Current Legal Issues Affecting Central Banks, Volume V

Foreword to Chapters 16 and 17

Robert Effros
Published Date:
May 1998
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Two subjects are examined in Chapters 16 and 17, bank secrecy and derivatives. Bank secrecy seems a simple subject, but it is difficult. Derivatives seem difficult, but, from the point of view of contractual law, they are simple. A contract providing that if the value of a basket of securities on the stock exchange goes over 100, the party will pay the counterparty the difference, is elementary. From the legal point of view, its technology is basic. It is simple compared to an offtake agreement with an electricity power station, a construction agreement for a refinery, or a financial lease of an aircraft.

However, what makes derivatives difficult is not the contract—which, when stripped of its jargon, is something most people can understand—but rather the environment. There are two aspects to this environment. The first is prophecy. Derivatives contracts involve taking views on prices, and prophecy has been found to be more difficult than history. The second aspect is the wide variety of general financial law in the world’s 311 jurisdictions. The key point is that there is a mosaic of different laws and, therefore, a lack of harmony that results in legal perils and legal expense. Such perils may be favored in life, art, or nature, but in international law they are not commendable.

The worldwide position on netting is important in the field of derivatives contracts. First, in some countries all transactions can be netted without restriction. Generally, this group comprises the common law countries together with the Germanic countries, Scandinavia, and a few other countries.

In a second group of countries, netting is limited or has been prohibited by insolvency law, but there is a statute providing for netting in particular markets or for particular contracts. These countries include Belgium, Canada, France, Ireland, South Africa, and the United States. In some of these countries, it is necessary for the contract to be within the terms of the statute in order for the netting provisions to operate in the case of the insolvency of one party to the derivatives contract.

In the third group, netting is not possible usually because of the absence of the right of setoff in cases of insolvency. This group includes most of the former Franco-Latin countries, including many Latin American countries and African countries. The group also includes Madagascar, the Philippines, and the United Arab Emirates.

Finally, there is a group of countries where the matter has not yet been resolved. This group includes most of the countries with economies in transition, such as Russia. While netting is probably available in China, the bankruptcy statutes in Belarus, Kazakhstan, Russia, and the Ukraine are still too skeletal to deal with the matter.

Honest minds can legitimately hold different views on whether netting should be allowed in cases of insolvency. However, it is unsatisfactory that so many divergent legal frameworks exist. This creates huge legal risks.

Netting is not only important in the context of derivatives contracts but also in relation to payments systems. Some countries, for example, Britain, are moving away from end-of-the-day settlement to real-time gross settlement in order to prevent the daylight overdraft and the collapse of multilateral netting in the evening if one bank should fail. Multilateral netting could, of course, be validated by statute, as has been done in the United States.1

The disadvantage of real-time gross settlement is that, when payments are bunched up and the central bank is prepared to grant an overdraft that has to be collateralized, the subject of collateral is more complicated than netting. Again, there are a very large number of countries where problems exist regarding the law of collateral over investment securities. One of the smallest groupings of countries with similar laws on collateral over investment securities—currently comprising the Channel Islands, Japan, Scotland, South Korea, the Southern African countries, and Quebec—may one day be one of the largest groupings. The reason that this small group might become much larger is that it has a moderate, procreditor, mercantilist culture. Its laws provide for reasonably wide security (but not as radical and all-embracing as the English version). Unlike the Germanic, Scandinavian, and the Franco-Latin countries, these jurisdictions—or most of them—have permitted divided ownership in the form of the trust.

Turning briefly to the subject of bank secrecy, one of the key questions is whether a country should criminalize breaches of bank secrecy. Some countries have done so: first, because secrecy is regarded as a fundamental policy (for example, as in Switzerland) and second, because if the rule is civil only it is difficult to prove loss or damage for a breach of secrecy—usually because the breach does not result in any loss. Tax haven countries sometimes criminalize breaches of bank secrecy in order to encourage their domestic banking industry. The objection to criminalization is that it can lead to a stiffening of the law and the need for clear-cut exceptions—the gateways have to be specifically defined by reason of the criminality of the rule.

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