4.1 Banks and others enter into netting arrangements in respect of their obligations to pay and receive sums of foreign currencies for at least four separate purposes. The first is to reduce the number of payment messages that have to be exchanged between the counterparties and their correspondent banks in the country of each relevant currency. This lowers message transmission costs, and possibly handling costs, as well as the chance of mistakes by correspondents. It also provides a simple audit and reconciliation trail.
4.2 The second purpose is to reduce both counterparty credit risk and liquidity risk. This can be done by entering into formal agreements resembling, in many respects, a legal "right of set-off" between a banker's liabilities to his counterparty and his claims on that counterparty. A legally enforceable netting scheme will reduce a bank's credit risk on its unsettled foreign currency transactions from a gross amount to a net amount, on either a day-by-day basis or the basis of the total position, depending on the form of netting adopted.
4.3 The third purpose is to reduce the need for intra-day liquidity or credit used to bridge timing gaps between gross payments and gross receipts. The need for such intra-day liquidity can be particularly acute if payments must be sent and received over interbank systems that employ or are subject to binding credit or intra-day overdraft constraints. Netting can also reduce the need to hold liquid clearing balances, on an overnight basis, with foreign correspondents, or at the central bank of the currency in question.
4.4 The final purpose for which a netting scheme might be entered into relates to the implementation of the Basle Capital Agreement. By effecting a binding reduction in its on or off-balance- sheet assets and/or liabilities, through netting or otherwise, a bank may be able to minimise the amount of free capital required to be allocated to that segment of its business.
4.5 These various demands for netting schemes are being met by an increasing supply. Advances in information technology have made it feasible for interbank networks, computer and telecommunication companies and other suppliers to offer netting facilities on a competitive commercial basis. Automated handling of payment messages, reliable processing systems and timely communications all contribute to a situation where substantial operational benefits can be offered by the suppliers, quite apart from any reductions in credit risk or liquidity risk that can also be obtained.
