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Banking Interpretations

August 22, 1997

Dear                   :

This is in response to your letter regarding the effect of certain provisions of the New York Banking Law on a plan by the to establish a bank (“    Bank”) to provide a continuous linked settlement system to reduce foreign exchange settlement risk and increase efficiency of the settlement of foreign exchange transactions.

From your letter and subsequent conversations with your colleague, I understand that the Bank would work as follows.  The Bank would, through the use of central bank funds, provide its members with a structure whereby at the time of settlement of a foreign exchange transaction, a member’s payment would be irrevocably exchanged for the correct amount of currency, through the posting of debits and credits to the member’s account on the books of the Bank, or if the settlement could not occur, the principal paid out by the member will be returned.  Your letter stated that the only transactions that would be handled by the Bank would be foreign exchange transactions which would be characterized as “qualified financial contracts” (“QFC’s”) for purposes of section 618-a of the New York Banking Law.

Bank members would establish accounts at the     Bank and at the central bank of the member’s home country.  The member’s account at the     Bank would have sub-accounts devoted to each different currency in which the member expects to trade.  At the time that a foreign exchange transaction has been agreed to between two members, both parties would send messages to their respective central banks, requesting that the central bank debit their accounts with the central banks and credit their accounts at the  Bank.[1]  The Bank then would provide the appropriate debits and credits to the members’ accounts: (1) on a transaction by transaction basis; (2) on netted transactions between the same two parties pursuant to a master agreement between the two parties; and (3) on multilateral settlements via or once a final net amount is reached.  The Bank will settle only between two members, not across various members.

During the business day, the member banks will fund their accounts as needed in order to avoid the     Bank maintaining credit balances at the end of the day.  A schedule will be developed so that members will know at what time during the day each currency settlement will take place.   If there is not enough of one currency available in the member’s account to enable the Bank to settle a transaction denominated in that currency, then the Bank will convert other currencies in the member’s subaccounts to settle the outstanding transaction. 

Each member also will post certain collateral that can be reached by the Bank should it be needed to settle a transaction.  The collateral will be both cash and non-cash, the latter government securities meeting certain eligibility criteria to be established by the Bank.  The Bank will appoint one or more collateral agents to act as holders of the collateral and the securities collateral will be provided in such a way that the     Bank will be able to rehypothecate the securities to banks that will act as liquidity backups (“liquidity banks”) in the event that the     Bank needs to access funds under facilities set up by the liquidity banks in order to settle transactions if a member fails to fund its short position.  If a member cannot fund its account in time to settle a transaction, and the member’s other subaccounts are insufficient to meet the funding need, the Bank will pledge that member’s collateral to the liquidity bank to obtain funds to settle the trade and the member will replenish its account the next day, with an added fee for not funding its account in time.  If the member continues to be unable to settle a trade, the collateral that the member had pledged is debited and used to settle the trade.  If the collateral is insufficient or otherwise cannot be used, the Bank will use the collateral of the other members to settle and those members then would have a claim against the member that failed to settle, or that member’s collateral.  The     system will be run along risk models that will not permit a member to maintain an overdraft nor have insufficient collateral to satisfy claims on it for settlement filed either by the Bank or by a member whose own collateral was tapped to settle a transaction that the other member could not fund in time.

In order for the Bank system to run efficiently, you state that it is critical that the Bank be able to quickly liquidate collateral and settle transactions in the event that a member defaults on its obligations, particularly in the event of a liquidation.  Thus, you request confirmation that the settlement transactions will be considered qualified financial contracts (“QFC’s”) within section 618-a of the New York Banking Law and thus in the event of a default of a member that is a New York State-licensed branch or agency of a foreign bank (“New York branch or agency”),[2] the     Bank would be able to retain and immediately apply the collateral according to the provisions of section 618-a without the effect of the automatic stay provisions of section 619(1)(d) of the Banking Law.

The term “qualified financial contract” is defined in section 618-a(2)(d) in part as follows:

any securities contract, commodity contract, forward contract (including spot and forward foreign exchange), repurchase agreement, swap agreement, and any similar agreement, any option to enter into any such agreement, including any combination of the foregoing, and any master agreement for such agreements (such master agreement, together with all supplements thereto, shall be treated as one qualified financial contract), provided that such contract, option or agreement, or combination of contracts, options or agreements is reflected in the books, accounts and records of the banking organization or a party provides documentary evidence of such agreement.

In the situation you posit in your letter, the contract entered into is a contract between the     Bank and each member, related to a settlement of a foreign exchange transaction entered into between two members.  Each member collateralizes its obligation to provide settlement funds to the     Bank by pledging both cash and non-cash collateral.

For purposes of this letter, it is assumed that the arrangements between the Bank and the member are reflected in the books, records and accounts of the member and that all amounts pledged are properly perfected security interests or valid liens enforceable against third parties.  It also is assumed that the original foreign exchange transactions between the two members fall within the definition of a “qualified financial contract” in section 618-a.

There appear to be three QFC’s in your scenario.  The first QFC is a foreign exchange transaction between the two members.  The other two QFC’s are between each member and the     Bank.  Thus, a foreign exchange transaction, which is a QFC, has had the settlement portion of the transaction severed from the agreement to enter into the foreign exchange arrangement in order to provide for more certainty that the two parties actually will be able to settle the foreign exchange transaction that they have negotiated. 

It would seem reasonable to conclude that if a qualified financial contract is essentially split into two, each of those parts should be able to be viewed as a QFC.  Or, in addition, the settlement transaction between the     Bank and its member could be seen as a “similar agreement” and also, under that theory, could be viewed as a separate QFC. 

Once it has been established that the transactions are QFC’s, the next issue is the applicability of the automatic stay provisions to the retention and use of the defaulting member’s collateral. Section 618-a(2)(d) states, in relevant part, that “[a] party to a [QFC] with the branch or agency of the foreign banking corporation, which party has a perfected security interest in collateral, or other valid lien or security interest in collateral enforceable against third parties pursuant to a security arrangement related to such [QFC], may retain all such collateral and upon repudiation or termination of that qualified financial contract in accordance with its terms, apply such collateral in satisfaction of any claims secured by the collateral” up to the amount of the member’s global net payment obligation. The term “party” should be read broadly to achieve its intended purpose to allow collateral pledged in connection with QFC’s with the New York branch or agency to be available to satisfy the claims of QFC creditors.  While the     Bank may not be a party to the initial transaction between the two members, it does become a party to two separate QFC’s, and related security arrangements, arising out of the initial transaction between the two members.

As you know, while acknowledging that section 618-a must be read broadly in connection with achieving its stated purpose, at the same time, the Department is mindful also of its need for certainty in determining the obligations of a New York branch or agency in the event of a liquidation and what assets will be available to satisfy those obligations. To that end, section 618-a(2)(e) requires that all QFC’s, together with related security arrangements, be reflected on the books and records of the banking organization.  The Department must be assured that the books and records of the banking organization regarding its obligations arising under the QFC are clear.

Taking all of the above into account, after review of your letter and the analysis contained therein, and the subsequent discussions regarding your letter, we concur in your opinion that under the facts presented, the settlement transactions between the Bank and its members are QFC’s within the definition of that term in section 618-a. The severing of the settlement function of a QFC from the remainder of the transaction, in the manner described in your letter, does not render the function performed by the Bank any less a QFC than if the counterparties settled the QFC directly between themselves. 

However, it should be noted that in order for the Bank to retain and liquidate the collateral pledged to it by the member, section 618-a requires that the New York branch or agency be a participant in the transactions, because only a party to a QFC with a New York branch or agency of a foreign bank may retain and apply the collateral free of the automatic stay imposed under section 619 of the Banking Law.  See Banking Law, § 618-a(2)(d).  Therefore, the master agreement between the     Bank and its member should make sure that the New York branch or agency will be a participant in the settlement arrangement.  It is not necessary that at the time that the Superintendent takes possession of the New York branch or agency of a member that the branch or agency have an open settlement transaction with the     Bank, but it is necessary that the New York branch or agency be considered a participant in the overall agreement between the Bank and the member.

Please note carefully that this opinion is limited to the facts as you described them in your letter and also is dependent upon the fact that the security arrangement is entered into and may be used solely with respect to the QFC’s described in your letter, i.e., foreign exchange transactions.  If those facts change, then so might this opinion.

I trust that this letter is helpful.  If you have any questions, please advise.

Very truly yours,

Kathleen A. Scott
Assistant Counsel

[1] If a member bank wishes to have currency other than its home country currency sent to its account at the     Bank, it will have funds transferred from an account it maintains at a bank in the country of the currency to be paid, which correspondent bank then has its account at the central bank of that country debited, with the funds sent to the     Bank for the benefit of the member’s account.  It is hoped that eventually banks will be able to maintain accounts at central banks other than their home countries’ central banks.

[2] This letter deals only with the situation where the member maintains a New York State-licensed agency or uninsured branch.  A New York State-chartered insured bank, and a New York State-licensed insured branch of a foreign bank, would be liquidated by the Federal Deposit Insurance Corporation according to the Federal Deposit Insurance Act; if the foreign bank that maintains a New York State-licensed agency or uninsured branch also maintains a federally licensed branch or agency in the United States, then the Office of the Comptroller of the Currency would conduct a consolidated nationwide liquidation pursuant to the provisions of the National Bank Act. See 12 U.S.C. § 3102(j).  There are several types of uninsured state-chartered banks in New York, but it is assumed that these institutions will not be members of the Bank.

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