May 2000 Updates
When trading partners agree to offset their positions or obligations, they are netting. By doing so, they reduce a large number of individual positions or obligations to a smaller number of positions or obligations, and it is on this netted position that the two trading partners settle their outstanding obligations. Besides reducing transaction costs and communication expenses, netting is important because it reduces credit and liquidity risks, and ultimately systemic risk.
Netting takes several forms. There is netting by novation, which means that an existing obligation is discharged by replacing it with a new obligation. When two parties agree to obligation netting, they are legally bound to net amounts from two or more trades due in the same currency for settlement on the same day. Under an obligation netting agreement for foreign exchange transactions, counterparties are required to settle on due date all of the trades included under the agreement by either making or receiving a single payment in each of the relevant currencies. This reduces the amount at risk by lowering the number and size of payments that would otherwise be needed to settle the underlying transactions on a trade-by-trade basis. Close-out netting is an arrangement to settle all contracted but not yet due liabilities to and claims on an institution by one single payment, immediately upon the occurrence of one of a list of defined events, such as the appointment of a liquidator to that institution. If such an event does not happen, then each trade is settled individually on due date unless the counterparties also have a supplementary obligation netting agreement. Close-out netting does not, by itself, reduce routine foreign exchange settlement exposures.
Although netting is regarded as a tool to reduce credit risk, it carries with it some legal risk. This is because netting may not be legally enforceable in all the countries in which a financial institution operates and each type of netting has varying degrees of enforceability in the event of default.
The Angell "Report on Netting Schemes" (1989)is a primer on netting. It presented an analysis of the credit and liquidity risks experienced by participants in bilateral and multilateral netting arrangements for both interbank payment orders and forward-value contracts such as foreign exchange trades. The Report also looked at the effects of netting on the integrity of interbank settlement arrangements, the conduct of monetary policy, the complications posed for the allocation of supervisory responsibilities, and the effective oversight of cross-border netting schemes.
In 1990, the Bank for International Settlements issued minimum standards for the design and operation of netting schemes. (They are now known as the Lamfalussy standards after the chairman of the Committee that wrote the report, Mr Alexandre Lamfalussy.) The six standards are:
- Netting schemes should have a well-founded legal basis under all relevant jurisdictions.
- Netting scheme participants should have a clear understanding of the impact of the particular scheme on each of the financial risks affected by the netting process.
- Multilateral netting systems should have clearly defined procedures for the management of credit risks and liquidity risks that specify the respective responsibilities of the netting provider and the participants. These procedures should also ensure that all parties have both the incentives and the capabilities to manage and contain each of the risks they bear and that limits are placed on the maximum level of credit exposure that can be produced by each participant.
- Multilateral netting systems should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single net-debit position.
- Multilateral netting systems should have objective and publicly-disclosed criteria for admission which permit fair and open access.
- All netting schemes should ensure the operational reliability of technical systems and the availability of back-up facilities capable of completing daily processing requirements.
The explanations for these standards are contained in the "Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries" (1990). The document also analyses the impact of netting on credit, liquidity and systemic risk and sets out the principles for central bank oversight of cross-border and multi-currency netting and settlement schemes.
"Core Principles for Systemically Important Payment Systems (1999)" puts forward 10 principles. These extend the Lamfalussy Standards and apply more broadly to systematically important payment systems of all types rather than just foreign exchange. For example, the Committee on Payment and Settlement Systems advocates that "a system in which multilateral netting takes place should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the single largest settlement obligation." The CPSS also calls for clearly defined procedures for credit and liquidity risks management with the system operator's responsibilities in this area clearly spelt out.
The report also discusses the responsibilities of central banks in applying these core principles - here, it also picks up where the Lamfalussy report left off by adding to the principles of cooperative central bank oversight contained in the Lamfalussy report and by extending them to domestic systems. The report outlines four responsibilities of central banks in this context.
The near failure of the Long-Term Capital Management Fund brought to the fore the need for improvements in the close-out netting regimes for certain financial contracts. The President’s Working Group on Financial Markets report on "Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management" (1999) calls for improvement in the US Bankruptcy Code regarding netting. It calls for an expansion and clarification of the definitions of the financial contracts eligible for netting. It also wants the Code to explicitly allow eligible counterparties to net across different types of contracts, such as swaps, security contracts, repos and forward contracts. The United Nations Commission on International Trade Law model statute should be codified so as to establish clear conventions to differentiate between a ‘main’ insolvency proceeding and a ‘non-main’ proceeding for debtors located in more than one jurisdiction. These provisions would make it more likely that the jurisdiction of a main insolvency proceeding of an offshore fund would be determined by the principal place of business of the entity rather than the jurisdiction where the entity happens to be incorporated.
Netting has resulted in more favourable capital treatment for credit risks. Because netting reduces a bank's gross current exposure by 50% on average, the Basle Committee on Banking Supervision decided to allow banks to calculate credit risk capital on the netted amount for off-balance sheet positions. In April 1995, the Basle Committee released a new add-on formula that recognises the risk reduction effects of netting. The formula is as follows:
Add-on formula = (0.4 x notional x BIS%) + (0.6 x notional x BIS% x NGR)
where BIS% is the proposed percentage factor for the contract type and remaining maturity, and NGR is the current netted market or replacement value divided by current grossed market or replacement value. The formula is fully explained in "The Treatment of Potential Exposure for Off-Balance Sheet Items (1995)". The report also contains all the BIS percentage factors for different types of assets and maturity.
An attempt to take into account the effects of multilateral netting was made in April 1996. "Interpretation of the Capital Accord for Multilateral Netting of Forward Value Foreign Exchange Transactions" contains the Basle Committee's approach. It suggested that a participant's capital requirement for current credit exposure was the sum of the participant's pro rata share of the clearing house exposure it would be required to absorb from a default by every other participant, individually, in the clearing system. For future exposure, the Basle Committee proposed using the 'add-on' formulas mentioned above.
In a Consultative paper on on-balance sheet netting (1998), the Basle Committee proposes to extend netting to on-balance sheet items, such as deposits and loans. It proposes to accept novation as a means of reducing gross exposures to a single net amount, provided the following conditions are met:
- The reporting bank has a well-founded legal basis for concluding the netting or offsetting and the agreement is enforceable in each relevant jurisdiction.
- The maturity of the deposit is at least as long as the corresponding loan
- The positions are denominated in the same currency
- The reporting bank monitors and controls the relevant exposures on a net basis.
When a large financial firm becomes insolvent, it can cause widespread disruption and could trigger a systemic crisis. How international insolvencies should be managed is important to those who are directly involved in such cases such as lawyers and judges, but its systemic risk implications make it a central concern for policy makers and regulators.
Insolvency law generally reflects two basic premises - how to maximise the value of the insolvent firm and how to allocate appropriately the insolvent firm's assets between those affected by the insolvency. The way in which these basic premises are reflected in national legislation and public policy can vary substantially. In some jurisdictions, the main priority may be to protect the investor, in others the integrity and efficiency of markets is paramount so the insolvency procedures may be geared towards ensuring the smooth operation of settlement and payment systems. Ensuring that netting arrangements are enforceable when a firm becomes insolvent is an important element in insolvency laws under both priorities.
Most regulatory reports on insolvency have focussed on measures to limit disruption after an insolvency begins rather than on what might reduce the chances of an insolvency in the first place. A report by the IOSCO Technical committee on "Client Asset Protection (1996)" outlines the techniques, which can be used to protect clients' assets if a firm becomes insolvent. Three types of techniques together with their advantages and drawbacks are presented.
The first basic technique seeks to ensure that client assets are treated in a more favourable way than the other obligations of a firm. Client assets can be accorded preferential status over other creditor claims at little or no additional costs to the firm. Such a technique however only works if there is no shortfall in net assets and if the client does not have to wait until the administration of the insolvency to clear before receiving his money. Another method of protecting client assets in the event of insolvency is to separate the control of assets from beneficial ownership. In some jurisdictions, client assets must be held 'in trust' for clients and are not available to meet the claims of the firm's creditors.
The main methods of compensating clients of insolvent firms for losses include establishing schemes to compensate clients for losses arising from misappropriation of assets by the firm, and a mandatory requirement for firms to obtain private insurance against the risk of loss of, or shortfall in, client assets. An important advantage of compensation schemes and insurance is that their operation is separate from the insolvent firm and their costs are spread over a wide number of market participants. The drawback is that they usually cover only up to a specified amount.
Customers themselves can implement measures to minimise their exposure to authorised firms. They can enter into an arrangement to collateralise a cash balance, or establish accounts in their own name at banks or custodians while permitting the investment firm to exercise control over those accounts. Such private arrangements allow the client to customise his protection to meet his specific needs. The drawbacks include the high costs and time needed to negotiate such contracts that will also be costly to enforce.
The Basle Committee used the liquidation of Bank of Credit and Commerce International to illustrate some of the issues arising from an insolvency of a multinational bank. The study group which wrote "The Insolvency Liquidation of a Multinational Bank"(1992) noted a number of areas in which uncertainty and a potential for conflict could arise because there is no internationally-agreed procedures for the liquidation of a multinational bank. The main concerns noted are: (a) bank supervisors should pay attention to the nature and timing of communications among themselves and of their communications with creditors, shareholders and management; (b) the nature of liquidation rules may be relevant to the manner in which multinational banks are supervised; (c) differences in liquidation rules across jurisdictions in a winding-up can affect returns to depositors and other creditors and the operations of deposit protection schemes; (d) co-ordination and co-operation between liquidators can affect the returns to creditors in a liquidation and can be affected by the role of supervisors in a liquidation.
While recognising that the decision to close a multinational bank rests with the bank's home-country supervisor, the report suggests co-ordinated action with other supervisors to achieve certain objectives, such as ensuring that some creditors do not benefit at the expense of others prior to the commencement of the liquidation. The study group also noted that differences between liquidation regimes could have implications on how multinational banks are supervised. The liquidation of BCCI had many complexities and uncertainties due to the interaction of different liquidation regimes and other relevant laws. The BCCI case confirmed that effective consolidated supervision performed by home-country supervisors remains paramount in protecting depositors and other creditors. Further, these complexities and uncertainties reinforce the need for host-country supervisors to be satisfied that banks seeking to enter their markets are supervised by home-country authorities that perform consolidated supervision, which is consistent with BIS standards.
The differences in the insolvency set-off regimes of various countries (some permit set-off and others do not; some treat a multinational bank as a single legal entity while others regard a branch of a multinational bank as a separate legal identity) are exacerbated by the fact that there appears to be no clear, generally accepted principles of private international law. Moreover, there is no international convention regarding cross-border insolvency which provides for set-offs in one jurisdiction to be recognised overseas or which specifies the system of law governing the parties' rights. Differences in set-off affect the structure of deposit protection schemes. For example, it may be appropriate for deposit protection schemes to pay deposit protection on a gross basis in jurisdictions, which do not permit insolvency set-off, and on a net basis in places which do. Another issue is whether the deposit protection scheme, in making protection payments, should take into account any right of set-off a depositor might have in another jurisdiction.
The different features of the deposit protection schemes in member countries of the Basle Committee on Banking Supervision are described in a 1997 document, "Deposit Protection Schemes in the G-10 countries". Several European schemes are under review to bring them in line with the May 1994 European Union's Directive on deposit guarantee schemes. The main changes brought about by this Directive are a standardisation of the minimum amount of protection (i.e. ECU 20,000) and a requirement for deposits with branches (but not subsidiaries) of EU banks to be covered by the home country scheme. Consequently, branches of EU banks will normally be exempted from host-country arrangements, though supplementary cover may be available if the guarantee in the home country provides less cover. Conversely, for competitive reasons, protection by the home country scheme is limited to the ceiling of the host country scheme if the former provides more cover.
See also overviews on settlement risk, credit risk and market integrity
- Report on Netting Schemes" (1989)
- Report of the Committee on Interbank Netting Schemes of the
- Central Banks of the Group of Ten Countries" (1990)
- The Treatment of Potential Exposure for Off-Balance Sheet Items (1995)
- Interpretation of the Capital Accord for Multilateral Netting of Forward Value Foreign Exchange Transactions Client Asset Protection (1996)
- The Insolvency Liquidation of a Multinational Bank (1992)
- Deposit Protection Schemes in the G-10 countries (1997)
- Consultative paper on on-balance sheet netting (1998)
May 2000 Updates