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.
- The agencies have already discussed vulnerabilities inherent in government securities settlement with various market participants. These participants indicated an interest in pursuing structural change through the establishment of a utility to conduct settlement.
- The white paper identifies alternative utility types and different assessment criteria for evaluating these alternative utilities. The alternative utility models could be structured as follows: as an industry-owned depository and settlement entity that contracts with a commercial bank for the provision of most services; a private limited-purpose bank that furnishes the operational support itself; and a public utility for which the Federal Reserve provides depository and settlement services.
- The white paper examines these three models by examining how the facility
- reduces the current operational, financial, and structural vulnerabilities that are inherent in the settlement system;
- promotes efficiency and innovation with this business sector; and
- challenges the current services and policies of the Federal Reserve.
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 firstname.lastname@example.org or to Assistant General Counsel Michelle Profit at email@example.com; or mail them to Mary or Michelle c/o CUNAs 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
- Within the universe of about 1,700 dealers, the trading of U.S. government securities is concentrated largely among 22 primary dealers and a handful of interdealer brokers (IDBs).
- Interdealer brokers collect dealer quotes, post them to electronic screen services, and execute trades between dealers, thereby facilitating price discovery, liquid markets, and anonymity in the interdealer market; about one-third of dealer-to-dealer trades are executed through an IDB.
- Among the primary dealers, most trading activity is concentrated in five to ten dealers.
- Trading activity includes dealer financing (repo) transactions and outright purchases and sales on behalf of customers and for the dealer's own account.
- After a trade is executed, counterparts to the trade must compare trade details and determine settlement
- The Government Securities Clearing Corporation (GSCC) serves as the clearing utility and central counterparty for trade comparison and netting in the U.S. government securities market.
- GSCC is registered with and supervised by the SEC.
- Through trade comparison, netting, and central counterparty guarantees, GSCC decreases its participants' counterparty settlement risk and helps ensure orderly settlement in the marketplace.
- Each day, GSCC compares trades valued at more than $1.3 trillion. About one-third of these trades are for outright purchases and sales, and the remaining two-thirds are repo transactions.
- Following the clearance process, securities must be exchanged for funds (settlement) on either a gross or a
- Government securities are transferred against funds (settled) through depository institutions acting as agents for nonbank dealers. Interbank settlement occurs through the Fedwire securities transfer system.
- Settlement typically occurs one business day after the trade, either through transfers on the books of a depository institution or, if settlement must occur between two depository institutions, on the books of the Federal Reserve through the Fedwire securities transfer system. Repo transactions generally settle on a same-day basis.
- More than $800 billion in securities is transferred through the Fedwire securities transfer system each day.
- Two banks, Chase and The Bank of New York (BONY), provide settlement services to primary dealers that account for more than three-quarters of the value of Fedwire settlement activity. On a typical day, these two banks settle more than $600 billion in government securities transactions through Fedwire. The clearing banks apparently settle another $200 billion to $300 billion per day internally, excluding triparty repo transactions.
- GSCC settles net obligations valued at about $415 billion per day through its accounts at the two clearing banks.
- Chase's and BONY's client bases consist of the primary dealers, other dealers and banks, and GSCC.
- Repo transactions are a fundamental part of the settlement process. These transactions involve the secured financing of broker-dealer securities inventories by a large number of cash investors, with settlement occurring on the books of the clearing banks. In a typical triparty repo transaction, a broker-dealer contracts with a cash investor to provide a certain amount of securities in exchange for cash at the outset of the transaction. The clearing bank registers all movements of cash and on its books. Both the broker-dealer and the cash investor will use cash and securities accounts at the clearing bank, and the clearing bank will assist in settlment of the transaction. These transactions typically do not specify the individual securities that the broker-dealer will provide as collateral. The fact that triparty transactions do not uniquely specify individual securities allows the broker-dealers to trade their securities inventory during the normal business day, settling whatever transactions come due, without significant concern regarding their financing arrangements. Triparty transactions are typically arranged early in the morning so that dealers can be assured of meeting their financing requirements. For example, settlement of cash-market U.S. government and agency securities continues until 3:30 p.m. on a normal day, the time when the Fedwire book-entry transfer system closes. Soon after this point, the clearing banks begin to process the broker- dealer's triparty repo transactions. This processing involves comparing the generic triparty transactions that the broker-dealers have submitted with the specific securities that now reside in their accounts at the clearing bank. The clearing banks have developed routines for optimizing the allocation of specific collateral to individual triparty transactions to minimize the financing costs for the broker-dealers. The collateral optimization and allocation routines run in the late afternoon, with settlement of the triparty transactions on the books of the clearing bank typically occurring in the early evening.
- Over the last decade, the importance of the triparty repo market grew significantly, so that now it is integral to the financing methods of all major broker-dealers and involves nearly $1 trillion per day in transactions. All parties benefit from repo transactions: the brokers obtain a secured form of financing; the cash investors receive secure liquid outlets for the short-term investment of cash; and the clearing banks have a profitable line of business and an opportunity to cross-sell other custody and banking services to cash investors.
- The settlement of financing (repo) transactions occurs either through bilateral exchanges (delivery-versus- payment or DVP repos) of securities and funds between a dealer (borrower) and an investor (lender) or through the use of triparty repos on the books of the clearing banks.
UTILITIES DISCUSSED IN WHITE PAPER
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 papers 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 banks 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 proposals ability not to introduce new vulnerabilities. As a result, the white paper proposes that any potential change be assessed by it ability:
- To improve the operational resiliency of government securities clearing,
- To better insulate the clearing process from the risks of financial problems at a key service provider,
- To reduce the vulnerability of the clearing process to voluntary exit by firms that provide critical services,
- To prevent the introduction of new vulnerabilities
- To replicate the strengths of the current system that include ongoing innovation and delivery of service in a cost-effective manner, and
- To maintain or change the current policies and services of the Federal Reserve.
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 utilitys 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.
- 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?
- 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?
- 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?
- Can concerns about efficiency, innovation, and competition be addressed through governance? If so, how?
- 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?
- 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?
- 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?
- 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)?
- 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?
- Do you have any other comments on the white paper?
Eric Richard General Counsel (202) 508-6742 firstname.lastname@example.org |
Mary Mitchell Dunn SVP & Associate General Counsel (202) 508-6736 email@example.com
Jeffrey Bloch Assistant General Counsel (202) 508-6732 firstname.lastname@example.org
Catherine Orr Senior Regulatory Counsel (202) 508-6743 email@example.com