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The world’s central banks are cooperating to try and eliminate FX risk in international payments.

How Central Banks Cooperate to Reduce FX Risk in International SettlementsARTICLE

By Frances Coppola

Businesses that trade in multiple currencies are aware, of course, that they face many FX risks. But the source of certain FX risks is not always clear. In particular, the source of settlement risk can be obscure. While the world’s central banks are cooperating to try to eliminate settlement risk, it’s a work in progress – so it’s still important for financial decision makers to understand the mechanics behind settlement FX risk if they wish to minimize their exposure to it.

A forex contract is an agreement to exchange a quantity of one currency for a quantity of another. The ratio of the quantities is the exchange rate. So, for example, if a bank based in London enters into a forex contract to sell 100,000 pounds sterling and buy U.S. dollars at an exchange rate of 1.28, it will receive $128,000. We would expect this exchange to be instantaneous. But in practice, even with same-day settlement, the bank would not receive the dollars immediately. This is because London is five hours ahead of New York, where the U.S. leg of the contract would be processed. Thus, a trade done at 10 a.m. London time wouldn’t settle until New York trading begins two or three hours later (depending on time of year). During the intervening period, the bank incurs FX “settlement risk,” which is the risk that one leg of the contract will fail to settle. The FX risk is that the bank might pay 100,000 pounds sterling at 10 a.m. London time, but then fail to receive the $128,000 in return when New York opens.

How Herstatt Bank’s Failure Highlighted FX Risk In International Payments

This sort of FX risk is known as “Herstatt risk,” after a German bank whose failure in 1974 nearly caused meltdown of the international FX settlement system. At 3:30 p.m. local time on June 26, 1974, German regulators closed Bankhaus Herstatt. Normally, failure of a medium-sized European bank should not cause major disruption to the global financial system. But Bankhaus Herstatt was a major player in international forex. It acted as an intermediary for bank-to-bank forex trading involving Deutschmarks and U.S. dollars. The scale of its activities was far out of proportion to its size. Thus, when it failed, it was unable to meet its FX obligations.

When the regulators closed Bankhaus Herstatt, banks that had already paid deutschmarks and expected U.S. dollars to be delivered in New York found themselves out of pocket. Bankhaus Herstatt had not remitted funds to its New York correspondent banks, so the correspondent banks refused to deliver the dollars. Fearing that they in turn would be left out of pocket, other banks involved in the FX transactions halted outgoing payments for themselves and their customers. The chain reaction propagated across New York’s payments network. According to the Bank for International Settlements (BIS), the amount of gross funds transferred by this network declined by an estimated 60 percent in just three days.1

Herstatt Bank’s failure was one of the factors that led to the creation of central bank real-time gross settlement (RTGS) systems. The idea was that if transactions could be settled in real time, the time zone problem at the heart of the 1974 panic could be eliminated. Furthermore, since central banks can create unlimited quantities of their own currencies, no transactions would fail because of insolvency of an intermediary. So there is zero settlement risk in a U.S. dollar payment sent via Fedwire, for example, or in a sterling payment sent via CHAPs in the U.K.

Central Bank RTGS Systems Can’t Completely Eliminate Currency Risk

However, the introduction of central bank RTGS systems did not completely eliminate the FX risk highlighted by Bankhaus Herstatt’s failure. Central banks only have limited amounts of foreign currencies. So, to ensure that neither leg of the transaction could fail, two central bank RTGS systems needed to be involved – one for each currency. But this meant that the two legs of the FX deal would settle separately, each in their own time zone. There would be no risk of default, but there would still be another type of FX risk: in cross-currency transactions, settling the individual currencies in their own time zones can cause severe cash flow problems for banks and businesses.

An example provided by BIS makes the point: “For example, delivery of dollars to a bank in Japan by a U.S. bank in New York would occur during New York business hours, while the corresponding delivery of yen by the Japanese bank to its U.S. counterparty would occur during Tokyo business hours. The bank delivering yen could have to wait up to 12 hours before receiving dollars.”2

To resolve this problem, a group of banks called the G20 developed the Continuous Linked Settlement system (CLS), which would link together RTGS settlement in all major currencies so that FX transactions could be seamlessly done across time zones without incurring Herstatt risk.3

The CLS System – A Work In Progress

Since 2002, international FX settlement in major currencies has been executed via the CLS system. Currently, CLS settles 18 currencies and more are planned.4 CLS settles FX transactions in real time during a five-hour window when all 18 central bank RTGS systems are simultaneously online: the “legs” of FX transactions, including derivatives, are settled simultaneously. Transactions submitted after that window are stored until the next day.5

CLS eliminates Herstatt FX risk. But it does so by severely restricting the times during which FX transactions can be settled. This seemed a reasonable compromise when FX settlement was typically two days after the trade date and markets closed overnight. But now that trading activity continues day and night around the world, the five-hour CLS window appears too restrictive. A survey conducted by BIS in 2008 recommended that CLS should be extended to provide same-day settlement.6 In September 2013, CLS introduced same-day settlement of FX transactions in U.S. and Canadian dollars, including transactions submitted after the five-hour window.7 CLS says it is “actively seeking to extend the coverage of its settlement risk mitigation service - bringing in more participants, more currencies and providing more settlement sessions.”8

The Takeaway

The CLS system has successfully eliminated Herstatt FX risk for major currencies, and as more currencies join the system, the risk of losses in minor currencies will reduce too. Now, the challenge is to meet the needs of banks and businesses around the world for fast, reliable and secure FX settlement.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. "Settlement risk in foreign exchange markets and CLS Bank", BIS; http://www.bis.org/publ/qtrpdf/r_qt0212f.pdf
2. "Settlement risk in foreign exchange markets and CLS Bank", BIS, ibid.
3. "Mitigating Risk and Enhancing Financial Stability in the Global FX Market", CLS Group;https://www.cls-group.com/Publications/CLS Brochure DPS Web.pdf
4. Currencies, CLS Group; https://www.cls-group.com/About/Pages/Currencies.aspx
5. "How CLS works", CLS Group; https://www.cls-group.com/ProdServ/Settlement/Pages/How.aspx
6. "Progress in reducing foreign exchange settlement risk", BIS; http://www.bis.org/cpmi/publ/d83.pdf
7. "Same day settlement", CLS Group; https://www.cls-group.com/ProdServ/Pages/same-day-settlement.aspx
8. CLS Products & Services, CLS Group; https://www.cls-group.com/ProdServ/Pages/default.aspx

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