Settlement risk in foreign exchange transactions

March 1996

Introduction

Financial liberalisation, expanded cross-border capital flows and major advances in trading technology have led to dramatic changes and growth in foreign exchange trading in the last twenty years. While banks have upgraded their operational capacity to settle these trades over time, current settlement practices generally expose each trading bank to the risk that it could pay over the funds it owes on a trade, but not receive the funds it is due to receive from its counterparty. Given the estimated US$ 1 1/4 trillion of foreign exchange trades arranged daily, the resulting large exposures raise significant concerns for individual banks and the international financial system as a whole. Although the probability of a major disruption in the foreign exchange settlement process is low, its potential consequences in a market of this size and complexity are considerable.

This report, which was prepared on behalf of the Committee on Payment and Settlement Systems by its Steering Group on Settlement Risk in Foreign Exchange Transactions, offers a practical approach to dealing with this risk. The report analyses existing arrangements for settling foreign exchange trades and makes recommendations grounded in market realities. It calls upon individual banks and industry groups alike to improve current practices and devise safe mechanisms for addressing settlement risk. For their part, central banks have identified several avenues for cooperating with the private sector and for providing inducements to push this effort forward. I believe the report makes a compelling case that the private sector can, with a relatively modest expenditure of resources, make important progress in containing settlement risk.

The Committee on Payment and Settlement Systems is indebted to Peter Allsopp for his excellent leadership in chairing the Steering Group. Mr. Allsopp, who has made many fine contributions to the work of the Committee and its predecessor over the years, is retiring from the Bank of England this year. Able assistance in editing, translating and publishing the report was provided by the BIS.

William J. McDonough, Chairman  
Committee on Payment and Settlement Systems  
President of the Federal Reserve Bank of New York