Basel Committee on Banking Supervision

In the period between FX trade execution and final settlement, a bank is exposed to several different risks. The risks vary depending on the type of pre-settlement and settlement arrangements. The three main risks associated with FX transactions are principal risk, replacement cost risk and liquidity risk, which arise due to the possibility that a counterparty may fail to settle an FX trade. This failure may be temporary (eg operational or liquidity problems of the counterparty) or permanent (eg counterparty’s insolvency). A bank may become aware of a potential failure at any time between trading and the completion of settlement, particularly if the problem is due to insolvency. However, sometimes, a bank may only know that a problem has occurred on or after settlement day when it does not receive the currency that the counterparty was expected to deliver. Initially, a bank may not be able to identify the cause of the failure, nor determine whether the failure is temporary or permanent.

Banks should manage FX settlement-related risks in way that is similar to the management of equivalent risks from their other activities, while accounting for any features that are specific to FX risks.

The following terms are used throughout this chapter and have the meaning given below:

1. Bilateral netting: is a general term describing an arrangement to offset the obligations between two parties to a single bilateral obligation. The obligations covered by the arrangement may arise from financial contracts, transfers or both.
2. Central counterparty (CCP): an entity that interposes itself between counterparties to trades in a financial market, becoming the buyer to every seller and the seller to every buyer.
3. Close-out netting: is a form of netting which occurs following some predefined events, such as default. Close-out netting establishes a close-out payment based on the net present value of future cash flows due between a bank and a defaulting counterparty. Close-out netting is intended to reduce exposures on open contracts with a defaulting counterparty. (Also referred to as “default netting”, “open contract netting” or “replacement contract netting”).
4. CLS Bank International (CLS Bank): owned by the foreign exchange community, CLS Bank operates a multi-currency PVP cash settlement system to mitigate settlement risk in the foreign exchange market.
5. Confirmation and affirmation: are the processes in which the terms of a trade are verified either by market participants or by a central entity. A trade confirmation is legal evidence of the terms of an FX transaction. Trade affirmation involves acknowledging a counterparty trade notification or confirmation. Both trade confirmation and affirmation can take many forms (eg electronic, paper or voice over a recorded phone line).
6. Correspondent banking: is an arrangement in which one bank (correspondent) holds deposits owned by other banks (respondents) and provides payment and other services to those respondent banks. Such arrangements may also be known as “agency relationships” in some domestic contexts. In international banking, balances held for a foreign respondent bank may be used to settle FX transactions. Reciprocal correspondent banking relationships may involve the use of nostro and vostro accounts to settle foreign exchange transactions.
7. Credit support annex (ISDA CSA): a legal document that regulates credit support (collateral) for derivative transactions. It is one of the four parts that make up an ISDA master agreement, but is not mandatory. A CSA defines the terms or rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from “in the money” derivative positions. Terms include thresholds, minimum transfer amounts, eligible securities and currencies, haircuts applicable to eligible securities and rules for settling or resolving disputes over valuation of derivative positions.
8. Currency swap: an agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of a loan in another currency at some point in the future according to a specified formula. Currency swaps are over-the-counter derivatives and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps generally involve the exchange of the principal. (Also known as a “cross-currency swap”).
9. Derivatives: are financial contracts whose values depend on the value of one or more underlying reference assets, rates, currencies or indices.
10. Enforceable: means a legal document, agreement, right or obligation is enforceable if the party obligated can be forced or ordered to comply through a legal process.
11. Fail: a failure to settle a transaction on the contractual settlement date, usually due to technical or temporary difficulties. Fails typically arise from operational problems, while “defaults” arise from credit or solvency problems. (Also known as a “failed transaction”).
12. Financial market infrastructure (FMI): is a multilateral system among participating institutions, including the operator of the system, used for purposes of clearing, settling or recording payments, securities, derivatives or other financial transactions.
13. FX forward: a contract between two parties that agree to buy or sell an amount of currency against a second currency at a specified future date (more than two business days later) and at an agreed-upon rate on the date of the contract.
14. FX spot: the purchase of one currency for another, with immediate delivery according to local market convention (eg two business days) at an agreed-upon price on trade date.
15. FX swap: a contract between two parties that simultaneously agree to buy or sell an amount of currency against a second currency at an agreed-upon rate; and to resell or repurchase the same currency at a later date with the same counterparty, also at an agreed-upon rate.
16. In/out swap (with regards to CLS Bank only): an in/out swap comprises two equal and opposite FX transactions that are agreed-upon as an intraday swap between two CLS Bank settlement members. One of the two FX transactions is settled through CLS Bank to reduce each member’s net position in the two currencies. The other transaction is settled outside of CLS Bank. The combined effect of these two FX transactions reduces funding requirements of the two members during the CLS Bank settlement session, but leaves the institutions’ overall FX positions unchanged.
17. Initial margin: is collateral that is collected to cover potential changes in the value of each participant’s position (also known as “potential future exposure”) over the appropriate close-out period in the event the participant defaults.
18. Margin call: is a demand for additional funds or collateral (following the marked-to-market of a margined transaction) if the market value of the underlying collateral falls below margin requirements.
19. Master netting agreement: is a master netting agreement (eg ISDA or IFEMA) sets forth the standard terms and conditions applicable to all, or a defined subset of, transactions that the parties may enter into from time to time. Includes the terms and conditions for close-out and obligation netting.
20. Non-deliverable forwards (NDFs): are outright forward or futures contract in which counterparties settle the difference between the contracted NDF price or rate and the prevailing spot price or rate on an agreed notional amount.
21. Nostro account: is a foreign currency-denominated account (usually at a foreign bank) where a domestic bank keeps reserves to maintain its balance in that currency and to make and receive payments.
22. On-us settlement: settlement in which both legs of an FX transaction are settled across the books of a single institution. On-us settlement can occur either where one counterparty to a transaction provides accounts in both currencies to the other counterparty, or where one institution provides accounts to both counterparties to an FX transaction in both currencies. The account provider debits one of its customer’s accounts and credits the other, while making opposite debits and credits to its own account. Those credits can be made simultaneously (via PVP) or at different times, in which case one counterparty may be exposed to principal risk from the other counterparty. Irrespective of whether principal risk exists, normal correspondent credit risks are also likely to exist.
23. Payment-versus-payment (PVP) settlement: is a settlement mechanism that ensures the final transfer of a payment in one currency if, and only if, a final transfer of a payment in another currency occurs. PVP arrangements do not guarantee settlement. In a basic PVP arrangement, a trade will settle only if a bank and its counterparty pay in the correct amount. If the counterparty fails to pay in, a bank will receive back the currency it was selling, thus providing protection against principal risk. However, it will still be short on the currency that it was buying and face liquidity risk equal to the full amount of that currency, as well as the replacement cost risk on that amount.
24. Potential future exposure: is the most common measure of forward-looking exposure. It is the maximum expected exposure over a specified interval of time calculated at some level of confidence. Potential future exposure is the additional exposure that a counterparty might potentially assume during the life of a contract, or set of contracts, beyond the current replacement cost. It is calculated by evaluating existing trades executed against possible market prices in the future. Both initial margin and variation margin mitigate this future exposure. Variation margin mitigates actual price volatility so that the price protection provided by initial margin is maintained.
25. Principal risk: is the risk of outright loss of the full value of a transaction resulting from the counterparty’s failure to settle. This can arise from paying away the currency being sold, but failing to receive the currency being bought. Principal risk exists when a bank is no longer guaranteed that it can unilaterally cancel the payment of the currency it sold (the unilateral cancellation deadline). Given that a bank’s unilateral payment cancellation deadline may be one or more business days before the settlement date, this risk can last for a significant period of time. (Also referred to as “Herstatt Risk”).
26. Replacement cost risk: is the risk of loss due to unsettled transactions with a counterparty. The resulting exposure is the cost of replacing the original transaction at current market prices.
27. Risk appetite: means the aggregate level and types of risk a bank is willing to assume, decided in advance and within its risk capacity (that is, the maximum amount of risk a bank is able to assume given its capital base, risk management and control capabilities as well as its regulatory constraints), to achieve its strategic objectives and business plan.
28. Settlement finality: is the irrevocable and unconditional transfer of an asset or financial instrument, or the discharge of an obligation by the FMI or its participants in accordance with the terms of the underlying contract. Final settlement is a legally defined moment.
29. Straight-through processing: is automated processing that allows data to be entered into technical systems once and is then used for all subsequent processing of transactions.
30. Trade confirmation: is legal evidence of the terms of an FX transaction. A confirmation should include trade details, settlement instructions and other relevant information to allow each counterparty to agree to the trade terms. Trade affirmation involves acknowledging a counterparty trade notification or confirmation. Both trade confirmation and affirmation can take many forms (eg electronic, paper or voice over a recorded phone line).
31. Unilateral payment cancellation deadline: is the point in time after which a bank is no longer guaranteed that it can recall, rescind or cancel (with certainty) a previously submitted payment instruction. This deadline varies depending on the currency pair being settled, correspondent payment system practices, and operational, service and legal arrangements.
32. Variation margin: is an amount of collateral posted to cover exposures resulting from actual changes in market prices (also known as “mark-to-market margin”).

This chapter provides guidance to banks and supervisors on approaches to managing the risks associated with the settlement of FX transactions. It focuses on FX transactions that consist of two settlement payment flows. This includes FX spot transactions, FX forwards, FX swaps, deliverable FX options and currency swaps involving exchange of principal. It excludes FX instruments that involve one-way settlement payments, such as non-deliverable forwards (NDFs), non-deliverable options and contracts for difference. Certain principles discussed here (eg dealing with replacement cost risk) are also relevant for single-payment instruments.

Guideline 1: A bank should have strong governance arrangements over its FX settlement-related risks, including a comprehensive risk management process and active engagement by the board of directors.1

Strong governance of FX settlement-related risks

The board of directors is ultimately responsible for ensuring that the bank has strong governance arrangements that require all FX settlement-related risks be properly identified, measured, monitored and controlled on a bank-wide basis. This includes approving and overseeing the bank’s strategic objectives, risk appetite statement and corporate governance structure. The board oversees senior management and ensures that management’s actions to monitor and control FX settlement-related risks are consistent with the risk appetite, strategy and policies previously approved by the board. These efforts should be supported by appropriate reporting to ensure that the board receives sufficient and timely information regarding how the bank is managing its FX settlement-related risks. The bank’s overarching governance framework should include a comprehensive program of internal controls to measure these risks.

Comprehensive risk management framework

A bank’s risk management framework should cover all material risks inherent to the life cycle of an FX transaction, including principal risk, replacement cost risk, liquidity risk, operational risk and legal risk. The framework should reflect the size, nature, complexity and risk profile of the bank’s FX activities; provide mechanisms that properly identify, measure, monitor and control associated risks; and be integrated into the overall risk management process.

The board should approve and oversee how effectively management implements the bank’s risk policies, including policies for managing all of the risks associated with FX settlement. Policies and procedures should be comprehensive, consistent with relevant laws, regulations and supervisory guidance and provide an effective system of internal controls. Policies and procedures should be clearly documented. Once established, policies should be periodically reviewed for adequacy based on changes to financial markets and internal business strategies.

A bank should set formal, meaningful counterparty exposure limits for FX trading and settlement that include limits for principal risk and replacement cost risk. In particular, the size and duration of principal exposures that arise from non-PVP settlements should be recognised and treated equivalently to other counterparty exposures of similar size and duration. Limits consistent with the bank’s risk appetite should be established by the credit risk management department, or equivalent, on a counterparty basis. Usage should be controlled throughout the day to prevent trades that would create principal and replacement cost exposures that exceed these limits. Exceptions to established limits should be approved in advance (prior to trading) by the appropriate authority in accordance with established policies and procedures.

A bank should have sufficiently robust systems to capture, measure and report on FX settlement-related exposures on a bank-wide basis, across business lines and counterparties. The sophistication of systems should reflect the risk profile and complexity of the bank. Timely reports should be provided to the bank’s board and senior management and include appropriate key risk indicators and risk issues that could result in a potential loss.

A bank should ensure that its framework identifies FX fails and captures the full amount of the resulting FX settlement-related risks as soon as practicable, to allow senior management to make appropriate judgements regarding the nature and severity of the exposure.

A bank should clearly define, in its policies, the nature and types of incidents that would constitute issues requiring escalation to, and approval by, senior management or the board. There should be clear and detailed escalation policies and procedures to inform senior management and the board, as appropriate, of potential FX issues and risks in a timely manner, and seek their approval when required. This should include, but not be limited to, exceptions to established limits and fails management.

A bank should have an independent and effective internal audit function that can evaluate the effectiveness of management’s efforts to control or mitigate the risks associated with settling FX transactions. Internal audit should have an independent reporting line to the bank’s board or audit committee of the board, audit staff with the necessary expertise and experiences on the subject, and sufficient status within the bank to ensure that senior management responds appropriately to findings and recommendations. In addition, a bank should have an effective compliance function that manages compliance-related matters associated with settling FX transactions. The board should oversee the management of the compliance function.

A bank’s risk management framework should include procedures to identify the most appropriate settlement method2 for each type of FX transaction given the size, nature, complexity and risk-profile of the bank’s FX activities. A bank should carefully measure the size and duration of its principal exposures and assess all available settlement methods and their efficacy at reducing or eliminating principal risk and other FX settlement-related risks. These implications need to be identified, assessed and incorporated into the bank’s decision-making process. Once an appropriate settlement method is chosen, a bank should properly manage all FX settlement-related risks associated with that method. Where PVP arrangements are available, but a bank or its client has chosen not to use them, the bank should periodically reassess its decision.

When choosing to use or participate in an FMI, a bank should conduct robust initial due diligence to assess the associated risks. The initial due diligence should include a review of legal, operational, credit and liquidity risks associated with the use of an FMI and its participants and controls. A bank should have a thorough understanding of an FMI’s rules and procedures, as well as any responsibilities and FX settlement-related risks that it may assume through its use or participation, directly or indirectly. A bank must ensure that it has the appropriate policies, procedures and internal control structure to adequately manage its risks and to fulfil its responsibilities to the FMI and its clients. Once a bank chooses to use or participate in an FMI, it should conduct periodic monitoring to identify significant changes to the FMI’s processes or controls that may affect its risk exposures. If significant changes occur, the bank should update its risk analysis, as appropriate. The bank should refer to any available disclosures based on the Principles for financial market infrastructures (PFMI) when conducting its own due diligence and periodic monitoring of the FMI.

A bank may choose to be an indirect participant of a settlement or CCP arrangement (ie a customer of a direct participant). In this case, the FX settlement-related risks a bank faces will depend, in part, on the exact terms of the service provided by the direct participant. Thus, the risks associated with indirect participation may not be the same as those associated with direct participation.

A bank may choose to settle via correspondent banks. Under this settlement method, each counterparty to an FX trade transfers to the other counterparty the currency it is selling, typically using their correspondent banks for the currencies concerned. Once a payment instruction is irrevocable, the full amount being transferred is subject to principal risk, and some portion may be subject to replacement cost risk and liquidity risk. The bank’s risk management framework should include policies and procedures for evaluating the risks and benefits of using one or more correspondent banks to settle its FX transactions in each currency. The framework should consider the potential size, form and maturity of the bank’s exposure to its correspondents; and include an evaluation of each correspondent’s financial condition and the risk profile of each correspondent’s jurisdiction. It should include an assessment of any credit, liquidity, operational and legal risks associated with using correspondent banking services. The framework should provide for periodic reviews of the bank’s correspondent banks and have procedures in place to mitigate any FX settlement-related risks that may arise.

A bank should consider its level of dependence on other institutions for settling its FX transactions. It should assess the potential impact of disruption and mitigate the FX settlement-related risks, as appropriate. Such risk mitigants may include establishing dual or backup correspondent or settlement banks to make payments, or joining an FMI directly. The appropriate method should consider costs, testing arrangements, switching time, time to on- board, legal agreements, service fees, etc.

Guideline 2: A bank should eliminate principal risk by using FMIs that provide PVP settlement, where practicable.3 Where PVP settlement is not practicable, a bank should properly identify, measure, control and reduce the size and duration of its remaining principal risk.

In addition to a number of regional settlement arrangements, there are also mechanisms that provide global PVP settlement. PVP arrangements are designed to eliminate principal risk but will not eliminate a bank’s replacement cost risk or liquidity risk. A bank should identify and manage these risks effectively.

A bank may access the services of a PVP arrangement as a direct participant or as an indirect participant. A bank that is an indirect participant, or third party, should determine whether the settlement processes of the direct participant, or third party service provider (including any “internalised” or “on-us” settlement processes it may use) creates principal risk exposure. Principal risk exposures may occur between the bank and the direct participant, or between the bank and its counterparty (in internalised settlement).4 If principal risk exists, then the bank should manage it accordingly.

Where PVP is not practicable, a bank should manage its remaining principal risk by setting binding principal risk limits; measuring expected exposures appropriately to prevent those limits from being broken when trades are executed; and monitoring the subsequent status of the trades so that the bank can take prompt action when problems arise. Management of principal risk should be fully integrated into a bank’s overall risk management process.

A bank should ensure that principal risk to a counterparty is subject to prudent limits and an adequate credit control process, including credit evaluation and a determination of maximum exposure to a particular counterparty. Counterparty exposures arising from principal risk should be subject to the same procedures used to set limits on other exposures of similar duration and size to that counterparty.5

The trading limits applied by a bank should be binding, namely, usage should be monitored and controlled throughout the day to prevent trades that would create exposures during the settlement process that would exceed the limit.6 Where a bank is acting as a prime broker, it should have ex-ante processes in place to prevent client trades from creating exposures that would exceed the limit.7 When a decision is made to allow a client to exceed a limit, appropriate approval should be obtained. A bank that exceeds its principal risk limit with a particular counterparty should reduce its exposure as soon as is practicable.

To ensure that the limits are binding, a bank should use an ex-ante process that updates and reports exposure on a timely basis, preferably as each trade is executed. If a bank has limited capability to update and report exposure on a timely basis, then the bank needs to have effective post-trade risk management controls to minimise limit breaches.8

For a bank to estimate the expected principal risk that will arise from a trade during its settlement process and to determine whether the counterparty limit will be exceeded, it needs to accurately measure when that exposure will begin and when that exposure will end. This requires the bank to know the relevant unilateral cancellation deadline for the currency it sold and when the incoming payment for the currency it bought will be received with finality and is reconciled. A bank will also need to determine whether it is appropriate to use approximate, rather than exact, measures of exposure that may arise during a trade’s settlement.

A bank’s principal risk exposure to its counterparty begins when a payment order on the currency it sold can no longer be recalled or cancelled with certainty – this is known as the “unilateral payment cancellation deadline.”9 A bank should reduce the duration of its exposures by having the capability to unilaterally cancel payment instructions as late as practicable. This might require changes to systems and processes used to process internal payments. The exposure ends when the bank receives the purchased currency with finality. The duration of principal risk can vary depending on the currency pair being settled and the correspondent banking arrangements used by the bank and its counterparty.

A key factor in determining a unilateral payment cancellation deadline is the latest time a correspondent guarantees to satisfy a cancellation request (the guaranteed cut-off time). Service level agreements should identify this cut-off time. In instances where an agreement may not specify a guaranteed cut-off time or a bank may not have a written agreement, the bank and its correspondent should establish a specific cut-off time as late as practicable.10 Unilateral delay in sending payment instructions may increase the correspondent’s operational risk (eg incorrect execution of payment instructions).

A bank should be able to identify and halt individual payments up to the cut-off times (regardless of time zone issues) guaranteed by its correspondents or the payment system in which it participates without disrupting the processing of other outgoing payments.11 Where a bank’s internal operational factors limit the bank’s ability to do so, its effective unilateral payment cancellation deadline may be earlier than the guaranteed correspondent cut-off time. In some cases, the unilateral payment cancellation deadline may be earlier than the time the payment order is normally sent to the correspondent. This could occur, for example, if cancelling an internally queued, but still unsent, payment order requires manual intervention. To ensure effective processing consistent with unilateral payment cancellation deadlines under stress, a bank should periodically test with its branches and payment correspondents.

To appropriately calculate when the principal exposure of a specific trade will end, a bank should incorporate its process for reconciling incoming payments and the point in time that it will identify the final or failed receipt of the purchased currency. To avoid underestimating exposures, the bank should assume that funds have not been received until credit to its correspondent bank (nostro agent) account has been confirmed and the bank has determined which trades have successfully settled and which have failed to settle. A bank should minimise the period of uncertainty (ie the time between actual final receipt and reconciliation) by arranging to receive timely information on final payment receipt from its correspondent bank.

When calculating expected principal risk using approximation methods banks should identify the relevant unilateral payment cancellation deadlines and reconciliation process timelines for each currency pair to avoid underestimating principal risk.12

Effective monitoring of failed transactions is crucial for measuring and managing principal risk, as unexpected fails cause exposures to be higher than predicted. A bank should have a framework that monitors fails and properly accounts for them in its exposure measures.

Where PVP settlement is not used, a bank should reduce the size of its principal risk as much as practicable. A bank could use obligation netting to reduce the size of its principal risk exposures. Depending on trading patterns, legally binding obligation netting permits a bank to offset trades to a counterparty so that only the net amount in each currency is paid or received. To allow exposures to be measured on a net basis, netting arrangements should be legally sound and enforceable in all relevant jurisdictions.

A bank should use legally enforceable bilateral netting agreements and master netting agreements (eg ISDA)13 with all counterparties, where practicable. The netting agreements should contain legally enforceable provisions for close-out netting and obligation netting. A bank should understand the implications of not having a netting agreement with a counterparty (eg where FX trading is restricted to very short tenors) and manage this risk accordingly.

If a counterparty’s chosen method of settlement prevents a bank from reducing its principal risk (eg a market participant does not participate in PVP arrangements or does not agree to use obligation netting), then the bank should consider decreasing its exposure limit to the counterparty or creating incentives for the counterparty to modify its FX settlement methods.

Guideline 3: A bank should employ prudent risk mitigation regimes to properly identify, measure, monitor and control replacement cost risk for FX transactions until settlement has been confirmed and reconciled.

A bank should employ effective replacement cost risk management tools to identify, measure, monitor and control collateralised and uncollateralised exposures.

Limits on replacement cost risk should be established by maturity buckets to control current exposure and potential future exposure.14,15 Banks should consider other measures to further control the replacement cost risk, such as regularly measuring stress test results against limits.

Until the final settlement of FX transactions is confirmed and reconciled, a bank cannot be certain that it is no longer exposed to replacement cost risk for those transactions. To avoid underestimating potential replacement cost risk, a bank should assume that the exposure begins at trade execution and continues until final settlement of the transaction has been confirmed and reconciled.

A bank should identify and assess the impact of its assumptions regarding the timing and nature of settlement when measuring replacement cost risk under a close-out netting agreement. For example, a bank with close-out netting agreements might measure and manage replacement cost risk on a bilateral net basis with the assumption that either all transactions with a single counterparty due to settle on a particular day will settle or none will settle. Since payments to settle FX transactions may be made at any time, from the opening of business in the Asia-Pacific region to the close of business in the Americas, this assumption may be faulty.16 Therefore, the bank should manage its replacement cost risk according to actual settlement times to avoid underestimating its risk.

A bank should use bilateral netting agreements and master netting agreements with all counterparties in jurisdictions where netting is legally enforceable. The netting agreements should include provisions for close-out netting and obligation netting. Close-out netting reduces risk and provides legal clarity regarding a surviving bank’s claims and/or obligations with respect to a defaulted counterparty. It mitigates the risk of being forced to make payments of gross principal, or of gross marked-to-market losses, to the defaulted counterparty, while the defaulted counterparty’s obligations become unsecured liabilities in a bankruptcy process.

A bank should use legally enforceable collateral arrangements (eg ISDA credit support annexes) to mitigate its replacement cost risk. Collateral arrangements should describe the parties’ agreement on all aspects of the margining regime, including collateral eligibility, timing and frequency of margin calls and exchanges, thresholds, valuation of exposures and collateral and liquidation.

A bank should exchange (ie both receive and deliver) the full amount of variation margin necessary to fully collateralise the mark-to-market exposure on physically settling FX swaps and forwards with counterparties that are financial institutions and systemically important non-financial entities. Variation margin should be exchanged with sufficient frequency (eg daily) with a low minimum transfer amount. Margin would be permitted, but not required, for transactions with sovereigns, central banks, multilateral development banks or the Bank for International Settlements. Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework. Collateral management policies and procedures should at a minimum address: (a) collateral eligibility, (b) collateral substitution; and (c) collateral valuation and should be reviewed on a periodic basis.

Guideline 4: A bank should appropriately manage its liquidity needs and risks to ensure that it is able to meet its FX payment obligations on time.

Liquidity risk exists in addition to replacement cost risk. Whether a default is just a replacement cost problem or turns into a liquidity shortage depends on whether a bank can replace the failed trade in time to meet its obligations or, at least, to borrow the necessary currency until it can replace the trade. In principle, liquidity risk can exist throughout the period between trade execution and final settlement. In practice, the probability of the problem materialising as a liquidity shortage and a replacement cost depends on many factors, including:

1. The timing of the default. The closer the default is to the settlement date, the less time a bank has to make other arrangements.
2. Whether a bank has already irrevocably paid away the currency it is selling. If so, the bank may have fewer liquid assets available to pay for the replacement trade or to use as collateral to borrow the currency it needs.
3. The nature of the trade. The less liquid the currency being purchased and/or the larger the value of the trade, the harder it may be to replace.

A bank should manage its overall liquidity needs and risks in accordance with existing international supervisory guidance.17 A bank’s liquidity risk management framework should address how the bank’s liquidity needs and risks in each currency will vary based on the chosen method of settlement. A bank’s failure to meet its FX payment obligations in a timely manner may impair the ability of one, or more, counterparties to complete their own settlement, which can lead to liquidity dislocations and disruptions in the payment and settlement systems.

A bank should identify, measure, monitor and control its liquidity needs in each currency, taking into consideration the settlement method and applicable netting arrangements. A bank should be able to prioritise time-specific and other critical payment obligations to meet payment deadlines. This is particularly important for a bank that uses an FMI to settle its FX obligations. While settlement through an FMI can reduce a bank’s overall liquidity needs, it can also place high demands on a bank to make time-critical payments to settle its FX transactions. In order to meet its payment obligations in a timely manner, a bank should maintain sufficient available liquid resources and have the ability to mobilise those resources, as required. A bank should identify and manage the timeframes required to mobilise different forms of collateral, including collateral held on a cross-border basis.

A bank may face a significant liquidity shortfall if a counterparty fails to deliver a leg of an FX transaction (the purchased currency) on time. This situation may be exacerbated in a non-PVP settlement process, whereby the bank has already paid away the sold currency and cannot use those funds as collateral or to swap outright to obtain the needed counter- currency. A bank should account for these risks in its liquidity risk management framework and develop contingency plans to address possible liquidity shortfalls.

A bank may settle its FX payment obligations based on a bilateral or multilateral net position in each currency (position netting) even though the underlying obligations remain gross from a legal perspective. When this is the case, a bank should understand and address the risk that its liquidity needs could change materially following a settlement disruption. In particular, the failure of a counterparty or a settlement disruption in an FMI could lead to a scenario where a bank’s net liquidity needs increase significantly by reverting to gross liquidity needs.

A bank that settles its FX obligations through an FMI should assess the FMI’s rules and procedures to identify potential liquidity risks. For example, a bank should understand an FMI’s rules for rescinding trades and the associated liquidity impact on the bank. In addition, a bank may use certain liquidity-saving mechanisms (eg in/out swaps) to reduce its funding needs and should assess and manage its risk resulting from the absence of such mechanisms. Further, as noted above, a participant failure or a disruption to the operations of an FMI may change a bank’s liquidity requirements. For example, if a participant fails to make payment or settlement is disrupted, then the remaining participants may be required to make unexpected funding payments to settle their transactions. A bank should incorporate these risk scenarios into its liquidity stress tests and make appropriate adjustments to its liquidity management policies, procedures and contingency funding plans.

A bank may have additional responsibilities associated with being an FMI member that should be considered in its liquidity risk management framework. For example, a bank may provide third party settlement services, correspondent banking services or credit to its customers to facilitate FMI settlement. Further, a bank may also be a liquidity provider to an FX settlement FMI.18 If an FMI needs to draw on its liquidity facilities, a provider bank may experience liquidity stresses resulting from the combination of its own FX obligations and the needs of the FMI. As these situations are likely to occur during periods of significant market stress, a bank should incorporate these risk scenarios in its liquidity stress tests. In these scenarios, a bank should consider that normal funding arrangements may not be available.

Guideline 5: A bank should ensure that its systems support appropriate risk management controls, and have sufficient capacity, scalability and resiliency to handle FX volumes under normal and stressed conditions.

A bank’s operational risk management framework should address the accuracy, capacity and resiliency of its operational processes and systems for FX settlement. A bank should periodically reassess its operational risks, including risks that stem from changes in its FX portfolio (eg new products).

Operational risks can lead to inadequacies in the accuracy, capacity and resiliency of a bank’s operations and cause delays or errors in trading data or confirmation of FX trades. Further, operational risks can lead to losses resulting from the bank’s failure to meet obligations on time, and create or exacerbate other risks (eg principal risk, replacement cost risk, liquidity risk and reputational risk).

A bank should maximise the use of straight-through processing (STP) by employing systems that automatically feed transactions, adjustments and cancellations from trade execution systems to other internal systems, such as operations and credit-monitoring systems. STP helps to ensure that data is disseminated quickly, accurately and efficiently throughout the bank, and allows for effective monitoring and control of risks from trade execution to settlement. For example, STP can facilitate the timely confirmation of trades with counterparties and eliminate errors from manual processing. Maximising the use of STP, however, does not fully eliminate operational risk. In addition, STP systems require monitoring and sufficient capacity and scalability. If STP systems are disrupted, a bank should have contingency procedures to continue its operations.

A bank should establish processes and procedures that allow it to confirm or positively affirm FX trades as soon as practicable after execution to reduce the potential for losses from market risk or other sources. Where practicable, a bank should use electronic methods and standard settlement instructions to maximise the use of STP and allow for prompt confirmation and affirmation. Escalation procedures should be in place to resolve unconfirmed transactions. Trade confirmations and affirmations should be transmitted in a secure manner to mitigate the possibility of theft or fraudulent correspondence. As the confirmation and affirmation processes are critical controls, these functions should be handled independently of the trading division.

A bank should have a robust capacity management plan for its FX systems, including trading, credit monitoring, operations, prime brokerage and settlement systems. When assessing capacity needs, a bank should consider the sufficiency of FX systems and operational personnel.

A bank should ensure its FX systems have sufficient capacity and scalability to handle increasing and high-stress FX volumes. A bank’s capacity plan should include forecasting of expected and high-stress capacity needs. The forecasts should consider the FX trading behaviour of the bank and its clients. In addition, a bank should also work with relevant FMIs when establishing capacity policies and high-stress capacity requirements.

A bank should ensure its FX systems are designed appropriately for the scale of its current and expected FX business activity. For example, a bank that offers FX prime brokerage services should ensure that the operational arrangements supporting its prime brokerage activities integrate seamlessly with the bank’s FX systems and do not cause undue operational risk. Further, a bank should design its FX systems to accommodate the potential for large trading spikes in stress situations, as appropriate. Finally, a bank’s FX systems should be flexible enough to meet changing operational needs.

The capacity plan should include timely monitoring of trading volumes and capacity utilisation of key systems. Volume monitoring is critical to a bank that engages in high- frequency trading or has prime brokerage clients that engage in such activity, and should be reflected in the robustness of their capacity management plan. A bank should monitor trading volumes in a timely manner to prevent them from reaching a critical level and assess the potential for large FX trading spikes.

A bank should identify and address various plausible events that could lead to disruptions in their FX-related operations and should have appropriate systems, backup procedures and staffing plans to mitigate such disruptions. Business continuity plans should be documented and periodically reviewed, updated and tested.

Guideline 6: Contracts, and actions taken under contracts (including close-out netting and collateral agreements), should be legally enforceable with a high degree of certainty in all relevant jurisdictions even when a counterparty defaults or becomes insolvent.

Legal risk in FX settlement occurs when a counterparty’s contractual FX obligations are non-binding, unenforceable and subject to loss because:

1. the underlying transaction documentation is inadequate;
2. the counterparty lacks the requisite authority or is subject to legal transaction restrictions;
3. the underlying transaction or contractual terms are impermissible and/or conflict with applicable law or regulatory policies; or
4. applicable bankruptcy or insolvency laws limit or alter contractual remedies.

Legal problems may affect settlement of a foreign exchange transaction. They may also compromise the robustness of netting, the enforceability of unilateral cancellation times or certainty about the finality of the receipt of currency.

A bank should understand whether there is a high degree of certainty that contracts, and actions taken under such contracts, will not be subject to a stay beyond a de minimis period, voided or reversed. In jurisdictions where close-out netting may not be legally enforceable, banks should ensure that they have compensating risk management controls in place.19

A bank conducting business in multiple jurisdictions should identify, measure, monitor and control for the risks arising from conflicts of laws across jurisdictions. The identification of legal risk in various jurisdictions can be accomplished through:

1. legal opinions upon which a bank is entitled to rely that are commissioned by, and addressed to, a trade organisation or an FMI of which a bank is a member; or
2. legal opinions provided by the bank’s in-house or external counsel who are licensed to practice law in the jurisdictions for which they are providing such opinions.

All opinions should be reviewed for legal sufficiency by bank counsel, and be updated on a regular basis.

Changes in law (eg new or changing legal restrictions on the use of currency) may adversely impact a bank’s FX activities by rendering agreements and contracts unenforceable. A bank should have procedures to monitor for, and promptly assess, changes in law relevant to its FX agreements and contracts in jurisdictions in which it is doing business and jurisdictions of the currencies in which it transacts.

If a bank’s agreements and contracts are not legally enforceable, a bank may find itself with significant unexpected and/or un-hedged foreign exchange obligations. The financial ramifications for a bank that has actively traded in that currency could be severe.

A bank should obtain legal advice that addresses settlement finality with respect to its settlement payments and deliveries. The legal advice should identify material legal uncertainties regarding settlement finality so that the bank may assess when key financial risks are transferred. The legal advice and bank’s assessment should also consider the impact of relevant bankruptcy and insolvency laws and relevant resolution regimes. A bank needs to know with a high degree of certainty when settlement finality occurs as a matter of law and plan for actions that may be necessary if settlement finality is not achieved as a matter of law.

A bank should ensure that relevant contracts, including those with correspondent banks (nostro agents), specify the point at which funds are received with finality, and the point at which instructions become irrevocable and unconditional, taking into consideration the impact of relevant bankruptcy and insolvency laws and relevant resolution regimes.

A bank should clearly communicate the legal status of on-us settlements so that their customers and counterparties know when finality of settlement is achieved as a matter of law.