Foreign exchange settlement risk - Guidance being updated

The Basel Committee on Banking Supervision (BCBS) and the Committee on Payment and Settlement Systems (CPSS) are establishing a joint working group to revise the BCBS's “Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions” (2000), with the goal of ensuring that financial institutions adequately control their foreign exchange settlement exposures. The group will be chaired by Ms Jeanmarie Davis, Senior Vice President at the Federal Reserve Bank of New York.

Foreign exchange settlement risk is the risk that one party to an FX trade pays out the currency it sold but does not receive the currency it bought. It consists of both liquidity risk (the risk that the purchased currency is not received when due) and credit risk (the risk that the purchased currency is not received when due or at any time thereafter). In this situation, a party's foreign exchange settlement exposure equals the full amount of the purchased currency.

Foreign exchange settlement risk was identified as a significant risk to market participants in a 1996 CPSS report “Settlement Risk in Foreign Exchange Transactions”. An update to that report, “Progress in Reducing Foreign Exchange Settlement Risk”, published in May 2008, found that, through mechanisms such as CLS Bank, the financial services industry has made substantial progress in reducing FX settlement risk. The report notes, however, that part of the market still settles in a manner that does not mitigate FX settlement risk and that some bilateral settlement exposures are large in relation to capital.

CLS Bank provides a means of settling foreign exchange transactions on a "payment versus payment" basis. Established in 2002, CLS Bank currently settles FX-related payment obligations in 17 currencies. CLS Bank is owned by private sector banking and other financial institutions.

The 2008 report therefore recommended further action by individual institutions, industry groups and central banks:

• Individual institutions need to ensure that the risk controls and incentives they have in place favour the use of risk-reducing FX settlement methods.
• Industry groups should continue to develop services for settling FX trades that will help to reduce remaining risks, particularly services for settling same day and certain next day trades and trades involving additional currencies and counterparties.
• Central banks will work with supervisors to encourage continued progress by the financial industry.

The current announcement indicates the re-launch of the planned work between central banks and supervisors, which had been postponed with the onset of the financial crisis. This is an important step to ensure that market participants focus on FX settlement and that their exposures are properly controlled.

The guidance issued by the BCBS in 2000 was before CLS Bank and other payment versus payment (PVP) settlement systems were operational and does not fully reflect advances in the market and key differences between trades that settle through sound PVP arrangements and those that settle bilaterally through correspondent banking relationships. The revised guidance will address these and other developments with respect to FX settlement risk management.

The two committees plan to issue revised guidance by the end of 2011 for public comment.