1.1 The Group of Experts on Payment Systems of the central banks of the G-10 countries ("Payments Group") decided, in June 1988, to prepare a report on various kinds of international l y related financial netting schemes that have recently begun operations , or are being seriously proposed. The aim was to assess arrangements that might be used to net out amounts due between banks arising from foreign exchange contracts or from the exchange of payment instructions, on either a bilateral or a multilateral basis. It was perceived that these arrangements should be analysed with a view towards not only their contribution to the efficiency of financial markets and international payments systems, but also their effect on counterparty credit and liquidity risks. Systemic risks were of particular concern. To obtain information for this report, a Working Party discussed technical, legal and financial issues with a number of operators and promoters of interbank netting arrangements during the latter half of 1988. This report draws on those discussions, but does not refer specifically to any particular existing or proposed netting arrangement.
1.2 This report analyses netting arrangements from two distinct vantage points: first, as models of how credit and liquidity risks can be allocated in different netting and settlement structures, and, second, as examples of the difficult international financial policy issues raised by the development and operation of "cross-border" (or "offshore") payment systems and contract netting arrangements. The analytical body of the report focuses upon credit and liquidity risk issues. However, as noted in the "Summary and observations" section of the report and throughout, the operation of these arrangements in the cross-border context challenges certain critical assumptions which underlie current perceptions of the operation and supervision of international banking markets.
1.3 It should be noted at the outset of the report that a distinction is usually drawn between netting arrangements for obligations, such as foreign exchange contracts, and those for payment instructions. For many purposes the rights granted under foreign exchange contracts differ in nature from those conferred by payment instructions. Moreover, a "spot" foreign exchange contract may have a value date one or two days hence, while a payment instruction may be for "same-day" value when it is created. Nevertheless, for the purposes of this report, a foreign exchange contract and a payment instruction share the characteristic that both can be subject to the same types of netting techniques. The report relies on this fact in its analysis of risks in institutional forms of netting.
1.4 It should also be noted that a multilateral foreign exchange netting arrangement, which would typically comprise participants from a number of countries, could in principle be used as a payment system. Thus concerns about payment systems may, in certain circumstances, extend directly to foreign exchange netting arrangements.
1.5 This report is in seven sections. Following this introduction, Section 2 draws out some key observations by the Payments Group, some of which point to issues beyond the scope of the report. Section 3 analyses the types of financial risk to which participants in clearing systems are exposed, while Section 4 describes the reasons why banks may enter into netting arrangements and why a range of suppliers may offer such facilities. Section 5 contains a brief analysis of the legal basis for netting. Section 6 then discusses four particular institutional types of netting arrangement and analyses their different risk characteristics. Finally, Section 7 presents a global perspective of the nature of the liquidity risks facing participants in these netting schemes. An annex contains a glossary of certain terms used in the report: it is intended to bring an element of consistency into a field in which terminological inconsistencies have hitherto caused undue confusion.
