Financial Market Utilities, 45907-45921 [2012-18762]

Download as PDF Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES AMS will continue to seek assistance across USDA as appropriate on this issue. A few commenters requested that the NOP address concerns with the current use of antibiotics in organic tree fruit production through ensuring compliance with § 205.206(a)(3). Section 205.206(a) requires producers to use management practices to prevent disease through crop rotation, sanitation measures and cultural practices. Section 205.206(a)(3) lists specific cultural practices that enhance crop health, including selection of plant species and varieties with regard to suitability to site-specific conditions and resistance to prevalent pests, weeds, and diseases. Certifying agents are responsible for ensuring that all organic producers use management practices to prevent disease. Certifying agents verify that organic producers are meeting all USDA organic requirements including utilizing preventative management practices to prevent disease. These same commenters also stated that, as part of a strategy for addressing fire blight in organic apple and pear production, the NOP should consider variances under § 205.290 to allow antibiotic use in instances when fire blight disease puts orchards at risk. Temporary variances for the use of a synthetic substance that is not on the National List (i.e. use of tetracycline after October 21, 2014) cannot be granted per the current requirements at § 205.290(e). F. Effective Date This final rule reflects recommendations submitted to the Secretary by the NOSB. The amendment to the listing of one exempted substance and the addition of two substances to the National List were based on petitions from the industry and evaluated by the NOSB using criteria in OFPA and the NOP regulations. Because the amendments have been subject to extensive discussion and public comment and are considered vital to organic crops, processing and livestock production, AMS believes that producers and handlers should be able to use them on their operations as soon as possible. Furthermore, tetracycline is due to expire from the National List on October 21, 2012; this action must be finalized by October 21, 2012, to ensure that organic apple and pear producers have access to this substance for two additional years beyond its current expiration date. Accordingly, AMS finds that good cause exists under 5 U.S.C. Available online at: https://www.nifa.usda.gov/ funding/rfas/pdfs/12_orei.pdf. VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 45907 553(d)(3) for not postponing the effective date of this rule until 30 days after publication in the Federal Register. Dated: July 27, 2012. David R. Shipman, Administrator, Agricultural Marketing Service. List of Subjects in 7 CFR Part 205 [FR Doc. 2012–18819 Filed 8–1–12; 8:45 am] BILLING CODE 3410–02–P Administrative practice and procedure, Agriculture, Animals, Archives and records, Imports, Labeling, Organically produced products, Plants, Reporting and recordkeeping requirements, Seals and insignia, Soil conservation. For the reasons set forth in the preamble, 7 CFR part 205, Subpart G is amended as follows: PART 205—NATIONAL ORGANIC PROGRAM 1. The authority citation for 7 CFR part 205 continues to read as follows: ■ Authority: 7 U.S.C. 6501–6522. 2. Section 205.601 paragraph (i)(12) is revised to read as follows: ■ § 205.601 Synthetic substances allowed for use in organic crop production. * * * * * (i) * * * (12) Tetracycline, for fire blight control in apples and pears only until October 21, 2014. * * * * * 3. Section 205.603 is amended by: A. Redesignating paragraphs (b)(2) through (b)(7) as paragraphs (b)(3) through (b)(8); and ■ B. Adding paragraph (b)(2) to read as follows: ■ ■ § 205.603 Synthetic substances allowed for use in organic livestock production. * * * * * (b) * * * (2) Formic acid (CAS # 64–18–6)—for use as a pesticide solely within honeybee hives. * * * * * 4. In § 205.605(a), the substance ‘‘Attapulgite’’ is added in alphabetical order to read as follows: ■ § 205.605 Nonagricultural (nonorganic) substances allowed as ingredients in or on processed products labeled as ‘‘organic’’ or ‘‘made with organic (specified ingredients or food groups(s)).’’ * * * * * (a) * * * Attapulgite—as a processing aid in the handling of plant and animal oils. * * * * * PO 00000 Frm 00005 Fmt 4700 Sfmt 4700 FEDERAL RESERVE SYSTEM 12 CFR Part 234 [Regulation HH; Docket No. R–1412] RIN 7100–AD 71 Financial Market Utilities Board of Governors of the Federal Reserve System. ACTION: Final rule. AGENCY: The Board is publishing a final rule, Regulation HH, Designated Financial Market Utilities. This rule implements provisions of sections 805(a) and 806(e) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘Dodd-Frank Act’’ or ‘‘Act’’), including risk-management standards for financial market utilities (‘‘FMUs’’) that are designated as systemically important by the Financial Stability Oversight Council (the ‘‘Council’’) and standards for determining when a designated FMU is required to provide advance notice of proposed changes to its rules, procedures, or operations that could materially affect the nature or level of risks presented by the designated FMU. DATES: This final rule is effective September 14, 2012. FOR FURTHER INFORMATION CONTACT: Jennifer A. Lucier, Assistant Director (202) 872–7581 or Kathy C. Wang, Senior Financial Services Analyst (202) 872–4991, Division of Reserve Bank Operations and Payment Systems; Christopher W. Clubb, Senior Counsel (202) 452–3904 or Kara L. Handzlik, Senior Attorney (202) 452–3852, Legal Division; for users of Telecommunications Device for the Deaf (TDD) only, contact (202) 263–4869. SUPPLEMENTARY INFORMATION: SUMMARY: I. Background Title VIII of the Dodd-Frank Act, titled the ‘‘Payment, Clearing, and Settlement Supervision Act of 2010,’’ was enacted to mitigate systemic risk in the financial system and to promote financial stability, in part, through enhanced supervision of designated FMUs.1 Section 803 of the Dodd-Frank 1 The Dodd-Frank Act, Public Law 111–203, 124 Stat. 1376, was signed into law on July 21, 2010. E:\FR\FM\02AUR1.SGM 02AUR1 sroberts on DSK5SPTVN1PROD with RULES 45908 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations Act defines an FMU as a person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person. The basic risks that FMUs must manage include credit risk, liquidity risk, settlement risk, operational risk, and legal risk. These risks arise between financial institutions and FMUs as they settle payments and other financial transactions. In order to maintain financial stability, FMUs must be welldesigned and operated in a safe and sound manner. If a systemically important FMU fails to measure, monitor, and manage its risks effectively, it could pose significant risk to its participants and the financial system more broadly. Under section 805(a)(1) of the DoddFrank Act, the Board is required to promulgate risk-management standards governing the operations related to the payment, clearing, and settlement (‘‘PCS’’) activities of certain FMUs that are designated as systemically important by the Council. Section 805(a)(1) of the Act also requires the Board to take into consideration relevant international standards and existing prudential requirements in prescribing the regulations. For a designated FMU that is a derivatives clearing organization (‘‘DCO’’) registered under section 5b of the Commodity Exchange Act or a clearing agency registered under section 17A of the Securities Exchange Act of 1934 (collectively, ‘‘designated clearing entities’’), the Commodity Futures Trading Commission (‘‘CFTC’’) or the Securities and Exchange Commission (‘‘SEC’’), respectively, are granted authority to prescribe regulations, in consultation with the Council and the Board, containing applicable riskmanagement standards.2 Section 805(b) of the Act sets out the following objectives and principles for the risk-management standards: (a) Promote robust risk management, (b) promote safety and soundness, (c) reduce systemic risks, and (d) support the stability of the broader financial system. Section 805(c) of the Act states that risk-management standards may address areas such as (1) riskmanagement policies and procedures, (2) margin and collateral requirements, (3) participant or counterparty default 2 Under section 805(a)(2) of the Act, the CFTC and the SEC are also required to take relevant international standards and existing prudential requirements into consideration in prescribing regulations containing risk-management standards governing designated clearing entities. VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 policies and procedures, (4) the ability to complete timely clearing and settlement of financial transactions, (5) capital and financial resource requirements for designated FMUs, and (6) other areas that are necessary to achieve the objectives and principles for risk-management standards. In addition, section 806(e)(1) of the Dodd-Frank Act requires a designated FMU to provide 60 days’ advance notice to its Supervisory Agency of any proposed change to its rules, procedures, or operations that could, as defined in rules of each Supervisory Agency, materially affect the nature or level of risks presented by the designated FMU. Under section 803(b) of the Act, a ‘‘Supervisory Agency’’ means the federal agency that has primary jurisdiction over a designated FMU under federal banking, securities, or commodity futures laws.3 In April 2011, the Board published for comment a notice of proposed rulemaking (‘‘NPRM’’) to propose a new part to the Code of Federal Regulations (12 CFR part 234, Regulation HH) to establish risk-management standards for designated FMUs and requirements for advance notice of material changes to a designated FMU’s rules, procedures, or operations.4 The public comment period closed on May 19, 2011. II. Summary of Public Comments and Analysis The Board received twelve public comment letters on the NPRM. Comments were submitted by two payment systems, seven industry and other groups, one bank, and two other commenters. In general, the comments pertained broadly to three categories: (i) Risk-management standards, (ii) advance notice requirements and the materiality definition, and (iii) other miscellaneous comments. The Board considered these comments in developing its final rule as discussed in more detail below.5 A. Risk-Management Standards 1. International Standards Proposed § 234.3 sets out riskmanagement standards for designated FMUs that are payment systems, and 3 A Supervisory Agency includes the SEC and CFTC with respect to their respective designated clearing entities (as defined above), the appropriate federal banking agencies (including the Board) with respect to FMUs that are institutions described in section 3(q) of the Federal Deposit Insurance Act (12 U.S.C. 1813(q)), and the Board with respect to a designated FMU that is otherwise not subject to the jurisdiction of any of the agencies listed above. 4 See 76 FR 18445 (Apr. 4, 2011). 5 In addition, the Board is adopting several changes intended to clarify the requirements of the regulation. PO 00000 Frm 00006 Fmt 4700 Sfmt 4700 proposed § 234.4 sets out riskmanagement standards for central counterparties (‘‘CCPs’’) and central securities depositories (‘‘CSDs’’), based on the international risk-management standards developed by the Committee on Payment and Settlement Systems (‘‘CPSS’’) and the Technical Committee of the International Organization of Securities Commissions (‘‘IOSCO’’). These international standards were the Core Principles for Systemically Important Payment Systems (the ‘‘Core Principles’’) developed by the CPSS in 2001, and the Recommendations for Securities Settlement Systems and the Recommendations for Central Counterparties (collectively, the ‘‘CPSS– IOSCO Recommendations’’) developed jointly by the CPSS and IOSCO in 2001 and 2004, respectively. The Board believes these standards are the appropriate basis for setting initial riskmanagement standards under Title VIII for several reasons. First, section 805(a)(1) of the Act directs the Board to consider relevant international standards in prescribing riskmanagement standards under Title VIII. As explained in the NPRM, the Core Principles and the CPSS–IOSCO Recommendations were the international standards most relevant to risk management of FMUs.6 Second, FMUs are familiar with these standards as the long-standing basis for Part I of the Federal Reserve Policy on Payment System Risk (‘‘PSR policy’’).7 Third, the Board has significant experience applying these international standards to large-value payment and settlement systems pursuant to its PSR policy. CPSS and IOSCO recently conducted a comprehensive review of riskmanagement standards for PCS systems. On April 16, 2012, CPSS and IOSCO issued the final report on the ‘‘Principles for Financial Market Infrastructures,’’ which includes an updated, harmonized, and strengthened set of international risk-management standards (the ‘‘PFMI’’).8 CPSS and IOSCO intend for the PFMI to replace the Core Principles and CPSS–IOSCO Recommendations. As noted in the NPRM, the Board anticipates that it will review the new international standards, consult with other appropriate agencies and the Council, and seek public comment on the adoption of revised 6 See 76 FR at 18447. PSR policy is available on the Board’s public Web site at: https://www.federalreserve.gov/ paymentsystems/psr_policy.htm. 8 The Principles for Financial Market Infrastructures are available at https://www.bis.org/ publ/cpss101a.pdf. The final report reflects comments received during the public consultation period from March 10, 2011 to July 29, 2011. 7 The E:\FR\FM\02AUR1.SGM 02AUR1 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES standards for designated FMUs based on the new international standards. Commenters generally appeared to support the Board’s approach of using the Core Principles and CPSS–IOSCO Recommendations as a basis for its riskmanagement standards for designated FMUs under section 805 of the Act. Two commenters explicitly stated their support for the Board’s approach. Two other commenters stated that the proposed risk-management standards were largely prudent and sensible. One commenter was also supportive of the Board’s intention to evaluate the new international standards once they are final for the purposes of revising Regulation HH. Two other commenters expressed some general reservations with respect to the new international standards; one of the commenters cautioned the Board against adopting the new international standards ‘‘in full,’’ because doing so would include principles that may not directly relate to the risks posed by the designated FMUs and contemplated by Title VIII. After considering the public comments and for the reasons stated above, the Board continues to believe that the most suitable approach to establishing initial risk-management standards under Title VIII of the Act is to use the Core Principles and CPSS– IOSCO Recommendations as the basis for the standards promulgated by this notice, and to proceed with consideration of the PFMI as the basis for any future revisions. The Board agrees with commenters that international standards that are not, in some way or to some degree, related to existing or potential risks posed to or by a designated FMU should not be adopted for purposes of section 805 of the Act. As noted in the NPRM, the Board acknowledged that the scope of the Core Principles and CPSS–IOSCO Recommendations is broad and proposed to adopt by regulation particular standards, or portions thereof, that relate to the risks presented to or by a designated FMU, rather than those standards, or portions thereof, that apply more generally to financial markets or regulators. Similarly, the Board anticipates evaluating the appropriateness of each of the new PFMI for the purpose of possible revisions to Regulation HH. 2. Applicability of Standards to Retail Payment Systems Proposed § 234.3 is based on the entire set of the Core Principles. Some commenters questioned whether three standards included in the Core Principles could be applied to retail payment systems, particularly VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 automated clearinghouses (‘‘ACH’’) and check clearinghouses, should those systems be designated as systemically important by the Council. Specifically, proposed § 234.3(a)(3) would require any FMU that is designated on the basis of its role as operator of a payment system to have clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the system operator and the participants and which provide appropriate incentives to manage and contain those risks. Proposed § 234.3(a)(4) would require any designated FMU that is designated on the basis of its role as operator of a payment system to provide prompt final settlement on the day of value, preferably during the day and at a minimum at the end of the day. Proposed § 234.3(a)(5) would require any designated FMU that is designated on the basis of its role as operator of a payment system, and in which multilateral netting takes place, to, 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 settlement obligation. The Board received several comments on the applicability of these riskmanagement standards to retail payment systems, should they be designated by the Council. Several commenters stated their support for an exemption for retail payment systems from designation as systemically important by the Council under the Dodd-Frank Act. The Council, however, determined not to categorically exclude FMUs operating retail payment or other systems in its rule regarding the FMU designation process.9 As a result, commenters provided feedback on the ability of retail payment systems to meet certain of the Board’s proposed riskmanagement standards in the event the Council decides to designate them. One commenter specifically referenced proposed § 234.3(a)(3)–(5) as risk-management standards that, while appropriate risk controls for truly systemically important payment systems, were generally inapplicable (or had no relevance) to payments systems such as ACH clearing arrangements that permit the return of transactions within a certain timeframe. One commenter argued that the standard in proposed § 234.3(a)(3) regarding the management of credit and liquidity risk would have no application where a system that did not assume credit and liquidity risks in the first place by committing to pay funds that it had not received and where 9 See PO 00000 76 FR 44763, 44769 (July 27, 2011). Frm 00007 Fmt 4700 Sfmt 4700 45909 the payment system participants expect to manage their own credit and liquidity risks. Two commenters also stated that proposed § 234.3(a)(4) on settlement finality contradicts long-standing and established practices of ACH rules that allow for certain transactions to be reversed or returned for any reason until the banking day after the settlement date. One commenter stated that application of proposed § 234.3(a)(5) regarding the ability to complete settlement in the event the single largest participant is unable to settle would require a fundamental change in the nature of ACH debit transactions and the abolishment of the right to return the transaction. In general, these commenters stated that they do not believe that, if designated, retail payment systems would be able to comply with these proposed standards and, accordingly, asked that such systems be exempted from them. The Board notes that the proposed risk-management standards were designed to apply to large-value payment systems. This approach is consistent with the direction of the Council expressed in its final rule on the FMU designation process. Specifically, the Council stated that, within payment systems, it expects to focus at this time on FMUs that operate large-value systems and not on FMUs that operate low-value systems (such as check and ACH).10 The Council also decided not to include considerations more narrowly tailored to the characteristics of retail payment systems because the Council did not believe they were necessary or appropriate given the current focus for designations. Given the Council’s focus on largevalue systems, the Board does not anticipate that the Council will designate a FMU under Title VIII on the basis of its role as operator of a retail payment system. However, because the authority to designate systemically important FMUs resides with the Council, not the Board, the Board cannot be assured of the type of FMU the Council may designate in the future. In the event that the Council designates an FMU on the basis of its role as operator of a retail payment system, the Board would review, at that time, whether the risk-management standards in § 234.3 were appropriate for that 10 See 76 FR at 44769. The Council also decided, however, against including in the final rule any categorical exclusion for FMUs operating retail payment or other systems, both because there are not clear distinctions between various types of systems, and because such an exclusion would impair the Council’s ability to respond appropriately to new information, changed circumstances, and future developments. E:\FR\FM\02AUR1.SGM 02AUR1 45910 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES designated FMU, as it would for any type of newly designated FMU. In order to accommodate this review in the event that an unanticipated type of FMU is designated, and in consideration of the comments, the Board is adopting in the final rule a modification to proposed §§ 234.3(b) and 234.4(b) that clarifies that the application of individual riskmanagement standards could be waived in a situation where such standards could not appropriately be applied to a particular designated FMU. Both §§ 234.3(b) and 234.4(b) will be amended by inserting text that states ‘‘[t]he Board, by order, may waive the application of a standard or standards to a particular designated financial market utility where the risks presented by or the design of that designated financial market utility would make the application of the standard or standards inappropriate.’’ This revision is intended to bridge any gap between Council designation of a new type of designated FMU and the process of promulgating regulations appropriate for the new type of designated FMU, if necessary. In addition, the Board notes that with respect to a designated FMU that operates more than one payment system (e.g., one large-value and one retail), standards would apply only with respect to the system that provided the basis for the Council’s designation of the FMU. The Board is modifying § 234.3(a) and (b) to clarify this point. The Board also is making a parallel modification to § 234.4(a) and (b).11 The Board is also modifying §§ 234.3(a) and 234.4(a) to require a designated FMU to ‘‘implement rules, procedures, or operations designed to ensure that it meets or exceeds’’ the risk-management standards set forth in these sections. In addition, the word ‘‘should’’ has been deleted from the individual standards to clarify that these are requirements with which a designated FMU must comply. 3. Scope of Risk-Management Standards As noted above, the proposed riskmanagement standards for designated FMUs that operate as payment systems, CCPs, or CSDs are based on the Core Principles and CPSS–IOSCO Recommendations. Each set includes separate standards relating to efficiency, access criteria, and governance. Several commenters suggested that the Board eliminate some or all of these three proposed standards for payment systems, arguing that they address 11 To conform to these modifications, the Board is revising the definitions in § 234.2 (a), (b), and (e). VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 system operating issues that are outside the scope of the systemic risk issues contemplated by Title VIII of the DoddFrank Act. Specifically, the commenters questioned whether proposed § 234.3(a)(8), (9), and (10) regarding efficiency, access criteria, and governance, respectively, were relevant to systemic risk.12 The applicability of the efficiency standard was a common concern of the commenters that raised questions about the scope of the riskmanagement standards; a subset of these commenters also questioned whether either the access criteria or governance standard was within the scope of risk management. These standards in general were viewed as admirable goals that designated FMUs should aim to achieve, but nevertheless as goals that should be driven by market forces and not by regulatory mandate. Efficiency. The efficiency standard in proposed § 234.3(a)(8) states that an FMU that is designated on the basis of its role as operator of a payment system should provide a means of making payments that is practical for its users and efficient for the economy. Several commenters argued that the efficiency standard exceeds the Act’s objectives because it addresses operating system issues and not risk matters. One commenter argued that whether a form of payment is practical and efficient is largely a matter of judgment that is better left to the market and its participants. The Board believes the efficiency standard furthers the objectives set out in Title VIII of the Act to reduce systemic risks and support the stability of the broader financial system. A designated FMU supports the ongoing functioning and stability of the market it serves by providing effective, reliable PCS services to its participants and, in particular, completing timely clearing and settlement of financial transactions. An FMU that is designed or managed inefficiently or impractically may ultimately distort financial activity and market structure, increasing not only the financial and other risks of an FMU’s participants, but also the risks of their customers and end users. To avoid such outcomes, a designated FMU should consider the tradeoffs between, and seek a reasonable balance of, safety (i.e., risk management) and efficiency (i.e., direct and indirect costs) when designing and managing the system. For example, overly demanding financial resource requirements may 12 One commenter raised similar concerns with the corresponding access criteria and governance standards in proposed § 234.4(a)(2) and (8) with respect to CSDs and CCPs. PO 00000 Frm 00008 Fmt 4700 Sfmt 4700 create a liquidity demand so high that it would be impractical for participants to meet. Although liquidity is very important, an FMU that accumulates excessive liquid resources from its participants intraday may increase the participants’ opportunity cost of sending each payment. In such cases, participants that become liquidity constrained may be forced to delay submitting certain time- or missioncritical payments. Additionally, an FMU’s design, operating structure, scope of PCS activities, and use of technology can influence its efficiency and can ultimately provide incentives for market participants to use, or not use, the FMU’s services. For example, in certain cases, inefficiently designed systems may increase costs to the point where it would be cost-prohibitive for participants to use the FMU, and possibly drive market participants toward less safe alternatives, such as bilateral clearing or settlement on the books of the participants. In such cases, risks to the market participants increase as they seek less safe opportunities to lower direct costs; this behavior may reintroduce risk into the market that the FMU was intended to mitigate. As these examples suggest, a designated FMU must function efficiently, as well as safely, and provide services that are appropriate to the needs of its users without becoming cost-prohibitive to use. A designated FMU that is inefficient can have a direct, negative impact on financial stability. Accordingly, the Board believes that it is appropriate for a supervisor of a designated FMU to take into account the need for practical and efficient design of the designated FMU as part of the set of risk-management standards set forth in Regulation HH. For these reasons, the Board is adopting the efficiency standards in proposed §§ 234.3(a)(8) and 234.4(a)(6) essentially as set out in the NPRM. Access criteria. The access criteria standard in proposed § 234.3(a)(9) states that a payment system should have objective and publicly disclosed criteria for participation, which permit fair and open access. Some commenters argued that the access criteria standard did not relate to any of the risks contemplated by Title VIII of the Act. One commenter stated that the actions taken by the payment system, CSD, or CCP, create or mitigate risk, not the rules governing who can participate in them. Another commenter noted that the participation structure for payment systems can vary broadly and, while the participation criteria for these systems could be an issue for competition law, it was E:\FR\FM\02AUR1.SGM 02AUR1 sroberts on DSK5SPTVN1PROD with RULES Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations difficult to see how the criteria could directly affect the risks that were the focus of Title VIII. The Board believes that access criteria are important to a designated FMU’s risk-management framework and affect the level of risk a designated FMU presents to the financial system. Access criteria are typically referred to as an FMU’s ‘‘first line of defense’’ in ensuring it admits financial institutions that will be able to meet their obligations and not expose the FMU or its other participants to unacceptable risk. Access criteria need to be designed to ensure that participants meet appropriate operational, financial, and legal requirements to allow them to meet their obligations on a timely basis.13 However, these criteria need to be balanced against the FMU’s ability to effectively serve the market it supports, in particular markets that are subject to a statutory requirement for central clearing or settlement through an FMU. Although a designated FMU may use risk-based measures to control access, requirements that are unnecessarily discriminatory or overly restrictive can minimize the FMU’s overall effectiveness. Criteria that allow for fair and open access also may help achieve the Title VIII objectives of reducing systemic risk and supporting the overall stability of the financial system. A fair and open approach to participation criteria may help prevent the concentration of financial activity (and therefore risk) into a few large participants. By encouraging the reduction of risk concentration, the proposed standard helps lower the likelihood that a few financial institutions will be perceived as ‘‘too big to fail.’’ Broad participation in a designated FMU can, for example, increase the effectiveness of multilateral netting, facilitate crisis management by applying a consistent set of rules and procedures (e.g., default management, loss mutualization), and improve overall market transparency by increasing the number of transactions processed by the FMU. Accordingly, access criteria that do not permit fair and open access may reduce the overall risk-reduction benefits that a designated FMU can offer. For these reasons, the Board is adopting the access criteria standards in proposed §§ 234.3(a)(9) and 234.4(a)(2) essentially as set out in the NPRM. Governance. The governance standard in proposed § 234.3(a)(10) states that a payment system’s governance 13 For example, a designated FMU may set access criteria based on risk measures such as capital ratios, risk ratings, or other indicators. VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 45911 arrangements should be effective, accountable, and transparent. Some commenters claimed that although the decisions made by a designated FMU’s governing body can affect the risks it presents, the particular governance structure itself presents no such risks. Conversely, one commenter supported inclusion of the governance standard, stating that weak governance practices and poor risk-management procedures at designated FMUs could pose hazards both to participating financial institutions and to the market as a whole. Another commenter stated that risk management effectively encompasses governance, among other areas. The Board believes that effective, accountable, and transparent governance arrangements are critical to the effective risk management of a designated FMU. A strong governance arrangement provides a sound basis for compliance with the other riskmanagement standards in Regulation HH. A number of tools or techniques discussed in the Core Principles with respect to the governance standard have proved to be effective in ensuring effective governance, such as written strategic objectives and plans for achieving them and separation of risk management and audit functions from day-to-day operations. The Board expects supervisors to review a designated FMU’s governance arrangements against the background of these and other relevant techniques in order to promote robust risk management. In addition, given the role of the FMU’s board of directors in setting the overall risk-management framework of the designated FMU, the Board believes that a weak or ineffective governance structure could have systemic implications for the participants of the service, other FMUs, and other markets. Accordingly, the Board believes that a supervisor should consider a designated FMU’s governance arrangements when performing its systemic risk review. For these reasons, the Board is adopting the governance standard in proposed §§ 234.3(a)(10) and 234.4(a)(8) essentially as set out in the NPRM. performance of the CCP’s margin models and the related parameters and assumptions associated with such models by a qualified person who does not perform functions associated with the CCP’s margin models (except as part of the annual model validation) and also does not report to such a person.14 Two commenters noted that proposed § 234.4(a)(17)(i), although on the right track, should stress explicitly the complete independence of the organization conducting the validation. One of the commenters believed models must be validated annually by a qualified and independent organization with no financial stake in the outcome because no employee of a systemically important CCP should be expected to resist the inevitable direct and indirect pressures of management who may have incentives to achieve a less-appropriate and less-independent outcome. The other commenter also stated that model validation must be performed by a truly independent party with no financial stake in the outcome of the validation and expressed concern that a validator that is not sufficiently independent would face the conflict of interest that would lead designated FMUs to lower their margins in order to attract business and increase profits. The Board believes that a validator must be able to offer independent, unbiased conclusions and recommendations as part of the margin model validation process. It is unlikely that the person who was responsible for initially developing the margin model would be able to provide an independent, unbiased assessment of the product. Similarly, it appears unlikely that a person under the functional control of the developer would be able to provide independent, unbiased validation of the model without the influence of the developer and concern for employment security. Accordingly, proposed § 234.4(a)(17)(i) would require that the model validation be conducted by a qualified person who does not perform functions associated with the CCP’s margin model, such as development and implementation, and does not report to such a person.15 4. Independent Model Validation Proposed § 234.4(a)(17) requires a designated FMU that operates as a CCP to use margin requirements to limit its credit exposures to participants in normal market conditions and use riskbased models and parameters that are reviewed regularly. In addition, proposed § 234.4(a)(17)(i) would require a CCP to provide for annual model validation consisting of evaluating the 14 Proposed § 234.4(a)(17)(i) inadvertently referred to the margin models of the ‘‘clearing agency.’’ The Board has revised these references to ‘‘central counterparty’’ in the final rule. 15 This position is generally consistent with current supervisory guidance on model risk management by banks. See SR letter 11–7, p.3 (Apr. 4, 2011), which states: Validation involves a degree of independence from model development and use. Generally, validation is done by staff who are not responsible for model development or use and do not have a stake in whether a model is determined to be valid. PO 00000 Frm 00009 Fmt 4700 Sfmt 4700 E:\FR\FM\02AUR1.SGM Continued 02AUR1 45912 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations The Board recognizes the concern expressed in the comments that there may be financial considerations beyond the validator’s immediate employment security, and that there may be situations where a validator from outside the CCP may be needed to provide an appropriately independent validation. In such cases, the Board may hold a particular designated FMU to a stricter definition of independent validation that is appropriate for the level of risk presented by the designated FMU. Proposed § 234.4(b) allows for the Board, by order, to apply heightened risk-management standards to a particular designated FMU in response to the risks presented by that designated FMU. As a generally applicable standard, however, the Board believes it is appropriate to recognize basic requirements for an independent validation. For these reasons, the Board is adopting proposed § 234.4(a)(17)(i) essentially as set out in the NPRM. 5. Financial Resource Coverage sroberts on DSK5SPTVN1PROD with RULES Proposed § 234.4(a)(15) would require a designated FMU that is acting as a CSD to institute risk controls that include collateral requirements and limits, and ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle when the CSD extends intraday credit. Proposed § 234.4(a)(18) would require a designated FMU that is acting as a CCP to maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions. The Board specifically requested comment on whether such designated FMUs should be required to maintain sufficient financial resources to withstand the default by the participant with the largest exposure or obligation in extreme but plausible market conditions, where the ‘‘participant’’ means the family of affiliated participants when there is more than one affiliated participant (‘‘cover one’’), or whether such designated FMUs should be required to maintain sufficient financial resources to withstand the defaults by the two participants, plus any affiliated participants, with the largest exposures As a practical matter, some validation work may be most effectively done by model developers and users; it is essential, however, that such validation work be subject to critical review by an independent party, who should conduct additional activities to ensure proper validation. Overall, the quality of the validation process is indicated by critical review by objective, knowledgeable parties and the actions taken to address issues identified by those parties. VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 or obligations in extreme but plausible market conditions (‘‘cover two’’). Two commenters stated that, if the Board continued to base its financial resources standard on the number of participants that pose large risk exposures to a CCP, they supported the higher cover two requirement. One commenter cited the ‘‘interconnectedness of financial institutions’’ as one of the central dangers, which must be addressed by financial reforms and a reason for adopting a cover two standard. This commenter also suggested that the Board’s rule should conform to a similar standard proposed by the CFTC for systemically important DCOs, which included a cover two requirement.16 The other commenter supported a cover two standard because, during a period of extreme market stress, it cannot be guaranteed that there will be only a single default. Neither commenter, however, provided any analysis to support its contention that a cover two standard would be more appropriate as a generally applicable standard. Both commenters, however, expressed a preference for a financial resource coverage requirement based on an additional measurement as determined by a percentage of aggregate exposure, and suggested that the default rate used in stress tests be based on the larger of (a) the two members representing the largest exposure to the CCP and (b) the members constituting at least 33 percent of the exposures in aggregate to the CCP. The two commenters believed that the additional measurement captures the risk of a diverse, but interconnected, membership. As noted in the NPRM, the Board’s proposed financial resources standards would apply a heightened cover one requirement because the term ‘‘participant’’ would be interpreted as the largest family of affiliated participants if there was more than one affiliated participant. The Board believes that this interpretation will address the interconnectedness of participants through corporate ownership structures. With respect to risks presented by other types of interconnectedness (i.e., through common participation across markets or FMUs), the standards for a designated FMU’s financial resource coverage, as with all other standards set out in the 16 On November 8, 2011, pursuant to its authority under Title VII of the Dodd-Frank Act, the CFTC published its final rule on risk-management standards for DCOs. The CFTC elected to adopt a cover one requirement for all DCOs, and delay riskmanagement related rulemakings for systemically important DCOs until a later time. See 76 FR 69334 (Nov. 8, 2011). PO 00000 Frm 00010 Fmt 4700 Sfmt 4700 regulation, are generally applicable standards. The Board expects that a designated FMU would employ a riskmanagement framework that is appropriate for the risks faced by the FMU and the FMU may, at its own initiative, institute a cover two financial resource coverage requirement. In addition, the Board may require, by order, a particular designated FMU to exceed the generally applicable standards set out in the regulation to address the risks presented by, including those borne by, the FMU.17 Although the existing cover one standard was adopted by the Board in its PSR policy and applied in its supervision of payment and settlement systems since 1994, the Board has applied heightened financial resource coverage requirements when the appropriate situation arose. Therefore, although the Board agrees with the commenters that, in some cases, a higher requirement would be more appropriate to the level of risk presented by a particular designated FMU, the Board believes, at this time, that the most appropriate course is to adopt the cover one standard as generally applicable and impose a higher standard, including possibly a cover two standard, on a case-by-case basis when appropriate. The Board will consider the appropriateness of adopting a cover two standard in the context of possible revisions to Regulation HH in light of the PFMI. Accordingly, the Board is adopting the cover one standard in § 234.4(a)(15) and (18) essentially as set out in the NPRM. The Board believes the commenters’ concern regarding appropriately addressing the interconnectedness of a designated FMU’s participants and the suggestion of applying the additional measurement using a percentage of aggregate exposure are important to consider. Before determining the viability of this approach, however, the Board believes further analysis is needed regarding how the suggested additional measure would be applied, and such analysis could include identifying situations in which the additional aggregate exposure measure would capture risk that is not addressed by either a cover one or cover two standard, an explanation of how the additional measure would be calculated (including the appropriate time horizon to use), and an explanation of why a 33 percent aggregate exposure standard would be most appropriate for this approach. The Board will consider this approach further in the context of revisions to Regulation HH in light of 17 See E:\FR\FM\02AUR1.SGM § 234.4(b). 02AUR1 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES the PFMI. The Board welcomes and will review any supporting research on this issue that is submitted. 6. Legal Certainty of Netting Arrangements One commenter raised an issue regarding designated FMUs that allow netting of payments to and from individual participants. The commenter stated that, to ensure that the netting will be honored in a bankruptcy or other insolvency proceeding, Regulation HH must require that the designated FMU demonstrate that, under the policies, procedures, and documentation of the designated FMU, the netting permitted by the designated FMU will be given legal effect in default and insolvency situations through an analysis provided by outside legal counsel that is a nationally recognized expert in matters of corporate insolvency. The Board recognizes the importance of legal certainty of a designated FMU’s transactions, not only during default and insolvency situations, but also at all other times. To address these concerns, the Board proposed standards regarding a designated FMU’s legal framework for payment systems, as well as CSDs and CCPs. For example, proposed § 234.4(a)(1) states that the CSD or CCP should have a well-founded, transparent, and enforceable legal framework for each aspect of its activities in all relevant jurisdictions. As explained in the NPRM, the Board expects that a designated FMU will manage its legal risks within the context of currently applicable statutes and regulations, so it can ensure that its rules, procedures, and contractual provisions will be enforceable with a high degree of certainty.18 Legal certainty of each aspect of a designated FMU’s activities (including its netting function) is expected to be supported by existing law in all relevant jurisdictions. Obtaining an opinion of outside counsel is one method for a designated FMU to judge legal certainty of its rules and procedures, but it is not the only method. In many cases, the designated FMU’s in-house counsel may be better positioned to evaluate the intricacies of the designated FMU’s netting arrangements and the law of the jurisdictions that are relevant to the designated FMU’s operations. In addition, obtaining an opinion of outside counsel could involve significant expense for the designated FMU, depending on the complexity and number of relevant jurisdictions. The Board does not believe it is appropriate to impose such costs as a general 18 76 FR at 18447. VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 expectation when they may not be necessary in all cases. Whether legal certainty must be supported by an opinion of outside counsel or may be verified by in-house counsel is a decision that may be made initially by management of the designated FMU. In the event the Board determines in a particular situation that an opinion by outside counsel is warranted, it could require such an opinion in that case. For these reasons, the Board believes that the legal framework standard as proposed is sufficient to address the concerns raised by the commenter. 7. Costs of Risk-Management Standards to Participants One commenter urged the Board to ensure that the benefits of enhanced risk-management standards exceed the costs of implementing the standards on banks and their customers. The commenter stated that banks will feel the effects of the risk-management standards because any designated FMUs with whom the banks transact business will likely pass on the costs and constraints of enhanced supervisory oversight to their participants. The Board is keenly aware of the need to weigh the costs and benefits of particular rulemakings. Section 805(a) of the Act requires the Board to prescribe risk-management standards governing the operations related to the PCS activities of designated FMUs. The Board’s discretion lies not in whether risk-management standards must be promulgated, but rather in how the Board can best avoid unnecessary burden associated with the standards. With respect to the benefits of the risk-management standards, section 805(b) states that the objectives and principles for the standards are to (1) Promote robust risk management; (2) promote safety and soundness; (3) reduce systemic risks; and (4) support the stability of the broader financial system. The benefit of reducing systemic risk is, of course, difficult to quantify. Generally speaking, however, an FMU that is better positioned to withstand disruptive systemic events would result in much smaller costs being borne by the FMU, and its participants, and, more generally, the financial system and taxpayers. The costs of the risk-management standards can be viewed as a designated FMU’s incremental expenses in establishing and maintaining the systems and procedures necessary to meet the standards, and other Regulation HH requirements, over and above the risk-management measures the FMU would have otherwise adopted for business reasons. As the commenter PO 00000 Frm 00011 Fmt 4700 Sfmt 4700 45913 noted, such costs are generally passed on to a designated FMU’s participants. These costs could take the form of higher transaction costs, margin or collateral costs, and capital requirements. These costs should be weighed against the societal benefit of stability in the financial system and the economy more broadly. As explained in the NPRM, the Board proposed to adopt the Core Principles and CPSS–IOSCO Recommendations as the basis for the risk-management standards required by the Act, in part because that approach strikes a reasonable balance between furthering the Act’s goals of enhanced risk management and financial stability and controlling the costs imposed on the FMUs. As explained in the NPRM, the Core Principles and CPSS–IOSCO Recommendations were formulated by central banks and securities regulators over several years and with considerable discussion and input from the financial services industry. The Federal Reserve collaborated with participating financial system authorities in developing the three sets of standards. In addition, the SEC and CFTC participated in the development of the CPSS–IOSCO Recommendations. The three sets of standards, particularly those relevant to payment systems, have been incorporated into the Board’s PSR policy for many years. Further, the Board has used these standards, in conjunction with relevant laws and other Federal Reserve policies, when exercising its authority with respect to supervising payment and securities settlement systems.19 FMUs that are likely to be designated by the Council, as well as their participants, are wellacquainted with these standards and, in many cases, such FMUs have already incorporated these standards into their governance, risk-management, and operating frameworks. The Board, therefore, does not anticipate material additional costs associated with adopting the Core Principles and CPSS– IOSCO Recommendations into its regulation for participants in payment systems already managing towards these standards. Although these standards would be generally applicable, the Board is retaining the authority to impose a more stringent standard or waive a standard 19 The Core Principles and the Recommendations for Securities Settlement Systems were incorporated into the PSR policy in 2004 (https:// www.federalreserve.gov/boarddocs/press/other/ 2004/20041126/default.htm). The Recommendations for Central Counterparties was incorporated into the PSR policy in 2007 (https:// www.federalreserve.gov/newsevents/press/other/ 20070112a.htm). E:\FR\FM\02AUR1.SGM 02AUR1 45914 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations on a case-by-case basis in situations where it is warranted.20 The Board believes this is a more cost-effective approach to achieving the risk management objectives of Title VIII of the Act. For example, when a situation that warrants a higher standard is discovered, the Board will exercise its authority to tailor a higher standard for the risks presented. In addition, alternatively, if review of the PFMI demonstrates that a higher standard is more appropriate for general application, the Board will consider a revision to the regulation. B. Advance Notice of Material Changes sroberts on DSK5SPTVN1PROD with RULES 1. Materiality Threshold Section 806(e) of the Act requires a designated FMU to provide 60 days’ advance notice to its Supervisory Agency of any proposed change to its rules, procedures, or operations ‘‘that could, as defined in rules of each Supervisory Agency, materially affect the nature or level of risks presented’’ by the designated FMU. Proposed § 234.5(c)(1) states that the term ‘‘materially affect the nature or level of risks presented’’ means matters as to which there is a ‘‘reasonable possibility that the change could materially affect the performance of clearing, settlement, or payment functions or the overall nature or level of risk presented by the designated financial market utility.’’ Proposed § 234.5(c)(2) provides a nonexclusive list of changes that would materially affect the nature or level of risks presented, including changes that affect participant eligibility or access criteria; product eligibility; risk management; settlement failure or default procedures; financial resources; business continuity and disaster recovery plans; daily or intraday settlement procedures; scope of services; non-routine changes to the underlying technological framework for PCS functions; or governance. Proposed § 234.5(c)(3) provides a non-exclusive list of changes that would not materially affect the nature or level of risks presented, including a change that does not modify the contractual rights or obligations of the designated FMU or its participants; a change that does not adversely affect the safeguarding of securities, collateral, or funds for which the designated FMU is responsible; a routine technology upgrade; a routine administrative change; or a nonsubstantive change to rules, procedures, or other documentation. 20 One example of this approach is the financial resource coverage standard in § 234.4(a)(15) and (18) (cover one versus cover two). VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 The Board requested comments on all aspects of its proposed materiality rule, particularly on the appropriateness of the definition of ‘‘materially affect the nature or level of risks presented’’ and the utility of the non-exclusive lists for material and non-material changes. Commenters generally stated that the materiality standard would benefit from one or more of the following three adjustments: (1) A narrower scope of the definition itself, (2) a shorter list of inclusions, or (3) a more expansive list of exclusions. ‘‘Reasonable possibility.’’ Several commenters stated that the definition of ‘‘materially affect the nature or level of risks presented’’ is overly vague and were concerned that the Board would be flooded with advance notices of nonmaterial changes as a result. Three commenters generally stated that the definition of materiality is too vague and suggest a more narrowly drawn definition to provide for expeditious review. One commenter suggested revising the proposed materiality standard, which requires notice of proposed changes that have ‘‘a reasonable possibility’’ of material effect, to require notice only for those changes that are ‘‘reasonably likely’’ to have a material effect. The commenter stated that, with the proposed definition, designated FMUs were highly likely to err in favor of significantly ‘‘over-disclosing’’ changes to their rules, procedures, and operations, which would be overly burdensome to both the Board and the industry. The Board believes the proposed definition sets an appropriate minimum threshold for advance notices at this time. Proposed § 234.5(c) asks the designated FMU to consider whether it is reasonably possible that a change could have a material effect on the performance of its PCS functions or its overall risk profile. The Board recognizes that ‘‘possible’’ is a lower threshold than ‘‘likely.’’ Section 806(e)(1) of the Act uses the phrase ‘‘could * * * materially affect’’ the PCS functions or its overall risk profile of the designated FMU. This word choice indicates possibility, rather than likelihood.21 If Congress had intended that advance notices be submitted only for changes that were likely to have a material effect, it could easily have framed it in that way. In addition, when 21 ‘‘Could’’ is commonly defined as the past tense of ‘‘can,’’ and is used to indicate ‘‘possibility.’’ ‘‘Likely’’ is defined as ‘‘possessing or displaying the qualities or characteristics that make something probable.’’ American Heritage Dictionary of the English Language (Fourth Edition), https:// ahdictionary.com/. PO 00000 Frm 00012 Fmt 4700 Sfmt 4700 the Board seeks to fulfill its statutory responsibility, the lower threshold is appropriate to ensure that it is able to review a broad sampling of the types of material changes that the designated FMU normally makes in its operations. As the designated FMU submits advance notices, the Board will be able to provide feedback and filter out the specific types of rule changes normally considered by that particular designated FMU that do not warrant advance notices. Within this framework, the Board anticipates that it will be able to more precisely balance the regulatory burden of the advance notice requirement with its need to receive advance notice of material changes for the supervision of a particular designated FMU contemplated by Title VIII of the Act. Further, the suggested revision would require the designated FMU to determine which changes were likely to materially affect the performance of its PCS functions or its overall risk profile. Making this judgment without any input from the Board would increase the risk that the designated FMU would not submit an advance notice to the Board that the Board would determine could have a material effect. This not only could subject the designated FMU to supervisory criticism and possible modification or rescission of the change, but also could prevent the Board from obtaining valuable insight into the operations of the designated FMU as contemplated by the statute. Although a lower materiality threshold initially may result in a higher number of advance notice filings, the Board does not believe that this is a reason to change the definition. The Board will provide guidance, through ongoing dialogue during the supervisory process, to assist a designated FMU in determining whether a proposed change requires advanced notice. For the reasons set out above, the Board is retaining the ‘‘reasonable possibility’’ language in the definition of ‘‘materially affect the nature or level of risks presented’’ in § 234.5(c)(1) of the final rule. ‘‘Performance of clearing, settlement, or payment functions.’’ One commenter suggested deleting from the materiality definition the phrase ‘‘performance of clearing, settlement, or payment functions.’’ The commenter stated that the proposed definition of materiality overreaches the statutory purpose of ensuring sound risk management by requiring advance notice of changes that affect the performance of PCS functions in addition to the overall nature or level or risks presented. The commenter stated that changes implemented by the E:\FR\FM\02AUR1.SGM 02AUR1 sroberts on DSK5SPTVN1PROD with RULES Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations designated FMU that relate to the broad category of ‘‘performance,’’ as opposed to risk, are more appropriately vetted in the competitive marketplace. In referring to the performance of PCS functions, the Board intended to provide additional guidance to the scope of the advance notice requirement by including an express focus on the PCS functions of a designated FMU. The Board believes that the language in proposed § 234.5(c)(1) appropriately implements the statutory authority provided by the Act. To address the commenters’ concerns and provide clarity regarding the scope of the advance notice requirement in § 234.5(c)(1), the Board is adopting a revision to the proposed regulatory text to state that the term ‘‘materially affect the nature or level of risks presented’’ means matters as to which there is a reasonable possibility that the change could ‘‘materially affect the overall nature or level of risk presented by the designated financial market utility, including risk arising in the performance of payment, clearing, or settlement functions.’’ 22 This revision ensures that the definition follows the statutory authority, while also providing an indication that the Board expects designated FMUs to pay particular attention to providing advance notice of proposed changes to its rules, procedures, or operations regarding the performance of its PCS functions that could materially affect the nature or level of risks presented by the designated FMU. The additional guidance, however, does not limit the scope of ‘‘materially affect the nature or level of risks presented’’ to only those risks arising in the performance of PCS functions. A proposed change to any of the designated FMU’s rules, procedures, or operations that could materially affect the nature or level of risks presented by the designated FMU should be the subject of an advance notice, regardless of whether it is regarding the performance of PCS functions. Non-exclusive lists. Four commenters stated that the non-exclusive list of material changes in proposed § 234.5(c)(2) was too broad or the nonexclusive list of non-material changes in proposed § 234.5(c)(3) was too narrow. The commenters acknowledged the value of providing guidance regarding changes that were material or not material, but generally stated that the 22 The risks presented by the designated FMU’s performance of its PCS functions can go beyond the effect on the designated FMU itself and reach its participants or the market more broadly. VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 proposed lists did not appropriately draw this dividing line. One commenter stated that most items included on the material list in proposed § 234.5(c)(2) are described in a manner that would require a designated FMU to provide the Board notice of changes that would not necessarily affect the nature or level of risk in any manner. In particular, the commenter noted that ‘‘financial resources’’ is included in the list in proposed § 234.5(c)(2)(v), but is not modified by any quantitative or qualitative measure, so a designated FMU would be required to submit advance notice of any change in its financial resources, even changes that are not material, such as any changes that in any way affect capital, access to credit, or liquidity. Two commenters cited the ‘‘scope of services’’ item in proposed § 234.5(c)(2)(viii) as another example of an overly broad requirement that is unrelated to risk. For similar reasons, two commenters suggested deleting the ‘‘governance’’ item in proposed § 234.5(c)(2)(x). One commenter also suggested deleting the ‘‘participant eligibility or access’’ item in proposed § 234.5(c)(2)(i). The Board believes that material changes in the areas listed in proposed § 234.5(c)(2) could affect a designated FMU’s core functions and, as a result, might affect its ability to manage its risks appropriately and to continue to conduct systemically important PCS services. This may, in turn, affect the designated FMU’s ability to comply with the risk-management standards set out in §§ 234.3 and 234.4 to which they will be held. The list of material changes provided in proposed § 234.5(c)(2) was intended to track those risk-management standards, and the reasons for including these items in the list of material changes requiring an advance notice are similar in most cases. For example, the importance of understanding material changes in the financial resources of a designated FMU acting as a payment system would be critical to assessing the ability of the designated FMU to continue to provide systemically important PCS services in the event of a default, as well as its compliance with several of the proposed risk-management standards, such as the capability to ensure timely completion of daily settlements as set out in proposed § 234.3(a)(5). To address the commenters’ concerns that de minimis changes to the areas listed in § 234.5(c)(2) would require an advance notice, the Board is adopting revised language in the final rule to clarify that the changes that ‘‘materially affect’’ the areas listed would be PO 00000 Frm 00013 Fmt 4700 Sfmt 4700 45915 considered changes that materially affect the nature or level of risks presented by the designated FMU. Also, as explained above regarding the risk-management standard for governance in proposed § 234.3(a)(10), the Board believes that effective, accountable, and transparent governance arrangements are critical to effective risk management of a designated FMU. As a result, changes that materially affect a designated FMU’s governance arrangements should be submitted pursuant to the advance notice process. Similarly, the Board believes that access criteria can help ensure that a designated FMU admits financial institutions that will be able to meet their obligations and not expose the FMU or its other participants to risk, including through risk measures such as capital ratios, risk ratings, or other indicators. For this reason, the Board will have an interest in receiving advance notice of any material changes to a designated FMU’s participant eligibility or access criteria. Finally, understanding the scope of services offered by an FMU that is designated on the basis of its role as operator of a payment system is fundamental to being able to have a clear understanding of the payment system’s risk profile. A designated FMU’s services could affect the financial risks participants face through their participation in the system, as well as the level of risk that the designated FMU is incurring by providing the services. Commenters also suggested revising the list of non-material changes in proposed § 234.5(c)(3).23 One commenter stated that certain examples on the non-material list are so narrowly drawn as to be unhelpful in marking a reasonable line between circumstances that may compel advance notice and those that may not. As an example, the commenter cited the example of ‘‘a change that does not modify the contractual rights or obligations of the designated financial market utility or persons using its payment, clearing, or settlement services’’ set out in proposed § 234.5(c)(3)(i) and noted these types of changes, in essence, would be the types of clerical, non-substantive changes separately identified in proposed § 234.5(c)(3)(v). Another commenter 23 One commenter suggested that the final rule include in the non-material list of proposed § 234.5(c)(3) a greater range of operating rule changes for designated FMUs participating in the retail payment systems. As explained above, however, the Council has indicated that it expects to focus at this time on FMUs that operate largevalue systems and not on FMUs that operate lowvalue systems, such as check or ACH. 76 FR 44763, 44769 (July 2011). E:\FR\FM\02AUR1.SGM 02AUR1 sroberts on DSK5SPTVN1PROD with RULES 45916 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations supported a broad application of the example set forth in § 234.5(c)(3)(ii) (‘‘a change to an existing procedure, control, or service that does not adversely affect the safeguarding of securities, collateral, or funds in the custody or control of the designated financial market utility or for which it is responsible’’). After taking into consideration the comments noted above and reexamining the list of non-material changes, the Board is eliminating the examples in proposed §§ 234.5(c)(3)(i) and (ii). With respect to proposed § 234.5(c)(3)(i), the Board recognizes the commenter’s concern; however, the Board believes it is more prudent to capture a wider range of proposed changes at this time and therefore is reluctant to expand the example’s breadth. In addition, the Board is concerned that a broad application of the non-material change set forth in proposed § 234.5(c)(3)(ii) might inadvertently create an overlap with the advance notice requirement for material change set forth in § 234.5(c)(2)(iii) because both changes fall broadly within the area of risk management. In order to avoid this overlap, and any resulting confusion, the Board is removing the example in proposed § 234.5(c)(3)(ii). The list provided by the Board in § 234.5(c)(3) is not meant to be exhaustive. The Board believes that it is difficult to draw a bright line that could be uniformly applicable to all designated FMUs between changes that would require advance notice and those that would not because of the range of different designs and functions. The Board believes, at this time, that routine changes like those listed in the remaining examples of § 234.5(c)(3) would be considered clearly nonmaterial for the purposes of triggering the 60-day advance notice requirement. In addition, the Board believes that changes to fees, prices, or other charges for services provided by the designated FMU constitute business decisions that would not require advance notice. To that end, the Board is adopting an explicit exclusion for fees, prices, or other charges in § 234.5(c)(3)(ii). As mentioned above, as the supervisory process develops with a particular designated FMU, the Board anticipates that it will reach an understanding with the FMU about what constitutes a nonmaterial rule change for that FMU that would not require advance notice. 2. Expedited Review Proposed § 234.5(a) includes procedural requirements regarding advance notices of material changes, such as the required content of the VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 notices and the procedures and timing for the methods for approving such changes. These provisions essentially reiterate similar provisions in section 806(e) of the Dodd-Frank Act. Some commenters were concerned that the open-ended time frame for the Board to request additional information on a material change would unnecessarily delay action on certain changes to rules, procedures, or operations that are time sensitive, but do not materially affect the level of risks posed by the designated FMU. As a means of expediting the processing of advance notice submissions, commenters made several suggestions to limit the time of the Board’s review, such as (a) establishing a 10-day preliminary determination window in which the Board determines whether a proposed change requires advance notice or a full 60-day review and (b) limiting the Board’s authority to request additional information to assess the effects of the proposed change to within the first 30 days of the review period. The commenters were generally concerned that the Board would engage in an indefinite and extended review of advance notices that would hinder a designated FMU’s ability to manage its business. As a general matter, the Board recognizes the importance of reducing regulatory burden and being diligent in reviewing proposed material changes in a timely manner. Section 806(e)(1)(I) of the Act permits a designated FMU to implement a change in less than 60 days from the filing of the advance notice if its Supervisory Agency notifies the designated FMU that it does not object to the proposed change and authorizes the designated FMU to implement the change at an earlier date. The Board incorporated this statutory provision in proposed § 234.5(a)(8) and is retaining this provision in the final rule. This provision provides a mechanism for the Board to complete its review and inform the designated FMU that it may proceed before the expiration of the 60-day advance notice period. The Board expects to use this procedure as appropriate. The Board, however, recognizes that it must balance the need for expediency with the need to conduct a thorough review of any necessary supporting documentation or information related to a proposed change, in order to make an informed decision consistent with its statutory responsibilities. Therefore, the timeliness of the Board’s review may depend, in part, on the completeness of the information provided by and level of engagement with the designated FMU PO 00000 Frm 00014 Fmt 4700 Sfmt 4700 prior to and following the submission of the advance notice. 3. Advance Notice by Rule-Setting Bodies Two commenters responsible for developing and setting rules for retail payment systems suggested that the Board’s advance notice procedure permit the submission of a proposed rule change by the rule-writing body and that such submission satisfy the advance notice requirement for any designated payment system operating subject to the rules. As an initial matter, the Board will be mindful of the need for efficiency and minimizing regulatory burden, while also ensuring that the Board receives the necessary information on a timely basis in order to fulfill its responsibilities under the Act. The Board notes, however, that although such rule-writing arrangements exist for several retail payment networks, as noted above, such systems are not expected to be designated by the Council as systemically important at this time. If the Council designates any payment systems subject to such rule-writing arrangements and the Board is the Supervisory Agency for that system, the Board would review, at that time, the appropriate means for such systems to submit advance notices. 4. Emergency Changes One commenter requested that the Board take care in allowing designated FMUs to make immediate emergency changes to their governing rules under proposed § 234.5(b), particularly with respect to customer collateral and margin requirements. The commenter stated that situations that justify alteration of loss mutualization standards from international standards are rare and should be carefully scrutinized. The commenter also requested that the Board incorporate CPSS–IOSCO principles with regard to customer collateral and margin requirements so as to ensure that designated FMUs will apply loss mutualization standards that comport with international standards. Section 806(e)(2) of the Act contemplates the possibility that designated FMUs may need to implement material changes to their rules, procedures, or operations in emergency situations and includes a mechanism allowing for the ex-post notification of the Supervisory Agency regarding such emergency material changes. This mechanism was incorporated into proposed § 234.5(b). In order to take advantage of the emergency change process, a designated E:\FR\FM\02AUR1.SGM 02AUR1 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES FMU is required to explain to the Board within 24 hours of the implementation of the change, among other things, the nature of the emergency and the reason the changes was necessary for the designated FMU to continue to provide its services in a safe and sound manner. Pursuant to Title VIII and the proposed rule, the Board may require modification or rescission of the change if it finds that the change is not consistent with the purposes of the Act or rules or standards prescribed thereunder. The Board expects that emergency changes, including any changes to customer collateral and margin requirements, will occur rarely and will be carefully scrutinized. 5. Advance Notice and Competitive Issues Two commenters raised concerns regarding the advance notice procedure for designated FMUs that offer services that compete with services offered by the Federal Reserve Banks (‘‘Reserve Banks’’). One commenter involved in check imaging stated that if Reserve Banks engaged in check image services were not subject to the advance notice procedure under proposed § 234.5(a) and private-sector check-imageexchange rules were subject to the advance notice procedure, the Reserve Banks would enjoy a significant competitive advantage over the privatesector competitors. This commenter believed that the Reserve Banks would be able to change their check-image rules without being subject to the same delay and uncertainty as the competing designated FMU under the advance notice procedure. The commenter suggested that the Board include within the final rule provisions that seek to mitigate the potential for a negative impact on competition that may arise from the advance notice procedure for designated FMUs. Another commenter stated that it was beyond the scope of systemic risk regulation for the Board to ‘‘force a delay in implementing business-related changes; particularly in a competitive market in which the Reserve Banks offer the competing alternative.’’ The Board is cognizant of the competition between the Reserve Banks and private-sector service providers in certain financial services, including check and funds transfer services, and has long-standing policies to address such competitive issues. Under the Federal Reserve Act, the Board has general supervisory authority over the Reserve Banks, including the Reserve Banks’ provision of payment and settlement services (‘‘Reserve Bank financial services’’), that is much more VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 extensive in scope than the authority provided under Title VIII over designated FMUs.24 In practice, Board oversight of the Reserve Banks in many ways goes beyond the typical supervisory framework for privatesector entities, including the framework provided by Title VIII. For example, the Board applies robust risk-management standards to the relevant Reserve Bank financial services; conducts regular examinations; and reviews key strategic initiatives, prices and service terms, proposed material changes, and ongoing operations. The Board conducts regular examinations of the Reserve Bank financial services covering, among other things, operational safety and soundness and management effectiveness. It also regularly monitors the services’ operations and initiatives through reports, discussions with Reserve Bank management, and its oversight liaison roles on various Reserve Bank management groups. The Board is also involved in reviewing or approving proposed changes to the Reserve Banks’ rules, procedures, and operations, including those involving Reserve Bank financial services, from their inception. The Board’s oversight of these proposed changes is significantly broader and more detailed than the Title VIII advance notice procedures. For example, the Board reviews all changes to the Reserve Banks’ operating circulars, approves the Reserve Banks’ budgets, including budgets related to the Reserve Bank financial services, and approves major strategic initiatives, and the associated expenditures. Moreover, the Board recognizes the critical role Reserve Bank financial services, particularly the Fedwire Funds and Fedwire Securities services, play in the financial system and is committed to strong and effective supervision of these services that is comparable to, or exceeds, the requirements placed on similar private-sector entities. For example, the Board expects the Fedwire services to meet or exceed the Board’s PSR policy standards, which are consistent with the Regulation HH standards applied to designated FMUs. In addition, the Board will hold the Reserve Banks to advance notice requirements with respect to proposed material changes to Fedwire rules, procedures, and operations that are the same as, or higher than, the requirements for designated FMUs that are supervised by the Board.25 24 12 U.S.C. 221 et seq. the Board’s policy on ‘‘Oversight of Key Financial Infrastructures’’ related to Reserve Bank 25 See PO 00000 Frm 00015 Fmt 4700 Sfmt 4700 45917 Moreover, if the Council designates an FMU on the basis of its role as operator of a payment system that competes with another Reserve Bank service, the Board will ensure that the competing Reserve Bank service is held to the same or higher requirements as those set forth in Regulation HH. In addition, in order to address any competitive inequalities between Reserve Bank priced services and similar services provided by private sector entities, the Monetary Control Act of 1980 (the ‘‘MCA’’) requires Reserve Bank priced services to be priced explicitly and that fees be established on basis of all direct and indirect costs actually incurred, including taxes that would have been paid and a return on capital that would have been provided had the services been furnished by a private business firm.26 As required by the MCA, the Board also has established a set of pricing principles that governs the schedule of fees for the Reserve Bank priced services, which must give due regard to competitive factors.27 Board policy also requires that Federal Reserve actions are implemented in a manner that ensures fairness to other providers of payment services.28 In light of these policies, the Board believes that changes to Reserve Bank priced services rules or operating circulars are subject to no less scrutiny, and in many cases more scrutiny, than the review contemplated by Title VIII’s advance notice procedure. III. Administrative Law Matters A. Regulatory Flexibility Act Analysis The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) (‘‘RFA’’) generally requires an agency to perform an initial and a final regulatory flexibility analysis on the impact a rule is expected to have on small entities. However, under section 605(b) of the RFA, the regulatory flexibility analysis otherwise required under section 604 of the RFA is not required if an agency certifies, along with a statement providing the factual basis for such certification, that the rule will not have a significant economic impact on a substantial number of small entities. Based on current information, the Board believes that the payment systems that would likely be designated by the Council would not be ‘‘small entities’’ for purposes of the RFA, and Systems at https://www.federalreserve.gov/ paymentsystems/over_rbsystems.htm. 26 12 U.S.C. 248a. These costs are included in the private-sector adjustment factor for pricing Reserve Bank priced services. 27 12 U.S.C. 248a(c)(3). 28 The Board policy can be found at: https:// www.federalreserve.gov/paymentsystems/ pfs_standards.htm. E:\FR\FM\02AUR1.SGM 02AUR1 sroberts on DSK5SPTVN1PROD with RULES 45918 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations so, the final rule likely would not have a significant economic impact on a substantial number of small entities. The authority to designate FMUs, however, resides with the Council, rather than the Board, and the Board therefore cannot be assured of the identity of the FMUs that the Council may designate in the future. Accordingly, the Board has prepared the following final regulatory flexibility analysis pursuant to section 604 of the RFA. 1. Statement of the need for, and objectives of, the final rule. In accordance with Sections 805(a) and 806(e) of the Dodd-Frank Act, the Board is adopting the final rule as Regulation HH, new Part 234 of Title 12 of the Code of Federal Regulations. The final rule establishes risk-management standards for systemically important FMUs and standards for determining when advance notice is required to be provided by a designated FMU that proposes to change to its rules, procedures, or operations that could materially affect the nature or level of risks presented by the designated financial market utility. The reasons and justification for the final rule are described above in the Supplementary Information. 2. Summary of the significant issues raised by public comment on Board’s initial analysis, the Board’s assessment of such issues, and a statement of any changes made as a result of such comments. The Board did not receive any public comments regarding its initial regulatory flexibility analysis. 3. Small entities affected by the final rule. The final rule would affect FMUs that the Council designates as systemically important to the U.S. financial system for which the Board is the Supervisory Agency. The Board estimates that fewer than five largevalue payment systems would meet these conditions and be affected by this rule. Pursuant to regulations issued by the Small Business Administration (the ‘‘SBA’’) (13 CFR 121.201), a ‘‘small entity’’ includes an establishment engaged in providing financial transaction processing, reserve and liquidity services, or clearinghouse services with an average revenue of $7 million or less (NAICS code 522320). As noted in the NPRM, the Board does not currently believe that any of the payment systems that would likely be designated by the Council would be ‘‘small entities’’ pursuant to the SBA regulation. In addition, the Board does not believe at this time that, pursuant to section 803(8) of the Dodd-Frank Act, it would be the Supervisory Agency for any FMU that operates as a central VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 securities depository or central counterparty and that would likely be designated by the Council. 4. Recordkeeping, reporting, and compliance requirements. The final rule imposes certain reporting and recordkeeping requirements for a designated FMU. (See, for example, § 234.3(a)(3) (requiring clearly defined procedures for the management of credit risks and liquidity risks); § 234.5(a)(1) and (2) (requiring advance notice of changes that could materially affect the nature or level of risks presented by the designated FMU), and § 234.5(b)(2) and (3) (requiring notice of an emergency change implemented by a designated FMU).) The final rule also contains a number of compliance requirements, including the standards that the designated FMU must meet, such as having a well-founded legal basis under all relevant jurisdictions and having rules and procedures that enable participants to understand clearly the FMU’s impact on each of the financial risks they incur by participation in it. Payment systems under the Board’s jurisdiction (including certain payment systems the Board believes could be designated as systemically important) are generally already expected to meet these standards, or are at least familiar with these standards, so the rule would not likely impose material additional costs on those payment systems. 5. Significant alternatives to the revisions. Section 805(a) of the Act requires the Board to prescribe riskmanagement standards governing the operations related to PCS activities of designated FMUs, so other administrative methods for accomplishing the goals of the Act were not considered. One alternative to adopting risk-management standards based on the relevant international standards was to develop a different set of risk-management standards specifically for purposes of section 805(a) of the Act. As explained in the NPRM and above, the Board proposed to adopt the Core Principles and CPSS– IOSCO Recommendations as the basis for establishing initial risk-management standards required by section 805(a) of the Act, in part, because this approach presented advantageous cost efficiencies for the regulators and the FMUs. Furthermore, the new standards set forth in the PFMI were still under development at the time of the NPRM and not available for consideration as an alternative. As explained above, the Core Principles and CPSS–IOSCO Recommendations were formulated by central banks and securities regulators with considerable discussion and industry consultation. In particular, the PO 00000 Frm 00016 Fmt 4700 Sfmt 4700 Federal Reserve collaborated with participating financial system authorities and consulted with FMUs and their participants in developing the standards. In addition, the SEC and CFTC participated in the development of the CPSS–IOSCO Recommendations. The Board incorporated these standards in its PSR policy in 2004 and 2007 and has been guided by the policy, in conjunction with relevant laws and other Federal Reserve policies, when exercising its authority with respect to supervising large-value payment and securities settlement systems.29 Payment systems that would likely be designated by the Council, therefore, would likely be familiar with the Core Principles and could implement them promptly with relatively less burden than if the Board developed a different set of standards to implement section 805(a) of the Act. B. Competitive Impact Analysis As a matter of policy, the Board subjects all operational and legal changes that could have a substantial effect on payment system participants to a competitive impact analysis, even if competitive effects are not apparent on the face of the proposal.30 Pursuant to this policy, the Board assesses whether proposed changes ‘‘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’’ and whether any such adverse effect ‘‘was due to legal differences or due to a dominant market position deriving from such legal differences.’’ If, as a result of this analysis, the Board identifies an adverse effect on the ability to compete, the Board then assesses whether the associated benefits—such as improvements to payment system efficiency or integrity—can be achieved while minimizing the adverse effect on competition. This final rule promulgates riskmanagement standards and advance notice requirements for designated FMUs, as required by Title VIII of the Act. Some FMUs may be designated on the basis of their role as operators of payment systems that compete with similar services provided by the Reserve Banks, and designation subjects the FMU to an enhanced supervisory framework. Commenters have raised concerns regarding the Reserve Banks obtaining a competitive advantage over private-sector competitors through the 29 See footnote 19. ‘‘The Federal Reserve in the Payments System,’’ Fed. Res. Reg. Svc. § 9–1550, 9–1558 (Apr. 2009). 30 See E:\FR\FM\02AUR1.SGM 02AUR1 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations sroberts on DSK5SPTVN1PROD with RULES Board imposing a less-stringent supervisory framework on the Reserve Banks priced services than would be imposed on a competing designated FMU. As noted above, Board oversight of the Reserve Banks goes well beyond the typical supervisory framework for private-sector entities, including the framework provided by Title VIII. The Board applies risk-management standards to the Reserve Banks’ Fedwire and other financial services that are at least as stringent as those applied to designated FMUs pursuant to Title VIII. Further, the Board will hold Reserve Banks to procedural requirements that are the same as, or higher than, the requirements for designated FMUs supervised by the Board, with respect to advance notice of material changes to the rules, procedures, or operations of Reserve Bank priced services that compete with designated FMUs. Therefore, the Board does not believe the final rule promulgating riskmanagement standards or advance notice requirements for designated FMUs under Title VIII will have any direct and material adverse effect on the ability of other service providers to compete with the Reserve Banks. C. Paperwork Reduction Act Analysis In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3506; 5 CFR part 1320, Appendix A.1), the Board reviewed the final rule under the authority delegated to the Board by the Office of Management and Budget. As noted in the proposal, for purposes of calculating burden under the Paperwork Reduction Act, a ‘‘collection of information’’ involves 10 or more respondents. Any collection of information addressed to all or a substantial majority of an industry is presumed to involve 10 or more respondents (5 CFR 1320.3(c), 1320.3(c)(4)(ii)). The Board estimates there are fewer than 10 respondents, and these respondents do not represent all or a substantial majority of the participants in payment, clearing, and settlement systems. Therefore, no collections of information pursuant to the Paperwork Reduction Act are contained in the final rule. The Board did not receive any comments on this analysis. The Board has a continuing interest in the public’s opinion of the collection of information. Comments on the collection of information should be sent to Cynthia Ayouch, Acting Federal Reserve Board Clearance Officer, Division of Research and Statistics, Mail Stop 95–A, Board of Governors of the Federal Reserve System, Washington, DC 20551, with copies of such VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 comments sent to the Office of Management and Budget, Paperwork Reduction Project (7100–0199), Washington, DC 20503. List of Subjects in 12 CFR Part 234 Banks, Banking, Credit, Electronic funds transfers, Financial market utilities, Securities. Authority and Issuance For the reasons set forth in the preamble, the Board amends 12 CFR, Chapter II by adding part 234, as set forth below. PART 234—DESIGNATED FINANCIAL MARKET UTILITIES (REGULATION HH) Sec. 234.1 Authority, purpose, and scope. 234.2 Definitions. 234.3 Standards for payment systems. 234.4 Standards for central securities depositories and central counterparties. 234.5 Changes to rules, procedures, or operations. Authority: 12 U.S.C. 5461 et seq. § 234.1 Authority, purpose, and scope. (a) Authority. This part is issued under the authority of sections 805, 806, and 810 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) (Pub. L. 111–203, 124 Stat. 1376; 12 U.S.C. 5464, 5465, and 5469). (b) Purpose and scope. This part establishes risk-management standards governing the operations related to the payment, clearing, and settlement activities of designated financial market utilities. The risk-management standards do not apply, however, to a designated financial market utility that is a derivatives clearing organization registered under section 5b of the Commodity Exchange Act (7 U.S.C. 7a– 1) or a clearing agency registered with the Securities and Exchange Commission under section 17A of the Securities Exchange Act of 1934 (15 U.S.C. 78q–1), which are governed by the risk-management standards promulgated by the Commodity Futures Trading Commission or the Securities and Exchange Commission, respectively, for which each is the Supervisory Agency (as defined below). In addition, this part sets out requirements and procedures for a designated financial market utility that proposes to make a change to its rules, procedures, or operations that could materially affect the nature or level of risks presented by the designated financial market utility and for which the Board is the Supervisory Agency. PO 00000 Frm 00017 Fmt 4700 Sfmt 4700 § 234.2 45919 Definitions. As used in this part: (a) Central counterparty means an entity that interposes itself between the counterparties to trades, acting as the buyer to every seller and the seller to every buyer. (b) Central securities depository means an entity that holds securities in custody to enable securities transactions to be processed by means of book entries or an entity that enables securities to be transferred and settled by book entry either free of or against payment. (c) Designated financial market utility means a financial market utility (as defined in paragraph (d) of this section) that the Financial Stability Oversight Council has designated under section 804 of the Dodd-Frank Act (12 U.S.C. 5463). (d) Financial market utility has the same meaning as the term defined in section 803(6) of the Dodd-Frank Act (12 U.S.C. 5462(6)). (e) Payment system means a set of payment instructions, procedures, and rules for the transfer of funds among system participants. (f) Supervisory Agency has the same meaning as the term is defined in section 803(8) of the Dodd-Frank Act (12 U.S.C. 5462(8)). § 234.3 Standards for payment systems. (a) A designated financial market utility that is designated on the basis of its role as the operator of a payment system must implement rules, procedures, or operations designed to ensure that it meets or exceeds the following risk-management standards with respect to the payment, clearing, and settlement activities of that payment system: (1) The payment system has a wellfounded legal basis under all relevant jurisdictions. (2) The payment system’s rules and procedures enable participants to have a clear understanding of the payment system’s impact on each of the financial risks they incur through participation in it. (3) The payment system has clearly defined procedures for the management of credit risks and liquidity risks, which specify the respective responsibilities of the payment system operator and the participants and which provide appropriate incentives to manage and contain those risks. (4) The payment system provides prompt final settlement on the day of value, during the day and at a minimum at the end of the day. (5) A payment system in which multilateral netting takes place is, at a E:\FR\FM\02AUR1.SGM 02AUR1 45920 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations minimum, capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single settlement obligation. (6) Assets used for settlement are a claim on the central bank or other assets that carry little or no credit risk and little or no liquidity risk. (7) The payment system ensures a high degree of security and operational reliability and has contingency arrangements for timely completion of daily processing. (8) The payment system provides a means of making payments that is practical for its users and efficient for the economy. (9) The payment system has objective and publicly disclosed criteria for participation, which permit fair and open access. (10) The payment system’s governance arrangements are effective, accountable, and transparent. (b) The Board, by order, may apply heightened risk-management standards to a particular designated financial market utility in accordance with the risks presented by that designated financial market utility. The Board, by order, may waive the application of a standard or standards to a particular designated financial market utility where the risks presented by or the design of that designated financial market utility would make the application of the standard or standards inappropriate. sroberts on DSK5SPTVN1PROD with RULES § 234.4 Standards for central securities depositories and central counterparties. (a) A designated financial market utility that is designated on the basis of its role as a central securities depository or a central counterparty must implement rules, procedures, or operations designed to ensure that it meets or exceeds the following riskmanagement standards with respect to the payment, clearing, and settlement activities of that central securities depository or central counterparty: (1) The central securities depository or central counterparty has a wellfounded, transparent, and enforceable legal framework for each aspect of its activities in all relevant jurisdictions. (2) The central securities depository or central counterparty requires participants to have sufficient financial resources and robust operational capacity to meet obligations arising from participation in the central securities depository or central counterparty. The central securities depository or central counterparty has procedures in place to monitor that participation requirements are met on an ongoing basis. The central VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 securities depository’s or central counterparty’s participation requirements are objective and publicly disclosed, and permit fair and open access. (3) The central securities depository or central counterparty holds assets in a manner whereby risk of loss or of delay in its access to them is minimized. Assets invested by a central securities depository or central counterparty are held in instruments with minimal credit, market, and liquidity risks. (4) The central securities depository or central counterparty identifies sources of operational risk and minimizes them through the development of appropriate systems, controls, and procedures; has systems that are reliable and secure, and has adequate, scalable capacity; and has business continuity plans that allow for timely recovery of operations and fulfillment of the central securities depository’s or central counterparty’s obligations. (5) The central securities depository or central counterparty employs money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its credit and liquidity risks from the use of banks to effect money settlements with its participants and requires funds transfers to the central securities depository or central counterparty be final when effected. (6) The central securities depository or central counterparty is cost-effective in meeting the requirements of participants while maintaining safe and secure operations. (7) The central securities depository or central counterparty evaluates the potential sources of risks that can arise when the central securities depository or central counterparty establishes links either cross-border or domestically to settle transactions or clear trades, and ensures that the risks are managed prudently on an ongoing basis. (8) The central securities depository or central counterparty has governance arrangements that are clear and transparent to fulfill public interest requirements and to support the objectives of owners and participants and promotes the effectiveness of a central securities depository’s or central counterparty’s risk-management procedures. (9) The central securities depository or central counterparty provides market participants with sufficient information for them to identify and evaluate accurately the risks and costs associated with using its services. (10) The central securities depository or central counterparty establishes default procedures that ensures that the PO 00000 Frm 00018 Fmt 4700 Sfmt 4700 central securities depository or central counterparty can take timely action to contain losses and liquidity pressures and to continue meeting its obligations and provides for key aspects of the default procedures to be publicly available. (11) The central securities depository or central counterparty ensures that final settlement occurs no later than the end of the settlement day and requires that intraday or real-time finality be provided where necessary to reduce risks. (12) The central securities depository or central counterparty eliminates principal risk by linking securities transfers to funds transfers in a way that achieves delivery versus payment. (13) The central securities depository or central counterparty states its obligations with respect to physical deliveries, and the risks from these obligations are identified and managed. (14) The central securities depository immobilizes or dematerializes securities certificates and transfers them by book entry to the greatest extent possible. (15) The central securities depository institutes risk controls that include collateral requirements and limits, and ensure timely settlement in the event that the participant with the largest payment obligation is unable to settle when the central securities depository extends intraday credit. (16) The central counterparty measures its credit exposures to its participants at least once a day and limits its exposures to potential losses from defaults by its participants in normal market conditions so that the operations of the central counterparty would not be disrupted and nondefaulting participants would not be exposed to losses that they cannot anticipate or control. (17) The central counterparty uses margin requirements to limit its credit exposures to participants in normal market conditions and uses risk-based models and parameters to set margin requirements and reviews them regularly. Specifically, the central counterparty— (i) Provides for annual model validation consisting of evaluating the performance of the central counterparty’s margin models and the related parameters and assumptions associated with such models by a qualified person who does not perform functions associated with the central counterparty’s margin models (except as part of the annual model validation) and does not report to such a person. (ii) Reviews and backtests margin models and parameters at least quarterly. E:\FR\FM\02AUR1.SGM 02AUR1 Federal Register / Vol. 77, No. 149 / Thursday, August 2, 2012 / Rules and Regulations (18) The central counterparty maintains sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions. (b) The Board, by order, may apply heightened risk-management standards to a particular designated financial market utility in accordance with the risks presented by that designated financial market utility. The Board, by order, may waive the application of a standard or standards to a particular designated financial market utility where the risks presented by or the design of that designated financial market utility would make the application of the standard or standards inappropriate. sroberts on DSK5SPTVN1PROD with RULES § 234.5 Changes to rules, procedures, or operations. (a) Advance notice. (1) A designated financial market utility shall provide at least 60-days advance notice to the Board of any proposed change to its rules, procedures, or operations that could materially affect the nature or level of risks presented by the designated financial market utility. (2) The notice of the proposed change shall describe— (i) The nature of the change and expected effects on risks to the designated financial market utility, its participants, or the market; and (ii) How the designated financial market utility plans to manage any identified risks. (3) The Board may require the designated financial market utility to provide additional information necessary to assess the effect the proposed change would have on the nature or level of risks associated with the utility’s payment, clearing, or settlement activities and the sufficiency of any proposed risk-management techniques. (4) A designated financial market utility shall not implement a change to which the Board has an objection. (5) The Board will notify the designated financial market utility of any objection before the end of 60 days after the later of— (i) The date the Board receives the notice of proposed change; or (ii) The date the Board receives any further information it requests for consideration of the notice. (6) A designated financial market utility may implement a change if it has not received an objection to the proposed change before the end of 60 days after the later of— (i) The date the Board receives the notice of proposed change; or VerDate Mar<15>2010 16:21 Aug 01, 2012 Jkt 226001 (ii) The date the Board receives any further information it requests for consideration of the notice. (7) With respect to proposed changes that raise novel or complex issues, the Board may, by written notice during the 60-day review period, extend the review period for an additional 60 days. Any extension under this paragraph will extend the time periods under paragraphs (a)(5) and (a)(6) of this section to 120 days. (8) A designated financial market utility may implement a proposed change before the expiration of the applicable review period if the Board notifies the designated financial market utility in writing that the Board does not object to the proposed change and authorizes the designated financial market utility to implement the change on an earlier date, subject to any conditions imposed by the Board. (b) Emergency changes. (1) A designated financial market utility may implement a change that would otherwise require advance notice under this section if it determines that— (i) An emergency exists; and (ii) Immediate implementation of the change is necessary for the designated financial market utility to continue to provide its services in a safe and sound manner. (2) The designated financial market utility shall provide notice of any such emergency change to the Board as soon as practicable and no later than 24 hours after implementation of the change. (3) In addition to the information required for changes requiring advance notice in paragraph (a)(2) of this section, the notice of an emergency change shall describe— (i) The nature of the emergency; and (ii) The reason the change was necessary for the designated financial market utility to continue to provide its services in a safe and sound manner. (4) The Board may require modification or rescission of the change if it finds that the change is not consistent with the purposes of the Dodd-Frank Act or any applicable rules, order, or standards prescribed under section 805(a) of the Dodd-Frank Act. (c) Materiality. (1) The term ‘‘materially affect the nature or level of risks presented’’ in paragraph (a)(1) of this section means matters as to which there is a reasonable possibility that the change would materially affect the overall nature or level of risk presented by the designated financial market utility, including risk arising in the performance of payment, clearing, or settlement functions. (2) A change to rules, procedures, or operations that would materially affect PO 00000 Frm 00019 Fmt 4700 Sfmt 4700 45921 the nature or level of risks presented includes, but is not limited to, changes that materially affect any one or more of the following: (i) Participant eligibility or access criteria; (ii) Product eligibility; (iii) Risk management; (iv) Settlement failure or default procedures; (v) Financial resources; (vi) Business continuity and disaster recovery plans; (vii) Daily or intraday settlement procedures; (viii) The scope of services, including the addition of a new service or discontinuation of an existing service; (ix) Technical design or operating platform, which results in non-routine changes to the underlying technological framework for payment, clearing, or settlement functions; or (x) Governance. (3) A change to rules, procedures, or operations that does not meet the conditions of paragraph (c)(2) of this section and would not materially affect the nature or level of risks presented includes, but is not limited to the following: (i) A routine technology systems upgrade; (ii) A change in a fee, price, or other charge for services provided by the designated financial market utility; (iii) A change related solely to the administration of the designated financial market utility or related to the routine, daily administration, direction, and control of employees; or (iv) A clerical change and other nonsubstantive revisions to rules, procedures, or other documentation. By order of the Board of Governors of the Federal Reserve System, July 27, 2012. Robert deV. Frierson, Deputy Secretary of the Board. [FR Doc. 2012–18762 Filed 8–1–12; 8:45 am] BILLING CODE P DEPARTMENT OF TRANSPORTATION Federal Aviation Administration 14 CFR Part 21 Alaskan Fuel Hauling as a Restricted Category Special Purpose Flight Operation Federal Aviation Administration (FAA), (DOT). ACTION: Notice of policy. AGENCY: This notice of policy announces Alaskan fuel hauling as a restricted category special purpose SUMMARY: E:\FR\FM\02AUR1.SGM 02AUR1

Agencies

FEDERAL RESERVE SYSTEM

[Federal Register Volume 77, Number 149 (Thursday, August 2, 2012)]
[Rules and Regulations]
[Pages 45907-45921]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-18762]

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FEDERAL RESERVE SYSTEM

12 CFR Part 234

[Regulation HH; Docket No. R-1412]
RIN 7100-AD 71

Financial Market Utilities

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board is publishing a final rule, Regulation HH,
Designated Financial Market Utilities. This rule implements provisions
of sections 805(a) and 806(e) of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (``Dodd-Frank Act'' or ``Act''), including
risk-management standards for financial market utilities (``FMUs'')
that are designated as systemically important by the Financial
Stability Oversight Council (the ``Council'') and standards for
determining when a designated FMU is required to provide advance notice
of proposed changes to its rules, procedures, or operations that could
materially affect the nature or level of risks presented by the
designated FMU.

DATES: This final rule is effective September 14, 2012.

FOR FURTHER INFORMATION CONTACT: Jennifer A. Lucier, Assistant Director
(202) 872-7581 or Kathy C. Wang, Senior Financial Services Analyst
(202) 872-4991, Division of Reserve Bank Operations and Payment
Systems; Christopher W. Clubb, Senior Counsel (202) 452-3904 or Kara L.
Handzlik, Senior Attorney (202) 452-3852, Legal Division; for users of
Telecommunications Device for the Deaf (TDD) only, contact (202) 263-
4869.

SUPPLEMENTARY INFORMATION:

I. Background

Title VIII of the Dodd-Frank Act, titled the ``Payment, Clearing,
and Settlement Supervision Act of 2010,'' was enacted to mitigate
systemic risk in the financial system and to promote financial
stability, in part, through enhanced supervision of designated FMUs.\1\
Section 803 of the Dodd-Frank

[[Page 45908]]

Act defines an FMU as a person that manages or operates a multilateral
system for the purpose of transferring, clearing, or settling payments,
securities, or other financial transactions among financial
institutions or between financial institutions and the person. The
basic risks that FMUs must manage include credit risk, liquidity risk,
settlement risk, operational risk, and legal risk. These risks arise
between financial institutions and FMUs as they settle payments and
other financial transactions. In order to maintain financial stability,
FMUs must be well-designed and operated in a safe and sound manner. If
a systemically important FMU fails to measure, monitor, and manage its
risks effectively, it could pose significant risk to its participants
and the financial system more broadly.
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\1\ The Dodd-Frank Act, Public Law 111-203, 124 Stat. 1376, was
signed into law on July 21, 2010.
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Under section 805(a)(1) of the Dodd-Frank Act, the Board is
required to promulgate risk-management standards governing the
operations related to the payment, clearing, and settlement (``PCS'')
activities of certain FMUs that are designated as systemically
important by the Council. Section 805(a)(1) of the Act also requires
the Board to take into consideration relevant international standards
and existing prudential requirements in prescribing the regulations.
For a designated FMU that is a derivatives clearing organization
(``DCO'') registered under section 5b of the Commodity Exchange Act or
a clearing agency registered under section 17A of the Securities
Exchange Act of 1934 (collectively, ``designated clearing entities''),
the Commodity Futures Trading Commission (``CFTC'') or the Securities
and Exchange Commission (``SEC''), respectively, are granted authority
to prescribe regulations, in consultation with the Council and the
Board, containing applicable risk-management standards.\2\
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\2\ Under section 805(a)(2) of the Act, the CFTC and the SEC are
also required to take relevant international standards and existing
prudential requirements into consideration in prescribing
regulations containing risk-management standards governing
designated clearing entities.
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Section 805(b) of the Act sets out the following objectives and
principles for the risk-management standards: (a) Promote robust risk
management, (b) promote safety and soundness, (c) reduce systemic
risks, and (d) support the stability of the broader financial system.
Section 805(c) of the Act states that risk-management standards may
address areas such as (1) risk-management policies and procedures, (2)
margin and collateral requirements, (3) participant or counterparty
default policies and procedures, (4) the ability to complete timely
clearing and settlement of financial transactions, (5) capital and
financial resource requirements for designated FMUs, and (6) other
areas that are necessary to achieve the objectives and principles for
risk-management standards.
In addition, section 806(e)(1) of the Dodd-Frank Act requires a
designated FMU to provide 60 days' advance notice to its Supervisory
Agency of any proposed change to its rules, procedures, or operations
that could, as defined in rules of each Supervisory Agency, materially
affect the nature or level of risks presented by the designated FMU.
Under section 803(b) of the Act, a ``Supervisory Agency'' means the
federal agency that has primary jurisdiction over a designated FMU
under federal banking, securities, or commodity futures laws.\3\
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\3\ A Supervisory Agency includes the SEC and CFTC with respect
to their respective designated clearing entities (as defined above),
the appropriate federal banking agencies (including the Board) with
respect to FMUs that are institutions described in section 3(q) of
the Federal Deposit Insurance Act (12 U.S.C. 1813(q)), and the Board
with respect to a designated FMU that is otherwise not subject to
the jurisdiction of any of the agencies listed above.
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In April 2011, the Board published for comment a notice of proposed
rulemaking (``NPRM'') to propose a new part to the Code of Federal
Regulations (12 CFR part 234, Regulation HH) to establish risk-
management standards for designated FMUs and requirements for advance
notice of material changes to a designated FMU's rules, procedures, or
operations.\4\ The public comment period closed on May 19, 2011.
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\4\ See 76 FR 18445 (Apr. 4, 2011).
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II. Summary of Public Comments and Analysis

The Board received twelve public comment letters on the NPRM.
Comments were submitted by two payment systems, seven industry and
other groups, one bank, and two other commenters. In general, the
comments pertained broadly to three categories: (i) Risk-management
standards, (ii) advance notice requirements and the materiality
definition, and (iii) other miscellaneous comments. The Board
considered these comments in developing its final rule as discussed in
more detail below.\5\
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\5\ In addition, the Board is adopting several changes intended
to clarify the requirements of the regulation.
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A. Risk-Management Standards

1. International Standards
Proposed Sec. 234.3 sets out risk-management standards for
designated FMUs that are payment systems, and proposed Sec. 234.4 sets
out risk-management standards for central counterparties (``CCPs'') and
central securities depositories (``CSDs''), based on the international
risk-management standards developed by the Committee on Payment and
Settlement Systems (``CPSS'') and the Technical Committee of the
International Organization of Securities Commissions (``IOSCO''). These
international standards were the Core Principles for Systemically
Important Payment Systems (the ``Core Principles'') developed by the
CPSS in 2001, and the Recommendations for Securities Settlement Systems
and the Recommendations for Central Counterparties (collectively, the
``CPSS-IOSCO Recommendations'') developed jointly by the CPSS and IOSCO
in 2001 and 2004, respectively. The Board believes these standards are
the appropriate basis for setting initial risk-management standards
under Title VIII for several reasons. First, section 805(a)(1) of the
Act directs the Board to consider relevant international standards in
prescribing risk-management standards under Title VIII. As explained in
the NPRM, the Core Principles and the CPSS-IOSCO Recommendations were
the international standards most relevant to risk management of
FMUs.\6\ Second, FMUs are familiar with these standards as the long-
standing basis for Part I of the Federal Reserve Policy on Payment
System Risk (``PSR policy'').\7\ Third, the Board has significant
experience applying these international standards to large-value
payment and settlement systems pursuant to its PSR policy.
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\6\ See 76 FR at 18447.
\7\ The PSR policy is available on the Board's public Web site
at: https://www.federalreserve.gov/paymentsystems/psr_policy.htm.
---------------------------------------------------------------------------

CPSS and IOSCO recently conducted a comprehensive review of risk-
management standards for PCS systems. On April 16, 2012, CPSS and IOSCO
issued the final report on the ``Principles for Financial Market
Infrastructures,'' which includes an updated, harmonized, and
strengthened set of international risk-management standards (the
``PFMI'').\8\ CPSS and IOSCO intend for the PFMI to replace the Core
Principles and CPSS-IOSCO Recommendations. As noted in the NPRM, the
Board anticipates that it will review the new international standards,
consult with other appropriate agencies and the Council, and seek
public comment on the adoption of revised

[[Page 45909]]

standards for designated FMUs based on the new international standards.
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\8\ The Principles for Financial Market Infrastructures are
available at https://www.bis.org/publ/cpss101a.pdf. The final report
reflects comments received during the public consultation period
from March 10, 2011 to July 29, 2011.
---------------------------------------------------------------------------

Commenters generally appeared to support the Board's approach of
using the Core Principles and CPSS-IOSCO Recommendations as a basis for
its risk-management standards for designated FMUs under section 805 of
the Act. Two commenters explicitly stated their support for the Board's
approach. Two other commenters stated that the proposed risk-management
standards were largely prudent and sensible.
One commenter was also supportive of the Board's intention to
evaluate the new international standards once they are final for the
purposes of revising Regulation HH. Two other commenters expressed some
general reservations with respect to the new international standards;
one of the commenters cautioned the Board against adopting the new
international standards ``in full,'' because doing so would include
principles that may not directly relate to the risks posed by the
designated FMUs and contemplated by Title VIII.
After considering the public comments and for the reasons stated
above, the Board continues to believe that the most suitable approach
to establishing initial risk-management standards under Title VIII of
the Act is to use the Core Principles and CPSS-IOSCO Recommendations as
the basis for the standards promulgated by this notice, and to proceed
with consideration of the PFMI as the basis for any future revisions.
The Board agrees with commenters that international standards that are
not, in some way or to some degree, related to existing or potential
risks posed to or by a designated FMU should not be adopted for
purposes of section 805 of the Act. As noted in the NPRM, the Board
acknowledged that the scope of the Core Principles and CPSS-IOSCO
Recommendations is broad and proposed to adopt by regulation particular
standards, or portions thereof, that relate to the risks presented to
or by a designated FMU, rather than those standards, or portions
thereof, that apply more generally to financial markets or regulators.
Similarly, the Board anticipates evaluating the appropriateness of each
of the new PFMI for the purpose of possible revisions to Regulation HH.
2. Applicability of Standards to Retail Payment Systems
Proposed Sec. 234.3 is based on the entire set of the Core
Principles. Some commenters questioned whether three standards included
in the Core Principles could be applied to retail payment systems,
particularly automated clearinghouses (``ACH'') and check
clearinghouses, should those systems be designated as systemically
important by the Council. Specifically, proposed Sec. 234.3(a)(3)
would require any FMU that is designated on the basis of its role as
operator of a payment system to have clearly defined procedures for the
management of credit risks and liquidity risks, which specify the
respective responsibilities of the system operator and the participants
and which provide appropriate incentives to manage and contain those
risks. Proposed Sec. 234.3(a)(4) would require any designated FMU that
is designated on the basis of its role as operator of a payment system
to provide prompt final settlement on the day of value, preferably
during the day and at a minimum at the end of the day. Proposed Sec.
234.3(a)(5) would require any designated FMU that is designated on the
basis of its role as operator of a payment system, and in which
multilateral netting takes place, to, 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
settlement obligation.
The Board received several comments on the applicability of these
risk-management standards to retail payment systems, should they be
designated by the Council. Several commenters stated their support for
an exemption for retail payment systems from designation as
systemically important by the Council under the Dodd-Frank Act. The
Council, however, determined not to categorically exclude FMUs
operating retail payment or other systems in its rule regarding the FMU
designation process.\9\ As a result, commenters provided feedback on
the ability of retail payment systems to meet certain of the Board's
proposed risk-management standards in the event the Council decides to
designate them.
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\9\ See 76 FR 44763, 44769 (July 27, 2011).
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One commenter specifically referenced proposed Sec. 234.3(a)(3)-
(5) as risk-management standards that, while appropriate risk controls
for truly systemically important payment systems, were generally
inapplicable (or had no relevance) to payments systems such as ACH
clearing arrangements that permit the return of transactions within a
certain timeframe. One commenter argued that the standard in proposed
Sec. 234.3(a)(3) regarding the management of credit and liquidity risk
would have no application where a system that did not assume credit and
liquidity risks in the first place by committing to pay funds that it
had not received and where the payment system participants expect to
manage their own credit and liquidity risks. Two commenters also stated
that proposed Sec. 234.3(a)(4) on settlement finality contradicts
long-standing and established practices of ACH rules that allow for
certain transactions to be reversed or returned for any reason until
the banking day after the settlement date. One commenter stated that
application of proposed Sec. 234.3(a)(5) regarding the ability to
complete settlement in the event the single largest participant is
unable to settle would require a fundamental change in the nature of
ACH debit transactions and the abolishment of the right to return the
transaction. In general, these commenters stated that they do not
believe that, if designated, retail payment systems would be able to
comply with these proposed standards and, accordingly, asked that such
systems be exempted from them.
The Board notes that the proposed risk-management standards were
designed to apply to large-value payment systems. This approach is
consistent with the direction of the Council expressed in its final
rule on the FMU designation process. Specifically, the Council stated
that, within payment systems, it expects to focus at this time on FMUs
that operate large-value systems and not on FMUs that operate low-value
systems (such as check and ACH).\10\ The Council also decided not to
include considerations more narrowly tailored to the characteristics of
retail payment systems because the Council did not believe they were
necessary or appropriate given the current focus for designations.
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\10\ See 76 FR at 44769. The Council also decided, however,
against including in the final rule any categorical exclusion for
FMUs operating retail payment or other systems, both because there
are not clear distinctions between various types of systems, and
because such an exclusion would impair the Council's ability to
respond appropriately to new information, changed circumstances, and
future developments.
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Given the Council's focus on large-value systems, the Board does
not anticipate that the Council will designate a FMU under Title VIII
on the basis of its role as operator of a retail payment system.
However, because the authority to designate systemically important FMUs
resides with the Council, not the Board, the Board cannot be assured of
the type of FMU the Council may designate in the future. In the event
that the Council designates an FMU on the basis of its role as operator
of a retail payment system, the Board would review, at that time,
whether the risk-management standards in Sec. 234.3 were appropriate
for that

[[Page 45910]]

designated FMU, as it would for any type of newly designated FMU.
In order to accommodate this review in the event that an
unanticipated type of FMU is designated, and in consideration of the
comments, the Board is adopting in the final rule a modification to
proposed Sec. Sec. 234.3(b) and 234.4(b) that clarifies that the
application of individual risk-management standards could be waived in
a situation where such standards could not appropriately be applied to
a particular designated FMU. Both Sec. Sec. 234.3(b) and 234.4(b) will
be amended by inserting text that states ``[t]he Board, by order, may
waive the application of a standard or standards to a particular
designated financial market utility where the risks presented by or the
design of that designated financial market utility would make the
application of the standard or standards inappropriate.'' This revision
is intended to bridge any gap between Council designation of a new type
of designated FMU and the process of promulgating regulations
appropriate for the new type of designated FMU, if necessary.
In addition, the Board notes that with respect to a designated FMU
that operates more than one payment system (e.g., one large-value and
one retail), standards would apply only with respect to the system that
provided the basis for the Council's designation of the FMU. The Board
is modifying Sec. 234.3(a) and (b) to clarify this point. The Board
also is making a parallel modification to Sec. 234.4(a) and (b).\11\
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\11\ To conform to these modifications, the Board is revising
the definitions in Sec. 234.2 (a), (b), and (e).
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The Board is also modifying Sec. Sec. 234.3(a) and 234.4(a) to
require a designated FMU to ``implement rules, procedures, or
operations designed to ensure that it meets or exceeds'' the risk-
management standards set forth in these sections. In addition, the word
``should'' has been deleted from the individual standards to clarify
that these are requirements with which a designated FMU must comply.
3. Scope of Risk-Management Standards
As noted above, the proposed risk-management standards for
designated FMUs that operate as payment systems, CCPs, or CSDs are
based on the Core Principles and CPSS-IOSCO Recommendations. Each set
includes separate standards relating to efficiency, access criteria,
and governance. Several commenters suggested that the Board eliminate
some or all of these three proposed standards for payment systems,
arguing that they address system operating issues that are outside the
scope of the systemic risk issues contemplated by Title VIII of the
Dodd-Frank Act. Specifically, the commenters questioned whether
proposed Sec. 234.3(a)(8), (9), and (10) regarding efficiency, access
criteria, and governance, respectively, were relevant to systemic
risk.\12\ The applicability of the efficiency standard was a common
concern of the commenters that raised questions about the scope of the
risk-management standards; a subset of these commenters also questioned
whether either the access criteria or governance standard was within
the scope of risk management. These standards in general were viewed as
admirable goals that designated FMUs should aim to achieve, but
nevertheless as goals that should be driven by market forces and not by
regulatory mandate.
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\12\ One commenter raised similar concerns with the
corresponding access criteria and governance standards in proposed
Sec. 234.4(a)(2) and (8) with respect to CSDs and CCPs.
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Efficiency. The efficiency standard in proposed Sec. 234.3(a)(8)
states that an FMU that is designated on the basis of its role as
operator of a payment system should provide a means of making payments
that is practical for its users and efficient for the economy. Several
commenters argued that the efficiency standard exceeds the Act's
objectives because it addresses operating system issues and not risk
matters. One commenter argued that whether a form of payment is
practical and efficient is largely a matter of judgment that is better
left to the market and its participants.
The Board believes the efficiency standard furthers the objectives
set out in Title VIII of the Act to reduce systemic risks and support
the stability of the broader financial system.
A designated FMU supports the ongoing functioning and stability of
the market it serves by providing effective, reliable PCS services to
its participants and, in particular, completing timely clearing and
settlement of financial transactions. An FMU that is designed or
managed inefficiently or impractically may ultimately distort financial
activity and market structure, increasing not only the financial and
other risks of an FMU's participants, but also the risks of their
customers and end users. To avoid such outcomes, a designated FMU
should consider the tradeoffs between, and seek a reasonable balance
of, safety (i.e., risk management) and efficiency (i.e., direct and
indirect costs) when designing and managing the system. For example,
overly demanding financial resource requirements may create a liquidity
demand so high that it would be impractical for participants to meet.
Although liquidity is very important, an FMU that accumulates excessive
liquid resources from its participants intraday may increase the
participants' opportunity cost of sending each payment. In such cases,
participants that become liquidity constrained may be forced to delay
submitting certain time- or mission-critical payments.
Additionally, an FMU's design, operating structure, scope of PCS
activities, and use of technology can influence its efficiency and can
ultimately provide incentives for market participants to use, or not
use, the FMU's services. For example, in certain cases, inefficiently
designed systems may increase costs to the point where it would be
cost-prohibitive for participants to use the FMU, and possibly drive
market participants toward less safe alternatives, such as bilateral
clearing or settlement on the books of the participants. In such cases,
risks to the market participants increase as they seek less safe
opportunities to lower direct costs; this behavior may reintroduce risk
into the market that the FMU was intended to mitigate.
As these examples suggest, a designated FMU must function
efficiently, as well as safely, and provide services that are
appropriate to the needs of its users without becoming cost-prohibitive
to use. A designated FMU that is inefficient can have a direct,
negative impact on financial stability. Accordingly, the Board believes
that it is appropriate for a supervisor of a designated FMU to take
into account the need for practical and efficient design of the
designated FMU as part of the set of risk-management standards set
forth in Regulation HH. For these reasons, the Board is adopting the
efficiency standards in proposed Sec. Sec. 234.3(a)(8) and 234.4(a)(6)
essentially as set out in the NPRM.
Access criteria. The access criteria standard in proposed Sec.
234.3(a)(9) states that a payment system should have objective and
publicly disclosed criteria for participation, which permit fair and
open access. Some commenters argued that the access criteria standard
did not relate to any of the risks contemplated by Title VIII of the
Act. One commenter stated that the actions taken by the payment system,
CSD, or CCP, create or mitigate risk, not the rules governing who can
participate in them. Another commenter noted that the participation
structure for payment systems can vary broadly and, while the
participation criteria for these systems could be an issue for
competition law, it was

[[Page 45911]]

difficult to see how the criteria could directly affect the risks that
were the focus of Title VIII.
The Board believes that access criteria are important to a
designated FMU's risk-management framework and affect the level of risk
a designated FMU presents to the financial system. Access criteria are
typically referred to as an FMU's ``first line of defense'' in ensuring
it admits financial institutions that will be able to meet their
obligations and not expose the FMU or its other participants to
unacceptable risk. Access criteria need to be designed to ensure that
participants meet appropriate operational, financial, and legal
requirements to allow them to meet their obligations on a timely
basis.\13\ However, these criteria need to be balanced against the
FMU's ability to effectively serve the market it supports, in
particular markets that are subject to a statutory requirement for
central clearing or settlement through an FMU. Although a designated
FMU may use risk-based measures to control access, requirements that
are unnecessarily discriminatory or overly restrictive can minimize the
FMU's overall effectiveness.
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\13\ For example, a designated FMU may set access criteria based
on risk measures such as capital ratios, risk ratings, or other
indicators.
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Criteria that allow for fair and open access also may help achieve
the Title VIII objectives of reducing systemic risk and supporting the
overall stability of the financial system. A fair and open approach to
participation criteria may help prevent the concentration of financial
activity (and therefore risk) into a few large participants. By
encouraging the reduction of risk concentration, the proposed standard
helps lower the likelihood that a few financial institutions will be
perceived as ``too big to fail.'' Broad participation in a designated
FMU can, for example, increase the effectiveness of multilateral
netting, facilitate crisis management by applying a consistent set of
rules and procedures (e.g., default management, loss mutualization),
and improve overall market transparency by increasing the number of
transactions processed by the FMU. Accordingly, access criteria that do
not permit fair and open access may reduce the overall risk-reduction
benefits that a designated FMU can offer.
For these reasons, the Board is adopting the access criteria
standards in proposed Sec. Sec. 234.3(a)(9) and 234.4(a)(2)
essentially as set out in the NPRM.
Governance. The governance standard in proposed Sec. 234.3(a)(10)
states that a payment system's governance arrangements should be
effective, accountable, and transparent. Some commenters claimed that
although the decisions made by a designated FMU's governing body can
affect the risks it presents, the particular governance structure
itself presents no such risks. Conversely, one commenter supported
inclusion of the governance standard, stating that weak governance
practices and poor risk-management procedures at designated FMUs could
pose hazards both to participating financial institutions and to the
market as a whole. Another commenter stated that risk management
effectively encompasses governance, among other areas.
The Board believes that effective, accountable, and transparent
governance arrangements are critical to the effective risk management
of a designated FMU. A strong governance arrangement provides a sound
basis for compliance with the other risk-management standards in
Regulation HH. A number of tools or techniques discussed in the Core
Principles with respect to the governance standard have proved to be
effective in ensuring effective governance, such as written strategic
objectives and plans for achieving them and separation of risk
management and audit functions from day-to-day operations. The Board
expects supervisors to review a designated FMU's governance
arrangements against the background of these and other relevant
techniques in order to promote robust risk management. In addition,
given the role of the FMU's board of directors in setting the overall
risk-management framework of the designated FMU, the Board believes
that a weak or ineffective governance structure could have systemic
implications for the participants of the service, other FMUs, and other
markets. Accordingly, the Board believes that a supervisor should
consider a designated FMU's governance arrangements when performing its
systemic risk review. For these reasons, the Board is adopting the
governance standard in proposed Sec. Sec. 234.3(a)(10) and 234.4(a)(8)
essentially as set out in the NPRM.
4. Independent Model Validation
Proposed Sec. 234.4(a)(17) requires a designated FMU that operates
as a CCP to use margin requirements to limit its credit exposures to
participants in normal market conditions and use risk-based models and
parameters that are reviewed regularly. In addition, proposed Sec.
234.4(a)(17)(i) would require a CCP to provide for annual model
validation consisting of evaluating the performance of the CCP's margin
models and the related parameters and assumptions associated with such
models by a qualified person who does not perform functions associated
with the CCP's margin models (except as part of the annual model
validation) and also does not report to such a person.\14\ Two
commenters noted that proposed Sec. 234.4(a)(17)(i), although on the
right track, should stress explicitly the complete independence of the
organization conducting the validation. One of the commenters believed
models must be validated annually by a qualified and independent
organization with no financial stake in the outcome because no employee
of a systemically important CCP should be expected to resist the
inevitable direct and indirect pressures of management who may have
incentives to achieve a less-appropriate and less-independent outcome.
The other commenter also stated that model validation must be performed
by a truly independent party with no financial stake in the outcome of
the validation and expressed concern that a validator that is not
sufficiently independent would face the conflict of interest that would
lead designated FMUs to lower their margins in order to attract
business and increase profits.
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\14\ Proposed Sec. 234.4(a)(17)(i) inadvertently referred to
the margin models of the ``clearing agency.'' The Board has revised
these references to ``central counterparty'' in the final rule.
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The Board believes that a validator must be able to offer
independent, unbiased conclusions and recommendations as part of the
margin model validation process. It is unlikely that the person who was
responsible for initially developing the margin model would be able to
provide an independent, unbiased assessment of the product. Similarly,
it appears unlikely that a person under the functional control of the
developer would be able to provide independent, unbiased validation of
the model without the influence of the developer and concern for
employment security. Accordingly, proposed Sec. 234.4(a)(17)(i) would
require that the model validation be conducted by a qualified person
who does not perform functions associated with the CCP's margin model,
such as development and implementation, and does not report to such a
person.\15\
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\15\ This position is generally consistent with current
supervisory guidance on model risk management by banks. See SR
letter 11-7, p.3 (Apr. 4, 2011), which states:
Validation involves a degree of independence from model
development and use. Generally, validation is done by staff who are
not responsible for model development or use and do not have a stake
in whether a model is determined to be valid. As a practical matter,
some validation work may be most effectively done by model
developers and users; it is essential, however, that such validation
work be subject to critical review by an independent party, who
should conduct additional activities to ensure proper validation.
Overall, the quality of the validation process is indicated by
critical review by objective, knowledgeable parties and the actions
taken to address issues identified by those parties.

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[[Page 45912]]

The Board recognizes the concern expressed in the comments that
there may be financial considerations beyond the validator's immediate
employment security, and that there may be situations where a validator
from outside the CCP may be needed to provide an appropriately
independent validation. In such cases, the Board may hold a particular
designated FMU to a stricter definition of independent validation that
is appropriate for the level of risk presented by the designated FMU.
Proposed Sec. 234.4(b) allows for the Board, by order, to apply
heightened risk-management standards to a particular designated FMU in
response to the risks presented by that designated FMU. As a generally
applicable standard, however, the Board believes it is appropriate to
recognize basic requirements for an independent validation. For these
reasons, the Board is adopting proposed Sec. 234.4(a)(17)(i)
essentially as set out in the NPRM.
5. Financial Resource Coverage
Proposed Sec. 234.4(a)(15) would require a designated FMU that is
acting as a CSD to institute risk controls that include collateral
requirements and limits, and ensure timely settlement in the event that
the participant with the largest payment obligation is unable to settle
when the CSD extends intraday credit. Proposed Sec. 234.4(a)(18) would
require a designated FMU that is acting as a CCP to maintain sufficient
financial resources to withstand, at a minimum, a default by the
participant to which it has the largest exposure in extreme but
plausible market conditions. The Board specifically requested comment
on whether such designated FMUs should be required to maintain
sufficient financial resources to withstand the default by the
participant with the largest exposure or obligation in extreme but
plausible market conditions, where the ``participant'' means the family
of affiliated participants when there is more than one affiliated
participant (``cover one''), or whether such designated FMUs should be
required to maintain sufficient financial resources to withstand the
defaults by the two participants, plus any affiliated participants,
with the largest exposures or obligations in extreme but plausible
market conditions (``cover two'').
Two commenters stated that, if the Board continued to base its
financial resources standard on the number of participants that pose
large risk exposures to a CCP, they supported the higher cover two
requirement. One commenter cited the ``interconnectedness of financial
institutions'' as one of the central dangers, which must be addressed
by financial reforms and a reason for adopting a cover two standard.
This commenter also suggested that the Board's rule should conform to a
similar standard proposed by the CFTC for systemically important DCOs,
which included a cover two requirement.\16\ The other commenter
supported a cover two standard because, during a period of extreme
market stress, it cannot be guaranteed that there will be only a single
default. Neither commenter, however, provided any analysis to support
its contention that a cover two standard would be more appropriate as a
generally applicable standard.
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\16\ On November 8, 2011, pursuant to its authority under Title
VII of the Dodd-Frank Act, the CFTC published its final rule on
risk-management standards for DCOs. The CFTC elected to adopt a
cover one requirement for all DCOs, and delay risk-management
related rulemakings for systemically important DCOs until a later
time. See 76 FR 69334 (Nov. 8, 2011).
---------------------------------------------------------------------------

Both commenters, however, expressed a preference for a financial
resource coverage requirement based on an additional measurement as
determined by a percentage of aggregate exposure, and suggested that
the default rate used in stress tests be based on the larger of (a) the
two members representing the largest exposure to the CCP and (b) the
members constituting at least 33 percent of the exposures in aggregate
to the CCP. The two commenters believed that the additional measurement
captures the risk of a diverse, but interconnected, membership.
As noted in the NPRM, the Board's proposed financial resources
standards would apply a heightened cover one requirement because the
term ``participant'' would be interpreted as the largest family of
affiliated participants if there was more than one affiliated
participant. The Board believes that this interpretation will address
the interconnectedness of participants through corporate ownership
structures. With respect to risks presented by other types of
interconnectedness (i.e., through common participation across markets
or FMUs), the standards for a designated FMU's financial resource
coverage, as with all other standards set out in the regulation, are
generally applicable standards. The Board expects that a designated FMU
would employ a risk-management framework that is appropriate for the
risks faced by the FMU and the FMU may, at its own initiative,
institute a cover two financial resource coverage requirement. In
addition, the Board may require, by order, a particular designated FMU
to exceed the generally applicable standards set out in the regulation
to address the risks presented by, including those borne by, the
FMU.\17\ Although the existing cover one standard was adopted by the
Board in its PSR policy and applied in its supervision of payment and
settlement systems since 1994, the Board has applied heightened
financial resource coverage requirements when the appropriate situation
arose. Therefore, although the Board agrees with the commenters that,
in some cases, a higher requirement would be more appropriate to the
level of risk presented by a particular designated FMU, the Board
believes, at this time, that the most appropriate course is to adopt
the cover one standard as generally applicable and impose a higher
standard, including possibly a cover two standard, on a case-by-case
basis when appropriate. The Board will consider the appropriateness of
adopting a cover two standard in the context of possible revisions to
Regulation HH in light of the PFMI. Accordingly, the Board is adopting
the cover one standard in Sec. 234.4(a)(15) and (18) essentially as
set out in the NPRM.
---------------------------------------------------------------------------

\17\ See Sec. 234.4(b).
---------------------------------------------------------------------------

The Board believes the commenters' concern regarding appropriately
addressing the interconnectedness of a designated FMU's participants
and the suggestion of applying the additional measurement using a
percentage of aggregate exposure are important to consider. Before
determining the viability of this approach, however, the Board believes
further analysis is needed regarding how the suggested additional
measure would be applied, and such analysis could include identifying
situations in which the additional aggregate exposure measure would
capture risk that is not addressed by either a cover one or cover two
standard, an explanation of how the additional measure would be
calculated (including the appropriate time horizon to use), and an
explanation of why a 33 percent aggregate exposure standard would be
most appropriate for this approach. The Board will consider this
approach further in the context of revisions to Regulation HH in light
of

[[Page 45913]]

the PFMI. The Board welcomes and will review any supporting research on
this issue that is submitted.
6. Legal Certainty of Netting Arrangements
One commenter raised an issue regarding designated FMUs that allow
netting of payments to and from individual participants. The commenter
stated that, to ensure that the netting will be honored in a bankruptcy
or other insolvency proceeding, Regulation HH must require that the
designated FMU demonstrate that, under the policies, procedures, and
documentation of the designated FMU, the netting permitted by the
designated FMU will be given legal effect in default and insolvency
situations through an analysis provided by outside legal counsel that
is a nationally recognized expert in matters of corporate insolvency.
The Board recognizes the importance of legal certainty of a
designated FMU's transactions, not only during default and insolvency
situations, but also at all other times. To address these concerns, the
Board proposed standards regarding a designated FMU's legal framework
for payment systems, as well as CSDs and CCPs. For example, proposed
Sec. 234.4(a)(1) states that the CSD or CCP should have a well-
founded, transparent, and enforceable legal framework for each aspect
of its activities in all relevant jurisdictions. As explained in the
NPRM, the Board expects that a designated FMU will manage its legal
risks within the context of currently applicable statutes and
regulations, so it can ensure that its rules, procedures, and
contractual provisions will be enforceable with a high degree of
certainty.\18\
---------------------------------------------------------------------------

\18\ 76 FR at 18447.
---------------------------------------------------------------------------

Legal certainty of each aspect of a designated FMU's activities
(including its netting function) is expected to be supported by
existing law in all relevant jurisdictions. Obtaining an opinion of
outside counsel is one method for a designated FMU to judge legal
certainty of its rules and procedures, but it is not the only method.
In many cases, the designated FMU's in-house counsel may be better
positioned to evaluate the intricacies of the designated FMU's netting
arrangements and the law of the jurisdictions that are relevant to the
designated FMU's operations. In addition, obtaining an opinion of
outside counsel could involve significant expense for the designated
FMU, depending on the complexity and number of relevant jurisdictions.
The Board does not believe it is appropriate to impose such costs as a
general expectation when they may not be necessary in all cases.
Whether legal certainty must be supported by an opinion of outside
counsel or may be verified by in-house counsel is a decision that may
be made initially by management of the designated FMU. In the event the
Board determines in a particular situation that an opinion by outside
counsel is warranted, it could require such an opinion in that case.
For these reasons, the Board believes that the legal framework standard
as proposed is sufficient to address the concerns raised by the
commenter.
7. Costs of Risk-Management Standards to Participants
One commenter urged the Board to ensure that the benefits of
enhanced risk-management standards exceed the costs of implementing the
standards on banks and their customers. The commenter stated that banks
will feel the effects of the risk-management standards because any
designated FMUs with whom the banks transact business will likely pass
on the costs and constraints of enhanced supervisory oversight to their
participants.
The Board is keenly aware of the need to weigh the costs and
benefits of particular rulemakings. Section 805(a) of the Act requires
the Board to prescribe risk-management standards governing the
operations related to the PCS activities of designated FMUs. The
Board's discretion lies not in whether risk-management standards must
be promulgated, but rather in how the Board can best avoid unnecessary
burden associated with the standards.
With respect to the benefits of the risk-management standards,
section 805(b) states that the objectives and principles for the
standards are to (1) Promote robust risk management; (2) promote safety
and soundness; (3) reduce systemic risks; and (4) support the stability
of the broader financial system. The benefit of reducing systemic risk
is, of course, difficult to quantify. Generally speaking, however, an
FMU that is better positioned to withstand disruptive systemic events
would result in much smaller costs being borne by the FMU, and its
participants, and, more generally, the financial system and taxpayers.
The costs of the risk-management standards can be viewed as a
designated FMU's incremental expenses in establishing and maintaining
the systems and procedures necessary to meet the standards, and other
Regulation HH requirements, over and above the risk-management measures
the FMU would have otherwise adopted for business reasons. As the
commenter noted, such costs are generally passed on to a designated
FMU's participants. These costs could take the form of higher
transaction costs, margin or collateral costs, and capital
requirements. These costs should be weighed against the societal
benefit of stability in the financial system and the economy more
broadly.
As explained in the NPRM, the Board proposed to adopt the Core
Principles and CPSS-IOSCO Recommendations as the basis for the risk-
management standards required by the Act, in part because that approach
strikes a reasonable balance between furthering the Act's goals of
enhanced risk management and financial stability and controlling the
costs imposed on the FMUs. As explained in the NPRM, the Core
Principles and CPSS-IOSCO Recommendations were formulated by central
banks and securities regulators over several years and with
considerable discussion and input from the financial services industry.
The Federal Reserve collaborated with participating financial system
authorities in developing the three sets of standards. In addition, the
SEC and CFTC participated in the development of the CPSS-IOSCO
Recommendations. The three sets of standards, particularly those
relevant to payment systems, have been incorporated into the Board's
PSR policy for many years. Further, the Board has used these standards,
in conjunction with relevant laws and other Federal Reserve policies,
when exercising its authority with respect to supervising payment and
securities settlement systems.\19\ FMUs that are likely to be
designated by the Council, as well as their participants, are well-
acquainted with these standards and, in many cases, such FMUs have
already incorporated these standards into their governance, risk-
management, and operating frameworks. The Board, therefore, does not
anticipate material additional costs associated with adopting the Core
Principles and CPSS-IOSCO Recommendations into its regulation for
participants in payment systems already managing towards these
standards.
---------------------------------------------------------------------------

\19\ The Core Principles and the Recommendations for Securities
Settlement Systems were incorporated into the PSR policy in 2004
(https://www.federalreserve.gov/boarddocs/press/other/2004/20041126/default.htm). The Recommendations for Central Counterparties was
incorporated into the PSR policy in 2007 (https://www.federalreserve.gov/newsevents/press/other/20070112a.htm).
---------------------------------------------------------------------------

Although these standards would be generally applicable, the Board
is retaining the authority to impose a more stringent standard or waive
a standard

[[Page 45914]]

on a case-by-case basis in situations where it is warranted.\20\ The
Board believes this is a more cost-effective approach to achieving the
risk management objectives of Title VIII of the Act. For example, when
a situation that warrants a higher standard is discovered, the Board
will exercise its authority to tailor a higher standard for the risks
presented. In addition, alternatively, if review of the PFMI
demonstrates that a higher standard is more appropriate for general
application, the Board will consider a revision to the regulation.
---------------------------------------------------------------------------

\20\ One example of this approach is the financial resource
coverage standard in Sec. 234.4(a)(15) and (18) (cover one versus
cover two).
---------------------------------------------------------------------------

B. Advance Notice of Material Changes

1. Materiality Threshold
Section 806(e) of the Act requires a designated FMU to provide 60
days' advance notice to its Supervisory Agency of any proposed change
to its rules, procedures, or operations ``that could, as defined in
rules of each Supervisory Agency, materially affect the nature or level
of risks presented'' by the designated FMU. Proposed Sec. 234.5(c)(1)
states that the term ``materially affect the nature or level of risks
presented'' means matters as to which there is a ``reasonable
possibility that the change could materially affect the performance of
clearing, settlement, or payment functions or the overall nature or
level of risk presented by the designated financial market utility.''
Proposed Sec. 234.5(c)(2) provides a non-exclusive list of changes
that would materially affect the nature or level of risks presented,
including changes that affect participant eligibility or access
criteria; product eligibility; risk management; settlement failure or
default procedures; financial resources; business continuity and
disaster recovery plans; daily or intraday settlement procedures; scope
of services; non-routine changes to the underlying technological
framework for PCS functions; or governance. Proposed Sec. 234.5(c)(3)
provides a non-exclusive list of changes that would not materially
affect the nature or level of risks presented, including a change that
does not modify the contractual rights or obligations of the designated
FMU or its participants; a change that does not adversely affect the
safeguarding of securities, collateral, or funds for which the
designated FMU is responsible; a routine technology upgrade; a routine
administrative change; or a non-substantive change to rules,
procedures, or other documentation.
The Board requested comments on all aspects of its proposed
materiality rule, particularly on the appropriateness of the definition
of ``materially affect the nature or level of risks presented'' and the
utility of the non-exclusive lists for material and non-material
changes. Commenters generally stated that the materiality standard
would benefit from one or more of the following three adjustments: (1)
A narrower scope of the definition itself, (2) a shorter list of
inclusions, or (3) a more expansive list of exclusions.
``Reasonable possibility.'' Several commenters stated that the
definition of ``materially affect the nature or level of risks
presented'' is overly vague and were concerned that the Board would be
flooded with advance notices of non-material changes as a result. Three
commenters generally stated that the definition of materiality is too
vague and suggest a more narrowly drawn definition to provide for
expeditious review. One commenter suggested revising the proposed
materiality standard, which requires notice of proposed changes that
have ``a reasonable possibility'' of material effect, to require notice
only for those changes that are ``reasonably likely'' to have a
material effect. The commenter stated that, with the proposed
definition, designated FMUs were highly likely to err in favor of
significantly ``over-disclosing'' changes to their rules, procedures,
and operations, which would be overly burdensome to both the Board and
the industry.
The Board believes the proposed definition sets an appropriate
minimum threshold for advance notices at this time. Proposed Sec.
234.5(c) asks the designated FMU to consider whether it is reasonably
possible that a change could have a material effect on the performance
of its PCS functions or its overall risk profile. The Board recognizes
that ``possible'' is a lower threshold than ``likely.'' Section
806(e)(1) of the Act uses the phrase ``could * * * materially affect''
the PCS functions or its overall risk profile of the designated FMU.
This word choice indicates possibility, rather than likelihood.\21\ If
Congress had intended that advance notices be submitted only for
changes that were likely to have a material effect, it could easily
have framed it in that way. In addition, when the Board seeks to
fulfill its statutory responsibility, the lower threshold is
appropriate to ensure that it is able to review a broad sampling of the
types of material changes that the designated FMU normally makes in its
operations. As the designated FMU submits advance notices, the Board
will be able to provide feedback and filter out the specific types of
rule changes normally considered by that particular designated FMU that
do not warrant advance notices. Within this framework, the Board
anticipates that it will be able to more precisely balance the
regulatory burden of the advance notice requirement with its need to
receive advance notice of material changes for the supervision of a
particular designated FMU contemplated by Title VIII of the Act.
---------------------------------------------------------------------------

\21\ ``Could'' is commonly defined as the past tense of ``can,''
and is used to indicate ``possibility.'' ``Likely'' is defined as
``possessing or displaying the qualities or characteristics that
make something probable.'' American Heritage Dictionary of the
English Language (Fourth Edition), https://ahdictionary.com/.
---------------------------------------------------------------------------

Further, the suggested revision would require the designated FMU to
determine which changes were likely to materially affect the
performance of its PCS functions or its overall risk profile. Making
this judgment without any input from the Board would increase the risk
that the designated FMU would not submit an advance notice to the Board
that the Board would determine could have a material effect. This not
only could subject the designated FMU to supervisory criticism and
possible modification or rescission of the change, but also could
prevent the Board from obtaining valuable insight into the operations
of the designated FMU as contemplated by the statute.
Although a lower materiality threshold initially may result in a
higher number of advance notice filings, the Board does not believe
that this is a reason to change the definition. The Board will provide
guidance, through ongoing dialogue during the supervisory process, to
assist a designated FMU in determining whether a proposed change
requires advanced notice. For the reasons set out above, the Board is
retaining the ``reasonable possibility'' language in the definition of
``materially affect the nature or level of risks presented'' in Sec.
234.5(c)(1) of the final rule.
``Performance of clearing, settlement, or payment functions.'' One
commenter suggested deleting from the materiality definition the phrase
``performance of clearing, settlement, or payment functions.'' The
commenter stated that the proposed definition of materiality
overreaches the statutory purpose of ensuring sound risk management by
requiring advance notice of changes that affect the performance of PCS
functions in addition to the overall nature or level or risks
presented. The commenter stated that changes implemented by the

[[Page 45915]]

designated FMU that relate to the broad category of ``performance,'' as
opposed to risk, are more appropriately vetted in the competitive
marketplace.
In referring to the performance of PCS functions, the Board
intended to provide additional guidance to the scope of the advance
notice requirement by including an express focus on the PCS functions
of a designated FMU. The Board believes that the language in proposed
Sec. 234.5(c)(1) appropriately implements the statutory authority
provided by the Act. To address the commenters' concerns and provide
clarity regarding the scope of the advance notice requirement in Sec.
234.5(c)(1), the Board is adopting a revision to the proposed
regulatory text to state that the term ``materially affect the nature
or level of risks presented'' means matters as to which there is a
reasonable possibility that the change could ``materially affect the
overall nature or level of risk presented by the designated financial
market utility, including risk arising in the performance of payment,
clearing, or settlement functions.'' \22\ This revision ensures that
the definition follows the statutory authority, while also providing an
indication that the Board expects designated FMUs to pay particular
attention to providing advance notice of proposed changes to its rules,
procedures, or operations regarding the performance of its PCS
functions that could materially affect the nature or level of risks
presented by the designated FMU. The additional guidance, however, does
not limit the scope of ``materially affect the nature or level of risks
presented'' to only those risks arising in the performance of PCS
functions. A proposed change to any of the designated FMU's rules,
procedures, or operations that could materially affect the nature or
level of risks presented by the designated FMU should be the subject of
an advance notice, regardless of whether it is regarding the
performance of PCS functions.
---------------------------------------------------------------------------

\22\ The risks presented by the designated FMU's performance of
its PCS functions can go beyond the effect on the designated FMU
itself and reach its participants or the market more broadly.
---------------------------------------------------------------------------

Non-exclusive lists. Four commenters stated that the non-exclusive
list of material changes in proposed Sec. 234.5(c)(2) was too broad or
the non-exclusive list of non-material changes in proposed Sec.
234.5(c)(3) was too narrow. The commenters acknowledged the value of
providing guidance regarding changes that were material or not
material, but generally stated that the proposed lists did not
appropriately draw this dividing line.
One commenter stated that most items included on the material list
in proposed Sec. 234.5(c)(2) are described in a manner that would
require a designated FMU to provide the Board notice of changes that
would not necessarily affect the nature or level of risk in any manner.
In particular, the commenter noted that ``financial resources'' is
included in the list in proposed Sec. 234.5(c)(2)(v), but is not
modified by any quantitative or qualitative measure, so a designated
FMU would be required to submit advance notice of any change in its
financial resources, even changes that are not material, such as any
changes that in any way affect capital, access to credit, or liquidity.
Two commenters cited the ``scope of services'' item in proposed Sec.
234.5(c)(2)(viii) as another example of an overly broad requirement
that is unrelated to risk. For similar reasons, two commenters
suggested deleting the ``governance'' item in proposed Sec.
234.5(c)(2)(x). One commenter also suggested deleting the ``participant
eligibility or access'' item in proposed Sec. 234.5(c)(2)(i).
The Board believes that material changes in the areas listed in
proposed Sec. 234.5(c)(2) could affect a designated FMU's core
functions and, as a result, might affect its ability to manage its
risks appropriately and to continue to conduct systemically important
PCS services. This may, in turn, affect the designated FMU's ability to
comply with the risk-management standards set out in Sec. Sec. 234.3
and 234.4 to which they will be held. The list of material changes
provided in proposed Sec. 234.5(c)(2) was intended to track those
risk-management standards, and the reasons for including these items in
the list of material changes requiring an advance notice are similar in
most cases. For example, the importance of understanding material
changes in the financial resources of a designated FMU acting as a
payment system would be critical to assessing the ability of the
designated FMU to continue to provide systemically important PCS
services in the event of a default, as well as its compliance with
several of the proposed risk-management standards, such as the
capability to ensure timely completion of daily settlements as set out
in proposed Sec. 234.3(a)(5).
To address the commenters' concerns that de minimis changes to the
areas listed in Sec. 234.5(c)(2) would require an advance notice, the
Board is adopting revised language in the final rule to clarify that
the changes that ``materially affect'' the areas listed would be
considered changes that materially affect the nature or level of risks
presented by the designated FMU.
Also, as explained above regarding the risk-management standard for
governance in proposed Sec. 234.3(a)(10), the Board believes that
effective, accountable, and transparent governance arrangements are
critical to effective risk management of a designated FMU. As a result,
changes that materially affect a designated FMU's governance
arrangements should be submitted pursuant to the advance notice
process.
Similarly, the Board believes that access criteria can help ensure
that a designated FMU admits financial institutions that will be able
to meet their obligations and not expose the FMU or its other
participants to risk, including through risk measures such as capital
ratios, risk ratings, or other indicators. For this reason, the Board
will have an interest in receiving advance notice of any material
changes to a designated FMU's participant eligibility or access
criteria. Finally, understanding the scope of services offered by an
FMU that is designated on the basis of its role as operator of a
payment system is fundamental to being able to have a clear
understanding of the payment system's risk profile. A designated FMU's
services could affect the financial risks participants face through
their participation in the system, as well as the level of risk that
the designated FMU is incurring by providing the services.
Commenters also suggested revising the list of non-material changes
in proposed Sec. 234.5(c)(3).\23\ One commenter stated that certain
examples on the non-material list are so narrowly drawn as to be
unhelpful in marking a reasonable line between circumstances that may
compel advance notice and those that may not. As an example, the
commenter cited the example of ``a change that does not modify the
contractual rights or obligations of the designated financial market
utility or persons using its payment, clearing, or settlement
services'' set out in proposed Sec. 234.5(c)(3)(i) and noted these
types of changes, in essence, would be the types of clerical, non-
substantive changes separately identified in proposed Sec.
234.5(c)(3)(v). Another commenter

[[Page 45916]]

supported a broad application of the example set forth in Sec.
234.5(c)(3)(ii) (``a change to an existing procedure, control, or
service that does not adversely affect the safeguarding of securities,
collateral, or funds in the custody or control of the designated
financial market utility or for which it is responsible'').
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\23\ One commenter suggested that the final rule include in the
non-material list of proposed Sec. 234.5(c)(3) a greater range of
operating rule changes for designated FMUs participating in the
retail payment systems. As explained above, however, the Council has
indicated that it expects to focus at this time on FMUs that operate
large-value systems and not on FMUs that operate low-value systems,
such as check or ACH. 76 FR 44763, 44769 (July 2011).
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After taking into consideration the comments noted above and
reexamining the list of non-material changes, the Board is eliminating
the examples in proposed Sec. Sec. 234.5(c)(3)(i) and (ii). With
respect to proposed Sec. 234.5(c)(3)(i), the Board recognizes the
commenter's concern; however, the Board believes it is more prudent to
capture a wider range of proposed changes at this time and therefore is
reluctant to expand the example's breadth. In addition, the Board is
concerned that a broad application of the non-material change set forth
in proposed Sec. 234.5(c)(3)(ii) might inadvertently create an overlap
with the advance notice requirement for material change set forth in
Sec. 234.5(c)(2)(iii) because both changes fall broadly within the
area of risk management. In order to avoid this overlap, and any
resulting confusion, the Board is removing the example in proposed
Sec. 234.5(c)(3)(ii).
The list provided by the Board in Sec. 234.5(c)(3) is not meant to
be exhaustive. The Board believes that it is difficult to draw a bright
line that could be uniformly applicable to all designated FMUs between
changes that would require advance notice and those that would not
because of the range of different designs and functions. The Board
believes, at this time, that routine changes like those listed in the
remaining examples of Sec. 234.5(c)(3) would be considered clearly
non-material for the purposes of triggering the 60-day advance notice
requirement. In addition, the Board believes that changes to fees,
prices, or other charges for services provided by the designated FMU
constitute business decisions that would not require advance notice. To
that end, the Board is adopting an explicit exclusion for fees, prices,
or other charges in Sec. 234.5(c)(3)(ii). As mentioned above, as the
supervisory process develops with a particular designated FMU, the
Board anticipates that it will reach an understanding with the FMU
about what constitutes a non-material rule change for that FMU that
would not require advance notice.
2. Expedited Review
Proposed Sec. 234.5(a) includes procedural requirements regarding
advance notices of material changes, such as the required content of
the notices and the procedures and timing for the methods for approving
such changes. These provisions essentially reiterate similar provisions
in section 806(e) of the Dodd-Frank Act. Some commenters were concerned
that the open-ended time frame for the Board to request additional
information on a material change would unnecessarily delay action on
certain changes to rules, procedures, or operations that are time
sensitive, but do not materially affect the level of risks posed by the
designated FMU. As a means of expediting the processing of advance
notice submissions, commenters made several suggestions to limit the
time of the Board's review, such as (a) establishing a 10-day
preliminary determination window in which the Board determines whether
a proposed change requires advance notice or a full 60-day review and
(b) limiting the Board's authority to request additional information to
assess the effects of the proposed change to within the first 30 days
of the review period. The commenters were generally concerned that the
Board would engage in an indefinite and extended review of advance
notices that would hinder a designated FMU's ability to manage its
business.
As a general matter, the Board recognizes the importance of
reducing regulatory burden and being diligent in reviewing proposed
material changes in a timely manner. Section 806(e)(1)(I) of the Act
permits a designated FMU to implement a change in less than 60 days
from the filing of the advance notice if its Supervisory Agency
notifies the designated FMU that it does not object to the proposed
change and authorizes the designated FMU to implement the change at an
earlier date. The Board incorporated this statutory provision in
proposed Sec. 234.5(a)(8) and is retaining this provision in the final
rule. This provision provides a mechanism for the Board to complete its
review and inform the designated FMU that it may proceed before the
expiration of the 60-day advance notice period. The Board expects to
use this procedure as appropriate. The Board, however, recognizes that
it must balance the need for expediency with the need to conduct a
thorough review of any necessary supporting documentation or
information related to a proposed change, in order to make an informed
decision consistent with its statutory responsibilities. Therefore, the
timeliness of the Board's review may depend, in part, on the
completeness of the information provided by and level of engagement
with the designated FMU prior to and following the submission of the
advance notice.
3. Advance Notice by Rule-Setting Bodies
Two commenters responsible for developing and setting rules for
retail payment systems suggested that the Board's advance notice
procedure permit the submission of a proposed rule change by the rule-
writing body and that such submission satisfy the advance notice
requirement for any designated payment system operating subject to the
rules. As an initial matter, the Board will be mindful of the need for
efficiency and minimizing regulatory burden, while also ensuring that
the Board receives the necessary information on a timely basis in order
to fulfill its responsibilities under the Act. The Board notes,
however, that although such rule-writing arrangements exist for several
retail payment networks, as noted above, such systems are not expected
to be designated by the Council as systemically important at this time.
If the Council designates any payment systems subject to such rule-
writing arrangements and the Board is the Supervisory Agency for that
system, the Board would review, at that time, the appropriate means for
such systems to submit advance notices.
4. Emergency Changes
One commenter requested that the Board take care in allowing
designated FMUs to make immediate emergency changes to their governing
rules under proposed Sec. 234.5(b), particularly with respect to
customer collateral and margin requirements. The commenter stated that
situations that justify alteration of loss mutualization standards from
international standards are rare and should be carefully scrutinized.
The commenter also requested that the Board incorporate CPSS-IOSCO
principles with regard to customer collateral and margin requirements
so as to ensure that designated FMUs will apply loss mutualization
standards that comport with international standards.
Section 806(e)(2) of the Act contemplates the possibility that
designated FMUs may need to implement material changes to their rules,
procedures, or operations in emergency situations and includes a
mechanism allowing for the ex-post notification of the Supervisory
Agency regarding such emergency material changes. This mechanism was
incorporated into proposed Sec. 234.5(b). In order to take advantage
of the emergency change process, a designated

[[Page 45917]]

FMU is required to explain to the Board within 24 hours of the
implementation of the change, among other things, the nature of the
emergency and the reason the changes was necessary for the designated
FMU to continue to provide its services in a safe and sound manner.
Pursuant to Title VIII and the proposed rule, the Board may require
modification or rescission of the change if it finds that the change is
not consistent with the purposes of the Act or rules or standards
prescribed thereunder. The Board expects that emergency changes,
including any changes to customer collateral and margin requirements,
will occur rarely and will be carefully scrutinized.
5. Advance Notice and Competitive Issues
Two commenters raised concerns regarding the advance notice
procedure for designated FMUs that offer services that compete with
services offered by the Federal Reserve Banks (``Reserve Banks''). One
commenter involved in check imaging stated that if Reserve Banks
engaged in check image services were not subject to the advance notice
procedure under proposed Sec. 234.5(a) and private-sector check-image-
exchange rules were subject to the advance notice procedure, the
Reserve Banks would enjoy a significant competitive advantage over the
private-sector competitors. This commenter believed that the Reserve
Banks would be able to change their check-image rules without being
subject to the same delay and uncertainty as the competing designated
FMU under the advance notice procedure. The commenter suggested that
the Board include within the final rule provisions that seek to
mitigate the potential for a negative impact on competition that may
arise from the advance notice procedure for designated FMUs. Another
commenter stated that it was beyond the scope of systemic risk
regulation for the Board to ``force a delay in implementing business-
related changes; particularly in a competitive market in which the
Reserve Banks offer the competing alternative.''
The Board is cognizant of the competition between the Reserve Banks
and private-sector service providers in certain financial services,
including check and funds transfer services, and has long-standing
policies to address such competitive issues. Under the Federal Reserve
Act, the Board has general supervisory authority over the Reserve
Banks, including the Reserve Banks' provision of payment and settlement
services (``Reserve Bank financial services''), that is much more
extensive in scope than the authority provided under Title VIII over
designated FMUs.\24\ In practice, Board oversight of the Reserve Banks
in many ways goes beyond the typical supervisory framework for private-
sector entities, including the framework provided by Title VIII. For
example, the Board applies robust risk-management standards to the
relevant Reserve Bank financial services; conducts regular
examinations; and reviews key strategic initiatives, prices and service
terms, proposed material changes, and ongoing operations.
---------------------------------------------------------------------------

\24\ 12 U.S.C. 221 et seq.
---------------------------------------------------------------------------

The Board conducts regular examinations of the Reserve Bank
financial services covering, among other things, operational safety and
soundness and management effectiveness. It also regularly monitors the
services' operations and initiatives through reports, discussions with
Reserve Bank management, and its oversight liaison roles on various
Reserve Bank management groups. The Board is also involved in reviewing
or approving proposed changes to the Reserve Banks' rules, procedures,
and operations, including those involving Reserve Bank financial
services, from their inception. The Board's oversight of these proposed
changes is significantly broader and more detailed than the Title VIII
advance notice procedures. For example, the Board reviews all changes
to the Reserve Banks' operating circulars, approves the Reserve Banks'
budgets, including budgets related to the Reserve Bank financial
services, and approves major strategic initiatives, and the associated
expenditures.
Moreover, the Board recognizes the critical role Reserve Bank
financial services, particularly the Fedwire Funds and Fedwire
Securities services, play in the financial system and is committed to
strong and effective supervision of these services that is comparable
to, or exceeds, the requirements placed on similar private-sector
entities. For example, the Board expects the Fedwire services to meet
or exceed the Board's PSR policy standards, which are consistent with
the Regulation HH standards applied to designated FMUs. In addition,
the Board will hold the Reserve Banks to advance notice requirements
with respect to proposed material changes to Fedwire rules, procedures,
and operations that are the same as, or higher than, the requirements
for designated FMUs that are supervised by the Board.\25\ Moreover, if
the Council designates an FMU on the basis of its role as operator of a
payment system that competes with another Reserve Bank service, the
Board will ensure that the competing Reserve Bank service is held to
the same or higher requirements as those set forth in Regulation HH.
---------------------------------------------------------------------------

\25\ See the Board's policy on ``Oversight of Key Financial
Infrastructures'' related to Reserve Bank Systems at https://www.federalreserve.gov/paymentsystems/over_rbsystems.htm.
---------------------------------------------------------------------------

In addition, in order to address any competitive inequalities
between Reserve Bank priced services and similar services provided by
private sector entities, the Monetary Control Act of 1980 (the ``MCA'')
requires Reserve Bank priced services to be priced explicitly and that
fees be established on basis of all direct and indirect costs actually
incurred, including taxes that would have been paid and a return on
capital that would have been provided had the services been furnished
by a private business firm.\26\ As required by the MCA, the Board also
has established a set of pricing principles that governs the schedule
of fees for the Reserve Bank priced services, which must give due
regard to competitive factors.\27\ Board policy also requires that
Federal Reserve actions are implemented in a manner that ensures
fairness to other providers of payment services.\28\ In light of these
policies, the Board believes that changes to Reserve Bank priced
services rules or operating circulars are subject to no less scrutiny,
and in many cases more scrutiny, than the review contemplated by Title
VIII's advance notice procedure.
---------------------------------------------------------------------------

\26\ 12 U.S.C. 248a. These costs are included in the private-
sector adjustment factor for pricing Reserve Bank priced services.
\27\ 12 U.S.C. 248a(c)(3).
\28\ The Board policy can be found at: https://www.federalreserve.gov/paymentsystems/pfs_standards.htm.
---------------------------------------------------------------------------

III. Administrative Law Matters

A. Regulatory Flexibility Act Analysis

The Regulatory Flexibility Act (5 U.S.C. 601 et seq.) (``RFA'')
generally requires an agency to perform an initial and a final
regulatory flexibility analysis on the impact a rule is expected to
have on small entities. However, under section 605(b) of the RFA, the
regulatory flexibility analysis otherwise required under section 604 of
the RFA is not required if an agency certifies, along with a statement
providing the factual basis for such certification, that the rule will
not have a significant economic impact on a substantial number of small
entities. Based on current information, the Board believes that the
payment systems that would likely be designated by the Council would
not be ``small entities'' for purposes of the RFA, and

[[Page 45918]]

so, the final rule likely would not have a significant economic impact
on a substantial number of small entities. The authority to designate
FMUs, however, resides with the Council, rather than the Board, and the
Board therefore cannot be assured of the identity of the FMUs that the
Council may designate in the future. Accordingly, the Board has
prepared the following final regulatory flexibility analysis pursuant
to section 604 of the RFA.
1. Statement of the need for, and objectives of, the final rule. In
accordance with Sections 805(a) and 806(e) of the Dodd-Frank Act, the
Board is adopting the final rule as Regulation HH, new Part 234 of
Title 12 of the Code of Federal Regulations. The final rule establishes
risk-management standards for systemically important FMUs and standards
for determining when advance notice is required to be provided by a
designated FMU that proposes to change to its rules, procedures, or
operations that could materially affect the nature or level of risks
presented by the designated financial market utility. The reasons and
justification for the final rule are described above in the
Supplementary Information.
2. Summary of the significant issues raised by public comment on
Board's initial analysis, the Board's assessment of such issues, and a
statement of any changes made as a result of such comments. The Board
did not receive any public comments regarding its initial regulatory
flexibility analysis.
3. Small entities affected by the final rule. The final rule would
affect FMUs that the Council designates as systemically important to
the U.S. financial system for which the Board is the Supervisory
Agency. The Board estimates that fewer than five large-value payment
systems would meet these conditions and be affected by this rule.
Pursuant to regulations issued by the Small Business Administration
(the ``SBA'') (13 CFR 121.201), a ``small entity'' includes an
establishment engaged in providing financial transaction processing,
reserve and liquidity services, or clearinghouse services with an
average revenue of $7 million or less (NAICS code 522320). As noted in
the NPRM, the Board does not currently believe that any of the payment
systems that would likely be designated by the Council would be ``small
entities'' pursuant to the SBA regulation. In addition, the Board does
not believe at this time that, pursuant to section 803(8) of the Dodd-
Frank Act, it would be the Supervisory Agency for any FMU that operates
as a central securities depository or central counterparty and that
would likely be designated by the Council.
4. Recordkeeping, reporting, and compliance requirements. The final
rule imposes certain reporting and recordkeeping requirements for a
designated FMU. (See, for example, Sec. 234.3(a)(3) (requiring clearly
defined procedures for the management of credit risks and liquidity
risks); Sec. 234.5(a)(1) and (2) (requiring advance notice of changes
that could materially affect the nature or level of risks presented by
the designated FMU), and Sec. 234.5(b)(2) and (3) (requiring notice of
an emergency change implemented by a designated FMU).) The final rule
also contains a number of compliance requirements, including the
standards that the designated FMU must meet, such as having a well-
founded legal basis under all relevant jurisdictions and having rules
and procedures that enable participants to understand clearly the FMU's
impact on each of the financial risks they incur by participation in
it. Payment systems under the Board's jurisdiction (including certain
payment systems the Board believes could be designated as systemically
important) are generally already expected to meet these standards, or
are at least familiar with these standards, so the rule would not
likely impose material additional costs on those payment systems.
5. Significant alternatives to the revisions. Section 805(a) of the
Act requires the Board to prescribe risk-management standards governing
the operations related to PCS activities of designated FMUs, so other
administrative methods for accomplishing the goals of the Act were not
considered. One alternative to adopting risk-management standards based
on the relevant international standards was to develop a different set
of risk-management standards specifically for purposes of section
805(a) of the Act. As explained in the NPRM and above, the Board
proposed to adopt the Core Principles and CPSS-IOSCO Recommendations as
the basis for establishing initial risk-management standards required
by section 805(a) of the Act, in part, because this approach presented
advantageous cost efficiencies for the regulators and the FMUs.
Furthermore, the new standards set forth in the PFMI were still under
development at the time of the NPRM and not available for consideration
as an alternative. As explained above, the Core Principles and CPSS-
IOSCO Recommendations were formulated by central banks and securities
regulators with considerable discussion and industry consultation. In
particular, the Federal Reserve collaborated with participating
financial system authorities and consulted with FMUs and their
participants in developing the standards. In addition, the SEC and CFTC
participated in the development of the CPSS-IOSCO Recommendations. The
Board incorporated these standards in its PSR policy in 2004 and 2007
and has been guided by the policy, in conjunction with relevant laws
and other Federal Reserve policies, when exercising its authority with
respect to supervising large-value payment and securities settlement
systems.\29\ Payment systems that would likely be designated by the
Council, therefore, would likely be familiar with the Core Principles
and could implement them promptly with relatively less burden than if
the Board developed a different set of standards to implement section
805(a) of the Act.
---------------------------------------------------------------------------

\29\ See footnote 19.
---------------------------------------------------------------------------

B. Competitive Impact Analysis

As a matter of policy, the Board subjects all operational and legal
changes that could have a substantial effect on payment system
participants to a competitive impact analysis, even if competitive
effects are not apparent on the face of the proposal.\30\ Pursuant to
this policy, the Board assesses whether proposed changes ``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'' and whether any such adverse effect ``was due to
legal differences or due to a dominant market position deriving from
such legal differences.'' If, as a result of this analysis, the Board
identifies an adverse effect on the ability to compete, the Board then
assesses whether the associated benefits--such as improvements to
payment system efficiency or integrity--can be achieved while
minimizing the adverse effect on competition.
---------------------------------------------------------------------------

\30\ See ``The Federal Reserve in the Payments System,'' Fed.
Res. Reg. Svc. Sec. 9-1550, 9-1558 (Apr. 2009).
---------------------------------------------------------------------------

This final rule promulgates risk-management standards and advance
notice requirements for designated FMUs, as required by Title VIII of
the Act. Some FMUs may be designated on the basis of their role as
operators of payment systems that compete with similar services
provided by the Reserve Banks, and designation subjects the FMU to an
enhanced supervisory framework. Commenters have raised concerns
regarding the Reserve Banks obtaining a competitive advantage over
private-sector competitors through the

[[Page 45919]]

Board imposing a less-stringent supervisory framework on the Reserve
Banks priced services than would be imposed on a competing designated
FMU. As noted above, Board oversight of the Reserve Banks goes well
beyond the typical supervisory framework for private-sector entities,
including the framework provided by Title VIII. The Board applies risk-
management standards to the Reserve Banks' Fedwire and other financial
services that are at least as stringent as those applied to designated
FMUs pursuant to Title VIII. Further, the Board will hold Reserve Banks
to procedural requirements that are the same as, or higher than, the
requirements for designated FMUs supervised by the Board, with respect
to advance notice of material changes to the rules, procedures, or
operations of Reserve Bank priced services that compete with designated
FMUs. Therefore, the Board does not believe the final rule promulgating
risk-management standards or advance notice requirements for designated
FMUs under Title VIII will have any direct and material adverse effect
on the ability of other service providers to compete with the Reserve
Banks.

C. Paperwork Reduction Act Analysis

In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3506; 5 CFR part 1320, Appendix A.1), the Board reviewed the final rule
under the authority delegated to the Board by the Office of Management
and Budget. As noted in the proposal, for purposes of calculating
burden under the Paperwork Reduction Act, a ``collection of
information'' involves 10 or more respondents. Any collection of
information addressed to all or a substantial majority of an industry
is presumed to involve 10 or more respondents (5 CFR 1320.3(c),
1320.3(c)(4)(ii)). The Board estimates there are fewer than 10
respondents, and these respondents do not represent all or a
substantial majority of the participants in payment, clearing, and
settlement systems. Therefore, no collections of information pursuant
to the Paperwork Reduction Act are contained in the final rule. The
Board did not receive any comments on this analysis.
The Board has a continuing interest in the public's opinion of the
collection of information. Comments on the collection of information
should be sent to Cynthia Ayouch, Acting Federal Reserve Board
Clearance Officer, Division of Research and Statistics, Mail Stop 95-A,
Board of Governors of the Federal Reserve System, Washington, DC 20551,
with copies of such comments sent to the Office of Management and
Budget, Paperwork Reduction Project (7100-0199), Washington, DC 20503.

List of Subjects in 12 CFR Part 234

Banks, Banking, Credit, Electronic funds transfers, Financial
market utilities, Securities.

Authority and Issuance

For the reasons set forth in the preamble, the Board amends 12 CFR,
Chapter II by adding part 234, as set forth below.

PART 234--DESIGNATED FINANCIAL MARKET UTILITIES (REGULATION HH)

Sec.
234.1 Authority, purpose, and scope.
234.2 Definitions.
234.3 Standards for payment systems.
234.4 Standards for central securities depositories and central
counterparties.
234.5 Changes to rules, procedures, or operations.

Authority: 12 U.S.C. 5461 et seq.

Sec. 234.1 Authority, purpose, and scope.

(a) Authority. This part is issued under the authority of sections
805, 806, and 810 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act) (Pub. L. 111-203, 124 Stat. 1376; 12
U.S.C. 5464, 5465, and 5469).
(b) Purpose and scope. This part establishes risk-management
standards governing the operations related to the payment, clearing,
and settlement activities of designated financial market utilities. The
risk-management standards do not apply, however, to a designated
financial market utility that is a derivatives clearing organization
registered under section 5b of the Commodity Exchange Act (7 U.S.C. 7a-
1) or a clearing agency registered with the Securities and Exchange
Commission under section 17A of the Securities Exchange Act of 1934 (15
U.S.C. 78q-1), which are governed by the risk-management standards
promulgated by the Commodity Futures Trading Commission or the
Securities and Exchange Commission, respectively, for which each is the
Supervisory Agency (as defined below). In addition, this part sets out
requirements and procedures for a designated financial market utility
that proposes to make a change to its rules, procedures, or operations
that could materially affect the nature or level of risks presented by
the designated financial market utility and for which the Board is the
Supervisory Agency.

Sec. 234.2 Definitions.

As used in this part:
(a) Central counterparty means an entity that interposes itself
between the counterparties to trades, acting as the buyer to every
seller and the seller to every buyer.
(b) Central securities depository means an entity that holds
securities in custody to enable securities transactions to be processed
by means of book entries or an entity that enables securities to be
transferred and settled by book entry either free of or against
payment.
(c) Designated financial market utility means a financial market
utility (as defined in paragraph (d) of this section) that the
Financial Stability Oversight Council has designated under section 804
of the Dodd-Frank Act (12 U.S.C. 5463).
(d) Financial market utility has the same meaning as the term
defined in section 803(6) of the Dodd-Frank Act (12 U.S.C. 5462(6)).
(e) Payment system means a set of payment instructions, procedures,
and rules for the transfer of funds among system participants.
(f) Supervisory Agency has the same meaning as the term is defined
in section 803(8) of the Dodd-Frank Act (12 U.S.C. 5462(8)).

Sec. 234.3 Standards for payment systems.

(a) A designated financial market utility that is designated on the
basis of its role as the operator of a payment system must implement
rules, procedures, or operations designed to ensure that it meets or
exceeds the following risk-management standards with respect to the
payment, clearing, and settlement activities of that payment system:
(1) The payment system has a well-founded legal basis under all
relevant jurisdictions.
(2) The payment system's rules and procedures enable participants
to have a clear understanding of the payment system's impact on each of
the financial risks they incur through participation in it.
(3) The payment system has clearly defined procedures for the
management of credit risks and liquidity risks, which specify the
respective responsibilities of the payment system operator and the
participants and which provide appropriate incentives to manage and
contain those risks.
(4) The payment system provides prompt final settlement on the day
of value, during the day and at a minimum at the end of the day.
(5) A payment system in which multilateral netting takes place is,
at a

[[Page 45920]]

minimum, capable of ensuring the timely completion of daily settlements
in the event of an inability to settle by the participant with the
largest single settlement obligation.
(6) Assets used for settlement are a claim on the central bank or
other assets that carry little or no credit risk and little or no
liquidity risk.
(7) The payment system ensures a high degree of security and
operational reliability and has contingency arrangements for timely
completion of daily processing.
(8) The payment system provides a means of making payments that is
practical for its users and efficient for the economy.
(9) The payment system has objective and publicly disclosed
criteria for participation, which permit fair and open access.
(10) The payment system's governance arrangements are effective,
accountable, and transparent.
(b) The Board, by order, may apply heightened risk-management
standards to a particular designated financial market utility in
accordance with the risks presented by that designated financial market
utility. The Board, by order, may waive the application of a standard
or standards to a particular designated financial market utility where
the risks presented by or the design of that designated financial
market utility would make the application of the standard or standards
inappropriate.

Sec. 234.4 Standards for central securities depositories and central
counterparties.

(a) A designated financial market utility that is designated on the
basis of its role as a central securities depository or a central
counterparty must implement rules, procedures, or operations designed
to ensure that it meets or exceeds the following risk-management
standards with respect to the payment, clearing, and settlement
activities of that central securities depository or central
counterparty:
(1) The central securities depository or central counterparty has a
well-founded, transparent, and enforceable legal framework for each
aspect of its activities in all relevant jurisdictions.
(2) The central securities depository or central counterparty
requires participants to have sufficient financial resources and robust
operational capacity to meet obligations arising from participation in
the central securities depository or central counterparty. The central
securities depository or central counterparty has procedures in place
to monitor that participation requirements are met on an ongoing basis.
The central securities depository's or central counterparty's
participation requirements are objective and publicly disclosed, and
permit fair and open access.
(3) The central securities depository or central counterparty holds
assets in a manner whereby risk of loss or of delay in its access to
them is minimized. Assets invested by a central securities depository
or central counterparty are held in instruments with minimal credit,
market, and liquidity risks.
(4) The central securities depository or central counterparty
identifies sources of operational risk and minimizes them through the
development of appropriate systems, controls, and procedures; has
systems that are reliable and secure, and has adequate, scalable
capacity; and has business continuity plans that allow for timely
recovery of operations and fulfillment of the central securities
depository's or central counterparty's obligations.
(5) The central securities depository or central counterparty
employs money settlement arrangements that eliminate or strictly limit
its settlement bank risks, that is, its credit and liquidity risks from
the use of banks to effect money settlements with its participants and
requires funds transfers to the central securities depository or
central counterparty be final when effected.
(6) The central securities depository or central counterparty is
cost-effective in meeting the requirements of participants while
maintaining safe and secure operations.
(7) The central securities depository or central counterparty
evaluates the potential sources of risks that can arise when the
central securities depository or central counterparty establishes links
either cross-border or domestically to settle transactions or clear
trades, and ensures that the risks are managed prudently on an ongoing
basis.
(8) The central securities depository or central counterparty has
governance arrangements that are clear and transparent to fulfill
public interest requirements and to support the objectives of owners
and participants and promotes the effectiveness of a central securities
depository's or central counterparty's risk-management procedures.
(9) The central securities depository or central counterparty
provides market participants with sufficient information for them to
identify and evaluate accurately the risks and costs associated with
using its services.
(10) The central securities depository or central counterparty
establishes default procedures that ensures that the central securities
depository or central counterparty can take timely action to contain
losses and liquidity pressures and to continue meeting its obligations
and provides for key aspects of the default procedures to be publicly
available.
(11) The central securities depository or central counterparty
ensures that final settlement occurs no later than the end of the
settlement day and requires that intraday or real-time finality be
provided where necessary to reduce risks.
(12) The central securities depository or central counterparty
eliminates principal risk by linking securities transfers to funds
transfers in a way that achieves delivery versus payment.
(13) The central securities depository or central counterparty
states its obligations with respect to physical deliveries, and the
risks from these obligations are identified and managed.
(14) The central securities depository immobilizes or
dematerializes securities certificates and transfers them by book entry
to the greatest extent possible.
(15) The central securities depository institutes risk controls
that include collateral requirements and limits, and ensure timely
settlement in the event that the participant with the largest payment
obligation is unable to settle when the central securities depository
extends intraday credit.
(16) The central counterparty measures its credit exposures to its
participants at least once a day and limits its exposures to potential
losses from defaults by its participants in normal market conditions so
that the operations of the central counterparty would not be disrupted
and non-defaulting participants would not be exposed to losses that
they cannot anticipate or control.
(17) The central counterparty uses margin requirements to limit its
credit exposures to participants in normal market conditions and uses
risk-based models and parameters to set margin requirements and reviews
them regularly. Specifically, the central counterparty--
(i) Provides for annual model validation consisting of evaluating
the performance of the central counterparty's margin models and the
related parameters and assumptions associated with such models by a
qualified person who does not perform functions associated with the
central counterparty's margin models (except as part of the annual
model validation) and does not report to such a person.
(ii) Reviews and backtests margin models and parameters at least
quarterly.

[[Page 45921]]

(18) The central counterparty maintains sufficient financial
resources to withstand, at a minimum, a default by the participant to
which it has the largest exposure in extreme but plausible market
conditions.
(b) The Board, by order, may apply heightened risk-management
standards to a particular designated financial market utility in
accordance with the risks presented by that designated financial market
utility. The Board, by order, may waive the application of a standard
or standards to a particular designated financial market utility where
the risks presented by or the design of that designated financial
market utility would make the application of the standard or standards
inappropriate.

Sec. 234.5 Changes to rules, procedures, or operations.

(a) Advance notice.
(1) A designated financial market utility shall provide at least
60-days advance notice to the Board of any proposed change to its
rules, procedures, or operations that could materially affect the
nature or level of risks presented by the designated financial market
utility.
(2) The notice of the proposed change shall describe--
(i) The nature of the change and expected effects on risks to the
designated financial market utility, its participants, or the market;
and
(ii) How the designated financial market utility plans to manage
any identified risks.
(3) The Board may require the designated financial market utility
to provide additional information necessary to assess the effect the
proposed change would have on the nature or level of risks associated
with the utility's payment, clearing, or settlement activities and the
sufficiency of any proposed risk-management techniques.
(4) A designated financial market utility shall not implement a
change to which the Board has an objection.
(5) The Board will notify the designated financial market utility
of any objection before the end of 60 days after the later of--
(i) The date the Board receives the notice of proposed change; or
(ii) The date the Board receives any further information it
requests for consideration of the notice.
(6) A designated financial market utility may implement a change if
it has not received an objection to the proposed change before the end
of 60 days after the later of--
(i) The date the Board receives the notice of proposed change; or
(ii) The date the Board receives any further information it
requests for consideration of the notice.
(7) With respect to proposed changes that raise novel or complex
issues, the Board may, by written notice during the 60-day review
period, extend the review period for an additional 60 days. Any
extension under this paragraph will extend the time periods under
paragraphs (a)(5) and (a)(6) of this section to 120 days.
(8) A designated financial market utility may implement a proposed
change before the expiration of the applicable review period if the
Board notifies the designated financial market utility in writing that
the Board does not object to the proposed change and authorizes the
designated financial market utility to implement the change on an
earlier date, subject to any conditions imposed by the Board.
(b) Emergency changes.
(1) A designated financial market utility may implement a change
that would otherwise require advance notice under this section if it
determines that--
(i) An emergency exists; and
(ii) Immediate implementation of the change is necessary for the
designated financial market utility to continue to provide its services
in a safe and sound manner.
(2) The designated financial market utility shall provide notice of
any such emergency change to the Board as soon as practicable and no
later than 24 hours after implementation of the change.
(3) In addition to the information required for changes requiring
advance notice in paragraph (a)(2) of this section, the notice of an
emergency change shall describe--
(i) The nature of the emergency; and
(ii) The reason the change was necessary for the designated
financial market utility to continue to provide its services in a safe
and sound manner.
(4) The Board may require modification or rescission of the change
if it finds that the change is not consistent with the purposes of the
Dodd-Frank Act or any applicable rules, order, or standards prescribed
under section 805(a) of the Dodd-Frank Act.
(c) Materiality.
(1) The term ``materially affect the nature or level of risks
presented'' in paragraph (a)(1) of this section means matters as to
which there is a reasonable possibility that the change would
materially affect the overall nature or level of risk presented by the
designated financial market utility, including risk arising in the
performance of payment, clearing, or settlement functions.
(2) A change to rules, procedures, or operations that would
materially affect the nature or level of risks presented includes, but
is not limited to, changes that materially affect any one or more of
the following:
(i) Participant eligibility or access criteria;
(ii) Product eligibility;
(iii) Risk management;
(iv) Settlement failure or default procedures;
(v) Financial resources;
(vi) Business continuity and disaster recovery plans;
(vii) Daily or intraday settlement procedures;
(viii) The scope of services, including the addition of a new
service or discontinuation of an existing service;
(ix) Technical design or operating platform, which results in non-
routine changes to the underlying technological framework for payment,
clearing, or settlement functions; or
(x) Governance.
(3) A change to rules, procedures, or operations that does not meet
the conditions of paragraph (c)(2) of this section and would not
materially affect the nature or level of risks presented includes, but
is not limited to the following:
(i) A routine technology systems upgrade;
(ii) A change in a fee, price, or other charge for services
provided by the designated financial market utility;
(iii) A change related solely to the administration of the
designated financial market utility or related to the routine, daily
administration, direction, and control of employees; or
(iv) A clerical change and other non-substantive revisions to
rules, procedures, or other documentation.

By order of the Board of Governors of the Federal Reserve
System, July 27, 2012.
Robert deV. Frierson,
Deputy Secretary of the Board.
[FR Doc. 2012-18762 Filed 8-1-12; 8:45 am]
BILLING CODE P

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