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Settlement Risk in Fx Transactions (1)

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42 views

Settlement Risk in Fx Transactions (1)

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pohomol858
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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SETTLEMENT RISK IN FX TRANSACTIONS

NOT FOR CIRCULATION

FX trade: two parties agree/contract to exchange (buy/sell) a quantity of one currency for a quantity of
another currency. The exchange rate is the price of one currency in terms of the other.

FX settlement: the two parties in the FX trade exchange the currencies sold and bought.

FX settlement risk: The risk that one party in a FX trade pays out the currency it sold but does not
receive the currency it bought

Why does FX settlement risk arise?


Settlement risk arises due to time zone differences.

The separate legs of a foreign exchange transaction are settled independently and in many cases at
significantly different times.

For example, a USD/JPY transaction is settled in Tokyo for the yen leg and New York for the USD leg with
the two cities operating 13 hours apart due to different time zones.

Currencies are cleared in their home country through the respective RTGS payment systems. Since the
working hours of the payment systems in the biggest foreign exchange centres – London, New York and
Tokyo – do not overlap completely, a large proportion of foreign exchange activity is settled outside the
business hours of one of the counterparties. Therefore, this leads to the risk that one party in a FX trade
pays out the currency it sold but does not receive the currency it bought.

HERSTATT BANK CASE

Herstatt Bank, was a medium-sized bank in Germany that was very active in foreign exchange trading.

The bank, anticipating US Dollar weakness sold USD against Deutschemark (DEM) in speculative trades,
but racked up significant losses in its bet against the US Dollar. German regulators discovered fraud and
concealment of large trading losses at the bank. On 26 June 1974, at 3:30 PM local time in Frankfurt, at
the close of banking hours, the German authorities closed Herstatt Bank.

On that day, some of Herstatt’s counterparties had irrevocably paid large amounts of Deutsche Marks to
Herstatt Bank in Frankfurt but had not yet received Dollars in New York in exchange, as the US financial
markets had just opened for the day (10 30 AM New York local time).

The transaction is depicted below. Figures are representative/not actual.


Herstatt’s closure started a chain reaction that disrupted payment and settlement systems. Its New York
correspondent bank, Chase Manhattan Bank (now part of JP Morgan Chase Bank) suspended all US
Dollar payments from the German bank’s account. The counter party banks that had paid Deutsche
marks to Herstatt earlier that day therefore became fully exposed to the value of those transactions,
effectively losing their unsecured claim against Herstatt Bank in the liquidation scenario.

Contagion effect: fearing the potential impact on Herstatt Bank’s counterparty banks, the other banks in
New York suspended payments and credit lines to the affected counterparties of Herstatt Bank, unless
they received confirmation that the counter-payment had already been received, leading to a gridlock in
the payments system

These disruptions were propagated further through the payments system in New York. Over the next
three days, the amount of gross funds transferred by this system declined by an estimated 60%.

The collapse of Herstatt Bank and the resultant gridlock in the New York payments systems led to the
realization by the market participants and the regulators about the significant level of risk in FX
settlements.

MITIGATING SETTLEMENT RISK IN FX TRANSACTIONS: PVP MECHANISM

Payment-versus-payment (PVP): according to this principle, the two legs of a FX transaction are settled
simultaneously, and in such a way that the one cannot occur without the other.
Several well-known global banks set up a limited purpose financial institution, CLS Bank, to develop the
PVP solution. CLS Bank is interposed between two trading parties in order to coordinate the mutual
liabilities created by a foreign exchange transaction. CLS Bank ensures that the flows of funds are
transferred simultaneously between the parties involved by means of the PVP mechanism so as to
eliminate settlement risk for the two parties.

Below is a simplistic representation of PVP mechanism involving a FX trade where JP Morgan Chase Bank
sells 1M USD to “Mitsubishi Bank” and buys equivalent amount of Japanese Yen (JPY) of 100 Million,
with settlement through CLS Bank/PVP mechanism.

The illustration above is for two parties and two currencies in a single trade. CLS Bank will first receive
funds from the two parties (JP Morgan and Mitsubishi) in its central bank account at the Federal Reserve
and Bank of Japan, and then settle the FX transaction.

The actual scenario is much more complex: CLS bank supports FX settlement in 18 currencies, for 70
settlement members, 25000 indirect members, with about USD 5.5 trillion being settled every day. CLS
members paying in and receiving payment on a gross basis, as assumed in the above illustration, is
extremely inefficient. Through multi-lateral netting as described below, CLS Bank has achieved about
96-99% reduction in funding requirement of its members.

How does CLS settlement work?


Please read:
https://www.cls-group.com/products/settlement/clssettlement/how-it-works//

Settlement through the CLS system takes place in phases.


At the beginning of the process, members submit details of FX transactions to be settled, through the
SWIFT network normally by 00:00 CET (Central European Time) on the settlement day.

CLS bank matches and verifies the transactions.

Based on all the instructions, CLS Bank then calculates each settlement member’s net total pay-
in/payout position for each currency; CLS Bank multilaterally nets all the instructions between the
settlement members, calculating each institution’s pay-in obligations for the day, to ensure settlement
of all their instructions on a payment-versus- payment basis.

Therefore, CLS member banks have to fund only their net positions on CLS Bank’s central bank accounts.
(Please refer XL sheet on Multi-lateral netting uploaded/shared separately).

At 06:30 CET issues a pay-in schedule for each member (arrived at through multi-lateral netting).

Payments to CLS Bank by members and payouts by CLS Bank to members are executed between 07:00
and 12:00 CET, when RTGS systems of the 18 currencies in which CLS Bank offers settlement are open.

Payments between settlement members and CLS Bank are made through the local RTGS payment
system using the account that, for each currency, CLS Bank holds at the respective central bank.

CLS bank has access to central banks accounts and RTGS systems of all the 18 currencies that it offers
settlement.

Further (optional) reading:


https://www.bis.org/publ/qtrpdf/r_qt0212f.pdf

https://www.snb.ch/en/mmr/reference/continuous_linked_settlement/source/continuous_linked_settl
ement.en.pdf

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