Introduction

An all important credit risk for purposes of evaluating Offshore Financial Centers is the risk that an intermediary party to a transaction poses with respect to transactions of counter-parties. Offshore Tax Havens provide extraordinary tax regimes and reduced or negligible regulation costs. They are a conduit necessity of international corporate structure in the global economy. But the risks associated with different legal systems and a non-regulatory environment must be part of the evaluation of an Offshore Center. The intention of this writing is to provide an awareness of settlement systems of financial institutions servicing a particular Offshore Financial Center. Understanding the risk inherent in these processes better enables the risk to be managed. Management results from the ability to reduce, eliminate, and control the exposure. The purpose is to assure there is not an unexpected or undue risk in transactions between counter-parties. (1)

Risks and Functions of a Settlement System

In international financial transactions, market instruments reflecting satisfaction of obligations impose a delay factor in a final settlement or discharge of the underlying obligation. It is the delay factor that occasions the risk. The greater the amount of time elapsed during the performance of this function, the further a transaction becomes removed from its true economic terms. The essence involves the mechanics of the collection and clearing process of a particular settlement system servicing a Financial Haven.

The intermediary of the most significance is the actual settlement system. Counter-parties within the system can be numerous and naturally are subject to their own credit risk. A clearing system is not itself a bank. Normally, banks collectively comprise members of the settlement system. It maintains running, daily computations of the debts and credits to its members. However, transfers on its booking system should not be construed as comparable to a financial institution.

A settlement system of financial institutions has no operating funds generally and makes no payments. Because a net settlement system is not a bank and does not have currency denominated balances, upon the conclusion of each business day the system is required to net out, with no remaining amount due any member. Each participant commences a business day with a zero balance and concludes its business day with a zero balance. The interaction of the system enables the members to conduct settlement through the system by virtue of debits and credits and without the necessity of maintaining capital balances and expenditures. It greatly enhances their profitability.

The Elements of the Risks

The activity generated during the course of a business day by the net settlement system members raises the basic issues essential to analysis of the risk profile. Financial institutions are drawn to the use of systems because it lowers their credit risk and frees up liquidity. A financial institution is able to minimize its credit risk because a net settlement system eliminates many facets of a multi-lateral, complex method of settlement. Utilizing a net system wherein mutual debts are set-off one against the other with any balance becoming a debt obligation is a concept of settling the difference. This process promotes efficiency and makes possible the maintenance of surplus liquidity among members in addition to increased profits.

There are three basic issues arising within such a system that are important to an evaluation of Offshore Financial Centers. These issues can be framed in the manner following:

1. When a payment is regarded as having entered the settlement system and becoming an irrevocable obligation;

2. The point at which an obligation is discharged in final settlement; and

3. The type of recourse that is available if a default occurs by another member of the system.

Settlement systems will vary with individualized rules of the particular system, but an obligation of performance becomes an irrevocable obligation at the point in time when it is released in the net settlement system. (2) The construction of the point in time in which a final discharge is made is governed by the settlement system rules. The multi-lateral agreement is a contract between members, and the members collectively take on an irrevocable obligation when the obligation enters into their system. (3) This obligation creates a hybrid risk. This is a hybrid credit risk comprised of liquidity risk and a mixture of market and credit risk.

Based on this, it essential to examine be the rules that govern members of a settlement system in which an Offshore Financial Center maintains its participation. These locations are traditionally not in deep financial markets and have an element of fragility. Specifically within the settlement system, the stipulations determining the time at which an obligation becomes an irrevocable obligation to the settlement system members is critical. Past history has instrumental for international bankers and the lessons of systemic liability. With present day derivative instruments of 22nd Century sophistication in an informational – technology era, the measures of risk management have the potential to turn the table on the very thing they seek to protect.

Regarding settlement systems functioning as intermediates to Offshore Financial Center banks, a second important concern is the point at which an obligation is regarded as a final discharge. The precedents are scant and drafted quality contractual agreements declaring when payment takes place appear to be the most definitive source to the resolution of the management of this exposure. (4)

Finally, the recourse allowed a member bank of a settlement system has great significance. The liability of the system members can be a collective contractual agreement, an insured membership standard, reserve method, or hybrid of these concepts. The method of the particular systems rules will be indicative of its stability and ability to control the management of risk. It provides some evidence of the financial sophistication of a particular financial center.

In conclusion as to settlement systems, it is helpful to bear in mind the scrutiny to which banks are subjected when located in Financial Havens. The profits of the narcotics industry have grown to enormous proportions. Instrumental in their operations have been banks located in Offshore Financial Centers and Financial Havens. Because of the enormous profits generated by the narcotics industry, the business of managing these profits became a very lucrative enterprise for financial institutions.

The activities of offshore and foreign banking institutions became a second component of their integrated drug business. The management of these profits involves a process of money laundering. Money laundering is basically the conversion illegal activity profits into assets of a financial nature having the appearance of legitimate origins. (5)

Involved in this whole process is the fact all United States dollars deposited offshore are eventually collected in a settlement system and shipped back to the Federal Reserve Bank in New York. These self-regulated settlement systems have been forced in some instances to review and impose limitations on the amounts of United States currency to be settled within the system within a certain time frame. There have been circumstances in which the settlement system members have sought to avoid membership rule compliance. This aspect of risk is beyond the scope here, but it is vitally important to consider the risk in which a Financial Haven involves itself in a settlement system accommodating voluminous transactions of this nature. It can taint one’s activities with a broad brush that may not be a correct portrait of the financial activities. (6)

******************

Footnotes

1. See generally, Richard Dale, The Regulation of International Banking, (Prentice-Hall 1985). Also see, New York University Law Review, Vol. 64 (Oct. 1989), Smedresman and Lowenfeld, “Eurodollars, Multinational Banks, and National Laws.”

2. Delbeck v. Manufacturers Hanover Trust Company, 609 F.2d 1047 (2nd Cir. 1979). This case sets out facts to describe a net settlement system.

3. Id. at note 2.

4. See generally, Evra Corp. v. Swiss Bank Corp., 673 F.2d 951 (7th Cir. 1982). Also see, Hadley v. Baxendale, 9 Ex. 341, 156 Eng. Rep. 145 (1854). Also note that in Delbrueck v. Manufacturer Hanover Trust Company, 609 f.2d 1047 (2nd Cir. 1979), the court discusses settlement and irrevocability and states that it occurs at a time after transfer and in the settlement system. However in this case it became an irrevocable obligation to make payment, whereas final discharge is an instance when a payment has actually been received which was not the factual circumstance of the case. The irrevocable obligation to make payment was structured so as to require payment the following day. The following day of payment would be the real final discharge.

5. See generally, William L. Richards, Offshore Financial Centers and Tax Havens, 1995, Tulane Law Library Archives, Tulane University, New Orleans, Louisiana, Chapter 7, page 344.

6. Id. at note 5.

In accordance with Circular 230 Disclosure