9-1001

RISKS IN PAYMENT, CLEARING, SETTLEMENT, AND RECORDING SYSTEMS

The basic risks in payment, clearing, settlement, and recording systems may include credit risk, liquidity risk, operational risk, and legal risk. In the context of this policy, these risks are defined as follows:⁶

Credit risk: The risk that a counterparty, whether a participant or other entity, will be unable to meet fully its financial obligations when due, or at any time in the future.
Liquidity risk: The risk that a counterparty, whether a participant or other entity, will be unable to meet fully its financial obligations when due, although it may be able to do so in the future. An FMI, through its design or operation, may bear or generate liquidity risk in one or more currencies in its payment or settlement process.⁷ In this context, liquidity risk may arise between or among the system operator and the participants in the FMI, the system operator and other entities (such as settlement banks, nostro agents, or liquidity providers), the participants in the FMI and other entities, or two or more participants in the FMI.
Operational risk: The risk that deficiencies in information systems or internal processes, human errors, management failures, or disruptions from external events will result in the reduction, deterioration, or breakdown of services provided by the FMI.⁸
Legal risk: The risk of loss from the unexpected or uncertain application of a law or regulation.

These risks also arise between financial institutions as they clear, settle, and record payments and other financial transactions and must be managed by institutions, both individually and collectively.⁹

Further, FMIs may increase, shift, concentrate, or otherwise transform risks in unanticipated ways. FMIs, for example, may pose systemic risk to the financial system because the inability of one or more of its participants to perform as expected may cause other participants to be unable to meet their obligations when due. The failure of one or more of an FMI’s participants to settle their payments or other financial transactions as expected, in turn, could create credit or liquidity problems for participants and their customers, the system operator, other financial institutions, and the financial markets the FMI serves. Thus, such a failure might lead ultimately to a disruption in the financial markets more broadly and undermine public confidence in the nation’s financial system.

Mitigating the risks that arise in FMIs is especially important because of the interdependencies such systems inherently create among financial institutions. In many cases, interdependencies are a normal part of an FMI’s structure or operations. Although they can facilitate the safety and efficiency of the FMI’s payment, clearing, settlement, or recording processes, interdependencies can also present an important source or transmission channel of systemic risk. Disruptions can originate from any of the interdependent entities, including the system operator, the participants in the FMI, and other systems, and can spread quickly and widely across markets if the risks that arise among these parties are not adequately measured, monitored, and managed. For example, interdependencies often create complex and time-sensitive transaction and payment flows that, in combination with an FMI’s design, can lead to significant demands for intraday credit or liquidity, on either a regular or an extraordinary basis.

The Board recognizes that the Reserve Banks, as settlement institutions, have an important role in providing intraday balances and credit to foster the smooth operation and timely completion of money settlement processes among financial institutions and between financial institutions and FMIs. To the extent that the Reserve Banks are the source of intraday credit, they may face a risk of loss if such intraday credit is not repaid as planned. In addition, measures taken by Reserve Banks to limit their intraday credit exposures may shift some or all of the associated risks to financial institutions and FMIs.

In addition, mitigating the risks that arise in certain FMIs is critical to the areas of monetary policy and banking supervision. The effective implementation of monetary policy, for example, depends on both the orderly settlement of open market operations and the efficient movement of funds throughout the financial system via the financial markets and the FMIs that support those markets. Likewise, supervisory objectives regarding the safety and soundness of financial institutions must take into account the risks FMIs, both in the United States and abroad, pose to financial institutions that participate directly or indirectly in, or provide settlement, custody, or credit services to, such systems.

⁶

The definitions of credit risk, liquidity risk, operational risk, and legal risk are consistent with those presented in the PFMI.

⁷

Deliveries of currency are payments, and FMIs that conduct such activity should consider these deliveries to be payments in the management of liquidity risk.

⁸

Operational risk also includes physical threats, such as natural disasters and terrorist attacks, and information security threats, such as cyberattacks. Further, deficiencies in information systems or internal processes include errors or delays in processing, system outages, insufficient capacity, fraud, data loss, and leakage.

⁹

Several existing regulatory and bank supervision guidelines and policies also are directed at financial institutions’ management of the risks posed by interbank payment and settlement activity. For example, the Board’s Regulation F (12 CFR part 206) directs insured depository institutions to established policies and procedures to avoid excessive exposures to any other depository institution, including exposures that may be generated through the clearing and settlement of payments.