During the past year, the Committee continued to pursue its longstanding interest in the netting of foreign exchange contracts.
As noted above, the Committee prepared a comment letter to the Secretary of the board of Governors of the Federal Reserve System supporting the recognition of netting by novation in the risk-based capital framework, to the same extent that such arrangements have been recognized for regulatory reporting purpose.(See p. 16.) The risk-based capital guidelines, released in July 1988 by the Bank for International Settlements, largely reflected the Committee's views on the treatment of netting provisions.
Furthermore, the Committee attempted to facilitate a broader understanding of the principal attributes of various netting concepts, products and proposals. It was prompted to pursue this endeavor out of concern that many banks appeared to be either unaware of, or confused by some of the particular features of different netting mechanisms. The risk was that institutions may be adopting informal netting procedures that could mislead managements. A bank's net exposure may appear to be within prudent bounds while, in fact, there may be a very large gross credit exposure.
Two developments gave rise to this concern. First, during the autumn of 1987, FOREX USA Inc. at its Senior Dealers Conference had distributed a questionnaire on foreign exchange netting practices of U.S. banks. The results of that survey suggested a far greater use of cross-border netting than would appear justified given the limited progress in establishing netting agreements that would conform with legal codes in different countries. The second was a questionnaire distributed to institutions represented o the Committee as to their netting practices. A purpose of this second questionnaire was to shed some light on the significance of the FOREX exercise. A somewhat disturbing finding from this limited serve sample was that only about half of the participating[ institution insisted on having formal netting agreements with their netting counterparties. Apparently, several banks were willing to initiate informal agreements with counterparties to net foreign exchange payments between themselves.
In order to identify the major attributes of the various netting arrangements and proposals underway at the time the Committee established a subcommittee which conducted interviews with representatives of institutions providing, or proposing to provide, netting services. The subcommittee also arranged technical presentations or briefings on certain netting arrangements. In reporting its findings to the Committee the subcommittee made no recommendations favoring one netting product over another.
Meanwhile, the Group of Ten (G-10) central banks separately initiated their own study to evaluate the impact of foreign exchange netting arrangements on the efficient functioning of the foreign exchange market. In particular their study systematically assessed the contributions various netting arrangements could make to the reduction of counterparty and systemic risk. The G-10 central banks published their detailed findings in order to heighten awareness of the legal, financial, and structural issues raised by different netting systems. ( A copy of the "Report on Netting Schemes," prepared for the Bank for International Settlements by the Group of Experts on Payment Systems of the central banks of the Group of Ten countries, is being sent with this report.)
Interest in Netting Arrangements
Interest in foreign exchange netting has increased as the volume of banks' outstanding foreign exchange contracts has expanded both absolutely and in relation to capital. Netting arrangements may, under certain circumstances influence the efficiency of the foreign exchange market. Incentive for banks to implement netting arrangements may derive from at least four areas.
- Banks may enter into netting arrangements to reduce interbank payment flows or the number of settlement payment instructions that are exchanged between counterparties in order to reduce transaction costs and operational expenses.
- Foreign exchange netting may reduce counterparty credit risk exposure. When entering into a foreign exchange contract a bank incurs a credit risk that the counterparty may be unwilling or unable to fulfill its contractual obligations. A legally enforceable contractual netting arrangement may reduce a bank's credit risk exposure on its unsettled foreign currency transaction from a gross basis to a net basis on each separate forward date.
- Netting systems may reduce the intra-day liquidity requirements used to bridge timing gaps between gross payments and gross receipts.
Furthermore, the Basle Capital Agreement has provided a stimulus for the expansion of netting arrangements. In accordance with the Basle Capital Agreement under certain netting arrangements, a bank may be in a position effectively to reduce its on-or-off balance sheet assets and / or liabilities and thereby minimize the amount of required capital allocation.
Payments Netting and Contract Netting
There are two basis approaches that banks are adopting toward netting: Payments netting (in the sense of the netting of payments only) and contract netting. While these methods have certain operational similarities, they differ significantly in their legal risk-reduction characteristics.
Payments netting refers to the netting of the amount of payments made betwen institutions. Two institution that frequently trade with one another may find they have a sizeable number of transactions between them, with a given settlement date, and that some of these are offsetting. The two banks may agree not to proceed with each payment for each transaction but, instead, to make one net payment between themselves for each currency and value date. Such an agreement may be informal and ad hoc.
Payments netting may substantially reduce the number of settlement payments flowing between institutions, thereby diminishing the chances for processing errors. In addition, payments netting may reduce the amount of funds needed for routine settlement of transactions.
Payments netting does not reduce credit risk, however, the foreign exchange contracts giving rise to the obligations being netted remain in effect, and both parties remain legallly obligated to settle for the gross amount of their transactions. In the event of a bankruptcy procedding, a liquidator retains the ability to choose among individual contracts and determine which will and which will not honored. Therefore, the credit risks between the parties are unchanged. Certain forms of payments netting may be inconsistent with the Board of Governors policy on risk reduction in large dollar payment systems.
Contract netting, by contrast, involves a written agreement to substitute net payment obligations for gross obligations such that individual foreign exchange contracts are replaced, or superseded by a contrat governing many transactions. Two banks may enter into a formal agreement under which one runing net amount will be due between them for each future value date in each currency they trade. Ths is achieved by netting the second, and each subsequent deal with the first for that particular date and currency, thereby cancelling the original contract for the individual transaction and incorporating the transaction into a new, "novated" contract for the net amount. With contract netting interbank payment flows decrease. Moreover, counterparty credit risk is reduced from a gross to a net basis. A master netting agreement should have the effect of reducing credit risk from a gross to a net basis across all currencies and value dates.
Bilateral and Multilateral Netting
Payments netting and contract netting may both be arranged on either a bilateral basis, directly between two counterparties, or on a mutilateral basis. Under multilateral netting, there is likely to be a single central clearing facility or agent. Net amounts due to or due from each participant vis-a-vis the clearing group as a whole are calculated and settled by monetary transfers from net debtors to net creditors. The clearing agent may be substituted as principal for each of the counterparties, with respect to each other counterparty and with respect to each bilateral transaction covered by the multilateral netting arrangement.
Legal and other problems with multilateral netting raise questions, for example, regarding the form of substitution of a clearing agent as principal to a transaction and the arrangements for the posting of collateral. In addition, anti-trust concerns are raised if participantion were restricted to enhance the creditworthiness of the clearing facility, in lieu of high colleteral requirements. Largely for these reasons, netting initiatives currently underway tend to focus on bilateral contract netting.
Netting Initiatives
Several approaches to netting by novation came to the Committee's attention, including proposals by FXNET and the Options Clearing Corporation. FXNET, an English limited partnership, began implementing automated netting in London in May 1987. FXNET provides the model legal netting agreement and the computer software for the automated implementation of bilateral netting and close-out agreements for interbank foreign exchange dealing. FXNET-licensed system software may interface with a bank's own operations system in the confirmation and matching of foreign exchange transactions between two counterparties.
In New York, as of March 1989, two banks are actually netting through FXNET, two banks have completed the installation of the FXNET system and have begun training and testing, and another two banks are in the process of installing FXNET. Three additional banks have acquired, or have announced their intentions to acquired, FXNET licenses.
Early in 1988, the Options Clearing Corporation (OCC) undertook preliminary efforts toward developing a multi-lateral netting system in which each netting counterparty would bet against a centralized clearinghouse. Under this early proposal, a bilateral contract between participating trading parties would be extinguished and replaced by a contract between each of the parties and the clearinghouse. The clearinghouse would be substituted for each party as principal with respects to the other, and the posting of margins would enhance the credit-worthiness of the clearinghouse.
A netting test conducted by the OCC in Ottawa during February 1988 demonstrated that multilateral netting offered substantial reductions in the level of outstanding and sharply reduced both the number and size of foreign exchange-related payments. As the year progressed, however, the OCC redirected its attentions increasingly toward pursuing bilateral netting as vanous problems with multilateral netting proved difficult to result.
Price Risk Measurement
Another risk-management issue to attract Committee attention during 1988 was the development of a standard unit of measurement for price risk that could be used across a variety of trading instruments.
Since 1987, the Committee has taken an interest in the variety of techniques institutions have been using to assist senior management in monitoring trading risks and allocating bank resources in a manner that reflected both the market risks of the various instruments and the individual institution's resources and attitudes toward risk. The Committee intended to prepare a paper to discuss in very broad general terms, the types of approaches that were increasingly being employed to help manage exposures in foreign exchange and interest rate trading instruments both on-and off-balance street. Given the technical difficulties of the subject, Committee members drew on experts from their respective institutions to assist in developing an appropriate analytical framework for this study.
While pursuing this study, the subcommittee came to appreciate that despite general market consensus on main issues of risk measurement, significant differences exist among market participants on certain technical aspects of measurements systems. These differences arise from the very diversity of the financial institutions engaged in trading activities, their organizational structures, and to a lesser extent, the relative importance differences of methodology so that the potential readers of the report could choose the methods most appropriate for their institutions. The report that was finally approved by the committee therefore differed from a preliminary draft, inasmuch as it did not include specific choices among alternatives illustrated by examples in a highly technical appendix. Instead, the final report provided an overview on the concept of price volatility measurement, rather than a rigorous mathematical framework, to convey to senior-level bank management the broad principles of using volatility-based position guidelines in evaluating risk across a variety of market instruments.
New Product Development
The Committee's discussions also touched on the importance for financial institutions of establishing formal programs to control the introduction of new products. Such programs have become essential for managing successfully the growing number, and growing complexity, of financial instruments and services. Some member banks indicated that this is an area that has recently come under increasing regulatory scrutiny.
Before a new product can be marketed or trade, these programs require that detailed research and documentations must be competed. This helps to assure that all ramifications of the product are fully explored in advance of the product's introduction. Potential customers are identified; likely business volumes are estimated; minimum profit margins are set: and, as a result revenues are projected. These results are then viewed in relation to the aggregate risks associated with the product. Several types of risk (price, issuer, counterparty, etc.) may be associated with a given product and each is assessed. Plans are formulated for how such risks will be measured and managed. Furthermore, these programs require that all accounting, auditing, operational, legal and regulatory issues must be examined and resolved. In the case of a new product which is a small variation of an already existing product, the process may be abbreviated. But some product memorandum is always necessary because even a minor variation can raise substantive issues.
A key benefit of these programs is that all of the relevant areas of the bank (such as legal, accounting, operations) are formally brought together in the approval process. This process is generally accomplished by having a special, carefully-selected committee established within the organization whose members must assess and sign off on the aspects of the product related to each of their responsibilities.
In addition to in-bank personnel, outside legal counsel, auditors and consultants are often brought into the process. The hiring of an outside consultant is particularly important when the trading and positions of a product require mathematical models for the evaluation of price risk.
