Are you measuring your Settlement Risk exposures correctly?
The Global FX Committee recently strengthened its language on Settlement Risk in the FX Global Code, with a particular emphasis on the proper measurement, monitoring and control of exposures.
The emphasis on measurement is important. Settlement Risk is the risk of loss of principal when a counterparty to an FX transaction pays away the currency it sold and does not receive the currency that it purchased.
Delay between payment and reconciliation
Accepted industry practice is to mark settlement risk exposure against a counterparty to a trade, for the value date of that trade. This approach ignores the fact that for a significant portion of trades, payments are released and made irrevocable on the day prior to settlement, and the inbound settlement is not reconciled until the day after settlement. This “Settlement Window” may be extended due to time zone differences, processes or the “I will pay you once you’ve paid me” problem discussed in Part 2 of this series.
Consider a European bank selling AUD and buying USD. Due to time differences they must send the AUD payment before leaving the office on the day prior to settlement, so that it can be settled during the local settlement window. The inbound USD payment is received on the settlement date, but after the European bank has closed for the day, and is only reconciled as having been received with finality on the following day.
In this case the bank has been exposed to settlement risk for three days, the day prior to settlement date, settlement date itself, and the day after. Extrapolate this to AUD payment instructions being released on a Friday and USD funds being reconciled on Tuesday and we have a five-day settlement window.
As a result, it is not unusual for a financial institution's actual settlement exposures to exceed their capital.
Settlement risk is understated at an industry level
The industry practice of settlement risk exposures being applied only on the value date of the trade dramatically understates the actual duration of the settlement exposure of the trade, and by extension results in banks reserving less capital against credit risk than should be the case.
A more nuanced approach to the measurement of settlement risk would consider the direction of trades and the operational processes that support settlement of each currency pair, which may differ for each currency pair and will create a challenge for any any form of standardisation.
Alternatively, by eliminating settlement risk from your FX business through PvP settlement, you remove the issue of under-measuring credit exposures, and ensure alignment with the FX Global Code.
Settlement Circle’s Settlement Optimisation Service (SOS) is available to all market participants and across all currencies. Let’s have a chat about how using our service can ensure best practice and eliminate settlement risk.
By Declan Clements, November 2021
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