August 12, 2002
Ms. Jennifer J. Johnson
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, D.C. 20551
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
||Interagency White Paper on Structural Change|
In the Settlement of Government Securities
Federal Reserve Docket No. R-1122
S.E.C. File No. S7-15-02
Ladies and Gentlemen:
JPMorgan Chase Bank appreciates this opportunity to comment on the "Interagency White Paper on Structural Change in the Settlement of Government Securities: Issues and Options" (the "White Paper"). JPMorgan Chase Bank ("JPMorgan") is the primary banking subsidiary of J.P. Morgan Chase & Co. and is one of the two major banks engaged in the settlement of U.S. government securities transactions. It is important to note that we also clear and act as a triparty custodian in connection with the financing of corporate securities, municipal securities and other assets that provide liquidity to our broker dealer clients and satisfy the investment appetite of triparty buyers that fund this activity on a daily basis.1 Because of JPMorgan's well-developed securities lending program, we are also able to rapidly execute bonds borrowed transactions against securities held in our customers' clearance accounts.2 J.P. Morgan Securities Inc., an affiliate of JPMorgan, is also one of the 22 primary government securities dealers. Our firm, therefore, has a very substantial interest in promoting the efficient and reliable settlement of government securities transactions.
The discussion of possible approaches to structural changes in the provision of settlement services for U.S. government securities by the staffs of the Board of Governors of the Federal Reserve System ("FRB") and the Securities and Exchange Commission ("SEC") is thoughtful and provocative. As you know, this issue has been discussed and evaluated in the past, but has received new attention since the terrorist attacks of September 11, 2001. This is consistent with a business-wide focus on risk reduction, business continuity and contingency planning that we see across our organization. We agree that it is appropriate to re-examine the structure of securities settlements, not only within our own organization but throughout the industry, including other clearing banks, intermediaries, broker dealer clients, investors and the Federal Reserve System.
After careful consideration, we have concluded that the structural changes discussed in the White Paper would neither benefit the financial community nor create a settlement system superior to that which exists today. Moreover, we believe that a utility would have two inherent disadvantages that weigh against adoption. One is the concentration of services in a single provider, increasing risk to the system should that provider experience catastrophic computer, communications or other failure. The other is the "unbundling" of credit and clearance services now offered as a package by the clearing banks, and the increased settlement and financing costs that would ensue.
The existing structure for the settlement of government securities transactions is characterized by reliable and efficient operations, ample liquidity and funding, competition, innovation and valuable intellectual capital and overall financial strength. Due consideration should be afforded to these characteristics when evaluating the desirability of structural changes.
We offer the following in support of our conclusion:
The Current Structure: What We Provide
- Reliable and Efficient Operations. JPMorgan's government securities settlement operations are a critical component of the functioning of the financial markets. We take very seriously our responsibility in this regard and therefore have made very substantial investments in the facilities, systems and people supporting these operations. Currently, we process an average of 87,000 securities transactions per day, reflected in daily general ledger activity of about $1.75 trillion. These figures include triparty repurchase activity of about $450 billion on a daily basis. We take considerable pride in the reliability and efficiency of our operations, including our performance on September 11, 2001 and throughout the period following, about which more will be said later in our comments.
- Liquidity and Funding. As part of our services, we provide large amounts of credit to our broker dealer and financial institutional customers that need to fund their intraday and overnight securities positions. We provide significant intraday liquidity to the government securities settlement market through the extension of secured credit to cover daylight overdrafts generated by Fedwire securities clearance transactions. We selectively provide unsecured intraday credit to many of the same clearance clients. Intraday extensions of credit also allow for the return of securities used as triparty collateral, thereby making securities available for settlement activity. We also make credit available against assets other than government securities held in our customers' accounts. Finally we often provide overnight financing to broker dealers via reverse repurchase transactions and secured loans. By far, the secured intraday liquidity is the most critical need of our customers and the most significant exposure associated with the clearance and settlement of government securities.
We also serve institutional investors, such as large money market funds and others, that wish to engage in repurchase transactions with our broker dealer customers. As the FRB and the SEC have acknowledged, the triparty repo mechanism is critical to the core clearance activities in the underlying securities. Triparty investors rely upon the independence and professionalism of the clearing banks to assure the orderly processing of transactions and the protection of their collateral and cash. The cash infusion these investors provide is essential to the maintenance of the U.S. government securities market. Further, the credit JPMorgan is able to provide in support of these activities permits broker dealers to substitute cash for securities collateral throughout the day, thereby providing greater liquidity to the market.
- Competition, Innovation and Intellectual Capital. As noted in the White Paper, competition in the provision of settlement services benefits the users by fostering innovation and efficiency. Through competition, the clearing banks are motivated to provide high quality, dependable service and to utilize state of the art technology that enhances the availability of information and control to our clients, all at competitive prices. The triparty repo business associated with clearance and settlement is a good example of this. Competition spurs JPMorgan to invest in technology and systems that will provide greater efficiencies in the allocation of triparty collateral and thereby maximize liquidity for our broker dealer customers. The competitive pressures that encourage innovation and cost reduction are not likely to exist in a utility that would not have the same incentive to attract or retain business. As underscored by the events of September 11, we have knowledgeable and resourceful people who can be relied upon to keep critical operations functioning in extreme circumstances. Throughout the emergency, it was apparent that our people had the experience to respond quickly and efficiently to unexpected challenges. We believe that dual clearing banks with multiple independent operating locations are in a better position than a single utility to assure that the necessary depth of talent will be available to operate primary or back-up sites in an emergency.
- Financial Strength. The commercial banks that participate in clearance are large, well capitalized and diversified organizations. While the FRB and the SEC have expressed a concern about the impact of weakness in a particular business function that could impair a bank's ability to sustain a presence in clearing, we believe that the diversification of the banking business overall mitigates this risk. Throughout our banking history, the various businesses within our organization have evolved, grown or diminished largely on the basis of the needs of the financial markets. JPMorgan believes this is a strength of maintaining the clearance business within the context of a larger banking business that can provide credit and other financial support. Our capital base reinforces this.
Contingency Planning and Preparedness
We believe that the existing structure for the settlement of government securities transactions delivers highly efficient and reliable services to the marketplace. While we agree that the events of September 11, 2001 hold important lessons for those responsible for the operations of business and government generally, we do not believe that a further concentration of government securities settlement services in a single utility would enhance the ability of the system to withstand operational, financial or structural vulnerabilities. Rather, we believe that the existing structure, utilizing the operations of two large commercial banks, is robust and capable of withstanding shocks. Based upon our experiences on September 11, 2001, we have made certain enhancements to our contingency planning. We think that the industry should do more. By improving contingency arrangements, we believe that the existing structure will be less vulnerable than a utility. It also possesses certain inherent advantages, such as those described above, that would be difficult to replicate in a utility.
- Contingency Planning Today. The clearing banks are currently subject to contingency planning requirements mandated by the FRB. JPMorgan has a comprehensive Business Continuity Program that requires each line of business to maintain contingency plans to provide essential business and technology service levels in the event of disruption to the normal operating environment. Contingency plans are tested at least annually to assure their workability and to verify the effectiveness of alternate sites. The Business Continuity Program is reviewed annually by JPMorgan's Board of Directors.
JPMorgan's Business Continuity Program functioned effectively on September 11, 2001, despite the enormous impacts of the events of that day and the proximity of many of our people and facilities to the World Trade Center. At the time, the clearance business of JPMorgan had separate independent operating sites in three locations in lower Manhattan, all of which became inaccessible by order of governmental authorities. Nevertheless, due to the flexibility of our contingency plans and the dedication of our human resources, we were able to transfer our settlement operations to a contingency site outside the restricted zone. More importantly, JPMorgan was able to rely upon remote data centers established in two states and two separate telecommunications facilities. As a result, JPMorgan was able to continue clearance, settlement and financing for our customers, including those whose World Trade Center offices were destroyed or who otherwise were unable to communicate in the ordinary course. We also provided facilities for many customers who were displaced from their ordinary operating sites. While JPMorgan was hampered by disruptions in communications and processing, and difficulties with reconciliation, JPMorgan was at all times fully operational and its government securities clearing activities for clients functioned normally throughout the emergency and in the days following.
- Need for Enhanced Contingency Planning. Since September 11, 2001, JPMorgan and other institutions in the securities clearance and settlement business have recognized the need to strengthen our contingency planning. We have devoted considerable time and resources to defining the lessons learned from our experience as well as that of other industry participants. The impact of the World Trade Center disaster on lower Manhattan has reinforced the importance of geographical dispersion of primary and back-up operations sites. Prior to September 11, our plan met all contingency requirements then in place because we had primary, independent systems operating on separate power and telephone grids. We now understand that greater separation of primary and back-up sites is necessary, since our operating sites prior to September 11, while fully compliant at the time, were not sufficiently separated when the entire area of lower Manhattan was closed. We have since taken a number of steps to improve our contingency plans, including the establishment of an additional operational site. Any of our operational, data or telecommunications sites is capable of supporting the functions of the others.
A final point on contingency planning is that the reliance upon physical operational sites is not as critical as the housing and protection of data. Key personnel are able to function from variable sites, including their homes. We believe the focus should be on maintaining data in a secure location where it will be accessible to clearing bank personnel from a range of locations. This further supports our view that the standardization and protection of data is more critical than operational facilities.
- A Proposal for Standardized Messaging. As became evident on September 11 and the days following, it is difficult if not impossible for one clearing bank to back up the other on short notice because of differences in technology used by the clearing banks and the inaccessibility of information related to securities and funds positions as between the banks. Solving this problem would contribute greatly to the ability of the current system to withstand shocks in an emergency and would, as noted above, provide multiple layers of backup.
We recommend that the industry immediately begin consideration of the adoption of compatible technology by clearing banks and the development of a real time repository for data from clearing banks. Successful completion of these initiatives would permit a clearing bank, an existing or newly created utility or the FRB to back up a clearing bank that was not able to operate from its primary or contingency sites. The data repository should be maintained by a third party not affiliated with the clearing banks. Terms for access to and use of the data repository should be agreed in advance to facilitate its use in emergency conditions. It will also be necessary to arrange in advance for financing that would replace the financing ordinarily provided by a clearing bank that is not able to operate. As a clearing bank, JPMorgan would welcome the opportunity to participate actively in this effort.
A longer term concern of the FRB and the SEC, and also clearly in the forefront of the broker dealers' and investors' concerns, is the way in which the industry would be capable of responding if one of the clearing banks were to exit the business. Conceivably, one of the banks might exit the clearance business either voluntarily or involuntarily, and the decision could be due to any of a number of factors: immediate financial vulnerability or longer-term strategic business decisions. Financial problems related or unrelated to clearing could cause a clearing bank to exit.
- Involuntary Exit. We believe that the likelihood of an involuntary exit from the clearance business is extremely remote in the case of JPMorgan. JPMorgan is the flagship bank of J.P. Morgan Chase & Co., one of the largest U.S. financial institutions with more than $42 billion in equity capital supporting its activities. JPMorgan itself is a financially sound, strongly capitalized institution. Risk-based capital guidelines of the FRB impose capital requirements on JPMorgan that are based on the credit risk and risk management profile of the bank, and JPMorgan's capital adequacy under these guidelines is strong. Nevertheless, were JPMorgan forced to exit the business, or were the other major clearing bank to do so, we believe that an enhanced contingency plan such as that proposed above would support continuity of the business at least for some period of time until alternatives could be evaluated and implemented, if necessary. In particular, we believe that systems and messaging standardization would provide a solid groundwork for numerous future alternatives.
- Voluntary Exit. JPMorgan Chase has made a significant investment in the clearance business and is committed to continue to build and maintain the business for our clients and to serve the government securities marketplace. Through our predecessor organizations, this business has evolved and prospered in JPMorgan since at least 1939. If our strategy were to otherwise change, (for instance, if we were to determine that it was no longer consistent with business and risk objectives), we can assure the FRB and the SEC that any decision to curtail or terminate our involvement in the clearance business would only be made after a thorough examination of its merits, our obligations to shareholders, and the impacts of such a change in strategy. Any such exit would be done in conjunction with regulatory consultation and an orderly transition. In the case of a voluntary exit as well as an involuntary exit, we believe the development of compatible technology for the delivery of settlement services would ease the exit process.
- Some Credit Matters. In responding to the White Paper, it is essential to address the potential for clearing and settlement to be unbundled from the credit that is vital to this business. The users of government securities settlement services today have the benefit of financing provided by the balance sheets of two major commercial banks. We do not think it would be a simple matter to replicate such financing under the Old Euroclear Model or the Private Limited-Purpose Bank discussed in the White Paper. While we acknowledge that financing could in concept be unbundled from clearance and could be provided by third parties not involved in clearance operations, it is doubtful as a practical and economic matter that this credit could be made available at the same cost and with the same efficiency as the clearance banks are able to offer. Further, lenders, in our experience, have not volunteered for this opportunity even under the most stable circumstances. There are reasons for this. With our integrated client relationships, we are able to furnish credit at better rates. We are able to implement triparty transactions with smaller cash movements than would be necessary in interbank transactions, and we are able to extend intraday credit against securities in transit, with only modest charges to broker dealers in the nature of standard clearance fees. Triparty repurchase services require significant investment and testing, involving a range of functions including price verification, collateral profile matching and auto-selection from a dealer's inventory. Because the clearing banks process the whole activity of a dealer customer, significant efficiencies are achieved by providing clearance and triparty services in one place. For these reasons, while other providers could enter the clearance and triparty business with the right economic investment, we think it would be impractical to unbundle these complementary activities and that to do so would be unattractive and uneconomical for clearing banks as well as for their dealer customers.
- Entrance of Other Providers. Support for the clearing bank structure is not intended to preclude or discourage the entrance of additional providers of credit, settlement or triparty services. Other than the economic investment that would be required, there are no barriers to other institutions entering this business. In fact, a standardization of data as proposed above would facilitate such entry since the information could be replicated by a new provider.
- The Role of the FRB. One alternative posed in the White Paper is that the FRB become the provider of depository and settlement services. The FRB has stated that it generally prefers private-sector solutions absent a market crisis. JPMorgan agrees that this activity should be retained in the private sector and that it is not necessary for the FRB to assume the role that the clearing banks currently fill. JPMorgan appreciates the need for regulatory involvement in the clearance system, but we do not believe it is either necessary or appropriate for the FRB to become a commercial participant. There is policy precedent for this. In connection with the enactment of the Monetary Control Act of 1980, there were clear policy statements by the FRB as to the importance of maintaining competition in the provision of financial services. In issuing guidelines for the introduction or enhancement of new services, the FRB stated, amongst other criteria, that a Federal Reserve Bank "must expect its provision of the service to yield a clear public benefit" and that "the service should be one that other providers alone cannot be expected to provide with reasonable effectiveness, scope and equity."3 The FRB has further observed that the government "should be prepared to remove itself from the provision of those services that can be supplied more efficiently by the private sector".4 We believe that clearance and settlement services are being adequately and efficiently provided by the clearing banks under the existing structure and we see no need for commercial participation in these services by the FRB at this time.
- Industry Oversight. As part of a continuing evaluation of strategies for the provision of clearance and settlement, the FRB and the SEC have asked what type of decisionmaking framework should be created, and which groups should be represented in that process. At this stage, we do not believe that the creation of a new advisory or oversight body is necessary. In our experience, including the most extreme market disruptions of September 11, the industry participants have functioned well under the guidance of industry associations and the regulators. JPMorgan has confidence in the efficacy of our regulators and other industry participants. Temporary disruptions are resolved through mutual cooperation because the participants are interdependent and have common interests. JPMorgan does not believe it is necessary or desirable to create new and redundant organizations, and we would be wary of supplanting already tried and established methods.
In conclusion, we believe that the existing private sector clearing banks should continue to provide settlement services for U.S. government securities transactions, with the possibility of the entrance of additional providers. We believe in the merit of private sector commercial operation that is able to provide for the industry's evolving needs, through multiple services integral to the financing, clearance and settlement of government securities. We believe this system is stronger and more resilient than a single utility is likely to be. We support enhanced contingency planning and testing. We support the regulatory agencies' coordination and oversight of this planning, testing and implementation of emergency plans in times of crisis. We support a degree of standardization that would enable clearing banks to substitute for each other in the event that clearance and settlement are either interrupted or terminated by one of the service providers. We believe it is in the best interest of the various market participants to build an environment that is capable of changing quickly in response to crisis, rather than disrupting the current structure by introducing new procedures that are neither urgent nor, ultimately, necessary. This will best put the market in a position of preparedness to adapt and respond to any number of situations, whether these are immediate crises or longer-term strategy changes.
We appreciate the opportunity to present our views and are committed to working with the FRB, the SEC and the industry to reinforce strengths of the existing structure and to bring about changes that will benefit the industry and its participants.
JPMORGAN CHASE BANK
||A repurchase agreement is a financing arrangement used primarily in the government securities market whereby a dealer or other holder of government securities sells the securities to an investor and agrees to repurchase them at an agreed future date at an agreed price. JPMorgan serves as a custodial agent for the dealer and the investor.|
||In a " bonds borrowed" transaction, a dealer with a clearance inventory can borrow securities from a lending client against securities in the dealer's account.|
||Board of Governors of the Federal Reserve System, "FRS Role in Nation's Payment Mechanism, Priced Services - Policies and Procedures", August 14, 1984, reprinted in CCH Fed. Banking L. Rep ¶19,467 (1984).|
||Board of Governors of the Federal Reserve System, "Federal Reserve System Guidelines for the Provision of Financial Services", Federal Reserve Regulatory Service, Locator Number 7-19 (June 1987), reprinted in CCH Fed. Banking L. Rep ¶19,462B (1987).|