraints, or due to a dominant market 
position of the Federal Reserve deriving from such differences. If no 
reasonable modifications would mitigate the adverse competitive 
effects, the Board will determine whether the anticipated benefits are 
significant enough to proceed with the change despite the adverse 
effects.
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    \4\ These procedures are described in the Board's policy 
statement ``The Federal Reserve in the Payments System,'' as revised 
in March 1990. (55 FR 11648, March 29, 1990).
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    The Board does not believe that the adoption of this policy 
statement will have a direct and material adverse impact on the ability 
of other service providers to compete effectively with the Reserve 
Banks' payments services. The repeal of the Board's existing policies 
for small-dollar payments clearing arrangements, together with the 
Board's proposal for an enhanced net settlement service, should reduce 
costs and other potential barriers for private check and ACH clearing 
and settlement arrangements that compete with the Federal Reserve. 
While the Reserve Banks are not subject to this policy statement, the 
Board notes that settlement risk exposures arising from services 
provided by central banking organizations are inherently different than 
for private-sector organizations. In

[[Page 34892]]

addition, the Reserve Banks are subject to Part I of the Policy 
Statement on Payments System Risk, which requires them to implement an 
extensive program of risk controls, including ongoing monitoring of all 
depository institution customers, net debit caps, and fees that are 
charged to depository institutions for the use of intraday credit.

Federal Reserve System Policy Statement on Payments System Risk

    The Board is amending its ``Federal Reserve System Policy Statement 
on Payments System Risk'' (57 FR 40455, September 3, 1992) under the 
heading ``II. Policies for Private-Sector Systems'' by removing ``A. 
Privately Operated Large-Dollar Multilateral Netting Systems'' in its 
entirety and adding in its place ``A. Privately Operated Multilateral 
Settlement Systems'' and removing ``C. Private Small-Dollar Clearing 
and Settlement Systems'' in its entirety.

II. Policies for Private-Sector Systems

A. Privately Operated Multilateral Settlement Systems

Introduction
    Multilateral settlement systems, such as clearinghouses and similar 
arrangements, may produce important efficiencies in the clearance and 
settlement of payments and financial contracts. Participants in such 
systems, typically depository institutions, exchange payments for their 
own account or the accounts of their customers in a coordinated fashion 
and settle the resulting obligations on a multilateral, often net, 
basis.
    A variety of credit, liquidity, and other risks can arise in the 
clearing and settlement process that institutions must manage in the 
normal course of business, regardless of the method of clearing and 
settlement. Existing supervisory standards are generally directed at 
ensuring that institutions establish appropriate policies and 
procedures to manage such risks. For example, Federal Reserve 
Regulation F directs insured depository institutions to establish 
policies and procedures to avoid excessive exposures to any other 
depository institutions, including exposures that may be generated 
through the clearing and settlement of payments.<SUP>18</SUP>
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    \18\ See 12 CFR 206.
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    However, the use of multilateral settlement systems introduces the 
risk that a failure of one participant in the system to settle its 
obligations when due could have credit or liquidity effects on 
participants that have not dealt with the defaulting participant. 
Multilateral settlement may, in some cases, also have the effect of 
altering the underlying bilateral relationships that arise between 
institutions during the clearing and settlement process. As a result, 
the incentives for, or ability of, institutions to manage and limit the 
risk exposures to other institutions, as required under Regulation F, 
may be reduced. In addition, in some cases, there may be no timely or 
feasible alternative to settlement through the multilateral system in 
the event that the system fails to complete settlement, due, for 
example, to a participant default. These factors may create added risks 
to participants in certain multilateral settlement systems relative to 
other settlement methods. As a result, a number of multilateral 
settlement systems and their participants have implemented a variety of 
risk management measures to control these risks.
    Clearinghouses also may generate systemic risks that could threaten 
the financial markets or the economy more broadly. The failure of a 
system to complete settlement as and when expected could generate 
unexpected credit losses or liquidity shortfalls that participants in 
the system are not able to absorb. Thus, the inability of one 
participant to meet its obligations within the system when due could 
lead to the illiquidity or failure of other institutions. Further, the 
disruption of a large number of payments and the resulting uncertainty 
could lead to broader effects on economic activity. In addition, as the 
Federal Reserve has established net debit caps and fees for daylight 
overdrafts, along with other risk management measures for Federal 
Reserve payment services, the potential exists for intraday credit 
risks to be shifted from the Federal Reserve to private, multilateral 
settlement arrangements, either domestically or in other countries, 
that have inadequate risk controls.
    The Board believes that these concerns warrant the application of a 
risk management policy to those multilateral settlement systems that 
have the potential to raise systemic risks, particularly in cases where 
risks may not be adequately addressed by existing supervisory guidance 
on management of exposures to other depository institutions. The Board 
recognizes that multilateral settlement systems differ widely in terms 
of form, function, scale, and scope of activities. Thus, risk 
management measures may be designed differently for different systems. 
This policy statement, therefore, is designed to permit market 
participants to determine the best means of addressing risks, within 
the guidelines provided. As a general rule, risk management measures 
should be commensurate with the nature and magnitude of risks involved.
    The Board's adoption of this policy in no way diminishes the 
primary responsibilities of participants in, and operators of, 
multilateral settlement systems to address settlement and other risks 
that may arise in these systems. In addition, the Board encourages all 
multilateral settlement systems to consider periodically cost-effective 
risk management improvements, even if not specifically required under 
this policy. Insured depository institutions participating in 
multilateral settlement systems are also expected to limit any 
significant bilateral credit and liquidity exposures to other 
institutions as required under Federal Reserve Regulation F.
Scope and Administration of the Policy
    This policy statement applies to privately operated multilateral 
settlement systems or arrangements with three or more participants that 
settle U.S. dollar payments, including but not limited to systems for 
the settlement of checks, automated clearinghouse (ACH) transfers, 
credit, debit, and other card transactions, large-value interbank 
transfers, or foreign exchange contracts involving the U.S. dollar 
where the aggregate gross value of payments is expected to exceed $5 
billion on any day during the next 12 months. <SUP>19</SUP> Further, 
the policy does not apply to clearing and settlement systems for 
securities or exchange-traded futures and options, and is not intended 
to apply to bilateral relationships between financial institutions, 
such as those involved in traditional correspondent banking. The Board 
may also apply this policy to any non-U.S. dollar system based, or 
operated, in the United States that engages in the multilateral 
settlement of non-dollar payments among financial institutions and that 
would otherwise be subject to this policy.
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    \19\ The gross value of payments settled refers to the total 
dollar value of individual payments or transactions that are settled 
in the system, which represents the sum of total debits or total 
credits to all participants prior to any netting of settlement 
obligations. ``On-us'' transactions that do not require interbank 
settlement, but may in some cases be processed by the system, may be 
excluded for purposes of these calculations. Where a system conducts 
multiple settlements per day, these settlements should be aggregated 
for purposes of this calculation if they are conducted among the 
same group of participants subject to the same rules and procedures.

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[[Page 34893]]

    The Board expects to be guided by this policy statement in taking 
action in its supervisory and operational relationships with state 
member banks, bank holding companies, and clearinghouse arrangements, 
including, for example, the provision of net settlement services and 
the implementation of the Bank Service Company Act. <SUP>20</SUP> 
Systems subject to this policy may be asked to provide to the Federal 
Reserve peak and daily average aggregate gross and net settlement data 
for the most recent 12-month period or calendar year, as well as peak 
and daily average settlement position data for individual participants.
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    \20\ 12 U.S.C. 1861-67.
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Risk Factors and Risk Management Measures
    An analysis of settlement risks in any multilateral settlement 
system should begin with the identification of key risks and exposures. 
For purposes of this policy, the general categories of settlement risk 
include credit risk--the risk to participants or to the system that a 
participant will be unable to meet fully its settlement obligation; 
liquidity risk--the risk that participants or the system will have 
insufficient funds available to meet settlement obligations as and when 
expected; operational risk--the risk that operational factors in the 
settlement process may cause or exacerbate these credit or liquidity 
risks or disrupt the settlement of payments; and legal risk--the risk 
that legal uncertainties in the settlement process may cause or 
exacerbate these credit and liquidity risks.
    Systems subject to the policy that exhibit one or more risk factors 
should assess whether their policies and procedures adequately address 
those specific risks, including consideration of the risk management 
measures listed below. In general, risk management controls should be 
proportional to the nature and magnitude of risks in the particular 
system. The Board does not expect that all of the specific risk 
management measures listed below will be necessary or appropriate for 
all systems; moreover, there may be other risk management measures that 
will address a particular risk factor. Systems that exhibit one or more 
risk factors may not need to implement any additional risk controls as 
a result of this assessment if existing risk controls adequately 
address the particular risk.
    If necessary, the Board and its staff will work with systems to 
determine whether changes in their policies or operations are required 
and, if so, whether steps proposed by the system would adequately 
address the risk factor. In some cases, an operational change may 
mitigate a particular risk factor. In other cases, systems may need to 
develop or modify written rules, policies, and procedures that specify 
the rights and obligations of participants, as well as other relevant 
parties, such as settlement agents for the system, in the event that a 
settlement cannot be completed as and when expected. Such rules and 
procedures should be disclosed to all participants and their primary 
regulatory authorities.
    To facilitate the analysis under this policy, systems may need to 
develop the capability to simulate credit and liquidity effects on 
participants and on the system resulting from one or more participant 
defaults, or other possible sources of settlement 
disruption.<SUP>21</SUP> Systems may also need to test the operational 
capability to execute settlement failure procedures, where these differ 
from normal settlement procedures. Documentation of any significant 
legal analysis or agreements relevant to risk management may also be 
appropriate.
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    \21\ Such simulations may include, if appropriate, the effects 
of changes in market prices, volatilities, or other factors.
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    (1) Credit risk. Risk factors: A multilateral settlement system 
would give rise to credit risk if its rules or practices significantly 
increase or shift the bilateral obligations or credit exposures between 
participants in the clearing and settlement process. For example, a 
clearinghouse operator or agent that provides an implicit or explicit 
guarantee of settlement could shift bilateral exposures. Such a 
guarantee might be implemented through the establishment of a central 
counterparty for all transactions, or through other provisions in the 
system's rules, such as a guarantee of members' settlement obligations, 
third-party credit arrangements, or the system's ability to recover 
settlement-related losses from participants. Additionally, a system may 
expose participants to credit risk to one another, due for example, to 
agreements to mutualize any settlement losses.
    Risk management measures: Measures that are commonly used to 
mitigate credit risk in a multilateral settlement system and provide 
support for settlement guarantees include monitoring of participants' 
financial condition, caps or limits on some or all participants' 
positions in the system, and requirements for collateral, margin, or 
other security from some or all participants. Systems in which 
participants have significant bilateral exposures to one another or to 
the system, such as through loss-sharing agreements, may need to 
implement mechanisms for participants to control these exposures if 
they are significant. Use of settlement methods with same-day finality 
may also shorten the duration of credit risk exposure in a system.
    (2) Liquidity risk. Risk factors: A multilateral settlement system 
would give rise to liquidity risk for its participants if a delay, 
failure, or reversal of settlement would be likely to cause a 
significant change in settlement amounts to be paid or received by 
participants on the settlement date. The degree of liquidity risk in a 
particular system is likely to be greater (1) the larger are gross 
payment flows relative to netted amounts to be settled; (2) the larger 
are participants' settlement positions relative to their available 
funding resources; (3) the later that participants would be notified of 
a settlement disruption relative to the timing of activity in the money 
markets and other funding channels, and (4) the greater the likelihood 
that a settlement failure of the particular system would be accompanied 
by abnormal market conditions.
    Risk management measures: One approach to mitigating liquidity risk 
is to implement measures to reduce significantly both the probability 
and the effect of a settlement disruption. For example, many of the 
measures described above that are commonly used to mitigate credit risk 
may reduce the probability and effect of a participant's inability to 
meet its settlement obligations when due. External liquidity resources 
available to the system and adequate operational contingency 
arrangements may also mitigate liquidity risk.
    Some systems anticipate performing a recast of settlements in the 
event of a participant default, by recalculating multilateral net 
settlement obligations among participants. These systems are expected 
to assess, and where necessary address, the liquidity impact on 
participants of such a procedure.<SUP>22</SUP> For example, timely 
notification of settlement failure before or during the period of 
active money market trading should permit participants readily to 
borrow funds to cover any shortfalls due

[[Page 34894]]

to the recast. Individual participants may also take steps to limit 
their own liquidity exposures in the system or increase available 
liquidity resources.
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    \22\ For example, in a ``recast'' of settlements, some or all 
transactions involving the defaulting participant would be removed 
from the system's settlement process, to be settled or otherwise 
resolved outside the system. A revised multilateral settlement with 
recalculated settlement obligations would then be conducted among 
the remaining participants. In an ``unwind,'' transactions or 
settlement obligations to be settled on the day of the default for 
all participants would be removed from the system.
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    (3) Operational risk. Risk factors: Operational risks, such as 
those relating to the reliability and integrity of electronic data 
processing facilities used in the clearing and settlement process, are 
addressed in standard supervisory guidance for depository institutions 
and their service providers. Operational risk factors for purposes of 
this policy statement include those that could hinder the timely 
completion of settlement or the timely resolution of a settlement 
disruption in a multilateral settlement system. For example, for a 
system that anticipates recasting settlement obligations in the event 
of a participant default, operational obstacles could make it difficult 
or impossible for participants to arrange settlement outside the system 
on a timely basis in the event of a settlement failure. As a result, 
those participants expecting to receive funds could face significant 
liquidity risk. In addition, in some cases, failure to complete 
settlement on a timely basis could change the rights of participants 
with respect to the underlying payments, creating potential credit or 
liquidity risks. For example, institutions that are unable either to 
return or to settle for checks presented to them on the same day may 
lose the right to return the checks for insufficient funds.
    Further, certain risk control procedures implemented by a 
particular system may themselves entail operational risks. The ability 
of a system to execute a recast of settlements, implement guarantee 
provisions, or access lines of credit may depend on the operational 
reliability of the system's facilities.
    Risk management measures: Multilateral settlement systems and their 
participants typically mitigate the risk of operational failure in 
their daily processing activities through standard techniques, such as 
contingency plans, redundant systems, and backup facilities. For 
purposes of this policy statement, systems should ensure the reliable 
operational capability to execute procedures used to resolve a 
participant default or other settlement disruption as well as to 
implement other risk management measures.
    For example, if a system anticipates recasting settlements by 
excluding transactions of a defaulting participant, it should ensure 
that the system can perform any required processing, generate the 
necessary information, and provide the information to participants in a 
timely manner. To the extent that payments would be expected to be 
settled outside the system, procedures should be established to notify 
participants such that they have adequate time, settlement information, 
and operational capabilities to complete such settlements before the 
close of critical funds transfer systems. A system that does not 
anticipate recasting settlements but plans to settle all positions as 
and when expected should ensure that operational procedures to 
implement risk management measures are in place, such as means of 
access to lines of credit in a timely manner.
    (4) Legal risk. Risk factors: Legal risk may exist in a 
multilateral settlement system if there is significant uncertainty 
regarding the legal status of settlement obligations or of the 
underlying transactions in the event of a settlement failure. 
Significant legal uncertainty could exacerbate efforts to achieve an 
orderly and timely resolution and could expose participants to 
significant credit and liquidity risks. For example, if the obligations 
of participants with respect to underlying transactions exchanged in 
the system have no enforceable legal status in the event of a system 
settlement failure, the ability of the participants to revert to other 
methods of settlement on a timely basis may be in doubt. Legal risk 
would also arise if the legal enforceability of any significant risk 
management measures, netting agreements, or related arrangements, is 
not well supported.
    Risk management measures: Systems should address legal risk 
factors, where significant exposures may arise, by ensuring that 
operating rules or other agreements between participants will be 
enforceable in the event of a settlement failure. As part of this 
process, systems may wish to obtain legal opinions as to the 
enforceability of its rules and agreements under applicable legal 
regimes. Additionally, when the transactions settled through the system 
are not otherwise covered by an established body of law, the system 
should ensure that the rights and obligations of the participants are 
adequately addressed through the system's rules or participant 
agreements.
Application of the Lamfalussy Minimum Standards
    Certain multilateral settlement systems are also required to meet 
the Lamfalussy Minimum Standards.<SUP>23</SUP> These standards were 
designed to address the main risk factors that may be present in 
multilateral settlement systems and to provide confidence that such 
systems can settle all positions as and when expected in the event that 
a participant cannot meet its settlement obligations, thereby reducing 
substantially the risk that a default by one participant will cause 
defaults by others. To determine whether a system is also required to 
meet the Lamfalussy Minimum Standards, the Board will consider 
additional factors that include the following: settlement of a high 
proportion of large-value, interbank or other financial market 
transactions, such as foreign exchange transactions; very large 
liquidity exposures that have potentially systemic consequences, such 
as by virtue of a high ratio of gross payments to net settlement 
obligations; or systemic credit exposures relative to participants' 
financial capacity.
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    \23\ The Report of the Committee on Interbank Netting Schemes of 
the Central Banks of the Group of Ten Countries (Bank for 
International Settlements, November 1990), known as the Lamfalussy 
Report, recognized that netting arrangements for interbank payment 
orders and forward-value contractual commitments, such as foreign 
exchange contracts, have the potential to improve the efficiency and 
the stability of interbank settlements through the reduction of 
costs along with credit and liquidity risks, provided certain 
conditions are met. That Report developed and discussed ``Minimum 
Standards for Netting Schemes'' (Lamfalussy Minimum Standards) and 
``Principles for Co-operative Central Bank Oversight'' of such 
arrangements. These standards have been adopted by the central banks 
of the G-10 and European Union countries. The text included in this 
policy statement includes editorial modifications to the original 
standards.
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    Lamfalussy Minimum Standards for the Design and Operation of 
Privately Operated Large-Dollar Multilateral Settlement Systems: 1. 
Multilateral settlement systems should have a well-founded legal basis 
under all relevant jurisdictions.
    2. Multilateral settlement system participants should have a clear 
understanding of the impact of the particular system on each of the 
financial risks affected by the netting process.
    3. Multilateral settlement systems should have clearly-defined 
procedures for the management of credit risks and liquidity risks which 
specify the respective responsibilities of the netting provider and the 
participants. These procedures should also ensure that all parties have 
both the incentives and the capabilities to manage and contain each of 
the risks they bear and that limits are placed on the maximum level of 
credit exposure that can be produced by each participant.
    4. Multilateral settlement systems should, at a minimum, be capable 
of ensuring the timely completion of daily settlements in the event of 
an inability to settle by the participant with the largest single net 
debit position.

[[Page 34895]]

    5. Multilateral settlement systems should have objective and 
publicly-disclosed criteria for admission which permit fair and open 
access.
    6. Multilateral settlement systems should ensure the operational 
reliability of technical systems and the availability of backup 
facilities capable of completing daily processing requirements.
    Risk management measures: For systems that the Board has determined 
are required to meet the Lamfalussy Minimum Standards, systems and 
their participants should consider the following risk management 
measures: (1) to the extent that participants have significant credit 
and liquidity exposures to other participants, establish bilateral net 
credit limits vis-a-vis each other participant in the system; (2) 
establish and monitor in real-time system-specific net debit limits for 
each participant; (3) establish real-time controls to reject or hold 
any payment or foreign exchange contract that would cause a 
participant's position to exceed the relevant bilateral and net debit 
limits; (4) establish liquidity resources, such as cash, committed 
lines of credit secured by collateral, or a combination thereof, at 
least equal to the largest single net debit position; and (5) establish 
rules and procedures for the sharing of credit losses among the 
participants in the netting system.<SUP>24</SUP>
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    \24\ The term ``largest single net debit position'' means the 
largest intraday net debit position of any individual participant at 
any time during the daily operating hours of the netting system.
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    Alternative risk management measures may provide an equivalent 
level of assurance that the Lamfalussy Minimum Standards are met, 
depending on the nature and scope of the system. However, the Board 
strongly encourages systems to develop real-time risk management 
controls where necessary to provide an appropriate level of risk 
control. The Board may also encourage or require higher risk management 
standards, such as the ability to ensure timely multilateral settlement 
in the event of multiple defaults, of individual systems that present a 
potentially high degree of systemic risk, by virtue of their high 
volume of large-value transactions or central role in the operation of 
the financial markets.

Offshore Systems

    The Board has a long-standing concern that steps taken to reduce 
systemic risk in U.S. large-dollar payments systems may induce the 
further development of multilateral systems for settling U.S. dollar 
payments that are operated outside the United States. Such systems, if 
implemented with inadequate attention to risk management, may increase 
risks to the international banking and financial system. In addition, 
offshore arrangements have the potential to operate without sufficient 
official oversight.
    As a result, the Board has determined that offshore, large-dollar 
multilateral settlement systems and multicurrency clearing and 
settlement systems should at a minimum be subject to oversight or 
supervision, as a system, by the Federal Reserve, or by another 
relevant central bank or supervisory authority. The Board recognizes 
that central banks have common policy objectives with respect to large-
value clearing and settlement arrangements. Accordingly, the Board 
expects that it will cooperate, as necessary, with other central banks 
and foreign banking supervisors in the application of the Lamfalussy 
Minimum Standards to offshore and multicurrency systems. In this 
regard, the Principles for Co-operative Central Bank Oversight outlined 
in the Lamfalussy Report provide an important international framework 
for cooperation.

    By order of the Board of Governors of the Federal Reserve 
System, June 18, 1998.
Jennifer J. Johnson,
Secretary of the Board.
[FR Doc. 98-16694 Filed 6-25-98; 8:45 am]
BILLING CODE 6210-01-P