multilateral netting arrangements in operation for over-the-counter derivatives transactions. The issues raised in the Lamfalussy Report continue to be the important issues surrounding potential multilateral netting arrangements.

Netting on a multilateral basis is an extension of bilateral netting. Multilateral netting is achieved arithmetically by taking the sum of each participant´s bilateral net positions with each of the other participants. This sum is called the "net-net" position and represents the participant´s net position with the system as a whole. When the netting is conducted through a central entity which is legally substituted for the original counterparty to each derivatives transaction, the net-net position will constitute a bilateral net position between each participant and the central counterparty. The sum of the net-credit and net-debit bilateral positions with the central counterparty is always zero.

Multilateral netting arrangements could be constructed on a "centralized" or "decentralized" approach to credit losses. In a centralized approach, the central counterparty assumes all credit risks and the responsibility for managing those risks. In such arrangements, the central counterparty usually requires participants to post collateral to fully secure any exposure. The ability of the system as a whole to withstand the default of individual participants, or other adverse developments, depends entirely on the risk management procedures of the central counterparty and its capacity to absorb financial losses.

In decentralized multilateral netting arrangements, the participants would retain significant responsibilities and incentives for credit risk management. Specifically, in the event of a participant´s default, credit losses would be allocated on a pro-rata basis among the surviving participants based on their bilateral exposures to the defaulter. The viability of this system depends on the ability of the participants to manage and satisfy their "contingent liabilities" under the loss-sharing formula. Collateral requirements could be used to secure these contingent liabilities.

Multilateral netting arrangements could provide three primary benefits. First, other things being equal, multilateral netting could incrementally reduce credit risk in the system beyond the reduction that could be obtained by bilateral netting. Second, multilateral netting could provide efficiencies by releasing capital currently used to support derivatives transactions and by generating savings in the settlement and risk management processes. Third, multilateral netting may serve to broaden the access to the derivatives market to include weaker credits and smaller participants on a collateralized basis. Such arrangements could be particularly useful for transactions among derivatives dealers and for participants willing to collateralize exposures.

Multilateral netting arrangements also have the potential to produce some systemic risks. The Lamfalussy Report discussed two such risks. First, multilateral netting arrangements have the potential to concentrate risk by funneling transactions through a central counterparty, thereby making the system vulnerable to the central counterparty´s (or central counterparties´ in a risk-sharing arrangement) ability to manage risk and absorb losses. Second, the existence of a multilateral netting arrangement could actually increase, rather than reduce, credit risk if it induced participants to expand their derivatives activities or if it weakened their incentive for bilateral credit discipline.