2.2 By reducing the number and overall value of payments between financial institutions, netting can enhance the efficiency of domestic payment systems and reduce the settlement costs associated with the growing volume of foreign exchange market activity. Netting can also reduce the size of credit and liquidity exposures incurred by market participants and thereby contribute to the containment of systemic risk.

2.3 Effective reductions in exposures, however, depend upon the legal soundness of netting arrangements in producing binding net exposures that will withstand legal challenge. The concept of netting, in the broadest sense, is given effect under the law of all G-10 countries. But binding net exposures may not be achievable by all banks in all circumstances. For example, cross-border netting arrangements raise choice-of-law and conflict-of-law questions that cannot be easily resolved. Establishing a sound basis for the assertion of net exposures will, therefore, require thorough legal preparation by the participants in netting schemes and by netting providers .

2.4 If, instead of achieving reductions in actual credit and liquidity exposures which participants would experience in the event of a counterparty default, netting merely obscures the level of exposures, then netting arrangements have the potential to contribute to an increase in systemic risk. .Moreover, even when actual exposures are reduced, multilateral netting systems can shift and concentrate risks in ways that could increase systemic risk by increasing the likelihood that one institution's failure will undermine the condition of others. The degree of systemic risk in multilateral systems depends on the strength of the incentives for the netting provider and the participants to manage and contain their exposures and on their capacity to absorb losses in the event of a default.

2.5 The Committee considered different possible risk-management procedures for multilateral netting systems, particularly in relation to proposals now being developed by bankers to establish multilateral systems for foreign exchange contracts. At one end of the spectrum are arrangements under which all risks would be borne and managed by the provider of the netting service or central counterparty. Participants in such systems might be required to post collateral or margin to secure fully the system's exposure to them. At the other end of the spectrum are completely decentralised arrangements under which, in the event of a participant's default, credit losses associated with its net position vis-à-vis the central counterparty would be allocated on a pro-rata basis among the surviving participants. Under such arrangements the principal risk-control mechanism would be participants' bilateral limits on their exposures to other participants.

2.6 In principle either centralised or decentralised arrangements, or some combination of the two, should provide credit and liquidity safeguards that would ensure the systems' abilities to manage exposures and complete settlements. A centralised, collateral-based approach appears likely to provide somewhat greater protection against systemic risk but it would do so at the cost of the use of the necessary collateral, which would then become unavailable for other purposes. A purely decentralised approach would avoid that cost and would maintain incentives for participants to manage their own exposures but without the same level of assurance of the system's ability to ensure the completion of settlement. A decentralised approach to the allocation and management of risks, however, could be combined with a collateral facility to ensure the satisfaction of participants' loss-sharing obligations in the event of a crisis.

2.7 By altering settlement costs and credit exposures, these proposed multilateral netting systems for foreign exchange contracts could alter the structure of credit relations and affect competition in the foreign exchange markets. But the lack of any actual experience with such systems makes it difficult to predict the impact which any particular system would have on activity in the foreign exchange markets or on the stability of the financial markets generally.

2.8 The principal concern for monetary policy with respect to netting systems results from the possibility that a system's risk-management procedures may be inadequate and, thereby, contribute to systemic risk or financial fragility in a way that would impede the attainment of monetary policy objectives. Netting per se, however, is unlikely to impair the effectiveness of the instruments of monetary policy in the long run, although the operation of netting systems could, at certain times, complicate the daily conduct of monetary management in some countries. In particular, it may be difficult for a central bank to oversee effectively the liquidity- management practices of a cross-border or multi-currency netting system that is located abroad but the operation of which affects settlement practices in its domestic, interbank funds market.

2.9 More generally, the development of truly trans-national interbank settlement arrangements, made possible by the application of advanced communications and data-processing technologies, has permitted a separation of the netting or clearing process among a group of banks in one financial centre from the final settlement of their net positions in another. This geographic division of functions which have traditionally been integral parts of domestic payment and settlement systems complicates the task of assessing the impact of particular systems on market practices and systemic risk.