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Minimum Standards for the Design and Operation of Cross-Border and Multi-Currency Netting and Settlement Schemes

II. 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.

2.1 Different types of schemes for the netting of financial obligations seek to net different elements of financial risk. A necessary precondition for the sound use of any netting scheme is that the participants have a clear understanding of the different impact which the scheme may have on each of their credit and liquidity exposures.

2.2 In general terms, netting schemes can be applied to two categories of financial obligations. There are schemes for the netting of financial contracts which typically involve reciprocal commitments for future payments in the same or different currencies, such as spot and forward foreign exchange and interest rate and currency swap contracts. Netting schemes can also be applied to payment orders, denominated in a single currency, without regard to the underlying transactions.

2.3 To assess the impact of a netting scheme, participants should first have a thorough understanding of the credit and liquidity risks associated with the obligations to be netted. They should then carefully consider the impact of the netting scheme on each of these risks. Examples of some of these risks and the different ways they can be affected by different netting schemes are given below.

Credit and Liquidity Risks

2.4 On forward contractual obligations which involve reciprocal commitments, such as foreign exchange contracts, it is important to distinguish the forward replacement cost credit risks which exist prior to the settlement date from those credit risks which occur on the settlement date itself. If a bank enters into a forward foreign exchange contract with a counterparty who subsequently defaults prior to the settlement date, it can be assumed that the bank would not pay out the currency it was obligated to deliver without any expectation of receiving the return currency payment from the counterparty. However, the counterparty's failure to perform may cause a hedged position to become an open position in the market. To close this position, the bank would have to replace the currency payments and receipts (which are in default) by entering into a replacement contract with a third party. Even in the absence of hedging, the loss of a contract could mean that the bank suffers the loss of unrealised gains on its original position.

2.5 At the time that a foreign exchange contract is initiated it can be replaced at almost no cost because the exchange rate specified in the contract presumably is close to the prevailing market rate. But after time has elapsed and rates have changed, the market value of the currency receivable under the contract may well exceed the market value of the currency payable. The present value of the difference between the market value of the currency receivable and the currency payable is the contract's forward replacement cost. The potential forward replacement cost associated with a foreign exchange rate contract depends upon the volatility of both the relevant exchange rate and interest rates, through their influence on present values.

2.6 The credit risk associated with forward replacement cost -or forward replacement cost risk -usually increases with the term to maturity of the contract because potential changes in foreign exchange rates become larger with the passage of time. Spot contracts entail a limited amount of forward replacement cost risk while long-dated forward contracts can entail substantial replacement cost risk. Because the direction of changes in exchange rates is uncertain, both parties to a foreign exchange contract are exposed to forward replacement cost risk.

2.7 On the settlement date, the magnitude and distribution of credit risks will be quite different from those of forward replacement cost risk. Foreign exchange contracts typically require currency payments to be made in the country of issue of each currency. If the hours of operation of the national payment systems of the currencies do not overlap, then one of the counterparties to the contract must pay out one currency prior to receiving payment of the other. Even if the hours of operation do overlap there is usually no means available for assuring the simultaneous final and irrevocable settlement of both currency legs of a foreign exchange transaction. During the interval between the settlement of each leg, the party that has made the first payment risks losing the full value of the second in the event that the counterparty were to default on its obligation. This credit risk at settlement -or cross-currency settlement risk -is generally known as Herstatt risk after the 1974 failure of the Bankhaus Herstatt.

2.8 For example, given the time differences between the Tokyo and New York business days, a party that sells Japanese Yen in exchange for US dollars must irrevocably pay out the Yen approximately eight hours before it receives payment in US dollars. (However, this gap can be as long as 18 hours.) During this period between payment of Yen and receipt of U S dollars, the party that has paid Yen is exposed to the loss of the full principal value of the US dollar payment. In theory this credit risk is asymmetric. The counterparty due to receive Yen is exposed only to forward replacement cost risk because it presumably would not pay out US dollars in the event that the other party were to default on its obligation to pay Yen. In practice, however, banks may not be able to monitor settlements being completed through correspondent accounts in sufficient time to withhold payments and will only become aware of counterparty defaults when account information is available the next day. Where this is the case, both parties will have a Herstatt exposure. But banks with intra-day information processing capabilities may be able to avoid Herstatt exposures in some currency pairs.

2.9 In contrast to the reciprocal payment obligations under foreign exchange contracts, individual payment orders exchanged between banks may or may not give rise to actual credit risks. Whether they do so will depend on the nature of the relationship between the two banks and other actions they may take. In any arrangement for the delivery of payment orders that are subsequently to be settled in an agreed medium of exchange, the receiving party (the payee) bears an exposure with respect to the sending party (the payor) until the settlement is completed. When the payor is also the debtor on an underlying transaction, the exposure incurred by the receiving party is an expression of its exposure as creditor. However, when the two parties are correspondent banks, or acting on behalf of others, then the exposure is just the expectation of payment. In this case, by simply receiving a payment order, a party does not expose itself to any credit risk. But it may take further steps in reliance upon the receipt of settlement for the payment order, for example, by granting a customer an irrevocable credit in the expectation that the payment order will be settled; if settlement is not completed, the bank will have incurred a credit risk with respect to the sending party (payor) of the payment order.

2.10 The receiver of a payment order, and both counterparties to a foreign exchange contract, are exposed to liquidity risks at settlement. All financial institutions have incentives to minimise their holdings of relatively low-yielding transactions balances. Consequently, if an anticipated settlement payment is not received, an institution may need to borrow or liquidate assets in that currency to offset the short-fall in its transaction account. Of course, at the time that a settlement payment fails to occur, the party expecting the payment may not know whether it is experiencing only a liquidity exposure, resulting from a delay in payment, or a credit exposure, resulting from the counterparty's default.

2.11 If, in the settlement of a foreign exchange contract, for example, a counterparty default is detected before a bank pays out its currency obligation, liquidity risk may still exist. In this case, although the non-defaulting bank would experience a deficit in the currency receivable this would be offset by a surplus in the currency payable. But, as a matter of liquidity management, in order to cover the deficit in one with the surplus in the other, either a same-day foreign exchange transaction or a combination of a two-day borrowing transaction and a normal spot trade would be required. These transactions may be difficult, if not impossible, to complete late in the business day. For example, a bank expecting to deliver US dollars against the receipt of Yen -which are not, in fact, delivered - may not be able to sell (its "surplus") US dollars or borrow Yen late in the Tokyo business day in order to meet its need for Yen that same day. It faces liquidity risk even though it faces little or no credit risk and the amount subject to risk is always the full principal amount of the payment to be received.

Impact of Netting Schemes on Credit and Liquidity Risks

Netting of bilateral forward credit exposures.

2.12 Some netting schemes are intended solely to reduce to a single net-credit exposure the forward replacement costs associated with a number of individual transactions with a given counterparty by including them under a single legal agreement. The obligation of each party to the other, under such netting or master agreements, is to perform all of the included transactions. In the event of a counterparty's default on this overall obligation, the surviving party's forward credit exposure would be the cost of replacing the sum total of the transactions included under the agreement. This would normally be expressed as the sum of the discounted present values of the unrealised gains and losses on all included transactions.

2.13 In the absence of a legally enforceable netting agreement, in some jurisdictions the liquidating authority of a failed institution may be able to choose whether to affirm or disaffirm individual transactions which the closed institution had concluded with a given counterparty. In effect, the liquidating authority would be able to perform those contracts that are profitable to the estate of the closed institution and to default on those contracts that are unprofitable. Counterparties on the latter contracts would then be ranked as unsecured general creditors of the failed institution.

2.14 A surviving counterparty is therefore exposed to the possibility that the liquidating authority will perform those contracts on which the survivor will experience a loss (those on which the estate of the failed institution will experience a gain) and default on those contracts on which it would have experienced a gain (those on which the estate would have experienced a loss). Thus, in the absence of an effective netting arrangement, if the liquidating authority were successful in asserting its claims, the surviving counterparty's credit losses would equal the "gross" amount of the credit exposures on its profitable contracts, rather than the "net" difference between this amount and the amount of the corresponding forward replacement cost exposure which the failed institution had on the surviving counterparty.

2.15 For example, suppose that at the time of default the surviving counterparty had two outstanding forward foreign exchange contracts with the failed institution and that, at prevailing exchange and interest rates, it would cost the survivor US$ 100 to replace the first contract but it would cost the liquidating authority US$ 80 to replace the second. In seeking to maximise the assets of the closed institution, the liquidating authority might attempt to enforce the second contract but repudiate the first. If the authority were successful, the surviving counterparty would be exposed to a loss of US$ 100 (the gross exposure). However, if the counterparty had a legally enforceable master agreement or overall netting contract with the failed institution covering both transactions, it could prevent such selective enforcement or "cherry picking" of profitable positions. As a result, the surviving counterparty's exposure would be the net-replacement cost of the two contracts combined or US$ 20 instead of US$ 100.

2.16 However, such bilateral netting arrangements may not include any provision for the netting of the payment flows which occur between the counterparties on the value dates of the underlying transactions. If this were the case, on the day of a counterparty's default, the surviving party would still be exposed to Herstatt risk on the gross level of settlement payments for value that day. Moreover, both counterparties would routinely experience liquidity demands and liquidity risks on the gross amount of payments to be made on all of their individual transaction.

Netting of bilateral payment flows.

2.17 Some schemes are designed solely for the netting of payment orders in a single currency and have no effect on forward credit exposures. Under these arrangements, two parties may agree to the netting of payment orders issued to and by one another for a given value date. The payment orders themselves may represent the settlements of different types of transactions both between the two parties as principals and also on behalf of customers. As payment orders are exchanged they would be legally extinguished and replaced by a single running balance due to or from one counterparty to the other which would be the only sum remaining to be settled between the parties.

2.18 These arrangements can reduce the routine liquidity demands and the aggregate liquidity and credit risks, in the relevant currency, associated with the nothing to reduce the Herstatt risk associated with the settlement of cross-currency obligations and may even increase this element of risk. For example, if payments in settlement of only one currency leg of a cross-currency contract are included in a payment netting, the other currency legs might remain to be settled on a gross basis. Depending upon the timing of the netting as a legally binding calculation and of the subsequent settlement of the single-currency net amounts, in relation to the timing of the gross settlement of the other currency payments, the duration and character of the Herstatt risk could be changed.

Netting-by-novation and current-account arrangements.

2.19 Other netting schemes achieve a reduction in the level of forward replacement cost risks and also of cross-currency settlement and liquidity risks. Netting-by-novation agreements, and similar arrangements such as current account agreements, provide for forward-value contractual commitments to be replaced by new obligations under a single netting agreement in which a running balance will be due between two parties in each currency for each future value date. Individual foreign exchange contracts between two parties, for example, will be discharged at the time of their confirmation when the amounts due will be added to the running accounts under the agreement. On each value date, only single sums in each currency -due to or from each counterparty -remain to be settled. (This not only describes the bilateral arrangement entered into by pairs of counterparties but, also, the bilateral relationship between a clearinghouse and each of its participants in those multilateral netting systems where the clearinghouse becomes a substituted "central counterparty" to each of the transactions entered into by the members.)

2.20 These netting arrangements reduce the number of payments to be made on each value or

settlement date to the number of currencies traded between the counterparties (or between the participants and the clearinghouse). They also reduce the level of the routine liquidity demands in each currency to the single net amount as well as the level of the liquidity exposure. While Herstatt risk remains, the level of this exposure will be reduced.

2.21 All of the net amounts due on the future settlement dates form part of a single contract. Where legally enforceable against a liquidating authority, in the event of a counterparty default there will be a single, net forward replacement cost exposure representing the discounted present value of the sum of the amounts due across currencies and value dates. While taking a different legal form, novation and current account arrangements produce the same results as master agreements with respect to forward credit exposures while simultaneously reducing payments flows and liquidity risks. (Where explicit provisions for the netting of payments in each currency due on settlement dates are added to master agreements, the overall risk reduction results of each approach will be identical.)

2.22 It is particularly important to note that, under both the master agreement and novation or current account agreement approaches, although the level of credit exposure may be reduced from that which would be experienced in the event of cherry picking, the possibilities of a future change in exposure remain. Thus , the fact of forward replacement cost risk is unchanged by netting and participants in netting schemes will need to monitor and limit both their current exposures and the potential for an increase in their future exposures.

Position or advisory netting.

2.23 There are also arrangements for the "netting" of payment orders or settlements of forward contracts which have no legal significance and produce no reduction in credit or liquidity exposures. By providing for the routine settlement of net amounts, these forms of netting may induce participants to place an unfounded reliance on the net amounts to be settled and, thereby, lead to an increase in risks.

2.24 Position netting systems for payment orders provide an example of these risks. These arrangements (which can be either bilateral or multilateral) may rely solely upon the reversing of all payment orders to and from a participant that is unable to settle the net amount due at the end of the day. Such netting arrangements provide for reductions in operating costs and permit a reduction in routine liquidity demands. But there is no corresponding reduction in actual credit and liquidity exposures. Participants may naturally come to place an unfounded reliance on their net-settlement positions as reflecting the extent not only of liquidity demands but of their liquidity risks. Indeed, this reliance is an inherent part of the netting process and is essential for the economising of settlements: participants initiate payment orders in anticipation of the successful netting of the orders made against those received. As a result, in the absence of other safeguards, position netting systems may induce participants to take on liquidity exposures and credit exposures considerably in excess of what they are capable of dealing with in a crisis.

Contact us * Risk Library * Documents by Author * Committees at the Bank for International Settlement (BIS) * Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries * Minimum Standards for the Design and Operation of Cross-Border and Multi-Currency Netting and Settlement Schemes