Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions

July 1999

Introduction

1. Foreign exchange (FX) settlement risk is the risk of loss when a bank in a foreign exchange transaction pays the currency it sold but does not receive the currency it bought. FX settlement failures can arise from counterparty default, operational problems, market liquidity constraints, and other factors. Settlement risk exists for any traded product but, given the size of the foreign exchange market, for many banks FX transactions form the greatest source of settlement risk exposure. For large banks, FX transactions can involve credit exposures amounting to tens of billions of dollars each day, and in some cases, exposures to a single counterparty in excess of an institution's capital.

2. FX settlement risk clearly has a credit risk dimension. If (as is usually the case under current market practices) a bank cannot make the payment of the currency it sold conditional upon its final receipt of the currency it bought, it faces the possibility of losing the full principal value of the transaction. However FX settlement risk also has an important liquidity risk dimension. Even temporary delays in settlement can expose a receiving bank to liquidity pressures if unsettled funds are needed to meet obligations to other parties. Such liquidity exposure can be severe if the unsettled amounts are large and alternative sources of funds must be raised at short notice in turbulent or unreceptive markets. Finally, FX settlement risk also has a wider systemic risk dimension.

3. As with other forms of risk, the development of counterparty settlement limits and the monitoring of exposures against these limits is a critical control function and should form the backbone of a bank's FX settlement risk management process. FX settlement risk should be managed through a formal and independent process with adequate senior management oversight and should be guided by appropriate policies, procedures and settlement exposure limits. FX settlement risk measurement systems should provide appropriate and realistic estimates of settlement exposures on a timely basis.

4. This guidance builds on the work completed by the Committee on Payment and Settlement Systems of the Bank for International Settlements, in particular their reports, Settlement Risk in Foreign Exchange Transactions (March 1996) and Reducing Foreign Exchange Settlement Risk: A Progress Report (July 1998).

Invitation to comment

The Basel Committee is issuing this paper for consultation. Comments should be submitted no later than 30 November 1999. The Committee intends to release a final version of the paper once all comments have been considered. Comments should be sent to:

Basel Committee on Banking Supervision
Attention: Mr William Coen
Bank for International Settlements
CH-4002 Basel, Switzerland

Fax: +41 61 280 9100