Minimum Standards For Netting Schemes

3.2 A direct means of achieving central banks' common objectives of containing systemic risk and moral hazard, while encouraging improvements in the efficiency of interbank settlements, is to ensure that private interbank netting and settlement systems are designed and operated so that the participants and the service providers have both the incentives and the ability to manage the associated credit and liquidity risks. As a first step toward ensuring the adequacy of the risk-management practices of private interbank netting arrangements, the Committee has agreed upon minimum standards for the design and operation of cross-border and multi-currency netting schemes . These minimum standards are set forth below and are repeated in Part C of this Report with supporting explanations.

1. Netting schemes should have a well-founded legal basis under all relevant jurisdictions.

2. Netting scheme participants should have a clear understanding of the impact of the particular scheme on each of the financial risks affected by the netting process.

3. Multilateral netting systems should have clearly-defined procedures for the management of credit risks and liquidity risks which specify the respective responsibilities of the netting provider and the participants. These procedures should also ensure that all parties have both the incentives and the capabilities to manage and contain each of the risks they bear and that limits are placed on the maximum level of credit exposure that can be produced by each participant.

4. Multilateral netting systems should, at a minimum, be capable of ensuring the timely completion of daily settlements in the event of an inability to settle by the participant with the largest single net-debit position.

5. Multilateral netting systems should have objective and publicly-disclosed criteria for admission which permit fair and open access.

6. All netting schemes should ensure the operational reliability of technical systems and the availability of back-up facilities capable of completing daily processing requirements.

3.3 The primary responsibility for ensuring that netting and settlement systems have adequate credit, liquidity, and operational safeguards rests with the participants. The presentation of these minimum standards by central banks in no way diminishes this responsibility. On the contrary, it is the Committee's intention to heighten awareness of the risks associated with netting and settlement systems and of the need for their prudent management by market participants. .Moreover, these are minimum standards that all schemes should meet; they are not a statement of best practices to which schemes should aspire.

3.4 There are clearly several ways of prudently managing the risks associated with netting and settlement mechanisms. The standards are intended to be sufficiently flexible to permit market participants to adopt different risk-management techniques. Their presentation is designed to indicate both the issues that market participants should address and the standards against which their different approaches should be measured. The Committee's intention is to encourage market participants to develop systems that can contribute both to improving efficiency and reducing risk.

3.5 The Committee's work has focused on netting and settlement arrangements for interbank payment orders and for foreign exchange transactions and the suggested minimum standards have been drafted with these particular instruments and netting systems for them in mind. But these standards may also provide a useful starting point for the consideration of risk-management procedures for funds settlements associated with clearing arrangements for other financial instruments.

3.6 In establishing minimum conditions, the Committee's intention is to preserve the freedom of individual central banks to apply higher standards where necessary. This should help to contain moral hazard and provide flexibility for central banks to ensure that interbank settlement arrangements in their own currency are consistent with the central bank's market practices. For example, the Committee believes that it would be highly desirable for systems to be able to withstand multiple defaults and that such structures should be encouraged by central banks whenever possible.

Principles For Co-operative Central Bank Oversight

3.7 Central banks oversee developments in their domestic interbank markets and in the payment and settlement systems that support these markets. In their capacities as the ultimate providers of interbank settlements and as lenders of last resort, central banks have a special interest in the credit and liquidity management practices of banks, as well as the settlement arrangements that link their credit and liquidity exposures within the domestic banking system, in order to assess banks' abilities to withstand adverse developments without the need for recourse to extraordinary central bank support. This "oversight" of the domestic payment system serves to co-ordinate the various functions of the central bank and may also involve a co-ordination of the responsibilities of the monetary and supervisory authorities.

3.8 The development of cross-border and multi-currency systems demonstrates the need for a similar oversight function to be performed with respect to these systems which directly link the credit and liquidity exposures of banks in different countries. "International" financial trading activities traditionally have been settled through the correspondent services of "domestic" clearing and settlement systems. Although interbank payments in a given currency are still ultimately settled through accounts with the central bank of issue, the private sector is now developing truly trans-national interbank settlement systems which separate the netting or clearing process among a group of banks in one financial centre from the final settlement of their positions in another. Cross-border and multi-currency netting systems are examples of the se developments that are of special concern to central banks because of their potential influence on the overall credit structure of financial markets and, particularly, of the foreign exchange and interbank funds markets.

3.9 The Committee recommends that central banks respond to this situation by agreeing to act in accordance with the principles set forth in Part D of this Report. In summary, these principles provide that:

• Netting systems should be subject to oversight by an authority that accepts primary responsibility to do so;

• There should be a presumption that the "host-country" central bank (in whose market the system is located or operating) will undertake this responsibility but that, in certain cases, it could be mutually agreed that another authority would undertake the primary responsibility;

• The responsible authority should review the design and operation of the system as a whole and consult with other central banks and supervisory authorities that may have an interest in the system's prudent operation;

• Determination of the adequacy of the settlement arrangements should be the joint responsibility of the central bank of issue and the authority with primary responsibility; and that

• In the absence of confidence in the soundness of the design or management of a cross-border or multi-currency netting or settlement system, a central bank should discourage use of the system by institutions subject to its authority.

3.10 These principles apply to any netting or clearing system for payments or currency obligations that is located outside the country of issue of the relevant currency or currencies and are designed to serve at least three objectives. Firstly, their application should ensure that cross-border systems are subject to review "as systems" by a single authority with responsibility to consider the system's impact in different countries. Secondly, they should provide a co-operative approach to ensure that the interests of different central banks and supervisory authorities are reflected in the oversight of any one system. Thirdly, co-operation between central banks should, in particular, help to preserve the discretion of individual central banks with respect to interbank settlements in their domestic currency.