Central bankers encouraged by private sector progress on reducing FX settlement risk
13 July 1998
The private sector has made encouraging progress in tackling foreign exchange settlement risk, but much still remains to be done, William J. McDonough, President of the Federal Reserve Bank of New York and outgoing Chairman of the Committee on Payment and Settlement Systems (CPSS) of the Group of Ten central banks, said today. A newly published report by the CPSS assesses the progress made since the launch two years ago of the G-10 central banks' concerted strategy to reduce the systemic risks associated with settling foreign exchange deals.
The G-10 central bank Governors agreed to reaffirm and strengthen their strategy to tackle foreign exchange settlement risk and they today requested the Basle Committee on Banking Supervision (the Basle Committee) to develop international supervisory guidance for banks on foreign exchange settlement risk. Mr. McDonough, recently appointed as Chairman of the Basle Committee, stated that this guidance will be a key element of the strengthened central bank strategy to address the problem.
The G-10 Governors today also reaffirmed the role of the CPSS in working with private sector initiatives aimed at reducing foreign exchange settlement risk, in promoting the strategy worldwide, and in monitoring the progress of the strategy.
Foreign exchange settlement risk has been a top priority for the G-10 central banks since the publication of a CPSS report in March 1996 which showed that banks face huge exposures in the settlement of foreign exchange transactions, and that at any point in time the amount at risk from the failure of even a single counterparty could exceed a bank's total capital.
The progress report released today was prepared under the auspices of the CPSS, chaired for the previous four and a half years by Mr. McDonough. It was drawn up by the CPSS Steering Group on Settlement Risk in Foreign Exchange Transactions chaired by Lawrence M. Sweet of the Federal Reserve Bank of New York. Announcing the release of the report, Mr. McDonough said today:
"Central banks two years ago called for action by the private sector to reduce foreign exchange settlement risk. Today we are optimistic about the steps that have been taken by the private sector in response to that call. In particular, the encouraging progress of industry initiatives during this period has confirmed the view of the G-10 central banks that multicurrency services are best provided by the private sector.
Progress at the individual bank level has also been positive but more needs to be done. Through the guidance to be developed by the Basle Committee, I hope we can demonstrate that it makes sense for all banks to take action to manage and control their foreign exchange settlement risk and that none will be at a disadvantage in doing so."
The 1996 report, known as the Allsopp Report, showed that banks could reduce these risks through improved procedures and risk management, and that well designed multicurrency settlement mechanisms and netting arrangements could greatly enhance the ability of individual banks to reduce their foreign exchange settlement risk.
The G-10 central bank Governors in 1996 endorsed the three-track strategy for foreign exchange settlement risk set out in the Allsopp Report:
- action by individual banks to control their foreign exchange settlement exposures,
- action by industry groups to provide risk-reducing multicurrency services, and
- action by central banks to induce rapid private sector progress.
The report released today assesses the progress made in each of these areas over the last two years:
- Individual banks. Many major market participants have made significant progress in dealing with FX settlement risk: awareness is much higher, senior level responsibility for the risk has been established, the risk is measured and controlled appropriately, and steps have been taken to reduce the risk. However, it is also true that some market participants are still reluctant to take the necessary action.
- Industry groups. Bilateral netting services have grown and there is now greater certainty about the shape of multilateral netting as a result of the merger of the two existing schemes (ECHO and Multinet) into a single company, CLS Services. CLS Services has also successfully raised capital and selected a vendor to build a "continuous linked settlement bank" (the CLS Bank) to settle foreign exchange deals. Industry groups are also exploring alternative approaches to the problem such as replacing traditional foreign exchange trades with contracts for difference (CFDs).
- Central banks. Significant improvements have been made to wholesale payment systems, including the introduction of new systems and actual and planned extensions of operating hours. Central banks have worked cooperatively with industry groups and with national supervisors in their efforts to reduce foreign exchange settlement risk.
NOTES FOR EDITORS
What is FX settlement risk?
Foreign exchange settlement risk is the risk that one party to a foreign exchange trade will pay out the currency it has sold but not receive the currency it has bought (because of a default by the party from whom it is buying the currency). The CPSS's Allsopp Report (Settlement Risk in Foreign Exchange Transactions, Basle, March 1996) noted that current market practices could create interbank FX settlement exposures lasting several days and that, given the scale of FX trading, this meant that at any point in time the amount at risk from the failure of even a single counterparty to settle its obligations could exceed a bank's total capital.
What is the G-10 central banks' strategy for reducing the risk?
The strategy emphasises action by the private sector to tackle the problem. Specifically, it involves a three-track approach involving action by individual banks to control their foreign exchange settlement exposures, action by industry groups to provide risk-reducing multicurrency services and action by central banks to induce rapid private sector progress.
What progress has been made in reducing the risk?
Action by individual banks
- Many of the major participants in the market have made significant progress in dealing with foreign exchange (FX) settlement risk: awareness of the issues is now much higher, including at senior management levels, and a number of banks are devoting significant resources to tackling the problem.
- A substantial number of the banks surveyed during the two-year monitoring period have established clear senior level responsibility for managing the risk and, for control purposes, they now treat FX settlement exposures like other credit exposures of the same size and duration.
- There has been some reduction in exposures as well as some improvement in the methods used to measure them.
- Further near-term improvements seem likely in all these areas.
Action by industry groups
- Bilateral netting has grown with the increased use of services provided by FXNET, Valunet and S.W.I.F.T. Accord as well as bilateral arrangements based on IFEMA and other standard industry contracts.
- A company, CLS Services, has been set up to develop plans for a "continuous linked settlement" bank (the CLS Bank) to settle foreign exchange deals.
- The subsequent merger of CLS Services with the two existing multilateral netting companies, ECHO and Multinet, has created greater certainty about the future shape of multilateral netting.
- Other industry groups are exploring alternative approaches to the problem, such as replacing traditional FX trades with instruments called contracts for difference (CFDs).
Action by central banks
- Significant improvements have been made to wholesale payment systems in recent years, including the introduction of new systems, with potential benefits for the settlement of foreign exchange deals.
- Extensions to the operating hours of systems have also taken place, or are being planned, increasing the overlap in system hours in different currencies.
- The relevant central banks have been in discussion with CLS Services about CLS Bank access to central bank accounts and domestic payment systems.
- Representatives of the CPSS have been working with national supervisors on the issue of FX settlement risk.
Has there been enough progress?
Looking at developments as a whole over the past two years, encouraging progress has been made in tackling the problem of FX settlement risk and considerable momentum has been achieved that could lead to further, substantial progress. Nevertheless, much remains to be done. For example, although many more surveyed banks have established clear senior level responsibility for managing FX risk and include their exposures under appropriate controls, the G-10 central banks are still concerned that one in ten of the surveyed banks failed to meet these benchmarks. Moreover, the improvement observed in the measurement of exposures is from a generally low level; the result is that at the moment over 60% of the banks in the survey are still underestimating their exposures. There also remains considerable scope for reducing exposures by improving current practices and increasing the use of bilateral and multilateral obligation netting.
Many industry initiatives are still under development. Moreover, the G-10 central banks believe that, although industry solutions could in due course substantially reduce the foreign exchange settlement risk faced by individual banks, such solutions by themselves are unlikely to eliminate the risk entirely: it is therefore important to ensure that momentum is also maintained by individual banks in managing their FX settlement exposures.
Why has the strategy been strengthened?
When launching the original strategy in 1996, the G-10 central banks noted that they would closely monitor the progress of private sector action over a two-year period to determine the need for further action. This assessment has now taken place and has led to the conclusion that the strategy should be strengthened to maintain the momentum that has been achieved.
What are the next steps?
As modified by today's announcement, the strengthened strategy can be summarised as follows:
Action by individual banks. Those banks that have not yet done so should take immediate steps to apply an appropriate credit control process to their FX settlement exposures. This recognises the considerable scope for individual banks to address the problem by improving their current practices for managing their FX settlement exposures.
Action by industry groups. Existing and prospective industry groups should continue to develop and offer services and products that contribute to the risk-reducing efforts of individual banks. This reaffirms the G-10 central banks' view that multicurrency services are best provided by the private sector, as was stated in the Allsopp Report of 1996.
Action by central banks. The G-10 central banks, through the CPSS, will continue to promote the strategy worldwide and to monitor progress. Each central bank will continue its efforts to make, or to seek to achieve, improvements to national payment systems that help to bring about a reduction in FX settlement risk. Each central bank will also continue to stimulate private sector action in its domestic market through the best combination of publicity, moral suasion and measures by the appropriate supervisory authorities. Finally, the Basle Committee on Banking Supervision will reinforce these efforts by developing international supervisory guidance on banks' management of FX settlement risk.
What form will the international supervisory guidance take?
The Governors of the G-10 central banks have asked the Basle Committee to develop international supervisory guidance on the prudential management and control of FX settlement risk, consistent with the recommendations of the Allsopp Report. The Governors have not asked the Basle Committee to consider the imposition of capital charges on FX settlement exposures.