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Statements to the Congress.

I am pleased to be here today to discuss the provisions of H.R.6, the Financial Institutions Safety and Consumer Choice Act of 1991, concerning Payment System Risk Reduction. Subtitle A of title VI of H.R.6 contains provisions designed to confirm the validity of contractual agreements providing for the netting of payment obligations between and among financial institutions, including depository institutions, securities brokers or dealers, and futures commission merchants.

The Board strongly supports these provisions as an important step in reducing systemic risk in the U.S. financial system and maintaining the competitiveness of U.S. financial institutions and markets. We understand, however, that the committee is concerned that these provisions may conflict with provisions of the Commodity Exchange Act and rules promulgated thereunder as well as provisions of the Bankruptcy Code. The Board believes that the purpose of these netting provisions is consistent with the purposes of the Commodity Exchange Act and would support amendments to H.R.6 designed to clarify the relationship between the netting provisions, the provisions of the Commodity Exchange Act, and other federal laws.

On every business day, financial institutions engage in transactions with one another that involve trillions of dollars. These transactions involve normal day-to-day payments between commercial businesses as well as foreign exchange, securities, and commodities transactions. The certainty of settlement of payments associated with these transactions is critical to the efficiency of the U.S. economy and to the role of the dollar as an international trade currency. The failure of a major financial institution could call into question the status of billions of dollars of these transactions and jeopardize the soundness of its financial institution counterparties, thereby creating systemic risks for the financial system.

To limit these risks, many financial institutions enter into netting contracts under which the payment obligations between two parties, or among several parties, are netted so that each party to the netting contract is required or entitled to make or to receive only a single payment that is the net of all of that party's transactions. Thus, in a bilateral netting contract-that is, a netting contract involving only two parties-one party makes a single, net payment to the other party. In a multilateral netting contract-that is, a netting contract involving several parties-each party in a net debtor position makes a single payment, and each party in a net creditor position receives a single payment. Because individual net payments are far smaller than the gross value of the payment obligations to be settled between and among the parties, the effect of the failure of one of the parties in a net debtor position to settle its payment obligation is far smaller than the effect of unwinding all of the underlying transactions. Further, the amount of any failed net payment can often be covered by margin or other collateral requirements, or by coinsurance or other arrangements to ensure that underlying transactions are settled with the minimum of systemic risk to the financial markets. The value of netting in reducing systemic risk was recognized in 1990 in a Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries.

The operations of the New York Clearing House Interbank Payments System, also known as CHIPS, demonstrates the ability of netting to reduce systemic risk. Each day CHIPS participants exchange payments totaling, on average, about $870 billion. However, the net payments made at the end of the day to settle these transactions total, on average, only about $6.7 billion, with the single largest debtor making a payment of less than $1.9 billion. To limit systemic risk further, CHIPS has instituted arrangements under which the single largest debtor's position is covered by a collateralized coinsurance system based on the participants' dealings with the failed participant. Under this arrangement, CHIPS participants can be assured that the system would settle in the event of the failure of a large participant and that individual transactions processed through the system would not have to be unwound. Other payment or clearing systems have similar netting and settlement arrangements. Critical to these systems is the ability to net their participants' positions on either a bilateral or a multilateral basis.

The ability to reduce the systemic risk to financial markets by netting is important not only to the safety and soundness of U.S. financial institutions but also to the competitiveness of U.S. financial markets with foreign financial markets. Investors will be attracted to financial markets in which they can be certain their transactions will be subject to prompt final settlement.

We believe that under the laws of the United States and the various states there is a fairly high degree of certainty that netting contracts would be enforced. Nonetheless, the slightest doubt as to the validity of carefully drawn netting contracts presents unacceptable levels of systemic risk due to the enormous volume of dollar transactions that are settled each day.

The provisions of subtitle A of title VI of H.R.6 are designed to remove any such doubts by providing that, as a matter of federal law, netting provisions of contracts between and among depository institutions, securities brokers and dealers, futures commission merchants, and commodities and securities clearing organizations are valid and binding on the parties. These provisions would provide certainty that the netting provisions would be enforced, even in the event of the bankruptcy of one of the parties.

We do not believe that these provisions were intended to validate contracts that are otherwise invalid because they violate provisions of federal law. Nevertheless, the Board understands that the committee has expressed concern that the netting provisions of H.R.6 would override provisions of the commodities, securities, or banking laws. For example, under federal commodities and securities laws, certain rules of clearing organizations or contract markets are not considered to be valid unless they have received required regulatory approvals. We believe that the netting provisions of H.R.6 were not intended to validate such contracts.

Similar concerns were raised concerning the Senate version of this legislation. In response to these concerns, the Senate version was revised to include provisions clarifying that this legislation does not validate netting contracts prohibited by or requiring agency approval prior to becoming effective under relevant federal law. The Board supported these clarifications and supports the addition of similar clarifying provisions to title VI, subtitle A of H.R.6.
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Title Annotation:statement by Oliver Ireland
Publication:Federal Reserve Bulletin
Article Type:Transcript
Date:Nov 1, 1991
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