Mutualized industrywide risk mitigation through the shared ownership of payment and settlement systems has long been a pillar of the global financial infrastructure. On any business day U.S. payment and settlement systems in the securities, futures, options, cash, and currency markets settle transactions valued at over $13 trillion.
What should be of great interest to those in the risk management profession is the benefit and the systemic risk all financial institutions share in using these systems, whether from failure of individual transactions, a member's inability to meet obligations to other members, or systemic vulnerabilities like systemwide outages.
Treasury Secretary Henry Paulson has put payment and settlement systems into the debate about our latest financial crisis by saying they generally are not subject to any standards or to any specifically designated regulatory system or governance structure. "Our current regulatory regime is almost solely focused above ground, at the tree level. The real threat to market stability is below ground, at the root level, where the health of financial firms is intertwined."
The vulnerability of this "intertwined" financial system had been a subject of much debate dating back to October 1987, when the U.S. market infrastructure suffered its first structural collapse.
In discussing the recent financial crisis and the reasons for bailing out Bear Stearns Cos., it was recognized that JPMorgan Chase & Co. was a member of all the world's payment and settlement systems and could step in rather seamlessly as the guarantor of Bear Stearns' obligations.
More complex examples of vulnerability abound.
The 1974 Herstaat Bank failure froze payments and prompted the Bank for International Settlements to establish what is known today as the Basel Committee to study systemic risk. The newly installed Nymex futures-clearing system failed and froze funds for two days in the 1990s. On Sept. 11, 2001, the government securities settlement system collapsed as a result of the destruction of Bank of New York's downtown New York facilities. In 2005 the paper backlog of unsettled transactions in the rapidly growing over-the-counter derivatives market nearly froze the collateralized debt and credit default swaps markets, where no organized payment and settlement system exists.
Mr. Paulson's recent "Blueprint for a Modernized Financial Regulatory Structure" addresses this most critical vulnerability by proposing a federal charter for systemically important payment and settlement systems. The proposal includes giving the Federal Reserve Board the primary authority to establish regulatory standards for these systems.
He further comments that such standards may be quite different than those for other types of financial services providers, because payment and settlement systems exist to provide services within short time frames and with minimal risk to the funds and instruments transferred. Thus, risk-based capital standards, currently the focus of the Basel II regime, may not provide the same degree of protection for payment and settlement systems as for traditional financial institutions.
At its heart, Basel II sets a risk-adjusted capital standard for financial institutions. Looking within the general structure of the broad categorization of risk, the "payment and settlement" business line is now categorized under "banking," to the exclusion of asset management, trading and sales, retail brokerage, and corporate finance.
This banking categorization suggests monetary settlements exclusively and should be reviewed with a view to being included as an all-inclusive loss event type under all the business lines. Doing so would assure the capturing of both physical assets and contract settlements in addition to traditional money settlements and help provide dimension to the impact of systemic payment and settlement risk.
Two recently formed entities — the Continuous Linked Settlement Bank, a foreign-exchange settlement system, and Omgeo, a post-trade matching service for securities transactions — operate as mutualized risk-sharing facilities within the global payment and settlement system.
In the OTC derivative market, the President's Working Group is proposing a mutualized risk-mitigating facility to act as a central counterparty to support the payment and settlement of derivative contracts. A proposed industry-owned utility for the matching, clearing, and settlement of standardized reference data would minimize operational risk of data failures for all who subscribe to its standardized services.
The Basel Committee has stated that financial institutions will be allowed to reduce capital for operational risk by as much as 20% through the use of risk mitigators. Currently the primary one is insurance. All the existing and proposed risk-sharing industry-owned payment and settlement systems should qualify its members to receive further relief under the stated Basel II criteria.
Reduced systemic risk within a seamless, real-time, centrally regulated payment and settlement system would be a just reward for the institutions that embrace more mutualized risk mitigation within the Basel II framework. In response, regulators should be willing to revisit Basel's 20% limit for the maximum reduction of capital for operational risk.
