VIA E-MAIL TO firstname.lastname@example.org
August 9, 2002
Ms. Jennifer J. Johnson
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, D.C. 20551
Re: Docket No. R-1122
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. S7-15-02
Dear Ms. Johnson and Mr. Katz:
The Bank of New York ("BNY" or "Bank") welcomes the opportunity to comment on the Interagency White Paper on Structural Change in the Settlement of Government securities ("White Paper").
BNY is one of the largest securities services providers in the world. We have over $6.6 trillion of client assets under custody for over 5,700 institutions worldwide. The Bank services cross-border assets of $2 trillion and maintains the world's most extensive sub-custodian network, spanning 101 markets.
The clearance and settlement of Government securities transactions is a pivotal component of the United States debt markets and global financial markets. The Government Securities market is comprised of $2 trillion of next day settlement trades (of which, after netting, $400 billion settle at the clearing banks daily), $200 billion in daily transactions in the delivery repo market, and between $1.6 and $2.7 trillion of transactions daily that settle same day through the clearing banks. BNY and JP Morgan Chase ("Chase") are the two clearing banks currently supporting the Government securities market. The Bank's clearing customers include primary dealers, broker-dealers, insurance companies, banks, money managers, bank-affiliated securities dealers, inter-dealer brokers and mortgage banks (collectively, "Dealers").
BNY has been a clearing bank for broker-dealer clearance and settlement since the beginning of active trading in United States Government securities. The Bank handles between 100,000 to 200,000 trades per day at a gross daily value of between $1.2 and $1.7 trillion. On average, 32% (40% on mortgage-backed securities settlement days) of the trades cleared by BNY are "internal". These "internal" trades are transactions between customers at BNY and are not delivered across the Federal Reserve securities wire. The Bank custodizes and services in excess of $540 billion of Tri-Party repo securities and thus facilitates, through collateral management and other support services, Tri-Party repo funding by institutional investors (as described more-fully later) at the level of approximately $525 billion daily. This market's smooth functioning has been advanced by continuing innovations, including in Tri-Party repo processing and in domestic and global collateral management services.
Broker-Dealer Services is a key business for our Bank and Government securities clearance is a crucial element of serving these customers. We will continue to commit the human, financial and technical resources to support and to provide innovations in this business line. We have served as clearing bank for our Dealer customers in times of stability and times of stress.
Recognizing the importance of the broker-dealer customer base to BNY and the role of Government securities clearance in serving those customers, the Bank has made substantial investments in technological innovation and in hardening the infrastructure supporting this business. For example, we will implement multiple operations centers and will have split-site processing with key operating personnel outside of New York City ("NYC"). The Bank is also establishing multiple data centers outside NYC, each with the ability to serve as our primary data center. Fully redundant communication links will be implemented, and the primary data center will be located outside of the NYC metropolitan region.
In the present clearing structure, the clearing banks provide the mechanism for the essential liquidity for creditworthy Dealers. Intraday this liquidity enables Dealers to settle transactions and to arrange funding from investors, and enables investors to promptly unwind investments. End-of-day, the liquidity provided by the clearing banks enables Dealers to finance securities which failed to settle as planned or which did not attract an investor as expected. The dollar amounts involved are sizeable and necessitate the clearing banks' performance of considerable credit and business due diligence, which is facilitated by the multi-dimensional relationships between themselves and their Dealer customers. It is not certain that the required liquidity would be available or available at current terms if there were a material change in the relationship between clearing banks and their customers.
Below are our comments on The White Paper process, a description of the present role of the clearing banks, and our comments on The White Paper proposed alternatives, evaluation criteria and evaluation process.
The White Paper Process In Perspective
The tragic events of September 11, 2001 present an opportunity to examine the present system and determine areas for improvement. The September 11 processing interruptions in the Government securities market highlighted industry infrastructure areas which need to be addressed, and are presently being vigorously addressed by market participants. It has also been recognized that more attention must be given to connectivity testing and the role of telecommunication providers, and steps are proceeding in this area. The resolution of these infrastructure issues may well reduce the need to consider structural changes such as those suggested for comment in the White Paper.
We believe the models suggested for consideration by the White Paper must be measured against the accountability format of the present, private-sector mechanism. Today's clearing bank structure has evolved, rather than been created by government design, and is considered to be the world model. It is a product of the harmonization of private-sector corporate responsibility on one hand, and a vigorous regulatory oversight and examination regimen on the other. Within these constraints, the processing and financing requirements of a demanding Dealer community have been met in an environment of dependability and innovation. And in the process, the Tri-Party repo process has provided the mechanism for a large and dependable source of Dealer funding, meeting the investment requirements of state, local and foreign governments and many institutional investors including mutual funds, pension funds and university endowments.
The Present Role of Clearing Banks in Government Securities Transactions
Of course, it is implicit in the White Paper that possible utility or public sector alternatives must be tested against the aggregate of the attributes of the present clearing bank mechanism.
Appendix 1 of the White Paper describes the general process for clearing and settling transactions in Government securities. The roles of the Dealers, the Government Securities Clearing Corporation and the clearing banks--Chase and BNY--are summarized, and the function of the repo financing mechanism is outlined. Appendix 2 describes the Tri-Party repo funding mechanism in more detail. Although the roles of the clearing banks are covered in Appendix 1 of The White Paper, we hope it would be helpful to amplify this aspect, including, most importantly, the role of the clearing banks' providing intra-day and overnight liquidity, from our vantage point as one of the parties presently filling this role.
As illustrated in the following discussion, the role of the clearing bank is more than that of a simple delivery-versus-payment mechanism. The clearing banks provide essential technical and financial support for a complex process that is dependent on both the internal liquidity provided by the clearing bank and the clearing bank's ability to facilitate the Dealers arranging external credit through Tri-Party repo and other programs. We manage our liquidity relationship to the Dealer community on the basis of our ability to aggregate information regarding collateral, creditworthiness, inter-market considerations, and fees and services across multiple products. In our role as Tri-Party collateral agent, we offer a safeguard service for some Tri-Party investors by providing an independent valuation and eligibility test for the collateral that is allocated to their repos nightly.
BNY Settlement Process
The BNY clearance and settlement process is essentially a combination of BNY's processing applications, the real-time gross settlement application "GSCX", and the Bank's collateral management system, "RepoEdge®". Dealer customers interface with the Bank through various messaging applications such as MQ, and the Bank interfaces with The Federal Reserve securities and funds wires using the Federal Reserve messaging protocols.
The Bank's technology and applications enable Dealers to process transactions in online real time, batch, "dribble batch", SWIFT or manual modes, providing cost-effective solutions for a wide variety of user needs. By supporting multiple formats, protocols and access methods, the clearing banks provide customized service, as opposed to the single standard common to utilities. The Bank, in accordance with Federal Reserve policy, limits the number of "street" accounts available to the dealer community, and, therefore, provides substantial sub-accounting, including 15(c)3-3 and other segregated accounts, for its Dealer customers. The Bank's systems also comply with the Federal Reserve's reporting requirements, and provide our customers with a variety of risk management tools. The technology necessary to provide this service is complex and requires significant investment. Over the past five years, BNY has spent over $100 million on application enhancements and development efforts in its process of constant innovation.
The Bank provides securities clearance in two formats--remote clearance and in-house clearance. In remote clearance, which is provided to the bulk of the Bank's customers, the Bank's applications reside in the customers' offices, and the Dealer's staff load transactions and clear exceptions (e.g. match receives and delivers, eliminate data entry errors, DK's etc.). With in-house clearance, BNY staff, rather than dealer personnel, perform most of the required transaction input functions.
"Banking" Services for Dealers
BNY's clearing and settlement services to its Dealer clients are supported by a variety of "banking" facilities, including forms of financial intermediation and collateral management facilities. The Bank provides traditional credit support to its Dealer customers through bank lines and other banking accommodations for many purposes including, for example, working capital and back-up lines, on a continuing basis and at very high dollar values. The collateral management services, referred to as BNY's Global Collateral Management ("GCM"), provide the Dealer with the tools to use its Government securities efficiently as collateral to satisfy financing and liquidity needs on a global basis.
The process of the Bank's providing trade support and liquidity to a Dealer may begin at the time of the trade. For example, in a delivery-versus-payment transaction, specifying delivery to BNY provides the Dealer's counterparty with settlement safety in that the counterparty knows that either both sides (cash and securities) of the trade will settle or neither will settle and value will be returned to the counterparty. Moreover, the United States Treasury is similarly assured that securities sold to clearing Dealers under the Federal Reserve Bank ("Reserve Bank") auction bidding process will be settled by the clearing banks unless The Reserve Bank is notified otherwise prior to settlement. This liquidity support continues during the settlement process as BNY extends intra-day credit to creditworthy Dealers by receiving securities on a delivery-versus-payment basis at the Reserve Bank on behalf of the Dealer. After settlement occurs, the Bank continues to provide both intra-day and overnight financing of creditworthy Dealers' securities during the time they are held in inventory. Further, the clearing bank mechanism allows the Dealer the flexibility to use the collateral value of securities to satisfy its global liquidity requirements.
This access to funds-versus-collateral goes beyond the daily intra-day settlement of securities or unwinds of Tri-Party repos to repay lenders, described more specifically below. The Dealer may use the value of the securities held at the Bank to meet margin requirements throughout the day at various Chicago and New York exchanges and elsewhere. Each of these industry exchanges and utilities establishes intra-day trading and credit limits for their participants. When their participants reach such predetermined thresholds, they are no longer permitted to trade or settle transactions on the respective exchanges or utilities. In these instances, the Dealer receives a margin call or request for a "progress payment" that requires a funds payment or increase in posted margin (often in the form of an increase to a Letter of Credit) before settlement will be resumed. Often, the Dealer is able to meet these inter-market requirements only through the liquidity provided by the Bank based upon the collateral value of the securities held for the Dealer.
These same securities held at the Bank provide the Dealer with the mechanism to obtain necessary funding on a global basis. Securities on deposit in New York may be used as collateral for advances made by the Bank's European and Asian offices in foreign currency to meet local settlement and margin requirements. Without the 24-hour-a-day liquidity that GCM provides, a Dealer might find itself unable to meet its global settlement needs because its liquidity is locked up in U.S. collateral and restricted by U.S. settlement practices.
Dealers may limit use of Reserve Bank daylight overdrafts and maximize the use of the market value of their securities inventory by consolidating their funds transfer activity at the same bank that performs securities clearance. This practice allows the Dealers the use of "net free equity" (essentially, the market value of assets exceeding the value of securities subject to the clearing bank's security interest in those assets) to cover the intra-day mismatch between incoming and outgoing funds. Use of this intra-day net free equity enables the Dealer to move liquidity from one product (e.g. Government securities settlements) to another (e.g. derivatives). This net free equity provided by the clearing bank mechanism may be used by the Dealer to provide its clients with the ability to move more easily between various investment strategies. Often a Dealer's client would be constrained from moving between various products (e.g. a mutual fund to a fixed income product) due to the timing difference of redemption proceeds verses settlement requirements. However, the Bank's ability to allow the Dealer funds movements secured by their Government securities collateral bridges this timing difference and allows settlement to occur in both products.
Securities Lending and Other Margin Requirements
Dealers engage in securities lending transactions in which they borrow securities from banks, broker-dealers, and institutional investors for the purpose of accomplishing timely delivery when they have fails or have sold securities short. Such transactions in Government securities are also cleared through the Dealer's clearing bank. The lender customarily requires a deposit in excess of the value of the borrowed securities. Dealers frequently request their clearing bank to provide that margin differential in the form of loans or letters of credit collateralized by securities held for the Dealer at the clearer. The collateral held at the clearing bank is sometimes not readily-marketable securities and, therefore, might be difficult for the Dealer to finance in the traditional repo market or to borrow against from sources other than the clearing banks.
The repo market is critical to a Dealer's efficiently financing inventory. In the repo market, securities may be financed via (a) delivery repo (i.e. securities delivered versus payment), (b) hold in custody ("HIC") repo (i.e. securities remain in the Dealer's account, subject to a security interest granted by the Dealer in favor of the investor), or (c) Tri-Party repo (i.e. a clearing bank acts as custodian for the dealer and investor, and securities movements are controlled by the bank). While delivery repo is considered safe for investors who pay when securities are received by their custodian and get paid when securities are returned, delivery repo is often not desirable because it requires investors to incur the costs of moving the securities, often between banks. HIC repo saves the investor the clearing expenses, but it is not acceptable to many investors because of the inherent risks associated with the Dealer itself holding the repo collateral.
The Tri-Party repo structure enables the investor to avoid the direct clearing expenses they would have incurred if they had entered into a delivery repo and provides the investor with the benefits of an independent bank custodian that they do not have in HIC repo arrangements. The risks undertaken by the clearing bank in the Tri-Party arrangement are not insubstantial. During the normal course of Tri-Party processing, Dealers gather inventory in value-for-value exchanges where they receive securities and are required to pay cash. Since they do not have the cash, they usually borrow intraday from their clearing banks for many hours during the day until their Tri-Party repo transactions are completed and the clearing bank is repaid with cash received from investors. The total clearing bank repo funding support for Government securities Dealers is approximately 10,000 transactions per day for approximately $1.2 trillion of value. When the repo transactions mature, usually the next morning, the securities are returned versus payment to creditworthy Dealers, and the cash (usually raised through intraday clearing bank loans to the Dealer) is returned to the investor. Since a similar portion of the Dealer's inventory is again financed by repo that night, the clearing banks usually carry the daylight overdraft exposures to their creditworthy Dealer customers through the entire clearing day. These exposures, which can be tens of billions of dollars for a single Dealer, peak between 10:30 and 11 AM each day and require the clearing banks to do extensive credit and business due diligence.
"RepoEdge®" is the Bank's mechanism for servicing the Tri-Party repo financing of Dealer overnight positions. This application enables Dealers to use their worldwide assets in repo transactions. For institutional investors, the Tri-Party mechanism provides convenient custody servicing for their repo investments.
The source for assets used in Tri-Party repo is the Dealer's "box" at the Bank (the custodial facility for all of the Dealer's Government securities in position after trading, borrowing and lending activity for such holdings) together with its other-market holdings which are tracked by the Bank's RepoEdge® system. The Tri-Party repo financing transaction process begins with the negotiation and agreement of repo deal terms between the Dealer and the investor. RepoEdge® is then programmed with Tri-Party repo instructions. RepoEdge® automatically screens the available collateral against the eligibility requirements of the repo investor, and eligible collateral in the "box" is identified and allocated to the repo. The RepoEdge® system also provides additional support services such as end-of-day projections.
The Relationship of Bank, Dealer and Investor
The Bank's ability prudently to clear Dealers' securities and finance Dealers' positions is grounded upon the Bank's extensive business relationships with those Dealers. Because of these relationships, the Bank must, and is incented to, monitor the Dealer's activities across markets both domestically and overseas; maintain up-to-date knowledge of each Dealers' business and financial condition; evaluate its creditworthiness; and assess its ongoing processing and financing needs. Dealers benefit from competition between the clearing banks in the present model. Repo investors benefit from the efficient clearing processes and the settlement protection provided by the clearing bank in the Tri-Party repo process.
Clearing Bank "Banking" In Times of Stress
In our role as a clearing bank, BNY has been involved in a variety of Dealer crisis situations in the Government securities market. Some situations have been caused by difficulties at a specific firm (i.e. Drexel, Kidder, Yamaichi), and others because a market segment (i.e. hedge funds during the Long Term Capital crisis) became troubled. Whether caused by a single firm's bankruptcy or by market speculation of adverse prospects for a firm or an industry group, in our experience, stressful situations in the market usually result in a combination of loss of confidence and counterparty anxiety with respect to trading and settlement. These, in turn, lead to diminished liquidity for the Dealer(s) involved. Most Dealers use a variety of short-term funding sources including commercial paper, bank loans, and repos. To the extent that maturities occur when confidence is lost, commercial paper holders, lending banks, and repo counterparties may opt to end their financing of the Dealer at maturity rather than extend facilities further into an uncertain future.
Clearing banks have played important roles in such stressful situations in the past. Because clearing banks are in a position to evaluate the financial condition of the Dealer in distress, they can determine if a creditworthy Dealer's positions can be safely financed by the clearing bank or, in some cases, by a syndicate of the Dealer's banks for which the clearing bank might serve as collateral agent. If the clearing bank concludes that, under the circumstances it can provide emergency financing, time can allow the Dealer to regain the confidence of other market participants, and new financing can be put into place or the Dealer can conduct an orderly sale of the portfolio or make arrangements for alternate financing with minimized disruption to the market.
As mentioned earlier, significant amounts of Dealer inventory are financed on an overnight repo basis and through short term commercial paper. Indeed, Dealers are able to carry inventory at higher levels because overnight funding is readily available to them. Banks can assist creditworthy Dealers in arranging emergency funding from a variety of sources on the basis of banks' having access to the funds market for raising loan proceeds and because banks also have many institutional clients which might become repo counterparties through the use of Tri-Party repo processing arrangements.
Historically, the clearing bank's position as central repository of the Dealers' securities and funds during these financial crises has allowed the Dealers the maximum flexibility to maintain an orderly settlement process. In some situations, under appropriate circumstances and after other alternative sources are exhausted, the clearing bank may seek liquidity support from the Federal Reserve Discount Window, where the troubled Dealer's collateral could be rehypothecated.
In times of stress, clearing banks also provide comfort to counterparties that wish to continue trading and settling. Counterparties can rely upon clearing banks either to take the securities delivered and pay for them, or to return them. In this example, clearance provides a method to avoid gridlock in the market settlement process.
Clearing banks have also been helpful to regulators in times of stress. They have provided independent analyses of the Dealer's condition and position, assurance of the content of the Dealer's portfolio, and status reports on clearance in progress and the financial results thereof. Clearing banks have also suggested innovations by which emergency financing might be undertaken.
The White Paper describes operational concerns, financial vulnerabilities (i.e. the abrupt involuntary exit by a clearing bank) and the structural vulnerability of voluntary exit, perceived to exist in the present private-sector clearing bank model. The White Paper invites consideration of a utility or public-sector alternative to the present mechanism.
Old EuroClear model
One suggestion of a utility structure is the Old EuroClear model of an industry-owned depository and settlement entity, which contracts with a commercial bank (or banks) for services such as operational and credit services. The two clearing banks would be likely candidates as service providers but, presumably, other banks or non-bank entities could seek to participate. If the clearing banks were to provide services, they would likely retain many of the same technological and involuntary vulnerabilities as asserted for the present model, but voluntary exit could be mitigated by such things as contractual obligations to remain as service provider. The participation of additional banks would involve start-up costs and would most likely have at least a short term effect on unit pricing. The utility would furnish securities and cash accounts to Dealers, and settlements would take place on the books of the utility-bank. The utility would furnish intra-day financing, and the bank or banks providing operational services, or other banks, would provide Tri-Party repo services. The intra-day financing requirements at the levels required would continue to be huge, and the mechanism for a new Tri-Party repo system would require basic realignment of the present arrangements.
Private Limited-Purpose Bank
An alternative type of industry-owned depository and settlement mechanism proposed for consideration by the White Paper is a private, limited-purpose bank like The Depository Trust Company ("DTC") or the new Euroclear Bank. In this model, the utility itself, rather than a contractor bank as service provider, would furnish operational support. The utility would also need to arrange a sizeable back-up liquidity facility to ensure settlement if a participant failed to cover an overdraft. Credit facilities at levels required to accommodate the size of the market today would be well beyond what has thus far been undertaken in the utility-depository environment, and would likely be very expensive. Such a utility would likely require a very large capital base and/or complex risk control and financing mechanisms. In the absence of a very large capital base at the utility, the dealer community and investors alike would have to consider the acceptability of the usual utility mechanisms to mitigate the risks which are today borne by the clearing bank's capital, including capital requirements for eligibility (which might be too high to permit a significant percentage of Dealers to be direct participants), debit caps, margin requirements, mutualization of risk (i.e. where participants in the utility share the risk of nonperformance by one participant) and the like. Absent a very substantial capital base, the utility may be deemed an unacceptable delivery location. The White Paper states that overnight funding, including Tri-Party repo, could be provided by the limited-- purpose bank or by commercial banks. It is unclear that such financing would be available at rates comparable to those offered currently at clearing banks. The creation of the required Tri-Party repo funding arrangements and facilities for the daily unwind of Tri-Party repo would be very large and difficult projects. Substitutes for the current funds transfer and other services would also have to be developed.
Enhancement of Federal Reserve Services
A third alternative suggested for consideration in the White Paper is for the Federal Reserve to provide clearance and settlement services directly to non-bank securities Dealers. In this model, the Federal Reserve would, in a major change from Federal Reserve policy which has existed for decades, provide non-bank Dealers direct access to securities accounts and to intra-day and overnight credit. Either the Federal Reserve or commercial banks would provide some form of Tri-Party repo overnight funding. The details for such new credit facilities would need to be addressed along with capital requirements and Fedwire cap limits.
The White Paper provides evaluation criteria for a utility or public sector alternative to the present clearing bank model. It would require that any alternative reduce existing operational, financial, and structural vulnerabilities, which are described for the current arrangements, and not introduce new vulnerabilities. Alternatives must be tested for their implications on the efficiency and innovativeness of the settlement process and related financial transactions, and their ability to deliver services in a cost-effective manner. The Paper points out that assumptions will have to be made about the initial investment required and the potential for savings over time.
Lastly, the White Paper notes that alternatives for restructuring the clearing and settlement process will require an assessment of their implications for Federal Reserve services and policies. The Paper notes that some proposals would require the Federal Reserve to broaden dramatically the scope of its services and its long-standing policies precluding non-depository bank access to Federal Reserve accounts and credit. Consideration of the proposals would entail an assessment of the legal and operational ability of the Federal Reserve to provide the required services. It would also require an assessment of the "moral hazard" of the central bank directly interfacing with securities Dealers, rather than interaction with that community, as now, through commercial bank intermediation. This "hazard" is generally characterized as the concern that there could be a diminution of appropriate levels of prudence as market participants might instead rely upon the Federal Reserve's direct role in the process.
An assessment of the impact on liquidity and the financing markets must be a prime consideration when comparing any alternative to the present mechanism. Inasmuch as the present structure relies on the multi-dimensional relationship of the clearing banks with their Dealer customers, it has to be assumed that the liquidity support now provided by such banks could not be continued in the same way and to the same magnitude if the present clearing bank customer relationship were changed in a material way. In addition, the risks and costs of the transition to a different model will also need to be addressed.
The Evaluation Process
As policy makers balance the competing benefits and risks of significant structural change in the very large and critical Government securities market, we suggest that the following considerations be taken into account:
BNY recognizes the key role of the clearing banks in the Government securities market and is committed to continue to serve the Dealer community as a clearing bank. The industry's need for infrastructual improvements, as highlighted by the events of September 11th, has been addressed and changes are in progress.
Although alternatives presented by the White Paper to the present private-sector clearing bank mechanism appear to respond in varying degrees to the vulnerabilities described within the present system, they raise important operational, economic, public policy, concentration and transition considerations which will be very difficult to overcome. Moreover, none of the proposals appears to provide the required intra-day and end-of-day liquidity and funding that is essential for the settlement of Government securities in the magnitudes they are traded and financed by Dealers today.
The private sector has created a dependable and adaptable model for settlement and, in response to evolving industry needs and competitive initiatives, has enhanced that model extensively over the years. We believe it is sound policy to reevaluate the present model, and we welcome the chance to participate in the White Paper process. We are prepared to contribute to the further consideration of this very important subject.
Very truly yours,
/s/ Gerald L. Hassell