Settlement risk in foreign exchange transactions.

• Author: Bergundhaugen, Jon
• Position: Case study of Norway's Norges Bank - Statistical Data Included

Each day huge amounts of money are transferred between financial institutions around the world as settlement for foreign exchange (FX) transactions. Owing to time zones and technological limitations, parties to settlement transactions normally assume full and unsecured risk with regard to counterparty exposure. A bank's risk exposure for each transaction often lasts for as long as 48 hours, sometimes entailing credit risk against certain counterparties which exceeds the bank's equity. The central banks of the G-10 countries have for many years worked to induce participants to take steps to contain this risk. Banking crises and political unrest can spread through FX settlement risk, which may inflict considerable losses on Norwegian banks and jeopardise financial stability. Norges Bank has recently conducted a survey of FX settlement risk in Norwegian banks, modelled on analyses for the G-10 countries. The survey showed that the bulk of the volume is under acceptable control, but that there is still considerable room for improvement.

1. Introduction

   Over the past 20 years, liberalisation and internationalisation of capital markets, combined with advances in FX trading technology, have led to considerably stronger growth in FX trading than implied by the growth in international trade in goods. According to an international survey carried out by the Bank for International Settlements (BIS) in April 1998, daily FX trading had reached all estimated USD 1500 billion.(1)

   This article starts by explaining how FX settlement risk arises and discusses special features of this risk. It goes on to discuss how banks and public authorities can help reduce exposures and risk. In keeping with international practice and recommendations, in spring 2000 Norges Bank carried out a survey of FX settlement risk in Norwegian banks. This article describes the survey and provides a preliminary assessment of the main findings.

2. Foreign exchange transactions and settlement

   Only a small proportion of FX transactions are effected in order to provide greater access to the currency purchased as an asset or a means of transaction. Transactions of this kind are for instance often associated with international trade or investment. The majority of transactions are motivated by perceptions of changes in exchange rates, that is to say taking positions for financial motives. Private market participants have estimated that this applies to well over 90% of the market. However, whatever the purpose of the transaction, it is normal market practice to deliver the sum in its entirety in one currency in return for an equivalent value in the other currency.

   Settlement of FX transactions involves two payments being effected in two independent national payment systems on a given date. The risk for each party is that the counterparty may not fulfil its obligation in the bought currency, either permanently or temporarily. In the worst case scenario, the bank will be unable to revoke payment in the sold currency. If the counterparty is insolvent (is placed under public administration), so that the payment problem is not only temporary, the bank's legal claim on the estate in liquidation will be on a par with that of any other creditors. The fact that the counterparty is normally a foreign bank increases the uncertainty and the legal risk in situations like this. Legal protection for special FX agreements is described in section 3.

   Settlement for FX transactions can be classified according to different stages based on the risk status of the settlement for the parties. This classification forms the basis for the definition of FX settlement exposure durations provided by the BIS (1996):

   The chart shows that the actual credit exposure for FX settlements does not start until the bank's payment instruction for the sold currency cannot be cancelled unilaterally (cancellation deadline). It also shows that a bank maintains full credit exposure also in the period after receiving the currency purchased when it is due, since the bank does not yet know whether it has received these funds with finality. The bought amount must therefore be treated as credit exposure until the point at which the bank's internal control functions identify the settlement as successful and final (receipt-identification time). The use of correspondent banks for executing settlement tends to increase the duration of exposures. The same is tree of transactions where the two currencies belong to different time zones, since the operating hours of the two payment systems are not the same.

   In addition to the credit risk dimension, FX settlement risk has a liquidity risk dimension. The parties incur the risk of higher costs resulting from bought currency not being received at the time expected. This risk exists even if the affected bank is able to hold back payment of the sold currency. The risk is linked particularly to the extra costs of using alternative sources of liquidity in the currency in question, often at short notice.

   Experience shows that the likelihood of a real loss on the credit element of FX settlements must be regarded as low, requiring the closure of a bank to occur extremely unexpectedly in the market without time for the bank's counterparties (or their correspondent banks) to revoke their payments. Even so, this situation has been known to happen, notably with the failure of Bankhaus Herstatt in June 1974, which led to considerable losses for the bank's counterparties in USD/DEM transactions.

   Losses in the form of liquidity-related extra costs may be incurred far more frequently, since factors such as market nervousness or technical failure may be a sufficient trigger. One example of uncertainty of this kind was during Iraq's invasion of Kuwait in August 1990. Many of the Kuwaiti banks' counterparties in the FX market at that time were affected when correspondent banks held back payment for several days. A large share of these payment transactions are based on credit lines, and the correspondent banks were unwilling to take up increased positions in relation to the Kuwaiti banks until they were certain that these banks would continue operations.

3. Reducing risk

   In many...