Echo, European Multilateral Netting Group Starts Ball Rolling, Up By End Of 1991?

A consortium of banks in Europe is developing plans for a multilateral foreign exchange netting system -- the first of its kind. The system is scheduled to become operational towards the end of next year.

The Exchange Clearing House Organization (ECHO) has sent a 190-page invitation to tender to more than 15 software houses, which will not only write the software but will specify the hardware. Bids are due at the end of this month. Once bids are in, the final business plan should be presented for the banks' approval in November.

The ECHO clearing system will net spot and forward trades in 24 currencies, including ECUs. Once implemented, ECHO is expected to reduce the proportion of actual settlements to around 10 percent of the gross transactions put through the system. So far, 16 banks have agreed to participate in the project but Graham Duncan, the project manager, says that membership is open to others.

Multilateral netting differs from bilateral netting in that a clearing house will act as a principal in settling trades whereas bilateral netting systems, such as London-based FXNET, involves bank-to-bank agreements.

ECHO Netting is being set up in tandem with similar foreign exchange multilateral netting systems in the United States and Canada (see related article, this issue). Duncan said that while the three systems won't be identical from a systems point of view, it is expected that they would be linked together once they are operational.

Duncan said that setting up a multilateral clearing system in Europe involves particular problems in dealing with different legal systems, particularly insolvency laws.

However, providing that monetary authorities in various jurisdictions approve of ECHO's structure, there is the prospect that ECHO members will be subjected to the European Community's (EC) capital requirements provisions on only the net amounts settled through ECHO. This potentially could represent a significant cost saving. A draft EC directive requires banks to maintain capital of at least 10 percent of their long or short currency positions, whichever is higher. Duncan said that exactly how authorities will treat multilateral netting remains unresolved so far. A committee of central bankers under the auspices of the Bank for International Settlements is scheduled to make recommendations about this in the autumn.

Duncan said that in the meantime ECHO is liaisoning with the Bank of England in working out its netting procedures. It has also consulted the U.S. Federal Reserve.

ECHO's plans provide for clearing of all transactions by currency and value date rather than pairs of currencies. One advantage of this approach is that there would be a "single amount owing" if one of ECHO's members should be declared insolvent. In such an event, clearing procedures would make it difficult for liquidators to engage in what is called 'cherry picking.'

Under most national insolvency laws, a liquidator has the right to collect all creditor positions before settling debtor positions. In the case of foreign exchange transactions, 'cherry picking' would occur when the liquidator gets payment on profitable foreign exchange trades but leaves the losing ones to be settled along with other debts.

Graham said a key point of ECHO Netting's structural arrangements is that it should prevent domino effects, which would occur when the failure of one bank to complete its outstanding FX transactions causes other banks to fail to complete their trades. Such a muddle occurred in 1974 when Bankhaus Herstatt was declared insolvent by the Bundesbank during the middle of the U.S. trading day.

ECHO Netting's members will also be shareholders in the clearing house, which will be located in London. Members will effectively guarantee completion of trades if a member should default. This will be worked out under a loss allocation formula, which ensures that those banks who weren't a counterparty to transactions with a defaulting bank aren't penalised.

Algemene Bank Nederland

Amsterdam-Rotterdam Bank

Banca Commerciale Italiana

Bankers Trust, London

Banque Bruxelles Lambert

Banque Internationale a Luxembourg

Banque Nationale de Paris

Barclays Bank

Chase Manhattan Bank, London

Creditanstalt-Bankverein

Credito Italiano

Deutsche Bank

Dresdner Bank

Generale Bank

Midland Bank

Osterreichische Landerbank