CUNA Regulatory Comment Call


May 25, 2004

Revisions to Policy Statement on Payments System Risk
(NOT A MAJOR PROPOSAL)

EXECUTIVE SUMMARY

Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Associate General Counsel Mary Dunn at mdunn@cuna.com and to Assistant General Counsel Michelle Profit at mprofit@cuna.com; or mail them to Mary and Michelle c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Building, Suite 600, Washington, D.C. 20004. You may also access the proposed rule at http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040421/default.htm.

DISCUSSION

The policy changes proposed by the Board include changes to the scope of the policy to include payments and securities settlement systems operated by the Reserve Banks, establishment of clearer risk-management expectations for all systems subject to the policy based on current industry and supervisory risk-management concepts, and incorporation of the Core Principles and Recommendations as the Board’s risk-management standards for systemically important payments and securities settlement systems, respectively. The Board is also proposing a new introduction to and reordering of the current parts of the PSR policy in order to provide a more coherent framework for the overall policy and better communicate the Board’s concerns and objectives regarding payments systems risk. The proposed changes do not affect the current Part I of the PSR Policy that concerns Federal Reserve daylight credit policies except to renumber this part of the policy as the new Part II.

The Board believes that these proposed structural and substantive changes more clearly ground the PSR policy in the Board’s high-level objectives, provide a more coherent structure for the overall policy, and better communicate the Board’s concerns about risks for the nation’s payments and securities settlement system and the implications of these risks for the Federal Reserve. In particular, the Board revised the introduction to the overall policy to include a clear statement of the Board’s public policy objectives and provide a general discussion of the types of risks encountered in settling payments and securities transactions, how those risks arise, and why the Board believes they must be controlled.

Changes to the Policy’s Scope, Definitions, and Application. The proposed policy extends its scope to include payments and securities settlement systems operated by the Reserve Banks, which is consistent with the Core Principles and the Recommendations. The scope continues to cover those private-sector payments systems that expect to settle an aggregate gross value exceeding $5 billion on any day during the next twelve-month period and extends the same threshold to private-sector securities settlement systems and Reserve Bank payments and securities systems. While the direct application of the policy will be limited to those systems above the threshold, the Board encourages all payments and securities settlement systems to consider the risk-management approach set out in the policy.

The proposed policy also clarifies the definition of a “system” for purposes of applying the policy, defining a system to be a “multilateral arrangement (three or more participants) among financial institutions for the purposes of clearing, netting, and/or settling funds or securities transactions among themselves or between each of them and a central party.” This definition also identifies three key characteristics of systems, which would be used individually or in combination, to determine if an arrangement qualifies as a system for purposes of the policy: (1) a set of rules and procedures, common to all participants, that govern the clearing (comparison and/or netting) and settlement of payments or securities transactions, (2) a common technical infrastructure for conducting the clearing or settlement process, and (3) a risk-management or capital structure in which credit losses are ultimately borne by system participants rather than by the system operator, a central counterpart or guarantor, or the system’s shareholders. Futures and option clearing organizations and correspondent banking services continue to be excluded from the coverage of the policy.

Finally, new language clarifies how the policy will be applied by the Board, both when the Board exercises its existing authority and, if it goes not have direct or exclusive authority, when it works with other authorities to promote the aims of the policy.

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

Incorporation of the Core Principles and Recommendations. The proposed policy adopts the Core Principles and the Recommendations with no modifications and presents them as the Board’s standards for systemically important systems. Private-sector systems currently expected to meet the Lamfalussy Minimum Standards would, under the proposed policy, be expected to comply with the Core Principles. Similarly, private-sector systems currently subject to the Board’s policy requirement for delivery-against-payment systems would be expected to comply with the relevant portions of the Recommendations. As noted below, the Core Principles and the Recommendations would apply to Reserve Bank’s payments and securities settlement systems that meet the relevant policy criteria.

The proposed policy introduces six characteristics that would be used by the Board, on a case-by-case basis, to identify systems, including Federal Reserve systems that would be considered systemically important. To determine whether a system is systemically important for the purposes of this policy, the Board may consider, but will not be limited to, one or more of the following factors:

In applying the standards to systemically important systems, the policy seeks to be flexible, recognizing that systems differ in the specific instruments they settle, the markets and institutions they serve, and the legal and regulatory constraints under which they operate. The policy states that these factors will be considered when assessing the way in which a systemically important system addresses any particular standard.

QUESTIONS REGARDING THE PROPOSAL

  1. Do the benefits of a bright line quantitative threshold based on a system’s daily gross settlement value outweigh the costs of using more complex factors to determine whether a system is covered by the policy? Should more qualitative or judgmental criteria be used instead? If a quantitative threshold is appropriate, does a threshold of $5 billion a day continue to be reasonable? Should other quantitative criteria be considered? Please explain.
















  2. Is the definition of what constitutes a system, and explicit exemptions from this definition reasonable and appropriate? The proposed policy also clarifies the definition of a “system” for purposes of applying the policy, defining a system to be a “multilateral arrangement (three or more participants) among financial institutions for the purposes of clearing, netting, and/or settling funds or securities transactions among themselves or between each of them and a central party.” Please explain.
















  3. Do the general policy expectations of a sound risk-management framework, laid out in part B of the revised policy, give more structure and specific guidance to system operators and participants than the current policy’s primary focus on types of risks and the general need to manage these risks? The proposed revisions continue to provide flexibility but set out four key elements of a sound risk- management framework that the Board believes will provide systems with more structured guidance. These elements are based on a review of current industry and supervisory concepts of sound risk management: (1) clearly identify risks and set sound risk-management objectives; (2) establish sound governance arrangements; (3) establish clear and appropriate rules and procedures; and (4) ensure the employment of the resources necessary to implement the system’s risk-management objectives and implement effectively its rules and procedures. Please explain.
















  4. In applying the Core Principles and the Recommendations, do the six criteria presented in the proposed policy appear reasonable for determining if a system is systemically important (i.e. whether the system has the potential to create significant liquidity disruptions or dislocations should it fail to perform or settle as expected; whether the system has the potential to create large credit or liquidity exposures relative to participants’ financial capacity; whether the system settles a high proportion of large-value or inter-bank transactions; whether the system settles transactions for critical financial markets (markets for federal funds, foreign exchange, and commercial paper; U.S. government and agency securities; and corporate debt and equity securities); whether the system provides settlement for other systems; whether the system is the only system or one of a very few systems for settlement of a given financial instrument). Are there other factors that the Board should consider when determining whether a system is systemically important? Please explain.













  5. Do you have any additional comments on this proposal?
















  6. Please submit your name, address, and phone number.
















Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com
Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 • mdunn@cuna.com
Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com