6.2 An additional arrangement, which could be called "no netting", provides a benchmark against which to assess credit and liquidity risks of the various netting systems. In the case of no netting, it is assumed that gross obligations remain outstanding until they are due and discharged by settlement. The same assumption is made with respect to both foreign exchange obligations and payments ⁶

6.3 Various informal foreign exchange netting arrangements have traditionally been employed in certain financial centres. These arrangements, which have usually resulted from efforts to reduce the numbers of payments to be made between counterparties, have included bilateral position netting. For example, on the value date of a group of foreign exchange contracts, pairs of counterparty banks may calculate net amounts due to each other, and settle the contracts bilaterally with payments for net amounts. The legal implications of these arrangements, however, have typically been unclear, so there is considerable uncertainty about legal liability to pay gross or net amounts in the event of a counterparty experiencing financial difficulties. A widely held assumption is that parties remain responsible for gross amounts in the event of such difficulties.

6.4 Position netting can provide economic efficiencies relative to arrangements involving no netting for pairs of counterparties that exchange sizable numbers of obligations, including payments. Settling net positions clearly reduces the number of settlement payments to be made between counterparties, and thus may reduce costs if the price of the netting service does not overwhelm savings from reduced numbers of payments. There may be other efficiencies. For example, reduced numbers of payments, reductions in errors, and stricter adherence to settlement deadlines may all produce savings by reducing the need to maintain costly balances, or obtain credit, to meet settlement obligations.

6.5 In theory, credit risks are unchanged by position netting relative to the case of no netting since the gross obligations underlying the netted amount are not extinguished. Any netting of gross obligations under local laws of set-off would seem to be equally applicable to the cases of no netting and position netting, although no legal analysis has been seen to this effect.

6.6 n practice, there is a danger that netted amounts will be treated as if they represented the actual credit exposure between pairs of counterparties for the purposes of establishing dealing and other credit lines. If this is done, counterparties run the risk of having very large gross exposures, even though net exposures appear to be within prudent bounds. Credit risk for the financial system as a whole could also increase as a consequence.

6.7 Under normal conditions liquidity risk is clearly reduced for counterparties through position netting. This is because the netting calculation allows settlement payments due from a counterparty to be used to offset, or settle, payments due to the counterparty. This contrasts with the case of no netting in which individual settlement payments must be exchanged for a large number of gross obligations, and various kinds of delays and disruptions in making any of the settlement payments can adversely affect the liquidity position of a counterparty. Moreover, the interruption of these planned settlement payments can affect directly the liquidity position of correspondent banks, and indirectly the position of third parties. It must be emphasised that these liquidity risks are usually managed adequately in the money and credit markets, although at a price to those involved that may make netting financially attractive.

6.8 Services offering bilateral netting by novation may be limited to the provision of model netting contracts, or may also provide communications links and accounting facilities that allow participants to match and confirm transactions and to record novated net amounts.

6.9 Arrangements employing bilateral netting by novation appear to offer similar efficiencies to bilateral position netting, although the costs of developing and negotiating the netting arrangements are not inconsiderable. Beyond these narrow efficiencies, arrangements for bilateral netting by novation can provide significant reductions in credit risk compared with position netting or no netting. Credit exposure may be reduced from a gross to a net amount. Future amounts due from a counterparty in a variety of currencies may be reduced to a "single stream of net payments" in one currency, or in some cases, as in those triggering close-out provisions, to a single net amount due in one currency. (The "single stream of payments" and close-out concepts are discussed briefly in paragraphs 5.5 and 5.7 above.)⁷ The accomplishment of this reduction in exposure, however, depends entirely on the legal enforceability of the novated net contract as having superseded the original gross contracts so that they cannot be selectively revived by a receiver of a closed counterparty. Netting by novation also generally reduces liquidity risk, compared with bilateral position netting, since net amounts due cannot be "unwound" into individual obligations on a gross basis.

6.10 Vendor-provided proprietary communications systems or networks can be used to facilitate netting between subscribers to the network. A number of large correspondent banks maintain their own networks and offer services to their bank customers. There are also important co-operative and non-bank-run systems for international interbank communications. These networks could easily offer to tabulate gross and net amounts due between pairs of subscribers, for relevant currencies and value dates, with this information being provided to the subscribers so as to facilitate reconciliations and bilateral net settlements; these facilities could also be supplied on a multilateral basis.

6.11 These networks may not themselves formalise any netting arrangements. They may, however, offer participants a strong operational and commercial incentive to adopt bilateral position netting, possibly without a full understanding of the underlying issues, as discussed in paragraphs 6.3 to 6.7 above.

6.12 Another form of netting is that for multilateral position netting. This is typically found in a multilateral system, with special communications and accounting arrangements. "Clearing accounts" may be provided to participants by a clearing or settlement agent, who may hold balances for or provide credit to the participants, in order to facilitate settlements. The employment of a single central clearing account is also a logical possibility, as are other arrangements for accommodating settlements. The essence of multilateral netting is that net amounts due to or due from each participant vis-à-vis the clearing group as a whole, for value on a given day, are calculated and then settled by transfers of monetary balances from net debtors to net creditors. However, as in the bilateral case, the settlement liability of participants is not limited to net amounts when the group undertakes multilateral position netting.

6.13 If insoluble settlement difficulties arise because a net debtor bank cannot fund its outpayments, the rules of the system often require or permit the "unwinding" of payments to and from the participant(s) having difficulties, in order to arrive at multilateral net positions for the remaining participants that can ultimately be settled on the working day follow in g the originally scheduled settlement. It is because of this possibility of "unwinding" that such a system has typically to be considered an arrangement for multilateral position netting. Moreover, in such circumstances, the status of gross payment instructions and net positions under various relevant national laws is not entirely clear.

6.14 In the abstract case of multilateral position netting, all gross financial obligations (such as foreign exchange contracts) or payment instructions remain outstanding until settlement is final. The calculation of multilateral positions serves only to advise participants of what is due from or due to the clearing group as a whole. From one perspective, the credit risk in multilateral position netting is the same as in the case of no netting, since all gross obligations remain outstanding. From another perspective, however, there are strong operational and commercial pressures for participants in such multilateral systems to begin to act as if their bilateral net positions, or even their multilateral net positions, were the measure of their credit exposure even though this would not be the case. Such unfounded reliance has the potential to increase the true credit risk borne by an individual participant, as well as the credit risks borne by others in the payment system and in the financial markets generally, and therefore may increase systemic risk.

6.15 Liquidity risk is an especially difficult problem in multilateral position netting systems. The manner of calculating each participant's multilateral net settlement obligation shows why this is so. The basic calculation for a given participant starts with the bilateral net amounts due to or due from each other participant. These bilateral positions, positive or negative, are then netted to produce a single multilateral net amount due to or due from the group. If one participant is unable to settle its position, these systems typically provide for the recalculation of multilateral positions, through an unwinding of payments or obligations. When this is done, bilateral "net credits" due from a defaulting participant to others are no longer available to offset bilateral "net debit" positions in the multilateral netting. Those who were due funds on net from a defaulting participant are likely to find that their multilateral net settlement obligation, and thus their need for liquid funds, has increased dramatically. This in turn may seriously affect the financial position of these participants. Thus the liquidity risks for participants in multilateral position netting systems can be significant in the event of defaults.

6.16 More general liquidity problems may also arise, most likely as a result of operational difficulties. For example, the institution which acts as the "settlement agent" for a multilateral position netting system may be unwilling or unable to initiate the daily settlement payments to the net creditor participants until it has received all the amounts due from the net debtor participants. Any delay in effecting payment by a single net debtor could lead to problems for all net creditors, possibly affecting their settlements due in other markets or systems.

6.17 Systemic liquidity risk can be particularly significant in the event of defaults. As noted above, after the recalculation of multilateral net positions, each (remaining) participant may owe more or receive less. Participants in the payment or netting system that have not even dealt with a defaulting participant may have an increase in liquidity needs if participants with whom they have dealt face liquidity strains as a result of a settlement failure. Moreover, with certain clearing arrangements there are potential cross-market liquidity effects. Either greater payments or smaller receipts resulting from a recalculated settlement can absorb liquid funds needed for settlements in other currencies or markets in the same time zone, or possibly in later time zones. All of these types of effects give rise to concerns about economic "externalities" in multilateral systems, that is, effects on "third parties", within or without multilateral arrangements, that may have their financial position unexpectedly altered by a default even though they have had only limited dealings, or indeed no dealings at all, with a defaulting institution.

6.18 An example of multilateral netting by novation and substitution would, for the purpose of discussion, be provided by a hypothetical foreign exchange clearing house or clearing corporation. National clearing houses might be established that would permit participants to achieve a legally effective multilateral netting of all their foreign exchange contracts with other participants. For a contract submitted by a pair of participants, the clearing house would be substituted as the counterparty to each, and the obligations between the participants would be discharged. Further, the clearing house would maintain a running novated net position for relevant currencies and value dates vis-a-vis each participant. This process would result, for a given set of contracts to be netted, in a pattern of net amounts due to the clearing house from each participant, or vice versa, that are equivalent to the multilateral net position of each participant vis-a-vis the netting group as a whole.

6.19 The clearing house, as a central counterparty, would explicitly take both credit and liquidity risk. At the same time, members would have counterparty credit and liquidity risk with respect to the clearing house, not to their trade counterparties. Thus the clearing house would have to manage its credit exposure to each participating counterparty as well as liquidity risks associated with settlements. To facilitate risk management, the obligations of individual participants might be collateralised, so that the clearing house might be able to reject contracts submitted for netting if insufficient collateral had been posted. Margin calls could also be a possibility. The size of collateral requirements and the basis for their calculation across currencies, the sharing of risks in the event defaults exceed posted collateral, and the eligibility criteria for collateral would all need to be worked out. The procedures for multi-currency settlements would also require careful attention.

6.20 The key to reductions in credit risks in clearing house arrangements, relative to arrangements with no netting or with bilateral netting by novation, would be the set of agreements covering the multilateral netting by novation and substitution. If these agreements were invalid, then resulting credit risks could be even larger than in cases of no netting, since participants might not know, and might thus be unable to control, their ultimate exposures.

6.21 Assuming the legal enforceability of the multilateral arrangements, there could be reductions in credit risk compared to a system of bilateral netting by novation. The reduction in risk for an individual participant would occur because the multilateral netting would allow bilateral net debit positions, vis-a-vis others, to offset bilateral net credit positions in the same currency, thus reducing net credit exposure. However, for participants without any bilateral net debit positions, credit exposure would be unchanged by the cross-participant netting.

6.22 One of the troubling aspects of clearing house arrangements would be any reliance on collateral to secure net amounts due. The taking of large amounts of high-quality collateral, for example, could reduce the risks of settlement failures to negligible levels, and thus similarly reduce the riskiness of settlement claims on a clearing house. For financial market participants as a whole, however, credit risk would not necessarily be reduced beyond the level implied by the multilateral netting of obligations. Furthermore, reductions in the riskiness of claims on a clearing house could come at the expense of the unsecured creditors of participants. By posting a proportion of its high-quality assets as collateral for clearing house debts, the assets available to a participating bank's unsecured creditors, including its depositors, in the event of its insolvency could be reduced. In ideal circumstances these creditors would react by raising the cost of credit to a participant in order to compensate for any implied increase in risk. However, it is not clear that such market mechanisms would work adequately, particularly if the amounts of collateral posted were not disclosed to creditors; and in any case it could be harder for participants to assess the creditworthiness of the clearing house than that of their individual counterparties in the markets.

6.23 The effect of multilateral netting by novation and substitution on liquidity risk is ambiguous relative to the case of bilateral netting by novation. The net amounts due on a given value date are reduced, or at most unchanged for some participants, relative to the bilateral netting case. This reduces liquidity risk for individual participants, for the clearing group as a whole, and probably for financial markets generally. On the other hand, clearing house arrangements require a centralisation of settlement payments: all settlement payments are between the clearing house and individual participants. In this case the inability of one participant to settle a position can create shortfalls of cash in one or more currencies that are needed for settlement. The liquidity risk to other participants from such events, even assuming no ultimate credit risks exist, then depends on the ability of the clearing house to raise the cash needed to complete settlements. ⁸ Thus the multilateral character of a clearing house would provide no assurance that liquidity risks will be less than in the case of bilateral netting by novation. It is conceivable that liquidity risks could actually be greater. Similar conclusions hold with respect to systemic liquidity risk.

6.24 The membership and capital structure of a clearing house would also raise important risk issues. Once a multilateral clearing house had been established, there could be important incentives to expand membership in order to realise greater economies in netting and to lower average unit transaction costs. Increasing membership, however, could lower the average creditworthiness of participants. This, in turn, could affect the credit standing and liquidity of the clearing house and also the quality of any loss-sharing arrangements among participants. Such developments might lead naturally to the consideration by the clearing house of special risk control mechanisms, in addition to the posting of collateral.

6.25 The amount of capital a clearing house would need to support its obligations is a difficult question, particularly if significant amounts of collateral were pledged to it. This is particularly relevant to the need to mobilise liquidity through its own resources, in order to complete the daily settlement. Because of its role as counterparty to all transactions, the creditworthiness and overall financial strength of a clearing house would have to be high before its use by banks would make sense as a replacement for existing interbank counterparty exposures.

6.26 The more general concern raised by clearing house mechanisms relates to the nature of the clearing house itself. As a financial institution, it would have claims on and liabilities to its participants, but it might perhaps not be a bank, under the laws of its country of incorporation. Indeed, in some countries it might not need to be subject to any form of authorisation or regulation, although its prudent and efficient operation would be crucial to the integrity of the foreign exchange (and possibly other) markets, while in other countries it could be subject to two or more regulators working according to different rules and objectives.

6.27 It may be convenient to conclude the discussion of the various netting arrangements by summarising their respective risk aspects, while always assuming their legal enforceability. They are compared with the benchmark "no netting" case. For obligations clearing systems (e.g. foreign exchange contract netting) the case of no netting refers to the situation in which gross obligations remain outstanding until they are due and discharged by settlement. For payment systems the case of no netting refers to the situation in which individual (gross) payments remain outstanding until they are settled and discharged.

1. Bilateral position netting reduces liquidity risks to counterparties, and perhaps others such as correspondent banks, relative to the case of no netting; but it leaves counterparty credit risk unchanged, or may induce increases in risk if net exposures are treated as if they were true exposures.

2. Bilateral netting by novation reduces both liquidity and credit risks to counterparties, and possibly to the financial system (other things being equal), relative to the case of no netting and to the case of bilateral position netting.

3. Multilateral position netting may reduce liquidity risks relative to the cases of no netting and bilateral netting, under certain circumstances; if significant defaults occur, liquidity risks may be higher; credit risks are the same as, or may be larger than, in the case of no netting; credit risks are greater than in the case of bilateral netting by novation.

4. Multilateral netting by novation and substitution has the potential to reduce liquidity risks more than any other institution al form , but this depends critical l y on the financial condition of any central counterparty to the netting; if the liquidity of a central counterparty is weak, the liquidity risks of this institutional form may be greater than in the case of bilateral netting by novation; the credit risks of this institutional form are generally less than in other forms that have been considered, subject again to the identity and condition of any central counterparty.

Footnotes:

6. Some would argue that the case of "no netting" for payment instructions is the situation in which instantaneous settlement and discharge of payments is possible over interbank payments systems operated by central banks, and for some purposes this is a useful assumption. In this report, however, it is assumed that gross payments and netted payments are to be settled at the same time. This assumption allows the report to focus on the effects of netting per se on risk, holding constant the time of settlement and discharge. Reducing the time until discharge of an unsettled payment would normally be expected to reduce the intemporal credit risk arising from the unsettled payment itself.

7. The reduction in counterparty credit risk should not be regarded as coming at the expense of other creditors to a particular institution, as long as parties intend to deal with each other on a net basis and this is well known in financial markets.

8. The clearing house might need to borrow on its own account, intra-day or overnight, perhaps under pre-established credit lines; but there could be pressure on the clearing house to use collateral posted by its participants against credit risks to be mobilised for liquidity purposes.