[First published by AccountingCPD.net]

Many multinational corporates have a pooling arrangement for the cash balances owned by their various subsidiaries. For example this could be with Bank Mendes Gans in Amsterdam, under Dutch law, with every subsidiary holding as many currency accounts as it needs and periodically transferring surplus balances into them, or drawing funds out if they are needed to make payments.

Balances of one subsidiary are not lent to another, and balances in one currency need not be converted: the calculations made by the bank are notional. The net interest outcome for the multinational will be close to what would have been achieved by zero-balancing, but without the inconveniences of intercompany loans or fx conversions.

That needs to be contrasted with the service (pioneered by the same Bank Mendes Gans for Dow Chemical and Phillips Electronic) called Multilateral Netting. This service deals with the sales of goods and services that one part of the multinational makes to another, in whatever currency, and subjects them to a periodic settlement process.

The subsidiaries must each agree for their intercompany Accounts Payable and Receivable to be settled in this way, appointing either a bank or a sister subsidiary as the agent to manage the process. The sister subsidiary would usually be the treasury centre or in-house bank, whilst the bank would customarily be Mendes Gans or Citibank.

Intercompany invoices are issued by the selling subsidiary to the buying one in the normal course of business. Once a month (typically) the settlement process kicks in, whereby the netting agent gathers all intercompany invoices that have reached due date, and subjects them to a calculation.

Each subsidiary has its intercompany Accounts Payable and Receivable, in whatever original currency, re-expressed in their home currency, and then totalled as a single payment – also in their home currency – that is their netting result for the period.

Payer subsidiaries must transfer that amount to the netting agent on due date; receiver subsidiaries get their amount paid out to them.

Where the netting agent is a bank, the settlement can be passed across a bank account that the subsidiary holds with the bank: if the agent is Bank Mendes Gans, these will be the same accounts as have been opened for the pooling service.

Where the netting agent is a sister company, the settlement can be passed across a memo account that the subsidiary holds with the treasury centre or in-house bank.

The process saves on foreign exchange conversions done at the subsidiary level, and on the fees for international commercial payments if each invoice was settled individually.

The vital point is that the Accounts Payable and Receivable never cease to be the assets or liabilities of the original subsidiaries, and do not become the assets or liabilities of the netting agent. The assets and liabilities do not get novated to the agent. If the agent is a bank, it would be ludicrous to expect that the bank would become the creditor of all of a multinational’s intercompany Accounts Payable or the debtor of its intercompany Accounts Receivable.

This is all a well-trodden path, over the last 40 years, and universally understood, unless of course you are the European Central Bank (“ECB”).

The ECB has signed a Multilateral Netting Agreement with the 24 National Central Banks (“NCBs”) who participate in the TARGET2 payment system: that is the 19 Eurozone NCBs and the NCBs of 5 non-Eurozone EU Member States. The purpose of the Multilateral Netting Agreement is to establish a pooling of the balances on the accounts that exists to process TARGET2 payments.

Each NCB holds a nostro account with and a vostro account for every other NCB to process cross-border TARGET2 payments: that is 552 accounts in all. Each NCB also holds a nostro account with and a vostro account for the ECB: another 48 accounts. In total there are 600 TARGET2 accounts distributed around the ECB and 24 NCBs.

At the end of the TARGET2 business day, the 552 NCB-to-NCB accounts are zero-balanced into the ECB’s nostros, a movement that is reversed as the first booking of the following TARGET2 business day, which is about 50 minutes later.

The accounting, however, follows a convoluted path whereby two NCB’s accounts with one another are first deemed to be combined into one balance. Then that single bilateral balance between NCBs is novated into two balances with the ECB: the debtor NCB instead becomes a debtor of the ECB and the creditor NCB becomes a creditor of the ECB.

Then the ECB combines these positions (23 positions for each NCB) with the balances of the nostro and vostro accounts it has with the NCB directly, and comes up with one claim on or liability to each NCB. The ECB reports these positions per NCB monthly, and then puts onto its balance sheet the grand total of all its claims less its liabilities. It puts, in a note to its accounts, the total of its TARGET2 claims and the total of its TARGET2 liabilities. The ECB accounting is invalid since the NCBs do not constitute a Single Counterparty towards the ECB in the way that a group of subsidiaries of the same multinational are made to become a Single Counterparty towards Bank Mendes Gans or Citibank in a pooling set-up. The ECB should show all of its individual claims and liabilities on its balance sheet, not the net of them.

The novation technique when applied to a bank balance is invalid as well if the account remains open and if the balance is returned to it within the hour, as occurs in TARGET2.

The TARGET2 legal and operational techniques use shreds and snatches of all the main Cash Management techniques: zero-balancing, pooling and multilateral netting. But the result is a dog’s dinner that looks shaky from a legal standpoint. Its main effect is to obscure the original balances: during the business day, on any other day than month-end, and in the ECB’s annual accounts. A little knowledge is a dangerous thing and the ECB seem to have half-informed themselves about how these techniques work, and to their own advantage: even the triply-netted month-end imbalance in TARGET2 exceeds €1 trillion, so heaven knows how much is owing intra-day, or at close of business on any other day than the last one in the month.