Report of the Working Group on Government Securities Clearance and Settlement

Federal Reserve Bulletin, Winter, 2004

The Federal Reserve Board, on January 7, 2004, released the report of the private-sector Working Group on Government Securities Clearance and Settlement and endorsed its recommendations.

The Working Group, formed by the Board after the September 11, 2001, terrorist attacks in New York City, recommended nine steps to mitigate risks to the financial system from the interruption or termination of the services of a clearing bank as the result of either operational or non-operational problems.

All of the major participants in the U.S. government securities markets depend on one of two commercial banks to settle their trades and facilitate financing of their positions. The terrorist attacks demonstrated ways that operational disruptions to a clearing bank's services could disrupt the trading, clearance, and settlement of government securities. Those events also reinforced government officials' longstanding concerns about the potential consequences of voluntary or involuntary exit from the business by either of the two clearing banks.

The Working Group recommendations are the following:

* Regulators should monitor and test implementation of the clearing banks' plans to satisfy the regulators' sound practices and implementation timelines for core clearing and settlement organizations as described in the Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System, issued April 8, 2003, by the Board, the Office of the Comptroller of the Currency, and the Securities and Exchange Commission (SEC).

* The private sector should develop a secure and resilient telecommunications infrastructure for clearance and settlement of U.S. government securities. The official sector should support this effort.

* Market participants, regulators, and others in the official sector should encourage further efforts to reduce the specific threats posed by cyber-terrorism.

* To minimize the adverse effect of any temporary reduction in clearing bank capacity, market participants should act now to: (1) review their existing documentation for U.S. government securities and repurchase transactions and seek to clarify their obligations to counterparties in the event of a future temporary disruption at a clearing bank; and (2) ensure that the Fixed Income Clearing Corporation's existing netting and guaranteed settlement services are used as much as practical.

* With the same objective, regulators should review their authority to temporarily liberalize or suspend various regulations when such actions could contribute to the restoration of orderly markets or if compliance with such regulations may be unusually costly during a temporary disruption. As an element of their contingency planning, regulators should consider in advance the costs and benefits of liberalization or suspension of such regulations. Likewise, they should review their authority to suspend trading or settlement activity and consider in advance the costs and benefits of such measures.

* In the event of a temporary reduction in clearing bank processing capacity, the following should occur: (1) market participants should explore changes to the settlement cycle for U.S. government securities and limitations on collateral substitutions in repurchase transactions; (2) the Federal Reserve should consider altering the operating hours of the Fedwire system, liberalizing the terms of its government securities lending program, and, when necessary and appropriate, injecting additional liquidity into the marketplace; and (3) consistent with their contingency plans, regulators should consider liberalizing or suspending relevant regulations when appropriate to mitigate adverse effects on the trading and settlement of government securities.

* Market participants and regulators should support efforts, such as The Bond Market Association's effort to enhance the value of its Emergency Subcommittee, that would provide a source of real-time information on the functioning of the government securities clearance and settlement system and offer a potential sounding board for actions being contemplated by market participants, the Federal Reserve, the SEC, the U.S. Department of the Treasury, or other regulators.

* In the event of a permanent exit of a clearing bank, every effort should be made to sell the exiting bank's clearing business to another well-qualified bank.

* Additional work should be undertaken to further develop the concept of creating a new bank (NewBank), a dormant entity, ready for activation in the event that a clearing bank permanently exited and no well-qualified bank steps forward.

The Board supports these recommendations and plans to establish another private-sector working group to work on developing the NewBank concept.

The Working Group, established by the Board in November 2002, was chaired by Michael Urkowitz, Senior Adviser to Deloitte Consulting. Its members included senior representatives of the two clearing banks for government securities (J.P. Morgan Chase and the Bank of New York), the Fixed Income Clearing Corporation, securities dealers, an interdealer broker, a custodian bank, a money market fund, The Bond Market Association, and the Investment Company Institute. Staff of the Federal Reserve, the SEC, and the U.S. Treasury participated in the Working Group as observers and technical advisers.