Settlement Risk—A Form of Credit Risk

 It was noted in Chapter 2 that foreign exchange trading is subject to a particular form of credit risk known as settlement risk or Herstatt risk, which stems in part from the fact that the two legs of a foreign exchange transaction are often settled in two different time zones,with different business hours. Also noted was the fact that market participants and central banks have undertaken considerable initiatives in recent years to reduce Herstatt risk. Two such efforts are worth mentioning. In October 1994, the New York Foreign Exchange Committee, a private-sector group sponsored by the Federal Reserve Bank of New York, published a study entitled Reducing Foreign Exchange Settlement Risk, which examined the problem of settlement risk from a broad perspective. The Committee found that foreign exchange settlement risk is much greater than previously recognized and lasts longer than just the time zone differences in different markets. In the worst case, a firm can be “at risk” for as long as 72 hours between the time it issues an irrevocable payment instruction on one leg of the transaction and the time payment is received irrevocably and unconditionally on the other leg. The Committee recommended a series of private sector “best practices” to help reduce Herstatt risk, including establishing arrangements to net payments obligations, setting prudent exposure limits, and reducing the time taken for reconciliation procedures. More recently, in March 1996, the central banks of the major industrial nations issued a report through the Bank for International Settlements, called Settlement Risk in Foreign Exchange Transactions, which highlighted the pervasive dimensions of settlement risk, expressed concern about the problem, and suggested an approach for dealing with it. The report confirmed the finding of the New York Foreign Exchange Committee that foreign exchange settlement exposure can last up to several days, and it recommended a three-track strategy calling for: individual banks to improve management and control of their foreign exchange settlement exposures industry groups in the private sector to provide services that will contribute to the risk reduction efforts of individual banks; and Some steps have been taken to reduce settlement risk, and others are being considered to help deal with this problem. There are “back-end” solutions, using netting and exchange clearing arrangements to modify the settlement process and “front-end”solutions,which change the nature of the trade at the outset,modifying what is to be exchanged at settlement.   Steps have also been taken to improve central bank services in order to reduce foreign exchange settlement risk. At the beginning of 1998, the Federal Reserve extended Fedwire operating hours.Fedwire is now open 18 hours a day. Its operational hours overlap with the national payment systems in all other major financial centers around the world. Similarly, CHIPS has expanded its hours and introduced other improvements.

Settlement Risk—A Form of Credit Risk

CREDIT RISK

 Credit risk, inherent in all banking activities, arises from the possibility that the counterparty to a contract cannot or will not make the agreed payment at maturity. When an institution provides credit, whatever the form, it expects to be repaid. When a bank or other dealing institution enters a foreign exchange contract, it faces a risk that the counterparty will not perform according to the provisions of the contract. Between the time of the deal and the time of the settlement, be it a matter of hours, days, or months, there is an extension of credit by both parties and an acceptance of credit risk by the banks or other financial institutions involved. As in the case of market risk, credit risk is one of the fundamental risks to be monitored and controlled in foreign exchange trading. In banking, the reasons a counterparty may be unwilling or unable to fulfill its contractual obligations are manifold.There are cases when a corporate customer enters bankruptcy, or a bank counterparty becomes insolvent, or foreign exchange or other controls imposed by governmental authorities prohibit payment. If a counterparty fails before the trade falls due for settlement (pre-settlement risk), the bank’s position is unbalanced and the bank is exposed to loss for any changes in the exchange rate that have occurred since the contract was originated. To restore its position, the bank will need to arrange a new transaction, and very likely at an adverse exchange rate, since no one defaults on a contract that yields positive gains. In situations of bankruptcy, a trustee for the bankrupt company will endeavor to “cherry pick,” or perform according to the terms on those contracts that are advantageous to the bankrupt party, while disclaiming those that are disadvantageous. In foreign exchange trading, banks have long been accustomed to dealing with the broad and pervasive problem of credit risk. “Know your customer” is a cardinal rule and credit limits or dealing limits are set for each counterparty—presumably after careful study of the counterparty’s creditworthiness—and adjusted in response to changes in financial circumstances. Over the past decade or so, banks have become willing to consider “margin trading” when a client requires a dealing limit larger than the bank is prepared to provide. Under this arrangement, the client places a certain amount of collateral with the bank and can then trade much larger amounts. This practice often is used with leveraged and hedge funds.Also,most institutions place separate limits on the value of contracts that mature in a single day with a single customer, and some restrict dealings with certain customers to spot only, unless there are compensating balances. A bank’s procedures for evaluating credit risk and controlling exposure are reviewed by bank supervisory authorities as part of the regular

CREDIT RISK

Value at Risk

 The rapid growth of derivatives in recent years—growth both in the amounts traded and in the innovative new products developed—has introduced major new complexities into the problem of measuring market risk. Banks and other institutions have seen the need for new and more sophisticated techniques adapted to the changed market situation. Consider, for example, the question of the valuation of derivatives. If a trader entered into a contract for the forward purchase of $10 million of pounds sterling six months hence at today’s 6-month forward price for GBP, the notional or face value of the contract would be $10 million. The market value (gross replacement value) of the contract would at the outset be zero—but that market value could change very abruptly and by significant amounts. Neither the notional value of that forward contract nor the snapshot of the market value as of a particular moment provides a very precise and comprehensive reflection of the risk, or potential loss, to the trader’s book. For currency options, the problem is much more complex—the value of an option is determined by a number of different elements of market risk, and values can change quickly, moving in a non-linear fashion. Market participants need a more dynamic way of assessing market risk as it evolves over time, rather than measuring risk on the basis of a snapshot as of one particular moment, or by looking at the notional amounts of funds involved. In a report of the Group of Thirty entitled Derivatives: Practices and Principles, industry members recommended a series of actions to assist in the measurement of market risk. They recommended that institutions adopt a “value at risk” (VAR) measure of market risk, a technique that can be applied to foreign exchange and to other products. It is used to assess not only the market risk of the foreign exchange position of the trading room, but also the broader market risk inherent in the foreign exchange position resulting from the totality of the bank or firm’s activities. VAR estimates the potential loss from market risk across an entire portfolio, using probability concepts. It seeks to identify the fundamental risks that the portfolio contains, so that the portfolio can be decomposed into underlying risk factors that can be quantified and managed. Employing standard statistical techniques widely used in other fields, and based in part on past experience, VAR can be used to estimate the daily statistical variance, or standard deviation, or volatility, of the entire portfolio. On the basis of that estimate of variance, it is possible to estimate the expected loss from adverse price movements with a specified probability over a particular period of time (usually a day).

Value at Risk

MARKET RISK

 Market risk, in simplest terms, is price risk, or “exposure to (adverse) price change.” For a dealer in foreign exchange, two major elements of market risk are exchange rate risk and interest rate risk—that is, risks of adverse change in a currency rate or in an interest rate. Exchange rate risk is inherent in foreign exchange trading. A trader in the normal course of business—as he buys or sells foreign currency to a customer or to another bank—is creating an “open” or “uncovered” position (long or short) for his bank in that currency, unless he is covering or transferring out of some previous position.Every time a dealer takes a new foreign exchange position—in spot, outright forwards, currency futures, or currency options—that position is immediately exposed to the risk that the exchange rate may move against it, and the dealer remains exposed until the transaction is hedged or covered by an offsetting transaction. The risk is continuous—and a gap of a few moments or less can be long enough to see what was thought to be a profitable transaction changed to a costly loss. Interest rate risk arises when there is any mismatching or gap in the maturity structure. Thus, an uncovered outright forward position can change in value, not only because of a change in the spot rate (foreign exchange risk), but also because of a change in interest rates (interest rate risk), since a forward rate reflects the interest rate differential between the two currencies. In an FX swap, there is no shift in foreign exchange exposure, and the market risk is interest rate risk. In addition to FX swaps and currency swaps, outright forwards, currency futures, and currency options are all subject to interest rate risk. There are two forms of market risk—an adverse change in absolute prices, and an adverse change in relative prices.With respect to relative price changes,“basis risk”is the possibility of loss from using, for example, a U.S. dollar position to offset Argentine currency exposure (in the expectation that the Argentine currency will move in step with the U.S. dollars), and then seeing the Argentine currency fail to maintain the relationship with the U.S. dollar that had been expected. It can also occur if a short-term interest rate that was used to offset a longer-term interest rate exposure fails to maintain the expected relationship because of a shift in the yield curve. To limit basis risk, traders try to stay well informed of statistical correlations and covariances among currencies,as well as likely yield curve trends. Various mechanisms are used to control market risk, and each institution will have its own system. At the most basic trading room level, banks have long maintained clearly established volume or position limits on the maximum open position that each trader or group can carry overnight, with separate—probably less restrictive—intraday or “daylight” limits on the maximum open position that can be taken during the course of a trading session. These limits are carefully and closely monitored, and authority to exceed them, even temporarily, requires approval of a senior officer.

MARKET RISK

BACK OFFICE PAYMENTS AND SETTLEMENTS

Every time a deal to buy or sell foreign exchange is agreed upon by two traders in their trading rooms, a procedure is set in motion by which the “back offices”of the two institutions confirm the transaction and make the necessary funds transfers. The back office is usually separated physically from the trading room for reasons of internal control—but it can be next door or thousands of miles away. For each transaction, the back office receives for processing the critical information with respect to the contract transmitted by the traders, the brokers, and the electronic systems. The back offices confirm with each other the deals agreed upon and the stated terms—a procedure that can be done by telephone, fax, or telex, but that is increasingly handled electronically by systems designed for this purpose. If there is a disagreement between the two banks on a relevant factor, there will be discussions to try to reach an understanding. Banks and other institutions regularly tape record all telephone conversations of traders. Also, electronic dealing systems and electronic broking systems automatically record their communications. These practices have greatly reduced the number of disputes over what has been agreed to by the two traders. In many cases, banks participate in various bilateral and multilateral netting arrangements with each other, instead of settling on the basis of each individual transaction. As discussed in Chapter 8, netting, by reducing the amounts of gross payments, can be both a cheaper and safer way of settling. Payments instructions are promptly exchanged—in good time before settlement—indicating, for example, on a dollar-yen deal, the bank and account where the dollars are to be paid and the bank and account where the yen are to be paid. On the value date, the two banks or correspondent banks debit-credit the clearing accounts in response to the instructions received. Since 1977, an automated system known as SWIFT (Society for the Worldwide Interbank Financial Telecommunications) has been used by thousands of banks for transferring payment instructions written in a standardized format among banks with a significant foreign exchange business. When the settlement date arrives, the yen balance is paid (for an individual transaction or as part of a larger netted transaction) into the designated account at a bank in Japan, and a settlement occurs there. On the U.S. side, the dollars are paid into the designated account at a bank in the United States, and the dollar settlement—or shift of dollars from one bank account to another—is made usually through CHIPS (Clearing House Interbank Payments System), the electronic payments system linking participating depository institutions in New York City.

BACK OFFICE PAYMENTS AND SETTLEMENTS