Settlement of Foreign-Exchange Transactions

Lone Natorp, Market Operations and Tina Skotte Sørensen, Payment Systems

SUMMARY

For the last 25 years, participants in the financial markets have focused on reducing the settlement risk on foreign-exchange transactions. In 1996, the central banks formulated a strategy in accordance with which the private banks have improved their own management of foreign-exchange settlement risk. The establishment of the international clearing and settlement system CLS^[1] Bank International in 2002 has enabled settlement of foreign-exchange transactions without any mutual credit risk between the parties. As more and more foreign-exchange trading migrates to CLS, it will therefore be possible to reduce the aggregate settlement risk. Surveys show that Danish market participants generally manage settlement risk prudently, but also that some participants can reduce their settlement risk by optimising settlement procedures or by settling via CLS.  

INTRODUCTION

The daily transaction value in the international foreign-exchange markets exceeds 1,900 billion dollars.^[2] When a foreign-exchange transaction has been concluded, it is settled via two opposite payments between the parties. A transaction in e.g. kroner against euro involves a payment in kroner by one party to the other and a payment in euro in the opposite direction.

Foreign-exchange transactions have traditionally been settled by remitting the agreed amounts via correspondent banks^[3]. With this settlement form, the parties incur a mutual credit risk equivalent to the traded amount. In view of the very large trading volumes, this settlement risk can potentially have an impact on financial stability. The case of Bankhaus Herstatt in 1974 highlighted this issue, but there are also more recent examples of how settlement problems in the foreign-exchange markets have jeopardised financial stability, cf. Box 1.

Since 2002, the international clearing and settlement system CLS Bank International has enabled settlement of foreign-exchange transactions in a manner whereby the parties do not incur a mutual credit risk. Around half of the global foreign-exchange trading is estimated to take place via CLS. The remaining transactions are settled via traditional channels.

Financial stability is an important objective for the central banks. Since the failure of Herstatt, central banks have therefore worked with supervisory authorities and private banks to reduce foreign-exchange settlement risk. The work of the central banks is coordinated in the BIS^[4]

Committee on Payment and Settlement Systems, CPSS. In 1996, CPSS formulated a strategy to reduce foreign-exchange settlement risk, which has been followed up regularly. Most recently, in April 2006, BIS conducted a survey of the market participants' management of foreign-exchange settlement risk, including their use of CLS. BIS' work in this respect is described in Box 2.

The following presents a general description of various settlement methods and the related risks, as well as an account of Danish participants' foreign-exchange settlement risk, based on the above BIS survey, among other things.

DIFFERENT SETTLEMENT METHODS AND THE ASSOCIATED RISKS

Settlement risk on a foreign-exchange transaction arises when one party to the transaction has supplied the sold currency and has not yet received the purchased currency. Settlement risk comprises various types of risk:

• Credit risk is the risk of financial loss as a consequence of a counterparty's inability to meet its obligations, so that the purchased currency is received neither at the time of settlement nor at a later time.
• Liquidity risk is the risk of incurring a loss because the purchased currency is not received at the expected time. The loss arises e.g. if alternative liquidity can only be obtained at a cost.
• Operational risk is the risk of losses due to human errors, system errors and external events such as natural disasters, acts of terrorism, etc. In connection with foreign-exchange settlement, operational risk typically results in unexpected credit and/or liquidity risk on the purchased currency.

The most frequently used settlement methods and the related risks are described below. The terminology used is taken from the BIS reports on settlement risk.

Settlement via correspondent banks and payment systems
A foreign-exchange transaction can be settled by exchanging the traded amounts via the traditional channels for international payments. Settlement of e.g. a euro/dollar transaction involves two opposite payments in, respectively, euro and dollars that are effected independently in payment systems for the two currencies, or via the parties' correspondent banks in euro and dollars.^[5]

The BIS method for calculation of settlement risk
Settlement of foreign-exchange transactions via correspondent banks and payment systems involves settlement risk since the parties must supply the sold currency without having any guarantee that they will receive the purchased currency^[6]. The exposure is equivalent to the purchased amount and lasts from the time of remittance of the sold currency until the time when the purchased currency has been received. The various settlement phases are illustrated in Chart 1.

As a minimum, the total exposure to settlement risk is equivalent to the sum of the transactions where payment of the sold currency is irrevocable, and where the purchased currency has not yet beenreceived, and the transactions where it is known with certainty that the purchased currency has not been received. In Chart 1, this is equivalent to the sum of status (2) and (5) transactions. To this should be added the potential settlement risk on transactions where receipt of the purchased currency has not yet been verified. In Chart 1, this means that a proportion of the status (3) transactions should be added to the exposure. The maximum exposure is thus the sum of status (2), (5) and (3) transactions.

The duration of a market participant's exposure to settlement risk on the individual transaction depends on the currencies traded and whether the transaction is settled via direct entry in payment systems or via the correspondent bank network. It is also of significance whether the two sides of the transaction are settled in different time zones.

Surveys from 1997 showed that the settlement risk on a transaction typically had a duration of 10-37 hours, depending on the currencies traded. In some cases, the duration of the settlement risk was more than three days. Consequently, a market participant's current total exposure to settlement risk could be the aggregate value of several days' trading.

Settlement via CLS
CLS is an international clearing and settlement system that settles foreign-exchange transactions in 15 currencies at present^[7]. CLS was established as a bank owned by 69 of the world's largest private banks. In CLS, the two eligible payment instructions relating to a foreign-exchange transaction are settled simultaneously, i.e. Payment versus Payment, PvP. The parties to the transaction only supply the currency they have sold if they simultaneously receive the currency they have bought. Consequently, the parties to a CLS transaction incur no mutual credit risk. CLS settlement is described in Box 3.

CLS currently has 55 direct participants (settlement members), whose foreign-exchange transactions are settled via accounts with CLS. Only CLS shareholders can join as direct participants. In addition, there are around 750 indirect participants (third parties), who submit and settle their foreign-exchange instructions via direct participants. Direct participants are typically large international banks, while the – relatively – smaller banks, brokers, funds and non-financial corporations often participate as indirect participants.^[8]

Transactions in CLS are settled by transferring the traded amounts between the relevant participants' accounts with CLS. The two sides of the transaction are entered to CLS' books simultaneously, i.e. PvP. Even though transactions are thus settled individually, the participants' payments to CLS are effected on a net basis^[9]. Net pay-ins are split into
several smaller pay-ins, which must be received by CLS at fixed times during the settlement day. Pay-outs to participants are made on an ongoing basis. Pay-ins to and pay-outs from CLS take place via the national RTGS^[10] systems. A participant need not be connected to all 15 RTGS
systems, but may choose to let a " nostro agent" handle its pay-ins and pay-outs. A total of 48 large banks, typically settlement members themselves, offer nostro services to CLS participants.^[11] For a more detailed description of CLS settlement see the Appendix.^[12]

Settlement risk in CLS
The establishment of CLS has changed the risk scenario for foreign-exchange settlement. The application of the PvP settlement principle has eliminated the traditional credit risk between the parties to a foreign-exchange transaction. Settlement still involves a certain degree of liquidity risk since pay-ins to CLS must observe tight deadlines. In the structure of CLS settlement, great importance has, however, been attached to limiting the participants' liquidity requirements and thus their liquidity risk. A core element is that pay-ins to CLS take place on a net basis. This reduces the liquidity requirement in CLS considerably, cf. Box 3. The liquidity requirement is reduced further by splitting the individual participants' pay-ins in a given currency into several smaller, time-lagged pay-ins. In addition, liquidity management is supported by a number of online facilities, issue of initial pay-in schedules, etc.

For indirect participants in CLS settlement, the risk scenario is slightly different. Indirect participants incur no credit risk on their trading counterparties, but instead they may incur a minor credit risk on the direct participant. This is the case if the indirect participant pays in the sold foreign exchange to the direct participant in the morning and receives the purchased foreign exchange during the day. Unlike settlement outside CLS, the settlement risk is always incurred intraday, and the exposure solely corresponds to the net amount for each of the currencies sold.^[13]

The concentration of settlement of foreign-exchange transactions in CLS means that risk is concentrated in CLS. CLS is a complex system that in practice interlinks 15 RTGS systems and 55 participants. Operational problems in the CLS system or settlement errors could therefore have a major global impact. For example, lacking or delayed pay-ins to CLS by one participant could delay pay-outs to other participants, so that RTGS systems in other countries might have to stay open for longer.

As a provision against system failures, parallel operation of the CLS system has been established in London and New York, and a complete " out of region" back-up solution is underway. When this solution has been fully implemented as planned in 2007, CLS will comply with the US authorities' enhanced requirements^[14] after the attacks on the World Trade Center in New York on 11 September 2001. In addition, further contingency planning ensures that settlement can be concluded even if the participant with the largest negative net position does not meet its payment obligations. Any losses in connection with settlement are covered by a loss sharing agreement between the direct participants, which are large, well-capitalised private banks.

CLS BANK INTERNATIONAL	Box 3
CLS was established in 2002 by some of the world's largest private banks in response to the BIS strategy's call for development of risk-reducing settlement facilities. CLS currently settles foreign-exchange transactions in 15 currencies. The Danish krone, along with the Norwegian krone and the Swedish krona, joined CLS in September 2003. New currencies are added on an ongoing basis. In April 2006, CLS settled an average of 125,000 foreign-exchange transactions daily, for a total value of 1,350 billion dollars. This is estimated to constitute around half of the global trade in foreign exchange.1 The distribution of CLS settlement by currencies is shown in the Chart below. As the Chart illustrates, a large share of the foreign-exchange transactions have one leg in dollars. The participants' payments to CLS are netted. Total daily pay-ins to CLS in April 2006 averaged 42 billion dollars, compiled as the sum of all net pay-ins translated into dollars. Net pay-ins constitute between 1 and 8 per cent of the gross settlement, which is the total trading value, depending on the currency. The Chart shows the netting effect (net pay-ins as a percentage of gross settlement) for the various currencies. It is seen that the netting effect increases with the gross settlement value for the currency in question. The largest gross daily settlement value in CLS so far was just over 2,700 billion dollars. Total net pay-ins were 51 billion dollars. This record was achieved on 20 September 2006, the date on which quarterly futures settlement took place. The record for number of transactions, just over 250,000, was set on 17 January 2006, the day after Martin Luther King Day in the USA. Transactions in dollars cannot be concluded for settlement on US public holidays. The general pattern in connection with US public holidays is that settlement is postponed until the following day, so that the settlement volume in dollars almost doubles on these days.
TRANSACTION VALUE AND NETTING EFFECT IN CLS BY CURRENCIES
Note: Averages for April 2006.
1 The CLS settlement figures are not directly comparable with the BIS statistics for global foreign-exchange trading.

Overall, settlement of foreign-exchange transactions via CLS reduces the settlement risk considerably compared with traditional settlement methods. This is confirmed by a survey of the settlement risk of large US CLS participants two years after the introduction of CLS.^[15] The aggregate settlement risk in the foreign-exchange market can thus be reduced by increasing the proportion of transactions settled via CLS. CLS is continuously working to introduce new currencies and products in CLS settlement. In future, this will enable CLS participants to settle a larger share of their foreign-exchange transactions via CLS. In addition, an influx of new participants is essential to the further growth of CLS settlement. Primarily the number of indirect participants is expected to rise.

FOREIGN-EXCHANGE SETTLEMENT BY DANISH MARKET PARTICIPANTS

In the spring of 2006, BIS launched a survey of settlement risk on foreign-exchange transactions. The purpose is to establish the extent to which the objectives of the BIS strategy have been met, and whether further measures are required in order to reduce settlement risk. Approximately 100 financial institutions and enterprises from around 20 countries participate in the BIS survey. The participants have been selected with a view to covering at least 80 per cent of the foreign-exchange trading in the country in question. In addition, importance has been attached to the inclusion of different types of market participant, including both CLS participants and market participants without CLS access. For the purpose of the survey, the participants have supplied data for foreign-exchange transactions settled in April 2006 and answered questions about how they manage settlement risk in practice. The survey is based on the BIS definitions, cf. above. BIS expects to publish a report on the findings of the survey in 2007.

Danmarks Nationalbank is responsible for the Danish part of the survey, comprising seven Danish market participants. Two of these do not currently have access to CLS settlement. Some of the results of the Danish part of the survey are outlined below. First, different settlement methods used by Danish participants are described. This is followed by a review of the participants' foreign-exchange settlement within and outside CLS, respectively. For settlement outside CLS, the exposure to settlement risk is calculated, as well as its duration and the concentration of settlement risk on the Danish participants' counterparties. Finally, the Danish participants' management of settlement risk in practice is described.

Settlement methods used in Denmark
Chart 3 shows the distribution by settlement methods for the seven Danish participants in the BIS survey. The five participants that have direct or indirect access to CLS settle an average of approximately 80 per cent of their transactions via CLS. The remaining transactions are settled via the traditional channels for international payments, or alternatively via own accounts¹⁶ and bilateral netting¹⁷. Indirect participants in CLS, who do not trade on behalf of customers, have the option to settle via CLS only. This is the case for one of the Danish participants in the survey, cf. Chart 3.

The two participants in the survey that do not have access to CLS mainly settle foreign-exchange transactions in the traditional manner via correspondent banks and/or payment systems. Consequently, these participants are exposed to settlement risk equivalent to the full amount of the purchased currency.

Danish participants' use of CLS
The BIS survey shows that CLS is now the most common method for settlement of foreign-exchange transactions among the large market participants in Denmark. This means that the credit risk on foreign-exchange settlement has been reduced significantly, which also benefits financial stability in Denmark.

Chart 4 shows CLS settlement in kroner on the basis of CLS data. It is seen that net pay-ins are very small relative to the aggregate value of the transactions settled, which illustrates the liquidity savings from net pay-ins, cf. above. On certain days – Danish or US public holidays – very few transactions in kroner are settled, if any. The reason is that the other leg in krone transactions is virtually always in dollars.

The tight deadlines for pay-ins for CLS settlement require strict liquidity management by the participants. For the Danish CLS participants, the largest single pay-ins on a daily basis are typically kr. 1-2 billion, but pay-ins exceeding kr. 10 billion are seen a few times a year. No Danish CLS participant has indicated that the tight deadlines and the size of the individual pay-ins are problematic.

The BIS survey shows that on average approximately 20 per cent of the Danish CLS participants' foreign-exchange transactions are still settled in the traditional manner or via other settlement methods that involve some risk. The primary reason is that not all transactions can be settled via CLS. According to the participants, this applies to transactions in currencies or with counterparties that are not part of CLS, or transaction types, e.g. intraday transactions, that cannot be settled via CLS.

Danish participants' settlement via correspondent banks and payment systems
Foreign-exchange transactions settled via traditional channels for international payments involve settlement risk on the full transaction amount, cf. above. It is important that the Danish market participants are aware of the size and duration of their exposures when settling outside CLS, and know how to reduce and manage such settlement risk.

Size of the settlement risk
Chart 5 shows the total average daily exposures to settlement risk for the Danish participants in the BIS survey, except the one participant that always settles via CLS. The Chart shows that, after dollars, euro and kroner are the most frequently traded and settled currencies. On average, the Danish participants' aggregate daily exposure to settlement risk is approximately 34 billion dollars for all currencies taken as one. The exposures of the individual participants vary considerably in size.

In order to show whether these large exposures to settlement risk constitute a serious risk, the exposure of each participant can be compared to its equity capital. For participants with access to CLS, the exposure is lower than the equity capital in some cases, but slightly higher in other cases. For one of the participants without access to CLS, the exposure is several times the equity capital. This means that delayed payments from or failure of just a few counterparties could have serious implications, and consequently this participant must be extra prudent in its management of settlement risk. 

Duration of the settlement risk
The exposure to settlement risk lasts from the time when payment of the sold currency becomes irrevocable to the time when final receipt of the purchased currency is verified, cf. Chart 1. Table 1 shows the exposures in hours of Danish participants in the BIS survey to settlement risk. The duration is calculated using the BIS definition and is shown for
selected currencies. The longest and shortest exposures of the Danish participants are shown and averages calculated.

It is seen that the duration of the participants' exposures to settlement risk varies considerably. The BIS survey shows that the variation is attributable to major differences in the settlement practices of the participants. One participant has thus reduced the duration of the exposure to settlement risk, so that only intraday risk is incurred for the most frequently traded currencies^[18]. In contrast, one of the participants without access to CLS settlement is exposed to settlement risk for a far longer time than the other Danish participants.

For the individual participant, the duration of the exposure varies, depending on the currencies traded. This is a result of time differences, since the longest exposures are typically seen when the sold currency is from a more easterly time zone than the purchased currency^[19]. The longest average exposures of the Danish participants relate to purchases of dollars, euro or kroner against yen, but the dollar/euro and dollar/kroner exposures are also long.

Concentration of the settlement risk
If the purchased currency is received from a small number of counterparties, the settlement risk is concentrated. This implies greater dependency on the individual counterparty meeting its obligations than if the settlement risk is distributed on a larger number of counterparties. The Danish participants in the BIS survey that have access to CLS spread their settlement risk on many counterparties, while the two participants that do not have access to CLS spread their settlement risk on a smaller number of counterparties.

Danish participants' management of settlement risk
The size and duration of the exposure to settlement risk may be considerable when transactions are settled outside CLS. However, market participants can actively limit their settlement risk by reducing the duration of the exposures. This can be done by postponing payment of the sold currency and/or by checking for receipt of the purchased currency at an earlier time.

The BIS survey shows that a few Danish participants have made considerable progress in their efforts to reduce the duration of the exposure. Among other things, they can enter payments directly to several of the relevant payment systems during the actual settlement day. Moreover, they check for receipt of the purchased currency regularly throughout the settlement day. One of the participants employs staff that check for certain currencies until 6 p.m. or later (Danish time) on the settlement day.

As Table 1 shows, however, several participants should be able to reduce the duration of their exposures substantially. For participants that settle solely via correspondent banks, the duration of the exposures can be reduced if agreements are concluded to postpone the deadline for remittance/withdrawal of amounts supplied. If settlement takes place via correspondent banks, receipt of the purchased currency cannot be verified until it has been confirmed by the correspondent bank, e.g. via a statement of account. The duration of the exposure may be reduced via an agreement with the correspondent bank to forward confirmation as soon as possible.

At present, it is not possible to eliminate settlement risk completely, and consequently market participants must be able to manage the existing settlement risk prudently. The Danish participants in the BIS survey have stated that they set limits to the exposure vis-à-vis the individual counterparties at any given time, depending on the credit ratings of the counterparties. In addition, the participants calculate their exposures to settlement risk on an ongoing basis. In other words, the participants manage their settlement risk in the same way as other types of credit risk.

CONCLUSION

Danmarks Nationalbank supports the BIS strategy to reduce the settlement risk on foreign-exchange transactions and participates in the work to implement this strategy. The most recent BIS survey shows that the Danish participants generally manage settlement risk prudently. There is, however, scope for further reduction of settlement risk. This particularly applies to market participants whose exposure to settlement risk is very large in relation to their equity capital. Even though the individual market participant can reduce the duration of the exposure, CLS is the only settlement method that ensures settlement of foreign-exchange transactions without credit risk on the counterparty. Indirect participation in CLS significantly limits the credit risk.

Appendix: Structure of CLS Settlement

CLS settlement participants hold multi-currency accounts with CLS, in which their balances in the various CLS currencies are registered. On the basis of the trading instructions submitted, CLS calculates the participants' net positions in each currency. Pay-ins to CLS take place in the national RTGS systems by transfer of the relevant amounts from the participants to the CLS account at the central bank and are automatically credited to the participants' accounts with CLS.

Foreign-exchange transactions are settled by transferring the amounts between the relevant participants' accounts with CLS. The two eligible payment instructions are settled simultaneously (PvP). Settlement of a transaction takes place subject to a number of risk measures, including that a participant's overall balance for all currencies must not be negative. This ensures that CLS does not incur a credit risk on the participants.^[20]

In connection with pay-outs, CLS transfers funds from its own central bank account to the participants' central bank accounts via the national RTGS systems. At the same time, the pay-outs are debited to the participants' accounts with CLS. Pay-out are subject to CLS risk measures. If a participant does not have an account in an RTGS system, or does not have access to sufficient liquidity in a given currency, a nostro agent^[21] in the relevant currency may be used.

The participants' pay-ins to and pay-outs from CLS are effected in the national RTGS systems for the currencies in question, as described above. To allow this, the RTGS systems must be open at the same time across the relevant time zones. Settlement in CLS has therefore been scheduled to take place between 7.00 a.m. and noon Central European Time (CET), i.e. afternoon/evening in Asia/Pacific and night/early morning in North America.^[22] The CLS settlement cycle is outlined in Box 4.

LITERATURE

BIS, 1996. Settlement Risk in Foreign Exchange Transactions, Report prepared by the Committee on Payment and Settlement Systems, Bank for International Settlements, March 1996.

BIS, 1998. Reducing Foreign Exchange Settlement Risk: A Progress
Report, Report prepared by the Committee on Payment and Settlement Systems, Bank for International Settlements, July 1998.

BIS, 2000. Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions, Basel Committee on Banking Supervision, Bank for International Settlements, September 2000.

BIS, 2005. Triennial Central Bank Survey. Foreign Exchange and Derivatives Market Activity in 2004. 

Board of Governors of the Federal Reserve System et al., 2003. Interagency Paper on Sound Practices to Strengthen the Resilience of the U.S. Financial System, April 2003.

CLS Bank International, Regulator's Summary, International Rules and Member Handbook.

CLS home page: www.cls-services.com

Danmarks Nationalbank, 2005. Payment Systems in Denmark.

Norges Bank, 2000: Settlement risk in foreign exchange transactions. Economic Bulletin, Q4 2000.

The Payments Risk Committee, 2005. Foreign Exchange Settlement Risk, Report by the FX Settlement Risk Task Force, February 2005.