Cross-Border Netting Scheme

A cross-border netting scheme is an arrangement for netting payment or trade obligations among participants established in more than one country, or for obligations in more than one currency. Instead of settling every foreign exchange deal or cross-border payment gross, participants calculate net positions and settle only those. Because the participants, the currencies and the settlement accounts sit in different legal systems, the scheme's safety depends on the netting being enforceable everywhere a participant could fail.

These schemes gained attention in the late 1980s, as banks set up multilateral FX netting services and euro-currency clearing arrangements. Central banks worried that losses in such schemes could cross borders faster than supervisors could respond. Their answer was a set of minimum standards and a framework for cooperative oversight, which shaped later systems such as CLS and fed into today's Principles for Financial Market Infrastructures.

A group of friends living in different countries share holiday costs. Instead of sending money back and forth after every dinner, they keep one shared list and, at the end of the trip, each person pays or receives a single amount. That is netting.

The cross-border twist is that each friend lives under different rules. If one goes bankrupt at home, a court there might ignore the shared list and demand every original bill be paid in full. A cross-border netting scheme only works if every country involved agrees that the list counts. Making sure of that is the hard part.

Participants submit trades or payment instructions to the scheme, which may be operated by a central party or by the participants jointly. The scheme matches the instructions and nets them, bilaterally or multilaterally, to produce a net position for each participant in each currency. Net positions are then settled, often through accounts at the central bank of each currency or at a settlement bank. Netting may be achieved by novation, so that each new trade is legally merged into a running net obligation, or by substitution of a central counterparty, so that every participant faces the scheme operator rather than each other.

In 1990, the central banks of the G10 countries, working through the Bank for International Settlements, published the Report of the Committee on Interbank Netting Schemes, known as the Lamfalussy Report. It set six minimum standards for cross-border and multi-currency netting schemes:

1. Netting schemes should have a well-founded legal basis under all relevant jurisdictions.
2. Participants should clearly understand the scheme's impact on each of the financial risks involved.
3. Multilateral schemes should have clearly defined procedures for managing credit risk and liquidity risk, with limits on exposures.
4. Multilateral schemes should, at a minimum, be able to complete daily settlement on time if the participant with the largest net debit position cannot settle.
5. Schemes should have objective and publicly disclosed criteria for admission that allow fair and open access.
6. Schemes should ensure the operational reliability of their technical systems and have backup facilities.

The report also set out principles for central bank oversight, giving the central bank of the country where the scheme is located primary responsibility, in cooperation with the central banks of the currencies involved. This cooperative model is still used for multi-currency infrastructures.

In the 1990s, banks operated multilateral FX netting services such as ECHO and Multinet, which netted FX obligations among banks in several countries. Their limits, chiefly that they did not remove the risk that one currency leg is paid and the other is not, helped lead to CLS, which began operating in 2002. CLS combines multilateral netting of members' funding with payment versus payment settlement across its member currencies, overseen by a committee of central banks led by the Federal Reserve. EURO1, the euro large-value system run by EBA CLEARING, is another example: its participants are banks from many countries, and it settles net positions in T2.

The main risk is legal uncertainty. If a participant's home insolvency law does not recognise the scheme's netting, its liquidator may be able to cherry-pick obligations, so other participants face gross rather than net exposures. Schemes therefore obtain legal opinions for every participant's jurisdiction, and some jurisdictions have passed laws protecting netting in designated systems, such as the European Union's Settlement Finality Directive. Time-zone differences add Herstatt risk if currency legs settle at different times, and multi-currency schemes must hold liquidity in each currency to meet the Lamfalussy-style requirement to survive a large participant's failure.

Cross-border netting schemes are a specific case of multilateral netting and bilateral netting; what sets them apart is the need to make the netting stick in every jurisdiction involved.

• Committee on Payments and Market Infrastructures (CPMI)