Central bankers call for more action to reduce foreign exchange settlement risk (publication of consultative report)

Note: The original deadline for comments (12 October 2007) indicated in the report has been extended to 11 January 2008

"The financial services industry has made significant progress in dealing with foreign exchange settlement risk. However, more can and should be done to tackle remaining exposures and to guard against the risk of reversing the progress that has already been achieved," said Timothy F Geithner, President of the Federal Reserve Bank of New York and Chairman of the Committee on Payment and Settlement Systems (CPSS).

The CPSS has today published a consultative report, Progress in reducing foreign exchange settlement risk, that contains the results of a major survey of how over 100 banks and other institutions active in the FX market manage the risks that can arise when settling foreign exchange transactions. The report contains specific recommendations for individual institutions, industry groups and central banks to reduce and control remaining exposures that may still present systemic risk and to guard against possible backsliding. The report is available on the BIS website, www.bis.org.

"Foreign exchange settlement risk has long been a concern of the G10 Governors and the CPSS due to the implications for systemic risk. Because the survey shows that more needs to be done, central banks will explore ways to work with banking supervisors and other regulators to ensure that financial institutions adequately control their foreign exchange settlement exposures on an ongoing basis," said Mr Geithner.

"The Basel Committee on Banking Supervision welcomes this important report, and we have already begun to discuss how best we can work with the CPSS to encourage further progress," said Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision.

In 1996 the G10 central banks endorsed a comprehensive long-term strategy to reduce the systemic risk that arose from the way foreign exchange transactions were settled. The survey results just published show that the strategy has achieved significant success. In particular, 55% of FX obligations are now settled using CLS, a specialised service for settling FX trades on a "payment-versus- payment" basis. "This important accomplishment reflects the strong policy commitment, resources and efforts of major banks and other institutions across the globe in taking up central banks' call for industry action to reduce FX settlement risk," said Mr Geithner.

However, more needs to be done. For instance, the survey shows that 45% of FX transactions are still settled outside CLS, with most of these using traditional mechanisms that are subject to foreign exchange settlement risk. Furthermore, half of all FX settlement exposures last overnight, not just intraday.

In the light of this evidence, the report proposes an overall strategy consisting of recommended actions for individual institutions, industry groups and central banks:

• At the most basic level, individual institutions need to ensure that the risk controls and incentives they have in place support fully informed and appropriate choices among available FX settlement methods.  
• Industry groups are encouraged to continue to develop services for settling FX trades that will help to reduce risk, particularly services for settling same day and certain next day trades.  
• The report also indicates a number of steps central banks will take to encourage continued progress by the financial industry.

Information for editors

The report is being issued now as a consultation document and comments are invited from any interested parties. Comments should be sent to the CPSS Secretariat (cpss@bis.org) by 12 October 2007; e-mails should mention foreign exchange settlement risk in the subject line of the e-mail. The comments will be published on the BIS website, www.bis.org, unless commentators have requested otherwise. A final version of the report will be published after the consultation period has ended.

What is the CPSS?

The Committee on Payment and Settlement Systems (CPSS) is a forum for central banks to monitor and analyse developments in payment and settlement arrangements and to consider related policy issues. The chairman of the CPSS is Timothy F Geithner, President of the Federal Reserve Bank of New York. The survey was coordinated by the CPSS Sub-Group on Foreign Exchange Settlement Risk. The chairman of the sub-group is Lawrence M Sweet, Senior Vice President of the Federal Reserve Bank of New York. The CPSS secretariat is hosted by the BIS. More information about the CPSS and its publications can be found at http://www.bis.org/cpss/index.htm.

What is foreign exchange settlement risk?

Foreign exchange settlement risk is the risk that one party to an FX trade pays out the currency it sold but does not receive the currency it bought. It consists of both liquidity risk (the risk that the purchased currency is not received when due) and credit risk (the risk that the purchased currency is not received when due or at any time thereafter). In this situation, a party's foreign exchange settlement exposure equals the full amount of the purchased currency. For more information about foreign exchange settlement risk and how it arises, see Settlement risk in foreign exchange transactions (BIS, 1996) which can be found at http://www.bis.org/publ/cpss17.htm

What is CLS Bank?

CLS Bank provides a means of settling foreign exchange transactions on a "payment versus payment" basis. Established in 2002, it currently settles on average more than $3 trillion each day in FX-related payment obligations in 15 currencies. CLS Bank is owned by private-sector banking and other financial institutions. For more information go to http://www.cls-services.com/.

What was the strategy launched by central banks in 1996?

The strategy for reducing foreign exchange settlement risk emphasised action by the private sector to tackle the problem. Specifically, it involved a three-track approach involving action by individual banks to control their foreign exchange settlement exposures, action by industry groups to provide risk-reducing multicurrency services and action by central banks to induce rapid private sector progress. The strategy was set out in Settlement risk in foreign exchange transactions (see above).