This document presents the Basle Committee's interpretation of the Capital Accord for a bank that participates in a multilateral netting arrangement for foreign exchange contracts. Consistent with the framework of the Capital Accord, the interpretation focuses only on forward replacement risk, the potential cost of replacing the cash flows on outstanding contracts in the case of counterparty default, and not on settlement risk.

The Basle Capital Accord sets forth capital requirements for banks' off-balance-sheet activities (forwards, swaps, purchased options and similar derivative contracts). The Accord was recently amended to recognise the benefits of legally enforceable bilateral netting agreements for capital purposes, both for the calculation of a bank's current exposure and its potential future exposure. Off-balance-sheet contracts traded on exchanges are excluded from the framework of the Accord, provided that they are subject to daily receipt and payment of cash variation margin.

In recent years, there have been industry initiatives to extend the benefits of netting beyond bilateral netting to multilateral netting, covering contracts which originate within a group of counterparties. This is achieved in practice by netting through a central clearing house all transactions that originate bilaterally between the participating counterparties. The legal techniques for achieving this netting may vary, but the result is that for every eligible transaction agreed by a pair of participants, the clearing house would be interposed as the contractual legal counterparty to each participant.

Unlike the existing exchanges that are exempt from the capital requirements of the Accord, the emerging multilateral netting systems addressed here do not provide for daily receipt and payment of cash variation margin. As a result, the exposure of a participant to the multilateral netting arrangement can build up over time. In the event of a default by one or more of the clearing house participants, the surviving participants could face significant losses (the case where the defaulting member fully collateralises the exposure it presents to the clearing house is discussed in Section IV. below).

Given this difference to the exchanges that qualify for an exemption under the Capital Accord, there is a need for near-term guidance as to how a bank participating in a multilateral netting arrangement for forward value contracts should apply the risk-based capital framework. The approach outlined in this document provides a relatively simple interpretation of the existing Capital Accord for establishing the capital requirement in relation to the risk faced by a participant in such a multilateral netting arrangement. Over the longer-term, a more comprehensive review of the risks inherent in multilateral netting systems and other types of exchanges and clearing houses could lead to a formal amendment of the Capital Accord.

As background, the following section discusses the treatment of off-balance-sheet contracts under the Accord, including recent amendments to recognise bilateral netting in the calculation of both current and potential future credit exposure. Section II. presents the Committee's interpretation of the Capital Accord for banks that participate in multilateral netting systems for foreign exchange contracts. Section III. discusses the risk-weighting of a participant's credit exposure. Section IV. addresses the treatment of collateral in the multilateral netting environment. Section V. discusses the potential risk arising from the simultaneous default of two or more participants of the multilateral netting system. The final section considers the risk of a default by the clearing house itself.