Financial Stability 2/2002
5 Settlement risk
Increased trade and liberalisation of capital markets has lead to a considerable
increase in foreign exchange transactions the last 20 years. One consequence
of this is that banks’ exposures in connection with foreign exchange transactions
have become substantial. Traditionally, these exposures have been unsecured,
although very short-term, and they have resulted in considerable liquidity and
credit risk for banks. As a result of this, the authorities in a number of countries
have put increasing pressure on the banking industry to improve their risk management
in this area. The international foreign exchange banks’ response to this
has been CLS (Continuous Linked Settlement), which commenced ordinary operations
on 14 October 2002 and will probably remove most of the credit risk connected
with the settlement of foreign exchange transactions. So far, CLS settlements
may only be made in seven currencies (AUD, CAD, CHF, EUR, GBP, JPY and USD).
According to current plans, the Scandinavian currencies will be included in
the first half of 2003. The focus on banks’ foreign exchange settlement
risk has increased after a number of initiatives between 1997 and early 2002
reduced settlement risk in the national clearing and settlement system.
Key concepts
Foreign exchange settlement risk: The risk that one party in a foreign
exchange transaction will pay for the currency it sold without receiving the
currency it bought. Such risk may be divided into liquidity risk and credit
risk.
- Liquidity risk: The risk of increased costs because purchased
currency is not received when due.
- Credit risk: The risk of loss of all or part of a contract amount because
the counterparty fails to meet its obligation.
Payment Versus Payment (PVP): A mechanism which ensures that final
transfer of one currency occurs if and only if a final transfer of the other
currency takes place.
Exposure duration: The period during which a party in a foreign
exchange transaction is exposed to settlement risk. The period extends from
the time of final transfer of once currency until confirmation of final transfer
of another currency.
Foreign exchange settlement risk
Foreign exchange settlement risk consists of both liquidity risk and credit
risk. While liquidity risk is the risk of increased costs because a counterparty
fails to meet an obligation when it is due, credit risk is the risk of direct
losses because a counterparty is unable to meet an obligation either when it
is due or at any time thereafter. Surveys in Norway and abroad show that banks’
foreign exchange settlement exposures are considerable and that in some cases
the amount of a bank’s exposure to a single counterparty may exceed the
bank’s core capital (Chart 5.1). Foreign exchange settlements must therefore
be seen as a considerable source of risk for banks.
Chart 5.1
The work to limit the risk connected with foreign exchange transactions has
been difficult because such transactions are settled in national settlement
systems that operate independently of each other. Banks have therefore been
exposed to their counterparties from the time of final transfer of one currency
until confirmation of final transfer of another currency. Such exposure periods
may extend over several days, especially if the two legs of the transaction
have been settled in different times zones. Another problem is that the settlement
rules may differ from one country to another. How long the remitting bank can
wait to cancel a payment may, for example, vary between countries. This is a
particular problem if one bank becomes insolvent.
With CLS, foreign exchange transactions will be settled in one common multicurrency
bank, the CLS Bank (CLSB). The CLSB will maintain accounts for all participating
banks in all currencies that are included in the system. Settlement of transactions
will be executed individually (gross) and requires that both parties have met
their payment obligations. It will not be possible to cancel transactions that
have been settled even if one of the parties becomes insolvent. With CLS, both
sides of a trade are settled simultaneously on a payment versus payment basis.
This eliminates the credit risk connected with transactions in those currencies
that are included in CLS.
Execution of CLS settlement as planned requires that banks have met their payment
obligations to the CLS system. Since banks’ foreign exchange transactions
are considerable, positions can be so large that banks experience problems raising
adequate liquidity. However, CLS has several features that limit banks’
liquidity needs and thus the risk of being unable to meet their obligations.1
Most important is that payment obligations are based on banks’ net positions
in each currency. Banks’ liquidity needs will thus be considerably lower
than if they had to procure cover for each individual transaction as is required
in other gross settlements. The netting effect will probably be between 75%
and 90% in most currencies.
1 See Norges Bank’s Annual report on
payment systems (2001) for a more detailed account of CLS settlement and banks’
payment obligations.
So-called in/out swaps have been introduced to further limit risk. This means
that banks can reduce their positions by swapping currency within the CLSB and
reverse the currency swap outside the CLSB the same day. This will reduce banks’
liquidity needs, but will reintroduce a measure of credit risk because one leg
of the transaction will be settled outside the CLS system.
Challenges associated with CLS
CLS should remove most of the credit risk associated with banks’ foreign
exchange transactions if there is extensive support for the system. Settlement
in CLS presupposes that both parties in a foreign exchange transaction participate
in CLS. So far, it appears that the system will receive extensive support, but
the extent to which banks will use CLS to settle transactions remains to be
seen.
CLS means that the settlement systems in a number of countries will be linked
together. This means that operational failures in one country may have consequences
for other countries that are linked to CLS. In the work to establish CLS, considerable
emphasis has therefore been placed on ensuring that the participating banks’
systems, the national settlement systems and the CLS systems are as robust as
possible. From the time the solutions were developed until they became operational,
the various systems were tested for more than half a year. New participants
will have to go through extensive testing before they may link up to CLS. Based
on this, the central banks for the first seven currencies linked to CLS have
found that the robustness and stability of the operational solutions are adequate.
Although the solutions have been developed and tested in an acceptable manner,
the system will be vulnerable to operational failures.
If a bank does not pay in an adequate amount to CLS, it will not be possible
to settle all or parts of the bank’s transactions. This will mean that
the bank’s counterparties’ payment obligations will change, and
situations may arise where the counterparties are asked to pay in a large amount
in one currency when they originally should have received currency. The deadline
for making such unexpected payments will be short, and in extreme cases the
counterparties may have problems raising the necessary liquidity. As a consequence
of this, it will be impossible to settle a number of transactions in CLS. To
avoid such problems, it is important that banks participating in the system
have good liquidity management.
CLS and the Norwegian payment system
In Norway, the banking industry and Norges Bank have cooperated closely in
preparing for the inclusion of the Norwegian krone in CLS. This work encompasses
issues related to liquidity and operational solutions. An important premise
for the operational solutions is that banks may also send and receive transactions
to and from CLS in the event of an operational failure in the Norwegian payment
system. The banking industry and Norges Bank have therefore developed contingency
solutions which specify the various participants’ responsibilities in
the event of such a failure. In addition, the solutions in both the Banks’
Payment and Central Clearing House (BBS) and Norges Bank have been adapted to
impede long delays caused by technical problems. The risk of non-settlement
or a considerable delay in settlement in CLS due to an operational failure in
the Norwegian payment system should therefore be limited.
CLS may affect banks’ liquidity needs, and emphasis has been placed on
evaluating whether a liquidity shortage may be a problem when the Norwegian
krone is included in the system. With current transaction patterns, the risk
of this seems limited, but banks are nonetheless working on measures to improve
liquidity. One of the measures is to change the time of certain settlements
in NBO (Norges Bank’s Settlement System) so that the liquidity will be
available for CLS in the most critical period. In addition to this, the Scandinavian
countries will establish more effective solutions for cross-border collateral.
These solutions will mean that in critical situations, a bank may move liquidity
from one Scandinavian country to another within the short deadlines set by CLS.
Thus, conditions seem to favour an inclusion of NOK in CLS in the first half
of 2003.
BIS reports
The BIS has published three reports about foreign exchange settlement risk.
In 1996, ”Settlement Risk in Foreign Exchange Transactions” was
published and showed that banks’ exposures in connection with foreign
exchange transactions were protracted and that control was lacking. The report
recommended initiatives at three levels: i) central banks, ii) groups in the
private financial sector, and iii) individual banks. While individual banks
and groups in the financial sector were to take responsibility for specific
measures to reduce risk, the central bank’s role was to contribute to
banks’ awareness and progress. In 1998, “Reducing Foreign Exchange
Risk: A Progress Report” was published. This report stated that banks
had improved their risk management routines and that internal distribution
of responsibility had been more clearly defined. On the other hand, banks’
exposures had increased due to higher foreign currency turnover. In 2000,
“Supervisory Guidance for Managing Settlement Risk in Foreign Exchange
Transactions” was published. This report stressed that banks should
have formal routines and procedures to limit the risk connected with foreign
exchange settlements and that banks’ management should monitor the work
to limit the risk. It also pointed out that the supervisory authorities should
focus on whether banks have given adequate consideration to the possibility
of using netting or other private sector initiatives to reduce risk.
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