Supervisory Guidance for Managing Settlement Risk in Foreign Exchange Transactions

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 the size of the foreign exchange market makes FX transactions the greatest source of settlement risk for many market participants, involving daily exposures of tens of billions of dollars for the largest banks. Most significantly, for banks of any size, the amount at risk to even a single counterparty could in some cases exceed their capital.

2. FX settlement risk is a form of counterparty risk involving both credit risk and liquidity risk. As with other forms of risk, banks need to ensure that they have a clear understanding of how FX settlement risk arises. On the basis of this understanding, policies for managing the risk should be developed at the highest levels within the bank and implemented through a formal and independent process with adequate senior management oversight. As part of this process, a bank has to have measurement systems that provide appropriate and realistic estimates of FX settlement exposures on a timely basis. The development of counterparty settlement limits and the monitoring of the exposures against these limits is a critical control function. The bank also needs to have procedures for reacting in a prompt and balanced manner to failed transactions or other settlement problems.

3. The purpose of this guidance is to provide banking supervisors with information about FX settlement risk and its management that they should take into account when assessing a bank's policies and procedures. Establishing and implementing proper risk management policies can be a major task for a bank and it is likely that not all banks will have completed this task yet. However, understanding and recognition of FX settlement risk has increased significantly in recent years, not least because of the work of the Committee on Payment and Settlement Systems (CPSS) 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). All banks should therefore be expected to have a good understanding of FX settlement risk and to have formulated clear and firm plans for how to manage it. Even if those plans have not yet been fully implemented, the process of doing so should be well underway.

4. This guidance was drawn up in close consultation with the CPSS. It has also benefited from comments received on the consultative draft issued in July 1999.