R. Alton Gilbert

R. Alton Gilbert is an assistant vice president at the FederalReserve Bank of St. Louis. Richard I. Jako provided researchassistance.

Implications of NettingArrangements for Bank Riskin Foreign Exchange Trans-actions

tHE MAJOR FINANCIAL institutions of manynations are active participants in the market forforeign exchange. The exchanges of currenciesthat take place through this market facilitate in-ternational trade and the international flow ofcapital for investments.

The volume of transactions in the foreign ex-change market—already very large—has grownrapidly in recent years. As of April 1989, thedate of the last international survey, foreign ex-change transactions had an average value of$640 billion per business day.

With dollar amounts in this lofty range, par-ticipants in the foreign exchange market couldincur substantial losses if the other parties totheir transactions ~s’ere to default on the pay-ments required to settle their side of the trans-

actions. To reduce the costs of transactions andlimit the size of these possible losses, somebanks engage in bilateral netting of their for-eign exchange transactions.’ In bilateral netting,two banks exchange daily only the net units ofcurrencies in the transactions between them.

Some groups of banks have also studied thepossibility of multilateral arrangements for net-ting foreign exchange transactions, though noneare in operation at this time.2 Members of amultilateral netting arrangement would settletransactions with each other by making pay-ments to a clearing house for their net positionin each currency with the other members.

As part of their responsibility to avoid disrup-tions in the operation of payment systems, cen-tral banks have a strong interest in such netting

1Netting agreements between pairs of banks may apply topayments in settlement of transactions other than foreignexchange. This paper, however, limits analysis to the net-ting of foreign exchange transactions. All participants inthe foreign exchange market are called banks to simplifyexposition. In some markets, the important participants in-clude firms that are not banks. See Federal Reserve Bank

of New York (1989) and Bank of England (1989). See glos-saw on page 14 for definition of netting and other termsused in this paper.

2See Deeg (1990), Duncan (1991), Luthringhausen (1990)and Polo (1990).

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

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

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 processIll 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 andth participants. These procedures should also ensure that all parties have both the incentivesand the capabilities to manage and contain each of the risks they bear and that limits are placedon the maximum level of credit exposure that can be produced by each participant

IV Multilateral netting systems should at a minimum be capable of ensuring the timely completionof daily settlements in the event of an inability to settle by the participant with the largest singlenet-debit position

V. Multilateral netting systems should have objective and publicly disclosed criteria for admissionwhich permit fair and open access

VI All netting chemes should ensure the operational reliability oftechnical systems and the availability of back up facilities capable of completing daily processing requirements

SOURCE. Bank for International Settlements (1990c)

art angements.” Since foreign exchange transac ting ai iangements foi hinkers n ho ma~de~eloptions often mx olve parties headquartered in them (see table 1).’different countries, a default by one participant ,, - -

- . - - I his paper illusti ates the risk in settling for-ts likely to affect those in other countries. Banks - - . - -

eign exchange transactions and the risk implica-adversely affected by such defaults typically - . - -

- - - - . - tions of netting, using a hypothetical example ofwould turn to then’ central banks for assistance . - -

- - - - - - transactions among three banks. 1 his exercisein coping with liquidity problems. . . - - -

illustrates how netting may reduce risk, ii net-In recent years, promoters of interbank net- ting arrangements conform to the guidelines in

ting arrangements have requested the views of the Lamfalussv Report.5

central banks individually on projects that ap-peared to have implications for a number of F ‘U :t it K FT UGH Ft Ut FlU K UK —

countries. ‘The central banks of 10 major indus- - -

trialized countries recently issued a joint state-ment, through the Bank for International Set- A foreign exchange transaction is an agree-tlements, about the netting of foreign exchange ment by two parties (generally large banks) totransactions, This is commonly called the “Lain- exchange currencies on a given date, called thefalussv Report,’’ named after the committee value date of the transaction. ‘I’he most commonchairman who drafted the report. The commit- type of transaction between participants in thetee expressed concern about the risks involved foreign exchange market, a spot transaction, isin settling foreign exchange transactions and an agreement between two parties to exchangediscussed the potential benefits and drawbacks units of currencies two business days from theof netting arrangements. The central bankers date the transaction is negotiated. A transactionlisted minimum standards for the design of net- with a value date more than two days after the

3See Summers (1991) for a discussion of the role of central of netting. See Juncker, Summers and Young (1991) for abanks in the operation of payment systems. general discussion of the issues raised by netting ar-

4bank for International Settlements (1990c). rangements.5Cody (1990) also provides an introduction to the risk insettling foreign exchange transactions and the implications

date of negotiation is called a forward transac -______________________________________________tion. Some forward transactions have valuedates more than a year into the future, but Table 2most call for settlement within a month. Several Foreign Exchange Market Activity inother types of transactions, including futures April 1989 (billions of U.S. dollars)tcontracts, options and swaps, have been deve-loped to more effectively limit the effects of Countries and items Value of transactions per daychanges in exchange rates on the wealth of United Kingdom $ 1872

banks and their customers.” united States 1292Japan 115

Large commercial banks are the major par- Switzerland3[555 I 57

ticipants in the foreign exchange market. The Singapor 55latest international survey of foreign exchange Hong Kong 49activity, in April 1989, indicates that the three Australia 30

France 195%) 26most active centers are London, New York and Canada 15Tokyo (table 2). The value of foreign exchange Netherlands 13transactions has been growing faster than inter- Denmark [90°/il 13national trade in goods and services (table 3). Sweden 3

Such growth reflects more than the growth of Belgium [90°/i] 10- Italy l75°/°l 10

international trade; it also reflects international Other countries4 22capital flows and transactions by banks andtheir customers to manage exchange rate risk. otat 744

Transactions in the foreign exchange market Adjustment for

link the major financial institutions of the world, double-counting 204

In the London market, for instance, 80 percentof the value of foreign exchange transactions in Total repor ed netApril 1989 was by firms ivith headquarters out- turnove 540side of England.~In the survey of foreign cx- Estimated gaps inchange market activity in New York, 40 percent reporting 100of the value of transactions was reported by

- . Estimated globaloffices of foreign banks.” 1 hus, one of the im-

- ... . . . turnover $ 640portant ivays in which a major financial institu-tion can affect institutions in other countries is

- . . Value of transactions in currencies other than U S dot-by defaulting on foreign exchange transactions. tar converted to dollars at prevailing exchange ratesThe figures for individual countries indicate turnover

a <~, ‘sa — - - net of double counting arising from local interbank bust- - - - ness The totals at the foot of the table are estimates of

‘-31: I’ /naj ii a3 ta.t’ turnover net of double-counting a ising from both localand cross-border interbank business.

2Based on estimates of domestic and cross-border interThe process of confirmation and settlement bank business arranged through brokers,

begins after traders at two banks agree on the 3No adjustment for less than full coverage, estimated- market coverage is given in square bracketsterms of a transaction. Each bank sends the

other a message specifying the terms of the ~ Greece Ireland Norw y Portugaltransaction, using a variety of methods, includ-

- SOURCE- Bank for International Settlements (1990a)ing telephone calls. If the details of the mes-sages match, the transaction is consider-edconfirmed. settlement. On the value date, banks transmit

‘I’he next step depends on the value date of information to initiate payment. The steps to in-

the transaction. If it is a forward transaction, itiate payment depend on the payment systemwith a value date several weeks or months into used in the country issuing the currency andthe future, the information is stored for future the relationship of the paying bank to that pay-

“For a more detailed discussion of the foreign exchange “Federal Reserve Bank of New York (1989).market, see Chrysfat (1984).

‘Bank of England (1989).

aan’,r.c~5 a,,, a

Table 3Growth ofTrade and

Foreign Exchange Market TraInternational Banking Activity

nsactions, Foreign

Countries

Value of foreign exchangetransactions: percentagechange between March 1986to April 1989 net turnover

Exports and imports ofgoods and services:percentage changefrom 1/1986 to 1/1989

United Kingdom 108% 62%

United States 120 44

Japan 140 82

Canada 58 44

Total 116 56

SOURCE Bank for International Settlements (1990a)

ment system. For a bank paying in a currencyother than that of its home country, paymentgenerally is made by a correspondent headquar-tered in the foreign country. A correspondent isa bank that holds deposits amid provides servicesfor other banks. The paying bank commonlysends a message over SWIFT, instructing its cor-respondent to make payment to the counter-party in the foreign exchange transaction.’

Suppose, for instance, that a bank headquar-tered in the United States must pay Germanmarks to a counterparty to settle a foreign ex-

change transaction. The U.S. bank instructs itsGerman correspondent to make payment to thecounterparty (or the counterparty’s German cor-respondent). The German correspondent debitsthe account of the U.S. hank denominated inmarks and transfers the marks to the counter-party. Suppose a U.S. hank is obligated to paydollars. It would send a message over CHIPS tomake payment to the counterparty, either di-rectly if it is a member of CHIPS, or through acorrespondent in New York who is a memberof GRIPS)°

Banks assume the risk that their counterpar-ties will default on payments on their side offoreign exchange transactions. Effects on coun-terparties of default on settlement obligationsdepend on the financial condition of the bankthat defaults. A solvent hank may default for avariety of reasons. Operating problems (for cx-ample, computer failure) may prevent themfrom executing their payment instructions. Asolvent counterparty may not have funds in theproper currency on the value date, or- simplymay forget to send payment oi-ders to settlesome of their transactions.

Defaults by solvent banks on settlement obli-gations may have systemic effects, preventingother banks from settling their obligations.These banks may turn to their central banksfor short-term loans denominated in the curren-

‘SWIFT (Society for Worldwide Interbank FinancialTelecommunication) is an electronic system, located inBrussels, Belgium, for sending messages among theworld’s major banks,

“See Bank for International Settlement (1990b) for adescription of payments systems in various countries.CHIPS (Clearing House for lnterbank Payments System) isan electronic payments system operated by the New YorkClearing House Association- CHIPS participants (131 as ofthe end of 1990) exchange payment messages duringeach business day and settle for the net amounts at day-

end with transfers of reserve balances at the FederalReserve. See Federal Reserve Bank of New York (1991).A large share of CHIPS messages involve payment for thedollar side of foreign exchange transactions. Given thatmost foreign exchange transactions involve the US. dollar,CHIPS has a major role in the settlement of foreign ex-change transactions. See Federai Reserve Bank of NewYork (1987),

Table 4Payments in Settlement of Foreign Exchange Transactions under Gross Set-tlement and Bilateral Netting

Gross settlement Bilateral netting

Transaction Direction of Units of Direction of Units ofCounterparties number payment currencies - payment currencies

Bank A and I Bank A to Bank B t too Bark A to Bank B 50Bank B Banic B to Bank A $175 Bank B to Bank A $90

(Pro’:t o’ $10.00 for Bank A) tProlil of $750 for Bank Aj

2 BankAtoBankB SB5Bank B to Bank A 1 50

(Profit of —82 50 fo’ Band A~

Bank A and I Bank A to Bank C 100 Bank A to Bank C $92.50Bark C Bank C to Bank A $170 Bank C to Bank A 50

(Profit of $500 For Bank Ay tP~ofitof —51000 for Bank A)

2 Bank A to Bank C $262.50Bank C to Bank A 1 ‘50

~Pro’iIof —$1500 For Bank A)

Bank B ano 1 Bank B to Bank C 150 Bank B to Bank C 1100Ban~C Bank C to Bank B 5262 50 Bank C to Bank B $17750

lProfit of $15.00 fo- Bank B) lProfit of $1250 tor Bank B)

2 BankBloBankC 58500Bank C to Bar.k B 1 50

fP’ofit of — $2.50 for Bank B)

cies necessary to settle their obligations. Thus,central banks have a collective interest in mini-mizing the chances of such liquidity problems.

Most liquidity problems am-c often only tem-porary. Bankruptcy and liquidation of a par-ticipant in the foreign exchange market, how-ever, pose a more serious threat to individualcounterparties and create the potential for sys-temic disruptions in the payment system (defaultby one bank causing default by others). Under ageneral definition of bankruptcy, the value ofliabilities exceeds the value of assets. Some largebankm-upt banks have been reorganized with as-sistance of their home governments. ‘The reor-ganized banks continue to operate as going con-cerns, making payments in settlement of theirobligations. Such reorganizations impose no loss-es on their counterparties.

In other cases, however, bankrupt bankscease to operate as going concerns. The courtsappoint receivers to liquidate the bankrupt

banks’ assets and make payments to their credi-tors. The receivers may impose losses on otherbanks that were counterparties to foreign ex-change transactions. Such losses depend on thelegal pr-inciples followed by bankm’uptcy courtsand the nature of netting agreements betweencounterpar ties -

The effects of the liquidation of a participantin the foreign exchange market on its cOunter’-parties are illustrated below Legal assumptionsare specified along the way as the exampleraises questions about the principles followedby bankruptcy courts. In each case in which abank is assumed to go bankrupt, it is also as-sumed to be liquidated by a court-appointedreceiver.

The.E~rampIe

Suppose three banks (A, B and C) engage infom’eign exchange transactions in two currencies:the U.S. dollar and the British pound. Eachbank has foreign exchange transactions with theother two. ‘Table 4 lists the transactions between

the counterparties to be settled on the samevalue date. Each pair of banks has two transac-tions to settle. In one transaction, a hank paysdollars in exchange for pounds; in the other, abank pays pounds in exchange for dollars.

The exchange rate on the value date is $1.65per British pound. Transactions to he settled onthe value date were negotiated a few days earli-er- when the exchange rate was higher: sometransactions were negotiated with an exchangerate of $1.70; others, with an exchange rate of$1.75. Transactions are of varying size, creatingimbalances in the flows of currencies betweencounterparties.

The example is designed to be as simple aspossible and yet illustrate the risk involved innetting arrangements. ‘rhere must he at leasttwo transactions between a pair of banks ifbilateral netting is to reduce the volume of pay-ments and settlement risk. Three is the mini-mum number of banks for multilatemal netting.

ia,, It/i ~ ~ ~ ~

the I%,.:n,nfler am.! t:i:nue: ttj ‘I tans~

Figure 1 illustrates how bilateral netting af-fects the flows of currencies between Banks Aand B in settling the transactions listed in table 4.Under gross settlement, banks make paymentsto each other to settle each transaction betweenthem. To settle transaction number 1, Bank Apays £ 100 to Bank B, receiving $175 in turn.Since the exchange rate is $1.65 on the valuedate, this exchange of currencies yields a profitof $10 to Bank A. (Bank A receives $175, whereasthe £ 100 paid by Bank A has a value of $165on the value date). Bank A pays $85 to Bank Bin settlement of transaction number 2, receiving£ 50. This exchange yields a loss of S2.50 forBank A on the value date.

Banks A and B can economize on transactionsby netting their payments flows. As illustratedin the bottom half of figure 1, Bank A couldpay £ 50 to Bank B and receive $90 from BankB. Bilateral netting reduces the number of pay-ments from four to two arid the value of pay-ments, converted to dollars at the exchange rateof $1.65, from $507.50 to $172.50.

!ts’k ui ~~.;E:I~’!!!.flf!j~’(fl’~‘-pfl L~r-

C!! •anLe TC1:I!flsa(IIt( .~ rtflar.ri ai%thlIth.g .[tr’anee.!m!m

To illustrate how netting arrangenients affectrisk, one must first understand the risk thatbanks assume without a netting agreement.

Legal ,%aeu t pLaa’ta .... This section specifiesseveral assumptions about the legal principlesthat the bankruptcy court follows when bankssettle their transactions without netting arrange-ments. While these principles are not applied inall cases, they at-c common and they simplifythe analysis.

One assumption concerns the application of le-gal rights of set-off permitted by the court. Un-der’ the legal rights of set-off, the counterpartyof a failed bank may settle its obligations withthe receiver by paying the net amount of thetransactions between them. If on net the failedbank owes a solvent counterparty, the counter-party is a general creditor of the failed bank forthe net amount. Applying the rights of set-off tothe foreign exchange transactions between apair of banks yields the same loss to the solventcountem’party as it would under bilateral netting.Applying the legal rights of set-off, however, isuncertain and varies among the courts of differ-ent countries.” In this paper, rights of set-offare assumed not to apply in bankr’uptc~.Eachtransaction is treated separately, not linked toother transactions between the same par-ties.

The court with jurisdiction in a bankruptcycase is assumed to appoint a receiver. In mak-ing payments to settle foreign exchange transac-tions or defaulting on transactions, the receiveracts to maximize the return to all creditors ofthe failed bank, without regard for the counter-parties to foreign exchange transactions as aparticular group of creditors.

A final issue concerns the status of claimnsagainst a bankrupt bank that result from itsdefault on foreign exchange transactions. Sol-vent counterparties are assumed to have thestatus of general creditor’s. In our example, loss-es are calculated under the assumption thatgeneral creditors receive nothing. All proceedsfrom the liquidation of assets go to creditorswith more senior claims.

‘1

Bank for International Settlements (1989), pp. 13-14.

9

Figure 1Flow of Currencies Between Banks Under Gross Settlement and Bilateral Netting

Gross Settlement

Transaction #2

£ 100

£ 50

. 585

Number of Payments: 4Dollar Value: $507.50

Bilateral Netting

£50

1I\

Profit to Bank A:

-$2.50

Profit to Bank A:

nnnHL!ULH

$90

~.50

~~~BANK B

UUL:U

Number of Payments: 2

Dollar Value: $172.50

Transaction #1 Profit to Bank A:

$10.00

RRfl~___ ULHL

______ __-j

‘These legal assumptions yield the maximumnlosses to counterparties. Thus, the losses calcu-lated in particular cases can be viewed as themaximum, not necessarily the most likely, losses.

pa~are Suppose Banks A and B agree to set-tle theim’ tm-ansactions as illustrated in the tophalf of figure 1, the gross settlement method.Suppose also that Bank A goes hankmupt beforethe four payments are executed on the valuedate. The possible loss to Bank B depends onthe timing of the bankruptcy of Bank A.

In one situation, called jjre-settlement failure,Bank A goes bankrupt before the value date,and Bank B knows about this event by theopening of business on the value date. In theother situation, called settlement failure, a bankmakes payment on the value date for its side offoreign exchange transactions but does not re-ceive payment from a counterparty.

One feature of the foreign exchange marketthat makes banks vulnerable to settlement fail-ure is the difference in the time zones of cen-tral banks. The failure of the Herstatt Bank in1974 illustrates the relationship between timezones and settlement failure. On June 26, 1974,German banking authorities closed Herstatt asof the close of business in Germany. Herstatthad received payment in marks during Germanbanking hours for its foreign exchange transac-tions with that value date. It was closed, how-ever, before the time for making payments indollars in New York. Counterparties of Herstattwere left without the dollars they expected, af-ter paying marks to Flerstatt earlier in the day.’2

Our example of settlement failure in this paperreflects the implications of differences in timezones. One bank is assumed to go bankrupt af-ter the time for payments in pounds but beforethe time for making payments in dollars.

Pre-Settlement Failure — Suppose Bank Agoes bankrupt before the value date. Without anetting agreement between Banks A and B, thelegal obligations of each hank are those speci-fied in the individual transactions between them.With an exchange rate of $1.65 on the valuedate, transaction number I is profitable to BankA. The receiver of Bank A will pay £ 100 toBank B to settle transaction number 1. Bank B is

obligated to pay $175 to Bank A to settle thistransaction. Since transaction number 2 is notprofitable to Bank A on the value date, the re-ceiver will default on transaction number 2.Bank B anticipated a profit of $2.50 on the valuedate from transaction numnber 2. Thus, the bank-ruptcy of Bank A imposes a loss of $2.50 onBank B. ‘Table 5 shows the loss to each bankdue to the bankruptcy of its counterparty be-fore the value date, under both gross settlementand netting arrangements.

Settlement Failure — Suppose Bank A goesbankrupt on the value date after payment inpounds but before payment in dollars. Bank Adefaults on its payment of $85 to Bank B on thevalue date. Under gross settlement of transac-tions, however, Bank B is obligated to pay the$175 to Bank A. Bank B becomes a general cre-ditor of Bank A for $85. The maximum loss toBank B, as table 6 indicates, is $85.

Settlement failure can create liquidity problemsfor the counterparties of a failed bank. SupposeBank B pays the $175 to Bank A before discov-ering that Bank A is bankrupt. ‘T’he cash bal-ances of Bank B denominated in dollars will he$85 below the level it had projected for thevalue date. Bank B might request a discountwindow loan from the Federal Reserve to coverthe $85 shortfall in its m’eserve account.

f•~~7a sa.Cfef!tLs

If Banks A and B engage in bilateral netting, theeffects of the bankruptcy of Bank A on Bank Bdepend on whether paying the net amount dis-charges the obligations between counterparties.

ta-eel ;%eetitfletiufls Under one type ofagreement called position netting, two banksagree to net their payments to reduce transac-tions costs, hut the agreement has no effect ontheir legal obligations. Under’ the legal assump-tions in this paper, the position netting agree-ment would not prevent the receiver frommaking payments in settlement of some transac-tions hut defaulting on other’s with the samecounterparty. The bankruptcy court would treatthe payment obligation of Banks A and B asthough they had no netting agreement. Thebankruptcy of one party has the same implica-

‘2Moore (1974).

Table 5Bank Losses from Pre-SettlementFailure

-- Losses to

Failure of - - Bank A Bank B Bank C

Bank AGross settlement $ 250 $15.00Bilateral netting 0.00 10.00Multilateral netting 0.00 250

Bank BGross settlement $10.00 250Bilateral netting 750 0.00Multilateral netting 0.00 000

Bank CGross settlement 500 15.00Bilateral netting OflO 12.50Multilateral netting 0.00 250

Table 6Bank Losses from Settlement Failure

Losses to

Failure of Bank A Bank B Bank C

Bank AGross settlement $ 85.00 5262 50Bilateral netting 0.00 9250Multilateral netting 0.00 2.50

Bank BGross settlement $17500 85.00Bilateral nettng 90.00 0.00Multilateral netting 000 0.00

Bank CGross settlement 170 00 262.50Bilateral netting 0.00 177.50Multilateral netting 0.00 85.00

tii}I)~, It)! liii’ ii)tintil1liuit\ LIS 1 the~ ‘,t’ttletltiLiri~zu’I iou” LIr,1u1U Ihi i1rn’,’, settleinruil method.

Netting agreements that reduce this exposureto loss mandate that banks discharge their obli-gations by paying the net amount of the trans-actions between them. The legal language forsuch agreements is netting by novation. Thispaper assumes that bankruptcy courts recognizea contract for netting by novation as the onlycontract between counterparties for settlementof foreign exchange transactions.

A provision of bilateral netting contracts thatreduces risk is called closeout, which becomeseffective when a receiver or liquidator is ap-pointed after a bank declares bankruptcy.” Anetting agreement includes a formula that con-verts all outstanding transactions between apair of counterparties, for all value dates, intoone amount payable immediately. The closeoutprovision prohibits the receiver of a bankruptbank from making payments in settlement fortransactions with some value dates but default-ing on transactions with other value dates.”Bankruptcy courts are assumed to recognizecloseout provisions as valid parts of netting ar-rangements.

— As the bottom

half of figure 1 illustrates, the one contract be-

tween Banks A and B under netting by novationcalls for Bank A to pay £ 50 and receive $90. Atthe exchange rate of $1.65 on the value date,this contract is profitable for Bank A. Thus, thereceiver of Bank A would pay the £ 50 to BankB to settle the contract. The bankruptcy of BankA prior to the value date would impose no losson Bank B, since Bank B had anticipated honor-ing its contract with Bank A before discoveringthat Bank A was bankrupt. In each case of pre-settlement failure illustrated in table 5, the loss-es are smaller under bilateral netting by nova-tion than under gross settlement.

— The bankruptcy ofBank A after payments in pounds but beforepayments in dollars imposes no loss on Bank Bsince, under the netting agreement, Bank A hadno obligation to pay dollars to Bank B. As table6 indicates, in settlement failure, the loss to abank from the bankruptcy of its counterparty is

“Bank for International Settlements (1989), p. 13.“One firm that offers legal advice and a oommunications

network for bilateral netting by novation is FXNET. Thenetting oontract drafted by FXNET includes netting by no-vation and closeout. See Bartko (1990). For further refer-ence to FXNET, see Scarlata (1992), this Review. Plans

for multilateral netting include similar closeout provisionsin contracts between individual members and the clearinghouses that would act as paying agents for the netting ar-rangements. See Duncan (1991). These closeout provi-sions limit the losses of solvent banks resulting fromdefault by counterparties.

12

smaller under bilateral netting by nox’ation thanunder’ gross settlement for each combination offailed hank amid counterparty.

‘The assumptions in this paper concerning theprinciples that bankruptcy courts follow yieldthe maximum reductions in losses from netting.These reductions in losses could he smaller un-der alternative assumptions.

‘The Lamfalussv Report indicates that hilatem-alnetting could increase risk in settling foreign ex-change transactions if netting arrangements donot have a sound legal basis. If netting obscuresthe level of exposures, then netting arrange-merits have the lJotential to contribute to an in-crease in sstemic risk.’’’’ The argument thatbilateral netting may pose greater risks is basedon assumptions about how banks that are activein the foreign exchange market set credit limitswith counterparties. Banks with bilateral nettingagreements max’ set credit lirni ts with each otherbased on their net positions rather than thegross value of the underlying transactions he-tween them. If a bankruptcy court requirespayments by a solvent countem-pam’tv based onthe value of the underlying transactions ratherthan the netting agreement, the exposure of thesolvent counterpartv would he larger than cx-pected. This point indicates why the LamfalussvReport emphasizes the legal basis for netting ar-i-angements (table 1).

Banks may be able to further reduce theirtransaction costs and their exposure to loss byengaging in multilateral nettimig. No multilateralnetting arrangements are in operation at thistime. This section examines the implications of amultilateral netting arr’angement modeled aftera draft of the plans of the ECHO NETTING sys-tem in London.”

I .a~ ,rmi~Iona — In the contract formultilateral netting, members of a netting at’-rangement establish a clearing house, whichreceives and pays out currencies in settlementof foreign exchange transactions. The clearinghouse is the counterparty for each tm’ansactionbetween members of the multilateral netting ar-rangement. Each member settles its legal obliga-

tions with the other’s by making payments tothe clearing house. ‘The clearing house assumesresponsibility for paving all net amounts due tomembers, even if a member defaults on its pay-ments to the clearing house.

‘l’he contract in a inulti lateral netting arrange-ment is assumed to include a closeout provision.If a member of the clearing house goes bank-rupt, its receiver has only one decision to makeabout the foreign exchange transactions that thefailed bank negotiated with other’ members:make the pa~mnentsto settle the one contractwith the clearing house or default.

a ~.:I ~.~:‘~•aa a. d ~‘ . a a ~:, .~ a —

F’igum-e 2 presents the payments between rnem-hers of the netting arrangement and the clear-ing house, derived from payments that wouldhe made under bilateral netting in table 4. Thecalculation of the numbers in figure 2 is illus-trated for Bank A. Under bilateral netting, BankA pays the other banks £ so (Bank B) and $92.50(Bank C) and receives $90 (Bank B) and £ 50(Bank C). Under mnultilatemal netting, therefore,Bank A owes the clearing house $2.50 and theclearing house owes Bank A nothing on thevalue date. Figure 2 also indicates the paymentsbetween the clearing house and Banks B and C.

Any clearing house losses resulting from thedefault of a member are allocated to the othermembers in proportion to the losses they wouldhave incurred under bilateral netting. This for-mnula gives each member of the arrangement anincentive to avoid transactions with members itconsiders to he in danger of going bankrupt.

— If Bank A goesbankrupt before the value date, its receiver willdefault on the payment of $2.50 to the clearinghouse. The loss of $2.50 is allocated to Bank C,since only Bank C would have a loss underbilateral netting.

If Bank B goes bankrupt before the valuedate, its receiver will make the payment of £ 50to settle the contract with the clearing house,since it yields a profit of $5 to Bank B. As tableS indicates, the bankruptcy of Bank B beforethe value date imposes no loss on the otherbanks. The bankruptcy of Bank C imposes a lossof $2.50 on Bank B. In each case in table 5, the

“Bank for International Settlements (1990c), p. 3. “Duncan (1991).

Figure 2Payments Between Members of a Multilateral Netting Arrangement andthe Clearing House

Profit to Bank C: -$2.50

Profit to Bank A: -$2.50

Profit to Bank B: $5.00

$87.50

r

Number of Payments: 5

DELL

CLEARiNGHOUSE

$85 £50

DELL.Dollar Value: $340

A Glossary of TermsHi tale rat ne t~ing Ui arrau igenmulI bet WI ‘eru ti~o parties in u h ich they c \ C hLtLige only

the tict t.uuiil s of the c:ur’u’eric’ies slx’rif ed iii the I ratisactions l)c’tweenthem, rather than the flflflfl(~ie”for each transaction mtli~-itItuallv.

Clearing house An i u 1st it uI ion est at; tished b~a grou p of I ianks to facili IaR’ the set tie-mont oF obligations among themselves. Each hank settles its ohliga—lions with the others by making payruienl lo the clearing hotist’ fortim net amount owed I he other nieuiihers.

Cowl I erparty I he other pa i-h i ti a t ‘a cmi c-tion. in i lo reign exchange tu-a ns&Lc t ion,otie party agrees to make pLiyuru’rIt in one currency and its cotuntccr-parft agrees to pay in ~tricit he current :v.

Foreign exchange - ‘~ii a gu-eenienI b I WI) ~d it ies (generaflv large batik si to P’LiliLi nge CLI

transact ion ret ~cits on a gi~eui dam te.

Gross set tienien I A mel tic id of ru iaking pan- men t s bet ~V‘eti a pair of patti us in wI tic 1each pa rt~ nia kesase.pa rate pa’ men L in set F foment of ea cli transac-lion between theun.

Legal rights oF - ii tier hank rupt c’ Ian - a right to net oh I ga tic ins ym it Ii a bank u’ti pmset—off cotu nLc’rpa eLy.

%Iulti lateral nelling .-\n ai-rangecnent betweeut t hirer or more parties in which each uimm~her ritakes pa~’went s to a cleari rig house for the net pa” merits due toliii- other uiiemhc’rs and receives frcuuui [lit clearing house the netatuiot.unls cute from the other uticuuihers.

~etting An ar-rangeurieuit by which l}LtuIic’s with more than one transact on tciaettit’ Oil a gi~cr1 (IL! te excha uige onI~the ic t amounts of the t rinsac-tiouis bet;~eeui them.

r~el t ing by Flte repiac ~nerut of ttvo cx is F imig ccnit i-acts he t ~ ecu i In o parties furnovation delivery ol a specified currency out I he saruie date liv a single net

contract for that date, so that the origria I corfl racts a i-c satisfied auntdisea nit ci.

Position tie I I Ing lie tie tt i ng I )f payment oh I iga t u Otis I )O t ~veen t lao or more pa tieswhieh neither satisfies nor discharges the original ohhgatioris thatla tit netted.

Pre—settlenient Bankruptcy of a hauik prior to the value date ol transactions with LI

fai In re coo ii te party.

Set Iteunen I ( oun pIc ticm Of a pa~inc mit bet n eeri two pa ut es di~cha rgi rig an oh!-ganon.

Settlt’nwnt tailure Default by a batik oIl pavrnc’nt in one ctirrenr~-after the hauuk andits counterpartv had uuiade pavunc’nts in the other c:urrc,ric:v.

S~’slenuicrisk ftc risk that thc’ inalnIut~-of ouic iristitrutiori wilhiui a payment s~steniito uuueet ils obhigatiouis when chic ~~ill cause citlier liarticipatutts tci heunable to mec’t their obligations ~vheuithur.

Value date [he date on which banks exchange culTencies iui settlement of ~ulcu—cign exchange tu’ansac ticn’i.

loss under multilateral netting is either zero orsmaller than under bilateral netting.

t4~n~ Faiinn~ Suppose Bank A goesbankrupt after the payment of pounds but be-fore the payment of dollars. The loss to beborne by members of the clearing house is$2.50, the payment obligation of Bank A. Thisloss is imposed on Bank C, which would have aloss of $92.50 under hilateral netting (table 6).

Bank B has no obligation to pay dollars to theclearing house. Thus, the bankruptcy of Bank Bafter the payment of pounds hut before thepayment of dollars imposes no losses on othermembers of the clearing house. The bankruptcyof Bank C after payment in pounds imposes aloss of $85 on Bank B. ‘the loss in each case un-der multilateral netting in table 6 is either zeroor less than the loss under bilateral netting.’~

.Iiquidittz Requirenreni!:;: / the(1~k~ar/nt,~.tionse

One of the concerns central bankers haveabout multilateral netting is whether the clear-ing house would have access to sufficient li-quidity to make payments to other members ifone of them defaults. The Lamfalussy Report in-dicates that a clearing house should “be capableof ensuring the timely completion of daily settle-ments in the event of an inability to settle bythe participant with the largest single net-debitposition.” in figure 2, Banks A and C each havenet debit positions of $250. The clearing housewould need access to at least $250 to meet theminimum liquidity requirement of the Lamfal-ussy Report. This requirement is a cost of oper-ating the clearing house, either as the oppor-tunity cost of liquid assets held by the clearinghouse or the cost of credit lines. Bilateral net-ting, in contrast, involves no such costs.

Banks assume risk in settling foreign exchangetransactions. ‘this paper examines the implica-tions of netting by using a hypothetical exam-

pie. The example shows how netting schemescan reduce the size of losses to counterpartieswhen a bank goes bankrupt and is liquidated.

A committee of central bankers from the ma-jor developed countries recently examined theimplications of netting arrangements for risk.‘I’he committee’s report indicates that netting ar-rangements may either increase or decreaserisk, depending on whether they meet certainminimum standards listed in the report.

Bilateral netting could reduce the loss when acounterparty defaults, if the bankruptcy courtwould 1-ecognize the payment of the net amountbetween the counterparties as a settlement ofthe transactions between them. It could increaserisk in settlement of foreign exchange transac-tions, however, if counterparties set creditlimits based on their net exposures hut thecourt requires payment in settlement for eachunderlying transaction between counterparties.

Multilateral netting can reduce the losses re-sulting from default even more than bilateralnetting, if the clearing house created to settletransactions has access to the liquid assets ne-cessary to complete the settlement. Lack ofsufficient liquidity for the clearing house couldcreate a major disruption in the operation ofthe payment system.

Bank for International Settlements. Report on Netting Schemes(BIS, Febnuany 1989)._______ - Survey of Foreign Exchange Market Activity (BlS,February 1990a).

_______ - Large-Value Funds Transfer Systems in the Groupof Ten Countries (BIS, May 1990b).

Report of the Committee on Interbank NettingSchemes of the Central Banks of the Group of Ten Coun-tries (BIS, November 199Cc).

Bank of England. ‘The Market in Foreign Exchange in Lon-don:’ Bank of England Quarterly Bulletin (November 1989),pp. 531-35.

17The generality of the result that netting reduces losses tosolvent counterparties can be investigated by srmulatrngthe losses resulting from default in an example with morebanks and more transactions and with some terms of thetransactions chosen at random. Our simulation includes 10banks. Each has 10 transactions to settle with each of theother nine banks. The size of the transactions and ex-change rates are chosen at random. The multilateral net-

ting arrangement uses the loss-sharing formula describedabove. Each of the IC banks is assumed to go bankrupt,imposing losses on nine counterparties. In each of the 90cases of losses to counterparties, losses are smaller underbilateral netting than under the gross settlement method,and losses under multilateral netting are either zero orsmaller than under bilateral netting.

16

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