By Stanley Epstein, Principal Associate, Citadel Advantage.
The word “risk” is pretty high in most folk’s awareness these days. This greater consciousness of the “R” word has in part been driven by the 2008 financial crisis and its persistent refusal to “go away”. Any article on risk needs to set its baseline by ensuring that the word “risk” has a clear definition.
There are many different explanations of the word risk. My preference is to keep it short and to the point. Dictionery.com’s definition that “risk” is “exposure to the chance of injury or loss” suits me fine.
The concept of trading in foreign currencies also needs some explanation. The events of the past few years have led to the impression that foreign currency trading is somehow “bad” and that it is linked to speculation and shady deals.
Let us dispel this notion at the outset. Foreign currency is a vital component that is linked directly to cross border trade and cross border investments. Importers need to pay for their imports; exporters need to be paid. Financial institutions need to invest money in other countries as they seek to maximise returns in respect of shareholders, pensions and the like. Foreign loans may be held in respect of short, medium and long-term financing requirements.
Trading in foreign currencies is a highly skilled, specialist operation. It is usually carried out by banks, brokers and specialist financial institutions.
Although there is a wide range of risks that can be classified as relating to foreign currency trading I am going to limit myself to three “core” risks that affect this type of activity – currency risk, settlement risk and operational risk.
Currency Risk
The price that a currency is traded at is the exchange rate (or the foreign-exchange rate, forex rate or FX rate). It is always stated in terms of another currency. The FX rate spells out how much one currency is worth in terms of the other – e.g. one British pound is worth 1.60 US dollars.
Currency risk is the risk that comes about from the change in price of one currency against another. This usually occurs as a result of changes in demand for one of the currencies. Changes in demand are often driven by changes in basic macroeconomic conditions such as inflation, employment, taxation, changes in cross-border trade or other factors. Political instability or civil disturbances can drastically change the FX rate in literally seconds.
When businesses conduct transactions in different currencies, the business is exposed to risk. The risk arises because the currencies price may move in relation to each other between the start and the finalization of the transaction. Revenue and costs can move up or down as exchange rates change. If a firm has borrowed money in a different currency, the repayments on the loan could change or, if the firm has invested in another country, the returns on investment may alter with exchange rate movements — this is usually known as foreign currency exposure.
Settlement Risk
Settlement risk is the risk that one counterparty to a transaction does not deliver a security or its cash value according to the agreed settlement terms after the other counterparty has already delivered security or cash value for its side of the deal.
This particular risk was very prevalent in foreign exchange settlements because of the nature of FX settlement practices. This risk is also known as Herstatt risk after the German bank that made this type of risk famous. On 26th June 1974, German bank regulators withdrew that bank’s license to operate. They did this at the end of the banking day in Germany (4:30pm local time). However some banks had undertaken foreign exchange transactions with Herstatt on that day and had already paid Deutsche Mark to the Herstatt, believing they would receive US dollars later the same day in the US from Herstatt's US accounts. 4:30 pm in Germany was 10:30 am in New York! Herstatt’s failure stopped all dollar payments to its counterparties at that time, leaving these counterparties unable to collect payments due to them. Today CLS Bank, which was eventually created as a result of these events, has eliminated this type of risk in the seventeen currencies that are covered (as of the end of 2010).
Operational Risk
An operational risk is one that comes about from the carrying out of a firm’s business functions. Operational Risk is defined in the Basel Accords as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”.
This type of risk is very wide ranging. It comes about from the risks connected to people, systems and processes through which the firm operates. Included are other categories such as fraud risks, legal risks, physical or environmental risks.
There are many operational risks that can be directly related to Foreign Currency Trading. In what follows I highlight a few that I consider the most critical.
Electronic trading with customers – FX trading activity is increasingly centered on remote electronic workstations. This requires much greater care regarding special precautions concerning passwords and system access. These measures would include recognizing the importance of guarding individual passwords, protecting the software and hardware on individual workstation and the need to have up-to-date virus protection.
24/7 Operations and “Off-Site” Trading - Foreign exchange trading takes place on a continuous round the clock basis. Twenty-four-hour trading can distort the distinction between regular end-of-day and intra-day position risk limits. This change requires that additional control procedures are in place for trading that is conducted outside of normal business hours, either from the office or elsewhere.
Mistrades – These could arise for a number of different reasons such as an unacceptable counterparty name was presented or the cover amount presented could not cover the transaction
Disputes – Usually come about over misunderstandings or errors either by a trader or a broker. Managers and traders need to recognize that when a trade is aborted, it may not be possible for the broker to find another counterparty at the same original price.
Product design – The development of new products must be properly supported and approved. This covers a whole gamut of issues such as product approval, implementation procedures, signoffs by legal, compliance, tax, audit, systems, operations, business unit, risk management, and accounting departments.
