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.

single net-debit position.

4.1 All netting systems should establish settlement and failure-to-settle procedures that will ensure the timely completion of daily settlements in each of the currencies accepted in the system. As a minimum condition, in the event of a failure to pay by the participant with the largest single net-debit position, the netting provider or central counterparty and the participants should be able to ensure the satisfaction of the remaining participants' direct and contingent obligations for settlement that day within the normal constraints of the money markets in which settlement occurs. In most cases this will require the permanent availability of specifically-identified credit and liquidity resources. Furthermore, although this minimum condition is something that all systems should satisfy, it is highly desirable for systems to be able to withstand multiple defaults.

4.2 Three factors should be considered in the design and operation of settlement and failure-to-settle procedures: (a) the size of the positions to be settled; (b) the resources available to complete the settlement; and (c) the time available to adjust positions and to mobilise available resources. Each of these factors need to be assessed in relation to one another. Thus, in general terms, the larger the size of the positions to be settled (and therefore, in decentralised systems, the larger the size of surviving participants' contingent loss-sharing obligations in the event of a default) and the shorter the time to adjust positions, the greater will be the need for credit and liquidity resources to be explicitly set aside in advance. Correspondingly, the smaller the net-settlement positions and the greater the length of time within the money-market day for adjustments in positions, the less need there may be for specified and pre-established credit and liquidity resources to assist in the completion of settlements. However, consideration may also need to be given to other factors, such as the level of peak intra-day positions. Moreover, in the design and management of particular systems, each of these factors will need to be assessed not only in relation to one another but also in relation to the normal requirements and practices of the relevant money markets.

4.3 In single-currency netting systems the size of the liquidity short-fall produced by a participant's inability to settle its net-debit position will be equal to the size of the ultimate credit exposure which would exist if the settlement failure were the product of the institution's failure. Procedures for the management and allocation of liquidity exposures can exactly parallel those for credit exposures. This is not the case in multi-currency systems. In particular, liquidity exposures could exist in multi-currency systems in the absence of any credit risks. Thus, the design of settlement and failure-to-settle procedures for multi-currency systems must address a wider and a more complicated set of risks.

Single-currency Systems

Centralised liquidity-risk management.

4.4 Assurance of the timely completion of daily settlements could be completely undertaken by the provider of a single-currency payment netting system. Indeed, such an assurance of settlement would be implicit in any netting-provider guarantee of credit risks. The assurance of settlement would be based upon the netting provider's own resources in relation to the size of the participants' positions to be settled. However, the netting provider could require participants to post collateral to provide some or all of the necessary resources. In either case, to satisfy the minimum condition, the available credit and liquidity resources would have to be at least equal to the largest net-debit position permitted. Procedures for settlement would also have to give the netting provider sufficient time to draw on the resources in the event of a participant's inability to settle.

4.5 Alternatively, a netting provider could guarantee same-day settlement by absorbing the liquidity risk posed by a participant's inability to satisfy its direct obligation on the settlement date, but with any resulting credit losses to be allocated among the system's surviving participants on the following day. Each participant's contingent obligation to cover credit losses would be based upon a pro-rata distribution of the failed participant's unsettled net position, while the netting provider would be expected to manage and cover any liquidity short-fall during the settlement.

4.6 In contrast to a full netting-provider guarantee system, credit risk would ultimately be borne by the participants who would be expected to manage this on a decentralised basis; liquidity risk would be managed by the netting provider on a centralised basis. The viability of this arrangement would depend, firstly, upon the liquidity resources of the netting provider to assure same-day settlement and, secondly, upon the credit resources of the individual participants to absorb next-day credit-loss allocations. The netting provider would need to be able to set limits on each participant's "net-net" settlement position while the participants would need to be able to manage and contain their own credit exposures through bilateral limits.

Decentralised liquidity-risk management.

4.7 It may be possible for a settlement short-fall to be allocated directly to the remaining participants on the settlement date. In this case, if a participant did not settle its net-debit position, the netting provider would allocate to each of the surviving participants a same-day, pro-rata share of this amount (assuming that the multilateral, net-net positions are legally binding). Participants would need to be capable of satisfying the full amount of both their direct and contingent obligations on the settlement date and, therefore, would also need the ability to manage and contain each of these exposures.

4.8 Particular care would need to be taken in assessing the soundness of a same-day, decentralised allocation of liquidity and credit exposures. For example, it is apparent that such a same-day allocation would be an inappropriate means of ensuring the timely completion of settlement if it occurred only at the very end of the business day because the timing would limit the remaining participants' ability to adjust their positions in the money market. But such an arrangement could be appropriate if the failure-to-settle procedure s were implemented sufficiently early in the business day to ensure that the remaining participants had adequate time to adjust their positions prudently. Depending upon the size of their contingent obligations and the timing of the procedures, it might be appropriate for participants to set aside a quantity of highly-liquid assets equal to their maximum contingent obligations. However, still consistent with a decentralised approach to liquidity-risk management, the participants themselves could be responsible for using these assets to secure additional funding in the market to complete settlement.

4.9 There are several decentralised approaches to liquidity-risk management that would clearly fail to satisfy the minimum conditions of ensuring the timely completion of daily settlements while at the same time maintaining the necessary incentives and capabilities for participants to manage and contain their risks. For example, the liquidity short-fall resulting from a participant's inability to satisfy its net-debit position could be directly "passed-through" to those participants who were in a net-credit position on that day. Alternatively, in the event of a participant's inability to settle, the netting provider could simply delay the completion of settlement until the next day. In either case, it could be planned for the short-fall to be recovered the next day from the defaulting participant or, if necessary, reallocated pro rata among the surviving participants. In both cases, participants could be exposed to liquidity risks produced by the default of a participant with whom they may have had no direct dealings and, thus, would have no direct means of managing and containing their liquidity risks. This might actually lead to an increase in liquidity risks compared to what would exist without netting

4.10 In the absence of a central counterparty that would be substituted on each payment order included in the netting process, the multilateral "net-net" positions of the participants may not be legally binding. In this case, the short-fall resulting from a participant's inability to settle its net-debit position might only be resolved by recalculating a new set of multilateral net positions for each of the remaining participants, removing from the calculation all payments made to and from the defaulting participant. In such a "reversal" or "unwind" procedure, the "contingent obligation" of a surviving participant would not be its pro-rata share of the defaulting participant's net-net position based upon its bilateral position with that participant but, instead, would be equal to the full amount of its bilateral position. If the position were a bilateral net-credit, due from the defaulting participant, it would no longer be available to off-set bilateral net-debit positions which the surviving participant had with other participants.

4.11 Under such position or advisory netting arrangements, settlement depends upon each participant's ability to manage each of its bilateral positions and the multilateral netting is only advisory -reflecting the level of neither credit nor liquidity exposures. But because routine liquidity demands are reduced, the netting process encourages participants to manage their liquidity positions on a multilateral net-net basis even though their actual exposures are likely to be much higher. In the light of this mismatch and the possibility that such a reversal of payments could lead to a sudden and sizeable change in the remaining participants' settlement obligations, as the sole mechanism for managing the risks of a participant's inability to settle, a reversal process cannot be viewed as an acceptable means of ensuring the timely completion of daily settlements.

4.12 It may nonetheless be possible for a reversal procedure to be made consistent with the need to ensure the participants' abilities to complete the settlement of their adjusted positions by applying a further multilateral limit designed to contain the possible effect of a reversal of payments. In addition to the bilateral limits participants set for one another and the multilateral limits imposed on all participants' net-net debit positions, a "reversal limit" could be imposed on the amount produced by subtracting each participant's largest bilateral net-credit position from its multilateral net-net position. This is the amount which a participant would need to be able to settle as a result of a reversal and would be the equivalent of a limit imposed on the sum of participants' direct and contingent obligations. Implementing such a real-time limit could be costly to the netting provider and appear to be a significant constraint on the efficiency of the netting process from the participants' perspective. A reversal procedure which lacked such a mechanism for ensuring that the participants' recalculated settlement obligations would remain within their credit and liquidity resources would fail to satisfy the minimum condition of ensuring the timely completion of settlement.

Multi-currency Systems

4.13 The liquidity-risk management issues associated with multi-currency netting systems are particularly difficult and important. This results from the multiple liquidity risks to be managed and the complex relationship between the liquidity and credit risks. In particular, the central counterparty in a multi-currency system must manage the liquidity risks associated with the possibility of a participant's failure in each currency accepted for netting. The central counterparty may face credit exposures equal to the amount of the liquidity exposure or not, depending upon the timing of the different currency settlements and the particular combination of the defaulting participant's net-credit and net-debit positions.

4.14 In the daily settlement of the net positions produced by a multilateral netting system for foreign exchange contracts, for example, the central counterparty would face a sequence of net settlements in each currency accepted in the system. Thus, the system as a whole would face liquidity risks in each currency and the central counterparty would need to be able to ensure the timely completion of settlement in each currency.

4.15 At the same time, the system may face a credit exposure on the full amount of a participant's net-debit position in one or more currencies. This would be the case where a participant, that was a net receiver of those currencies which settled earlier in a given calendar day, failed to pay its net-debit position (in one or more of the currencies which settled later in the day) and was subsequently closed. Having paid out the net-credit positions, but having failed to receive the net-debit positions , the central counterparty could face liquidity exposures in the latter currencies and credit exposures of an equal amount.

4.16 The central counterparty could also experience liquidity exposure but little or no credit exposure. For example, if a participant were a net debtor in a currency which settled early in the calendar day, such as the Japanese Yen, and a net creditor in a currency which settled later in the day, such as the US dollar, and it failed to pay its Yen net-debit position, the central counterparty might be able to hold back the payment of the US dollar net-credit position and, thereby, maintain a surplus of US dollars to offset the short-fall in the Yen. But even so, the central counterparty would face a liquidity short-fall in Yen and, in order to ensure the timely completion of the system's Yen settlement, would need to be able to borrow or acquire additional Yen funds before the close of Yen money markets and settlement systems for that day. Moreover, the long position in US dollars, not yet actually received from that day's US-dollar net-debtors, would not be directly available to secure additional Yen funds in Tokyo. Thus, even in the absence of credit risks, the central counterparty would need to be able to manage liquidity exposures in each currency.

Centralised, collateral-based, liquidity-risk management.

4.17 Multilateral netting systems which adopt centralised risk-management arrangements, based upon the collateralisation of credit exposures, could extend this approach to the management of liquidity exposures. A centralised approach to liquidity-risk management could also be combined with a decentralised approach to the overall management of credit exposures. In either case, the central counterparty would need to arrange committed lines of credit in each currency while also ensuring that it had sufficient assets to repay any borrowings necessary to complete settlement.

4.18 The necessary assets to ensure the central counterparty's ability to borrow in each currency, as well as its ability to repay any borrowing in the event of credit losses, could come from either or both of two sources: collateral requirements or the prepayment of net-debit positions. Collateral could be posted by participants in amounts sufficient to ensure the ability of the central counterparty to borrow funds equal to the largest, single, permissible net-debit position in each currency. In systems with collateral-based management of credit risks the additional quantity of collateral necessary might not be very large. A requirement for the prepayment of net-debit positions in each currency -in effect, cash collateral -a day or two prior to each settlement date, might also provide a quantity of assets sufficient to ensure the completion of settlements . In the event of a participant's non-payment, net-credit positions due to that participant in other currencies could be withheld. The surplus currencies would already have been received and, thus, would be available to secure borrowings in currencies where there was a short-fall. Moreover, non-receipt of payments to cover net-debit positions a day or two in advance of the settlement date would give the central counterparty advance warning of problems.

Decentralised liquidity-risk management.

4.19 It may be possible for multi-currency systems to provide for a same-day, prorata allocation of a liquidity short-fall to the defaulting participant's trading counterparties in some of the currencies included in the system. In general terms, the arrangements in each currency would be similar to those which would apply in a decentralised approach to liquidity-risk management in single currency systems. Once again, the viability of such procedures would depend upon the ability of the participants prudently to adjust their positions within the constraints of the relevant money markets. This, in turn, would depend upon the size of the positions, the amount of time for making adjustments, and the participants' available credit and liquidity resources.

4.20 If this approach were to be adopted, participants' access to liquidity in each of the currencies accepted by the system would need to be carefully examined. Each participant would need to be able to set bilateral limits on the level of the liquidity exposure which it was willing to incur with respect to each other participant. Once again, because the system would be relying on the participants to absorb the exposures -in this case, the liquidity short-fall -the central counterparty would need to be able to set overall limits for each participant's total liquidity-sharing obligations. These limits on contingent liquidity obligations, however, would place yet another constraint on bilateral activity -in addition to limits on credit exposures.

4.21 The need for liquidity limits is another reflection of the difference between single-currency and multi-currency systems. In a single-currency system participants can set one limit on their contingent obligations, in the event of another participant's failure, which would cover both liquidity and credit exposures because these would be the same amount. But in multi-currency systems the liquidity exposure associated with a participant's failure to pay a net-debit position in one currency (which may or may not also reflect a credit exposure) will be quite different from the overall credit exposure on its position -including both forward replacement costs and Herstatt risks.

Comparison of liquidity-risk management techniques.

4.22 Use of the fully collateralised approach would provide a strong assurance of the system's ability to complete daily settlements in the event of a participant's default However, the posting of collateral or requiring the prepayment of net-debit positions (or some combination of the two) would replace liquidity risks associated with settlement with a new set of credit risks. For example, the central counterparty would presumably need to provide for the overnight investment of currencies that were prepaid so as to be able to give the participants some return on their prepaid funds. Choices would need to be made between investment in government securities, which would lower the credit risks but also increase the opportunity costs to the participants, and interbank placements, which would lower the opportunity costs but increase the credit risks.

4.23 If settlement volumes were large, participants would be likely to view the opportunity costs of full collateralisation of liquidity risks as a significant drawback. But such procedures would have the substantial benefit of making the cost of managing these exposures explicit and, thereby, increase the transparency of settlement risks. A major benefit of a prepayment requirement would be the elimination of Herstatt risks for the central counterparty. This would significantly reduce the total level of credit risks experienced by the system as a whole. Finally, provided that binding limits are placed on participants' daily settlement positions, to keep them within the level of available resources, the collateralisation approach to liquidity-risk management is the one most likely to meet the minimum condition of ensuring the timely completion of settlement .

4.24 In contrast, a completely decentralised approach to liquidity-risk management would impose no explicit costs of an ongoing nature in terms of the opportunity costs of posted collateral or prepaid funds. But in order to provide the same degree of assurance of the ability of the system as a whole to complete daily settlements in a timely manner, the limits placed on the level of participants' contingent liquidity obligations could be quite constricting. In such a system, participants would need not only to be highly creditworthy but also to have access to reliable sources of liquidity in each of the relevant currencies. Even so, highly-creditworthy participants with access to liquidity probably would face tighter limits on their activity than with a collateral-based approach. The necessity of such limits on activity is likely to impose significant implicit costs on participants' use of the system.

4.25 Overall, in the design and. operation of particular systems, it will be necessary for netting system providers and participants to weigh carefully the explicit costs of the collateral approach against the implicit costs of the distribution approach while maintaining the same degree of certainty that the system will be able to ensure the timely completion of settlements in each currency.