BIS Strategy for Dealing with Foreign Exchange Settlement Risk


Casson, Peter (1996) BIS Strategy for Dealing with Foreign Exchange Settlement Risk. Journal of International Banking and Financial Law, 11, (7), 326-329.

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1. INTRODUCTION
The collapse in 1974 of Bankhaus Herstatt, a small Cologne bank, first highlighted the risks associated with the FX settlement process. In this case, a number of counterparties irrevocably sold Deutschmark to Herstatt prior to the announcement that Herstatt's banking licence had been withdrawn and that it had been ordered into liquidation. The counterparties had expected to receive US dollars later the same day in New York but, following the announcement, Herstatt's correspondent bank in New York suspended US dollar payments, leaving the counterparties exposed. The risks associated with the FX settlement process have more recently been revealed in the cases of Drexel Burnham Lambert (1990), BCCI (1991), the attempted Soviet coup d'état (1991) and Barings (1995).

Foreign exchange settlement risk is basically the risk that one party to a foreign exchange transaction may pay the currency it sold but not receive, on the settlement date, the currency that it bought. There are a number of dimensions to FX settlement risk for a party to a transaction. First, credit risk arises whenever a bank cannot make a sale contingent upon receipt of the bought currency, the amount at risk being the full value of the bought currency. Second, a bank needs to cover the amount of the bought currency until such time as the counterparty meets its obligation if the bought currency is not received on the settlement date. Third, if the bought currency is not received on the settlement date, a bank may be left with an unhedged, or open market, position. There may consequently be a cost in replacing, at current exchange rates, the amount of the original transaction. A bank is therefore exposed to the risk that it may experience loss due to an unfavourable movement in the exchange rate. Finally, a bank is exposed to the risk of having to pay interest charges or penalties if it fails to make an FX settlement on time because of error or technical failure.

Central banks are concerned about the risks to the international financial system that arise from the ways in which FX trades are settled. In response to the problems identified by the failure of Bankhaus Herstatt, the G-10 central banks have worked together in an attempt to improve international payment arrangements and so minimise systemic risk. Their work has led to a number of studies, including the Report on Netting Schemes in 1989, the Report of the Committee on Interbank Netting Schemes in 1990, and the report on Central Bank payment and settlement services with respect to cross-border and multi-currency transactions in 1993. The latest report, and the subject of this article, is by the Basle Committee on Payment and Settlement Systems (“CPSS”), entitled Settlement Risk in Foreign Exchange Transactions (Bank of International Settlements, Basle, March 1996). It analyses existing arrangements for settling FX trades and makes recommendations.

The remainder of this article is divided into four sections. The CPSS approach to the definition and measurement of FX settlement exposure is described in section 2. The findings of a survey that the CPSS conducted to identify current practices for settling FX trades and to identify best practice are described in section 3. The CPSS recommend a three-track approach for reducing the risks associated with the FX settlement process. This is described in section 4, with the overall approach of the CPSS being summarised in the final section.

2. SETTLEMENT RISK
The CPSS develops a definition of, and a way of measuring, settlement exposure, from a consideration of the FX settlement process. A simplified description of this process is illustrated on the previous page.

Three critical times are identified for each trade: (a) the unilateral payment cancellation deadline; (b) the point at which the bought currency is due for receipt with finality, i.e. the receipt is irrevocable and unconditional; (c) the point at which the bought currency is identified by a bank either as being received with finality or as not being received from the counterparty. On this basis, the CPSS proposes that a bank's FX trade can be classified into five broad categories:

(1) Status R (Revocable). A bank's payment instruction for the sold currency has either not been issued, or has been issued but may be cancelled unilaterally by the bank.
(2) Status I (Irrevocable). A bank's payment instruction for the sold currency cannot be cancelled unilaterally and the final receipt of the bought currency is not due. The payment instruction cannot be cancelled unilaterally either because it has been finally processed by the relevant payments system, or cancellation depends on the consent of the counterparty or another intermediary.
(3) Status U (Uncertain). A bank's payment instruction for the sold currency cannot be unilaterally cancelled, the receipt of the bought currency is due, but the bank does not know whether or not it has received the currency with finality.
(4) Status F (Fail). A bank has established that it did not receive the bought currency from a counterparty.
(5) Status S (Settled). A bank has established that it received the bought currency with finality.
This analysis of the settlement process is incorporated into a definition of settlement exposure. The CPSS definition, which includes reference to both the amount at risk and the length of time the amount is at risk, is: “A bank's actual exposure – the amount at risk – when settling a foreign exchange trade equals the full amount of the currency purchased and lasts from the time a payment instruction for the currency sold can no longer be cancelled unilaterally until the time the currency purchased is received with finality.”

Two measures of a bank's current settlement exposure are proposed by the CPSS. First, a bank's minimum settlement risk exposure is defined as being equal to the sum of its Status I and F trades, that is the total of those transactions that cannot be revoked unilaterally and of those where the bought currency is due but is known not to have been received from the counterparty. Unless a bank is able to identify final and failed trades immediately, there is the possibility that some of the trades of Status U may also have actually failed. A second measure, a bank's maximum settlement risk exposure is therefore proposed. This is the sum of its Status I, F and U trades.

It is possible for a bank to estimate its potential minimum and maximum exposure, in respect of the trades that have currently been executed, at any point in the future by using its knowledge of how FX transactions go through predictable changes of status. The potential minimum exposure that a bank will face at some future date is defined as the value of trades that are currently known to have failed together with trades that will have Status I at that future date. The potential maximum exposure at some future date is the potential minimum exposure at that date, together with the failed trades that may be identified over the projection period, and the trades that are projected to have Status U at the future date.

3. MARKET SURVEY
Banks in each of the G-10 countries were surveyed by the CPSS in order to document current practices for settling foreign exchange trades and to identify best practices. The survey was in three stages. First, approximately eighty banks were asked to list their current payment cancellation deadlines and receipt identification times. Second, several banks from each country were asked more detailed qualitative questions about their practices in managing FX settlement exposure. Finally, comments were sought from selected banks on a definition of, and a methodology for measuring, FX exposure that were contained in a CPSS discussion paper.

The report presents the results under three main headings: (a) the duration and size of banks' FX settlement exposures; (b) the potential impact of changing practices on FX settlement exposure; and (c) market responses and initiatives. Market responses and initiatives are considered separately at the level of the individual bank and of the industry group.

The Duration and Size of FX Settlement Exposures
The results of the survey indicate that currently the minimum exposure period (duration of Status I) for most banks lasts one to two business days. An additional one to two days is then required in order to establish whether the bought currency had been received on time (duration of Status U). Although no comprehensive statistics are reported on banks' actual levels of FX settlement exposure, there are indications that the current levels of exposure are high. It is estimated, for example, that the value of FX trades raised that are arranged each day is US$1.25 trillion, and some banks are reported to be settling, on a single day, FX trades worth in excess of US$1bn with a single counterparty.

The Potential Impact of Changing Practices
The CPSS identifies two methods that a bank may use in order to reduce the size of its FX settlement exposure. These are the use of bi-lateral and/or multi-lateral netting facilities, and improvement in payment cancellation and receipt identification procedures. Netting reduces the number and size of payments that would otherwise be necessary to settle underlying transactions on a trade-by-trade basis and thereby the amount at risk.

A number of approaches may be taken to defining what constitutes best practice in payment cancellation and receipt identification procedures. One approach, identified in the Report, is that of the New York Foreign Exchange Committee (“NYFEC”) who define best practice as one giving banks the ability to cancel, unilaterally, its payment instruments up until the opening time on settlement day of the large-value transfer system (“LVTS”), and to identify their final and failed receipts immediately upon finality of the local LVTS.

Market Responses and Initiatives
Market responses and initiatives are considered separately at the level of the individual bank and of the industry group. At the level of the individual bank, the market responses are considered mainly in terms of awareness of FX settlement risk, its measurement, and risk control. There is evidence that, although banks generally had an appreciation of the concept of FX settlement risk, in some banks there is no single officer with an understanding of the settlement process as a whole and its associated risks. Banks tend to regard FX settlement risk as an intra-day amount not larger than a single day's expected receipts and so generally underestimate its duration and size. It is reported that “. . . many banks are not aware that they can incur sizable FX settlement exposures overnight and during weekends and holidays”. Finally, some banks do not currently impose limits on their FX settlement exposures.

Industry groups have acted to increase awareness of settlement risk, and have developed netting services. Bilateral netting services are provided to many banks by FXNET, SWIFT and VALUNET; and multilateral netting and settlement services, by ECHO. The report, however, notes that many banks have not been willing to commit resources to reduce settlement risk and so have not supported these services.

4. REDUCING SETTLEMENT RISK
The CPSS adopts the view that private sector institutions, both individually and collectively, have the ability to reduce the risks associated with the FX settlement process. A three-track strategy is proposed which requires control of FX settlement exposures by individual banks, the provision of risk reducing multi-currency services by industry groups, and action by central banks to encourage progress in the private sector.

Individual Banks
It is recommended that an individual bank should improve its back office payments processing, correspondent banking arrangements, obligation netting capabilities and risk management in order to gain better control over its FX settlement process. This requires, in particular, that appropriate procedures be adopted to measure, and manage, FX settlement exposures, and to reduce excessive exposures.

The market survey reveals that many banks currently underestimate the amount and duration of their FX settlement exposures. In order to control settlement risk it is necessary to measure exposures appropriately. The CPSS consequently recommends that a bank should adopt procedures to update exposure calculations periodically, and to measure its minimum and maximum exposure at any moment on the basis of all available information. This means that there should ideally be procedures in place to update current and future exposures as new trades are executed and existing trades move through the settlement process.

The CPSS notes that “(O)nce a bank fully understands and quantifies its FX settlement exposures, it could apply rigorous risk/reward analysis to them and conclude that a reduction in exposures for given trading levels is in its economic interests.” In particular, it suggests that a bank should adopt procedures, based on internal credit analysis, to control its exposure to a single counterparty. As well as setting an overall limit on the exposure to a single counterparty, a bank may set sub-limits on different duration of credit exposures.

Finally, it is suggested that a bank could reduce its overall actual, and potential, FX exposure, for a given level or trading, by attempting to eliminate overly restrictive cancellation deadlines, and by shortening the time it takes to identify final and failed receipts of bought currencies.

Industry Groups
The CPSS wishes to encourage industry groups to develop appropriate multi-currency services with a view to reducing the settlement risk of individual banks. Following the view that the private sector has the ability to reduce FX settlement risk, the CPSS recommends that the development of multi-currency services should be left to private, rather than public, sector. In reaching this conclusion, it is argued that no inherent barriers to private sector provision have been identified. Indeed, it is noted that some risk-reducing services are already provided by the private sector, and that market demand for such services should increase as banks become increasingly aware of the need to control FX settlement exposure. In addition, it is suggested that development by the private sector has additional benefits, in particular, as it is able to draw upon methods for controlling risk that have already been developed in the sector and which have proven to be successful. The market is also seen to promote competition and ongoing innovation and would continually provide pressure to increase the cost-effectiveness of arrangements.

It is suggested that there are two distinct aspects to a settlement mechanism: the payment-receipt relationship and the timing of settlement.

– First, two potential types of payment-receipt system are identified: a guaranteed receipt system whereby a counterparty is guaranteed that if it fulfils its settlement obligations it will receive, on time, what it is owed; and a guaranteed refund system whereby a counterparty is guaranteed that any settlement payment will be either cancelled or returned if its counterparty fails to meet its settlement obligation.
– Second, the timing of settlement may be either simultaneous (all the participants make payment of every currency they owe into the system before any funds are paid out) or sequential.
The combination of the type of payment-receipt relationship and the timing of settlement leads to four potential settlement systems: (1) guaranteed receipt with simultaneous settlement; (2) guaranteed receipt with sequential settlement; (3) guaranteed refund with simultaneous settlement; and (4) guaranteed refund with sequential settlement. The CPSS notes that whilst each of the settlement systems could potentially reduce FX settlement exposures, they each have their own particular strengths and weaknesses. Settlement risk would be further reduced, it is suggested, if the settlement systems were to be combined with bi-lateral, or multi-lateral, obligation netting of the underlying trades.

Although FX settlement risk can be reduced through multi-currency settlement mechanisms, such mechanisms may also lead to new sources of systemic risk. In particular, a disruption in the settlement of one currency could result in disruption in the settlement of other currencies. The report notes that by “making the settlement in every currency dependent on the settlement of every other currency, multi-currency settlement systems might both increase the risk of undesirable global payments gridlock and constrain the ability of central banks of issue to respond in a relatively independent manner to all home-currency settlement problems”.

Central Banks
Finally, the CPSS recommends that central banks facilitate action by individual banks and industry groups to reduce FX settlement exposure. In relation to individual banks, the Report recommends that central banks take measures to increase banks' awareness and understanding of FX settlement exposure and offer a clear definition of FX settlement exposure and provide guidelines on how it can be measured. In addition, central banks can provide guidance on how FX settlement exposure can be controlled by banks improving their own settlement procedures and practices, as well as using market-wide systems and arrangements. In relation to industry groups, it is suggested that central banks work with industry groups to develop well-constructed multi-currency settlement services and bilateral, or multilateral, multi-currency obligation netting arrangements.

5. SUMMARY
Foreign exchange settlement risk is a problem for individual banks and poses a threat to the stability of the financial system as a whole. The CPSS recommends a comprehensive strategy under which “the private and public sectors can together seek to contain the systemic risk inherent in current payment arrangements for settling foreign exchange transactions”. The role of central banks is seen primarily as that of facilitating developments by individual banks and industry groups.

The problems of controlling FX settlement risk at the level of the individual bank are addressed by the CPSS, and it recommends in particular that banks should improve their methods of measuring and managing FX exposures, including credit control. At the level of industry group, the CPSS recognises the benefits of the netting arrangements that are currently provided by industry groups, and recommends the development of multi-currency settlement services.

There is already indication that an industry group is developing multi-currency settlement services. The Group of 20, an association of leading international banks, has recently been reported as having proposals for a central clearing house bank with an instantaneous settlement system linked to national payment systems. Concern about the proposals has, however, been expressed by FXNET, a leading provider of bi-lateral netting services. Its concern is that such a clearing house may be in competition with, rather than complementary to, netting services, and because of this some banks may prefer to do nothing until they have had an opportunity to compare the systems. If this is the case, further progress towards reducing the risks associated with foreign exchange settlement may have to await a resolution of the relationship between netting and settlement services.

This article is an expanded version of “Basle Committee publishes new report on “Herstatt risk”” that appeared in the Financial Times Financial Regulation Report, May 1996.

Item Type: Article
Subjects: H Social Sciences > HD Industries. Land use. Labor > HD28 Management. Industrial Management
Divisions: University Structure - Pre August 2011 > School of Management
ePrint ID: 35651
Date Deposited: 12 Feb 2007
Last Modified: 27 Mar 2014 18:22
URI: http://eprints.soton.ac.uk/id/eprint/35651

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