1. the impact of netting, per se, on the liquidity risks of participants, in both bilateral and multilateral arrangements, and of their correspondents;

2. the role of the settlement agent in multilateral systems, and the allocation of liquidity risks between the settlement agent and the particinants;

3. the cross-border implications of liquidity risk in offshore clearing arrangements, particularly the cross-border allocation of risks between the settlement agent and the participants;

4. the impact of centralised multi-currency clearing house arrangements on general market liquidity risk.

7.2 The impact of netting arrangements is generally to reduce liquidity risks for correspondent banks and others involved in the payment process. However, as noted above, an important distinction must be drawn between netting arrangements based on legally enforceable netting by novation and those based on simple position netting. Both kinds of netting reduce liquidity risks under normal circumstances in which liquidity shortfalls can be successfully managed without "unwinding" payments, or obligations, included in a netting. Liquidity risk is reduced because the amounts due for settlement are reduced through the netting. Only systems of netting by novation, however, work to reduce liquidity risks in circumstances that could otherwise lead to an "unwinding" of netted amounts. ⁹ In such circumstances an " unwinding" of payments in position netting may have the potential to create greater liquidity problems, and thus greater risks, than clearing arrangements with no netting.

7.3 A more technical analysis of the impact of netting on the cash, or liquidity, position of correspondent banks in ordinary circumstances is as follows. Without netting, one correspondent bank may receive payment instructions from customer banks during the day to deliver funds to the account of a second correspondent bank The second correspondent may likewise receive instructions to deliver funds to the account of the first. In practice, both correspondents are uncertain about the existence, time of arrival and amounts of these offsetting payments, which are sources of risk to their final cash ("liquidity" or "reserve") position each day. Bilateral netting, and to a greater extent multilateral netting, in effect, ensure that offsetting payments are made simultaneously, thus eliminating a source of liquidity risk to the individual correspondent banks.

7.4 A similar analysis holds for pairs or groups of banks that settle payments or obligations directly over interbank payment and settlement systems. Pairs of banks, for example, may know the schedule of payments each owes the other on a given day. However, there may be uncertainty as to the intra-day timing of payments, possibility of errors, likelihood of computer failures, and the like. The effect of netting is to reduce the impact of these sources of risk on the liquidity position of banks, other things being equal. Groups of banks that settle payments or obligations over these interbank systems are in a similar position to the correspondent banks. For the group as a whole there may be significant numbers of offsetting payment instructions. Each individual bank, however, is usually uncertain about the existence, timing and magnitude of these payments. Again, multilateral netting reduces the impact of this uncertainty on the cash positions of banks.

7.5 Netting of obligations may be expected to have some long-term monetary implications through effects on variables such as bank demands for cash and credit. Netting reduces the amount of intra-day and overnight central bank balances, central bank credit or private bank credit needed to make the settlement payments for a given set of obligations over the ultimate interbank payment systems in a given country. Reduced uncertainty as to the cash position of banks might also be expected to reduce both the intra-day and overnight demand for cash. In a global context, moreover, multi-currency (obligations) netting systems may simultaneously affect bank demands for cash in a number of countries. Such effects, and their ultimate magnitude, however, are extremely difficult to project.

7.6 The role of a settlement agent for a multilateral netting arrangement is, at a minimum, to receive settlement payments from net debtors in the netting, or clearing, and to make disbursements to net creditors. A settlement agent may also have other banking functions, such as providing credit to finance settlements and holding collateral to secure settlement obligations. Normally, a settlement agent will also monitor the development of the settlement for operational and financial difficulties. In some respects the settlement agent may become the de facto regulator of a multilateral netting arrangement, particularly if it is responsible for setting the terms of access to the arrangement, and determining the acceptability of individual contracts for netting.

7.7 The allocation of liquidity risks between a settlement agent and participants in a multilateral clearing arrangement depends upon the banking functions given to the settlement agent. At one extreme the settlement agent may take no liquidity risk. This, in effect, allocates the liquidity risks of settlement to the participants in the system. At the other extreme a settlement agent could bear all of the liquidity risks of settlement. For example, the "agent" could disburse settlement payments to net creditors before receiving amounts due from net debtors in a clearing, thus temporarily financing a settlement. This allocates all liquidity risk to the "agent". Overall, it is important to recognise that liquidity risks in netting arrangements are borne by someone, and that there is a need to analyse and manage these risks properly.

7.8 Offshore systems create some unique problems for the management of liquidity difficulties, if they arise, by virtue of time-zone differences. Such problems also affect the size and allocation of liquidity risk. For example, at settlement times for an offshore system it will be night or early morning in other countries. The senior managers of international banks that participate in offshore systems may not be available to engage in consultations or make the decisions needed to solve liquidity problems, and to complete settlements in a timely manner. Similarly, the appropriate central bank personnel in some countries may not be readily available. These and related problems may imply that the market for the currency in question may lack sufficient depth, at that particular time, to enable any liquidity requirements to be mobilised in the market-place.

7.9 In addition, when a clearing system located offshore has participants from a number of countries, authorities from at least three categories of countries may have interests in developments affecting it, including the host country for the system, any countries in which participant banks in it have their headquarters, and possibly the country that issues the currency cleared on the system.

7.10 Offshore arrangements may also have specific cross-border implications for liquidity risk. There can be a problem of dependency of settlements if settlements for an offshore system are made using a net settlement system in the country that issues the settlement currency ("country of issue"). If liquidity problems delay settlements for the system in the country of issue, then settlements for the offshore system can also be delayed. Much less likely in practice, but logically possible, is the risk that delays in entering some of the settlement payments from the offshore system could create liquidity strains or settlement delays in the country of issue.

7.11 Further, the mechanisms adopted for settling offshore systems may have direct implications for the allocation of liquidity risks concentrated in an offshore clearing system. For example, if settlements for the offshore system are made through correspondent banks or privately operated payment systems in the country of issue, liquidity risk may fall in the first instance on the private banking system in that country. If central banks offer cross-border settlement services to offshore systems, liquidity risk may be shifted onto the central banks. However, if the central bank, or a correspondent bank, in a host country for an offshore system offers settlement, liquidity risk may implicitly be assumed by the host country.

7.12 The prospect that large-scale centralised multi-currency clearing houses might be developed for the traditional foreign exchange market adds poignancy to the questions about the international structure of settlements, and liquidity risk, that are already being raised by currency futures and options clearing systems. Presumably a clearing house in each country would clear contracts in major international currencies, and other currencies as well. The participants would probably include international banks from a number of countries, including the host country ¹⁰ .The settlements for even one foreign exchange clearing house would be likely to require carefully timed settlements in the country of issue for each currency handled by the clearing house.

7.13 The clearing house would be regarded as a settlement agent for the clearing arrangement, if it were required to both collect and disburse settlement payments. Moreover, because the clearing house would be the central counterparty to foreign exchange contracts, it would bear significant liquidity risks in the first instance.

7.14 Thus any proposal to handle the settlement of foreign exchange obligations through a clearing house would raise at least three important liquidity issues. First, the development of new large-scale central financial institutions would raise questions about the implicit financial relationship between central banks and such institutions. The concentration of liquidity risks, formerly borne by a large group of correspondent banks, in one institution on which international banks and markets would depend would make clearing houses too important to the functioning of financial markets to permit failures.

7.15 Second, clearing house arrangements would face cross-currency liquidity risks even when the clearing credits due to a participant in one currency fully offset the clearing debits due from that participant in another currency. If the participant were to default, a fully margined or collateralised clearing house might be protected against credit risk. However, the clearing house could experience a temporary liquidity problem if credits in one currency could not be rapidly liquidated to satisfy the timely settlement of obligations in another currency.

7.16 Third, there is the classic problem posed by the Herstatt case. For example, a clearing house might choose to settle each currency as soon as possible on a given value date. This would lead to a sequence of settlements moving from one time-zone to the next, following the sun. Under this approach it is clear that the establishment of clearing houses would not necessarily eliminate the liquidity effects of closing a bank while one side of its foreign exchange contracts remains unsettled. In all, this analysis points towards the need for careful multi-currency liquidity and collateral management by both prospective clearing houses and their participants.

7.17 If a clearing house were to administer settlements through accounts at a separate financial institution, as would be likely, then a designated "settlement agent" would be involved . A possibility is that one or more correspondent banks would act as settlement agent(s) in each currency. Defaults by such banks would pose serious liquidity and other risks to the clearing house, and thus to all its participants. If the timing of settlements required all payments to a clearing house to be made, in all currencies, before disbursements, settlements could be at risk for extended periods. These periods would be shorter in the case of sequential currency-by-currency settlements.

7.18 Some have suggested that central banks might act as settlement agents for clearing houses, in preference to commercial banks. Such a suggestion raises a number of important questions that would require detailed analysis. For example, would central banks need to open accounts for a clearing house, or possibly a participant, that had no physical presence in the country of the central bank? Would central banks have to extend their hours of operations to accommodate clearing house settlements, and what would be the effect on domestic money markets of any extended hours of operation? Would there be implied commitments of financial support for the clearing house? Would a central bank need to hold collateral pledged to a clearing house by participants? Could any such collateral be mobilised to provide support for settlements in other currencies, involving other central banks?

7.19 The alternative approach, that commercial banks should act as the settlement agents for clearing houses, also raises some important issues for the supervisors and central banks of the banks and currencies concerned. As discussed above, it could concentrate liquidity risk on those banks; this in turn could have implications for those banks' payments through their domestic payment systems, particularly if the clearing house arrangement has any potential to unwind its participants' daily net positions.

7.20 Consider finally the implications of a series of foreign exchange clearing houses in different countries. It would be natural to link such clearing houses in some fashion, so as to handle cross-border foreign exchange transactions, and thus to obtain further benefits from netting. The system liquidity risks from such linkages, however, would need to be carefully assessed. If one clearing house in an interlinked system experienced a liquidity problem, there would clearly be a potential for the whole linked system to experience a problem.

7.21 In summary, there would appear to be a trade-off in terms of liquidity risk if centralised clearing houses are established. On the one hand, the netting of obligations would reduce liquidity risk for the participants in the clearing house, and possibly for financial markets generally. On the other hand, the centralisation of settlements could make liquidity problems more serious if they were to occur. In assessing the liquidity risks of any clearing house proposals, both factors in the trade off would need to be kept in view

Footnotes:

9. An important caveat is that certain set-off rights under local law may result in some bilateral netting of obligations in events of default, which might reduce somewhat the liquidity risks of gross obligations (see paragraph 5.9 above)

10. There is also a possibility that securities firms from countries without universal banking laws and even some multinational industrial firms would want to join a foreign exchange "clearing house".