CUNA Regulatory Comment Call

July 1, 2002


White Paper on Potential Structural Changes in the Settlement of Government Securities to Reduce Vulnerability After 9/11


The Board of Governors of the Federal Reserve (Federal Reserve) and the Securities and Exchange Commission (SEC) (collectively, "the agencies") request comment on a white paper that discusses ways to reduce vulnerability in the settlement of government securities. The white paper discusses three strategies for reducing vulnerability, without deciding whether any type of change is warranted. Comments on this white paper are due to the Federal Reserve and the SEC by August 12, 2001.

Please send your comments to CUNA by July 29. Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Associate General Counsel Mary Dunn at or to Assistant General Counsel Michelle Profit at; or mail them to Mary or Michelle c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Bldg., Suite 600, Washington, DC 20004. For a copy of this proposal, which was published in the Federal Register on May 13th, please press here.


After the terrorist attacks on September 11th, the Federal Reserve and the SEC discussed the current vulnerabilities in the settlement of government securities with various market participants. In particular, participants were interested in the establishment of a utility to conduct settlement. The white paper focuses on possible approaches for creating a utility and possible assessment criteria for evaluating the various approaches.

This section of the comment call focuses on the background regarding clearing and settlement arrangements so some readers already familiar with that structure may want to proceed directly to the next section that summarizes the utilities discussed in the white paper.

Clearing and Settlement Arrangements for Government Securities


The white paper explores how the establishment of a utility, in alternative forms, would structurally change the vulnerability of the settlement of government securities. The white paper’s purpose is to facilitate discussion that assesses the settlement of government securities transaction by describing three ways in which a utility might be organized. These three alternatives are discussed in light of how they would affect the current operational, financial, and structural vulnerabilities that exist in the system.

The business of settling trades in government securities involves the provision of a range of services: the transfer of government securities against funds (settlement), the provision of intraday credit to facilitate these settlements, position management services for primary dealers (including the matching of settlement instructions with incoming securities, automated options for handling mismatches, and the real-time reporting of transactions), and overnight and term financing through triparty repurchase agreements (repos). Settling trades, providing intraday credit, and providing tools (software) for position management are sometimes referred to as ``core clearing.'' The financing provided through triparty repos also is critical to the functioning of the government securities market. Triparty services for government securities currently are provided by the same banks that provide core clearing, but different entities may be able to offer the two types of services, as is the case for other types of securities.

The white paper discusses the how the current system depends on two central players. Only two banks--JP Morgan Chase and The Bank of New York--provide the full range of services required by major market participants. All the primary dealers depend critically on either Chase or BONY for core clearing services and triparty repo arrangements, which are integral to the dealers' financing, and institutional investors rely on these clearing banks to place large volumes of funds in the highly secure and liquid triparty repos. The Federal Reserve also is dependent upon the clearing banks' records for open market transactions conducted through triparty arrangements, and the U.S. Treasury relies on the clearing banks for the settlement of a major portion of its securities at issuance.

The fact that there there are only two clearing banks gives rise to operational, financial, and structural vulnerabilities. The operational problems are caused by the concentration in the market. If either of the two banks has problems, then those problems can significantly impede the settlement of dealers’ trades and the reconciliation of their positions. Moreover, the two banks use different technology, so market participants cannot easily move to another service provider. The financial problem arises because both clearing bank’s may be hurt from losses caused by related or unrelated activities. Finally, there is structural vulnerability because if either firm decides to leave the market it would concentrate the risk of settlement services with one commercial bank. This concentrated risk would probably be unacceptable to market participants, public policy makers and the remaining clearing bank.

Any proposal to restructure government securities settlement must be assessed by its affects on the current operational, financial, and structural vulnerabilities and the proposal’s ability not to introduce new vulnerabilities. As a result, the white paper proposes that any potential change be assessed by it ability:

After September 11th, market participants met with the Federal Reserve and decided that clearing banks as well as other market participants needed to improve their contingency backup arrangements. Second, market participants decided that backup securities accounts would be difficult to arrange and of little value. These participants were interested in examining the concept of an industry utility as one possible structural change. The white paper facilitates discussion of how a utility would change settlements of government securities by describing some approaches to organizing an industry utility. The white paper furnishes a framework to facilitate more discussion. Neither the Federal Reserve nor the SEC has determined that any of the approaches are an improvement over the current arrangements. The three utility types are discussed below.

Old Euroclear Model

A utility can be structured as an industry-owned depository and settlement entity that contracts with commercial banks for the provisions of most services. Shareholders in this utility would largely be securities and banking industry participants. The governing body typically would be elected by shareholders, and it would establish membership criteria, prices, operating budgets, and investment priorities. The utility would contract with a bank for the operation of the settlement and depository services. Settlements would take place on the books of this bank, which would furnish securities and cash accounts to dealers. It would also furnish intraday financing, subject to risk controls it would establish. Overnight financing, including triparty repo services would be provided either by the bank supplying the operational support or perhaps by other banks.

This model addresses operational vulnerability because the utility would contract with many entities to provide support for depository and settlement activities.

This model does not address as well the financial and structural vulnerabilities within the current system. The utility would be exposed to financial risk through its providers. For example, a bank providing operational and credit services could involuntarily exit the business because of financial difficulties unrelated to clearing activities. This risk would be diversified if more than one firm provided these services. In addition, the ability of this model to address the structural vulnerability caused by a very small number of providers is speculative. The structural vulnerability of this utility would depend on the ability of the utility to negotiate long-term contracts with suppliers that persuade suppliers to remain in the business.

The ability of this utility to deliver innovative services will depend critically on the governance structure of the utility, the standards it sets for banks supplying services; and the utility’s policies. These all could create competition among the supplying banks, which may foster innovation.

This model would not require any changes in the policies of the Federal Reserve. The model continues to rely on private banks to provide operational and credit support for settlements; the utility itself would be a vehicle for administration and governance rather than a provider of services.

A private limited purpose-bank

A private limited-purpose bank is an alternative type of industry- owned depository and settlement mechanism. This model does not contract with a commercial bank; the utility itself would furnish the operational support. Settlements of government securities currently require aggregate extensions of hundreds of billions of dollars of intraday credit to dealers, and a private limited-purpose bank would need to arrange a backup liquidity facility to ensure final settlement in the event one of its participants failed to cover an overdraft. Based on the experience of other utilities in arranging facilities a fraction of that size, a private limited-purpose bank might find arranging sufficient backup liquidity support difficult. The utility may have to rely on the Federal Reserve. Overnight funding, including triparty repo services, could be provided by the limited-purpose bank or perhaps by other commercial banks.

The creation of a limited-purpose bank to function as the utility would concentrate depository and settlement activity within one entity, thereby concentrating operational risk. This utility may improve its operational risk if it devotes the resources to backup facilities. The current system requires each clearing bank to incur these costs; so conceivably, a limited-purpose bank could devote more resources to backup facilities than an individual clearing bank but would still offer a cost savings.

This model is less financially vulnerable than the existing system. A limited-purpose bank is less exposed to financial problems from unrelated activities than a full-service bank because of limits on the scope of its activities. Similarly, it is unlikely to voluntarily exit the business of clearing, having been created solely for that purpose.

The ability of a limited-purpose bank to address financial and structural vulnerabilities is more uncertain if it does not provide triparty services and these services remain concentrated among a few banks. Triparty services are so integral to the financing of dealers in government securities markets that these markets will be operationally, financially, and structurally vulnerable to the banks that provide such services. These banks, which have broader business lines than a limited-purpose bank, will be vulnerable to losses in activities unrelated to clearing and triparty services. They are also free to voluntarily exit the triparty business. If the separation of core clearing from triparty services lowers the barriers to entry and attracts entrants to the triparty business, then the accumulation of more competitors would reduce structural vulnerabilities.

The ability of this model to deliver services efficiently and innovatively will depend upon the governance structure of the limited- purpose bank. Assuming that users own the bank and control the governance structure, these users will have incentives to monitor costs and to create mechanisms for developing new products. Some of this pressure to innovate thus might be lost if triparty services were provided exclusively by the utility.

This model would change Federal Reserve policy and its role in settlment. The Federal Reserve may be the only feasible entity to provide an adequate backup liquidity facility. Providing this facility to a limited-purpose bank would entail a change in policy with respect to discount window access for limited-purpose banks or trust companies. It is unclear whether risk to the Federal Reserve or moral hazard would increase. With the current arrangements, the Federal Reserve effectively provides backstop liquidity to the clearing banks. Providing the same liquidity to a utility might, in fact, entail less risk and moral hazard because of the restrictions on the utility's activities, more intense supervision of the utility, and greater transparency. The creation of this type of utility would also reduce (and might eliminate) the Federal Reserve's role in settling secondary market transactions for government securities. The vast majority of transactions would be settled on the books of the limited-purpose bank, particularly if it were providing triparty repo services as well as core clearing.

Enhancement of Federal Reserve services

A third alternative is a public utility in which the Federal Reserve provides depository and settlement services. The Federal Reserve and the SEC generally prefer private-sector solutions. In a simple version of this model, the Federal Reserve would need to provide nonbank securities dealers, as well as the GSCC (and possibly interdealer brokers), direct access to securities accounts, funds accounts, and secured credit. As noted earlier, dealers routinely use substantial intraday credit, which would need to be supplied by the Federal Reserve. A dealer also might find itself unable to fund its holdings of government securities in a financial crisis, and in that event, the Federal Reserve would need to provide liquidity support in the form of overnight credit. For this model to be effective, the Federal Reserve would have to furnish operational support by developing products that replicate at least some of the position management and information services currently provided to the dealers by the clearing banks. Dealers would continue to need the overnight funding supplied by triparty repo services. These services might be provided by commercial banks. Alternatively, the Federal Reserve could develop the product. In this case, the Federal Reserve would need to consider how triparty services might be offered without also extending accounts to nonbank institutional investors, perhaps by using these investors' accounts at their custodian banks. Participant may also explore variation of this public utility type. For example, the Federal Reserve could provide direct operational interfaces with the dealers, but the dealers' transactions could settle through accounts held at depository institutions. In this way, depository institutions would intermediate the intraday credit used in the settlement process.

If the Federal Reserve provides accounts, credit, and services directly to dealers, the existing vulnerabilities in the government securities market would be reduced. Under this model, the Federal Reserve would be providing the operational support for the settlement process, and these enhanced products would be integrated into the existing backup contingency arrangements for the Fedwire system. The Federal Reserve's arrangements have been more robust than those of private-sector firms and other market utilities, and the Federal Reserve has spent appropriate amounts to meet contingency requirements. Federal Reserve services are not vulnerable to disruption because of financial difficulties.

To address vulnerabilities fully, the Federal Reserve may need to develop triparty repo as well as core clearing services. If the Federal Reserve limits its enhanced services to core clearing, there may be opportunities for a wider set of firms to offer triparty services, reducing structural vulnerability in the triparty market. A separation between core clearing and triparty repos, however, would require an additional transfer of securities from the dealer to the triparty provider, as is the current process with certain transactions. The number of additional transfers could be reduced through the creation of a facility to transfer securities in blocks (bulk transfers) rather than security by security. It is not clear whether this model could deliver services as cost effectively as the current system or how product innovation would be affected.

This model represents a marked departure from existing Federal Reserve policy. The Federal Reserve would need to provide accounts and hundreds of billions of dollars of credit to nondepository institutions routinely during the day and, in a crisis, overnight. From a risk-management perspective, however, credit extensions presumably would be collateralized with highly liquid securities, and government securities brokers and dealers would be subject to federal regulation by the SEC or the Treasury. Direct access to dealers could be perceived as providing dealers with broad access to liquidity support from the Federal Reserve. Any adverse effects on market discipline would be mitigated by federal regulation of the dealers, collateralization of the credit extensions, fees for intraday and overnight credit, and the potential for the Federal Reserve to impose quantity constraints on the amount of intraday credit extensions. Still, expansion of access could raise concerns about moral hazard.


  1. Have the vulnerabilities in the government securities market been identified correctly? Are there other vulnerabilities that should be considered in evaluating the need for structural change?

  2. Are there other structural approaches to a utility that should be given serious consideration besides the three basic options described in this paper? If so, what are they?

  3. Are the evaluation criteria set out in this paper the relevant ones for assessing the merits of an industry utility? If not, what other criteria are relevant?

  4. Can concerns about efficiency, innovation, and competition be addressed through governance? If so, how?

  5. Is it feasible to separate the provision of core clearing from the provision of triparty repo service? Would the separation of core clearing from triparty repo enable other banks to compete more effectively in the provision of triparty services? Can triparty repo services be provided by a utility?

  6. How much intraday credit would a utility need to provide in the settlement of government securities trades? Would a utility likely be able to arrange backup liquidity through committed lines of credit at commercial banks of the magnitude necessary to ensure timely settlment in the event a participant failed to cover an intraday credit extension?

  7. What is the likely size of the initial investment to create an industry utility? What factors determine the effects of a utility on costs generally? On costs to dealers of core clearing services? On financing costs to dealers?

  8. Who should own a private utility? How should its board of directors be chosen? What legal form should it take (for example, should it be a bank, a registered clearing agency, or an Edge Act corporation)?

  9. What should be the next step in evaluating alternative structures? What type of decisionmaking framework should be created, and which groups should be represented in that process?

  10. Do you have any other comments on the white paper?

Eric Richard • General Counsel • (202) 508-6742 •
Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 •
Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 •
Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 •