5.2 Counterparties may also agree to a binding netting of their bilateral payment obligations. Two banks can recognise that they have various obligations to pay each other sums in a given currency on a single date, and enter into a formal agreement to accept a single net amount, to or from one another, in discharge of those payment obligations. This can be termed legally "binding payments netting". This type of netting does not directly effect a discharge of the underlying foreign exchange contracts or other obligations which have generated the payments being netted, and the parties remain obligated to settle the gross amounts of these obligations.

5.3 "Netting by novation" provides a means of reducing counterparty credit risk by effecting a discharge of each individual foreign exchange contract, or other obligation, as it is netted. (This can also be referred to as "obligation netting".) Two banks can enter into a formal agreement under which one running net amount will be due between them for each future value date in each currency they trade. This is achieved by netting the second, and each subsequent, deal with the first for that particular date and currency, and thereby effecting a new (novated) contract for the net amounts. This novation process may take place automatically within the trading day, on the exchange of confirmations between the two banks: the bilateral agreement can provide that, at the instant the confirmations are matched, the previous contracts shall have been satisfied by means of the novation process and are therefore extinguished and replaced by the novated contract. This process can be repeated an infinite number of times until the cut-off time for a particular settlement date. Then settlement instructions, for the final net amounts, are sent to the participants' correspondent banks in the countries of the currencies concerned.

5.4 Netting by novation aims to satisfy all the purposes described in Section 4 above: in particular, it aims to reduce liquidity risk, on both the counterparty and its correspondent bank, and to reduce counterparty credit risk from a gross to a net basis in respect of each separate forward date. The utility of netting by novation, in terms of reducing these risks, depends entirely on the legal enforceability of the novated net contract having superseded the original gross contracts so that they cannot be selectively revived by a receiver or liquidator of a counterparty that is closed.

5.5 A bilateral agreement for netting by novation can be drawn up so as to provide that the novated net amounts due on each separate forward date for each currency form a single stream of payments due under the master contract between the two banks. If such an agreement is upheld, any receiver or liquidator of one of those banks will be unable to be selective in terms of the currencies or the payments to be received or made on the individual forward dates.

5.6 Although netting by novation is, in essence, a bilateral mechanism, it can be operated on a multilateral basis within a larger group of banks, but in that case a third party may be employed - for instance, some form of clearing house - to undertake the novated net obligation as counterparty to each participating bank. This process is described as "novation and substitution".

5.7 "Netting by close-out" relates to the treatment of future obligations between two banks when a defined event of default, such as the appointment of a receiver or liquidator, occurs. Two banks can enter into a formal bilateral agreement stipulating that, if a close-out event occurs, the present value of all future amounts due between them will be calculated to provide amounts due that day, and then be recalculated into a base currency to produce one single payment due to or from the closed bank, which the receiver or liquidator is obliged to honour, so as to satisfy all the outstanding obligations between the two banks. ⁵ Close-out can apply either to gross liabilities and claims arising under the original contracts between the two banks, or to their novated net liabilities and claims, in the event that they both also participate in an agreement to net by novation. Close-out provisions can be found in both bilateral and multilateral netting arrangements.

5.8 Since netting by close-out only operates upon the occurrence of a defined event, it can have no impact upon the number of payment messages passing between the participating banks and their correspondents in their normal trading relationships. Equally, it has no impact on liquidity risk or credit risk in respect of the counterparty's correspondent bank for the currency in question; nor on any intra-day timing difficulties which might affect the normal settlement process.

5.9 In addition to netting under contractual arrangements, parties may enjoy legal rights of set-off vis-a-vis immediate counterparties to defined financial obligations. These rights come into play in calculating amounts due between parties in the event of default, typically including bankruptcy, and have the effect, if applicable, of netting amounts due on eligible obligations. The existence and enforceability of these rights, however, are subject to a significant degree of uncertainty, since they are typically determined under local law, through litigation, bankruptcy and other legal proceedings. In addition, the existence and scope of such rights will vary from country to country. Thus, although rights of set-off have the potential to reduce certain gross credit exposures between counterparties to net amounts, the dependence on such rights is likely to be subject to greater uncertainty, and therefore credit risk, than dependence on legally enforceable netting contracts.

Footnotes:

4. In addition to the legally distinct concepts involved in these various netting arrangements, their precise form will vary with the laws of the countries in which they are established.

5. It is the obligation to make this payment that, in essence, distinguishes a close-out agreement from the "single stream of payments" concept described in paragraph 5. 5.