An influential committee of central bankers has called on the industry to do more to drive out temporal risk in foreign exchange settlement, amid concerns that the full potential of private sector risk reduction efforts such as that offered by CLS Bank is not being realised.
A consultative report, based on a global survey of 109 institutions by the BIS Committee on Payment and Settlement Systems (CPSS), has called for further action to reduce foreign exchange settlement risk. It finds that CLS Bank was used to settle 55% ($2.1 trillion) of the total FX settlement obligations of the surveyed institutions as of April 2006. But 32% of FX settlement still occurred through traditional correspondent banking arrangements, where the size and duration of risk exposures is significant.
While this is an improvement from 1997, when an estimated 85% of the obligations were settled via correspondent banking arrangements, the industry still needs to do more, according to Timothy F Geithner, President of the Federal Reserve Bank of New York and Chairman of the Committee on Payment and Settlement Systems (CPSS).
"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," he said.
The survey finds that the duration of FX settlement exposures in correspondent banking arrangements remains significant - on average, significantly more than 24 hours. And the $1.2 trillion of daily obligations settled by this method generate exposures on a single day basis that reach an estimated maximum of $0.9 trillion (i.e. 71% of $1.2 trillion) for the irrevocable period of the trade cycle (between when the trade can no longer be revoked and when the receipt of bought currency is due.)
Traditional correspondent banking leads to exposures when settling FX trades because there is no direct link between the payment of the two currency legs and thus there is a risk of paying the currency sold but not receiving the currency bought.
Based on the results of the survey, CPSS makes a number of recommendations for action. Individual institutions, it says, need to ensure that the risk controls and incentives they have in place support fully informed and appropriate choices among available FX settlement methods.
Meanwhile, industry groups should 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.
It also recommends that central banks work more closely with banking and non-bank regulators to support potential improvements in local payments law and the operations of large-value payment systems and to encourage appropriate risk management procedures for FX settlement exposures.
The CPSS is calling for comments its survey and recommendations from interested parties.
Rick Schumacher, product manager at Wall Street Systems, says that CLS Bank has done a great job of supporting growth in FX trading and reducing settlement risk, but the industry is concerned about the cost of using it to settle trades. "CLS certainly has its place, but there's a real desire to bring the cost down. It's hard to justify a buck or two a trade," he says. "That's why there are a number of other initiatives underway, looking at things such as pre-netting over certain platforms to reduce the volume of data going over CLS.
"For bank to non-bank transactions, the banks are also creating additional solutions outside CLS within their own infrastructures to let clients confirm their own trades or attach settlement instructions. This kind of thing helps to reduce cost and risk and also adds value for the bank's clients."