On July 27, 2011 the Financial Stability Oversight Council (“FSOC”) issued a final rule (the “Final Rule”) implementing section 804 of the Dodd Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), which provides the FSOC with the power to designate a financial market utility (“FMU”) as systemically important. Section 804 specifically permits such a designation if “the failure of or a disruption to the functioning of the FMU could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the United States financial system.” The Final Rule discusses the criteria, process, and procedures for the designation of FMUs as systemically important.
According to the Final Rule, “FMUs form a critical part of the nation’s financial infrastructure” and exist in many markets to support, facilitate, transfer, clear, and settle financial transactions. The role of FMUs is critical to the proper functioning of financial markets, but their function and interconnectedness may create systemic risks. Section 804(a)(1) of the Dodd-Frank Act states that the FSOC “on a nondelegable basis and by a vote of not fewer than 2⁄3 of the members then serving, including an affirmative vote by the [Treasury Secretary], shall designate those financial market utilities or payment, clearing, or settlement activities that the [FSOC] determines are, or are likely to become, systemically important.” In general, the definition of FMU is “any person that manages or operates a multilateral system for the purposes of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person.” The designation of a FMU as systemically important subjects the FMU to additional risk management standards, capital, margin, and collateral requirements, examination and enforcement actions, and other prudential measures, all at the discretion of regulators.
The Final Rule mandates a two-stage process for evaluating the systemic importance of an FMU prior to a vote of proposed designation by the FSOC. The first stage would largely consist of a data-driven process, whereby the FSOC would identify a preliminary set of FMUs which may be systemically important. In the second stage, the FMUs identified through the first stage would be subject to a more in-depth review, which will focus on qualitative factors as well as institutional and market specific considerations. FMUs which reach the second stage are permitted to submit written materials to the FSOC in support of or in opposition to their potential designation upon the receipt of notification from the FSOC of their consideration for designation. The first stage of FSOC review utilizes the following considerations and subcategories:
- Consideration (A): Aggregate Monetary Value of Transactions Processed by an FMU
- Subcategory (A)(1): Number of transactions processed, cleared or settled by the FMU
- Subcategory (A)(2): Value of transactions processed, cleared or settled, by the FMU
- Subcategory (A)(3): Value of other financial flows that may flow through an FMU
- Consideration (B): Aggregate Exposure of an FMU to Its Counterparties
- Subcategory (B)(1): Credit exposures to counterparties
- Subcategory (B)(2): Liquidity exposures to counterparties
- Consideration (C): Relationship, Interdependencies, or Other Interactions of an FMU With Other FMUs or Payment, Clearing or Settlement Activities
- Consideration (D): Effect That the Failure of or Disruption to an FMU Would Have on Critical Markets, Financial Institutions or the Broader Financial System
- Subcategory (D)(1): Role of an FMU in the market served
- Subcategory (D)(2): Availability of substitutes
- Consideration (E): Any Other Factors That the FSOC Deems Appropriate
During the second stage of review, the FSOC will analyze each FMU which passed first-stage consideration using qualitative and quantitative factors and will consider the relationship between the considerations above to reach a conclusion regarding whether a FMU meets the Dodd-Frank Act basis for systemic risk designation. During the second stage of review, the two critical determinations for designation are:
(1) Whether the failure of or a disruption to the functioning of the FMU now or in the future could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets; and
(2) Whether the spread of such liquidity or credit problems among financial institutions or markets could threaten the stability of the financial system of the United States.
In addition to delineating the analysis used by the FSOC to designate FMUs as systemically important, the Final Rule discusses the definitions of key terms used as part of this rulemaking, confidentiality issues related to notices by the FSOC, extensions of time periods, and the waiver or modification of notice and hearing requirements under this rulemaking for emergency situations.
The full text of the Final Rule is available here.
The Working Group will continue to monitor any developments and provide timely coverage at Weil’s Financial Regulatory Reform Center. If you are interested in discussing the Final Rule, please contact Working Group members Derrick D. Cephas (212-310-8797 or firstname.lastname@example.org), Heath Tarbert (202-682-7177) (email@example.com), or Alex Radetsky (212-310-8905 or firstname.lastname@example.org).