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