Remarks by

William J. McDonough, President
Federal Reserve Bank of New York

before the

Symposium on Risk Reduction
in Payments, Clearance and Settlement Systems

New York, New York

January 25, 1996


It is a pleasure to be a part of this private-sector effort to enhance the international understanding of risk reduction in payments, clearance and settlement systems. Events such as this symposium serve to establish a dialogue on these issues that is vital to improved risk management. This event is particularly impressive in terms of the range and quality of participants. I am also delighted to see that my former colleague Jerry Corrigan, who played such an important role in bringing attention to payment issues while at the New York Fed, remains committed to reducing risk in this area.

This morning I will first outline some of the major risks that face payments, clearance and settlement systems as identified by the Committee on Payment and Settlement Systems (CPSS) and will then assess where the public and private sectors stand in tackling these risks and consider what steps should be taken in the future. I would also like to turn to the efforts that we have all made to reduce risks in payments systems. My talk will generally have an international focus, but domestic and international issues are not easily separated.

The CPSS and its predecessor groups have long been at the forefront of efforts to identify, define, and promote solutions to risks in payments and settlement systems. It has taken an increasingly more policy-oriented approach over the years, seeking to help regulators and market participants make sensible choices when confronting problems and risks. There is a tendency on the part of some to believe that payments work is mired in details and not in policy analyses and prescriptions. I believe quite the opposite, that central banks have put forward a conceptual and pragmatic agenda that has helped change attitudes and shape new approaches to promoting safe and sound payments systems. I should also point out the private sector s vital role in achieving improvements in payments system safety, a theme I will return to later in the talk.

Central banks' interest in the payments system, as evidenced in the work of the CPSS, grows out of a variety of concerns. These include carrying out monetary policy, serving as fiscal agent for our national governments, and promoting the safety and soundness of banks where that is a central bank responsibility, in addition to acting as a payments system operator. To take one example, monetary policy implementation and fiscal agency responsibilities can directly involve the central bank in buying and selling securities or foreign exchange and the central bank, as an active participant, has an obvious interest in the smooth functioning of the payments system.

More broadly, the ability to make and receive payments with confidence remains a cornerstone of any commercial system. The extent of that confidence determines, to an important degree, the decisions of investors and businesses on where to place their funds or locate their commercial ventures. The issues associated with maintaining this confidence become more complex as payment mechanisms proliferate and change with technological advancements. In addition, as the financial markets and commerce become more global, central banks need to worry about the international payments linkages that join markets and economies together. These linkages must become a bulwark against the transmission of payments problems across borders and cannot be allowed to become propagators of those problems.

The Governors of the central banks of the Group of Ten countries established the CPSS to monitor and analyze developments in domestic payments and settlement systems as well as in cross-border and multilateral netting schemes. The CPSS also provides a means for the coordination of the oversight functions undertaken by the G-10 central banks with respect to private cross-border and multilateral schemes.

The CPSS has grown to become an important international focal point of a broad-based effort to understand and improve payments systems. It provides for collective consideration by central banks of the implications of payments issues. The G-10 central banks have been at the core of these discussions, but steps have been taken to increasingly coordinate with central banks outside the G-10 countries. Moreover, the work of the CPSS is designed to engage the private sector and individual regulators in the struggle to improve the safety and soundness of the payments system. The policies and insights developed by the CPSS are intended to be used and expanded upon by market participants. In this context, the CPSS maintains contacts with other G-10 Committees and many global payment system providers, industry associations and other regulatory authorities.

The CPSS and its predecessor, the Group of Experts on Payment Systems, have undertaken a host of reports and projects that have enhanced the understanding and oversight of the payments system. I would like to give you some background on these reports because they illustrate the issues we have dealt with, the risks we have sought to identify, and some of the steps central banks have taken or are now taking to deal with these risks.

These efforts have focussed mainly on securities settlements and on cross-border payments, with particular attention given to the issues surrounding foreign exchange settlements. Two reports on securities settlements, one in 1992 on delivery versus payment in securities settlement systems (the DVP Report) and a second in 1995 on cross-border securities settlement, developed an analytical framework for examining the settlement of securities trades and identifying the risks involved. A key finding of the DVP Report is that there are several risks inherent in settling securities trades and that the important features of any settlement system are the controls used to manage and eliminate those risks, and not the form that the settlements take. To be sure, the DVP Report developed new insights into the design of securities settlement systems, but it also made the point that no one design can eliminate all risks and therefore each system must identify and control the risks that remain.

The key risks are credit and liquidity risk, and central bankers' main concern is that these risks could become so overwhelming as to involve systemic risk. I have found that it is always useful to define terms, and what I mean by credit risk is the threat that a counterparty will not settle an obligation for full value, either when due or at any time thereafter. In the event of a counterparty default, credit risk includes both replacement cost risk and principal risk. Replacement cost risk refers to the possibility of losing unrealized gains on unsettled contracts with a defaulting counterparty. The larger credit risks, however, arise in connection with contracts scheduled to settle on the day a counterparty defaults. On such contracts, the non-defaulting counterparty may be exposed to principal risk, that is, the risk of losing the full value of securities or funds that have been transferred to the defaulting counterparty without receiving recompense.

Liquidity risk is the risk that a counterparty will not settle an obligation for full value when due, but on some unspecified date thereafter. The reason that a counterparty fails to settle may be technical or temporary, in which case the event is termed a failed transaction rather than a default. Liquidity problems from failures to settle occur regularly and ordinarily are quite manageable, but they have the potential to create systemic problems if they occur in an unsettled financial environment. In those cases, failures to settle may undermine confidence in the creditworthiness of counterparties, inducing some participants to withhold deliveries or payments and, in turn, preventing others from fulfilling their obligations.

Even without a loss of confidence, liquidity risk is a matter of concern. The seller of a security may be forced to borrow funds or to liquidate assets to avoid failing to meet its own payment obligations on other transactions. The buyer of the security may be forced to borrow the security to complete an obligation to deliver it to a third party. The costs associated with such liquidity pressures depend on the liquidity of the markets in which the affected party must make its adjustment; the less liquid the markets, the more costly the adjustments.

The Report concluded that principal risk can be eliminated if securities settle on a delivery versus payment (DVP) basis, that is, if securities are delivered if and only if payment occurs. This does not eliminate all risks, however. Liquidity risks remain. Also, credit is extended in many settlement processes to permit participants to buy their securities. In these cases, lenders continue to face credit risk. Securities settlement systems have developed a variety of means for dealing with these risks, such as imposing system-wide debit caps, failure to settle procedures, loss allocation rules and the provision of alternate liquidity sources. These measures are designed to give participants and system organizers the incentives to identify exposures and the means for limiting those exposures, as well as ways to deal with problems when they occur. While the details of the rules and procedures can and do differ across arrangements, the main policy issues remain: how are risks identified, what incentives are created for controlling those risks, and what means are provided for managing them.

A key finding of the Cross-Border Report is the importance of understanding the risks that arise when systems and intermediaries are linked and of understanding the risk inherent in the tiering of relationships that takes place among settlement participants. Interdependence of systems and institutions is a fact of commercial and financial life. The risks that grow out of these interdependencies are often difficult to discern in the abstract, yet they can become foremost in the minds of market participants in periods of market stress.

The DVP Report focused on settlement of trades between two direct participants in a central securities depository. The Cross-Border Report noted that in a cross-border trade one or both counterparties typically settle through one or more intermediaries, such as a local custodian bank, a global custodian, or an international central securities depository. The involvement of other intermediaries in the settlement process introduces credit and liquidity exposures stemming from the need to coordinate the movement of securities and funds and their safekeeping as well.

Central banks are particularly concerned with the possible systemic implications of credit or liquidity risk. Systemic risk is the danger that the inability of one institution to meet its obligations will cause other institutions to fail to meet their obligations. This is the main reason we are adamant that payment arrangements at the core of the settlement system are able to resolve problems and are strong enough to withstand major failures. Unconstrained credit risk could, in the event of a single default, cause other banks and firms to topple, with disastrous consequences. Poorly developed liquidity management techniques could cause gridlock, tying up entire markets, and possibly cause other defaults. Therefore, central banks are concerned with the possibility that defaults or widespread technical failures might result in losses or liquidity pressures that cannot be managed effectively or contained with existing arrangement, and therefore with the need to develop the means for handling problem situations.

It is important to note that many of these concerns are present in the consideration of foreign exchange settlement risk--how to deal with principal and liquidity risk. FX settlement risk is the threat that a bank will fulfill its side of an FX deal by delivering one currency but the counterparty will not deliver its currency. As such it is generally analogous to principal risk in securities settlements. The G-10 central banks and others have spent much time and effort in the last few years to deal with this risk in one way or another.

Initially, this work was often associated with efforts to understand the benefits and risks of netting. The earlier work of the Group of Experts on Payment Systems resulted in the 1989 Report on Netting Schemes, also known as the Angell Report. This report analyzed the credit and liquidity risks experienced by participants in bilateral and multilateral netting arrangements for both interbank payment orders and forward-value contractual commitments, such as foreign exchange contracts. The Report also identified a number of broader policy issues and expressed concern over the difficulty of providing effective oversight of cross-border netting systems.

While not directly associated with the CPSS, a senior level committee headed by Alexandre Lamfalussy, general manager of the BIS, was set up by the G-10 Governors to deal with these broader policy issues and concerns. As a result of the committee's work, the BIS published a study on interbank netting schemes in 1990 known as the Lamfalussy Report. This report recommended a set of minimum standards for the operation of cross-border and multi-currency netting schemes and principles for cooperative oversight by central banks. Netting, done well, has the potential to reduce credit and liquidity risks. Done poorly it can obscure true risks and cause systemic problems if there is a market disruption. The minimum standards are designed to ensure that participants and service providers produce arrangements which obtain the benefits of netting without introducing systemic risks. Under these standards, participants should have the incentives and ability to manage credit and liquidity risks.

As the Lamfalussy Report did not directly attack the issue of settlement risk in foreign exchange trades, the CPSS published the 1993 report Central Bank Payment and Settlement Services with Respect to Cross-Border and Multi-Currency Transactions, commonly referred to as the No&eumll Report. This report was analytical in nature and outlined the thinking of the G-10 central banks on ways to address settlement risks. The analysis was designed to advance the current understanding of the issues involved in reducing or eliminating FX settlement risk and deliberately did not produce recommendations. Instead, it sought only to evoke industry reaction.

The CPSS has not been alone in its efforts to understand FX settlement risk. In 1994 the Foreign Exchange Committee, which includes as its members individuals from commercial banks, other private organizations and the New York Fed, released a thought-provoking study showing that foreign exchange settlement risk, long believed to be an intra-day risk, is in fact an overnight risk. This can happen because many payment instructions effectively become irrevocable the day before settlement, as banks, or their correspondents, begin the process of sending payments instructions through their internal systems and then into national payment systems. The study also included recommendations on how private sector market participants can themselves reduce FX settlement risk through their internal procedures.

It is important for the private sector to take further action on these insights. The exposures in FX settlement risk are considerable. Foreign exchange trading totals over $1 trillion per day, and when one considers that the exposure extends overnight-- or longer--the exposures to the world s banking system are significant. Note that a bank has risk no matter what currency it is paying. That is, virtually every FX deal will result in a settlement exposure. A bank may face principal risk even when paying the later settling currency because its payment instructions may become irrevocable before it can confirm that the counterparty has paid. The conventional wisdom had been that an FX deal produced a settlement exposure only half the time--when a bank was paying the earlier settling currency. This view also feeds the impression that a bank can protect itself by canceling payments during a crisis. Unfortunately, it may find that the payments have already gone out the door.

Finally, some in the private sector tolerate settlement risk in the mistaken belief that central banks can manage all problems so that defaults are benign, or at least so that defaults occur after business hours. The belief is mistaken for two reasons. For one, settlement exposures extend overnight in many cases and are not extinguished by day's end. For another, the window of opportunity for closing an institution when all the world s markets and payments systems are closed is fairly narrow if it exists at all. Along these same lines, in some countries institutions can only be closed when the courts are open--a lesson of the BCCI closing.

As for the CPSS, it currently is finishing a report on FX settlement risk. President Tietmeyer of the Bundesbank mentioned this work earlier this month. In 1994, the CPSS established the Steering Group on Settlement Risk in Foreign Exchange Transactions to take a coordinated look at the dimensions and sources of FX settlement risk. Recognizing that FX settlement risk may depend not only on the payments system infrastructure but also on the way market participants use this infrastructure, the CPSS instructed the Steering Group to document current market practices for, and barriers to, managing settlement risks in a prudent manner. In carrying out its task, the Steering Group has conducted a survey of banks' payments practices in all G-10 countries with regard to the settlement of foreign exchange transactions. It has also worked to establish a definition of foreign settlement risk and outline measures that can be taken to reduce the risks in cross-currency settlements. A report summarizing the Group s work currently is under review and will be available to the financial community this spring. While I cannot discuss the report's findings just yet, I think it's fair to say that there will be plenty of opportunity for private sector initiatives in reducing settlement risk. Also, the central banks are ready to work closely with the private sector in achieving this goal.

I said earlier that I wanted to discuss the private sector's efforts to reduce risk in payments and settlement systems. Over the years, the private sector has made great contributions to identifying and reducing payments risks. These advances often have come out of work and cooperation with the public sector and I, for one, believe this model will be invaluable in helping to reduce FX settlement risk. Three private sector initiatives and advances come to mind: the G-30 recommendations on securities clearance and settlement, the improvements in CHIPS, and the development of foreign exchange clearing houses.

The Group of Thirty made nine recommendations in 1989 for enhancing and harmonizing securities clearance and settlement on a global basis. Putting these recommendations into practice internationally has not been a simple task. Of the two recommendations that needed implementation in the United States, one was completed last year, and the other is expected next month. The move to settling most securities trades on the third business day after trade, so-called T+3, went into effect last June. The final improvement, settling trades in same-day funds, will complete the effort which has taken many twists and turns over the years. Let me applaud the leaders in the securities clearance industry who pushed this through and their regulators who helped make this happen.

The New York Clearing House, which operates the Clearing House Interbank Payments System, or CHIPS, has made a series of improvements over the years to the risk controls in that system. These have included net debit caps and liquidity arrangements backed by collateral, both of which are designed to assure that CHIPS can settle, even if the largest bank on the system cannot complete its transaction at the closing. These improvements are continuing today as CHIPS has put forward additional measures to increase the Clearing House's ability to withstand defaults. Early last year, the Clearing House also published a discussion paper on means of dealing with settlement risk in foreign exchange transactions. This so-called Green Paper has been successful with industry groups analyzing the Paper s models and developing additional ideas that are currently under study.

The Lamfalussy Report anticipated the efforts to establish foreign exchange clearing houses, a challenge that has been taken up by two private sector groups. One group, centered in Europe and called ECHO, went live in August 1995. A second effort, based in North America and called Multinet, is on the drawing boards. Both systems are designed to achieve multilateral netting of FX trades and to provide controls that reduce risks by assuring participants that the final settlement of each currency will take place even if the largest participant in the group is itself unable to settle its obligations. Central banks have required the two initiatives to be designed so that they meet the Lamfalussy minimum standards. This process has entailed considerable interaction between the private and the public sectors which has been highly positive and productive.

Central banks also have taken steps on an individual basis to reduce risks in major payments systems. The Federal Reserve, for example, has instituted a number of controls and introduced fees to reduce daylight overdrafts on our Fedwire System. The daylight overdraft fee, originally set at 10 basis points and now set at 15 basis points, has led to a significant reduction in the amount of intra-day credit extended to depository institutions. The implementation of caps, collateral for frequent and material overdrafts, and the modest fee for overdrafts, represented an effort to find a combination of incentives to encourage banks to reduce their overdrafts. In the decision to introduce fees, instead of imposing additional debit cap reductions or collateral requirements, careful consideration was given to the risk of pushing participants to other payment mechanisms. Although the fees are fairly modest, they have been sufficient to cause major securities dealers and their clearing banks to alter the way they arrange delivery of securities on repurchase agreements. At the same time, some major banks have altered the timing of their funds transfers to minimize overdrafts.

Looking outside the U.S., a variety of central banks around the globe have begun introducing new real-time gross settlement systems for making wholesale payments, or are seeking to enhance their current systems to provide for real- time gross settlement. European central banks have agreed that each country should have a real-time gross settlement system for making large value payments as they harmonize their payments