United States of America: The Fedwire Securities Service’s Observance’s of the CPSS-IOSCO Recommendations for Securities Settlement Systems

The report gives a summary of the detailed assessment report on the implementation of the Basel Core Principles for Effective Banking in the United States and its recommendations, securities and futures market regulatory, insurance regulation, Fixed Income Clearing Corporation -Government Securities Division (FICC-GSD) system, and other recommendations such as Depository Trust Company (DTC) against the Recommendations for Securities Settlement Systems (RSSS), the National Securities Clearing Corporation (NSCC) against the Recommendation for Central Counterparties (RCCP), the Fedwire Securities Service (FSS) against the Committee on Payment and Settlement Systems -International Organization of Securities Commission (CPSS-IOSCO) RSSSs as well. The U.S. authorities welcomed the Financial Sector Assessment Program (FSAP) and independent reviews, and appreciated significant undertaking associated with reviews in the wake of the crisis.

Abstract

The report gives a summary of the detailed assessment report on the implementation of the Basel Core Principles for Effective Banking in the United States and its recommendations, securities and futures market regulatory, insurance regulation, Fixed Income Clearing Corporation -Government Securities Division (FICC-GSD) system, and other recommendations such as Depository Trust Company (DTC) against the Recommendations for Securities Settlement Systems (RSSS), the National Securities Clearing Corporation (NSCC) against the Recommendation for Central Counterparties (RCCP), the Fedwire Securities Service (FSS) against the Committee on Payment and Settlement Systems -International Organization of Securities Commission (CPSS-IOSCO) RSSSs as well. The U.S. authorities welcomed the Financial Sector Assessment Program (FSAP) and independent reviews, and appreciated significant undertaking associated with reviews in the wake of the crisis.

I. Introduction and Methodology

1. The assessment of the Fedwire Securities Service (FSS),1 owned and operated by the Federal Reserve System, against the CPSS-IOSCO Recommendations for Securities Settlement Systems (RSSSs) reveals that the system is sound, efficient, and reliable. For operational risks, the U.S. requirements go beyond those of the RSSSs. However, some regulatory changes are needed to ensure “fair” and open access to the system by other entities than U.S. banks. Although the Federal Reserve Board oversees the system based on its supervisory responsibility for the Banks, it would be beneficial and effective to have an explicit legal basis for oversight of all systemically important securities clearing and settlement systems.

2. The assessment of FSS was undertaken in the context of the IMF Financial Sector Assessment Program (FSAP).2 Prior to the mission, the Federal Reserve Board assessed the FSS following the RSSSs methodology published in 2002 by the CPSS-IOSCO. The assessment has been based on the self assessment, and a review of the relevant rules and regulations. The assessment also benefited from discussion with the operator of the system and meetings with market participants arranged by the authorities. Relevant authorities have been very co-operative in providing additional confidential information and organizing additional meetings, when required.3

II. Institutional and Market Structure—Overview

3. The Reserve Banks operate FSS on a consolidated basis through the Federal Reserve Bank of New York’s Wholesale Product Office. In their capacity as fiscal agents, the Federal Reserve Banks act as the central securities depositories (CSD) for securities issued by the Treasury, federal agencies, government sponsored entities, and certain institutional organizations. The FSS is also the key interbank settlement system for Fedwire-eligible securities. FSS’ participants include depository institutions and certain other institutions, including U.S. branches and agencies of foreign banks. The key statistics of FSS are provided in Table 1.

Table 1.

Key Statistics of FSS, 2007–09

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Source: The Federal Reserve.

4. Various institutional and market arrangements facilitate the issuance, trading, clearing, and settlement of Fedwire-eligible securities. The Reserve Banks, through FSS, provide key issuance and settlement services. In addition, the FICC and the two clearing banks, JP Morgan Chase (JPMC) and Bank of New York Mellon (BoNY), perform clearance and settlement functions for market participants. A large share of settlement of Government securities is internalized in the two clearing banks. No official figure is available on internalization.

5. The FSS is overseen by the Federal Reserve Board, which regularly assesses the FSS against the RSSSs. The assessments have been made publicly available since 2007. Furthermore, the Federal Reserve banking supervisors, the Securities Exchange Commission (SEC), and the Treasury provide relevant perspectives on the market context in which Fedwire operates. In particular, the SEC is the regulator of many participants in the government securities market and the central counterparty (CCP).

III. Main Findings

Legal Framework (Rec. 1)

6. The FSS activities are governed by a consistent set of laws, regulations, and contractual arrangements that form a sound legal foundation for clearing, settlement, and custody activities. This set of law and regulations is public and readily accessible to system’s participants.

Pre-settlement Risk (Rec. 2–5)

7. Confirmation services for FSS eligible securities to direct participants that are cleared by CCP are provided by FICC. The FSS does not require settlement instructions to be matched prior to settlement. The settlement cycle for FSS eligible securities is generally shorter than T+3 with the exception of mortgage backed securities (MBS) that occurs on a monthly basis. The costs/benefits of the reduction of the settlement cycle have been assessed, and market participants considered establishing the CCP more appropriate than reducing the settlement cycle.

Settlement Risk (Rec. 6–10)

8. Securities settled in FSS are issued on a dematerialized basis (except for a limited number of securities that can be immobilized). Transfer of ownership occurs when securities are transferred between participants within the system. The FSS enables delivery versus payment (DVP) on a real time basis. The transfer of securities and cash occurs simultaneously and is final when the securities and cash accounts are credited and debited.

Operational Risk (Rec. 11)

9. The FSS has in place adequate procedures to identify and minimize the sources of operational risk that may arise in the settlement process. Contingency plans and back-up facilities are regularly tested and maintained to ensure the resilience of the FSS. The business continuity plan takes into account the dependence between FSS and Fedwire Funds. A risk-based review of the IT system supporting the FSS functioning is conducted by independent external auditors. Senior management regularly monitors operational reliability issues.

Custody Risk (Rec. 12)

10. The FSS operates an indirect holding system where securities (or interest in securities) are held for the sole benefit of the direct participants whose account has been credited and not for the benefit of any other party. Physical and technical controls as well as periodic audits are performed to ensure that the Reserve Banks records are accurate and to ensure that customers’ securities are adequately managed.

Other Issues (Rec. 13–19)

11. The FSS access and exit criteria are publicly disclosed. Currently, some key market participants such as nonbank broker-dealers are not allowed to access the FSS on the basis of non-risk related criteria. Furthermore, entities not physically present in the United States, cannot have access to FSS, as they are not covered by U.S. banking supervision authorities. Following the Monetary Control Act (1980), the Federal Reserve Banks are required to recover direct but also imputed costs that would have been incurred if a private firm was offering this service. The FSS uses a proprietary message format, which can be translated to and from international message standards. It is currently not envisaged to use instead SWIFT or ISO standards. Market participants are provided with sufficient information on FSS, including laws, regulations, rules, and procedures. Moreover, the FSS has completed a self assessment following the RSSSs assessment methodology. The self assessments are disclosed on the Federal Reserve website. The responsibilities and objectives of relevant public authorities with regard to securities settlement systems are clearly defined and publicly disclosed. The Federal Reserve Board is exercising oversight over the FSS, based on its supervisory responsibility for the Reserve Banks. The Government and Accountability Office have the legal power to audit the FSS as a Treasury Agent.

Table 2.

Summary of Observance with the CPSS-IOSCO Recommendations

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Table 3.

Recommended Action plan to Improve Observance of CPSS-IOSCO Recommendations

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IV. Authorities’ Response to the Assessment

12. The U.S. authorities strongly support the FSAP program, welcome this independent review, and thank the assessors for all the work to produce this report. They appreciate the significant undertaking associated with a review of the biggest financial sector in the world, as well as the challenges that accompany the first assessment of a large advanced country in the wake of the crisis.

13. The authorities are pleased to note the assessment reflects the high degree of compliance of the Fedwire securities service with the RSSSs, and are largely in agreement with the assessment’s comments and recommendations. The authorities will explore the possibility of introducing settlement instruction matching in the Fedwire securities service, taking into account the relevant costs and benefits associated with such a matching feature. The authorities will also reassess the business case for extending FSS service operating hours and seek ways to ensure that the needs and interests of smaller and midsize participants continue to be taken into account.

14. The assessment also recommends that a rolling settlement period of no later than T+3 be adopted in the U.S. mortgage-backed securities (MBS) market. While the authorities agree in principle that reducing the settlement period reduces settlement risk, they note that such a change for the U.S. MBS market requires careful study and close consultation with market participants given the characteristics of the instruments being settled, existing trading practices, and significant operational changes that are likely to be needed. The U.S. authorities believe that near-term risk reduction efforts should focus on the industry proposal to implement a central counterparty for mortgage-backed securities.

15. With regard to the recommendation concerning residual risks associated with the provision of intraday credit to participants in the Fedwire securities service, the authorities note that a rigorous program for assessing, monitoring, and mitigating the risks associated with the provision of intraday credit to Fedwire accountholders is in place. Nevertheless, the authorities are further strengthening this program as a result of a comprehensive policy review conducted from 2006 to 2008 and the planned implementation of an explicit collateralization policy in late 2010 or early 2011. As a result, the authorities are confident that the residual risks noted in the assessment are adequately monitored and controlled.

1

The underlying Detailed Assessment Report was published in May 2010 and is available at http://www.imf.org/external/pubs/cat/longres.cfm?sk=23869.0.

2

For further discussion see the accompanying Financial System Stability Assessment (FSSA), (www.imf.org).

3

This assessment was carried out by Daniela Russo (external expert) and overseen by Elias Kazarian (IMF).