The Board of the Governors of the Federal Reserve System (the Federal Reserve Board) published new rules in the Federal Register on March 15, 2024, that will require certain financial market utilities (FMUs) to maintain contingent management and operational plans for tail-end risk scenarios, including a “severe weather event or other natural disaster that causes significant damage to a designated FMU’s production site and disrupts core payment, clearing, or settlement processes.”^[1] The amendments update and refine operational risk management requirements in Regulation HH, which applies to FMUs designated as systemically important to the stability of the U.S. financial system by the Financial Stability Oversight Council (FSOC) pursuant to Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act).^[2] The amendments were initially proposed in 2022 in response to emergent threats in the risk “landscape” in which systemically-important FMUs operate, including threats arising from global climate change.^[3]

 

Section 803(6) of the Dodd-Frank Act defines an FMU as an entity that “manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions and the person,” and the Financial Stability Oversight Council (“FSOC”) has the authority to designate certain FMUs as systemically important to allow the Federal Reserve Board to mitigate risks in the financial system through an enhanced supervisory framework for designated FMUs.^[4] Failure or a disruption of an FMU could create a significant risk of liquidity shortfalls among financial institutions or markets and thereby threaten the stability of the financial system, and to date only two FMUs have been brought under the supervision of the Federal Reserve Board through FSOC designation: (i) The Clearing House Payments Company, L.L.C., on the basis of its role as operator of the Clearing House Interbank Payments System (CHIPS) and CLS Bank International (CLS).^[5]

 

CHIPS utilizes complex netting algorithms to settle large-volume payments between major U.S. financial institutions, sometimes to the tune of $1.5 trillion per day.^[6] CLS Bank CLS is a special purpose bank chartered by the Federal Reserve that settles payment obligations that arise from foreign exchange (FX) transactions, with an average total trading volume that also approaches $1.5 trillion per day.^[7] Pursuant to section 805(a)(1)(A) of the Dodd-Frank Act, the Federal Reserve Board is required to prescribe risk-management standards governing the operational framework of designated FMUs.^[8] These standards are promulgated by the Board through formal administrative rule-making and codified in Title 12 Section 234 of the U.S. Code of Federal Regulations (12 CFR § 234), also known as Regulation HH.^[9]

 

Regulation HH was adopted in July 2012 to implement, among other legislative priorities, the statutory provisions of section 805(a)(1)(A) and was last updated in November 2014 to incorporate risk-management standards from the Principles for Financial Market Infrastructures (PFMI), a set of prudential standards issued by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) that act as the international benchmark for regulation and supervision of systemically-important payment systems.^[10] Fundamentally, the PFMI standards recognize that market forces alone cannot achieve public policy objectives of safety and efficiency in the global financial system because FMUs, their operators, and their participants do not necessarily bear all the risks and costs associated with an FMU’s core functionalities, nor can the institutional structure and operational design of an FMU sufficiently internalize incentives to enhance safety and efficiency.^[11] Regulation HH imposes regulatory requirements on FMUs that enhance these incentives for the purpose of mitigating externalities that manifest as existential risks to the financial system.

 

In October 2022, the Federal Reserve Board published a notice of proposed rulemaking to update, refine, and add specificity to operational risk management requirements in Regulation HH to respond to changes in the technological and regulatory landscape in which designated FMUs have operated in the decade since Regulation HH was last amended.^[12] Nearly two years after the public comment period for the proposed amendments to Regulation HH closed in December 2022, the Federal Reserve Board adopted final amendments to Regulation HH on March 15, 2024.^[13] Alongside technical or clarifying revisions throughout 12 CFR § 234, the amendments to Regulation HH focus on four critical aspects of operational risk management: (i) review and testing; (ii) incident management and notification; (iii) business continuity management and planning; and (iv) third-party risk management.

 

Notably, several provisions in the finalized amendments emphasize the threat of unanticipated weather events to systemically-important FMUs, which have become more relevant in the evolving risk “landscape” in which FMUs operate as global climate change has accelerated the severity and frequency of these events in recent years.^[14] For example, designated FMUs will be required under the amendments to maintain data center arrangements with multiple production sites, rather than a typical arrangement where one site is considered “primary” and another site is treated as a “backup” site.^[15] Instead, an FMU will be required  to maintain a minimum of two locations that are sufficiently geographically distant from each other to have distinct “risk profiles,” which include susceptibility to “the same severe weather event.”^[16] Additionally, designated FMUs must update their incident management and notification protocols to take into account the risk of severe weather events.^[17] Maintaining multiple data centers and updating incident management and reporting protocols are costly requirements for the Federal Reserve Board to impose on utilities like CHIPS and CLS, especially considering how these systems operate primarily for the purpose of increasing settlement efficiency and speed.^[18] The responsibility of the Federal Reserve Board, however, is to safeguard the stability of the financial system, which occasionally requires implementing regulations that internalize certain costs to ensure that FMUs are operated safely.

 

While the final amendments to Regulation HH do not explicitly mention climate change, their emphasis on internalizing the risk of severe weather events implicitly recognizes the myriad of existential threats that have been accelerated by climate change in recent years. Wildfires burned more than 4 million acres in California in 2020, and the 2018 Camp Fire was the single most destructive wildfire in the state’s history.^[19] In September 2022, Hurricane Fiona caused catastrophic damage in Florida and Puerto Rico that left the majority of Puerto Rican residents without access to electricity or clean drinking water.^[20] The Atlantic coast and the Gulf of Mexico are simultaneously experiencing some of the highest rates of sea level rise in the world, which, combined with record rainfall, has the potential to cause catastrophic flooding.^[21] Each of these changes to patterns of severe weather has been directly attributed through scientific research to the accelerating effects of climate change.^[22] Recognizing the existential threat that these changes pose to critical infrastructure, including financial market infrastructure, is critical to ensuring that the effects of climate change do not cause unanticipated but cascading damage to the financial system. As the Federal Reserve Board implements and enforces its recent amendments to Regulation HH, it should fully consider climate change as an existential threat and ensure that critical financial market infrastructure is sufficiently prepared and protected.

^[1] “Financial Market Utilities,” The Board of Governors of the Federal Reserve, 89 FR 18749 at 18757 (Mar. 15, 2024), https://www.federalregister.gov/documents/2024/03/15/2024-05322/financial-market-utilities#h-39.

^[2] Id. at 18749-50.

^[3] Id.

^[4] 12 U.S.C. 5462(9).

^[5] The Board of Governors of the Federal Reserve System, Designated Financial Market Utilities (Jan. 29, 2015), https://www.federalreserve.gov/paymentsystems/designated_fmu_about.htm.

^[6] Adam Hayes, What Is the Clearing House Interbank Payments System (CHIPS)?, Investopedia (Feb. 24, 2024), https://www.investopedia.com/terms/clearing-house-interbank-payments-system-chips.asp#:~:text=CHIPS%20acts%20as%20a%20netting,CHIPS%20nets%20and%20releases%20payments.

^[7] Keith Tippell, CLS FX trading activity January 2022, CLS (Feb. 16, 2022), https://www.cls-group.com/news/cls-fx-trading-activity-january-2022/.

^[8]  12 U.S.C. 5464(a)(1).

^[9] 89 FR 18749 at 18749-50. See also 12 CFR § 234.

^[10] Id. at 18751.

^[11] Committee on Payment and Settlement Systems, Principles for financial market infrastructure (April 2012), https://www.bis.org/cpmi/publ/d101a.pdf.

^[12] “Financial Market Utilities, The Board of Governors of the Federal Reserve System, 87 FR 60314 (Oct. 5, 2022), https://www.federalregister.gov/documents/2022/10/05/2022-21222/financial-market-utilities.

^[13] 89 FR 18749.

^[14] Id. (although the final rule does not explicitly mention climate change as the originator of these emergent risks).

^[15] Id. at 18757.

^[16] Id.

^[17] Id.

^[18] About CHIPS, The Clearing House, https://www.theclearinghouse.org/payment-systems/CHIPS#:~:text=CHIPS%20is%20the%20largest%20private,liquidity%20savings%20mechanism%20available%20today, (noting the purpose of CHIPS to provide “fast and final payments and the most efficient liquidity savings mechanism available today”).

^[19] See How Climate Change Is Fueling Extreme Weather, Earthjustice (July 19, 2023), https://earthjustice.org/feature/how-climate-change-is-fueling-extreme-weatherhttps://earthjustice.org/feature/how-climate-change-is-fueling-extreme-weather. See also, Sarah Ravani and Lauren Hernandez, California wildfire: What we know about the Camp Fire, San Francisco Chronicle (Nov. 18, 2018), https://www.sfchronicle.com/california-wildfires/article/California-wildfire-What-we-know-about-the-13377845.php.

^[20] Supra n. 19, Earthjustice.

^[21] Id.

^[22] Id.