General effect on foreign exchange markets.

3.2 The potential for netting to reduce credit risks may need to be viewed in a dynamic context . The reduction in participants ' credit exposures , and al so in their settlement and processing costs, will reduce the incremental cost of additional transactions. This may prompt netting scheme participants to expand their trading activities which, in turn, would tend to deepen the markets. The impact of bilateral netting, undertaken by individual counterparty pairs, may be only marginal and would affect the foreign exchange market gradually. But the introduction of a multilateral netting system, particularly if it included a significant number of market participants or included the major market makers, could have both a more immediate and more significant impact.

3.3 The resulting increase in market liquidity could affect price volatility, but the direction and magnitude of the effect is not obvious a priori. Some believe that greater liquidity may encourage trading strategies that result in increased volatility. Others believe that more liquid markets can more readily absorb imbalances between supply and demand and may therefore tend to be less volatile. Extensive theoretical and empirical studies of a number of markets have not resolved this issue and the Committee has not attempted to do so. But given central banks' interest in avoiding instability of exchange markets, uncertainty about the likely impact of multilateral netting on market volatility is clearly a matter of concern.

3.4 Even if market participants do not expand their overall level of activity, the reduction in credit exposures to netting counterparties could induce firms either to concentrate their trading activities on a few major counterparties or to expand the level of their credit exposures in other markets. Increased concentration of trading would be particularly likely if, in the absence of netting, the constraint imposed by hitting trading limits had forced firms to seek a wider range of counterparties. Some market participants have indicated that this is the case and that the potential for further trading with preferred counterparties is an important incentive to adopt netting.

3.5 Alternatively, reductions in credit exposures incurred in foreign exchange trading could induce participants to shift credit and capital resources to entirely different markets. Although credit exposures in some activities may be reduced because of netting, the expansion of other activities could leave a bank's overall level of credit risk unchanged.

3.6 However, a major source of risk in trading foreign exchange, and related products covered by netting arrangements, will continue to be the position or market risk experienced by market participants. Thus, banks' needs to control their exposure to movements in interest rates and exchange rates should continue to be the main brake on overall activity.

Impact of multilateral contract netting systems.

3.7 The Angell Report expressed the view that the introduction of multilateral netting systems for foreign exchange transactions could alter significantly the structure of interbank credit relationships in the foreign exchange market and, thereby, change the character and nature of the market itself. The Committee's further analysis indicates that centralised, collateral-based systems , on the model of the clearing organisations employed by options and futures exchanges, would be likely to have this effect. Use of a decentralised approach to credit risk management, however, would tend to preserve the current structure of credit relations but would raise other issues.

3.8 The introduction of an exchange-style clearing organisation, with centralised risk management and the collateralisation of exposures, would transfer the responsibility for credit decisions away from market participants to the central counterparty. At the same time, it would impose collateral requirements as the principal limit on counterparty credit exposures.

3.9 Although the initial efforts to promote multilateral netting systems for foreign exchange, analysed in the Angell Report, contemplated the use of a centralised, collateral-based system, schemes now envisaged by groups of bankers entail varying degrees of decentralisation of risk allocation and risk management. Because losses would be allocated among the surviving participants on the basis of their bilateral dealings with a defaulting participant, surviving participants would continue to have the incentive to make credit judgments about their counterparties. Bilateral credit limits would thus remain a significant risk-control mechanism.

3.10 In the absence of any actual operating experience with the proposed systems, it is not easy to compare in the abstract the likely impact of the centralised and decentralised approaches on activity in the foreign exchange markets. The centralised approach would weaken the existing type of bilateral credit discipline in the foreign exchange market while the decentralised approach would tend to preserve it. But the centralised approach would impose a different type of risk management and collateral requirements which could also serve as a brake on exposures and the level of activity.

3.11 Banks may perceive the decentralised approach as avoiding the cost of posting the collateral on which the centralised approach relies for limiting credit exposures. However, even in a decentralised system some collateral or pool of assets is likely to be needed to secure credit lines for the system's liquidity management and to ensure its ability to repay any borrowings. As mentioned in Section 2, it has not been established that a purely decentralised approach to liquidity management would be viable in all currencies. In other words, a collateral-based approach to liquidity risk management may be necessary even in a system with a decentralised approach to credit risk management. Thus, it is not obvious, a priori, how much smaller the collateral requirements would be in decentralised systems.

3.12 Any requirement to pledge assets to secure obligations that are not currently secured in the foreign exchange markets would increase demand for the eligible assets. If the total market for the assets held as collateral were small, there could be a reduction in the depth of the secondary market and unwelcome price effects at times when the collateral was pledged or liquidated. In some countries any substantial effect in reducing the availability of collateral in the banking system for other purposes, including the securing of central bank credit, could be viewed as a cause for concern by the authorities.

3.13 If multilateral netting significantly reduced transactions costs and counterparty risks, participation could prove to be essential to compete as a market maker in foreign exchange. If membership standards allowed for broad access competition could be enhanced. However, if membership were restricted in some way, the creation of a multilateral netting system could adversely affect competition.

Monetary policy and systemic disturbances.

3.14 Interbank payment and settlement arrangements provide the basic mechanism for the exchange of monetary value among financial institutions and, as such, are fundamental components of each country's banking and monetary system. Large-scale netting arrangements are likely to become important parts of the interbank settlement process and, thus, have the potential to influence both the structure and behaviour of the markets through which monetary policy is conducted.

3.15 In principle, netting outside of a domestic payment system that reduces the volume of payments within that system might be expected to reduce demand for the settlement medium -which in interbank markets is usually reserves held with the central bank. In practice, the effect of netting on the demand for bank reserves in the country of issue will be heavily dependent on institutional arrangements. To the extent that banks hold overnight reserve balances with the central bank in excess of amounts needed to meet reserve requirements, the demand for excess reserves could be reduced as could the demand for overnight central bank credit. As a result, in countries with operating objectives for bank reserves minor adjustments of both the objectives and reserve-supplying procedures might need to be taken by the central bank.

3.16 The operation of a large-scale foreign currency netting system could have an effect on the conduct of monetary policy in countries other than the country of issue if it tended to increase the attractiveness of the currency being netted in relation to other currencies - particularly in relation to the domestic currency in the country hosting the system. Again, any effect on the demand for reserve balances and other implications would depend on institutional arrangements. But any effects are likely to be small and to occur gradually, giving the central banks concerned time to respond.

3.17 In some countries the daily conduct of monetary policy could become more difficult if the timing and procedures used for the payment of net-settlement positions created a large and highly time-specific demand for reserve balances when net debtors or their correspondents were required to deliver funds to the account of the settlement agent. The central bank of issue might need to take this into consideration in the timing of its market operations, particularly if the effect of the settlement procedures was felt late in the day and was likely to affect demand for reserve balances.

3.18 The principal concern for monetary policy, however, stems from the possibility that the inadequacy of a netting system's risk-management procedures could contribute to systemic risk or financial fragility in a way that impeded the attainment of monetary policy objectives. An unresolved settlement could have a direct impact on overnight or short-term money-market interest rates or oblige the central bank to engage in reserve supplying operations that ran counter to long-term policy objectives.

3.19 A central bank might be insufficiently informed on the operation of a netting system operating in its currency outside of its borders. In particular, it might lack knowledge of the system's settlement procedures or of the procedures to be invoked in the event of a settlement failure. Although the resulting lack of transparency might not affect the routine conduct of monetary policy it might limit the central bank's ability to respond promptly in an appropriate way in the event of a crisis. The ability of the central bank of issue to influence the design and risk-management practices of systems operating abroad might also be relatively limited.

Trans-national systems and national oversight.

3.20 The lack of transparency of "off-shore" netting to the central bank of issue is one aspect of a wider problem confronting central banks and supervisory authorities. The application of communications and computer technologies to banking services has made possible the geographic dispersion of the functions of netting or clearing, on the one hand, and the ultimate settlements in a given currency, on the other. Although multilateral netting systems directly link the credit and liquidity risks and risk management of banks in different countries, there is no one central bank or supervisory authority in a natural position to consider the overall soundness and prudential adequacy of these systems.

3.21 The functions in the netting process include those of the communications provider, the netting provider or central counterparty, the bank(s) acting as settlement agent(s) in the country (or countries) of issue, and the participants. At a minimum, cross-border netting systems involve a division of functions between two countries: the netting provider and the participants will be located in one country and the settlements will be conducted by their foreign offices or correspondents in the country of issue. However, a proper assessment of the systemic risk implications will require consideration of the netting process and its internal risk safeguards as well as the adequacy of the settlement arrangements in the country of issue and the system's failure-to-settle procedures.

3.22 The process of netting payment orders may not be at all apparent to bank supervisors. The gross payments processed through a netting system are unlikely to be reflected in the accounts of the participants or the netting provider. Normally bank examiners would not "see" the netting process, or the size of the exposures and contingent obligations which participants may be incurring, unless they looked at records of electronic payment instructions made and received. Similarly, if there is a single settlement agent, the netsettlement payments will routinely sum to zero and pass-through the agent's books and accounts.

3.23 Any potential problems caused by a lack of co-ordination among national authorities could be exacerbated by the development of multi-currency systems. Implementation of one or more of the proposed multilateral systems for foreign exchange contracts would create a new type of financial intermediary that would play a central role in the foreign exchange markets and an important role in the national payment systems of each country whose currency is eligible for netting. The failure or illiquidity of such an intermediary would have systemic consequences by imposing losses on all of its participants or by creating liquidity pressures in the money markets for each of the included currencies.