This section presents the Committee's interpretation of the existing Capital Accord for a bank participating in a multilateral netting system for forward value contracts. The Committee's approach builds upon the belief that a well constructed multilateral netting system can reduce forward credit exposure for its participants. It also assumes that the multilateral system has received approval from the relevant authority responsible for its oversight, and that it therefore satisfies certain standards concerning, at a minimum, the legal soundness of the netting arrangement, the sound design and operation of the system, the sufficiency of liquidity arrangements, and the mechanisms for managing collateral. These standards are defined primarily by the legal and payment systems experts of the host authorities together with the authorities responsible for the supervision of the participants in the netting arrangements.

(1) Current exposure

While each contract in the multilateral netting arrangement shows the clearing house and one of the participants as the legal counterparties, this does not mean that the forward credit risk of a participant should be measured in terms of its net bilateral claim on the clearing house. The primary risk of loss for a participant arises from the possibility of another participant's default, not from a default by the clearing house itself (the risk of default by the clearing house itself is considered in Section VI. below). Depending on the structure of the clearing system, participants may be responsible for satisfying claims of other participants in the event a participant defaults, according to the system's pre-established loss-allocation rules. The clearing house would, on a daily basis, determine the loss it would incur if a participant failed, allocate that loss among the surviving participants according to the pre-established loss-allocation formula, and notify each participant of its exposure vis-a-vis every other participant in the system (referred to as the primary loss allocation).

Consequently, a participant's capital requirement for current credit exposure is best determined on the basis of the primary loss allocations of the clearing house (that is, the participant's pro rata share of the clearing house exposure). Since a defaulter cannot be identified in advance, a participant's total net current exposure is the sum of the primary loss allocations it could be required to absorb from a default by every other participant, individually, in the clearing system. The following example shows how the current exposure amount based on primary loss allocations could be determined for a simple clearing house structure (other types of loss allocation rules are also possible).

Table 1 shows that participant B owes the clearing house the net amount of $250. If participant B were to default, the clearing house would experience a loss of $250. The clearing house would allocate this loss to survivors C and D since they have bilateral net claims on participant B in the amounts of $100 and $400, respectively. C and D's total bilateral claims amount to $500, of which C is owed 20% and D 80%.

Thus, as indicated in Table 2, C's primary loss allocation vis-a-vis B would be $50 (20% of 250) and D's primary loss allocation would be $200 (80% of 250). The sum of the primary loss allocations for participant A, and thus its current credit exposure, would be zero. Similarly, the current credit exposure would be 200 for participant B, 150 for participant C, and 200 for participant D.

This example also illustrates that current exposure can be understated significantly when it is based on the net bilateral exposure of a participant vis-a-vis the clearing house. Table 1 shows that participant D's net bilateral exposure to the clearing house is zero (market value is -100) but its loss allocation exposure, and therefore real credit risk, is 200 (Table 2).

(2) Potential future exposure

The capital charge for the potential future exposure of a bank participating in a multilateral netting arrangement for forward value contracts would continue to be calculated on the basis of the notional bilateral relationships with each of the other clearing house participants. That is, the add-on under multilateral netting would be calculated as if netting occurred bilaterally with the same set of counterparties, applying the bilateral netting formula:

The Anets with respect to each of the bilateral counterparties of the reporting bank would be summed to arrive at the total add-on for potential future exposure for the reporting bank. Consequently, a participant and/or the clearing house would have to keep track of its gross potential future exposure, gross current exposure, and bilaterally netted current exposure to each of the other participants in the multilateral system.

The approach taken by the Committee is relatively conservative and pragmatic, reflecting the difficulties of approximating a multilateral netting participant's potential future exposure. In contrast to bilateral netting, where potential future exposure is a function of the volatility of the contracts between two counterparties, a multilateral netting participant's potential exposure can depend on the transactions across all participants of the clearing house, as well as on the arrangements for sharing losses should a participant default. The Committee would welcome empirical or theoretical analysis by the industry on the volatility of current exposure under multilateral netting as compared with the volatility of current exposure under bilateral netting for the same set of contracts and counterparties (whereby the multilaterally netted current exposure of a participant is defined as the sum of the primary loss allocation amounts).

The Committee has considered the question of whether to allow a multilateral netting clearing house to use its own simulations as a basis for setting the capital requirement for potential future exposure. It concluded that this issue requires further study. Moreover, it is of the view that the question of whether to allow simulations also extends to the non-netting and bilateral netting environment and therefore needs to be considered in a broader context.